Financial Intelligence - Karen Berman & Joe Knight
Excellent book. Finance underpins everything, and this explains everything in an approachable, mostly non-technical way. There are a bunch of notes below, but it’s only scratching the surface of what the book includes. Anyone in any position in any organisation would benefit from a read, and it’s one I’ll be re-reading.
General finance concepts
The art of accounting and finance is the art of using limited data to come as close as possible to an accurate description of how well a company is performing.
Numbers are used to make decisions, internally (budgets, capital expenditures, staffing, …) and externally (outside investors, bankers, vendors, customers, …)
For all financial numbers:
- What were the assumptions in this number?
- Are there any estimates in the numbers?
- What is the bias those assumptions and estimates lead to?
- What are the implications?
When the numbers are based on accountants’ assumptions and estimates, then the accountants and finance folks have effective control.
Managers who understand cash flow tend to be given more responsibilities, and thus tend to advance more quickly, than those who focus purely on the income statement.
Be able to identify the biases, assumptions, and estimates means you (and others) will know when your decisions and actions are on solid ground.
You need cash to pay the bills, not profits, because profits aren’t real money.
Matching principle: The costs and expenses on the income statement are those it incurred in generating the sales recorded during that time period (i.e. not based on cash in/out). For example, expense payments may come before or after a sale is made, but are recorded in the period the sale is made.
Accruals: the portion of a revenue or expense item that is recorded in a particular time span.
“Buying stocks is like trying to anticipate who will win a beauty contest. You want to choose not the person who you think is the most beautiful but the person you think everyone else will see as most beautiful.” - John Maynard Keynes
Business decisions
Is free cash flow, EBITDA, or some other measure important in this industry and this company?
Materials and inventory: What if you see a good deal on an important raw material? If you buy a lot of it, the inventory line on the balance sheet increases, the accounts payable line increases. What are the optics of this? Also, may need to draw down its cash, pay for warehousing, even borrow money - so, do you save money?
Customer mix: What if you target smaller businesses as customers? Accounts receivable may rise (less reliable, worse processes), so may end up increasing “bad debt”. Therefore have to increase gross margin to compensate for the increased risk?
Company heath
- Is the company solvent? i.e. assets > liabilities therefore positive owners’ equity?
- Can the company pay its bills? Focus on current assets (particularly cash) vs current liabilities.
- Has owners’ equity been growing over time?
Income statement
A change in one statement nearly always has an impact on the other statements. Every sale recorded on the income statement generates an increase either in cash (if it’s a cash sale) or in receivables. Every payroll dollar recorded under COGS or under operating expenses represents a dollar less on the cash line or a dollar more on the accrued expenses line of the balance sheet. A purchase of materials adds to accounts payable, and so on. Always consider how changing one line on one statement will affect the others.
An internal income statement may or may not include footnotes. If it does, we recommend reading them very carefully. They are probably going to tell you something that the accountants think everybody should be aware of. External income statements usually include many, many footnotes. You may want to scan them: some may be interesting, others not so much.
Unless you’re a financial professional, you can usually ignore items like “amortisation of purchased intangible assets.” Most lines with labels like that aren’t material to the bottom line anyway. And if they are, they ought to be explained in the footnotes.
Sometimes parentheses or negative signs indicate the mathematical difference, not favourable or unfavourable (i.e. a negative COG(S) could be reduced cost (good), but a negative revenue is reduced sales (bad))
Revenue
Revenue is recorded/recognised/booked when the product or service is delivered, not when the bill is paid. As customers have not paid yet, the revenue number does not reflect real money and neither does the profit line at the bottom.
Bonuses should be paid (or not) based on true changes in performance, not on financial manipulation.
Channel stuffing: shipping unordered items to distributors at the end of a quarter (perhaps with “unconditional right” to send the goods back) - boost profits due to more “sales”.
Backlog or bookings: Not-yet-recognised sales, i.e. orders that have been signed but not yet started, or the revenue not yet recognised on partially completed projects. A growing backlog might indicate increasing sales - or it might mean that the company is experiencing production problems. So considering how much of the backlog will convert to sales in a given period of time.
Expenses
What’s included in COGS? The salary of the person who manages the plant that manufactures the product? The wages of the plant supervisors? Sales commissions?
Allocation: Apportionments of costs to different departments or activities
Example: R&D from January to June, sales from July. Is it covered as it’s spent (January to June)? Is R&D amortised over the revenue-generating life of the good (July onwards)? What about R&D expenses that do not result in an asset likely to generate revenue (e.g. improving efficiency)? What are the implications on gross profit per month, on available cash, on decisions about pricing and R&D investment?
Example: A machine with a 12-month maintenance contract. How much of the initial purchase price should be recorded for the month it’s sold?
Once you’re outside of COGS - “below the line” - the level of attention from senior management may be significantly lower.
Sales, general, administrative expenses (SG&A, or just G&A) (although sales and marketing may have its own line)
Depreciation is a noncash expense: it’s already been paid for (CAPEX), so no more money is going out the door.
Amortisation (patents, copyrights, and goodwill) are all assets - they cost money to acquire, and they have value - but they aren’t physical.
Assets are rarely worth what the books say they are worth (e.g. depreciated/amortised over 10 years but no longer valuable due to technological advancement)
“Other income/expense” - usually this is gain or loss from selling assets, or from transactions unrelated to the everyday operations of the business
Taxes
“One-time charge”: extraordinary items, write-offs, write-downs, or restructuring charges. They’re estimates; if too high - that is, if the actual costs are lower than expected - then part of that one-time charge has to be “reversed.” A reversed charge adds to profit in the new time period, so profits in that period wind up higher than they would otherwise have been - and all because an accounting estimate in a previous period was inaccurate.
Exchange rates risk: can hedge, but costs money.
OPEX vs CAPEX + depreciation
Operating expenses show up on the income statement, and thus reduce profit. Capital expenditures show up on the balance sheet; only the depreciation of a piece of capital equipment appears on the income statement.
There are rules about what must be classified where (e.g. any purchase over a certain dollar amount counts as a capital expenditure, while anything less is an operating expense), but the rules leave a good deal up to individual judgment and discretion.
If you argue operating expenses are investments (e.g. in new markets) and won’t start paying off for years, these expenses disappear off the income statement, so profits rise.
It’s best to try and match the expenses of equipment to the revenue that it is used to generate. But depreciation time period is a prediction, a judgement. If a longer period is used, less depreciation from revenue each month, so higher profits. If reassessed and extended suddenly, it looks like a jump in profits, which can boost stock price - but nothing tangible changed. If equipment needs replacing earlier, there’s a sudden hit to profits, so the stock price might plummet.
Profit
Gross profit
Can be greatly affected by decisions about when to recognise revenue and by decisions about what to include in COGS.
Operating profit, or EBIT (or EBITDA)
Some people feel EBITDA is a better measure of a company’s operating efficiency, because it ignores noncash charges such as depreciation altogether.
Net profit
Bonuses can be linked to net profit, leading to fraud (e.g. smoothing, adjusting timing so finances look more stable)
Three possible (legal) net profit boosters:
- Increase profitable sales → takes time
- Reduce COGS → takes time
- Reduce operating expenses (e.g. layoffs) → quick
Contribution margin
= sales - variable cost
If positive, but profit negative (due to high fixed costs): try to increase volume
If negative, the company loses money with each unit it produces - drop product line or increase prices
Balance sheet
In accounting terms, equity (capital from shareholders + profits - dividends) = assets - liabilities
In reality, share price (market capitalisation) = whatever a willing buyer will pay
The market value of a company almost never matches its equity or book value on the balance sheet
Assets
Current assets: turned into cash in less than a year.
Long-term assets: have a useful life of more than a year, are depreciated or amortised.
“Allowance for bad debt” - but many companies use the bad-debt reserve as a tool to “smooth” their earnings, both hiding unexpected losses, or unexpected profits (which might signal management isn’t in control)
Inventory
Forms: finished goods, work-in-process, raw materials
Decrease your inventory, other things being equal, and you raise your company’s cash level. A company always wants to carry as little inventory as possible.
Goodwill and intangibles
Purchase price = asset price + goodwill
Goodwill used to be amortised over 30 years, i.e. it reduces profits. Most physical assets depreciated over less than 30 years, which incentivised overvaluing goodwill and undervaluing assets during acquisition. Now it is no longer amortised (as goodwill value could increase over time), i.e. no reduction of profits. Therefore even higher incentive to acquire “high” goodwill / lower physical asset companies.
Tangible net worth = total assets - intangible assets - liabilities. If negative, worry - if bankrupt, no way to get money back.
Prepaid assets
Prepaid asset e.g. $60,000 prepaid rent. Every month you move $5,000 out of the prepaid-asset line on the balance sheet and put it in the income statement as an expense for rent. That’s called an accrual, and the “account” on the balance sheet that records what has not yet been expensed is called an accrued asset account.
Current vs historic value, mark-to-market
Suppose an asset (e.g. land) has increased in value. If we “mark it up” on the balance sheet to its (predicted/assumed) current value, we can record a profit on the income statement - but cash hasn’t changed, nor has the underlying business, and the profit is not guaranteed. Because of this, typically historic values are used. Sometimes companies “sell” assets to shell companies, allowing them to record a profit.
Current value (mark-to-market) okay if: one, their value must be able to be determined without an appraisal; two, they must be held by the company as short-term investments. Example: stocks and bonds. However, gains and losses are purely on paper. Also, how is “short-term” guaranteed? What happens in a crisis e.g. stock market crash (and recovery)?
Liabilities
Deferred revenue: money that has come in but is as yet unearned (e.g. a prepaid flight ticket, a project in progress)
Cost of capital and replacing higher-cost equity with lower-cost debt: may increase perceived risk, which may increase beta of stock and increase cost of equity further; may also increase debt interest rate demands
Cash
Buffett: evaluates a business on its long-term rather than its short-term prospects; looks for businesses he understands; places the greatest emphasis on a measure of cash flow that he calls owner earnings (the money an owner could take out of his business and spend for his own benefit)
Failure even though profitable: pay its vendors in 30 days, wait 60 days for receipts from its customers - always has to front the cash, an ever increasing amount as sales increase.
Failure even though cash in bank: receives payments before paying its vendors, so positive cash, but costs outweigh sales (not profitable), so survive based on float.
Some companies (over)use commercial paper (short-term loans) to substitute cash, constantly rolling them over, paying minimal interest and keeping minimal cash on hand - but if the market shuts down, or they’re called in… banks in 2008/2009.
Cash flow statement
Less room for manipulation of the numbers on the cash flow statement than on the others.
Cash From or Used in Investing Activities: investments made by the company, not by its owners, e.g. cash spent on capital investments i.e. asset purchases, including investment in acquisitions or financial securities
Cash From or Used in Financing Activities: receives a loan, equity investment, pay off the principal on a loan, share buy back, pay a dividend → if a shareholder invests more money in a company, the cash involved shows up under financing, not investing
Reconciliation: getting the cash line on a company’s balance sheet to match the actual cash the company has in the bank
Building from other statements
You can calculate a cash flow statement by looking at the income statement and two balance sheets. Make “adjustments” to net profit: e.g. accounts receivable (change in receivables from one balance sheet to the next), depreciation (noncash expense). If an asset increases, cash decreases - so we subtract the increase from net profit. With a liability, the opposite is true. If liabilities increase, cash increases too - so we add the increase to net income.
Things to monitor
- Operating cash flow (“cash provided by operating activities”) vs net income
- Inventory trends - more or less efficient?
- Depreciation vs new investment - reinvesting, or cash cow?
- Dividend - reinvesting, or cash cow?
Free cash flow
= operating cash flow - net capital expenditures (purchases of PPE)
Net capital expenditures is almost always a negative number. Ignore the minus sign, just subtract the absolute value of that line from operating cash flow.
Ratios
Any ratio will reflect the estimates and assumptions.
Individual companies typically like to create their own key ratios, depending on their circumstances and competitive situation.
Companies may decide on a particular way of calculating some of the numbers. For example, return on assets: total assets number from the most recent point in time? or “average” total assets from most recent two statements? or “rolling average” from 3+?
Financial folks tend to use 360 as the number of days in a year, just because it’s a round number.
Profitability ratios
Operating margin: A good indicator of how well managers as a group are doing, as nonfinancial managers don’t have much control over the other items (interest, taxes) that are subtracted to get net profit margin.
ROA: An ROA that is considerably above the industry norm may suggest that the company isn’t renewing its asset base for the future.
ROE: Company A may have a higher ROE than Company B because it has borrowed more money.
RONA, ROTC, ROIC, ROCE: Return on net assets, return on total capital, return on invested capital, return on capital employed = NOPAT / (total equity + total interest-bearing debt). NOPAT (net operating profit after tax): How much money the company would have made if it (a) had no debt and thus (b) had no interest costs but (c) had to pay taxes on all of its operating profits. Note: NOPAT represents money earned during an entire year, but total capital is shown for a single point in time, the end of the year (therefore may be better to use an average).
Leverage ratios
Financial leverage (debt): allows a company to grow beyond what its invested capital alone would allow and earn profits that expand its equity base. A business can also deduct interest payments on debt from its taxable income → debt-to-equity.
Operating leverage: the ratio between fixed costs and variable costs; increasing your operating leverage means adding to fixed costs with the objective of reducing variable costs.
Interest coverage = operating profit / annual interest charges.
Operating lease: The lease payments count as an expense on the income statement, but there is no asset and no debt related to that asset on a company’s books. Its apparent asset base will be lower and PPE turnover higher.
Liquidity ratios
Current: Too high suggests the company is sitting on its cash rather than investing it or returning it to shareholders.
Quick: Excludes inventory.
Efficiency ratios
DII, DSO, DPO
Monitor and understand trends for all.
PPE turnover, total asset turnover
Big five
- Revenue growth from one year to the next
- Earnings per share (EPS)
- Earnings before interest, taxes, depreciation, and amortisation (EBITDA)
- Free cash flow (FCF)
- Return on total capital (ROTC), or return on equity (ROE)(if financial firm).
Relationships
(net income / revenue) × (revenue / assets) = (net income / assets)
net profit margin percentage × asset turnover = ROA
CAPEX and ROI
Defined as CAPEX if: 1, large; 2, returns for several years; 3, involves risk.
CAPEX timing may depend on periods of cash availability, not periods of high profits.
The longer the investment outlook, the more estimating is required, hence the higher the risk.
A company adds value for its shareholders only if it earns a risk-adjusted profit greater than what it could have earned by investing that same capital elsewhere. An investor can probably earn 2~4 percent on a treasury bond, so he’ll want a substantially higher return on his equity.
Required rate of return (“hurdle rate”) is often weighted average cost of capital (WACC) (i.e. cost of funding the project) + 2~3% buffer.
Economic Value Added (EVA) = ROTC – WACC
Capital expenditure proposal / business case
- Determine initial cash outlay (may be across multiple years) → note which are estimates
- Project future cash flow (not profit) → the hard bit
- Evaluate future cash flows (payback period, NPV, IRR)
- Strategic fit (also consider alternatives / opportunity cost)
Using IRR exclusively can lead you to favour a quick-payback project with a high-percentage return when you should be investing in longer-payback projects with lower-percentage returns. It’s often best to use both IRR and NPV, plus Profitability index ((NPV + initial investment) / initial investment).
To invest or not to invest
- What is the monthly cash flow return we will get on this?
- Is this the right time to invest? How is our cash flow?
- What is the additional labour cost?
- Ae there better ways we could spend that cash to grow the business?
Sometimes a senior executive might ask you to justify a decision he has already made - “please redo the analysis with “new” information”. Some investments are “no brainers”, such as ensuring equipment required to produce goods is functioning.
Working capital
Throughout the production cycle, the form taken by working capital changes (cash → inventory → receivables → cash) but the amount doesn’t change.
Reduce working capital by: reducing DSO, reducing DII, increasing DPO.
Days sales outstanding
The longer a company’s DSO, the more working capital is required to run the business.
“2/10 net 30” means that customers get a 2% discount if they pay their bill in 10 days and no discount if they wait 30 days
DSO is an average. Do an aging analysis: total receivables under 30 days, total for 30 to 60 days, etc.
Days inventory outstanding
Every item in inventory ties up cash, which means that the cash cannot be used for other purposes.
Reduce inventory by: salespeople sell standard products with limited variation; few product variations for inventory management; reliable machinery reducing downtime requiring backup inventory.
Days payables outstanding
Risks: A company that delays payments may put a key supplier out of business. It may find that suppliers are raising their prices to cover the cost of the additional financing they must line up. It may face slower delivery times and even lower quality, which could delay projects and thus delayed revenue payments based on project completion, creating a downward spiral.
Cash conversion cycle
= DSO + DII – DPO
How much cash it takes to finance the business: sales per day × the number of days in the cash conversion cycle.
Culture
Openness
There’s a simple antidote to politics: sunlight, transparency, and open communication. When people understand a company’s objectives and work to attain them, it’s easier to create an organisation built on a sense of trust and a feeling of community. In the long run, that kind of organisation will always be more successful than its less open counterparts.
Frontline employees and supervisors should know the broad outlines of what the organisation needs so that they can work smarter on the job. The more employees understand the business, the better the business performs.
Are there new KPIs this quarter not because some executive randomly decided it, or because the company’s financial situation had changed? Most people are willing to adapt to a new situation if they understand the reason.
Money Maps
The map traces the entire business process at a fictional company, showing how much of each sales dollar goes to paying the expenses of each department, and then highlighting how much is left over as profit. Try two maps: one for targets, one for actual.
Training
One big obstacle to effective training is the assumption - common at many large companies - that people in responsible positions already know finance. It’s difficult to get people to admit that they don’t know finance. Nobody wants to look dumb in front of his or her peers, bosses, or direct reports. There’s no point in asking people to raise their hands and volunteer for a class. Always include the foundational (not “basic”) elements of finance in every class - how to read an income statement and balance sheet, what revenue recognition means, and what the difference is between capitalising and expensing.