How Finance Works: The HBR Guide to Thinking Smart About the Numbers

If this all sounds dry or out of reach, don't worry. The author's on a mission to make finance accessible and his approach is just that. He uses household names for his case studies; writes in a friendly, conversational tone; and includes the thoughts of financial experts, who explain their day jobs in an engaging manner.

That's why we think this book has a wide audience. "How Finance Works" is for anyone who's curious about finance and wants to understand it better, from students, to project managers, to CEOs. Even if your role doesn't have a financial component today, knowing how numbers work may make it easier to climb the career ladder.

If you're already well versed in finance, this book is still a valuable read. There's always more we can learn, and the case studies are fascinating, shining a light on some of our best-known companies, from Starbucks to Amazon to Netflix.

The author is used to teaching finance to people at different stages on their business journeys. A renowned economist, Mihir Desai is the Mizuho Financial Group Professor at Harvard Business School, a Harvard Law School professor, and a former Wall Street analyst. He's the creator of a massive online open course, or MOOC, called "Leading with Finance" on Harvard's online business school. He's also the author of "The Wisdom of Finance: Discovering Humanity in the World of Risk and Return."

So keep listening to hear how to measure a company's profit, to learn the difference between hedge funds and mutual funds, and to hear what managers can do with excess cash.

If you flick through a copy of "How Finance Works," you'll notice an array of graphs, charts, tables, and equations. This can feel daunting, but don't be put off by appearances. Desai's goal is to bring lightness into what can be a heavy, dry subject. He achieves this from the first line of Chapter One with the phrase, "We're going to play a little game."

In fact, Chapter One is a big game. Desai provides a table of numbers representing the balance sheets of 14 anonymous companies. He sets out each company's assets and liabilities in percentage ratios so we can easily compare them. He then explains all the terms on the balance sheet – from accounts receivable, to preferred stock, to long-term debt – and asks us to work out which sector each company is in. Which companies are in the service industry, which ones are retailers, and which ones are banks? Can we tell from their balance sheets? Can we guess from their level of assets or debt?

As the game continues, Desai reveals the names of the companies, which include some big hitters like Facebook, Microsoft, Dell, Citigroup, Starbucks, and Amazon.

We begin to learn why companies in certain industries carry a lot of debt, sit on a large amount of cash, or have low or high profit margins. The chapter ends with a quiz that helps readers put their newfound knowledge to the test.

This is a great way for readers to build their financial literacy and get comfortable with numbers, and Desai's playful approach and down-to-earth writing style sets the tone for the rest of the book. He uses phrases like, "Sometimes finance people seem to divide everything by everything, just to confuse us," and, "Much of finance involves looking at a bunch of numbers and coming up with interesting things to say about them." Desai gives the impression that he's on the reader's side; that he understands how confusing it can all seem.

Another nice touch is that the author invites five financial experts to comment on aspects of their industry. We hear from the chief financial officer of beverage company Heineken; the former CFO of Biogen, a global biotechnology company; the global head of private equity for investment bank Morgan Stanley; the co-founder of Scopia Capital, a multibillion-dollar New York-based hedge fund; and an equity research analyst, which is a job Desai's father used to do. Their observations pop up throughout the book in green boxes, under the heading Real-World Perspectives.

There are orange boxes dotted throughout the book, too, under the heading Reflections. Here, Desai asks us to think deeper about a topic. He poses questions and offers examples. These sections really engage the reader, as do the quizzes at the end of each chapter.

So let's take a closer look at some of the wisdom in this book, starting with how to measure a company's profitability.

You may have noticed that finance is full of acronyms, which can be off-putting to newcomers. Desai doesn't want financial jargon to be a barrier, so he tackles what he calls one of the all-time great financial acronyms: EBITDA.

The first half of the acronym – EBIT – is, in Desai's words, "a fancy finance term" for operating income. It stands for "earnings before interest and taxes." Companies may be subject to different tax rates or have different capital structures, so EBIT allows us to compare their performance. As an example, a retailer in the United States would face different tax rates to a German retailer. Net profit factors in taxes, so you'd get a distorted view of these two companies' performance if you used net profit as a measure. EBIT levels the playing field.

The second half of the acronym – DA – stands for depreciation and amortization. Depreciation refers to the way in which physical assets, such as machinery, vehicles, or equipment, lose value over time. Amortization refers to the same process, but for intangible assets, such as patents or copyrights. So depreciation and amortization include expenses that don't involve any cash outlay.

Spending without spending? Here's an example. Let's say you build a factory: you have to account for the factory's loss of value over time by charging yourself an expense, but no cash is actually paid out. So EBITDA is a measure of the cash a company generates through its operations. Desai goes on to offer examples of companies with different EBITDA margins.

We like the way the author breaks down this term into digestible chunks. He provides easy-to-understand examples to help out any financial novices, while keeping experts interested with a range of solid case studies.

Let's now explore the seemingly complex world of capital markets – where stocks, bonds and other financial instruments change hands.

If you don't work in finance, it's easy to think that capital markets have nothing to do with you. It's also easy to be skeptical about traders, investors, and hedge funds, in the wake of the financial crisis. But capital markets are key to the growth of the economy, as well as to the growth of our own pension pots.

Desai gives us a "who's who" of capital markets by describing the job of an equity research analyst called Alberto Moel. To do his job, Moel speaks with individuals from what's called "the buy side." He talks to CEOs and CFOs of companies that he's following to find out information, so he can assess how a company's performing today and might perform in the future.

He also speaks with institutional investors. These are money or asset managers who invest large amounts of capital on behalf of clients, with a view to getting the maximum return. They might be in charge of mutual funds, pension funds, foundation or endowment funds, sovereign wealth funds, or hedge funds. Desai talks us through the difference between each of these funds.

For example, mutual fund managers invest money on behalf of individuals of varying degrees of wealth and sophistication. They invest in a range of stocks or bonds, so they have diversified portfolios, and they're tightly regulated.

Hedge funds are less tightly regulated, because only wealthy investors buy into them. That means the managers of these funds have a different approach to risk. They can also use "leverage" to increase returns. For example, they can take $10,000 of a client's money and use it to borrow an additional $10,000 from a broker, giving them $20,000 to invest.

While mutual funds spread their money across a range of companies, hedge funds might invest much bigger amounts in a single company, allowing them to steer corporate policies and strategies to yield bigger returns for their investors. They may then manage their risk by investing in a second company that's likely to perform differently from the first. In other words, they hedge their bets.

So, as you heard, analysts like Moel spend a lot of time speaking with people on the buy side. But they also work for investment banks on what's known as the "sell side." Within these banks, they talk to traders, salespeople, and investment bankers, passing on information they've gleaned about companies. Traders and salespeople buy and sell financial instruments, while investment bankers arrange financing for companies, such as initial public offerings, or IPOs, or through mergers and acquisitions.

Desai goes into much more detail, adding insights from analysts and hedge fund managers. He does a great job of simplifying a complex industry, but if you're new to capital markets or struggle with mathematics, you're still going to have to concentrate. There's a lot to take in.

Let's now look at what companies do with their cash.

Desai introduces this section with a story about the tech company Apple. In 2013, Apple shareholders began to protest against CEO Tim Cook. Apple had mounting piles of cash, and they wanted Cook to distribute the money to them. Since then, Apple has handed out more than $280 billion to shareholders, mostly by buying back shares.

At the time of the Apple revolt, Google's parent company, Alphabet, changed its shareholding structure – increasing the voting rights of key shareholders so it wouldn't face a similar challenge. Alphabet has since generated lots of cash but hasn't shared out very much, choosing instead to invest the money in its various businesses.

Once a company has generated cash, what should managers do with that money? Should they invest in new projects, buy other companies or products, or give it to shareholders? These are big questions, and it's important for companies to make the right choice, as shareholders are becoming less tolerant of mistakes.

Desai runs us through the pros and cons of the different approaches, and offers some great tips for managers who need to decide how to allocate their capital. A manager's best bet is to invest money in what's known as a "positive net present value project," or NPV for short. This is anything that will allow capital to grow. It could be a new product or a new property, plant, or equipment, or it could mean merging with or acquiring another company. If there aren't any such opportunities, a manager should distribute cash to shareholders by paying out dividends on a regular or one-off basis, or through buying back shares.

Each choice comes with a trade-off, as well as the potential to make mistakes, and Desai highlights some of the pitfalls. We hear how computer hardware company Hewlett-Packard failed to do its due diligence when it bought the search and data analysis company Automony, and how the AOL and Time Warner merger collapsed.

Desai offers a comprehensive and detailed analysis of how, when, and why to distribute cash, and we like that he brings the theory and the numbers to life with anecdotes.

These examples, along with the insights from experts, and the author's friendly tone, make "How Finance Works" accessible to readers who wouldn't usually pick up a book like this. We wouldn't say it's an easy read. If finance isn't your thing, you're going to have to focus, think, and perhaps re-read sections so it all goes in. There are plenty of charts, graphs, equations, and lists of numbers to digest too.

But overall, Desai has succeeded in his mission to demystify finance and bring in a note of playfulness. He clearly knows his subject like the back of his hand, and his passion shines through. So if you'd like to get a grip on finance, we recommend you give this book a go, and don't forget to check out Mind Tools' other articles and resources on finance.

"How Finance Works: The HBR Guide to Thinking Smart About the Numbers" by Mihir Desai is published by Harvard Business Review Press.

That's the end of this episode of Book Insights. Thanks for listening.