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Copyright ©2012 Kevin Cope

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CONTENTS

Foreword
Introduction

Part 1: 5 Key Drivers of Any Business and How to Influence Them

Chapter 1: Cash
Chapter 2: Profit
Chapter 3: Assets
Chapter 4: Growth
Chapter 5: People
Chapter 6: The Big Picture: Linking the Five Drivers

Part 2: Simplifying Financial Statements Through the 5 Drivers

Chapter 7: Deciphering Financial Statements and the Annual Report
Chapter 8: Income Statement: Tracking Profit
Chapter 9: Balance Sheet: Tracking Assets
Chapter 10: Statement of Cash Flows
Securing Your Seat at the Table
Resources
Acknowledgments
About the Author
About Acumen Learning
Index
Dedicated to my wife, Karen, and our children,
who are truly the greatest joy of my life.
 FOREWORD

I strongly believe that the first job of any leader is to inspire trust. Whether that leader is
a surgeon leading a team through an intricate medical procedure, an executive leading
a team in implementing a strategy, or a quarterback leading a football team to a
comeback victory—it’s trust in the leader that inspires others to willingly choose to follow.
So what inspires trust? Trust is the confidence that emerges when character and
competence converge. If I were questioning whether or not I needed surgery, I wouldn’t
trust a dishonest and self-serving surgeon—no matter how competent he or she might be.
Nor would I trust a quarterback who’s unable to make plays or deliver results—even if he
has impeccable character. But when I see the consistent demonstration of both character
and competence, I do trust. And Kevin Cope, the author of this exceptional book, is a person
who consistently demonstrates both—and is a person I trust immensely.
Kevin is a long-time friend and confidant. As such, he listens empathically and offers
sound advice when I ask for it. He is also a business colleague who worked with me for
several years in a time of unprecedented business growth, opportunity, and challenge. In
that role, I have seen him time and again roll up his sleeves and find a way to get the job
done superbly well. While I wouldn’t trust Kevin to quarterback a fourth quarter comeback
(believe me, I’ve played flag football with him!), and I definitely wouldn’t trust him to
perform surgery on me (he’s not a doctor), I absolutely do trust Kevin’s ideas on business,
organizations, and people. He’s earned that trust through a demonstrated track record of
character and competence—particularly in the area of business acumen.
In fact, it is because of my trust in Kevin in these areas that I strongly encouraged him to
write this book. His “five drivers” model and his ideas concerning business are simply too
good—too valuable, too insightful, too clear—to not share. Kevin has the gift of being able
to take complex issues and make them simple. Never is this gift more needed than in the
world of business acumen, particularly regarding how business works and how
organizations make money and successfully grow. And when it comes to understanding how
business acumen can transform an individual—and, in turn, an organization—there is no
one I trust more than Kevin Cope.
But enough said about my friend Kevin; now let’s talk about you. You’re picking up this
book because you likely work for a business or for some type of organization that needs to
operate on sound business principles. Now just because a person works for a business
doesn’t mean he or she fully understands business. You and I both know plenty of bright
business graduates who can’t quite seem to apply that knowledge in relevant ways that
create value for the business. We’ve all run across colleagues and peers who have years of
experience and know everything there is to know about their particular function—HR,
operations, marketing, sales, R & D, or some other role—but who would rather have a root
canal than to have to give an opinion or interpretation of the company’s latest financial
results.
We’re also aware of those who think they know business when all they really know is the
jargon of business—often number crunchers who, as Oscar Wilde put it, “know the price of
everything but the value of nothing.” We likewise see countless passionate entrepreneurs
who are certain they understand business, but start companies that fail to gain any traction
and end up not even getting off the ground.
In short, just because a person is “in” business doesn’t mean that person “gets” business.
That’s where this book comes in. It’s the best book I know to explain how business really
works and how organizations make money. It’s actionable. It’s simple without being
simplistic. And it’s written in an engaging and insightful style.
So if you’re that business grad or entrepreneur who can’t put your finger on why success
seems to elude you … or that functional expert with years of experience who’s tired of being
overlooked when your company presents new career opportunities … or that numbers
person who’s wrestling with how you can become relevant to those who don’t look at the
numbers in the same way you do … or—like me—an executive who’s looking for a quick
reference field guide to help you focus your team on the simple fundamentals of business
success … this book is for you.
Whatever your situation—and whether you’re just getting started in business, trying to
get reenergized about your business, or actually running a business—I strongly encourage
you to read Seeing the Big Picture and carefully consider what Kevin has to say. I am
convinced that doing so will help you become a more competent businessperson. And if you
combine that competence with strong character, you’ll inspire your peers, your team, your
boss or your CEO, to trust your decisions. They’ll come to see you not only as a leader of
people, but also as a leader of the business. And that’s what good business acumen is all
about.
Stephen M. R. Covey, author of
New York Times bestseller The Speed of Trust
 INTRODUCTION

The only real security that a person will have in this world is a reserve of knowledge, experience,
and ability.
—Henry Ford

Everything should be made as simple as possible, but not simpler.

—Albert Einstein

H ave you ever found yourself in one of these situations? You’re talking with a senior
leader of your company and wish you could say something really insightful to show
your knowledge of the business, but your brain goes numb and you can’t come up
with anything meaningful.
You’re attending a meeting with managers or financial types and as they start reviewing
financial statements, you get lost. You hope no one discovers that the smile on your face or
the nod of your head hides the gap in your knowledge. You can’t see what the numbers
have to do with what you have to get done today or this week.
Your CEO wants everyone to work harder to meet the company’s overall financial
objectives. Your manager asks for ideas from the team, but you’re struggling to see how
improving your job performance will impact the company’s revenue or stock price.
You’ve got a great idea for a weekend business that you and a friend or your spouse could
start up to bring in some extra money, but you don’t know how much money you would
need to get started or how to handle financial matters once you do. You just don’t want to
be like all those other start-ups that flop.
If you’ve experienced moments like these, you certainly are not alone. In fact, you’re a
member of a fairly large group—businesspeople who struggle to understand how the
moving parts of a company work together to make it successful and how financial metrics
like profit margin, cash flow, and stock price reflect how well each of those moving parts is
doing its job.
The solution to your confusion is developing your business acumen, your ability to see the
big picture.

WHAT BUSINESS ACUMEN CAN DO FOR YOU

Years ago a colleague of mine was consulting with a group of senior NASA managers at
Cape Canaveral. He tried to explain, in simple terms, an organizational change strategy.
The managers seemed confused. In an effort to clarify, he said, “Please don’t make this
more complicated than it is. It’s not rocket science.” To which they sincerely answered, “We
wish it were. We’d understand it better!”
Many people, even those with jobs that others think of as incredibly complex, view their
business much like rocket science: a lot of complexity, hard-to-understand data and
formulas, communications in a language that barely resembles English. Yet most of them
wish they could more clearly understand the business of their business and how to help their
companies perform better. What they are wishing for is business acumen.
Business acumen is keen, fundamental, street-smart insight into how your business
operates and how it makes money and sustains profitable growth, now and in the future.
In 2002, after ten years as an executive with FranklinCovey, consulting with and teaching
for dozens of organizational clients, I founded my own training and consulting firm,
Acumen Learning. We created and began delivering the Building Business Acumen ®
seminar. Over the last ten years we have expanded and deepened the initial course. Our
focus became the practical application of business acumen to help people—at all levels, in
any company, in any industry—become more effective in their current jobs and more
successful in their future careers.
After working with more than eighty thousand participants in more than thirty countries,
including many clients in the Fortune 500 and sixteen of the Fortune 50, the primary lesson
we’ve learned is that businesspeople want to become more effective and valuable, to secure
their seat at the table and influence decisions, to impact company performance. They want
to use their full potential to help their business make money and sustain profitable growth.
They want these things for two reasons. First, we all instinctively seek out greater
engagement—a way to feel that the work we do is worthwhile and makes a difference.
Second, they understand something crucial. If you want to be in a better position—a job
you like more with better pay, better long-term opportunities, and greater security, for
example—you need to understand the key drivers of business and use that knowledge to
make good things happen.
To do that, you need the ability to

1. See the “big picture” of your organization—how the key drivers of your business relate
to each other, work together to produce profitable growth, and relate to the job you do
each day
2. Understand important company communications and data, including financial
statements
3. Use your knowledge to make good decisions
4. Understand how your actions and decisions impact key company measures and the
objectives of your company’s leadership
5. Effectively communicate your ideas to other employees, managers, and executives

For some of you, this list might resonate immediately. For others, it might raise an
important question. Why should you care? Isn’t making these connections the responsibility
of the executives, the senior leadership, or maybe your boss? Not if you want to be doing
something different and better in your career three years from now.
If, through your questions, ideas, comments, analysis, proposals, and performance, you
exhibit business acumen, you will be seen as a more valuable contributor. You will
demonstrate your worth to the company, and other people will notice.
And that, in a nutshell, is the path to success in almost any career.
THE BIG PICTURE

Robert was an excellent call center supervisor … or so he thought. He was dedicated to

saving the company money because he was worried that they would outsource the call
center to an overseas operation. He rarely recommended employees for recognition or
raises. If his team presented ideas about new software or equipment that could improve
productivity, he would listen but never take them to management for consideration. And he
constantly harped on the importance of getting through calls as quickly as possible and up-
selling customers as much as possible. He was fanatical about doing his job well.
Robert didn’t realize that his narrow focus on cost control and “doing his job well”
ignored the big picture of how his company made money and sustained profitability. He
wasn’t connecting the dots between his efforts, customer relations, and future sales revenue.
Or the huge cost of employee turnover the company was incurring every time one of his
employees left to go somewhere with better pay and a stronger focus on serving customers.
He failed to consider the impact he had on efficiency, profits, and morale by refusing to
raise his team’s ideas with management.
Ultimately, Robert was viewed by senior management as “a serviceable supervisor in
need of development; not likely management material.” While he wasn’t let go, his
performance reviews were never stellar and he could tell that he was being sidelined, but he
didn’t understand why. Robert missed out on seeing the big picture of his main job: to
contribute to building a company experiencing long-term, sustainable, profitable growth.
So many of us fall into the same trap. Like Robert, over time, we tend to become more
specialized and get very good at focusing on the specific parts of our jobs, so much so that
we fail to see the big picture—how what we do fits into the overall picture of helping the
company make money, achieve its strategic objectives, and be profitable.
Some of us decide to get degrees in management, hoping to get that big-picture
perspective. But while management education provides excellent training in areas such as
accounting, marketing, or finance, students can graduate without an overall knowledge of
how a business runs successfully. Their knowledge of the key drivers of business and how
they work together can be fragmented, disjointed from the reality of daily operations.
And as with Robert’s managers, many leaders assume that their teams have a much
stronger grasp of the big picture of how their companies grow profitably—greater business
acumen—than they actually do, so few take the time to do on-the-job training to deepen
that knowledge.
Do you think you’re better off than Robert? That you wouldn’t have made the same
mistakes? Now’s your chance to prove it. Take the Big Picture Quick Quiz shown here. The
questions were not picked at random; they are the result of research and interviews with
hundreds of executives and CEOs from dozens of different industries. They reflect the areas
of performance that senior leaders have on their minds and want employees to have on
theirs.
We’ve administered the Big Picture Quick Quiz to over sixty thousand people. On
average, people know the answer to fewer than two of the questions.
These questions focus on the overall business, not the operations of your department or
division. I suspect that you might be more familiar with some of the performance measures
for your immediate team. But your senior management team wants the entire business to be
profitable, not just a single unit. They want all employees to understand and better
contribute to how the entire company makes money.

THE BIG PICTURE QUICK QUIZ

Answer the following questions based on your company’s performance in the most
recent fiscal year. And don’t look up the answers!

1. How much cash was on hand at year-end?

2. How much cash was generated from operations?
3. What was the net income (net earnings, or net profit)?
4. What was the net profit (net income, or net earnings) margin?
5. What was the total revenue (or total sales)?
6. What was the inventory turnover (for retail and manufacturing firms)?
7. What was your return on assets?
8. By what percentage did total revenue (sales) grow or decline over the previous
year?
9. By what percentage did net income (net earnings, or net profit) grow or decline
over the previous year?
10. How do your results compare to your competition?

Now check your answers against any of the financial reports you have on hand.
How did you do? How many questions did you get right? Do you even know where to
get this information?

The problem is that while we understand our jobs, the big picture seems too complex to
grasp. Complexity is an underlying challenge in any business, regardless of size, industry,
or stage of development. Large companies, especially, have many moving parts—
departments and divisions (always reorganizing), product lines (always changing), layers
of management, competitive realities, unclear decision-making processes, regulatory
pressure, shifting budgets, new strategies. A small problem within any single element might
produce a ripple effect throughout the organization, requiring major repairs. But without
knowing the true source of the difficulty (which is not always readily identifiable), we
might “fix” the wrong thing as we tinker with the business.
Developing business acumen helps us cut through this complexity, get a bird’s eye view of
a business, and understand our specialized roles within it. Simplifying complexity and
broadening our understanding of the business enables us to fix present problems, prevent
new ones, and take advantage of opportunities to grow.
How do we simplify the complex? By looking at the key drivers that make all the parts of
a business run.

THE 5 KEY DRIVERS OF ANY BUSINESS

When you break down even the largest, most complex multinational company—like
Walmart, Apple, Toyota, or Boeing—into its most fundamental elements, you’ll find the
same drivers that power your business, or any business. What are those drivers?

• Cash
• Profit
• Assets
• Growth
• People

How did we distill it down to these five? We used the core financial statements—the
statement of cash flows (cash), the income statement (profit), and the balance sheet (assets)
—as the foundation. These are the statements every company uses to judge its current
strength and its future prospects. The fourth driver, growth, is reflected in all of these
statements and for public companies is an important objective for shareholders. And the
fifth driver is quite simple: without good employees providing value to paying customers,
the other four drivers cease to exist.
The 5 Key Drivers will help you understand and visualize how even the most complicated
business can be analyzed and improved. Like the twenty-six characters of the English
alphabet, the 5 Key Drivers combine in a multitude of ways to form the foundation of
organization, products, market position, financing, human resources, and every other
strategy or decision in a company. Leaders must set and achieve goals and obtain results in
these five areas in order to achieve the most important objective for any company: long-
term, sustainable profitability to support its mission.
You’ve probably heard of these essential elements, but you may not really understand
their full importance and interdependence in creating success. While each driver is unique,
it is also completely dependent on all of the other drivers, as shown in the model. You
cannot affect one without influencing the performance of another. Leaders have to take the
connections between the drivers into account as they make their decisions, or they risk
becoming overly focused on one driver and running a business into the ground.
 Your ability to understand these relationships and affect these drivers through your
decisions and actions can increase your own ability to contribute to the long-term
profitability and growth of your company. So in chapters 1 through 5, I will explore each of
the five drivers in depth, explaining how they are defined, their importance to a business,
how leaders balance each of the drivers as they work toward strategic goals, and how any
employee can influence them. In chapter 6, I’ll look at the big picture the five drivers
create; how they relate to each other and work together to create sustainable, profitable
growth; and how they are influenced by factors in the broader business environment.
Management’s general objective is to achieve a balance among the drivers; supreme focus
on one and neglect of the others can be disastrous over time. Throughout the book, I’ll offer
up real-world stories to help you understand what the drivers may mean to your business,
and I’ll use the hypothetical story of Austin’s Cycle Shop to deepen your understanding of
how the drivers play out in a business month to month and year to year.
A key component of business acumen is being able to communicate about the 5 Key
Drivers. The language of business is accounting and finance. And this means numbers. And
numbers intimidate many people. But if you think of financial statements like you would a
health report from your doctor, you may not be as intimidated. You don’t need to
understand every number or how it was calculated, but recognizing a critical few pieces of
information, those that reflect the 5 Key Drivers, will help you understand the health of any
company.
While business acumen is more than just accounting, an important part of it is
understanding a company’s “financials.” So in chapter 7 I’ll explain how financial
statements work, and in chapters 8 through 10 I’ll take the three most important financial
statements—the income statement, the balance sheet, and the statement of cash flows—and
de-intimidate them, simplify them. I’ll show how these three financials measure the 5 Key
Drivers and how they describe the real-world performance of your company. You’ll be able
to look for and understand only the most important data and not be concerned with the rest
of the complexity.
I encourage you to explore our website www.seeingthebigpicture.com, which offers tools,
resources, and further education to help you continue to develop your business acumen.

INFLUENCING THE WHOLE

If you want to be more visible and valued, demonstrate that you understand how your
department or unit fits into the big picture of the overall business.
If you want to influence the thinking and decisions of your supervisor or manager,
address the topics that senior leaders, including your boss, are concerned about.
Communicate your ideas and proposals in language that he or she understands.
If you want to be seen as a major contributor, show that you understand the relationships
among the key drivers of your overall business—not just how your department works.
If you want to be a more effective leader, better able to engage your team, link your
team’s actions with the overall needs and strategic goals of the company. Keep in mind,
even your managers might not be as knowledgeable in some of these areas as you think.
While they may be functionally brilliant, they may not see the big picture. But I encourage
you to ask questions of the type raised in this book and be willing to act on the answers.
You’ll be recognized as a contributor, somebody who demonstrates business acumen through
savvy questions and effective actions.
I hope you’ll refer to the book and the resources in it often and apply them in your
present job and throughout your future career.
 PART I
——————

Key Drivers of Any Business and How to Influence Them

 Chapter 1
CASH
The only unforgivable sin in business is to run out of cash.
—Harold Geneen

M y wife and I were raising four children, all wonderful boys, when she was
diagnosed with cancer. The treatment worked and she is doing well today, but the
doctors told us that she wouldn’t be able to have any more children. We had been
hoping for a daughter to round out our family, so we decided to adopt. Eventually, we
welcomed a darling baby girl into our lives. You might suspect what happened next. Soon
after finalizing the adoption, my wife got pregnant—with a little girl. So now we have an
amazing family of eight.
The process of adoption inspired us with an idea. One day, we would like to start an
organization that helps families through the adoption process, which can take much time,
money, and patience.
Every day, people are inspired to fulfill a need they see in the market or the world by
starting a business. What about you? I’m sure that in your life you’ve had lots of ideas for
businesses or products or services. Maybe it’s just a hobby, or maybe you have grander
entrepreneurial dreams. Ask yourself this question: What is the one thing you would need to
actually launch your business?
A marketable product or service? Time? Drive? Well, yes, but they will not necessarily get
you out of the gates.
What you really need to start and sustain almost any business is cash.
Cash is the fuel that drives a business. Without cash, a business can’t pay its bills, can’t
pay its employees, can’t buy the goods it needs to produce the products or services it sells,
can’t generate revenue or profit. Without cash, eventually a company will go out of
business. And with a reasonable amount of cash on hand or the ability to easily get more, a
company can weather tough market and economic storms, can grow by investing in new
software or research or equipment, can take advantage of new market opportunities, and
can even buy out competitors.
A business must have cash to survive and thrive.

THE IMPORTANCE OF CASH

In 2008, major companies such as Bear Stearns, Lehman Brothers, General Motors, Fannie
Mae, Freddie Mac, and at least twenty-two major banks either went bankrupt, were
purchased cheaply, or ran to the government for a bailout because they did not have
adequate cash. They each experienced a severe liquidity crisis.
Large, well-known companies like these, who most people believed were “too big to fail,”
developed serious cash problems through a series of events. First, because of their own
financial mismanagement, they failed to generate enough cash through operations to pay
the bills. When this happens, a company usually borrows money from a bank or financial
institution. But that option wasn’t available to these organizations. Their poor financial
situations significantly lowered their credit ratings, making them high-risk borrowers. And
financial institutions were developing liquidity problems of their own due, in large part, to
bad loan portfolios, so they didn’t have cash to lend. Their next option was to seek out cash
from investors, but the markets were starting to get shaky, and investors were wary of
companies that were already showing signs of weakness.
Thus began the series of bailouts, buyouts, and bankruptcies.
Why does cash play such an important role in the life of a business? Let’s consider the
role of cash in your life. You use cash (or checks or a debit card) every day to pay for your
rent or mortgage, food, doctor visits, your cell phone bill, and cappuccinos. If you pay bills
with your credit card, you are borrowing cash that the credit card company sends to the
vendor. You make investments with cash. You even pay for large purchases like your home
or vehicles with cash: What cash you don’t pay directly from your own funds, you borrow
from a bank or other lender in the form of a loan.
Likewise, all businesses—from giants like Walmart, Citibank, and Microsoft to the small
neighborhood flower shops or mom-and-pop diners—need cash to pay their bills and other
obligations. According to a U.S. Small Business Administration study, only 44 percent of
small businesses survive at least four years, and one of the primary reasons is inadequate
capitalization—too little cash. Without cash, a business will fail, so business owners and
leaders often find creative ways to get it when times are tough.
Fred Smith, who founded Federal Express at age twenty-seven in 1971, is a great
example. In a 1979 interview, Smith said, “People thought we were bananas. We were too
ignorant to know that we weren’t supposed to be able to do certain things” (New York
Times, January 7, 1979). Federal Express’s first two years were grim. In fact, on its first
night of business, the fledgling company shipped only 186 packages on its fourteen Falcon
jets routed to twenty-two cities. It was not uncommon for Federal Express drivers to dig into
their own pockets to pay for gas. Despite his $84 million in start-up capital (another term
for cash), Business Week reported that within a few months of delivering his first packages
in March 1973, Smith was desperate for cash. The challenges and risks of starting a major
global business were significant. Federal regulations were severely hampering his efforts to
compete with the U.S. Postal Service. Suddenly, he didn’t even have enough cash to pay a
jet fuel bill, and if he didn’t pay the supplier, FedEx would be unable to fly planes or pay
employees. So what did he do? He went to Las Vegas and played the blackjack tables. He
wired $27,000 back to his FedEx headquarters and the employees got paid … and you know
the rest of the story.
I wouldn’t recommend using the blackjack strategy to get cash for your business—or your
life! But it’s tempting for people and businesses to take risks when they need cash now to
ensure their future survival.

AKA
Other terms or phrases people use when they are talking about cash are cash and cash
 equivalents, cash on hand, cash available, cash balance, capital, and money.

MEASURING A COMPANY’S CASH AND LIQUIDITY

In order to evaluate a company’s ability to survive and grow even in difficult economic
times—its financial strength—we can look at three components of cash:

1. How much cash does the company currently have available, immediately? This is called
its cash position.
2. How much cash will it generate and spend through its operations during a given
period? This is called cash flow.
3. In addition to a company’s cash position, how quickly and inexpensively could it
generate more cash by selling assets? This is called liquidity.

Those in business and finance—investors, banks, shareholders, vendors—measure a

company’s cash position in relationship to its financial obligations—how much it has versus
how much it owes—and its track record of generating cash flow from operations.
If you think about it, these are the same concerns you have about your own financial
situation. How much do you have in your bank accounts and how much do you owe every
month? How sure are you that you’ll get more cash next month? If you lost your job or
other income, would you be able to keep paying your bills? I hope you can see how the
second question in particular is directly tied to the liquidity of the company you work for. If
its financial situation is unstable, how long can it support yours? This is a good reason to
pay attention to these issues.

Cash Position

Usually, when businesspeople use the term cash, they are referring to a company’s cash
position—the amount of cash a business has at any single point in time, which, for public
companies, is reported at the end of a quarter or at the close of its fiscal year.
But how is that number calculated? Is it just a lump sum sitting in a bank account
somewhere? Not quite.
The most obvious factor in determining the cash position is actual cash on hand,which
includes currency, coin, and checks in hand—on the premises—but not yet deposited. It also
includes cash balances in accounts of all types at banks and other financial institutions.
The second part of the equation is cash equivalents: any short-term securities or other
financial instruments, such as stock market or money market investments, certificates of
deposit, or short-term treasury bills, that can be sold or converted to cash quickly, usually
within ninety days.
You can’t pay bills with money you don’t have yet, so a company’s cash position does not
include accounts receivable—money owed to a company from customers who purchased
goods or services on credit. Accounts receivable represent cash to be collected in the future,
but your cash position is the cash that can be spent now.

Cash Flow

Companies rich in cash exemplify the saying “Cash is king!” However, it is not only the
amount of cash a company has on hand now, but also a company’s ability to generate cash
flow in the future, that is important. As the financial columnist Jim Jubak says, “Cash cows
are kings.”
Many investors, financial analysts, and company leaders consider cash flow to be the
most important indicator of a company’s financial health and strength—its ability to be
successful and make money over the long term. Many, including the late Peter Drucker,
consider cash flow to be even more important than profit.
Cash flow is simply the volume of cash that flows through a business as a result of
operations over a period of time. The two factors of cash flow are cash inflows, which is
cash received in the form of sales, and cash outflows, or the expenses the company must
pay as its various moving parts perform their functions. Simply put, cash flow is cash
received less cash paid out as part of the core business operations. A company can have
either a positive cash flow—total cash inflows are greater than total cash outflows—or a
negative cash flow—outflows are greater than inflows.
You can see why investors, shareholders, and employees should be concerned about a
company that is consistently paying out more cash than it’s bringing in. That company
probably isn’t profitable in the short term, and if it can’t adjust its operations to bring in
more cash, it will eventually be unable to pay its bills and be forced to declare bankruptcy
or close its doors.
Let’s meet Austin and his cycle shop to see how cash position and cash flow actually play
out in a business.

Austin’s Cycle Shop

A few years ago Austin opened his own bicycle sales and service shop—called Austin’s
Cycle Shop. He determined that he needed $50,000 to get up and running, so he used
money from his own savings and borrowed money from a bank and a private investor,
his brother-in-law. Start-up costs—his store lease, professional fees, licenses, furnishings
for the store, inventory (bikes and parts), and equipment—were $40,000. He put the
remaining $10,000 in the bank as a safety net for the early months when sales and
revenue might be shaky. So his initial cash position was $10,000.
But during the first year, Austin collected $70,000 from selling and servicing bicycles.
He also had expenses of $55,000 (he took a very small salary that first year). So how
much cash did he generate from his operations? What was his cash flow? Right,
$15,000. He never touched his initial cash reserves, so at the end of year 1, he had a
total cash position of $25,000 ($10,000 + $15,000).
In his second year, he received $100,000 in cash from sales and spent $80,000 in
 operating his business, so he generated $20,000 in cash flow.

An important note: Cash flow is not profit. In the next chapter we’ll look at the profit a
company makes in relationship to its ability to generate significant cash flows and how
they are different.

Liquidity

When we talk about how liquid a company is, we are referring to its cash position plus its
ability to generate cash quickly and without much cost by selling its assets. (To liquidate
means to sell assets to turn them into cash.) By definition, cash and cash equivalents are the
most liquid assets. But that doesn’t mean that a company that doesn’t have a lot of cash on
hand is illiquid. Walmart, for example, consistently carries relatively (relatively being a key
word here) low balances of cash and cash equivalents, yet it is still a very liquid company.
Why? Because it also carries large amounts of inventory that it is constantly converting into
cash—it has a strong ability to generate substantial cash flow through rapid inventory
turnover.
On the other hand, if a company did not have large amounts of cash and owned mostly
fixed assets—assets such as real estate and office buildings that could take months or even
years to sell at uncertain prices—it would be considered less liquid. If that company couldn’t
show that it had the ability to generate solid cash flow, investors and stockholders would
start to worry.
If we want a deeper understanding of cash and how a company actually generates it, we
have to look at all the ways a company gets cash and uses it.

HOW COMPANIES GET AND USE CASH

There are three types of activities in which companies participate to either get or use cash.
Each of the following activities is a source of cash for a company but also requires it to
disburse cash. The hope for any company is that it gets more than it uses.
Operating activities: Cash generated from your company’s core business activities less
the cash expenses from those activities is its cash flow or cash from operations, as we just
discussed. Operating activities are the most important source of cash because they are the
activities the company engages in to make money (like selling bicycles, for instance) and
therefore should be an ongoing source of cash. Simply put, you get cash from sales and you
use cash for expenses to determine cash flow from operating activities.
Investing activities: Investing activities require a company to use cash to purchase
things like equipment or facilities (vehicles, computers, warehouses), real estate, stocks or
bonds (securities), and other businesses through mergers and acquisitions. A company uses
cash in this way because it believes that it will be able to either use the assets it invests in to
create more cash flow as part of its core business, or earn interest or dividends or be able to
sell the investment for more money than it paid for it. Investing activities are necessary for
most businesses, but they come with a bit of risk because a return on the investment (cash
in greater than cash out) is not a guarantee.
A company can sell existing assets (like buildings or equipment) to generate cash, but
that isn’t a sustainable way to get cash, primarily because you wouldn’t have use of the
asset anymore. It would be like a carpenter selling his tools to raise money. While he got
cash in the short-term, he has reduced his ability to generate cash in the future. After the
Gulf oil spill of 2010, British Petroleum investors began to worry that the company would
divest itself of too many valuable assets, trapping them in an organization with
increasingly fewer cash-generating holdings. After BP divested itself of $7 billion in assets,
investor concerns presented themselves in the increase of the oil company’s interest paid on
debt, according to the Guardian (“What will BP sell next?,” July 22, 2010); yields on five-
year dollar bonds jumped to a sky-high 8 percent at the height of the panic (they’d been at
3 percent before the spill).
Financing activities: A company can get cash through financing activities by borrowing
from financial institutions or investors or selling shares of company stock. Conversely, it
may use cash in these activities by paying back loans, paying dividends to stockholders, or
buying back shares of company stock. For more information on why this might occur, see
chapter 6 or go to our website (www.seeingthebigpicture.com).
Cash received and used in each of these three areas is tracked on a company’s statement
of cash flows, which shows sources of cash (where it comes from) and how cash is used
(where it goes). I’ll discuss the statement of cash flows in chapter 10. Again, cash generated
from operations (the core business) is the best source of cash because your company doesn’t
have to sell assets (investing activities) or borrow money (financing activities).
Overall, the formula for determining how much cash has been generated through any of
these activities is:

Cash in – Cash out = Cash generated

So to keep the amount of cash generated positive and growing, companies want to
increase the “cash in” at a greater rate than the “cash out” as they grow overall.

Generating More Cash

Most companies are interested in generating more cash, even if they already have a strong
cash position and cash flow. Improving operating cash flow in particular is a sign that the
company is doing well and should continue to do well, at least in the near term.
So how might your company work to generate more cash?
Fundamentally, it will start with operations and try to increase revenues (cash in) or
reduce expenses (cash out). From there, it will invest in resources or assets, like two new
ovens to cook more pizzas faster, that it can use to generate more cash flow. And if it needs
money for a big strategic initiative, like opening five new stores, it will seek financing.
Businesses may also attempt to bring in cash more quickly than they expend it. This
supplies the company with immediate cash and may eliminate the need for borrowing (and
thus the expense of interest). Dell’s cash flow strategy is to collect money from the customer
for orders placed over the phone or Internet before it builds or ships the product. The
company then negotiates with its suppliers to pay them two to three months later,
providing Dell with plenty of cash on hand to meet its short-term obligations.
But the goal for any business is to generate as much cash as possible from operations now
and in the future.
What does this mean for you? Depending upon your role in your company, you will have
different opportunities to impact cash. For example, if you’re in sales or marketing, you can
help generate more cash faster by increasing sales revenue. If you work directly with
customers, you can provide excellent service so that customers are more likely to continue
buying from the company. If you’re in accounting, you might negotiate longer payment
terms with suppliers (but be careful that you don’t negatively impact the relationship or
give up discounts for early payment) to hold on to cash as long as possible. Or you might
work to make sure more customers pay their bills on time or early. If you’re part of the
financial management staff, you might be responsible for looking for better financing terms
on loans for new equipment.
And everyone can work to contain expenses and reduce the outflow of cash by cutting
down on all waste. Get the most out of resources like computers. Find ways to get jobs done
more efficiently so that less money is spent. If you can contribute to your company’s cash
and cash flow, you’ll be valued.

DECIDING HOW AND WHEN TO USE CASH

We’ve outlined the ways in which a company can get and use cash, but knowing the options
is a lot different from deciding what it should do. After paying its normal bills and operating
expenses for running the business, the remaining cash flow can be used in a variety of ways
(investment and financing activities), all with the goal of sustaining and growing the
business.
A primary purpose of any business is to produce a return on the investment of its
stockholders (owners or shareholders). And cash is just like any other asset: it should be
used to produce a return. Consequently, two of the most important roles that business
leaders play are (1) determining how best to generate cash and (2) deciding how to use it
wisely and efficiently to generate even more cash flow in the future.
Let’s revisit Austin to see how a business owner or leader makes these kinds of decisions.

Austin’s Cycle Shop

Austin had choices in what to do with the $25,000 cash he had at the end of his first
year. He could put the entire $25,000 in the bank and have maximum liquidity. Or he
could use part or all of it in investing activities, such as remodeling the building,
making a down payment on a truck, or buying stocks or mutual funds for a greater
return than his savings account offered. Or he could use it in financing activities, such
as paying back part of his bank loan or repaying his investor.
 But Austin decided that for maximum safety and liquidity, he would keep all of his
$25,000 cash balance at the end of his first year in the bank. He had done well in the
first year, but you never know when a competitor might open up across the street or a
piece of equipment might break.
But in his second year, he had higher sales and more cash flow, so he decided to start
using his cash. He paid back a portion of his bank loan, he bought a used truck so that
he could offer to pick up and deliver customers’ bikes, and he bought out his brother-in-
law’s investment. His brother-in-law was supposed to be a silent investor, but it didn’t
quite turn out that way and Austin was getting tired of the stream of advice he was
getting during holiday meals.

Austin could have used even more than $15,000 cash in nonoperational activities. He
still had a cash position of $30,000. He could have used, say, $10,000 more ($25,000
total) to buy more equipment or pay off more of his loan. He would have ended the
year with only $20,000 ($45,000 total cash available minus $25,000 used for investing
and financing activities)—which is less cash than the $25,000 he had at the end of year
1.
Would ending the year with less cash than he started with have made Austin a bad
manager? Not at all. He would have simply made a business decision that it was more
important to his future operations to acquire assets, pay back the loan, and repay his
investor. And because he generated more cash from operations—greater cash flow—in
his second year ($25,000) than in his first ($15,000), Austin should be considered a
good business manager, especially in a start-up enterprise.
 Companies use cash generated from operating, investing, and financing activities for
many good business purposes. The top uses of cash by corporations include paying
dividends to stockholders, buying back stock, investing in mergers or acquisitions, investing
in research and development (R&D), and making capital expenditures (investing in plants,
equipment, real estate, etc.).
Obviously, having strong cash flow opens up more options for using cash to sustain and
grow the business. Companies such as Apple, Google, and Microsoft, which generate lots of
cash flow to create large cash balances, have massive capabilities denied to other
companies with less liquidity. They can invest heavily in research and development, acquire
other companies, pay to hire and develop top talent, and spend billions of dollars on
marketing and advertising to generate more sales and more cash flow. They can take risks
with new products, markets, and technologies—and fail—without a devastating impact
upon their operations. And when they win, they win big! Apple, Google, and Microsoft are
extremely profitable, in addition to being cash cows.

SO HOW MUCH CASH IS ENOUGH—OR TOO MUCH?

While a company can never have too much cash flow, its cash position is a little different.
The rule of thumb for how much cash a company should keep on hand is: There is no rule of
thumb about how much cash a company should keep on hand.
Every company differs in how much cash it needs for operations and to protect itself in
case of a sudden financial hit (its reserves). CFOs, CEOs, and financial managers have to
consider the following variables, among others, as they try to determine how much cash to
keep tucked under the mattress, so to speak, and how much to reinvest in the company to
keep it growing:

• The seasonality of the company’s sales. If a company primarily sells year-end holiday
decorations, it may need less cash in reserves in November and December (when it
would have a lot of cash flow from sales) than in other months (when its cash flow is
much lower).
• The company’s growth trend and its forecast for future growth in sales.
• Strategic objectives that might require or generate a lot of cash, such as acquisitions,
mergers, asset purchases, or product development.
• Estimates for cash reserves that might be necessary to address sudden changes in the
industry or economy—the company’s rainy day fund.
• The company’s ability to borrow money or raise cash by selling stock. This is affected
by the company’s credit rating, current interest rates, debt levels, and how easy it is to
access capital from lenders or investors.
• The average amount of time it takes to turn the company’s investments, such as R&D,
inventory, and receivables, into cash (the cash conversion cycle). For big retailers, it’s
not much time at all. For other companies, it can take awhile to sell through inventory
or collect cash that’s owed to the company.
 Boeing, for example, began planning its newest plane, the 787, after the 9/11 attacks in
2001; it named the plane the “Dreamliner” in 2003 when it began serious development
efforts. In 2007, it revealed its first prototype to the world at a launch party. After
numerous delays, the 787 took its maiden flight in December of 2009. Boeing delivered the
first 787 to customers in 2011, but with a backlog of more than 840 planes on order, it will
be 2014 before some customers get their 787s. Once production is in full swing, the target is
to assemble one airplane every three days—which sounds almost miraculous.
According to an article in the Seattle Times, “The company’s original internal target for its
own development costs was $5 billion. But … several Wall Street analysts estimate that
fixing the litany of manufacturing problems, plus paying penalties to suppliers and airlines
[for delays], has piled on an additional $12 billion to $18 billion” (Dominic Gates,
“Dreamliner’s woes pile up,” December 18, 2010). So what has Boeing done to appease
investors? It has kept strong cash reserves. At the end of 2010, Boeing had $10.5 billion in
cash and cash equivalents. Not a bad cash position, and one that keeps the company liquid
and safe in the face of problems with getting a product to market.
Of course, companies can be criticized for holding cash. Can you imagine you or your
family ever having too much cash? I’m sure it’s a problem we would all like to wrestle with!
A business, however, isn’t exactly like a family. It can have too much cash, because its
purpose is to produce a return on all assets, and cash sitting in a bank account isn’t
necessarily producing the best return possible.
Business leaders have to consider the following issues when looking at cash reserves:

• What is the rate of return on cash sitting in a bank account or mutual fund?
• What is the opportunity cost of hoarding large sums of cash rather than investing in
new products, growing new markets, or making a strategic acquisition? In other
words, what could have been earned by using the cash in an alternative investment?

If a company has too much cash, the leaders usually start looking for ways to reinvest it
in the business. Stockholders may want the cash to be disbursed as dividends (a payment to
investors for each share of stock they own) or used to buy back stock in order to reduce the
number of shares outstanding (this would give existing shareholders a greater percentage of
earnings per share owned, which may also mean an increase in the stock price).
Microsoft has been criticized for retaining too much cash, and shareholders have
disagreed with management at times on how it should be used. In July 2004 it had over $70
billion in cash and liquid investments. Later that year it declared a special stockholder
dividend of $32 billion, or $3.00 per share, possibly the largest total dividend in business
history. With almost $40 billion in cash and investments today, Microsoft shareholders often
question the need for so large an amount still held by the company.
While holding on to too much cash isn’t necessarily a good thing, occasionally a company
may choose to do it. Perhaps management has a strategy of conserving cash to prepare to
make a major acquisition or to commit to a large-scale expansion. Or it believes the
industry or general economy is headed for rough times and wants a sufficient reserve to ride
out the storm. When the credit crisis began in December 2007, many companies reduced
their expenditures in order to raise their cash balances. They were protecting themselves
from the financial storm that could result from lower sales and limited access to capital
through financing.
In 2006, Ford’s new CEO, Alan Mulally, raised $23 billion by borrowing and leveraging
assets. At the time, some questioned the strategy, but when the credit crisis caused what
economists already call the “Great Recession”, Ford was better positioned. While GM filed
for bankruptcy and needed billions from the U.S. government to stay afloat, Ford was able
to weather the storm.

Cash is fuel. Without it, the engine of a business can’t run, the various moving parts can’t
function, and eventually the business slows down and dies. But for businesses flush with
cash, the engine keeps revving faster and faster.
In the next chapter, we’ll explore one of cash’s closest counterparts—profit.

INSIGHTS INTO CASH

• Cash is the fuel of business. All companies require cash to operate, pay bills, and
invest for the future. Lack of cash is a primary reason businesses fail.
• At any point in time, the cash position is the amount of cash on hand and in financial
accounts, plus short-term securities convertible to cash within ninety days (called cash
equivalents).
• During any period of time (month, quarter, year), cash flow is all cash collected from a
company’s operations (core business) less all cash used (disbursed) for expenses to run
the core business. The ability to generate cash flow is usually considered more
important than the amount of cash on hand at a given point in time.
• Liquidity refers to a company’s available cash and its ability to turn its assets into cash
quickly and inexpensively.
• A business gets and uses cash in three basic activities: (1) operations (core business);
(2) investing, or buying and selling assets; or (3) financing, by receiving and paying
back loans (debt) or selling stock to investors, paying dividends, or buying back its
own stock.
• You can impact cash by helping to increase revenues, cut costs, delay (appropriately)
payables (money owed by the company), and accelerate collection of accounts
receivable (money owed to the company).
• A business with too much cash is earning very little return on this asset compared to
what it might earn through alternative uses. Shareholders prefer that excess cash be
invested or given back to them.
 Chapter 2
PROFIT
Profit is like oxygen, food, water, and blood for the body; they are not the point of life, but without
them there is no life.
—Jim Collins

O n March 10, 2000, the NASDAQ hit a high note, all because of trades for a special
category of companies—the dot-coms. But then the slide began, and many of the
companies that were traded in high volume and for amazing prices on March 10 no
longer existed just a year or two later. Why?
No profits.
The dot-com bubble was an astounding time of speculation. Hundreds of companies went
public even though they had never turned a profit. Everybody was sure that the future of e-
commerce would push those numbers out of the red and into the black—but for many, it
didn’t happen. Quite simply, these companies couldn’t generate enough revenue to cover
their costs, either because of poor management or a poor market for their services. Warren
Buffett famously avoided the dot-com crash because of his basic rule that if you don’t
understand how a company makes money, you shouldn’t own the shares. He couldn’t see a
clear plan for profitability.
In the previous chapter, I said that cash is the fuel that drives the engine of any business.
If that’s true, then profit determines if and for how long that engine will keep running.
Profit is simply the difference between how much you make by selling goods and services
(revenues) and how much it costs to produce and sell them (expenses), but it is not the same
thing as cash flow, which I’ll explain in a moment. Obviously, you want to sell your
products for more than they cost! It’s amazing how some businesses lose track of this simple
idea. The dot-coms and all of their investors and stockholders epitomize the profit-blind
behavior that can lead companies to their demise.
A company’s future is ultimately determined by how much cash it generates from profits,
where that cash comes from, and how rapidly and consistently it comes in over time. For
publicly held companies, stock price is determined primarily by how quickly, by how much,
and with what consistency investors believe the company will increase its profits. Just as
with cash generation, your core business operations are the most important source of
profits. Profit might also be earned from investments, selling assets, or other means. But
your company’s financial health is measured primarily by how profitably you can conduct
your core business over time—to generate increasing sales, control expenses, and grow your
income.

AKA
When discussing the profit for a company as a whole, people might use the terms profit,
 net profit, income, net income, earnings, or net earnings.

PROFIT AND CASH FLOW ARE DIFFERENT

While on the surface it might seem that profit and cash flow are just about the same, they
are not. The differences amount to how each one is calculated and when each one is
recorded on the books. These may seem like accounting technicalities, but each of these
numbers is meaningful in a unique way, so it’s important to understand the difference.
As we discussed in chapter 1, cash flow is the difference between actual cash received and
actual cash used in the process of doing business (from core operations). Each day, month,
quarter, and year, a company receives a certain amount of cash and pays out a certain
amount of cash. It’s that simple. Analysts look at cash flow carefully because it’s a very real
measure of how a company is doing (whether it will be able to pay its bills tomorrow or
next week or next month).
Profit, on the other hand, is revenue from the sale of services and products—whether
payment in the form of cash has been received yet or not—minus all expenses—expenses
paid in cash, expenses to be paid in cash at a later date, and expenses accounted for in
other ways.
While you could say that the profit isn’t “real” because the cash hasn’t moved in and out
of the company, it’s still important to know whether a company is earning income (making
more than it’s spending) from its daily operations over a period of time. If we didn’t
calculate profit (or income) this way, a company could appear to not earn any income one
month, be hugely profitable the next, and so on, depending on when its bills are due and
when its customers pay their debts. But that wouldn’t be a very good indicator of how
consistently it’s earning income from its core operations, would it? Even if its financial
performance was steady overall, it might seem erratic if we didn’t follow this type of
accounting system, which is called accrual-basis accounting.
Another way to think of accrual-basis accounting is that it tracks transactions. Sales,
expenses, and profits are recorded when the transaction is made. Apple records the sale of a
computer when the customer picks it up at the store and the expense for making the
computer at the same time, even if the customer arranges to pay for it over several months
and the cost of putting the computer together was paid a few months before the sale was
ever made. Small companies may use cash-based accounting, in which you record a sale
when cash is received and expenses when they are paid.
When we look at income statements in chapter 8, we’ll explore all of the factors that
affect the profit calculation.

THE BOTTOM LINE AND OTHER MEASURES OF PROFIT

When it comes to profit, there are two common measures people focus on: gross profit and
net profit. Each of these measures is an important indicator of financial health.
Gross profit is a useful measure for companies on a day-to-day basis because it tells them
how much money they are earning on each product or service they sell. Gross profit is
calculated by subtracting the cost of a particular product or service (what it cost the
company to buy or make it, or the cost of goods sold) from the sale price. More often, we
refer to total gross profit, which is all revenue (sales from the core operations) less the total
cost of goods sold. A company wants to earn as much as possible from each sale, so it will
look at gross profit as it sets prices, decides whether to sell a product or service, determines
the product and service mix it will offer, and decides how much money it should budget for
buying or making a product or delivering a service.
When businesspeople talk about how profitable a company is, they are usually referring
to the amount of net profit (net income) it earned. And when you hear leaders say that a
new strategy is going to improve the bottom line, they are talking about net profit—
because net profit is generally the last line, or the bottom line, on the income statement.
Net profit is simply all revenue recorded by the company minus all expenses, including cost
of goods or services sold, discussed above, and expenses not related to the sale of a
particular good or service, such as salaries, rent, advertising costs, utilities, and so on. These
costs are referred to as operating expenses, and I’ll talk more about them later in the chapter.
One operating expense frequently discussed is overhead, or general and administrative costs,
which includes the salaries of support personnel, rent, supplies, and other similar items.
Without a strong gross profit, a company can’t book a net profit, because gross profit must
be high enough to cover all of the operating costs.
For both gross profit and net profit, leaders and analysts will often focus on the profit
margin, which is the amount of profit divided by the amount of revenue, expressed as a
percentage. (The terms you’ll hear them use are gross profit margin or gross margin or net
profit margin or net margin.) Why do people care about margins? Because they tell us how
efficiently a company is turning revenue into profit. For instance, if the net profit margin is
13 percent (the average for large companies), then eleven cents out of every dollar received
is profit. Even though one company has lower profit in dollars than another, its profit
margin might be significantly higher, indicating a well-managed business that generates
more profit from every dollar of revenue.
Note: You may see gross margin used interchangeably with gross profit. The two are not the
same, but in casual usage, you may see gross margin with a dollar figure after it. When you
do, what you are seeing is actually gross profit.
Let’s return to the story of Austin and his bike shop to understand this better.

Austin’s Cycle Shop

Austin has made it through year three of his business. He’s a bit more established and
feels confident that he can keep cash flowing to keep the doors open, but he’s becoming
more focused on profit. He needs to be if he wants to survive and grow. Austin’s gross
profit is his sales price per bicycle or part sold, less his direct costs of buying the bicycle
or part from his supplier and any related costs. Austin’s net profit will be what’s left
over from the gross profit of all his sales after he deducts his remaining operating costs:
the salaries of the people working in the shop, rent for his shop space, advertising
 online and in local publications, utilities, interest on debt, and taxes.
For his third year of operations, this is what his profit looked like:

Revenue 140,000
Cost of goods sold (COGS) (91,000)
Gross profit 49,000
Operating costs (38,000)
Net profit before tax 11,000
Tax (4,000)
Net profit (net income) $ 7,000

Austin’s gross margin is 35 percent ($49,000 / $140,000). His net margin is 5 percent
(7,000 / 140,000). For retailers, those margins are average, but you’d expect higher
than average margins for a specialty retailer like Austin.

The average net profit margin of the S&P 500 was about 13 percent in 2011. This means
that for every one hundred dollars in revenue, a company would generate eleven dollars in
profits. Recall from the previous chapter that Microsoft generates substantial cash flow. It
was also the fourth most profitable public company in the United States in 2010, earning
$18.8 billion, and had a very healthy net profit margin of over 30 percent, well above the
S&P average. Likewise, Apple and Coca-Cola beat the S&P average with net profit margins
higher than 20 percent. Some would think that the two largest companies in America,
Walmart and ExxonMobil, would also enjoy a higher than average net profit margin, but
they don’t. ExxonMobil generated $30 billion in earnings in 2010, more than any other
company that year; its net profit margin was 8.2 percent. Walmart generated $16.3 billion
and had a net profit margin of only 3.8 percent, which means for every hundred dollars
Walmart sells it generates three dollars and eighty cents in profits. These are all
tremendously successful companies, so why the variation in their net profit margin?
Think about it this way: You don’t have to buy your gas from ExxonMobil and you don’t
have to buy your milk from Walmart, but can you buy an iMac from someone other than
Apple? Can you buy a license of Microsoft Office from someone other than Microsoft? While
there are a lot of soda pop choices, my sister will order a water if Diet Coke isn’t on the
menu. Companies that sell commodities, products that are readily available from multiple
vendors, will typically have lower profit margins compared to companies that are selling
something unique or exclusive. Remember this: If you’re not unique, you better be cheap.

TWO WAYS TO INCREASE PROFITS

Most company leaders would like to increase profits—and most investors would like
companies to increase their profits. It is almost always a primary factor in a company
strategy and can become the main focus, particularly if profits have been holding steady or
declining. There are two fundamental ways to increase business profits from operations:
grow revenues and/or reduce expenses. Strategies based on either of these goals can be
difficult to execute and can have unexpected results. Sometimes growing revenues requires
making investments that might not earn a return in the near future—or at all. Growing
revenues by raising prices could have the effect of lowering sales. And reducing expenses
requires careful analysis. If you cut employee benefits, for instance, you might lose valuable
employees and incur greater costs to hire new people and train them. Many companies
struggling during the recent downturn boosted their profits by laying people off. The
challenge is that, as demand increases, they may not have enough of the right employees in
place to meet their customers’ needs.
Austin recognized the tricky situation he was facing.

Austin’s Cycle Shop

Austin was disappointed with his operations. His monthly sales revenue was increasing.
However, his expenses had also been creeping upward. His cost of goods sold had
suddenly jumped because of supplier consolidations and price increases. His overhead
had also grown faster than sales because he had hired two part-time employees—a
service and repair technician and a sales clerk.
Since Austin’s margins were declining, he had a big problem: He wasn’t earning
much personally. If something didn’t change, his family wasn’t going to be able to
afford his business much longer.
Austin was earning $300 for every higher-end bicycle he sold:

Product (bicycle) sales price: $1,000

Cost of goods sold: (700)
Gross profit: $ 300

He had two options to increase profit: (1) raise revenues by increasing prices or
selling more of his products and repair services, and/or (2) lower his costs. If he raised
his prices, his gross profit would be greater on each bicycle sold, but he might sell fewer
units and reduce his total gross profit. If he lowered his sales prices, he could sell more
bikes, but at a lower gross profit. Would the increase in sales make up for that? If he
could find some way to reduce his cost of goods sold (the cost of the bicycle), he could
lower his price, maintain his gross profit on each unit, and increase sales, creating
greater cash flow and profits. But the cost was set by his supplier.
The way Austin saw it, his two options were actually four:

A Try to negotiate with his supplier to lower his cost of goods sold to $600 to enable
a lower sales price of $900 while keeping a gross profit of $300. The lower prices
could increase sales, thus increasing total gross and net profits and cash flow.
B Try to lower cost of goods sold to $600, keep the same sales price of $1,000, and
 increase gross profit to $400.
C Increase the sales price to $1,100 if cost of goods sold stayed at $700, to generate
higher gross profit of $400.
D Increase sales price to $1,100 and lower cost of goods sold to $600, to create gross
profit of $500.

We’ll find out what path Austin took in the following pages.

Grow Sales Revenue

There are two ways to grow sales revenue: increase the price of the goods or services sold or
increase the sales volume.
People might be willing to pay a higher price for your product (thus growing sales
revenue and increasing gross profit) if there is value added to the product through enhanced
features or better ongoing support, or if market demand supports the higher price.
However, increasing the price might also result in fewer products sold; customers might not
be willing to pay the higher price. The result could be more gross profit on each product
sold, but less total gross and net profit.
Consider what happens when oil companies increase gas prices. When prices are in a
steady upward trend, customers may buy more efficient vehicles, take fewer road trips, and
ride the bus to work when they can. But using less gas requires changing our habits,
sometimes substantially. The oil companies count on the fact that many of us won’t be
willing to make those changes. And for most of us, gas is a necessity; we won’t stop buying
it entirely unless we can no longer afford it.
If a company thinks it can’t increase prices without hurting demand, it will often work to
increase sales volume through strategies like the following:

• Lower prices to increase demand for the product.

• Innovate products and services to create new offerings that are more profitable or in
higher demand.
• Improve the quality and skill sets of customer service and sales teams.
• Use aggressive marketing and sales strategies to drive demand for products. If you are
in sales or marketing, your work will have a direct influence on generating more sales
revenue.
• Open a new location, begin selling products online, or develop new distribution
channels through relationships with other companies.
• Develop new customer markets through geographic or demographic diversification.

A new trend in the entertainment industry in the United States is helping concert
promoters and artists ensure that tickets will sell—and maybe sell out—during tough
economic times. Promoters are putting tickets on sale far in advance of the actual show,
sometimes with a lead of almost a year. The goal is to get access to the limited dollars
people have to spend on entertainment before somebody else does, such as a promoter of
another show that same week or month. The promoters offering early purchase options are
beating their competition to the market in order to meet their sales volume projections.
A classic example of increasing sales through price reduction is Henry Ford’s plan to sell
more cars by making them affordable to even his own factory workers. He presented his
idea to his board, which, thinking that he was in the wrong, tried to oust him, even suing
him for control of the company. But Ford prevailed. In 1909, prices were at $220. By 1914,
he had slashed prices to $99. Margins on each unit plummeted, but sales skyrocketed, and
net income rose from $3 million in 1909 to $25 million in 1914.

Austin’s Cycle Shop

Austin decided customers would pay more for his products, so the first tactic he tried
was to raise the price of his best-selling bike by $100. His gross profit per bike
increased to $400. But instead of increasing his total gross profit, the strategy reduced
 his gross profit by $200! What happened? He had averaged ten sales per month for a
total gross profit of $3,000—to be increased, he had hoped, to $4,000 (10 × $400).
However, the next month he sold only seven bikes at the higher price for a total gross
profit of only $2,800 (7 × $400). His strategy had backfired, so he dropped his price
back to the original.

As Austin found out, if we increase our sales price too much, we can price ourselves out of
the market. Customers will buy the same or similar products and services from our
competitors for lower prices or because of perceived greater value—perhaps with added
quality, warranties, services, or accessories for the same price.
If we keep prices the same, better advertising, better marketing, customer referral
incentives, and broader distribution might drive increased sales. But these initiatives might
require more costs to fund the additional marketing or distribution. And there is always the
risk that sales won’t increase enough to make up for the added cost. Keep in mind that for
every unit sold, the cost of goods sold has to be accounted for, so the effect on the bottom
line may be minimal.
Let’s look at a simple example of the effect on the bottom line of increasing revenue. This
company increased its revenue by $3,000, but notice the effect that has on net profit:

Increase in revenue $ 3,000

Less: Cost of goods sold (2,100)
Gross profit $ 900
Less: Operating expense (450)
(Due to higher marketing costs)
Net profit before taxes $ 450
Less: Taxes (33%) (150)
Net profit $ 300

Remember the law of profit margins. Only a small percentage (for most companies) of
revenue produced turns into actual net profit. Here, $3,000 in additional revenue produced
only $300 in net profit.
We’re growing sales … and losing money! Many a business leader has heard this cry. It’s not
enough to grow sales revenue if you want to increase profit. If expenses are increasing at a
faster rate than sales, you’ll reduce profits until you lose money even though sales are going
up! This is what happened to many of the dot-com businesses in the late nineties, which
resulted in the dot-com crash at the turn of the century.
Like every business strategy, strategies for growing sales revenue have to be analyzed
carefully.
Reduce Costs

Reducing costs to increase profit often seems like the easiest path, because reducing any
type of expense (assuming the same sales volume) will result in increased profit for the
company. There are many sources of costs in any business, so there may be lots of
opportunities to make cuts without putting the burden on one particular area. However, the
reality is that there are only so many costs that a company can control in the short term.
For instance, short of abandoning a lease and paying all of the fines or fees for doing so, a
company can’t change the rent it pays on its properties until leases are up for renewal.
While cost cutting is often an easy target for any company trying to drive profit, it can’t
come at the expense of the customer. For example, in a cost-cutting move in 2007, Circuit
City laid off all sales associates paid 51 cents or more per hour above an “established pay
range”—essentially firing 3,400 of its top performers at once. Unfortunately, Circuit City
found out too late that these higher-paid associates were the most knowledgeable about the
products and in the best position to serve customers. Over the next eight months Circuit
City’s share price dropped by almost 70 percent and in November of 2008, the company
declared bankruptcy.
Even so, companies need to constantly drive efficiencies and innovation to control costs
and stay competitive. For any business, there are four basic categories of expenses or costs.

• Cost of goods sold (COGS)

 • Operating expenses
• Interest expense
• Taxes

Cost of Goods Sold (COGS): COGS is sometimes called cost of sales or direct cost because
it is directly associated with the production or sale of individual product units or services.
These costs include the cost of raw materials and labor to manufacture products, the cost of
inventoried products purchased from suppliers or distributors for sale in a retail business,
and other similar expenses. COGS is sometimes called variable costs because the more
products sold, the higher these total costs become; the total costs are reduced when sales
volume declines. To be profitable, you must at least have a COGS that is less than your
product sales price. As an accounting professor put it, “You can’t lose money on the unit
and make it up on the volume”—although some companies try hard to do it! If you are
selling each unit at a loss, adding up a lot of negative numbers isn’t going to give you a
positive one. And to have an actual net profit, you must also have enough left over on
every sale to cover operating expenses, interest, and taxes.
Many employees can influence the COGS by negotiating with suppliers, reducing scrap,
and improving efficiency so less labor, cost, and time is needed. If you work in purchasing
or procurement, you can focus on reducing the COGS by getting better prices on inventoried
products or raw materials. But keep in mind that lowering COGS too much might result in
lower-quality products or service—manufacturing defects, fewer upgrades or add-ons, or
reduced customer service and support. Those lower costs might end up actually costing the
company millions of dollars in lost sales revenue or recall expenses if quality suffers
enough.
On the other hand, seemingly negligible cuts to cost can add up to a big boost for profits.
To address its profit challenges, General Mills saved $1 million a year by reducing the
number of pretzel shapes in its Hot ’n Spicy Chex Mix. It makes hundreds of such cost-
cutting decisions each year through a process called margin management. By minutely
analyzing every aspect of the product from ingredients to box size and the number of
different varieties it offers, executives reduced the cost of goods sold for Hamburger Helper
by 10 percent. And eliminating multicolored lids on Yoplait yogurt saved $2 million a year.
Operating Expenses: Operating expenses include salaries of support functions like IT,
HR, and finance; travel; rent; utilities; sales and marketing expenses; research and
development costs; and the cost of capital allocations for equipment and buildings used to
run the business. Operating expenses that remain unchanged (over the short term)
regardless of the volume of products sold are also called fixed costs. When a company goes
through a period of lower sales and revenue, those fixed costs become very worrisome, and
leaders have to start making tough decisions to sustain the company, such as laying off
employees, hopefully with better results than Circuit City’s. When times get really tough,
they may implement mass layoffs, dismissing large numbers of people at once. In February
2011, as a result of the slow economic recovery, more than fourteen hundred companies had
mass layoffs, involving a total of 130,818 people, according to the Bureau of Labor
Statistics. And that was a good month compared to the previous two and a half years.
But in the absence of severe financial circumstances, companies often seek to lower their
operating costs without ever considering laying off employees. And they turn to their
employees to help them do it. Everyone within an organization can work to reduce
overhead expenses by reducing waste of all types. If you’re a manager, you might institute
measures and metrics in key cost areas for your team to track, and then act on the data to
improve efficiency. Human resources personnel can contribute by identifying the most
effective and efficient people possible for positions at every level in the company. Leaders
can make cost-cutting initiatives visible in the organization and communicate the reasons
for them clearly.
Walmart, one of the world’s largest companies (the largest in 2010), has strict cost
controls throughout the organization. It searches for the most affordable healthcare options
to offer its employees, and it combines shipments so that trucks drive with full loads,
maximizing efficiency as it moves inventory throughout the country. Even Walmart’s
business executives fly coach.
Let’s take a look at how Austin worked to reduce both his cost of goods sold and his
operating expenses and see how that worked out for him.

Austin’s Cycle Shop

To lower his cost of goods sold, Austin began shopping for a new supplier who might
compete for his business. It worked. He found a second supplier and used its pricing to
negotiate a better deal with his current supplier. He was able to reduce his COGS by
$100, putting his gross profit at $400. Sales held at about ten bikes per month,
increasing his total gross profit to $4,000 per month. Things were looking up.
A few months went by with increasing sales, and Austin decided to take a risk and
decrease his sales price to $950 to see if he could increase the number of bikes sold.
Sales jumped up to twenty units each month and he was raking in $7,000 a month in
gross profit. Things were going so well with the current price and gross profit that he
decided to stick to the formula.
Austin was happy that his profits were on the rise, but he also realized that he could
be doing a better job controlling his operating expenses—his overhead. For the year,
his overhead would be higher than the previous year because he had two employees for
the entire period. He was watching his bottom line carefully. New bike sales revenue
was outstripping bike-servicing revenue, so he decided to reduce the hours of his service
and repair technician. He also reduced the hourly pay of his sales clerk and created a
sales commission incentive plan. His sales remained on an upward trend, and he felt
sure his net profit margin would look better this year.

Interest and Other Expenses: Many companies, including Austin’s, have other expenses
that they have to account for, such as interest on loans, losses on investment transactions,
or other expenses related to borrowing and investing money. Sometimes these expenses are
one-time events (nonrecurring or extraordinary expenses) such as the purchase or sale of
assets, a lawsuit, the discontinuation of a business unit, or other costs not associated with
running the daily business. Companies will work hard to avoid some of these expenses (such
as a loss on an investment), but expenses in this category are sometimes necessary if a
company wants to make a bold move to grow, such as buying out a competitor.
Taxes: One factor that companies have to take into account as they work to increase
profit is that they will also be increasing their taxable income, possibly increasing their
federal, state, and local taxes. So cost-cutting measures don’t result in a dollar-for-dollar
increase in profit (just as revenue increases do not); the savings are partially offset by the
increase in taxes due. But if a company reduces its tax liability directly, the money saved
does increase its profit dollar for dollar.
How can a company do that? By reinvesting profits into the development of the business
and taking advantage of tax breaks. General Electric (GE) made the news in 2010 when it
earned net income of $14.2 billion but, according to an April 16, 2010, CNN article, paid no
U.S. federal taxes. A primary factor is that about $9 billion was earned overseas and
reinvested. And GE’s circumstances aren’t unusual. Boeing paid no federal taxes from 2008
to 2010, Bank of America paid no taxes in 2010, and ExxonMobil paid no taxes in 2009, a
year when it was the second most profitable company in the world. The tax code for
businesses is complicated, and there are a variety of tax breaks that can reduce a company’s
taxable income to $0.
Many companies would rather use their money to invest in the company and grow it
(expenses that reduce the bottom line) than pay taxes. So they may sacrifice profit in order
to spend their money to further their overall strategy.
While reducing expenses can be difficult, it is often the most efficient way to improve the
bottom line. Let’s return to the example of increasing revenue. You’ll remember that
increasing revenue by $3,000 produced $300 in net profit. But what happens if we reduce
the COGS for that revenue by $300 and operating expenses by $100?

It took $3,000 in increased revenue to produce $300 in net profit. But it took only $400 in
cost reductions to increase profit by $270. You can see why companies regularly institute
organization-wide cost-cutting measures.
 If a company wants to increase profits and continue to grow, it must increase revenues
and control costs.

INSIGHTS INTO PROFIT

• Profit is the difference between the revenues you generate and the expenses incurred
to create them.
• Profit is measured in dollars on the income statement and is also referred to as
earnings or income.
• Gross profit is revenue less cost of goods sold. Net profit is revenue less all costs,
including operating costs (overhead) and other costs. Profit margin (gross or net) is
profit as a percentage of revenue (profit divided by revenue).
• Investors evaluate the worth of companies in large measure by their potential to
consistently increase profits from their core business over time.
• Profits are increased by some combination of growing sales revenues and/or reducing
costs.
• We can increase revenue by raising product prices and/or selling more products to the
same or new customers.
• We can reduce costs by decreasing the cost of goods sold (direct costs) and/or reducing
operating expenses (overhead or general and administrative expenses).
 Chapter 3
ASSETS
Apple has some tremendous assets, but I believe without some attention, the company could,
could, could—
I’m searching for the right word—could, could die.
—Steve Jobs, on his return as interim CEO in 1997

S outhwest Airlines is one of the largest domestic airlines in terms of the number of
passengers who fly on its planes each year. And it has by far the best financial
performance record in American commercial aviation. It has been profitable every
year in its over-forty-five-year history, including the crisis period following 9/11. It was
profitable even during the Great Recession that began in December 2007, while American
Airlines, Delta, and United all lost billions of dollars. In 2010 Southwest earned $459
million in a still-tough economy.
How has it achieved such sustained profitability? A big factor has been smart, efficient
use of its assets.
Its focus on fast turn times—time spent unloading and reloading planes—between flights,
an average of twenty-five minutes compared to the industry average of thirty-five to sixty
minutes, means that key assets like airplanes and pilots are idle for less time every day,
month, and year. Its strategy of point-to-point flights (rather than the traditional hub-and-
spoke pattern of most major airlines) helps it minimize connection times, flight delays, total
trip time, and fuel costs.
As a result, Southwest gains more flying time per pilot and requires fewer total employees
per aircraft, using its human assets more efficiently.
Unlike other airlines that use a number of different types of aircraft, Southwest uses only
one model: the efficient Boeing 737. Savings in crew training, maintenance and ground
service personnel training and in parts and inventory, plus the capability to substitute any
aircraft for any other, produce substantial efficiencies, cost savings, and passenger
satisfaction.
Like Southwest’s airplanes, fuel, hangars, and crews, everything a company uses to
produce revenue is an asset. Whether tangible, like cash, buildings, or equipment, or
intangible, like patents or copyrights, assets are the resources used to get the results leaders
strive for. They support the financial strength of the company. Yet where assets are
concerned, leaders face a dilemma—a dilemma at the root of many strategic decisions: how
to balance asset strength, which provides flexibility in meeting obligations, taking
advantage of opportunities, and surviving difficult economic conditions, with asset
utilization, which generates a high return on investment to meet the stockholder objectives of
sustained corporate growth and earnings.

WHAT ARE ASSETS AND HOW DO WE USE THEM?

Your house, your cash savings, your investments—these are all assets that you own. While
you may not necessarily use them to produce revenue, you do use them to support a certain
standard of living, to support your personal growth in a variety of ways.
Likewise, your company has assets and uses them to support its growth by producing
revenue and profits. Without enough assets or the right combination of assets, your
company can’t remain in business; it can’t be profitable. You sell your inventory of products
(an asset) to generate revenue. You lease buildings to house your people and equipment to
perform your work. You use transportation assets, like airplanes and trucks, for travel and
shipping. You use cash assets (covered separately in chapter 1 because of their importance)
to pay bills, to make investments, and to buy inventory, materials, and equipment. And
your accounts receivable are assets that represent a source of future cash flow such as
written contracts your company has with customers or other parties that indicate payments
you will receive. Even your business relationships, such as joint ventures with other
companies or a partnering agreement with a key supplier, can be considered assets, even if
they are not listed on the balance sheet. They are used to produce revenue, cash flow, and
profits for your business.
Intellectual property (IP) and patents can also be hugely important assets for some
companies. In their book Rembrandts in the Attic (Harvard Business Press, 1999), Kevin
Rivette and David Kline explain how Dow Chemical profited immensely from analyzing and
maximizing the company’s previously mismanaged IP assets. Forced to cut costs by an
industry-wide recession in the early 1990s, Dow conducted a yearlong audit of its patents.
The end result was $50 million saved immediately due to a reduction in taxes and
maintenance fees for unneeded patents. But more important, better management of IP
assets resulted in increased patent licensing revenues: They shot up from $25 million in
1994 to more than $125 million by the end of the decade.
Although they are not represented on any financial statement, your people (employees
and customers) are your most important asset. Without them, none of your other assets
make any money. Since employees and customers are central to a company’s business
success, they will be addressed in more detail in chapter 5.

ASSET STRENGTH: LIQUIDITY

How would you answer the question “How strong is your company?” You might think about
your cash flow or your profit, but if you are speaking to a potential investor or analyst,
they would also be interested in asset strength.
Your company’s asset strength reflects its ability to meet its financial obligations now and
in the future, to survive the storms and fluctuations of business, and to take advantage of
profitable opportunities when they arise. It manages these feats of strength by possessing
cash and other assets of greater value than its liabilities—its debts and future financial
obligations. These assets and liabilities are communicated on the balance sheet, which we’ll
explore in chapter 9.
What is the most important indicator of asset strength? Liquidity. Recall from chapter 1
that the more liquid a business is, the more cash it has readily available (cash position), or
can generate, quickly and without much cost, for important purposes: solving difficult
problems, riding out down markets, and creating or taking advantage of opportunities to
grow. And businesspeople can make an important impact on a company’s liquidity by
conserving cash and contributing to cash flow. Cash, and the ability to generate cash, is
perhaps your company’s most important asset—after its people.
Anything that impacts cash positively (see chapter 1) strengthens your assets. Increasing
product prices, decreasing costs, selling more products, or introducing more products can all
improve your company’s cash position and strengthen your asset base and liquidity. With
more cash, the company can acquire many different types of assets—including other
businesses—to make more money.
Because liquidity or asset strength is so important, we examine it from multiple angles.
Leaders look at the total value of assets and subtract the total amount of liabilities
(financial obligations like debt) to see what’s left over (hopefully a positive number). This is
called equity, and just like the equity in your home (its market value minus what you owe
on your mortgage), it represents a reserve for possibly raising cash. Analysts might also
look at equity as part of a ratio comparing it to total debt (called the debt-to-equity ratio).
We’ll discuss these measures in more detail in chapter 9.
Leaders and accountants are also concerned with a company’s ability to cover its debts in
the short term, so they compare cash and other liquid assets to bills that have to be paid in
the next twelve months (called short-term liabilities). Stronger companies can pay their bills
and still have liquid assets left over. If you have just enough liquid assets on hand to cover
yourself for twelve months, your asset strength may be shaky. If your revenue suddenly
drops, or a customer delays paying you, you may have trouble making payments. And if a
compelling opportunity for growth suddenly crops up, you may not be able to take
advantage of it. However, some strong companies, such as Walmart, have lower levels of
liquid assets in relationship to short-term liabilities but generate such massive and steady
cash flow that there is no concern about the company’s ability to meet its obligations.
Finally, the nature of your company’s assets, particularly assets used to generate revenue
versus those that aren’t, influences asset strength. For example, large amounts of real estate
or other fixed assets not used to produce revenue provide less financial strength than the
same dollar value in assets that are directly used in producing revenue.
Credit rating agencies such as Standard & Poor’s (S&P) and Moody’s use this information
about asset strength, plus in-depth analysis of financial history, profit and cash flow
generation, and other information, to assess the risk to investors of lending money to, or
purchasing stock in, companies. The more equity a company has, the less risky it is, because
it has resources to fall back on in case of troubled times. But rating agencies don’t only
assess companies. S&P made headlines in August of 2011 when it downgraded the United
States from its AAA credit rating (for the bonds it sells to raise money) for the first time in
history.

Austin’s Cycle Shop

Austin, as always, was searching for ways to grow his business and become more
profitable. He saw his larger competitors in the market thriving as the popularity of
 cycling as a form of exercise and as a competitive sport grew. He wanted to take
advantage of the boom, but was struggling. Austin had been digging into his cash over
time, and now he had an opportunity that could change his future profits, but he wasn’t
sure he could take advantage it.
Austin’s supplier said that if he placed larger orders for bicycles, parts, and
accessories (his inventory, an asset), he could get a substantial discount. If he could
reduce his cost of goods sold, Austin could lower his sales prices—which could mean
more units sold and more profit.
But Austin would need more up-front cash and storage space, which he didn’t have.
He couldn’t sell his inventory of bicycles and parts faster to generate more cash flow
because he didn’t want to lower his prices any more. He could not borrow any more
money because the bank didn’t think he had enough asset strength to support a loan:
His liquid assets were not sufficiently large in relationship to his liabilities.
Austin wondered if he had been neglecting his asset strength and if it would cost him
a major opportunity to take his business to the next level.
He started thinking about bringing in an equity partner to invest in the shop. With
more cash, his balance sheet would be stronger, his liquidity would improve, and he
would be able to place larger inventory orders, lower his price, sell more bikes faster,
and generate more cash and profit.
It was the best choice, he decided, and he started the process of seeking out an
investor.

Liquidity is an important aspect of asset strength. However, cash doesn’t earn a great
return, which brings us back to the dilemma mentioned at the beginning of the chapter:
balancing liquidity with utilization.

ASSET UTILIZATION: PRODUCTIVITY

Accumulating assets, particularly liquid assets, can be a necessary strategy for some
companies, but the purpose of assets, even cash, isn’t to be socked away. The purpose of
assets is to be put to use to generate revenue, a return on the asset. However, while cash
doesn’t earn a very high return, utilizing cash to acquire other assets that earn higher
returns can mean less flexibility in meeting unforeseen problems or opportunities, which
typically require ready cash.
When leaders discuss asset utilization, they mean how effectively and efficiently you use
your assets to produce revenue or to reduce costs. The biggest factor in asset utilization is
productivity: the amount of work accomplished or goods produced per unit of assets used
(including equipment, time, labor, people, or cash).
A machine making one hundred widgets per day is more productive, and is being better
utilized, than a similar widget machine making only fifty per day. This is a case of
underutilization of an asset. In your company, you can play a role in identifying, reducing,
or eliminating underperforming assets and replacing them with more efficient ones. And
you can look for ways to use existing assets more efficiently.
Stretch your mind a little as you look for creative ways to maximize asset productivity.
Kingsford, the leading manufacturer of charcoal in the United States, was founded when
Henry Ford learned of a way to turn the wood scraps from automobile production into
charcoal briquettes. Ford in effect converted the waste from one asset into an asset in its
own right!
Measuring productivity is almost a science. There are many different types of assets, and
you need different types of measures to determine how productive each asset is. For
instance, how you measure the productivity of a marketing employee is substantially
different from how you measure the productivity of a widget machine. While there are some
universal financial measures, many companies (think about manufacturing companies)
need to understand in fine detail how productive each asset is to make sure they are
investing wisely and using each asset to maximize the return on those investments.
Let’s begin by looking at employee productivity. The productivity of employees reflects
how much work employees can accomplish (as measured by tasks accomplished or work
product created) in an hour, day, week, etc. For example, a call center employee properly
handling twelve calls per hour is more productive than one handling only eight calls per
hour with the same degree of effectiveness. However, if we have to pay the higher-
performing employee twice as much to produce 50 percent more than the lesser-performing
employee, the company might not be better off. And the key phrase is “properly handling
calls.” If the more productive employee is rushing through calls, leaving customers
dissatisfied, then the employee isn’t actually more productive in the big picture.
A company has various ways to determine the productivity of its workforce, depending
upon the nature of its business, industry, and the specific functions individual workers
perform. One measure is how much revenue is produced, or the total dollar value of goods
or services sold, divided by the total number of employees. In some companies, all
employees have to track their time to projects they work on. This is particularly true in
service companies, such as law firms, advertising agencies, accounting firms, and design
firms, which need to be sure they are being paid for the assets they utilized in performing
the work. The clients are billed for every hour worked by any employee on their projects.
But in recent years, law firms in particular have been condemned for overbilling—inflating
the hours listed on invoices. And in Florida, the top officials of a security firm were actually
arrested on racketeering charges as a result of defrauding one county by millions of dollars.
According to whistleblowers, the company sometimes left security posts empty because it
didn’t have enough staff (assets) to fill them, but billed the county for the time worked
anyway.
At work, do you ever think, “It takes too long to get things done around here”? Do you
work in any system or process that can be improved? One way to assess how efficiently
assets are being used to achieve certain goals, such as completing a project, making a sale,
or creating a product, is to measure cycle time. Cycle time is the total time required to
complete any activity or process, and includes the time taken between initially thinking up
a “big product idea” and actually getting it to market; between receiving an insurance
claim and processing it; between receiving raw material and manufacturing a finished
product and shipping it; or between deciding to hire a new employee and having that new
employee report to work on his or her first day.
Whenever the cycle time of a business process can be reduced, productivity is increased,
time is saved for other uses, costs are saved, and people and other assets are better utilized.
This is often called business process improvement. McDonald’s is known as the innovator in
standardized, efficient processes that have become fast-food industry norms. Anywhere you
go in the world, you will find that a Big Mac and the process for making it and serving it
are virtually the same. Business process improvement is a key factor in helping people and
other assets perform more productively. You can work with your team and others in your
company to identify and streamline your processes, particularly the process of making and
implementing decisions, which eats up a lot of time in some companies.
Inventory is also an asset, and a particularly important one for retailers. The productivity
or utilization of inventory is measured by inventory turnover, or the number of times a
company sells through its average inventory in a year. If a retail shoe store such as Payless
carries, on average, inventory worth $100,000 in retail sales value, and if its annual sales
are $1 million, then it sells out its inventory an average of ten times per year for an
inventory turnover of 10. If a competitor has a similar shoe inventory worth $100,000, but
has an inventory turnover of 20, then the competitor sells twice the volume and makes
twice the revenue ($2 million) and twice the total gross profit. Note that inventory turnover
can also be calculated as cost of goods sold divided by inventory.
While determining the productivity of individual assets is important in making day-to-day
management decisions, broader strategic decisions—whether to take on more debt, whether
to improve cash position, etc.—may be affected by your company’s overall asset utilization.
Asset utilization is measured by return on assets, which is your profit divided by your total
assets (reported on your balance sheet).
These measures are some of the tools leaders use to make tough decisions in how they
balance asset strength and asset utilization.

Austin’s Cycle Shop

Austin only wanted to work with an investor who was knowledgeable about his
industry and who could bring experience to the table. He’d tried the silent investor path
with his brother-in-law, and that hadn’t worked well. As he talked to investors and as
they looked at his financial statements, they asked questions about his operations,
specifically how he was utilizing his assets. When Austin began considering their
questions, he came to some important realizations about his company.
First, he was not using his human capital in the smartest way possible. He had his
one sales associate, who worked for part salary and part commission, working hours
when Austin couldn’t or didn’t want to be in the store, which really meant when
business was slow. But now he realized that he also needed her there when business
was booming, to help close more sales. So he decided to shift her hours so that she could
generate more sales per hour of work.
He was also wasting leased space. He was storing a fair amount of inventory in the
back room, when he could be using the space to expand his bike service and repair
 operation. His was one of the few shops that offered that service, so he needed to
maximize it. He could lease warehouse space for much less than his retail space, and
then use his retail space to generate more service revenue. He would have to hire
another technician, but his margin on service was better than his margin on bike sales,
so he thought it would be worth it.
Making these two simple changes in how he utilized his assets resulted in immediate
growth in sales and profit. And the interest of two investors.

ASSET STRENGTH VERSUS ASSET UTILIZATION: MAKING THE TOUGH

DECISIONS

Let’s say you inherit $100,000 in cash. What can you do to be financially secure and also
earn more income? You could put it all in a money market fund for 1 percent or less today
and have maximum liquidity and financial strength. Or you might use all the cash to buy a
condo or townhouse outright—no mortgage or monthly payments. You can rent it out, have
very low costs, and have a healthy 10 to 12 percent return. You would have higher
utilization, but no cash left over, little financial strength, and no liquidity.
However, there is a third option, one that is more balanced. You could balance your need
for both strength (liquidity) and utilization (return) by putting $50,000 into a money
market fund and using the remaining $50,000 as a 50 percent down payment to buy a
$100,000 property. Although you would have a mortgage payment, you would still receive
a good return on renting the property, plus the modest return from the $50,000 in the
money market fund. Voilà! You have both asset strength and utilization.
Similarly, a business needs to balance the amount of low-yielding cash it retains for
liquidity with the need to put its cash to work by investing in higher-yielding but illiquid
assets. A company can buy additional business units, invest in production plants, purchase
capital equipment, and borrow at a lower interest rate to invest the proceeds at a higher
yield to increase utilization. But in that scenario the financial strength (liquidity and ratio
of debt to assets) of the company is reduced, so investment opportunities need to be
balanced with the need for liquidity.

Maximum STRENGTH

• All cash position, maximum liquidity—minimum investment in other assets, such as

buildings, equipment, plants, inventories, or other businesses
• Little or no debt
• Excellent strength to meet obligations and overcome difficulties
• Very little current return on cash assets, minimum to no investment for future return
or company growth
Maximum UTILIZATION

• Low cash and cash equivalents—because cash earns minimum current return
• High debt compared to equity
• Assets are mostly inventories, fixed assets, and business units that earn high returns
• Maximum income-producing assets and greater debt fuel growth, but result in less
ability to overcome problems and meet new opportunities that require cash

To find this balance, every businessperson involved in these types of decisions must
understand how to assess the return on investment expected when using cash or loans to get
access to an asset.

Analyzing Opportunities for Balance: Return on Investment

Everything in business requires decisions.

And many decisions ultimately require spending money, or investing capital. How do
businesspeople determine whether to spend money to acquire a particular asset? The better
decision is frequently the one that provides a greater return on investment (ROI) than the
alternatives being considered. Determining ROI for individual project choices can help
obtain balance.
Any investment in assets (buildings, manufacturing plants, large equipment, machinery,
vehicles, etc.) should produce some sort of income stream or contribute to the production of
revenue. At a minimum it must generate a return greater than the interest paid on the loan
to buy the assets (or the interest that could have been earned on the cash). Typically, the
income or profit produced by any asset divided by its cost is the ROI for that asset.
However, ROI can be measured in many ways: retail sales organizations, for example,
might measure annual sales per square foot of their retail stores. Ultimately, calculating
ROI comes down to cost-benefit analysis. To do this type of analysis, first determine the costs
of the opportunity or investment (cost) to be made (cash, labor costs, the cost of running a
machine, etc.), and then assess the benefits to be gained (how revenue or product value
could be created). Then, divide the benefit by the cost to calculate the percentage return on
the investment.

Identifying the benefits of alternative options through ROI analysis is an extremely

important application of business acumen. This analysis helps you compare “apples with
apples” when considering very different opportunities.
 Walmart, for example, uses ROI analysis when determining where to open new stores. If
it is considering two or three locations, it will first estimate how much profit it expects to
generate from the new store. It will then look at the cost of leasing space (or building its
own building) in the different locations. While it might seem easy to just divide the
anticipated annual profit by the annual cost of the lease to determine ROI, there are other
factors to consider. For instance, one location may have better traffic patterns, which could
result in increased sales and profit. While the lease in that location might be more
expensive, the resulting profit might be worth it. Another factor is the community response.
If the community is resistant to Walmart opening in the location that has better traffic flow,
that could potentially hurt sales. All of these factors and more have to be assessed carefully
when determining how to use cash to invest in a lease for a new store.
ROI analysis also includes risk assessment. In general, riskier investments should require
the opportunity to receive a higher return than safer investments. The potential of higher
return compensates for taking the greater risk. If one opportunity is relatively safe and can
yield a 12 percent ROI, and the alternative is highly risky but will yield only 15 percent,
then the 12 percent option could be the better choice. The increased risk may not be worth
just a little more return. You might consider a riskier asset investment more seriously if the
possible ROI is 50 percent or 80 percent or 200 percent.
If you’re in a position to buy assets, make recommendations to purchase office
equipment, real estate, or technology, make other capital investments, or hire people,
always evaluate the ROI. To learn more about different measures of or factors in ROI, go to
our website, www.seeingthebigpicture.com.
If assets are not producing good returns, they should be sold to increase cash reserves or
invested in other assets that will generate greater profits and cash flow. Many companies
sell fixed assets, such as land and buildings, to invest the money in income-producing assets,
such as new product lines or productive equipment. Some companies sell their office
buildings and lease them back—the return they can get on the cash freed up is greater than
the cost of their lease. In January of 2011, GE completed the sale of its majority stake in
NBCUniversal, took the $8 billion, and put it to work buying energy companies that have a
higher long-term growth potential and greater competitive advantage.

Opportunities and Vision Drive Asset Decisions

Of course, all of the analysis in the world doesn’t matter if a company isn’t keeping an eye
out for opportunities to produce a greater return on its assets and to use those assets to
grow. Some of the greatest companies in the world are great because they chose to reach
beyond their competitors and invest in assets (often through research and development)
that would help them grow in the future—help them access new markets, help them create
unimagined products, help them solve a problem never solved before.
FedEx invented the overnight package delivery industry as we know it today. It
developed technological assets to innovate package-tracking capabilities. It also innovated
the use of other assets (planes, personnel, physical facilities) to grow quickly and profitably
worldwide, although UPS, its largest domestic competitor, controls a larger percentage of
the market. In its 2010 fiscal year, FedEx had revenue of almost $35 billion and realized
over $1.18 billion in net income (profit). Its capital expenditures for the year were $2.8
billion, of which $1.5 billion was investments in more fuel-efficient aircraft. Yet its annual
return on assets was substantially lower than UPS, a company that already puts a lot of
time and effort into using its assets efficiently (going so far as to develop routes that
contain as few left turns as possible, saving fuel and the driver’s time). Will FedEx’s
investments into more efficient assets pay off in the future with continued growth in market
share and profit? We’ll see.
Some companies come out ahead by wisely opting out of certain assets and opportunities.
JPMorgan Chase reported profits in 2008 when other investment banks were closing or
suffering huge losses. It has largely avoided the investment in assets that poisoned so many
financial institutions: mortgage-backed securities. As a result, it was able to acquire the
troubled firms of Bear Stearns and Washington Mutual on favorable terms, recognizing that
these assets could be used for significant future benefit under better management.
Where is your business, your market, the economy headed? Forecasting accurately and
assessing those future changes with the vision of your company as a guide will help you
plan your asset needs more effectively. Consider inventory levels, staffing requirements,
customer service personnel, raw material needs, and any other significant asset demands of
your business based on your plan for the future. If you can forecast accurately, making
adjustments now can save or make money in the future.

INSIGHTS INTO ASSETS

• Assets include anything of value, tangible or intangible, used to produce revenue and
profit or that can be converted to cash. Although they aren’t listed on the balance
sheet, people (your employees and customers) are considered by many to be a
company’s most important asset.
• Leaders face the constant challenge of balancing asset strength and asset utilization to
produce the maximum return on investment and to ensure growth and profitability.
• Asset strength or financial strength is measured by the amount and nature (liquid or
illiquid, productive or nonproductive) of your assets. Asset strength affects the overall
capability of your company to pay its bills, meet its financial obligations, overcome
difficulties, take advantage of opportunities, and generate cash flow and profits.
• Liquidity refers to how easily and rapidly your assets can be turned into cash. More
liquid companies have greater capability to move quickly to solve problems and take
advantage of market opportunities.
• Employees can impact asset strength by doing anything that benefits cash position.
• Asset utilization is the measure of how productively your assets are working to make
money—to drive sales and profits.
• The productivity of employees reflects how much work employees can accomplish and
is often affected by the tools and technology they have and the training and education
they receive.
• Inventory turnover measures how many times a year you sell through your average
inventory.
• Return on assets is a measure of how efficiently and productively a company uses its
assets.
• Employees can improve asset utilization by eliminating inefficient or nonproducing
assets, getting more productivity from existing assets, making business processes more
efficient, and by working to use personal time more effectively.
• Leaders work to balance asset strength and utilization by carefully assessing all
opportunities, particularly using return on investment and similar forms of cost-
benefit analysis. The vision and forecast for the company, the industry, and the
overall economy also affect asset decisions.
 Chapter 4
GROWTH
You should approach growth not as an assumption, but as a well-thought-out decision.
—Edward D. Hess

T he dot-com industry has had a fairly checkered past in terms of the viability and
survival of businesses. But unlike so many dot-coms, Amazon has not simply survived
—it has thrived. Jeff Bezos launched his operations in 1995, and if you had wanted to
buy all the outstanding stock of Amazon in December 2011, it would have cost you about
$90 billion.
The growth lesson from Amazon is that Bezos made a deliberate, strategic decision to
constantly reinvest cash in the business to push growth. In its first full year of operations
(1996), Amazon.com generated $15.7 million in sales. Revenue was eight times that the
following year. By the end of 1999, sales were $1.6 billion. Yet the company wasn’t
profitable until 2003.
In the early years of Amazon’s life cycle, venture capital was available, Bezos assembled
an able management team, and market conditions were right. Then in 1997, the company
went public. However, by 2000, in the midst of the dot-com bust and without profits to back
up its worth, the company’s stock had lost two-thirds of its value. Strategic changes were
made in management’s planning and execution, including the very nature of the company
they were building.
Eventually, Bezos’s strategy to “get big fast” by gaining market share, building brand
equity, and worrying about profits later paid off. After booking its first profit in 2003, the
numbers skyrocketed. In 2007, profits were $190 million, and in 2010 Amazon produced
profits of $1.152 billion and generated $3.495 billion in cash from its operations.
The phrase “grow or die” reflects the realities of the business world. If your company does
not grow—expanding product and service lines, cultivating new customers and markets,
increasing its financial strength and ability to attract new capital for further growth—your
competitors will. They will draw away your customers and erode your market share, and
that will set the company on a downward spiral that can be hard to escape. Not every
business needs to grow at the level of Amazon, but without growth, most businesses can’t
survive. But why is that?
Constant change is a reality in today’s business environment, and growth is one of the
only ways to handle it. Change forces a company to adapt to new competition, to
anticipate evolving customer needs, and to look for new opportunities—it forces a company
to grow. Companies that merely seek status quo will see change as threatening, while
companies with a growth mind-set will look for the opportunities that change can bring.
Investors expect growth, employees are energized by it, customers are attracted to it, and
executives are measured by it.
WHY FOCUS ON GROWTH?

Have you ever worked for a successful, profitable, high-growth company? What was it like?
Exciting, I bet. People were energized. They saw new opportunities to be involved in
interesting projects. Career paths opened up as the company expanded its operations,
products, and markets. Talented people joined the organization, offering stimulating
perspectives and innovative ideas. Productivity increased, bonuses were handed out, and
salaries were competitive. Morale was high. I imagine that’s what it’s been like for many
employees of Amazon over the years.
But for companies that aren’t growing, the picture is very different. If a company isn’t
adapting to changes in its environment by offering greater value, better prices, or
innovative products, customers turn to aggressive competitors, the company begins losing
market share, and the best people leave. Sales stall and then decrease; margins and
profitability shrink; stock price drops and shareholders are disappointed; cost-cutting
increases; people are let go; morale decreases; productivity, quality, and service fall; more
customers turn to competitors and the company loses more market share; stock price drops
further; sales decrease even more; profitability shrinks further …
Well, you get the sad picture.
These vastly different pictures explain why growth may be your CEO’s number-one
priority. And long-term, sustainable, profitable growth is the primary objective of any CEO
of a publicly held company—who wants to keep his or her job! There may be small mom-
and-pop operations that continue year after year at about the same level of sales and
profitability. But any larger or publicly held enterprise that does not grow its sales and
profits risks this “downward decline and die” cycle that ultimately spells doom, or at least a
buy-out by a competitor. In the technology sector, lack of foresight and growth can lead to
particularly swift failures and buyouts. In 2010 HP jumped into the tablet and smartphone
market by rescuing Palm Inc., which hadn’t been able to keep pace with surging
competitors like Apple, Google, and Samsung. HP struggled to grow their new division and
less than a year later, in the summer of 2011, it announced plans to terminate their tablet
and smartphone initiatives.
If your company is publicly held, your CEO is focused on growth because people buy
stock hoping that the share price will rise and/or dividends will be paid. The stockholders
elect the board of directors to oversee their investment. And the board hires the CEO to
successfully run the company—to assure that the stock price goes up. The CEO can’t control
the price of your company’s stock in the investment market. However, the surest way any
CEO can influence company stock price is to build a “growth company”—to increase sales
revenue and profit year after year.
But how do we measure growth?

AKA
When businesspeople talk about a company’s growth, they are usually referring to the
growth of its revenue, but may also be referring to the growth of its income or profit.
GROWTH IN THE TOP LINE AND BOTTOM LINE

A company measures its growth in many ways: increase in number of employees, market
share, number of offices, number of states or countries served, number of customers,
amount of assets, and so on.
But when we speak of a company’s growth, we are usually referring to its top-line
revenue growth and bottom-line profit growth. Top line refers to the first line on the income
statement: revenue. By what percentage did company revenues grow this year compared to
last? Or how much did they grow in one quarter this year compared to the same quarter last
year?
As we discussed in chapter 2, the bottom line is a company’s net income or profit, shown
on the last line of the income statement. The increase in percentage, or the rate of growth of
both revenue and profit, is a widely used criterion for evaluating the worth, and stock price,
of any company. However, a business can grow its top-line revenue but have its bottom-line
profit decline. How is that possible? Because its costs increase at a faster rate than its
increase in sales.
While it might seem obvious that a company should grow its sales faster than its costs,
this isn’t always easy to do. Companies striving to grow have to take risks and make
decisions about investments in the future. If they misjudge a future growth opportunity, or
if competitors undercut their prices and steal customers, or if the economy takes an
unexpected downturn, companies can find their costs increasing faster than sales. And some
growth strategies require leaders to reinvest potential profits into the company again and
again. As we saw earlier, Amazon followed that strategy for years.
For many companies, declining profits or lack of profits in the short term may not be an
issue. But over time, the bottom line is more important than revenue growth, a lesson
learned by all of the dot-coms that didn’t make it through the crash of 2001.
Wall Street looks closely at growth in earnings or profit and at earnings per share (EPS)
as critical measures of growth, especially for a mature company. They’ve realized that if a
company’s total costs continually exceed its total revenue, it will ultimately be unable to
borrow or raise other capital to finance its deficit. Eventually, a company with a shrinking
bottom-line—regardless of top-line growth—will be forced to file for bankruptcy or just go
out of business.

ORGANIC AND INORGANIC GROWTH

Companies grow revenues and profits in two ways: organically (internal growth) or
inorganically (growth through mergers or acquisitions). Some businesses adopt one approach
over another, while others use a combination of the two. Neither model is right or wrong;
both have benefits and drawbacks.
A business grows organically, or from the inside, when it hires and trains new employees,
opens new offices or stores, builds new plants to produce more goods or to serve different
customers, expands its marketing initiatives and product sales into new areas
geographically or demographically, or introduces new products and services developed by
its workforce.
Organic growth offers maximum control over the timing of the expansion and the nature
of the operations. There is generally less risk because management controls most aspects of
the endeavor, and the company is usually expanding into business arenas it already
understands.
And every person in a company can contribute to organic growth by helping to increase
sales revenue and profitability. Functions such as sales, marketing, product or brand
management, strategic planning, or retail store management have a direct influence. But
support functions like human resources, IT, and finance also contribute to growth. For
example, people in human resources can become more effective in the timely, prioritized
hiring of talented employees to increase sales, build customer loyalty, and manage the
organization more efficiently, resulting in reduced costs and increased margins.
With organic growth, however, the business also incurs 100 percent of the costs of
expansion and operation, which can be considerable. The management team must stay on
top of all aspects of the new offices, stores, or plants and oversee the hiring and training of
all the new people—none of which is particularly easy! Organic growth can also be slow; it
takes time for new sales territories to generate revenue, for new people to become fully
trained and productive, and for new plants to become profitable.
So to grow revenue more rapidly, many companies buy, or merge with, existing
businesses. This inorganic growth is faster than organic growth because existing customers
and revenue streams are immediately acquired. Management teams, employees, production
plants, offices, salespeople, and other company assets are already in place. Product brands
and distribution channels are already established.
In 2010, sales were strong for both Apple (up 52 percent) and Google (24 percent);
because sales of their products and services were up, they were experiencing strong organic
growth. However, Microsoft had sales up only 6.9 percent in 2010, after dropping 3.3
percent in the previous year. Investors saw that the company was not experiencing strong
organic growth, and Microsoft’s stock price trailed behind Apple’s and Google’s. That’s one
of the reasons why Microsoft resorted to a big purchase—paying 40 percent more for Skype
than what many analysts thought the company was worth.
But inorganic growth carries its own set of challenges. It takes substantial capital to
acquire another business. And the objective of reducing costs by combining operations is
rarely carried out seamlessly: Employees might be terminated, undermining morale and
productivity; information and technology systems might be incompatible, requiring more
cash investment and causing delays; and merging organizational cultures can raise
unanticipated resistance. In fact, various studies have shown that about 70 percent of all
mergers and acquisitions don’t meet the business objectives set by the senior leadership
team. While some work out wonderfully, like the match between Disney and Pixar, others
actually erode the value of the business. After Sprint and Nextel merged in 2005, Nextel
experienced an exodus of executives and managers, most citing incompatible cultures within
the two freshly partnered companies. From there, it just got worse—fierce competition and
a bad economy forced Sprint/Nextel to lay off many workers, and stock prices dropped
dramatically.
 Austin’s Cycle Shop
Austin was in his seventh year now. His margins were strong, he was profitable, and he
was making a nice living from the business. But Austin was ambitious, and he knew
there were market opportunities to be pursued.
The city he was in had grown geographically over the previous six years. One newer
residential neighborhood didn’t have a bike shop yet, and he wanted to beat his
competitors into it. He had already scouted out some space that would work well for his
needs and that had good foot traffic. Opening another shop would also make him the
first local bike shop to have more than one location.
At the same time, he found an opportunity to buy another store near campus from an
owner who was ready to retire. With more stores, Austin could buy inventory for all the
shops at greater discounts, tap into the college market, and drive more cash and profit.
Motorized scooters had become popular among students, and adding this product line
in the acquired store could increase sales. Austin also knew that if he didn’t buy the
shop, another competitor might, buying market share and potentially cutting into his
business.
Could he do both moves at once? Acquire a competitor and open a shop in a new
neighborhood? Although he’d heard horror stories about acquisitions, he thought that in
this case, opening a new store in an untested market was possibly the riskier growth
strategy.
Austin has asset strength, and he thought he could get enough capital from his
investor and the bank. But to analyze the return on these investments (ROI), he decided
to develop a business plan for his company’s future expansion. He had to figure out
how much cash he would need, carefully assess projected revenue and profit from the
new stores, analyze personnel needs, explore lease costs in the new neighborhood, and
gather a host of other information about costs and opportunities to present to investors.
He just hoped they saw the potential he saw.

GROWTH AND THE BUSINESS LIFE CYCLE

Start-up, growth, maturity, decline: These are the classic stages of a business’s life, although
management gurus of various stripes and colors have put their own spin on the idea of the
business life cycle. While this is a useful way to think about how a company develops and
grows, it’s also misleading, because having one stage labeled “growth” implies that the
company isn’t growing the rest of the time. Of course it is—until it’s declining. And while
we use the term life cycle, businesses rarely progress from one stage to another in a step-by-
step fashion. A company might move back and forth between growth and maturity as new
markets or technologies become available. Or a new division within a mature company
might exhibit all of the behaviors of a start-up.
Still, the growth of a company changes over time, and using the stages of the life cycle
helps us anticipate what type of growth we might expect in a company. For instance, a
start-up might struggle along for a while with little growth, just enough to keep it alive as it
attracts customers or clients. But then it hits its stride and takes off. This is the growth stage
and it can take a company from a small operation to a global organization. Growth is often
very high in this period. Just look at the Inc. 500, Inc. magazine’s ranking of companies
with high revenue growth over a three-year period. In 2010, AtTask, which was number 500
on the list, had grown 604 percent during the previous three years. The companies on this
list are fast-growth organizations, but that level of growth isn’t uncommon when a business
takes off. Going from $50,000 in revenue to $100,000 in revenue may not be all that
difficult, but that’s a 100 percent growth rate. Going from $50 million to $100 million?
That’s not so easy to do in one year—or even five. Unless you’re Jeff Bezos, apparently,
who took Amazon from $0 to $1.6 billion in a bit less than five years. In 2010 Amazon had
a five-year average annual growth rate of about 37 percent for revenue and 40 percent for
earnings per share. Although its rate of growth has slowed, its recent results are not too
shabby.
Rapid growth is often unsustainable as a business increases in size and complexity. At
almost $400 billion in revenue, Chevron would have to add $20 billion in sales to grow a
mere 5 percent! Fast-growing companies eventually top out and enter maturity, attaining a
growth rate that is more steady and sustainable. For instance, the five-year average sales
revenue growth rate from 2007 through 2011 for the S&P 500 (large, publicly traded
companies) was around 8 percent, and the earnings per share (EPS) growth rate was 7
percent. (In the last couple of years, the downturn in the economy has lowered these
percentages.) Still, a mature company could move back into a high-growth period because
of new products or other market expansion. Apple was one of Fortune’s one hundred fastest-
growing companies in 2011 even though it has been around for more than thirty years.
Of course, what we hope to see throughout all of these stages is growth in both the top
line and the bottom line. That’s a good indicator that the growth is sustainable and that the
company is less likely to suddenly crash and burn. Companies that have strong cash
positions, good profit margins, and asset strength have the foundation to support growth
both in the short and long term.
Companies of all sizes, industries, and product-service mixes can grow both revenues and
profits consistently, but sometimes they fail to do so. Shown here is a chart of Walmart’s
impressive revenue-growth record over nineteen years compared to that of Sears Holding,
two competitors in the same industry. One creates spectacular revenue growth; the other
doesn’t. The difference is management’s approach to vision and execution.
For its fiscal year ending January 2011, Walmart grew its revenues to $421.8 billion,
more than 3 percent over prior year sales of $408 billion. Although the growth rate has
slowed for Walmart during 2010 and 2011, it still grew by more than $13 billion in a
struggling economy. That increase is almost equal to the current size—in terms of total
revenue—of Toys “R” Us.
 While fast growth can be a wonderful thing, it can often require risky investments. Lots
of companies never make it past the start-up stage, and of those that make it into the
growth phase, many don’t make it to maturity. To grow, every company has to take some
risks, and if the leaders miscalculate, those risks can result in the demise of the company.
What makes all the difference is the skill of the leaders in establishing a vision for the
company, creating sound strategy based on that vision, and then executing the strategy
successfully. Steve Jobs retirement as CEO of Apple in August of 2011 and his subsequent
passing two months later received a lot of attention because he exhibited such an amazing
combination of vision, strategy, and execution.
The execution of growth strategies is where every person in the organization plays an
important role. Every function can contribute to reducing costs to improve profits, to
driving quality improvement, and to improving customer service, all of which contribute to
either top-line or bottom-line growth.

INSIGHTS INTO GROWTH

• Companies either continue to grow or risk dying. Companies growing profitably tend
to be more energized, innovate products and services, expand market share, and
attract motivated top talent.
• Your CEO’s most important job is to ensure sustainable, profitable growth in order to
create value for owners/shareholders.
• Companies not growing can enter a “downward decline and die” cycle of higher costs,
lower sales, lost market share, lower share price, cost cutting, reduction in force,
demoralized employees, lost productivity, lost customers, more loss of market share,
and so on. The competition will take over their markets, customers, brand positioning,
and even their best people.
• The investment community looks primarily at the sales and earnings growth of a
company when valuing its stock price.
• Growth is reflected primarily on a company’s income statement. Both top-line growth
(increasing revenue), and bottom-line growth (increasing profits) are essential over
time. Top-line growth in sales does not necessarily mean bottom-line growth in
profits. Over time, growth in profits is more important than growth in revenue.
• Organic growth means internal expansion—opening new stores, selling more
products, and entering new demographic or geographic markets. Inorganic growth
means merging with or acquiring new businesses to increase revenue.
• Growth expectations may change based on a company’s stage of development. High
growth may be realistic in the early years but may be less sustainable as the company
matures and becomes larger and more complex.
• Risks of high growth include expenses that grow faster than sales revenue, a decline in
quality, and burnout among employees. Many companies grow sales rapidly but lose
money and go out of business.
 Chapter 5
PEOPLE
In business, you get what you want by giving other people what they want.
—Alice MacDougall

W hen new employees of Nordstrom arrive for orientation, they receive a binder with
the word Welcome on the cover and the following message, with emphasis as
shown, on the first page:

As we travel along the road of life, we encounter paths that lead to a great
opportunity for growth. To recognize the doors that open to a bright future is the
key. Once inside, we crave support from our colleagues. We know that the health of
our relationships is paramount to our own success, and that the joy of sharing ideas
leads to a diversity of options. Our reward is access to a wealth of knowledge that
we would have otherwise overlooked. Welcome to Nordstrom. Our door is open.

In addition to the orientation binder, Nordstrom has an employee handbook. It is a 5½-

inch by 7½-inch card with seventy-five words and only one rule: “Use good judgment in all
situations.”
And that is exactly what employees do. Which is why no discussion of stellar customer
service can omit Nordstrom—perhaps one of the best examples of anticipating, meeting,
and exceeding customer needs in its century of retail operations. Robert Spector and Patrick
McCarthy, authors of The Nordstrom Way to Customer Service Excellence (Wiley, 2005),
provide this account of how a customer, who fell in love with a pair of Donna Karan pants
that were on sale, was serviced:

The store was out of her size, and the salesperson was unable to track down a pair at
the five other Nordstrom stores in the Seattle area. Aware that the same slacks were
available across the street at a competitor, the salesperson secured some petty cash
from her department manager, marched across the street to a competing retailer,
where she bought the slacks (at full price), returned to Nordstrom and then sold them
to the customer for the marked-down Nordstrom price. (p. 28)

Nordstrom’s culture encourages these “heroics,” and the resulting benefits of employee
and customer loyalty have been profound.
In our graphic model of the 5 Key Drivers, we place people in the middle because people
make the decisions, supply the financial resources, buy the products, provide the labor and
services, and otherwise create and contribute to everything else about a business. They
drive cash, profit, assets and growth.
Meeting, exceeding, or even better, anticipating the wants, needs, and expectations of your
employees, customers, and other important stakeholders is essential to your financial
success. People are your business, and of all your stakeholders, employees, and customers
are the most important. Most organizations recognize the need to satisfy both employees
and customers. However, your satisfaction level in life and in business is not so much a
function of the results you achieve, as it is a function of your expectations concerning those
results.
Suppose your boss calls you in and gives you a $1,000 year-end bonus. Are you a happy
camper? If you had been expecting a $100 bonus, you are thrilled to receive $1,000!
However, if you had been counting on at least $10,000 and had already maxed out your
credit cards for a vacation, new furniture, or down payment on a car, you are definitely not
pleased!
 In each case, you receive exactly the same result: a $1,000 bonus. But you experience
vastly different satisfaction levels based on your expectation. It is the same with employees
and customers of any business.
We often can’t control the circumstances influencing our employees’ or customers’
expectations. However, we can do much to discover and manage those expectations,
because an important thing for any business is to perform consistently according to them. If
you can do that, you can encourage and maximize satisfaction, and therefore loyalty, to
your business. And the actual results you deliver will be spectacular! Consider the following
wisdom from Maya Angelou: “People will forget what you said, people will forget what you
did, but people will never forget how you made them feel.”

EMPLOYEES: THE FOUNDATION OF SUCCESS

Google has what is possibly the most rigorous hiring system of any company in the history
of business. Most people go through more than ten interviews before they are hired.
Applicants also undergo rigorous testing. While the business world is torn about Google’s
practices—some saying they’re eliminating the most qualified applicants, some saying they
are brilliant—people line up in droves to apply. Why? Because of the way Google treats its
employees.
Google expects great things. It wants brilliant people who can come up with innovative
ideas that anticipate trends in the market and the future desires of Google customers. To
make those goals possible, Google encourages employees, specifically its engineers, to
spend 20 percent of their time dreaming up new ideas, not working on current projects. The
Google “campus” is a massive complex that offers employees free gourmet meals, a twenty-
four-hour fitness center, a nutritionist, an in-house doctor, a personal trainer, a swimming
pool, a spa, a dry cleaner, massage therapists, and a Wi-Fi-equipped biodiesel shuttle for
people who have longer commutes.
Why does Google offer these things?
Two reasons: They want to attract the very best people with the best ideas. And if they
offer all of these services, employees don’t have to leave the campus to access them. So,
more convenience for employees and more work performed for Google.
Google isn’t the only company to recognize that having great employees who contribute
to a company’s success has to begin with hiring the right employees. I recently heard the
CEO of Zappos, Tony Hsieh, describe how his organization’s hiring process is focused
heavily on how well a person will fit into the company culture and support its vision of
“delivering happiness.” Once a person makes it through the hiring process, he or she begins
training, including being on the phones for two weeks—no matter the role. But here is what
I thought was most interesting. After this initial on-boarding process, Zappos actually
makes an offer to the new employee of $3,000—to leave! This offer forces employees to
really reflect on the question of whether this is the company they want to be a part of. In a
sense, it requires them to recommit to the company. Tony explained that those employees
who reject this offer and stay come back the next day with a renewed sense of commitment
and ownership.
 You know the old saying, “A’s hire A’s and B’s hire C’s.” The best companies have a way
of attracting the best people, and the best people help create even better companies.

The Number-One Reason Good Employees Leave

In his book First, Break All The Rules—written with coauthor Curt Coffman—Marcus
Buckingham of the Gallup Organization described the results of surveys of tens of thousands
of people. Those surveys revealed that the number-one reason employees leave their jobs is
their relationship with their manager. While perks are great, how people feel about their
managers is much more important to employee satisfaction. If they feel valued, receive
regular praise, are rewarded for their efforts, are included in decision making, and feel that
they are contributing to a clear vision, they are far more likely to stay. Employees who feel
that leadership doesn’t know where it’s headed and who feel they aren’t valued always have
one foot out the door.
A May 2011 USA Today article (“Employee Loyalty Is at a Three-Year Low”) stated, “Fed
up, workers are seeking greener professional pastures: Slightly more than one in three hope
to find a new job in the next 12 months.” This attitude is surprising in a down economy. But
what most leaders should be concerned about is another point the article makes: Employers
are generally unaware of these high dissatisfaction levels. The best thing managers can do
is take a personal interest in the career aspirations of their employees.
With the recent recession-induced focus on cost cutting, which often impacts employee
pay, benefits, job security, and morale, companies need to reconsider how they will keep
their good employees; if they don’t, they could face an exodus.

The Value of a Good Culture

In many companies, a strong, positive, employee-focused culture helps ensure that

employees get the relationships they want with management and other perks that might
outweigh, say, the importance of salary. Of course, few companies are big enough or
profitable enough to offer the types of perks Google offers to its employees. But every
company can use its resources wisely to create a culture and offer benefits that attract top
talent. A small company that can’t afford to offer extensive benefits might offer a fun work
environment, flexible hours, the option to bring kids to work, or a variety of other features.
In tough economic conditions, “doing more with less” is a popular catch phrase. But if you
try to do too much more with much less, you risk burnout in your people. Will better
equipment and tools improve their productivity without causing a stressful work
environment? What about more education? It’s hard to consider investments like these
when you’re facing financial uncertainty, but many productive and profitable companies
attribute their success in part to their commitment to ongoing employee training and
education—in good times and bad.
For the Ritz-Carlton (a division of Marriott International since 1997), employee education
and training is key to the company’s fabled success in guest satisfaction, which I’ll discuss in
a few pages. The company conducts continuing detailed analysis of all aspects of its
operations, involving employees at every level. Ritz-Carlton has identified 970 potential
problems that may arise with overnight guests. First-year managers and employees receive
250 to 300 hours or more of training on how to handle these issues. Ritz-Carlton enjoys the
lowest turnover rate of any luxury hotel chain in the industry.
General Electric is another great example of a company with a strong focus on employee
development, spending more than $1 billion a year developing its people, even in a
“recession” economy. Business Week recently rated GE as the best at developing leaders, a
reflection of its investment and efforts.
While culture and work environment are important factors of employee satisfaction,
management can only set an example and establish goals. It’s up to every employee to
work to sustain a positive workplace culture.

Internal Customers

The idea of employees as “internal customers”—both of the company and of each other—
has gained popularity in the past few decades. It reflects the realization that the most
successful companies have the best employees and the longest tenures within their
workforces. Recent studies on the cost of turnover—from $5,000 for a minimum wage
position to 200 percent of annual salary for a leadership position—helped emphasize the
importance of keeping valuable employees happy. And as Stephen R. Covey said, “Always
treat your employees exactly as you want them to treat your best customer.”
Just as many business leaders now think of employees as customers, many employees
recognize that their colleagues are also their customers. Your internal customers are the
people you work with or serve within your organization; you are the internal customer to
others who serve and work with you. Who are your internal customers? Are you meeting
their needs and exceeding their expectations? What are you doing to anticipate their future
needs? Are you prepared to meet those needs? Have you performed surveys or analysis of
how well you’re doing and where you are headed in serving your internal customers? Do
you hold periodic meetings to discuss process improvement, including how to enhance
communication and cooperation between yourself and your internal customers?
My firm, Acumen Learning, has surveyed thousands of people and asked about their
internal customers (their colleagues). The results consistently show that departments or
individual employees say they provide service to their internal customers at a superior level
than those internal customers say they receive. We tend to judge others by their actions,
while we judge ourselves by our intentions. However, as with external customers, perception
is reality—and the only reality that counts is the perception of our customers concerning the
level of product or service they receive. They will make future purchase or employment
decisions based on those perceptions. When is the last time you asked an internal
department or a colleague you serve about their level of satisfaction with your work and
what their needs are? If you aren’t asking this question several times a year, you may be
missing an opportunity.
It is often a primary role of human resources departments to ensure employee satisfaction
and internal customer efficiency by implementing effective training programs, feedback
mechanisms, and facilitating interdepartmental dialogue. But all businesspeople need to
focus on how to develop and keep valuable employees and how to offer great internal
service to one another. While revenue comes from customers, customers come from
employees. And both are expensive to replace.

Austin’s Cycle Shop

Austin had received the funding he needed to expand his operations, but now he needed
to make some important decisions about how to combine operations in three locations:
his current store, a new store, and an acquired store.
Austin talked regularly with his own employees about how they felt about working
for him and what could be improved for greater customer and employee satisfaction.
He surveyed his current customers and customers of the acquired shop and found that
they would like to hear more about cycling tips, deals, great rides, and more from
Austin and his employees. Austin decided to get the employees involved in creating a
regular e-mail newsletter to build a more loyal customer base and give employees an
opportunity to be creative and share their knowledge.
He needed to spend more time training and coaching his employees in how to create
a more complete customer experience, one that was consistent across all locations. He
had never created a real training program before, but as he began searching for new
employees for the new stores, he knew it was time. An important point of that training
would be helping his employee teams work effectively together, in addition to thinking
of the employees in other stores as internal customers.
He wanted to keep key people for the long term, so he began to look at competitive
wages and benefits. And he began a career path discussion with each of his employees
to better plan for their future growth—so that his business could grow profitably.

CUSTOMERS: BEYOND SATISFACTION

As essential and important as internal customers are to any business, they are there to serve
the “external customers”—the people who pay for your products and services, keeping your
business alive. A sign on the wall of a business I frequent got it right: “Our customers are
not a distraction from our business … they are our business.”
Sam Walton, founder of Walmart, one of the largest corporations and private sector
employers in the United States, established the company’s strategic focus: His business is
“all about the customer.” Walmart’s commitment to provide a better quality of life for its
customers through their consistent cost savings is an essential key to the company’s long-
term success.
Customers are your lifeblood, your source of revenue and cash flow. Without customers,
you are ultimately out of business. As Tom Peters, author of The Pursuit of Wow!, states, you
need to wow your customers every day. Or your competitors will. And depending upon the
industry in which you operate, the cost of getting a new customer is two to ten times more
than the cost of keeping an existing customer, so you really want to keep the customers you
have.
Ritz-Carlton regularly ranks among the highest luxury hotel chains in the annual hotel-
guest-satisfaction survey conducted by J.D. Power and Associates. It was number one in this
category in 2007, 2008, and 2010, and number two in 2009. It is the only two-time winner
of the Malcolm Baldrige National Quality Award in the service category. Throughout this
small luxury hotel chain, one strategic goal is 100 percent customer retention. Every
employee, each of whom has been trained at the highest level, is empowered to spend up to
$2,000—without checking with anyone, using only his or her best judgment—to
immediately correct any problem or handle any guest complaint.
But to proactively fix problems and avoid having to pay to correct too many of them,
Ritz-Carlton also performs regular and meaningful customer reviews to assess how well it is
meeting its guests’ needs and expectations. This is something your business can and should
do. Of course, then you have to take action on the results.

Anticipation and Innovation

Most businesses try to satisfy customer needs and expectations. Other enterprises even
make a conscious effort to exceed them. But truly successful companies achieve an even
higher level of excellence, a more powerful form of competitive advantage. They anticipate
the needs of customers and innovate to meet those future needs. Microsoft’s “Where do you
want to go today?” campaign has practical financial relevance.
While it is critical to continually survey customers and other stakeholders to determine
their needs, recommendations, and desire for future products and services, that only tells
you what the client is thinking right now. Customer feedback has limitations because people
can’t always identify what it is they’ll want in the future. But strategically, you can’t plan
for right now; you have to plan for the future if you want to ensure your company’s
survival.
Effectively using the principle of anticipation and innovation is the ultimate competitive
advantage. Dr. W. Edwards Deming, management and quality guru, said, “Innovation
comes from the producer—not from the customer” and pointed out that no customer asked
for a microwave oven. Henry Ford said that if he’d asked his customers what they wanted,
they would’ve asked for a faster horse.
The innovative thinking of entrepreneurs—regardless of the size or maturity of their
company—leads the consumer marketplace. Pocket-sized cell phones, GPS navigation,
iPods, ebooks, and tablet computers are just a few examples of game-changing product
innovations from producers over the last decade.
What happens to companies that fail to anticipate or meet customer needs? Can a big,
strong, powerful, dominating company fail to anticipate in its industry, fall from
competitive grace, lose leadership position and opportunities, and become relegated to
“also ran” status?
General Motors, Ford, and Chrysler dominated the U.S. and international passenger-
vehicle markets for decades. In 2008 GM lost its top sales position to Toyota, and in 2009
GM and Chrysler received multibillion-dollar bailouts from the federal government and filed
for bankruptcy. In their 2008 fiscal years, GM lost $31 billion and Ford lost $14 billion. In
2007 the majority interest in Chrysler was sold to a private equity firm after its parent for
nine years, Daimler AG, tired of its continued losses. In June of 2011, the U.S. government
sold its remaining stake in Chrysler to Fiat. Why have the Big Three declined so
dramatically? Because over the years they have consistently missed the customer demand
for cost-effective, fuel-efficient, high-quality cars, trucks, and SUVs that exhibit appealing
style and features. But the Japanese automakers anticipated American consumer desires and
have captured major market share.
In September of 2010, Blockbuster filed for bankruptcy. In February of 2011, Borders filed
for bankruptcy. These once-dominant organizations didn’t anticipate the shift in how
people would view movies and read books. History is full of many more examples of
companies that failed because they failed to anticipate. As Albert Einstein said, “The
significant problems we face today cannot be resolved at the same level of thinking we
were at when we created them.”
Of course, on the flip side you have companies like Apple. Not surprisingly, Fortune and
Fast Company both listed Apple as the most innovative company in the world in 2010.
Nobody can anticipate customer needs and desires better than Apple, and as Fast Company
put it, they chose Apple for “dominating the business landscape.”
Anticipating customer needs is essential for product and service innovation. The Ritz-
Carlton has a deliberate program of data capture and analysis after each guest’s visit,
information they use to anticipate the needs of returning guests. From desired room
temperature, to type and firmness of pillow and mattress, to preferred morning newspaper,
fulfilling guest needs is the focus not only of the current stay, but for every future stay.
What innovative ideas can you contribute to your business in anticipating customer
needs?

Austin’s Cycle Shop

Austin needed to make sure the new store and the acquired shop were set up to
maximize revenue and profit. The key, he knew, was identifying what customers in
these neighborhoods were looking for.
He regularly surveyed his own customers, but the needs of his new customers would
be different because the demographics of the neighborhoods were very different. In his
current shop, he mostly catered to sport cyclists, so he carried high-performance bikes.
Near the college campus, he’d be dealing with a younger demographic made up of
people who didn’t have as much cash to spend. He reviewed the sales history for the
acquired shop and his assessment was confirmed. The inventory of high-performance
bikes had a poor turnover rate, but the lower-cost models had strong sales numbers. He
decided to keep a few high-performance models on hand but to focus his inventory on a
range of affordable bicycles. He would also begin selling scooters, because they were
very popular with college students.
In the new shop, he would be in the middle of a highly residential neighborhood. He
spent some time in the new neighborhood, watching families who were out and about.
Cycling among families seemed common, and so he knew he would need to sell kids’
 bikes. It was a fairly affluent neighborhood, and there was a broad range of higher-end
kids’ bikes that were highly adjustable and designed to last for a long time. He had also
seen some innovative baby carriers from his suppliers that he thought would be good
sellers. And it seemed like touring bikes would be a good idea for the adult inventory,
with some high-performance bikes and parts on hand for the local fanatics.
One thing that surprised him was the number of scooters he saw in the neighborhood.
He hadn’t anticipated that. He decided that he would also offer scooters at the new
store, which would give him greater leverage in negotiating with suppliers.

What Are Your Customers Really Buying?

What do your customers really want or need? Perhaps they don’t truly know. To answer the
question, you can begin by considering what they are actually buying. If you think about it
deeply enough, you may find that your customers are buying something deeper than you
thought, something more than just a simple product or service. Knowing what product or
service your customer is really buying becomes all-important in managing expectations and
in anticipating needs.
When families eat out, are parents buying hamburgers, or are they buying a fun outing
with the kids? Customers buy automobiles not just for transportation but also for status and
prestige. They buy clothing to make personal statements. Why do customers buy your
products and services? What do they really want or need? They probably are paying for
convenience, reliability, value, prestige, time savings, and other intangible benefits that
may or may not be related to a product’s actual use or application.
McDonald’s started off by selling exactly the same hamburger you could get in almost any
restaurant. Today they sell a fun family experience, complete with toys and playground—
with hamburgers and other menu items on the side. Starbucks started off by providing the
opportunity to participate in a social experience patterned after the coffee houses of Italy.
At my business, Acumen Learning, one client, a large wireless phone company, indicated
that cell phones are one of the top five status symbols for teens—in other words, their
parents are paying for much more than the functionality of the phone. SUVs and minivans
aren’t sold so much for transportation as to facilitate a lifestyle. (And why did it take car
manufacturers so many years to figure out that sliding doors on both sides of a minivan
might be a good idea?)
Anyone in business-to-business sales knows that it’s an absolute necessity to understand
what your customer is really buying from you. Why? In the B2B world, you can benefit
greatly from knowing how your customer’s business creates profits. If you understand the 5
Key Drivers as applied to your customer, and then show how your product or service can
impact a combination of your customer’s cash, profit, assets, growth, and people, you will
enjoy a significant sales advantage because you understand what it is your customer is
really buying—improved business performance.
A top executive at one of the largest computer manufacturers recently said to me, “My
salespeople can speak all day long about the features of our products. I need them to tell
their customers how it will help them improve their profits.” Our course helped this
company’s salespeople connect the product features with the bottom-line results those
features could provide. At the end of the day, this is what the customer wants to know.
Customers often don’t recognize their own needs or how to meet them; they don’t
recognize the possibilities. Keeping current customers and attracting new ones means
anticipating needs that they might never articulate.

No company is immune to market failure and loss of industry leadership. It is essential to

always study and anticipate customer needs, and to invest in the technology and marketing
capability to remain competitive. Just as important, cultivating teamwork inside the
organization ensures that internal customers will be better able to serve the external ones.
Understanding how your company benefits from its relationship with its most crucial asset
—people—can help you impact stakeholder satisfaction and the bottom line, whether you’re
the CEO or new hire fresh out of college.

INSIGHTS INTO PEOPLE

• People are the most important resource for any company. Employees and customers
are two important stakeholders to your business.
• Successful companies usually have a history of strong employee satisfaction and longer
employee tenure, so companies work hard to keep employees satisfied and to attract
top talent.
• Internal customers are those employees or departments to whom we provide work
product, information, or output. Most employees are both internal suppliers and
internal customers to each other.
• Satisfaction and loyalty are more a result of expectations met than actual results
achieved. Managing customer expectations is critical in creating loyalty. Delivering on
the expectations is essential.
• Your customers are the lifeblood of your business. You should focus on your customers
more than on your competitors.
• Anticipating and innovating to meet unstated present and future customer needs is a
key to long-term competitive success.
• Most innovative, breakthrough products are a result not of customer requests but of
innovative anticipation of unexpressed customer needs and opportunities in the
marketplace.
• Customers buy more than just products. They purchase trustworthiness, convenience,
prestige, or a memorable experience. Determine what your customers are buying.
 Chapter 6
THE BIG PICTURE: LINKING THE 5 DRIVERS
The whole is more than the sum of its parts.
—Aristotle

F or six decades, Toyota generated profits year after year. Then, in 2009, its record
crumbled under the pressure of the global recession and it booked its first annual net
loss—of $7.7 billion. For some companies, this loss might have signaled their demise.
But Toyota has excelled in ways that have helped it weather what was just the beginning of
a violent storm. What are the keys to the company’s success? Asset strength, a clear vision
of what consumers want now and in the future, consistent revenue growth, and maximum
efficiency in asset utilization to generate profits and cash. The company understood each of
the 5 Key Drivers—cash, profit, assets, growth, and people.
The recession was just the first of many hits to come. A massive recall in 2009 and 2010
to solve an accelerator problem (which some claim was the result of an overdeveloped focus
on controlling costs). A fine from the U.S. government of almost $16 million for not alerting
officials to the problem early enough. And then, the horrific earthquake that hit Japan in
March 2011, causing heartbreak and devastation for Toyota’s home country. And from a
business perspective, an ongoing loss of production as suppliers are unable to fill orders.
Despite the hits that kept coming, Toyota focused on what it knew best: making cars
people wanted as efficiently as possible. It declared a state of profit emergency in 2009 and
took drastic measures to book a profit in 2010. The plan?

• Deliver more eco-friendly vehicles (more hybrid models) and piggyback on

government promotion (tax breaks, for instance)
• Introduce special editions to meet the specific needs of consumers in certain regions
• Cut variable costs by about $3.5 billion by reducing costs at manufacturing plants,
among other strategies
• Cut fixed costs by about $4.75 billion by reducing capital expenditures (it closed and
sold a major plant, for instance)
• Reduce R&D expenses by streamlining product development
• Reduce G&A costs, such as travel expenses
• Improve labor efficiency by implementing job sharing and other measures

Did it work?
Absolutely. Despite the continued global economic crisis, the company earned $2.2 billion
in 2010 and over $5 billion in 2011 as a result of its efforts. If Toyota had not been stronger
financially, if its asset position had been weaker, if its operations had been less efficient, if
its customers had had a poor opinion of the company, if it hadn’t been growing steadily for
decades, it would never have been able to achieve this one-year turnaround in profit.
A company that excels in any one driver must also excel in others—and frequently, in all
of them. The 5 Key Drivers, as we’ve seen in the previous five chapters, are completely
interdependent; over the long-term, it is impossible to be excellent in one and severely
deficient in the others. Any change in one driver affects the others.

DIVISION OF LABOR, UNITY OF PURPOSE

So often in our attempts to get on the same page, we overlook the fact that organizations—
like books—have many different pages. It’s how all of the pages combine to create the
entire book, or the entire organization, that is most important. In your company (and most
others), the various functions and departments (the pages) have different areas of focus,
specific divisions of labor. But when they work together, they should all have unity of
purpose.
The following chart shows some of the key functions that exist in many organizations and
the drivers they usually focus on.

Function Primary Focus

Sales People (customers), profit (revenue), growth
Human resources People (employees), growth (by attracting the best employees)
Finance Cash, profit, assets, growth
Marketing Growth (through increased sales)
Facilities management Assets, growth
Information technology Assets, growth
Customer service People (customers), growth
Senior leadership Growth, profit, people, cash, assets
CEO Growth, profit, people, cash, assets

It’s entirely appropriate for different functions to focus on the 5 Key Drivers in different
ways at different times. But with this focus, they need to make sure they are not sub-
optimizing the whole. They must continually see the big picture and understand how their
actions are affecting all of the drivers. You can see from the chart above that most senior
leaders and CEOs of public companies focus primarily on growth and profit, as these tend
to drive stock prices higher. You will often hear CEOs state that the goal of the company is
something like “To build a profitable, growing, and enduring company.”
It seems simple when presented, but not so obvious in daily practice. When you talk with
people in other departments, look at the issue or topic at hand from their perspective and
from their functional responsibility. One of the most important applications of business
acumen is communicating with colleagues from other departments on the basis of what’s
important to them. When a human resources officer speaks with a finance manager about a
key initiative, talking about employee satisfaction might result in impatient yawns.
However, discussing cost of capital, return on investment, and the expense reductions
realized from the initiative will get the finance manager’s attention. If you connect with
what’s important to people in other departments, they’ll pay more attention to your ideas.

SHIFTING FOCUS: THE URGENCY CONTINUUM

CEOs, senior leaders and managers, and the company as a whole naturally shift focus
among the five drivers over time along an urgency continuum. Depending on the stage of an
organization’s development, and based upon complex internal and external factors
throughout a company’s history, senior management gives priority to different drivers at
different times. Remember Toyota’s laser focus on profit in 2010. And when a company
makes a huge purchase—as Google did when it announced plans to purchase Motorola
Mobility in 2011—it is in a way shifting its focus away from cash and toward assets and
growth. Another example occurred in 2008, when banks shifted their focus away from
profits and growth and toward cash in an effort to strengthen their financial position
during the Great Recession.
Now, just because a company shifts its focus from one driver to another doesn’t mean that
the company loses focus on the other drivers. For example, a company in crisis that needs to
focus on cash shouldn’t ignore its customers or forget about long-term growth. In fact, a
renewed customer focus might be necessary to generate the critical cash required for an
investment in assets necessary to fuel long-term growth.
 Urgent: Cash. In the start-up stage of a company’s history, the need for cash is typically
the urgent focus of management, possibly superseding all other priorities. But the start-up
years aren’t the only time a company might be focused on cash. In 1993 when Lou Gerstner
took over as CEO of deeply troubled IBM, he said the company’s mission was to “survive.”
In his book Who Says Elephants Can’t Dance (HarperCollins, 2002), he said that few people
understood how perilously close IBM came to running out of cash.
During an economic crisis, like the one that began in December 2007, many companies
focus much more on cash so that they can feel secure in their ability to ride out the worst to
come, particularly when credit and capital are hard to come by. But when a company
focuses on cash, what does that mean? Often it means conserving cash by cutting costs and
investments to improve profitability, which will likely slow future growth.
Near Term: Profit and Assets. In the normal development of a business, leaders want to
reach a point where cash flow from operations meets normal cash requirements. Once this
point is reached, companies will often zero in on profit-generating initiatives and
investments in assets to build asset strength. A management team can then focus more time
and energy on creating greater profit margins and using its assets more efficiently to obtain
a greater return on investment.
Long Term: Growth and People. Ultimately, a CEO wants to focus the company on
attracting the best employees and customers, creating long-term, sustainable, profitable
growth. When Apple purchased the music streaming business LaLa in 2009, Apple’s
management was upfront about the fact that one of its primary reasons for purchasing the
company was LaLa’s engineers. Mature companies that have cash, consistent profits, and
asset strength have a solid foundation that allows them to concentrate on growth and
people strategies that continue to move the company forward in the long term.
Shifting With the Company

Any time you impact any of the 5 Key Drivers, you are impacting the overall success of your
company. The question is, are you having the maximum impact and the right impact? For
instance, if senior leadership says that profitability is all-important this quarter and asks
employees to identify ways to reduce costs, you should certainly follow that lead. However,
you have to apply your business acumen to make smart, productive decisions. Cutting costs
too much could adversely affect product and service quality, reducing customer satisfaction
and leading to lower sales and profits. And if you were responsible for increasing revenue
to improve profitability, raising prices too high or using cash to launch product lines
without sufficient research and analysis into customer tastes could result in lower sales and
profits.
Every businessperson should ask the following questions to make sure that his or her daily
decisions and activities are contributing in the best and most efficient way possible:

• “Which driver is the most important for our company (and why)?”
• “How can I impact this driver? What resources do I need?”
• “What effect on each of the other drivers will this action have?”
• “How can the impact be measured?”

If you think about these questions regularly, you’ll stand out among your peers and prove
your value to the organization.

THE 5 DRIVERS IN A PUBLIC COMPANY

Unlike the head of a private company, the CEO of a publicly traded corporation faces
unique pressures that influence the entire organization. First, all important actions that he
or she takes are publicly visible through full-disclosure reporting to the SEC and to
shareholders. Second, the CEO’s most important job becomes increasing shareholder value,
which means making the stock price increase over time. Investors often have a short-term
focus and want to see growth every quarter. Frequently, decisions that might increase short-
term stock price are not necessarily in the company’s long-term best interests.
The level of oversight, reporting requirements, government compliance, legal and
accounting obligations, and consequences for failure to comply are far more complex and
rigid for a public company than for one that is privately owned. The annual expense of
meeting these requirements—legal, accounting, and otherwise—is very heavy.

Austin’s Cycle Shop

It had been two years since Austin acquired a competitor and opened a new store. He
had developed growing brand recognition for his excellent products and services. He
focused more and more on expanding his customer base and on the continued growth
of his business.
The various stores excelled in different ways, but he wanted all of his employees to
be focused on his vision for the company: a new type of bicycle shop, focused on the
highest levels of service, that could grow locally, regionally, and even nationally. He
began having regular all-staff meetings with his employees to share how the company
was doing overall and what types of challenges each store was facing. The meetings
were also intended to get employees involved in discovering solutions to those
challenges and in finding opportunities to grow the business.
After the first few meetings, the employees seemed to catch on to Austin’s vision and
offered up interesting ideas for increasing growth and profitability, including a
dynamic cross-store inventory-management system that would help any store meet any
customer’s needs quickly.
This process helped Austin discover his new overall vision for the company: to create
a national brand and one day take the company public. How? Take the company
online, selling bikes and parts to a broad range of customers—customers whose needs
he better understood through the development of his various shops. But he knew he
would need to go even further to offer unique products and services to bicycle
enthusiasts.
Austin sought out another investor who could offer the capital he needed to hire an
online retail-consulting firm. The consultants helped him hire the right Web developers,
assess marketing approaches and possible partnerships, and anticipate capital and
asset needs. He developed relationships with custom bicycle manufacturers as well as
local retailers in key geographic areas, which helped him offer a level of service unlike
anything the other online retailers could match. He was even able to develop his own
line of branded bicycles by working with the major manufacturers.
It took a couple of years to really achieve success through his online venture. Once he
had, he decided to take his privately held company public. He needed increased access
to both equity and debt capital from public markets to grow his earnings.
Austin would have a lot of expenses as his company went through an Initial Public
Offering (IPO). There would be added overhead costs, plus the time he would have to
devote to complying with SEC regulations and reporting requirements. He would have
to focus on delivering consistently increasing quarterly earnings so that investors would
see his company as a growth stock and push the price higher.
However, he felt that the benefits outweighed the costs. As he looked at the
competitive landscape, he felt that by becoming a public company he would have a
significant advantage over locally owned cycle shops and small online retailers—he
could grow more rapidly and profitably. He wanted to become the Amazon of bikes—
and steal bike business away from Amazon!
He began working on the IPO with a securities broker-dealer and attorneys.
From personal lessons learned, Austin knew that despite becoming a public company
he would have to continue his focus on the 5 Key Drivers—the foundation of his future
success. The big picture of Austin’s Cycle Shop was expanding, but the fundamentals
would never change.
THE EVEN BIGGER PICTURE: THE EXTERNAL ENVIRONMENT

While maximizing the 5 Key Drivers is the central tenet of business acumen, you must
consider other factors, external to your business, when trying to make smart, effective
decisions. The dynamics of such influences as the national economy, your competitors,
industry issues, and the political and social environment are critical to your company’s
success. Within this broader framework, leaders make real-world decisions and exercise
their best business judgment. Your fundamental grasp of the external environment is
essential to connecting the dots and applying your own acumen.
The environment in which your business operates is characterized by dynamic change. In
fact, external factors are the primary cause of cyclical changes in the growth or profitability
of many organizations, because the growth or contraction of the overall economy tends to
be cyclical and ever changing. Your company must continually adjust, innovate, and even
reinvent itself to keep pace with the uncertain complexities of the economic, political,
social, and business environment.
Most of what goes on in the external environment is beyond the direct control or even
influence of your company or any company—even giants like Apple, GE, Microsoft, and
Walmart. But that doesn’t mean that business leaders are powerless. As Stephen R. Covey
says, “You cannot always control what happens to you, but you can control your response
to it.” Even without being able to control these factors, a business can anticipate, prepare,
and choose its strategic response to them.
Nokia, for instance, completely missed a market it could have dominated. “Everyone
underestimated how incredibly successful the iPhone would be,” said Dan Hesse, who was a
director on Nokia’s board when the device was first launched. “We took the iPhone
seriously, but Nokia management underestimated it, certainly” (Greg Bensinger, “Sprint
CEO on Jobs,” Wall Street Journal, August 25, 2011). Once the worldwide leader in handset
sales, Nokia has fallen to number three. While Nokia focused on competing with RIM’s
BlackBerry device, Steve Jobs built the iconic iPhone and articulated what he called a post-
PC era of iPads, app stores, and cloud-based services. Nokia and RIM executives neither
grasped the changing needs of customers nor embraced the evolving technology to meet
them, and now these category creators are finding it difficult to even be competitive in the
category they helped to create.
 As you continue to study the environment in which your business operates, keep asking
yourself, “What changes are about to take place, and how will they likely impact the 5 Key
Drivers of my business? How can we successfully be prepared for the threats and take
advantage of the opportunities?” Commit to an ongoing study of what’s happening in the
economy, in your industry, and in the markets in which you operate. Your business acumen
must include a working knowledge of the business world outside your company and how it
might influence your future.
To get you started down that path, I’ll lay the foundation for two external influencers
that can affect the direction of your company.

Financial Markets
Financial markets reflect the combined impact of all the other external factors. By
“financial markets” we mean the availability and cost of capital from all sources, national
and international. This includes loans from banks and other institutions, borrowing money
by selling debt instruments (like bonds), or raising equity capital in the stock market.
Financial or money markets reflect national and international, rather than local,
conditions.
In the United States, the Federal Reserve sets key interest rates and influences the supply
of money nationwide. Whether a small entrepreneur in her local community can get a start-
up loan or whether larger companies can raise capital to expand, and at what price and
terms, is greatly influenced by federal policy. The availability and price of money affects
the ability of all companies to grow, to innovate products, and to take needed risks; it
changes access to the capital the company needs to make critical investments in assets.
Companies are just like homeowners in this way: the ability to get a mortgage loan at a
local bank is impacted by federal monetary policy.

The Stock Market

For public companies, the stock market plays an important role in directing the focus of the
CEO and other leaders. They want the stock price to always be increasing, and when it’s
not, you’ll see a lot of worried frowns.
Why should they—and you—be concerned about your company’s stock price? First,
because your stock price is a reflection of the market’s confidence in your company’s future
performance. People primarily buy stock because they believe they will make money as
your stock price increases over time or through dividends. But a company also benefits in
other ways when its stock price is higher:

• Acquisitions—When stock price is higher, the company can use fewer shares to buy
another company.
• More cash from secondary offerings—When a public company sells more shares to
investors in a secondary offering, it can sell a smaller percentage of the company to
raise the same or greater cash if the stock price is higher.
• Better credit ratings—One of the determinants of a public company’s credit ratings
relates to its stock price. With higher credit ratings, it can raise debt or equity capital
at lower rates and with better terms.
• Desirable stock options—An increasing stock price indicates a successful company. It
can provide more desirable stock options to retain and attract smart, talented
employees.
• Buy-out defense—A higher stock price is a defense against a takeover. As the stock
price goes up, so does the company’s value, and therefore its sales price.

In addition to being focused on growth in sales and profits, companies can influence their
stock price through stock buybacks. Many companies use their excess cash to buy back their
own stock, thus reducing the number of shares outstanding and increasing the earnings per
share. Generally this tactic will increase the stock’s market price. One justification is that
buying one’s own stock shows that the company management believes in itself—investing
in its own stock gives the highest, safest return. This approach is intended to raise
confidence for investors and encourage them to also buy the stock—increasing demand, and
hopefully, the price.
Regardless of whether your company is public or private, the 5 Key Drivers and the major
influences of your business environment should be the foundation of the decisions you make
to keep your company on the path to profitable, sustainable growth.

INSIGHTS INTO THE BIG PICTURE

• The big picture is the overall perspective of how your company makes money through
the 5 Key Drivers. It includes the context of the outside environment.
• All 5 Drivers are interdependent. Any impact on one affects the others.
• Companies known for excellence in one driver usually excel in others as well.
• Different organizational departments or functions tend to prioritize different drivers.
To have influence within your company, learn to “speak the language” of people who
have functional responsibilities different from your own.
• Anything you can do to impact any of the 5 Drivers influences the big picture. Among
the key questions to ask is “How can I impact this driver and measure the results?”
• In addition to the impact of the 5 Key Drivers, business performance is affected by
dynamic, complex forces in the external environment, including financial markets and
the stock market.
 PART II
——————

Simplifying Financial Statements Through the 5 Drivers

 Chapter 7
DECIPHERING FINANCIAL STATEMENTS AND THE ANNUAL
REPORT
“Rule number 1: Never lose money. Rule number 2: Never forget rule number 1.”
—Warren Buffett

A
corporate health report. A moving picture of growth. Statistics that help predict the
outcome of the next move, the next growth strategy. All of these analogies—medical,
movies, sports—have been used by authors and others (including me) to help people
get a better sense of what financial statements really mean and why they are important in
the business world. And just like in medicine or movie editing or baseball, for the
uninitiated, financial statements can seem overwhelming.
But they don’t have to be. The key is to understand that, unless you’re a CFO or a
financial analyst or a commercial loan manager, you don’t have to understand everything
in these statements to discover important clues about the health and sustainability of a
company. Throughout this and the next three chapters I’ll explain what financial statements
can reveal and show you the most important numbers, metrics, and measures to look for
and what they mean. In this chapter, I’ll also explain the basics of an annual report, which
is where you will find these financial statements, at least for public companies.

AKA
The income statement, balance sheet, and statement of cash flows are often referred to
collectively as the financials.

THE THREE MOST IMPORTANT STATEMENTS AND THE 5 KEY DRIVERS

The three financial statements (frequently called “the financials”) that every public
company prepares and shares are the income statement, the balance sheet, and the
statement of cash flows, all of the statements I’ve referred to in earlier chapters. You will
often hear the word consolidated used with these statements, which simply means that
figures from all subsidiaries and business units are included in the financial statements.
Public companies must file quarterly reports (Form 10-Q) and annual reports (Form 10-K)
with the Securities and Exchange Commission (SEC), which are made available to the
public. Privately held companies prepare these statements for tax purposes and because
they help leaders and owners understand how the company is performing.
The income statement (also called the profit and loss statement or P&L) reports revenues,
expenses, and “bottom line” net income, or profitability. And for public companies, it
includes earnings per share of stock.
 The balance sheet shows company assets, liabilities, and shareholder equity, and therefore
reveals the financial strength of the company. When analyzed with the income statement, it
also reveals how efficiently assets are being utilized.
The statement of cash flows reports where a company gets its cash and how it uses it in
three activities: operations or core business activities; investing, by buying and selling assets;
and financing, through receiving and paying loans, selling and repurchasing stock, or
paying dividends.
These three statements connect like puzzle pieces. The income statement begins with
revenues and ends with net income. Net income is the first line on the statement of cash
flows, which then shows cash flowing into and out of the company to end with a calculation
of the current amount of cash and cash equivalents on hand (cash position). The balance
sheet then begins with cash and cash equivalents and outlines other assets and liabilities to
get to a calculation of shareholder’s equity. The three statements start with a reflection of
the activities the firm engages in with customers (revenues) and then create a bridge to how
those activities drive greater value for the shareholders (shareholder’s equity).
 The numbers and the figure will help you see how the financial statements of Austin’s
Cycle Shop, presented in chapters 8,9, and 10, tie together.
The 5 Key Drivers are not just a theoretical model of what is important to any business.
As I explained in the introduction, they are based on the reports that all business leaders use
to track financial performance. These financial statements are critical because they track
the elements of a company that can lead to its success or its failure: cash, profit, assets, and
growth over time:

Cash: Statement of cash flows

Profit: Income statement
Assets: Balance Sheet
Growth: Companies seek to grow the results measured on all three financial statements
And of course, People: The activity that these financial statements reflect is how well
employees are providing value to customers.
THE BASICS OF FINANCIAL STATEMENTS

You don’t have to be a certified electrician with a deep understanding of the wiring diagram
in your home to turn on a light switch. You just need to know which one or two switches
control the lights you want to turn on and off, and where they are located. Similarly, you
don’t need to understand most of the line items on the financial statements to understand
the statements’ basic message. You just need to know which primary switches turn on the
right financial lights—revealing the truth of a company’s financial health. I’ll explore those
switches for each financial statement in the following chapters. I’ll begin with a Big Picture
Breakdown for those people who are only interested in the highlights and then dive deeper,
working through line by line, for those who think they need a more in-depth understanding.
Before diving in, though, there are a few basic rules and hurdles that you should be
familiar with. They will help you make sense of most financial statements.
First, recall from the discussion of accrual-basis accounting in chapter 2 that most large
organizations follow that approach, which influences when revenue, expenses, and profit
are “booked” or recorded in accounting systems and when they appear on financial
statements.
Second, in the United States, all audited financial statements are prepared according to
rules established by the accounting profession and governmental agencies. These generally
accepted accounting principles (GAAP) are developed by the Financial Accounting
Standards Board (FASB), a private nonprofit association of the accounting profession. The
SEC requires that the financial statements of all public companies be prepared according to
GAAP. These rules are also used by the IRS to calculate a company’s income taxes.
Companies outside of the United States often follow the International Financial Reporting
Standards (IFRS).
Third, the amounts on the financial statements of larger companies are often truncated.
At the top of the statements, you will see the notation “In thousands,” “000s dropped,” “In
millions,” or “000,000s dropped,” which means that when you read the numbers, you must
add those missing zeros to get the actual number: for example, $470 is actually $470,000 if
the statement is presented in thousands and $470 million if the statement is presented in
millions. For smaller companies, the exact figures are usually shown, but be careful to check
for this notation so you read the financial statement figures correctly.
Fourth, even though the fundamental organization of financial statements is consistent,
companies may label items differently, which can make reading them a challenge (revenue
might be called net sales, for instance). The financial statements of a company in one
industry might look different from those of a company in another industry. For instance, the
financials of banks and financial institutions look different from those of retailers. After
reviewing a few financials, however, you’ll be able to understand most of the major entries.
In the following chapters, I’ll explain the most common line items and the different terms
you might see used to communicate the same thing. Getting acquainted with your own
company’s terminology is important. It will be relatively constant over time.
Last, keep in mind that numbers are only meaningful within a certain context, within a
larger story. So when looking at key measures on a financial statement, it may be useful to
review four basic characteristics. I’ll explore these for some of the key line items on each
statement:

• Amount: The amount of the item, which you may want to be positive or negative, as
high as possible (like revenue) or as low as possible (like cost of goods sold).
• Trend: The trend over the last two or more years. Is the item going up or down, and
by what percentage? Why? Is the rate of change accelerating or slowing? Is this the
right direction?
• Ratio: The ratio of the item to other relevant items. You should also look at the trend
of the ratio. I’ll explain what ratios to review for some of the key line items.
• Industry and competitor analysis: How do these numbers compare to the industry and
key competitors? Ask why your company is doing better or worse.

To help you find your way through the most important measures, we’ve developed a
“Navigating the Financials” graphic, shown here, which we use in our workshops. You can
go to our website at www.seeingthebigpicture.com and access a PDF version of this
document. There are instructions for how to use it online. In our workshops, we have found
it extremely useful in helping participants better understand the relationships among the 5
Key Drivers and key company metrics found on their own financial statements.
 Now that you know some basics about financial reports, where can you find them? For
privately held companies, the CEO might send some or all of the statements out to
employees or may have a meeting with all staff to go over the key financial metrics. If you
work for a small company and haven’t seen the financials, you might ask your manager if
it’s possible to do so, or at least get a report of key metrics. If you work for a publicly held
company, the financials, along with other information, are readily available in the annual
report.

READING AN ANNUAL REPORT

I’ve already described the annual report—the Form 10-K—that public companies are
required to file with the government and make available to shareholders. It consists of
fifteen “items” that a company must address. The great detail and disclosure in these reports
are intended to help shareholders understand the business they are investing in. Although I
find much of the 10-K’s content not particularly important, the following three items are
very valuable in analyzing a company, particularly because this is where the financial
statements live.
Item 1: Business: This section of the 10-K provides a basic overview or description of the
company. It might include information about product or service lines, how it conducts
business, customer information, etc. If you are a salesperson preparing to call on a client, a
supply chain manager evaluating a new supplier, or a prospective employee preparing for
an interview with the company, this item might be helpful.
Item 7: Management Discussion and Analysis (MD&A): Sometimes preceded by an
“Overview” or called “Management’s Report,” this section contains a discussion of the
company’s performance over the last year. It also previews opportunities and potential
problems with future performance. It can be lengthy and technical. But I encourage you to
read it, as it discusses important happenings in the business.
Item 8: Financial Statements: Here’s where you will find the three key financial statements
(those that I’ll explain in detail in chapters 8 through 10). The financials are accompanied
by an auditor’s report, a letter signed by independent accountants affirming their
performance in auditing the financial statements prepared by the company management
team. Usually this is a boilerplate letter, but you should scan the last couple of paragraphs
for any exceptions to a “clean” report.
Also included in Item 8 are the Notes to Financial Statements, a collection of
supplemental information pertaining to the financial statements. Reading the notes front-
to-back is an instant cure for insomnia. However, if you have a question about line items in
the financials, you will often find the answers referenced in the notes. There is important
information contained in these pages.
In addition to the Form 10-K that’s filed with the SEC, most public companies will produce
a much more reader-friendly version of their annual report for shareholders, prospective
investors, the business and financial media, and the public. Even some private companies,
who are not required to file a Form 10-K, will publish an annual report to communicate to
their stakeholders their assessment of the year. You’ll find that, as in the financial
statements, the 5 Key Drivers stand out prominently in these annual reports, possibly with
one emphasized over the others at times. While no two annual reports are alike (there are
no standards or rules as there are for the 10-K) you’ll want to look for and read the
following:
Financial Highlights. Analysts and investors often start their review of an annual report
with the financial highlights; sometimes you’ll find these highlights on the inside of the front
cover and perhaps spilling across two or three pages. These highlights are extracted from
the complete financial statements, and you’ll typically see at least two years of data
summarized, perhaps three or more. Key financial highlights might pertain to the 5 Key
Drivers, market share, products, or other data.
CEO’s Letter to Shareholders. Generally, you’ll find a letter to the shareholders signed
by the CEO. This letter is very important. Read it carefully. It indicates the issues and
initiatives most important to the senior leadership of the company. Usually the “spin” of
this letter is positive—even reporting on a bad year, the CEO might comment about how
bright the future looks, or how the company is “on its way back up.”
However, this letter is a good place to find out what went on during the previous year,
what the outlook for the future is, and what strategies are important to the chief executive.
The drivers most frequently addressed by almost every CEO in these letters are growth and
profitability. Frequently CEOs reference their people by discussing the company’s customers
and employees. If there are specific initiatives for improving profitability, you’ll find
references to margins or cost containment or expense reduction. If you’ll read this letter and
keep a simple tally of how often cash, profit, assets, growth, and people are referenced,
you’ll get an idea of which drivers the CEO is focused on.
Marketing: Many annual reports are prepared with colorful photos and graphics and
glowing prose explaining how wonderful the company is. They read more like a marketing
brochure than a financial report—because they actually are. Like the letter from the CEO,
the marketing portion of the annual report will typically have a positive spin, but
reviewing this information will give you insights into the company’s products, customers,
and culture.
Compliance: Form 10-K. The last section of the annual report is part or all of the
company’s financial statements or its actual Form 10-K. It might be printed on thinner
paper with black ink and no graphics, and is written in language that is obviously not
intended as easy reading. If you’re dealing with a public company and don’t see the entire
Form 10-K in your copy of the annual report, go to the company’s website and look for an
“Investor Relations” section, or do a search on the SEC’s website (www.sec.gov/edgar).
While reading every line of a company’s financials, annual report, or 10-K is almost
never necessary, a review of key items is a surefire path to understanding a company’s
current situation, its goals, and its chances for long-term success. In the next three chapters,
I’ll simplify the financial statements so that you can get in and get out with what you need.

INSIGHTS INTO FINANCIAL STATEMENTS AND ANNUAL

REPORTS

• The income statement, the balance sheet, and the statement of cash flows are the
financial statements that reflect performance around the 5 Key Drivers. Although the
financial statements of different companies are organized similarly, they may use
different terms.
• When analyzing numbers on the financial statements, you should review four basic
characteristics:

1. Amount
2. Trend
3. Ratio (the amount compared to other numbers)
4. Comparison to competitors and/or industry
• Public companies are required by the SEC to file Form 10-K, an annual report that
contains the three key financial statements. While there are a standard fifteen items in
Form 10-K, three are noteworthy:

• Item 1: Business
• Item 7: Management’s Discussion and Analysis (MD&A)
• Item 8: Financial Statements and Supplementary Data

• Companies may choose to release an additional annual report that’s easier to read
than a Form 10-K. The purpose of this annual report is to communicate company
strategy, market and brand the company, and share financial highlights.
 Chapter 8
INCOME STATEMENT: TRACKING PROFIT
Remind people that profit is the difference between revenue and expense. This makes you look
smart.
—Scott Adams

I magine it’s November 2008. You’re a salesperson for a restaurant supply company, and
Starbucks is one of your prospects. In preparation for your big pitch, you check out
Starbucks’ latest press releases and like what Starbucks’ CEO has to say about the
company’s fiscal year 2008 results: “We began the new fiscal year with a healthier store
portfolio that will allow for operating margin expansion. Despite a global economic
environment that shows no immediate signs of improvement, the steps we took in FY08
position us to deliver EPS [earnings per share] growth in FY09 … We appear to be more
resilient than many other premium brands. And while we cannot call isolated signs of
improving sales a trend, we are encouraged by our ability to drive increased traffic at a
relatively low cost … I am optimistic we are well positioned to weather this challenging
economic environment.”
It sounds like the company is on track to grow and be profitable despite the recession.
This is great news for you, but later in the day a colleague sends you a link to a Fortune blog
column that tells a different story: “Starbucks’ Schultz needs to get real … needs less
optimism and a stronger dose of reality in his brew” (Patricia Sellers, November 11, 2008).
Youch! Which is it? How are you going to approach your sales pitch now? You might
never know the real results of Starbucks unless you look at their income statement and use
it to help you answer questions like these:

• What were the company’s sales revenues?

• What types of expenses did it have?
• What was its net profit margin?
• What was its net income and earnings per share?
• How are all of these numbers trending?

These are the questions business leaders have to answer on an almost daily basis. More
than just knowing the answers, they are responsible for developing strategies and plans
that optimize these metrics to keep the company profitable and growing. It is their primary
responsibility to the stakeholders of the company, and the income statement is one way
they communicate the results of their strategies and decisions. By the way if you look at
Starbucks stock performance after Howard Schultz’s comments, he was right!

AKA
 The income statement is also referred to as a statement of earnings, a statement of
operations, or more commonly, a profit and loss statement or P&L.

PURPOSE AND EQUATION

The purpose of an income statement is to show whether the company made or lost money
during the period being reported, usually a quarter or a fiscal year—to show whether a
company generated a profit or a loss. This is one reason many companies refer to their
income statement as a profit and loss statement (P&L), a sign that it’s going to teach us
something about the profit driver we explored in chapter 2. But it also reveals important
information about the growth driver (chapter 4), because an income statement typically
provides data for the current reporting period (quarter or year) and data from the two
previous periods. This makes it easy to see the growth in key measures from one period to
the next.
Every financial statement is laid out based on a simple formula. The income statement
will always start with revenue (the top line), subtract expenses, and end with a calculation
of net income or net profit (the bottom line).

Revenue – Expenses = Profit

Think about an income statement like climbing down a ladder. The top rung (top line)
represents your sales. Then you’ll have a bunch of rungs that represent different costs or
expenses. Finally, the bottom rung (bottom line) represents your profit, or how much you
made after you subtracted all your expenses. Your family budget follows a similar formula.
You earn money from your job and maybe some investments; this is your top line. Then you
subtract your mortgage, your car payment, gas, food, entertainment, etc.; these are your
expenses. What’s left over at the end of the month is your bottom line, and you hope it’s not
negative. If it is, you start to look for trends, for ways to control your budget, like eating
out less to control your food costs.
While a bit more complex, business leaders use the income statement to make equally
important decisions to keep sales and profit growing.
As we explore the income statement, I’ll first give you what I call my Big-Picture
Breakdown so that you can get key information from any income statement in a matter of
minutes, and for those interested in more detail, I’ll dig in and give you some guidance on a
deeper analysis of the numbers that you can get through in about thirty minutes with some
practice.
Note: As you walk through the financials in this chapter and the next two, it may be
easier for your study to download and print Austin’s Cycle Shop fi ancial statements by
going to www.seeingthebigpicture.com. You may find that taking notes on the financials
will also enhance your understanding.
 BIG PICTURE BREAKDOWN:
THE INCOME STATEMENT IN A MATTER OF MINUTES
What do you want to see when assessing a company through an income statement
and only have a couple of minutes? Let’s break it down.
Revenue growth year over year: Total revenue (also called sales) is referred to as
the top line, because it’s at the top of the income statement. You’ll want to look at the
revenue totals shown for the past three periods. Is revenue increasing? If so, great. If
not, this is a big red flag. Steadily decreasing revenue is a sign that the company
 might be struggling. Next, calculate the rate of growth using the following formula to
determine the rate of change:

Compare the growth rates for the past few years. Even if revenue is heading up
each year, a declining rate of growth in revenue might indicate problems with the
long-term viability of the company, particularly if the economy and industry have
been strong.
Net income growth year over year: Net income, or profit, is referred to as the
bottom line of the income statement (even though earnings per share is presented
below net income). Has it been increasing over time? Has the rate of growth been
steady or improving? If not, compare it to revenue. If revenue is growing, but net
income isn’t, your expenses are growing faster than your revenue, which may not be
good. But some sound business strategies might increase expenses and reduce profit in
certain periods, like investing in new product development to make the company
more profitable in the future. If profit is declining, do some research to see if
company leaders have made those types of investments.
Net profit margin: If you divide the “bottom line” net income by the “top line”
total revenue, you have calculated net profit margin. Recall from chapter 2 that net
profit margin reveals how much profit is generated by each dollar of revenue.
Obviously, you want your revenue to produce as much profit as possible, except when
you are reinvesting potential profits into the company as part of a growth strategy.

THE INCOME STATEMENT IN ABOUT 30 MINUTES

We just covered the income statement in a matter minutes. If you want to go deeper—
maybe you have a big budget meeting with your VP—you should carefully review the
following six measures:

• Revenue
• Cost of goods sold
• Gross profit or gross margin
• Operating income
• Net income (profit)
• Earnings per share (EPS)

As I walk you through each of these six measures it’s important to remember that
different companies will use different terms in their financial statements. If you remember
that revenue and sales are essentially synonymous, and that income, earnings, and profit
are synonymous as well, it will be easier to read any income statement.
In chapter 7 we discussed the importance of looking at four basic characteristics of a
financial measure: amount, trend, ratio, and industry or competitor comparison. While I
won’t do this for every line item, I will do it for the most important, in this chapter and the
next two (note that ratio analysis isn’t always possible or necessary). And I would
encourage you to do it for any line item that is of particular interest to you.
Let’s return to Austin’s Cycle Shop to dig into a “real” income statement. Austin’s is now
seventeen years old and has been a public company for about five years—five good years,
in fact. Austin’s consolidated income statement, shown on page 124, presents numbers for
the years ending December 31, 2012, 2011, and 2010. You see that total revenue is the first
item. It is followed by expenses, which are often presented in order of the most directly
related to operations (cost of goods sold) to the most indirectly related to operations (taxes).
The bottom line is net income, with an additional line for earnings per share for publicly
traded companies.
Keep in mind that the income statement we’re using is a bit simplified; most income
statements show line items not contained in Austin’s. But you don’t have to understand
every line item to get a very good sense of a company’s performance.

Revenue

Revenue is the dollar amount of goods and services sold as a result of your normal business
activities. A company’s health depends on how well it makes money doing what it normally
does—not from extra, nonrecurring activities, such as selling a business unit (which are
shown as other income further down the sheet). Revenue is sometimes referred to as sales,
gross revenue, or operating revenue.
The total revenue—the “top line”—is one of the key measures to examine on any income
statement. Usually, when a company says that it grew by x or y percent, it’s talking about
growth in revenues. Austin’s has total revenue of $8,300 or $8.3 million for 2012 (remember
the numbers are in thousands). This is the money that Austin’s makes from the sale of bikes
and other goods and services. The revenue received from services—like bike repair—is
included in this line item, although some companies might list it separately.
While Austin’s Cycle Shop seems to have strong revenue, the proof is really in the
comparison. Remember, growth is the key. From 2010 to 2011, Austin’s revenues grew more
than 12.5 percent, and from 2011 to 2012 its sales grew more than 15.3 percent. Its
revenues are trending up, and the rate of revenue growth has increased. And if we compare
Austin’s revenue growth to the sporting goods industry overall, for which sales grew on
average about 7 percent annually during the most recent five-year period, the results are
even more impressive.
Overall, Austin’s revenue numbers provide only positive indicators for the performance of
the company.
Cost of Goods Sold

Several categories of expenses are listed after total revenues, but many P&Ls list cost of
goods sold (COGS), which is sometimes called cost of sales, as the first line item under
revenues. As I described in chapter 2, COGS includes the cost of purchasing inventory such
as raw materials, costs of product assembly, and other costs directly associated with
producing individual products.
Austin’s has combined the cost of product sales and services, although some companies
may separate the costs out, particularly if they separated them under revenue. Its COGS for
2011 was $4.6 million. You’ll notice that, as an accounting practice, none of the numbers in
the expense categories are shown as negative (in parentheses). Everyone just knows that
expenses are deductions from revenue.
COGS has increased steadily each year, but that’s common when revenue is increasing.
The good news is that while COGS increased 18.6 percent from 2010 to 2011, it increased
only 9.5 percent from 2011 to 2012, so the rate of growth is decreasing. That means better
profitability, as we’ll see next.

Gross Profit and Gross Margin

Even though, as you may recall from chapter 2, gross profit is an important indicator of
profitability and gross profit margin is an important measure for certain industries, such as
manufacturers and retailers, few income statements have a line item labeled “gross profit.”
I’ve included it on Austin’s P&L to keep it simple, but generally, you just have to calculate
it. Luckily, it’s easily done by subtracting cost of goods sold from the total revenue.

Gross profit = Total revenue – Cost of goods sold

Austin’s gross profit for 2012 is $3.7 million (sales of $8.3 million less cost of goods sold
of $4.6 million). Gross profit for 2011 was $3 million, and for 2010 it was $2.56 million,
showing a nice upward trend.
Gross profit margin (gross margin for short) is gross profit as a percent of total revenue.
It is an important measure because it indicates how much profit is being generated from
your sales before subtracting out overhead and other types of expenses. To some degree, it’s
a ratio of efficiency and profitability.
To calculate gross margin, you simply divide gross profit by total revenue and multiply
by 100:

For 2012, Austin’s gross profit margin or gross margin is:

 A gross profit margin of 45 percent is quite good, particularly compared with the retail
bicycle industry average of 37 percent. I find it helpful to write this percentage next to
gross profit as I do my analysis. The gross profit margin for 2011 was 42 percent and for
2010 was 40 percent. Gross profit margin was up from 2011 to 2012 by 3 percentage
points. This is a big improvement, and if you saw this on an income statement, you would
want to find out why it improved. For example, was it a one-time occurrence because of a
deal the company got on inventory, or will it hold steady in upcoming reporting periods?

Operating Expenses

After the costs of goods sold are subtracted from total revenue, operating expenses are
itemized on the income statement. This is one area where you may find dramatic differences
from company to company.
For 2012, Austin’s first operating expense listed is research and development of $500,000.
As its name implies, this is the money spent on researching and developing new products or
enhancements to existing products. This is one expense that you want to spend the right
amount on: cutting it may impact future sales or profit, and spending too much impacts
near-term profit. I like to compare this amount to what the competition is spending. If it’s
substantially more or less and sales happen to be declining, that is a red flag.
The next line item, which is also fairly straightforward, is sales and marketing of
$850,000. This expense could—should—help drive future sales. General and administrative
expenses, often referred to simply as G&A or overhead, follow. This line item includes rent,
utilities, and salaries of corporate staff, such as finance, HR, and IT personnel. An
important note about G&A expenses: They are often targeted when expense reductions are
needed because cutting these costs should have less of an impact on sales than cutting R&D
or sales and marketing. So keep an eye out for big changes in this line item and do research
to find out what they mean.

Depreciation and amortization is the last operating expense on Austin’s income

statement, and it bears a little more explanation. According to the SEC website,
depreciation “takes into account the wear and tear on some assets, such as machinery,
tools and furniture, which are used over the long term. Companies spread the cost of
these assets over the periods they are used. This process of spreading these costs is
called depreciation or amortization [depending on the type of asset]. The ‘charge’ for
using these assets during the period is a fraction of the original cost of the assets.” The
IRS gives specific guidelines for the number of years different types of assets can be
depreciated or amortized.
 Higher deductions—expenses—in a given year result in lower taxable net income, and
thus lower taxes, which is why reinvesting profits into a business is a tactic company
leaders use not only to spur growth, but also to reduce their tax burden.

Operating Income

Once all of the operating expenses have been accounted for, there is enough information to
calculate operating income—a very important number that shows how much money the
company is making from its core operations or basic business activities. Operating income
is the profit from core operations—what’s left after the cost of goods sold and operating
expenses are deducted from revenues, and before subtracting additional expenses that most
employees and managers can’t control, such as interest and taxes. Operating income for
many companies is often referred to as earnings before interest and taxes, or EBIT, if there
are no unusual expenses in addition to interest and taxes.
Operating income shows how well the company executes its core business functions day
to day. Because of this, some analysts, finance professionals, and CEOs see it as a better
indicator of profitability than net income. Ideally, this figure should be increasing in dollar
amounts each year, as well as increasing in rate of growth year over year. Austin’s
operating income in the current year was $1.494 million. Growth from 2010 to 2011 was 15
percent and from 2011 to 2012 was 26 percent, an improving trend. Young companies
typically grow revenue and operating income faster in the early years than in later years as
the business matures. Still, this jump in the rate of growth is quite good.
Operating income or profit as a percent of revenue (operating income divided by
revenue, or operating margin) is an important ratio called operating margin. For 2010,
2011, and 2012, Austin’s operating margin was 16 percent, 16.4 percent, and 18 percent,
respectively. This is a steady improvement in the ratio, indicating that Austin’s recent
operating costs are growing but not as fast as sales. Some costs stay constant or grow more
slowly when volume rises, which improves profits.
Operating margins, like other margins, can vary dramatically from industry to industry
and from company to company. For a recent five-year period, the average operating
margin for the S&P 500 companies was about 16 percent. Retail stores tend to average less
than other industries, so Austin’s operating margin is currently very strong. And Austin’s
recent growth of 26 percent in operating income is significantly above the average growth
rate for most companies.

Other Expenses and Income

Nonoperating expenses are those costs that do not relate to the basic operations of the
company. Although not listed on Austin’s income statement, you may find a line item in this
section labeled “nonoperating income or expenses,” which could refer to the sale of an asset
or business. These incomes or losses would be listed in this section because they are not part
of the company’s core business. Moving to the next line item, Austin’s had interest income
of $300,000 in 2012, which is the interest earned on its cash and investments. We then find
an interest expense of $96,000. This is the interest Austin’s paid on its debt for the year. You
may wonder why companies borrow money when they seem to have plenty of cash on
hand. There are several reasons, including very cheap borrowing rates and the desire to
keep plenty of cash on hand for future investments for growth. The last expense is the
provision for income taxes in the amount of $611,000. This includes taxes paid and taxes
accrued (owed) but not yet paid.

Net Income or Net Earnings—The Bottom Line

How much net income (profit) did Austin’s make after all expenses were paid and all
revenue was accounted for? This is the bottom line, and in many ways is the most
important figure on the income statement. Austin’s net income for 2012 was $1.087 million.
It was positive, so that’s a strong starting point. Better than that, net income has increased
each year. And the rate of growth improved from 24 percent from 2010 to 2011, to 28
percent from 2011 to 2012. Good news for the company, but why did it occur? If you
worked for Austin’s Cycle Shop, this is a question you should ask, and we will answer it
next.
Net income as a percent of total revenue is called net margin or net profit margin (net
income divided by revenue, or “bottom line” divided by “top line”), as we discussed in
chapter 2. Austin’s net profit margins (rounded) were 11 percent for 2010, 12 percent for
2011, and 13 percent for 2012 (this is an important percentage you may want to write on
the income statement next to net income). Austin has been able to contain the rate of
growth of the company’s costs to be less than the rate of growth of its revenue—that’s good.
If the net profit margin were decreasing, it would mean that sales were growing at a rate
less than costs—that wouldn’t be so good. The S&P 500 average net profit margin for the
last five years is around 11 percent, so Austin’s has been able to survive and thrive.
Remember that companies with unique offerings, like Apple, typically have higher margins,
while companies like Walmart, which sell commodities, have lower than average profit
margins. If you aren’t unique, you better be cheap!

Earnings Per Share

For public companies, income statements will include some final entries that calculate the
earnings (profit) generated per share of common stock outstanding—the EPS. This may be
the most important measure in determining a company’s share price. Why? Because for any
investment, the more profit it generates the more valuable it is. A company that is able to
earn more per each share of stock over time will see its stock price go up; as we discussed in
chapter 6, this is important to employees, leaders, and shareholders. Earnings per share are
calculated by dividing the net income by the average number of shares of common stock
outstanding during the year or period:
 There are two ways to present earnings per share. Basic EPS uses the number of currently
outstanding shares of common stock as the denominator; Austin’s basic EPS for 2012 is
$0.27. Diluted EPS adds to the outstanding common stock the number of shares that would
be outstanding if all stock options of value—options to purchase stock, usually at a stated
price, granted to employees and other stakeholders—were exercised. Austin had 298,000
stock options outstanding in 2012 (4,300,000 diluted shares minus 4,002,000 basic shares).
Therefore, Austin’s diluted EPS for 2012 is $.25, which is no change from 2011, but an
increase from 2010 ($.22), a positive trend. Most analysts use fully diluted EPS for their
apples-to-apples comparisons, so assume fully diluted when you read about EPS in the media
or elsewhere.
One last point: Over time the number of shares outstanding might change, and therefore
EPS might change with the same net income. Austin and his board of directors can choose to
issue more shares of stock to raise more money; give stock options to employees; or buy
back shares of stock and “retire” them. Note that they have increased the average number of
common shares outstanding each year from 2010 to 2012. This explains why net income
increased 28 percent from 2011 to 2012, while EPS remained flat.

You can improve your company’s income statement by helping to increase revenue or
reduce expenses, which creates more profit. If you are part of a public company, your
contribution to increasing net profit, or earnings, will also increase EPS. By helping to
increase revenue or decrease expenses, you are helping to increase your stock price! The
ideas in chapter 2 for what you can do specifically to impact profit apply to the income
statement, too.

INSIGHTS INTO THE INCOME STATEMENT

• The income statement measures profitability.

• The income statement formula is Revenue – Expenses = Profit (Net Income). It shows
top-line revenue (sales), deducts all expenses, and shows bottom-line net income or
profit.
• The income statement is a financial “motion picture” showing company performance
over a period of time, such as a month, quarter, or fiscal year.
• The income statement is also referred to as the statement of operations, statement of
earnings, the profit and loss statement, or the P&L.
• Key measures to watch on an income statement are total revenue, gross profit,
operating income, net income, and earnings per share (for public companies).
• Net profit margin is your “bottom line” net income or earnings as a percent of total
revenues or sales.
• Everything you do to impact profit—primarily increasing sales or reducing expenses,
including cost of goods sold—influences the bottom line of your income statement.
 Chapter 9
BALANCE SHEET: TRACKING ASSETS
There are men who can write poetry, and there are men who can read balance sheets. The men
who can read balance sheets cannot write.
—Henry R. Luce

W hen Lehman Brothers declared bankruptcy on September 15, 2008, it had assets of
about $691 billion, making it the largest bankruptcy filing in history. The second
largest happened just eleven days later when Washington Mutual, with $328
billion in assets, went under and was purchased by Chase. These two bankruptcies, along
with the many that followed, were significant contributors to the Great Recession. Warren
Buffett, once said, “It’s only when the tide goes out that you learn who’s been swimming
naked,” meaning companies are able to hide unhealthy risk when times are good, but are
quickly exposed during economic downturns.
How prepared is your company to weather the storms of business or take advantage of a
major opportunity? If there were a significant downturn in your market or the economy, a
severe credit crisis, another 9/11, or an unforeseen opportunity to make a major
acquisition, would your company be capable of performing? What reserves or staying
power do you have? These are the questions a balance sheet can answer.

PURPOSE AND EQUATION

The balance sheet provides information on assets, liabilities, and equity—factors of your
asset strength and, along with the income statement, indicators of how effectively your
assets are being utilized to produce a return.
Just like the income statement, the balance sheet follows a basic equation:

Recall from chapter 3 that your assets are the resources and items you own that have
economic value, such as cash, accounts receivable, buildings, equipment, and other things
you use to produce revenue or income. Liabilities are debts you owe, such as bank loans,
accounts payable, mortgage loans, etc. Equity (stockholders’ equity or net assets) is what
the owners (stockholders) would have left over after selling all of the assets and paying off
all the liabilities.
Asset strength is a strong indicator of overall financial health. Why? Because a company
can rely on its assets in times of trouble. Suppose you, as an individual, have plenty of cash
in savings, investments of different types, good equity in your home (all assets), and very
little debt. You’re more likely to survive financially during a downturn or loss of job, aren’t
you? The same principle is true of companies.
Remember, asset strength is primarily measured in terms of liquidity—how much cash
and cash equivalents are available or could be generated quickly by selling assets—and the
relationship of liabilities to assets and equity. You want your assets to be greater than your
liabilities, and the more equity you have, the less risk you carry. If your company has a loan
of $1 million to be repaid in ninety days, and it has $5 million of cash or assets that can be
turned into cash within ninety days, it’s in good shape. But if it’s the reverse—well, good
luck!
Let’s explore the relationship between assets, liabilities, and equity a bit more before we
dive into the balance sheet.

WHY THE BALANCE SHEET BALANCES AND WHY MORE EQUITY EQUALS
LESS RISK

Assets must equal liabilities plus equity; let’s explore why.

Suppose you want to purchase a home (asset) and the price is $200,000. Where do you
get the money to buy it? You take out an 80 percent mortgage loan (liability) for $160,000
and make a down payment of $40,000 (equity). The capital you used to buy your home—
your $160,000 liability (mortgage loan)—plus your $40,000 equity (cash down payment)
equals $200,000, the price of your asset (home). Now suppose you get very lucky and
within six months of purchasing the home the market goes up and your home is now worth
$50,000 more. You haven’t paid down the principal portion of the mortgage loan much, so
now your $250,000 asset equals your $160,000 liability plus your $90,000 ($40,000 +
$50,000) equity. The $50,000 jump in value increased your equity in the house.
This is exactly how a balance sheet for a company works. The balance sheet shows your
company’s assets and the sources of capital (cash) used to acquire or fund those assets. The
balance sheet “balances” because it shows that the money to purchase your assets came
from (or balances with) the total of what you borrowed (liabilities) plus what you earned or
contributed from your own pocket (equity).
The home example is also a good example of why asset strength and strong equity are
equated with less risk. Let’s say that instead of increasing in value, your home value
dropped by $50,000. Now your $150,000 home would equal your $160,000 liability plus
$10,000 in negative equity. That’s what you would have to pay the bank if you sold your
home today, in order to maintain good credit with the bank. If you are still able to make
your loan payments, then negative equity may not be a problem. However, if you had more
equity from the start to offset the liability of the loan, a drop of $50,000 wouldn’t have
resulted in negative equity. Or if you had other assets, such as $15,000 in the bank,
covering the negative equity in your home wouldn’t be a problem. If you didn’t have assets
to cover your negative equity, that would make you a risky borrower.
This is why banks, investors, and analysts review the balance sheet closely to determine
how risky it is to loan money to, invest in, or buy stock in a company. They want to see
enough asset strength to cover all of the eventualities that businesses are exposed to every
day, such as a downturn in the market or the failure of a new product.
A significant contributor to the credit crisis that began in 2007 was financial institutions,
lowering their lending standards and accepting riskier loans, with borrowers investing very
little of their own money, say 5 percent. As the value of homes dropped, many lost all of
their equity (in 2011 about one in seven homes was underwater) and their incentive to keep
making payments. And as loans for banks went south, they had less money to lend to
others, including businesses.
To help you understand how to quickly get key indicators of your company’s financial
strength from the balance sheet, I’ve presented the Big Picture Breakdown. If you’re ready
for a more in-depth look at the balance sheet, read through the rest of the chapter, too.
 BIG PICTURE BREAKDOWN: THE BALANCE SHEET IN A MATTER OF
MINUTES
What do you want to see when assessing a company through a balance sheet and only
have a couple of minutes? Let’s break it down for a quick analysis.
Cash position: Recall from chapter 1 that a company’s cash position is the amount
listed for “cash and cash equivalents”—how much it has on hand or in accessible
accounts at any point in time. A company should have a strong cash position on its
balance sheet so that it can weather tough times or take advantage of opportunities.
The worse the economy or the industry is doing, the more cash you want to see on
hand.
Cash position change: How has the cash position changed year over year or
quarter over quarter? If it has increased, that may be a good thing—unless the
company is holding on to too much cash (cash earns a pretty lousy return) or isn’t
investing in the growth of the company. If it has decreased, why? Has the company
used cash for a big investment for future growth? Or have revenue and profits been
dropping, forcing the company to dig into its cash to keep the doors open?
Equity ratio: The equity ratio is total shareholders’ equity divided by total assets,
expressed as a percentage:

A high or strong equity ratio means that more of the total assets are financed by
shareholders’ or owners’ equity than by liabilities, or debts. Banks tend to have lower
ratios, hi-tech companies higher. A higher ratio means that a company has more
equity to borrow against if it needed to (the company is a good credit risk), and the
ability to borrow money is an important factor in the potential growth of a company.
Return on Assets (ROA): ROA measures the profit generated on the company’s
assets. The purpose of assets is to earn a return for the stakeholders, and profit is the
best form of return. The equation is:

The higher the percentage, the better. The S&P 500 average is typically about 7
percent.
THE BALANCE SHEET IN ABOUT 30 MINUTES

A balance sheet is a snapshot, providing a financial picture of your company on a specific

date—usually the last day of a month, quarter, or fiscal year. Accounting standards require
that at least two periods be shown. If you look at the balance sheet for Austin’s Cycle Shop,
you’ll see information as of December 31, 2012, and December 31, 2011.
The most important line items on any balance sheet, and the ones we’ll fully analyze in
the following pages, are:

• Current assets, particularly cash and cash equivalents

• Total assets
• Current liabilities
• Total liabilities
• Shareholders’ equity

Current Assets

A balance sheet always lists assets beginning with the most liquid—the current assets.
Current assets are those the company expects to convert to cash within twelve months.
(Note that I’m using guidelines for U.S.-based companies. Businesses based outside of the
United States might have different formats.)
It’s important to note that the dollar amount of assets included on the balance sheet is
typically the original cost of the asset less any accumulated depreciation. Inventories are
valued at either cost or market value, whichever is lower. These accounting rules guard
against inflating the value of assets, but they might also lead to understating the true value
of a company. For example, a company that purchased a building thirty years ago might
show no value for the building on its balance sheet because the asset has been entirely
depreciated (“written off”) over this period. However, the building might still be in good
condition and valuable if sold—possibly worth even more than its original cost.
Corporate raiders evaluate companies based on the fair market value of its assets—not the
dollar amount on their balance sheet (its book value).
Cash is the most liquid asset, so is listed first within current assets. It includes funds in
banks and other financial accounts as well as cash equivalents that are almost as liquid as
cash, such as an interest in a money market fund. The reason this is such an important line
item, as discussed in chapter 1, is because it reflects a company’s flexibility, or its ability to
take advantage of opportunities in the marketplace, invest in new products, or survive
through downturns.
Obviously, we want to see that a company has enough cash to cover its immediate
expenses and still have a surplus for emergencies. As we discussed in chapter 1, there is no
magic number. It varies from company to company and industry to industry. Retailers, like
Target, generally carry less cash compared to large technology companies like Cisco,
Google, and Apple, which carry much more. If the amount of cash held is too high, you
might ask whether the company is holding too much cash—cash that it could be investing to
earn a higher return elsewhere or that it could use to pay dividends to investors, if it’s
public. Austin’s showed cash and cash equivalents of $827,000 for 2012.
We generally want to see the amount of cash increasing over time, or at least increasing
as revenue and earnings are increasing. However, a company may make a strategic
decision to use cash to invest in an opportunity, pay dividends to shareholders, or even pay
bonuses to employees. If there is a drop in cash from period to period, you should ask the
question “How was that cash used?” which can be answered by reviewing the statement of
cash flows, as we’ll discuss in the next chapter. Austin’s cash balance did grow from
$580,000 to $827,000, a 43 percent increase year over year. You may remember that
Austin’s net income or profit grew by 28 percent in the same period (as shown on the
income statement), so the increase in cash is not surprising.
After cash, companies itemize other current, but slightly less liquid, assets. Short-term
investments, such as securities like stocks and bonds that will mature within one year, were
$1.189 million for Austin’s. If a company has this line item on its balance sheet, it has a
strong enough cash position that it can invest some of that cash to generate a higher return
without risking its financial security.
Companies identify accounts receivable, money due from customers who have purchased
on credit, on their balance sheet. Austin’s accounts receivable was $1.242 million in 2012,
decreasing from $1.303 in 2011, even though sales increased. That is actually a good sign,
because it shows that the company is collecting cash faster and can use that collected money
sooner to invest in income-producing assets.
The next line item is inventory of $652,000 and reflects the actual costs of the inventory,
such as raw materials, the labor, and the manufacturing overhead involved in creating the
inventory. Austin’s inventory grew 80 percent—from $362,000 to $652,000—which is a
faster growth rate than its sales, a potential red flag. Austin’s shouldn’t build up more
inventory than it needs, as this ties up cash, adds storage costs, and increases the risk of
outdated product. A buildup of inventory could be justified if Austin’s is planning for a big
sales push or increase in demand with new store openings.
Prepaid expenses is money your company has paid to another entity, which can be
considered an asset until the products or services paid for have been delivered. For example,
companies may pay their insurance premiums in January and have the benefit (an asset) of
being covered for the next six months. Austin’s prepaid expenses and other current assets
increased from $412,000 in 2011 to $705,000 in 2012. Part of this may have been due to
down payments on inventory it has yet to receive. Ideally, a company would prepay
expenses as little as possible, unless it can obtain good discounts, so that it can keep its cash
longer.
Once all the current assets are listed, they are totaled, and the total is a good indicator of
liquidity, particularly when compared to current liabilities (I’ll discuss the current ratio
when we review liabilities). Austin’s had total current assets of $4.615 million in 2012.

Total Assets

After the total current assets line, the balance sheet presents assets that are fixed or long-
term in nature. Companies don’t intend to turn these assets into cash in the next twelve
months. For example, Austin’s long-term investments of $3.202 million differ from
investments in the current asset section because the company intends to hold them for more
than one year. A company sitting on more cash than it needs in the short term will look for
ways to invest it for a higher return through long-term assets.
Austin’s property, plant, and equipment amount of $2.913 million represents the cost of
these assets, less the total depreciation that has been booked for them (refer to chapter 8 for
a review of depreciation). Austin’s increase of nearly $1 million in property, plant, and
equipment is in line with the growth strategy for the business.
A curious asset you may see on some balance sheets is goodwill. Goodwill has nothing to
do with how well liked a company is or what good deeds it has done. It is the difference
between how much a company pays to acquire another company and the value of the
acquired company’s tangible assets. So goodwill accounts for the value of the intangible
assets that were acquired. When P&G bought Gillette (the razor company), much of the
value it acquired was not property, plant, and equipment but intangibles like the Gillette
brand name, supplier relationships, and the people who were part of Gillette. Austin’s Cycle
Shop purchased a small supplier that had goodwill and other intangible assets that were
worth about $10,000 to Austin’s. Austin’s wasn’t simply buying the fixed assets from this
supplier; it also purchased the supplier’s contacts, brand strength, and employee expertise,
all of which added value to what Austin’s was buying. Goodwill stays on the books forever,
unless there is a reason to reduce the value. For example, if all of the employees left and
sales dropped, the value of the acquisition would drop, and that would be reflected in the
goodwill line item. And if Austin’s decided to later sell the supplier’s business, the goodwill
would be taken off of the balance sheet.
“Other assets” of $1.787 million is the last asset listed on Austin’s balance sheet, and it
represents the value of noncash assets that are longer term, such as prepaid expenses,
accounts receivable, and notes due. You’ll notice this line item is growing, and faster than
Austin’s sales. One of Austin’s strategies to boost sales and profits is to offer financing to its
bicycle and motorized scooter customers for up to two years. Since this is money owed to
Austin’s, it is listed as an asset. If much of the growth in this line item is due to Austin’s
financing more of its sales, Austin’s could see a boost in profits, since collecting interest
makes financing a profitable business as a result of the interest paid. Of course, this
increases Austin’s risk, too. Some customers may default on their loans. And financing
affects cash flow because the company doesn’t receive the cash when it sells a bicycle on
credit. Boosting sales by offering credit is a strategy Austin’s leaders will want to carefully
monitor.
With all assets listed, you can calculate total assets. This line item is important because it
represents the foundation the company is building to support its future growth; it is a core
component of asset strength and liquidity. In 2012, Austin’s had total assets of $12.527
million, which grew from $8.962 million the previous year, a substantial 40 percent
increase. Retailers might normally grow total assets at 6 to 10 percent per year, so Austin’s
asset growth of more than 40 percent is spectacular. Clearly Austin is setting the company
up for more sales growth and increased profitability going forward. He is purchasing
companies, investing in fixed assets, and growing the cash position.
 Other than growth, when reviewing total assets it’s helpful to calculate the return on
assets (ROA), which was mentioned in the Big Picture Breakdown on page 141 as one of the
most important ratios associated with the balance sheet. It reflects asset utilization and
organizational efficiency because it tells us how much profit is generated for each dollar
invested in assets. Return on assets is calculated as net income divided by total assets. From
Austin’s income statement in the previous chapter, we know that its net income for 2012
was $1.087 million. That gives it an ROA of 8.7 percent; for every $100 of assets, the
company is currently earning $8.70. That’s a good ROA, surpassing the average ROA for
most industries of about 7 percent and for Austin’s industry of about 5 percent. (ROAs have
been pushed down in recent years by the recession, but the average five-year ROA for
software companies is about 13 percent and for auto companies is about 4 percent.)
Austin’s ROA in 2011 was a bit higher at 9.5 percent. While Austin’s return on assets
dropped 0.8 percent in the past year, that is nothing to panic over—but it is a trend to
watch. A company should be striving to improve its ROA over time, using its assets more
and more efficiently to generate profit. However, it’s not uncommon to see a drop in ROA
in companies that are focused on growth. They may invest in a number of assets to prepare
for growth, but it may take time for those assets to generate the profit expected. For
instance, Austin’s purchased a company this year, and acquisitions can be notoriously slow
at proving their worth.

Current Liabilities

Liabilities—obligations we have to others—are used to finance and grow operations, and

are thus necessary in most companies. However, accumulating too many liabilities,
particularly in relation to assets or equity, can be a sign that a company is becoming too
leveraged or less liquid, or that profits may begin to suffer. More liabilities usually mean
greater interest payments, and interest payments impact the bottom line. A significant
factor in the downgrade of the U.S. government’s credit rating in 2011 was the
accumulation of too much liability (debt).
Because liabilities are paid or settled over time, they are listed in order of those due the
soonest (current liabilities, such as trade accounts payable) to those due latest (such as long-
term debt or mortgage loan notes). As we go through Austin’s liabilities you will notice that
each line item has increased in the past year, and as you can guess, this is due to Austin’s
strategy for growth. Also, remember that a good cash strategy is to pay liabilities as slowly
as possible without incurring penalties or damaging supplier relationships.
Current liabilities are liabilities due to be paid within twelve months. As shown on
Austin’s balance sheet, current liabilities begin with accounts payable of $361,000—the
total of invoices the company has in hand but has not yet paid. This would include expenses
for utilities, rents, inventory purchased, etc. Next, income taxes payable of $576,000 are
taxes that are owed but have not yet been paid. For example, a company paying taxes on a
quarterly basis will accrue taxes for three months before making payment. “Accrued payroll
and related expenses” refers to money that is owed to employees but has not yet been paid.
This does not mean that Austin’s is holding out on its employees’ paychecks! The $571,000
in 2012 may be related to commissions, bonuses, or benefits that are earned over time and
paid at the end of the quarter or year. Other accrued liabilities of $750,000 is the catchall
for liabilities that do not fit into the above line items, such as retirement obligations.
It is preferable for current liabilities to be less than current assets. Austin’s current
liabilities for the 2012 were $2.258 million, less than the current assets of $4.615 million—a
good sign. Austin’s current liabilities grew 27 percent in the last two years, a substantial
increase, particularly considering that current assets grew by only 21 percent. This is a bit
of a red flag. Austin’s has been pushing for growth, and that typically results in a jump in
liabilities.
A critical question to ask when reviewing current liabilities is “Are there enough current
assets to pay for all the current liabilities?” The current ratio, one of the most important
measures of liquidity, can help you answer this question. The current ratio is simply current
assets divided by current liabilities. The higher the current ratio, the more liquid and secure
a company is, because it is more able to pay off its current liabilities. If the current ratio is
greater than 1, the company has more current assets than current liabilities. If it’s less than
1, the company has more current liabilities than current assets and would be unable to pay
off its current liabilities if they suddenly came due unless it borrowed money or sold an
asset. Austin’s current ratio for 2012 was about 2.0 and tells us that for every dollar it will
owe in the next year, it should have about 2 dollars coming in. Although the current ratio
dropped slightly from 2.1 in 2011, it compares very favorably with many retailers. By
current-ratio analysis alone, Austin’s Cycle Shop is more conservatively structured than
either Walmart or Target. The average company today has a current ratio of about 1.1.

Total Liabilities

Once the current liabilities are tallied, the long-term liabilities are listed. These are financial
obligations that extend beyond twelve months. Austin’s long-term debt of $343,000 in 2012
is up from $143,000 in 2011, but since Austin’s has a strong equity position, as we will see
shortly, this does not raise a concern. The company has financed some of its growth by
borrowing, which is a good way to fund growth, especially when interest rates are low.
Many companies itemize their long-term debts, including line items for mortgage loans,
retiree benefits, long-term lease obligations (for office space, equipment, or other assets),
and notes or bonds issued that are due to be paid beyond twelve months.
Once all liabilities are listed, they can be tallied to determine total liabilities, an important
line item because it reflects the total debt of the company, which can be compared with
total assets or equity. In 2012, Austin’s had total liabilities of $2.601 million, which grew a
substantial 35 percent (from $1.924 million) over the previous year. This was less than the
total asset increase of 40 percent, so the company is becoming slightly less leveraged.
To get some context for total liabilities, let’s look at the debt ratio, a comparison of total
liabilities to total assets (total liabilities divided by total assets). Austin’s debt ratio has been
about 0.21 for the past two years, which means that about 21 percent of its asset value is
financed through debt. This is quite low, a good sign of financial strength. Many companies,
including retailers, have debt ratios that are much higher, meaning they incur a fair amount
of debt to acquire their assets.
Shareholders’ Equity

Shareholders’ equity is the third major category after assets and liabilities. It is sometimes
called stockholders’ equity, or partners’ capital if the business is a privately held partnership
and is the difference between total assets and total liabilities.
There are a few items that may be included under stockholders’ equity, particularly for
public companies. The first is common stock and additional paid-in capital. When stock is
first issued, it is valued at a nominal figure, a par value such as $0.01 (1 cent) per share.
When the stock is purchased by investors, its price is always substantially more than par
value. The additional amount paid by investors over the par value per share is known as
additional paid-in capital. For Austin’s Cycle Shop, equity coming from stock (actual cash
paid for the stock when it was issued) was $5.011 million in 2012. The number of shares of
common stock issued and outstanding are identified on the balance sheet as well. You can
see from 2011 to 2012 that the number of shares issued and outstanding increased from
3,210,000 to 4,002,000, which means that Austin’s issued more stock. As a result, additional
paid-in capital, or cash generated from issuing stock, increased from $3.210 million to
$5.011 million.
We just discussed how equity is built in a company through issuing stock to shareholders.
The other important way to build equity is through a company’s profits. When a company
shows a profit or loss on its income statement, this amount (less dividends distributed to
shareholders) is added (profits) or subtracted (losses) to the retained earnings category on
the balance sheet. If it were not, assets would not balance with liabilities and equity. Profits
and losses accumulate over the years in retained earnings. So retained earnings is a
reflection of the accumulated profits that have not been paid out as a dividend. As earnings
are retained in the company, the assets grow. As you can see, Austin’s retained earnings
grew by $1.087 million from 2011 to 2012, which is the exact amount of net income shown
on the income statement in 2012. Since Austin’s is not paying a dividend, all of its 2012 net
income or profit was retained in the company and therefore increased the company’s
shareholders’ equity.
In 2012, Austin’s had shareholders’ equity of $9.926 million, a growth rate of a
substantial 41 percent over 2011 (from $7.038 million). This is slightly more than its total
asset increase of 40 percent because its liabilities grew at a slower rate of 35 percent.
Shareholders’ equity is used to calculate a number of ratios. The one that I mentioned in
the Big Picture Breakdown at the beginning of this chapter is the equity ratio, which
measures equity as a percentage of assets. For Austin’s Cycle Shop, this ratio was 79 percent
in 2012 and slightly less in 2011. This suggests that the company has a lot of equity to
borrow against if it needs to raise cash. The average equity ratio varies greatly by industry,
with banks generally below 10 percent and tech companies often over 50 percent. With the
average company at around 25 percent, Austin’s ratio is very strong.
Another important ratio related to shareholders’ equity is the debt-to-equity ratio, which is
calculated as total liabilities divided by shareholders’ equity. While good companies can
have liabilities equal to two or three times the amount of equity, this relationship is
important to consider. A higher percentage of equity or assets in relationship to liabilities
indicates greater financial strength. The debt-to-equity ratio indicates how “leveraged” a
company is, meaning how much it has relied on debt to fund its investments, and therefore
its growth. A high debt-to-equity ratio means that it has relied more heavily on debt.
What does this mean? Well, with debt come interest expenses, and the more debt, the
more interest. So if a company is heavily leveraged, meaning it is primarily using debt to
fund its investments, its earnings may be affected over time by interest payments, which
impact the bottom line. If times get bad, a highly leveraged company might go under, which
happened to many companies in 2008 and 2009. That said, debt is not a bad thing. Most
companies need it to grow. And debt can be less costly than other ways of raising capital
because, for one, interest payments are tax deductible (they lessen the amount of income on
which a company has to pay taxes).
Austin’s debt-to-equity ratio is 0.26 ($.26 of debt to $1 of equity; it can also be written as
.26:1 or 26 percent) for 2012 and 0.27 for 2011. That’s quite low. Most companies try to be
in the 0.5-to-1.5 range, but this can vary by industry.
The last line on the balance sheet is total liabilities and shareholders’ equity. And as you now
know, it always equals, or “balances” with, total assets.
What can you do to make a positive impact on the balance sheet of your company?

You can help reduce or eliminate nonproducing assets and acquire more effective assets
in the future—for example, keeping inventories down without impairing sales. You can
make better use of or conserve cash. You can negotiate better terms on credit and debt. And
you can work to improve profitability using the assets you already have.

INSIGHTS INTO THE BALANCE SHEET

• The balance sheet measures financial strength, especially your company’s liquidity and
ratios of liabilities (debt) to equity and assets.
• The balance sheet formula is Assets = Liabilities + Equity. This financial statement
presents assets first, then liabilities, followed by shareholders’ equity.
• The balance sheet must balance the amount of assets with the source of funds to
acquire them: liabilities (debt) coming from creditors plus equity coming from the
owners.
• The balance sheet is a financial snapshot taken at the end of a month, quarter, or
fiscal year.
• Key measures to look for include cash, current assets, total assets, current liabilities,
total liabilities, and shareholders’ equity.
• Assets are listed beginning with those most liquid through those least liquid. Current
assets are those that should be converted to cash within twelve months.
• Net income from the income statement divided by the total assets on the balance sheet
 is a measure of your company’s overall productivity, called return on assets (ROA).
• Liabilities are in order of those due first through those due latest. Current liabilities are
those coming due within twelve months.
• The current ratio, which is current assets divided by current liabilities, is a key
indicator of liquidity.
• Shareholders’ equity is equal to assets minus liabilities and is generated by
shareholders investing in and profits retained by the company.
• The debt-to-equity ratio indicates how much debt is used to finance the growth of the
company over time.
• Everything you do to impact cash, profits, and assets influences your balance sheet.
 Chapter 10
STATEMENT OF CASH FLOWS
Cash flow is more important than profit.
—Peter Drucker

D o you remember when you were in college and in the third week of a month, you
would run out of money? So you would make that dreaded call to Mom and Dad.
And when you told them you had run out of money, what was the first question they
asked? I’m betting it was “What did you do with your money?” Answering that type of
question is the purpose of the statement of cash flows. It shows where you got the money,
where you spent it, and what you had left over. Of course, this is probably something you
wouldn’t have wanted to send to your parents. Seeing a hefty sum spent at the local pub as
a line item probably wouldn’t have made them rush to send you more cash.
In many ways, it’s appropriate that we began this book discussing cash and now
approach the end by addressing the same topic. Cash flow is that important. Without strong
cash flow, a company will quickly die. With it, a company can weather almost any storm.
Henry Fudge, owner of Fudge Family Farms, a highly regarded pork producer, learned this
lesson the hard way, as he explained to Craig Rogers in his column “Chefs with Issues: Five
Sustainable Lessons from a Family Farm” (CNN.com June 2, 2011). To grow his business, he
entered into a relationship with a wholesaler, who agreed to buy Henry’s prime cuts. But
that left Henry with too much inventory of “off cuts.” Whole animal usage is critical to
farms that raise and sell protein animals. Holding on to inventory that he had to invest
substantial resources to raise and slaughter limited the cash flow he should have been
generating from that product. Although Henry’s total revenue initially grew through sales of
his premium pork, his profit and cash flow by comparison plummeted, becoming a major
contributor to the eventual demise of his business.

AKA
The statement of cash flows is also referred to as the cash flow statement and the sources
and uses of cash statement.

PURPOSE AND EQUATION

The statement of cash flows (or the cash flow statement) measures the amount of cash your
company generates and uses during a particular reporting period (usually a quarter or a
fiscal year), including where it comes from and where it goes. It provides important
information about a company’s ability to generate cash, pay its debts, make acquisitions,
survive market downturns, invest in growth, pay dividends, buy back stock, and otherwise
exercise its financial strength.
While the income statement and balance sheet reveal important information about a
company, you can’t tell from them how much cash your company generated during the
reporting period or how much cash was generated from normal operations in contrast to
investing and financing activities, the three categories of activities we discussed in chapter
1. This information is just as important as profit or equity when you are trying to assess the
health of your company and how you can help it grow. Providing this information is the
purpose of the statement of cash flows.
The basic equation for the statement of cash flows is:
 BIG PICTURE BREAKDOWN: THE STATEMENT OF CASH FLOWS IN A
MATTER OF MINUTES
If you only have a couple of minutes to review the statement of cash flows, you can
still learn a lot about a company:
Cash from operating activities: On the statement of cash flows, look for the line
item “net cash provided by operating activities.” The dollar amount for this line item
had better be positive, unless the company is new and is spending cash to get started.
For a mature company, negative cash flow is a very bad omen, and a company with
negative cash flow over time is unlikely to survive. This is the most important number
on the statement of cash flows!
Growth in cash from operating activities: Ideally, you want the cash provided
by operating activities (cash flow) for a company to increase year over year. This
means the core business is generating more cash as the company grows, operations
are becoming more efficient, and leaders have a better understanding of what
resources they need and when. That said, there could be a sound business reasons why
the number would decline from one period to the next. When cash generated goes
down—or up—significantly from one period to the next, this is a red flag that should
prompt you to ask, “Why?”
Cash used in (provided by) investing activities: I prefer to see a negative
number here, because it indicates a company is investing in assets. Investing in assets
is important in order to both maintain existing assets and to acquire new assets
needed to support growth.
Cash provided by (used in) financing activities: A positive number for this line
item means the company is borrowing money or issuing stock. A negative number
means the company is using cash to reduce debt and/or provide value to shareholders.

THE STATEMENT OF CASH FLOWS, IN ABOUT 30 MINUTES

In the cash flow statement, the entries show cash flowing into and out of the business for
operating, investing, and financing activities; the total amount of cash generated from all
of the activities; and the cash position. Positive numbers mean a source of cash for the
business, and negative numbers mean cash used by the business. (Note that negative
numbers are shown in parentheses. Negative numbers do not mean a loss—just that cash
was used for a certain purpose rather than received.) For this reason, some finance people
will refer to this statement as a Sources and Uses of Cash Statement. The cash flow
statement includes numbers from the three most recent reporting periods, making it easy to
see changes and trends.
The most important items on this financial report are

• Net cash provided (or used) by operating activities

 • Net cash provided (or used) by investing activities
• Net cash provided (or used) by financing activities
• Net change in cash and cash equivalents

Let’s look at Austin’s cash flow statement to explore how the numbers reveal important
details about the business.

Cash Provided (or Used) by Operating Activities

A review of a cash flow statement always begins with determining cash flow from
operations, because cash generated from normal business operations, specifically related to
the sale of its products or services, is the most important source of cash. To reach a
calculation of cash flow from operations, the statement of cash flows begins with net
income and makes adjustments to show how cash flowed into and out of the company.
You’ll notice that the first line of Austin’s statement of cash flows is the bottom line from
the income statement, and both have the same label: net income. Austin’s net income for
the most recent year was $1.087 million. For Austin’s, and any larger organization, net
income is an accrual-based number—meaning it is based on the revenues and expenses
booked or recorded in a particular period as a result of sales in that period. The company
may receive cash from that booked revenue or use cash to pay those booked expenses in a
different period, so net income isn’t an accurate measure of cash flow. Remember from
chapter 2 that profit and cash flow are not the same thing. Because financial statements are
based on accrual-basis accounting, the statement of cash flows begins with an accrual-based
calculation of net income. However, because the statement of cash flow is trying to
determine actual cash flow from operations (cash actually received or disbursed, not
booked), it must make adjustments to net income to get to an accurate amount.
On Austin’s statement of cash flows, the first adjustment to net income is depreciation
and amortization of $486,000. Why is this a positive adjustment to net income on the
statement of cash flows? You will notice on the income statement that this same amount
and title, depreciation and amortization of $486,000, is an expense, which reflects the
decrease in value of certain assets over time. But this is a noncash expense. Austin’s didn’t
have to pay someone $486,000. Therefore, it is added back to net income on the statement
of cash flows, because this expense didn’t require the use of cash.
Right after depreciation and amortization is a group of line items labeled “Change in
operating assets and liabilities.” These adjustments show changes year over year in some of
the balance sheet accounts that may use or generate cash. Let’s look at each line item. The
first, accounts receivable of $61,000, reflects the reality that cash was generated by
reducing receivables (collecting money owed to the company) from the prior year. If you
look back to the balance sheet, you can see that Austin’s receivables did decrease by
$61,000 from 2011 to 2012. The inventories line item of negative $290,000 indicates that
this amount of cash was spent to increase inventories. The accounts payable amount of
$111,000 reflects the fact that, in growing the business, Austin’s Cycle Shop funded part of
its growth by buying items on credit. Increasing accounts payable over the previous year
was a source of $111,000 in cash. Income taxes payable of $165,000 indicates that Austin’s
income taxes have increased by this amount in the past year, but have not been paid, so is a
source of cash. This same explanation applies to the next two line items, accrued payroll
and related expenses, and other accrued liabilities. Since the amount of these obligations
have increased from 2011 to 2012, but have not yet been paid, Austin’s still has the use of
the cash, which means they are reflected on the statement of cash flows as a source of cash.
At the end of the category, the summary entry “net cash provided by operating activities”
is calculated by adding the positive (cash in) and negative (cash out) numbers. The net
amount flowing into or out of the business is the total. In the Big Picture Breakdown at the
beginning of the chapter, I explained how important this number is—the most important
number on the sheet. Unless the company is very young, this number had better be positive.
In the most current year, Austin’s Cycle Shop’s operating activities generated cash flow of
$1.528 million, which bodes very well for the survival of the company.
For Austin’s Cycle Shop, the trend is positive from 2010 to 2011, increasing 61 percent.
But from 2011 to 2012 it decreases almost 25 percent. Part of your study of the financials
would be to find out why cash flow from operations decreased in the past year. Two
obvious causes are that cash was used to increase inventories and to prepay expenses.
The most important ratio to analyze here is the amount of cash flow generated from
operating activities compared to profit (net income) for the same period. Calculating this
for Austin’s, we would divide the cash from operations by the net income ($1,528 divided by
$1,087 = 1.4). You generally want this ratio to exceed 1.0, meaning you want cash flow to
be greater than profit. Why? Because it reflects a company’s ability to effectively turn
profits into cash. Remember, a sale does not generate cash until it is collected. For 2010,
2011, and 2012, the cash flow/profit ratios are 1.7, 1.5, and 1.4, which reflects good cash
generation. The ratios are trending down, which can be attributed to growth efforts, but
Austin’s will want to watch this trend carefully.

Cash Provided (or Used) by Investing Activities

After operating activities, the statement reveals cash flows from investing activities. Unlike
cash flow from operations, which should be positive, healthy companies frequently use cash
in investing activities, as does Austin’s in each of the three years shown. For 2012, Austin’s
had net cash used in investing activities of $3.282 million, which is shown in parenthesis to
indicate cash out or a use of cash. These negative numbers are typical and simply mean that
management takes cash generated from operations (or financing activities) and invests
more cash in assets. For example, Austin’s used $1.217 million to purchase investments,
$655,000 for purchase of other assets, and $1.410 million to acquire property and
equipment.
When reviewing competitors’ cash flow statements, take note of who is investing cash,
buying assets, or even acquiring other companies to support future growth. A company
growing well this year but not investing in its future growth will likely see growth slowing.
In total, Austin’s investing activities used cash of $3.282 million in 2012, $2.237 million in
2011, and $1.581 million in 2010. Austin and the board are investing more each year in
order to support the growth of the business. A company with a positive amount here would
be selling assets to generate cash, which is not sustainable. For example, a company could
sell off one of its stores to generate cash, but would then have one less store. If a company
continued this strategy they might end up with a lot of cash, but no stores and no retail
business.

Cash Provided (or Used) by Financing Activities

Finally, the cash flow statement shows cash in and out from financing activities. This
section reveals how a company is financing its business. Austin’s issued stock to generate
$1.801 million in cash. It also increased its long-tem debt (borrowed cash) by $200,000. If
the company were to repay this money next year, it would be shown as negative $200,000,
because cash would be used to reduce debt.
If the company is public, this section will show whether a company is paying a dividend
and/or buying back stock. These are strategies that companies use to leverage their excess
cash and provide value to stockholders. Dividend payments offer value in a very direct way,
and a stock buyback makes the remaining shares worth more money (fewer shares means
that each share is tied to a greater percentage of the company’s earnings), thus raising the
stock price. You’ll see from Austin’s cash flow statement that there is no line item for total
dividends paid. The company is experiencing good growth, and therefore it is not surprising
that it would not be paying a dividend. And although there is a line item for common stock
repurchases, Austin’s has not repurchased any shares in the last three years.
Understanding how the competition is funding its business or using excess cash is also
useful. Are competing businesses borrowing money? Are they issuing or buying back stock?
Are they paying a dividend? These are important questions to consider as you dive into a
company’s financing strategies. In the most recent year, Austin’s financing activities
generated cash of $2.001 million. And because this line item is growing we can assume that
Austin’s strategy to borrow more money and issue more stock is supporting strong growth
plans.
Net Change in Cash and Cash Equivalents
Toward the bottom of the statement, you can see the increase in cash and cash
equivalents for 2012 of $247,000. Remember the basic equation for this statement adds
together the net increase or decrease in cash for the three categories combined.
Of the three categories, cash provided from operations is the best way to generate cash. This
reflects how the company’s core operations are doing. Generating money by selling
investments or assets is not sustainable. If cash is generated through borrowing, the
company will have to pay it back in the future with interest.

Cash and Cash Equivalents at End of Year

The net change in cash is the amount—$247,000 for 2012—added to (or subtracted from)
the cash and cash equivalents at the beginning of the year—$580,000—to create the cash
and cash equivalents at the end of the year—$827,000, which is the last line item on a
statement of cash flows, and the first line item on the balance sheet. Thus, the statement of
cash flow tells the story of how Austin’s ended up with $827,000 in the bank. Austin’s cash
has been increasing each year, which is generally positive because cash has grown as the
company has grown. But there might be sound business reasons why a healthy company
would have a reduction in cash balances in one year compared to the prior year. The
statement of cash flows would give you clues as to why this happened.

The statement of cash flows helps us understand how a company is balancing its need to
retain cash with its need to use cash to grow the business. It reveals how cash was used to
further strategies that might change from year to year, just as the focus on particular drivers
might shift over time.

INSIGHTS INTO THE STATEMENT OF CASH FLOWS

• The statement of cash flows measures cash generation.

• The cash flow statement basic equation is: Cash from (or used in) operating activities
+ Cash from (or used in) investing activities + Cash from (or used in) financing
activities = Net change in cash. These also represent the key measures found on the
statement.
• The three primary sources (and uses) of cash include operating activities, investing
activities, and financing activities.
• The cash flow statement begins with net income from the income statement and makes
adjustments to calculate cash flow, then ends with cash and cash equivalents, which is
where the balance sheet begins.
• You want cash from operations, the most important number on the page, to increase
each year. Cash balances might not increase because of other strategic uses of cash.
• Everything impacting profit and uses of cash also influences your cash flow statement,
such as expense reduction and sales increase.
 SECURING YOUR SEAT AT THE TABLE

To know and not to do is not to know.

—Proverb

S o you’ve learned a bit about how your company functions and how to tell whether it’s
successfully growing and generating profit. What do you do now?
What I’ve provided here is just the foundation, a foundation you can turn into deep
knowledge about how your company operates now and should operate in the future. Why
go to the trouble? It’s the best and fastest way to prove your worth and to secure a seat at
the decision-making table, something that can make your work more rewarding and your
career more successful.
Securing your seat at the table means adding value, developing and continuing to
exercise your ability to influence decisions and decision-makers within your organization.
You must study business generally, your business specifically, and then make and act upon
sound decisions.
Your application of business acumen requires a focus on the chief concerns and goals of
your boss or CEO. You’ll need to develop and apply continued insights concerning market
trends, competitor analysis, strategic choices, financial markets, consumer trends, and
more. You’ll need to communicate effectively using the 5 Key Drivers within the context of
your company’s strategic goals if you want to contribute to your company’s growth, and to
your own.
As you grow in your influence at the decision-making table, you’ll need to stretch
yourself, move outside your comfort zone. It can be challenging to find the time and energy,
but the rewards will be worth it. Your knowledge and contributions will build your
credibility, career, and company.
I challenge you to move forward with a commitment to do it.
In pursuing your personal or business objectives, you must never omit the hard work of
preparation. An admiring audience member said to the virtuoso concert pianist, “I’d give
my life to play like that.” The predictable response: “I have.”

SIX IDEAS FOR BUILDING BUSINESS ACUMEN

Here are six practical ideas to encourage and support your ongoing development and
application of sound business acumen.

1. Commit the Time to Study and Research

Set aside time for regular study and research.

Your days are already full, crowded with professional and personal activities.
Nevertheless, find opportunities to carve out the time to advance your credibility, your
career, and your company. How much time do you spend watching television? Could you
chat with coworkers less and read industry information more? Could you use your lunch
time more productively? An hour of research even once a week will have a great payoff.
Whether you can spend an hour a week or a half-hour daily, set aside time for study and
preparation—regularly. Then put it to use!
The Resources section in the back of this book offers a host of opportunities to learn more
about business in general and your industry specifically. You can also sign up for our
monthly newsletter or access other resources at www.seeingthebigpicture.com.
You should also devote time to learning how your company is organized and operates: its
organization and internal structure, who the key officers are, your primary products and
services, your present and future goals. Understand the important priorities, values, and
strategies of your CEO, division head, and direct supervisor.
Do you know how your company is doing financially or what its financial goals are? Go
deeper than the big picture of your company and explore the financials of each division or
department if you can. How are the 5 Key Drivers being prioritized throughout your
organization?
You can learn this by reading

• the annual report;

• e-mail and other communications from your boss and company officers;
• company press releases;
• materials on the company website;
• quarterly Form 10-Q filings and annual 10-K filings;
• and other resources about your company, including interviews of your senior
leadership in all media. Ask your supervisor how to access additional internal
operating data if it isn’t readily available.

Also, if you are an employee of a public company, listen to your CEO’s quarterly
conference calls with Wall Street analysts. This quarterly call provides a current report on
your company’s operations and financial performance and your CEO’s priorities and future
plans. If you miss the actual call, an archived recording will likely be found on your
company’s website in the investor relations section.
You should also know who your three to four most important competitors are and learn
their basic financial data, strategies, products and services, and strengths and weaknesses.
Read their annual reports, their websites, and information about them in the media.
Finally, learn what is happening in the external environment that might affect your
company. Read or listen to financial, economic, and business news from websites and print
and broadcast media, including books, magazines, the Wall Street Journal, and the business
section of any large metropolitan daily paper.
As Harold S. Geneen, once CEO of ITT and father of the international conglomerate, once
said, “When you have mastered numbers, you will in fact no longer be reading numbers,
any more than you read words when reading books. You will be reading meanings.”
2. Talk with Key Company Managers

Build relationships with key leaders and managers at your company. Start with your boss or
supervisor. Talk regularly with peers or teammates in different departments who have
specific expertise. Ask questions that reveal your own research. Share your helpful insights
in return.
Talk with your boss or supervisor about the big picture of your organization and how
your team or department, and you personally, can have a more significant impact.
Learn the key measures and “dashboard metrics” that your boss and your division’s or
company’s senior management are focused on. Discuss with your supervisor how you can
better achieve these targets so you know how your team, and your job function, fit in.
Setting up these discussions need not be complicated or overly formal; meet people for
lunch, or set brief appointments in their offices.
Let your reasons be known: you want to become more knowledgeable in order to make
more effective contributions.
Build relationships!

3. Be Proactive—Contribute and Follow Through

Whenever an assignment or opportunity for action results from your study, discussions, or
meetings, follow through and do it. Report back in a timely way to the appropriate parties
so others will realize you have done it!
When realistic or appropriate, put your comments and questions into succinct,
meaningful, and timely e-mails or memos addressed to appropriate personnel. However,
don’t overwhelm people with a flood of ideas or recommendations. Be targeted in your
approach.
Draw up a brief written action list concerning any or all of the 5 Key Drivers. Link your
actions to results that “move the needle” in areas important to your boss and senior
management and that support the key measures they have identified. Identify in writing
how your actions impact the drivers. Give a copy to your boss or supervisor and discuss.

4. Attend Industry Meetings and Make Outside Contacts

If your company provides any occasion for you to attend industry conferences or major
customer meetings, take the opportunity. Network with those you meet there. Read the
literature available. Grow your own database of contacts. Keep in touch with them over
time, as possible. Gain your own direct sources of helpful industry, economic, or business
information. Stay in communication with those you meet.

5. Find a Mentor

Ask a coworker—maybe a peer or senior manager—to work with and mentor you. Your
partner should be someone to whom you can make a commitment regarding your business
acumen action plan and to whom you can be accountable. That person may want to further
his or her own knowledge, and you can help and support each other. Being a mentor to
someone else will help you both.
Above all, be accountable to yourself in your assignment to see your company’s big
picture and continue developing your business acumen.

6. Influence Management

To influence senior management, you have to follow all of the above recommendations as
you prepare yourself to present an idea or opportunity.
Then, when asking a leader to consider seriously your views or recommendations, follow
these four important suggestions—principles that have worked for thousands of employees
across many industries and types of companies:
Listen to understand: Listen first. Your sole purpose in listening? To understand where the
individual or management team is coming from, to get what’s important to them. In every
meeting, listen carefully for opportunities to ask insightful questions and learn even more.
If you deeply understand their point of view, their needs and priorities, it will first influence
you. Then you’ll be better equipped to influence them.
Present their case and needs to them: Once you have listened deeply, make a “my
understanding of your needs and objectives” summary before making your own proposals.
Once managers know that you really do understand their perspective, they will be more
open to listening to your analysis and proposals. You’ll have built greater trust.
Speak their language: Once you’ve established mutual understanding, connect your analysis
and recommendations to their strategic goals, concerns, and needs. Link your message to
what’s important to them, in financial language they understand. Demonstrate the impact
of your proposal or analysis on those drivers important to them. Remember that every
department or function has differing priorities.
Use ROI analysis: Ultimately, every business decision boils down to determining how best
to use cash for maximum return on investment. Make a convincing case for a favorable ROI
through your recommendation. (Refer to chapter 3 for more on ROI, or go to
www.seeingthebigpicture.com to download a more complete explanation of calculating
return on investment.)

YOUR VALUE ADDED

Your ultimate ability to become a more valuable, and valued, employee is primarily up to
you. Your contribution to the success of your department, division, or company will add to
your own success. Helping others along the way will add dimensions of experience,
knowledge, and insight that will benefit both them and you.
As you become better known for your insightful business acumen, you will become more
credible as a contributor and more valued as a member of your company, thus building your
career. Wherever your career takes you, your ability to understand and implement the 5
Key Drivers and to exercise the acumen associated with them will lead to sustained success.
I encourage your continued commitment and hard work. Persevere. I’m confident it will
pay off!

THE BEGINNING OF MY STORY

When I first got out of college, I began my career in banking. I will always remember my
enthusiasm and my desire to excel in my first job after college, to set the organization on
fire with the sheer brilliance of my performance.
Well, as it turned out, I created more smoke than fire. I quickly realized how little I had
actually learned in school. I struggled even to keep up a stumbling pace with my associates
who had spent just a few years in the real world.
I remember how there was nothing more discouraging than being dressed for success and
feeling like a failure—sitting in a meeting with managers and senior executives, totally in
over my head, trying to follow basic concepts of the financial discussion.
I was usually at a loss to make any intelligent comments, much less any meaningful
contribution. I regularly found myself hoping that no one would call on me for anything
important, in case I actually had to say something and reveal that I had only faint clues as
to what they were talking about.
So, early in my career, the embarrassment of ignorance compelled me to make a
commitment to competence.
There is no more empowering feeling in business than that of being in the company of
experienced leaders and being able not only to follow the flow of their discussion but to
make intelligent contributions to it. There’s nothing like sitting in an important meeting
with colleagues and managers and having everyone nod his or her head in acknowledgment
of your insightful comments and recommendations.
I wrote this book simply to educate and encourage you. Please believe me when I say, “If
I can do it, you can do it!” Really! Anyone can build business acumen. The key will be to
move forward, adopting Nike’s slogan at face value. Just do it!
Whatever your background, schooling, or experience, there is nothing about the 5 Key
Drivers that is beyond your grasp.
I sincerely hope that you will make a commitment to building your business acumen
through ongoing study and action. Continue to use this book as a reference guide, a
resource.
The ultimate key? To engage. My very best wishes for your success, and my
encouragement once more to stay with it! Remember …

What lies behind us and what lies before us are tiny matters compared to what lies within us.
—Proverb
 RESOURCES

Books

David Allen (2001): Getting Things Done: The Art of Stress-Free Productivity
Larry Bossidy, Ram Charan, and Charles Burck (2002): Execution: The Discipline of Getting
Things Done
Marcus Buckingham and Curt Coffman (1999): First, Break All the Rules: What the World’s
Greatest Managers Do Differently
Dale Carnegie (1937): How to Win Friends and Influence People
Jim Collins (2001): Good to Great: Why Some Companies Make the Leap … and Others Don’t
Jim Collins and Jerry I. Porras (1997/2002): Built to Last: Successful Habits of Visionary
Companies
Stephen R. Covey (1989/2004): The 7 Habits of Highly Effective People: Powerful Lessons in
Personal Change
Stephen M. R. Covey (2006): The Speed of Trust: The One Thing That Changes Everything
Peter F. Drucker (1967/2002): The Effective Executive: The Definitive Guide to Getting the Right
Things Done
Thomas L. Friedman (2005): The World Is Flat: A Brief History of the Twenty-First Century
Atul Gawande (2009): The Checklist Manifesto: How to Get Things Right
Michael Gerber (1995/2001): The E-Myth Revisited: Why Most Small Businesses Don’t Work
and What to Do About It
Chip and Dan Heath (2010): Switch: How to Change Things When Change Is Hard
John C. Maxwell (1998/2007 [rev. ed.]): The 21 Irrefutable Laws of Leadership: Follow Them
and People Will Follow You

Magazines and Newspapers

Business Week and BusinessWeek.com

Fast Company and FastCompany.com
Forbes and Forbes.com
Fortune and Fortune.com
Harvard Business Review and hbr.org
Investor’s Business Daily
Smart Money and SmartMoney.com
Wall Street Journal and wsj.com
Local newspaper business section or local financial newspaper
Websites

CEOExpress.com
Finance.Google.com
Finance.Yahoo.com
Hoovers.com
MoneyCentral.msn.com
Nasdaq.com
Reuters.com
SEC.gov
Individual business websites
 ACKNOWLEDGMENTS

“If I have seen further, it is by standing on the shoulders of giants.”

—Sir Isaac Newton

I was always in love with the idea of writing a book … until I started writing a book. The
idea of it was much easier than the actual effort. I could not have done it without
support from my friends who made giant contributions.

• My assistant and business manager Sharon Biegler has been with me from the
beginning … she is the glue that holds everything together.
• Keith Gulledge who got me going.
• Mike Wright who kept me going.
• Stephen M.R. Covey, a great thinker, leader, and mentor, and Jeri Covey, a wise
sounding board.
• Pam Walsh, a fantastic coach who believes in me, yet keeps my feet on the ground.
• And talk about a team who sees the big picture—special thanks to the talented Lari
Bishop and her colleagues at Greenleaf Book Group.

This book, from its concepts to its individual character, is the result of some of my
talented friends at Acumen Learning, including Brent Barclay, Ryan Barclay, Ben Cook, Jeff
Cope, Ryan Cope, Lisa Hutchings, Randy Porter, Jason Richards, Lance Richards, Kenny
Snarr, Ryan Stirland, and Mark Wood. This team performs an amazing amount of
amazingly important work for our clients day-in and day-out. While bad business practices
and bad business behavior dominate much of the news, I find that the vast majority of
businesses and business leaders are doing great things. It is an honor to have partnered with
great organizations including sixteen of the FORTUNE 50 and to have worked closely with
so many capable and commendable people, who just so happen to work in business. We
have the best clients, and we hope they learn as much from us as we learn from them.
I have many brilliant colleagues who have offered advice and unending support. In
particular, my thanks to Paul Brockbank, Kim Capps, Ram Charan, Craig Christensen,
David Covey, Ken Evans, Joe Folkman, Amy Green-Williams, Joseph Grenny, Jeff Hill, Rich
Hill, Randy Illig, Gary Judd, Greg Link, Stephan Mardyks, Rod Morely, Gabe Williams, and
Jack Zenger.
I have been blessed with great parents, Lloyd and Kathleen Cope, who have always been
there and who have relentlessly cheered me on.
And most of all, I thank God daily for my wife Karen and our children Austin and his wife
Brittany, Spencer, Ryan, Conner, Isabella, and Noelle. I could fill volumes expressing my
love and admiration for each one of you. I am humbled to be part of your lives.
 ABOUT THE AUTHOR

K evin Cope is not only a successful executive, he is also a trusted resource and
confidant to business leaders from around the world and a sought-after keynote
speaker. For over twenty-five years, Kevin has promoted the idea that the brightest
minds in business understand the essence of how a company makes money, and they use
this knowledge to drive their decisions. These people have been described as having
business acumen, and you’ll find them everywhere from the factory floor to the corner
office.
Recognizing that business acumen is about seeing the big picture and not just about
financial literacy, Kevin founded Acumen Learning in 2002, a training company that has
gone on to teach Kevin’s 5 Drivers business model to some of the world’s most respected and
successful companies. Kevin’s specialty is teaching employees and leaders how to speak the
language of business as fluently as they speak the language of their department or function.
Kevin believes that businesspeople who exercise their business acumen execute better,
smarter, and faster business decisions that drive sustainable and profitable growth.
Please visit www.seeingthebigpicture.com to learn more about Kevin and his ideas.
 ABOUT ACUMEN LEARNING

We educate and inspire individuals and organizations by Building their Business Acumen, thus
accelerating their ability to accomplish great results. This inspires us and we are enjoying the
journey!

THE BIG PICTURE

Acumen Learning has tested over 60,000 employees working for some of the most
recognizable companies in the world. We have found that while most employees understand
their function really well—they know their responsibilities as an IT professional, or they are
really smart as an operations manager, etc.—90 percent of them don’t understanding
important business measures. Those who do understand these business and financial
concepts (typically C-level executives and the finance department) often struggle to
communicate their knowledge with stakeholders and employees with clarity and in an
engaging way.
This lack of understanding, clarity, and engagement results in leaders who struggle to
align their team’s actions and strategy with corporate results, departments that are too
insular, and organizations that scramble when it comes to turning increased complexity into
financial advantage. Employees within these organizations lack the understanding and
conviction to explain what they need to do in clear, simple terms, and how their team, or
organization will improve the company’s moneymaking process. This leads to a lack of
engagement and a feeling of being disconnected. The results are employees who shy away
from making important business decisions, employees who make uninformed business
decisions, or employees who slow down the decision making process in an effort to avoid
making the wrong choice.
Since its founding in 2002, Acumen Learning’s 5 Drivers business model and financial
strategies have been field tested with tens of thousands of people in over thirty countries
and at sixteen of the FORTUNE 50—developing businesspeople who can see the big picture
without losing sight of the details, who can cut through complexity and conquer
uncertainty, and who consistently make the right strategic bets that deliver clear and
measurable business results. In short, our business acumen training, web sessions, and
keynotes will help you develop not just smarter people, but smarter businesspeople.

BUILDING BUSINESS ACUMEN® TRAINING, WEB SESSIONS, AND KEYNOTES

Think about it, you can spend your training dollars on everything from communication
skills to management techniques and end up with great leaders who don’t know whether
their efforts are good, bad, or indifferent when it comes to achieving profitable and
sustainable growth. Business acumen training from Acumen Learning will provide needed
clarity and will teach employees how to leverage their leadership skills to strengthen their
company’s financial position. Every department from operations to sales, and every role
from an up-and-coming manager to a seasoned executive will clearly see how they can
practice and perfect their business acumen to build their credibility, their career, and their
company.
If you are interested in business acumen training for your team, we’re ready when you
are.
Contact Acumen Learning:
801-224-5444
[email protected]
www.acumenlearning.com
You can read our free newsletter at www.acumenlearning.com/subscribe.
 INDEX
A
accounts payable, 148
accounts receivable, 16–17, 144, 159
accrual accounting, 32–33, 114, 159
Acumen Learning, 2–3, 85, 91
Amazon, 66–67, 68, 70, 74
American Airlines, 49
amortization, 130, 159
amount as key criteria, 115, 126
Angelou, Maya, 81
annual reports, 117–19
Apple, 7, 25, 32–33, 35, 36, 68, 71–72, 75, 76, 89, 99, 103, 133, 143
assets. See also balance sheet
characteristics, 50–51, 137–39
on financial statements, 113, 116, 142–47
liquidity and, 19, 51–55
overview, 49–50, 64–65
productivity and, 55–59
on urgency continuum, 99
asset strength, 50, 51–55, 59–64, 94, 137
asset utilization, 50, 55–60
AtTask, 74

B
balance sheet
assets, 142–47
Big Picture Breakdown, 141
equation, 137–38
liabilities, 147–49, 152
overview, 111–13, 136–37, 142, 152–53
purpose of, 137–38
risk indicators, 139
shareholders’ equity, 150–52
Bank of America, 47
basic EPS, 134
Bear Stearns, 13, 63
Bensinger, Greg, 103
Bezos, Jeff, 66–67, 74
Big Picture concept, 4–7, 10
Blockbuster, 89
board of directors, 68–69
Boeing, 7, 26–27, 47
bonds, 19, 53, 105, 149
book value, 143
Borders, 89
bottom line, 33, 41, 69–70, 123, 125, 132–33
British Petroleum, 20
Buckingham, Marcus, 82
Buffett, Warren, 30–31, 136
business acumen, vi–vii, 1–4, 7, 10, 165–72. See also key drivers; management

C
capital, 14. See also cash
cash. See also statement of cash flows
activities types, 19–22
cash position policy, 25–28
components of, 15–19
on financial statements, 113, 116, 143
generation of, 21–22
importance of, 13–15
overview, 12–13, 29
on urgency continuum, 98–99
uses of, 22–25
cash accounting, 33
cash balance. See cash position
cash equivalents, 16, 162–63. See also cash
cash flow, 15, 17–18, 32–33, 159
cash flow from operations, 16, 24, 99, 158–61
cash flow statement. See statement of cash flows
cash generation, 21–22
cash position, 15, 16–17, 25–28, 52, 112, 141
Chase, 136
Chevron, 75
Chrysler, 89
Circuit City, 42–43, 44
Cisco, 143
Citibank, 14
Coca-Cola, 35, 36
Coffman, Curt, 82
common stock, 133–34, 150
competitor analysis, 116, 126
consolidated financial statements, 111
cost, 34, 42–48, 126, 130
cost of goods sold (COGS), 33, 38, 43–44, 45–46, 128
Covey, Stephen R., v–vii, 84, 103
credit ratings, 13, 53, 106, 147
current assets, 142–44
current liabilities, 147–49
current ratio, 148–49
cycle time, 57

D
Daimler AG, 89
debt ratio, 149
debt-to-equity ratio, 52–53, 151
Dell, 21
Delta Airlines, 49
Deming, W. Edwards, 88
depreciation, 130, 142, 159
diluted EPS, 134
direct costs, 43
Disney, 72
dividends, 20, 24, 27–28, 112, 143, 150–52, 162
Dow Chemical, 51
Drucker, Peter, 17

E
earnings, 126, 150–51. See also profit
earnings before interest and taxes (EBIT), 131
earnings per share (EPS), 70, 75, 106, 111, 127, 133–34
Einstein, Albert, 89
equity, 52–53, 137–39
equity ratio, 141, 151
expenses
on income statement, 123, 130–31
profits and, 31, 32
reducing, 21, 36–37, 134
types, 42–48
external environment, 102–6, 167–68
ExxonMobil, 36, 47

F
Fannie Mae, 13
Federal Express (FedEx), 14–15, 63
Federal Reserve, 105
Fiat, 89
Financial Accounting Standards Board (FASB), 114
financial statements analysis criteria, 115–16, 126
basics of, 114–17
interrelationship of, 7–9, 111–13
overview, 110–11, 120
financing activities, 20, 112, 157, 161–62
fiscal period or year, 123, 142, 155
fixed assets, 19, 145
Ford, Henry, 40, 55, 88
Ford Motor Co., 28, 40, 55, 89
Form 10-K, 111, 117–19
Freddie Mac, 13
Fudge Family Farms, 154–55

G
Gallup Organization, 82
Gates, Dominic, 26–27
Geneen, Harold S., 168
general and administrative costs (G&A), 34, 130
General Electric (GE), 47, 62, 84, 103
Generally Accepted Accounting
Principles (GAAP), 114
General Mills, 44
General Motors, 13, 28, 89
Gerstner, Lou, 98
Gillette, 145
goodwill, 145–46
Google, 25, 68, 72, 81–82, 83, 97, 143
gross margin, 34, 128–29
gross profit, 33–36, 38, 128–29
gross profit margin, 34, 128–29
gross revenue, 127
growth. See also income statement
business life cycle and, 74–76
on financial statements, 113, 116
importance of, 67–69
measuring, 69–70
organic/inorganic, 70–73
overview, 66–67, 77
on urgency continuum, 99
growth companies, 68

H
Hesse, Dan, 103
HP, 68
Hsieh, Tony, 82

I
IBM, 98
income, 126. See also profit
income-producing assets, 62
income statement
Big Picture Breakdown, 125
cost of goods sold, 128
earnings per share, 127, 133–34
equation, 123–25
gross profit and gross margin, 128–29
net income or net earnings, 132–33
operating expenses, 129–31
operating income, 131–32
other expenses and income, 132
overview, 111–13, 121–22, 126–27, 134–35
purpose of, 123–25
revenue, 127
indirect costs, 126
industry analysis, 116, 126
inorganic growth, 70–73
intangible assets, 50, 145
interest expense, 46, 132, 151–52
internal customers, 84–86
International Financial Reporting Standards (IFRS), 114
inventory, 57, 142, 144
inventory turnover, 19, 57–58
investing activities, 19–20, 112, 157, 161
ITT, 168

J
J.D. Power and Associates, 87
Jobs, Steve, 76, 103
JPMorgan Chase, 63, 136
Jubak, Jim, 17

K
key drivers, vi, 7–9. See also assets; cash; growth; people; profit
key drivers interrelationship
external environment effects, 102–6
on financial statements, 113, 116
organizational function and, 96–97
overview, 94–96, 107
in public companies, 100–102
on urgency continuum, 97–100
Kingsford, 55
Kline, David, 51

L
LaLa, 99
leasing activities, 42, 59, 61–62, 149
Lehman Brothers, 13, 136
liabilities, 53, 137–38, 147–49, 152
life cycle, 74–76
liquidity, 13, 15, 18–19, 51–55, 137–39.
See also cash
long-term debt or liabilities, 147, 149, 162

M
management. See also business acumen
Big Picture concept, 4–7, 10
cash position views, 25–26
drivers by organizational function, 96–97
employee retention and, 82–85
external environment effects, 102–6
growth objectives of, 68–69
letter to shareholders, 118–19
of public companies, 100–102
trust in, v–vii
urgency continuum, 97–100
Management Discussion and Analysis (MD&A), 117
margin, 34, 133
market share, 67
Marriott International, 84
McCarthy, Patrick, 79
McDonald’s, 57, 91
Microsoft, 14, 25, 27–28, 35, 36, 72, 88, 103
Moody’s, 53
Motorola Mobility, 97
Mulally, Alan, 28

N
NASDAQ, 30
NBCUniversal, 62
net assets, 137
net earnings. See net income; profit
net income, 31, 33, 69, 111–12, 123, 125, 127, 132–33, 158–59, 160.
See also profit
net margin, 34, 133
net profit, 33–36, 41, 123
net profit margin, 34–36, 125, 133
net sales, 115
Nextel, 72
Nokia, 103–4
nonoperating expenses, 132
Nordstrom, 78–79

O
obligations. See liabilities
operating activities, 19, 24, 112, 157, 158–61
operating expenses, 34, 44–46, 129–31
operating income, 131–32
operating margin, 131–32
options, 106, 134
organic growth, 70–73
overhead, 34, 44–45, 130
owner’s equity, 112, 137, 150–52

P
Palm Inc., 68
Payless, 57
people
customers, 87–93, 103–4, 112, 113
employees, 81–86, 113
overview, 78–81, 93
on urgency continuum, 99
Peters, Tom, 87
P&G, 145
Pixar, 72
private companies, 111, 116–17, 150
producing assets, 62
productivity, 55–59
profit. See also income statement
cash flow vs., 32–33, 159
cost reduction and, 42–48
on financial statements, 113, 116
increasing, 36–38
measuring, 33–36
overview, 30–31, 48
revenue growth and, 36, 38–42, 47–48
on urgency continuum, 99
property, plant and equipment, 145
public companies, 31, 68–69, 100–102, 134, 150, 162, 167

R
rate of return. See return on investment
ratios, 52–53, 116, 126, 131–32, 141, 148–49, 151
receivables, 159
retained earnings, 150–51
return on assets (ROA), 58, 141, 146–47
return on investment (ROI), 60–62, 170
revenue, 125, 127, 129
revenue growth, 36, 38–42, 47–48
RIM, 103–4
risk, 138–39
Ritz-Carlton, 84, 87–88, 89
Rivette, Kevin, 51
Rogers, Craig, 154

S
sales, 125, 126, 127
sales revenue, 38–42
sales volume, 39–40
Samsung, 68
Schultz, Howard, 121–22
Sears Holding, 75–76
Securities and Exchange Commission (SEC), 100, 111, 114, 118, 119
Sellers, Patricia, 122
shareholders, 68–69, 100, 112, 137
shareholders’ equity, 112, 137, 150–52
Skype, 72
Smith, Fred, 14–15
Southwest Airlines, 49–50
S&P 500, 35, 75, 132, 133, 141
Spector, Robert, 79
Sprint, 72
Standard & Poor’s (S&P), 53
Starbucks, 91, 121–22
statement of cash flows
Big Picture Breakdown, 157
cash and cash equivalents, 162–63
equation, 156
financing activities, 20, 112, 157, 161–62
investing activities, 19–20, 112, 157, 161
operating activities, 19, 112, 157, 158–61
overview, 111–13, 154–55, 158, 163–64
purpose of, 155
stock
EPS, 70, 75, 106, 111, 127, 133–34
price, 31, 68–69, 97, 100, 105–6, 133, 134
selling or repurchasing, 20, 24, 27, 106, 112, 162
stockholders, 68–69, 100, 112, 137
stockholders’ equity, 112, 137, 150–52
stock options, 106, 134
T
Target, 143, 149
taxes, 46–47, 130–31, 132, 148, 151–52
top line, 69–70, 123–25, 127
total assets, 145–47
total liabilities, 149, 152
total revenue, 125, 127, 129
total sales. See total revenue
Toyota, 7, 89, 94–95, 97
Toys “R” Us, 75
trends, 115, 126
trust, v–vii

U
United Airlines, 49
UPS, 63
urgency continuum, 95, 97–100
U.S. government, 53

V
variable costs, 43

W
Walmart, 7, 14, 19, 36, 45, 53, 61–62, 75–76, 87, 103, 133, 149
Walton, Sam, 87
Washington Mutual, 63, 136
Wilde, Oscar, vi

Z
Zappos, 82