The Finance Gem 2023💎 Week #12

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

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This week's strategic finance insights:

• The Financial Analysis Scorecard

• 7 Finance and FP&A Skills you need to Learn for Management Roles

• Your Adjusted EBITDA is Not Cash Flow

• Financial Analysis is critical to your success

• The Cash Conversion Cycle (CCC)

Without further ado, let's begin:

Here is my recommended Financial Analysis Scorecard to help guide your analysis.

Key components to include:

1️⃣ Horizontal (trend) analysis

🎯 How to perform: calculate financial statement elements over several years relative to a base year or the prior year (historical sales year over year or historical sales relative to current year) to identify trends and patterns

2️⃣ Vertical (common size) analysis

🎯 How to perform: calculate financial statement elements as a percentage of total assets (for balance sheet) or total revenues (for income statement) to identify meaningful changes between periods

3️⃣ Ratio analysis

🎯 How to perform: calculate both individual and collective ratios depending on your objectives (financial health vs covenant compliance

🎯 Remember that there are several formula variations for some ratios, and formula components are dependent on accounting standards used, making them less comparable across international jurisdictions

🎯 There are 4 main ratio categories: profitability, efficiency, liquidity and solvency

⚫ Profitability ratios measure the business ability to earn adequate returns and employ resources effectively

⚫ Efficiency ratios measure the efficiency of business operations in turning assets into cash

⚫ Liquidity ratios measure the business ability to cover short term obligations with current assets

⚫ Solvency ratios measure the business debt levels and ability to service that debt

4️⃣ Sensitivity & Scenario analysis

🎯 How to perform: change one or multiple variables in the analysis to determine what the impact would be on key metrics

5️⃣ Cash Flow analysis

🎯 How to perform: calculate cash flow from operations, investments and financing, as well as free cash flows, to understand cash flow sources, adequacy and availability to meet critical business obligations and achieve key business objectives.

1️⃣ Understanding financial statements

🎯 Objective: evaluate your organization's or unit’s financial health, identify red flags, measure and monitor performance, allocate resources effectively

🎯 Skills to learn:

>> read and interpret financial statements

>> horizontal (trend) analysis

>> vertical (common size) analysis

2️⃣ Analyzing ratios and metrics

🎯 Objective: condense and analyze complex financial information to understand business risks and opportunities

🎯 Skills to learn:

>> liquidity ratios (e.g. current ratio)

>> profitability ratios (e.g. gross margin)

>> solvency ratios (e.g. debt-to-equity ratio, debt coverage ratio)

>> efficiency ratios (AR/AP/Inventory/Asset turnover)

>> cash flow analysis (operating, financing, investing, free cash flow to equity, EVA)

>> ratio trend analysis

3️⃣ Preparing/Reviewing budgeting and forecasting

🎯 Objective: plan as well as estimate future financial performance based on historical data, trends, pipeline, backlog, and other financial/non-financial information

🎯 Skills to learn:

>> incremental budgeting

>> activity based budgeting

>> zero based budgeting

>> statistical analysis

4️⃣ Cost Analysis

🎯 Objective: understand cost behavior and how changes in volume and mix affect profitability

🎯 Skills to learn:

>> cost-volume-profit analysis

>> direct vs indirect costs

>> product vs period costs

>> direct vs indirect costs

>> costing methods

5️⃣ Investment analysis

🎯 Objective: evaluate the risks and returns of potential investments

🎯 Skills to learn:

>> net present value

>> internal rate of return

>> payback period

6️⃣ Presentation and communication

🎯 Objective: impact and influence to coordinate resources and achieve results

🎯 Skills to learn:

>> financial storytelling

>> effective listening

>> impact and influence

>> adaptive leadership

>> change management

>> effective performance management

>> team management

>> strategic thinking

7️⃣ Risk assessment

🎯 Objective: identify, assess, evaluate and respond to financial risks impacting your organization

🎯 Skills to learn:

>> market risk

>> credit risk

>> liquidity risk

>> operational risk

Here are 10 sneaky EBITDA Adjustments to be aware of. Depending on the side you're playing for, you may find yourself arguing pro or against these:

1️⃣ Provisions

⚫ Guarantees. Future tax obligations. Asset Retirement Obligations. Asset impairment. Losses. Pensions. Severance costs.

The traditional view is that these aren’t actual obligations and should be added back to EBITDA, especially when a lot of management assumptions which could later be provide incorrect are involved in determining the provisioned amounts. Others however believe that provisions represent real anticipated expenses and should be included.

2️⃣ Non-operating income

⚫ This is usually passive income which isn’t related to the company’s core operations.

Most parties will agree that if the company isn’t actively in the business of generating that income, it shouldn’t be part of the company’s EBITDA.

3️⃣ Unrealized gains or losses

⚫ These are increases or decreases in the value of an asset or a liability that has not yet been sold or settled.

The typical view is that paper gains and losses don’t belong in EBITDA, while others believe declines in asset values are extremely relevant for current and future profitability and should in fact be included.

4️⃣ One-time revenue or expenses

⚫ These are the result of non-recurring transactions.

The typical view is that because they aren’t repeatable they do not belong in EBITDA. However, others may seek evidence to prove the contrary and support that what appears to be a one-time event will actually repeat in the next period.

5️⃣ Foreign exchanges gains or losses

⚫ These are the result of incidental transactions outside the company’s core operations.

If the company isn’t an FX boutique or exchange, FX gains and losses typically aren’t part of the company’s EBITDA. This becomes a contentious topic when FX gains are claimed to be the result of purposely crafted and implemented FX hedging strategies

6️⃣ Goodwill impairment

⚫ This is a decrease in the value of goodwill reported following an acquisition.

While this indicates concerns regarding the original price paid in the acquisition, it is still typically considered a “paper loss” that doesn’t belong in EBITDA.

7️⃣ Asset write-downs

⚫ These are decreases in the value of an asset, usually following non-recurring events like sharp technological advancements that rendered a machine obsolete ahead of its time.

The usual consensus is that because they’re non-cash, they don’t belong in EBITDA.

8️⃣ Litigation or insurance expenses outside the regular course of business.

⚫ These are the result of non-recurring transactions such as one-time lawsuits, large financing deals or outlier commercial contracts.

Some will argue that if they aren’t repeatable, they don’t belong in EBITDA.

9️⃣ Owner compensation over/under market value

⚫ In private companies, owners often don’t pay themselves a fair salary, or they pay themselves more than a comparable executive role would pay an employee.

A buyer will usually adjust the owner’s salary to level up to the market and will impact EBITDA upwards or downwards in the process.

🔟Share-based compensation

⚫ “If options aren’t a form of compensation, what are they? If compensation isn’t an expense, what is it? And if expenses should not go into the calculation of earnings, where in the world should they go?” (Warren Buffett)

Some will argue that these aren’t actual cash outflows while others will maintain that they are real expenses incurred to attract and retain executive level talent.

Financial Analysis is critical to your success.

🎯 if you’re an accountant or finance professional, it will help you understand which key key metrics to monitor and manage to help your organization achieve its objectives

🎯 if you're a manager, it will help you better understand your organization’s performance results and capital investment criteria, which will help you align individual and organizational goals across your team and maximize your effectiveness.

🎯 if you’re an employee, it will help you better understand the priorities and performance drivers of your organization, so you can make better decisions for your own professional and career goals.

🎯 if you’re an investor, it will help you better understand the level of aggressiveness behind management decisions, the drivers and sustainability of the business cash flows, and whether an investment aligns with your strategic objectives.

🎯 if you’re an owner, it will help you make more informed decisions and allocate resources in your company more effectively.

**Here are 10 benefits of Financial Analysis to keep in mind:**

1️⃣ Informed decision-making: use data to drive decisions that optimize your operations, drive profitability, and promote sustainable growth.

2️⃣ Performance evaluation: assess your organization's performance in key areas, such as liquidity, solvency, profitability, and efficiency, and enable management to identify improvements areas.

3️⃣ Resource allocation: optimize your resource allocation by ensuring that your investments are geared towards projects and activities that generate the highest returns.

4️⃣ Risk management: identify and mitigate potential risks, such as credit risk, market risk, and operational risk, which can negatively impact your organization's financial stability, sustainability and capacity to remain a going concern operation.

5️⃣ Strategic planning: develop and refine your long-term strategies, set realistic goals, and align your operations with your strategic objectives.

6️⃣ Cost control: monitor and manage your costs effectively, with a focus on identifying inefficiencies, implementing cost-saving measures and optimizing your cost structure.

7️⃣ Benchmarking: compare your performance against industry standards or competitors, to identify the areas where you have a competitive advantage and those where you need to improve.

8️⃣ Compliance: ensure your compliance with regulatory requirements and financial reporting standards, as well as align with industry best practices.

9️⃣ Stakeholder relations: communicate your organization’s financial health test results and financial performance achievements to investors, lenders and other stakeholders, to develop confidence and attract capital under competitive terms.

🔟 Early warning system: identify potential performance issues, contractual agreement breaches or unfavorable trends before they escalate into significant problems, to enable timely intervention and course correction.

☑️ What is the CCC:

🎯 a cash flow KPI used to evaluate the efficiency of your company's working capital management

🎯 an essential tool to understand how effectively your company is managing liquidity and cash flow

☑️ How to calculate the CCC:

CCC = DIO + DSO - DPO

🎯 Days Inventory Outstanding (DIO) = the average number of days it takes your company to sell its inventory

= Average Inventory / Purchases x 365

>> Simplified formulas use COGS instead of Purchases in the denominator

>> Purchases = Ending Inventory - Opening Inventory + COGS

🎯 Days Sales Outstanding (DSO) = the average number of days it takes your company to collect payment from customers

= Average Accounts Receivable / Credit Sales x 365

🎯 Days Payable Outstanding (DPO) = the average number of days it takes your company to pay suppliers for goods and services received

= Average Accounts Payable / COGS x 365

☑️ What the CCC means:

🎯 Your Inventory is outstanding from the moment you receive (or take title) of the product and until you sell it to your customer(s)

🎯 Your Payables are outstanding from the moment you receive your supplier’s invoice until the time when you pay that invoice

🎯 Your Receivables are outstanding from the moment you invoice your customer until the time your customer pays you

🎯 The CCC measures the length of time from Cash Out to Supplier to Cash In from Customer

☑️ How to use the CCC:

🎯 Track over periods, compare against historical and forecasted results, use to forecast future cash availability, compare with peers

🎯 The shorter the CCC, the faster your company converts inventory into cash, the better your liquidity, efficiency and operating cash flow

🎯 The longer the CCC, to the longer your company takes to collect receivables & pay suppliers, which can result in cash flow issues and potential financial distress

🎯 Negative CCC indicates you’re leveraging your substantial bargaining power with suppliers and strong supply chain management to finance your working capital assets, operations and growth - i.e you only pay suppliers after collecting payment from customers

☑️ How to manage the CCC:

🎯 The correct approach to managing the CCC is focused on optimization:

>> reduce DIO without jeopardizing sales due to stock outs

>> reduce DSO without loosing sales opportunities

>> increase DPO without jeopardizing supplier relationships

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