Long ago there was a man who lived in a cave. He
never ventured outside, but sometimes he went near the cave entrance
and when the sun was shinning just right, he saw his shadow. And
he thought - that's what I look like.
One day he got up his courage and ventured outside
the cave. Lo & behold, he came to a lake and saw his reflection
in the still water. Imagine his surprise when he discovered what
he really looked like.
Are you like a man who judges his appearance by
his shadow, not realizing it shows nothing of his true image?
The story by Plato is an example of how reality can be distorted
when you lack complete information, such as when doing a financial
analysis comparing leases solely on the basis of Cash Flow. There
is another measurement - the P&L impact.
Importance of P&L?
First and foremost, in a corporation the cost charged to a manager's
budget is the PreTax P&L, not the Cash Flow. Since performance
evaluations and bonuses are based on budgets, it is important
to know how the impact of an action (e.g. leasing space) impacts
the budget.
Profit & Loss (P&L) is what companies use when reporting
financial results. A company's P&L is perhaps more important than
its Cash Flow. It shows whether or not a business has achieved
its primary objective - earning a profit.
You have probably heard people say, "Profitability
is key." Profitability is different from Cash Flow. Profitability
is the number reported to Wall Street and quoted in newspapers
in earnings per share (EPS).
Cash Flow represents the cash coming in (sales/revenues
collected) less money actually spent (salaries, rent, costs of
doing business, paying off money borrowed, etc.).
A company can be profitable, but have a negative
cash flow. Alternatively, a company may be losing money on paper,
yet have a positive cash flow.
Although it is rare, large real estate transactions
can impact a company's profitability, and what they have reported
to Wall Street analysts, and ultimately, the stock price.
A company's key financial metric can vary over time
and in any particular fiscal year. The key metric can range from
the Net Present Value of the AfterTax Cash Flow, to how much Capital
is required in that year, to what is the PreTax P&L impact in
the current fiscal year.
Corporate managers are measured (and bonused) based
on their P&L performance. Typically this measurement does not
include taxes, since corporations actually keep another set of
books for paying taxes, thus the real measurement is the Pretax
P&L. It is important for a corporate real estate manager or an
operating business unit manager to be sure the costs for an action
being proposed or taken is within their budget, and their budget
is a Pretax P&L, not a Cash Flow.
P&L vs. Cash Flow
In accounting for rent on a P&L basis, companies have three
choices - Cash Flow, Effective Rent, and GAAP Rent. Cash Flow
rent uses whatever the actual cash paid for rent to generate the
rent costs on the P&L.
Effective rent takes the Base Rent and any rent
abatement input (free rent), determines the average rent and uses
that to generate the base rent costs on the P&L. Rent increases
are added to the effective rent to generate the rent shown on
the P&L.
GAAP rent takes the Base Rent, rent abatement and
any increases (or decreases) and then determines the average rent
and uses that number to generate the rent on the P&L. The
increases must be a known amount or a known percentage. For example,
if rent goes up 3% annually, GAAP rent could be used; however,
if rent goes up by the CPI (which is an unknown amount and can
vary), GAAP rent should not be used.
Since taxes are based on the P&L, one needs
to account for the rent properly in order to calculate the taxes
correctly, which is necessary to compare the true Net Present
Value of the AfterTax Cash Flow.
Two additional key differences between P&L and Cash
Flow are Capital/Depreciation and Timing. Companies (and the IRS)
categorize costs as Expense and Capital.
Capital is typically a one-time cost and if it
has a useful life of more than one year it may be capitalized.
Note that different companies have different rules about what
is capitalized vs. being "expensed," assuming a useful life of
more than one year (furniture for example). Typically the break
point is determined by the cost. The IRS rule is an asset is capitalized
if the life of the asset is greater than one year and the cost
is greater than $100. However, companies have agreements with
the IRS that increase the $100 rule; in some cases as high as
$25,000.
When a cost is Capitalized, the total cost is NOT
shown in the first year in a P&L analysis. Instead, the cost is
depreciated and spread out over some period of time. Note that
there are a number of ways to depreciate the costs such a straight-line,
double declining balance, etc. The tax department in a company
determines the approach, and the approach may be different between
the Tax Return and what is reported to Wall Street as the P&L.
For simplicity and ease of understanding, using straight-line
depreciation (that is dividing the cost by the number of months
of its useful life) is typically best for corporate real estate
financial analysis.
Timing is everything. The P&L does not show Capital
as a lump sum, but instead shows the cost as depreciation over
some period of time. Assume you are spending $1 million to construct
the interior improvements for a 10 year lease, thus the depreciation
would be $100,000 per year ($1 million divided by 10 years).
In a Cash Flow analysis, the $1 million shows as
a cost in the first year, but in a P&L analysis, only the depreciation,
the $100,000, shows as a cost in the first year. So, in comparing
the Cash Flow to the P&L analysis, the Cash Flow is $900,000 higher
than the P&L ($1 million less $100,000).
Relationship Between P&L and Cash
Flow
There are three fundamental parts to a companies financial reports
- the P&L, a Cash Flow statement, and the Balance Sheet, and they
are all related.
Assume you sell a widget for $1,000 and your cost
of selling the widget is $600. In a typical P&L report, the $1,000
is recorded as a sale and $600 is a cost, leaving a profit of
$400. This profit is shown as soon as the product is shipped,
not when the bills are paid and the sales revenue collected.
In a simple transaction, the $1,000 is shown on
the Balance Sheet and Cash Flow Statement as an Account Receivable
and the $600 cost is shown as an Account Payable.
When the customer pays and the $600 cost is paid,
the Cash Flow statement is updated to show the the additional
$400 and the Balance Sheet is updated to show the $400 as cash
and as retained earnings.
The key is timing - on the P&L, the profit is shown
as soon as the product is shipped. However, on the Cash Flow and
Balance Sheet the net cash is not shown until all bills are paid
and the customer has paid for the product.
Special Considerations
Taxes are based on the P&L, not on Cash Flow. Consequently, you
need to calculate the P&L before you can calculate the taxes.
And, to calculate the P&L, you need to categorize costs as Expense
or Capital, and then show the depreciation of the Capital costs
in the P&L calculation. The P&L does not show Capital as a lump
sum, but instead shows the cost as depreciation over some period
of time.
When calculating P&L, it is vitally important to
measure the P&L based on a company's fiscal year for reporting
financial results.
The fiscal year can be a calendar year, January
through December, or it can start at any month in a year. For
instance, most Japanese-owned companies have a fiscal year that
starts in April and ends in March, while the federal government
has a fiscal year that starts in October and ends in September.
Showing a P&L analysis in Lease Years (Year 1, Year
2, etc.) can be extremely misleading. For instance, if a lease
starts in October and a company has a calendar year fiscal year,
then only three months of the P&L costs will impact the first
fiscal year, not twelve months if an analysis uses Lease Years.
For instance, in the earlier example of a $1 million
capital expenditure depreciated over 10 years, on a P&L basis
only three months of depreciation would show in the first year,
a $30,000 cost vs. a $100,000 cost in a Lease Year analysis.
Financial Metrics
The key financial metric in corporate real estate financial analysis
depends on who is measuring and priorities. Usually when companies
say that "Cash is King!" the key metric is capital.
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Profitability is key. If profitability is the most important
metric, then measuring and comparing the Pretax P&L impact
is most important. Sometimes the key is the first year P&L
impact, other times managers want to compare the P&L by
year.
It is important to note that other than retail, corporate
real estate is a cost to a company and there is no profit
unless space is purchased and later sold assuming appreciation
of the asset. When space is leased, the cost goes right
to the company's bottom line. The theory is that the occupants
of the building (staff, manufacturing, etc.) will generate
a profit that will offset the cost of the real estate. Consequently,
most P&L and Cash Flow analyses for corporate real estate
do not include any profit and just show the occupancy cost
of the space.
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In general, CFOs make comparisons based on the Net
Present Value of the AfterTax Cash Flow. However, depending on
priorities, they may also compare the P&L impact and the capital
required. Business unit managers who are charged back the cost
of their space look for the Pretax P&L impact in both the current
fiscal year and over the term of the lease.
The Bottom Line
Companies have at least two bottom lines - the bottom line for
P&L (the number reported for profitability) and Cash Flow (the
actual cost that represents money actually spent).
When doing a financial analysis, one needs to look
at both numbers. Depending on a company's priorities at that time,
the P&L can be more important than Cash Flow.
For individual managers, whether corporate real
estate managers or the business unit manager, the Pretax P&L represents
the cost that is charged to their operating budget. The Pretax
P&L is the budget cost with which they are measured by management,
and frequently a key measurement in their bonus plan.
So, help yourself and your customers by being sure
to calculate the P&L impact as well as the Cash Flow when comparing
properties and doing your financial analyses.
