About This Book

This book is – first and foremost – a guide. A detailed step-by-step guide to making a quantum leap in our corporate performance and, therefore, in your shareholders’ value.

It covers such important issues as what exactly the ‘quantum leap’ means in very practical terms; how it can – and must – be measured; what needs to be done – also in very practical terms – to make this quantum leap and how exactly to do it. In that way, the book is, indeed, a blueprint (or a ‘road map’, if you will) for this quantum leap.

But this book is more than just a ‘technical’ guide. I want it to be a powerful source of inspiration for you. A powerful source of inspiration that will create a permanent and formidable inner drive and cause a no less permanent and irresistible desire to make this quantum leap.

Why inspiration? Because decades of successful – and unsuccessful – corporate restructuring and reengineering projects which were ostensibly supposed to facilitate a quantum leap in corporate performance and financial value – proved beyond the reasonable doubt that without such a drive the project is doomed to failure.

Therefore, I will devote some significant effort to prove – also beyond the reasonable doubt – that you both can and must make this quantum leap in your corporate performance. By ‘you’ I mean an entrepreneur, an active investor, a top manager or a corporate restructuring project manager. This is the primary target audience of this book, but by no means the complete one.

This book can be used – and quite successfully, I am sure – as a textbook in an academic, commercial or corporate environment. Or as a self –study guide. However, it would be most useful and valuable when you are faced with the need for a quantum leap in your corporate performance or just with conducting a comprehensive business audit (CBA) or a corporate restructuring/reengineering project.

I personally believe that (1) every entrepreneur, active investor and top manager in every business entity there is needs this quantum leap and can (and must!) make it; (2) the ultimate objective of every CBA is to find a way to make this quantum leap and (3) every corporate restructuring/reengineering project must result in such quantum leap.

You make a quantum leap in three steps (I will cover them in detail later). First, you must obtain a comprehensive and detailed picture of your current situation (‘AS IS’). Second, you must develop a no less comprehensive and detailed vision of your desired situation (‘TO BE’). And, finally, you must develop and implement financial and operational transition plans to get from ‘AS IS’ to ‘TO BE’.

In this guide, I will cover all three steps; however, I will devote the lion’s share of this book to the first step which involves a comprehensive business analysis. Why? Because (1) it is by far the most important step – there can be no quantum leap without a thorough understanding of where you are now; (2) developing a vision of ‘TO BE’ situation involves pretty much the same process as a detailed picture of your current situation and (3) so-called ‘passive investors’ need the tools for performing a CBA (‘due diligence’) without having to think about making any ‘quantum leap’. 

Questions for analyzing your intrapreneurship management system

1.      How much financial value is created by your corporate intrapreneurial activities?

2.      How comprehensive is the description of your IMS?

3.      How well-structured is the description of your IMS?

4.      How accurate and up-to-date is the description of your IMS?

5.      How comprehensive is your IMS?

6.      How well-integrated are your IMS components?

7.      How efficient is your IMS overall?

8.      How comprehensive is your intrapreneurship motivation system?

9.      How personalized and customized is your intrapreneurship motivation system?

10.  How efficient is your intrapreneurship motivation system in terms of idea generation?

11.  How optimal are your idea documentation requirements?

12.  How efficient are your idea documentation templates for financial and operational plans, IRACORACI, etc.?

13.  How comprehensive is your idea evaluation system?

14.  How solid is your idea evaluation methodology?

15.  How efficient is your idea evaluation process?

16.  How efficient are your idea evaluation tools?

17.  How competent is your idea evaluation personnel?

18.  How well-motivated is your idea evaluation personnel?

19.  How efficient is your idea evaluation system – in terms of filtering out ‘bad ideas’ and accepting ‘good’ ones?

20.  How comprehensive is your idea implementation system?

21.  How efficient is your idea implementation process?

22.  How efficient is your idea implementation support system?

23.  How efficient is your process for integrating your intrapreneurial projects into your business system?

24.  How efficient is your idea implementation system overall?

How efficient is your post-implementation evaluation system?

Analyzing Your Intrapreneurship System

By definition, intrapreneurship refers to entrepreneurial activities of employees in their workplace. In other words, behaving like an entrepreneur while working within an organization. Not necessarily large, by the way. Actually, it is usually easier to be an intrapreneur in a small business than in a huge multinational corporation.

An intrapreneur, according to The American Heritage Dictionary is "a person within a large corporation who takes direct responsibility for turning an idea into a profitable finished product through assertive risk-taking and innovation". In other words, into a ‘business within a business’ – a product, service, business unit, etc.

In a broader sense, more applicable to a CBA, an intrapreneur is ‘a corporate employee, who turns a potentially profitable idea into a corporate project that generates a significant amount of financial and aggregate value’.  

Why more appropriate? Because of IRACORACI. For your company (or any company, for that matter), it really does not matter how to generate financial value – by increasing revenue with new products and services, avoiding costs, optimizing risks or avoiding increase in working capital.

Therefore, any idea (not just a new product or service) proposed by an intrapreneur that can do at least one of these things, deserves support and implementation.

What needs to be done to maximize financial value created by your intrapreneurs (which can be very substantial) and thus to radically increase the efficiency of utilization of your human capital?  A highly efficient corporate intrapreneurship management system (IMS). Which must include the following four core components:

1.      Personalized and customized intrapreneurship motivation system - comprehensive and well-balanced between financial (e.g, share in cash flows from a new product) and non-financial (emotional) elements.

2.      Idea evaluation system – complete with documentation/presentation requirements; financial valuation models; IRACORACI description; methodology, process and tools; and, last but not the least, highly competent and motivated personnel. The last one is no less vital component of your IMS than the intrapreneurs themselves

3.      Idea implementation system, including financial, operational and business plan templates; highly efficient corporate process; no less efficient support system – financial, managerial, technical and other resources; and, of course, the right procedures for integrating each new intrapreneurial project into your whole business system – with maximum synergy, of course.

4.      Post-implementation evaluation system – with the usual ACRC – analysis, conclusions, recommendations for improving both the results of idea implementation and improvement of your whole IMS supported by the necessary comments and all relevant corporate documentation

Questions for analyzing your best management practices adoption system

1.      How efficient is your system for developing your own BMP?

2.      How comprehensive is your BMP knowledge base?

3.      How well-structured is your BMP knowledge base?

4.      How accurate and up-to-date is your BMP knowledge base?

5.      How solid is your methodology for continuous updating of your BMP knowledge base?

6.      How efficient is your process for continuous updating of your BMP knowledge base?

7.      How efficient are your tools for continuous updating of your BMP knowledge base?

8.      How competent is your BMP knowledge base management personnel?

9.      How efficient is the training component your BMP adoption system overall?

10.  How efficient is the coaching component your BMP adoption system overall?

11.  How efficient is the consulting component your BMP adoption system overall?

12.  How efficient is your BMP adoption system overall?

13.  How comprehensive is your network of partners - providers of BMP adoption services?

14.  How efficient are your relationships with these partners?

15.  How efficient is your BMP adoption monitoring system?

Best Management Practices Knowledge Base

To achieve your fundamental objectives – maximize financial value for your shareholders and to transform your company into a powerful money-making machine – you must maximize the aggregate performance of your business entity.

To maximize your corporate performance, you will obviously need to use the best management practices (BMP) to manage objects, processes and projects in their responsibility areas.

Some of these BMP you will develop yourself, but most of the time the most efficient way would be to find these practices in your external environment and adopt them to your specific corporate conditions. And to make sure that your employees do, indeed, use the best practices there are.

To make it possible, you need a highly efficient system of identifying and adopting the BMP. This system must include the following components:

1.      A comprehensive, well-structured, accurate and up-to-date BMP knowledge base

2.      A highly efficient methodology, corporate process and tools for continuous update of this BMP knowledge base

3.      A highly competent knowledge management personnel

4.      A no less highly efficient system for adopting the BMP – including the necessary training, coaching and consulting (internal and external)

5.      A network of highly competent partners – professionals in training, coaching and consulting – providers of BMP adoption services

6.      A highly efficient monitoring system for making sure that you employees, indeed, do adopt and use BMP on a regular basis

Cash Conversion Cycle

The cash conversion cycle (CCC) is one of several measures of management effectiveness. It measures how fast a company can convert cash on hand into even more cash on hand. The CCC does this by following the cash as it is first converted into inventory and accounts payable, through sales and accounts receivable, and then back into cash. Generally, the lower this number is, the better for the company.

CCC is calculated as DIO + DSO – DPO; which makes perfect sense, as your company must invest cash into both inventory and accounts receivable, but conserves cash when it is financed by your suppliers with accounts payable.

Although it should be combined with other metrics (such as return on equity and return on assets), it can be especially useful for comparing close competitors, because the company with the lowest CCC is often the one with better management.

From slightly different perspective, CCC measures how long a firm will be deprived of cash if it increases its investment in current assets (inventory and A/R) in order to increase its sales. Therefore, it thus becomes a measure of the liquidity risk caused by its growth.

However, shortening the CCC creates its own risks: while a firm could theoretically achieve a negative CCC by collecting from customers before paying suppliers, a policy of strict collections and lax payments is not always sustainable. Or even possible. 

Days Payables Outstanding

Days Payables Outstanding – DSO - or ‘Payables Conversion Period’ refers to average number of days your company takes to pay its suppliers. If this can be maximized, the company holds onto cash longer, maximizing its investment potential; therefore, a longer DPO is generally better.

As your DIO and DSO, your DPO is an important component of another important metrics – Cash Conversion Cycle.

Days Sales Outstanding

Days Sales Outstanding – DSO - or ‘Receivables Conversion Period’ refers to the number of days needed to collect on sales. Generally speaking, higher DSO ratio can indicate a customer base with credit problems and/or a company that is not very efficient in its collections activity. A low ratio may indicate the firm's credit policy is too rigorous, which may be hampering sales.

Higher DSO can also be an indication of inadequate analysis of applicants for open account credit terms. An increase in DSO can result in cash flow problems, and may result in a decision to increase the creditor company's bad debt reserve.

Due to the high importance of cash in running a business, it is in a company's best interest to collect outstanding receivables as quickly as possible. By quickly turning sales into cash, a company has the chance to put the cash to use again - ideally, to reinvest and make more sales. The DSO can be used to determine whether a company is trying to disguise weak sales, or is generally being ineffective at bringing money in.

Total Assets Turnover

Total Assets Turnover (or just ‘Assets Turnover’) is the amount of sales generated per dollar of your assets. It is an indicator of the efficiency with which your company is using its assets to generate revenue and is calculated as your net sales divided by average assets for the corresponding accounting period.

In the context of this formula, ‘net’ means sales net of returns, allowances for damaged or missing goods and any discounts allowed by your sales policies. Therefore, it is the same as the term Gross Sales used in this guide.

Generally speaking, the higher the ratio, the better it is, since it implies the company is generating more revenues per dollar of assets.  But since this ratio varies widely from one industry to the next, comparisons are only meaningful when they are made for different companies in the same sector.

Inventory Turnover

Inventory Turnover (aka ‘inventory turns’, ‘stockturn’, ‘stock turns’, ‘turns’, and ‘stock turnover’) refers to a number of times inventory is sold or used in a time period such as a year. It is calculated by dividing your COGS (Cost of Goods Sold) by your Average Inventory for your accounting period. 

This ratio should be compared against industry averages. A low turnover implies poor sales and, therefore, excess inventory. A high ratio implies either strong sales or ineffective buying. Therefore, as is the case with any other KPI, your Inventory Turnover values need to be carefully optimized.

Average Collection Period

Average (or ‘Debtor’) Collection Period (ACP) is the average time taken to collect trade debts (your accounts receivable). In other words, it shows how many days your credit sales remain on average in your A/R before they are collected. And thus allows to compare the real collection period with the granted/theoretical credit period.

For example, your company may find that its average collection period is actually 45 days or more, although its granted period is 30 days. Monitoring the average collection period is important for a company's cash flow and its ability to meet its obligations when they come due.

ACP is calculated by dividing 365 (the number of days in a year) by your Receivables Turnover

Possessing a lower average collection period is seen as optimal, because this means that it does not take a company very long to turn its receivables into cash. However, it is usually preferable to (1) come up with optimal granted period for each category of your clients and (2) make sure that real collection period always matches the declared one.

Receivables Turnover

Receivables Turnover [Ratio] (RT) is used to measure how efficiently your company manages its sales on credit. More specifically, how it extends credit and collects debt. In other words, this ratio is the most important KPI for your accounts receivable management system.

RT is calculating by dividing your Net Credit Sales by your Average Net Accounts Receivable for your accounting period (net of bad debts that is). 

Net Credit Sales (or Net Receivable Sales) refers to sales to customers on credit, less all sales returns and sales allowances. Net credit sales by definition do not include any sales for which payment is made immediately in cash. A sales allowance is a reduction in the price charged by a seller, due to a problem with the sold product or service, such as a quality problem, a short shipment, or an incorrect price.

Low RT definitely means that your company has a significant problems with collecting you’re A/R. On your customer debt, that is (by maintaining accounts receivable, firms are indirectly extending interest-free loans to their clients).

In other words, that a large portion of your credit sales ends up stuck in you’re A/R account. Which is pretty bad for your cash flows. Which means that you must (1) reassess your credit extension rules and procedures and (2) improve your collection process.

High RT means that your company and collects well. Whether it sells a lot on credit or not, depends on another financial ratio – your net credit sales to total sales.  

Efficiency Ratios

As I mentioned before, efficiency (‘activity’) ratios measure the efficiency of the firm's use of resources (in terms of converting these resources to cash, of course). Efficiency ratios are used to measure the relative efficiency of a firm based on its use of its assets, leverage or other such balance sheet items. These ratios are important in determining whether a company's management is doing a good enough job of generating revenues, cash, etc. from its resources.

There are many activity ratios, but the most widely used are eight of them: Receivables Turnover, Average Collection Period, Inventory Turnover, Inventory Conversion Period, Total Assets Turnover, Stock Turnover, Degree of Operating Leverage and Days Sales Outstanding. 

Debt Service Coverage Ratio

Debt Service Coverage Ratio (DSCR) also known as "debt coverage ratio," (DCR) is supposed to determine whether a company in question generates enough cash from operating activities to make all necessary interest, principal and lease payments. It is calculated as the ratio of cash available for debt servicing (Gross Cash Flow) to the total sum of interest, principal and lease payments.

Which is not completely accurate as it does not take into account the necessity to make Gross Investment into working capital and long-term assets. Therefore, these adjustments need to be made to make DSCR more realistic. 

Debt-to-Equity Ratio

The debt-to-equity (D/E) ratio (sometimes called ‘risk’, ‘gearing’ or ‘leverage’) is another indicator of both corporate structure and measure of corporate financial risks. It indicates the relative proportion of shareholders' equity and debt used to finance a company's assets.

The two components are usually taken at book value, but the ratio may also be calculated using market values for both, if the company's debt and equity are publicly traded, or using a combination of book value for debt and market value for equity financially. In this case, the latter approach is far more accurate, of course.

As I stated above on numerous occasions, debt-to-equity ratio – as the whole corporate structure – needs to be optimized to come up with an optimal WACC, ROIC, economic profit and financial value. 

Debt Ratio

Debt ratio is calculated as total liabilities divided by total assets. It shows the percentage of a company's assets that are financed with debt.

The higher this ratio, the more leveraged the company and the greater its financial risk. Debt ratios vary widely across industries, with capital-intensive businesses such as utilities and pipelines having much higher debt ratios than other industries like technology. Banks have probably the highest.

In the consumer lending and mortgage businesses, debt ratio is defined differently - as total debt service obligations divided by gross annual income.

Return on Invested Capital

Return on Invested Capital (ROIC) is a very important financial metric. It is used to measure your company’s efficiency at allocating the capital under its control to profitable investments. The return on invested capital measure gives a sense of how well a company is using its money to generate returns.

ROIC is a measure of your operational performance (in a sense of cash flow from operations); Therefore, it is measured by dividing your NOPLAT by your invested capital.

Your effective tax rate, obviously. Invested capital represents the total cash investment that your shareholders and debtholders have made into your company and is usually calculated in two ways:

In operating approach, investment capital (IC) is operating net working capital + net property, plant & equipment + capitalized operating leases + other operating assets + operating intangibles − other operating liabilities − cumulative adjustment for amortization of R&D.  

In financial approach, IC is total debt and leases + total equity and equity equivalents − non-operating cash and investments. Both must obviously yield the same number which allows to balance invested capital calculation form in your corporate financial valuation model.  

ROIC is important because it allows to determine whether your business makes economic sense (FCF determines whether it makes financial sense) and whether it creates or destroys financial value.

If ROIC exceeds your WACC (this difference is called economic profit), then your business creates value and thus makes economic sense; if it does not, value is destroyed and your business makes no economic sense. 

Return on Assets

Return on Assets (ROA) is calculated as your net income divided either by average total assets for the appropriate accounting period. It basically shows, how good are your assets in generating profit.  

ROA is a useful metric for comparing companies in the same industry, it varies widely across different industries. ROAs gives an indication of the capital intensity of the company, which, obviously will depend on the industry; companies that require large initial investments will generally have lower return on assets.

DuPont formula breaks ROA into two components: profit margin (net income divided by assets) which is multiplied by sales divided by total assets.

Again, from financial value perspective, you are much more interested in cash ROE measured as your FCF divided by your average shareholders’ equity for the period.

Return on Equity

Return on equity (ROE) is your net Income divided by your average shareholders’ equity for the period used in preparing your P&L.

It measures the rate of return on the ownership interest (shareholders' equity) of the common stock owners. It measures a firm's efficiency at generating profits from every unit of shareholders' equity. ROE shows how well a company uses investment funds to generate earnings growth. ROEs between 15% and 20% are generally considered good.

Sometimes, it is more useful to use so-called ‘DuPont formula’ (aka ‘strategic profit mode’) for calculating your ROE. In this formula, ROE equals your net margin multiplied by asset turnover multiplied by financial leverage.

Splitting return on equity into three parts makes it easier to understand changes in ROE over time. For example, if the net margin increases, every sale brings in more money, resulting in a higher overall ROE. Similarly, if the asset turnover increases, the firm generates more sales for every unit of assets owned, again resulting in a higher overall ROE.

Finally, increasing financial leverage means that the firm uses more debt financing relative to equity financing. Interest payments to creditors are tax deductible, but dividend payments to shareholders are not. Thus, a higher proportion of debt in the firm's capital structure leads to higher ROE. 

However, you must always keep in mind that net income is not cash. It is your profit on an accrual basis. Therefore, from a financial valuation perspective, you are much more interested in cash ROE measured as your FCF divided by your average shareholders’ equity for the period.

Current Cash Debt Coverage Ratio

This ratio is a ‘hybrid’ ratio as it includes items from two different financial statements – your balance sheet and your cash flow statement (in direct form). Financial ratio analysis uses mostly direct form of CFS so it is advisable to prepare it using both direct and indirect method.  

Current Cash Debt Coverage Ratio is calculated by dividing your net cash flow from operating activities by your average current liabilities for the same period. Thus, it indicates the ability of your business to pay its current liabilities from its operations. Which makes it a solid liquidity metric.

Obviously, a higher current cash debt coverage ratio indicates a better liquidity position. Generally a ratio of 1:1 is considered very comfortable because it means that your business is able to pay all of its current liabilities from the cash flow of its own operations.

Absolute Liquid Ratio

Absolute Liquid Ratio (ALR) goes one step further than your Quick Ratio. It removes accounts receivable from your current assets used to calculate the ratio, leaving only absolutely liquid assets. Which makes ALR the most meaningful ratio of all these three.

Basically, it tells whether you have enough cash and cash equivalents (you can pay your current liabilities with your marketable securities) to cover all your short-term financial obligations should they come due at the same time and in full amount. Although this scenario is, in reality, highly unlikely. 

Quick Ratio

Quick Ratio (aka ‘acid test’) is in some way a slight improvement over the current ratio, because the former takes inventory and other less liquid assets out of you current assets. What remains is cash, marketable securities and accounts receivable.

Quick Ratio theoretically determines whether a firm has enough short-term assets to cover its immediate liabilities without selling your inventory (which might be a major hassle, disruptive to your operations and may require a steep discount to the book value of your inventory).

However, even Quick Ratio is far from perfect. First, you still have you’re A/R. Which can be a major pain in you-know-where. Unless you decide to sell it to a third party (this is called ‘factoring’). Naturally, at a significant discount that depends squarely on the quality of you A/R. In terms of their probability of being paid on time and in full.

On average, discount rates for invoice factoring fall between 2 and 7% of the value of the receivables factored.  A typical 30-day invoice will be discounted 2 to 4%.  The fee for an invoice that has aged 60 days would be 4-7%.

Second, you can sell your inventory; that fact that Quick Ratio totally ignores. Therefore, it is still better to use Current Ratio as your primary liquidity measure but make the abovementioned ‘cash conversion adjustments’.

In reality your liquidity ratios are a part of your risk management system. They refer to a risk of all your current liabilities coming due at the same time and in full. Which rarely happens (other than in a terminal case of corporate liquidation). Therefore, you must describe several realistic liquidity scenarios and make sure that you know exactly how to meet your obligations under each one. 

Current Ratio

Current Ratio is also called "liquidity ratio", "cash asset ratio" and "cash ratio". The last two synonyms are misleading totally and the first one – substantially. It is the ratio of your total current assets (cash, marketable securities, inventory, accounts receivable, prepaid expenses, etc.) to your total current liabilities.

It is supposed to measure a company's ability to pay short-term obligations. But only ‘supposed to’. Why? Because you can’t generally swap (‘barter’) your current assets for your current liabilities. To pay the latter, you need cash.

Therefore, you must first convert your current assets into cash, which might be a problem. Sometimes, a serious problem – for example, with you’re A/R. Or even with your inventory. With prepaid expenses it is downright impossible.  

Therefore, even if your current ratio exceeds 100% (if it falls below that, your company is in big trouble), it does not mean that your company does not have a liquidity problem.

To make sure it does not, you have to make ‘assets to cash conversion adjustments’ (or ‘liquidation adjustments’) and match dates and amounts of cash receipts with amounts and dates due of your current liabilities. Which requires a highly efficient system for managing your working capital (i.e. both your current assets and current liabilities).

Liquidity ratios

As I mentioned before, liquidity ratios measure your company’s ability to meet its short-term financial obligations. The key ratios in this category are current ratio, quick ratio, absolute liquid ratio and current cash debt coverage ratio.

Unfortunately, liquidity ratios are not true measure of liquidity because they tell about the quantity but nothing about the quality of the current assets (i.e., how liquid these assets really are). And, therefore, should be used carefully.

For a useful analysis of liquidity, these ratios are used in conjunction with efficiency ratios such as receivables turnover ratio, accounts payable turnover ratio and inventory turnover ratio etc. And, obviously, supported by in-depth evaluation of actual liquidity of assets used in computing liquidity ratios. 

Types of Financial Ratios

How can we structure financial ratios by function? By identifying which corporate financial performance areas we can measure and analyze with the ratios in question.

So what exactly can we measure and analyze using financial ratios?

1.      Liquidity (aka ‘solvency’). Ability of the company to pay its debt (meet its short-term financial obligation). This ability is measured, obviously, by liquidity ratios.

2.      Profitability. How much profit your company generates from your gross sales, assets, equity and the like. This ability is measured by profitability ratios. Which are the most popular metrics used in financial analysis, by the way.

3.      Leverage. The efficiency of corporate capital structure (i.e., its method of financing its assets) and the ability of the company in question to meet its long-term financial obligations. This ability is measured by profitability ratios. Aka ‘solvency ratios’.

4.      Efficiency of utilization of corporate resources. Well, not all resources, of course, just its assets. And not all efficiency – to measure that, you will need the whole CBA. Just the efficiency of converting assets into cash or sales. This ability is measured by efficiency ratios. Aka ‘activity ratios’ or ‘operating ratios’.  Or ‘asset turnover ratios’. Or simply ‘turnover ratios’.

5.      For a public company, it is important how public investors (the ‘market’) values the company in question. To measure and analyze this value, market ratios are used. Aka ‘valuation ratios’ (no surprise here).  

KPI Classification Diagram

Cash Flows Statement Ratios

Cash Flows Statement (CFS) ratios are conceptually similar to your income statement ratios, only they show the distribution of Gross Cash Flow rather than Gross Sales. CFS allows to calculate and analyze five useful ratios:

·         Investment in Operating Working Capital / Gross Cash Flow

·         Investment in Capital Assets / Gross Cash Flow (the former includes investment in capitalized operating leases and in intangibles)

·         Gross Investment / Gross Cash Flow

·         Free Cash Flow / Gross Cash Flow

·         Cash Flow Available to Investors / Free Cash Flow (this one in a well-managed company must be equal to 100%)

I have covered the basics of optimizing these items – and, therefore, these ratios in the previous section on Cash Flow Statement (indirect form).  

Statement of Retained Earnings Ratios

Statement of Retained Earnings contains the ingredients to calculate only one ratio – a Dividend Payout Ratio – by dividing dividends accrued (declared) by net income for the same period. It reflects you dividend policy which is a part of your financial value monetization strategy.

You actually do not need this statement to calculate this ratio, though. You can take the amount of dividends from your cash flow statement (which is even better because it shows dividends actually paid) and your net income – from your income statement. So this statement is still pretty much useless for financial analysis purposes.

The traditional view is that a stable dividend payout ratio indicates a solid dividend policy by the company's board of directors. And a reduction in dividends paid is looked poorly upon by investors, and the stock price usually depreciates as investors seek other dividend-paying stocks.

Reality is, as usual, a little bit more complex. It is all about time value of money, actually. For example, if a private company is aiming at an IPO in the foreseeable future, it will definitely stop paying dividends as to get the most of its stock offering, it will need to reinvest all of its free cash flows into the company.

The same thing happens when a company sees a major expansion opportunity and needs to lay its hands on every dollar it can get to pursue it. Which means that you always have a choice – distribute your free cash flow as dividends or invest it into your business expansion. The choice that needs to be made based on financial KPI values generated by solid financial models. 

Effective Tax Rate

Effective Tax Rate is the real tax rate that your company is paying - as opposed to its declared (marginal) tax rate. It is calculated by dividing your tax expense by your pre-tax profit (EBT). Depending on how efficient your tax optimization system is, your effective rate can be much lower than your marginal rate, saving you money (sometimes, a lot of money).

Therefore, it is very important to develop and deploy a highly efficient tax optimization system that will minimize your taxes and at the same time keep you out of legal trouble (the latter is never worth it).

You must also keep in mind that you must add your spending on your tax optimization system to your total tax expense to arrive at correct value of your Effective Tax Rate.  

Interest Coverage Ratio

Interest Coverage Ratio (aka ‘Times Interest Earned’) is calculated by dividing a company's EBITDA (not EBIT!) by the company's interest expenses of the same period. This ratio is supposed to show how easily a company can pay interest on its outstanding debt.

The lower the ratio, the more the company is burdened by its debt expense. When a company's interest coverage ratio is 1.5 or lower, its ability to meet interest expenses may be questionable. An interest coverage ratio below 1 (100%) indicates the company is not generating sufficient revenues to satisfy interest expenses. A company that barely manages to cover its interest costs may easily fall into bankruptcy if its earnings suffer for even a single month.

Unfortunately, this ratio is quite misleading. It tends to present interest coverage situation better than it actually is. Why? Because EBITDA is calculated on an accrual basis and you need cash to make your interest payments. Cash that might be stuck in your accounts receivable. Or inventory. Or other current assets.

That’s why to make sure that your interest payments are well-covered, you will really need a solid methodology, highly efficient process and very competent personnel for managing your cash and the whole working capital.

Profit Margin

Profit Margin (aka ‘net profit margin’ or ‘after-tax profit margin’) is calculated by dividing your net income by your gross sales. It shows how much your company earns at the end for each dollar of gross sales. It needs to be analyzed in exactly the same way as your operating margin.

However, you must always keep in mind that your net income is calculated on an accrual basis. Therefore, from financial value perspective, the far more useful KPI is your free cash flow margin (free cash flow divided by your gross sales). FCF margin shows how much cash flow your company generates from each dollar of your gross sales.

Operating Margin

Operating Margin (aka ‘operating profit margin’) is operating income (EBIT) divided by gross sales. Operating margin gives analysts an idea of how much a company makes (before interest and taxes) on each dollar of sales.

When looking at operating margin to determine the quality of a company, it is best to look at the change in operating margin over time and to compare the company's yearly or quarterly figures to those of its competitors. This will show whether your company is (1) getting more – or less – operationally efficient over time and (2) more or less efficient than its competitors (or other benchmarks). And whether you need to take corrective action – and which one.  

Gross Margin

Gross Margin equals Gross Profit divided by Gross Sales. Gross Profit is Gross Sales minus VAT or sales tax minus sales commissions minus Cost of Goods Sold. Gross Margin shows the share of Gross Sales that is left after you pay the government, your sales agents and your suppliers (the latter includes only variable costs).

Gross Margin on a percentage basis needs to be maximized, of course, but within a certain limits that depend on your industry and your product. If you are selling a relatively small number of high-margin products, you have one target (benchmark); if you are selling a large number of low-margin, you would have a very different target. 

Income Statement Ratios

Income Statement Ratios are all about margins. In fact, it is recommended to prepare a margin-based income statement (parallel to the ‘regular’ one). ‘Margin-based’ means that all items on this income statements are expressed as a percentage of gross sales. Financial (‘economic’) meaning of this statement is to show where exactly goes the money that your customer pays for your products and services.

Financial Ratio Analysis Methodology

‘Static’ numbers on your financial statements by themselves are useless. They do not tell you anything. To obtain valuable knowledge from these numbers, you must compare them to (1) the historical values of the same items on the previous statements; (2) values of same items on financial statements of other companies, usually in the same industry – this is called ‘benchmarking’, and (3) compare these values with values of other items (‘accounts’) on the same or other financial statements.

The latter requires calculation of the difference or, much more often, the ratio between these items (e.g. debt and equity on your balance sheet). These ratios are called – for obvious reasons – financial ratios.

Thus, financial ratios refer to a special category of KPI (no surprise here) or ‘metric’ used to measure and maximize a certain aspect of corporate financial performance. This category is ‘special’ in a sense that every KPI in this category is, indeed, a ratio of items from the same or different financial statements.  

For the abovementioned reasons, financial ratios analysis is a very important component of financial analysis and the CBA in general. Therefore, to maximize the value of this analysis, your financial analyst must follow the optimal ratio analysis methodology. Which must give the right answers to the following four key ratio analysis questions:

1.      Which ratios to choose out of literally hundreds that can be computed?

2.      How to best structure them?

3.      How to analyze them?

4.      How to optimize their values?

Well, there are definitely two obvious ways to structure financial ratios – by financial statement (balance sheet, P&L, cash flow statement and statement of retained earnings) and by their function in analyzing your financial performance. In other words, which dimension of your financial performance a particular ratio allows to measure and optimize. The latter usually cover two sub-dimensions: performance proper and risk.

I will start with the most natural – and by far the easier – classification. By financial statement. As I did before with other corporate objects and KPI, I will cover these ratios from the internal (management and active investor) perspective rather than from external - passive investor – perspective.

For each ratio, I will give a brief description of its meaning and function in financial analysis, explanation of computation methodology (when needed) and another methodology – for optimizing the value of a financial ration in question. 

You would analyze each ratio as you would any other KPI – compare it with historic values and other companies to do ‘ACRC’ – analysis write-up, make conclusions, develop recommendations and make comments (if needed).  

And follow with development and implementation of financial and operational plan for optimizing the value of the KPI in question – supported by textual comments and all relevant corporate documentation.  

Your key analysis and optimization tool is, obviously, your KPIS – KPI Scorecard, a component of both the CBA Toolkit or much more functional CBA Workbench (CBAW).

Questions for Analyzing Your Cash Flow Statement

1.      How solid is your operational working capital (OWC) management methodology?

2.      How efficient is your OWC management process?

3.      How efficient are your OWC management tools?

4.      How competent is your OWC management personnel?

5.      How solid is your net capital expenditures (NCE) management methodology (including managing capital leases and intangibles)?

6.      How efficient is your NCE management process?

7.      How efficient are your NCE management tools?

8.      How competent is your NCE management personnel?

Cash Flow Available to Investors

Cash Flow Available to Investors is your free cash flow adjusted for non-operating items. It is helped (increased) by your interest income and hampered (decreased) by investments (waste, actually) in excess cash, non-operating assets and the like.

In a business entity that operates at maximum performance, these adjustments are equal to one big fat zero. And, therefore, your Cash Flow Available to Investors is equal to your Free Cash Flow. As it should be. 

Excess Cash

Excess Cash is an additional amount of cash beyond what a company normally needs to have on hand (see above). In that section I showed that there should be no excess cash in your bank accounts. Zero. None. Zilch. Zip. Nada. If you have it, you have something very wrong with your cash management system. And you better fix it – and fast.

Because, in addition to what I covered in the section on cash, your excess cash hurts your business in three more ways:

1.      It lowers your return on assets

2.      It increases your cost of capital

3.      It increases overall risk by destroying business value and can create an overly confident management team

Free Cash Flow

Free Cash Flow is one of the most important – fundamental – corporate performance indicators. By itself and as a vital component for calculating financial value of your business entity.

Free cash flow (FCF) represents the cash that a company is able to generate after making all payments (expenditures) necessary required to sustain its business. In other words, the necessary investments in current and capital operating assets.

It is essentially the money that the company could theoretically return to shareholders if the company was to grow (expand) no further. Or the amount of cash can be extracted from a company without hurting its operations. In practice, it is the money that can be either paid out to shareholders or reinvested into your company.

Free Cash Flow is calculated as:

Revenues – Expenses – Required Investments

Therefore, to maximize FCF, you have to either increase revenues, avoid costs (reduce expenses) or reduce required investments. Or do it in any combination. These options are usually represented as an acronym ‘IRACRI’. By avoiding costs and reducing investments, I obviously mean removing waste. Fat, not meat. 

Increase (Decrease) In Accumulated Other Comprehensive Income

A rare item (personally, I have never seen one before). Accumulated Other Comprehensive Income is an entry that is generally found in the shareholders' equity section of the balance sheet. Accumulated other comprehensive income is used to sum up unrealized gains and losses because those items have not been settled. This account can include unrealized gains and losses from investments held by the firm, company pension funds and foreign currency transactions.

In an unlikely event that you encounter this item, you will need to bring in an experienced auditor to figure out the exact economic meaning of this item and how it affects the corporate cash flows.

Net Capital Expenditures

Net Capital Expenditures is functionally the same thing as your Investment in Operating Working Capital, only referring to capital (long-term) rather than current operating assets.

In order to maximize their sales, capital-intensive companies have to constantly invest into upgrading or replacing their existing equipment. Net Capital Expenditures is exactly the amount of such investment over the time period. Net of accumulated depreciation, of course.

Therefore, your fundamental objective in managing your Net Capital Expenditures (NCE) is exactly the same as in managing your OWC. It is to optimize the latter to maximize the difference between your Gross Cash Flow and your NCE. Which, as usual, will require (1) solid methodology; (2) efficient business process; (3) efficient tools and (4) highly experienced and competent personnel.

    

Companies that are not capital intensive, usually do not have to worry about this item. 

Investment in Capitalized Operating Leases (or, more accurately, ‘in Capital Leases’) is functionally identical to Net Capital Expenditures, only structured as a capital lease and not a purchase. Therefore, it must be analyzed and managed in exactly the same way.

Investments in Intangibles and Goodwill is also functionally identical to Net Capital Expenditures, only it covers intangible, rather than tangible, operating assets. Therefore, it must be analyzed and managed in exactly the same way. 

Investment in Operating Working Capital

Your working capital (WC) is a difference between your current assets and current liabilities. I will cover WC in the section on financial ratios. Operating Working Capital is (no surprise here) the operating component of your WC.

On the asset side, it includes pretty much everything with the exclusion of prepaid expenses and ‘other’ current assets not related to your company operations; on the liabilities side, however, it includes only accounts payable and accruals directly caused by your operations. Thus excluding current portion of long-term-debt, short-term capital lease obligations, etc.

By definition, both asset and liability components of our OWC include only non-interest-bearing items (interest-bearing are a part of financing, not operating activities).

‘Investment in Operating Working Capital’ means that as your sales are recorded and reposted on your P&L on the accruals basis, some of them end up increasing your working capital (if not properly offset by appropriate current liabilities). And thus decreasing your cash flow. Which means that you have to subtract your Investment in Operating Working Capital from your Gross Cash Flow.

Your Investment in Operating Working Capital is, indeed, an investment. To maximize your sales (and thus your Gross Cash Flow) you must offer appropriate customer credit terms. Which result in inevitable increase in your OWC.

Therefore, your fundamental objective in managing your OWC is to optimize the latter to maximize the difference between your Gross Cash Flow and the increase in your OWC. Which, as usual, will require (1) solid methodology; (2) efficient business process; (3) efficient tools and (4) highly experienced and competent personnel.  

Gross Cash Flow

Gross Cash Flow is NOPLAT adjusted for depreciation and amortization. D&A is a non-cash ‘expense’; therefore, to calculate cash flow, you need to add it back together to your operating system, already adjusted for taxes.

Obviously, you need to maximize your Gross Cash Flow, which requires maximization of sales and optimization of expenses. In other words, you need to be careful not to cut ‘meat’ with the ‘fat’. Therefore, you must differentiate between investments and waste when analyzing your expenses.  

Cash Flow Statement

Cash Flow Statement (aka ‘statement of cash flows’ or CFS) is used to calculate and report cash flows into and out of business. As financial value is determined by cash flows (free cash flows, to be more precise), CFS is by far the most important financial statement for a financial analysis. P&L and balance sheet are important, too, but only to the extent how changes in balance sheet and P&L accounts affect corporate cash flows.

Unlike P&L and balance sheet, CFS can be prepared using either direct or indirect method (i.e., in direct or indirect form). The direct method of preparing CFS results in a more easily understood report; however, the indirect method is substantially more convenient for building financial valuation models, because it focuses more on cash flows while the direct method is more concerned with changes in corporate cash position.

Direct Method

Direct method for preparing a CFS breaks corporate cash flows into operating, investing and financing activities. Each of these flows can be either positive (cash inflow) or negative (cash outflow).

Sum of these flows gives the net increase or decrease in the amount of cash in corporate bank accounts, which is then added to cash at the beginning of the financial year to yield cash at the end of financial year. Often ‘cash equivalents’ are added to ‘cash’ which is a bit misleading, because ‘cash equivalents’ are marketable securities and spending cash on these instruments is actually a financing activity.

Indirect Method

With indirect method, CFS calculates two cash flows: (1) free cash flow that is used in financial valuation model for a business entity prepared using the discounted cash flows (DCF) method; and (2) cash flow available to investors. ‘Investors’ in this particular context refer to holders both of corporate stock (investors proper) and holders of the long-term debt of the company (i.e., creditors).

Cash flow available to investors has a dual purpose in this CFS. It (1) indicates how the cash flow generated by the firm's assets are distributed to the debt holders and equity holders and (2) is used to balance the CFS, making sure that it is done correctly. Which is another major advantage of indirect method.

This ‘balancing of the model’ becomes possible because cash flow available to investors is calculated twice (two ways): from operating and financing activities

Oh, and FAS 95 (standard for cash flow reporting issued by FASB as part of GAAP) requires a supplementary report similar to the indirect method if a company chooses to use the direct method. Which makes the indirect method almost universally used.

For all these reasons, in this guide I will cover only the indirect form of CFS. 

Financial Statements Analysis Methodology

You fundamental business management objective is two-fold: (1) maximize financial and aggregate value of your company and (2) transform your company into a powerful money-making machine that will operate at maximum performance (and, therefore, generate the maximum amount of financial and aggregate value) at all times. Obviously, these objectives are closely interrelated.

No less obviously, your financial statements analysis (FSA) is only as good and valuable as it helps you achieve these two fundamental objectives.

On the surface, your FSA deals with just numbers. Numbers that appear in corresponding accounts on your financial statements plus your key financial ratios. But it is just the surface, or a ‘front-end’. Front-end of the issue (object) that needs to be analyzed and optimized. The object that yields the value at the front-end.

The object in question can be your accounting receivable management system or an investment project financed by your bank loan or a piece of equipment (also an investment project, by the way) financed by a long-term note payable and the like.

More specifically:  

Your front-end – the numbers. The values of items on your financial statements (which are actually your financial KPI). Which need to be optimized (not all KPI values must be maximized).

Your back-end systems (such as your A/R management system that I mentioned). Such system typically includes (1) description; (2) methodology; (3) process; (4) tools; (5) in-house personnel and might also include (6) external providers of goods or services, such as a collection agency in the case of A/R management. This system, obviously, needs to be optimized to maximize its efficiency.

Your back-end projects such as the ones that I mentioned. These projects must generate the maximum amount of financial value measured by their financial KPI (NPV and IRR). They need (1) financial model; (2) operational plan; (3) business plan; (4) all relevant project-related corporate documentation and (5) project managers and personnel. Obviously, you will need to maximize financial value generated by each project.

To make a valuable contribution to achieving your fundamental business management objectives, you must analyze and optimize both front- and back-end. And to do it in the right way:

The numbers on financial statements. You deal with these KPI like with any other KPI – look at their current and historic values – benchmark, planned and actual; analyze KPI dynamics, develop conclusions; write recommendations and comments and develop and implement financial and operational plans for optimizing KPI values.  

Your key tool for analyzing your financial KPI are the dedicated KPI scorecards – KPIS – which are a part of both the CBA Toolkit and the by far more functionally rich Comprehensive Business Analysis Workbench (CBAW).

The back-end systems and objects. You thoroughly document them; analyze them using the appropriate CBA questions; develop conclusions; write recommendations and comments and develop and implement financial and operational plans for optimizing these systems and objects.

With objects you always have a choice of use ‘as is’, use for a different purpose (not with all objects); upgrade or sell/lease out. With loans and other debt instruments there is almost always an option of refinancing.

Obviously, you must always make a choice based on thorough financial analysis of available options using solid financial models and supporting documentation. 

Questions for Analyzing Your Balance Sheet Items

1.      How well does your capital structure conform to the matching principle between your assets and liabilities/capital?

2.      How optimal is your capital structure in terms of your WACC?

3.      How optimal is the amount of cash in your bank accounts in terms of risk/return?

4.      How solid is your cash management methodology?

5.      How efficient is your cash management process?

6.      How efficient are your cash management tools?

7.      How competent is your cash management personnel?

8.      How optimal is your cash/equivalents (marketable securities) ratio?

9.      How optimal is your marketable securities portfolio (in terms of risk/return)?

10.  How optimal is your balance between cash/credit/prepayment sales?

11.  How optimal is your portfolio of accounts receivable (in terms of duration)?

12.  How efficient is your system for performing customer credit checks?

13.  How efficient is your system for calculating credit scores?

14.  How comprehensive is your customer database?

15.  How solid is your A/R management methodology?

16.  How efficient is your A/R management process?

17.  How efficient are your A/R management tools?

18.  How competent is your A/R management personnel?

19.  How competent is your A/R collection agency?

20.  How efficient are your relationships with your A/R collection agency?

21.  How solid is your inventory management methodology?

22.  How optimal is your methodology for inventory costs allocation?

23.  How efficient is your inventory management process?

24.  How competent is your inventory management personnel?

25.  How efficient are your inventory management tools?

26.  How competent is your inventory management personnel?

27.  How efficient is your method and process for evaluating prepayment/purchase on credit choice?

28.  How efficient is your Short-Term Notes Payable management system?

29.  How efficient is your system for maximizing financial value of your PPE (equipment, buildings and land)?

30.  How optimal are your depreciation and amortization schedules from tax benefits standpoint?

31.  How efficient is your system for putting together (determining terms and conditions) of your long-term notes receivable?

32.  How efficient is your system for monitoring and managing your long-term notes receivable?

33.  How efficient are your long-term investments from operational standpoint?

34.  How solid is your A/P management methodology?

35.  How efficient is your A/P management process?

36.  How efficient are your A/P management tools?

37.  How competent is your A/P management personnel?

38.  How solid is your methodology for estimating your employee pension funding?

39.  How efficient is your process for estimating your employee pension funding?

40.  How solid are your tools for estimating your employee pension funding?

41.  How competent are your actuaries?

42.  How efficient is our employee benefit system in terms of generating an incremental financial value compared to motivation system that includes no benefits?

43.  How much incremental financial value does each new benefit add?

44.  How optimal is your equity structure (in terms of various types of securities)?

45.  How optimal are terms, conditions and other features of each security issue?

46.  How efficient are your procedures for dealing with your treasury stock?