Steps 1, 2: Analyze Fundamentals
The corporate financial system is driven by a firm’s goals, business unit choices and strategies,
market conditions, and 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
strongly influence the firm’s competitive and profit performance, its need for external finance, and
access to debt and equity markets. Clearly, many of these questions require information beyond that
contained in a company’s published financial reports.
Step 3: Analyze 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
percentage of cost of goods sold; and then applying a “reasonable value” for each category 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 “conditions” will be
unchanged from those that influenced the historical performance.
Step 4: Assess 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 for assessing firm’s future profitability is to analyze its past pattern of
profitability.
1. What has 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 industrywide 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?
