Analyze the Profit and Loss account

The financial analysis is the cornerstone of the valuation of the solvency of your clients. Don't panic! It is simple. The most important is:

the understanding of the balance sheet and of the profit and loss account,
their analysis with key indicators.

We are not going to get lost in interminable calculations but we will analyse simply what is the most important. By chance, it is in front of our eyes on first pages of the financial statements of your customers.

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Understand the profit and loss account

The profit and loss account highlights the turnover accomplished over period given (usuually 1 year) from which it subtracts expenses supported by the business during the same period. The result of this subtraction shows the benefit or the loss made by the company at the end of the financial year.

Compare the evolution of the turnover and the profitability on last 3 financial years (5 so possible) to determine the medium-term viability of your client.

Turnover and profitability are two key indicators for any business, second one even more than the first one.
As long as a business is profitable the risk of insolvency is low. A turnover increase without profitability or strengthening of shareholders equity weakens the business.

Why?

Simply because the need in cash rises with the increase of the turnover while financial resources do not increase.
Consequently, problems of financing of growth and cash difficulties can appear, which can be controlled only with thirds contributions (banks, factoring, credit given by suppliers etc).
This will reduceh the financial autonomy of the company.

Go further with income statement intermediate balances

These indicators help to determine if the company is profitable and to understand what are the main factors contributing to the net result (positive or negative). Is the company's business is profitable or not ? Is she burdened by financial costs or is her net income improved temporarily by an exceptional profit ?
This analysis will help you not to get fooled by an "artificial" positive result or to not stop your analysis to a net loss but based on an intrinsically profitable and viable business.

Intermediate balance	Calculation	Interpretation
Trade margin	Sales of goods - purchases of goods + Goods inventory change	Relevant indicator to determine the gross margin of an activity of reselling such distribution or trading.
Value added	Trade maring + Production - purchases of raw material - other purchases and external charges	Represents the creation of value that the company provides to goods and services purchased from third parties. The value added must be sufficiently high to absorb all other expenses of the company.
operating profit before depreciation and amortization (EBITDA)	Value added - tax - wages and salaries - payroll taxes	Remaining amount after deduction of operating expenses to value added. It is a key indicator of profitability and business performance as it is independent of the financial policy of the company. EBITDA should maintain and develop the means of production and pay the capital invested.
Operating profit	EBITDA - depreciations and provisions	Operating profit includes the amortization of fixed assets and provisions for risk (eg accrual of bad debts).
Financial result	Financial income - financial charges	This purely financial result is often negative because firms are generally consumers of financial products (lines of bank overdrafts, bank loans, factoring etc ...). A significant negative financial result often reflects a weak financial structure and an excessive recourse to banks. Warning!
Result before tax	Operating profit + financial result	Final result calculated from operating income and expenses. It is independent of taxation and exceptional income and expenses.
Exceptional result	Exceptional income - Exceptional expenses	This result relates to unusual activity. For example, a capital structure transaction can create an exceptional result. Be careful because it can distort the true profitability of the business and distort an analysis that would be based solely on net income.
Net income(profit or loss)	Result before tax + exceptional result - income tax	The net income represents the profit or loss at the end of the year (the difference between total revenue and total expenditure). It is increasing (if positive) or decreasing (if negative) the equity. If positive, it can remain invested in the company or be partially distributed to shareholders as dividends.

The most important is to determine what are the main part in the P&L contributing to the net income (positive or negative) and to understand what is the size of the company, what are its strengths and weakness, the evolution in its turnover and profitability...etc. These indicators allow you to refine your understanding of the business by zooming into some key points generating income or losses. A detailed analysis will also help you to check if there are some manipulations in the financial statements.

The cash flow

The cash flow represents the excess cash generated by the activity of the company during the year. It allows:

to repay loans,
to pay shareholders,
to invest,
to strengthen the financial structure of the company.

The cash flow is a key indicator in many aspects. It is very important for shareholders because it is strongly linked to their earnings. It gives confidence to creditors about the company's ability to repay the debts and allows managers to invest in the development of their business.

How calculate the Cash flow: Net income + depreciation

Next: understand and analyse the balance sheet