Accounting is the language of practical business life…but you have to know enough about it to understand its limitations – because although accounting is the starting place, it’s only a crude approximation. And it’s not very hard to understand its limitations. – Warren Buffett
The most successful entrepreneurs preach that all businesses should be driven by purpose, not profit. To make the world a better place, to improve the lives of others.
Humans need a narrative to tell themselves. A story to inspire them to get out of bed every morning. A company should thus be mission led, guided with purpose, meaning and aspiration. Not about making stacks of money.
“our mission is to be the world’s most profitable company”
Not exactly inspiring, would you agree?
Whilst I agree with this rhetoric (I wouldn’t be human if I didn’t), following this advice literally can be dire. The reality is that, without profit, your business is a charity. To create an enterprise, an organisation that outlives its founders, you need capital. Relying on VCs and bank financing is not a long-term business strategy. The only way to be self-sufficient is to generate your own capital.
Capital, in the form of profit.
So it begs the question – what is profit?
What is ‘profit’
The mixed connotations of the word ‘profit’ equally translates to the finance world.
In finance-speak, Profit is referred to as many things:
- EBIT (earnings before interest and tax)
- EBITDA (earnings before interest, tax and depreciation)
- NPBT (Net Profit before tax)
- NPAT (Net Profit after tax)
- Net Profit
All these variants are calculated differently and mean different things. When trying to understand your financial position, using these terms interchangeably can be deadly.
Why ‘Profit’ is misleading
When meeting new business owners and entrepreneurs about their finances, the subject of discussion is almost always about the bottom line. Profit.
Where is it? How can I make more?
I cringe when people talk about Profit. Not because it’s a dirty word. But rather, because it’s simply the wrong metric to be looking at.
It is not the best metric to give you a complete and clear view of your financial performance.
Why? Because it is often manipulated.
Your expenses are not ‘real’
If you’re in the 98% of the businesses that turnover less than $10m of annual revenue, chances are your ‘accounting profit’ is misleading. Your savvy tax accountant has probably given you advice to deduct some personal expenses in your business, like the family car, some home office rent. She has probably recommended some ‘tax adjustments’ to your accounts so that your Director’s compensation is based on tax brackets, rather than market salaries.
When evaluating the financial health of a business, financial analysts will often make adjustments to the accounts to ‘normalise them’. The purpose of this is to remove the effects of unusual revenue and expenses, in order to understand a company’s true profit from its normal operations.
Most small business accounts are prepared for tax purposes, not commercial purposes. These normalisation adjustments can have a significant impact on ‘profit’.
Let’s take an example:
In the above example, the EBITDA reported in the profit and loss was $510,000. After normalising this profit for market value Director salaries and rent, the true EBITDA value is $250,000. This 10% difference to ‘profit’ made a $1M difference to the company valuation.
Are you constantly asking yourself why your profit never equates to the cash in your bank account?
Chances are your cash is tied up in ‘Working Capital’. Working Capital equates to balances like Accounts Payable, Accounts Receivable and Inventory.
The problem with profit is that it doesn’t consider the cashflow impacts of working capital – like the GST and PAYG you owe to the ATO, or the investment of stock you purchased in preparation for Christmas sales.
This is particularly misleading for Startups trying to understand their ‘burn rate’. Most founders look at EBITDA as a measure to understand their monthly burn. The problem is that EBITDA doesn’t factor these cashflow items.
Capital Expenditure or CAPEX is the amount spent to acquire or improve a long-term asset such as equipment or buildings. Manufacturing businesses, for example, have high amounts of CAPEX as they need to maintain equipment and machinery to sell their product. Capital expenditure is capitalised on the balance sheet and only impacts ‘profit’ via Depreciation.
Depreciation rates are often set by a vanilla table established by the Tax Office, or self-assessed by Management. Just because these rates are ‘neat figures’, it doesn’t mean the ATO necessarily knows the useful life a hydro combustion engine, as an example. It has its flaws.
As ‘Depreciation’ is a non-cash, intangible cost, it’s often ignored by most business owners. The reality is, depreciation is a real cost to business.
Albeit it an inaccurate one.
Finding ‘what is true’
The great irony of accounting
The ancient Mesopotamians first invented accounting to document ‘what is true’.
The irony is that traditional accounting is taking us further and further away from the truth. New accounting standards are invented every day, which is making financial statements more complex for laymen, (and accountants!) to understand.
So what is true?
“revenue is vanity, profit is sanity, cash is reality”
So if profit is misleading, what is real?
Well, what we know for certain is our bank account balance. How much cash I have to pay the bills.
Unfortunately, exclusively looking at your bank account is not a sure way of understanding if you’re profitable.
Entrepreneurs should, therefore, monitor a Frankenstein metric that considers both accounting profit and cashflow.
This metric is Free Cashflow.
Free Cashflow – the true metric of financial performance
Free cashflow (FCF) measures the company’s ability to generate cash from its business operations, after accounting for capital expenditures.
It’s calculated as Earnings Before Interest and Tax, less net change in working capital, less capital expenditure.
Free cashflow may be a foreign concept, but it is a metric commonly used by financial analysts when evaluating company performance. For example, Billionaire investor Warren Buffett uses a modified calculation of free cashflow to assess investments. It’s a metric used by financial analysts because it gives a clearer view of a company’s ability to generate cash and profits.
Unlike profit, it’s much harder to manipulate cash flow.
Free Cashflow leaves clues
The primary benefit of assessing free cashflow is that it provides clues on how to improve business performance. For example, as Free Cashflow considers working capital movement, drilling into the components of this balance can help us understand what changes we can make to unlock cash.
In this example, although the company made an accounting profit of $510,000, it only generated $150,000 of free cashflow. A total of $350,000 of cash is tied up in working capital, which suggests the company can look to increase cashflow by:
- Reducing accounts receivable days; and
- Improving their inventory cycle so they hold less stock.
So why is Free Cashflow uncommon to measure?
It is highly unlikely Free cashflow is reported in your financial statements or monthly board report. Why? Because it’s not required. The majority of financial statements are prepared in accordance with accounting standards and the tax office. They are prepared and designed by rational robots. i.e accountants, and not designed for humans.
In other words, traditional financial statements are not designed to help entrepreneurs understand their finances.
We’re on a mission to change this.
So, next time you sit down with your accountant to review your financial position, stop and ask to assess your free cashflow position. It’ll give you a more accurate picture of your financial position and shine a light on how to improve it.