Day 50 in MIT Sloan Fellows Class 2023, Financial Management 1, How to read accounting information
This course is exploring how bankers and companies think about finance and how to make a decision from various financial information. Most classes have case studies and assignments. It is our core and quite intensive program.
Ratio Analysis
Before diving into Pro forma or other analyses, we need to glance at some ratios to understand company's financial health and financial policy.
- % of Sales( apply for all Income statement components and cash/debt balance)
- Profitability
- Various turnovers and days
- A/R days
- A/P days
- Inventory days
- Total asset turnover(Sales/Total assets)
- Fixed asset turnover(Sales/PPE)
- Balance
- Debt/(Debt + Equity)
- Debt/Total Assets
- Debt/Equity
- Liabilities/Total Assets
- Total Assets/Liability
- Current Ratio(Current assets/Current liabilities)
- Intrest Coverage(EBIT/Interest expenses
For example, if you have long A/R days and short A/P days, you need to review financial policy because you have higher risk of cashout.
Uses and sources analysis
Source and Use of funds is a typical analysis to summarize a firm’s changes in financial position from one period to another.It has been replaced by the cash flow statement (1989) in US audited annual reports.
Typical sources of capital include:
- Bank debt;
- Vendor financing (VTB or earnout);
- Mezzanine debt;
- Earnouts; and/or Equity.
Typical uses of capital include:
- Capital assets;
- Working capital;
- Goodwill; and/or Transaction costs.
In this analysis and pro forma, cash and notes payable are always "plug" components, which are flexibly modified based on some external changes.
Proforma analysis
Pro forma analysis is simple "prediction" analysis for the next couple of years or months. You need to set some assumptions like COGS should be x % of revenue or inventory should keep the same level of the current balance.
Circulation
If you face some significant event, you need to modify pro forma. For example, disaster, recession, competitors' rapid movement or just vast demand in market etc.
You need to change the Income statement first, and then get cracking on B/S. When you change notes payable or accrued tax, you need to fix the income statement again. Thus, there is some circulated modifications happened in financial analysis. The recent software already automated this circulation process.
From bank's perspective
From bank's perspective, always need to consider the balance between interest payment and risk of default. Also, just in a case of default, we need to consider collateral.
The following perspectives are typical questions bankers would have
- How much $ do you need?
- Why?
- For how long?
- What are the risk?
- What is the collateral?
Collateral should be cash, A/R, PPE and Inventory. Except for cash, you need to multiply some percentage to estimate the risk of failed liquidization.
