This week I’m teaching a course on Financial Analysis at my alma mater, University of California, Irvine. It got me thinking about the fundamentals of financial analysis and how we use financial statements in business.
Preparing to teach a course like this is humbling. I spend a lot of my day thinking in terms of finance, analyzing the financials of both public and private companies. I take for granted what I know. But I also take for granted the basics. Distilling the complex to the simple is anything but. Through the process of preparing, I’m forced to return to fundamentals.
Cash = Valuation
The foundation of financial statement analysis is understanding how the balance sheet, the income statement (P&L), and the cash flow statement all inter-relate in order to determine the earning potential of a business. But more importantly, and a point I press home to students, is to understand the difference between cash and earnings, between accrual and cash accounting.
Students are generally taught the basics of accrual accounting early on. Revenue recognition, expense recognition, matching principal, gross margin, and operating profit are all examples of accrual based metrics. These metrics are critical to assess the health of a company. But they only tell a fraction of the story. Understanding the cash position of a business is as important, if not more important, in my experience.
Ultimately investors buy a business for its ability to generate cash. Valuation comes down to the amount of cash it is expected to return over the life of the asset, adjusted for time and risk. The more cash the asset produces, the more the asset it worth. The longer it takes to produce that cash, the less the asset is worth. The greater the uncertainty that the asset will produce the cash, the less it is worth.
When we perform valuations on businesses we spend a lot of time understanding how cash flows through a business. We ask management a lot of questions to explain what happened in the past. But we also ask as many questions about what they expect in the future. Our role is to tease out all the relevant data that often is trapped inside of a business owners mind, and put it into Excel, and build a cash flow model to determine the value of a business.
Your Business Is Stealing from and Lying to You
The tricky part about cash is that it’s tricky. Working capital never shows up on a P&L. But it certainly impacts valuation. And your bank account. Working capital left unmanaged steals money right out of your bank account.
Capex doesn’t show up on a P&L until months and years later (via depreciation), and even then, we remove it from our analysis, labeling depreciation a “non cash” expense. We use EBITDA as a shortcut to estimate the value of a business, overlooking the fact that depreciation at some point must be replenished. But in an industry where technology is constantly evolving and investment is increasing, removing depreciation expense from earnings may be more than a simple white lie.
Don’t Believe Anything You Hear and Only Half of What You See
What always attracted me to financial statements is the ability to tell, and interpret, a story. But who’s story? And is it believable? Or verifiable?
Financial statements are crafted by managed according to the laws of the land (GAAP, IFRS, etc.). The laws are imperfect, all systems are. But imperfect laws are better than no laws. And ignorance is not a valid defense.
Financial statements tell a story, and it is up to the user to interpret that story. The more proficient in the language the story is told, the greater the ability to recognize the true story.
What do your financial statements say about your business? When a buyer or a banker looks at your business, what story are you telling?
One way to see the story your financials are telling is to fill out the Value Builder survey. There is a section on working capital management built into the survey. The survey ranks on 8 value drivers that influence the value of your business. You can get your score for free at https://mewescfo.wpengine.com/score. After you fill out the survey we’ll get on the phone and walk through the results together.
Another is to perform a valuation on your business. Valuations provide a way to view your business from the perspective of a buyer and provide a much deeper dive into the nuances of your business. They often serve as a sort of insurance, ensuring that your assumptions about the value of your business are backed up by fact.
As always, hit REPLY and tell me what you think.
Until next week!