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,
- 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
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 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.
- 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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