Nate Clark's Musings

As told through a conversation with my bold alter-ego…

Why are you talking about this?

One thing I wish they had taught me more about in engineering school is financial statements. Investors use them to help them assess the quality of a business, so if you ever want to invest in a company, sell stock, raise debt funding, or sell a business then you need to care about these things. Even if you don’t invest or own a business, your manager (or their manager) does, so understanding what they care about will do wonders for your career. As an engineer you can make a much stronger case for working on a project if you understand how it will impact the financial statements and thus the stock price.

Got it. So what are financial statements? Where did they come from?

In response to the Great Depression in the 1930s, the US passed the Securities Exchange Act of 1934. That law, among other things, established the Securities and Exchange Commission (SEC) and required public companies to file audited financial statements every quarter to help investors understand what’s going on in the businesses they invest in. Part of the reason for the speculative bubble that led to the Great Depression was that businesses were completely opaque prior to this law and people didn’t really understand what they were investing in. Financial statements give investors a window into how a business operates. Everything I’m talking about is US-centric but many other countries have similar rules.

There are three main parts to financial statements: the income statement, the cashflow statement, and the balance sheet. These statements have to be prepared by external auditors and must abide by GAAP, the Generally Accepted Accounting Practices (rumor has it just prior to their attempted IPO, WeWork’s CFO thought the first ‘A’ stood for “awesome!” (that’s a joke)).

Hilarious. So anyway, what’s an Income Statement?

The purpose of the income statement is to show how profitable a business is in the steady-state. Income statements show revenue, i.e., how much money is generated from sales, and expenses. Let me show you an example from Apple’s 2023 annual report (their financial year ends Sept 30):

All of these numbers are in millions, so in the Oct ’22 – Sept ’23 year, Apple sold $383 billion(!) worth of stuff. The ‘Net’ part of ‘Net sales’ just means they subtracted customer returns and that sort of thing – it doesn’t count if you sold something that’s brought back for a refund. Cost of sales is how much it took to produce that stuff: the iPhone factories, parts, computing costs to run the App Store, salaries of people working in the factories, etc. Operating expenses are any costs to run the business that aren’t directly involved in creation of the products. Think salaries for management and salespeople, insurance, electricity bills at corporate headquarters, IT, and that sort of thing. Net income is what’s left when you take all the revenue and subtract all the costs. At the end of the day, Apple made $97 billion last year. Not too shabby.

It’s worth noting that sales represent when a product or service is delivered, NOT when the company actually received the money. This means that the number is an estimate. A plumber probably won’t have 100% of their customers pay their bills when the invoices are delivered for example, so they would guess at the fraction of people who would pay when making an income statement. As another example, even though you purchase airline tickets in advance, the airline can’t recognize the sale until you actually get on the plane. Companies give their best guess as to how much revenue will actually come in the door when putting income statements together.

It seems sort of weird that factories would show up here. Isn’t that the sort of thing you pay for once and use for a really long time? Wouldn’t the year you built the factory look like a really bad earnings year on the income statement?

Very observant, bold alter-ego! If we recognized the entire cost of one-time-ish purchases (also known as Capital Expenditures, or capex) in their entirety at the time of purchase, it would make the income statement look pretty wild from year to year and very much not indicative of steady-state earnings. Years they built a new factory would look terrible, but the years they didn’t would look great. This would make it hard for investors to understand whether something fundamentally changed with the business.

To avoid that problem GAAP tells companies to depreciate these expenses over the estimated lifetime of the asset. So if it cost Apple $200m to build a new factory, the accountants would ask someone to guess at how long the factory would be useful. If that person said 10 years, Apple would add $20m in the cost-of-sales row for the next 10 years instead of $200m one time. There’s a similar concept called amortization, which is exactly the same thing as depreciation but for intangible assets like patents (I don’t know why they needed a second word for that). All sorts of things get depreciated and amortized, including software development.

How do they know the factory will be useful for 10 years in that example?

They guess! It’s impossible to know how long software will be used when you write it or when the factory will be obsolete. And yes, CFOs have been known to play games to make their earnings look better by increasing the estimated useful life of stuff. The most famous example of this was Waste Management, the garbage hauling company, which slowly increased the lifetime of their garbage trucks to juice net income even though nothing changed with the trucks. They eventually had to readjust their earnings down $1.7 billion and got into all sorts of trouble!

Wow, that’s nuts. Ok, I get the gist of what the income statement is telling me. What do investors typically care about when they look at an income statement?

• Earnings quality – Does the revenue come from selling products and services, or is it due to one-time events like selling a business unit or winning a lawsuit? Obviously investors prefer the former.
• Consistency – If revenues are consistent and/or show predictable patterns of growth then there’s less risk for investors, and they will pay a premium to own those types of businesses. That’s why subscription businesses are all the rage these days.
• Profitability – This usually takes the form of some sort of ratio like net profit margin, which is net income / revenue. In the Apple example that’s 96,995 / 383,285 = 25.3%. Higher margin means the business is capturing more of the revenue, which is great for business owners. It’s worth noting that net margin numbers are only comparable within a particular industry – a good net margin in software companies is usually 15-25%, where retail businesses like clothing sales are killing it if they get to 5%. Aside: the fact that Apple has a net margin of 25% with most of their revenue coming from hardware devices is absolutely ridiculous.

So if you’re in an engineering or product organization, focusing on projects that generate recurring revenues and high revenues relative to the cost are the most impactful for the share price.

I’ve heard this term EBITDA. Does that relate to the income statement in some way?

EBITDA, pronounced EE-bit-DAH, stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. The story behind its creation is actually really interesting, but I’m not going to go into it here. EBITDA is just net income with some costs removed, namely taxes, interest expenses on outstanding debt, depreciation, and amortization (duh). The reason people like EBITDA as a metric is because it focuses on the core of the business, excluding certain costs that can vary a lot based on how companies choose to run themselves.

For example, imagine two identical companies that produce widgets. If Company A chose to purchase their widget-making machines by issuing bonds (thus paying interest) and depreciated the machines over 10 years, and Company B chose to purchase the same machines with last year’s profits and are depreciating them over 12 years, then these two companies would have very different net incomes, despite being otherwise identical.

Many (most?) investors care a lot about EBITDA, but there are some vocal critics as well. Notably, Warren Buffett has written, “References to EBITDA make us shudder,” and his partner Charlie Munger said, “every time you see the word EBITDA, you should substitute the words ‘bullshit earnings’,” since it excludes so many real costs to running the business. EBITDA is a non-GAAP number, and the SEC even forbids companies from reporting EBITDA/share.

You’ll sometimes see mentions of “adjusted EBITDA” as well. This is just the standard EBITDA number with even more expenses pulled out. Whether or not this is meaningful to help investors understand the business depends a lot on what they adjust. Some of the GAAP rules are pretty stupid, IMO, so this can sometimes be a useful number, but if you’re an investor you must think very carefully about whether the removed costs produce meaningful insights. Most importantly, now you understand this meme:

At the end of the day a lot of people care about EBITDA, so EBITDA margin (EBITDA / net revenue) is more common to run into than net margin. And if you’re an engineer trying to justify your projects this is one of the two main metrics I’d focus on.

Are there any other metrics I should be aware of as an engineer?

If you’re part of a SaaS company, you should also know of the Rule of 40. The rule of 40 states that in healthy SaaS companies the EBITDA margin + revenue growth rate should be greater than 40. The idea behind this rule is that it’s ok to have low margins if you have very high growth. Once growth inevitably slows, though, it’s important to have the discipline to ensure your products become more profitable. If you can hit this goal your stock will absolutely kill it.

Enough about income statements already. What’s up with the balance sheet?

The balance sheet shows a snapshot of what the company owned, what it owed, and what’s left over. The left-over part is the owners’ equity value, aka the total value of all the company’s stock. These numbers must add up to zero, thus the ‘balance’ in ‘balance sheet’. Let’s take a look at Apple’s again.

Current assets are assets the company expects to use or convert to cash in the next year: money sitting in the bank, money customers owe them (aka receivables), and that sort of thing. Non-current assets are not readily convertible to cash or assets that provide benefits to the company on a longer timeline, like buildings, deferred tax refunds, and investments in other companies. Liabilities include bonds that the company has issued, money the company owes to vendors, etc. The leftover part is the equity, also known as book value.

There are all sorts of assets which don’t show up on a balance sheet. For example, the company’s brand, their customer list, and talented employees are all valuable company assets that don’t show up here at all. Other assets, e.g., patents, do show up here but are really hard to value. Again, this leads to a lot of estimates in coming up with the numbers in this chart.

Why is Apple’s total equity value $62 billion? I thought all the stock (i.e., the market cap) was worth like $3 trillion.

This is because of all the assets that aren’t on the balance sheet. The market has decided that those are worth about $2.938 trillion, i.e., the difference between the market cap and the book value.

One interesting side note is that when Company A buys Company B, Company A must pay the market price (at least) for B. When Company B shows up on A’s balance sheet though those non-balance sheet assets need to be accounted for to make everything balance out. The non-balance-sheet assets will show up on A’s balance sheet under a row called “goodwill,” which is just the delta between what Company A paid and Company B’s book value.

When you see goodwill on a balance sheet, just know that it’s the totally made-up number A decided that B’s intangibles are worth. GAAP requires that A revisit the goodwill number annually to see if it passes muster for credibility, and if you see it decrease significantly, it’s a sign that something bad happened to B’s business after A acquired it or that A overpaid.

Seems like there’s a whole lot of stuff missing from the balance sheet. Why do investors find this useful?

There are definitely some interesting characteristics to be gleaned here:

• Liquidity – Does the company have enough cash or short-term assets to meet their short-term liabilities? It doesn’t matter how profitable the business is in the steady-state if they don’t have enough cash to pay their bills right now. You’ll sometimes see this expressed as the Current Ratio or Quick Ratio, which are similar ways to measure liquidity.
  
  Quick Ratio = (cash + marketable securities + net accounts receivable) / current liabilities. In the Apple example this would be ($29,965 + $31,590 + $29,508) / $145,308 = 0.63. Higher ratios mean the company is less likely to run into cash problems, though if the number is too high then the company is probably sitting on too much cash. Investors like to see numbers around 1. But as with everything else you need to consider context, e.g., auto manufacturers tend to be lower because of large parts inventories, and absolutely no one would be worried about Apple’s ability to raise short-term cash despite the 0.63 number.
  
• Debt Capacity – Does the company have an appropriate amount of debt for its long-term financial stability? This is often evaluated through debt-to-equity or debt-to-assets ratios. Generally speaking, debt-to-equity above 2 starts to raise eyebrows.

Anything I can do about these as an engineer?

Nope, not really. This is mostly the CFOs domain. It’s definitely helpful to know this stuff when you’re investing or if you happen to be joining a company that lets you look at the financials prior to starting so you can avoid walking into a disaster.

Alrighty then, last but not least, what’s the cash flow statement?

The cash flow statement shows cash moving in and out of the company in a particular time period. Recall the income statement shows the steady-state profitability of a company. The cash flow statement augments that with the timing of when money comes in or leaves. Timing of cash flows is very important, since it’s definitely possible to run out of money even in steady-state profitable businesses.

Let’s take a look at Apple’s cash flow statement:

The top line shows they started the year with $25 billion in the bank. The Operating activities section shows cash generated or used by the core business, e.g., they made $97 billion in net income (this is the same number from the income statement). The “Changes in operating assets” section tells us how the balance sheet evolved from one year to the next. For example, accounts receivable dropped $1.688 billion, meaning that in the last year the amount of money customers owed them fell.

Investing activities shows money that was spent/generated on longer term investments. Remember the $200m factory we talked about above? All $200m would show up here, rather than the depreciated $20m, because the cash actually left the building. The last section shows cash movements from financial transactions like paying dividends, buying back stock, or paying down bonds.

Summing it all up, Apple ended up with $30.737 billion in the bank at the end of the year.

What do investors care about when they look at one of these?

The cash flow statement can tell you a lot about the health of the company and priorities of the management team.

• Cash flow from operations – If the company is healthy, you’d expect it to generate enough cash to sustain the business and provide capital for investing in the future.
• Investing activities – Typically, you’d like to see some decent-sized negative numbers here to show that the company is developing future products and has plans for growth.
• Financing – Is the company paying down its debt? Is it selling a lot of stock to raise capital?
• Free cash flow (FCF) – This metric represents the cash a company has on hand to give back to shareholders and is one that many investors put a lot of weight on. It’s calculated by taking cash flow from operations and subtracting capital expenditures. Apple’s FCF for 2023 was $110.543b – $10.959b = $99.584 billion. This number is a lot lumpier than net income because the capex is not depreciated, but it presents a more realistic picture about profits the company has left over to use at a particular point in time. Along with EBITDA, this is one of the top two metrics investors care about in my experience.

Cool, cool. Those do seem pretty useful. As an engineer, what can I do to affect the cash flow statement?

Most of your impact can be in the operating activities part of the statement:

• If you build physical things, try not to keep huge inventories of parts or finished products lying around.
• If you interact with customers, sell to the ones that pay their bills quickly. That directly impacts the receivables.
• If you need to make a large capital expenditure, can you time it to coincide with periods of high income? E.g., say you have a really big customer that renews their contract every five years. Timing large capex to coincide with that renewal can help make the cash flow statement look a little better to investors who don’t take the time to dig in and truly understand what’s going on.

Wow, thanks for explaining all this. I will now be a better engineer for understanding this stuff.

You’re welcome 🙂

Let me leave you with a few fun thought experiments to test your understanding:

• How does moving an application from on-prem infrastructure to the cloud affect EBITDA and FCF?
• How does the decision to build vs. buy a piece of software affect EBITDA and FCF?
• If presented with the option to do research in-house or purchase a company that did similar research (think pharmaceutical companies), which do you think would look better to investors?