Lessons in Corporate Finance

CHAPTER 2 Determining a Firm’s Financial Health (PIPES-A)

How do you evaluate the current and future financial health of a firm? This is an important first question (in this book we will initiate much of our discussion with questions which will be in italics). If you are considering lending money to a firm, acquiring a firm, or entering into competition with one, you want to assess its financial health before making your decision. Answering the question above involves three of the most basic tools of corporate finance: ratio analysis, sources and uses, and pro formas. We will discuss the first two, ratio analysis and sources and uses, in this chapter, and pro formas in the next.

We begin the process of answering this question by using a fictional medium-sized firm in the plumbing supply business. The firm is located in Pinellas County, Florida (near St. Petersburg). We call it Pinellas Plumbing Equipment and Supply (PIPES).

PIPES has been in business for 15 years, and its founder and current owner, Ken Steele, is preparing to meet a local banker, John Morgan, to discuss a possible loan. PIPES currently has a line of credit with another local bank for $350,000.

What kind of questions should Mr. Steele expect from the banker? John Morgan, the banker, might begin by asking Mr. Steele to describe the company to him. Why would Mr. Morgan ask Mr. Steele for a description of a business he already knows about, seeing that he is from the same small town? Because Mr. Morgan first wants ...