A while back, my training business, the Business Literacy Institute (BLI), created a financial literacy test to assess the financial knowledge of managers and executives in companies with at least 150 employees. The results were interesting. The average score was 38%, which meant most of the leaders at these larger companies would fail in a basic financial literacy test. My publisher, Harvard Business Review Press, was so surprised by the average score, they had BLI write a forethought article, Are Your People Financially Literate?
At BLI, I have trained thousands of executives in large public companies, like General Electric, Boeing, MetLife, Comcast/NBC Universal, LinkedIn, World Bank, and United Nations, to name a few. We consistently use our assessment when training these large clients and usually see them score around the average. It is true that some senior teams score in the high 50 percentages (which is about a D+ grade). Based on our experience in the financial training world, this proves there is a significant lack of financial acumen.
So, how do entrepreneurs score on our assessment? You might not be too surprised to know that they usually score much lower than their corporate managers, often with scores in the high 20 percentages. Most small business owners don’t go into business to generate cash flow or a strong and growing EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization)—they go into business because they have an idea, or they are good at selling a product or service. Simply put, finances are an afterthought for the majority of these small business owners.
This lack of financial literacy in the small business world is dangerous. When a small business owner starts to work with bankers for financing, they are introduced to what I like to call the “banker ratios.” Bankers really don’t understand many of the businesses they finance because many of the “banker ratios” aren’t relevant to small businesses. This disconnect can really challenge a small business needing financing to grow but they just don’t fit into the bankers set ratio standards.
In my training classes and my book, Financial Intelligence, I go over a simple example to illustrate the difference between cash and profit taken from the income statement. In this example, we have a very small business that is growing revenue quickly and selling their products to a much larger corporation on credit. (Does this sound familiar to anyone?) It turns out that the corporation pays their invoices in 60+ days, yet the small business pays its employees every two weeks and their suppliers in 30 days. When we run the math, the small business is profitable with growing revenue, but it runs out of cash in 3 months.
In this example, I ask, “What could we do to solve the problem?” Oftentimes, I get the answer, “Grow revenue.” Most entrepreneurs look to grow revenue first, with the belief that all else will work out on its own. The irony of our simple example is that the more the small business grows and sells, the worse their cash problem becomes.
A successful entrepreneur will eventually learn that profit is not cash. They will also learn that there are key metrics on financial statements that drive value. Things like EBITDA, Free Cash Flow, Return on Equity, and Gross Profit Margin Percentage come into play. The successful entrepreneur will eventually realize the need to learn finance, find that expertise in an employee or partner, or ultimately fail.
If you are starting a small business, my recommendation is to become financially savvy by taking an accounting and financial analysis class at a local college, and find partners that have a solid financial background as you start your business. I know that these types of solutions might not sound appealing, but it is better to understand financial information before you miss payroll and shut down!
The Business Literacy Institute offers a number of resources to help with financial literacy. Check out the glossary of finance terms on our website, and our book Financial Intelligence published by Harvard Business Review Press. You can also sign up for our online training course and take our Financial IQ Quiz to assess where you stand now.