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5)      Financial analysis

 

Caveat: this section makes extensive use of the concepts developed in section 4).

 

Financial analysis is the art of analyzing past financial statements in order to understand how the business is going, with the ultimate purpose of understanding its value drivers, and more specifically:

 

-          how wealth is generated, through the analysis of the income statements and the principal financial ratios.

 

-          what are the investments that have been necessary in order to generate this wealth, as reflected by Capital expenditures (Capex), Depreciations & Amortizations (D&A) and the Change in Working Capital. It will be an occasion to discover whether the company’s  industrial equipments are modern or obsolete, whether its investing policy is aggressive or minimalist, whether the company can manage its growth properly and keep its Working Capital in check.

 

-          how these investments are being financed, and what is the current financial position of the company (from both a static standpoint with the current level of debt, but also from a dynamic perspective with the notions of liquidity and solvability).

 

-          Eventually, and most importantly for the entrepreneur and other financial investors, what is the level of profitability of the business in terms of Return On Capital Employed and Return on Equity, and whether those ratios are congruent with (respectively) the Weighted Average Cost of Capital and the Required Rate of Return on Equity.

 

a)      Wealth creation

 

The wealth creation cycle of your company is probably what you will want to look at first. It can be analyzed by looking at certain ratios (most of them have been codified and are commonly used by the financial community). We will first start by giving the principal financial ratios underpinning the analysis of the wealth creation cycle of a business. We will then move on to explain how these ratios shall be interpreted in order to extract as much information about the company’s operations as possible.

 

The following table gives the principal financial ratios associated with the operating cycle of a business:

 

 

 

i.                    Commercial Profit

 

Commercial profit measures the profit realized by the trade of goods, i.e. by purchasing goods and reselling them at a profit. It is assumed that the company hasn’t manufactured the products but is simply acting as retailer. Profit related to products manufactured by the company will be accounted for below.

 

In the breakdown of commercial profit, one must be careful to adjust for the variation in inventories of purchased goods: indeed, when this inventory decreases, this means that previously purchased goods were used in order to generate the sales: therefore, the commercial profit realized during the period must be adjusted downward. Reciprocally, when this inventory increases, this means that some of the goods purchased during this fiscal year have been stocked because they could not be sold. One must adjust for this fact by adding back the cost of these goods to the commercial profit.

 

Please note that goods in inventories are usually valued at their acquisition price (according to the FIFO method: First In First Out, an accounting concept which has been developed in section 4), so that purchasing goods and transferring them to inventories has no immediate impact on the commercial margin (which guarantees that this ratio cannot be artificially inflated too easily).

 

In order to analyze commercial profit, it may be interesting to check:

 

-          How this ratio evolved during the past 5 years (percentage increase or percentage decrease).

 

-          How it compares to the sales of finished products (those manufactured by the company) and services in terms of relative importance (in other words, is our company making the bulk of its sales on trade or by manufacturing and selling its own products and services ? How has this proportion changed during the years ?