If you’re anything like the picture of a lawyer painted by our contributor Edward Smith of TELEFÓNICA UK (see Where are all the lawyer-CEOs?), you might be thinking about flicking past this section out of fear of being outed as a finance-phobe. We know that’s a stereotype… but lots of our in-house lawyer friends have confided that, for many, finance is an Achilles heel.
Fear no longer! In a regular feature, GC will be taking you through the salient features of finance in its various forms – so you can impress the CFO (or at least nod your head in the correct places).
So how much is your company worth?
The three key financial documents
These are essentially the building blocks for giving a picture of the financial state of a company.
The balance sheet
This is a term we all hear from CFOs and accountants – we may even use it ourselves. But what actually comprises a company’s balance sheet?
Basically the balance sheet should show:
- Assets. Assets are what the company owns, or its physical assets. This will include real estate, raw materials and finished goods. It can also include financial instruments such as stocks and bonds, as well as accounts receivable from suppliers or customers. Assets are always recorded on the balance sheet using their historical valuation. So if you bought an office building in 1980, its original purchase price will be used to determine its value on the balance sheet. Of course, in real terms the building may well be worth substantially more.
- Accountants use the historical value to mitigate against unpleasant surprises and to prevent having to constantly revalue assets.
Debts/liabilities. Debts or liabilities are what the company owes to others. They can include bank loans or other forms of corporate financing such a corporate debt. They will also include accounts liable – all the bills and liabilities that the company has not yet paid for.
The equity value of the company is based upon the combination of its assets and liabilities, and is calculated using the basic accounting equation:
ASSETS – LIABILITIES = OWNER’S EQUITY VALUE
The income statement
The second of the three most important financial documents a company produces is the income statement. This is divided into operating and non-operating costs.
Operating expenses are deducted to reveal operating profit. From this point, any non-operating revenues and expenses are listed. Non-operating profits are anything that is not connected with the day-to-day activities of a company. Examples might include the business selling some real estate, such as an office building, leading to a one-off profit, or buying a new building or equipment.
Revenues and expenses are listed on the income statement in order of when they are received or spent. They are categorised as operating or non-operating activities. Sales and the cost of items sold are listed to determine potential profits.
Many companies will use forecasted accounting and may take into account sales agreed even if the money has not actually been realised yet. This is what appears to be at the crux of recent issues facing UK supermarket Tesco, which is said to have engaged in early booking of rebates from suppliers leading to a vast overstatement of profits.
The figures gathered from calculating operating and non-operating expenses and profits show income before interest, taxes and amortisation or EBITA (Equity Before Interest Taxes and Amortisation). Amortisation is the accounting process used to calculate the depreciation of intangible assets over time. IP, for example patents, would be a good example of such intangible assets.
Taxes are then deducted from the EBITA to reveal the net income. Shareholder distributions are typically made using this net income, so investors will watch the figure closely. Investors and financial analysts also look closely at the operating portion of the income statement to determine if the business is being run and managed effectively, and may take action if that is not felt to be the case.
‘Repeated lack of cash flow on the statement is usually a red flag for investors.’
Cash flow statement
All publicly traded companies will have to report this, usually on a quarterly basis.
It basically does what it says on the tin: detailing where cash is flowing out for expenses, operating costs and so on, but also where cash has been coming in, for example via sales and profits.
Unlike the income statement, which will often use accrual accounting and factor in profits not yet realised, the cash flow statement should show how much operating capital a company actually has. Repeated lack of cash flow on the statement is usually a red flag for investors.
What does my company’s value actually mean to me?
It is always pertinent to keep your eye on the company’s financial statements. Even if you feel the legal department is adding excellent value, if the company is strapped for cash that extra lawyer you need may be deemed a luxury. On the other hand, if you find out things are looking rosy maybe it’s the time to ask for two positions!
How the legal department can demonstrate value is a key question and is one that our columnist Paul Hughes discusses in A Dangerous Game of Bluff.
Of course, if you can maintain maximum productivity with minimum cost you will definitely be on your CFO’s Christmas card list – no matter what the balance sheet says!