WHAT HAVE BEEN THE AVERAGE LEVEL, TREND AND VOLATILITY OF PROFITABILITY?

Steps 1, 2: Analysis of Fundamentals

The corporate financial system is driven by the goals, business unit choices and strategies, market

conditions and the operating characteristics. The firm’s strategy and sales growth in each of its

business units will determine the investment in assets needed to support these strategies; and the

effectiveness of the strategies, combined with the response of competitors and regulators, will

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strongly influence the firm’s competitive and profit performance, its need for external finance, and its

access to the debt and equity markets. Clearly, many of these questions require information beyond

that contained in a company’s published financial reports.

Step 3: Investments to Support the Business Unit(s) Strategy(ies)

The business unit strategies inevitably require investments in accounts receivable, inventories,

plant & equipment, and possibly, acquisitions. Step 3 of the process is an attempt to estimate the

amount that will be tied up in each of the asset types by virtue of sales growth and the

improvement/deterioration in asset management. An analyst can make a rough estimate by studying

the past pattern of the collection period, the days of inventory, and plant & equipment as a percent of

cost of goods sold; and then applying a “reasonable value” for each to the sales forecast or the

forecast of cost of goods sold. Extrapolation of past performance assumes, of course, that the future

underlying market, competitive and regulatory “drivers” will be unchanged from the conditions that

influenced the historical performance.

Step 4: Future Profitability and Competitive Performance

Strong sustained profitability is an important determinant of (1) a firm’s access to debt and/or

equity finance on acceptable terms; (2) its ability to self-finance growth through the retention of

earnings; (3) its capacity to place major bets on risky new technologies, markets, and/or products;

and (4) the valuation of the company.

A reasonable starting point is to analyze the past pattern of profitability.

1. What have been the average level, trend and volatility of profitability?

2. Is the level of profitability sustainable, given the outlook for the market and for competitive

and regulatory pressures?

3. Is the current level of profitability at the expense of future growth and/or profitability?

4. Has management initiated major profit improvement programs? Are they unique to the firm

or are they industry-wide and may be reflected in lower prices rather than higher

profitability?

5. Are there any “hidden” problems, such as suspiciously high levels or buildups of accounts

receivable or inventory relative to sales, or a series of unusual transactions and/or accounting

changes?

Step 5: Future External Financing Needs

Whether a company has a future external financing need depends on (1) its future sales growth;

(2) the length of its cash cycle; and (3) the future level of profitability and profit retention. Rapid sales

growth by a company with a long cash cycle (a long collection period + high inventories + high plant

& equipment relative to sales) and low profitability/low profit retention is a recipe for an everincreasing

appetite for external finance, raised in the form of loans, debt issues, and/or sales of

shares. Why? Because the rapid sales growth results in rapid growth of an already large level of

total assets. The increase in total assets is offset partially by an increase in accounts payable and

accrued expenses, and by a small increase in owners’ equity. However, the financing gap is

substantial. For example, the company portrayed in Table A requires $126 million of additional

external finance by the end of year 2010 to finance the increase in total assets required to support 25%

per year sales growth in a business that is fairly asset intensive.