How to evaluate the situation of a company through the theory of three lenses?
Need to assess the company's situation
In 2016, there were 2 million microenterprises employing less than 10 people with an annual turnover or total annual balance sheet of less than €2 million. This represents an increase of 5.2% from 2015, and an increase of 16.8% from 2010. The market requires entrepreneurs to be constantly on the lookout for threats to effectively manage their business and respond to current problems. Starting a business is a straightforward process, but often due to low start-up capital, entrepreneurs face relatively high business costs such as taxes, Social Security, rent, employment or advertising, which - especially at the beginning of the business - are higher than revenues. In addition, for those who open a business alone, things will not be made any easier by having to deal with every aspect of running the business personally. Constant monitoring of changing regulations is necessary to operate legally.
Competition these days appears at every turn and meticulously fights for customers. The difficulty of getting them
and late payments are another barrier to stabilization in the first months of business. According to the Euler Hermes report, as many as 80% companies close after the first year. The main problem is high competition and low profitability. This figure suggests that still not all Polish entrepreneurs have learned the art of running their own business, which does not exclude the fact that many of them have very high potential that they could develop in the future.
Closing a business is often associated with low income or the ability to cover only expenses. However, it is in such cases that a sound assessment of the company's financial situation plays a huge role. Decisions should not be made under the influence of emotions. Ratio analysis is considered one of the most important elements of assessing a company's finances. It reflects the financial situation of the company and allows a clear assessment by analyzing groups of indicators of profitability, liquidity or inventory turnover. The complexity of the analysis requires that you take the time to evaluate the financial condition and, based on the results and cool analysis, take further action.
Not every area related to running a company needs to be handled in-house. There are times when it is better to abandon or outsource certain processes in the company. Hence, any analysis carried out can show both the weaknesses and strengths of the business and determine the next steps.
According to economists Prof. Czekaj and Prof. Dresler, a distinction is made between investment decisions and financial decisions of a company. Investment decisions involve the formation of assets necessary for business, that is, they mean the use of capital. Financial decisions, on the other hand, concern the sources of financing these assets, i.e. their size, types and structure. Let's look at assessing a company's situation through the lens of the three-lens theory.
Three Lens Theory - a reliable assessment of activity?
The financial statement is a document that reflects the processes of the enterprise. It contains a collection of information about the company's assets and the sources of their financing (financial balance sheet and statement of changes in equity), the economic benefits obtained by the company in the reporting year (income statement) and the state and movement of cash in the fiscal year (cash flow statement). In addition to the aforementioned elements, the full financial statements also contain supplementary information, where the figures given in the previously mentioned sections are explained.
The structure of the financial statements allows the company to be evaluated from three points of view, or as Prof.
J. Ostaszewski, to look at them through "an eyepiece made of three lenses."
The three lens theory involves looking at a company from three aspects:
Each of the lenses individually reveals a certain slice of knowledge about the company, but only when viewed through the prism of all of them does it allow for a complete and reliable assessment, so it is increasingly being used to assess a company's situation.
In small enterprises whose financial statements are not subject̨ to mandatory audit by auditors, the report may bé limited only to the balance sheet, income statement and notes (Law
on Accounting dated September 29, 2004, as amended).
Three lens theory vs. income statement
The first lens allows you to analyze the economic aspect including all the phenomena related to profit, loss, cost of sales, return on capital, sales revenue. In the financial statements, these categories correspond to the income statement. Among other things, this account shows the value from operating activities.
In the economic aspect of the Three Lenses Theory, operating profit occupies a very important position due to its informational value considered in three planes:
- in the event of a loss from operations in the fiscal year, the company is assured that its core business is unprofitable and can take steps to rectify the situation;
- The concept of operating profit makes it possible to determine with which aspect of the company's operations the revealed problem is related;
- Operating profit is the basis for constructing measures of profitability, giving the opportunity to compare companies within a single sector, while ignoring differences in their financial structures.
The second information element, in order of calculation, is EBIT. The term EBIT is an acronym for Earnings Before Interest and Taxes, which refers to a certain level of income meaning profit (or loss) before interest
and taxation. It should also be added that the value of the EBIT measure is affected by the results of extraordinary events and financial income. This measure is widely used in financial analysis according to international standards in highly developed countries. Many other indicators and measures are constructed using it, if only from the plane of debt analysis.
Companies, when trying to calculate a given indicator, make it a priority to answer the question about their actual capabilities.
There is no single, absolute calculation template for EBIT. It is believed that the freedom left to the businessman in this matter may be beneficial to him mainly because he chooses the formula that is most advantageous from a value perspective. However, it is just as often illusory, and can sometimes be a cause of confusion, especially when different recipients of financial information use different calculation formulas.
Only by knowing the specifics of an entity's economic activity, including, in particular, the manner and scope of its economic activities that translate into the recurrence of certain groups of revenues, can one reliably determine the level of its basic profit, which is indicated precisely by the categories of EBIT. So, before calculating these figures, it is necessary to first examine the revenues of a given entity, and only on the basis of this analysis can the basic profit be estimated.
On the other hand, by analyzing only the financial situation, we are not always able to know the specifics of an industry. In such a case, the safest solution is to use EBIT calculation formulas based on the level of profit (loss) from sales, since the category of sales and equalized revenues is usually the basic revenue category.
On the other hand, taking - which happens quite often in practice - as the starting point for EBIT calculations the financial result
from operating activities seems to be a less favorable solution, since other operating income is implicitly treated as permanently related to business activity. To simplify - sales of non-financial fixed assets or grants are inherent attributes of business activity. Typically, this approach allows EBIT to take on higher values, but it can be artificially inflated beyond the entity's actual bottom line, and the financial projections prepared and decisions made based on them are subject to an increased risk of failure.
What should you look for in cash flow?
Wanting to take a closer look at the company, it is worth evaluating it through the second lens - financial. Many companies think about the impact of management efficiency on the amount of funds. The answer to this question should be sought
In the statement of flows on operations, already mentioned cash flow.
This category is a monetary representation of the financial result (surplus in the case of a positive value, or loss
in the case of a negative value). The largest part of cash income is generated within operating activities. In contrast, costs or cash expenditures are absorbed within investing and financing activities.
The study of cash flows is very important because companies, especially in the long term, need to control their liquidity. Its temporary or permanent loss leads in most cases to the bankruptcy of the company. Equally undesirable is the persistence of over-liquidity in the company, which can indicate
of mismanagement or lack of elementary knowledge of investing (on the principle of "cash uninvested loses value"). This situation indicates that management is not taking advantage of opportunities for additional profits, if only in the financial market (e.g., Treasury bonds).
The primary source of financial surplus (profit) in a manufacturing enterprise should be operating activities. The situation is different for service enterprises or those engaged in investing as part of their core business, in which case the bulk of the financial surplus can be generated on investment activities (changes in ownership of property rights, movables, fixed assets, real estate, etc.) or financing.
Evaluating a company through an asset lens
The third lens - the asset lens - is to find the risks associated with the business. It is helpful for this purpose to find answers to such questions as:
- What are the sources of funding for the company's assets?
- What resources are included in the company's assets?
- How is the relationship of fixed versus current assets shaped, and how does this relationship translate into operational risk?
- How is the structure of liabilities shaped and what is the share of foreign capital in liabilities that translates into financial risk for the company?
The choice of a company's asset management strategy is often dictated by the individual risk appetite of the owner or management. Achieving higher profits is usually associated with taking higher risks, and these risks are not necessarily actual risks, but only risks perceived by decision-makers and closely related to their knowledge of industry changes and innovation potential in the company. In practice, there are three basic asset financing strategies: dynamic, conservative, moderate.
A dynamic financial strategy, commonly referred to as an aggressive strategy, involves minimizing net working capital. The value of this capital can be close to zero or sometimes even take a negative value. When this value is zero, it can be inferred that only fixed assets are financed with fixed capital, and current assets are
entirely financed by short-term liabilities. On the other hand, with a negative value of net working capital, it should be inferred that part of the fixed assets is also financed by short-term liabilities.
Higher risk for a company is usually linked to the level of working capital employed
in the company. This risk increases as the level of net working capital decreases. When this capital takes on a negative value, there will be a financial imbalance in the enterprise. If the company assumes generating large profits, it must decide on a very risky strategy often associated with significant fluctuations in liquidity. An aggressive strategy with a negative value of net working capital requires constant maintenance of the
and renewing liabilities of a short-term nature. Another aspect of this issue is the need to quickly liquidate fixed assets when liquidity is at risk, which does not always come easily
and brings benefits.
A conservative strategy, also known as a passive strategy, is characterized by the constant maintenance of a high level of net working capital. In this strategy, all fixed assets and most current assets are financed with fixed capital. The company has a constant ability to dispose of them. When choosing this strategy, there is a significant reduction in financial risk. Liquidity does not require much effort, as essentially all of the company's assets are financed with capital that does not require a quick return - equity. In this strategy, the price for low financial risk is to give up additional sources of capital acquisition and the resulting benefits.
The moderate strategy, in its assumptions, includes maintaining an optimized level of liquidity, assuming an average return on net capital. This type of strategy is a compromise solution to the other two strategies, that is, a trade-off between financial risk and return on equity. Net working capital is present in this strategy, although at a lower value than in the conservative strategy. Fixed capital is involved in financing the fixed portion of current assets and total fixed assets. The variable part of current assets, on the other hand, is covered by short-term liabilities. When choosing this strategy, the company must take care
o a satisfactory level of liquidity.
Knowledge of a company's financial situation is a must. Without such knowledge it is difficult to make the right business decisions, i.e. whether to cut costs or rather increase sales. It turns out to be important not only the situation in a specific area, such as liquidity, but also of the whole enterprise, since managers, management and especially owners expect a clear opinion: "it's good" or "it's bad." Therefore, it is worth paying attention to an accurate assessment of the company's situation - which will result in additional economic benefits.
- Wait J., Z. Dresler, Enterprise financial management. Fundamentals of theory, Wyd. Naukowe PWN, Warsaw 2001, pp. 14-15.
- Accounting Act of September 29, 2004, as amended.
- Ostaszewski J., Finance, published by Difin, Warsaw 2003, p. 237.
- Stefanski A., EBIT and EBITDA as measures of business performance, www.finanseicontrolling.pl/controlling/ebit-i-ebitda-jako-miary-efektywnosci-dzialalnosci-gospodarczej.