The Finance Gem 💎 Week #76

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THIS WEEK’S ISSUE AT A GLANCE

1. This issue’s Finance Gems 💎 vote your favorite at the end of the newsletter.

• How to Manage Your Cash

• The 36 Responsibilities of the CFO Office

• Connecting the three financial statements

• EBITDA vs. EVA vs. RI

• IRR vs. NPV

2. If you haven’t had a chance to join me and Oracle Netsuite VP Ranga Bodla on September 3rd, you can still download our free business guide: CEO vs. CFO: how two critical roles shape strategy. I’d love your feedback, so please reply to this email and let me know what you thought of this session.

THIS WEEK’S FINANCE GEMS

1.How to Manage Your Cash

You need to learn to Manage Cash.

Here's why:

To seize growth opportunities

To protect against critical business risks

To avoid financial distress and loss of business value

To maximize shareholder value and return on investment.

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Here’s what you need to know:

🎯 Cash comes into a business from 3 main sources:

Operations

Investments

Financing

🎯 Cash 1.0 is optimizing AR, AP and Inventory terms and turnover

🎯 Cash 2.0 is working on:

Cash Flow Forecasting Techniques

Effective Debt Management

Capital Expenditure (CapEx) Cash Flow Optimization

🎯 Here are 4 critical reasons to remember for managing cash:

1️⃣ Seize Growth Opportunities:

⚫ you need agility to capitalize on acquisitions, expansions, or innovation

⚫ cash reserves may not be sufficient, so having a strategy to attract the incremental cash you need will allow you to take quick action on opportunities and give you a competitive edge.

2️⃣ Protect Against Critical Business Risks:

⚫ cash acts as a financial buffer against economic downturns, demand fluctuations, or supply chain issues

⚫ taking steps to ensure sufficient excess cash will help ensure your operational stability and strategic focus during unforeseen challenges

3️⃣ Avoid Financial Distress and Loss of Business Value:

⚫ effective cash management will prevent cash flow shortfalls, which are a leading cause of business failure.

⚫ the worst time to get other people's money (bank, investors) is when you actually need it

⚫ planning ahead will help you meet short-term liabilities (payroll, suppliers, debts) and avoid eroding business value and reputation.

4️⃣ Maximize Shareholder Value and Return on Investment:

⚫ strategic investments and operational decisions that drive long-term growth and profitability require advanced cash flow planning

⚫ managing cash effectively will always position companies favorable to generate and provide superior returns to shareholders

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2. The 36 Responsibilities of the CFO Office

The 36 Responsibilities of the CFO Office

The CFO is responsible for managing your company's:

↳ Financial operations & Financial strategy

It is a demanding role overseeing:

↳ Executive leadership

↳ Business partnering

↳ Strategic Finance

↳ Controllership

↳ Treasury

↳ FP&A

▶ Here are the main responsibilities of the CFO office you should know:

Executive Leadership:

• Vision and Strategy Development: Setting long-term goals, steering the strategic direction, and aligning finance with overall business strategy.

• Leadership and Team Development: Fostering team growth, mentoring, and planning for leadership succession.

• Stakeholder Management: Engaging the board, managing investor relations, and ensuring clear communication with all stakeholders.

• Ethics and Corporate Governance: Upholding regulatory compliance and promoting high ethical standards.

Business Partnering:

• Cross-functional Collaboration: Providing financial insights across departments and spearheading cross-departmental projects.

• Strategic Advisory: Offering crucial financial advice and helping shape business strategy.

• Performance Improvement: Driving operational efficiencies and leading cost-saving initiatives.

• Change Management: Supporting organizational changes and managing the financial implications.

Controllership:

• Financial Reporting: Ensuring adherence to accounting standards.

• Internal Controls: Safeguarding data integrity and ensuring regulatory compliance.

• Tax Compliance: Managing tax planning and regulatory filings.

• Audit Management: Coordinating with external accountants to ensure efficient audits.

• Accounts Payable and Receivable: Overseeing timely processing and maintaining compliance.

Payroll and Benefits

• Cost Accounting: Aiding decision-making through meticulous cost analysis.

• Financial Information Systems: Maintaining accurate ledger entries and reconciliations.

Treasury:

• Cash Management: Ensuring liquidity for operations and strategic initiatives.

• Risk Management: Managing financial risks, including FX and interest rate exposures.

• Capital Structure Management: Optimizing cost of capital and financial flexibility.

• Investments: Aligning risk and return.

• Banking Relationships: Maintaining robust institutional relationships.

• Financial Covenant Compliance: Ensuring adherence to credit agreements.

• Foreign Exchange Management: Mitigating risks associated with foreign currency exposure.

• Debt Management: Overseeing debt operations and ensuring compliance.

Financial Planning & Analysis (FP&A):

• Budgeting and Forecasting: Guiding annual budgets and ongoing forecasts.

• Scenario Planning: Preparing for future scenarios with long-term planning.

• Performance Management: Monitoring financial and non-financial KPIs.

• Financial Analysis: Utilizing dashboards and KPIs to drive performance.

• Business Planning: Aligning strategic plans with financial goals.

• Capital Budgeting: Managing long-term investment strategies.

• Profitability Analysis: Enhancing profitability through rigorous analysis.

• Management Decision Support

Strategic Finance:

• Mergers and Acquisitions: Effectively managing M&A activities.

• Investor Relations: Keeping stakeholders informed and engaged.

• Investment Analysis: Evaluating potential investment opportunities.

• Strategy & Planning: Developing and implementing strategic financial plans.

3. Can you connect your three financial statements ?

Did you know Your Financial Statements Talk to Each Other?

Here’s How to Connect the Three Main Financial Statements

➡️The Balance Sheet uses information from the Income Statement for its reporting.

and

➡️The Income Statement uses the assets, liabilities, and equity from the Balance Sheet in its activity.

and

➡️ The Cash Flow Statement acts as a bridge between the Income Statement and Balance Sheet by showing the amount of cash that was generated in, and used by, the business.

Here’s how to integrate them in a dynamic model.

1️⃣ Net Income flows from the Income Statement to the Balance Sheet (through Retained Earnings) and to the Cash Flow Statement (through Operating Cash Flow).

2️⃣ Changes in Current Assets and Liabilities from the Balance Sheet are aggregated to calculate Changes in operating Assets and Liabilities in the Cash Flow Statement (Operating Cash Flow).

3️⃣ Depreciation Expense is added back into the Operating Cash Flow section of the Cash Flow Statement. In the Investing Cash Flow section, the Depreciation Expense is then deducted from the opening Fixed Assets balance and any changes in Fixed Assets are accounted for to calculate the net Investing Cash Flow.

4️⃣ The opening balance of Long Term Debt is deducted from the ending balance to calculate Financing Cash Flows.

The opening balance of Equity is also added to Net Income for the period and subtracted from the ending balance to finalize the calculation of Financing Cash Flows

5️⃣ The prior period’s closing cash balance plus the current period’s sum of cash flows from operations, investing, and financing becomes the closing cash balance for the period on the Balance Sheet.

Remember:

☑️ To put together a Cash Flow Statement you only need 2 balance sheets and the income statement covering the period of time between the two balance sheets.

☑️ Use it to understand how cash moved in and out of the business during the period and draw critical insights on the business, its health and its risk profile

☑️ Positive cash flows aren’t always a positive indicators and negative cash flows aren’t always negative indicators.

4. EBITDA vs. EVA vs. RI

EBITDA vs. EVA vs. RI

How are you measuring profitability?

Is your profitability sufficient to cover

🎯 the opportunity cost of equity?

🎯 the opportunity cost of debt?

🎯 or both?

If your measure of profit is

❌EBITDA, then you're not considering for the opportunity cost of any capital financing sources

❌ Residual Income (RI), then you're only considering the opportunity cost of equity

✔️ Economic Value Added (EVA), you're finally considering both the opportunity cost of equity and that of debt

Why is this important?

➡️ To operate and grow sustainable, companies need to generate returns above the opportunity cost of all resources used, not just cover the costs recorded on the books.

Here’s what you need to know:

1️⃣ Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA)

> Formula: EBITDA = EBIT + Depreciation + Amortization

> EBITDA does not consider the cost of capital (debt or equity) and might also provide a distorted picture of financial health, especially for companies with high levels of debt or substantial capital investment needs

2️⃣ Residual Income (RI)

> Formula: RI = EBIT - Interest - Tax - (Equity Capital * Cost of Equity)

> The accuracy of RI is highly dependent on the cost of equity estimation plus it does not expressly consider the cost of borrowing, making it less suitable for companies with significant levels of debt.

3️⃣ Economic Value Added (EVA)

> Formula: EVA = EBIT x (1-Tax Rate) - (Total Invested Capital * Cost of Capital)

> Only EVA accounts for the opportunity cost of both debt and equity capital.

> EVA might be less relevant for companies whose value primarily comes from internally generated intangible assets (like intellectual property or brand recognition), which are not traditionally recognized on the balance sheet or factored into the cost of capital

🎯 Which one of these 3 profit measures should you use?

Ideally, EVA at the company level, RI at the divisional level.

🎯 And what about EBITDA?

Just don’t use it to measure value creation.

Thank you to those who joined us for a discussion with Oana Labes, president of Financiario, on her learnings from successful partnerships between the CEO and CFO. What we covered:

• How the CEO/CFO partnership shapes strategy.

• Why KPI alignment is not enough to drive effective financial and business strategy.

• The need for a skill overlap to strategically align the two roles.

• Maximizing enterprise value through strategic financial planning.

Learn more by downloading our free business guide here.

WORK WITH ME

If your finance team is struggling to produce the automated, self-updating monthly reports, rolling forecasts and intelligent business insights you need to grow the business, Financiario can help.

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5. IRR vs. NPV

Here’s what you need to know if you’re looking to analyze your investment opportunities:

➡️ IRR answers “What’s the rate of the expected return?”

➡️ NPV answers “How much is the expected return?”

% IRR represents the percentage rate of return at which the net present value of costs (negative cash flows) and benefits (positive cash flows) equal zero (the discount rate for which NPV = $0).

$ NPV represents the dollar value of an investment today taking into account the time value of money by discounting future cash flows to the present.

🎯 Internal Rate of Return (IRR)

Acceptance Rule: The Internal Rate of Return method uses a straightforward acceptance rule: if the IRR of a project exceeds the appropriate discount rate, the project should be accepted. Conversely, if the IRR is less than the discount rate, the project should be rejected.

Pros:

The IRR method takes into account the time value of money, which makes it a valuable tool for assessing the profitability of investments over time.

It is relatively easy to understand and communicate, making it popular among finance professionals for quick comparisons.

Cons:

One major limitation of the IRR method is the potential for multiple IRRs if the project’s cash flows change from positive to negative periodically. This can lead to ambiguity in decision-making.

The IRR method does not allow for ranking projects effectively since it assumes reinvestment of cash flows at the project's own IRR, which might not be realistic.

It does not indicate the impact of the project on the firm’s value in absolute dollar terms, limiting its utility in financial planning.

Unlike NPVs, IRRs cannot be simply added together for different projects, which restricts its use in evaluating overall portfolio performance.

🎯 Net Present Value (NPV)

Acceptance Rule: The NPV method allocates cash flows to each period of the project’s life and calculates the present value of these cash flows using an appropriate discount rate. Projects are accepted if they have a positive NPV, indicating that they are expected to generate value over and above the cost of capital. Projects with a negative NPV should be rejected as they would decrease firm value. A project with an NPV of $0 provides a return exactly equal to the discount rate, suggesting no net gain or loss in value.

Pros:

Like IRR, NPV considers the time value of money, providing a sound basis for making investment decisions.

NPV is based on absolute dollar values, which simplifies the process of comparing and aggregating the financial impact of multiple projects.

The method allows for the use of varying discount rates for different periods or projects, enabling a more nuanced approach that can incorporate different levels of risk.

Cons:

Forecasting long-term cash flows accurately is often challenging, which can make NPV calculations less reliable.

NPV assumes that all cash flows occur at the end of each period, which may not align with actual cash flow timings in many projects.

Future economic conditions such as tax rates, capital cost allowances, inflation, and changes in operating cash flows can introduce significant uncertainty into NPV calculations.

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