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because you™ve used funds to pay down the overall balance in
the account.
The company™s ending inventory was $940,000 lower than its
beginning inventory (you™ll find both inventory levels on the
income statement on page 22). That acts to free up (increase)
cash previously sitting in inventory.
Since depreciation on equipment didn™t physically decrease
the company™s cash balance”it™s only an accounting fiction”
accounting rules call for it to be shown as an inflow of cash
from operations.
Cash flows from investing activities. Cash may come in
and go out because of various investing activities that aren™t con-
nected to business as usual.
Figure 4-3 shows that A.I.™s management bought more than
$2 million worth of property and equipment (which caused cash
to go out) and sold some obsolete or unneeded equipment (which
brought cash in). The net effect of these investing activities de-
creased cash about $1.9 million.
The investment in property and equipment is an investment
in the company™s future; it should enhance its competitive posi-
tion. (Let™s have a round of applause for proactive management!)
And the inflow from equipment sales was minimal, a good
sign. Unlike some cash-strapped companies, A.I. hasn™t been
forced to sell off equipment to cover expenses.
A company that™s forced to do that is like a sinking ship that
jettisons its cargo to stay afloat. If it survives at all, it™ll just be an
empty shell that eventually washes up on the rocky shoals of
bankruptcy. There it™ll be picked clean by beachcombing scav-
engers such as vultures wearing Armani suits and fiddler crabs

Figure 4-3
Cash flows from investing activities
Purchase of property and equipment (2,080,695)
Proceeds from sale of equipment 160,000
Net cash used for investing activities ($1,920,695)
43
Understand the Cash-Flow Statement


Figure 4-4
Cash flows from financing activities
Sale of common stock 25,000
Sale of bonds 65,750
Cash dividends paid (50,000)
Net cash inflow from financing activities $40,750


wearing tiny little “IRS Swat Team” caps, mirrored sunglasses,
and, of course, white socks (required by their government con-
tract).
Cash flows from financing activities. A.I. raised $90,750 in
cash by selling common stock and bonds this year (see Figure
4-4). The company also paid out
BT
est
$50,000 in cash dividends to
ip
stockholders and ended up with
a net cash inflow of $40,750 from A company that has to rely on
financing activities. financing activities (such as
As Figure 4-1 shows, A.I. had selling stock or bonds) to sat-
a net increase in cash this year, isfy most of its cash require-
and most of its cash came from ments is headed for trouble.
operations. That™s good. Healthy
companies are able to meet their
normal cash requirements through operations.
Long-term financing (selling shares of stock or bonds, or get-
ting a multi-year loan) should be used to raise funds for acquir-
ing new machinery, equipment, or facilities”never to pay daily
business bills.
A negative cash flow from operations means that the com-
pany failed to meet its cash needs. In that case, the company
must lower expenses quickly or raise cash. The notes at the end
of one small corporation™s annual report discreetly revealed that
it was so hard up for cash that it had borrowed on the cash
surrender value of its life insurance policy on the chief execu-
tive officer!
The final entry on A.I.™s cash-flow statement is the ending
44 THE AGILE MANAGER™S GUIDE TO UNDERSTANDING FINANCIAL STATEMENTS


cash balance for the year, which is (no surprise) the same as the
cash balance on the balance sheet.



The Agile Manager™s Checklist
The cash-flow statement reconciles a company™s cash
balance from one year to the next.
The cash-flow statement shows the net cash flow from:
Normal operations;
s
s Investing activities, such as buying new equipment
and selling obsolete equipment;
s Financing activities, such as selling stock or bonds

and paying out dividends.
While depreciation is deducted on the income statement
to come up with net income, it doesn™t decrease the
company™s cash.
Note how much a company invested in its operations.
It™s a telling figure.
Chapter Five


Financial Analysis:
Number-Crunching for Profit




“Just dropped in to see what condition your condition was in.”
PARAPHRASE OF 1960S
LINE FROM A POPULAR SONG




“Besides return on investment for the products this department
produces, I like to look at companywide things like sales per em-
ployee and return on net assets,” said the Agile Manager.
“Why bother?” said Steve. “Don™t we have plenty of bean
counters at corporate to worry about stuff like that?”
“I don™t care whether we do or not. It™s part of my early warning
system. Tells me about the overall health of the company. If the
sales-per-employee figure is slipping, for example, then I™m careful
about requesting funds for a new hire. If the return on assets or
equity is declining, I can expect some kind of belt-tightening pro-
gram. It™s not a question of if, but when.”
“But how do you know what those numbers mean to the senior
managers? How do you know what makes ™em happy or sad?”
“I don™t know for sure. But I suspect they™re doing what I do:
Comparing them to figures for our competitors. Look at this,” he
said pulling a sheet from the top drawer of his battered desk. “This

45
46 THE AGILE MANAGER™S GUIDE TO UNDERSTANDING FINANCIAL STATEMENTS


is a list of common ratios for our industry. It™s compiled by the
Medical Products Manufacturers Association from real numbers. To
be part of the organization, you have to submit financial data.”
“Hmm,” said Steve thoughtfully as he gazed at the page. “The
average sales per employee for a company our size is $322,500.
And based on your calculation””Steve leaned over to glance at
the Agile Manager™s yellow pad”“we™re at around $375,000.
Hey”bonus city this year, right?”
“Sure”if it were up to me alone,” said the Agile Manager chuck-
ling. “But that figure will benefit you in other ways. I just got the
approval to hire another developer, which will take the load off the
rest of us. And we™ll be getting a new test bench next month . . .”

Most people seem drawn to, indeed, fascinated by, things with
beautiful shapes. It™s part of our aesthetic, kinder-gentler-art-
loving side to want to gaze upon visually appealing objects that
speak to and nurture our inner spirit . . . the daring lines of a
Dodge Viper, the breathtaking beauty and simplicity of a tulip
in May, or the financial statements of a company that outwardly
seems so rock-solid that it seems to work out twice a day.
But how can you gently strip away its corporate clothing layer
by layer to reveal whether that company is really in great shape
or just trying to dazzle you with the business version of a face
lift, tummy tuck, Rogaine, or hair transplants?
By reading this chapter, of course!

Liars May Figure, But Figures Don™t Lie
Financial analysis is the company version of an annual physi-
cal (cough). Sometimes it™s called “ratio analysis,” although some
of the digital checkups we™ll do are ratios and some aren™t.
Financial analysis can be fun. Don™t adjust your glasses; you
read that right. Why fun? Because statements conceal lots of
important (and sometimes delightful or terrifying) facts just by
the way they™re laid out. The information isn™t all that obvious.
It™s not that someone™s trying to pull a fast one (usually not,
anyway). But eyeballing statements to evaluate a company™s con-
Financial Analysis: Number-Crunching for Profit 47


dition will only give you eyestrain. They don™t connect certain
pieces of information the way they™ll be connected, related, and
explained in plain language here.
BT
est
You™ll notice that we sort of
ip
eased up to the topic of a com-
pany™s financial fitness casually, as There™s no “best” calculation
if we were approaching the firm that answers the question,
in a singles bar.We checked it out “How™s the business doing?”
in general from a distance by
ogling the income statement and
balance sheet. Now it™s time to make a serious move.
Take Precautions First
“Precautions” here means there™s no one best calculation you
can do with a company™s financial statements that neatly an-
swers the question, “How™s the business doing?” Some of the
calculations we™ll do may show that it™s in great shape. Others
may show it™s in trouble.
And something else: Most of what you™ll find out about our
friend Avaricious Industries in this chapter will mean lots more
when stacked up against comparative data from a reliable source.
“Comparative data” means what™s typical for other companies
in the same line of business as A.I. “Reliable source” can refer to
several possible places:
The company™s trade association, which should be able to
s

summarize the average performance for a company in that
particular industry.
Dun & Bradstreet, which publishes key ratios for more than
s

one hundred lines of business each year.
Robert Morris Associates™ Annual Statement Studies, which
s

examines the annual financial statements of lots and lots of
companies of all sizes and in all industries. Your library
should have a copy. (And business owners: Be aware that
your banker will probably check your financial statements
against it when you march in to ask for a loan.)
48 THE AGILE MANAGER™S GUIDE TO UNDERSTANDING FINANCIAL STATEMENTS


One more tidbit. Remember that what™s considered good per-
formance in one industry may be not so good in another. It
depends on the nature of the business itself. Retailing businesses,
for example, are very different creatures from cement producers,
computer manufacturers, or companies that write software. Each
group of animals in the business zoo has distinct norms and
behavior.

Financial Voyeurism
Think of the calculations you™re going to learn about as indi-
vidual windows you can look through. They are just like the
windows in a house. Each gives you a different view of what™s
going on inside, and some views
BT est may be lots more interesting than
ip others. But no one window in a
house lets you see everything
Most of the information that
that™s going on inside, just like no
financial analysis uncovers
one calculation shows you every-
takes on a lot more meaning
thing that™s going on inside a
when you compare it with
company. You have to do a num-
industry standards.
ber of them.
So let™s play Peeping Tom (fi-
nancially speaking) and see what happens when we peek over
A.I.™s corporate window sills. Grab your calculator and come
on!

Analyzing an Income Statement
Here we™ll hark back to Figure 2-1 and pull off whatever
numbers we need. (It™s reproduced on the next page.)
Ratio of Net Income to Net Sales. Find this by dividing net
income by net sales:
Net income
= $ 1,509,601 = $.04 : $1
Net sales $38,028,500
This ratio tells you how much net income (or profit) a com-
Financial Analysis: Number-Crunching for Profit 49




Avaricious Industries

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