Monday, October 30, 2006


Some businesses are amazing when profits are reported. Investors alike focus too much on the Income Statement and forget the Balance Sheet. Why is it so? Take for example, at time, businesses report X amount of profit but then there is a decrease in Shareholder's Equity. Isn't this a cause for further concern and investigation for those who are planning to buy into the business or those who already have a stake?
There are many such cases happening without any benefit to the investors. Imagine, if you operate a bakery business and spent $100K on machinery, supplies and so on. At the end of year one, your income statement shows a profit of $15K, while your shareholder equity shows $80K. In such cases, I think it is apparent something is not correct. Though such discrepency can be attributed to a number of reasons, for example, full distribution of all profits, depreciation policy, incorrect expensing policy and so on. Earnings per share or profitability is not a safe or good enough measure towards valuing the performance of the business. What will be a better measurement is the performance of the management's ability to increase the value of the shareholder's equity or net asset value per share over time.
Another matter that is frequently being promoted is a particularly pernicious practice. That is trumpeting EBITDA (Earnings before interest, taxes, depreciation and amortization). Doing so implies that depreciation is not truly an expense, taking it as a "non-cash" charge. That's absurd. In truth, depreciation is viewed as a particularly unattractive expense because the cash outlay it represents is paid up front, before the asset acquired has delivered any benefits to the business. Imagine, if you will pay all your employees for the next ten years of their services at the start of the year (similar to the way you would lay out cash for a fixed asset for a useful period of 10 years). In the following years, compensation would be a "non-cash" expense - a reduction of a prepaid compensation asset established in the first year. Would anyone argue that the recording of the expense in years 2 through ten would be simply a bookkeeping formality?

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