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Operational Finance : Finance for Managers, Certification link.

1. Financial Analysis

  • Operational Finance focuses on the daily activities driving a business forward.
    • a model of financial analysis and diagnosis, using financial forecasts, and designing an action plan when needed.
  • Corporate (or Structural) Finance : studies how to finance the fixed assets, and also the combination of debt and equity that a company should have.
  • Strategic Finance: focus on developing comprehensive financial plans for their companies

Case Study : Ask credit from a bank (Credit (short term) and Loan (long term)).

1.1 Business Analysis

What are you doing? Business analysis to build expectation.

  • Sales:
    • What? Where? Economic condition.
    • Cyclicality - fit with the economic cycle (e.g. car industry).
    • Seasonality (e.g. ice-cream).
    • Clients / Suppliers.
  • Strategy (why am I good to my clients?): cheap, good, variety.
  • Management team - trust.

1.2 P&L Analysis

Do you make money?

  • Sales: value and growth. Growth could be large for startup.
  • Gross Margin & COGS (costs of good sold) : percentage of sales.
  • OPEX (operational expense) : electricity, salaries, overhead.
  • Operating profit / Sales.
  • EBITDA / Sales.
  • Financial Results (~2.5% EBIT).

Operational Risks vs. Financial Risks (interest expenses with stable income).

1.3 Balance Sheet Analysis

Do you need money?

  1. Look at the big numbers.
  2. Look at the evolution over the years.
  3. Look at the operational ratios.

2. Operational Ratios and Forecasting

2.1 Operational ratios

Days of Collection: (for receivables) the number of days the customers take to pay.

  • $Days\ of\ Collection = \frac{RECEIVABLES}{Daily\ Sales}$ (“Daily Sales” is sales per day)
  • Impact (of customer pay delay): $Extra\ Money\ Needed = Days\ Delay * Daily\ Sales$

Days of Inventory: the number of days I take to sell the inventory.

  • $Days\ of\ Inventory = \frac{INVENTORY}{Daily\ COGS}$
  • Impact (of excess inventory) : $Extra\ Money\ Needed = Days\ More * Daily\ COGS$
  • “Turns Over” = inverse of “Days of Inventory”

Days of Payment (to suppliers) : the number of days I take to pay the suppliers.

  • $Days\ of\ Payment = \frac{PAYABLE}{Daily\ PURCHASES}$
  • $Stock\ Initial + Purchases - COGS = Final\ Stock$, $Purchases \approx COGS$
  • Impact: $Extra\ Money\ Free = Days\ Delay * Daily\ PURCHASES$

Takeaways:

  • The evolution tell if the company is well managed.
  • look at the consequences in the balance sheet: longer collection, inventory or payment.
  • top management usually believes that the condition (collection, inventory, payment) is better than it really is.

2.2 Forecast

Forecast P&L - Forecast Sales, then others.

Forecast Balance Sheet, derived from sales. Put cash and credit at the end. If total assets > (total liabilities + equity) , the difference will go to credit.

3. Diagnosis and Action Plan

3.1 Diagnosis

Diagnosis: Why do they need more and more credit? Structure problem : as company grow, the need of funds to operate grows faster than the working capital.

Need of Funds (NFOs) are funds required to finance a company's operations.

  • Sources of needness for money : Delay in selling what you buy from suppliers - receivables and inventory.
  • NFO = RECEIVABLES + INVENTORY - PAYABLES (directly related to sales)
  • NFOs are "use of assets".

Working Capital (WC) is the long-term funding available to finance the NFO once the fixed assets have been financed.

  • WC = EQUITY + LONG-TERM DEBT - FIXED ASSETS or WC = Current Assets - Current Liabilities
  • WC is "source of funds".
  • if NFO < WC, we have extra CASH.
  • id NFO > WC, we need to ask for CREDIT.

3.2 Action Plan

Plan to solve the problem drawn from diagnosis.

  • NFO ： Changing REC, INV, PAY.
  • WC： Changing LT Debt, FA, or Equity. We could work on P&L (making money).

Sustainable Growth : WC should grow faster or equal to NFO. $\Delta NFO <= \Delta WC$

  • $\Delta NFO_{t} = NFO_{t}^{\%} * \Delta Sales_{t}$ (assuming NFO per sale is constant)
  • $\Delta WC_{t} = \frac{Net\ Income_{t}}{Sales_{t}} * Sales_{t} = ROS_{t} * (Sales_{t -1} + \Delta Sales_{t})$ (with Return on Sales，ROS)
  • As a result , $\frac{NFO_{t}^{\%} * \Delta Sales_{t}}{Sales_{t -1}} = \frac{ROS_{t} * (Sales_{t -1} + \Delta Sales_{t})}{Sales_{t -1}}$
  • We have $NFO_{t}^{\%} * g = ROS_{t} * (1 +g)$
  • We have $g = \frac{ROS_{t}}{NFO_{t}^{\%} - ROS_{t}}$

4. Sensitivity Analysis, NFO Revisited, and ROE

Sensitivity Analysis, how sensitive the results are if the key variables changed.

Seasonal Companies

Return On Equity ROE, more interesting for shareholders.

\[ROS = \frac{Net\ Income}{Salse} \frac{Sales}{Assets} \frac{Assets}{Equity} = ROS * Turnover * Leverage = \frac{Net\ Income}{Equity}\]

Blind Financial Statements