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3 Bottom Lines

3 Bottom Lines

The idea that a company has three bottom lines catches a lot of businesspeople by surprise.  After all, everyone knows that the financial goal of a business is to make a profit — to increase this ‘one’ bottom line.

If only it were so simple! If it were, we wouldn’t need anything more than an income statement to see how a company was performing. But the world is rarely as simple as we’d like it to be. If you have been around the business world for a while, you know that profit alone is never a sufficient measure of a company’s performance. Companies can be profitable, but go belly-up. Companies can be increasing their profits while actually performing worse than before. Companies can be making a profit that looks like a lot of money in dollar terms. But if you stop and analyze the profit, you realize the shareholders would be better off investing in CD’s or Treasury Bills.

How can this be? The answer is that ‘profit is only one measure of a business’s financial performance. It isn’t a bad measure, but it can’t do the measurement job by itself. You can’t get an accurate picture of a company’s financials without three separate statements. And you can’t judge a company’s performance with fewer than three distinct bottom lines. Not surprisingly, each bottom line derives primarily from one of the financial statements. And like the financial statements themselves, each has distinct advantages and disadvantages.

Net profit is the first of the three bottom lines. It comes from the income statement and it shows whether your company’s sales in any given time span exceeds its costs. It shows whether you’re “making money.”

As a performance measurement, net profit has a lot to recommend it. The business world understands it. It can’t be distorted by random variations in a company’s cash flow. It spreads depreciation over an asset’s useful life, so that, for example, your profit doesn’t disappear just because you bought an expensive new machine. But net profit also has many drawbacks as a measurement. If you keep an eye only on net profit, for example, you may be able to keep expenses from exceeding sales. But you won’t know how much cash is going into your bank account. Maybe receivables are increasing. Maybe you are spending more than you need to spend on inventory. If all your profits are tied up in receivables and inventory, you may run out of cash and have to suspend operations even though you are ostensibly making money. Short of that, you may be doing a poor job at managing your cash and managing your fixed assets. You might be turning a profit, but is it really more than you could earn if you liquidated the business, took the money, and invested it in T-Bills? How do you know?

Another drawback of profit as a metric: it is susceptible to accounting distortions. When accountants figure net profit, they often can choose among various legitimate methods of calculating depreciation and valuing inventories. Profit will vary depending on which method they choose. Remember, the income statement is an abstraction. So profit is an abstraction too.

Operating cash flow (OCF) is an excellent second bottom line. You find it on the cash-flow statement. It shows how much net cash is flowing into your company, independent of what you may receive from lenders and investors and independent of what you spend on fixed assets or other investments. It shows the cash you’re generating from operations.

Why is this helpful? Unlike net profit, OCF is based on real events… cash going in and cash going out… and not on accounting theory. Because of this, OCF can’t be manipulated internally, merely by following different rules for preparing the financials. If your OCF is consistently positive, you know you are generating enough cash from operations to meet your regular obligations.

OCF can also be used to test the quality of a company’s earnings (or profit). Are the profits on the income statement real or have they somehow been manipulated?

In general, OCF should consistently be larger than net profit. If it is, that’s a sign that a business is doing a good job of managing assets such as receivables and inventory. Financial people say that it is doing a good job of ‘turning its profits into cash.’ If OCF is consistently smaller than net profit, the company is doing a poor job. In some cases, fraud has been discovered when OCF was consistently lower than net profit.

So why not use OCF as a single bottom line? Unfortunately, it too can be manipulated… not internally, by choosing different accounting procedures, but externally. For instance, a company can arrange or decide to pay its vendors late, temporarily increasing OCF. It can also increase OCF by sacrificing profitability, which is not necessarily wise. In some industries for example, it is common for an operating company to sell its accounts receivable to another business known as a factor. The factor pays so much on the dollar for the receivables and then attempts to collect the full amount, which is how it makes money. The operating company trades $1 worth of receivables for (say) $.85 worth of cash. This move obviously improvs the company’s immediate operating cash flow. But it can hurt immediate profits because a sale worth $1 has effectively been transformed into a sale worth $.85.

Return on assets (ROA) is the third bottom line. It’s calculated by taking net profit (from the income statement) and dividing by average assets. Assets are found on the balance sheet. To find average assets for a given period, you add the assets at the beginning and the assets at the end, then divide by two. For example, if a company has $1 million in assets at the beginning of a year and $1.2 million at the end, its average assets for the year are $1.1 million. If it made $100,000 in net profit during the year, it’s ROA is $100,000 divided by $1,100,000, or approximately 9 percent.

ROA is a terrific bottom line. It encompasses net profit, so it shows you whether you’re doing a good job managing sales and expenses. It also shows you how effectively you’re managing assets such as receivables, inventory, and fixed assets. ROA helps you evaluate what’s really happening when your profit moves in one direction or the other. If your profit has risen but ROA has declined, for instance, it means your assets have grown faster than your profits. That’s usually a sign that you’re not managing your assets effectively.

ROA has one other big advantage: it allows a company to compare itself to competitors in the same industry. Profit levels and cash flow can differ widely from one company to another. But ROA is a kind of universal solvent for companies in the same business: it shows how much profit a company is earning for a given level of total assets,

Why not just ROA? One reason is that it is a little more complex than the other measures and so can be harder for people without financial training to understand. But the real reason is that it too is an abstraction. The numerator (net profit) has the drawbacks described above. The denominator (average assets) depends on how accountants value inventory, how they depreciate fixed assets, and so on. ROA is a good measure; it just isn’t perfect… and it still doesn’t tell you how much cash you netted last month!

The truth is, you need all three bottom lines. You need all three measures. Without them, you just can see the big picture. Your company can look good in terms of dollar profits but poor when you consider ROA. Your company can be earning a profit but unable to meet payroll because there’s not enough cash. Your company can have a satisfactory ROA but flat or declining sales…  possible recipe for disaster. With all three, however, you can tell if you’re really making money. More important, you can use the knowledge you gain to manage the business more effectively. From a financial perspective, improvement on the three bottom lines is the goal of a business. Every company needs to make a profit, generate cash, and produce sufficient return on investment to be competitive. These three bottom lines, defined here generically, give you a powerful tool for evaluating a business’s performance. You don’t need a degree in finance to understand and use them. All you need is a little practice.

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