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The Agile Manager™s Guide To

UNDERSTANDING
FINANCIAL STATEMENTS
The Agile Manager™s Guide To

UNDERSTANDING
FINANCIAL STATEMENTS
By Joseph T. Straub




Velocity Business Publishing
Bristol, Vermont USA
For Pat and Stacey
Velocity Business Publishing publishes authoritative works of the
highest quality. It is not, however, in the business of offering profes-
sional, legal, or accounting advice. Each company has its own cir-
cumstances and needs, and state and national laws may differ with
respect to issues affecting you. If you need legal or other advice
pertaining to your situation, secure the services of a professional.
Copyright © 1997 by Joseph T. Straub
All Rights Reserved
Printed in the United States of America
Library of Congress Catalog Card Number 97-90831
ISBN 0-9659193-5-8
Title page illustration by Elayne Sears
Second printing, April 1999
If you™d like additional copies of this book or a catalog of
books in the Agile Manager Series„, please get in touch.
n Write us:
Velocity Business Publishing, Inc.
15 Main Street
Bristol, VT 05443 USA
n Call us:
1-888-805-8600 in North America (toll-free)
1-802-453-6669 from all other countries
n Fax us:
1-802-453-2164
n E-mail us:
action@agilemanager.com
n Visit our Web site:
www.agilemanager.com
The Web site contains much of interest to business people”tips
and techniques, business news, links to valuable sites, and instant
downloads of titles in the Agile Manager Series.
Contents


Introduction ......................................................................... 7

1. Financial Statements:
Who Needs Them ........................................................... 9
2. Understand the Income Statement ............................... 17
3. Understand the Balance Sheet ...................................... 27
4. Understand the Cash-Flow Statement .......................... 37
5. Financial Analysis:
Number-Crunching for Profit ...................................... 45
6. Inventory Valuation
(Or, What™s It Worth?) ................................................... 67
7. Depreciation .................................................................. 77

Glossary .............................................................................. 85
Index .................................................................................. 93
Books in the Agile Manager Series„:

Giving Great Presentations
Understanding Financial Statements
Motivating People
Making Effective Decisions
Leadership
Goal-Setting and Achievement
Delegating Work
Cutting Costs
Influencing People
Effective Performance Appraisals
Writing to Get Action
Hiring Excellence
Building and Leading Teams
Getting Organized
Extraordinary Customer Service
Customer-Focused Selling
Managing Irritating People
Coaching to Maximize Performance
Introduction


It happens.
You™re at a meeting, and the boss looks right at you and says,
“What™s the ROI on that product again?”
You gulp, trying desperately to remember what “ROI” means.
You search your mind for the “R.” Revenue? Ratio? Return?
You have no idea. Rats. Turning red, you mumble, “Gee, I don™t
know offhand. I can get back to you, though.”
The boss stares at you a few seconds before changing the
subject. He doesn™t even have to say it out loud: “I expect you to
know these things.”
Or you™re in a job interview, and the interviewer is testing
your facility with numbers. “The job requires a passing ability
to make sense of the department™s finances. Nothing too diffi-
cult. Take a look at these for a few minutes,” she says, shoving
what appear to be financial statements in front of you. “When
you™re ready, tell me what the debt-to-equity ratio is. And while
you™re at it, the current ratio and return on equity.” She gives
you a quick smile, as if it were the easiest thing in the world to
pull those figures off the papers in front of you.

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8 THE AGILE MANAGER™S GUIDE TO UNDERSTANDING FINANCIAL STATEMENTS


Actually, coming up with those figures is one of the easier
things to do in the business world. Once you become acquainted
with such things as the income statement and balance sheet, the
numbers leap off the page at you.
The Agile Manager™s Guide to Understanding Financial Statements
is your guide. You™ll learn what the most-used financial state-
ments are and what they tell you. You™ll learn useful ratios that
will enable you to analyze your operations and improve them.
You™ll learn how to assess the financial health of your company,
an important skill as companies come and go faster than ever.
And you™ll attract the notice of higher-ups, who tend to pro-
mote those who understand the profit motive and use the lan-
guage of numbers.
Best of all, you™ll acquire peace of mind.You™ll see that num-
bers aren™t scary things, that they™re simply another language
that sheds light on business operations. And that speaking in the
language of numbers is none too difficult to learn.
You can read Understanding Financial Statements in one or two
sittings, then refer to it again and again as you need to. The
contents, glossary, and index”and the “Best Tips” and “Agile
Manager™s Checklist” boxes”make it easy to find what you™re
looking for.
In short, The Agile Manager™s Guide to Understanding Financial
Statements will help you get maximum benefits in your job and
career with the least amount of effort.
Chapter One


Financial Statements:
Who Needs Them




“I don™t know. It™s a mysterious thing.”
ROGER SMITH, FORMER GENERAL MOTORS CHAIRMAN (WHEN ASKED
BY FORTUNE TO EXPLAIN THE CAUSE OF GM™S FINANCIAL WOES)




“Here you go, partner,” said the Agile Manager to Steve, his
assistant, as a he threw a small stack of stapled sheets on the desk.
Steve looked up quizzically. “The quarterlies. There™s a note for
you on top.”
“The quarterly whats?” asked Steve as he looked down and
saw rows of numbers on the top page.
“Our quarterly financial statements,” responded the Agile Man-
ager. He had meant only to toss them on the desk as he strode by,
but now he laid his clipboard down and leaned toward Steve. “I
need you to calculate a few ratios for me before Wednesday™s
department meeting.”
Steve™s heart began to pound and his face turned red. The Agile
Manager noticed and said, “What™s the big deal? You have an
MBA, right?”
“Who told you that? I was an English major.”

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10 THE AGILE MANAGER™S GUIDE TO UNDERSTANDING FINANCIAL STATEMENTS


The Agile Manager™s jaw dropped slightly. He™d inherited Steve
from his predecessor, and he couldn™t be happier with Steve™s or-
ganizational skills and business sense, especially his insight into
markets and the psychology buyers bring to it. “You™re kidding,”
he said.
“No.” Steve didn™t know whether to laugh or remain stone-faced.
“So what do you know about financial statements?”
“Nothing. And I™m scared to death of numbers,” he added. “I
don™t seem to understand them.” And he thought, I™m even more
afraid of people finding that out . . .
“Good!” said the Agile Manager, brightening. “Together we™ll
face that fear and you™ll be a better man because of it. And more
useful to me. We start tomorrow at 9:00 A.M.”
After the Agile Manager left, Steve was glum. He thought, Why
me? You don™t need financial statements to understand business,
anyway. Or do you?

Who needs financial statements? You, for starters, and for a
number of good reasons. But we™ll get back to that in a moment.
Plenty of other parties have a keen interest in what these odd
documents have to say, so let™s get them out of the way now.
We™ll save the best”what™s in it for you”for last.
Several groups of people have a vested interest in a company™s
financial statements. They include:
1. Management. Financial statements show the essence of
management™s competence and the sum total (pun intended) of
its success. Top managers may be able to hide behind the tinted
windows of stretch limos and armies of flunkies and assistants,
but the results of their decisions”and whether they™ve made or
lost money for the company”will show up on its financial state-
ments. They can run from the numbers, but they can™t hide.
2. Stockholders. Ever bought stock in a company because
the CEO dressed nicely or its products claimed to improve your
sex life? Probably not. More than likely, you bought stock be-
cause the company had a history of solid financial performance.
Or, if it was a new business, because you or your stockbroker
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Financial Statements: Who Needs Them


believed it would make some serious money down the road.
How could you tell? By what it reported on its financial state-
ments, of course. They reveal both past performance and future
potential. (And as Charlie Brown once observed, “There™s no
heavier burden than a great potential.”) So we invest in the pos-
sibilities that we uncover on the statements and bail out when
the statements signal inept management or a dim future. The
former usually precedes the latter.
Stockholders who don™t understand financial statements end
up relying solely on a stockbroker™s advice. That puts them at a
disadvantage. They don™t understand what the broker is talking
about, they can™t interpret the company™s annual report (although
the photographs probably look pretty), and they can™t ask intel-
ligent questions and make in-
BTest
formed decisions about whether
ip
to buy or sell. (One clue to cor-
porate trouble anyone can under- When you can read financial
stand: The worse shape a business statements, you won™t be to-
is in, the more flashy its annual tally dependent on the advice
report usually looks.) of stockbrokers or your depart-
3. Present and potential ment™s bean counter.
creditors. These include bond-
holders, suppliers, commercial
banks that may give the company a line of credit, landlords, and
anyone else the company might end up owing money to.
Creditors that have loaned money to a company with one
foot in the grave, or sold stuff to it on account, usually won™t
throw good money after bad. They™ll ask to see financial state-
ments if they suspect trouble. If they™re really nervous, they may
also demand more collateral (security) for the loans they™ve made
already.
One creditor reportedly made quite an exception for real-
estate developer Donald Trump, though.
Back when The Donald was in a bit of a bind, his chief num-
ber-cruncher managed to convince a major bank that had loaned
12 THE AGILE MANAGER™S GUIDE TO UNDERSTANDING FINANCIAL STATEMENTS


him money to pay the six-figure insurance premiums on the
Trump Princess, a yacht. Trump™s minion argued that Donald
couldn™t afford ™em, and if the insurance lapsed and the yacht
were destroyed, the bank would lose a major chunk of collateral.
So wouldn™t it be smart to pay the insurance? The bank did.
(Note: Trump is a professional. Don™t try this technique yourself.)
Potential creditors want to verify that the business is in good
shape and evaluate how much debt it can safely shoulder before
they commit themselves. After they™ve made the loan or given
the company an open-book account, they™ll demand, naturally,
to see future financial statements to confirm that the company
is staying afloat.
How important is it to be able to read financial statements?
Consider this. A graduate student who was working on his
master™s degree in accounting was sent out by a professor to

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