Financial Swiss Army Knife: A User-Friendly Tool for Facilitating Financial Analysis and Due Diligence

This valuable tool can serve as both a translator of complex financial information and an indicator of opportunities for enhancing financial performance. Click here to download the Financial Swiss Army Knife.

[powerpress: http://gsbm-med.pepperdine.edu/gbr/audio/fall2011/JohnScully_article.mp3]

financial swiss army knifeBefore you make a decision, you want to be sure to do your homework. Investing in a company is certainly no exception. Individuals evaluating whether to invest in an existing business routinely seek to understand the business’ ability to generate free cash flow (i.e., the ability to generate cash from operations for potential distribution to investors) and to identify opportunities for improving the business’ return on equity (ROE). Of course, this is often easier said than done. Calculating free cash flow can be a time-consuming task. Similarly, demonstrating and documenting how to improve ROE can be challenging, especially when proposed ROE improvements involve scenarios more complicated than just increasing profitability through expense reduction. For example, individuals with limited understanding of ROE may not readily appreciate how, under certain circumstances, it is possible for profitability to deteriorate and yet overall ROE to improve, such as when working capital reductions and increased distributions to common stockholders combine to offset the lower profits.

In order to facilitate financial analysis and due diligence on an existing business (including calculating free cash flow and documenting ROE improvement scenarios), this paper presents a tool that enables individuals even with limited financial background to perform a detailed financial analysis and to present the results in a clear and straightforward manner.

Swiss Army Knife[1] for Financial Analysis


















Click on image to download file

















The tool, which can be downloaded by clicking here, is an Excel spreadsheet that includes six interconnected worksheets in individual tabs. Products of this tool include:


Worksheets

A: Three-year horizontal and vertical income statement analysis

B: Three-year horizontal and vertical balance sheet analysis

C: Automatic calculation of three years of financial ratios [2]

D: Clear presentation of a free cash flow analysis

E: Three-part DuPont extended return on equity (ROE) calculation for three years[3]

F: Worksheet for generating “what-if” analyses to highlight and measure opportunities for improving ROE and return on assets (ROA)[4]

Worksheets A, B, C, and E are standard tools for gauging which aspects of an entity’s financial performance are improving or deteriorating across recent accounting periods.  Worksheet D provides insights into an entity’s ability to generate funds from operations and potentially distribute cash to investors, even if that entity is not generating profits. Worksheet F facilitates what-if analysis for improving ROE and, while the worksheets generally reflect a corporate structure, sheet F’s what-if analysis can be performed on any type of business entity (sole proprietorship, partnership, etc.) by inserting into worksheet B total common equity figures rather than inputting values for individual common equity line items.

This discussion assumes readers are familiar with the basic functions of A, B, C, and E and accordingly concentrates on benefits provided by D and F.

Methodology: How it Works

For investors, the ability to generate cash from operations may serve as the ultimate barometer of an investment’s financial success or failure. Nevertheless, preparing a free cash flow analysis can be daunting because:

  • Typically published financial statements do not conveniently isolate the two key components of a free cash flow analysis, namely net operating profit after tax (NOPAT) and changes in net operating capital (NOC).
  • Published financial statements often buried within footnotes required capital expenditure, disposal, and depreciation information.
  • The impact of working capital on cash flow may be confusing to users with limited financial expertise. For example, such users may not readily recognize the adverse cash impact of growing current assets, such as receivables, and the favorable impact of increasing non-interest bearing liabilities such as accounts payable.

Worksheet D’s free cash flow presentation addresses all these concerns by:

  • Providing a clear trail for tracing NOPAT and NOC calculations back to underlying income statement and balance sheet components.
  • Utilizing information on changes in net fixed assets, eliminating the need to research footnote information.
  • Highlighting how specific working capital components impact fee cash flow.

Assuming worksheets A, B, C, and E expose areas of financial deterioration (or phrased more positively, opportunities for improvement), worksheet F can clearly quantify whether proposed remedial actions can improve ROE even if those actions adversely impact the organization’s profit dollars and profit margins. For example, suppose an entity’s days sales outstanding (DSO) has increased, impairing the organization’s total asset turnover (TAT) and causing investors to keep more equity in the organization than may otherwise be required. As a result, the organization may consider hiring additional collections-related personnel. Although this approach may increase salary expense and reduce profitability, the key issue is whether or not improved collections can sufficiently reduce receivables to allow for increased distributions to owners with the overall result being reduced assets, lower common equity, and improved ROE.

In addition, worksheet F offers a working area for easily running and documenting “what-if” scenarios for improving ROE and ROA. Clear documentation is especially important for those scenarios that may seem counter-intuitive at first, for example, the scenario described above where ROE improves despite increased expenses and lowered profitability.

Exhibit A: Starbucks

Starbucks Corporation’s financial information is employed here to illustrate how the tool works.[5] [6] Starbuck’s income statement and balance sheet data have been posted into worksheets A and B. The tool then automatically completes sheets C, D, E, and F (except for the “what-if” user input area of F).

The worksheets follow three conventions. First, Year 0 refers to the most recent year for which financial information is available, Year -1 refers to the prior year and Year -2 to the year before that. Second, in order for the sheets to calculate information correctly, Year 0 data must be posted in column M of worksheets A and B. Year-1 data must be posted to column H of these worksheets and Year-2 data to column F. And third, interest figures used on worksheets C and D represent the net of interest expense and interest income from worksheet A.

Note: The tool contains two versions of worksheet F. In the first version of worksheet F, the “what-if” (columns G, H, and I) area is left blank in order to allow users to practice running their own scenarios. In the second version (which includes the word “completed” in the sheet’s label) the “what-if” area has been completed to reflect the proposals outlined below.

We will start by examining how worksheet D identifies key components of Starbucks’ ability to generate free cash flow. The income tax rate employed here is assumed to be 35.3 percent, which is based on the actual average for the past three years as reflected on worksheet A. Individual circumstances may require other approaches for estimating the tax rate used on worksheet D.

In 2008, Starbucks produced $335.1 million in NOPAT (see cell H14) and increased its investment in net operating capital (cell H32) by $190.9 million from $2,985.0 million in 2007 to $3,175.9 in 2008. As result, Starbucks’ 2008 free cash flow (namely, the organization’s 2008 NOPAT minus the NOC change from 2007 to 2008) was $144.2 million (cell H34).

In 2009, Starbucks’ NOPAT was $373.7 million (cell L14), revealing growth of $38.6 million over 2008. However, in 2009, Starbucks’ free cash flow was $624.5 million (cell L34), accounting for growth of $480.3 million over 2008’s $144.2 million. How did Starbucks achieve such impressive 2009 free cash flow? Although 2009’s $373.7 million NOPAT was a major factor, the other major component was the $250.8 million decline in NOC to $2,925.1 million from $3,175.9 million in 2008. Closer inspection of NOC components reveals how, between 2008 and 2009, net operating working capital increased by $169.2 million (cell N24), but net PP&E declined by $420 million (cell N26).

Although all of worksheet D’s free cash flow information derives from the income statement (worksheet A) and the balance sheet (worksheet B), worksheets A and B alone do not identify the amount of free cash flow generated by an organization nor do they highlight the key factors impacting that free cash flow, for example, the key role played by Starbucks’ 2009 NOC reduction.

To summarize, benefits of worksheet D include automatic calculation of free cash flow and identification of specific components impacting that free cash flow, while avoiding the need to research footnote information for depreciation, disposal, and capital expenditure information.

Interpreting the Results

Social Media - sales are up!Next let’s see how the DuPont pro forma worksheet F can help quantify and document opportunities for improving ROE. Notice the DuPont extended worksheet (worksheet E) shows that, although PM improved from 3.04 percent in 2008 to 4.00 percent in 2009, 2009 PM still lagged considerably below 2007’s 7.15 percent. In addition, 2009’s 1.75 TAT was considerably below 2008’s 3.26 TAT. Can this information, along with information from worksheets A, B, and C, help to identify some opportunities for improving ROE?

For example, starting with PM, observe that in 2008 general and administrative expense (G&A) represented 4.4 percent of revenue (worksheet A, cell H37), whereas in 2009, G&A represented 4.6 percent revenue (cell M37). If Starbucks could have maintained a G&A target of 4.4 percent of revenue, then the company’s 2009 G&A would have been $9,774.6 million revenue * 4.4 percent, or $430.1 million, which is $22.9 million less than the actual 2009 figure. This cost reduction is posted in the P&L section of the Completed F Worksheet (cell G11). Given pretax income increases by $22.9 million as a result of this cost reduction, the income taxes should increase by $8.1 million (assuming a 35.3 percent rate, which is the average tax rate for past three years based on information from worksheet A). Posting this $8.1 million income tax increase into cell G16 results in 2008 net income increasing by $14.8 million. The worksheet automatically adjusts the equity section of the balance sheet for these increased net earnings, but in order to keep it in balance, we assume here that cash would have also increased due to the $14.8 million net of tax cost savings.

Are reasonable opportunities also available for balance sheet improvement? The income statement shows that between 2008 and 2009, total revenue declined by 5.9 percent (worksheet A, cell P14), but inventory declined by only 4.0 percent (worksheet B, cell P14). Notice also on sheet C that the inventory turnover ratio declined from 14.99 turns in 2008 to 14.70 turns in 2009. If Starbucks was able to maintain the 2008 inventory turnover ratio through 2009, then 2009 inventory would have equaled $9,774.6 total revenue divided by 14.99 turns, or $652.1 million, which is $12.8 million lower than the actual $664.9 million ending inventory. To be conservative, let’s assume that the organization would have needed to incur $4 million in higher expenses to sustain this higher inventory turnover ratio. If so, income taxes would decrease by $1.4 million (based on 35.3 percent average tax rate * $4 million) and net income would be $2.6 million lower (based on $4.0 million higher expenses offset partially by $1.4 million lower income taxes).

To reflect this information on the completed version of worksheet F, column H shows:

-$12.8 million for lower inventory (cell H26)

+$4.0 million increased expenses (cell H11)

-$1.4 million for lower income taxes (cell H16)

Assuming cash serves as the offset for all these items, then cash would change by -$2.6 million for lower net income and by +$12.8 million for lower inventory, a net of +$10.2 million.

The company would now have a total of $25 million additional cash (which is $14.8 million from G&A savings plus $10.2 million net from the inventory reduction effort). So assuming the company had actually implemented these proposed changes, the organization could presumably have returned this incremental cash to shareholders. To reflect this distribution, -$25 million is posted into cell I24.[7]

Cells B47 through G62 summarize the ROE impact of these pro forma changes. ROE increases by .46 percent to 13.29 percent from 12.83 percent. The improvement is achieved via a .12 percent increase in PM and a slight improvement in TAT from approximately 1.75 to 1.76.

Conclusion

In summary, this example based on Starbucks’  2007 through 2009 financial statement information demonstrates how users can easily employ the attached tool to:

  • Generate automatically a free cash flow analysis from underlying income statement and balance sheet information (worksheet D).
  • Quantify how specific “what-if” scenarios can impact an entity’s ROE (worksheet F) and document clearly how these scenarios impact the income statement, balance sheet, and ROE components.
  • Present results that can be readily understood by audiences with a range of financial expertise.

Anyone considering an investment in an existing business can generate a similar analysis by posting the business’ past three years of income statements and balance sheet information and allowing the tool to populate related sections throughout worksheets A through F. With this background analysis complete, an individual can then use worksheet F to propose, measure, and document detailed scenarios for improving the business’ ROE. Thus, this valuable tool can serve as both a translator of complex financial information and an indicator of opportunities for enhancing financial performance.


[1] Swiss Army Knife is a registered trademark of Victorinox AG and its affiliates, which have no relationship to the subject matter of this article.

[2] Definitions of financial ratios and free cash flow can vary slightly depending on the source. For example, some sources use average balances in the denominator when calculating turnover ratios, whereas other sources use ending balances. For two reasons the formulas employed here are based on information from Eugene F, Brigham and Michael C. Ehrhardt, Financial Management: Theory and Practice, 13 ed., Mason, Ohio: South-Western Cengage Learning, 2009, chapters 2 and 3. First, Pepperdine University Executive Programs finance classes regularly use this text and second, all data needed to complete these formulas can be found on the income statement and balance sheet, eliminating the need to research footnotes.

[3] The three-factor DuPont extended formula dissects the basic ROE formula into the underlying components of profit margin (PM), total asset turnover (TAT), and equity multiplier (EM):

ROE     =          Net income – preferred dividends/Common equity

ROE     =          PM * TAT * EM

Where

PM       =          (Net income – preferred dividends) / total sales

TAT      =          Total sales / total assets

EM       =          Total assets / common equity

[4] Although ROA is not a specific component of a typical three-part DuPont extended analysis, ROA can provide useful information when ROE is meaningless due to an entity’s negative common equity.

[5] Starbucks Corporation. (2008). 10-K Annual Report 2008. Retrieved Nov. 30, 2011 from SEC EDGAR website http://www.sec.gov/edgar.shtml.

[6] Starbucks Corporation. (2009). 10-K Annual Report 2009. Retrieved Nov. 30, 2011 from SEC EDGAR website http://www.sec.gov/edgar.shtml.

[7] Column I is reserved for distributions to shareholders, with distributions reflected as a reduction to cash in cell M24. The spreadsheet automatically generates an offsetting reduction to common equity in cell M40.

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The Role of Finance in the Strategic-Planning and Decision-Making Process

The fundamental success of a strategy depends on three critical factors: a firm’s alignment with the external environment, a realistic internal view of its core competencies and sustainable competitive advantages, and careful implementation and monitoring.[1] This article discusses the role of finance in strategic planning, decision making, formulation, implementation, and monitoring.

[powerpress: http://gsbm-med.pepperdine.edu/gbr/audio/winter2010/PedroKono_article.mp3]

Any person, corporation, or nation should know who or where they are, where they want to be, and how to get there.[2] The strategic-planning process utilizes analytical models that provide a realistic picture of the individual, corporation, or nation at its “consciously incompetent” level, creating the necessary motivation for the development of a strategic plan.[3] The process requires five distinct steps outlined below and the selected strategy must be sufficiently robust to enable the firm to perform activities differently from its rivals or to perform similar activities in a more efficient manner.[4]

A good strategic plan includes metrics that translate the vision and mission into specific end points.[5] This is critical because strategic planning is ultimately about resource allocation and would not be relevant if resources were unlimited. This article aims to explain how finance, financial goals, and financial performance can play a more integral role in the strategic planning and decision-making process, particularly in the implementation and monitoring stage.

The Strategic-Planning and Decision-Making Process

1. Vision Statement

The creation of a broad statement about the company’s values, purpose, and future direction is the first step in the strategic-planning process.[6] The vision statement must express the company’s core ideologies—what it stands for and why it exists—and its vision for the future, that is, what it aspires to be, achieve, or create.[7]

2. Mission Statement

An effective mission statement conveys eight key components about the firm: target customers and markets; main products and services; geographic domain; core technologies; commitment to survival, growth, and profitability; philosophy; self-concept; and desired public image.[8] The finance component is represented by the company’s commitment to survival, growth, and profitability.[9] The company’s long-term financial goals represent its commitment to a strategy that is innovative, updated, unique, value-driven, and superior to those of competitors.[10]

3. Analysis

This third step is an analysis of the firm’s business trends, external opportunities, internal resources, and core competencies. For external analysis, firms often utilize Porter’s five forces model of industry competition,[11] which identifies the company’s level of rivalry with existing competitors, the threat of substitute products, the potential for new entrants, the bargaining power of suppliers, and the bargaining power of customers.[12]

For internal analysis, companies can apply the industry evolution model, which identifies takeoff (technology, product quality, and product performance features), rapid growth (driving costs down and pursuing product innovation), early maturity and slowing growth (cost reduction, value services, and aggressive tactics to maintain or gain market share), market saturation (elimination of marginal products and continuous improvement of value-chain activities), and stagnation or decline (redirection to fastest-growing market segments and efforts to be a low-cost industry leader).[13]

Another method, value-chain analysis clarifies a firm’s value-creation process based on its primary and secondary activities.[14] This becomes a more insightful analytical tool when used in conjunction with activity-based costing and benchmarking tools that help the firm determine its major costs, resource strengths, and competencies, as well as identify areas where productivity can be improved and where re-engineering may produce a greater economic impact.[15]

SWOT (strengths, weaknesses, opportunities, and threats) is a classic model of internal and external analysis providing management information to set priorities and fully utilize the firm’s competencies and capabilities to exploit external opportunities,[16] determine the critical weaknesses that need to be corrected, and counter existing threats.[17]

4. Strategy Formulation

To formulate a long-term strategy, Porter’s generic strategies model [18] is useful as it helps the firm aim for one of the following competitive advantages: a) low-cost leadership (product is a commodity, buyers are price-sensitive, and there are few opportunities for differentiation); b) differentiation (buyers’ needs and preferences are diverse and there are opportunities for product differentiation); c) best-cost provider (buyers expect superior value at a lower price); d) focused low-cost (market niches with specific tastes and needs); or e) focused differentiation (market niches with unique preferences and needs).[19]

5. Strategy Implementation and Management

In the last ten years, the balanced scorecard (BSC)[20] has become one of the most effective management instruments for implementing and monitoring strategy execution as it helps to align strategy with expected performance and it stresses the importance of establishing financial goals for employees, functional areas, and business units. The BSC ensures that the strategy is translated into objectives, operational actions, and financial goals and focuses on four key dimensions: financial factors, employee learning and growth, customer satisfaction, and internal business processes.[21]

The Role of Finance

Financial metrics have long been the standard for assessing a firm’s performance. The BSC supports the role of finance in establishing and monitoring specific and measurable financial strategic goals on a coordinated, integrated basis, thus enabling the firm to operate efficiently and effectively. Financial goals and metrics are established based on benchmarking the “best-in-industry” and include:

1. Free Cash Flow

This is a measure of the firm’s financial soundness and shows how efficiently its financial resources are being utilized to generate additional cash for future investments.[22] It represents the net cash available after deducting the investments and working capital increases from the firm’s operating cash flow. Companies should utilize this metric when they anticipate substantial capital expenditures in the near future or follow-through for implemented projects.

2. Economic Value-Added

This is the bottom-line contribution on a risk-adjusted basis and helps management to make effective, timely decisions to expand businesses that increase the firm’s economic value and to implement corrective actions in those that are destroying its value.[23] It is determined by deducting the operating capital cost from the net income. Companies set economic value-added goals to effectively assess their businesses’ value contributions and improve the resource allocation process.

3. Asset Management

This calls for the efficient management of current assets (cash, receivables, inventory) and current liabilities (payables, accruals) turnovers and the enhanced management of its working capital and cash conversion cycle. Companies must utilize this practice when their operating performance falls behind industry benchmarks or benchmarked companies.

4. Financing Decisions and Capital Structure

Here, financing is limited to the optimal capital structure (debt ratio or leverage), which is the level that minimizes the firm’s cost of capital. This optimal capital structure determines the firm’s reserve borrowing capacity (short- and long-term) and the risk of potential financial distress.[24] Companies establish this structure when their cost of capital rises above that of direct competitors and there is a lack of new investments.

5. Profitability Ratios

This is a measure of the operational efficiency of a firm. Profitability ratios also indicate inefficient areas that require corrective actions by management; they measure profit relationships with sales, total assets, and net worth. Companies must set profitability ratio goals when they need to operate more effectively and pursue improvements in their value-chain activities.

6. Growth Indices

Growth indices evaluate sales and market share growth and determine the acceptable trade-off of growth with respect to reductions in cash flows, profit margins, and returns on investment. Growth usually drains cash and reserve borrowing funds, and sometimes, aggressive asset management is required to ensure sufficient cash and limited borrowing.[25] Companies must set growth index goals when growth rates have lagged behind the industry norms or when they have high operating leverage.

7. Risk Assessment and Management

A firm must address its key uncertainties by identifying, measuring, and controlling its existing risks in corporate governance and regulatory compliance, the likelihood of their occurrence, and their economic impact. Then, a process must be implemented to mitigate the causes and effects of those risks.[26] Companies must make these assessments when they anticipate greater uncertainty in their business or when there is a need to enhance their risk culture.

8. Tax Optimization

Many functional areas and business units need to manage the level of tax liability undertaken in conducting business and to understand that mitigating risk also reduces expected taxes.[27] Moreover, new initiatives, acquisitions, and product development projects must be weighed against their tax implications and net after-tax contribution to the firm’s value. In general, performance must, whenever possible, be measured on an after-tax basis. Global companies must adopt this measure when operating in different tax environments, where they are able to take advantage of inconsistencies in tax regulations.

Conclusion

The introduction of the balanced scorecard emphasized financial performance as one of the key indicators of a firm’s success and helped to link strategic goals to performance and provide timely, useful information to facilitate strategic and operational control decisions. This has led to the role of finance in the strategic planning process becoming more relevant than ever.

Empirical studies have shown that a vast majority of corporate strategies fail during execution. The above financial metrics help firms implement and monitor their strategies with specific, industry-related, and measurable financial goals, strengthening the organization’s capabilities with hard-to-imitate and non-substitutable competencies. They create sustainable competitive advantages that maximize a firm’s value, the main objective of all stakeholders.


[1] M.E. Porter, “What is Strategy?” Harvard Business Review, 74, no. 6 (1996). [purchase required]

[2] D. Abell, Defining the Business: The Starting Point of Strategic Planning, (New Jersey: Prentice-Hall, 1980).

[3] J.S. Bruner, The Process of Education: A Landmark in Education Theory, (hyperlink no longer accessible). (Boston: Harvard University Press, 1977).

[4] J.A. Pearce and R.B. Robinson, Formulation, Implementation, and Control of Competitive Strategy, (New York: Irwin McGraw-Hill, 2000).

[5] C.S. Clark and S.E. Krentz, “Avoiding the Pitfalls of Strategic Planning,” Healthcare Financial Management, 60, no. 11 (2004): 63–68.

[6] T. Jick and M. Peiperl, Managing Change: Cases and Concepts, (New York: Irwin/McGraw-Hill, 2003).

[7] J.C. Collins and J.I. Porras, “Building Your Company’s Vision,” Harvard Business Review, 74, no. 5 (1996). [purchase required]

[8] Pearce and Robinson.

[9] J.A. Pearce and F. David, “Corporate Mission Statement: The Bottom Line,” The Academy of Management Executive, 1, no. 2 (1987): 109–116. [purchase required]

[10] R.K. Johnson, “Strategy, Success, a Dynamic Economy, and the 21st Century Manager,” The Business Review, 5, no. 2 (2006).

[11] M.E. Porter, “How Competitive Forces Shape Strategy,” Harvard Business Review, 57, no. 2 (1979).

[12] Ibid.

[13] A.A. Thompson, A.J. Strickland, and J.E. Gamble, Crafting and Executing Strategy, (New York: McGraw-Hill/Irwin, 2009).

[14] Pearce and Robinson.

[15] Thompson, Strickland, and Gamble.

[16] B. Jovanovic and G.M. MacDonald, “The Life Cycle of a Competitive Industry,” The Journal of Political Economy, 102, no. 2 (1994: 322–347).

[17] C.A. Lai and J.C. Rivera, Jr., “Using a Strategic Planning Tool as a Framework for Case Analysis,” Journal of College Science Teaching, 36, no. 2 (2006): 26–31.

[18] M.E. Porter, Competitive Advantage: Techniques for Analyzing Industries and Competitors, (New York: The Free Press, 1980).

[19] Thompson, Strickland, and Gamble.

[20] R.S. Kaplan and D.P. Norton, “Using the Balanced Scorecard as a Strategic Management System,” (hyperlink no longer accessible). Harvard Business Review, 74, no. 1 (1996).

[21] Ibid.

[22] Peter Grant, “How Financial Targets Determine Your Strategy,” Global Finance, 11, no. 3 (1997): 30–34

[23] Ibid.

[24] Sidney L. Barton and Paul J. Gordon, “Corporate Strategy: Useful Perspective for the Study of Capital Structure?” The Academy of Management Review, 12, no. 1 (1987): 67–75.

[25] B.T. Gale and B. Branch, “Cash Flow Analysis: More Important Than Ever,” Harvard Business Review, July–August (1981).

[26] H.D. Pforsich, B.K.P. Kramer, and G.R. Just, “Establishing an Effective Internal Audit Department,” Strategic Finance, 87, no. 10 (2006): 22–29.

[27] Q. Lawrence, “Hedging in Perspective,” Corporate Finance, 115, no. 36 (1994).

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