Thread by @joshuamschultz

Just because you need to submit financials in GAAP, doesn't mean its the best way to look at your financials.

I have been teaching an alternative method of breaking down your finances that allows you to see
1. How the machine runs
2. How well it is doing

Here is how. 👇🏼

1. The realization buried in this technique is that you have two machines running at all times
1. operational machine
2. finance machine

The finance machine is leveraging up and down your operational machine.

So we need to separate these to better analyze

Separating these components has the additional benefit of making forecasts and analysis more accurate given less volatility in the individual components than the combined.

So let's start...

1. Equity Restatement

Remove any equity accounts that are not related to your direct ownership, but appear on the income statement.

1. Preferred Dividends
2. Dividends Payable that is on the balance sheet
3. Minority interest

(If removing here, remove on the balance sheet too)

Take the remaining accounts and separate them into operating and financial.

Financial include: Stock repurchase, Options exercised, dividends paid (or owner withdrawals).

Operational: Net income, below the line items, Comp Income, gain / loss on the financials

Your equity change will still be the difference between the beginning and ending equity (minus the non-related equity accounts),

you will just be dividing the accounts and tallying them up

Financial equity total = Transactions
Operations equity total = Owner Equity

2. Now Reorder the balance sheet.

GAAP uses Assets, Liabilities, and Equity to separate the accounts.

They are ranked by
assets -> liquidity
liabilities -> maturity

We don't have to follow this!
We can make it far more useful.

For each account, decide if its related to financing the business, or running the business (operational).

For the most part.

Excess cash, loans and interest-bearing accounts - Financial

Others - Operations

Put all Operational on top, net them out, that is Net Operating Assets

Put all the Finance together, net them out, that is Net Financial Obligations (if debt owed, Net Financial Assets if you are in the black here).

Within each category, you can divide by assets and liabilities, but it isn't necessary for this.

We can delete Equity part here.

-- Interlude --

We now have equity specific to us as owners broken out by
- Transactions
- Owner Equity

and our balance sheet is
NOA
NFO

If we net NOA and NFO, we will end up with our equity number. If not, check your math.

3. Restate Income statement

We can now divide the accounts in the income statement

Your top portion will be all operational accounts.

The bottom portion will be all financial accounts (interest payments and receipts, etc)

The extra step with the income statement is to "allocate" the taxes.

Taxes are usually created from profitable operations,

and reduced through financing and holding NFO.

Tax allocation cont...

Use statutory tax rate for operations, and use the financial number as a plug to arrive at actual taxes

(note: it will prob be a negative tax).

These two sections
1. Operational Income OI
2. Financial Expense FE

will net to the owner inc on equity stmt

4. Terminology

We now have
Transactions +
Owner Income =
Your specific Equity (CE)

NOA -
NFO =
CE

OI -
NFE =
Owner Income

5. We now look at the profitability of our operation

1. OI / NOA (think of this as your operational profitability)

This is the unlevered return of your business operation considering all the operational assets and liabilities you use.

Breaking it down

We can sell a few high margin items (margin) a year (turnover), or low margin items over and over and over.

So we can break down OI / NOA into Margin and Turnover

OI / Sales * Sales / NOA

This rolls up to the same OI/NOA, but separates turnover and margin

6. Understanding your interest rate

If you are using debt in your business, here is where we can see how much its helping.

Compare your interest rate to your NOA/OI.

If its close or higher, you are destroying value.

This is the equiv of borrowing at 5% to invest in the markets at 2%... you are destroying 3%.

So make sure the "spread" is positive.

your spread is Profitability (OI/NOA) - Borrow Rate.

Borrow Rate = FE/NFO (Calculated earlier).

The bigger this spread, the better.

7. Leveraging your operational profitability

There are two ways to leverage your operational profitability for more profits.

1. Increase the spread through various levers
2. Borrow more to put into the operation machine at a positive spread.

8. Breaking down leverage

We already looked at the spread.

your borrowing leverage is borrowings (NFO) over your personal equity (CE).

When you multiply the Spread by your Leverage, you get total financial impact in addition to operational profitability.

This type of analysis can help you understand
1. The state of your business
2. The impact of financing
3. The business model and structure

plus you can take it much much farther, how?

Calculate all on a monthly basis and look at the various ratios over time to understand
1. how they are changing
2. what levers should be used, or unused
3. compare to benchmark companies in the industry

etc.

Hope this helps you get a quick start in analyzing your financials!