Study: many executives 'financially illiterate,' can't read balance sheets

A majority of executives in a recent survey were unable to distinguish profit from cash, an income statement from a balance sheet. Should we be concerned?
Written by Joe McKendrick, Contributing Writer

Yikes!  A new study out of the Business Literacy Institute, published at the Harvard Business site, reports that among a sample of executives taking a basic financial-literacy exam, the average score was only 38% -- an F minus-minus.

The test was a 21-question exam developed in conjunction with Alliant International University’s Marshall Goldsmith School of Management, administered to a random sample of about 300 US managers.

Many of the responding executives surveyed, report study authors Karen Berman and Joe Knight of BLI, didn't have a grasp of fundamental financial concepts:

"A majority were unable to distinguish profit from cash. Many didn’t know the difference between an income statement and a balance sheet. About 70% couldn’t pick the correct definition of “free cash flow,” now the measure of choice for many Wall Street investors."

Does this really matter?

Berman and Knight say yes, having top decision-makers that can't read balance sheets or understand the levers they have to increase cash flow will not only hurt them professionally, but hurt the business as well. "Those who can’t speak the language of business can’t contribute much to a discussion of performance and are unlikely to advance in the hierarchy," they say. "They may be caught off guard by financial shenanigans, as many employees at Enron were. They will be unable to gauge the health of a prospective employer."

For the organization, having financially illiterate executives means missing opportunities to improve a business's balance sheet through savvy strategies such as improving gross margins, decreasing inventory or reducing days sales outstanding.

Berman and Knight are authors (with John Case) of Financial Intelligence: A Manager’s Guide to Knowing What the Numbers Really Mean (Harvard Business Press, 2006).

What exactly is "free cash flow," by the way? Many executives were stumped by this question. Berman and Knight provide some sample scores from the financial IQ exam they administered to executives:

To investors and analysts, free cash flow is a key number because:

It reflects the operating cash that has flowed into the business in the current year -- 40%

It is the cash that can be used to pay shareholders their dividends -- 30%

It reflects the cash that is "free," the company doesn't have to pay interest on it  -- 22%

It is the cash that shareholders have put into the business -- 8%

Do you know the right answer? Check it out at Berman and Knight's Financial IQ Test results page.

This post was originally published on Smartplanet.com

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