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- The Finance Gem 💎 Week #71: Root Cause Analysis, EBITDA Adjustments and Cash Flow Drivers
The Finance Gem 💎 Week #71: Root Cause Analysis, EBITDA Adjustments and Cash Flow Drivers
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WELCOME TO ISSUE NO #71
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THIS WEEK’S ISSUE AT A GLANCE
This issue’s finance Gems 💎 vote your favorite at the end of the newsletter.
The 3 Cash Flow Drivers
20 EBITDA Adjustments to Know
12 Root Causes for Business Failures for Leaders
1. The Finance Gem has gone bi-weekly
Thousands of you reached out and answered polls over the past few months to suggest the length and frequency of the newsletter could be revised. I’ve listened and now The Finance Gem is published 2x per month or bi-weekly. You will also find more custom content, expanded topics and practical examples included in every issue, to help you both understand and apply concepts better.
2. Check out the results of some of this week’s polls and share your votes and comments below:
Poll #1 - what’s your take?
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What’s the best strategy to optimize a company's cash flow ? |
Here’s my take: the first, third and fourth options are incomplete by-products of the second one. Optimizing the cash conversion cycle implicitly requires:
➡️ Effective receivables management by issuing invoices immediately, carefully managing credit payments, enforcing payment terms, and electronic payment methods to reduce transaction times
➡️ Effective payables management by negotiating extended payment terms with suppliers and scheduling payments strategically to maintain a healthy cash reserve
➡️Efficient inventory levels by implementing just-in-time systems or similar methods to reduce holding costs and free up cash
Poll #2 - what’s your take?
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Which of these EBITDA issues do you think leads to the most problems? |
Here’s my take: all these issues are the result of misusing EBITDA, and they’re all interconnected.
➡️ Overemphasis on EBITDA frequently obscures underlying profitability and cash flow challenges, leading companies to neglect their financial health. This oversight may lead to ineffective management of operations and investments, potentially resulting in liquidity crises, higher leverage, inability to service debt obligations and a substantially weakened financial standing.
➡️ When acquisitions are overvalued based on inflated EBITDA projections or aggressive EBITDA adjustments, it risks depleting resources, distracting from core operations, significant goodwill write-downs, higher leverage and reduced debt servicing capacity.
➡️ When EBITDA becomes the central metric for assessing company performance, management may feel pressured to adopt aggressive accounting tactics to enhance this figure artificially. This manipulation can mislead stakeholders about the company's actual economic condition, fostering decisions that aren't aligned with its financial reality. Needless to say that results in poor decision-making and potential legal and regulatory repercussions when the true financial state of the company is revealed.
Poll #3 - what’s your take?
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THIS WEEK’S FINANCE GEMS
The 3 Cash Flow Drivers
What drives your cash flow?
There are 3 Main Cash Flow Drivers you should Know.
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Operating Cash flows into your company from 3 main sources:
☑️ Revenue Growth
☑️ Operating Profits
☑️ Working Capital efficiency
How does it work?
Operating Cash Flow is the cash generated from a company’s core business activities.
The formula for Operating Cash Flow, CFO or OCF is as follows:
=Revenue
-COGS
-Operating Expenses
+Depreciation and Amortization
+Other non-cash items (e.g. gains/losses on assets sales)
+/ Changes in Working Capital
Here’s how each of these components impact your ability to grow your Operating Cash Flow:
0️⃣ Depreciation, Amortization and other Non-Cash Items have no impact on Cash.
1️⃣ Revenue growth refers to the increase in your company's revenue over time.
↳ Revenue Growth = (Current Revenue/Prior Revenue -1) x 100
↳ A higher rate of revenue growth generally leads to more cash flow, as more money is flowing into the business.
↳ What drives revenue growth:
- Sales volume: the number of units sold
- Pricing strategy: price increases for new and existing clients
2️⃣ Operating Margin refers to the relative proportion of operating income to revenue.
↳ Operating Margin = Operating Income/Revenue x 100
↳ A higher operating margin means that a larger proportion of revenue is being converted into profit, which can further be used to generate cash flow.
↳ What drives operating margin growth:
- Reduction of COGS relative to revenue: better contractual agreements with suppliers, automation
- Reduction of Selling, General and Administrative costs relative to revenue: marketing, payroll, overhead, shipping costs
3️⃣ Capital Efficiency refers to how effectively a company uses its assets and liabilities to generate cash flow.
↳ A company that is capital efficient is able to turn its assets into cash faster, which means its requires less overall capital and can generate a higher return on its shareholders’ investment.
↳ What drives capital efficiency?
- Efficient use of long term capital assets (PPE): your company’s ability to generate profit from the operation of its assets (ROA)
- Efficient use of short term working capital assets: your company’s ability to optimize its cash conversion cycle
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20 EBITDA Adjustments to Know
EBITDA gets adjusted all the time.
But adjusted EBITDA is still not cash.
When analyzing adjustments to EBITDA, stakeholders might have different perspectives depending on their interests, roles, or strategic objectives. Here's a pro and con view for each of the 20 common EBITDA adjustments:
1. Provisions and Reserves
Pro: Investors seeking to understand the operational earnings power might exclude these as they represent non-cash items.
Con: Creditors or analysts might include them in EBITDA to assess the full scope of potential future liabilities impacting long-term profitability.
2. Non-operating Income
Pro: Excluding it helps focus on core business profitability, essential for operational comparison.
Con: Including it might be argued for by management to show all sources of income enhancing the total financial strength.
3. Unrealized Gains or Losses
Pro: Excluding them avoids volatility in earnings analysis, focusing on actual operational performance.
Con: Including might be favored in industries like investment where asset valuation plays a critical role in performance assessment.
4. One-time Revenues or Expenses
Pro: Excluding provides a cleaner, more sustainable earnings view, important for investors focused on long-term value.
Con: Management might include these to reflect the total economic activities during the period.
5. Foreign Exchange Gains or Losses
Pro: Excluding them in companies with incidental foreign transactions simplifies performance analysis.
Con: For multinational corporations, including these reflects the comprehensive impact of global operations on profitability.
6. Goodwill Impairment
Pro: Excluding it removes non-cash impacts, focusing on current operating results.
Con: Inclusion could be argued for from a valuation perspective, reflecting potential overpayment or strategic missteps in acquisitions.
7. Asset Write-downs
Pro: Removing these focuses on regular business operations and performance.
Con: Including them provides a more complete view of management's investment decisions and their outcomes.
8. Litigation or Insurance Expenses
Pro: Excluding non-routine items presents a smoother, more predictable earnings track.
Con: Including could show the full financial exposure and risks the company occasionally faces.
9. Excessive Owner Compensation
Pro: Adjusting to industry standards makes financial statements comparable across businesses.
Con: Some might argue it should be included to show the true cost structure under current management.
10. Share-based Compensation
Pro: Excluding non-cash expenses like this can clarify operational cash flow generation.
Con: Including it provides a full view of compensation costs, essential for understanding total employee-related expenditures.
11. Below Market Compensation
Pro: Standardizing compensation levels in analysis to industry norms helps in comparing operational efficiency.
Con: Keeping original figures might better reflect the current operational cost advantage or disadvantage.
12. Personal Expenses
Pro: Excluding them purifies EBITDA from non-business related outflows.
Con: Arguably, these should be included if reviewing the full financial behavior of the company under current ownership.
13. Travel and Entertainment Expenses
Pro: Excluding non-essential expenses provides a clearer picture of necessary operational costs.
Con: Inclusion might be argued to assess the lifestyle and managerial style of current management.
14. Pension Expenses
Pro: Excluding non-standard or discretionary pension costs aligns operational costs with industry benchmarks.
Con: Including these could illustrate the company’s commitment to employee benefits and its impact on financial health.
15. Professional Fees
Pro: Excluding unusual or one-time fees helps focus on the ongoing costs of operations.
Con: Including them can provide insight into the expenses incurred for strategic initiatives or compliance.
16. Aggressively Expensed/Capitalized Items
Pro: Adjusting for aggressive accounting practices normalizes EBITDA, making it more comparable.
Con: Some argue to include to showcase management's strategic financial decisions, whether conservative or aggressive.
17. Fair Market Rent
Pro: Adjusting rent to market rates standardizes overhead costs for comparative analysis.
Con: Original figures may better reflect the specific advantages or disadvantages negotiated by the current management.
18. Tax Minimization Strategies
Pro: Excluding effects of tax planning focuses on the operating earnings before tax strategies.
Con: Including might be preferred to show the full effectiveness of management’s financial planning.
19. Severance Costs
Pro: Excluding one-time reorganization costs clarifies ongoing operational expenses.
Con: Inclusion provides a complete picture of the costs associated with structural changes in the company.
20. Percentage Of Completion Revenues
Pro: Adjusting recognized revenue to completed work aligns reported earnings with actual project progress.
Con: Inclusion of revenue based on work progress might be argued to reflect a more real-time view of business activities and performance.: Inclusion provides a complete picture of the costs associated with structural changes in the company.
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12 Root Causes for Business Failures every Leader needs to Know
12 Root Causes for Business Failure that every Leader should Understand.
Every one of these can be further broken down into its own fishbone diagram and individual root cause analysis.
1. Strategic Misalignment: strategic initiatives aren’t aligned with market needs and the overall business goals.
Root Causes:
Unclear business objectives
Ineffective business model
Poor market positioning
Inadequate innovation
2. Operational Inefficiencies: inefficient and ineffective operations across the organization.
Root Causes:
Outdated processes
Supply chain disruptions
Quality control failures
Resource mismanagement
3. Financial Constraints: unhealthy financial practices that hinder business operations and growth.
Root Causes:
Cash flow issues
High operational costs
Undercapitalization
Poor financial planning and analysis
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Thanks so much for reading.
Oana