Operational Finance¶

Why This Matters¶

Most companies that fail do not fail because they have a bad product. They fail because they run out of cash. Operational Finance is the discipline that prevents this outcome. Where Financial Accounting teaches you to read financial statements and Corporate Finance teaches you to value investments and optimize capital structure, Operational Finance sits in the middle -- it teaches you to diagnose why a company is bleeding cash, forecast how much financing it will need tomorrow, and build an action plan to fix the problem before it becomes fatal.

This course is built around a single, repeatable analytical framework developed by Professor Eduardo Martinez Abascal: analyze the business qualitatively, read the P&L and balance sheet quantitatively, diagnose the root cause of financial distress using balance sheet differences, propose a realistic action plan, and forecast future credit needs to confirm the diagnosis. Every session reinforces this loop. The cases escalate in complexity from straightforward ratio analysis (Polypanel) through seasonal cash management (Baby Dolls), negative working capital models (Amazon), credit management (Pirelli), and short-term financing decisions (Novocabos), culminating in full wrap-up diagnostics (WestWood Foods A & B).

The central insight is deceptively simple: debt is always a consequence, never a cause. When a company's debt balloons, the real problem is always upstream -- the company is growing too fast for its working capital, managing its inventory or receivables poorly, investing in fixed assets it cannot afford, or generating losses that erode equity. If you fix the root cause, the debt takes care of itself.

This is the most mechanical course in the MBA finance sequence. Master the framework and the formulas, and you can diagnose any company's operational financial health on the back of a napkin.

How It All Connects¶

The course follows the Martinez Abascal diagnostic loop in a strict sequence. Sessions 1-3 build the analytical toolkit using a single company (Polypanel): financial analysis ratios in Session 1, P&L and balance sheet forecasting in Session 2, and the relationship between growth and financial needs in Session 3. Sessions 4-6 introduce complications: seasonality (Baby Dolls), cash conversion cycle optimization (Amazon 2018), and credit management when selling to risky customers (Pirelli - Reifen Ritter). Session 7 covers the financing toolkit -- short-term instruments and financial structure decisions (Novocabos). Sessions 8-9 are full wrap-ups where you apply everything end-to-end (WestWood Foods A & B). Session 10 is review, and Session 11 is the exam.

The textbook is "Finance for Managers" (FFM) by Eduardo Martinez Abascal, 3rd Edition. Chapters 1-4 map directly to Sessions 1-3.

Session 1: Financial Analysis¶

The Short Balance Sheet¶

The first and most important move in operational financial analysis is simplification. Do not get lost in 40 line items. Compress the balance sheet into a "short balance sheet" with just four blocks:

Assets side: NFO + FA Financing side: Debt + Equity

Note: NFO is sometimes called WCR (Working Capital Requirements) or NWC (Net Working Capital) in other textbooks. At IESE in this course, the standard term is NFO.

P&L Analysis Framework¶

If a company is not making money, it is because of exactly one of three things: (1) it sells too little, (2) it has a low margin, or (3) it spends too much on operating expenses. There are no other possibilities.

Track these drivers and their evolution over time:

Profitability Ratios¶

Return on Sales (ROS):

ROS = Net Profit / Sales

The Intuition: For every euro of revenue, how many cents drop to the bottom line? A declining ROS means the firm is losing pricing power or cost discipline.

Return on Equity (ROE):

ROE = Net Profit / Equity

The Intuition: The return shareholders earn on their invested capital. This is the ultimate measure of whether management is creating value for owners.

Return on Assets (ROA):

ROA = EBIT / Net Assets

The Intuition: How efficiently does the firm use all its assets to generate operating profit, regardless of how those assets are financed? Uses EBIT (not net profit) because it strips out financing decisions.

DuPont Decomposition of ROE:

ROE = ROS x Turnover x Leverage

Which expands to:

ROE = (Net Profit / Sales) x (Sales / Net Assets) x (Net Assets / Equity)

The Intuition: ROE can be high for three completely different reasons: (1) fat margins, (2) fast asset turnover, or (3) heavy leverage. The DuPont decomposition tells you which engine is driving the return -- and which poses risk. A company earning 20% ROE through leverage is a fundamentally different animal from one earning 20% ROE through margins.

Quick Mental Math: If ROS is 5%, Turnover is 2x, and Leverage is 3x, then ROE = 5% x 2 x 3 = 30%. But that 3x leverage means 67% of assets are debt-funded -- high risk.

Solvency and Efficiency Checks¶

Beyond the profitability ratios, always check:

Efficiency Drivers (NFO Components)¶

If NFO as a percentage of sales has changed significantly, investigate the three operational levers:

Days Sales Outstanding (DSO) -- Collection Days:

DSO = (Accounts Receivable / Sales) x 365

The Intuition: How many days, on average, before customers pay you.

Days Inventory Outstanding (DIO) -- Stock Days:

DIO = (Inventory / COGS) x 365

The Intuition: How many days, on average, inventory sits in the warehouse before being sold.

Days Payable Outstanding (DPO) -- Payment Days:

DPO = (Accounts Payable / COGS) x 365

The Intuition: How many days, on average, you take to pay your suppliers.

Quick Mental Math: If you collect in 30 days, your receivables balance equals roughly one month's sales. If raw materials are 40% of sales and you store them for one month, inventory equals 40% of one month's sales.

Session 2: P&L and Balance Sheet Forecast¶

Forecasting Purpose¶

You forecast for three reasons: 1. To confirm your diagnosis of the company's problems 2. To calculate exactly how much credit the company will need in the future (how much, when, and why) 3. To test whether your proposed action plan actually resolves the financial problems

Step 1: Forecast the P&L¶

Start with revenue. Estimate the growth rate of sales and project forward. Then apply your assumptions about margin and operating expenses:

Step 2: Forecast the Balance Sheet¶

Build each block of the short balance sheet using specific formulas:

NFO Forecast:

NFO depends entirely on two things: (1) the size of sales and (2) your operational policies (collection days, inventory days, payment days).

Rule: If sales grow by g% and policies remain constant, NFO grows by exactly g%.

Rule: If you change a policy, adjust the relevant component. Example: if collection days increase from 30 to 45, multiply the receivables component by 1.5 (= 45/30).

Accounts Receivable Forecast:

A/R = (DSO / 365) x Projected Sales

Inventory Forecast:

Inventory = (DIO / 365) x Projected COGS

Accounts Payable Forecast:

A/P = (DPO / 365) x Projected COGS

NFO Forecast (assembled):

NFO = Operating Cash + A/R + Inventory - A/P - Other ST Operating Liabilities

Fixed Assets Forecast:

FA = Previous FA - Depreciation + Capex

Equity Forecast:

Equity = Previous Equity + Net Profit - Dividends

Long-Term Debt Forecast:

LT Debt = Previous LT Debt - Debt Repayment + New Debt

Step 3: The Plug (Funding Gap Analysis)¶

Once you have projected all four blocks (NFO, FA, Equity, LT Debt), the balance sheet will not balance. The difference is the funding gap:

Funding Gap = (NFO + FA) - (Equity + LT Debt)

The Intuition: The plug tells you exactly how much short-term credit the company must arrange. If you are preparing the forecast for a bank meeting, this is the number the banker needs.

Session 3: Growth and Financial Needs¶

The Fundamental Rule of Growth¶

Growth consumes cash. Every euro of additional sales requires additional working capital to finance the receivables, inventory, and operating cash that support those sales. If you do not plan for this, you grow yourself into a liquidity crisis.

Growth-Driven NFO Increase:

If Sales grow by g% and policies (NFO%) are constant:

DELTA NFO = NFO(current) x g

The Intuition: A company with 100M in NFO that grows sales by 20% will need 20M of additional working capital -- before investing a single euro in new equipment. That 20M must come from somewhere: retained earnings, new equity, or new debt.

The NFO vs. Working Capital Framework¶

Working Capital (WC):

WC = Equity + LT Debt - FA

The Intuition: Working capital is the portion of permanent financing (equity + long-term debt) that is left over after funding fixed assets. Whatever remains is available to fund NFO.

The Golden Rule:

NFO is always financed with WC + Short-Term Credit.

Therefore:

Short-Term Credit = NFO - WC

If WC grows slower than NFO (or falls), the company has a structural financial problem: its permanent financing is no longer sufficient to fund daily operations, and it must rely increasingly on expensive, volatile short-term credit.

Causes of WC Decline:

Self-Sustainable Growth¶

A company can grow without external financing only if its retained earnings generate enough WC to fund the incremental NFO. The maximum self-sustainable growth rate depends on profitability (how much profit is retained) and capital intensity (how much NFO each euro of sales requires).

Quick Mental Math: If NFO is 25% of sales and net margin is 5% with 100% retention, retained earnings fund NFO growth of 5/25 = 20%. Any growth beyond 20% requires external financing.

Session 4: Seasonal Need of Funds¶

Why Seasonality Changes Everything¶

If your business has seasonal sales (toys before Christmas, ice cream in summer, fashion at collection launch), you cannot use annual averages to forecast NFO. Annual averages will dangerously underestimate your peak funding needs and dangerously overestimate your trough needs.

Month-by-Month NFO Forecasting¶

For seasonal businesses, you must calculate NFO month by month:

Monthly A/R = (DSO / 30) x That Month's Sales

Monthly Inventory = (DIO / 30) x That Month's COGS (or next month's, if building stock in advance)

Monthly A/P = (DPO / 30) x That Month's Purchases

The key months to identify are: - Maximum credit month: When NFO peaks and cash is at its lowest -- this is when you need the largest credit line - Maximum cash month: When NFO troughs and cash is at its highest

Permanent vs. Seasonal (Temporary) Funding Needs¶

The Intuition: A toy company must maintain some inventory year-round (permanent). But in September-November, inventory triples as it builds stock for Christmas (seasonal). The permanent component should be funded with long-term capital. The seasonal spike should be funded with a revolving credit line that is drawn in September and repaid in January when cash floods in from holiday sales.

Danger Zone: If you finance permanent working capital needs with short-term credit, you are structurally mismatched. The credit line will never be fully repaid, and the bank may not renew it -- triggering a liquidity crisis even though the business is fundamentally profitable.

Session 5: Management of Cash Cycle¶

Cash Conversion Cycle (CCC)¶

The Cash Conversion Cycle measures the number of days between paying your suppliers for inputs and collecting cash from your customers for outputs. It is the operational heartbeat of working capital management.

CCC = DIO + DSO - DPO

The Intuition: DIO + DSO is the total time cash is tied up (in inventory, then in receivables). DPO is how long your suppliers effectively lend you money. The difference is how many days you must finance from your own resources or credit.

Quick Mental Math: If DIO = 45, DSO = 30, DPO = 60, then CCC = 45 + 30 - 60 = 15 days. The firm must finance 15 days of operations. If daily sales are 1M euros, that is 15M euros tied up permanently in working capital.

CCC Management Levers¶

Negative Working Capital (The Amazon/Aldi Model)¶

When DPO > DIO + DSO, the CCC is negative. This means the firm collects cash from customers before it pays suppliers. The suppliers are effectively financing the firm's operations for free.

Hard Discount Retail Example (Aldi): - Inventory turns ~50x per year (DIO approximately 7 days) - Average collection period: 7 days (mostly cash/card sales) - Payment to suppliers: 30 days - CCC = 7 + 7 - 30 = -16 days (approximately; source data shows 23 days of negative WC) - At 40B euros annual sales (approximately 150M euros/day), 23 days of negative WC = 3.45B euros of permanent free cash sitting in Aldi's accounts - At 1% interest, that is 34.5M euros/year in interest income just from operating efficiency

Traditional Retailer Comparison: - Sell within ~50 days, pay suppliers in 60-70+ days - Also achieve negative WC, but by squeezing suppliers (who are unhappy) - Aldi achieves the same result through operational speed (fast inventory turns), allowing it to pay suppliers in 30 days -- a win-win

The Intuition: Negative CCC is not a financial trick. It is an operational achievement. It comes from extreme inventory management discipline, not from abusing suppliers. The firms that achieve it (Amazon, Aldi, Costco) have world-class supply chains.

Session 6: Credit Management¶

The Credit Decision¶

When you sell on credit (instead of demanding cash upfront), you create accounts receivable. This is a business decision that sits at the intersection of sales strategy and financial management:

Credit Terms and the Cost of Trade Credit¶

Suppliers often offer early payment discounts. A standard term looks like:

"2/10, net 30" -- meaning 2% discount if paid within 10 days; otherwise the full amount is due in 30 days.

If you do not take the discount, you are effectively borrowing money from the supplier for the extra 20 days. The annualized cost of this implicit loan:

Cost of Trade Credit = (Discount % / (1 - Discount %)) x (365 / (Full Payment Days - Discount Days))

Example: 2/10, net 30:

Cost = (0.02 / 0.98) x (365 / 20) = 0.0204 x 18.25 = 37.2% annualized

The Intuition: Paying 2% to borrow for 20 days is astronomically expensive when annualized. If your bank offers a credit line at 6%, you should always draw on the credit line to pay the supplier on day 10 and capture the discount. The spread (37.2% - 6% = 31.2%) is pure profit from financial management.

Quick Mental Math: Any discount term where the annualized cost exceeds your borrowing cost should be taken. "1/10, net 60" = (0.01/0.99) x (365/50) = 7.4% -- closer to bank rates, so the decision is tighter.

Aging Analysis¶

An aging analysis segments accounts receivable by how overdue they are:

The Intuition: Aging analysis forces you to see your receivables not as a single number but as a portfolio with different risk tiers. A company with 100M in A/R where 80M is current is in a completely different position from one where 40M is 90+ days overdue.

Session 7: Short-Term Financing and Financial Structure¶

Short-Term Financing Instruments¶

Factoring: The Mechanics¶

In factoring, you sell your receivables to a specialized financial company (the factor):

The Intuition: Factoring is a tool, not a strategy. Used surgically to bridge a temporary cash gap, it is effective. Used as a permanent crutch because the business cannot manage its receivables, it destroys margins.

Financial Structure Decisions¶

The mix of short-term credit, long-term debt, and equity determines the firm's financial structure. Key principles from this course:

Maturity Matching Principle:

The Intuition: Finance long-lived assets with long-lived funding. Finance temporary needs with temporary funding. Mismatch creates risk: if you finance a factory (20-year asset) with a 1-year loan, you face rollover risk every year.

Debt Capacity Indicators:

Sessions 8-9: Wrap-Up -- Analysis, Diagnosis, and Action Plan¶

The Complete Diagnostic Framework¶

This is the master framework you apply to any company. It is the core deliverable of the entire course.

Step 1: Business Analysis (Qualitative)

Before touching a single number, understand the business:

Step 2: P&L Analysis (Quantitative)

Track the evolution of Sales growth, Margin %, Opex %, EBITDA %, and Net Profit over multiple years. Identify trends and inflection points.

Step 3: Balance Sheet Analysis (Short Balance Sheet)

Compress to NFO + FA = Debt + Equity. Track the evolution of each block. Check asset quality (aging of receivables, inventory obsolescence, FA productivity).

Step 4: Diagnosis (Balance Sheet Differences)

The diagnostic tool is the difference in balance sheets from the last year the company was healthy to the present.

Compute: DELTA NFO, DELTA FA, DELTA Debt, DELTA Equity

The Cardinal Rule: Debt is always a consequence, never a cause of problems.

If a company needs more credit, it can only be because NFO increased, WC decreased, or both. If WC has fallen, it can only be because of: (1) losses, (2) investment in FA, or (3) repayment of long-term debt.

Step 5: Action Plan

Your proposed solution must pass four tests:

The Intuition: If the diagnosis is "collection days increased from 30 to 55 because the sales team stopped following up on overdue invoices," the action plan is to fix the collection process -- not to restructure the debt. If the diagnosis is "inventory days doubled because production is building stock nobody wants," the action plan is to fix the demand forecasting -- not to seek a new credit line.

Critical Warning: If the firm's competitive advantage IS its generous credit terms (e.g., it wins deals by offering 90-day payment to customers), you cannot shrink collection days without destroying the business model. In this case, you must find alternative levers (reduce inventory, negotiate longer supplier terms, raise equity).

Step 6: Forecast (Confirm the Diagnosis)

Build a forward-looking balance sheet to calculate: - How much credit will be needed - When will it be needed (which month, which year) - Whether the proposed action plan generates enough improvement to close the funding gap

Quick Reference¶

Back-of-Napkin: How to Diagnose if a Company Has a Financing Problem¶

Run through this checklist in under 10 minutes with just a P&L and balance sheet:

If steps 3 and 4 both flash red, the firm has a structural operational finance problem. If step 1 also flashes red, the situation is urgent.

Master Formula Sheet¶

Profitability:

Working Capital and NFO:

Efficiency (Days):

Forecasting:

Credit Management:

Key Diagnostic Rules¶

1. Debt is always a consequence, never a cause. Trace the real problem upstream to NFO, FA, or Equity.
2. Growth consumes cash. Every percentage point of sales growth requires proportional NFO growth.
3. Never use annual averages for seasonal businesses. Forecast month by month.
4. NFO must be financed by WC + credit. If WC < NFO, the firm has a structural problem.
5. Minimize effort, maximize perspective. Use the short balance sheet. Focus on the big numbers. Use few ratios, but understand them deeply.
6. Action plans must protect competitive advantage. If your edge is long credit terms to customers, you cannot fix collections without destroying the business.

Glossary¶