Financial Analysis – Why it’s needed & what it is
Financial planning & analysis (FP&A) are key to the success of any business. Initial improper financial planning & analysis can result in the adoption of a business model that is doomed to failure. Examples include insufficient gross margin to cover all expenses and required profitability, inconsistent capacity to meet volume requirements (such as insufficient customer parking, insufficient customer seating, production bottlenecks, etc), insufficient inventory, too lose credit extension that result in excessive receivables and potentially devastating bad debt write-offs, among others. Good initial planning requires good numbers that have been tested for cost overruns, calculations of peak-period volumes & capacity, calculations of inventory breath & depth compared against the competition, and evaluation of the trading cycle, to just deal with the situations mentioned above.
A typical business owner or entrepreneur does NOT have the skill set necessary to perform the above analysis unless they happen to have a strong financial background. Therefore, it is incumbent on the entrepreneur to seek out that skill set to cover these risks which are too large to ignore. A wise entrepreneur will not simply seek out such advice at start-up, but will want those same services when it comes to quarterly or annual business reviews and when significant changes are being contemplated (new ventures, expansions, closures, restructuring, refinancing, etc). The entrepreneur may also need such services during the first several iterations of the budgeting process. If the proper consultant is chosen, the entrepreneur and their executive team will learn the financial analysis process over time, gradually weaning themselves from the consultant’s most frequent services to them. However, review and transactional assistance will still be required.
A financial analysis should analyze sales for composition and correlation with economic & industry trends. It should analyze Costs of Goods Sold (COGS) and Operating Expenses for fixed (be wary) and variable expenses. It should analyze the Gross Margin for pricing discipline.
Strong Operating Margins in relation to financing and other costs are needed as well as relative to the investment required to generate them (ie, there must be sufficient ROI). The tax rate is reflective of aggressiveness & integrity. The Net Margin reveals how much risk the company is taking and informs any sensitivity analysis.
Risk analysis should start by ranking assets in decreasing size – asset concentrations reveal the asset risks being undertaken (i.e., large receivable balances and a small net margin means credit control had better be excellent). The analysis should look at receivable & inventory days. The same should be done to the credit side, giving attention to the structuring of the larger components. Funding type should match asset type or you have an asset/liability management problem (a term that should be cropping up again after 20 years of non-use). Equity should be sufficient for both the asset and funding risks undertaken.
Typically, changes in the balance sheet dominate cash flow — does management have control over its asset investments and does the level of investment support efficient operations? Scrutiny should be given to related party transactions (rents & leases and receivables & payables) – these can reflect an off-balance sheet strength or pilfering of the company.
How much capital infusion is required to fund sales growth [net capital required = (A/R increase + Inv inc) – (A/P inc + NPAT inc + Non Cash Charges inc)]? The profitability from that increase divided by the net capital required yields an ROI on that project. That rate should exceed the company’s Cost of Capital (COC) by a sufficient margin of error.
Financial analysis is a learned discipline that allows one to systematically analyze any company or transaction in order to appreciate its strengths and weaknesses. This provides information for risk assessment and improvement. A wise man considers the costs before undertaking any project.
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