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.
|Financial Structure Modeling||Description||Analysis||Implications||Applications||Examples|
|1. Cost Structure Analysis (CSA)||Analyze the composition of costs within the financial structure, including fixed and variable costs.||– Identify and categorize various cost components, such as direct costs, indirect costs, and operating expenses. – Calculate the cost of goods sold (COGS) and gross profit margins. – Evaluate cost trends, cost drivers, and their impact on overall expenses.||– Provides insights into the efficiency of cost allocation and resource utilization. – Helps in identifying cost reduction opportunities and cost drivers.||– Analyzing the cost structure of a manufacturing process. – Assessing the cost components in a service-based business model.||Cost Structure Analysis Example: Evaluating the variable and fixed costs in a software development company.|
|2. Profitability Assessment (PA)||Assess the financial performance and profitability of the business model.||– Calculate key profitability metrics such as gross profit margin, operating profit margin, and net profit margin. – Analyze revenue growth trends, gross profit, and net income. – Compare profitability metrics to industry benchmarks and competitors.||– Evaluates the overall financial health and sustainability of the business model. – Helps in identifying areas where profitability can be improved or optimized.||– Assessing the profitability of a retail business through margin analysis. – Comparing the profitability of different product lines within a company.||Profitability Assessment Example: Analyzing the operating profit margin of a technology startup over three fiscal years.|
|3. Cash Flow Analysis (CFA)||Examine the cash flows within the financial structure, including operating, investing, and financing activities.||– Prepare cash flow statements to track cash inflows and outflows from different activities. – Analyze the cash conversion cycle, liquidity ratios, and working capital. – Assess the impact of cash flow trends on liquidity and financial stability.||– Provides insights into the liquidity position and cash management capabilities of the business. – Helps in forecasting future cash flows and identifying cash flow challenges or opportunities.||– Conducting a cash flow analysis to assess the impact of inventory management on cash flow. – Evaluating the cash flow patterns of a real estate investment portfolio.||Cash Flow Analysis Example: Analyzing the operating cash flow and investment cash flow of a manufacturing company.|
|4. Financial Modeling (FM)||Develop comprehensive financial models to project future financial performance and scenarios.||– Create financial models that incorporate revenue forecasts, cost projections, and cash flow predictions. – Conduct sensitivity analysis and scenario planning to assess the impact of various factors on financial outcomes. – Generate financial statements and performance indicators for different scenarios.||– Enables strategic planning by simulating different financial scenarios and outcomes. – Supports decision-making by providing a forward-looking view of financial performance.||– Building a financial model to project revenue growth and profitability for a startup. – Assessing the financial impact of potential acquisitions through scenario modeling.||Financial Modeling Example: Developing a three-year financial model for a new product launch, considering different pricing and market penetration scenarios.|
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,
- 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.
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.
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 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.
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
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 2021, 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.
Therefore, looking at cash flows help us have a more balanced view of the overall business.
As an opposite example, Netflix runs 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 its subscription revenue model, and it will be repaid over the years.
- 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 also important to look at those costs that 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.
- Introduction: Reverse engineering businesses involves analyzing three critical elements: cost structure, profitability, and cash flow generation. These elements reveal how a company spends money, generates income, and sustains its operations.
- Collective Incentives and Dynamics: An organization’s financial structure informs its behavior. Unlike individuals, organizations follow dynamics driven by incentives. Analyzing cost structure, profitability, and cash flows helps uncover these collective incentives.
- Key Elements for Understanding:
- Cost Structure: This represents how a company allocates resources to maintain demand for its products or services. It’s a crucial part of assessing operational scalability.
- Profitability: This indicates whether a company generates more income than it spends. It identifies where the highest-margin business segments lie.
- Cash Flow Generation: Free cash flow generated from operations, excluding non-cash expenses and capital expenditures, highlights how a company sustains and invests in its growth.
- Cost Structure:
- A company’s cost structure reveals how it allocates resources to sustain its core assets.
- For instance, Google’s significant ongoing expenses are directed at maintaining its search platform and reducing traffic acquisition costs.
- It’s important to consider both current revenue-generating costs and those financing future core assets.
- Profitability indicates a company’s ability to generate more income than expenses.
- Netflix, for example, runs a negative cash flow model where content development costs are amortized over time as subscribers stick to the platform.
- High-margin business segments are usually the most crucial parts of the company.
- Cash Flow Generation:
- Free cash flow is the cash generated through operations after adjusting for non-cash expenses and capital expenditures.
- Amazon’s e-commerce platform has tight margins but generates substantial cash flows to fuel its growth.
- Cash flow balances profitability, providing insight into a company’s overall health.
- Balancing Perspectives:
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