Finance

Perspective: Finance

You probably know it already: there are tons of financial KPIs out there. But we will limit ourselves to a few common ones. For more details, see Financial Intelligence for Entrepreneurs.

There is a proliferation of names and designations in the field of financial indicators. This has various origins:

In Germany, Switzerland and Austria, different terms are used in some cases due to different regulations (HGB in Germany, UGB in Austria, OR in Switzerland).
Listed companies often publish their figures in accordance with international standards (GAAP, IFRS), which leads to additional confusion of terms.
There is a difference between the total cost method (production income statement, by nature) and the cost of sales method (sales income statement, by function). Small companies often use the total cost method. The cost of sales method is more complex and requires Profit Center accounting, which is why it is more likely to be used by larger companies.
The official designations are sometimes very long. For example, the official term for $COS$ (Cost of Sales) in the Austrian Commercial Code (UGB) is "Aufwendungen für Material und sonstige bezogene Herstellungsleistungen", meaning "Expenses for materials and other purchased production services". This explains nicely what this item is all about. But this term is crying out for an abbreviation, because no normal person would write it in a formula for a KPI.
Simplified de facto standards such as the BWA (Betriebswirtschaftliche Auswertung, a simplified monthly income statement without accruals and deferrals), which is common in Germany, are used to coin terms that are not known in other countries.

So here is a short list of the terms as we use them at Power Partners.

Income Statement

Costs by Nature Method

Some of the abbreviations used are not standardized. The breakdown is a mix between financial accounting and controlling. It is simplified, but has proven useful for consultings and to build a common understanding.

Breaking down by nature of costs means that we classify all costs by the nature, such as:

direct expenses
personnel expenses
overhead expenses

The income statement is:

       Term used                       Contains
       at pwrp         
       ~~~~~~~~~~~~~~                  ~~~~~~~~~~~~~

       Revenue                R        Services, Trade
     - Direct Expenses        DX       Purchase of goods, raw mat., sub-contr.
    ------------------------        
       Gross Earnings         E^gross  Gross Margin

     - Personnel Expenses     X^pers   Personnel expenses, social security
     - Overhead Expenses      X^oh     Room rental, vehicles, IT, marketing
     - Depreciation, Amort.   DA       Depreciation, value adjustments
    ------------------------        
       Operating Profit       EBIT    

     - Interest               I        Financial expenses, financial income
    ------------------------     
       Earnings Before Taxes  EBT

     - Taxes                  T
    ========================
     = Earnings               E

Variable	Name EN	Name DE	Alternative Designations EN	Alternative Designations DE
R	Revenue	Umsatzerlöse	Sales	Betrieblicher Ertrag aus Lieferungen und Leistungen
$X^{direct}$	Direct Expenses	Direkte Aufwände	Direct Costs, Cost of materials, merchandise, services and energy.	Einzelkosten
$E^{gross}$	Gross Earnings	Rohertrag	Gross Profit, Top Line, Gross Earnings	Rohergebnis, Bruttoertrag, Bruttogewinn, Bruttoergebnis 1
$X^{personnel}$	Personnel Expenses	Personalaufwand
$X^{overhead}$	Overhead Expenses	Gemeinkosten	Other Operating Expenses	Sonstige betriebliche Aufwendungen
DA	Depreciation and Amortization	Abschreibungen		Abschreibungen und Wertberichtigungen
EBIT	Operating Profit	Betriebsergebnis	Earnings before interest and taxes, Operating profit
I	Interest	Zinsen	Net financial expenses
EBT	Earnings Before Taxes	Ergebnis vor Steuern	Profit before taxes
T	Taxes	Steuern	Taxes, Direct Taxes
E	Earnings	Ergebnis	Earnings, Profit, Net profit, Net income, Bottom-line	Gewinn, Erfolg

DX is different from COS for two reasons
- DX also includes changes in inventory
- DX does not contain direct expenses appearing in the Operating Expenses part, such as e.g. production salaries
PX, OX and DA are Operating Expenses

Costs by Function Method

This is the "better" method, which is also more complicated. It is very common in the English-speaking world, especially in the USA. In continental Europe, it is used typically only by larger companies. In Spain and Italy, it is very uncommon.

With the costs-by-function method, instead of allocating costs by nature (e.g. salaries, rent, fleet), we allocate them by function (cost-of-sales, administration, R&D, etc.).

    Term used at pwrp                Description
    ~~~~~~~~~~~~~~~~~~~~~~           ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~
       Revenue                R
     - Cost of Sales          COS    variable costs, incl. production salaries
    ----------------------          
       Gross Earnings         E^gross    

     - Sales Costs            SX     incl. sales salaries
     - R&D Costs              RDX    incl. R&D salaries
     - General Costs          GX     incl. admin salaries
     - Depr. and Amort.       DA     Depreciation, amortization
    -----------------------
       Operating Profits      EBIT
     - Interest               I      Financial expenses, financial income
    ------------------------     
       Earnings Before Taxes  EBT
     - Taxes                  T
    ========================
     = Earnings               E

Difference between the cost-by-nature and cost-by-function methods

The difference between the cost-by-nature and the cost-by-function method is that in the latter, the all the production and/or service costs are included in the top line: raw materials, labour costs, and all other costs directly associated with production are part of $COS$.

The cost-by-function method is also called production income statement because $COS$ takes into account all costs necessary for production.

To calculate the $COS$, however, an overhead cost allocation must be made: It has to be decided which personnel costs are included in the $COS$, and which salaries are administrative. This is not always clear-cut: for example, is post-calculation part of administration or part of the core activity? There is room for discretion, making it harder to analyse and compare an income statement by nature .

Financial Account vs Controlling

In Germany, there is generally accepted controlling terminology that defines "Vollkostenrechnung" und "Teilkostenrechnung". In English, the closest term is "Cost Accounting".

Teilkostenrechnung only allocates the individual costs, i.e. the direct costs, to a product. It corresponds to the costs-by-nature method.
Vollkostenrechnung allocates all costs to a Cost Unit (aka Kostenträger). Full cost accounting allows the calculation of a contribution margin. It corresponds to the costs-by-function method.

From EBIT onwards, the two methods do not differ.

Financial Accounting	Controlling	Alternative Designations
Cost-by-nature	Teilkostenrechnung	activity-based costing, cost type accounting
Cost-by-function	Vollkostenrechnung	Production cost accounting, Cost unit accounting

Balance Sheet

Again, we take the liberty of simplifying radically.

  Assets                        Liabilities
~~~~~~~~~~~~~~~~~~~~~~         ~~~~~~~~~~~~~~~~~~~~~
  Cash and equiv.    | LIQ     |   Credit Line
+ Acc. Receivables   |  AR  AP | + Accounts Payables
+ Inventories        | INV     |
---------------------|         |----------------------------
= Current Assets     |         | = Current Liabilities
+ Non-current Assets |       D | + Debt
                     |         |---------------------------
                     |         | = Total Liabilities
                     |      EQ | + Total Equity
=====================|         |===================
= Total Assets       |   A  L  | = Total Capital

Whereby applies:

\[ \text{balance sheet total} = \text{total assets} = \text{total capital} \]

Financial KPIs

ROE and ROC

Return on Equity is Earnings divided by equity:

\[ ROE=\frac{E}{EQ} \]

More precisely, it is the yearly earnings, divided by the average shareholders equity of that year:

\[ \%ROE=\frac{\$E \, \text{p.a.}}{\varnothing \$EQ^{shareholders}} \cdot 100 \]

The $ROE$ defines the profitability of a company. This is highly sector-specific, but generally speaking, the higher the $ROE$, the better.

Return on Capital is earnings divided by the balance sheet total, i.e. the total assets $A$:

\[ ROC=\frac{E}{A}=\frac{E}{L} \]

Just as the $ROE$, the $ROC$ combines the income statement with the balance sheet.

If a company mainly manages without borrowed capital (e.g. because it has grown organically, or you have a venture fund as an investor), then $ROC$ is the right measure.

However, if you are financed by borrowed capital (e.g. by a bank or Family & Friends), $ROC$ is the more meaningful measure.

ROE

Name: Return on Equity

KPQ: How profitable is my company?

Variations: ROC

Type: Rate

Scale: $-\infty < ROE < \infty$

Reference value: There are different schools of thought. The return on equity depends on the degree of debt financing, but also on the industry. It also changes over time, depending on the general economic situation. Generally speaking, one can say:

\< 0%: bad, value is being destroyed
> 5%: OK, the company generates significantly more than a bank account
> 10% (or > 20% depending on the industry): good

ROS

Return on Sales measures the operating profit per sales revenue:

\[ ROS = \frac{EBIT}{R} \]

ROS

Name: Return on Sales

KPQ: How profitable is my company?

Other names:

Variations:

${\text{Gross Profit Margin}}=\frac{\text{Gross Earnings}}{\text{Revenue}}=\frac{E^{gross}}{R}$

Type: Margin

Scale: $-\infty\, < ROS < 100\,\%$

Reference Values: The return on sales depends on the industry. For SMEs, the average value is approx. 7.5%. Approximate guide values for various industries are

Manufacturing industry: 5%
Construction: 10%
Knowledge-intensive services: 12%
Other services: 5%

MOC

Months of Cash (Finanzielle Reichweite) divides cash by operating expenses:

\[ \text{MOC}\,=\frac{LIQ}{X^{operating}} \]

Whereby:

$LIQ$: Cash, cash equivalents, and unused credit lines
$X^{operating}$: Operating Expenses per month, typically as an average over the last 6 months

MOC

KPQ: How many months could my business survive in the worst case (i.e. if no new orders come in, if customers don't pay their debts, if I don't get new credit, etc.)?

Variations:

Fixed cost approach: Operating expenses are often adjusted downwards on the grounds that, for example, employees could be laid off at short notice, offices or leasing contracts could be terminated. This increases the range.
Receivables approach: A particularly cautious variant reduces the cash and cash equivalents by the liabilities without including the receivables.

Unit: months

Type: Retention period

Scale: $0 < MOS < \infty$

Reference Values:

< 1 months: red
3 months: orange
6 months: green
> 1 year: orange. Your company is very secure. However, it is important to remember that this security comes at a price. Shouldn't you rather invest this liquidity in growth?

Personnel Expense Ratio

The Personnel Expense Ratio puts the salaries in relation to the sales revenue.

\[ \text{Personnel Expense Ratio}=\frac{X^{personnel}}{R} \]

Personnel Expense Ratio

KPQ: How efficiently do we deploy our employees?

Type: Quote

Frequency: typically annually. If you delimit quarterly or monthly and post work in progress etc., then you can also measure the personnel expense ratio more frequently.

Scale: $0 < \text{Personnel Expense Ratio} < \infty$

Reference Value: Depending on industry. Industries with a personnel cost ratio greater than 50% are considered personnel-intensive. Larger companies typically have a lower personnel cost ratio. Typical values per sector are (although there are also considerable differences within the sectors):

Wholesale: 6%
Retail trade: 11%
Construction: 25%
Production: 30%
Craft: 35%
Consulting: 65%