 Financial Analysis Management includes :

(1) Enlightening strategic choice involves :

(a) financial assessment of investments (profitability forecasts, risk assessment) ;

(b) search, assessment and negotiation of long-term funding (equity, long-term debt) ;
(c) treasury management (bank overdrafts, credit facilities, securities management).

Such matters bring about critical consequences as for the long-term viability of any firm.
They are interrelated with business strategy (=entrepreneurial decisions regarding
technologies, products and markets that the top management will take on developing
and operating). → The strategic choice is prospective.

(2) Examining the economic performance of the firm.

→ The performance analysis is retrospective.

It need to look at the relevance and efficiency of past strategic decisions.

Performance analysis is a compass aiming at assessing strategy, in view of

- Enhancing it (as long as it performs well),
- Improving it (in order to tackle weaknesses) and/or challenging it (if it proves
disappointing).

Financial statement analysis is part of this performance analysis scheme. Indeed, any
business strategy must take and pass two closely linked tests:

 The test of solvency : it basically consists of paying off debts.

 The test of profitability : … of making profits (that is, ensuring that income >
costs)

If the firm doesn’t meet even one of these two requirements…

→ The insolvency makes the business unsustainable and inevitably leads to bankruptcy
(that is the disposition of this assets at cheap price)

→ The low profitability (worse or negative) means the wastes money that investors put into
the company. Profitability is the evidence of wealth creation and “shareholder value”.
This is the primary goal of any “capitalist” business.
Any bad performance on this aspect of the firm’s economy has major (and fearsome)
implications on its governance : top management dismissal, social plans following massive
layoffs, offshoring of business units and the like.

All primary stakeholders of the firm take an interest in assessing corporate financial
statements and in performing financial analysis.

- First, we have the shareholders but also investment companies (banks, hedge
funds…)

- All agents having financial stakes includes clients, suppliers, staff and even
competitors. Financial press and public administration may eventually be added to
this (non-comprehensive) list.

The steps of financial statement analysis :

Step 3: Once fitted with documents ready-to-use, the analyst can retrieve relevant
information and calculate indicators that will serve as the bedrock of the final analysis.
Ratios are particularly significant in that respect.

Step 4 : The ratios (and other figures) make it possible to have an overall judgment on the
solvency and the profitability of the company, constituting the essence of any financial
diagnosis.

1. Financial Analysis of the income statement

1.1. The intermediate balances (IB)

The income statement is specifically suitable to profitability analysis since it compares

the value created (income) and the value lost (costs) by the business within one year.
The purpose of any business is obviously to generate profit, that is, a net income
(all income - all costs).

The 4 first IBs that lead to the operational income ascertain that the business under
analytical scrutiny does create value (if income > costs => net income) or destroy
value (if income < costs => loss).

Once created through efficient operations, income must be distributed to three

categories of stakeholders:

(1) creditors (under the form of interests on loans);

(2) the State (under the form of income tax);
(3) stockholders (also denoted shareholders), under the form of dividends.

In exchange of such services, creditors (that lend money to the firm), public authorities
(that supply public services to the firm) and stockholders (that provide equity to the firm)
expect some compensation (under the form of interest, tax and dividends, respectively).

a). Sales margin (marge commerciale):

Sales of commodities – cost of commodities

(vente marchandises – achat marchandises)

This IB applies only (or mainly) to the trade sector (wholesale and retail).

b). Added value (valeur ajoutée) =

Sales margin + Products sold - Procurement of materials and services

Basically, value added amounts to the annual turnover of the firm - its annual sales -
the cost of all raw materials, all supplies and all kind of services that it purchases
from independent suppliers.

Let’s keep in mind that the bigger the gap between sales and procurement, the bigger
the added value.

c). Earnings before Interest, Taxes, Depreciation and Amortization (EBITDA

= excédent brut exploitation)

Added Value - (operating taxes + staff costs)

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 EBITDA is an important indicator since it approximates the “annual cash flow” of a
company. Indeed, all income and costs that EBITDA includes do imply a cash debit
(entrance) or cash credit (cash exit). This is not the case with all sorts of income and
costs.
Yet, cash-flow is the net treasury that a business annually gets from its whole activity.
It’s a key indicator of its investment capacity (the bigger the cash-flow, the higher the
investment capacity).

d). Operating income (résultat d’exploitation) =

EBITDA - (depreciation/amortization allowances)

In sum, the operating income includes annual sales (= turnover) as the positive element
and, as a negative element, costs that operations inevitably entail such as procurement,
operating taxes, staff costs and depreciation allowances. Only when the former is above
the latter does the business earn money (create value).

e). Income before provision for income tax (résultat courant avant impôt) =

Operating income + financial revenues - Interest charges

As long as income before provision for income tax is positive, it means that the business
is profitable enough to cover the costs of the funds borrowed from banks and other
lenders.

f). Extraordinary Items (résultat exceptionnel) =

Extraordinary Income (gains) - Extraordinary Costs (losses)

Extraordinary Items are non-recurring constituents of income (or loss) but their amount
can be significantly high. This is because the gist of these extraordinary items comes
from the sale of assets (difference between the income from sale and the cost of the
asset). Disposing of assets is not part of the usual business activity (put differently, it is
not part of operations).

g).

Income before provision for income taxes + Extraordinary Items - Income taxes

OR

All annual income – all annual cost

This is the balance that tells the analyst if the business makes annual profit or not. And this
is the bottom line of the income statement that will draw attention from shareholders since
net income is what amounts to them.

1.2. The turnover (chiffre d’affaires) :

Turnover (sales revenues) is usually (and by far) the main element of the annual income.
Any turnover basically amounts to a quantity of goods (or services) multiplied by a price (or
a gamut of prices). The analysis of the turnover allows for assessing the competitive
position of the business (its market share) and its commercial dynamism.

Thus, it is interesting to observe the evolution of the firm’s turnover, through time (over a
period of several years, the longer the better, in general). A growing turnover indicates that

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the product sold is valued (demanded) by the consumers (or the clients); indeed, it comes
from an increase of quantities sold and/or an increase of prices, both signaling the appeal of
the product supplied on the market. On the contrary, a decreasing or even steady turnover
is a sign of a declining market (and/or a declining supply).

With regard to the turnover, three standard situations may occur :

- When the turnover decreases from one year to another over a long period of time,
two issues are addressed to the management :

(1) does the whole market face a downturn ? If yes, this might mean that the product
became obsolete, so that the firm confronted to this assessment should go for a change of
activity (disinvestment in the current activity followed by a reinvestment in another).

(2) in case the turnover of competitors keeps on growing whereas the firm’s one is
decreasing, this sounds like a serious alarm to the ears of the managers: indeed, such a
case means that the supply of the firm specifically does not match the wants of the market.
This calls for changes in the process of production (or commercialization), innovation,
quality upgrading or cost killing, in order to render the product more attractive ang gain
market shares.

- When the turnover slightly increases (from 1% to 5% a year) or stagnates, the firm
should forestall a possible downturn in the future. A steady turnover usually
indicates a saturation of the market. It addresses about the same issues as above
but it gives managers more time to anticipate and entertain change.

- When the turnover increases at a significant annual rate (between 5% and 15% per
year), the activity may be said dynamic. Over 15% per year even emphasizes a
tremendous commercial performance that validates past strategic choices. It means
that the firm must invest more in its activity and make the price-quality bundle of its
supply ahead of competitors.

1.3. The main ratios derived from the income statement  :

IBs and turnover are absolute monetary amounts, that is, monetary quantities. In itself, it
gives information about the size of operations (and the business under scrutiny) but it does
not portend for its economic efficiency.

Ratios inferred from the income statement are usually broken down into two categories : (1)
operating ratios and (2) profitability ratios.

a). Operating ratios :

We hereunder focus on two (only) amongst the most commonly used activity ratios.

RATIO MEANING

Added Value / annual turnover
Numerator : 2nd SIG
Denominator : income statement
(income)
This ratio is necessarily < 1. It delivers information
about the operating process of the firm. The higher it
is, the more internalized (the less outsourced) is the
operating process. Then, it is insightful to relate this
ratio to profitability ratios, in order to know whether
internalization (or outsourcing) is a wise operating
option.

Turnover / any physical indicator This ratio says how much turnover is produced by
(number of employees, number of each employee (or each unit of product) in the firm.

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 product units, etc.) We take an example in the oral course. The higher it
is, the more productive is the firm.

b). Profitability ratios:

Let us focus on four of them (the most commonplace)

RATIO SIGNIFICATION
Interest charge / financial debt The first account of this ratio estimates the cost of
firm’s loans. Of course, for the sake of profitability, the
Numerator : income statement (costs) lower, the better.

Denominator : balance sheet (liabilities) in the A high ratio signals a risky business, at least in the
first case. Income statement in the second eyes of lenders
case.

Operating income/ turnover = gross margin This ratio assesses the profitability of firm’s
operations. Of course, the higher, the better.
Numerator : 4th SIG

Denominator : income statement

Net income / turnover = net margin
Here again, the higher the better. 5% (or more) is
Numerator : 7th SIG usually deemed a palatable standard.

Denominator : income statement

Net income / equity = Return on Equity This is the shareholders master ratio. It estimates the
(ROE) financial return of the funds invested in the firm by the
owners. It may boil down to a rate of savings return.
Numerator : 7th SIG

Denominator : balance sheet (top of the

liability column)

2. Financial Analysis of the balance sheet

Like the income statement, the balance sheet is a document made on the basis of
accounting principles. Yet, accounting principles are not always consistent with the
concerns of financial analysis. This is not so much an issue regarding the French income
statement but it is regarding the balance sheet, unless the latter is designed accordingly
with international accounting norms (IAS-IFRS).

Since it is a technical issue requiring deep knowledge in finance and accounting from
students, I will not dwell on that issue. Suffice to say (and keep in mind) that, in practice,
when an analyst is confronted with the accounting documents of any French firm, she must
restate them in order to make it tractable for the sake of analytical needs.

Here under is a schematic representation of the balance sheet that the financial analyst
should work from (after restatement)

The main feature of the balance sheet here above lies in its order of presentation: both
assets and liabilities are presented by order of liquidity (assets) and enforceability
(liabilities). Such a rigorous order of presentation is peculiar to the “financial” balance sheet;

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the balance sheet designed according to the French GAAP does not follow such an order
that precisely.

What does it mean ? First, assets are classified by increasing order of liquidity (from the
less liquid to the more liquid assets). Second, liabilities are classified by increasing order
enforceability (from the less mature to the more mature liabilities). Put differently, both
assets and liabilities are presented from the longer term (the more durable) to the shorter
term (the less durable)1.

ASSETS (LEFT COLUNM)

Fixed assets
Intangible, tangible and financial assets (immobilisations incorporelles, corporelles,
financières)
Current assets
Inventories (stocks)
Receivables (créances d’exploitation et hors exploitation) 2
Cash and marketable securities (disponibilités)
TOTAL ASSETS

LIABILITIES (RIGHT COLUMN)

Equity
Long term liabilities
Financial debt (dettes financières)
Payables (dettes d’exploitation et hors exploitation)
Current (short term) liabilities
Financial debt (dettes financières)
Payables (dettes d’exploitation et hors exploitation)
TOTAL LIABIILITIES

2-1. What are “assets” and “liabilities”  ?

Whereas the income statement reviews the source and amount of both costs and income
within a year (in order to know whether the firm earned or lost money), the balance sheet
reviews both the assets it owns (and operates) and the liabilities it collected in order to
finance investments.

The balance sheet assesses the wealth (assets) of the firm and the way it funded that
wealth (liabilities) since its constituency. Whereas the income statement tells about the
profitability of the firm, the balance sheet gives insights about its solvency and liquidity.

We may state things as follows: at the beginning of its existence, the new firm needs to
invest in means of production (assets), whatever it chose to produce. Thus, it also needs
funds to do so; such funds are provided by the shareholders (equity) and the lenders
(liabilities). The former expect that the new business will make profits so that shareholders
can be paid back under the form
of dividends. The latter expect that the new business will be profitable enough to pay
interests back.

The more the new business will grow, the more it will invest in new fixed assets. And the
more funds it will collect from shareholders and creditors under the form of new equity and
debt. So, the balance sheet will grow as well. Of course, in the course of thriving, the new
business will develop its operations, increase its client portfolio, manage more cash so that
its current assets will grow too.
1
This is a French convention. Note that in the United States, this is the contrary: assets and liabilities are
presented by descending order of liquidity and enforceability
2
Includes client accounts (créances clients) and bills receivables (effets à recevoir)

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One basic condition allowing for such a development lies in managing operations
successfully: whatever its product, it must be attractive to clients and return profit (disclosed
in the income statement). Thus, it can be said that profitability is a condition for
development and development leads to increase assets and liabilities in the balance sheet,
more assets leading to bigger operations and bigger operations leading to increasing
turnover and costs.

a). Assets  :

What are assets ? It is akin to “ownership” and “investment”. Assets are any valuable
property right (either tangible, intangible or financial) that a firm uses in the course of its
operations.

Assets may be broken down into two large categories:

- Fixed assets include intangibles (such as brands, patents, software, contracts or

rights the firm is the owner of), tangibles (lands, building, machinery, equipment,
vehicles, furniture, etc.) and financial investments (loans, shares in subsidiaries)
that make up the means of production. Such fixed assets can be operated, rent or
sold, so they always have a financial value. But they are difficult to sell off so that
they are not liquid.

- Current assets encompass less valuable assets that are inherent to regular
operations. Their turnover rate is high: such assets are not really investments but
rather short-term possessions that the firm renews frequently, as a function of its
operating cycle. This includes inventories, short term claims (denoted “receivables”)
and very liquid assets such as marketable securities and cash.

b). Liabilities:

Liabilities include the funds that the business collects from capital providers. Here again,
liabilities may be broken down into two categories:

- Equity (les fonds propres) is provided by the owners of the firm3. Equity is not
repayable (it is somehow “given” to the firm by the owners) but it is very demanding
with regard to profit.

- Debt (synonymous of “liability”) is provided by the creditors (lenders), foremost

banks. Debt must be paid off over the long or the short term, contingent on the
contract terms. Financial debt corresponds to “loans”: this is merely money borrowed
and repaid as such. Payables are debts that are not loans: they are deferred
payments (a time lapse that the firm gets from any stakeholder -supplier,
administration and the like- to pay back what it owes to them).

2-2. Working capital (fonds de roulement), working capital requirement (besoin en

fonds de roulement), treasury (trésorerie)  :

All three indicators are calculated from balance sheet data:

a). Working capital =

(Equity + long term liabilities) – fixed assets

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It can be a single owner in the case of a proprietorship (entreprise individuelle). In the case of companies
(sociétés commerciales), whatever its legal status, equity is provided by the shareholders (denoted
« stockholders » in the case of a corporation).

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 In textbooks, working capital is recommended to be slightly positive. Indeed, working
capital balances long term liabilities with long term assets. A slight surplus of liabilities
over assets means that the firm can rely partly on long term liabilities to finance short
term assets. This is usually deemed a safety net for the firm since financing all short-
term assets with short term liabilities is considered risky. Some textbooks recommend
that the working capital amounts to 10% of the annual turnover.

b). Working capital requirement

(Inventories + receivables) – short-term payables.

When the working capital requirement (WCR) is positive (this is largely the case, at least
in the industrial sector), it means that the current operating assets are greater than the
current operating debt . Yet assets are possessions that always require financing. Since
working capital is, when positive, an excess of long-term liabilities over long-term assets,
it makes sense to devote this excess (working capital) to financing operating assets
short-term excess (the working capital requirement) . This is why WC and WCR should
ideally match.

At first glance, any business should wish to have a NEGATIVE WCR. Why is that so ?

Because when WCR is negative, the operating cycle provides the business a capacity of
investment. Instead, when WCR is positive, it confronts the business to a need for
funding (so, a need to borrow).

But WCR can be weak (even negative) for bad reasons : little amounts of inventories
and receivables might mean that the company sells too little (so the turnover is weak,
maybe even decreasing through years). And big amounts of payables might mean that
the company is at pains to pay off its invoices… So, analyzing WCR properly is subtle.

c). Treasury :

Working capital – working capital requirement

or

(cash + marketable securities) – short-term financial debt.

Treasury hints at the financial capability of the firm. Whether positive (cash > short
financial debt), the firm has more cash in bank than payments to make within the
coming year; this signals a secure profile. To the contrary, when negative (cash < short
financial debt), the firm has less cash in bank than payments to make within the coming
year. This may seem unwary but it depends on the amount at stake. For instance, when
the balance sheet is drawn up at the end of the year (31-12-N) and that the treasury
calculated from this balance sheet is slightly negative, it means that the firm may
dispose of several months to find (or generate) the missing cash in order to pay back its
debts. There is no reason to panic when confronted with a negative treasury.

Textbooks usually recommend that the treasury is null (equal to 0). That would mean
that working capital and working capital requirement are equal and that is purportedly
the perfect case. In fact, no matter the treasury is slightly positive or negative as long as
the amount is negligible (that is what “slightly” means…). Too positive a treasury means
that the firm hoards too much cash (so invests too little). Too negative a treasury means
that the firm invests too much (has not enough cash in bank). That’s why close to 0 is a
good target.

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2-3. Main ratios derived from the balance sheet  :

Two main categories of ratios may be derived from the balance sheet (and sometimes, a
combination of balance sheet and income statement data): management ratios and
financial structure ratios (including liquidity and solvency ratios).

a). Management ratios

There are several management ratios that are akin one to another. The following one is
epitomizing the others.

RATIO SIGNIFICATION
(Working capital requirement / turnover) This ratio translates the financial requirement related
x 360 to the operating cycle into a number of sales days (or
months). The lower, the better. The best situation
Numerator : WCR lies in a negative ratio since in case of negative sign,
the WCR turns the “financial requirement” into a
Denominator: income statement financial capacity.

b). Financial structure ratios

These ratios may themselves be divided into two categories: liquidity and solvency ratios.

 Liquidity ratios :

RATIO SIGNIFICATION

Fixed assets / total assets
Numerator : top of the assets column
Denominator : total assets
This ratio is logically < 1 but is usually high
(between 0,7 and 0,9). The higher, the less
liquid are the assets and the more risky is
the strategy of the firm with regard to
liquidity

Current assets / current liabilities = This ratio may be above or below 1. It is

current ratio. usually recommended to be around 1 since
it means that short-term assets match short-
Numerator : bottom of the asset column term debt, so that liquidity is optimal

Denominator : bottom of the liability column

(cash + market securities) / current

liabilities = immediate liquidity ratio This ratio is usually far below 1 (between 0
and 0,5). It basically means the same as the
Numerator : bottom of the current asset current ratio but relates perfectly liquid
column assets to current liabilities.

Denominator : bottom of the liability column

At equal current ratio, the higher the immediate liquidity ratio, the better with regard to
liquidity. Put differently, when the current assets = 100, the more these current assets
comprise cash (and marketable securities) instead of inventories and receivables, the
better.

But beware of the following point: interpreting a ratio through the lens of liquidity only may
overlook other crucial aspects of the economic performance

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Be that as it may, liquidity ratios may be deemed “short term solvency ratios”. In other
words, lacking cash (or current assets) to pay off current liabilities may lead a firm to
bankruptcy even if its business model is fundamentally sound.

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  Solvency ratios :

RATIO SIGNIFICATION

Equity / total liabilities = financial
independence ratio
Numerator : top of the liability column
Denominator : total liabilities
This ratio is logically < 1. It is usually deemed that
its ideal value should hover around 0,3. The higher
the ratio, the more reliable the firm in the eyes of
shareholders and creditors. In turn, large equity
downgrades the return on equity (ROE) of the firm.

(Equity + long term liabilities) / total

liabilities This ratio is logically < 1 and usually ranged
between 0,5 and 0,8. Its meaning is basically the
Numerator : top of the liability column same as the financial independence ratio. The
higher, the more solvent is the firm.
Denominator : total liabilities

This ratio is under scrutiny of banks (and creditors).

Financial Debt / EBITDA
Numerator : short and long term liabilities
Denominator : 3rd SIG
The lower, the more solvent is the firm. It is usually
assessed that a sound ratio is ranged between 3
and 6. It means that firm’s loans shall not represent
more than 6 years of annual cash flow, otherwise
solvency is under threat

These ratios assess the long-term solvency of the firm. They hardly call for additional
comment. In a nutshell, a firm must avoid to bear too much debt, unless becoming under
pressure of refunding. On another hand, a firm must avoid to bear too little debt since it
usually signals a risk-averse profile detrimental to profitability (any company needs to raise
debt in order to invest…).

Definition :

 Financial analysis = provides an assessment of the business financial situation.

 Solvency = Assessing the business’s ability to pay off liabilities (honoring regular
payments)

 Profitability = Assessing the business’s ability to create value (make profits) over
the long haul

 Process of financial analysis :

1. An “informational” input : income statement and balance sheet (general accounting)

2. Reprocessing of accounting statements : from accounting statements to financial

statements

3. A material ready for analysis : indicators, financial benchmarks and ratios

4. The final step : financial diagnosis – a statement about business’s solvency and
profitability.

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