A Brief Overview of Auditing and Assurance

A firm informs its stakeholders about its revenues, operating expenses, interest and tax expenses, net profit, and other similar information through its financial statements. Suppose you had bought the stock of a firm based on a thorough analysis of its financial statements. A few years later, there is news that the firm had used fraudulent accounting to report fictitious revenue, which vastly overstated its profit. Following this, the firm goes bankrupt and you end up losing the money that you had invested in the firm’s stock. Wouldn’t it be awful to lose your hard-earned money just because you relied on information that you had expected to be accurate. It is therefore imperative that the users of financial statements feel assured that the information in the financial statements is accurate. How are financial statements assessed for reliability and accuracy? This is the “big picture” in the auditing and assurance course.

Generally Accepted Accounting Principles are the rules that govern the accounting world

Financial statements would be accurate and reliable if firms prepared them in accordance with GAAP. There are, however, many different motivations and temptations for executives to cut corners and falsify accounts. Therefore, public firms are required to have their financial statements audited by an independent auditing organization. The auditing firm is somewhat like a detective agency. It snoops around, with the active cooperation of the firm though, to determine if there is a significant misstatement in the firm’s prepared financial statements.

In the auditing course, we studied the audit process; how it is initiated and its different stages and what should auditors look for during the audit and how should they conduct themselves. The topics included management fraud, assessing the quality of the firm’s internal control system, employee fraud, potential problems with respect to revenue collection, expenditures, production, and finance and investment, and the use of sampling for auditing.

The Big Four Accounting/Auditing Firms: PricewaterhouseCoopers, Deloitte, KPMG, and Ernst & Young

Audits are performed in accordance with auditing standards known as GAAS (generally accepted auditing standards). Upon completion of the audit, the auditing firm offers an opinion on the financial statements. If the auditor issues an unqualified opinion, the users of the financial statements have reasonable assurance to rely on these statements.  Note that auditors provide reasonable assurance, as opposed to absolute assurance.

Just because financial statements are audited and signed off by the auditor does not guarantee that all is well. Many firms are large and complex. Their financial statements reflect thousands of different transactions and activities; it is therefore not easy for an outside firm to come and spot problems in the financial statements of the firm. It is even more difficult to spot problems if the management of the firm makes a conscious effort to cover up any accounting shenanigans. Therefore, despite an auditor’s best efforts, it is possible that some problems go undetected. Furthermore, the auditor is supposed to be an independent organization but it not independent in the true sense. The auditor gets paid a fee for its auditing services and might not want to risk losing the client’s business should it incur the displeasure of the client.

Enron’s demise left many investors in shambles

There have been many cases where auditors have failed to spot blatantly fraudulent accounting. A number of high profile corporate frauds such as the ones at Enron and HealthSouth led to the passing of the Sarbanes Oxley Act in 2002. This Act, commonly known as SOX, established new standards and tightened existing standards for reporting and auditing of financial statements. For example, the Public Company Accounting Oversight Board (PCAOB) was created to oversee auditing firms. Likewise, several new standards were established to limit the conflict of interest between the client and the auditor.  In our course, we discussed the auditing industry, the auditing profession, and the auditing environment post SOX.

Through this course, I experienced the “softer” side of accounting. Unlike the typical accounting course, the auditing course did not have number work; few accounting classes are this qualitative in nature. I found the course useful because it dealt with the human element of accounting and made me knowledgeable about a specific career path within accounting. I am, however, not planning a career in auditing.  Therefore, I will not be taking any other auditing related courses.

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A Brief Overview of Intermediate Accounting I

Intermediate Accounting (Seventh Edition) by Spiceland, Sepe, and Nelson is the course text for both Intermediate I+II

In a blog about the CPA exam, a blogger wrote about accounting majors having to slay a “double-headed monster” called Intermediate Accounting. Double-headed alludes to the fact that in most schools, intermediate accounting is taught in two parts. Typically, students take the two courses in back-to-back semesters. Having just completed Intermediate Accounting I, I must say that the monster part is a bit overstated.

Intermediate Accounting I is taken after completing the introductory financial accounting course. The word intermediate in the course title suggests that the content of the course is similar to the financial accounting course but at a more advanced level. For the most part, this is true. When I looked at my Intermediate Accounting I course syllabus, most of the topics appeared familiar. In fact, the first few chapters in the textbook covered very little new ground (be warned that the intermediate accounting textbook is probably the heaviest among all business textbooks). But subsequent chapters covered familiar topics in great depth and also covered some new topics. A second difference is that the intermediate accounting course does not focus as much on bookkeeping as does the financial accounting course.

This statement of comprehensive income shows the the different “sub-incomes” that are not discussed in detail in financial accounting

Let me give a couple of examples about the difference in coverage between financial accounting and intermediate accounting. In financial accounting, we learned about inventory and how it affects the income statement. In Intermediate I, we studied the retail inventory method for converting inventory valued at retail to cost. Likewise, in financial accounting, income statement reporting is simplified in the sense that one only examines net income. In Intermediate I, you learn how to classify income as income from continuing operations, income from discontinued operations, and income from extraordinary gains or losses. Each of these “sub-incomes” is separate and is shown net of tax; for example, income from continuing operations would be revenue from continuing operations less costs from continuing operations less taxes (tax rate*difference between revenues and costs).  If you were comfortable with the material in financial accounting you are likely to feel comfortable with the material covered in Intermediate Accounting I as well.

The motivation for many accounting students in the class: the CPA exam

Intermediate Accounting I can be a bit tedious for non-accounting majors. Students who want to become accountants and take the CPA exam are likely to have a greater motivation to learn the different rules and procedures than non-accounting majors. My career focus is finance. In addition to concentrating in finance, I am also concentrating in accounting because I believe that the study of accounting will make me a better student and practitioner of finance. It will provide me a thorough background of a firm’s financial statements, which is essential knowledge for finance professionals. After completing Intermediate Accounting I, I feel a lot more comfortable with reading and interpreting financial statements than I did before taking the course. This ability will be further strengthened when I take Intermediate Accounting II next semester (Spring 2015).

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My Second Stock Purchase

Coca Cola (KO): The first addition to my portfolio

Who was the first person to fly non-stop solo across the Atlantic? Charles Lindbergh. Who was the second? Who knows and who cares? Typically, the “first” gets much more importance than the second and the third; the first is also often more memorable. Last year, I blogged about my first stock purchase when I purchased 30 shares of The Coca Cola Company (Ticker: KO). Since then, I have expanded my portfolio to two stocks. I’m going to give importance to the “second” by posting about my second stock purchase.

At the time I blogged about my first stock purchase, there was talk of an impending market correction. In anticipation, I had decided to wait for the correction to buy my second stock. It is easier said than done though. There has been no correction so far. There was something like a mini-correction but it happened too quickly for me to react. The problem with waiting for a correction to buy stocks is that it is hard to figure out when a correction has started and even harder to figure out when it will end. Timing the market is a difficult. My advice is “Don’t try it.”

I had also written that it didn’t make sense to have money lying in my brokerage account without earning any interest. One option for me was to park my money in a low-beta stock. The idea was that I would earn some return and if there was a market correction, my low-beta stock would not fall as much. But, at the time I decided not to pursue this option.

Eventually, something unplanned led to my second stock purchase. At the beginning of last semester, a recruiting announcement from the Board of Portfolio Managers, a student organization at my school, piqued my interest. I wanted to apply for membership to this organization but I didn’t meet one eligibility criterion. Applicants were required to have a personal portfolio of at least two stocks. I had to buy a second stock to meet this criterion. In my KO blog, I had written about the importance of buying a stock after thoroughly researching the company and understanding its business. I didn’t, however, have the time to follow this advice for my second stock purchase.

Duke Energy (DUK): The second stock in the portfolio

I decided to play safe and buy a utility stock. Utilities have relatively low price volatility and are considered “safe” stocks. The saying is that utilities are recommended for widows and orphans because these stocks provide a steady dividend with limited downside potential. Based on some quick research, I decided to buy shares of Duke Energy Corporation (DUK). Duke is the largest electric power company in the United States and has a growing presence in solar and wind energy. The stock had been underperforming because earlier during the year there had been a huge coal ash spill from a closed Duke plant into a river. The price of the stock had fallen into the 60s and was oscillating in the low to mid-70s when I decided to buy the stock. I couldn’t place a limit order because I didn’t have time to wait. I placed a market order for 20 shares that got filled at $74.20. I was now eligible to apply to the Board of Portfolio Managers.

I lucked out on my purchase because after I bought the Duke stock, it began a steady climb. I purchased it on September 19 at $74.20 and at the time of writing this blog (January 2, 2015) its closing price was $84.05. This gives me an unrealized gain of 13.27% in under three months, a lot more than what the S&P 500 gained during the same period. I also received a dividend of $0.795 per share. I guess I am doing quite well so far with the Duke stock. Not bad at all.

One of many Duke Energy plants

I am unsure about what I should do with the Duke stock now. I had not purchased it as a long-term buy although it has long-term potential. It is gone up very fast and I am concerned that it will fall and my current gain will evaporate. In fact, during the last few days it has fallen from an intraday high of $87+ to $84.05. I am not expecting it to go up from here. It is not a high-growth stock that can keep going up and up without an end in sight. It’s a boring utility. Utilities are supposed to be priced correctly (In my finance textbook, the discussion of stock valuation based on the Gordon Growth Model uses a utility as a reference). Duke is trading above the consensus analyst price target of $82. I am not sure what is driving the stock. One recent piece of good news was a 7.2% rate increase approval in North Carolina. Most of Duke’s business is regulated, which means that regulators determine the price that Duke can charge. I have to dig a little deeper to figure out if there is something else behind the steady price rise. Actually, it might just be a sector effect because the utilities sector has been the best performing sector during 2014. Not sure though why the utilities sector did so well in 2014 – it’s hard to explain.

I purchased the Duke stock to become eligible to apply for membership to the Board of Portfolio Managers. I applied but I wasn’t accepted. Oh well! At least the stock did well.

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A Brief Overview of Managerial Economics I

Managerial Economics by Allen, Doherty, Weigelt, and Mansfield: the course’s optional text

At my school, managerial economics is taught as a two-semester course. How the principles of economics can be applied by managers is the big picture in Managerial Economics I.

Graph for Cournot Competition

We began the course with a review of the key principles studied in an introductory microeconomics course with an emphasis on supply and demand, elasticity, indifference curves, and the use of marginal revenue equals marginal cost for decision making. We also reviewed simple optimization techniques that are studied in an elementary calculus course. Specifically, we learned how to use derivatives to solve maximization and minimization problems and partial differentiation for maximization solutions involving multiple variables.

Game Theory Matrix: Prisoner’s Dilemma

A large part of the course focused on price and quantity decisions in different market structures such as perfect competition, oligopoly, and monopoly. For example, we discussed the Bertrand model in which firms compete on price, the Cournot model in which firms compete on output, and the Stackelberg model in which one firm has a first mover advantage. We also studied the three price discrimination options available to a monopolist. One topic that I particularly liked was game theory. We discussed several examples of the application of game theory in a duopolistic market structure. I found game theory appealing because it offers unintuitive insights for decision making. Finally, we studied decision tree analysis to incorporate uncertainty in decision making. The instructor used problem sets and cases as key learning tools.

This course was not very different from an introductory microeconomics course. The focus was on application of economic principles as opposed to the descriptive focus in the introductory microeconomics course. A concern that I have with the models that we discussed in the course is that they are based on restrictive assumptions because of which they might not be applicable in actual managerial situations. Next semester, I will be taking Managerial Economics II in which the emphasis is more on business strategy and less on graphs and curves, which are staples in most economics courses.

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Brooklyn Nets: A Win is a Win

Disgusting. Perplexing. Exciting.

Most can agree that the sequence of events in last night’s Nets vs Magic game were just a tad bizarre.

As a Nets fan, they were also a bit discomforting. On the bright side, however, Brooklyn defeated Orlando 100-98 and improved to 16-16; the Nets are back at .500 for the first time since they were 4-4 in mid-November. And the team is 1-0 in 2015. That being said, Lionel Hollins, Brooklyn’s head coach, still had some matters to discuss in the locker room.

Through 3 quarters in Orlando, the Nets were dominant. The team’s shooting was absolutely torrid; they shot 63.5% from the field through the first 40 minutes of play. Up 86-61 entering the fourth quarter and 95-71 after Alan Anderson’s three-pointer with 8:15 left to play, it looked like the Nets were well on their way to cruising to a blowout victory. Well, that’s not how things unfolded.

Joe Johnson’s two free throws ended up being the difference in the final box score

After rookie Elfrid Payton’s made free throw with 1:04 remaining, the Nets lead was cut to 98-95. Brooklyn was held scoreless for nearly six minutes and watched its lead evaporate rapidly, ending each possession with either a turnover or a missed shot. After shooting lights out for over three quarters, the Nets went ice cold. Evan Fournier’s three-point attempt with 23 seconds left would have tied the game at 98-all but fortunately for the Nets, it did not go in. Joe Johnson drained two free throws in typical Joe Johnson fashion. The man, as always, plays with ice in his veins; if the Nets had to pick one player to take the last shot, it would be Johnson.

Elfrid Payton almost foiled the Nets’ plans but his late three was not quite enough

Jarrett Jack tracked down a loose ball following a jump ball tie-up on the following possession but he stepped out of bounds with 13 seconds remaining. Had he stayed in-bounds, Brooklyn probably would have sealed the victory. This game, however, was destined to have Nets fans reaching for their blood pressure medications. Payton missed a jumper from inside the arc, maneuvered through the lane, grabbed his own miss, and drained a three-pointer from the side wing with 3.8 seconds left. The lead was down to just two! The Nets were out of timeouts too. Jarrett Jack shook off his defender, took the in-bounds pass, and tossed the ball high up into the air to finish the game. Brooklyn successfully avoided what could have been the largest meltdown of the NBA season to date. Let’s look at both the positives and negatives from the game.

Plumlee going in for a thundering dunk

The good: The Nets won! They’ve picked up serious momentum since Lionel Hollins has placed Jarrett Jack in the starting lineup, winning now six of their last seven games (including a road win against the Bulls that snapped the team’s seven game winning streak). Jack actually played his worst game of late, having as many points as turnovers (6). Deron Williams, Brooklyn’s usual starting point guard, played his best game coming off the bench, scoring 16 points on 5-10 shooting to go along with 7 assists (and only one turnover) in 29 minutes. Brook Lopez played exceptionally well in limited action, scoring 16 points on 7-8 shooting to complement his 8 rebounds (well over his average of 5.7 per game despite considerably less playing time) and 3 blocks. Mason Plumlee continued his dominant play of late, falling one rebound short of a double-double (18 points on 9-10 FG, 9 rebounds, 2 blocks). Plumlee exhibited his usual hustle and once again took advantage of his increased playing time. Joe Johnson knocked down two free throws when they mattered most; they proved to be the difference in the final score. To top it all off, 38-year-old Kevin Garnett played well in his 18 minutes on the court; he scored 9 points, which included his first three-pointer in over a year! The Nets as a team shot 41-72 (56.9%) from the field and outrebounded the Magic 45-37. Nikola Vucevic, Orlando’s best player, was held to 10 points and 4 rebounds (season average of 18.1 points and 11.3 rebounds per game).

Channing Frye went 3-6 from downtown for the Magic

The bad: Up until the start of the fourth quarter, not much could be said. Brooklyn was careless with the ball, racking up 22 turnovers including 15 between Jack (6), Plumlee (5), and Johnson (4). Orlando only committed half as many turnovers (11); as a result, despite getting outrebounded, the Magic were able to take 16 more field goal attempts than the Nets. Brooklyn started playing half-hearted defense in the second half of the fourth quarter and allowed Orlando to score in flurries. The perimeter defense was especially bad as the Magic went on to shoot 50% (11-22) from behind the arc. Evan Fournier, Channing Frye, Victor Oladipo, and Tobias Harris all connected on multiple attempts. The free throw shooting was also atrocious, especially down the stretch. Plumlee went 0-3 from the line on the night, Karasev watched his two free throw attempts both rim out, and D-Will missed one of two clutch free throws in the closing minutes. The Magic entered the 4th quarter having scored only 61 points; they outscored the Nets 37-14 in the final quarter! The Nets completely failed to close out what should have been an easy, lopsided win.

Takeaways: The Nets cannot afford such careless play if they want to ascend to the ranks of the elite; even at .500, they currently have the 7th best record in the East. They still have a long way to go to get to the top though. However, if they play like they did in the first three quarters, Brooklyn will surely emerge as a top-4 team in the East. The Magic entered the game with a record of 13-22 so it’s safe to say most teams will require more effort to beat.

Coach, we want some more playing time!

Coach Hollins should reward both Lopez and Williams for their excellent showing last night by playing them an extra 5-6 minutes in the next game or two. Having the former all-stars come off the bench has seemed to work for the team; as of now, there is no reason to change the starting lineup. Despite Williams’ accomplishments of the past, Jack should continue to start.

Although last night’s game was rather tough to watch near the end, Coach Hollins has to be pleased with the way his team has been performing of late. Hopefully, the Nets can continue their winning ways in South Beach tomorrow night when they take on the Heat.

Lionel Hollins has plenty to smile about

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On Overview of Acting in Public: Performance in Everyday Life

The theater? Of course!

For quite some time, I have wanted to take a course to improve my public speaking skills. During my freshman year, I took a management communication course that included a couple of speeches and presentations but the course didn’t do a lot to improve my speaking skills. I stumbled on the right course to take when by chance I read an article about students taking theater courses to strengthen their speaking skills. It made perfect sense! I was surprised that it had not dawned on me that some theater courses might be beneficial for strengthening speaking skills.

The Schwartz Center: Home to the Performing and Media Arts Department

I searched the courses offered at my university’s Performing and Media Arts Department and found a course that seemed tailor made for my needs – Acting in Public: Performance in Everyday Life. The course description sounded appropriate and as a studio course, the enrollment was capped at 12 students. It had a great instructor too; the professor has a lot of real theater experience. Additionally, he has written national award-winning plays and has a Ph.D. in theater AND an M.D. degree. Yes, he is a professor of theater as well as a practicing physician. The stated purpose of the course was to increase the student’s effectiveness of meeting the demands and enjoying the opportunities of public speaking.

I gave my eulogy inside the Sage Chapel (shown above)

For this course, we met twice a week.  In one class, we would discuss and work on different aspects of speaking such as posture, gestures, eye contact, voice, stage presence, speech making as storytelling and a whole lot of related stuff.  We had about three readings for each of these classes. In the other class, we held speaking performances. Through the semester, each student had to do ten one-minute speaking performances (elevator speech, public apology, stand-up comedy, eulogy, tour guide, sales pitch, pep talk, Sunday sermon, and two performances to be selected from a menu of options – I picked “teach a skill” and “famous public speech”) and a one-minute Shakespeare pantomime. We were given written guidelines for each performance and we could adapt our performances from existing speeches. Most performances were done in a small studio; however, some speeches were done in different venues. The eulogy was done in a chapel, the tour guide performance was done on a street, and the pantomime was done in a football stadium (in the middle of the field). Based on pre-assigned questions, the audience provided instant feedback using i-clickers. After each performance, the audience and the instructor gave suggestions for improvement. Sometimes, a student would have to do a speech a second or even a third time. All performances were recorded and videos were uploaded on Blackboard (electronic course management system) for subsequent review by students at home.

Even this guy has been known to make a speech or two

After the first five performances, we did a five-minute speaking performance that combined the speeches from the first five one-minute performances. We did the same after the next five performances. Toward the end of the semester, we did a five-minute performance that combined 30 seconds from each of the ten speaking performances. And, finally we did a five-minute performance that combined bits and pieces from our top seven performances. We had two quiz-bowl type competitions on the course readings and one five-minute speech in which we read out the “pearls” that we had gathered from the different course readings. At the end of the semester, we submitted two short papers. One was a self-critique and the other was a description of what we had learned that we would continue to use after the course was over.

This course required a significant time commitment throughout the semester but it was worth it. I got lots of speaking practice and specific feedback on how to improve. By the end of the course there was a noticeable improvement in my public speaking skills. Post course, it’s important that I make a conscious effort to use what I learned in the course in my everyday life. That is what Acting in Public: Performance in Everyday Life is all about.

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Profit, Cash Flow, and Firm Value

Public companies are financed through debt and equity capital. Providers of debt capital expect a return in the form of interest payments and they also expect to get the principal amount back at the end of the loan period. Providers of equity capital expect to share the profit of the firm after the debt providers have been paid. In essence, the providers of capital benefit if the firm is profitable. The concept of profit in business is not as straightforward as it is in everyday usage. There are different types of profits. In this post, I will explain the different types of profits and the relationship between profit, cash flow, and firm value.

Typically, a firm reports its profit (loss) in its income statement. The income statement, however, is based on accrual and not cash accounting. This means that the profit in the income statement does not correspond with the firm’s actual cash inflows and outflows during the reporting period. Financial analysts, however, are more interested in free cash flow (the cash remaining after all expenses have been accounted for) from a firm’s operations than in accounting profit. I will describe how cash flow used in financial analysis is computed from information available in financial statements.

Sample income statement

I’ll start with the different profit subtotals in an income statement (a sample statement that I copied from the Internet is given above).

Gross profit is the difference between sales and cost of goods sold. Gross profit margin is calculated by dividing gross profit by sales. A high gross profit margin (say 80%) indicates that the firm has 80 cents per dollar of sales to pay off its operating expenses. All things being equal, a high gross margin indicates cost efficiency and/or pricing power. Firms with strong brands and customer loyalty can charge high prices and are therefore more likely to have high gross profit margins.

Note that gross profit is not a cash flow. Sales are often made on credit. Under accrual accounting, a sale is booked if there is an assurance that the revenue is forthcoming. Thus, the sales figure includes sales that have been booked or that have been shipped, but for which cash payment has not yet been received. Similarly, the cost of goods sold may include materials for which payments have been promised but not yet made.

Gross profit is sales revenue minus direct expenses. Cost of goods sold, which includes the cost of materials and labor, is a direct expense. Costs such as utility and wage expenses, which are incurred for operating the business but are not directly associated with a product or service, are indirect expenses. Operating profit is calculated by deducting indirect expenses from gross profit.

One important indirect expense is depreciation expense. Depreciation is a non-cash expense, which means that it does not represent actual cash flow. Suppose a firm purchases a machine for one million dollars. The firm expects the machine to last for 10 years and uses a straight-line depreciation policy (same amount of depreciation expense allocated each year) and does not expect the machine to have any salvage value (value at end of the useful life of the machine). This firm will record $100,000 in depreciation expense each year ($1,000,000/10) in its income statement. This $100,000, however, does not leave the firm in this reporting year. It is a set amount that the firm expects the machine to essentially lose in worth.

Operating income is an indicator of the health of the company’s main business activity. It does not include interest expense (this is viewed as a financing expense and not as an operating expense). Because operating income is income before interest payments have been deducted, it is relevant to both bondholders and stockholders.

Besides operating income, some firms also have non-operating income and expenses. Net income is derived from taking operating income and adding other income, subtracting interest expense, deducting taxes, and then accounting for any income/loss/gains from discontinued operations and/or extraordinary items. Both the discontinued operations and extraordinary items should be reported net of tax.

Commonly “profit” refers to net income. Because net income is computed by deducting interest and taxes, bondholders and the government do not have residual claims on it; stockholders are the only ones who have a claim on net income. A firm keeps some of its net income to reinvest (retained earnings) and pays out the rest to stockholders as dividends. The total net income divided by the number of shares outstanding yields EPS, or earnings per share. A company might separately report EPS from continuing operations and EPS that also includes discontinued operations and extraordinary items.

Financial analysts use the information from the income statement and balance sheet to compute cash flow and also compute income types other than the three I discussed above. I will now describe the other types of income and the computation of cash flow.

EBIT: earnings before interest and taxes. Sometimes also called PBIT (profit before interest and taxes).

EBIT = revenues – cost of goods sold – operating expenses + non-operating income.

If there is no non-operating income (zero in the equation above) the EBIT and operating income are the same. Because interest and taxes have not been deducted from EBIT, both the government and bondholders (in addition to stockholders) have residual claims on EBIT. Because EBIT does not include interest or taxes, it is a profitability measure that is independent of capital structure and tax rate, two components that are not uniform among firms.

What is the relevance of EBIT (assuming it is equal to operating income)? A company can have a high operating income but a low net income. Because net income is the final measure of profitability (all revenues – all expenses), a low net income may “mistakenly” not reveal strong operations.

EBIAT: earnings before interest after taxes

EBIT includes the claims of the government, bondholders, and shareholders. Financial analysts are often interested in the profits available for bondholders and shareholders. In such contexts, taxes are deducted from EBIT to give EBIAT or earnings before interest after taxes. EBIAT is also referred to as tax-effected EBIT.

Related metrics are NOPAT, or net operating profit after taxes (sometimes referred to as NOPLAT or net operating profit less adjusted taxes). If there is no non-operating income, NOPAT equals EBIAT.

EBITDA: earnings before interest, taxes, depreciation, and amortization

EBIT often includes a significant chunk of non-cash expenses. To compute cash flow from EBIT, non-cash expenses have to be added to EBIT. Adding the prominent non-cash expenses of depreciation and amortization to EBIT gives EBITDA.

The government, bondholders, and stockholders all have residual claims on EBITDA (as with EBIT) because interest and taxes have not been deducted. Because interest is not included, EBITDA indicates a company’s capacity to service its debt. In businesses with high fixed costs (ex: airline industry) that have sizeable depreciation expenses, EBITDA is a useful metric. High depreciation expenses can result in a low or even negative EBIT. In such cases, EBITDA is a better indicator of earnings than EBIT. EBITDA is also useful for comparing companies with different capital structures, tax rates, and depreciation policies. By stripping EBIT of non-cash expenses, EBITDA is a good metric for comparing companies that are in similar markets. Even though EBITDA is a non-GAAP item, many firms routinely report it. But, because it is a non-GAAP item, companies have flexibility in how they report it.

Keep in mind, however, that EBITDA is not a measure of cash flow as it does not  account for capital expenditures (purchases of long-lived assets to which the depreciation is allocated) or changes in net working capital (accounts for changes in receivables and payables related to credit sales).

EBITDA is sometimes mistaken as operating cash flow. It can be used as a quick proxy but it not the same as operating cash flow. Capital expenditures have to be deducted from EBITDA to compute cash flow. Additionally, EBITDA is based on gross profit, which has a non-cash component to it; this non-cash component also has to be adjusted for.

Now I will discuss different types of cash flows:

OCF: Operating cash flow

The expression for OCF is:

OCF = EBIT + Depreciation – Taxes

OCF is the cash that a company makes from its business operations. Taxes are viewed as an operating expense while interest is viewed as a finance expense (interest is viewed as a financing expense in financial analysis but in accounting, interest is considered an operating expense).

A positive OCF indicates that the cash inflows are greater than the cash outflows from daily business operations. A negative OCF is a worrisome sign. It is possible for a firm to have a positive net income but have negative OCF.

OCF is a better indicator of the cash that comes in from the regular business than EBIT. Why? Depreciation is a non-cash expense so it is added back and taxes are removed because they are considered an operating expense. These taxes correspond to the operating income; the company’s overall taxes may be more or less depending on the non-operating income or loss. As mentioned earlier, EBIT – Taxes is known as tax-effected EBIT, or NOPAT or EBIAT.

Cash Flow From Assets = OCF – CapEx – Increase in Net Working Capital

Cash flow from assets is the cash available for creditors and stockholders. In other words, the assets of a firm produce cash, which is used to pay bondholders and stockholders. As noted above, to determine cash flow from assets, OCF has to be adjusted to include changes in capital expenditures and net working capital. Why do have to make these adjustments?

The depreciation expense that is recorded is allocated over the life of long-lived assets such as property, plant, and equipment. If we add back depreciation, we must also account for the cash spent on equipment purchases called capital expenditures.

Net working capital is the difference between current assets and current liabilities. It refers to the amount of money on hand that can be used to pay off short-term obligations. Any increase in receivables will cause it to increase and any increase in payables will cause it to decrease and vice versa. So, why do we subtract an increase in working capital (non-cash)? Well, an increase in working capital indicates that receivables have increased more (or decreased less) relative to payables. Receivables are to be received later as the name indicates; they are not available now. This means if a firm’s receivables increase, it will have less money on hand now; this is why increases in working capital decrease cash flow from assets.

Another term, free cash flow (FCF), is used interchangeably with cash flow from assets. Free cash flow is also referred to as unlevered cash flow. This is cash flow from which debt expense has not been deducted. Because interest has not been deducted, both creditors and investors have residual claims on unlevered free cash flow.  Some firms may have a negative free cash flow. This is not bad if these firms are heavily investing in capital expenditures that will generate cash flows in the future.

Levered cash flow is unlevered cash flow less interest expense.

Enterprise Value. Remember this one. It refers to the acquisition cost of a company; it’s the sum of the firm’s market capitalization and net debt.

Say you have an extraordinary sum of money earning you meager returns. This bores you. You take out a sizeable chunk and decide to buy a company. You do this by buying all of the company’s outstanding shares. You now have 100% ownership of the company. However, along with the ownership of the company, you also obtain responsibility for all of the company’s outstanding debt. You also get ownership of the cash the company has; this cash can be used to pay off some of the debt. Therefore, your acquisition cost of the company would be its market capitalization (the price you paid for buying all shares) plus its net debt.

A firm’s implied enterprise value can be found by discounting its projected future free cash flows using an appropriate cost of capital. If net debt is deducted from EV what remains is equity value. Equity value represents the total value of a firm that is available to owners (shareholders but not bondholders or government). This also includes the value of employee stock options which have yet to be exercised.

Equity value can be used to calculate an implied share price. Implied share price is obtained by dividing equity value by outstanding number of diluted shares (outstanding shares plus any stock options or convertible bonds). Why is it implied? It is implied because we are making the calculation based on our projections of the firm’s future cash flows. The market price of the stock is known. Comparing the implied equity price with the market price tells us if the company’s stock is under or over valued.

This ends my story about profit, cash flow, and value.

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