“Year-over-year EBITDA improved 6%, while gross margins reflected our most inefficient quarter since 1929; net operational expenses…wah, wah, wah.”
Ever sat in a meeting wondering what your CFO or President is talking about when going over financials? Wonder no more. Here are some key tools and terms you need to understand before having the muscle to go to the table with your finances, or at least be conversant in the buzzword bingo of accounting.
Understanding the meaning behind the maze of financial reporting techniques and terminology can be daunting. Most of us just glaze over and listen to Cramer when looking to invest in publicly traded businesses. However, when it comes to your own business or the or the one you work for, gaining a clear understanding of the major components of financial statements is very useful in determining the health of your organization, and more importantly, assuring confidence with potential or current funding sources or acquirers.
Imagine your business's finances as a house with a foundation (balance sheet) that demonstrates stability, floor plan and living space (profit and loss statement) that reflects how well we operate, and the roof (cash flow statement) that reveals if we have enough protection from the elements. These are the primary tools in the world of business finance, and we will discuss others such as EBITDA that is often used to compare “like houses”, so you can keep ahead of the Joneses.
Related Article: To LLC or Not to LLC?
The Foundation, AKA Balance Sheet
Let’s start with how folks see the value of your enterprise, or the balance sheet. A balance sheet shows what assets you have as of a specific point in time (e.g. cash, inventory, or real estate) vs. liabilities you owe (e.g. payables or debt), with the difference being shareholders’ equity.
“Matter can be neither created nor destroyed” and so it goes with this financial report—only the Fed can create money, but the rest of us need to show where it all came from. In a nutshell, your assets must be offset by your liabilities, commitments or equity. When trying to determine how much a company is worth, one place to start is looking to see how much total equity is in the company. This gives you a pretty good idea of what the business is worth on paper if you were to shut down and liquidate tomorrow.
The Floor Plan, AKA Income Statement
Next on the list is the living space and floor plan—the profit and loss, or income statement. Are we set up for comfortable success? The income statement looks at a period of time, usually the quarter or full year. This statement reveals revenue streams such as the sale of goods and services, and any other type of income from ordinary operations pitted against the cost of goods sold such as raw materials and labor.
Together, these yield a businesses’ gross profit. You then subtract expenses such as selling, general and administrative expenses (SG&A), leases, professional fees, rent, taxes and the like to get net income, which feeds right into cash flow. SG&A applies to the cost of selling goods and services, general expenses for operations and administrative expenses, which usually covers big ticket salary items like over-paid CEOs and those not directly involved with the production of goods and services.
The Roof, AKA Cash Flow
Besides the above, there is much more to valuing a business. With the foundation and living space taken care of, let’s take a look at the roof which protects us from bad weather—cash flow. The cash flow statement i
s crucial in determining the day-to-day stability of a company.
The cash flow statement shows whether cash went up or down and why. Even though a business is financially viable with a lot of equity, poor cash flow can eventually have a negative impact on the health of your organization, especially if you run out of cash!
Even if you sell something profitably, does it take a really long time for your customers to pay you? Do your vendors require you to pay them immediately? Will you need to take on more debt to make payroll? Do you have a big lease payment on the fleet of private jets?
The cash flow statement will help answer these questions, and is often looked at by financial markets as a sign that a company has wiggle room if things turn down, we clearly need to get rid of the private jets!
In addition to these three financial statements, there are other calculations useful to investors and management. Many times, EBITDA is used instead of Net Income or Cash Flow because it allows for an easy way to compare companies in a specific industry or category.
Earnings Before Interest Taxes Depreciation and Amortization, or EBITDA, removes the effects of how poorly a company is financed, how bad the company’s tax accountant is, and expenses that do not utilize cash to bring the focus to the business of being in that business.
Costs removed from earnings are interest expenses associated with financing, how assets are classified and depreciated (varies by company depreciation policy, and how old the assets are), different tax obligations, and amortization of intangible assets. Intangible assets create non-cash expenses and were generally invented by accountants to confuse everyone and create job security.
Removing these items from the picture can be extremely helpful in comparative analysis, especially if a potential acquirer would finance the business differently, has a better tax avoidance strategy, and does not care about expenses that do not expend cash.
Gross Profit Margin
Finally, there are efficiency measures that give an idea of how well a company is run. A ratio such as gross profit margin can give you a quick look into how well management is doing compared to their peers.
For instance, gross profit margin shows the ratio of revenues less the cost of goods sold divided by revenues. If this number is low (e.g. 2%), the business could be susceptible to economic downturns, or, maybe another company in the same industry has a 12% margin (indicating it may have higher prices, lower costs or, generally, just a better management team).
In our case, if we have a whopping 80% gross profit margin, but our net income and cash flow are negative, we might want to look at that payroll number, and, yes, get rid of the private jets!
While we have over simplified some of the details in reporting financial viability, a basic grasp of the concepts discussed here can put you in the driver’s seat for discussing the financial aspects of your company without having to drag your accountant along. More importantly, a deeper understanding of these tools can guide you to some key management decisions that will ensure the long-term success of your business.