BU7516 – Advanced Financial

Statement Analysis

Topic 1 Solution Pack

Lecturer: Neil Dunne / Desmond Cox

1
 The Analytical Income Statement and
Balance Sheet

Multiple choice questions

Question # Question Option # 1 Option # 2 Option # 3 Answer

EBITDA is After net Before

operating After depreciation financial depreciation and
1 profit expenses amortisation 3
and amortisation

Do not always
clearly
Always clearly distinguish
distinguish between Have about the
The income
between operating and same
2 statement and 2
operating and financing information
balance sheet
financing activities content
activities

The effective Corporation

tax rate is Corporation Corporation tax/earnings
3 calculated as before tax 3
tax/net earnings tax/EBIT

NOPAT is Net operating

4 equivalent to Net earnings profit after tax EBIT 2

Tax savings Tax savings

The tax shield Tax savings from from from debt
5 amortisation financing 3
represents deprecation

Amount a firm
has invested in its
operating
Invested activities and Book value of Book value of
6 capital is which requires a equity 1
total assets
defined as the return

Book value of Book value of

equity + equity +
Invested
noninterest netinterest Neither option 1
7 capital is 2
bearing debt bearing debt nor option 2
equal to

2
Question # Question Option # 1 Option # 2 Option # 3 Answer

It depends –
sometimes it is
Inventory is part of invested
Net-interest
8 generally Invested capital capital – other 1
bearing debt
included in times it is part of
net-interest
bearing debt
It depends –
sometimes it is
Current
part of invested
liabilities
Net-interest capital – other
9 should always Invested capital 3
bearing debt times it is part of
be treated as
net-interest
part of a firm’s
bearing debt (if
interest bearing)

3
 Review questions
1. What are the three analytical areas where ratio analysis appears useful?
• Profitability analysis
• Growth analysis
• Liquidity analysis

2. What are the typical sources of noise in a time-series analysis?

• Different accounting policies across time
• The impact of special and unusual items
• The impact of acquisitions and divestments of businesses (different risk profile)
• The impact of new products/markets (different risk profiles)

3. What are the typical sources of noise in a cross-sectional analysis?

• Different accounting policies across firms
• The impact of special and unusual items
• A comparison with firms that are not truly comparable
• The use of different definitions of financial ratios across firms being compared

4. Why is it important to make a distinction between operating and financing activities?

• The purpose of dividing accounting items into operating and financing related activities
is to obtain a better knowledge of the different sources of value creation in a firm. For
example, investors consider operating profit as the primary source of value creation and
in most cases they value operations separately from financing activities. Lenders consider
operating profit as the primary source to support servicing of debt. Therefore, analysts
spend time on reformulating the income statement and balance sheet so that these
statements reflect the contribution from operating and financing activities, respectively.

5. What is NOPAT?
• Net Operating Profit after Tax and is measured as earnings before interests and tax, EBIT
less tax (on EBIT).

6. How is invested capital defined?

• Invested capital represents the amount a firm has invested in its operations that requires a
return.

7. What challenges does an analyst typically face when measuring NOPAT and invested
capital?
A number of items need to be carefully considered before it can be decided if they belong to
operations or financing. Examples include:
• Tax on ordinary activities

• Investment in associates and related income and expenses from associates

• Receivables and payables to group enterprises and associated firms
• Cash and cash equivalents
• Prepayment and financial income as part of core operations

4
• Exchange rate differences
• Derivative financial instruments
• Minority interests
• Retirement benefits
• Tax payable

5
Case Study 1
Q1

NOPAT (= EBIT - TAXES ON EBIT)

The IS does not disclose EBIT
However, it does disclose Profit before tax

€m Year 8 Year 9 Year 10

Gross profit 9,000 6,729 6,890
Other income 582 1,010 629
Admin expenses -1,530 -3,669 -3,292
EBIT 8,052 4,070 4,227
Less taxes on EBIT (W1) -2,577 -1,139 -1,479
NOPAT 5,475 2,931 2,748

Net financial expenses after tax

Year 8 Year 9 Year 10
Interest expense 968 897 2,213
Interest income -184 -79 -289
Financial expenses before tax 784 818 1,924
Less tax shield of interest -251 -229 -673
Net financial expenses after tax 533 589 1,251

Year 8 Year 9 Year 10

Working 1 - Taxes on EBIT
Tax per accounts 2,326 910 806
Tax shield of finance costs (W2) 251 229 673
Tax on EBIT 2,577 1,139 1,479

Working 2 - Tax shield of finance costs (= tax rate * interest paid)

Year 8 Year 9 Year 10

NBC 784 818 1,924
Effective tax rate (Tax/EBT) 32% 28% 35%
(2,326/7,268)(910/3,252) (806/2,303)
Tax shield of NBC 251 229 673

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Q2

(Invested capital) OP assets - Op liabs BE plus NIBD

Analytical balance sheet Year 7 Year 8 Year 9 Year 10
Total assets 80,957 72,384 86,861 111,597
less: cash and cash equivalents -5,542 -4,642 -5,570 -6,963
less:
deferred tax liability -347 -347 -416 -521
trade and other payables -18,288 -9,148 -10,978 -13,722
Other liabilities -1,700 -1,500 -1,800 -2,250
Net operating assets (Inv cap) 55,080 56,747 68,097 88,141

Equity (BE) 38,922 43,864 46,205 47,702

Bank loan NC 21,200 17,045 26,885 46,682
Bank loan C 500 480 576 720
Cash and cash equivalents -5,542 -4,642 -5,570 -6,963

BE + NIBD (Invested capital) 55,080 56,747 68,097 88,141

Q3
Year 8 Year 9 Year 10
ROIC 9.8% 4.7% 3.5%
(NOPAT / avg Invested Cap)
5,475 2,931 2,748
55,914 62,422 78,119

Profit margin (NOPAT / Revenue) 35.1% 11.6% 9.9%

5475 / 15588 2931 / 25205 2,748 / 27,890
ATO (Revenue / avg Inv Cap) 0.28 0.40 0.36
15,588 / 55914 25205/62,422 27820 / 78119

ROIC (check for validity) 9.8% 4.7% 3.5%

Return on equity 11.9% 5.2% 3.2%

(Profit after tax / Book value E) (4,942/41,393) (2,341 / 45,035) (1,497/46,954)
(remember, use avg Bal sheet no's)

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Q4
ROIC is the overall measure of operating profitability. ROIC declines sharply over the period
(negative trend). The level is also unsatisfactory. With a WACC of 10%–12%, XT Company has
destroyed value during the period, except maybe for Year 8, where ROIC is fairly close to 10%.

ROE, which also takes financial leverage into consideration, tells the same story: A decrease in
profitability over time. In Year 10 ROIC is below net financial expenses (negative spread). Thus,
in Year 10 ROE is lower than ROIC and at the same time financial leverage increases – as a result,
profitability deteriorates even further.

Q5
Index numbers and common-size analyses are two approaches that can be used to obtain a better
understanding of the profitability. An explanation for the decrease in profitability is a decrease in
the profit margin. Index numbers and common-size analyses will provide additional information
on determining which cost items explain the drop in profit margin over time.

8
Profitability Analysis

Multiple choice questions

Question # Question Option # 1 Option # 2 Option # 3 Answer

Return on Overall
invested capital Utilisation of Revenue and profitability of
1 (ROIC) informs 3
invested capital expense relation the
about the operations
A useful Weighted
benchmark when average cost
2 assessing the Cost of equity Sales growth of capital 3
level of ROIC is (WACC)

The overall
Profit margins Utilisation of Revenue and profitability of
3 2
inform about the invested capital expense relation operations

The turnover ratio Overall

of invested Utilisation of Revenue and profitability of
4 capital informs 1
invested capital expense relation the
about the operations
When interpreting
financial ratios it Both option 1
5 is important to The level only The trend only 3
and option 2
address

A service Low profit High turnover

company is High profit margins and ratios and
6 margins and low high turnover 2
generally negative
characterised by turnover ratios ratios sales growth
In order to obtain
a ‘deeper’
understanding of
a firm’s profit
margin and An index
An analysis
turnover ratio of An index analysis and a
7 of financial 2
invested capital, it analysis only common-size
risk
useful to analysis
decompose the
financial ratios by
performing

9
Question # Question Option # 1 Option # 2 Option # 3 Answer

Profitability
taking into
The overall
Return on equity account both Returns to
8 profitability of 2
informs about the operating and debt holders
operations
financial
leverage
ROIC +
ROIC + (ROIC − ROIC + (ROIC − (ROIC − net
Return on equity WACC) × cost of equity) × borrowing
9 3
is defined as Financial Financial cost) ×
leverage leverage Financial
leverage

10
Review questions
1. What is the definition of ROIC, profit margin and turnover rate of invested capital?

• ROIC (return on invested capital) after tax is measured as:

ROIC =

Net operating profit after tax (NOPAT)

Invested capital

ROIC before tax is measured as:

ROIC = EBIT
Invested capital
Profit margin after tax is defined as:

Profit margin = Net operating profit after tax (NOPAT)

Net revenues
Profit margin before tax is defined as:

Profit margin = Earnings before interests and taxes (EBIT)

Net revenues
The turnover rate of invested capital is defined as:

Net revenue
Turnover rate of invested capital =
Invested capital

2. When is it useful to define ROIC before and after tax, respectively?

To avoid the impact of different tax rates, ROIC should be measured before tax when
performing a benchmark analysis. Since taxes are an expense for shareholders ROIC should
be measured after tax when measuring value creation.

3. A company experiences a drop in ROIC from 12% in Year 1 to 5% in Year 4. Provide

potential explanations for the drop in ROIC of 7 percentage points.

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 One explanation is a decrease in the profit margin – i.e. the revenue/expense relation. Another
explanation is a decrease in the turnover ratio of invested capital – i.e. the utilisation of
invested capital.

4. What is the appropriate benchmark for ROIC?

Weighted average cost of capital (WACC) or ROIC from peers – i.e. comparable companies.

5. What actions can a management take to improve the profit margin?

Improve revenue (develop better products, increase sales of existing products, entering new
markets etc).
Reduce costs (production, sales, distribution, marketing, administration etc). Change
the product mix (improve sales on high margin products).

6. A company that realises a turnover rate of invested capital of 4 has invested capital 180
days on hand – true or false?

False – it has invested capital 90 days on hand (360/4.0).

7. What actions can the management take to improve the turnover rate of invested capital?

• Improve revenue while maintaining invested capital at the same or at even lower level
• Reduce invested capital while maintaining revenue at the same or an even higher level (reduce
inventory, accounts receivable and extend accounts payables etc).

8. Explain the similarities and differences of indexing and common-size analyses.

Index numbers show the trend in important operating items. However, index numbers do not
reveal the relative size of each item. For this purpose, common-size analysis is more useful.
Common-size analysis scales each item as a percentage of revenue.

9. What is the definition of ROE?

Return on equity = Net earnings after tax

Book value of equity

10. How does financial leverage affect the return to shareholders?

See lecture notes.

11. What is the appropriate benchmark for ROE?

The appropriate benchmark is the cost of equity (shareholders’ required rate of return).

12
Case Study 2:

Analytical statements and financial ratios

Suggested solutions

a. In order to measure the profitability in DSV please assess whether special items should
be included in forecasts, when the purpose is to value DSV based on a DCF model.

Answer:
When the purpose is valuation and the DCF model is used to quantify the value, the purpose of
the historical analysis is to determine historical levels and trends in order to make forecasts.

Income recognised as special items consists primarily of gains on disposals of non-current assets.
This item is only significant for 2008, which indicates that divestitures are related to acquisitions
in that year (i.e. divestment of operations of acquired companies that does not fit the profile of
DSV). This means that there is a capital gain. This gain is hardly recurrent and should therefore
be eliminated from the historical analysis, the aim of which is to use the historical data for
budgeting/forecasting purposes.

If the gain from sale of non-current assets relates to assets that have been owned by DSV for
years, this reflects that DSV has depreciated these assets over a too short period of time. This
indicates that the gain should be distributed over the average depreciation period. If the
depreciation period is for instance 3 years, the gain should be spread over 2006, 2007 and 2008
to neutralise the 'excess' depreciation for the period.

In the subsequent analysis it was decided to eliminate the gain so that it does not influence the
calculated ratios in question 2c. The student may choose a different solution provided s/he makes
proper arguments.

Expenses recognised as special items consist of mainly restructuring charges related to acquired
companies. These costs will not recur in 2011. This indicates that they are transitory. It is therefore
clear that if the purpose is budgeting (valuation), such costs should not be included in the
forecasted financial statements and derived financial ratios.

If the student doubts management's statements in the note and believes that restructuring costs are
recurrent (permanent), it can be argued that such costs should be included in the subsequent
analysis (calculation of key figures in question 2c). In the subsequent analysis, the choice has
been to show the calculated ratios both with and without the effects of restructuring costs
classified under special items. The student is expected to choose only one of the methods.

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 b. Calculate the invested capital for DSV for the period 2006–2009. Please make short
comments about the accounting items when you are in doubt about the classification (i.e.
whether the items relate to operating or financing activities).

Answer:
Invested capital is defined as capital invested in operations that require a return; alternatively as
equity plus net interest-bearing debt. The purpose of this assignment is therefore to test the
student's ability to reformulate the balance sheet so that the operating and financing activities are
kept separate. Although most items should not cause problems, the following items need further
examination:

Deferred tax assets / liabilities

It is debatable whether deferred tax assets are actually assets. In the DSV case it seems likely that
the company can exploit the asset, since earnings are positive throughout the period. Usually,
deferred tax assets are related to operations. Consequently, there are strong reasons to treat the
item as an operating item.

It is also debatable whether deferred tax liabilities are actually liabilities or 'quasi-equity items’
(if the liabilities are not payable for many years to come or maybe never have to be paid). In the
solution, deferred tax assets and liabilities are recognised as part of invested capital.

Cash
It is debatable whether part of cash has been tied up in operations over the years. In the absence
of information, all cash is assumed to have been offset against interest-bearing debt, and thus
constitute part of financing activities. The student may choose to deal with (parts of) the item
differently, if s/he judges that a certain percentage of cash has been tied up in operating assets
over the year.

Assets held for sale (and liabilities related to assets held for sale)
As these assets are converted into cash within a short time period, and as they will not be part of
the continuing business, they are treated as cash (i.e. part of net financials). It is obviously
important that the return from these assets/liabilities is not included in operating earnings
(although this is not possible to determine given the information that is available). In this context
it should be noted that if liabilities related to assets held for sale over the period are subtracted
from assets held for sale, the net amounts are low. It can therefore be assumed that the effect on
operations is minimal.

Pensions
Pensions are recognised at present value (value in use). An operating expense is recognised in the
income statement in the year when the pension obligation arises (when the expense is lower than
if measured at nominal value) and, in addition, interest expenses are recognised. Interest expenses
in future periods are calculated as a percentage of value in use. Pensions, therefore, have the same
properties as interest-bearing debt and should be treated accordingly.

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Provisions
Provisions are measured at present value (value in use). The same arguments apply to this item
as for pensions, and the item should be treated as interest-bearing debt – i.e. as part of financing
activities.

In the following, invested capital for DSV for the period 2006–2009 has been calculated. In the
proposed solution, the calculation of invested capital is shown from both the 'asset side' and
'liability/financing side'. It is sufficient for students to show one of the methods. The students will,
however, lose a control option by just showing one of the methods.

Based on the above invested capital is calculated as follows:

Invested capital 2006 2007 2008 2009

Total assets 16,062 16,304 23,725 22,180
Other securities -148 -125 -156 -105
Cash -407 -383 -516 -390
Assets held for sale -142 -121 -82 -211
Deferred tax -308 -300 -429 -449
Trade payables -5,757 -5,857 -7,802 -7,108
Invested capital 9,300 9,518 14,740 13,917

Equity 3,844 3,649 3,857 5,530

Net-income bearing debt Pensions

559 405 810 884

Provisions 269 178 379 562
Provisions 81 147 288 373
Financial liabilities 4,604 4,900 7,084 6,637
Financial liabilities 638 604 2,973 620
Liabilities related to assets held for sale 2 264 103 17
Other securities -148 -125 -156 -105
Cash -407 -383 -516 -390
Assets held for sale -142 -121 -82 -211
Net-interest bearing debt 5,456 5,869 10,883 8,387
Invested capital 9,300 9,518 14,740 13,917

c. Calculate ROIC after tax, profit margin after tax, invested capital turnover and EVA in
order to evaluate the profitability for DSV for the period 2006–2009. To make the
calculations easier you are asked to use the end-of-year numbers for balance sheet items.

First NOPAT is calculated (without the impact of gains on sale of non-current assets and
with/without the effects of restructuring costs), which is a prerequisite for estimating ROIC,
the profit margin after tax and EVA. NOPAT is also estimated based on both the effective

15
 and the marginal tax rates. Using the effective tax rate is based on the assumption that the
tax rate is identical for both operating items and net financial items. Use of the marginal tax
rate assumes that net financials (net financial expenses) provide a tax value equal to the
current corporation tax rate in Denmark of 25%. It should be noted that using the effective
tax rate as well as the marginal tax rate is associated with noise. It is expected that the student
will choose only one of the methods.

Effective tax rate:

NOPAT (without special items, income) 2006 2007 2008 2009

EBIT 1,221 1,854 2,014 1,015
Special items, income - - -437 -5
Adjusted EBIT 1,221 1,854 1,577 1,010
Effective tax rate 0.29 0.30 0.23 0.58
Tax on EBIT 355 552 369 591
NOPAT 866 1,302 1,208 419

NOPAT (without special items) 2006 2007 2008 2009

EBIT 1,221 1,854 2,014 1,015
Special items, income - - -437 -5
Special items, expenses 283 28 359 693
Adjusted EBIT 1,504 1,882 1,936 1,703
Effective tax rate 0.29 0.30 0.23 0.58
Tax on EBIT 438 560 453 996
NOPAT 1,066 1,322 1,483 707

Marginal tax rate (25%):

Marginal tax rate

NOPAT (without special items, income)
2006 2007 2008 2009
EBIT 1221 1854 2014 1015
Special items, income 0 0 -437 -5
Adjusted EBIT 1221 1854 1577 1010
Tax on EBT 295 472 377 269
Net financial expenses 207 268 404 555
Tax shield (25%) 52 67 101 139
Tax on EBT 347 539 478 408
NOPAT (without special items, income) 874 1,315 1,099 602

NOPAT (without special items) 2006 2007 2008 2009

EBIT 1221 1854 2014 1015
Special items, income 0 0 -437 -5
Special items, expenses 283 28 359 693

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 Adjusted EBIT 1504 1882 1936 1703
Tax on EBT 295 472 377 269
Net financial expenses 207 268 404 555
Tax shield (25%) 52 67 101 139
Tax on EBT 347 539 478 408
NOPAT (without special items) 1,157 1,343 1,458 1,295
As shown, it will not mean any large difference whether the effective tax rate or the marginal tax
rate is used in the period 2006–2008. However, there is a large difference in 2009. The effective
tax rate in 2009 is 58%, which is hardly representative of the actual tax rate in DSV. This indicates
that NOPAT should be calculated based on the marginal tax rate.

Below, the respective financial ratios and EVA without the impact of gains on sale of noncurrent
assets and with/without restructuring costs have been calculated. Moreover, the financial ratios
are based on both the effective and the marginal tax rates.

Effective tax rate

Financial ratios (without gains from non- 2006 2007 2008 2009
current assets)
ROIC, year-end balance sheet numbers 9.3% 13.7% 8.2% 3.0%
Profit margin 2.7% 3.7% 3.2% 1.2%
Assets turnover (invested capital) 3.4 3.7 2.5 2.6
EVA-calculations:
ROIC, year-end balance sheet numbers
9.3% 13.7% 8.2% 3.0%
WACC 9.0% 9.0% 9.0% 9.0%
Spread (ROIC-WACC) 0.3% 4.7% -0.8% -6.0%
Invested capital 9,300 9,518 14,740 13,917
EVA 28.8 445.6 -118.9 -833.2

Financial ratios (without special items) 2006 2007 2008 2009

ROIC, based on end of year balance sheet 11.5% 13.9% 10.1% 5.1%
Profit margin 3.3% 3.8% 4.0% 2.0%
Asset turnover (for invested capital) 3.4% 3.7 2.5 2.6
EVA-calculations:
ROIC, based on end of year balance sheet
11.5% 13.9% 10.1% 5.1%
WACC 9.0% 9.0% 9.0% 9.0%
Spread (ROIC-WACC) 2.5% 4.9% 1.1% -3.9%
Invested capital 9,300 9,518 14,740 13,917
EVA 229.4 465.3 156.1 -545.4
Marginal tax rate

17
Financial ratios (without gains from non- 2006 2007 2008 2009
current assets)
ROIC, year-end balance sheet numbers 9.4% 13.8% 7.5% 4.3%
Profit margin 2.7% 3.8% 2.9% 1.7%
Assets turnover (invested capital) 3.4 3.7 2.5 2.6
EVA-calculations:
ROIC, year-end balance sheet numbers
9.4% 13.8% 7.5% 4.3%
WACC 9.0% 9.0% 9.0% 9.0%
Spread (ROIC-WACC) 0.4% 4.8% -1.5% -4.7%
Invested capital 9,300 9,518 14,740 13,917
EVA 37.3 458.4 -227.6 -650.3

Financial ratios (without special items) 2006 2007 2008 2009

ROIC, based on end of year balance sheet 12.4% 14.1% 9.9% 9.3%
Profit margin 3.6% 3.8% 3.9% 3.6%
Asset turnover (for invested capital) 3.4 3.7 2.5 2.6
EVA-calculations:
ROIC, based on end of year balance sheet
12.4% 14.1% 9.9% 9.3%
WACC 9.0% 9.0% 9.0% 9.0%
Spread (ROIC-WACC) 3.4% 5.1% 0.9% 0.3%
Invested capital 9,300 9,518 14,740 13,917
EVA 320.3 486.4 131.4 42.7

d. Based on your answer to the above calculations, please assess the profitability for DSV
for the period 2006–2009.

The student should comment on both the level and the trend. Since the effective tax rate is
expected to give misleading information for 2009, the following comments concern financial
ratios based on the marginal tax rate. Comments based on the effective tax rate should be
acceptable since it cannot be expected that the student will have time to calculate a set of ratios
based on both the effective and marginal tax rates.

Financial ratios without gains from disposal of non-current assets, but inclusive
of restructuring costs:
Except for 2007, DSV experiences a decline in profitability measured by ROIC over the period
2006–2009. This is particularly the case in 2009. The decrease in ROIC is due to a decline in both
the operating margin and the asset turnover – i.e. both the income/expense relation and the ability
to utilise invested capital has deteriorated. A further analysis could clarify and thereby explain
this decline (see also answer 2e below for inspiration). If the WACC of 9% is used to assess
whether the level is satisfactory, it is actually only in the first 2 years that the rate of return after
tax exceeds the WACC. Earnings for 2008 and 2009 are under considerable pressure. EVA

18
confirms the above. In the first 2 years EVA is positive, while EVA is negative for 2008 and
2009. If, therefore, financial data are used which disregard gains from the sale of non-current
assets, DSV destroys value in year 2008 and especially in 2009.

Financial ratios without special items:

The financial ratios such as ROIC and operating margins improve, as expected, when
restructuring costs are eliminated.

The trends are the same as before/above – however, the ROIC is higher than the WACC
throughout the period, making EVA positive in all 4 years of the analysis. Moreover, it appears
that the primary driver for the decline in EVA is a decreasing turnover rate for invested capital –
i.e. lower utilisation of invested capital.

Based on these figures it is clear what role restructuring costs play in DSV in the analysed period.
Going forward, it is crucial that confidence can be had in management's assertion that special
items, including restructuring costs, will disappear in 2011. It will expectedly have a positive
impact on DSV's future earnings and thus enable DSV to generate returns on invested capital that
will exceed the cost of capital (WACC).

e. DSV’s management is concerned about the decrease in ROIC. They ask you to identify
the accounting items, applied to calculate the profit margin, which has developed
unfavourably during the period 2006–2009, and which management should pay attention
to in the future.

To answer the question, indices of revenue and operating costs are calculated:

Index numbers 2006 2007 2008 2009

Revenue 100 109 117 113
Direct costs 100 108 117 108
Other external expenses 100 107 106 114
Staff costs 100 111 120 140
Amortisation and Depreciation 100 74 122 162
Special items, net 100 10 281 247
The cost item numbers in bold increase more than revenue. This means that the adverse
development in other external expenses, staff costs, depreciation and amortisation and special
items accounts for the decrease in the operating margin. While other external costs are rising only
marginally faster than revenue, the other items increase substantially faster than revenue. This
means that the management of DSV should implement operational initiatives with a view to
reducing costs for these items relative to revenue.

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Case Study 3
Answer 1

Taxation 16.3
Profit/ (loss) before taxation 35.6
45.8%

Operating profit 134

Tax on operating profit (134*45.8%) -61.4
NOPAT 72.6
Finance expense -101.8
Finance income 3.4
Share of post tax profit/ (loss) from joint venture 0.4
Tax savings from net interest bearing debt (98.4*45.8%) 45.1
Net financial expenses after tax -52.9
Profit 19.7

Invested capital

Total assets 1,495.10

Cash and cash equivalents -206.3
Available for sale investment -0.3
Derivative financial instruments, non-current 0
Derivative financial instruments, current -16.4
Trade and other payables, current -287.5
Provisions, current -10.5
Income tax liabilities, current -13.9
Deferred income tax liabilities, current -
Trade and other payables, non-current -85.3
Provisions, non-current -13.4
Deferred income tax liabilities, non-current -94.1
Invested capital (net operating assets) 767.40

Invested capital
Equity -269
Loans and borrowing non-current 1,199.80
Derivative financial instruments, non-current 8.5
Loans and borrowing current 39.8
Derivative financial instruments, current 11.3
Cash and cash equivalents -206.3
Available for sale investment -0.3
Derivative financial instruments, non-current 0
Derivative financial instruments, current 16.4
Invested bearing debt, net 1,036.40
Invested capital (financing) 767.40

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 Items that could be classified as both operating and financing:
Provisions It could be classified as interest-bearing if it is measured a fair value
(present value)

Income tax It could be classified as interest-bearing if local tax authorities charge

liability/assets interest/offer an interest

Deferred tax It could be considered as 'quasi-equity' and therefore reclassified as

liability/assets equity

Other
receivables It should be considered as financing if it is interest bearing

Investments in It should be considered as non-operating if the investment in associates

associates is not considered as part of core operations

Answer 2

Financial ratios
Return on invested capital after tax 9.5% (72.6/767.4) × 100
Return on invested capital before tax 17.5% (134/767.4) × 100
Profit margin (after tax) 5.0% (72.6/1.463.6)*100
Profit margin (before tax) 9.2% (134/1.463.6)*100
Turnover rate of invested capital 1.9 (1.463.6/767.4)

Return on invested capital (after tax) is calculated as:

Net operating profit after tax / invested capital (shown as a percentage)

This ratio shows that there is a 9.5% return on the capital invested, using the profit after tax figure.

Return on invested capital (before tax) is calculated as:

Earnings before interest and tax / invested capital (shown as a percentage)

This ratio shows that there is a 17.5% return on the capital invested, using the profit before tax
figure.

Profit margin (after tax) is calculated as:

Net operating profit after tax / net revenues (shown as a percentage)

This ratio shows the profit after tax figure as a percentage of the net revenue achieved.

21
Profit margin (before tax) is calculated as:

Earnings before interest and tax / net revenues (shown as a percentage)

This ratio shows the profit before tax figure as a percentage of the net revenue achieved.

Turnover rate of invested capital is calculated as:

Net revenue / invested capital

This ratio shows the company’s ability to utilise invested capital. In this case, it shows that New
Look has tied up invested capital for 190 days (360/1.9).

Answer 3

Company B is showing a lower return on invested capital and a lower profit margin. This could
be because the company is new in the market, with newer assets, and has higher expenses than
New Look.

Company C is showing a better return on invested capital and a higher profit margin when these
are measured after tax. However, measured before tax New Look appears more profitable.
Including taxes may most likely blur the underlying efficiency of the operations. Therefore, it is
generally recommendable to exclude taxes when comparing financial ratios of different firms.

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Growth Analysis

Multiple choice questions

Question # Question Option # 1 Option # 2 Option # 3 Answer

A firm’s sustainable
growth rate is ROIC × (1payout Profit margin × ROE ×
1 3
defined as ratio) (1-payout ratio) (1payout ratio)

How fast a firm

The sustainable can grown while
The growth in The growth in
2 growth rate informs maintaining the 1
invested capital operating profit
about same financial
leverage
It depends –
investors
generally prefer
a high
The sustainable sustainable
As high as As low as
3 growth rate should growth rate 3
possible possible
always be only if the
return on equity
exceeds cost of
capital

Higher Lower
A higher payout sustainable sustainable Neither option
4 2
ratio results in a growth rate growth rate 1 nor option 2

Always destroys Always add Sometimes add

5 Growth in revenue value value value 3

Growth in revenue Recurring

6 is generally (sustainable) Mean reverting Negative 2

Analysts prefer
growth in special
Analysts are
7 items relative to Correct False 2
indifferent
growth in the core
business
Growth in
economic value An unchanged
8 added (EVA) can A higher WACC A lower WACC 3
WACC
be obtained by
Share buy-back Positively if and
always affect only if ROIC
9 earnings per share Positively exceeds net Negatively 2
(EPS) borrowing costs
Growth and cash Positively Negatively
10 flows are generally correlated correlated Not correlated 2

23
Review questions
1. How is a firm’s sustainable growth rate measured?

See formula on slides

2. What types of information can be retrieved from the sustainable growth rate?

The sustainable growth rate informs how fast a company can grow while preserving its
financial risk, i.e. maintaining the financial leverage at the same level despite growth.

3. What factors affect a firm’s sustainable growth rate?

ROIC, NFE, financial leverage, minority interests’ share of profit and the payout ratio.

4. A firm’s sustainable growth rate should be as high as possible – true or false?

False – a positive sustainable growth rate indicates that a firm reinvests some of its earnings
in its business. This is only attractive for shareholders if these investments generate a return
that exceeds the cost of capital.

5. How should a firm’s growth rate be measured if value creation is a key objective?

Growth is only attractive if it adds to the value of the business. Growth in Economic Value
Added (EVA) ensures that growth is associated with value creation.

6. Growth is always of the same quality – true or false?

False – growth based on recurring items is more sustainable than growth based on
nonrecurring or transitory items.

7. Growth in EPS is always value creating – true or false?

EPS does not take into account investments and risk. Thus, growth in EPS may be negatively
correlated with value creation.

8. Does a share buy-back program always result in improved EPS?

No – share buybacks only adds value if ROIC exceeds net financial expenses in percent
(NFE). Sometimes NFE is labelled as net borrowing costs (NBC)

9. What is the relation between a firm’s growth rate and its liquidity?

Growth is typically associated with investments in inventories, accounts receivable and

property, plant and equipment. Growth is therefore negatively correlated with liquidity.

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Case Study 4

Solutions

Answer 1
Using the sustainable growth rate formula from the lecture notes:

Sams Ltd Competitor 1 Competitor 2

Return on invested capital after tax 10.0% 10.0% 4.0%

Net financial expenses after tax 4.0% 4.0% 10.0%

Financial leverage 5.0 2.0 2.0

Payout ratio 0% 0% 0%

Sustainable growth rate 40.0% 22.0% -8.0%

Answer 2
Sams Ltd and Competitor 1 have exactly the same underlying performance. However, due to
different financial leverage Sams Ltd is able to grow significantly faster than competitor 1. Please
note that the higher sustainable growth rate comes at the expense of a significantly higher financial
risk.

Competitor 1 and Competitor 2 experience different sustainable growth rates despite an identical
financial leverage. The negative sustainable growth rate in competitor 2 is purely a result of a
negative spread between return on invested capital and net financial expenses.

Answer 3
As pointed out above, the sustainable growth rate indicates at what pace a company can grow
while preserving its financial risk. However, the sustainable growth rate does not provide
information about the value creation. A high sustainable growth rate indicates that the company
has chosen to reinvest a large proportion of its accounting profit and thus chosen not to distribute
it to investors. From a shareholder’s perspective this is only interesting if reinvestments derived
from accounting profit will be invested in profitable projects, i.e. projects where ROIC>WACC.
The sustainable growth rate should therefore not be maximised but rather optimised.

Growth in EVA ensures that growth is profitable. Growth in EVA therefore appears as a better
measure for growth if the purpose is to ensure that growth is associated with value creation.
However, growth in EVA does not inform about the pace a company can grow while preserving
its financial risk.

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Answer 4
Growth in the EVA is due to growth in the core business or transitory items, although growth in
the core business is considered of higher quality. Sams Ltd. could achieve this by:

• Assessing which are its most profitable products and concentrating on manufacturing and
retailing these.

• Outsourcing production to countries with lower wages.

• Reducing working capital (inventories, receivables and accounts payable).

• Spin-off unprofitable operations.

• Reduce the cost of capital – renegotiate the terms, work on an optimal capital structure, etc.

• Grow the core business.

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Liquidity Risk Analysis

Multiple choice questions

Question # Question Option # 1 Option # 2 Option # 3 Answer
The liquidity risk Ability to satisfy
Historical growth
1 informs about a all future Profitability 2
rates
firm’s obligations
Is useful as it
A distinction informs the
Is meaningless as Neither
between short analyst about
2 this distinction is option 1 nor 2
and long-term the short-term
liquidity risk arbitrary option 2
and long-term
liquidity risks
The number of
The
The average
The liquidity cycle days it takes to seasonality
3 convert net investments on
measures in cash flows
a yearly basis 1
working capital during a year
into cash
Book value of Current
The current ratio Total assets/total assets/curre
4 equity/total 3
is defined as liabilities nt liabilities
liabilities
An unbiased A biased An unbiased
The current ratio measure of measure of measure of
5 short-term long-term 2
is shortterm liquidity
risk liquidity risk liquidity risk
How many
months a firm can
The 1
continue its
The cash burn operations How much cash shareholders
cash
6 rate informs assuming the a firm invest on
contribution
about current a yearly basis over the last
performance and 12 months
without additional
funding
Financial Different signals Similar signals
leverage and about the Neither
about the
7 solvency ratios longterm option 1 nor 2
longterm liquidity
provide liquidity option 2
risk risk

27
Question # Question Option # 1 Option # 2 Option # 3 Answer
The
proportion of
capital
The capital How much cash a Investments in expenditure
8 expenditure ratio firm invest on a intangible a company 3
informs about yearly basis assets is able to
fund through
its
operations
A shortcoming of
financial ratios
Do not say Neither
measuring the Are difficult to
9 anything about option 1 nor 3
short and calculate
risk option 2
longterm liquidity
risk is that they
For financial
ratios to be more It is necessary to It is
It is necessary
useful in compare with necessary to
to compare with
10 measuring the financial ratios compare 1
a firm’s growth
short-term and from comparable each ratio
rate
long-term liquidity companies with WACC
risk

Review questions
1. Why is it important to monitor the short-term and long-term liquidity closely?
Lack of liquidity can among other things:
• Limit management's freedom of action
• Reduce the potential for profitable investment opportunities
• Force managers to divest profitable businesses with a substantial discount
• Increase financial expenses
• Lead to suspension of payment and possible bankruptcy

2. Provide examples of financial ratios measuring the short-term liquidity.

• Liquidity cycle
• Current ratio and quick ratio
• Cash flow from operations (CFO) to short-term debt ratio
• Cash burn rate

3. Provide examples of financial ratios measuring the long-term liquidity.

• Financial leverage and solvency ratio
• Interest coverage ratio
• Cash flow to debt ratio
• Capital expenditure ratio

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 4. What are the potential shortcomings of financial ratios measuring liquidity risk?
• Financial ratios measuring liquidity risk are
• Based on historical accounting information and, therefore, backward-looking
• Only describing parts of a company’s financial position
• Less useful in the absence of an appropriate benchmark
• Less useful if they are not used together
Furthermore, since the financial ratios rely on accounting data it is important to adjust for
differences in accounting quality across time and across companies. For example, reported
EBIT may be affected by a gain or a loss that is transitory in nature. Reported EBIT is
therefore not sustainable in the future and adjustments need to be made accordingly.

5. How can these shortcomings be addressed?

Perform a comprehensive analysis that uncovers all important aspects of a company’s
financial position. In addition to the financial analysis outlined in this chapter, it should
include a strategic analysis that encompasses an assessment of the industry attractiveness and
the competitive edge of the company being analysed relative to its peers. Ideally, the financial
analysis and the strategic analysis should be merged into a quantitative assessment of the
future cash flow potential of the company, i.e. a forecast of the short-term and longterm cash
flow.

Case Study 5

Suggested solutions

Q1
List financial ratios that provide information on short-term and long-term liquidity risk

Short-term liquidity risk measures:

• Liquidity cycle

• Current ratio

• CFO to short-term debt ratio

Long-term liquidity risk measures:

• Financial leverage (based on market values and book values, respectively)

• Interest coverage ratio (based on EBIT and cash, respectively)

• CFO to debt ratio

• Capital expenditure ratio (based on depreciation as a proxy for reinvestments)

29
Q2
a. Compare Clean Inc and Car Inc’s short-term liquidity risk
Car Inc appears as having a lower short-term liquidity risk than Car Inc. However, due to
fundamental differences in the economic structure of the two companies, a comparison of
current ratio between the companies is more or less meaningless. Car Inc is more likely an
asset-heavy company with investments in both non-current and current assets. Clean Inc, on
the other hand, is an asset-light company with only a few investments in assets in general.
Clean Inc has therefore a current ratio that by nature is lower than the current ratio of Car Inc.

b. Discuss the usefulness of current ratio as indicator of short-term liquidity risk

The basic idea of the current ratio is that the larger the ratio, the greater the likelihood that a
sale of current assets is able to cover current liabilities. Some argue that a current ratio greater
than 2.0 is an indication of a low short-term liquidity risk.
+ Current ratio is easy to calculate
+ Financial ratios, including the current ratio, are a cost-effective way of rank companies
according to their credit risk
- Many aspects of a company’s financial position are not covered by the current ratio
- It is questionable whether current net working capital is able to predict the development of
future cash tied up in working capital
- In the event of liquidation, it is doubtful whether assets can be realised at book value

- As noted above, the current ratio is industry specific. Thus, for the current ratio to be useful
it must be compared with peers’ current ratio, i.e. companies with a similar economic
structure
- The current ratio is, like all other financial ratios, affected by the applied accounting policies

Q3
What are the shortcomings of financial ratios measuring short-term and long-term liquidity risk?

Financial ratios measuring liquidity risk are:

• Based on historical accounting information and, therefore, backward looking

• Only describing parts of a company’s financial position

• Less useful in the absence of an appropriate benchmark

• Less useful if they are not used together

30