Chapter 12

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 three 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 as long as the changes in working capital are neg- ligible compared to EBITDA. Below 2 times, the analyst can sleep soundly; between 2 and 4, everything will depend on the company’s sector of activity, which determines the stability of its cash flow; a ratio of 4 to 7 is only acceptable for LBOs; and above 7 times, the company will have a hard time paying back its debts. The operating income/financial expenses ratio is also used with a critical value of at least 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.

  • Is the company exposed to a foreign exchange risk on its debt? In other words, does it generate cash flows in the same currency as its debt?