Chapter 9 Analyzing Historical Performance

1. Chapter 9 Analyzing Historical Performance Presented by Shan Li

2. Organization of this chapter • Reorganizing the accounting statements to gain greater analytical insights and to calculate ROIC and economic profit • Calculate free cash flow • Breaking down ROIC and Developing an integrated perspective • Analyzing credit health and liquidity • Dealing with more advanced issues in analyzing financial performance

3. Reorganizing The Accounting Statements • The purpose of reorganization of accounting statements is to calculate Invested Capital, NOPLAT,ROIC and Economic Profit. • ROIC and Economic Profit reflect more of an economic than accounting view of the company. For example: distinguish operating from non-operating assets.

4. Invested Capital • Need to reorganize the balance sheet. • It reflect how much of the capital has been invested in operating activities and other non-operating activities. • Operating invested capital: the amount invested in the operation of the business. OIC = operating working capital + net property, plant and equipment + net other assets

5. Invested Capital-9 items • Operating current assets • Comprise all current assets used in or necessary for the operation of the business. • OCA= cash balance + trade accounts receivables + inventories. • Specifically excluded are cash and marketable securities greater than the operational needs of the business.

6. Invested Capital-9 items • Non-interest-bearing current liabilities • Such as accounts payable and accrued expense • Net working capital=Operating current assets – Non-interest-bearing current liabilities • Net property, plant and equipment • Is the book value of the company’s fixed assets • NPPE=Gross PPE – Accumulated depreciation

7. Invested Capital-9 items • Other operating assets, net of other liabilities • Any other assets or non-interest-bearing liabilities related to the operation of business • Non-operating assets • Any assets not included in operating invested capital should be added when total investor funds. • For example: Goodwill, Excess cash and securities, Non-operating investments.

8. Invested Capital-9 items • Equity • Is the sum of all common equity accounts • Such as paid-in capital and retain earnings, preferred shares, and minority interest in consolidated subsidiaries • Quasi-equity items • Accounts recorded as liabilities for accounting purpose, but should be treated as equity to determine how much capital the shareholder have invested. • For example: deferred income taxes

9. Invested Capital-9 items • Adjusted equity • Is the sum of all equity accounts plus all quasi-equity accounts • Interest-bearing debt • Includes long-term debt, short-term debt, current maturities of long-term debt, and capital lease

10. NOPLAT • NOPLAT-Net Operating Profit Less Adjusted Taxes • Need to reorganize income statement • Represents the after-tax operating profits of the company after adjusting the taxes to a cash basis

11. NOPLAT-4 items • EBITA • EBITA-Earning Before Interest, Taxes and Amortization of goodwill • Is the pretax operating income that a company would earned if it had no debt and no goodwill amortization • Includes all types of operating income, including most revenues and expenses • Excludes interest income and expense, gain or loss from discontinued items, extraordinary income or loss, investment income from non-operating invests

12. NOPLAT-4 items • Taxes on EBITA • Represent the income taxes that are attributable to EBITA • Are taxes the company would pay if it had no debt, cash above operating needs, or non-operating income or expenses

13. NOPLAT-4 items • Change in deferred taxes • Deferred taxes are the difference between the provision for income taxes in the income statement and the actual taxes paid in cash. • Can be made by calculating the change in accumulated deferred income taxes on the company’s balance sheet • For example: accumulated deferred taxes in 1995 was 192, in 1996 was 224. Therefore, change in deferred taxes is 224-192=32.

14. NOPLAT-4 items • Reconciliation to net income • To ensure that nothing is missing in the calculation of NOPLAT • To ensure a complete understanding of the company’s financial statements

15. ROIC • ROIC-Return On Invested Capital • ROIC= Net operating profit less adjusted taxes Invested capital • Invested capital is generally measured at the beginning of the period or as an average of the beginning and end of the period. • ROIC is a better analytical tool because it focuses on the true operating performance of the company.

16. Economic Profit • It measures the dollars of economic value created by a company in a single year. • Economic profit=Invested capital x (ROIC-WACC) or • Economic profit=NOPLAT-Capital charge or • Economic profit=NOPLAT-(Invested capital x WACC) • Economic profit combines spread and size of company into dollar performance

17. Free Cash Flow • Free cash flow is a company’s true operating cash flow. • It is the total after-tax cash flow generated by the company that is available to all providers of the company’s capital, both creditors and shareholders. • Free cash flow is before financing and therefore not affect by the company’s financial structure.

18. Free Cash Flow • FCF=NOPALT-Net investment =[NOPLAT + Depreciation]-[Net investment + Depreciation] =Gross cash flow-Gross investment Where net investment is the change in invested capital.

19. Free Cash Flow-14 items • Depreciation • Includes all the noncash charges deducted from EBITA except goodwill amortization • Gross cash flow • Represents the total cash flow thrown off by the company’s operation • It is the amount available to reinvest without relying on additional capital • GCF=NOPLAT + Depreciation

20. Free Cash Flow-14 items • Change in operating working capital • Is the amount the company invested in operating working capital during the period. • Capital expenditure • Include expenditures on new and replacement property, and equipment • Capital expenditure=increase in net property, plant and equipment + depreciation expenses

21. Free Cash Flow-14 items • Increase in other assets, net of liabilities • Equals the expenditure on all other operating assets including deferred expense, and net of increases in non-current, non-interest-bearing liabilities • Gross investment • Is the sum of a company’s spending for new capital • Includes working capital, capital expenditures, and other assets • GI=change in working capital + capital expenditure + change in other assets + foreign currency translation effect

22. Free Cash Flow-14 items • Investment in goodwill • Equals the expenditures to acquire other companies in excess of the book value of their net assets • IIG=net changes in goodwill + amortization of goodwill

23. Free Cash Flow-14 items • Non-operating cash flow • Represents the after-tax cash flow from items not related to operations • Includes cash flow from discontinued operations, extraordinary gain or loss, and the cash flow from investments in unrelated subsidiaries • TV=PV of FCF + PV of After Tax Non-Operating CF and Marketable Securities

24. Free Cash Flow-14 items • Change in excess marketable securities • Excess marketable securities are the short-term investments that the company holds above its target balance to support operation. • The change in excess marketable securities can be treated as non-operating cash flow or as financing cash flows.

25. Free Cash Flow-14 items • Foreign Currency translation effect • Is driven by the changes in translation rates applies to both assets and debt • Treat this gain or loss as non-operating cash flow • Total funds available to investor • =FCF + all non-operating items

26. Free Cash Flow-14 items • Change in Debt • Represents the net borrowing or repayment on all the company’s interest-bearing debt • Includes short-term debt and capital lease • After-tax interest expense • =pretax interest expense x (1-marginal tax rate)

27. Free Cash Flow-14 items • Dividends • Includes all cash dividends on common and preferred shares • Share issues/repurchases • Includes both preferred and common shares and the effects of conversions of debt to equity

28. Breakdown ROIC ROIC = NOPLAT Invested Capital NOPLAT=EBITA x (1-Cash tax rate) ROIC= EBITA x (1-cash tax rate) Invested Capital

29. Breakdown ROIC EBITA EBITA Revenues Invested Capital = Revenues x Invested Capital • Operating Margin (EBITA/Revenues) measures how effectively the company converts revenues into profits. • Capital turnover ( Revenue/Invested capital) measures how effectively the company employs its invested capital.

30. Credit Health and Liquidity • Interest Coverage • Is the amount of earnings available to pay interest expense • It provides a sense of how far operating profits could fall before the company would have difficulty servicing its debt. • Measures the company’s financial cushion • Interest Coverage= EBIT/Interest expense

31. Credit Health and Liquidity • Debt/Total Investor Funds • Measures the company’s reliance on debt capital • Expressed both at book value (creditors often use) and at market values

32. Credit Health and Liquidity • Investment Rate • Is the ratio of investment to available funds • Net basis : Net investment / NOPLAT • Gross basis: Gross investment / Gross cash flow • Investment rate > 1 : company is consuming more funds than it is generating

33. Credit Health and Liquidity • Dividend Payout Ratio • Is total common dividends divided by income available to common shareholders • = Common Dividends / Net Income available to common • If a company has investment rate >1 and a high dividend payout ratio, it must be borrowing money to fund a negative free cash flow to pay interests and dividends.