financial-structure

Financial Structure Modeling And Analysis In A Nutshell

In corporate finance, the financial structure is how corporations finance their assets (usually either through debt or equity). For the sake of reverse engineering businesses, we want to look at three critical elements to determine the model used to sustain its assets: cost structure, profitability, and cash flow generation.

How companies think

Understanding the financial structure of an organization can also inform a lot about the collective incentives which push the company to “behave” in a certain way. 

In short, an organization is a scaled entity; it doesn’t “think” as an individual. Instead, it follows simple dynamics driven by specific incentives.

To understand those incentives, my argument is to look at three key elements:

  • Cost structure,
  • Profitability,
  • And cash flows.

In short, from the way an organization “decides” at a collective level how to spend money to finance its long term assets, what part of the business drives profitability, and how it generates cash to sustain its operations, you can get its logic in the marketplace. 

Let’s look at each of them to understand how they can help us understand any organization.

Cost structure

cost-structure-business-model
The cost structure is one of the building blocks of a business model. It represents how companies spend most of their resources to keep generating demand for their products and services. The cost structure together with revenue streams, help assess the operational scalability of an organization.

The cost structure informs the way a company decides to spend its money, and how those financial resources are used to sustain its core asset.

For instance, when it comes to Google, a good chunk of ongoing expenses are spent to keep its search platform running.

traffic-acquisition-cost
The traffic acquisition cost represents the expenses incurred by an internet company, like Google, to gain qualified traffic on its pages for monetization. Over the years Google has been able to reduce its traffic acquisition costs and in any case to keep it stable. In 2017 Google spent 22.7% of its total advertising revenues (over $21 billion) to guarantee its traffic on several desktop and mobile devices across the web.  

Looking at the cost structure doesn’t mean only to look at what’s generating revenues right now. It’s also important to look at those costs that help a company renew its business model.

For instance, Google’s Alphabet spends substantial resources to keep its other bets running

In short, we want to have use a counterbalanced approach:

  • Look at the costs that are financing the core assets that fuel the current business model.
  • Look at the costs that are financing future core assets that will trigger a new business model.

Profitability

is-netflix-profitable
Netflix is a profitable company. It generated over $1.2 billion in 2018, a 116% increase compared to 2017, primarily driven by substantial growth in paid memberships. However, Netflix has negative cash flows as it invests massively on content license agreements and original content.

Profitability is the ability of a company to generate more income than it spends. As simple as that. For instance, in the graph above you can appreciate how Netflix is a profitable company, its income far exceeds its expenses (we’ll see in the next paragraph why we need to counterbalance profitability with cash generation).

Profitability informs where a company generates most of its income. Usually, the higher margin part of the business is also the most interesting. For instance, Google generates most of its money from its ad network. While its network members’ side is way less profitable.

how-does-google-make-money
Google has a diversified business model, primarily making money via its advertising networks that, in 2019, generated over 83% of its revenues, which also comprise YouTube Ads. Other revenue streams include Google Cloud, Hardware, Google Playstore, and YouTube Premium content. In 2019 Google made over $161 billion in total revenues.

Google tough has to keep its less profitable side of the business because it works as an amplifier for its core profit generation center. Therefore, profitability needs to be assessed from several perspectives:

  • Usually, the higher-margin side will be also the most important. Think of how Google ad network is also the core cash machine.
  • Other with lower margin sides might be used to push the core asset of the organization.

There are a few exceptions to this rule. One example is Amazon, in that case, to really understand the company you need to look at a third element: cash flow generation.

Cash flow generation

free-cash-flow
Free cash flow is the cash a company generates through its operations, once you take off the non-cash expenses, changes in working capital and capital expenditures. Thus this is the cash “free” to distribution that a company can potentially invest back into the growth of the business.
is-amazon-profitable
Amazon is a profitable company. Its operating income and net income passed $12.4 billion and $10 billion respectively in 2018. The operating income was driven primarily by Amazon AWS, contributing $7.29 billion. Amazon has been consistently profitable since 2015 when it posted 596 million in profits.

When you look at the core business model of Amazon (e-commerce platform) you can appreciate how it runs at very tight profit margins.

As of 2019 Amazon has much wider overall profit margins but this is primarily thanks to Amazon AWS, Amazon Prime and other services that run at a higher marginality.

Instead, while Amazon‘s core e-commerce platform ran at tight margins over the years, in reality, it generated a substantial amount of cash flows, which made it possible to fuel and finance the growth of the business.

amazon-business-cash-machine

Therefore, looking at cash flows help us have a more balanced view of the overall business.

As an opposite example, Netflix running at wider profit margins, it also runs negative cash flows, due to its operating model, where the company anticipates cash to produce shows which will be available on the platform to sustain it subscription revenue model, and it will be repaid over the years.

Key takeaways

  • The cost structure can help us understand how companies spend money to keep fueling the growth of their core assets. At the same time, it’s important also to look at those costs who are not generating revenue but might help a company build the next core asset.
  • Profitability helps assess what part of the business generates more income, thus it’s also the most important piece of the business. In some cases, organizations keep less profitable units, if those help fuel the core part of the business.
  • Profitability needs to be balanced with the cash flow generation. Indeed, a company like Amazon generates tight margins on its e-commerce platform, but that is balanced by the fact, the same business unit also generates abundant cash to finance the aggressive growth of the business.

By looking at those three aspects it is possible to understand the financial model of any organization.

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Published by

Gennaro Cuofano

Gennaro is the creator of FourWeekMBA which target is to reach over two million business students, executives, and aspiring entrepreneurs in 2020 alone | He is also Head of Business Development for a high-tech startup, which he helped grow at double-digit rate | Gennaro is an International MBA with emphasis on Corporate Finance and Business Strategy | Visit The FourWeekMBA BizSchool | Or Get in touch with Gennaro here