The CFO Role
Use common size financial statements (P&L and BS as % of sales), analyze trends and changes.His role is different to that of an accountant or an economist, his objective is to forecast financial needs and make the right decisions in order to maximize shareholders value.
In order to maximize shareholders value the CFO must:
- Manage working capital (do not run out of cash! -> growth implies working capital requirements)
- Find the optimal capital structure (what % debt vs what % equity -> risk vs return)
- Make good investment decisions (invest in projects which have NPV >0 OR IRR>WACC)
The CFO’s guiding equation is:
CORPORATE RISK = FINANCIAL RISK + BUSINESS RISK
-> Never have both financial and business risk high!!
If the company is publicly traded, take care of both earnings and investors confidence.
STOCK PRICE = EPS (earnings) x P/E Ratio (investors confidence)
Important to note that a firm’s main value drivers are -> SALES and GROSS PROFIT.
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WATCH OUT FOR RED FLAGS
- Seasonality -> high financial risk (don’t forecase w/quarterly information); seasonality requires conservative financial policies although there is a trade-off between efficiency and financial risk.
- Net Profit VS Cash Generated from Operations
- Using short-term to finance long-term needs
- EPS vs Net Profit (are they issuing new shares?)
- Changes in Gross Margin -> reflection of competition
- Changes in Operating Expenses -> reflection of economies of scale or efficiencies
- ROA > WACC -> the company is creating value (watch out to include only operating assets in ROA, not strategic assets).
- ROE = indication of how well is the company financial structure (leverage)
- Assume mean regression (trend is to go towards the mean)
- Profitability is different to liquidity, a profitable company can go bankrupt, or maybe the company is losing ownership and control bc needs to issue new shares, etc.
- Growth is a problem for the CFO
- Respond quickly to recesion -> is sales are going down, take inventory and payables down quickly too
- A good financial policy can be a source of competitive advantage
- INFLATION: it is an additional form of growth that will add financing needs and will also increase company costs.
RULES OF THUMB
- Average risk premium = 4 to 6%
- Average P/E ratio = 15
- Average Annual growth = 3.2%
- Average Risk Free = 3%
TOOLS
- Use common size financial statements (P&L and BS as % of sales), analyze trends and changes.
- CAGR = (sales y5 / sales y1) potencia 1/4 – 1
- Understand segment reporting
- Watch out for seasonalities
- % change = y2 – y1 / y1
Tags: basic financial rationale, business risk, CFO role, corporate risk, financial risk, guiding equation
