This is the second of four articles on Making Money. Making Money Part One: Don’t Let Work Get in the Way argued that ‘Cost of Goods Sold’ activities should come first. This article will explore how you can use your income statement to make more money. The following articles will explore how you can use the other two basic financial statements to do the same.
Israeli physicist and business guru Eliyahu M. Goldratt is our guiding author for this series. He defined the goal of making money as follows: “This is the goal: To make money by increasing net profit, while simultaneously increasing return on investment, and simultaneously increasing cash flow.”
Calculating Net Profit is the purpose of the Income Statement. Every manager receives (or should be receiving) regular Income Statements. (If you’re not, stop now and give us a call!) Most managers understand how to use the thresholds of this statement, while others do not. Some managers may even recognize how Income Statements can deceive them.
Income Statements calculate four subtotals before arriving at the fifth total of Net Income. Those five are Revenue (top line), Gross Profit (Revenue – Cost of Good Sold), Earnings Before Interest & Taxes (Gross Profit – Operating Expenses), and Earnings Before Taxes (EBIT – Interest). Those should be used to highlight four immediate ways to make more money.
Revenue – Sell More
Gross Profit – Be More Efficient at Making Goods
EBIT – Cut Overhead Expenses
EBT – Pay off Debt
Net Profit – Get a Better Tax Accountant
As simple as those principles are, they remain perhaps the most important fundamentals to making more money. Too many managers we work with accept the status quo as given and focus on making the decisions they can while not changing anything of consequence. Sometimes a manger must step back and employ Box II Thinking–what can I substantially change today that will move the needle tomorrow and take care of problems before they happen?
Public corporations keep two sets of books, two sets of Income Statements, two sets of Balance Sheets, and two sets of Cash Flow Statements. One set of books is meant for the IRS. One set of books is meant for the SEC. While some of the differences are mandated by the two agencies’ filing requirements, other differences are arbitrarily set by management in order to pay less taxes and elevate share price.
That does not mean all managers or statements lie. That does mean all managers and statements can lie.
The rest of this blog is a reminder of the ways in which Income Statements can lie. It is Preferred CFO’s hope to assist you in making more money by helping you avoid “lying” to yourself, and reading Income Statements for the information they actually provide rather than what you think they provide.
Capital & Depreciation
Capital expenditures and depreciation can be set in ways that reflect the real dynamics of the business and in ways that do not reflect the real dynamics of the business. Both real and unreal ways are usually acceptable within Generally Accepted Accounting Principles. Whatever definitions you use on your taxes or when speaking to investors (although the danger and harm of a poor reputation should be considered), be aware of the real capital assets used and the approaching need for new assets.
Warren Buffet famously asked, “Does management think the tooth fairy pays for capital expenditures?” Perhaps the greatest lie is to use EBITDA instead of EBIT when making managerial decisions.
Don’t let your money get taken by the tooth fairy. Make sure your Income Statement is being honest about capital expenditures.
Timing & Matching
The matching principle of accounting requires that production costs be recognized at the same time as the revenue they create. That’s an important step toward keeping your Income Statement honest, but it’s imperfect. Half-finished projects and half-sold projects can be mayhem when broken up by calendar reporting periods.
While your official statements need to follow standard calendar periods, a manager with awkward timing can benefit from an Income Statement that covers an arbitrary period.
Additionally, the matching principle comes with a catch. It obscures how much cash you actually have, and too much cash out with too little cash in can be dangerous for many reasons. Remember that the Cash Flow Statement remains an important check on the reality presented by the Income Statement.
Generally Accepted Account Principles (GAAP) allow and even require management to make arbitrary decisions about measuring costs. Inventory is measured using either First In First Out (FIFO) or Last In First Out (LIFO), and a shift from one to the other can cover a loss in real earnings. Receivables do not always or even usually have perfect credit, and lower-than-expected collections ratios mean making less money than expected. Defining normal expenditures as “extraordinary” can also artificially inflate earnings.
Changing assumptions about any of these factors should be a yellow flag that calls your attention to investigate. Embezzlement and hidden losses aside, if assumptions are changing, something in your business is changing. Not know what that change is will cost you money.
Income Statements can exclude non-essential expenditures like research and development. However, research and development are frequently essential to tomorrow’s income, no matter how non-essential they are to today’s income. Capital expenditures are not the only piece of overhead that needs to be accounted. If ignored, other fundamentals like personnel, marketing, sales, operations, and equipment can imply a much higher income today than is actually justified.
It may seem paradoxical to read that one makes money by making sure the Income Statement tells you you’re making less, but knowledge of reality is better than an illusion of fantasy. Recognizing the truth allows you to improve it.
The tips in this article are only the tips of icebergs. Financial analysis is the science and art of using data to maximizing earnings, especially accounting data. Assisting you in making more money by helping you avoid lying to yourself is what we do best. You don’t need a full time CFO. You just need us. We are your part-time, outsourced CFO.
Look for Part Three on Balance Sheets and Part Four on Statement of Cash Flows.