Analyzing how a company is financed can quickly become an area where non-specialists lose their footing, partly because of the jargon involved and partly because of the complex technical developments that some approaches may entail. While it is not necessarily possible to simplify certain financial calculation methods, the first obstacle can be addressed by setting out practical fundamentals in straightforward language.

A company’s annual balance sheet already provides an initial overview of its financing, from which the following indicators can be derived:

• working capital requirement, meaning the funds the company needs to finance its operating cycle (debtors, inventories, work in progress, etc.), taking into account the credit it manages to obtain from suppliers;
• working capital, meaning the funds theoretically freely available to the company to finance its operating cycle, namely equity and long-term debt, after deducting fixed assets;
• cash position, meaning the difference between these two values: what would be needed and what is actually available.

Depending not only on the company’s financial health but also on its line of business, this value (as well as the two preceding ones) may be either positive or negative. In grocery retail, for example, excess liquidity is normal: customers pay cash, while purchases from suppliers are made on credit. In manufacturing, by contrast, it is rare for a company to finance all its inventory and work in progress through suppliers. In that case, it must resort to short-term borrowing if its equity is insufficient.

The company’s trajectory can be assessed by examining how these values change over several years. Year-on-year balance sheet comparisons also make it possible to establish another set of indicators: sources and uses of funds. They answer the question: What generated funds and what consumed them?

Yet the balance sheet presents a static picture that only partially reflects a company’s activity. That activity is measured above all by revenue, annual profit, and in particular by the liquidity generated: cash flow. The latter has several meanings: gross or after interest, based on actual cash inflows and outflows, or still including investments. Used for forecasting purposes, the aim of its analysis is to know exactly what will remain in the till at year-end.

If one now wants to capture the full range of financial movements affecting the company, cash flow analysis must be combined with that of sources and uses of funds. The result is a comprehensive view of corporate financing that can be refined as needed.

Guidelines for appropriate financing:

• maintain balance: long-term investment – long-term financing
• distinguish between accounting net income and net cash flow
• measure the liquidity impact of accounting transactions
• keep future financing needs linked to replacement investments in view
• anticipate liquidity shortfalls and the alternative financing solutions required
• limit debt to the level of repayment capacity generated by cash flow
• anticipate the impact of revenue growth or decline on net cash