Financial analysis

- key ideas

Professor Chris Higson

Value creation is the big idea in finance
► A business needs assets to earn profit
► It raises capital from investors to buy the assets
► So the return on capital = profit/assets, measured some way or other.

Growth and return – the two dimensions of value creation

► Business creates value when its return on capital is greater than the cost
of capital, which is the return the investors could get elsewhere.*
► Then creates more value by growth

► Financial value creation, defined this way, is evidence of a successful

business strategy that has created competitive advantage.

* Usually measured as the weighted average cost of capital, WACC, which

is the blended cost of debt and equity capital.
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 The growth/return matrix

%
positive

Value destroying Value creating

‘bad’ growth ‘good’ growth

Growth in 0
sales or investment Value releasing Value limiting
divestment & other missed
remedial action opportunities?

negative
0 % positive

Spread = Return on capital - Cost of capital

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Some balance sheets…
Tiffany Odfjell Asahi Publicis
US$m, Jan 2018 US$m, Dec 2017 Yen bn, Dec 2017 €m, Dec 2017
Cash 1291 24% 207 10% 177 5% 2469 10%
Trade receivables 231 4% 61 3% 433 13% 9,750 41%
Inventories 2,254 41% 21 1% 156 5% 385 2%
Other 207 4% 37 2% 47 1% 649 3%
Current assets 3,983 73% 326 16% 813 24% 13,253 56%
Property, plant, equipment 991 18% 1,302 65% 718 21% 590 2%
Intangibles 0 0% 0% 1,539 46% 9,574 40%
Investments 0 0% 357 18% 5 0% 64 0%
Other 494 9% 15 1% 273 8% 299 1%
Long-term assets 1,485 27% 1,674 84% 2,534 76% 10,527 44%
Total assets 5,468 100% 2,000 100% 3,347 100% 23,780 100%

Short-term debt 121 2% 238 12% 378 11% 366 2%

Trade payables 202 4% 16 1% 434 13% 11,541 49%
Other 403 7% 75 4% 241 7% 2,125 9%
Current liabilities 725 13% 329 16% 1,052 31% 14,032 59%
Long-term debt 883 16% 845 42% 902 27% 2780 12%
Provisions 287 5% 6 0% 182 5% 591 2%
Other 325 6% 4 0% 57 2% 419 2%
Long-term assets 1,495 27% 855 43% 1,142 34% 3,790 16%
Minorities, pref. shares 15 0% 0 0% 8 0% 2 0%
Paid-in share capital 1,257 23% 199 10% 225 7% 3,772 16%
Reserves 1,976 36% 617 31% 920 27% 2,184 9%
Shareholders' funds 3248 59% 816 41% 1153 34% 5958 25%
Total liabs & sh. funds 5,468 100% 2,000 100% 3,347 100% 23,780 100%
 … and their income, and margins

Tiffany Odfjell Asahi Publicis

US$m, Jan 2018 US$m, Dec 2017 Yen bn, Dec 2017 €m, Dec 2017
SALES 4,170 100% 843 100% 2,085 100% 9,690 100%
Cost of sales -1,565 -649 -1,295
GROSS PROFIT 2,605 62% 193 23% 789 38% Op. Exp.
SG&A -1,810 -179 -593 -8,185
OPERATING PROFIT 795 19% 14 2% 196 9% 1,505 16%
Other income 8 134 6 -204
Exceptionals 0 0 -66
EBIT 803 19% 149 18% 202 10% 1,235 13%
Interest -42 -56 -5 -51
EARNINGS BEFORE TAX 761 93 197 1,184
Tax -391 -2 -58 -312
EARNINGS AFTER TAX 370 91 139 872
Minorities 0 0 2 -10
EARNINGS 370 9% 91 11% 141 7% 862 9%

Other comprehensive income 118 20 182 -560

COMPREHENSIVE INCOME 488 110 323 302

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… and profitability
Tiffany
US$m, Jan Odfjell
US$m, Dec Asahi Publicis
€m, Dec
2018 2017 Yen bn, Dec 2017 2017
Sales 4,170 843 2,085 9,690
EBIT 803 149 202 1,235
Earnings 370 91 141 862
Comprehensive Income 488 110 323 302

Return on Equity 11.4% 11.1% 12.2% 14.5%

Comprehensive RoE 15.0% 13.5% 28.0% 5.1%
Return on capital employed 27.1% 8.8% 9.0% 18.6%
EBIT margin 19.2% 17.6% 9.7% 12.7%
Asset turn 1.41 0.50 0.92 1.46
Shareholders' funds 3,248 816 1,153 5,958
Short-term debt 121 238 378 366
Long-term debt 883 845 902 2,780
Cash -1,291 -207 -177 -2,469
Net debt -288 877 1,103 677
Capital Employed 2,961 1,693 2,256 6,635
gearing -10% 52% 49% 10%

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The Balance Sheet is key
► The balance sheet tells how much capital the business is using
► The shape and weight of the balance sheet depends on….
► Destiny, the technology of the industry the business is in,
► and on efficiency of management...
- tight working capital management,
- efficient use of tangible assets,
► but also on the balance sheet model management choose...
- own non-strategic assets, non-value-creating divisions?
- tangible assets can be securitised, operating leased
- outsource some functions?
► and on the GAAP accounting rules…

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Important things to understand about Balance Sheets
► Shareholders’ equity is overwhelmingly the main source of finance for
companies
► Shareholders’ equity is the balance sheet measure of shareholders'
wealth. It is simply a balancing figure; but that is what wealth is – the
difference between someone’s assets and liabilities.
► Beware two big downward accounting biases in equity:
► Mainly, assets are in the balance sheet at cost, what the company
paid for them,
► Intangible assets are not in the balance sheet, unless the company
acqured them.

► Never forget – goodwill and intangibles are assets. The company paid
for them!
► Goodwill impairment is very disruptive. AOL Time Warner!

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Watch comprehensive income
► The economic income of an entity is its comprehensive income, which is
the earnings reported in the income statement, plus the other
comprehensive income (OCI) taken directly to shareholders’ funds.
► Main sources of OCI:
► Revaluation, fair value of land and buildings and intangibles,
available-for-sale investments and some financial instruments
► Foreign exchange translation differences
► Changes in fair values of cash flow hedges, net of tax,
► Actuarial gains and losses on defined benefit plans
► The cumulative effect of changes in accounting policy

► GAAP presentation is getting more comprehensive

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The idea of comprehensive income
► Comprehensive income is change in owners’ wealth in balance sheet
terms; effectively ∆ balance sheet
► Income theory tells us that
Comprehensive accounting income ≡
Dividend + change in shareholders’ funds

► Comprehensive income has two components:

► Earnings
Realised income, recognised in the income statement.
► Other comprehensive income (OCI)
The components of income that GAAP says are dealt with as movements in
shareholders’ funds in the balance sheet.

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Measures of return
Separation of operating and financing
► A core aim in financial economics is to cleanly separate operating from
financing.
► So these are the ‘bright lines’ in financial analysis
► Income EBIT
► Balance sheet capital employed
► Cash flow free cash flow

► In practice this can require a lot of judgement, there is plenty of

ambiguity

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EBIT

Sales
Cost of sales
Gross profit
Sales, general and administration
Operating profit
Exceptionals, other income
EBIT (Earnings before interest and tax)

Net interest paid (interest and financing costs, paid less received
Earnings before tax
Tax
Earnings after tax
Minorities, preference dividend
Earnings, net income

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Capital employed and Net operating assets
CURRENT ASSETS Cash
Current Assets ex cash
Receivables
- Current Liabilities ex debt
Inventory
WORKING CAPITAL
LONG-TERM ASSETS PPE
LONG-TERM ASSETS
Intangibles
- LONG-TERM LIABILITIES ex debt
Investments

TOTAL ASSETS NET OPERATING ASSETS

CURRENT LIAB Debt
Payables Long-term + Short-term debt - Cash
LONG-TERM LIAB Debt NET DEBT
Payables
Provisions
SHAREHOLDERS’ Minorities
FUNDS Prefs SHAREHOLDERS’ FUNDS
Equity
TOTAL L&SF CAPITAL EMPLOYED
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Measuring return – ROCE
Balance Sheet
Net operating assets, the firm’s operating assets, less operating liabilities
= Capital employed, the finance from outside investors
= shareholders’ funds (equity) + borrowing – cash (net debt)

Income statement
the income the firm earned for the investors in capital employed is called
‘EBIT’ Earnings before interest and tax

Return on Capital Employed (ROCE) = EBIT

Average Capital Employed
► Compare this to the pretax weighted average cost of capital
► Alternatively, After-tax ROCE uses Earnings before interest, after tax
► ROCE focuses on the profitability of the assets, of the 'entity' however
financed. It levels the playing field when comparing companies or
divisions that are financed with different amounts of debt.

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The drivers of profitability
The key drivers of profitability are
the profit margin on $1 sales,
and the balance sheet you need to support $1 sales, measured by the
asset turnover

Profitability Equation:
EBIT EBIT Sales
== ×
Capital employed Sales Capital employed

ROCE = EBIT margin × Asset turn

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The drivers of profitability

Return on capital employed

EBIT margin Asset turn

driven by driven by
Gross margin Land and Buildings/Sales
SG&A /Sales Plant and Machinery/Sales
R&D /Sales Inventory/Sales
Receivables/Sales
Other income Payables/Sales
Exceptionals …..

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Measuring return – Equity return
Return on Equity
Earnings/Average Equity Shareholders’ Funds

Comprehensive Return on Equity

Comprehensive income/Average Equity Shareholders’ Funds

► Compare these to the cost of equity capital

Market to book
Market capitalisation/Equity Shareholders’ Funds
► Compare this to 1 (unity)

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Issues of definition
► Key constructs: earnings, equity, EBIT, capital employed
In terms of definition, equity measures are straightforward

► EBIT and capital employed are troublesome.

► Principal test is motive – did it arise with a financing motive?
► The ‘bright line’ in financial economics between operating and financing
is ambiguous in practice:

► ‘Financial’ is not the same as ‘financing’

► Financial derivatives blur the line between EBIT and financing charges
► Does capital employed include – pensions, deferred tax, provisions…?
► Should we exclude from income – abnormal, exceptional, non-recurring
items?

These are definitional questions – what is the economic construct?

The accounting question is different. Does GAAP provide the data
integrity to measure these constructs correctly?

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Some other return on capital vocabulary
► ‘Return on equity’ is pretty universal

► Enterprise-level returns are called many, many things, inter alia:

► Enterprise- entity-, asset-, business-

► ROCE return on average capital employed (ROACE)
return on net assets (RONA)
return on assets, or operating assets (ROA)
► After-tax ROCE return on invested capital (ROIC)
► EBIAT net operating profit after tax (NOPAT)
net operating profit less adjusted taxes
(NOPLAT)

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Measures of return
– economic profit
Measuring Return – Economic profit
► An alternative to comparing the return on capital to the cost of capital is
to internalize it by making a ‘capital charge’ against profit
► Economic Profit = EBIAT - WACC × av. capital employed
► So the question, ‘is ROCE > WACC?’ is logically equivalent to question
‘is economic profit positive?’
► General Motors applied this concept in the 1920s and General Electric
coined the term residual income in the 1950s
► Economic value added (EVA) is a proprietary branding of the same idea,
wrapping in some accounting adjustments

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Equivalence
Measuring economic profit, and comparing a return on capital to the cost of
capital, are the same thing. These statements are equivalent:

Return on capital is greater than the cost of capital

Profit
Capital > cost of capital

Multiply both sides of the inequality by ‘capital’ and rearrange,

Economic profit is positive

Profit - capital × cost of capital > 0

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Equivalence – an example
WACC is 8% Z with old
X inc Z inc assets
Capital employed 1000 3000 1500
EBIAT 150 200 200
Capital charge -80 -240 -120
Economic profit 70 -40 80
After tax ROCE 15.0% 6.7% 13.3%

Both measures share the same insights and weaknesses

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Economic profit for internal control and rewards
Economic profit is attractive for internal, management control and reward,
purposes.
It solves the incentive problem of ‘return maximisers’

Three projects, which should we do?

Capital Income
a 1000 200
b 1000 150
c 1000 120
Cost of capital is 8%

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Why use economic profit?
For internal control and management incentives
► It combines both growth and return spread in one number
► So solves the incentive problem of ‘return maximizers’

For external performance analysis

► It’s more robust to business-model reengineering and ‘lighter-than-
air’ balance sheets
For valuation
Economic value
= pv (at WACC) of expected free cash flow
equivalently:
= starting capital employed + pv (at WACC) of expected economic profit
EP valuation is more transparent in capital budgeting

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EVA
► The consulting firm Stern Stewart took economic profit and
commercialized it as EVA
► EVA is economic profit but with a number of accounting adjustments
► Originally 164 adjustments, now far fewer
► The big ones – R&D, operating leases, etc
► Also capitalize losses, on the full-cost principle
► But not inflation, i.e. uses historic cost
► As a result, Stewart admits is safer to monitor changes, rather than level
► EVA typically uses a CAPM WACC

► Stern Stewart promoted EVA very strongly as an investment metric

► But there is no evidence EVA has incremental explanatory power
► Biddle et al (1997) predict the following %s of shareholder returns
and company values: Earnings 7%, Raw Residual Income 5%, EVA
4.5%, Cash Flow 2.5%

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Measures of financial structure
Measures of financial leverage
The key financing decision is how to fund capital employed – mix of
borrowing and equity

Book gearing = Net debt

Capital employed

Gearing, aka leverage, debt ratio, debt/equity ratio…

Interest cover = EBIT

Interest payable

Market gearing = Current value of net debt

Enterprise value

‘Enterprise value’ is capital employed at current value: i.e. market

capitalization plus current value of net debt and of other non-equity

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The equity cushion
► The Victorian foundation principle of the limited-liability joint-stock
company is that shareholders invest equity in the business to protect
creditors
► Balance sheet

Equity Assets

Liabilities

► Equity ratio = Equity

Total assets

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What does a strong balance sheet mean?
► A strong balance sheet is resilient, protects us from negative shocks

► Features of a strong balance sheet:

► High equity ratio,
► Low debt, so spare borrowing capacity if you need it.
► Plenty of cash, liquid assets,

► Plenty of saleable tangible assets

► Doesn’t include goodwill, that cannot be sold in a downturn

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Young’s 2006 numbers
Young’s balance sheet at y/e 2006
ASSETS
Current assets 11,032
Long-term assets 217,568

TOTAL ASSETS 228,600

CLAIMS
Current liabilities 19,544
Long-term liabilities 66,391
Shareholders’ funds 142,665

TOTAL L&SF 228,600

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Young’s income statement at y/e 2006
Sales 123,873
Costs -110,274

Operating profit 13,599

Exceptionals and other 2,117
EBIT 11,482

Net interest paid -3,873

Earnings before tax 7,609
Tax -2,958
Earnings 4,651
Young’s capital employed at y/e 2006
ASSETS Capital Employed
Current assets 11,032 0 (cash)
Long-term assets 217,568

CLAIMS
Current liabilities 19,544 283 (s-t debt)
Long-term liabilities 66,391 54,140 (l-t debt)
Shareholders’ funds 142,665 142,665
197,088

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Young’s WACC at y/e 2006?

Debt Equity

Riskless rate (10-year gilt) 4.1% 4.1%

Risk premium credit spread 1.0% 5.0% equity premium

equity risk 4.3% 0.85 x 'beta'
5.1% 8.4%

Tax 30% -1.5% -

Gearing 20% 0.20 3.6% 0.80 8.4%

WACC 7.4%

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Dimson, Marsh, Staunton
► DMS* tracked the returns to the 17 equity markets with reliable history
from 1900; now 110 years of data
► Historically, the equity premium is much lower than believed
► The real equity return was 6.52% (US), 5.23% (Rest of World)
► It’s ‘a game of two halves’. From 1900 to 1949 the world real return on
equities was just 3.5%, but 1950-2005 it was 9.0%
► The annualized (geometric) premium over long bonds was 4.5% (US) and
4.1% (Rest of World)

► Looking forward, they argue

► Equity premium is likely to be 3.0-3.5% on bills, ~0.8% less on
bonds…
► … because the 20th century was a period of exceptional equity
performance. Only the dividend yield component can be assumed to
persist

*Dimson E, Marsh P, Staunton M, ‘The Worldwide Equity Premium: A

Smaller Puzzle’ in Handbook of the Equity Risk Premium, Elsevier, 2008
[on VLE]
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Young’s – what happened next
► In 2006
Young&Co was a vertically-integrated, medium-sized brewing business,
as it had been for several hundred years,
As AIM-listed, Young’s had not been required to adopt IFRS.
► In financial year 2007
The beer brands and all brewing and wholesale operations were
transferred to Wells & Young’s Brewing Company Limited, in which
Young’s had 40%.
Sold the Wandsworth brewery site for £69m cash; but invested the
proceeds in more pubs.
John Young died on 7 September 2006, aged 85, having been
chairman of Young's for 44 years. He was a legend in the brewing
industry, and resolute in maintaining Young's as a vertically-
integrated traditional family brewery.

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Young’s – what happened next, cont.
► In FY 2008
Young’s produced IFRS accounts for the first time; froze valuations
► In FY 2011
Young’s acquired Geronimo Group for £60m cash. Geronimo, founded in
1995, had a high quality estate of 26 individually designed, food-led,
managed pubs in Central London and SE England.
► In FY 2012
Young’s sold its 40% shareholding in Wells & Young’s Brewing
Company to Charles Wells Ltd for £15.1m in cash, receivable in three
instalments to February 2014. This investment cost £22.5m in 2007.
Young’ started revaluing its real estate again, under IFRS rules
► By FY 2017
Young’s has bedded down its new ‘PubCo’ business model. How is
Young’s doing financially?

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Framework for financial analysis
The framework of financial analysis
We use accounting data to tell the company’s economic story, which is an
assessment of risk and return and what drives it.
► Profitability Is the company creating value, or destroying it? Accounting
measures as value metrics, to proxy the measures of economic return
from corporate finance and investment analysis:
► ROCE and ROE, for IRR; Price/book, for NPV
► Organic growth rate
► Economic Profit, combined measure of return and growth

► Forensic Analysis Systematic analysis of the drivers of profitability

► Financial Structure Analyse the volatility and risk of the return, using
measures of financial leverage and operating leverage, measures of
financial structure.

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Framework for financial analysis
► Accounting Review Review whether the accounting has the data
integrity to give reliable financial measures. Consider whether to adjust
the data, or retain the insights at the judgement level

► Valuation Use the financial analysis as the basis to project the

financials into the future:
► Free cash flow
► Organic growth rate
► or, Economic Profit

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The accounting review
► To get
► reliable measures of financial structure
► return on capital that can be compared to the cost of capital

requires the financial statements to have the data integrity of a properly

conducted capital budgeting exercise

► Balance sheet is complete in assets and liabilities

That is, it records all the assets over which the firm has property rights,
and all the claims that outsiders have over the firm
► Balance sheet is measured at current value
In particular, it values assets and liabilities at opportunity cost
► Income is complete – comprehensive income

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Balance sheet completeness
► Asset side
► Home-grown intangibles
► Under-recorded assets, conservative provisioning and write-downs

► Liability side
► ‘Off-balance-sheet financing’, contracting to ‘net’ asset and liability
- Operating leases
- Securitization of receivables
- Non-consolidation
► Other challenges
- Pension and employee benefits
- Deferred taxation
- Contingencies
Summary
► GAAP has focussed on completeness.
► Home-grown intangibles will remain the main source of bias
► May be over-complete – control versus ownership (property rights)

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Balance sheet measurement
► Tangible and intangible fixed assets
► Depreciated historic cost, less impairment
► IFRS allows revaluation option, but not common
► Inventory
► Lower of cost or realizable value
► Biological assets (IFRS)
► Measured at fair value less estimated point of-sale costs

► Financial assets and liabilities

► Available for sale, trading assets at ‘fair value’
► Held to maturity assets valued at amortized cost

Summary
► Strong downward bias in balance sheet values,
► Rumours of GAAP’s push to fair value, are incorrect.

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Income
► Income measurement
► The use of accrual accounting to shift revenues and costs between
periods, to manage (flatter or depress) earnings
► Revenue recognition
► Cost recognition

► Presentation and classification of income

► Cost of sales vs SG&A, financing vs operating
► Ordinary and exceptional, big bath, pro forma accounting

► Comprehensive income
► Earnings vs reserve accounting

Summary
► In the long run, presentation is more important than measurement?
► GAAP is converging comprehensive income and earnings
► What does ‘realised income’ mean now?

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The challenge
► This data integrity is hard or impossible to achieve in practice:

► GAAP conservatism
- The accounting rules are getting closer, but still fall short
- GAAP balance sheets will strive to fully state liabilities, while
tending to understate liabilities
- This has an equal and opposite effect on reported income
► Accounting choice
- GAAP gives managers discretion and flexibility in how they
record certain items
- We need to be vigilant for the consequences of this

► Nonetheless, this ‘investment’ accounting model is the touchstone for

thinking about GAAP. It gives us the framework for reviewing accounting.

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