Financial Analysis

Steps 1, 2: Analysis of Fundamentals

The corporate financial system is driven by the goals, business unit choices and strategies, market

conditions and the operating characteristics. The firm’s strategy and sales growth in each of its

business units will determine the investment in assets needed to support these strategies; and the

effectiveness of the strategies, combined with the response of competitors and regulators, will

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strongly influence the firm’s competitive and profit performance, its need for external finance, and its

access to the debt and equity markets. Clearly, many of these questions require information beyond

that contained in a company’s published financial reports.

Step 3: Investments to Support the Business Unit(s) Strategy(ies)

The business unit strategies inevitably require investments in accounts receivable, inventories,

plant & equipment, and possibly, acquisitions. Step 3 of the process is an attempt to estimate the

amount that will be tied up in each of the asset types by virtue of sales growth and the

improvement/deterioration in asset management. An analyst can make a rough estimate by studying

the past pattern of the collection period, the days of inventory, and plant & equipment as a percent of

cost of goods sold; and then applying a “reasonable value” for each to the sales forecast or the

forecast of cost of goods sold. Extrapolation of past performance assumes, of course, that the future

underlying market, competitive and regulatory “drivers” will be unchanged from the conditions that

influenced the historical performance.

Step 4: Future Profitability and Competitive Performance

Strong sustained profitability is an important determinant of (1) a firm’s access to debt and/or

equity finance on acceptable terms; (2) its ability to self-finance growth through the retention of

earnings; (3) its capacity to place major bets on risky new technologies, markets, and/or products;

and (4) the valuation of the company.

A reasonable starting point is to analyze the past pattern of profitability.

1. What have been the average level, trend and volatility of profitability?

2. Is the level of profitability sustainable, given the outlook for the market and for competitive

and regulatory pressures?

3. Is the current level of profitability at the expense of future growth and/or profitability?

4. Has management initiated major profit improvement programs? Are they unique to the firm

or are they industry-wide and may be reflected in lower prices rather than higher

profitability?

5. Are there any “hidden” problems, such as suspiciously high levels or buildups of accounts

receivable or inventory relative to sales, or a series of unusual transactions and/or accounting

changes?

Step 5: Future External Financing Needs

Whether a company has a future external financing need depends on (1) its future sales growth;

(2) the length of its cash cycle; and (3) the future level of profitability and profit retention. Rapid sales

growth by a company with a long cash cycle (a long collection period + high inventories + high plant

& equipment relative to sales) and low profitability/low profit retention is a recipe for an everincreasing

appetite for external finance, raised in the form of loans, debt issues, and/or sales of

shares. Why? Because the rapid sales growth results in rapid growth of an already large level of

total assets. The increase in total assets is offset partially by an increase in accounts payable and

accrued expenses, and by a small increase in owners’ equity. However, the financing gap is

substantial. For example, the company portrayed in Table A requires $126 million of additional

external finance by the end of year 2010 to finance the increase in total assets required to support 25%

per year sales growth in a business that is fairly asset intensive.

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Table A Assuming a 25% Increase in Sales ($ in millions)

Assets 2009 2010

Cash $ 12 ↑ 25% $ 15

Accounts receivable 240 ↑ 25% 300

Inventories 200 ↑ 25% 250

Plant & equipment 400 ↑ 25% 500

Total $852 $1,065

Liabilities and Equity

Accounts payable $100 ↑ 25% $ 125

Accrued expenses 80 ↑ 25% 100

Long-term debt 272 Unchanged 272

Owners’ equity 400 footnote a 442

Total $852 $ 939

External financing need 0 126

Total $852 $1,065

a It is assumed (1) that the firm earns $60 million (a 15% return on beginning of year equity) and pays out $18 million as a cash

dividend; and (2) that there is no required debt repayment in 2010.

If, however, the company reduced its sales growth to 5% (and total assets, accounts payable and

accrued expenses increased accordingly by 5%), the need for additional external finance would drop

from $126 million to $0.

High sales growth does not always result in a need for additional external finance. For example, a

food retailer that extends no credit to customers, has only eight days of inventory, and does not own

its warehouses and stores, can experience rapid sales growth and not have a need for additional

external finance provided it is reasonably profitable. Because it has so few assets, the increase in total

assets is largely offset by a corresponding, spontaneous increase in accounts payable and accrued

expenses.

Step 6: Access to Target Sources of External Finance

Having estimated the future financing need, management must identify the target sources (e.g.,

banks, insurance companies, public debt markets, public equity market) and establish financial

policies that will ensure access on acceptable terms.

1. How sound is the firm’s financial structure, given its level of profitability and cash flow, its

level of business risk, and its future need for finance?

2. How will the firm service its debt? To what extent is it counting on refinancing with a debt or

equity issue?

3. Does the firm have assured access on acceptable terms to the equity markets? How many

shares could be sold and at what price in “good times”? In a period of adversity?

4. What criteria are used by each of the firm’s target sources of finance to determine whether

finance will be provided and, if so, on what terms?

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The evaluation of a firm’s financial structure can vary substantially depending on the perspective

of the lender/investor. A bank may consider a seasonal credit a very safe bet. Considerable

shrinkage can occur in the conversion of inventory into sales and collections without preventing

repayment of the loan. In contrast, an investor in the firm’s 20-year bonds is counting on its

sustained health and profitability over a 20-year period.

Step 7: Viability of the 3-5 Year Plan

1. Is the operating plan on which the financial forecasts are based achievable?

2. Will the strategic, competitive, and financial goals be achieved?

3. Will the resources required by the plan be available?

4. How will the firm’s competitive, organizational, and financial health at the end of the 3-5

years compare with its condition at the outset?

Step 8: Stress Test under Scenarios of Adversity

Financing plans typically work well if the assumptions on which they are based turn out to be

accurate. However, this is an insufficient test in situations marked by volatile and unpredictable

conditions. The test of the soundness of a 3-5 year plan is whether the continuity of the flow of funds

to all strategically important programs can be maintained under various scenarios of adversity for the

firm and/or the capital markets—or at least be maintained as well as your competitors are able to

maintain the funding of their programs.

Step 9: Current Financing Plan

How should the firm meet its financing needs in the current year? How should it balance the

benefits of future financing flexibility (by selling equity now) versus the temptation to delay the sale

of equity by financing with debt now, in hopes of realizing a higher price in the future?

The next section of this note is designed to provide familiarity with the financial measures that can

be useful in understanding the past performance of a company. Extrapolation of the past

performance, if done thoughtfully, can provide valuable insights as to the future health and balance

of the corporate financial system. Historical analysis can also identify possible opportunities for

improved asset management or margin improvement, as well as provide an important, albeit

incomplete, basis for evaluating the attractiveness of a business and/or the effectiveness of a

management team.

Financial Ratios and Financial Analysis

The three primary sources of financial data for a business entity are the income statement, the

balance sheet, and the statement of cash flows. The income statement summarizes revenues and

expenses over a period of time. The balance sheet is the list of what a company owns (its assets),

what it owes (its liabilities), and what has been invested by the owners (owners’ equity) at a specific

point in time. The statement of cash flow categorizes all cash transactions during a specific period of

time in terms of cash flows generated or used for operating activities, investing activities, and

financing activities.

The focus of this section is on performance measures based on the income statements and balance

sheets of SciTronics—a medical device company. The measures can be grouped by type: (1)