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MBA in 2 minutes | Lesson 10: How to diagnose health of a firm

Updated: Jan 8, 2021

We will be solving practical challenges through MBA concepts. No theory only applications !

You would encounter many professional circumstances where you would be asked to diagnose the health of an organisation. This can be from the standpoint of acquisitions and investments that Private Equity guys do day in and day out or analyzing competitor's strengths and weaknesses.

In this lesson, we will cover on how to get started. Again accountants would ace this lesson and it's a skill that any business professional should definitely be familiar with. So let's get started.

Step 1:

In any business situation, one must know the bigger picture. Which company is under the scrutiny ? It can be your own firm or department. Now, why are you doing it ? This is needed to tie the math to intuition of business- which trust me is very rare skill in the market.

Step 2:

Now we get into analyzing operating activities. Our smart ass accountants have already covered us. Accounting has a list of operating ratios that help us in diagnosis . All you need is to do the math. Few of such operating ratios are:

  • Gross margin ratio= (Sales- Cost of Goods Sold)/Sales (basically profitability of the company)

  • Working Capital days= Receivable days+ Inventory days- Payable days (very important metric to gauge running cash in the firm )

  • Receivable turnover= Sales/Average account receivables (account receivables is the future money to us); Receivable days=365/Receivables turnover

  • Inventory turnover= COGS/Average inventory; Inventory days= 365/ Inventory turnover

  • Payable turnover = COGS/ Average Account Payable (account payable is the future money from us to vendors); Payable days= 365/Payable turnover

I know it's a lot of accounting jargon but if I were you I would focus on mainly top two bullets.

Step 3:

Now let's get practical with Amazon - a publicly traded firm. We will determine it's operating ratios (through it's income statements and balance sheets- which we have covered in previous lessons).

The exercise can help you become good in investing stocks also because let's be honest it's your money and we better deal with it rationally. Next, you would do this exercise against a potential competitor, eg Walmart because any number is good or bad based on a) historical data b) competitor data- otherwise data doesn't narrate a story in silo (Am I'm giving consulting gyaan here :p).

PFB screenshot of the quick analysis for you to have a comparative health checkup.

Amazon vs Walmart's activity ratios

Many might argue if operating ratios are enough to gauge health of a company. My strong argument would be that its infact the heart of it.

Financial analysts who monitored operating ratios of Jet Airways predicted it's down fall 5-6 years before it's bankruptcy. They could do so based on pure operating ratios because that's always where you start seeing red signals. For eg, when the oil prices were going down and the industry player's costs were also going down, Jet's gross margins were going down- something which now you can also do for a potential defaulter under your radar :p

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