Finance: What Managers Need to Know

Summary

In this interview, Joe Knight, co-owner of the Business Literacy Institute and author of the 'Financial Intelligence' book series, discusses his practical approach to teaching finance, emphasizing the importance of understanding financial statements without delving into complex accounting principles. Knight highlights the distinction between finance and accounting, stressing the need for transparency and the role of financial literacy at all levels of an organization. He also addresses the difference between profits and cash flow, the significance of key performance metrics, and the increasing demand for financial transparency in businesses.

Takeaways

• 📚 Joe Knight emphasizes a practical approach to teaching finance, focusing on what's important for non-financial professionals to understand.
• 🏆 His book 'Financial Intelligence' was listed as one of the best 100 by 800 CEO read, indicating its practical value for business leaders.
• 🤝 Joe's discussion with Bob Kaplan highlights the difference between academic teaching of finance and practical, on-the-job financial literacy.
• 👩‍🏫 Finance education should be accessible and relevant, not requiring an in-depth knowledge of complex accounting principles like double-entry bookkeeping.
• 🎨 The 'art' of finance refers to the estimates and assumptions made in financial reporting, which can vary based on the preparer's judgment.
• 📊 Finance is about analyzing numbers for decision-making, while accounting is recording transactions to create historical financial information.
• 🔑 Transparency in financial reporting is increasingly valued, especially in light of corporate scandals like Enron, for building trust with investors.
• 💡 Sharing financial information with employees can lead to 'psychic ownership', where they feel a personal stake in the business's success.
• 💼 Employees don't need to become accountants or financial analysts; they need to know key metrics that drive their business's success.
• 💵 Cash flow is now more critical than ever, especially in a tightened credit market, and it's distinct from profit as it involves the timing of cash收款.
• 🔍 Questioning financial numbers is encouraged to ensure accuracy and prevent fraud, as those familiar with finance are more likely to detect discrepancies.

Q & A

What is Joe Knight’s approach to teaching finance, and how does it differ from a typical academic approach?

Joe Knight's approach focuses on practical, real-world application of finance principles. Instead of delving into technical details like the double-entry accounting system, he teaches essential financial concepts that employees on the shop floor need to know to drive business success, such as gross profit per hour. This contrasts with the academic approach, which is more detailed and theoretical, often including concepts like credits and debits.

Why does Joe Knight believe it’s unnecessary to teach credits and debits to non-accountants?

Joe believes non-accountants, especially those working directly in the operations of a business, don't need to know the intricacies of credits and debits. Instead, they need to understand key metrics that affect their work and the business's success, like gross profit per hour, which can impact their bonuses and the overall success of the company.

What does Joe Knight mean by 'psychic ownership,' and why is it important in business?

'Psychic ownership' refers to employees feeling a sense of ownership in the business when they understand its financial health and key numbers. When employees see how their actions affect the company’s success, they are more likely to behave as if they are owners and contribute to the business’s profitability and performance.

How does Joe differentiate between finance and accounting?

According to Joe, accounting is about recording historical financial transactions and maintaining the integrity of financial records, while finance is about analyzing those numbers to make informed decisions about managing a business. Accounting provides the data, and finance uses it to make strategic choices.

Why does Joe think understanding finance is important for all employees, not just finance professionals?

Joe believes finance is a universal language in business. He likens it to playing a game without knowing the score. Understanding finance allows employees from all departments to see how their work contributes to the company's success, making them more effective and aligned with the company’s goals.

What role does transparency play in finance, according to Joe Knight?

Transparency in finance means making financial information clear and accessible, so stakeholders, including investors and employees, can understand the true state of the business. Joe highlights the increasing importance of transparency, especially in the wake of corporate scandals like Enron, where a lack of transparency led to fraudulent practices.

What are some key financial metrics that Joe suggests are important for most businesses?

Joe mentions two key metrics that are important for project-based businesses like his: the percentage of labor directly applied to projects and the dollars generated per direct labor hour. These metrics help determine the profitability and efficiency of the business.

Why is cash flow becoming more important than profit in recent years, according to Joe Knight?

Joe explains that in the current economic environment, having strong cash flow is crucial for business survival because credit markets have tightened. While profit measures long-term performance, cash flow is a more immediate measure of a company's ability to pay its bills and invest in its operations.

How can understanding finance help prevent fraud in an organization?

Joe points out that fraud is often discovered by employees who understand finance and notice irregularities in the numbers. When more people in the organization are financially literate and involved in reviewing the numbers, it becomes harder for fraud to go unnoticed.

What are some reasons why cash and profit do not always align in a business?

Joe highlights three reasons: (1) Sales are recorded when a product is shipped or a service is completed, not when payment is received. (2) Businesses use cash to purchase large assets but depreciate them over time, creating a mismatch between cash outflow and profit recognition. (3) Expenses are recorded when services are incurred, not when payments are made, further disconnecting cash flow from profit.

Outlines

00:00

🧑‍🏫 Introduction to Joe Knight’s Practical Finance Approach

The conversation starts with an introduction to Joe Knight, co-author of the Financial Intelligence book series and a financial educator. Joe discusses his unique approach to teaching finance, which contrasts with traditional academic methods. He focuses on practical, real-world applications for non-financial professionals, like shop floor workers, rather than emphasizing detailed accounting concepts like credits and debits. Joe recounts a story involving Bob Kaplan, a renowned academic, highlighting the difference between teaching finance in an academic setting versus a practical business environment. His goal is to help employees understand key financial metrics relevant to their roles, such as gross profit per hour, and to simplify financial literacy to drive business success.

05:01

🏢 Empowering Employees Through Financial Transparency

Joe Knight explains the concept of 'psychic ownership,' where employees who understand the financial health of their company feel a sense of ownership and responsibility. By sharing key financial data with employees, businesses can foster a culture where everyone feels accountable for the company's performance. Joe argues that even though specialization is essential in modern economies, understanding basic financial metrics is crucial for all employees, regardless of their department. This awareness allows them to make informed decisions that positively impact the business. He emphasizes the importance of identifying one or two key performance indicators (KPIs) that drive success and linking these metrics to employee rewards, such as bonuses, to motivate and align everyone with the company's goals.

10:01

💸 Understanding Cash Flow vs. Profit and the Importance of Financial Transparency

Joe delves into the differences between cash flow and profit, emphasizing that while profit is recognized at the point of sale, cash flow reflects the actual movement of money, which may lag due to delayed payments or investments in capital assets. He outlines three reasons why profit and cash flow can differ: the timing of sales versus payments, capital expenditures like buying equipment, and the timing of expense recognition. Joe highlights the growing emphasis on transparency in business, especially post-2009, where companies are expected to be open about their financial situations. He discusses how transparency can help detect fraud and increase trust among stakeholders. Joe points out that financial transparency has become a critical focus in the business world, helping to prevent scenarios like the Enron scandal, where a lack of openness led to massive corporate fraud.

Keywords

💡Financial Intelligence

Financial Intelligence refers to understanding and analyzing financial data to make informed business decisions. In the video, Joe Knight emphasizes its importance for managers and employees, regardless of their background. It's about knowing key financial metrics that drive business success without getting bogged down in complex accounting concepts like debits and credits.

💡Double-entry Accounting

Double-entry accounting is a method where every financial transaction affects at least two accounts. Joe contrasts his teaching method with traditional approaches that emphasize this system. He argues that while it’s important for accountants, employees in other roles don't necessarily need to learn it to understand their company's financial health.

💡Gross Profit per Hour

Gross profit per hour is a key metric Joe discusses as crucial for project-based businesses. It reflects how much profit is generated per hour of direct labor, helping businesses measure efficiency. Joe highlights its importance in helping employees understand how their work contributes to the company’s success and their potential bonuses.

💡Estimates and Assumptions

In finance, estimates and assumptions refer to the judgment calls accountants make when recording transactions or creating financial statements. Joe explains that these factors add an element of 'art' to accounting, as they can vary based on the person preparing the financial reports. This 'art' introduces variability, which businesses need to monitor.

💡Psychic Ownership

Psychic ownership is the feeling employees have when they are fully aware of and engaged with the financial performance of their company. Joe Knight introduces this concept, explaining that when employees understand the financials, they act like owners, which motivates them to improve performance even if they don’t have a formal ownership stake.

💡Key Metrics

Key metrics are the critical numbers that a business monitors to assess its performance. Joe advises companies to focus on one or two of these metrics, such as gross profit per hour, to help employees understand how their work affects the company's financial outcomes. Identifying the right metrics simplifies financial training and decision-making.

💡Transparency

Transparency in business refers to the openness and clarity with which financial information is shared. Joe Knight mentions that in today’s corporate environment, transparency has become a critical issue. Companies are expected to openly share accurate financial data with stakeholders, contrasting with the opaque practices that led to scandals like Enron.

💡Cash Flow

Cash flow is the movement of money in and out of a business. Joe stresses its importance, especially in difficult economic environments where access to credit is limited. He explains that cash flow is different from profit because companies might be profitable on paper but still face liquidity issues due to delayed payments or large expenses.

💡Fraud Detection

Fraud detection involves identifying discrepancies in financial data that may indicate fraudulent activities. Joe emphasizes that when more employees understand and engage with a company’s financial data, it becomes harder for fraud to occur. This engagement helps identify unusual transactions early, preventing larger financial crimes.

💡Profit vs Cash Flow

Profit vs Cash Flow highlights the difference between accounting profits and the actual cash available to a business. Joe explains that while profit is recorded when a sale is made, the cash might not be received for months. This distinction is crucial because a business can be profitable but still run out of cash, leading to financial difficulties.

Highlights

Joe Knight's approach to teaching finance focuses on practical applications, helping non-financial professionals understand key metrics without delving into the complexities of the double-entry accounting system.

Knight emphasizes teaching employees on the shop floor about the importance of gross profit per hour and how it impacts business success and their bonuses.

Knight's book 'Financial Intelligence' was recognized as one of the top 100 by 800-CEO-Read, highlighting its unique approach to simplifying finance for non-specialists.

Bob Kaplan, author of 'The Balanced Scorecard,' questioned how finance could be taught without covering credits and debits, leading to a debate on academic vs. practical finance teaching.

Knight's experience in teaching finance stems from explaining the importance of specific metrics to employees who do not necessarily need to know the intricacies of accounting.

The concept of 'psychic ownership' arises when employees understand the company’s financials, leading them to take initiative and act like business owners, despite not having actual ownership.

Knight argues that finance should not be seen solely as a specialized area, as understanding key numbers is crucial for everyone in a business, regardless of their department.

Finance involves analyzing historical accounting information to make business decisions, while accounting focuses on recording and reporting past transactions.

In Knight’s business, two key metrics drive success: the percentage of labor applied to projects and gross profit per hour for direct labor.

Knight highlights the importance of transparency in finance, especially after events like the Enron scandal, where lack of transparency led to significant fraud.

Understanding cash flow is more important than ever, especially for small businesses, where generating cash flow is key to surviving tight credit markets.

Knight explains the distinction between cash and profit, noting that profit can be recognized without immediate cash inflow due to delayed payments or depreciation.

He stresses the need for general managers to ask financial analysts questions and challenge the numbers, especially in light of the estimates and assumptions that go into financial reports.

Transparency has become a critical focus in American business, with many companies now requesting training on the topic to ensure stakeholders have a clear view of financial performance.

Knight's insights reveal that finance, while often considered a rigid science, actually involves a lot of estimates and assumptions, making it somewhat 'artistic' in nature.

Knight advocates for businesses to share their financials widely within the organization to foster a sense of ownership and drive better performance from employees.

Transcripts

hi I'm Sarah green from Harbor business

org I'm joined today by Joe knight

co-owner of the business literacy

Institute and author with Karen Berman

of the financial intelligence book

series he's also the author of a blog on

Harvard Business or called financial

intelligence Joe thanks so much for

joining us today thanks for having me

Joe how is your approach to teaching

finance different than the typical

academic approach you know one of the

things I had to learn when I taught

finance is that I had about 40 minutes

and I had a bunch of people that were

technical that weren't that interested

and I had to figure a way to get at

what's important and teach them why they

need to know the numbers and how they

affect them recently our book was listed

as one of the best 100 by 800 CEO read

and as part of that I was involved in a

session where several authors got

together and on a panel and presented

their books and I happen to be sitting

seated next to Bob Kaplan who was picked

as one of the best 100 with his with his

a well known book the balanced scorecard

and at the end of the session after we

presented to the Harvard alumni in this

session the moderator mentioned why he

liked each of the books and when he got

to my book he said you know the reason

why I like Joe's book financial

intelligence is because he taught us how

to read the statements without bringing

up credit or debit once and everybody

laughed and the session was over and as

people were coming out of the audience

Bob Kaplan was sitting next to me leaned

over and said Joe how can you teach

finance without going over the

double-entry accounting system and

credits and debits and and we started

debating about it and after that

experience I kind of reflected on that

and I realized that Bob Kaplan's

teaching academic people people at the

Harvard Business School getting an MBA

and he has a full semester and he has

these people for two hour blocks and he

should be teaching a lot of detail and

the double-entry accounting system

I learned to teach finance by telling

the people on the shop floor that are

making machines in our company what they

need to know to drive success in the

business and they don't need to know

credits or debits they need to know why

girls profit per hour is so critical and

they need to know when their gross

profit per hour is high enough

how much profit we'll make because that

will affect their bonus and affect the

success of the business and so I come at

it from for more of a practical position

where these people just need to know

what they need to know some of these

people don't want to be accountants they

don't want to be full-time financial

analysts but they do need to know what

score's need to be said certain levels

to be successful and that's all that I'm

trying to do is help them understand

what scores are important and why they

need to know them and that doesn't

require a lesson on the double-entry

accounting system and credits of debits

no matter how exciting that may appear

to be Joe you talk a lot about the art

of Finance but what's so artistic about

a P&L and do we really want finance to

be artistic isn't that what got the

Enron guys in trouble well actually we

don't want our our finance to be

artistic the challenge is is accountants

have to take transactions that happen in

many different ways and fit them into a

month a quarter of a year so there's a

lot of estimates and assumptions that go

into creating a statement and some of

that becomes very artistic if you will

we think of accounting as a science but

in reality there's a lot of estimates

and assumptions and a lot of the

statements can come from the personality

or the opinion of the person creating

the numbers consequently when management

goes to look at those numbers they find

out that they might not be exactly what

they thought they were because it's

based on estimates and assumptions in

art what's the difference between

finance and accounting because you use

both those terms there we do and and I

think you should understand that

everyone needs to understand that

finance is actually analyzing and

looking at numbers and making decisions

about how to run a business how to get

the numbers how to manage cash flow and

understand those kinds of things

accounting on the other hand their task

is to take transactions and figure out

how to create historical information

about what's happening with the business

finance people take that historical

information and use it to make business

decisions if you don't have good

accounting that you can rely on and buy

good accounting I mean accounting that

is consistent considerably applied and

accurate then you're not going to have

good financial analysis so the basis of

any good system is a good solid

historical accounting system and a lot

of that relies on the integrity and the

competency of the accountants putting in

the numbers

and to think of finance as a specialized

area finance and accounting both and I

think most general managers want to

leave the numbers to the numbers guys or

women is that is that a problem I think

it is a big problem I come from a world

where we shared our numbers I own a

small business called set point Systems

Incorporated and we do manufacturing

automation we built a few rollercoasters

in fact and in that business we learned

that when we shared the numbers with the

employees and show them how the business

would perform was performing they turned

around and did tremendous things for our

business in fact I coined kind of a

little phrase I call it psychic

ownership when the employees understand

the numbers and they can see what's

going on the business financially they

feel like it's their business and they

feel like when the numbers aren't right

they're going to figure out a way to

turn them around and make things better

and even though they're not owners they

still act like owners and they behave

like owners in the way they perform and

I think getting the numbers out to the

people in an operational way and finding

those one or two key numbers that drive

success in your business and bringing

them to everyone is very powerful in a

business it should go way beyond just

the accounting and Finance people but in

some sense our whole economy is built on

specialization right otherwise we would

still be hunting and gathering so how do

you find that balance well I think it's

the business is like a game and if you

don't understand the finances you're

basically playing a game where you don't

know score and so I believe that no

matter what your background is you know

whether you're an engineer or if you're

in sales and marketing or you're in

operations or if you're almost on the

floor putting a product together if you

don't know how score is kept you're

going to get in trouble and so I think

that finance is one of those things that

you need to be universally understood in

any business and when I say any business

I say that very broadly we use the term

not for profit but guess what not for

profit businesses also have to make a

profit in other words even

not-for-profits have to generate more

income than what goes out or they won't

survive I like to use the term not for

tax because that's really what

not-for-profit means but every

organization has to generate more in

flow than outflow and that's a simple

thing that everyone has to understand in

a business so what

least that a general manager or employee

in a business needs know about finance

well I think at the very minimum any

employee should understand one or two

key metrics or numbers that will drive

success in the business and one of the

things we find is that it's easy to

teach these metrics if there's one or

two one of the problems that finance

people have is they want to share all

the numbers and we could get into 20 or

30 metrics and it confuses people but if

you find one or two maybe three key

numbers that define success in your

business and then you link that to key

key drivers that bring that bring

rewards to the employees through bonus

and you train them on those numbers

it becomes very powerful as long as you

don't go too far with it so every

business is different industries are

different but if you can find those few

key metrics and really drive them

through your organization it's going to

make a big difference what's an example

maybe of some metrics that you think are

probably universally applicable across

most businesses well you know I would

say that there there are very few that

are totally Universal because every

business is different but I can tell you

about setpoints key numbers a couple of

numbers we focus on because we're a

manufacturing business that works on big

projects is the percentage of our labor

that's directly applied to projects

number one and number two the dollars we

generate for every direct hour we spend

now that in our business that drives

success and in those two numbers gross

profit per hour and percentage of labor

direct is a great metric for a

project-based business any project-based

business if those two numbers are in the

right range you're going to be

profitable and our people know that so

in their businesses how do you how do

general managers and employees know what

the right questions aren't to ask of

their financial people well first of all

I think there are no bad questions and I

think because finance does have that

estimate or that art to it that we

talked about earlier it's a

responsibility the management group to

ask questions of the numbers and to

understand where the finance person got

the numbers when they put them together

one of the things that people might not

realize is as a financial analyst there

is an accountant early in my career for

example when I was at Ford Motor Company

if the numbers didn't balance and it was

7:00 at night and I was really tired I'd

worked on it for another few hours and

then it was 10 then 11 at about midnight

I

the numbers balance and I just go home

now the next morning when we had our

meeting I wouldn't raise my hand and say

guess what I just made up that number

last night so you need to understand

that we're making estimates when we

prepare those statements and it's okay

to ask questions and to challenge the

numbers and to question things because

if not you're making decisions business

decisions based on the analyst numbers

that were maybe plugged or maybe

estimate estimated or even in some cases

fraudulent and so it's really important

that everyone get involved in the

numbers and understand the numbers

another thing that's important about

understand the numbers is if everyone

looks at the numbers and watches them on

a weekly basis it becomes very difficult

for fraud to creep into a business

because everyone's seeing that and

involved in the numbers and so that's

another reason why finance should be

viewed by many people one of the things

we learned is in fraud cases virtually

every one of them were discovered by

someone in the organization who

understood finance and noticed something

was wrong so it makes sense that if more

people understood the numbers there

would be more people that were on top of

the numbers and could understand and

find cases of fraud let's talk a little

bit about cash and profits because we've

been hearing a lot about those in 2009

maybe because no one seems to have very

much of either of them what's the

difference there and and just talk to me

a little bit about those elusive goals

okay

well first of all the shift has been to

cash flow in this environment everyone

knows that if you have cash you're going

to survive the credit markets have left

have tightened up now I'm in a small

business and especially for small

businesses it's very difficult to raise

money right now so there's a big premium

on generating cash flow the problem is a

lot of people don't understand this

profit and cash flow are two different

things

there's three primary reasons why that's

the case first profit is recognized when

you make a sale unfortunately we count

sales when we ship a product or when

we've done the work or completed the

project not when we collected the money

so consequently we might have invoiced

millions of dollars but we might not see

that money for 60 days and in a tough

economy it could be as long as 90 days

and so you could have a lot of sales

which generate profit and wait 90 days

60 days to to receive the cash a second

reason why cash and profit don't match

because sometimes in business we take a

lot of our cash and use it to buy big

pieces of equipment a truck a building

and those trucks and buildings eat up

all our cash but we depreciate the cost

of those over several years and so our

cash is gone but we appear profitable

because of depreciation so that's

another reason and then third we don't

incur expenses on the income statement

when we actually pay the expense we

incur the expense when we receive the

service an example of that would be

payroll when we when we pay our

employees on June 1st we're actually

paying them for work they did in May so

we're going to charge the income

statement in May for payroll we paid in

June so again cash went out in June the

expense was charged in May so all of

these moving parts are happening we

could have profit at the bottom here and

cash could be here or here or anywhere

and so it's very hard to track the two

side-by-side consequently the cash flow

statement has become more and more

important over the last few years let's

talk about another emerging trend at

Transparency that's a word that we maybe

didn't hear very much 10 years ago now

it's everywhere whether you're talking

about ethics or sustainability or

finance how have you seen that playing

out you know it's interesting I trained

a lot of big corporations in over the

last few years I have not or like if I

go back three or four years ago I never

heard the word transparency now several

of my clients ask if we'll teach a

module on transparency and the issue is

is is we believe now that a company

that's publicly traded should be

transparent financially so the thinking

is is an outsider an investor can go

online to Edgar gov or to a typical

government site go through the SEC look

up the numbers on that company and get

some indication of what's really

happening in the business a company like

Enron was the opposite of transparency

Enron spent tremendous amounts of effort

and time trying to figure out ways to

keep the real numbers from getting

public and so the opposite would be

let's let the news go out as it is let's

share the numbers as they are really

happening let's be transparent to our

investors to our out to the outside

stakeholders in the business and and in

the case with fraud and with

he's going bankrupt and all these

problems we've seen in the banking

system

transparency is becoming a very very

important topic and one that is a big

focus in American business today Joe

thanks so much for joining us today

you're very welcome that's Joe Knight

co-author of financial intelligence the

book series and the blog on Harvard

Business org