# How to make a financial diagnosis

May 15, 2020

The opinions of the employees of s You are personal.

Analogous to the way a doctor checks a patient’s vital signs – such as blood pressure or temperature – to determine their health, it is possible for financial reasons to “diagnose the situation of the company,” explains Guillermo Pozos, Professor of finance at ITAM.

How to make a financial diagnosis

The Financial reasons They are indicators or signs of the performance of your company and are obtained through a share, relationship or quotient of the values ​​of two concepts or items that are either contained in the profit and loss account or in the balance sheet. These are tools you can use to get a “quick overview” of a company’s situation, said Fernando Orozco, Commercial Director of ArCcanto.

Everyone evaluates a part of the company and together they form a powerful weapon to understand what is being done right or wrong in a company and to correct the course. Be careful: these financial signals are relative; Therefore, you need a comparison parameter. Their interpretation depends on the company itself: how many years it was founded, how its performance has developed over time, what activity it is in and what industry it is in.

Financial indicators can be compared to:

• The history of the same company.
• Other companies in the same industry.
• Goals set by management or the board of directors of the company.

Here are some of the key financial reasons explained by the two sources mentioned.

## Reasons for activity

These determine the efficiency with which a company uses its resources during operation.

BEARING ROTATION
= Cost of sales / inventories
Expressed in: times

To calculate this ratio, the cost of sales (which is directly related to the manufacture of a product or the provision of a service) that is shown in the profit and loss account is divided between the inventories in the assets on the balance sheet.

The result of this division shows how quickly a company is able to exchange the inventories it produces for claims. Although each sector is different, costs such as inventory costs and losses generally arise when stocks are not moving.
Suppose a shoemaker has:

Cost of sales: 535,000
Inventories: 180,000

The inventory turnover results in the following:

535,000 / 180,000 = three times

The practical interpretation of this result is that the shoe company replenishes its inventory three times a year.

Another way to express this indicator is by taking inventory days by dividing 360 (the days of a fiscal year) by the rotation. This results in:
360/3 = 120 days

Therefore, the company changes its accounts receivable every 120 days. Note: The lower the storage days, the better for the company.

ROTATION OF CHARGES
= Sales / receivables
Expressed in: times

The receivables represent the amount of money that corresponds to the sale of credit for goods or the provision of services to a customer. In other words, the goods you have already sold and are expected to pick up. The speed of a company’s collection is determined by the rotation of the collections, which is the number of times a company converts sales to cash each year.

Suppose two grocery stores have the following sales and receivables:

Company A Company B.
Annual sales 120,000 180,000
Receivables 20,000 15,000

The turnover rotation shows the following result:

In the case of A:
120,000 / 20,000 = 6 times

In the case of B:
180,000 / 15,000 = 12 times

The practical interpretation of this result is that company A charges its customers six times a year, while B does it twelve times. Therefore, B has a better turnover rotation than A.

Another way to express the rotation is to accumulate days by dividing 360 (the days of a fiscal year) by the rotation. This results in:

In the case of A:
360/6 = 60 days

In the case of B:
360/12 = 30 days

Therefore, company A needs 60 days to charge its customers, while B takes 30 days. Note: The lower the collection days, the better for the company.

PAYMENT RATE
= Cost of sales / liabilities
Expressed in: times

It shows how quickly a company pays its suppliers. A company’s debts are the loans they have granted it. Since a company is primarily funded by suppliers, this indicator is crucial because you know how often you pay, what you need to do better financial planning.

Assume that the shoemaker mentioned above has:

Cost of sales: 535,000
Accounts Payable: 60,000

The rotation of the payments shows the following result:
535,000 / 60,000 = 9 times (rounded)

The practical interpretation of this result is that the shoe company pays its suppliers nine times a year. Another way to express this indicator is to pay days by dividing 360 (the days of a fiscal year) by the rotation. This results in:

360/9 = 40 days

The shoe manufacturer pays its suppliers every 40 days. Note: the longer the payment days, the better for the company.

FINANCIAL CYCLE
= Collection turnover + inventory turnover
– Payment rotation
Expressed in: days

This is the time it takes for a company to convert its inventories into cash. This cycle may or may not favor business. The shorter the financial cycle, the better for the company because it uses its resources more efficiently. However, if the result is unfavorable, the company will need to use paid finance (e.g. bank loans) to continue operating.

Back to the case of the shoe manufacturer who introduces the following days of the collection rotation:

Turnover: 765,000
Claims: 156,000
Collection rotation = 765,000 / 156,000 = 5 times
# Collection days = 360/5 = 72

Here are the three dates used to calculate the footwear company’s financial cycle:

# Collection days: 72
# Inventory days: 120
# Pay days: 40

The financial cycle produces the following result:
72 + 120 = 192 – 40 = 152 days

The practical interpretation of this result is that the shoe manufacturer has to finance 152 days of its operation because the sale and collection takes longer than the payment of its suppliers. This is a high and unfavorable financial cycle for the company, as selling and collecting 192 days and paying its suppliers takes only 40 days.

This situation could be represented schematically as follows:
Sale of inventory 120 days
Payment 72 days
Full financial cycle 192 days
Payment to suppliers 40 days
152 days to complete the cycle

## Debt, solvency and liquidity ratios

They analyze the company’s short (up to 12 months) and long-term (more than 12 months) solvency.

LEVERAGE
= Total liabilities / equity
Expressed in: percent

The extent to which a company was financed by debt. It expresses the percentage that creditors have funded for each peso that shareholders have invested in the business.

Overall liability is the sum of the short and long-term loans that a company uses to finance itself. For example, creditors can be suppliers, the Ministry of Finance, employees or banks. While equity is shareholders’ money.

Suppose a sporting goods manufacturer has:

Equity: 10
Total liabilities: 4

The leverage ratio gives the following result:

4/10 = 0.40 x 100 = 40%

The practical interpretation of this result is that for every peso the partners invested in the clothing store, their creditors financed 40% or 40 cents. In itself, this situation is neither good nor bad; In fact, a company that is in debt has more resources to invest. To measure leverage, you need to put it in context. For example, compare it historically to see if it has grown or decreased over time, or against a competitor’s leverage.

SOLUTION TEST
= short-term assets / short-term liabilities
Expressed in: times
Horizon: convey

Solvency is the ability to cover your debts. In practice, this ratio indicates the pesos that a company has in the short term to pay every peso that it owes on the same horizon.

The Current assets These are all the resources that the company can convert to cash in the short term (which means less than a year in finance). And that’s why you can easily dispose of them.

Short-term liabilities relate to short-term debts, including third party financing such as suppliers or banks. These are commitments that you have to meet in less than a year.

For example, imagine a retail warehouse with the following balance:

Available assets 40 Liabilities to suppliers 60
Accounts receivable from customers 30 Other current liabilities 40
Inventories 60 Short-term liabilities 100
Current assets 130 Long-term liabilities 100
Net fixed assets 270 Total liabilities 200
Equity 200

Total assets 400 Total liabilities plus capital 400

The solvency test gives the following result:

130/100 = 1.3 times

The practical interpretation of this result is that for every peso that the company has to pay at the latest one year, its short-term assets weigh 30 cents. Since you have more than one weight for each weight, the indicator can be interpreted as cheap.

Acid test (liquid)
= short-term assets – inventories / short-term liabilities
Expressed in: times
Horizon: immediately

Liquidity is the quality of assets that can easily be converted into money. Of the company’s cash, accounts receivable, and inventories (its short-term or short-term assets), the latter will take the longest to become cash since they are sold first, then this sale will become part of the accounts receivable, and will eventually become 30 days later or longer in Money converted.

By eliminating inventory, you get a more realistic indicator of what a company can pay immediately.
Take up the previous example:

The retail warehouse had short-term assets of \$ 130 million and inventory of \$ 60 million. The short-term liability is \$ 100 million.

The acid test gives the following result:

130 – 60/100 = 70/100 = 0.70 times

The practical interpretation of this result is that for every peso that the company has to pay in its short-term assets and discounted inventories within one year at the latest, 70 cents are available. In other words, in the short term, the business doesn’t look as good as the solvency ratio suggests: it has little liquidity and could (although not necessarily because a more thorough analysis of the case would be needed) could have problems to pay his debts.

On the other hand, an excessive level of liquidity is also not necessarily good, as this indicates that the company is not investing in the generation of the product or service it offers. The available resources are retained, but they generate virtually no returns.

## Reasons for profitability

EBITDA
= Operating result + depreciation
Expressed in: \$ (Pesos)

It measures the company’s ability to make profits based on the resources invested. And it is calculated as follows:

Ebitda (Abbreviation for earnings before interest, taxes, depreciation and amortization) is an indicator of what a company earns or loses from its core business by eliminating distortions due to financial and accounting decisions. It is taken from the income statement and used to measure profitability, but not cash flow. Eliminate the cost of funding working capital and replacing old equipment (which can be significant).

The calculation is made by adding depreciation to the operating result again, ie the profit that a company must achieve. Depreciation is a provision that reduces the tax base and represents the annual loss in value of certain assets, such as real estate, computers and patents.

In order to maintain the operating result, which is the basis on which the Treasury levies taxes, depreciation and amortization are deducted from gross profit and expenses that include salaries and commissions from sales representatives. Advertising and promotion; per day; Salaries, pay slips, and office expenses for executives.

Here is an example: Imagine a grocery store has an operating profit of \$ 106,000 from the following information:

Net sales 765,000
Cost of sales 535,000
Gross profit 230,000
Operating expenses:
Depreciation 28,000
Selling, general and administrative expenses 96,000
Operating profit 106,000

His Ebitda would be the following:

106,000 + 28,000 = 134,000 USD

To express it as a margin, it is divided by net sales and multiplied by 100.

134,000 / 765,000 = 0.175 × 100 = 17.5%

The practical interpretation of this result is that the company made a profit of \$ 134,000 before tax on sales of \$ 765,000, excluding depreciation or amortization reserves.

In other words, for every peso of sales that it generates from its main business, it earns 17 cents before deducting taxes, depreciation and amortization.

Profitability in sales
= Net profit / net sales
Expressed in: percent

This ratio indicates the percentage of the net profit that a company makes (or loses) for each peso sold.
Imagine a bakery has the following profit and loss account:

Net sales 400,000
Cost of sales 200,000
Gross profit 200,000
Operating costs 40,000
Operating profit 160,000
Financing costs (interest) and taxes 120,000
Net profit 40,000

The profitability of sales shows the following result:

40,000 / 400,000 = 0.1 × 100 = 10%

The practical interpretation of this result is that for every peso the company generates from sales, a margin of 10% or 10 cents profit after tax is achieved. The higher this margin, the better for the company.

Return on investment (or return on investment)
= Net profit / equity
Expressed in: percent

This ratio indicates the percentage of net profit generated by the capital that shareholders have invested in a company. Also known as ROE (Return Over Equity). And it gives shareholders a clear idea of ​​how their investment will benefit them.

For example, two companies with similar assets but a very different liability structure:

Company A Company B.
Total assets 100 100
Total liabilities 75 30
Equity 25 70
Operating profit 40 30
Net income 10 20

The balance sheets of the companies could be shown schematically as follows:

Company A Company B.
Total assets 100 100
Total liabilities 75 70
Equity 25 30

Assets = liabilities + equity

It can be seen that A is leveraged more than B (see leverage ratio). The leverage is 300% or 42% (by dividing total liabilities by equity and multiplying by 100).

But what is more attractive from a shareholder perspective in terms of profitability?
The return on investment or ROE gives the following result:

In the case of A:

10/25 = 0.4 × 100 = 40%

In the case of B:

20/70 = 0.28 × 100 = 28%

The practical interpretation of these results is that for every peso that A’s shareholders invested in the company, they achieved a margin of 40% or 40 cents of profit after tax; B’s shareholders received 28% or 28 cents. The higher this margin, the better for the company and its shareholders.

Therefore, company A, which is more heavily indebted than B, is more attractive from an investor’s point of view because it makes a higher profit by investing less money in the business.