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?

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.

 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

Steps 1, 2: Analyze Fundamentals

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;

(4) The valuation of the company. A reasonable starting point for assessing firm’s future profitability is to analyze its past pattern of profitability.

1. What has been the average level, trend, and volatility of profitability?

2. Is the level of profitability sustainable, given the outlook for the market and for competitive and regulatory pressures?

 3. Is the current level of profitability at the expense of future growth and/or profitability?

4. 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?

5. 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  its future sales growth;
(1) The length of its cash cycle; 

(2) 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–This document is authorized for use only by Curtis Hitzeman in FIN-320-T1999 Principles of Finance 21EW1 at 1.