Financial Structure, Profitability, and Solvency Analysis
Item 8: Financial Structure and Analysis of Balances
Profitability Analysis
The profitability of an investment measures the relationship between the benefit and the resources used to obtain such a benefit. There are two types of profitability: economic and financial.
RE = Return on Equity
RF = Return on Assets
RE = Profit / Assets
RF = (Profit – Interest on Debts) / Equity
The company’s goal is to maximize performance for its owners. The most attractive profitability for investors is the financial return, as it measures the benefit to the owner in comparison with the resources risked by the owner.
Relationship Between RE and RF
RE – RF = (RE – k) * (Debt / Equity)
Where:
- Equity = Capital and Reserves
- k = Average cost of debt
- Debt/Equity measures the ratio of debt to equity, or the firm’s capital structure.
- When RE is greater than k, the greater the RF.
- When RE is less than k, the lower the RF.
Profitability Analysis
RF depends on three factors: RE, the cost of debt (k), and the debt ratio.
- The larger the k, the lower the profitability.
- k is a variable that can multiply our gains, but also our losses (leverage effect), depending on the factor (RE – k).
- The higher the RE, the greater the RF.
Important Formulas in Profitability
RE = Profit / Assets
RF = (Profit – Interest on Debts) / Equity
Profit Margin = Profit / Sales
Leverage = Assets / Equity
Asset Turnover = Sales / Assets
Average Cost of Debt = Financing Costs / Total Debts
Fixed Asset Turnover = Sales / Fixed Assets
Current Asset Turnover = Sales / Current Assets
Solvency Analysis
The main function is to achieve a balance between profitability and solvency.
- Fixed assets should be financed by permanent capital.
- Current assets should be financed with short-term debt. However, a portion of current assets should be financed by permanent capital. More specifically, a portion of the realizable assets should be funded by permanent capital, and this would be the working capital.
Working Capital
Working capital is the part of the assets financed with permanent capital (equity + long-term debt), and is equal to the difference between current assets and current liabilities. Long-term debt should finance all fixed assets, and part of the current assets must finance the available assets over the short-term.
Important Formulas of Solvency
Financing of Fixed Assets = Fixed Capital (Equity + Long-Term Debt) / Fixed Assets (a value greater than 1 is desirable)
Financing of Current Assets = Current Liabilities / Current Assets (a value less than 1 is desirable)
Total Solvency = Total Assets / Total Liabilities (must be greater than 1 to avoid bankruptcy)
Short-Term Solvency = Current Assets / Current Liabilities (must be greater than 1 to pay immediate debts)
Cash Ratio = Cash / Current Liabilities (used to compare one year with another)
Item 9: Working Capital and Average Maturity Period
Working Capital
Working capital can be defined as:
a) The difference between current assets and current liabilities: WC = CA – CL
b) The part of current assets that is financed by permanent resources: WC = Permanent Capital – Fixed Assets
The working capital must be positive. Otherwise, it would mean that current liabilities are financing fixed assets. This imbalance between asset liquidity and debt enforceability could lead to suspension of payments.
This process can be broken down into four sub-periods:
- Dm: Average time raw materials remain in the warehouse
- Df: Average period of manufacture
- Dv: Average sales period
- Dc: Average collection period from customers
D = Dm + Dv + Df + Dc – Dp (suppliers)
Rotations and Average Balances
- Sm: Average balance of raw materials
- M: Annual consumption of raw materials
- Sf: Average balance of work-in-progress
- F: Cost of production
- Sv: Average stock of finished goods
- C: Cost of sales
- Sc: Average balance of customers
- V: Sales
- P: Total volume of purchases from suppliers
- Sp: Average balance of suppliers
a) Number of times during the year the stock of raw materials is renewed:
rm = Annual Consumption of Raw Materials / Average Annual Stock of Raw Materials = M / Sm
Number of days that the stock is in the warehouse:
Dm = 365 / rm = (365 * Sm) / M
b) rf = Cost of Production / Average Stock of Products During Production = F / Sf
Df = 365 / rf = (365 * Sf) / F
c) rv = Cost of Sales / Average Stock of Products = C / Sv
Dv = 365 / rv = (365 * Sv) / C
d) rc = Sales / Average Balance of Customers = V / Sc
Dc = (365 * Sc) / V
e) rp = Purchases from Suppliers / Average Balance of Suppliers = P / Sp
Dp = 365 / rp = (365 * Sp) / P
Average Maturity Period: The amount of time that inventory or commodities spend in the store, plus the time spent in the manufacturing process, plus the time it takes for finished products to be sold, plus the time it takes for customers to pay, minus the time it takes to pay suppliers.
D = Dm + Dv + Df + Dc – Dp = 365 * (Sm / M + Sf / F + Sv / C + Sc / V – Sp / P)
Treasury
Treasury, or cash flow, measures the company’s ability to meet immediate payments. The purpose is to anticipate future treasury needs by estimating inflows and outflows so as not to generate significant misalignments.
Variations in treasury at two different times may be due to:
- Operating cash flow: Cash inflows (receivables) or outflows (payables)
- Non-operating cash flow: Cash outflows (repayment of long-term debts) or cash inflows (increased equity)
Benefits of Having a Good Treasury Balance
- Ability to obtain supplier discounts for cash payment
- Good reputation for the company
- Better ability to address possible emergencies and cyclical recessions