FINANCIAL INTELLIGENCE

A MANAGER’S GUIDE TO KNOWING

WHAT THE NUMBERS REALLY MEAN

BY KAREN BERMAN AND JOE KNIGHT WITH JOHN CASE

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Table 1

The following is a sample set of financials for an imaginary company.

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Table 2

Sweet Dreams Bakery Income Statement

Table 3

Table 3

Fine Apparel Income Statement

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Table 4

Note 1: Why do we need to adjust for depreciation when looking at the change in property, plant,

and equipment (PPE)? Remember that every year PPE on the balance sheet is lowered by the

amount of depreciation charged to the assets in the account. So if you had a fleet of trucks that

were acquired for $100,000, the balance sheet immediately after the acquisition would include

$100,000 for trucks on the PPE line. If depreciation on the trucks was $10,000 for the year, then

at the end of twelve months, the line in PPE for trucks would be $90,000. But depreciation is a

noncash expense, and since we’re trying to arrive at a cash number, we have to “factor out”

depreciation by adding it back in.

Note 2: Notice the dividends footnoted on the balance sheet? Multiply the dividend times the

number of shares outstanding and you get roughly $166 million (which we’re representing as just

$166). Net income of $248 minus the dividend of $166 equals $82—the precise amount by

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which shareholders equity increased. This is the amount of profit that stayed in the company as

retained earnings. If there is no dividend paid out or new stock sold, then the cash provided or

used by equity financing would be zero. Equity would simply increase or decrease by the amount

of profit or loss in the period.

Now we can construct a cash flow statement along the following lines. Of course, with a full

balance sheet like this one, you have to put the change in cash in the right categories as well. The

words on the right show where each number comes from:

Table 5

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The “cash at end,” of course, equals the cash balance on the ending balance sheet.

Figure 1

Discounting Equation

In words, the total expected cash flow of $3,900 is worth only $3,350 in today’s dollars when

discounted at 8 percent. Subtract the initial cash outlay of $3,000, and you get an NPV of $350.

How should you interpret this? If the NPV of a project is greater than zero, it should be accepted,

because the return is greater than the company’s hurdle rate. Here, the return of $350 shows you

that the project has a return greater than 8 percent.

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Table 6

Projected Incremental Income Statement

You have an opportunity to build a new plant that will increase your business’s production

capacity for three years. The plant costs $30 million and will last for four years (we’ll continue to

keep the time frames short for purposes of illustration). It will produce enough new product to

generate $60 million in additional revenue in each of the next three years.

The projected incremental income statement for the project might look something like this:

It looks like a good project, doesn’t it? You invest $30 million and get a profit of $45 million

over three years. But we have deliberately omitted a critical point. The example compares profit

from the project to cash that was invested. As you’ll remember from earlier chapters, profit is not

the same as cash. Comparing a profit return to a cash investment is like comparing nectarines to

bananas.

Typically, you need two steps to get from operating profit to cash. First you must add back any

noncash expenses. Depreciation, for instance, is a noncash expense that lowers profit but does

not affect cash flow. Second, you must consider the additional working capital. More sales will

require more inventory and will lead to more accounts receivable—two key elements of working

capital. Both of these investments will have to be financed with cash.

So let’s assume that this new increase in sales will require you to sell to new customers that have

poorer credit ratings than your current customers. Perhaps it will take sixty days to collect from

these customers instead of forty-five days. Perhaps you will need to increase your accounts

receivable by, say, $10 million during these three years. Meanwhile, assume that your inventory

will need to increase by $5 million to cover the additional sales. (The finance people can

estimate all these numbers with some precision on the basis of your past financials; for the

purposes of this example, we’re merely assuming what they will be.)

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Table 7

To convert the profit to cash flow, the calculation would look as follows:

Now the project looks much more appealing. The calculations suggest that the $30 million

investment will return $75 million over three years. Of course, you still need to apply net present

value analysis to see if this investment makes sense for the business.

Figure 2

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Figure 3

Figure 4

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Figure 5