Private equity firms may act surreptitiously in public, but they expect total transparency from their investee management teams. In practice, this means managers must deliver accurate and constant financial information. But, to ensure coverage of all risks and issues when conducting private equity analysis, the information needs to be of the right type.
It is often lamented that managers focus on the P&L way too much. This can create a range of problems; the most severe being bankruptcy. (Also, the P&L only represents paper earnings and is therefore somewhat disconnected from reality.) Therefore, in the context of private equity analysis, here’s commentary on each financial statement:
- Profit and loss: revenue will always be important regardless of lectures about top vs. bottom line. Without revenue, well, there’s not much of a business. In saying this, pay particular attention to profit margins to understand how revenues convert to value. The gross margin will give insight into the attractiveness of the offering and indicate how differentiated the offering really is. In comparison, the operating margin will uncover how efficiently the business is running as an enterprise; are costs too high or are managers engaging in profligacy? Lastly, private equity firms rarely acknowledge net profit figures. Net profit is an accounting construct relevant only to the taxman. All else equal, lower net profit and lower taxes are best. This is only the start of private equity analysis.
- Balance sheet: working capital management is key to most businesses, even if they don’t know it. Confusingly, both increases and decreases in working capital can indicate issues. If working capital decreases to negative, it reflects an inability to cover short-term liabilities, which will ultimately lead to insolvency. But, an increase in working capital can also indicate slower collections, higher debtor days and increased bad debts. This is especially important in the current economic climate. Inventory, debtor and creditor management is also very important as efficiency becomes key when growth slows. The non-current balance sheets items have uses too, but in times like these, the current sections of the balance sheet receive the most attention. This is the next step to private equity analysis.
- Cash flow: we were all taught in school that a business could post a positive net profit and still become bankrupt. Well, it’s true and it’s proving an invaluable lesson for many public companies that haven’t focused enough on cash flow. Cash is the ultimate measure of performance, so keep attuned to the drivers of it. Apart from the usual P&L movements and changes in working capital (from the balance sheet), make sure you control capex like a ruling Eastern Bloc dictator. Unbridled capital asset expenditure won’t show up on a P&L and won’t come to the surface of a Balance Sheet until the end of year, but it will show up on weekly or monthly cash flow reports. Equally, keep an eye on debt and the ability to meet repayments. Be vigilant with reporting against covenants on a frequent basis. As we’re seeing more frequently, unmanaged debt can put a business into bankruptcy overnight. And this is the private equity analysis icing on the cake.
Especially in these times, it’s important to be diligent and disciplined with private equity analysis and financial management. In a previous post I mentioned that everyone seems to think their business is counter-cyclical now, but don’t fall for it. Be honest with yourself and plan for rainy days.