What Is Financial Literacy?
Financial literacy is the ability to read and use common financial reports and ratios to assess business performance. There is enormous value for leaders in understanding this building block of business acumen. It allows them to make informed decisions and project the financial impact of their day-to-day choices. It makes leaders more confident — and more competent in their roles. It is difficult to be a strong player in any game if you can’t read the scorecard.
Three Elements of Financial Literacy
Being financially literate requires understanding three domains:
- Financial reports.
- Ratios and metrics.
- Investment analysis.
Financial Reports tell the “story” of a business. The three most common financial reports are the Income Statement, Balance Sheet, and Cash Flow Statement.
The Income Statement describes the revenue generated, the expenses incurred, and the profits (or losses) made during a specific period of time. It helps a leader understand what it costs to generate a dollar of revenue and how much margin or profit a business is generating.
The Balance Sheet reflects the assets owned by a business and the liabilities and equity used to fund them at a specific point in time. The Balance Sheet depicts the financial health of the business and how effectively specific assets, such as accounts receivable or inventory, and liabilities, such as accounts payable or debt, are used to generate results.
The Cash Flow Statement indicates how cash is generated, how it’s used, and whether it’s generating positive cash flow. Positive cash flow is critical as it funds ongoing business operations. Financially literate leaders know how their decisions — as well as the decisions and actions of their teams — impact each of these reports.
Financial Ratios and Metrics:
The three reports listed above yield a variety of financial ratios and metrics that enable leaders to answer important questions about their business.
For example, gross margin helps a leader understand the relationship between pricing and cost of goods sold. It helps a leader determine if prices or cost of goods sold are too high or too low.
Inventory turnover indicates how often a company is selling and replacing its inventory. It enables a leader to understand how effectively inventory is being managed.
Debt-to-equity ratio reflects the relationship between debt and shareholder equity. It allows a leader to determine if a business is carrying too much debt or perhaps has the opportunity to assume more.
The financially literate leader uses ratios and metrics to assess business performance over time, ask important questions, and make adjustments through well-informed decisions.
Investment analysis helps leaders make choices and enables them to compare projects and consider how risky or conservative they might be.
Common investment analysis tools include Return on Investment, Discounted Cash Flow, Net Present Value, and Internal Rate of Return.
Businesses have myriad investment opportunities and limited resources. These analysis tools allow leaders to forecast and compare the financial impact of one opportunity to another and make the best choices. The financially literate leader uses investment analysis tools when assessing or proposing investment opportunities.
Leaders learn to use all three elements of financial literacy through experience. While it’s straightforward to understand the theory of reports, ratios and analysis, it’s the experience of using these tools that deepens a leader’s appreciation of their value.
A business simulation can provide a practical and engaging experience for learning about, practicing, and applying financial literacy skills. Doing this in a risk-free, controlled environment can accelerate a leader’s time to fluency and enable better decision-making on the job. It’s smarter to build these skills in a risk-free environment than at work with real dollars and consequences.
Put your understanding to the test with this Financial Acumen Quiz.
Ned Wasniewski is a managing partner at Insight Experience and has led multiple functions, including program facilitation, program management, delivery operations, account management, and business development. Ned has more than 20 years of experience in the management education business with a singular focus on the development and delivery of simulation-based learning experiences.