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File: DFHB MOD04 TOP01

Module 4 - Topic 1: Who wins? Returns


0:08 Welcome to our fourth and final module, assessing
0:12 financial performance.
0:14 So in this module we're going to bring everything together
0:18 and look at various tools and techniques that can be used to
0:22 assess the financial performance of a business.
0:27 Ratios are typically used to measure the performance of the
0:32 financial [INAUDIBLE] of a business.
0:35 But ratios shouldn't be used in isolation.
0:39 They can be a great help, but just referring to one part of
0:43 the business and not how everything fits together,
0:48 doesn't make them as useful as they can be.
0:51 And so I want to work you through this in these very
0:53 first topic where we look at two firms, some simple
0:57 financial information, and I ask the question, who wins?
1:02 Meaning who's performing best?
1:04 Let's presume the two firms are similar in terms of the
1:08 sector that they operate in.
1:11 So I've got two firms.
1:13 Let's call them A and B. And the first thing we ask is,
1:20 what revenues are they generating?
1:23 So let's suppose that firm A is generating revenue of $100
1:27 million and firm B is generating
1:31 revenue of $130 million.
1:34 So just looking at revenues alone we come to the
1:38 conclusion that B wins, because B is generating more
1:44 revenue than A.
1:46 But of course revenue in isolation doesn't tell me
1:49 anything about the size of the business or the size of the
1:53 assets that the business has.
1:55 So let's bring together revenue and assets.
1:59 And you notice I'm looking at a profit and loss item,
2:02 revenue; and I'm looking at a balance sheet item, assets to
2:06 assess the performance of those assets.
2:08 Are they generating sufficient revenue?
2:11 So suppose A is also generating $100 million in
2:16 revenue from $100 million in assets.
2:20 B, however, carries assets of $150 million.
2:25 So if we look at assets in isolation,
2:29 we'd say B wins again.
2:31 Because B has more assets than A. But what we need to do is
2:37 link revenue and assets to see which of the businesses is
2:40 generating the best revenue per dollar of assets.
2:44 So if I divide assets into revenue we'll see that for A
2:52 we get a one-to-one relationship.
2:54 For every $1 in assets, there's $1 in revenue.
2:59 For B, for every dollar in assets, is
3:02 about $0.87 in revenue.
3:07 So actually on the basis of the performance of
3:09 the assets, A wins.
3:13 Because A is generating more revenue per dollar of assets
3:17 than B. So perhaps B has acquired some assets that are
3:21 not yet performing well enough.
3:22 Perhaps there's capacity in those assets, perhaps it's a
3:25 plant that has some unused space.
3:28 Perhaps B's building up some current assets--
3:32 inventory, stock, receivables, that are not generating any
3:35 profits for the business.
3:37 But let's not stop there.
3:40 What about the profitability of the two firms?
3:45 So A might be generating more revenue per dollar of assets,
3:51 but what about its profits?
3:53 So let's suppose A is generating
3:55 $10 million in profits.
3:58 And B is generating $14.3 million in profits.
4:04 So just based on profits alone, again, B wins because
4:10 it has more profits than A.
4:13 But what about the profit margin?
4:15 And we saw that earlier, is the profits of the business
4:19 divided by the revenue.
4:23 There's a second ratio that will help us
4:25 tell the story here.
4:26 And here it is.
4:27 The profit margin for A is 10 divided by 100, so 10%.
4:34 Whereas the profit margin for B, 14.3
4:39 divided by 130, or 11%.
4:43 So now B wins, because it's generating a higher profit
4:47 margin than A.
4:49 So are you confused?
4:52 You probably should be.
4:53 Because we really still can't come to a conclusion, who wins
4:56 or who's performing best.
4:58 A is generating a better amount of revenue per dollar
5:04 of assets that it has.
5:06 B is generating a higher profit margin.
5:10 So it's making more profits per dollar of
5:12 revenue that it has.
5:14 So if we have to decide which is performing best, we can do
5:18 a very simple thing.
5:21 Let's take those two items and multiply them together.
5:25 So let's take what we've called asset utilisation which
5:31 was revenue divided by assets and multiply that by the
5:38 profit margin, profit divided by revenue.
5:44 And when we do that, we get our return on assets.
5:51 And for A and for B, what are the results.
5:56 Well for A, the asset utilisation was 100% percent
6:01 and its profit margin was 10%.
6:04 Multiply one by the other and the return on
6:08 assets for A is 10%.
6:11 Let's check B. It wasn't performing as well, around
6:15 87%, on asset utilisation.
6:18 But it had a higher profit margin, 11%.
6:22 Multiply one by the other and we get a return
6:25 on assets of 9.5%.
6:28 There's a lot more things for us to look at on these two
6:30 firms, and in the next topic we'll look at risks in those
6:35 two businesses.
6:36 But using this simple relationship here, we can at
6:39 least come to our first conclusion.
6:42 The benefits of higher asset utilisation in A are more than
6:47 offset, or more than offsetting the higher profit
6:50 margin in B. So A, at this stage, is winning.
Module 4 - Topic 2: Who wins? Risks
File: DFHB MOD04 TOP02

0:08 In this topic, we continue to investigate the performance of


0:13 businesses by comparing our two hypothetical businesses,
0:16 firm A and firm B. So have a look at the information on the
0:20 screen, pause it for a few minutes and then come back to
0:24 me, and we'll talk about a new aspect of information with
0:28 respect to the two firms.
0:40 So how did you go looking at the two firms?
0:42 You'll notice that I put some more information in about the
0:44 businesses.
0:46 First of all, this time, I'm including information on how
0:52 the balance sheet assets have been financed.
0:55 So you'll notice that in firm A, there is no debt and $100
1:02 million in equity.
1:04 So in other words, all of A's assets are financed by the
1:09 owners, or the equity.
1:12 With b, half of the assets are financed with debt, and half
1:17 of the assets are financed with equity, or owner's funds.
1:23 So what does this mean?
1:24 Well, we may conclude that there's a new element of risk
1:30 in our assessment.
1:32 And this type of risk we could call financial risk.
1:36 And it reflects the way the assets are being funded.
1:41 So B carries a lot more debt that A. Well, in fact, A has
1:45 no debt in this case.
1:48 So what does that mean?
1:49 Well, it means we can't just look at
1:51 the assets in isolation.
1:52 We need to look at how those assets are being financed and
1:56 what are the implications in terms of these future
1:58 obligations.
1:59 And clearly, B must repay that debt at
2:02 some time in the future.
2:06 If we take a look at the ratio of debt to assets, it's a nice
2:10 easy way to measure this exposure.
2:13 We see that in A, it's 0.
2:17 And in B, 50% of the assets are financed by debt.
2:23 So half of the pie, the assets, is financed by future
2:26 obligations to lenders, or bankers.
2:31 Let's measure the return on equity for the business.
2:34 This is the return that the owners get.
2:37 And we get the return on equity by taking the profit
2:41 and dividing by the equity on the balance sheet.
2:46 And for A, the return on equity, $10 million in
2:49 profits, divided by $100 million in equity gives a
2:53 return on equity of 10%.
2:56 In B, notice profits of 14.3 divided by equity of 75 gives
3:07 a return on equity of about 19.1%.
3:12 So the owners in B are getting a much higher return than the
3:17 owners in A. And we might start to think that means B is
3:21 performing better.
3:23 Not entirely because we just saw a moment ago that B is
3:27 taking on more risk than A in terms of the debt that exists
3:32 on its balance sheet.
3:33 So it's not so easy just saying the business generating
3:36 the highest returns is necessarily the
3:39 better-performing business.
3:41 We need to take into account factors such as a risk, and,
3:44 in this case, the financial risk, the debt
3:46 on the balance sheet.
3:48 So what you need to know is that the more debt that a firm
3:52 has on its balance sheet, the higher the return that owners
3:56 will get, all else equal.
3:59 It doesn't necessarily mean the owners are doing better
4:01 because they must also ensure that their firm repays that
4:06 debt first.
4:07 They wont' get any dividends until that debt's been paid.
4:11 So there are larger future obligations in B relative to
4:14 A.
4:16 But it even gets more complicated because what if I
4:19 said to you, A has a higher business risk than B?
4:26 So financial risk was referring to how much debt the
4:30 business has on its balance sheet.
4:33 So what if A and B are in different sectors and A has
4:40 been determined to carry more risk, business risk, than B.
4:44 So suppose it faces stiffer competition from competitors.
4:48 Suppose it's more exposed to movements in commodity prices
4:53 or currencies?
4:55 So its revenues, and its profits, are more unstable,
4:58 more volatile, more variable.
5:01 So now we have even more interesting aspects to the two
5:05 firm's performance to consider.
5:08 B has more financial risk.
5:11 A has more business risk.
5:14 How do these two things settle out, or pan out?
5:20 There's no easy way to answer the question.
5:23 But we know what happens in share markets.
5:27 We ask the question, what return do the shareholders, or
5:31 the owners, want from the business?
5:35 And let's take the case of A. We saw the return on equity.
5:38 That's the return to the owners are actually
5:41 getting, was 10%.
5:44 But if we say they require a return of 9%, given the nature
5:52 of the business, then this is a good situation because the
5:55 owners are getting a higher return than
5:57 what they would want.
5:58 If they don't get a higher return, some may sell their
6:01 shares or part of the business.
6:04 Is they require an 11% return, and they're only getting a 10%
6:08 return, the shareholders or owners might not be happy.
6:13 Now it's not for this subject to go into details about how
6:17 we work out what return shareholders require.
6:20 But what we can say is this.
6:22 If it was a supermarket, and we compare it to an airline,
6:27 we can say the shareholders or owners of a supermarket chain
6:30 would probably require a lower return than those in an
6:33 airline, simply because the risk, or the business risk, in
6:38 a supermarket is much lower than that in an airline.
6:42 People buy milk, and bread, and eggs whether it's boom or
6:46 recession, summer or winter.
6:49 But with an airline, boom, we might see people travelling
6:53 overseas, doing business, having holidays, more cargo,
6:57 going across to other countries.
6:59 But in a recession, that should slow down.
7:02 We'll leave that at this topic.
7:03 And in the next topic, look at A and B again and ask who's
7:07 winning in terms of the cash position of the two
7:11 businesses.
Module 4 - Topic 3: Who wins? Cash
File: DFHB MOD04 TOP03

0:07 In this topic, we continue our investigation of the


0:10 performance of firms A and B, but with some more information
0:14 on the cash flow position of the two businesses.
0:17 So have a look at the information on the screen,
0:19 pause it for a few minutes, and then come back to me.
0:31 So the new information that I put into the table is here,
0:36 the cash flow information.
0:38 So I've added the cash flow from operational activities,
0:41 something we looked at in the previous module.
0:44 And you'll see that, for firm A, there's $10 million in cash
0:48 flow from its operations Firm B, $11.7 million.
0:53 So, on the surface, B is generating more cash from its
0:57 core, from its operations, than A.
1:01 That doesn't necessarily mean B is doing better.
1:04 Let's look at the percentage of the cash flow from
1:10 operations coming from the revenue of the two businesses.
1:15 So let's divide the cash from operations by the revenues of
1:19 the business, and we see for A, 10%.
1:23 Meaning, for every dollar in revenues, there's 10% in cash
1:27 being generated from the core business.
1:31 For B, 11.7 divided by $130 million in revenue.
1:37 Only 9% returns.
1:40 So for every dollar in revenues, only $0.09 in cash
1:44 from operations.
1:45 So while B had more cash from operations, it's not
1:50 necessarily generating as much cash per dollar of revenues.
1:54 And that could point to something we talked about in
1:58 an earlier module.
2:00 And that is, is B holding much larger amounts of current
2:06 assets, or working capital, which we said tend to absorb
2:09 cash out of the business.
2:12 There's a clue in here.
2:14 Have a look at the profits of the businesses, 10 for A and
2:18 14.3 for B. And what do you see?
2:22 10 for A, 14.3 for B. Now line that up with the cash from
2:28 operations, 10 for A and 11.7 for B. So we see, here's the
2:35 profit, here's the cash from operations, and while A has a
2:41 match between the profits and the cash from operations, B
2:46 there's a gap.
2:47 Higher profits, lower cash from operations.
2:50 By the tune of about $2.6 million.
2:55 So what that pinpoints is, there is probably working
2:59 capital sucking cash out of the business.
3:02 A big buildup in receivables, perhaps.
3:05 Perhaps excessive buildup in inventories, or perhaps not as
3:11 much credit from suppliers.
3:14 Let's imagine we went back to the operating cash cycle and
3:17 the funding gap for the two businesses.
3:20 Now here I've just made up some numbers because you don't
3:22 have enough information to be able to do this so far.
3:27 Just suppose you did the calculations based on the
3:30 previous module, and you came up with this information.
3:33 And what do you see?
3:35 Well, for A, 20 days cash tied up in inventory, 10 days cash
3:41 tied up in receivables, a 30 day operating cash cycle.
3:47 For B, 30 days inventory, 40 days receivables, 70 days in
3:53 the operating cash cycle.
3:54 So a 40 day difference.
3:56 So B, clearly, holding stock longer.
4:01 B clearly waiting much longer before it gets
4:04 cash from its customers.
4:07 Then take away the payables, and we see the days payables.
4:10 For A, 30 days is how long A takes to pay its suppliers.
4:15 B also takes 30 days, on
4:17 average, to pay it's suppliers.
4:19 So there is a zero funding gap for A. Meaning A doesn't need
4:24 to be raising debt to finance its operating cash cycle.
4:28 Whereas there's a 40 day funding gap for B. Meaning it
4:32 does need to raise cash to support its operating cycle.
4:36 And that might explain a few things that we saw earlier.
4:41 So do you recall, B had more debt?
4:46 And that lines up with the longer cash flow cycle that it
4:51 has, the more current assets that it's holding.
4:54 B had more revenues.
4:58 And, perhaps, it has more revenues because it's giving
5:01 its customers so much longer time to pay.
5:04 So the higher revenues look good, but it's having
5:07 implications for funding on the balance sheet, and the
5:10 higher cost of interest.
5:13 Also, B may have more current assets than A as a result of
5:19 this funding gap of 40 days, and the longer
5:23 operating cash cycle.
5:24 So that means it also will probably have more total
5:28 assets than A, which we saw when we look
5:31 at the figures earlier.
5:33 So you see how we can line up the numbers to tell a story.
5:37 We integrate across the profit and loss statement, the
5:40 balance sheet, and the cash flow information.
5:43 In the next topic, I'll look at A and B, start at to date,
5:48 and just ask one of the key questions for each of the
5:51 items that an analyst may have in mind.
Module 4 - Topic 4: Knowing the Right Questions
File: DFHB MOD04 TOP04

0:00 [MUSIC PLAYING]


0:08 In this topic, I want to bring together the analysis we've
0:12 done over the last three topics on our firms A and B by
0:17 asking, what are the right questions to ask?
0:23 So let's have a look at the information we've got on A and
0:25 B, and I put in the comments column a question that an
0:29 analyst may ask to decide whether the figure that's
0:33 being seen is good or not.
0:37 So first of all, asset utilisation.
0:39 Asset utilisation--
0:41 revenue of the firm divided by the assets.
0:45 That's an important measure because it says for every
0:48 dollar in assets how much revenue or
0:51 income is being generated.
0:53 And if assets are not being well managed, if there's lots
0:56 of extra capacity in the business, if the firm's
0:59 holding a lot of current assets that it doesn't need,
1:03 we'll see this ratio lower than it might have
1:06 otherwise have been.
1:08 So the question I ask for A. We see that A is performing
1:11 well relative to B, 100% asset utilisation.
1:15 For every $1 in assets, there's $1 in revenue.
1:19 But the question I ask is, is A replacing
1:22 its assets fast enough?
1:24 You may recall that as assets depreciate through time, this
1:30 figure in the denominator comes down.
1:32 The carrying value or the book value declines.
1:36 That will have the impact of increasing this ratio if the
1:40 revenue remains the same.
1:42 So it's very easy to report a high asset utilisation figure.
1:47 Just simply don't replace the assets fast enough.
1:50 And that's not something that we want to see.
1:52 We want a firm to be replacing its assets.
1:55 Remember that those non-current
1:56 assets is its future.
2:01 Let's look at the profit margin.
2:02 And we saw that B had a higher profit margin than A, 11%
2:06 compared to 10%.
2:08 And my question would be, is B deferring important
2:12 expenditures?
2:14 How is it achieving a higher profit margin than A?
2:17 Should the firms be similar in terms of the businesses that
2:20 they're in?
2:22 If you cut back marketing, if you cut back advertising, if
2:26 you cut back on quality control, if you cut back on
2:30 the best employees, you may achieve a higher profit margin
2:34 in the particular measurement period.
2:36 But if we're not spending in the right areas, that may have
2:40 a detrimental impact on future revenues of the business and
2:44 very important when trying to assess the future for the
2:46 business and its health.
2:49 The return on assets.
2:50 We saw that A had a higher return on assets.
2:54 My question would be, what about risk?
2:58 The firm might be generating a higher return on assets, but
3:01 how is that balance sheet being financed?
3:03 Is there a lot of debt?
3:05 Is the debt excessive?
3:07 Are the revenues of the business
3:09 subject to high variation?
3:12 If we look at the first of those questions, we see that B
3:17 carried more debt than A. And my question
3:20 would be, is that excessive?
3:23 So we need to ask questions around benchmarks.
3:26 Do firms of this size and this risk characteristics carry a
3:30 ratio of debt to assets of around that figure?
3:33 If so, then this might be determined to be an
3:37 appropriate level of debt on the balance sheet.
3:40 And we might ask the question, why doesn't A have any debt on
3:43 the balance sheet given debt can be a good funding source
3:46 for a business?
3:49 If the firm has high volatility in its income, then
3:52 50% of the balance sheet funded by debt might be
3:55 considered to be large.
3:57 If it has low volatility in its revenue, like a
4:00 supermarket, it could probably take on more debt.
4:03 With business risk, our example said the business risk
4:07 in A was higher.
4:09 Business risk is a difficult thing to measure.
4:12 We need to take into account specific factors, such as
4:14 exposure to commodity prices, exchange rates, the markets it
4:19 operates in, the strength of the competitors, a heavy
4:23 reliance on one key supplier perhaps, maybe a heavy
4:27 reliance on just a few customers.
4:29 Maybe a heavy reliance on a very big project, and if that
4:33 project fails, the business could go with it.
4:35 So difficult to assess risk, but that's the type of
4:38 questions we might ask.
4:40 Notice the lower risk in B might explain why it
4:45 can carry more debt.
4:47 If it carries lower business risk, then there's less chance
4:50 of the firm having to get into difficulties with respect to
4:54 the repayment of its debt.
4:56 The return on equity.
4:58 Well, we saw that B had a higher return on equity, and
5:02 that was largely attributed to the extra debt it had on its
5:05 balance sheet.
5:06 More debt, less equity, so higher returns on equity.
5:10 And my question is, it's a higher return, but what return
5:15 would the owners want in a business like that?
5:18 If they want a 20% return, then 19% is not enough.
5:22 If they want a lower return, 19% could be an excellent
5:25 performance.
5:27 So investors themselves need to weigh up the risks in the
5:29 business and decide whether they're getting an appropriate
5:33 return for the risks they're taking.
5:35 The cash flow position.
5:37 We saw that B was generating less cash from operations per
5:43 dollar of revenue than A, $0.09 relative to $0.10.
5:47 And my question is, does it have a lot of current assets
5:50 and are they excessive?
5:51 Because we've seen current assets suck
5:54 cash out of the business.
5:56 They need to be run at an optimal level, not too little
6:00 and not too much.
6:02 And we've seen that in previous modules.
6:05 Because B has more current assets, then the question is,
6:09 what's the operating cash cycle?
6:11 And we calculated that at 70 days for B compared to 30 days
6:15 for A. So clearly, much longer inventory periods and much
6:20 longer time waiting for customers to pay.
6:23 So my question would be, is its funding gap large?
6:26 If the operating cash cycle's large, that could be offset by
6:29 the firm taking time to pay its suppliers, taking
6:32 advantage of its credit terms.
6:35 So we see that B does have a larger funding gap than A. And
6:39 my question would be, does B, or even A for that matter,
6:43 have a strong reliance on supplier credit?
6:47 What is the impact of that on the funding gap?
6:50 And what happens if that supplier or suppliers withdraw
6:54 their credit terms?
6:55 Where will the business be in terms of its ability to meet
6:59 its cash flow requirements?
7:01 So which firm wins, A or B, in terms of their performance?
7:05 Well, it might seem disappointing, but we can't
7:08 really answer that question clearly.
7:11 These questions show the types of issues that we need to get
7:14 answers to in order to form some assessment of the
7:17 performance of the business.
7:19 There are never any simple answers in
7:21 doing financial analysis.
7:24 In the next topic, I'll introduce a different example
7:27 and ask the question, should the CEO in that
7:29 firm receive a bonus?
7:31 [MUSIC PLAYING]
Module 4 - Topic 5: Should the CEO get a Bonus?
File: DFHB MOD04 TOP05

0:00 [MUSIC PLAYING]


0:08 In this topic, I'd like to use some financial information, to
0:11 address a question.
0:14 Should the CEO get a bonus?
0:17 So have a look at the information on the screen.
0:20 Pause it and then come back to me.
0:35 So you would have seen the profits of the firm going
0:39 down, the revenues of the firm going up, the assets of the
0:45 firm going up over three years.
0:48 The CEO wants a bonus, and this is the basis of the CEO's
0:53 arguments--
0:54 the Chief Executive Officer.
0:56 The CEO says despite a very difficult three years, the
1:02 return on equity--
1:04 that is, the return generated for the
1:06 owners of this business--
1:07 has maintained a high level at 20%.
1:13 And that's the basis for the claims for a bonus.
1:18 Let's take a look.
1:19 In year one, profit of 10.
1:22 Equity of 50.
1:23 A return on equity, 10 divided by 50, of 20%.
1:29 In B, profits are declining, but also so is the equity.
1:34 So it's smaller.
1:35 And the result, a 20% return as well.
1:40 The third year, profits are down to $7 million, but at the
1:44 same, equity has come down as well.
1:47 And the return maintained at 20%.
1:51 So it's a hypothetical example, but how could we
1:55 address this issue or this claim from the CEO that the
1:58 CEO should get a bonus on the basis of maintaining the
2:01 returns to owners over those three difficult years?
2:07 You might be concerned about profits falling, but assets
2:10 are rising, and the firm is lowering its equity.
2:13 And hence maintaining the return on equity.
2:17 Let's see.
2:22 So here I've pulled out some of the ratios that we've been
2:24 looking at, and added another one, and joined them-- or
2:27 linked them--
2:28 to help me to tell a story about the
2:30 performance of this business.
2:33 So the first three, you should recognise.
2:34 Revenue over assets, telling me how hard the assets are
2:38 working in terms of generating revenues.
2:42 And the first thing we'll see is the return on assets are
2:45 going down from 100% in the first year-- so a dollar for
2:48 dollar basis--
2:50 to $0.95, or 95% in the third year.
2:54 So the asset utilisation is declining.
3:03 Not a good thing.
3:05 Now, they may be reasons for that.
3:06 The firm might be acquiring assets for the future.
3:09 But generally, we expect to see that ratio maintained and
3:14 hopefully improving as the firm utilises the assets more
3:17 intensively.
3:19 The profit margin.
3:21 It was $0.10 in the dollar in the first year.
3:24 By the third year, it's down to under $0.07, or 6.7%.
3:30 Not a good thing.
3:32 Not only are the assets not generating as high of revenues
3:35 as previously, but now the revenues are not generating as
3:40 much profit as previously.
3:43 And when we multiply these two ratios together--
3:46 revenue over assets times the profit over revenue, the asset
3:54 utilisation figure times the profit margin--
3:58 the two revenues cancel out.
4:00 And we're left with profit over assets, which is the
4:03 return on assets.
4:05 So the return on assets is declining over time.
4:09 So how did the CEO manage to maintain the return on equity,
4:14 which is profit over equity?
4:19 Well, can you spot it?
4:21 The ratio of assets to equity at each period is going up.
4:27 And what that means is this firm is raising more and more
4:32 debt each year.
4:34 Go back to the previous example and you can see here.
4:38 Look at year two.
4:41 Debt went from 50--
4:42 or liabilities from 50 to 55.
4:45 But the assets didn't change.
4:48 So what was that extra $5 million in debt used for?
4:52 Well, it was used to reduce equity.
4:55 And sometimes that's called an equity
4:57 buyback, or a share buyback.
5:00 So the CEOs raising $5 million extra debt, but not using it
5:04 to buy new assets which generate new cash flows, but
5:07 instead using that money to reduce
5:10 the equity of business--
5:11 to buy some of the equity back from the shareholders.
5:15 So the firm is increasing its financial risks by taking on
5:18 more debt and less equity through time.
5:21 And in the third year, it's even more dramatic.
5:24 Debt went up by $20 million, from $55 to $75.
5:28 So the CEO of this firm has managed to maintain a 20%
5:32 return on equity over the three years.
5:34 But the firm has lower asset utilisation, so its assets not
5:40 working as hard as previously.
5:42 Its profit margins declined, and it's taking on more risk.
5:47 Should the CEO get a bonus?
5:49 Probably not.
5:51 In the next topic, we'll look at the management of work
5:54 capital in the business in more detail.
Module 4 - Topic 6: Working Capital Assessment
File: DFHB MOD04 TOP06

0:08 In the last topic, we decided the CEO probably


0:11 shouldn't get a bonus.
0:13 Another area where CEOs, unfortunately, often get it
0:17 wrong is the day-to-day financial
0:20 management of the business.
0:21 And essentially, that means the management of the firm's
0:24 working capital.
0:25 And it's something that I've referred to a
0:27 lot over this subject.
0:29 So working capital--
0:31 all firms need working capital.
0:34 That is the cash to run the business on
0:37 a day-to-day basis.
0:39 We know that working capital is made up of current assets
0:43 and current liabilities.
0:46 So current assets, things like receivables--
0:50 we do a sale.
0:51 We give customer credit.
0:52 We need the cash to continue to operate because we're not
0:55 receiving the cash from the customer for some time.
0:58 Stock, or inventory, we need cash to pay for that, unless
1:02 suppliers are giving us good credit terms.
1:05 And remember, even in a service business, having a
1:09 team of actors waiting to do a gig also is absorbing cash if
1:15 we're paying them while we're waiting for
1:16 them to do their work.
1:19 So working capital is fundamental to a business.
1:24 Often, working capital is measured in terms of the ratio
1:27 of current assets to current liabilities.
1:31 And so here it is, sometimes called the current ratio.
1:36 And the conventional wisdom is, this ratio should be
1:42 something in the area of 2 or greater.
1:47 And the argument is, in the next 12 months, if there's at
1:53 least $1 in cash going out, we'd like to see $2 in cash
1:57 coming in--
1:59 hence the current ratio of 2.
2:02 But bear in mind something.
2:04 We know that a buildup in current assets relative to
2:10 current liabilities can have implications
2:13 for our funding gap.
2:16 So like most things in life, we don't want this number to
2:19 be too big.
2:20 And we don't want it to be too small.
2:22 We don't want the current ratio to be underweight, or
2:25 overweight, because both can be detrimental to health.
2:30 So let's go back to that link between the current assets,
2:34 current liabilities, and the funding gap.
2:38 In an earlier topic, we talked about working out the
2:43 operating cash cycle and the funding gap.
2:46 And I've put the formulas in here because we didn't get an
2:48 opportunity to do that.
2:50 So how long are we waiting before we sell our stock.
2:54 That's measured in terms of the days in inventory.
2:57 And the formal measure is, take the inventory of the
3:00 business and divide by cost of goods sold per day.
3:04 And make sure you include weekends in there as well.
3:09 365 days appropriate because, you see, we still pay interest
3:14 on our debt, even, unfortunately, on weekends.
3:18 Days receivable.
3:20 That is, the receivables of the business at a particular
3:22 point in time divided by the sales revenue per day.
3:26 Again, take the revenue and divide by 365 days.
3:30 List the days payable, which is the payables, on the
3:33 balance sheet, divided by cost of goods sold per day.
3:38 So there are the three formulas that are used to work
3:41 out the operating care cycle and the funding gap.
3:45 Typically, we like to see averages
3:47 used for these things.
3:49 But if they're not moving too much, then using the spot day
3:52 balance is fine.
3:54 So let's look at an example of this.
3:56 In fact, it's an earlier example that we saw.
3:59 Here's a firm.
4:00 It has revenue of $200 million, cost of goods sold of
4:04 $161 million, leading to a gross profit of $39.
4:10 On its balance sheet, its current assets and current
4:13 liabilities are $26 million in stock or inventory, $30
4:17 million in receivables, and $5 million in payables.
4:22 I've worked out the revenue per day and the cost of goods
4:25 sold per day, or cost of sales per day, so just divide the
4:29 revenue by 365 and the cost of sales by 365.
4:35 And I produce the cash flows cycle.
4:37 And here it is for the business--
4:39 59 days.
4:41 This firm is waiting until it sells its inventory, on
4:46 average, 55 days further before it gets the cash from
4:50 its customers.
4:52 So an operating cash cycle of 114 days.
4:56 Thankfully, there is some time to pay suppliers but,
4:59 unfortunately, not too much.
5:01 On average, this firm is paying its
5:02 suppliers over 11 days.
5:05 So that leads to a funding gap of 112 days.
5:10 What does that 112 days mean?
5:13 Here's a simple rule of thumb.
5:15 Take the 102 days for the funding gap and make that a
5:21 percentage of 365 days in the year.
5:24 And if we do that, that turns out to be about 28%.
5:29 And here's what this means.
5:32 For every $100 million in new sales, this firm would need to
5:39 go out and borrow around $28 million in funding just to
5:47 support those sales.
5:49 Now, the real number is probably slightly lower than
5:52 that, but that's not material here.
5:54 $28 million in debt, or $28 million in cash that could
5:59 have been used for some other purpose, is going into
6:02 supporting this large funding gap which arises because of
6:05 the large working capital needs of the business.
6:09 If this company is paying interest on it debt of 10%,
6:13 this $28 million in debt means $2.8 million in interest
6:19 expense every year.
6:23 That needs to be weighed up against the benefits of a high
6:26 current ratio.
6:29 In the next topic, we'll look at a concept called the
6:32 sustainable growth rate of a business.
6:35 It will help us work out whether a business is growing
6:38 its revenues too fast for its own good.
Module 4 - Topic 7: Sustainable Growth (Part 1)
File: DFHB MOD04 TOP07

0:00 [MUSIC PLAYING]


0:08 In the last topic we looked at working
0:10 capital management issues.
0:12 Now I want to turn to the concept of the sustainable
0:15 growth rate of a business.
0:18 It may be a surprise to learn that a firm may be growing too
0:24 fast for its own good.
0:28 How can that be?
0:29 What do we mean by that?
0:31 Well, let's think about our balance sheet, profit and
0:33 loss, and even cash flow statement relationships that
0:36 I've been talking about.
0:38 Suppose a firm is increasing its revenues.
0:43 A good sign.
0:45 But as a firm increases its revenues, it typically needs
0:49 to increase its assets.
0:52 It needs assets to support them, certainly current assets
0:56 to support those revenues.
0:57 But also, it may be needing to invest in non-current assets,
1:02 a plant, equipment, to support the growth in those revenues.
1:08 We'd always like to see the firm being able to increase
1:11 its revenues without it decreasing its assets.
1:13 But if things are at capacity, sometimes there's no choice.
1:18 We need to invest more in non-current assets if there's
1:21 significant revenue growth.
1:23 Now as we increase assets, of course, we need to increase
1:27 the funding of those assets.
1:29 And that typically means more debt, unless the firm has
1:35 sufficient retained earnings from last period or previous
1:38 periods to finance this growth in assets.
1:42 And the reality for many businesses is the owners, the
1:45 shareholders want to be paid high dividends.
1:48 They want some cash back.
1:51 So the firm makes some profits, pays some of those
1:54 profits back to the shareholders as dividends,
1:56 leading to not high levels of retained earnings to help
2:00 finance growth in future periods.
2:04 The sustainable growth rate of a business tells us how much
2:09 we can increase the revenue of the business while maintaining
2:14 our debt ratios--
2:15 so for example, our ratio of debt to assets.
2:20 It's very easy to grow a business.
2:23 We could go and borrow a lot of money, buy a chain of
2:26 stores, coffee shops, bookshops, whatever they may
2:29 be, and in the process, be increasing our revenues.
2:33 But as we've learned, there's all of that debt on the other
2:36 side of the balance sheet that needs to be repaid.
2:39 And so we need to take that into consideration.
2:41 The sustainable growth rate, as I said, says how much we
2:44 can grow over a particular period while maintaining a
2:48 target ratio of debt to assets or perhaps debt to equity and
2:52 also not issuing any new equity.
2:57 And the reason we don't want to issue new equity every year
3:00 is the shareholders don't particularly like having to
3:04 put more funds into a business every year to support its
3:07 ongoing growth.
3:09 They often will do it if it's a major acquisition, perhaps
3:12 of another firm.
3:14 But generally, owners want the business to be
3:17 self-sustaining.
3:18 They want yesterday's profits and retained earnings to be
3:21 financing today's growth.
3:23 So how can we measure the sustainable
3:25 growth rate of a business?
3:27 Well, the shortcut way is to take the return on equity of
3:31 the business and multiply it by something we called the
3:35 retention rate.
3:38 Now the retention rate says, how much of the profits is the
3:43 firm keeping after it pays its dividends?
3:47 Because that is the retained earnings that help finance
3:50 growth in the next period.
3:54 So the return on equity here needs to be the profit after
3:57 tax this year divided by the balance of the equity accounts
4:02 that we closed the previous year with.
4:05 So when I say closing equity, it's the closing equity last
4:11 year or last period.
4:17 The retention rate is the retained earnings this year
4:24 divided by the profit after tax this year or this period.
4:28 Here I have a firm that closed the previous financial year
4:33 with $40 million in equity on its balance sheet.
4:37 So it opened this financial year with $40 million.
4:42 Then over the course of the year, it generated $20 million
4:46 in profits.
4:48 It paid $10 million in dividends, leading to $10
4:51 million in retained earnings.
4:54 So notice, this retained earnings gets added into the
4:57 40, to give me the new equity figure this year, hence the
5:02 term, retained earnings.
5:05 So what's the sustainable growth rate for this business?
5:08 How fast can this business grow over the next 12 months?
5:13 Let's use our formula.
5:15 So the first thing we need is the profit after tax divided
5:19 by the opening equity.
5:22 The return on equity, that is.
5:24 And this is 10--
5:27 I'm sorry, 20, profit after tax, divided by the opening
5:31 equity of 40.
5:33 So that's 50%.
5:36 Now take the retention ratio.
5:38 And the retention ratio was the retained earnings in the
5:41 profit and loss statement divided by the
5:44 profit after tax.
5:46 So the retained earnings were 10.
5:49 The profit after tax was 20.
5:52 So again, 50% is the retention ratio.
5:56 So that tells us that the firm keeps 50% of its profits for
6:00 financing growth and distributes the other 50% to
6:04 its shareholders.
6:06 So what's our sustainable growth rate for this business?
6:09 The sustainable growth rate is our return on equity of 50%
6:16 times our retention ratio of 50%.
6:20 This firm can grow over the next 12 months at 25%,
6:25 provided it maintains its return on equity at a similar
6:29 level, and it maintains its dividend payouts at a similar
6:34 level, it doesn't allow its debt to blow out beyond a
6:38 target ratio or a target level, and it doesn't issue
6:43 any new equity to its shareholders.
6:46 In the next topic I'll prove that this works.
6:49 [MUSIC PLAYING]
Module 4 - Topic 8: Sustainable Growth (Part 2)
File: DFHB MOD04 TOP08

0:00 [MUSIC PLAYING]


0:09 In the last topic I introduced you to the
0:10 sustainable growth rate.
0:13 I want to take it further in this topic and ask a couple of
0:16 key questions.
0:18 First of all, can we show that 25%, which was the sustainable
0:23 growth rate in the last exercise, is the right growth
0:26 rate for this firm?
0:28 Secondly, what happens if a firm exceeds its sustainable
0:32 growth rate?
0:34 And third, how can a firm improve its
0:37 sustainable growth rate?
0:39 So let's first of all have a look at the last example.
0:42 And here's the data up on the screen.
0:45 And let's go to year two now and see
0:47 what actually happened.
0:50 Now, we worked out in the last example that this business
0:52 could grow its revenues by 25%.
0:58 And that's what's happening in this exercise.
1:00 Revenue was 100, and it's now gone to 125.
1:05 So it's my job to prove to you that this is the appropriate
1:09 growth rate for this business, if it maintains it's similar
1:12 level of operations in year two as in year one.
1:16 So first, if it has extra revenue of 125, it needs some
1:20 assets to support that revenue.
1:23 And if we look at previously, for every dollar in assets,
1:29 there was a dollar in revenue.
1:31 So this time we're maintaining that relationship.
1:34 So we're assuming the firm operates at a similar level of
1:37 asset utilisation.
1:39 Next it's expenses.
1:42 Previously, it was an 80% cost margin.
1:45 80 into 100, we maintain that margin here, 80%, leading to a
1:50 20% profit margin, $25 million.
1:55 Of that $25 million, the firm paid half of that out as
1:58 dividends to the shareholders, just as it did in
2:01 the previous years.
2:02 So see, the firm's financials are essentially a clone of the
2:06 previous year, operating at similar levels.
2:09 That left retained earnings of 12 and 1/2.
2:13 And do you recall where they go?
2:15 Well the firm opened its equity with 50.
2:18 Over the next year it made another 12 and 1/2.
2:22 So this comes down here to increase the
2:24 equity from 50 to 62.5.
2:29 Liabilities fund the gap between the 125 in assets that
2:33 are needed and the $62.5 million available to equity.
2:37 And do you notice something?
2:39 The ratio of debt to assets or liability to assets, 50% here
2:44 and 50% here.
2:46 So the film is maintaining it's debt ratios.
2:48 So there's proof that the sustainable growth rate works.
2:52 Next question, what happens if the firm is growing too fast?
2:58 Well, if the firm's growing too fast, it will need to
3:01 raise more and more debt to finance its operations.
3:04 And there'll come a point where it breaches what we
3:07 might call it speed limit, too much debt relative to the size
3:10 of the balance sheet.
3:12 That has implications for the firm's credit rating.
3:15 That means the cost of interest may start to go up or
3:18 the interest rate will start to rise.
3:20 But also, the owners will start to become unhappy at all
3:23 of that extra debt on the balance sheet that they need
3:25 to cover for.
3:27 What can a firm do to improve its sustainable growth rate?
3:31 Well, let's look at the two things again, the return on
3:34 equity and the retention ratio.
3:38 So what it wants to do is improve the return on equity
3:42 without taking on extra risk or also increase
3:47 its retention ratio.
3:49 So let's look at each of those items and see how they impact
3:52 on the sustainable growth rate.
3:54 In order to increase the retention ratio, the firm
3:57 would have to cut its dividends.
4:02 That might not make for very happy owners or shareholders.
4:06 And management might not be around too long if they
4:09 continually cut dividends to finance growth.
4:12 So we need to generally look at the other side, improving
4:15 the return on equity without taking on extra risks.
4:19 So what sort of things are available to management?
4:22 Well, management could cut costs.
4:25 That would certainly improve profits and return on equity.
4:28 But often, that's a short term on myopic approach.
4:32 If there's fat in the business, there's always an
4:35 opportunity to reduce some of that fat and cut the costs.
4:38 But if you're reducing important expenditures in
4:41 marketing, advertising, human resources, it's most likely
4:45 have an impact on revenues in future periods.
4:48 The firm could issue a new equity, but we've already said
4:53 issuing new equity is generally
4:55 not a preferred option.
4:56 Equity is expensive, and owners don't like having to
4:59 put more money into their business every just to finance
5:02 its ongoing growth.
5:04 Probably the best thing it could do is improve its asset
5:08 utilisation, the ratio of revenue over assets.
5:14 If we see a firm with skilled employees, skilled management,
5:17 and skilled leaders, they are able to continually get more
5:21 revenue out of an existing asset base without taking on
5:25 extra risks.
5:27 And that's a sure sign of a good future for a business.
5:31 In the next topic I'll look at the issues of risk with more
5:35 and more debt on a balance sheet, in more detail.
Module 4 - Topic 9: Risk Assessment
File: DFHB MOD04 TOP09

0:08 In this topic, I want to look at risk ratios in more detail.


0:15 There are a number of ways that we can assess the risk of
0:18 a business, some related to financial risk--
0:20 so how much debt the firm is carrying--
0:23 and others related to business risk.
0:26 As with any piece of financial analysis, there's no simple
0:29 ratio that solves everything.
0:31 There's no one size fits all approach.
0:34 All we can do is utilise whatever information is
0:37 available to us, but always try to integrate it to make
0:41 sure it tells a story.
0:43 I've talked about in the last couple of topics how a firm
0:45 might grow too fast for it's own good.
0:49 Growing revenues is great.
0:50 But if it comes with the requirement to raise more and
0:53 more debt, the firm may collapse under its own weight.
0:57 It has a lot of debt to service, a lot
1:00 of interest to cover.
1:01 So the first set of risk ratios typically cover the
1:05 amount of debt a firm has.
1:07 We've talked about the ratio of debt over assets.
1:13 What should that be?
1:14 Well, it depends on the firm.
1:16 I've said a business that's in retail, food, discretionary,
1:21 we need to adjust for those different types of businesses.
1:24 So food or staples can carry much more debt than a
1:28 discretionary business.
1:30 People buy much more milk and bread and eggs then they buy
1:32 white goods.
1:34 So there's no simple rule for this.
1:36 Debt to equity is a ratio that's quite common, and it
1:40 really tells me a similar thing.
1:42 For every dollar in equity, how much debt is there?
1:46 So if the debt to assets figure was 50%, 50 over 100,
1:51 then we could say that the ratio of debt to equity would
1:55 likely be 50 over 50, or 1, when we take into account the
2:01 structure of the balance sheet of a business.
2:04 Interest cover is also a useful way of assessing the
2:08 ability of a firm to meet its interest requirements.
2:11 So we take the earnings before interest and taxes, and into
2:15 that we divide the interest expense.
2:18 And this says for every dollar in interest, how much earnings
2:22 before interest do we have?
2:24 And generally this number, we like to see somewhere in
2:27 excess of three.
2:29 So in other words, for every dollar of interest, we'd like
2:32 to say $3 or more in EBIT.
2:35 There's no simple rule here, but a cover ratio of three
2:39 tends to be the bare minimum.
2:43 Other ratios, cash flow from operations relative to my
2:48 current liabilities.
2:50 Current liabilities, remember, are obligations we may need to
2:54 meet within the next 12 months.
2:56 So how much cash flow from operations historically is
2:59 coming in relative to the current liabilities and will
3:02 we have sufficient cover there?
3:04 Also an important indicator could be the
3:06 firm's access to debt.
3:09 Does the firm have sufficient funding lines in place so that
3:14 if there's a prolonged strike, for example, the firm doesn't
3:17 have to close down?
3:19 It can draw on its credit lines and be able to meet some
3:22 of its obligations.
3:24 Access to debt could be a sign of good health for a business.
3:28 Other things that I talked about is reliance
3:31 on a few key customers.
3:35 If a firm doesn't have a large or diversified revenue base,
3:40 it could be in trouble.
3:41 It only needs to lose a major contract or a major customer
3:45 or client and then not be in a position to meet its
3:47 obligations.
3:49 We also said an over reliance on one or two suppliers.
3:54 It's great to have unique relationships with suppliers.
3:57 It's good to have a strong bond with them.
3:59 But if we have an excessive reliance on one or two of them
4:04 and they decide not to do business with us anymore for
4:07 whatever reason that might be, the business could be in
4:09 difficulty.
4:11 And remember, finally, providing for the future.
4:14 We talked about how much capital expenditure is the
4:18 firm making, relative, perhaps, to its depreciation.
4:23 And if a firm's depreciating its assets but not replacing
4:27 them at a reasonable rate, the assets may not be in a
4:30 position at future periods to be available to perform to the
4:34 level that we need them to.
4:37 So with all of this in mind, in the next and final topic
4:41 for this subject, I'll bring everything
4:43 together with a summary.
Module 4 - Topic 10: Assessing Financial Performance
File: DFHB MOD04 TOP10

0:08 So this brings us to the end of this module and to the end
0:12 of this subject.
0:14 And so what are some of the key learnings from this module
0:16 and from the subject overall?
0:19 Well for me, there are probably three main things.
0:22 The first thing is when attempting to diagnose
0:26 financial health of a business, we can't look at any
0:31 of the information that's contained in finance reports
0:34 in isolation.
0:36 It's no use looking at the size of the revenues or the
0:39 size of the assets or the size of the profits without linking
0:43 those three items in some way.
0:46 Similarly, it's no use looking at those items without taking
0:49 into account cash flow generation, risk, funding.
0:56 Everything needs to be considered as a whole rather
1:00 than the parts.
1:02 Secondly, a good piece of analysis is forward looking.
1:07 When we look at financial reports, what we're seeing is
1:10 what has happened in the past.
1:12 It's the most recent set of revenues.
1:15 It's the most recent set of assets.
1:17 The past can be a guide to the future if we
1:20 know where to look.
1:22 We need to look for early warning signs.
1:24 We need to look for red flags.
1:26 So, is the balance sheet lazy?
1:29 And by saying lazy, is working capital starting to build to
1:34 levels that may be unsustainable--
1:37 too much inventory, too many receivables?
1:40 Are the assets being allowed to depreciate, the non-current
1:43 assets, and not being replaced quickly enough?
1:47 Now remember, these things reflect the people who run the
1:50 business, the leaders, the management, the executives.
1:55 So when we look at the balance sheet figures or we look at
2:00 the profit and loss figures and even the cash flow, what
2:02 we're really seeing is a footprint left by management.
2:05 It's their decisions that are reflecting in those numbers.
2:09 And be mindful of the enormous amount of assumptions and
2:12 estimates that go into producing those figures.
2:15 So if something doesn't quite look right, trust your
2:18 instinct and be prepared to look deeper.
2:21 The notes to the accounts that go in annual reports, or
2:23 financial reports, can have a lot of the
2:25 information in them.
2:26 But they can also, when what you're looking for, help to
2:29 answer the questions that you may have.
2:32 The third item is what do we tend to see when firms are
2:36 starting to become fragile?
2:38 And there's usually a modus operandi.
2:43 One of the first things is they start to cut costs.
2:47 That's understandable.
2:48 Things are not looking very good, we need to cut costs.
2:51 But remember, costs are not bad things--
2:55 excessive costs might be.
2:56 But costs drive revenue.
2:59 We just can't continue to cut costs and then expect to have
3:04 happy, engaged employees, good relationships with suppliers,
3:09 our brand strong in the marketplace.
3:12 So watch for signs of a firm cutting costs because when
3:16 cutting costs becomes excessive, the implications
3:20 for the future may not be good.
3:22 It's OK for firms investing in new processes and systems and
3:25 procedures.
3:26 It's good if they're attempting to employ the right
3:29 type of people.
3:30 These things come with a cost.
3:32 We have to take our mind away from just the current period
3:35 and be forward looking and think about where this
3:37 business is going to be over next two, three, even up to
3:41 five years.
3:42 So cutting costs, be wary of that.
3:46 Next, these firms tend to defer
3:48 major investment decisions.
3:50 And I've already shown you a number of times of how we can
3:53 look to the cash flow statement and
3:54 track through time.
3:56 Is the firm replacing its assets at an appropriate rate?
4:00 Is it investing in new assets and new technology and new
4:03 systems and new processes?
4:05 Does the firm have a feeling of innovation?
4:09 It's OK to take risks as long as those risks are not
4:12 sufficient enough to wipe the business out.
4:14 So, managed risks are important.
4:18 The reliance on the big project, I mentioned.
4:21 Often you will see in a firm in difficulty an excessive
4:24 reliance on a major contract, a major
4:27 customer, a big project.
4:29 Management have to be forward looking.
4:31 They need to be thinking about new revenue sources and new
4:34 opportunities and always be willing to reassess what's
4:38 going on in the business or the market that they're
4:40 operating in.
4:41 We just can't look at this firm.
4:43 We need to think about the economy, technology, and those
4:47 developments.
4:48 Who would have thought just a few years ago that there will
4:50 be no such thing as stores to hire DVDs or videos from?
4:56 Things move fast.
4:57 And so we need to make sure that the management team
5:00 demonstrate evidence of being forward looking in their
5:03 investment decisions and in their investment in innovation
5:06 and research.
5:08 Very important.
5:09 And these are things that tend to get cut very quickly.
5:12 Often an early warning sign is employees leaving.
5:16 Employees are the inside people, particularly senior
5:18 executives.
5:19 So if you hear that the chief financial officer's leaving--
5:21 sometimes they'll say something nice like, going to
5:24 spend more time with my family--
5:26 often they're leaving because they see the business doesn't
5:29 have a good future.
5:30 So key movements in employees can be critical.
5:33 And if a business is listed on the stock exchange, whenever
5:36 there's a major change in the leadership team, that has to
5:40 be announced to the market.
5:42 And that can often be a sign.
5:44 Firms that are not doing so well tend to focus on profits
5:47 because that's a good signal to the market, but perhaps not
5:50 on cash generation.
5:51 So the cash flow statement, remember I said it's an x-ray
5:55 into the business.
5:56 So be familiar with the cash flow statement.
5:59 I often look at the cash flow statement before I look at
6:01 anything else.
6:02 Is there sufficient cash coming in from the core
6:04 operations?
6:06 And be wary of businesses that keep talking about market
6:08 share and growth.
6:10 We saw with the sustainable growth rate, a business can
6:12 grow too fast for it's own good.
6:15 What a business needs is to grow but have sufficient
6:18 retained earnings to finance that growth.
6:20 We can't keep going to the market and raising new funds
6:23 all the time.
6:24 It's costly, and eventually they dry up.
6:27 Sometimes, being a smaller business can be a more
6:30 valuable business.
6:32 Just giving lots of credit to customers can increase market
6:34 share but cause problems for the business at a future date.
6:38 Finally, I'll say this, and it's an old rule, do you
6:42 understand the business model of the firm?
6:45 Is it transparent and clear how the firm generates its
6:49 income, where it spends its money, what its assets should
6:53 look like, how often they should be replaced?
6:56 If you can't understand its business model simply and
7:00 succinctly, it's probably a good sign that you should not
7:04 be investing in that business.
7:07 So thank you for joining me on this journey in how to
7:10 diagnose the financial health of a business.
7:13 You should be able to apply this information, whether
7:16 you're an employee in a business, you're putting
7:18 together a business case, you're an investor in a
7:20 business, you might be lending money to the business, you
7:23 might be a potential owner of the business, maybe even a
7:26 customer to the business, a supplier to the business.
7:30 There's always a wealth of information
7:33 in financial reports.
7:34 You just need to know where to look.
7:36 I hope to join you again sometime
7:38 somewhere in this journey.
7:39 Thank you.