Mastering Financial Tools285
EXHIBIT
Source: Adapted from Harvard Business Review, Finance Basics (20-Minute Manager
Series). Boston: Harvard Business Review Press, 2014.
Net income $ 347,500
Operating activities
Accounts receivable
Inventory
Total changes in operating
assets and liabilities
Cash flow from operations
(56,500)
291,000
Cash flow from investing activities
Financing activities
Investing activities
Prepaid expenses
Accounts payable
Accrued expenses
Income tax payable
Depreciation expenses
(43,000)
(80,000)
(25,000)
20,000
21,000
8,000
42,500
Short-term debt decrease
Long-term borrowing
Capital stock
Cash dividends to stockholders
(65,000)
90,000
50,000
—
Cash flow from financing activities
Increase in cash during year
75,000
$ 166,000
* Assumes sale price was at book value; the company had yet to start depreciating this asset.
Sale of property, plant,
and equipment
Capital expenditures
(200,000)
267,000*
(467,000)
Amalgamated Hat Rack cash flow statement for
the year ending December 31, 2018
Again using the Amalgamated Hat Rack example, we see that in 2018
the company generated a total positive cash fl ow (increase in cash) of
$166,000. This is the sum of cash fl ows from operations ($291,000), invest-
ing activities (minus $200,000), and fi nancing ($75,000).
The cash fl ow statement shows the relationship between net profi t,
from the income statement, and the actual change in cash that appears in
the company’s bank accounts. In accounting language, it “reconciles” profi t
and cash through a series of adjustments to net profi t. Some of these ad-
justments are simple. Depreciation, for instance, is a noncash expense, so
286Managing the Business
you have to add depreciation to net profi t if what you’re interested in is the
change in cash. Other adjustments are harder to grasp, though the arith-
metic isn’t diffi cult. If a company’s accounts receivable are lower at the end
of 2018 than they were at the end of 2017; for example, it took in “extra”
cash from operations, so we would add that to net profi t as well.
This document is useful because it indicates whether your company is
successfully turning its profi ts into cash, and that ability is ultimately what
will keep the company solvent, or able to pay bills as they come due.
How the cash fl ow statement relates to you.
If you’re a manager in a large corporation, changes in your employer’s cash
fl ow won’t typically have an impact on your day-to-day job. Nevertheless,
it’s a good idea to stay up to date on your company’s cash situation, with
your leader’s support, because it may affect your budget for the upcoming
year. When cash is tight, you will probably want to be conservative in your
planning. When it’s plentiful, you may have an opportunity to propose a
bigger budget. Note that a company can be quite profi table and still be
short of cash as a result of a lot of new investments, for example, or trouble
collecting receivables.
You may also have some infl uence over the items that affect the cash
fl ow statement. Are you responsible for inventory? Keep in mind that
every addition there requires a cash expenditure. Are you in sales? A sale
isn’t really a sale until it’s paid for, so watch your receivables.
The income statement
Of the three main fi nancial statements, the income statement has the
greatest bearing on a manager’s job. That’s because most managers are re-
sponsible in some way for one or more of its elements—generating revenue,
managing profi t and loss, or managing expense budgets.
Unlike the balance sheet, which is a snapshot of a company’s position
at one point in time, the income statement shows cumulative business re-
sults within a defi ned time frame, such as a quarter or a year. It tells you
whether the company is making a profi t or a loss—that is, whether it has a
Mastering Financial Tools287
positive or negative net income (net earnings)—and how much. This is why
the income statement is often referred to as the profi t-and-loss statement,
or P&L. The income statement also tells you the company’s revenues and
expenses during the time period it covers. Knowing the revenues and the
profi t enables you to determine the company’s profi t margins.
As we did with the balance sheet, we can represent the contents of the
income statement with a simple equation:
Revenues – Expenses = Net Income
An income statement starts with the company’s sales, or revenues.
This is primarily the value of the goods or services delivered to customers,
but you may have revenues from other sources as well. Note that revenues
in most cases are not the same as cash. For companies that use an accrual
method of revenue recognition (most larger companies), if a company de-
livers $1 million worth of goods in December 2018 and sends out an invoice
at the end of the month, for example, that $1 million in sales counts as
revenue for the year 2018 even though the customer hasn’t yet paid the bill.
Various expenses—the costs of making and storing a company’s goods,
administrative costs, depreciation of plant and equipment, interest ex-
penses, and taxes—are then deducted from revenues. The bottom line—
what’s left over—is the net income (or net profi t, or net earnings) for the
period covered by the statement.
Let’s look at the various line items on the income statement for Amal-
gamated Hat Rack in exhibit 16-3.
The cost of goods sold, or COGS, represents the direct costs of manu-
facturing hat racks. This fi gure covers raw materials, such as lumber, and
every thing needed to turn those materials into fi nished goods, such as
labor. Subtracting cost of goods sold from revenues gives us Amalgam-
ated’s gross profi t—an important measure of a company’s fi nancial perfor-
mance. In 2018, gross profi t was $1,600,000.
The next major category of cost is operating expenses, which include
the salaries of administrative employees, offi ce rents, sales and marketing
costs, and other costs not directly related to making a product or delivering
a service.
288Managing the Business
For the period ending December 31, 2018
Retail sales
Corporate sales
Total sales revenue
Less: Cost of goods sold
Gross profit
Less: Operating expenses
Less: Depreciation expenses
Earnings before
interest and taxes
Less: Interest expense
Earnings before
income taxes
Less: Income taxes
Net income $ 347,500
300,000
647,500
110,000
757,500
42,500
800,000
1,600,000
1,600,000
3,200,000
1,000,000
$ 2,200,000
Amalgamated Hat Rack income statement
EXHIBIT
Source: Adapted from Harvard Business Review, Finance Basics (20-Minute Manager
Series). Boston: Harvard Business Review Press, 2014.
Depreciation appears on the income statement as an expense, even
though it involves no out-of-pocket payment. As described earlier, it’s a
way of allocating the cost of an asset over the asset’s estimated useful life.
Subtracting operating expenses and depreciation from gross profi t
gives you a company’s operating earnings, or operating profi t. This is often
called earnings before interest and taxes, or EBIT, as it is on Amalgam-
ated’s statement.
The last expenses on the income statement are typically taxes and any
interest due on loans. If you get a net profi t fi gure after subtracting all ex-
penses, as Amalgamated does, your company is profi table.
As with the balance sheet, comparing income statements over a period
of years reveals much more than examining a single income statement. You
can spot trends, turnarounds, and recurring problems. Many companies’
annual reports show data going back fi ve years or more.
Mastering Financial Tools289
How the income statement relates to you.
Let’s look at the three managerial activities that the income statement
captures:
GENERATING REVENUE. In one sense, nearly everyone in a company helps
generate revenue, but it’s the primary responsibility of the sales and mar-
keting departments. If your revenues rise faster than the competition’s, you
can reasonably assume that the folks in sales and marketing are doing a
good job.
It’s critical that managers in these departments understand the in-
come statement so that they can balance costs against revenue. If sales
reps give too many discounts, for instance, they may reduce the company’s
gross profi t. If marketers spend too much money in pursuit of new custom-
ers, they will eat into operating profi t. It’s the manager’s job to track these
numbers as well as revenue itself.
MANAGING A P&L. Many managers have P&L responsibility, which means
they are accountable for an entire chunk of the income statement. This
is probably the case if you’re running a business unit, a store, a plant, or
a branch offi ce, or if you’re overseeing a product line. The income state-
ment you’re accountable for isn’t quite the same as the whole company’s.
For instance, it’s unlikely to include interest expense and other overhead
items, except as an “allocation” at the end of the year. Even so, your job is to
manage revenue generation and costs so that your unit or product line con-
tributes as much profi t to the company as possible. For that, you need to
understand and track revenue, cost of goods sold, and operating expenses.
MANAGING BUDGETS. Running a department means working within the
confi nes of an expense budget. If you oversee a unit in information or
human resources, for example, you may have little infl uence on revenue,
but you will surely be expected to watch your costs closely, and all those
costs will affect the income statement. Staff departments’ expenses usu-
ally show up in the operating expenses line. If you invest in any capital
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