Financial Statement Analysis – Using leading indicators (Part 2)
31 Jan, by
Author: Michael M Lee
1. INTRODUCTION
This is the second of my 5-article series on the inadequacy of traditional financial statement analysis (FSA) in predicting, preventing and protecting business and financial risks of a company. The following 2 leading indicators are useful in managing such risks.
1.1 Financial limits to growth, and
1.2 Two-level sales analysis.
2. FINANCIAL LIMITS TO GROWTH (FLTG)
FLTG or more specifically, financial limits to sales growth is a concept which is rather intuitive. The formula points to an indicative sales growth rate, which should be used only as a guide to managing future sales growth.
Given the current operating characteristics and financial policies of a company, we would be able to predict the sustainable level of sales/revenue growth in the following year and into the future. Current operating characteristics are derived from 3 financial ratios; net profit margin (NPM), debt/equity ratio (D/E ratio) and total assets turnover (TA T/O ratio). Financial policies include policies on dividend distribution and depreciation.
2.1 The rationale
In FLTG, we are using current financial ratios to predict the future. The rationale is as follows:
2.1.1 NPM
The greater the NPM (or profit after tax, PAT), the higher the new funding resource, and the more operating resources it can generate for the future, since net profits are accumulated into revenue reserves. (Please refer to my ERAA diagram in Part 1 of this series). However, this new funding resource is reduced by the dividend distribution policy.
2.1.2 D/E ratio
Within constraints, the higher this ratio, the higher new total funding resources are generated. Therefore, arising from a) above, retained profits after dividend distribution and new debt supposedly generated based on current D/E ratio will provide the total new funding resources (left hand side of the Balance Sheet) for the future operating resources for the company’s business (right hand side of Balance Sheet).
2.1.3 TA T/O ratio
The total new funding resources generated in b) above can procure same amount of new operating resources (Please see ERAA diagram in Part 1). And depending on the current TA T/O ratio, these new operating assets will be able to generate certain amount of new sales accordingly.
In gist, the new sales that can be generated is expressed in the sales growth rate G, which is given by the FLTG formula as
G = P x R x L / (A – P x R x L)
Where P = NPM or PAT/Sales
R = Retention rate or (PAT – dividend) / PAT
L = Leverage or (Liabilities + equity) / equity
A = Total assets turnover or Total assets / sales
Note: Any reader who needs an illustration of the application of FLTG formula can email me at mtclee@singnet.com.sg. (with your name and contact #).
The FLTG formula provides us with the sustainable sales growth rate G and if we exceed that rate without proper funding, liquidity will weaken, and the company’s financial health becomes an issue. It should be noted that FLTG is only indicative and it is a “range” concept, not a “point” concept.
2.2 A practical application of FLTG
One practical FLTG application is in the company’s yearly budget exercise. In any yearly budgeting exercise, the following key considerations will have to be addressed.
2.2.1 Are budget assumptions reasonable?
If budget assumptions are not reasonable, the budget numbers cannot hold on their own.
2.2.2 Is sales budget too aggressive?
If sales budget for the coming year is a100% increase over current year, the increase without proper justification cannot be delivered. This is where the FLTG tool can moderate the sales budget to a deliverable level.
2.2.3 With additional increase in budgeted sales, is there a corresponding additional increase in working capital to support it?
Most companies do not address this area adequately or at all, and FLTG tool can help.
2.2.4 Is funding for the additional working capital increase addressed?
Again, this is an area which is inadvertently left out in budget exercises, and the FLTG tool can also help. This is also one of the reasons why budgets fail to deliver in some companies.
2.3 Cashflow mis-matches
The inevitable consequences of not addressing FLTG are mis-matches in cashflows (cash outflows are much greater or faster than cash inflows) and this is the beginning of financial trouble. This arises when significant increases in sales are not adequately supported by working capital and funding resources.
Another cause of cashflow mis-matches arises from the power of suppliers and/or customers. As indicated in Michael Porter’s “Competitive strategy: Five forces”, the power of suppliers may result in a company having to settle payables much earlier than normally expected. Likewise, the power of customers may result in collections much later than normally expected. This challenges one of the fundamental principles of good working capital management which requires collection days to be much shorter than payment (payable settlements) days.
For a brief discourse on the BCG Matrix, please refer to Chapter 4 of “Key Management Models” by Marcel van Assen et al. 2nd Edition Prentice Hall 2009.
3. TWO-LEVEL SALES ANALYSIS (TLSA)
The TLSA applies segment information at 2 levels viz, trend and segment. It provides signs when an industry or the economy is slowing down and/or when there is product or geographic concentration risks, among other useful indications.
Public listed companies are required to present segment information (by major product categories and by geography) for year-end financial reporting. For non- public listed companies, segment information will have to be first prepared.
The following TSLA diagram which I have designed encapsulates the areas which provide leading indicators of any impending business and financial risks.
3.1 Sales Trend Analysis
The first level analysis is to review monthly/quarterly sales in total and by major product categories. This can also be done by region. Whenever there is a decline in two consecutive quarters (of say, at least 10%, depending on industry), management must analyse the reasons for the decline. It could well be a precursor of impending recession, unless it is due to seasonality. Therefore, a history of trends must be kept and monitored.
If the quarterly trend is flat, the analysis may show that marketing efforts are not effective, or the product category has no longer any growth potential. Certain decisive actions will have to be taken.
If the quarterly trend shows an upsurge, it may pose a FLTG problem and funding must be in place to support the growth upsurge. Otherwise, there will be a need to cut back on excessive growth that can result in business and financial risks.
3.2 Segment Information Analysis
There are 3 areas where segment information can be used to manage the future direction of the company.
a) concentration risk areas
b) return on investment on major product categories/regions
c) BCG focus
3.2.1 Concentration risk areas
Depending on the number of major product categories, no one major product category sales should be significantly higher than the average sales for each category. The analysis also extends to territory of operations. If the sales concentration is also in a territory with high country risks, the concentration risk is compounded. This does not mean that we must quickly steer away from such a situation but close monitoring of the risks it poses is required.
3.2.2 Return on investment
As the segment information has both the net profit and net assets for each major category of products, an analysis of return on investment of each individual category and in comparison, with other categories could be readily performed. The veracity of the results depends very much on the proper allocation of net assets to each major product category. When certain product category is under-performing for two consecutive quarters without reasonable cause, management actions will have to be taken.
3.2.3 BCG focus
The Boston Consulting Group (BCG) designed the BCG Matrix for product portfolio planning based on product life cycles. It focuses on market growth and market share of each product or product category and then aligns them in the matrix. The product ends up either being
a) a cash cow to be harvested,
b) a star to be further invested in,
c) a dog to be divested, or
d) a question mark to be put on hold and investigated.
Additional segment information for each product category will have to be gathered and compiled for this exercise.
For a brief discourse on the BCG Matrix, please refer to Chapter 2 of “Key Management Models” by Marcel van Assen et al. 2nd Edition Prentice Hall 2009.
4. QUARTERLY REVIEWS
It is important that management and board of companies review these 3 areas every quarter
- No financial limits to growth issues
- No concentration risk problems, and
- A good indication of when the industry/economy is slowing down and be prepared for its eventuality.
Therefore, the CFO/Finance Manager must present these indicators for review and discussion, well ahead of time. In this way, the company’s growing performance can be sustainable and will not be disrupted by business and financial risks, unwittingly.
5. CONCLUSION
The 3 critical areas in performance management that determine the future growth and success of a company’s business and its “going concern” anxieties can now be monitored effectively.
The next finance area that can make a significant impact on business performance is capital structure. This will be explained/ discussed in Part 3 of this series.
Note:
Michael M Lee’s other accounting articles in website: www.cfodesk.com.sg; LinkedIn: “Michael M Lee”; and Facebook: “Michael Lee” are:
- 8 Oct 2018: “Debit & Credit” – Upon this Rock, the House of Accountancy was built!
- 17 Oct 2018: Financial Statement Analysis (an overview) – moving from lagging indicators to leading indicators.
- 26 Nov 2018: Traditional Financial Statement Analysis – using lagging indicators (Part 1)
- 18 Dec 2018: Financial Statement Analysis – using leading indicators (Part 2)——————————-MMLee 17th Dec 2018—————————-
