Operational finance

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calculated as net income/sales. Look at its evolution and compare it with the industry average.

c) Return on equity (ROE) calculated as net income/previous year’s equity. ROE gives you an indication of how profitable the company is for shareholders. The mínimum ROE should be at least the cost of debt or return that lenders obtain when lending money to the company. The difference between the ROE and the risk-free rate is called the risk Premium.

You may also look at the return on net assets (RONA) calculated as EBIT/net assets. This ratio gives you the return of the assets as if they were financed solely with equity.

6. Finally look at the risks of the P&L. The risk of a company has two components:

a) Operational risk, or how sensitive is your EBIT to changes in sales, margins and opex.

b) Financial risk, or how big your financial expenses are, compared to EBIT. In other words, how close you are to losses due to financial expenses

Important comment

Look directly at the big numbers: sales, margin%, and opex%. With these three numbers only you may have a clear analysis of the P&L. At the end of your analysis youneed to answer these questions: Is the company profitable? Will you invest your money in it? How risky is the company?

1.4 Main concepts in the balance sheet

Current assets (CA): assets that come from current operations.

o Cash: current accounts in the bank, and marketable securities.

o Receivables: notes representing money that the customers owe to the company.

o Inventory

They may vary greatly from year to year depending on the company’s comercial or manufacturing policies.

Fixed assets net (FA): Every company requires a mínimum of investment in buildings, plant, machinery, furniture, computers…These assets usually do not change very much from year to year..

The liabilities and equity side of the balance sheet tell us who is financing the company. We may distinguish three main groups: spontaneous funds, debt, and equity.

Spontaneous funds (SF): provide cost-free financing that the company receives without any explicit cost or interest to pay.

o Payables or money owed to suppliers due to purchases on credit.

o Other liabilities such as: tax deferred, or money owed to tax authority

Short-term debt (STD): Typically a line of credit or any other short-term debt with the Banks

Long-term debt (LTD): financing negotiated with the Banks with long term maturity and paying interest.

Equity: monies invested by shareholders plus the retained earnings from previous years.

Summary

Any company invests solely in current assets and non-current assets. The only sources of money are: spontaneous funds, debt and equity.

Need of funds for operations (NFO)

NFO are the funds required to finance a company’s operations. If you operate, you may have to invest money in:

o Receivables – since you sell but do not get paid immediately

o Inventory or future sales

o In some cases, you may need to maintain mínimum cash or cash necessary for operations.

Your operations will help you to finance part of these current assets since you will have:

o Payables, you purchase but do not pay immediately. Your suppliers help you to finance your operations.

o Other SF such as: accrued expenses, deferred taxes, etc.

NFO is a “use of funds” and it must reside on the assets side. N fact, we may Split the assets of any company in two main components: FA and NFO

FA plus NFO = NA

FA requires strategic decisions to be taken . NFO requires no decisión by top management and come directly from the company’s daily operations.

Any change in your customer credit policy will have an effect on the balance sheet, namely, change in your NFO and therefore, in the amount of financing required.

WC is current assets minus current liabilities and this includes the credit which is not included in the NFO. In fact, we calculate the NFO to know how muche credit we will need.

The main purpose of the operational finance is to see the financial consequences of operational decisions, in other words, to calculate the changes in NFO resulting from operational decisions.

NFO is directly related to sales since all its components are related to sales. The NFo will follow the same pattern as