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Each quarter, earnings season sparks interest in corporations large and small. Analysts eagerly await the financial overview offered by senior managers by way of conference call. The managers cover general strategic developments followed by a detailed review of the income statement. Sales, costs, expenses and earnings are closely examined with the final performance tally culminating in net earnings. Unfortunately, these calls tend to downplay, if not ignore, the cash flow statement. Given the economic challenges facing companies today, the cash flow statement may prove to be a useful performance indicator for the company and more specifically, the management team.

The cash flow statement details the amount of cash generated from a company’s operations, investing activities and financing activities. In other words, it addresses the company’s ability to generate cash segmented by various business activities. It can indicate whether the cash is a product of a growing business or clever financial engineering. And most of all, it often serves as a good indicator of solid business management. When a company effectively generates consistent cash increases from business operations while deploying cash judiciously for growth related initiatives, it signals a management team on the right track.

In today’s challenging business environment, inventory management distinguishes the good companies from the bad ones. Business managers often turn their attention towards inventory in an effort to control their working capital. Inventory turnover represents the number of days it takes for inventory to convert to sale. This is an important metric because inventory is costly. It takes up space, requires financing and grows stale. The longer a company holds onto it, the greater the cost. Consider a company that turns over inventory four times per year. On average, the company would take three months to sell each item. If its competitors turn over inventory 12 times per year on average, they would possess a significant cost advantage. Companies such as Dell, Wal Mart and Toyota have done a superior job managing their inventories which has reduced costs and ultimately increased profits.

Attend our Accounting and Financial Statements course in person or online to learn more about inventory management as well as other methods of working capital management.

There are many ratios commonly used for the financial analysis of a company, and perhaps the best known is the Price/Earnings (PE) ratio. Ratios are powerful tools because rather than considering some number on its own, they allow us to evaluate a number in the context of another number. Let’s see how this works.

Imagine there are two companies, A and B. Both earned (i.e. made a profit of) $1 million last year - will they have the same value? Suppose A is in an industry that’s dying out and B is in a growth industry – (assuming that both companies have the same number of outstanding shares) which will have the higher stock price? B has the brighter future, the higher likelihood of providing long-term value, so it will have a higher stock price. So given the same earnings, B has the higher price and therefore the higher price/earnings ratio. Thus, the PE ratio is a measure of investors’ optimism about future growth.

Normally we wouldn’t compare companies in different industries. Since different industries have different growth prospects, we would not expect companies across those industries to necessarily have similar PE ratios. But companies within an industry are all subject to the same market forces, so we would generally expect them to have the same growth expectations, and therefore the same ratio of their current price relative to their current profits (earnings). What if we find a company that has a PE ratio that’s higher than the industry average? What might we wonder? This company’s price is higher relative to its earnings than everyone else in the industry (on average) so perhaps that price is too high and this company is overvalued. Or maybe there’s a good reason for investors to be more optimistic. And, of course, if a company has a PE ratio lower than the industry average, then maybe they’re undervalued and a good buy. Or maybe there’s a good reason why their price should be lower. Ratios such as this don’t provide a final decision; they’re just a potential flag to take a further look.

Speaking of taking a further look, next time we’ll take a different look at the PE ratio and how it might be used to determine a company’s value. Better yet, take one of our seminars to learn about many other powerful yet simple analytical ratios!

In a past article we considered the various expenses a company incurs related to financing, as well as “costs” that aren’t expenses. More recently we recognized the fact that when we talk about revenue and expenses, we’re simply talking about items that affect Retained Earnings, except for one.

Before we get there, let’s review. We’ve now recognized the fact that the whole point of having a company, from a financial perspective at least, is to pay out dividends and/or increase Retained Earnings. But wait - isn’t the point of the business to make a profit? The answer, of course, is yes – the profit that we make is EXACTLY the sum of our change in Retained Earnings and the dividends that we pay out. Which is why the Income Statement (or P&L or Statement of Earnings - it has many names) is simply an itemization of all of the changes to Retained Earnings EXCEPT dividends.

In other words, we can think of it this way: during a given period, we operate the business - we increase Retained Earnings when we have revenue and we decrease Retained Earnings when we have expenses. Then we may choose to pay a dividend. Before we account for dividends, our change in Retained Earnings is equal to our Net Income (i.e. profit). THEN we may choose to distribute some of those earnings (i.e. profits) to the owners (i.e. pay out a dividend). Paying a dividend doesn’t reduce our profit; it just reduces the profit that we’ve kept in the company (i.e. the Earnings that we’ve Retained). When it comes to tax time, we pay taxes on our profits, which is simply the difference between our revenue and our expenses. Just because we decided to distribute some of those profits (i.e. paid a dividend) rather than retain them doesn’t mean that we didn’t earn them, and so of course we don’t include dividends on the Income Statement. So if dividends don’t reduce our profit (i.e. they aren’t expenses), then by definition they are not tax-deductible.

Explore these concepts and more at one of our upcoming live and online/on-demand seminars. All of our seminars are taught by Wharton and Harvard MBAs with the rare ability to distill seemingly complex concepts in simple, understandable, and very useful terms. Sign up today!

You didn’t have to go to business school to know that profit is the difference between how much we sell something for and how much it cost, and our overall business profit is total revenue minus expenses. In recent articles we’ve discussed the nature of various expenses. Now we’ll take a look from a different perspective.

Let’s consider the way we account for sales. Though intuitively we think of a sale as an exchange of our inventory for money (or an IOU), from an accounting perspective these are two separate transactions. First we handle the sale. Because we use Double-Entry Accounting (more on that another time or in one of our seminars), every transaction will affect at least two accounts on the Balance Sheet in order to maintain a balance between the two “sides” of our business. It’s a cash sale, so cash increases and what else happens? No other assets change - all that’s really happened to assets is we’ve received cash (remember - we’ll handle the inventory change later), so it must be something on the other “side” of the Balance Sheet. We don’t owe creditors more money because we’ve sold something, and nor does it mean that owners have invested more capital. By making a sale we’ve increased Retained Earnings - which makes sense since it means that selling increases the value of our Owners’ Equity. Next let’s address our having sold some inventory. Inventory decreases on the Balance Sheet and what else? Retained Earnings goes down. We no longer have the inventory and so the value of our business is diminished.

How about paying the rent? Cash and Retained Earnings both decrease. Same when we pay utilities or other bills. When we make a loan payment, our cash asset is reduced and on the other side liabilities go down by the amount of the principal payment and Retained Earnings goes down by the amount of the interest. When we Depreciate assets, Retained Earnings and Accumulated Depreciation go down by the same amount.

So looking at things from this perspective we can see that the Income Statement (a/k/a Profit & Loss or P&L) is simply a list of all of the items that affect Retained Earnings, and by “profit” we mean the net change in Retained Earnings since the prior Balance Sheet - except for one: Dividends. Learn more about that in a future article - and, of course, at one of our many upcoming seminars - sign up today!

Depreciation - one of the most interesting topics in Accounting. Of course, by interesting we mean “Accounting” interesting, not necessarily “interesting” interesting… Depreciation is interesting because there are many ways to think about it. And it’s a lot more than just an Accounting or Tax fiction.

Let’s back up for a moment. Recently we talked about the fact that buying assets isn’t an expense. In addition to coming from paying for some service (utilities, rent, etc), expenses come from using up our assets (selling inventory or using some of the useful life of equipment). But the portion of the life of an asset (or inventory) that we haven’t used yet remains and has not become an expense. As we use up the life of the asset, we recognize that it has (at least theoretically, perhaps) lost some market value, and so we recognize it as a Depreciation expense.

Notice something about how this works. We pay the cash now for an asset (yes, we might be financing it, but from an Accounting perspective the loan is independent from the actual purchase) and we expense it over the life of the asset, which may be 20 years or more (depending on the schedule used for this “asset class”). So most of the expense will happen long after we actually paid for the asset – it will be a non-cash expense. That doesn’t make it a fiction (though the schedule may be somewhat subjective) - it just means that instead of recognizing the whole cost as an expense immediately, for all the reasons above, we’re spreading out that cost over the expected life of the asset.

Speaking of spreading things out over time, that’s what amortizing means (think of amortizing a loan – we spread out the repayments over time). Some of the assets that we amortize are tangible, so that the spreading out of the costs is at least potentially related to its loss of value in the market. Intangible assets such as licenses and other contracts are also amortized, but since we don’t relate these expenses to some reduction in market value, we refer to them simply as Amortization, not Depreciation, but they work exactly the same way.

“Interesting?” Then why miss out on so much more fun? Sign up for one of our in-person, live online, or on-demand seminars!

An expense reduces our profit in recognition of some business cost. Simple enough. The tricky thing is what do we consider business costs?

Let’s take inventory for a moment. Is buying inventory a business cost? It does cost us some money (now, or later if we’ve purchased on credit). However, we still have the inventory once it’s been purchased, and it is listed as an asset on our Balance Sheet. Though we’ve converted money into inventory, we don’t consider it a cost because we still have the inventory. It becomes a cost when we actually use the inventory - it’s the Cost of Goods Sold expense. Similarly, when we buy a piece of equipment, we still have it. A year later, the equipment is (likely) still in operation. We don’t consider the purchase of the equipment to be a cost. We consider the actual usage of the equipment (or simply the fact that it has become a year older) to be the expense. More on this in a future article.

What if we pay for a multi-year service contract? Same concept applies - it becomes an expense when we actually use up the contract. When we buy the contract, its value becomes an asset on our Balance Sheet, which is then reduced as we use (and actually expense) the service.

Let’s go one step further. What if we’re paying employees (or contractors, etc) to build something for us. Perhaps it’s a building. Maybe it’s an improvement to an existing building. Or it may be software that we’ll be using for years to come. We’re paying people - sounds like a wage expense, right? But like the items above, we still have these assets after we’ve paid for them. And like the items above, they’ll become expenses as we use up their useful life. In the meantime, we capitalize these expenses; in other words, we treat them just like the purchase of any other assets, and they are listed on our Balance Sheet.

Soon we’ll discuss the sort of expenses these types of assets create, as well as the true nature of expenses. If you find these pointers to be useful, imagine the value you’ll get from taking one of our courses!

Now we’re not making any sense, right?  Liabilities and expenses are both things you have to pay for – why aren’t they the same, you might wonder. 

Recently we have been taking a look at expenses - what they are (costs of operating the business), how they may be used to…adjust…corporate earnings (by varying estimates and accounting choices), and how they relate to loan payments (paying down principal is NOT an expense, but interest is an expense).  So what about liabilities?

Liabilities are what we owe - to lenders and anyone who has sold us goods or services on credit - suppliers, professionals, etc. If we pay for our expenses when they come due, or in advance (we pay the rent when it’s due, we buy inventory for cash, we prepay for insurance), then those expenses never become liabilities.  If we’ve paid for them on credit, then those expenses generate liabilities because we still owe them, not simply because they are expenses.  And if we have a liability because we need to repay money we’ve borrowed, then as discussed in a recent article, those repayments are not expenses.

Looking at it another way, expenses are items that happen in time and liabilities are persistent.  An expense happens in a moment - the rent comes due, interest comes due, we use a service, or it’s payday.  We then add the expenses to our Income Statement (a/k/a P&L Statement, or Profit & Loss).  If we pay for them at the time, or prepaid for them, then that’s it – they never become liabilities.  If we haven’t paid for them yet, then they create liabilities related to those expenses – but those liabilities are not the expenses themselves.  Liabilities persist for a period of time – they’re created when the bill comes due, or we borrow money, and they go away once the bills are paid or the debt is repaid.

More confused than ever?  We hope not! It sounds a lot more complicated than it really is.  Stay tuned as we look further at Expenses vs. Capitalization and the true nature of expenses.  Better yet, sign up for one of our upcoming live, online, or on-demand courses for a more complete understanding!

Ever wonder why certain public companies meet or beat the earnings number predicted by Wall Street research analysts? GE, Microsoft, Apple are just a few of many corporate behemoths that tend to impress analysts and investors quarter after quarter. So how are they able to consistently able to beat these numbers, even in a slow economy? Two factors contribute to this:

1. Guidance
2. Profit Smoothing

As much as we would like to believe that the stars align for such companies, the reality is that managing earnings is more a product of skill than divine intervention.

When it comes to guidance, corporate managers tend to under-promise and hope to over-deliver. It works something like this: Company X just released its quarterly earnings report and beat the consensus earnings number. The consensus number is the average of analysts’ prediction for net earnings (also referred to as net income, net profit or the bottom line). Company X was pleased to report that due to aggressive cost cutting, they were able to beat the consensus number by one penny per share (total net earnings divided by total shares of stock outstanding). Beating the estimate is always a good thing and will often drive the stock price higher. While analysts and investors rejoice, the corporate management pats itself on the back for achieving strong results.

So how did they pull this off? At the conclusion of last quarter, Company X purposely issued very conservative earnings guidance even though there were several large sales likely to close before the end of the quarter. To play it safe, they sought to keep expectations low knowing they could easily surpass them and push the stock price higher.

As it turned out, several of the planned sales fell through. Time to bring in the heavy artillery. In this case, the heaviest of all is profit smoothing. Company X can adjust the assumptions on non-cash gains and expenses to make the earnings number beat expectations. Still too low? Why not lower the charge against a bad loan portfolio? How about changing the depreciation schedule to lower the expense taken in the near term? Through some combination of non-cash adjustments, Company X is able to generate the right earnings number. Unfortunately, once in a while no amount of profit smoothing will save a company from a bad earnings number which is what happened to GE a few quarters ago. And when that happens, look out below!

Recently we began a discussion about expenses: what are expenses - and what are they not, and talked about a few examples.  This time we’ll look at expenses related to financing.

There are two common issues that come up regarding finance-related expenses.  First let’s start with the debt-related one - some assume that our entire loan payments are expenses.  On the other hand, a common mistake is for an entire loan payment to be applied to paying down a loan.  Why is this so confusing?

Loan payments, of course, consist of both principal and interest – some of the payment reduces principal, and the rest of the payment covers the interest that we owe on the loan.  Think about what happens when we borrow the money in the first place - does it increase our profit?  Of course not.  It would be great - well, in the short term, anyway - if we could increase our profits simply by borrowing money, but of course this isn’t the case.  So when we pay back the principal, it also doesn’t decrease our profit - it’s not an expense.  But the interest is an expense - it is the cost that we incur for borrowing the money for this period of time.  So the whole loan payment doesn’t reduce what’s owed - only the principal portion does that, and neither is the whole loan payment an expense - only the portion that pays the interest.

In terms of Equity, we wonder why it’s not an expense when we distribute profits to owners (i.e. pay dividends).  The answer is subtle, but simple.  Dividends are a distribution of profits - they aren’t used to determine the profits themselves.  Profits for a given period are determined by subtracting expenses from revenue, and then those profits are either distributed to owners or they’re kept in the company as Retained Earnings (earnings is another name for profits, so Retained Earnings are simply profits kept in the company instead of being distributed).  So we don’t count dividends as an expense (though we wish we could, because expenses reduce our taxes).

Stay tuned in coming weeks as we build on these concepts and discuss Expenses vs. Liabilities, Expenses vs. Capitalization, and the true nature of expenses.  Better yet, sign up for one of our upcoming live, online, or on-demand courses for a more complete understanding!