Finding the North Star

Last week we introduced Three Statement Modeling and how it's had the single-largest impact on my career above all other skills.

This week, before we dive into "in the weeds modeling," let's zoom out and address some "business thinking," because keeping these core concepts in mind will be your North Star when suddenly you find yourself in row 1,094 at 10:30pm.

The Actual Big 4

There's a lot of fancy stuff in the world of finance today. We've got machine learning, predictive analytics, AI, and more Financial Planning software than I can count.

Honestly it can be overwhelming, and I often find myself thinking "what skill do I need to learn next just to keep up?!"

There's some good news in all of this though, and it comes back to a fundamental truth I've seen time-and-again throughout my career.

At the end of the day, businesses and stakeholders primarily care about four things:

1. Revenue
2. Gross Margin
3. EBITDA
4. Cash

And here's the kicker -- let's pick any old Revenue, Expense, or Capex item -- if you can automatically (subconsciously) tell me how the Rev/Exp item affects each part of the list above, it will make you an invaluable member of your team, and any technological advances will only serve to help you, not hurt you.

Let's talk through it...

Revenue

One of my favorite phrases:

Everybody loves to talk Revenue or "top line."

Now don't get me wrong, Revenue is important (it's where it all starts after all), but it's just the tip of the iceberg.

Below that we've got our Cost of Goods Sold (COGS) as well as our Operating Expenses.

And if your expenses are large, all the Revenue in the world won't make up for a bloated cost structure.

Your job: know what affects Revenue and what doesn't.

Quick quiz: A company purchases and capitalizes new equipment. How does that affect Revenue?

(answers at the bottom)

Gross Margin

Now we're getting somewhere, but there's a catch.

First, Gross Margin?

It's the percent of direct profit of the Company's primary product or service, but does not contemplate any Operating Expenses.

Simple example, if a company sells shoes for $100 and the cost to make those shoes is $60, then the gross profit would be $40, or 40% of the sale.

And said another way, for every $1.00 of Revenue generated, only $0.40 "flows" to the bottom.

Revenue isn't so fancy anymore. It's mostly vanity.

But, the catch I mentioned?

This is only the first part of "sanity" from the quote above, because at the end of the day Gross Profit is merely an illustrative figure to help the company determine how profitable it's products (or services) are on a unit-by-unit basis.

There are still plenty of Operating Expenses (often called "below the line") to come before the Company generates a real profit.

To take it one step further, it's common to hear that "SaaS companies have very high Gross Margins." And yes, this is true, but generally because their cost structure doesn't carry too many direct costs (other than maybe Hosting and some Customer Success hires).

However, their Headcount spend is often off-the-charts, and these early-stage SaaS companies need to continually raise cash in the form of Series A, B, C, D, etc., until they are breakeven on their cash from subscriptions.

It just so happens that the Headcount spend is "below the line" so it gets removed from the "Gross Margin conversation" even though it's still a massive expense.

So keep in mind: an expense is an expense is an expense. For cash purposes, it doesn't matter if it's "above the line" or "below the line," so that's why Gross Margin is helpful but only tells you part of the story.

Quick quiz: That same shoe company reduces it's direct costs by $5 per pair of shoes. How does that affect Gross Margin?

(answers at the bottom)

EBITDA

Okay so EBITDA is a gigantic topic that deserves (and will receive) its own email.

However, for the purposes of this email let's assume:

• EBITDA was assembled under normal course
• without any crazy Adjustments

EBITDA is a rough proxy for the Operating Cash flow of the business and gets us closer to (but not at) the "reality" of cash.

So, if it's kind of "half-profit, half-cash, kind of both but neither one," then why do people care so much about it?

It's because the purpose of EBITDA is to provide a relatively normalized representation of a Company's core operating performance so it can be (a) benchmarked against other companies and most importantly (b) used as a basis for valuation.

Your job: Know that EBITDA is genuine in its intent, but it's a non-GAAP metric, which means it can be manipulated to paint a rosier picture of operations in an attempt to secure a higher valuation or be in covenant compliance.

Quick quiz: That equipment purchase from earlier, how does it affect EBITDA?

(answers at the bottom)

Cash

Now we've finally made it to "reality."

Cash. There's nothing quite like it. You can't dress it up with Revenue or hide it with EBITDA.

At the end of the day, cash is what pays the bills, and you either have enough or you don't.

So how do we forecast cash? Two primary ways:

1. 3-Statement Financial Model
2. 13-Week Cash Flow Forecast

Again, two topics that will need their own emails, but here's the gist:

1. 3-Statement Financial Model: translates the Accrual Accounting of the Income Statement into Cash via the "indirect method" in the Statement of Cash Flows. From there, changes to the Income Statement and Balance Sheet will affect the projected cash amount.
2. 13-Week Cash Flow Forecast: much more detailed than the 3-Statements, this forecast uses the "direct method" and forecasts the exact timing of incoming receivables and outgoing payables.

If you zoom way out, your 13-Week Cash Flow Forecast should directionally match your 3-Statement Model, but generally speaking the 3-Statement model will be used for larger strategic discussions, whereas the 13-Week Cash Forecast will be used for managing the tactical day-to-day bills.

Ultimately, a business will live or die depending on its management of cash.

Everything else, although helpful for context, is just window dressing.

Your job: Try to train your brain to distinguish between accrual-based business items and cash-based business items.

Quick quiz: Again, that equipment purchase from earlier, how does it affect Cash?

(answers at the bottom)

Quiz Answers

Revenue:

Q: A company purchases and capitalizes new equipment. How does that affect Revenue?

A: From an accounting standpoint, none. The equipment would be capitalized on the Balance Sheet as a Fixed Asset, the cash would hit the Statement of Cash Flows, and the Expense would be depreciated in the Income Statement over the useful life of the equipment. However, you could argue that the new equipment will help increase Revenue in the future, and therefore may affect the Revenue forecast.

Gross Margin:

Q: That same shoe company reduces it's direct costs by $5 per pair of shoes. How does that affect Gross Margin?

A: Hopefully this one was a layup. The COGS drops from $60 to $55, so the Gross Profit is now $45 and the Gross Margin is 45%. The incremental $5.00 "flows down" to help cover the Operating Expenses of the business, and all else equal, increases EBITDA by the same $5.00.

EBITDA:

Q: That equipment purchase from earlier, how does it affect EBITDA?

A: It doesn't affect EBITDA. The equipment depreciation that hits the Income Statement gets "added-back" to EBITDA (it's the "D" in the acronym) so it's what I like to call an "EBITDA-neutral expense."

Cash:

Q: Again, that equipment purchase from earlier, how does it affect Cash?

A: The equipment cost gets paid out of the business immediately (today). It's your job as the Finance Professional to ensure there's enough cash on hand to cover the equipment cost and also have enough leftover to cover the day-to-day business expenses, else you risk drawing on outside financing.

In Summary

This email ended up being a lot longer than I'd planned, but hey, there's a lot to say.

A good exercise: practice these "mini quizzes" in your head. How is each of the "actual Big 4" affected in the short-term and long-term? If you can nail this, you're well on your way to being a strategic partner alongside the Management Team.

That's it for today. See you next time.

—Chris

Before you go...

Did you know? A ton of former students loved my ​Financial Modeling Courses​ because they came away thinking like business owners, not just "Excel jockeys" (honestly, no one cares if you use VLOOKUP or XLOOKUP). Here's what one student said:

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