Whether you invest in the stock market via index funds or individual companies for your retirement, the success of your investments depends on the profits of publicly-traded companies. As Benjamin Graham said, the stock market is a weighing machine in the long term and only a voting machine in the short term. What it weighs with are the profits generated by the companies. Profits are the fuel that feed the stock market machine. This article is a guide to profit, like a business, in your own personal finances.
How Profit is Generated
In my corporate experience in M&A and as a business leader, I have had the privilege of evaluating various new businesses, emerging technologies and established or even declining businesses in need of an acquirer or partner. Since I am not an accountant, my view of corporate finance comes from a very different perspective, and is much more “hands on”, from business and investing perspectives. However, accounting standards play a big part of how profits are accrued and reported.
Whether the company follows U.S. GAAP or IFRS or any other globally accepted accounting standards (maybe not this one!), there are many common elements to how a business is viewed and managed in financial terms. At a basic level, the following items are generally common:
- Gross Revenue: This is what the company reports (or accrues in some cases) from sales of goods and services to its customers. Products are priced keeping profits and competition in mind, so pricing and volume determine this figure.
- Net Revenue: This is what remains after the company pays off any revenue-level taxes, fees and commissions. This is a key figure as this is the money a company gets to work with.
- Cost of Revenue or Cost of Goods Sold (COGS): These are direct costs. If a company makes widgets, a widget’s material and direct labor involved in its production and running its plant would figure here. In some cases, direct purchase of the widget made by another company would be its COGS.
- Gross Margin (or Gross Profit): Item 2 minus 3. This is a good measure of competitiveness of a company. I like to see how its Gross Margin fares among the industry peers.
- Selling, General & Administrative (SG&A) expenses: Sales expenses, marketing and ads (celebrities doesn’t come cheap), expense accounts, lavish dinners, mahogany-paneled Board rooms, swanky corporate offices, outside consultants and lawyers’ fees, and all the fanfare that goes with running a company (as the CEO approves) goes here. This also has some essential items like R&D expenses and product launch expenses, to keep a company innovative and competitive in the marketplace.
- EBITDA: Item 4 minus 5. Useless figure except in the M&A world, and the consultants love it. EBITDA stands for Earnings before Interest, Taxes, Depreciation and Amortization. I call it useless because the expenses don’t stop here, and using EBITDA alone as a proxy for profit gives a distorted picture.
- Depreciation & Amortization: If the company is a manufacturer or has lot of fixed assets (property, plant, equipment) – including the corporate jet or limousine – they all wear down and have periodic need for repairs. They eventually need replacement as well. Accounting world treats this is a non-cash expense because the company may not spend it each year they account for it, but it is every bit real because things wear down in the real world and there is no getting around that.
- Interest: This is what the company pays to the banks and bond holders for lending their money to the company, which the company uses for buying the things mentioned in Item 7 and some of Item 5. Here, third parties (banks/bond owners) are involved and they must get paid what they are promised. A company loses its credit rating if its interest payments are too high compared to its profits, and can be forced into bankruptcy if it stops paying the interest.
- Pre-tax Profit: What remains after you subtract Items 5, 7 and 8 from Item 4. Higher the better.
- Taxes: There is no escape here, though many companies try everything under the sun including tax inversion…very different from this inversion! Their idea is to minimize taxes paid to any and all governments, where-ever the business operates.
Net Profit (“Bottom line”):Item 9 minus Item 10. Also called Net Income. A key objective for a company is to maximize this item. This is what investors often mean by show me the money. In an ideal world, net profit should match the free cash flow that the company generates, but since we have some non-cash expenses (ex, item 7) and income (ex, deferred revenue, too specialized a topic for this article), the figures generally don’t match. So, the company separately prepares a cash flow statement to record how it makes and uses cash.
- Dividends: Portion of Item 11 that the company pays to its shareholders, set by the Board of Directors. If the Board decides to pay out 50% of net income, then that’s what the shareholders get as dividends. The rest is called ‘retained earnings’ (or ‘carry forward’ in some countries). This can be used to: a) pay down debt b) invest in profitable new projects c) buy back shares and/or d) add to the cash pile of the company. All of these actions impact the balance sheet of the company and help improve future P&L statement.
The above list is what is presented as Profit & Loss (P&L) statement or simply, Income Statement, like this one. I am not getting into some nuances here but this is largely it. You can do the P&L over a year, a quarter, a month or even a day, but for practical purposes and to avoid making accounting their main profession, most companies publish this over a quarter and a year to their shareholders. Combined with Balanced Sheet and Cash Flow statements, these three financial statements are the ‘holy trinity’ of finance and investment analysis. We, as investors, can get a peek into a company’s health for that period when these three statements are made available.
Once you see a P&L in this way, it should be clear to you that shareholders are the last in line to collect what’s left over. A number of things can go wrong that can reduce or eliminate net profits, but usually, most of the expenses (Item 5 onward down) are fairly predictable to a company that has been in business for a while. So, a lot of attention is paid to Gross Margin (Item 4) because if that holds up or preferably, moves up even a bit, you will get a noticeable positive impact on the bottom line (net profit) because other costs are largely fixed.
What does this mean for you?
Companies that increase their net profits consistently are valued more by shareholders and have a higher market value. Think of yourself like a company. Market value to companies is like net worth is to individuals. The table below shows how each item in the business P&L matches to your personal P&L. You can use this to increase your own ‘profits’ and net worth. The important line items are shown with a green check mark (‘tick’ mark for our UK/Australian/Indian/NZ readers). Items that negatively affect your personal business are marked with triangular warning signs.
We make money from being investors in well-managed businesses, so why not manage our own finances this way?
Your Personal P&L
What To Do
Pitfalls to Watch For
Focus on getting a better paying job and getting promoted
Career-destroying behaviors, Risky opportunity cost ventures
Net or After-Tax Income
(or "Netto" as the Europeans call it)
* Maximize pre-tax savings to reduce your taxable income
* Live in lower tax territories
Don't try to be too smart beyond what the law provides (pay your fair share of income taxes)
Your Core Expenses
* Track what it costs to live an 'essentials-only' sustainable lifestyle
* Practice sensible frugality
Benchmark your core expenses to be below average for your income peers, but don't go overboard in extreme frugality, which may not be sustainable for you
Your Discretionary Income
If you did the best you could in the first 3 areas above, this would be the highest you can reach and maintain
Be careful about including too many 'wants' in your core expenses, to avoid shrinkage of Gross Margin
Your Discretionary Expenses
* Learn the difference between 'want' and 'need'
* Reduce as much as you reasonably can (new cars, expensive vacations, bigger house, second house etc,)
Calling a discretionary expense as 'core' or thinking it will give you much happiness
Depreciation & Amortization
Your One-off Expenses
* Budget for it, as a leaky roof or broken appliance needs to be fixed
* Budget this to be no more than 10% of your total expenses (buy used where it makes sense to throw away than repair)
* Accidents, avoidable health issues, Greedy relatives, friends and charlatans
Your Mortgage/Student Loan/Car Loan/Credit Card Interest
* Itemize all interest into separate categories so each gets the focus it deserves
* Reduce or eliminate this within a set time period, ideally to zero
Lumping interest in 'core' or 'discretionary' expenses so it stays hidden
Your After-Tax Savings
* Like a good company, your goal is to maximize this
* Set increasingly challenging targets each year till you get to a sustainable maximum (should be no less than 25% of net income, can be as high as you can manage)
* Getting lost in the above line items and forgetting Net Profit as the main objective
* Stopping with saving (not investing efficiently)
(or NQA - 'no questions asked' money in TFR household)
Keep this to be 20% of the Net Profit figure maximum (or max 5% of net income)
* Going overboard in fun money or not having fun at all (both extremes)
Net Profit adds to your Net Worth. If this Net Profit is invested efficiently, it helps you reach your FIRE dreams.
If we want to maximize net profit and net worth, we must learn to think and act like a smartly-managed business. Use the above table as your guide. What do you think? Share in comments below.