What’s the impact on financial analysis?
Literature typically differentiates between four stages. The early stage (or: launch stage, idea stage), the growth stage, maturity stage, and the decline stage. A firm in the decline stage can either reinvent itself and revive, be sold and integrated into another firm, or shut down. The chart above illustrates the common sales development.
Early-stage companies (startups) have low levels of revenue, if at all. Oftentimes, these firms encounter themselves in a thriving high-growth environment. The failure rate is high in the beginning. This makes the going concern assumption impossible, or at least challenging.
Challenges relate to the lack of historical data. Given the early stage, there are often no historical financials. Also, projections are often difficult given the probability of failure. Financials are rarely very granular, it’s rather “top-line” and “bottom-line”.
Firms in the growth stage are often characterized by dynamic financials. For example, a high earnings growth rate as well as higher margins. This is due to less competition in the niche market. Over time, competitors will enter the market. This will lead to lower revenue growth and a reduction in margins.
Over time, competitors will enter the niche. Eventually, this will lead to lower earnings margins and lower revenue growth. Also, financials are often distorted. Margins can be too high because of no competition. Or margins can be too low because investments in further growth are recorded as expenses. If the firm is backed by private equity, financials can even be distorted by acquisitions, if it follows a buy-and-build strategy.
Mature firms grow at the market rate and exhibit steady levels of revenues and earnings. M&A activities are the main driver for growth. Internal transformation (efficiency projects, restructuring) is what improves margins.
The organic and inorganic portions of the drivers of growth need to be identified. In a due diligence, a like-for-like comparison needs to be established. Also, the impact of the transformation projects needs to be quantified.
Declining firms typically show lower levels of revenue. These firms also exhibit lower earnings (margins). Declining firms are often targeted by turnaround investors. These investors focus on divested business units that need to be restructured.
Analyzing these firms requires an understanding of the market and how it will develop. Is it the market that is in decline or this particular firm? This question helps understand the future of the company.
- Different stages across the life cycle require different angles.
- While early-stage firms embrace the market potential and develop a competitive advantage, declining firms try to reinvent themselves and extend the life cycle.
Financial due diligence needs to focus on the characteristics that each stage of the life cycle exhibits. A generic approach won’t account for the differences and unique aspects. And that’s what makes financial analysis interesting. There are rarely two firms at an identical point in their life cycle and so, there are always different considerations.