The Finance Gem 2023💎 Week #7

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 & accounting topics:

• 5 Simple Steps to Quickly Analyze an Income Statement

• 20 EBITDA Adjustments to Know, Use, and Beware

• Do you know your Margin from your Markup?

• What is Overhead and how does it drive your EBITDA?

• Maintenance vs. Growth CAPEX

• Did you know your Financial Statements talk to each other?

• 5 𝐊𝐞𝐲 𝐄𝐁𝐈𝐓𝐃𝐀 𝐑𝐚𝐭𝐢𝐨𝐬 𝐲𝐨𝐮 𝐒𝐡𝐨𝐮𝐥𝐝 𝐊𝐧𝐨𝐰

• Are you trying to evaluate a company’s financial performance?

Without further ado, let's begin:

When you analyze an Income Statement, your key objectives should be to determine if the company is earning a profit, to identify trends over time, and to compare with industry benchmarks or competitors.

For a quick trend analysis, here are 5 steps I recommend you take:

1️⃣ Analyze Revenue changes over time

(Sales) Revenue is the money earned by the business during a reporting period.

🎯 The more the Revenue changes throughout the year, the more frequently it should be monitored (weekly, monthly, quarterly and annual)

🎯 Use horizontal analysis to analyze Revenue trending over time.

Year over year change =( Current period/Previous period) - 1

🎯 Remember that Revenue is an accounting metric, so it's useful to review it together with Bookings and Backlog, non-GAAP metrics showing the volume of closed sales awaiting fulfilment (future revenues).

2️⃣ Analyze Other Income changes

Other Income is not Sales Revenue but rather Income derived from activities unrelated to the main focus of the business.

🎯 Use horizontal analysis to analyze Other Income trending over time.

3️⃣ Analyze Gross Profit Margin changes

This is the residual proportion of Revenue left in the business after direct costs (COGS or COS) have been deducted.

🎯 Gross Profit is the dollar value of the difference.

Revenue - COGS = Gross Profit ($)

🎯 Gross (Profit) Margin is the relative difference.

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

🎯 Use horizontal analysis to analyze Gross Margin trending over time.

4️⃣ Analyze Net Profit Margin changes

🎯 This is the residual proportion of Revenues left in the business after direct costs (COGS or COS) as well as Operating Expenses (OPEX) have been deducted.

🎯 Net Profit is the dollar value of the difference.

Revenue - COGS -OPEX = Net Profit ($)

🎯 Net (Profit) Margin is the relative difference.

(Revenue - COGS - OPEX) / Revenue = Net Profit Margin (%)

🎯 Use horizontal analysis to analyze Net Margin trending over time.

5️⃣ Analyze Depreciation expense changes

🎯 This is the regular allocation of the capitalized cost of fixed assets (depreciation) into expenses over their useful lives.

🎯 Capital intensive businesses need to constantly maintain, upgrade and grow their asset base

🎯 At a minimum, the amount of maintenance capital investment should mirror depreciation expense.

🎯 Use horizontal analysis to analyze Depreciation expense trending over time.

1// Provisions and Reserves

🎯 Guarantees. Future tax obligations. Asset Retirement Obligations. Asset impairment.

🎯 These are potential future cash payment obligations, but while they shouldn’t reduce your current EBITDA, the future changes in their associated balance sheet accounts might.

2// Non-operating income

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

🎯 If your company isn’t actively in the business of generating that income, it shouldn’t be part of your EBITDA.

3// Unrealized gains or losses

🎯 These are increases or decreases in the value of an asset or a liability that you haven’t yet sold or settled.

🎯 Paper gains and losses don’t belong in EBITDA.

4// 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.

5// Foreign exchange gains or losses

🎯 These may be the result of foreign exchange transactions outside your company’s core operations.

🎯 Alternatively, if your business is carried out in international markets, FX gains and losses definitely belong in your company’s EBITDA.

6// Goodwill impairment

🎯 This is a decrease in the value of your reported goodwill 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.

7// Asset write-downs

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

🎯 Because they’re non-cash, they don’t belong in EBITDA.

8// 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.

9// Excessive Owner compensation

🎯 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.

10// Share-based compensation

🎯 In the words of Warren Buffet, “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?”

11// Below Market Compensation

🎯 This is general labor compensation above or below the fair market value of what a similar company would expect to pay to manage that type of human capital.

🎯 If there’s a material difference driven by non-arms length arrangements, you should adjust it to align with the market.

12// Personal Expenses

🎯 These are automobile expenses, insurance, legal and professional fees, home utilities, personal telephone, and payroll - all paid for the benefit of your non-arms length third parties

13// Travel and Entertainment Expenses

🎯 This includes your travel and entertainment expenses personal to the business owner and non-arms length third parties, and deemed unnecessary for a new owner to operate the business.

14// Pension Expenses

🎯 This includes your pension expense and other ancillary costs paid for the personal benefit of the business owner and other non-arms length third parties.

15// Professional Fees

🎯 This includes your professional legal, accounting and other advisory fees that another owner wouldn’t be expected to incur.

16// Aggressively expensed/capitalized items

🎯 This includes aggressive accounting decisions driven by your current management decisions, even if they are in compliance with applicable accounting principles.

17// Fair Market Rent

🎯 This includes below or above market rental costs due to your non-arms length agreements, which should be adjusted to reflect a fair market cost.

18// Tax Minimization Strategies

🎯 This includes accelerating expenses and/or deferring income as a result of you implementing basic year-end tax-planning techniques used to manage income taxes.

19// Severance Costs

🎯 This includes costs incurred as part of your one-time reorganization where staff was laid off.

20// Percentage Of Completion Revenues

🎯 This includes the revenues you recognized on long-term contractual engagements based on the percentage of costs incurred relative to the total estimated contractual costs.

🎯 Your high interim EBITDA on Percentage of Completion contracts is always at risk of reversing into losses resulting from underestimated project costs.

▶️Margin shows how much of a product's sales revenue you got to keep.

▶️Markup shows how much over cost you've sold it for.

🎯 Let's dig deeper into each of these:

1// Margin is the proportion of the selling price that exceeds Direct Cost (COGS).

✅ Margin = Gross Profit / Revenue

✅ Margin = Markup /(1+Markup)

Margin (or Gross Profit Margin) is calculated as a percentage. Meanwhile, Gross Profit is calculated as an amount.

2// Markup is the percentage by which the product cost is increased to arrive at the selling price.

✅ Markup = Gross Profit / Product Cost

✅ Markup = Margin / (1-Margin)

Markup can be calculated based on a product's variable cost or based on its total (absorption) cost.

Marking up the variable cost could result in under costing and underpricing the product, which in turn may increase revenues at the expense of reduced profitability and cash flows.

Marking up the absorption cost could result in over costing and overpricing, which in turn could reduce revenues also at the expense of reduced profitability and cash flows.

🎯 How to use Margin and Markup:

✅ Both Margin and Markup calculate the difference between price and cost.

✅ Margin relates that difference to the product Price.

✅ Markup relates that difference to the product Cost.

✅ If you know the Product Cost, use Markup to determine an appropriate selling Price.

✅ If you know the Product Gross Profit, use it to determine the Gross Profit Margin and track profitability over time.

✅ And because Price is (ideally) always larger than Cost, remember that Markup will always be the larger metric.

Here are 10 Critical Things You Should Know:

1️⃣ 𝐓𝐡𝐞𝐫𝐞 𝐚𝐫𝐞 2 𝐦𝐚𝐢𝐧 𝐭𝐲𝐩𝐞𝐬 𝐨𝐟 𝐎𝐯𝐞𝐫𝐡𝐞𝐚𝐝.

⚫ Non-Manufacturing Overhead

⚫ Manufacturing Overhead

2️⃣ 𝐍𝐨𝐧-𝐌𝐚𝐧𝐮𝐟𝐚𝐜𝐭𝐮𝐫𝐢𝐧𝐠 𝐎𝐯𝐞𝐫𝐡𝐞𝐚𝐝 (𝐎𝐇) includes the indirect costs of running your business (rent, utilities, insurance, depreciation, administrative salaries, accounting and legal fees, office supplies, marketing, etc)

3️⃣ 𝐌𝐚𝐧𝐮𝐟𝐚𝐜𝐭𝐮𝐫𝐢𝐧𝐠 𝐎𝐯𝐞𝐫𝐡𝐞𝐚𝐝 (𝐌𝐎𝐇) includes the indirect costs of manufacturing your physical products (factory rent, factory utilities, factory depreciation, factory machinery maintenance, factory supplies)

4️⃣ Each type of Overhead can be further segmented by the nature of the expenses incurred into Fixed Overhead and Variable Overhead.

Which is how you end up with 4 𝐭𝐲𝐩𝐞𝐬 𝐨𝐟 𝐎𝐯𝐞𝐫𝐡𝐞𝐚𝐝:

⚫ Fixed Manufacturing Overhead

⚫ Variable Manufacturing Overhead

⚫ Fixed Non-Manufacturing Overhead

⚫ Variable Non-Manufacturing Overhead

5️⃣ Manufacturing Overhead, both fixed and variable, is part of your Product Costs, together with Direct Labor and Direct Materials.

6️⃣ Non-Manufacturing Overhead, both fixed and variable, is part of your Period Costs, together with your R&D expenses.

7️⃣ The largest Fixed Manufacturing Overhead expense is typically Manufacturing Depreciation (and Amortization)

8️⃣ The largest Fixed Non-Manufacturing Overhead expense is typically Payroll.

9️⃣ As Manufacturing Overhead gets incurred, it is accrued as a product cost and built into the cost of your ending inventory during production.

🎯 Because it skips the income statement and lives on your balance sheet until that inventory is sold, it positively impacts your Income and your EBITDA.

🎯 Even once the product is sold and MOH becomes part of your Cost of Goods Sold, the depreciation component of Fixed MOH continues to positively impact EBITDA because it gets excluded from the calculation.

🔟 As Non-Manufacturing Overhead gets incurred, it is simply expensed as a period cost.

🎯 Because it is reported immediately in your income statement, it reduces your Income and negatively impacts your EBITDA.

So here you have it: Overhead and its direct impact on your EBITDA and Net Income.

🎯 Manufacturing Overhead accrued in ending inventory balances increases your EBITDA and Net Income

🎯 Non-Manufacturing Overhead is expensed immediately and reduces your EBITDA and Net Income

Maintenance vs. Growth CAPEX

You should have 2 main objectives for your Capital Assets:

🎯Maintain the assets you own - to continue operating at the current capacity

🎯Acquire new assets - to expand your capacity and support your revenue growth

**1️⃣ Maintenance capital expenditures (CAPEX) keep your company's existing operations running well.**

⚫ Think of repairing an asset that broke down, replacing an asset that reached the end of its useful life, or upgrading an asset to meet the minimum required safety standards.

⚫ This is capital spend you make to maintain the company's current level of production

⚫ It’s considered non-discretionary, meaning it’s unavoidable to enable you to continue operating in the current manner

⚫ It gets expensed when incurred, so it reduces profitability for the period but will have no impact on cash flow or EBITDA.

⚫ It should match or exceed your depreciation expense.

❌ If it doesn’t, you are likely underinvesting in the maintenance of your long term assets.

❌ This will likely reduce your ability to generate sufficient cash flow in the future, reducing both earnings and returns for the business.

2️⃣ **Growth CAPEX is over and above maintaining your company's current level of production, to enable future growth and revenue**

⚫ Think of expanding an asset’s production capacity, improving an asset’s energy consumption; building a new production facility, or acquiring a new ERP software

⚫ This is the capital spend you make to expand the company's operations and includes items such as new equipment, facilities, and acquisitions.

⚫ It’s considered discretionary which means you don’t have to pay for these expenses but instead you’re choosing to

⚫ It gets capitalized as a betterment of existing assets or as an entirely new asset, either of which will increase the balance of capital assets.

⚫ It will increase your depreciation expense, lowering your profitability for the period but without impacting EBITDA

🎯Here are two critical questions to answer:

1️⃣ How to determine Maintenance vs Growth CAPEX?

Use the Cash Flow Statement:

⚫ Find the Depreciation Expense at the top of the Operating Cash Flow section

⚫ Find the total amount spent on purchases of PPE in the Investing Cash Flow section

⚫ Compare the two amounts: any excess of investment in CAPEX over depreciation expense can usually be assumed to be growth CAPEX.

2️⃣ How to use Maintenance and Growth CAPEX to calculate Cash Flows?

It depends on your objectives:

⚫ If you are calculating **historical Free Cash Flow,** use the total cash invested in Fixed Asset purchases from the Investing section of your cash flow statement.

⚫ If you are estimating forward looking **maintainable Free Cash Flow**, use maintenance CAPEX net of its tax benefits (tax shield)

⚫ If you are preparing **budgeted or forecasted Cash Flow**, use maintenance CAPEX + growth CAPEX to project the Fixed Asset purchases required to both sustain the current output and increase it to achieve revenue growth targets

If you want to understand how, start with your Income Statement or P&L.

1️⃣ 𝐓𝐡𝐞 𝐏𝐫𝐨𝐟𝐢𝐭 𝐚𝐟𝐭𝐞𝐫 𝐓𝐚𝐱 𝐟𝐫𝐨𝐦 𝐲𝐨𝐮𝐫 𝐈𝐧𝐜𝐨𝐦𝐞 𝐒𝐭𝐚𝐭𝐞𝐦𝐞𝐧𝐭 𝐟𝐥𝐨𝐰𝐬 𝐢𝐧𝐭𝐨 𝐭𝐡𝐞 𝐄𝐪𝐮𝐢𝐭𝐲 𝐨𝐧 𝐲𝐨𝐮𝐫 𝐁𝐚𝐥𝐚𝐧𝐜𝐞 𝐒𝐡𝐞𝐞𝐭.

Unless you've distributed it all out to the shareholders, in which case there's nothing left to flow.

2️⃣ 𝐓𝐡𝐞 𝐏𝐫𝐨𝐟𝐢𝐭 𝐚𝐟𝐭𝐞𝐫 𝐓𝐚𝐱 𝐟𝐫𝐨𝐦 𝐲𝐨𝐮𝐫 𝐈𝐧𝐜𝐨𝐦𝐞 𝐒𝐭𝐚𝐭𝐞𝐦𝐞𝐧𝐭 𝐚𝐥𝐬𝐨 𝐟𝐥𝐨𝐰𝐬 𝐢𝐧𝐭𝐨 𝐭𝐡𝐞 𝐂𝐚𝐬𝐡 𝐨𝐧 𝐲𝐨𝐮𝐫 𝐁𝐚𝐥𝐚𝐧𝐜𝐞 𝐒𝐡𝐞𝐞𝐭.

But only after it gets adjusted for:

⚫ non-cash expenses in the Income Statement (such as depreciation for fixed assets, amortization for intangible assets, gains or losses on sales of fixed assets, or stock based compensation)

⚫ cash invested into current assets and current liabilities on the Balance Sheet

⚫ cash invested into fixed assets on the Balance Sheet

cash received or paid out in financing transactions (equity or debt) on the Balance Sheet

3️⃣ 𝐖𝐡𝐞𝐧 𝐲𝐨𝐮𝐫 𝐂𝐚𝐬𝐡 Flow 𝐚𝐧𝐝 𝐲𝐨𝐮𝐫 𝐍𝐞𝐭 𝐏𝐫𝐨𝐟𝐢𝐭 𝐚𝐫𝐞 𝐝𝐢𝐟𝐟𝐞𝐫𝐞𝐧𝐭 𝐢𝐧 𝐚𝐧𝐲 𝐠𝐢𝐯𝐞𝐧 𝐩𝐞𝐫𝐢𝐨𝐝, 𝐢𝐭'𝐬 𝐥𝐢𝐤𝐞𝐥𝐲 𝐛𝐞𝐜𝐚𝐮𝐬𝐞 𝐨𝐟 𝐨𝐧𝐞 𝐨𝐟 𝐭𝐡𝐞𝐬𝐞 𝐫𝐞𝐚𝐬𝐨𝐧𝐬:

⚫ you've paid out cash to shareholders or lent cash out to others, often related companies

⚫ you haven't yet collected everything you're owed by customers

⚫ you've used cash to pay suppliers

⚫ you've spent cash to buy fixed assets

⚫ you've made principal payments on debt

Are you trying to evaluate a company’s financial performance?

Don’t use EBITDA.

Here’s why:

🎯 EBITDA is flawed and unfit for most of the roles it has today.

🎯 EBITDA frequently gets adjusted to suit users individual needs and help mitigate their risks.

🎯 EBITDA needs replacing with a better profitability/cash flow measure that:

☑️ includes working capital investment

☑️ includes long term capital investment

☑️ includes payment obligations on debt

☑️ includes tax payment obligations

Here are 5 alternatives to EBITDA you can consider, depending on your business objectives:

1. Adjusted EBITDA

= Net Income + Interest + Taxes + Depreciation + Amortization + Adjustments

⚫Possible Adjustments List:

>> non-recurring expenses (management/M&A)

>> normalized depreciation/amortization (management, M&A)

>> rental expenses (banks)

>> proforma “what-if” expenses or cost savings (M&A)

>> CAPEX, cash taxes and distributions (banks)

✅Pros: easily calculated

❌Cons: most adjustments won't include debt payments, CAPEX or working capital investments

🎯How to use (depending on choice of adjustments):

>> Valuation: estimate future company cash flows to determine potential enterprise value based on multiples

>> Debt Servicing: estimate annual debt servicing capacity (principal + interest)

2. 𝗢𝗽𝗲𝗿𝗮𝘁𝗶𝗻𝗴 𝗖𝗮𝘀𝗵 𝗙𝗹𝗼𝘄(𝗢𝗖𝗙)

= Net Income + Depreciation/Amortization + Other Non Cash Items +/ Changes in Working Capital

✅Pros: includes tax payment obligations and working capital investment

❌Cons: doesn’t include long term capital investment or payments on debt obligations

🎯How to use:

>> Financial Health: calculate the amount of cash generated by core operations to pay for fixed asset maintenance/investments, debt servicing costs, and shareholder distributions

3. 𝗙𝗿𝗲𝗲 𝗖𝗮𝘀𝗵 𝗙𝗹𝗼𝘄 𝘁𝗼 𝘁𝗵𝗲 𝗙𝗶𝗿𝗺 (𝗙𝗖𝗙𝗙 𝗼𝗿 𝗨𝗻𝗹𝗲𝘃𝗲𝗿𝗲𝗱 𝗖𝗮𝘀𝗵 𝗙𝗹𝗼𝘄)

= Operating Cash Flow + Interest x (1- Tax Rate) +/- Changes in Fixed Assets

✅Pros: includes tax payment obligations, working capital investment, and long term capital investment

❌Cons: doesn’t include debt payment obligations

🎯How to use:

>> Valuation: estimate the value of the company (debt + equity) as the present value of future Free Cash Flows to the Firm (FCFF) discounted at the weighted average cost of capital (WACC)

4. 𝗙𝗿𝗲𝗲 𝗖𝗮𝘀𝗵 𝗙𝗹𝗼𝘄 𝘁𝗼 𝗘𝗾𝘂𝗶𝘁𝘆 𝗛𝗼𝗹𝗱𝗲𝗿𝘀 (𝗙𝗖𝗙𝗘 𝗼𝗿 𝗟𝗲𝘃𝗲𝗿𝗲𝗱 𝗖𝗮𝘀𝗵 𝗙𝗹𝗼𝘄)

= Operating Cash Flow +/- Changes in Fixed Assets +/- Changes in Net Debt

✅Pros: includes working capital investment, tax payment obligations, long term capital investment, and payment of debt obligations

❌Cons: could be complex to calculate and information may not be readily available

🎯How to use:

>> Valuation: estimate the value of the company equity as the present value of future Cash Flows to Equity (FCFE) discounted at the required rate of return on equity

>> Business decision making:

- how much capital to distribute to shareholders?

- how much capital to retain in the business to support growing working capital needs from growing sales?

- how much debt can the business actually service?

- how much capital can be used to invest in M&A activity

5. Economic Value Added

= EBIT - Taxes - WACC x (Fixed Assets + Net Working Capital)

✅Pros: includes tax payment obligations as well as a cost of capital charge for working capital investment, long term capital investment, and outstanding debt.

❌Cons: could be complex to calculate.

🎯How to use:

>> Valuation: estimate the value of the company by adding the current capital invested in the company’s assets to the present value of current and future EVA.

>> Performance management: set performance targets based on EVA

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