Value Basics – Financial Valuation Fundamentals

(Editor’s Note: This is part 1 in a series of four articles that will appear each Monday for the next four weeks. Lockhart is a Director at Point Management Group.)

Before launching into methods of defining, measuring and articulating value, a short review of key basics of valuation is required to establish a foundation.

The Balance Sheet

A Balance Sheet is one of the 3 fundamental components used to evaluate the financial aspects of a company or business unit. The balance sheet displays the total assets against how those assets are financed and shows the financial position of the company or business unit at a point in time. This point in time is typically the end of an accounting period but could be used to reflect the financial position at any time. As such, it is critical for accounting and financial modeling purposes.

The balance sheet is divided into two sections. The basic structure is Assets = Liabilities + Equity, although it often becomes more complex. Thinking of it as a proper equation is useful as any transaction will end up changing both sides.

Assets represent money invested and generally include:

  • Cash and securities
  • Inventory
  • Plant, facilities and equipment
  • Goodwill

Liabilities represent that which is owed to external parties. Equity is what was financed by the owners or shareholders directly.

Example balance sheet:

The Income Statement

The second of the core artifacts for financial assessment is the Income Statement. The statement shows a company or business unit’s profit and loss over a period of time. Included in this report are the revenues, costs, gross profit, sales, marketing and other administrative expenses, other expenses and income, taxes paid and net profit.

The basic structure of the Income Statement is Revenue – Expenses = Net Income.

Different from the Balance Sheet, the Income Statement shows income and expenses from all business activities over a period of time. Generally, this period matches the accounting period used on the Balance Sheet but may be generated at any time. This ‘rolling’ time period view is important to understand since some expenses (e.g. cost of goods sold) may not line up with revenue from sales in the same accounting period. The revenue isn’t recognized until it is actually earned. Additionally, some expenses are not just cash outflows but may represent longer-term costs such as depreciation.

Example Income Statement:

 

The Cash Flow Statement

The third core financial artifact of any business is the Cash Flow Statement. This document reports the cash generated and spent during a specific time period (usually a quarter or year). It acts as an important connection between the Balance Sheet and the Income Statement in that is shows how money is moving into and out of the business.

There are three sections comprising a cash flow statement. These sections detail the Operating Activities, the Investing Activities and the Financing Activities. Operating Activities deal with the revenue generating activities of the business (i.e. cash flows from assets and liabilities). Investing Activities detail cash flows from long-term assets and other investments. Financing Activities deal specifically with cash flows resulting from borrowing (loans) or equity (bonds, stocks, dividends).

Example Cash Flow Statement:

 

Other Common Financial Measures

In addition to these three core artifacts, there are other dimensions to financial reporting typically used by businesses when discussing financial health or planning. Many of these are generally used at a company-wide level and include things such as:

  • Gross Profit Margin (or Gross Margin)
    • (Sales – COGS) / Sales
  • Net Profit Margin (or just Profit Margin)
    • Net Income / Sales
  • Financial Leverage
    • (Liabilities + Owners Equity) / Owners Equity –OR–
    • Total Assets / Owners Equity
  • Cost of goods sold
    • Labor costs
    • Hardware / capital costs (depreciables)
    • Other operational expenses (Can include other services and/or software)
    • Cost of time
    • Cost of capital

These are all interesting metrics. For the Architect, however, one set of measures comes in to play more frequently. These are measures of Capital Expenditure (CAPEX) and Operational Expenditure (OpEx).

It is important to understand the difference between CAPEX and OpEx:

Capital expense
In throughput accounting Money spent on inventory Money spent turning inventory into throughput
In technology Costs incurred delivering the solution Costs associated with operating and maintaining the solution
Definition Capital expenditures are expenditures creating future benefits. A capital expenditure is incurred when a business spends money either to buy fixed assets or to add to the value of an existing asset with a useful life that extends beyond the tax year. OpEx refers to expenses incurred in the course of ordinary business, such as sales, general and administrative expenses (and excluding cost of goods sold – or COGS, taxes, depreciation and interest).
Also known as Capital Expenditure, Capital Expense, CAPEX Operating Expense, Operating Expenditure, Revenue Expenditure, OpEX
Accounting treatment Cannot be fully deducted in the period when they were incurred. Tangible assets are depreciated, and intangible assets are amortized over time. Operating expenses are fully deducted in the accounting period during which they were incurred.

 

The Basics and Value

Companies or business units use these basic financial analyses to measure and report their financial health. These artifacts are also often used to illustrate delivery of value: “Revenue for 2019 increased to $200K due to the SuperWidget being delivered for a cost of $96K. Our SuperWidget team delivered $104K worth of value to the company!”

But this doesn’t tell us that the Development team produced $104K in value or the Sales team did. Merely that the initiative that produced the SuperWidget ended up making more money than it cost.

When it comes down to a specific group within a business, or perhaps a specific initiative, many of these ‘macro’ measures don’t make as much sense. And they can become very subjective measures of who added what value to the company.

Architects can’t solve that problem. But Architects can absolutely define the value that they bring to an effort, help to measure that value and then articulate that value.

 

Next Article: “Defining Value”