Finance As A Foreign Language

Many of my friends are not “math” people.  They studied social sciences, have degrees in history, or went to law school because, throughout their experiences, there wasn’t an emphasis on math.  As such, their eyes gloss over whenever numbers come into the mix.  Imagine their response when the number phobic asks about that sure-thing stock tip they recently received, and I start talking about how a current ratio under one "gives me pause to how sustainable the growth is given its inventory heavy nature." This sounds complicated and possibly intimidating.

The jargon coupled with the numbers instills fear in people when it should not. Jargon is meant to make something seem difficult and even foreign. It is meant to create insiders and outsiders by simply speaking in tongues. Sadly, jargon in many respects comprises the basic building blocks of the language of finance. 

For instance the current ratio is measuring the firms ability to manage its working capital. What is this bizarre thing called working capital? Investopedia will tell you that working capital is, “...a measure of both a company’s efficiency and its short-term financial health. Working capital is calculated as current assets minus current liabilities.”  This definition presupposes that you know both what makes a firm financially healthy, and what current assets and liabilities are.  Working capital is the gas in the fuel tank of a company. It is a way of seeing if the firm has enough cash coming cash in to cover their day-to-day operations. If there is not enough gas (working capital) then the car(company) won’t run.

An asset is something a business owns. A liability is something a business owes. A current asset is something that you own that you can reasonably expect to consume during a business’s fiscal year. Conversely, a current liability is a debt a business will pay in that same fiscal year. 

Math simplified. Jargon demystified.

The complexity of the concept grows, as you may presume, when a deal attorney documents working capital requirements in a purchase agreement; or when an investment bank analyzes the impact of a firm's working capital on potential capital structures. Yet it all falls back on the fundamentals of what working capital is and how it impacts a business.

Learning a language can be difficult but there are tricks to it.  Native Japanese speakers often find it hard to learn a foreign language. The standard process of learning grammar rules and phonic sounds falls short in turning instruction into an actionable skill. Successful language teachers in Japan provide a third ,queue by instructing the placement of the tongue, which allows the student to learn the basics in a more easily applied manner.

The way Private Equity Primer sees it, when teaching the language of finance, a good instructor not only tells you to replicate the sounds and practice the grammar rules, but he or she will simplify things for applied practice. We walk our students through cases to demonstrate what the impact of working capital will have on the total valuation of a deal, in a technology business versus a mining business. We empower our students to see how the definitions of working capital affect potential clients by stripping away the jargon and seeing how the pieces fit together, and how the language of finance sounds in practice.

In the coming weeks Private Equity Primer will post more on the topic of networking capital and its considerations in transactions. Keep coming back to see how our Deal Sherpas lead deal professionals to the next summit of performance.

To train the best deal attorneys, bankers, consultants, and aspiring students, Private Equity Primer created industry-leading training that leverages repetition to mastery, case study delivery, and real world simulations.  Please check out our full service offerings and subscribe to our email list for the latest on training, transaction knowledge, and the ever-changing landscape of legal services, investment banking, and accounting. 

Training Your Brand Ambassadors

The quality of your employees—past, present, and future—are directly tied to your firm’s branding. An employee’s name, knowledge, and quality of work are tethered to your firm’s name and logo by every resume they submit, every interview they have, and every time someone browses their LinkedIn page. Recruiters routinely look at the brand name of a firm when selecting for candidates. It should not be a surprise that your customers are doing the same thing with the employees that leave your firm. Ex-employees are your brand ambassadors whether you like it or not. 

Mark Herrmann, the Deputy Counsel for Aon, framed the issue succinctly in The Curmudgeon’s Guide to Practicing Law, when he wrote, “I will forever associate your face with the quality of work that comes under your name. If I associate your face with lumps of coal, I will not ask for your help on other cases.” This quote highlights how cultivating quality,and successful employee alumni impacts your firm’s brand, regardless of what professional service you are in,.

As more and more firms implement employee-alumni programs to bolster their brand and business development efforts, the impact of your past employees on your brand will continue to grow.  According to a recent Wall Street Journal article, many companies like SAP, Nielsen, and The Gates Foundation are following the way of McKinsey and Ernst & Young by implementing and promoting employee alumni programs. Law firms, accounting firms, and consulting firms, have for years benefited and actively leveraged the diaspora of employees as a means of securing business and bolstering the sales pipeline.

To avoid the downside scenario of having inferior employee brand ambassadors, it is critical to invest in training. For years, Private Equity Primer’s Deal Sherpa, Richard Grosshandler, taught an afternoon course on modeling for the private equity interview to outgoing analysts at Harris Williams & Co.  Harris Williams embraced the simple fact that training employees is a broadcast beacon to the quality of your firm's services. Investing in training today helps firms reach the next summit of performance while enhancing the branding and future sales efforts of those firms.

To train the best deal attorneys, bankers, consultants, and aspiring students, Private Equity Primer created industry-leading training that leverages repetition to mastery, case study delivery, and real world simulations.  Please check    out our full service offerings and subscribe to our email list for the latest on training, transaction knowledge, and the ever-changing landscape of legal services, investment banking, and accounting. 

 

An Introduction to Income Statement Modeling

Private Equity Primer's Deal Sherpas developed the following overivew on the basics of income statement modeling for a group of college interns working for Splash 4 Partners.  The interns had limited to no-exposure to financial modeling and were tasked with rapidly evaluating the growth prospects of a publically traded company. This was the first part in a larger training that built up to evaluating the buyout value of a division of the assigned company.  The company evaluated was a client of Splash 4 Partners exploring its strategic options.

Please enjoy and share the desktop reference for income statement modeling.   

Income Statement Modeling

Accurate financial modeling is all about fundamentals. As a result, some of this might look pretty basic. However, thinking through the drivers of a business and mapping out what is to be calculated and measured saves you time when you are building and manipulating the model. 

In other words, ask yourself what are the major key performance indicators for the company.  Having this vision of what is important is critical in analyzing a business systematically and by the numbers.

To peer into the future of a company, you have to understand where it is today.  This is why you need to start by looking at historic financials.

When you look at a business, regardless of sector, identify what the fundamental revenue and cost drivers of the business are.  Don’t get overly hung up on the name of the business model that the examined company can be categorized.  Understand the drivers of how the company makes and loses money first.  The financials are nothing more than a numerical picture of the strategies, decisions, execution, transactions and operations of a business.

The concept of business models is helpful only in so far that a brick and mortar retail company, a software-as-a-service business, or direct marketing business all possess core drivers that are present in other brick and mortar retail, software-as-a-service, and direct marketing companies. 

When examining a company ask yourself two question:

This looks like basic accounting.  Remember it’s about the fundamentals.

As you go through this exercise, your objective is to understand the company’s profitability and what levers (aka: drivers, variables) can be pulled to meaningfully impact said profitability.

When modeling for earnings (profit/loss), as an equity researcher would when looking at a public company, you are not just trying to get to that quarter’s or year’s one time profit/ loss.  Rather your goal is to understand the basis of their recurring operations.  Meaning you want to calculate the normalized earnings.  By gaining a clear picture of the recurring revenue and expenses, you then have the ability to start to gaze into the future and forecast.

Note: This is income statement focused.  In some businesses GAAP or accounting profit can deviate substantially from cash profit or cash flow generated in a period.  While the focus here is on forecasting accounting profit, later we will deal with forecasting cash flow.

On a historic basis, the EPS calculation is simple as there is no guessing.  You have the historic figures to get you the actual number.  When forecasting future years, you have to gross up or down the shares outstanding due to share buyback programs, secondary offerings, and options being executed.

To Infinity & Beyond

Forecasting the future is hard.  The future rarely maps one for one into columns, rows, numbers, and our predefined categories.  Many forecasters say that the one thing you know about a model when it is finished is that it is not right.

This is why you are not looking for it to be on the nose, but rather to be as precise as possible.  You will be forced to simplify things.  If you have done academic style discounted cash flow modeling, you likely have used simplifying assumptions with an indefinite time horizon.  This calls for flat lining many drivers and inputs into perpetuity.  We know that prices and volume are rarely constant over time, making this type of modeling rather imprecise and little more than directionally helpful.

What you see with most models in equity research and investment banking is forecasting between three and five years out.  Generally speaking (though highly dependent on the business and situation), your one year numbers are going to be closest to reality.  Years two and three will decouple some from reality, and years four and five are more about being in the ball park (likely in the cheap seats far from the action).  The further out the forecast moves, your conviction behind being accurate should decrease.

Revenue Modeling

How does a company make money?  Understanding the answer to this is to understand the basis of the company itself—its point for existing in the first place.  Many companies have multiple revenue streams.  Take lululemon for instance, they sell through:

1.       Brick and mortar retail

2.       Online

3.       Third party yoga studios

In short, they have three ways or channels of reaching their customers. 

Similarly, many software-as-a-service companies have multiple revenue streams.  The subscription fees often being the primary line of revenue and consulting & training being a secondary income stream.

For the purpose of illustration, we will keep with the lululemon example.  Each revenue stream can be broken down to its elements.  I will focus on their brick and mortar operations below.  Keep in mind that if you understand what revenue source is generating the greatest increase or decrease to revenue, you can then compare that to the actions of management and their investment in time, labor, and capital to assess growth strategies and probability to profitable execution.

Brick and Mortar Retail

What are the components of this revenue stream?

 

Clearly, each of these variables listed can be broken down more and more.  For instance, if lululemon followed the model of other retailers and had many types of stores (e.g. boutique urban vs. large suburban) getting to an accurate forecast would mean understanding how these stores differ not only by square footage but also by the inventory each stocks. 

Access to data will often drive the granularity and precision in which you can model.  For instance, same store sales is the figure often calculated by the company.  Many companies change the basis of months to fit their definition of what a “mature store” or store that reaches its normalized sales basis.  Without access to the raw data you are at the mercy of the data supplier.

This is why you need to contemplate other accurate ways to calculate revenue.

 

What will change the revenue projections for this income stream is sales volume and the amount of retail space. Clearly there are drivers behind each of these variables.  If you can get to sales volumes and the retail space controlled, then you can get to a brick and mortar’s projected revenue streams.

Modeling Expenses

How does a company spend money?  This is driving at cost centers.  Break out expenses into fixed versus variable.  Most direct costs, COGS, and costs of production tend to be variable; while operating expenses or indirect expenses tend to be more fixed.  Rent, for instance, is usually a fixed cost.  Variable would be the number of employees needed in a factory based on production demand.  The higher percentage of fixed expenses a business has, the less play and flexibility it has in managing its cost structure to profitability during a downturn.

The simple and less robust way of modeling expenses is taking the average of the last three years (good for mature, steady, and flat growth companies, not very accurate for high growth companies) and gross up or down based on projected demand and investment.  This technique is generally ill advised if better information is available.

One can get far more granular by moving to the balance sheet and modeling specific working capital requirements in relation to projected revenue levels.  

To train the best deal attorneys, bankers, consultants, and aspiring students, Private Equity Primer created industry-leading training that leverages repetition to mastery, case study delivery, and real world simulations.  Please check outour full service offerings and subscribe to our email list for the latest on training, transaction knowledge, and the ever changing landscape of legal services, investment banking, and accounting. 

What I Learned From Managing Junior Staff in a Firm without Formal Training or a Culture of Mentorship

At a firm at which I once worked, my boss fired one junior analyst and welcomed the self-initiated departure of several more due to performance issues. My boss and I routinely discussed the calculus of letting the junior analyst and interns go versus keeping them on.  We estimated the number of hours I spent fixing their mistakes, the number of times a mistake had been repeated after it had been pointed out, and the times that support staff got blamed for the whole thing. 

Looking back, I believe the firm had no real formal training for new hires, as the senior analysts and team leaders were not incentivized to mentor junior staff as management tracked days on planner and overages more than anything else. Be careful about what you measure because that will get managed. I think that my department head felt justified in the occasional dismissal and the routine departure of junior staff in that they had not performed at a level that would result in a full time offer or promotion. In my eyes, there is some kind of circular logic going on here.

Without training and with little mentorship, the fates of underperforming staff became predictable.  They became discouraged.  Many became disengaged from the work, feeling as if their effort was undervalued or simply unnoticed.  As I took over or reassigned their work for efficiency purposes, I think many began to resent me.  Several of my former co-workers have told me of a liquored intern at a holiday party that referred to me in the colloquial as that asshole. The juniors began to routinely show up late, left early, took long lunches, and ignored emails.  I began to look at managing junior staff as a burden that lead to hurt feelings, longer hours, and stress.  I came to believe that institutionally, the firm failed the hires more than hires failed the firm.

In my opinion an underinvestment in onboarding led to the firm’s lost in efficiency, a decrease in moral, and helped to spawn an “us versus them” culture. Short term efficiencies measured by individual projects ruled the day, when a longer time horizon and a focus on training and mentorship would have likely both created operational gains for the firm, and improved moral.

It has been my experience that when a failure in process and organizational structure occurs, individual employees find the personal hack for themselves.  For the more senior analysts and team leads, it was cutting out the junior staff.  For underperforming junior staff, it became small acts of rebellion and on the job searches for other employment.

Training takes time. Mentorship is on-going. In an age when one time use is the norm for products and employees change firms every two years, it can be easy to skimp on training and mentorship, while focusing on a single metric of efficiency.  Before you blame an underperforming employee for their poor performance, ask yourself, did the firm fail them or did the employee fail the firm?  Loyalty and accountability has to start somewhere and the role of management is to solve for co-operation.

Maybe better efforts, better attitudes, greater efficiency, and longer tenures start with the investment of training and mentorship in employees.  We humans lived in bans for tens of thousands of years and fostered co-operation through resource sharing.  Training and mentorship are about inclusion.  Train to include and include to perform.

To train the best deal attorneys, bankers, consultants, and aspiring students, Private Equity Primer created industry-leading training that leverages repetition to mastery, case study delivery, and real world simulations.  Please check out our full service offerings and subscribe to our email list for the latest on training, transaction knowledge, and the ever-changing landscape of legal services, investment banking, and accounting. 

*Note:  This post is one individual’s opinions, beliefs, and interpretation of events.  As such, kindly read them as beliefs surrounding events rather than a definitive recitation of facts.