INDEX
0. Introduction ............................................................................................................................ 4
1. Financial analysis .................................................................................................................... 6
1.1 Sources selection and data “triangulation” ...................................................................................... 6
1.1.1 Income statement ............................................................................................................................................ 8
1.1.2 Balance sheet ................................................................................................................................................... 9
1.1.3 Cash flow statement ...................................................................................................................................... 11
1.1.4 Changes in equity ........................................................................................................................................... 13
1.2 Segmental analysis ........................................................................................................................ 14
1.3 Common size analysis .................................................................................................................... 14
1.4 Benchmarking ............................................................................................................................... 18
1.4.1 Identify strategic objectives ........................................................................................................................... 19
1.4.2 Sample selection ............................................................................................................................................ 19
1.4.3 Involvement modality .................................................................................................................................... 20
1.4.4 Performances choice for the comparison ...................................................................................................... 20
1.4.5 Data correction............................................................................................................................................... 20
1.5 Reclassification and adjustments ................................................................................................... 22
1.5.1 Reclassification of the Balance Sheet ............................................................................................................. 22
1.5.2 Reclassification of the income statement reclassification ............................................................................. 25
1.5.3 Adjustments ................................................................................................................................................... 26
1.6 Exercises on financial statement recap .......................................................................................... 27
2. Financial Statement Consolidation ........................................................................................ 31
2.1 What is consolidation .................................................................................................................... 31
2.1.1 Definition of group of companies................................................................................................................... 31
2.1.2 Group accounting ........................................................................................................................................... 32
2.2 When is required ........................................................................................................................... 33
2.2.1 Control............................................................................................................................................................ 33
2.2.2 Joint control ................................................................................................................................................... 33
2.3 Full consolidation method (line by line) ......................................................................................... 34
2.3.1 Pre-consolidation adjustments ...................................................................................................................... 34
2.3.2 Consolidation adjustments............................................................................................................................. 35
2.4 Equity method............................................................................................................................... 40
3. Accounting-based indicators.................................................................................................. 41
3.1 Profitability analysis ...................................................................................................................... 41
3.1.1 Shareholders’ perspective .............................................................................................................................. 42
3.1.2 Overall company’s perspective – middle line managers’ perspective ........................................................... 43
3.1.3 Stakeholders’ perspective .............................................................................................................................. 46
3.1.4 Risk/Operational Efficiency Matrix ................................................................................................................. 47
3.2 Liquidity analysis ........................................................................................................................... 49
3.2.1 Balance Sheet Perspective ............................................................................................................................. 49
3.2.2 Cash Flow statement perspective .................................................................................................................. 52
3.3 Absolute indicators ....................................................................................................................... 53
3.3.1 Residual income ............................................................................................................................................. 53
3.3.2 Cash Flow ROI ................................................................................................................................................. 54
3.4 Conclusions ................................................................................................................................... 54
4. Cost of capital ....................................................................................................................... 55
4.1 Cost of Equity Ke ........................................................................................................................... 56
4.1.1 Risk free rate rf ............................................................................................................................................... 56
4.1.2 Market return rm ........................................................................................................................................... 57
4.1.3 Beta levered βL (equity beta) ......................................................................................................................... 58
4.1.4 Case study ...................................................................................................................................................... 60
4.2 Cost of the debt Kd ........................................................................................................................ 61
5. Analysis of the Leverage ........................................................................................................ 64
5.1 Du Pont Approach ......................................................................................................................... 65
5.2 Financial Analyst approach ............................................................................................................ 66
5.2.1 Simplified version ........................................................................................................................................... 66
5.2.2 Real life version .............................................................................................................................................. 67
5.3 Theoretical approach..................................................................................................................... 67
Exercises on Accounting-based Indicators.................................................................................. 69
6. Enterprise value (EV) & Equity value (E) ................................................................................. 71
6.1 Cash generation cycle .................................................................................................................... 71
6.2 Enterprise value (assets-side perspective) ..................................................................................... 73
6.3 Equity value (equity side) .............................................................................................................. 75
6.4 Exercise ......................................................................................................................................... 77
7. Value drivers and scorecards ................................................................................................. 79
7.1 Value Drivers ................................................................................................................................. 79
Performance drivers ................................................................................................................................................ 82
Resource drivers ...................................................................................................................................................... 84
Key Risk Indicators (KRIs) ........................................................................................................................................ 85
Characteristics of value drivers ............................................................................................................................... 85
7.2 Balanced Scorecards ...................................................................................................................... 86
8. Relative valuation ................................................................................................................. 89
8.1 Relative Valuation: main steps ...................................................................................................... 89
8.1.1 Defining comparable companies .................................................................................................................... 89
8.1.2 Defining possible multiples ............................................................................................................................ 90
8.1.3 Analyze multiples ........................................................................................................................................... 94
9. Target Setting & Budgeting ................................................................................................... 98
9.1 Plan and control cycle ................................................................................................................... 99
9.2 Budgeting system ........................................................................................................................ 101
9.3 Case study part I: Operating Budgeting........................................................................................ 103
9.4 Case study part II: Capital expenditure budgets and Financial budgets ........................................ 110
10. Financial Planning ............................................................................................................. 118
10.1 Bank loans (short and long term) ............................................................................................... 118
10.2 Syndicated bank loans or bridge bank loans (short and long term) ............................................ 119
10.3 Corporate bonds (long term) ..................................................................................................... 120
10.4 Leasing (long term) .................................................................................................................... 122
10.5 Factoring (short term) ............................................................................................................... 123
10.6 Lines of credit (short term) ........................................................................................................ 124
11. Management Reporting .................................................................................................... 126
11.1 Definition .................................................................................................................................. 127
11.2 Responsibility centers and reporting framework ....................................................................... 128
11.3 Reporting requirements ............................................................................................................ 130
11.4 How to organize the management reporting process................................................................. 132
11.5 Reporting at the Corporate level ............................................................................................... 132
Periodic Management Reporting .......................................................................................................................... 133
12. Management Reporting at the BU level: Transfer Pricing .................................................. 134
12.1 The Business Unit Level ............................................................................................................. 134
Two issues to breakdown corporate’s EBIT into business units’ EBIT ................................................................... 135
12.2 BU exchanges and transfer price................................................................................................ 136
Case study on Transfer Prices ............................................................................................................................... 137
12.3 Transfer Pricing methods ........................................................................................................... 139
12.3.1 Market-based transfer prices ..................................................................................................................... 139
12.3.2 Cost-based + markup transfer prices ......................................................................................................... 139
12.3.3 Negotiated transfer prices ......................................................................................................................... 140
12.3.4 Dual transfer prices .................................................................................................................................... 140
12.4 Exercise ..................................................................................................................................... 141
13. Management reporting at the BU level: Cost Allocation .................................................... 144
13.1 Segment Margin ........................................................................................................................ 144
13.2 Corporate Costs ......................................................................................................................... 147
14. Reporting at the Responsibility Centers level ..................................................................... 150
14.1 Indicators for Responsibility Centers ......................................................................................... 150
Example ................................................................................................................................................................. 151
14.2 Short case about a Cost Center .................................................................................................. 152
14/09/2022
0. Introduction
Financial accounting:
•
It provides the “numbers” we normally hear about a company (revenues, profit, assets value, ...):
financial accounting enables to beyond the “numbers” and to understand the connection between
those numbers.
•
It is a fundamental part of company evaluation, i.e., it contributes (together with “expectations”)
to determine for example:
o The shares’ price and market capitalization1 of a company in the day-by-day trading
(financial analysis). The problem with the stock market is that it is influenced by the
environment around the company itself, so it is not strictly connected to how the company
is actually doing.
o The target price in an M&A (due diligence). Ex. Tiffany was evaluated x10 more than what
was written on the balance sheet, because of the value of their brand.
o The selling price of shares in an Initial Public Offering IPO (due diligence)
o The credit stability (rating services): it talks about the stability of the company.
3 “numbers” that are fundamental in a financial statement:
•
•
•
Revenues --> understand how big the company is.
Net income --> how profitable the company is.
Cash from continuous operations --> how well the company is doing, about the real situation of
the company. Cash is important because
These numbers give us an initial understanding of a company.
Annual report analysis sheds light on certain aspects of the company but at the very end is the analyst who
has to provide his/her own interpretation. In fact, not all the indicators have the same relevance and
indicators pose questions more than providing answers.
Ex.
Continuous operations = core operations of the company.
From this example, we can see that revenues ¯, net income ­, cash ¯ --> controversial numbers, these
numbers are just the starting point.
1
Market capitalization = current market price per share * total number of outstanding shares.
From this example, we can see that they are making money from the media, rather than from the parks,
experiences, etc. So, we could understand where to invest, what to optimize, etc.
1. Financial analysis
Financial analysis is a process of selecting, evaluating, and interpreting financial data, along with other
pertinent information, in order to formulate an assessment of a company’s present and future financial
condition and performance.
Inputs of the financial analysis:
•
•
•
Market data: information about the industry in general --> the environment around the company,
including the major clients, the economical situation, etc.
Financial disclosures: investor relations (public traded companies are obliged to publish those data,
so they can be found on the website of the company; instead, private companies are not obliged to
disclose these information).
Economic data: economic information about the industry (not sure?)
The financial analysis depends on the aim we want to achieve.
Financial analysis is more than calculating indicators, and it requires the following steps:
1.
2.
3.
4.
5.
6.
7.
Sources selection and data “triangulation”
Segmental analysis
Common size analysis
Reclassification and adjustments
Benchmarking
Accounting based indicators (selection)
Interpretation
1.1 Sources selection and data “triangulation”
Triangulation means putting data together: we need to find the information that will help us.
Type of information used:
•
•
•
•
Financial disclosures: consolidated financial statements, shareholder letter and segmental analysis.
We could also add all the presentations for the investors. *
Non-financial disclosures: sustainability report and country report.
Market data: market price of stock, volume traded (you can understand how many shareholders
are stable, so the volatility of the company or the market) and value of the bonds.
Industry and economic data: information about the industry in which the company is operating,
like the pharmaceutical industry for AstraZeneca.
*Financial disclosure: SEC filing is a financial statement submitted to SEC (US Securities and Exchange
Commission) by publicly traded corporations. There are different types of formats:
o
o
o
Form 10-K: audited financial statement. Audited means validated by an audit.
Form 10-Q: unaudited financial statement.
Form 20-F: annual financial statement filed by a non-US company that has listed equity shares in
the US.
POLLEV ABOUT THE FIRST LESSON
1) Financial accounting is a fundamental of company evaluation, what for?
a) To determine the price during due diligence for IPO, M&A, shares’ price.
b) To acknowledge its credit rating.
c) Together with market expectations to see the complete picture at a certain moment.
d) All the answers are correct.
The major goal of financial accounting is a), specifically when we are talking about overall company
evaluation. C) is true because external expectations can have an influence.
2) Financial analysis is triangulation of:
a) Market and sustainability data
b) Economic data and financial documentation
c) Financial, market and economic data
d) All the information the financial analysis can find
The major information in the triangulation is: financial documentation, market documentation and
economic data. D) is not correct because if we use all the information, we can find we will never end.
3) The financial documents are:
a) Income statement, balance sheet, cash flow statement, changes in equity and notes.
19/09/2022
RECAP OF FINANCIAL STATEMENTS
1.1.1 Income statement
The 2 major information are revenues and net profit/income, so we can have an understanding of the
dimension and the profitability of the company.
The IS is divided into 3 parts:
1. Operations: revenues and cost of sales are due to operations --> this is the only part that changes
based on the type of IS we chose. The application of one method or the other depends on what the
company wants to highlight.
2. Financing: financial incomes, financial interests, income from investments, interest payable and
similar expenses, income receivables and similar incomes, value adjustments of financial assets, etc.
3. Taxation: taxes.
There are 2 alternatives of how to represent information in the IS: by nature, or by function.
Method 1: cost of sales (also called “by function”)
Costs are provided based on
their function, as marketing
costs, R&D costs, distribution
costs, etc.
Companies that provide an IS by
function are obliged to provide
the disclosure of the costs by
nature in the notes.
For example, one of the major
costs for 3M is R&D costs, so
they will probably show the IS by
function.
Method 2: by nature
Costs are divided based on
their nature, as cost of raw
materials, cost of staff
(wages, etc.), cost of
production, etc. If we have
depreciation and
amortization, they are due
to long term assets.
For example, banks show
costs by nature.
Ex. IS by function
Consolidated = means that the financial statement refers to the profit of the whole group (so more than 1
company). When we are consolidating, it means that we are managing the other companies of the group.
Net profit before minority interests = this happens when some businesses of the group are not 100% owned
by the group (for example the Barilla group could own only 95% of another company). It is important to
compute the net profit before minority interests because we need to subtract the minority interest, so that
part of of the profit which will go to the remaining owners of the company. We will talk about it in the
lesson about consolidation.
Ex. Reclassified consolidated IS by nature
EBITDA = proxy of the cash flow if we are talking about an asset company.
EBIT = proxy of the cash flow if we are talking about a service company.
Ex. AstraZeneca, IS by function --> if we look at the notes, we will also have the disclosure of the costs by
nature. Their business is based on R&D --> significant cost.
1.1.2 Balance sheet
The major information are assets, equity, and liabilities.
ASSETS = how we are producing. EQUITY + LIABILITIES = how we are financing the production.
ASSETS = EQUITY + LIABILITIES
ASSETS
Non-current assets: long term, over 12 months.
• PPE: property, plant, and equipment.
• Rights of use: patents, etc.
• Intangible assets: not physical assets.
• Financial investments
• Investment property
• Goodwill --> when we acquire another
company, we could have to pay a “plus”
for the brand’s name, reputation, etc. The
goodwill is the difference between the
price paid (market price) and the value on
the BS. We will talk about it in the lesson
about consolidation.
Current assets: short term, within 12 months, they
could be transformed into money within 12
months.
• Cash and cash equivalent
• Inventories
• Trade receivables
• Current financial assets
EQUITY
Shareholders’ rights
Equity
• Attributable to the parent
• Attributable to non-controlling interests
Retained earnings (come from the net income
from the IS) = sum of all the net income of the
previous years
LIABILITIES
Debt holders’ rights (banks, market, government,
employees, suppliers)
Non-current liabilities
• Lease liability = means that the company is
renting something to produce their
products
• Provisions
• Pensions
• Financial debt
• Tax liabilities
Current liabilities
• Lease liability
• Financial debt
• Tax liabilities
The assets part of the BS tells us if the company is a production company or a service company:
® If PPE is very high with respect to the other assets --> production company. Other costs that could be
relevant for a production company are patents and intangible assets.
Usually, for a company, non-current assets are higher than the current ones. For re-selling companies like
Amazon, the current assets can be higher than the non-current assets.
POLLEV
1) What can you tell about this company?
a) This is a service company, as goodwill is higher than all other voices
b) This company produce a product that requires both assets and human resources
c) This company lives only through M&A
d) This company will fail soon, as the goodwill is higher than PPE
D. is wrong because we don’t know
anything about the cash so we cannot
say if the company will fail only based
on the BS.
C. is half right, because goodwill is
very high so they company is growing through M&A (mergers and acquisitions), but the company does not
live only through it.
A. is wrong because goodwill does not concern if the company is a production company or a service one.
B. is correct because they have high PPE, and they have high intangible assets so they will probably are
knowledge-intensive.
2) Shareholders' equity is always placed before liabilities on the statement of financial position (Balance
sheet).
FALSE, in EU companies we place equity before liabilities (non-current before current), in American
companies they start from current liabilities, then noncurrent liabilities, then equity.
1.1.3 Cash flow statement
The most important information is the net cash from continuous operations. This could be benchmarked
with EBIT (or EBITDA if the company is capital-intensive) because EBIT (or EBITDA) is proxy of the cash.
The CF statement is important in the budgeting process because from this document we can see if there
are some areas in which we have to invest more or less.
3 parts concerning cash in and cash out:
1. Operational: this part could be different +
2. Investments: purchases of PPE, proceeds from sale of equipment +
3. Financing: proceeds from issuance of common stock, of long-term debt, dividends paid =
= Net increase/decrease in cash
+ Cash at the beginning of the period
= Cash at the end of the period (will be written also in the BS in the current assets)
2 methods: direct and indirect --> difference only in the operational part. It depends on what the
companies what to show.
•
Direct flow: cash logic, we record inflows and outflows: so, cash receipts, cash paid to suppliers,
employees, interests paid (interests on the debt that we took in order to produce, for example to
buy machineries, therefore is due to production and so it’s inside the operational part), income tax
paid, etc.
•
Indirect flow: accrual logic, we start from the EBIT (net profit before interests and taxes, IS), and we
make some adjustments:
+
+
+
•
Gain on sale of facility (different from “proceeds from sale of equipment” because gain on sale
of facility was not planned so it is a non-recurring operation)
Depreciation and amortization (due to long term assets): these are not real cash outflows; we
are putting money aside to make up for the loss of value of our assets.
Provisions for losses on accounts receivable
Increase in trade receivables
Decrease in inventories
Decrease in trade payables
POLLEV
1) The company announces great results & an increase in cash. You examine the cash flow & see an
outflow from operating activities & inflow from investing & financing activities. Does the statement
support company's announcement? No, because the inflows of cash do not come from the operating
activities, so their recurrent activities, but from the financing activities. The company did not good
because they do not have an inflow of the operations, which is their core business.
2)
LINK BETWEEN FINANCIAL STATEMENTS
•
•
•
Net income from IS goes to the Retained Earnings in the equity part of the BS and also in the CF at
the beginning of the operating activities (if the CF is made with the indirect method).
Long term assets in the BS are connected to the IS by nature and also present in the CF (indirect
method) among the operating activities and/or among the investing activities as “capital
expenditures”.
Current assets from the asset part in the BS is connected with the beginning cash and the ending
cash in the CF.
1.1.4 Changes in equity
This document is important for the potential future investors and the shareholders because this document
shows them the potential changes in volumes of the shares and estimate if it a safe position for them. Also,
this document shows if the company want to diminish or increase the n° of stocks on the market.
In fact, usually companies are motivating C-level managers by giving them the “stock option”: they can
decide whether to acquire the share or to take a bonus (money). This money will be taken from the
retained earnings (so from the “equity” part of the BS).
(This document does not show the price of the shares, which is defined by the market, not by the
company.)
We have some information:
•
•
•
•
•
•
Number of shares:
Legal reserve:
Retained earnings:
Stock option reserve
Treasury shares
Non-controlling interests: % of the shares not due to the company
POLLEV
What would be a company’s ending retained earnings if the following amounts were given:
Ending retained earnings = opening retained earnings + income (revenues – total expenses) – dividends
paid = 6200 + (102500 – 98500) – 5000 = 5200$
Gains from revaluating investments --> not connected to the changes in equity
Issue of shares --> is not part of the retained earnings, it’s part of the capital
21/09/2022
1.2 Segmental analysis
Once we gathered all the data, we can analyze the company from different perspectives. Whenever we
have the consolidated financial statements, we have the “aggregated information”, so we need to be able
to take decisions --> segmental analysis provide further information that will allow us to take informed
decisions.
Ex. Segmental analysis of the revenues from a geographical perspective: where should LVMH develop?
Asia, because now it is the biggest portion of their market share (29% of total revenue). Also United States
is quite a big market. We should also have information about the saturation of these markets.
Ex. Segmental analysis of the revenues from a sector perspective: which sector should we invest in? We
should have more information to answer this question as it depends also on how we imagine the future to
be, and not only on the growth of the specific sector. This table is useful to understand how the company is
constructed and how each sector is doing (for example here we don’t have problematic divisions). They
actually decided to invest in selective retailing because they believed this would become a very important
channel.
Ex. Segmental analysis of the revenues from a sector perspective: Volkswagen group. We can see that
some divisions are negative (so they are not doing good, like SEAT) but the group will not close them
because they are used for their brand positioning, for the brand picture, not to gain profit.
Segmental analysis is crucial whenever we are doing the benchmarking of a company. The more similar
the companies, the better the competitor analysis we can make. It is difficult to compare the segment of
the companies because companies provide “aggregated” data, not data about each sector (as they are not
obliged to publish them).
For example, LVMH can be compared to Kering, however LVMH has some parts that Kering doesn’t have.
When choosing a competitor, we should think about the geographical area and about the products, are
they similar?
1.3 Common size analysis
This analysis provides a snapshot of the company and help us to understand many things. This is the first
analysis we see, and it is the basis for identification for the real things we have to investigate on.
Common-size analysis is the restatement of financial statement information in a standardized form.
•
•
Vertical common-size analysis uses the aggregate value in a financial statement for a given year as
the base, and each account’s amount is restated as a percentage of the aggregate.
•
Balance sheet: Aggregate amount is total assets.
•
Income statement: Aggregate amount is revenues or sales.
Horizontal common-size analysis uses the amounts in accounts in a specified year as the base, and
subsequent years’ amounts are stated as a percentage of the base value. Useful when comparing
growth of different accounts over time.
Usually for both analysis we take 5 years.
APPLIED TO
TIME FRAME
Vertical common size
BS, IS (but can also be done for the CF
statement)
We analyze 1 specific year, but we
compare with what has happened in the
previous years.
Horizonal common size or trend analysis
Any document
At least 3 years because we need to look
for trends.
HOW
OBJECTIVE
In the IS, we take the net sales/revenues as
100%. We transform € in % by dividing
each element by the revenues for the IS
and the total assets in the BS.
In the IS, we can see which % of the
revenues is the net income (usually around
10%).
In the BS, we can see the distribution of
the assets (which % of the total assets are
current, non-current, etc.).
We can compute EBITDA margin and EBIT
margin (found in IS by nature).
We take a certain year as the baseline, so
every value of this year is 100%.
We want to see how each voice changes
over the years.
Ex. Vertical common analysis of an IS
It’s important to understand how
the company is changing
throughout the years: is the
company able to minimize some
of the crucial points? For
example, is the company able to
minimize the cost of goods sold?
Ex. Vertical common analysis of the BS
From the vertical
analysis of the assets
part of the BS, we can
see that:
• PPE are increasing
so this is good because
hopefully (if nothing
else changes) it means
that we are producing
more, so we have
more revenues, so
more net income.
This is a production
company (asset-heavy
company) and they
were able to maintain
almost the same
configuration. This
analysis allows us to
see if a company has
reconfigured its
business.
Ex. Horizontal analysis of the same BS: we can see the element that has grown the most is PPE (we could
see also if the company decreased some assets) --> we can see the decisions management has taken in
those years.
Ex. Vertical analysis: the relevance of the industry.
Different types of companies have a different distribution of the assets.
•
•
•
ENI: 70% are non-current assets
because the company is a production
company (they mostly have PPE).
More RIGID company.
Facebook: 50%-50% because the
goodwill is very high (they have
acquired many companies).
IMA: 62% are current assets because
their business is much faster --> for
them is more important to be
ELASTIC.
If we look at the incidence of the operating costs: for Facebook, the major cost is R&D; for IMA is raw
materials; for ENI is purchases, services and other so they are quite dependent on their supplier.
Ex. Vertical analysis
The company with the highest income is B (893$). The company in which the net income is a higher % of
the net sales is A (A 5,7% - B 4,8%), so A is managing better their costs (it’s more efficient).
Attention: the absolute numbers give us the idea of the dimension so when comparing different
companies, we should consider that. In fact, bigger companies have to manage more complexity, so they
will probably be less efficient. Percentages (margin ratio indicators) help us compare different companies,
but we should not forget the fact that they could have a different dimension.
POLLEV
1) The objectives of segment reporting are:
a) For a better understanding of the performance and evaluation of the organization’s results
b) To provide information to the stakeholders about the important units of the organization to
evaluate and make decisions about investments
c) To analyze the most profitable or less-making units
d) To make better decisions by taking in mind the business from different segments
e) All of the above
2) Margin ratios are product of: VERTICAL ANALYSIS.
1.4 Benchmarking
Ex. Eni 2017 results --> positive net profit, so the company is gaining something. But how is the company
performing? We don’t have the horizontal common analysis, so we don’t know if in the previous years it
was better or not --> we could benchmark it, so compare the company with the industry and competitors.
ROE = 7%2. How can we explain this value? Is
this a contingency, is it a market trend?
Looking at competitors can be helpful:
A lower EBIT and a higher net profit means
that the earning coming from operations is not
high and a lot of profit comes from nonoperating activities (look at TOTAL).
Instead, ENI and BP have a higher EBIT than
the net profit, so this means that their
operations are doing good.
According also to the dimension of the company (looking at the total assets), ENI is doing quite well. These
companies are also compared based on the ROA because these companies are asset heavy.
Ex. Automotive sector. Why Volkswagen had
a drop in 2015? They cheated so this led to a
drastic situation. So, if we look at trend
analysis and competitor analysis we can see if
some major events happened.
What is benchmarking?
It’s a process that companies apply in order
to understand the real performance of the company by comparing it with other companies in the industry.
“The continuous process of measuring its own products, services, practices against the toughest
competitors or those companies recognized as industry leaders”.
Benchmarking never ...
1) ...ends: it is a continuous process that needs recalibration in the perspective of continuous
improvement
2) ...copies: information learned is not copied but adapted to the specificities of context (company’s
history, needs, culture, structure, ....)
3) ...cheats: it should be an honest, legal, and virtuous analysis.
Benchmarking process
1.
2.
3.
4.
5.
2
Identify strategic objectives: we need to have an idea about what we want to achieve.
Sample selection: 5 - 10 competitors is a good number (with similar strategic objectives)
Involvement modality: how do we communicate with competitors.
Performances choice for the comparison
Data correction
ROE = net income/equity. This value takes into account the major investors: shareholders are the most vulnerable of
all investors, because if a company goes bankruptcy, they will be the last to be paid. Shareholders look at this value.
1.4.1 Identify strategic objectives
2 perspectives: performance or process. Usually, we do the benchmarking by performance because it’s a
little bit easier to calculate the performances, rather than comparing processes.
•
Performance: we are looking for the best practices in terms of some indicators, like flexibility,
timeliness, quality, costs, etc. We are comparing financial and non-financial indicators. Problems:
o No guarantee that the various best practices are comparable
o Tradeoff between the benchmarked performances and the others
o Possibility of a time lag between performance and processes
•
Process: comparison of the processes, best practices in terms of organizational structure,
responsibilities, technologies, etc.
o Processes include a variety of factors, so difficulty of focusing the analysis on competitive
differential
o Difficulty to link processes and performance
1.4.2 Sample selection
Different options exist:
1) Leader Benchmarking: benchmarking on a specific performance or process. We are comparing the
company with the leader of the market.
• (performance) Fincantieri benchmarked itself against Boeing on its quality-focused strategy
• (process) IBM benchmarked itself against Federal Express on its logistics system
2) Sector Benchmarking: benchmarking with companies that act within the same industry.
3) Internal Benchmarking: benchmarking with different units of the same company.
The performances that we need to be looking for are those important for the company in terms of how the
company will imagine itself/want to be in the future.
In the case of controlling management, the sector benchmarking is the most suitable approach: reasonable
and feasible goals, without being under-stimulating.
We are going to compare AstraZeneca mainly based on the financial performance (we could do a leader
benchmarking or do a sector analysis compare for example the sustainability).
1.4.3 Involvement modality
Two different ways:
1) Unconscious --> Indirect involvement of competitors (data can be found on external resources)
Information is gathered through web sites, publications, magazines, employees, customers and vendors,
suppliers, databases, reverse engineering, balance sheets and other institutional public documents.
2) Conscious --> Direct involvement of the competitors, which provide the needed information. Best and
more precise results BUT: necessity of the organizations approval and necessity of reveal the own data.
1.4.4 Performances choice for the comparison
1) Definition of the scope: identification of the areas of the company that need to be benchmarked.
Examples:
• Whole company
• Some products/services (only finished goods, service features, ...)
• Work processes (manufacturing, supply, logistics, ...
• Support Functions (HR, Marketing, ...)
2) Definition of the measurement system: definition of indicators for comparison
• ROE, ROA,
• More specific indicators depending on the objectives: like the incidence of intangible assets and the
number of patents to understand if the company is innovative, etc.
1.4.5 Data correction
The best practices may descend from two different reasons:
1) Better management: to be individualize through benchmarking.
2) Difference in the conditions of the context: to be eliminated to make companies comparable. Factors
influencing context include:
• Scale (for example, Barilla and Nestlé: Nestlé is much bigger so we would need to scale it down).
• Strategy (efficiency vs. effectiveness) (for example mission and vision could be different, so we can
look for them in the Letter to the shareholders and stakeholders).
• Market expectations and perception (difficult to quantify)
• Product itself in Leader Benchmarking (for example, different companies could be leaders in
different areas, so it could be difficult to compare companies, like Apple and Samsung).
Conclusion: the first thing is to identify the strategy of the company and understand which will be the
goals. To do so, we should perform the common analysis to understand the major voices and how the
company is constructed --> this will help in the sample selection to choose the competitors.
26/09/2022
POLLEV
1) Common size analysis of IS reveals:
a) The structure of the company --> wrong, it is in the BS
b) The best performing units of the company --> wrong, we see this in the notes (most likely)
c) The dimension of the company --> wrong, common size analysis is about percentages and % don’t
show dimension (to know the dimension we need the absolute numbers)
d) The most important expenses of the company --> correct, if the IS is by nature
2) Horizontal & vertical analysis:
a) It does not provide useful managerial information --> wrong, trends are very important.
b) It is an initial step in a company’s analysis to identify the most problematic points in the financial
statements
c) It is part of the budgeting process --> wrong
3) The benchmarking analysis is done for:
a) Understanding the company about which the benchmarking is done --> yes
b) Understanding the competitors --> no, the objective is not to understand the competitors (the
benchmarking could also be done internally)
c) To understand the market --> no, the benchmarking is much more specific.
4) Internal benchmarking:
a) it is not a crucial analysis to the company’s performance --> not true always, it depends on the
dimension of the company. Yes, for smaller companies. For big conglomerates, it is actually
important.
b) it is the easiest and most commonly performance --> yes, easy to compare the units inside a
company.
c) it is usually focused on the process, rather than of performance --> not true
5) Company performing sector benchmarking:
a) is looking for innovation --> no, leader benchmarking is looking for innovation.
b) is positioning itself on the market --> yes
c) is searching for the best processes --> it depends on the type of analysis
d) requires a lot of time --> it is not the major characteristic
1.5 Reclassification and adjustments
Ex. LVMH, IS by function: we can find the “Diluted EPS” means including all the shares that most probably
will be issued (so, also stock options and potential additional shares).
Basic EPS > Diluted EPS (the denominator is greater in the case of diluted EPS). The n° of shares will be
present in the Changes of Equity Statement.
Reclassification and adjustments are done to provide more readable and more comprehensive
information about the company for the final users, so the stakeholders and shareholders.
In fact, if we took a financial document and we computed some KPIs, like ROE, we would probably have a
different figure with respect to what is written on the document --> this is due to the reclassification and
adjustments.
Accounting principles might differ between organizations. Accounting choices can vary from one
organization to another.
Reclassification and adjustments aim to reorganize financial statement in order to:
•
•
•
Increase their readability
Underline key financial results
Improve the comparability between different enterprises
What is object of reclassification and adjustments?
• Balance Sheet
• Income statement
• Usually, we DO NOT reclassify the Cash Flow statement.
1.5.1 Reclassification of the Balance Sheet
The purpose of the Balance Sheet reclassification is to highlight:
•
FC: Fixed Capital --> assets that we use in the long-run (non-current assets)
•
NWC: Net Working Capital
•
NFD: Net Financial Debt
In this way we can compare different companies by looking at these values.
Fixed capital
Net working capital
The definition of Net Working Capital is linked to the notion of working capital cycle NWC.
Net Working Capital is a measure of the operating liquidity (€) of a company and represents the amount of
the liquidity necessary to run the business during the working capital cycle (time).
The working capital cycle3 is defined as the average time it takes to acquire materials, services and labour,
manufacture the product, sell the product and collect the proceeds from customers.
The NWC takes into account:
•
•
•
receivables,
payables,
inventories.
NWC underlines the ability of an organization in managing the operating cycle (receivable, payables,
inventories):
In practice there are different labels and formulas that are used to compute the NWC, for example we can
use the following simplified formula:
Net Working Capital = Current assets – Current liabilities
Is it better to have a high or low NWC? There is not a universal answer. It depends on the company
dimension and on the product. If 2 companies produce the same product, it is interesting the compare the
amount of money they need to complete the production cycle.
Normally, liabilities are cheaper than
equity because shareholders have a
high risk, instead stakeholders have a
lower risk.
Ex. Fincantieri: due to an increase in
Trade Payables, we have a change in
the NWC of the company. If a company
has a negative NWC, it’s not good,
because it is good when the current
assets are higher than the current
liabilities (because it means that we
would be able to repay our debts). The
problem is that that the trade
receivables have diminished.
Having a negative NWC DOESN’T
MEAN that the company is failing, it
could be for example that the company
made a big investment, therefore they had less cash. The important thing is that overall, there is a positive
trend. If the NWC is negative, we should investigate and understand the reason behind it.
3
The working capital cycle can be 1 day or even a couple of years, it depends on the company. For pharma companies,
patents have to be disclosed within 5 years (by law).
So, the Working Capital is all the money needed for production (it is represented by all the cash out flows in
the operating part of the cash flow statement). The NWC is the Working capital, minus the liabilities within
the 12 months period.
Net working capital = working capital (receivables, inventories) – liabilities (tax, payables) =
= current assets (minus cash) – current liabilities (minus debt)
Net financial debts NFD
NFD consist of the total debts (bonds*, bank debts and other financial liabilities; both current and noncurrent) of the company less available cash and cash equivalent.
*Bonds are securities issued by the company.
In the debt we are NOT taking into account taxes, employees, etc.
It can be considered as a driver about the ability of the enterprise to reimburse its debts if they were all due
today. It is calculated by adding short-term and long-term debt and subtracting all cash and cash
equivalents. We subtract cash and cash equivalent because that amount could be immediately used to pay
back the debts.
Is better to have a high or low NFD? Having a debt is a strategic decision (short or long term, to cover
what) so when comparing the NFD of different companies we need to take into account their strategy and
their structure:
Financial leverage = total debt/equity (<= 3, but it depends on the industry)
So, the NFD depends on the industry and on how the company is operating: the company could be mostly
financed by the debt or by the equity --> the NFD could be negative if the cash is much bigger than the
debt. If NFD is negative, it means that the management of operations is quite good.
Ex. Henkel. 2014: negative amount. The
financial debt increased (because they
acquired other companies) but the cash
remained similar.
Was it a good or bad decision? We need
to know more information, like the
income, to say if it was an improvement
or not.
NET DEBT = NET FINANCIAL POSITION
Example of a RECLASSIFIED CONSOLIDATED STATEMENT OF FINANCIAL POSITION:
For example, this company is majorly financed by the equity (83,8%).
1.5.2 Reclassification of the income statement reclassification
The objective of the reclassification of the IS is to highlight:
•
Value added = revenues – raw materials – G&A
expenses = which type of actions the company
performs to add value to the final product
•
EBITDA = value added – personnel costs (HR costs)
•
EBIT = EBITDA – depreciation & amortization
•
EBT (earnings before tax and extraordinary items) =
EBIT – net financial expenses
EBIT and EBITDA give more information about how the
company is doing (more than the net income), because they
show the real results of the company due to the operations.
Ex. Fincantieri: we can see the EBITDA and the EBIT margin
1.5.3 Adjustments
Reclassifying means changing the structure of financial documents to highlight some elements (the
“building blocks” are the same).
Adjustment: the structure is the same, but we decide if we want to ADD/REMOVE some of the building
blocks. So, adjustments refer to the amendment of an item (number) disclosed in annual reports.
® Why adjustment?
When unexpected events occurred or when accounting principles have changed over the years, the
disclosed numbers in annual reports can be revised to provide a fair representation of the current
situation
® What is adjusted?
EBIT, EBITDA, Operating profit, net profit, (more rarely current assets) ... are typical items that can
be adjusted.
Adjusted EBIT = excludes certain adjustements from net profit from continuing operations including
gain/losses on: disposal of investments, restructuring, impairments, asset write-offs and unusual.
Adjusted EBIT is used for:
•
•
•
Internal reporting to assess performance
As part of the budgeting and decision making processes
To provide additional transparency to the Group’s core operations.
28/09/2022
POLLEV
1) Reclassification is not done for:
a) Increasing the readability
b) Underlining key financial results --> false, the key financial results underlined are the fixed capital
FC, the net working capital NWC and the financial debt NFD.
c) Income statement
d) Cash flow statement
2) Adjustment of the operating profit is:
a) Yearly procedure done by all companies to increase readability of the IS --> no, it is not done
yearly, it is done when extraordinary events happen (like Covid)
b) Barely done by any company
c) A fair representation of the current situation
d) Requiring specific external conditions --> no, the unexpected events could also be internal
3) NWC is not:
A. Current assets – current liabilities --> wrong, this is a formula for NWC
B. Current assets (less cash) – current liabilities (less debt) --> wrong, this is a simplified formula
C. Accounts receivable + inventories – receivables
D. Accounts receivable – receivables --> YES, this is NOT a formula for NWC
4) NFD:
a) Is a financial liquidity metric that measures a company’s ability to pay all its debts If they were due
today
b) Consists of the total bonds less available cash --> wrong, it misses bank debts
c) Is the sum of leasing and bank debt excluding cash and cash equivalent --> wrong, leases are not
included
1.6 Exercises on financial statement recap
Solution
SOLUTION
See excel spreadsheet for ex. 4 and 5.
https://polimi365my.sharepoint.com/:x:/g/personal/10811096_polimi_it/EcZtWKv1NbREnd9OyW106ugBENX3saoI64tm19k
wene_-w?e=KBy2QN
03/10/2022
2. Financial Statement Consolidation
Consolidation is the basis to understand how big companies are organized.
2.1 What is consolidation
Consolidation means putting together all the data from the companies of the group in a single set of
financial documents that represent all the companies as one.
The consolidated financial statement combines a set of financial documents:
•
Balance sheet
•
Income statement
•
Cash flow statement
•
Statement of changes in equity
•
Notes to the financial statements
of separated legal entities that are controlled by a parent company (hence a group) and present them as
a unique entity.
A consolidated financial statement is the financial statement of a group of companies in which assets,
liabilities, revenues, costs and cash flows of each organization inside the group are presented as a unique
entity.
It provides external accountability for a group rather than for a single company.
It has direct connection to the price of the shares of the group, so it is important or external accountability.
The problem with aggregated information is that we don’t know the performance of each single company,
we see just the overall final result.
2.1.1 Definition of group of companies
•
A group of companies is an economic entity formed by a set of companies (separate legal entities)
which are either companies controlled by the same company, or the controlling company itself -->
there are different representations.
•
Different possible types of relationships:
o
Holding + other companies, the holding just manages and do not perform any operating
activity.
o
Head company + other companies: the head company manages and also perform operating
activities.
The other companies could be related to the parent entity in different ways:
•
Subsidiaries: fully controlled by another entity (the parent), more than 50% of the shares of the
company (at least 50% + 1 share, so the parent has the majority of voting rights.)
•
Associate: the parent has significant influence (between 20% and 50%) on their activities.
•
Joint arrangement: 2 companies decide to create a joint company, 2 or more parties have joint
control.
The rules of consolidation will be different based on the type of relationship between the parent and the
other companies:
Criteria
Example of indicator
Accounting method
SUBSIDIARIES
Control
> 50%
Full consolidation (line
by line)
ASSOCIATES
Significant influence
> 20%
Equity method
JOINT ARRANGEMENT
Joint control
n/a
Depends on type
For the other investments in other companies: financial instruments (IFRS 9/39).
2.1.2 Group accounting
When we provide information about a company, we can have different types of companies. We want to
show how the company is organized, so group accounting is needed to:
1) Provide more reliable information about the composition of assets and liabilities.
Example: company B’ has long-term assets, instead B’’ has current assets (B’ and B’’ have the same
value). Which company is actually represented by the consolidated statement?
2) Provide more reliable information about the income of the group
From a group point of view, an entity cannot recognize revenue (and related profit) from sales to itself;
all sales must be to external entities. Infra-group transactions are eliminated.
Within the notes of the group, it is specified how the subsidiaries are considered and how they performed
the consolidation.
As we have already seen, the net income is divided into:
•
•
Net profit attributable to the group
Non-controlling interests: if we are not owning 100% of the subsidiaries, some of the income is due
to the shareholders of the subsidiaries.
2.2 When is required
2.2.1 Control
IFRS 10 regulates the consolidation process. It is necessary to prepare consolidated financial statements
when there is CONTROL between two parties (A exerts control over B).
According to IAS/IFRS control exists when:
•
Power: > 50% of the shares so we are able to take decisions about how the subsidiary company is
managed.
•
Exposure (rights) to variable returns: if the subsidiary is having a great profit/losses, the parent
company is going to decide what to do --> so in good or bad situations, the parent is the company
who is going to respond and absorb the results
•
Ability of the investor to affect its return through its power: able to decide which actions need to
be taken to improve the company. The investor is actively participating at the management level of
the subsidiary.
All 3 conditions need to be present to assure that you have the full control.
2.2.2 Joint control
In some cases, rather than control there can be JOINT CONTROL – JOINT ARRANGEMENTS (IFRS 11). A joint
arrangement can be of two types:
•
Joint venture --> third entity is constituted and jointly controlled by two organizations. The joint
controlling companies do not have the rights on individual assets.
•
Joint operation --> there is not a third entity or there is a third entity by the joint controlling
companies have the rights on individual assets. (This usually happens when 2 companies co-create
something new).
Both subsidiaries and joint
arrangements are
disclosed in consolidated
annual reports, but the
approach to consolidation
is different.
IFRS is providing the
guidelines to define what
could be done:
2.3 Full consolidation method (line by line)
Consolidation process:
® Pre-consolidation adjustments
® Consolidation adjustments
2.3.1 Pre-consolidation adjustments
1. Collect the individual companies’ financial statements --> it is a time-consuming phase
2. Make them uniform as concerns:
a. The accounting time period they refer to: differences between reporting dates cannot be
longer than 3 months
b. The accounting policies --> how we consider depreciation and amortization, local
legislations could be different, GAAP, etc.
c. The reporting currency: if necessary, translation must take place --> the problem is that the
currency rate is not stable.
d. The layout
3. Combine assets, liabilities, income, equity, expenses and cash flows of the parent with those of its
subsidiaries; each item shall be added according to its accounting category to determine the
aggregate financial statement.
CLOSING PERIOD
•
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
•
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
•
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
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
•
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
Ex. R&D costs are expensed differently in the EU (according to IFRS)
REPORTING 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. 2 approaches:
•
•
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.
If the rate used for translating income statement values does not coincide with the one used for the
balance sheet, it causes a “translation difference” to be classified in a special owners’ equity reserve
named “translation reserve”.
AGGREGATION
The aggregation 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.
Ex. This is simply doing A + B and reporting all the voices together. This is the AGGREGATED information,
NOT the CONSOLIDATED one.
2.3.2 Consolidation adjustments
4. Offset (eliminate) the carrying amount of the parent's investment in each subsidiary against the
parent's proportionate share of equity of each subsidiary --> otherwise we would be adding the
investment 2 times. It is easy when the subsidiaries are 100% owned by the parent company, but
when we have less that 100%, we need to take out the % of the investment.
5. Recognize and measure the share of equity attributable to other shareholders in non-wholly owned
subsidiaries (i.e. non-controlling interests)
6. Eliminate any intra-group assets, liabilities, equity, income, expenses and cashflows relating to
transactions between consolidated entities
7. Calculate and allocate the group's and non-controlling interests' results
8. Prepare the final consolidated financial statements
OFFSET THE PARENT’S INVESTMENT IN EACH SUBSIDIARY
Ex. Case 1 – The value of the investment matches the book value of the subsidiary equity
•
•
•
acquisition involves 100 per cent of the subsidiary's shares (there are no non-controlling interests)
there are no infra-group transactions
value of the investment matches the book value of the subsidiary’s equity
We need to eliminate investment 100 = equity 100
The cost of the investment in most real cases this does not match the book value of the subsidiary’s
equity!
The purchase price paid for the investment is ideally attributable to the following components:
®
®
®
®
+ book value of subsidiary’s equity
+/- changes in assets and liabilities’ values*
-/+ tax effects on those changes**
+/- goodwill***
*For unrecognized surpluses in assets' and liabilities' values we add the surpluses (positive or negative) to
the subsidiary's assets and liabilities values, so that all the subsidiary's assets and liabilities are recognized
at their fair values at the time control is acquired.
**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 --> DEFERRED TAX. We want to recognize such future obligation (or benefit) though the separate
recognition of deferred tax liabilities (or assets)
***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,
the 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.
Ex. We buy a company X for 100. We made a revaluation at the fair value and the company X costs 120 -->
price paid – fair value = -20 is the gain that we have received and must be allocated in the IS.
This is not frequent but could happen when the company that we are buying has a problem with debt. One
of the biggest examples is when LVMH bought Dior at the price of $13.2bln.
Ex. Case 2 – The value of the investment does not match the book value of the subsidiary equity
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:
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%.
Aggregated
PPE
Goodwill
Other intangible
assets
Deferred tax
assets
Investments
TOTAL ASSETS
Common stock
Elimination of
investment
1000 [1]
300 [4]
Consolidated
-
100 [3]
100
2700
10200
4500
(2700) [2]
(1300)
(1500) [2]
8900
3000
2500
5000
3500
300
5000
Retained earnings
Non-controlling
interests
Deferred tax
liabilities
Current and noncurrent liabilities
TOTAL LIABILITIES
AND EQUITY
1100
-
(500) [2]
600
-
-
500 [3]
500
4600
200 [1]
4800
10200
(1300)
8900
[1] Recognition of surplus on PPE and provisions
[2] Elimination of investment (2700) and subsidiary equity (1500+500)
[3] Recognition of deferred tax liabilities 1000*0,5=500 (an increase of the assets counts as more taxes to
pay because we produce more, so it’s a liability) and deferred tax assets 200*0,5=100.
[4] To calculate the goodwill, we need to consider the investment and the equity -->
2700 (investment) – 2000 (equity of the subsidiary)
– [1000 (surplus of the assets) – 500 (effect on the taxation)]
+ [200 (surplus of the provisions) – 100 (effect on the taxation)] =
= 2700 – 2000 – 500 + 100 = 300
N.B: We need to subtract from the investment the surplus of the assets because it’s a gain; instead, the
surplus on the provisions is a loss, so we add it to the investment. We also need to adjust the surpluses by
applying taxes.
NON-CONTROLLING INTERESTS
•
Non-controlling interests arises when a subsidiary is not wholly controlled by the parent
•
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 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
1. at fair value – the so-called full goodwill accounting, or
2. at the non-controlling interest's proportionate share of the investee's identifiable net
assets
Ex. STAR acquires LIGHT by purchasing 60% of its equity for 300 million in cash. The fair value of the noncontrolling interests is determined to be 200 million. The company's tax rate is on a 40% basis.
BS of LIGHT at the date of acquisition:
The fair value 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:
Method 1: full goodwill method
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:
Total value (100%) = fair value of non-controlling interests 200 (40%) + consideration paid by the parent
company 300 (60%) = 500
Goodwill = total value 500 – book value of equity 190 – [surplus 300 – effect on taxes 300*0,4 = 120] = 500
– 190 – (300-120) = 500 – 190 – 180 = 130
Surplus = (140-50) + (75-30) + (255-90) = 90 + 45 + 165 = 300
Method 2: proportionate share of the investee’s identifiable net assets
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 recognized and measured in the consolidated financial
statements is only the amount attributable to the portion belonging to the parent company.
• The value of the non-controlling interests is 76 (book value of the proportionate share of the investee’s
identifiable net assets)
• The portion of net surpluses belonging to the controlling entity is 108 (180 x 60%)
Price paid (60%): 300
Book value of equity (60% of 190): 114
Net surplus on identifiable assets (60% of 180): 108
--> Goodwill = 300 – 114 – 108 = 78
ELIMINATION OF INTRA-GROUP TRANSACTIONS
•
•
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 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, so with
companies outside the group.
Ex. The supply of goods from one company to another is equivalent to the transfer of goods from
one warehouse to another within the same company.
Ex. Financing provided by a holding company to subsidiaries is equal to a cash transfer from a
division to another within the same company.
The adjustments posted to eliminate intercompany payables and receivables, revenues and expenses
follow the steps below:
1. Identify which values of credit/debit and costs/revenues arising from intra-group transactions are
recorded in the financial statements of the companies included in consolidated financial statement
2. Make sure there is mutual equivalence between the accounts, if this equivalence is not present,
reconcile intra-group values
3. Delete the mutual accounts (receivables and payables, costs, and revenues).
The adjustments posted to eliminate intercompany profits and losses related to fixed assets and
inventories follow the steps below:
•
Adjusting the carrying values of assets that have been the subject of the intra-group transaction
and that are still recognized in the balance sheet of the acquiring company; the value of these
goods must be brought back to the original value as if they had never been sold.
•
Adjusting the income items related to those goods that are 'generated' by the infra-group
transaction. The result of operations of companies involved in the transaction, in fact, may be
changed as a result of the intra-group transaction, and this change must be eliminated.
Ex. Company A has an 80% stake in Company B. On 1.1.X Company A sold to Company B a plant for a total
amount of 1.100 (book value: 900; yearly depreciation quota: 100). During the year X, Company B recorded
depreciation for 110.
•
Adjustment 1: eliminate the surplus gain recorded by A (1.100-900=200)
•
Adjustment 2: bring back to 900 of the value of the asset recorded by B (purchased and recorded
for 1.100)
•
Adjustment 3: eliminate the amount exceeding the ‘original’ depreciation quota (110 – 100 = 10)
The adjustments posted to eliminate intra-group dividends follow the steps below:
•
Eliminating the financial income, recognized by the company that receives the dividends
•
Reintegrating the reserves of the company that distributes the dividends
•
Decreasing in shareholders' equity attributable to non-controlling interests by the number of
dividends received by them.
The distribution of dividends by a parent company to its shareholders does not constitute an infra-group
transaction. In this case, those who receive the dividends (the parent's shareholders) are external to the
group, since the group is made of the parent company and its subsidiaries.
2.4 Equity method
This method is applied when we don’t have subsidiaries (so there is not control), but associates (only
significant influence).
•
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
05/10/2022
3. Accounting-based indicators
Analysis of Financial Statements
In fact, first of all we need to know the strategy of the company, then we can start the financial analysis.
® The aim of the analysis of an Annual Report is to provide a quick and useful overview of the company’s
main results (performance). Learning how to read the financial statements can allow us to understand
the company’s performances and if the company was able to achieve its strategic objectives.
® The overview summarizes relevant information about:
• the economic profit achieved and its components (profitability analysis)
• the status of liquidity and its “coherence” with existing present obligations (liquidity analysis)
“Revenues is vanity” --> revenues are proxy of the company’s dimension, size (other indicators of size are
market capitalization and number of full-time employees). Why a company wants to be big? To increase its
bargaining power and the political relevance. Revenues alone are not enough.
“Profit is sanity” --> tells you if the company is profitable.
“Cash is reality” --> because what really matters is the capability to make money to invest, to grow.
Without money, we need to take loans to finance the grow.
Financial analysts usually:
•
compare present with past company’s performance (3-4 years minimum, we need to find a trend
and because we want to see the results of the strategy and strategy takes time) and define an
historical trend, further investigating potential impacts of contingencies or non-ordinary events
(like covid) related to the company’s own activities.
(For example, Pfizer was forced to slow down the production of some very profitable medicine to
produce the vaccines. We need to understand the implications of the disruption).
•
compare the performance of the company with that of other firms (usually main competitors),
further investigating potential impacts of contingencies or non-ordinary events related to the
industry(ies) where the company operates.
Considering only the company over 3-4 years is not enough, we need to compare it with other
players in the industry in order to see if the company outperforms or not the other competitors. We
need to understand the baseline between all the companies. For example, before covid, companies
needed +10 years to develop a new drug, but for the vaccines, they did it in 1-2 years. Will pharma
companies go back to the 10 years or not?
Assumption: we consider a company in a normal context. If the context is not normal, this means that we
will get weird numbers and we need to find an explanation.
What are Accounting based indicators? They are financial indicators because they are calculated on the
financial statements. They are slow, reliable, accurate, produced after many months. We cannot take fast
decision on the basis of these indicators, in fact they are not enough and we will see other types of
indicators.
3.1 Profitability analysis
Understanding of the capability of the company in making profit and to identify its main components.
So, we want to understand the capability of the company to have revenues that outperform costs, so that
at the end the company is able to produce a positive profit. We need to understand the reasons, the
determinants behind the fact that revenues are greater than costs over time.
WHY? Because we want to predict what will happen in the next year (“outlook” of the company is what the
company will generate in the next year) because we are interested if the company will survive in the next
year, if it will be reliable in the next year. Also, suppliers and investors are interested in this.
Ex. AstraZeneca competitive advantage = patents, intangible assets, R&D, etc.
3 perspectives very different, tell different things about the company --> these results need to be combined
to get the full picture. This is the problem with the accounting-based indicators: we need a lot of them, and
we need to merge them together in a coherent way.
1. Shareholder’s perspective (and of the top managers): owners are interested to have a positive net
income, because the dividends are based on that. Top managers are CEO and CFO, because they are
evaluated by the shareholders based on this parameter.
2. Overall company’s perspective/perspective of the middle line managers: managers working in the
company, responsible for an business unit or a function. For middle line managers, the EBIT is the
most important element because it tells them if they were able to efficiently generate revenues from
the resources they were given. They need to use resources to generate revenues, minimizing costs.
Middle line managers cannot decide on financial costs (interests) and taxes --> managed by the CFO.
3. Stakeholders’ perspectives: 2 main traditional stakeholders --> banks or bond holders (interests) and
government (taxes). This reasoning is old: nowadays, there are many other relevant stakeholders, like
employees and implications for the planet.
3.1.1 Shareholders’ perspective
(1) In this case, “Return” refers to the net income, because the shareholders are interested in that.
Equity = rights the shareholders have on the assets, the book value of the company, the cumulative
investment made over time by the shareholders.
MEANING = it measures the “interest rate” on shareholders’ equity, how much they earned on the
investment they made in the company.
They are interested in this because shareholders could have invested their money in something else, but
they decided to invest in this company, so they want this investment to be profitable.
When the net profit is a loss, the ROE is negative (so it is not informative). For example, it could happen in
football companies.
(2) Net profit margin or “bottom lie margin”. Bottom line is net profit, top line is revenues.
MEANING = capability of a company to transform revenues into net income. It tells the proportion between
net profit and revenues, so it also gives us an idea about the costs.
It measures the percentage of profit that shareholders can retain from revenues (the starting point of
Income Statement). Typically, is less than 1, but it could also be > 1, for example in the case of disposal of
assets, positive taxes, and other peculiar cases.
The impact of the operating, financial and fiscal activities on NPM should be analyzed:
(3) Payout ratio = dividends (of the current year) / net profit (of the past year).
We compare these figures because at the end of the previous year, the shareholders decide if they want to
leave the money inside the company (to re-invest and sustain the growth of the company, usually happens
for startups) OR to take the money as dividends. So, the dividends of this year are paid based on the net
profit of the previous year.
It measures the percentage of net profit that is returned by cash to shareholders.
It is the “real” monetary reward of shareholders ... and not always the higher the better. If the payout ratio
is 100%, it means that the company is not reinvesting, so the company needs to take money from other
people, like banks. To judge the value of this indicator, we need to know the context, the strategy, the
situations behind it, because this value could mean different things.
Which of the following ratios is the most informative for financial analysis? There is not a universal
answer, they are all very relevant.
a) ROE --> it is relevant but suffers from limitations. In many cases, the ratio could increase because
the equity is decreasing! Some companies could be overcapitalized, and others undercapitalized.
b) Net profit margin NPM --> probably this is the most relevant, because we can understand if the
company is generating revenues from the continuous operations.
c) Payout ratio
d) They are very similar --> no, they are quite different.
3.1.2 Overall company’s perspective – middle line managers’ perspective
Considering all the middle line managers as a team (that is why it is called “overall company”).
(1) Return on Assets. In this case, Return is EBIT, because it is from the middle line perspective.
It measures the ability of managers to generate profit by using company’s assets. It is also used in
managers’ internal evaluation.
This indicator is very relevant because the objective of the middle line managers is to use the assets, so the
resources, in a very efficient way, so creating a very high EBIT (revenues – costs).
EBIT is the most important result for a company because it shows if a company is able to sustain its
competitive advantage. The execution, the result of a strategy is the maximization of the EBIT over time -->
ROA is a thermometer of the execution of the strategy. If the EBIT is not superior to your competitors,
either you are in a transitory period, or your strategy is not producing any result.
ROA is the parameter used to evaluate middle line managers --> they should try to minimize the assets (ex.
pharma companies have high costs and high assets, capital-intensive) and maximize the EBIT using strategy.
N.B: we use EBIT and not EBITDA because companies could decide not to have machineries and to
outsource (so considering EBITDA wouldn’t be fair when benchmarking).
If we don’t change anything, what will happen to ROA? It depends on the time.
•
•
In the short term, assuming that nothing happens in
the market, the ROA is increasing because EBIT is
constant, and assets lose value due to depreciation.
In the long term, ROA decreases because EBIT will
decrease because we will lose our competitive
advantage if we don’t change anything.
Assume that at a certain moment, the company wants to
make an investment. What happens to ROA?
•
•
In the short term, ROA decreases
because assets are increasing while
EBIT is decreasing (revenues – costs:
revenues are almost constant,
because it’s too soon to see the
benefits of the investment and costs
are increasing)
In the long term, ROA increases
because assets are decreasing
(because of depreciation) and EBIT is
increasing (because revenues are
high, and costs are low)
(2) Return on Invested capital.
To improve ROA to better capture the result of the company, we try to refine ROA. For example, not all the
assets are “true” assets, in the sense that “true assets” are resources used to generate revenues.
On the right side of the BS:
•
•
Equity = long term investment made by the shareholders
Liabilities = could be financial or not. To distinguish liabilities -->
o Non-financial liabilities are liabilities without an explicit interest rate, for example payables.
o Financial liabilities = used to finance the company, they have an explicit interest rate, like bank
debts and bonds.
Total assets – liabilities without an explicit rate (payables) =
= equity + financial liabilities (current & non-current) =
= invested capital = actual resources invested and that managers use to create profit
--> N.B: ROI is always higher than ROA, because we are decreasing the denominator.
(3) Return on Capital Employed.
Problem: current financial liabilities are not really investments, so we could use another indicator (ROCE)
that refines the ROI.
Capital employed = equity + non-current financial liabilities
If payables are very small, ROA » ROI. If current liabilities are very little, ROI » ROCE. So, they are very
similar because it’s just a refinement of the denominator.
Which of the following ratios is the most used by financial analysts: ROA, ROI or ROCE? They are very
similar, to say which is the most relevant we need to know the industry, because it depends on the structure
of the company. We should read the “management of report” to see which indicators are used by the
company. Typically, ROA is the most used, because it is also connected to other indicators. According to
Lettieri, the most interesting indicator is ROI.
ROA = ROS * ATR
(4) Operating Profit Margin (also known as ROS, return on sales).
Sales = volume of sales. It measures the margin % that can be retained from revenues. Very important
indicator because it tells us the capability of the company to have a price significantly higher than the cost,
so it measures the result of the strategy (is it a premium price strategy or a volume strategy?).
If we look at this formula:
ROS
N.B: EBITDA margin = EBITDA/revenues (or EBITDA/total assets, but less common).
(5) Asset Turnover Ratio ATR. It identifies the capability of the company to manage assets efficiently for
generating revenues, it is an efficiency indicator.
How many times the assets rotate to generate the revenues. The higher the ATR the better: it means that
we have not that many assets but rotate a lot. This is positive because assets are expensive, so we don’t
like asset-intensive businesses (capital-intensive industries are typical chemical, oil).
10/10/2022
3.1.3 Stakeholders’ perspective
This perspective is limited, is not comprehensive, and quite old because this perspective only considers 2
types of stakeholders: banks and governments.
Actually, we can have many different other stakeholders: clients, employees, etc. Companies are
developing new indicators.
Indicators used by financial stakeholders (banks):
(1) Debt-to-equity ratio (D/E): attention because in this case debt refers to all the third-party liabilities
(both financial and non-financial: bank debts, payables, pensions, provisions, etc.) because we are in the
accounting part of the course.
This ratio tells in which % the assets are owned by the shareholders. It tells the capability to support the
growth and acquisition of the assets through resources provided by third parties such as banks, not by
shareholders. It is a proxy of the risk of a company.
It is very different industry from industry: usually the limit is 3 for a corporation without risk. For example,
in the soccer industry is more than 10, for Google or Zara or other family businesses is close to 0.
This indicator is also called Financial Leverage: a company is “leveraging” when it’s increasing this indicator,
meaning that the company is acquiring new assets asking resources to banks or bond holders (instead of
shareholders).
(2) Interest Coverage Ratio (ICR): in the financial analysis in the Income Statement, we have financial
expenses (usually high because we assume that the company grows thanks to banks loans) and financial
income (usually close to 0 because the general assumption is that the company is using the money to buy
tangible and intangible assets, not to invest in the stock exchange market, so they do not generate gains
through financial acquisitions but through their operating activity4).
The main idea of this ratio is to know how many times the EBIT is covering the financial expenses. Measure
of how safe the business is. If it’s close to 1, the business is very risky because the net income will be
negative (because the EBT will be 0). The ICR should be more than 1 in order to be safe.
4
Usually, EBT is lower than EBIT because the financial expenses are greater than the financial incomes. The net
income usually is lower than EBT, except when taxes are positive (rare but could happen).
What if the ICR is high, like 10-20? It depends. It could be very bad when companies are not risking so are
not growing so are losing their competitive advantage (this could happen in family businesses). For
example, Piquadro had very low financial expenses because of a lack of strategy. But it could be good
because the EBIT is very high and so we are outperforming competitors.
The number in itself doesn’t tell a lot, we should compare with other companies and look at the trend.
Financial expenses include interests costs and additional financial costs. Usually, interest costs are the
majority of the financial expenses.
(3) Cost of Debt: interest costs are connected to banks debts or bonds (securities). Debt with explicit
interest rate: banks debts and bonds.
Meaning: average cost of taking loans and getting money from other people. Average cost of debt is usually
compared to the ROI. For example, if cost of debt is 10% and ROI is 5% --> not sustainable because you
collect money at a higher rate than what you gain. This is not really correct, because cost of debt considers
bank debts while ROI considers both financial liabilities and equity. However, this comparison is still used
because liabilities usually are much higher than equity (except for family businesses).
(4) Effective Tax Ratio: it tells the impact of taxation on profit. Generally, this indicator over time usually
does not change, so it’s not really interesting. It could be interesting when comparing companies from
different companies. In Italy is 40-44% on average, in Croatia is close to 20%, Romania and Bulgaria is 10%.
3.1.4 Risk/Operational Efficiency Matrix
Used by auditing companies, consultancy companies, etc.
2 axes:
•
•
The risk is expressed in terms of D/E.
The operational efficiency we use the ROA to
measure the efficiency of the operating activities.
In both axes, we consider the AVERAGE OF THE
INDUSTRY WHERE THE COMPANY IS COMPETING.
(Usually, it’s available online.)
When the market is very concentrated, we use the median value instead of the average.
Considering the risk axis: the average refers to the average D/E of the industry. We say that a company is
risky ONLY IF the D/E ratio is higher than 3 (not if it is higher than the industry average!). When D/E is
higher than 3 it means that interest costs are very high --> the higher the interest costs, the higher the
probability that the EBIT won’t cover them and so that the net income could be negative.
Considering the ROA axis: when the ROA of the company is higher than the industry average, we say that
the company is outperforming the market. When the company’s ROA is lower than the industry average, it
means that the company is not exploiting its competitive advantage the right way.
The 4 quadrants of the matrix:
•
•
•
•
Happy face: high EBIT, low interest costs. It means that the company is the market leader. The
situation is very good. The only question is: is this situation stable?
Cloudy/foggy quadrant: ROA is low so EBIT is low, and low interest costs. In this situation the
company is not risky, and profitability is not high --> the company is surviving. We should try to
change the situation (and move to the right) because we are not getting significant gains. Small to
medium enterprises are usually there (following the market leaders).
Ban area: low EBIT and high interest costs (ICR is probably low). They risk to having losses because
the EBIT is low, and interest costs are high. We should avoid this area.
Lightning bolts area: EBIT is high (you are the leader) but also interest costs are high. The concern
is that we could easily go back to the ban area if we lose the capability to have a high EBIT.
Moving to the right horizontally is very difficult and not frequent: it means that the company should change
its competitive advantage and become the market leader. For example, going from the cloud to the happy
face is not easy at all.
What could we do to move from the cloudy area to the happy face area?
We need to improve our competitive
advantage: to do that we need INVESTMENTS.
--> so, we need money: they can be asked to
bank, bond holders, crowd, shareholders, etc.
With investments, we move up because we are
increasing the LEVERAGE (by increasing the
debts) and slightly on the left because the EBIT
is decreasing (because revenues are not going
to increase immediately, depreciation is high,
and costs increase).
To move right, we need to increase the EBIT a
lot: this happens thanks to the previous
investments if the strategy is working (so
revenues increase, and costs decrease).
To move down to the happy area, we need to decrease the risk, so we repay our debts and decreasing the
leverage.
This is the IDEAL JOURNEY: it is very difficult that a company follows exactly this path because there are
competitors that are reacting when you are getting money from a bank.
In fact, competitors will decrease prices (they can do it because they have lower interests) to scare you and
not allow you to become the market leader. You must have enough financial resources to also face these
challenges.
Map AstraZeneca and competitors in this map before and during the pandemic.
3.2 Liquidity analysis
Try to understand the capability of the company to have a positive cash flow, as the difference between the
cash out flows and cash inflows.
WHY? Because cash is necessary to allow the company to grow and to meet the obligations. Cash is
fundamental to allow the company to survive, because the company wants to survive.
The main goal is to verify the capability of the company to meet its financial obligations to different
stakeholders, mainly banks, bond holders, suppliers, etc.
It’s a very short-term analysis because we are looking at the NEXT YEAR. The most relevant documents are
the Balance Sheet and the Cash Flow Statement.
We have ratios and absolute indicators. We will see 2 different perspectives:
•
•
Balance Sheet perspective: the knowledge comes from the balance sheet, assets-liabilities
perspective
Cash flow perspective: the knowledge comes from the CF statement
3.2.1 Balance Sheet Perspective
(1) Net working capital
Net working capital = current assets – current liabilities
It is the amount of money needed (or generated) during the working capital cycle5.
The idea is to understand if in the next financial year, the money generated by the current assets6 will be
enough to pay for the liabilities that will cash out in the next 12 months, so if the company will be able to
meet its financial obligations. It’s a broad view of the 12 months, it should be more than 0.
Being an absolute indicator, it makes sense if the companies are similar in size (ex. AstraZeneca and Pfizer
have very different dimensions --> we cannot use absolute indicators).
(2) Net Operating working capital (NOWC)
Net operating working capital = receivables + inventories – payables
General assumption: companies do not have a lot of cash. We do not consider cash because cash is
expensive, so we should invest it and not keep it unused. When companies keep a lot of cash it could be
bad because it means that they don’t know want to do with it (like Piquadro or Google) or it could be good
because they are preparing the ground to buy another company in cash.
Payables = postponing the payment of purchases in the next 12 months. Current receivables and
inventories that will cash in in the next 12 months.
It should be more than 0.
This parameter is very important because it is used to compute the net cash flow.
For a startup: high receivables and inventories, low payables. The problem is that during the present year
you have to pay suppliers, but no one pays you, so you struggle to survive. This indicator looks at the next
year, but for a startup the problem is the present year.
® Between (1) and (2) the most relevant is (2).
5
Working capital cycle = from the purchasing of raw materials to production, to selling of the products.
Current assets = assets that will transform into cash within 12 months: cash and cash equivalent, receivables, current
financial investments, and inventories.
6
(3) Current ratio
The current ratio should be more than 1: the cash generated by the current assets should cover the cash
out due to current liabilities.
(4) Quick ratio (acid-test ratio)
The numerator is = current assets – inventories.
Industries in which the quick ratio is preferred:
•
•
•
Electronic goods we prefer the quick ratio because the obsolescence of the products is very high.
Same goes for the fashion goods: the value of these products decreases very fast because every
season there is a new collection.
Same also for highly perishable goods.
POLLEV
1) Which of the following statement is correct:
a) Current ratio should be preferred for being comprehensive
b) Quick ratio should be preferred for being prudent
c) Both ratios should be calculated
d) One of the two ratios should be preferred case by case: --> we should understand when and why
one of the other is more appropriate. We should use the current ratio when we think that the
inventories will cash in, instead if we think that they will not cash in, we need to use the quick ratio
for prudence.
(5) Inventory Turnover ratio
This is used when Inventories are a big part of the current assets. Made-to-stock production. Efficiency ratio
--> capability of the maximizing the output (revenues) and minimizing the inventories (input) because
inventories are perishable and expensive (we want to get closer to the idea of just-in-time, so zero
inventories).
Inventories are used to decouple production and sales (buffering), it’s a need from an organizational
standpoint. We want to avoid the stock out. However, inventories are expensive, so we want them to
rotate fast and have a small warehouse.
(6) Days Sales Outstanding (DSO)
It is the average period that the customer takes to pay the receivables, measured in days. Usually, it’s 60 or
90 days. Number of days that a company allows the client to be paid.
(7) Days Payables Outstanding (DPO)
Purchases = of products and services from suppliers. Average number of days a supplier allows the
company to postpone the payment.
It is very difficult to compute it because in many cases, because financial reports do not disclose purchases.
We can try to guess it by using some proxy. Attention: the cost of goods sold is different from the
purchases (because COGS includes depreciation)!
POLLEV
2) Which one of the following is correct:
a) DSO should be > than DPO
b) DSO should be < than DPO --> in theory, this is correct, because we want money from clients as
soon as possible and we would like to have a very large DPO. Actually, it depends.
c) DSO should be similar to DPO
d) It depends
Should be DSO lower or higher than the DPO? If we think about Porter’s Value Chain: the main idea is that
the company should have a low DSO and a high DPO because this allows to increase the bargaining power
along the value chain to gain the most. This is true is we look at players in the same value chain.
This reasoning fails if we look at the competition between different value chains: it’s my value chain against
competitors’ value chains. The more we fight within our value chain, the more competitors gain.
For example, a big company could decide to have a high DSO to allow small distributors to survive during
the financial crisis (by allow them to have more liquidity to pay employees, etc.). The company was big
enough to sustain the distributors. If the suppliers are in a moment of crisis, we should reduce the DPO.
We act like a bank in a certain way (bankeffect: the leader provides money and
liquidity along the value chain).
We need to protect our value chain! So,
the strategy related to DSO and DPO
should consider also the value chain.
®
DPO and DSO are relevant to
manage the bargaining power but also the
capability of the supply chain to survive
over time.
3.2.2 Cash Flow statement perspective
(1) Cash Flow-to-Debt ratio
Operating cash flow = cash flow from operating activities, it is the 1st result in the cash flow statement.
Attention: “operating cash flow” also considers cash in and out about financial activities and fiscal activities
(so taxes and interests), it’s different from EBIT.
Debt = financial liabilities (mainly bank debts).
The inverse of this ratio tells us how many years we need to (self) generate sufficient cash to pay back
financial liabilities. This ratio tells us the % of the financial liabilities we pay every year. The threshold is 10%
(or 10 years). Not every time the rule is “the sooner the better” because it depends on the investing
strategy.
(2) Short-term Debt Coverage
It’s more than 1, because we want the cash flow from operating activities to be enough to pay back the
money to banks in the short term (due within the next year).
(3) Capital expenditure coverage
CAPEX or capital expenditures = installment
paid that year (usually, we buy assets in
installments, so a smaller amount for every
year).
CAPEX = total asset bought ONLY when we
have a single installment, so we pay for the
asset in one moment (it is very unlikely).
This ratio tells us if the operating cash flow is
enough to cover the installment of the
equipment. The inverse of this ratio tells us
how many years we need to (self) generate
sufficient cash to fully pay the assets.
Note: this concept is connected to the BCG matrix (of the Boston Consulting Group, the matrix with the
star, the dog, the cash cow and the question mark).
The idea of the BCG matrix is the self-funding of the company --> the cash flow from operating activities
should cover all the investments (balance or unbalance between these cash flows).
LIQUIDITY MATRIX (not so relevant, less used than the risk/efficient matrix). On the x-axis we have the
short-term liquidity (threshold is 1), on the y-axis we have the long-term liquidity (threshold is 10%). The
problem of this matrix is that it assumes that the higher the long-term liquidity, the better (which is not
always true).
Happy face: very good liquidity both in the long
and in the short term.
Ban area: not able to meet obligations neither in
the long nor in the short term.
Lightning: no problem in the short term, but
could have problem in the future.
Cloudy: able to meet obligations in the long term,
not sure in the short term.
3.3 Absolute indicators
Borderline between profitability and liquidity, also connected to value-based indicators.
3.3.1 Residual income
Linked to the profitability analysis, very important. Can be used to benchmark companies ONLY if they have
a similar size.
Residual income (RI) = EBIT – K*Invested capital > 0
Invested capital = equity + financial liabilities (denominator of the ROI).
K = WACC = cost of capital of the company considering the cost of equity (shareholders) and the cost of
banks debts.
Residual income = what remains of the EBIT once we pay shareholders and banks. This indicator DOES NOT
consider taxes. It should be more than 0 because we need to be able to pay the taxes.
A company has the right to exist until its ROI is higher than WACC (because we invest to see a return that
should be able to pay the banks and the shareholders, so it’s creating money):
ROI = EBIT/invested capital > WACC
Which should we use: RI or ROI? Let’s consider this situation:
If we use as a decision criterion the ROI, we wouldn’t make the investment. Instead, if we look at the RI we
would do it. --> Conflict
® RI prefers very large investments being an absolute indicator, so it prefers large investments able to
generate EBIT.
® ROI prefers smaller investments with a faster remuneration, being a ratio.
What should we do? Theory tells us to prefer RI, but large investments are risky. So, we should use it when
a company is in a situation of “perfect information”, so the future is very predictable, we should use the RI
because we can understand what will happen, so we are sure that the investment will be profitable.
When the horizon is very foggy, it’s not good to make large investments, so we should prefer ROI and make
smaller, incremental investments.
Another situation is when a company doesn’t not have liquidity or when cannot get a loan, the company
must make small investments and use the ROI.
3.3.2 Cash Flow ROI
Very interesting but not easily calculated, typically used by CFOs (because they have all the data).
Market value of the assets (also called fair value) --> very difficult to compute because a company does not
disclose the market value, only the book value.
Cash flow = capability to generate cash
The meaning of the indicator is the n° of years needed to self-generate the cash to purchase once again all
the assets of the company. Proxy of the capability of the company to repay its resources.
3.4 Conclusions
Talking about liquidity, there are no “golden rules”, even if some models exist.
Altman’s Z score: try to predict the capability of a company to avoid bankruptcy.
We can see that the most important parameter is ROA --> connection between liquidity and profitability.
17/10/2022
4. Cost of capital
Capital = everything that a company has in terms of resources, so the value of the company.
N.B. Book value of the company = value of the assets of the company.
Different logics on the “cost of capital”
ASSETS PERSPECTIVE
EQUITY AND LIABILITIES PERSPECTIVE
Invested capital = capital invested in the
resources for the production or to provide
services = equity + financial liabilities
The first thing we consider when the capital, is
equity. Equity = shareholders put money inside
the company.
Then, Liabilities can be distinguished:
• Financial: liabilities with explicit interest
rate, ex. bank debts. To compute
interests, we use the formula --> Cost of
interest: ICR = EBIT/financial expenses.
• Non-financial: ex. payables, liabilities due
to other stakeholders like to employees,
the government, etc.
Cost of the equity capital = Ke
Cost of the debt capital (pre-tax) = Kd
WACC = Weighted Average Cost of the Capital -->
statistically calculated based on previous data.
The drawback is that it cannot preview things.
WACC is used a lot internally and externally to
evaluate how well a company is doing. Usually,
WACC is compared to ROI.
We need to understand the cost of different
typologies of fundings to grow the company: we
need to decide how we want to increase the
invested capital --> through equity or through
debt?
It’s a decision that depends on the cost of the
action (the return must be higher than the
investment)
•
•
•
•
E = shareholder’s equity
D = debt (only financial debt)
E + D = invested capital
tc = corporate tax rate
We need to understand the structure of the company (the debt-to-equity ratio) and the weights to
attribute to each parameter to have the most correct formula.
Ke is weighted on the equity part of the formula; Kd is weighted on the debt portion of the formula.
Financial interests are paid before taxes, so we have a benefit because Kd is discounted on the tax rate.
(1-tc) = tax shield --> we need to multiply Kd for this factor because the cost of debt is computed before the
taxes, so we need to subtract the tax rate.
Kd is cheaper than Ke because it is less risky (debtholders are repaid before shareholders). How do we
calculate Ke and Kd?
4.1 Cost of Equity Ke
Ke is the cost of equity capital for an enterprise
•
Ke is how much an enterprise has to remunerate its shareholders for the risk they take by providing
equity capital to the enterprise --> shareholders expect a return
•
Ke is the minimum expected return for shareholders
•
If we had to compare Ke with a financial indicator to see if the company is doing good, we would
compare it with ROE. If ROE > Ke --> the company is doing good.
•
Ke is not contractually defined --> shareholders do not receive Ke as a return, they are
remunerated year by year through dividend policy. Dividends are not fixed (there are different
dividend policies to be applied), and it is what shareholders receive. Shareholders hope to gain
market value, so that when they sell their shares, they gain something.
•
Ke can be estimated through the CAPM (Capital Asset Pricing Model) method
(rm – rf) = market premium
4.1.1 Risk free rate rf
rf = risk free rate --> it is not zero, we want to find the less risky security on the market: treasure bonds
(bonds of the government). We need to understand to which market our company should refer to
(European market, US market, etc.).
rf is the theoretical return on an investment with no risk. With "no risk" we mean that:
•
•
the investment is done in a condition of perfect information
there is no uncertainty about what will happen in the future
Under these assumptions does a risk-free investment exist? No, there is not a security with zero risk on the
market.
Can we identify a proxy for rf?
® Government bonds are less risky than corporate bonds
® We select the return on the least risky government bond of the currency area of evaluation (look at
the currency of the financial statements, so where the company is operating)
® In Eurozone the 10Y German Bond is used as a proxy of rf, for America is the American 10Y bond.
4.1.2 Market return rm
rm = market return --> rm is the return on a theoretical market portfolio which contains all the stocks in
the market.
We want to understand the possible return we could have if we put out the shares of the company.
We can use a proxy:
® Market indexes that are representative of the market where the company operates.
Examples: FTSE MIB for the Italian market, DAX for Germany, S&P 500 for US, etc.
Indexes have different numbers of companies included and different types of companies: for example, for
IT companies we should use the NASDAQ index.
POLLEV
1) You want to evaluate the Ke of a company operating only in Italy. Which rf and market index would
you use?
a) Italian 10Y government bond and FTSE MIB
b) Italian 10Y government bond and EUROSTOXX 50
c) German 10Y government bond and FTSE MIB --> for all the countries in EU (that have the €) we use
the German bond for the rf. Since the company is operating only in Italy, we use the Italian market
for the rm.
d) German 10Y government bond and DAX
2) You want to evaluate the ke of an Italian company operating only in Europe (Eurozone). Which rf and
market index would you use?
a) German 10Y government bond and EUROSTOXX 50
b) Italian 10Y government bond and EUROSTOXX 50
c) Italian 10Y government bond and FTSE MIB
d) German 10Y government bond and FTSE MIB
3) You want to evaluate the ke of an IT start-up company operating only in the US. Which rf and market
index would you use?
a) American 10Y government bond and DOW JONES
b) American 10Y government bond and NASDAQ composite
c) American 10Y government bond and S&P 500
d) German 10Y government bond and NASDAQ composite
4.1.3 Beta levered βL (equity beta)
βL measures how volatile is the firm stock if compared to the overall market movements.
Volatility means that a company stock value changes a lot during time compared to other companies in the
market. So, βL tells us how the company is doing compared to the market.
– βL>1 means that the stock is more volatile than the market --> the stock is more aggressive, high risk, but
bigger opportunity to have profit.
– βL=1 means that the stock is as volatile as the market
– βL<1 means that the stock is less volatile than the market --> the stock is more defensive, more stable,
This is not good nor bad for the company, it is just important information for investors playing on the
market.
Example: the stock displayed below is aggressive,
defensive or in line with the market? The
companies above the line are aggressive, the
companies below are defensive.
βL (beta levered) measures how volatile is a stock if compared to the overall market movements:
•
•
It depends on the capital structure (D/E) of the firm
Also known as “equity beta”
βU (beta unlevered) 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!
Also known as “asset beta” --> because it is not based on the equity of the company but on the
data from comparable companies or the industry.
HOW TO ESTIMATE βL
® In case of a listed company: it is easy --> it can be computed through a regression of the stock returns
against the market returns.
® In case of an unlisted company:
o We cannot use the regression since basically the company does not have listed stocks.
o We have to infer the unlevered beta βU. We can follow two methods:
1) Comparable companies
2) Beta industry
1) COMPARABLE COMPANIES METHOD (for unlisted companies)
The first thing we have to do is to know the capital structure of the firm, so the D/E ratio. Knowing our
capital structure (D/E) --> we choose companies traded on the market that have a similar capital
structure. We assume that similar companies in terms of D/E ratio should be able to generate the same
value, so the same return for shareholders.
1. We take comparable companies for which we have βL (because they are listed on the market)
2. We compute the βU of each comparable company
--> HOW? by stripping out the capital structure characteristics from βL, so we need to take out the
leverage (D/E ratio) --> in this way we have a measure of the underlying volatility of the company
without considering the specific capital structure of each comparable company
3. We compute the average beta βU,avg of the comparable companies
4. We re-lever βU,avg with the capital structure characteristics of the target company
--> HOW? By adding the capital structure of the specific company.
2) BETA INDUSTRY METHOD (for unlisted companies)
As second best as beta unlevered it could be used the one of the industry in which the company operates.
The assumption is that companies in the same industry are very similar in the way they are structured.
With this method, we are not choosing ourselves the comparable companies, we already have the βL,avg,
the average D/E and tax rate so we can calculate the βU,avg of the industry.
4.1.4 Case study
Alpha is a US-based company. You want to estimate its equity cost of capital Ke and WACC. The company is
not listed, but you have identified some comparable companies.
You have available also the Balance Sheet of Alpha whose main data are Equity = 650 mln$, Financial Debt
= 350 mln$ (interest = 4%), tax rate 35%. As for market indexes, the FTSE MIB is forecasted at 20% while
S&P500 is 14%.
For risk free rates refer to the next Table.
SOLUTION
Capital structure of Alpha: D/E = $350mln/$650mln = 0,538
US-based --> US 10Y government bond --> rf = 2.06%
rm = 14% (S&P 500)
Ke = rf + βL*(rm - rf) = 2.06% + βL*(14%-2.06%) = 2.06% + 0,7*(14%-2.06%) = 10,4%
βL estimation:
Comparable
company
Comp 1
D
E
βL
Corporate Tax
BU
BU,ave BL,target
(mln$)
(mln$)
rate
400
230 1,2
0,35 0,56
0,517
0,7
Comp 2
700
400
1,1
0,32 0,50
Comp 3
600
350 1,15
0,35 0,54
Comp 4
500
290
0,32 0,46
1
WACC = 7,67%
Kd = 4% = interest rate
Ke = 10,4%
tc = 35%
4.2 Cost of the debt Kd
Kd is the cost of debt for an enterprise:
•
Kd is the interest that the enterprise has to pay on financial debts to remunerate the debtholders
for the risk they take by providing debt capital to the enterprise
•
Kd is the return for debtholders (other difference with Ke, which is the expected return)
•
Kd is contractually defined (it is present in each contract, major difference with Ke)
•
Kd can be computed as the Cost of Debt = Interest Expenses/Financial Liabilities.
•
Kd =rf +CDS
® rf = risk-free rate
® CDS = Credit Default Spread, associated with the enterprise credit rating (not calculated by the
company, the company is evaluated on a yearly basis, and it takes into consideration many
factors, including geopolitical issues.)
The CDS for an enterprise can be estimated using the "financial" characteristics of the firm. As
first step, we can refer just to the interest coverage ratio:
Interest Coverage Ratio = EBIT / Interest Expenses
The higher the ICR, more able we are to cover our interest expenses (ICR is a proxy of Kd).
Examples:
1) Two companies are identical (same business, same size etc.) but they have a different capital structure.
While company A has D/E=5, company B has D/E=1. All other things being equal, which company has
the riskier profile?
Company A is riskier because it has more debt. If D/E > 3, the company is quite risky. Between 1 and 3 is
normal when a company is growing, then you will convert it into assets, then into equity.
2) Two companies are identical (same business, same size, same capital structure etc.) but while company
C has a liquidity shortage, company D has stable cash flows. All other things being equal, which
company has the riskier profile?
Company C because whenever we have similar companies, but we should have enough money to repay
our suppliers (many companies are trying to shorten the days to receive money in order to maintain the
cash flows).
Example about the ICR:
For different companies, we obtain the following (early 2009):
In this example, Disney is doing better because it has a higher ICR (thanks to the higher EBIT). We can see it
also from the companies’ ratings:
Enterprise
Disney
Aracruz
Tata
Bookscape
Market Cap
> $ 5 billion
< $ 5 billion
< $ 5 billion
< $ 5 billion
ICR
8.31
3.70
5.15
6.22
Rating
AA
BB+
AA
For Tata Chemicals, we will use the synthetic rating of A-, but we also consider the fact that India faces
default risk (and a spread of 3%):
Kd = rf + country spread + company spread
When the economic situation of the country is not stable, we also need to consider the country spread
because it is riskier for banks to lend companies money.
POLLEV
1) Company A is going to leverage more (= debt increases). What will happen to Kd?
a) Kd remains as it is
b) Kd decrease
c) Kd increase --> if the company has more debt, we need to make sure than we produce more to pay
our debts. Producing more is a process, so in the short term, Kd will go up. In the long term, it will
go down (if we are able to pay back our debt and increase the EBIT).
2) Company A is going to leverage more (= debt increases). What will happen to WACC?
a) Increase
b) Decrease
c) Remains as it is
d) None of the above --> it depends on the balance of the different factors: it depends on how much
Kd and Ke increase and how much the factor (E/E+D) decrease.
If we are leveraging:
® Kd increases
® D/(D+E) increases
® E/(E+D) decreases
® Ke increases because it depends on the D/E ratio.
N.B: When a company is growing, it has to increase the debt to increase the invested capital, so the assets
(D/E increases).
Due to the increased assets, over time, the net profit in the IS should increase --> the equity increases --> D/E
decreases.
If a company is continuously increasing the assets through the debt, it could maintain the D/E almost
constant during the years.
Whenever we are able to pay back our debt, the WACC will grow because Ke is greater than Kd.
If we are not able to pay back our debt, the Kd will grow a lot because of the bad credit rating.
WACC depends on the structure of the company, so the higher is not the better.
19/10/2022
5. Analysis of the Leverage
End of the Analysis of the Financial Statement part based on the Accounting Indicators.
In this part, LEVERAGE is D/E where D = TOTAL LIABILITIES (financial and non-financial).
When we talk about CORPORATE STRATEGY, D = ONLY FINANCIAL LIABILITIES. Chapter 4 was about
Corporate Strategy, so we used this definition.
The main goal of the Financial Leverage analysis is to understand how the company has exploited the
leverage (ex. the financial resources collected from other stakeholders than the shareholders, mainly
banks) to increase the profitability.
The leverage is a proxy of the decision about the sources of funding:
•
•
Equity = ask money to shareholders
Borrow money from banks and bond holders = leverage
The main idea is to minimize the WACC (cost of capital). The main objective of corporate strategy is to
sustain the growth over time and the competition against competitors at the minimum cost possible.
If we are changing the D/E, we are changing the WACC. The higher the D/E, the higher the risk because we
are leveraging. We talked about it in the risk/efficiency matrix. The risk is the D/E – when D/E > 3 the
company is very risky, so it’s asking too much money to other people.
Capability to generate profit using the financial leverage, by taking the perspective of the shareholders:
so, to have a higher ROE than competitors. Capability of the company to generate money in order to
maximize ROE.
Is the ROE a function of D/E? How is the leverage affecting the way we generate value for the shareholders?
We need to analyze the trend over a short period (3-4 years) and against a few competitors: we need to
consider the transient period and compare the choices with the ones of competitors. What are the results
of this choice? Was it a good or bad choice? What did the competitors do?
There are different approaches to the analysis of the Leverage. Even if they differ, the key takeaways that
can be gathered are very similar.
We will review three different approaches that were formalized by different stakeholders:
® Du Pont approach (developed by top managers because they needed it), comes from practice due
to professional interest in this analysis
® Financial analyst approach (developed by financial auditing companies), comes from practice of
consultancy groups
® Theoretical approach (developed by scholars of accounting), comes from academia
They provide the same answers but use different variables and reasonings. We do not need to use all 3
methods in the deliverable, 1 is enough (but we need to justify the reason behind our choice).
5.1 Du Pont Approach
The main idea is to clarify the relation between the ROE and the D/E. We need to find the mathematical
relation to maximize the ROE.
We start from the definition of ROE = net profit/equity.
Then we divide by the revenues to highlight on the
ratio net profit/revenues = NPM.
We get a relation between the ROE and the NPM: to
maximize the ROE we need to maximize the NPM.
Then, we multiply by the total assets:
Revenues/assets = ATR = asset turnover ratio (it’s an
efficiency indicator because revenues are the output
and assets are the input --> we want to maximize the
output and minimize the input to be efficient).
The ratio between assets/equity can be written as:
since “assets = liabilities + equity” --> (1 + D/E) =
EQUITY MULTIPLIER
Du Pont formula: ROE = NPM * ATR * (1 + D/E)
We want to decrease the operating costs and the taxes and the financial expenses in order to have a high
NPM. We can show what happens to the NPM by showing the different elements.
The formula shows what happen to the ROE once we increase or decrease the leverage D/E. if we increase
the leverage --> we also increase the ROE. Since Kd < Ke, it is usually better to leverage (risk capital is
higher). Leveraging more is NOT reducing the equity or increasing the dividends, but it is INCREASING THE
DEBT by borrowing money to SUSTAIN THE INVESTMENT STRATEGY, so to grow, buy equipment, invest in
the pipeline and in R&D, etc.
However, we cannot increase the leverage too much because the company is becoming riskier. If we
leverage too much and too fast, what happens in the short term?
® The ATR decreases significantly because revenues are not increasing (because it takes time for
them to increase) and assets are growing (could be because cash is increasing) --> we are “fat”: lot
of resources, revenues are not changing (yet).
® The NPM decreases because financial expenses increase (because we are collecting money from
the bank, so D is increasing, but also Kd is increasing because it’s a function of the ICR*), and
revenues are not changing much. Also, depreciation is increasing. Also, EBIT is decreasing. The
investment could lead to a higher cost of labor or to automatization and so we could decrease the
cost of labor.
*ICR = EBIT/financial costs. ICR decrease because EBIT decreases (due to depreciation and potential labor
costs) and financial costs increase.
5.2 Financial Analyst approach
There are 2 versions.
5.2.1 Simplified version
This method cannot be used in practice because the assumptions are not real:
1) Tax rate = 0 --> taxes = 0 (never true)
2) Financial income = 0 (could be true in manufacturing companies)
Under these assumptions, net profit = EBIT – I (financial costs) = EBT (earnings before taxes)
We want to isolate EBIT and equity:
I/EBIT = 1/ICR
Then, we multiply and divide by the assets:
EBIT/assets = ROA
Assets/equity = 1 + D/E = equity multiplier
In the formula we can see: ROA and the equity multiplier --> leads to the risk/operational efficiency matrix
(it is the direct consequence about this approach).
® ROE is proportional to ROA: the perspective of the shareholders is not that different from the
perspective of the middle-line managers’ perspective --> top managers and other managers are
moving in the same direction (the 3 perspectives of the profitability analysis are combined!) -->
ROA maximization leads to ROE maximization
If we increase the financial leverage: this is an opportunity to increase the ROE.
What might happen to the company if we leverage to fast and too much?
1) The ROA decreases because assets increase (because we are investing in a growth strategy) and
EBIT decreases (because of more depreciation due to the presence of more assets, possible more
labor costs).
2) ICR = EBIT/FINANCIAL COSTS decreases because EBIT decreases, and financial costs increases -->
1/ICR increases --> 1 – 1/ICR could become 0 or even negative! --> ROE could be negative: we are
generating a loss because the company is not able to sustain the financial costs
If we look at the risk/operational efficiency matrix
5.2.2 Real life version
Usually not asked at the oral exam. Can be applied in the deliverable, but is better to apply to Du Pont
approach because it’s simpler and we get the same results.
Assumptions:
1) Tax rate are not 0
2) Financial interests – financial income = net financial interest I*
ICR* = EBIT/I* = EBIT/net financial
interests
5.3 Theoretical approach
Assumptions:
1) Tax rate are not 0
2) Financial interests – financial income = net financial interest I* = EBIT – EBT
Then, net profit = EBIT – I* – taxes
We multiply by EBT to find the ratio: net profit/EBT = s = impact of fiscal activities
--> It tells how much of the EBT remains
after the taxes, it is connected to the
tax rate, it reflects the fiscal pressure in
the specific country (so it is connected
to the geographical coverage)
--> s = 1 when taxes are 0 (never true).
We can assume s = 1 when we are
more interested in the financial part
We multiply the EBIT by assets and the I* multiplied by D (liabilities):
in this way we get the ROA = EBIT/assets.
I*/D = r = average cost of capital (NOT the
WACC, it is the average cost of the debt
capital)
Kd and r are different (but r can be considered
a proxy of the cost of debt capital Kd)
® Kd = financial interests/financial debt
® r = I*/liabilities
if payables = 0, the denominators are almost
the same.
If the financial income = 0, the numerators are
the same.
When we are analyzing a big corporation --> the closer we are to this theory. Nowadays, companies are
very different.
Net financial interests I* could be negative if the financial income > financial costs, for example when the
company is not leveraging.
What do we do in the case of I* < 0? We must add the financial income to EBIT, and we consider EBIT*. The
assumption is that we do not affect that much the ROA.
We can see the 3 most important activities in the IS: operating activities (ROA), financial activities (r), and
the fiscal activities (s) + the leverage (D/E).
We can assume s = 1 because we are not that interested in the fiscal pressure as it depends on the
geographical coverage, …
1. in case s = 1 --> ROE is produced by the ROA (same comment as the previous approach), so there is
a connection between the perspective of the managers and the shareholders.
2. The leverage is moderating the difference between (ROA – r) --> ROA measure the capability of the
managers to make the most out of the assets they were given. r is a proxy of Kd, so of the cost of
money. The idea is that the company should have an high ROA able to cover r --> what matters is
that ROA > r! So the what we generated with the money we used to buy the assets should be
higher than the cost of the money. If this is not verified, the company is not able to generate
money for the shareholders.
3. Actually, the very thing we need to verify is that ROI > WACC --> we need to consider also the
remuneration of the shareholders (ROA > r is not enough). The company must compare the cost of
the invested capital WACC and the return on the invested capital ROI. Same story of applying the
residual income.
What happens if we increase D/E?
1.
2.
3.
4.
The fiscal impact s doesn’t change (tax rate does not change)
ROA will decrease for the things said before
D/E increasing --> we are leveraging
(ROA – r)? if it is positive, there is an advantage to leverage. Since ROA decreases and r increases*,
we should stop leveraging when ROA gets closer to r, because otherwise we would get a negative
difference.
*r increases because Kd increases --> ICR increases.
Conclusions: these approaches mainly say the same thing. We should explain how the D/E affects ROE
passing through the operating and financial activities.
If a company behaves differently from the assumptions?
Example: ROA and r are extremely different --> the company should leverage a lot more. We see that the
leverage remains constant or even reducing the leverage. Why? Try to find an explanation. There is a
temporal lag between ROA and r (ROA is defined at the end of the year, r at the beginning --> this could be
due to the fact that competitors were bad, etc. so expectations were different from expected).
Why are companies not leveraging?
•
•
Managers do not know what to do with the leverage (no strategic plan) --> proof is that cash is too
high
Managers don’t care because they only care about ROI and WACC, so if they are close they will not
leverage --> their only concern is to remunerate the shareholders
Exercises on Accounting-based Indicators
1. You are trying to calculate ROE of Wind Ltd for 2018, but you do not have access to the complete
Financial Statements. You were able to gather just the following information:
•
Total Assets = 150 mln €
•
Total Liabilities = 70 mln €
•
Asset Turnover Ratio (ATR) = 2
•
Effective tax rate = 35%
•
CAPEX Coverage = 0.5
•
Net Profit Margin (NPM) = 10%
ROE = net profit/equity = 30/80 = 37,5%
Equity = assets – liabilities = 150-70 = 80mln€
Net profit = NPM* ATR*total assets = 0,1*2*150mln€ = 30mln€
NPM = net profit/revenues
ATR = revenues/assets
2. You are trying to calculate ROA for Company Alpha in 2019. You do not have access to the complete
Financial Statements, but just to the following data:
Total Assets = 150 mln€
Total (Current and Non-Current) Liabilities = 80 mln€
Asset Turnover Ratio (ATR) = 2
Corporate tax rate = 35%
Financial Revenues = 2 mln€
Financial Expenses = 7 mln€
ROE = 15%
ROA = EBIT/assets = 21,15/150 = 14%
EBIT = EBT + (financial expenses – financial revenues) = 16,15 + (7-2) = 21,15mln€
EBIT = EBT – taxes = X – X*35% --> X = EBIT/(1-35%) = 10,5/(1-0,35) = 16,15mln€
ROE = net income/equity
Net income = ROE * equity = 15% * (150-80) = 15%*70 = 10,5mln€
POLLEV
Assuming that only the BS of the last fiscal year is available, which of the following accounting-based
indicators can be computed?
1.
2.
3.
4.
5.
ROE, Net working capital, quick ratio
ROE, quick ratio, ATR --> ATR = revenues/assets
ROE, current ratio, CAPEX coverage --> CAPEX coverage in the Cash flow statement
Net working capital, Days Sales outstanding, Equity --> DSO = (trade receivables/revenues) * 365
None of the above
Net working capital = current assets – current liabilities
Current ratio = current assets/current liabilities
Quick ratio = receivables + cash + short term investment/current liabilities
ROE = net profit/equity --> net profit is also in the equity!
26/10/2022
6. Enterprise value (EV) & Equity value (E)
Intrinsic method or DCF Discounted Cash Flow model = method used to calculate EV and E.
What is the goal for an enterprise?
1. To maximize the return for the shareholders, so the ROE: this means that the company is
profitable and that is able to distribute dividends and accumulate the net profit in the retained
earnings.
However, we cannot pay salaries, suppliers, etc. with the net profit --> we need cash!
“Revenue is vanity, profit is sanity, cash is reality”
2. It is important that a company has cash from operating activities: the core activities should bring in
money + we need to optimize cash outflows.
Max Cash Flow from Operating Activities
However, one year is not enough (because cash inflows and outflows could be impacted by specific
choices), we have to look at several years: how many years? The time depends on the strategy of
the company as each firm has its own planning time. For some companies could be 1 year, for
others 5 years, up to 10-20 years.
6.1 Cash generation cycle
ACCOUNTING PERSPECTIVE (1 year):
1. Shareholders provide cash to the enterprise through the equity (financing activities)
2. Debtholders provide cash to the enterprise through debts (we find debts in the cash flow
statement in the financing activities: we will see the cash in and the cash outflows)
3. We use this cash for CAPEX, so for the investing activities, so into the core business activities
4. Business activities will create cash flow from operations. (Operating activities)
5. Cash from operating activities is used to pay:
o Taxes to the State (Operating activities)
o Interests to Debtholders (Operating activities)
o Debt repayment to Debtholders (financing activities)
o Dividends to Shareholders (financing activities)
FINANCE PERSPECTIVE (several years, time is connected to the strategy):
From this perspective we have 2 sides: assets-side (shareholders and debtholders) or equity-side (only
shareholders). These perspectives help us understand how the company is doing in terms of cash.
Enterprise value = the entire company seen from an external perspective.
Equity value = interesting for investors.
6.2 Enterprise value (assets-side perspective)
•
•
Takes into account both shareholders and debtholders.
Focus on business in general
Cash generation (t) =?
We start from EBIT(t) because when forecasting the future7:
I.
•
we translate strategy and competitive advantages in expected revenues vs operating costs
•
we adjust them in expected cash inflows vs cash outflows
We start from EBIT(t): what is the possible cash flow generated within these years?
The problem with EBIT is that it underestimates cash generation because it considers D&A among
operating costs even if they do not generate cash outflows. In this view, we must adjust EBIT (t)
readding D&A (t):
EBIT (t) + D&A (t) => EBITDA
EBIT + D&A is the first proxy of cash flow generation.
II.
Since EBIT (t) considers Revenues (t), we need to translate revenues in cash inflows, so we must
consider receivables:
Cash inflows (t) = Revenues (t) – Receivables (t) + Receivables (t-1) -->
EBIT (t) + D&A (t) – Receivables (t) + Receivables (t-1)
III.
Since EBIT (t) considers Costs of Good Sold (t), we need to translate costs in cash outflows, so we
must consider inventories:
Cash outflows (t) = COGS (t) + Inventories (t) - Inventories (t-1) -->
EBIT (t) + D&A (t) – Receivables (t) + Receivables (t-1) - Inventories (t) + Inventories (t-1)
IV.
To translate costs in cash outflows me must consider payables:
Cash outflows (t) = Costs - Payables (t) + Payables (t-1).
--> Net Operating Working Capital NOWC = Receivables (t) + Inventories (t) - Payables (t)
--> - D NOWC (t – t-1) = - NOWC (t) + NOWC (t-1)
7
We will see the full cycle during the lectures about budgeting.
V.
Taxes are computed directly on EBIT because Shareholders and Debtholders are assumed as a
single entity8 and thus financial costs are assumed as an “internal flow” that does not act as a tax
shield:
Taxes = EBIT * tc
EBIT * (1-tc) = NOPAT = Net Operating Profit After Taxes
EBIT (t) + D&A (t) – D NOWC (t – t-1) – taxes (t)
VI.
In case of DISPOSAL of Assets (disposal = selling of tangible and intangible assets), we must
consider: Net CAPEX = CAPEX (t) – Disposals (t)
EBIT (t) + D&A (t) – D NOWC (t – t-1) – taxes (t) – CAPEX (t) = FCFF (t) = Free Cash Flow to Firm
• We want the FCFF > 0: but one year is not enough
• We want the sum of all the FCFF from now to infinite > 0: we hope
that the company is able to generate positive cash flows each year. We
put infinite because we hope that the company will live forever.
Problem: this is not realistic as the money changes value over time -->
we need to consider discontinuities.
• We use WACC is used to make adjustments: we use WACC to
translate discontinuities because we are considering the whole
company (Ke+Kd). Problem: this is not easy --> we divide the formula.
• T = analytical forecast = time horizon of the
strategy.
• We use the time of the strategy because the
strategy can help us have an idea of the cash
inflows and outflows because the strategy
includes which types of investments we want to do, if we want to make new launches, enter new
markets, etc.
Terminal Value TV = value of the company for the period for which we are not able to provide forecasts,
so from T to
infinite.
8
Normally we would compute taxes on EBT, but since we are considering shareholders and debtholders together, we
calculate the taxes on EBIT --> interests are considered as dividends, so they will be paid after the taxes and deducted
from the net profit. In this way, we are not exploiting the tax shield, so paying less taxes because we deduct interests
from EBIT.
Enterprise Value =
EV is focused on the “inside” of the company because of the FCFF and the WACC. If we want to maximize
the EV we need to increase FCFF and decrease the WACC. To have a perspective of the market, we need to
consider also the market capitalization (that we will see in the lecture about Relative Valuation).
How to manage TV?
1. TV = 0 --> This choice makes sense when T is long enough
2. FCFF(t) = FCFF(T) when t>T
3. FCFF(t+1) = FCFF(t)*(1+g) when t>T (g = yearly growth rate) --> optimistic approach: we are pretty
sure that the company will grow.
N.B: proxy for the “g” growth rate could be something outside the company --> ex. GDP, growth
rate of the industry, etc.
6.3 Equity value (equity side)
•
I.
Focus on shareholders.
We are taking the asset-side, so the FCFF, as the basis, and then we make adjustments: FCFF (t) must
be adjusted taking into account financial activities (financial costs and financial income) and the
variation of taxes. We need to add back the tax shield that we didn’t consider in the FCFF.
FCFF – financial costs (t)*(1-tc) + financial income (t)*(1-tc)
II. FCFF (t) must be adjusted taking into account the collection of new debts (t) and the repayment of
current debts (t):
FCFF – financial costs (t)*(1-tc) + financial income (t)*(1-tc) + debt (t) – debt repayment (t)
III. FCFF (t) must be adjusted taking into account the share capital (t), so the collection of Equity (t) and
the payment of dividends (t):
FCFF – financial costs(t)*(1-tc) + financial income(t)*(1-tc) +
+ debt(t) – debt repayment(t)
+ share capital(t) – dividends(t) = FCFE(t) = Free Cash Flow to Equity
Equity Value E = in this case the adjustment is Ke (because we are considering only the equity side)
How to manage TV?
1. TV = 0 --> This choice makes sense when T is long enough
2. FCFE(t) = FCFE(T) when t>T
3. FCFE(t+1) = FCFE(t)*(1+g) when t>T --> optimistic approach
Why do we need to calculate both EV and E?
•
EV allows us to understand how the company is developing and is the first proxy of the value of the
company itself (the market value of the company is different from the book value on the balance
sheet). For example, we calculate EV before M&A.
--> EV calculate through the intrinsic method is an estimation of the value of the company on the
market (for not listed companies).
Problem: we are making a lot of assumptions, like T, g, etc.
•
E estimates the cash generated through the equity --> shareholders w ould like to understand the
value of the Equity. It is usually used to evaluate if it is a good moment to buy or sell the shares of
the company.
The Enterprise Value and the Equity Value are used by C-level managers to take important decisions: how
much the company is worth, selling of the shares, etc. They are the slowest indicators, they aggregate data.
Accounting-based indicators (ROE, ROI, etc.) are used by managers. They are slower, they need at least a
quarter of year or a year.
Value drivers are the early signals of the value of the company (fast indicators, closest to the reality) -->
operational level.
6.4 Exercise
You want to evaluate the Equity Value of the company Sama.
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 2015 (25 mln €), 2016 (33 mln €) and 2017 (36 mln €).
There will be changes in the financial structure (Table 2).
Cost of equity will be 14% (2015), 14.2% (2016), and 15.4% (2017). Finally, you have prospects of the NWC
for the next 3 years (Table 3). After the period of analytical forecast, the FCFE are supposed to increase
infinitely (g=3%).
Table 1
Table 2
Table 3
Equity Value?
E = S FCFE/(1+ke)^t
FCFE = FCFF – financial costs(t)*(1-tc) + financial income(t)*(1-tc) + debt(t) – debt repayment(t) + share
capital(t) – dividends(t)
FCFF = EBITDA(t) - DNOWC (t - t-1) – taxes(t) – CAPEX(t) =
FCFF (2015) = 115 + 4 – 32.2 - 25 = +61,8
NOWC = 4
- Receivables (t – t-1)
- Inventories (t – t-1)
Payables (t – t-1)
2014
64
33
35
2015
64
35
41
- 64 + 64 = 0
- 35 + 33 = -2
41 - 35 = 6
Taxes = EBIT*tc --> tc = income tax expenses/EBT = 35,4/101 = 35% --> Taxes = 92*35% = -32.2
CAPEX(t) = 25 (no info about disposals)
FCFF (2016) = 105 -7 – 26,6 – 33 = 38,4
- DNOWC = 0 – 5 -2 = -3
EBIT*tc --> tc = 23,1/66 = 35% --> Taxes = 76*35% = 26,6
FCFE = FCFF – net interests (t)*(1-tc) + debt(t) + share capital(t) – dividends(t) =
FCFE (2015) = +61,8 + 5,9 – 10 = 57,7
Financial revenues (t)*(1-tc) = +9*(1-35%) = +5,9
Debt(t) = 102-112 = -10 --> in the case of this exercise, to understand how much of the debt was
repaid, we look at the difference of the debt between the years.
Share capital(t) = 0 (no changes in share capital)
Dividends = 0 --> since we don’t have information about them, so we assume that they are 0.
We take the last year we can forecast, in this case 2017, and we increase the E:
EV usually is bigger than E (because we are considering both the debt and the equity)
POLLEV
The calculation of either EV or E can be carried out by subjects who are INSIDE the enterprise (CEO, Clevels) because we need a lot of data and also it is very questionable when external financial analysts do it.
14/11/2022
7. Value drivers and scorecards
These are the last type of indicators we will see. They are also called non-financial indicators and Key
Performance Indicators. Until now, we have seen:
® ACCONTING-BASED INDICATORS --> the two main performances are profitability and liquidity: we
can refer to ROE, ROI, Cash Flow from Operations, etc. They only look at the next 12 months, but do
not consider the medium-long term perspective.
® VALUE-BASED INDICATORS --> they aim at maximizing enterprise value EV and equity value E.
These indicators look at the medium-long term perspective.
The problem with these 2 types of indicators is that it is very difficult to connect the everyday actions to
the financial statements and to the capability of generating enterprise value.
2 main difficulties:
1. Timeliness: these indicators require time to be calculated --> we need something faster
2. Specific responsibility: how the different functions are responsible of such performance. Ex. if we
assume that ROI is below expectations: who is accountable for that? Is it due to revenues were not
enough, or because COGS was too high, or because of poor marketing? For example, if the reason
is poor quality or long delivery times, how can we prove that by using the financial statements? It is
pretty much impossible.
These value indicators are not enough to manage the organization, we need another type of indicators -->
VALUE DRIVERS
7.1 Value Tree
The tool that we use to answer these questions is to develop the VALUE TREE (invented by Pirelli): the main
idea is to create a cause-effect relationship.
We start from the enterprise value, and we can see that the value-based indicators (EV, FCFF, cost of
capital, TV) are connected to the accounting-based indicators (EBITDA, revenues, cash costs, receivables,
inventories, payables).
N.B: From a survey done by large-sized companies:
•
The usage of traditional financial ratios is 85,7% (it means that 15% of the large companies are not
using traditional financial indicators!).
•
Discounted cash flow (DCF = value-based indicators): only 47,6% of companies are using these
indicators --> most of the large enterprise are not using these indicators.
As said before, we need to look for “EARLIER SIGNALS” (= value drivers).
For instance, we can see revenues as revenues coming from existing products + revenues from new
products. In more detail we can look at:
•
•
Customer satisfaction, delivery time and social friendliness as factors influencing revenues from
existing products.
Time to market9, new products per year, relationship with universities as factors influencing
revenues from new products.
Looking at this last line we can define clear objectives: like reducing time to market, improving customer
satisfaction, establish more relationship, etc. We can clearly define the actions because we are closer to
the functions.
® The “trap of too many indicators”: if at the bottom line we have too many indicators, actions, goals
--> we risk having conflicts and contradictions and to lose the sight of the big picture (it can be
overwhelming). Also, the indicators shouldn’t be isolated, but they are connected: the real value is
in the connections!
9
Time to market = time that goes by between the moment of the idea and the first unit sold on the market.
Pirelli’s value tree
The indicators on the right side are those that create value, so they are the ones that create a competitive
advantage. We need to find causal linkages between indicators.
So, we define the value drivers: they provide us with information about the capability of the company to
generate value and they relate to the concept of enterprise value.
•
•
Value Drivers refer to indicators which provide Managers with EARLIER SIGNALS (drivers) of value
creation --> they need to be FAST in order to allow to make decisions!
Drivers are endless and company specific --> 3 categories
7.2 Value drivers
The problem is that there are so many value drivers: in order to make huge lists of indicators, we classify
them into categories:
1. Performance drivers: mainly non-financial of the present performance of the company (time,
quality, productivity, flexibility, environment and society)
2. Resource drivers: mainly non-financial, reflect the main resources of the company that will be able
to generate value in the future (money, technology, human resources, image and reputation)
3. Key risk indicators: that provide early signals about what might happen in the next future and allow
managers to anticipate potential risks and implement corrective actions.
7.2.1 Performance drivers
We have 5 main domains in accounting and 2 different focuses:
•
External focus --> revenue drivers, capability of the company to generate superior revenues.
•
Internal focus --> cost drivers, capability of the company to minimize the full product cost
(COGS).
REVENUES DRIVERS
Why maximizing the revenues? Maximizing the revenues lead to maximize the EBITDA, connected to
the cash flow, connected to the EV.
How can we have higher revenues than competitors? We can try to increase the selling price per unit
(the company compared to competitors has a premium price) OR we keep the selling price as it is but
since we have superior capabilities compared to other companies, we can increase the market share
(so we increase the volume). The ideal case is to increase both the price and the market share.
•
Time:
o Time to order affect revenues because either we can ask a higher price because of faster
delivery, or we increase the revenues because more people buy from our company because
we are faster.
o Similar reasoning for the time to market: if a company has a lower TTM it can enter the
market before others, we have a higher chance at being superior to competitors.
•
Quality: customer satisfaction (it is difficult to gather information about it), claims instead are
objective.
•
Flexibility: capability to change fast and cheap, so without using too many resources. Product
range: capability of the company at customizing the product as the customer requires. “Delayed
choices” is the capability to postpone allowing changes.
•
Environmental and social responsibility: customers today are more conscious and buy more from
companies that are green. Emission level and product compliance.
COST DRIVERS
Why is it important to minimize the full product cost? Because lower costs lead to higher gross profit,
that is connected to the cash generation, so connected to the EV. Also, if we are able to reduce the
costs, we can reduce the price and keep the same contribution margin --> by reducing the price we will
enjoy a larger market share.
•
•
•
•
•
Time: if we improve cycle time (throughput time) we can reduce the COGS
Quality: improving spoilage % leads to reduce COGS.
Productivity: assets efficiency and labor productivity.
Flexibility: time of change and skills range.
Environmental and social responsibility: energy savings.
Since we have so many drivers, we can create the “relevance vs performance” matrix:
•
•
Relevance is the importance (it is different for each company)
Performance
We can identify 4 quadrants (the thresholds are the average): the top left quadrant is the one in which
we have to concentrate because it refers to important drivers which are currently not correctly
addressed.
Possible overkill means that we are very good at those indicators, but they are not that relevant.
This matrix is connected to the Blue Ocean Strategy: raise, eliminate, reduce and create. The example
of the “yellow tail” wine: they reduced the prestige of the vineyard, the wine complexity and the wine
range. They eliminated aging quality and marketing. And they raised the price.
Problem: how can we say when an indicator is relevant? When it is able to generate value.
7.2.2 Resource drivers
Indicators of Resource State aims at capturing potentialities for enterprises to innovate and grow in the
medium-long term. The idea is to understand which are the resources that are crucial for the value creation
of the company, so to maximize the EV over time.
In spite of the different labels and clusters, 4 types of resources should be considered: Financial,
Technological, Human & Organizational, Image & Reputation.
The “state” of each resource should be assessed against 3 types of measures:
•
•
•
Quantity
Quality
Accessibility
FINANCIAL RESOURCES (money)
•
•
•
Quantity: we can measure it as bank debts, as cash from operating activities, etc. (cash: not correct
because there is the assumption that cash should be low because it is an opportunity to invest).
Quality: average cost of debt Kd, or WACC.
Accessibility: capability to increase the resources in terms of quality and quantity, for example
financial leverage.
TECHNOLOGICAL RESOURCES
•
•
•
Quantity: total patents awarded or pending
Quality: incidence of new product sales (in many cases, a lot of patents are not exploited at all, the
revenues come from 10-15 patents).
Accessibility: relationship with research centers/universities
HUMAN AND ORGANIZATIONAL
•
•
•
Quantity: number of employees by role
Quality: number of employees that have Ph.Ds. and MBAs (this is a simple calculation but very
limited).
Accessibility: education level
INTELLECTUAL CAPITAL = this is a competitive advantage connected to the knowledge
Intellectual capital joins different types of intangible assets and it has three main dimensions:
– HUMAN CAPITAL, which refers to the skills, training, education, experience, quantity, and quality
of employees --> so the knowledge of the employees measured in terms of degrees (simple but
limited) or in terms of exams
– (internal) STRUCTURAL CAPITAL, which refers to intangible assets and knowledge embedded in
organizational structures and processes; this dimension comprises patents, research and
development, technology --> all the knowledge stored in a company
– RELATIONAL CAPITAL encompasses relationships with customers and suppliers, brand names,
trademarks and reputation --> idea of open innovation, capability to extract knowledge from the
network. How can we measure it? It is quantifiable in terms of relationship with suppliers,
customers, etc. but we should also assess the quality of these relationships.
7.2.3 Key Risk Indicators (KRIs)
They provide managers an idea of what might happen to allow managers to take action.
Key Risk Indicators (KRI) are defined as metrics that allow managers to monitor and anticipate the impact of
one or more adverse events (risks) that might negatively influence10 the capability of an enterprise to reach
its goals.
Typically, they refer to three typologies:
•
•
•
MICRO-ENVIRONMENT: drivers that refer to the company’s internal environment (e.g., employees’
satisfaction; absenteeism; machine failures etc.)
MESO-ENVIRONMENT: drivers that cover the company’s perimeter (company’ supply chain), such
as suppliers, distributors, customers (e.g., potential for vertical integration).
MACRO-ENVIRONMENT: drivers that refer to the macro-economic context and the global market
(e.g., PEST analysis).
Characteristics of value drivers
® TIMELINESS – high; this is the main advantage of these measures
® LONG-TERM ORIENTATION – it can be high if the right indicators are selected, ex. those aligned to
competitive advantages
® MEASURABILITY – it might be ambiguous; this problem is solved by implementing a protocol for each
indicator where the following information is clarified:
– Measure: Title of the measure
– Purpose: Why does the company want to measure this?
– Formula: How this measure must be measured?
– Unit of analysis: which is the object of measurement?
– Frequency: How often does the company measure this?
– Sources of data: From where data can be collected?
® COMPLETENESS – each indicator refers to a specific factor (no synthetic measure)
® SPECIFIC RESPONSIBILITIES – high; measures related to day-by-day
10
We are missing the opportunities, the potential positive impacts --> limited view.
Accounting based indicators are in the middle, try to combine the benefits of both approaches.
Indicators from all three groups should be considered to inform managers’ decision-making.
7.3 Balanced Scorecards
Tentative to provide the framework to provide all these indicators in a way that is informative for
managers. In fact, these indicators are useful only if they are used by managers to take action.
The “balanced scorecards” is an alternative approach to the value tree. It was invented by at Kaplan and
Norton (Harvard, 1992). The idea is to connect strategy with indicators (as we can see strategy is in the
middle of the framework).
The Balanced Scorecards suggest identifying relevant indicators on four perspectives:
•
•
•
•
Financials --> we look at the financial statements
Customers --> we need to know what is important for our customers
Internal processes
Learning & Growth
These 4 quadrants, called scorecards, should be balanced. The max n° of indicators should be 20 (Pareto’s
approach: 20% should explain the other 80%).
•
The FINANCIAL PERSPECTIVE analyses the company trend towards shareholders with reference to:
– Long-term Value (EV, E)
– Profitability (ROE, ROI, EBIT)
– Cash Generation (Cash Flow)
•
The CUSTOMER PERSPECTIVE highlights performance about the relation with the market:
– Size (market share, sales)
– Delivery time
– Customer satisfaction
•
The INTERNAL PROCESS PERSPECTIVE includes measures oriented to the control of internal
efficiency:
– Average cost per unit
– Productivity
– Cycle Time
•
The LEARNING & GROWTH PERSPECTIVE shows the innovative capability of the company:
– Time to Market
– Learning curve
– Competencies
First Generation of Balanced scorecards
Problem (white dots): we cannot gather data for all the perspectives (learning and growth data is not
measurable) --> pay attention to the feasibility of those indicators.
How is Siemens performance? What is the conclusion? We cannot get it (main limitation of this 1st
generation). We could say that since the financial is good, they will probably be good in the short term.
However, the processes are not good so in the long term they will damage the internal processes. Also the
customer perspective is not that good.
New generation of balanced scorecards (2004)
“Balance is irrelevant, causality matters”: we need logical chains instead of balance. We need causality, a
logical connection between indicators (it wasn’t anything new because it was already present in the Pirelli’s
value tree). The innovation of the balance scorecard is the introduction of the 4 perspectives.
Example of a logical chain:
Example: Jaguar
We start from strategy: different companies have different brand, reputation, competitive advantage,
technologies. The main idea behind Jaguar is customization (highest level of detail and customization). We
need to define which are the relevant indicators based on the specific strategy of the company (indicators
stem out from the strategy).
The first value driver is “employee
skills in installing options” and it is
connected with the number of
options available and the time to
install an option.
By increasing the skills, we increase
the n° of options and we reduce the
time to install an option, and this
leads to customer satisfaction.
By increasing the customer
satisfaction, we increase the
contribution margin because we can
ask a premium price.
By increasing the number of cars
sold and the contribution margin we
increase the gross profit.
This is a cognitive map: map that shows the logical connections among the different factors. The value of
the balanced scorecard is to align the different perspectives of the people: in fact, different people make
different maps because different think that the company generates value in different ways. This can lead to
identify the most relevant indicators and the strongest connection. We can also use different sized arrows
to highlight the importance of the connections.
16/11/2022
8. Relative valuation
This is an alternative methodology to the Intrinsic method to evaluate the Enterprise Value and the Equity
method.
It is an evaluation method based on evaluating a company based on similar companies that have been sold.
These companies are called “comparable companies” (different from “competitor companies”).
In relative valuation, the value of an asset is compared to the values assessed by the market for similar or
comparable assets.
Relative Valuation is widely used to estimate the ‘company value’ --> It compares the (target) company
with other similar listed ones.
® It is easy to do the calculations (more than the intrinsic method which is based on the EV and the
terminal value) and it is fast.
® If we correctly chose the comparable companies, it is difficult to make huge mistakes.
® The terminal value can be calculated through the relative valuation (instead of the free cash flow to
firm).
® M&A are done through relative valuation
Relative Valuation is pervasive:
•
Most valuations on Wall Street are relative valuations
•
Almost 85% of equity research reports are based upon a multiple and comparables
•
More than 50% of all acquisition valuations are based upon multiples
•
Rules of thumb based on multiples are often the basis for final valuation judgments
8.1 Relative Valuation: main steps
There are four main steps in relative valuation: define comparable companies, define possible multiples,
analyze multiples and apply multiples.
8.1.1 Defining comparable companies
“A comparable firm is one with cash flows, growth potential, and risk similar to the firm being valued. It
would be ideal if we could value a firm by looking at how an exactly identical firm - in terms of risk, growth
and cash flows - is priced. Nowhere in this definition is there a component that relates to the industry or
sector to which a firm belongs. Thus, a telecommunications firm can be compared to a software firm, if the
two are identical in terms of cash flows, growth and risk.
In most analyses, however, analysts define comparable firms to be other firms in the firm’s business or
businesses. [....]. The implicit assumption being made here is that firms in the same sector have similar
risk, growth, and cash flow profiles and therefore can be compared with much more legitimacy.”
Factors that determine if a company is comparable are cash flow, growth potential and risk:
® Cash flow: real money the company is generating
® Growth rate: growth of revenues, of profit, of assets --> it depends on what is most significant for
our company to grow.
® Risk: D/E, leverage, ICR
It is not possible that two companies have the same growth rate or cash flow or risk --> we will need to take
some thresholds (for example, companies bigger than 100M). Usually, the first thing that we look at are
companies in the same sector, because it is likely that they have a similar structure.
In terms of the assumptions that we have to do, they are implicit (compared to the DCF model): we are
choosing companies through which we are going to evaluate our companies.
The identification of comparable companies is one of the most difficult tasks of this approach to
evaluation.
– Identify first the target company value drivers (what are the most important things for the
company)
– Identify those companies with the same value drivers
– Define companies’ specificities:
•
•
•
•
•
•
•
Sector
Geographical Market
Presence of divisional structure
Size (assets or sales)
Presence or not of comparative advantages
Innovation/development models
(Accounting principles)
“In the context of valuing equity in firms, the problems [of finding comparable assets] are compounded
since firms in the same business can still differ on risk, growth potential and cash flows” (Damodaran,
2002)
To have very stable data, we should have a lot of comparable companies to have a lot of data (this will
provide statistical insurance).
Example: Fincantieri
Sector: construction of big boats and ships. It is very difficult to find comparable companies for diversified
businesses because it is difficult to find another company with the same businesses inside.
One of the possible ways is to find 2/3/4 comparable companies for each market. Or we can find companies
which are not in the same sector (construction of boats) but are comparable in terms of being system
integrators, revenues, D/E, etc. for example airbus and Boeing.
8.1.2 Defining possible multiples
Once we identify comparable companies based on CASH, GROWTH and RISK, we need to CONVEST MARKET
VALUES INTO STANDARDIZED VALUES, since the absolute values cannot be compared.
® DEFINE POSSIBLE MULTIPLES = means converting assets market values into standardized values.
There are 2 types of multiple: asset-side or equity-side.
We will choose the multiple based on:
•
The objective of the evaluation: if we want to identify the EV, we need to use the asset-side
multiple; if we want to identify the E, we need to use the equity-side.
•
Typology of company: we use the assets-side if the company is producing mainly through its assets,
if a company is based on human resources or technology, for example IT companies, we use the
equity side multiple.
Example: we are a company that is growing will continue to grow (we are not market leader, but we will
probably become it). We want to sell: how do we evaluate the company? We need to understand the
possible threshold and the pool of comparable companies.
We can create whatever multiple we want but we need to follow some rules to avoid over or under
evaluating.
NUMERATOR ®
DENOMINATOR ¯
Market value of equity
(equity investors only)
Revenues
Accounting revenues
Earnings
Net income or
Earnings per share
Net income +
depreciation
FCFE
BV of equity
Cash flow
Book value
Market value for the firm
= market value of equity +
market value of debt
Drivers (ex. n° of
customers, of subscribers,
of units sold, etc.)
Operating income (EBIT or
EBITDA)
EBIT + D&A = EBITDA
FCFF
EV = market value of
equity + market value
of debt - cash
BV of equity + BV of debt
BV of equity + BV of
debt – cash
In the next part we will see some of the most used multiples from the asset-side and the equity-side.
ASSETS-SIDE: ENTERPRISE VALUE
•
•
•
EV multiples take as reference (numerator) Enterprise Value of comparable companies.
E = EV - Net Financial Position --> EV = E + NFP
o E = market capitalization
o NFP = (long-term + short-term debts) – available cash
EV multiples use a parameter (denominator) coherent to an enterprise value perspective!
To be used for manufacturing companies that make significant use of the assets (ex. ATR is important).
Examples of multiples:
EV/EBIT --> to be used for established companies, but ONLY WHEN D&A is not important
– Advantage: focus on operating management
– Disadvantage: it does not consider different choices in Depreciation and Amortization (direct
influence --> cash), so it is used when D&A is not important
EV/EBITDA --> to be used for established companies, preferred to EV/EBIT
– Advantage: good proxy of cash (THE MOST USED for companies that produce and have D&A)
– Disadvantage: neglect CAPEX for different industries
EV/FCFF
– Advantage: is a cash flow
– Disadvantage: less stable than other indicators
EV/Sales --> used for startups and companies at an early stage or when profitability values are negative
– Advantage: if the above multiples are negative, they are meaningless; in those cases, an
alternative is using sales (so EV/sales is used when companies are not able in the moment to create
value, and for example have a negative EBIT)
– disadvantage: it does not consider profitability (so how we are spending to produce, so the costs)
CASE STUDY:
Attention: if it was
written “potential
comparable
companies” we
have to select the
correct
comparables based
on the
characteristics of
the company we
want to evaluate.
EQUITY-SIDE: EQUITY VALUE
•
Equity-side multiples take as reference (numerator) the Equity Value of comparable companies
Market capitalization of the company or equally its stock price (P). The market capitalization of
the company is given by the price of the stock on the official exchange multiplied by the number of
outstanding shares.
•
Equity-side multiples use a parameter (denominator) coherent to an equity value perspective!
•
To be preferred when comparables have a similar capital structure, as equity side multiples are
affected by the capital structure itself.
Examples:
P/E (or PE called Price Earnings ratio)
= Market price / Earnings = market price per share / earnings per share (EPS)
– Advantage: quick (THE MOST USED!)
– Disadvantage: affected by depreciation, amortization, profit, or loss of discontinued operations.
Variables:
– Price: Usually the current price; sometimes, average price over last 6 months or year
– EPS: Time: most recent financial year (current), most recent fourquarters (trailing), expected in
the next fiscal year or next four quarters (leading), some future years
– PEG: the ratio between the P/E and the earning growth.
This allows better considering the forthcoming growth (CAGR) perspectives of the company
Compound Annual Growth Rate
P / BV
The ratio between the market capitalization of a company and its 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 2
8.1.3 Analyze multiples
Multiples are easy to use and easy to misuse! Whenever we are doing relative valuation, we need to take
into consideration how the multiples have been constructed and verify statistically the position of the
multiples for the comparable companies. We could also calculate different multiples and choose the most
stable ones.
Multiples & sectors
Additional multiples specific to some sectors:
Subscriber-based businesses are
for example Netflix, Amazon
Prime, etc.
Oil and gas companies excludes
exploration expenses because
for them are very big and they
require time and money while
having nothing to do with the
operating activities of the
company.
Whenever we are choosing the multiples, we
need to think about the sector and what is near
to their competitive advantage and value
creation.
For example, for AstraZeneca could be
interesting to look at EV/R&D expenses or
EV/patents.
To choose the best multiple:
•
Identify a subset of multiples that are significant from a theoretical point
Comparable company A Comparable company B Comparable company C Comparable company D
EV/EBITDA 3.8x
6.6x
5.4x
4.1x
P/E
10.1x
11.5x
11.8x
10.9x
•
Identify one or more driver that could explain the variance among the multiples of the different
comparable companies
o Average
o Adjusted average
o Standard deviation
•
Check the relation between fundamentals and multiples
Four steps for understanding multiples
1. Define the multiple
In use, the same multiple can be defined in different ways by different users. When comparing and using
multiples, estimated by someone else, it is critical that we understand how the multiples have been
estimated
2. Describe the multiple
Too many people who use a multiple have no idea what its cross sectional/industry distribution is. If you do
not know what the cross sectional/industry distribution of a multiple is, it is difficult to look at a number
and pass judgment on whether it is too high or low.
3. Analyze the multiple
It is critical that we understand the fundamentals that drive each multiple, and the nature of the
relationship between the multiple and each variable.
4. Apply the multiple
Defining the comparable universe and controlling for differences is far more difficult in practice than it is in
theory.
CASE STUDY: WHATSAPP
$19b: largest Facebook acquisition (2014) --> 1/10 of Facebook market value.
Acquired by Facebook through a mixed acquisition, 4$ billion cash and about 184 million shares of
Facebook Class A common stocks.
WhatsApp was launched in 2009 it was acquired when it was a 5-year-old company.
Steps of relative valuation:
1. Analysis performance
• Revenues - each user was charge 0.99$
• According to Forbes valuation Whatsapp was worthy 20$ billion
• Monthly active WhatsApp users, as in December 2013, were 450 million. Facebook users were 1.3b
but only 120mln were Facebook Messanger monthly active users.
• Extraordinary growth in users.
2. Identify comparable companies & explain the choice
For the purpose of this exercise, we assume that firms in the same sector have similar risk, growth, and
cash flow profiles and therefore can be compared with much more legitimacy.
Multiples have a short-term nature since they are based on historical data or short term forecasts so they
might be distorted for long term perspectives.
Good for fast growing companies like WhatsApp
According to Wall Street analyst the two most used multiples for the IT companies and start-ups in the last
10 years were:
1. EV/Sales or EV/Revenues
2. EV/EBITDA
3. EV/Users (which is multiple specific for social media)
Another parameter to take into consideration is ROIC ratio.
21/11/2022
9. Target Setting & Budgeting
This is part of the last chapter of the course: PLAN & CONTROL.
“Target setting” means setting the goals (we can connect this lecture with the balance scorecards).
The concept of target setting is linked to budgeting.
Timeline:
What we have discussed so far
refers to the analysis of past
financial statements, which
shows the results of past actions,
strategies, motivations --> the
first part of the course was
about analysis of past financial
statements through ratio
analysis.
Looking at the enterprise value
and equity value, we are looking
at the next financial reports, so
at the future financial
statements.
We divide the future into 2 periods: the analytical period and the terminal value. The analytical period is
based on the assumption that we are able to draft the financial reports for the next year. As this capability
decrease, and we cannot draft the future financial statements, we need to use the terminal value.
•
•
EV and E --> used when we are inside the company
Relative valuation --> used when we are outside of the company, because we don’t have the
information to draft future financial statements.
If we take the approach of the CFO or top managers (so we have all the information needed), how can we
draft the future financial statements?
From “outside” to “inside”
We need to change the perspective: when we talk about the financial ratio analysis we are talking about
external accountability, like the financial statements and other non-financial documents that are disclosed
outside the company.
We should balance on one hand, we should try to disclose as much as we can to convince shareholders and
stakeholders, like banks, bond holders, financial analysts, employees and future employees, customers,
suppliers, etc.
Another perspective: internal accountability --> what are the information that the company need to
disclose within the company itself? We are producing data that is relevant for actors inside the company,
like employees11, managers, organization units.
Important implication: the level of standardization decreases as each company can produce and organize
this process in a very different way and inform decision-making on a different way.
11
Employees also can receive additional information about the function they work in.
Management accounting
Management accounting is different from financial accounting (the production of financial reports) and
cost accounting (part of management accounting).
Definition from the CIMA (Chartered Institute of Management Accounts):
Management Accounting is the process* of identification, measurement, accumulation, analysis,
preparation, interpretation, and communication of information used by management** to plan and
control within an entity and to assure appropriate use of and accountability*** for its resources.
*Sequence of different activities.
**At different levels: top managers and middle line management.
***Managers are accountable for the results and the use of resources.
N.B: “Management accounting also comprises the preparation of financial reports for non-management groups
such as shareholders, creditors, regulatory agencies and tax authorities” --> according to this definition, financial
accounting is part of management accounting according to this definition.
9.1 Plan and control cycle
This cycle comes from cybernetics (part of information science, so from a very different discipline focused
on understanding how different part of the same system can work together for a shared goal, which is the
movement in a certain direction, in a certain way).
Similarly, in a company there are functions that need to be aligned to maximize the capability of the
company to generate EV or E.
Organizing people is not as easy as organizing mechanical parts --> we need to pass through leadership,
motivation, incentives, etc.
Controlling a company is very different than controlling a robot: we need to introduce non-financial
indicators to say what functions need to do.
® Cybernetic approach: the main idea is to align different part of the organization to achieve a
common goal, the maximization of the EV --> we do this alignment through the PLAN & CONTROL
CYCLE.
The plan & control cycle can be applied for the next 12 months. If the strategic planning is over 10 years,
we will divide it in 10 sub-periods of 1 year, because this is the period during which the company produces
the financial statements (which are the thermometer of the results of the company’s strategy).
We deploy the strategy in plan & control cycles of 1 year. If we look at the single year, we think at shortterm goals (the long-term goal is still the maximization of EV):
1) GOALS: short-term goals are in terms of
o Financial Indicators: ROE, ROI, ROS, ATR, D/E, CF from operating activities
o Non-financial indicators: customer satisfaction, delivery time, carbon footprint
--> these indicators are relevant because we want to make the financial statements the most
interesting and meet the expectations of the different stakeholders.
2) RESOURCES: all resources made available to managers to achieve such goals
o From the financial statements: machinery, patents, brands, money
o Not included in the financial statements: employees, competencies, data, network
3) PLAN OF ACTION: actions that the different parts of the organizations should implement to make
the most out of the resources to meet the goals. We should be able to tell each part of the
organization what they are expected to do. What the different Business Units / Organizational Units
of the enterprise should do in the next 12 months to meet the expected Goals against the Recourses
that will be made available?
4) MEASUREMENT OF ACTUAL RESULTS: periodically measure the results (typically every 3 months,
quarterly financial statements). For startups every week, for mature companies every
month/quarter. What are the actual results that the company has achieved?
5) VARIANCE ANALYSIS: we need to measure how far are the results from the goals, to see the
potential alignment or misalignment. What is the “distance” between actual results and targets
(goals)? Why do they differ? Is the result of external or internal contingencies?
6) FEEDBACK: We want to introduce some feedback, meaning corrective actions. It could be a change
in the actions, in the amount or type resources, or change the goals (changing the goals is the last
option because it leads to losses in terms of reputation, etc.) What Managers should do differently
to align actual results and targets? Should they need more or different resources? Are contingencies
so different from expected than Goals must be revised?
Considering the PLAN&CONTROL CYCLE, there are 4 systems:
I. Budgeting system: focused on define the
PLAN OF ACTION.
II. Control system: measure the results
achieved by the company, based on cost
accounting.
III. Reporting system: measurements of the
gaps between goals and results +
communication of these numbers because
management must think about potential
feedback.
IV. Incentive system: we are not dealing with
it. (This is included because employees are not
mechanical parts but need motivation in order
to move in the right direction. This motivation could be based on money, or on reputation, and other kinds
of gratification.)
9.2 Budgeting system
Why do we need to budget and to define a PLAN OF ACTION? This is not a trivial question actually; this is
quite an old question.
Today there is a lot of enthusiasm about other methodologies called “beyond budgeting”, one of them is
the “humanistic approach” --> since the company is not made of robots, to align their behavior with the
goal of the company, we need to communicate with them and have a positive attitude towards them (like
“coaching” them to motivate them). This approach could lead to chaos as employees will not knowing what
to do and there will be no harmony and alignment.
The budgeting process is still very relevant.
Example:
The CEO wants to increase
the market share because
it is connected with the
size, so with cost
advantages (this is valid for
every company).
The problem with is goal is
that there is not a target.
We need to know how
much, so the target
number.
Then there is another problem: what should each function (and the employees within them) do? Once each
function knows what to do, they need to start thinking about the actions they need to put in place to
achieve that goal.
These actions are interconnected: what is the best coherent plan of action?
This is the goal of the budgeting process: to define a coherent plan of action that allows to reach all the
objectives. It is a long process (April-November) and typically there are 10-15 revisions to define this plan.
Budgeting process
Budgeting is a set of procedures and activities aimed at assigning to organizational units:
® The goals, targets – ex. reference values for their performance
® The resources needed to achieve these results.
N.B: Balance Scorecard method is useful to align the strategy of the company and the KPIs and setting the
targets.
A key feature in budgeting is the role of people involved in the process:
– Managers responsible for organizational units.
– Other employees working within organizational unit affected by target setting.
– Accounting and finance functions supporting the process.
The output of the budgeting process in the MASTER BUDGET = collection of budgets that allow the
company to produce the financial reports for the next year.
A budget is:
•
the quantitative expression of a proposed plan of action by management for a specified period and
•
an aid to coordinating what needs to be done to implement that plan
•
is it more than just allocating money!
The Master Budget is a document that:
•
•
Expresses management’s operating and financial plans for a specified period
Comprises a set of budgeted financial statements
These documents are needed to apply the financial ratios analysis to show shareholders and stakeholders
that they will meet expectations. These are also used to calculate the EV and E.
We recognize 3 typologies of budgets:
1. Operating budget --> budgeted EBIT --> economical equilibrium (revenues and operating costs)
2. CAPEX budgets --> connected to the idea that the company buys assets to grow --> budgeted CAPEX
--> technical equilibrium (available capacity vs. needed capacity)
3. Financial budgets --> budgeted cash flow statement --> cash equilibrium (cash inflows vs. cash
outflows). Does the company needs more money?
These documents are then used to prepare:
•
•
•
Budgeted Income Statement
Budgeted Balance Sheet
Budgeted Cash Flow Statement
N.B: almost all big companies apply the budgeting procedure.
9.3 Case study part I: Operating Budgeting
QUESTIONS (FIRST PART)
1. Determine the expected EBIT (Net Operating Income) for 2023.
2. Check if expected ROS (Return on Sales) will be more than 15%.
N.B: full costing method = materials, labor, and plant-related costs. The production capacity cannot be
increased in the short term --> this means that there is a bottleneck.
N.B: the LIFO method is not compliant anymore with IFRS, the only methods accepted are the average cost
and the FIFO method.
N.B: Actual data = a data that we observe, that occurs. Standard = best guess that engineers can make
assuming a condition of normal efficiency (not over- or under-performing).
SOLUTION (theoretical Budgeting Process)
Target setting
The Chief Executive Officer (CEO) negotiates the targets in terms of financial ratios (e.g., ROE, NPM etc.)
with the shareholders. The CEO discusses the expectations of the shareholders for the next year because
he/she is the bridge between the company and the shareholders.
The Chief Financial Officer (CFO) shares these goals with all Managers and opens the budgeting process
that will identify that plan of actions that will allow the whole company to meet the expected targets. The
CFO is the orchestrator of the budgeting process, so he/she is responsible for the quality of the process.
AFC Case Study: ROS (Return on Sales) 2023 > 15%. We focus on the Operating Budget for now.
Budget of revenues
The Chief Financial Officer (CFO) invites:
• the Marketing Manager (who oversees price setting), and
• the Sales Manager (who oversees sales)12
to agree the expected quantities that will be sold for every product-line at a certain price, every month, in
the various geographical markets, through the different channels (retails vs internet).
If we fail this first forecast, we fail everything else. This estimation could be easy if we have historical data
about a certain product, but it is difficult for new products. The more products, distribution channels,
markets, etc. we have, the more difficult this process is.
AFC Case Study: they agree on 70€/units and 1000 units --> Budgeted Revenues = 70€/unit * 1,000 units =
70,000€.
Budget of production
The Chief Financial Officer (CFO) invites the Logistics Manager (who oversees the level of inventories of
finished goods and the service level agreements (SLAs) with the distributors/final customers) to agree the
expected inventories to meet the expected SLAs. Remember: inventories are needed to avoid stock outs,
etc. so they guarantee a certain service level.
12
Usually, the marketing manager and the sales managers are two different people supposed to be in conflict by
theory because the marketing manager wants to increase the price even if sales decrease and the sales manager
wants the opposite. In some companies, these two figures could be the same person: the marketing & sales manager.
N.B: for Porter, sales is the selling of existing products, marketing is the developing of new products. In our view, we
consider both marketing and sales refer to existing products.
AFC Case Study: in our case we need to increase the level of inventories in 2023 -->
Budgeted Production (units) =
+ Budgeted Sales: 1’000 units
+ Target ending inventories of finished goods: 75 + 50 units
- Beginning inventories of finished goods: 75 units
= 1,050 units
The Chief Financial Officer (CFO) invites the Operations Manager (who oversees the production of finished
goods) to verify that the budget of production defined so far will be feasible considering the resources
(materials, labor hours, machine hours) that will be made available.
N.B: the logistics manager and the operations manager could be the same person.
AFC Case Study:
The only constrain is about machine hours:
•
•
Capacity available = 3,000 h – 150 h = 2,850 h
Capacity needed = 1,050 units * 3 h/unit = 3,150 h
The budget of production is NOT feasible... 300 h will miss!!!
N.B: in general, production is the bottleneck. “Top line” companies are those in which the most important
element is the revenues --> marketing and sales managers are those who lead (95% of the companies) and
“bottom line” companies are those in which the most important line is the net profit (this can be the case
for very specific products, like luxury, or for products for which the sourcing of materials is very difficult -->
so it is difficult to increase the sales).
The Operations Manager must evaluate different alternatives to make the budget of production feasible...
AFC Case Study: some alternatives (to be evaluated against the information available)
•
•
•
•
•
•
Increase machine hours (new assets --> CAPEX): this means combining short term and long term
Reduce sales by increasing the price per unit --> we don’t have information to do that
Reduce the level of target ending inventories of finished goods --> we cannot do that because of the
case study constraints.
Reduce the number of hours for planned maintenance --> never do that
Reduce the machine hours needed for each unit --> because the standard data are the best data, we
cannot expect to do better
Search for a third-party supplier --> we have information about purchasing finished goods from
an outsourcer: 45€/unit
The price per unit is 70€/unit > 45€/unit. If this condition is not satisfied, our decision depends on
the strategy: we could reduce the market share or we could sell at price cost because we want to
keep our reputation and satisfy loyal customers.
Now that the Operations Manager has identified how to make feasible the budget of production, she
confirms the production-mix to the Chief Financial Officer.
AFC Case Study: Budgeted Production Mix = Units MAKE + Units BUY
•
•
Units MAKE = 2,850h / 3h/unit = 950 units
Units BUY = 1,050 units – 950 units = 100 units
Budgeted Production Mix = 950 units MAKE + 100 units BUY
Budget of COGS
The Chief Financial Officer supported by the plant controllers, who know the bills of materials and the
production cycles, calculate the expected full product cost of every product-line
AFC Case Study: The company will produce 950 units MAKE
Full product cost = cost of direct materials + cost of direct labor + plant Overhead13
The Chief Financial Officer supported by the plant controllers, who know the bills of materials and the
production cycles, calculate the expected full product cost of every product-line.
Cost of direct materials?
•
•
Materials in the warehouse 1€/kg
Materials that will be purchased 2€/kg
Since the approach is LIFO, only the new
materials are being used (because we have
more raw inventories at the end than at the
beginning). The choice between the LIFO and
FIFO approach depends on the physical
structure of the warehouse.
Cost of direct materials = 950 units * 6 kg/unit * 2 €/kg = 11,400€
Cost of direct labor = 950 units * 2 h/unit * 8 €/h = 15,200€14
(plant) variable Overhead = 2,850 h * 1.5 €/h = 4,275€
(plant) fixed Overhead = 3,000€ + 2,000€ + 605€ = 5,605€
Full product cost = 36,480€
Budgeted full product cost per unit = 36,480 / 950 = 38.40 €/unit
Cost (MAKE) = 38.40 €/unit < Cost (BUY) = 45€/unit
13
Plant overhead = indirect production cost. We differentiate the overhead and the period costs.
Attention! Typically, in the budgeting process we consider the Cost of labor as a variable cost. Normally, the cost of
labor is fixed, people are paid even when they do nothing, so the cost of labor shouldn’t be depended on the number
of units in small and medium enterprises. In large corporations, the cost of labor is variable because the large majority
of the employees have a contract, but there are also people who work when it is necessary to avoid spare capacity
and increase the capacity at need. So, here the assumption is that we are considering a large enterprise.
14
23/11/2022
Continuation of the previous lecture.
We want to compute the COGS because we want to prepare the IS by function.
Why companies prefer to draft the IS for the next financial year using the “by function” template
instead of the one “by nature”?
Because companies want to coordinate all the functions/BUs to provide them with targets,
resources and a plan. The COGS include product cost, and the COGS is the cost incurred by the
operations functions. For example, the cost of R&D is the cost of the R&D unit, the cost of sales is
the cost of the sales function, etc. So, in a budgeting process we want the IS by function because
we want to see the organizational chart. The IS by function tells us the consumption of resources
by each BU. This is aligned with the cybernetic perspective.
The Chief Financial Officer supported by the plant controllers, who know the bills of materials and the
production cycles, calculate the expected full product cost of every product-line.
Knowing that the company is going to sell 1’000 units, we need to know the sales mix because some units
cost 40€/units and others cost 38.40€/unit.
Remember that the company uses a LIFO approach and prefers to sell units bought from an outsourcer and
to keep as inventory units that the company produced.
Sales-mix = 1,000 units = 900 units MAKE + 100 units BUY
What MAKE units will be sold?
•
•
Those that are already in the warehouse (75 units, 40 €/unit)
Those that will be produced in 2023 (950 units, 38.40 €/unit)
Budget of Cost of Goods Sold = 900 units * 38.40 €/unit + 100 units * 45 €/unit = 39,060 €
Remember: the COGS is not the cost of goods produced!!! --> they are inventories and will be included
among the assets.
According to the “matching principle” we register in the IS:
•
Revenues generated in the period by the documented delivery of the products/services (there is
an invoice that tells responsibilities and movement of property). We do not care if we have been
paid or not (because we are not talking about cash flows).
•
Costs are recorded in the IS if one of this 3 reasons is true:
o When costs are connected to products/services that have been sold (materials, labor,
depreciation, rent, insurance, etc.)
o When the utility of the cost ends in the period (“period costs”)
o When costs are generated as the allocation over time of the value of an asset =
depreciation.
N.B: 100*45 = 4500€ is the budget allocated for the procurement unit.
Budget of Gross Margin
The Chief Financial Officer knowing the budged of revenues and the budget of cost of goods sold can
budged the gross margin:
+ Budget of Revenues + 70,000€
- Budget of Cost of Goods Sold - 39,060€
= Budgeted Gross Margin = 30,940€
Budget period costs
The Chief Financial Officer involves the Managers of the other Functions to budget the period costs:
•
•
Sales & Marketing
Administrative & General
Period costs do not depend on the targets we want to achieve, for example in terms of volume of units
sold. For example, how can we compute the right number of resources to allocate for marketing or R&D?
Typically, companies try to overcome this complexity with the following two approaches (both with pros
and cons):
1) INCREMENTAL APPROACH
The budgeted period costs of year (t) are calculated on the costs incurred the previous year (t-1).
Budgeted Period Costs (t) = Actual Period Cost (t-1) * (1+α)
Typically, we increment the costs α > 0 because it considers:
• Inflation
• The expected growth of the company
We do this budgeting for each organizational unit because α is different for each organizational
units because they grow differently --> but very small increase in general.
It could also be < 0, meaning that we are reducing costs over time, for example when a unit is not
efficient.
PROS: low cost of implementation --> not difficult to do, we just need an excel spreadsheet.
CONS: amplifications of errors over time (because we are not considering una-tantum expenses) +
we need to agree on the value of α.
2) ZERO-BASED BUDGET (ZBB)
The Budgeted Period Costs are redefined every year. Each Manager has to:
• Define the minimum set of resources required for running the Unit --> managers from each
function need to define the minimum they need to survive
•
Propose additional “packages” of initiatives --> managers need to pitch their innovative
ideas
The CFO talks to the managers and then decides how much to give to each of the function more
than the minimum budget.
PROS: the method is theoretically more precise
CONS: it requires high costs and time for implementation + usually managers ask for more money
than the minimum (also because they fear that the CFO will not fund the innovative ideas) --> it is
very complicated to apply, it requires negotiation, and it could be exhausting.
® Typically, companies run the ZBB only every 3 years (to reduce conflicts between managers and
CFO + to have a clear slate and erase errors coming from the incremental approach), accepting the
errors of the incremental approach in the meanwhile.
In our exercise, we are given the budgeted period costs:
Budgeted Period Costs (Sales) = 4,800€ + 2% * 70,000€
Budgeted Period Costs (Marketing) = 4,300€
Budgeted Period Costs (Administration) = 5,000€ + 2,000€
Budgeted Period Costs (General) = 5,000€
Budget of Period Costs = 22,500€
Budget of EBIT
This budget does not meet the target of the ROS. What do we do? We need to change the plan of action.
HOW?
•
•
•
Increase the sales --> no, because calling again the sales and marketing managers means that we
need to start negotiations again and they usually lasts months (like 3-4 months) --> so typically we
don’t change the revenues nor the COGS in the short term. In theory, we should do this.
Decrease the COGS --> usually we cannot do better than that because they are based on best
guesses by engineers.
Period costs --> it’s easier to change them in the short period, for example by cutting R&D
expenses and marketing expenses --> we don’t have any idea about what these costs will actually
be --> usually we don’t change the % of the sales commissions. This is theoretically wrong, but this
is what happens in practice.
Why should the CFO talk to the managers instead of deciding everything himself/herself? The budgeting
process must be bottom-up because of many reasons:
•
•
•
From an organizational perspective, it is an interruption for the managers and employees to think -> it could be an opportunity to align the employees and managers with a shared vision.
Because the CFO is not knowledgeable about everything
This is the only moment when the managers see the company as a whole
9.4 Case study part II: Capital expenditure budgets and Financial budgets
We started from the EBIT because the EBIT is the first reflection of the strategy of the company and reflect
the competitive advantage and if the strategy is working. EBIT is the first proxy of the result of the strategy
in the short term.
Budget of Capital Expenditures
CAPEX = refers to both tangible and intangibles, this is the budget for the installments supposed to be paid
the next year, not for the purchasing.
It outlines amount and timing of capital expenditures (CAPEX).
Examples:
• Buying new equipment
• Acquiring new patents
• Building a new store
• Purchasing and installing a materials handling system
We have a list of all our investments that have been
approved in the previous years.
The first column refers to what we have paid in the
previous years, the next columns we have the
installments that we still need to pay.
The relevant data for us is
170’000€, so the amount of
money (cash outflow) that the
company needs to pay for the
installments. Why?
1. Because if we want to
build the financial budget,
we need to know how
much the company has to
pay in the next year = cash
flow for investing activities.
2. Knowing all these
investments, we will know
if the company has the
capacity needed in the
operating budgets.
Waiting for approval: the investment is interesting, but we postpone an approval because the company has
no idea if it has the capability to generate enough cash flow in the next year.
AFC Case Study:
•
On 01/01/2023 the company will buy another equipment for 10,000 €, depreciation over 10 years.
This asset will be paid as follows: 5,000 € in 2022 and 5,000 € in 2023.
•
On 01/01/2023 the company will buy an information system for production scheduling for 5.000 €
that will be paid in the second semester of 2023. This investment will be depreciated over 5 years
from 2023 (so we will see 1000€ in the due to depreciation in the IS).
Equipment: assets will increase of 5000€ while payables increase 5000€.
Financial budget
Very important because they forecast the cash flow statement for the next year, which is fundamental to:
® Understand the financial sustainability of the strategy for the next year
® To estimate the EV and E
Attention! The cash flow statement and the FCFF/FCFE are calculated differently!!!
The basic document is the cash budget, which aims at evaluating the budgeted inflows and outflows of the
organization.
There are two ways for calculating a cash budget:
•
•
Direct Approach
Registration line-by-line of future cash
inflows and cash outflows --> we try to
forecast the cash flow statement line
by line. This is not very used because
it’s exhausting.
Indirect Approach
From the EBIT (important because it
reflects the strategy in the long term)
by adjusting accrual principle into
financial principle (so transforming
revenues into cash inflows and costs
into cash outflows, so from the IS to
the Cash Flow Statement).
The Cash flow Statement classifies cash
inflows/cash outflows in three categories:
– Cash flow from operating activities,
cashflows generated by the operating, financial
and fiscal activities.
– Cash flow from investing activities, cashflows generated by the acquisition or disposal of non-current
assets.
– Cash flow from financing activities, cashflows generated by changes in the equity capital and financial
debts.
The final step is to evaluate the closing CASH availability to verify the financial equilibrium for the next 12
months:
We assume that the closing cash of the
previous year is the same as the beginning
cash in the present year. We are interested in
the closing cash (it is positive or null).
EBIT
+ D&A (t)
+ D Net Operating
Working Capital =
Payables (t) – payables
(t-1) + receivables (t-1)
– receivables (t) +
Inventories (t-1) –
Inventories (t)
+8,440
Budgeted EBIT comes from the operating budgets (we keep it even if it doesn’t
satisfy the target)
+3,000
Depreciation and amortization are costs but not cash outflows: these are a
reflection of the matching principles. If we use EBIT, we are over-estimating the
cash outflows, because not all the costs are cash costs. EBITDA is a good proxy
of the cash outflows.
Budgeted D&A comes from operating budgets.
-2,500 - 2,020 + 2,750 = 1,770
We need to correct the revenues because they do not represent the cash
inflows since we have receivables. Receivables of the next year are considered
in the revenues because of the matching principle, but they are not cash
inflows. Instead, we need to add the receivables from the previous year to
avoid underestimating the revenues.
Receivables (2022) = 15,000
Receivables (2023) = [70,000*3 (DSO=3)]/12 = 17,500
- Receivables (2023) + Receivables (2022) = -2,500
In the IS, we include in the COGS just the units that we have sold (not the ones
we produced) because of the matching principle. In the cash flow statement,
we need to consider also the units that we produced and not sold, because
they represent cash outflows because we need to consider the purchases, and
not the consumption:
Inventories (2022) = 4,000€
Inventories raw materials (2023) = 1000 + 50kg *2€/kg = 1,100€
Inventories finished good (2023) = 3,000 + 50*38,415 = 4,920
- Inventories (2023) + Inventories (2022) = - 6,020 + 4,000 = - 2,020
We need to reduce the EBIT by the receivables and inventories of this year
because otherwise we are overestimating the cash inflows. Then, we need to
add the receivables and inventories of the previous year, because those costs
are not cash outflows (because they have been paid in the past year). Basically,
we need to reduce the EBIT of the difference between the receivables and the
inventories of this year and the previous year.
15
We need to use the lowest value between the price on the market (70€) and the production cost (38,4€).
+ Cash inflows from
financial revenues (t)
- Cash outflows from
financial expenses (t)
- Paid taxes (t)
CASH FLOW FROM
OPERATING
ACTIVITIES
- CAPEX
+ Disinvestments
CASH FLOW FROM
INVESTING ACTIVITIES
+ Cash inflows for
increase in share
capital (t)
- Cash outflows from
decrease in equity (ex.
dividends) (t)
+ Cash inflows for new
financial debts/bonds
(t)
- Cash outflows for
closing financial
debts/bonds (t)
CASH FLOW FROM
FINANCING
ACTIVITIES
We also need to increase the EBIT by the difference between the payables of
this year – payables of the previous year because we need to correct the overestimation of the cash outflows.
Purchases (2023) = (950*6 +50)*2 = 11,500
(DPO=6)
Payables (2023) = (11,500*6)/12 = 5,750
Payables (2023) – payables (2022) = 5,750 – 3,000 = +2,750
+600
– 1,200
These are usually the same voices that we see on the IS, but it depends on how
the company is paying the banks (we must refer to the cash flow statement).
Bank coupons = 400
Interests to banks = 8000*10% = 800 (kd = 10%)
– 4,520
Unpaid taxes = 600
Taxes = EBT*tax rate (50%)
EBT = EBIT – financial interests = +8,440 – 600 = 7,840
Taxes = 7,840 * 50% + 600 = 4,520
+ 4,550
- 10,000 + 0
Total installment approved for the year for investments in non-current assets.
We don’t have information about disposal of non-current assets.
- 10,000
- 1,000
We don’t have information about planned increases in share capital.
Decrease in equity = net profit – dividends = 2,000 – 1,000 = 1,000
- 2,000
The case study does not provide information about planned increases in debt
capital.
Repayment of bonds for 2,000
- 3,000
We have a problem: how can we solve it? We have several options:
® We can revise the capex budget and not buy a new machinery (this could be a problem because we
couldn’t be able to satisfy the production)
® We could try to reduce the DSO
® We could ask to increase the DPO
® We could ask for a new bank debt --> most typical option
To solve a CASH UNBALANCE, we use FINANCIAL PLANNING.
We add a new debt in the financing activities --> we have more interests --> taxes changes because EBT is
different.
Increasing the debt or increasing the depreciation --> tax shield because they both reduce the EBT.
Now we solved the cash unbalance:
We need to compare:
•
•
Cash flow from operating activities and investing activities --> we want CF from investing to be
large and negative because we want to invest to grow. But we want at the same time to have a
CF from operating activities (so the self-generate cash) to cover the investing activities
(according to the Boston consulting group).
We need the CF from financing activities --> in case the CF from operating activities do not
cover CAPEX we need money from banks to sustain the investing strategy.
The cash flow statement does not highlight the situation of sub-periods across the year:
•
•
ex. cash inflows concentrated at the year-end
•
problem of liquidity at the beginning of the year
We can define a different cash budget detailing the situation throughout the year:
ex. Per semester, per quarter, per monthly.
Budgeted Financial Statements
The last step in the Master Budget is drafting the complete Budgeted Financial Statements:
•
Completing Income Statement
•
Defining Balance Sheet
•
Defining Cashflow Statement
Once we will have all Budgeted Financial Statements, we will apply Financial Analysis through
Ratios/Absolute Indicators to verify that the plan of action will meet shareholders’ goals.
IS:
BS:
•
•
•
•
•
NON CURRENT ASSETS (t) =
Non-current Assets (t-1) + New non-current Assets (t) – D&A (t)
= 25,000 + 10,000 + 5,000 – 3,000 = 37,000
BANK DEBTS = 8,000 + new debt of 10,000 = 18,000
BONDS = 4,000 – repayment of 2,000 = 2,000
PAYABLES = 5,750 + 5,000 =10,750
RESERVES = retained earnings “other stakeholders’ rights” (2022) + net profit (2022) – dividends
(2023) = 7,400 + 2,000 – 1,000 = 1,000
N.B: the goal of the Budgeting analysis is not to produce the financial statements, but to run the financial
ratios analysis on the new financial statements to see if the company will survive.
30/11/2022
10. Financial Planning
In the budgeting, we met a problem: if our cash is negative, what do we have to do? --> We have several
solutions, but it depends on how much money we are missing. For example, if we are planning acquisition
or other big investments, the amount of money we need is big. We are facing operational inefficiencies that
would probably last a few months; the amount of money is much smaller.
So, in the financial planning we have diversification in terms of the time: we have different solutions for
the cash insufficiency in the short-term planning vs. long-term planning.
10.1 Bank loans (short and long term)
•
•
Bank loan is a debt provided by a bank to the company
Can be either long or short term, depending on the maturity
INTEREST
Interest expenses to be paid to the bank
• FIXED RATE: for example, 5% each year. It does not change.
• FLOATING RATE: it does depend on some parameters, like repayment of bank
loans, index of the stock market, etc. Usually, it is the mixture of different factors
that are contractually defined.
MATURITY Contractual term of loans
REPAYMENT Repayment of capital:
SCHEME
• AMORTIZED REPAYMENT: we pay the interests + a portion of the loan each year
• BULLET: we repay the capital in one shot, at maturity date (usually at the end)
Repayment of interests: it can be monthly, quarterly, annually (it is contractually defined)
PRIORITY IN Priority in the repayment of interests and capital, debtholders have the priority on equity
CASE OF
holders.
DEFAULT
What are the problems with bank loans?
•
Bank loans require warranties --> the company must say what will happen if it won’t be able to pay +
the company must disclose their financial information because the bank wants to make sure that the
company can repay the debt.
•
Mortgage is a form of guarantee which is constituted by real estates.
•
In cases 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
•
The issue of a long-term loan implies other costs such as the negotiation costs, evaluation of the
mortgage value, insurance premia.
10.2 Syndicated bank loans or bridge bank loans (short and long term)
Used by big corporations so make acquisitions.
•
A syndicated loan is provided by a group of lenders (so by a group of banks). This is because the
requested investment is so big that it would compromise the situation of a single bank. So, in this case
several banks put together the capital for the company.
•
To organize this, we need a third party that organize the procedure. It is structured, arranged, and
administered by one or several commercial or investment banks known as “arrangers”. Additional
cost to be paid to the arranger.
•
The aim is to lend money to a borrower with a unique contract (the interest rate is unique). This allows
the partition of credit that a stand-alone bank could not disburse.
•
Almost impossible to re-negotiate the terms.
Example: Digi Communications. They took a €163M loan from 3 banks in different European countries (with
different currencies).
10.3 Corporate bonds (long term)
Securities issued by the company to raise money, even from individuals. Securities have an interest called
“coupon”.
How? The company should have a sound reputation. The company does not need to be traded but needs
to have a good reputation in the market. In fact, if the company is not well-know, people in the security
market will not buy their bonds.
•
A bond is a security that requires the issuer (so the company) to pay specified interests (coupons)
and make principal payments to the bondholders at maturity or even on specified dates
•
The bond emission can be targeted to
– Institutional investors (country governments can buy companies’ bonds)
– Retail investors (public)
– Both
INTEREST
Interest expenses to be paid to bondholders
MATURITY Contractual term or settlement of bonds
REPAYMENT Repayment of capital:
SCHEME
• AMORTIZED REPAYMENT: we pay a portion of the capital each year
• BULLET: we repay the capital in one shot, at maturity date (usually at the end)
Repayment of interests: it can be monthly, quarterly, annually (it is contractually defined)
PRIORITY IN Priority in the repayment of interests and capital, bondtholders have the priority on
CASE OF
equity holders.
DEFAULT
Types of coupons
We can have:
•
•
debt securities: there could be bonds with a “zero coupon”
hybrid securities: at maturity, bondholders can decide if we want to take the money or convert it
into shares (also contractually defined).
Zero coupon: the bond pays no coupon (this is unlikely for corporate bonds) --> it is such a reliable
company (so it is almost impossible that the company will fail) and the currency is favorable that we will for
sure gain money.
Coupon: the bond pays coupons over time
– Fixed rated coupon: the amount of coupon is contractually defined
– Floating rate coupon: the algorithm for computing the coupon is contractually defined
Corporate bond emission
The upper part of the schema is how the company receives money.
The issuing of the bonds is a similar procedure to going through an IPO. Usually, there is an
underwriting & selling group and an agent bank that help with the process. Then, we issue the
bonds. The agent bank also makes sure than there are investors that will buy the bonds (he makes
sure than a certain minimum is achieved).
The lower part of the schema is how the company is paying back the money.
Coupon and capital payment. Also payment of the fee of the agent bank.
Bonds and loans are long term (loans could also be short term).
2 big differences: bonds cannot be renegotiated, and it is not something that can be done by every
company because of the transaction costs, because of the need of a sound reputation. For small amount
of money and smaller companies, it makes more sense to get a bank loan.
10.4 Leasing (long term)
•
A lease is a contractual agreement between a lessee (user = company) and a lessor (the owner of
the asset). The lease is targeted to a specific asset.
•
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.
MATURITY
REPAYMENT SCHEME
Contractual term or settlement of the lease
Scheduled rent: monthly, quarterly, semiannually, annually
There are 2 typologies of leasing: operating lease vs. finance lease.
1) OPERATING LEASE
• An operating or service lease is usually signed for a period much shorter than the actual life of the
asset
• The asset is generally standardized
• At the end of the life of the lease, the equipment reverts back to the lessor, who will either offer to
sell it to the lessee or lease it to somebody else. The lessee usually has the option to cancel the
lease and return equipment to the lessor.
• The ownership of the asset resides with the lessor, with the lessee bearing little or no risk if the
asset becomes obsolete --> so the lessee does not have to put the asset on its BS.
• The lessee pays the rent, but installation, maintenance and other costs are on the behalf of lessor
• Example: vending machines.
2) FINANCE LEASE
•
•
•
•
•
Finance lease generally lasts for the life of the asset
The asset is generally less standardized than operating lease
At the end of the life of the lease, the equipment reverts back to the lessor, but it is generally
redeemed by the lessee. A financial lease generally cannot be cancelled
In many cases, the lessor is not obligated to pay insurance and taxes on the asset, leaving these
obligations up to the lessee
A finance lease imposes substantial risk on the shoulders of the lessee
10.5 Factoring (short term)
•
Factoring is a credit service that concerns the acquisition of commercial credit by an intermediary
(factor) in order to receive advance payments
•
The factor pays a percentage to the counterparty as soon as it receives an assignment or the
receivable.
4. The company CREDITOR has sold 1000€ of products to a client DEBTOR.
5. The client has not paid yet: the payment is postponed.
6. The company owns a credit which can be sold to an intermediary, the FACTOR to receive money
immediately.
7. The credit is sold for a lower price, for example 800€ (discount of 20%).
The interest is related to the % discount. The discount is contractually defined.
The factoring agreement can be:
•
with recourse (with insurance): 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 (without insurance): the factor assumes the insolvency 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. Usually, in this case the factor asks for
a big discount (even 50% and more).
10.6 Lines of credit (short term)
Like a credit card: a bank gives us like 3000€ monthly that we are able use.
For companies, they usually have a tot amount of money they can use (not obliged to do so) every month
or every 3 months. The fee to open a credit line is usually very small. If the company repays the money
within the contractually defined date, we do not pay any interest. Otherwise, the interest rate will be very
big. So, this is used for cash imbalances within a few months.
•
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; otherwise, it will become a very onerous obligation
•
It is quite usual to have access to different credit lines. This is due to the fact that this multiple
access could turn to generate a positive effect on the company liquidity in case of unpredicted
situations in cash flows.
Exercise
Company JOY is preparing the budget for the accounting year 2021 (January-December 2021). While
preparing the cash budgets, they realise that they will have a problem of cash in 2021. They consider to fix
this problem with a bank loan of 20,000€ with a duration of five years to be activated on January 1st, 2021.
The bank offers to JOY different possibilities in terms of interest rate (always fixed), repayment of debt and
commissions. There are three possibilities (A, B, C).
For all the three options:
• The payment of the debt interest will start in January 2021.
• The commission is upfront and must be paid the 1st January 2021, at the activation of the bank loan.
• In case of amortised loan, the amortisation is linear (equally divided across the 5 years), starts in 2021 and
the annual repayment done at the end of the year.
OPTION A
OPTION B
OPTION C
• Annual fixed interest rate: 10%
• Commission: 3,200
• Repayment of debt: bullet (at
maturity date)
• Annual fixed interest rate: 5%
• Commission: 200
• Repayment of debt: amortized
• Annual fixed interest rate: 6%
• Commission: 0
• Repayment of debt: amortized
Interests = 20,000*10% = 2000€
Interests = 20,000*5% = 1000€
Interests = 20,000*6% = 1200€
B is best: 200 + 1000*5 = 5200€
C = 1200*5 + 0 = 6000€
Exercise
You are comparing the conditions of two loans. They have the same duration and interest rate, that is fixed.
They only differ for their repayment scheme: amortized and bullet.
To select the alternative that is more convenient, the cost of capital of the company should be taken into
consideration.
Ceteris paribus the convenience of the two loans from a company perspective depends on the cost of
capital of the company. Cash outflows that happen later in time are discounted more, increasing the
attractiveness of the bullet scheme that postpone the repayment of the whole amount of the loan in the
last year, while only interests are paid in the previous years.
5/12/2022
11. Management Reporting
We discussed about the plan and control cycle (from the cybernetic approach) --> now we enter into the
CONTROL part of the plan and control cycle.
1) We discussed the goals and the need to set targets (we could have very different indicators: valuebased indicators, accounting-based indicators and value drivers) --> this is part of the discussion
between the shareholders and the CEO --> the assumption that we can deploy a long-term strategy
in the short-term period is not so applicable anymore because it is very difficult to foresight what
will happen in 10 years. Let’s assume that we can still do that.
2) Plan of action: budgeting --> how to define the plan of action that aims at reaching the goals set
before, scorecards are used to show the connections among indicators --> we need to set the
target values
3) Measurements of actual results (this is not part of our course, but it is part of cost accounting --> it
is assumed that we know it --> look at the MOOC): ability to cost out what the company did or to
cost out an organizational unit, a product, etc.
4) Reporting system: we need to calculate the variance between the target and the actual values in
order to introduce some feedback (so a corrective action). Control has neutral feeling in English: it
refers to regulation, setting of parameters. BOTH overperforming and underperforming is bad!!
Reporting system
Example: Jaguar. We have the target and the actual results of 2020:
We need to understand the composition of variations of the different targets --> what did the company did
good/wrong? What feedbacks should be put in place?
We need to use the conceptual map --> we can use the scorecards both to define the strategy to define the
plan of action, but also to understand the potential variations and the corrective actions.
A professor invented two approaches to develop knowledge:
1st loop: variances = actual – targets (very simplistic
knowledge)
2nd loop: we try to verify the assumptions and if they
truly reflect what is happening (every arrow in the
balance scorecard is a hypothesis). For example,
according to the Jaguar scorecard, we should have
had higher gross profit because we increased the
customer satisfaction and reduced the time to
install. This means that the assumptions were wrong
--> WHY THE MODEL DOES NOT WORK??
11.1 Definition
Process of communication to a manager who is responsible (ACCOUNTABLE) for the allocation or the use
of specified resources of information regarding current and expected performance that are relevant for
her/his decision-making.
--> The goal is to feed managers with information that will be used to make decisions.
Information that is:
• Relevant --> A bad manager is someone who does not know what information are relevant: the
more we are fed by the company, the more they don’t know what is relevant to them. Every
manager could have very different needs, not all the data are relevant.
• Reliable --> managers need reliable stories
• Timely --> when they need it (timeliness is very different for different indicators)
Example: Consider a company and the following 2nd quarter results: Variation = actual – target (in red
unfavorable variations).
•
•
•
Negative variation of sales
Positive variation of full product cost
Negative variation of raw material purchasing costs
WHAT HAPPENED ACTUALLY
The Procurement Unit opened a contract with a new supplier of raw materials whose quality proved to be
very poor. As result, the Operations Unit experienced significant problems, being obliged to increase the
kg/unit and to rework the products to guarantee the expected quality of finished goods. The Sales Unit
faced shortages of products and had to manage many cases of stock out and delays in delivery.
TAKEAWAYS
(1) Reporting must be based on a reliable understanding of the reasons that generated the variations
between actual and targets
(2) Incentives must reinforce favorable behaviors
(3) Accounting-based indicators are relevant16 but are not enough: try to explain that the main reason of
the variations has been the poor quality of raw materials through such indicators
(4) Organizational Units are intertwined and the result of one Unit affect the result of the others
(cybernetic view of the company) --> the organizational units are not independent!
16
Because in the end all the stakeholders use them to evaluate the company.
11.2 Responsibility centers and reporting framework
“Management reports” are the most relevant source of information for managers --> management reports
give an opportunity to understand what is happening.
Management reporting is part of INTERNAL ACCOUNTABILITY --> every company can decide to create a
different structure.
Structure and contents might change according to:
•
•
•
Addressees (how is going to receive the information):
® Board of Directors (C-levels) / Chief Executive Officer
® Head of Divisions (Country Manager, Product Manager, etc.)
® Head of Functions (Sales Manager / Operations Manager, etc.)
Purposes:
® Pure monitoring of actual performance vs variance analysis
® Identification of the reasons of variances to support corrective actions – i.e., changes to existing
plans for the months to come
Frequency: Daily vs. weekly vs. monthly vs. quarterly vs. annual reporting
Organigram of a company
Representation of the structure of the company. At the top, there is the CEO. Under the CEO, we have
different functions. Functions = operational, finance, personnel, legal, etc.
Under the COO, we have 3 divisions/business units at the organizational level. Again, under each Head of
division there is another functional layer.
--> Which are the Business Units? The divisions at the organizational level.
In accounting, there are different organizational units in terms of RESPONSIBILITIES, so what they are
accountable for:
•
Different Responsibilities
•
REVENUE CENTRE = An organizational unit whose manager has control over revenues, but not over
costs or investment funds, typically the sales unit (the main goal is to maximize revenues)
•
COST CENTRE = An organizational unit whose manager has control over costs, but not over
revenues or investment funds (the idea is to minimize the costs). Resource consumption is related
to volume of production, examples are operations or logistics.
•
EXPENSE CENTRE = An organizational unit whose manager has control over costs, but not over
revenues or investment funds. Resource consumption is NOT related to volume of production, ex.
marketing, R&D, etc. all period costs.
•
PROFIT CENTRE = An organizational unit whose manager has control over BOTH costs and revenues
(so this manager has control over the EBIT and his objective is to maximize the EBIT), but no control
over investment funds. Business Units are profit centers.
•
INVESTMENT CENTRE = An organizational unit whose manager has control over costs, revenues,
and investments in operating assets also called strategic business units.
N.B: Cost center and expense center is a terminology used in academia.
Because of the different responsibilities, we provide different information to the managers of different
units.
Ex. sales unit manager --> no information about the EBIT because it’s not his/her concern.
What we are doing is to spread the information from the top to the bottom but giving only certain parts of
the information --> decentralizing the information.
Attention! With this decentralization, we risk losing the big picture.
Reporting framework
Organization formed by the Corporate with a number of Business Units (organizational level). Inside each
BU, we have the different Responsibility Centers (functional layer): revenues center, cost center, expense
centers.
Decentralization of Reporting: PROs and CONs
PROS
Top management freed to concentrate on
strategy (they can’t waste time in solving every
problem in the company --> we should avoid
“micromanaging”)
•
Lower-level managers gain experience in
decision-making --> training, developing
decision-making capabilities
•
•
Decision-making authority leads to job
satisfaction
•
Lower-level decision often based on better
information
•
Improves ability to evaluate managers (top
managers have the responsibility to prepare
future managers)
CONS
• May be a lack of coordination among
autonomous managers (the more the units are
autonomous, the higher the risk of misalignment)
• Lower-level managers may take decisions
without seeing the “big picture”
• Lower-level manager’s goals may not be those of
the organization (people have personal goals)
Balancing pros and cons, the company should decentralize. The closer to the problem, the faster and the
easier to solve them. Many companies still do not decentralize, and the reporting is still concentrated at the
corporate and BU level.
11.3 Reporting requirements
It is important to discuss the requirements for the reporting system.
•
•
Completeness: to what extent the report contains all the relevant information
Measurability: to what extent the report should contain easy, measurable information, like the
average cost per unit, or the price. ex. customer satisfaction is not really measurable.
•
•
•
•
Long term: to what extent the information should be oriented to the long-term
Timeliness: to what extent the information should be easily accessible and available in real time
Specific responsibilities: the capability to understand the performance of each BU
Stability across time --> important for external accountability.
We consider these 5 requirements. The relevance of these requirements is different when we think about
different levels:
•
For the CORPORATE levels:
o It is important the completeness --> they need to consider all the parameters because they
are responsible for all the decisions.
o Long-term orientation. The top managers oversee the strategy and must understand the
implications of choices. They must guarantee the survival over time.
•
BUSINESS UNITS’ and RESPONSIBILITY CENTERS:
o It is important to have measurable parameters --> they need to make choices based on
these numbers + their careers and bonuses depend on these targets.
o Timeliness --> they must know if something is not working well when they have still time to
fix it.
o Specific responsibilities --> they are interested in parameters that are relevant specifically
for them
Knowing the pros and cons of the indicators we can create this table:
•
•
•
Value based indicators (EV and E): long-term oriented + complete (include the competitive
advantages of the company), not easily measurable, they are calculated over a long period of time.
Value drivers: very measurable, very timely (thanks to the fact that they give early signs), easy to
identify the specific responsibility
Accounting-based indicators: in the middle.
Given these two tables, we can create a theoretical reference/guideline for organizing the management
reporting process:
11.4 How to organize the management reporting process
1) Corporate level: the most important indicators are EV and E. Then, we have some indicators
connected to the shareholders’ perspective (ROE and NPM). Then, we can use some value drivers
connected to the real competitive advantages of the company.
2) Business unit level: focused on the short term (performances in the next 12 months). They are
interested in the cash generation, but the backbone is the accounting-based indicators because the
must guarantee the results in the financial statements.
3) Responsibility centers: they need information about costs and revenues, but their main interest
are the value drivers, because they need to be very fast in making decisions.
Managing report is crucial --> all parts should work together.
EVA = Economic Value Added, NOPAT = Net Operating Profit After taxes = EBIT – taxes --> we discuss it in
the FCFF.
*Segment margin = revenues – direct costs = contribution margin – direct FC
11.5 Reporting at the Corporate level
Typically, the management reports for C-level managers are based on these 3 chapters:
I.
The external (exogenous) landscape analysis: (macro-economic indicators – GDP values and trends
in the main market countries, inflation rates, interest rates, currency exchange rates, other
important facts occurred in the period, etc.)
All the chiefs are provided with the most relevant parameters, it’s like a short PEST analysis. They
need to set the strategy and the actions based on what is happening in the market.
II.
The Income Statements
• For a Group: Income Statement of the consolidated companies (the Holding, the Subsidiaries)
• For each company: the total Income Statement, the Income Statement of each Strategic
Business Unit / Division
The Income Statement must be explained and aligned with the strategy.
III.
The Cash Flow Statements
• Focus on Cash Flow from Operating Activities
• Relationship with the Cash Flows from Investing and Financing Activities
The capability of a company to generate cash is fundamental. Also, is important because it means
that the company is able to fund additional investments and grow.
IV.
Information about the state of progress of the investment plan (use of capital budget)
How is the company proceeding in the investment plan? There could be some delays.
V.
Other (complementary) information about:
• State of progress/results of specific (strategic) projects (ex. digital transformation of the
company, sustainability, and circular economy projects)
• Drilldowns on specific geographical markets
• Other (often non-financial) information --> market shares, time-to-market, customer
satisfaction, carbon footprint, sentiment analysis on social media, etc.
Example of periodic Management Reporting
IS “by function” because we want to see specific responsibilities.
The blue portion is the 1st loop learning: variance = actual – budgeted --> we are missing the explanation
about what happened.
We can do other 2 analyses:
Periodic Management Reporting
The starting point is the profitability analysis with a focus on the Income Statement:
1. The traditional framework includes actual vs budgeted data, where variances (deviations) are also
reported (absolute and % values)
2. Usually, the statement includes at least two sections:
•
Actual vs budget values concerning the last timeframe (in case of monthly reporting: last month).
• Cumulated actual vs. budget values for the Year-To-Date (YTD)
3. In some cases, a further section is added, which includes the expected results for the whole year,
usually called “forecast” or “pre-closing”, vs. the total budget values (as from initial budget) and/or vs.
previous forecast (if any)
4. Sometimes actual and budgeted data are compared also with the corresponding actual data of previous
year to enable a “Year-To-Year” comparison.
12/12/2022
12. Management Reporting at the BU level: Transfer Pricing
Today we will talk about TRANSFER PRICING, which concerns the management.
When we are talking about management within a company, we can use the Management Control Cycle.
We use this cycle each time we have to achieve a specific goal, like increasing the ROE of a certain amount.
Having a goal in mind, we have to consider the resources (human, physical, investments, etc.) we have and
the risks we are taking.
These lead to ACTIONS: in order to achieve a goal, we need to implement some actions, like to increase the
ROE we need to increase the net profit. How? Increasing the revenues or decrease the costs. This means
telling people in the BUs what to do and assigning KPIs.
Then, we need to assure that we are going in the correct direction through the CONTROL SYSTEM.
Then, we need to measure the results and perform the variance analysis between the budgeted numbers
and the real ones. Finally, we have FEEDBACK to correct potential misalignments and improve.
Usually, this process takes a year.
MANAGEMENT REPORTING is the “Process of communication to a manager who is responsible for the
allocation or the use of specified resources of information regarding current and expected performance
that are relevant for her decision-making”.
It is very important when talking about transfer pricing and cost allocation that these topics are connected
with the overall management system.
12.1 The Business Unit Level
We have different types of Business
Units. Within a business unit, we can
have different responsibility centers.
In terms of business units in a big
corporation, BUs are smaller
companies that form the bigger
group.
When we talk about responsibility
centers --> they are responsible for
their department.
Reporting at the BU level
When talking about BUSINESS UNITS, the backbone of the reporting system is the accounting-based
indicators: ROI or ROA, RI or EVA, Segment margin.
Instead, concerning value-based indicators, we are interested in cash generation, so the main objective is
EBITDA. This is because each BU does not take decisions about investments17, but they take decisions
about revenues and costs (so the first part of the IS).
Value drivers for the competitive advantages of the specific advantages.
RESPONSIBILITY CENTRES accounting-based indicators connected to the revenues and cost/expenses. The
backbone of their reporting system are value drivers (quality, timing).
Two issues to breakdown corporate’s EBIT into business units’ EBIT
Reporting at the Business Unit level relies mainly on accounting-based indicators (and EBITDA) to be
applied to the Income Statement till the EBIT. To generate it, two relevant issues arise:
17
Decisions about investments (besides revenues and costs) are taken at the corporate level.
1.1) TRANSFER PRICING:
Deciding how the BU should relate to each other because of the existing transactions with other BUs
within the company (intra-company exchanges).
Transfer pricing has important impact on the final results and on the relationship between different
BU. All of the BU are assessed on the EBITDA, so transfer pricing is important because for example if
a BU1 sells to another BU2, the same amount is revenues for BU1 and costs for BU2.
So, when the CFO (corporate level) decides the typology of transfer price to assign to the BUs,
he/she has to take into account many aspects --> he/she needs to find the system to have the best
possible scenario for the whole company.
1.2) CORPORATE COST ALLOCATION:
How to correctly distribute the cost that we have on the corporate level between the different BUs,
because the corporate manages the resources that are used by the BUs. At the corporate level we
will always have administrative costs (they impact the EBITDA) --> how do we distribute them
between BUs to have the most realistic picture?
The objective is always OPTIMIZATION of the whole company.
12.2 BU exchanges and transfer price
•
Transfer price is a “fictitious” price for evaluating intra-company exchanges: it is the price one division
charges for a product or service supplied to another unit.
•
The transfer price is:
o A cost to the receiving division
o A revenue to the supplying division
•
Once defined, transfer prices affect:
o Divisions performances
o Divisions decisions
o Company result
•
Transfer prices are a relevant problem: nearly 60% of world trading activity is intra-company
•
A transfer pricing system is required for several purposes:
o To provide information that motivates divisional managers to make good economic decisions -> high implication collaboration between BUs
o To communicate data that will lead to goal-congruent decisions --> the aim of a good transfer
price policy is maximizing the final profit
o To provide information for evaluating divisional performances --> to making clear who is
responsible for what.
o To ensuring divisional autonomy
o To plan tax, intentionally moving profits between divisions or locations --> depending on where
taxation is more favorable.
Transfer pricing and taxes
The divisional exchanges for multinational companies can be used for transferring profit from one country
to another taking advantage of different tax rates (income taxes, duties, ...) --> the OECD tries to make
companies follow the rules.
IN 1995 OECD (Organization for Economic Co-operation and Development) published a guidance reflecting
an international consensus reached by OECD member countries:
"arm's length principle" should be used to determine transfer prices for tax purposes. This principle states
that the transfer prices for dealings between associated enterprises should be those which would have been
agreed between them, for comparable transactions in comparable circumstances, had they been
independent entities acting at arm's length.
This means that at least some of the production must be done in the country where they will be taxed -->
this also help creates workspaces.
Case study on Transfer Prices
We have 2 divisions: one is producing the
wood; one is producing the paper from the
wood.
Cost and production data
Average units produced
Average units sold
Variable manufacturing cost per unit
Variable finishing cost per unit
Fixed divisional cost (unavoidable)
WOOD
100’000
PAPER
100’000
$20
$2’000’000
$30
$4’000’000
We have to define the transfer price, the price for the wood and the price for the paper.
Assume the following data for the wood division:
Capacity in units
Selling price to outside
Variable price per unit
100,000
$ 60
$ 20
Fixed price per unit (based on capacity)
$ 20
(2’000’000/100’000)
The Paper Division is currently purchasing 100,000 units from an outside supplier for $50 but would like to
purchase units from the Wood Division.
® Problems with acquiring outside: quality and timing cannot be controlled + costs due to
suppliers’ management.
® Positive sides: more negotiation and possible lower prices.
What could be the correct transfer price?
5. We need to look at the capacity: is it enough? --> Yes (100’000 requests and production)
TRANSFER PRICE = VARIABLE COST + LOST CONTRIBUTION MARGIN
6. Transfer price for the wood division at capacity: 20 + 40* = $60 --> selling price
7. Transfer price for the wood division when it has idle capacity: $20 --> variable cost
*Lost contribution margin = 40 (because we wanted to sell it outside for $60)
Overall situation
ALTERNATIVE 1: grade B wood, 50$ internal transfer price
Good result for wood, paper doesn’t make any profit.
ALTERNATIVE 2: grade A wood, 60$ internal transfer price
Paper has a negative result --> bad result. For the corporate level (after consolidation), it does not change.
Another solution could be that wood sells outside and paper buys from an outsourcer --> but is paper able
to maintain the same quality? Usually, we avoid very important BU for production to buy outside.
12.3 Transfer Pricing methods
12.3.1 Market-based transfer prices
TRANSFER PRICE = MARKET PRICE
Great way to stress the internal production because we are relating to market. We are putting the
producing BU in the situation to relate to market (whatever is happening).
This is great whenever we have the way to identify how much the product is worth:
•
Listed prices of identical/similar products/services
•
Actual price of intermediate products if sold to external customers
•
Price offered by competitors
Advantages: since we are referring to the external market, this is good both for the selling and the buying
departments. We are able to focus on efficiency.
Problems:
•
•
•
Non-homogeneous markets --> if the selling department is selling in different geographical
markets, fluctuation of the currencies can lead to problems.
High variability of prices (for example, due to inflation, or the war, prices can fluctuate a lot --> we
may not be able to predict the final price of the products because of the fluctuation of the variable
costs)
Strategic divisions --> if we have a division on which the price of the product really depends on the
quality, we want to assure that we buy from another internal division.
12.3.2 Cost-based + markup transfer prices
TRANSFER PRICE = COST + MARK-UP
One of the most used approaches is the one based on cost because we want to assure that the selling unit
has a markup. There are different configurations:
1) Full actual cost transfer prices
• Sum of the actual cost of all resources that are used in producing a good or delivering a service.
• Problem: Specific responsibilities of BUs --> the selling unit is in a very good position, while the
buying unit will have to absorb all the inefficacies of the selling unit as a cost. In order to
improve, the buying unit can only work on its variable costs (because it cannot negotiate the
price) --> this will affect the product. We want to avoid creating the situation where some BUs
have to absorb the inefficiencies of others.
2) Full standard cost transfer prices
• Budgeted costs of all resources that are going to be used in the long term.
• Problem: Decision-making, for the costs --> the budgets are prepared at the business unit level
and approved by the corporate. We need to be careful about what each BU has budgeted and
the real situation (we would like that the variance is close to 0)18.
• With respect to the actual cost policy, it reduces the inefficiencies in the BUs. It can lead to a
change in variable costs.
3) Marginal cost transfer prices
• Sum of variable costs (variable direct costs + variable indirect costs)
• Problem: decision-making, about not being sure that the markup will cover everything that we
need --> if the fixed costs are not very big, this is a very good option (ex. for the services).
The cost + markup methodology compared to the market one, leads to better communication between the
BUs and provides better results for the divisions. Problem: it is worst related to the efficiency to the
market because we are referencing to our own costs (and not to the market).
12.3.3 Negotiated transfer prices
Negotiated transfer prices: the divisions of a company are free to negotiate the transfer price between
themselves and then to decide whether to buy and sell internally or deal with outside parties.
Information related to market prices or marginal and full costs can inform the negotiation process.
Pros:
– Increased autonomy and decision-making
– Emphasis on adapting capability of business units
Cons:
– Decreased integration --> BUs are going to look on the market for outside solutions to maximize
their own EBITDA
– Depends on the culture of the company
12.3.4 Dual transfer prices
Under a dual transfer pricing scheme, the selling price received by the upstream division differs from the
purchase price paid by the downstream division.
Usually, the motivation for using dual transfer pricing is to allow the selling price to exceed the purchase
price, and the buying price to be the lowest possible, resulting in a corporate-level subsidy that encourages
the divisions to participate in the transfer. The objective is to maximize the EBITDA for both divisions. This is
used when quality of the final product is crucial and cannot be outsourced.
•
•
18
Pros: Increased integration --> best situation for both the selling and the buying units, we are sure
about the quality and conformity of the product at the end.
Cons: Possible sub-optimized decisions --> who is going to balance this difference? Corporate level
will absorb this inefficiency by having an extra-cost.
A positive variance analysis can cause problematics. For example, a higher request than expected may lead to
unsatisfaction by customers because we are not able to satisfy it.
For example (wood and paper):
o
o
For the selling division the TP = 110% of its full manufacturing cost (44 = 40*110%)
The buying division pays 95% of the external market price
N.B. The most used are the market-based transfer price and the cost + markup transfer price. Dual transfer
prices method is very rare, only used when we really want to have internal integration.
To sum up, which method should we use?
Even though the market is not the best solution, it leads to integration because we don’t have additional
costs for the management of the suppliers.
N.B: prices are negotiated between ranges given by the market.
Adaptability --> negotiated transfer prices allow a company to adapt to whatever is happening in the
market, and to execute at the best as possible. It will work for the companies where the product and the
component of the product are common (so many companies to buy from). It we are producing something
unique; it won’t work because, most likely, it will be difficult to find market price and we need to make sure
that BUs are working together to control the quality.
Dual Transfer Prices
12.4 Exercise
Group AERO is composed by the parent and three subsidiaries: A, B and C. A is the upstream company of
AERO that supplies and sells internally components to both B and C. AERO adopts a transfer pricing policy
based on FULL ACTUAL COST plus a mark-up of 10% on the full actual cost (for example if the unit full
actual cost of a product is 10€/unit, the transfer price is 11€/unit). The transfer price is calculated and then
charged internally every month. The calculation of the unit actual cost is composed of three items: (1) direct
materials; (2) direct labor; and (3) manufacturing overhead (OVH).
In January 2021, Subsidiary A has already produced 800 products using 1,500 machine-hours. At the end of
January 2021, on the same day, Subsidiary A receives two additional orders (“4” and “5”), whose
requirements are reported below:
While raw materials are available and workers are paid on an hourly basis without capacity constraints,
there is a constraint on the machine capacity. The maximum total machine capacity is 2,000 hours per
month.
1) Considering the transfer pricing policy adopted, which of the following sentence is correct?
a) For the Business Unit A, it is indifferent producing for B or C.
b) The best option for A is to produce 100 unit for B (order 4) and 350 unit for C (order 5)
c) Total revenues for the additional two orders for A are 20.143,75 €.
d) The best option for A is to produce 150 unit for B (order 4) and 275 unit for C (order 5)
SOLUTION
FULL ACTUAL COST plus a mark-up of 10% on the full actual cost
Beginning of 2021: A already produced 800 products using 1,500 machine-hours
New orders 2021: 150 units * 1.5h/unit + 350 units *1h/unit = 575 hours
Maximum total machine capacity is 2,000 hours per month < 1500 + 575 = 2075 h needed --> we do not
have enough capacity.
Full actual cost product for B = (15+13+11.25) €/unit = 39.25€/unit --> Transfer price B = 43.175€/unit
Full actual cost product for C = (15+13+7.5) €/unit = 35.5€/unit --> Transfer price C = 39.05€/unit
b) 350 units C --> 350 h --> 2000 – 1500 – 350 = 150h for C --> 150/1.5 = 100 units
100units * 43.175€/unit + 350 * 39.05€/unit = 17’985€
c) Wrong
d) 150units * 43.175€/unit + 275 * 39.05€/unit = 17’215€
2) Which of the following statements about transfer prices among business units that are part of the
same legal entity is TRUE?
1. Among the different options, DUAL transfer prices should be preferred
2. In the case of FULL ACTUAL cost-plus mark-up, inefficiencies of the upstream unit (the seller) do not
affect the downstream unit (the buyer), because they are absorbed as a corporate cost
3. Among the different options, FULL STANDARD cost-based plus mark-up transfer prices should be
preferred even if they need to be redefined very frequently
4. In case of an internal transaction among business units, there is no impact on the taxes incurred by
the corporation
1.
2.
3.
4.
No, because we don’t have information about having to maximize the integration.
No, the buyer unit is affected by the upstream inefficiency.
No, the costs do not have to be redefined very frequently.
YES, this is true because the BU are part of the same legal entity.
3) The introduction of a transfer pricing systems based on full standard cost + mark up:
A. Can have an effect of the taxes paid by the selling unit when the selling and the buying units are two
different legal entities.
B. Has always a fiscal effect on both the selling and the buying units.
C. Can have a fiscal effect on the buying unit, even if the selling and the buying units are not two different
legal entities.
D. Does not have a fiscal effect.
A.
B.
C.
D.
YES, transfer pricing has an effect when the BU are not part of the same legal entity.
No, if they are part of the same legal entity, there is no legal effect.
No, if they are part of the same legal entity, there is no legal effect.
No, it does have a fiscal effect
HOW TO RECOMMEND A TP:
You must focus your attention first on the product that is exchanged and on the capacity of the selling unit.
•
•
•
•
If the product is common and sold by many competitors + selling unit is at full capacity (The
upstream BU would not accept a TP lower than the price in the market and the downstream BU
would not accept a TP higher than the price in the market.) --> MARKET-BASED TP
If the selling unit has spare capacity --> MARGINAL COST TP
When the downstream BU is not able to cover the market price and it is strategic for the corporate
--> DUAL TP
Market-based TP should be preferred to full standard product cost plus mark-up TP when a market
price is available and is sufficiently homogeneous.
14/12/2022
13. Management reporting at the BU level: Cost Allocation
Business Units are PROFIT CENTERS.
They do not have the ability to make
investments decisions and their main
goal is to maximize the EBIT.
If they are strategic BU, they are
investment centers. They have the
ability to make decisions about the
investment strategy.
In our discussion, BUs are considered
as Profit Centers.
The backbone of the
reporting system at the BU
level are the ACCOUTINGBASED INDICATORS (slow
indicators).
It is also important to
consider specific value drivers
because profit centers need
to be able to make decisions
quickly.
13.1 Segment Margin
Today, we will talk about the SEGMENT MARGIN:
Segment Margin = revenues – direct costs
Example
This is another type of IS --> “IS by contribution margin”. This can be used only for internal accountability.
This is interesting because the intermediate result is the contribution margin --> very important for shortterm decisions. The maximization of the value in the short-term is the maximization of the contribution
margin.
Costs are classified in variable and fixed costs:
•
•
Variable costs are = DM + DL + manufacturing OVH (ex. energy)
Fixed costs are = non-manufacturing OVH (ex. rent)
Contribution margin = revenues – variable costs
Contribution margin per unit = price per unit – variable cost per unit
EBIT = contribution margin – fixed costs
® The IS by nature is interesting because it shows the EBITDA --> which is the first proxy of the cash
flow (even though it is not a very good approximation). It is used by small and medium enterprises.
Costs are classified according to their nature (labor, materials, D&A, rent, etc.).
® The IS by function is important for the budgeting process because we can see the specific
responsibilities of the different organizational units, in terms of the results and the level of used
resources. Also, in a benchmarking activity is more interesting to compare product costs and period
costs of different companies. Costs are classified in period and product costs.
Looking at this example --> the management is not happy because the ROS (EBIT/revenues) is very low,
close to 5%, so we
will probably have
problems covering
financial and fiscal
expenses.
Fixed costs are very
high --> they are a
proxy of risk.
What do we do?
SEGMENTATION: IDENTIFY THE RESULTS ACHIEVED BY THE BUs (or other type of segments).
Prepare contribution format segmented income statements first showing the total company broken down
between sales territories and then showing the Northern territory broken down by product line. Show both
Amount and Percent columns for the company in total and for each segment.
The company is divided into two sales territories: Northern and Southern. The Northern territory recorded
$300,000 in sales and $156,000 in variable expenses during June; the remaining sales and variable expenses were
recorded in the Southern territory.
Fixed expenses of $120,000 and $108,000 are traceable to the Northern and Southern territories, respectively.
The rest of the fixed expenses are common to the two territories.
Attention! Some fixed costs are TRACEABLE (direct costs), so we can directly assign them to a specific BU
(ex. specific market campaigns, specific R&D expenses, etc.). There are also fixed costs that are COMMON
(indirect costs) and are run at the corporate level --> how do we assign them to each BU?
N.B: the distinction between direct and indirect costs is due to a managerial decision made by the CFO.
Usually, only the relevant costs are traced.
At this point we have the SEGMENT MARGIN for each BU = REVENUES – DIRECT (variable + fixed) COSTS
and the CORPORATE COSTS, which are the common costs that still need to be allocated to the segments.
Comments: The
Northern Unit is not
selling enough and has
higher fixed expenses.
Looking at the segmentation per products of the Northern territory:
The company is the exclusive distributor for two products: Paks and Tibs. Sales of Paks and Tibs totalled
$50,000 and $250,000, respectively, in the Northern territory during June. Variable expenses are 22% of the
selling price for Paks and 58% for Tibs. Cost records show that $30,000 of the Northern territory’s fixed
expense are traceable to Paks and $40,000 to Tibs, with the remainder common to the two products.
Comments: the product
mix privilege the Tibs
product, which has a lower
contribution margin. Packs
has high fixed expenses.
The company should
increase the sales of the
Packs segment because
this product has a higher
contribution margin and
because we can better
spread the fixed costs.
The information provided is very poor: we are using only accounting-based indicators. We should also try to
add non-financial indicators like value drivers which could be important, for example, why the company
cannot increase the sales of Packs? Is it related to customer satisfaction, is it the quality, is it the delivery
time?
The segment margin is one of the most significant accounting-based indicators to report at the BU level
for 2 reasons:
1) To break down the problem and going more in detail to identify the reasons behind the variance.
2) Connected to the specific responsibilities: the segment margin tries to maximize the specific
responsibilities because the segment margin only considers the direct costs.
13.2 Corporate Costs
CORPORATE COSTS are costs run at the corporate level ON BEHALF OF THE BUs and typically these costs
are not traced.
Examples of Corporate Costs: R&D activities, legal activities, brand marketing campaigns, IT security,
finance costs, HR unit, etc.
Corporate costs can be:
•
DIRECT corporate Costs (i.e., Traceable) are those corporate costs that can be specifically and
exclusively identified with a particular BUSINESS UNIT.
Ex. If the R&D department carried out applied research on behalf of BUSINESS UNIT (A), the incurred
costs are DIRECT to BU(A).
•
INDIRECT Corporate Costs (i.e., Not Traceable) are those costs that cannot be identified specifically
and exclusively with a particular BUSINESS UNIT.
Ex. If the R&D department carried out basic research on behalf of the whole company, the incurred
costs are INDIRECT to the BUs.
When corporate costs are traced, there is no problem. The corporate costs allocation problem is for the
indirect corporate costs.
We have 3 strategies:
1) No allocation --> we are not allocating the indirect fixed expenses --> these costs will remain at the
corporate level
- PRO: very simple, no additional costs/time/resources needed for the allocation, appreciated by
managers because they will not have this cost.
- CON: managers will take these resources for free by not knowing this cost, the risk is to have an
uncontrolled use of resources.
- When it is used: when we cannot use the other 2 methods.
2) Complete allocation --> we allocate all the corporate costs.
- PRO: managers will be aware of these costs, and they should generate a profit able to cover
also these costs. They will also contain their demands
- CON: need to be precise (otherwise managers could be upset), risk of not using services even if
they are needed
- How to allocate: theoretically, we should do it accordingly to the services delivered (ex. n° of
marketing campaigns, n° of R&D projects) or accordingly to the benefits generated (very
difficult to measure the value generate by something). When this is not straightforward,
“default” drivers are used: revenues or full time equivalent (FTE) employees, because they are
a proxy of size, because the idea is that the bigger you are the more resources you consume.
- When to use this: we use proportionate allocation with a driver risk if the resources are not
much used, so we want to discourage their use.
3) Partial allocation --> we should use this method when it can be used.
- PRO: try to maximize the specific responsibilities, clear decision-making
- CON: it cannot be applied to all types of corporate costs. it can be used for finance office costs.
Example of allocation
•
•
capacity for internal consulting = 200 h
overall costs = 50,000 €
Two Business Units:
•
•
BU(A) = use of 100 h of the corporate Finance Office
BU(B) = use of 60 h of the corporate finance office
Total usage = 160h (80% of the available capacity) --> we must have spare capacity
COMPLETE ALLOCATION/PROPORTIONAL ALLOCATION/ACTUAL CONSUMPTION
•
•
•
Cost per hour = 50,000€ / 160h = 312.5€/h
Costs to BU(A) = 312.5€/h * 100h = 31,250€
Costs to BU(B) = 312.5€/h * 60h = 18,750€
Problem: we know the cost of the hour only at the end of the period.
PARTIAL ALLOCATION: fees
•
•
•
•
Cost per hour: 50000€/200hours = 250€/h --> we know the cost per hour before the consumption
Cost to BU(A) = 250€/h * 100h = 25’000€
Cost to BU(B) = 250€/h * 60h = 15’000€
Costs NOT allocated = 50’000 – 40’000 = 10’000€ --> these costs remain as corporate costs, because
the responsibility of the spare capacity is of the corporate level.
POLLEV
Which statement is correct?
A. Corporate Costs can be distinguished into three main groups: direct costs, indirect costs, and period
costs. --> no, it does not make sense
B. Corporate Costs can be allocated to Business Units using the following approaches: a market-based
approach or a cost-based approach; the cost-based approach can rely on either actual or standard
costs. --> no, these approaches are for transfer prices
C. A partial corporate cost allocation based on proportional allocation drivers allows to fairly allocate
costs related to spare capacity among the Business Units --> no, proportional approach is for a
complete allocation.
D. A partial corporate cost allocation based on fees should be preferred in the case of costs related to
spare capacity. --> YES
Which sets of indicators is MORE APPROPRIATE to measure the performance of an intra-company
manufacturing Business Unit?
A. EVA, NOPAT, n. of claims, time to market --> no, because the focus of the BU level is the EBIT.
NOPAT also considers taxes, which is not a responsibility of the middle line managers. They could
be relevant if the BU are SEPARATE LEGAL ENTITIES because in that case, they are responsible for
their taxes.
B. EBIT margin, FCFF, n. of claims, time to market --> no, because FCFF includes taxation.
C. FCFE, time to market, n. of claims, scrap rate --> no, because FCFE includes taxation and interests.
D. Time to market, delivery time, n. of claims, scrap rate --> YES, even though it is missing accountingbased indicators.
Which statement on reporting at the BU level is FALSE?
A. To isolate the performance of BUs within the company, two specific problems must be addressed:
the existence of intercompany exchanges and the presence of resources used by the BUs that are
managed at the corporate level.
B. To meet the "specific responsibility" requirement for reporting at the BU level, companies must
allocate all corporate costs to the BUs. --> this is false because the only way to meet the specific
responsibilities is to apply the partial allocation
C. The existence of intercompany exchanges has fiscal implications when the BUs, belonging to the
same group, are autonomous juridical entities located in different countries.
D. When using non-financial indicators at the BU level, it is convenient to identify indicators that
isolate specific responsibilities of each BU.
14. Reporting at the Responsibility Centers level
The topic is
reporting at the
responsibility
centers level, so at
the single
organizational
units’ level.
We will see
revenues centers,
cost centers and
expense centers.
As seen before, the backbone of the reporting system at this level are the value drivers (non-financial
indicators: performance drivers, key risk indicators, resource drivers, etc.). We select the most relevant
value drivers for each center. This is the theory.
However, typically in companies, reporting at this level is based on accounting-based indicators.
14.1 Indicators for Responsibility Centers
•
•
•
Revenues centers: the main goal is to maximize revenues.
Cost centers: the main goal is to minimize the product costs.
Expenditure centers: the main goal is to minimize the period costs.
These goals are not coherent with the cybernetic approach: the goals of these centers should be to
meet the targets, not to overperform. Going beyond the target could be problematic.
Expenditure centers: they have power over costs which are not connected to the volume of activity (period
costs). We budget them using the Zero-based approach or an incremental approach. The traditional
reporting is not applicable --> we cannot apply the theory about the variation of the volume and efficacy.
We do an analysis line by line --> no capability to provide additional information to explain what happened.
Example
The 1st step is to measure the variance (actual – target), the 2nd step is to understand the reasons behind
the variance. In responsibility centers, the focus is on the 2nd loop and on the budgeting process.
Cost Behavior: Variable vs Fixed Costs
•
Knowledge of how costs will vary with different levels of activity/volume is essential for decisionmaking / reporting
•
Costs can be classified in two broad categories:
– Variable costs: vary in DIRECT PROPORTION to the volume of activity. Thus, the total variable costs
are linear, and the variable cost per unit is constant (examples: direct materials, direct labor, sales
commissions).
– Fixed costs: remain constant over wide ranges of activity for a specified period. The total fixed costs
are constant for all levels of activity, whereas fixed costs per unit decrease proportionally with the
level of activity (examples: depreciation of machines, supervisors’ salaries, rent of office space)
Cost-Volume-Profit Analysis Diagram
The concept of FC and VC is valid
only in a specific (and small,
typically a variation of 30%) range
of variation of the volume of
activity/sales.
When we increase the volume of
sales, we need to increase the n°
of employees, of equipment, etc.
Also, there are economies of
scale.
So, this is a theoretical
representation.
The point in which REVENUES = TOTAL COST --> EBIT = 0 is called BREAK EVEN. In corporate finance, we use
the term “payback time”.
What happened in the example? Why the actual EBIT > budgeted EBIT?
There is an increase in the volume of sales --> more REVENUES, more VC, FC stays the same --> more
CONTRIBUTION MARGIN --> EBIT increases.
The EBIT line starts in – FC because when sales are 0, VC are 0. Then the EBIT increases with the
contribution margin.
EBIT flexible = it is the expected value of the EBIT once we know the real value of sales. If we run again the
budgeting process and we know the actual volume of sales, we will get the EBIT flexible. This is important!
•
Budget EBIT – Flexible EBIT = variation due to the variation of the volume --> the reason behind
this variation of the EBIT is simply the increase in the sales.
•
Actual EBIT – Flexible EBIT = variation due to the variation of the efficiency of the company -->
why the actual EBIT is not on the line of the EBIT? This means that our budgeting process is not able
to predict the real number. This means that something happened that led to a change in our
efficiency. This is the interesting number for the CFO --> we need to understand what happened to
improve the budgeting process.
14.2 Short case about a Cost Center
Variations: revenues, VC,
use of DM, use of DL,
manufacturing OVH.
The theory tells us that we
have to minimize the
costs.
We eliminate the line of
the period costs because
the cost center manager is
not responsible for those.
Is this a bad result? No,
because it is normal that
when we produce more,
we need more resources.
We need to introduce the FLEXIBLE BUDGET, substituting the budget sales to the actual sales.
Now we can look at the differences:
•
•
The difference between FLEXIBLE BUDGET and BUDGET is due to ΔVOLUME that is not
responsibility of cost centers. This variation is not relevant because the volume of production is
not responsibility of cost centers.
The difference between ACTUAL and FLEXIBLE BUDGET is due to ΔEFFICIENCY that is responsibility
of cost centers.
o Good performances on the cost of material (why?) and the plant overhead
o Bad performance on the cost of labor --> why?
Now we need to understand the reasons behind this:
Since the volume is the same for the calculation of the cost
of materials/labor both in the case of the flexible budget
and of the actual case --> the change is the unitary cost of
materials/labor.
As we have seen, the unitary cost of materials/labor is =
Kg/unit * €/kg or h/unit * €/h
So, the variation is due to either the variation of the usage
(Kg/unit or h/unit) or the price (€/kg or €/h) or a combination
of the 2.
We need to generate another FLEXIBLE BUDGET to disentangle the variation due to the variation of the usage
and the variation due to the variation of the price.
We have the following values:
To calculate the FLEXIBLE BUDGET per unit, we need to multiply the actual usage and the standard price.
This is because the usage is responsibility of the responsibility centers, while the price is not.
•
The difference between FLEXIBLE BUDGET (budgeted use per unit) and FLEXIBLE BUDGET is due to
ΔUSE that is responsibility of cost centers. If we look at the difference, the operations manager has
been able to reduce the usage of materials per unit (good performance).
•
The difference between ACTUAL and FLEXIBLE BUDGET (budgeted use per unit) is due to ΔPRICE
that is NOT responsibility of cost centers. If we look at the difference, the actual number is higher
because this means that the price per unit has increased --> but this is not responsibility of the
operations manager (it depends on the procurement manager).
To sum up, THE ONLY VARIANCE WHICH IS A RESPONSIBILITY OF THE COST CENTERS IS THE VARIANCE OF
THE USAGE.
® The variation of the volume is responsibility of the sales manager
® The variation of the price is responsibility of the procurement manager
® The variation of the cost of labor is responsibility of the HR unit.
We need to integrate this information with value drivers to be able to implement feedback.
The variance analysis follows an hierarchical approach:
® I level: Total variance
® II level: Volume variance and Efficiency variance
® III level: Use, Price/cost
At each level we introduce a device for dividing different contribution to the total variance, an intermediate
budget called: flexible budgets --> they are a combination of actual and budgeted figures.