How would you rate your financial smarts? Would you like to feel more confident when your co-workers start throwing out jargon and acronyms like “capital structure ratio” and “CFS?”
If you’ve ever sat in a meeting and heard Greek when the finance person starts talking or been terrified that someone will actually ask a question about your financial report, you’re not alone. Surprisingly, many managers and decision makers have a very limited knowledge of financial topics.
That’s a shame, because increasing your financial acumen can help you not only understand what your co-workers are saying, but make more informed decisions for the company.
What is financial acumen?
Financial acumen is a basic knowledge of financial and accounting topics. Having financial acumen means you know what you need to know in order to make important business decisions. With a basic financial understanding, you’ll be able to see how these decisions will shape your organisation’s overall performance and, ultimately, long-term success.
So, what do you need to know?
Anyone in a business management or decision-making position should know some basic terms and principles of finance. These include:
A financial report is your company’s written record of its business activities and financial performance. Your company may issue financial reports monthly, quarterly and/or annually. Note that there will be a difference, especially in detail, between your internal financial reports – commonly referred to as management reports and those published externally for reporting purposes. These latter reports tend to include what are known as the 3 key financial statements:
- Income Statement or Profit and Loss Account
The income statement details your company’s revenue and expenses for the report period. It also includes your company’s overall profit, or net income/profit (expenses subtracted from revenue).Your internal management reports will probably be detailed and the ones you will see may only relate to your own area.
- Balance Sheet
This is produced for financial reporting purposes for the whole company, so you will not necessarily see it except for when it is published. The balance sheet details your company’s assets, liabilities, and shareholders’ equity. Unlike the income statement, which shows finances over a period of time, the balance sheet is a single snapshot, and usually includes a date at the top of the sheet. This date, usually the end of the period covered by the statement, tells you when this snapshot was “taken.”
- Cash Flow Statement
Again this statement will only be produced for the company as a whole and so at a department or business unit level, you may not see it. The cash flow statement (CFS) measures how much cash your company generated and how it was spent. This helps you understand where money is coming from and where it’s going to, as well as whether or not you’re generating enough cash flow to cover your commitments e.g. loan repayments.
Key Financial Ratios
If financial statements tell you the “what,” financial ratios give you the “so what.” You can think of financial ratios as a way of comparing data from your financial reports and measuring the relationship between different elements of that report. (A ratio shows how many times one value contains or is contained within another.) For example, financial ratios might help you calculate profitability, liquidity and return on investment.
There are many different financial ratios, but the most important can be grouped into four key types:
A profitability ratio, as you can probably guess, shows how profitable your company is, or in other words, how well you can generate profit from your activities. Profitability ratios include Gross Profit Margin, Net Profit Margin, EBIT or EBITDA Margin
- Capital Structure
Capital structure refers to the way a company funds its activities, operations and growth. Companies typically fund their operations using a combination of debt and equity, but for most companies a higher amount of equity than debt is preferred since it is less risky – remember debt always needs to be repaid at some point Certain ratios can help you calculate and analyse capital structure: these include debt ratios, debt-to-equity ratios, also known as leverage or gearing.
- Return on Investment
Return on investment (ROI) measures how profitable an investment is. It can help you evaluate the current value of your investments and/or decide whether to pursue a new investment. The shareholders of the company will be continually looking at the return that their investment is generating by comparing the net profit with their investment – their shares. This is referred to as Return on Equity.
Liquidity is your company’s ability to quickly and affordably convert assets into cash, so a liquidity ratio measures your ability to do just that. How easily can you pay off short-term debts as they become due? Your liquidity ratio should tell you this. Some types of liquidity ratios include the current ratio or working capital ratio and the quick ratio. See Cash Flow forecasting below.
A more important, indeed vital, tool for monitoring cash flow and ensuring the company remains solvent is by preparing a cash flow budget or forecast. During COVID, cash flow forecasting became absolutely critical for many businesses and the frequency of revising their forecasting increased with scenario planning.
As well as the technical business terms mentioned above, financial acumen includes an understanding of broader business principles. While these principles are far too lengthy and complex to be comprehensively explained in this article, we’ll give a broad overview of each and let you do further research on your own.
- Cash Flow Forecasting
Cash is the lifeblood of the business. An important, indeed vital, tool for monitoring cash flow and ensuring the company remains solvent is by preparing a cash flow budget or forecast. During COVID, cash flow forecasting became absolutely critical for many businesses and the frequency of revising their forecasting increased with scenario planning.
- The Business Cycle
The business cycle refers to a sequence of economic upswings and downswings (also known as expansions and contractions, or recessions). You’ve probably noticed that the market tends to do very well for a period of time, then dive into a recession before eventually climbing back up into a period of economic prosperity. Business activities like hiring, production, and sales tend to be tied to these phases. In the most basic terms, this is a business cycle. You may want to research the distinct phases of the business cycle and how each affects business activity.
Financial planning includes documenting your current financial situation, setting financial goals for the future, and creating a roadmap to achieve them. Elements to include in this plan include elements from your financial report: income statement, cash flow statements, and balance sheet, as well as profit and loss projections for the next few years. You may want to research the different sections of a traditional business plan and the reasons for creating one.
- Year End Activities
At the end of the year, there are several tasks that any well managed company should complete in order to get (and keep) their finances in order. These include organising all your financial information from the past year, budgeting for next year and forecasting and goal-setting for the future. You’ll also want to do some tax planning and, naturally, run and analyse a final financial report for that year.
- Expense Control
Expense or cost control means reducing your spending to increase profits. Identify where you can afford to cut costs, then make a plan to do just that. While cost control tends to focus on the big, long-term picture, expense control refers to the smaller things you can change immediately.
Budgeting and Costing
The last main area we’ll focus on here is budgeting and costing. Understanding how, when and why to make changes to a budget is essential to successful company management, as is knowing how to plan and control costs. As such, you should have a basic understanding of the following:
- Budget setting
- Monitoring and control
- Variance analysis
- Cost planning and control
- Budget Setting
You’ve likely already had some experience with budgeting, whether professionally or personally, but there’s more to budgeting than just throwing numbers into a spreadsheet. You may want to spend some time researching the most successful budgeting strategies and considerations.
- Monitoring and Control
Monitoring and control is key for keeping track of how a business is performing. It involves continually tracking and reporting on financial performance, then evaluating the results and making changes to company operations accordingly. Monitoring and controlling helps you catch short-term problems before they turn into long-term issues that could significantly impact your company’s performance.
- Variance Analysis
Have you ever budgeted for a certain amount, only to have the thing you budgeted for end up costing more than you’d planned? When this happens, the process of comparing the projected budget to the actual budget and figuring out why the two numbers are different in the first place is called variance analysis. Sometimes, the cause of variance may be outside your control—for example, unexpected market conditions or a project roadblock. Other times, it may simply be down to ineffective planning or human error.
- Cost Planning and Control
Cost control means identifying and cutting back on business expenses in order to increase profit. The first step to cost control is budgeting. Then, as you put your budget into practice, you may notice certain areas where spending is over-budget. In that case, you have your work cut out for you figuring out how to either bring those costs down or cut back in other areas. Many companies use outsourcing as a way of reducing costs.
How’s your financial acumen?
While the principles discussed here should give you a good starting basis for increasing your financial acumen, there’s a whole lot more to learn. As a business leader or manager, you’re probably not looking to become a financial wizard, but gaining a high degree of financial awareness is a valuable trait for anyone in a leadership position.
Take the financial acumen self-assessment to find out how financially aware you are , then download your report to see if you need to upgrade your financial knowledge. And if you need help improving your financial acumen, you know where to find us. (Hint: right here.)