Risk analysis or risk management are concepts usually associated with financial institutions or large corporations. But risk is something that also small businesses encounter on a regular basis. They may however shy away from performing risk analysis since this concept may seem so “big enterprise”. But it’s not. Risk analysis is simply the identification and evaluation of scenarios that may happen.
Let’s define first what risk is. With risk we usually mean the chance that something undesirable will occur, which we then try to avoid or minimize. But risk can also mean a chance that something desirable will happen. In either case, the more uncertainty exists about the potential outcome the riskier we perceive it. Hence, to reduce this uncertainty and risk we should increase our knowledge about the uncertain events.
What are the sources of uncertainty? In business situations uncertainty arises in many ways. Demand for company’s products for example is uncertain since it depends on many economic factors and sometimes unknown customer preferences. Optimal prices to charge for company’s products or services may be uncertain since they are driven by unknown customer expectations and competitors’ pricing. And even operating expenses may be uncertain when it comes to forecasting required investments needed to bring a product to market.
Some of these uncertainties are outside of company’s control. Weather, for example, is an uncertainty that cannot be controlled and if you are selling umbrellas this uncertainty will impact your sales. But you can at least prepare yourself by analyzing potential weather scenarios and ordering the number of umbrellas that will maximize your profit. Other uncertainties, on the other hand, can be reduced by company’s actions. For example the uncertainty about optimal product pricing can be reduced through market research and pricing analysis helping to narrow down on only few desirable price points.
Most businesses need to make decisions in light of these uncertainties by taking calculated risk. Risk analysis provides the means to make this calculation. Risk analysis is nothing more than the analysis of potential uncertainties that may have an impact on the business. This scenario analysis can help to quantify the potential risks.
Scenario analysis in its basic form identifies few potential cases of what could happen. In this basic form, however, usually only few scenarios can be evaluated although in reality there are many uncertainties that need to be analyzed at once. Here is where Monte Carlo simulation can help.
Monte Carlo simulation is a sophisticated scenario analysis that can evaluate thousands of scenarios at once. Businesses can then better understand the uncertainties they encounter. You can find more about Monte Carlo simulation either in one of our previous posts or in our Monte Carlo simulation tutorial. Needless to say, Monte Carlo simulation is embedded in some of FinanceIsland’s tools to help identify for example potential outcomes of return on investment or company’s cash flows. This allows every company to perform risk analysis.
In the previous post we have discussed the importance of cash. Cash is king not only for the fiscal health of a business but also when it comes to any investment analysis. Hence, all financial analyses evaluating future returns need to be based on cash flows. Sometimes, however, the financial data is only available as accounting flows on an income statement. In those cases accounting flows need to be translated into cash flows. Here it’s how.
It’s very common and most of the time easy for companies to create an income statement describing an investment project. Incremental units are translated into revenues and cost of sales. The actual investments in engineering and marketing activities are subtracted from the resulting gross margin. And the resulting operating income is used to determine taxes, which then leads to net income or net profit.
However, net income on an income statement doesn’t represent cash flows. As described in the previous post, a company may record revenues now but it may receive cash from customers for these sales much later. Or it may record cost of raw materials as cost of sales now but pay bills from the supplier much later. Instead of identifying these detailed cash flows, there are five adjustments that can be used to translate net income into cash flows.
First, capital depreciation needs to be added back to net income. Capital depreciation is an expense representing the depreciation of capital expenditures. Accounting (and tax) rules sometimes require companies to spread the cost of equipment or property over its useful life. This capital depreciation results in smaller periodic expenses over longer period of time. In reality, however, the company may pay for the equipment or property with a one-time cash payment leading to a one-time impact from the cash flow perspective. Hence, capital depreciation needs to be added back to net income to arrive at cash flows. At the same time, capital investment needs to be subtracted since it consumes cash due to this one-time payment. This is then the second adjustment. These two adjustments have a net zero effect over a longer period of time, but they lead to changes in periodic, e.g., monthly, cash flows.
The third adjustment addresses the fact that the company may receive money from its customers a while after it has billed them and after it has recorded these sales as revenues. As mentioned in the previous post, accounts receivable is where these expected payments from customers are recorded. Changes in accounts receivable can be used to translate net income into cash flows. These changes describe how much more or how much less cash has been tied in accounts receivable. There is a metric in accounting called days sales outstanding (DSO), which describes the number of days between the time a sale is recorded in the accounting systems and the time the company receives cash for that sale. With DSO the changes to cash flows can be easily calculated from revenues. These changes usually lead to cash from customers being available at a later time than the corresponding revenues.
Similarly to changes in accounts receivable, changes in accounts payable is the fourth adjustment used to translate net income into cash flows. Accounts payable represent how much cash is waiting to be used to pay suppliers. Changes in accounts payable describe how much more or how much less cash payments to suppliers have been delayed. Here too there is an accounting metric called days payables outstanding (DPO), which describes the number of days between the time a purchase is booked in the accounting systems and the time the supplier is paid for that purchase. DPO can be used to easily calculate changes in accounts payable from cost of sales. These changes usually lead to cash owed to suppliers being available for some time before the corresponding purchases are paid.
The final fifth adjustment are changes in inventory to reflect that some of the cash is tied in inventory, which is not reflected on the income statement. Net income only reflects the cost of sales of the company’s products and assumes that these products are turned into revenues once a sale is made. However, the products may spend some time in inventory where raw materials are turned into finished goods. Finished goods may even continue staying in inventory if the products cannot be sold right away. The accounting metric inventory turns per year represents the number of times the average inventory is sold during a year. Together with cost of sales, this metric can be used to calculate the additional cash tied in inventory.
To summarize, cash flows cannot be always identified easily but an income statement is usually readily available. Periodic net income can then be translated into periodic cash flows using the five adjustments described above. Some of FinanceIsland’s tools use this technique to derive cash flows from the income statement.
The phrase “cash is king” is being used on many occasions in the finance world. Although I usually don’t like generalizations, I must say that this phrase is true in many circumstances. So, why is cash king?
Cash is needed to pay bills, compensate employees, and make purchases. Hence, a business needs enough cash as an asset for short-term operations. It also needs to ensure that there is sufficient stream of cash in-flow to cover all these expenditures in the future. Cash availability is an important metric to measure the overall fiscal health of a business.
In the accounting world a company can show a decent profit on its income statement. But that profit doesn’t necessarily mean that the company is financially healthy. When a sale is made, for example, the revenue is shown on the income statement, but it may be a while before the company receives cash for that sale. When this sale is made, a company increases its accounts receivables on its balance sheet, which in accounting terms increases also its net worth. However, the company could still be short on cash to keep its operations running. Despite its positive net worth the company could fail and be technically bankrupt.
There are several ways a company can improve its cash position. It can of course spend less, but this may have a negative effect on generating sales in the long-term. There are though three other ways to improve cash position by addressing three accounting elements: accounts receivable, accounts payable, and inventory.
As indicated above, accounts receivable is where the company records a sale to a customer until the customer pays for that sale. The cash is basically held captive in accounts receivable until the customer pays the bill. To improve its cash position, the company should collect money from the customer sooner than later.
Accounts payable is the equivalent of accounts receivable but the company is now on the paying side. Accounts payable is where the company records any money that it owes to its suppliers for purchases of materials, supplies, or services. Although these suppliers need to be paid at some point in time, the company has usually some time when to address this liability. The later these bills are paid the more cash is available to run the business.
Inventory is an accounting measure describing the financial value of raw materials and finished goods before they are sold to customers. Since cash can only be generated once a sales is made, inventory is another place where cash is held captive. Of course, there is a need for inventory to transfer raw materials into finished goods. It may also make financial sense to have enough finished goods inventory to react to sudden increases in demand. Hence, there is a need for the right balance between tying cash in inventory and quickly turning the inventory into a sale. While keeping this balance in mind, the sooner you can turn inventory into a sale the better.
The chart below illustrates cash flow and the interrelations between cash and accounts receivable, accounts payable, and inventory for a simple manufacturing business. This company buys raw material from a supplier, transforms it into finished goods, and sells them to a customer.
Once the company receives raw materials from the supplier, it starts manufacturing the products. At the same time it books the invoice from the supplier as accounts payable, but it still can use the cash intended to pay this invoice for other purposes for some time. Once the products are manufactured, the company sells them to the customer and awaits payment. The expected payment is booked as accounts receivable, but the corresponding cash is not available to spend yet until it is received from the customer. The inventory that is being processed consumes cash as well, which is not available for other purposes.
To increase its cash position – represented by the green areas in the chart – the company should maximize the accounts payable bubble by delaying payments to suppliers. It should minimize the accounts receivable bubble by collecting cash from customers as soon as possible, ideally immediately when the sale is made. And the company should minimize the inventory bubble by quickly turning inventory into a sale.
The purpose of a for-profit business of any size is to make profit. However, when people say that the company is making money or that an investment has a good return, they often mean different things. And sometimes they don’t even have profit in mind. So, let’s look how a company transforms sales into profit by defining revenues, cost of sales, and operating expenses.
First of all, sales are not sales. There are gross sales, which represent unit sales of products or services at list or gross price. This list price represents the price that a company may publish in its official price list. Most of the time, however, companies offer discounts off these list prices.
Discounts may include negotiated discounts with specific customers, which are then offered anytime to these customers as long as the negotiated contract is in place. Discounts may also include time- or deal-limited price reductions offered as part of a promotion activity. Some companies that use distribution partners to sell their products classify also costs associated with supporting these distribution partners as discounts.
Gross sales minus discounts lead to net sales or net revenues. Net revenues represent the money that the company receives from its customers.
Net revenues = gross sales – discounts = units * list price – discounts
Second, all of the products or services that are sold to customers need to be produced and delivered, which creates cost. This cost of sales (COS) is obvious in a manufacturing environment: all the materials and parts that are needed to assemble the product plus the people assembling it plus the manufacturing facility are all part of COS. In a service business cost of sales may not be obvious, but delivering the service usually requires people providing the service to customers. The cost of these employees represents COS in a service business.
Once all costs of sales are accounted for, they are subtracted from net sales to calculate gross margin or gross profit. Sometimes gross margin percentages, which are gross margins as percentage of net revenues, are used to compare companies in an industry to determine how efficient their operations are.
Gross margin = net revenues – cost of sales
Third, every company incurs costs associated with operating the business. These costs are called operating expenses. Operating expenses are usually divided in engineering expenses or research & development (R&D), marketing and sales expenses, and other expenses. Other expenses can include administrative expenses that are not accounted for anywhere else or allocations from headquarters in large organizations.
When subtracting operating expenses from gross margin we arrive at operating income or operating profit.
Operating income = gross margin – operating expenses
Most companies pay taxes. Taxes are based on the operating income the company achieves and are usually a percentage of the operating income. When subtracting taxes from operating income we get finally to net income or net profit. This net income is at the end the measure that can be used when talking about “making money”.
Net income = operating income – taxes
= units * list price – discounts – cost of sales – operating expenses – taxes
What we have reviewed here is the income statement or profit & loss statement (P&L). This statement is an important document describing the profitability of the company. It is used mostly for accounting and taxation purposes. For investment purposes, however, it is more appropriate to evaluate cash flows, which may differ from the measures described here. But on cash flows and why cash is king at some other time.
Although net present value (NPV) rocks, it is hard to believe that any financial metric representing the future outcome of an investment correctly describes what will REALLY happen. After all, cash flows that are inputs into the NPV analysis are forecasts and forecasts are never accurate. In lieu of a good crystal ball, you can run some scenario analyses or go straight to Monte Carlo simulation.
Monte Carlo simulation is a sophisticated scenario analysis. It’s a technique where you can model thousands of scenarios in a matter of seconds. Unlike typical scenario or what-if analyses that allow you to analyze the impact of changing one input variable at a time, Monte Carlo simulation analyzes all possible combinations at once. In a typical scenario analysis, you manually calculate as many scenarios as you deem necessary. Monte Carlo simulation, on the other hand, calculates these scenarios automatically, based on your definition of simulation parameters. It allows you to run thousands of scenarios instead of the few in a typical what-if analysis.
Monte Carlo simulation was popularized by physicists in the 1950s at the dawn of the computer age and it got its name from the Monte Carlo Casino in Monaco. Games of chance played at a casino exhibit random behavior that is bound by the characteristics of the game. When rolling a die for example, you know that a number between 1 and 6 will come up, but you don’t know which one.
Similarly, in an investment project you may know the range of possible financial outcomes, but you don’t know exactly which one will materialize. Monte Carlo simulation allows you to model all potential scenarios driven by the uncertain inputs. As a result you will know not just whether an investment will be profitable, but how likely it is to be profitable and how profitable it is likely to be.
Although Monte Carlo simulation will not eliminate uncertainties in business decisions, it can help you to understand them in normal business circumstances. For example, if there is a chance of negative financial outcome in your business, Monte Carlo simulation allows you to assess what might go wrong and helps you to be proactive with the decisions you make. Similarly, if you’re allocating resources among several projects, Monte Carlo simulation helps you to determine which ones have the greatest chance of success.
Monte Carlo simulation can especially be helpful in financial projections for investments that are not based on repeated past experiences. These projections are most often badly flawed. Although Monte Carlo simulation will not help to predict all possible events, it will help to prepare for those events.
Monte Carlo simulation can only go so far, however. It is, like also standard scenario analyses, only accurate for scenarios not wildly different than typical business circumstances. There may be, however, extraordinary, though not absolutely unlikely events that are widely different. Events like these, referred to also as Black Swans, have a low likelihood of occurrence, but big impact. Since Black Swans are unexpected by definition, they are not modeled in financial analyses. But more on Black Swans at some other point in time.
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About this blog This is a blog by FinanceIsland mostly about financial analyses in businesses, covering topics such as proper investment analysis, cash flow projections, and managing uncertainty. For more about us and our online financial analysis tools please follow the links on top of this page.
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