Financial analysis made easy (and quick!)

Summary

Jean, a finance expert, shares a quick method to assess a business's financial health. He emphasizes the importance of consistent profit margins and the impact of borrowing on capital utilization. The script covers key financial ratios like return on equity and capital employed, and discusses the significance of gearing, efficiency, solvency, and liquidity in evaluating a company's financial stability and attractiveness for investment.

Takeaways

• 📊 Assessing a business involves looking at the financial statements and understanding the industry context without significant changes in the business model.
• 📈 The gross profit margin and operating profit margin should remain relatively stable year-on-year, indicating consistent pricing and cost management.
• 💰 Profit after tax, or net profit, should also show minimal variance from year to year, reflecting a consistent tax regime and stable business operations.
• 🏦 The balance sheet illustrates the composition of a company's capital, including shareholders' funds, long-term liabilities, and current liabilities.
• 🤔 Profit evaluation should consider the perspective of both shareholders and debt holders, assessing returns on equity and capital employed.
• 📉 Gearing or financial leverage is a measure of debt relative to equity, indicating the extent of borrowed capital in the business.
• 🔄 Working capital management is crucial, as it can lead to a need for borrowing if there is a gap between cash outflows and inflows.
• 🛠 Return on assets measures how effectively a company is using its assets to generate profit.
• 💡 Understanding why a company has borrowed is essential, as it could be due to losses, capital expenditure, or working capital needs.
• 💸 The ability to afford borrowings is determined by the company's cash flow, which should ideally show more cash in than out.
• 🌟 Investment attractiveness is the final consideration, evaluating the company's growth, profitability, efficiency, solvency, and liquidity.

Q & A

What is the proposed shortcut for quickly assessing a business according to Jean?

Jean suggests a quick shortcut that involves looking at the business's financial statements, particularly the income statement, and evaluating the consistency of revenue, cost of goods, and profit margins year on year.

Why is it important to ensure the business has not changed significantly before using the shortcut?

It's important because the shortcut relies on the consistency of the business operations. If the business has changed significantly, such as in what it sells or to whom, the historical financial data may not be a reliable indicator of its current state.

What does the gross profit margin represent and why is its consistency important?

The gross profit margin represents the gross profit expressed as a percentage of revenue. Its consistency is important because it indicates that the business is maintaining a stable relationship between its costs and the prices it charges to customers.

How does the operating profit margin relate to the business's overheads and pricing strategy?

The operating profit margin is similar to the gross profit margin but includes overheads. Its consistency suggests that the business is effectively managing its overheads and is able to pass on cost increases to customers through its pricing strategy.

What does the term 'gearing' or 'financial leverage' refer to in the context of business finance?

Gearing or financial leverage refers to the proportion of a company's debt relative to its equity. It indicates how much the company relies on borrowed money versus the money invested by its owners.

Why is the return on equity (ROE) a key metric for shareholders?

ROE is a key metric for shareholders because it measures the return they are getting on their investment. It shows how efficiently the company is using the shareholders' capital to generate profits.

What is the significance of return on capital employed (ROCE) in evaluating a business?

ROCE is significant as it measures the profit a company generates in relation to all the capital it has at its disposal, including both shareholder equity and borrowed funds. It indicates the overall efficiency of the company in utilizing its capital for profit generation.

Why is understanding the reasons behind a company's borrowing important?

Understanding the reasons for borrowing helps assess whether the debt is justified and strategically beneficial. It could be due to losses, capital expenditure, or working capital needs, and each reason has different implications for the company's financial health.

How can a company's liquidity be assessed through its cash flow?

Liquidity can be assessed by examining the company's cash flow statement, which shows the inflow and outflow of cash over a period. A positive cash flow indicates that the company is generating enough cash to cover its expenses and potentially repay its debts.

What is the purpose of analyzing a company's balance sheet in the context of the provided script?

Analyzing the balance sheet helps to understand the composition of the company's capital, including shareholders' funds, long-term and short-term liabilities, and how these funds are being reinvested in the business, such as in fixed assets or inventories.

What does the term 'working capital gap' refer to and why is it important for a business?

The working capital gap refers to the difference between the time it takes for a company to pay its suppliers and the time it takes to collect payment from its customers. It's important because it can create a temporary cash flow imbalance that may require financing.

Outlines

00:00

📊 Understanding Business Performance Through Financial Statements

Jean introduces a method for quickly assessing a business's financial health, emphasizing the importance of consistency in a company's operations and industry. The focus is on analyzing the income statement, looking at revenue, cost of goods, and service costs to determine gross profit margin, which ideally should not fluctuate significantly year over year. Operating profit margin and net profit margin are also discussed, with the suggestion that these should remain stable unless there have been changes in the business. The balance sheet is briefly mentioned to illustrate the composition of a company's capital, including shareholders' funds and long-term liabilities. The concept of return on equity (ROE) and return on capital employed (ROCE) is introduced as a way to measure the effectiveness of capital utilization by the business.

05:02

🏦 Analyzing Financial Leverage and Business Affordability

This paragraph delves into the concept of gearing or financial leverage, comparing a company's total debt to its equity to understand the extent of borrowing. Jean discusses the reasons businesses typically borrow, such as funding losses, capital expenditures, or working capital gaps. The importance of understanding why a business has borrowed and validating the presence of these borrowings is highlighted. The paragraph also covers how to assess whether a business can afford its borrowings by examining profit margins, cash flow, and liquidity. The focus is on ensuring that the business's cash inflow exceeds outflow and understanding the overall cash position, which is crucial for debt repayment and financial health.

10:03

🔍 Comprehensive Business Evaluation Framework

Jean concludes with a structured approach to writing a financial report on a business, summarizing the key points discussed in the previous paragraphs. The framework includes evaluating growth, profitability, efficiency, solvency, and investment attractiveness. Growth is assessed by examining revenue increase and sustainability. Profitability is measured through various profit margins and the return on capital employed. Efficiency is determined by analyzing the return on assets and working capital management. Solvency is evaluated by understanding the company's gearing and its ability to afford its borrowings, with cash flow being the key indicator. Lastly, investment attractiveness is considered based on all the parameters discussed, providing a holistic view of the business's financial health and potential as an investment.

Keywords

💡Finance Courses

Finance courses refer to educational programs focused on financial management, investment strategies, and related financial topics. In the video, Jean mentions running finance courses worldwide for about 20 years, indicating their expertise and the video's educational intent.

💡Profit and Loss Statement

A profit and loss statement, also known as an income statement, is a financial report that outlines a company's revenues, costs, and expenses during a specific period, ultimately showing the profit or loss. The script discusses this statement as a fundamental tool for assessing a business's financial health.

💡Gross Profit Margin

Gross profit margin is the percentage of revenue that remains after subtracting the cost of goods sold. It indicates how much profit is generated from each dollar of sales. The video emphasizes the importance of this margin's consistency year over year as a sign of a stable business.

💡Operating Profit Margin

Operating profit margin, also known as operating margin, measures the profitability of a company's core operations before considering interest and taxes. It's calculated as operating profit divided by revenue. The script suggests that changes in this margin should be minimal, reflecting operational efficiency.

💡Return on Equity (ROE)

Return on Equity (ROE) is a measure of the return on investment for the shareholders of a company, calculated by dividing net income by shareholder equity. The video describes ROE as a way for shareholders to evaluate the company's performance in utilizing their capital.

💡Return on Capital Employed (ROCE)

Return on Capital Employed (ROCE) is a financial ratio that evaluates the efficiency with which a company uses the capital at its disposal to generate profit. It includes both equity and debt. The script explains that ROCE provides insight into how well a company is using all its capital sources.

💡Gearing or Financial Leverage

Gearing or financial leverage is the ratio of a company's debt to its equity. It indicates the degree to which a company is using borrowed money to finance its operations. The video script discusses the importance of understanding why a company has borrowed and the implications of its debt level.

💡Working Capital

Working capital is a measure of a company's short-term financial health, calculated as current assets minus current liabilities. The script mentions working capital in the context of a gap that may require financing, highlighting its role in managing short-term liquidity.

💡Capital Expenditure (CapEx)

Capital Expenditure (CapEx) refers to the funds a company spends to acquire, upgrade, or maintain physical assets. In the video, Jean mentions CapEx in the context of understanding why a company might need to borrow for capital-intensive investments.

💡Liquidity

Liquidity in a business context refers to the ability of a company to meet its short-term obligations with its current assets. The script discusses liquidity in relation to cash flow, emphasizing the importance of positive cash flow for debt repayment and overall financial stability.

💡Investment Attractiveness

Investment attractiveness assesses whether a company is a worthwhile investment based on various financial metrics and the company's overall performance. The video concludes with this concept, suggesting that all the discussed financial ratios and analyses contribute to determining a company's attractiveness to potential investors.

Highlights

A quick shortcut for assessing a business is proposed, emphasizing understanding the industry and the business's consistency.

The importance of a stable business model that hasn't changed significantly in terms of what it sells and to whom.

Assessing a business involves examining the basic income statement and ensuring there are no drastic changes in costs or revenue.

Gross profit margin should remain relatively stable year on year, indicating cost management and pricing strategy.

Overheads and operating profit margin should increase with inflation, reflecting cost management and price adjustments.

Profit before tax and net profit percentage should be consistent, barring any significant business changes.

The balance sheet provides insight into the funding of a business, including shareholders' funds and liabilities.

Return on Equity (ROE) measures the return shareholders receive on their capital investment.

Return on Capital Employed (ROCE) evaluates the business's performance using both shareholders' and borrowed capital.

Gearing or financial leverage is a measure of the proportion of borrowed money to equity in a company.

Understanding why a business borrows money is crucial, including for losses, capital expenditure, or working capital.

Return on Assets (ROA) assesses how efficiently a company is using its assets to generate profit.

Working capital gap analysis is vital for understanding the cash flow needs of a business.

Solvency and the ability to afford borrowings are determined by the company's cash flow and liquidity.

Investment attractiveness is evaluated based on growth, profitability, efficiency, solvency, and overall cash performance.

A financial report structure is suggested, focusing on growth, profitability, efficiency, solvency, and investment attractiveness.

Margins, utilization of capital, and liquidity are key components in assessing a business's financial health.

The importance of consistent year-on-year financial metrics for a stable and predictable business assessment.

Transcripts

hi uh I'm Jean for V evaluation um I've

been running finance courses all over

the world now uh for the last 20 years

or so and people often ask me Jean is

there a quick 30- second way of actually

assessing a business of course there

isn't so but what I'll propose to you is

a quick shortcut that that you might

find helpful and I think to position

this clip you have to appreciate

when we get to that stage we've gone

through the business we've assessed the

business we know what it's about we

understand the industry and there's also

an important caveat in the sense that

the business has not changed it's

selling roughly the same things to the

same kind of people and that's kind of

important so with that in mind we've

gone through the accounts unearth

nothing sort of horrific or spectacular

so with that in mind let's proceed so

what we have here is a basic income

statement of profit and loss of a

business

what you expect to see is revenue sales

going up to a level that you can

understand as your cost of goods or cost

of manufacturer or cost of services go

up typically if possible and our

appreciate is not always possible but by

and large you put up the cost to your

clients so what that means is the gross

profit percentage or the gross profit

margin which is gross profit Express as

a percentage of Revenue year on year

doesn't change much okay change by very

very small man amounts being

mathematics likewise as all your

overheads go up at least by inflation

and sometimes more you pass it on to

your client through through your prices

so this means that like the gross profit

the operating profit margin likewise

doesn't change from year to year or not

by much and by that we mean operating

profit as a percentage of Revenue as a

percentage of sales

Finance cost or interest implies you've

borrowed some

money and uh we'll come with that in a

bit that gives you profit before tax and

then taxation well obviously all

countries vary in the taxation regime

but because tax is roughly the same

percentage every year and if your

borrowings haven't changed too much for

the same rationale as the above two The

Profit after tax or the net profit

percentage and again Express as a

percentage of Revenue typically would

not change by much every year unless

there had been some changes in the

business so we have a profit well good

bad well good or bad in respect of

what visualizing a balance sheet and of

course the real balance sheets are not

presented in this format this is for

purposes of illustration we have

shareholders funds which is what the

shareholders have put in plus profit

which they've kept back over the years

there could be long-term liabilities

long-term borrowings and there could be

others and there could also or there

more likely to be some current

liabilities uh small shortterm

borrowings trade suppliers things like

that that's basically where what funds a

business and those funds will be

reinvested in fixed assets property

computer equipment Airline for example

aircraft for an airline company and they

would also have inventories and similar

things if uh for for most businesses so

when we look at the profit we ask the

question well profit good or bad for

whom and I guess one of our starting

points has to be the owners the

shareholders so in the first instance

the shareholders are going to say this

is our Capital this is what belongs to

us and it's made up typically of two

tranches the share Capital which they

physically invested and profits which

the company possibly would have kept

back over the years so some sometimes

this is called net asset value sometimes

this is called total Equity so I divide

the profit of the tax BS to give me

what's called the return on Equity so

the owners take a view as to what return

they've had on their

business but then they further say hang

on a second here not only as a

shareholder you have my money you've

also borrowed money and that is just

another form of capital so let me judge

your performance on the total capital

that you have which is a combination of

the shareholders capital and monies that

you may have borrowed the there are

wider issues here but we're keeping it

simple for the time being and we call

this return on Capital employed which is

the profit on all the capital at the

disposal of the business and that gives

you a inkling as to how well the company

is actually using its

capital so you've borrowed money how

much well how much Vis A what and one

expression of debt is what we call

gearing or financial leverage we compare

the total debt against the equity of the

company meaning how much have you the

owners put in and how much have you

borrowed we call this

gearing now there's no magic figure here

I think what matters is do we understand

why that business is borrowing can we

validate the presence of borrowings in

that business and unless you've had a

major acquisition a restructure

something extraordinary typically

businesses borrow for three main reasons

one is there a loss if there's a loss it

implies very simply expenses bigger than

Revenue someone has to fund that or

capital expenditure capital expenditure

meaning we need to replace fixed assets

and therefore we ask the questions what

have you bought why have you bought but

also how well you are using those assets

and one measurement there are a few

others we call return on assets which

which means just that which is profit

divided by total asset how well are you

utilizing the assets of the

business another question we would also

ask which would possibly necessitate

borrowings is what we call working

capital let's say we're dealing with a

buy and sell business it's probably

easier to visualize uh abama Stocker in

my inventories today and my stock and my

inventories sit on my shelves for about

30 days uh I make a sale and I give my

debtors my trade payables 30 days to pay

me I'm out of cash for 60 days from the

time I made the purchase to the time I

physically get cash from my client my

suppliers will come in they might give

me 30-day credit or 40-day credit but

for most businesses it creates an

imbalance I amount of cash for about 60

but I'm getting Finance for about say 20

25 or 30 I have what's called a working

capital Gap and this would require

funding as well so we've established the

presence of borrowings I understand why

you borrowed and I guess the next

question we have to ask ourselves is can

this business afford those borrowings

now there are two there are a number of

ways of looking at

this going back to the profit and loss

income statement I have to pay the bank

interest or Finance cost how many times

is that covered by The Profit at least

is my interest safe on that level of

performance for the year that's one way

of looking at it a better way would be

to look at the cash flow of the business

essentially we are saying let me look at

all the cash in during a year and all

the cash out during the year what is it

driving cash what is absorbing cash and

hopefully in is bigger than out and if

not why and why are you funding yourself

because it is cash flow that repays debt

absolutely nothing else and we call this

liquidity and the cash flow of the

business not only will support that the

debt is capable of being supported but

also gives you a strong understanding of

the overall cash position of a

business so so in summary if you were to

write a financial report on a business

you might find the following struction

template very very helpful and we've

seen those themes already in this very

very short clip growth is the company

growing increase in Revenue how has the

company increased is that growth

sustainable can they keep growing like

that profitability is the company

profitable and we measure those in the

first instance of our margins we looked

at gross profit margin we looked at

operating profit margin we looked at net

profit margin and we concurred year on

year they shouldn't change by much so

that's one aspect the margins of

profitability the second aspect is that

profit is good for whom and viav what

well one first question is for the

shareholders to ask how well are you

making a capital work we call this

return on equity which is profit divided

by shareholders funds the shareholders

asking a very valid question are you

making a decent enough return on our

investment but then a second question is

posed in that he he here not only you

have our Capital you've also borrowed

money chances of

so I will judge your profit performance

on all the capital at your disposal and

we call this return on Capital employed

which is combination of what we've put

in I Equity plus debt what you may have

borrowed and we call this return again

on on on Capital employed so

profitability has two strengths margins

and utilization of capital of

shareholders and all providers of

capital which will be dead people so

compan has borrowed money why could it

have borrowed money well one area we

call efficiency I chances are it's

invested in fixed assets it's invested

in assets how well are you utilizing the

assets at your disposal and one

measurement is return on assets the

second line of inquiry is appropo

working capital which we've seen already

is there a working capital Gap and if

there is is it satisfactory and does it

need to be financed and those those

those two lines of inquiry talk to us

about

efficiency so there has been borrowing

well this is what we refer to as

solvency how much have you borrowed no

magic figure we call this gearing or

sometimes financial leverage uh why have

we borrowed explained by a loss and or

working capital and or acquisition of

fixed assets or assets capital

expenditure and we have and we seek to

understand the presence of these

borrowings next key question can the

company afford these borrowings only

cash flow will tell us that and this is

where liquidity comes in where we look

at the entire cash performance over a

year and we look put very simply at cash

in and cash out and hopefully cash in

should be bigger than cash out if not

why not and how is the company actually

funding it its business on a

year-by-year

basis and finally you may be looking at

that business as an investor and the

last key point I guess is investment

attractiveness IE is that company worth

investing in given all the parameters

that you've just seen a voila doesn't

take long does it