Operational finance

Analysis And Diagnosis

1.1 Introduction

By “operational finance” we mean the financing required by current operations y “structural funance” we mean how to finance the fixed assets and also what combination of debt and equity we should have.

Operational finance and structural finance make up what is known as corporate finance.

Genreally speaking, financial analysis refers to the analysis of the P&L and balance shett. Strictly speaking, financial analysis refers to the balance sheet or where the company invests its money (assets) and from where the company gets that money (financing)

1.2 Analysis of the business

Only if we understand the business we will be able to analyse the financial statements which will, after all, be a reflection of the company’s policies and performance.

To understand the business we should review all the functional áreas: sales, production, personnel, management and strategy.

Sales and customers:

• What does the pany sell? How much does it sell?

• Are sales seasonal or uniform throughout the year

• Customers: many or few? Small or big?

Management and personnel:

• Who is in charge? Number of employees?

Strategy

• Competitive advantages of the company or why does the customer buy from you?

Summary: The review of the business could be summarized in these three simple questions: What does the company sell? To whom? And why do the customers buy from them?

1.3 Profit and Loss statement analysis

Our first recommendation is to simplify the P&L you want to analyse and reduce it to the most significant ítems.

Cost of goods sold(COGS): variable cost in sales, typically raw material and labour necessary for production. Always a percentage of sales.

Gross margin (sales minus COGS): A percentage of sales. This percentage may decrease if the competition is strong.

Operating expenses (opex): Typically salaries and overheads. In theory: a fixed cost not related to sales

Earnings before interests, taxes, depreciation and amortization (EBITDA)

Cash flow produced by the business prior to expenses related to fixed assets, debt and taxes.

Depreciation. Typically a percentage of fixed assets. It is a fixed charge not related to sales. Depreciation is an expense but we do not have to pay it. Depreciation is a way to distribute the investment in fixed assets over several years.

Earnings before interest and taxes (EBIT)

Earnings before taxes (EBT)

Net income or net profit or profit after taxes.

Analysis of the P&L in six steps

Look at the concepts, number and its evolution and only then give your opinión.

1. Sales

o Size of sales

o Sales growth: growing sales will probably mean growing financial needs

o Find out if sales are seasonal or uniform throughout the year. Find out if sales are cyclical or stable

2. Gross margin: calculated as gross margin / sales in percentage. If margin in percedntage decreases, it can only be for two reasons: either decline of prices or increase of COGS. The increase of COGS in percentage terms can only be due to more expensive components or more expensive labour.

3. Operating expenses as percentage of sales. If a company doesn’t make money it is usually due to or because of small margin% or big opex %.

The EBITDA margin% (EBITDA/sales) used commonly in multinationals is the consequence of margin% and opex%. That is why I prefer to look at the margin% and then opex% rather than at the EBITDA%.

4. Other big numbers in the P&L

5. Profitability. Does the company make money?

a) Look at the size of the profit and its evolution. Compare it with the size of the debt.

You may also calculate the cash flow from operations (CFO)

CFO = net income + depreciation.

Compare the CFO with the size of debt and with the investments in net assets expected for the future. This will give you an idea of whether the company will produce enough money to cover the repayment of debt and the new investment and, therefore, if there will be money left for the shareholders.

b) Return on sales (ROS)

...