During consulting projects, you will have to, one way or the other, conduct quite a lot of financial analyses. Even if you don’t want to be a master of finance I would suggest learning the essential financial analyses. Such analyses will not be the most exhilarating part of the project, but without them, you will not be able to present your conclusions properly. That’s why we will briefly discuss different types of financial analyses. Before embarking on your journey make sure that you have a good grasp of Excel and a good understanding of finance & accounting. Before you start running make sure that you can walk. What kind of financial analyses you will be conducting during consulting projects
General analysis of financial statements.
At the beginning of the project, you will want to understand the firm. In this sort of situation most likely you will start with some basic analysis of the profit & loss statement (income statement), cash flow, and to some extent the balance sheet. This will give you a good overview of the business and you will be able to answer a few basic questions:
- Is the firm growing or not?
- Does the profit grow along with the revenues or maybe costs are eating away the profit?
- What is the profitability of the firm and does it change over time?
- What is the structure of the revenues? Which business units, products are the most important?
- Does the profitability differ by business units? Which business units are the most profitable?
- How does a specific cost position behave?
- Is the company generating cash on the operational level?
- What happens with the cash?
- How capital intensive the growth is?
- What is the financial structure of the firm?
As you can see general financial statements will give you a good overview of the business. In many cases, by looking at the CF and profit and loss statement we can already guess what kind of problems the firm is experiencing and what you have to do to increase the profits.
Financial analysis of indicators
A bit more advanced tool is to look at so-called financial indicators. They are great because they enable you to compare firms from the same industry of different sizes.
We have 4 main groups of financial indicators:
- Profitability ratios. These indicators tell you how big the relative profit (on a different level) is in relation to something else. Usually, we would look at the relation of profits and sales or type of assets. As we said we also look at different types of profits (Gross Margin, EBITDA, EBIT, Net Profit). We will use them to see how profitable the firm is in comparison with the competitors and to check how the profitability has been changing over time. Below is a short movie showing the most often used profitability ratios
- Liquidity ratios. These indicators will tell you what the liquidity situation of the firm is. In other words, we check whether we can easily pay our immediate, short-term liabilities using a class of current assets. This used to be important as it would give you a good idea of whether the firm can go bankrupt due to liquidity problems. In a world where the interest rates are close to zero, the importance of those indicators is much smaller.
- Activity / Efficiency ratios help you define how efficient the firm is in managing inventory as well as its relationships with suppliers (Liabilities) and customers (Receivables). This group of ratios is often used to estimate what could be the potential of improvements in the cash position of the firm. If for example, the Inventory Conversion Period is going down then the cash should increase.
- Debt Ratios. The final group of ratios shows you the long-term risks related to having a specific structure of financing. Here we relate the Debt level to total assets, equity, or to EBITDA. In this way, we can see whether we don’t have the danger of going bankrupt due to having too much debt.
Apart from that we can disaggregate the main indicators and use this disaggregation to learn more about the business. One of the most famous approaches to disaggregation of ratios is the DuPont model. Below is an example of the model:
In short, indicators, ratios will help you see how relatively good or bad the firm is generating profit, managing its liquidity and debt. Ratios are great for comparing firms with competitors and tracking their performance in time.
One of the most complicated and at the same valuable thing is to create a financial model of the firm in Excel and use it to understand the business but also forecast its performance. In most cases, you will use the bottom-up approach and the main KPIs of the business to model the profit and loss statements. On other occasions, you may also consider modeling the cash flow or at least working capital. Below is an example of a financial model for a retail business:
Check also other examples of business models:
- E-commerce financial model
- Consulting firm financial model
- Restaurant financial model
- FMCG financial model
- SMCG financial model
We have put a few tips on creating financial models in our post How to create a financial model so I suggest checking it.
After you have created the financial model you can also do the valuation of the business. In other words, you can try to estimate how much the business is worth. Valuation is a must for the following type of consulting projects:
- M&A. As a consultant you may be hired to support the buys or selling party. Consultants are usually hired to conduct due diligence, especially the commercial part of the due diligence. As a part of such projects, you will have to create a full financial model and estimate the value of the firm
- Turn-around. During turnarounds, you may also have to do some valuation of either the whole business or part of it. This is done in order to understand whether the business is worth saving and how much money we can pour into it to make it work. In certain cases, especially when it comes to liquidity, cash flow is a problem. You may be forced to sell part of the business. In such a situation, you will have to do a fast evaluation of business units and decide which business the firm has to sell to survive
- Strategy projects. Also as part of strategic projects, you most likely will have to do a simplified valuation. Strategy boils down to picking one of many options for developing the business. Usually, you would pick the option that gives you the highest valuation of the business (from the shareholder point of view). Therefore, you have to translate the nice deck of 400 slides into models in Excel and estimate the value of options on the table.
- Supporting PE in value creation. PE funds like to hire management consultants to help them with increasing the value of the business that they have just bought. Since PE is interested in increasing the value of the business, you will have to show in what way the improvements or growth will translate into a higher value of the business. This will require a lot of smaller valuation models. You will be rather estimating the additional value coming from a specific project, rather than the value of the whole business.
Bear in mind that you have to main methods of valuation that you will be using:
- Discounted Cashflow methods (DCF methods). In these methods, you calculate the value of the business based on the cash flows generated by the firm in the future. This will require creating a full financial model with a cash flow forecast. DCF is nothing more than NPV applied to the cash flows of the firm
- Multiplier methods. In these methods, you calculate the value of the business in a simplified way assuming it is equal to profit (usually Net Profit or EBITDA) multiplied by certain, specific for the industry multiplier. For example, if the multiplier is 10 and the Net Profit of the firm is USD 50 M then the Value of Equity is USD 50 M (Net Profit x Multiplier). For this method, you need only the multipliers and a good understanding of the profit.
Financial analyses related to M&A
As we have said consulting firms are the favorite partners of PE but also firms big corporations specializing in M&A. Apart from valuation management consulting firms do a lot of other financial analyses. Below are some of the main ones:
- Estimation of Potential Synergies. PE and big corporations in some cases buy more than companies from the same industry and try to consolidate them to gain economies of scale and the mythical synergies (for example reduction of head office costs). This exercise is not easy and they rather go for the impartial view of the consulting firm
- Valuation of potential targets. Big firms quite often don’t have their own M&A departments. That is why they hire consulting firms to identify, estimate the value, and rank potential targets. This helps them efficiently find the best potential targets for acquisitions.
- Value Creation Plan in Excel. Firms are bought to increase the value of the buyer. Not all firms are great at identifying the main growth drivers. That is why they hire consulting firms to list all potential improvements, growth opportunities. Consulting firms estimate the value behind every idea and create a sound value creation plan. This will require a lot of financial analysis in Excel. Below is an example of such an analysis
- Comparison of M&A vs organic growth options. M&A is only a means to an end. That’s why you also have to make sure that it’s the best option given the specific goals and the situation. In some cases, organic growth makes more sense. Bear in mind that for some firms speed matters more than capital efficiency.
- Forecasting of the firm after the M&A. After acquisition the new mother company will have problems with forecasting the firm they have just acquired. In certain situations, you may be asked to create a forecasting model that will help them predict and manage the new business.
- Divestment analyses. Finally, big firms and PE funds not only acquire but also sell a lot of business units. As a consultant, you may be asked to estimate what divestment makes sense and what will be the impact for the whole group. Many divestments will drastically change the profit and loss statement of other business units in the group. That is why always take into account all the links between the businesses.
Firms do a lot of investment. During consulting projects quite often you have to check whether they make sense. Before you start analyzing the investment make sure that you understand what type of investment it is and what the purpose is. Generally speaking, we can divide investments into 3 groups:
- Replacement Investments. These investments are the easiest to estimate. You have to look at the current cost of using a specific machine, tool and compare it with the costs of using a new machine, or a tool. This will enable you to decide whether the investments makes sense
- Investments required by the customer. Some investments (especially into new products) are triggered off by the customer. If you have to analyze such investments you will have to compare the potential benefit coming from the customer (additional gross margin from products sold) with the costs and Capex related to the investment. In this category, we will also have the investments into a new capacity to scale the business.
- Investments reducing costs. A lot of investments are done to reduce costs. The best example is an investment into automation or investment that helps you lower the usage of materials. Below is an example of analysis:
- Removing bottlenecks. Finally, in some cases, you invest to remove a bottleneck. This sort of investment requires a bit different approach, especially when it comes to estimating the potential benefit related to removing the bottleneck.
That’s in short when it comes to financial analyses. If you want to check how to do such analyses in practice check my online course Financial Analysis for Management Consultants & Analysts with more than 5 hours of content that will show you how to conduct financial analysis in Excel. You will also get in the course plenty of examples of financial analyses done during consulting projects