2018 Volume 21 Issue 1

Three-Minute Financial Analysis for the Non-Financial Manager

Three-Minute Financial Analysis for the Non-Financial Manager

A 12-Step Approach

This three-minute exercise, while not a full financial analysis, can enable the non-financial manager to take a quick look at the financial performance of an organization and evaluate its potential strengths and weaknesses.

At times, non-financial managers (NFMs) participate in critical discussions focused on identifying the financial strengths and weaknesses of an outside organization—for example, when determining whether to extend significant credit to a new customer, when assessing the financial viability of a critical supplier, or, perhaps most importantly, when evaluating the financial performance of an acquisition target or even the attractiveness of a potential acquirer. Such discussions and associated activities, especially those relating to merger and acquisition opportunities, can represent critical events in the life of a company and can offer unique opportunities for individuals to demonstrate their value to an organization. As a result, the NFM’s ability to participate fully and quickly in these discussions may represent a positive career event or, on the other hand, may highlight the NFM’s limited skill set and diminish colleagues’ perception of the NFM’s career potential.[1]

Figure 1: Netflix a Great Revenue Story

The discussion offered in this article:

  • Provides an approach for evaluating an organization’s financial statements in approximately three minutes without requiring any other analytical tools, software, or even knowledge of financial ratios.
  • Offers a generalized approach focusing on commonly utilized financial statement categories rather than assuming a specific industry knowledge. As a result, the NFM can use this approach even when addressing businesses operating within unfamiliar industries.
  • Identifies 12 critical items (including a brief, everyday language description of the meaning of each item) that the NFM should look at when expected to address quickly another organization’s financial strengths and weaknesses.
  • Recommends the sequence in which to examine these items.
  • Provides an example of how to utilize this approach by examining Netflix’s 2016 10-K Report.[2] (Note: All financial statement figures cited below can be found between pages 40 and 43 of the 10-K Report, and the terminology employed here is intended to facilitate locating where each figure specifically resides within the financial statements.)

Despite practice often to the contrary, there are three major reasons why the approach advocated here begins with the statement of cash flows. First, since the statement of cash flows incorporates information from both the income statement and balance sheet, the statement of cash flows provides an integrated perspective from which to examine the income statement and balance sheet rather than the siloed perspective that may result when starting with either of the other two statements. Second, as noted by Eugene F. Brigham and Michael C. Ehrardt, authors of the popular MBA text, Financial Management: Theory & Practice, “Some financial analysis can be done with virtually no calculations. For example, we always look to the statement of cash flows first, particularly the net cash provided by operating activities.”[3] Third, and most importantly, the investing activities section of the statement of cash flows alone highlights clearly when a company has been involved in any merger and acquisition related activity. Typically, neither the income statement nor the balance sheet provides such clear insight. So unless NFMs begin their analysis with the statement of cash flows, they risk the possibility of mistakenly assuming all observed income statement and balance sheet growth is organically based, which in turn may require re-working the analysis if they belatedly discover business combination insights upon reaching the statement of cash flows.

Numbered items below reflect the specific areas on which the NFM should focus, the financial statement where each item is located, and the recommended sequence in which to address each item.[4]  

Table 1: Financial Statements

Statement of Cash Flows (p. 42)

            Cash flows from operating activities:[5]

#1 Net cash flows provided by operating activities—reflects the net amount of cash generated or consumed in day-to-day operations before considering the impact of any long-term assets (such as plant and equipment) acquired by the organization during the reporting period.

Netflix experienced net cash outflows from day-to-day operations of $1,474 million in 2016 and $749 million in 2015, compared to a net cash inflow from operations of $16 million in 2014. Observation: Although there may be many good reasons for looking favorably upon Netflix, it would appear to be a concern that in both 2016 and 2015, day-to-day operations consumed much more cash than was generated.

            Cash flows from investing activities:

#2 Capital expenditures—represents long-term property, plant, and equipment acquired to use in the business.

Netflix’s expenditures for property and equipment and DVD content assets amounted to a combined $185 million in 2016, $169 million in 2015, and $145 million in 2014. Observation: The amount spent on these long-term assets employed in the business grew each year at the same time that net cash generated from day-to-day operations declined significantly. (See observation #1 on cash flow from operating activities.)

#3 Acquisition of other businesses—indicates the amount expended to acquire other businesses.

Netflix’s statement of cash flows did not identify any cash expenditures specifically relating to acquisition of other businesses. As a result, when turning to the income statement and balance sheet, the NFM can be confident that all reported growth resulted solely from organic activity.

            Cash flow from financing activities:

#4 Net cash flows from financing activities—equals the net amount of cash exchanged between a company and its stockholders and/or lenders (excluding interest payments, which are reported separately in the supplemental disclosures at the bottom of the statement of cash flows). Note: A positive figure means that during the reporting period, the company had received more cash from stockholders and lenders than it had returned to them, whereas a negative figure means the company had returned more cash than it had received.

Netflix’s cash flows relating to activities with lenders (excluding interest payments, which, as noted earlier, are shown at the bottom of the statement in the supplemental disclosure section) and shareholders reflected a net cash inflow to the company of $1,468 million in 2016, $1,809 million in 2015, and $1,114 in 2014. Observation: In all three years, Netflix received significantly more funds from lenders and shareholders than Netflix distributed to these parties. These net cash inflows from financing activities presumably helped to cover the net cash outflows from operating activities and acquisition of long-term assets to support operations.

Balance Sheet (p. 43)[6]

#5 Total assets—provides quick insight into the size of the company in terms of assets owned.[7]

For Netflix, 2016 total assets grew to $13,587 million versus $10,203 million in 2015.

#6 Cash and short-term investments—highlights the amount of funds readily available for meeting company obligations and supporting initiatives.

While Netflix’s total assets grew between 2015 and 2016 (as noted in #5), the amount of total assets comprised specifically by the combination of cash and short-term investments declined to $1,734 million from $2,310 million.

#7 Current interest bearing liabilities—reflects obligations to lenders coming due within the next 12 months which must either be paid or rolled over.

Netflix’s balance sheet did not specifically identify any current interest bearing liabilities. (The 10-K Report’s footnote #4 showed debt repayments not starting to come due until 2021.)

#8 Long-term interest bearing liabilities—represents interest bearing obligations owed to lenders but not due within the coming 12 months.

Netflix’s long-term debt grew to $3,364 million in 2016 from $2,371 million in 2015.

Income Statement (p. 40)

#9 Total revenue—represents total value of products and services sold to customers.[8]

For Netflix, total revenue grew from $5,504 million in 2014 to $6,780 million in 2015 to $8,831 million in 2016. Observation: Even without calculating revenue growth percentages, Netflix clearly has experienced rapid revenue growth.

#10 Net income—reflects the difference between the value of products and services sold to customers less the value of all the resources consumed in generating the related sales to customers.

While Netflix’s total revenue has been growing significantly year-over-year, the net income story was more erratic. In 2014 net income was $267 million, and in 2015 net income declined to $123 million. In 2016 net income grew to $187 million but remained well below 2014’s $267 million.

#11 Gross profit—represents total revenue minus only the costs of direct labor, overhead, and direct expenses relating to the revenue generated (in other words, it ignores expenses relating to marketing, general and administrative functions, interest, and income taxes).

Netflix’s income statement did not include a row for reporting gross profit.

#12 Operating income—reflects total revenue less all operating expenses (i.e., non-operating expenses such as interest expense and income taxes are excluded from the calculation).

Netflix’s 2014 operating income was $403 million, declined to $306 million in 2015, and recovered partially to $380 million in 2016.

Figure 2: Netflix Net Income and Operating Cash Flow

Key Takeaways

So in terms of these 12 items, the key takeaways arising from Netflix’s 2014 through 2016 financial statements are the following:

  • Cash flow from day-to-day operating activities was negative in 2015 and deteriorated further in 2016. Even in 2014 when cash flow from operating activities was positive, the amount was insufficient to cover the costs of acquiring long-term assets employed in the business. (See #1 and #2.)
  • Net cash flows from financing activities demonstrated that the company continues to obtain significant amounts of cash from lenders and stockholders. (See #4.) Therefore, other than the interest payments reflected in the supplemental disclosures, day-to-day operations are not generating cash for distribution to lenders and shareholders.
  • Although total assets grew in 2016 and 2015, the amount of total assets represented by cash and short-term investments actually declined, even though borrowings increased by around $1,000 million between 2015 and 2016. (See #5, #6, and #8.)
  • Revenue showed steady growth from 2014 thru 2016. However, profitability in terms of both operating income and net income declined in 2015 versus 2014 before partially recovering in 2016. (See #9, #10, and #12.)

Interestingly, applying this same 12-step approach to Twitter’s 2016 10-K Report shows a very different financial picture. Although Twitter experienced slow revenue growth and lingering net losses from 2014 through 2016, the organization importantly demonstrated positive and growing annual cash flow from operating activities, highlighting the need for NFMs and other individuals to appreciate the distinction between earnings and cashflow performance.[9]

Figure 3: Twitter vs Netflix

Summary

Although the 12-step approach outlined here may not comprise a full financial analysis of an organization, this approach does enable the NFM to gain quick insights into the financial performance of an organization and, perhaps more importantly, to contribute effectively to the management team’s evaluation of the financial strengths and weaknesses of an outside organization.

For practice, NFMs are encouraged to apply this 12-step approach to Netflix’s September 2017 year-to-date financial results as presented on pages 7 through 9 of the Company’s “Q3 17 Letter to Shareholders”[10] and strive to complete this 12-step analysis in three minutes or less.

This three-minute exercise represents a small investment for the NFM seeking to develop a stronger financial skill set. After conducting this 3Q2017 analysis, the NFM may find it interesting to reflect on whether the 2016 observations presented above differ significantly from the NFM’s own findings about 3Q2017 year-to-date results. In other words, has Netflix’s financial story changed significantly since the end of 2016?

The NFM may also want to watch for quarterly earnings press releases of other prominent companies and then immediately analyze the included financial statements using the 12-step approach outlined here. The NFM may find it interesting to observe how colleagues react as the NFM begins providing timely financial insights about these companies even before related news stories begin to circulate widely.

 

References

[1] Thank you to the many Pepperdine University Executive Program students and alumni who have applied the approach outlined here and provided feedback on their results.

[2] Netflix, Inc. (2017). Form 10-K (Annual Report). New York, NY: Edgar Online, Inc. Retrieved from http://files.shareholder.com/downloads/NFLX/5301007296x0xS1628280%2D17%2D496/1065280/filing.pdf.

[3] Brigham, E. F., & Ehrhardt, M. C. (2017). Financial Management: Theory and Practice. Boston, MA: Cengage Learning, p. 103.

[4] A company’s financial statements may not always reflect all 12 items. For example, if an organization has not borrowed any money from lenders, then the financial statements will likely not show any current or long-term interest bearing obligations. Also, terminology may vary from one company to the next. For example, instead of using the term “long-term interest bearing liabilities,” a company’s balance sheet may refer specifically to such obligations as mortgages payable, notes payable, etc.

[5] For detailed explanation of the statement of cash flows, see Financial Accounting Standards Board Accounting Standards Codification, ASC 230, https://asc.fasb.org/topic&trid=2134446.

[6] Although Netflix’s 10-K includes three years of income statement and cash flow information, the balance sheet reflects only two years of information.

[7] For detailed explanation of the balance sheet, see Financial Accounting Standards Board Accounting Standards Codification, ASC 210, https://asc.fasb.org/topic&trid=2122208.

[8] For detailed explanation of the income statement, see Ibid., ASC 225, https://asc.fasb.org/topic&trid=2122288.

[9] Twitter, Inc. (2017). Form 10-K (Annual Report). New York, NY: Edgar Online, Inc. Retrieved from http://files.shareholder.com/downloads/AMDA-2F526X/5470885401x0xS1564590%2D17%2D2584/1418091/filing.pdf.

[10] Netflix, Inc. (2017). “Q3 17 Letter to Shareholders.” Retrieved from http://files.shareholder.com/downloads/NFLX/5301007296x0x959841/8E7F87AB-2E5C-41DB-862B-E872EF39B039/Q3_17_Shareholder_Letter_COMBINED.pdf.

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Author of the article
John J. Scully, PhD, CPA
John J. Scully, PhD, CPA

John Scully is a Practitioner Faculty member with Pepperdine University’s Graziadio School of Business and Management and he is also a board member and co-founder of Ecliptic Enterprises Corporation, an organization focusing on space avionics and sensor systems.  From 2001 to 2017 Dr. Scully also served as Ecliptic’s CFO. His professional experience includes more than 30 years in accounting and finance, primarily with engineering and consulting related organizations. In the 1980s, he held several accounting and auditing positions with DuPont. While working in DuPont’s internal audit organization, he conducted audits in Argentina, Australia, Brazil, Mexico and New Zealand. Later he moved to Roy F. Weston, Inc. (later renamed Weston Solutions), an engineering and consulting organization. He held several positions at Weston, including manager of corporate audit, group controller and west region controller. Dr. Scully subsequently moved to Aon Consulting, an international employee benefits and human resources consulting organization. He initially served as west region controller and later became Aon Consulting’s corporate controller. In 2001 Dr. Scully and a team of engineers co-founded Ecliptic.  In 2017 he started Path1 LLC, a financial consulting organization.  Dr. Scully is a licensed CPA in the State of Pennsylvania.

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