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Warning: TT: undefined function: 32ANALYSIS OF FINANCIAL STATEMENTS 1Oriol Amat1 Based on the book Análisis integral de empresas, Profit, Barcelona, 2018. Introduction Introduction Parts of company analysis Qualitative analysis 1.3. WHO: the entrepreneur, the management team and the people who are p...

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ANALYSIS OF FINANCIAL STATEMENTS1 Oriol Amat

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Based on the book Análisis integral de empresas, Profit, Barcelona, 2018. 1

1. Introduction 1.1. Introduction 1.2. Parts of company analysis 1.3. Qualitative analysis 1.3.1. WHO: the entrepreneur, the management team and the people who are part of the company 1.3.2. WHAT does the company do? Strategic aspects 1.3.3. HOW does the company do it? Operational aspects 1.4. Life cycle of companies 1.5 Reasons for failure 1.6. Conclusions 2. Financial statements 2.1. Introduction 2.2. Balance sheet 2.3. Profit and loss account 2.4. Statement of changes in equity 2.5. Cash flow statement 2.6. Valuation rules 2.7. Notes 2.8. Management report 2.9. Auditor’s report 2.10 Examples 2.11 Accounting manipulation 2.12. Conclusions 3. Analysis of the balance sheet 3.1. Introduction 3.2. Indebtedness 3.3. Short-term solvency 3.4. Collection and payment terms 3.5. Asset management 3.6. Forecasting insolvency 3.6.1. Quantitative models to forecast insolvency 3.6.2. Qualitative models to forecast insolvency 3.7. Conclusions

4.Analysis of the P&L 4.1. Objectives of analysis of P&L 4.2. Vertical and horizontal analysis of P&L 4.3. Analysis of the margin per products 4.4. Break-even point 4.5. Analysis of efficiency and effectiveness 4.6. Conclusions

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5. Return and growth 5.1. Introduction 5.2. Analysis of the ability to generate profit 5.2.1. Analysis of sales 5.2.2. Analysis of expenses 5.3 Value creation 5.3.1. Profitability 5.3.2. EVA 5.3.3. Self-financing 5.4. Balanced growth 5.5 Stock exchange ratios 5.6. Conclusions 6. Working capital analysis 6.1. Operating cycle and cash cycle 6.2. How to calculate working capital needs 6.3. Differences between actual working capital and working capital needs 7. Industry analysis 7.1. Industry influences 7.2. Average ratios 7.3. Ideal ratios 7.4. Limitations of analysis using industry data 7.5. Conclusions 8. Analysis of consolidated accounts 8.1. Introduction 8.2. Types of companies 8.2.1. Parent company and subsidiary 8.2.2. Joint-ventures 8.2.2.1. Joint ventures unincorporated 8.2.2.2. Joint ventures incorporated 8.2.3. Associated company 8.3. Consolidated annual accounts 8.3.1. Consolidated balance sheet 8.3.2. Consolidated profit and loss account 8.3.3. Consolidated statement of changes in the equity 8.3.4. Cash flow statement 8.3.5. Consolidated management’s report 8.4. Ratios used when analyzing consolidated accounts 8.5. Conclusions

9. Analysis with inflation 9.1. Impact of inflation on accounts 9.2. Partial measures to deal with the consequences of inflation in the accounts

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9.3. Methods to adjust accounts for inflation 9.4. Conclusions 10. International analysis 10.1 .Introduction 10.2. Subjects in which the main international accounting differences occur 10.3. IFRS and international accounting standardization 10.4. Conversion of annual accounts in foreign currency 10.4.1. Closing exchange rate method 10.4.2. Monetary/non-monetary method 10.5. Country risk 10.6. Conclusions 11. Integration 11.1. Introduction 11.2. Pyramids of ratios 11.3. Preparing the financial control report 11.4. Addressing financial problems 11.5. Writing a financial analysis report 11.6. Conclusions

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1 Introduction

Objectives This chapter aims to help understanding the following subjects: ― Objectives of company analysis ― Parts of the analysis: SWOT (Strengths - Weaknesses - Opportunities - Threats), cause-effect diagram and recommendations. ― Qualitative elements that affect company success: WHO - WHAT - HOW Who leads and is part of the organization? What does the organization do? How does it do it?

1.1. Introduction A business company is analyzed to assess its history, as well as its present situation and future perspectives so the right decisions can be made regarding the organization. This analysis is not only in the best interest of the company's management, but also for anybody somehow related to it, such as banks, shareholders, employees, trade creditors or competitors. Knowing the company better allows for better performance in reaching objectives, whether they are to make more money, provide better quality products and services or contribute to a better world. An accurate diagnosis of the company's situation facilitates the implementation of the right measures required to correct weaknesses and future threats as well as the reinforcement of strengths in reaching objectives. 1.2. Parts of company analysis A thorough analysis of a company may include the following parts: ― Economic situation and perspectives: before starting to analyze a business organization, it is convenient to have a clear idea of the general situation of the economy and its perspectives, since these aspects have a strong influence on the present and future evolution of any organization. The subjects to be studied are the following: ― Gross Domestic Product: it provides information concerning levels of activity, that is, the possibility of economic recession or expansion.

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― Unemployment rate: it helps visualize economic tendencies and may anticipate how easy or how hard it may be to find employees. ― Interest rates: the cost of financing, if not very high, may foster economic growth. However, when interest rates are high, economy slows down. ― Consumer Price Index: it may influence the level of profitability, mostly when increments in expenses may not be passed on via prices. ― Exchange rates: the evolution of exchange rates may influence exports and imports. ― Level of activity in industries that are engines of the economy, such as housing, cars, tourism and so forth. ― Credit risk: bad debts in credit institutions, evolution of unpaid obligations and so forth. When we have a clear idea whether we are in recession or in an economic bonanza time, or whether the general situation is likely to worsen or to improve in the near future, we may begin to analyze the situation of the company. ― SWOT (Strengths - Weaknesses - Opportunities - Threats): analyzing the situation of a company provides information about its strengths and weaknesses. The latter are to be corrected for the company to avoid serious problems that may limit evolution or even cause shutdown. Examples of weaknesses would be the lack of money, excessive expenses or insufficient sales. Strengths are those features that may be used to face the future with better chances of success. Examples of strengths would be having cash surplus, good service quality, high employee motivation, good manufacturing infrastructures, highly-demanded products and an excellent image among trade debtors. The study of weaknesses and strengths is complemented with an analysis including industry and market to identify threats and opportunities. Threats (new competitors, market globalization, and difficulty to find qualified labor, or new regulations that may hinder the organization) represent dangers at close range that should be confronted with the help of opportunities. Examples of opportunities are an increased demand due to changes in the market, or a potential launching of new products and services based on company synergies. The SWOT analysis may be based solely on annual accounts or on all kinds of information about the organization. In the first case we need balance sheet analysis techniques; in the second, we will have to analyze all company areas, so as not to limit the study to just capital, financial and economic aspects. This book will deal mainly with the techniques used when analyzing a balance sheet. In this introductory chapter, however, we will also refer to a more general view of company analysis. ― Cause-effect diagram: Once we have the list of strengths-weaknesses-opportunities-threats, it is useful to represent them using the so-called cause-effect diagram. It begins by identifying the main strong and weak points that affect other areas of the company. For example, if a company's products are hardly competitive due to a lack of an adequate innovation policy and, on top, the company has excessive expenses, it may incur losses. If financing comes from 6

a be forced into excessive short-term debt, thee company may not be able to honor payments and suspending them. The cause-effect diagram for this example could be the onne shown in figure 1.1. This diagram is read fro m the top down; however, later on we will see other examples of diagrams arranged from the b ottom up.

Figure 1.1. Example of a cause-effect diagram ― Recommendations: Once the cause-effect diagram is drawn, it will be easy to issue recommendations that may soolve main weaknesses. It is a question of fightingg threats and using opportunities in good time. Foor example, according to figure 1.1., some of the recommendations could be the following: ― Bad innovation policy: invvest in innovation in order to achieve competitive products. ― Insufficient sales: elaborat e a new marketing plan in order to have more sales. ― Excessive debt: increase caapital or sell assets to reduce debt and financial exxpenses. ― Excessive expenses: analyyze all expenses with the aim to find those sussceptible of being reduced without hurting comppany quality. If these recommendations are effective, benefit will grow and debt can bbe honored, which means the danger of suspendi ng payments will be avoided. Recommendations should be as specific as possible, because this allowss quantification to show convenience and impactt. Using the previous example, quantification cou uld be as follows: ― Invest 300,000 euros in inn novation to achieve competitive products. ― Invest 200,000 euros in proomoting and advertising in order to raise sales by y 10%. ― Increase capital by 100,0000 euros and sell for 400,000 euros a building the company does not need to perform its activity. ― Excessive expenses: reduce overheads by 15%. nience of recommendations: The last part of the analysis is to ― Demonstrate the conven demonstrate that the recomm mended proposals will allow the company to impprove its situation 7

and reach its objectives more easily. This implies quantifying the foreseeable effects of the recommendations on the company's profitability and solvency. Figure 1.2. presents the components of company analysis.

Data collection and analysis

SWOT

Recommendation proposal

Cause-effect diagram

Demonstrate recommendation convenience

Figure 1.2. Company analysis process 1.3. Qualitative Analysis As mentioned before, this book is devoted to the analysis of financial statements. However, some other considerations that are also useful for a more global analysis of the company have been included in this introductory chapter. A frequently asked question when analyzing business organizations concerns the difference between companies that succeed and those that fail. Experience identifies qualitative factors (as well as strategic and operational) that increase the possibilities to succeed in a business project. These qualitative factors are related to WHO (that is, the people), WHAT the company does and finally, HOW it does it. 1.3.1. WHO: the entrepreneur, the management team and the people who are part of the company There are success factors closely related to the entrepreneur, the management team and all the other people who cooperate with the company. They may be the following: ― Degree of participation in the project. Entrepreneurs and directors in successful companies are characterized by a full participation. For them, the company is part of their life project. This degree of participation often requires 50-hour weeks. The rest of the actors are not expected to devote so much time, but the more the better. ― They have an adequate training level. Consequently, recruitment processes and training plans are adequate, because hiring and training personnel is considered a fundamental investment. ― They have enough knowledge of the industry. Since they are fully devoted to their project and have expertise in the industry, they may detect competitive advantages to make the company better than its competitors. 8

― Managerial skills. They know how to listen, lead meetings and negotiate well. ― They are people with a remarkable level of humility, considering the success they have achieved. This humbleness favors a better relationship with subordinates, trade debtors and trade creditors. ― Another common feature is that whenever problems appear (and they always do), successful entrepreneurs and company directors do not put the blame on external factors. This attitude facilitates finding solutions to the problems. ― They are optimistic by nature and also good organizers. They know how to get the best out of their subordinates and available resources. ― This means they show remarkable leadership and walk the talk. As a result, their subordinates follow them. ― They are also people who decide on long-term objectives and make decisions thinking about the future and not about immediate profit. ― They have adequate incentives to motivate everybody working for the company. ― They promote a good working climate and low absenteeism levels. To assess these aspects concerning the people requires knowing them and asking others who may also know them (banks, trade creditors, trade debtors). Some of the main virtues found in management team members often become important defects. For example, a highly-devoted participation in the company's business may mean overlooking other important subject, such as family life or even personal health. It is not uncommon for entrepreneurs to become obsessed with the company. This means the big challenge they face is to find balance between how much time they have to devote to the company and their family and personal life. 1.3.2. WHAT does the company do? Strategic aspects There is a second group of aspects to be considered when assessing the qualitative elements that is closely related to WHAT the company does. ― Industry in which the company develops its activities. Some industries have great future potential, for example those related to services supplied to people (healthcare, old people's homes, boutique hotels, training) or business organizations (logistics) or the Internet (travelling, training). Other industries, however, face more hardships. For example mining, automotive parts or textiles. There are also industries more affected by economic recession than others (housing, tourism, airlines, car industry). It will be easier for a company to succeed if they develop their activity in an industry with clear future perspectives in which competitiveness is not too strong.

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Some of the aspects to take into account in order to asses an industry and its perspectives include information about sales in physical and monetary units, competitors evolution, or market share. ― Barriers to entry: industries in which barriers to entry are high are more interesting for those companies seeking entry, since it will be difficult to have new competitors. Examples of barriers to entry are patents, technology, necessary capital, distribution network. ― Geographic markets in which the company does business: the bigger the geographic diversification, the more the risk is diminished. However, the company must have adequate control of its operations in the different markets. ― Products and services provided by the company: stages of the life cycle the company's products are going through (introduction, growth, maturity and decline). This information tells if the company succeeds at innovation and if there is enough demand for the product, now and in the future. It is also useful to have information about orders. ― Strategic plan: objectives to reach in the medium and long-term as well as the plan to achieve them. It is not enough to have a good strategic plan; what characterizes successful companies is that they make an adequate implementation of their strategic plan. ― Dependencies: the absence of dependencies related to trade debtors, trade creditors, climate, technology, banks and any other type is another feature that contributes to the long-term life of the company. To depend excessively on something or someone may put the life of the company at risk when there is a problem. For example, if a client represents over 20% of sales and for whatever reason the company loses this client, survival will be hardly possible. ― Power to negotiate with trade debtors, trade creditors, banks, employees: the power to negotiate is a key element to develop future performance. ― Competitive advantages: all the previous information should help identifying competitive advantages for the company, whether in costs, image, prestige, quality, design, product differentiation or proximity to the client. 1.3.3. HOW does the company do it? Operational aspects There are also operational aspects included among the features that separate successful companies from failing ones. We are basically referring to subjects such as processes, trade debtors and finance: ― Processes: excellence in processes (whether in innovation, purchases, manufacturing, total quality, logistics, commercialization, post-sale services or administration) requires different elements, such as striving for total quality, innovation and flexibility. ― Trade debtors: the previous features should provide higher client satisfaction and loyalty; in other words, higher sales.

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ompany succeeds in subjects just as the ones meentioned before, it ― Finance: if the co will generate satisfacctory financial results. This requires efficient aasset management (thanks to making a better use of them) and an increment in proffits (thanks to an increase in sales and a reduction in expenses). It should all be reflected d on increments of generated wealth. The key factors presented so far may be represented in a diagram as the onne shown in figure 1.3., considered to be a strateegy map, a concept used when creating a balanced scorecard for a company. The figure illustrattes several cause-effect relationships among key factors related to people and the HOW (processses, customers and finance). Hig gh value creation

Growth capacity

Profitability

Solvency

Leverage

Fina ance Return

Profit reinvestment

Profits

Sales

Clients Satisfied customers

S Sales of new products

Exports

Product diversification

Internationalization

Processes Efficiency in costs TTotal quality and assets

Training

Incentives

Innovation

Client―oriented

Personnel participation

People

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Figure 1.3. Example of cause-effect relationships in successful companies.

The following list includes the minimum data required to know a company well. ― Industry: ― Industry situation and perspectives ― Situation and movements of main competitors ― Background and legal data: ― History ― Company headquarters and branches ― Statutes ― List of shareholders ― Members of the company's highest authorities (board of directors, board of trustees, governing council) ― Participation in other companies ― General aspects: ― Strategic plan: objectives, action plan ― Company founders profiles ― Company culture ― Organizational chart and highest positions ― Contracts with other companies ― Innovation, manufacturing, logistics and quality: ― Research and development ― Ability to market new products ― Manufacturing process ― Productivity ― Productive capacity being used ― Equipment conditions ― Assessment of fixed assets by independent expert ― Raw materials, components and trade creditors ― Outsourcing

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― Maintenance ― Total quality: prevention and evaluation activities ― Non-quality: errors, claims ― Actions concerning prevention and quality assessment ― Errors and costs due to bad quality ― Investments and actions concerning the environment ― Logistics costs ― Delivery terms ― Marketing and sales ― Marketing plan ― Prices, disc...