Case Analysis on Assessing a Company's Future Financial Health

December 9, 2022

Case Analysis on Assessing a Company’s Future Financial Health

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Case Analysis on Assessing a Company’s Future Financial Health

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Assessing a Company’s Future Financial Health

Assessing the long-term financial health of a company is an important task for management as it formulates goals and strategies and for outsiders as they consider the extension of credit, long-term supplier agreements, or an investment in a company’s equity.

History abounds with examples of companies that embarked on overly ambitious programs and subsequently discovered that their portfolios of programs could not be financed on acceptable terms. The outcome was frequently the abandonment of programs mid-stream at considerable financial, organizational, and human cost.

It is the responsibility of management to anticipate a future imbalance in the corporate financial system before its severity is reflected in the financials, and to consider corrective action before both time and money are exhausted. The avoidance of bankruptcy is an insufficient standard. Management must ensure the continuity of the flow of funds to all of its strategically important programs, even in periods of adversity.

Figure A provides a conceptualization of the corporate financial system, with a suggested step-by- step process to assess whether it will remain in balance over the ensuing 3 to 5 years. The remainder of this note discusses each of the steps in the process and then provides an exercise on the various financial measures that are useful as part of the analysis. The final section of the note demonstrates the relationship between a firm’s strategy and operating characteristics; and its financial characteristics.

Figure A

The Corporate Financial System

Analyze Goals Step 1 Strategy

Market, Competitive Technology

Regulatory and Operating Characteristics

Step 2 Analyze Revenue Outlook

growth rate
volatility, predictability

Step 3 Step 4

Analyze Investment in Assets Assess Economic Performance

to support growth
profitability
improvement/deterioration in asset management
cash flow
volatility, predictability Step 5 Step 6

Assess External Financing Need Ensure Access to Target Sources of Finance

$ amount
lending/investing criteria
timing, duration
deferability
attractiveness of firm to each target source

Step 7 Assess Viability of 3 to 5-year Plan

consistency with goals
achievable operating plan
achievable financing plan

Step 8 Perform Stress Test for Viability Under Various Scenarios Step 9 Formulate Financing and Operating

Plan for Current Year

This document is authorized for use only by Ryan Howell in FIN-320-X1024 Principles of Finance 21EW1 at Southern New Hampshire University, 2021.

The corporate financial system is driven by a firm’s goals, business unit choices and strategies, market conditions, and operating characteristics. The firm’s strategy and sales growth in each of its business units will determine the investment in assets needed to support these strategies;

and the effectiveness of the strategies, combined with the response of competitors and regulators, will strongly influence the firm’s competitive and profit performance, its need for external finance, and access to debt and equity markets. Clearly, many of these questions require information beyond that contained in a company’s published financial reports.

Step 3: Analyze Investments to Support the Business Unit(s) Strategy(ies)

The business unit strategies inevitably require investments in accounts receivable, inventories, plant & equipment, and possibly, acquisitions. Step 3 of the process is an attempt to estimate the amount that will be tied up in each of the asset types by virtue of sales growth and the improvement/deterioration in asset management.

An analyst can make a rough estimate by studying the past pattern of the collection period, the days of inventory, and plant & equipment as a percentage of cost of goods sold; and then applying a “reasonable value” for each category to the sales forecast or the forecast of cost of goods sold. Extrapolation of past performance assumes, of course, that the future underlying market, competitive, and regulatory “conditions” will be unchanged from those that influenced the historical performance.

Step 4: Assess Future Profitability and Competitive Performance

Strong sustained profitability is an important determinant of (1) a firm’s access to debt and/or equity finance on acceptable terms; (2) its ability to self-finance growth through the retention of earnings; (3) its capacity to place major bets on risky new technologies, markets, and/or products; and (4) the valuation of the company.

A reasonable starting point for assessing firm’s future profitability is to analyze its past pattern of profitability.

What has been the average level, trend, and volatility of profitability?
Is the level of profitability sustainable, given the outlook for the market and for competitive and regulatory pressures?
Is the current level of profitability at the expense of future growth and/or profitability?
Has management initiated major profit improvement programs? Are they unique to the firm or are they industrywide and may be reflected in lower prices rather than higher profitability?
Are there any “hidden” problems, such as suspiciously high levels or buildups of accounts receivable or inventory relative to sales, or a series of unusual transactions and/or accounting changes?

Step 5: Assess Future External Financing Needs

Whether a company has a future external financing need depends on (1) its future sales growth; (2) the length of its cash cycle; and (3) the future level of profitability and profit retention. Rapid sales growth by a company with a long cash cycle (a long collection period + high inventories + high plant & equipment relative to sales) and low profitability/low profit retention is a recipe for an ever-increasing appetite for external finance, raised in the form of loans, debt issues, and/or sales of shares.

Why? Because the rapid sales growth results in rapid growth of an already large level of total assets. The increase in total assets is offset partially by an increase in accounts payable and accrued expenses, and by a small increase in owners’ equity. However, the financing gap is substantial. For example, the company portrayed in Table A requires $126 million of additional external finance by the end of year 2010 to finance the increase in total assets required to support 25% per year sales growth in a business that is fairly asset intensive.

Table A Company Financials Assuming a 25% Increase in Sales ($ in millions)

2009 2010 Assets

Cash $ 12 ↑ 25% $ 15

Accounts receivable 240 ↑ 25% 300

Inventories 200 ↑ 25% 250

Plant & equipment 400 ↑ 25% 500

Total $852 $1,065

Liabilities and Equity

Accounts payable $100 ↑ 25% $ 125

Accrued expenses 80 ↑ 25% 100

Long-term debt 272 Unchanged 272

Owners’ equity 400 footnotea 442

Total $852 $ 939

External financing need 0 126

Total $852 $1,065

a It is assumed (1) that the firm earns $60 million (a 15% return on beginning of year equity) and pays out $18 million as a cash dividend; and (2) that there is no required debt repayment in 2010.

If, however, the company reduced its sales growth to 5% (and total assets, accounts payable and accrued expenses increased accordingly by 5%), the need for additional external finance would drop from $126 million to $0.

High sales growth does not always result in a need for additional external finance. For example, a food retailer that extends no credit to customers, has only eight days of inventory, and does not own its warehouses and stores, can experience rapid sales growth and not have a need for additional external finance provided it is reasonably profitable. Because it has so few assets, the increase in total assets is largely offset by a corresponding, spontaneous increase in accounts payable and accrued expenses.

Step 6: Ensure Access to Target Sources of External Finance

Having estimated the company’s future financing needs, management must identify the target sources (e.g., banks, insurance companies, public debt markets, public equity market) and establish financial policies that will ensure access to financing on acceptable terms. Consider the following questions:

This document is authorized for use only by Ryan Howell in FIN-320-X1024 Principles of Finance 21EW1 at Southern New Hampshire University, 2021.

Assessing a Company’s Future Financial Health 911-412

How sound is the firm’s financial structure, given its level of profitability and cash flow, its level of business risk, and its future need for finance?
How will the firm service its debt? To what extent is it counting on refinancing with a debt or equity issue?
Does the firm have assured access on acceptable terms to the equity markets? How many shares could be sold and at what price in “good times”? In a period of adversity?
What criteria are used by each of the firm’s target sources of finance to determine whether finance will be provided and, if so, on what terms?

The evaluation of a firm’s financial structure can vary substantially depending on the perspective of the lender/investor. A bank may consider a seasonal credit a very safe bet. Considerable shrinkage can occur in the conversion of inventory into sales and collections without preventing repayment of the loan. In contrast, an investor in the firm’s 20-year bonds is counting on its sustained health and profitability over a 20-year period.

Step 7: Assess Viability of the 3- to 5-Year Plan

Consider the following questions:

Is the operating plan on which the financial forecasts are based achievable?
Will the company achieve its strategic, competitive, and financial goals?
Will the resources required by the plan be available?
How will the firm’s competitive, organizational, and financial health at the end of the 3 to 5 years compare with its condition at the outset?

Step 8: Perform Stress Test under Scenarios of Adversity

Financing plans typically work well if the assumptions on which they are based turn out to be accurate. However, this is an insufficient test in situations marked by volatile and unpredictable conditions. The test of the soundness of a 3- to 5-year plan is whether the continuity of the flow of funds to all strategically important programs can be maintained under various scenarios of adversity for the firm and/or the capital markets—or at least be maintained as well as one’s competitors can maintain the funding of their programs.

Step 9: Formulate Current Financing Plan

How should the firm meet its financing needs in the current year? How should it balance the benefits of future financing flexibility (by selling equity now) with the temptation to delay the sale of equity by financing with debt now, in hopes of realizing a higher price in the future?

The next section of this note discusses the financial measures that can be useful in understanding the past performance of a company. Extrapolation of the firm’s past performance, if done thought- fully, can provide valuable insights into the future health and balance of the corporate financial system.

Historical analysis can also identify possible opportunities for improved asset ma na gement or margin i m p r o v e m e n t, and can provide an important, albeit incomplete, basis for evaluating the attractiveness of a business and/or the effectiveness of a management team.

This document is authorized for use only by Ryan Howell in FIN-320-X1024 Principles of Finance 21EW1 at Southern New Hampshire University, 2021.

911-412 Assessing a Company’s Future Financial Health

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Financial Ratios and Financial Analysis

The three primary sources of financial data for a business are its income statement, the balance sheet, and statement of cash flows. The income statement summarizes revenues and expenses over a period of time. The balance sheet shows what a company owns (its assets), what it owes (its liabilities), and what has been invested by the owners (owners’ equity) at a specific point in time. The statement of cash flow categorizes all cash transactions during a specific period in terms of cash flows generated or used for operating activities, investing activities, and financing activities.

The focus of this section is on performance measures based on the income statements and balance sheets of SciTronics—a medical device company. The measures can be grouped by type: (1) profitability measures, (2) activity (asset management) measures, and (3) leverage and liquidity measures. Please refer to the financial statements of SciTronics as shown in Exhibits 1 and 2. As you work through the questions in this section, please also consider three broad questions:

What is your assessment of the performance of SciTronics during the 2005–2008 period?
Has its financial strength and its access to external sources of finance improved or weakened?
What are the 2–3 most important questions you would ask management as the result of your analysis?

Case Analysis on Assessing a Company’s Future Financial Health

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