i
Copyright © 2020 Justin Spencer-Young
All rights reserved.
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Dedicated to my father, Russell, who gave me the gift of an enquiring
mind and the drive to be better. My dad always believed in me and
showed up every time I needed him. He gave me the fight to play hard
and the humility to play fair.
Thanks Dad.
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Self-Published – Justin Spencer-Young
Kinross Rd
Dainfern North
Johannesburg
All rights reserved
Copyright © 2020 Spencer-Young & Associates
No part of this book may be reproduced or transmitted in any form or by
any electric or mechanical means, including photocopying and recording,
without the written permission of the author.
First edition – October 2020
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Table of Contents
Foreword ............................................................................................................. 1
Acknowledgements ............................................................................................. 3
Introduction ......................................................................................................... 4
Why I Wrote This Book?.................................................................................. 4
Are There Really Secrets? ............................................................................... 6
Who Is This Book For? ..................................................................................... 8
What Will You Get from This Book? ............................................................... 9
The Cycle of Business ........................................................................................ 11
Capital ................................................................................................................ 15
Equity Capital................................................................................................. 15
Debt Capital ................................................................................................... 17
Characteristics of Capital .............................................................................. 19
Capital on the Balance Sheet ........................................................................ 20
Operations on the Balance Sheet ................................................................. 23
The Difference Between the Accounting View and the Finance View of
Business ......................................................................................................... 26
What is Your Work Address? ........................................................................ 29
Profitability ........................................................................................................ 31
Income Statement Basics .............................................................................. 31
What is Your Street Address? ....................................................................... 32
Operations and Capital Streets ..................................................................... 33
Income Statement Gymnastics ..................................................................... 34
Operating Leverage ....................................................................................... 42
Accounting for Gill’s Bookshop ......................................................................... 47
Getting Ready to Start Trading ..................................................................... 47
The First Year of Trade .................................................................................. 49
The Difference Between Profit and Cash ..................................................... 53
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Growth ............................................................................................................... 57
Sustainable and Actual Growth Rates .......................................................... 59
Measuring Performance.................................................................................... 61
Performance of the Operations .................................................................... 61
Weighted Average Cost of Capital ................................................................ 65
The Return on Equity..................................................................................... 67
Managing ROE is Like Herding Cats .............................................................. 71
The Lighter Than Air Balance Sheet .............................................................. 73
How Much Profit is Enough? ......................................................................... 74
Value Creation Dressed in a New Suit .......................................................... 75
The Application of Value Creation .................................................................... 78
Shoprite Holdings (SHP) ................................................................................ 78
Pick ‘n Pay (PIK) ............................................................................................. 82
Woolworths (WHL) ........................................................................................ 84
Clicks (CLS) ..................................................................................................... 86
Summary of Secrets .......................................................................................... 88
References ......................................................................................................... 90
Complimentary Resources ................................................................................ 91
Finance on Steroids ....................................................................................... 91
Company Value on Excel Steroids................................................................. 92
Online Business Simulation........................................................................... 93
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Foreword
If the quality of our relationships affects the quality of our thinking, then it
behooves us to know a little about the author of a book that has the potential
to alter how we see the world. Whilst the subject matter of this book is largely
about financial value, it is underpinned by the author’s personal values. It is
therefore both a privilege and honor to write this foreword for Justin, above all,
a man of value.
I first noticed Justin when he said a few words of thanks and goodbye on behalf
of his MBA class of 2003. Appropriately these words were aimed at Professor
Mike Ward his finance lecturer and my boss at Wits Business School. Whilst
Justin’s words escape my memory, it is the sincerity with which he spoke that
remain with me. I expect you will have a similar experience with the words in
this book. Turn them over and you will find sincerity and a sound foundation.
Value is a word full of opportunity and optimism. Justin has taught me how
value can be measured, evaluated, and created. I invite you to engage with this
book and the author with the widest possible lens.
For the past two decades Justin has searched for the intersection where
organizational value is created. Do not be surprised if the mystery of finance is
resolved as you work through the secrets of finance. Justin’s gift is the ability to
debunk and demystify the accounting constructs and complications of finance.
His talent is to simplify on the one hand whilst also encouraging a more complex
engagement with the topic. Allow me to draw on an analogy to explain this
phenomenon: Justin is an above average golfer and as I have stood alongside
him on many golf courses I have observed his grasp of the swing mechanics and
fundamentals but more importantly I have seen how he overcomes the
1
constraints of these swing ‘laws’. He frees his mind to imagine, envision and feel
the weight and subtle breaks that will impact on the underlying fundamentals.
This is the kind of author we need. One that can build a foundation without
limiting the possible.
It is no surprise then that Justin positions himself as a builder at heart. This book
will help you build a strong financial foundation; one on which future value can
be created.
Sean Temlett
BA, MBA (Wits), Gapologist
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Acknowledgements
My finance learning journey stared when Max Mackenzie shared with me the most unaccounting way of looking at a balance sheet. Max drew it on the lecture room black
board early on in my MBA studies. It was as if a light bulb went on for me and suddenly,
I could see. From that moment on the world of finance opened for me and I knew that I
would find a new career in finance.
Later in my learning journey Chris Muller revealed the world of Monte-Carlo simulations,
delta hedging, and real option theory amongst other exciting finance concepts that
stoked the flames of interest in finance. Since then I have had the privilege of spending
many hours with Chris, both in the classroom and at his home where he has taught me
more that I could ever imagine. The most valuable teaching asset that I could ever have
is a database of historical financial data of many listed companies. Chris is the source of
this data…it is priceless. Thank you, Chris.
My good friend Sean Temlett has spent many hours in the classroom with me on
assignments for corporate clients. Sean always inspired me to be better in my delivery
and to raise my game. We spent many hours discussing how to deliver our message more
efficiently. Sean always had the best ideas, and I am way better as a finance teacher
because of what I have learnt from Sean.
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Introduction
Why I Wrote This Book?
There are more than enough textbooks on this subject matter. By this subject matter I
mean the subject of accounting, business finance, business performance, value creation,
finance for non-financial managers, you name it. These are all books that are written
with the intent of helping non-accountants understand the world of accounting.
I have been learning and teaching business finance for two decades. I have used many
textbooks as part of my courses. Every time I use them, I think to myself, “this will do, it
kind of ticks the boxes”. I still have not found the ideal textbook that is written with the
intent to teach non- financial professionals and managers about business performance.
Since the ideal book on this subject does not exist, or at least I have not found it yet, I
decided to write it. I decided to write this book based on the material that I use and the
process that I follow in my teaching. That means that this book is intended to fulfil two
functions. One is to be an educational read about business finance and the second, to
be a comprehensive set of course notes for a subject that I teach daily.
You will see very quickly that the way that I teach this subject is nothing like how it is
laid out in your average business finance book, hence my need for this book.
It is important to point out that I am not an accountant. I am simply a builder. My career
started as a project manager in the commercial construction industry. I came to the
world of business finance after realising that as a builder, with an undergraduate degree
in BSc Building, I knew nothing about accounting and finance. I wanted to change that.
After 7 years in the construction industry I gave up my job and went back to university
full time to get a master’s degree. On my second round through university, this time a
business school, I discovered my love for the subject of finance. I also discovered that
the subject of business finance is hugely over-complicated by accountants.
Over the last 10 years of teaching the subject of business finance almost every day, I
have worked out how to deliver the learning that non-accountants need. How do I know
what they need? I ask them, and those that know what they need, tell me. They need to
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understand business performance so that they can manage a business better. They also
tell me that accountants and the information that they provide are not conducive to
doing this. Mostly because the information needs to be decoded from accounting-speak
into a language that non-accountants can easily understand. I call that the language of
business.
Here is a short story that will give some colour to what I am talking about. Several years
ago, I was consulting for a large, well known, JSE listed corporate in South Africa. I was
working with the company on several investment deals in the small medium enterprise
(SME) sector. Whilst meeting with the chief financial officer and several other board
members of the listed company, a question came up. The question was about how an
investment in an SME would be consolidated and reported on the balance sheet of the
listed corporate. The chief financial officer (CFO), who was of course an accountant, did
not know the answer and was hesitant to decide about the way forward before getting
clarity. During the meeting he phoned the managing partner of the audit firm to get an
opinion. The two accountants had a conversation and were not able to reach consensus.
Apparently, the managing partner had to ask another accountant who was a specialist
in the area. The result is not important. What I want to point out is that even a collection
of accountants need help to understand the rules of the game that they have written.
The meeting was abandoned because the accountants could not decide at that time.
The accounting function in a business fulfils two major functions. The first is compliance.
This includes verification of accuracy and truth. The second is to provide information so
that business performance can be measured and used in decision making. All those
textbooks that are “not ideal” and do not really do the job are trying to cover the detail
of both functions. They end up doing a poor job of both. The intention of this book is to
cover business performance only.
This book is written such that it covers both simple and complex subjects of business
performance. If this is the first time that you are venturing into this world then you will
find the basics of business performance here. If you have some experience of accounting
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and business finance then you too will find something that will make you sit up and
think…” oh wow, I never saw it like that”.
Managing expectations when it comes to learning business finance is important. There
is a big difference between knowing your ABCs and being able to understand a
Shakespeare classic. Naturally, one needs to develop skills over time. This takes practise
and may require one to cover certain material several times before the nuances can be
fully internalised. As you start reading this book be aware of where you are on your
business finance learning journey. Are you just starting out with the ABCs? Or are you
looking for the Shakespeare classic? This book contains both. The book starts out slow
with the basics and then ramps up as it progresses. A word of caution, there are some
insights in the basics that are important when it comes to the more complex material
later.
Over many years of teaching business finance I have found that in one class there can
be a broad range of accounting capabilities. Extraordinarily little at one end and a
qualified accountant at the other. My teaching has evolved over the years so that I
deliver ABCs and Shakespeare in the same class. This book is written in the same way. I
am sure that you will find what you are looking for here.
Are There Really Secrets?
The subject of business finance has been written about extensively, of course there are
no secrets! However, the subject matter is known to just a few people and is continually
made to be more complicated. There might as well be secrets that are kept from many
people.
Ask yourself this…when looking at the qualifications of those who make up most of the
c-suite, what is the common denominator? You will notice that generally the CEO and
CFO of most substantial businesses have an accounting qualification. They are the
holders of the secrets. Although accountants would strongly disagree that there is
anything secretive about their profession. The use of the word “secrets” is used to
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suggest that the knowledge is held by some and not others. This is not solely the fault of
accountants but rather of an outcome of education systems.
Accountants are trained in a way that they get exposure to all corners of a business and
are required to process every transaction in the book of accounts. Through this training
a natural outcome is a holistic understanding of business. So, the fact that accountants
often make up most of the c-suite is not unusual. This is not a problem. The problem is
that those who are not accountants, the vast majority of employees in business, have
little or no idea or understanding of the financial metrics of a business. Poor education
and complexity are a high barrier to entry. Typically, only a university degree gets you
access to the business world of accounting and finance.
It is well known that in South Africa the math education has been poor for a large
majority of people. This continues today. The result of this poor education is that for
those who do not become accountants, there is extraordinarily little financial education
and understanding in business. So many people are financially illiterate, both in terms
of personal finance and business finance.
I am on a mission to change this.
I was once one of those people who had little to no financial education, despite having
an undergraduate degree. I did a Bsc (Building Science) and came out of university with
almost no training in business finance. I did do Accounting 1 and Accounting 2 as part of
my undergraduate degree. However, I did these courses with the full-time accounting
students. They wanted to be accountants and I wanted to be a builder. I was not really
interested in debits and credits. I was more interested in bricks and cement. My youth
and lack of understanding of the importance of accounting meant that I did just enough
to scrape by. Only later in life did I come to understand the importance of business
finance. Part of the problem was also the way in which the accounting course was
taught. Third year accounting students taught the course, and the learning process was
about following the Generally Accepted Accounting Principles (GAAP) textbook. There
was no context on how GAAP and business were related. A sterile GAAP explanation by
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a third-year student was not going to get this wannabe builder inspired to understand
business finance.
Years later I see the missed opportunity. But I was not ready to learn about business
finance until much later in life.
My mission is to make financial education more accessible. To obtain a financial
education there are generally only two paths. One path is to go to university and study
accounting. The second path is the route that I followed. That is to go to business school
and focus on a financial path of learning. This is a less direct route as it normally follows
an undergraduate degree in an unrelated field. Both routes require a significant
commitment of time and money, which are barriers to attaining a financial education.
This book is one step of many in my mission to educate people about money, business
performance and value creation. An important component of my mission is to make
access to financial education easy and affordable.
Please join me on my mission to provide financial education to more people. You can
start by educating yourself. This book is a great place to begin.
Who Is This Book For?
This book is really for those who fit into the category of a non-accountant. That is not to
say that there is no value here for accountants and financial professionals.
The reason I say non-accountants is because my intention in this book is not to turn you
into an accountant. Rather, to share insights and as I call them “secrets” about how to
analyse and interpret financial information. Then, to enable you to use this information
to make better management decisions and investments.
The style and philosophy of my approach is quite un-accounting. That is why many
students who have come through my classroom over the years have told me how much
they have learnt from my process.
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I often have accountants tell me that they were able to gain a whole new perspective on
business performance after attending my business finance classes.
Here is a list of problems that you may want to overcome as far as financial knowledge
is concerned. If any of the items on this list resonates with you, then this book is for you.
1.
You feel like the accountant in your business is speaking a foreign language.
2.
You rarely understand the information that accountants give you.
3.
You want to understand business performance better.
4.
You want to understand the levers that drive business performance.
5.
You want to find out if your business is creating or destroying value.
6.
You want to find value-creating businesses to invest in.
7.
You want to make better business decisions using financial data.
8.
You want to understand how all the silos (HR, marketing, operations, IT, etc.)
of business link together.
9.
You want to understand business growth.
10. You want to understand investor expectations.
What Will You Get from This Book?
You will learn a practical way to understand business performance. Most importantly,
you will learn how to interpret financial information. The perspective taken in this book
is a business perspective rather than an accounting perspective. At this stage you may
not know what the difference is.
I like to use the analogy of looking at business through different lenses. The accounting
lens gives one perspective. The business lens gives another.
One of my favourite hobbies is flyfishing. If you have ever stood on the side of a stream
and tried to look into the water to spot the fish, then you will know that the reflection
of light on the water makes this very difficult. When you put on a pair of polaroid lenses
it is as if the reflection disappears completely. You can see deep into the water and
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finding the fish is much easier. I hope that this book will act as a pair of polaroid lenses
that helps you to see into businesses more clearly.
To continue the fishing analogy, a different perspective from polaroid lenses makes a
difference. However, there are also certain skills required to spot fish in the water. In
the context of accounting and busines performance, learning and knowledge is best
gained through application and practise. There is a reason why accountants spend years
doing company audits. This is the practise part of their learning.
The challenge with simply reading a book is that the practise is often omitted. To
overcome the lack of practise this book contains the analysis of several listed companies.
In the analysis of these business we will use the tools and frameworks that are outlined
in the book.
I will show you how financial data can reveal tremendous secrets if you know what to
look for.
This book will elevate your knowledge of business performance and value creation to a
level that 90% of employees do not have. But ultimately the following statement will be
true:
“If you are not willing to learn,
no one can help you.
If you are determined to learn,
no one can stop you.”
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The Cycle of Business
Several years ago, I read a book called “The Origin of Wealth” by Eric Bienhocker.
Amongst the many words of wisdom in his book, this quote stood out for me the most:
“The objectives of every business are
to endure and grow”
The complexity and simplicity of this statement fascinates me. When I think of the word
“endure”, I think of sustainability, survival, living to fight another day, resilience, and
overcoming tough times. You may think of even more. But the reality is that a business
cannot endure if it is not profitable or at least have the prospect of becoming profitable
soon. But profits are not enough. A business must produce cashflow. Understanding the
difference between profit and cashflow is particularly important. I am amazed how often
I come across well educated people who just assume that what the profit is in the income
statement is what is in the bank account. I will cover more on the difference between
profit and cashflow later.
The word “grow” can mean so many different things. It generally means more of
something. More revenue, more profits, more assets, more customers, more employees
and as the cynic might say, more problems. Growth seems like such a natural endeavour.
We grow as human beings and when we stop growing, we start dying. The same can be
said for business.
Inspired by Erik Bienhocker’s endure and grow, the following diagram represents the
“Cycle of Business”.
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Profit
Value
Growth
Capital
Cycle of Business
Think of the Cycle of Business as a train track on the floor of a kids bedroom. Profit,
growth, capital, and value are the stations. The arrows are the train tracks connecting
the stations. Let’s start with profit. That is the number one priority of any business. The
simplest definition of profit is to earn income (sales from a customer) that is higher than
the expense of generating that income (cost of manufacture and overheads).
Unfortunately, there is a lot more to consider when talking profit. Short term
opportunistic profit versus long term sustainable profit are two vastly different
concepts. Erik Bienhocker’s endure and grow cycle is based on long term sustainable
profit. Long term sustainable profit requires a business to consider several broader
elements such as:
•
Will the customer return to buy again?
•
Can the business sustain the quality and service at higher volumes?
•
Can the suppliers continue to meet the demand for raw materials?
•
Will capacity constraints impact on profitability?
•
Are enough human capital skills available to meet the demand requirements?
•
Is the business environment conducive to retaining human talent?
•
What capital requirements are needed to grow the profitability of the business?
Today, the pursuit of profit is demonised by many. Mostly by those who don’t fully
understand the nuances that are behind the numbers in the income statement. The
pursuit of profit is an ongoing trade-off to balance the needs of many stakeholders. But
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ultimately all these stakeholders come second let’s the those who risk their capital. That
being the shareholders.
More on profitability to come later…for now, to progress to the next step in the endure
and grow cycle. Let’s assume that we are considering a business that is profitable.
Once we have a track record and we are making profits there is pressure from
shareholders to make more profits. This is the winner’s curse. No good deed goes
unpunished. The better you perform, the greater the expectations. Thus, we find
ourselves moving onto GROWTH to meet these demands for more. Growth requires
capital.
Capital comes from two sources - equity and debt. Equity is money from shareholders
and debt is money from banks. Capital comes at a cost. Shareholders have an
expectation of a return and so do banks. The “contract” on how the business provides
those returns to shareholders and banks is different. But the expectation of a return is
still there. These expectations of return are loosely referred to as the cost of capital. We
will explore the relative cost of capital at a later stage.
The next station on our cycle of business is the VALUE station. The business objective is
to provide returns to the capital providers that are greater than the cost of capital. This
principle of a business producing returns that are greater than the cost of capital is what
it means for a business to create value.
Returns
>
Cost Of Capital
The concept of returns needing to be greater that the cost of capital is not a perspective
that is taken by accountants. Accountants are primarily concerned with the compliance
of reporting historical data. As I said before, this book is not about compliance with
reporting standards. The philosophy of this book is about business performance and
value creation. This philosophy requires us to view a business through a different lens
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than that of an accountant. The principal of returns needing to be greater than the cost
of capital is the cornerstone of this philosophy.
On the surface the cycle of business looks quite simple. However, underneath the
simplicity is a complex set of interactions between the different components. The capital
structure influences the profitability. More debt creates interest expenses that reduce
profits. The profitability impacts the ability of a business to grow. A more profitable
business produces internal equity capital for growth. The profitability and capital
structure determine the ability to create value. This web of cross influence gets
complicated. The purpose of this book is to reveal how this web can be interpreted and
translated into business performance.
Profit
Value
Growth
Capital
This brief explanation of the “Cycle of Business” started with PROFIT, then went on to
GROWTH, CAPITAL and VALUE. That is the framework that many business finance books
follow. In this book we are going to start with CAPITAL. That is after all the source of all
businesses.
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Capital
Equity Capital
Capital by the simplest definition is money. A capitalist is someone who has money and
wants to put that money to work to earn a return. Just as a farmer might put a horse to
work to plough a field. The return is a field ready for planting. Providers of capital
typically have descriptors of investor, shareholder, partner, and others. We will use the
term shareholder.
We cannot really discuss capital without discussing risk. Each shareholder has their own
appetite for risk. Risk is often seen as the downside if the investment does not work out.
However, risk is the double-edged sword of the probability of reward or loss. Capitalists
seek a return in exchange for taking risk and providing capital. A capitalist will balance
the expectations of return based on the amount of risk he/she is prepared to take on.
Hence, the well know saying of higher risk requires a higher return. But of course, higher
risk also means potential for higher loss.
The most well-known academic model that relates to capital and risk is the Capital Asset
Pricing Model otherwise known as CAPM. This model attempts to quantify risk and
return for equity investors. Despite the CAPMs ubiquity of use there is a significant
amount of research that highlights its shortcomings. We are not going to explore the
CAPM or its shortcomings in this book. The References section contain articles that
document this well.
Several years ago, I discovered that empirical market data is the best source of
information about what shareholders expect as a return. Empirical data is useful in that
it can be used to describe the risk that relates to an investment. Unfortunately, empirical
data is always historic and only describes what happened. We need to know how to use
this data to forecast what might happen in the future.
The following graph (on the next page) uses empirical data to show the historic returns
of the All Share Index (ALSI). The timeline for this data is forty years (1980 – 2020). The
15
interesting story in the data is that it includes many different socio-political events. The
nature of the economy that it describes has changed immensely over the timeline.
Chart 1: ALSI Returns Chart 1980 - 2020
In the 1980’s the South African economy had a strong mining bias. Today the economy
has a bias towards financial and industrial services. The data includes the darkest days
of Apartheid. It includes the transition to an open economy in the mid 1990’s. There are
several major events that caused significant market corrections. These events often had
their source in international markets and here in South Africa we suffered from the
secondary fall out. More recently, however, we appear to be creating our own ball and
chain. The ALSI indicates the recession that South Africa has been in for the last five
years. While the technical definition of a recession is two quarters of negative GDP
growth, the sideways movement of the ALSI is telling a story about the state of the South
African economy.
Chart 1 above represents share price returns using the natural log (Ln) of the change in
share price from one month to the next. One can see from the chart that there is a strong
upward trend in the data. We use empirical data to calculate the cumulative average
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growth rate (CAGR) of the returns. Over the last 40 years the CAGR of the share price
returns is 15.5%. Add to this the average annual dividend yield of 2.5% and we end up
with a total return CAGR of 18% per annum.
There are 388 companies listed on the JSE at the time of writing. The ALSI consists of
approximately 160 companies measured and ranked by market capitalisation, which is
share price multiplied by issued shares. These 160 companies represent 99% of the value
of the whole JSE market.
CAGR of the historical returns of the JSE ALSI are used as a proxy for future returns.
Investors can use this information as a benchmark against which to measure other
investments.
It is important to recognise that the CAGR of 18% per annum is an average across all
companies that are part of the ALSI. Different sectors like mining, retail,
telecommunications, etc. will have their own CAGR based on the data for those sectors.
Using the 18% CAGR of the ALSI, investors can use this as a benchmark for other
investments. One might call the 18% CAGR a “high water mark” and aim to achieve
returns above that level in exchange for the risk of investing. This is the source of equity
capital for a business.
Debt Capital
The other source of capital for a business is debt. Debt has quite different characteristics
to equity. Debt providers (banks) are not in the business of taking risk in the way that
equity providers are. Debt providers require surety to protect themselves from loss. In
exchange for taking less risk, banks accept a lower return for the capital that they
provide to businesses.
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Chart 2: Repo and Prime Rates 2004 – 2020
The REPO rate is the rate that the South African Reserve Bank lends to the commercial
banks. The commercial banks add 3.5% and the result is the PRIME lending rate that is
advertised to customers. Banks then assess each customer based on their criteria to
offer a lending rate that may be higher or lower than the Prime rate.
At the time of writing, the Repo and Prime rates shown in the chart at 3.5% and 7%
respectively are uncharacteristically low. The average long-term prime rate in South
Africa is approximately 10% per annum.
There is a significant difference between personal debt and business debt. The
difference is primarily based on when tax is paid.
In our personal capacity, as an employee of a business we must pay taxes before we pay
any of our personal expenses, including interest expenses. The actual payment of the
taxes is largely the responsibility of the employer to pay it on behalf of the employee.
In a business, taxes are paid after expenses are deducted from income. Specifically,
interest expenses are paid before taxes are paid. This means that if a business increases
18
its debt on the balance sheet it will have the effect of reducing the profit in the income
statement due to the increase in the interest expense. The reduction in profit will reduce
the tax. This is referred to in business as the tax shield. The tax shield creates a tax
incentive for business to borrow money.
The ability to borrow money, because it has a tax incentive, is restricted by the fact that
debt adds risk and reduces profits. This means some debt is beneficial, too much is
deadly.
Characteristics of Capital
We can now compare the cost of debt with the expectation of return that shareholders
have. We loosely call the shareholders expectation of return – “cost of equity”.
Cost of Debt
10%
Cost of Equity
18%
Since equity costs 18% per annum and debt costs 10% per annum (before we consider
the tax effect), we can see that debt is cheaper than equity. There are many more
characteristics than cost, but cost is probably the most important when it comes to
comparing the two sources of capital.
The Comparative Characteristics of Debt and Equity
Characteristics
Debt
Equity
Cost
10% (South Africa)
18% (South Africa)
Tax deductible
Yes
No
Source of return
Interest
Dividend/share price growth
Participation
Contractual
Vote at AGM
Risk
Capital repayment
Share price / bankruptcy
Time
Defined
Undefined
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How a company uses capital is largely driven by where it is in its life cycle. Typically, new
start-up businesses are confined to the use of equity. This is mostly because banks are
not in the business of taking risk on start-up businesses unless a shareholder signs surety
with a bank for the debt.
In an expansion phase of a growing business, the use of debt is quite common. Especially
if the business has developed a track record of profitability and positive cash flows. We
will cover various ratios that are used to measure the proportions of debt and equity in
the business. For now, we are still exploring the mechanics of using different sources of
capital.
Capital on the Balance Sheet
Let us look at how these sources of capital may be represented on a balance sheet. The
series of diagrams that follow represent how the balance sheet of a business might
evolve from the start of a business to a more mature phase of development.
Equity
Cash
Uses of
Capital
Sources of
Capital
Basic Balance Sheet 1
This balance beam is the simplest and most visual way to show how capital is
represented in a business. The shareholder provides equity to the business by way of
buying ordinary shares. This is facilitated by a cash transaction between the shareholder
and the business where the shareholder transfers the cash to the business. Thus, we
20
represent the source of the capital on the one side of the balance beam and the use of
the capital on the other side of the balance beam. The term, “sources and uses of
capital” is common when referring to the balance sheet.
The next step in representing the use of capital on a balance sheet would be to add the
debt component. That would look as follows:
Equity
Cash
Debt
Sources of
Capital
Uses of
Capital
Basic Balance Sheet 2
In this representation the business is using a combination of debt and equity to fund the
business. For now, the capital is simply sitting in cash. The intention is to put the cash to
work by investing it in productive assets. It is important to notice that the height of the
towers on each side of the balance beam are the same, suggesting the balance beam is
in a state of balance. Therefore, Sources of Capital = Use of Capital.
At this stage it is important to highlight the relative costs of capital. The shareholders
have an expectation of return of 18%. Remember the ALSI graph. This is based on
empirical data of a portfolio of shares on the JSE over the last 40 years. The bank has an
expectation of receiving interest on the debt that it lends to a business. The bank’s
expectation is around 10% based on a long-term average of the cost of debt in South
21
Africa. Combining the cost of equity and the cost of debt in the proportion that these
sources are used in business produces a weighted average cost of capital (WACC).
If we simply put these two expectations together and assume that half the capital is
equity and half is debt, we would get a weighted average cost of capital of 14%. [(18% +
10%)/2]. This is a simplistic view of the cost of capital. However, at this stage it is useful
to plant the seed about the cost of capital. We will expand on it later.
Equity
18%
Cash
Debt
10%
Ave 14%
Cost of Capital Balance Sheet 3
The capital providers (shareholders and bank) have a combined expectation of return of
14% per annum. We loosely refer to this as the cost of capital. The business has a
responsibility to provide a return to the shareholders and the bank that at least meets
their expectations. How would the business go about doing this? Simply, the business
must put the cash to work. Putting the cash to work means investing it in some
productive way that it can generate returns. Leaving the cash in the bank might generate
a return of 5% per annum from a money market account. The problem is that 5% is not
enough to meet the expectations of the capital providers. After all, the capital providers
could simply keep their cash in a bank and get the 5% return without having to invest it
in the business. The business must put the cash to work in a way that it generates a
return that is higher than the average cost of capital of 14%. This is the basic principle of
22
value creation. Generating returns that are higher than the cost of capital. This is what
is meant by “VALUE” in the business cycle.
Profit
Value
Growth
Capital
Operations on the Balance Sheet
The next step is to put the cash to work. A business could do so by investing in productive
assets. For now, we will assume that this business is a manufacturing business. The next
iteration of the development of the balance sheet would see the cash being turned into
fixed assets or as many accountants still call it…PP&E (property, plant, and equipment).
Equity
Fixed
Assets
Debt
Cash
Capital
Operations
Operations Balance Sheet 4
23
After acquiring the fixed assets, the business may be ready to start producing products
for sale to customers. The business must buy raw materials from a supplier and produce
finished goods for sale. This would cause further developments in the balance sheet. Let
us assume that the business can buy raw materials on credit from a supplier. This would
create a current liability in the form of a creditor or accounts payable. If we also assume
that the business sells its product on credit to a customer who pays 30 days later. This
would create a current asset in the form of a debtor or accounts receivable.
At this point it is important to explore how accountants handle these transactions in the
balance sheet and how we are going to do it differently.
Accountants see the world through the lens of ASSETS and LIABILITIES. Business
operates in a world of CAPITAL and OPERATIONS. Most of the employees in a business
are involved in or are responsible for some or other operational function. Only a few
senior employees are responsible for the capital sources of a business. The diagram
below represents a balance sheet seen through the lens of accountants.
Equity
Fixed
Assets
Debt
Current
Liabilities
Current
Assets
Liabilities
Assets
Accountants View of the Basic Balance Sheet 5
24
Accountants simply see money owing to a supplier (creditor) as a liability, specifically a
current liability which is likely to be settled within the next 12 months. Hence the word
current. The current liabilities are grouped together with the other liabilities. We are
going to explore why this makes sense when viewed through the lens of accountants.
But when viewed through the lens of business operations it makes no sense.
From a business operations perspective the supplier is critical to the operations of the
business, even though technically, the money owing to a supplier is a liability. Viewing
the supplier as part of the operations rather than simply a liability helps one get a
different perspective of the business. Especially when it comes to measuring
performance.
There is also another important consideration in the context of the sources of capital.
Whilst a supplier can be an important source of funding for a business, typically, the
funding is free. We may say that it does not have a cost like debt and equity does. We
call it “free” because the supplier does not charge interest on the funding assuming that
it is paid within the agreed time of 30, 60, or 90 days.
The creditor or supplier funding is not always free, specifically if the supplier is offering
an early settlement discount. By choosing not to take an early settlement discount the
credit is costing the business money.
For the purposes of looking at a business through the lens of CAPITAL and OPERATIONS
we are going to put the suppliers and thus the creditors and other current liabilities on
the operations side of the balance sheet. To do this we have to change the sign and
deduct the current liabilities from the current assets on the operations side of the
balance sheet. The result is a term called working capital. Working capital is current
assets minus current liabilities (CA – CL) and represents the short-term assets and
liabilities used in the operations of the business.
25
The Difference Between the Accounting View and the Finance View
of Business
Accountants see a business through the lens of ASSETS and LIABILITIES and use the
following formula to represent the balance sheet of a business:
Assets
=
Equity
+
Liabilities
We can expand this formula to include the sub-components. Assets can be broken down
into long-term assets, known as fixed assets (FA) and short-term assets, known as
current assets (CA). Liabilities can also be broken down into long-term liabilities or L-T
Debt and short-term liabilities, known as current liabilities (CL). The expanded formula
would look like this:
Assets
FA
+
Liabilities
CA
=
Eq
+
L-T Debt
+
CL
As we discussed earlier, creditors are a major part of the current liabilities and can be
seen to be part of the operations of a business rather than simply as a liability. If we
colour code the components of the formula to represent the items that are part of
capital and operations, then the formula would look like this:
FA
+
CA
=
Eq
26
+
L-T Debt
+
CL
If we re-write the formula, grouping the operations items and capital items together,
the formula would look like this:
Working Capital
FA
+
CA
-
=
CL
Operations
Eq
+
L-T Debt
Capital
When we convert the formula to the balance sheet, it would look like this:
Equity
Fixed
Assets
Debt
Working
Capital
Capital
Operations
Capital and Operations Balance Sheet 6
Now that we have laid out the framework, let’s add some detail and ensure that all the
terminology is covered. The emphasis is on some as accountants have created a great
deal of complexity over time and not all of that will be covered here.
27
Equity generally consists of two parts. The first part being the share capital that was put
into the business in exchange for share certificates that represent the shareholder’s
ownership of the business. The second part is the retained earnings that represents the
profits that have been made in the income statement and kept in the business after
dividends have been paid. Hence the word retained.
Retained earnings in the balance sheet are cumulative. As a business makes profits that
are kept in the business over time the retained earnings get bigger…assuming that the
business is profitable. Making a loss would reduce the retained earnings in the balance
sheet.
Debt on the capital side of the balance sheet is long-term debt which the accountants
call non-current liabilities. This debt is repayable over a period of more than a year;
hence it is long-term debt.
Adding the total equity to the total debt (Equity + Debt) gets us the total capital or simply
CAPITAL as it is displayed in the balance sheet image below.
The fixed assets consist of long-term assets like buildings, property, vehicles, computers,
furniture…you name it, there are many. The general definition of a fixed asset is if you
can drop it on your toe and it hurts then it is a fixed asset. This analogy suggests its
tangible nature. Accountants call fixed assets, non-current assets. Accounts like to call
things what they are not. Terms like non-current assets and non-current liability are just
a sophisticated way of telling the reader that this asset is not a short-term asset or the
loan from the bank is not a short-term loan. There is an age-old suspicion that if the
accountants were responsible for naming the days of the week then Sunday would be
called “not- Monday”.
The accounting balance sheet also includes Intangible Assets and Investments and
Loans. For the purpose of our balance sheet and for the sake of simplification we will
include these as part of the fixed assets.
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Equity
Debt
Share Capital
Retained Earnings
Long-term Debt
Non-current Liabilities
Capital
Fixed
Assets
Property, Plant
Equipment, Vehicles
Intangibles,
Investments & Loans
Working
Capital
Debtors, Inventory
Creditors, Overdraft,
Tax
Operations
Terminology and the Balance Sheet 7
What is Your Work Address?
The best way to understand the dynamics of the balance sheet is to explore how you
might impact the balance sheet in your daily job. If we were to refer to the two sides of
the balance sheet as the Capital suburb and the Operations suburb, which suburb do
you work in?
Most people will put themselves in the Operations suburb. If you are tempted to put
yourself in the capital suburb, then ask yourself these questions:
•
Are you responsible for determining the amount of dividends that are paid to
shareholders?
•
Are you responsible for negotiating with the banks about the contractual terms
of long-term debt?
•
Are you responsible for raising equity capital from shareholders through rights
issues?
29
These are the responsibilities of those who work in the capital suburb. Typically, these
responsibilities fall to the CEO, CFO and other senior members of the board of directors.
Everyone else in the business is responsible for using the operating assets in some way
to generate sales and make a profit to provide returns to the capital providers. It is highly
likely that you work in the operations suburb. If you are a typical entrepreneur, then you
have a work address in both the capital and the operations suburbs…entrepreneurs are
required to do a bit of everything in their business. When we discuss the income
statement, we will find out your street address in the suburb that you work in.
30
Profitability
Profitability is the subject of the income statement. The best way to explore this subject
is with a visual representation, the same way that we did it with the balance sheet.
Income Statement Basics
Sales
Sales represents income from selling products or services.
COS
Cost of sales represents the cost of producing the products that we sold.
GP
Gross Profit is Sales minus Cost of Sales (GP = Sales – COS).
Exp
Expenses or overheads (E.g. rent, salary, admin)
Dep
Depreciation is a non-cash expense that represents the use of fixed assets.
PBIT
Profit before interest and tax also known as EBIT or operating profit.
Int
Interest is the cost of borrowing money. It is not debt repayments.
PBT
Profit before tax or earning before tax (PBT = PBIT – Interest).
Tax
Tax payable based on the PBT. (28% corporate tax rate in South Africa).
PAT
Profit after tax or earning after tax (PAT = PBT – Tax).
Div
Dividends are the reward to shareholders for their investment.
RE
Retained earnings is the portion of the profits that the business keeps.
Notice the use of the term profits, it is more common these days to talk earnings. Profits
and earnings can be used interchangeably. Net income also used to refer to the profit
after tax.
31
The layout of the income statement can vary a great deal. In the income statement
displayed above, dividends and retained earnings have been included. Normally these
items are not included in the income statement but rather in a statement called
“Changes in Equity”. The changes in equity are important for compliance but we can use
the information in the balance sheet for our purpose of understanding business
performance.
What is Your Street Address?
When we discussed your work address in the balance sheet you were able to determine
which suburb you worked in. Operations or Capital. Now we are going to find out which
street you work in.
The income statement can also be broken into Operations and Capital, as we did in the
balance sheet. The profit before interest and tax (PBIT) or EBIT is commonly referred to
as operating profit…put another way we might call it the profit from the operations.
There are only three “streets” in the operations suburb. They are SALES, COST of SALES
and EXPENSES. Determining your street address is largely based on the activities that
you do in your job that impact the income statement the most.
Here are the activities or job roles that go with the different “streets” in the operations
suburb:
1.
Sales street
Customer facing, key accounts manager, sales manager, advertising,
marketing.
2.
Cost of sales street
Operations, manufacturing, logistics and delivery, quality, procurement.
3.
Expenses street
Legal, human resources, information technology, other support roles.
32
The following income statement diagram explains this concept further:
Operations and Capital Streets
Sales
COS
Operations
GP
Exp
Dep
PBIT
Capital
Int
PBT
Tax
PAT
Div
RE
Sales street is customer facing. If you are a
salesperson, sales manager, or key accounts manager
then you work in sales street. Some businesses call
these roles business development. That is just
another name for sales. If you are advertising or
marketing, then you also work in sales street.
Cost of Sales street is about manufacturing the
product and the delivery of the product or service to
the customer. This would include logistics, quality
control. Procurement from suppliers is part of cost of
sales street. If you work in a call centre that is not a
sales call centre than you are in cost of sales street.
Expense street is the catch-all street. Strictly speaking
from an accounting perspective everyone is expense
street as salaries form part of the expenses. However,
this is a functional view of the income statement not
an accounting view. Expense street is the support
facility to those who are in sales and cost of sales
street. Therefore, if your responsibilities include legal,
information technology, human resources, various
financial functions, and let’s say any other support
role then you work in expense street.
Capital street is made up of interest and dividends.
These items relate to the debt and equity on the
balance sheet.
Street Address in the Income Statement
33
Income Statement Gymnastics
Income statement gymnastics is about the dynamics of profit, volume, and expenses.
These three elements are interrelated. Understanding how they work together helps
with the holistic understanding of the income statement.
The profit triangle is the common representation of the profit, volume, expense
elements.
Margin
Profit
Volume
Expenses
The Profit Triangle
The profit motive is the driving force of a business. Generally, more volumes drive up
profits provided there is a positive margin, and the expenses don’t increase in proportion
to the volume increases. Higher margins due to price increases may reduce volumes of
sales thus creating the ever-present trade off in business between price and volume. The
nature and behaviour of the expenses are important to understand as they have a direct
impact on profits.
Expenses can be loosely categorised as variable or fixed. Variable expenses are expenses
that change as the volume of sales changes. More sales bring about more cost of sales
simply because a business must purchase more raw materials to meet the sales demand.
Let’s use a simple example to demonstrate this dynamic. The local bookshop called Gill’s
Bookshop has an average selling price per book of $22 and an average cost per book of
$12. The average profit margin per book is $10 ($22 - $12 = $10). If we assume that the
34
bookshop has monthly fixed costs of rent and salaries that amount to $6,000, how many
books would the book shop have to sell to break even.
If we set this up using a simple income statement grid, then it would look as follows:
Sp
Cp
M
Per unit
Vol =
-
22
12
10
Sales
CoS
Gp
Exp
PBT
6,000
0
Listed on the left-hand side of the income statement are the per unit selling price (Sp),
cost price (Cp) and margin (M). On the right-hand side of the income statement is where
we will calculate the numbers that represent the business based on the volume of sales.
For now, only the fixed expenses and the PBT are listed because that is all the known
information that we have. The fixed expenses were given to us as $6,000. Because we
are calculating the breakeven position of the business then we can assume that the PBT
is zero. We need to calculate the Gp, CoS, Sales and Vol to get the full picture of the
business. We will complete the blank spaces next to Sales, CoS and Gp as we proceed.
Some clarity on the difference between margin and mark-up would be useful to us at
this stage. Measured in currency the margin and the mark-up are the same.
SP – CP = Margin
$22 – $12 = $10
Mark-up is the increase from the cost price (Cp) to the selling price (Sp), which again is
just the difference between the two. When we measure margin and mark-up as a
percentage, we get different answers.
Margin is measured as a percentage of selling price (Sp). Mark-up is measured as a
percentage of cost price (Cp).
Margin% = M/Sp x 100 = 10/22 x 100 = 45,45%
35
Mark-up% = M/Cp x 100 = 10/ 12 x 100 = 83.33%
Mark-up% is the percentage that we add to the cost price (Cp) to calculate the selling
price (Sp).
A definition of fixed expenses is required before we continue. Fixed expenses do not
change based on an increase in sales volume, provided that the business stays within its
capacity. I.e. The business does not have to hire more people or rent more space to
service the increased volume. If the expenses of $6,000 are all fixed, then we can assume
that the business will need a Gp of $6,000 to break even. Mathematically, Gp – Exp =
PBT or 6,000 – 6,000 = 0. The grid is updated as follows:
Sp
Cp
M
Per unit
Vol =
22
12
10
Sales
CoS
Gp
Exp
PBT
GP added here
6,000
6,000
0
We can now ask the question…how many profits of $10 per book are needed to make
$6,000 in gross profit? Using the formula of Gp/M will calculate the volume of sales (Vol
= Gp/M). 6,000/10 = 600 books. The grid would represent this as follows:
Vol calculated
Sp
Cp
M
Per unit
Vol =
22
12
10
Sales
CoS
Gp
Exp
PBT
600.00
6,000
6,000
0
From here we can use the volume to calculate the Sales and Cost of Sales. To do this we
multiply the volume (Vol) by the selling price (Sp) to get the Sales (Sales = Vol x Sp). We
36
multiply the volume (Vol) by the cost price (Cp) to get the Cost of Sales (CoS = Vol x Cp).
This would look as follows:
Sp
Cp
M
Per unit
Vol =
600.00 Vol = GP/M
22
12
10
Sales
CoS
Gp
Exp
PBT
13,200 Vol x Sp
7,200 Vol x Cp
6,000
6,000
0
From this grid we can conclude that the book shop would have to sell 600 books and
make $13,200 in Sales to break even. $7,200 would be paid to the supplier and $6,000
would be the gross profit which is used to cover the fixed cost of the business.
We can codify this process into a set of rules that we might call them Income Statement
Gymnastic Rules and they would be as follows:
Rule 1. Use a grid. This helps identify the information that you have what you need to
calculate.
Rule 2. Put any known information into the grid.
Rule 3. At the point of breakeven PBT = 0. This is considered a known position and
especially useful place to measure different profit scenarios from.
Rule 4. At the point of breakeven, gross profit and fixed expenses are equal. Gp = Exp.
This is only true if all the expenses are fixed expenses.
Rule 5. Volume = Gp/M. This is the golden rule of income statement gymnastics. If the
margin is represented as a percentage, the rule still applies. However, gross profit
divided by margin% is equal to Sales, not volume ( Gp/M% = Sales).
Rule 6. Once you have calculated the volume using Rule 5 you can calculate Sales (Sales
= Vol x Sp).
Rule 7. Once you have calculated the volume using Rule 5 you can calculate CoS (Cos =
Vol x Cp).
37
In my years of teaching experience, the income statement gymnastics is the part that
students battle with the most. I teach these dynamics using a simple one-product
business to lay the foundation. Typically, a sustainable business has multiple products.
Based on the weighted average of the volume of each of the products sold the business
would determine an average gross profit margin percentage. This average gross profit
margin is normally represented as a percentage. In the case of Gill’s Bookshop, the
average gross margin is 45.45%.
Margin% = M/Sp x 100 = 10/22 x 100 = 45,45%
This income statement grid includes the margin percentage and the cost of sales
percentage. If you are working your way up the income statement from the PBT position
the arrow sequence shows the order of calculations. Take a “short left” at Gp. Divide Gp
by margin and get volume (Vol = Gp/M)
Sp
Cp
M
100.00%
54.55%
45.45%
Per unit
Vol =
600.00
22
12
10
Sales
CoS
Gp
Exp
PBT
13,200
7,200
6,000
6,000
0
If you are using the margin percentage instead of the currency, the sequence is the same,
except Gp divided by Margin percentage results in Sales instead of volume (Gp/M% =
Sales).
Sp
Cp
M
100.00%
54.55%
45.45%
Per unit
Vol =
600.00
22
12
10
Sales
CoS
Gp
Exp
PBT
13,200
7,200
6,000
6,000
0
38
In summary the two golden formulas of the income statement would look like this:
Vol
=
Gp
Note: This formula uses margin
as a currency
Margin
Sales
=
Gp
Note: This formula uses margin%
Margin%
To help with the understanding of the behaviour of fixed and variable expenses let’s
create another scenario for the book shop. What if the book shop wanted to make a
profit of $2,000? Think about what must happen…
•
We can increase the price and make more profit per book. This might cause the
volume to go down as customers might buy less.
•
We could try and negotiate with the book suppliers to get the books at a lower
cost price. The suppliers may lower the cost price if we buy big enough volumes.
Let us assume that we are not ready to do that yet as our bookstore is too small
to store the additional book stock.
•
We could reduce the salaries…that might not be met with enthusiasm form the
employees. We could also try and negotiate a lower rental from the landlord.
That would help reduce the $6,000 fixed cost. Let’s assume for now that we are
getting the lowest rental possible.
•
The only option left is to increase the volume of sales. To do this we might have
hire someone to do some direct marketing in the local community to attract
39
more people to the bookstore. If we hired a full-time employee to do this it
would add to the fixed costs. This would add more pressure to increase the
volume.
•
Let’s apply some magical thinking for now and assume that we can increase the
volume of sales. What volume would be required to make a profit before tax
(PBT) of $2,000?
The income statement grid would look like this:
Sp
Cp
M
Per unit
Vol =
800.00
22
12
10
Sales
CoS
Gp
Exp
PBT
17,600
9,600
8,000
6,000
2,000
Profit target
Working from the bottom of the income statement, we set the PBT to be the target of
$2,000 that we want to achieve. Add on the way up the income statement ($2,000 +
$6,000), therefore the Gp must be $8,000. As we asked last time, how many $10s do we
need to make $8,000. We apply the formula of Vol = Gp/M, the “short left” referred to
earlier, to get the volume of 800. Selling more volume means more sales revenue from
the customer, but we also must pay more to the supplier for the extra books that they
sold us. The cost of sales (CoS) is variable, it went up as we sold more, but the fixed costs
remained the same, hence the term fixed.
The benefit of being able to do income statement gymnastics is being able to do resource
planning based on the business model. For example, in the last scenario where the profit
target was increased to $2,000, we were able to determine the new volume of sales
required to earn that profit. We could now ask questions like…”do we have enough
salespeople to sell the extra 200 books?” In the context of Gill’s Bookshop, perhaps
having salespeople may not be appropriate. We might ask about what we would spend
on Facebook advertising to bring new customers to the bookshop. The advertising cost
40
would be recognised as a fixed expense for the month. We should ask if we have the
supply of book stock to meet this increased volume of sales.
If we needed to employ an additional staff member, the fixed cost would increase. We
would probably want to know how many book sales would be required to cover the
additional fixed expense salary. Let us assume that Gill’s Bookshop employs another
staff member at a fixed expense of $2,500. A change in the fixed cost will change the
break even point of the business.
The new breakeven calculation would be represented as follows:
Sp
Cp
M
Per unit
Vol =
850.00
22
12
10
Sales
CoS
Gp
Exp
PBT
18,700
10,200
8,500
8,500
0
Increased Vol
New fixed expenses
The original breakeven volume was 600 books. The new breakeven volume with the new
employee is 850 books. This means that the new employee would have to sell 250 books
to cover their salary cost. This is an example of how the breakeven point and using the
grid can work effectively plan and set targets.
If Gill’s Bookshop wanted to achieve an after-tax profit (PAT) of $2,000 and the tax rate
is 28%, we can extend the income statement grid to include this. Starting with the PAT
of $2,000, the first step is to divide the PAT by 1 – Tax rate. The result is the PBT. (PBT =
PAT / (1-Tax rate).
Per unit
Sp
Cp
M
100.00%
54.55%
45.45%
Vol =
1,128
Sales
CoS
Gp
Exp
100% PBT
28% Tax
24,811
13,533
11,278
8,500
2,778
778
72% PAT
2,000
22
12
10
41
From PBT we would follow the same procedure as we did earlier. It is important to note
that to get from PAT to PBT one cannot simply add 28% to $2,000. A “short left” as we
did earlier with the GP/M% calculation is required to jump up from PAT to PBT.
If Gill’s Bookshop wanted to increase the PAT to $3,000, we could re-calculate the
income statement grid to find out the increase in Sales and increase in volume required.
The following grid shows this scenario. Note how the fixed expenses remained
unchanged and how the variable expenses (CoS) increased as the volume did.
Sp
Cp
M
100.00%
54.55%
45.45%
Per unit
Vol =
1,128
1,267
22
12
10
Sales
CoS
Gp
Exp
24,811
13,533
11,278
8,500
27,867
15,200
12,667
8,500
100% PBT
28% Tax
2,778
778
4,167
1,167
72% PAT
2,000
3,000
Operating Leverage
Depending on the nature of a business, the proportion of variable and fixed expenses
can differ hugely. Unfortunately, expenses do not always neatly fit into the definition of
fixed or variable. Expenses can also move from being fixed to variable and vice versa
depending on how certain resources are used in a business.
The proportion and nature of variable and fixed expenses in a business is often referred
to as the business model. To demonstrate the concept of operating leverage let’s
broadly categorise businesses into three different business models. Type 1 is a business
that has variable expenses only. Type 2 has a combination of variable and fixed
expenses and Type 3 has fixed expenses only.
42
Type 1 – Variable expenses only
Sales
% change
Variable expenses
Fixed expeses
Total expenses
Profit
% change
Base scenario Scenario 1 Scenario 2
100,000
90,000
110,000
-10%
10%
92,000
82,800
101,200
0
0
0
92,000
82,800
101,200
8,000
7,200
8,800
-10%
10%
The base scenario in the Type 1 model describes a business that has $100,000 in sales
and $92,000 in variable expenses. There are no fixed expenses. Variable expenses plus
fixed expenses equal total expenses. Sales minus total expenses leaves a profit of $8,000.
In scenario 1 where the sales are reduced by 10%, the variable expenses are also
reduced by 10% and therefore the total expenses are reduced by 10%. The result is a
reduction in the profit of 10%. We say that the reduction in profit is directly proportional
to the reduction in sales. In scenario 2 where the sales are increased by 10%, we see an
increase in the profit by 10%. Again, directly proportional. Can you think of a type of
business that consists of variable expenses only? A business that has no fixed expenses
is typically an informal business or street vendor. Such a business does not employ
anyone or rent any space. This is a low risk business as it is impossible for the business
to make a loss. However, growing a business that has variable costs only must deal with
continually growing expenses.
Type 2 – Variable and fixed expenses
Sales
% change
Variable expenses
Fixed expeses
Total expenses
Profit
% change
Base scenario Scenario 1 Scenario 2
100,000
90,000
110,000
-10%
10%
52,000
46,800
57,200
40,000
40,000
40,000
92,000
86,800
97,200
8,000
3,200
12,800
-60%
60%
43
The base scenario in the Type 3 model describes a business that has $100,000 in sales
and $52,000 in variable expenses and $42,000 in fixed expenses. Variable expenses plus
fixed expenses equal total expenses. Sales minus total expenses leaves a profit of
R8,000.
In scenario 1 where the sales are reduced by 10%, the variable expenses are also
reduced by 10%, but the fixed expenses remain the same. The result is a reduction in
the profit of 60%. The fixed expenses that are not reduced when the sales are reduced
has a large impact on the reduction of the profits. In scenario 2 where the sales are
increased by 10% we see an increase in the profit by 60%. The large increase in the profit
is because when the sales are increased, a large portion of the expenses do not increase,
thus adding leverage to the profit increase. This business model is typical of a
manufacturing business. The proportion of fixed to variable expenses can vary
substantially in this type of business model.
Type 3 – Fixed expenses only
Sales
% change
Variable expenses
Fixed expeses
Total expenses
Profit
% change
Base scenario Scenario 1 Scenario 2
100,000
90,000
110,000
-10%
10%
0
0
0
92,000
92,000
92,000
92,000
92,000
92,000
8,000
(2,000)
18,000
-125%
125%
The base scenario in the Type 3 model describes a business that has $100,000 in sales
and $92,000 in fixed expenses. There are no variable expenses. Variable expenses plus
fixed expenses equal total expenses. Sales minus total expenses leaves a profit of $8,000.
In scenario 1 where the sales are reduced by 10%, there is no reduction in the expenses
since all the expenses are fixed. The result is a reduction in the profit of 125%. In
scenario 2 where the sales are increased by 10%, we see an increase in the profit by
125%. Again, there is no increase in the fixed expenses so all the extra sales drop to the
44
bottom line and becomes profit. The leverage effect on the profit is higher when there
is a greater proportion of fixed expenses. This business model is that of a service business
that typically employs a substantial amount of people and rents a large amount of space
to accommodate the employees. There is no way to sugar-coat the statement that
employing people adds fixed expenses to a business but most importantly it adds risk.
Especially in an environment where regulation prevents a business from being flexible
in reducing employment expenses.
The following table includes all the business models.
Type 1 Variable Only
Type 2 Semi Fixed
Type 3 Fixed Only
Base scenario Scenario 1 Scenario 2 Scenario 1 Scenario 2 Scenario 1 Scenario 2
Sales
100,000
90,000
110,000
90,000
110,000
90,000
110,000
% change
-10%
10%
-10%
10%
-10%
10%
Variable expenses
92,000
82,800
101,200
46,800
57,200
0
0
Fixed expeses
0
0
0
40,000
40,000
92,000
92,000
Total expenses
92,000
82,800
101,200
86,800
97,200
92,000
92,000
Profit
8,000
7,200
8,800
3,200
12,800
(2,000)
18,000
% change
-10%
10%
-60%
60%
-125%
125%
Increasing Fixed Expenses
Increasing Risk
Notice how as the amount of fixed expenses increase so does the variance in the profits.
In Type 1 the profit variance is from -10% to +10%. A variance of 20%. In Type 2 the profit
variance is from -60% to +60%. A variance of 120%. In Type 3 the profit variance is from
-125% to +125%. A variance of 250%. This variance in profitability is the measure of risk
in a business. Simply put, the business risk is the risk of making a loss when sales are
reduced.
The business models described in this section clearly differentiate between variable and
fixed expenses. The difficulty that one faces when looking into the business model is that
it is not always clear if an expense is variable or fixed. In addition, in the income
statement the variable expenses are not always neatly contained to the cost of sales.
Likewise, the fixed expenses don’t always fit neatly into the expense line. Fixed expenses
are often included in the cost of sales. Especially if they are labour expenses that are
45
incurred in the manufacturing process. Also, variable expenses are included with fixed
expenses in the expense line. There is no common standard on where the costs are
recorded in the income statement. This creates problems in comparing the gross profit
percentage between two businesses, especially when the costs have been allocated
differently between the CoS and expenses lines.
If one business includes fixed expenses in its cost of sales and another does not, then
the gross profit margins are not comparable. This means that measuring profit further
down the income statement at the operating profit level is better for comparison.
46
Accounting for Gill’s Bookshop
Getting Ready to Start Trading
The purpose of this chapter is to take a step - by- step journey through the set up and
operation of Gill’s Bookshop over the timeline of a year. On the journey we will look at
all the transactions that a business might make and how these transactions are
processed in the book of accounts. The accountants would use what they call a trial
balance to account for all the transactions. We are going to do something similar.
However, the jargon and the accounting format can get in the way of the understanding.
So, we are going to use common business terminology and a simple to understand
process.
Gill’s Bookshop has two lines of business. The first line of business is selling old secondhand books and the second line of business is printing and book binding. Gill is setting
up to operate out of a small retail shop in a busy shopping centre where she has signed
a lease for a year. Gill has employed a full-time shop assistant to help customers and
look after the “front of shop” while she works in the back office. Gill has invested capital
in the business to buy the original book stocks and the printing and binding equipment.
Gill invested $50,000 to get her bookshop up and running. The invested capital is
recorded under Capital while the cash in the bank is recorded under Operations.
Balance sheet showing initial investment
Capital
Share capital
Operations
50,000 Cash
50,000
50,000
50,000
Using the cash invested in the business Gill purchased the printing and binding
equipment for $20,000 and shelving for $12,000. This equipment would be considered
capital expenditure or capex. The printing and binding equipment will be depreciated
over 5 years at a rate of $4,000 per annum. The shelving will be depreciated over 6 years
47
at a rate of $2,000 per annum. The timeline for the depreciation of these assets is based
on the “Wear and Tear” schedule that is provided by the tax authority.
Balance sheet showing capex or fixed asset purchases
Capital
Share capital
Operations
50,000 Cash
Printing & binding equipment
Shelving
18,000
20,000
12,000
50,000
50,000
Gill then purchased a healthy supply of second-hand book stock for $8,000. She paid
cash for these books. As the $8,000 inventory comes onto the balance sheet the
equivalent amount of cash is paid out of the bank account.
Balance sheet showing inventory purchases
Capital
Share capital
Operations
50,000 Cash
Printing & binding equipment
Shelving
Stock --> Books
10,000
20,000
12,000
8,000
50,000
50,000
Notice that with each transaction the cash is simply reduced as the cash is used to
acquire the assets and the book stocks. In the next transaction, Gill purchases different
paper types and ink for the printer from a supplier who granted 30 days credit terms. In
this transaction with the supplier, Gill takes ownership of the paper and ink stock but
still owes the money to the supplier. This is recorded as a creditor. The supplier credit
terms are 30 days from invoice and are interest free as long as the account is not in
arrears.
48
Balance sheet showing inventory purchased on credit
Capital
Share capital
Operations
50,000 Cash
Printing & binding equipment
Shelving
Stock --> Books
Stock --> Paper & Ink
Creditor
10,000
20,000
12,000
8,000
2,000
(2,000)
50,000
50,000
At this point Gill has set up her operation and is now ready to start trading. She has
acquired the assets and the inventory that the business needs to start trading. Gill has
employees to help her and she has a prime location in the local shopping centre so she
can attract passing shoppers.
The First Year of Trade
The following transactions take place during the year and are recorded in the income
statement.
•
Sales of R$132,000 are generated from both sources of business. 38% of the
sales was done on credit to the printing customers and the average settlement
period for these customers is 30 days.
•
The credit sales amounted to $50,160. At the end of the financial year the
outstanding debtors amount was $4,122.74.
•
The cost of sales which represents the raw material cost of paper and ink and
the supply of books came to $72,000.
•
The fixed expenses for the year amounted to $42,000. This amount included all
the salaries, rent and administration costs.
•
The depreciation charge for the printing and binding equipment was $4,000
and the depreciation for the shelving was $2,000. Think of the depreciation as
the cost of using the fixed assets. If Gill’s Bookshop rented the shelving, binding
49
and printing equipment assets rather than owning them then we would
substitute the depreciation expense for a rental expense. Depreciation is a noncash expense which means we deduct the expense in the income statement,
but we do not pay cash to anyone.
•
There was no interest expense as there was no debt.
•
The tax rate for the year was 28%.
•
Gill decided to pay a 20% dividend.
The following income statement was compiled at the end of the year. The income
statement is for the year ended 31 December 20XX. All the transactions listed above
have been considered in this income statement.
Income statement for the year ending 31 December 20XX
Sales
Cos
Gp
Exp
Dep
PBIT
Int
PBT
Tax
Pat
Div
RE
132,000
72,000
60,000
42,000
6,000
12,000
12,000
3,360
8,640
1,728
6,912
A full year has passed, and the balance sheet needs to be updated to reflect the changes
that have taken place. There have been many cash transactions during the year and the
cash account needs to be reconciled to the bank statement to ensure that all the
transactions have been recorded.
The following transactions need to be processed in the balance sheet:
50
•
The retained earnings must be carried over to the balance sheet. The retained
earnings are shareholder’s money that is being kept by the business. Hence, it is
recorded under equity on the capital side of the balance sheet. Retained earnings
is cumulative in the balance sheet.
•
At the final stock-take at the year-end it was determined that there was $6,800
worth of book stock and $12,00 worth of paper and ink stock.
•
The fixed assets need to be depreciated since these assets have been used for a
year.
•
The debtors (what customers owe the business) must be included in the balance
sheet. There were no debtors at the start of the year, but since Gill’s bookshop
made credit sales the debtors has amounted to $4,122.74.
•
The creditors (what the business owes to suppliers) needs to be updated. Only the
supplies of ink and paper provide credit. Since 38% of the sales is made up of
printing and binding, therefore the same proportion of the cost of sales is used to
determine the creditors. The creditors amount at year end was $2,248.77. The
formula for this calculation is: Creditors = (COS x 38%)/365 x 30.
•
The cash position needs to be updated. There have been inflows and outflows from
the cash account since Gill’s Bookshop started trading. All the cash transactions
must be reconciled and reported in a cash flow statement.
The two balance sheets that follow are the balance sheets at the start of the year
and at the end of the year. The differences between the two balance sheets are
discussed below.
51
Balance sheet at the START of the year
Capital
Share capital
Operations
50,000 Cash
Printing & binding equipment
Shelving
Stock --> Books
Stock --> Paper & Ink
Creditor
10,000
20,000
12,000
8,000
2,000
(2,000)
50,000
50,000
Balance sheet at the END of the year
Capital
Share capital
Reatained earnings
Operations
50,000 Cash
6,912 Printing & binding equipment
Shelving
Stock --> Books
Stock --> Paper & Ink
Debtors
Creditor
21,038
16,000
10,000
6,800
1,200
4,123
(2,249)
56,912
56,912
Notice the following differences:
1.
The addition of retained earnings on the capital side of the balance sheet. This
came from the income statement (Capital)
2.
Reduced value of the printing and shelving assets after deducting depreciation
(Operations).
3.
Lower stock values for both books and printing materials (Operations).
4.
The introduction of debtors because of credit sales (Operations).
5.
The creditors are slightly different (Operations).
6.
The cash figure has increased (Operations).
As a reminder: The left-hand side of the balance sheet, as shown above, reflects the
CAPITAL which tells the reader where the capital came from and how much is invested
in the business. The right-hand side shows how the capital is invested in the
52
OPERATIONS of the business. The money on the left and the money on the right are the
same monies. The two sides of the balance sheet describe who gave the business the
money and how the money is being used.
The Difference Between Profit and Cash
Sales
COS
GP
Exp
Dep
PBIT
Int
PBT
Tax
PAT
Div
RE
Sales in the income statement includes both cash and credit sales.
Immediately this creates a difference between profit and cash. The
income statement does not “care” that the customer has not paid.
The profit is deemed to have been earned even if the customer has
not paid. The unpaid sales are reflected in the balance sheets as a
debtor and an adjustment needs to be made in the cashflow
statement to reflect this.
Cost of sales creates a similar cash problem to sales. A business can
have both cash and credit purchases from suppliers. Again, the
income statement does not “care” that the supplier has not been
paid. The calculation of profit assumes that the cost of sales has been
paid. The unpaid suppliers are represented in the balance sheet as a
creditor and an adjustment needs to be made in the cashflow to
reflect this.
The cost of sales also only represents the inventory that was sold. If
a business purchased more inventory than it sold, then this purchase
of extra inventory would have the effect of reducing the cash and
would be reflected as a build of inventory on the balance. Again, an
adjustment for this would have to made in the cashflow.
The expenses do not include the purchase of capital equipment. They
only reflect the cost of using the capital equipment via the
depreciation expense. To determine the cashflow in the business we
need to take into account that depreciation is a non-cash expense.
That means depreciation has reduced the profit, which benefits the
business in that less tax is paid, but it has not reduced the cash.
Cash from shareholders and debt from the bank are not reflected in
the income statement. These are balance sheet items. Any changes
in these components will have an impact on the cash in the business
and need to be reflected in the cashflow.
53
The difference between profit and cash is a subject that causes a great deal of confusion
for many. The best way to explain the differences is to start with a review of how the
income statement records certain activities and thus can produce a profit figure that
bears little resemblance to the cash flow.
Broadly speaking there are five components to cashflow in a business. We call them the
sources and uses of cash. These components are as follows:
1.
Cash from operations. This uses the operating profit (PBIT) in the income
statement. We add back depreciation to adjust for the fact that depreciation is
a non-cash expense. Starting the cashflow with operating profit automatically
considers sales, cost of sales and operating expenses. We just need to make the
adjustments for debtors, inventory, and creditors.
2.
Cash from working capital. Here is where we make the adjustment for changes
in debtors, inventory, and creditors. To do this we need to compare two
successive balance sheets and find the differences between the two years. The
working capital rules are:
a.
An increase in debtors means customers are taking longer to pay and
therefore reduces the cash in the business.
b.
An increase in inventory holding means that the business has
purchased more inventory than it needed for the period and cash has
been consumed, thus reducing the cash on hand.
c.
An increase in the creditors means that payment to suppliers has been
delayed. This could be because of negotiating longer payment terms.
A delay in paying suppliers will increase the creditors and thus increase
the cash in the business.
d.
All these rules work visa versa.
e.
Note how the cashflow rules for changes in debtors and inventory are
the same because they are both current assets (CA). Creditors are part
54
of the current liabilities (CL) and thus the cashflow rule is the opposite
to that of the current assets.
3.
Cash from investing activities. This component is generally about the
investment in fixed assets. Purchasing new assets to increase the capacity of
the business has the effect of reducing the cash. This component also includes
the acquisition of new business. Should a business sell off assets then this would
increase the cash flow.
4.
Cash from financing activities. Financing activities relate to the change in debt
in the business. Increasing the amount of debt in the business will increase the
cashflow. Increasing the debt results in higher interest expenses. The interest
expenses is included in this section and is usually an out flow if the business has
debt on the balance sheet. Sometimes the changes in overdraft are also
considered in this section of the cashflow. However, this is left up to the
discretion of the accountant.
5.
Cash from shareholder activities. Issuing new shares to shareholders via a
rights issue will increase the cash to the business. Buying shares back from
shareholders will reduce the cash. This section also contains the dividends that
are paid to shareholders and is an outflow of cash when dividends are paid.
The structure of cashflow statement of a business seems to vary a great deal.
Accountants have a knack for complicating the cashflow. The best way to simplify the
cashflow is to simply create two separate lists for “Cash In” and “Cash out” and list the
relevant cash transactions under each heading.
55
The cashflow for Gill’s Bookshop could be set up as follows:
Cashflow for the year
Cash in
Operating profit
Add dep
Cash out
Creditors
Stock--> Books
Stock--> paper & Ink
12,000
6,000
18,000
249
1,200
800
Sum of cash in
20,249
Debtors
Interest
Tax
Dividends
4,123
3,360
1,728
9,211
Net cashflow
Opening cash
Closing cash
11,038
10,000
21,038
The opening cash balance at the beginning of the year is $10,000 and the closing cash
balance at the end of the year is $21,038. The job of the cashflow statement is to
reconcile the cash transactions that account for the difference. The sum of the “cash in”
minus the “cash out” is the net cashflow. The ideal net cashflow for a year is zero. A net
cashflow of zero represents a perfect balance between cash inflow and cash outflows.
The numbers in the above cashflow are calculated as follows:
Cashflow transactions
Cash in
Cash from operations 12,000 + 6,000
Creditors
2,249 -2,000
Stock--> Books
8,000 - 6,800
Stock--> paper & Ink
2,000 -1,200
56
Cash out
Debtors
Interest
Tax
Dividends
0 - 4,123
3,360
1,728
Growth
Growth is a function of opportunity and funding. Opportunity is about being able to sell
more. Selling both new and existing product and services to more customers in new and
existing markets. Every business needs to balance their rate of growth with their funding
capability.
To fund growth a business can access internal funding through using profits that are
retained in the business. This source of funding is classified as equity since the profits
belong to the shareholder. Should the internal funding sources not be sufficient to fund
the growth a business can turn to external sources of new debt and equity.
Knowing the sustainable growth rate can help a business find the balance between
growth and cashflow to avoid the problem of growing itself bankrupt.
Growth is typically measured by the percentage change in Net Assets from one year to
the next. Visually, this can be seen in the following diagram.
% change
in NA
Equity
Fixed
Assets
Equity
Fixed
Assets
Debt
Working
Capital
Debt
Working
Capital
TC
NA
TC
NA
Capital and Operations Balance Sheet 6
57
The change in Net Assets in the balance sheet can come about for many reasons. Here
are some reasons for the Net Assets to change:
1.
Increased sales could result in higher debtors.
2.
Increased sales could result in higher cash.
3.
More inventory may have been purchased.
4.
The creditors may have been reduced.
5.
The business may have purchased more fixed assets.
The increase in Net Assets on the Operations side of the balance sheet must be matched
by an increase on the Capital side of the balance sheet.
An increase on the Capital side can come from the following sources:
1.
Profit from the income statement in the form of retained earnings.
2.
New debt.
3.
New equity.
A business that wants to fund its growth should always look internally for capital first.
Assuming that there is no cash readily available to fund the growth, internal capital could
be freed up from the following areas:
1.
Reduction in debtors and stock.
2.
An increase in creditors.
3.
The sale of redundant assets.
4.
Liquidation of investments and loans made to third parties.
Once these internal sources from the Operations have been fully exploited, then the
business can consider the Capital funding sources.
To increase the profits flowing from the income statement the business must consider
its dividend policy carefully. A reduction in the dividend, assuming a dividend is being
paid, will increase the retained profits on the Capital side of the balance sheet and
increase the cash on the Operations side. Any expense efficiency in the business would
58
also help increase the retained earnings and cash, however, in a growing business the
expenses may likely be increasing.
If the internal sources of capital and the retained earnings are not sufficient to fund the
growth in Net Assets, then the business should look to using new debt. Using new debt
assumes that the business hasn’t already exceeded its debt capacity.
New debt comes ahead of the new equity option simply because debt is the cheaper
source of capital. The business can determine its sustainable growth rate based on the
percentage change in Net Assets that can be achieved without having to change the
capital structure. A more conservative form of the sustainable growth rate would be the
rate that the Net Assets can grow without having to use an external source of new
capital.
Sustainable and Actual Growth Rates
Sustainable Growth Rate (SGR): The SGR is
the percentage change in equity that can
be funded from the retained earnings
flowing from the income statement.
SGR = ∆RE/Opening Equity x 100
Actual Growth Rate (AGR): The AGR is the
percentage change Net Assets from one
year to the next.
AGR = ∆NA/Opening NA x 100
59
∆RE
∆NA
Equity
Fixed
Assets
Debt
Working
Capital
TC
NA
We can codify the decision process based on the outcome of the SGR and AGR
calculations. The following rules would apply:
Scenario 1: SGR > AGR
1.
The company could grow faster.
2.
There will be a build-up of cash in the balance sheet.
3.
A higher dividend could be paid.
4.
The business could do a share buyback to return cash to shareholders.
Scenario 2: AGR > SGR
1.
There are not sufficient retained earnings coming from the income statement
to meet the growth needs.
2.
Reduce the dividend.
3.
Extract cash from the working capital.
4.
Sell redundant assets.
5.
Liquidate investment and loans.
6.
Raise new debt.
7.
Raise new equity.
60
Measuring Performance
Performance of the Operations
Measuring performance in a business is about getting beneath the numbers and
discovering what is really going on. There are countless ratios that can be calculated in
business. It can be quite overwhelming.
The measure of performance of the operations is called Return On Net Assets (RONA).
RONA measures the profit from the operations (PBIT) against the Net Assets used in the
operations. The formula for RONA is:
RONA
=
PBIT
x 100
Ave Net Assets
The reason why we use the components of operating profit (PBIT) and Net Assets is
because both items are critical components of the Operations. The specific use of the
average net assets is so that we can incorporate any changes in net assets that might
occur from one year to the next. This makes for a more accurate calculation.
The following diagram represents the location of the components:
61
Sales
Capital
Operations
Equity
Fixed
Assets
Debt
Working
Capital
Dep
TC
NA
PBIT
CoS
Operations
Gp
Exp
Capital
Int
PBT
Tax
PAT
Div
RE
RONA is driven by two underlying components. The components are PROFITABILITY and
ACTIVITY. To uncover these components, we need to do some mathematical
gymnastics. We do this by multiplying the RONA formula by Sales/Sales. Yes, that is right.
We are multiplying by 1. The result of the formula will not change. Let us see what
happens.
RONA
=
PBIT
Ave Net Assets
62
x
Sales
Sales
The rules of multiplication allow us to swap the denominators and the result of the
equation will not change. When we swap the denominators, we are looking to see what
each of the functions are measuring. Swapping the denominators would result in this:
RONA
PBIT
=
Sales
x
Sales
Ave Net Assets
Let us look at each box and see what is being measured. The green box is measuring the
profit from the operations or the operating profit percentage (PBIT%). This is simply the
proportion of sales that has remained in the business after the operating expenses have
been paid. This is called the PROFITABILITY. For those who have their “work address” in
the operation suburb, this is the profit output from their efforts.
The primary responsibility of those who work in the operations suburb is to generate
sales by using the resources that are available to them in the operations (Net Assets).
That is what is being measured in the orange box. We call this ACTIVITY. Some might call
it efficiency. The ideal Activity is as high as possible. That is, as much Sales as possible,
with the need for as little Net Assets as possible in the business.
We now have a simple dashboard that we use to measure the performance of the
operations. The following diagram contains the dashboard:
RONA
=
PBIT%
63
x
Activity
To use the dashboard, it helps to know where the different pieces come from in the
financial statements. The following diagram represents where the pieces of the
dashboard come from:
Capital
Operations
Sales
CoS
Equity
Fixed
Assets
Debt
Working
Capital
Dep
NA
PBIT
Exp
Operations
TC
Gp
Green arrow → The components of PROFITABILITY
(PBIT%)
Yellow arrow →The components of ACTIVITY
PBT
*For ease of representation, the average totals in
the balance sheet have not been used
PAT
Capital
Int
Tax
Div
RE
Earlier when we discussed the weighted average cost of capital (WACC). We determined
that those who work in the Capital suburb are responsible for raising the capital that is
required to fund the net assets in the Operations. The responsibility of those in the
Operations suburb is to provide a return that is higher than the WACC. That is the
measure for value creation.
64
RONA
PBIT
=
x
100
> WACC
Ave Net Assets
Weighted Average Cost of Capital
Earlier we touched on the weighted average cost of capital (WACC). WACC is central to
business performance. It represents the combined expectations of the shareholders and
the debt providers. Our earlier calculation simply added the costs of equity and debt and
divided by two on the assumption that equal proportions of capital are being used. We
calculated a WACC of 14%. That was suitable at that time. However, WACC has more to
it.
WACC combines the return expectations of the shareholders and banks based on the
proportional use of these sources of capital. The proportional use should be determined
based on the market value of the capital. The WACC formula is a s follows:
WACC
=
Ke
x
Equity%
+
Kd
x
Debt%
Ke = Shareholders expectation of return. In South Africa we use 18% based on the CAGR
of the AlSI. In the USA Ke = 10%. The higher expectation in South Africa is based on higher
inflation and higher levels of perceived risk in the South African market.
Kd = After tax cost of debt. The theory requires us to determine the market cost of debt.
However, since we use WACC as a proxy for risk over the long term we are going to use
a long-term average of the cost of debt. In South Africa that is approximately 10% per
annum. This is the before-tax cost of debt. An adjustment for the fact that the interest
65
expense is tax deductible and has the effect of reducing the amount of tax payable. The
adjustment is made by using the formula, Kd = Interest rate x (1 – tax rate).
Equity% and Debt% are part of the same calculation. Calculate the market value of the
equity by multiplying the number of issued shares by the most recent share price. The
result is the market capitalisation of the business or the market value of the equity.
(Market Cap = # issued shares x share price). Add the market cap to the market value of
the long-term debt (use the book value of the long-term debt as a proxy). Think of WACC
more as an estimation rather than an exact science. The difference between the market
value of the debt and the book value of the debt is not material. Add the market cap of
the equity to the book value of the long-term debt and get the total capital. Calculate
the market value of the equity as a percentage of the total capital. Do the same for the
long-term debt.
The theory on WACC suggests that a business will aim towards achieving an optimal
capital structure over the long term. An optimal capital structure is a combination of
equity and debt that results in the lowest WACC. The optimal capital structure is in a
Debt% (also known as the debt ratio) range between 30% and 40%. The optimal Debt%
is a function of the profit margins of the business. Higher profit margins can support a
higher Debt%.
Here is a WACC calculation using the generic components of WACC:
Ke = 18%
Kd = 10% x (1 – 28%) = 7.2%
Equity% = 70%
Debt% = 30%
WACC = (Ke x Equity%) + (Kd x Debt)
WACC = (18% x 70%) + (7.2% x 30%) = 14.8%
66
In South Africa, the use of debt is conservative in comparison to the optimal capital
structure. A WACC of 17% is quite common. To get a WACC this high the Equity % is 90%
and therefore the Debt% is 10%.
The Return on Equity
There are three areas of the business that drive returns to shareholders. Without the
shareholders taking risk and investing their money in the business there can be no
product for the customer and no job for the employee. Just like we did for RONA we
want to identify levers in a business that influence returns to shareholders.
Remember, the philosophy of Eric Beinhocker, to endure and grow. Our intention is to
build a long-term sustainable business and to be able to identify the characteristics of
such a business. The characteristics can be uncovered through unpacking the return on
equity (ROE) formula.
Three characteristics will emerge as we investigate the ROE formula. These
characteristics are PROFITABILITY, ACTIVITY and LEVERAGE. The problem is that to
uncover these three characteristics we need to jump through a few math hoops as we
did with RONA. The formula for return on equity (ROE) is:
ROE
PAT
=
x 100
Ave Equity
If we take a closer look at the components, we see the use of profit after tax (PAT) which
is the profit that belongs to the shareholder. As we work our way down the income
statement when we get to PAT there are no more expense obligations to be paid. The
67
only decision is how much to give back to the shareholder as a dividend and therefore
how much to retain in the business to fund future growth. The average equity is the sum
of the total equity from this year is and last year’s balance sheet, divided by 2 years. The
ROE formula is measuring the shareholder’s profit that has been generated by using
shareholder’s equity. Essentially the formula is dividing shareholder profit by
shareholder investment.
The following diagram shows where the different parts of the Return on Equity (ROE)
formula come from. For simplicity equity is shown as coming from only one balance
sheet in the diagram. For more accuracy we should get the average equity from the last
two years of balance sheets.
Capital
Operations
Sales
CoS
Debt
Working
Capital
TC
Gp
Exp
Dep
NA
PBIT
Operations
Fixed
Assets
Int
PBT
Tax
PAT
Div
RE
68
Capital
Equity
The next image contains some mathematical gymnastics, this time with one extra hoop
to jump through. The outcome is quite revealing. We multiply the ROE formula by
Sales/Sales and Net Assets/Net Assets. In other words, we multiply by 1 and then
multiply by 1 again. Mathematically the ROE will not change. The formula would look
like this:
ROE
=
PAT
Sales
x
x
Ave Equity
Sales
Ave Net Assets
Ave Net Assets
The rules of multiplication allow us to swap the denominators and the result of the
equation will not change. When we swap the denominators, we are looking to see what
each of the functions are measuring. Swapping the denominators would result in this:
ROE
=
PAT
Sales
x
Sales
x
Ave Net Assets
Ave Net Assets
Ave Equity
Let us look inside each box and see what the component is that is being calculated. The
green box is measuring Profit After Tax (PAT) in relation to Sales which is a measure of
PROFITBILITY. The orange box is measuring the amount of Sales that is generated from
the Ave Net Assets. The primary responsibility of those who work in the operations
suburb is to generate sales by using the resources that are available to them in the
operations. That is what is being measured in the orange box. We call this ACTIVITY.
Some might call it efficiency. The red box has a formula in it that is somewhat unintuitive.
We can swap out the Ave Net Assets for the Ave Total Capital, which is the same number
on the opposite side of the balance sheet. Remember, NA = TC. So, we are just changing
our perspective to help us understand the formula better. The result is the same. If we
69
measure the Total Capital (TC) over the Equity, we are measuring how much debt is
being used. We call this measure LEVERAGE.
We have carried out a decomposition of the ROE formula and the result is that we have
uncovered the three drivers of ROE. Accountants would call this a DuPont
decomposition. There is nothing new about it. However, this decomposition is not an
accounting decomposition using assets and liabilities. This is a decomposition that uses
operations and capital. We can now show the formula in the form of a dashboard that
would look like this:
=
ROE
PAT%
x
Activity
x
Leverage
The following diagram helps us identify where each of the ROE components can be
found in the financial statements.
Capital
Operations
Equity
Fixed
Assets
Debt
Working
Capital
Sales
CoS
NA
Exp
Dep
PBIT
Operations
TC
Gp
Green arrow → The components of PROFITABILITY
(PAT%)
Yellow arrow →The components of ACTIVITY
Red arrow → The components of LEVERAGE
*For ease of representation, the average totals in the
balance sheet have not been used
PBT
Tax
PAT
Div
RE
70
Capital
Int
Managing ROE is Like Herding Cats
Once we understand return on equity and its dynamics, all other performance measures
are subcomponents of its three drivers.
If a business had opportunity to grow and chose to raise debt to acquire new assets, the
following sequence of events might take place.
Event #1: The business raises debt capital. Raising debt capital would cause the leverage
to increase. We could use an up arrow to represent the increase in debt.
1
ROE
=
PAT%
x
Activity
x
Leverage
Event #2: Raising debt would increase the cash in the operations, thus increasing the
Net Assets and reducing the Activity because net Assets are the denominator in the
activity formula (Activity = Sales / Ave Net Assets). This outcome assumes that no new
sales have been achieved yet. The sales will likely only come later once the cash has been
invested in new assets. At this point the benefits to ROE from using debt would be
negated by the lower activity. In the short term we would use a down arrow to show the
decline in Activity.
2
ROE
=
PAT%
x
Activity
71
1
x
Leverage
Event #3: The new debt would likely increase the interest expense in the income
statement resulting in a lower PAT%. This could be represented with a down arrow for
PAT%. The net outcome in the short term would be a decline the returns to shareholders
as measured by ROE.
2
3
ROE
=
PAT%
x
Activity
1
x
Leverage
The business objective in the long term is to generate ROE > 18%. This is considered
value creation. In the short term, actions taken to achieve long term value creation can
appear as poor performance. The acquisition on new assets almost always reduces the
Activity of the business in the short term. Over time the intention of the investment is
to drive more volumes of sales at higher margins. To do this the business must
continually invest in maintaining its competitive advantage through innovative use of its
existing assets and or the development of new assets.
It turns out that the most productive way to increase ROE is to improve the profitability
of the business. In the ideal world, high profitability with the need for as few net assets
as possible (i.e. high activity) to produce profitability is the holy grail of value creation.
72
The Lighter Than Air Balance Sheet
Apple is a company that has managed to benefit from the returns that come from the
holy grail. Apple’s business model and the ROE dynamics reveal how they have been
able to perform so well.
The starting point is to look at the profit margins of Apple. For many years Apple has
maintained a PAT% of more than 20%. Apple has done this through developing
tremendous brand loyalty and many successful products and services that are worldclass. Measuring the Activity of Apple, we find a business that has high Sales with few
Net Assets. In other word, high ACTIVITY.
•
If we look specifically at the fixed assets of Apple, we will see that they have
extraordinarily few fixed assets as they have outsourced the manufacturing
and delivery logistics to others. One could argue that from a strategic point of
view Apple are able to control the manufacturing assets of others without
having to own the assets, therefore, requiring less capital to be invested.
•
The current assets are primarily made up of debtors and inventory. Since no
one really buys on credit from Apple the debtor’s book is small. The “just in
time” inventory system means that as the products roll off the production line,
they find their way to the customer or a franchised retail store. This result is
limited inventory in the system and efficient use of working capital.
•
Apple buys on credit from its suppliers which means that it has a sizable
creditors balance.
•
The combination of low fixed assets and low working capital requirements
means that the net assets of Apple are exceptionally low. Hence, the term
73
“lighter than air balance sheet.” Yet the value of the business is remarkably
high.
It is well known that the value of a business is not reflected in the value of the net assets.
The value of the business comes from the cashflow that the business can produce. The
primary reason for buying a business is to swap cash today for more cash in the future,
considering risk and time value of money.
In the discussion above, cash was conveniently left out. Apple holds a large amount of
cash. The cash would form part of the working capital. However, the risk of holding cash
is low relative to the other risk in a business. Therefore, leaving out the cash helps
emphasise the point. The term “lighter than air balance sheet” has a bit of smoke and
mirrors to it, but it was conceived more as a marketing gimmick than a real financial
objective. Nevertheless, there is a gem of truth hiding in the smoke.
How Much Profit is Enough?
Ask someone how much profit is enough. The common answer is that there is no such
thing as enough profit. We always want to make more profits. To a large degree that is
true provided that the pursuit of more profit is done with the long-term sustainability of
the business in mind. Once again, the wise words of Eric Bienhocker.
The question about “how much profit is enough?” is not to suggest that we stop the
pursuit of more profit. The question is to ask at what point the business has made
enough profit to meet the expectations of the shareholders and deliver on the promise
of returns and value creation.
To answer this question, we go back to the expectations that we discussed earlier. The
expectation based on historical returns of the All Share Index (ALSI). The shareholders
expectation of return on a portfolio of shares is 18% per annum. Thus, the business
needs to earn a certain amount of profit that when measured against the average equity,
the return to shareholders is greater than 18%. Providing a return to shareholders that
is greater than their expectation is the definition of value creation.
74
We could represent this as follows:
ROE
=
PAT
x 100 > 18%
Ave Equity
The DuPont decomposition and the Return on Equity measures have been in use for
millennia. There are hardly any secrets here. However, when I explore these concepts in
the classroom, they are almost always very new concepts to managers and executives
who are just starting their journey of finance learning.
Value Creation Dressed in a New Suit
If you were to try and sell business performance consulting services to corporates based
on the knowledge of DuPont decomposition, you would likely be unsuccessful. C-suite
executives will tell you that every accountant knows DuPont analysis like the back of
their hand, and they have plenty of accountants to measure the performance of their
business. Yet of course, accountants are so busy trying to keep up with the compliance
standards that the business performance often gets neglected. It is left for the
investment community to reflect on the performance.
In the early 1980’s a gentleman by the name of Joel Stern created a measure call
economic value add or EVA. The purpose of this measure was to “account” for the cost
of equity in the business and measure returns denominated in currency. The income
statement accounts for the cost of debt in the interest expense but does not account for
the fact that equity has a “cost” and that the business must take this cost into account
before declaring the profits.
Joel Stern created this formula:
75
=
NOPAT
-(
Net Assets
x
WACC
(
EVA
The innovation in the formula is very clever. At the time of its development it went with
a sales pitch that asked business executives if they were creating or destroying value.
The need to know the answer to this question was a shoe-in for Joel Stern and his
consulting business to provide business performance consulting services to corporate
America.
The term NOPAT, meaning net operating profit after tax, is not an accounting term. It is
calculated by subtracting the tax from the operating profit (NOPAT = PBIT – Tax). NOPAT
is a rich measure of the performance of the operations of a business. It considers all of
the operating expenses and it takes into account the tax. What it leaves out is the
interest expenses (debt cost) and the dividend payment (partial equity cost). Therefore,
NOPAT is the profit available from the operations of the business to pay the debt and
equity costs.
The next part of the EVA formula in the brackets is the calculation of the debt and equity
cost. Multiplying the net assets by the weighted average cost of capital (WACC)
calculates the annual currency denominated cost of the capital for the business.
The use of net assets in the EVA formula was a clever inclusion. Net assets are not an
accounting measure. It is a measure that we created by converting the balance sheet
from assets and liabilities to operations and capital. The EVA formula could have used
total capital instead of net assets. This would have made it more obvious. By using net
assets in the formula, Joel Stern’s intentions may have been to somewhat deceive the
accountants. Accountants are quite familiar with the term net asset value (NAV) which
is simply the book value of the equity. This sleight of hand added complexity to EVA. EVA
was no doubt sold on the basis that it was too complicated for businesses to try and
76
calculate their own EVA, and the services of Joel Stern would be needed to determine if
the CEO was creating value or not.
After deducting the capital cost from NOPAT, if the result is positive then the business is
deemed to be creating value and the EVA is of course positive. A negative EVA suggests
that the business is destroying value.
The following diagram compares the components of EVA and ROE to explore the
similarities:
=
NOPAT
-(
1
ROE
=
PAT%
x
Net Assets
2
x
Activity
WACC
(
EVA
3
x
Leverage
Unpacking each of these components:
#1 Both of these items measure profitability. The only difference is that NOPAT is
before interest and dividends and PAT% is before dividends.
#2 Activity uses the net assets in its calculation by dividing Sales by net assets. The
components are part of the same measure.
#3 Leverage is a measure of debt in the business in a similar way to WACC. Leverage
and WACC are both measuring proportions of debt and equity.
One can only conclude that ROE through the lens of a DuPont decomposition and EVA
are essentially the same thing. ROE measure returns in percentage and EVA measures
returns in currency. I can only say well done to Joel Stern for dressing DuPont up in a
sexy ball gown and selling it to executives.
77
The Application of Value Creation
This section covers several great examples of South African JSE listed companies that
can be used to apply the dashboard of ROE and EVA. The intent is to determine if the
businesses are creating value.
Shoprite Holdings (SHP)
SHOPRITE HOLDINGS LTD
Share Price @ Year End
EVA = Ecconomic Value Add
ROE = Pa x A x L
WACC
101.80
1,434,522,515
37.08%
17.7%
150.67
1,037,429,914
29.54%
17.6%
Turnover
T/O GROWTH
Cost of Sales
Gross Profit
GP%
Expenses
Depreciation
Operating profit (EBIT)
OP%
Total Interest Paid
Interest Received
Profit Before Tax
Taxation
Profit After Interest and Tax
PAT%
Ordinary Dividends Paid
Retained Profits
30-Jun-11
72,297,777,000
7.3%
57,624,408,000
14,673,369,000
20.3%
9,770,198,000
948,520,000
3,895,960,000
5.4%
125,964,000
94,614,000
3,876,494,000
1,346,826,000
2,529,668,000
3.5%
1,189,411,000
1,340,257,000
30-Jun-12
82,730,587,000
14.1%
65,752,642,000
16,977,945,000
20.5%
11,235,389,000
1,132,907,000
4,480,845,000
5.4%
223,437,000
159,024,000
4,481,833,000
1,438,889,000
3,042,944,000
3.7%
1,421,598,000
1,621,346,000
Balance sheet
185.50
918,392,094
26.18% Declining ROE
17.5%
30-Jun-13
92,747,314,000
12.4%
73,316,296,000
19,431,018,000
21.0%
12,607,369,000
1,347,715,000
5,320,294,000
5.7%
429,059,000
283,494,000
5,193,979,000
1,578,545,000
3,615,434,000
3.9%
1,696,418,000
1,919,016,000
Growing Sales
Consistent GP%
Increasing OP%
Increasing PAT%
Total Equity
Ordinary Share Capital
Share Premium
Non-Distributable Reserves
Distributable Reserves
Outside Shareholders Interest
30-Jun-11
7,143,599,000
616,583,000
293,072,000
(332,478,000)
6,507,523,000
58,899,000
30-Jun-12
12,807,899,000
647,314,000
3,672,069,000
(320,146,000)
8,745,805,000
62,857,000
30-Jun-13
15,252,490,000
647,328,000 Increasing
3,672,069,000 share capital
760,333,000
10,104,346,000
68,414,000
Preference Shares
Deferred Tax
Other Non-Current Liabilities
Long Term Interest Bearing
Total Capital
2,450,000
25,377,000
1,058,442,000
23,578,000
8,253,446,000
2,450,000
152,085,000
880,875,000
4,004,066,000
17,847,375,000
2,450,000
197,135,000
831,383,000
3,820,701,000 Increasing debt
20,104,159,000
78
Fixed Assets
Intangible Assets
Investments & Loans
Other Non-Current Assets
Net Current Assets
Current Assets
Inventory
Trade Receivables
Cash & Near Cash
8,168,749,000
719,105,000
63,964,000
394,362,000
(1,092,734,000)
11,357,577,000
7,055,867,000
2,301,616,000
1,961,551,000
9,668,559,000
894,296,000
107,592,000
816,211,000
6,360,717,000
19,418,860,000
8,680,109,000
2,718,228,000
7,939,333,000
11,713,741,000
1,039,192,000
140,780,000
494,656,000
6,715,790,000
20,100,902,000
10,317,417,000
3,470,269,000
6,138,671,000
Current Liabilities
Trade Payables
Dividends Payable
Tax Payable
Short-Term Interest Bearing
Net Assets
12,450,311,000
9,911,860,000
4,851,000
464,316,000
2,069,284,000
8,253,446,000
13,058,143,000
12,850,338,000
4,955,000
151,025,000
51,825,000
17,847,375,000
13,385,112,000
12,856,690,000
6,434,000
186,666,000
335,322,000
20,104,159,000 Increase in NA
Notice how the ROE dropped between 2011 and 2012 (Highlighted with a red box).
Using the ROE dashboard of ROE = P x A x L we can hunt down the cause.
Shoprite raised approximately R7.3 billion in new capital in 2012. R4 billion came from
new debt and R3.3 billion came from new equity. This capital was intended to fund the
expansion plans into Africa.
The increase in the Net Assets from R8,2 billion in 2011 to R17.8 billion in 2012 is the
cause of the decline in Activity and thus the decline in ROE. This would be represented
on the ROE dashboard as a decline in the Activity.
79
The relative performance chart plots the performance of a R1 investment in Shoprite
(SHP) over the last 15 years as compared to a R1 investment in the All Share Index (ALSI).
The red line is SHP and the blue line is the ALSI. A R1 investment in the ALSI in 2005
would be worth R3.80 today in 2020. A R1 investment in SHP would be worth R7.47
today. However, in late 2012 when SHP raised the capital to invest in Africa the R1
investment was worth R14.77. This might suggest that SHP has not been able to deliver
on the promise of higher returns from its African investments.
SHP value creation metrics
Share Price @ Year End
EVA = Ecconomic Value Add
ROE = Pa x A x L
WACC
154.00
769,554,593
23.99%
17.4%
30-Jun-14
173.50
671,015,560
23.20%
17.4%
30-Jun-15
166.32
1,496,274,282
23.92%
17.2%
30-Jun-16
199.38
1,375,700,122
21.41%
17.2%
30-Jun-17
220.61
409,712,409
17.73%
17.2%
30-Jun-18
Since 2015 SHP has been able to create value. EVA is positive and ROE is consistently above or
close to 18%. SHP appears to have suffered from the winner’s curse. Up until the end of 2012
when SHP raised capital for its investments in Africa it had produced consistent returns in the mid
80
30% range. There were plenty of buyers of SHP shares, hence the steep and consistent climb in
share price and relative performance. Until SHP can show signs of returning to returns to
shareholders in at least the high 20% range, it may not be able attract new buyers to drive the
share price back up.
81
Pick ‘n Pay (PIK)
PICK N PAY STORES LTD
Share Price @ Year End
EVA = Ecconomic Value Add
ROE = Pa x A x L
WACC
52.82
327,324,033
27.92%
17.2%
56.34
451,948,402
29.57%
17.6%
69.45
617,089,394
29.10%
17.6%
11-Aug-20
72.66
663,823,827
26.96%
17.3%
44.34
69.33
974,701,255
31.09%
17.1%
Turnover
T/O GROWTH
Cost of Sales
Gross Profit
GP%
Expenses
Depreciation
Operating profit (EBIT)
OP%
Total Interest Paid
Interest Received
Profit Before Tax
Taxation
Profit After Interest and Tax
PAT%
Ordinary Dividends Paid
Retained Profits
28-Feb-15
66,940,800,000
6.1%
54,994,300,000
11,946,500,000
17.8%
9,826,500,000
714,500,000
1,250,500,000
1.9%
119,000,000
59,400,000
1,205,200,000
343,500,000
861,700,000
1.3%
461,800,000
462,300,000
29-Feb-16
72,445,100,000
7.9%
59,474,800,000
12,970,300,000
17.9%
10,537,100,000
778,400,000
1,483,700,000
2.0%
119,000,000
60,900,000
1,473,500,000
408,100,000
1,065,400,000
1.5%
589,500,000
571,500,000
28-Feb-17
77,486,100,000
7.3%
63,549,400,000
13,936,700,000
18.0%
11,222,300,000
820,900,000
1,727,500,000
2.2%
119,000,000
126,100,000
1,715,200,000
471,700,000
1,243,500,000
1.6%
753,500,000
769,200,000
28-Feb-18
81,560,100,000
5.3%
66,309,800,000
15,250,300,000
18.7%
12,356,900,000
913,500,000
1,798,900,000
2.2%
119,000,000
184,100,000
1,768,100,000
471,800,000
1,296,300,000
1.6%
866,500,000
299,600,000
28-Feb-19
88,293,200,000
8.3%
71,539,300,000
16,753,900,000
19.0%
13,365,800,000
1,026,100,000
2,181,300,000
2.5%
119,000,000
258,800,000
2,199,800,000
550,300,000
1,649,500,000
1.9%
938,000,000
695,700,000
Total Equity
Ordinary Share Capital
Share Premium
Non-Distributable Reserves
Distributable Reserves
Outside Shareholders Interest
28-Feb-15
3,130,100,000
6,000,000
(187,300,000)
3,311,400,000
-
29-Feb-16
3,897,800,000
6,000,000
8,900,000
3,882,900,000
-
28-Feb-17
4,079,300,000
6,000,000
(578,800,000)
4,652,100,000
-
28-Feb-18
4,023,600,000
6,000,000
(934,100,000)
4,951,700,000
-
28-Feb-19
4,316,800,000
6,000,000
(1,336,600,000)
5,647,400,000
-
Preference Shares
Deferred Tax
Other Non-Current Liabilities
Long Term Interest Bearing
Total Capital
1,138,500,000
492,800,000
4,761,400,000
9,500,000
1,239,600,000
83,000,000
5,229,900,000
14,600,000
1,398,600,000
84,000,000
5,576,500,000
13,700,000
1,571,600,000
79,500,000
5,688,400,000
14,200,000
1,719,400,000
6,050,400,000
4,187,000,000
1,010,200,000
280,800,000
442,100,000
(1,158,700,000)
8,786,400,000
4,654,500,000
2,958,100,000
1,173,800,000
4,950,900,000
1,004,900,000
660,400,000
501,600,000
(1,887,900,000)
9,467,100,000
5,152,000,000
3,332,200,000
982,900,000
5,583,600,000
984,300,000
408,500,000
724,400,000
(2,124,300,000)
10,401,600,000
5,994,600,000
3,445,100,000
961,900,000
6,054,400,000
991,300,000
470,600,000
842,300,000
(2,670,200,000)
10,621,900,000
5,963,700,000
3,529,100,000
1,129,100,000
6,189,300,000
970,600,000
286,400,000
745,200,000
(2,141,100,000)
11,662,800,000
5,697,200,000
4,462,400,000
1,503,200,000
9,945,100,000
9,026,800,000
126,800,000
791,500,000
4,761,400,000
11,355,000,000
10,625,400,000
183,000,000
546,600,000
5,229,900,000
12,525,900,000
10,501,900,000
174,800,000
1,849,200,000
5,576,500,000
13,292,100,000
10,829,100,000
213,700,000
2,249,300,000
5,688,400,000
13,803,900,000
10,659,800,000
19,100,000
3,125,000,000
6,050,400,000
Balance sheet
Fixed Assets
Intangible Assets
Investments & Loans
Other Non-Current Assets
Net Current Assets
Current Assets
Inventory
Trade Receivables
Cash & Near Cash
Current Liabilities
Trade Payables
Dividends Payable
Tax Payable
Short-Term Interest Bearing
Net Assets
82
Key Ratios
PAT% (Pa)
Net Asset Turnover (Activity)
Leverage - on the surface
28-Feb-15
1.3%
14.06
1.52
29-Feb-16
1.5%
13.85
1.34
28-Feb-17
1.6%
13.90
1.37
28-Feb-18
1.6%
14.34
1.41
28-Feb-19
1.9%
14.59
1.40
PIK has increasing profit margins year on year from 2015 to 2019. Its activity ratio has
been gradually improving since 2016. The leverage has mostly stayed constant. The
increasing profit margins and improving Activity are the reason for the increase in ROE
over the last few years. The changes are small, and performance is moving in the right
direction. For many years PIK has been the underdog to SHP.
In comparing the relative performance charts, PIK has underperformed the AlSI. Since
2005 SHP has been the hands down winner. However, over the period from 2015 to
2018 PIK has been the better performer. Unfortunately, 2019 and 2020 has been hard
on all the retailers.
83
Woolworths (WHL)
WOOLWORTHS HOLDINGS LTD
Share Price @ Year End
EVA = Ecconomic Value Add
ROE = Pa x A x L
WACC
74.41
1,587,193,922
41.17%
17.1%
98.60
1,109,473,555
26.10%
16.6%
84.02
120,933,326
25.43%
16.1%
11-Aug-20
61.65
1,239,084,045
28.39%
15.7%
34.46
55.45
(7,231,803,958)
-20.95%
15.7%
30-Jun-14
39,707,000,000
12.7%
24,209,000,000
15,498,000,000
39.0%
10,683,000,000
640,000,000
3,943,000,000
9.9%
136,000,000
112,000,000
4,104,000,000
1,114,000,000
2,990,000,000
7.5%
1,999,000,000
577,000,000
30-Jun-15
56,506,000,000
42.3%
33,356,000,000
23,150,000,000
41.0%
15,873,000,000
1,245,000,000
5,587,000,000
9.9%
1,494,000,000
116,000,000
4,432,000,000
1,312,000,000
3,120,000,000
5.5%
2,146,000,000
(1,329,000,000)
30-Jun-16
65,004,000,000
14.7%
38,618,000,000
26,386,000,000
40.6%
17,592,000,000
1,514,000,000
6,969,000,000
10.7%
1,494,000,000
48,000,000
6,033,000,000
1,680,000,000
4,353,000,000
6.7%
2,176,000,000
1,400,000,000
30-Jun-17
67,411,000,000
4.0%
40,739,000,000
26,672,000,000
39.6%
17,097,000,000
1,640,000,000
7,626,000,000
11.3%
1,494,000,000
96,000,000
6,726,000,000
1,278,000,000
5,448,000,000
8.1%
3,014,000,000
2,183,000,000
30-Jun-18
68,592,000,000
1.8%
41,700,000,000
26,892,000,000
39.2%
19,944,000,000
1,692,000,000
(1,668,000,000)
-2.4%
1,494,000,000
71,000,000
(2,434,000,000)
1,115,000,000
(3,549,000,000)
-5.2%
2,781,000,000
(6,823,000,000)
Total Equity
Ordinary Share Capital
Share Premium
Non-Distributable Reserves
Distributable Reserves
Outside Shareholders Interest
30-Jun-14
6,952,000,000
678,000,000
(741,000,000)
6,692,000,000
323,000,000
30-Jun-15
14,297,000,000
10,802,000,000
(1,914,000,000)
5,363,000,000
46,000,000
30-Jun-16
19,853,000,000
11,237,000,000
1,826,000,000
6,763,000,000
27,000,000
30-Jun-17
19,066,000,000
11,375,000,000
(1,283,000,000)
8,946,000,000
28,000,000
30-Jun-18
13,126,000,000
11,399,000,000
(409,000,000)
2,123,000,000
13,000,000
Preference Shares
Deferred Tax
Other Non-Current Liabilities
Long Term Interest Bearing
Total Capital
332,000,000
963,000,000
623,000,000
8,870,000,000
516,000,000
2,634,000,000
14,922,000,000
32,369,000,000
6,000,000
2,850,000,000
15,703,000,000
38,412,000,000
658,000,000
2,541,000,000
12,137,000,000
34,402,000,000
758,000,000
2,607,000,000
11,711,000,000
28,202,000,000
Fixed Assets
Intangible Assets
Investments & Loans
Other Non-Current Assets
Net Current Assets
Current Assets
Inventory
Trade Receivables
Cash & Near Cash
3,519,000,000
2,946,000,000
907,000,000
820,000,000
678,000,000
14,077,000,000
3,436,000,000
1,090,000,000
9,542,000,000
14,508,000,000
15,700,000,000
949,000,000
2,047,000,000
(835,000,000)
8,251,000,000
5,881,000,000
1,270,000,000
891,000,000
15,402,000,000
18,965,000,000
1,019,000,000
3,664,000,000
(638,000,000)
10,340,000,000
7,117,000,000
1,402,000,000
1,525,000,000
13,846,000,000
19,595,000,000
1,057,000,000
208,000,000
(304,000,000)
10,287,000,000
6,990,000,000
1,258,000,000
1,787,000,000
13,959,000,000
13,410,000,000
1,034,000,000
247,000,000
(448,000,000)
11,497,000,000
7,542,000,000
1,661,000,000
2,023,000,000
Current Liabilities
Trade Payables
Dividends Payable
Tax Payable
Short-Term Interest Bearing
Net Assets
13,399,000,000
5,171,000,000
189,000,000
8,039,000,000
8,870,000,000
9,086,000,000
8,631,000,000
259,000,000
196,000,000
32,369,000,000
10,978,000,000
10,370,000,000
393,000,000
215,000,000
38,412,000,000
10,591,000,000
9,377,000,000
26,000,000
1,188,000,000
34,402,000,000
11,945,000,000
9,672,000,000
124,000,000
2,149,000,000
28,202,000,000
Turnover
T/O GROWTH
Cost of Sales
Gross Profit
GP%
Expenses
Depreciation
Operating profit (EBIT)
OP%
Total Interest Paid
Interest Received
Profit Before Tax
Taxation
Profit After Interest and Tax
PAT%
Ordinary Dividends Paid
Retained Profits
Balance sheet
84
Key Ratios
PAT% (Pa)
Net Asset Turnover (Activity)
Leverage - on the surface
30-Jun-14
7.5%
4.48
1.28
30-Jun-15
5.5%
1.75
2.26
30-Jun-16
6.7%
1.69
1.93
30-Jun-17
8.1%
1.96
1.80
30-Jun-18
-5.2%
2.43
2.15
WHL was the champion retailer from 2009 to 2015. Their investment in David Jones in
2015 has turned out to be their kryptonite. WHL took on approximately R14 billion in
debt and R10 billion in new equity to make the acquisition. Notice how the ROE declined
from 41% in 2014 to 26% in 2015 when the acquisition was made.
The new debt reduced the Pat% from 7.5% to 5.5%. The new assets on the balance sheet
reduced the Activity from 4.48 to 1.75. The debt worked in its favour but the strength of
the downward movement in Profitability and Activity was just too much. In 2018 WHL
had to take on an impairment charge of approximately R6 billion. This is a non-cash
expense in the income statement which has the effect of reducing the equity in the
balance sheet to match the write down in the asset value.
The relative performance chart reflects the value destruction from shareholders since
the David Jones deal was done in 2015. R1 invested in WHL in2005 would have been
worth R10.77 in 2015. It is now worth R3.05. Less than the return of the ALSI.
85
Clicks (CLS)
CLICKS GROUP LTD
Share Price @ Year End
EVA = Ecconomic Value Add
ROE = Pa x A x L
WACC
69.15
562,113,533
44.32%
17.9%
91.54
675,071,680
50.28%
18.0%
121.10
721,446,950
45.87%
18.0%
11-Aug-20
148.80
793,389,990
43.46%
18.0%
228.59
203.00
802,341,840
38.26%
18.0%
Turnover
T/O GROWTH
Cost of Sales
Gross Profit
GP%
Expenses
Depreciation
Operating profit (EBIT)
OP%
Total Interest Paid
Interest Received
Profit Before Tax
Taxation
Profit After Interest and Tax
PAT%
Ordinary Dividends Paid
Retained Profits
31-Aug-14
19,149,524,000
9.2%
15,026,159,000
4,123,365,000
21.5%
2,646,274,000
201,769,000
1,247,388,000
6.5%
46,157,000
5,497,000
1,206,728,000
341,883,000
864,845,000
4.5%
429,277,000
(569,250,000)
31-Aug-15
22,070,092,000
15.3%
17,545,318,000
4,524,774,000
20.5%
2,890,127,000
218,543,000
1,386,593,000
6.3%
62,231,000
4,922,000
1,329,284,000
374,709,000
954,575,000
4.3%
490,758,000
464,582,000
31-Aug-16
24,170,879,000
9.2%
19,156,612,000
5,014,267,000
20.7%
3,184,875,000
237,824,000
1,565,248,000
6.5%
62,231,000
6,255,000
1,514,651,000
420,779,000
1,093,872,000
4.5%
585,757,000
508,115,000
31-Aug-17
26,809,101,000
11.2%
21,185,124,000
5,623,977,000
21.0%
3,518,202,000
259,657,000
1,808,709,000
6.7%
62,231,000
10,501,000
1,774,272,000
496,630,000
1,277,642,000
4.8%
677,399,000
602,031,000
31-Aug-18
29,239,688,000
9.1%
23,062,579,000
6,177,109,000
21.1%
3,797,573,000
289,239,000
2,040,394,000
7.0%
62,231,000
25,757,000
2,045,000,000
569,790,000
1,475,210,000
5.0%
811,578,000
719,121,000
Total Equity
Ordinary Share Capital
Share Premium
Non-Distributable Reserves
Distributable Reserves
Outside Shareholders Interest
31-Aug-14
1,566,973,000
2,754,000
3,497,000
(99,260,000)
1,659,982,000
-
31-Aug-15
2,012,807,000
2,754,000
3,497,000
(118,008,000)
2,124,564,000
-
31-Aug-16
2,452,241,000
2,754,000
3,497,000
(186,689,000)
2,632,679,000
-
31-Aug-17
3,300,350,000
2,752,000
3,497,000
59,391,000
3,234,710,000
-
31-Aug-18
4,427,868,000
2,686,000
513,848,000
(42,497,000)
3,953,831,000
-
Preference Shares
Deferred Tax
Other Non-Current Liabilities
Long Term Interest Bearing
Total Capital
2,782,000
283,683,000
1,853,438,000
308,503,000
2,321,310,000
405,541,000
2,857,782,000
402,257,000
3,702,607,000
447,546,000
4,875,414,000
Fixed Assets
Intangible Assets
Investments & Loans
Other Non-Current Assets
Net Current Assets
Current Assets
Inventory
Trade Receivables
Cash & Near Cash
1,135,007,000
475,133,000
35,161,000
126,335,000
81,802,000
4,420,621,000
2,614,196,000
1,609,721,000
195,631,000
1,221,658,000
499,135,000
29,671,000
258,699,000
312,147,000
5,546,775,000
3,249,914,000
1,892,046,000
400,738,000
1,345,024,000
537,593,000
45,948,000
578,642,000
350,575,000
5,869,689,000
3,478,717,000
2,021,172,000
369,800,000
1,533,935,000
561,113,000
52,119,000
707,114,000
848,326,000
6,866,834,000
3,753,794,000
2,412,567,000
700,473,000
1,843,402,000
580,271,000
117,529,000
691,462,000
1,642,750,000
8,331,413,000
4,227,336,000
2,580,262,000
1,523,815,000
Current Liabilities
Trade Payables
Dividends Payable
Tax Payable
Short-Term Interest Bearing
Net Assets
4,338,819,000
4,244,477,000
94,342,000
1,853,438,000
5,234,628,000
5,118,802,000
115,826,000
2,321,310,000
5,519,114,000
5,426,638,000
92,476,000
2,857,782,000
6,018,508,000
5,885,517,000
132,991,000
3,702,607,000
6,688,663,000
6,621,644,000
67,019,000
4,875,414,000
Balance sheet
86
Key Ratios
PAT% (Pa)
Net Asset Turnover (Activity)
Leverage - on the surface
31-Aug-14
4.5%
10.33
1.18
31-Aug-15
4.3%
9.51
1.15
87
31-Aug-16
4.5%
8.46
1.17
31-Aug-17
4.8%
7.24
1.12
31-Aug-18
5.0%
6.00
1.10
Summary of Secrets
This chapter is the equivalent of the postscript (P.S). It is the last paragraph after the
letter that people jump to if they do not want to read all the detail.
The secrets referred to in the chapter title are not secrets in a way that that the
information is new and is being exposed for the first time. Those who have formal
training in accounting and finance know these secrets as if they are part of everyday life.
However, the case has been made that the financial information of a business is not
universally understood. Generally, people are financially illiterate when it comes to
business finance. The secrets in this book and the summary that appears below are new
information and insights to many who have little financial experience and understanding
of a business.
The secrets in this summary are expressed as formulas, nuggets of information, and
simple financial truths. There is no explanation with them. The explanations are in the
book. Some of the secrets are repeated several times where jargon is used to express
the same thing in different ways.
1.
Shareholders are the primary stakeholders in business. Without a shareholder
there is no business.
2.
Shareholders trade off risk for return. More risk increases the expectation of
return…and loss.
3.
Shareholders returns are realised through dividends and share price growth.
4.
The weighted average cost of capital (WACC) is the minimum return that is
expected to be produced by the operations of the business.
5.
Value creation is the generation of returns from the operations that are higher
than WACC.
6.
Value creation for the shareholder is the generation of returns that exceeds the
shareholders expectations, given the risk of the investment.
7.
Profits in the income statement are simply the opinion of the accountant.
8.
Cashflow and profit can bear little resemblance to each other.
9.
Managing Return on Equity (ROE) can be like herding cats.
88
10. More debt can increase the ROE.
11. RONA > WACC
12. ROE > Shareholder expectations (18% in South Africa, 10% in USA).
13. RONA = ROTC = ROFE = ROCE
14. Return on Net Assets = Return on Total Capital = Return on Funds Employed =
Return on Capital Employed.
15. NOPAT is the best profit measure of the operations
16. NOPAT = PBIT – Tax
17. RONA = PBIT/Average Net Assets x 100
18. RONA = PBIT% x Activity
19. PBIT% = PBIT/Sales x 100
20. Activity = Sales/Average Net Assets
21. ROE = PAT/Average Equity x 100
22. ROE = Pat% x Activity x Leverage
23. PAT% = PAT/Sales x 100
24. Leverage = Average Total capital / Average Equity
25. Return on Invested Capital (ROIC) = NOPAT/ Average Net Assets x 100
26. NOPAT% = NOPAT/Sales x 100
27. ROIC = NOPAT% x Activity
28. CAGR = (Vfinal/Vbegin)^(1/t)-1
29. EVA = NOPAT – (Net Assest x WACC)
30. Ke = Cost of Equity = Shareholders expectations
31. Kd = After Tax Cost of Debt
32. Kd = Interest rate x (1 – Tax rate)
33. WACC = Ke x Equity% + Kd x Debt%
89
References
Mike Ward and Allan Price. 2014. Turning Vision into Value.
Erik Beinhocker.2010. The Origin Of Wealth.
Mike Ward and Chris Muller. 2012. Empirical testing of the CAPM on the JSE.
90
Complimentary Resources
Finance on Steroids
Finance on Steroids is a 6-part video training series. This video series compliments this
book by exploring the detailed application of the value creation theory.
Where this book just dips its toe in the water, Finance on Steroids goes into depth.
Finance on Steroids was developed to help use the value creation tools to find great
performing businesses to invest in. Included with the Finance on Steroids are:
•
Detailed historical performance analyses of several different listed companies.
•
Value creation and value destruction insights on how higher performing
management teams can go off the rails.
•
Company performance charts for 20 listed companies.
•
Excel spreadsheets containing sample data of historical performance.
•
An introductory training on company valuation using a listed company
Finance on Steroids will give you MBA finance skills without having to pay hundreds of
thousands of Dollars to get an MBA.
91
Company Value on Excel Steroids
Company Value on Excel Steroids is the next level up from Finance on Steroids. This 18part video training series is all about valuation. The training series takes you on a journey
of building a robust Excel valuation model that uses historical data to value large listed
companies.
You will learn how to:
•
Measure historical perfromance.
•
Forecast future potential high road and low road business perfromance using
historical data.
•
Forecast integrated financial statements for use in valuation.
•
Calculate future growth rates, free cashflows and terminal values.
•
Discount future cashflows using appropriate risk adjustments.
•
Value the shares of a company and compare them to the market share price.
Ultimately the objective of this training is to equip you with the skills to find great
businesses that are undervalued and ripe for long term investment.
As an entrepreneur you will gain the skills to be able to get new insights into the value
of your own business. You will be able to translate the learning into identifying the levers
of valuation that you can pull in your business to drive value creation.
92
Online Business Simulation
The Online Business Simulation is the most incredible team learning experience. It is the
opportunity to practise all the financial skills that you have learned in this book. You are
appointed to the executive team of a multi-national listed company. Your job, with your
management team, is to run a motor manufacturing business that competes in several
international markets. You will be exposed to the following dynamics:
•
Working with your team.
•
Setting the strategic direction of your business.
•
Managing an international sales force.
•
Planning the operations to produce products and services.
•
Implementing your financial learning about performance and value creation.
•
Marketing and promoting your products and services to grow your business.
•
Learning to lead under the daily pressure of being in the c-suite.
•
Exploring your own leadership style and maturity with guidance and feedback
from coaches.
The simulation is run over 3 days, using online conference facilities and proprietary
software. The training facilitators provide feedback and coaching to help you develop
your management and leadership skills to raise your game so that you can make the
jump to the next level in your career.
93
94