BUSINESS SIZE-UP OVERVIEW Two purposes: • Understanding the past • e.g. are inventory levels consistent with production process? • e.g. are accounts receivables consistent with credit terms? • Predicting the future: • External and internal examination of key success factors and capabilities • Used in conjunction withquantitative analysis (e.g., projected financial statements or projected cash flows)
BUSINESS SIZE-UP FRAMEWORK • Internal (firm) factors • Operations • Management • Marketing • Past financial performance • liquidity • profitability • capacity • asset management • External factors • economy • industry • Future financial performance • key success factors? • firm capabilities? • Implications for financing
EXTERNAL SIZE-UP: ECONOMY • “Business cycle”? • In a recession, inventories and accounts receivable grow relative to sales, profit margins and cash flows decline and lenders pay more attention • Future interest rates? • Depend on default risk, interest rate risk and inflation • Government? • Taxes, regulations, assistance programs • Implications for the future: key economic variables?
EXTERNAL SIZE-UP: INDUSTRY • Size, growth and profitability of industry? • Competition? • Ease of entry, pressure from substitute products, bargaining power of buyers/suppliers, existing rivalries • Competitive strategies? Low cost producer or differentiated products? • Opportunities/risks • Political, economic, social, technological • Implications for the future: key success factors for industry?
INTERNAL SIZE-UP: OPERATIONS • Cost vs. quality? • Process? • Job shop, line flow or project • Plant and equipment? • Capacity, scheduling • Inventory? • Raw material, work in progress and finished goods • Workers? • Skills, training, rewards, labour relations • Implications for the future: supply risk?
INTERNAL SIZE-UP: MARKETING • Consumer analysis: needs, buying process • Marketing mix: • Price • discounts and allowances, credit terms • Promotion • advertising and promotion • Product • features, quality, service, warranties • Place (distribution channels) • Implications for the future: demand risk?
INTERNAL SIZE-UP: MANAGEMENT • Experience of key personnel • Focus and drive • Character • Leadership • Strategy • Implications for the future: capabilities?
INTERNAL SIZE-UP: FINANCE • Liquidity • Efficiency • Profitability • Capacity • Implications • From the past: financial health? • For the future: profitability and financing needs
FINANCIAL SIZE UP: RATIOS • Examine relation between numbers in the income statement and balance sheet • Usefulness: • Compare to internal targets (e.g. accounts receivable management) • Consider trends for a given firm • Compare to industry and / or comparable firm
FINANCIAL SIZE UP: LIQUIDITY • Current ratio • can short term claims be covered by liquid assets • Acid test or quick ratio • exclude inventories and prepaid expenses Current Assets Current Liabilities Cash + S.T. Securities + Accounts Receivable Current Liabilities
FINANCIAL SIZE UP: LIQUIDITY • Collateral analysis • Compute value that could be obtained in liquidation • Can obligations be met? • Typical recovery rates • Cash 100% • Accounts receivable 75% • Inventory 50% • Land Market value • Other fixed assets 20%
FINANCIAL SIZE UP: EFFICIENCY • Accounts payable turnover (days) • Accounts receivable turnover (days) • Inventory turnover (days) Accounts Payable Purchases / 365 Accounts Receivable Net Sales / 365 Ending Inventory Total Cost of Goods Sold / 365
FINANCIAL SIZE UP: PROFITABILITY • Sales growth • Net profit margin • Gross profit margin Year ‘t’ Net Sales -1 Year ‘t-1’ Net Sales Net Income (after tax) Net Sales Gross Income Net Sales
FINANCIAL SIZE UP: PROFITABILITY • Return on assets (ROA) • could substitute earnings before interest and taxes for net profit (removes effect of “capital structure”) • Return on equity (ROE) • equity includes preferred stock, minority interests and retained earnings Net Income (after tax) Total Assets Net Income (after tax) Net Worth
FINANCIAL SIZE UP: CAPACITY • Debt to assets • Debt to equity • Interest coverage • ability to meet interest payments out of recurring profits Current liabilities + Long-term debt Total Assets Current liabilities + Long-term debt Net Worth Earnings before interest and taxes Interest expense Net income before taxes + interest expense = Interest expense
OVERALL SIZE-UP IMPLICATIONS • Opportunities • what is critical to success? • does firm have capabilities? • impact on future financial requirements? • Risks • Business risk: • focuses on Earnings before Interest and Taxes (EBIT)? • Financial risk: • focuses on capital structure (debt versus equity)