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.

Financial Structure ModelingDescriptionAnalysisImplicationsApplicationsExamples
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.

Read: Business Analysis: How To Analyze Any Business

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.

what-is-google-tac
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, keep it stable. In 2021 Google spent 21.75% of its total advertising revenues (over $45.56 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, which net profits were $5.1 billion in 2021. Growing from $2.7 billion in 2020. The company runs a negative cash flow business model, where it anticipates the costs of content development and licensing through the platform. Those costs get amortized over the years, as subscribers stick to the platform.

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 (now Alphabet) primarily makes money through advertising. The Google search engine, while free, is monetized with paid advertising. In 2021 Google’s advertising generated over $209 billion (beyond Google Search, this comprises YouTube Ads and the Network Members Sites) compared to $257 billion in net sales. Advertising represented over 81% of net sales, followed by Google Cloud ($19 billion) and Google’s other revenue streams (Google Play, Pixel phones, and YouTube Premium).

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.
amazon-profitability-1994-2021

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.

cash-conversion-cycle-amazon

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.

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 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.

Key Highlights

  • 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:
    • 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:
    • Analyzing all three aspects gives a comprehensive understanding of an organization’s financial model.
    • Cost structure reveals resource allocation, profitability identifies income-generating segments, and cash flow generation indicates sustained growth and investment.

Connected Financial Concepts

Circle of Competence

circle-of-competence
The circle of competence describes a person’s natural competence in an area that matches their skills and abilities. Beyond this imaginary circle are skills and abilities that a person is naturally less competent at. The concept was popularised by Warren Buffett, who argued that investors should only invest in companies they know and understand. However, the circle of competence applies to any topic and indeed any individual.

What is a Moat

moat
Economic or market moats represent the long-term business defensibility. Or how long a business can retain its competitive advantage in the marketplace over the years. Warren Buffet who popularized the term “moat” referred to it as a share of mind, opposite to market share, as such it is the characteristic that all valuable brands have.

Buffet Indicator

buffet-indicator
The Buffet Indicator is a measure of the total value of all publicly-traded stocks in a country divided by that country’s GDP. It’s a measure and ratio to evaluate whether a market is undervalued or overvalued. It’s one of Warren Buffet’s favorite measures as a warning that financial markets might be overvalued and riskier.

Venture Capital

venture-capital
Venture capital is a form of investing skewed toward high-risk bets, that are likely to fail. Therefore venture capitalists look for higher returns. Indeed, venture capital is based on the power law, or the law for which a small number of bets will pay off big time for the larger numbers of low-return or investments that will go to zero. That is the whole premise of venture capital.

Foreign Direct Investment

foreign-direct-investment
Foreign direct investment occurs when an individual or business purchases an interest of 10% or more in a company that operates in a different country. According to the International Monetary Fund (IMF), this percentage implies that the investor can influence or participate in the management of an enterprise. When the interest is less than 10%, on the other hand, the IMF simply defines it as a security that is part of a stock portfolio. Foreign direct investment (FDI), therefore, involves the purchase of an interest in a company by an entity that is located in another country. 

Micro-Investing

micro-investing
Micro-investing is the process of investing small amounts of money regularly. The process of micro-investing involves small and sometimes irregular investments where the individual can set up recurring payments or invest a lump sum as cash becomes available.

Meme Investing

meme-investing
Meme stocks are securities that go viral online and attract the attention of the younger generation of retail investors. Meme investing, therefore, is a bottom-up, community-driven approach to investing that positions itself as the antonym to Wall Street investing. Also, meme investing often looks at attractive opportunities with lower liquidity that might be easier to overtake, thus enabling wide speculation, as “meme investors” often look for disproportionate short-term returns.

Retail Investing

retail-investing
Retail investing is the act of non-professional investors buying and selling securities for their own purposes. Retail investing has become popular with the rise of zero commissions digital platforms enabling anyone with small portfolio to trade.

Accredited Investor

accredited-investor
Accredited investors are individuals or entities deemed sophisticated enough to purchase securities that are not bound by the laws that protect normal investors. These may encompass venture capital, angel investments, private equity funds, hedge funds, real estate investment funds, and specialty investment funds such as those related to cryptocurrency. Accredited investors, therefore, are individuals or entities permitted to invest in securities that are complex, opaque, loosely regulated, or otherwise unregistered with a financial authority.

Startup Valuation

startup-valuation
Startup valuation describes a suite of methods used to value companies with little or no revenue. Therefore, startup valuation is the process of determining what a startup is worth. This value clarifies the company’s capacity to meet customer and investor expectations, achieve stated milestones, and use the new capital to grow.

Profit vs. Cash Flow

profit-vs-cash-flow
Profit is the total income that a company generates from its operations. This includes money from sales, investments, and other income sources. In contrast, cash flow is the money that flows in and out of a company. This distinction is critical to understand as a profitable company might be short of cash and have liquidity crises.

Double-Entry

double-entry-accounting
Double-entry accounting is the foundation of modern financial accounting. It’s based on the accounting equation, where assets equal liabilities plus equity. That is the fundamental unit to build financial statements (balance sheet, income statement, and cash flow statement). The basic concept of double-entry is that a single transaction, to be recorded, will hit two accounts.

Balance Sheet

balance-sheet
The purpose of the balance sheet is to report how the resources to run the operations of the business were acquired. The Balance Sheet helps to assess the financial risk of a business and the simplest way to describe it is given by the accounting equation (assets = liability + equity).

Income Statement

income-statement
The income statement, together with the balance sheet and the cash flow statement is among the key financial statements to understand how companies perform at fundamental level. The income statement shows the revenues and costs for a period and whether the company runs at profit or loss (also called P&L statement).

Cash Flow Statement

cash-flow-statement
The cash flow statement is the third main financial statement, together with income statement and the balance sheet. It helps to assess the liquidity of an organization by showing the cash balances coming from operations, investing and financing. The cash flow statement can be prepared with two separate methods: direct or indirect.

Capital Structure

capital-structure
The capital structure shows how an organization financed its operations. Following the balance sheet structure, usually, assets of an organization can be built either by using equity or liability. Equity usually comprises endowment from shareholders and profit reserves. Where instead, liabilities can comprise either current (short-term debt) or non-current (long-term obligations).

Capital Expenditure

capital-expenditure
Capital expenditure or capital expense represents the money spent toward things that can be classified as fixed asset, with a longer term value. As such they will be recorded under non-current assets, on the balance sheet, and they will be amortized over the years. The reduced value on the balance sheet is expensed through the profit and loss.

Financial Statements

financial-statements
Financial statements help companies assess several aspects of the business, from profitability (income statement) to how assets are sourced (balance sheet), and cash inflows and outflows (cash flow statement). Financial statements are also mandatory to companies for tax purposes. They are also used by managers to assess the performance of the business.

Financial Modeling

financial-modeling
Financial modeling involves the analysis of accounting, finance, and business data to predict future financial performance. Financial modeling is often used in valuation, which consists of estimating the value in dollar terms of a company based on several parameters. Some of the most common financial models comprise discounted cash flows, the M&A model, and the CCA model.

Business Valuation

valuation
Business valuations involve a formal analysis of the key operational aspects of a business. A business valuation is an analysis used to determine the economic value of a business or company unit. It’s important to note that valuations are one part science and one part art. Analysts use professional judgment to consider the financial performance of a business with respect to local, national, or global economic conditions. They will also consider the total value of assets and liabilities, in addition to patented or proprietary technology.

Financial Ratio

financial-ratio-formulas

WACC

weighted-average-cost-of-capital
The Weighted Average Cost of Capital can also be defined as the cost of capital. That’s a rate – net of the weight of the equity and debt the company holds – that assesses how much it cost to that firm to get capital in the form of equity, debt or both. 

Financial Option

financial-options
A financial option is a contract, defined as a derivative drawing its value on a set of underlying variables (perhaps the volatility of the stock underlying the option). It comprises two parties (option writer and option buyer). This contract offers the right of the option holder to purchase the underlying asset at an agreed price.

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