Introduction to Theoretical Finance GEST-S318

Transcription

1 Introduction to Theoretical Finance GEST-S Prof. Laurent Gheeraert

2 1. What is Finance? Basics of Accounting & Financial Statements Analysis Prof. Laurent GHEERAERT Solvay Brussels School of Economics & Management

3 3 Objectives of this session BDM, 2013 reference: Chapter 1: "The corporation" Chapter 2: "Introduction to Financial Statement Analysis" 1. Understanding what accounting and finance are about 2. Getting a basic understanding of the major financial statements a. Income statement b. Balance sheet c. Cash flow statement 3. Building on accounting basics to perform financial analysis (e.g., ratios) a. Performance b. Liquidity c. Solvency

4 4 Corporate Finance 101 Activities of the firm and related Cash Flows Investment Dividend Projects A B Z Investment FIRM Issuance of stock Issuance of debt (bond) Shareholders Debtholders CF from operations Interest / Debt payment

5 5 Financial objectives of the company Make the right decisions Correctly follow up CREATE / MAXIMIZE VALUE Which value? Market Value ( book value) Company Value = Enterprise Value = (net) Debt Value + Equity Value Or Equity Value

6 6 What is Corporate Finance? INVESTMENT DECISIONS: Which REAL ASSETS to buy? Real assets: will generate future cash flows to the firm Intangible assets : R&D, Marketing,.. Tangible assets : Real estate, Equipments,.. Current assets: Inventories, Account receivables,.. FINANCING DECISIONS: Which FINANCIAL ASSET to sell? Financial assets: claims on future cash flows Debt: promise to repay a fixed amount Equity: residual claim DIVIDEND DECISION: How much to return to stockholders?

7 Corporate Governance 101 (1/2) Two major types of companies Unlimited liability (e.g., sole proprietorships) Limited liability (e.g., limited liability companies, corporations) + Mix (e.g., partnerships) A company can be many owners Separation between ownership and control Shareholders ("Principal") Board of Directors & Chief Executive Officer, CEO ("Agents") 7

8 Corporate Governance 101 (2/2) Typical organization chart of a corporation General Assembly Board of Directors Chief Executive Officer (CEO) Chief Financial Officer (CFO) Chief Operating Officer (COO) Controller Treasurer Accounting Tax department Capital Budgeting Risk Management Credit Management PAST Based on historical information FUTURE Based on projections of the future 8 Source: BDM 2011

9 9 Accounting key principles and objectives Main objective of accounting: display a fair view of the company s economic situation Key accounting principles: Double entry accounting Accrual accounting Identifying revenues for the period Matching the corresponding costs to the revenues Not the same as cash received What happened? Historical cost Non cash expenses (depreciation, ) No transaction netting On-going concern Permanent use of accounting methods Conservative Realized gains (and realizable losses) Useful for third parties (e.g., taxable income, debtholders ) Different from the financial perspective

10 Accounting view of the firm Balance sheet = picture of the company at a given moment Income statement = film between two balance sheets Fixed assets Net Working Capital Shareholders equity (SE) Long-term debt Sales Operating expenses = Earnings before interest and taxes (EBIT) Interest expenses Taxes Current assets Current liabilities = Net income (earnings after taxes) Retained earnings Dividend payments 10

11 Notations Income statement REV Revenue (also called Turnover ) CGS Cost of goods sold = M1 (purchases, i.e. cost of raw material) Δ INV SGA Selling, general and administrative expenses = EXP (non personnel expenses) + PERS (personnel cost) DEP Depreciation (and amortization) EBIT Earnings before interest and taxes Int Interest expenses TAX Taxes T c Tax rate NI Net income (sometimes called (Net) Earnings or Net Profit ) Balance sheet FA Fixed assets (net) AR Accounts receivable INV Inventories CASH Cash & cash equivalents SE Equity capital LTD Long term debt AP Accounts payable STD Short-term borrowing D Interest-bearing debt (= STD + LTD) Statement of retained income DIV Dividends RET Retained earnings Others I Investment (Gross) = Capital expenditure 11

12 Income statement: key measures Revenue - CGS Gross profit GROSS PROFIT = REV CGS - EXP Added Value - PERS ADDED VALUE = REV CGS EXP EBITDA = Earnings Before Interest, Tax, Depreciation and Amortization - DEP EBITDA = REV CGS SGA * EBIT = Earnings Before Interest and Tax - Int - TAX NI = Net Income EBIT = REV CGS SGA DEP NI = REV CGS SGA DEP Int TAX 12 * SGA = EXP + PERS

13 13 * A piece of land cannot be depreciated, as it has theoretically no limited useful life. On the contrary, the historical cost of a building will be depreciated (after excluding the historical cost of the land). ** Depreciation and amortization are similar concepts: Tangible assets are depreciated, while intangible assets are amortized. OPEX vs. CAPEX OPEX = Operating expense Ongoing costs to run the business Fully taken as accounting charge when accrued Example: paper, toner, power and maintenance costs for a photocopier Other examples: consulting fees, office supplies, travel costs, administrative costs CAPEX = Capital expenditure Investment in Fixed Assets (FA) In accounting, several types of FA are usually depreciated or amortized** over time according to their expected useful life* Example: purchase of a photocopier Other examples: purchase or replacement of a machine, commercial vehicle, patent, large R&D investment Depreciation An allocation of the cost of an asset to the periods in which the asset is used (cf. matching principle) Accounting charge ( expense ) Non-cash expense

14 Depreciation Depreciation example: A machine is bought for 100 EUR in year 0 No complementary investment over time It is depreciated linearly* over 5 years yearly depreciation charge = 1/5 of historical price (1/5 * 100 = 20 EUR) Year Machine historical price = GROSS Fixed Asset Depreciation Cumulated Depreciation Machine residual book value = NET Fixed Asset NET FA = GROSS FA (historical price) cumulated depreciation NET FA = the residual book value of the machine market value or resale value of the machine! In case the machine is sold: resale price book value = accounting profit (if negative: accounting loss) in the year when the machine is sold The speed of depreciation impacts taxes! (see next) 14 * Several depreciation methods exist; the linear method is still widely used.

15 Income statement: key measures Revenue - CGS Gross profit GROSS PROFIT = REV CGS - EXP Added Value - PERS ADDED VALUE = REV CGS EXP EBITDA = Earnings Before Interest, Tax, Depreciation and Amortization - DEP EBITDA = REV CGS SGA * EBIT = Earnings Before Interest and Tax - Int - TAX NI = Net Income EBIT = REV CGS SGA DEP NI = REV CGS SGA DEP Int TAX 15 * SGA = EXP + PERS

16 16 Interests and taxes Corporate tax base = EBIT interest = EBT ( Earnings Before Tax ) Corporate tax rate = T C Corporate taxes = EBT * T C Interests Are charges to be paid on the financial debt, short- or long-term ( interestbearing debt ) Are tax-deductible (interests reduce the corporate tax base) A company with no debt ( all-equity financed company ) has no tax-deductible interests Corporate taxes of an all-equity company = EBT * T C = EBIT * T C

17 Income statement: structure EBITDA (operational) + EBITDA (financial) + EBITDA (exceptional) = EBITDA - Depreciation and amortization = EBIT - Interest charges - Tax = Net income 17

18 Typical balance sheet (accounting view) Overview of a company s resources and allocations (uses) At a given point in time (e.g., 31/12) Accounting view = belongings (assets) and obligations (liabilities) Assets (belongings) Equity and liabilities (commitments) Increasing liquidity Current assets Fixed assets (FA) Inventories (INV) Accounts receivable (AR) Cash & cash equivalent (CASH) Current liabilities Stockholders' equity (SE) Provision (PROV) * Long-term debt (LTD) ** Short-term debt (STD) ** Accounts payable (AP) Increasing payability / duration FA + INV + AR + CASH = SE + PROV + LTD + AP + STD 18 * Henceforth, PROV are assumed to be zero ** Financial debt = interest-bearing debt = LTD + STD

19 Summarized balance sheet 1 (economic view #1) Economic view = uses (assets) and resources (equity and liabilities) Economic view 1: shift Accounts Payable (AP) to the left-hand side of the balance sheet as AP typically stems from the company s activity NB: this entails a change ( AP) in the total assets, as well as the total equity and liabilities Assets Equity and liabilities Fixed assets (FA) Working capital requirement (WCR) Stockholders' equity (SE) Interest-bearing debt (D) Cash & cash equivalents (CASH) FA + WCR + CASH = SE + D 19 Working capital requirement (WCR) = + Accounts receivable + Inventories + Prepaid expenses Account payable Accrued payroll and other expenses Interest-bearing debt (D) = + Long-term debt (including: Notes payable to banks) + Short-term debt (including: Current maturities of longterm debt)

20 Summarized balance sheet 2 (economic view #2) Accounting view = uses (assets) and resources (equity and liabilities) Economic view 2: shift CASH to the right-hand side of the balance sheet as cash is generally not a productive asset that the company should accumulate, and can rather be viewed as reducing the company s debt NB: this entails a change ( CASH) in the total assets, as well as the total equity and liabilities Assets Equity and liabilities Fixed assets (FA) Working capital requirement (WCR) Stockholders' equity (SE) Net Debt * (net D) FA + WCR = SE + D NLB ** = SE + net D ** Net Liquid Balance (NLB) = + Cash & cash equivalents Short-term financial debt * Net Debt (net D) = + Interest-bearing debt Cash & cash equivalents 20

21 Net Working Capital Net working capital can be defined / understood in two ways: As an investment to be funded: Current Assets Current Liabilities As a source of financing: Stockholders' Equity + LT Debt Fixed Assets Fixed Assets Net Working Capital Stockholder s Equity Current ratio: a measure of NWC Current ratio = Current assets / Current liabilities Current Assets Long term Debt Current Liabilities Net working capital = Current assets Current liabilities Current ratio > 1 NWC > 0 21

22 22 Net Working Capital vs. Working Capital Requirement Summarized balance sheet identity: FA + WCR + CASH = SE + LTD + STD Can be written as: WCR + (CASH STD) = (SE + LTD FA) WCR + NLB = NWC Basic liquidity management rules: 1) NWC > 0 (otherwise, illiquid assets are funded by short-term liabilities) 2) NWC > WCR (otherwise, the firms needs to rely on its cash or to use short-term borrowing to cover the gap between NWC and WCR) HOWEVER A comfortable liquidity main lower profitability!

23 23 Income statement and balance sheet: Recap Income statement EBIT = REV CGS SGA Dep TAX = T c * (EBIT Int) NI = EBIT Int TAX Income statement = Statement of Comprehensive Income (IFRS official terminology) Profit and Loss Statement Profit and Loss Account ( P&L ) Statement of Revenues and Charges Balance sheet equation FA + AR + INV + CASH = SE + LTD + AP + STD Working Capital Requirement: WCR AR + INV AP = (Current assets CASH) (Current liabilities STD) Summarised balance sheet: FA + WCR + CASH = SE + D

24 Links between income statement and balance sheet Evolution over time of balance sheet items (main end-of-year writings) SE t+1 = SE t + ΔK t t+1 + RET t t+1 where: ΔK t t+1 is the total capital increase (or, if negative, the capital reimbursement) which took place in between time t and time t+1 RET t t+1 = NI t t+1 DIV t t+1 FA t+1 = FA t + I t t+1 DEP t t+1 (in other terms: I t t+1 = ΔFA t t+1 + DEP t t+1 ) as: FA t = Net FA t Gross FA t (gross) = cumulated I 0 t (NB: sale of asset = negative I) FA t = Gross FA t cumulated DEP 0 t 24

25 25 Balance sheet The Balance Sheet gives a picture of the company at a given moment

26 26 Balance sheet (French): Bilan

27 27 Balance sheet (Dutch): Balans

28 28 Income Statement P&L accounts The income statement is the film between two accounting years Turnover or net sales Cost of goods sold Gross profit Selling, general and administrative expenses Gross operating income + Net interest income = EBITDA Depreciation & provisions Impairment Depreciation & provisions Impairment Extraordinary items Operating income EBIT Interests Taxes Net income = Income before taxes

29 29 Income Statement (French): Compte de résultats

30 Income Statement (Dutch): Winst- en verliesrekening 30

31 31 Illustration Creating MyCompany.com You create a company for a project: All-equity financing OR: Equity + debt financing Step 1: Creation Assets 0 Equity 0 Step 1: Creation Assets 0 Equity 0 Step 2: Equity offering + asset (cash) Step 2: Equity offering + borrowing + asset (cash) Asset 100 Equity 100 Asset 100 Equity 20 Debt 80

32 32 Illustration: Operating MyCompany.com A puzzle MyCompany.com's business consists in selling finance books to its participants Initial balance sheet t = 0 (all-equity) Cash 100 Book Equity 100 Operations year 1: Sell each Buy 2 50 each Income statement year 1: Revenue 200 Expenses -100 Net Income 100 Final cash account =? can this be determined based on the above information?

33 33 Illustration: Operating MyCompany.com Additional complications Initial balance sheet t = 0 (all-equity) Cash 100 Book Equity 100 Operations year 1: Borrow (@ 5% interest rate) and buy second-hand 200 Sell Buy 2 50 each Income statement year 1: Revenue 100 Cost of goods sold -50 Depreciation -100 (straight-line depreciation, over 2 years) Interest -10 Net Income -60 Final cash account =? can this be determined based on the above information?

34 34 Accounting view of the firm: Measuring performance Measure of performance / profitability ROE: return on equity ROE NI SE ROA: return on asset (after interest & tax) ROA NI Asset ROA(gross): return on asset (before interest & tax) Link between ROE and ROA: financing structure of the firm Measures of the leverage D/SE = λ = leverage coefficient D/Asset Asset/SE D Asset 1 Asset ROE ROA (1 ) ROA SE

35 35 Breaking down performance The du Pont system: NI REV Assets ROE REV Assets SE Profit Margin Asset Turnover Financial Leverage ROA Profit margin: net income per of revenue Asset turnover: revenue per invested in assets Example (leasing company): 6.0% = 10.4% x 0.06 x %

36 Performance drivers analysis: Who is who? (1/2) LVMH Moet Hennessy Louis Vuitton (60,000 employees) engages in the manufacture and sale of luxury products worldwide. The company s luxury goods include wines and spirits; fashion and leather goods; perfumes and cosmetics; and watches and jewelry. Its wine and spirits product line primarily consists of champagne, sparkling and still wines, cognac, and various other luxury spirits. The company s fashion and leather goods product portfolio comprises trunks, leather goods, ready-to-wear, shoes, jewelry, accessories, sunglasses, books, eyewear, children s wear, and silk accessories. Its perfumes and cosmetics product line includes fragrances, make-up, and skincare products. The company also engages in the specialty retailing of luxury goods. As of December 31, 2009, it operated approximately 2,423 stores worldwide. The company was founded in 1854 and is headquartered in Paris, France. Carrefour S.A. (472,000 employees) operates hypermarkets, supermarkets, convenience stores, and cash and carry stores worldwide. Its hypermarkets offer staple products; urban, casual, sportswear, and maternity lines of clothing; home decoration products; and tableware collection, as well as supermarkets provide non-food ranges, such as apparel, culture and leisure, and tableware products. The company s convenience stores offer products for preparing meals, including an assortment of fresh produce and a butcher s department; ready-to-eat products and daily items; and mobile phone top-up vouchers. It also operates hard discount stores; acts as a wholesaler for catering and food industry professionals; and provides online shopping services. As of December 31, 2010, the company operated 15,937 stores, including 1,401 hypermarkets, 2,952 supermarkets, 5,059 convenience stores, 6,373 hard discount stores, and 152 cash and carry stores. Carrefour S.A. was founded in 1959 and is headquartered in Boulogne- Billancourt, France. ArcelorMittal (265,000 employees), together with its subsidiaries, engages in the production and marketing of steel worldwide. The company offers semi-finished flat products, such as slabs; finished flat products, including plates, hot and cold rolled coils and sheets, hot dipped and electro-galvanized coils and sheets, and tinplate and color coated coils and sheets; semi-finished long products comprising blooms and billets; finished long products, such as bars, wire-rods, structural sections, rails, and wire products; seamless and welded pipes and tubes; and stainless steel products. Its products are sold primarily to customers in the distribution and processing, automotive, pipe and tubes, construction, packaging, general industry, household equipment, and appliances industries. The company, formerly known as Mittal Steel Company N.V., was founded in 1989 and is headquartered in Luxembourg. 36 Source:

37 37 Performance drivers analysis: Who is who? (2/2) Example 1: Example 2: Example 3: Year ROE 4.8% 0.2% 18.9% ROA (net) 2.3% 0.1% 7.8% Profit margin 3.9% 0.2% 8.4% Asset turnover Leverage Year ROE 3.2% 12.5% 21.6% 23.9% ROA (net) 0.6% 2.4% 4.4% 4.8% Profit margin 0.4% 1.5% 2.8% 2.9% Asset turnover Leverage Year ROE 12.6% 15.7% 17.4% 17.5% ROA (net) 5.5% 6.4% 6.7% 6.6% Profit margin 10.3% 11.8% 12.3% 12.3% Asset turnover Leverage

38 38 Performance drivers The du Pont system: Return on Equity Return on Assets Leverage Profit Margin Asset Turnover Income statement Manage: Pricing strategy Value added Link between income statement and balance sheet (asset side) Manage: Fixed assets (e.g., utilization) Current assets Balance sheet (liability side) Manage: Balance between D & SE Liquidity

39 39 Return on invested capital (ROIC) Return on assets (net) = NI / Total assets Advantage: fits with DuPont system ROE = ROA x Equity multiplier Limitation: Net income = EBIT - Interest expense - Taxes Depends on capital structure: 1. Interest expense: function of interest-bearing debt 2. Interest expense : tax deductible Preferred measure: Return on Invested Capital (ROIC) ROIC EBIT (1 T C ) SE D ROIC = ROE of all-equity financed firm = ROA(gross) * (1 T C )

40 40 Leverage - example Cost of debt 4% 4% Tax rate 30% 30% Balance sheet Total assets 100, ,000 Book Equity 100,000 5,000 Debt - 95,000 Income statement EBIT 5,500 5,500 Interest - 3,800 Taxes 1, Net income 3,850 1,190 Accounting ratios Return on Equity (ROE) 3.85% 23.80% = Return on Invested Capital (ROIC) 3.85% 3.85% [ROIC - r D (1-T C )] 1.05% 1.05% X X X Debt / Book Equity

41 41 Leverage - example Financial leverage increases the range of possible ROEs, i.e., the risk of shareholders!

42 ROE = NI / SE Accounting view of the firm: main ratios Profitability Efficiency of the use of owners capital High ROE usually means high risk Based on book value (the market value of the equity is often different!) ROIC = EBIT (1 T c ) / Assets Efficiency of the use of company resources (stockholders equity and debt) Does not depend on the capital structure of the firm Based on book value (the market value of the equity is often different!) Profit margin = Return on Sales = NI / REV Fixed vs. variable costs: SGA vs. CoGS Gross profit: REV CoGS Cost ratio: CoGS / REV 42

43 Accounting view of the firm: main ratios Liquidity Net Working Capital = Current Assets Current Liabilities = SE + LTD FA Current ratio = Current Assets / Current Liabilities Acid test (= quick ratio) = (Current Assets INV) / Current Liabilities Rotation and days outstanding (see next) Capacity of the firm to meet its short-term obligations and payments 43

44 Item from the balance sheet Accounting view of the firm: main ratios Activity / Liquidity Turnover ( speed ) Ratio name Ratio definition Ratio name Days outstanding Ratio definition (precise) Ratio definition (simplified) Total Assets (A) TA turnover REV / Assets Fixed Assets (FA) FA turnover REV / FA Inventory (INV) Inventory turnover CoGS / INV Days of inventory ( on hand ) (DOH) INV* / CoGS X 365 INV* / REV X 365 Accounts Receivable (AR) Receivables turnover REV / AR Collection period = receivable days = days sales outstanding (DSO) AR* / REV X 365 AR* / REV X 365 Accounts Payable (AP) Payables turnover M1 / AP Payable period = payable days = days payable outstanding (DPO) AP* / M1 X 365 AP* / REV X 365 Working Capital Requirement (WCR = INV + AR AP) WCR turnover REV / WCR Cash conversion cycle (measure of how fast a euro spent returns to the company in payment for a sale) DOH + DSO DPO Cash (CASH) Cash period = days sales in cash CASH* / REV X 365 CASH* / REV X The average between beginning of period, and end of period should be used. More precisely, the number of days in the accounting year (could be different from 365 days in some specific cases, such as the first or last year of operations, or in specific calendar situations).

45 45 Accounting view of the firm: main ratios Solvency Financial leverage Indicates the origin of external funds Several measures D / SE (= leverage coefficient, λ), D / A, A / SE, Coverage: income available to debt service Times interest earned: EBITDA / Int Times burden covered: EBITDA / [Int + principal repayment] Long term capacity of the firm to meet its debt engagements

46 Accounting view of the firm: ratio analysis Typical uses A ratio is not interesting by itself It requires a comparison Evolution in time Comparison within industry / region / country Comparison between industries / regions / countries Comparison to absolute norms (?) 46

47 47 Accounting view of the firm: ratio analysis Limitations Dependence on conventions Example: Year Fixed assets EBIT. (1-T C ) ROIC 30% 37% 50% 75% 150% Dependence on accounting standards used Accounting values versus market values No real absolute benchmarks Be conscious of the limitations inherent in ratio analysis!!

48 Financial Planning Based on Revenues Assumptions on key ratios relating Revenues to: Gross margin: m = EBITDA / Revenues Working capital requirement: w = WCR / Revenues Net fixed assets: a = NFA / Revenues Financial policy: Payout ratio p = DIV / Net Income Lambda = leverage Debt / Book Equity Depreciation d = Depreciation / Fixed Assets -1 Environment: Tax rate T C Cost of debt i 48

49 Sustainable growth What growth rate can a company achieve without requiring additional external equity? Assets = (a+w) Revenues Assets = Shareholders Equity + Debt = Shareholders Equity + Shareholders Equity = Net Income (1 Payout)(1 + ) = (Revenues) (Profit Margin)(1-Payout)(1+ ) "sustainable growth : K = 0 g(sustainable) = Revenues / Revenues = (Profit Margin)(1 Payout)(1+ ) / (a+w) 49

50 Sustainable Growth: example a+w = 0.30 Net Profit margin = 15% Payout ratio = 50% = Debt / Book Equity = 2/3 g(sustainable) = [15% (1-0.50) (1+2/3) ] / 0.30 = 41.67% 50

51 Thank you for your attention Prof. Laurent Gheeraert