Corporate Financial Analysis

Abstract

This chapter is devoted to financial analysis through financial ratios and cash flows. The first part of the chapter reports the reorganization of the balance sheet and the income statement, which represents key preparatory steps to perform a proper financial ratio and cash flow analysis. In the second part of the chapter, we propose a novel methodology for monitoring the monetary cycle and an organized assessment of financial ratio analysis. Finally, in the last part of the chapter, we focus on how to calculate cash flow and how to interpret them for different purposes: valuation and debt sustainability analysis.

Appendix—A Comprehensive Financial Analysis Method

In this chapter appendix, we present a case study application. The analyzed companies are from the food sector (processing, preservation, and production of meat products) and have a turnover of about € 20 million and an invested capital of € 19.1 million. In Table 1.8, we show the balance sheet and the income state reorganized for the years T, T + 1, and T + 2.

Table 1.8 APP—Balance sheet outline, reorganized through the by-function method

The reorganized asset balance consists of three aggregates:

• Surplus assets: investments that are not related to the company’s core business (in this case equal to zero);

• Fixed capital: investments in tangible, intangible, and financial fixed assets employed to carry out the production cycle;

• Inventory (including advances to suppliers) and Receivables (including all receivables from customers, tax-related receivables, and accrued income and prepayments).

As for the liabilities side of the balance sheet, the first aggregate is represented by the company’s equity capital, which results from the set of resources that shareholders have contributed to the company or have accumulated over the years through the capitalization of profits. The next two aggregates include M/LT and ST net financial debt (short-term financial debt net of cash and cash equivalents). The fourth aggregate consists of payables, which includes all payables to suppliers, employees, and taxes that the firm has yet to pay.

Here below is the outline of the income statement, reorganized through the value-added approach (Table 1.9).

Table 1.9 APP—Income statement reorganized through value-added method

The reorganization scheme of the income statement first identifies the operating income and costs of materials, services, and labor, highlighting the added value and determining the EBITDA. Immediately afterward, the income statement outline highlights the depreciation/amortization of fixed assets, which once subtracted from the EBITDA to determine the EBIT margin. By subtracting the financial charges (representing the cost of funding resources), the extra-ordinary expenses, and taxes from the EBIT you can obtain the net income for the fiscal year.

The reclassified balance sheet and income statement represent the starting point for the analysis of the economic and financial dynamics of the company through financial ratios and cash flow statements. As for the analysis through financial ratios, here below is an overview that easily allows both a static and dynamic analysis (otherwise referred to as “quadro di sintesi”—Cappelletto, 1999). In particular, if you read the table vertically, it is possible to identify the company’s balances for each year (T, T + 1, T + 2), whereas if you read it horizontally, it is possible to see the trend of these balances over time (Table 1.10).

Table 1.10 APP—Overview for company financial assessments

Specifically, the four main lines of investigation evolve as follows:

• Turnover. The operating efficiency decreases over the analyzed time period. This decrease is mainly explained by the decline in sales that was registered over the covered period. The table also shows an increase in the monetary cycle, which is mainly given by a decrease in the deferred payments of suppliers.

  On the other hand, the times of credit collection and inventory management remain substantially stable over the analyzed period.

• Asset balance. The company finances investments in fixed capital and part of the working capital through long-lasting funding sources, like equity (mainly) and M/LT financial payables. Although the coverage ratio of fixed capital decreases over time, it stands at values above 100%.

• Financial balance. The financial situation is balanced given that exposure to banks is not high. However, there is a worsening performance linked to a decrease in the amount of equity capital.

• Economic balance. As for margins, the company shows an unbalanced situation with a deterioration of profitability. The spread between ROIC and ROD changes from positive to negative values. This imbalance in terms of profitability is explained by a rather significant decrease in profitability during the analyzed period; in fact, the ROIC deteriorates over time, going from 8.29 to 1.31%.

Lastly, through the cash flow statement, it is possible to determine the resources generated by the current administration and evaluate their use over the analyzed period.

The steps required to develop a cash flow statement are:

• Identifying the EBITDA, which represents the company’s “potential” cash flow, with all revenues collected and all costs paid for;

• Identifying the change in NOWC from one fiscal year to the next, which represents how much the company collected in a year, net of what it paid in the same year;

• Identifying the current operating cash flow (Net Current OCF), which is calculated by subtracting the change in NOWC and taxes from the EBITDA.

Subsequently, through the tables and outlines presented above, it is necessary to identify: the resource requirements that are absorbed by the new investments in fixed capital, the cash flows related to surplus assets (extra-management), and those related to the financial area. Let’s refer to the following outline of Step 2 (Table 1.11).

Table 1.11 APP—Outline of the cash flow statement (Step 2)

In this case study, during the year T + 2, the company generated a net current operating cash flow (net current OCF) of € 421,733, which is down from the amount that was generated the previous year (€ 1,541,697). The debt service coverage ratio (DSCR) for year T + 2, considering the changes in NOWC, is equal to:

$${\text{DSCR}}_{T + 2} = \frac{421{,}733}{{32{,}255 + 93{,}288}} = 3{.}36$$

Despite the lowering operating cash flows, the company maintains an excellent DSCR. The resources that were generated by the production cycle were allocated to shareholders through distribution of dividends. The cash flow statement also shows a decrease in M/LT and ST loans, offset by a more proportional decrease in cash inflows (the company uses both cash and equivalents and the net operating cash flows to repay the financial debt). Investments did not lead to cash outflows since the company disinvested part of its assets in T + 1 and the fixed capital remained virtually unchanged in T + 2.