The Finance Gem 💎 - Holiday Edition

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

From time to time, I will also share more content in the newsletter, so make sure you're getting the emails in your Inbox. 

This week at a glance:

• 10 Critical Facts you Need to Know about Gross Profit and Business Profitability. 

• What’s Corporate Finance all about? 

• How Do You Protect Your Cash Flow? 

• 3 Tips to Increase Your Impact and Influence in Finance & Accounting Management Presentations 

• Is Free Cash Flow Free? Free For Whom? Free To Do What? 

Without further ado, let's begin:

1️⃣ Gross Profit calculates the profit made by the business after paying for the direct costs of doing business, including labor, materials, and other direct costs of manufacturing a product or delivering a service.

2️⃣ Gross Profit is not Gross Profit Margin. Gross Profit is an amount measured in units of currency ($, €, £). Gross Profit Margin is a ratio measured as a percentage (Gross Profit/Revenue x 100). Gross Profit Margin is a relative measure to revenue, making it much more useful for trend analysis and decision support.

3️⃣ Gross Profit can be manipulated. Companies facing financial distress have been known to report increasing ending inventory balances despite flat or dropping Sales Revenues in an attempt to temporarily distract investors or lenders from the reality of their Operating Losses.

4️⃣ Gross Profit Margins should be analyzed in tandem with Operating Profit Margins and Net Profit Margins over several periods, to identify trends and inform strategic decisions.

5️⃣ Gross Profit measures how well a business is using its resources to produce a product or a service. The intensity of capital resources required by a business is dependent on several factors, including industry and business model.

6️⃣ A low Gross Profit Margin business with a majority variable cost structure has low operating leverage. This indicates a superior ability to sustain periods of economic slowdown.

7️⃣ A high Gross Profit Margin business with a majority fixed cost structure has high operating leverage. This indicates that after covering fixed costs, the majority of incremental Gross Profit accrues to Net Profit.

8️⃣ Gross Profit Margin is not the same as Contribution Margin. The Gross Profit Margin is the residual sales price of a product or service after all direct costs of the product or service (percentage of sales). The Contribution Margin is the residual sales price of a product or service after all variable costs.

9️⃣ Gross Profit is only as accurate as the Cost of Goods Sold/Cost of Sales calculation. COGS/COS may include direct costs (labor and materials) or indirect costs (machinery depreciation, warehouse utilities, stock-based compensation).

🔟 If management isn't consistent in how they allocate expenses to cost of sales compared to other expense categories, it becomes highly inaccurate to compare financial results across different periods.

Five words: Capital Allocation for Value Creation.

☑️ Corporate Finance deals with the distribution, and investment of a company’s financial resources / capital in a way that maximizes shareholder value.

☑️ There are 5 major ways to allocate capital for shareholder value creation, as opposed to value destruction:

1️⃣ Organic Growth

☑️ This strategy grows the size of the business operation (such as by investing in R&D or growing the Sales and Marketing team) which in turn increases operating cash flows.

☑️ These either get distributed or get reinvested into more assets which further increases the value of the business.

2️⃣ Inorganic Growth (Mergers and Acquisitions)

☑️ This is an alternative way of allocating capital to grow the business. Instead of expanding their existing operations, companies can acquire other operations.

☑️ Here they leverage their knowledge, resources, and strategic differentiators to generate higher cash flows from, or in, these acquired targets - and they reinvest or distribute the incremental cash flows for the benefit for their shareholders.

3️⃣ Debt Retirement 

☑️ This capital allocation strategy uses free cash flows to pay down debt obligations, which accomplishes several positive outcomes for the business.

☑️ It lowers leverage thereby improving the business risk profile, it improves the business’s ability to withstand periods of reduced economic activity due to reduced debt servicing obligations, and it increases the future ability to secure leverage for growth.

4️⃣ Capital Distributions

☑️ This strategy implies that free cash flows are paid out of the business to investors.

☑️ There is no question that investors value businesses that provide them a steady source of income from dividend payments, but the challenge with this strategy is that it increases the leverage profile of the business and may reduce its growth opportunities.

5️⃣ Share buy-backs

☑️ In the capital markets buy-backs have a positive perception because they reduce outstanding shares, improve financial ratios, and improve the value of existing shares.

☑️However, similarly to dividend payments, this strategy also pays out cash flows outside the business, so depending on the company’s future borrowing needs, it may inadvertently have the effect of restricting growth by reducing equity and increasing the leverage ratio of the business.

.1️⃣ Not having a rolling cash flow forecast 

Forecasted cash flows show your company’s projected operating, investing and financing cash flows for the next fiscal period (and beyond for rolling cash flows), based on year-to-date results, fiscal year plans, and the ongoing effects of current strategic initiatives.

2️⃣ Paying suppliers early With the exception of a few strategic reasons, making early payments to suppliers outside of contractual terms has little benefit for your company while putting unnecessary pressure on cash flows.

3️⃣ Not securing access to a short term working capital line of credit 

Short term lines of credit for the financing of working capital assets are critical for growing companies or those with seasonal or irregular cash flow patterns.

4️⃣ Not negotiating sufficient access to short term working capital financing 

A line of credit with an insufficient limit will be of little use for a growing company faced with a large sale opportunity. A large line of credit which cannot be accessed due to an insufficient borrowing base of accounts receivable and inventory will pose a similar challenge.

5️⃣ Miscalculating the cash flow basis for bank covenant calculations. Covenant calculations can be based on:✔️EBITDA✔️Adjusted EBITDA (individual formula)✔️Free Cash Flow (FCF)✔️Operating Cash Flow (OCF)Understand the specific terms provisioned in your company’s lending agreement.

6️⃣ Invoicing late

Invoices should be sent out as soon as contractual obligations have been met to minimize collection times and maximize the cash absorbed by accounts receivable.

7️⃣ Not preparing a regular cash flow statement 

Without the benefit of a cash flow statement, your company cannot determine and analyze it’s cash inflows and outflows by source.

8️⃣ Mistaking cash flow sources

Permanent increases in operating assets need to be financed with permanent capital, whether equity or debt (financing cash inflows).

Cash from asset sales (investing cash inflows) for example, is not a sustainable source of financing for negative operating cash flows. 

9️⃣ Ignoring the quality of cash flows

Cash absorbed by low quality assets, such as accounts receivable with a low collection probability, or obsolete inventory, should be properly reflected as such in your company’s accounting bad debt or inventory reserves. 

🔟 Improperly budgeting cash availability for debt obligations

Debt obligations (principal, interest, bonuses, royalties, warrants, etc) are repayable with cash, so your company needs to accurately provision both the timing and the amounts correctly in the cash flow forecast to ensure obligations can be met when they come due. 

Framing is the technique of using a story to tell another story. In Finance and Accounting, it’s what helps you go from numbers to insights, so you can influence your audience’s perception and communicate your message effectively.

Here are 3 Tips to help increase your strategic influence in Management Presentations:

1️⃣ Focus on the positive side of the argument.

Your objective is to help drive meaningful action to improve future results.

☑️Instead of:“ Quarterly EBITDA trailed behind forecast by 16%.”

☑️Try: "Quarterly EBITDA forecast was achieved at 84% of target”. Here is how we can capture the remaining 16% in the upcoming quarter.”

2️⃣ Discuss numbers in perspective.

Your objective is to discourage your audience from distorting reality due to insufficient data.

☑️Instead of:“ Days Sales Outstanding (DSO) have increased from 46 days to 75 days during the year.”

☑️Try:" DSO increased from 46 days to our 3-year average of 75 days. Last year’s DSO of 46 days was exceptionally low as we prioritized liquidity at the expense of sales growth during the pandemic. "

3️⃣ Explain the meaning and impact of the numbers.

☑️Your objective is to zoom way out and dig much deeper as necessary, to help your audience understand why they should care.

☑️Instead of:“ Capital asset investment totaled $225,000 this second quarter.”

☑️Try:“ Capital asset investment totaled $225,000 this second quarter. This is projected to result in the breach of the Fixed Charge Coverage Ratio bank covenant at year-end unless we adjust our CAPEX spending strategy."

If EBITDA is flawed, we need another measure of cash flow that makes up for its many faults

𝟬. 𝗘𝗕𝗜𝗧𝗗𝗔  = Net Income + Depreciation/Amortization + Tax + Interest 

𝟭. 𝗢𝗽𝗲𝗿𝗮𝘁𝗶𝗻𝗴 𝗖𝗮𝘀𝗵 𝗙𝗹𝗼𝘄(𝗢𝗖𝗙)  = Net Income + Depreciation/Amortization + Other Non Cash Items +/ Changes in Working Capital  

𝟮. 𝗙𝗿𝗲𝗲 𝗖𝗮𝘀𝗵 𝗙𝗹𝗼𝘄 (𝗙𝗖𝗙)= Operating Cash Flow +/- Changes in Fixed Assets 

3. 𝗙𝗿𝗲𝗲 𝗖𝗮𝘀𝗵 𝗙𝗹𝗼𝘄 𝘁𝗼 𝘁𝗵𝗲 𝗙𝗶𝗿𝗺 (𝗙𝗖𝗙𝗙 𝗼𝗿 𝗨𝗻𝗹𝗲𝘃𝗲𝗿𝗲𝗱 𝗖𝗮𝘀𝗵 𝗙𝗹𝗼𝘄= EBITDA - Interest - Cash Taxes +/- Changes in Working Capital +/- Changes in Fixed Assets 

. 𝗙𝗿𝗲𝗲 𝗖𝗮𝘀𝗵 𝗙𝗹𝗼𝘄 𝘁𝗼 𝗘𝗾𝘂𝗶𝘁𝘆 𝗛𝗼𝗹𝗱𝗲𝗿𝘀 (𝗙𝗖𝗙𝗘 𝗼𝗿 𝗟𝗲𝘃𝗲𝗿𝗲𝗱 𝗖𝗮𝘀𝗵 𝗙𝗹𝗼𝘄)  = Free Cash Flow +/- Changes in Net Debt  

There are clearly several Cash Flow measures currently in use, and they all attempt to achieve a similar objective.  They all go from Profits (important) to Cash Flows (vital) in order to: - measure business health - measure leverage and/or distribution capacity - monitor performance.  

Be careful because the name “Free Cash Flow” is highly misleading. 

It comes from the concept that FCF should represent residual cash flows after all business operating costs and capital investments have been paid for, and is presumably available for discretionary distributions or investments by management and shareholders.

Free Cash Flow isn't free of all obligations and ready to be distributed or invested.

In reality, the company must first satisfy the priority claims on its cash flows from debt holders with FCFF and only once it has met all principal and interest obligations for the period can it spend the remaining FCFE.

➡️Advantages of Free Cash Flow based metrics: 

• They're easy to calculate 

• They're jointly available to both capital providers and borrowers  

• They account for both CAPEX and cash consumed by sales growth or working capital efficiency losses 

➡️Limitations of Free Cash Flow based metrics: 

• Assume all CAPEX is a required investment, despite the fact most companies have a mix of replacement and growth CAPEX 

• Overstate CAPEX in the year of acquisition and understates it in subsequent years  

• There is no standardized calculation of Free Cash Flow so it’s important to check with your bank or investor for their definitions

A final question: Can FCF be manipulated? Absolutely.

For example, a company that wants to increase free cash flow can simply under-invest in fixed assets. 

Here's a truly powerful comparison of these Cash Flow metrics, courtesy of the Corporate Finance Institute.

That's a wrap for this week. Hope you enjoyed the newsletter and learned something valuable to power up your work life or personal finances.

Happy Holidays and see you next year!

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