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The remainder of this course will be broken down into three parts. First, we have financial literacy and reading financial statements. This is a crash course in financial accounting. That will be the subject of our next few lessons as we work our way through the income statement, balance sheet and statement of cash flows.
Later in the course, we will spend a few lessons drilling into management accounting, which is a more detailed look at what is going on and discusses how information is used by managers to make informed decisions to course correct.
Lastly, we will look at the realm of finance, which is forward looking. In finance, we are trying to predict the future so that we can make long-term decisions around investing and financing.
For now, realize that financial accounting is primarily backward looking. So let’s begin by looking back and learning from what has happened.
The hallmark of financial intelligence is being able to pick up financial statements, makes sense of them, ask the right questions to fill in the gaps, and finally, to make informed decisions. Every set of financial statements tells a story. The financial story is often buried in the numbers, but believe me there is a story at play and this story has a pervasive impact on the role you are playing as the entrepreneur, executive, or director. The wrong story can cut off your necessary growth funding, demand cost containment measures, or cause you to sell/close one or more lines of business. A positive story causes others sorts of conversation around making further investment, growing the business, and what to do with excess cash that is generated by the business.
As you learned earlier, a set of financial statements has three primary statements –NOT ONE STATEMENT –as many non-financial people might believe. But admittedly, the income statement tends to get the most attention and result in the most questions. So let’s walk through the income statement and arm you to ask more incisive questions.
Every manager is familiar with an income statement. Your role is to hold management accountable for the results presented on this statement. The trouble with financial reporting is that often it lacks in giving you insight into how the business is performing in an operational sense. For sure, financial statements give you a few clues so you can ask the right questions, but it doesn’t dive deep like you might find in management accounting. The best way to describe the objective of the income statement is that it is a measure of the amount of accounting income generated during a given period.
By “accounting” income, I mean the recognition of revenues and expenses in accordance with accounting rules. Those accounting rules are called Generally Accepted Accounting Principles or GAAP if you want to sound like an accountant. Not like Gap the Store, G-A-A-P. The calculation of net income using GAAP, those rules that tell you what is or is not a revenue or expense, is NOT the amount of money collected during period. Remember, we have a separate statement of cash flows for that. It’s a common misconception that accounting income represents a pile of cash for that amount –it’s almost never the same thing.
So let’s take a moment to educate you about the gap you may have in understanding GAAP.The global standard, or set of rules for accounting, is the International Financial Reporting Standards or IFRS. All public companies abide by these standards, except for those in the United States, where there is a separate set of rules set by the Financial Accounting Standards Board or FASB. These accounting principles, rules in a simplistic sense, not only govern how, what and when amounts gets reported in the financials, but also what gets disclosed in notes that accompany the financial statements. The accompanying notes are the longest part of the financial statements and often ignored, but we will talk about those later. However, not all organizations have to use the international accounting standards, which can be quite cumbersome and commonly result in financial statements that can upwards of 100 pages in length in some circumstances.
For example, if we are talking about a private company in Canada –there are a special set of somewhat simplified principles called the Accounting Standards for Private Entities. Many countries have similar such rules which are streamlined versions of the International Standards. These standards result in far less complexity and less disclosure. So by comparison, you might have financial statements that are 20 pages in length versus 100 pages under international standards. Non-profits organizations have their own set of accounting principles. Government entities have their own accounting principles. And Pension plans yet another set of accounting principles. So depending on the type of organization you are working with, recognize that at the outset, there are different accounting rules at play.
When it comes to the income statement, generally speaking the difference between for-profit and not-for-profit entities is that for profit entities focus on matching their costs to the revenues. This means that all costs associated with earning a dollar of revenue need to be expensed at the same time. When it comes to not-for-profit entities and governments, generally speaking it’s the other way around. These entities spend money and need to match the spending against sources of revenue that have been raised for that purpose. Some sources are for specific purposes and those revenues only get recorded when the funds are disbursed for the specified purpose.
So for example, consider a church that raises money to repair its steeple. The fundraising revenues are only reported as revenue once the church spends the money on the steeple repairs. Other sources of revenue for not-for-profit organizations are unspecified or non-restricted. These are recognized as revenues as they are raised and are funds generally available to offset operating expenses. As we go through the remainder of the this course, we will reference the financial statements of for-profit entities. The principles of financial intelligence apply broadly, however, the nature of the organizational context dictate the appropriate accounting rules. Let’s work our way through the income statement.
When someone asks what the “Top line” of any business is, they are asking how much is total annual sales or revenue. This line is reported for accounting purposes net of the money you give back to your customers in the form of discounts, returns, and allowance of varying sorts. Gross sales, sales before such “funny money,” is merely an interesting number and doesn’t mean anything in the financial statements. It’s the net sales that gets recorded and important. However, as a fiduciary, you will be interested in knowing the difference between the two because in some industries, there is a lot of funny money being passed back and forth between the business and its customers. Food service businesses are notorious for what is called “trade spending.” The difference between gross and net sales can be as much as 10-20% for some companies, for others industries, there is very little difference between net and gross sales.
Trade spending are incentives that you provide to your customers and can come in dozens of different varieties including:
-Buying group programs.
-Slotting allowances-Listing fees.
-Promotional pricing-This list goes on and on.
Top line sales growth is one important indicator, however, don’t mistake sales growth as the be all end all of financial achievement. In fact, many a company who have placed a disproportionate emphasis on top line performance have suffered because it inadvertently caused them to lose focus on the bottom line. Be weary of a manager that tells you “bigger is better.” I’ve seen this happen at far too many organizations during my career. It’s easy to sell more product if you are giving it away! Think of sales in this regard as a “vanity” number. It’s fun to run around holiday parties bragging you own million dollar company, but if the company isn’t making any money, that’s a lot of effort for no return. So for this reason, financial intelligence dictates that you must work your way down the income statement all the way to the bottom line to get a sense of the true story of management performance.
Cost of sales comes next below sales. Cost of sales is probably the hardest number to really understand and dissect, though conceptually it’s pretty straightforward. Conceptually, cost of sales represents the cost of the inventory or the cost of providing service that is sold to customers during the period. However, the tricky part is understanding what costs are included in this number. In a retail environment, the cost of sales is the landed cost of goods (purchase costs plus the shipping and handling cost incurred to bring the inventory into the store). But cost of sales will also include what is called “shrinkage,” which means inventory that is obsolete, spoiled, lost or stolen. This is a number you should be interested in but is never shown on the face of the financial statements.
In a manufacturing environment, cost of sales is even more complex. Production costs are attributed to each unit of inventory manufactured. These units then go into a finished goods inventory making them available or sale. You can reconcile the cost of sales by taking your finished goods at the beginning of the period adding to that the cost of the finished goods manufactured during the period and then subtracting the finished goods at the end of the period. This too will give you the cost of sales that gets expensed in the income statement.
For manufacturing entities –you will want to better understand how effective and efficient management is in producing finished goods inventory. For that, you need to understand that the production costs that you see on the screen before you –the $47 -includes both direct and indirect costs.
Direct costs are generally obvious, such as raw materials and the direct labour that go into each unit of production –as illustrated by the pictures at the bottom of your screen. Indirect costs are harder to recognize because these include all the overhead costs of the manufacturing facility. This includes management salaries, plant facilities costs like insurance and property taxes, and any repairs and maintenance and depreciation on the production equipment and facilities. Indirect costs get allocated to inventory costs on the basis of a cost driver, such as units produced or hours of machine time.
Our GAAP rules generally say that cost of inventory is the lesser of cost to produce or the net realizable value of the inventory. Net realizable value of inventory is based on what we expect to sell the inventory for, so most often, the actual cost of inventory is going to be less and that is what you will see in your cost of sales. The second thing for you notice using this schedule is that because costs incurred to manufacture inventory first get allocated to finished goods inventory, production costs incurred in the plant sometimes don’t hit the income statement in the same period as the goods are manufactured. These costs can get hung up in inventory, which is a balance sheet account. As finished goods inventory is sold, these costs are posted in cost of sales on the income statement. As a result, sometime the performance of your manufacturing operation isn’t immediately apparent just by looking at the income statement.
So, the challenge for you will be to understand the efficiency of the manufacturing process using this limited amount of information. The clue is to look at your gross profit and gross profit margin percentage and watch for any unusual or unexplained fluctuation. Gross profit is net sales minus cost of sales. Gross profit margin percentage is gross profit divided by sales. You would expect that the business would have some consistency in how it prices its products, which shows up in this percentage. When this percentage changes, you better believe there is a reason. It could be a production cost issue, it could be a pricing issue, it could be a sales mix issue –ie. selling more lower margin products than higher margin products. It’s not going to be spelled out for you on the income statement. This is where your financial intelligence is required to get to the bottom of this.
I’ll remind you again, that in a later lesson, we will give you a crash course in management accounting that will allow you to drill into cost of goods manufactured even further, but at this point, you’ve got the gist of it.
Below gross profit, you have overhead costs. General overhead costs are much easier to understand because often these are simply the costs spent or incurred by each functional manager across the organization –excluding the production and operations people. General overhead or G&A (General and administrative) or SG&A (Selling, general and administrative costs) include the cost of your sales function, HR, finance, executive, supply chain, IT, research and development etc.
When you subtract overhead costs from gross profit, you are left with operating margin or operating income. This represents the income generated from operations during the period. Generally speaking, this is of interest when you evaluate management’s ability to run the business because it excludes financing costs and income taxes, which are often controlled outside of operations.
For new businesses or high growth businesses that are yet to turn a profit, you may hear someone ask, or you may want to ask yourself, what is the “burn rate?” Burn rate is the rate at which cash spent each month. You can calculate how many months a business will survive by taking the amount of cash on hand and dividing it by the burn rate. This indicates the maximum time a company has to either figure out its business model or raise its next round of financing. Typically, you would exclude cost of sales in the burn rate unless these costs are fixed, such as in the case of running a manufacturing facility. Burn rate would also exclude any non-cash costs such as depreciation. You’ll learn more about non-cash costs in a moment, but just as it sounds, some expenses on the income statement don’t represent cash out the door.43
For mature businesses, there are often other costs below operating income that factor into the calculation of bottom line earnings. These include financing costs and income taxes, which as I just said are often outside of the control of the non-finance managers. Financing cost are those cost paid to banks and lenders for money the business has borrowed. If you are lucky enough to generate a profit, the government will levy income taxes, which vary by jurisdiction but typically range from 15%-30%. Small businesses often attract a lower rate of corporate tax than large businesses. So, the proverbial bottom line is simply:
Net income = Sales –cost of sales –overhead expenses –financing costs –income taxes. Bottom line is what matters. The bottom line represents the notional value (at least in accounting terms) that accrues to the shareholders of the business or in the case of a non-profit –the members, the citizens, the charity or who ever else represents the equity of a business. There is nothing vain about this number.
This bottom line is also called your net margin. In this lesson, I’m going to show you how to analyze the income statement so that you can ask incisive questions and truly understand how net income is generated by the organization and its business model.
If you convert the net income as a percentage of total sales, it’s another way of saying, out of every dollar of sales, how much falls all the way to the bottom line. Different businesses even within the same industry will have different levels of profitability. This is called vertical analysis because we are looking down the income statement. Along the way, we have a few other margins that can be calculated. Each of these types of margins (gross profit margin, operating margin and net margin) in percentage terms can be compared against benchmarks set by peers or other divisions. If you see a percentage changing and you don’t have a good understanding as to why, this is a great point for you raise and probe until you understand how these margins are determined and compared.
We already talked about gross profit margin in our last lesson. Cost of sales tends to vary with the level of sales whereas expense overheads tend to be more fixed. We talked about direct and indirect costs in our last lesson. In this lesson, let me introduce the idea of variable cost versus a fixed cost. Variable costs vary with the amount of sales activity. Fixed costs don’t change with sales activity. Fixed costs feed into the calculation of the burn rate previously discussed, whereas variable costs would typically be excluded.
An even more useful way to challenge the numbers provided by management is to compare these numbers using what is called horizontal analysis. For this analysis, it’s often useful to have a basis of comparison. That basis of comparison might be the prior period or a budget or both. When we compare actuals against those numbers, it kind of stands out when they differ. Sometimes the explanations are obvious, other times, you will need to probe.
The budget or a prior period are the last known points in time. And when you compare currently unvetted results against previously vetted results, you can deepen your understanding of what happened. Did sales go better or worse than plan? Did management spend more or less money than the previous period? Are the margin numbers better or worse than budgeted and why? It is management’s responsibility to have good explanations for each of these sorts of questions.
Let’s take it a step further and talk using other ratios. Ratios are pretty simple, the compare two pieces of financial information that should be related. We already calculated ratios when we looked a gross profit margin and net profit margin. Ratios are very powerful when it comes to analyzing financial statements and as a result, there are dozens of ratios that one might calculate. For instance, there should be a relationship between the amount of sales and the amount of receivables (receivables are basically your customer IOUs). It is also interesting to calculate a ratio of the amount of net earnings and the amount of investment by the shareholders. This ratio is called a return on equity. When we make these comparisons, we are better positioned to assess financial performance.
Included with this course is a guide discussing all the various ratios you could calculate and how to interpret them. Financial ratios really help us with developing an understanding of the story at a deeper level. Let’s look a few of our favorites that help ensure that management is delivering enough earnings for the amount of capital invested in the business.
$1 million of net income might sound good on the surface, but without knowing how much money was invested in the company in the first place, you don’t know whether that is a good result or a poor result. If shareholders put $10 million into the business, this would imply a return on equity for the shareholders of 10%, which isn’t bad. However, if the shareholders invested $100 million, this would imply a return on equity of 1%, which is horrible and less than you could likely earn from investing in something much safer, say a government bond. Return on equity benchmarking depends on risk/reward considerations. The more risky a business, the higher the expectation of return for shareholders. Thus, start up businesses tend to expect higher returns than established businesses. Many entrepreneurs are looking to make returns of 20% or more on the capital they invest in their business.
For mature businesses, like a utility or a residential apartment building, the expectations are far lower because the risk is far lower –we know those types of businesses will make money. So for these businesses, shareholders will expect a rate of return of say 6-9%.I will try not to make things too complicated for you, but realize that when it comes to investment in a business, total financing includes more than just the money invested by shareholders. Often, banks and lenders invest capital.So, a second ratio you can calculate is called the return on capital employed or ROCE if you want to sound like a finance geek. It’s a little more complicated, but what it does and why its better than a return on equity calculation is that it considers all sources of capital employed. Capital employed equals shareholder’s equity plus debts provided by banks and lenders. In this way, it eliminates the effect of financing using debt because two companies that are otherwise the same, may achieve very different returns on equity ratios because one company maybe using more debt than the other.To calculate ROCE use net operating profit and then subtract taxes attributable to net operating profit. What is not included is interest costs. The ROCE will often yield a lower percentage for a profitable company than return on equity. For ROCE ratios you are looking for >10% but will vary considerably based on the maturity of the business and its size. Higher is better.
For large mature companies, say a utility company, the ROCE can be compared to something called the Weighted Average Cost of Capital or WACC. WACC is an estimate of how much a business pays for all of its various sources of capital in a weighted average aggregate. So if ROCE is above the WACC benchmark –woohoo, you are creating shareholder value. If its below this benchmark, boohoo, you are eroding shareholder value.Finally, one more metric that you will sometimes see, particularly if you are looking at a public company, is the Earnings Per Share or EPS. EPS is quite simply the total amount of earnings made during the period divided by the average number of shares outstanding during the period. The best way to interpret this number is that it is an accounting indication of how much accounting value has been recorded and attributed to each share. It’s not cash earned per share. It’s not the shareholder’s return per share. It’s a mathematical calculation that gives you an indication of accounting return. There are two varieties of this calculation, the basis EPS and the diluted EPS. Basic EPS takes net earnings and divides it by the actual shares outstanding.
Diluted EPS comes into play when a company has issued options or debt which can be converted to common shares at some predetermined rate. When that “rate” is beneficial to the holders of options or debt, that means conversion to shares is dilutive to existing shareholders. Dilutive in the sense that they get less earnings per share than they otherwise would, so this is a required disclosure you may see in a set of financial statements.
Dilutive is a fun word to use don’t you think? Dilution sounds bad and it is. Anything that reduces EPS or erodes shareholder value is said to be dilutive or is dilution. The opposite of dilution is accretion. Anything that increases EPS or creates shareholder value is said to be accretive. Now you can sound like you really know something about finance. What else can we teach you to sound cool?
If you are with me so far, there is another measure that once understood allows you to talk-turkey like a pro. Let’s talk about EBITDA or Earnings Before Interest Taxes Depreciation and Amortization. EBITDA is largely your revenue minus you cash based operating expenses. It’s very similar to operating income we discussed earlier only that it adds back depreciation and amortization charges. Why do we add back depreciation and amortization? Well, it’s because these are “non-cash” expenses on the income statement. Depreciation and amortization arise from capital costs that were expended in previous periods. A capital cost is an investment in a long life asset like real estate or equipment. Capital costs when incurred don’t get expensed directly to the income statement. Instead, we drip a portion of the capital cost to the income statement each year over the life of the respective assets.
This is an accounting phenomena and as a results, these are considered Non-cash charges and thus get added back in calculating EBITDA. Of course, depending on how your income statement is organized, you may not see an operating income line. In this case, just follow the acronym: EBITDA = Earnings before interest, taxes, depreciation and amortization –that’s your formula. Example: A company makes $7 net income, pays $3 in taxes, has no financing charges yet because we haven’t talked about that and depreciation and amortization of $9 (which could be included in cost of sales or overhead expense –probably a bit of both). Therefore, EBITDA is net income of $7 and we add back $3 for income taxes and add back $9 for depreciation, which equals $19 of EBITDA.
EBITDA is a proxy number that many business people use for operating cash flow. You’ll learn later that this flawed in theory, but in practice, it’s the norm. Every owner, executive, and director should know the EBITDA of their business.
Why is EBITDA a useful thing to know and why should you add EBITDA to your business vocabulary?Well, EBITDA is another useful way of benchmarking yourself against your peers. You might want to compare yourself against a competitor and one way to do this is to calculate EBITDA to compare the size of your business or EBITDA margin to see whether you are more or less efficient than your competitor.
EBITDA is also something you can use if you are talking with a banker. Banks lend money based on how much EBITDA you have in a business. The rule of thumb is that bank will loan between 2 –4 times the amount of EBITDA you are sustainably able to generate. So if you generate $19 in EBITDA per our previous example, you can go to the bank and get a loan for between $38 -$76 million, that’s really handy to know.
EBITDA is also a metric that executives use to buy and sell businesses. Public companies will buy and sell businesses and trade themselves based on an EBITDA multiple of between 6-12 times. Private companies tend to have a lower multiple of between say 3-8 times.
What do I mean by a multiple? Well again, if you are at a conference and you meet someone with an interest in selling their business and they tell you that the business generates $2 million in EBITDA annually, you can quickly determine whether there is common ground for consummating a transaction. You might think to yourself that you’d be willing to pay 4 times EBITDA to acquire their business. If $8 million is close the asking price the seller has in mind, you might have yourself a deal. Many a deal is struck using this simple metric of EBTIDA.
These simple rules of thumb help an entrepreneur, executive or director talk about numbers and negotiate deals that are approximately close enough. Then they can go back to the office and get the lawyers and the accountants working out the details of the deal. The hired professional will exercise a little more financial rigor and analysis to ensure whatever deal is struck is a good one for the company, but 9 times out of 10, it’s the entrepreneurs and executive that negotiate the deal terms.
As we wrap up our discussion of the income statement, let me leave you with a few warnings on where the income statement most often gets misinterpreted. The first one is a biggie. It’s a myopic focus on the income statement as the “be-all, end-all” of financial performance. Sure it’s very important, but it’s only part of the financial story. Money invested in capital assets and working capital, the collection of cash, and the financing strategy are all equally important elements that require the balance sheet and the statement of cash flows to sort out. Thus, stay tuned for those lessons. The income statement does not give you a strong indication of financial risk. For this, you need to look at the balance sheet and the debt position of the business. And finally, the most common of all misconceptions is that net income = net cash.
There are many reasons why this is not true including the first one which we talked about in this lesson:
-Depreciation and amortization are allocations of capital expenditures incurred in previous periods, but expensed in the current period.
-Capital expenditures from the current period are thus excluded all together from the income statement directly.
-Other non-cash expenses –for example if you issue stock options, these are an expense but don’t result in any cash going out.
-Gains and losses are another non-cash example and these can arise from foreign currency, sale of assets, or the write-down of inventory.
-And finally, not all revenues may be collected or all expenses paid during the reporting period.
-POINT BEING, THE INCOME STATEMENT IS NOT CASH FLOW.
In our next lesson, we will test what you have learned and have you analyze an income statement.
Well, are you ready? In this lesson, you do the analysis. This is a real income statement for a mid-size public company. If it helps you feel any better about the situation knowing what the company does, it fabricates steel industrial products. These numbers represent the year end numbers for 20X2.
20X1 has been provided for comparative purposes. Let’s get started. Pause the video as we go and gather your thoughts:
First off, think to yourself, are you impressed with these numbers or not. Where might you want to ask questions? To start with, prepare a hor
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