How do you know if a business is doing well?

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“Financial Performance” is a term used to describe how well a business is doing in terms of earnings and cash flow. 

In our last blog post we looked at how to analyse financial statements and identified some ratios that we should pay attention to when assessing the financial health of a company. 

Our previous blogs have also explored how rating agencies assess companies, starting out broad in scope then becoming more company specific. 

There are several ways to monitor a firm’s financial performance, but you should always remember that “Cash is King”. 

Credit investors main concern is if the company you lend to via the bond market can make the interest and principal payments on its debt. 

The cash flow statement lets us know how much cash a business generates over any given reporting period. 

Ideally, when looking at the financial performance of a company, you want to do it over the longest period so you can have as much evidence and history to make an informed decision off.

Not only this, but one needs to understand the business’ relative size and trend when considering a performance indicator for any given business. 

These considerations apply not only within the context of the company but also in the broader context of the industry in which the company operates. 

Cash Flow from Operations (CFO)

CFO tells us how much cash a business generates in its day-to-day business. 

Ideally, you want to see a positive trend in its magnitude as time passes. 

A major factor that can play a large part in a company’s earnings and cash flow throughout the year is seasonality. 

Being aware of the ebbs and flows that relate to seasonality is important as a decline in cash flow in each quarter might be benign, while unanticipated changes could pose warning signs. 

Imagine a retailer heading into Christmas

Retailers usually increase the amount of stock they have in order to meet higher anticipated demand in the fourth quarter of the year. 

The result is a seasonal cash outflow in Q3. 

When Christmas comes, there is a reduction in stock due to sales and cash increases as customers pay for sales. 

This usually continues to some extent into January (Q1) with the new year sales.

Ratios are useful

We have previously mentioned that ratios are sometimes more useful to look at when operating cash flow. 

For example, cash flow should be seen as a ratio to the amount of debt that the company has. 

This gives us a sense of how quickly a company may be able to pay back its debt. 

If it does not already include them, CFO should be adjusted for interest costs. 

Although interest payments may sometimes appear in cash flow from financing (CFF), an adjustment is made because a company must honour its interest payments in order to operate. 

If it doesn’t or it cannot pay its interest, the company will default. 

Free Cash Flow

This tells us how much cash is left over from operating cash flow after a company has paid for the maintenance of land, buildings, and equipment. 

The formula to work this out is CFO – CAPEX. 

That is, cash flow from operations less capital expenditure. 

Companies with a high capital intensity will tend to have a high level of maintenance CAPEX. 

That is, they employ a large proportion of fixed assets such as auto manufacturers. 

Maintenance CAPEX is essentially expenditure to maintain and replace existing infrastructure. 

Therefore, free cash flow is generally lower for such companies. 

Don’t forget to look at ratios

It is common to look at free cash flow as a ratio to sales or outstanding debt. 

This allows comparison over time which is important. 

Not only this, but it allows comparisons within an industry and also tells you how quickly it could pay down debt. 

Income Statement

The earnings that are the starting point for the cash flow statement are derived from the Income Statement. 

The income statement tells us a lot about a business because it allows us to look at how revenue has evolved over time – it is important to see growth here. 

Growth is viewed on an annual basis and sequentially. 

When there are periods of negative revenue growth it is important to understand what is driving a decline in sales. 

Is it company or industry specific?

What is being done to mitigate future declines?

The higher the earnings the better

This rule is key – and after looking at revenue on an income statement you will have all the costs associated with running a business. 

You should look at these as a percentage of the revenue for comparative purposes. 

The cost structure of a company is important in assessing a company’s capacity to generate higher earnings. 

For example, a company with high fixed costs will tend to have lots of variation in its profit margin because they require large factories or expensive high-tech software. 

This is known as having high operating leverage. 

At low levels of revenue, the fixed costs dominate profit margins which are low. 

At high levels of revenue, as the costs are fixed, profit margins are high as costs do not increase. 

This is in large part what determines a business’ cyclicality. 

Conversely, if a company has low operating leverage it usually has a cost base that is variable. 

This means that it grows or shrinks in proportion to the sales. 

An example might be a business where the largest cost is the sales commission on the services it provides. 

The higher the sales the higher the commission. 

In this case, a variable cost structure means that costs and margins will remain a relatively constant proportion of sales. 

The key earnings metrics we want to monitor are Gross Profit, EBIT, and EBITDA. 

These are usually expressed as a percentage of sales. 

Finally, you want to monitor the amount of debt on a company’s balance sheet. 

We touched upon leverage in this blog. 

Leverage is the ratio of Debt to EBITDA. 

The lower the ratio the better. 

For any given company, you want to see this trend lower over time. 

Comparing companies within industries is important. 

Conversely, comparing companies across industries loses a bit of relevancy with regards to the metric. 

For instance, cable companies with large, stable, and visible earnings can maintain high leverage. 

On the other hand, a clothes retailer cannot. 

This is because they tend to have seasonal, cyclical sales exposed to fast fashion. 

This translates to lower visibility on revenue, earnings, and cash flow development. 

Therefore, they will be much less likely to tolerate the same level of leverage as the cable company. 

Generally, the higher the variability in revenue, earnings, and cash flow, the less ability a company has to take on leverage. 

Keep an eye on working capital!

Working capital refers to the current balance sheet accounts that are used in the day-to-day running of a company. 

The three main accounts are Inventories, Accounts Receivable and Accounts Payable. 

Inventory

This is the value of goods produced or in production which will be sold to generate revenue. 

An increase in inventories represents the use of cash and a reduction in inventories is a source of cash as goods are sold. 

Accounts Receivable

This represents the cash that the company is owed. 

This is normally a function of inventory sales and customers have a given time period in which to pay for them. 

An increase in receivables is a use of cash and a decrease is a source of cash. 

Accounts Payable

This is the sum of payments the company itself must make to suppliers. 

The suppliers provide the materials that are needed to manufacture the inventory. 

The company, like its customers, will have a time frame in which to make the payments to suppliers. 

A decrease in accounts payable is a use of cash and an increase is a source of cash. 

Our next blog post…

We will look at the economics and industry drivers that you should understand to help learn the risks you are taking when investing. 

As usual, all of this content can be found on our free Bond Academy, a CPD accredited course that offers 5 hours of CPD activity.

If you have any ideas on topics that you’d like for us to talk about, please email me: anil@wisealpha.com.