Many managers are not comfortable reviewing the financial data that finance and accounting staffs provide to them. Yet according to Wharton accounting professor Richard A. Lambert, financial statements — like cash flow statements, balance sheets and income statements — reveal information that managers cannot afford to ignore because of what they show about a company’s opportunities and risks. In his new book in the Wharton Executive Education Essentials Series, Finance & Accounting, Lambert demystifies financial statements and shows managers how to use the data to make better business decisions for long-term profit. Stephen J. Kobrin, a Wharton management professor and executive director of Wharton Digital Press, talked with Lambert about how managers can use financial statements to create and refine strategy, stay on top of expenses, establish proper benchmarks for gauging performance and more.
An edited transcript of the interview follows:
Stephen J. Kobrin: Does every manager really need to understand financial data? Don’t they have finance and accounting staffs to handle that?
Richard A. Lambert: They often do have finance and accounting staffs to handle some of it, but managers have a different job than they do. The job of the finance and accounting staff is to produce the information; the job of a manager is to use it. To use it well, you have to understand what is in the numbers, what is not in the numbers and what the terms mean.
Kobrin: What’s the biggest mistake that managers make when they try to use finance and accounting data?
Lambert: There are two extremes. One is, I don’t know what this is, so I’m not going to pay any attention to it. The other is the exact opposite: They fixate on the bottom line so much that anything that makes the bottom line higher must be good and anything that makes the bottom line lower must be bad. Both of those are mistakes.
Kobrin: In your book, you talk a lot about the ambiguity and subjectivity of financial data. But aren’t numbers objective? How can numbers be subjective and ambiguous?
Lambert: Numbers are objective. What the number is supposed to represent, however, is subjective. Accounting and finance involves making predictions about the future. We have to put financial statements together while a lot of activities — and their future consequences — are still playing out. We may have made sales, but we haven’t collected them all. We may have made investments that are going to last for a long time, so what are they going to be worth later? We may have estimates for what pension expenses are going to be. Almost every number in a financial statement is actually based on somebody’s estimate of what things are going to be in the future.
That leads to ambiguity and subjectivity because nobody has a crystal ball to know what the future is going to be. It’s your best guess. Because there is subjectivity, it opens up the door for manipulation, too.
Kobrin: In your book, you talk a lot about benchmarks. What do you mean by benchmarks? Can you give us some examples?
Lambert: A benchmark is something to compare a number to. If profits were $50, is that good? Well, is it good compared to what? One benchmark might be to compare to how much you invested to make the $50. Another benchmark might be to look at what you made last year so that you could look for improvement. A third benchmark might be, what are other divisions — or our competitors — doing? All of these help gauge if your performance is really good or not.
Kobrin: In your book, you caution managers against using numbers developed for external reports — for example, stockholders statements — to actually run the business. Aren’t those solid numbers?
Lambert: There are really two reasons. One is the level of aggregation. The numbers that are reported to the stockholders are for the firm as a whole. To be a good manager, you need to know how the parts of the firm are working. It could be a good year for the firm, but that doesn’t mean that every part of the firm did well. You want to know where you did well and where you didn’t do well, so that you can go in and change your strategy. But the other reason is that the rules you are required to follow to put together the financial statements to send to shareholders often aren’t really the best gauge of how your business is doing. A good example of this is that there are many things that are investments from an economic perspective, like research and development or investment in training or those kinds of things. Doing those things is good for the company, but they will actually make your profits lower in the year that you do them. So, you don’t want to just focus solely on that number to make good, long-term decisions.
Kobrin: You also argue that managers need to get into the footnotes of financial statements, which seem dense and difficult. Why?
Lambert: The footnotes are dense and difficult, and that’s actually why they are valuable. The footnotes tell you how the numbers were calculated. If you see the profits are $50, it is important to know how that $50 was calculated because it could be good or it might not be good. The accounting methods that were to be used to calculate that $50 number will be explained in the footnotes. It’s a really good source of information to figure out what the numbers really mean.
Kobrin: Rick, why did you write the book?
Lambert: I wanted to reach a broader audience than we teach with our usual communication mechanisms, such as the MBA program and executive education classes. I wanted to write a book that was readable and relevant to managers, with a lot of real-world examples, so you could see how to apply the information that the accounting and the finance people provide you.
Kobrin: Rick, what can managers do to make sure they stay on top of costs? I think of the problems that the automobile companies had — GM in particular — with healthcare. Is there a way that managers can look forward, stay on top of costs and avoid surprises?
Lambert: There are a couple of ways. One is to make sure you know what the costs are. Having reports available that indicate what your costs are and what the breakdown of the costs are is important. Another thing is to recognize that not all costs are incurred in the form of cash right now. Healthcare and pension benefits are a good example of that. Many of them represent cash outlays that you are not going to pay into the future. If you are running your business on a cash basis, you might not count those expenses because you are not writing the checks today. Nevertheless, you have to be aware that you have incurred the obligation to pay this in the future and take that into consideration in making your operating decisions.