Financial analysis in your business

Back in January 2008 CFO.com published an article titled “Preparing your company for recession” about how smart companies can prepare themselves for recession by using predictive modeling techniques and Monte Carlo simulations. The same is true during economic recovery: predictive modeling and Monte Carlo simulations can help companies to better anticipate the upturn.

As CFO.com explained in 2008, financial crises are an inevitable part of the business cycle and companies that respond rapidly and wisely often emerge stronger. According to research from The Hackett Group, companies should (1) look for cost-savings from long-term structural changes, (2) seek ways to free cash from working capital, and (3) hone their planning and forecasting capabilities. Predictive modeling and Monte Carlo simulations help companies to address the latter by identifying key revenue and cost drivers.

Scenario modeling is especially useful in fluctuating and unstable market conditions. It’s much easier to make predictions of sales, prices, or costs in a steady, mature market. And it’s also relatively easy to make predictions in a constantly declining or constantly growing market. But if the decline or growth are unknown in size and duration, predictions become difficult. Here is where Monte Carlo simulation comes in.

As Hackett recommended, Monte Carlo simulation can help to forecast outcomes during financial crises, a very uncertain market condition. This uncertain market condition exits also during market recovery where the level and timing of recovery are unclear. Companies that applied predictive modeling and Monte Carlo simulations to manage uncertainty during recession will be able to apply these skills to manage uncertainty during the recovery.

But it’s never too late to apply sophisticated scenario modeling tools like Monte Carlo simulation. Monte Carlo simulation helps to identify a range of potential scenarios in an uncertain environment. The result of the simulation is a range of financial outcomes for the business. With this information companies can better manage uncertainty in the volatile economic recovery.

FinanceIsland has just launched three new finance apps with Monte Carlo simulation. Ten years after the idea was born, three years after the technology became available, two years after first proof of concept, and one year after the development and testing cycle, we are ready. These three new tools represent the first implementation phase of our vision to offer sophisticated online finance applications to manage uncertainty.

The first new tool, ROI analysis with Monte Carlo simulation, is divided into two parts: standard ROI analysis and Monte Carlo simulation. This tool allows you to calculate the return on investment (ROI) that you can expect from a R&D, marketing, or capital investment project. The tool will tell you also how likely it is that the investment will have positive return. The tool will perform discounted cash flow analysis, it will calculate key ROI metrics such as net present value, and it will allow you to model uncertain projections using Monte Carlo simulation.

The second tool, cash flow forecast, can help you to predict future cash flows expected in your business and can help you to determine the likelihoods of these cash flows. The tool will calculate income and cash flow projections, it will help you to identify most relevant drivers of cash flows using the sensitivity chart, and it will allow you to model uncertainties in financial flows using Monte Carlo simulation.

The third new tool is the optimal supply estimator. If you need to order or produce fixed number of products well in advance of the time when these products will be sold, this tool will help you to identify the optimal order or production quantity. It will help you to maximize margin based on the uncertain demand by calculating contribution margin for several supply options and by modeling uncertain demand (and price) with Monte Carlo simulation.

In addition to the new apps, we have also slightly redesigned the existing lease-or-buy calculator. This tool can help you in deciding between leasing and buying capital equipment, and if buying between cash and financed purchase. The tool will calculate the total cost of leasing and buying where you will be able to choose the least expensive lease-buy option based on discounted cash flow analysis and net present value.

All these tools are ready to use. They are supported through guided and simplified analysis processes. And they are delivered to you online as a service, so you can instantly benefit from new features we add on a regular basis. The only technical requirement is a newer internet browser with Flash version 10 or higher installed.

All tools are offered on a subscription basis. For more information please check the pricing page or subscribe directly.

Risk analysis or risk management are concepts usually associated with financial institutions or large corporations. But risk is something that also small businesses encounter on a regular basis. They may however shy away from performing risk analysis since this concept may seem so “big enterprise”. But it’s not. Risk analysis is simply the identification and evaluation of scenarios that may happen.

Let’s define first what risk is. With risk we usually mean the chance that something undesirable will occur, which we then try to avoid or minimize. But risk can also mean a chance that something desirable will happen. In either case, the more uncertainty exists about the potential outcome the riskier we perceive it. Hence, to reduce this uncertainty and risk we should increase our knowledge about the uncertain events.

What are the sources of uncertainty? In business situations uncertainty arises in many ways. Demand for company’s products for example is uncertain since it depends on many economic factors and sometimes unknown customer preferences. Optimal prices to charge for company’s products or services may be uncertain since they are driven by unknown customer expectations and competitors’ pricing. And even operating expenses may be uncertain when it comes to forecasting required investments needed to bring a product to market.

Some of these uncertainties are outside of company’s control. Weather, for example, is an uncertainty that cannot be controlled and if you are selling umbrellas this uncertainty will impact your sales. But you can at least prepare yourself by analyzing potential weather scenarios and ordering the number of umbrellas that will maximize your profit. Other uncertainties, on the other hand, can be reduced by company’s actions. For example the uncertainty about optimal product pricing can be reduced through market research and pricing analysis helping to narrow down on only few desirable price points.

Most businesses need to make decisions in light of these uncertainties by taking calculated risk. Risk analysis provides the means to make this calculation. Risk analysis is nothing more than the analysis of potential uncertainties that may have an impact on the business. This scenario analysis can help to quantify the potential risks.

Scenario analysis in its basic form identifies few potential cases of what could happen. In this basic form, however, usually only few scenarios can be evaluated although in reality there are many uncertainties that need to be analyzed at once. Here is where Monte Carlo simulation can help.

Monte Carlo simulation is a sophisticated scenario analysis that can evaluate thousands of scenarios at once. Businesses can then better understand the uncertainties they encounter. You can find more about Monte Carlo simulation either in one of our previous posts or in our Monte Carlo simulation tutorial. Needless to say, Monte Carlo simulation is embedded in some of FinanceIsland’s tools to help identify for example potential outcomes of return on investment or company’s cash flows. This allows every company to perform risk analysis.

In the previous post we have discussed the importance of cash. Cash is king not only for the fiscal health of a business but also when it comes to any investment analysis. Hence, all financial analyses evaluating future returns need to be based on cash flows. Sometimes, however, the financial data is only available as accounting flows on an income statement. In those cases accounting flows need to be translated into cash flows. Here it’s how.

It’s very common and most of the time easy for companies to create an income statement describing an investment project. Incremental units are translated into revenues and cost of sales. The actual investments in engineering and marketing activities are subtracted from the resulting gross margin. And the resulting operating income is used to determine taxes, which then leads to net income or net profit.

However, net income on an income statement doesn’t represent cash flows. As described in the previous post, a company may record revenues now but it may receive cash from customers for these sales much later. Or it may record cost of raw materials as cost of sales now but pay bills from the supplier much later. Instead of identifying these detailed cash flows, there are five adjustments that can be used to translate net income into cash flows.

First, capital depreciation needs to be added back to net income. Capital depreciation is an expense representing the depreciation of capital expenditures. Accounting (and tax) rules sometimes require companies to spread the cost of equipment or property over its useful life. This capital depreciation results in smaller periodic expenses over longer period of time. In reality, however, the company may pay for the equipment or property with a one-time cash payment leading to a one-time impact from the cash flow perspective. Hence, capital depreciation needs to be added back to net income to arrive at cash flows. At the same time, capital investment needs to be subtracted since it consumes cash due to this one-time payment. This is then the second adjustment. These two adjustments have a net zero effect over a longer period of time, but they lead to changes in periodic, e.g., monthly, cash flows.

The third adjustment addresses the fact that the company may receive money from its customers a while after it has billed them and after it has recorded these sales as revenues. As mentioned in the previous post, accounts receivable is where these expected payments from customers are recorded. Changes in accounts receivable can be used to translate net income into cash flows. These changes describe how much more or how much less cash has been tied in accounts receivable. There is a metric in accounting called days sales outstanding (DSO), which describes the number of days between the time a sale is recorded in the accounting systems and the time the company receives cash for that sale. With DSO the changes to cash flows can be easily calculated from revenues. These changes usually lead to cash from customers being available at a later time than the corresponding revenues.

Similarly to changes in accounts receivable, changes in accounts payable is the fourth adjustment used to translate net income into cash flows. Accounts payable represent how much cash is waiting to be used to pay suppliers. Changes in accounts payable describe how much more or how much less cash payments to suppliers have been delayed. Here too there is an accounting metric called days payables outstanding (DPO), which describes the number of days between the time a purchase is booked in the accounting systems and the time the supplier is paid for that purchase. DPO can be used to easily calculate changes in accounts payable from cost of sales. These changes usually lead to cash owed to suppliers being available for some time before the corresponding purchases are paid.

The final fifth adjustment are changes in inventory to reflect that some of the cash is tied in inventory, which is not reflected on the income statement. Net income only reflects the cost of sales of the company’s products and assumes that these products are turned into revenues once a sale is made. However, the products may spend some time in inventory where raw materials are turned into finished goods. Finished goods may even continue staying in inventory if the products cannot be sold right away. The accounting metric inventory turns per year represents the number of times the average inventory is sold during a year. Together with cost of sales, this metric can be used to calculate the additional cash tied in inventory.

To summarize, cash flows cannot be always identified easily but an income statement is usually readily available. Periodic net income can then be translated into periodic cash flows using the five adjustments described above. Some of FinanceIsland’s tools use this technique to derive cash flows from the income statement.

The phrase “cash is king” is being used on many occasions in the finance world. Although I usually don’t like generalizations, I must say that this phrase is true in many circumstances. So, why is cash king?

Cash is needed to pay bills, compensate employees, and make purchases. Hence, a business needs enough cash as an asset for short-term operations. It also needs to ensure that there is sufficient stream of cash in-flow to cover all these expenditures in the future. Cash availability is an important metric to measure the overall fiscal health of a business.

In the accounting world a company can show a decent profit on its income statement. But that profit doesn’t necessarily mean that the company is financially healthy. When a sale is made, for example, the revenue is shown on the income statement, but it may be a while before the company receives cash for that sale. When this sale is made, a company increases its accounts receivables on its balance sheet, which in accounting terms increases also its net worth. However, the company could still be short on cash to keep its operations running. Despite its positive net worth the company could fail and be technically bankrupt.

There are several ways a company can improve its cash position. It can of course spend less, but this may have a negative effect on generating sales in the long-term. There are though three other ways to improve cash position by addressing three accounting elements: accounts receivable, accounts payable, and inventory.

As indicated above, accounts receivable is where the company records a sale to a customer until the customer pays for that sale. The cash is basically held captive in accounts receivable until the customer pays the bill. To improve its cash position, the company should collect money from the customer sooner than later.

Accounts payable is the equivalent of accounts receivable but the company is now on the paying side. Accounts payable is where the company records any money that it owes to its suppliers for purchases of materials, supplies, or services. Although these suppliers need to be paid at some point in time, the company has usually some time when to address this liability. The later these bills are paid the more cash is available to run the business.

Inventory is an accounting measure describing the financial value of raw materials and finished goods before they are sold to customers. Since cash can only be generated once a sales is made, inventory is another place where cash is held captive. Of course, there is a need for inventory to transfer raw materials into finished goods. It may also make financial sense to have enough finished goods inventory to react to sudden increases in demand. Hence, there is a need for the right balance between tying cash in inventory and quickly turning the inventory into a sale. While keeping this balance in mind, the sooner you can turn inventory into a sale the better.

The chart below illustrates cash flow and the interrelations between cash and accounts receivable, accounts payable, and inventory for a simple manufacturing business. This company buys raw material from a supplier, transforms it into finished goods, and sells them to a customer.

Once the company receives raw materials from the supplier, it starts manufacturing the products. At the same time it books the invoice from the supplier as accounts payable, but it still can use the cash intended to pay this invoice for other purposes for some time. Once the products are manufactured, the company sells them to the customer and awaits payment. The expected payment is booked as accounts receivable, but the corresponding cash is not available to spend yet until it is received from the customer. The inventory that is being processed consumes cash as well, which is not available for other purposes.

To increase its cash position – represented by the green areas in the chart – the company should maximize the accounts payable bubble by delaying payments to suppliers. It should minimize the accounts receivable bubble by collecting cash from customers as soon as possible, ideally immediately when the sale is made. And the company should minimize the inventory bubble by quickly turning inventory into a sale.