1/ THE IMPORTANCE OF THE OPERATING CYCLE

Let’s take the example of a greengrocer, Mr G, who is “cashing up” one evening. What does he find? First, he sees how much he spent in cash at the wholesale market in the morning and then the cash proceeds from fruit and vegetable sales during the day. If we assume that the greengrocer sold all the produce he bought in the morning at a mark-up, then the balance of receipts and payments for the day will be a cash surplus.

Unfortunately, things are usually more complicated in practice. It’s rare that all the goods bought in the morning are sold by the evening, especially in the case of a manufacturing business.

A company processes raw materials as part of an operating cycle, the length of which varies tremendously, from a day in the newspaper sector to seven years in the cognac sector. There is, then, a time lag between purchases of raw materials and the sale of the corresponding finished goods.

This time lag is not the only complicating factor. It is unusual for companies to buy and sell in cash. Usually, their suppliers grant them extended payment periods, and they can in turn grant their customers extended payment periods. The money received during the day does not necessarily come from sales made on the same day.

As a result of customer credit,² supplier credit³ and the time it takes to manufacture and sell products or services, the operating cycle of each and every company spans a certain period, leading to timing differences between operating outflows and the corresponding operating inflows.

Each business has its own operating cycle of a certain length that, from a cash flow standpoint, may lead to positive or negative cash flows at different times. Operating outflows and inflows from different cycles are analysed by period, e.g. by month or by year. The balance of these flows is called operating cash flow. Operating cash flow reflects the cash flows generated by operations during a given period.

In concrete terms, operating cash flow represents the cash flow generated by the company’s operations. Returning to our initial example of an individual looking at his bank statement, it represents the difference between the receipts and normal outgoings, such as food, electricity and rent.

Naturally, unless there is a major timing difference caused by some unusual circumstances (start-up period of a business, very strong growth, very strong seasonal fluctuations), the balance of operating receipts and payments should be positive.

Readers with accounting knowledge will note that operating cash flow is independent of any accounting policies, which makes sense since it relates only to cash flows. More specifically:

• neither the company’s depreciation and provisioning policy,
• nor its inventory valuation method,
• nor the techniques used to defer costs over several periods have any impact on the figure.

However, the concept is affected by decisions about how to classify payments between investment and operating outlays, as we will now examine more closely.

2/ INVESTMENT AND OPERATING OUTFLOWS

Let’s return to the example of our greengrocer, who now decides to add frozen food to his business.

The operating cycle will no longer be the same. The greengrocer may, for instance, begin receiving deliveries once a week only and will therefore have to run much larger inventories. Admittedly, the impact of the longer operating cycle due to much larger inventories may be offset by larger credit from his suppliers. The key point here is to recognise that the operating cycle will change.

The operating cycle is different for each business and, generally speaking, the more sophisticated the end product, the longer the operating cycle.

But most importantly, before he can start up this new activity, our greengrocer needs to invest in a chest freezer.

What difference is there between this investment and operating outlays?

The outlay on the chest freezer seems to be a prerequisite. It forms the basis for a new activity, the success of which is unknown. It appears to carry higher risks and will be beneficial only if overall operating cash flow generated by the greengrocer increases. Lastly, investments are carried out from a long-term perspective and have a longer life than that of the operating cycle. Indeed, they last for several operating cycles, even if they do not last forever given the fast pace of technological progress.

This justifies the distinction, from a cash flow perspective, between operating and investment outflows.

Normal outflows, from an individual’s perspective, differ from an investment outflow in that they afford enjoyment, whereas investment represents abstinence. As we will see, this type of decision represents one of the vital underpinnings of finance. Only the very puritanically minded would take more pleasure from buying a microwave than from spending the same amount of money at a restaurant! Only one of these choices can be an investment and the other an ordinary outflow. So, what purpose do investments serve? Investment is worthwhile only if the decision to forego normal spending, which gives instant pleasure, will subsequently lead to greater gratification.

This is the definition of the return on investment (be it industrial or financial) from a cash flow standpoint. We will use this definition throughout this book.

The impact of investment outlays is spread over several operating cycles. Financially, capital expenditures are worthwhile only if inflows generated thanks to these expenditures exceed the outflows by an amount yielding at least the return on investment expected by the investor.

Note also that a company may sell some assets in which it has invested in the past. For instance, our greengrocer may decide after several years to trade in his freezer for a larger model. The proceeds would also be part of the investment cycle.

3/ FREE CASH FLOW

Before-tax free cash flow is defined as the difference between operating cash flow and capital expenditure net of fixed asset disposals.

As we shall see in Sections II and III of this book, free cash flow can be calculated before or after tax. It also forms the basis for the most important valuation technique. Operating cash flow is a concept that depends on how expenditure is classified between operating and investment outlays. Since this distinction is not always clear-cut, operating cash flow is not widely used in practice, with free cash flow being far more popular. If free cash flow turns negative, then additional financial resources will have to be raised to cover the company’s cash flow requirements.

1/ EARNINGS AND THE OPERATING CYCLE

The operating cycle forms the basis of the company’s wealth. It consists of both:

• additions to wealth (products and services sold, i.e. products and services whose worth is recognised in the market); and
• deductions from wealth (consumption of raw materials or goods for resale, use of labour, use of external services such as transportation, taxes and other duties).

The very essence of a business is to increase wealth by means of its operating cycle.

It may be described as gross insofar as it covers just the operating cycle and is calculated before non-cash expenses such as depreciation and amortisation, and before interest and taxes.

2/ EARNINGS AND THE INVESTING CYCLE

3/ THE DISTINCTION BETWEEN OPERATING COSTS AND FIXED ASSETS

Although we are easily able to define investment from a cash flow perspective, we recognise that our approach goes against the grain of the traditional presentation of these matters, especially as far as those familiar with accounting are concerned:

• Whatever is consumed as part of the operating cycle to create something new belongs to the operating cycle. Without wishing to philosophise, we note that the act of creation always entails some form of destruction.
• Whatever is used without being destroyed directly, thus retaining its value, belongs to the investment cycle. This represents an immutable asset or, in accounting terms, a fixed asset (a “non-current asset” in IFRS terminology).

For instance, to make bread, a baker uses flour, salt, yeast and water, all of which form part of the end product. The process also entails labour, which has a value only insofar as it transforms the raw material into the end product. At the same time, the baker also needs a bread oven, which is absolutely essential for the production process, but is not destroyed by it. Though this oven may experience wear and tear, it will be used many times over.

This is the major distinction that can be drawn between operating costs and fixed assets. It may look deceptively straightforward, but in practice is no clearer than the distinction between investment and operating outlays. For instance, does an advertising campaign represent a charge linked solely to one period with no impact on any other? Or does it represent the creation of an asset (a brand)?

4/ THE COMPANY’S OPERATING PROFIT

From EBITDA, which is linked to the operating cycle, we deduct non-cash costs, which comprise depreciation and amortisation and impairment losses or write-downs on fixed assets.

This gives us operating income or operating profit or EBIT (earnings before interest and taxes), which reflects the increase in wealth generated by the company’s industrial and commercial activities.

The term “operating” contrasts with the term “financial”, reflecting the distinction between the real world and the realms of finance. Indeed, operating income is the product of the company’s industrial and commercial activities before its financing operations are taken into account. Operating profit or EBIT may also be called operating income, trading profit or operating result.

5/ EARNINGS AND THE FINANCING CYCLE

6/ RECURRENT AND NON-RECURRENT ITEMS: EXTRAORDINARY AND EXCEPTIONAL ITEMS, DISCONTINUED OPERATIONS

We have now considered all the operations of a business that may be allocated to the operating, investing and financing cycles of a company. That said, it is not hard to imagine the difficulties involved in classifying the financial consequences of certain extraordinary events, such as losses incurred as a result of earthquakes, other natural disasters or the expropriation of assets by a government.

They are not expected to occur frequently or regularly and are beyond the control of a company’s management – hence, the idea of creating a separate catch-all category for precisely such extraordinary items.

We will see in Chapter 9 that the distinction between non-recurring and recurring items is a difficult and subjective distinction, all the more so as accounting standards do little to help us.

Among the many different types of exceptional events, we will briefly focus on asset disposals. Investing forms an integral part of the industrial and commercial activities of businesses. But the best-laid plans may fail, while others may lead down a strategic impasse.

Put another way, disinvesting is also a key part of an entrepreneur’s activities. It generates exceptional “asset disposal” inflows on the cash flow statement and capital gains and losses on the income statement, which may appear under exceptional items or not. It is for the analyst to decide whether these gains and losses are recurring, and thus part of the operations; or not, and then constitute non-recurring items. More generally, some non-recurring items have a cash impact, some have none (goodwill depreciation, for example).

By definition, it is easier to analyse and forecast profit before tax and non-recurrent items than net income or net profit, which is calculated after the impact of non-recurrent items and tax.

7/ NET INCOME

Net income measures the creation or destruction of wealth during the fiscal year. Net income is a wealth indicator, not a cash indicator. It incorporates wealth-destructive items like depreciation, which are non-cash items, and most of the time it does not show increases in value, which are only recorded when they are realised through asset sales.

1/ THE BY-FUNCTION INCOME STATEMENT FORMAT

This presentation is based on a management accounting approach, in which costs are allocated to the main corporate functions:

As a result, personnel expense is allocated to each of these four categories (or three where selling, general and administrative costs are pooled into a single category), depending on whether an individual employee works in production, sales, research or administration. Likewise, depreciation expense for a tangible fixed asset is accounted for under cost of goods sold if it relates to production machinery, to selling and marketing costs if it concerns a car used by the sales team, to research and development costs if it relates to laboratory equipment, or to general and administrative costs in the case of the accounting department’s computers, for example.

The underlying principle is very simple indeed. This format clearly shows that operating profit is the difference between sales and the cost of sales irrespective of their nature (i.e. production, sales, research and development, administration).

On the other hand, it does not differentiate between the operating and investment processes, since depreciation and amortisation is not shown directly on the income statement (it is split up between the four main corporate functions), obliging analysts to track down the information in the cash flow statement or in the notes to the accounts.

2/ THE BY-NATURE INCOME STATEMENT FORMAT

The by-nature format is simple to apply, even for small companies, because no allocation of expenses is required. It offers a more detailed breakdown of costs.

Naturally, as in the previous approach, operating profit is still the difference between sales and the cost of sales.

In this format, costs are recognised as they are incurred rather than when the corresponding items are used. Showing on the income statement all purchases made and all invoices sent to customers during the same period would not be comparing like with like.

A business may transfer to inventory some of the purchases made during a given year. The transfer of these purchases to inventory does not destroy any wealth. Instead, it represents the formation of an asset, albeit probably a temporary one, but one that has real value at a given point in time. Secondly, some of the end products produced by the company may not be sold during the year and yet the corresponding costs appear on the income statement.

To compare like with like, it is necessary to:

• eliminate changes in inventories of raw materials and goods for resale from purchases to get raw materials and goods for resale that were used rather than simply purchased;
• add changes in the inventory of finished products and work in progress back to sales. As a result, the income statement shows production rather than just sales.

The by-nature format shows the amount spent on production for the period and not the total expenses under the accruals convention. It has the logical disadvantage that it seems to imply that changes in inventory are a revenue or an expense in their own right, which they are not. They are only an adjustment to purchases to obtain relevant costs.

Exercise 1 will help readers get to grips with the concept of changes in inventories of finished goods and work in progress.

To sum up, there are two different income statement formats:

• the by-nature format, which is focused on production, in which all the costs incurred during a given period are recorded. This amount then needs to be adjusted (for changes in inventories) so that it may be compared with products sold during the period;
• the by-function format, which is built directly in terms of the cost price of goods or services sold.

Either way, it is worth noting that EBITDA depends heavily on the inventory valuation methods used by the business. This emphasises the appeal of the by-nature format, which shows inventory changes on a separate line of the income statement and thus clearly indicates their order of magnitude.

Like operating cash flow, EBITDA is not influenced by the valuation methods applied to tangible and intangible fixed assets or the taxation system.

1/ MAIN ITEMS ON A BALANCE SHEET

Assets on the balance sheet comprise:

• fixed assets,¹ i.e. everything required for the operating cycle that is not destroyed as part of it. These items retain some value (any loss in their value is accounted for through depreciation, amortisation and impairment losses). A distinction is drawn between tangible fixed assets (land, buildings, machinery, etc.),²intangible fixed assets (brands, patents, software, goodwill, etc.) and investments. When a business holds shares in another company (in the long term), they are accounted for under investments;
• inventories and trade receivables, i.e. temporary assets created as part of the operating cycle;
• lastly, marketable securities and cash that belong to the company and are thus assets.

Inventories, receivables,³ marketable securities and cash represent the current assets, a term reflecting the fact that these assets tend to “turn over” during the operating cycle.

Resources on the balance sheet comprise:

• capital provided by shareholders, plus retained earnings, known as shareholders’ equity;
• borrowings of any kind that the business may have arranged, e.g. bank loans, supplier credits, etc., known as liabilities.

THE BALANCE SHEET

By definition, a company’s assets and resources must be exactly equal. This is the fundamental principle of double-entry accounting. When an item is purchased, it is either capitalised or expensed. If it is capitalised, it will appear on the asset side of the balance sheet, and if expensed, it will lead to a reduction in earnings and thus shareholders’ equity. The double-entry for this purchase is either a reduction in cash (i.e. a decrease in an asset) or a commitment (i.e. a liability) to the vendor (i.e. an increase in a liability). According to the algebra of accounting, assets and resources (equity and liabilities) always carry the opposite sign, so the equilibrium of the balance sheet is always maintained.

It is European practice to classify assets starting with fixed assets and to end with cash,⁴ whereas it is North American and Japanese practice to start with cash. The same is true for the equity and liabilities side of the balance sheet: Europeans start with equity, whereas North Americans and Japanese end with it.

A “horizontal” format is common in continental Europe, with assets on the left and resources on the right. In the UK, the more common format is a “vertical” one, starting from fixed assets plus current assets and deducting liabilities to end up with equity. These are only choices of presentation.

2/ TWO WAYS OF ANALYSING THE BALANCE SHEET

A balance sheet can be analysed either from a capital-employed perspective or from a solvency-and-liquidity perspective.

In the capital-employed analysis, the balance sheet shows all the uses of funds for the company’s operating cycle and analyses the origin of its sources of funds.

A capital-employed analysis of the balance sheet serves three main purposes:

• to illustrate how a company finances its operating assets (see Chapter 12);
• to compute the rate of return either on capital employed or on equity (see Chapter 13); and
• as a first step to valuing the equity of a company as a going concern (see Chapter 31).

In a solvency-and-liquidity analysis, a business is regarded as a set of assets and liabilities, the difference between them representing the book value of the equity provided by shareholders. From this perspective, the balance sheet lists everything that a company owns and everything that it owes.

A solvency-and-liquidity analysis of the balance sheet serves three purposes:

• to measure the solvency of a company (see Chapter 14);
• to measure the liquidity of a company (see Chapter 12); and
• as a first step to valuing its equity in a bankruptcy scenario.

1/ FIXED ASSETS, ALSO CALLED NON-CURRENT ASSETS

These represent all the investments carried out by the business, based on our financial and accounting definition. In IFRS and US GAAP it would also include operating lease right of use assets.

It is helpful to distinguish wherever possible between operating assets and non-operating assets that have nothing to do with the company’s business activities, e.g. land, buildings and subsidiaries active in significantly different or non-core businesses. Non-operating assets can thus be excluded from the company’s capital employed. By isolating non-operating assets, we can assess the resources the company may be able to call upon in hard times (i.e. through the disposal of non-operating assets).

The difference between operating and non-operating assets can be subtle in certain circumstances. For instance, how should a company’s head office on Bond Street or on the Champs-Elysées be classified? Probably under operating assets for a fashion house or a car manufacturer, but under non-operating assets for an engineering or construction group which has no business reason to be on Bond Street (unlike Burberry).

2/ OPERATING WORKING CAPITAL

Operating working capital is the difference between uses of funds and sources of funds linked to the daily operations of a company.

Uses of funds comprise all the operating costs incurred but not yet used or sold (i.e. inventories) and all sales that have not yet been paid for (trade receivables).

Sources of funds comprise all charges incurred but not yet paid for (trade payables, social security and tax payables), as well as operating revenues from products that have not yet been delivered (advance payments on orders).

The net balance of operating uses and sources of funds is called the working capital.

If uses of funds exceed sources of funds, the balance is positive and working capital needs to be financed. This is the most frequent case. If negative, it represents a source of funds generated by the operating cycle. This is a nice – but rare – situation!

It is described as “working capital” because the figure reflects the cash required to cover financing shortfalls arising from day-to-day operations.

Sometimes working capital is defined as current assets minus current liabilities. This definition corresponds to our working capital definition + marketable securities and net cash – short-term financial and banking borrowings. We think that this is an improper definition of working capital as it mixes items from the operating cycle (inventories, receivables, payables) and items from the financing cycle (marketable securities, net cash and short-term bank and financial borrowings). You may also find in some documents expressions such as “working capital needs” or “requirements in working capital”. These are synonyms for working capital.

Operating working capital comprises the following accounting entries:

Only the normal amount of operating sources of funds is included in calculations of operating working capital. Unusually long payment periods granted by suppliers should not be included as a component of normal operating working capital.

Where it is permanent, the abnormal portion should be treated as a source of cash, with the suppliers thus being considered as playing the role of the company’s banker.

Inventories of raw materials and goods for resale should be included only at their normal amount. Under no circumstances should an unusually large figure for inventories of raw materials and goods for resale be included in the calculation of operating working capital.

Where appropriate, the excess portion of inventories or the amount considered as inventory held for speculative purposes can be treated as a high-risk short-term investment.

Working capital is totally independent of the methods used to value fixed assets, depreciation, amortisation and impairment losses on fixed assets. However, it is influenced by:

• inventory valuation methods;
• deferred income and cost over one or more years (accruals);
• the company’s provisioning policy for current assets and operating liabilities and costs.

As we shall see in Chapter 5, working capital represents a key principle of financial analysis.

3/ NON-OPERATING WORKING CAPITAL

Although we have considered the timing differences between inflows and outflows that arise during the operating cycle, we have, until now, always assumed that capital expenditures are paid for when purchased and that non-recurring costs are paid for when they are recognised in the income statement. Naturally, there may be timing differences here, giving rise to what is known as non-operating working capital.

Non-operating working capital, which is not a very robust concept from a theoretical perspective, is hard to predict and to analyse because it depends on individual transactions, unlike operating working capital, which is recurring.

In practice, non-operating working capital is a catch-all category for items that cannot be classified anywhere else. It includes amounts due on fixed assets, extraordinary items, etc.

4/ CAPITAL EMPLOYED

Capital employed is the sum of a company’s fixed assets and its working capital (i.e. operating and non-operating working capital). It is therefore equal to the sum of the net amounts devoted by a business to both the operating and investing cycles. It is also known as operating assets.

Capital employed is financed by two main types of funds: shareholders’ equity and net debt, sometimes grouped together under the heading of invested capital.

5/ FINANCIAL RESOURCES OR INVESTED CAPITAL

Capital employed is financed by two financial resources: shareholders’ equity and net debt.

Shareholders’ equity comprises capital provided by shareholders when the company is initially formed and at subsequent capital increases, as well as capital left at the company’s disposal in the form of earnings transferred to the reserves.

The company’s gross debt comprises debt financing, irrespective of its maturity, i.e. medium- and long-term (various borrowings due in more than one year that have not yet been repaid), and short-term bank or financial borrowings (portion of long-term borrowings due in less than one year, discounted notes, bank overdrafts, etc.) to which IFRS and US GAAP add operating lease liabilities. A company’s net debt goes further by deducting cash and equivalents (e.g. petty cash and bank accounts) and marketable securities, which are the opposite of debt (the company lending money to banks or financial markets), that could be used to partially or totally reduce the gross debt. It is also called net financial position.

Net debt, or net financial position, can thus be calculated as follows:

A company’s net debt can be either positive or negative. If it is negative, the company is said to have net cash.

In the previous paragraphs, we looked at the key accounting items, but some are a bit more complex to allocate (pensions, accruals, etc.) and we will develop these in Chapter 7.

From a capital-employed standpoint, a company balance sheet can be analysed as follows, with the example of the ArcelorMittal group, the world steel leader. This balance sheet will be used in future chapters.

BALANCE SHEET FOR ARCELORMITTAL

Items specific to consolidated accounts are highlighted in blue and will be described in detail in Chapter 6.

1/ BALANCE SHEET LIQUIDITY

A classification of the balance sheet items needs to be carried out prior to the liquidity analysis. Liabilities are classified in the order in which they fall due for repayment. Since balance sheets are published annually, a distinction between the short term and the long term turns on whether a liability is due in less than or more than one year. Accordingly, liabilities are classified into those due in the short term (less than one year), in the medium and long term (more than one year) and those that are not due for repayment.

Likewise, what the company owns can also be classified by duration as follows:

• assets that will have disappeared from the balance sheet by the following year, which comprise current assets in the vast majority of cases;
• assets that will still appear on the balance sheet the following year, which comprise fixed assets in the vast majority of cases.

From a liquidity perspective, we classify liabilities by their due date, investments by their maturity date and assets as follows:

Accordingly, they comprise (unless the operating cycle is unusually long) inventories and trade receivables.

Balance sheet liquidity therefore derives from the fact that the turnover of assets (i.e. the speed at which they are monetised within the operating cycle) is faster than the turnover of liabilities (i.e. when they fall due). The maturity schedule of liabilities is known in advance because it is defined contractually. However, the liquidity of current assets is unpredictable (risk of sales flops or inventory write-downs, etc.). Consequently, the clearly defined maturity structure of a company’s liabilities contrasts with the unpredictable liquidity of its assets.

Therefore, short-term creditors will take into account differences between a company’s asset liquidity and its liability structure. They will require the company to maintain current assets at a level exceeding that of short-term liabilities to provide a margin of safety. Hence the sacrosanct rule in finance that each and every company must have assets due to be monetised in less than one year at least equal to its liabilities falling due within one year.

2/ SOLVENCY

In accounting terms, a company may be regarded as insolvent once its shareholders’ equity turns negative. This means that it owes more than it owns.

Sometimes, the word solvency is used in a broader sense, meaning the ability of a company to repay its debts as they become due (see Chapter 12).

3/ NET ASSET VALUE OR THE BOOK VALUE OF SHAREHOLDERS’ EQUITY

This is a solvency-oriented concept that attempts to compute the funds invested by shareholders by valuing the company as the difference between its assets and its liabilities. Net asset value is an accounting and, in some instances, tax-related term, rather than a financial one.

The book value of shareholders’ equity is equal to everything a company owns less everything it already owes or may owe. Financiers often talk about net asset value, which leads to confusion among non-specialists, who can construe them as total assets net of depreciation, amortisation and impairment losses.

Book value of equity is thus equal to the sum of:

When a company is sold, the buyer will be keen to adopt an even stricter approach:

• by factoring in contingent liabilities (that do not appear on the balance sheet);
• by excluding worthless assets, i.e. of zero value. This very often applies to some intangible assets (see Chapter 7).

1/ OPERATING REVENUES

Operating receipts should correspond to sales for the same period, but they differ because:

• customers may be granted a payment period; and/or
• payments of invoices from the previous period may be received during the current period.

As a result, operating receipts are equal to sales only if sales are immediately paid in cash. Otherwise, they generate a change in trade receivables.

2/ CHANGES IN INVENTORIES OF FINISHED GOODS AND WORK IN PROGRESS

As we have already seen in by-nature income statements, the difference between production and sales is adjusted for through changes in inventories of finished goods and work in progress.¹ But this is merely an accounting entry, to deduct from operating costs those costs that do not correspond to products sold. It has no impact from a cash standpoint.² As a result, changes in inventories need to be reversed in a cash flow analysis.

3/ OPERATING COSTS

Operating costs differ from operating payments in the same way as operating revenues differ from operating receipts. Operating payments are the same as operating costs for a given period only when adjusted for:

• timing differences arising from the company’s payment terms (credit granted by its suppliers, etc.);
• the fact that some purchases are not used during the same period. The difference between purchases made and purchases used is adjusted for through change in inventories of raw materials.

These timing differences give rise to:

• changes in trade payables in the first case;
• discrepancies between raw materials used and purchases made, which are equal to change in inventories of raw materials and goods for resale.

The total amount of the timing differences between operating revenues and costs and between operating receipts and payments can thus be summarised as follows for by-nature and by-function income statements:

Astute readers will have noticed that the items in the central column of the above table are the components of the change in operating working capital between two periods, as defined in Chapter 4.

Over a given period, the change in operating working capital represents a need for, or a source of, financing.

If positive, it represents a financing requirement and we refer to an increase in operating working capital. If negative, it represents a source of funds and we refer to a reduction in operating working capital.

The change in working capital merely represents a straightforward timing difference between the balance of operating cash flows (operating cash flow) and the wealth created by the operating cycle (EBITDA). As we shall see, it is important to remember that timing differences may not necessarily be small, of limited importance, short or negligible in any way.

4/ CAPITAL EXPENDITURE

Capital expenditures³ lead to a change in what the company owns without any immediate increase or decrease in its wealth. Consequently, they are not shown directly on the income statement. Conversely, capital expenditures have a direct impact on the cash flow statement.

A company’s capital expenditure process leads to both cash outflows that do not diminish its wealth at all and the accounting recognition of impairment in the purchased assets through depreciation and amortisation that does not reflect any cash outflows.

Accordingly, there is no direct link between cash flow and net income for the capital expenditure process, as we knew already.

5/ FINANCING

Financing is, by its very nature, a cycle that is specific to inflows and outflows. Sources of financing (new borrowings, capital increases, etc.) do not appear on the income statement, which shows only the remuneration paid on some of these resources, i.e. interest on borrowings but not dividends on equity.

Outflows representing a return on sources of financing may be analysed as either costs (i.e. interest) or a distribution of wealth created by the company among its equity capital providers (i.e. dividends).

To keep things simple, assuming that there are no timing differences between the recognition of a cost and the corresponding cash outflow, a distinction needs to be drawn between:

• interest payments on debt financing (financial expense) and income tax, which affect the company’s cash position and its earnings;
• the payments made to equity capital providers (dividends), which affects the company’s cash position and earnings transferred to reserves;
• new borrowings and repayment of borrowings, capital increases and share buy-backs,⁴ which affect its cash position, but have no impact on earnings.

Lastly, corporate income tax represents a charge that appears on the income statement and a cash payment to the state which, though it may not provide any financing to the company, provides it with a range of free services and entitlements, e.g. police, education, roads, etc. Corporate income tax is not always paid as soon as it becomes a cost, thus creating another time lag between a cost and its payment (similar to a variation in working capital).

We can now finish off our table and walk through from earnings to decrease in net debt:

FROM THE INCOME STATEMENT… TO THE CASH FLOW STATEMENT

1/ FROM NET INCOME TO CASH FLOW

As we have just seen, depreciation, amortisation, impairment losses on fixed assets and provisions are non-cash costs that have no impact on a company’s cash position. From a cash flow standpoint, they are no different from net income.

These two items form the company’s cash flow, which accountants allocate between net income on the one hand and depreciation, amortisation and impairment losses on the other hand, according to the relevant accounting and tax legislation.

The simplicity of the cash flow statement shown in Chapter 2 was probably evident to our readers, but it would not fail to shock traditional accountants, who would find it hard to accept that financial expense should be placed on a par with repayments of borrowings. Raising debt to pay financial expense is not the same as replacing one debt with another. The former makes the company poorer, whereas the latter constitutes liability management.

As a result, traditionalists have managed to establish the concept of cash flow. We need to point out that we would advise computing cash flow before any capital gains (or losses) on asset disposals and before non-recurring items, simply because they are non-recurrent items. Cash flow is only relevant in a cash flow statement if it is not made artificially volatile by inclusion of non-recurring items.

Cash flow is not as pure a concept as EBITDA. That said, a direct link may be established between these two concepts by deriving cash flow from the income statement using the top-down method:

or the bottom-up method:

* So as not to take them into account in the computation of cash flow as they are already included in net income.

Cash flow is influenced by the same accounting policies as EBITDA. Likewise, it is not affected by the accounting policies applied to tangible and intangible fixed assets.

Note that the calculation method differs slightly for consolidated accounts,⁵ since the contribution to consolidated net profit made by equity-accounted income is replaced by the dividend payment received. This is attributable to the fact that the parent company does not actually receive the earnings of an associate company since it does not control it, but merely receives a dividend.

Furthermore, cash flow is calculated at group level without taking into account minority interests. This seems logical, since the parent company has control of and allocates the cash flows of its fully-consolidated subsidiaries even if they are not fully owned. In the cash flow statement, minority interests in the controlled subsidiaries are reflected only through the dividend payments that they receive.

Lastly, readers should beware of cash flow as there are nearly as many definitions of cash flow as there are companies in the world!

The preceding definition is widely used, but frequently free cash flows, cash flow from operating activities and operating cash flow are simply called “cash flow” by some professionals. So, it is safest to check which cash flow they are talking about.

2/ FROM CASH FLOW TO CASH FLOW FROM OPERATING ACTIVITIES

In Chapter 2 we introduced the concept of cash flow from operating activities, which is not the same as cash flow.

To go from cash flow to cash flow from operating activities, we need to adjust for the timing differences in cash flows linked to the operating cycle.

This gives us the following equation:

Note that the term “operating activities” is used here in a fairly broad sense, since it includes financial expense and corporate income tax.

3/ OTHER MOVEMENTS IN CASH

We have now isolated the movements in cash deriving from the operating cycle, so we can proceed to allocate the other movements to the investment and financing cycles.

The investment cycle includes:

• capital expenditures (acquisitions of tangible and intangible assets);
• disposals of fixed assets, i.e. the price at which fixed assets are sold and not any capital gains or losses (which do not represent cash flows);
• changes in long-term investments (i.e. financial assets).

Where appropriate, we may also factor in the impact of timing differences in cash flows generated by this cycle, notably non-operating working capital (e.g. amount owed to a supplier of a fixed asset).

The financing cycle includes:

• capital increases in cash, the payment of dividends (i.e. payment out of the previous year’s net profit) and share buy-backs;
• change in net debt resulting from the repayment of (short-, medium- and long-term) borrowings, new borrowings, changes in marketable securities (short-term investments) and changes in cash and equivalents.

This brings us back to the cash flow statement in Chapter 2, but using the indirect method, which starts with net income and classifies cash flows by cycle (i.e. operating, investing or financing activities; see next page).

In practice, most companies publish a cash flow statement that starts with net income and moves down to changes in “cash and equivalents” or change in “cash”, a poorly defined concept since certain companies include marketable securities while others deduct bank overdrafts and short-term borrowings.

Net debt reflects the level of indebtedness of a company much better than cash and cash equivalents or than cash and cash equivalents minus short-term borrowings, since the latter are only a portion of the debt position of a company. On the one hand, one can infer relevant conclusions from changes in the net debt position of a company. On the other hand, changes in cash and cash equivalents are rarely relevant as it is so easy to increase cash on the balance sheet at the closing date: simply get into long-term debt and put the proceeds in a bank account! Cash on the balance sheet has increased but net debt is still the same.

CASH FLOW STATEMENT FOR ARCELORMITTAL ($M)

However, it is easy to deduct the change in cash available and cash equivalents from the change in indebtedness:

1/ FULL CONSOLIDATION

The accounts of a subsidiary are fully consolidated if the latter is controlled by its parent. Control is defined as the ability to direct the strategic financing and operating policies of an entity so as to access benefits. It is presumed to exist when the parent company:

• holds, directly or indirectly, over 50% of the voting rights in its subsidiary;
• holds, directly or indirectly, less than 50% of the voting rights but has power over more than 50% of the voting rights by virtue of an agreement with other investors;
• has power to govern the financial and operating policies of the subsidiary under a statute or an agreement;
• has power to cast the majority of votes at meetings of the board of directors; or
• has power to appoint or remove the majority of the members of the board.

The criterion of exclusive control is the key factor under IFRS standards. It can encompass companies in which only a minority is held (or even no shares at all!) provided the subsidiary is deemed to be controlled by the parent company.

As its name suggests, full consolidation consists of transferring all the subsidiary’s assets, liabilities and equity to the parent company’s balance sheet and all the revenues and costs to the parent company’s income statement.

The assets, liabilities and equity thus replace the investments held by the parent company, which therefore disappear from its balance sheet.

That said, when the subsidiary is not controlled exclusively by the parent company, the claims of the other “minority” shareholders on the subsidiary’s equity and net income also need to be shown on the consolidated balance sheet and income statement of the group.

Assuming there is no difference between the book value of the parent’s investment in the subsidiary and the share of the book value of the subsidiary’s equity,⁴ full consolidation works as follows.

• On the balance sheet:
  
  • the historical cost amount of the shares in the consolidated subsidiary held by the parent is eliminated from the parent company’s balance sheet and the same amount is deducted from the parent company‘s reserves;
  • the subsidiary’s assets and liabilities are added item by item to the parent company’s balance sheet;
  • the subsidiary’s equity (including net income) is then allocated between the interests of the parent company, which is added to its reserves, and those of minority investors in the subsidiary (if the parent company does not hold 100% of the capital), called minority interests, which is added on an individualised line of shareholders’ equity below the group’s share of shareholders’ equity.
• On the income statement, all the subsidiary’s revenues and charges are added item by item to the parent company’s income statement. The subsidiary’s net income is then broken down into:
  
  • the portion attributable to the parent company, which is added to the parent company’s net income to create the line net income attributable to shareholders or group share net income;
  • the portion attributable to third-party investors, which is shown on a separate line of the income statement under the heading “minority interests”.

From a solvency standpoint, minority interests certainly represent shareholders’ equity. But from a valuation standpoint, they add no value to the group since minority interests represent shareholders’ equity and net profit attributable to third parties and not to shareholders of the parent company.

To illustrate the full consolidation method, consider the following example assuming that the parent company owns 75% of the subsidiary company.

The original non-consolidated balance sheets are as follows:

In this scenario, the consolidated balance sheet would be as follows:

Or, in an alternative form:

Group assets and liabilities thus correspond to the sum of the assets and liabilities of the parent company and those of its subsidiary. Group equity is equal to the equity of the parent company increased by the share of the subsidiary’s net income not paid out as dividends since the parent company started consolidating this subsidiary. Minority interests correspond to the share of minority shareholders in the equity and net income of the subsidiary.

The original income statements are as follows:

In this scenario, the consolidated income statement would be as follows:

Or, in a more detailed form:

Right up until the penultimate line of the income statement, financial analysis assumes that the parent company owns 100% of the subsidiary.

2/ EQUITY METHOD OF ACCOUNTING

When the parent company exercises significant influence over the operating and financial policy of its associate, the latter is accounted for under the equity method. Significant influence over the operating and financial policy of a company is assumed when the parent holds, directly or indirectly, at least 20% of the voting rights. Significant influence may be reflected by participation on the executive and supervisory bodies, participation in strategic decisions, the existence of major intercompany links, exchanges of management personnel and a relationship of dependence from a technical standpoint.

Most companies that were consolidated under the proportionate method are now consolidated under the equity method, since the former method has been banned by IFRS.

Equity accounting consists of replacing the carrying amount of the shares held in an associate (also known as an equity affiliate or associated undertaking) with the corresponding portion of the associate’s shareholders’ equity (including net income).

This method is purely financial. Both the group’s investments and aggregate profit are thus reassessed on an annual basis. Accordingly, the IASB regards equity accounting as being more of a valuation method than a method of consolidation.

From a technical standpoint, equity accounting takes place as follows:

• the historical cost of shares held in the associate is subtracted from the parent company’s investments and replaced by the share attributable to the parent company in the associate’s shareholders’ equity including net income for the year;
• the carrying value of the associate’s shares is subtracted from the parent company’s reserves, to which is added the share in the associate’s shareholders’ equity, excluding the associate’s income attributable to the parent company;
• the portion of the associate’s net income attributable to the parent company is added to its net income on the balance sheet and the income statement.

The equity method of accounting therefore leads to an increase each year in the carrying amount of the shareholding on the consolidated balance sheet, by an amount equal to its share of the net income transferred to reserves by the associate.

However, from a solvency standpoint, this method does not provide any clue to the group’s risk exposure and liabilities (debts, guarantees given, etc.) vis-à-vis its associate. The implication is that the group’s risk exposure is restricted to the value of its shareholding.

To illustrate the equity method of accounting, let us consider the following example based on the assumption that the parent company owns 20% of its associate:

The non-consolidated balance sheets are as follows:

In this scenario, the consolidated balance sheet would be as follows:

The non-consolidated income statements are as follows:

In this scenario, the consolidated income statement would be as follows:

1/ SCOPE OF CONSOLIDATION

The scope of consolidation, i.e. the companies to be consolidated, is determined using the rules we presented in Section 6.1. To determine the scope of consolidation, one needs to establish the level of control exercised by the parent company over each of the companies in which it owns shares.

2/ GOODWILL

It is very unusual for one company to acquire another for exactly its book value.

Generally speaking, there is a difference between the acquisition price, which may be paid in cash or in shares, and the portion of the target company’s shareholders’ equity attributable to the parent company. In most cases, this difference is positive as the price paid exceeds the target’s book value.

1/ HARMONISING ACCOUNTING DATA

Since consolidation consists of aggregating accounts, give or take some adjustments, it is important to ensure that the accounting data used are consistent, i.e. based on the same principles.

Usually, the valuation methods used in individual company accounts are determined by accounting or tax issues specific to each subsidiary, especially when some of them are located outside the group’s home country. This is particularly true for provisions, depreciation and amortisation, fixed assets, inventories and work in progress, deferred charges and shareholders’ equity.

These differences need to be eliminated upon consolidation. This process is facilitated by the fact that most of the time consolidated accounts are not prepared to calculate taxable income, so groups may disregard the prevailing tax regulations.

Prior to consolidation, the consolidating company needs to restate the accounts of the to-be-consolidated companies. The consolidating company applies the same valuation principles and makes adjustments for the impact of the valuation differences that are justified on tax grounds, e.g. tax-regulated provisions, accelerated depreciation for tax purposes and so on.

2/ ELIMINATING INTRA-GROUP TRANSACTIONS

Contrary to the simplified vision we presented in Section 6.1, consolidation entails more than the mere aggregation of accounts. Before the consolidation process as such can begin, intra-group transactions and their impact on net income have to be eliminated from the accounts of both the parent company and its consolidated companies.

Assume, for instance, that the parent company has sold to subsidiaries products at cost plus a margin. An entirely fictitious gain would show up in the group’s accounts if the relevant products were merely held in stock by the subsidiaries rather than being sold on to third parties. Naturally, this fictitious gain, which would be a distortion of reality, needs to be eliminated.

Intra-group transactions to be eliminated upon consolidation can be broken down into two categories:

• Those that are very significant because they affect consolidated net income. It is therefore vital for such transactions to be reversed. The goal is to avoid showing the same profit twice in two different years. The reversal of these transactions upon consolidation leads primarily to the elimination of:
  
  • intra-group profits included in inventories;
  • capital gains arising on the transfer or contribution of investments;
  • dividends received from consolidated companies;
  • impairment losses on intra-group loans or investments; and
  • tax on intra-group profits.
• Those that are not fundamental because they have no impact on consolidated net income or those affecting the assets or liabilities of the consolidated entities. These transactions are eliminated through netting, so as to show the real level of the group’s debt. They include:
  
  • parent-to-subsidiary loans (advances to the subsidiary) and vice versa;
  • interest paid by the parent company to the consolidated companies (financial income of the latter) and vice versa.

3/ TRANSLATING THE ACCOUNTS OF FOREIGN SUBSIDIARIES

1/ WHAT ARE ACCRUALS?

Accruals are used to recognise revenue and costs booked in one period but relating to another period. “To accrue” basically means to transfer revenue or costs from the P&L to the balance sheet.

2/ HOW ARE THEY ACCOUNTED FOR?

The main categories of accruals are:

• prepaid costs, i.e. costs relating to goods or services to be supplied later. For instance, three-quarters of a rental charge payable in advance for a 12-month period on 1 October each year will be recorded under prepaid costs on the asset side of the balance sheet at 31 December;¹
• deferred income, i.e. income accounted for before the corresponding goods or services have been delivered or carried out. For instance, a monthly magazine records three-quarters of the annual subscription payments it receives on 1 October under deferred income on the liabilities side of its balance sheet at 31 December.

We should also mention accrued income and cost, which work in the same way as deferred income and prepaid cost, only in reverse. For example, a company can accrue R&D costs, i.e. consider that it should not appear in the P&L but as an intangible asset that will be amortised or depreciated.

3/ HOW SHOULD FINANCIAL ANALYSTS TREAT THEM?

Deferred income and prepaid cost form part of operating working capital.

1/ WHAT ARE CASH ASSETS?

Cash assets correspond to short-term investment of a company’s cash surpluses (see Chapter 50).

2/ HOW ARE THEY ACCOUNTED FOR?

From an accounting point of view, such investments can only be considered as cash equivalent if they are very liquid, short term, easily converted into cash for a known amount and exposed to a negligible risk of change in value.

In practice, a certain number of criteria are applied (especially for UCITS): benchmark index, frequency of liquidity value, penalties in the event of exit, volatility, counterparty risk, etc.

Under IFRS, cash assets are valued on the basis of their fair value, with any gains and losses recognised in the income statement as financial income.

3/ HOW SHOULD FINANCIAL ANALYSTS TREAT THEM?

In a period of negative short-term interest rates, such as in the Eurozone, Switzerland and Japan since 2015, it is advisable to be particularly vigilant about cash assets generating zero or positive returns, which cannot fail to involve risk taking.

The classification of cash assets or long-term investment assets is important when evaluating the liquidity of a company. From an economic point of view, the analyst will try to understand, first and foremost, whether the asset contributes to operating earnings (and should thus be integrated into capital employed), or if it is a financial investment (whether long or short term). It will then be deducted from net debt.

1/ WHAT ARE CONSTRUCTION CONTRACTS?

In some cases, it may take more than a year for a company to complete a project. For instance, a group that builds dams or ships may work for several years on a single project.

2/ HOW ARE THEY ACCOUNTED FOR?

Construction contracts are accounted for using the percentage of completion method, which consists of recognising at the end of each financial year the sales and profit/loss anticipated on the project in proportion to the percentage of the work completed at that time. US accounting rules recognise both the percentage of completion method and the completed contract method, where revenue recognition is deferred until completion of the contract.²

3/ HOW SHOULD FINANCIAL ANALYSTS TREAT THEM?

Construction projects in progress are part of the operating working capital. The percentage of completion method results in less volatile profits as they are spread over several fiscal years, even if the completed contract method may seem more prudent. Analysts should be aware of changes in accounting methods for construction contracts (which are not possible under IFRS) as such changes may indicate an attempt to artificially improve the published net income for a given year.

1/ WHAT ARE CONVERTIBLE BONDS AND LOANS?

Convertible bonds are bonds that may be converted at the request of their holders into shares in the issuing company. Conversion is thus initiated by the investor.³ If they are not converted, they are repaid in cash at maturity.

2/ HOW ARE THEY ACCOUNTED FOR?

When they are issued, convertible bonds and loans are allocated between debt and equity accounts⁴ since they are analysed under IFRS standards as compound financial instruments made up of a straight bond and a call option (see Chapter 24). The present value of the coupons and reimbursement amount discounted at a fair borrowing rate of the firm is accounted for as debt. The remainder is accounted for as equity. In addition, each year the company will account for the interest as it would be paid for a standard bond (part of this amount corresponding to the actual amount paid, the rest being a notional amount).

3/ HOW SHOULD FINANCIAL ANALYSTS TREAT THEM?

The approach we recommend is to examine the conditions governing conversion of the bonds and to make the equity/debt classification based on the results of this analysis. For instance, if the share price already lies well above the conversion price, then the bonds are very likely indeed to be converted, so they should be treated as equity. For valuation purposes, the related interest expense net of tax should be reversed out of the income statement, leading to an increase in net income. The number of shares should also be increased by those to be issued through the conversion of the convertible bonds.

On the other hand, if the share price is below the conversion price, then convertible bonds should be treated as conventional bonds and stay classified as borrowings.

1/ WHAT ARE DEFERRED TAX ASSETS AND LIABILITIES?

Deferred taxation giving rise to deferred tax assets or liabilities stems from differences between the taxable and book values of assets and liabilities.

On the income statement, certain revenues and charges are recognised in different periods for the purpose of calculating pre-tax accounting profit and taxable profit.

In some cases, the difference may be temporary due to the method used to derive taxable profit from pre-tax accounting profit. For instance, a cost has been recognised in the accounts, but is not yet deductible for tax purposes (e.g. employee profit-sharing in some countries), or vice versa. The same may apply to certain types of revenue. Such differences are known as timing differences.

In other circumstances, the differences may be definitive, i.e. for revenue or charges that will never be taken into account in the computation of taxable profit (e.g. tax penalties or fines that are not deductible for tax purposes). Consequently, there is no deferred tax recognition.

On the balance sheet, the historical cost of an asset or liability may not be the same as its tax base, which creates a temporary difference. Depending on the situation, temporary differences may give rise to a future tax charge and thus deferred tax liabilities, while others may lead to future tax deductions and thus deferred tax assets. For instance, deferred tax liabilities may arise from:

• assets with a tax base that is lower than their book value when sold or used. The most common example of this derives from the revaluation of assets upon the first-time consolidation of a subsidiary. Their value on the consolidated balance sheet is generally higher than their tax base used to calculate tax-deductible depreciation and amortisation or capital gains and losses;
• capitalised costs that are deductible immediately for tax purposes, but that are accounted for on the income statement over several years or deferred;
• revenues, the taxation of which is deferred, such as accrued financial income that becomes taxable only once it has been actually received.

Deferred tax assets may arise in various situations including costs that are expensed in the accounts but are deductible for tax purposes in later years only, such as:

• provisions that are deductible only when the stated risk or liability materialises (for retirement indemnities in certain countries);
• certain tax losses that may be offset against tax expense in the future (i.e. tax-loss carryforwards, long-term capital losses).

Finally, if the company were to take certain decisions, it would have to pay additional tax. These taxes represent contingent tax liabilities, e.g. stemming from the distribution of reserves on which tax has not been paid at the standard rate.

2/ HOW ARE THEY ACCOUNTED FOR?

It is mandatory for companies to recognise all their deferred tax liabilities in consolidated accounts. Deferred tax assets arising from tax losses should be recognised when it is probable that the deferred tax asset can be used to reduce tax to be paid.

Deferred tax liabilities are not recognised on goodwill where goodwill depreciation is not deductible for tax purposes, as is the case in the UK, Italy or France. Likewise, they are not recorded in respect of tax payable by the consolidating company on distributions (e.g. dividend withholding tax) since they are taken directly to shareholders’ equity.

In some more unusual circumstances, the temporary\ePubPageBreak?> difference relates to a transaction that directly affects shareholders’ equity (e.g. a change in accounting method), in which case the temporary difference will also be set off against the company’s shareholders’ equity.

IFRS does not permit the discounting of deferred tax assets and liabilities to net present value.

Deferred tax is not the same as contingent taxation, which reflects the tax payable by the company if it takes certain decisions. As examples one may think about tax charges payable if certain reserves are distributed (i.e. dividend withholding tax), or if assets are sold and a capital gain is registered, etc. The principle governing contingent taxation is straightforward: it is not recorded on the balance sheet and no charge appears on the income statement.

3/ HOW SHOULD FINANCIAL ANALYSTS TREAT THEM?

1/ WHAT ARE DILUTION PROFIT AND LOSSES?

Where a parent company does not subscribe either at all or only partially to a capital increase by one of its subsidiaries that takes place at a value above the subsidiary’s book value, the parent company records a dilution profit.

Likewise, if the valuation of the subsidiary for the purpose of the capital increase is less than its book value, the parent company records a dilution loss.

2/ HOW ARE THEY ACCOUNTED FOR?

For instance, let us consider the case of a parent company that has paid 200 for a 50% shareholding in a subsidiary with shareholders’ equity of 100. A capital increase of 80 then takes place, valuing the subsidiary at a total of 400. Since the parent company does not take up its allocation, its shareholding is diluted from 50% to 41.67%.

The parent company’s share of the subsidiary’s equity increases from 50% × 100 = 50 to 41.67% × (100 + 80) = 75, which generates a non-recurrent gain of 75 − 50 = 25. This profit of 25 corresponds exactly to the profit that the parent company would have made by selling an interest of 50% − 41.67% = 8.33% based on a valuation of 400 and a cost price of 100 for 100%, since 25 = 8.33% × (400 − 100).

3/ HOW SHOULD FINANCIAL ANALYSTS TREAT THEM?

Dilution gains and losses generate an accounting profit, whereas the parent company has not received any cash payments. They are, by their very nature, non-recurring. Otherwise, the group would soon not have any subsidiaries left. Naturally, they do not form part of a company’s normal earnings power and so they should be totally disregarded.

1/ WHAT ARE FINANCIAL HEDGING INSTRUMENTS?

Their purpose is to hedge against a financial risk linked to a variation in exchange rates, interest rates, raw materials prices, etc. (see Chapter 51). This may arise out of a commercial operation (receivable in foreign currency, for example, or a financial operation – such as a debt at a variable rate). They rely on derivatives such as options, futures, swaps, etc. (see Chapter 51).

2/ HOW ARE THEY ACCOUNTED FOR?

Accounting for financial hedging instruments made up of derivatives (options, futures, swaps, etc.) is very complicated.

Oversimplifying it, the basic principle is that financial hedging instruments must be booked on the balance sheet at their fair value (which is generally their market value) and changes in value must be booked as income or expense in the P&L.

Nevertheless, if financial products are acquired to hedge against a specific risk, then a system known as hedge accounting can be put in place in a proportion for which the company is able to prove (and document) that the hedge is adjusted (amount, duration) to the underlying amount. The remainder will not qualify for hedge accounting and variations in value will appear on the income statement.

IFRS distinguishes between two types of hedge:

• fair value hedge, and
• cash flow hedge.

The difference between the two is not always that clear. For example, hedging against a foreign exchange risk of a receivable in dollars could be considered to be a fair value hedge since it is used to secure the value of this receivable or as a cash flow hedge guaranteeing the counter value of the effective payment by the client.

3/ HOW SHOULD FINANCIAL ANALYSTS TREAT THEM?

Before all else, financial managers must try to check that the financial instruments are not linked to speculative transactions (and this independently of the accounting option that was possible). They should also try to divide hedging operations into commercial operations and financial operations.

Accordingly, it would be logical to integrate into EBIT the changes in the value of financial instruments if these were contracted to hedge operating receivables or debts. The balance of assets/liabilities of financial instruments must then be included in capital employed (generally under working capital).

If the financial instruments are hedging placements or financial debts, then they should be attached to net debt (on the balance sheet) and the change in their value to the income statement.

1/ WHAT ARE IMPAIRMENT LOSSES?

Impairment losses are set aside to cover capital losses, or those that may be reasonably anticipated, on assets. They can be incurred on goodwill, other intangible assets⁸ and tangible assets.

2/ HOW ARE THEY ACCOUNTED FOR?

Impairment losses are computed based on the value of cash generating units (CGUs).⁹ The firm needs to define a maximum number of largely independent CGUs and allocate assets for each one. Each year, the recoverable value of the CGU is computed if there is an indication that there might be a decrease in value or if it includes goodwill. If the recoverable value of the CGU is lower than the carrying amount, then an impairment loss needs to be recognised. Impairment is first allocated to goodwill (if any) and then among the other assets.

The recoverable value is defined as the highest of:

• the value in use, i.e. the present value of the cash flows expected to be realised from the asset;
• the net selling price, i.e. the amount obtainable from the sale of an asset in an arm’s-length transaction¹⁰ less the costs of disposal.

If the value of the CGU increases again, then the impairment can be reversed on all assets but goodwill.

3/ HOW SHOULD FINANCIAL ANALYSTS TREAT THEM?

Impairment losses are netted off directly against assets, and provided that these losses are justified, there is no need for any restatements. Conversely, we regard impairment losses on tangible assets as non-recurring items. As discussed on page 81, we consider impairment losses on intangible fixed assets (including goodwill) as non-operating items to be excluded from EBITDA and EBIT.¹¹

1/ START-UP COSTS

2/ RESEARCH AND DEVELOPMENT COSTS

3/ BRANDS AND MARKET SHARE

4/ CONCLUSION

To sum up, our approach to intangible fixed items is as follows: the higher the book value of intangibles, the lower their market value is likely to be; and the lower their book value, the more valuable they are likely to be. This situation is attributable to the accounting and financial policy of a profitable company that seeks to minimise its tax expense as much as possible by expensing every possible cost. Conversely, an ailing company or one that has made a very large acquisition may seek to maximise its intangible assets in order to keep its net profit and shareholders’ equity in positive territory.

1/ WHAT ARE INVENTORIES?

Inventories include items used as part of the company’s operating cycle. More specifically, they are:

• used up in the production process (inventories of raw materials);
• sold as they are (inventories of finished goods or goods for resale) or sold at the end of a transformation process that is either under way or will take place in the future (work in progress).

2/ HOW ARE THEY ACCOUNTED FOR?

3/ HOW SHOULD FINANCIAL ANALYSTS TREAT THEM?

Firstly, let us reiterate the importance of inventories from a financial standpoint. Inventories are assets booked by recognising deferred costs, hence excluded from the income statement. Assuming quantities remain unchanged, the higher the carrying amount of inventories, the lower future profits will be. Put more precisely, assuming inventory volumes remain constant in real terms, valuation methods do not affect net profit for a given period. But, depending on the method used, inventory receives a higher or lower valuation, making shareholders’ equity simply higher or lower accordingly.

Hence the reluctance of certain companies to scale down their production even when demand contracts. Finally, we note that, tax-related effects apart, inventory valuation methods have no impact on a company’s cash position.

From a financial standpoint, it is true to say that the higher the level of inventories, the greater the vulnerability and uncertainty affecting net income for the given period. We recommend adopting a cash-oriented approach if, in addition, there is no market serving as a point of reference for valuing inventories, such as in the building and public infrastructure sectors, for instance. In such circumstances, cash generated by operating activities is a much more reliable indicator than net income, which is much too heavily influenced by the application of inventory valuation methods.

Consequently, during inflationary periods, inventories carry unrealised capital gains that are larger when inventories are moving more slowly. In the accounts, these gains will appear only as these inventories are being sold, even though these gains are there already. When prices are falling, inventories carry real losses that will appear only gradually in the accounts, unless the company writes down inventories, as was done by ArcelorMittal in 2015, 2019 and 2020, for example.

The only financial approach that makes sense would be to work on a replacement cost basis and thus to recognise gains and losses incurred on inventories each year. In some sectors of activity where inventories move very slowly, this approach seems particularly important. In the early 2010s Italian banks carried loans on their books for amounts that were well above their value. We firmly believe that had loans been written down to their market value, the ensuing crisis in the sector would have been less severe. The Italian banks would have recognised losses in one year and then posted decent profits the next, instead of resorting to all kinds of creative solutions to spread losses over several years, earning them the reputation of a perpetually sick man.

1/ WHAT ARE LEASES?

One must distinguish between operating leases allowing a company to use some of its operating fixed assets (i.e. buildings, plant and other fixed assets) under a rental system, and finance or capital leases allowing the company to purchase the asset at the end of the rental contract for a predetermined and usually very low amount (see page 377).

Finance leases raise two relatively complicated problems for external financial analysts:

• Firstly, leases are used by companies to finance the assets. Even if those items may not appear on the balance sheet, they may represent a considerable part of a company’s assets.
• Secondly, they represent a commitment, the extent of which varies depending on the type of contract:
  
  • equipment leasing may be treated as similar to debt depending on the length of the period during which the agreement may not be terminated;
  • real-estate leasing for buildings may not be treated as actual debt in view of the termination clause contained in the contract. Nonetheless, the utility of the leased property usually leads the company to see out the initially determined length of the lease, and the termination of the lease may then be treated as the early repayment of a borrowing (financed by the sale of the relevant asset).

2/ HOW ARE THEY ACCOUNTED FOR?

A lease is either a finance lease¹³ or an operating lease.

The distinction between operating or financial leases depends on whether or not a purchase option exists, on the length of the contract (greater than or equal to 75% of the life of the asset) and the present value of the rents in relation to the value of the asset (greater than or equal to 90% of the value).

Under IFRS, and since the application of IRFS 16 beginning in 2019, companies no longer distinguish between financial and operating leases. All leases must be recognised as tangible fixed assets on their balance sheets, whenever the length of the contract is longer than one year, is for an asset worth more than €5,000, where the rent is not indexed to a variable indicator of the company such as sales made in the rented property (store, cinema), and in instances where the contract cannot be considered as a service, for example renting 1,000 sq. m of storage space in a hangar, without knowing the precise area in the hangar for the products.

To determine the value to be recorded as a right of use in the balance sheet, one must discount the expected rents over the probable duration of the lease. The discount rate is either the implicit interest rate contained within the (financial) lease or the marginal interest rate at which the company could incur debt to finance the acquisition of the operating asset. The asset is then depreciated on a straight-line basis over the life of the lease. As a counterparty to this new asset, the company records a new financial debt in its liabilities. This debt is reduced each year by an amount corresponding to the rent paid less financial expenses calculated, using the aforementioned interest rate. In the first few years, the rental debt is therefore higher than the value of the rental asset.

In the income statement, the rental expense is removed from other external expenses. Two items appear: financial expenses, generated by the rental debt sitting on the balance sheet at the given interest rate, and a depreciation expense stemming from usage rights and amortised over the length retained for the rental contract. The sum of these two expenses is frequently different to that of the rent paid, exceeding it at the beginning of the contract, and below it at the end of the contract. Initially, it would appear as if the EBITDA is inflated by the amount of the rent, and the operating result by the amount of the financial expenses. We will come back to this shortly.

In the cash flow statement, operating cash flow increases by the amount of the depreciation expense on the leased assets. Here, we allow readers to stop and pinch themselves. No, they are not dreaming: a change in accounting rules, which does not physically change cash flows, nevertheless changes the operating cash flows in the IFRS cash flow statements!

As the IASB is unfortunately unable to make cash magically appear in cash registers, the final reconciliation is done in the financing cash flows with a pseudo cash outflow created due to the reduction in rental debts.

Under US accounting standards, a usage right is recorded in the balance sheet under fixed assets with a corresponding financial lease liability. But under a widespread consensus, American groups identify operating lease rents in the income and cash flow statements as an operating expense and will continue to treat financial leases as financial leases. The decrease in the value of usage rights is carried out on the balance sheet by a parallel reduction in the rental debt.

Therefore, it is no longer possible to compare EBITDA or operating margins between US groups and groups operating under IFRS.

3/ HOW SHOULD FINANCIAL ANALYSTS TREAT THEM?

The reader should beware of a company with large operating leases. They add fixed costs to its income statement and raise its breakeven point.

As finance leases are a real debt, it is logical to capitalise the assets financed in this way in the balance sheet and to add the value of rental commitments made to financial debts. When this is not done in the financial statements, they should be restated in this way using the information provided in the notes.

On the other hand, since operating leases do not correspond, with a few exceptions, to a real debt, the new IFRS (and American) accounting standards do not seem, to us, to provide a fair view of the company’s situation. Ideally, the analyst should revert to a distinction between operating leases (not treated as debt) and financial leases (treated as debt) by reversing the effects of IFRS 16 on the financial statements.¹⁴

1/ WHAT ARE OFF-BALANCE-SHEET COMMITMENTS?

The balance sheet shows all the items resulting from transactions that were realised. But it is hard to show in company accounts transactions that have not yet been realised, commitments that have been made but will not necessarily come into effect (e.g. the remaining payments due under an operating lease, orders placed but not yet recorded or paid for because the goods have not yet been delivered, deposits). However, such items may have a significant impact on a company’s financial position.

2/ HOW ARE THEY ACCOUNTED FOR?

These commitments may have:

• a positive impact – they are not recorded on the balance sheet, but are stated in the notes to the accounts, hence the term “off-balance-sheet”. These are known as contingent assets; or
• a negative impact – they cause a provision to be set aside if they are likely to be realised, or they give rise to a note to the accounts if they remain a possibility only. These are called contingent liabilities.

3/ HOW SHOULD FINANCIAL ANALYSTS TREAT THEM?

Analysts should always be concerned that a company may show some items as off-balance-sheet entries while they should actually appear on the balance sheet. It is therefore very important to analyse off-balance-sheet items because they reflect:

• the degree of accounting ingenuity used by the company; this judgement provides the basis for an opinion about the quality of the published accounts;
• the impending arrival on the balance sheet of the effects of the commitments (e.g. purchases of fixed assets or purchase commitments that will have to be financed with debt, guarantees given to a failed third party that will lead to losses and payments with nothing received in return).

The key points to watch are as follows:

1/ WHAT ARE PROVISIONS FOR EMPLOYEE BENEFITS AND PENSIONS?

Pension and related commitments include severance payments, early retirement and related payments, special retirement plans, top-up plans providing guaranteed resources and healthcare benefits, life insurance and similar entitlements that, in some cases, are granted under employment contracts and collective labour agreements.

A distinction is made between:

• defined benefit plans, where the employer commits to the amount or guarantees the level of benefits defined by the agreement. This is a commitment to a certain level of performance, usually according to the final salary and length of service of the retiring employee. These plans may be managed internally or externally;
• defined contribution plans, where the employer commits to making regular payments to an external organisation. Those payments are paid back to employees when they retire in the form of pensions together with the corresponding investment revenue. The size of the pension payments depends on the investment performance of the external organisation managing the plan. The employer does not guarantee the level of the pension paid (a resource-related obligation). This applies to most national social security systems.

2/ HOW ARE THEY ACCOUNTED FOR?

Defined contribution plans are fairly simple to account for as contributions to these plans are expensed each year as they are incurred.

Defined benefit plans require account holders to disclose detailed and specific information. A defined benefit plan gives rise to a liability corresponding to the actuarial present value of all the pension payments due at the balance sheet closing date (defined benefit obligation or, in US GAAP, projected benefit obligation – PBO).

In countries where independent pension funds handle the company’s commitments to its workforce, the market value of the pension fund’s assets is set off against the actuarial value of the liability, and the difference, if any, normally gives rise to a pension provision. The method used to assess the actuarial value is the projected unit credit method, which models the benefits vested with the entire workforce of the company at the assessment date. It is based on certain demographics, staff turnover and other assumptions (resignations, redundancies, mortality rates, etc.). The discount rate used is the yield on high-grade corporate bonds, in practice those rated AA.

Consequently, the net pension costs in the income statement for a given year are mainly composed of:

• a service cost, which represents the present value of benefits earned by employees during the year;
• an interest cost, which represents the increase in the present value of the pensions payments due at the balance sheet closing date since the previous year due to the passage of time – this is generally recognised in financial expense;
• a theoretical return on assets, computed using the discount rate used to compute the present value of pension payments due¹⁵;
• other non-recurring items.

In a move that has broadened the debate, the IASB have stipulated that all benefits payable to employees (i.e. retirement savings, pensions, insurance and healthcare cover and severance payments) should be accounted for. These standards state in detail how the employee liabilities deriving from these benefits should be calculated. US accounting standards also provide for the inclusion of retirement benefits and commitments other than just pension obligations, i.e. mainly the reimbursement of medical costs by companies during the active service life of employees.

3/ HOW SHOULD FINANCIAL ANALYSTS TREAT THEM?

How, therefore, should we treat provisions for employees’ benefits and pensions that may, in some cases, reach very high levels, as is often the case with German companies?

Our view is that provisions for retirement benefit plans are very similar to a financial liability vis-à-vis employees. This liability is adjusted each year to reflect the actuarial (and automatic) increase in employees’ accrued benefits, just like a zero-coupon bond,¹⁶ where the company recognises an annual financial charge that is not paid until the bond is redeemed.

Consequently, we suggest treating such provisions as financial debt. When the pension provision does not cover 100% of the deficit between pension commitments and assets held to cover these commitments, the pension provision must be topped up until it is equal to this debt, which would then decrease the shareholders’ equity by an equal amount. The result of the past situation is thus taken into account.

In terms of business valuation, future commitments towards its employees will be measured by discounting the annual pension service cost (discounted cash flows) or by applying a multiple (multiples method) to it. This assumes that the differences between interest costs and the theoretical return on pension assets are treated as financial charges. These must be deducted from EBITDA and EBIT and added to financial charges unless the company has already applied this rule in its accounts, as often – but not always – happens.

1/ WHAT ARE PREFERENCE SHARES?

Preference shares combine¹⁷ characteristics of shares and bonds. They may have a fixed dividend (bonds pay interest), a redemption price (bonds) and a redemption date (bonds). If the company were to be liquidated, then the preference shareholders would be paid a given amount before the common shareholders would have a right to receive any of the proceeds. Sometimes the holders of preference shares may participate in earnings beyond the ordinary dividend rate, or have a cumulative feature allowing their dividends in arrears, if any, to be paid in full before shareholders can get a dividend, and so on.

Most of the time, in exchange for these financial advantages, the preference shares have no voting rights. They are known as actions de préférence in France, Vorzugsaktien in Germany, azioni risparmio in Italy and preferred stock in the US.¹⁸

2/ HOW ARE THEY ACCOUNTED FOR?

Under IFRS, preference shares are accounted for either as equity or financial debt, depending on the results of a “substance over form” analysis. If the preference share:

• provides for mandatory redemption by the issuer at a fixed¹⁹ date in the future; or
• if the holder has a put option allowing him to sell the preference share back to the issuer in the future; or
• if the preference share pays a fixed dividend regardless of the net income of the company;

then it is financial debt.

Under US GAAP, preference shares are treated as equity.

3/ HOW SHOULD FINANCIAL ANALYSTS TREAT THEM?

Let’s call a spade a spade. If the preference share meets all our criteria for consideration as equity:

• returns linked solely to the company’s earnings;
• no repayment commitment;
• claims on the company ranking last in the event of liquidation

then it is equity. If not, it is a financial debt.

1/ RESTRUCTURING PROVISIONS

2/ PROVISIONS FOR DECOMMISSIONING OR RESTORATION OF SITES

1/ WHAT ARE STOCK OPTIONS?

Stock options are options to buy existing shares or to subscribe to new shares at a fixed price. Their maturity is generally between three and ten years after their issuance. They are granted free of charge to company employees, usually senior executives. Their purpose is to motivate executives to manage the company as efficiently as possible, thereby increasing its value and delivering them a financial gain when they exercise their stock options. As we will see in Chapter 26, they represent one of the ways of aligning the interests of managers with those of shareholders.

2/ HOW ARE THEY ACCOUNTED FOR?

Under IFRS, the issuance of fully vested stock options is presumed to relate to past service, requiring the full amount of the grant-date fair value to be expensed immediately. The issuance of stock options to employees with, say, a four-year vesting period²¹ is considered to relate to services over the vesting period. Therefore, the fair value of the share-based payment, determined at the grant date, should be expensed on the income statements over the vesting period. The corresponding entry is an increase in equity for the same amount.

Stock options are usually valued using standard option-pricing models,²² with some alterations or discounts to take into account cancellations of stock options during the vesting period (some holders may resign) and conditions which may be attached to their exercise, such as the share price reaching a minimum threshold or outperforming an index.

3/ HOW SHOULD FINANCIAL ANALYSTS TREAT THEM?

Do stock options and free shares make pre-existing shareholders poorer? Yes, because the eventual exercise of stock options and the granting of free shares mean that shares are issued at a lower price than their value at the time. Of course, we could hope that granting them would lead to higher motivation and greater loyalty on the part of the company’s staff, which would at least make up for the dilution. But as much as this may be true, it is very difficult to measure the positive effects, and they may go hand in hand with the pernicious effects they can have on managers who get stock options (e.g. retention of dividends and bias in favour of the riskiest investments and debt, and that doesn’t even include accounting manipulation, which is another story).

Can we say that the company gets poorer by the amount of the stock options granted freely? No, it is the shareholders who potentially get poorer while the recipients of these instruments benefit, not the company, whose assets and debts are still worth what they were.

Conceptually, an accounting charge is an item which increases the amount of a liability due, which reduces the value of an asset or which sooner or later results in cash being paid out. But here, this is not the case. The granting of stock options/free shares does not lead to any flows for the company if they are not exercised, or to new equity if they are. In a nutshell, a charge may lead to bankruptcy since sooner or later it generates a reduction in assets or an increase in debts. Granting stock options, on the other hand, strengthens the solvency of the company (and the granting of free shares certainly does not weaken it). How then can the granting of stock options or free shares be booked as a charge? For us, this just doesn’t make sense.

We recommend, in terms of valuation, deducting the value of stock options from the value of capital employed in order to obtain the value of equity, without modifying the number of shares issued.

Alternatively, we can reason in fully diluted terms, as if all the options granted that are in the money were exercised and the funds collected used to buy back existing shares at their current value (treasury method, described in Section 22.5), or to pay back a part of the debt or increase available cash (funds placement method, described in Section 22.5). The number of shares will obviously be adjusted as a consequence. Options that are out of the money must receive the same treatment after having multiplied their quantity by their delta, which measures the probability that they will end their lives in the money.

1/ WHAT ARE TANGIBLE ASSETS?

Tangible assets (or property, plant and equipment)²³ comprise land, buildings, technical assets, industrial equipment and tools, other tangible assets and tangible assets in process.

Together with intangible assets, tangible assets form the backbone of a company, namely its industrial and commercial base.

2/ HOW ARE THEY ACCOUNTED FOR?

Tangible assets are booked at acquisition cost and depreciated over time (except for land). IFRS allows them to be revalued at fair value. The fair value option then has to be taken for a whole category of assets (e.g. real estate). This option is not widely used by companies (in particular because the annual measurement of fair values and booking of changes in fair value is complex),²⁴ except:

• on first implementation of IFRS;
• following an acquisition, where it is required for the tangible assets of the purchased company.²⁵

Some tangible assets may be very substantial; they may have increased in value (e.g. a head office, a store, a plant located in an urban centre) and thus become much more valuable than their historical costs suggest. Conversely, some tangible assets have virtually no value outside the company’s operations. Though it may be an exaggeration, we can say that they have no more value than certain start-up costs.

Note that certain companies also include interim financial expense into internally or externally produced fixed assets (provided that this cost is clearly identified). IFRS provides for the possibility of including borrowing costs related to the acquisition cost or the production of fixed assets when it is likely that they will give rise to future economic benefits for the company and that their cost may be assessed reliably. Under US GAAP, these financial costs must be included in the cost of fixed assets.

3/ HOW SHOULD FINANCIAL ANALYSTS TREAT THEM?

The accounting policies applied with respect to fixed assets may have a significant impact on various parameters, including the company’s or group’s net income and apparent solvency level.

For instance, a decision to capitalise a charge when it is allowed and record it as an asset increases net income in the corresponding year, but depresses earnings performance in subsequent periods because it leads to higher depreciation charges.

Accordingly, financial analysts need to take a much closer look at changes in fixed assets rather than fixed assets at a given point in time. The advantage of adjustments is that they are shown at their current value.

1/ WHAT ARE TREASURY SHARES?

Treasury shares are shares that a company or its subsidiaries owns in the company itself. We will examine the potential reasons for such a situation in Chapter 37.

2/ HOW ARE THEY ACCOUNTED FOR?

Under IFRS, treasury shares are systematically deducted from shareholders’ equity. If they are sold by the company in the future, the disposal price will directly increase equity, and no capital gain or loss will be recognised in the income statement.

3/ HOW SHOULD FINANCIAL ANALYSTS TREAT THEM?

Whatever their original purpose, we recommend deducting treasury shares from assets and from shareholders’ equity if this has not yet been done by the accountants. From a financial standpoint, we believe that share repurchases are equivalent to a capital reduction, regardless of the legal treatment. Likewise, if the company sells back the shares, we recommend that these sales be analysed as a capital increase.

Treasury shares must thus be subtracted from the number of shares outstanding when calculating earnings per share or computing market capitalisation.

1/ WHAT IS FINANCIAL ANALYSIS FOR?

Financial analysis is a tool used by existing and potential shareholders of a company, as well as lenders or rating agencies. For shareholders, financial analysis assesses whether the company is able to create value. It usually involves an analysis of the value of the share and ends with the formulation of a buy or a sell recommendation on the share. For lenders, financial analysis assesses the solvency and liquidity of a company, i.e. normally leads to an understanding of its ability to honour its commitments and repay its debts on time.

We should emphasise, however, that there are not two different sets of processes depending on whether an assessment is being carried out for shareholders or lenders. Even though the purposes are different, the techniques used are the same for the very simple reason that a value-creating company will be solvent and a value-destroying company will, sooner or later, face solvency problems. Both lenders and shareholders look very carefully at a company’s cash flow statement because it shows the company’s ability to repay debts to lenders and to generate free cash flows, the key value driver for shareholders.

2/ FINANCIAL ANALYSIS IS MORE PRACTICE THAN THEORY, MORE ART THAN SCIENCE

The purpose of financial analysis, which primarily involves dealing with economic and accounting data, is to provide insight into the reality of a company’s situation on the basis of figures. Naturally, knowledge of an economic sector and a company and, more simply, common sense may easily replace some financial analysis techniques. Very precise conclusions may be made without sophisticated analytical techniques.

Financial analysis should be regarded as a rigorous approach to the issues faced by a business that helps rationalise the study of economic and accounting data.

Financial analysts are heavily dependent on accounting figures which do not systematically give an appropriate view of the economic and financial reality of a company. Consequently, from time to time, they have to adjust some elements of the published accounts to make them more relevant and easier to interpret.

3/ IT REPRESENTS A RESOLUTELY GLOBAL VISION OF THE COMPANY

It is worth noting that although financial analysis carried out internally within a company and externally by an outside observer is based on different information, the logic behind it is the same in both cases. Financial analysis is intended to provide a global assessment of the company’s current and future position. Indeed, an internal or external analysis seeks to study the company primarily from the standpoint of an outsider looking to achieve a comprehensive assessment of abstract data, such as the company’s strategy and its results. Fundamentally, financial analysis is a method that helps to describe the company in broad terms on the basis of a few key points.

An analyst’s effectiveness is not measured by their use of sophisticated techniques but by their ability to uncover evidence of the inaccuracy of the accounting data or of serious problems being concealed. As an example, a company’s earnings power may be maintained artificially through a revaluation or through asset disposals, while the company is experiencing serious cash flow problems. In such circumstances, competent analysts will cast doubt on the company’s earnings power and track down the root cause of the deterioration in profitability.

We frequently see that external analysts are able to piece together the global economic model of a company and place it in the context of its main competitors. By analysing a company’s economic model over the medium term, analysts are able to detect chronic weaknesses and separate them from temporary glitches. For instance, an isolated incident may be attributable to a precise and non-recurring factor, whereas a string of incidents caused by different factors will prompt an external analyst to look for more fundamental problems likely to affect the company as a whole.

Naturally, it is impossible to appreciate the finer points of financial analysis without grasping the fact that a set of accounts represents a compromise between different concerns. Let’s consider, for instance, a company that is highly profitable because it has a very efficient operating structure, but also posts a non-recurrent profit. We see a slight deterioration in its operating ratios. In our view, it is important not to make hasty judgements. The company probably attempted to adjust the size of the exceptional gain by being very strict in the way that it accounts for operating revenues and costs.

1/ ANALYSIS OF THE COMPANY’S MARKET

Understanding the company’s market generally leads analysts to reach conclusions that are important for the analysis of the company as a whole.

2/ PRODUCTION

(b) Production models

In a service-dominated economy, the production models used by an industrial company are rarely analysed, even though we believe this is a very worthwhile exercise.

The first step is to establish whether the company assumes responsibility for or subcontracts the production function, whether production takes place close to points of sale or whether it has been transferred to low-labour-cost countries and whether the labour force is made up of permanent or temporary staff, etc. This step allows the analyst to measure the flexibility of the income statement in the event of a recession or strong growth in the market.

In doing so, the analyst can detect any inconsistency between the product and the industrial organisation adopted to produce it. As indicated in the following chart, there are four different types of industrial organisations:

The project-type organisation falls outside the scope of financial analysis. Although it exists, its economic impact is very modest indeed.

The workshop model may be adopted by craftsmen, in the luxury goods sector or for research purposes, but as soon as a product starts to develop, the workshop model should be discarded as soon as possible.

Mass production is suitable for products with a low unit cost, but gives rise to very high working capital owing to the inventories of semi-finished goods that provide its flexibility. With this type of organisation, barriers to entry are low because as soon as a process designer develops an innovative method, it can be sold to all the market players. This type of production is frequently relocated to emerging markets.

Process-specific production is a type of industrial organisation that took shape in the late 1970s and revolutionised production methods. It has led to a major decline in working capital because inventories of semi-finished goods have almost disappeared. It is a continuous production process from the raw material to the end product, which requires the suppliers, subcontractors and producers to be located close to each other and to work on a just-in-time basis. This type of production is hard to relocate to countries with low labour costs owing to its complexity (fine-tuning), and it does not provide any flexibility given the elimination of the inventories of semi-finished goods. A strike or an accident affecting a supplier or subcontractor may bring the entire group to a standstill.

But readers should not allow themselves to get carried away with the details of these industrial processes. Instead, they should examine the pros and cons of each process and consider how well the company’s business strategy fits with its selected production model. Workshops will never be able to deliver the same volumes as mass production!

This being said, new production methods are developing (3D printing) that combine the flexibility of the workshop with the cost advantage of mass production. These methods have already gained mass adoption in certain industries (dental implants, oil and gas industry, etc.).

(c) Capital expenditure

A company should not invest too early in the production process. When a new product is launched on the market, there is an initial phase during which the product must show that it is well suited to consumers’ needs. Then the product will evolve, more minor new features will be built in and its sales will increase.

From then on, the priority is to lower costs; all attention and attempts at innovation will then gradually shift from the product to the production model.

Investing too early in the production process is a mistake for two reasons. Firstly, money should not be invested in a production process that is not yet stable and might even have to be abandoned. Secondly, it is preferable to use the same funds to anchor the product more firmly in its market through technical innovation and marketing campaigns. Consequently, it may be wiser to outsource the production process and not incur production-related risks on top of the product risk. Conversely, once the production process has stabilised, it is in the company’s best interests to invest in securing a tighter grip over the production process and unlocking productivity gains that will lead to lower costs.

More and more, companies are looking to outsource their manufacturing or service operations, thereby reducing their core expertise to project design and management. Roughly speaking, companies in the past were geared mainly to production and had a vertical organisation structure because value was concentrated in the production function. Nowadays, in a large number of sectors (telecoms equipment, IT, pharmacy, cosmetics, etc.), value lies primarily in the research, innovation and marketing functions.

Companies therefore have to be able to organise and coordinate production carried out externally. This outsourcing trend has given rise to companies such as Foxconn, Fareva and Flex, whose sole expertise is industrial manufacturing and who are able to secure low costs and prices by leveraging economies of scale because they produce items on behalf of several competing groups.

3/ DISTRIBUTION SYSTEMS

A distribution system usually plays three roles:

• logistics: displaying, delivering and storing products;
• advice and services: providing details about and promoting the product, providing after-sales service and circulating information between the producer and consumers, and vice versa;
• financing: making firm purchases of the product, i.e. assuming the risk of poor sales.

These three roles are vital, and where the distribution system does not fulfil them or does so only partially, the producer will find itself in a very difficult position and will struggle to expand.

Let’s consider the example of the retail furniture sector. It does not perform the financing role because it does not carry any inventory aside from a few demonstration items. The logistics side merely entails displaying items, and advice is limited, to say the least. As a result, the role of furniture producers is merely that of piece-workers who are unable to build their own brand (a proof of their weakness), the only well-known brands being private-label brands such as IKEA, Made.com, etc.

It is easy to say that producers and distributors have diverging interests, but this is not true. Their overriding goal is the same, i.e. that consumers buy the product. Inevitably, producers and distributors squabble over their respective share of the selling price, but that is a secondary issue. A producer will never be efficient if the distribution network is inefficient.

So what type of distribution system should a company choose? Naturally, this is a key decision for companies. The closer they can get to their end customers, possibly even handling the distribution role themselves, the faster and more accurately they will find out what their customers want (pricing, product ranges, innovation, etc.). And the earlier they become aware of fluctuations in trading conditions, the sooner they will be able to adjust their output. But such choice requires special human skills, investment in logistics and sales facilities and substantial working capital.

This approach makes more sense where the key factor motivating customer purchases is not pricing but the product’s image, after-sales service and quality, which must be tightly controlled by the company itself rather than an external player. For instance, Apple has progressively created its own retail network and has reduced the number of third-party retailers it supplies.

Being far from end customers carries with it the opposite pros and cons. The requisite investment is minimal, but the company is less aware of its customers’ preferences, and the risks associated with cyclical ups and downs are amplified. If end customers slow down their purchases, it may take some time before the end retailer becomes aware of the trend and reduces its purchases from the wholesaler. The wholesaler will, in turn, suffer from an inertia effect before scaling down its purchases from the producer, who will not therefore have been made aware of the slowdown until several weeks or even months after it started. And when conditions pick up again, it is not unusual for distributors to run out of stock even though the producer still has vast inventories.

Where price competition predominates, it is better for the producer to focus its investment on production facilities to lower its costs, rather than to spread it thinly across a distribution network that requires different expertise from the production side.

The common use of e-commerce represents a revolution in terms of distribution. It has reshuffled the cards in what was previously an oligopolistic sector, but with fierce competition (mass retail outlets); perhaps to the benefit of what is now a de facto monopoly (Amazon). This being said, the Internet allows small producers to reach a very large target audience at a lower cost (Augustinus Bader); and despite not controlling the full scope of distribution, the proximity to the customer is often much closer than in a franchised network with numerous intermediaries. This has occurred elsewhere: after very difficult years, online streaming of music content has provided the music industry with fresh impetus.

The sheer quantity of data available on customer behaviour generated by e-commerce has become a major issue. This has become key for companies in the 21st century.

4/ THE COMPANY AND ITS PEOPLE

All too often, we have heard it said that a company’s human resources are what really count. In certain cases, this is used to justify all kinds of strange decisions. There may be some truth to it in smaller companies, which do not have strategic positions and survive thanks to the personal qualities and charisma of their managers. Such a situation represents a major source of uncertainty for lenders and shareholders. To say that the men and women employed by a company are important may well be true, but management will still have to establish strategic positions and build up economic rents¹ that give some value to the company aside from its founder or manager.

5/ ENVIRONMENTAL, SOCIAL AND GOVERNANCE POLICY (ESG)

Depending on the company, environmental issues are more or less important. Crucial in heavy industry (ArcelorMittal, for example), significantly less so in service industries (such as WPP). But one must be wary of appearances, as some sectors can find themselves at the centre of unintuitive controversies (the energy costs generated by cryptocurrency mining).

The financial analyst must also understand the issues and politics surrounding gender, diversity and good governance (representativeness, board independence, see Chapter 43).

On these topics, the analyst must identify the issues and understand how the company manages them. They can have immediate and also long-term financial impacts on the cost of capital or the company’s ability to attract the talents that will guarantee its future value.

1/ TREND ANALYSIS OR THE STUDY OF THE SAME COMPANY OVER SEVERAL PERIODS

Financial analysis always takes into account trends over several years because its role is to look at the past in order to assess the present situation and to forecast the future. It may also be applied to projected financial statements prepared by the company. The only way of teasing out trends is to look at performance over several years (usually at least three where the information is available).

Analysts need to bring to light any possible deterioration so that they can seize on any warning signals pointing to major problems facing the company. This approach has two important drawbacks:

• trend analysis only makes sense when the data are roughly comparable from one year to the next. This is not the case if the company’s business activities, business model (e.g. massive use of outsourcing) or scope of consolidation change partially or entirely, not to mention any changes in the accounting rules;
• accounting information is always published with a delay. Broadly speaking, the accounts for a financial year are published between one and four months after the year end, and they may no longer bear any relation to the company’s present situation. In this respect, external analysts stand at a disadvantage to their internal counterparts who are able to obtain data much more rapidly if the company has an efficient information system.

2/ COMPARATIVE ANALYSIS OR COMPARING SIMILAR COMPANIES

Comparative analysis consists of evaluating a company’s key profit indicators and ratios so that they can be compared with the typical (median or average) indicators and ratios of companies operating in the same sector of activity. The basic idea is that one should not get up to any more nonsense than one’s neighbours, particularly when it comes to a company’s balance sheet. Why is that? Simply because during a recession most of the lame ducks will be eliminated and only healthy companies will be left standing. A company is not viable or unviable in absolute terms. It is merely more or less viable than others.

The comparative method is often used by financial analysts to compare the financial performance of companies operating in the same sector, by certain companies to set customer payment periods, by banks to assess the abnormal nature of certain payment periods and of certain inventory turnover rates, and by those examining a company’s financial structure. It may be used systematically by drawing on the research published by organisations (such as central banks, Datastream, Standard & Poor’s or Moody’s, etc.) that compile the financial information supplied by a large number of companies. They publish the main financial characteristics, in a standardised format, of companies operating in different sectors of activity, as well as the norm (median or average) for each indicator or ratio in each sector. This is the realm of benchmarking.

This approach has two drawbacks:

• The concept of sector is a vague one and depends on the level of granularity applied. This approach analyses a company based on rival firms, so to be of any value, the information compiled from the various companies in the sector must be consistent, and the sample must be sufficiently representative.
• There may be cases of mass delusion, leading to all the stocks in a particular sector being temporarily overvalued. Financial investors should then withdraw from the sector.

3/ NORMATIVE ANALYSIS AND FINANCIAL RULES OF THUMB

Normative analysis represents an extension of comparative analysis. It is based on a comparison of certain company ratios or indicators with rules or standards derived from a vast sample of companies.

For instance, there are norms specific to certain industries:

• in the hotel sector, the bed-per-night cost must be at least 1/1,000 of the cost of building the room, or the sales generated after three years should be at least one-third of the investment cost;
• the level of work in progress relative to the company’s shareholders’ equity in the construction sector;
• the level of sales generated per square metre in supermarkets, etc.

There are also some financial rules of thumb applicable to all companies regardless of the sector in which they operate and relating to their balance sheet structure:

• fixed assets should be financed by stable sources of funds;
• net debt becomes significant above three times EBITDA.

Readers should be careful not to set too much store by these norms, which are often not very robust from a conceptual standpoint because they are determined from statistical studies. These ratios are hard to interpret, except perhaps where capital structure is concerned. After all, profitable companies can afford to do what they want, and some may indeed appear to be acting rather whimsically, but profitability is what really matters. Likewise, we will illustrate in Section IV of this book that there is no such thing as an ideal capital structure.

1/ THE PRINCIPLES OF CREDIT SCORING

Credit scoring is an analytical technique intended to carry out a pre-emptive check-up of a company.

The basic idea is to prepare ratios from companies’ accounts that are leading indicators (i.e. two or three years ahead) of potential difficulties. Once the ratios have been established, they merely have to be calculated for a given company and cross-checked against the values obtained for companies that are known to have run into problems or have failed. Comparisons are not made ratio by ratio, but globally. The ratios are combined in a function known as the Z-score, which yields a score for each company. The equation for calculating Z-scores is as follows:

where a is a constant, R_i the ratios, _i the relative weighting applied to ratio R_i and n the number of ratios used.

Depending on whether a given company’s Z-score is close to or a long way off normative values based on a set of companies that ran into trouble, the company in question is said to have a certain probability of experiencing trouble or remaining healthy over the following two- or three-year period. Originally developed in the US during the late 1960s by Edward Altman, the family of Z-scores has been highly popular, the latest version of the Z″ equation being:

where X₁ is working capital/total assets; X₂ is retained earnings/total assets; X₃ is operating profit/total assets; X₄ is shareholders’ equity/net debt.

If Z″ is less than 1.1, then the probability of corporate failure is high, and if Z″ is higher than 2.6, then the probability of corporate failure is low, the grey area being values of between 1.1 and 2.6. The Z″-score has not yet been replaced by the Zeta score, which introduces into the equation the criteria of earnings stability, debt servicing and balance sheet liquidity.

Some private organisations or companies publish or sell their scoring analysis and results on companies: Ellisphere, Altares, Pouey International, Dun & Bradstreet, Creditsafe, etc.

Some “Fintech” startups (such as Kabbage, Faircent or OnDeck) have developed credit scoring methods to facilitate the process of granting (or not granting) loans to individuals or very small entities.

2/ BENEFITS AND DRAWBACKS OF SCORING TECHNIQUES

Scoring techniques represent an enhancement of traditional ratio analysis, which is based on the isolated use of certain ratios. With scoring techniques, the problem of the relative importance to be attached to each ratio has been solved, because each is weighted according to its ability to pick out the “bad” companies from the “good” ones.

That said, scoring techniques still have a number of drawbacks.

Some weaknesses derive from the statistical underpinnings of the scoring equation. The sample needs to be sufficiently large, the database accurate and consistent and the period considered sufficiently long to reveal trends in the behaviour of companies and to measure its impact.

The scoring equation has to be based on historical data from the fairly recent past and thus needs to be updated over time. Can the same equation be used several years later when the economic and financial environment in which companies operate may have changed considerably? It is thus vital for scoring equations to be kept up to date.

The design of scoring equations is heavily influenced by their designers’ top priority, i.e. to measure the risk of failure for small and medium-sized enterprises. They are not well suited for any other purpose (e.g. predicting in advance which companies will be highly profitable) or for measuring the risk of failure for large groups. Scoring equations should thus be used only for companies where the business activities and size are on a par with those in the original sample.

Scoring techniques, which are a straightforward and rapid way of synthesising figures, have considerable appeal. Their development may even have perverse self-fulfilling effects. Prior awareness of the risk of failure (which scoring techniques aim to provide) may lead some of the companies’ business partners to adopt behaviour that hastens their demise. Suppliers may refuse to provide credit, banks may call in their loans, customers may be harder to come by because they are worried about not receiving delivery of the goods they buy or not being able to rely on after-sales service.

1/ SALES

Before sales volumes can be analysed, external growth needs to be separated from the company’s organic growth, so that like can be compared with like. This means analysing the company’s performance (in terms of its volumes and prices) on a comparable-structure basis and then assessing additions to and withdrawals from the scope of consolidation. In practice, most groups publish pro forma accounts in the notes to their accounts, showing the income statements for the relevant and previous periods based on the same scope of consolidation and using the same consolidation methods.

If a company is experiencing very brisk growth, then analysts will need to look closely at the growth in operating costs and the cash needs generated by this growth.

A company experiencing a period of stagnation will have to scale down its operating costs and financial requirements. As we shall see later in this chapter, production factors do not have the same flexibility profile when sales are growing as when sales are declining.

Where a company sells a single product, volume growth can easily be calculated as the difference between the overall increase in sales and the selling price of its product. Where it sells a variety of different products or services, analysts face a trickier task. In such circumstances, they have the option of either working along the same lines by studying the company’s main products or calculating an average price increase, based on which the average growth in volumes can be estimated.

An analysis of price increases provides valuable insight into the extent to which overall growth in sales is attributable to inflation. The analysis can be carried out by comparing trends in the company’s prices with those in the general price index for its sector of activity. Account also needs to be taken of currency fluctuations and changes in the product mix, which may sometimes significantly affect sales, especially in consolidated accounts.

In turn, this process helps to shed light on the company’s strategy, i.e.:

• whether its prices have increased through efforts to sell higher-value-added products;
• whether prices have been hiked owing to a lack of control on administrative overheads, which will gradually erode sales performance;
• whether the company has lowered its prices in a bid to pass on efficiency gains to customers and thus to strengthen its market position;
• etc.

The impact of changes in exchange rates on business activity should be compared with the exposure of costs to these same currencies. A company producing and selling in the same country will only be exposed on the margin in contrast to an exporting company which is exposed on sales.

2/ PRODUCTION

Sales represent what the company has been able to sell to its customers. Production represents what the company has produced during the year and is computed as follows:

First and foremost, production provides a way of establishing a relationship between the materials used during a given period and the corresponding sales generated. As a result, it is particularly important where the company carries high levels of inventories or work in progress. Unfortunately, production is not entirely consistent insofar as it lumps together:

• production sold (sales), shown at the selling price;
• changes in inventories of finished goods and work in progress and production for own use, stated at cost price.

Consequently, production is primarily an accounting concept that depends on the methods used to value the company’s inventories of finished goods and work in progress.

A faster rate of growth in production than in sales may be the result of serious problems:

• overproduction, which the company will have to absorb in the following year thanks to market growth or conversely, by curbing its activities, bringing additional costs;
• overstatement of inventories’ value, which will reduce the margins posted by the company in future periods.

Production for own use does not constitute a problem unless its size seems relatively large. From a tax standpoint, it is good practice to maximise the amount of capital expenditure that can be expensed, in which case production for own use is kept to a minimum. An unusually high amount may conceal problems and an effort by management to boost book profit superficially.

3/ GROSS MARGIN

Gross margin is the difference between production and the cost of raw materials used:

It is useful in industrial sectors where it is a crucial indicator and helps to shed light on a company’s strategy.

This is another arena in which price and volume effects are at work, but it is almost impossible to separate them out because of the variety of items involved. At this general level, it is very hard to calculate productivity ratios for raw materials. Consequently, analysts may have to make do with a comparison between the growth rate in cost of sales and that in net sales (for by-function income statements), or the growth rate of raw materials and that in production (for by-nature income statements). A sustained difference between these figures may be attributable to changes in the products manufactured by the company or improvements (deterioration) in the production process.

Conversely, internal analysts may be able to calculate productivity ratios based on actual raw material costs used in the operating cycle, since they have access to the company’s management accounts.

4/ GROSS TRADING PROFIT

Gross trading profit is the difference between the selling price of goods for sale and their purchase cost:

It is useful only in the retail, wholesale and trading sectors, where it is a crucial indicator and helps to shed light on a company’s strategy. It is generally more stable than its components (i.e. sales and the cost of goods for sale sold), with the distributor being able to pass on price increases to the end customer and competition market dynamics imposing a price reduction when the purchase price of goods sold decreases.

5/ VALUE ADDED

This represents the value added by the company to goods and services purchased from third parties through its activities. It is equivalent to the sum of gross trading profit and gross margin used minus other goods and services purchased from third parties.

It may thus be calculated as follows for by-nature income statements:

Other operating costs comprise outsourcing costs, property or equipment rental charges,² the cost of raw materials and supplies that cannot be held in inventory (i.e. water, energy, small items of equipment, maintenance-related items, administrative supplies, etc.), maintenance and repair work, insurance premiums, studies and research costs, fees payable to intermediaries and professional costs, advertising costs, transportation charges, travel costs, the cost of meetings and receptions, postal charges and bank charges (not interest on bank loans, which is booked under interest expense).

For by-function income statements, value added may be calculated as follows:

At company level, value added is of interest only insofar as it provides valuable insight regarding the degree of a company’s integration within its sector.

Besides that, we do not regard the concept of value added as being very useful. In our view, it is not very helpful to make a distinction between what a company adds to a product or service internally and what it buys in from the outside. This is because all the decisions of a company are tailored to the various markets in which it operates, such as the markets for labour, raw materials, capital goods, to cite but a few. Against this backdrop, a company formulates a specific value-creation strategy, i.e. a way of differentiating its offering from that of its rivals in order to generate a revenue stream.

This is what really matters – not the internal/external distinction.

In addition, value added is only useful where a market-based relationship exists between the company and its suppliers in the broad sense of the term, e.g. suppliers of raw materials, and suppliers of labour. In the food sector, food-processing companies usually establish special relationships with the farming industry. As a result, a company with a workforce of 1,000 may actually keep 10,000 farmers in work. This raises the issue of what such a company’s real value added is.

6/ PERSONNEL COST

This is a very important item because it is often high in relative terms. Personnel expense and payroll charges also include employee incentive payments, stock options and profit-sharing.

Although personnel cost is theoretically a variable cost, it actually represents a genuinely fixed-cost item from a short-term perspective.

A financial analysis should focus both on volume and price effects (measured by the average total salary cost ratio) as well as the employee productivity ratio, which is measured by the following ratios: or . Since external analysts are unable to make more accurate calculations, they have to make a rough approximation of the actual situation. In general, productivity gains are limited and are thinly spread across most income statement items, making them hard to isolate.

Analysts should not neglect the inertia of personnel cost, as regards either increases or decreases in the headcount. If 100 additional staff members are hired throughout the year, this means that only 50% of their salary costs will appear in the first year, with the full amount showing up in the following period. The same applies if employees are laid off.

7/ EARNINGS BEFORE INTEREST, TAXES, DEPRECIATION AND AMORTISATION (EBITDA)

As we saw in Chapter 3, EBITDA (earnings before interest, taxes, depreciation and amortisation) is a key concept in the analysis of income statements. The concepts we have just examined, i.e. value added and production, have more to do with macroeconomics, whereas EBITDA firmly belongs to the field of microeconomics.

EBITDA is the difference between all operating revenues and all operating expenses that will eventually result in a cash inflow or outflow. It is computed as follows:

Alternatively, for by-nature income statements, EBITDA can be computed as follows:

Other operating costs comprise redundancy payments, recurring restructuring charges, payments relating to patents, licences, concessions, representation agreements and directors’ fees. Other operating revenues include payments received in respect of patents, licences, concessions, representation agreements, directors’ fees, operating subsidies received.

Impairment losses on current assets include impairment losses related to receivables (doubtful receivables), inventories, work in progress and various other receivables related to the current or previous periods. Additions to provisions primarily include provisions for retirement benefit costs (when not already included in employee salary costs), litigation, major repairs and deferred costs, statutory leave, redundancy or pre-redundancy payments, early retirement, future under-activity and relocation, provided that they relate to the company’s normal business activities. In fact, these provisions represent losses for the company and should be deducted from its EBITDA.

Since it is unaffected by non-cash charges – i.e. depreciation, amortisation, impairment charges and provisions, which may leave analysts rather blindsided – trends in the EBITDA/sales ratio, known as the EBITDA margin, form a central part of a financial analysis. All the points we have dealt with so far in this section should enable a financial analyst to explain why a group’s EBITDA margin expanded or contracted by x points between one period and the next. The EBITDA margin change can be attributable to an overrun on production costs, to personnel cost, to the price effect on sales or to a combination of all these factors.

Our experience tells us that competitive pressures are making it increasingly hard for companies to keep their EBITDA margin moving in the right direction!

The following table shows trends in the EBITDA margins posted by various sectors in Europe over the 2000–2022 period (2021 and 2022 are Exane BNP Paribas estimates).

Source: Exane BNP Paribas

It clearly shows, among other things, the tiny but stable EBITDA margin of food retailers and the very high EBITDA margin for the telecom operators, which need heavy investment, thus requiring high margins in order to get sufficient returns.

8/ OPERATING PROFIT OR EBIT

Now we come to the operating profit (EBIT), an indicator whose stock is still at the top. Analysts usually refer to the operating profit/sales ratio as the operating margin, trends in which must also be explained.

Operating profit is EBITDA minus non-cash operating costs. It may thus be calculated as follows:

Impairment losses on fixed assets relate to operating assets (brands, purchased goodwill, etc.) and are normally included with depreciation and amortisation by accountants. We beg to differ, as impairment losses are normally non-recurring items and as such should be excluded by the analyst from the operating profit and relegated to the bottom of the income statement. If the impairment of fixed assets were recurrent, one would legitimately have to question the relevance of the valuation of such assets.

As we saw in Chapter 3, the by-function format directly reaches operating profit without passing through EBITDA:

The emphasis placed by analysts on operating performance has led many companies to attempt to boost their operating profit artificially by excluding charges that should logically be included. These charges are usually to be found on the separate “Other income and costs” line, below operating profit, and are, of course, normally negative. For instance, we have seen operating foreign exchange losses, recurring provisions environmental liabilities and anticipated losses on contracts excluded from operating profit. In other cases, capital gains on asset disposals have been included in recurring EBIT.

Other companies publish an operating profit figure and a separate EBIT figure, presented as being more significant than operating profit. Naturally, it is always higher, too.

The following table shows trends in the operating margin posted by various sectors over the 2000–2022 period.

The reader may notice, for example, how cyclical the mining sector is in stark contrast to the food sector.

Source: Exane BNP Paribas

1/ NET FINANCIAL EXPENSE/INCOME

It may seem strange to talk about net financial income for an industrial or service company whose activities are not primarily geared towards generating financial income. Since finance is merely supposed to be a form of financing a company’s operating assets, financial items should normally show a negative balance, and this is generally the case. That said, some companies, particularly large groups generating substantial negative working capital (like big retailers, for instance), have financial aspirations and generate net financial income, to which their financial income makes a significant contribution.

Net financial expense thus equals financial expense minus financial income. Where financial income is greater than financial expense, we naturally refer to it as net financial income.

Financial income includes:

• income from securities and from loans recorded as long-term investments (fixed assets). This covers all income received from investments other than participating interests, i.e. dividends and interest on loans;
• other interests and related income, i.e. income from commercial (rare!) and other loans, income from marketable securities, other financial income;
• write-backs of certain provisions and charges transferred, i.e. write-backs of provisions, of impairment losses on financial items and, lastly, write-backs of financial charges transferred;
• foreign exchange gains on debt;
• changes in unrealised capital gains for marketable securities.

Financial expense includes:

• interest and related charges;
• foreign exchange losses on debt;
• net expense on the disposal of marketable securities, i.e. capital losses on the disposal of marketable securities;
• amortisation of bond redemption premiums;
• additions to provisions for financial liabilities and charges and impairment losses on investments.

Net financial expense is not directly related to the operating cycle, but instead reflects the size of the company’s debt burden and the level of interest rates. There is no volume or price effect to be seen at this level. Chapter 12, which is devoted to the issue of how companies are financed, covers the analysis of net financial expense in much greater detail.

Profit before tax is the difference between operating profit and financial expense net of financial income.

2/ NON-RECURRING ITEMS

Depending on accounting principles, firms are allowed to include more or fewer items in the exceptional/extraordinary items line. Under IFRS rules, extraordinary and exceptional items are included in operating profit without identifying them as such. Nevertheless, the real need for such a distinction has led a large number of companies reporting in IFRS to present a “recurring operating profit” (or similar term) before the operating profit line.

Non-recurring items should be defined on a case-by-case basis by the analyst.

Without any doubt, extraordinary items and results from discontinued operations are non-recurrent items.

Exceptional items are much trickier to analyse. In large groups, closure of plants, provisions for restructuring, etc. tend to happen more or less every year in different divisions or countries and should consequently be treated as recurring items. In some sectors, exceptional items are an intrinsic part of the business. A car rental company renews its fleet of cars every nine months and regularly registers capital gains. Exceptional items should then be analysed as recurrent items and as such be included in the operating profit. For smaller companies, exceptional items tend to be one-off items and as such should be seen as non-recurrent items.

It makes no sense to assess the current level of non-recurring items from the perspective of the company’s profitability or to predict their future trends. Analysts should limit themselves to understanding their origin and why, for example, the company needed to write down the goodwill.

3/ INCOME TAX

The corporate income tax line can be difficult to analyse owing to the effects of deferred taxation, the impact of foreign subsidiaries and tax-loss carryforwards. Analysts usually calculate the group’s effective tax rate (i.e. corporate income tax divided by profit before tax), which they monitor over time to assess how well the company has managed its tax affairs. A weak tax rate must be explained. It may be due to the use of tax losses carried forward (due to past difficulties) that will be depleted one day or another. It may also be explained by aggressive tax optimisation schemes which are not risk-free, especially when countries are running high levels of debts and/or deficits and society no longer accepts such behaviour.

In the notes to the accounts, there is a useful table that explains the reconciliation between the theoretical tax rate on companies and the tax rate effectively paid by the company or the group (it is called “tax proof”).

4/ GOODWILL IMPAIRMENT, INCOME FROM ASSOCIATES, MINORITY INTERESTS

Regarding goodwill impairment, the main questions should be: Where does this goodwill come from and why was it depreciated?

Depending on its size, the share of net profits (losses) of associates³ deserves special attention. Where these profits or losses account for a significant part of net income, either they should be separated out into operating, financial and non-recurring items to provide greater insight into the contribution made by the equity-accounted associates, or a separate financial analysis should be carried out of the relevant associate. As a last-resort solution they could be added to EBIT.

Minority interests⁴ are always an interesting subject and beg the following questions: Where do they come from? Which subsidiaries do they relate to? Do the minority investors finance losses or do they grab a large share of the profits? An analysis of minority interests often proves to be a useful way of working out which subsidiary(ies) generate(s) the group’s profits.

1/ THE SCISSORS EFFECT

The scissors effect is, first and foremost, the product of a simple phenomenon.

If revenues are growing by 5% p.a. and certain costs are growing at a faster rate, then earnings naturally decrease. If this trend continues, then earnings will decline further each year and ultimately the company will sink into the red. This is what is known as the scissors effect.

Whether or not a scissors effect is identified matters little. What really counts is establishing the causes of the phenomenon. A scissors effect may occur for all kinds of reasons (regulatory developments, intense competition, mismanagement in a sector, etc.) that reflect the higher or lower quality of the company’s strategic position in its market. If it has a strong position, it will be able to pass on any increase in its costs to its customers by raising its selling prices and thus gradually widening its margins.

Where it reduces profits, the scissors effect may be attributable to:

• a degree of increased competition that may prevent a company from passing on sharp increases in its raw materials costs to its customers via its selling prices. For example, a synthetic textile company would find it difficult to incorporate oil price hikes in its selling prices if at the same time the cost of wool or cotton is falling;
• a statutory freeze on selling prices, making it impossible to pass on the rising cost of production factors (e.g. energy prices in some countries, where governments decide on such freezes);
• psychological reluctance to put up prices. For example, when you sell your product at £19.99, you may find it difficult to exceed the £20.00 threshold;
• poor cost control, e.g. where a company does not have a tight grip on its cost base and may not be able to pass rising costs on in full to its selling prices. As a result, the company no longer grows, but its cost base continues to expand.

The impact of trends in the cost of production factors is especially important because these factors represent a key component of the cost price of products. In such cases, analysts have to try to estimate the likely impact of a delayed adjustment in prices. This depends primarily on how the company and its rivals behave and on their relative strength within the marketplace.

But the scissors effect may also work to the company’s benefit, as shown by the last two charts in the following figure.

2/ PITFALLS

A company’s accounts are littered with potential pitfalls, which must be sidestepped to avoid errors of interpretation during an analysis. The main types of potential traps are as follows.

(a) The stability principle (which prevents any simplistic reasoning)

This principle holds that a company’s earnings are much more stable than we would expect. Net income is frequently a modest amount that remains when charges are offset against revenues. Net income represents an equilibrium that is not necessarily upset by external factors. Let’s consider, for instance, a supermarket chain where the net income is roughly equal to the net financial income. It would be a mistake to say that if interest rates decline, then the company’s earnings will be wiped out. The key issue here is whether the company will be able to slightly raise its prices to offset the impact of lower interest rates, without eroding its competitiveness. It will probably be able to do so if all its rivals are in the same boat. But the company may be doomed to fail if more efficient distribution channels exist.

The situation is very similar for champagne houses. A poor harvest drives up the cost of grapes and pushes up the selling price of champagne. Here the key issues are when prices should be increased in view of the competition from sparkling wines, the likely emergence of an alternative product at some point in the future and consumers’ ability to make do without champagne if it is too expensive.

It is important not to repeat the common mistake of establishing a direct link between two parameters and explaining one by trends in the other.

That said, there are limits to the stability principle.

1/ DEFINITION

Breakeven is the level of activity at which total revenue covers total costs. With business running at this level, earnings are thus zero.

Put another way:

• if the company does not reach breakeven (i.e. insufficient sales), the company posts losses;
• if sales are exactly equal to the breakeven point, profits are zero;
• if the company exceeds its breakeven point, it generates a profit.

2/ CALCULATING THE BREAKEVEN POINT

Before the breakeven point can be calculated, it is vital for costs to be divided up into fixed and variable costs. This classification depends on the period under consideration. For instance, it is legitimate to say that:

• in the long term, all costs are variable, irrespective of their nature. If a company is unable to adjust its cost base, it is not a viable company;
• in the very short term (less than three months), almost all costs are fixed, with the exception of certain direct costs (i.e. certain raw materials);
• from a medium-term perspective, certain costs can be considered variable, e.g. indirect personnel cost.

Before starting to calculate a company’s breakeven point, it is wise to define which type of breakeven point is needed. This obvious step is all too commonly forgotten.

For instance, we may want to assess:

• the projected change in the company’s earnings in the event of a partial recession with or without a reduction in the company’s output;
• the sensitivity of earnings to particularly strong business levels at the end of the year;
• the breakeven point implied by a strategic plan, particularly that resulting from the launch of a new business venture.

The breakeven point can be presented graphically:

The breakeven point is the level of sales at which fixed costs are equal to the contribution margin, which is defined as the difference between sales and variable costs. At the breakeven point, the following equation therefore holds true:

where Sales₀ is the level of sales at the breakeven point and m is the contribution margin expressed as a percentage of sales.

In 2021, Exane BNP Paribas estimated that the typical European listed group with a revenue of €100 had €28.5 of fixed costs, €61.1 of variable costs and an operating profit of €10.4. Accordingly, a decrease of 1% in turnover results in a decrease of 3.7% in operating profit. The operating leverage measures the sensitivity of operating result to changes in sales. In this example it is 3.7% / 1% = 3.7.

The above figure rather simplifies things. In fact, fixed costs are not fixed regardless of the level of activity, they are fixed by range of activity and rise or decline in stages.

Some use the term break-even point to measure the moment in the year when a company starts to make profits. Thus, a company with a net income representing 1.1% of its sales will be deemed to start working for its shareholders only from 28 December, i.e. 4 days (1.1% × 365) before the end of the year. This is at most a colourful way of speaking, especially to people with no management skills. In fact, the sales made in the last four days of the year in our example do not constitute full profit because the company still incurs expenses. This is therefore a second abuse of language!

3/ THREE DIFFERENT BREAKEVEN POINTS

The breakeven point may be calculated before or after payments to the company’s providers of funds. As a result, three different breakeven points may be calculated:

• operating breakeven, which is a function of the company’s fixed and variable production costs that determine the stability of operating profit¹;
• financial breakeven, which takes into account the interest costs incurred by the company that determine the stability of profit before tax and non-recurring items;
• total breakeven, which takes into account all the returns required by the company’s lenders and shareholders.

Operating breakeven is a dangerous concept because it disregards any return on capital invested in the company, while financial breakeven understates the actual breakeven point because it does not reflect any return on equity, which is the basis of all value creation.

Consequently, we recommend that readers calculate the breakeven point at which the company is able to generate not a zero net income but a positive net income high enough to provide shareholders with the return they require. To this end, we need to adjust the company’s cost base by the profit before tax expected by shareholders. Below this breakeven point, the company might generate an accounting profit but will not (totally) satisfy the profitability requirements of its shareholders.

Interest charges represent a fixed cost at a given level of sales (and thus capital requirement). A company that experiences significant volatility in its operating profit may thus compensate partially for this instability through modest financial expense, i.e. by pursuing a strategy of limited debt. In any event, earnings instability is greater for a highly indebted company owing to its financial expense, which represents a fixed cost.

To illustrate these concepts in concrete terms, we have prepared the following table calculating the various breakeven points for ArcelorMittal:²

		2016	2017	2018	2019	2020
Sales		56,791	68,679	76,033	70,615	53,270
Operating Fixed Costs	FC	12,495	13,979	14,474	14,418	12,606
Financial Fixed Costs	FiC	1,441	427	1,558	1,207	956
Variable Costs	VC	39,930	49,060	54,235	54,799	40,081
Contribution margin as % of sales		29.7%	28.6%	28.7%	22.4%	24.8%
Operating breakeven		42,085	48,935	50,486	64,373	50,915
Position of the company relative to operating breakeven as a %		35%	40%	51%	10%	5%
Financial breakeven		46,939	50,430	55,921	69,762	54,777
Position of the company relative to financial breakeven		21%	36%	36%	1%	–3%
Total breakeven3		66,486	77,039	77,525	94,146	76,880
Position of the company relative to total breakeven		–15%	–11%	–2%	–25%	–31%

Based on these considerations, we see that the operating leverage depends on four key parameters:

• the three factors determining the stability of operating profit, i.e. the stability of sales, the structure of production costs and the company’s position relative to its breakeven point;
• the level of interest expense, which is itself a function of the debt policy pursued by the company.

From our experience we have seen that, in practice, a company is in an unstable position when its sales are less than 10% above its financial breakeven point. Sales 20% above the financial breakeven point reflect a relatively stable situation and sales more than 20% above the financial breakeven point for a given business structure indicate an exceptional and comfortable situation.

The 2008–2009 and the Covid-19 economic crisis have demonstrated that being 20% above the breakeven point is not enough in cyclical sectors where activity can suddenly collapse by 20%, 30% or 40% as in the cement, steel or car industries.

1/ ANALYSIS OF PAST SITUATIONS

Breakeven analysis (also known as cost–volume–profit analysis) may be used for three different purposes:

• to analyse earnings stability taking into account the characteristics of the market and the structure of production costs;
• to assess a company’s real earnings power;
• to analyse the difference between forecasts and actual performance.

2/ STRATEGIC ANALYSIS

1/ STEADY BUSINESS, PERMANENT WORKING CAPITAL

Calculated from the balance sheet, a company’s working capital is the balance of the accounts directly related to the operating cycle. These amounts are very liquid; that is, they will either be collected or paid within a very short period of time.

No matter when the books are closed, the balance sheet always shows working capital, although the amount changes depending on the statement date. The only exceptions are the rare companies whose operating cycle actually generates cash rather than absorbs it.

Working capital is liquid in the sense that every element of it disappears in the ordinary course of business. Raw materials and inventories are consumed in the manufacturing process. Work in progress is gradually transformed into finished products. Finished products are (usually) sold. Receivables are (ordinarily) collected and become cash, bank balances, etc. Similarly, debts to suppliers become outflows of cash when they are paid.

As a result, if the production cycle is less than a year (which is usually the case), all of the components of working capital at the statement date will disappear in the course of the following year. But at the next statement date, other operating assets will have taken their place. This is why we view working capital as a permanent requirement.

Even if each component of working capital has a relatively short lifetime, the operating cycles are such that the contents of each are replaced by new contents. As a result, if the level of business activity is held constant, the various working capital accounts remain at a constant level.

All in all, at any given point in time, a company’s working capital is indeed liquid. It represents the difference between certain current assets and certain current liabilities. But thinking in terms of “permanent working capital” introduces a radically different concept. It suggests that if business is stable, current (liquid) operating assets and current operating liabilities will be renewed and new funds will be tied up, constituting a permanent capital requirement as surely as fixed assets are a permanent capital requirement.

2/ SEASONAL BUSINESS ACTIVITY, PARTLY SEASONAL REQUIREMENT

When a business is seasonal, purchases, production and sales do not take place evenly throughout the year. As a result, working capital also varies during the course of the year, expanding then contracting.

The working capital of a seasonal business never falls to zero. Whether the company sells canned vegetables or raincoats, a minimum level of inventories is always needed to carry the company over to the next production cycle.

In our experience, companies in seasonal businesses often pay too much attention to the seasonal aspect of their working capital and ignore the fact that a significant part of it is permanent. As some costs are fixed, so are some parts of the working capital.

We have observed that in some very seasonal businesses, such as toys, the peak working capital is only twice the minimum. This means that half of the working capital is permanent, the other half is seasonal.

3/ CONCLUSION: PERMANENT WORKING CAPITAL AND THE COMPANY’S ONGOING NEEDS

Approximately 30% of all companies close their books at a date other than 31 December. They choose these dates because that is when the working capital shown on their balance sheets is lowest. This is pure window dressing. Bordeaux vineyards close on 30 September, Caribbean car rental companies on 30 April.

A company in trouble uses trade credit to the maximum possible extent. In this case, you must restate working capital by eliminating trade credit that is in excess of normal levels. Similarly, if inventory is unusually high at the end of the year because the company speculated that raw material prices would rise, then the excess over normal levels should be eliminated in the calculation of permanent working capital. Lastly, to avoid giving the impression that the company is too cash-rich, some companies make an extra effort to pay their suppliers before the end of the year. This is more akin to investing cash balances than to managing working capital.

Although the working capital on the balance sheet at year end can usually not be used as an indicator of the company’s permanent requirement, its year-to-year change can still be informative. Calculated at the same date every year, there should be no seasonal impact. Analysing how the requirement has changed from year end to year end can shed light on whether the company’s operations are improving or deteriorating.

You are therefore faced with a choice:

• if the company publishes quarterly financial statements, you can take the permanent working capital to be the lowest of the quarterly balances and the average working capital to be the average of the figures for each of the four quarters;
• if the company publishes only year-end statements, you must reason in terms of year-to-year trends and comparisons with competitors.¹

1/ THE MENU OF RATIOS

(a) Days’ sales outstanding (DSO)

The days’ sales outstanding (or days/receivables) ratio measures the average payment terms the company grants its customers (or the average actual payment period). It is calculated by dividing the receivables balance by the company’s average daily sales, as follows:

As the receivables on the balance sheet are shown inclusive of VAT, for consistency, sales must be shown on the same basis. But the sales shown on the profit and loss statement are exclusive of VAT. You must therefore increase them by the applicable VAT rate for the products the company sells or by an average rate if it sells products taxed at different rates.

Receivables are calculated as follows:

(b) Days’ payables outstanding (DPO)

The days/payables ratio measures the average payment terms granted to the company by its suppliers (or the average actual payment period). It is calculated by dividing accounts payable by average daily purchases, as follows:

Accounts payable are calculated as follows:

To ensure consistency, purchases are valued inclusive of VAT. They are calculated as follows:

The amounts shown on the profit and loss statement must be increased by the appropriate VAT rate.

When the figure for annual purchases is not available (mainly when the income statement is published in the by-function format), the days’ payables ratio is approximated as:

(c) Days’ inventory outstanding (DIO)

The significance of the inventory turnover ratios depends on the quality of the available accounting information. If it is detailed enough, you can calculate true turnover ratios. If not, you will have to settle for approximations that compare dissimilar data.

You can start by calculating an overall turnover ratio, not meaningful in an absolute sense, but useful in analysing trends:

Depending on the available accounting information, you can also calculate the turnover of each component of inventory, in particular raw materials and goods held for resale, and distil the following turnover ratios:

• Days of raw material, reflecting the number of days of purchases the inventory represents or, viewed the other way round, the number of days necessary for raw materials on the balance sheet to be consumed:
  
  
• Days of goods held for resale, reflecting the period between the time the company purchases goods and the time it resells them:
  
  
• Days of finished goods inventory, reflecting the time it takes the company to sell the products it manufactures, and calculated with respect to cost of goods sold:
  
  
• If cost of goods sold is unavailable, it is calculated with respect to the sales price:
  
  

Days of work in progress, reflecting the time required for work in progress and semi-finished goods to be completed – in other words, the length of the production cycle:

For companies that present their profit and loss statement by nature, this last ratio can be calculated only from internal sources as cost of goods sold does not appear as such on the P&L. The calculation is therefore easier for companies that use the by-function presentation for their profit and loss statement (cost of sales).

2/ THE LIMITS OF RATIO ANALYSIS

Remember that, in calculating the foregoing ratios, you must follow two rules:

• make sure the basis of comparison is the same: sales price or production cost, inclusive or exclusive of VAT;
• compare outstandings in the balance sheet with their corresponding cash flows.

Turnover ratios have their limitations:

• they can be completely misleading if the business of the company is seasonal. In this case, the calculated figures will be irrelevant. To take an extreme example, imagine a company that makes all of its sales in a single month. If it grants payment terms of one month, its number of days’ receivables at the end of that month will be 365;
• they provide no breakdown – unless more detailed information is available – of the turnover of the components of each asset (or liability) item related to the operating cycle. For example, receivables might include receivables from private-sector customers, international customers and government agencies. These three categories can have very different collection periods (government agencies, for instance, are known to pay late).

You must ask yourself what degree of precision you want to achieve in your analysis of the company. If a general idea is enough, you might be satisfied with average ratios, as calculated above, after verifying that:

• the business is not too seasonal;
• if it is seasonal, then the available data refer to the same point in time during the year. If this is the case, we advise you to express the ratios in terms of a percentage (receivables/sales), which does not imply a direct link with actual payment conditions.

If you need a more detailed analysis, you will have to look at the actual business volumes in the period just prior to the statement date. In this case, the daily sales figure will not be the annual sales divided by 365, but the last quarter’s sales divided by 90, the last two months divided by 60, etc.

If you must perform an in-depth audit of outstandings in the balance sheet, averages are not enough. You must compare outstandings with the transactions that gave rise to them.

1/ GROWTH OF THE COMPANY

In principle, the ratio of working capital to annual sales should remain stable.

If the permanent requirement equals 25% of annual sales and sales grow from €100m to €140m, the working capital requirement should grow by €10m (€40m × 25%).

Growth in business volume causes an increase in working capital. This increase appears, either implicitly or explicitly, in the cash flow statement.

We might be tempted to think that working capital does not grow as fast as sales because certain items, such as minimum inventory levels, are not necessarily proportional to the level of business volume. Experience shows, however, that growth very often causes a sharp, sometimes poorly controlled, increase in working capital at least proportional to the growth in the company’s sales volume.

In fact, a growing company is often confronted with working capital that grows faster than sales, for various reasons:

• management sometimes neglects to manage working capital rigorously, concentrating instead on strategy and on increasing sales;
• management often tends to integrate vertically, both upstream and downstream. Consequently, structural changes to working capital are introduced as it starts growing much more rapidly than sales, as we will explain later on.

When a company is growing, the increase in working capital constitutes a real use of funds, just as surely as capital expenditures do. For this reason, increases in working capital must be analysed and projected with equal care.

Efficient companies are characterised by controlled growth in working capital. Indeed, successful expansion often depends on the following two conditions:

• ensuring that the growth in working capital tracks the growth in sales rather than zooming ahead of it;
• creating a corporate culture that strives to contain working capital. If working capital grows unchecked, sooner or later it will lead to serious financial difficulties and compromise the company’s independence.

Today, companies faced with slower growth in business manage working capital strictly through just-in-time inventory management, greater use of outsourcing, digitalisation of customer and supplier relationship management, financial incentives for salespeople linked to customers’ payments, etc. (as we will see in Chapter 49).

2/ RECESSION

By analysing the working capital of a company facing a sudden drop in its sales, we can see that it reacts in stages.

Initially, the company does not adjust its production levels. Instead, it tries other ways to shore up sales. The recession also leads to difficulty in controlling accounts receivable, because customers start having financial difficulties and stretch out their payments over time. The company’s cash situation deteriorates, and it has trouble honouring its commercial obligations, so it secures (or forces, especially as year-end approaches) more favourable payment terms from its suppliers. At the end of this first phase, working capital – the balance between the various items affected by divergent forces – stabilises at a higher level. This situation was experienced in particular by car manufacturers in late 2020.

In the second phase, the company begins to adopt measures to adjust its operating cycle to its new level of sales. It cuts back on production, trims raw material inventories and ratchets customer payment terms down to normal levels. By limiting purchases, accounts payable also decline. These measures, salutary in the short term, have the paradoxical effect of inflating working capital because certain items remain stubbornly high while accounts payable decline.

As a result, the company produces (and sells) below capacity, causing unit costs to rise and the bottom line to deteriorate.

Finally, in the third phase, the company returns to a sound footing:

• sales surpass production;
• the cap on purchases has stabilised raw material inventories. When purchases return to their normal level, the company again benefits from a “normal” level of supplier credit.

Against this background, working capital stabilises at a low level that is once again proportional to sales, but only after a crisis that might last as long as a year.

It is important to recognise that any contraction strategy, regardless of the method chosen, requires a certain period of psychological adjustment. Management must be convinced that the company is moving from a period of expansion to a period of recession. This psychological change may take several weeks, but once it is accomplished, the company can:

• decrease purchases;
• adjust production to actual sales;
• reduce supplier credit which the company had tried to maximise. Of course, this slows down the reduction in working capital.

We have seldom seen a company take less than nine months to significantly reduce its working capital and improve the bottom line (unless it liquidates inventories at fire-sale prices).

3/ VALUE CHAIN INTEGRATION STRATEGIES

Companies that expand vertically by acquiring suppliers or distributors lengthen their production cycle. In so doing, they increase their value added. But this very process also increases their working capital because the increased value added is incorporated in the various line items that make up working capital, notably receivables and finished goods inventories. Conversely, accounts payable reflect purchases made further upstream and therefore contain less value added. So they become proportionately lower.

4/ NEGATIVE WORKING CAPITAL

The operating cycles of companies with negative working capital are such that, thanks to a favourable timing mismatch, they collect funds prior to disbursing some payments. There are two basic scenarios:

• supplier credit is much greater than inventory turnover, while at the same time customers pay quickly, in some cases in cash: food retailing, e-commerce companies, motorways, companies with very short production cycles like newspaper or bread companies, companies whose suppliers are in a position of such weakness – printers or hauliers that face stiff competition, for example – that they are forced to offer inordinately long payment terms to their customers;
• customers pay in advance. This is the case for companies that work on military contracts, travel agencies, collective catering companies, companies that sell subscriptions, etc. Nevertheless, these companies are sometimes required to lock up their excess cash for as long as the customer has not yet “consumed” the corresponding service. In this case, negative working capital may offer a way of earning significant investment income (on resulting treasury placement) rather than presenting a source of funding that can be freely used by the firm to finance its operations.

A low or negative working capital is a boon to a company looking to expand without recourse to external capital. Efficient companies, in particular in mass-market retailing, all benefit from low or negative working capital. Put another way, certain companies are adept at using intercompany credit to their best advantage.

The presence of negative working capital can, however, lead to management errors. We once saw an industrial group that was loathe to sell a loss-making division because it had a negative working capital. Selling the division would have shored up the group’s profitability but would also have created a serious cash management problem, because the negative working capital of the unprofitable division was financing the working capital of the profitable divisions. Short-sightedness blinded the company to everything but the cash management problem it would have had immediately after the disposal. Recurring losses were disregarded.

We have seen companies with negative working capital, losing money at the operating level, that were able to survive because of a strong growth in sales. Consequently, inflows generated by increasingly negative working capital with growth in revenues allowed them to pay for the operating deficit. The wake-up call is pretty tough when growth slows down and payment difficulties appear. Unsurprisingly, no banker is keen to lend money in this scenario.

5/ WORKING CAPITAL AS AN EXPRESSION OF BALANCE OF POWER

Economists have tried to understand the theoretical justification for intercompany credit, as represented by working capital. To begin with, they have found that there are certain minimum technical turnaround times. For example, a customer must verify that the delivery corresponds to their order and that the invoice is correct. Some time is also necessary to actually effect the payment.

But this explains only a small portion of intercompany credit, which varies greatly from one country to another:

Several factors can explain the disparity:

• Cultural differences: in Germanic countries, the law stipulates that the title does not pass to the buyer until the seller is paid. This makes generous payment terms much less attractive for the buyer, because as long as the supplier is not paid, the goods delivered cannot be processed.
• Historical factors: in France, Italy and Spain, bank credit was restricted for a long time. Companies whose businesses were not subject to credit restrictions (building, exports, energy, etc.) used their bank borrowing capacity to support companies subject to the restrictions by granting them generous payment terms. Tweaking payment terms was also a way of circumventing price controls in the Mediterranean countries.
• Technical factors: in the USA, suppliers often offer two-part trade credit, where a substantial discount is offered for relatively early payment, such as a 2% discount for payment made within 10 days. Most buyers take this discount. This discount explains the low level of accounts payable in US groups’ balance sheets. As a by-product, failure of a buyer to take this discount could serve as a very strong and early signal of financial distress.

Furthermore, Delaunay and Dietsch (1999) have shown that supplier credit acts as a financial shock absorber for companies in difficulty. For commercial reasons, suppliers feel compelled to support companies whose collateral or financial strength is insufficient (or has become insufficient) to borrow from banks. Suppliers know that they will not have complete control over payment terms. They have unwittingly become bankers and, like bankers, they attempt to limit payment terms on the basis of the back-up represented by the customer’s assets and capital.

That said, it is unhealthy for companies to offer overly generous payment terms to their customers. By so doing, they run a credit risk. Even though the corporate credit manager function is more and more common, even in small companies, credit managers are not in the best position to appreciate and manage this risk. Moreover, intercompany credit is one of the causes of the domino effect in corporate bankruptcies.

How else can we explain why 16 of the 41 non-financial groups in the Eurostoxx 50 in 2019 enjoyed negative working capital requirements, including Orange, Airbus, Unilever, AB InBev and Air Liquide!

The development of reverse factoring (see Section 21.3, 2/) is another (more positive) expression of the balance of power: the client, a large group, gives its smaller suppliers the benefit of its access to attractive banking terms. It is also often an opportunity to lengthen payment terms (suppliers are not very sensitive to this because they discount the debt).

1/ ANALYSING THE COMPANY’S CURRENT PRODUCTION CAPACITY

The current state of the company’s fixed assets is measured by the ratio

A very low ratio (less than 30%) indicates that the company’s plant and equipment are probably worn out. In the near term, the company will be able to generate robust margins because depreciation charges will be minimal. But don’t be fooled, this situation cannot last forever. In all likelihood, the company will soon have trouble because its manufacturing costs will be higher than those of its competitors who have modernised their production facilities or innovated. Such a company will soon lose market share and its profitability will decline.

If the ratio is close to 100%, the company’s fixed assets are relatively new, and it will probably be able to reduce its capital expenditure in the next few years.

2/ ANALYSING THE COMPANY’S INVESTMENT POLICY

Through the production process, fixed assets are used up. The annual depreciation charge is supposed to reflect this wearing out. By comparing capital expenditure with depreciation charges, you can determine whether the company is:

• expanding its industrial base by increasing production capacity. In this case, capital expenditure is higher than depreciation as the company invests more than simply to compensate for the annual wearing-out of fixed assets;
• maintaining its industrial base, replacing production capacity as necessary. In this case, capital expenditure approximately equals depreciation as the company invests just to compensate for the annual wearing-out of fixed assets;
• underinvesting or divesting (capital expenditure below depreciation). This situation can only be temporary or the company’s future will be in danger, unless the objective is to liquidate the company.

Comparing capital expenditure with net fixed assets at the beginning of the period gives you an idea of the size of the investment programme with respect to the company’s existing production facilities. A company that invests an amount equal to 50% of its existing net fixed assets is building new facilities worth half what it has at the beginning of the year. This strategy carries certain risks:

• the risk that economic conditions will take a turn for the worse;
• the risk that production costs will be difficult to control (productivity deteriorates);
• technology risks, etc.

3/ ANALYSING THE CASH FLOWS GENERATED BY INVESTMENTS

The theoretical relationship between capital expenditures on the one hand and the cash flow from operating activities on the other is not simple. New fixed assets are combined with those already on the balance sheet, and together they generate the cash flow of the period. Consequently, there is no direct link between operating cash flow and the capital expenditure of the period.

Comparing cash flow from operating activities with capital expenditure makes sense only in the context of overall profitability and the dynamic equilibrium between sources and uses of funds.

The only reason to invest in fixed assets is to generate profits, i.e. positive cash flows. Any other objective turns finance on its head. You must therefore be very careful when comparing the trends in capital expenditure and cash flow from operating activities. This analysis can be done by examining the cash flow statement.

Be on the lookout for companies that, for reasons of hubris, grossly overinvest, despite their cash flow from operating activities not growing at the same rate as their investments. Management has lost sight of the all-important criterion that is profitability.

All the above does not mean that capital expenditure should be financed by internal sources only. Our point is simply that a good investment policy grows cash flow at the same rate as capital expenditure. This leads to a virtuous circle of growth, a necessary condition for the company’s financial equilibrium, as shown in graph A in this figure:

Graphs B, C and D illustrate other corporate situations. In D, investment is far below the company’s cash flow from operations. You must compare investment with depreciation charges so as to answer the following questions:

• Is the company living off the assets it has already acquired (profit generated by existing fixed assets)?
• Is the company’s production equipment ageing?
• Are the company’s current capital expenditures appropriate, given the rate of technological innovation in the sector?

Naturally, the risk in this situation is that the company is resting on its laurels, and that its technology is falling behind that of its competitors. This will eat into the company’s profitability and, as a result, into its cash flow from operating activities at the very moment it will most need cash in order to make the investments necessary to close the gap vis-à-vis its rivals.

Generally speaking, you must understand that there are certain logical inferences that can be made by looking at the company’s investment policy. If its capital expenditure is very high, then the company is embarking on a project to create significant new value rather than simply growing. Accordingly, future cash flow from operating activities will depend on the profitability of these new investments and is thus highly uncertain.

Lastly, ask yourself the following questions about the company’s divestments: do they represent recurrent transactions, such as the gradual replacement of a rental car company’s fleet of vehicles, or are they one-off disposals? In the latter case, is the company’s insufficient cash flow forcing the company to divest? Or is the company selling old, outdated assets in order to turn itself into a dynamic, strategically rejuvenated company? Is this asset-pruning?

4/ ANALYSING INVESTMENT CARRIED OUT THROUGH EXTERNAL GROWTH

Companies can grow their fixed asset base either through outright purchases (internal growth) or through acquisition of other companies owning fixed assets (external growth).

There are three main risks behind an external growth policy:

• That of integrating assets and people, which is always easier on paper than in real life. This is the first reason why so many mergers fail to deliver on promises (see Chapter 45).
• That of regular changes in the group perimeter, which complicates its analysis and can hide real difficulties (as illustrated by Steinhoff’s difficulties).
• That of having overpaid for acquired companies. By carrying out an analysis of prices paid (see Chapter 31), the external analyst can detect overpayments only if they are provided with enough information by the acquirer.

The frequency of acquisition of other companies gives clues about the concentration inside a sector. The higher the latter, the lower the former.

1/ WORKING CAPITAL ANALYSIS

The average VAT rate of ArcelorMittal is not disclosed, so we have taken a rate of 20%.

In days (d) of net sales	2011	2012	2013	2014	2015	2016	2017	2018	2019	2020
	58 d	52 d	54 d	46 d	39 d	50 d	54 d	61 d	50 d	30 d
	35 d	34 d	39 d	33 d	35 d	41 d	39 d	38 d	34 d	39 d
	93 d	88 d	94 d	86 d	81 d	107 d	108 d	113 d	94 d	89 d
	46 d	44 d	51 d	48 d	45 d	70 d	67 d	63 d	57 d	69 d

In the most acute phase of its crisis, ArcelorMittal had been able to reduce its WCR by half, from \$14.9bn in 2011 to $6.8bn in 2015, a drop of more than 50%, freeing up \$8bn of cash, while sales had only dropped by a third. Part of this decline was mechanical as it was due to the drop in its sales, but another part was due to its own efforts as evidenced by a WCR of only 39 days in 2015. It was in the area of inventories that the most significant effort was made.

With the return to better health from 2016 to 2018, WCR ratios deteriorated and returned to their levels of the early 2010s, resulting in a cash outflow of \$6bn. A company can indeed hardly maintain an iron discipline, even in the steel industry, specific to a period of potentially fatal crisis, when it is overcome. \$8bn are regained in 2019–2020 when the economic situation for ArcelorMittal starts to deteriorate again.

2/ CAPITAL EXPENDITURE ANALYSIS

Unsurprisingly, given the steel industry situation, which reduces ArcelorMittal’s self-financing capacity and does not encourage investment, the ratio of net fixed assets to gross fixed assets is declining: from 57% in 2015 to 55% in 2020, without however becoming worrying.

If in 2015, annual investments were 85% of depreciation (at about $2.7bn), since then they have gradually increased to 125%, and are devoted to maintenance and productivity improvements, and then again from 2018 onwards to volume growth. In 2020, they were reduced to 100% of a strongly reduced cash flow.