Financial Statement Analysis
for Valuation
Introduction to
Financial
Statements
Financial Statement
What and For Whom?
What?
A compulsory, public (EU law)
and standardized (IFRS, law)
report on company financials.
For Whom?
Shareholders
Financial intermediaries
Analysts
Other companies
Investors
Regulators
COMPANY´S ECONOMIC ENVIRONMENT
“Main Street”
“Wall Street”
cash from customers
cash to suppliers
cash to and from owners
Assets
(business
operations)
Equity
Debt
cash to and from debt holders
4
Nature of Financial Statement Data
•  Measures period results
•  Relies heavily on historical (vs market) values
•  Uses accrual (vs cash) accounting which is based on rules
(IFRS, US GAAP, laws) and managerial judgment
•  Externally audited
•  Augmented with additional notes and reports
•  Managers have incentives to manage earnings, e.g. for
executive compensation, loan covenants, share issue, taxes
•  Quality of accounting depends on management skills and
whether flexibility is used to give “truer” or “non-truer” view
BUSINESS STRATEGY ANALYSIS
Krishna G. Palepu, Paul M. Healy and Erik Peek, Business Analysis and Valuation: 3rd IFRS Edition
© Copyright Cengage Learning EMEA 2013
Key Financial Statements
Statement of profit or loss
- Revenues, Expenses, Profit (period result)
Balance sheet
- Assets, Liabilities, Equity (book value)
Statement of cash flows
- Cash Flows (Operating, Investing, Financing)
Statement of comprehensive income
- Non-owner changes in equity (not shown in Income
Statement)
Statement of changes in equity
- detailed changes in components of equity
SIMPLIFIED INCOME STATEMENT
(ADOPTED FROM: PWC GUIDE ON IFRS)
Continuing operations
Revenue
Cost of sales of goods
Gross profit
Administrative expenses
Other Income
Operating profit
Finance costs – net
Profit before income tax
Income tax expense
Profit from continuing operations
Profit from discontinued operation
Profit for the period
Profit attributable to owners
Profit attributable to Non-controlling interests
https://inform.pwc.com/inform2/s/
Illustrative_IFRS_consolidated_financial_statements_for_2015_year_ends/informContent/
1536293207143629#ic_1536293207143629
8
SIMPLIFIED BALANCE SHEET, ASSETS
(ADOPTED FROM: PWC GUIDE TO IFRS)
ASSETS
Non-current assets
Property, plant and equipment
Intangible assets
Deferred tax assets
Investments
Other non-current assets
Current assets
Inventories
Trade and other receivables
Financial assets
Cash and cash equivalents
Other current assets
Total assets
9
SIMPLIFIED BALANCE SHEET, LIABILITIES AND EQUITY
(ADOPTED FROM: PWC GUIDE ON IFRS)
LIABILITIES
Non-current liabilities
Borrowings
Deferred tax liabilities
Employee benefit obligations
Other non-current liabilities
Current liabilities
Trade and other payables
Current tax liabilities
Other current liabilities
Total liabilities
Net Assets
EQUITY
Share capital
Reserves
Retained earnings
Capital and reserves attributable to owners
Non-controlling interests
Total equity
10
SIMPLIFIED STATEMENT OF CASH FLOWS
(ADOPTED FROM: PWC GUIDE TO IFRS)
Cash generated from operations
Interest paid
Income taxes paid
Net cash inflow from operating activities
Purchases/sale of assets
Other investment activities
Dividends received
Interest received
Net cash (outflow) from investing activities
Proceeds from issuance of shares
Payment for shares bought back
Dividends paid
Other financing activities
Net cash inflow (outflow) from financing activities
Net increase (decrease) in cash and cash equivalents
11
Key Concepts of Financial Statement
Revenues (realization principle)
Expenses (matching and conservatism principle)
Profit = Revenues – Expenses
Assets (produce future benefits)
Liabilities (obligations to be met in the future)
Assets = Liabilities + Equity
Ending Equity = Beginning Equity + Comprehensive Income
- Amounts Paid to Shareholders
+ Amounts Received from Shareholders
Ending Retained Earnings = Beginning Retained Earnings
+ Net Income - Dividends
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Accounting vs Cash Flow/Market Value
Both are needed for getting a complete picture. Differences:
Recognition of revenues in time
1. 
ACCOUNTING
CASH
2. 
CASH
Recognition of expenses in time
1.
ACCOUNTING
CASH
2. 
CASH
Value of assets or liabilities
1. 
ACCOUNTING < MARKET
2. 
MARKET < ACCOUNTING
ACCOUNTING
ACCOUNTING
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Accounting Flexibility
In good use:
- accrual items are matched to firm’s true economics
- recognition and capitalization is based on best estimates
In bad use:
- flexibility in recognition, capitalization, depreciation, fair
value etc. is used to manage earnings and balance sheet
- accounting policies are changed to change results
- future obligations are not reported (off-balance sheet)
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Red flags in Financial Statements
Unexplained changes in
- accounting policies
- Operating Profit/Cash Flow from Operations
Recognizing revenues too early from long projects
Recurring costs stated as non-recurring
Non-recurring income recorded as operating income
Deferral of costs by unjustified capitalization
Boosting Earnings by long depreciation or amortization times
Underestimating Pension Liabilities by optimistic assumptions
Liabilities put Off-balance-sheet
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Standardizing and
adjusting Financial
Statements
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Why adjustments?
Valuation is based on the concept of “similar companies”:
• 
• 
• 
• 
• 
• 
• 
Cost of equity, beta, risk-level
After Tax Cost of debt, debt ratings
Price / Earnings
Return on Equity
Debt to Equity
Growth of Sales
Enterprise Value/EBITDA
Need similar concepts and measurement of
Equity, Debt, Net Income, Sales, Taxes, EBIT, …
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Templates
IFRS full model Financial Statement templates, see
https://inform.pwc.com
http://www.iasplus.com
In the following we go through our textbook (Palepu et al) template.
1. Using a common template is mostly reorganizing line-items.
- e.g. Net Profit and Total Assets do not change
2. Readjustments correct and restate some items.
- accounting items change (e.g. profits, equity, assets)
- cash items do not normally change (e.g. cash balance, dividends)
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Income Statement
Income Statement (by function)
Sales
(e.g. revenue, turnover, commissions)
Cost of Sales
(cost of products sold, depreciation on manufacturing)
Gross profit
SG&A
(administrative, sales, depreciation on admin. facilities)
Other operating income, net of expense
( R&D, start-up costs)
Operating profit
Investment income
(income from associates, dividend income, rental income)
Other Income, Net of Other Expense
(forex gains/losses, asset impairments, restructuring)
Interest Income
Interest Expense
Profit before tax
Tax expense
Profit from continuing operations
Net gain/loss from Discontinued Operations
Profit after tax
Minority interest – Income Statement
(profit attributable to non-controlling interests)
Net profit to ordinary shareholders
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Balance Sheet: Assets
Non-current Tangible Assets
Non-current Intangible Assets
Investments
Deferred Tax Asset
Derivatives - Asset
Total Non-current Assets
Inventories
Trade Receivables
Other Current Assets
Cash and Marketable Securities
Total Current Assets
Total Assets
(property ,plant and equipment, land, assets held for sale)
(goodwill, product development costs, deferred charges)
(investments in associates, minority equity investments)
(tax claims)
(derivative financial instruments)
(inventory, finished goods, raw materials, stocks)
(accounts receivable, trade debtors)
(prepaid expenses, current derivatives, assets held for sale)
(cash, short-term investments, time deposits)
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Balance Sheet: Liabilities and Shareholders’ Equity
Ordinary Shareholders’ Equity
(share capital, share premium, retained earnings, treasury shares)
Minority Interest – Balance Sheet (non-controlling interest)
Preference Shares
(preference shares, convertible preference shares)
Total Equity
Non-current Debt
(long-term borrowings, finance lease obligations, pension benefits)
Deferred Tax Liability
(tax claims against the company)
Derivatives – Liability
Other Non-Current Liabilities
(non-interest bearing liabilities)
Total Non-current Liabilities
Trade Payables
(accounts payable, trade creditors)
Current Debt
(current borrowings, current portion of non-current borrowings)
Other Current Liabilities
(accrued expenses, income tax liabilities, dividends payable)
Total Current Liabilities
Total Liabilities and Shareholders’ Equity
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Statement of Cash Flows (Palepu et al)
Net Profit
(from Income Statement)
Non-Operating Gains (Losses) (gain on disposal of assets, gain on foreign exchange)
Non-Current Operating Accruals (depreciation and amortization, deferred revenues, costs, taxes)
Operating Cash Flow Before Working Capital Investments
Net Investments in Working Capital (changes in receivables, payables, inventories, provisions)
Operating Cash Flow Before Investment in Non-current Assets
Interest received
Dividends Received
Net Investment in Non-current Operating Assets (R&D, CAPEX, acquisitions)
Free Cash Flow Available to Debt and Equity
Interest Paid
Net Debt (Repayment) or Issuance (principal payments, issuance of debt, net change in borrowings)
Free Cash Flow Available to Equity
Dividends (Payments)
(cash dividends on ordinary/preferred shares, distributions)
Net Share (Repurchase) or Issuance (issue of shares, repurchase, issue of subsidiary equity)
Net Increase (Decrease) in Cash Balance
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Readjustments to
Financial
Statements
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Distortions you might have to correct
Why distortions: non-suitable rules, earnings management when
issuing shares, meeting covenants, getting bonuses,…
Typical big item distortions:
-  Non-standard depreciation or amortization rates
-  Bad assets not impaired
-  Off-balance sheet leases or obligations not fully reported
-  R&D capitalized differently than industry practice
-  Pension obligations not fully recognized
-  Revenues recognized too early
-  Recycling of gains/losses (comprehensive vs normal income)
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Readjustments, Asset impairment
Suppose a company is believed to have overstated fair value of
its acquisition, and consequently goodwill. You want to writedown assets that company has not written down (Palepu p.162)
The price of acquisition was 129.4M£. Company estimated fair
value of net assets to be 79.2M£ and goodwill 50.2M£. Bad
asset you want to impair is worth 72.4M£. Tax rate is 28%.
Write-down will create the following readjustments
Assets will go down by the value of written down asset.
Shareholders’ Equity will go down.
Deferred Tax Liability will go down.
Other Expenses will go up.
Tax Expense will go down.
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Readjustments, Asset Impairment(2)
Needed equations
Retained Earnings(t) = Retained Earnings(t-1) + Profits(t)
Assets = Liabilities + Shareholders’ Equity
Profits = Revenues - Expenses
Price = Fair value of Net Assets(to Equity) + Goodwill(to IntangibleAssets)
Income Statement
∆Other Expenses = 72.4M£
∆Tax Expense = TaxRate x ∆Profit = 0.28 x(- 72.4M£) = -20.3M£
∆Profit = ∆(Revenues – Expenses) = -(72.4M£ + (-20.3M£)) = -52.1M£
Balance Sheet
∆Assets = -72.4M£
∆DefTaxLiability = TaxRate x ∆(BookAssets-TaxAssets) = 0.28 x (-72.4) = -20.3M£
∆Shareholders’ Equity = ∆Retained Earnings = ∆Profit = -52.1M£
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Operating vs. Financial Lease Payments
Opera&ng lease Lease Payment PMT= Assets= Debt= Interest= Cash Out Financial lease Lease Payment PMT= Assets= Debt, PV of annuiHes = Interest payment= Principal payment = Cash Out Asset = 1000, interest rate 10% pa, 5 years Year 0 Year 1 Year 2 Year 3 263.80 263.80 263.80 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 263.80 263.80 263.80 Asset = 1000, interest rate 10% pa, 5 years Year 0 Year 1 Year 2 Year 3 0.00 0.00 0.00 1000.00 800.00 600.00 400.00 1000.01 836.21 100.00 163.80 263.80 656.03 83.62 180.18 263.80 457.83 65.60 198.19 263.80 Year 4 263.80 0.00 0.00 0.00 263.80 Year 5 263.80 0.00 0.00 0.00 263.80 Year 4 0.00 200.00 Year 5 0.00 0.00 239.82 45.78 218.01 263.80 0.00 23.98 239.82 263.80 Total 1318.99 0.00 1318.99 Total 0.00 318.99 1000.00 1318.99 Laitoksen nimi
* In Excel, payments from PMT(0.1,5,1000,0,0)
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Operating Lease
INCOME STATEMENT Sales leasing costs Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Total 500.00 500.00 500.00 500.00 500.00 2500.00 263.80 263.80 263.80 263.80 263.80 1319.00 236.20 236.20 236.20 236.20 236.20 1181.00 Profit before taxes Taxes (50%)= 118.10 118.10 118.10 118.10 118.10 590.50 Net Profit 118.10 118.10 118.10 118.10 118.10 590.50 BALANCE SHEET, Assets Leasing Assets 0.00 0.00 0.00 0.00 0.00 Other Assets 700.00 700.00 700.00 700.00 700.00 Cash 118.10 236.20 354.30 472.40 590.50 818.10 936.20 1054.30 1172.40 1290.50 Total Assets BALANCE SHEET, Equity & Liabili&es Equity Debt Equity and Liabili&es 700.00 818.10 936.20 1054.30 1172.40 1290.50 (0% div.) 0.00 0.00 0.00 0.00 0.00 818.10 936.20 1054.30 1172.40 1290.50 Laitoksen nimi
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Financial Lease
INCOME STATEMENT Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Total 500.00 500.00 500.00 500.00 500.00 2500.00 deprecia&on 200.00 200.00 200.00 200.00 200.00 1000.00 interest payment 100.00 83.62 65.60 45.78 23.98 318.99 200.00 216.38 234.40 254.22 276.02 1181.01 Sales Profit before taxes Taxes (50%) 100.00 108.19 117.20 127.11 138.01 590.50 Net Profit 100.00 108.19 117.20 127.11 138.01 590.50 BALANCE SHEET, Assets 1000.00 800.00 600.00 400.00 200.00 0.00 700.00 700.00 700.00 700.00 700.00 136.20 264.22 383.22 492.31 590.51 1636.20 1564.22 1483.22 1392.31 1290.51 BALANCE SHEET, Equity & Liabili&es Equity 700.00 800.00 908.19 1025.39 1152.50 Debt 1000.01 836.21 656.03 457.83 239.82 0.00 1636.21 1564.22 1483.22 1392.31 1290.50 Leasing Assets Other Assets Cash Total Assets 0.00 Equity and Liabili&es 1290.50 (0% div.) Laitoksen nimi
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Financial ratios
in operating vs. financial leases
OPERATING LEASE
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 ROA (Net Profit/Total Assets) 0.14 0.13 0.11 0.10 0.09 ROE (Net Profit/Equity) 0.14 0.13 0.11 0.10 0.09 D/E (Debt/Equity) 0.00 0.00 0.00 0.00 0.00 Year 1 Year 2 Year 3 Year 4 Year 5 0.06 0.12 1.05 0.07 0.12 0.72 0.08 0.11 0.45 0.09 0.11 0.21 0.11 0.11 0.00 FINANCIAL LEASE
Year 0 ROA (Net Profit/Total Assets) ROE (Net Profit/Equity) D/E (Debt/Equity) Laitoksen nimi
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Some formulas for the above example
Payment from Excel PMT function (or with NPV formulas)
Equity(t) = Equity(t-1) + Net Profit(t)
Interest payment(t) = Interest Rate * Ending Debt Balance(t-1)
Leasing Debt(t) = Leasing Debt(t-1) – Principal Payment(t)
Leasing Payment(t) = Interest Payment(t) + Principal Payment(t)
Cash Assets(t), Oper. Lease = Cash Assets(t-1), Oper. Lease
+ Net Profit(t)
Cash Assets(t), Fin. Lease = Cash Assets(t-1), Fin. Lease
+Net Profit(t) + Depreciation(t) – Principal Payment(t)
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Adjustments, Leasing
Operating Lease is like rental, Financial Lease is like buy with debt.
Analyst may want to capitalize all operating leases to make debt visible.
Transforming operating to financial leases causes the following changes.
Previous (Beginning) Balance Sheet
- Non-Current Asset is increased
- Non-Current Liabilities is increased
Current (Ending) Balance Sheet
- Legacy increase of Non-Current Assets from Previous Balance Sheet
- Legacy increase of Non-Current Liabilities from Previous Balance Sheet
- Change in Leased Asset Base (new leases – depreciation)
- Repayment of Lease Debt
- Change in Deferred Tax Liability through change in Taxes
- Change in Shareholders’ Equity through change in Net Profit
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Adjustments, Leasing(2)
Income Statement
Cost of Sales is decreased by lease expense
Cost of Sales is increased by depreciation expense
Interest Expense is increased by interest on lease capital
Tax is increased
Example (Palepu, p. 152, second ed., similar p. 143 third ed. )
Lease Assets = PV(Estimated lease payments for 7 years; cost of debt = 4.7%)
(2007)  = PV(75.3)+PV(68.5,49.9,45.2,37.0,37.0,11.9; 4.7%) = 71.9+209.7 = 281.6
(2008)  = PV(76.1)+PV(54.8,49.0,40.5,24.4,24.4,16.7; 4.7%) = 72.7+176.4 = 249.1
New Leases 2008 deduced from forecasts vs actual
value of 2007 forecast of lease debt for 2008 = 209.7*1.047 = 219.6
actual lease debt in 2008 = 249.1
increase from long term lease debt value = 249.1 – 219.6 = 29.5
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Adjustments Leasing (3)
forecasted annual lease payments for 2008 = 75.3
actual lease payments for 2008 = 82.6
increase in annual lease payments 2008 = (82.6 – 75.3) = 7.3
total increase in leased assets in 2008 = 29.5 + 7.3 = 36.8
Depreciation expense of leased assets in 2008
Asset at the beginning of 2008 = 281.6
Assets increased in 2008 (in the middle of the year) = 36.8
Depreciation in 2008 = (281.6 + 0.5*36.8)/7 = 42.9
Net Change in (Lease) Assets 2008 = 36.8 – 42.9 = -6.1
Division of lease payment to interest and principal
Interest = 4.7% x (281.6 +0.5 x 36.8) = 14.1
Repayment of Debt = 82.6 – 14.1 = 68.5
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Adjustments, Leasing (4)
Changes in taxes in financial reporting (not actual taxes)
leasing expenses in original operating lease = 82.6
leasing expenses in financial lease = 42.9 + 14.1 = 57.0
increase in tax(26%) expense = 0.26 * (82.6 – 57.0) = 6.7
increase in Deferred Tax Liability = 6.7
Adjustments to Balance Sheet 2007 (=beginning value for 2008)
Assets: Leased assets +281.6
Liabilities: Lease Debt +281.6
Adjustments to Income Statement 2008
∆Profit Before Tax = ∆Lease expense -∆Depreciation -∆Interest
= 82.6 - 42.9 - 14.1 = +25.6
∆Taxes = 26% x 25.6 = +6.7 (Not paid so also ∆Def.TaxLiab. = 6.7)
∆Net Profit = ∆(PBT – Taxes) = ∆PBT - ∆Taxes = +25.6 – 6.7 = +18.9
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Adjustments, Leasing (5)
Adjustments to Balance Sheet 2008
Assets
∆Non-Current Assets = ∆Beginning Lease Assets + ∆New Lease
Assets - ∆Depreciation of Lease Assets = 281.6 + 36.8 – 42.9 = 275.5
Equity and Liabilities
∆Shareholders’ Equity = ∆Net Profit = 18.9
∆Non-Current Debt = ∆Beginning Lease Debt + ∆New Lease Debt
-∆Repayment of Debt = 281.6 + 36.8 - 68.5 = 249.9
∆Deferred Tax Liability = ∆Taxes = 6.7
Check:
∆Assets = 275.5
∆Liabilities + ∆Shareholders’ Equity = 249.9 + 6.7 + 18.9 = 275.5
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Adjustments, Pension Liabilities(€€€)
Accounting rules give companies flexibility to smooth or defer
recognition of pension liabilities from underlying economics.
Note: both obligations and assets depend on assumptions!
Simplified economics of pension liabilities*
Funded Status = Pension Obligation – Plan Assets
Change in Funded Status = Change in Obligations (current
service costs, interest cost, actuarial gains/losses, benefits
paid, other) – Change in Plan Assets (actual returns,
contributions, benefits paid, other)
Economic period cost = service cost + interest cost (opening
obligations) +/- actuarial gains/losses – actual returns on plan
assets +/- other
IFRS Net Liability = Funded Status – Unrecognized Past Service
Cost +/- Unrecognized Actuarial gains/losses (discretionary)
* See Robinson et al: International Financial Statement Analysis p.684
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Adjustments, Pension Liabilities (2)
Example, Carlsberg 2011, in DKK millions ( see Palepu p 158 third edition and
http://www.carlsberggroup.com/Investor/DownloadCentre/Pages/documentlist.aspx p. 91)
Total Obligations = 10339 (no unrecognized actuarial gains/losses or past service costs)
Total Plan Assets = 7099
Funded Status
= 3240 ( = here IFRS Net Pension Liability)
Change in Obligations = 1009 ( = Current service cost, 176 +
Interest Cost, 376 + Actuarial Gains/Losses, 849 + Benefits paid,
-478 + other, 86)
Change in Plan Assets = 199 ( = Actual Return, 83 + Contributions,
331 + Benefits paid, -391 + Other 172)
Change in Funded Status = 814 ( = 1009 – 199)
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Adjustments, Pension Liabilities (3)
Economic Period Cost = 1215 ( = Service Cost, 176 + Interest
Cost, 376 + Actuarial Gains/Losses, 849 – Actual Return, 83 –
Settlements, 103)
Cost in Income Statement = 122 ( = Service Cost, 176 +
Interest Cost, 376 – Expected return, 327 – Settlements, 103)
Cost in Comprehensive Income = 1093 ( = Actuarial Gains/
Losses, 849 + (Expected Return, 327 – Actual Return, 83))
Note: Economic Period Cost =
Recognized Cost in Income Statement
+ Recognized Cost in Comprehensive Income
+ Unrecognized Costs
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Adjustment towards Economic Situation
In Carlsberg 2011, no need to adjust Liabilities in Balance Sheet
because there are no unrecognized pension items. Net
Economic Pension Liability is in Non-Current Liabilities (3263).
If the analyst likes to recast Income Statement according to
(harsh, non-smoothed) economic situation, then Costs from
Comprehensive Income (1093) increase normal Income
Statement Personnel Costs (1093) and tax expense has to be
lowered according to 24% tax rate (262). Net Income would be
lowered by the (after tax) amount of 831 ( = 1093 – 262).
Note:The original Net Profit for Carlsberg 2011 is 5692 and this
adjustment would lower Net Profit to 4861 – a drop of 14.6%
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Adjustment of assumptions in Obligations
Simple model: Pension Obligation = NPV(Total Benefit)
NPV(Total Benefit) = No. of Retirees(n) * Benefit level(n) / (1 + r)n
Benefit level(n+1) = Benefit level(n)*(1+g)
No. of Retirees constant 30 years, then declines in 30 years to 0
Carlsberg assumes (Note 25 p.92): g = 2.9%, r = 3.6%
Analyst assumes: g = 2.9%, r = 3.5%
In Excel put Benefit(1) = 1, Retirees(1) = 100 and calculate
Total Benefit(n) = 1*100*(1+0.029)^n/(1+0.035)^n
(n <= 30)
Total Benefit(n) = 1*100*(1+0.029)^n*(1-(n-30)/30)/(1+0.035)^n (n > 30)
NPV(Total Benefit; 3.5%) = 3892, NPV(Total Benefit: 3.6%) = 3809
Increase in NPV = 2.18% ( = (3892 – 3809)/3809)
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Adjustment of assumptions in Obligations (2)
The Pension Obligations rose 2.18% when discount rate was
lowered 0.1% points.
Carlsberg 2011 Pension Obligation is originally 10339. Now it is
increased by 225 (=0.0218 * 10339). The total (225) goes into
Balance Sheet.
Liabilities: Retirement Benefit Obligations changes by
Deferred Tax Liability changes (24% tax rate) by
225
-54
Equity:
-171
Equity changes by
Note: Net change in Total Assets = Equity and Liabilities = 0
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Expensing R&D costs
R&D EXAMPLE, EXPENSED VS. AMORTIZED (5 YRS.) INCOME STATEMENT, EXPENSED Sales costs R&D cost Profit before tax Taxes(20%) Net Profit 1 100 50 50 0 0 0 2 100 50 0 50 10 40 3 100 50 0 50 10 40 4 100 50 0 50 10 40 5 100 50 0 50 10 40 1 0 200 200 100 100 200 2 40 200 240 140 100 240 3 80 200 280 180 100 280 4 120 200 320 220 100 320 5 160 200 360 2 50 10 0 40 3 50 10 0 40 4 50 10 0 40 TOTAL 500 250 50 200 40 160 BALANCE SHEET, EXPENSED Cash Other Assets Total Equity Liabili&es Total 260 100 360 CASH FLOW STATEMENT, EXPENSED Cash from opera&ons Sales -­‐ Cost -­‐ R&D expense Taxes paid Cash to investements Change in Cash 1 0 0 0 0 5 50 10 0 40 TOTAL 200 40 0 160 Laitoksen nimi
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Capitalizing R&D costs
INCOME STATEMENT, AMORTIZED (5 YRS.) Sales costs R&D amor&za&on Profit before tax Taxes(20%) Net Profit 1 100 50 10 40 8 32 2 100 50 10 40 8 32 3 100 50 10 40 8 32 4 100 50 10 40 8 32 5 100 50 10 40 8 32 1 -­‐8 240 232 132 100 232 2 34 230 264 164 100 264 3 76 220 296 196 100 296 4 118 210 328 228 100 328 5 160 200 360 1 2 3 4 5 50 8 50 -­‐8 50 8 0 42 50 8 0 42 50 8 0 42 50 8 0 42 TOTAL 500 250 50 160 40 160 BALANCE SHEET, AMORTIZED (5 YRS.) Cash Other Assets Total Equity Liabili&es Total 260 100 360 CASH FLOW STATEMENT, AMORTIZED (5 YRS.) Cash from opera&ons Sales -­‐ Cost Taxes paid Cash to investements Change in Cash TOTAL 250 40 0 160 Laitoksen nimi
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Adjustment, Capitalizing R&D
Astra Zeneca (see Palepu p.146). Amortization schedule (middle
of year investment, 5 yrs.): 10%, 20%,20%,20%,20%,10%
Year
R&D outlay
2009 
2008
2007
2006
2005 
2004 
TOTAL
4.4
5.2
5.2
3.9
3.4
3.5
____
25.6
Amortization 2009
0.44 (1 yr. 10%)
1.04 (2 yr. 20%)
1.04 (3 yr. 20%)
0.78 (4 yr. 20%)
0.68 (5 yr. 20%)
0.35 (6 yr. 10%)
____
4.33
Capital left 2009
3.96 (1 yr. 90%)
3.64 (2 yr. 70%)
2.60 (3 yr. 50%)
1.17 (4 yr. 30%)
0.34 (5 yr. 10%)
0.0 (6 yr. 0%)
____
11.71
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Adjustment, Capitalizing R&D (2)
In AstraZeneca analyst wants to recast 2009 financial statements as
if R&D had been capitalized (tax rate 28%)
Changes in Balance Sheet 2009
Assets: Non-Current Assets
Liabilities: Deferred Tax Liability
Equity: Shareholders’ Equity
+11.7 (Capitalized R&D Asset)
+3.3 (28% * 11.7, in the recast)
+8.4 (72% * 11.7)
Changes in Income Statement 2009
Operating Expenses
-4.4 (delete R&D expense)
Operating Expenses
+4.3 (put in R&D amortization)
Tax Expense
0.0 (actual tax not changed)
Net Profit
+0.1 (Costs decrease by 0.1)
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Finally
Financial Statement for Valuation
Starting from official (IFRS, USGAAP) Financial Statement and
its Attachments, we have now:
- standardized classifications for our own template
- made adjustments to correct big item distortions
- made adjustments to match industry practice if needed
We are ready to look at
- financial ratios
- inputs for valuation models
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Financial Ratios
and Cash Flows
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What are Financial Ratios used for ?
To analyze a company’s financial position and development
- profitability
- operating efficiency
- financial strategy
- dividend policy
To compare company ratios with competitors and industry
To calculate inputs for valuation formulas
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DRIVERS OF PROFITABILITY AND GROWTH
Various return concepts
Accounting (book value) based returns
Net Profit
Return on Equity (ROE) =
Shareholders' Equity
Market based return
Holding period (realized or expected) return(t) =
(Price(t) - Price(t-1)) + Dividends(t)
Price(t-1)
Required return = (equilibrium, e.g. CAPM) price of equity ke
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Return on Equity (ROE)
•  Counterparty to market return on equity
•  ROE is return for all equity (common, preferred, minority)
•  Equity is measured as Average Total Equity during fiscal
year (CFA) [but analysts often use ending balance, Palepu
uses beginning balance in Ch 5]
•  ROE has a tendency to revert to “normal” levels
•  Maximizing ROE is not the same thing as maximizing value
•  ROE depends on leverage of the company
•  ROE changes if interest rates or accounting policies change
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Decomposing ROE for analysis
DuPont Analysis
Standard decomposition (2)
ROE = ROA x Equity Multiplier =
Net Profit
Total Assets
x
Total Assets Shareholders' Equity
Standard decomposition (3)
ROE = Profit Margin x Asset Turnover x Equity Multiplier
Net Profit
Sales
Total Assets
x
x
= Sales
Total Assets Shareholders' Equity
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Advanced ROE decomposition
Problems in standard: operating and financing performance not separated,
earnings and asset ownership don’t match. Advanced formula:
ROE = Return on Business Assets + Spread x Financial Leverage
where
NOPAT+NIPAT
Return on Business Assets (ROBA) =
Business Assets
Spread = Return on Business Assets – Interest Expense After Tax / Debt
Debt
Financial Leverage =
Equity
Interest Expense After Tax = Interest Expense * (1 – Tax Rate)
Net Operating Profit After Taxes (NOPAT) =
Net Profit – NIPAT + Interest Expense After Tax
Net Investment Profit After Taxes (NIPAT) = (Investment Income + Interest
Income) * (1 – Tax Rate)
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Definitions continue…
Operating Assets = Operating working capital + Net Non-current
Operating Assets
Investment Assets = Minority Equity Investments + Other Non-operating
Investments + Excess Cash and Marketable Securities
Debt = Total interest-bearing non-current liabilities + Current debt and
current portion of non-current debt
Operating working capital = (Current Assets – Excess Cash and
Marketable Securities) – (Current Liabilities – Current debt and
current portion of non-current debt)
Net Non-current Operating Assets = Non-current Tangible and Intangible
Assets + Derivatives – (Net) Deferred Tax Liability - Non-interest-bearing
Non-current liabilities
Book vs Market concepts
ROE
vs re (Cost of Equity)
ROA
vs WACC (Weighted Average Cost of Capital)
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FURTHER ANALYSIS OF RETURN ON BUSINESS
ASSETS AND RETURN ON OPERATING ASSETS
ROBA
=
NOPAT
Business Assets
+
NIPAT
Business Assets
=
NOPAT
Operating assets
×
Operating assets Business assets
+
NIPAT
Investment assets
×
Investment assets Business assets
= Return on operating assets ×
Operating assets
Business assets
+Return on investment assets ×
Return on operating assets =
NOPAT
Sales
×
Investment assets
Business assets
Sales
Operating assets
H&M VERSUS INDUSTRY PEERS: COMPARISON OF ROE COMPONENTS
Useful Profitability Measures
related to ROE first standard component (Net Profit / Sales)
Gross Profit Margin =
Sales - Cost of Sales
Sales
EBITDA Margin = Earnings Before Interest, Taxes, Depreciation and Amortization
Sales
EBIT Margin = Earnings Before Interest and Taxes
Sales
NOPAT Margin =
Net Operating Profit After Taxes
Sales
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Useful Asset Turnover (Efficiency) Measures
related to ROE second standard component (Sales / Assets)
Working Capital* Turnover = Sales / Working Capital
Oper. Working Capital Turnover = Sales/Oper. Working Capital
Fixed Asset Turnover = Sales / Fixed Assets
Non-Current Asset Turnover = Sales / Non-Current Assets
Total Asset Turnover = Sales / Total Assets
Trade Receivables Turnover = Sales / Trade Receivables
Trade Payables Turnover = Purchases / Trade Payables
Inventories Turnover = Cost of Sales / Inventories
Also modified ratios are used, like
Days’ Inventories = Inventories / Average Cost of Sales per Day
* Working Capital = (Current Assets – Current Liabilities)
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A COMPARISON OF KEY INCOME
STATEMENT RATIOS FOR H&M AND ITS
INDUSTRY PEERS
ASSET MANAGEMENT RATIOS FOR
H&M AND ITS PEERS
Useful Financial Leverage Ratios
related to ROE third standard component (Assets / Equity)
Short-term liquidity
Current Assets
Current Ratio =
Current Liabilites
Quick Ratio =
Cash Ratio =
Cash and Marketable Securities + Trade Receivables
Current Liabilites
Cash and Marketable Securities
Current Liabilites
Operating Cash Flow Ratio =
Cash Flow From Operations
Current Liabilities
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Useful Financial Leverage Ratios
related to ROE third standard component (Assets / Equity)
Long-term (book*) solvency
Equity Multiplier =
Debt-to-Equity =
Debt-to-Capital =
Total Assets
Total Equity
Current Debt + Non-Current Debt
Shareholders' Equity
Current Debt + Non-Current Debt
Current Debt + Non-Current Debt + Shareholders' Equity
* Market based ratios are used in WACC calculations
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Popular financial riskiness measures
(risk and return go together!)
Interest Coverage (Earnings Basis)* =
Net Profit + Interest Expense + Tax Expense
Interest Expense
Interest Coverage (Cash Flow Basis) =
Cash Flow From Operations + Interest Expense + Tax Expense
Interest Expense
* CFA defines as EBIT/Interest Expense
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COMPARISON OF H&M AND INDITEX
DEBT AND COVERAGE RATIOS
Sustainable (book) growth rate
At sustainable growth rate key profitability and solvency ratios
remain constant.
Sustainable Growth Rate (g*) = ROE x (1 – Dividend Payout Ratio)
Dividend Payout Ratio = Cash Dividends Paid / Net Profit
If planned growth (g) > g* then profitability, efficiency or leverage
have to increased or dividend payout
lowered
If planned growth (g) < g* then profitability, efficiency or leverage
might decrease or dividend payout ratio
should be increased
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Sustainable growth rate analysis
Two parts: how value is generated and how it is distributed
Value generation (different frames):
ROE = Profit Margin x Asset Turnover x Equity Multiplier
ROE = Return on Business Assets + Spread x Financial Leverage
Value distribution (to owners immediately or kept inside the firm)
Dividend Payout Ratio = Cash Dividends Paid / Net Profit
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SUSTAINABLE GROWTH RATES FOR
H&M AND ITS PEERS
Cash Flow Analysis
•  Cash (vs accrual) based view on company’s financial situation
•  How much cash do operations produce?
•  How much cash is used for working capital and non-current
asset investments? Compared to Depreciation?
•  Does company finance growth by internal or external funds?
•  How easily can company pay debt obligations?
•  Is debt needed to pay out dividends ?
•  BASIS FOR STANDARD FCF VALUATION
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CASH FLOW ANALYSIS FOR H&M AND INDITEX