• 121 06/16/2021

An unbalanced balance sheet in a three-statement financial model can be a nightmare if you don't understand the mechanics that would otherwise result in a balanced balance sheet. In this post we will explore how the cash flow statement balances a three-statement model, and we will include common errors that result in a broken model together with instructions on how to fix them.

The beautiful thing about accounting and the three-statement models it helps inform is that they create a closed system. What affects the income statement also affects the balance sheet, and any change on the balance sheet must be captured by the cash flow statement. As evidence of these deeply intertwined relationships, look no further than the fact that, at this point in the model building process, each line item on the cash flow statement has already been addressed on the income statement, balance sheet and the associated supporting schedules, with the exception of cash. This is visible in the image that follows.

In a financial model, the purpose of the cash flow statement is to calculate the amount of cash generated in each accounting period, building from net income. The result, cash generated in the period, is added to the previous period’s ending cash balance to arrive at the cash balance for the period, which links back to the balance sheet. This sum is what balances the model. To understand why, let’s quickly review a concept first introduced in the Introduction to Financial Statements video series.

Recall that the balance sheet is just a formal presentation of the fundamental accounting equation (the assets of a company = its liabilities + its equity). If the accounting equation is rearranged, per the image below, you can see this relationship more clearly.

If the cash flow statement adjusts the left-hand side of the equation (assets) by the company’s cash flow in that period, and the income statement adjusts the last part of the right-hand side of the equation (stockholders’ equity) by net income, then it follows that the cash flow statement, which starts with net income and ends with cash flow in period, is making adjustments so that the accounting equation holds true.  And that is how the accounting equation, and by extension the balance sheet, is balanced in financial models.

To make this concept really stick, lets look at how this works using a financial model as the visual. Here you can see the link from the income statement to the balance sheet, where retaining earnings grows by the amount of net income in each accounting period. And then the cash flow statement adjusts net income for non-cash items and every change on the balance sheet to arrive at cash generated in the period. And this cash is added to the cash balance on the balance sheet.

Mechanically, this is the most important concept to focus on as it relates to projecting the cash flow statement, because there is nothing worse than an unbalanced model. I cannot tell you how many times an unbalanced model kept me in my cubicle residence overnight. Enough that I created the Handbook for Analysts Screaming at their Monitors at 4 AM but later renamed it Balancing the Model. This link will walk you through the most common errors found in an unbalanced balance sheet and explain how to fix them as quickly as possible. Hopefully the framework provided in this post coupled with the tips available in Balancing the Model will keep you from punching a monitor :)

• 120 06/14/2021

Adjusted EBITDA is a very common metric that can be found in many investor presentations, which makes understanding EBITDA and acceptable adjustments to this figure important. Unfortunately EBITDA is frequently used as a proxy for cash flow. As the video featured in this post will demonstrate, it is anything but. In businesses that require heavy capital expenditures or those with heavy debt burdens, the discrepancy between EBITDA and cash is vast. Add to this the adjustments investment bankers and management teams will use to embellish or even exaggerate earnings and the metric can become meaningless.

EBITDA does have its purposes, however (as the Private Equity Training Curriculum frequently points out). In the context of debt service, EBITDA can be helpful because adding back interest expense, taxes and non-cash charges including depreciation and amortization, provides a quick back of the envelop approach to evaluating how much interest expense a company can tolerate.

But, it has become pretty common for this metric to include additional adjustments when there’s an attempt to raise capital or sell shares to make the company look even more profitable than it is. WeWork arguably pushed the envelope on an otherwise common attempt to inflate earnings with words vs. dollars when it introduced an even more exaggerated version of adjusted EBITDA: Community Adjusted EBITDA.

In April of 2018, the WSJ reported that WeWork's revenues had doubled to \$866 million ahead of the company's proposed bond offering. Co-founder Adam Neumann was creating a fantastic investment narrative and investors had piled into the 8-year-old company providing \$6 billion at up to a \$20 billion valuation. The challenge facing the company: losses had also doubled to \$933 million. Fortunately, a marketing solution was available in the form of an exaggerated adjusted EBITDA calculation.

It called the fully adjusted number “community adjusted Ebitda,” by which it subtracted not only interest, taxes, depreciation and amortization, but also basic expenses like marketing, general and administrative, and development and design costs. Those earnings were \$233 million, WeWork said.

“I’ve never seen the phrase ‘community adjusted Ebitda’ in my life,” said Adam Cohen, founder of Covenant Review, a bond research company.1

In July of 2018, the FT punched back at WeWork's valuation. CEO and cofounder Adam Neumann supported a lofty \$20 billion valuation claiming that WeWork is a “community” and a “state of consciousness” that brings people together to “change the world.” In contrast, the FT reported:

WeWork’s claim to disrupter status in serviced offices also requires scrutiny. The existence of older providers such as IWG is the elephant in the office. Like them, WeWork has a business model underpinned by unglamorous property market arbitrage: leasing offices, fixing them up and renting them out at a higher rate. If the groups are fundamentally the same, it makes no sense to value WeWork at \$20bn — more than 10 times expected sales.

IWG is the world’s largest serviced office provider, with more than 10 times the number of offices and a profitable business model. Yet it has an equity value below \$4bn. This values IWG at 1.2 times forward sales. If valued at the same multiple, WeWork would be worth around \$2.7bn.2

The word that should leap off the page is "profitable." WeWork could not be compared to IWG based on profitability because it was on schedule to lose \$1 billion annually at the time of this analysis. Well, at least based on any standard measure of profitability. Which brings us back to "community adjusted EBITDA," which the FT skewered.

By stripping out almost every cost — from advertising to those associated with setting up new offices — this figure was positive at \$233m last year. [CFO Artie Minson] says he received no pushback from investors. But such flattering bespoke measures of profits remain a red flag for many investors. Online coupon site Groupon abandoned its own individual measure after attracting negative attention. WeWork would be wise to do the same.2

For reasons that defy logic, SoftBank’s Masayoshi Son chose to ignore the red flags and pushed WeWork’s valuation to \$47 billion in private dealings with Neumann by summer of that year. By October, just six weeks later, the valuation plummeted by 70%. Fast forward to May of 2020 and WeWork’s valuation stands at \$2.9 billion.

Per the introduction, when EBITDA is used as a proxy for cash flow, heavy scrutiny should be applied. Adjusted EBITDA requires an even more thorough review. There may be instances where the adjustments are acceptable, but in any instance where it would otherwise be a recurring expense, these adjustments should be ignored. As the saying goes, “You Can’t Eat EBITDA.”

1Eliot Brown | “A Look at WeWork’s Books: Revenue Is Doubling but Losses Are Mounting” | The Wall Street Journal | 4/25/2018

2Elaine Moore Eric Platt | “Lex in depth: Why WeWork does not deserve a \$20bn price tag” | The Financial Times | 7/2/2018

• 119 03/04/2021

Per Michael Porter there are two ways to compete, by charging lower prices or by developing differentiated products and offerings. In this context product differentiation is the only way to avoid a race to the bottom.

What are Diffentiated Products? Product differentiation is a company’s ability to effectively communicate to its target customer why its product is superior. Please see the video that follows for more detail. We have also included a list of examples just beneath the video player.

Examples of Differentiated Products:

1. Chipotle: Became known for healthy fast food by marketing high quality ingredients.
2. Dollar Shave Club: Separated itself from the competition with a direct-to-consumer model and hilarious advertising. It was the first subscription-based service in its space, which was otherwise dominated by giants.
3. Porsche: Established itself as a premium sports car that could also be an everyday car. The company is associated with performance and quality, but the reliability separates it from high-end competition that requires considerable maintenance.

Per the video, product differentiation does not have to be sleek or sexy. Ideas that come immediately to mind are well established brands, but an article in The Economist argued that this could be applied to even the most mundane or commoditized products:

Philip Kotler gives the example of the brick industry, which is about as close to being a commodity business as is possible. Yet one company in the industry was able to differentiate itself by altering its method of delivering bricks. Instead of dumping them on the ground (and breaking several), it stacked them together on pallets and used a small crane to lift them off their truck. So successful was the firm with this method that before long it became standard industry practice. The firm then, of course, had to look for new ways of differentiating itself.

When differences in product or service are difficult to communicate, subtle differences in how the firm presents itself to clients can help influence the selection process. But the most important thing to be aware of is that once a clear distinction has been established, the company can potentially benefit for years from this same distinction.

Models are:

A) really boring
B) pretty sweet
C) super important
D) somewhat easy
E) kind of hard
F) fun
G) all of the above

*Answers a, b, c, d, e, f and g are all correct.