FINANCIAL ANALYSIS : Financing
Analysing how a company is financed can be performed either by looking at several fiscal years, or on the basis of the latest available balance sheet.
In the dynamic approach, your main analytical tool will be the cash flow statement. Cash flow from operating activities is the key metric.
Cash flow from operating activities depends on the growth rate of the business and on the size and nature of working capital. Cash flow from operating activities must cover capital expenditure, loan repayment and dividends. Otherwise, the company will have to borrow more to pay for its past use of funds.
The company uses shareholders' equity and bank or financial debts to finance its investments. These investments must gradually generate enough positive cash flow to repay debt and provide a return to shareholders.
In the static approach, analysis tries to answer the following two questions:
- Can the company repay its debts as scheduled? To answer this question, you must build projected cash flow statements, based on assumed rates of growth in sales, margins, working capital and capital expenditure. To perform a simplified analysis, you can calculate the net debt/EBITDA ratio. If the company is to have an acceptable capacity to meet its repayment commitments as scheduled, the ratio should not be in excess of 4. Similarly, the EBIT/debt service ratio should be at least equal to 3.
- Is the company running the risk of being illiquid? To answer this question, you must compare the dates at which the company's liabilities will come due and the dates at which its assets will be liquidated. Assets should mature before liabilities. If they do, the company will remain liquid.