Soapbox

August 15, 2014 5:47 pm

Financial illiteracy rampant in the corporate world

Business schools must put finance in a broader context for a new generation of executives

Six years after the global financial crisis began, financial illiteracy remains rampant in the corporate world. This is a dangerous state of affairs and business schools are partly to blame.

Business schools themselves contributed to the 2008 crisis – not by teaching too much finance, but by teaching too little. Instead of regarding finance as a central part of any business like leadership, innovation or strategy, far too many schools saw it as a narrow technical subject or a geeky sideshow. For many non-finance executives, a finance course was a bit like a dose of cough medicine – not pleasant, but only to be taken once and then quickly forgotten.

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This narrow approach to finance had serious consequences. In particular, a lack of finance knowledge made it harder for non-financial managers and independent board members to prevent the numerous corporate and financial collapses before and during the crisis.

Six years on, the situation has not improved much, if at all. Business schools urgently need to put finance in a broader context and to start educating a new generation of more financially literate executives, but very few are doing so. This means far too many managers are still frighteningly unaware of the financial consequences of their decisions.

Even experienced executives with profit-and-loss responsibility often cannot distinguish profit from cash, or an income statement from a balance sheet. And the majority of executives from junior level to the C-suite do not know their company’s cost of capital – as revealed by my own surveys in recent years of more than 1,000 managers before they started a programme at IMD. Too many bosses obsessively pursue growth and destroy value for their company, often through ill-advised mergers and acquisitions, without properly analysing whether the returns exceed the cost of capital.

Executives who do not understand finance are harming their own career prospects and storing up future disasters for their companies. These managers are less able to discuss financial performance and investment decisions with operations, marketing, human resources, IT and other departments. And they are less willing, or even afraid, to ask the important questions that could help them to avoid wrong decisions, so their companies’ internal controls are weakened as a result.

Business schools must emphasise that financial literacy is a requirement for managers at all levels and not just for chief financial officers, accountants and treasurers. And this process does not just involve teaching basic concepts such as accounting ratios and terminology. After all, managers can learn about these in a textbook or on a massive open online course.

Where business schools can really add value is by getting executives to apply these concepts to their daily jobs. This means using them in their decision making, and understanding the financial impact of their many day-to-day managerial choices. The learning process does not need to be complex or painful and classroom discussion between executives is an especially valuable part of it.

In particular, managers should focus on the principles of cash flow based management. In other words, the value of assets today – whether capital investments, real estate, or even companies themselves – should correspond to expected future cash flows. The financial crisis has shown us what happens if those principles are ignored.

Armed with this understanding, managers at all levels will know how to make better decisions about investments, financing (loans, bonds and equity markets), managing risks, growth versus profitability and the costs of having an inadequate capital structure.

At the same time, business schools should make financial specialists much better at connecting with the rest of the business and at linking finance to overall company strategy. They could do this, for example, by offering more programmes for financial executives on business partnering skills such as leadership, communication and interpersonal skills.

But business schools’ top priority must be to raise the overall level of financial literacy within companies, so that executives better understand the risks posed by bad decisions.

Like any field, finance has its own language. If executives do not start learning that language today, their job or their company could be at risk tomorrow.

The coming decades will hopefully see further improvements in basic literacy, as more and more of the world’s population learn to read and write. Financial literacy is also crucial for future prosperity and business schools must do much more to promote this.

The author is a finance professor at IMD and is the author of “Finance for Executives: A practical guide for managers”.

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