Financial analysis made easy (and quick!)
Summary
TLDRJean, 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
📊 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.
🏦 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.
🔍 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.
Mindmap
Keywords
💡Finance Courses
💡Profit and Loss Statement
💡Gross Profit Margin
💡Operating Profit Margin
💡Return on Equity (ROE)
💡Return on Capital Employed (ROCE)
💡Gearing or Financial Leverage
💡Working Capital
💡Capital Expenditure (CapEx)
💡Liquidity
💡Investment Attractiveness
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
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