“One of my favorite pieces of research finds that people fear asking difficult/sensitive questions far more than being asked difficult/sensitive questions.” – Mark Manson
Ouch. Got shut out on book reading in May. I did binge watch a bunch of Netflix, while the family was visiting friends in California though.
Updated stats through May:
Read Articles
Books
January
65
4
February
49
1
March
64
3
April
53
2
May
97
0
June
July
August
September
October
November
December
Total
328
10
Here are my most influential reads – in no particular order:
Margin of Safety by Seth Klarman – “There’s a fine line between diversification and over-diversification. 10-15 holdings is enough for Klarman.”
Intel Problems – “It is manufacturing capability, on the other hand, that is increasingly rare, and thus, increasingly valuable.”
This is nuts, where are the profits? – “It’s not often you come across a chart that makes you immediately spit your peppermint tea out, copy and paste the link, and send it to all your finance banter WhatsApp groups (soon to be Signal, obvs).”
How to write a user manual – “And if you manage a team or run a company, until you make the unspoken norms spoken, they’ll wreck havoc on your organization.”
How to Lose Money When the Stock Market is at All-Time Highs – “Even when the stock market overall is up in a given year, there are almost always going to be a large number of stocks within the index that are down.” SMS here – it is likely going to work the other way too.
Selling hours – “Many workers preferred a reliable regular paycheck, and owners decided to profit by investing in productivity and keeping the upside.”
Wise Words from Lou Simpson – “Over the long run appreciation in share prices is most directly related to the return the company earns on its shareholders’ investment. Cash flow, which is more difficult to manipulate than reported earnings, is a useful additional yardstick.”
Note: This is based on when I read the article, not necessarily when it was first published. Unfortunately, my backlog of things I would like to read always seems to dwarf the amount of time I can devote to reading.
Mrs. SFTE decided to torture our daughter the other week. She made tacos. Taco Tuesday you know. But with a wrinkle. She made hard tacos.
These were the new and improved version. These hard tacos had flat bottoms so they stood up on their own. However, they still broke down the middle, spilling all the contents as my daughter found out the hard way.
I honestly cannot remember the last time I ate hard tacos. Guessing here; but I think you could measure that time in decades.
It’s funny how your perspective changes. I think the first time I realized there was such a thing as soft tacos was at a restaurant at an age not too much older than my daughter. What a paradigm shift that night was. Maybe they were widely available before that. I really have no idea. All I know is that from my perspective there was only one kind of taco: hard. And once I realized soft tacos were an option, I never went back.
Sort of like soft tacos for my daughter – until the other night. She had no idea. Ha ha ha….
In today’s low rate world, where growth is becoming harder to come by, focusing on risk adjusted returns is more important than ever.
“A risk-adjusted return is a calculation of the profit or potential profit from an investment that takes into account the degree of risk that must be accepted in order to achieve it. The risk is measured in comparison to that of a virtually risk-free investment—usually U.S. Treasuries.” – Investopedia
Dividend stocks might yield 3-4%. Which feels better than the 1-2% you can earn in treasuries. And way better than the 0.5 – 1% you can earn in money markets or CDs (if that is even possible).
What are you trading for the extra return.
Risk.
Is that a good trade right now? Don’t know. Been thinking about it a lot though.
“The answer is that there is no, and can be no safe, dependable way to make a high return in a low-return world,” Marks said. “It’s too good to be true.” – Howard Marks
Do not say “EBITDA is a good proxy for cash flow”1.
I worked as a cash flow lender for quite awhile and never heard a colleague at our institution ever say anything to that effect. In the business world, I do hear the folks make the simplification. It’s a shortcut that can get you in trouble.
I am a firm believer that you can tell a lot about a person’s knowledge of financial statements by understanding where they focus their attention. More on this later.
However, I find that managers, business unit leaders, and maybe even C level executives tend to spend a lot of time on the income statement, and not much else. And when focusing on the income statement (a.k.a., P&L, profit & loss), most attention is paid to revenue and EBITDA (earnings before interest, taxes, depreciation, and amortization). Also, business folks like to adjust EBITDA by removing non-operating items or other one-time, non-recurring items.
Again, I am not going to opine on how I utilize financial statements right now or where I spend the majority of my time. But the other statements are there for a reason. The balance sheet and statement of cash flows provide information not available on the income statement.
But let’s address why you should not make the statement that “EBITDA is a good proxy for cash flow.”
EBITDA is a good proxy for operating income. It focuses the readers of the financial statements on what generally accepted accounting principles (GAAP) say the accounting profit (or loss) of the business is for the period. It does this by ignoring certain items (i.e., push them below the line):
Interest – interest is typically paid on debt. Debt is a financial engineering / capital structure decision for most businesses, not an operational one. Also, some companies have debt and others don’t. Setting aside interest payments helps look at the operations of the business regardless of capital structure.
Taxes – a note of caution here, read your debt covenants carefully, as this is generally read as income taxes. In my opinion, taxes such as commercial activity taxes and other “taxes and fees” are very much a part of operations and most lenders agree. However, taxes on income can be heavily influenced by interest payments, depreciation, amortization, and other deductions. So, setting income taxes aside let’s you focus on the operations of the business, without those distortions.
Depreciation – this one is a bit more murky in my mind. However, depreciation on capital spending is generally considered not part of operations. And it is highly dependent on the type of business and accounting policies in place.
Amortization – this one can be extremely murky as well. Commonly, intangible assets and goodwill, such as those created during an acquisition, lead to amortization. Also, capitalizing certain software development costs can also create amortization. And with the introduction of ASC 606, capitalizing certain contract costs (i.e., commissions) will create amortization. I personally have some difficulty calling some of these non-operational – especially software companies that capitalize software development costs or really any commission expense based on selling contracts (please show me something more operational than selling your products). But typically all amortization is excluded from EBITDA.
Non-Operational Adjustments – oh, what a slippery slope this one can be. But many “non-recurring” items are excluded or “added back” when calculating EBITDA, creating “adjusted EBITDA”.
But EBITDA may not approximate cash flow for quite a few reasons. It’s also a little unclear what people mean when they say “cash flow”. The cash flow statement has three major sections:
Cash Flow from Operations
Cash Flow from Investing
Cash Flow from Financing
But setting that aside, the cash flow statement is explaining why the amount of cash changed and by how much. So let’s stick with that spirit and ask is EBITDA a good proxy for “the changes in cash” in a business.
Like all things, it depends on the business a bit, but let’s look at a few elements excluded from EBITDA that can help explain why EBITDA does not serve as a good proxy for cash flow:
Interest – debt investors generally like to be paid in cash. Bummer, I know. So, depending on how much cash interest is being paid, this one can cause EBITDA and cash flow to diverge pretty substantially.
Taxes – yep, Uncle Sam, likes cash too.
Depreciation – generally non-cash, but the thing that causes depreciation, capital spending, typically involves cash. Capital spending does not show up on the income statement.
Amortization – many of these items are non-cash, although some are cash events. Software developers, regardless of whether you are electing to capitalize their salary expense, typically like to be paid in cash. And, so do sales people. Especially sales people.
Non-Operational Adjustments – yep, many of these are cash events, regardless of whether or not you consider them operational. Shove enough cash events “below the line” and you will create some large variances.
What else could cause EBITDA and cash flow to diverge? Here are a few big ones.
Subscriptions – many subscriptions are billed in advance. So the company receives all the cash upfront, and then ratably recognizes revenue over the term of the agreement. Depending on the term and how it spans reporting periods, this can create some really large variances between EBITDA and cash flow. For example, let’s say a company signs a one year subscription agreement for $100,000 with a customer on July 1, 2021 through June 30, 2022. According to the terms of the agreement, the customer will pay upfront.
2021
2022
Revenue / EBITDA
$50,000
$50,000
Cash Flow
$100,000
$0
Variance
$50,000
-$50,000
Side note: You can see why in a growing subscription business, cash flow would be overstated vs. a business in more of a steady state stage. Also, you can see where a declining subscription business could encounter some cash flow issues not apparent by only looking at the income statement.
Prepaid Expenses – same concept as above but with expenses. The company pays upfront, but ratably recognizes the expenses over some longer period.
Accruals – this whole article is predicated on using the accrual based accounting method. So, let’s say you accrue year end incentives but pay those out some time after year end. Depending on how large those are (they are high six figures in most my businesses), that will cause EBITDA and cash flow to look different.
Distributions – this one is a bit grey based on the definition of cash flow, but if a business is making distributions to owners / shareholder (i.e, dividends), these are not going to show up anywhere on the income statement. Those types of activities show up in the Cash Flow from Financing section and are generally not considered operational. However, it does mean you could have a business where EBITDA is significantly higher than cash flow depending on the size of the payments.
Financing Events – either selling securities or redeeming them won’t show up anywhere on the income statement. Similar to distributions, these events are not considered operational. But they certainly impact cash flow.
I guess you could amend the original statement to say “operating cash flow”, but I would argue, this just makes you less wrong.
So, I would encourage you never to say “ EBITDA is a good proxy for cash flow.” Instead, avoid the shortcut altogether, and get to know the statement of cash flows.
This article is predicated on using the accrual based accounting method.
“You’re free when no one can buy your time.” – Farnam Street
April was an interesting month. The biggest realization for me – which seems to be happening to lots of folks – is that “working from home” has some downsides that appear to be accumulating over the last twelve plus months. These, I think, are exacerbated by quite a few exogenous stressors still out there (no, the pandemic is not over). These have be gradually wearing on me, hopefully hit a low point in April, and have made me evolve my thinking on permanent work from home. You will see quite a few reads below relating to my exploration of some of those topics and the broader influence of the pandemic.
Updated stats through April:
Read Articles
Books
January
65
4
February
49
1
March
64
3
April
53
2
May
June
July
August
September
October
November
December
Total
231
10
Here are my most influential reads – in no particular order:
Outgrowing software – “At a certain point, everyone has grown up with this stuff, everything is a software company, and the important questions are somewhere else.”
Affluent Americans Rush to Retire in New ‘Life-Is-Short’ Mindset – “Their potential exodus from the corporate world, combined with a sharp increase in the number of business owners seeking to retire sooner than they anticipated, is a worrying phenomenon for companies that rely on their accumulated expertise.”
Welcome to the YOLO Economy – “Raises and time off may persuade some employees to stay put. But for others, stasis is the problem, and the only solution is radical change.”
The discard pile – “Walking away from something that we’re used to, even if it’s unjust or inefficient or ineffective–it usually takes far too long. Fear, momentum and the status quo combine to keep us stuck.”
3 Valuable Techniques To Stop Yourself From Overthinking – “Our delayed return environment strongly influences our modern lives. We face lots of uncertainties every day, and being worried and overthinking is part of our nature.”
An uncertain future – “I love old houses but my personality isn’t suited for them. They stress me out. (My ex-wife and I owned an old house too — she still lives there — and it caused me endless stress, as well.)”.
Delight in Uncertainty – “Commit to dancing with it. Turning away from the uncertainty gives you certain predictable results in your life. What would it be like to do something different? Commit to doing something different: face it, be with it, dance with it.”
Note: This is based on when I read the article, not necessarily when it was first published. Unfortunately, my backlog of things I would like to read always seems to dwarf the amount of time I can devote to reading.
