Profit Is an Estimate

The Core Insight

Karen Berman and Joe Knight gave a twenty-one question finance exam to a representative sample of American nonfinancial managers. The average score was 38 percent. A majority failed to distinguish profit from cash. About 70 percent failed to pick the correct definition of free cash flow.

The exam sets up the claim the book is built on. Financial statements are a reflection of reality rather than reality itself. Nobody knows how long a truck lasts, so someone estimates how much of it to expense this year. Every estimate carries a bias, a direction the number gets pushed by whoever assembled it.

The authors attach four questions to any number on a statement. What assumptions produced it, what estimates sit inside it, what bias they create, and what that bias implies.

Most founders treat the financials as a scorecard the accountant hands back, and read the bottom line as the verdict. Berman and Knight argue that the bottom line is a construction. The assumptions inside it are where the business gets decided, and a founder who cannot name them reads someone else's opinion.

The Framework

Financial intelligence, in the authors' accounting, is four skill sets stacked in order.

• The foundation is reading the three statements and knowing why the balance sheet balances.
• The art is finding where estimates were applied and testing what a different one does.
• The analysis is the ratios and the returns on assets, equity, and capital.
• The big picture reads those numbers against economy, competition, regulation, and technology.

The income statement reports revenues, expenses, and profit across a period. The balance sheet reports what the company owned, owed, and was worth on one day, where assets must equal liabilities plus equity. The cash flow statement reports the money that moved.

One piece of accounting carries the rest, and it is the matching principle. Costs get matched to the revenue they generated rather than to the period the cheques cleared. A sale is recorded on delivery, whoever pays and whenever.

The statements form one system. A company opens a month with 25 dollars of cash and 25 dollars of equity. It buys 50 dollars of parts on credit, sells 100 dollars of product on terms, and incurs 25 dollars of other expenses. Net profit is 25 dollars, equity rises to 50 dollars, and the bank holds nothing.

Key Ideas

One Assumption Moves Profit by Half

A delivery company does 10,000 dollars of business in its first full month, against 5,000 dollars of direct cost and 3,000 dollars of overhead. It bought a 36,000 dollar truck, straight-lined over three years at 1,000 dollars a month. Net profit is 1,000 dollars.

Change the one assumption. Decide the truck lasts a year and depreciation becomes 3,000 dollars a month, turning the 1,000 dollar profit into a 1,000 dollar loss. Decide it lasts six years and depreciation becomes 500 dollars a month, and net profit rises to 1,500 dollars, up 50 percent. The truck and the work are identical in all three.

Waste Management ran that lever at scale. The company announced a pretax one-time charge of 3.54 billion dollars, admitting it had earned that much less than reported. It held 20,000 garbage trucks bought at an average 150,000 dollars each, depreciated over the industry standard eight to ten years. Executives stretched the schedule to twelve, thirteen, and fourteen years. They did the same to about 1.5 million Dumpsters, moving twelve years to fifteen, eighteen, or twenty. Trucks and Dumpsters alone pumped up pretax earnings by 716 million dollars.

A Growing Company Can Grow Itself Broke

Three structural facts separate profit from cash. Revenue is booked when the product ships, though the customer has thirty days or more to pay. Expenses are matched to that revenue rather than to the month the money left. Capital expenditures never reach the income statement, and only their depreciation does.

Sweet Dreams Bakery supplies specialty groceries and starts January with 10,000 dollars. Sales run 20,000, then 30,000, then 45,000 dollars, against cost of goods at 60 percent and 10,000 dollars a month of expenses. The income statement shows a 2,000 dollar loss, then 2,000 dollars of profit, then 8,000 dollars.

The bakery pays vendors in thirty days and collects in sixty. January collects nothing and spends 10,000 dollars, so the opening cash is gone. February collects nothing, pays January ingredients of 12,000 dollars plus 10,000 dollars of expenses, and ends 22,000 dollars in the hole. March collects January sales of 20,000 dollars, then pays 18,000 dollars of February cost and 10,000 dollars of March expenses. Its most profitable month ends 30,000 dollars in the hole, deeper than the month before. Growth is the cause, and the authors call this the standard way profitable companies go under.

The mirror case runs the other way. Fine Apparel sells expensive menswear, collects at the register, and negotiated sixty-day vendor terms. On sales of 50,000, 75,000, and 95,000 dollars against 70 percent cost, it loses money every month. Cash still climbs from 10,000 dollars to 105,000. Profitable and cash-poor needs someone who can arrange money. Cash-rich and unprofitable needs someone who can cut cost.

The number the authors trust most is free cash flow, which is operating cash flow minus net capital expenditures. Buffett calls the same idea owner earnings. On the sample company, 498 million dollars of operating cash flow minus 205 million dollars of capital spending leaves 293 million dollars.

Four Families of Ratio Answer Four Questions

Every calculation in the book runs on one sample company, in millions of dollars. Sales of 8,689, gross profit of 1,933, operating profit of 652, net profit of 248, total assets of 5,193, and equity of 2,457.

The first family divides a profit line by revenue, assets, or equity.

• Gross margin is gross profit over revenue, or 22.2 percent.
• Operating margin is operating profit over revenue, or 7.5 percent, and it grades the managers as a group.
• Net margin is net profit over revenue, or 2.8 percent, and it varies enormously by industry.
• Return on assets is net profit over total assets, or 4.8 percent, and it runs too high as well as too low.
• Return on equity is net profit over equity, or 10.1 percent.

The second family measures how much of the asset base runs on borrowed money. Debt to equity is total liabilities over equity, 2,736 over 2,457, or 1.11. Interest coverage is operating profit over interest, 652 over 191, or 3.41. A coverage ratio near 1 means the lenders take the profit.

The third family asks whether the bills get paid. The current ratio is current assets over current liabilities, 2,750 over 1,174, or 2.34. The quick ratio strips inventory and gives 1.26. Most bankers will not lend to a company sitting near 1.

The fourth family times the working capital cycle, on a 360 day year. Days in inventory is average inventory over cost of goods per day, or 74.2 days. Days sales outstanding is ending receivables over revenue per day, or 54.4 days. Days payable outstanding uses ending payables, or 54.5 days.

One identity holds the families together. Net profit margin multiplied by asset turnover equals return on assets. When price competition blocks the margin route, the balance sheet route stays open.

Return on Capital Is the Verdict on the Whole Business

Return on net assets, return on total capital, and return on invested capital all measure one thing. Each divides the return the business generated by the outside money it uses. The numerator is net operating profit after tax, and the denominator is equity plus interest-bearing debt.

Income before taxes is operating profit of 652 minus interest of 191, or 461. The tax rate is 213 over 461, or 46 percent. Tax on operating profit is 652 times 46 percent, or 301, leaving net operating profit after tax of 351. Interest-bearing debt is the credit line of 100 plus the current portion of 52 plus long-term debt of 1,037, or 1,189. Total capital is 1,189 plus equity of 2,457, or 3,646. The return is 351 over 3,646, or 9.6 percent.

That 9.6 percent means nothing until it meets the cost of capital. The book assumes 30 percent debt at 6 percent and 70 percent equity with a beta of 1.25. Cost of debt lands at 4.5 percent, cost of equity at 13 percent, and the weighted average at 10.45 percent. The company therefore returns 0.85 percent less than its capital costs, putting its providers about 31 million dollars behind on 3.646 billion.

Single Days of Working Capital Are Worth Millions

Working capital is current assets minus current liabilities, and it cycles. Cash buys raw material, which becomes work in process, then finished goods, then a receivable, then cash again.

The cycle has a length: days sales outstanding plus days in inventory minus days payable outstanding. On the sample company that is 54 plus 74 minus 55, or 73 days. One day of sales here is just over 24 million dollars. Multiply 73 days by 24,136,000 dollars and about 1.8 billion dollars sits financing operations.

The single day arithmetic is what to memorize. Cutting one day off days sales outstanding raises cash by 24 million dollars. Cutting one day of inventory raises it by nearly 19 million dollars. Adding one day to payables adds about 19 million. Careful management improves the financial picture with no change in revenues or costs.

Payables run the other way, and the trade is real. One Fortune 50 company told suppliers to expect payment in 120 days during the crisis after 2008. The soft costs resist measurement: a key supplier goes under, prices rise, deliveries slow.

Practical Applications

Compute four numbers from your own accounts, on a 360 day year. Days sales outstanding, days in inventory, days payable outstanding, and the cycle they add up to. Then divide annual sales by 360 and price one day.

Run the depreciation test on your last income statement. Take every capitalized asset, change its useful life by one defensible step in each direction, and recompute net profit. The gap between the two answers is the share of your bottom line that is a judgment call.

Put a thirteen week cash forecast beside the profit forecast before the next growth push. The bakery was profitable in March and 30,000 dollars deeper in the hole than in February. Faster growth widens that gap.

Set the credit rule before the sales pressure arrives. One small company in the book named its ideal customer Bob. Bob works at a large firm that pays on time and wants an ongoing relationship. Meet the traits and get terms, and days sales outstanding stays down.

Who This Is For

The founder who signs financial statements built by someone else gets the most from this book. It lands hardest before a raise, a loan, or a pricing decision. Anyone who reads the profit line and stops reading is the intended reader.

The book is written for managers inside established companies, and the entrepreneur framing sits on top of a corporate training curriculum. The last part is the authors' consulting practice written up as chapters. Some tax and reporting specifics have aged, including the sample tax rate of 46 percent and the mark-to-market rules rewritten after 2008. The ratio benchmarks vary far more by industry than the text admits. A current ratio of 2.34 carries a different verdict in software, retail, and heavy manufacturing. The scandal anthology also repeats, and three cases carry the argument while the rest decorate it.

Skip it if you close your own books, or if you already argue with your CFO about which assumptions produced the quarter.

The Decision

Two numbers settle whether this book has work to do in your company. Your days sales outstanding for last month, and the cash tied up in one day of sales.

Then run the assumption test on the largest estimate in your income statement. Depreciation, the allowance for bad debt, or how much salary lands in cost of goods sold. Move it one defensible step and recompute the bottom line.

Compute the cash conversion cycle this week from your own accounts. Add days sales outstanding to days in inventory, subtract days payable outstanding, and multiply the result by one day of sales. The answer is money you have already earned, sitting somewhere other than your bank account.