Corporate Financial Mastering: Simple Methods and Strategies to Financial Analysis Mastering

Introduction

Why do people go to doctors for checkups? It's probably for one or both reasons:

To stay as healthy as possible as they age; or

To get well from a certain sickness or medical condition.

Why do people consult with fitness professionals, e.g., trainers and coaches? It's probably for one or both reasons, too:

To stay as fit as possible as they age; or

To become fitter or to become fit again after going through something that has rendered them unfit for extended periods of time.

Now, why do people need to stay as fit and healthy as possible? It's simple; for optimal quality of life and longevity. Obviously, a sick and weak body will most likely result in lifelong suffering, which will also most likely be short. Being optimally healthy and fit maximizes the likelihood of people living a long and high quality of life.

Businesses are like people, too. They need to be optimally fit and healthy if they are to give their stakeholders optimal profitability and longevity. But instead of using blood chemistry tests, x-rays, treadmill tests, weights, and repetitions to determine a business' financial health and fitness, finance professionals use a different set of numbers, i.e., financials.

To determine a person's health and fitness, professional consultants conduct medical and fitness exams on them. To determine a business's financial health and fitness, finance professionals conduct financial analysis.

Within the pages of this book, you'll learn how to conduct financial analysis on your business or the companies whose stocks you're interested in investing in. In particular, you'll learn:

What are the foundations on which a business' financial health and fitness are built on;

What are the raw materials, i.e., financial data, you'll need to analyze a business' financial health and fitness and more importantly, where to get them;

How to make sense of the financial data you have to evaluate each of the key pillars of a business' financial health and fitness; and

How to bring your evaluations of each key pillar together to come up with a general conclusion of a business's financial health and performance.

By the time you're done reading this book, you'll be ready to hit the ground running and start evaluating your business or other people's businesses accurately. So, turn the page now if you're ready to learn corporate financial analysis.

Chapter 1

The Four Pillars

of Financial Analysis

If you remember from the introduction, the two main aspects of financial analysis are financial health and fitness. To be more consistent with the financial services industry, these two main aspects are a financial condition (health) and performance (fitness). The three main pillars upon which these two are based on are:

Liquidity;

Profitability;

Capital Adequacy; and

Asset Quality.

Liquidity

Liquidity refers to a company's ability to meet its financial obligations as they fall due. Such financial obligations include:

Loans with banks or financing companies;

Credit purchases from suppliers;

Salaries of employees; and

Utility bills.

The reason why liquidity is at the top of our financial analysis food chain is simple; without cash, businesses will grind to a halt. Never mind if a business is very profitable and has adequate capital. If it doesn't have enough cash, its suppliers, creditors, and employees will stop supplying them with needed resources to continue operating.

Now, you may be wondering is it possible to be profitable and have enough capital and yet, be illiquid, i.e., not have enough money to meet financial obligations? Yes, it is.

To understand how this is so, you'll need to know the two main ways financial transactions are recorded under accounting rules; cash basis and accrual basis.

Under the cash basis, income is recorded only when cash is received. Also, expenses are recorded only when cash is disbursed.

Under the accrual basis, income is recorded as soon a business has sold products or rendered services, not when it receives cash payments for them. Expenses are recorded when they're incurred, i.e., the business has already received products or services, not when they've paid for them already.

Most, if not all, businesses, especially corporations, use the accrual basis for recording financial transactions. Businesses that sell products or provide services mostly on credit have higher liquidity risks compared to those that sell mostly in cash. Why?

Let's compare two businesses, Company A and Company B. Both companies have:

Annual sales of $100,000;

Total annual expenses of $50,000;

Annual debt payments (not expenses) of $30,000;

Annual net income of $50,000; and

Cash balance of $10,000.

However, 50% of Company A's sales, i.e., $50,000, were on credit and payable in one year. This means Company A only receives $50,000 in cash annually, which is less than its total annual financial obligations (operating expenses + debt payments). Even using its cash reserves of $10,000, it will only have $60,000, which is still less than its annual financial obligation of $80,000.

This means Company A isn't able to meet all of its annual financial obligations amounting to $80,000, and as such, it's illiquid. Yes, it's very profitable with a $50,000 annual net income, but because 50% of its sales are on credit, little cash is coming in compared to the cash it has to payout.

Compare it to Company B, whose credit sales only comprise 20% of total annual. Thus, its annual cash sales are $80,000, which is already equal to its annual financial obligations of $ 80,000. Its annual cash sales alone already make it a liquid company, even without taking into consideration the $10,000 in cash reserves.

Now, let's look at the flip side. Let's say both Companies A and B have:

Annual sales of $100,000;

Total annual expenses (all paid in cash) of $105,000;

Annual debt payments (not expenses) of $10,000;

Annual net loss of $10,000: and

Cash balance of $50,000.

This time, Company A's credit sales account for 70% of annual sales or $70,000. This gives it annual cash receipts totaling $70,000. But its annual financial obligations of $115,000 (expenses + debt payments) is still greater than its annual cash receipts. However, adding its cash balance of $50,000 makes it able to pay all of its $115,000 financial obligations for the year, with $5,000 extra:

Total Annual Expenses (all paid in cash) = $110,000

Annual Debt Obligations = $5,000

Total Annual Financial Obligations = $115,000

Annual Cash Receipts = $70,000

Cash Balance = $50,000

Total Cash Available for Obligations = $120,000

Now, this is a simple illustration, but it's easy enough to understand to drive home the importance of liquidity.

Profitability

The primary goal of putting up a business is to make money, i.e., earn profits. Even non-profit organizations need to figure out how to make profits through donations and pledges because if they spend more than what they earn, they'll eventually become illiquid and cease operations.

Liquidity is more concerned about current financial health, while profitability is more concerned about sustaining financial health. Given the example of how a losing business can still be liquid despite losing money, such liquidity can't be sustained without continuous profits.

Relying on continuous capital infusions to sustain liquidity and financial health is a stupid idea. If the primary goal of putting up a business is to make money, why would investors continue putting in money in a business that continuously loses it? Might as well donate the money to the charity where it'll make a difference.

Sustained profitability is key to financial longevity. Thus, this should be the primary metric by which you measure a company's financial fitness or performance.

Operational Efficiency

How a company operates or uses its resources is key to its success and failures. The more a company's ability to use its resources efficiently, the lower its costs become, the higher its revenues climb, and the greater its net income becomes. The less efficient it becomes at doing so, the higher its expenses can be, and the lower its revenues may become.

When it comes to operating efficiency, there are two main areas that you'll need to focus on as an analyst: inventory movement and collection of receivables. Why?

Inventory movement refers to how fast a company is able to move inventory out of its custody into the possession of customers. In short, it's about how fast a company sells its inventories.

Why is that important? The longer inventories stay in a company's possession, the less cash is available for the company to use for its operations. In a sense, it can affect a company's liquidity.

Slow-moving inventories also mean fewer sales, which leads to reduced sales revenues. Hence, it can also impact profitability.

The other important aspect of operating efficiency is the collection of receivables, i.e., how fast a company's ability to collect payments on its credit sales to customers. You see, credit sales can help boost revenues, but if not managed wisely, it can result in overdue accounts that can impact liquidity, too. And a lot of credit sales turn sour; it's going to impact profitability as well.

Operating efficiency is the long-term key to long-term liquidity and profitability. That's why people should never underestimate it.

Solvency

The company funds its assets in two ways: owners' money (capital) and debt (liabilities). While a company can be funded entirely with capital from owners, it can't be funded entirely with debt. No financial institution will be crazy enough to lend to businesses