This lesson before going to speak about the third step of the business analysis, the Financial Analysis which is strictly connected to the Strategy Analysis and more deeply to the accounting analysis, wants to analyse better the accounting analysis. As we can see in this slide, the financial statement is the most important public report that provides the analyst, and this is our perspective, the tools to understand accounting numbers in order to analyse the economic and financial situation of a firm. This is what we mean for financial analysis. But to do this we need to have a financial statement without any particular pitfall. In other words, accounting numbers have to be unbiased. The prior task of the analyst before getting to this step was to identify potential red flags in the accounting system. Another important task requires to recast the financial statement in order to compare different reports..
But why is financial analysis so important? Is it no sufficient the accounting analysis to understand the business? Financial analysis is based upon the accounting analysis but it is going behind because its goal is to evaluate the performance of a firm finding an easy way to do this and also trying to predict future trend. It could be divided into two principal tools: ratio analysis and cash flow analysis. Ratio analysis provides the foundation for making forecasts of future performance. Cash analysis also helps us to understand the level of liquidity of the firm in order to assess the possibility to make new investments or to give dividends to shareholders.
We can distinguish two main directions of analysis. The first is called time series comparison. In this case the analyst compare several ratios over several years in order to examine the strategy followed by managers and the level of performance reached by the firm. In the other direction, we can find the cross sectional comparison in which the analyst compare ratios belonged to different firms that operate in the same industry for example. In this way, the analyst wants to understand where a particular firm is positioned in the market and if its performances are better or worse than its competitors. Generally, these two kinds of analysis are integrated to each other because they give different information that increase the level of comprehension of the business. For instance, in our book it is explained the different level of strategy lead by Porsche and Volks.. throughout the analysis of financial ratios. As we show you after, the two companies have a high level of efficiency and solvency but using different tools of strategy. Porsche is recognised for the high price of the cars and a particular ratio show this. Now carry on with the next slide.
As it is shown here, the level of profitability and the expected growth of the business analysed could be decompose in two different directions. The first one is identified with the product market strategy and the second one represents the financial market strategy of the firm. We want to point out that even if this analysis could be investigated in any contest and for any firm, nevertheless it has a specific meaning if it is applied to public company for a lot of reasons. First of all, the quality and quantity of information is different. Public companies have to give more information, because this is required by the law, but also they want it in order to raise capital from the market for planned investments. Anyway, managers achieve their targets using these four levers. In particular, for the product strategy, they need to be able to manage revenue and expenses, and this is what we name Operating Management. At the same time, they must manage working capital expenditure and future investments because the growth of a business is strictly connected to the high level of investments in tangible or intangible assets. Furthermore, managers cannot work just from the asset side of the balance sheet but they need to plan the financing policy of the firm in terms of Financing strategy, for instance find a good relationship between investments and financial position, and Dividend policy. The financial Market strategy is important because investors who gave money to the firm are going to expect to receive more money from the company. Under this view managers are evaluated principally for the level of dividend they could give to shareholders and also in order to eliminate the risk of hostile takeover. For any of these aspect we need to find ratios that are able to explain the profitability and the growth of the firm. Before going to calculate ratios, the financial statement, such as published by companies, is not useful for ratio and cash flow analysis. The analyst recasts the financial statement in order to find an easy way to represent balance sheet, income statement and cash flow statement.
Let’s start with the balance sheet. As we know the balance sheet shows two side: assets take place in the left side and liabilities and shareholders’ equity are represented in the right side. But assets are composed by operating assets and financial assets. At the same level, in the liabilities we can find liabilities originated from the operating activities (trade payables, provisions, etc..) and liabilities originated from the financial market (loans from the bank, bonds). In order to facilitate the analysis, we want to find a way to classify the operating assets to the left side and financial liabilities to the right side. To do this, financial assets are going to be classified at reduction to the capital and operating liabilities take place in the asset side….. After this changing assets become net operating assets and liabilities side becomes the capital side in which we can find just the shareholders’ equity and net debt.
In this slide, we analyse deeply the composition of the net operating assets that is composed by non current net assets (in particular tangible and intangible assets minus other non current liabilities) and the net working capital. The net working capital is the difference between operating current assets, like inventories, trade receivables and other current assets minus current operating liabilities such as trade payables. You need to pay attention to this kind of alternative classification because it is different from the financial statement traditionally used in the financial analysis, especially in Italy where it is originated analysing the level in which assets is going to get liquidity. For example, an element of difference is the classification of the cash & cash equivalents. In our view it is classified in the Capital of the balance sheet. In the other, we never find it in the right side of B.S. but it is classified in the net working capital. Because of the difficulty of the subject, I think it’s better before proceed to the next step analyse a balance sheet of the Volsk… and process used to get to this point. You find it at the end of the five chapter of your book but I thought to make some copies that make easy our work. I would like to know from you what is the difference between the “Consolidated balance sheet” the “Standardised balance sheet” and “condensed balance sheet”. Do you have any other question???? Ok let’s move to the other slide.
In this case the analysis takes into account the income statement of the company. The analyst wants to gather information that he thinks they are useful for assessing profitability and growth of the firm. So the published statement of earning needs some changes. We can identify three main areas that correspond to three intermediate income results. The first is called operating income and it gives information related to the real activity of the firm. Substantially if the firm doesn’t have a good level of operating income, it means that some problem is likely to occur because the company doesn’t find, inside the business, the resources to carry on the activity. Inside of it, we can have different margins. The most important are: Gross Profit : it is the first income margin. It is the difference between Sales and the Cost of sales. Normally, Revenues have to be more in value than the expenses. So this margin must be positive in order to satisfy the other expenses; EBITDA : Earning Before interest taxes depreciation and amortization. In comparison with the previous margin, in this margin other expenses are added and in particular distribution expenses, administrative expenses and other operating expenses. EBIT : it is similar to EBITDA but we consider also the expenses which are non cash items, like depreciation and amortisation of assets. Revenues must be able to cover also these kind of expenses. NOPAT : it is very common margin and stands for Net Operating Profit After Taxes. It is no so difference from the EBIT but in this case the analyst consider the figurative taxes associated to the operating income. Especially in the valuation process, this margin is the first point of income methods. The second area is represented by the financial income. It’s the result of expenses related to the level of debt and the structure of capital of the firm. As we know, debtholders borrow money to the firms in order to receive capital plus interests. So interests income and interests expenses are the components of this area. The operating income minus the financial income represents the profit after interests before taxes. The next area is the income taxes comprehensive of current taxes and deferred taxes. Generally the analyst classifies this area in the previous areas. It is considered in reduction of operating income and in reduction of financial income (so in this case it is positive for the effect of tax shield). At the end, if the result of this long process is positive we can find the earning to equity ehich colud be divided in reserves and dividends to shares. Let’s take the example of Volks… and try to understand the method used to classify the profit into different areas…
We are ready to carry on our lesson dealing with financial ratios because we have already completed the recasting of financial statement. We start this part taking into consideration the first and well-known ratio ROE. Does Someone know this ratio?? What does it mean ROE?? ROE is the net income of an entity expressed as a percentage of its equity capital. So here we can find net income generated by the income statement and here the equity capital. It is a comprehensive indicator of a performance of a firm that gives the analyst a series if information about managers.
It provides an indication of firm’s performance. I suggest you paying a lot of attention to this ratio because it could be not sufficient in order to analyse the general profitability of the business. Remember: We need to have a sufficient number of ratios with a systematic reading, whether we’d like to be able to have a reasonable certainty to understand the profitability. ROE answers to this question: managers’ behaviour…. Were they good to manage money…… Moreover, it could give information about abnormal return that means capacity of the business to generate profit more than its cost of equity capital. If it happens, the high level of profitability could attract new competitors to enter into the market…
We can decompose ROE into two different ratios, ROA and Financial Leverage ROA : it is an indicator of net profit to assets and it means how much profit the business is able to generate for each euro of assets; Financial Leverage : is the ratio between Assets and equity and it indicates the capacity of equity to generate some quantity of assets.
Also ROA could be decompose in two ratios and as we can see they are: ROS : return on sales that indicates how much profit the company is able to keep for each euro of sales. It is an important ratio which shows the strategy of the firm: cost leader or differentiator Asset turnover : it is a ratio between sales and total assets. To understand the meaning of these two ratios we can calculate the ROE; ROA, FINAn.---- of Volk..and Porsche… Could you tell me the information derived from the ratios.
We can arrive at an other decomposition of ROE that shows us a better information of the level of profitability. We need something we have already seen before and in particular…we know that ROE is a ratio between net profit and equity…net profit is the difference between Nopat and net interest after taxes…so ROE = NOPAT/Equity – NIAT/EQUITY… NOPAT/EQUITY could be rewrite as NOPAT/NET Assets …….(pag. 202). At the end of this calculation we arrive at this formula…ROE=Operating ROA + Spread *F.L. What does it mean??? The level of ROE depends on two elements…the first Is related to the operating income assets were able to reach and the second element is derived from the capacity of the firm to use in economic way the debt in order to increase the profitability to equity….the spread if positive provide us the indicator that the return on assets is more in value than the cost of debt…and the effect is amplified by the net financial leverage. In a situation in which the firm is able to generate income from the operating activities it is better to use debt if we want to increase the ROE.
In the fourth slide I showed you the steps followed by analyst in order to assess profitability and growth. After having decomposed the global performance indicator ROE in the operating aspect and in the financial aspect we are ready to calculate some specific ratios.
First of all, we are going to speak about the operating management…We said before that ROS is the main ratio to assess how managers are able to generate value from operating activities…but we can arrive at a deeper level of analysis. We can calculate at least three other ratios…And they are Gross profit margin a ratio between the Gross Profit to Sales. What kind of information give us??? Analysing this ratio the analyst could understand if the firm has reached a good level of efficiency in production (Cost of sales related to the Sales) and also to identify better the strategy adopted by the firm in term of premium price received by using a strategy of differentiation instead of costs. Maybe its product are recognised by customers as unique and they are ready to pay much more than normal product.. An other explanation of having a large gross profit could be derived from the production process because the firm is able to have good relationships with suppliers and in general with operators positioned in the chain of value. As it’s clear, understanding the meaning of this ratio is possible and more simple whether the analyst has implemented a good level of strategy analysis in order to assess the market in which the firm operates and policy adopted to reach some objectives. Remember that in the gross profit margin…we haven’t considered SGA expenses…but just cost physical and direct associated to the sales…. I’d like to ask you a question??? Do you think that gross profit margin is important to valuate operating management for any firm??? Or it is required in some specific industry???? In order to consider other important expenses, we have other two main ratios…they are very similar to each other..the only difference consists of NOPAT considers expenses related to accounting policy while EBITDA doesn’t do it…and also Nopat consider the effect of tax…(it is more complete…) But They give approximately the same information…indication of operating performance that reflects operating policies..
Carry on with the next slide…here is the valuation of investment management done through the analysis of the W.C. management and Non-current…Could you explain the difference between these two areas?? What do we consider for W.C. and…?
Managing working capital means managing three different components of it…the focus is: Inventories management…. Trade receivables management… Trade payables management… According to us…for a firm, is it good to have a high level of trade receivables If we consider to have a same amount of revenues??? Why Yes or why not??? What do you think about inventories…?? Also in the area of W.C. we can identify operating risks of the business. Ratios could help us to solve this problem and we have identified for each two important ratios….
Financial Analysis A valid instrument which the analyst uses to understand what has happened and what will happen to the business Ratio Analysis Cash Flow Analysis It is useful for making forecasts of the firm’s future performance It is useful to examine the firm’s liquidity
Financial Analysis Financial tools Time-series comparison Ratio Analysis Cash Flow Analysis Cross-sectional comparison Two main comparisons Purpose : Understand Better the Business
Ratio Analysis The value of a firm is based upon its profitability and growth Product market strategy Financial market strategy Operating Management Investment Management Financing strategy Dividend policies
Business Activities Net Financial Assets (NFA) Financial liabilities The firm Capital markets Shareholders Equity Financing Activities Net Operating Assets (NOA) Operating Activities Recasting Balance Sheet ASSETS CAPITAL Operating Liabilities
Business Activities Net Operating Assets (NOA) Net Non-Current Assets Net Working Capital Non current Intangible/Tangible Assets - Other non-current liabilities Inventories Trade Receivables Other current assets Recasting Balance Sheet - Trade Payables - Current Liabilities
Business Activities Recasting Income Statement Operating Income Financial Income Income taxes Earning to Shareholders Gross Profit Profit After Interests before taxes Profit after taxes Net Profit Ebitda/Ebit Sales Cost of sales Other operating expenses Amortisation, Interest income Interest expense Tax expense Dividend, etc.. NOPAT
Business Activities Cash Flow Statement Cash Flow From Operations Cash Flow From Investments Cash Flow From Financing Act. Cash Flow to Equity Assets Liabilities Assets Liabilities Balance sheet 2006 Balance sheet 2007 Cash&Cash Equ. (1459) Cash&Cash Equ. (1755)
Business Activities Measuring Profitability ROE NET PROFIT SHAREHOLDERS’ EQUITY RETURN ON EQUITY INCOME STATEMENT BALANCE SHEET
Business Activities The Main Meanings of ROE Firm’s Performance Managers’ Behaviour Abnormal Return Good indicator, even if not sufficient, to explain the general profitability of the business Are Managers good to employ financial capitals in profitable investments?? Does the business generates profit more than its cost of equity capital ??
Business Activities Decomposing Profitability ROE ROA X Financial Leverage Assets Shareholders’ equity Net Profit Assets
Business Activities Decomposing Profitability ROA ROS X Asset Turnover Sales Assets Net Profit Sales
Business Activities Decomposing Profitability ROE Operating ROA + ( Spread x Net Financial Leverage) (Operating ROA – Net Interest after tax/Net Debt) NOPAT Net assets Net debt Equity
Ratio Analysis The value of a firm is based upon its profitability and growth Product market strategy Financial market strategy Operating Management Investment Management Financing strategy Dividend policies
Business Activities Investment Management Product market strategy Investment Management Asset turnover Working Capital Management Non-current assets Management
Business Activities Working Capital Management Inventories Management Receivables Management Payables Management Investment Management (Operating current assets – Operating current liabilties)
Business Activities Inventories Management Inventories Turnover Days’ Inventories Cost of sales Inventories Inventories Average cost of sale x day It is expected to have a high rotation of inventories Investment Management
Business Activities Trade receivables management Trade Receivables Turnover Days’ Receivables Sales Trade receivables Inventories Average sales x day It is better to give less credit to your clients Investment Management
Business Activities Trade payables management Trade Payables Turnover Days’ Payables Purchases Trade payables Trade payables Average cost of materials x day It is better to receive more credit from your suppliers Investment Management
Business Activities Net non-current assets Management It is defined as = (Total non current assets – Non-interest-bearing – Non-current liabilities) Net non-current assets turnover PP&E turnover Sales Net non-current assets Sales Net property, plant & equipment Investment Management
Business Activities Product Management How well does the company manage its inventories? If inventories ratios are changing, what is the underlying Management systems? Are new product being planned? How well does the company manage its credit policies? Is the company artificially increasing sales by loading distribution channels? Is the company take advantage of trade credit? Is it relying too much on trade credit? Are the company’s investment in plant and equipment consistent with its competitive strategy? Answer these questions??
Business Activities Current liabilities & short-term liquidity Current ratio Quick ratio Cash ratio Operating cash flow ratio Current assets Current liabilities Current assets - Inventory Current liabilities Cash & cash equivalents Current liabilities Cash Flow from operations Current liabilities Financial Management
Business Activities Debt & long-term solvency Liabilities to equity ratio Total liabilities Equity (Current debt + Non-current debt) Equity Debt to equity ratio Net Debt to equity ratio Net Debt to capital ratio (Net Financial Position ) Equity (C.D. + Non-C.D.) (C.D. + Non-C.D. + Equity) Interest Coverage Ratio Financial Management
Business Activities Cash Flow Analysis Ratio Analysis/ Accrual Accounting Balance Sheet Income Statement Cash Flow Analysis/ Cash Accounting Cash Flow Statement It is a document contained in the Financial Statement for firms which are obliged to adopt IFRS
Business Activities Cash Flow Analysis Is the cash flow from operating positive or negative? If it is negative, what are the reasons? How much cash did the company invest in growth? Did the company use internal cash flow to finance growth, or did it rely on external financing? Did the company pay dividends from internal free cash flow, or did it rely on external financing? What type of external financing does the company rely on?
Prospective Analysis Performance Forecast Earnings Forecast Cash Flow Forecast Balance Sheet Forecast Forecasting growth in sales Increases in Working Capital Decreases in cash inflows
Prospective Analysis Forecastes Growth in sales Expenses follow the sales’ growth Investment and Plant track sales Key drivers Sales forecast Profit margin forecast
Prospective Analysis Points of departure Period of time in which the prospective analysis starts 2008 2007 2005 2009 2010 2013 2000 The past performances of the business are well-known Past, present and future information are integrated together Purpose : Getting to a good and reasonable valuation of the business
Prospective Analysis Points of departure Making long-term forecasts Time-series behavior of ratios already analysed Assumptions for future years Sales Prediction Analysis of the context Previous analysis Retail firm Consider previous years sales Expansion in new stores
<ul><li>Firms strategy : </li></ul><ul><ul><ul><li>What lines of business is it likely to be in? </li></ul></ul></ul><ul><ul><ul><li>Are new products likely? (Customer acceptance for new?) </li></ul></ul></ul><ul><ul><ul><li>What is the product quality strategy? </li></ul></ul></ul><ul><ul><ul><li>At what point in the product life cycle is the firm? </li></ul></ul></ul><ul><ul><ul><li>What is the firm’s acquisition and takeover strategy? </li></ul></ul></ul><ul><li>Market for the products : </li></ul><ul><ul><ul><li>How will consumer behaviour change? </li></ul></ul></ul><ul><ul><ul><li>What is the elasticity of demand for products? </li></ul></ul></ul><ul><ul><ul><li>Are substitute products emerging? </li></ul></ul></ul>Prospective Analysis Main questions
Prospective Analysis Marketing Plan New markets Pricing plan Promotion & Advertising Brand management