What are some of the key insights from the field of finance, for business owners, managers, and investors? Let me walk you through five big ideas that can help you improve your business, and build a better understanding of decision making and financial reporting. Finance idea number one.
Profit is not necessarily the same as cash flow. Let’s say you are full of ideas, you like to invent stuff. You have come up with a breakthrough product, and got a prototype working.
However, your personal strength is really in inventing, not in manufacturing, nor in selling. So you get somebody else to do the manufacturing of your product for you. They produce the goods according to your specifications, ship them to you, and you pay cash on delivery.
You also get somebody else for the selling of the product to consumers. You ship the goods to a retailer, but instead of the retailer paying you immediately, you will receive payment after thirty days. This month, you buy 100 units at $80 each, and sell 50 units at $100 each.
The other 50 units stay in inventory. How much profit do you make? You deliver and sell 50 units at $100 each, so your revenue is $5000.
The cost to you of sourcing those 50 units that you have now sold, is 50 units at $80 each, so your Cost Of Goods Sold is $4000. In short, you sell 50 units at $20 margin per unit, so generate a profit of $1000. How much cash flow do you generate?
Well, you don’t get paid by the retailer until one month from now, so cash in is zero. You paid your supplier on delivery, so cash out is $8000. Total cash flow is negative $8000.
Profit on your shipment is recognized when you deliver the goods to your customer (the retailer). Cash flow is recognized when cash comes in or cash flows out. You could be profitable yet go bankrupt!
Finance idea number two. Each financial statement tells a story. The balance sheet gives you an overview of assets, liabilities, and equity.
It shows what we own on the left, and what we owe on the right. The income statement shows you how revenue minus expenses equals profit (or loss), or in other words how sales minus costs equals income (or loss). The cash flow statement shows you how you got from the cash balance at the start of the year, through cash inflows and cash outflows during the year, to the cash balance at the end of the year.
A balance sheet is a picture at a point in time, usually the end of the month, end of the quarter, or end of the year. An income statement is a movie of profitability during a month, quarter, or year. A cash flow statement is a documentary movie about movements in the most fascinating account on the balance sheet: cash.
Finance idea number three. Book value (what a company is worth on paper, based on the balance sheet) is not necessarily the same as market value (what someone is willing to pay for it). Let’s look at Apple Inc.
The book value of its equity on the balance sheet of March 30, 2019, is around $106 billion. The number of outstanding shares 4. 7 billion units, so the book value per share is around $22.
55. If you look at the market value of the share price (in early May 2019), you see the share price around $200. Book value, or accounting value, is based on a company’s historical financial results, looking back.
Market value, or economic value, depends on the expectations of investors for the future of the company, looking forward. Finance idea number four. There are many ways to drive Operating Income!
If you listen to CEO’s and CFO’s, it sometimes seems that the only thing they can think of is cost cutting, cost cutting, and more cost cutting. While that could certainly be an appropriate way forward, there are more options to choose from. Price.
Are you charging a price to your customers for your goods and services that accurately reflects the value you are creating for them? Volume. What opportunities do you have to sell more units?
Mix. Can you focus more resources on selling the higher margin products and services in your portfolio, versus the lower margin ones? Productivity.
Can you generate the same amount of output with fewer resources, or more output with the same amount of resources? Sourcing benefits. Can you renegotiate your contract with your existing suppliers to get lower price or more value, or can you find alternative suppliers that give you a better deal?
Spending more. Can you spend more on research and development, to develop your product or service faster and better, and generate more revenue and margin? Can you spend more on marketing to establish your brand?
Can you spend more on learning and development to improve the skills of your employees? Finance idea number five. It’s your lucky day!
Somebody wants to give you $100. Would you like to receive that $100 right now, today? Or would you like it one year from now?
I am pretty certain you would say $100 today. All sorts of things could happen during a year, right? MrSomebody might change his mind about giving you the money, MrSomebody could go bankrupt and be unable to give you the money, or there could be inflation that decreases the purchasing power of the $100 you receive.
That’s the idea of time value of money. $100 today is not the same as $100 one year from now. If I asked you what it would take for you to agree to wait for a full year, the answer might be an extra $5.
In that case, $100 today equals $105 one year from now, and we have put a “price” on time. That’s what time value of money means. It is a key concept in evaluating investment proposals, using Net Present Value, and Internal Rate of Return.
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