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• Published by Smarter Comics
• Based on the bestselling book Financial Intelligence: A Manager’s Guide to Knowing What the Numbers Really Mean
• Available June 4, 2012
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Here's how you compute net present value:

1. Determine the initial investment involved in the capital project.
2. Project the future benefits of the project in cash flows.
3. Determine the minimum interest return the investment should generate.
4. Discount the future projected cash flow using the minimum rate of return and compare it to the initial investment.
5. If the present value of the future benefits exceed the initial investment, then the project should be funded.
6. If the present value of the future cash flow is lower than the initial investment then the project should be scrapped.

Taking on projects with negative NPV will put a small company out of business. With limited capital one needs to make sure that the cash generated by the business is invested in a way that will improve returns.

Government stimulus money can improve our economy if the money is allocated to projects that generate positive NPV. Capital expended for political purposes rarely, if ever, takes NPV into account.

Several years ago Joe taught a corporate finance MBA class as an adjunct professor at Westminster College, a small liberal arts college in Salt Lake City. In this capacity he was asked to observe and mentor a new professor of finance. This professor happened to be a senior finance executive for the state of Utah.

The topic for the class was capital budgeting tools, including net present value. As an example, the state of Utah finance executive used a major conference center project that was planed for a small community in southern Utah. As he presented the numbers and explained the NPV concept, it was clear he did not really know how to calculate net present value. After struggling for a bit he asked Joe to step in and teach the concept. After Joe completed the analysis with the class, they found that the project had a negative NPV. In other words, the cost of the project was not justified by its benefits.

Given the results, Joe noted that the state of Utah should not undertake the project. The state executive replied, "Yeah, I know this project had a negative NPV because we had some outside consultants calculate it for us. But we started the project anyway because everyone at the state wanted it and it was approved by the Governor's office." At that point Joe said if he ran his business that way, it would be out of business in short order. Everyone in the class laughed except the state executive.

NPV is an important tool for the private sector. Government employees and lawmakers should also use NPV to determine whether public projects and stimulus packages are justifiable.

Today EBITDA remains a valuable, if controversial, number for evaluating a company's earnings. After all, the WorldCom meltdown was facilitated by financial fraud related to EBITDA.

Before we examine why EBITDA is favored by some and scorned by others, we need to consider EBIT (Earnings Before Interest and Taxes). As you might know, EBIT is synonymous with Operating Income, and is the profit or loss that is generated by operations of a business before interest expenses and taxes. In essence, it's the number that tells you how much profit or loss your operation is generating.

EBITDA is a form of EBIT. Actually, Joe likes to say it's an obvious form of EBIT — EBIT "DUH" (sorry...it's hard to make jokes about EBITDA). It stands for Earnings Before Interest, Taxes, Depreciation, and Amortization.

Depreciation and amortization are unique expenses. First, they are non-cash expenses — they are expenses related to assets that have already been purchased, so no cash is changing hands. Second, they are expenses that are subject to judgment or estimates — the charges are based on how long the underlying assets are projected to last, and are adjusted based on experience, projections, or, as some would argue, fraud.

EBITDA is a number often used in the financial industry as a loan covenant. Borrowing limits for businesses often are set as percentages of EBITDA. One of the most common methods to value small businesses being acquired is by using multiples of EBITDA. For example if you own a business that generated $1 million dollars of EBITDA last year and companies in your industry typically sell for 7 times EBITDA, then the sale price of your business will probably be in the $7 million dollar range.

Bankers like EBITDA because it will eventually represent operating cash flow (since the non-cash expenses are added back in). That helps to explains why bankers like the ratio in loan covenants. If EBITDA is good, the thinking is, operating cash flow will not be far behind.

EBITDA can also be misused. In the mid-nineties when Waste Management was struggling with earnings, they changed their depreciation schedule on their thousands of garbage trucks from 5 years to 8 years. This made profit jump in the current period because less depreciation was charged in the current period. Another example is the airline industry, where depreciation schedules were extended on the 737 to make profits appear better. When WorldCom started trending toward negative EBITDA, they began to change regular period expenses to assets so they could depreciate them. This removed the expense and increased depreciation, which inflated their EBITDA. This kept the bankers happy and protected WorldCom's stock.

Because EBITDA can be manipulated like this, some analysts argue that a it doesn't truly reflect what is happening in companies. Most now realize that EBITDA must be compared to cash flow to insure that EBITDA does actually convert to cash as expected.

In our Financial Intelligence Test one of the questions people miss most often involves EBITDA (even senior finance people missed the EBITDA-based question). Many of us can define what the term EBITDA means, but we also should know why it's important and how it is should be used.

Does your company measure EBITDA? How helpful have you found it to be?

A Fortune 100 company we work with held a two-day class recently to teach various mid-level managers the foundational elements of finance. The class focused on how to read financial statements and then, using their own public GAAP 10K statements, how to read, analyze and understand the story that their numbers are telling.

Because the participants all came from one division of the company (and because the company is so big), we wanted to include data that has a "line of sight" to the participants, that is, data that relates to what they do — or at the very least, is about their unit. That data also is available publicly in the 10K.

We were told, however, that we were not to include any of that public data in the training manual, and furthermore not to share the information verbally with the participants. Crazy as it sounds, they did not want public data shared in the class.

Most leaders we work with enthusiastically agree with our approach to use their own data to ensure that their employees, managers and leaders have an opportunity to learn not only the basics of finance, but also how their particular company and the divisions measure success: their key numbers, their statements, their results. Yes, we can teach the basics of a generic income statement or balance sheet, but the learning really hits home when employees have an opportunity to apply the concepts to their own company. With their own information, they can understand how their decisions impact the income statement, see how cash is being used with the cash flow statement, know where to focus to meet the company's financial goals, and understand the meaning of the most recent financial results. (In a private company the difficulty is clear, and we work with those companies to find a solution that keeps information confidential but provides a learning opportunity.)

In the case of the Fortune 100 company above, we held the class without the division's data, using only the company-wide data and financials. The feedback we received was positive, but, not surprisingly, the comments indicated that we should have included information about the participants' division, as that would have made the program more relevant to how they can focus on the company's success.

To truly have an impact, employees, managers and leaders need to both understand financial data and have access to the real numbers that their performance affects.

How open is your company with its financial data? Do you think it should be more or less open?

Some HR departments have embraced that call to action. One large company we know identified business acumen as the second of four critical traits for its HR professionals. Other HR teams, however, have been less attuned to the problem — like our Fortune 500 client whose HR managers didn't know what the company's financial goals were and didn't even know who to ask to find out.

Where does the blame rest? Let's look at some of the factors.

Avoidance. We found that some HR folks would rather not learn about the numbers. They want to focus on the people issues in their company. But almost everything in HR intersects with numbers in some way: budgets, compensation, insurance benefits. If an HR manager doesn't understand the numbers around those issues, they probably aren't doing their job very well. Here, the blame is on the HR folks.

Perception. Is it really true that most human resource professionals can't speak the language of business? Or is that simply an outdated perception? We've found that the problem is not universal; we've worked with many HR folks who understand the financial statements and key metrics of their companies and are champions of furthering financial literacy in the organization. Here, the blame is on the business side, not them.

Assumptions. When clients tell us that they don't ask everyone in the organization to listen to their earnings call, because they won't understand it, then we know there are assumptions being made about how smart people are. Here, we put the blame on the C-Suite. It is part of their job to help change expectations and assumptions within the company.

Trust. Sharing financial data with employees means that you trust them to use the information appropriately. In recent years we've had several companies call us to train their employees, but say that they are reluctant to use their own financial statements as the teaching tool. How can you teach your employees about financial statements, and then tell them, sorry, you can't see ours? That sends the wrong message.

We know that HR professionals can become financially intelligent and, in the process, set a great example for the rest of their organization.

Do you work in HR or on the business side? How do you see this issue?

Last year we developed a simple financial literacy test, in part because executives almost always assume their managers and leaders know more about finance than they really do, and in part because it's a great tool to assess people's knowledge before we develop a custom training program for them.

To better understand the financial intelligence landscape, we recently commissioned a national study of managers at U.S. businesses with at least 150 employees. The average score on our test from the sample group was a paltry 38 percent.

We were not surprised by the test results. Frankly, finance and accounting professionals don't do a very good job of explaining the numbers. They are good at generating reports and information but too often wrongly assume that people know what the numbers really mean.

Recently, Joe was meeting with the COO of a multi-billion dollar public company. The COO said, "Joe, I read your book Financial Intelligence and I really enjoyed it. It was straightforward and really got at the basics. I think for my mid-level managers this material would be great to put into a course. On the other hand, for my direct reports this stuff is too basic."

Joe told this executive that he was assuming too much and that he was confident that even the COO's executive vice presidents needed to review the fundamentals. This COO asked us prepare a pilot course on basic financial concepts for his direct reports to see if it hit the mark.

The first topic of the morning was on the income statement. As Joe went over the statement and discussed how to use the information, the questions started coming. At one point during the EBITDA discussion one of the attendees asked what the number really meant and why it was so important.

Joe could see the COO about fall out of his chair in the back of the room. It turns out that this team was working on an acquisition of a smaller private company and much of the negotiations involved EBITDA (many small businesses are priced based on a multiple of EBITDA).

This experience was not unique among our clients. When highly successful employees are promoted to positions of management and leadership, it is assumed that they suddenly understand the financial information provided to them.

We believe that improving the financial intelligence of business managers and leaders is critical to their success, both personally and professionally, and to their companies' success. Improving financial literacy ensures that everyone understands how financial success is measured and how they make an impact, helping to achieve long-term financial health in good times and helping to weather the economic and strategic storms in bad times. We hope, too, that it will lower the probability of financial fraud. (Virtually every fraud case is discovered by a financially savvy employee.)

We encourage you to find ways to increase the financial intelligence level in your organization. The Financial IQ quiz is a quick way to assess where you stand now.

For more, see the Forethought we wrote for this month's issue of Harvard Business Review: "Are Your People Financially Literate?"

1. Too much leverage
The basic concept of financial leverage is taking the proceeds of a loan and investing that money to receive a higher rate of return. The difference in the rates (the interest rate of the loan and interest rate earned on the investment) is called the spread.

Businesses, such as banks, borrow money from others through deposits or loans and pay a fixed interest rate on the debt. Then they take that borrowed money and invest it, expecting, of course, to get a higher return. At a traditional bank, deposits are paid 1-2 percent interest rates and the money is then loaned out at 5-20 percent interest rates. It's easy to see how commercial banks make money — they will be profitable as long as there is a nice spread.

Lehman Brothers was overleveraged. They borrowed money in order to invest in mortgage-backed securities (MBS) (as well as a variety of other investments). In the case of the MBSs, when it was revealed that the assets used as collateral for those mortgage-backed securities were worth a lot less than they thought, the MBSs became worthless and Lehman Brothers' spread went from positive to negative. In balance sheet terms, they started with a balance sheet in which they owned more than they owed. They ended up with a balance sheet in which they owed more than they owned. That's never good, and Lehman Brothers went bankrupt.

2. Risky debt-to-equity ratios
Debt-to-equity ratios tell you how much debt a company has for every dollar of equity. The calculation is easy: divide total liabilities by shareholders' equity (both found on the balance sheet). In the case of commercial banks, the FDIC likes to see a debt-to-equity ratio of about 10 to 1, meaning for every dollar of equity, the bank has $10 of debt. With that level of debt to equity, a bank can weather the storm of a loss due to bad loans or a shrinking interest spread.

Investment banks, however, are not regulated by the FDIC. Their debt-to-equity ratios tend to be much higher. Lehman Brothers, for example, had, at various times, debt-to-equity ratios of 30-60 to 1. If a firm is running at $60 of debt for every $1 of equity, their cushion is dangerously small. Any drop in the value of the assets underlying their investments, or in their spread, pushes the firm to bankruptcy. This was the case for Lehman.

3. Upside-only compensation schemes
Another factor that spelled disaster for Lehman Brothers was the bonus system that compensated people for generating stellar returns. In general, the investment banks set up plans that paid a bonus when the firm performs well. But when the firm did poorly, employees weren't asked to give any money back. The plan rewarded risk taking for high returns but did not punish for low returns or losses. There was no personal downside to taking risk.

Our two cents on the bigger picture
Taken together, the bias to use high levels of financial leverage to increase returns, combined with risky debt-to-equity ratios and upside-only bonuses, was a recipe for disaster. In hindsight, it's easy to see how this happened. The Wall Street banks were designed in multiple ways to take risk. Somehow, the system needs to match the risk with the potential rewards.

The benefits of sharing the numbers are tremendous, as Joe has seen firsthand at Setpoint Systems, where they have an open book philosophy. Each employee is trained to understand financial statements — shared weekly. Bonuses are tied to the company's performance.

The employees at Setpoint feel psychic ownership — they care about how the company does week-by-week and they want to see the numbers moving in the right direction. Financial transparency has helped Setpoint create a committed workforce.

Over the years Setpoint has seen amazing things happen because of financial transparency and psychic ownership. One of our favorites is what we call the motorcycle story. Early in Setpoint's history, the two founders (both engineers) decided to develop an all-aluminum motocross frame. This was is the early '90s, and they felt that a good light motorcycle frame did not exist. They assigned one of their Setpoint teams to develop this frame. Joe was a part-time CFO consultant at the time and told the two founders that this idea did not make sense financially. After some research they found out that it would cost several million dollars to market this new frame in trade magazines and at motocross races. For a small start-up company the idea was not viable. The project was killed.

Setpoint Systems tracks two key metrics based on the business of capital equipment manufacturing automation. One of the key numbers that drives profits is gross profit per hour. Everyone in the company knows that if GP per hour is high enough, they will qualify for a bonus.

About two years went by. One day a shop technician was out of work, his project completed. He went to one of the founders and asked him if there was something he could work on. The founder said, "go to my garage and get the partially assembled motocross frame and engine. If you work on it for a couple of days, we could be riding the motorcycle by the weekend." Later that day, as Joe was walking though the shop, he saw the technician working on the frame. Joe thought, "Oh no, I thought we killed this project long ago." Joe walked up to the technician and asked him what he was doing. His answer was music to Joe's finance ears. He said, "Joe, I'm not sure what I'm doing but I do know that I am generating zero gross profit per hour." After reporting this answer to the founders, the frame was removed and the technician was reassigned to more profitable work.

Financial transparency, along with clear key numbers that everyone can focus on, can help to drive profitability and success. It was true long before it was a buzz word on Wall Street. And it's still true now.

Some believe that expensing stock options helps to more truly represent a company's financial standing; thus it's appropriate. Others believe that expensing options hinders the ability of small growth companies to succeed.

Recently Joe attended a national conference where a keynote speaker, a former CEO of one of the most successful retail chains, said that had he been forced to expense options during the growing years of the business, the company would never have succeeded. First, because they would have used fewer options to recruit, thus limiting the talent they could attract. Second, they would have taken much longer to get to profitability because of the added expense of options. The law changed in 2006, and people are still debating it. So go accounting controversies! Here is a primer on the subject.

Stock options are often used as a way to entice employees to join a small start-up company at lower than market salaries. Often, these employees are betting that the stock options will be worth millions when the company's shares grow above the option's strike price, or its price when the option was issued.

The strike price of an option is usually issued to new employees at or above the fair market value of the stock on the date of issue. For example, the strike price may be $3.00 a share, but at the time of issue the company's stock is trading at $2.50 a share. That is when the option is considered underwater there is no taxable gain to the employee who is issued this option.

Until 2006, these options were simply reported in the notes section of the financial statements in accordance with the Generally Accepted Accounting Principles (GAAP), but did not impact the financial statements themselves. In 2006 FAS 123 of the GAAP code was modified to require companies to show options as an expense on the income statement. This means that the costs of these options would be shown as employee compensation along with salaries and other expenses. The controversy began.

The argument for expensing options was simple. First, investors like Warren Buffet argued for years that many companies enticed executives and managers with lower-than-market salaries because they also offered options. This inflated the companies' profits because of the lower salaries — hence lower expenses on the income statement.

In addition, if the company did well and the stock options appreciated, then the shares outstanding were diluted by these options that were now "in the money."

The other side of the argument is based on the fact that it is very difficult to value options that are under water at the time of issue. Many accounting purists would say that there is no tangible value at the time of issue because the option is priced at or below the current market price.

There was a corporate uproar when GAAP changed. Congress was lobbied to reverse the decision of the Financial Accounting Standards Board (FASB). It is quite rare for Congress to get involved in accounting policy and in the end the changes stood and companies now expense options.

We like to say that accounting is primarily adding and subtracting, and when it gets complicated, we multiply and divide. Now, with the expensing of options, differential calculus became part of the equation. The value of an option involves the volatility of a stock, its current price, terms of the option, and its vesting period. The two most frequently used models to value options are the Black-Scholes and the binomial models.

So how have companies handled the accounting change? Some have stopped using options or limited their use. Others provide pro-forma statements for investors that show profit before the expensing of options.

We believe that the market has adjusted to this new accounting rule and it has not adversely impacted small growing companies. Furthermore, it does give a more accurate picture of a company's expenses.