The Finance Gem 💎 Week #22 - CFOs, Cash Flow and Financial Analysis

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Now let’s on to this week's strategic finance insights:

  • EBITDA is not Cash Flow

  • The CFO Checklist

  • ROI vs ROIC vs ROE vs ROCE vs ROE vs ROA

  • 4 Simple Steps to Assess the Financial Health of a Business

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EBITDA is not Cash Flow

Here are 10 things you need to know about EBITDA:

1// “EBITDA” is essentially accounting (operating) profit with interest, taxes, depreciation, and amortization added back to it.

☑️It’s claim to fame is that it can be used to analyze and compare profitability between companies and industries because it eliminates the effects of financing, taxes, and accounting policy choices.

2// “Cash Flow” can be used loosely to mean several things.

☑️In the context of EBITDA it is a measure of the amount of cash generated by your business operations, calculated (indirectly) by adjusting net income for depreciation, amortization, other non-operating non-cash expenses, as well as for changes in the balances of current assets and current liabilities. (Operating Cash Flow or OCF)

3// Both EBITDA and OCF add back depreciation and amortization.

☑️ However, unlike EBITDA which never looks at depreciation and amortization again, OCF simply adjusts these items out so that Investing Cash Flows can better capture them as part of the calculation of the funds actually spent or earned in transactions involving fixed assets.

4// EBITDA does not eliminate operating non-cash expenditures like stock based compensation, provisions and reserves.

☑️You may have incurred these expenses in the current period and correspondingly reported reduced Net Income and Retained Earnings, but your cash balances weren’t also impacted and OCF will capture that.

5// EBITDA does not include the tax expense you actually paid during the period.

☑️ While every company’s tax circumstances differ based on a multitude of factors, your taxes paid represent a cash payment that reduced your cash available for other uses, and this will be reflected in OCF.

6// EBITDA does not consider the increase (or decrease) in your working capital accounts.

☑️ Working capital accounts like Accounts Receivable, Accounts Payable, Inventory and Prepaid Expenses can absorb a substantial amount of the revenues earned in the period, which depletes your cash balances despite posting strong Net Income and EBITDA.

☑️ Alternatively, working capital accounts can also release a substantial amount of cash into your business despite the fact it may have incurred operating losses during that period.

7// EBITDA does not include the interest expense incurred and paid by your business in the current period on account of borrowing capital.

☑️ While every company’s capital structure differs based on their individual financing choices, your interest paid (as opposed to interest accrued but not paid) does represent a cash payment which reduced your cash available for other uses, and OCF will capture that.

8// EBITDA will frequently exclude foreign exchange losses on the claim that they are non-recurring.

☑️ There may be several circumstances where the impact of foreign exchange transactions could be deemed non-operating and non-recurring, such as following a one-off acquisition or an asset purchase.

☑️ However, none of that changes the fact your FX gains and losses will directly impact your cash balance and OCF will capture that while EBITDA may not.

9// EBITDA will frequently exclude severance and reorganization costs under the claim that they are non-recurring.

☑️ While these costs may indeed not be expected to reoccur in the foreseeable future, they do represent a cash payment which reduced your cash available for other uses, which is going to be reflected into the OCF but possibly not in your EBITDA.

10// EBITDA will mostly exclude grant and other similar type of extraordinary income on the claim that they are non-operating in nature and thus should be excluded from operating profits.

☑️ While these sources of income may not be a direct result of your commercial trade activity, they are still a result of indirect operating activities and they represent inflows that increase your available cash balances; this will be reflected into the OCF but likely not in your EBITDA.

The CFO Checklist

Are you a CFO? Do you want to become one?

Then you’ll need to Master Financial Management.

Here is a strategic checklist across 15 key areas of the CFO role, to help you stay on track.

1. Budgeting and Forecasting: plan for the future and set a roadmap for growth.

2. Cash Flow Management: ensure enough liquidity is available for business operations and strategic initiatives.

3. Financial Analysis: understand the financial health of the organization and enable data-driven decision-making.

4. Working Capital Management: ensure efficient operations and optimal use of company short-term assets and liabilities.

5. Capital Structure: identify the optimal balance of debt and equity financing, to manage risk and minimize cost of capital.

6. Risk Management: anticipate potential financial risks and mitigate them.

7. Tax Planning: ensure the company is making best use of tax advantages and is in compliance with tax laws.

8. Financial Reporting: provide transparency to shareholders, regulators and other stakeholders.

9. Cost Accounting: provide insights into cost efficiency; control and reduce costs.

10. Investment Evaluation: assess new business opportunities and investments.

11. Financial Planning: support long-term sustainability and growth of the organization.

12. Mergers and Acquisitions (M&A): expand business operations and enter new markets.

13. ESG-Driven Financial Management: align the company's financial management with Environmental, Social, and Governance (ESG) factors, increasingly important in the global business environment.

14. People Management and Leadership: manage and lead people effectively.

15. Technology and Digital Transformation: leverage technology for efficiency, improved decision-making and strategic advantage.

For a limited time you can download the CFO Checklist for free here.

ROI vs ROIC vs ROE vs ROCE vs ROE vs ROA

This is the ultimate battle of the Returns.

Performance metrics are confusing. Here’s how to navigate them.

1️⃣ Return on Investment (ROI)

- Formula: ROI = (Net Profit / Cost of Investment) * 100%

- Caveat: ROI doesn't consider the time value of money, which makes it less useful for multi-period investments.

2️⃣ Return on Invested Capital (ROIC)

- Formula: ROIC = EBIT (1-Tax) / (Long Term Debt + Equity - Non-Operating Cash)

- Caveat: ROIC may be misleading for companies with large non-operating cash balances.

3️⃣ Return on Equity (ROE)

- Formula: ROE = (EBIT - Interest - Tax) / Equity

- Caveat: ROE can be heavily inflated by excessive use of leverage

4️⃣ Return on Capital Employed (ROCE)

- Formula: ROCE = EBIT / (Long Term Debt + Equity)

- Caveat: ROCE's lack of consideration for cost of debt can lead to misleading results for companies with substantial leverage and interest costs

5️⃣ Return on Assets (ROA)

- Formula: ROA = (EBIT - Interest - Tax) / Total Assets

- Caveat: ROA includes depreciation so it might be lower for capital-intensive businesses.

4 Simple Steps to Assess the Financial Health of a Business

Knowledge is Power, so learn the basics of financial analysis and empower yourself to make better decisions in the world of Finance and Accounting.

☑️If you’re an accountant or finance professional, this will help you understand the key underlying drivers you should monitor and manage as you analyze financial performance results

☑️If you're a manager, this will help you better understand your organization’s capital allocation priorities, which will help you align individual and organizational goals across your team and maximize your effectiveness.

☑️If you’re an employee, this will help you better understand the priorities and performance drivers of your organization, so you can make better decisions for your own professional and career goals.

☑️If you’re an investor, this will help you better understand the risk levels underpinning management decisions, the drivers and sustainability of the business cash flows, and whether an investment aligns with your strategic objectives.

☑️If you’re an owner, this will help you make more informed decisions and allocate resources in your company more effectively.

Here are my recommended 4 Simple Steps to Assess the Financial Health of a Business:

1️⃣ Analyze the Balance Sheet

Objectives: evaluate liquidity, solvency, efficiency and asset values to determine the business overall financial health, risk-return profile, capital structure, leverage capacity.

2️⃣ Analyze the Income Statement

Objective: evaluate profitability and operating leverage from Gross Margin to EBIT and NOPAT (EBIT x (1-tax)) to determine the business ability to sustainably generate sufficient revenue to cover expenses, earn a profit, as well as have the financial flexibility to withstand periods of slower economic activity.

3️⃣ Analyze the Cash Flow Statement

Objective: evaluate sources and uses of cash, to assess the business ability to generate sufficient operating cash flow to finance operations, fund debt repayment and invest in growth.

4️⃣ Perform a Full Ratio Analysis

Objective: use in conjunction with trend (horizontal) analysis and common size (vertical) analysis, to understand business profitability, liquidity, solvency, efficiency, debt servicing capacity, and cash flow generation ability to meet strategic objectives.

🎯 Remember that context can fundamentally alter how the financial analysis tells the story.

🎯 For informed decision-making and strategic planning make sure to:

➡️ Identify the ratios that fit your business objectives, both internal and external. ➡️ Tailor financial analysis and benchmarking to the business and its individual situational factors (industry, geography, size, etc.). ➡️ Track ratios over time to identify trends and inform strategic planning

If you need help making better strategic finance decisions, here are 3 ways I can help you:

  1. Upgrade your (or your team’s) strategic finance skills with The Cash Flow Masterclass. Leverage my unique on-demand video course to improve your knowledge, elevate your decision making and accelerate your career.

  2. Enjoy full size, print-ready PDFs of my strategic finance infographics and cheat sheets for your personal use. Until June 11 you can use coupon code GEM25 to take an additional 25% off as a thank you for being a loyal Finance Gem subscriber. Order here.

  3. Apply to sponsor a future issue of The Finance Gem.

The mother of Cash and EBITDA - compliments of Nicolas Boucher

Thanks so much for reading. See you next week.