Financial Statement Analysis – The VISA Approach (Using both leading and lagging indicators) (Final Part 5)
31 Jan, by
Author: Michael M Lee
This final part of my 5-part serial articles on Financial Statement Analysis (FSA) presents a totally new approach to traditional FSA, the V.I.S.A. Approach, which embraces;
a. Lagging (historical) indicators such as financial statement ratios, and
b. Leading (predictive) indicators such as Financial Limits to Growth (FLTG) and the 2-level Sales Analysis.
To address not only existing issues and problems but also “predicts” what may go wrong with the company going forward.
These leading indicators are most important to the future financial health of a company as they surface/highlight the impending problems/issues the company may face in its ongoing development. They present answers to the following yet-unknown questions/issues:
a. Is the company expanding beyond its financial limits, which may lead to subsequent weak or poor operating performance?
b. Are there growing signs of a slowdown in the economy or industry?
How do we gauge that impending onset and be prepared for it?
c. Is there a concentration risk in major product categories or geographic regions?
d. Are too much resources applied to certain sectors of the businesses?
2. The V.I.S.A. Approach
As mentioned in Part 4 of my articles, the natural order of Adequacy, Impairment, Volatility, and Sustainability is important. This is consistent with the economic flow of transactions as depicted in my ERAA diagram.
3. Adequacy of Funding Resources
a. How do we assess that funding resources are not adequate?
We will know it when sales is expanding beyond its financial limits (ie use the Financial Limits to Growth (FLTG) test). This results in inadequacy of working capital (inventory, cash) to support its growth, which must be made good by additional funding resources.
b. How much additional funding is needed to satisfy adequacy?
The FLTG test will specify how much increase in total assets (and therefore working capital) is required to support growth in sales beyond its limits. Such required increase in total assets must be funded by debt/LTL (long-term liability) and/or equity.
c. What capital structure is appropriate?
In Part 3 of this series (FSA – Is there an optimal capital structure?), I concluded that the banks basically determine the appropriate capital structure ie the quantum of LTL banks are prepared to fund given the company’s corporate plans, marketing and operational strategies, projected P&L and cashflows. .As debt is cheaper than equity, it is obvious that debt funding is preferred and it can be totally debt funding without any requirement to maintain current debt-equity ratio.
When a company intends to expand sales beyond its financial limits, it must have a definitive and defensible corporate strategy, marketing and sales plans that will satisfy bankers to extend more loans. Even if funding must come from shareholders, such corporate plans are required to convince shareholders to support. In other words, sales cannot be increased haphazardly or opportunistically! The consequence is very clear – corporate failure!
4. Impairment of assets
a. How do we assess that certain classes of assets are impaired?
In this area, financial ratios are helpful. We start off by assessing the current ratio and acid-test ratio. If these are inordinately high, we will have to look at the quality of current asset components (inventory and accounts receivable (AR)) to assess the extent of impairment. Next, we must drill down to the level of ageing analysis to identify the specific items of impairment; by customer from AR ageing, and by product, from inventory ageing.
b. How do we prevent impairment from happening?
Impairment of assets can occur in Property, plant and equipment (PPE), investments or working capital (WC) items. For PPE, it is a question of regular maintenance. For investments, we perform year-end impairment tests. For WC items, it is about focussing on regular ageing analysis.
c. What level of total assets or operating resources are needed to minimise the occurrence of impairment?
Total assets must always be kept lean so that profitability and turnover measures (Return on assets, Total assets turnover) can be enhanced.
Basically, AR and inventory turnover ratios are the key ratios to determine a healthy level of working capital and total assets position.
5. Profit & Loss (P&L) Statement
a. How do we minimise volatility in Profit & Loss Statement (P&L)?
Volatility in P&L centres around sales or revenue, which is the largest number in the P&L. Any significant movement from one period to the next causes volatility to the bottom line or Profit after tax (PAT). Leading indicators such as Financial Limits to Growth test will rein back opportunistic growth within financial limits. The 2-level sales analysis will spot potential concentration risks in major product lines or geographic spread. Such risks if left unnoticed can cause volatility in PAT.
b. How do we monitor volatility?
Using FLTG test and the 2 leading indicators to monitor sales on a quarterly basis will be helpful.
6. Cashflow Statement
a. How is sustainability defined?
The most important measure in the Cashflow Statement is the Cashflow from operating activities, which must be sustainable. Sustainability means the Operating Cashflow must be positive and is growing from period to period.
b. How can we ensure sustainability of operating cashflow?
Operating Cashflow is required to pay dividends, fund investments in fixed assets and repay loans. If it runs out due to the magnitude of payments, then new funding resources must be obtained.
Sustainability of operating cashflows is the consequence of managing all the other key factors (funding resources adequate, no impairment of assets, and no volatility in sales and/or PAT) well.
For the current period, we will need to know whether there is a net usage of working capital (WC) for operations or an increase in working capital. Obviously, a net usage in WC means year-end WC is reduced compared to beginning-of-year WC and this may impact sales/operations for the next period. Likewise, an increase in WC during the period means a higher WC at yea- end to fund sales/operations for the next period.
The net operating Cashflow after investing and financing activities is equally vital as it indicates how the next period of operations will be affected.
7. What then is the V.I.S.A. Approach to Financial Statement Analysis?
Under the V.I.S.A. Approach to financial statement analysis, we address how well we can strengthen the foundations of operations and finance to build a healthy and sustainable company going forward. This is done by first recognising the key factors (V.I.S.A. components) in each of the financial statements
a) Adequacy of funding resources and Impairment of Assets in the Balance Sheet
b) Volatility of Profit & Loss Statement
c) Sustainability of Operating Cashflows in the Cashflow Statement.
Then using both lagging (historical) and leading (predictive) indicators we assess the known and potential risks. Remedial measures and strategic plans are then devised to mitigate or forestall those risks.
The diagram below summarises the lagging (historical) and leading (predictive) indicators that apply to each of the V.I.S.A. components or key factors in the financial statements.
Central to the V.I.S.A. Approach is the appreciation of the economic flows of transactions through the accounting system as depicted in the ERAA diagram. Then the key factors (V.I.S.A. components) in each of the financial statements, which pose potential risks to the financial health of the company must be recognised. Reviewing and analysing these key factors using both lagging and leading indicators on a regular basis (quarterly) and taking the appropriate actions to mitigate or forestall the risks will save the company from unintended corporate failure.
As a quick practical approach, we can start off with analysing operating cashflows for sustainability (together with other aspects of cashflow analysis) over 2 or 3 periods of time. If it passes the sustainability test, it could be indicative that the other key factors are well managed.
——————————-6 Apr 2019 Michael M Lee—————————-