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Professor Thomas Piper prepared the original version of this note, “Assessing a Firm’s Future Financial Health,” HBS No XXXXXXXXXX, which is being
eplaced by this version prepared by the same author. This note was prepared as the basis for class discussion.
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Assessing a Company’s Future Financial Health
Assessing the long-term financial health of a company is an important task for management as it
formulates goals and strategies and for outsiders as they consider the extension of credit, long-term
supplier agreements, or an investment in a company’s equity. History abounds with examples of
companies that embarked on overly ambitious programs and subsequently discovered that their
portfolios of programs could not be financed on acceptable terms. The outcome was frequently the
abandonment of programs mid-stream at considerable financial, organizational, and human cost.
It is the responsibility of management to anticipate a future imbalance in the corporate financial
system before its severity is reflected in the financials, and to consider co
ective action before both
time and money are exhausted. The avoidance of bankruptcy is an insufficient standard.
Management must ensure the continuity of the flow of funds to all of its strategically important
programs, even in periods of adversity.
Figure A provides a conceptualization of the corporate financial system, with a suggested step-by-
step process to assess whether it will remain in balance over the ensuing 3 to 5 years. The remainder
of this note discusses each of the steps in the process and then provides an exercise on the various
financial measures that are useful as part of the analysis. The final section of the note demonstrates
the relationship between a firm’s strategy and operating characteristics; and its financial
characteristics.
This document is authorized for use only by Gregory Charles in FIN-320-T5873 Principles of Finance 21EW5 at Southern New Hampshire University, 2021.
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Figure A The Corporate Financial System
Analyze Goals
Step 1 Strategy
Market, Competitive Technology
Regulatory and Operating
Characteristics
Step 2 Analyze Revenue Outlook
growth rate
volatility, predictability
Step 3 Step 4
Analyze Investment in Assets Assess Economic Performance
to support growth profitability
improvement/deterioration
in asset management
cash flow
volatility, predictability
Step 5 Step 6
Assess External Financing Need Ensure Access to Target Sources
of Finance
$ amount lending/investing criteria
timing, duration
deferability
attractiveness of firm
to each target source
Step 7
Assess Viability of 3 to 5-year Plan
consistency with goals
achievable operating plan
achievable financing plan
Step 8
Perform Stress Test for Viability
Under Various scenarios
Step 9
Formulate Financing and Operating
Plan for Cu
ent Year
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Assessing a Company’s Future Financial Health XXXXXXXXXX
3
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
usiness 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 cu
ent 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
eceivable or inventory relative to sales, or a series of unusual transactions and/or accounting
changes?
Step 5: Assess 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 ever-
This document is authorized for use only by Gregory Charles in FIN-320-T5873 Principles of Finance 21EW5 at Southern New Hampshire University, 2021.
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4
increasing 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 $126 million of additional external finance by
the end of year 2010 to finance the increase in total assets required to support 25% per year sales
growth in a business that is fairly asset intensive.
Table A Company Financials Assuming a 25% Increase in Sales ($ in millions)
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Assets
Cash $ 12 ↑ 25% $ 15
Accounts receivable 240 ↑ 25% 300
Inventories 200 ↑ 25% 250
Plant & equipment 400 ↑ 25% XXXXXXXXXX
Total $852 $1,065
Liabilities and Equity
Accounts payable $100 ↑ 25% $ 125
Accrued expenses 80 ↑ 25% 100
Long-term debt 272 Unchanged 272
Owners’ equity 400 footnotea XXXXXXXXXX
Total $852 $ 939
External financing need XXXXXXXXXX
Total $852 $1,065
a It is assumed (1) that the firm earns $60 million (a 15% return on beginning of year equity) and pays
out $18 million as a cash dividend; and (2) that there is no required debt repayment in 2010.
If, however, the company reduced its sales growth to 5% (and total assets, accounts payable and
accrued expenses increased accordingly by 5%), the need for additional external finance would drop
from $126 million to $0.
High sales growth does not always result in a need for additional external finance. For example, a
food retailer that extends no credit to customers, has only eight days of inventory, and does not own
its warehouses and stores, can experience rapid sales growth and not have a need for additional
external finance provided it is reasonably profitable. Because it has so few assets, the increase in total
assets is largely offset by a co
esponding, spontaneous increase in accounts payable and accrued
expenses.
Step 6: Ensure Access to Target Sources of External Finance
Having estimated the company’s future financing needs, management must identify the target
sources (e.g., banks, insurance companies, public debt markets, public equity market) and establish
financial policies that will ensure access to financing on acceptable terms. Consider the following
questions:
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Assessing a Company’s Future Financial Health XXXXXXXXXX
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1. How sound is the firm’s financial structure, given its level of profitability and cash flow, its
level of business risk, and its future need for finance?
2. How will the firm service its debt? To what extent is it counting on refinancing with a debt or
equity issue?
3. Does the firm have assured access on acceptable terms to the