In the Classroom
Sharpen Your Pencils: Finding Value in Shrinking Bottom Lines
Financial statements may sometimes look like a pile of dinosaur bones — particularly to a non-financial manager. But managers with the knowledge to read them can tell a great deal about the characteristics, habits, and health of the companies they represent. And in an environment of tighter budgets and tougher hurdles for new projects, this kind of knowledge can be essential in developing proposals, assessing investments, and managing initiatives.
"This is the way you tell how your company is doing," says Rick Lambert, Wharton accounting professor and academic director of Wharton's Finance and Accounting for the Non-Financial Manager. "Are you doing well today? How does your performance relate to the past? If you want to understand your company, these are extremely useful tools."
This is the way you tell how your company is doing. Are you doing well today? How does your performance relate to the past? If you want to understand your company, these are extremely useful tools.
–Richard Lambert, Miller-Sherrerd Professor; Professor of Accounting; Academic Director, Finance and Accounting for the Non-Financial Manager
Seeing Beyond the Numbers
Like archeologists picking through a dig, executives in a recent session of the program were given a set of unidentified financial statements and were asked to match them with a dozen companies in different industries. After a few days in the classroom learning the fundamentals of finance, they could do this with surprising accuracy.
They first distinguished service companies from other firms, based on the presence of inventory in companies that produce or sell a product. Then the managers made finer distinctions among advertising, airline, commercial bank, electric utilities, railroad, and software firms in services. They also spotted an auto manufacturer, department store, men's clothing manufacturer, supermarket, petroleum company, and chemical manufacturer among the financial numbers of manufacturing and retail firms.
The auto manufacturer, for example, has a high cost of goods sold, given the investments in making its products, and many expenses for property, plant, and equipment. But automakers have low inventory, since "as soon as the car rolls off the line it is no longer inventory."
Managers in the program learn to look at key ratios such as return on equity (ROE), which is the net income divided by shareholder equity, and return on assets (ROA), the net income divided by total assets. They examine ratios related to the company's margins, including gross profit percentage, operating profit margin, and net profit margin. They also look at ratios related to accounts receivable, including turnover (sales over average customer receivables), as well as inventory ratios, including inventory turnover (cost of goods sold divided by average inventory). These ratios and other financial information allow the managers to see the companies behind the numbers.
Crucial Financial Knowledge
This exercise, which Lambert described as "some combination between CSI and a game show," has a serious purpose. It is a test of skills in reading financial statements that could offer crucial insights into the health of a business or the evaluation of a new project. The ability to flesh out the stories from the dry numbers of financial statements is critical in making the financial case for a new initiative. Is a proposed acquisition target truly a good deal? Is the company sound? What are the financial vulnerabilities of your own company, and how can you address them? How do the financial statements of your competitors stack up?
During the Finance and Accounting for the Non-Financial Manager program, executives learn how to create, read, and analyze key financial statements — the balance sheet, income statement, and cash flow statement. Faculty examine how to assess earnings quality by looking at issues such as sales, cost of goods sold, and indirect expenses. They apply these insights to case studies to practice analyzing investments of actual companies. For example, participants analyze and create financial statements for a startup business and explore financial statements of a large rubber manufacturer. Faculty discuss the financial statements and decisions of diverse companies such as Walt Disney, Continental Airlines, Quaker Oats, and General Motors. Managers also examine cost accounting, managerial accounting, and alternative investments such as hedging, derivatives, and options.
Evaluating Projects
Evaluating projects is a crucial skill for any manager. Is a planned project going to produce the returns expected? What are the assumptions behind the plan? What are the tax implications? Managers need to be able to evaluate new initiatives that come to them and need rigorous financial analysis to pitch their own new ideas.
In the program, faculty consider how to evaluate projects, using discounted cash flow analysis and other tools to examine return on investment, impact on market share, payback, and net present value. Managers look at alternatives for investing in the project and their impact on expenses and returns.
The "time value of money" is a key concept in making such investment decisions. This recognizes that a dollar today is actually worth more than a dollar five years from now. That dollar today could be put into other investments besides the project at hand, so managers need to weigh the current dollars invested against the future dollars returned. To do this, they have to determine the cost of capital in making the investment. Managers also need to consider tax implications, incidental effects on the rest of the business, working capital requirements, sunk costs, opportunity costs, and allocated overhead costs. Only after such analysis can they truly get their hands around the investment and potential returns from the project.
The Bottom Line Is Not the Bottom Line
The Wharton program allows managers to understand that while statements may seem cut-and-dried, they are far from it. In archeology, scientists update theories based on new evidence, which can be reinterpreted in different ways. The bottom line, thus, is not the bottom line. There are many judgment calls that go into creating financial statements; they require a trained eye in reading and interpreting them.
The Wharton program gives managers an understanding of the nuances of financial statements that will help them to identify opportunities or signs of trouble. As shown in the exercise of recognizing firms from their financial statements, it allows managers to see the true contours of the company behind the numbers. In a time of rapid changes in the business environment, this knowledge can help managers make better decisions and be better prepared for survival in an environment of the survival of the fittest.
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