The Finance Gem 2023💎 Week #2

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 is brought to you by Nicolas Boucher. Nicolas is one of the top Finance and Accounting content creators on Linkedin today, and the author of the highly-recommended course Become a High-Performing Finance Professional. If you're an ambitious finance professional who wants to become irreplaceable in today’s job market, check out Nicolas's highly recommended course or check out his newsletter. He also posts a wealth of practical finance tips and actionable FP&A advice regularly on Linked, so make sure you follow him so you don't miss out.

This week's highlights at a glance:

• Does Free Cash Flow FCF care about Working Capital?  

• Blended vs. P+I Loan Amortization 

• The CFO Dashboard  

• Your Adjusted EBITDA is Not Cash Flow 

• Plans vs. Budgets vs. Forecasts vs. Pro Formas vs. Projections

Without further ado, let's begin:

Absolutely. All cash flow measures do. But why?

⚫Free Cash Flow FCF is Operating Cash Flow OCF adjusted for the Net Changes in Fixed Assets.

⚫And Operating Cash Flow OCF is Net Income adjusted for Non-Cash items, Depreciation and Amortization, and Net Changes in Working Capital.

So putting these together:

⚫Free Cash Flow FCF is:

= Net Income

+ Depreciation/Amortization

+/- Non-Cash Items

+/- Changes in Working Capital

+/- Changes in Fixed Assets

Because Net Working Capital is being adjusted out, it’s clear that Free Cash Flow cares deeply about Working Capital.

Here’s why:

1️⃣ The cash invested into Inventory and Accounts Receivable is not available for the company to put to other uses.

⚫️ As Inventory is sold and turned into Receivables, and Receivables are sold and turned to Cash, the amount of cash invested in working capital assets (or Net Working Capital) during the year will change.

⚫️ It’s important to remember that the timing of the Net Working Capital measurement can have a magnifying or minimizing effect on Free Cash Flow, so time your reporting wisely.

2️⃣ A company’s net earning potential is directly reduced by its working capital requirements.

⚫️ When a company’s ability to grow Revenues is dependent on it growing its Net Working Capital first, Free Cash Flow will reflect that.

⚫️ The company’s capacity to scale earnings and service debt will not grow in line with topline Revenue, because part of the newly generated cash will stay invested in the current assets that power those revenues.

⚫️ The company’s DCF valuation, calculated by further adjusting FCF to arrive at FCFE and then discounting those cash flows, will also reflect the true cash flow generation power of the business.

I recently saved a client exactly $504,475.99 in interest costs. 

Over half a million dollars.

I’ll show you exactly how I did it, so you too can help your clients make better financing decisions.

➡️The trick is to understand one simple finance concept: Loan Amortization.

Let me explain:

☑️ Term Debt can be repaid via regular payments (amortized) or one bullet repayment at the end of the loan (non-amortized).

☑️Amortized loans can be repaid via regular Blended payments or a Principal + Interest payments.

>>Blended payments are calculated the way you would expect the use the PMT function in Excel.

⚫ PMT (interest rate for the period, number of periods, loan amount). There isn’t usually a residual amount left at the end of the period, so the FV in the formula is 0.

⚫ The payment remains the same for however long the interest rate is guaranteed.

⚫ Commercial interest rates can be fixed or variable, guaranteed by the lender for 1 to 5 years, or up to 25 years in special hedging arrangements.

⚫ The proportion of principal payments in the total payment will vary over the term. At first, most of the payment amount will be made up of interest costs. As the loan balance is paid down, the interest portion of each payment will also drop.

>>Principal + Interest payments are calculated by dividing the loan amount by the number of repayment periods and establishing a regular principal payment amount.

⚫ At the beginning of each payment period, interest is calculated on the outstanding loan balance and added to the fixed principal repayment to make up the total loan repayment for the period.

⚫ For P+I payments, the principal amount stays fixed, unlike blended payments where the entire payment stays fixed.

⚫This results in an accelerated repayment of the loan via principal payments, and major overall interest cost savings over the life of the loan.

⚫ There are two major challenges to be aware of with Principal + Interest payments:

➡️the added initial cash flow pressures due to higher upfront total payments compared to the blended amortization alternative

➡️the added challenge of budgeting for a total payment amount which isn’t fixed and is decreasing from one period to the next

Ok, so here’s the overview of the transaction where my client financed a commercial property through a term loan with a Principal + Interest amortization schedule:

>>Loan Amount: $2,625,000

>>Annual interest rate: 6.29%

>>Amortization term: 25 years

>>Total Interest Cost over period (Blended payments): $2,650,938

>>Total Interest Cost over period (P+I payments): $2,146,463

Total Interest Cost savings from P+I vs Blended payments: $504,475.99

Click in the box below to access and download a copy of the Excel template including the two loan amortization tables and associated charts. Remember that model inputs are color coded blue.

A strong business cash culture starts at the top.

It starts with CEOs and CFOs making cash and capital efficiency metrics a top company priority, on an equal footing with profitability and P&L metrics.

➡️ Good cash management helps companies navigate downturns.

➡️ It also helps them maximize growth opportunities like expansions or M&A activity.

➡️ So here's my improved recommended CFO KPI dashboard., tracked across 3 critical areas:

✅ working capital ✅ expenditures ✅ financial health

➡️ Use it to advance your organization's strategic objectives, around:

✅cash flow ✅profitability ✅financial health

Click in the box below to access and download a copy of the Excel template for CFO Dashboard. Customize it with your data and turn it into a real financial dashboard.

Your Adjusted EBITDA is Still Not Cash Flow.

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. These are future cash payment obligations, and while it can be argued they shouldn’t reduce current EBITDA, the year-over-year changes in these might at some point.

2️⃣ Non-operating income

This is usually passive income which isn’t related to the company’s core operations. 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. Paper gains and losses don’t belong in EBITDA.

4️⃣ One-time revenue or expenses

These are the result of non-recurring transactions. If they aren’t repeatable and the objective is to assess the economic value of recurring cash flows, they may not belong in EBITDA.

5️⃣ Foreign exchanges gains or losses

These are the result of foreign exchange transactions outside the company’s core operations. If the company isn’t an FX boutique or exchange, FX gains and losses shouldn’t be part of the company’s EBITDA.

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 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. 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. If they aren’t repeatable, they probably don’t belong in EBITDA.

9️⃣ Owner compensation in excess of market value

In private companies, owners often 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 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)

Plans vs. Budgets vs. Forecasts vs. Pro Formas vs. Projections

They’re not all created equal or equally useful.

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

🎯 A plan is a set of intended actions for achieving specific goals or objectives.

🎯 A budget is a financial plan that allocates resources to specific activities or projects.

🎯 A forecast is a financial statement predicting future financial performance based on historical data and credible assumptions.

🎯 A pro forma is a financial statement forecasting the results of a company’s anticipated transaction.

🎯 A projection is a financial statement forecasting future performance based on a set of clear assumptions about future events or conditions.

🔖Here’s an example:

➡️ A plan would outline the steps to $35 million in Revenues and $5 million in EBITDA.

➡️ A budget would allocate financial resources across the various company departments to achieve these goals.

➡️ A forecast would estimate the annual financial results based on the company’s historical data, historical trends, current weighted pipeline and outstanding backlog.

➡️ A proforma would present the impact on EBITDA if Revenues increased to $45 million per year. Or the impact of a new debt financing round on the company’s financial ratios.

➡️ A projection would estimate the annual financial results assuming interest rates and inflation both climbed to 8%. Or assuming the USD/EUR foreign exchange rate dropped to 0.85

1. Sponsor this newsletter, to promote your work and be of service to our highly engaged professional community made up of CFOs, CEOs, CPAs, MBAs, and other executive leaders.

2. Forward this newsletter, because if you enjoyed it, your network would probably enjoy it too. Send it to your friends and colleagues to share the knowledge. They'll appreciate you, and you'll also be helping me fulfil my personal mission to inspire and support business professionals around the world to become strategic in their understanding and use of finance.

3. If this email was forwarded to you, subscribe to receive it in future.