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When did you "get" finance?
 

Californicated88's picture
PE
 
Points)
 on 8/13/12 at 5:30pm
18854207.jpg

When did you first “get” finance? I know this is kind of a silly question, but it struck me as a good discussion topic the other day as I was plowing through an lbo model. We learn an absurd amount in school, and the majority of it ends up floating away because it has little or no relevance to our careers. But for the things that do stick, when did you find that you were actually able to apply that knowledge, draw conclusions from it, and add value?

Follow my reasoning here – take, for example, intro level finance and accounting. You learn about debits and credits, FIFO & LIFO, the time value of money, and how to (almost) always trust the wisdom of NPV analysis when choosing among projects. All interesting things, but when you’re in school and these concepts have little or no bearing on your life beyond that which you need to know for the exams, they remain just that: concepts in abstraction. Even in all those interviews you prepped for, where you could walk anyone through a DCF, track a $10 change in depreciation through the three financial statements, and explain how leverage amplifies returns, did you really get what all that means? For me, the “a-ha!” moment involved capital expenditures.

Sure everyone knows that they’re listed on the cash flow statement under investing activities, you have “capitalized” this and “capitalized” that, and you learn to dutifully subtract the CapEx as a key step to arriving at free cash flow. While performing diligence on a company back in my banking role, I noticed that the company had an extremely high amount of “capitalized” software development costs – we’re talking a CF/CapEx ratio of like .05x. This struck me as odd, but not completely off-putting as the company’s EBITDA was high, and the industry loves EV/EBITDA multiples. Regardless, I dug a little deeper, teasing out maintenance versus expansion CapEx, and trying to get a better handle on the company’s internal financial controls. I learned that the company was arbitrarily capitalizing its software development costs and amortizing them over management’s “estimation of the useful life of the software.” In other words, the company was breakeven at best, and management’s aggressive accounting painted a questionable picture of the company’s financial health. I presented my findings later that week, and my analysis was the basis for our subsequent conversations with management. I added value!

Arriving at even this tiny conclusion on my own without any guidance from an Associate, VP, etc. made me feel like a champ. Call me a nerd, but it felt great to have used some intellectual horsepower that day. WSO, when did the “a-ha!” moment happen for you?

See my WSO Blog
Tags:

Comments

SwerveBack's picture

Great Insight! Thanks

ST
(Orangutan, 306
 
Points)
 on 8/13/12 at 5:55pm

Great Insight! Thanks

couchy's picture

ur saying the CapEx should've

(King Kong, 1,364
 
Points)
 on 8/13/12 at 6:58pm

ur saying the CapEx should've been som sort of OpEx? pretty cool insight - one of my Aha! moments was truly understanding differences between net income vs. operating cash flow vs. EBITDA / EBIT vs. FCF vs. ex-cash earnings etc. and which one you should focus on for valuation.

SirTradesaLot's picture

Still waiting after over ten

O
 
Points)
 on 8/13/12 at 7:16pm

Still waiting after over ten years.

Turbo leverage for capital explosion -- BD Capital

My WSO Blog

Ron Paul's picture

I'm curious exactly how you

 
Points)
 on 8/13/12 at 8:10pm

I'm curious exactly how you went about this:

Californicated88:

I dug a little deeper, teasing out maintenance versus expansion CapEx, and trying to get a better handle on the company’s internal financial controls.

Also, were you pretty adept in reading 10Ks at that point in your career?

ladubs111's picture

Californicated88: When did

IA
 
Points)
 on 8/13/12 at 8:24pm
Californicated88:

When did you first “get” finance? I know this is kind of a silly question, but it struck me as a good discussion topic the other day as I was plowing through an LBO model. We learn an absurd amount in school, and the majority of it ends up floating away because it has little or no relevance to our careers. But for the things that do stick, when did you find that you were actually able to apply that knowledge, draw conclusions from it, and add value?

Follow my reasoning here – take, for example, intro level finance and accounting. You learn about debits and credits, FIFO & LIFO, the time value of money, and how to (almost) always trust the wisdom of NPV analysis when choosing among projects. All interesting things, but when you’re in school and these concepts have little or no bearing on your life beyond that which you need to know for the exams, they remain just that: concepts in abstraction. Even in all those interviews you prepped for, where you could walk anyone through a DCF, track a $10 change in depreciation through the three financial statements, and explain how leverage amplifies returns, did you really get what all that means? For me, the “a-ha!” moment involved capital expenditures.

Sure everyone knows that they’re listed on the cash flow statement under investing activities, you have “capitalized” this and “capitalized” that, and you learn to dutifully subtract the CapEx as a key step to arriving at free cash flow. While performing diligence on a company back in my banking role, I noticed that the company had an extremely high amount of “capitalized” software development costs – we’re talking a CF/CapEx ratio of like .05x. This struck me as odd, but not completely off-putting as the company’s EBITDA was high, and the industry loves EV/EBITDA multiples. Regardless, I dug a little deeper, teasing out maintenance versus expansion CapEx, and trying to get a better handle on the company’s internal financial controls. I learned that the company was arbitrarily capitalizing its software development costs and amortizing them over management’s “estimation of the useful life of the software.” In other words, the company was breakeven at best, and management’s aggressive accounting painted a questionable picture of the company’s financial health. I presented my findings later that week, and my analysis was the basis for our subsequent conversations with management. I added value!

Arriving at even this tiny conclusion on my own without any guidance from an Associate, VP, etc. made me feel like a champ. Call me a nerd, but it felt great to have used some intellectual horsepower that day. WSO, when did the “a-ha!” moment happen for you?

What sector was that?

Californicated88's picture

Sector: Software @Ron Paul -

PE
 
Points)
 on 8/13/12 at 8:30pm

Sector: Software

@Ron Paul - The company was private and we had access to their audited financials. And it definitely took me a while to figure it out. Like I was trying to say in the OP, I conceptually understood CapEx through my classwork, etc., but it didn't really click until this particular scenario.

Ie: upon receiving the financials, the line of reasoning went something like: ok, this company has nice EBITDA margins...wow its CapEx is high in and of itself, wait - if I subtract it from EBIAT, this company is barely generating cash...and so on and so forth. I had to do a bunch of follow up research on capitalizing software dev costs vs expensing them, the rationale behind doing either, comparing this company to public companies and see if they expense/capitalize their dev costs, etc. My only exposure to this sort of thing before related to capitalized or operating leases.

All this research eventually led to the question of "ok, why would the company want to do this? Oh because it can smooth out earnings (given that you're amortizing the software dev costs over 5+ years), and also in this particular case, the company was shifting from an on-premise to a SaaS delivery model. I can see WHY they would want to do that, but the fact remains that they're barely generating cash." And at this point, I circled back with the deal team. Interesting stuff.

See my WSO Blog

R0bin's picture

When I read Rich Dad Poor Dad

(Orangutan, 291
 
Points)
 on 8/13/12 at 8:31pm

When I read Rich Dad Poor Dad

Baby you're the perfect shape, baby you're the perfect weight. Treat me like my birthday, I want it this way and I want it that way. It makes a man feel good baby.

ladubs111's picture

Californicated88: Sector:

IA
 
Points)
 on 8/13/12 at 8:45pm
Californicated88:

Sector: Software

@Ron Paul - The company was private and we had access to their audited financials. And it definitely took me a while to figure it out. Like I was trying to say in the OP, I conceptually understood CapEx through my classwork, etc., but it didn't really click until this particular scenario.

Ie: upon receiving the financials, the line of reasoning went something like: ok, this company has nice EBITDA margins...wow its CapEx is high in and of itself, wait - if I subtract it from EBIAT, this company is barely generating cash...and so on and so forth. I had to do a bunch of follow up research on capitalizing software dev costs vs expensing them, the rationale behind doing either, comparing this company to public companies and see if they expense/capitalize their dev costs, etc. My only exposure to this sort of thing before related to capitalized or operating leases.

All this research eventually led to the question of "ok, why would the company want to do this? Oh because it can smooth out earnings (given that you're amortizing the software dev costs over 5+ years), and also in this particular case, the company was shifting from an on-premise to a SaaS delivery model. I can see WHY they would want to do that, but the fact remains that they're barely generating cash." And at this point, I circled back with the deal team. Interesting stuff.

Don't all software companies have cap ex around that >.05x cap ex/CFO ratio?

Californicated88's picture

ladubs111: Californicated88

PE
 
Points)
 on 8/13/12 at 8:54pm
ladubs111:
Californicated88:

Sector: Software

@Ron Paul - The company was private and we had access to their audited financials. And it definitely took me a while to figure it out. Like I was trying to say in the OP, I conceptually understood CapEx through my classwork, etc., but it didn't really click until this particular scenario.

Ie: upon receiving the financials, the line of reasoning went something like: ok, this company has nice EBITDA margins...wow its CapEx is high in and of itself, wait - if I subtract it from EBIAT, this company is barely generating cash...and so on and so forth. I had to do a bunch of follow up research on capitalizing software dev costs vs expensing them, the rationale behind doing either, comparing this company to public companies and see if they expense/capitalize their dev costs, etc. My only exposure to this sort of thing before related to capitalized or operating leases.

All this research eventually led to the question of "ok, why would the company want to do this? Oh because it can smooth out earnings (given that you're amortizing the software dev costs over 5+ years), and also in this particular case, the company was shifting from an on-premise to a SaaS delivery model. I can see WHY they would want to do that, but the fact remains that they're barely generating cash." And at this point, I circled back with the deal team. Interesting stuff.

Don't all software companies have cap ex around that >.05x cap ex/CFO ratio?

Yup - you're correct. Although I was saying the opposite - CFO/CapEx was super low, not CapEx/CFO.

See my WSO Blog

ladubs111's picture

Californicated88: ladubs111

IA
 
Points)
 on 8/13/12 at 8:59pm
Californicated88:
ladubs111:
Californicated88:

Sector: Software

@Ron Paul - The company was private and we had access to their audited financials. And it definitely took me a while to figure it out. Like I was trying to say in the OP, I conceptually understood CapEx through my classwork, etc., but it didn't really click until this particular scenario.

Ie: upon receiving the financials, the line of reasoning went something like: ok, this company has nice EBITDA margins...wow its CapEx is high in and of itself, wait - if I subtract it from EBIAT, this company is barely generating cash...and so on and so forth. I had to do a bunch of follow up research on capitalizing software dev costs vs expensing them, the rationale behind doing either, comparing this company to public companies and see if they expense/capitalize their dev costs, etc. My only exposure to this sort of thing before related to capitalized or operating leases.

All this research eventually led to the question of "ok, why would the company want to do this? Oh because it can smooth out earnings (given that you're amortizing the software dev costs over 5+ years), and also in this particular case, the company was shifting from an on-premise to a SaaS delivery model. I can see WHY they would want to do that, but the fact remains that they're barely generating cash." And at this point, I circled back with the deal team. Interesting stuff.

Don't all software companies have cap ex around that >.05x cap ex/CFO ratio?

Yup - you're correct. Although I was saying the opposite - CFO/CapEx was super low, not CapEx/CFO.

If CFO/Cap Ex was .05x your implying Cap ex was 20x larger than CFO right.

Californicated88's picture

ladubs111: Californicated88

PE
 
Points)
 on 8/13/12 at 9:03pm
ladubs111:
Californicated88:
ladubs111:
Californicated88:

Sector: Software

@Ron Paul - The company was private and we had access to their audited financials. And it definitely took me a while to figure it out. Like I was trying to say in the OP, I conceptually understood CapEx through my classwork, etc., but it didn't really click until this particular scenario.

Ie: upon receiving the financials, the line of reasoning went something like: ok, this company has nice EBITDA margins...wow its CapEx is high in and of itself, wait - if I subtract it from EBIAT, this company is barely generating cash...and so on and so forth. I had to do a bunch of follow up research on capitalizing software dev costs vs expensing them, the rationale behind doing either, comparing this company to public companies and see if they expense/capitalize their dev costs, etc. My only exposure to this sort of thing before related to capitalized or operating leases.

All this research eventually led to the question of "ok, why would the company want to do this? Oh because it can smooth out earnings (given that you're amortizing the software dev costs over 5+ years), and also in this particular case, the company was shifting from an on-premise to a SaaS delivery model. I can see WHY they would want to do that, but the fact remains that they're barely generating cash." And at this point, I circled back with the deal team. Interesting stuff.

Don't all software companies have cap ex around that >.05x cap ex/CFO ratio?

Yup - you're correct. Although I was saying the opposite - CFO/CapEx was super low, not CapEx/CFO.

If CFO/Cap Ex was .05x your implying Cap ex was 20x larger than CFO right.

Yes. Hence the major red flag.

See my WSO Blog

ladubs111's picture

Californicated88: ladubs111

IA
 
Points)
 on 8/13/12 at 9:36pm
Californicated88:
ladubs111:
Californicated88:
ladubs111:
Californicated88:

Sector: Software

@Ron Paul - The company was private and we had access to their audited financials. And it definitely took me a while to figure it out. Like I was trying to say in the OP, I conceptually understood CapEx through my classwork, etc., but it didn't really click until this particular scenario.

Ie: upon receiving the financials, the line of reasoning went something like: ok, this company has nice EBITDA margins...wow its CapEx is high in and of itself, wait - if I subtract it from EBIAT, this company is barely generating cash...and so on and so forth. I had to do a bunch of follow up research on capitalizing software dev costs vs expensing them, the rationale behind doing either, comparing this company to public companies and see if they expense/capitalize their dev costs, etc. My only exposure to this sort of thing before related to capitalized or operating leases.

All this research eventually led to the question of "ok, why would the company want to do this? Oh because it can smooth out earnings (given that you're amortizing the software dev costs over 5+ years), and also in this particular case, the company was shifting from an on-premise to a SaaS delivery model. I can see WHY they would want to do that, but the fact remains that they're barely generating cash." And at this point, I circled back with the deal team. Interesting stuff.

Don't all software companies have cap ex around that >.05x cap ex/CFO ratio?

Yup - you're correct. Although I was saying the opposite - CFO/CapEx was super low, not CapEx/CFO.

If CFO/Cap Ex was .05x your implying Cap ex was 20x larger than CFO right.

Yes. Hence the major red flag.

Ya I was thinking I missread cuz of the shear size. But then again smaller private companies with cash flow in the millions i guess it wouldn't be that unheard of spending WAY more than you earn since the SAAS and cloud space got tons of private investors throwing money into it so they can either go IPO or get acquired by IBM, salesforce, oracle, etc. for like 100x revenues and call it STRATEGIC acquistion...

shark-monkey's picture

My Ah Ha moment was when I

HF
 
Points)
 on 8/13/12 at 10:05pm

My Ah Ha moment was when I read through your article and found that capitalizing development costs complied with GAAP when the software is used for its own use, and can also be capitalized when the software's feasibility has been reasonably established...

Fear is the greatest motivator. Motivation is what it takes to find profit.

NOPLAT's picture

when i discovered zerohedge

CF
(Monkey, 54
 
Points)
 on 8/13/12 at 10:16pm

when i discovered zerohedge

Soros's picture

No one ever said it wasn't

O
(Baboon, 100
 
Points)
 on 8/13/12 at 11:00pm

No one ever said it wasn't GAAP. However getting a deeper view of a companies financials in the footnotes can give you a better understanding of how things are really going with a company. If they make changes that are very favorable, even if it is GAAP compliant, it may be worth looking into.

BTbanker's picture

After I watched Boiler Room,

IB
 
Points)
 on 8/13/12 at 11:24pm

"A man generally has two reasons for doing anything. One that sounds good, and the real one." - J.P. Morgan

IRRelevent's picture

The day I no longer needed a

PE
(Monkey, 51
 
Points)
 on 8/14/12 at 1:42pm
Vyraal's picture

This pretty much.

O
 
Points)
 on 8/14/12 at 2:27pm
Unforseen's picture

Teaching my boss what R

(King Kong, 1,099
 
Points)
 on 8/14/12 at 2:38pm

Check out my Blog

HarvardOrBust's picture

What was the point of this?

PE
 
Points)
 on 8/14/12 at 3:09pm
Californicated88's picture

@HarvardOrBust - It turned

PE
 
Points)
 on 8/14/12 at 4:16pm

See my WSO Blog

JimmyDnFFX's picture

Excellent thread.

O
(Baboon, 134
 
Points)
 on 8/24/12 at 8:47am

80% of life is just showing up

-Woody Allen-

hungaroe's picture

When during my first year,

CF
(Baboon, 126
 
Points)
 on 8/24/12 at 10:17am
That_Aston's picture

Is it actually possible to

CF
(Gorilla, 573
 
Points)
 on 8/24/12 at 2:22pm

Here to learn and hopefully pass on some knowledge as well. SB if I helped.

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