When evaluating a company’s financing, both dynamic and static analysis are essential. Initially, a
company invests in assets like land and equipment and in operational needs such as working capital.
To fund these, it raises equity or debt, aiming for these investments to eventually generate positive cash
flows. A virtuous cycle allows the company to grow, repay debt, and potentially borrow more.
Conversely, a vicious cycle, marked by constant new investments and low operational cash flow, leads
to perpetual borrowing without debt repayment or dividends. The dynamic analysis examines this cycle,
while the static approach assesses the company’s current ability to repay debt and its risk of illiquidity
based on asset financing and free cash flow.

1. THE COMPANY’S FINANCING – DYNAMIC ANALYSIS

Cash flow from operating activities

The cash flow statement, which separates operating, investing, and financing activities, is crucial for
valuing a company and assessing investment decisions. Cash flow from operating activities hinges on
three key factors: the company’s growth rate, operating margins, and working capital. Therefore,
analyzing the cash flow statement logically follows the examination of the company’s margins and
working capital changes. This analysis focuses on the profitability of the company’s operations rather
than the value of its assets. For example, a fast-growing company with high working capital might show
insufficient cash flow from operating activities despite increasing inventory values and a strong net
income. This could indicate poor return on capital employed and vulnerability to sector downturns.
By analyzing the cash flow statement, we discovered that such a company’s trade activities were
unprofitable, and capital gains barely offset operating losses. Additionally, the company’s growth
involved substantial borrowing, increasing its risk in case of a recession.

The cash-flow after interest

Free cash flow after interest is calculated by subtracting cash flows from investments (capital
expenditures net of fixed asset disposals) from cash flows from operating activities, thereby reflecting
the firm’s investment policy. If free cash flow after interest is negative, it indicates the company will need
external financial resources from shareholders or lenders to cover the cash demands of its operations
and investments. If positive, the company can reduce debt, pay dividends without incurring new debt, or
accumulate cash for future needs. Thus, free cash flow after interest significantly influences the
company’s financing strategy.

The company financing

Understanding how a company finances its growth involves analyzing new equity capital, new debt,
reinvesting cash flow from operating activities, or asset disposals. Key aspects include equity capital
issues, debt policy, and dividend policy. When financing through new equity issuance, it is necessary to
evaluate whether the company sought new equity from shareholders to reduce debt or finance new
capital expenditures. Conversely, share buybacks might indicate an attempt to alter the financial
situation or a lack of investment opportunities. For debt financing, analyzing net increases or decreases
in the company’s debt burden is crucial. Paying down debt might aim to improve financial structure,
reflect a lack of growth opportunities, or repay high-interest loans. Increasing debt could mean utilizing
unutilized debt capacity, financing significant investments, or reducing shareholders’ equity and
disrupting financial equilibrium.

Dividend policy is another crucial aspect. Evaluating if the dividend policy aligns with the company’s
growth strategy and the reinvestment of cash flows aligns with the capital expenditure program is key.
Comparing dividends with investments and operating cash flows provides a clearer picture of financial
health. Capital expenditure should not be limited to operating cash flow. Investing in new projects until
their marginal profitability equals the required rate of return is essential. Investing less indicates
underinvestment, while investing more suggests overinvestment, regardless of cash availability.
Each division should finance itself based on its profitability and associated risk, distributing generated
cash flow to its capital providers. Studying the balance between the company’s various cash flows to
establish rules considers the company as an isolated entity, contrary to financial theory. However,
determining the investment cycle that the company’s financing cycle can support, particularly its debt
repayment ability, remains critical.

2. THE COMPANY’S FINANCING – STATIC ANALYSIS

Focusing on a multi-year period, we have examined how the company’s margins, working capital, and
capital expenditure programs shape its various cash flows. Now, we can shift our attention to the
company’s absolute level of debt at a given point in time and its ability to meet its commitments while
avoiding liquidity crisis.

The company’s debt repayment

The best way to answer this fundamental question is to take the company’s business plan and project
future cash flow statements. These statements will reveal whether the company generates enough cash
flow from operating activities to cover its capital expenditure and still meet its debt repayment
obligations without needing additional equity from shareholders. If additional equity is required, you
must assess the market’s appetite for a capital increase, which depends on the current shareholders. A
company with a core shareholder may find it easier to secure funding than one with widely held shares,
as the core shareholder may underwrite the share issue. The value of equity capital also plays a role; if
it’s low, interest may come only from vulture funds.

This assumes access to the company’s business plan or the ability to construct one based on scenarios
of business growth, margins, changes in working capital, and capital expenditure levels. Analysts and
lending banks use a “quick-and-dirty” method to gauge debt repayment ability: the ratio of net debt to
EBITDA, a common financial covenant in debt contracts. This measure is useful because EBITDA
approximates cash flow from operating activities, minus changes in working capital, interest, and taxes.
A value of 2.5 is critical; below this, the company should generally meet its repayment obligations. This
implies that the debt could be repaid in 2.5 years if the company halted all capital expenditure and tax
payments.

Conversely, net debt exceeding 2.5 times EBITDA is considered heavy and raises doubts about
repayment capabilities. In leveraged buyouts (LBOs), this ratio can exceed 5 or 6, classifying the debt
as “high-yield” or “junk bonds.” These ratios are indicative rather than absolute references. Bankers
prefer lending to sectors with stable cash flows (food retail, utilities, real estate) even with high net debt
to EBITDA ratios, unlike sectors with volatile cash flows (media, capital goods, electronics). If past cash
flow statements show negative free cash flows after financial expenses, banks will be reluctant to lend,
regardless of EBITDA levels. When working capital changes significantly compared to EBITDA, the net
debt/EBITDA ratio loses its relevance.

The risk of illiquidity

To understand liquidity, consider the company’s balance sheet at a specific point in time, which displays
its assets and commitments. This historical snapshot can be used to classify assets and commitments
based on how quickly they convert to cash. Liquidity assesses when a particular commitment will result
in a cash outflow and when a particular asset will bring in cash. A company becomes illiquid when it can
no longer meet its scheduled commitments.

To meet these commitments, a company must either monetize its assets or secure new loans, though
new loans merely delay the problem until the next repayment date, requiring the company to find new
resources. Illiquidity occurs when the maturity of the assets exceeds that of the liabilities. For example,
if a loan due in six months is used to buy a machine with a three-year useful life, there is a risk of
illiquidity if the machine cannot be resold at a reasonable price or if the business is unprofitable.
Similarly, borrowing short-term funds to finance inventories that take longer to turn over presents the
same risk.

The risk of illiquidity arises when assets convert to cash more slowly than liabilities need to be paid, as
the maturity of assets is longer. Thus, liquidity measures the speed at which assets turn over compared
to liabilities. An illiquid company does not necessarily have to declare bankruptcy but must find new
resources to cover the gap, sacrificing some independence as new resources are allocated to past
uses. During a recession, this task becomes more challenging, potentially leading to bankruptcy.
Analyzing liquidity involves examining the risk that the company will need to “borrow from Peter to pay
Paul.” For each maturity, you must compare the company’s cash needs with the resources available. A
balance sheet is considered liquid when, for each maturity, the assets converting to cash (sold
inventories, paid receivables, etc.) exceed the liabilities due. To measure liquidity, we must compare the
maturity of a company’s assets to that of its liabilities. This principle leads to several ratios commonly
used in loan agreements to help banks monitor the risk associated with their borrowers.

This ratio indicates whether the assets that will be converted into cash within a year exceed the debts
that need to be paid within the same period.

This ratio excludes inventories, recognizing that part of the inventories is necessary for ongoing
operations and may not be quickly liquidated in urgent cash needs. A quick ratio below 1 suggests
potential short-term liquidity problems, requiring either a cash injection or facing bankruptcy.

The cash ratio is typically low and its fluctuations are often difficult to interpret. Traditional financial
analysis advocates for a buffer between short-term sources and uses of funds to mitigate business risks
such as inventory loss, customer defaults, sales decline, and business interruptions. By maintaining a
current ratio above 1, the company ensures it has more current assets than current liabilities,
safeguarding its ability to meet obligations like paying suppliers, servicing loans, or paying taxes. From
a long-term perspective, a current ratio above 1 indicates that stable sources of funds (like equity and
long-term debt) exceed fixed assets. Conversely, a current ratio below 1 suggests that fixed assets are
being financed by short-term borrowings or negative working capital, which can be risky since these
liabilities will soon be due, while fixed assets convert to cash slowly.

While the current ratio was once the cornerstone of financial analysis, this focus was excessive. The
current ratio primarily reflects the balance between short-term and long-term financing, a key concern in
the credit-based economies of the 1970s. Today, the focus is more on the balance between equity and
debt, regardless of maturity. Nonetheless, financing permanent working capital with short-term
resources remains unhealthy and can leave a company vulnerable during a liquidity crisis, potentially
leading to bankruptcy.

Financing working capital

Since working capital is a constant need, it should ideally be financed through long-term debt or
shareholders’ equity. However, most companies use revolving credit facilities, which are flexible and
often collateralized by receivables and inventories. Over-reliance on short-term credit can exhaust
borrowing capacity, increase interest expenses, and limit operational flexibility. Companies must
analyze how their operating needs will evolve to ensure effective financing. High-export or construction
companies often face risks due to insufficient equity and reliance on revolving credits.
Companies with negative working capital can reduce shareholders’ equity based on strong cash
positions. These companies can react swiftly in crisis but face risks like changes in supplier payment
terms and business volume contractions, which can strain financial resources.