Finance for Entrepreneurs

FE - #10617
Joaquim Pina
DCSA
FCT-NOVA

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Economic-Financial Analysis
• What?
• Few indicators based on financial statements, particularly the Balance sheet
and Income Statement
• Why?
• Summarize in a easy to read form the many aspects of the firm soundness
• How?
• Comparison --intra-temporal and intertemporal–, using absolute
values/percentages, index numbers/graphs, (items in) financial statements,
particularly Balance sheet and Income statement
• Financial ratios

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Comparing financial statements
• Horizontal analysis
• Shows the time evolution of the items in the financial statements

• Vertical analysis
• Shows the structure of the Assets and the Financing (in Balance sheet) and
the major sources of Revenues and of Costs (in Income statement)

Final assessment of firm soundness requires reading together the findings from
comparisnon analysis with those from financial ratios

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Financial ratios
• Firm activity, either comercial/internal management or
financial choices, is reflected in financial statements
• Ratios are easy to read sumaries of those statements

• However, use with care (attending to their nature):

• Not consider qualitative information; ratios may be analyst-specific
• Seasonality, single “events”/outliers, and inflation affect values differently;
• Per se each ratio bears little information; requires a broader view, including
comparison against other firms/activity sector/economy dynamics

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Types of ratios I
• Financial
• Liquidty and mid/long-term solvency - essentialy based on Balance sheet
• Economic
• Profitability, and self financing ability - essentialy based on Income statement
• Economic-financial
• Combines the ones before - profitability and assets; decomposition
highlighting financing structure
• Activity
• Efficiency in assets management; sensitive to sector/economy; e.g.
Sales/Assets

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Types of ratios II
• Technical
• Production and activity in general; use physical units or mix these with
economic-financial; namely, productivity, e.g., Activity/Means used such as
Production or Sales over Payroll
• Market
• PER = Price/ Net profit per share (Price-Earnings Ratio)
• EPS = Net profit per share / Price (Earnings Per Share)
• Payout ratio = Dividend per share / Net profit per share
• Market-Book ratio = Market value of firm (capitalization=quote*shares) / Capital
(accounting) value
• Tobin q = Market value of assets / Cost of replacement of assets

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Liquidity analysis
• In units
• Working capital = Current assets – Current liabilities (>0); essentially,
(Inventories+Customers+Cash) – Suppliers

• Liquidity ratios
• Current ratio = Currents assets / Current liabilities (>1)
• Quick ratio = (Current Assets – Inventories)/ Current liabilities (compare with
sector)
• Immediate liquidity = Cash / Current liabililities

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Activity and productivity
• Liquidity cycle = Days receibales + Days Inventory – Days payable

• Inventory turns = Cost of Goods sold / Inventories (average)

• Days Inventory = [Inventories (average) / Cost of Goods sold]*360
• Accounts receivable turns = Sales / Accounts receivable (average)
• Days Receivables = [Accounts receivable (average) / Sales]*360
• Accounts payable turns = Purchases / Accounts payable (average)
• Days Payables = [Accounts payable (average) / Purchases]*360
• Note: actually use Suppliers instead of all paybales; further, Purchases=Cost of Goods sold + end of period
Inventories less initial Inventories

• Asset turnover = Sales / Assets (activity/productivity measure)

All measures in this slide, compare against sector

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Leverage/Solvency
• Debt-to-Equity = Liabilities / Equity (compare with sector)
• Equity to Assets = Equity / Assets (compare with sector)

• Long-term indebtedness = Non-current liabilities / Assets

• Interest coverage ratio = Operating profit / Interest expenses

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 Profitability
• ROA = Net profit / Assets (Return on Assets)
• ROE = Net profits / Equity (Return on Equity)
• ROS = Net profit / Sales (Return on Sales)

May compute ratios above using, e.g., EBITDA, EBIT (or EBT)

• Additionally, e.g., Gross Margin, defined as Sales – Cost of Goods sold, in % of

Sales, is obtained as (Sales – Cost of Goods sold)/Sales

All measures in this slide, compare against sector

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DuPont and Financial/Operating leverage
• Dupont decomposition
ROE = ROS * Asset turnover * (Assets/Equity)

• Financial leverage
Assets/Equity (>1)

• Operating leverage
• Related with Sales effect on Operating income; can be measured,
e.g., as Gross Margin / Operating Income
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Profitability: alternative decomposition
ROE =[EBIT/Sales]*[Sales/Assets]*
Investment policy (i.e., EBIT/Assets into margin and rotation)
[Assets/Equity]*[EBT/EBIT]*
Financing policy (links to Dupont, financial leverage and interest weight)
[NetProfit/EBT]
Fiscal effect

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Break-even analysis
• Break-even point
• Net profit = Revenues – Costs
= Price*Quantity – Fixed costs (Fc) – Variable costs (Vc)
• Net profit = [Price*Quantity – Vc] – Fc = (Price-Unit Vc)*Quantity – Fc
Contribution margin (CM) Unit CM
• Q corresponding to Break-even, obtained from
0 = (P-Unit Vc)*Q – Fc, i.e., Q=Fc/Unit CM
• Corresponding to this Q, there is a Break-even Revenue, P*Q
• Can compute the Safety Margin, defined as (P*Q-P*Q)/P*Q or (Q-Q)/Q

Note: An approximation to Vc is Cost of Goods sold and Fc are External Services and Payroll

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Alt - Note: What about Services?
• Selling services usually yield small Cost of Goods sold; how to
approximate get Cost of services sold?

• Either take a large portion of Payroll and some portion of External

services
Or, more accurately,
• Use the Income statement by functions, instead of that by nature,
which offers the Cost of sales

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Note: Income statement by function
• Early we presented the Income statement by nature of expense/revenue
• NOW, below find a snapshot of Income statement by function
Income statement (by function)
+ Sales (of goods/services)
- Cost of sales
= Gross Margin
- Distribution costs
- Administrative costs
- Other operational costs
= Operating profit/loss
+ Financial revenue (namely, Interest)
- Financial costs (namely, Interest)
= EBT (i.e., Earnings Before Tax)
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Firm size
• EU definition

See https://ec.europa.eu/growth/smes/business-friendly-environment/sme-
definition_en

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Benchmarking
• Benchmarks

• Leading company

• Sector, country specific, upper quartile/median/average/lower

quartile
See The European Committee of Central Balance-Sheet Data Offices (ECCBSO) – database
at https://www.eccbso.org/;
Specific information and analysis at BACH and ERICA, https://www.bach.banque-
france.fr/?lang=en
May also check Banco de Portugal statistics at
https://www.bportugal.pt/QS/qsweb/Dashboards

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Company valuation
• Brand valuation
• E.g., Best Global Brands, https://interbrand.com/best-brands/
• Product/geographic market trends; team…

• Financial indicators
• E.g. Assets, Profitability; DCF…
• Stock market based indicators
• Includes Market quote (and capitalization); see PER, mentioned indicators

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