“Hello Michael,

Thank you for a great website. I posted this to your forum and decided to email you too.

My question relates to understanding financial statements. I have a master’s in political science from a great school but have no clue what is on financial statements. I have an offer from BCG but my question is what would happen when I join. How important is this skill as a consultant, what must I know and how do I learn it. Everyone has a different opinion here.

I don’t want to get kicked out after all the work preparing to get in.

Thank you in advance!

Dasha”

***

Hi Dasha,

Thank you for the email.

I will not touch on case interviews at all since that has no bearing on your performance once you join the firm. The rest of your questions are also easy to answer, but I will take care to explain them since my advice may be counter intuitive.

You need to keep some facts in your mind as we discuss the answers.

Fact 1: Until you make partner at BBM, you are just an apprentice who is still learning the ropes. I don’t mean to sound harsh here, but logic dictates that if there are levels below partnership, capability separates the levels and the highest level is the most capable, then the lower levels are still learning. Moreover, you do not have tenure until you become a partner and there is always a strong chance of being managed out for poor performance.

Most people who claim to understand business finance really only understand the income statement side.

Fact 2: If you cannot understand the financial statements, you cannot understand a business, and cannot best advise management. That is not to say you cannot advise a client on marketing or organizational issues, but at the end of the day unless you can translate this to concrete shareholder value impact, it is just speculation on the ultimate impact that shareholder care about: shareholder value.

Choosing to ignore the balance sheet is like saying you are fluent in Spanish when you only know 10% of the words. I even know a few people who published business books but cannot read a balance sheet.

Fact 3: If you cannot understand the balance sheet, you cannot understand a business, and cannot best advise management. Most people can understand an income statement, and cash flow statement. They are intuitive. These are important of course but the real action takes place in the balance sheet. Most people who claim to understand business finance really only understand the income statement side. A colleague once joined a much respected bank in London and mentioned she was intimidated by all the sharp minds around. My response was to not worry, 90% of the people in her team sound they understand the balance sheet but even very senior people will not know what is happening. 4 months after she joined she regaled me with stories about some of the silly comments made which demonstrated a lack of understanding of the basics of balance sheet analyses.

Choosing to ignore the balance sheet is like saying you are fluent in Spanish when you only know 10% of the words. I even know a few people who published business books but cannot read a balance sheet. I am at a loss how they feel they can help clients create the maximum value, or even test the validity of their assertions.

You will hear countless stories from younger consultants – those very early in their careers, those who left early and those who were managed out early – that they did not need to know finance. Before assuming they are correct, there are a couple of things to understand here.

First, everyone is different. The people making this claim could have very well have picked up the finance knowledge needed quite quickly. So while they did not go through formal training, they picked up the skill on engagements. To say you did not need a skill is quite different from saying you picked up it easily and many people regularly confuse these two points.

Second, let’s look at someone making this claim but this person has yet has never had to analyze a balance sheet or build an economic model. Does this mean finance skills are not important? It is possible this person did not actually get staffed onto an engagement requiring much financial skill. They could have just been designing organizational structures. If so, how can they say they did not need it? Solving a finance problem without deploying finance skills is an example of “not needing it.” It does not mean they should not have used the skill or their results could not have been much better if they had used the skill.

Read that line again. Never being placed on such a tough project where you need finance skills is just good luck. If the person left management consulting too early, the opportunity to use finance skills may not have arisen, or the firm could very well have managed them out because of this lack of skills. In fact, since they never stayed to partnership, they could never know. So be wary of whose advice you take.

Third, many juniors can get away for a few months or even a year without being exposed to financial calculations. It is unlikely but possible. Do not use this one outlier of advice to draw a trend.

Fourth, I know several partners who were slightly weaker on the numbers side. I cannot say they led the most influential parts of the business, nor can I say I interacted much with them. There is a certain perverse logic here. You become a successful partner if clients like you. Let’s define “like”. No one likes a consultant. Given the money paid for a partner’s time, they either perform or are replaced. It is all about who creates the most value for clients and over time, unless you can read that balance sheet and dissect the numbers you will ultimately be leaving opportunities on the table: a process of natural selection. Yet, you can still become partner with an adequate grasp of the numbers. I can assure you many Harvard or Wharton MBA partners who focus on strategy, marketing etc. have a good enough grasp of the numbers but some will be better.

Psychologists should use balance sheets for Rorschach tests. I can assure you no two people are seeing the same thing.

Strategy partners always have a ridiculous grasp of the numbers. We have no choice but to be like this. When a client appoints and works alongside us, not only are we trying to bring value to them, we are also up against our client’s competitors and their armies of consultants. He who knows the numbers and understands the linkages always wins because they can see gaps and strategies others cannot.

Psychologists should use balance sheets for Rorschach tests. I can assure you no two people are seeing the same thing.

Even today, I am a numbers hog. But, I am never tired poring through spreadsheets and data because I like doing it. I always believe in speaking extensively with staff and then comparing this anecdotal evidence with the numbers. You must always do both. It is just naturally the way I operate. I always tell people it is easy to find me in a restaurant. I will be the guy with stacks of annual reports and spreadsheets. I have no problem eating and going through numbers.

Surprisingly many people know the numbers but do not understand the linkages. I know lots of people who can recite the meaning of ROA, EROC, EV, asset dissipation etc, but actually have no idea how to generate meaning from this.

Want to see an example of what I mean? Here is an interaction I had with a candidate, not a client, who wanted to understand why I said approaching a profitability case by cutting costs and raising revenue is flat wrong and I would fail you for it if you faced me in the final round and spouted this wisdom.

This guy took the time to understand the linkages. Most would not. And the scary thing is that this is such a basic concept on the income statement that everyone should understand it, and you can imagine the damage done to client if you do not.

See if you can follow the unedited discussion and extract the counter-intuitive understanding here.

***

Candidate: Relative to other podcasts I was a bit confused about what you are saying here [podcast 122]. I had to listen to it a few times before getting a clearer picture of the implications of what was said. I don’t believe that you are saying that it is “wrong” to explore top line cost reductions when looking at a profitability framework.

Rather you are saying that it depends on the context of the particular case in question. For example, if this case was GM circa 2008 where demand is declining, there is too much capacity in the industry, and the current compensation scheme is not competitive relative to peers. In this scenario the correct analysis would be to focus on reducing top-line costs (i.e. employee compensation) faster than the expected fall in revenue due to reduced production (i.e. due to moral, restructuring costs, etc). in such a case it would not be wise to recommend GM to expand into another industry where they have little comparative advantage (i.e. finance, airline manufacturing) to expand into .

However, if the external conditions are different or there is a market segment that the client has not fully penetrated then a top-line cost focused analysis would be counterproductive. What do you think?

Michael: I am not sure if we are in agreement. I will summarize the concept here. It is not an easy concept that is why so many people make a mistake here.

If a company merely cut its costs to increase profits, it would not grow.

If a company merely focused on revenue to increase profits without cutting costs, it would grow unprofitably.

In the real world, you cannot just pursue one angle.

You have to increase costs since costs must go up to invest in revenue producing initiatives.

However, you know the costs are well used if the return they generate exceeds the original cost incurred.

Therefore, increasing costs is not bad if the returns are there.

In fact, any company is increasing its costs to grow, but the returns are greater.

Therefore, to say you will merely cut costs to increase profits does not take into account what shareholders look for: growth and ROIC.

Cutting costs is not a solution by itself.

Does this make sense?

Candidate: OK, just to be sure that I understand what you are saying:

1. Shareholders always want growth and ROIC

2. To create growth you must increase the total cost

3. As long as the return from the marginal dollar invested is positive, total costs should increase

4. If costs is beneficial if the ROIC is positive.

What I am having a bit of trouble with is understanding how to apply your position to the case where ROIC is negative due to an overinvestment in fixed and/or variable costs. I would find it helpful if you could apply your perspective to GM in early 2008 or another industry currently experiencing overcapacity such as petroleum refining.

Michael: Let’s discuss GM. The most important thing to remember is that you are looking at GM’s aggregate ROIC.

Second, I went through Bloomberg and skimmed GM’s 2004 to 2008 annual reports; costs were driven by retirement costs and finished goods inventory, versus in-process inventory. The first is not a capital fixed cost but just as bad.

The second is more interesting. GM built factories to build products no one wants.

These reinvested savings will show up as a cost on the income statement of the division which received the capital.

That said…

GM’s ROIC across different divisions would be very different. So, it should cut its costs in those areas/divisions where it is not able to produce products earning a marginal positive return.

It should then take that saving and invest it in divisions where the marginal return is positive.

These reinvested savings will show up as a cost on the income statement of the division which received the capital.

Moreover, if the investment works and revenues increase, variable costs will have to go up.

This is what BCG actually recommended and did 3 years ago.

Candidate: I see, that is a very nuanced point you are making. Even if the aggregate ROIC is negative and the firm needs to cut capacity in some divisions, the reallocation of capital will be placed on the costs side of the ledger.

This is counter to intuition that costs have actually decreased due to the company on aggregate getting rid of stuff while it figures out how to invest the proceeds of the released cash flow. If I understand this correctly then the only way costs could decrease from an accounting perspective were if the company began to horde cash, deleverage or increase dividends.

I agree that this is not desirable from a consulting perspective as it is akin to admitting that shareholders have a better use of the firm’s capital than the firm itself. From perspective of an investor that holds a portfolio of companies, some companies will have a higher return than others making the return of capital beneficial under certain circumstances.

Michael: This is not a nuanced point. This just requires the ability to follow a $ though a balance sheet, which is not something people do.

Yes, the savings/capital reallocation must go to the cost side unless it is just sitting as cash or gets displaced to shareholders. Neither option is preferable.

This view is important to understand the life cycle of value. Savings mean little unless you can understand how it is going to be recycled back into the business.

At the end of the day, a company is merely an investment vehicle and needs to do just that.

***

Granted, you will not face an interviewer like me every day that pushes for the deep insights, but this case is also something I do with our corporate finance clients and the failure rate is through the roof.

My point is that it is vital to think deeply about the meaning of even the simplest concepts. Every single person attacking a profitability case assumes they know what they are doing. This discussion indicates how a good understanding of finance can unlock so much more value for clients.

Now ask yourself how you would have done the case: It is 2008 and GM’s profits are down from over-investment in fixed assets and a demand drop. What would you do?

To be clear, “really understanding finance” does not in any way imply you should know more than another person. It means you extract deeper meaning from what you do know.

This goes to the heart of my earlier argument. The average consultant would merely approach this as a plain vanilla case of cutting costs and boosting revenue, naively thinking they are mutually exclusive. The one who really understands finance can tackle the logic above and come out with a much more nuanced strategy.

To be clear, “really understanding finance” does not in any way imply you should know more than another person. It means you extract deeper meaning from what you do know.

Here is something very counter-intuitive. Having an MBA or being trained in finance does not in any way mean someone understands how to read income statements. Think about that for a minute.

Daily we read about financial scandals not because of some sophisticated chicanery, but because investors are sometimes just unable to check even the most basic things due to lack of knowledge. As shocking as this may sound, I have found the same thing with MBAs. Many, in fact the majority, cannot read a balance sheet. Anyone can read an income statement – even a bull. Place a bull in front an income statement bleeding red ink and it will charge it. Place it in front of an income statement in the black and we have a peaceful Zen master.

Lots of people and consultants will tell you how easy it was for them to pick up the finances to analyze and build an income statement and some variation of a cash-flow statement. That is nothing, if not too easy.

Even with MBAs from great schools, most will struggle to read the balance sheet and extract the implications. They can tell you what each item means and loosely the impact, but to understand its implications is a vital skill.

That said, you do not need an MBA or finance degree to read balance sheets or build them. I know many consultants who made partner without this formal degree. They did not have the degree, but they knew how to read balance sheets and help companies. An MBA helps but consulting firms provide sufficient training on the job, though that is harder to pick up given the work load.

In summary:

• You need to understand a balance sheet.

• You need to learn to do this over time.

• Having an MBA would imply you can read a balance sheet. It does not guarantee it.

• You do not need an MBA to learn this skill. You can learn it on the job – though an MBA can make it far easier.

• You will never make a great partner or business person unless you can understand a balance sheet.

• Knowing more about finance is not the same as truly grasping the implications of what little finance you do know – he latter is always preferred.

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Comments

3 responses to How much finance must a BCG consultant know?

  1. Thanks!

  2. Hi Jojo,

    Not a problem. This kind of thinking is about the basics of finance and the strategy of finance.

    To see this kind of thinking in action I would recommend reading McKinsey Quarterly and HBR articles on accounting and corporate finance. BCG Perspectives is also relatively good.

    These three sources analyze finance topics the way I have above.

    Michael

  3. Hi Michael,

    This is interesting. I was wondering if there’s a specific book you’d recommend to better grasp the implications of the balance sheet. I work in finance and it took me a couple of re-reads to get what you were saying.

    Thanks.

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