Josh Aharonoff
Apr 20, 2023
Welcome to another edition of Legit Numbers - it’s great to have you here!
Each week we discuss key Finance & Accounting topics to help you grow in your career
This week's digest encompasses a variety of subjects, including EBITDA calculations and comprehending fixed assets and capex.
What we’ll be covering in this edition:
Cost of Goods Sold (with 12 examples)
4 Levels of Profitability on the P&L
Calculate EBITDA
123 Examples of Financial Statement Accounts (with definitions)
Fixed Assets & Capex
Let's dive in...
➡️ WHAT IT IS:
The costs to produce and deliver what you are selling to customers
➡️WHY IT’S IMPORTANT
The higher your COGS, the less your Gross Profit, the less you make on each sale
➡️ JOURNAL ENTRIES
Since COGS is an expense on the P&L, it goes up with a Debit
The Credit can be cash, inventory, AP, or anything else
➡️ 12 EXAMPLES OF COGS (with definitions)
*Note that some companies may consider some of these as opex / other expense…it all depends on what you’re selling
Manufacturing Companies:
1️⃣ Direct materials cost → The cost of raw materials that are directly used in the production process.
2️⃣ Direct labor cost → The cost of wages and benefits paid to employees who directly work on the production process.
3️⃣ Factory overhead cost → Indirect costs associated with the production process, such as rent, maintenance, and electricity.
4️⃣ Purchases of raw materials → All costs associated with buying raw materials used in the production process.
5️⃣ Freight-in cost → The cost of shipping raw materials to the production facility.
6️⃣ Depreciation of production equipment → The amount of depreciation expenses related to production equipment over a certain period of time.
7️⃣ Obsolescence expense: The cost for damaged & defective goods that can no longer be sold to the general public
Saas Companies:
8️⃣ Web hosting → The cost of renting server space from a web hosting provider to store website files and make them accessible over the internet.
9️⃣ Server costs → The expenses associated with purchasing or renting physical servers and maintaining them to support website operations and data storage.
🔟 Domains → The cost of purchasing and renewing domain names, which serve as the website's address on the internet.
1️⃣1️⃣ Customer support → The cost of providing support services to customers, including answering questions, addressing concerns, and offering technical assistance.
1️⃣2️⃣ Merchant processing fees → The fees charged by payment processors for processing online payments, such as credit card fees or transaction fees.
1️⃣ Gross Profit
Formula → Revenue - COGS
This tells you how much is left after each sale
To me, this may be the most important metric on your P&L
Because if your margins are negative…
No matter how high your sales are, it won’t fix your problem
2️⃣ Net Operating Income
Formula → Gross Profit - Operating Expenses
This is often times equated with EBITDA…
and is a good preview of things before your net income
But Net Operating income can be very different compared to EBITDA (ex: if a company has Depreciation in COGS)
It’s in essence your net income, before your net other income items (which may or may not be significant)
3️⃣ Net Other income
Formula → Other Income - Other Expenses
This formula represents the profitability of your OTHER income & expense accounts
These accounts represent activity outside of your normal course of operations
They can be significant, or insignificant, depending on various factors in the company
4️⃣ Net Income
Formula → Net Operating Income + Net Other Income
This represents your bottom line profit
It in essence is what’s left over after you take out ALL of your EXPENSES from ALL of your INCOME
5️⃣ BONUS: EBITDA
Formula → Net Income + Interest Expense - Interest Income + Taxes + Depreciation + Amortization
This is a popular metric, and is often used to value a company, and estimate it’s free cash flows
While it’s a helpful metric, it also has it’s limitations, as it doesn’t always closely align to free cash flows
It’s also not a GAAP metric, hence you won’t find it on the P&L!
Before we calculate EBITDA, let's start with:
➡ What is EBITDA?
EBITDA's literal definition is
Earnings
Before
Interest
Taxes
Depreciation
Amortization
➡ Why is EBITDA so important?
Well.. a number of reasons...the 2 biggest being:
1️⃣ EBITDA is commonly used to value businesses
2️⃣ EBITDA is commonly referenced on a number of ratios
➡ OK, so how is EBITDA calculated?
Like the name implies..
Take your net income
[+] Interest Expenses
[-] Interest Income
[+] Taxes
[+] Depreciation
[+] Amortization
➡️ What are some common misconceptions with EBITDA?
1️⃣ EBITDA is not a GAAP metric
That’s right…for that reason, you won’t find it on a profit and loss
2️⃣ EBITDA does not equate to cash flows
Your cash flows can wildly differ from period to another when compared to EBITDA, depending on how things like accounts receivable / payable, and fixed assets come into the mix (to name a few)
3️⃣ EBITDA is not the same as net operating income
While in many cases these 2 items may be the same (like below), for some companies, it can differ
An example can be if a Fixed Asset is necessary in order to carry our revenue, in which case Depreciation would be included in cost of goods sold
Click the image below to be taken to the template & GIF
These contain every Financial Statement account I've seen in my career...
And there's so much to be said about each of them
Let’s start with the Profit & Loss
➡️ What is the Profit & Loss (P&L)?
The P&L tells you what you are EARNING…
and what you are CONSUMING…
Learn more about the P&L over here https://lnkd.in/eDspfRQX
The P&L is broken out by:
▪️ REVENUE → what you are earning via sales
Read more about revenue over here https://lnkd.in/ejNEsaxq and here https://lnkd.in/euGAPzvW
▪️ COGS → the cost to carry out your revenue
Read more about COGS over here https://lnkd.in/eYw8EVeT
▪️ OPEX → the cost to operate your business
Read more about Opex over here https://lnkd.in/eyECjBfP
▪️ OTHER INCOME / OTHER EXPENSE → Other income & expense amounts that don’t relate to your core business
Learn more about Other Income / Expense over here https://lnkd.in/e5Vcb5C9
➡️What is the Balance Sheet?
The Balance Sheet is a snap shot in time of your businesses
Learn more about the balance sheet over here: https://lnkd.in/eFDAMQnQ
The Balance Sheet is broken out by…
▪️ ASSETS Items of economic value that the business owns / substantially controls)
Learn more about Assets over here https://lnkd.in/eCcp68Zy
▪️ LIABILITIES - what the business owes to creditors
Learn more about Liabilities over here https://lnkd.in/ecwi6cE9
▪️ OWNERS EQUITY (what the business owes to owners)
Learn more about Owners Equity over here https://lnkd.in/eGrWvUYU
The more you are able to understand these statements
the better off you are to understanding your business
Click the image below to be taken to the guide on my LinkedIn.
Fixed Assets & Capex
➡️ What are Fixed Assets?
Fixed assets are physical assets that are utilized over a long period of time
These assets often times can’t get easily converted to cash
➡️ What’s Capex?
Capex stands for Capital Expenditures, and it represents the $$ used to acquire Fixed Assets
➡️ What are some examples of Capex?
🔧 Machinery & Equipment
💻 Laptops
🏨 Buildings / Land
🛋️ Furniture
➡️ How do Fixed Assets & Capex Get recorded?
Since fixed assets are used over multiple periods, they get capitalized on your balance sheet
When you make a purchase:
Debit Fixed asset
Credit Cash
Fixed assets then get expensed as the benefit is used via an account called Depreciation / Accumulated Depreciation
Debit Depreciation Expense
Credit Accumulated Depreciation
I’ve seen some companies record accumulated depreciation for each fixed asset type, while others record 1 combined accumulated depreciation account for all fixed assets
➡️ Why can Capex be so tricky?
A few reasons…
1️⃣ There are different depreciation methods (Straight line & Double declining often the most popuar)
2️⃣ Capex may result in a large cash outlay, but because it doesn’t show on your P∓L, it may be missed
3️⃣ There are different rules for depreciation methods used for tax purposes vs GAAP
Capex can be a large piece for one company, and a small piece for another - it all depends on your what exactly your business does
And that concludes this week's edition of Legit Numbers.
If you found this newsletter valuable, please consider leaving a quick 30-second testimonial here.
Also, I'm always open to suggestions on topics you'd like me to cover, so please respond to this email and let me know your thoughts.
Until next week, take care!