Additions to wealth and deductions to wealth

What would your spontaneous answer be to the following questions?

• Does purchasing an apartment make you richer or poorer?
• Would your answer change if you were to buy the apartment on credit?

There can be no doubt as to the correct answer. Provided that you pay the going rate for the apartment, your wealth is not affected whether or not you buy it on credit. Our experience as university lecturers has shown us that students often confuse cash and wealth. Cash and wealth are two of the fundamental concepts of corporate finance. It is vital to be able to juggle them around and thus to be able to differentiate between them confidently.

Consequently, we advise readers to train their minds by analysing the impact of all transactions in terms of cash flows and wealth impacts. For instance, when you buy an apartment, you become neither richer, nor poorer, but your cash decreases. Arranging a loan makes you no richer or poorer than you were before (you owe the money), but your cash has increased. In this respect, the proverb ‘‘He who pays his debts gets richer’’ is nonsense from a financial viewpoint. If a fire destroys your house and it was not insured, you are worse off, but your cash position has not changed, since you have not spent any money.

Raising debt is tantamount to increasing your financial resources and commitments at the same time. As a result, it has no impact on your net worth. Buying an apartment for cash results in a change in your assets (reduction in cash, increase in property assets) without any change in net worth. The possible examples are endless. Spending money does not necessarily make you poorer. Likewise, receiving money does not necessarily make you richer.

The job of listing all the cash flows that positively or negatively affect a company’s wealth is performed by the income statement, which shows all the additions to wealth (revenues) and all the deductions to wealth (charges or expenses or costs). The fundamental aim of all businesses is to increase wealth. Additions to wealth cannot be achieved without some deductions to wealth.

Earnings represent the difference between revenues and charges, leading to a change in net worth during a given period. Earnings are positive when wealth is created or negative when wealth is destroyed.

Since the rationale behind the income statement is not the same as for a cash flow statement, some cash flows do not appear on the income statement (those that neither generate nor destroy wealth). Likewise, some revenues and charges are not shown on the cash flow statement (because they have no impact on the company’s cash position).

The distinction between operating charges and fixed assets

Although we were easily able to define investment from a cash flow perspective, we recognise that our approach went against the grain of the traditional presentation, especially as far as those familiar with accounting are concerned: . whatever is consumed as part of the operating cycle to create something new belongs to the operating cycle. Without wishing to philosophise, we note that the act of creation always entails some form of destruction;

. whatever is used without being destroyed directly and thus retaining its value belongs to the investment cycle. This represents an immutable asset or, in accounting terms, a fixed asset.

For instance, to make bread, a baker uses flour, salt and water, all of which form part of the end product. The process also entails labour, which has a value only in so far as it transforms the raw material into the end product. At the same time, the baker also needs a bread oven, which is absolutely essential for the production process, but is not destroyed by it. Though this oven may experience wear and tear it will be used many times over.

This is the major distinction that can be drawn between operating charges and fixed assets. It may look deceptively straightforward, but in practice is no clearer than the distinction between investment and operating outlays. For instance, does an advertising campaign represent a charge linked solely to one period with no impact on any other? Or does it represent the creation of an asset (e.g., a brand)?

Earnings and the financing cycle

Debt capital

Repayments of borrowings do not constitute costs, but as their name suggests, merely repayments. Just as common sense tells us that securing a loan does not increase wealth, neither does repaying a borrowing represent a charge. The income statement shows only charges related to borrowings. It never shows the repayments of borrowings, which are deducted from the debt recorded on the balance sheet. We emphasise this point because our experience tells us that many mistakes are made in this area.

Conversely, we should note that the interest payments made on borrowings lead to a decrease in the wealth of the company and thus represent an expense for the company. As a result, they are shown on the income statement.

The difference between financial income and financial expense is called net financial expense/(income). The difference between operating profit and financial expense net of financial income is called profit before tax and nonrecurring items.

Shareholders’ equity

From a cash flow standpoint, shareholders’ equity is formed through issuance of shares less outflows in the form of dividends or share buybacks. These cash inflows give rise to ownership rights over the company. Dividends are a way of apportioning earnings voted on at the general meeting of the shareholders once the company’s accounts have been approved. For technical, tax and legal reasons, most of the time they are not shown on the income statement, except in the United Kingdom.

‘‘Retained earnings’’ is the term frequently used to designate the portion of earnings not distributed as a dividend. This said, if we take a step back, we see that dividends and financial interest are based on the same principle of distributing the wealth created by the company.5 Likewise, income tax represents earnings paid to the State in spite of the fact that it does not contribute any funds to the company.

Recurrent and nonrecurrent items: extraordinary and exceptional items, discontinuing operations

We have now considered all the operations of a business that may be allocated to the operating, investing and financing cycles of a company. This said, it is not hard to imagine the difficulties involved in classifying the financial consequences of certain extraordinary events, such as losses incurred as a result of earthquakes, other natural disasters or the expropriation of assets by a government. They are not expected to recur frequently or regularly and are beyond the control of a company’s management. Hence the idea of creating a separate catch-all category for precisely such extraordinary items.

Among the many different types of exceptional events, we will briefly focus on asset disposals. Investing forms an integral part of the industrial and commercial activities of businesses. But it would be foolhardy to believe that investment is a one-way process. The best-laid plans may fail, while others may lead down a strategic impasse.

Put another way, disinvesting is also a key part of an entrepreneur’s activities. It generates exceptional ‘‘asset disposal’’ inflows on the cash flow statement and capital gains and losses on the income statement, which usually appear under exceptional items. Lastly, when a company disposes of some segments of its activity or entire sections of a business, the corresponding gains or losses are recorded under discontinuing operations. One of the main puzzles for the financial analyst is to identify whether an extraordinary or exceptional item can be described as recurrent or nonrecurrent. If it is recurrent, it will occur again and again in the future. If it is not recurrent, it is simply a one-off item.

Without any doubt extraordinary items and results for discontinuing operations are nonrecurrent items. Exceptional items are much more tricky to analyse. For large groups, closure of plants, provisions for restructuring, etc. tend to happen every year in different divisions or countries. In some sectors, exceptional items are an intrinsic part of the business. A car rental company renews its fleet of cars every 9 months and regularly registers capital gains. Exceptional items should then be analysed as recurrent items and as such be included in the operating profit. For smaller companies, exceptional items tend to be one-off items and as such should be seen as nonrecurrent items.

The International Accounting Standards Board (IASB) has decided to include extraordinary and exceptional items within operating charges without identifying them as such. We think it is unwise and hope that, one day or another, accountants will switch to the more relevant recurrent vs. nonrecurrent items classification.

By definition, it is easier to analyse and forecast profit before tax and nonrecurrent items than net income or net profit, which is calculated after the impact of nonrecurrent items and tax.

A distinction needs to be made between cash and wealth. Spending money does not necessarily make you poorer and neither does receiving money necessarily make you any richer. Additions to wealth or deductions to wealth by a company is measured on the income statement. It is the difference between revenues and charges that increases a company’s net worth during a given period.

From an accounting standpoint, operating charges reflect what is used up immediately in the operating cycle and somehow forms part of the end product. On the contrary, fixed assets are not destroyed directly during the production process and retain some of their value. EBITDA shows the profit generated by the operating cycle (operating revenues
operating charges).

As part of the operating cycle, a business naturally builds up inventories, which are assets. These represent deferred charges, the impact of which needs to be eliminated in the calculation of EBITDA. In the by-nature format, this adjustment is made to operating revenues (by adding back changes in finished goods inventories) and to operating charges (by subtracting changes in inventories of raw materials and goods for resale from purchases). The by-function income statement merely shows sales and the cost of goods sold requiring no adjustment.

Capital expenditures never appear directly on the income statement, but they lead to an increase in the amount of fixed assets held. This said, an accounting assessment of impairment in the value of these investments leads to noncash expenses, which are shown on the income statement (depreciation, amortisation and impairment losses on fixed assets). EBIT shows the profit generated by the operating and investment cycles. In concrete terms, it represents the profit generated by the industrial and commercial activities of a business. It is allocated to:

• financial expense: only charges related to borrowings appear on the income statement, since capital repayments do not represent a destruction of wealth;
• corporate income tax;
• net income that is distributed to shareholders as dividends or transferred to the reserves (as retained earnings).