Structuring a Financial Analysis*

There are many reasons for doing a financial analysis. From inside a company, the focus
could be to identify areas in need of improvement or to estimate and evaluate funding
alternatives. From the outside, the purpose is generally to assess whether some funds provider
such as a bank, trade creditor, or stock investor should commit funds. Regardless of the
purpose, the general approach is similar.
In our first class we focused on cash flow—the real concern of all funds providers. What
we found was that although there are great differences among companies, the cash flow
drivers are similar. We didn’t derive an exhaustive list, but we did identify six forces affecting
cash flow.
• The nature of the industry. Funding is largely the result of marketing and operations and
there is a tendency for firms in an industry to have similar production/marketing
technologies. All cable companies, by their nature, require huge amounts of fixed assets
to provide service to their customers. There are the downlinks, head‐end, trunk cables,
drops, cable boxes, and the installation and service fleets. It doesn’t matter whether the
company is Cox or Comcast the fixed assets are huge.
• Management decisions. Companies make choices that differentiate themselves from
their competition. This differentiation or segmentation is the essence of strategic
management. So, one cable company might decide to keep installation in‐house and
another might outsource installation (operations differentiation). The choice will affect
asset requirements but both companies will still be asset intensive because they are
cable companies. As another example, Nordstrom’s and Penney’s are both in the
department store industry but they serve different clientele (marketing differentiation).
From our case discussion, we saw how a change in Dollar General’s strategic policy
about the sale of end‐of‐season goods affected their financing needs.
• Profitability. The first place a business looks for money is what the business can
generate internally. This is the cash flow from operations (CFO). CFO is the cash
generated by the day to day running of the business. It involves the cycle of sourcing the
product, making the final product for manufacturers, selling the product, and finally
collecting cash from customers. The CFO section of the cash flow statement starts with
accrual net income, as shown on the income statement, and then adjusts the accrual
net income with depreciation expense and balance sheet changes so that the final result
is the company’s cash income. For example, net income includes all sales but some sales
are actually not collected. By including the change in accounts receivable, the CFO
adjusts net income to get to the actual cash of the operations. Net income is the

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©Peter C. Eisemann. No portion of this document may be reproduced without the express written consent of the author.

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 primary driver of CFO and CFO is a major source of funds for most businesses.
Therefore, profitability importantly affects cash flow. A highly profitable firm will benefit
from strong cash flow, while a firm with low profitability will have weak (or even
negative) CFO.
• Growth. Sales and production growth require additional assets. If the company will
produce more, it will need more fixed assets to do that production. For a wholesaler,
growth will lead to more warehouse space, office equipment, and transportation assets.
The company will also need to keep more inventory on board to support the higher
sales. Of course, if sales are higher there will be more customers and that will lead to
higher accounts receivable. Growth drives asset needs. Note how we saw that in the
Cartwright case. Conversely, in the Wiegandt case we expected the large sales decrease
to lead to a contraction of key assets. Growth is such an important force affecting cash
flow that it is one of the first things we look at when analyzing a company.
• Cyclicality. Our economy goes through stages of expansion that are punctuated by
briefer periods of contraction (recession). This variability is referred to as the business
cycle. When we look at a business we always ask how that business will be affected by
cyclicality. Product characteristics mostly determine the degree of cyclicality. For
example, companies that sell postponable consumer durables (e.g., furniture) will be
very cyclical. We clearly saw this with Wiegandt. On the other hand, companies
specializing in necessities (e.g., medicine, food) will be much less cyclical.
• Seasonality. All companies have some intra‐year sales variability. Jewelry stores have a
huge Christmas sales spike. Grocery stores see sales changes around holidays and
vacation periods. The sales variability will cause profits to be uneven through the year
and will induce systematic changes in accounts receivable and inventory. Sometimes the
seasonality can also be pronounced on the production side. For example, farming and
food production are weather driven and, therefore, seasonal. Toy World emphasized
this point.

One of the lessons we can draw from the six forces is that financial analysis cannot be
done in a vacuum. We can’t just look at some numbers and reach a conclusion. Instead, we
must give careful thought to all that we know about the business. What is the nature of the
product and production in the industry? How does that affect the business? What strategic
choices have management made?
When I start a business analysis I begin by trying to get a good handle on the six forces
discussed above. This doesn’t require much number crunching at first. Simply think about the
company. Your earlier MBA courses (Managing in the Global Economy, Marketing
Management, Operations Management, and Corporate Finance) should have prepared you for

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this stage. The next step is to dig into the numbers. The cash flow statements, common‐size
income statements, and financial ratios provide a wealth of information that will lead to insight.
Here are examples of some questions you will want to address as you conduct your
analyses. The list is not exhaustive but it will orient you to the process. I have organized them
into three categories.

Marketing analysis:
• What is the nature of the company’s product?
• What influences the demand for this particular product? How does demand change over
time? Is demand cyclical? Seasonal? Are there any recent developments? Are sales
growing? At what rate? What is driving growth? Are sales strengthening? Weakening?
• How is the company’s product differentiated from the products of other companies?
Why do customers buy one product over another?
• What is the nature of competition? How strong is the company’s competitive position?
How do you see it changing?
• How is the product priced?
• How is the product promoted?
• How is the product distributed?
• Is the company’s market position improving or deteriorating? How successful have their
marketing efforts been? Do you see problems or opportunities?
• For each item consider what has happened and what you believe will happen.
• To a large extent the marketing arena identifies the value proposition of the company.

Operations analysis:
• This basically covers the asset side of the company and how the company produces or
provides its product.
• How does the company produce its product (if a manufacturer) or obtain its product (if
a retailer or wholesaler)?
• What is the nature of the asset requirements for the company? Is the company asset
intensive (i.e., does the firm require a large amount of assets to generate sales)? Why? A
firm that is asset intensive will have a low TAT. See the DuPont analysis table provided in
class to gain some perspective.
• How well do they manage sourcing and production, accounts receivable, inventory, and
fixed assets? Have there been major changes in assets in the past or predicted in the
future? Does the company have any other significant assets? Relevant measures include
total asset turnover, average collection period, inventory days, and fixed asset turnover.
• Another dimension of operations is human resources. Are there significant human
resources issues affecting performance? Don’t underestimate the importance of this
one.
• Are there any operations‐related critical success factors? How well have these factors
been managed in the past? What are your expectations?

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Financial analysis:
• How has the company funded itself? Have there been major changes? What
precipitated the changes? What factors are driving their funding needs?
• What are the significant findings from analysis of the company’s cash flow statement? Is
the company’s cash flow healthy? Why? Make sure you include discussion of the cash
flow from operations including the key drivers.
• How liquid is the company? How has that changed? Relevant measures include the
current ratio, acid test or quick ratio, accounts payable days, and cash flow from
operations. Also consider the amount of cash and securities on hand as well as the
availability of additional borrowing (remember Haefren Baum vs. Backhaus).
• How has leverage changed? Is leverage risk high or low? Relevant measures include
debt/equity, debt/EBITDA, times interest earned, and EBITDA/interest.
• How profitable is the company? What is creating that level of profitability? Are there
any significant changes occurring? Make sure that you consider the components or
drivers of profitability. Relevant measures include the individual elements of the
common‐size income statement, return on equity, and return on invested capital.
• Are owner cash distributions appropriate? A relevant measure is the dividend payout
ratio.
• Do the company’s current funding sources appear to be the appropriate type for its
needs? Is the type of funding correct or does it need realignment?

One tool that can help you pull together many of the numbers is DuPont analysis. It is a
system of tying together many of the ratios and the common‐size income statements to gain
insight about the company. The idea is that a key performance ratio is the return on equity
because it measures performance from the perspective of the company’s owners. The ROE
drivers are profit margin, total asset turnover, and leverage. Each of those three can be further

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 Return on
equity

Asset
Profit margin Assets/Equity
turnover

Gross margin Ave. coll. per Debt/Equity

Operating Inventory
Coverage
expenses days

Fixed asset
Interest
turnover

Taxes

decomposed to gain further understanding. If you look at a company this way you will find that
the ratios are not a random group of numbers. They are systematically related. As you go
through the ratios also incorporate the information on the cash flow statement. For example, in
Cartwright inventory was a major use on the CF statement. Why? There are two drivers: sales
growth and inventory days. We saw that growth was high and that pumped up inventory but
we also saw that stretching of days further increased the inventory investment. The more we
can tie these things together the more insight we will gain.