In previous posts, I discussed how to audit the pro forma spreadsheet and how to confirm that the pro forma financial model accurately represented the business model. In this final post of the series, we will look at analyzing the actual financial statements.
Any analysis of financial statements will, at a minimum, try to answer the following questions:
Liquidity - Will there be sufficient cash to operate the business?
Leverage - How much debt is required? Will profit be sufficient to repay the debt?
Profitability - Will the company earn enough to sustain growth and provide a proper return to investors?
Based on an analysis of the financial statements, an investor must be able to reasonably expect that:
The business will survive
The business will generate the investor's required ROI
Investors and lenders will have the same basic questions:
How will the money I contribute be used in the company's operations?
Do the pro forma financials clearly show how the company will generate funds to repay my investment?
What is my fallback position if the company's operations cannot generate sufficient funds to repay my investment?
It is important to remember that not all investors have the same objective. Each investor will have their own requirements for such items as:
Return on investment
Term of investment
Type of collateral, if any
Structure of the debt - subordinated, convertible, revolver, term loan
Equity - common stock, preferred stock, warrants
CASH FLOW CYCLE
An analysis of the pro forma financial statements should give the user a clear understanding of the company's cash flow cycle. The cash flow cycle - which is the time required to convert cash into assets, then back into cash - is illustrated below.
Analyzing financial statements also provides insights into a company's working capital requirements. Working Capital is the amount of funds required to maintain the cash flow cycle. The pictures below illustrate the concept of working capital as it relates to a company's balance sheet.
Following are general concepts to keep in mind as you review the pro forma financial statements:
THE BALANCE SHEET
Lists items owned (Assets) that are converted to cash.
Shows how assets were purchased - Cash, Debt, Equity.
Gives insight into the company’s liquidity and leverage positions.
Liquidity is how quickly an asset can be converted to cash.
Leverage is the level of debt relative to total assets or equity.
Illiquid means that assets cannot be easily converted to cash.
Insolvent means the company is unable to pay debts owed.
PROPER DEBT STRUCTURE
Does the term of the debt match the term of the need for financing?
Examples of short term debt needs include receivables and inventory financing.
The types of short term debt include supplier credit, bank line of credit, single-payment loan, factoring, asset-based financing.
Examples of long term needs include the purchase of equipment, fixed assets, land, or a building.
The types of long-term debt include installment loans, asset-based loans, and leasing.
THE INCOME STATEMENT
Shows how well the company covers its operating expenses and earns funds to reinvest in the business.
The gross profit shows if the company can pay for its raw materials.
The operating profit shows if the company can cover its daily business costs, as well as non-operating expenses - debt for example.
The net profit shows if the company is earning enough money to cover all expenses, sustain long-term growth, and provide a proper return to investors.
An essential part of financial statement analysis is using ratios to examine the relationship between different components of the income statement and balance sheet. The idea is that the value of the ratio should be consistent with the industry standard and, ideally, the ratio for the company will be consistent from year to year.
Here is an overview of some of the key ratios you want to examine. There is a good article about financial ratios on the Corporate Finance Institute's website.
Current Ratio - Are current liabilities are covered by current assets?
Burn Rate - How much cash is used every month?
Receivables Turn - Number of days to convert receivables into cash
Inventory Turn - Number of days to convert inventory into cash
Payables Turn - Number of days to pay trade credit
Debt Ratio - Percentage of assets financed by debt
Debt / Equity Ratio - Shows level of debt relative to total equity
Gross margin - Profit after paying Cost of Goods Sold
Operating margin - How efficient are the company’s operations?
Net margin - How well are all expenses managed?
Times Interest Earned - Is operating profit sufficient to pay interest expense?
Debt Service Coverage - Is operating profit sufficient to pay all debt obligations?
Return on Assets - How well are assets managed to produce sales and profits
Return on Equity - How well is equity used to produce a profit? Is this company a good investment opportunity?
Finally, you want to examine the cash flow statement, which shows you how cash comes into the business, and how cash is used in the business.
There are two types of cash flow statements - the Accounting Cash Flow Statement and the Operational Cash Flow Statement
Accounting Cash Flow Format
Shows net inflow / outflow of cash over time
Fills in information gaps due to accrual accounting and non-cash expenses
Cash Flow from Operating Activities
Cash Flow from Investing Activities
Cash Flow from Financing Activities
You can find a nice cash flow statement template at accountingtools.com.
Operational Cash Flow Format
Cash from Sales
Minus Cash Production Costs
Equals Gross Cash Profits
Minus Cash Operating Expense
Equals Cash After Operations
Minus Financing Costs
Equals Net Cash Income
Minus Debt Amortization and Capital Expenditures
Equals Financing Surplus / (Requirements)
Plus Total External Financing
Equals Cash After Financing / Actual Change in Cash
The picture below is an example of an Operational Cash Flow Statement