The Finance Gem 💎 Week #21 - Management, Cash Flow and EBITDA

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• The Management Cheat Sheet

• Debt vs. Equity

• 5 Alternatives to EBITDA

• The place and purpose of the CFO Office in your Org Chart

Because Management needs Finance, and Finance needs Management.

𝐇𝐞𝐫𝐞 𝐢𝐬 𝐰𝐡𝐚𝐭 𝐓𝐡𝐞 𝐌𝐚𝐧𝐚𝐠𝐞𝐦𝐞𝐧𝐭 𝐂𝐡𝐞𝐚𝐭 𝐒𝐡𝐞𝐞𝐭 𝐢𝐧𝐜𝐥𝐮𝐝𝐞𝐬:

🎯 The 7 Main Cost Drivers

🎯 How to Calculate Project Profitability

🎯 The Balanced Score Card

🎯 The Dupont Formula as a Top Financial Performance KPI

🎯 12 Financial Skills for Managers

🎯 Margin vs. Markup

🎯 20 Business Red Flags

🎯 16 Types of Costs

🎯 Gross Profit vs. Contribution Margin

🎯 IRR vs. ROI

🎯 EBITDA vs. Cash Flow

Financing can be broadly categorized into two main types: debt financing and equity financing.

There are however several hybrid financing alternatives which have both debt and equity features which you should know.

1. Senior secured debt:

a. Term loan: A long-term, amortizing loan with a fixed interest rate.

b. Revolving credit facility: A line of credit that allows a company to draw and repay funds as needed.

c. Asset-backed loan: A loan secured by specific assets, such as accounts receivable or inventory.

d. Equipment financing: A loan used to finance the purchase of equipment, with the equipment as collateral.

e. Mortgage loan: A loan secured by real property, such as land or buildings.

2. Senior unsecured debt:

a. Unsecured term loan: A loan without collateral, authorized based on the strength of business cash flow.

b. Unsecured revolving credit facility: A line of credit without collateral that allows a company to draw and repay funds as needed.

c. Corporate bond: A debt security issued by a company, typically with a fixed interest rate and maturity date.

d. Commercial paper: Short-term, unsecured promissory notes issued by companies, typically with maturities of up to 270 days.

e. Private placements: Debt securities privately placed with institutional investors, often with more flexible terms than publicly issued bonds.

3. Subordinated debt:

a. Junior bonds: Bonds that rank below senior debt in the capital structure.

b. Mezzanine debt: A subordinated loan that may include equity features, such as warrants or conversion rights.

c. High-yield bonds: Bonds by companies with lower credit ratings, offering higher interest rates to compensate for increased risk.

d. Second-lien loans: Loans that have a secondary claim on collateral, ranking below senior secured debt.

e. Convertible bonds: Bonds that can be converted into a predetermined number of common shares, ranking below senior debt.

4. Preferred equity:

a. Cumulative preferred stock: Preferred shares that accumulate unpaid dividends, which must be paid before any dividends are paid to common shareholders.

b. Non-cumulative preferred stock: Preferred shares that do not accumulate unpaid dividends.

c. Participating preferred stock: Preferred shares that allow investors to participate in additional earnings or growth beyond their fixed dividend.

d. Convertible preferred stock: Preferred shares that can be converted into common stock at a predetermined conversion ratio.

e. Callable preferred stock: Preferred shares that can be redeemed or "called" by the issuer at a predetermined price after a specified date, providing the issuer with flexibility to retire the shares if market conditions change.

5. Common equity:

a. Founder Stock: These are equity shares given to company founders. They often have special voting rights and vesting schedules, allowing founders to control key company decisions. They may convert to common stock in public companies during an IPO.

b. Initial public offering (IPO): The process by which a company offers its shares to the public for the first time, raising capital and creating a market for its stock.

c. Secondary offering: A subsequent offering of shares to the public, typically by existing shareholders or the company itself.

d. Rights issue: A capital-raising event in which existing shareholders are offered the right to purchase additional shares in proportion to their existing holdings, typically at a discount.

e. Employee stock option plan (ESOP): A plan that grants employees the option to purchase company shares, often at a discounted price, as part of their compensation package.

f. Crowdfunding: A method of raising capital by soliciting small investments from a large number of individuals, often via online platforms.

g. Convertible notes/SAFEs (Simple Agreement for Future Equity*): These are investment vehicles used in private companies, particularly at the early stages. They are a form of debt that can convert into equity in the company during future financing rounds. These instruments offer a way for companies to raise money without setting a specific valuation.

*note the jury is still out on whether SAFEs are Debt or Equity, with many auditors choosing to include them in Debt.

Don’t use EBITDA.

Here’s why:

🎯 EBITDA is flawed and sadly 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:

✅Pros: easily calculated

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

🎯How to use (adjusted to a measure to free cash flow):

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:

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:

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:

• 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:

Here’s what your org chart does in simple terms:

🎯 it outlines the structure of your company

🎯 it shows your different departments and teams

🎯 it provides a plan for organizing your people and resources

🎯 it defines roles and inter-relations, the span of control, and the reporting hierarchies

🎯 it promotes communication and coordination to improve your organizational effectiveness and avoid inefficiencies

Because your organization is different than others, your org chart will also look differently.

And while the design of your org chart may differ from that of other companies, it will still need to perform all the relevant functions necessary to operate your business.

So what is the purpose of the CFO Office in a typical org chart?

In very simple terms, your company’s CFO takes care of your company's money and makes sure that they’re working to support your company’s goals.

The CFO office has 3 main functions reporting to it: controlling, treasury, and FP&A.

🎯 The Controlling function ensures financial reporting complies with internal policies and external regulations.

🎯 The Treasury function ensures that your company has enough funds to meet its financial obligations.

🎯 The FP&A function (financial planning and analysis) ensures that your CFO and senior management have the right support to make informed financial decisions

Let’s break down the structure and work for each of these:

1️⃣ The Controlling function is structured around 6 main sub-functions with different responsibilities

⚫ financial reporting involves the preparation of monthly, quarterly, and annual financial statements in accordance with generally accepted accounting principles (GAAP).

⚫ compliance involves ensuring that the company's financial operations are conducted in accordance with relevant laws, regulations, and internal policies

⚫ risk management involves identifying, assessing, and mitigating financial reporting risk

⚫ audit management involves coordinating and leading the annual audit process, liaising with external auditors, and assessing necessary changes.

⚫ budget oversight involves ensuring the accuracy, completeness, and consistency of the budget data, and its compliance with accounting principles and internal regulations.

⚫ tax management involves ensuring the compliance with regulatory reporting requirements and tax filings.

2️⃣ The Treasury function is structured around 6 main responsibilities

⚫ cash management involves forecasting daily cash requirements and managing short term liquidity

⚫ banking management includes ensuring the efficient operation of the company's banking and cash management systems.

⚫ currency risk management involves managing the company's foreign currency exposure and devising strategies to minimize risk.

⚫ risk management involves the assessment, management, and mitigation of key threats to the corporation's treasury operations (liquidity, credit, interest rate).

⚫ financing involves the coordination of long-term and short-term funding needs and strategies.

⚫ investment management involves identifying the most suitable investment opportunities for the company's excess cash, in line with its financial strategy and risk appetite.

3️⃣ The FP&A function is structured around 6 main responsibilities

⚫ budget management involves leading the process of creating the budget, including working with various departments to develop their individual budgets, analyzing those budgets for alignment with company strategic goals, and making adjustments as necessary

⚫ financial analysis involves interpreting the company financial information and providing updates and information as needed to the CEO, the executive team, and the board of directors.

⚫ forecasting involves providing accurate and timely financial and operational trend analysis including forecast vs. budget.

⚫ scenario analysis involves creating and using financial models to analyze aggregate sets of assumptions and their potential impact on the company's financial health and future performance.

⚫ strategic planning involves providing assistance for decision-making such as tracking performance by product, customer or region, evaluating major capital expenditure plans, and negotiating contracts.

⚫ performance management involves establishing and monitoring performance indicators, highlighting trends and analyzing variances.

1. Upgrade your or your team’s strategic finance skills with The Cash Flow Masterclass. Leverage this unique on-demand video course to improve your knowledge, elevate your decision making and accelerate your career. Check it out at oanalabes.com 

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Thanks so much for reading. See you next week.

Oana