The Finance Gem 2023💎 Week #1

Welcome to this week's edition of The Finance Gem 💎- where I bring you my unabbreviated Linkedin posts you loved, so you can save them, and those posts you missed, so you can enjoy them.

This newsletter edition was sponsored by Financiario - The Financing Advisory Firm for Growing Businesses. Financiario helps growing companies to strategically plan, negotiate, and manage their financing requirements. Their unique expertise in commercial lending, finance and accounting complements and expands the capacity of Controllers, VP Finance and CFOs. Financiario provides ongoing strategic advice, financial models and presentations that help position companies for long term profitability, solvency and liquidity. Check out some case studies on their Blog.

This week at a glance:

• 6 Things you didn’t know about Amortization.  

• EBITDAC vs EBITDAR vs. EBITDA vs. EBIT 

• Gross Margin is Not Contribution Margin. 

• Operating vs. Financial Leverage

• Your Operating Lease can Build or Break your EBITDA ratios

Without further ado, let's begin:

1️⃣ It’s confusing.

In finance, it refers to the repayment of a loan over time.

In accounting, it means expensing or writing off the cost of an intangible asset over time.

2️⃣ It’s not always regular.

In personal finance, the amortization of a loan is always done through regular payments throughout the life of the loan.

In commercial finance, the payments can be regular or irregular, tailored to the cash flow patterns of the business.

3️⃣ It’s not always necessary.

Loans can be amortizing or non-amortizing.

With an amortizing loan, you pay back the loan balance gradually over time.

With non-amortizing loans, you only pay interest throughout the loan term and repay the principal amount through a lump sum at the end.

4️⃣ It can be tricky.

Amortizing loans can be repaid through either blended payments or Principal + Interest payments.

Blended payment arrangements establish equal monthly payments of principal and interest over an agreed-upon amortization period.

Principal + Interest arrangements establish a fixed principal payment amount every month and a variable interest payment amount on top of that.

Guess which option makes the lender the most money?

It's the Blended repayment schedule. On a $2.6MM loan with an average rate of 6%, the lender would make about $460,000 more by signing a client up on a blended vs P+I loan.

And now you know what repayment schedule to choose to keep that money in your own pocket.

5️⃣ It’s complex.

The accounting of loans amortizing through blended payments requires you to:

✅ split every blended payment and estimate the principal and interest amounts

✅ apply the principal payment to reduce the associated liability

✅ expense the interest cost.

Beyond these regular accounting entries, year-end adjustments are almost always needed to bring the ending period loan balances in line with the lender statement.

6️⃣ It’s critically important.

There are multiple financial implications for loan amortizations:

✅ they reduce free cash flows available to service other debt, invest in business growth, or fund capital distributions to shareholders.

✅ they increase the risk of default of the business.

✅ they require careful cash flow planning to ensure adequate funding of payments.

✅ they require careful budgeting to ensure the business generates adequate profits to afford the payments.

Do you know what they are and how to use them?

1️⃣ EBITDAC = Net Income (Net Earnings) + Interest + Taxes + Depreciation + Amortization + Coronavirus

⚫ Newest EBITDA offspring, used to assess profitability independent of the company’s capital structure, tax circumstances, and effects of the Covid-19 Pandemic.

⚫ Key uses: business valuations, mergers & acquisitions deals, banking/lending transactions

⚫ Key metrics: EBITDAC/(Principal + Interest), EBITDAC/Interest, EBITDAC/Revenue

2️⃣ EBITDAR = Net Income (Net Earnings) + Interest + Taxes + Depreciation + Amortization + Rental Payments

⚫ Used to assess profitability independent of the company’s capital structure, tax circumstances, and choice of asset financing methods.

⚫Under an operating lease, a company is obligated to make a series of minimum annual lease/rental payments for the use of an asset. Depending on the accounting standards followed, for some companies the asset may not appear on the balance sheet, and no related debt obligation may be capitalized.

⚫When the annual lease/rental payment is significant in relation to the total annual debt payments, EBITDA is then adjusted to reflect the company’s net earning capacity to service both the capitalized debt obligations and leases.

⚫ Key uses: business valuations, mergers & acquisitions deals, banking/lending transactions

⚫ Key metrics: EBITDAR/(Principal + Interest + Lease Payments)

3️⃣ EBITDA = Net Income (Net Earnings) + Interest + Taxes + Depreciation + Amortization

⚫ Used to assess profitability independent of the company’s capital structure and tax circumstances.

⚫ Often adjusted to eliminate other non-cash expenses like stock compensation, provisions, and gains/losses on asset sales.

⚫ Key uses: business valuations, mergers & acquisitions deals, banking/lending transactions, management

⚫ Key metrics: EBITDA multiples, Enterprise Value EV/EBITDA, EBITDA/(Principal + Interest), EBITDA/Interest, EBITDA/Revenue

4️⃣ EBIT = Net Income (Net Earnings) + Interest + Taxes

⚫ Used to assess profitability independent of the company’s capital structure and tax circumstances.

⚫ Mostly used in industries where company operations don’t rely on a large asset base that requires consistent maintenance and significant leverage costs.

⚫ Key uses: business valuations, mergers & acquisitions deals, banking/lending transactions, management

⚫ Key metrics: EV/EBITDA, EBIT/ Interest, EBIT /Revenue

The Gross (Profit) Margin (GM) is the sales price of a product or service, less all its direct costs (COGS or COS) expressed as a percentage of sales.

☑️ Gross (Profit) Margin (GM) is a ratio calculated in percentages (%).

Gross Margin = Gross Profit / Revenue = (Revenue - COGS)/Revenue

The Contribution Margin (CM) is the sales price of a product or service, less all its variable costs (direct materials, direct labor, and indirect product costs).

☑️ Contribution Margin (CM) is (despite its name which suggests a ratio) a measure of absolute value calculated in currency units ($).

Contribution Margin (CM) = (Sales Price per unit - Variable Cost per unit)

⚫The Contribution Margin (CM) represents the incremental profit per unit earned on the sale after covering variable costs (direct materials, direct labor, and variable overhead/indirect product costs).

⚫ It is used to understand the total revenues required to cover all fixed costs and break even, or earn a certain amount of profit in the business.

You have 2 main Controls to improve Business Profitability and avoid Distress.

Many companies use them jointly to compound profitability and growth, but they can be as deadly as they are attractive.

Do you know what they are?

𝗢𝗽𝗲𝗿𝗮𝘁𝗶𝗻𝗴 𝗟𝗲𝘃𝗲𝗿𝗮𝗴𝗲 𝗮𝗻𝗱 𝗙𝗶𝗻𝗮𝗻𝗰𝗶𝗮𝗹 𝗟𝗲𝘃𝗲𝗿𝗮𝗴𝗲.

They have the power to amplify the company's earnings in both directions.

➡️ Modest increases in revenue can greatly enhance earnings.

➡️ Modest drops in sales can trigger dramatic losses.

1️⃣ 𝗢𝗽𝗲𝗿𝗮𝘁𝗶𝗻𝗴 𝗹𝗲𝘃𝗲𝗿𝗮𝗴𝗲 𝗶𝘀 𝗽𝗿𝗼𝗱𝘂𝗰𝗲𝗱 𝘁𝗵𝗿𝗼𝘂𝗴𝗵 𝘁𝗵𝗲 𝘂𝘀𝗲 𝗼𝗳 𝗳𝗶𝘅𝗲𝗱 𝗼𝗽𝗲𝗿𝗮𝘁𝗶𝗻𝗴 𝗲𝘅𝗽𝗲𝗻𝘀𝗲𝘀 (𝘀𝘂𝗰𝗵 𝗮𝘀 𝗿𝗲𝗻𝘁 𝗼𝗿 𝗱𝗲𝗽𝗿𝗲𝗰𝗶𝗮𝘁𝗶𝗼𝗻).

➡️High fixed costs >> Low variable costs >> High Gross Margins >> High Operating Leverage

➡️The more fixed costs a company has, the more sales it needs to generate to cover them which introduces significant risk in the business.

➡️However, after covering fixed costs, most of each new dollar of sales trickles into profit.

➡️For operating leverage to be beneficial, the company must be operating above its breakeven point (sales - variable costs > fixed costs)

2️⃣ F𝗶𝗻𝗮𝗻𝗰𝗶𝗮𝗹 𝗹𝗲𝘃𝗲𝗿𝗮𝗴𝗲 𝗶𝘀 𝗽𝗿𝗼𝗱𝘂𝗰𝗲𝗱 𝘁𝗵𝗿𝗼𝘂𝗴𝗵 𝘁𝗵𝗲 𝘂𝘀𝗲 𝗼𝗳 𝗯𝗼𝗿𝗿𝗼𝘄𝗲𝗱 𝗰𝗮𝗽𝗶𝘁𝗮𝗹 𝘄𝗵𝗶𝗰𝗵 𝗴𝗲𝗻𝗲𝗿𝗮𝘁𝗲𝘀 𝗳𝗶𝘅𝗲𝗱 𝗳𝗶𝗻𝗮𝗻𝗰𝗶𝗮𝗹 𝗰𝗼𝘀𝘁𝘀 (𝘀𝘂𝗰𝗵 𝗮𝘀 𝗶𝗻𝘁𝗲𝗿𝗲𝘀𝘁 𝗲𝘅𝗽𝗲𝗻𝘀𝗲).

➡️Financial leverage picks up where operating leverage leaves off.

➡️The higher the leverage, the higher the potential benefits (tax deductibility, lower cost of capital compared to equity, higher investment returns, higher potential shareholder value created) and potential risks (bankruptcy, financial distress, decreased valuation).

➡️Financial Leverage is typically measured with the use of leverage ratios like Debt to Equity, Debt to Assets, or Debt to EBITDA.

➡️For financial leverage to be beneficial, the interest rate on the debt must be less than the return on assets.

Together, Operating Leverage and Financial Leverage make up the Degree of Total Leverage.

➡️ During periods of economic slowdown, a high degree of leverage can greatly increase business risk and its probability of financial distress.

➡️What can you do? Consider:

☑️paying down debt or refinancing to reduce fixed payment obligations – seek principal payment vacations, seek loan restructuring to allow irregular payments, sell non-core assets and use the proceeds to reduce debt load by selling non-core assets and using proceeds to repay loans.

☑️temporarily switching fixed expenditures to variable as appropriate – outsource services which you previously had in house, sell and lease back assets as suitable, consider buying where you previously manufacturing your own inputs.

Even in the advent of IFRS 16.

☑️ New accounting standards have started a new era in Lease Accounting, by requiring the capitalization of assets and liabilities which previously eluded the balance sheet under operating leases.

☑️ However, there are still fundamental benefits for companies to consider operating leases for their capital financing needs, as opposed to finance (capital) leases or outright (cash) purchases.

Here are 3 benefits of leveraging operating leases for your growing business:

1️⃣ Unfunded CAPEX reduces your Coverage Ratios (modified Debt Service Ratio or Fixed Charge Coverage Ratio)

☑️ Any fixed asset purchase that isn’t financed with a lease or a loan consumes the company’s cash upfront, which reduces cash available for servicing debt obligations.

☑️ Using operating leases for the financing of fixed assets can help you avoid this significant challenge, keeping your business coverage ratios within healthy limits.

2️⃣ Leasing can dramatically improve productivity.

☑️ Unlike owned assets, assets leased through operating leases can be more easily traded back for upgrades, or disposed of on the secondary markets.

☑️ With an operating lease your company can avoid technological obsolescence and ensure it constantly benefits from technology advancements in support of business productivity improvements.

Why does that matter?

☑️ Because productivity upgrades improve output, lower costs, increase EBITDA and improve business coverage ratios.

3️⃣ Leasing supports longer financing amortization terms.

☑️ Operating leases are provided by specialized market players.

☑️ They know the market, they understand resale values, and they own the assets leased to you.

☑️ That means they can leverage all these benefits in the pricing of the leased asset, and they can transfer these benefits over to you as the lessee in the form of longer financing terms, and potentially lower interest rates as well.

☑️ With longer financing terms, the asset you now must capitalize (thank you IFRS 16) gets depreciated over a longer period, lowering annual financing and depreciation expenses.

☑️ While that doesn’t impact EBITDA, it definitely impacts the total Principal and Interest payment obligations to be serviced in the period, and therefore improves your business coverage ratios.

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