Why learning buzzwords is the key to understanding financial performance
If you really want to understand financial performance, you must first learn the specialized language that describes it.
Recently, the major American multinational General Electric (GE) made the announcement that it was going to sell its Industrial Solutions (IS) business to another large company, ABB, for $2.6 billion. The IS group makes all sorts of electrical equipment, from parts that are necessary for the operation of power grids to motor solutions, and the companies anticipate that the deal will close in early 2018. This business group garnered a rather small revenue relative to GE’s total sales, adding up to only $2.7 billion out of an almost $111 billion top line. Despite this, the IS group does comprise a larger part of ABB’s turnover last year, which totaled $33.8 billion. Accordingly, the acquisition of GE’s IS business will mark a notable upward trend in its top line. Even so, what does this mean for its bottom line? Is the IS group a profitable business, and therefore a smart acquisition? If it’s doing so well, why would GE decide to sell it off? And if it’s not successful, why would ABB be interested in purchasing it? The official press release on this deal cites IS’s EBITDA and EBITA margins to be about 8% and 6% respectively. Are these margins high or low? Are they good or bad?
At this point, I dare say that readers with a financial background will have a good idea of how to answer these questions. Understandably, those less familiar with finance might not. I’m guessing that one reason is because financial professionals often use different terms for the same concept. They also use a lot of acronyms. In the opening paragraph, I deliberately used other ways besides ‘revenue’ in reference to the monetary value of a company’s sale of its products and services.
EBITDA and EBITA are good examples of the common practice of using acronyms rather than the actual name of a financial term. EBITDA stands for earnings before interest, taxes, depreciation and amortization; and EBITA stands for earnings before interest, taxes and amortization. EBITDA and EBITA are variations of EBIT, or earnings before (subtracting) interest and taxes. In other words, EBIT is operating profit. Simply put, EBITDA and EBITA margins measure the profitability of the operations of a business in a way that is closer to its actual cash flow because the non-cash items – depreciation and amortization – are not subtracted from revenue when computing operating profit.
A simple numerical illustration should suffice. Suppose revenue is 100, and cost and expenses are 95. Operating profit or EBIT would then be five and the EBIT margin would be 5% (5/100). But suppose further that depreciation makes up two and amortization one of the company’s total cost and expenses. By not subtracting these items, we would have an EBITDA margin of 8% and an EBITA margin of 6%. I assume that financial analysts would generally agree that these figures are relatively low for a business that makes things, particularly when compared to the higher margin products that both GE and ABB make. In fact, some analysts are wondering if ABB might be paying too much for this particular asset.
For GE, this deal looks like a good one. It will be shedding a lower-margin part of its business as it seeks to focus on the higher margins in its other businesses (e.g. jet engines and medical equipment), while also building up what promises to be the next big thing in technology: the internet of things (IoT). The fact that ABB agreed to pay $2.6 billion must mean that it believes it will benefit from various synergies. Indeed, that is what ABB’s chief executive said in a presentation to analysts.
I’m sure all Dialogue readers would know what GE stands for. But how many, particularly those in North America, would know what ABB stands for, let alone what it makes? I happen to have done corporate education work for ABB in years past. (Besides electrical products such as circuit breakers and transformers, it is one of the world’s leading manufactures of industrial robots.)
For a consultant, a small but important part of understanding what a client company does is the mastery of its frequently used acronyms. ABB uses quite a few. I once told the managers in one of my seminars that it is sometimes confusing to understand what they do and their key business problems, because they use so many acronyms. One manager in the class responded by asking me, “Don’t you know what ABB stands for?” I quickly replied with great confidence “Asea Brown Boveri…” “No,” he quipped, “it stands for Acronyms Beyond Belief.”
– Phil Young PhD is an MBA professor and corporate education consultant and instructor.
An adapted version of this article appeared on the Dialogue Review website.