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STEP 1: Theory Review (8-10 minutes)
STEP 1: Theory Review (8-10 minutes)
In this module, we will focus on two main topics.
First, we will look at Vertical and Horizontal Capital Analysis.
Second, we will learn the Golden and Silver Rules of Financing.
Let’s start with the first topic—Vertical and Horizontal Capital Analysis:
In Horizontal Analysis, we look at changes over time. We compare Equity and Liabilities from one year to the next, both in money and in percentages. This tells us how the company pays for its growth. Does it take on new debt? Or does it use its own profits?
In Vertical Analysis, we look at the percentage split. We check how much of the company is funded by Equity versus Total Liabilities. We also calculate Permanent Capital, which is Equity plus Long-term Debt. This shows how much stable, long-term money the company has.
Next, we look inside both blocks to check the Quality of Capital:
8Inside Equity: Is the company saving its own past profits as Retained Earnings? Or is it issuing new shares to outside investors?
Inside Liabilities: Does the company use safe, Long-term Debt? Or does it rely on Short-term Debt that must be paid back within 12 months?
Let’s look at the details in the table on the screen.
First, let's concider the horizontal analysis: To calculate this, we take the change in capital from last year to this year, divide it by last year's capital, and multiply by one hundred percent.
First, let's concider the horizontal analysis: To calculate this, we take the change in capital from last year to this year, divide it by last year's capital, and multiply by one hundred percent.
In Horizontal Analysis, first we check how Equity and Debt change from one year to the next.
This shows us if the company is paying for its growth with its own profits or by taking on new debt.
It is a healthy sign when Equity grows faster than Debt, and a warning sign when Debt grows much faster than Equity.
And now let's concider the vertical analysis: In the formula, we divide Equity—or Permanent Capital—by Total Equity and Liabilities.
And now let's concider the vertical analysis: In the formula, we divide Equity—or Permanent Capital—by Total Equity and Liabilities.
In Vertical Analysis, as next we look at what percentage of the company is funded by owners versus debt.
Here, we also calculate Permanent Capital, which is Shareholders' Equity plus Long-Term Debt.
This block is very important because it is safe, stable money that does not need to be paid back within twelve months.
Now, let's look at the Internal structure inside Equity: To get this number, we simply divide Retained Earnings by Total Shareholders' Equity.
Now, let's look at the Internal structure inside Equity: To get this number, we simply divide Retained Earnings by Total Shareholders' Equity.
Next, we look inside Shareholders' Equity to check the quality of the company's own money.
We check how much of Equity comes from Retained Earnings—meaning saved profits—versus initial Share Capital from owners.
A strong company builds its wealth by saving its own profits year after year.
And Finally let's look at the the Internal structure inside Liabilities: Here, we divide Long-Term Debt by Total Liabilities.
And Finally let's look at the the Internal structure inside Liabilities: Here, we divide Long-Term Debt by Total Liabilities.
We look inside Total Liabilities to check the quality of the company's debt.
We compare safe Long-Term Debt, which is paid back over many years, with urgent Short-Term bills due within one year.
The company is much safer when Long-Term Debt is larger than Short-Term Debt.
The next table is a great tool to test different capital scenarios. We do not have time to play with it in class today. However, I encourage you to try it at home. Maybe we will come back to it in a future class.
Now, let’s move to the second part of our theory review: the Golden and Silver Rules of Financing.
Now, let’s move to the second part of our theory review: the Golden and Silver Rules of Financing.
The Golden Rule is very strict. It says that Long-term Assets should be 100% covered by Shareholders' Equity (Equity / Long-term Assets ≥ 100%).
The Silver Rule is more practical for big companies. It says that Long-term Assets should be 100% covered by Permanent Capital—meaning Equity plus Long-term Debt ([Equity + Long-term Debt] / Long-term Assets ≥ 100%).
Let’s look at the table on the screen to see how this works.
Let's look at the golden Rule of Financing:
Let's look at the golden Rule of Financing:
To calculate the Golden Rule, we divide Shareholders' Equity by Total Debt, and the result should be at least 1.0, or 100%.
To calculate the Golden Rule, we divide Shareholders' Equity by Total Debt, and the result should be at least 1.0, or 100%.
This means that at least 50% of the company must be funded by the owners' own money, so debt is never bigger than equity. This gives the company high financial safety and independence from banks.
And now, let's look at the silver Rule of financing: Here we use the exact same formula—we divide Shareholders' Equity by Total Debt—but the result only needs to be at least 0.5, or 50%.
And now, let's look at the silver Rule of financing: Here we use the exact same formula—we divide Shareholders' Equity by Total Debt—but the result only needs to be at least 0.5, or 50%.
This rule allows growing companies to use up to twice as much debt as equity, meaning at least one-third (33.3%) of total funding is Equity and up to two-thirds (66.7%) is Debt. It lets the company use financial leverage to grow faster while keeping a safe minimum buffer of owners' money.
Below the table, you also have a great simulator. You can click through it to see how changing a company's business model affects the Golden and Silver Rules.
Now, we are ready for Step 2: Group Work.
You can also play with the golden and silver rules of financing. You can do it at home. See tabe below.
Now, we are ready for Step 2: Group Work.
STEP 2: Group Work (15 minutes)
STEP 2: Group Work (15 minutes)
Please open our course website and click on your company's tab. You will find clear instructions there. First, please open the annual financial reports that you used last week.
By the way, quick question: do you remember how many pages your annual reports have in total?
I am also handing out printed worksheets. You can use them to do your math and write down your numbers. As you calculate your results, please type them into the live table on the website (shown on the screen). This way, we can all watch your progress live. Let’s see which team finishes first!
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