Boosting Your Financial IQ
Boosting Your Financial IQ
123: 6 Key Financial Concepts You Should Master
In this week’s episode of "Boosting Your Financial IQ," I explore critical financial concepts you need to know and understand. While there are countless financial metrics and theories, today, I’m cutting through the noise to focus on the six key concepts essential for maximizing free cash flow and, consequently, company value.
Join me as I break down:
- Net Operating Profit After Tax (NOPAT) - I’ll help you understand the true economic performance of your business by focusing on core operations and excluding non-operational income and expenses.
- Working Capital - I’ll teach you how to calculate and manage your operating working capital to ensure you have the cash flow necessary for daily operations.
- Capital Expenditures (CapEx) - I’ll explain the importance of investing in property, plant, and equipment, and how to compute CapEx from financial statements.
- Return on Invested Capital (ROIC) - I’ll show you how to measure the returns generated on all capital invested in the business and why this metric is crucial for assessing economic success.
- Growth - I’ll guide you in developing strategies for sustainable growth and help you understand the economic drivers that can boost your top line without sacrificing long-term profitability.
- Weighted Average Cost of Capital (WACC) - I’ll give you a solid understanding of your company's cost of capital, blending debt and equity, to accurately discount future cash flows and value your business.
By mastering these concepts, you’ll be equipped to drive significant value in your company, avoid common pitfalls, and strategically position your business for long-term success. Tune in for my straightforward, practical guide to transforming your financial acumen and boosting your business performance.
Cheers, and enjoy the episode!
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This is Boosting your Financial IQ, where I help business professionals with financial responsibility to elevate their careers and run profitable companies. My hope is that you'll apply these lessons to achieve your greatest ambitions, Cheers and enjoy. As it relates to finance, I would say there are only about 37 topics you should really understand in order to be successful in business. I'm totally messing with you. They're not 37. In fact, there's just one thing you should know, and that is free cash flow and how it drives value in a company. See, I spent a lot of years in university and I wish at the time, my professors would have just sat me down and said Steve, look, this is how you maximize firm value. But instead there is all this complexity, all these formulas, all this nerd talk, and it just left me very confused. So I'm going to cut through all this confusion and all this noise and tell you exactly the six key concepts that you must master as it relates to free cashflow and value creation, in order to be a powerhouse in your business and to increase the top line, maximize profitability and, like I said, to get down to free cashflow and to maximize it. So let's talk about key concept number one, which is net operating profit after tax, known as NOPAT. Now, the key word in that phrase is operating, because we want to exclude other income and expense that is not associated with the core operations of the business, because that's how we're going to understand the true economic performance of a company. Now think about it. During COVID, the government pumped a lot of money into businesses through its PPP program and right now I'm seeing the effects of that with companies, because for a long period of time businesses were on life support, even when their operating model wasn't super great, or just their overall business model wasn't great, because they were able to play with this money and play pretend business. And now they're starting to feel the effects of it as the economy is starting to slow down and competition is increasing in certain industries. So we want to exclude things that may skew the economic reality of the business so we could get right down to net operating profit after tax.
Speaker 1:Also, you need to understand the components to get down to net operating profit after tax. So we start with revenue, that represents the income a business generates from selling its products and services. Then we have cost of goods sold, which represents all the costs associated with producing that revenue, which gets us to gross margin or gross profit, which is profit, before accounting for overhead. Then we account for overhead, also known as OPEX, or operating expenses, which then gets us to operating income or loss, hopefully income. Then, after we account for taxes, we arrive at NOPAT, and that's why it's so critical to understand how to read an income statement but, more importantly, how to understand the story behind the numbers so you could pull certain drivers to maximize NOPAT.
Speaker 1:Now we can't just stop there. Instead, we have to move on to key concept number two, which is working capital. Now, working capital can be confusing for some people. That's why I did an episode solely dedicated to teaching you how to compute working capital, so be sure to check that out if you need a refresher. But essentially, when it comes to working capital, once again we want to look at operating working capital. So, when it comes to current assets, we want to look at operating cash, accounts, receivable, inventory prepaids and other assets related to operations. Notice, we are going to exclude excess cash from the calculation. Then, when we get to operating liabilities, we'll look at accounts, payable, accrued liabilities and other current liabilities, excluding interest-bearing debt. That's really critical to understand. So, when you take the difference between current assets and current liabilities, you arrive at working capital. But that's not all, because now we gotta move on to concept number three, which is CapEx, also known as capital expenditures, if you wanna take the long form. Now, 70% of companies that go bankrupt are actually profitable when they close their doors. They have NOPAT, but they don't have the cash because the cash is tied up in working capital concept number two and it's tied up in CapEx concept number three.
Speaker 1:Now, what is CapEx? Capex is essentially investments in property, plant and equipment. So think about it. This may include a company's building, pieces of machinery like a tractor or manufacturing equipment. It may include vehicles and so on and so forth All assets related to running the business. Okay, so that's your property plant equipment.
Speaker 1:Now, if you take your gross property plant equipment and you net that against accumulated depreciation, you arrive at your net PPNE. So that's what I'm referring to when I say net PPNE. So in order to compute CapEx, if you take your change in net property, plant and equipment from one period to the next and then you add back the current year depreciation, you can essentially back into CapEx. That's one way to do it. The other way to do it is to go to the statement of cash flows and look under investing activities and right there you'll see CapEx. But, like I said, it's investments to maintain your existing property plan equipment or to expand your property plan equipment, so you could go out there and do business and earn profit. So here's the cool thing If you take number two, your working capital, and number three, which is all your CapEx, or in other words, your accumulated net property, plant and equipment, and you combine those two together, then you get invested capital.
Speaker 1:Now this leads into concept number four, which is return on invested capital. Return on invested capital is a metric that is calculated by taking net operating profit after tax and dividing it by your invested capital, which is that is calculated by taking net operating profit after tax and dividing it by your invested capital, which is made up of working capital and your net PP&E. This is really important to understand because this will tell you how much a business is returning based on its invested capital, in other words, the amount of money that has gone into the business in order to make the business run. Now some companies that I work with they'll say look, steve, we're doing just fine. Look at, we have accounting profit. Yeah, maybe it's not as high as it should be, but we're still making money.
Speaker 1:But when you look at the true returns of the business, those returns may not be sufficient to cover the risk of that company. So let's say I look at a business, you know, and I compute the return on invested capital no Pat, divided by its invested capital, and it's 4%, and I compare that to the overall market. Just think about the stock market. I think over the last 50 years or so it's returned on average somewhere between eight and 9%. So let's just call it 9% in the business is earning 4%. Well, that's a 5% gap from what just the overall market is producing. If you drill down into that industry you may realize that, hey, this company is competing in a space that has an average return on invested capital of 12%, so the business is only earning 4%. So the owner of the business or the capital provider or providers aren't earning a sufficient return on their money and they're better off just liquidating the company and just dumping it into Apple.
Speaker 1:Now, I'm over-exaggerating here and I'm simplifying things. Obviously, don't just sell your business, liquidate it and put into Apple. You want to diversify, but my point is is that oftentimes owners of capital. They have so much money tied up into the business that they're really not doing this calculation to understand what are the real economic returns that this business is generating, because money does get trapped into working capital and CapEx and those two figures aren't on the income statement. That's why you just can't look at NOPAT in isolation.
Speaker 1:The fifth key concept to understand it's pretty easy is growth, and that's your growth of free cash flow and how to drive growth in a business. And that comes down to strategy having a really good strategy in your business and identifying, okay, where are we going to compete, how are we going to compete and how are we going to win. And when you combine that right with growth tactics and return on invested capital tactics, then that's where value is created. So, if you think about the essence of strategy, strategy really comes down to pursuing either differentiation or cost leadership or focus. Those are the three generic strategies. Now, those strategies, if you tie them back to the financial drivers that I'm referring to here return on invested capital and growth that's where value creation comes alive. Now, with return on invested capital, if you want to increase it, you can get price premiums or you can improve your cost and capital efficiencies.
Speaker 1:As it relates to growth, which is key concept number five, if you could understand how to best grow a business in a sustainable manner, then you're going to be a powerhouse. But too often leaders don't understand the real economic drivers of growth and they may pursue things like discounting or other sales tactics that may bump up the top line in the short term but really hurts the company in the long term. So mastering key concepts of growth number five is critical. And then the last concept to understand, as it relates to free cash flow and value creation, is weighted average cost of capital, also known as WAC, or in Steve's world I always call it wiggity, wiggity, wac. I don't know why. It's just back in school when my teachers were like WAC, wac, wac, I just thought wiggity, wiggity, whack, and then it just stuck.
Speaker 1:So don't say wiggity, wiggity, whack in your next board meeting or at your company, or they'll be like you are whack, but it stands for your weighted average cost of capital. It's basically your blend of your cost of debt and your cost of equity, so you take the weight of both. Just remember, with your cost of debt you have to take all your debt, look at the rates, weight them and then subtract out the cost of that. So you take your rate times one minus the tax rate to get your after-tax cost of debt, because interest expense is typically tax deductible. So there is some savings there.
Speaker 1:All right, so those are the concepts you need to understand because your WAC is going to be your discount rate when you build out your discounted cashflow model, which then helps you to understand the value of a company. So that's how these six key concepts work and relate back to free cashflow. But I could tell you like there's so much noise, there's so much complexity out there with this or that or this or that, but when it comes down to it, if you want to be successful in business, if you can understand what are the value drivers and then how to pull those value drivers and go execute in the real world, you'll be super successful. And then just cut out all the noise and distractions and just focus on that and I'm telling you it'll make all the difference in the world. All right, that's what I have for you. Thanks for joining me, cheers.
