Profit, Earnings & EBITDA

When people talk about ‘profits’, do they mean the same as ‘earnings’ and what’s this ‘EBITDA’ thing?

The truth is that they are all ways of describing the performance of an organisation.

‘Profit’ is a word that means the amount that is left from income after deducting expenses. But which expenses? That’s a good question. Profit is a loose term. We have different types of profit:

  • Gross profit: that’s profit after deducting the direct costs, that’s the cost that we have to incur to earn the income such as the cost of fuel and a driver for a bus company.
  • Operating profit: that’s the profit after deducting the direct costs and the indirect (or overhead) costs such as the cost of running the administrative team or the rent of the offices.
  • Net profit: that’s the profit after all the costs, direct, indirect, interest and tax. This is the profit that’s left over for the owners of the business.

‘Earnings’ then is a term used to describe the amount that the owners of the business have made from the organisation. So that’s effectively the same as net profit.

Lastly we have the newcomer to this world of profit terminology, EBITDA. This is the operating profit before the costs of depreciation are deducted. It is thought by some academics to be a better measure of the performance and cash generating ability of an organisation that the other measures and is very widely used by business and public sector organisations across the world.

If you would like to know more about Profit, earnings and EBITDA, contact us and we can deliver one of our course at your organisation or you can buy or Finance for Beginners on-line learning.

 

 

What’s NPV (Net Present Value) & DCF (Discounted Cash Flow) all about?

Often managers are asked to have an NPV (or DCF) calculation done on projects they are proposing. This NPV calculation will typically be performed by the Finance team. But what are they actually doing?

If I asked you to give me £100 now and I told you that I would give you back £100 in one year, would you do it?

I would hope you answered ‘no’ to this as there is no advantage to you in the deal. You understand that you would be better keeping the £100 and investing it in a bank account where you might get some interest.

What if I said that if you gave me the £100 now I will give you £110 in a year?

Now you might be interested. It would depend on how much money you could earn yourself by investing the £100 compared to the £110 I will give you. If you could earn more that £10 you won’t give me the money, if you couldn’t you would give me it.

If we take this into the business world and you were doing a project that required the business to invest £100k  as a result of which the business was going to get cost savings in year one of £50k and savings in year 2 of £70k, is this worthwhile for the business.

It depends again on how well the business could use this £100k elsewhere on other projects. The accountant will use the NPV technique to determine whether the project is worthwhile for the business.

If you want to know more about how the NPV process works we can provide in house courses focused on how your business assesses its projects.

The EBITDA multiple & Business Valuations

Many organisations promote EBITDA as a key way of valuing a business. The idea is that EBITDA (that’s Earnings Before Interest, Tax, Depreciation & Amortisation) measures the amount of cash that a business has generated during the year. While this is not quite accurate, it is a rough guide to the level of cash generated by the business from trading.

So the promoters of EBITDA as a business valuation tool state that if we found that the EBITDA of a business was say $1,000k each year and we wanted to buy this business and get a 10% return on our investment then we would be prepared to pay $10,000k. Let’s do the maths:

$1,000 return    = 10% return before tax

$10,0000 cost

We are using a multiple of 10 here, applied to the earnings. To get the multiple we take our required return (here 10%), turn it into a decimal (here 0.1) and use the reciprocal (1/0.1 = 10).

So using EBITDA we will get a 10% pre tax cash return on our investment if we pay $10,000k. However this approach ignores the issue of new capital investments required by the business that we have acquired. What happens, for example if the business we have bought requires a new piece of equipment for $500k in year 2? This will wipe out half of our cash return and reduce it to only 5% in that year. We will have effectively overpaid for our investment.

So the use of EBITDA is a little simplistic to give us an accurate required rate of cash return. We need to reduce the EBITDA figure by the level of average capital requirements before calculating our purchase price. EBITDA is therefore a good start point. It gives us a top end valuation; we certainly shouldn’t pay more than this figure applied to our multiplier. We should look to this figure and try and temper it down as the buyer.

 

 

All change in UK Accounting rules: FRS 100, FRS 101 & FRS 102

It’s finally happened, FRS 102 is here! The new blueprint for UK accounting was actually finalised in March this year.

So how will things look going forward? When will everything change? And which organisations will be affected? All key questions that are revealed below.

What are the reporting requirements going forward?

The Financial Reporting Council (FRC) now has responsibility for setting and maintaining UK accounting rules following the disbanding of the Accounting Standards Board (ASB). All UK businesses will fall into one of the following categories:

1. Companies quoted on the Stock Exchange or AIM will use EU adopted IFRS

2. Companies that qualify as ‘small’ under UK accounting rules will follow the UK FRSSE

3. Companies not in categories 1 & 2 above will follow FRS 102

Just a couple of points here. The UK FRSSE users can voluntarily use FRS 102 or full IFRS if they wish. This would be extremely unlikely as the FRSSE is so simple and straightforward to use and of course it therefore means that it costs less to prepare and publish accounts using the FRSSE.

Secondly, companies in category 3 above could use full IFRS if they chose. Again this would be unlikely due to cost implications.

What is FRS 102?

FRS 102 is part of a set of 3 UK standards that were published in November 2012 and March 2013. The first of these was FRS 100. In a nutshell this standard did away with all the existing UK SSAPs & FRSs. For those amongst you who, like me, are old enough to remember these standards you will no doubt be feeling a welling up in the tear ducts at the thought of the departure of these old friends!

Not only does FRS 100 sweep away all existing UK standards but it also introduces the blueprint referred to in the previous paragraph for UK accounting in the future. It does this with the help of two other new standards, FRS 101 & 102.

FRS 101 first of all is a little bit of a side show. It simply allows UK companies whose parent produces full IFRS to produce its own accounts using IFRS with a whole raft of limitations on the level of disclosure. This would allow a UK subsidiary of, say, a German quoted parent that uses full IFRS for group accounts, to produce a simplified version of IFRS accounts with limited disclosures on Property, Plant & Equipment, Financial Instruments and many other items.

We then have the main man of the moment, FRS 102. This standard is a one stop shop standard for UK companies that don’t use IFRS or the FRSSE. The document is about 350 pages long and covers every aspect of reporting. It is based on the IFRS for Small & Medium Entities so uses international language: words & phrases like ‘Statement of Financial Position’ rather than ‘Balance Sheet’, ‘Non Current Assets’ rather than ‘Fixed Assets’ and so on. I would describe the document as ‘the FRSSE for medium sized companies’.

The thing with FRS 102 is that the FRC didn’t want UK companies to just adopt the IFRS for Small & Medium Entities. They wanted something ‘uniquely British’.

So FRS 102 is different to the UK GAAP that went before. It has far fewer disclosure requirements for a start and also has some accounting substantive accounting differences as well. And FRS 102 is also different to the IFRS for Small & Medium Entities in that it allows things such as the capitalisation of development expenditure.

When it is used by UK companies it should make reporting much quicker and easier for users. Accountants will just have to get used to the differences first.

When will this all happen?

The standards are already published and they can be early adopted by organisations as soon as they wish. The mandatory date for adoption is the accounting date starting after 1 January 2015. This seems like a long time away, but remember, in the first set of accounts you will need comparative figures under the new rules. So, if you have a December year end, then you will need to start using FRS 102 for your 2014 accounts at least to shadow your current accounts as you will need FRS 102 figures for 2014 to go in your 2015 statements.

There’s clearly a lot to think about for most organisations and the start of 2014 is only 8 months away as I write.

If you would like help with understanding the impacts of FRS 102 and the new regime, contact me on [email protected]

 

 

 

Here we go with the NHS Commissioning Board

On the 1st October the NHS Commissioning Board (NHS CB) came in to being. I suppose the key question is, ‘what does the board do?’

Well the board is an executive non-departmental body which basically means that it has been established by government but operates independently of them. There are two key parts to the work of the board as follows:

1. From 1 October 2012 to 31 March 2013

The key aim of the board is to authorise all 212 of the new Clinical Commissioning Groups (CCGs) that will commission (buy) most healthcare services from the suppliers (hospitals, mental health trusts and others).

The new CCGs which are made up of existing medical practices (doctors surgeries) are being authorised in 4 waves to replace the existing commissioning organisations (PCTs). The NHS CB will be making sure they each have the correct legal requirements in place.

2. From 1 April 2013

The NHS CB will be responsible for overseeing the work of the CCGs and it will also have responsibility for commissioning some services directly, such as ensuring that dental services are commssioned throughout the country.

What does this mean to the average person in the street? Well if I need a hip replacement I will still go along to my local GP who will put me in the system for having the work done. I will still have the operation provided by the hip surgeon, probably at the same hospital that I would always have gone to.

The difference lies in what goes on behind the scenes, in the machinery of the NHS. My GP will ask the CCG to pay for the hip replacement. They will consider the case and commission the service from an appropriate hospital & then when I have successfully had the operation the CCG will pay the hospital, assuming the hospital sends them an invoice (it does sometimes happen that they don’t!).

Why are we changing from the existing system though? Well these new CCGs will be mainly led by doctors rather than commissioning professionals. These CCGs will focus on and understand better the medical needs of the patients and this will ultimately give better results for those patients. Will it really make a difference to the average patient? Who knows, but we’ll have an interesting 12 months ahead as the changeover really swings into action.

EBITDA

A widely used and often misunderstood way of tracking a business’ performance is to look at its EBITDA. What is this?

The acronym stands for Earnings Before Depreciation, Interest, Tax & Amortisation. But what is it actually telling us?
Earnings is another word for ‘Profit’. So EBITDA is basically your profit for the period before deducting certain costs.

These costs include interest and tax because these are usually outside of the control of the managers of a business. The tax charge will only apply if the business makes a profit and the level of the charge is decided upon by the government. Interest levels are set by the lender and most business managers will not have been responsible for taking out the loans that created the interest.

The depreciation charge is caused by having fixed (or non current) assets and again most business managers will not have authorised the purchase of these fixed assets in the first place.

The amortisation charge is caused by having intangible fixed assets like licences, patents & goodwill (amortisation is like depreciation but for intangible rather than tangible assets). Most business managers will not have been responsible for investing in these intangible assets.

So what we are doing in assessing a business using the EBITDA measure is looking at the profits of the business before deducting all of the costs that the business manager cannot control. EBITDA shows us how well the manager has performed in their role as manager.

In this sense EBITDA might be said to give us a misleading and overly optimistic view of the business itself (rather than the manager’s performance) as it excludes the key cost of depreciation.

Those in favour of EBITDA’s use would state that EBITDA is a quick way to get a feel for how much cash the operations of the business have generated in the year. Some organisations even refer to EBITDA as being the company’s ‘Free Cash Flow’ for the year.

Whatever the arguments for and against its use, EBITDA is commonly used by financial commentators and companies themselves as the primary indicator of their financial performance for the year.

If you would like to know more about EBITDA, have a look at the Business Videos tab on our site where there is a video entitled ‘Other Financial Terminology’ which gives more detail on EBITDA

New Finance for the Non Finance Manager on-line learning programmes

Have a look at our ‘On-line learning’ tab and check out our new Finance for the Non Finance Manager on line learning programmes. There’s loads of video content (over an hour on each programme) plus PowerPoint slide shows to download, Quizzes to test your understanding plus a Finance for the Non Finance Manager Case Study to help consolidate your learning.

Hours of fun and a great way to learn at your own pace!

Service Line Reporting in the NHS

NHS organisations are moving towards a system of financial reporting known as ‘Service Line Reporting’ (SLR)

Service Line Reporting is the same idea that’s used in the private sector for tracking the profitability of individual products and services. In the same way that a telecoms company knows the different costs and profits of its Pay As You Go customers compared to its Monthly Contract customers, an acute trust can find out the costs and profitability of performing cataract surgery as opposed to hip replacements using SLR.

If for example you are the Chief Executive of an Acute NHS Trust that is making a deficit, wouldn’t it be a great idea to know whether that deficit was due to a particular procedure that you were carrying out? It could be for example that the cataract surgey you were carrying out was actually very profitable but that the hip surgery was making huge deficits.

If you didn’t know this you may decide to cut costs across the trust to save money when this would have the impact of harming your succesful cataract procedures.

Armed with the knowledge that SLR gives you, you would identify that hip procedures were incurring losses and be able to target those specific procedures for cost saving and efficiency measures. You would also be encouraged to invest in and promote your succesful cataract procedures.

If you want to find out more about SLR, we have the following courses for you:

IFRS for SMEs

Currently under review by the ASB is a proposal that will revolutionise the way UK companies prepare their financial statements. If the plans get the go ahead, these are the accounting systems that UK companies will use to prepare their accounts from as early as 2012:

  • IFRS for AIM & Quoted companies
  • IFRS for other ‘publicly accountable entities’ e.g. Investment trusts, building societies
  • IFRSSE for non publicly accountable entities
  • UK FRSSE for small companies

The ‘IFRSSE’ is the International Standards Boards’ version of the Financial Reporting Standard for Small Entities that we have currently in the UK. It is a ‘one stop shop’ standard that covers all areas of financial reporting in one standard. Users will only need to look at the IFRSSE rather than the full standards when compiling their satutory accounts.

The IFRSSE was published last year and is very similar in style to its UK equivalent. The difference in content is that it offers a simplified version of International rather than UK Standards.

However, and it’s a big ‘however’, as you can see from the above list, the difference in impact is huge. While the UK FRSSE is used by companies that qualify as ‘small’ under the Companies Act, the UK’s Accounting Standards Board is proposing that this new standard will apply to all of those companies that fall in between the larger IFRS users and the small companies using the UK FRSSE.

This is potentially the biggest change to UK accounting since standards were introduced back in the 1970’s. You still have time to comment as the period doesn’t close until February. Press comments so far do suggest that the proposal faces no real opposition and so it does look likely to get the go ahead.

As always we will be offering courses on the content of the IFRSSE. You can either book a course for your organisation and we also hope to offer some public programmes.

Keep reading your accounting magazines for updates!