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A. B. Wilson Communications
Business Savvy 101: A Primer on Accounting and Finance

By Andrew B. Wilson

This is a lecture delivered to communications executives at  McDonnell Douglas. It has been reprinted in a number of publications, including Vital Speeches and Exectuive Speeches. Certain graphics (sample income statement and balance sheets) are omitted here.

Welcome to "Business Savvy 101." Many big thinkers, going back to Plato, have regarded business as a nasty, brutish activity, appealing only to the baser instincts -- to the acquisitive and, indeed, the duplicitous side of human nature. Your professors, George Cesaretti and I, do not share this point of view.

We will encourage you to elevate your thought processes when you
think of business. You should think of business in the same way you think of art, literature, or the possibility of marriage. That is to say, you should think deeply, and critically.

To do that you need certain tools -- conceptual tools. This course will provide them.

In all honesty, however, you can pick up the same tools at a number of other locations. For six or seven hundred dollars, you can take a two- or three-day course on accounting and finance from one of the large brokerage houses or accounting firms. And you can go to any bookstore and find a textbook on accounting and finance.

So what do George and I have to offer that you won't find at the other shops? First of all, as a special promotion, we are offering this course
absolutely free of charge.

Second, even though you can't beat the price, we're not the Macy's of the "business savvy" business; we're the high-class shop on Saville Row. You don't buy off-the-rack here; you get a suit that is tailor-made for your informational requirements.

Third, we do things with a certain flair. Frankly, it's hard not to laugh at the way some of our competitors promote their products. They make a big deal out helping you "read and understand annual reports".  Many annual reports are incredibly boring. Reading them can be like watching paint dry.

George and I put the emphasis where it belongs: First and foremost, this course is aimed at increasing your understanding of business. That's worth shooting for because business is important and exciting -- and because a greater sense of  "business savvy" will enable you to compete and play the game at a higher level. We will show you how to "read" an annual report, but that's incidental to the main purpose.

This morning we are going to go on a whirlwind tour of business and finance. We will look in on Don Trump and Carl Icahn; consider the probable effect of the December 3rd earthquake on the balance sheets of St. Louis companies, and conduct a surprise audit of the household finances of a McDonnell Douglas vice president who is sitting right here in this room.

The purpose of this journey will be to demonstrate how a few basic concepts -- the nature of a balance sheet, most particularly -- are powerful tools for understanding any business.

There are two fundamental statements of financial condition: the income statement and the balance sheet. Every publicly owned company puts these statements out on a quarterly basis. Each statement consists of a simple equation.

First, If you build something for $10 and sell it for $15, you book a $5

Second, Or, The latter shows how you would calculate your own net worth, right? You would make one list totalling up the value of all of
your assets, or things of value  -- your house, car, furniture and everything else. Then you'd make another list totalling up all of your debts or liabilities, including the balance owed on the car loan and the home mortgage. Then you'd subtract total liabilities from total assets to arrive at your net worth.

It's the same with corporations, only net worth is sometimes called share-holders' equity.

Now the really brilliant part of all this is that profits and losses flow into the balance sheet as additions or subtractions to net worth. If you build something for $10 and sell it for $15, you book a $5 profit which then becomes an addition to your net worth. But you can't stop there. You must then go on to add $5 to your assets in the form of cash or to subtract it from your liabilities or debts.

Conversely, if you sell something at a $5 loss, you must deduct $5 from shareholders' equity or net worth and then either add $5 to your liabilities in the form of increased debt or subtract the same amount from your assets.

Every single transaction under the sun always affects at least two accounts. Unless a transaction involves offsetting debits and credits within one of the three main categories   -- assets, liabilities and net worth  -- a change in one of those categories will always result in a corresponding change to one or both of the two other categories.

If the Chinese supply landing gear doors to Douglas Aircraft Company with payment to be made in 60 days, the transaction is recorded under liabilities as an increase to accounts payable and it is recorded under assets as an addition to inventories. The keeping of balances based, in this way, on double-entry bookkeeping, ranks as one of the greatest inventions in the history of man.

Commerce evolved in three main stages  -- from barter, to cash-and-carry, to trade between people financed by third party interests. A new method for dealing with the complexity of keeping accounts and organizing investment and credit was needed to make the third stage possible. That was provided by balance sheet accounting. It is the foundation of modern banking and finance as well as a means of corporate bookkeeping.

Being of Italian descent, Professor Cesaretti is proud of the fact that the balance sheet is an Italian invention. It was put into broad use in the Italian trading towns of Venice, Genoa and Florence in the thirteenth century. It was the springboard for an enormous expansion in trade and prosperity, which led Europe out of the Dark Ages and into the Renaissance.

As it happened, the same merchant banking families who became fabulously rich as a result of the expansion in trade were also to become the great patrons of the arts. The patrons of Michelangelo, Rafael and Leonardo.

As you think of the Mona Lisa, I invite you to imagine she is contemplating the nature of a balance sheet with a smile that says, "Simple, but not so simple." Or perhaps the smile is telling us, "Complicated, but not so complicated."

Though we would be jumping a little bit ahead in our story, we can extend the balance sheet equation out in one way: Or, we can give you the truncated version: Remember the Yogi Berra line, "It's never over til it's over." This is kind of like that. It says: "If you don't have it, you ain't got it." But it contains two important insights.

First, it tells you there are no unclaimed assets. You can't list anything as an asset, even something as valuable to you as the air you breathe, unless you can stake a claim to it.

Second, it tells you that the value of claims cannot possibly exceed the value of assets. If assets disappear, old claims may rattle their chains -- they may even take up residence in the corporate attic as poltergeists, wailing and moaning in the night -- but they cease to be of any value.

There are two kinds of claims to a corporation's assets: the claims of the creditors and the claims of the owners, or shareholders. One set of claims is called Liabilities and the other set is called Net Worth, or Shareholders' Equity.

As a general rule, the claims of the creditors take precedence over the claims of the owners and therefore carry less risk. But if the claims of the creditors are fully satisfied, the owners have rightful claim to all remaining assets. Owners have the possibility of unlimited gain.

What happens when the claims of the creditors are not being satisfied? This brings us to the trials and tribulations of Don Trump, one-time billionaire and author of the best selling book, The Art of the Welch.

Trump borrowed several billion dollars to acquire casinos and other properties. However, these properties are not generating enough cash to service the debt that Trump incurred in acquiring them. What's more, the properties are not worth nearly as much as Trump paid for them. In other words, his liabilities may well exceed his assets. And that is another way of saying he may have a negative net worth.

This is a highly unstable situation because it means there is no real owner on the premises -- no one who is bearing the brunt of the risk and therefore entitled to call the shots. Legally, Don Trump is still the owner, but economically, he's been neutered, left without a real claim to any assets. On the insistence of his creditors, Trump has been put on a strict allowance -- limiting his household expenditures to a few hundred thousand dollars a month. Tough, huh.

As we speak, the people who loaned money to Trump are eyeballing the assets -- including the Trump shuttle and the Taj Mahal casino -- and wondering: "Will we be better off if we put those assets up for sale on the courthouse steps -- in a bankruptcy proceeding -- or should we leave the Trump Organization intact in the hope that business will improve and
allow him to make good on most, if not all, of his debts?"

The people who think of profit as a dirty word, suggesting exploitation, might be surprised to know it comes from a Latin word, profectus, meaning advancement or improvement. That is an excellent description of the role played by earnings in the life of a company.

In a healthy situation, the net worth of a company increases steadily through earnings that are reinvested in the business.Every time a company makes a dollar and puts it back into the business, that has the effect, as we have seen, of adding a dollar to shareholders' equity or net worth, which is responsible for financing another dollar in assets or a reduction in
liabilities. Losses, of  course, have the opposite effect ofcausing net worth to shrink and liabilities to grow.

Shareholders contribute to paid-in capital or equity when they purchase newly issued shares. That contribution is likely to be particularly important in the early years of a company's existence when it is struggling to become established. As companies mature, however, retained earnings are the prime determinant of net worth.

You can see this very clearly in our own case. At the end of last year the total net worth of McDonnell Douglas was $3.3 billion. Retained earnings accounted for all but $317 million of that total.

If you are wondering how shareholders' equity is affected by movements in the price of the stock, the answer is, not at all.

The corporate world is like the art world in this regard. If a painter sells a painting for $100 and the same painting, years later, fetches $1,000,000 at Sotheby's, the artist isn't any richer as a result. It's the same with stock prices. Companies don't get any richer just because the price of their stock goes up.

So why do they care? For two very good reasons.

First, companies care about how their stock is trading for the same reason that the artist might care about the sale at Sotheby.

It has a great bearing on the price he can expect to get for new paintings. If the price of a company's stock has gone up ten times since its last public offering, it can expect to get about ten times as much money for any new shares that are issued.

Second, top management cares about how the company's stock is doing because the board of directors cares, and the board cares because the shareholders care. After all, it is the shareholders who elect the board, and the board which appoints top management.

Wal-Mart stores provide a good example of how the shareholders prosper when an enterprise does extremely well. The company had $1.2 billion in sales and $38 million in earnings in 1979 -- the year I wrote the story included in your homework for tonight.

Last year it had $25 billion in sales and $1 billion in earnings. Now if I had put $100 into Wal Mart stock in 1979, and kept it in, reinvesting the dividends, that investment would be worth more than $10,000 today.

A knowledge of financial statements and corporate governance does not enable George and me to predict whether there will be an earthquake on December third. However, if there is one and it destroys half the assets of all of the companies in St. Louis, the concepts that we have discussed here this morning will allow us to predict some of the things that are going to happen next with complete confidence.

You know right away that the elimination of 50% of the assets also means the elimination of 50% of the claims. That will mean major write-offs all around -- both at the companies themselves and at the banks that have lent money to them. As the companies write down the value of their assets, they will post huge losses -- losses that substantially reduce their net worth.

However, their liabilities will also decline as banks are forced to forgive some of their loans to keep their customers out of bankruptcy.

There is, however, another possibility to be considered. It may be that St. Louis companies are fully insured against earthquake damages. In this case, the total size of company balance sheets will not change but there will be a reordering of different items. Enormous numbers will suddenly appear under short-term assets, accounts receivable (insurance), making up for large declines in the values of property, plant and equipment.

Either way, when the ground stops shaking, it will be discovered that assets still equal liabilities plus net worth.

A balance sheet is a picture of a company's financial condition at a given moment, usually the close of business on the last day of a three month reporting period. Everything you see is in place as it was on that day.

Now I am going to show you two balance sheets, six months apart. This will give you an "audit trial" in following the fortunes of someone in this room.

We will start with the balance sheet as it looked a number of years ago. Our subject didn't own a house or a car or any other physical assets at this time, but he was debt-free and had $25,000 in nickels, dimes and quarters wrapped up in an old handkerchief that he used to carry on the end of a stick. He was proud of his status as the last in a distinguished line of hobos.

This was before Walter Diggs (McDonnell Douglas vice president for community relations) discovered a calling in corporate philanthropy.

This  is a strong balance sheet. His assets are not only highly liquid -- that is to say, easily converted into cash -- they are in fact cash. He has no debts so there is no question of excessive leverage in this situation.

Observe the strong working capital position. Working capital is the difference between current assets ($25,000 in this case) and current liabilities ($00). Having a good supply of working capital means you don't have to tap long-term savings in order to finance current expenditures, such as food, entertainment, and monthly utilities. That's good.

Unfortunately, our friend does not recognize his good fortune. He
has an opportunity to buy a house in Ladue -- on the St. Louis
Country Club grounds -- and he can't resist. He pours out $20,000 in nickels, dimes and quarters as a down payment on a $100,000 house, with the balance financed by a $80,000, 25 year mortgage. This is what his balance sheet looks like now.

Several things to notice here. First, there has been a four-fold increase in total assets. But there has been a sharp decline in working capital (down to $5,000 from $25,000). The balance sheet now shows a high degree of leverage (i.e., a high proportion of assets is financed with borrowed funds rather than owner investment). While McDonnell Douglas has a debt-to-equity ratio of .9 to 1, and that is considered high, our friend is up to 3.2 to 1.

In short, ladies and gentlemen, Walter has gone from being a cash-rich bum to a house-poor member of the country club set.

Many people confuse equity with cash. If you look at the two balance sheets above, you will see that the purchase of a house -- with a down payment of $20,000<197>reduces Walter Diggs' cash, but not his equity. Walter has $20,000 in homeowner's equity. But he can't write out a check or pay any bills with that. Unless he decides to sell his house, that money has disappeared. And if he sells his house for $80,000 or less, the entire proceeds will go to the bank holding the mortgage.

It is the same way with share-holders' equity. Shareholders' equity is not a pot of money waiting to be spent. It is money that has already been spent -- on acquiring assets or retiring debt. It represents owners' claims against assets -- claims that are subordinate to the claims of creditors.

If you think about it, a balance sheet represents a summing up and sorting out of every transaction that has ever occurred since the first day of business. There are journals and ledgers to keep track of a multitude of transactions on a daily basis, and these are like rivulets feeding into the larger stream of earnings shown on an income statement. An income statement then provides the link between two balance sheets.

It all fits together. And the balance sheet always balances. Now some of you may begin to smell a rat. You may be thinking: The bean counters can't be that good. They don't get the sums right every time.

I will let you in on a secret, even though it may cost me my job. They don't. And when there's a screw-up in the numbers, there is only one thing you can do. You go back and rewrite history.

This largely explains "the recurring series of non-recurring events" that John McDonnell has complained about. We rewrote history in the third quarter in reversing $58 million in earning that had accrued in the C-17 program between 1985 and the first quarter of this. We rewrote history last year with write-offs in helicopters that came about as a result of reevaluating inventories and earnings rates.

Analysts hate surprises of this sort. Corporate executives hate them even more. And they are a challenge for people like me when it comes to explaining matters to the press. Sometimes one is tempted to quote the Russian historian who complained of his profession, "The trouble is you never know what is going to happen yesterday."

Now that you know almost everything there is to know about a balance sheet, let's take a more detailed look at the income statement. Here is a longer and more detailed version of the income statement equation:

There are two kinds of costs to consider: fixed costs and variable costs. For the most part, cost of sales represents variable costs -- that is to say, costs that go up or down with changes in sales. Operating expenses, on the other hand, are mostly fixed costs. They are costs the company pays regardless of the level of activity in its factories. Operating expenses include executive salaries, office payroll, and engineering, selling and administrative expenses. They also include research and development and depreciation and amortization.

Net sales minus cost of sales equals gross profit. Net sales minus both costs of sales and operating expenses equals operating income. Listed below operating income in the income statement are interest expense (another fixed cost), non-operating gains and losses (say, from the sale of a subsidiary), and taxes. Last but not least is net earnings -- the famous "bottom line."

There is an important accounting convention to bear in mind as you look at an income statement, and that is called matching. Net earnings are not the difference between all of the cash that came in through sales and all of the costs that were incurred throughout the course of the years. It's more complicated than that.

Matching links accomplishments or revenues with related efforts or expenses. The revenues up there on the top line are linked in this way with the various costs listed below.

This means the one large category of soon-to-be revenues and already-incurred costs is left standing outside the door -- not admitted into the income statement. And that is inventories, which are raw materials, work in progress and finished goods waiting to be shipped.

Inventories do not cross the threshold from the balance sheet into the income statement until they stop being inventories by becoming goods sold.

McDonnell Douglas has over $1 billion invested in MD-11 inventories -- that's money already spent -- but apart from the down payments that the airlines give us, we don't get any cash until the sale of the airplanes is completed, and that happens at the time of delivery.

There is nothing especially alarming about this situation -- assuming you are able to deliver your product and get paid. And we have no doubts on that score. But it has had a substantial impact on our cash flow position. A big increase in inventories, like a big increase in other assets, must be
financed by increased debt or net worth.

Though inventories do not impact the income statement -- except insofar as they are responsible for increased interest payments -- the MD-11 and some other new programs do show up in a big way in the income statement under "research and development," which is an expense with no related and offsetting revenue stream. R&D knocked $617 million off our
bottom line. That's a large amount of money.

R&D costs include all of the non-recurring expenses that are incurred in the course of creating a new program like the MD-11 and getting it into production.

A number of years ago, companies were able to "capitalize" R&D -- that is to say, treat it as an asset, just like inventories, and therefore keep it off the income statement. Companies would then amortize the asset, or write it off gradually over a period of years.

Nowadays, you are not allowed to do that. You have to expense R&D -- that is to say, you write the cost off as it is incurred.

Now obviously we regard R&D as an investment -- something that will provide revenues and earnings in the future. But accounting conventions do not allow us or their companies to treat it that way.

There is one other joker in the deck here, and that is depreciation. Depreciation is opposite of appreciation. It reflects a decline in the value of long-term assets as a result of normal wear-and-term. It is listed as a cost under operating expenses. What makes it a joker is this: It is a non-cash cost.

You don't have to write out a check to anyone to cover the cost of depreciation. What's more, depreciation has the effect of reducing corporate income tax by reducing reported income.

You can see what the accountants were thinking when they decided to handle things in this way. They were thinking: The cost of fixed assets like plant and equipment ought to be distributed over the useful life of the assets. What's more, because depreciation adds to cash flow, companies will have the cash to reinvest in keeping fixed assets in good shape.

Here is the usual formula for calculating depreciation:
There are ways of accelerating depreciation and if you do that with a highly capital intensive company you quickly get to some very big numbers. Companies with poor or undistinguished earnings may have large cash flows as a result. And that makes them an inviting target for raiders and asset-strippers.

At this point, we need some stage directions: "Enter Carl Icahn, stage right, pursued and pursuing. Icahn rushes about the stage chasing other companies and being chased by a mob of angry pilots and stewardesses."

Carl Icahn and other raiders love companies that have lots of  depreciable assets because nobody, except the employees, cares whether you replace those assets in a timely fashion. Raiders are cash flow junkies. If you own the company and call the shots, you can go out and use the cash to acquire other companies.

Icahn has not bought any new airplanes in years. As the pilots and stewardesses see it, he is systematically mining the company's physical assets -- TWA's fleet of airplanes, principally -- in order to generate cash for takeover games.

You sometimes hear of companies disappearing in a kind of Bermuda
Triangle. They will be cruising along with good reported earnings -- everything looking A-OK-- and then, suddenly, wham -- they declare bankruptcy. But there is really no mystery here. The explanation is they ran out of cash. This can happen as a result of a buildup of inventories or receivables, difficulties in refinancing maturing loans, or most likely, a combination of the two. You need cash to pay your bills. If you can't pay your debts, you can be forced into bankruptcy.

Because of the critical importance of cash, public companies are obliged to include a third statement in their quarterly and annual reports, called the "consolidated statement of cash flows." This gives a detailed account of how the company has acquired or spent cash over the reporting period. It is laid out neatly in three sections: operating activities, investing activities and financing activities. Investments in long-term assets (the middle category) require cash. If the cash to make those investments didn't come from operating activities, or from a drawing down of the cash balance at the beginning of the reporting period, it must have come from financing activities.

Under "financing activities" you get a run-down of the company's short- and long-term borrowings over the period. Looking at the statement of cash flows, you can see at a glance how much inventories and receivables have grown over a three year period. This and other information is pulled together from the balance sheet, the income statement and the financial footnotes.

If you are concerned about a company's solvency, it is must reading.

I'd like to leave you with another one of the immortal thoughts of Yogi Berra: "Ninety percent of the game is half mental."

Business can be and often is very complicated. But the basic concepts are not that hard. If you add the concepts to your day to day thinking, applying them to everything you see and read about in the business world, you are well on your way to becoming a master of business savvy.

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Andrew B. Wilson

26 Taylor Place Drive
St. Louis, MO 63108
Phone: (314) 361-1195

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