Accounting
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Financial Statement Recovery
Introduction to Financial Accounting
Financial accounting is the branch of accounting intended for users outside the organisation
(external accountability). When we talk about financial accounting, we thus (quindi) refer to the
act of reporting information on the organisation in financial terms (financial reporting).
Financial Accounting is presented externally through mandatory financial reports. Financial
reports provide information about the financial position, financial performances, and cash flows of
an entity.
Financial reports include two time-frames documents:
• Annual report, which is published yearly and it is drafted according to principles defined by law
(IAS/IFRS). For IAS/IFRS the compulsory documents of annual report are:
- Balance Sheet (stato patrimoniale)
- Income Statement (conto economico)
- Cash Flow Statement (rendiconto finanziario)
- Statement of changes in equity (prospetto delle variazioni di patrimonio netto)
- Notes to the financial statements (nota integrativa)
N.B. Listed companies (società quotate) are also requested to provide within Annual Report:
- The report of external auditors (relazione di revisori esterni), stating that the annual report gives
a true and fair view of the situation of the company.
- The report of supervisory board (relazione del consiglio di vigilanza), stating that the decisions
undertaken by the company’s management are compliant with the normative and statutory
requirements.
- A management report, providing the view of the management and also additional comments to
the results reported in the annual report.
• Interim reports, that are published every 3 or 6 months
This graph explains how financial accounting works.
In particular, Financial Accounting provides the “numbers” we normally hear about a company
(revenues, profit, assets value…). It is a fundamental part of company evaluation, i.e. it contributes
(together with “expectations”) to determine for example the credit stability, the target price in a
M&A…
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Recovery of Financial Statements and Principles of Financial
Accounting
Principles - Accrual vs Cash Logic
According to Accrual principle, accounting registers events based on economic activity rather
than financial activity.
Balance Sheet in short
Balance Sheet describes the circumstances of an enterprise in a given point of time (usually
midnight of 31/12 of each year). The circumstances of enterprise are reported in terms of assets
and related rights (equity and liabilities):
- Assets (attivo) reports the enterprise’s resources.
- Equity and Liabilities (passivo) list the rights to those resources.
Every item is expressed in monetary value. Furthermore, IAS/IFRS do not identify a rigid
framework (struttura), in fact each company may decide how to draft its Balance Sheet.
The Balance sheet is so divided in two sections:
Since each resource must be assigned to someone who has the right over it, in every moment:
Total assets (Resources) = Total liabilities (Rights)
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Assets
As far as assets are concerned, they are divided in:
• Non-current assets are resources retained for the long term, over the enterprise’s normal cycle.
• Current Assets: held for collection, trading, sales or consumption within the enterprise’s
normal operating cycle (12 months).
• Assets classified as held for sale and disposal groups: held for sale within 12 months.
The following conditions must be met to be classified as held for sale:
1. commitment to a plan to sell.
2. the asset is available for immediate sale.
3. an active program to locate a buyer is initiated.
4. the sale is highly probable, within 12 months of classification as held for sale (subject to
limited exceptions)
5. the asset is being actively marketed for sale at a sales price reasonable in relation to its fair
value.
6. actions required to complete the plan indicate that it is unlikely that plan will be
significantly changed or withdrawn.
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Principles - assets evaluation
How do you register non current assets over the years? What are the principles?
There are three concepts which are useful to understand the logic behind evaluation of assets:
1. COSTS MODEL VS REVALUATION MODEL
Fair Value reflects an objective evaluation external to the enterprise, which is related to the
knowledge of sellers and buyers. It usually refers to market values.
IAS/IFRS give specific indications in relation to different items, for example:
- Building and land, evaluation with market parameters by expert examination (though not
compulsory).
- Machinery, evaluation with market parameters by expert examination (though not compulsory).
- Intangibles, for these items there is the need of an active market, in which prices are readily
available (transactions occur with sufficient frequency to provide pricing information on an
ongoing basis) and representative of 'customer based value' (CBV) (a customer would currently
transact at those prices).
How does the evaluation of assets in financial report changes with the two models?
Where BOOK VALUE = CARRYING VALUE: it is calculated netting the asset against its
accumulated depreciation (of the years preceding the one considered).
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What are the strengths and the weaknesses of Revaluation model based on Fair Value concept?
2. BENCHMARK TREATMENT VS ALLOWED TREATMENT
For several items, IAS/IFRS allows to adopt alternatively the two models (cost vs. revaluation).
In particular, it indicates a preferred accounting criteria (benchmark treatment) but also
indicates a possible alternative criteria in accounting (allowed treatment).
Example for property, plant and equipment
The initial measurement is at cost (initial value) but the measurement subsequent to the initial
recognition could be done according to:
• Cost model (Benchmark treatment): the asset is carried at its cost less accumulated
depreciation and impairment.
• Revaluation model (Allowed treatment): the asset is carried at a revalued amount, being its
fair value at the date of revaluation less subsequent depreciation, provided that fair value can be
measured reliably:
- If a revaluation results in an increase in value, it should be credited to equity under the
heading "revaluation surplus" unless it represents the reversal of a revaluation decrease of
the same asset previously recognised as an expense, in which case it should be recognised
as income.
- A decrease arising as a result of a revaluation should be recognised as an expense to the
extent that it exceeds any amount previously credited to the revaluation surplus relating to
the same asset.
- When a revalued asset is disposed of (dismesso, ceduto), any revaluation surplus may be
transferred directly to retained earnings, or it may be left in equity under the heading
revaluation surplus. The transfer to retained earnings should not be made through the
income statement (that is, no "recycling" through profit or loss).
3. IMPAIRMENT TEST
According to IAS/IFRS, companies must periodically review almost all assets to look for any
indication of an unrecoverable loss of their value.
An unrecoverable loss may occur as a result of:
- market value declines
- negative changes in technology, markets, economy, or laws
- obsolescence or physical damage
- worse economic performance than expected
In order to ensure the carrying value (= carrying amount = valore contabile, i.e. the amount
reported as the asset's current nominal "worth" for accounting purposes) is not impaired with
reality, companies are requested to perform an impairment test.
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The impairment test identifies the recoverable amount (valore recuperabile) of an asset. The
recoverable amount is the higher value between the fair value and the value in use, which is
evaluated at the discounted present value of estimated future cash flows expected to arise from
its continuing use plus its disposal at the end of its useful life (valore d’uso = valore attuale di tutti
i guadagni derivanti dall’attività in possesso più il prezzo di vendita).
If (Recoverable amount > “Expected” carrying value), this means that the real value of the
asset is higher than what is reported: the item is not impaired.
If (Recoverable amount < “Expected” carrying value), this means that the real value of the
asset is lower than what is reported: the item is impaired at the recoverable amount.
Case
Firm A owns an asset with useful life of 10 years, purchased at 31/12/2012 for 10.000 k€.
The asset is valued at cost model.
In 2018 an impairment test has been performed on the asset. The value in use of the asset is
3.000 k€ and the fair value is 4.000 k€.
Solution:
Carrying amount (01/01/2018) = asset cost - accumulated depreciation = 10.000 k€ - (5*1.000k€)
= 5.000 k€
Where the depreciation is 10000k€ /10 years = 1000 K€
Recoverable amount = max (3.000 k€ ; 4.000 k€) = 4.000 k€
Since the Recoverable amount < Carrying amount, the item is impaired at the highest between fair
value and value in use (4.000 k€) and the impairment loss (1.000 k€) is registered in Income
statement.
Some notes about non-current assets:
• Property, Plant and Equipment: for IAS16 they are “tangible assets retained by the company
for a long-term use, which are instrumental to the profit production (direct use in the production
of goods and services, uses in the administrative activities)”. Some examples are production
machineries, office machines, building, factories, lands…
They must be depreciated, with the exception of lands. The suggested model for depreciation is
straight-line depreciation.
• Investment property: this represents a property under a financial lease to earn rentals of for
capital appreciation or both. It is similar to tangible assets in Italian (and other national)
traditional balance sheets but it is included in a specific category.
• Intangible assets: IAS 38 defines intangible assets as “an identifiable non monetary asset
without physical substance”.
The three critical attributes of an intangible asset are: identifiability, control (power to obtain
benefits from the asset) and future economic benefits (such as revenues or reduced future
costs).
Not all the categories of intangible assets included by Italian (and other national) legislation are
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allowed by IAS/IFRS. The main items excluded by IAS/IFRS from Balance sheet are start-up,
pre-opening, and pre-operating costs, training cost and advertising cost.
An intangible asset may be acquired by the enterprise in three ways:
- by separate purchase.
- as part of a business combination
- by self-creation (internal generation)
N.B. The acquisition mode influences their recognition (cost model for reporting, BT, but with
differences on costs computation accordingly to the purchase mode).
Once defined the initial recognition IAS/IFRS divide Intangible assets in two categories:
- Other intangibles assets with finite life (e.g. Patent)
- Intangible assets with indefinite life (e.g. Goodwill)
• Goodwill: it arises when a company acquires another company for a price in excess of fair
market value of net identifiable assets acquired.
It represents the value of all favourable attributes that relate to a business enterprise.
It is recorded only when there is an exchange transaction that involves the purchase of an entire
business. Accounting goodwill does not equal economic goodwill.
Regarding the measurements:
- Initial measurement: the initial measurement is equal to the purchase price minus fair market
value of net assets acquired.
- Measurement subsequent to acquisition: it is not amortized, but must be assessed for
impairment.
N.B. Why might an acquirer pay more to purchase a company than the fair value of the target
company’s identifiable assets net of liabilities? Because there are items which have (or have
created) value but not recognized in financial statements. That items are:
1. Reputation: once distribution system is established, trained employees have value but they
are not recognized in company’s own financial statements.
2. Expenditures of target company in research and development may not have resulted in a
separately identifiable asset, but nonetheless may have created some value.
3. Strategic positioning versus a competitor or from perceived synergies may increase the
value of an acquisition. (e.g. the acquisition might have been aimed at protecting the value of
all of the acquirer’s own existing assets)
Case
Company A acquires fully Company B, at 5.000 k€.
Knowing the following data on assets and liabilities of Company B:
- Property/plant/equipment= 7.000 k€ (Fair Value of PPE = 9.000 k€)
- Intangible Assets = 4.000 k€
- Liabilities = 11.000 k€
What is the fair market value of net assets acquired?
Total Asset (at Fair Value) = PPE (at fair value) + Intangible assets = 9000 + 4000 = 13.000 k€
Total Liabilities = 11.000 k€
Fair market value of net asset aquired = Total assets (FV) – Total Liabilities
= 13.000 k€ - 11.000 k€ = 2.000 k€
Goodwill = acquisition cost - fair market value of net asset aquired
= 5.000 k€ - 2.000 k€ = 3.000 k€
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• Financial assets item could be present both within current and non-current assets, accordingly
to the related time-horizon. Financial assets refers to the general principles governing financial
instrument, which is a contract that gives rise to a financial asset of one entity and a financial
liability or equity instrument of another entity.
In particular, a financial asset is any asset that is:
- cash
- an equity instrument of another entity
- a contractual right:
a) to receive cash or another financial asset from another entity.
b) to exchange financial assets or financial liabilities with another entity under conditions that
are potentially favourable to the entity.
Liabilities
The liabilities are divided in:
• Non current liabilities: reporting stakeholders rights over enterprise’s resources in long-run.
• Current liabilities: reporting those to be settled within the enterprise normal operating cycle or
due within 12 months.
Case:
Firm contracted a debt of 10.000 k€ on 1/5/2017 to be settled within 12 months.
The firm pays interest for 1.200 k€ at the repayment of the debt.
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How do you register the operations in the financial statements of the year 2017 and 2018?
• Equity: represents all the rights shareholders have on the firm.
The total variation of shareholders’ right is registered in the Net profit item during the year of
exercise. At the end of the year it could be distributed to shareholder (distribution of dividends)
or kept in reserves (profit brough forward and Reserves).
Shareholders rights derive from two phenomena:
- Direct capital payment: at the moment of the establishment of the company or later on
(capital increase)
- Changes in the capital value due the management activities of the enterprise, that
“offbalance the BS”, creating changes in shareholders’ rights.
N.B. Equity is the residual interests in the assets of the enterprise, after deducting all its liabilities:
EQUITY = TOTAL ASSETS – THIRD PART LIABILITIES
Some notes about equity:
• Capital: capital accounts for the portion of equity obtained directly by provisions of
shareholders (direct shareholders’ payments are registered as capital). Different provisions paid
by shareholders correspond to different shareholders’ rights on enterprise’s resources or
different level of participation in the enterprise management.
Capital is defined as the total amount of shares subscribed (issued by the enterprise) at their
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nominal unit value, deducting treasury shares and shareholders receivables:
When a business is first established, two decisions must be taken:
- How much equity finance to raise;
- Into how many shares.
These decisions are based on judgment of the promoters of the business, mainly on marketability.
Shares nominal unit value is the value at which shares are initially offered.
Once the firm has started doing its business, value of ordinary shares usually is different from
nominal value. Equity capital rising may also occur:
- new issued shares;
- priced with reference to market prices (the difference between nominal and market value is
registered in reserves).
Equity capital rising occur for new issued shares, priced with reference to market prices, consider:
- N = new shares issued
- MP = market price of new issued shares
- If MP > NV (= Nominal Value of shares)
How to register an Equity Capital Rising:
- N*NV: this is registered in Balance Sheet (Equity part, under Capital)
- N*(MP-NV): this is registered in Balance Sheet (Equity part, under Reserves namely Share
Premium Reserve)
- N*MP: this is registered as a cash inflow, in Cash Flow Statement
Treasury shares are the cost of an entity's own equity instruments reacquired and kept by the
company in its own treasure.
Treasury shares may come from a repurchase or buyback, may be acquired and held by the
Group entity or by other members of the consolidated group.
Treasury shares are registered at nominal value. Gain or loss is not recognised on the purchase,
sale, issue, or cancellation of treasury shares.
As far as shareholders receivables are concerned, previous Italian accounting principles (before
the introduction of IAS /IFRS) did not require to deduce them directly from capital.
• Reserves are additional shareholders’ rights, which have been generated during the normal
operations of the company. They are classified in:
- Share premium reserve: account for the increase of per unit share value
- Profit brought forward: account for profit generated in previous years but not distributed
- Revaluation reserve: changes in (fair) value of items
- Other reserves: i.e. statutory, legal…
Income Statement in short
Income Statement describes the economic value (revenues and costs) of physical and financial
transactions undertaken by the company in a given period (usually, one year). It is drafted
accordingly to the accrual-basis accounting.
IAS allow to present Statement of Income (Profit and Loss Account) under two forms:
- By nature, where costs are aggregated on the basis of their nature (raw materials, staff costs,
depreciation and amortisation…)
- By function, where costs are aggregated on the basis of the activity to which they are referred
(costs of sales, selling costs, administrative cost…)
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The two formats (by nature or by function) differ for the classification criteria of costs:
Regarding the structure:
N.B. Earnings per share: entities (soggetti) whose securities are publicly traded or that are in the
process of issuing securities to the public are required to present the earning per share.
The goal is to improve performance comparisons between different enterprises in the same period
and between different accounting periods for the same enterprise.
Entities should present:
• Basic earning per share: is calculated as follows;
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• Diluted earning per share: is calculated as follow;
Cash flow in short
It summarises the results (inflows and outflows) of the financial transactions undertaken by the
company in a given period (usually, one year).
Cash flow statement is prepared on the cash logic (not on accrual logic) and it shows the
capability of an enterprise to generate cash in a specific period.
IAS/IFRS consider two options in presenting the Statement of cash flow:
• Direct method, where cash inflows and outflows are classified by nature.
• Indirect method, where cash inflows and outflows are initially derived by adjusting net profit for
the effects of non-cash transactions (e.g. depreciations).
Statement of cash flow classifies cash inflows and outflows in three category:
• Cash flow from operations, i.e. financial flows related to the main revenue-producing activities
of the company.
• Cash flow from investing activities, i.e. financial flows related to the acquisition and disposal
of long-term assets and other non-financial investments.
• Cash flow from financing activities, i.e. financial flows related to changes in the equity capital
and debts of the company, as well as in financial investments.
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Statement of changes in equity in short
As we already said, for IAS/IFRS the compulsory documents of Annual Report are:
- Balance Sheet
- Income Statement
- Cash flow Statement
- Statement of changes in equity: a statement showing either all changes in equity, or changes
in equity other than those arising from capital transactions with owners and distributions to
owners.
- Notes to the financial statements
The statement must show:
a) profit or loss for the period;
b) each item of income and expense for the period that is recognized directly in equity, and the
total of those items;
c) total income and expense for the period (calculated as the sum of (a) and (b)), showing
separately the total amounts attributable to equity holders of the parent and to minority
interest;
d) the effects of changes in accounting policies and corrections of errors, for each component of
equity.
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Financial Analysis I
Introduction
Financial Anais aimed to obtain a deeper understanding of the performance of an entity/group.
The focus is not only on the results but also on how we get the result.
There are many reasons to do financial analysis:
• M&A contexts
• benchmark analysis (intra-sector)
• identify reasons of positive/negative performances
• understand area of improvements
Official statement actually isn’t enough itself to evaluate the performance of an entity/group for
two reasons:
- It is prepared to satisfy legal requirements; the reason why I prepare a financial statement is
usually to show the net result. But sometimes only looking at the financial statement we can
have some misleading treatments and probably we will have to adjust them in order to highlight
the right performances.
- It is also prepared in accordance with accounting framework: even if you respect accounting
framework sometimes you can have some discrepancies and the accounting treatment could
have not the same management view.
But financial statement isn’t useless for the purpose of the analysis because is the starting point
of the whole analysis and also because there is attached the management report (technically not
part of the financial statements) which helps the understanding of the financial statements as it
provides additional information over the performance, some additional indicators and an outlook
of the performance.
Information included in the management report is important but:
• There is a lot of sell side vision bias: management report typically includes over-emphasis
towards positive features of the performance and optimism for future outlook.
• Focus on EBITDA / EBIT / NFP: such measures can be quickly considered by analysts, but
sometimes it is difficult to understand their genesis.
• discretionary measures: there is subjectivity under some measures like non-recurring items.
Said that, financial analysis is necessary.
Critical analysis of data available
When you look at the financial statement of a listed company, it provides more information of the
non-listed companies one. It is also more structured compared to non-listed companies’ financial
statements and subject restrictions and transparency obligations towards stakeholders and
investors.
In fact, sometimes the management of non-listed companies prefer to avoid to include some
informations in order to maintain their competitiveness.
It is important to highlight this differences:
• Non-Listed Italian companies prepare Financial Statements in accordance with OIC GAAP
(“organismo italiano di contabilità”)
• Listed Companies (European Groups) prepare Financial Statements in accordance with IAS/
IFRS, but also most of non-listed Italian companies can opt to choose IFRS for their financial
statements.
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• Listed Companies (USA) prepare Financial Statements in accordance with US GAAP and
Italian companies that report to the parent company in the US must follow them.
The accounting rules are continuously evolving. When analyzing financials prepared under the
same GAAP, analysis over the years must take into consideration any changes in the accounting
rules impacting on the financials, so as to make analysis “consistent”.
Accounting treatment of lease in the different frameworks generates significant impacts on
EBITDA reported.
Reclassification of data
Once you have a clear understanding of the financial statements, it is necessary to perform a
reclassification of them. In fact, reclassification of the financial statements facilitates the
accounting analysis.
Reclassification can be relevant for statements presented in more structured layouts (ex.: ITA
GAAP presentation – OIC)
Reclassification serves also an analysis purpose (and not a compliance one). Criteria can be
different. Among the various, re-classification can be interesting for current vs. non-current items.
Balance sheet - Assets
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Balance sheet - Liabilities
Income statement
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Cash flow
Ratio calculation and critical comparison
Your choice about the correct ratios to use depends on the aim of your financial analysis.
The most importants are:
• Net working capital, which is the difference between the current assets and the current
liabilities. This difference represents the most important index to assess the ability of the firm to
repay short term liabilities.
NET WORKING CAPITAL = CURRENT ASSETS - CURRENT LIABILITIES
Current assets are:
- Inventory
- Receivables
- Other rec
- Cash
Current liabilities are:
- Current financial liabilities
- Trade payables
- Other payables
• Net financial position is a key performance indicator which usually hold the listed company in
financial report. It is given by the difference between financial liabilities and cash/cash
equivalents. NFP summarizes the level of indebtness towards borrowers of financial resources
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to the firm. In the re-payment to the borrowers, entity shall take into consideration the cash and
equivalents, but also short term financial receivables.
NET FINANCIAL POSITION = FINANCIAL LIABILITIES - CASH/CASH EQUIVALENTS
Financial liabilities are:
- Non-current financial liabilities
- Current financial liabilities
• Net financial position/EBITDA: financial metric that indicates the “virtual” number of periods
that are needed to repay the financial liabilities.
• Net financial position/cash flow from operations: in comparison to the previous ratio, this
index is immediately focused on the ability to generate cash from operations.
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• Leverage: financial metric that measures the amount of leverage used by a company. Leverage
amplifies the good or bad effects of the income generation and productivity of the assets in
which we invest.
Leverage is an investment strategy of using borrowed money to increase the potential return of
an investment.
• Return on equity (ROE): it is considered the return on net assets and a measure of how
effectively management is using a company’s assets to create profits.
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• Return on investment (ROI): it measures the return of the capital invested.
• Day sales outstanding (DSO): it is a measure of the average number of days that it takes to
collect payment after a sale. DSO can be calculated on a yearly basis (365) or pro-rated to
shorter periods.
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• Day payable outstanding (DPO): it is a measure of the average number of days that it takes to
pay suppliers after a goods/services are received. DPO can be calculated on a yearly basis (365)
or pro-rated to shorter periods.
Once we have determined the amount of these ratios, it is useful to performe a comparison, in
order to determine two kind of performance:
• Performance year-on-year basis, whose attention points are:
- Accounting principles may change over time and companies adopt them accordingly ;
wheras operating activities do not changes, accounting results may be different as they
reflect different criterias.
- Extraordinary operations / events may be taken into considerations
• Performance intra-sectors (Benchmark), whose attention points are:
- Industry matters: many groups are diversified or they incorporate specific operations of the
value chain; identification of the proper sector / sub-sector where the entity operates is
crucial.
- Understanding the business model is also crucial.
Pratical Application: Tod’s and Geox
The aim of reclassification of data is to compare financial statements prepared through different
accounting principles.
But is reclassification needed for compliance? Shall the entities make a reclassification in their
financial statements? The answer is no. Financial schemes are prepared according to each
accounting frameworks: so reclassification is used only by the stakeholders in order to
understand what are the performances of the group and what are the key items of each
statements.
There are different types of reclassification, in fact balance sheet and income losses can be
reclassified under various methods. It depends for what the investiture is looking for.
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Typically, balance sheets are reclassified in order to summarise current/non-current activities and
current/non-current liabilities, while income statements are generally reclassified in order to show
most common KPIs such as EBITDA, EBIT and EBT.
For the purpose of a practical application we reference herein to two groups belonging to the
same sector: shoes manufacturing. We compare financials of two entities: TOD’S S.p.A. and
GEOX S.p.A. Statements can be found as included in the Annual Reports for the year ended
2019.
In terms of balance sheet, we have both financial statements of Geox and Tod’s.
As we can see, they are prepared according to IAS/IFRS so no reclassification is needed because
they are already aligned.
The assets are divided in non-current assets and current assets for both the entities. Then in the
non-current assets we have that assets which are mainly fixed (right of use, intangibile, other
intangible and property plant & equipment) then we can have other non-current assets such as
the financial receivables which are due in more than one year and other investments
(partecipation in other companies).
In the current assets we usually have the inventory, the account receivables that are due in less
than one year, the cash and the cash equivalents and other current assets (typically tax
receivables or prepayments).
On the liability side, we have non-current liabilities which are usually provisions for more than one
year, employee funds, deferred tax liabilities, financial liabilities, finance lease and other noncurrent liabilities. While in the current liabilities we can find what is due in one year.
While the difference in terms of balance sheet is usually difficult to understand, usually
understanding income statements result easier.
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As we can see, the reclassification was necessary because Tod’s income statement was classified
by nature while Geox’s one was classified by destination.
In these reclassified income statement, first of all we have the EBITDA, which is determined by a
difference between the total revenue and the cost of production. EBITDA is “earning before
interest taxation depreciation and amortization”.
After the EBITDA there is depreciation and amortization, which is the annual amount of each fixed
assets that are calculated based on the useful life.
The difference between the EBITDA and the depreciation and amortization is the EBIT, which is
“earnigns before interest and taxation”. After EBIT we have Interest expense/income which are
the results the financial position of the company.
After that, the difference between EBIT and net financial position is EBT, which is the EBT (earning
before taxes) and then we have the last cost which is represented by the taxes, which are divided
in deferred and current taxes.
Finally, the difference between EBT and the taxes is the net income.
But why in Geox the taxes are positives even if the EBIT is negative? This is due to deferred
taxation which is mainly the taxes that will be paid in the future.
In fact the tax income line is composed by two lines:
• Current taxes: they are calculated multiplying the EBT for the taxation rate (in Italy there is IRES
which is equal to 0,24).
• Deferred taxes: they are calculated by the difference between the accounting principle followed
by the company and the local legislation. It’s similar to a consideration like I have a cost in my
income statement but I have to pay the rated tax not in this year but in the following. (es.
deferred taxes min. 42 registrazione).
We have here the reclassification of both cash flows.
For the cash flow statement there isn’t a mandatory scheme, also for companies which adopt the
Italian GAAP (there are just suggested schemes).
The cash flow has three main areas:
• Cash flow from operating activities
• Cash flow used in investing activities: cash generated or paid throw investments.
• Cash flow from financial activities: for instance, the amount that the company received because
it has financial receivables or the amount that the company paid to the third party to reimburse
financial liabilities.
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Now let’s start with ratio calculation and critical comparison.
Balance Sheet
What are the main analysis that can be made into a balance sheet?
As example, once we have determined the main ratios, we should be able to answer to these
questions:
• Are the two companies able to meet short-term obligations? Are they in a going concern issue
(problema di continuità) or not?
• What is the level of debt? Are they in a high debtness situation or not?
• What are the caractheristics of the asset composition? What are the fixed, current and noncurrent assets of the entity?
• Is the company well managing cash flows through Accounts Payables/Receivables? Are they
managing good cash flow from current and non-current liabilities or not?
1. Are the two companies able to meet short-term obligations?
Let’s calculate the Net Working Capital of each company.
Remember that:
NET WORKING CAPITAL = CURRENT ASSETS - CURRENT LIABILITIES
Regarding Tod’s: NWC = 600.657 - 327.619 = 273.038
Regarding Geox: NWC = 499.835 - 335.752 = 164.083
Let’s calculate now NWC excluding cash.
NET WORKING CAPITAL w/out cash = (CURRENT ASSETS - Cash) - CURRENT LIABILITIES
Regarding Tod’s: NWC (w/out cash) = (600.657 - 86.426) - 327.619 = 186.612
Regarding Geox: NWC (w/out cash) = (499.835 - 36.064) - 335.752 = 128.019
For both the two firms, NWC and NWC (w/out cash) are positives: this means that the current
assets of the two entities are enough to cover the current liabilities.
If the NWCs would have been negatives, this would have been a really bad condition for the
entities, because they wouldn’t have enough resources to pay the liabilities.
Then we can also calculate the Quick Ratio, which is determined as:
Quick Ratio = (Cash + Short term investments + Receivables) / Current Liabilities
Regarding Tod’s: (86.426 + 186.062)/327.619 = 0,83 (83%)
Regarding Geox: (36.064 + 188.390)/335.752 = 0,67 (67%)
Those results mean that by using quick current assets (Cash and equivalents, Account
receivables), Tod’s is able to repay the 26% of current debts, while Geox only 11%.
2. What is the level of debt?
Let’s calculate the leverage of each company.
Remember that:
Leverage = Financial liabilities/Equity
Regarding Tod’s: Leverage = (84.023 + 136.272 + 87.822 + 22.084)/958.983 = 0,34
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Regarding Geox: Leverage = (10.562 + 73.965 + 66.512 + 19.584)/308.531 = 0,55
In the determination of leverage amount we consider current and non-current financial liabilities
and also the finance lease, which is the financial liability coming from the application of the
leasing.
There is also another leverage, which is calculated without the finance lease, because it is mainly
due to the application of the IAS/IFRS standards before 2018. In fact before this year you had to
consider as financial liability only financial leasing, because operating leasing was considered just
as a cost.
Regarding Tod’s: Leverage (w/out lease impact) = (84.023 + 87.822)/958.983 = 0,18
Regarding Geox: Leverage (w/out lease impact) = (10.562 + 66.512)/308.531 = 0,25
The reason why financial analysts continue to calculate leverage without the finance lease is
because so the leverage is comparable between different years and different companies.
As we can see, in both cases Geox has a greater leverage compared to Tod’s, even if both firms
have a low level of debtness. Usually firms have a level of indebtedness greater than 1, in order to
finance their investments.
Let’s calculate now Net Financial Position.
Remember that:
Net Financial Position = Financial Liabilities – Cash & Equivalents – Financial Receivables
Regarding Tod’s: (84.023 + 136.272 + 87.822 + 22.084) - 86.426 = (-) 243.775
Regarding Geox: (10.562 + 73.965 + 66.512 + 19.584) - 36.064 = (-) 134.559
The results are negatives because financial liabilities must be considered as a negative amount,
while cash & equivalents as positives amounts.
When you have positive NFP, this means you have more cash and financial receivables than
financial liabilities.
By dividing the NFP for the EBITDA/Cash Flow from Operations for each company, we can
understand the ability of the company to pay the Net financial position in a very short term.
Usually since NFP includes also non current liabilities, the annual EBITDA isn’t enough to cover
the NFP.
For both the companies, the NFP is more than 4 times of the EBITDA.
On the other hand, as far as Tod’s is concerned, the NFP is about to 11 times bigger than the
cash flow from operations, while for Geox is only about to twice.
3. What is the cost of debt?
Another ratio is the cost of debt, which measures the cost of debt for each company.
It is determined as follows:
Cost of Debt = Interest expense/Financial Debt
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We can see that Geox has best contracts with financial institutions, while Tod’s has worst contract
in term of interests.
4. Is the entity well managing the Net Working Capital
We have two other key ratios, which are DPO and DSO.
We can calculate them by using the balance sheet of both companies and the income statements.
In order to get the DPO, we must divide the account payables per the cost of production
(excluding the change in the inventories fp and sfp).
Regarding Tod’s: DPO = 137.733/(565.730*1,22) * 365 = 72,83 days
These are the average days in which Tod’s pays account payables.
N.B. 565.730 = Raw Material and Consuables Expenses + Services Expenses + Lease Expenses
+ Employee Expenses + Other OpEx
1.22 = VAT (IVA)
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DSO is calculated by dividing the account receivables for the net sales and multiplied per 365
days.
Regarding Tod’s: DSO = 186.062/(613.831*1.22) * 365 = 92 days
These 92 days are the average days for collecting the receivables.
We see a DPO which is lower than the DSO, so at the end of the day Tod’s is paying it’s supplier
quicker than time that Tod’s collect its own receivables from the customers.
This is not a good sign in financial analysis, because we pay faster than we receive. The best
situation is when DPO > DSO.
Income Statement
What are the main analysis that can be made into an income statement?
As example, once we have determined the main ratios, we should be able to answer to these
questions:
• Is the company profitable?
• How are the profits generated? What are the sources of losses/margins?
• What is the impact of «accounting» measurements like: amortization, deferrals, estimates?
Let’s calculate the ROE.
Remember that:
ROE = Net Income/Result
We can immediately see that Tod’s has increased its equity by 3,2% in the year. It’s not a good
profitability, but it’s a positive situation, while Geox has decreased its equity by 11%.
Let’s calculate now the ROI.
Remember that:
ROI = Operating Result/(Tot. Assets – Non-Financial Liabilities)
As we can see, Tod’s registered a positive ROI, while Geox didn’t.
Here we highlight which are the main margins of profit and loss.
For Tod’s the EBITDA is positive (51.487) such as for Geox (31.712). Even if these two ratios are
similar, for Geox the EBITDA isn’t enough to absorb the Depreciation & Amortization (which is
clearly higher than the EBITDA) leading to a negative EBIT.
Always regarding Geox, from the notes in the financial statement we can see that in the cost of
production there are three millions of restructuring expenses, meaning that there are extraordinary
costs that are not usually repeated across the years.
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Looking at financial position, this positive for Tod’s (22.416), meaning that it gives a good
contribution to the net income, while on the other hand for Geox it is negative (24.894) that worse
the position and the margins because EBIT was already negative and with a such negative
financial position the EBT goes down to -36.523.
Variance analysis
The last section is related to the financial analysis, which is aimed to compare two different
periods and, in this case, we compare the 2019 with the previous year (2018).
Balance sheet
In terms of balance sheet, we compare the different amounts of 2019 and 2018 in order to
calculate the variation in percentage and in absolute value and we can comment the variation for
each company.
For example, in Tod’s balance sheet is registered in right of use section, because in 2018 they
were equal to 0, while at the end of 2019 they amount to 158.839. This is due to application of the
IFRS 16 in the 2019: in this year the company booked these assets coming from these contracts
and relevant liabilities, while previously the rights of use were considered just an operative leasing.
There are no more significant variation for the others intangible assets.
We can see that tangible assets increased for 11.160 (13.2%). Usually tangible assets are moved
for three factors:
• Capitalization of the year, meaning that I’m buying an implant, an equipment, so I am
capitalising my expenses;
Depreciation
of the year, meaning the reviews of the value of intangible assets;
•
• Disposal of the year, meaning that I have disposed on or more of my tangible assets.
Moving on investments, there is a significant reduction (-103.035): it seems that Tod’s has sold
one or more of its participation in its subsidiary.
Moving to current assets, there are significant variations in account receivables, inventory cash &
cash equivalent. There are a lot of reasons for the inventory increase, also negative, such us
unsold final products.
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The reduction of account receivables is mainly due to the improvement of the day sales
outstanding. Since the time for collect receivable has reduced, also the number of account
receivables has decreased.
To understand cash & cash equivalents variance, the answer must be found in the cash flow
statement.
Going to equity, its variation ( is fully due to the net results of the period (33.758). Usually equity is
moved throw net result or throw the distribution of dividends.
In terms of non current liabilities, the variation is due to finance lease (always for the application of
IFRS 16).
Regarding current liabilities, there are significant variations. The first one is in the current financial
liabilities, it decrease for 80.177, probably because some of them have been included in non
current liabilities.
Income statement
Watching the variation of the income statement of a company is important in order to understand
how the company is performing and how the operations going.
Regarding total sales, there has been a decrease of 5%. This is not a good sign, but it has some
reasons of course, highlight in the notes or in the management report.
Going down, we can see the EBITDA is half then a previous year, another bad sign.
What is important to say is that operating expenses has decreased about to 5%.
It is equal to operating expenses, because there are no extraordinary expenses (which are
considerate in EBITDA)
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In terms of D&A, there is an increase of depreciation due to the application of the new accounting
principle, which generate the amortization of right of use.
Regarding the EBIT, there is a decrease of 96%. This is always a bad sign.
Tod’s has also a huge income from its participation (33.757). This are the dividends paid by its
subsidiary. This is what makes Tod’s balance sheet positive.
Cash flow statement
In the cash flow from operating activities, there is an improved cash flow, mainly due to the fact
that DSO has improved (422%).
Regarding cash flow from operating activities, there is a huge decrease due to the fact Tod’s has
less expenses and less capitalization (they also sold a subsidiary).
Moving to Cash flow from financing activities, there is a decrease mainly due to the fact IFRS 16
application and has also a big number of current financial liabilities.
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Financial statement consolidation
What is a group
A group of companies is an economic entity which is composed by a set of companies (which are
separate legal entities).
In particulate a group you can find:
• A controlling entity (which is called parent/holding)
• One or more controlled entities (subsidiaries)
We will focus on group accounting, which answers the question “how we can manage, how we
can account for the results of the entire group?”
Keep in mind that we will see the accounting practice (so we will need to be able to account the
numbers of the results of a group) but in reality group of companies could be really complex and
with a lot of interrelation with each other.
This are most common examples of group companies.
We need to be more precise. We need to clarify what is a subsidiary (which is the controlled
company in a group) and how we can recognize the subsidiary.
In order to identify a subsidiary, it is important to distinguish between the investment in a
subsidiary and other types of investments.
The parent company can have different types of investments with other legal entities. Depending
on the type of investment that the parent company is making, the other entity (the company on
the other side) can be of three different types:
• Subsidiary
• Associate
• Joint venture
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This is absolutely important since a different type of relation will require a different accounting
approach.
In order to be more precise, we have a parent company which could have three type of
investments:
• Subsidiary: only the relation between the parent and the subsidiary forms a group, because the
control of a company means that the power is held by the parent.
- Criteria: control (the parent company control the subsidiary)
- Accounting method: full consolidation
- Reference IAS/IFRS: IFRS 10, IFRS 3
Associate:
in the relation between the parent and the associate, the parent doesn’t have the
•
power/control, but just a significant influence (it takes part in decision making process, but it’s
not the one who make the final decision).
- Criteria: significant influence (exercised by the parent company on the associate)
- Accounting method: equity method
- Reference IAS/IFRS: IAS 28
• Join Control: regarding the relation between the parent and the joint venture, this last one
occurs when the parent invest some money together with someone else and they are
controlling another entity (typically in equal part).
- Criteria: joint control
- Accounting method:depend on type
- Reference IAS/IFRS: IFRS 11
If we have an investment in an associate or in a joint venture, we will see it in the section
“investments accounted for using the equity method”. It is in non-current assets.
In the case of Fiat-Chrysler, it invested an overall value of 2000€ in associates or in joint venture.
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What can we do if we want know in what associates and joint venture arrangement Fiat-Chrysler
did invest? We can see the note 12 next to the overall amount, which is the note in the financial
statement which gives us some details.
We can see that the overall value (equals to 2009€) is divided: 1871€ are invested in joint venture,
while 94€ in associates.
FCA’s ownership percentages and the carrying value of investments in joint ventures accounted
for under the equity method were as follows:
Equity method
We are investing for the first time in a company throw the equity method.
Equity method is used when the investor holds significant influence over investee, but does not
exercise full control over it, as in the relationship between parent and subsidiary.
Unlike in the consolidation method, there is no consolidation and elimination process.
The investor reports a proportionate share of the investee’s equity as an investment (at cost of
acquisition):
• Profit/loss from the investee increase/reduce the investment account by an amount
proportionate to the investor’s shares;
• Dividends paid out by the investee are deducted from this account
So, according to the IAS/IFRS, what we do is the initial recognition. The first time we buy the
shares of an associate, what we do is that we recognize the investment in the balance sheet
(financial assets, investments in associates) and we counter balance it with a reduction of cash (if
we pay in cash).
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What happens in the year after the initial recognition?
Basically, we recognise two different things:
• On one hand we recognise the investor’s shares on investee’s income statement: so what we do
is highlight the profit/loss from this associates (“profit from associates”) in net financial position.
We can counter balance it increasing or decreasing the account “investments in associates”.
• In the other hand, if you receive distributions (dividends) from investee, you receive cash and
you can counter balance it by adjusting “investments in associates”.
This is an overall review of what can happen to a company.
Why do we need to account for a group? In order to provide a more complete view to
stakeholders about the overall performances of the group.
Consolidated financial statement
Consolidated financial statements combine the financial statements of separate companies that
belong to the same group into one financial statement for the entire group.
The consolidated financial statement shows the accounts of the group as though the different
legal entities were one single legal entities.
How can we consolidate?
In practice, what I can do is taking as reference the IFRS 10, which establishes principles for the
preparation and the presentation of the consolidated financial statement when an entity controls
one ore more other entities. There are 4 key points:
• It requires a parent that controls other entities to prepare a consolidated financial statement;
• It defines the principles of control;
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• It sets out the accounting requirements and the procedures that must be followed in order to
prepare a consolidated financial statement;
• It sets out the exception to consolidation requirements.
Definition of control
According to IFRS10, “an investor controls an investee when it is exposed, or has rights, to
variable returns from its involvement with the investee and has the ability to affect those returns
through its power over the investee”.
So we have the control when three conditions occur:
• When a company has the power on another one: the company has the power when it has the
majority of voting rights (>50%). You can have power even though you haven’t the majority of
voting rights if the remaining shares are splitted through a lot of other companies (potential
voting rights). You could also obtain it through contractual rights.
That’s the reason why power is connected to substantive power, which means even if you
don’t have the majority of the share you can decide anyway, and so you can decide on the
relevant activities.
• There is control in the moment in which I am taking a risk, which means that I am exposed to
variable returns. You can have various responses in terms of performance, that could be
positives, negatives or both.
• You have the ability to affect the return, you have the possibility to give a direction on the future
results of the company.
If this three conditions exist, you have the control.
We need to distinguish when a company is a subsidiary or an associate of ours.
If we have more than 50% of voting rights, it’s clear that the company is controlled and it is a
subsidiary.
The problem is when the percentage is less than 50%. How can we distinguish a subsidiary from
an associate?
Thanks to the other two points: even tough we haven’t the majority of the voting rights, if you are
exposed to variable returns and you also have the ability to affect the return, you have clearly the
control, so the company is a subsidiary.
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Example
Green Co owns the following investments in other companies:
Green Co also has appointed five of the seven directors of Black Co.
Equity shares are the amount of money invested in other companies, while non-equity shares are
the portion of the shares of the companies in which we are making the investment but that we
don’t control.
1. How do we know that a company is a subsidiary?
When the parent owns more than the 50% of equity share and also when, even tohough the
parent owns less than the 50% of the voting rights, it has the power to affect returns.
2. Could we consider Violet Co as a subsidiary of Green Co?
Yes, because Green Co has more than 50% of the voting shares (80%).
3. Could we consider Amber Co as a subsidiary of Green Co?
No, because Green Co only have 25% of the equity shares, so they do not have control and
voting power.
4. Could we consider Black Co as a subsidiary of Green Co?
Yes, because Green Co has appointed five of the seven directors, so it can affect the decision
making process in the company Black Co.
How to consolidate
If I have to consolidate, what I’ve to do? I’ve a parent in Italy and three subsidiary (in Italy, in
France and in China). I’ve to consolidate, which means I’ve to prepare this financial statement
which sum-up the final results of the parent plus the final results of the three subsidiary.
So the assets of the group will be the sum of the assets of the 4 companies. Same speech for the
profit, the liabilities ecc.
Pre-consolidation adjustments
Pre-consolidation may be not necessary, it depends whether we need something to adjust or not
(while consolidation process is absolutely required).
Before starting the consolidation process, we have to align the closing period, the accounting
policies and the reporting currency between the different companies. It is a necessary passage in
order to assure coherence.
Closing period
We can consolidate companies which should the same closing period.
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We can see that the fiscal year for the 4 companies is different. Italian companies and Chinese
one have the same fiscal year, but the American one is different.
We cant sum-up the results of companies with a different fiscal year.
What can we do? The IFRS10 gives us some suggestions.
When the closing date of the financial statements of one or more subsidiaries is different from that
of the parent company, the subsidiary prepares interim financial statements at the closing date
of the parent company.
So, while Italian and Chinese subsidiary give to the parent the financial statement at the end of the
year, the American company has to prepare an interim financial statement (an additional report
that cover the fiscal year of the parent company, so since 1st January to 31st December) at the
end of the year.
When this is not feasible, the closing date of the financial statements of the subsidiary and the
parent company is allowed to be different on condition that:
• the difference between the closing dates does not exceed three months (in this case, American
company’s closing date does not exceed the three moths of difference, so we can sum up the
result with that financial statement);
• the duration of the financial year and the difference between the closing dates remain constant
over time;
• adjustments are made for significant transactions and events which occur between the closing
date of the subsidiary and the closing date of the parent company.
Accounting policies
If you are in a situation in which you have companies worldwide, you will have different
accounting policies.
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As we can see, in Italy we have the IFRS, in the USA we have the US GAAP, while in china we
have the China GAAP.
When one or more subsidiaries use different accounting policies than those adopted by the
group for similar transactions, then appropriate pre-consolidation adjustments are made as part of
the consolidation process. Operationally this can be achieved:
• By applying in the subsidiaries' individual accounts the accounting policies adopted by the
group, to the extent that these are not in contrast with local law (so, given that the parent is
Italian, all the subsidiary should prepare the financial statements following the IFRS);
• By requiring the subsidiaries to provide individual statements for the consolidation process
appropriately adjusted to be consistent with the accounting policies used for the consolidated
financial statements.
For instance, under US GAAP, Research & Development costs are expensed as incurred, but
under IFRS Research costs are expensed, like US GAAP, but, unlike US GAAP, IFRS has broadbased guidance that requires companies to capitalize Development expenditures, when certain
criteria are met.
Reporting currency
Reporting currency must be the same.
As we can see, each country as a different currency.
If the scope of consolidation includes companies that keep their accounts in a currency that is
different from the reporting currency of the consolidated financial statements, it is necessary to
translate financial statements denominated in currencies other than the reporting currency of the
consolidated financial statements.
Income statement items (including the profit for the year) are translated at:
- The effective exchange rate at the date of each transaction, or;
- The average exchange rate of the financial year.
Balance sheet items, except for the profit for the year, are translated at the exchange rate at the
reporting ("closing") date of the consolidated financial statements.
Consolidation process: simplest scenarios
Now that everything is aligned and ready for consolidation, how do we consolidate?
We have three main phases and we will discuss each one.
We have to combine like items (e.g assets, liabilities, equity...) of the parent with those of its
subsidiaries, then we have to offset the carrying amount of the parent’s investment in each
subsidiary and the parent’s portion of equity of each subsidiary, and lastly we have to eliminate
the intragroup transactions.
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Combine
This step consists in combining assets, liabilities, equity, income, expenses and cash flows of the
parent with those of its subsidiaries; each item shall be added according to its accounting
category.
Let’s see this example:
We have annual reports of the companies A and B.
We now sum up as follow:
Offset
If we simply sum up everything, we’re a little bit overestimating, because we want to results of the
overall group, but we also want to consider what happen inside it, so we need to delete what is
happening between our companies (otherwise we would increase the value of the company).
As far as second phase is concerned, we need to eliminate the fact that the parent is investing in
the subsidiary and the fact that the parent is controlling a part of subsidiary’s equity.
Let’s consider again another simple example.
We have the company A (the parent) which acquires a 100% of the subsidiary's shares.
There are no other kind of transactions inside the group, the only one is the fact that A acquires B.
Also, the value of the investment matches the book value of the subsidiary’s equity. In other words,
A acquires B for the exact amount of B’s equity (100).
Our purpose is to represent the situation as if A had acquired all the assets and liabilities of B
directly and in order to do so, we need to offset the item 'Investments' against B's equity value.
Since the investment in B (i.e. the accounting item "Investments") already incorporates the value
of B's assets and liabilities, we need to make sure that we are not counting those values twice.
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We just eliminate the amount of the investment of A in B.
How do we counterbalance this number (equal to 100?). With the value of A’s equity.
So we delete the investment, then we counter balance it by deleting the same amount of the in
the equity. That’s the right way to not consider what happens between the two companies and to
not overestimate the value of the group.
This is the simplest scenario ever, when the investments are equal to the equity because there is
no goodwill.
Eliminate
The third step is about if there are some transactions between the parent and the subsidiaries, we
need again to remove them, because without this we wold overestimate the group.
In fact, the supply of goods from one company to another within the group is equivalent, from a
consolidation point of view, to the 'transfer' of goods from one warehouse to another, within the
same company. So, intra-group supplies should leave the consolidated financial statements
untouched.
Furthermore, financing provided by a holding company to subsidiaries is equal, in terms of the
consolidated financial statements, to a 'cash transfer` from a division to another within the same
company.
IFRS 10 requires the full elimination of intra-group transactions between entities of the group, that
consist in:
- infra-group revenues and costs, receivables and payables;
- intercompany profits and losses, related to inventories and fixed assets;
- infra-group dividends.
From the perspective of the consolidated financial statements, the transactions that occur
between group companies are equivalent to transactions between divisions/ functions within a
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single company. Such transactions cannot be presented in the consolidated financial statements,
as these must present only those transactions that group companies have made with third
parties, i.e. outside the group.
Let’s see another example.
Company A has an 80% stake in Company B. A provided services to B for a total amount of 500
and company A has recognised the related revenue under operating revenues while company B
recognised the related costs under operating costs. On 31.12.X the transaction is settled only
partially, and intercompany payables and receivables are recognized for 300.
• Adjustment 1: eliminate the revenues recorded by A (500) and eliminate of the costs recorded by
B (500)
• Adjustment 2: eliminate the receivables recorded by A (300) and eliminate the payables
recorded by B (300)
Consolidation process: real scenarios
We need to move beyond from the simplest and unrealistic scenario. The reason is that it is
impossible to buy a company at the same price of the equity value, it is a situation that is not likely
to happen in reality.
In fact, according to IFRS 10, items should be combined at their fair value, not at the book value:
all the subsidiary assets and liabilities are recognized at their fair values at the time in which control
is acquired.
For instance, when company A acquires company B, what I do is book value of company A + fair
value of the assets and liabilities of company B.
The tax effects on such surpluses must be considered. The differences between the book and fair
values of the recognized items may create 'temporary differences' that will give rise to (or will
lower) taxes in the future. We want to recognize such future obligation (or benefit) though the
separate recognition of deferred tax liabilities (or assets).
Mickey-Mouse Case
On 31 December X company MICKEY buys 100% of shares in company MOUSE. The cost of the
investment is 2.700. The balance sheet of the two companies at the date of the acquisition is
reported in the following table:
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On the acquisition date, the fair value of the assets and liabilities of MOUSE equals their book
value, except for plant, whose fair value is 1.000 higher that the carrying amount, and provisions,
whose fair value is 200 higher than the book value.
The difference between the cost of the investment and owners’ equity is recorded as goodwill.
Consider that the tax rate applied by the two companies is 50%.
What do we have to do?
We have to sum-up line by line, which is the column “combine”.
Then, we have to considerate the fair value, so:
• The value of the plants isn’t 2500, but 2500 + 1000 =
• The value of current and non-current liabilities (provisions) isn’t 4600, but 4600 + 200 = 4800
The variation are in the column “eliminate”, while the final results are in the column “consolidated
SFP”.
Remember that we have to consider taxation, so we need to calculate “deferred tax assets” and
“deferred tax liabilities”:
• Deferred tax assets (risparmio di imposta): 200*0,5 = 100 (si tratta di un risparmio di i’imposta
dal momento che le liabilities sono aumentate).
• Deferred tax liabilities (debito di imposta): 1000*0,5 = 500 (dal momento che il valore delle
attività sono cresciuti, dovremmo pagarci più imposte).
When we account the fair value, if we have a delta fair value in liabilities, deferred taxes are
positive (assets), while if we have a delta fair value in assets, deferred taxes are negative
(liabilities).
Lastly we have to delete the investment, so we delete 2700 (la parentesi significa meno) and then
we can counter balance this with the value of the equity.
We can see that the investment is not the same of the book value. Moreover, total assets are not
equal to total liabilities: the missing match is the goodwill (300).
But why we do eliminate the retained earnings? The reason why is because we have to offset the
investment counterbalancing it with the equity, so we have to delete the book value of the
company we have just acquired. What is the book value/shareolder equity of Mouse? It is made
by shares/common stock (equal to 1500) and the retained earnings (500).
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If the investment value is higher/lower than the book value, we need to calculate the goodwill.
Note: you don’t have to depreciate the goodwill, you have to make the impairment test every year.
Goodwill is an asset representing the future economic benefits arising from other assets acquired
in a business combination that are not individually identified and separately recognized.
The difference between (i) the cost of acquisition and (ii) the parent's interest in the fair value of
the subsidiary's net assets/ liabilities at the acquisition date must be recorded in the following
way:
a) If positive (price paid > fair value of equity attributable to the parent) it must be included as an
asset, to so called goodwill in the consolidated financial statements;
b) If negative (price paid < fair value of equity attributable to the parent), estimates of the fair
values of assets/ liabilities of the subsidiary should be reviewed; the negative difference - if still
existing - must be allocated to the income statement as a gain.
How do we calculate the fair value?
The formula is:
How can we calculate the goodwill in the previous exercise?
The value of the goodwill is clearly the difference between the total liabilities and the total assets.
But what are non controlling interests?
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Non-controlling interests arises when a subsidiary is not wholly controlled.
For example, if a parent owns 85 per cent of a subsidiary, it has to consolidate 100 per cent of the
subsidiary’s net assets and results and report non-controlling interests of 15 per cent.
Regarding FCA financial statements, we have this situation:
With regard to the measurement of the non-controlling interests the investor may choose to
measure a non-controlling interest in the investee, at the acquisition date, according to two
approaches:
• at fair value - the so called full goodwill accounting, or;
• at the non-controlling interest’s proportionate share of the investee's identifiable net assets.
Example:
STAR acquires LIGHT by purchasing 60% of its equity for 300 million in cash.
The fair value of the non-controlling interests is determined to be 200 million.
The company's tax rate is on a 40% basis.
The key figures included in the Balance Sheet of LIGHT at the date of acquisition are summarized
in the table below:
The fair values for all assets and liabilities of LIGHT are equal to their book values, except for a
parcel of land, a building and a trademark. The fair values of those assets are given in the
following table:
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If the company chooses to apply the full goodwill method, the non controlling interests’ value is
equal to their fair value (200 million). In such a case, the total value of the company is equal to the
price paid by the parent company + fair value of non controlling interests
If STAR chooses to record the non-controlling interests at their proportionate share of the
amount of the investee's identifiable net assets, the goodwill recognised and measured in the
consolidated financial statements is only the amount attributable to the portion belonging to the
parent company (i.e. STAR).
The value of the non-controlling interests is 76 (i.e. book value of the proportionate share of the
investee’s identifiable net assets), while The portion of net surpluses belonging to the controlling
entity is 108 (i.e. 180 x 60%)
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Financial analysis: final assessment
This is an overall view of the ratios seen in this part of the course.
How we can perform an analysis? If we have to identify a possible list of phases, that is:
1. Collected the data and then critically analyse the data which are available (total assets, total
liabilities…);
2. Reclassify the data, otherwise you cannot calculate the ratios;
3. Calculate the ratios and make a critical comparison;
4. Make the analysis.
Ratio indicators
Companies often use diverse formulation of the indicators analysed in the theory. In particular the
richest area is the Operating return over the investments, where the numerator and the
denominator have slight variations.
This is the general formula of ROI (that we have already seen), which gives us an idea in terms of
what extent a company is able to transform its investment into operating results. The highest is
the ROI, the better is because we generate an always greater operating result.
There are other ways to determine the ability of the company to generate profit from the
investments. In particular, there are slightly differences in the dominator:
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ROA decomposition
We can determine the composition of ROA as follows:
Tod’s Case
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The four indicators have variations only at the denominator:
Numerator
ROI for Tod’s
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ROA for Tod’s
ROCE for Tod’s
50
ROACE for Tod’s
ROS and Asset Turnover Ratio’s
51
Finance
1
Cash flow
The relevance of cash flow in financial statement analysis
How can we understand whether a company is managing in a proper way or not the cash? By
considering its financial statements!
Basically, the structure of the cash flow statement is where we can find informations in terms of
“has the company enough cash?”.
In the cash flow we can find Cash at the beginning and Cash at the end of the period. Then we
have three different kind of cash:
- Net cash flows from operations (buying and selling products)
- Net cash flows from investing activities (buying and disposing the assets)
- Net cash flows from financing activities (debts and equity)
Remember that the Net cash flows from operations sometimes uses the EBITDA as a proxy,
because it is faster. In fact EBITDA is the difference between operating revenues (which are a
proxy of the cash in) and the operations costs (which are a proxy of the cash out).
But why is cash so important? Cash is very important because it is the basis for creating value.
This is the positive side. In a negative side, without cash a company doesn’t survive, because you
can’t invest in order to make the company creating value.
Typically, there is a common sentence in finance which says “turnover (fatturato) is vanity”,
because the larger is the business of the company, the larger will be the turnover, so people will
be astonished by your company.
There is another statement, which says “profit is sanity”, because you have always to ask
yourself how much you spend to generate that turnover. In fact you can have a huge business,
but if costs are higher than the costs you are not sane.
lastly, we must remind “but the cash is reality”, because it is impossible surviving in the long run
without it.
So, if a company wants to be a strong company, it should must respect this three components.
This to say that it’s important to analyse the profitability of the company and its revenue, but it is
extremely important to check the cash situation of the company.
The case of InnovEnergy
In 2020 Innovenergy has introduced a new service for clients: green consultancy. Clients with a
small additional fee have a check up of the possible savings linked to energy efficiency. To
stimulate clients the apply for the service, in the hard contingency of 2020, the payment from
clients is delayed in 2021 (receivables).
The proposal is successful and the additional turnover (revenues) for the first semester was
4,000,000€.
In September the accounting department calculated the marginality of the service allocating the
operating cost of the service which resulted to be 3,950,000€. All the operations (hence the entire
amount) for green consultancy are outsourced to a start up, that require the payment before going
to the clients.
With reference only to Green Consultancy for the first semester of 2020, calculate Turnover,
Operating Result, Cash generated.
(additional) Turnover = 4,000,000€
Operating result = 4,000,000 - 3,950,000 = 50,000€
Cash generated = - 3,950,000€
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In fact:
What can you do to manage this situation in order to survive? You can ask for loans, sell your
assets, delay your payments…
If we are postponing payments, we are acting on this liquidity situation so we can act on the
numbers of days we need to manage the relationships with the suppliers and the customers by
considering DPO and DSO: this is exactly the exit strategy.
Summing up, cash is crucial within a company because through it we can create new value and
so we can grow. How is this possible?
Basically, in the asset side we have the investments, which are composed by cash and cash
equivalents (receivables, inventories, other current and non current assets): if we have these
resources we employ them to create new value (and new money) in order to sell more and to
generate gross profit/operational profit.
If this is not enough and the company wants to grow more and more, we can ask additional
resources through debt and equity to the founders (which could be debt holders or shareholders).
This is the liabilities side, called funding.
Clearly, the opposite situation (when you have too much cash and cash equivalents) it’s always
not a good situation, because you have a lot of cash which could be invested in order to create
value.
How can we keep under control our cash situation? We can through some liquidity indicators, and
typically we distinguish between short term and long term liquidity indicators.
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We make this distinction because we need to be able to manage the everyday duties (short term)
but also to plan the availability of resources for the long term.
Short term indicators
Typically, the most common liquidity indicators for the short term are:
DPO - Example
Amazon is in a good situation because it has a lot of cash, which means Amazon receives
immediately the cash from its customers. Furthermore, if we consider the Amazon DPO, it is equal
to 112.9 days. So customers pays immediately, while Amazon pays its suppliers in 112.9 days in
average. That’s why there is a high availability of cash.
It is important to highlight the concept of cash conversion cycle: it is the difference between the
moment in which you receive the cash inflow and the moment in which you have your cash
outflow. So it describes the number of days that you need to transform your outflows in positive
inflows.
Net Working Capital - Example
We have this company, BRIO, which is evaluating the variance in NWC related to the introduction
of a new product.
We have some informations available:
- Additional Revenues: 1,200,000 (constant between 2023 - 2026)
- Time for receivables collection (DSO): 4 months
- Additional operating costs: 600,000 (constant between 2023 - 2026)
- Time for payables payment (DPO): 2 months
- Inventories: 10% revenues
- Production and revenues will start in January 2023 and end in December 2026
How can we calculate the Δ NWC in 2023, 2024, 2025 and 2026?
4
Remember that:
- NWC = receivables + inventories - payables
- Δ NWC = NWCt - NWC(t-1)
Let’s start from the 2023 which is the initial year.
Basically, we have a situation in which the company has nothing because it starts the production
in that year, so we just calculate the final value of receivables, inventories and payables.
Regarding the payables, at the end of 2023 they are equal to:
= (operating costs/months in a year)*time for payables payment = (600,000/12)*2 = 100,000
Regarding the receivables, at the end of 2023 they are equal to:
= (revenues/months in a year)*time for receivables payment = (1,200,000/12)*4 = 400,000
Regarding the inventories, at the end of 2023 they are equal to:
= revenues*10% = 1,200,000*0,1 = 120,000
So, Δ payables is equal to = payables 2023 - payables 2022 = 100,000 - 0 = 100,000
Δ receivables is equal to = receivables 2023 - receivables 2022 = 400,000 - 0 = 400,000
Δ inventories is equal to = inventories 2023 - inventories 2022 = 120,000 - 0 = 120,000
So ΔNWC for the 2023 will be:
= Δ receivables + Δ inventories - Δ payables = 400,000 + 120,000 - 100,000 = 420,000
How do we interpretate this result? The impact on cash is positive or negative?
With this NWC, the impact on cash is negative because I have more receivables and inventories
rather than having cash.
In fact at December 2023 we have 400,000 receivables, which means that we’re allowing our
customers to pay 400,000 cash in 2024 rather than paying us immediately. We can make the
same speech on the inventories: we have 120,000 inventories instead of liquid cash.
We also have 100,000 payables, which means that we will pay 100,000 to our suppliers in 2014
instead that immediately, but this is not a big enough good effect.
Regarding 2024 and 2025, we calculate the same initial and final amounts because it is written
that revenues and operating costs are constant, such as the inventories, in the period 2023-2026.
So clearly the ΔNWCs for 2024 and 2025 are equal to 0.
So there is no impact on cash of the NWC for those two years.
In 2026, the company stops the production. So this means that the final value of payables,
receivables and inventory are equal to 0, which means that the ΔNWC for 2026 is equal to
-420,000. So in this case the impact on cash is positive because we have cash rather than having
receivables and inventories.
Long term indicators
We can also consider the cash situation in the long term. Typically, the most common liquidity
indicators for the long term are:
5
Remembering that sometimes instead of EBITDA you can use the cash flow from operations,
which is the data that you can take from the cash flow statement.
If for instance NFP/EBITDA = 3, this means that the level of indebtedness is three times the
EBITDA, so this means that I need three EBITDA of the period considered to repay the debts.
This ratio is really important because it is used by credit rating agency for giving the rating to the
companies.
In fact, if you have a NFP which is too high, this means that you have too much debts and this
could be a signal of problems in facing your debts.
A critical value is usually >= 5, because this means that you’ll need 5 EBITDA to repay your NFP.
But if this value is too low, this is always a bad sign because this means you are not investing: so
a good value could be 2 o 3, but this strictly depends on the type of business.
NFP/EBITDA - Example
This is a fast food company (McDonald’s) with this financial situation:
To calculate the NFP, we have to make the difference between debts and cash & cash
equivalents. So:
NFP = (long term debts + spot term debts) - cash & cash equivalents = 24,732,300
If we divide this amount for the EBITDA, we have that:
NFP/EBITDA = 2,58
In any case, even if we have a NFP/EBITDA = 2,58, the credit rating assigned to McDonald’s was
just B and not A. This just to say that even though you have value that may be quite good, in
some case rating agencies don’t consider appropriated for the kind of business.
Value measurement
We can use the cash flow to look back how the company is performing, but we can also use cash
for another main activity, which is the value measurement.
The value of a company refers to the results generated by the company for its shareholders in
the long run. So we can use cash flow (looking at the past) to understand the ability of the
company to manage its liquid resources: this is clearly possible through the financial analysis.
The advantage of understanding the ability of the company to manage its cash is that we’re
relying on certain and certified data, because they are contained inside the financial statements.
On the other hand, measuring value looks ahead and it is used to quantify today the ability of an
enterprise to generate future cash flows. This is a more difficult passage because we’re
forecasting and if you forecast there is a level of uncertainty in making this kind of analysis.
This activity of estimating the ability of a company in generating value in the future it is also
defined as business valuation.
Measuring the value of an enterprise is needed when you are:
- Buying a business
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-
Selling a business;
Funding;
Selling a share in a business;
Litigating;
Making an exit strategy plan.
There are different approaches for measuring the future cash flows of an enterprise:
• Direct method: it is the most precise and complete method, but at the same time the longer.
• Relative valuation: is really simple and faster than the first one (it is usually the favourite
method).
• Value based proxies: this is even faster because you are using just some proxies.
Discounted Cash Flow (DCF)
As already said, this is the most precise and complete method which is based on the estimation
of future cash flow of a company.
DCF methods rely on the direct measure of the enterprise value:
Basically, with the discounted approach we estimate today the ability of the company to generate
cash in the future.
V(0), which is the economic value (or present value) of the company today, is equal to the
summing up from now till infinte (because we assume that a company will live forever) the net
cash flow (cash inflow - cash outflow) that the company is able to generate each year t.
We can sum up cash flows generated in different periods of time because we take into account
that the value of money changes across the time through the application of the discounted
formula, which means we divide the value of the net cash flow for 1 + the cost of capital.
If you want to calculate the value of the company, you have to sum up the cash flow that the
company is able to generate for each year (discounted).
But how do we estimate the net cash flow at the infinite?
The formula can be articulated differently, dividing the planning horizon in two parts: the first one
between time 0 and time t (which is the period in which you can make reasonable estimations),
the second one between t and infinite (which is the period in which we can’t make certain
estimations). This leads to:
TV is the terminal value, which is the value of the company from t till infinite. We’ll se in the next
week how to generate it.
So, in order to determine the economic value of a company, we need to calculate the net cash
flow (NCF), the terminal value (TV) and the cost of capital (K).
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Net cash flow
In the previous lectures we saw the net cash flow through an accounting perspective, according
to which cash flow was created by operating, investment and financing activity.
Now, in order to calculate this net cash flow, we keep a finance perspective, so we reorganise the
financial data in a way which is more functional compared to our desire to calculate the value of
the company.
It can be calculated in two ways, which are:
• FCFF (Free Cash Flows To Firm) available to both debt holders and shareholders;
• FCFE (Free Cash Flows To Equity) available to shareholders.
Depending on the fact we keep the ability of the company to generate cash for debt holders and
shareholders (FCFF) or the ability of the company to generate cash for shareholders only (FCFE),
we calculate the economic value in different ways.
In particulate, if we calculate the value of the company by considering the ability of the company
to generate cash for debt holders and the share holders, we say that we are adopting an invested
capital logic, and the type of value that we calculate is defined as enterprise value (EV).
On the other side, when we use a shareholders capital logic, in this case we are calculating
what is defined as equity value (E).
8
But what is the difference between the invested capital logic and shareholders capital logic?
To highlight this difference, consider that the company invests its money into project & activities
which will generate cash. So the red circle is clearly the circle of assets side logic, and the cash
generated is the FCFF which will be available for both shareholders and debt holders).
But we are aware that in reality the enterprise can receive money from both debt holders and
shareholders. The company have to pay interests and debt refunds to the debt holders because it
received debt capital from them (grey circle): moreover, since the company received share capital
from the shareholders, it will have to pay them dividends (blue circle).
So the FCFE considers the cash for shareholders after having payed also debt holders:
FCFE = FCFF - financial activities
This the overall synthesis for calculating the FCFF and the FCFE starting from an accounting
measure (EBIT):
9
Considering the profit and loss statement of the company, in order to determine the FCFF and
the FCFE, first of all we have to take the EBIT.
If it is unknown, we have to calculate the tax ratio (tc) by dividing the taxes for the earning before
taxes (EBT).
Now we can deduct the taxes on EBIT, which are the tax ratio multiplied for the EBIT itself.
Then we have to add the depreciation & amortisation and deduct the variation of the net
woking capital (Δ NWC), which we have already seen.
Lastly, we have to deduct the variation of the capital expenditures (Δ Capex).
Capital expenditure are just the difference between new investments and the disposal of assets.
New investments are cash outflows, while disposal of assets are cash inflows.
(FX = non current assets)
If we do so, we have calculated the free cash flow to firm.
Then, to calculate the FCFE, we have to add the cash flows from financial revenues, net of tax.
So we have to multiply the financial revenues for (1- tc).
Now we have to deduct cash flows from financial expenses, net of tax.
So, again, we have to multiply the financial expenses for (1- tc).
Then we have to consider the variation in the share capital, which is equal to increase in share
capital (which represents the increase of the company equity) minus decrease in share capital
(which is is the amount paid to the shareholders and it is no more available).
We have also to deduct the dividends, and lastly we have to consider the variation in debts,
which is equal to increase of debt (due to new loans/bonds) minus the repayment of debts (due to
the repayment of loans/bonds).
So we have obtained the FCFE.
This is the difference between accounting and finance perspective:
10
Cash flow calculation - Example
To calculate the FCFF:
11
To calculate the FCFE:
12
Company valuation: Same case
As a consultant, you have been asked to evaluate the Equity Value of the company Sama. This
company operates mainly in Europe in the beverage industry.
You have just estimated the company P&L for next 3 years (Table 1). Furthermore, you know that
the company will do capital expenditures in in 2021 (25 mln euro), 2022 (33 mln euro) and 2023
(36 mln euro). Moreover, you expect that there will be changes in the financial structure, as
reported in Table 2.
Finally, you have prospects of the net working capital for the next 3 years (Table 3). After the
period of analytic forecast, the FCFE are supposed to increase infinitely at a rate of 3%
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Computation of different costs of capital
As we said, in performing financial analysis we can adopt two different approaches: the invested
capital logic (where the cost of capital is represented by the WAAC) and the shareholder capital
logic (where the cost of capital is represented by the Ke). Let’s see how to calculate each of them
Ke - Cost of Equity
Ke is the cost of equity of a firm: it is how much a firm has to remunerate its shareholders for the
risk they take by providing equity capital to the firm.
From the investor perspective, it is the minimal amount that will be expect that the firm return to
the shareholders.
How can we estimate the cost of equity? To do that we use the Capital Asset Pricing Model
(CAPM).
14
According to this method, the cost of equity of a company will be equal to the risk free rate of
the market plus a factor called Beta Levered multiplied for another factor called market premium
that is the difference between the market return and the risk free rate.
rf: risk free rate
rf is the theoretical return on an investment with no risk. But does a risk free investment exist?
The answer is no, because no investor can be sure that an investment will return money back.
So, in order to calculate the rf we can use several proxies.
The most used proxy for the risk free rate are the government bonds (in general bonds are a
financial security that you buy from a company, not from the banks like a share company, and it is
like buying debt from it). But why generally government bounds are less risky than company
bonds? Because the economic situation that can change for the government is more stable, so it
can result less risky.
We select the return on the least risky government bonds of the currency area of evaluation. In
Eurozone the 10Y German Bonds is used as a proxy of the risk-free rate (-0.45%).
Now the question is: can governments fail? Of course, for example Greek was the first developed
country to default.
rm: market return
rm is the return on theoretical market portfolio which contains all the stocks in the market. In order
to proxy it we use several Market indexes that are representative of the market in which the
company operates.
Examples:
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ßL: Beta levered
ßL measures how volatile is the firm stock if compared to the overall market movements. It is the
risk accepted by the investor, by investing his capital in a company rather than generally in the
market.
Statistically, β is computed as the ratio between the covariance of the asset with the market
portfolio and the variance of the market portfolio:
It depends on the capital structure of the firm. ßL answers the question: “how much stock returns
differ from market returns?”. Higher ßL also means higher risk, in fact ßL is actually a coefficient of
the risk of the company.
We can distinguish different values:
- ß = 1: the target stock return and the market return follow the same trend during the time, so if
the market change, the company change in the same way.
- ß > 1: the target stock return is higher than the market return if it is increasing and lower if it is
decreasing. In this case we say that the stock of the market is an aggressive stock.
- 0 < ß < 1: the target stock return is lower than the market return if it is increasing and it is higher
if it is decreasing. In this case we say that the market stock is a defensive stock.
- ß = 0: the movement of the company’s stock is uncorrelated to the benchmark.
- -1 < ß < 0: the movement of the company’s stock is in the opposite direction, but in a lesser
amount than the benchmark.
- ß < -1: company’s stock move in the opposite direction of the benchmark.
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Examples:
But how can we estimate the ßL when we have an unlisted company? We cannot use the
statistical procedure since basically the company does not have listed stocks. In this case we
have to use the “unlevered beta”(ßU). To do it we can follow two different methods: comparable
companies and beta industry.
Let’s make first a clear description of ßL and ßU.
ßL measures how volatile is a stock if compared to the overall market movements. It depends on
the capital structure of the firm and it is also known as asset beta.
ßU measures how volatile is the underlying business, irrespective of the firm’s capital structure. It
depends on the industry/business of a firm (but not on the capital structure of the firm!) and it is
also known as asset beta.
The relation between ßL and ßU is given by:
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In order to estimate the of a specific company according to the comparable companies
methods, we have to follow these passages:
1. We take comparable companies for which we have ßL
2. We compute the ßU of each comparable company (i.e. by stripping out the capital structure
characteristics from ßL)
3. We compute the average beta ßU,avg of the comparable companies
4. We re-lever ßU,avg with the capital structure characteristics of the target company
According to the industry beta method, as second best as beta unlevered it could be used the
one of the industry in which the company operates:
Ke - exercise:
The US-based startup Cashme is looking for new funds and is preparing its pitch for institutional
investors. Such investors may support the internationalization of the company, which was not part
of the strategy in these years. As part of the presentation, they have to estimate the cost of equity.
Based on all the data reported, what is the estimated cost of equity (Ke)?
18
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WAAC - Weighted Average Cost of Capital
WACC is the Weighted Average Cost of Capital of the firm. It’s general formula is:
As we can see, the WACC is not composed just by the Ke but also by the Kd, that is the cost of
debt.
Kd: cost of debt
Kd is the cost of debt for a firm and it represents the interest that the firm has to pay on financial
debts to remunerate the debtholders for the risk they take by providing debt capital to the firm.
On the other hand, Kd is a return for debtholders which is contractually defined (so we don’t have
to estimate it).
Kd can be computed as:
Where rf is the risk free rate, while the CDS represent the credit default spread, associated with
the company credit rating.
This is an example of the classification of the CDS. It indicates the level of risk of the debt on the
company. For example the banks use it to understand the level of risk to give money to a
company. If you are in the low part of the rating, you have a high level of cost of debt.
Example:
Two companies are identical (same business, same size etc.) but they have a different capital
structure. Company A has D/E=5 while company B has D/E=1. All the rest being equal, which
company has has the riskier profile?
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It is clear that is the first one, because it has a debt that is five times the company’s equity, so the
risk of becoming unable to pay back the debt holders is really high.
WAAC - Exercise:
Knowing the cost of equity (Ke), calculate Cashme weighted average cost of capital (WACC):
Terminal Value
As we have already seen, the present value of a company can be formulated differently, dividing
the planning horizon in two parts: the first one between time 0 and time T, the second one
between T and infinite. This leads to:
So, three components must be calculated: the net cash flow, the cost of capital and the terminal
value.
Beyond the forecasting horizon (0-T), the precise estimation of cash flows is substituted by a
synthetic measure: Terminal Value (TV).
One alternative to measure the TV is calculating a Perpetuity.
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Perpetuity hypotheses that the NCF of the last year of the forecasting period (T) will stay
unchanged for the subsequent years.
Being NCFt the last year NCF, the terminal value TV(0) can be calculated as:
A variation is obtained considering a constant growth rate of NCFs. With g equal to the growth
rate, the terminal value becomes:
Example:
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Annuity approach is useful when the company is not likely to have a regularity or a growth of its
net cash flows on an infinite time horizon, but only on a certain number of years (‘n’ in the formula
below).
In this case, the Terminal Value becomes as follows, respectively in case of a constant or growing
net cash flow:
Summary:
TV - Exercise:
Company A is an energy company, focused on renewables. Some reliable estimates for the years
2020, 2021, 2022 and 2023 are available and reported below (data in k€):
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You also know that:
- Debt at the end of 2019 was 10,000 k€;
- Cost of equity (ke) can be considered constant during these years;
- Reliable estimates can be made only up to 2023;
- TVe (perpetuity with no growth) = 591,600 k€
Considering the available data and using the DCF methodology which is the EQUITY VALUE of
Company A?
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Company Valuation: real options and relative
evaluation
We have been discussing about the techniques of business valuation (how to calculate the
enterprise value and the cost of equity of companies).
The first thing we jumped into were the discounted techniques, which have this general formula:
We saw that these discounted cash flow techniques eventually need to consider the terminal
value of a company. There are two methods (with a couple of possibilities in terms of growth)
which are perpetuity and annuity.
Today we are looking to another method to calculate the terminal value of a company which is
called real options.
Then we are going to discuss about another completely different method of business valuation
which is called relative evaluation.
Real options
Real options are an alternative way to estimate the terminal value of a company.
This is an alternative because perpetuity and annuity methods are a little bit restricted because
they do not have realistic assumptions (the company should have an amount of cash flow since
the moment of the evolution up to infinite).
In fact, the future value of a company depends also on the ability of the resources of the company
itself of modifying its portfolio of activities in a way that is coherent with the evolution of the
competitive context.
So real options are a third possibility to assess the terminal value including strategic
considerations about the corporation business opportunities.
For example, by now we know that the present of a company current resources and current
activities, which are the ones which generate the current net cash flows.
But the current resources can eventually also be used to generate future activities which will
generate future net cash flows which with the DCF method we are not considering them, because
the net cash flows estimated is a proxy to estimate what happens since today up to infinite.
So the terminal value is trying to estimate these future activities that will generate future net cash
flows.
1
Real option is the right - but not the obligation - to undertake some business decision; typically
the option to make, or abandon, a capital investment.
Real options has an analogy in the financial world which is called call option.
A call option is a financial contract between two parties (i.e. the buyer and the seller), where:
- The buyer of the option has the right, but not the obligation to buy an agreed quantity of a
particular instrument from the seller of the option at a certain time (the expiration date) for a
certain price (the strike price).
- The seller (or "writer") is obligated to sell the commodity or financial instrument should the
buyer so decide. The buyer pays a fee (called a premium) for this right.
There are of course some equivalences between real options and call options.
The strike price in the call options, which is the price that will be booked by the buyer, is the
additional investment that a company can make.
The share price will be the present value of the cash flows expected from the additional
investment.
The expiration date is the period of time before the investment opportunity will disappear
Example: British Petroleum
In the ’70 British Petroleum had acquired some low profitable oil concessions in the North Sea,
but at the time they acquired those oil concessions their present value was negative due to the
characteristics of the oilfields (small oilfields with high extraction costs).
British Petroleum exploited these options only when the exploitation cost had been significantly
lowered (giving them positive net cash flows) thanks to:
- The development of new drilling technologies;
- The use of benchmarking, project management, learning networks aimed to reduce
administrative and general costs.
Types of real options
We can have different types of real options:
• Flexibility and Mix Options; these real options are related to enterprise’s ability to revise
investment and operating decisions over time as uncertainty is resolved. They include:
- Outsource production or sales;
- Delay production;
- Peak generating plants;
- Assembly configuration.
• Abandonment or Termination Options, that is the option to sell or close down a project. Some
examples are:
- Investment fractioning;
- (Airlines) routes closing where the demand is insufficient to make the connection profitable.
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• Expansion Options, that is the option to make further investments and increase the output if
conditions are favourable. Some examples are:
- Acquisition that would position the acquirer in a key emerging market;
- Early investments that are prerequisites or links in a chain of interrelated projects (e.g. R&D, a
lease on undeveloped land or a tract with potential oil reserves, a strategic acquisition, or an
information technology network).
Evaluating real options
We evaluate real options through an approach called decision three analysis, which includes four
phases:
1. The first is the definition of the entity of the investments (initial investment and additional
investment), so how much money the company will need to invest;
2. Definition of the possible scenarios (so the possible developments of the market in which the
company wants to invest);
3. Calculation of the probability (pi) and the present value for each scenario (PVi);
4. The value of the option is the maximum between the value obtained if the company does the
investment (present value of the net cash flow that the company will receive minus the total
investment) and the value obtained if the company does not do the investment (so 0),
multiplied for the scenario’s probability:
In the formula:
- T = year in which the company decides to exercise the option;
- N = number of possible scenarios.
Example: clothing company
Suppose a clothing company is considering the introduction of a
new line. The project life span is two years. An initial investment
of $50 (cash flows are in thousands) is required to fund the initial
development phase. At the end of a year, a further $50 are
required for production. Cash inflows from sales (net of selling
expenses) will occur at the end of the second year. There is
some uncertainty about the amount of the cash inflows
since it is unclear whether the market will embrace the new
line. The firm estimates that there is a 70% chance that the
new line will be a winner. They also believe that the new line
will become more visible after the first year and had estimated of
a couple of possibilities for the subsequent year. The
probabilities and the associated cash flows are illustrated on the
figure. The cost of capital is 10%. What is the expected value
of the project?
We calculate the value as the value of the NCF divided for (1 + k).
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On the year 0 we know that the investment is - 50k, wile the investment in year 1 is also 50k
discounted with the cost of capital.
The expected value fo the year number 2 is the sum of the scenarios good/good, good/bad, bad/
good and bad/bad, discounted for the cost of capital. So we can write:
(it is - 100, there is a mistake in slides)
So the present value of this investment is V(0) = - 4,4k. So the company will never do the
investment because the expected value of this investment is to lose money.
But let’s now consider the case where the firm has the option to abandon the project after the
first year. In this case, the second phase of the project would only proceed if the market direction
was favorable over the first year. If the market direction was unfavorable, the firm would
abandon the project, since proceeding would cost a further investment $50 and the expected
present value (at time 1) of the cash inflows is what follows in the tree. What is the expected
value of the project with the option of abandon?
At the year 0 the company still invests 50k in the project.
At the year 1 the second investment of 50k is no more certain, because it is conditioned by the
probability of the “going week” market thanks to the presence of the real option.
At the year 2, the expect value is just the sum of good/good and good/bad scenarios, because
the company has the option to abandon the investment the first year.
As we can see, the real option is considered inside the formula of the expected value.
There are two + 0,3(0) because the option of abandon (0) is always the maximum in both the
steps. Thanks to the presence of the real option, the company has an expected value of the
investment clearly higher than before.
Relative valuation
Relative valuation is a completely different way of approaching the business valuation of a
company.
Consider the following example. This is the data of the house market of Milan:
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What is the price of a 50 m2 flat in Milano?
To determine the price, we have to make the average square metre price multiplied for 50 metres.
The average square metre price in Milan is 4,500 €/m2, multiplying it for 50 m2 we obtain a price
of 225,000 €.
The only thing we did to determine a 50m2 apartment price is looking to an important parameter
(which is the price per square metre) and then informations about the house market.
This is the same idea that is behind relative valuation: to estimate the price of a company (the
enterprise value or equity value), what we need to do is to look at the market and not at the
features of the company itself.
Relative valuation methods do not try to determine a company’s intrinsic worth based on its
estimated future free cash flows discounted to their present value (which is what DFC methods
do). Instead, they determine a company’s value based on the market observation, by comparing a
firm value to that of its competitors.
These methods of relative valuation are also called as multiple methods. The idea behind these
methods is that the company we are evaluating has somehow the same characteristics (the same
value generation) of its competitors.
In syntesis, we have that in relative valuation the value of an asset is compared to the market
value for similar (or “comparable”) assets: this approach is widely used to estimate the “company
value” through the comparison of the (target) company with other similar listed ones.
There are four main steps in relative valuation:
1. Identifying comparable companies;
2. Defining possible multiples, which means converting assets market values into standardized
values relative to a key statistic (absolute prices cannot be compared);
3. Analyze multiples;
4. Apply multiples.
Comparable companies
Actually identifying comparable companies could be one of the hardest step.
A comparable company, when you are looking to the value of a company, you don’t usually take
just competitors as companies that have the same value. In fact, financially speaking, a
comparable firm is one with cash flows, growth potential, and risk similar to the firm being valued.
No one says that a comparable company is a company of the same industry or the same sector,
but there is the implicit assumption that companies within the same industry for example at least
they have common characteristics such as similar similar risk, growth, and cash flow profiles and
therefore can be compared with much more legitimacy.
For example, to evaluate if the risk of two companies you can look at the leverage ratio, Beta for
risk…
Another possible way besides making a check between cash flows, risk and growth is to identify
the target company value drivers (which is the key parameter that generates value for the
company), then you have to identify those companies with the same value drivers.
As example, Spotify is a comparable of physic music shop or Netflix? Clearly Netflix, because
Spotify is related to music, but what brings value to this company is actually being a digital
platform that distributes contents.
Lastly, you have to define companies’ specificities such as the sector, the geographical area, the
size, the presence or not of a competitive advantage ecc. because this could help us in the
determination of comparable companies.
For instance, we can have two companies that have the same value drivers and a that also
operate in the same sector such as twitter and Weibo (a Chinese microblog), but they are not
good comparable because twitter is banned in China so they have a strong diversification in
terms od geographical market.
So, this little details can make or can turn down potential comparisons between two companies.
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Defining possibile multiples
Defining possibile multiples means converting assets market values into standardized values
related to a key parameter of the company to be performed.
Once comparable companies are identified, market values need to be converted into
standardized values since the absolute prices cannot be compared because they don’t tell us
anything.
As the DCF methods, multiples are related to the asset side of the company (so the enterprise
value) an also to the equity side of the company (so with the equity value).
In the case of the asset side, the numerator of the multiple is represented by the enterprise value
of the comparable company and the dominator is a parameter of that company (a parameter
which is related to the value generation of that company).
Since the target company generates value such as the comparable one, the enterprise value of
the target company will be equal to the same parameter of the target company multiply by the
multiple of the comparable:
The same process occurs in the equity side. The equity of the target company is equal to its
parameter multiplied by the multiple of the comparable company, which has at the numerator the
equity of the comparable and at the denominator its parameter:
Let’s try now to understand which are the possibile parameter to use and then the possible
values.
The possible values are easy because in one hand we have the market value of the equity (equity
side) and in the other had we have the market value of the firm (enterprise value side).
But which parameters can we use?
The parameters are what you are getting in return of this value, which is what you are paying for
the asset.
So the parameters can be pretty much almost anything that gives value to the company, but we
can sum up them in:
• Revenues, not even the accounting revenues but even just the drivers of the revenues (the
number of customers, of subscribers ecc.);
• Earnings, like the operating income of the firm ;
• Cash flows, like the FCFF and the FCFE;
• Book value, so the accounting values of certain items inside the balance sheet, like the book
value of equity and the book value of debt.
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The thing is we have a really large amount of possible parameters, but more or less the same
multiples are used commonly. So we have four parameters that are commonly used on the assets
side to calculate the market value of the enterprise value and some others parameters that are
commonly used on the equity side to calculate the market value of equity.
So we are not using the equity value that we find in the balance sheet for the company, we use
the market capitalisation/market value of E which is the share price multiplied for the number
shares.
On the other side, when we talk about the market value of the enterprise value it is equal to the
market the capitalization of the company plus the net financial position, because when an investor
wants to acquire a company he will have to buy the equity and also the debt of the company
(minus the cash of the company itself).
We are going to see in detail these common multiple on the asset side and on the equity side and
also how to calculate them in particular situation.
Possible multiple: asset side
We know that the enterprise value multiples take as reference (numerator) the Enterprise Value of
comparable companies:
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The common multiple of the enterprise value need to use a performance parameter (denominator)
coherent to an enterprise value perspective. That’s why in the previous asset side multiples we
don’t see the FCFE because it is a parameter related to the equity and not to the overall assets of
the company.
The main assumption is that if a sample of comparable companies is valued by the market a
certain number (n) of times a given parameter, the target company can be valued the same way.
So we need to check that the company we are analysing uses the same parameter to be coherent
with the enterprise value.
In economic terms, the multiple represents the number of years the parameter should be
multiplied by to obtain the company EV.
Let’s look punctually the possible multiples on the asset side. All these multiples actually tell you
something about the company:
• EV/EBIT:
- Advantage: it is focused on operating management (the money that the company will gain
mainly through the operating activities)
- Disadvantage: it does not consider different choices in Depreciation and Amortization (which
are factors related with cash). If you have a lot of fixed assets, they are important things for
you because they generate value for you.
• EV/EBITDA:
- Advantage: it is a good proxy of cash, so it considers Depreciation and Amortization. Actually
is one of the most used because it tells you how many times the EV of the company is its
EBITDA.
- Disadvantage: it neglects the capital expenditures of the company and for certain companies
it is important because they decide to put the outsourcing (a crucial part of the value of a
company) activities inside the capital expenditures.
• EV/FCFF:
- Advantage: it is a cash flow (so consider the reality).
- Disadvantage: it is less stable than other indicators, it can change completely from an year to
another.
• EV/Sales:
- Advantage: if the above multiples are negative, the multiples are meaningless; in those cases
an alternative is using sales.
- Disadvantage: it does not consider the profitability of the company.
Case study
You are asked to evaluate company Kents, having available some data about comparable
companies in the following table:
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The P&L (profit and loss) of company Kents are:
The first thing that we can do is to calculate the multiples for each company:
So we can see that company A is 10 times its sales, 14 times its EBITDA and 17 times its EBIT.
Company B is 12 times its sales, 14 times its EBITDA and 16 times its EBIT and so on.
The comparable companies also have in average an enterprise value which is 11 times their sales,
14 times their EBITDA and almost 17 times their EBIT.
We can calculate now the enterprise value of Kents through these average multiples.
The EV of Kents, according to the EV/sales multiple, is 200*11 = 2200.
According to the average EV/EBITDA multiple, it is 120*14,33 = 1720,20, while according to the
average EV/EBIT multiple it is 105*16,86 = 1770,76.
Possible multiple: Equity Value
The equity multiples let the analyst to directly evaluate the company equity value:
At the numerator we have the market capitalization of the company which is given by the price of
the stock on the official exchange multiplied by the number of outstanding shares.
The multiples on the equity side are:
• P/E, which is the market price/earnings or the market price per share/earnings per share (EPS):
- Advantage: it is a quick multiple.
- Disadvantage: since it completely relies on the stock exchange, it not affected by
depreciation, amortization, profit or loss of discontinued operations.
N.B. For the market price, you can use the current price and sometimes the average price over
last 6 months or year. Regarding the EPS, they are referred to most recent financial year (current),
most recent four quarters (trailing), expected in the next fiscal year or next four quarters (leading),
some future years.
• PGE, which is the ratio between the P/E and the earning growth:
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- Advantage: this ratio allows better considering the growth perspectives of the company through
the CAGR.
- Disadvantage: the accuracy of the PEG ratio depends on the growth rate used. Using historical
growth rates may provide an inaccurate PEG ratio if future growth rates are expected to deviate
from historical growth rates.
To distinguish between calculation methods using future growth and historical growth, the terms
forward PEG and trailing PEG are sometimes used.
Example:
Assume the following data for two hypothetical companies:
• Company A:
- price per share = 46$
- EPS this year = 2,09$
- EPS last year = 1,74$
• Company B:
- price per share = 80$
- EPS this year = 2,67$
- EPS last year = 1,78$
Let’s calculate now the PEG ratio:
• Company A
- P/E ratio=46/2,09=22
- earnings growth rate = 20%
- PEGratio=22/20%=109
• Company B:
- P/E ratio = 80/2,67=30
- earnings growth rate = 50%
- PEG ratio = 30/50% = 60
Comparing only the P/E ratio, shares of company A are less expensive (the price is 22 times its
earnings) than the shares of the company B (which price is 30 times its earnings).
But since B’s PEG < 100 (or 1, considering 50 and not 0.5), and the growth rate of the company
anticipates its future growth, is possible to assume that the shares are undervalued, which makes
shares of company B a good investment.
The other two multiples that are less used are:
• P/BV: the ratio between the market capitalization of a company and its book value of Equity
(Share Capital + Reserves + Profit(Loss) of the year).
• P/FCFE: the ratio between the market capitalization of a company and its FCFE.
Case study
You want to estimate the equity value of Water through the relative valuation. You know that Water
has to pay 1 mln euro of interests and has a corporate tax rate of 40%. You have identified two
listed comparable companies (Still and Sparkling) whose price per share is 2,34 and 2,75 euro per
share respectively.
Furthermore, the earnings of Still have been 1,4 mln euro while the earnings of Sparkling have
been 1,85 mln euro.
Finally, you know that Still has 10 mln shares while Sparkling has 12 mln shares.
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You also know the following data of Water:
With the information available compute E (equity value) of Water:
Analyse multiples
How can we pick one multiple? In fact, when using multiples to evaluate a business, the values
obtained are likely to be different using different multiples, and deciding which multiple to use can
make a big difference to the value estimate...
There are technically four ways of selecting a multiple:
• Cynical approach: use the multiple that best fits your objective. While this clearly crosses the
line from analysis into manipulation, it is a common practice, calling for some cautions when
reading a report produced by a third party.
So, for instance, the analyst could use the multiple that best fits his story:
- if he is trying to sell a company, he could use the multiple which gives the highest value for
the company;
- if he is buying the same company, he could choose the multiple that yields the lowest value.
• Statistical approach: use the multiple that has the highest R-squared in the sector when
regressed against the parameters. It consists in three main steps:
- Identify a subset of multiples that are significant theoretical point;
- Identify one or more fundamentals that could explain the variance among the multiples of the
comparable companies;
- Check the relation between fundamentals and multiples.
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In this case we are comparing the EV/Sales and EV/EBITDA. As you can see, the growth of sales
doesn’t change anything regarding the multiple, while the growth of the EBITDA actually is
correlated to EV/EBITDA: this correlation will give you the statistical justification that EV/EBITDA is
the right multiple.
• Bludgeon approach: it consists in using all the multiples computed, however, putting them
together in an overall evaluation:
- Range of values, with the lowest value obtained from a multiple being the lower end of the
range and the highest value being the upper limit (the range could be large).
- Average of the values obtained from the different multiples (the average weight in the same
way different multiples)
- Weighted average, with the weight on each value reflecting the precision of the estimate.
• Value driver approach: use the multiple that seems to make the most sense for a specific
sector, given how value is measured and created in that context. Managers in every sector tend
to focus on specific variables when analyzing strategy and performance.
The multiple used will generally reflect this focus:
Apply multiples
The last step is the computation of the EV or E depending on the scope of the analysis.
We have already applied it by calculating the Enterprise value end the Equity value of the
companies.
As we can see, the relative valuation is a quicker and simpler analysis than the DCF methods.
A number of authors have argued that multi-period valuation models based on discounted cash
flows or residual income are superior to single-period multiple valuation approaches, which are
likely to result in less accurate valuations. However, the empirical evidence on valuation models
used by professional investors and financial analysts stands in contrast to the theoretical
superiority of multi-period valuation models. The strongest and most consistent empirical finding
is the primary importance of the P/E ratio.
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Conclusion on Value Measurement - Value based
Proxies
Value based proxies are indicators which try to approximate the value of an enterprise in
simplified way.
These indicators can be grouped in two different categories, depending on the starting point.
If the starting point for calculating these indicators is represented by accounting numbers
(numbers which come form the accounting statements) then we are talking about accounting
based indicators, while if the starting point for calculating these proxies are shares (the value of
the company in the market, we are talking about shares based proxies.
Accounting based proxies
They are indicators based on financial statements (we take data for calculating them from
financial statements) but, in addition to this, they have some information that is “looking forward”,
which means that these measures include the cost of capital and also other adjustments to
increase the precision in the measurement of value (and overcome limitations of ratio-based
accounting indicators).
If you look a the picture above, you can clearly distinguish two opposite situations:
• Discounted cash flow: it is the best measurement of value because it is the most precise.
These measures look forward, because they estimate the cash of the future years (long term
oriented).
• Traditional accounting indicators: they are the accounting based indicators which just keep
financial data, which means that you are looking back, because you are taking the data of 1,2..
years ago.
In between these two polarities, we have the accounting based proxies that keep as the starting
point the accounting data (so what we have on the left) and then they introduce some elements
forward looking of the DCF (the formula on the right). So they are the mirage of the two.
Example:
With this example we are trying to understand why traditional accounting indicators are not the
most appropriate indicators to evaluate the value of a company.
Consider the example of a Hotel Chain, owning three hotels:
If the ROI is positive it is a good situation, but let’s assume that the company to achieve a target
ROI of 30%. How can this return be obtained?
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The problem of acting on the numerator is that it takes time to see the effects of the measure after
the implementation (an higher price or a lower cost). In fact you are not convinced at 100% that if
you increase the price customers will still come, so you are not sure that your ROI in a couple of
weeks or a month will be the same.
Instead, if you act on the denominator, this means that you are reducing your investments so the
value of your total investments is lower. So reducing the denominator is more certain and faster
than reducing the numerator.
So ROI (but also ROA/ROCE ecc.) looks at the past. The idea is that if the company has a positive
return on investment, than I am saying that the company is able to generate cash/value in the
future. So every forecast is based on the past data (which is not the most sure way to make
forecasts).
Moreover, this kind of indicators has this measure problem called “denominator management”
because if you act on the denominator you are very fast in obtaining positive results in terms of
ROI.
That’s why we’ve introduced these accounting based proxies, because they start form something
simple (like ROI) but they mix this simplicity of the data took by financial statements with
something that is more forward looking.
In particular, accounting based proxies have these three main characteristics to join the past view
to the looking forward view:
So, they are not ratios but absolute values, because the goal is to define the total value that the
company is able to generate and the to address the problem of managing the denominator.
They introduce the cost of capital (Residual Income and Economic Value Added) which is part
of enterprise value formula (so they are looking forward because they consider the cost of capital
of the company).
Since you want to estimate the future cash, they use cash (cash EVA) rather than using accrual
data.
Residual income (RI)
Residual income is an accounting measure of operating result minus the amount for required
return on an accounting measure of investment (the investment multiplied by the cost of capital):
Residual Income (RI) = Operating Result – K* Investments
This is an absolute indicator which gives a proxy of the value generated from investments by a
company. The advantage of this accounting proxy is that it addresses the managing denominator
problem, while it is not a proper estimator of future cash because (apart from the cost of capital)
we don’t have any cash information. In any case it is always more precise than ROI in giving an
idea about the possibility of the company to generate future cash
In order to calculate the residual income, we need:
- Operating Result (which is also called Operating Income or Operating Margin), which can be
took form P&L (revenues - operating costs);
- K, which is the cost of capital of the company considered;
- Investment, which is obtained from the reclassified Balance Sheet, calculated as (Assets- Net
Financial Liabilities). Sometimes, it is also considered as capital employed (Equity + Long term
debts).
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Example:
Considering the same hotel company “Hotel Chain”.
Suppose the Hotel Chain is considering upgrading room features and furnishings at the San
Francisco Hotel. The upgrade will increase operating Income of the San Francisco Hotel by
70,000 € and increase its investments by 400,000 €.
Consider that k = 12% (usually it is the WACC)
Can you calculate ROI and RI for San Francisco Hotel comparing pre and post upgrade results?
Remembering that: Residual Income (RI) = Operating Result – K* Investments
As we can see, in the same situations the two indicators can be in conflict with each other ,
because if we look at the RI before and after the investment, what you can see is that RI has
increased so the company generated value, while if you look at ROI the value has decreased.
That’s why we can say that absolute values compared with ratios are more precise in detecting
the ability of the company in generating value for the future.
This means that if you want to compare the ability of different companies in making investments,
you can still use ROI, but if the purpose is to analyse the ability of the company in generating
value ROI is conditioned by the managing denominator problem and then of not considering the
real values generated.
Economic Value Added
It is a more precise indicator as a proxy of cash than RI and it is defined as:
This is a measure introduced by Stern and Steward consulting company (1992). It has a very
similar formula of the RI’s one with a couple of differences.
Formally EVA has nearly the same formulation as for RI (residual income), however Stern Stewart
states that it is necessary to “correct” Operating Income and Investment from financial statement
to have a more precise proxy for cash.
The operating income si adjusted for being a more cash-based data, that’s why the one in this
formula is not the same used for ROI and RI. In fact we duct the taxation (because we know as a
company that taxes are cash that will be no more available) and then we make some other
adjustments, like:
- Depreciation are added back, because it is a cost but not an expense;
- Extraordinary gains are added;
- Extraordinary losses are deducted.
That’s an operating income more similar to cash.
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Then we keep the cost of capital which corresponds to WACC and then we took investments.
The investments could be always calculated as (Assets- Net Financial Liabilities) or (Equity +
Long term debts), such as for RI and ROI.
Again, if we calculate the investments in this way this is an accrual data, so how can we transform
them into a more cash-likely data. The idea is to capitalise some expenses, so tipically
Investments are adjusted, considering:
- R&D, promotion, and employee training expenses are capitalized because are considered as
investments;
- Operating leases are capitalized;
- Non cash investments are added back, such as provisions or deferred tax provisions.
The idea is to adjust investments to have a measure that is more similar to the amount of cash
outflows because of financing these activities and then you calculate the formula.
Example:
Consider again the same situation. Suppose the Hotel Chain is considering upgrading room
features and furnishings at the San Francisco Hotel. Does your considerations change according
to EVA?
Additional data the computation of EVA:
- Tax rate: 30%
- Depreciation and amortization are equal to 5.000 and are the unique adjustment to Operating
income
- R&D expenses are equal to 20.000 and are the unique adjustment to Investment
- WACC= 10,5%
The solution is:
If we make a comparison of EVA with RI and ROI, of Cours we obtain different results:
- ROI = 24%
- RI = 120.000€
- EVA = 65.900€
The more we move from the ROI to the EVA, the higher is the precision of the indicator in
estimating the ability of the company in generating cash, but in any case we have cash yet
because ewe are not making a sum of discounted cash flows, so the precision willl be in any case
lower compared to the DCF methods for estimating enterprise value.
Cash Economic Value Added
The last indicator is Cash Economic Value Added (cash EVA) and aims at eliminating both the
denominator management and the misalignment between cash and accrual flows. This indicator
is calculated as:
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Cash EVA = Cash Flow from operating activities – K*Investments
Instead of using the Operating Result, you directly take the Cash Flow from operating activities.
In fact, if we take cash, we already have cash data. So keep in mind if you don’t want to adjust
your Operating Result in order to have a kind of proxy of cash, you can take the Cash Flow from
operating activities from your cash flow statement.
Shares based Proxies
Even if accounting based proxies are better than ROI/ROA because they consider the cost of
capital (K) and they do not led to the “denominator management” (because they are absolute
measures), they are still looking at past events: they are not forward looking because they start
from accrual.
Shares based proxies are a second category of value based proxies that rather than starting
from accrual data, take this data from the market (the value of the shares).
Of course, the main limitation is that we can use this kind of proxies only for listed companies.
The number of indicators proposed is very high, so we will focus on two diffused metrics: Market
Value Added and Total Shareholder Return.
Market Value Added
The Market Value Added (MVA) is an absolute indicator which is calculated as follows:
MVA = market value – invested capital
Where:
- Market value (value given by the market) = value of shares * number of shares
- Invested capital (capital contributed by debtholders and shareholders) = capital employed =
Equity + Financial liabilities
The idea of MVA is to give a proxy of the value created for the market thanks to capital
contributed by debtholder and shareholders.
The higher is the difference between market value and invested capital, the higher is the
perception by the market that you are creating value (in other words, it is your reputation on the
market).
But if you look at the formula, the MVA may actually understate the performance of a company
because it does not account for cash payouts, such as dividends and stock buybacks, made to
shareholders.
Total shareholder return
The total is a ratio defined as the financial gain that results from a change in the stock's price
(variance in the market value) plus any dividends paid by the company during the measured
interval divided by the initial purchase price of the stock (initial market value).
The idea is if I am investing a given amount of money in a company (which is the initial value),
what is the value that I will obtain back? The value that I will obtain back is the numerator, which
is the variance in the market value (the distinction between the initial value and the final one) plus
the dividends.
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So TSR is a ratio (this make possible to compare different investments/companies) which
summarises the financial benefits for shareholders: that’s why it is often used for private equity
and venture capital to understand whether an investment is convenient.
Example:
Let’s assume we have this data of A2A:
Calculate TSR and MVA and compare 2017 with 2018.
Remembering that MVA = market value - invested capital:
As we can see, in both cases the MVA is negative. This means the market has the perception that
the company is destroying value because the invested capital is higher than the market value of
the company.
Remembering that:
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It is important underlying that:
- Variance in market value 2018 = 4762,16 - 4448,86 = 313,3
- Variance in market value 2017 = 4448,86 - 3696,94 = 751,92
We can see that the TSR is positive but it has decreased over time, which means that the
company has been alway able to pay dividends and give a return to shareholders but the
performances has significantly decreased (the return was higher in 2017 compared to 2018).
So if I am an investor and I am choosing between two companies, I will choose the one with the
higher TSR.
If the company is not listed, I can use accounting based measures also because they compare
the book values which are more stable, but at the same time they look back instead of ahead.
So there is a trade off between accounting based proxies and shares based proxies and decision
depends on your purpose: if you want to invest money, I would say shares based are a little bit
more appropriated but at the same time keep in mind that accounting based (even if they are not
long term oriented as the other) they are more solid in the sense they are audited and verified
data.
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Control
1
Introduction to Planning and Control
In this section we will talk about:
- The need for a planning and control system
- The definition of a planning and control system
- The structure of a planning and control system
- The purposes of a planning and control system
- The requirements of a planning and control system
Need
Why do we need a planning and control system?
The reason why is mainly summarised by this picture:
The logic behind this chart is that enterprises now, even more than in the past, are in an
environment which is very competitive but at the same time they have to balance the needs, the
expectations and conflicts of different shareholders and stakeholders.
In fact, within a company you have different categories of people, who are debtholders such as
bondholders and bank (so basically the investors that are giving money to the enterprise for
different reasons), then we have shareholders (who buy a portion of the company’s shares) and
then we have all the other stakeholders (employees, governments, suppliers financial analyst…).
So, the reason why a company should be able to generate value is relevant for different
categories of actors but for different reasons: shareholders want money, bondholders want always
money but from a different perspective, customers want products, employees want a safe job…
At the same time, constraints and pressure given by these actors are really different because the
actors who interact with the company are different themselves.
Given this context, there is the need of the company to generate value in a context which is
unpredictable, a lot competitive and often shareholders and stakeholders are in competition.
How can a top management of a company be successful in creating value by maintaining this
balance between different tensions?
Through a planning and control system, which can be defined as an assembly of different
components aimed at:
- Guiding and leading managers and employees to pursue their goals;
- Motivating people, and then ensure that all the people are behaving coherently with respect to
the target of a company.
2
Definition
Let’s start with the identification of the key elements of a Planning and Control system:
• It is strictly connected with the company’s strategy. If you don’t have a strategy it is very difficult
to develop a planning and control system because you don’t know where to start from and what
to highlight.
• It is based on measures (which are called indicators) that support code of conduct and internal
decisions. They are the main component of Planning and Control system because without them
you can’t plan the activity of the company and control if it is successful.
• Planning and Control system is a planning system that look ahead (because it gives you a
direction), but at the same time is a control system that look at the past performances (you
check how good have been your actions).
• We can use it for vey long term plans but at the same time it can also support everyday
activities (such as DPO and DSO and the exchanges with your suppliers/customers).
A Planning and Control system is also called:
- Management control system
- Performance management system
- Performance measurement system
If you find one of those above, there are different ways to call the same thing.
The idea is always the same: we have a collection of components that guide the decison of a
company and the motivate people and their actions.
How can we understand which are these components and how they are correlated to each other?
Given that there are different words, also the different components of a Planning and Control
system and their connections are proposed in a different way.
Structure
So if you search in the literature reference frameworks for all these items, you will find a hundred
of different schemas which represent which are the components of the system and how they
related to each other.
We will see just three main frameworks:
- Otley (1998): it is a complete scheme for defining what is a planning and control system. The
main problem of this schema is that it mixes the components with the connections between
them (so the actions). That’s why is difficult to applicate this schema in reality.
- Simons (1994): it explicitly introduced the need to balance between motivational issues and
decision making, but underplays the notion of “planning and control”.
- Azzone (2000): it analyse separately the components and the actions, so there is a clear
distinction between them (this is our reference framework).
Otley (1998)
According to this framework, Otley said that if you want to identify a planning and control system
(which he called management control system), you have to take in consideration five components.
There are some key questions for each one of these components:
1. What are the key objectives that are central to the organization’s overall future success, and
how does it go about evaluating its achievement for each of these objectives?
2. What strategies and plans has the organization adopted and what are the processes and
activities that it has decided will be required for it to successfully implement these? How does
it assess and measure the performance of these activities.
3. What level of performance does the organization need to achieve in each of the areas
defined in the above two questions) and how does it go about setting appropriate
performance targets for them?
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4. What rewards will managers (and other employees) gain by achieving these performance
targets (or, conversely, what penalties will they suffer by failing to achieve them)?
5. What are the information flows (feedback and feed-forward loops) that are necessary to
enable the organization to learn from its experience) and to adapt its current behaviour in the
light of that experience?
The difficulty for this framework is that if you have to translate these 5 questions in something
which is real/that works, you don’t know how practically to do it. That’s the reason why even
though it is very pragmatic in identifying 5 elements that characterise a panning and control
system, it is very difficult to understand how these components interrelate with each other.
This author some years later updated that framework (2009) with the help of Ferreira, also
providing a visual representation of the framework which is this one:
Then they decided also to change the title: it is no longer a management control system, is a
performance management system, but the essence is the same.
They tried basically to unpack those 5 components: rather than five, they became 12.
As we can see, according to the framework, the company starts from the vision and the mission
which are translated in key success factors.
If you have success factors you need to have a structure, strategies and plans, measurement,
targets, performance evaluation and rewards.
All of these sequels works if you consider the fact that the system should be used, you should
have information flows, there should be coherence and you have to take in consideration some
changes because while making the analyse you realise these items do not work properly.
All of this is contextualised inside the culture of the company and then into the environment.
All the 5 components have been unpacked, but still there are some difficulties in understanding
how we can link all these items together.
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Simons (2009)
Another way of representing our planning and control system is the framework by Simons.
This framework is known as lever of control and it is one of the most famous framework in
strategy.
So, how did Simons apply the point of planning and control system?
The starting point is still strategy: we have a business strategy, so if we want a company to be
successful in creating value through the realisation of the business strategy, we have to consider
four different systems that should be present at the same time. These four systems are:
- Belief systems, which means that in an organisation you have to identify core values. So belief
means that all the employees share a value and even without rules people will behave in the
same way and this will ensure the alignment and the realisation of the strategy
- Boundary system, which is what people don’t have to do. Such as there are values, there are
also some boundaries, so you the “don’ts” that are actions that people and employees don’t
need to do.
- Diagnostic control system, which is the part of measurement, so measures and numbers are
collected within this system.
- Interactive control system, whose logic is that the environment is turbulent and if you wait for
the collection of measures form the diagnostic control system it could be too late. So how can
you detect the signals from the environment earlier than objective value provided by diagnostic
control system? By catching strategic uncertainities in an interactive way (talking directly to
people).
Azzone (2000)
This is the reference framework that we will use for describing and then for understanding the
structure of a planning and control system.
According to this framework, planning and control system is composed of three main
components (budget, set of performance measurement and reporting) that are connected to each
other through a set of actions, which is called cycle.
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What are the actions that we need to implement in order to define a budget?
We need to define an objective, consider resources and then we have to take in consideration
risks, that’s how we define a budget.
In the middle we have the system that you want to control which means the enterprise.
Given this system to control, we set our plans (target revenues, target customers…) relying on the
budget, then at the end of the period your action is to measure the actual results so you don’t
have budget values any longer but only actual values. This measurement happens through a set
of indicators called key performance measurement.
So we look ahead with the budget, you measure the result through a set of KPIs, the next step is
to report your results through a reporting system: a way to summarise your results for the
reporting is comparing the budget values with actual values and this method is the variance
analysis.
Lastly, on the basis of the variance analysis you can change/update the objectives or reorganise
your actions in a kind of different ways.
Purposes
So we have seen that a planning and control system is a set of components, where these
components are budget, set of measure and reporting system that are connected with each other
with the final purpose of orienting the decision making and then supporting/guiding the behaviour
of employees. These two goals are called as internal accountability support.
More over, a planning and control system has also an external accountability role, which means
that measures and data that we collect through the measures are also used to account and then
to report results outside.
Internal accountability
Internal accountability refers to the use of a planning and control system to guide management.
As we saw, a planning and control system helps managers through two ways:
- Supporting Decision making;
- Guiding people (Motivation).
The set of decisions that a planning and control system supports is large:
- Operational
- Management
- Strategic
The decision making cycle can be divided in four phases:
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1. Definition of goals and actions
This first phase aims at defining a plan of action, considering objectives, resources and risks.
The system provides information which are based on models and assumptions, like the price
(which could be historical or predicted) and the product cost (material, labour, others).
Obviously, defining the plan needs itself a model based usually on the profitability, whose
indicator is operating margin.
It is in this phase that the company set its target.
2. Measurement of results
After (or during) actions we want to know the results, that’s why we use measures. The
measurement would be useless if variables were known exactly since the planning phase or
pour models models were perfect.
It is important to underline that actual results differs from predicted data: this is due to
external variables (such as sales) and internal variables (such as the productivity).
Through this phase, the system and PMSs provide information on results and update on the
level of risk.
3. Variance analysis and 4. Feed-back
When results differ from forecasts we need to analyse variances in external variables and in
internal variables: the quality of the models is essential.
The final step after the analysis of variances are corrective actions, where it is important to
highlight the level of influence of external and internal environment.
But how can we use a planning and control system to motivate people?
Basically, motivating your employees is divided in two phases:
- people should move;
- People should move in the direction that is coherent with the company.
How can we ensure that people within the organization people put their efforts to pursue that you
want them to pursue?
There are some theories that can be taken into account:
1. Equity theory: it explains the importance for people to put efforts in the organization.
The idea is that everyone will provide some inputs (effort, time, skills…) inside your
organisation, so that they'll receive some outputs (salary, benefits…).
Why we are talking about equity? Because the people put their efforts inside the organisation
if they perceive to be treated as their colleagues: the situation is balanced when the “ratio” output/input - is similar among individuals doing similar activities. In fact, a perception of
difference leads individuals to modify the ratio.
If this ratio is not the same for everyone but it is higher for someone we are talking about
overestimation that leads to an increase of expectations of the person considered.
On the other hand, if the ratio is lower for someone there is an underestimation of the person
considered, so that this one will reduce his efforts.
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2. Choice theories: they take into account the fact that once I have convinced someone to
make the efforts, I have to avoid the problem of behaving not coherently with the organisation.
The theories we can take into account to convince people to behave as the organisation want:
• Expectancy theory: according to this theory, individuals are rational, so they act for
maximising their results with equal efforts. There are two elements considered in this
relation:
reward and the
effort.
The expectation is the ratio between the reward and the effort.
It can be decomposed into two main blocks: the reward/performance and performance/
efforts, which means that if I increase my efforts, my performance will be grater and so my
reward. The organisation leverage on this aspect to convince people in behaving in the
direction that the organisation want.
We need to develop a set of indicators that take into account two aspects:
- the system needs a set of measures able to catch specific responsibilities.
- The system must be complete.
• Goal setting theory: once you have set targets for employees, how can you set them?
According to this theory, individuals decide to which objective addressing their effort on the
basis of their importance for them (as individuals).
In the picture you can see a sort of trade.off between the difficulties of the objectives and
the results achieved. If the objectives are too simple and no challenging, you are not
motivates, such as they are too much difficult. Individuals increase their motivation when
well defined goals are set, they are challenging and hard to be reached, but they effectively
be reached.
External accountability
Planning and control systems are designed mainly for internal accountability but the alignment
with the use of indicators for external accountability is crucial.
Companies needs to communicate externally their results to:
- Shareholders
- Banks and other financers
- Central Government and local authorities
- Clients and suppliers
The number of reports and information we find on companies’ websites is wide:
- Financial reports
- Corporate governance reports
- Environmental reports
- …
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Requirements
The requirements of a planning and control system are:
• Measurability, is the ability to associate performance and risk with indicators that can be
clearly and univocally measured
• Completeness, intended as the capability of PMS to control all the factors relevant for
enterprises.
• Precision, which is the correlation between the diverse indicators and the present value as the
ultimate reference goal for companies.
• Long-term orientation, which is the capability to measure and manage long-term implications.
• Timeliness, focusing on the need for indicators to enable prompt managerial action.
• Specific responsibility, which is the capability of PMS to give organizational units (and
managers) responsibilities on which they can act.
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Budgeting
Definition
In order to define the budgeting we enlarge a little bit the perspective positioning the budgeting
into the planning process (looking ahead and making forecasts).
Considering that a company plans with a different time horizon, as we can see in the graph below,
typically when forecasts are made in the very long term (5-10-15 years) we are dealing with the
strategic planning, which is a strategic activity which involves top management (Chief Executive
Officer and sometimes the Business Unit Managers). The output of this activity is a document
called strategic plan also known as business plan.
In medium period (usually a couple of years) you do an activity called programming which means
that you translate your long term oriented vision into activities that will last for the next 2-3 years.
Tipically, when you make programs you also include functional managers (not just the top
management).
Lastly, in a short term horizon (1 year), you make instead a forecasting and planning activity which
is called budgeting. As you can see, when you make a budget you involve all the organisation.
More precisely, budgeting is a process through which an enterprise make three different things:
- The enterprise forecasts future cash flows, so the company identifies the future revenues, future
costs and future revenues (future intended as the value expected for the upcoming year);
- The company assigns targets (more specific objectives) to the organizational units;
- Lastly, the firm identifies the resources and the actions that it needs in order to realise the
forecasts that the company has identified.
Keep in mind that if you want budgeting, the starting point is always the strategic objective: once
you have this strategic direction you try to forecast the future financial flows and then, as a
consequence of the value that you want to achieve, you translate the strategic purpose in more
specific targets and identify the resources that you have to invest and the actions that must be
made.
Since we have defined the budgeting as a process, it is important to underline that every process
has an output.
The output of the budgeting process is a document (called Master Budget) that summarizes
financial forecasts and targets. The difference between this document and the traditional financial
statements (they are really similar in terms of content) is that the value that you can see inside the
master budget looks ahead rather than looking back.
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The distinctive elements of budgeting are the following:
• If we prepare the budget, it involves all the company (company-wide);
• It is a very concrete plan because we identify the amount of future profit, future cash and future
assets;
• It is derived from the strategy (you need to know why and how achieve that numbers);
• In preparing the budget, you have a crucial elements which is people. They are central because
you give targets to managers and you involved the employees because they are affected by the
target setting. Finally, the CFO /who is in charge to prepare the budget) support all the process.
Objectives
The reasons why we need a budget are different.
Budget support firstly the decision making role. It is used to define what to do: it translates long
term plans into operative actions and activities. With the budget we also answer to the question
“how to go (at that specific value?)” through the identification of the needed resources. Lastly, the
budget identify who is in charge to lead the actions, which means who is accountable for the
results at the year.
Connected with what we have just discussed, we can use budget to set targets and then
bonuses, which means trying to increase effort of people, to guide behaviour of people and to
enhance communication. So the budget support also the motivational role.
Sometimes the budget is also used for an external accountability purpose, so to communicate
future plans outside. This external accountability role is typically used by listed companies to
show to investors their future actions, while this in non-listed companies is really difficult.
Structure: Master Budget
The master budget is the output of the budgeting process. It is the document that forecasts
financial results of the upcoming period (typically one year).
Master Budget encompasses three main categories of budgets:
• Operating budget, which originate from the typical (characteristic) management of a business.
It defines revenues and operating costs, so the operating activity where we see the operating
result: its purpose is to see whether a company is able to generate revenues and to define the
amount of resources invested for generating that value.
• Capital expenditure budget (CAPEX), which define the investments, whether the company
invests, for instance, in financial or human resources for medium and long term period. So this
type of budget affects the assets side of the balance sheet.
• Financial budgets, which evaluate the impact of operating and investment plans on cash
inflows and outflows.
Once you prepared these documents, you have to condense everything into:
- Budgeted Income Statement;
- Budgeted Balance Sheet;
- Budgeted Cash Flow Statement.
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You can see in the picture above the typical flow.
Typically the budget starts form where do you want to go, so the strategies and the objective.
Then you go in parallel between the operating activity (what you want to sell, so you start the
budgeting revenues) and the identification of your investments (so the capital expenditures).
At this point you are aware that if you work on your operating activity and your capital
expenditures, this will affect your cash (you will have cash in and cash out) which in turn will affect
the income statement and then the overall financial statements.
Before analysing each document of the budget, it is important to underline that even though
budgeting process exists in whatever company, in any case there is a kind of heterogeneity in
how the process and then the document are structured by companies.
You can see differences in terms of the contents of the document itself, so sometimes you can
find very aggregated informations, which means that the three schemas (balance sheet, income
statement and cash flow statement) or you can find something which is a little bit more
disaggregated and with more detail.
You can also some different formats (something more visual with images and something more
descripted).
Regarding the articulation of the preparation process, the length and timing can be different.
Moreover the approach could be top down or bottom up.
Another element of difference is about the approach to the budgeting, which means that you can
have something very quick but less precise (the Accenture presentation will give us information
about how we can approach the budgeting).
Lastly, the other item that we have to keep into account is how often how we update our budget.
Typically there are two main approaches:
• According to the standard approach, you do something like this: you prepare the budget in
October, by the end of December everything is defined and you save the budget. Then, at the
end of January you have the actual value of the first month of the year: so you compare the
actual value of January with the budget value, so you start making a variance analysis
depending on the results of January, then you will do the same in February, in March, in April
and so on and then you will do what is defined as yearn forecast.
So basically at January 31st you will adjust the budget until December depending on the results
that you did in January: in February, you check if the results of this month are aligned with the
budget and then you adjust the results until December 2021.
This approach introduce the variance analysis, because at the end of each month you check
whether your actual value is aligned with the budget: if yes you’re happy, if no you try to
understand why it is not aligned.
• There is another approach known as rolling forecast, which is a kind of continuing budgeting,
because every month (or every quarter) you budget for the upcoming twelve months.
The purpose of the rolling budget is to give management the chance to revise plans and make
more accurate forecasts, but this is very time consuming and typically it is adopted for
companies that have a very dynamic environment.
In the graph below there is an example of a company which budgets every 3 months for the
next 18 months.
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Operating budget
The operating budget aims at forecasting the operating result/EBIT. We are making ourselves
what is the operating result of the next year.
This below is the structure of the operating budget:
To calculate the EBIT, we use budgeted revenues, budgeted cost of good sold and budgeted
period costs. As you can see, the non recurring expenses/income are equal to 0 because you
can’t forecast something unexpected, that’s why the operating result is equal to the EBIT.
Once we achieved the EBIT, we ask ourselves whether the budgeted operating result is
acceptable and consistent. Typically, we answer this questionably considering the return on sales
(ROS), so the impact of our operating result on the revenue that we have.
Now we enter the detail of how we budget each of this item. In fact, in order to develop the
operating budget, the following budgets need to be prepared:
1. Revenue budget
It is usually the first budget to be drafted.
Typically it has a really simple formula which is amount of products that you want to sell (the
quantity) multiplied by the price. If you have different products, you sum up their quantities and
prices and then you have finished to prepare your budget.
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The idea is that per each product that the company have, per each month of the upcoming year
the company just tries to identify how many units it wants to sell and the price.
We can do this as a final result for the entire company: in order to arrive at this final value, you
may need to identify the budget for each product line, for each geographical area, for each
client… (so they can reclassified in different ways).
The crucial part of the budget is the starting point (your objective), be cause depending on the
quantity that you want to sell and the price all the rest is a consequence.
So there is a strong linkage between the preparation of the revenue budget and the strategy.
How can we budget our revenue? We have to take into account the external environment (the
state of the local and national economies, the state of the industry’s economy and the nature of
the competition) and the internal environment, which is a little bit easier because you have to
consider relationships that you have with your clients, your operation plan, your strategy and so
on.
We can take into account these two environments by using external reports, investors’ and
market’s analysis and then we can develop our own analysis to understand what is happening in
the global environment to define our plans.
Anthea case: prepare the revenue budget
This case is aimed at exercising on forecasting financial results for the year 2021 for Company
Anthea. Anthea wants to achieve a target ROS (Return On Sales) in 2021 higher than 15%
compared with the value of the previous year.
Anthea hypotheses for building the 2021 budget:
• The company manufactures only one type of product;
• Inventories are accounted using the Last In First Out (LIFO) method;
• Inventories of Finished Goods are accounted using the full manufacturing cost method;
• The scale of production cannot be increased in the short-term;
• Target levels of inventories at 31/12/2021:
- Raw materials: + 5% kg compared to 31/12/2020;
- Finished Goods: + 50 units compared to 31//12/2020 (this decision cannot be modified).
Inventories at 31/12/2020 (pre-actual):
Relevant data:
a) Sales:
- Volume of sale: 1,000 units;
- Price: 70 €/unit.
b) Production:
- Maximum capacity (maintenance not included): 3,000 hours/year;
- Scheduled maintenance: 150 hours/year;
- Standard data used to plan production activity:
- Standard indirect costs:
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• Variable: 1.50 €/machine hour with this breakdown:
- Energy: 0.90 €/machine hour;
- Other costs: 0.60 €/machine hour;
• Fixed:
- Equipment depreciation: 3,000 €;
- Supervisor: 2,000 €;
- Other costs: 605 €;
- Price for purchasing finished goods from an outsourcer: 45 €/unit.
c) Other costs (non-manufactoring):
- Labor:
• wages sales department: 4,800 €;
• wages administration/human resources/R&D departments: 5,000 €;
- Sales commissions: 2% sales;
- Advertising and marketing expenses: 4,300 €;
- Costs for administrative activities: 2,000 €;
- Expenses for R&D: 5,000 €.
Determine the expected revenue for 2021.
Since it is:
- Units: 1,000 u (defined by Sales Manager)
- Price/unit: 70 €/u (defined by Marketing Manager)
The Revenue Budget will be equal to 70,000€
1-2. Production budget
When you finish point 1, there is a budget called “from 1 to 2” which is the production budget
which is the only budget expressed in units (not money
With this budget we define how many units we need to produce.
According to this budget, we can have that the quantity we want to sell equals the quantity that
we want to produce, but it may be not because of the inventory of finished goods. So what we do
is to check whats the level of inventories that we want to keep, which means that the units we
want to produce equals the units that we want to sell plus the targeted variation of the inventories:
Once you have these units, you have to check if the company has enough internal capacity in
terms of raw materials, labour… to produce those quantity (resource constraints).
So you have to check if:
Before starting calculate this, it is important to underweight the accounting principles on
inventories.
The IAS principle of reference for accounting inventories is IAS 2.
IAS/IFRS include, as Inventories, assets held for sale in the ordinary course of business (finished
goods), assets in the production process for sale in the ordinary course of business (work in
process), and materials and supplies that are consumed in production (raw materials).
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Inventories are required to be stated at the lower of:
• Cost, including:
- costs of purchase (including taxes, transport, and handling) net of trade discounts received;
- costs of conversion (including fixed and variable manufacturing overheads);
- other costs incurred in bringing the inventories to their present location and condition.
Net
realisable value (NRV), which is the estimated selling price in the ordinary course of
•
business less the estimated cost of completion and the estimated costs necessary to make the
sale.
The cost evaluation must take into account the sequence of use of goods:
• FIFO (first in first out): goods that leave the firm are those that have been in inventory the
longest. Consequently the inventory on hand is assumed to be the latest.
• Weighted Average cost: the business is regarded as a series of transaction that could not
reasonably be separated (The physical flow is ignored). Each units has a value equal to the ratio
between the total costs of goods produced and bought and the quantity produced or bought
over a considered period.
• IAS/IFRS do not permit the use of LIFO (Last In First Out): Goods that leave the firm are those
that have been in inventory the shortest. This is not permitted because the balance sheet holds
an unrealistically low and out-of date inventory figure.
Anthea case: production budget
According to the data, the production budget is equal to:
The variation of the inventories are 125 [75 (the value of the inventories at the beginning of the
year) + 50 (the budgeted variation of inventories at the end of the year)] - 75 (the value of the
inventories at the beginning of the year).
We have to check the capacity:
The resources to be checked are:
- Raw Materials: there are no constraints
- Labour: there are no constraints
- Machine Capacity: there is a constraint:
• AVAILABLE CAPACITY = (3,000 – 150) = 2,850 hours/year
• REQUIRED CAPACITY = 1,050 units * 3 hours/unit = 3,150 h/y.
We need additional 300hours. The plan is not feasible, so what can we do to pursue our
objective?
There are different alternatives:
- Increasing capacity by purchasing a new machine: NOT POSSIBLE
- Decreasing final inventories: NOT POSSIBLE: they are MANDATORY
- Increasing productivity: NOT POSSIBLE: it is a STANDARD VALUE!
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- Decreasing sales: NOT CONVENIENT (loosing market share)
- Decreasing maintenance time: DANGEROUS!
- Outsourcing: Purchasing Price < Selling Price [ 45 €/u < 70 €/u]
The purchasing price is lower compared with the selling one, so the company can produce the
maximum of the possible units (950) and buy the others (100) from an outsourcer.
2. Cost of good sold budget
Cost of good sold means that the focus is just on the units of goods that we have to produce
internally, because the cost of goods sold is exactly how much costs manufacturing a certain
quantity of products.
Cost good sold means that we have to prepare three main budgets:
2.1 Direct material budget, so how many raw material do we need to realise that product.
2.2 Direct labour budget, so how much cost for direct labour do we have.
2.3 What is the cost for the manufacturing OVH (variable and fixed).
Keep in mind that once you have calculated the cost of good manufactured, we have to consider
the amount of inventories.
Technically, what we do is something like this:
2.1 Direct material budget
This budget forecasts the amount of direct material involved in the production process.
To define the value of direct material, what we do is keeping the bill of material, identifying the
different components and then we realise this kind of table:
For each product we make a list of its components. For each component, we identify the usage
per unit and then the total units that you need. If you multiply the total units by the unitary cost,
then you will have the total value of the materials that you need.
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But is the quantity of raw materials that we need in the production the same that we need to buy?
The answer is no, because of inventories of raw material.
Given the quantity of raw materials that we need, what is instead the quantity that we need to
buy? We calculate it through this formula:
This is important because it will affect also your cash flow statement, because the cash outflow is
connected to what you buy.
2.2 Direct labour budget
But how can we calculate the cost for direct labour?
Typically if you are considering the manufacturing labour, it is a variable cost and you can
calculate how much does it costs considering the units that you need to produce multiplied by the
wage rates of cost of labour.
2.3 Manufacturing OVH budget
Finally, we move to overheads, which are also defined as indirect costs.
They are manufacturing overheads, so they are indirect resources that are used in the production
process but not uniquely attributable to a unit of your production.
It is necessary distinguishing between:
• Variable overheads: they fluctuate proportionally with the quantity that you produce (ex.
energy). The forecast is made considering usage per unit.
• Fixed overheads: all of those costs which are related to manufacturing process but which are
not connected wit the realisation of a unity of product. Forecast is made analysing the following
aspects: depreciation, insurance, plant supervisions…
So, if we sum up direct materials, direct labour and manufacturing overheads we have the total
cost for manufacturing our products. This is crucial because if we divide the total cost for the
units that we produce, we will obtain the unitary cost which is used in accounting.
Summing the beginning finished goods inventory with the cost of goods produced and the cost of
goods purchased, we will obtain the cost of goods available for sale.
Then, adjusting this value considering the value of the ending finished goods inventory, we obtain
the cost of good sold.
Anthea case: prepare the cost of good sold budget
Let’s start from calculating the direct material budget:
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There are two different costs per kg:
- 1 €/kg for raw materials already in the inventories;
- 2 €/kg for raw materials purchased during the coming year.
Since:
- The company applies a LIFO logic;
- The inventories increase at the end of 2021.
This implies that:
- The company will use only the raw materials purchased during 2020;
- The cost per kg will be 2€/kg.
So the direct material budget will be:
Direct Material Budget = 6 kg/unit * 2 €/kg * 950 units = 11,400 €
Then we can go ahead and the calculating the amount of units that we need to purchase, which is
instead 11,500€.
The quantity of raw materials manufactured is 11,400€, then we have to consider how many kilos
we need to purchase and then the cost of purchasing, which is affected by the quantity of raw
materials that we have in stock.
So, remember that the purchase of direct materials is:
5700 Kg are used in the production process for a value of 11,400, while 5750 are purchased for a
total cost for purchasing raw material = 11,500€.
Let’s move now to the direct labour budget:
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So the direct manufacturing labour budget is:
= hour/unit * 8 €/hour * 950 units = 15,200 €
Then we make a step ahead, which is the calculation of manufacturing overhead budget.
So we have to calculate:
• Budgeted variable overhead = 4,275 €
- Energy = 0.90 €/hour * 2,850 hours = 2,565 €
- Other variable costs = 0.60 €/hour * 2,850 hours = 1,710 €
• Budgeted fixed overhead = 5,605 €
- Equipment depreciation: 3,000 €
- Supervisor’s salary: 2,000 €
- Other costs: 605 €
If we sum all of these items we have the total budgeted overhead for the manufacturing process,
which will be 9,880 €.
Now, we can move on and calculate the cost of goods manufactured, which is the sum of:
+ BUDGETED COST OF RAW MATERIALS = 11,400 €
+ BUDGETED COST OF LABOUR = 15,200 €
+ BUDGETED OVERHEAD = 9,880 €
The budgeted cost of goods manufactured will be: 36,480 €
While the full cost per unit: 38.4 €/unit (36,480/950)
The cost of goods purchased is really simple:
Unites to be purchased = 100 units
Price per unit = 45 €/unit
So the budgeted cost per purchased finished goods will be: 4,500€
In order to calculate the cost of sales, we make the following passages:
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If we go a step ahead with this, what we can see is that if we make the difference between the
budgeted revenue and the budgeted cost of good sold we obtain the gross margin. Considering
our goal to calculate the operating result/EBIT, what is missing now are just the budgeted period
costs.
3. Period costs budget
Period costs are general and variable expenses which are also called non-manufacturing
overhead. They include three main categories of costs:
- Selling and marketing expenses: usually relevant marketing budget and division between fixed
and variable costs
- Administrative and general expenses
- Research and development expenses
Typically you will find them as SGA (selling and general administrative expenses). Their typical
characteristic is that they are not related to the production process (so with the number of units
that you produce and sell).
If you look in the annual report the incidence of this period costs is usually very very high.
Anthea case: prepare period cost budget
To prepare period costs budget, you detail one by one all the costs and sum up:
Selling and Marketing expenses = 10,500 €
- Wages sales department: 4,800 €
- Sales commissions: 2% revenues = 2% * 70,000 = 1,400 €
- Advertising and marketing expenses: 4,300 €
Administrative and General expenses = 7,000 €
- Wages administration / HR / finance & control: 5,000 €
- Costs for administrative activities: 2,000 €
Research and Development expenses = 5,000 € Expenses for R&D: 5,000 €
Summing up these cost, we obtain the period cost budget = 22,500€
The operating result will be:
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How to account for inventories: LIFO
In Anthea case study we saw that inventories were accounted using the Last In First Out (LIFO)
method, which means that the last component entering will be also the first going out. So what is
in the stock, if any, is evaluated at the value of the inventories (what is left at the end of the
period).
That’s how we accounted the inventories in this exercise.
At 31/12/2020 we have 75 units of finished goods whose value is 3000 €.
We also know that the company has a target to have 50 units more for the end of 2021.
So we have to calculate quantity and value of budgeted finished goods:
In green there is the data already available, in orange we have the delta of units that the company
wants. This means that the total amount of budgeted finished goods is 125.
The value of the quantity of finished goods depends on the logic of the inventories. According to
the LIFO logic, 75 of these units are evaluated at the initial value (which is 3000€), while the
additional ones are valued at the full manufacturing cost of the period (that was 38.4 €/unit).
So the value of finished goods will be 3000 + 38.4*50 = 4920.
Then, we do the same for raw material.
We know that the company consumes 6kg to realize one unit of product and the cost per kg in
2021 is 2€/kg. We also know that the company has as a target for raw material inventories a + 5%
kg compared to 31/12/2020.
So we have the initial quantity of raw material (1000) whose value is 1000 €.
Then we have a target quantity of + 5%, which means that at the end of 2021 the company wants
1000*0,05 = 50 units more compared to 2020. So the final value of raw material will be 1050: how
can we evaluate their final value?
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Given the LIFO logic, the value of 1000 initial units will be always 1000kg*1€/kg = 1000 €, while
the value of the additional 50 units will be the value of the year, so 50kg*2€/kg = 100 €. So the
final value will be 1000 € + 100 € = 1100 €.
Preparing P&L
Just to clarify, how do we account for the variation of raw materials?
Basically we have 70.000 which are the revenues. If we apply the P&L by function, we have to
identify the initial value of finished good inventory (3000) and then we have to consider direct
materials used, direct manufacturing labour and manufacturing overhead.
The value of the direct material used in the production is equal to what is purchased (11,500€)
minus the variation in the raw materials inventories (100€).
If we sum up all these three elements we have the cost of goods manufactured/available for sale,
the we consider the value of the inventory of finished goods so that we can calculate the value of
goods sold.
Instead, if you prepare a P&L by nature we do not see explicity the variation the value of the raw
materials simply because we consider the direct material used, so we already calculated this
difference.
We start from revenues and we add the variation of finished goods (1920) and work in progress
(0). Then we deduct all the operating costs: in this section you have to highlight the purchase of
raw materials (11,500) and the variation of the inventories of raw materials (100).
(Depreciation will be added after defining expected capital expenditure)
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If we compare the two income statements, you can see that whether you use an income
statement by nature or by function, they are just different ways to highlight the value of the
inventories. If you use it by nature, you can clearly see the variation of finished good, the raw
materials purchased and then the variation of their inventory, while if you use it by function you do
not see this because you just consider what is used and consumed in the production.
How to account for inventories: FIFO
The LIFO is applicable if the company works in Italy, because the Italian accounting principles
allows the least in first out logic, while if you consider the IAS/IFRS this logic cannot be adopted
any longer.
The reason why is because according to the LIFO logic, the value of the stock is the oldest one,
so if you continuously having something in stock, its value could be the one of 5-10 years ago.
For this reason, the logic adopted by the IAS/IFRS its the First In First Out Logic (FIFO), which is
the exactly the opposite: the first items (raw materials and finished good) that enters in the stock,
are also the first going out.
So what is left in the ventures is the new material, that’s why the value of the inventories is the
value of products produced/purchased in the period.
Anthea case: prepare the operating budget using the FIFO logic
Let’s start for the raw material inventory.
The initial value is the same of the LIFO logic (1000kg*1000€/kg = 1000€), what changes is the
final value of the raw material inventory: in fact all the raw materials in stock are valued as the last
quantity that has been purchased (so 2€/kg).
What instead about the calculation of the cost of raw material?
Since we have to produce 950 units, we said that the company needs to use 5,700 kg of raw
material:
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Since 1,000kg come from the stock (1€/kg) and then 4,700kg are purchased (2€/kg) so the total
cost for the raw material used will be 1,000 € + 9,400 € = 10,400 €.
The total cost of raw material is lower because we are using raw material whose value itself is
lower: in fact according to FIFO logic we use before the raw material in stock rather the the ones
just purchased.
This means that we are changing the full manufacturing cost such as the unitary cost:
Full manufacturing costs /units produced = 35.480€/950u = 37.35€/u
(in LIFO was 38.4 €/u)
Then we do the same thing for finished goods.
In this case, if we consider also to sell before the finished goods in stock, finished good are
valued at the full manufacturing stock:
This means that in our operating cost what changes are the direct material used and lastly the
value of the ending finished goods inventory. This also means that what cadges is our gross
margin and, consequently, the EBIT.
Inventories and their effects on financial results
This is a small comment on the impact of increasing/decreasing inventories could have on
financial results (EBIT and the cash flow).
The cost of good sold is calculated as the value of inventories at the beginning of the period plus
the what we purchase for the production process minus the value of inventories at the end of the
period. This means that the gross margin is the difference between the revenue and the cost of
good sold.
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Example:
Period 1: let’s assume that you have this situation in which a company purchases 2.000€ of Raw
Material that enter in stock.
If we look at the gross margin it is 0, because the revenue itself is equal to 0 such as the cost of
good sold (because we calculate it deducting the final inventories).
But if we look at the cash situation, the net cash is - 2000 because the company spent that
amount of money for raw material.
Period 2: the company uses the Raw Material purchased previously, employs 1000€ of Direct
Labour and incurs in 500€ of other production costs, to produce semifinished products (WIP),
which are entered in stock.
You can see that (again) the gross margin is 0, because revenues are still equal to 0 such as the
cost of good sold. The cost of good is 0 because the purchasing are 1000 + 500 = 1500, the initial
inventories are 2000 (the value of final inventories of period 1) while the final value of inventories
are 2000 + 1000 + 500 = 3500 because the company puts everything in stock.
If we look at the cash flow, the net cash is - 1500 because the company purchases direct labour
and incurs in other production costs.
Period 3: the company uses the semifinished products previously entered in stock, and employs
an additional 500€ of Direct Labour, to produce finished products, which are again entered in
stock.
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Again, the gross margin is 0 because the purchases are equal to 500, initial inventories
(inventories of period 2) are equal to 3500, while the final inventories are 4000 (3500 from the
inventories and the additional 500). The cash flow is always negative, due to the purchase of the
additional direct labour.
Period 4: The company sells the finished products previously entered in stock, obtaining a total
revenue of 5000€.
Now the gross margin is equal to 1000, because revenues are equal to 5000, purchasing are
equal to 0n because the company doesn’t buy anything, the inventories at the beginning of the
period (the final inventories of period 3) are equal to 4000 while the final inventories are 0, so the
cost of good sold is equal to 4000.
That’s why the gross margin is equal to 1000.
We also have a positive net cash (tabelle sbagliate), equal to 5000.
If we look at what is happening in term of profit (cash in and cash out), we can see that we have
no profit in the first three periods and a profit of 1000 in period 4 (in which goods are sold).
If we look at the cash situation, cash is something that happens immediately.
So the cost of good sold it is absorbed into the value of ending inventories, that’s why they are
called inventoriable costs, because they do not influence the profit until the products are sold.
On the other hand, period costs (selling, general and administrative costs) they are also called
non-inventoriable costs because they have an immediate impact on profit.
Capital expenditure budget
The capital expenditure budget identifies the amount of expenditures for fixed assets such as:
- Property
- Plans
- Equipment
- Technologies
- …
Capital expenditures (CapEX) are often contraposed to operational expenditure (OpEX): the
first one are the new investments into fixed assets, while the second one are costs for the
operating cycle of the business.
The capital expenditures, since they are new investments of the company, affect all of the three
financial statements:
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• They affect the balance sheet, because a new investment increases the non-current assets.
Again, remembering that it is a non current asset, we have to consider the value in the first year,
but then there will be the problem of considering the value of course to the years subsequent to
the first one.
• Since we have a new asset, we may have the annual depreciation that enters in our income
statement.
• The cash outflow of the year because of the investment is exactly our capital expenditure and it
affects the cash flow statement. We consider both the cash out for the acquisition of new
assets and the cash in of disposal of assets.
Anthea case: prepare the CapEX
This is the situation of the company:
- Assets already in the Balance Sheet refer to manufacturing equipment and will be depreciated
for 1,000€.
- On 01/01/2021 the company will buy another equipment for 10,000 €, depreciation over 10
years. This asset is paid as follows: 5,000 € in 2021 and 5,000 € in 2022.
- The company will buy a new information system (IT) for production scheduling for 5,000 € that
will be paid in the second semester of 2020. This investment is depreciated over 5 years from
2020.
We start detailing our capital expenditure strategy, since the acquisition:
The real capital expenditure of the year is the cash outflow of that year, so the 5,000€ that will be
in 2021. The depreciation of this equipment will bee 1,000€ (10,000€ /10 years) in 2021.
If we do the same for the second investment, we obtain:
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It is clear that the CapEX for the IT acquisition will be 5,000 € (the cash outflow in 2021). The
depreciation is again 1,000 € (5000 €/ 5 years),
The capital expenditures of the company in 2021 is the sum of cash outflows because the
acquisition of new investments in the year.
Instead the total depreciation is the sum of the depreciations of the new investments (equip and
IT) and the depreciation of the assets already in the balance sheet.
Financial Budget
Financial budget deals with cash, so the idea is to understand if we have cash enough to manage
the business of the upcoming year.
In making financial budget, a company prepares two many type of budget:
• Budgeted cash flow statement, which is the cash flow of the company prepared in advance with
the budgeted data: its goal is to assess the financial sustainability of operational and
investments plans.
• Detailed cash budget, whose idea is to show period by period (month by month/week by week/
quarter by quarter) the cash situation of the company (cash in and cash out) which must be able
to cover the expenditures.
Budgeted cash flow
The budgeted Cash flow statement assess the aggregated financial sustainability for the entire
forecasting period (usually one year).
There are two ways for calculating the cash budget:
- Direct method, through which we forecast and registrate all the future inflows and outflows: we
make a list of all the cash out and cash in without considering their nature and we just make the
difference.
- Indirect method, which is used by most companies because they start from adjusting the
accrual data to arrive at the financial one.
They apply this method thanks to the budgeted cash flow statement:
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We start from the operating profit and then we adjust it in order to calculate the FCFF and the
FCFE, which is the cash that the company will be able to generate in the upcoming year
Anthea case: prepare the budgeted cash flow
This is the structure of the budgeted cash flow statement and if we go step by step we can
highlight the different passages.
As first point, we go back to our capital expenditure data and then we add to the budgeted EBIT
the values of depreciation and the capital expenditures (which are negative because there are
only acquisitions and no disposals):
As second step, we calculate the variation of Net Working Capital.
The variation of the Net Working Capital is nothing more than the difference between the Net
Working Capitals of the two periods considered: ∆ NWC= NWC(t)– NWC(t-1).
The Net Working Capital is equal to: NWCt = ARt + INVt - APt, where:
- AR = Account receivables;
- INV = Inventories (raw material, Work in Progress and Finished goods);
- AP= Accounts payables
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How can we account for receivables?
We have to consider the initial value of them, which is the one that we have in our pre actual
balance sheet.
Then we have to calculate the final value of the receivables, which depends on the revenues
(which are = 70,000 €). Since the average collection period for receivable is 3 months, the final
value of the account receivable will be those amount of receivables of the last three month of
2021, so 17,500 €.
We can do the same thing for the payables.
We find the initial value of payables in the balance sheet, while the final value will depend on the
purchase of raw material = 11,500 € (not the cost = 11,400 €) and the collecting period.
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Regarding the inventories, this is what we have calculate previously (LIFO logic):
This is the summary of everything:
So ∆ NWC= NWC(t) - NWC(t-1) = 17,770-16,000 = 1,770 €. So:
The next step is the taxation, which is calculated as the tax rate multiplied by EBIT:
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If we make the sum of these items, what we have is the free cash flow to firm:
If we keep going with the calculation of financial strategy, we obtain what is following.
We start from dividends, which are the 50% of 2020 profit, so they are 1,000€.
Regarding instead the financial revenues, which according to the data are 600 €, but since the
taxation is 50%, the financial revenues net of tax are 300:
Now we can start with debts.
In particular we have this situation:
So we have:
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Then, according to the data, we consider the payment of interest on the past debts:
Finally we have:
If we sum up everything, we obtain the financial expenses (net of tax) and the variation of debt:
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If we sum up everything, we obtain the free cash flow to equity.
Also the FCFE is negative: this means that the company is not only destroying cash, but it doesn’t
have a solid financial planning to cover also its payments.
Detailed Cash budget
Since in the previous example there were negative FCFF and FCFE, it makes sense to prepare a
detailed cash budget. In fact the cash flow statement does not highlight the situation of subperiods across the year: there could be cash inflows concentrated at the end of the year and
problem of liquidity at the beginning.
This means that in practice what you do is something like this.
The company lists all its inflows:
Then all the outflows:
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Then we realise a synthesis scheme in which we join the two flows addressing three aspects:
- Opening level of cash;
- Total available cash;
- First cash balance, through which we check the exact amount of cash that the company has;
Sometimes you can have a minimum of cash required, a safe value, and then we have the cash
balance, which is the total cash at the end of the period. This 55 will be the opening level of
February and so on.
Typically besides this cash you also consider the debt position with banks (again month by
month): this is crucial because it is connected with your strategy of managing cash which may be
different in respect of the fact you have a positive or a negative operating result.
The last step in the Master Budget is drafting the complete Budgeted Financial Statements. The
informations from all other elements of a master budget is used to prepare a budgeted balance
sheet. A budgeted balance sheet projects the financial position of an organization at the end of a
future period.
Financial planning
Importance
The aim of financial planning is to understand how to manage properly financial needs of a
company.
In particular, we have to take in consideration that our financial structure (also defined as
coverage) should be aligned with investments structure, there should be an equilibrium.
If you think about a financial reclassified balance sheet (where you have exactly these two
perspectives), you can see in the assets the investments of a company (in fixed assets and net
working capital) and then, since you have these investments, you have to cover them with equity
or with net financials debts, which constitute the financial structure of the company.
Managing the financial planning means that we have to ensure the equilibrium between the type
of investments that we have in mind and the financial structure. This means there should be an
equilibrium in terms of time horizon (the financial structure must be able to cover long-term
debts). Moreover, we have to check the presence of a properly cash management balance (so
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that cash in is aligned with the cash out) and to take into account the equilibrium between the
return of the investments and the cost of capital.
So, how can we cover our investments?
Typically, the resource collection could take place on two principal markets:
- The equity market, that helps companies obtain financing through the issuance of shares and
in general terms of equity;
- The debt market, where financers lend money to a company, which is then obliged to
remunerate them and reimburse them according to an established contract.
This is important because changing equity or net the financial debts affects significantly the
equilibrium of a company.
The equity market
The equity market helps the enterprirse acquiring resources through the issuance of shares, which
could be:
- Common shares: they are the ordinary shares, you have the voting rights and then you receive
dividends after the preferred shareholders.
- Preferred shares: they are not associated with voting rights, but you have the possibility to
receive dividends before common shareholders.
Typically, you choose preferred shares when your purpose is to make money, while you rely on
common shares when you want instead to influence the decisions of a company.
Given that, there are two types of equity markets:
- Public equity market: companies are listed in the stock exchange so we can see each second
what is the value of a company. If a company want to be present in a public equity market it
has to pay a fee and at the same time it has to follow some requirements of that specific stock
exchange.
- Private equity market: rather than collecting shares through a listed stock exchange, you
collect these through private partners or institutional investors, who acquire shares of a
company.
The main idea of relying on the equity market is that if a company issues a new share who’s
buying the shares becomes part of company’s governance. Remember that shareholders are
always remunerated, just after the other stakeholders (they have residual rights).
While investing in shares is risky for the investors, it is instead typically recognised as a stable
source of financing for the company, because there are no time constraints and there is more
freedom in how to remunerate (dividends) or reimbourse capital to shareholders.
The debt market
The debt market is characterized by debtholders, who lend money to a company, which is then
obligated to remunerate them according to an established method and schedule.
Which are the possible instruments that we have. They are divided as follows:
• Long term instruments (more than 1 year)
- Bank/syndicated bank loans
- Corporate bonds
- Leasing
• Short term instruments (less than 1 year)
- Bank/syndicated bank loans
- Lines of credit
- Factoring
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Bank/syndicated bank loans
A bank loan is a debt provided by a bank to the company: it can be either long or short term,
depending on the maturity.
There are some features to be discussed:
• If a company ask for a debt, it has to pay an interest which is accounted as financial cost (so
affects the income statement) and it can be a fixed rate (the amount of the rate is contractually
defined) or a floating rate (the algorithm is contractually defined, bit an exact rate is not defined).
• There is a maturity which characterise every bank loan: it is the contractual term of loans.
• What affects significantly your cash in and cash out is the repayments scheme, which is the
frequency at which you provide money back. You have to distinguished the repayment of
interests (which could happen monthly, quarterly, semiannually, annually… depending con the
contract) and the repayment of capital: in this case the company can choose between a bullet
repayment (the repayment of capital is at maturity date) or amortized (the repayment of capital is
amortized over time).
• The main advantage of a bank loan compared instead with the equity market is the fact that a
debtholder is always repaid before than equity holders because he has a priority in case of
default.
How can we manage the amortized repayment of capital?
Amortized cost is calculated using the effective interest rate. The effective interest rate is the
rate that exactly discounts estimated future cash payments or receipts through the expected life
of the financial instrument to the net carrying amount of the financial asset or liability:
Example: amortized cost
In 2015 Cow company obtained a bank loan for a value of 2,000€ and a duration of 5 years; the
amount will be given back to the bank in 2020. The nominal interest rate is 4%. Cow has applied
an up-front cost = 50 €
For calculating the effective interest rate it is required to equal the present value of the debt
(1,950€, the money issued less the up-front cost) against the discounted estimated future cash
payments or receipts.
If we have a bullet repayment, the situation is the one in the first three lines of the table.
Basically we have years 0 in which the company Cow receives the money (debt = 2000) ant then
the company in year 5 (the end of the period) pays back the 2000 € received. There is also an
upfront payment for bank’s commission, and then we have to calculate interests, which are
0,04*2000 = 80 for each year (form year 1 to year 5).
If we have instead an amortized repayment, we have to calculate the effective interest rate.
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We have to think about the real cash that the company has in each year: in year 0, the actual
value of the debt is the nominal value of the loan minus the upfront payment (1950), for year 1 to
year 4 the company has cash outflows for 80, then in year 5 the company has a cash outflow of
2080.
The EIR is the rate which is required to have an equation between the present value of the debt
and the discounted estimated future cash payment.
The idea is that the nominal rate is 4%, but in reality, given that company’s cash outflows are not
2000 because of the payments, the real cash outflows that the company has at the end of the
period.
Once we have the real value of debt (1950) the next step is calculating the real financial cost for
the company, which is nothing than 1950*4,6% = 89,13 for the first year.
The discounted value of the debt at the end of the year 1 is equal to the value of the debt in year 0
(1950) plus the effective interest (89,13) minus the cash outflow (80). The financial cost in year 2
will be the admortized cost in year 1 multiplied by the EIR and so on for each year.
If you look year 5, you can see that the final value of the debt is alway 2000.
So, the amortized cost is the value of the debt at the end of each year, calculated through the EIR
which is the rate that discounts the future value of the debt. (esempio non chiaro)
To complete our overview, it is important to underline that sometimes banks ask warranties to
companies that want a loan.
Mortgage is a form of guarantee which is constituted by real estates: in case the borrower fails in
respecting its obligations, the bank can recoup the potential losses through the mortgage.
Nevertheless, the bank does not acquire the property of the mortgage but can sell it on the
market.
Lastly, the issue of a long-term loan implies other costs such as the negotiation costs, evaluation
of the mortgage value, insurance premia…
Anthea case: bank loans
In 2021, you would like to issue a new bank loan of 10,000 euro to cover capex. The maturity date
is after 5 years in 2026. The interest is a fixed rate of 10% to be paid annually, starting from 2022.
The commission fees amount to 1,000 euro to be paid in 2021.
Schedule the debt cash flows in cases of Bullet repayment.
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The first thing is that the company receives the loan, so it has cash in of 10000€ for this debt and
since it is a bullet payment, we already know that Anthea will have a cash outflow of 10000€ in
2026. Since the company has an annual interest rate of 10%, it will have cash outflow of 1000€
for each year since 2022.
There is also a commission paid in 2021 (1000€).
So in the last line there is the total cash in and cash out.
If the company is in this situation, what is the impact of a new loan in the financial budget for the
upcoming year?
There are two main impacts in terms of 2021 budget which are the following:
The first one is that we have an higher commission (- 1000€*0,5 = -500€), so we are worsening
our financial situation. Then we have cash in because of the debt (+10000€ and not 9000 because
the commission has been already considered), so the variation of the debt is 7400€.
If we ask for a bank loan, we can see that our FCFE is a positive value, while the negative FCFF is
not connected to finance, but to the operating cycle of the company. So to adjust the FCFE, you
have to operate on the financial sector of the activity, while to adjust the FCFF you have to act on
operating activities.
To conclude this section, there is another type of bank loans, which are the syndicated bank
loans. A syndicated loan is provided by a group of lenders: it is structured, arranged, and
administered by one or several commercial or investment banks known as arrangers.
The aim is to lend money to a borrower with a unique contract. This allows the partition of credit
that a stand-alone bank could not disburse.
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This is a final overview of bank loans and syndicated bank loans, with an accent on differences:
Corporate bonds
A bond is a security that requires the issuer (i.e. company) to pay specified interests (coupons)
and make principal payments to the bondholders at maturity or even on specified dates.
Typically when a company issues new bond, they are targeted to institutional investors, retail
inventors but also both of them.
The features of corporate bond are the followings:
• The interests (coupons) must be paid to bondholders.
• In terms of maturity, every bond has a contractual term or settlement.
• Again, what affects significantly your cash in and cash out is the repayments scheme. The
repayment of interests could happen monthly, quarterly, semiannually, annually… depending
con the contract, while the repayment of the capital can be a bullet repayment or amortized.
• The main advantage of corporate bonds is the fact that bondholders has a priority in the
repayment of interests and capital (have the priority in case of default on equity holders)
There are different types of bonds:
• Debt securities: the typical bond, a portion of company’s debts. They could be zero coupons
bonds, which means that there are no coupons associated (so bondholders do not receive any
interests) or coupon bonds, which means that the bond pays coupons over time at a fixed rate
(the amount of coupon is contractually defined) or at a floating rate (the algorithm for computing
the coupon is contractually defined: base + spread, which is defined on the rating of the
company, which is again defined on the interest coverage and level of risk of the company).
• Hybrid securities: is a generic term used to describe a security that combines elements of debt
securities and equity securities. They have more risk than traditional bonds, but could also
generate higher returns:
- In case of default, bondholders of hybrid securities are reimboursed only before shareholders
- If the company is not generating positive results, coupons can be postponed or even
cancelled.
How can a company manage the issue of a corporate bond?
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Typically investment bankers (consortium) underwrite the bonds, so they assume the risk of
buying the newly issued bonds. Then they sell these bonds to investors. So investment bankers
are the mediators between the company and the investors.
The investment bank earns a profit, based on the difference between its purchase price and the
selling price; this difference is sometimes called the underwriting spread.
Anthea case: bond emission
In 2021, you plan a bond emission of 10,000 euro, maturity date after 5 years, The coupon is fixed
rate of 12% to be paid annually, starting from 2022.
The commission fees amount to 2,000 euro to be paid to the underwriting group and 5% on the
value of emission to be paid to the selling group. These fees need to be paid in 2021.
Furthermore, the agent bank will require 2% commission on the value of bonds managed each
year, starting from 2022.
Schedule the debt cash flows in cases of bullet scheme.
In 2021 we have a cash in of +10000, which is the debt, while in 2026 we have a cash out of
-10000, which is the repayment of debt capital.
Then we have a repayment of the interests of -1200 (10000*o,12) from 2022 to 2026.
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Then we have also the commissions underwriters of -2000 and the commission selling group in
2021, while for each year from 2022 to 2026 there are the commissions agent of -200.
Again, what is the impact on company free cash flow?
In the case of bond, we have a FCFE which is positive, but less positive with a bank loan because
net financial expenses (the sum of commissions) are higher, while the variation of the debt is the
same.
Leasing
A lease is a contractual agreement between a lessee (user = company) and a lessor (the owner of
the asset).
The leasing is targeted to a specific asset, and it gives the right to the lessee to use an asset for a
period, making periodic payments to the lessor. The lessor could be the asset manufacturer or an
independent leasing company that buys the asset from the manufacturer and leases it out.
The main features are:
• In terms of maturity, every leasing has a contractual term or settlement.
• Regarding the repayment schema, there is a scheduled rent (monthly, quarterly, semiannually
or annually as defined in the contract).
How can we account for the leasing?
In 2019, there has been a new IFRS connected to the accountability of leasing which is IFRS16.
Following this IFRS, you have some guideline to account for leasing.
In particular, IFRS 16 defines a lease as a contract that conveys to the customer (“lessee”) the
right to use an asset for a period of time in exchange for consideration. Fulfilment of the contract
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depends on the use of an identified asset and control of the use of the asset during the lease
period.
So in the balance sheet the impacts are:
- Lease assets are recognized on the balance sheet at Present Value of future lease payments.
- Liabilities (debts) are recognized on the balance sheet at Present Value of future lease
payments.
In the income statement:
- Depreciation of lease assets (Value of asset divided by useful life)
- Interest expenses (Interest multiplied by the residual debt)
In the cash flow statement, the Cash Outflow equal to leasing charge, composed by Interest
quota (Interest multiplied by the residual debt) Capital quota (difference between leasing charge
and interests).
Anthea case: leasing
Capex includes a new equipment (the budgeted capex value for the new equipment in 2021 is
5,000 euro bearing a depreciation of 1,000 euro in 2021).
You plan to do a lease instead of buying the new equipment. As such, you will pay a rent of 1,200
each year for the next 10 years starting from 2021.
Assume that this kind of lease would not require additional costs.
Leasing effective interest rate = 4.3042%
So the company is paying the periodical lease, which is a kind of rent. This is the first item that we
will calculate.
Second point, we have to consider the value of the asset and its depreciation and finally we have
to understand the financial implication of this, in terms of the interest quota, the capital quota and
then the value of debt.
These are the three items connected to the fact that we are making for a leasing.
So the first thing is that we pay the lease of 1200 every year:
Now we need to identify the value of our asset, because according to IFRS16, if we have
something in leasing we have to acknowledge it in the balance sheet, even though we are not the
owner.
The present value/asset value initial is the discounted capital expenditure of that asset (vedere
parte capital expenditures) agh the effective interest rate: 10,000/ (1+ EIR) = 10,000/ (1+ 4.3042) =
9587€. The depreciation will be the present value of the asset divided by ten years, so the
depreciation is 9587€/10 years = 959€.
If you look at the data, the depreciation is always the same, the initial and final values are instead
calculated every time. The final value of the asset in a year is the initial value of the asset in that
year minus the depreciation. The initial value of the asset in a year is the final value of the year
before (except for the year 1, which is the present value of the asset).
This is what happens inside the balance sheet.
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Now we have to calculate instead to the interest quota, the capital quota and the final debt (net of
capital).
The interest quota is just the present value of the asset (the debt) multiplied by the interest rate:
Interest quota = debt * interest = 9587*4.3042 = 413 for the first year.
The capital quota is instead the difference between the leasing rent and the interest quota:
Capital quota = leasing rent – interest quota = 1,200 - 413 = 787 for the first year.
The final value of the debt is simply the difference between the initial value of the debt and the
capital quota: Debt (net of capital) final = debt initial – capital quota = 9,587-787 = 8800 for the
first year.
Clearly the initial value of the debt in a certain year is the final value of the year before, except for
the year 1 (which is the present value).
What are lease impacts on the free case flow?
As we can see leasing has more impacts compared to loans and bond and it is connected with a
negative FCFE but to a positive FCFF. Acting on leasing, the company is saving money on the
capital expenditures which means the possibility to have a positive FCFF but a negative FCFE.
Probably the option that allows the company to arrive at a positive situation is to have a leasing
plus a bank debt so that you can balance.
The EBIT has changed because we have to consider the initial value or the leasing plus the
depreciation of the asset that the company has. The depreciation changes since we have the
depreciation of the asset.
Capital expenditures are reduced because the company is not acquiring the asset but it has a
leasing: that’s why we have a positive FCFF.
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Finally, we have different net financial expenses because of the interest quota, then we have to
adjust the value of the debt for the capital quota of leasing rent.
These are the 4 aspects that affects the free cash flow.
The main advantage of the leasing is the fact that is flexible: there is the possibility of not
acquiring the asset and at the same time the possibility of using it. This is all managed as a
financial debt, so you are addressing both operation side and the financial structure.
Lines of credit
A line of credit is an available amount of money that a firm can borrow. It is a very flexible option
of financing. It should be used for covering short-term cash imbalances due to the mismatching of
operating cycle inflows and outflows (that’s why is very expensive as method).
The main features are:
• There is an interest (fixed rate) to be paid to the bank.
• There is no contractual maturity.
• The repayment of interests are scheduled monthly, quarterly, semiannually, annually as defined
in the contract, while the repayment of capital is not scheduled but it is amortized over time.
• Debt holders have the priority on equity holders.
Factoring
Factoring is a credit service that concerns the acquisition of commercial credit from the company
(creditor) by an intermediary (factor) in order to receive advance payments.
The factor (a financial institution) pays a percentage to the counterparty as soon as it receives an
assignment or the receivable.
Factoring main features are:
- the presence of a financial cost, which is the interest related to the percentage of discount on
the face value of the commercial credit.
- Contractual term defined in the contract.
- Scheduled repayment the day the debtor is supposed to pay.
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The factoring agreement could be:
• with recourse: the credit risk is on the creditor firm under reserve - i.e. the factor requires the
return of anticipated amounts to the party who sells the credit in case the debtor does not fulfil
its duties at maturity.
• without recourse: the factor assumes the credit risk. In this case, the factoring cost for the
creditor is comprehensive of this risk analysis, and in the case of insolvency, the factor cannot
recoup costs from the client who gives the credit. This arrangement is a protection against bad
debt quality, even if it is not costless.
Anthea case: factoring
In 2021 you plan to factor (with recourse) half of the accounts receivable you have. The factor will
give you in cash the 90% of the overall amount of accounts receivable (10% is taken as a
commission). For the NWC position of the firm refer to the first part of the case.
As we can see, in 2021 the company will have half of the receivables.
Moreover, The factor will get a commission: 0.1*(17,500 / 2) = 875, which net of taxes will be
875*0.5 = 437.5.
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If we see this impact in terms of free cash flow, we see that the net working capital increases
(remembering that it changes sign) because of the reduction of receivables, and then there are the
expenses for the factoring.
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Performance measurement
Given our system to control (which could be an entire company or an organisational unit) in
planning and control system we set the objectives through the budgeting, than we measure the
results through a performance measurement system (which is exactly what we are gonna discuss
today) and then we report the results to make a variance analysis.
Today we focus on the second step, which is connected with the fact that after preparing the
budget at a certain moment we have to measure the results of the actions that had been put in
place by the company.
Performance measurement refers to a set of measures, called Key Performance Indicators
(KPIs), that quantify how well a company achieves its objectives.
How can we select the most appropriate indicator for a company? Performance measures are
related to company’s strategy and they are used to support decision (understand whether a
company was successful or not in achieving its objectives), to set targets for the employees (to
evaluate people) and also to report results outside.
Classification of indicators
There are several classifications of indicators, but the one that we use is quite simple and
distinguishes between:
• Financial indicators: they are measures (numbers) expressed in monetary terms. The financial
indicators that we know are:
- Profitability indicators, that measure the ability of the company to generate profit.
- Liquidity indicators, which measure the ability of the company to manage cash.
- Financial structure, that measure the ability of the company to manage properly its capital
(intended as the balance between debt and equity).
We already know all of these financial indicators, but then there is also a second category of
indicators which is defined as non-financial indicators.
• Non-Financial Indicators: we are talking again about numbers, but which are not expressed in
monetary terms. Typically, non-financial indicators assess (they are used to measure) the ability
of the company to leverage on key factors defined as value drivers, which are the competitive
factors (the factors on which the company competes). We identify five different value drivers,
which are:
- Time;
- Quality;
- Productivity;
- Flexibility;
- Environment and social compatibility.
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What is the connection between financial indicators and non-financial indicators? The idea is that
if we identify the value drivers, we anticipate and we can detect something before it is quantified
by financial indicators.
Typically there is a sequence between some events: depending on the fact that we can have
many hours of maintenance or few hours of maintenance of our machinery, we can have a certain
number of defected product.
In fact, if we (as a company) are not making any maintenance hour on our machinery, the number
of defected product increases which means that the customer satisfaction decreases and then
also our revenues.
Considered the situation of our company, if we use financial indicators (like revenue) we will see
the monetary effect of the event when it is already closed, while if we use instead non-financial
indicator we are still measuring something that is closed (because if we want to measure defected
products the production should be completed), but we measure this before the moment in which
financial indicators assess this value.
So the point is that if you use non-financial indicators, you can have some signals/drivers of the
value creation: they anticipate something that for sure will be detected at the end of the period by
financial indicators.
This below is the entire view that connects non-financial indicators, financial indicators and the
final objective of the company which is creating value.
This also called value tree.
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On the left side we can see the cash generated by the company (NCF), in fact the objective of the
company is to maximize cash. How can we assess the ability of the company in generating cash?
We can use value based indicators.
The cash increases or decreases depending on the components of NCF, which are EBITDA, the
variation of operating working capital and the net investments in non-current assets.
How can we identify whether a company is able to generate operating result, to manage properly
the operating working capital and the investments? Through financial indicators.
The determinants of the financial indicators are the so called value drivers, which are measured
through non-financial indicators.
For instance, if the price of raw materials decreases, this means that the production costs
decreases such as the operating cash costs, so the EBITDA increases and then the NCF
decreases.
So through this value tree, value drivers are connected with items of our financial documents
which are connected with the ability of the company to generate cash.
Value drivers
Time
If the company is fast, it’s earlier in the market and can sell more but at the same time, if the
company shortens its production time, it saves money.
So time could be an item on which a company competes and it can affect (in the value tree) the
ability of the company to generate revenue as well as the ability of the company to manage costs.
These are some examples of possible indicators to measure time:
• If we stay focused on revenue (revenue driver), the idea is that the faster the company is, the
happier the customer will be. So we have to distinguish between:
- Time for delivering already existing (catalogued) products whose typical indicator is delivery
time. But how we quantify it? It could be the average delivery time, the percentage of
delayed deliveries or the average delay.
- Time for developing new products whose typical indicator is the time to market. It is exactly
the length of time it takes from a product being conceived until its being available for sale.
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The time in which you launch a new product into the market can make the difference if there
is a lot of competition in the market itself.
• We can also assess time for performing specific processes (cost driver). We have to highlight
non value added activities and identify significant opportunities for reducing costs. There are
two important categories of internal time measures:
- Throughput time: is the time that it takes for a product to be manufactured, from the
moment in which the company picks up the raw material to moment in which the product is
delivered to the market. Some companies can compete on the fact that the throughput time
is really compressed (they can save money but also arrive earlier in the market).
- Time efficiency
Quality
The second value driver that we can use is quality. It can be intended as the quality of the
products (which is something that the customers can see, so it is a revenues driver) but also as
the quality of the production process (which is instead something internal, that the customers
can’t see immediately so it is a costs driver).
The typical examples of product quality are:
- Quality of design (product characteristics), which can be assessed through customer surveys
and repairing/assistance feed backs.
- Customer responsiveness, which is the capability of a product/service to respond to needs and
wants of present and potential customers.
- Conformance quality, which refers to the performance of a product or service relative to its
design and product specifications from the customers’ perspective: it can be assessed through
the number of claims and the number of returned products.
Process quality refers to internal failures: we want to ensure that the production process works
very well. We can measure the waste, the scrap rate, the maintenance hours…
Productivity
The third value driver is productivity. It is a cost driver but it is not a value driver, in fact whiff we
act on productivity we can save money but we can’t act directly on revenues.
The typical definition of productivity is the ratio between an input and an output: the idea is to
maximize the output and minimise the input.
Productivity can be calculated with reference to the entire production of the company or with
reference to a single factor of the production (the productivity of labour, of materials, of
machineries…).
Flexibility
The fourth type of value driver is represented by flexibility. It is the capability of the company to
adapt quickly to the changes of the environment.
Flexibility could be at the same time a revenue driver and a cost driver. It depends on the impact
that it has: we do not define revenues and cost drivers upfront, since the same performance can
become a revenue or a cost driver depending on how a company uses its flexibility.
Here are some examples of flexibility indicators:
• Product flexibility, which is the capability of easily switching production from one item to another
and customising product/service to meet specific requirements of a customer.
• Volume flexibility, which is the ability to ramp production up and down to match market
demands.
• Delivery flexibility, which is the ability to change the timing of the delivery.
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Environmental and social compatibility
Environmental and social responsibility drivers quantify the ability of an organization to
manage its business respecting society and the environment. They can affect at the same time
revenues and costs, because if you act on the consumptions of your resources you can save
costs but at the same time you act on revenues because you are affecting the quality of your
product/service which is environmental sustainable.
So, these drivers have a strong impact on reputation (revenue driver) and can lead to cost
reduction (cost driver), but not least listed companies have to present a mandatory sustainability
report.
How can we identify these indicators? The most complete framework is the GRI (Global
Reporting Initiative), which is also the most used standard in organizations worldwide.
GRI standards are divided in two main areas:
• General standard disclosures, addressing high level elements of sustainability: Strategy and
Analysis, Organizational Profile, Identified Material Aspects and Boundaries, Stakeholder
Engagement, Report Profile, Governance, Ethics and Integrity
• Specific Standard disclosure, articulated in three categories: economic issues, environmental
and social practices.
Structure of indicators
Defining an indicator requires considering the following elements:
- KPI: we have to identify a title of the measure, the name of the KPI (delivery time, throughput
time, customer satisfaction…).
- Unit of analysis: we have to define the object of the measurement (it could be a product, a
company…).
- Value driver: which kind of value drivers does this KPI assess? Which competitive factor it is
measuring?
- Purpose: why do companies want to measure this KPI?
- Metric: it is the formula, the way through which companies calculate the KPI.
- Frequency: how often companies measure this?
- Source of data: from where companies get the necessary data?
Example: customer satisfaction of students
-
The KPI is customer satisfaction of students.
The unit of analysis could be a single lecture, an entire course, a module…
The value driver is the quality of the service.
The purpose of this KPI is to understand the effectiveness of teachers and teaching materials.
To assess the satisfaction of students, possible metrics could be the overall satisfaction (from 1
to 10), the interest in the topic (from 1 to 10)…
- How often do you have to collect the data? At the end of the course, monthly, before enrolling
to an exam…
- A possible source of data could be polimi online services.
The challenge of managing indicators: big data
One of the major challenges connected with the indicators that companies have to face is the
collection of data. In fact, there are too many data ad it is difficult select the ones that we need to
develop a new indicator.
Basically, if we have to summarise the evolution of data management within a company, we are in
the situation presented by the picture below.
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If we stay focused on financial indicators, the data source is represented by internal data.
Financial indicators are limited in terms of sources, they arrive every quarter, they are internal
numbers so they are certified (there are no doubts on the accuracy).
Then there is a second category of data, which are the external data sources that are
controlled by the company. An example could be the customers’ satisfaction, you don’t have
quarterly data but the amount of data increases considerably because if make a questioner to
your customers you will get a large set of answers.
The third category is the external data sources that are not controlled by the company. For
example, the data generated by or smartphone (localization, cookies…) is something that a
company cannot control, because it is a huge amount of data (biga data: high volume of data with
a high variety at a high velocity, generated continuously).
Just to give an idea about how a company can leverage on big data, this is what happens online
in 60 seconds. This shows that companies can rely on a huge amount of data in order to develop
an understanding of their customers but at the same time they have to problem to collect, clean
and analyse this data.
There is a list of which could be the opportunities connected with big data:
- If we leverage on this kind of data, we can leverage first of all a better knowledge of our
customers;
- We can have a real time monitoring on what is happening (without waiting for financial
indicators);
- And then we can anticipate customer needs, offering before they ask.
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But there are also some threats connected with big data:
- First of all, it is difficult to define who has the right competences and skills to manage this data;
- Companies can collect data until a certain point, in order to respect people’s privacy;
- Data are not certified, so companies could not be able to distinguish between real and fake
data.
But what should a company do if it wants to leverage big data?
If we want to develop KPIs based on big data, we don’t have just the phase two (which is the one
that we previously discuss about), but we have to add a data collection and preparation phase,
which is crucial (and instead is less relevant for traditional indicators) and then we have to add a
data visualisation phase that allows us to understand and summarise thousands of data.
1. Data collection and preparation
How can I collect data that are generated online by users and how can I prepare my data set in
order to calculate my KPI?
This phase implies several decisions that are summarised in the table below:
• The first one is the selection of data source, so where the company gets the data (from social
medias, website, blog…) and you can see that typically, if you want to listen to your users, the
source of data is something outside which means that it is not under the control of a company.
• The second point is the frequency of data collection, which could be in real time (if data are
generated continuously, like for telecommunication companies) or periodical (if data are
generated in different periods),
• The third point is the criteria for collecting data. Typically there are two main options, that are
downloading all the data defined per account, which is the easiest way, but if you want to have
a more complete view about the data, downloading by keywords is the best option (but we can
have a lot of useless data).
• The fourth point is that I have to identify the type of data that I want to extract, because if we
think about something online, you can download the text but also the tagging, the geological
informations etc. The more the things that you want to download, the higher the space you
need.
2. Data analysis
This is an example about possible KPIs that a company can develop in order to quantify users.
In the case of social media, through data analysis you can quantify the relations (how many
people are reached by the social media, how is distributed the pupularity, what is the virality of a
post), we can try to monitor the people’s opinion if we analyse the texts (so what are people
saying about a company) and finally we can also analyse the connection between people and we
can identify the users in the network.
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Reporting
In the previous lectures we have referred to the schema below as the decision making cycle or
planning and control system.
Until now, we have gone through the planning phase, which aims at defining a plan of action,
considering the coherence between objectives, the resources that we have ant the risks that our
company has to face. So during this phase the company set the targets and the actions that
should be done in order to achieve these targets.
The main activities in this phase is the budgeting process (that we have seen) and the risk
analysis.
Then we have the next phase, that is the one of measurement of actual results, which is
important in order to know how day by day business is proceeding.
Lastly, we have the reporting phase which is the process of communication to a manager who is
responsible for the allocation of specific resources. So in this phase you want to communicate
informations to planning managers (feed-back) regarding current and expected performances that
are relevant for the decision making process.
But why reporting is so important? For whom we have to report these informations?
It is really connected to the hierarchy of the company.
In the schema below we have the representation of the traditional schema of companies.
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We have corporation, we have different business levels (such as operation, finance, legal,
personnel office…) and if you consider operation business, we have different divisions (snacks,
beverages and confections) and then, if we go deeper in one of these divisions, there are other
functions (such as the bottling plant, the warehouse, the distribution…).
Here is important to understand what is the target of our reporting, because the manager of the
operation is different of course from managers of other divisions, they need different informations,
their choices are taken in completely different ways, so we have to manage it.
Considering an easy structure of the company, is really important to understand how changes the
reporting phase from the corporate level till the responsibility centres.
We will discuss about the corporate level in next lectures, now we focus on the responsibility
centres.
Before moving to responsibility centres, it is useful to give a definition about the boxes in the
chart.
Let’s start from the concept of a business unit: it is an organizational unit with a certain grade of
autonomy in choosing both the mix of products/services produced and the resources used.
A business unit usually refers to a specific group of customers and it is a unit that could be
managed separately from the rest of the company.
Responsibility (or operation) centres are organizational units in which managers have less
degree of authority compared to business units: they are not responsible both for revenues and
costs (contrary to business units). These centres are required to identify indicators capable of
monitoring only the performances that each responsibility center can influence.
Each responsibilities in fact has a box in the organisational chart and each of these centres has
one or more objectives that should be coherent with the implementation of the company’s
strategy.
Enterprises need responsibility centres in order to decentralised the activities because it is not
possible for a company to control everything centrally.
There are three types of responsibility centres:
- Revenues centre: these are organisational units that directly interact with the external market,
so the manager is responsible only for the revenues that are under his control. But you can’t
focused just on increasing the level of sales, there are other parameters that must be taken in
consideration: on of these is the quality of the raw materials/product sold.
- Cost centres: they are organisational units for which a relation between the output and
required resources can be observed, but they don’t have a direct link with the external market.
So the manager units are not responsible for the revenue generation, for the usage of assets or
for investments decisions, they are only responsible for certain kind of activities
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- Expense centres: these organisational units do not directly interact with the external market
and for which is not possible to set a standard relation between the input and the output. The
definition could seem similar to cost centres, but the distinction has been introduced to
highlight the fact there are some responsibility centres in which the resources consumption can
not be measured. Of course the resource consumption is related to the volume of production.
So when you have a centre in which the distinction is linked to the volume of production, you
are dealing with cost centres, for the expense centre this is not true.
The fact that resource consumption is related to the volume of production means that in cost
centres, once you know the volume of production, it’s quite easy to calculate the cost
associated (examples are the logistic or the operation), but this is not true for the expense
centres (what if you want to increase the customer satisfaction of 5%?).
So the cost centres are organisational units in which you can calculate the associate cost, you
know the volume of production and how to calculate the cost of these units. Then there are the
expense centres: the difference here is that is difficult to measure performances. These are
organisational units that are not linked to the volume of production, you know that there is an
expense (such as the marketing one) and one of the measures that you can act is the fact of
maintaining the total amount of these expenses beyond a certain limit established by the
company itself.
This is the main difference between costs centres and expense centres.
Variance analysis
In the reporting phase, we have to perform the comparison between the target values (so the
values that you have set during the budgeting phase) and the actual values: this is the meaning of
variance analysis.
The variance analysis is considered the traditional methodology, because it is customised
according to the specific type responsibility centre.
Actually, there is another methodology which is called activity based management (ABM), an
homogeneous approach.
Reporting and variance analysis are not the same thing: the first one is the act of communication
of the variances between target values and actual values to management (it is the light blue arrow
in the schema) while the second one is the methodology that we apply to assess these variances.
Variances could be caused by several factors: the idea is that managers can use this kind of
analysis to understand if there are some problems or opportunities inside the organisation.
Managers, for instance, could be interested if the actual expenses are higher or lower compared
to the budgeted ones.
Variance can be favourable or unfavourable:
- Favourable variances arise when actual results exceed budgeted;
- Unfavourable variances arise when actual results fall below budgeted.
So, if actual costs are lower than expected costs, this means that the variance is favourable.
This doesn’t mean that your performances are improving, because lower costs could also mean
that you are buying more low quality material (for instance), and the same is valid for unfavourable
variances in costs, because they do not imply that your performances are falling down.
Of course, the inverse logic is valid for revenues.
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Variance analysis applied to cost centres
Cost centres are organisational units that are responsible in the use of resources (the inout level)
but they are not responsible in determining the amount of sales (the output level).
Usually cost centres include manufacturing or physical transformation units.
The performance of these centres is usually measured through the total cost, which is the sum of
variable cost multiplied by the quantity plus the fixed costs.
The objective is the minimisation of the total cost, keeping it lower than a certain level.
traditionally, the performances of these centres have been measured through the variance
analysis.
The variance analysis follows a hierarchical schema, divided in three levels.
The first level refers to the difference between the total actual cost and the total budgeted cost,
which is called Total Cost Variance.
This difference can be divided in two components:
- The volume variance (linked to the output variation)
- Efficiency variance (related to the variance of the efficiency of transformation process).
This division is made through the introduction of a flexible budget, which is a mix of budgeted
values and the actual ones.
The third level examines the efficiency variance through two parametres:
- The variance of input prices (such as the one of raw material, hourly rate ecc.);
- The variance of input unitary usages (the kilogram of raw materials that you use for a unit of
product, for instance).
Example:
Let’s consider the case of a one product company.
This is the data for the financial year:
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The first step is the calculation of the total cost variance, which is the difference between actual
cost and budgeted cost:
A positive total cost variance is an unfavourable variance, because the total cost is higher than
expected. This is not a bad result for sure, because it is true that costs increased, but also the
volume of production.
So we have to further investigate, splitting the cost variance in order to understand what is the
weight of the effect of volume variance and efficiency variance.
The second step implies the introduction of a new budget, which is called flexible budget.
It is a fictitious one, an hybrid figure, because you have to mix budgeted values with the actual
ones.
In the case of cost centres, to construct the flexible budget you have to use the actual volumes of
production but you have to use the budgeted cost (the sum of budgeted variable costs and
budgeted fixed costs).
The difference between the flexible budget and the budgeted values is the volume variance, while
the difference between the actual results and the flexible budget is the efficiency variance.
In this case, the flexible budget is equal to:
In order to get the cost of raw materials, we have to multiply the budgeted unitary cost of raw
material by the actual quantity.
We do the same for the cost of labour, multiplying the budgeted unitary cost of labour by the
actual quantity, and then we sum all of this to the budgeted overhead (manufacturing fixed
overhead).
The flexible budget is equal to 360.000 €, so now we can make a comparison between budgeted
costs and actual ones in order to get the values of volume and efficiency variances.
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We do not have to include non-manufacturing overhead in these passages because in coste
centres we have to take into account only the costs that managers of these centres can influence.
On the other hand, cost of material and cost of labour are direct production costs, while
manufacturing fixed overhead are the indirect costs of production (such as D&A of machineries).
If we consider the volume variance, it is equal to +10000 €, while if we consider the efficiency
variance it is equal to -5000€.
In the first case, this volume variance is due to an increase of the final products (+1000 units).
In the second case (efficiency variance) you are being more efficient, because we have an actual
cost of materials lower than the expected one, such as the actual overhead, while the actual cost
of labour has increased compared to the budgeted one.
Now we have to further decompose the value of the efficiency variance, in order to understand
also a little bit more the weight of these components.
The third level examines the efficiency variance in detail, in reality it is partially controllable by the
cost centres, because it is often linked to the choices that have been made by the procurement
function. To go deeper, it is necessary to develop another fictitious budget, which is called
flexible budget 2 because it is again a mix of different variables.
At this level we can monitor two other variances:
- Price variance, that monitor the effect of the component material price variation, compared to
forecasted values. The calculation of this variance assesses how the company acquires its
resources, for example.
- The use variance instead checks what is the use of resources actually managed by the cost
centres.
We have already know the actual value of cost of materials, but to calculate it, we have to multiply
the actual variable unitary cost of raw materials by te actual quantity produced.
The variable unitary cost is obtained through the multiplication of the actual unitary usage of raw
material and the actual price of raw material:
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N.B. Variable unit cost (product i) = unitary use [(h or Kg) / u] * price or hourly rate [€ / (h or Kg)] =
[€/u]
We already know the flexible budgeted 1 cost of raw material, which is 126.000€:
The difference between the actual value of costs of materials is the fact that we use the budgeted
variable unitary cost of raw materials instead of actual variable unitary cost of raw materials.
Now we have to calculate the flexible budgeted 2 cost of raw material: the formula is the same,
but we have to use the flexible variable unitary cost of raw materials which is the product of the
actual unitary usage of raw material and the budgeted price of raw material:
We have a negative use variance, which is favourable because it points out that the actual use of
raw materials is lower than forecasted one. So the procurement manager has bought too much
material.
On the other hand, the price variation is positive.
We can do the same passages for the cost of labour.
Making a sum of these flexibles, we can obtain the total use variance and the total price variance.
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Once all the variances are calculated, the performance of cost centre can be measured above all
through the efficiency variance, under the hypothesis that it is responsible for both price and the
use of input, but sometimes you can asses only on the use variance, because the price of input of
your resources is not always controlled by the cost centre but by the procurement function.
To conclude, this approach is still widespread, but it has several limitations, special regarding
responsibility:
- This approach assess cost centres for choices that maybe are made by other organisational
units (the possible variation of input price is not decided by manufacturing units).
- Furthermore, there are other indicators that you should measure in order to really assess the
performance of this centre. Some examples are the quality of the components or the feasibility
of production.
So, you can use in your company this way to assess the performance of cost centres, but it is
better to use also some other non financial indicators that can assess these centres in a wide
manner, because they can evaluate some performances that we didn’t consider but also because
value drivers are early signals.
Variance analysis applied to revenues centres
Revenues centres are organisational units responsible for revenues on the market. The most
frequent example is the commercial unit in a company. Traditionally performances of revenues
centres are measured through the revenues/level of sales, but there could be some exceptions:
this happens when your company has products with significantly different profitability, so the total
variation margin (the difference between the revenues and the variable costs) is a more proper
indicator to evaluate the performances of this kind of centres.
Revenues are defined as the selling prices multiplied per the volume of sales, so the
performances of this sector are assessed throw this kind of measure.
Similarly to the cost centres, the variance between the actual and the forecasted figures can be
divided in two multiple levels to analyse the impact of several parameters.
Example:
Consider just one product:
The first step is the calculation of the total revenues variance, which is the difference between
the actual revenues and the budgeted revenues.
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(It is really similar to the cost centres case)
Then we have a second level variance, that consider the two parameters we have just mentioned
(volume and the price) and introduce another flexible budget, which is composed by the
forecasted selling price fixed in the budgeting process at the beginning of the year and the actual
volume of sales that you have reached at the end of the year, because in this way you can
evaluate the impact of these parameters: the comparison between the flexible budget give us the
volume variance (because the only parameter that changes is the sales volume), while the
difference between the actual results and the flexible budget can give you the price variance
(because the only parameters that changes is the selling price).
As we can see, the volume variance is negative, so it is unfavourable because you have lost
volume of sales. Anyway, as the manager of the revenues centres you can act on the price
variance for example, in order to achieve a better result at the end of the year, realising a positive
total variance at the end of the year.
Take into account that not always companies can act on the price variance, because there are
price makers companies (which have the power to set the price that they prefer, like in a
monopoly) and price takers (which are those companies that have to accept the price that is
prevailing in the market, which is the case of commodity market).
The third level is the most interesting one of revenue centres: at this level we can further analyse
the volume variance, assessing the impact of changes in the market shares and in the total size of
the market.
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In particular, the volume variance is given by the multiplication of the market share variance (the
variance in the portion of the market that you have) and the market size variance (the variance in
the size of the market in which you operate with your competitors). The latter is an external factor
on which you have no control, while the former is a parameter on which you can act.
The analysis is usually carried out for consumer market where market share is a crucial element:
for this reason this level requires the introduction of another hybrid budget which are called
flexible budget 1: the flexible budget 2 is the flexible budget of the second level. The difference
between the budget and the flexible budget give us the market share variance, while the
difference between the flexible budget 1 and the flexible budget 2 give us the market share
variance.
So, the budgeted revenues, as already seen in the first level, is the multiplication of the budgeted
volume of sales and the budgeted price.
At the second level we have calculated the flexible budget 2 revenues (that is the flexible budget),
because we consider the actual volume of sales but the budgeted price.
To calculate the flexible budget 1 revenues we have to decompose the formula volume times
selling price, and to consider the budgeted market share (s) and the actual market dimension (d)
In order to calculate the budgeted share you have to divide the budgeted volume of sales (200 u)
for the budgeted market dimension (4000 u): multiplying it for the the actual market dimension
(4.400 u) and the budgeted selling price (25€), we obtain the flexible budget 1 revenues.
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As we can see in the chart above, the market size has increased: this means that the company
will have more revenues because the market is growing.
The variation in the market share is negative, meaning that you are losing a portion of this market.
The traditional approach also for the revenues centres has some problems:
- RevenuesRevenues centres not always can control variations in price and quantity sold;
- Moreover, the yearly revenues are a not long-term oriented.
There are different possible solutions:
- Use of a wider set of indicators, in value drivers;
- Use of cross-unit teams for managing interdependencies.
Variance analysis applied to expense centres
Expense centres are organizational units that are characterized by:
- Output that is not easily identifiable with money (for example, is not easy to assess the impact
of marketing expenses on your company);
- It is difficult to define an input/output relation using the standard coefficients that we have seen
in the previous examples (administrative activities, R&D activities etc.).
There has been a limited attention to these centres, for their historical low incidence on total costs
of the company: traditionally, expense centres are assigned a predetermined budget and the
control on performances is not always possible.
Nowadays the expense centres have an higher impact on the cost structure of the organization: a
possible solution for their measurement is the construction of a set of indicators that include not
just the financial indicators but also other types.
This can be done through the Activity Based Method, which is a methodology method that can
be use also for cost centres and which implies that you have clear in mind what are the activities
done in the expense centres.
So here, the most important task to be carried out is the identification of the activities. We can
have two type of activities: the repetitive activities, that are carried out several times during the
year (invoicing, payroll) and the project oriented activities (R&D, design of new information
system).
Repetitive activities - efficiency oriented
The first type is the efficiency oriented activities, where the quantitative element is the one
predominant. The performance analysis is focused on comparing budgeted drivers and costs with
actual results through some efficiency indicators (as the cost of the resources used divided by the
volume of the activity output).
Example:
Let’s consider the case of the number of students enrolled in two academic years and the cost
per driver of the enrolment services.
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At the end, we can apply a similar calculation to the one we have seen before.
We calculate the forecasted value multiplying the budgeted cost/driver (that you have found to
evaluate this kind of activity) by the budgeted driver at the beginning of the year.
Then you can build the flexible budget by considering the budgeted cost/driver and the actual
driver and the actual value multiplying the actual cost/driver by the actual driver.
That’s how we can calculate the efficiency variance (the difference between the actual and the
flexible.
Repetitive activities - effectiveness oriented
The effectiveness oriented repetitive activities are those in which the qualitative element is the
most important. So in this kind of activities, the critical variable is the way through which the
output is delivered and not its volume.
Performances can be measured through these indicators:
- Overall cost of activities;
- The quality perceived by internal or external customers (customer satisfaction survey)
- The internal quality indicators
- Time…
Example 1:
If you want to understand the overall cost of the activities, in this case we have a list of activities
inside the university system.
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Here we have the green column, that represents the total cost for these activities.
The blue column represent instead the full time equivalent, that is a unit that indicates the
workload of an employee, in order to make it comparable across several contexts: a total FTE (full
time equivalent) of 1.00 is equivalent to a full time worker, while a FTE of 0.5 represents an
employee that work half time of a full time worker.
For some activities is possible to identify some drivers in the yellow column.
Example 2:
You can evaluate the quality perceived of effectiveness activities.
In this case you have the results about the surveys on student satisfaction concerning the
university services.
Each column represents the average level of students' satisfaction for each letter.
Example 3:
You can also integrate these two examples and mixing the efficiency measures with the
effectiveness ones.
In this chart you have the indicators of the previous two examples: you can assess the several
services on the basis of a cost per driver (efficiency measure) and through the students
satisfaction (effectiveness measure).
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Project activities
Project activities are usually characterized by the use of a significant amount of resources and
long duration. Each project should be defined, during the planning stage, in terms of:
- A set of objectives to achieve (defined both in quantitative and qualitative terms, according to
the activity orientation – efficiency or effectiveness);
- A timetable definition coherent with the objectives achievement;
- The allocation of resources for each phase of the project.
Example:
The most used indicators to understand how a process is proceeding are various.
When you want to assess the performance you can use the cost variance, that assess the
difference between the cost of the work plan and the actual cost of that you have at the end of
the project.
So here we have a phase of project management in which you have several Italian universities
with different resource allocations:
Reporting phase
Reporting is the process through which a set of information are summarised and communicated.
The fact we are reporting something can be associated to two different purposes:
- We summarise and communicate informations for external accountability (this is not our goal):
the company wants to show outside (to its stakeholders) how it is performing. This can be done
through financial reports (based on financial statements) as well as non-financial reports (based
on company’s objectives, values and so on).
- But we will focus on how the company can report data for internal accountability, in order to
support internal decisions. We are thinking about that the company is measuring something
and then how it can report this information to the top, middle and operation management,
through both financial and non financial indicators.
When preparing internal reports, we have to keep in mind that the first point is to identify who is
the decision maker. In fact, internal reports address internal decision makers at different levels:
- Top management level (corporate and BU level):
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- Middle management
- Operative level
This is crucial because depending on who is receiving the informations, the structure and the
content of our report will be different. It is important to underline that they contain (financial and
non financial) indicators that provide a synthetic and concise view about a specific topic/activity
and, as already said, they are typically used to support the decision making process.
Usually, the name that we give to internal reports is dashboard. So when we talk about the
dashboard, we are talking about the fact that we are delivering a set of informations to someone
within the organization.
Dashboard
What is a dashboard and to what extent a dashboard is different from information exchange?
We have a dashboard when we have at least these four features:
• Within a dashboard we have financial and non financial KPIs connected to the relevant
activities;
• A dashboard should be presented in a unique format (and so the KPIs are presented in a unique
tool);
• Since dashboard supports everyday activities of the company, so the KPIs are periodically
updated;
• Lastly, there should be a decision maker that relies on this data.
If these four features exist, we have a dashboard.
Origin and evolution
Dashboards have been initially developed during 1980s with the purpose to give managers a set
of synthetic information to support decision making, presented in a comprehensive manner.
Tableau De board
The first type of dashboard is the Tableau De board, developed in the 80s. It was not a really
successful tool, at least as the following dashboards that we will se later on.
The idea beyond this dashboard is the fact that a company should translate it vision and mission
into objectives, then into critical success factor and finally in KPI.
The point is translating strategic aspects in something that is measurable.
Moreover, the authors (Epstein and
Manzoni) says that if your company has
divisions, departments, regions and so
on, you can have as many tableau as
many business units you have.
The reason because this dashboard is
unsuccessful is the fact that the authors
says that you have to translate strategy
into something measurable, but they do
not say how to do this in a proper way.
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Balanced scorecard
In 1991 Kaplar and Norton developed this dashboard which is really useful and still used.
Basically, these authors say that the balanced scorecard is a managerial tool that should support
decision makers by giving a comprehensive measure about how the organization is progressing
towards the achievement of its strategic goals.
The adjective balanced is due to the fact that within the dashboard there is a balance within:
- Financial and non financial indicators;
- Short and long-term measures:
- Performance drivers (leading indicators) with outcome measures (lagging indicators).
This is the structure of the balanced scoreboard:
You can see that, unlike the Tableau De Board, we have a framework about how organising
informations for internal reporting. And basically, following the proponents of the balanced
scoreboard, the dashboard that we should develop for internal reporting must have this structure.
The starting point is always represented by the vision and the strategy. Then, how can you control
whether you are successful or not in achieving your strategy?
They say that you have to list indicators and that then you have also to group them into four main
perspectives, which are:
• Financial perspective, which answers to the question “to succeed financially, how should we
appear to our shareholders?”We are focusing on what are the aspects that are relevant for our
shareholders.
The financial perspective analyses the company trend towards shareholders with reference to:
- Size (market share, sales)
- Profitability (ROE, ROI, net operating income)
- Cash generation (cash flow)
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• Customer perspective, which answers the question “to achieve our vision, how should we
appear to our customers?” This means that we have to think about what is relevant for our
customers quality of the product, te price of the product and so on).
The customer perspective highlights performances linked to the organisation relation with the
market:
- Product range; frequency of new product introduction
- Delivery time
- Costumer satisfaction survey
• Internal business process perspective, which answers the question “to satisfy the
shareholders and the customers, what business processes must we excel at?” If I I want the
customers to be happy and if I want to be financially successful, how should I be organised?
The internal process perspective includes measures oriented to the control of internal efficiency:
- Average cost of production
- throughput time
• Learning and growth perspective, which answers to the question “to achieve our vision, how
will we sustain our ability to change and improve?” So basically, you try to address the issue of
how you can keep under control the fact that you are always investing time and energies.
The learning and growth perspective is instead oriented at highlighting the innovative capability
of the company; there are measures such as the time to market and the learning curve.
Following the dashboard schema, for each area you also have to identify the specific objectives,
which could be: increasing liquidity in the short term, increasing the price on earnings, the
amounts of the investments and so on. Then, per each specific objective within each area, you
can identify a specific indicator (the measure).
Once you have the measure, you set the target: if your objective is to increase the ROS, what is
the target that you should have? For example, + 3% could be a target.
Lastly, you have to list the initiatives, which are the possible actions that you can put in place in
order to achieve the specific objective and the target.
Compared with the previous dashboard, it is more structured: you have a concrete schema in
order to translate strategy in something that is monitorable and controllable.
We can have different types of balanced scorecards within the same company, according to the
different unit of analysis:
• Strategic Balanced Scorecards (for corporate and BU):
- Focus on what the organisation is trying to achieve;
- Work out what needs to happen to achieve it;
- Monitor whether it is achieved.
• Operational Scorecards (which have organizational functions):
- Identify the most important important processes to be monitored;
- Define which aspects of the process to monitor;
- Agree on what is considered best practice.
• Employee Scorecards, which mean having a scorecard for every employee of the company.
But how can implement this type of scorecard? Through a process called cascading, which
means that if you have a strategic objective, you try to understand what is its impact on every
single unit and function of the company, and then from the function to the single employee.
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As we can see in the graph, we have the overall vision, we translate it into objectives within a
scorecard of the company. Then we identify priorities for the single business unit and then we
have the unit business scorecard. Lastly we translate the business unit priorities into team or
individual objectives and activities. This is the concept of cascading.
The main advantage of having a balanced scorecard is the fact that you have a concrete example
on how you can translate in everyday actions and then the table with the objectives, measures,
targets and initiatives is something very concrete that forces individuals to understand what are
the specific everyday activities they have to put in place if they want to achieve some specific
objectives.
Moreover, it can be used to evaluate the management and it covers different types of
performances (financial and non financial): it also provides a big picture of the situation and it is
adaptable for profit and non-profit companies.
On the other hand, the balanced scorecard can be too much centralised and rigid in the moment
in which it is top-down defined.
Moreover, this activity is time consuming, because you need time to develop the scorecard and
finally if the business is continuously changing it is not so flexible as a tool because you have to
readjust it from the beginning (low system agility.
Strategy map
Nowadays the balanced scorecard is still widely adopted, but there is another tool that has been
developed at the beginning of 2000 that is the Strategy Map, an evolution and an adjustment of
the balanced scorecard.
The idea of the strategy map is simply to identify a hierarchy and then the connections between
the different components of the balanced scorecard. What the strategy map does is nothing more
than identifying the connections between the different areas of the balanced scorecard according
to the hierarchy in the following picture.
So, if you are working on learning and growth (if you are investing in people, in quality and so on)
this means that you are affecting the internal processes (competences of people change, for
example). When you change the internal activities this can impact on products and services that
we are delivering to our customers, having also an impact on the financial results.
Talking about a company, usually the main aim is to increase the revenues.
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In the strategy map there is also a clear distinction between the objectives and the indicators,
because what is connected here are not the indicators but just the objectives in every building
block.once we have the objectives, for each of them we identify an indicator.
This below is the complete view of a strategy map:
In the circles we have the objectives, then for each of them we can identify how they are
connected to each other and then we also identify an indicator: in this way, you are forced to
understand how your strategy and your objectives are connected to each other and whether they
contribute to your final objective of maximing the financial results.
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Nowadays we are in situation in which the word balanced scorecard is no longer used, but we
can find the more general dashboard. So the providers just offer a service in developing
interactive dashboard.
How to develop a dashboard?
What should we do if we want to develop a dashboard in practice?
1. Decision maker & unit of analysis
The first step is the fact that you should have a decision maker and unit of analysis: we should
ask ourselves who is the user of the dashboard. Depending on the user, the type of information
will be different.
2. Reference framework
We have to identify the framework that is more appropriate for our situation. While developing a
dashboard it is important to consider the type of framework that wants to be adopted:
- Traditional BSC with 4 perspective
- Strategy map (or second generation BSC)
- Ad hoc scorecard
The choice of the scorecard is strictly dependent on the unit of analysis and the receiver of the
information.
3. Indicators
The indicators are selected according to the objectives:
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In selecting the indicators, we select them depending on the objectives that we keep under
control. Remember that in choosing the indicators we are aware that we have accounting-based
indicators (ROE, ROI, DPO, DSO and so on), then we have value-based indicators (those
connected with the measurement of the present value of the company) and lastly we have all the
non-financial indicators (customer satisfaction, scrape rate and so on).
It is impossible to define the best set of indicators, since the choice depend on strategy but we
have to keep in mind that each of these indicators has some advantages and disadvantages,
which are summarised in the table above.
The measurability represents how easy is to quantify the measures: for an accounting indicator is
simple, but for the value based indicators this is really difficult (for example, reminder how long is
calculating the net present value) and then for non financial indicators this is strictly dependent on
the type of metric that you are using.
Remembering that if you are measuring something, you have to identify who is responsible for
that result. This is simple in case of non financial indicators because they are very specific and
measure something narrow, while in the case of value based indicators that’s not so easy (all the
company is responsible for the present value). For the accounting based indicators, it depends on
the type of indicator (for the ROE, the ability to identify who is responsible is really low).
In terms of completeness, to what extent the indicator is able to catch the overall ability of the
company to perform properly? Clearly this is high for value based indicators, while it is really low
for non financial indicators, which are very specific.
In terms of timeliness, we obtain the information fast or not? Again, if we have accounting based
indicators absolutely not, because we have to wait the end of the year before having this data,
while if we have the non financial indicators they can arrive immediately.
In terms of long term orientation, clearly the non financial indicators are the best.
Precision means that you want to use the indicator to understand the ability of the company to
maximise the shareholder value. If we have the non-financial indicator, it is not precise at all, we
need a larger view and so the value based indicators.
Technically speaking, value-based indicators and non-financial indicators are at the opposites: the
advantages of one are the disadvantages of the other. In between we have the accounting-based
indicators.
The reason why when we think about a corporate scorecard you may need non-financial
indicators is because they can anticipate something before the revenue impact (we can anticipate
customer satisfaction, for example). So typically they have the advantage of catching something a
little bit in advance, they measure something that is small within a company which means that is
easy to identify who is responsible for that performance. Typically they are also fast in achieving
data but they are too narrow, so you don’t have an overall view about how the company is
performing.
On the other hand, in value-based indicators you have the overall view (FCF) and the long term
orientation, but it is difficult to measure and also it is difficult to account who is responsible for
achieving a specific objective.
This is the reason why the idea of balance scorecard is exactly to balance between different type
of indicators, at least if you work at corporate level.
So, given the fact that I have to balance from different indicators, how can I develop a very strong
indicator? (example of question for the oral exam)
Which the indicator that you would use to keep under control this aspect? Could you provide me
an example of indicator?
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Then you start identifying the type of indicator, the metric and so on.
Here below there ate two examples:
The reason why the firs indicator is a bad indicator is because its metric is not a metric.
Remember that the metric is the formula that you use for calculate the value. The metric is the
one like in the good example.
Moreover, the target “increase each month” is not a target since it is too generic: in the second
case it is specific.
Lastly, the data source should be the exact point where you collect the information: in the bad
example we haven’t identified who is accountable and in charge of giving that data, while in the
good example we point out that is the H&R department.
4. Operating tool
The last step is the operating one, which is the tool that you use to show the result of your
dashboard.
A wide variety of Business Intelligence tools are available on the market to develop dashboard:
- Integrated with internal IT system;
- “lighter” versions that connects data from different sources.
The main advantage of these tools is represented by interactivity and effective visualisations.
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Corporate Cost Allocation
Measuring the performances of singular organisational units within an enterprise could introduce
some problems.
The idea is that each unit should be isolated from the rest of the company un order to assess it.
The level for which performances are measured, identifies the depth of the management control
system. Theoretically, the system can be limited to measuring the performances for the company
as a whole or it could be detailed with specific indicators for each different level (the business
units, the functionals units, the operational centres and so on).
In order to isolate the performances of business units within the company, next time you will deal
with one of the two measure problems which affect this schema, which is the existence of
transactions between the business units (ex. a BU that acquire something from another BU within
the company). The solution to this problem is addressed with the adoption of transfers pricing.
But today we are referring to the other problem, the resources that are used by the business units
but that are managed at the corporate level.
The first thing to say is that companies have to decide whether these resources should be
included in the assessment of business unit performances or not. In the case of the allocation, the
problem is understanding the specific responsibilities of each business unit and on this basis
splitting the total cost among the business units.
So, why do we need to allocate corporate costs? There are four essentials purposes of corporate
cost allocation:
• To provide informations that are relevant for economic decisions and to perform a
decentralisation. The typical informations we are dealing with are the decision of adding a new
product, the decision about whether manufacturing a component inside the company or acquire
it and so on.
• To motivate managers and other employees, above all when they have to design product that
are simple to be manufactured (because the product could be realised through repetitive and
standard actions, so there is need of motivation).
• To justify costs or compute reimbursement .
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• To endure accountability for each organisational unit, which means to measure income and
assets for reporting to external parties for example.
But in practice how can we allocate these corporate costs? We have three alternatives solutions:
• The first possibility is the one of adopting a complete allocation, which means that you have
the total amount of cost and then you split it among all the business units. It avoids the
proliferation of corporate costs, but there is the problem of detecting specific responsibilities.
• The second option is the adoption of a partial allocation, which means that to business units
are assigned only the costs that can be directly associated to them.
For example, R&D activities can be divided in two categories: the basic resource activities,
whose potential use is for the entire company (so the cost will be splitter among all the BU) and
applied researches that are carried out for just one specific business unit (so the cost will be
charged only on the specific BU that asked for the service).
Through this method
• The third possibility (the one is less used) is the one of avoiding any allocations, so business
units performances are measured and assessed only on the basis of the cost sustained at their
level. Clearly there is the risk of uncontrolled use of resources.
Corporate costs allocation: Example
Sandy Corporation manufactures clothes washers and dryers in two international Business Units:
- Clothes Washer Division in Paris (CWD)
- Clothes Dryer Division in Prague (CDD)
Sandy Corporation collects costs at the following levels in its organisation.
At the corporate level we have:
- Treasury costs: 600.000 € interest on debt used to finance the construction of new assembly
equipment which cost 4.000.000 € in the Paris Division and 2.000.000 € in the Prague Division.
- Human resources costs: 1.200.000 € in recruitment and ongoing employee training and
development.
This is the situation:
As we can see, we have different specific costs for both divisions.
So, if Sandy Corporation decides to allocate Corporate costs, how should its manager proceed?
Corporate costs allocation: COMPLETE ALLOCATION
Let’s start with the complete allocation methodology.
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The cost of the new assembly equipment could be used as allocation basis. So we divide the
interest of debt for the total cost of the assembling equipments in order to obtain the driver to
allocate this cost.
Then to allocate the total treasury cost you have to multiply the cost in charge of each division by
each driver.
We have a similar situation for the HR costs. Sandy Corporation analysis indicates that the
demand for corporate human resource management costs for recruitment and training varies with
direct labour costs. So these costs are allocated to divisions on the basis of the total direct labour
costs incurred in each division.
We calculate the driver as the division of the total cost with the total labour costs.
Then we multiply the driver for the cost in charge of each division in order to obtain the allocation
of the costs.
At the end we have spliced completely all the costs at corporate level.
Corporate costs allocation: PARTIAL ALLOCATION
In this case we are not splitting all the costs within the business units but only a part of them.
For the treasury costs, we can assume that a fee has been introduced to allocate them.
The cost to manage one bill has estimated (on the basis of the previous years) equal to 4,5€ and
you know that the CWD has managed 60.000 bills while the CDD 70.000.
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So, by multiplying the cost per each bill by the bills managed by each division, we can estimate
the total cost for each division and then we sum them:
We find that the total cost is less that the cost you have to split, so there is an unused capacity,
which means that you have paid for a resource (treasury) but you are not able to split all the cost
between the business units. This happens because they are not using the service at the maximum
level. This 15.000 will remain at the corporate level.
Regarding instead the HR costs, we introduce the ABM method. We split the costs not on the
basis of the use of a fee, we evaluate instead the consumption drivers.
Human Resources provide 30% of their services to manage staff in the CWD, while the 20% is
devoted to the management of the CDD; the remaining time concerns corporate staff
management (50%).
These costs are allocated to business units on the basis of the time devoted to each division so
on the basis of a consumption driver.
So we multiply the total corporate cost by this driver:
This is the final situation:
As we can see, corporate costs are not completed allocated, so they still remain at the corporate
level.
Let’s sum up what we have seen. Here there is the comparison of the two methodologies
adopted.
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The complete allocation reduces responsibilities at the corporate level (they are transferred to
the BU), and makes explicit that corporate resources are not free to use, but impact on company
performances.
However, there are problems of decision making, because this methodology is based on a
proportional division, so you have to understand what is the driver through which you have to split
these costs.
Really often companies use the revenues as the basis of the allocation: this means that if a
business unit has more revenues of another one, I will charge the first one because it is making
more profits.
This is not always fair because an increase revenues does not always mean an increase in
available corporate resources and this extremely this could lead to a decrease in the EBIT,
because the cost structure of the BU could increase but not proportionally to the revenues.
Then we have seen another solution that is the partial allocation.
We have used two different methods: one is the allocation based on consumption driver, the one
we applied for the HR costs. In this case there was a problem: the lower will be the demand for a
corporate service, the higher will be its cost. This system discourage the use of the service who it
is available: if no one is using the HR services a part from a specific BU, at the end this BU will
have to pay for all the service.
On the contrary, the higher is the saturation of this resource, the more convenient will be the use.
So this could lead to potential conflicts among BU for defining the priorities for the using of
corporate services.
Regarding instead the Treasury costs, we have seen the possibility to adopt a fee system. This
solution prevents this problem of making more convenient the use the services when it is
saturated, so when all the BU are using the services because it is more convenient in term of
costs. In fact we can distinguish what is effectively used by the company and what can be saved.
So the fact of not allocating could be seen as an alternative, but this would lead to an
uncontrollable use of the resources, that’s why it is not used.
Corporate costs are in practice always completely allocated, except for some exceptions such as
the administrative resources.
Activity Based Management (ABM)
The Activity Based Management is actually an evolution of the Activity Based Cost
methodology. The latter was a cost allocation method, which consists in identifying the indirect
costs/overheads that should be allocated.
Then you have to identify also the activities that determine the consumption of this overheads,
because the final goal is to split this cost among the different activities. The next step is to define
drivers, so an activity driver that is an indicator which explains the consumption of each activity
and then we can calculate the portion that is in charge with each activity.
Example of ABC
Textile Company produces scarves and ties. The company wants to assign the machine
depreciation of the year (90.000 €) using an ABC approach. The following data are available:
- Ties produced: 10.000 units (unit time of production = 30 min)
- Scarves produced: 20.000 units (unit time of production = 20 min)
The machine is used for both the production and the setup actvities. During the last year, the total
setup time was 50.000 minutes.
One setup was performed before launching the production of ties, and another setup was
performed before launching the production of scarves.
To carry out the ABC methodology, we have to follow a sequence of different steps:
Step 1: Identification of indirect costs
The only indirect cost is the one related to machine depreciation (90.000 €).
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Step 2: Identification of activities through which we have to split the machine depreciation.
We know that the machine is employed for two main activities: the production and setup of
scarves and ties.
Step 3: Dividing overheads among the different activities.
The allocation basis/driver could be for example the time for performing both the activities. The
cost allocation will be as follows:
So, in order to calculate the total time of production, we just need to multiply the unit time of
production for each unit produced for both scarves and ties and then we sum it.
The setup time was given by the text.
The allocation coefficient is given by by the division of the overhead cost with the total time. The
portion of the overhead that should be assigned to each activity (production and setup) is equal to
the coefficient multiplied for each activity’s total time.
Step 4: Defining activity drivers
The choice of activity drivers is arbitrary and usually depends on the available data. Here, we use
the production time as the activity driver for the production activity (700.000 min) and the number
of setups as the driver for the setup activity (two setups in total).
Step 5: Calculating the allocation coefficient per each activity
This is the same approach of Step 3 but here we use the cost of the activity as the total cost to be
assigned between the two products. Calculations will give the following results:
Step 6: Apportioning activity costs
Apportioning activity costs to each product by using the previously identified allocation
coefficient.
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So we can distinguish two different phases in the activity based cost:
• The first phase is the costs understanding, which is useful to identify the activities for which
the company resources are used and how much resources are used by each of these activities
through specific indicators.
• The second phase is the costs allocation, which determine what portion of indirect costs
should be charged to each products.
————————————————————————————————————————
Through the Activity Based Management systems, we are focusing only on the first phase that is
the costs understanding. We do so for two reasons:
• The cost allocation is a more costly and time consuming methodology and sometimes the
benefit of the second phase are not considered enough to run it.
• Managers would like to stress the use of informations for managing rather than using them for
calculating costs.
The most important thing to do in ABM is to map and identify all the activities of each unit.
You have to remember to make distinction between activities, in particular between value added
activities and non-value-added activities.
The difference between these two activities is the fact that the latter are activities that have not a
direct client or for which maybe the client doesn’t recognise a benefit in the end.
The focus of this methodology is to reduce the impact of these activities con the cost structure of
the company, to eliminate them and to highlight the importance of the value-added activities.
So you should go very in depth with each activity, representing and represent it as microenterprise, with its own resources (personnel, services, materials…), clients (both external or
internal) and its own suppliers (again external and internal).
Taking into account the most relevant activities (usually those which consume 80% of overall
costs), for each of them you can identify the most appropriate driver in order to asses the activity.
This is important because activities with the same driver can be merged because you can’t find
other drivers to evaluate them.
In the case of activities with similar drivers (NOT equal drivers), the following simulation is
suggested:
- You can select two representative products for each activity (a standard one and a customised
one);
- Then you calculate the product costs under two different hypotheses: (i) merging activities with
similar drivers and (ii) keeping activities separated;
- If the costs calculated under the two different hypotheses do not significantly vary, activities
can be merged, otherwise they can remain separated.
Then you can focus on secondary activities (so the ones that consume less than 20% of overall
costs) by merging them with the more similar relevant activity.
But in the end, why we need all these efforts? This process is important because you have to
calculate the cost per activity, so it is better to have the proper number of activities in order to
evaluate them. At the end the goal is always reducing the cost per activity and you can do that in
different ways, for example you can act on the cost per driver or on the volume of the activity.
Example:
You have identified two activities:
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If you want to decrease the total cost of the activity, you can act on the cost per driver in two
different ways.
If you are able to decrease the number of the suppliers (ex 10% reduction from 320 to 288), in the
end you realise a reduction in the total costs, equal to 96.000€, but in the end the cost per driver
is the same.
You can have the same result if you act on the cost per driver, by reducing for example the cost
per order (from 50€ to 40€) thanks to the implementation of a new information system.
The design of a Performance Management System
We have already seen in the Performance Measurement System it should be able to assess
different levels: the higher will be the depth, the higher will be the costs but also the capability to
monitor the unit performances and so the tracking of specific responsibilities.
As a consequence, the depth of the Management Control System is reduced when the style of
management is centralised. In this case we are dealing with decentralization; giving
responsibilities at different levels of the organisation means decentralize.
Why it is so important the decentralization?
There are many advantages:
- The top management is more free to concentrate on strategy, there are other lower managers
responsible for the activities;
- Lower-level managers gain experience in decision-making, because they are more in charge of
taking difficult decisions;
- Decision-making authority leads to job satisfaction because each of us has a bit of autonomy
and so power to decide;
- Lower-level decision often based on better informations because the managers are closed to
the problem;
- Improves ability of the managers to evaluate other managers.
There are also some disadvantages:
- May be a lack of coordination among autonomous managers, because they could have
different plan of actions;
- Lower-level managers may take decisions without seeing the “big picture” in mind;
- Lower-level manager’s goals may not be the same of the organisation.
The management controlling system has some requirements. They are different for each
organisational level and their importance is different across the level.
They are summarized in the table below:
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(3+ means very important, while + it is not so relevant)
The timeliness is not relevant for the corporate level because they deal with strategy, which is set
once a year (decisions are less frequent). Instead timeliness is essential at the operational level
where decisions are made continuously every day.
Also the measurability becomes more important at the operational level. It means that you are
able to measure the concepts. The business and operational units need well measured concepts
because they will be evaluated on the basis of them.
Long term orientation is an important aspect for the corporate level, because the strategic plans
are normally oriented to the long term, in order to make the company survive. The other
organizational units instead are short-term oriented because they have to reach the targets fixed
by the corporate.
The completeness of information is important at the corporate level because they need the full
picture to evaluate the importance of those phenomenas that impact on the value creation.
The specific responsibility is a dimension which is not critical for the corporate level, because
shareholders will evaluate the top management on the basis of the net income, not on the result
of the operational activity, the taxation and so on.
On the contrary business units needs specific responsibilities because they have to understand
how to improve and how to move toward the future.
To sum up, the number of parameters that can be influenced by a single organizational unit
decreases, as well as the set of information required for management and control. But also, the
impact of wrong decisions on the overall results of the enterprise diminishes. As a result, it is less
risky to have less precise indicators.
In order to have a suitable
indicator for several managerial
needs, you are required to
present a mix of the several
indicators for the different
organisational levels, which
must be consistent with the
level that you are facing.
This schema sum up al the
indicators.
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When designing a performance management systems, two dimensions of analysis need to be
considered: the system to control and the type of the indicators.
At the corporate level, management controlling system should use value-based as the main
indicators. Then they should be supported by some specific accounting based indicators because
they are able to monitor company’s performances.
At the business unit level, indicators based on the financial statements are more suitable, because
they are the backbone of the reporting system: this means that middle managers are usually
assessed by the corporate level, which requires that they performances are assessed through
measurable indicators.
At the operational centres level, these organisational units are responsible for the activities. Value
drivers are the backbone of the reporting system because they need early signals and fast
information in order to take actions to fix the problems.
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Transfer Pricing
Transfer pricing is related to the fact that business units are responsible for revenues and for costs
and they can also make transactions among them. So there could be a business unit which sells
its products and services to another business units that belongs to the same corporation.
So the transfer pricing problem going deeper in understanding how these transactions may occur.
Definition
Transfer price is a fictitious price (so it is not a real price) that is used to evaluate intra-company
exchanges. More precisely, it is the price applied to the products or services objects of an internal
transaction between two business units belonging to the same corporation.
Clearly, the transfer price represents:
- A cost for the receiving business units (the one which acquires the product/service);
- A revenue for the supplying business unit (the one which produce the product/services).
N.B. We are talking about the transactions between business units belonging to the same
company, not the exchanges that occur among the subsidiaries or the associates of a parent
company.
It is important to highlight the fact that transfer price impact on the performances of the
different divisions, because in one hand it represents a cost, in the other it represents a revenue.
Moreover, transfer price is important because it affects the business units’ decisions, because
they are autonomous so they can decide whether is more convenient to make internal
transactions or to refer to an external supplier.
Lastly, transfer price is also important because it affects the overall result of the company.
Transfer price goals
Why it’s important to study transfer price? It is important because nearly 60% of world trading
activity is intracompany. So that’s why a transfer pricing system (which means how the
company decide to regulate the internal transactions between its business units) is required for
several purposes:
• to provide information that motivates divisional managers to make good economic decisions;
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• to communicate data that will lead to goal-congruent decisions, ensuring
coherence between divisions;
• to provide information for evaluating divisional performances;
• to ensuring divisional autonomy;
• to plan tax, intentionally moving profits between divisions or locations.
Transfer pricing system and tax
In multinational companies, different BUs may be spread in different countries and have
transactions among them. Since each country has its own fiscal regulations, companies may
decide to strategically allocate BUs in countries where there is a lower tax rate.
In this way they can take advantage of divisional transactions for transferring profit from one
country to another taking advantage of different tax rates (income taxes, duties…) in order to save
money.
As you can imagine, this is not a fair behaviour of corporations. For this reason in 1995 the
Organisation for Economic Co-operation and Development (OECD) published a guidance
reflecting an international consensus reached by OECD countries in regulating multinational
enterprises transactions, whihc have been updated year after year.
This guideline states that when an internal transaction arises between business units of a
multinational enterprise, these business units should act as separate entities, so they should be
fair in the exchange and the arm’s length principle should be used.
The arm’s length principle states that the price applied to the object of an internal transaction
(between two business units belonging to the same corporation) should be the same price that
could be applied on the external market in comparable transactions and circumstances, as if the
business units were independent entities.
Moreover, another guideline that has been introduced by the OECD is that parent companies have
to fill a country-by-country report to provide an overview of where profits are made and taxes
are paid for each country where the divisions are placed (so that there is more transparency).
Transfer pricing methods (managerial perspective)
Transfer Pricing Methods have important managerial implications, as decision making and
motivation of business units, which are a priority for performance management.
The objective of Transfer Pricing Methods is to understand how to define the price that should be
charged on the product/service that is the object of the internal transaction. There are several
methods through which we can set the price of the internal transaction and so the transfer price.
These methods are:
• Market-based transfer prices;
• Dual transfer prices;
• Cost-based transfer prices, which is differentiated according to the cost that we consider;
• Negotiated transfer pricing.
Market based transfer pricing
Referring to the Market based transfer pricing means that the prices that are applied to the
objects of the internal transactions are the same that would be applied to the same products and
services when they are sold/bought on the external market.
Since that we are dealing with an internal transaction, we can lower and correct the price taking
into in consideration the fact that are lower transaction and administrative costs that are typical of
the internal transactions between business units.
In this case, the advantages are divided between the two units between whom the transaction
takes place. Moreover, this policy avoids the risk of the buying unit using an external customer
instead of an internal unit.
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When does a market based transfer pricing work? It works when it is easy to define the market
price: there are situations in which it is easier, like in the homogeneous markets (so markets in
which the products/services have more or less the same characteristics and the prices are stable),
while there are other markets with high variability where the process of computing market prices
is more difficult.
A corporation that is working in a homogeneous market that decide to adopt the market based
transfer pricing, can use three different sources in order to define the reference market price. In
particular, the three sources are:
- Listed prices (published on the market) of identical/similar products/services;
- Actual price of intermediate products if they are also sold to external customers;
- Price offered by competitors (I take as reference the prices applied by competitor to compute
the price of my internal transaction).
When does market based transfer pricing have some problems? When we deal with markets that
have some sources of variability. This is the case of:
- Non-homogeneous markets, so a reference market with products/services with different
characteristics and so it is difficult to define perfectly a product that is equal to the one that you
are considering;
- A market where is a high variability of prices, so the prices go up and down really often during
the year so it is really difficult to set a reference price on the market;
- When we are dealing with strategic business units.
High variability of prices
Consider the case of a company operating in the oil market, where there is a high variability of the
price during the months. So it is really difficult to set a reference price on the market through the
market based transfer pricing.
One solution could be taking the average price. Since the price is changing a lot during the
months, I just take the average price on the market and use it as reference for my internal
transactions. But this option doesn’t work properly.
In fact, considering the case of a company operating in the oil market which is divided into two
business units:
- one devoted to the oil purchases (the upstream BU);
- the second carrying out the oil refining (downstream BU).
An internal transaction between of these two business units occurs with the oil as the object of
the internal transaction. The corporation decides to regulate this internal transaction with market
based transfer pricing and to take as reference the average price of oil on the market (updated
month by moth).
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During the month, the price changes a lot. So that’s what happens:
- When the price on the market is higher than the transfer price, for the upstream BU (the unit
that sells to the other) it is more convenient to sell the oil to the market rather than selling it to
the downstream business unit;
- On the other hand, when the price on the market is lower than the transfer price, for the
downstream BU it is more convenient to purchase oil from an external supplier rather than
buying it from the upstream BU.
So it is clear that setting the average price of the market as the reference price does not work
because of the opportunistic behaviours of the two business units (since they are autonomous in
taking decisions about the products/services produced and the resources used).
In order to avoid opportunistic behaviours, a possible solution could be set the transfer price on a
daily base instead of on a monthly base.
Strategic business units
The other situation in which the market based transfer pricing doesn’t work is when we are
dealing with strategy business units.
A strategic business unit is a business unit with the peculiarity of being focused on carrying out
specific phases of a process of the value chain or on a specific product line.
Moreover, this type of business unit operates with competitive disadvantages compared to
external suppliers, because it is smaller compared to competitors on external market.
The reason why companies have SBUs although these disadvantages is because they are useful
to achieve a better understanding of the market or a particular phase of the process.
For example, LG is retaining its business unit dedicated to the mobile phones (despite its
disadvantages when competing with Apple and Samsung) because through this business unit LG
can be present also on the market of mobile phones and it can increase its knowledge on the
market and so on.
So, a SBU has a great potential of leverage in negotiations because they have specific knowledge
on critical processes for the organization as a whole.
In order to understand why the market based transfer pricing doesn’t work when we are dealing
with strategy business units, let’s make another example.
Suppose that within a company there are two business units which exchange products:
- A, which is the upstream business unit that sells products and services to the downstream
company. It has a critical success factor that is the economy of scale (price and costs depend
on the volume of the production).
- B, that is the downstream business unit. It is a strategic business unit that has lower market
share compared to its competitor C (which is the market leader).
Suppose that there is an exchange between A and B. A can be the
supplier for both B (the business unit) and C (the external customer).
Since the price varies according to the volumes purchased and since
B is smaller compared to C, the price at which B purchases the
products from A it is higher (= 100) compare to the purchase price for
C (= 70) because B is smaller than C and so it will purchase a smaller
volume of products than the one purchased by C.
If B was was independent company, it would exit the market because
it has not a sufficiently big scale to compete on the market.
So, it is clear that if the transfer price of transaction between A and B was based on the market
price (so it would be equal to 70) we would penalize A, which would have no convenience in
internal exchanges.
On the other hand, if the transfer price remained fixed at 100, B would be penalized, as it has
higher purchasing costs compared to C, and it would be forced to exit the market.
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So, when we are dealing with SBUs, the market based transfer pricing doesn’t work properly
because we can’t align the interests of the two SBUs.
We can solve this problem through the dual transfer pricing.
Dual transfer pricing
According to Dual transfer pricing methods, the selling price received by the upstream division
is different from the purchase price paid by the downstream division. The difference between the
two values is compensated by a cost that is sustained by corporation and it is accounted under
the item reserves in the balance sheet. This process highlight the cost that a company has to
sustain in order to run a strategic business unit.
Considering the previous example, if we apply the dual transfer pricing method the transfer price
for A would be always 100, but the transfer price for B would be equal to 70, because the
difference (100-70 = 30) is charged to a corporate account.
This makes evident that the company decided to maintain in house its strategic BU, although it is
not competitive on the market.
Cost based plus mark-up transfer price
According to the cost based plus mark-up transfer pricing, the transfer price of the object of the
internal transaction is computed as the cost for the seller (to make the object of the transaction)
plus a mark-up in order to provide a positive margin to the upstream business unit.
Depending on how we value the cost from which we start the computations of the transfer price,
we can have different configurations of it:
- Full actual cost transfer price: sum of the actual costs of all resources used to produce a
product or deliver a service.
- Full standard cost transfer price: sum of the budgeted costs of all resources that are going to
be used in the long-term
- Marginal cost transfer price: sum of variable costs sustained for the production of the object
of the transaction (both direct and indirect variable costs).
Full actual cost transfer price
In the full actual cost transfer pricing, the costs that we considers are all the actual costs (both
variable and fixed) that are used in the production of a good/service. It is computed as follows:
It is clear that the transfer price increases when variable costs and fixed costs increase: since
business units are autonomous, they have incentives to have inefficiencies to increase the cost of
production in order to increase the transfer price and sell the products to other business units at a
higher price.
So, the inefficiencies of the upstream BU are translated into improved performances for the
upstream BU itself, but they are also translated in worsened performances for Downstream BU
(because they have to pay an higher price).
How can we solve this problem? Through the introduction of full standard cost transfer price.
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Full standard cost transfer price
The full standard cost transfer price considers just the budgeted costs of all resources that are
going to be used in the long-term. Under this configuration, the transfer price is expressed as:
If we express then the EBIT of the upstream business unit, since it is revenues - costs, it will be:
The revenues for the upstream BU are represented by the transfer price multiplied by the real
quantity of the internal transaction, while the costs are equal to the actual variable cost multiplied
by the real quantity plus the actual fixed costs sustained by the upstream BU.
Since the upstream BU wants to increase its EBIT, it can do it by increasing its efficiency, and so
by increasing the real quantity to sell or decreasing the cost of production.
That’s how we can resolve the problem of the inefficiencies of the upstream BU.
But what about the downstream BU and the company?
Under a full standard cost transfer price, the EBIT of the downstream BU is expressed as:
The revenues for the downstream BU are represented by the price of its final product multiplied by
the quantity of the final product that it has sold, while the cost sustained by the downstream BU
for the production process are equal to the sum of the conversion cost (so the cost for
transforming the semi-finished products that they acquired from the upstream BU into final
products for the external market) and the cost for purchasing the semi-finished products from the
upstream BU (they are both multiplied by the real quantity, since they are unitary costs).
Since the downstream BU would like to have a positive EBIT, this will be positive when the price
of the downstream product should be higher of the sum of the conversion costs and the
purchasing costs of the semi-finished products from the upstream BU:
From the company perspective, the price of the final product sold on the market by the
downstream BU should be higher than only the variable costs, because the fixed costs sustained
by the upstream BU would be sustained independently from the volume produced. So for the
company the price at which the final product should be sold in order to have a positive margin
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should be higher than the sum of variable costs at the downstream level and the variable costs at
the upstream level:
As you can see, the threshold on the price (how the downstream business unit will set the price
on its final product) is different from the perspective of the company. In particular, this difference
will lead the downstream BU to sell at a price that is higher compared to the one of the company,
and so it will produce a lower number of quantity compared to the one desired by the company in
order to guarantee itself a positive EBIT.
It is clear there is a problem of underused capacity.
Full standard cost - Example:
We have to BUs: A is the upstream BU while B is the downstream BU.
What is the minimum price for which the downstream BU will accept a new order?
What is the minimum price for which the company will accept a new order?
The exercise ask us to validate the two threshold that we have seen at the downstream level and
at the company level.
Firstly, we have to compute the transfer price according to the full standard cost, which is equal
to:
In order to determine the minimum price for which the downstream BU will accept a new order,
we have to validate the threshold of the downstream business unit on price:
So only if p > 73€ it is convenient for B to accept a new order, because only like this the
downstream BU will have a positive margin.
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If we want instead to determine the minimum price for which the company will accept a new
order, we have to validate the threshold of the company on price:
Only if p > 60€, it is convenient for the company to accept a new order.
A solution to align the downstream perspective and the company perspective could be to change
the method of computation of the transfer price, moving to the marginal cost transfer price.
Marginal cost transfer price
The marginal cost transfer pricing is a solution for the misalignment of the downstream BU’s
and company’s perspectives, in order to solve the underused capacity of the downstream BU.
In particular, the transfer price is determined as the sum of just variable costs (both direct and
indirect) plus a mark-up: this is how we avoid the misalignment between downstream BU’s and
company’s perspectives.
however, by adopting this model we have other problems.
Within the transfer price we are not considering the fixed costs, but the upstream BU needs to
sustain the fixed costs in order to produce the object of the transaction and these impact on its
EBIT. So, for the upstream BU not considering fixed cost is a problem.
What we could do is increasing the mark-up, in order to guarantee a positive operating margin
and to cover the fixed costs.
Moreover, the advantage of this solution is abstract not only because there is the problem of fixed
costs for the upstream BU but also because the two threshold are still different due to the fact in
the company’s perspective we do not consider the mark-up, while in the downstream BU’s
perspectives we don’t.
Negotiated transfer price
This is the last method for setting the transfer price.
Negotiated transfer price means that what we have seen so far is not more valid: the transfer
price set through this method is not set at the corporate level, but is the based on the assumption
that the two business units can negotiate and that they can find an agreement about the price or
the transaction.
So the business units of the company considered are free to negotiate the transfer price between
themselves and to decide whether to buy and sell internally or deal with outside parties.
The strengths of this method are the fact you are giving more autonomy to the business units and
you are setting them free to take their decisions and also to be more adaptable to the external
market.
On the other hand, there is a higher cost of negotiation (since the business units have to
negotiate, this is an activity which represents an additional cost), there is no guarantee that there
will be an integration among business units because they can use an external outsourcer).
Moreover, the power of the business units assumes a relevant weight, because the higher is the
power of a BU, the higher will be its bargaining power and so it will be more able to negotiate a
price that is more convenient for it but not for the other BU.
This are the weaknesses of the negotiated transfer price.
How can we deal with these weaknesses?
By putting two constraints:
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- First of all, the company can allow the BUs to negotiate the transfer price but then they are
obliged to buy internally and not from an external supplier (constraint on integration).
- Then, the company analyses the internal transactions and fixes a variability range of prices, in
order to avoid bias due to contractual power of a BU.
Model for choosing transfer prices
How can a corporate choose which is the most appropriate method for setting the transfer price,
according to different situations?
The choice depends on the integration and on the adaptability that the company wants to reach.
If the corporation wants to be an integrated enterprise and to have control over the BUs
(because maybe the external environment is really turbulent), the methods that should be chosen
are the ones in whihc the transfer price is set by the corporation, so the price based on market or
the price based on cost.
If instead the corporation wants to give more power and autonomy to its BUs and to have more
independent companies because the external environment is not so turbulent, it can goes for a
negotiated transfer price.
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