Financial Statement Analysis

Financial statement analysis
Christophe Thibierge
thibierge@escpeurope.eu
Agenda of this module

Develop a good understanding of the financial documents
(Income statement, Balance sheet, Statement of cash-flows)
Learn the fundamental ratios and indicators
Understand the different kind of cash-flows, and the way they are
generated
2
C. Thibierge - www.thibierge.net
Contents
accounting and financial information (the issue of databases)
the income statement
margins, cash flows
the balance sheet

liquidity and debt ratios
the Operating Working Capital
ratios of return
return on assets
return on capital employed (ROCE)
return on equity (ROE) and gearing / leverage
the statement of cash flows

Appendixes
3
Financial information
Accounting standards and harmonization
Local standards (US GAAP, UK GAAP, Plan comptable
gnral...)
IFRS International Financial Reporting Standards
Financial reports
Balance sheet
Income statement
Cash flow statement
Notes to the accounts
Web sites
corporate (e.g. Danone, Microsoft, Sanofi...)
stock markets (e.g. Euronext, Nasdaq)
meta-sites (e.g. Yahoo Finance)
4
Two documents... in one

An event always impacts 2
accounts
Difference Opex / Capex

Difference interest / Debt
Difference depreciation / investment (Capex)
...
Contents
margins, cash flows
the balance sheet

ratios of return
return on assets

Appendixes
6
The income (profit & loss P&L) statement
A movie of activities during a period

Revenues - Expenses = Net Earnings
Intermediate results explain Net earnings
Net earning is not 100%, instant, cash
7
A startup in pharmaceuticals
Dermic-Oz
INCOME STATEMENT
Sales
- cost of goods sold*
Gross profit
- Selling, General and Adm. Expenses*
Operating profit (EBIT)
- Interest
+ Financial revenues
Earnings Before Tax (EBT)
Extraordinary items
- Tax
Net Earnings
* including depreciation for :
EBITDA
2009
2010
2011
2012
2013
134,4
-25,8
108,5
-146,6
-38,0
-4,1
0,0
-42,2
0,0
0,0
-42,2
-5,3
194,2
-35,0
159,3
-188,6
-29,3
-5,7
0,0
-35,1
0,0
0,0
-35,1
-6,0
291,7
-47,0
244,7
-244,9
-0,2
-7,9
0,0
-8,2
0,0
0,0
-8,2
-6,8
373,8
-59,7
314,1
-297,9
16,2
-10,2
0,0
6,0
0,0
-2,0
4,0
-7,7
481,9
-75,1
406,7
-361,3
45,4
-13,3
0,0
32,1
0,0
-10,7
21,4
-8,6
2009
-32,7
2010
-23,3
2011
6,6
2012
23,8
2013
54,0
8
Detailed P&L
INCOME STATEMENT
Sales own production
Milestones revenues
Royalties on sales and other revenues
Total sales and revenues
- cost of goods sold (excl. Depreciation)
- depreciation (operating assets)
Gross profit
- Research and Development expenses
- selling and marketing expenses
- overheads and administrative costs
- depreciation (non operating assets)
- interest expenses
+ financial revenues
Extraordinary items
- Tax
Net Earnings
EBITDA
2009
2010
2011
2012
2013
134,4
0,0
0,0
134,4
-22,6
-3,2
108,5
-69,9
-14,9
-59,6
-2,1
-38,0
-4,1
0,0
-42,2
0,0
0,0
-42,2
188,2
0,0
6,0
194,2
-31,3
-3,7
159,3
-103,6
-19,8
-62,8
-2,3
-29,3
-5,7
0,0
-35,1
0,0
0,0
-35,1
258,5
5,0
28,2
291,7
-42,8
-4,2
244,7
-149,9
-26,2
-66,2
-2,6
-0,2
-7,9
0,0
-8,2
0,0
0,0
-8,2
332,6
0,0
41,2
373,8
-55,0
-4,7
314,1
-193,0
-32,9
-69,1
-2,9
16,2
-10,2
0,0
6,0
0,0
-2,0
4,0
422,1
0,0
59,8
481,9
-69,8
-5,3
406,7
-244,9
-41,0
-72,1
-3,3
45,4
-13,3
0,0
32,1
0,0
-10,7
21,4
2009
-32,7
2010
-23,3
2011
6,6
2012
23,8
2013
54,0
9
Major items
Sales : amount delivered and billed
Cost of goods sold : direct costs
Selling, general and administrative expenses : indirect costs
( overheads )
EBITDA : Earning before interest, tax, depreciation and
amortization
EBIT : Earning before interest and tax
EBT : Earning before tax
Net earnings
10
The income statement
A movie of activities during a period

Revenues - Expenses = Net Earnings
Intermediate results explain Net earnings
Net earning is not 100%, instantaneous, cash
11
Cash and non-cash scriptures

INCOME STATEMENT
Sales own production
Milestones revenues
Royalties on sales and other revenues
Total sales and revenues
- cost of goods sold (excl. Depreciation)
- depreciation (operating assets)
Gross profit
- Research and Development expenses
- selling and marketing expenses
- overheads and administrative costs
- depreciation (non operating assets)
- interest expenses
Extraordinary items
- Tax
Net Earnings
EBITDA
2009
2010
2011
2012
2013
134,4
0,0
0,0
134,4
-22,6
-3,2
108,5
-69,9
-14,9
-59,6
-2,1
-38,0
-4,1
0,0
-42,2
0,0
0,0
-42,2
188,2
0,0
6,0
194,2
-31,3
-3,7
159,3
-103,6
-19,8
-62,8
-2,3
-29,3
-5,7
0,0
-35,1
0,0
0,0
-35,1
258,5
5,0
28,2
291,7
-42,8
-4,2
244,7
-149,9
-26,2
-66,2
-2,6
-0,2
-7,9
0,0
-8,2
0,0
0,0
-8,2
332,6
0,0
41,2
373,8
-55,0
-4,7
314,1
-193,0
-32,9
-69,1
-2,9
16,2
-10,2
0,0
6,0
0,0
-2,0
4,0
422,1
0,0
59,8
481,9
-69,8
-5,3
406,7
-244,9
-41,0
-72,1
-3,3
45,4
-13,3
0,0
32,1
0,0
-10,7
21,4
2009
-32,7
2010
-23,3
2011
6,6
2012
23,8
2013
54,0
12
Cash-flow
Top-down approach
EBITDA
- interest expenses
Extraordinary items
- Tax
Cash-flow
2009
-32,7
-4,1
0,0
0,0
0,0
-36,9
2010
-23,3
-5,7
0,0
0,0
0,0
-29,0
2011
6,6
-7,9
0,0
0,0
0,0
-1,3
2012
23,8
-10,2
0,0
0,0
-2,0
11,6
2013
54,0
-13,3
0,0
0,0
-10,7
30,0
2009
-42,2
5,3
-36,9
2010
-35,1
6,0
-29,0
2011
-8,2
6,8
-1,3
2012
4,0
7,7
11,6
2013
21,4
8,6
30,0
Bottom-up approach
Net Earnings
+ adding back depreciation
Cash-flow
13
Some limits
Bottom-Up approach
Commonly used Lazy
Can lead to mistakes
Cash-flow is not cash-flow

Some non-cash scriptures remain (change in inventories)
Does not consider delays in payment / collection
There is a better calculation : (Operating or Free) cash-flow
Nonetheless, useful
14
Contents
margins, cash flows
the balance sheet

ratios of return
return on assets

Appendixes
15
The balance sheet (B/S)
Picture of the company at a given date

Assets are recorded on a historical cost basis
But can/must be revalued (IFRS)
Provisions and depreciation account for reduction in assets values
16
Dermic-Oz balance sheet

BALANCE SHEET
Assets
2009
2010
2011
2012
2013
Property, plant and equipment

- Depreciation
Net property plant and equipment
Non-consolidated companies
Net fixed assets
69,1
-23,4
45,7
0,0
45,7
78,7
-29,4
49,4
0,0
49,4
89,4
-36,2
53,2
0,0
53,2
100,3
-43,9
56,4
0,0
56,4
112,3
-52,5
59,8
0,0
59,8
Inventories*
Accounts receivable**
Cash and Marketable securities
Net current assets
30,6
25,0
397,8
453,4
42,0
36,4
363,7
442,2
56,6
51,9
328,0
436,5
71,8
64,9
328,8
465,4
93,5
80,1
319,0
492,7
TOTAL ASSETS
* after accounting for provisions of :
** after accounting for provisions of :
499,1
0,0
0,0
491,5
0,0
0,0
489,7
0,0
0,0
521,9
0,0
0,0
552,5
0,0
0,0
Liabilities and Sh. Equity

Shareholders' Equity
Paid-in capital
Net earnings
Retained earnings
2009
2010
2011
2012
2013
429,9
600,0
-42,2
-128,0
394,8
600,0
-35,1
-170,1
386,6
600,0
-8,2
-205,2
390,6
600,0
4,0
-213,4
412,0
600,0
21,4
-209,4
Long Term debt
54,7
74,7
74,7
94,7
94,7
Accounts payable
13,5
19,6
27,9
34,9
43,1
1,1
2,4
0,4
1,6
2,6
499,1
491,5
489,7
521,9
552,5
Short term debt / Notes payable

TOTAL LIABILITIES & SH. EQU.
17
Operating Working Capital (OWC)

Net Working Capital (NWC)
Working Capital Requirements (WCR)
Working capital needs
Working capital
Item which is not present in the balance sheet

Crucial indicator for
Financial analysis
Financial planning
Short-term management
Capital budgeting
Company valuation / stock market valuation
18
Dermic-Oz OWC
Operating Working Capital (OWC) =

Inventories + Accounts receivable Accounts payable

Inventories
+ Accounts receivable
- Accounts payable
= Operating Working Capital (OWC)
2009
30,6
+25,0
-13,5
42,1
2010
42,0
+36,4
-19,6
58,8
2011
56,6
+51,9
-27,9
80,5
2012
71,8
+64,9
-34,9
101,7
2013
93,5
+80,1
-43,1
130,5
A discussion at Dermic-Oz
19
Operating Working Capital
Real investment in cash, just like investment in Machines or Buildings

Generally correlated with Sales, and paid in advance
Compulsory investment
Never to be forgotten...
Sales
Illiquidity
OW
C
Time
20
OWC correlated to sales ?
OWC=InventoriesReceivables Payables
OWC
Inventories
Receivables
Payables
365=
365
365
365
Sales
Sales
Sales
Sales
21
Application

Inventories
+ Accounts receivable
- Accounts payable
= Operating Working Capital (OWC)
2009
30,6
+25,0
-13,5
42,1
2010
42,0
+36,4
-19,6
58,8
2011
56,6
+51,9
-27,9
80,5
2012
71,8
+64,9
-34,9
101,7
2013
93,5
+80,1
-43,1
130,5
2009
83,1 d.
67,9 d.
-36,6 d.
114,4 d.
2010
78,9 d.
68,5 d.
-36,9 d.
110,5 d.
2011
70,8 d.
64,9 d.
-35,0 d.
100,8 d.
2012
70,1 d.
63,4 d.
-34,1 d.
99,3 d.
2013
70,8 d.
60,7 d.
-32,7 d.
98,9 d.
OWC in days of sales

Inventories in days of sales
+ Accounts receivable in days of sales
- Accounts payable in days of sales
= Operating Working Capital (OWC) in days
Inventories = DOH = Days On Hand

Accounts receivable = DSO = Days of Sales Outstanding
Accounts Payable = DPO = Days of Payment Outstanding
22
Contents
margins, cash flows
the balance sheet

ratios of return
return on assets

Appendixes
23
Ratios of return concept

Earnings
Ratio of Return=
Investment
Assets
or
Capital
Engaged
Shareholders'
Equity
Financial Debt
or
Net Debt
24
Return on assets (ROA)

EBIT
EBIT Sales
=
Assets Sales Assets

Return On Assets = Operating margin x Asset turnover
Cater Pillar
Tom Cat Herring
25
Contents
margins, cash flows
the balance sheet

ratios of return
return on assets

Appendixes
26
Capital engaged (employed)

BALANCE SHEET
Assets
2013
Property, plant and equipment

- Depreciation
Net property plant and equipment
Non-consolidated companies
Net fixed assets
112,3
-52,5
59,8
0,0
59,8
Inventories
Accounts receivable
Net current assets
93,5
80,1
319,0
492,7
TOTAL ASSETS
552,5
Liabilities and Sh. Equity

Paid-in capital
Net earnings
Retained earnings
2013
412,0
600,0
21,4
-209,4
Long Term debt
94,7
Accounts payable
43,1
Short term debt / Notes payable

TOTAL LIABILITIES & SH. EQU.
Capital employed (engaged)
2013
Net fixed assets

Operating working capital (OWC)
= Capital employed (engaged)
59,8
130,5
319,0
509,4
Financial debts (Long and short T)
= Capital employed (engaged)
412,0
97,3
509,4
2,6
552,5
27
Capital engaged (employed) and ROCE
Net fixed assets

OWC
= Capital engaged
N-4
247,8
126,6
23,3
397,7
N-3
174,3
162,3
24,5
361,1
N-2
100,8
196,8
25,8
323,4
N-1
27,3
234,9
26,9
289,1
N
10,2
215,6
26,3
252,0
Financial debts (Long and short T)
= Capital engaged
256,6
141,1
397,7
227,8
133,3
361,1
199,5
123,9
323,4
174,8
114,4
289,1
154,1
97,8
252,0
Return On Capital Employed (ROCE) = Operating margin x Capital engaged turnover

28
Return on capital employed (ROCE)

Fixor
Operating margin
x Capital engaged turnover
= Return on Capital Employed (ROCE)
N-4
10,0%
1,76
17,6%
N-3
12,6%
2,14
27,1%
N-2
11,8%
2,54
29,9%
N-1
11,3%
3,04
34,2%
N
11,3%
3,41
38,7%
N-1
4,3%
5,44
23,6%
N
5,7%
5,48
31,1%
Happy Hostels
Operating margin
x Capital engaged turnover
= Return on Capital Employed (ROCE)
N-4
4,3%
5,34
22,8%
N-3
2,4%
5,35
13,1%
N-2
3,6%
5,39
19,6%
29
Return on capital employed (ROCE)

EBIT
EBIT
Sales
=
Fixed assetsOWC Sales Fixed assetsOWC

Return On Capital Employed = Operating margin x Capital engaged turnover
Tom Cat Herring
30
Contents
margins, cash flows
the balance sheet

ratios of return
return on assets

Appendixes
31
World with no tax
Sh. Equity
Capital
Engaged
EBIT
20
Debt
Interest
Earnings
12
32
No tax, but a leverage effect...
Sh. Equity = 20
Capital Engaged =
100
Debt = 80
ROE=
EBIT
ROCE=
CapEng
20
=20 %
100
Interest
Interest rate=
Debt
8
=10 %
80
Net Earnings
Sh. Equity
12
=60 %
20
33
Formula without tax
ROE=ROCE ROCEi
Debt
Equity
Leverage effect
The final return for the shareholder consists in

The return on operations
+ The leverage effect
This effect, in turn, consisting in
A differential (ROCE i)
Multiplied by the Leverage (D / E)
34
Formula with tax
The leverage effect :
ROE= ROCE ROCEi
Debt
Equity
1T
Effective tax
rate for
company
35
Application and comments
36
Limits Compare companies
(ROCE Interest) x Leverage = Leverage effect
Cool Jazz
Hard Rock
Heavy Metal
100
15 %5 %
=5 %
200
150
11 %6%
=5 %
150
250
15 %14 %
=5%
50
37
Limits / dangers of the concept
In order to increase the Return, you have to increase Risk (D/E)

Better high differential x low leverage than the opposite
Everything starts from the operations
To be used as a tool for diagnosis, not for prospective
management
38
Some more thoughts for experts
What do we do with Cash ?

Part of the Capital engaged ?
Deducted from debt, to show Net debt ?
What do we do with financial revenues ?

Part of the ROCE ?
Deducted from interest, to show Net interest ?
39
Contents
margins, cash flows
the balance sheet

ratios of return
return on assets

Appendixes
40
Back to cash-flows
The statement of cash-flows :

Cash-flow from operations / operating cash-flow
Cash-flow from investments
Cash-flow from financing
= cash generation (or cash consumption) over the year
41
From cash-flow to operating cash-flow

Operating Cash-flow =
Cash-flow
- Increase in Operating Working Capital
2010
-35,1
6,0
-29,0
2011
-8,2
6,8
-1,3
2012
4,0
7,7
11,6
2013
21,4
8,6
30,0
increase in inventories
+ increase in receivables
- increase in payables
= increase in Operating Working Capital
11,4
11,4
-6,2
16,7
14,6
15,5
-8,3
21,7
15,2
13,0
-7,0
21,2
21,8
15,2
-8,2
28,8
Cash-flow
- increase in OWC
= Operating cash flow
-29,0
-16,7
-45,7
-1,3
-21,7
-23,0
11,6
-21,2
-9,5
30,0
-28,8
1,2
Net earnings
+ add back Depreciation / writeoffs
Cash-flow
2009
-42,2
5,3
-36,9
42
Cash is king
Net earnings : not 100%, instant cash

Net earnings + Depreciation = cash-flow
Cash-flow increase in Op. Work. Cap. =
real, instantaneous, operating cash-flow
Operating cash-flow Investment =
Free cash flow

43
Dermic-Oz
Statement of cash-flows
2010
-35,1
6,0
-29,0
2011
-8,2
6,8
-1,3
2012
4,0
7,7
11,6
2013
21,4
8,6
30,0
increase in inventories
+ increase in receivables
- increase in payables
= increase in Operating working capital
11,4
11,4
-6,2
16,7
14,6
15,5
-8,3
21,7
15,2
13,0
-7,0
21,2
21,8
15,2
-8,2
28,8
Cash-flow
- increase in OWC
= Operating cash flow (A)
-29,0
-16,7
-45,7
-1,3
-21,7
-23,0
11,6
-21,2
-9,5
30,0
-28,8
1,2
Investments (net of disinvestments)

= cash flow from investments (B)
-9,7
-9,7
-10,7
-10,7
-10,9
-10,9
-12,0
-12,0
*Free cash-flow to Equity (A+B)
-55,4
-33,7
-20,5
-10,7
+ increase in capital
- dividends
+ increase in debt
= cash flow from financing (C)
,0
,0
21,3
21,3
,0
,0
-2,0
-2,0
,0
,0
21,2
21,2
,0
,0
1,0
1,0
CHANGE IN NET CASH (A+B+C)

+ Cash at beginning of year
= cash at end of year
-34,1
397,8
363,7
-35,7
363,7
328,0
0,7
328,0
328,8
-9,7
328,8
319,0
Cash in the balance sheet
363,7
328,0
328,8
319,0
Net earnings
+ add back Depreciation / writeoffs
Cash-flow
2009
-42,2
5,3
-36,9
Appendix 1
Ratios
Ratios of margin
46
Balance sheet ratios
47
Ratios of return...
48
...and a focus on ROCE / ROIC
Note : WCR = working capital requirements = OWC = operating working capital
49
Liquidity ratios
50
Solvency ratios
51
Appendix 2
Consolidated accounts
Audit and IFRS
Consolidation
Perimeter
Different consolidation methods
Revaluations
Audit opinions... and their signification
53
Appendix 3
Basics of cost accounting
The question of Fixed and Variable costs

120
VC 10
VC 90
FC 90
FC 10
Riskos
Coolos
55
Appendix 4
How to do
a financial analysis
How to do a financial analysis
2 ideas :
go from basic observations to complex models ; dont forget
basics !
Everything must be connected : tell the story
57
Example of inductive analysis
Companys development
growth
asset structure ; capital structure (debt equity)
Profitability
Margins
Operating working capital
Return on assets, Return on Capital Employed (ROCE), Return on
Equity (ROE)
Cash flow(s)
Risk
short-term (liquidity)
long-term (solvency)
58
How to comment on a ratio / indicator

1. Level, evolution
2. Good / bad ; risky / safe
3. Possible explanationS
1. Hypothesis 1
2. Hypothesis 2
3. ...
4. Try to validate the correct hypothesis tell the story

5. Recommendations
59
Occam's razor
60
As a conclusion
Grace comes from perfection,

perfection comes from art
...and art does not come easily !
Norman McLean,
A river runs through it
61

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Financial Statement Analysis

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Financial statement analysis

Agenda of this module

the balance sheet

the statement of cash flows

Two documents... in one

Difference Opex / Capex

the balance sheet

the statement of cash flows

The income (profit & loss P&L) statement

A movie of activities during a period

The income statement

A movie of activities during a period

Cash and non-cash scriptures

Cash-flow is not cash-flow

the balance sheet

the statement of cash flows

The balance sheet (B/S)

Picture of the company at a given date

Provisions and depreciation account for reduction in assets values

Dermic-Oz balance sheet

Property, plant and equipment

Liabilities and Sh. Equity

Long Term debt

Short term debt / Notes payable

Operating Working Capital (OWC)

Item which is not present in the balance sheet

Operating Working Capital (OWC) =

Operating Working Capital (OWC)

Operating Working Capital

Real investment in cash, just like investment in Machines or Buildings

OWC correlated to sales ?

Operating Working Capital (OWC)

OWC in days of sales

Inventories = DOH = Days On Hand

the balance sheet

the statement of cash flows

Ratios of return concept

Return on assets (ROA)

Assets Sales Assets

Tom Cat Herring

the balance sheet

the statement of cash flows

Capital engaged (employed)

Property, plant and equipment

Liabilities and Sh. Equity

Long Term debt

Short term debt / Notes payable

Capital employed (engaged)

Net fixed assets

Capital engaged (employed) and ROCE

Net fixed assets

Return On Capital Employed (ROCE) = Operating margin x Capital engaged turnover

Return on capital employed (ROCE)

Return on capital employed (ROCE)

Fixed assetsOWC Sales Fixed assetsOWC

Tom Cat Herring

the balance sheet

the statement of cash flows

World with no tax

No tax, but a leverage effect...

Formula without tax

The final return for the shareholder consists in

Formula with tax

The leverage effect :