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FINANCIAL INTELLIGENCE Chapter 1 – You cant always trust the numbers     

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One time charged: take one thing and put it on a quarter so the other quarters look fine. The art of accounting and finance is the art of using limited data to come as close as possible to an accurate description of how well a company is performing. Revenue or sales: value of what a company sold during a given period. When should revenue be recognized? When product is delivered Income statement (profit and loss statement P&L, testament of earnings, statement of operations): shows revenues, expenses and profits for a period. Bottom line: net profit (net income, net earnings). Operating expenses: costs required to keep business going (salaries, benefits, insurance costs). Listed in the income statement and subtracted from the revenues to determine profit. Capital expenditures: purchase of a long term investment item (ie. computers and equipment). Listed in the balance sheet (but depreciation which is a part shows in the income statement).

Chapter 2 – Spotting Assumptions, Estimates and biases    

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Accruals and allocations are used to try to create an accurate picture of the business for the month. Accruals: portion of a revenue or expense that is recorded in a particular time. Purpose to match costs and revenues in a time period as accurately as possible. Allocations: assignment of a cost to different departments or activities. Depreciation: allocate costs of equipment. Spread the costs out over the equipment’s useful life. Better way of estimating the companies true costs in any given period. Most capital investments (not land) are depreciated. Valuation methods o Price to earnings ratio method: look at a company’s profits and see how other markets value similar companies in relation of their earnings. o Discounted cash flow method: look at cash and use interest rate to see how much is the future stream of cash worth today. o Asset valuation method: look at assets and intangibles and estimate how much they are worth.

Chapter 3 – Why increase your financial intelligence  

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Bankers and investors don’t like to see too much goodwill in a balance sheet, they rather see assets they can touch and in a pinch sell off. Goodwill: when a company acquires another company, the difference between the net assets acquired (assets -liabilities) and the amount of money actually paid for the company. I.E name, reputation… Balance sheet: reflects assets, liabilities and owners equity. Aka what a company owned. Owed and how much it is worth.. I balances assets=liabilities + owners equity. All financial statements flow to the balance sheet. CASH AND PROFIT ARE DIFFERENT Cash: money in bank (plus bonds and stocks).

Chapter 4 – The rules accountants follow and why you don’t always have to 

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Generally accepted accountant principles (GAAP) rules standards and procedures while preparing financial statements. Established and administered by the Financial accounting Standards Board (FASB). They are guidelines and principles do they are open to interpretation and judgment. Public companies have to adhere to GAAP. GAAP Principles: o Monetary units and historical costs: everything is in currency (the same) and historical costs help for valuation. o Conservatism: recognize a loss as soon as it can be quantified, record a gain until the gain actually happened. Recording a gain can happen if:  Evidence of transaction  Delivery occurred  Price is fixed or can be determined  Collectability is assured o Consistency: can’t change methods because info wouldn’t be comparable year to year. o Full disclosure: if a method or assumption changes, disclose it. o Materiality: something significant International Standards (IFRS) simpler than GAAPs, to compare 100 countries.

Chapter 5 – Profit is an estimate   

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Income statement doesn’t measure cash that came, used and left. It measures sales or revenues, costs or expense and profits. Any incomes statement begins with sales. Sales happen when the product of service is delivered, it doesn’t matter if it has already been paid for. Matching principle: all costs should be matched to an associated revenue. (i.e. cartridges bought to be sold in 4 months, truck bought to be used during time, taxes payed at the end of the year but created monthly. Income Statement purpose: measure whether products or service that a company provides are profitable

Chapter 6 - Cracking the code os income statement    

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Income Statement = Profit and Loss Statement (P&L) = Operating Statement = Statement of Operations = Earnings Statement = Statemen of Earnings Creating income statements for smaller business units have provided managers in large corporations with enormous insights on their units financial performance. Pro forma: projection of the income statement. Categories: o Sales or revenue (top line) o Costa and expenses o Profit (surplus, deficit or net revenue for a nonprofit) (bottom line) Many numbers in the income statement reflects estimations and assumptions.

Chapter 7 – Revenue          

Income normally means profit which is the BOTTOM LINE. Revenues are sales just those two names. A company can recognize a sale when IT DELIVERS A PRODUCT OR SERVICE to the customer. Revenue recognition is a common arena for financial fraud. Sales or revenue: dollar value of all the products or services a company provided to its customers during a period of time. Rule: revenue MUST have been earned. The sales always reflect the accountants judgements about when they should recognize the revenue. Earnings per share (EPS): company’s’ net profit divided by the number of shares outstanding. If EPS doesn’t meet expectations stock price can drop. Channel stuffing: ship unordered software to distributors at the end of the quarter to increase sales. Backlogs or bookings: not-yet-recognized sales (orders that have been signed out but not yet started or partially completed projects). Deferred revenue: money that has come but its yet unearned (like paying for airplane tickets). Accounts put deferred revenue in the balance sheet under ‘liability’ because the company still owes the service.

Chapter 8 - Costs and Expenses 

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Costs of good sold or costs of services (or costs of revenue or costs of sales): include all costs directly involved in the producing of a product or delivering a service. I.e. materials, labor (wages) of manufacturing line, Operating expenses (below the line, overhead): sales, general administrative expenses): costs that are not related to making the product or delivering services (could be sales, marketing, rent, utilities, research, etc.). There are good and bad operating expenses. Bad operating expenses are also called “unnecessary bureaucracy or lard”. COGS is not the same as variable costs and operating expenses are not the same as fixed costs. Depreciation and Amortization: it goes in operating expenses. Is the expensing of a physical asset over its useful life. It’s a non cash expense. Non cash expense: charged to an income statement in a period but not paid out in cash. Amortization: the same as depreciation but it applies to intangibles (patents, copy rights, goodwill, etc.). Other income/expense: not related to everyday operations): taxes… One time charged: extraordinary items, write offs, write charges, restructuring charges. For restructuring the company.

Chapter 9 - The many forms of profit  

Revenue- costs or expense = profits = earnings = income = margin Profit: the amount left over after expenses are subtracted from revenue. o Gross profit: sales- cost of goods. Must be sufficient to cover operating expenses, taxes, financing costs and net profit. o Operating profit: ross profit- operating expenses (including depreciation and amortization) EBIT. Profit company earns from the business it is in (that why it doesn’t include the substraction of

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taxes and interest). EBITDA: some people feels it measures better a company efficiency because it ignores noncash o Net profit: bottom line. Revenue-ALL costs and expenses, taxes , interest etc. Ways to increase it 1. Profitable sales (new markets, new prospects…) 2. Lower production costs ( find inefficiencies, implement changes. 3. Reduce operating expense (almost always means reduce head count Contribution margin = sales- variable costs. It shows how much you have to produce to cover your fixed costs and provide profit to the company. It helps mangers to compare product profitability Hedge: buy financial instruments that allow to buy or sell currency to protect the company form exchange rate effect (locking exchange rates).

Chapter 10 – Understanding Balance Sheet Basics           

Balance Sheet: Statement of what a business owns and owes in a particular time. Difference between what it owes and owns represents equity. Equity (book value): shareholder stake in the company. Assets-Liabilities. It shows the accumulation of profits or losses left in the business through time. Companies have 2 goals: increase profitability and increase equity. Profit is you grade, equity is your GPA (it shows your cumulative performance but just in point of time). The income statement affects the balance sheet but it doesn’t determine it. Assets: what company owns Liabilities: what company owes Owners’ equity: what company is worth Unlike income statements, balance sheets are almost always for the entire organization. In non profit world, equity is sometimes called net assets. Fiscal year: 12 month period.

Chapter 11: Assets (more estimates and assumptions except for cash)  

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Currents assets: anything that can be turn into cash in less than a year. Long term assets: include physical assets that have a useful life of ore than 1 year usually anything that is depreciated or amortized. They can also include land, goodwill and long term investments (none of which are depreciated). Cash and cash equivalents (LIQUID ASSETS): money in the bank, publicly traded stock or bonds (because you can turn them into cash in a day or less). Accounts receivable: amount s customers owe the company, all the promises (revenues) that haven’t been collected. Like a loan from the company to its customers (and Allowance form bad debt: what is calculated the company owes the customer obligations). Allowance for bad debt: the amount customers wont pay (is an estimated based in the past). Its subtracted from accounts receivable to make it more accurate reflection of the value. Inventory: finished goods inventory (products ready to be sold) + WIP (work in progress inventory)+ stand back (raw materials inventory). Property, Plant and equipment (PPE): physical assets the company own. The # we use here is the purchase cost.

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Less: accumulated depreciation: land doesn’t depreciate but buildings and equipment do. Add all the charges of depreciation that has taken since the asset was bought. Goodwill: only shows in a balance sheet if the company has bought companies. Difference between $ pay and physical assets of the company acquired. So it’s the ‘additional value, the intangibles’. Acquisitions: a company buys another (including merger and consolidation). Intangibles: value that you cant touch. These are not in the balance sheet unless the company acquire another company an it appears in the form of ‘goodwill’. BUT intellectual property also appears in the balance sheet. Tangible net worth: total assets-intangibles- liabilities… if this is negative it could be a red flag, company might have bought a lot of companies to have more goodwill to amortize it over a longer time and increase profits. Intellectual property, patents and other intangibles: amortized Accruals and pre paid assets: when you prepaid something it but then you effectively used it, you change it to accrual. Valuation is done considering purchasing value, except for ‘market-to-market accounting’ where you have to take the actual value. Two conditions, value must be able to be determined immediately, it should be a short term asset.

Chapter 12: On the Other Side - Liabilities an Equity 

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Liabilities: financial obligations company has with other entities. o Current portion of long term debt: the part that has to be paid within a year. o Short term loans: usually secured by current assets or inventory. o Accounts payable: what the company owes its vendors. Any balance in the company credit card is included here. o Accrued expense or other short-term liabilities: everything else company owes, payroll is an accrued expense because its money paid for a job that was already done. o Deferred revenue: money received for products you haven’t delivered yet, like airplane tickets. o Long-term liabilities: loans, and deferred bonuses, compensations, taxes pensions. Owners’ equity: (shareholder equity, stockholders equity)capital from investors + profit retained over time. o Preferred shares: shares that receive a fixed dividend and before any other common stock holder, don’t’ have a vote, can’t force the company into bankruptcy (unlike bonds). Vlaue in balance sheet: price. o Common share: holds votes, 1 stock 1 vote. Pick directors, value in balance sheet: issuing price ‘par value’ or ‘paid in capital’. May or may not pay dividends. o Dividends: funds from the equity distributed to shareholders. o Retained Earnings: the part of the profits that is reinvested and not given as dividends. o Stake holder equity is not what a company would be worth if someone buys it. That depends con valuation method (private) or markup*stock (public). Physical capital: whatever company owns Financial capital: equity plus whatever the company borrowed.

Chapter 13: Why the balance sheet balances

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Owners equity is affected only when a company takes funds from its owners, pays our money to its owners, or records a profit or loss.

Chapter 14: The Income Statement affects the balance sheet    

Net profit add to owners equity unless it’s paid out in dividends. Net losses decrease owners equity Company loses money, liabilities go up, exceed assets, net profits turns negative, candidate for bankruptcy. Every sale in the income statement either increases cash or accounts receivable in the balance sheet.

Chapter 15: Cash is a Reality check  

Owners earning is a measure of companies ability to generate cash. Cash is the least affected by the art of finance.

Chapter 16: Profit DOESN’T EQUALS CASH (and you need both)   

Profit starts with revenue but it reflects promises not cash necessarily. Expense can be incurred but cash might not move: vendor lend me. Or expense can be less than what was actually paid like with rent for the whole year. Cashflow in the long run is no protections against unprofitability

Chapter 17 - The Language of cash flow 

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Types of cash flow: inflows and outflows o Cash from or used in Operating activities: related to the actual operations. Cash that helps the business operating. Salaries, rent, customer payed bills, etc. A company with a consistently healthy operating cashflow is probably profitable (it can finance its growth internally without borrowing or selling more stocks). o Cash from or used in Investing Activities: by the company not its owners.  Capital investments: purchase of assets  Investment in acquisitions or financial securities o Cash from or used in Financing activities: borrowing and paying loaners or transactions between company and shareholders. Pay a loan, buy its own stock, pay a dividend, shareholder investment. Financing a company: how it gets its cash (debt, equity – people that buy stocks or both). Net borrower: borrowing more than its paying off.

Chapter 18 – How Cash Connect5s with everything Else   

Reconciliation: getting the cash line on a balance sheet to match the actual cash the company has. Rule: if the asset increases the cash decreases. Rule: is a liability increases cash increase too.

Chapter 19: Why Cash Matters 

If cash is coming from operations GOOD THING

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Investing cash flow big? Company might be investing in the future Free Cashflow (owners earnings) = Operating cashflow – l Net capital expenditures l (purchases of property plant and equipment in absolute value). o Free cashflow is used because cash is not subject of assumptions, easy to audit o Companies with weak free cash flow cant afford internally financing so it has to go outside to look for money.

Chapter 20: The Power of Ratios Chapter 21: Profitability Ratios (the higher the better mostly)  

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Gross Profit Margin % = Gros profit / Revenue It tells you how much of every dollar you get to use in the business. Negative trend indicates 1) sales people are discounting 2) costs are rising. Operating profit margin % (or operating margin) = Operating profit (EBIT) / Revenue It tells you how well the company is running from an operational standpoint. Negative trend indicates that costs and expenses are rising faster than sales. Net profit Margin % (or Net Margin or ROS – return on sales) = Net Profit / Revenue: how much from every 1 dollar the company gets to keep after EVERYTHING has been paid. Return on assets (ROA) = Net Profit / Total Assets. Tells you how much from every dollar invested in the company returned as profit. Return on Equity (ROE) = Net Profit / Shareholders Equity It tells us how much (%) of what was inverted as equity returns as profit. Used to compare company against competitors or other industries. With this ratios investors decide whether to invest or not (bonds are risk free and pay 4%).

Chapter 22: Leverage Ratios (the balancing act)      

How and How extensively a company uses debt. Debt allows a company to grow even beyond what’s invested capital alone would allow. That’s why it’s called leverage. Operating leverage: ratio between fixed costs and variable costs. Financial leverage: the extent in which a company’s assets base is financed in debt. Debt to Equity = Total Liabilities / Shareholders Equity. How much debt the company has for every dollar of equity. Interest Coverage = Operating Profit / Annual Interest Charges

Chapter 23: Liquidity Ratios (can we pay our bills) 

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Current Ratio = Currents Assets / Current Liabilities Too low when it gets close to one, lesss than 1 you will run out of cash. Too high means you have cash sitting instead of reinvesting or paying dividends. Quick Ratio = Currents (Assets – Inventory) / Current Liabilities Acid test ‘how easy would it be to pay off debts without selling inventory’. Lenders and vendors check the quick ratio to give credit (because inventory has a linger journey to cash).

Chapter 24: Efficiency Ratios (making the most of our assets)

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Inventory days (DII) = Average Inventory / (COGS/day) It measures number of days inventory stays in the system. Inventory turns = 360/DII How many times in a year your should restock because you turn out of inventory. Day Sale Outstanding = Ending Accounts Receivable / (Revenue/days) Also known as average collection period and receivable days. How much time it takes the company to collect the cash from sales (how fast customers pay bills). Days Payable Outstanding = Ending Accounts Payable / (COGS/Days) Average days it takes the company to pay bills (invoices). Higher DPO better cash position but less happy vendors. Property, plant and equipment Turnover = Revenue / PPE how many dollars of sales does the company gets out of investment in PPE. How efficient are you generating revenue form fixed assets Total...