Lucernex expert Jim Duport describes the important of the P&L statement and compares use of real estate Cash flow analysis vs P&L analysis.
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.
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.
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.
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.
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
Real Estate Cash Flow Analysis
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.