You can find Justin on the Tweets as @justinscarboro2 and he is well worth following because he is very knowledgeable on the Stocks and I think until just a few years ago he was an Analyst in the Retail Sector and he has also worked in many Senior Roles in various Companies, most recently with Air Partner AIR.
After reading it through I decided it was pretty involved and made the decision to chop it into 2 Parts - next Week I will published the bit on Company Valuation.
I hope you enjoy it and huge thanks again to Justin for providing this excellent material.
The thought of Profit & Loss accounts, Balance Sheets and Cash Flow Statements often fills people’s minds with dread and that is before information is extracted from these vehicles to try to understand the valuation(s) of a company. This paper was put together so that colleagues who were not familiar with the financial world, would gain a greater insight. Operational decisions in every organisation should be supported by information and data so that the financial effects are understood.
We will also look at Company Valuations and Acquisitions.
This paper will try to provide a simple guide to show how operational and financial decisions are interlinked. Do not be daunted, once finished you will be an expert!
First some basics in order to understand Profit & Loss accounts, Balance Sheets and Cash Flow statements – the ‘financial statements’, which in the case of a company cover an ‘accounting period’, typically referred to as a company’s financial year (FY).
The best way to think about these statements is by looking at them from a personal perspective and how your own financial statements compare to a company’s.
The Profit & Loss account
Look at this as though it is a summary bank statement which over any specific period shows income and expenses or revenue and costs. The summary lines for both personal and a company P&L’s are the same, they are just called different things:
- What comes into your own bank account can cover many things but it is mostly salaries plus any interest you may get on savings or dividends received from owning shares.
- For a business, revenue and sales are the same basically although the one significant difference is that a company can ‘accrue’ for revenues pertaining to the sale of a good or service in an accounting period but for which the actual cash has not been received in that accounting period. Profit is thus recorded in the P&L from this activity despite cash not being received in that period (the outstanding cash to be received is recorded in the Balance Sheet as a Receivable Asset).
- Your own personal spending, no matter what it is on is mostly the same as the costs which a company incurs although as in the case of the revenue accrual above, companies can accrue for costs/expenses in an accounting period but where the case has not been paid out (and as with revenue accruals, the expense accrual gets recorded in the balance sheet as a Creditor Liability).
- There is one other important difference – Depreciation and Amortisation, both of which have an impact on the definition of ‘Profit’.
- If a company buys an asset, this normally incurs Depreciation which is an accounting adjustment, to reflect the annual fall in value of an asset (the value reduction is normally spread over the economic useful life of an asset). This annual depreciation is charged through the P&L account, but it is not a cash item – Depreciation is the ‘D’
- The same goes with Amortisation. If Company A buys Company B for £100 but Company B only has £50 of Net Assets (all assets less all liabilities), the difference of £50 is defined as an Intangible Asset or Goodwill which can cover people, brand names, a customer list, intellectual property etc. The Goodwill is recorded in the balance sheet of a company and is normally ‘Amortised’ (spread) over the estimated economic life of that asset. If the estimated life in this case is 10 years, then the £50 of Goodwill would be amortised ie an annual charge of £5 goes directly through the P&L account which lowers ‘Profit’ – Amortisation is the ‘A’
The net result of all the components that go through the P&L is in the case of an individual ‘Leftovers’ or in the case of a company ‘Profit’. I will come onto different profit definitions later but just remember the D and the A.
The Balance Sheet
How much are you worth? How much is a company worth? The same question but how you arrive at the answers are very different.
- As an individual, you are worth the net amount of what you own and what you owe – your own personal balance sheet, your Net Asset Value (NAV).
- For a company the answer depends on which sort of company you are. If you are a property company, then it is quite simple i.e. the value of all the properties less the value of any outstanding debts – the Net Asset Value.
- However, many companies do not own ‘physical assets’ and the NAV may apply. The way these ‘asset light’ companies are valued is typically a multiple of various measurements such as revenues, profit or cash flow. This is very subjective though because there are multiple definitions of profit and cash flow.
- I will come onto valuation later but the message holds in that a balance sheet can apply to an individual’s net worth, but it does not necessarily tell you much about a company’s net worth.
If we compare the basic Balance Sheet of an individual and a company, you can see that they are different, with the company balance sheet being far more complex (even in this simple example).
- Your own balance sheet is easy to understand – what you own less what you owe.
- A company balance sheet tries to show the same things although there can be hundreds of lines, both assets and liabilities and a multitude of accounting standards define what you can and can’t do regarding the recording of various assets and liabilities. Report & Accounts (R&A) are useful to help understand the components of the balance sheet but what you see in the R&A is just a summary of huge amounts of amalgamated data, i.e. it is useful but do not fully rely on it.
- Aside from accruals as I mentioned earlier, another difference is that a company may be required to put aside a ‘Provision’ in its balance sheet, which is also reflected/charged through the P&L account (a negative effect on profits). A provision is meant to represent a potential future liability which could be a provision for making people redundant, it could be a legal dispute or could be a potential bad debt. As individuals we also have provisions, but we do not think of them in accounting terms, e.g. keeping money aside for a future holiday.
- Bear in mind that a provision or indeed a cost accrual made by a company may never materialise and as such could be reversed back through the P&L (a positive effect on profits) in future years.
- Whilst it is very difficult to prove from the R&A, conservative companies often over-provide for things which means they can afford to burden the P&L with extra costs in a specific accounting period and still be able to report profits in-line or above expectations. When a company warns on profits, you know that it has run out of provisions or cost accruals, i.e. it has nothing left in the tank.
The Cash Flow statement
Profits do not equal Cash, certainly not in the case of a company. You only need to think about the ‘D’ and the ‘A’ in the P&L account or the ‘accruals and provisions’ in the balance sheet to now understand this.
The definition of a cash flow statement is a financial statement that shows how changes in the balance sheet and P&L account affect cash and cash equivalents – it is a cash reconciliation between the balance sheet and P&L account. After all, a P&L account may have recorded revenues where the cash had not yet been received and a balance sheet may have a provision which could be a non-cash item.
- Your own cash flow is easy to understand. What cash you earn, less what cash you spend gives you the cash you have left.
- For a company there are many factors which affect the cash flow and they can be looked at in two buckets – Operating Cash Flow and Investing/Financing Cash Flow.
- Operating Cash Flow relates to all cash flows incurred in the normal course of business, so the company profit to which if you remember, both the D and the A are added back because they were non-cash items. If we refer to the P&L account and our ‘profit’ we can call this operating profit or EBIT (earnings before interest and tax). If we take the EBIT and add back the D and the A we get to ‘EBITDA’.
- After EBITDA you adjust for things like net working capital (e.g. the net amount of say your stock, plus monies owed from things already sold (Debtors), less monies that you may owe to suppliers (Creditors) and also taxes.
- The second bucket is comprised of cash you may spend but which is not incurred in the day to day running of your company, e.g. capex (Capital Expenditure) - (although this could be split between maintenance capex and growth capex).
- What is common is that your personal leftovers are the same as a company’s leftovers but is often referred to as Free Cash Flow.
- Free Cash Flow (FCF) is defined as before any cash is paid out in the form of Dividends or used for Acquisitions. Once cash is then used for dividends or acquisitions, any excess cash is then reflected in the balance sheet as a change in cash and cash equivalents.
The Basics Conclusion
Do not get het up with the complexities of financial statements. They can be complex and they are all inter-related but always think of them in your own personal terms. Yes some of the terminology is confusing but at least now you should know about and understand EBIT versus EBITDA, that Profit does not equal Cash and that your personal leftover or spare cash is your own Free Cash Flow!
Financial Statement terminologies and what they mean
All financial terminology used stems from the P&L account, Balance Sheet and Cash Flow statement. So, if you have a rudimentary understanding of the financial statements then you will be able to understand the terminologies:
- Revenue: Income generated in a specific accounting period but for which cash may not have been received.
- Gross Profit: Gross profit is a company's total revenue (equivalent to total sales) minus the cost of goods sold. It is the profit a company makes after deducting the costs associated with making and selling its products, or the costs associated with providing its services.
- Operating Costs: An expense incurred in carrying out day-to-day activities, but not directly associated with production. Operating expenses include such things as payroll, sales commissions, employee benefits and pension contributions, transportation and travel, amortization and depreciation, rent, repairs, and taxes. It is often abbreviated to OPEX.
- Operating Profit: Operating profit = Gross Profit less OPEX and is the same as EBIT (Earnings before Interest and Tax), whereas EBITDA is more closely aligned with ‘cash profit’ with the D and the A added to the EBIT.
- Profit margin: Profit divided by revenue or sales. The ‘profit’ can be EBIT or EBITDA giving an EBIT or EBITDA margin. It is sometimes referred to as return on sales.
- Profit Before Tax: Otherwise known as PBT and is EBIT or Operating Profit plus or minus any interest paid (bank loan interest) or interest received (from cash deposits).
- Net income: Otherwise known as NOPAT (Net Operating Profit After Tax) = PBT less Taxes.
- Retained earnings: Net Income less Dividends paid out to shareholders.
- Earnings Per Share: Referred to as EPS = Net Income divided by Average number of shares in issue over the accounting period.
- Net asset value: The value of what you own (assets) less the value of what you owe (liabilities). The NAV is sometimes referred to as Shareholder Equity.
- Gross debt: The sum of all outstanding debt, e.g. loans or bonds.
- Net debt: Gross debt less current cash and cash equivalents.
- Market capitalisation: Market cap or MC is a listed company share price times the Actual number of shares it has in issue.
- Enterprise Value: Referred to as EV and is the market capitalisation plus the net debt or market capitalisation less net cash.
- Free cash flow: Referred to as FCF and is a company’s cash flows which are available before any spending on acquisitions or dividends. It shows how healthy a company’s cash flows are and what is available for reinvestment or distribution.
- Capital: Often referred to as Capital Employed and is the sum of Shareholder Equity and Net Debt.
- Return on Equity: Otherwise known as ROE and is simple Net Income divided by the NAV – expressed as a percentage.
- Return on Total Assets: Otherwise known as ROA. Expressed as a percentage of Net Income divided by Total Assets. A pretty meaningless term because it does not take into account how those assets were purchased, i.e. with debt.
- Return on Investment: Otherwise known as ROI. It is a measure of what economic benefit or profit can be generated from spending capital where EBIT (pre-tax) or Net Income (post-tax) are used as the numerator.
- Cash Flow Return on Investment: Similar to ROI but where EBITDA is used as the numerator.
- Internal Rate of Return: Known as IRR or ‘hurdle rate’ and is the return required by a company to evaluate whether a project should go ahead. It is more complex than an ROI because it forecasts the cash flows of a project for multiple future years and then discounts that back (using the WACC as below) to give a value of those cash flows in today’s money – the NPV or Net Present Value.
- Discounted Cash Flow: Known as DCF. A very similar calculation to the IRR apart from the fact DCF derives an actual monetary value whereas an IRR derives a percentage return.
- Return on Capital: Otherwise known as ROCE (Return On Capital Employed). The ‘return’ part or numerator can be either pre-tax (EBIT) or post-tax (NOPAT) and is divided by the Capital Employed and expressed as a percentage. Clearly the higher the ROCE, the more efficient use of capital.
- Cost of Capital: This is often referred to as the Weighted Average Cost of Capital (WACC). This is the cost of a company’s funds (both Shareholder Equity and Debt) used to appraise an investment project. For the project to be financially effective, the ROCE should be higher than the WACC. A typical WACC is between 8.0% to 12.0% depending on the size of the company (smaller companies tend to have higher capital costs) - Note that the greater the debt component the lower the WACC because the cost of debt is lower than the cost of equity.
- Cost of Equity: Is a theoretical measurement of how much a company pays to equity investors to compensate for the risk they undertake by investing their capital in said company. Often expressed as Ke.
- Cost of Debt: The rate that a company pays on its current debt, often expressed as Kd.