How Finance Works: The HBR Guide to Thinking Smart About the Numbers

by Mihir Desai

if you want to progress in your career, you’ll need to engage deeply in finance—it is the language of business, the lifeblood of the economy, and increasingly a dominant force in capitalism. So neglecting finance and hoping to survive meetings by thoughtfully nodding your head is an increasingly untenable choice.

Income statements show how a company realizes net profit after taking into account all its revenues and costs, much as you might consider your salary as revenue and your costs (e.g., food, housing, and so on) before you can figure out what you might be able to save.

The beginning of much financial analysis consists of looking at a series of numbers and thinking they are interesting. The best first step when looking at a sea of numbers is to look for extreme numbers and then create a story about these numbers.

Coca-Cola has a very valuable brand, maybe the most valuable thing it owns, but it really doesn’t know exactly how valuable its brand is. So accountants ignore it. That’s the accounting principle of conservatism. The idea that we should ignore something just because we don’t know its precise value is also something that makes many people in finance distrust accounting.

Preferred stock is often called a hybrid instrument because it combines elements of both debt and equity claims.

Broadly speaking, the ratios in table 1-7 deal with four questions. First, how is the company doing in terms of generating profits? Second, how efficient or productive is the company? Third, how does it finance itself? The final question revolves around liquidity, which refers to the ability of a company to generate cash quickly.

Most companies go bankrupt because they run out of cash. Liquidity ratios measure this risk by emphasizing the company’s ability to meet short-term obligations with assets that can quickly be converted into cash.

EBIT is just a fancy finance term for something you already know as operating profit.

increases in productivity mean you can squeeze more from less. More narrowly, productivity ratios measure how well a company utilizes its assets to produce output. Over the long run, increases in productivity are the most important contributor to economic growth.

financial analysis is about much more than just the numbers, which are simply tools to help us understand what drives performance across time, across companies, and across industries. Each number is helpful, but no one number tells the whole story.

Cash can mean many things, so we’ll explore three alternative definitions of cash—earnings before interest, taxes, depreciation, and amortization (EBITDA); operating cash flow; and free cash flow.

The conservatism principle implies that companies should record lower estimated values of their assets and, by extension, higher estimates of their liabilities—in short, they err on the side of being conservative.

remember this sentence: revenue is vanity, result is sanity, and cash is king. Emphasizing only the growth of revenues can be ridiculous and dangerous. Measuring only on the growth of profit would also be dangerous. Cash is the most important. Your capacity to transform your business into cash that you can use to finance your activities, repay your debt, or distribute to your shareholders is the key.

short sellers are incentivized to look for flaws, weaknesses, and discrepancies, they see things that others don’t see. Given that, one could make the argument that short sellers are a force for positive social good, as opposed to something evil.

Finance, at its heart, is trying to solve the deepest problem in modern capitalism—the principal-agent problem, or the separation of ownership and control.

Capital allocation is the most important financial problem facing a CFO and CEO.

The idea of profitability is incomplete and problematic because it detracts from the idea of cash. Economic returns are better measured by cash; there are many ways to measure cash—EBITDA, operating cash flow, and, most usefully, free cash flow.

Valuation is an art, not a science; it is an art informed by science, but the most critical elements of it are subjective, and the process is prone to error. Be mindful of the hidden biases inherent in the process, especially the allure of synergies and the incentives of advisers.