The Three Bottom Lines


 

By: Bill Kay

The question I am most asked on the subject of financial analysis is “What should you look at on financial statements to determine the true health of a company?” My answer is to look at the trend over the last 3 to 5 years on the Three Bottom Lines to quickly analyze the financial statements of any company to see its true financial health. What are the Three Bottom Lines?

  1. Net Profits

  2. Cash Flow From Operations

  3. Return On Assets (ROA)

Net Profits (The bottom line from the Income Statement)

The Income Statement gives us one important perspective on the health of a business—it’s profitability over a specified calendar period. Think of an Income Statement as a movie of all of the sales or revenue that the company generated during a period such as a month, a quarter, or a year. Remember that sales/revenue starts at zero at the beginning of the company’s fiscal year. The top line of the Income Statement is created as products are sold or services are delivered to customers. At the end of a period, the movie stops and all of the sales and revenues are compared or matched to all of the costs and expenses to determine if money was made or lost.

In accrual accounting, the Income Statement does not look at the cash coming in or going out of a business, it only looks at what was actually sold against what it cost. We might not have received the cash from the customer yet; we might not have paid all of the expenses yet. So, the bottom line (net profits or net earnings or net income) is not cash. Remember this when you look at a company’s bottom line.

Sales & Revenue – Costs & Expenses = Net Profits

It’s always important to look at the trend of the top line (sales/revenues) and the bottom line (net profits) over a period of years.  Also look at the Return On Sales (ROS), which is calculated by dividing the bottom line (net profits) by the top line (sales/revenues). This measures the company’s efficiency in generating profits for a given amount of sales. Is ROS or Net Profit Margin going up or down over the years?  We can also use ROS to compare companies against competitors in their industry.  What percentage are they making on the bottom line for each dollar sold on the top line against their competitors?

Remember that profits are not the same as cash. The analogy that I like to use is that profits are very important, but a company can go for a while without generating profits. Profits are like food. All of us can go for a while without eating, but sooner or later, we have to eat to live. It’s the same with any business. More important than profits is cash. Remember the old saying that “Cash is King.” Cash is like oxygen. How long can we live without oxygen? Not very long. How long can a business operate without cash?  Not very long. When a business runs out of cash, checks bounce, the lights go out, and the company either finds more cash or goes into bankruptcy.

Cash Flow from Operations

The Cash Flow Statement has become one of the most important financial statements since the Financial Accounting Standards Board (FASB) required all public companies to include one in their annual reports back in 1987. The indirect Cash Flow Statement starts with net profits (the bottom line from the Income Statement) and then reconciles net profit to operating cash flow according to Generally Accepted Accounting Principles (GAAP).

The indirect way to create a Cash Flow Statement is to look at three areas of cash flow:

  1. Cash Flow from Operations (actual cash generated from operations of the business)

  2. Cash Flow from Investing (cash spent or generated on buying or selling property, plant, or equipment)

  3. Cash Flow from Financing (cash generated or spent on financing the business through debt or equity)

Cash Flow from Operations is the key indicator of successful financial management of a business. We always want this number to be higher than the Net Profits of the company. When it is higher, it shows that the company’s managers have generated cash by running the business efficiently.

The Cash Flow from Operations looks at how much net cash is flowing into the business, independent of what the company receives from lenders and investors and independent of what the business spent on property, plant, and equipment and other investments. It shows the actual cash generated from operations of the business. This number is a real number based on actual cash coming in and going out of the business.

Return On Assets (ROA)

Usually when we use the term “return” we are looking at the bottom line or net profits of a company against something else, in this instance, against assets. Where do we find the total assets of a company? The total assets are found on the Balance Sheet. Total assets are everything that the company owns. So how much money was made on all of those assets? How much profit did the company generate with all of the assets owned?

ROA is calculated by taking net profits (bottom line) from the Income Statement and dividing it by the average assets the business owns from the Balance Sheet. Or, for all of the assets of the business, how much money did these assets generate in profits? Are the managers using everything the business owns (assets) to generate a good profit compared to other companies in their industry? This is an excellent ratio to use to compare a company against its competitors in its industry.

Net Profits / Average Assets = Return On Assets

Do not forget to look at the trend in all Three Bottom Lines the next time you want to analyze the health of a company. Benchmarking these three key indicators against the best companies in an industry is a wonderful, quick way to determine the true health of a company. 

More in-depth information can be found in the following resources.
Finkler, Steven A., Finance & Accounting for Nonfinancial Managers, 1996 Prentice-Hall, Inc.
Gill, James O. and Moira Chatton, Understanding Financial Statements, 1999 Crisp Publications, Inc.

By: Bill Kay

© 2015 Alliance Training and Consulting, Inc.

 


 

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