**Section I. FINANCIAL ANALYSIS

The following six chapters provide a gradual introduction to the foundations of financial analysis. They examine the concepts of cash flow, earnings, capital employed and invested capital, and look at the ways in which these concepts are linked.

They are fundamental for readers who have only a vague knowledge of the business world and basic accounting techniques. In this case, our advice is to read them and reread them before going further.

Let’s work from A to Z (unless it turns out to be Z to A!)

Let’s begin our understanding of the business by analysing the cash flows that pre-exist any accounting or management system.

Section 2.1 CLASSIFYING COMPANY CASH FLOWS

Let’s consider, for example, the monthly account statement that individual customers receive from their bank. It is presented as a series of lines showing the various inflows and outflows of money on precise dates and the type of transaction (debit card payment or cash withdrawal, for instance).

Our first step is to trace the rationale for each of the entries on the statement, which could be everyday purchases, payment of a salary, automatic transfers, internet subscriptions, loan repayments or the receipt of bond interests, to mention a few examples.

The corresponding task for a financial manager is to reclassify company cash flows by category to draw up a cash flow document that can be used to:

  • analyse past trends in cash flow (the document put together is generally known as a cash flow statement1); or
  • project future trends in cash flow, over a shorter or longer period (the document needed is a cash flow budget or plan).

With this goal in mind, we will now demonstrate that cash flows can be classified into one of the following processes:

  • Activities that form part of the industrial and commercial life of a company:
    • operating cycle;
    • investment cycle.
  • Financing activities to fund these cycles:
    • the debt cycle;
    • the equity cycle.

Section 2.2 OPERATING AND INVESTMENT CYCLES

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.

Section 2.3 FINANCIAL RESOURCES

The operating and investment cycles give rise to a timing difference in cash flows. Employees and suppliers have to be paid before customers settle up. Likewise, investments have to be completed before they generate any receipts. Naturally, this cash flow deficit needs to be filled. This is the role of financial resources.

The purpose of financial resources is simple: they must cover the shortfalls resulting from these timing differences by providing the company with sufficient funds to balance its cash flow.

These financial resources are provided by investors: shareholders, debtholders, lenders, etc. These financial resources are not provided with “no strings attached”. In return for providing the funds, investors expect to be subsequently rewarded by receiving dividends or interest payments, registering capital gains, etc. This can happen only if the operating and investment cycles generate positive cash flows.

To the extent that the financial investors have made the investment and operating activities possible, they expect to receive, in various different forms, their fair share of the surplus cash flows generated by these cycles.

At its most basic, the principle would be to finance these treasury shortfalls solely using capital that incurs the risk of the business. Such capital is known as shareholders’ equity. This type of financial resource forms the cornerstone of the entire financial system. Its importance is such that shareholders providing it are granted decision-making powers and control over the business in various different ways. From a cash flow standpoint, the equity cycle comprises inflows from capital increases and outflows in the form of dividend payments to the shareholders.

Like individuals, a business may decide to ask lenders rather than shareholders to help it cover a cash flow shortage. Bankers will lend funds only after they have carefully analysed the company’s financial health. They want to be nearly certain of being repaid and do not want exposure to the company’s business risk. These cash flow shortages may be short term or long term, but lenders do not want to take on business risk. The capital they provide represents the company’s debt capital.

The debt cycle is the following: the business arranges borrowings in return for a commitment to repay the capital and make interest payments regardless of trends in its operating and investment cycles. These undertakings represent firm commitments, ensuring that the lender is certain of recovering its funds provided that the commitments are met. Debt can finance:

  • the investment cycle, with the increase in future net receipts set to cover capital repayments and interest payments on borrowings; and
  • the operating cycle, with credit making it possible to bring forward certain inflows or to defer certain outflows.

From a cash flow standpoint, the life of a business comprises an operating and an investment cycle, leading to a positive or negative free cash flow. If free cash flow is negative, then the financing cycle covers the funding shortfall. But free cash flow cannot be forever negative: sooner or later investors must get a return and/or get repaid, and they can only get a return and/or get repaid by a positive free cash flow.

The risk incurred by the lender is that this commitment will not be met. Theoretically speaking, debt may be regarded as an advance on future cash flows generated by the investments made and guaranteed by the company’s shareholders’ equity.

Although a business needs to raise funds to finance investments, it may also find, at a given point in time, that it has a cash surplus, i.e. the funds available exceed cash requirements.

These investments are generally realised with a view to ensuring the possibility of a very quick exit without any risk of losses.

Although at first sight short-term financial investments (marketable securities) may be regarded as investments since they generate a rate of return, we advise readers to consider them instead as the opposite of debt. As we will see, company treasurers often have to raise additional debt even if at the same time the company holds short-term investments without speculating in any way.

Debt and short-term financial investments or marketable securities should not be considered independently of each other, but as inextricably linked. We suggest that readers reason in terms of debt net of short-term financial investments and financial expense net of financial income.

Putting all the individual pieces together, we arrive at the following simplified cash flow statement, with the balance reflecting the net decrease in the company’s debt during a given period:

SIMPLIFIED CASH FLOW STATEMENT

 n – 2n – 1n
 Operating receipts
− Operating payments
   
= Operating cash flow   
− Capital expenditure
+ Fixed asset disposals
   
= Free cash flow before tax   
− Financial expense net of financial income
− Corporate income tax
+ Proceeds from share issue
− Dividends paid
   
= Net decrease in debt   
 With:
 Repayments of borrowings
− New bank and other borrowings
+ Change in marketable securities
+ Change in cash and cash equivalents
   
= Net decrease in debt   

This short chapter is seminal and the reader who is discovering the notions it contains for the first time should not hesitate to read it twice in order to grasp them fully.

SUMMARY

QUESTIONS

EXERCISES

ANSWERS

BIBLIOGRAPHY

NOTES

  1. 1   Or sometimes as a statement of changes in financial position.
  2. 2   That is, credit granted by the company to its customers, allowing them to pay the bill several days, weeks or, in some countries, even several months after receiving the invoice.
  3. 3   That is, credit granted by suppliers to the company.

Time to put our accounting hat on!

Following our analysis of company cash flows, it is time to consider the issue of how a company creates wealth. In this chapter, we are going to study the income statement to show how the various cycles of a company create wealth.

Section 3.1 ADDITIONS TO WEALTH AND DEDUCTIONS FROM WEALTH

What would your spontaneous answer be to the following questions?

  • Does purchasing an apartment make you richer or poorer?
  • Would your answer change if you were to buy the apartment on credit?

There can be no doubt as to the correct answer. Provided that you pay the market price for the apartment, your wealth is not affected whether or not you buy it on credit. Our experience as teachers has shown us that students often confuse cash and wealth.

Consequently, we advise readers to train their minds by analysing the impact of all transactions in terms of cash flows and wealth impacts.

For instance, when you buy an apartment, you become neither richer nor poorer, but your cash decreases. Arranging a loan makes you no richer or poorer than you were before (you owe the money), but your cash has increased. If a fire destroys your house and it was not insured, you are worse off, but your cash position has not changed, since you have not spent any money.

Raising debt is tantamount to increasing your financial resources and commitments at the same time. As a result, it has no impact on your net worth. Buying an apartment for cash results in a change in the nature of your assets (reduction in cash, increase in real estate assets), without any change in net worth. The possible examples are endless. Spending money does not necessarily make you poorer. Likewise, receiving money does not necessarily make you richer.

The job of listing all the items that positively or negatively affect a company’s wealth is performed by the income statement,1 which shows all the additions to wealth (revenues) and all the deductions from wealth (charges or expenses or costs). The fundamental aim of all businesses is to increase wealth. Additions to wealth cannot be achieved without some deductions from wealth. In sum, earnings represent the difference between additions to and deductions from wealth.

Since the rationale behind the income statement is not the same as for a cash flow statement, some cash flows do not appear on the income statement (those that neither generate nor destroy wealth). Likewise, some revenues and costs are not shown on the cash flow statement (because they have no impact on the company’s cash position).

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

(a) Principles

Investing activities do not appear directly on the income statement. In a wealth-oriented approach, an investment represents a use of funds that retains some value.

That said, the value of investments may change over time:

  • it may decrease if they suffer wear and tear or become obsolete;
  • it may increase if the market value of certain assets rises. Most of the time, by virtue of the principle of prudence, increases in value are recorded only if realised through the disposal of the asset.2

(b) Accounting for a decrease in the value of fixed assets

The decrease in value of a fixed asset due to its use by the company is accounted for by means of depreciation and amortisation.3

Impairment losses or write-downs on fixed assets recognise the loss in value of an asset not related to its day-to-day use, i.e. the unforeseen diminution in the value of:

  • an intangible asset (goodwill, patents, etc.);
  • a tangible asset (property, plant and equipment);
  • an investment in a subsidiary.

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

(a) Debt capital

Repayments of borrowings do not constitute costs but, as their name suggests, merely repayments.

Just as common sense tells us that securing a loan does not increase wealth, neither does repaying a borrowing represent a charge.

We emphasise this point because our experience tells us that many mistakes are made in this area.

Conversely, we should note that the interest payments made on borrowings lead to a decrease in the wealth of the company and thus represent an expense for the company. As a result, they are shown on the income statement.

Similarly, when a company invests cash in financial products (money market funds, interest-bearing accounts), the interest received is recognised as financial income. The difference between financial income and financial expense is called net financial expense/(income).

The difference between operating profit and net financial expense is called profit before tax and non-recurring items.4

(b) Shareholders’ equity

From a cash flow standpoint, shareholders’ equity is formed through issuance of shares minus outflows in the form of dividends or share buy-backs. These cash inflows give rise to ownership rights over the company. The income statement measures the creation of wealth by the company; it therefore naturally ends with the net earnings (also called net profit). Whether the net earnings are paid in dividends or not is a simple choice of cash position made by the shareholder.

If we take a step back, we see that net earnings and financial interest are based on the same principle of distributing the wealth created by the company. Likewise, income tax represents earnings paid to the state in spite of the fact that it does not contribute any funds to the company.

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.

Section 3.2 DIFFERENT INCOME STATEMENT FORMATS

Two main formats of income statement are frequently used, which differ in the way they present revenues and expenses related to the operating and investment cycles. They may be presented either:

  • by function,5 i.e. according to the way revenues and costs are used in the operating and investing cycle. This shows the cost of goods sold, selling and marketing costs, research and development costs and general and administrative costs; or
  • by nature,6 i.e. by type of expenditure or revenue, which shows the change in inventories of finished goods and in work in progress (closing minus opening inventory), purchases of and changes in inventories of goods for resale and raw materials (closing minus opening inventory), other external costs, personnel expenses, taxes and other duties, depreciation and amortisation.
Presentation ChinaFranceGermanyIndiaItalyJapanMoroccoRussiaSwitzerlandUKUS
By nature  0%23%30%100%66%10%100%21%27%10% 0%
By function 92%53%67%  0%27%90%  0%75%66%90%60%
Other  8%23% 3%  0% 7% 0%  0% 4% 7% 0%40%

Source: 2020 annual reports from the top 30 listed non-financial groups in each country

The by-nature presentation predominates to a great extent in Italy, India and Morocco. In the US, the by-function presentation is largely predominant.7

Whereas in the past, France, Germany and Switzerland tended to use systematically the by-nature or by-function format, the current situation is less clear-cut. Moreover, a new presentation is making some headway; it is mainly a by-function format but depreciation and amortisation are not included in the cost of goods sold, in selling and marketing costs or research and development costs, but are isolated on a separate line.

The two different income statement formats can be summarised by the following diagram:

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:

FunctionCorresponding cost
ProductionCost of sales, or cost of goods sold
CommercialSelling and marketing costs
Research and developmentResearch and development costs
AdministrationGeneral and administrative costs

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.

SUMMARY

QUESTIONS

EXERCISES

ANSWERS

BIBLIOGRAPHY

NOTES

  1. 1   Also called a Profit and Loss statement or P&L account.
  2. 2   But IFRS have created some exceptions to this principle that we will see in Chapters 6 and 7.
  3. 3   Amortisation is sometimes used instead of depreciation, particularly in the context of intangible assets.
  4. 4   Or non-recurrent items.
  5. 5   Also called by-destination income statement.
  6. 6   Also called by-category income statement.
  7. 7   The US airline companies are an exception as most of them use the by-nature income statement.

The end-of-period snapshot

So far in our analysis, we have looked at inflows and outflows, or revenues and costs during a given period. We will now temporarily set aside this dynamic approach and place ourselves at the end of the period (rather than considering changes over a given period) and analyse the balances outstanding.

For instance, in addition to changes in net debt over a period, we also need to analyse net debt at a given point in time. Likewise, we will study here the wealth that has been accumulated up to a given point in time, rather than that generated over a period.

The balance represents a snapshot of the cumulative inflows and outflows previously generated by the business.

To summarise, we can make the following connections:

  • an inflow or outflow represents a change in “stock”, i.e. in the balance outstanding;
  • a “stock” is the sum of inflows and outflows since a given date (when the business started up) through to a given point in time. For instance, at any moment, shareholders’ equity is equal to the sum of capital increases (net of capital decreases) by shareholders and annual net income for past years not distributed in the form of dividends plus the original share capital.

Section 4.1 THE BALANCE SHEET: DEFINITIONS AND CONCEPTS

The purpose of a balance sheet is to list all the assets of a business and all of its financial resources at a given point in time.

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

 SHAREHOLDERS’ EQUITY
FIXED ASSETS 
(or NON-CURRENT ASSETS) 
 LIABILITIES
CURRENT ASSETS 

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.

Section 4.2 A CAPITAL-EMPLOYED ANALYSIS OF THE BALANCE SHEET

To gain a firm understanding of the capital-employed analysis of the balance sheet, we believe it is best approached in the same way as the analysis in the previous chapter, except that here we will be considering “stocks” rather than inflows and outflows.

More specifically, in a capital-employed analysis, a balance sheet is divided into the following main headings.

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

 in $m20162017201820192020
 Goodwill5,6515,7375,7285,4324,312
+Other intangible fixed assets49
+Tangible fixed assets34,78236,97135,63835,10429,807
+Equity in associated companies4,2975,0844,9066,5296,817
+Other non-current assets2,5383,8846,3262,4204,462
=NON-CURRENT ASSETS (FIXED ASSETS)47,31751,67652,59849,48545,398
 Inventories14,73417,98620,74417,29612,328
+Trade receivables7,6828,8889,4128,0056,872
+Other operating receivables1,6651,9312,8342,7562,281
Trade payables11,63313,42813,98112,61411,525
Other operating payables4,5975,1976,3075,8045,596
=OPERATING WORKING CAPITAL (1)7,85110,18012,7029,6394,360
 Non-operating receivables    4,329
Non-operating payables2,0872,5755,0144,9935,884
=NON-OPERATING WORKING CAPITAL (2)(2,087)(2,575)(5,014)(4,993)(1,555)
=WORKING CAPITAL (1+2)5,7647,6057,6884,6462,805
 CAPITAL EMPLOYED = NON-CURRENT ASSETS + WORKING CAPITAL53,08159,28160,28654,13148,203
=SHAREHOLDERS’ EQUITY GROUP SHARE30,13538,79042,08638,52138,280
+Minority interests in consolidated subsidiaries2,1902,0662,0221,9621,957
Deferred tax assets5,8377,0558,2878,6807,866
+Deferred tax liabilities2,5292,6842,3742,3311,832
=TOTAL GROUP EQUITY29,01736,48538,19534,13434,203
 Medium- and long-term borrowings and liabilities11,78910,1439,31610,3449,000
+Bank overdrafts and short-term borrowings6,5937,8098,1477,3056,307
Cash and equivalents, marketable securities2,6152,7862,3544,9955,963
+Pensions liabilities8,2977,6306,9827,3434,656
=NET DEBT24,06422,79622,09119,99714,000
 INVESTED CAPITAL = (GROUP EQUITY + NET DEBT) = CAPITAL EMPLOYED53,08159,28160,28654,13148,203

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

Section 4.3 A SOLVENCY-AND-LIQUIDITY ANALYSIS OF THE BALANCE SHEET

The solvency-and-liquidity analysis of the balance sheet, which presents a statement of what is owned and what is owed by the company at the end of the year, can be used:

  • by shareholders to list everything that the company owns and owes, bearing in mind that these amounts may need to be revalued;
  • by creditors looking to assess the risk associated with loans granted to the company. In a capitalist system, shareholders’ equity is the ultimate guarantee in the event of liquidation since the claims of creditors are met before those of shareholders.

Hence the importance attached to a solvency-and-liquidity analysis of the balance sheet in traditional financial analysis. As we shall see in detail in Chapters 12 and 14, it may be analysed from either a liquidity or a solvency perspective.

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).

SUMMARY

QUESTIONS

EXERCISE

ANSWERS

BIBLIOGRAPHY

NOTES

  1. 1   “Non-current assets” in IFRS terminology.
  2. 2   Known as property, plant and equipment in the US.
  3. 3   Known as debtors in the UK.
  4. 4   Required by the European Fourth Directive.

Or how to move mountains together!

Chapter 2 showed the structure of the cash flow statement, which brings together all the receipts and payments recorded during a given period and determines the change in net debt position.

Chapter 3 covered the structure of the income statement, which summarises all the revenues and charges during a period.

It may appear that these two radically different approaches have nothing in common. But common sense tells us that a rich woman will sooner or later have cash in her pocket, while a poor woman is likely to be strapped for cash – unless she should make her fortune along the way.

Although the complex workings of a business lead to differences between profits and cash, they converge at some point or another.

First of all, we will examine revenues and costs from a cash flow standpoint. Based on this analysis, we will establish a link between changes in wealth (earnings) and the change in net debt that bridges the two approaches.

We recommend that readers get to grips with this chapter, because understanding the transition from earnings to the change in net debt represents a key step in comprehending the financial workings of a business.

Section 5.1 ANALYSIS OF EARNINGS FROM A CASH FLOW PERSPECTIVE

This section is included merely for explanatory and conceptual purposes. Even so, it is vital to understand the basic financial workings of a company.

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.

 Increase in trade receivables  
Sales for the period or=Operating receipts
 +Reduction 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:

BY-NATURE INCOME STATEMENTDIFFERENCECASH FLOW STATEMENT
Net sales− Change in trade receivables (deferred payment)= Operating receipts
+ Changes in inventories of finished goods and work in progress− Changes in inventories of finished goods and work in progress (deferred charges) 
− Operating costs except depreciation, amortisation and impairment losses− Change in trade payables (deferred payments)= − Operating payments
 − Change in inventories of raw materials and goods for resale (deferred charges) 
===
= EBITDA− Change in operating working capitalOperating cash flows
BY-FUNCTION INCOME STATEMENTDIFFERENCECASH FLOW STATEMENT
Net sales− Change in trade receivables (deferred payment) + Change in trade payables (deferred payments)= Operating receipts
− Operating costs except depreciation, amortisation and impairment losses− Change in inventories of finished goods, work in progress, raw materials and goods for resale (deferred changes)= − Operating payments
= EBITDA− Change in operating working capital= Operating cash flows

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

 INCOME STATEMENT DIFFERENCE  CASH FLOW STATEMENT
 EBITDAChange in operating working capital=Operating cash flow
  Capital expenditure=Capital expenditure
  +Disposals=+Disposals
Depreciation, amortisation and impairment losses on fixed assets+Depreciation, amortisation and impairment losses on fixed assets (non-cash charges)   
=EBIT (operating profit)  = Free cash flow before tax
Financial expense net of financial income   Financial expense net of financial income
Corporate income tax =Corporate income tax
  +Proceeds from share issues=+Proceeds from share issues
  Share buy-backs Share buy-backs
  Dividends paid=Dividends paid
=Net income (net earnings)+Column total =Decrease in net debt

Section 5.2 CASH FLOW STATEMENT

The same table enables us to move in the opposite direction and thus account for the decrease in net debt based on the income statement. To do so, we simply need to add back all the movements shown in the central column to net profit.

The following reasoning may help our attempt to classify the various line items that enable us to make the transition from net income to decrease in net debt.

Net income should normally turn up in “cash at hand”. That said, we also need to add back certain non-cash costs (depreciation, amortisation and impairment losses on fixed assets) that were deducted on the way down the income statement but have no cash impact, to arrive at what is known as cash flow.

Cash flow will appear in “cash at hand” only once the timing differences related to the operating cycle as measured by change in operating working capital have been taken into account.

Lastly, the investing and financing cycles give rise to uses and sources of funds that have no immediate impact on net income.

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)

  20162017201820192020
 OPERATING ACTIVITIES     
 Net income1,7344,5755,330(2,391)(578)
+Depreciation, amortisation and impairment losses on fixed assets2,7212,7682,7992,9692,894
+Other non-cash items50(1,263)(3,173)2,720(132)
=CASH FLOW4,5056,0804,9563,2982,184
Change in working capital1,0001,84183(3,042)(1,841)
=CASH FLOW FROM OPERATING ACTIVITIES (A)3,5054,2394,8736,3404,025
 INVESTING ACTIVITIES     
 Capital expenditure2,4442,8193,3053,7722,578
Disposal of fixed assets1192226468237
+Acquisition of financial assets77744838
Disposal of financial assets1,182443013183,017
=CASH FLOW FROM INVESTING ACTIVITIES (B)(1,143)(2,830)(3,722)(3,824)676
=FREE CASH FLOW AFTER FINANCIAL EXPENSE (A – B)2,3621,4091,1512,5164,701
 FINANCING ACTIVITIES     
 Proceeds from share issues (C)3,115(226)(90)1,477
 Dividends paid (D)61141220332181
 A − B + C − D = DECREASE/(INCREASE) IN NET DEBT5,4161,2687052,0945,997
 Decrease in net debt can be broken down as follows:     
 Repayment of short-, medium- and long-term borrowings8,4294,3633,6695,1105,782
New short-, medium- and long-term borrowings1,5263,2662,5325,657753
+Change in cash, cash equivalents and marketable securities (short-term investments)(1,487)171(432)2,641968
=DECREASE/(INCREASE) IN NET DEBT5,4161,2687052,0945,997

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

  20162017201820192020
 A − B + C − D = DECREASE/(INCREASE) IN NET DEBT5,4161,2687052,0945,997
Repayment of short-, medium- and long-term borrowings8,4294,3633,6695,1105,782
+New short-, medium- and long-term borrowings1,5263,2662,5325,657753
=Change in cash, cash equivalents and marketable securities (short-term investments)(1,487)171(432)2,641968

SUMMARY

QUESTIONS

EXERCISE

ANSWERS

BIBLIOGRAPHY

NOTES

  1. 1   This adjustment is not necessary in by-function income statements, as explained in Chapter 3.
  2. 2   In accounting parlance, this is known as a “closing entry”.
  3. 3   Or investments in fixed assets.
  4. 4   When a company buys back some of its shares from some of its shareholders. For more details, see Chapter 37.
  5. 5   For details on consolidated accounts, see Chapter 6.

A group-building exercise

This chapter deals with the basic aspects of consolidation that should be understood by anyone interested in corporate finance.

An analysis of the accounting documents of each individual company belonging to a group does not serve as a very accurate or useful guide to the economic health of the whole group. The accounts of a company reflect the other companies that it controls only through the book value of its shareholdings (revalued or written down, where appropriate) and the size of the dividends that it receives.

The goal of this chapter is to familiarise readers with the problems arising from consolidation. Consequently, we present an example-based guide to the main aspects of consolidation in order to facilitate analysis of consolidated accounts.

Section 6.1 CONSOLIDATION METHODS

Any firm that controls other companies exclusively should prepare consolidated accounts and a management report for the group.1

Consolidated accounts must be certified by the statutory auditors and, together with the group’s management report, made available to shareholders, debtholders and all other parties with a vested interest in the company.

Listed European companies have been required to use IFRS2 accounting principles for their consolidated financial statements since 2005 and groups from most other countries have been required or allowed to use these accounting standards since then.

The companies to be included in the preparation of consolidated accounts form what is known as the scope of consolidation. The scope of consolidation comprises:

  • the parent company;
  • the companies in which the parent company has a material influence (which is assumed when the parent company holds at least 20% of the voting rights).

However, a subsidiary should not be consolidated when its parent loses the power to govern its financial and operating policies, for example when the subsidiary becomes subject to the control of a government, a court or an administration. Such subsidiaries should be accounted for at fair market value.

For instance, let us consider a company with a subsidiary that appears on its balance sheet with an amount of 20. Consolidation entails replacing the historical cost of 20 with all or some of the assets, liabilities and equity of the company being consolidated.

There are two methods of consolidation which are used, depending on the strength of the parent company’s control or influence over its subsidiary:

Type of relationshipType of companyConsolidation method
ControlSubsidiaryFull consolidation3
Significant influenceAssociateEquity method

We will now examine each of these two methods in terms of its impact on sales, net profit and shareholders’ equity.

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:

Parent company’s balance sheetSubsidiary’s balance sheet
Investment in the subsidiary515Shareholders’ equity70Assets28Shareholders’ equity20
Other assets57Liabilities 2  Liabilities 8

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

Consolidated balance sheet
Investment in the subsidiary (15 − 15) 0Shareholders’ equity (70 –15 + 20)75
Assets (57 + 28)85Liabilities (2 + 8)10

Or, in an alternative form:

Consolidated balance sheet
Assets85Shareholders’ equity group share (75 − 5)70
  Minority interests (20 × 25%) 5
  Liabilities10

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:

Parent company’s income statementSubsidiary’s income statement
Costs80Net sales100Costs30Net sales38
Net income20  Net income 8  

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

Consolidated income statement
Costs (80 + 30)110Net sales (100 + 38)138
Net income (20 + 8) 28  

Or, in a more detailed form:

Consolidated income statement
Costs110Net sales138
Net income:   
Group share 26  
Minority interest (8 × 25%)  2  

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:

Parent company’s balance sheetAssociate’s balance sheet
Investment in the associate5Shareholders’ equity60Assets45Shareholders’ equity35
Other assets57Liabilities2  Liabilities10

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

Consolidated balance sheet
Investment in the associate (5 − 5 + 20% × 35)7Shareholders’ equity (60 – 5 + 7)62
Other assets57Liabilities2

The non-consolidated income statements are as follows:

Parent company’s income statementAssociate’s income statement
Costs80Net sales100Costs30Net sales35
Net income20  Net income5  

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

Consolidated income statement
Costs80Net sales100
Net income (20 + 5 × 20%)21Minority interest (5 × 20%)1

Section 6.2 CONSOLIDATION-RELATED ISSUES

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.

(a) Level of control and ownership level

The level of control6 measures the strength of direct or indirect dependence that exists between the parent company and its subsidiaries, joint ventures or associates. Although control is assessed in a broader way in IFRS (see page 72), the percentage of voting rights that the parent company controls (what we call here “level of control”) will be a key indication to determine whether the subsidiary is controlled or significantly influenced.

To calculate the level of control, we must look at the percentage of voting rights held by all group companies in the subsidiary provided that the group companies are controlled directly or indirectly by the parent company.

Control is assumed when the percentage of voting rights held is 50% or higher or when a situation of de facto control exists at each link in the chain.

It is important not to confuse the level of control with the level of ownership. Generally speaking, these two concepts are different. The ownership level7 is used to calculate the parent company’s claims on its subsidiaries, joint ventures or associates. It reflects the proportion of their capital held directly or indirectly by the parent company. It is a financial concept, unlike the level of control, which is a power-related concept.

The ownership level is the sum of the product of the direct and indirect percentage stakes held by the parent company in a given company. The ownership level differs from the level of control, which considers only the controlled subsidiaries.

Consider the following example:

A controls 60% of B, B controls 70% of D, so A controls 70% of D. D and B are therefore considered as controlled and thus fully consolidated by A. But A does not own 70%, but 42% of D (i.e. 60% × 70%). The ownership level of A over D is then 42%: only 42% of D’s net income is attributable to A.

Since C owns just 10% of E, C will not consolidate E. Neither will D as it only owns 15% of E. But since A controls 20% of C, A will account for C under the equity method and will show 20% of C’s net income in its income statement.

The ownership level of A over E is 20% × 10% + 60% × 70% × 15% = 8.3%. The percentage of control of A over E is 15%.

How the ownership level is used varies from one consolidation method to another:

  • with full consolidation, the ownership level is used only to allocate the subsidiary’s reserves and net income between the parent company and minority interests in the subsidiary;
  • with the equity method of accounting, the ownership level is used to determine the portion of the subsidiary’s shareholders’ equity and net income attributable to the parent company.

(b) Changes in the scope of consolidation

It is important to analyse the scope of consolidation, especially with regard to what has changed and what is excluded. Indeed, a decision not to consolidate a company means concealing its losses, its shareholders’ equity as well as the amount of its liabilities.

Using the equity method for consolidating a subsidiary, which should in fact be fully consolidated, allows one to avoid showing its debts in the group’s consolidated balance sheet.

Certain techniques can be used to remove subsidiaries still controlled by the parent company from the scope of consolidation. These techniques have been developed to make certain consolidated accounts look more attractive. These techniques frequently involve a special-purpose vehicle (SPV). The SPV is a separate legal entity created specially to handle a venture on behalf of a company. In many cases, from a legal standpoint the SPV belongs to banks or to investors rather than to the company. That said, the company must consolidate the SPV if it controls it, even without owning a single of its shares, as explained in the first paragraph of Section 6.1. These rules make it very difficult to use this type of scheme under IFRS or US GAAP.

Changes in the scope of consolidation require the preparation of pro forma financial statements. Pro forma statements enable analysts to compare the company’s performances on a consistent basis. In these pro forma statements, the company restate past accounts to make them comparable with the current scope of consolidation.

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.

(a) What does this difference represent?

In other words, why should a company agree to pay out more for another company than its book value? There are several possible explanations:

  • the assets recorded on the acquired company’s balance sheet are worth more than their carrying cost. This situation may result from the prudence principle, which means that unrealised capital losses have to be taken into account, but not unrealised capital gains;
  • it is perfectly conceivable that assets such as patents, licences and market shares that the company has accumulated over the years without wishing to, or even being able to, account for them, may not appear on the balance sheet. This situation is especially true if the company is highly profitable;
  • the merger between the two companies may create synergies, either in the form of cost reductions and/or revenue enhancement. The buyer is likely to partly reflect them in the price offered to the seller;
  • the buyer may be ready to pay a high price for a target just to prevent a new player from buying it, entering the market and putting the current level of the buyer’s profitability under pressure;
  • finally, the buyer may quite simply have overpaid for the deal.

(b) How is goodwill accounted for?

When first consolidated, the assets of the new subsidiary or joint venture are valued at their fair value and are recorded on the group’s balance sheet in these amounts. Intangible assets of the acquired company in particular are valued, even if they aren’t recognised on its balance sheet: brands concerned, patents, software, emissions permits or landing rights, customer lists, etc. Accordingly, the equity capital of the newly consolidated company will be revalued.

The difference between the price paid by the parent company for its shares in the acquired company and the parent company’s share in the revalued equity of the acquired company is called goodwill. It appears on the asset side of the new group’s balance sheet as intangible assets.

For associates recently accounted for under the equity method of accounting, goodwill is calculated extra-accountably since their assets and liabilities are not included in the consolidated balance sheet. They are then added to other goodwill.

Under IFRS and US GAAP, goodwill is assessed each year to verify whether its value is at least equal to its net book value as shown on the group’s balance sheet. This assessment is called an impairment test. If the market value of goodwill is below its book value, then goodwill is written down to its fair market value and a corresponding impairment loss is recorded in the income statement.8 This impairment loss cannot be reversed in the future.

To illustrate the purchase method, let’s analyse now how LVMH accounted for the acquisition of the luxury hotels group, Belmond, in 2019.

Prior to the acquisition, LVMH’s balance sheet (in billions of EUR) can be summarised as follows:

Intangible assets31.0Shareholders’ equity34.0
Other fixed assets17.8Net debt18.9
Working capital7.2Deferred tax3.1

While Belmond’s balance sheet (in billions of EUR) was as follows:

Intangible assets0Shareholders’ equity0.3
Other fixed assets1.1Provisions0.6
Working capital−0.1Net debt0.1

LVMH acquired 100% of Belmond for €2.3bn paid for in cash. Therefore, LVMH paid €2bn9 more than Belmond equity. This amount is not equal to goodwill, as LVMH proceeded to a revaluation of assets and liabilities of Belmond as follows:

  • intangible assets
+€0.1bn
  • other fixed assets
+€1.2bn
  • working capital
+€0.1bn
  • deferred tax liability10
+€0.4bn
  • net debt (fair value)
+€0.0bn

Total adjustments amount to €1.0bn (–0.1 + 1.2 + 0.1 – 0.4 – 0.3). Consequently, the amount of goodwill created was €2.0bn – €1.0bn = €1.0bn. The simplified balance sheet of the combined entity was therefore as follows:

Intangible assets31.0 + 0 + 0.1 = 31.1Shareholders’ equity34.0
Goodwill1.1Net debt18.9 + 0.6 + 0.0 + 2.3 = 21.8
Other fixed assets17.8 + 1.1 + 1.2 = 20.1Deferred tax3.1 + 0.1 + 0.4 = 3.6
Working capital7.2 – 0.1 + 0.1 = 7.2  

Finally, transactions may give rise to negative goodwill under certain circumstances. Under IFRS, negative goodwill is immediately recognised as a profit in the income statement of the new group.

(c) How should financial analysts treat goodwill?

From a financial standpoint, it is sensible to regard goodwill as an asset like any other, which may suffer sudden falls in value that need to be recognised by means of an impairment charge. We advise our readers to treat impairment charges as non-recurring items and to exclude them for the computation of returns (see Chapter 13) or earnings per share (see Chapter 22).

Can it be argued that goodwill impairment losses do not reflect any decrease in the company’s wealth because there is no outflow of cash? We do not think so.

Granted, goodwill impairment losses are a non-cash item, but it would be wrong to say that only decisions giving rise to cash flows affect a company’s value. For instance, setting a maximum limit on voting rights or attributing 10 voting rights to certain categories of shares does not have any cash impact, but definitely reduces the value of the excluded shares.

Recognising the impairment of goodwill related to a past acquisition is tantamount to admitting that the price paid was too high. But what if the acquisition was paid for in shares? This makes no difference whatsoever, irrespective of whether the buyer’s shares were overvalued at the same time.

Had the company carried out a share issue rather than overpaying for an acquisition, it would have been able to capitalise on its lofty share price to the great benefit of existing shareholders. The cash raised through the share issue would have been used to make acquisitions at much more reasonable prices once the wave of euphoria had subsided.

It is essential to remember that shareholders in a company which pays for a deal in shares suffer dilution in their interest. They accept this dilution because they take the view that the size of the cake will grow at a faster rate (e.g. by 30%) than the number of guests invited to the party (e.g. by over 25%). Should it transpire that the cake grows at merely 10% rather than the expected 30% because the purchased assets prove to be worth less than anticipated, then the number of guests at the party will unfortunately stay the same. Accordingly, the size of each guest’s slice of the cake falls by 12% (110 / 125 − 1), so shareholders’ wealth has certainly diminished.

(d) How should financial analysts treat “adjusted income”?

Some groups (particularly in the pharmaceutical sector) like Pfizer or Sanofi, following an acquisition, publish an “adjusted income” to neutralise the P&L impact of the revaluation of assets and liabilities of its newly acquired subsidiary. Naturally, a P&L account is drawn up under normal standards, but it carries an audited table showing the impact of the switch to adjusted income on operating income and net income.

As a matter of fact, by virtue of the revaluation of the target’s inventories to their market value, the normal process of selling the inventories generates no profit. So how relevant will the P&L be in the first year after the merger? This issue becomes critical only when the production cycle is very long and therefore the revaluation of inventories (and potentially research and development capitalised) is material.

We believe that for those specific cases, groups are right to show this adjusted P&L.

Section 6.3 TECHNICAL ASPECTS OF CONSOLIDATION

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

(a) The problem

The translation of the accounts of foreign companies is a tricky issue because of exchange rate fluctuations and the difference between inflation rates, which may distort the picture provided by company accounts.

For instance, a parent company located in the Eurozone may own a subsidiary in a country with a soft currency.11

Using year-end exchange rates to convert the assets of its subsidiary into the parent company’s currency understates their value. From an economic standpoint, all the assets do not suffer depreciation proportional to that of the subsidiary’s home currency.

On the one hand, fixed assets are protected to some extent. Inflation means that it would cost more in the subsidiary’s local currency to replace them after the devaluation in the currency than before. All in all, the inflation and devaluation phenomena may actually offset each other, so the value of the subsidiary’s fixed assets in the parent company’s currency is roughly stable. On the other hand, inventories (usually), receivables and liabilities (irrespective of their maturity) denominated in the devalued currency all depreciate in tandem with the currency.

If the subsidiary is located in a country with a hard currency (i.e. a stronger one than that of the parent company), then the situation is similar but the implications are reversed.

To present an accurate image of developments in the foreign subsidiary’s situation, it is necessary to take into account:

  • the impact on the consolidated accounts of the translation of the subsidiary’s currency into the parent company’s currency;
  • the adjustment that would stem from translation of the foreign subsidiary’s fixed assets into the local currency.

(b) Methods

Several methods may be used at the same time to translate different items in the balance sheet and income statement of foreign subsidiaries, giving rise to currency translation differences.

The most frequently used method is called the closing rate method: all assets and liabilities are translated at the closing rate, which is the rate of exchange at the balance sheet date.12 Revenues and charges on the income statement are translated at the average rate over the fiscal year.13 Currency translation differences are recorded under shareholders’ equity, with a distinction being made between the group’s share and that attributable to minority investors. This translation method is used under IFRS and it is relatively comparable to the US standard.

The temporal method consists of translating:

  • monetary items (i.e. cash and sums receivable or payable denominated in the foreign company’s currency and determined in advance) at the closing rate;
  • non-monetary items (fixed assets and the corresponding depreciation and amortisation,14 inventories, prepayments, shareholders’ equity, investments, etc.) at the exchange rate at the date to which the historical cost or valuation pertains (i.e. the exchange rate on the day on which the asset or liability was acquired or contracted);
  • revenues and charges on the income statement theoretically at the exchange rate prevailing on the transaction date. In practice, however, they are usually translated at an average exchange rate for the period.

Under the temporal method, the difference between the net income on the balance sheet and that on the income statement is recorded on the income statement under foreign exchange gains and losses.

(c) Translating the accounts of subsidiaries located in hyperinflationary countries

A hyperinflationary country is one where inflation is both chronic and out of control. In such circumstances, the previous methods are not suitable for translating the effects of inflation into the accounts.

Hence the use of a specific method based on restatements made by applying a general price index. Elements such as monetary items that are already stated at the measuring unit at the balance sheet date are not restated. Other elements are restated based on the change in the general price index between the date those items were acquired or incurred and the balance sheet consolidation. A gain or loss on the net monetary position is included in net income. IFRS prescribes this method, which is not allowed in the US where the temporal method is applied.

SUMMARY

QUESTIONS

EXERCISE

ANSWERS

BIBLIOGRAPHY

NOTES

  1. 1   Unless (i) the parent is itself a wholly owned subsidiary or is virtually wholly owned and (ii) its securities are not listed or about to be and (iii) the immediate or ultimate parent issues consolidated accounts.
  2. 2   IFRS rules are produced by the International Accounting Standards Board (IASB), a private organisation made up mainly of accountants from various parts of the world.
  3. 3   Or simply consolidation.
  4. 4   Which means “no goodwill”, a topic to which we will return in Section 6.2.
  5. 5   Valued at historical cost less depreciation if any.
  6. 6   Or percentage control.
  7. 7   Or percentage interest.
  8. 8   Unlisted US companies are allowed to systematically depreciate goodwill over a period of up to 10 years.
  9. 9   2.3bn − 0.3bn = 2bn.
  10. 10  See Chapter 7.
  11. 11  A soft or weak currency is a currency that tends to fall in value because of political or economic uncertainty (high inflation rate).
  12. 12  This method is also called the current rate method.
  13. 13  IFRS recommend using the exchange rate prevailing on the transaction date to translate revenues and charges but this is rarely done for practical reasons, except when large fluctuations in exchange rates were registered.
  14. 14  As an exception to this rule, goodwill is translated at the closing rate.

Everything you always wanted to know but never dared to ask!

This chapter is rather different from the others. It is not intended to be read from start to finish, but consulted from time to time, whenever readers experience problems interpreting, analysing or processing a particular accounting item.

Each of these complex points will be analysed from these angles:

  • from an economic standpoint so that readers gain a thorough understanding of its real substance;
  • from an accounting standpoint to help readers understand the accounting treatment applied and how this treatment affects the published accounts;
  • from a financial standpoint to draw a conclusion as to how best to deal with this problem.

Our experience tells us that this is the best way of getting to grips with and solving problems. The key point to understand in this chapter is the method we use to deal with complex issues, since we cannot look at every single point here. When faced with a different problem, readers will have to come up with their own solutions using our methodology – unless they contact us through the vernimmen.com website.

The following bullet list shows, in alphabetical order, the main line items and principal problems that readers are likely to face:

  • accruals
  • cash assets
  • construction contracts
  • convertible bonds or loans
  • currency translation adjustments
  • deferred tax assets and liabilities
  • dilution profits or losses
  • financial hedging instruments
  • impairment losses
  • intangible fixed assets
  • inventories
  • leases
  • off-balance sheet commitments
  • pensions and other employee benefits
  • preference shares
  • provisions
  • stock options
  • tangible fixed assets
  • treasury shares.

Section 7.1 ACCRUALS

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.

Section 7.2 CASH ASSETS

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.

Section 7.3 CONSTRUCTION CONTRACTS

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.

Section 7.4 CONVERTIBLE BONDS AND LOANS

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.

Section 7.5 CURRENCY TRANSLATION ADJUSTMENTS

See Chapter 6.

Section 7.6 DEFERRED TAX ASSETS AND LIABILITIES

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?

(a) The simple case of losses

A group makes a pre-tax book and tax loss of 100. From a tax point of view, the tax due is zero. From an accounting point of view, and if there is reason to believe that the company is likely to make profits in the future that will enable it to use this tax-loss carryforward, then the loss will be reduced by a tax credit of 25.5 Accordingly, the after-tax loss will be booked at 75. In order to balance the books, a tax credit carryforward of 25 will be recognised in the balance sheet on the assets side.

The following year, if our group makes an accounting and taxable profit of 100, it will not pay any tax, as the tax-loss carryforward created that year will be set off against the tax due. From an accounting point of view, we’ll recognise a theoretical tax expense of 25 and reduce the deferred tax recognised previously in the balance sheet to 0.

This example clearly shows that the deferred tax credit was created by reducing the amount of the net accounting loss and thus increasing equity by the same amount. From a financial point of view, it is only of value if future operations are able to generate enough profits. But under no circumstances can it be considered as an ordinary asset that could be sold for cash. And it is most certainly not an element of working capital as it does not result from the time lapse between the billing date and the payment date. We’ll consider it as a fixed asset. At worst, it could be reversed against shareholders’ equity, if there are serious doubts about the company’s future ability to make profits.

(b) The case of provisions that are not immediately tax-deductible

In some countries, provisions for retirement benefits, restructuring and environmental risks are not tax-deductible when they are recognised. They are only tax-deductible when the related expense is paid. The accounting rule for consolidated accounts is different because allocations to these provisions are treated as tax-deductible when they are recognised. This is what results in the gap between real flows and the accounting treatment.

Let’s consider a group that is making pre-tax profits of 100 per year. This year, it must allocate 100 to a reserve to cover a risk that may materialise in three years. From a tax point of view, the net result is 756 as the reserve is not tax-deductible and the tax recognised is 25. From an accounting point of view, as the reserve of 100 is a cost, the net result is 0. The tax effectively paid (25) appears on the income statement but is neutralised by a deferred tax income of 25, which, in order to balance the books, is also recorded on the assets side of the balance sheet. Finally, the net tax recorded on the income statement is 0.

In three years, all other things being equal, the net tax result is 0 since the cost is tax-deductible and the tax effectively paid that year is thus 0. From an accounting point of view, the written-back provision cancels out the expense, so the pre-tax result is 100 − 100 (cost) + 100 (provision written back) = 100. The tax recognised by accountants is 25, which is split into 0 tax paid and 25 recognised through deduction from the deferred tax credit recognised in the balance sheet three years ago, which is thus used up.

The deferred tax credit carried on the balance sheet for three years has a cross-entry under equity capital that is higher by 25. This is tax that has already been paid but from an accounting point of view is considered as a future expense. Unlike inventories of raw materials, which have been paid for and which are also a future expense, deferred tax has no monetary value.

The financial treatment we advocate is simple: it is cancelled from assets and deducted from the provision under liabilities (so that it appears after tax) or from equity to reverse the initial entry.

(c) Revaluing assets

Revaluing an asset when it is first consolidated or subsequently (when tested for impairment)7 has two consequences:

  • The taxable capital gains if the asset is sold will be different from the book value of the capital gains recorded in the consolidated financial statements.
  • The basis for depreciation will be different, and will thus generate deferred taxes.

A group acquires a new subsidiary that has land recorded on its balance sheet at its initial acquisition value of 100. This land is revalued in the consolidated financial statements at 150.

We will then book a deferred tax liability of (150 − 100) × 25% = 12.5 in the consolidated financial statements. What is this liability from an economic point of view? It is the difference that will be booked in the consolidated financial statements between the tax actually paid on the day when the land is sold at a price of P: (P − 100) × 25% and the tax that will be recognised (P − 150) × 25%. The cross-entry on the balance sheet for this deferred tax is a lesser reduction of goodwill, which is reduced not by 50 but by (50 – 12.5).

Is this a debt owed to the tax administration? Clearly not, since the land would have to be sold for a tax liability to appear and then for an amount of (P − 100) × 25% and probably not 12.5! How do we advise our readers to treat this deferred tax liability? Deduct it from goodwill.

So, what of the case of the asset that has been revalued but that is depreciable? There is an initial recognition of the deferred tax liability being gradually reduced over the duration of the residual life of the asset by deferred tax credits due to the difference between a tax depreciation calculated on the basis of 100 and book depreciation calculated on the basis of 150.

Section 7.7 DILUTION PROFIT AND LOSSES

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.

Section 7.8 FINANCIAL HEDGING INSTRUMENTS

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.

(a) Fair value hedges

On principle, receivables and debts are booked at their historic cost (amortised cost) while financial instruments are booked at their fair value. The application of these principles could lead to an absurd situation. Let’s take, for example, a company that hedges a fixed-rate debt with a swap. If the company closes its financial year before the debt matures, the change in the value of the debt has no impact on the income statement, while the change in the value of the swap does impact the income statement. This is so even though both can set each other off!

In order to remedy this problem, IFRS recommends booking the changes in value of a receivable or a debt hedged by a financial instrument on the income statement. In this way, the gains or losses on the underlying asset are set off by the losses or gains on the hedging instrument. And there is no impact on the result.

(b) Cash flow hedges

Let’s take the example of a chocolate producer that hedges the future price of cocoa with a forward purchase. The company closes its financial year after putting the hedging in place but before the actual purchase of the cocoa. If the price of cocoa has fallen since the hedging was put in place, then the principle of fair value applied to financial instruments holds that the company should book a loss in terms of the change in the value of the forward contract. This isn’t logical as this loss only exists because the company wanted to be sure that the price at which it was to purchase its cocoa was fixed in advance so as to eliminate its risk.

The change in value of the financial hedging instrument is booked on the asset side and under equity (under “other comprehensive income”) without a loss or a gain being recorded on the income statement. Gains and losses on the hedging instrument only appear when underlying flows effectively take place, i.e. at the time of the effective purchase of the cocoa in our example. Our producer will then record a total expense (purchase price of cocoa lower than forecast and loss on the forward contract), which will reflect the price fixed in advance in its hedging contract.

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.

Section 7.9 IMPAIRMENT LOSSES

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

Section 7.10 INTANGIBLE FIXED ASSETS

Under IFRS, these primarily encompass capitalised development costs, patents, licences, concessions and similar rights, leasehold rights, brands, software and goodwill arising on acquisitions (see Chapter 6).

This line item requires special attention since companies have some degree of latitude in treating these items that now represent a significant portion of companies’ balance sheets.

Under IFRS, a company is required to recognise an intangible asset (at cost) if and only if:

  • it is probable that the future economic benefits that are attributable to the asset will flow to the company; and if
  • the cost of the asset can be reliably measured.

Internally generated goodwill, brands, mastheads, publishing titles and customer lists should not be recognised as intangible assets. Internally generated goodwill is expensed as incurred. Costs of starting up a business, of training, of advertising, of relocating or reorganising a company receive the same treatment.

1/ START-UP COSTS

(a) What are start-up costs?

Start-up costs are costs incurred in relation to the creation and the development of a company, such as incorporation, customer canvassing and advertising costs incurred when the business first starts operating, together with capital increases, merger and conversion fees.

(b) How are they accounted for?

Start-up costs are to be expensed as incurred under IFRS and US GAAP.

(c) How should financial analysts treat them?

It is easy to analyse such costs from a financial perspective. They have no value and should thus be deducted from the company’s shareholders’ equity.

2/ RESEARCH AND DEVELOPMENT COSTS

(a) What are research and development costs?

These costs are those incurred by a company on research and development for its own benefit.

(b) How are they accounted for?

Under IFRS, research costs are expensed as incurred in line with the conservatism principle governing the unpredictable nature of such activities.

Development costs should be capitalised on the balance sheet if the following conditions are met:

  • the project or product is clearly identifiable and its costs measurable;
  • the product’s feasibility can be demonstrated;
  • the company intends to produce, market or use the product or project;
  • the existence of a market for the project or product can be demonstrated;
  • the utility of the product for the company, where it is intended for internal use, can be demonstrated;
  • the company has or will have the resources to see the project through to completion and use or market the end product.

Under US GAAP, research and development costs generally cannot be capitalised (except specific web developments).

(c) How should financial analysts treat them?

We recommend leaving development costs in intangible fixed assets, while monitoring closely any increases in this category, since those could represent an attempt to hide losses.

3/ BRANDS AND MARKET SHARE

(a) What are brands and market share?

These are brands or market share purchased from third parties and valued, when allowed, upon their first-time consolidation by their new parent company.

(b) How are they accounted for?

Brands are not valued in the accounts unless they have been acquired. This gives rise to an accounting deficiency, which is especially critical in the mass consumer (e.g. food, textiles, automotive sectors) and luxury goods industries, particularly from a valuation standpoint. Brands have considerable value, so it makes no sense whatsoever not to take them into account in a company valuation. As we saw in Chapter 6, the allocation of goodwill on first-time consolidation to brands and market share leads to an accumulation of such assets on groups’ balance sheets. For instance, LVMH carries brands for €16bn on its balance sheet, which thus account for 36% of its capital employed. Since the amortisation of brands is not tax-deductible in most countries, it has become common practice not to amortise such assets so that they have an indefinite life. Brands are, at most, written down where appropriate.

Under IFRS, market share cannot be carried on the balance sheet and neither can training or advertising expenses, which are consequently part of goodwill but not individually identified as such.

Intangible assets with finite lives are amortised over their useful life. Intangible assets with indefinite lives undergo an impairment test each year to verify that their net book value is consistent with the recoverable value of the corresponding assets (see Section 7.9).

US rules are very similar to the IASB’s.

(c) How should financial analysts treat them?

These items usually add considerably to a company’s valuation, even though they may be intangible. For instance, what value would a top fashion house or a consumer goods company have without its brands?

That said, the value of brands, goodwill and shareholdings recorded on the balance sheet will be questionable if the company’s profitability is low because their economic rationale is precisely to provide additional profitability.

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.

Section 7.11 INVENTORIES

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?

(a) Costs that should be included in inventories

The way inventories are valued varies according to their nature: supplies of raw materials and goods for resale or finished products and work in progress. Supplies are valued at acquisition cost, including the purchase price before taxes, customs duties and costs related to the purchase and the delivery. Finished products and work in progress are valued at production cost, which includes the acquisition cost of raw materials used, direct and indirect production costs insofar as the latter may reasonably be allocated to the production of an item.

Costs must be calculated based on normal levels of activity, since allocating the costs of below-par business levels would be equivalent to deferring losses to future periods and artificially inflating profit for the current year. In practice, this calculation is not always properly performed, so we would advise readers to closely follow the cost allocation.

Financial charges, development costs and general and administrative costs are not usually included in the valuation of inventories unless specific operating conditions justify such a decision. IFRS requires interim interest payments12 to be included in the cost of inventories; US GAAP allows interim interest payments to be included in inventories in certain cases.

(b) Valuation methods

Under IFRS, there are three main methods for valuing inventories:

  • the weighted average cost method;
  • the FIFO (first in, first out) method;
  • the identified purchase cost method.

Weighted average cost consists of valuing items withdrawn from the inventory at their weighted average cost, which is equal to the total purchase cost divided by quantities purchased.

The FIFO method values inventory withdrawals at the cost of the item that has been held in inventory for the longest.

The identified purchase cost is used for non-interchangeable items and goods or services produced and assigned to specific projects.

For items that are interchangeable, the IASB allows the weighted average cost and FIFO methods, but no longer accepts the LIFO method (last in, first out) that values inventory withdrawals at the cost of the most recent addition to the inventory. US GAAP permits all methods (including LIFO) but the identified purchase cost method.

During periods of inflation, the FIFO method enables a company to post a higher profit than under the LIFO method. The FIFO method values items withdrawn from the inventory at the purchase cost of the items that were held for longest and thus at the lowest cost, hence giving a higher net income. The LIFO method produces a smaller net income as it values items withdrawn from the inventory at the most recent, and thus the highest, purchase cost. The net income figure generated by the weighted average cost method lies midway between these two figures.

Analysts need to be particularly careful when a company changes its inventory valuation method. These changes, which must be disclosed and justified in the notes to the accounts, make it harder to carry out comparisons between periods and may artificially inflate net profit or help to curb a loss.

Finally, where the market value of an inventory item is less than its calculated carrying amount, the company is obliged to recognise an impairment loss for the difference (i.e. an impairment loss on current assets).

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.

Section 7.12 LEASES

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

Section 7.13 OFF-BALANCE-SHEET COMMITMENTS

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:

Section 7.14 PENSIONS AND OTHER EMPLOYEE BENEFITS

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.

Section 7.15 PREFERENCE SHARES17

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.

Section 7.16 PROVISIONS

Provisions are set aside in anticipation of a future cost. Additions to provisions reduce net income in the year they are set aside and not in the year the corresponding cost will actually be incurred. Provisions will actually be written back the year the corresponding charge will be incurred, thereby neutralising the impact of recognising the charges in the income statement. Additions to provisions are therefore equivalent to an anticipation of costs.

1/ RESTRUCTURING PROVISIONS

(a) What are restructuring provisions?

Restructuring provisions consist of taking a heavy upfront charge against earnings in a given year to cover a restructuring programme (site closures, redundancies, etc.). The future costs of this restructuring programme are eliminated on the income statement through the gradual write-back of the provision, thereby smoothing future earnings performance.

(b) How are they accounted for?

Restructuring costs represent a liability if they derive from an obligation for a company vis-à-vis third parties or members of its workforce. This liability must arise from a decision by the relevant authority and be confirmed prior to the end of the accounting period by the announcement of this decision to third parties and the affected members of the workforce. The company must not anticipate anything more from those third parties or members of its workforce. Conversely, a relocation leading to profits further ahead in the future should not give rise to such a provision.

(c) How should financial analysts treat them?

The whole crux of the matter boils down to whether restructuring provisions should be recorded under operating or non-operating items: the former are recurrent in nature, unlike the latter. Some groups consider productivity-enhancing restructuring charges as operating items and business shutdowns as non-recurrent items. This may be acceptable when the external analyst is able to verify the breakdown between these two categories. Other companies tend to treat the entire restructuring charge as a non-recurrent item.

Our view is that in today’s world of rapid technological change and endless restructuring in one division or another, restructuring charges are usually structural in nature, which means that they should be charged against operating profit. The situation may be different for SMEs,20 where those charges are more likely to be of a non-operating nature.

On the liability side of the balance sheet, we treat these restructuring provisions as part of the operating working capital (or non-operating working capital for SMEs).

2/ PROVISIONS FOR DECOMMISSIONING OR RESTORATION OF SITES

(a) What are provisions for decommissioning or restoration?

Some industrial groups may have commitments due to environmental constraints to decommission an industrial plant after use (nuclear plant, etc.) or restore the site after use (mine, polluted site, etc.).

(b) How are they accounted for?

In such cases, as these commitments are generally over the very long term, provisions will be booked as the net present value of future commitments.

(c) How should financial analysts treat them?

These provisions should be treated as net debt.

Section 7.17 STOCK OPTIONS

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.

Section 7.18 TANGIBLE ASSETS

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.

Section 7.19 TREASURY SHARES

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.

BIBLIOGRAPHY

NOTES

  1. 1   If the company’s financial year starts as of 1 January.
  2. 2   The completed contract method consists of recognising the sales and earnings on a project only when the project has been completed or the last batch delivered. Nonetheless, by virtue of the conservatism principle, any losses anticipated are fully provisioned. This method is thus equivalent to recognising only unrealised losses while the project is under way. It may be used in the US where the recommended method is the percentage of completion method.
  3. 3   See Chapter 24.
  4. 4   This is known as “split accounting”.
  5. 5   Assuming a corporation tax rate of 25%.
  6. 6   Assuming a corporation tax rate of 25%.
  7. 7   See Chapter 6.
  8. 8   An intangible asset with indefinite useful life to be precise.
  9. 9   The CGU, as defined by the IASB, is the smallest identifiable group of assets that generates cash inflows from continuing use, these cash inflows being largely independent of the cash inflows from other assets or groups of assets.
  10. 10  A transaction done “at arm’s length” designates a transaction where two entities have acted as if they had no pre-existing relations of any kind.
  11. 11  Earnings before interest and taxes.
  12. 12  Interest on capital borrowed to finance production.
  13. 13  Capital lease in the US.
  14. 14  For more, see the Vernimmen.com Newsletter, 122, 1–4, September 2019.
  15. 15  The difference between the effective yield and the theoretical one is part of other comprehensive items which do not transit through the profit and loss account.
  16. 16  See Section 17.41/ (d).
  17. 17  Also called preferred shares.
  18. 18  For more details about preference shares, see Section 24.3.
  19. 19  Or determinable.
  20. 20  Small and medium-sized enterprises.
  21. 21  Which means that stock options cannot be exercised for at least four years.
  22. 22  For more, see Section 23.5.
  23. 23  Known as PPE.
  24. 24  For tangible assets (except investment property), an increase in the value of the asset will directly impact on equity (except if it reverses a previous loss) and a loss will be accounted through the income statement.
  25. 25  See Section 6.22/ (b).

In this section, we will gradually introduce more aspects of financial analysis, including how to analyse wealth creation, investments (either in working capital or capital expenditure), their financing and profitability. But first we need to look at how to carry out an economic and strategic analysis of a company.

Opening up the toolbox

Before embarking on an examination of a company’s accounts, readers should take the time to:

  • carry out a strategic and economic assessment, paying particular attention to the characteristics of the sector in which the company operates, the quality of its positions and how well its production model, distribution network and ownership structure fit with its business strategy, as well as its environmental, social and governance policies (ESG, see Chapter 1);
  • carefully read and critically analyse the auditors’ report and the accounting rules and principles adopted by the company when preparing its accounts. These documents describe how the company’s economic and financial situation is translated by means of a code (i.e. accounting) into tables of figures (accounts).

Since the aim of financial analysis is to portray a company’s economic reality by going beyond just the figures, it is vital to think about what this reality is and how well it is reflected by the figures before embarking on an analysis of the accounts. Otherwise, the resulting analysis may be sterile, overly descriptive and contain very little insight. It would not identify problems until they have shown up in the numbers, i.e. after they have occurred and when it is too late for investors to sell their shares or reduce their credit exposure.

Once this preliminary task has been completed, readers can embark on the standard course of financial analysis that we suggest and use more sophisticated tools, such as credit scoring and ratings.

But first and foremost, we need to deal with the issue of what financial analysis actually is.

Section 8.1 WHAT IS FINANCIAL ANALYSIS?

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.

Section 8.2 ECONOMIC ANALYSIS OF COMPANIES

An economic analysis of a company does not require cutting-edge expertise in industrial economics or encyclopaedic knowledge of economic sectors. Instead, it entails straightforward reasoning and a good deal of common sense, with an emphasis on:

  • analysing the company’s market and its position within its market;
  • studying its production model;
  • analysing its distribution networks;
  • identifying what motivates the company’s key people.
  • and, lastly, analysing the company’s ESG policy.

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.

(a) What is a market?

First of all, a market is not an economic sector as statistics institutes, central banks or professional associations would define it. Markets and economic sectors are two completely separate concepts.

What is the market for pay-TV operators such as Netflix, Sky, HBO or Canal+? It is the entertainment market, not just the TV market. Competition comes from cinema multiplexes, DVDs and live sporting events rather than from ITV, RTL TV, CBS or TF1, which mainly sell advertising slots to advertisers seeking to target the legendary housewife below 50 years of age.

So what is a market? A market is defined by consistent behaviour, e.g. a product or service satisfying similar needs, purchased through a similar distribution network by the same customers.

Once a market has been defined, it can then be segmented using geographical (i.e. local, regional, national, worldwide) and sociological (luxury, mid-range, entry-level products) variables. This is also an obvious tactic adopted by companies seeking to gain protection from their rivals. If such a tactic succeeds, a company will create its own market in which it reigns supreme. Nestlé, with its Nespresso machines and capsules, has created something unique which is more than just a product or a service but a combination of both. But before readers get carried away and rush off to create their very own market arenas, it should be remembered that a market always comes under threat sooner or later – think about the BlackBerry and smartphones.

Segmenting markets is never a problem for analysts, but it is vital to get the segmentation right! To say that a manufacturer of running shoes has a 30% share of the German running shoe market may be correct from a statistical standpoint but is totally irrelevant from an economic standpoint, because this is a worldwide market with global brands backed by marketing campaigns featuring international champions. Conversely, a 40% share of the northern Swiss cement market is a meaningful number, because cement is a heavy product with a low unit value that cannot be stored for long and is not usually transported more than 150–200 km from the cement plants.

(b) Market growth

Once a financial analyst has studied and defined a market, the natural reflex is then to attempt to assess the growth opportunities and identify the risk factors. The simplest form of growth is organic volume growth, i.e. selling more and more products or services.

That said, it is worth noting that volume growth is not always as easy as it may sound in developed countries given weak demographic growth (e.g. between −0.5% and +1% p.a. in Europe). Booming markets do exist (Internet of Things), but others are rapidly contracting (coal power plants, magazines) or are cyclical (transportation, paper production).

At the end of the day, in mature countries, the most important type of growth is value growth. Let’s imagine that we sell a product satisfying a basic need, such as bread. Demand does not grow much and, if anything, appears to be declining. So we attempt to move upmarket by means of either marketing or packaging, or by innovating. As a result, we decide to switch from selling bread to providing a whole range of speciality products, such as baguettes, rye bread and farmhouse loaves, and we start charging €1.10 or even €1.30, rather than €0.90 per item. The risk of pursuing this strategy is that our rivals may react by focusing on a narrow range of straightforward, unembellished products that sell for less than ours, e.g. a small shop that bakes pre-prepared dough in its ovens or the in-store bakeries at food superstores.

Once we have analysed the type of growth, we need to attempt to predict its duration, and this is no easy task. The famous 17th-century letter writer Mme de Sévigné once forecast that coffee was just a fad and would not last for more than a week. At the other end of the spectrum, it is not uncommon to hear entrepreneurs claiming that their products will revolutionise consumers’ lifestyles and even outlast the wheel!

Growth drivers in a developed economy are often highly complex. They may include:

  • technological advances, new products (e.g. robot vacuum cleaners);
  • changes in the economic situation (e.g. expansion of cruises with the rise in living standards);
  • changes in consumer lifestyles (e.g. food delivery services);
  • changing fashions (e.g. Prosecco);
  • demographic trends (e.g. popularity of cruises owing to the ageing of the population);
  • environmental considerations (e.g. electric cars, solar power);
  • delayed uptake of a product (e.g. mobile banking in Africa where the retail banking network is limited).

In its early days, the market evolves rapidly, as products are still poorly geared to consumers’ needs. During the growth phase, the technological risk has disappeared, the market has become established and expands rapidly, being fairly insensitive to fluctuations in the economy at large. As the market reaches maturity, sales become sensitive to ups and downs in general economic conditions. And as the market ages and goes into decline, price competition increases, and certain market participants fall by the wayside. Those that remain may be able to post very attractive margins, and no more investment is required.

Lastly, readers should note that an expanding sector is not necessarily an attractive sector from a financial standpoint. Where future growth has been over-estimated, supply exceeds demand, even when growth is strong, and all market participants lose money (e.g. the 3D printer industry). Conversely, tobacco, which is one of the most mature markets in existence, generates a very high level of return on capital employed for the last few remaining companies operating in the sector.

(c) Market risk

Market risk varies according to whether the product in question is original equipment or a replacement item. A product sold as original equipment will seem more compelling in the eyes of consumers who do not already possess it. And it is the role of advertising to make sure this is how they feel. Conversely, should consumers already own a product, they will always be tempted to delay replacing it until their conditions improve and thus will spend their limited funds on another new product. Needs come first! Put another way, replacement products are much more sensitive to general economic conditions than original equipment. For instance, sales in the European truck industry beat all existing records in 2007 when the economy was in excellent shape, before plunging due to very poor economic conditions in 2009 (–50%), then recovering slightly in 2011–2014 and more markedly since 2015 and falling back again drastically (–30%) in 2020 and recovering in 2021.

With this in mind, it is vital for an analyst to establish whether a company’s products are acquired as original equipment or as part of a replacement cycle because this directly affects the company’s sensitivity to general economic conditions.

All too often we have heard analysts claim that a particular sector, such as the food industry, does not carry any risk (because we will always need to eat!). These analysts either cannot see the risks or they disregard them. Granted, we will always need to eat and drink, but not necessarily in the same way. For instance, organic food consumption is on the increase, meat consumption is declining and consumption of vegetable proteins is growing fast.

Risk also depends on the nature of barriers to entry to the company’s market and whether or not alternative products exist. Nowadays barriers to entry tend to weaken constantly owing to:

  • a powerful worldwide trend towards deregulation (there are fewer and fewer monopolies, e.g. in railways and postal services);
  • technological advances (and in particular the Internet, e-commerce marketplaces…);
  • a strong trend towards internationalisation.

All these factors have increased the number of potential competitors and made the barriers to entry erected by existing players far less sturdy.

For instance, the five record industry majors – Sony, Bertelsmann, Universal, Warner and EMI – had achieved worldwide domination of their market, with a combined market share of 80%. Nevertheless, they have seen their grip loosened by the development of the Internet (Spotify, Apple Music) and artists’ ability to sell their products directly to consumers through music downloads – not to mention the impact of piracy!

(d) Market share

The position held by a company in its market is reflected by its market share, which indicates the share of business in the market (in volume or value terms) achieved by the company.

A company with substantial market share has the advantages of:

  • some degree of loyalty among its customers, who regularly make purchases from the company. As a result, the company reduces the volatility of its business;
  • a strong bargaining position vis-à-vis its customers and suppliers. Mass retailers in the UK are a perfect example of this;
  • an attractive position, which means that any small producer wishing to put itself up for sale, any inventor of a new product or new technique or any talented new graduate will usually come to see this market leader first, because a company with a large market share is a force to be reckoned with in its market.

That said, just because market share is quantifiable does not mean that the numbers are always relevant. For instance, market share is meaningless in the construction and public works market (and indeed is never calculated). Customers in this sector do not renew their purchases on a regular basis (town halls, swimming pools and roads have a long useful life). Even if they do, contracts are awarded through a bidding process, meaning that there is no special link between customers and suppliers. Likewise, building up market share by slashing prices without being able to hold onto the market share accumulated after prices are raised again is pointless. This inability demonstrates the second limit on the importance of market share: the acquisition of market share must create value, otherwise it serves no purpose.

Lastly, market share is not the same as size. For instance, a large share of a small market is far more valuable than middling sales in a vast market.

(e) The competition

If the market is expanding, it is better to have smaller rivals than several large ones with the financial and marketing clout to cream off all the market’s expansion. Where possible, it is best not to try to compete against the likes of Google. Conversely, if the market has reached maturity, it is better for the few remaining companies that have specialised in particular niches to be faced with large rivals that will not take the risk of attacking them because the potential gains would be too small. Conversely, a stable market with a large number of small rivals frequently degenerates into a price war that drives some players out of business.

But since a company cannot choose its rivals, it is important to understand what drives them. Some rivals may be pursuing power or scale-related targets (e.g. biggest turnover in the industry) that are frequently far from profitability targets. Consequently, it is very hard for groups pursuing profitability targets to grow in such conditions. So how can a company achieve profitability when its main rivals, e.g. farming cooperatives in the canned vegetables sector, are not profit-driven? It is very hard indeed because it will struggle to develop, since it will generate weak profits and thus have few resources at its disposal.

(f) How does competition work?

Roughly speaking, competition is driven either by prices or by products:

  • Where competition is price-driven, pricing is the main – if not the only – factor that clinches a purchase. Consequently, costs need to be kept under tight control so that products are manufactured as cheaply as possible, product lines need to be streamlined to maximise economies of scale and the production process needs to be automated as far as possible. Market share is a key success factor since higher sales volumes help keep down unit costs (see Boston Consulting Group’s famous experience curve, which shows that unit costs fall by 20% when total production volumes double in size). This is where engineers and financial controllers are most at home! It applies to markets such as petrol, milk, phone calls, and so on. Incumbents beware, however, as new technological advances such as 3D printing can upset the market equilibrium currently dependent on volume maximisation to drive costs lower, by enabling low volume production at low cost, thereby enabling greater production optimisation and further cost efficiencies.
  • Where competition is product-driven, customers make purchases based on after-sales service, quality, image, etc., which are not necessarily price-related. Therefore, companies attempt to set themselves apart from their rivals and pay close attention to their sales and customer loyalty techniques. This is where the marketing specialists are in demand! Think about Nespresso’s quality of product and service, Harrods’ atmosphere or, of course, Apple.

The real world is never quite as simple, and competition is rarely only price- or product-driven but is usually dominated by one or the other or maybe even a combination of both, e.g. vitamin-enhanced milk, or the premium fuel that protects your engine.

2/ PRODUCTION

(a) Value chain

A value chain comprises all the companies involved in the manufacturing process, from the raw materials to the end product. Depending on the exact circumstances, a value chain may encompass the extraction and processing of raw materials, R&D, secondary processing, trading activities, a third or fourth processing process, further trading and lastly the end distributor. Increasingly in our service-oriented society, grey matter is the raw material, and processing is replaced by a series of services involving some degree of added value, with distribution retaining its role.

The point of analysing a value chain is to understand the role played by the market participants, as well as their respective strengths and weaknesses. Naturally, in times of crisis, all participants in the value chain come under pressure. But some of them will suffer more than others, and some may even disappear altogether because they are structurally in a weak position within the value chain. Analysts need to determine where the structural weaknesses lie. They must be able to look beyond good performance when times are good, because it may conceal such weaknesses. Analysts’ ultimate goal is to identify where not to invest or not to lend within the value chain.

(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:

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.

The natural tendency for all industries is to evolve gradually, mirroring trends in the motor industry during the 20th century.

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.

Source: Modified from Utterback and Abernathy 1975

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.

(a) Shareholders

From a purely financial standpoint, the most important men and women of a company are its shareholders. They appoint its executives and determine its strategy. It is important to know who they are and what their aims are, as we will see in Chapter 41. There are two types of shareholder, namely inside and outside shareholders.

Inside shareholders are shareholders who also perform a role within the company, usually with management responsibilities. This fosters strong attachment to the company and sometimes leads to the pursuit of scale-, power- and prestige-related objectives that may have very little to do with financial targets. Outside shareholders do not work within the company and behave in a purely financial manner.

What sets inside shareholders apart is that they assume substantial personal risks because both their assets and income are dependent on the same source, i.e. the company. Consequently, inside shareholders usually pay closer attention than a manager who is not a shareholder and whose wealth is only partly tied up in the company. Nonetheless, the danger is that inside shareholders may not take the right decisions, e.g. to shut down a unit, dispose of a business or discontinue an unsuccessful diversification venture, owing to emotional ties or out of obstinacy. The Viacom Group would probably have fared better during the 2010s had the group’s founder not clung on to his position as executive chairman well into his nineties.

Outside shareholders have a natural advantage. Because their behaviour is guided purely by financial criteria, they will serve as a very useful touchstone for the group’s strategy and financial policy. That said, if the company runs into problems, they may act very passively and show a lack of resolve that will not help managers very much.

Analysts should watch out for conflicts among shareholders that may paralyse the normal life of the company. Telecom Italia’s recovery has undoubtedly been slowed down since 2018 by the battle between its two main shareholders (Bolloré and the activist fund Elliott) and the frequent management changes that this has brought about.

(b) Managers

It is important to understand the managers’ objectives and attitude vis-à-vis shareholders. The reader needs to bear in mind that the widespread development of share-option-based incentive systems in particular has aligned the managers’ financial interests with those of shareholders. We will examine this topic in greater depth in Chapter 26.

We would advise readers to be very cautious where incentive systems have been extended to include the majority of a company’s employees. Firstly, performance-based shares cannot yet be used to buy food or pay rents and so salaries must remain the main source of income for unskilled employees. Secondly, should a company’s position start to deteriorate, its top talent will be fairly quick to jump ship after having sold their performance-based shares before they become worthless. Those that remain on board may fail to grasp what is happening until it is too late, thereby losing precious time. This is what happened to so-called new economy companies, which distributed stock options as a standard form of remuneration. It is an ideal system when everything is going well, but highly dangerous in the event of a crisis because it exacerbates the company’s difficulties.

(c) Corporate culture

Corporate culture is probably very difficult for an outside observer to assess. Nonetheless, it represents a key factor, particularly when a company embarks on acquisitions or diversification ventures. A monolithic and highly centralised company with specific expertise in a limited number of products will struggle to diversify its businesses because it will probably seek to apply the same methods to its target, thereby disrupting the latter’s impetus.

Thus, the takeover of Marionnaud, a family\ePubPageBreak?> business in the distribution of perfumes, by a Hong Kong conglomerate was a failure (Séphora has since become the market leader), because the latter’s authoritarian culture was not very suitable for what has historically been a group of small merchants at heart.

On the other hand, the Despature family has successfully transformed its activities from the manufacture and distribution of Damart knitwear to the automation and motorisation of gates, doors and windows, Somfy. Its CEO had the intelligence to understand that for his situation he needed engineers and not marketing experts to manage this diversification, which has gradually become the group’s core activity.

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.

Section 8.3 AN ASSESSMENT OF A COMPANY’S ACCOUNTING POLICY

We cannot overemphasise the importance of analysing the auditors’ report and considering the accounting principles adopted before embarking on a financial analysis of a group’s accounts based on the guide that we will present in Section 8.4.

If a company’s accounting principles are in line with practices, then readers will be able to study the accounts with a fairly high level of assurance about their relevance, i.e. their ability to provide a decent reflection of the company’s economic reality.

Conversely, if readers detect anomalies or accounting practices that depart from the norm, then there is little need to examine the accounts because they provide a distorted picture of the company’s economic reality. In such circumstances, we can only advise the lender not to lend or to dispose of its loans as soon as possible and the shareholder not to buy shares or to sell any already held as soon as possible. A company that adopts accounting principles that deviate from the usual standards does not do so by chance. In all likelihood the company will be seeking to window-dress a fairly grim reality.

Section 8.4 STANDARD FINANCIAL ANALYSIS PLAN

Experience has taught us that novices are often disconcerted when faced with the task of carrying out their first financial analysis because they do not know where to start and what to aim for. They risk producing a collection of mainly descriptive comments without connecting them or verifying their internal consistency, i.e. without establishing any causal links, or mindlessly calculating a series of ratios without understanding the logic and rationale behind them.

A financial analysis is an investigation that must be carried out in a logical order. It comprises parts that are interlinked and should not therefore be carried out in isolation. Financial analysts are detectives, constantly on the lookout for clues, seeking to establish a logical sequence, as well as looking for any disruptive factor that may be a prelude to problems in the future. The questions they most often need to ask are “Is this logical? Is this consistent with what I have already found? If so, why? If not, why not?”

We suggest that readers remember the following sentence, which can be used as the basis for all types of financial analysis:

Let us analyse this sentence in more depth. A company will be able to remain viable and ultimately survive only if it manages to find customers ready to buy its goods or services in the long term at a price that enables it to post a sufficient operating profit. This forms the base for everything else. Consequently, it is important to look first at the structure of the company’s earnings. But the company needs to make capital expenditures to start operations: acquiring equipment, buildings, patents, subsidiaries, etc. (which are fixed assets) and setting aside amounts to cover working capital. Fixed assets and working capital jointly form its capital employed. Naturally, these outlays will have to be financed either through equity or bank loans and other borrowings.

Once these three factors (margins, capital employed and financing) have been examined, the company’s profitability, i.e. its efficiency, can be calculated, in terms of either its return on capital employed (ROCE) or its return on equity (ROE). This marks the end of the analyst’s task and provides the answers to the original questions, i.e. Is the company able to honour the commitments it has made to its creditors? Is it able to create value for its shareholders?

Consequently, we have to study the company’s:

  • wealth creation, by focusing on:
    • trends in the company’s sales, including an analysis of both prices and volumes. This is a key variable that sets the backdrop for a financial analysis. An expanding company does not face the same problems as a company in decline, in a recession, pursuing a recovery plan or experiencing exponential growth;
    • the impact of business trends, the strength of the cycle and its implications in terms of volumes and prices (gap vs. those seen at the top or bottom of the cycle);
    • trends in margins and particularly the EBITDA and EBIT margins;
    • an examination of the scissors effect (see Chapter 9) and the operating leverage (see Chapter 10), without which the analysis is not very robust from a conceptual standpoint.
  • capital employed policy, i.e. capital expenditure and working capital (see Chapter 11);
  • financing policy: This involves examining how the company has financed capital expenditure and working capital either by means of debt, equity or internally generated cash flow. The best way of doing so is to look at the cash flow statement for a dynamic analysis and the balance sheet for a snapshot of the situation at the company’s year end (see Chapter 12).
  • profitability by:
    • analysing its ROCE and ROE, leverage effect and associated risk (see Chapter 13);
    • comparing actual profitability with the required rate of return (on capital employed or by shareholders) to determine whether the company is creating value and whether the company is solvent (see Chapter 14).

In the following chapters we use the case of the ArcelorMittal group as an example of how to carry out a financial analysis.

ArcelorMittal is the world’s largest steel group. It employs 168,000 people and recorded sales of $53,270m in 2020.

Annual reports of ArcelorMittal from 2012 to 2018 are available on the website, www.vernimmen.com.

Let’s now see the various different techniques that can be used in financial analysis.

Section 8.5 THE VARIOUS TECHNIQUES OF FINANCIAL ANALYSIS

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.

Section 8.6 RATINGS

Credit ratings are the result of a continuous assessment of a borrower’s solvency by a specialised agency (mainly Standard & Poor’s, Moody’s, Fitch, Scope), or by banks for internal purposes to ensure that they meet prudential ratios and by credit insurers (e.g. Euler Hermes, Ellisphere). As we shall see in Chapter 20, this assessment leads to the award of a rating reflecting an opinion about the risk of a borrowing. The financial risk derives both from:

  • the borrower’s ability to honour the stipulated payments; and
  • the specific characteristics of the borrowing, notably its guarantees and legal characteristics.

The rating is awarded at the end of a fairly lengthy process. Rating agencies assess the company’s strategic risks by analysing its market position within the sector (market share, industrial efficiency, size, quality of management, etc.) and by conducting an analysis of the financials. That is to say, by conducting a financial analysis as we have presented it.

The main aspects considered include trends in the operating margin, trends and sustainability of return on capital employed, analysis of capital structure (and notably coverage of financial expense by operating profit and coverage of net debt by cash generated by operations or cash flow). We will deal with these ratios in more depth in Chapters 9 to 14.

ESG rating is becoming increasingly important. It can be independent, but is increasingly integrated with financial ratings by the major rating agencies.

Let us now deal with what may be described as “automated” financial analysis techniques, which we will not return to again.

Section 8.7 SCORING TECHNIQUES

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, Ri the ratios, betai the relative weighting applied to ratio Ri 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.

Section 8.8 ARTIFICIAL INTELLIGENCE APPLIED TO FINANCIAL ANALYSIS

For several decades now, attempts have been made to automate financial analysis in a more sophisticated way than via a linear equation (score method). What is now called artificial intelligence (AI) applied to financial analysis was called neural networks or expert systems a few years ago. But the use of algorithms to detect business failures comes up against the psychological barrier of potentially far-reaching decision-making occurring, given the amounts involved, without being able to understand the analysis carried out by the machine.

To our knowledge, today, AI is only used in practice for rating individuals (mainly consumer loans). It remains a research area for corporate finance.

SUMMARY

QUESTIONS

EXERCISES

ANSWERS

BIBLIOGRAPHY

NOTE

  1. 1   That is, earn a rate of return higher than justified by risk. See Chapter 26.

If financial analysis were a puppet, company strategy would be pulling its strings

An analysis of a company’s margins is the first step in any financial analysis. It is a key stage because a company that does not manage to sell its products or services for more than the corresponding production costs is clearly doomed to fail. But, as we shall see, positive margins are not sufficient on their own to create value or to escape bankruptcy.

Net income is what is left after all the revenues and charges shown on the income statement have been taken into account. Readers will not therefore be very surprised to learn that we will not spend too much time on analysing net income as such. A company’s performance depends primarily on its operating performance, which explains why recurring operating profit (or EBIT) is the focus of analysts’ attention. Financial and non-recurrent items are regarded as “inevitable” or “automatic” and thus less interesting, particularly when it comes to forecasting a company’s future prospects.

The first step in margin analysis is to examine the accounting practices used by the company to draw up its income statement. We dealt with this subject in Chapter 8 and shall not restate it here, except to stress how important it is. Given the emphasis placed by analysts on studying operating profit, there is a big temptation for companies to present an attractive recurring operating profit by transferring operating charges to financial or non-recurring items (or a “non-current” category in IFRS).

The next stage involves a trend analysis based on an examination of the revenues and charges that determined the company’s operating performance. This is useful only insofar as it sheds light on the past to help predict the future. Therefore, it is based on historical data and should cover several financial years. Naturally, this exercise is based on the assumption that the company’s business activities have not altered significantly during the period under consideration.

The main potential pitfall in this exercise is adopting a purely descriptive approach, without much or any analytical input, e.g. statements such as “personnel cost increased by 10%, rising from 100 to 110…”.

Margin trends are a reflection of a company’s:

  • strategic position, which may be stronger or weaker depending on the scissors effect; and
  • risk profile, which may be stronger or weaker depending on the breakeven effect that we will examine in Chapter 10.

As we saw in Chapter 8, analysing a company’s operating profit involves assessing what these figures tell us about its strategic position, which directly influences the size of its margins and its profitability:

  • a company lacking any strategic power will, sooner or later, post a poor, if not negative, operating performance;
  • a company with strategic power will be more profitable than the other companies in its business sector.

In our income statement analysis, our approach therefore needs to be far more qualitative than quantitative.

Section 9.1 HOW OPERATING PROFIT IS FORMED

By-nature format income statements (raw material purchases, personnel cost, etc.), which predominate in Continental Europe, provide a more in-depth analysis than the by-function format developed in the Anglo-Saxon tradition of accounting (cost of sales, selling and marketing costs, research and development costs, etc.). Granted, analysts only have to page through the notes to the accounts for the more detailed information they need to get to grips with. In most cases, they will be able to work back towards EBITDA1 by using the depreciation and amortisation data that must be included in the notes or in the cash flow statement.

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).

Sector200520102015201620172018201920202021e2022e
Aerospace & Defence7%5%7%8%7%9%8%4%7%9%
Automotive5%7%7%7%7%7%7%4%7%8%
Beverages19%23%24%24%25%25%24%22%23%23%
Building Materials12%9%10%11%11%11%11%11%12%13%
Business Services7%7%8%8%8%8%8%7%8%9%
Capital Goods5%10%10%10%10%10%10%9%10%12%
Chemicals12%13%13%14%14%14%13%13%14%15%
Consumer Goods10%11%11%11%11%11%11%10%11%11%
Food & HPC13%15%16%16%17%17%17%17%17%17%
Food Retail4%5%3%3%3%3%3%3%3%4%
General Retail12%12%9%9%8%8%8%5%8%9%
IT Hardware13%11%12%8%11%10%12%15%14%17%
IT Services6%9%9%11%12%12%13%11%14%16%
Leisure & Hotels7%6%8%8%8%7%7%-2%2%6%
Luxury Goods14%19%18%18%19%21%21%16%21%22%
Media16%18%18%16%16%16%15%14%15%16%
Medtech & Services7%14%15%16%16%16%16%14%16%16%
Mining28%19%6%11%13%13%12%18%20%17%
Oil & Gas14%10%3%3%7%9%8%5%7%10%
Paper & Packaging14%7%8%10%11%13%12%11%12%13%
Software28%31%28%28%25%27%25%25%22%23%
Steel9%4%3%5%6%6%2%-3%5%6%
Telecom Operators19%17%13%13%14%13%13%13%14%15%
Transport & Infrastructure7%8%8%9%9%8%8%0%6%9%
Utilities15%13%9%10%9%10%11%10%11%11%

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.

Sector200520102015201620172018201920202021e2022e
Aerospace & Defence10%8%10%11%10%12%12%9%11%13%
Automotive10%10%11%11%11%11%11%9%12%13%
Beverages25%29%30%29%31%31%31%30%30%30%
Building Materials16%14%14%15%15%15%16%16%17%18%
Business Services9%10%11%11%11%11%12%11%12%13%
Capital Goods8%13%12%12%12%12%13%12%14%15%
Chemicals17%18%18%19%20%19%19%21%20%21%
Consumer Goods14%14%14%14%15%14%14%14%15%15%
Food & HPC16%18%19%19%20%21%21%21%21%21%
Food Retail6%7%5%5%5%6%7%7%7%7%
General Retail15%16%12%12%11%11%13%12%14%15%
IT Hardware18%13%15%11%14%13%17%20%19%22%
IT Services8%11%12%13%14%15%17%16%18%20%
Leisure & Hotels11%9%10%10%10%10%12%7%10%12%
Luxury Goods17%23%23%23%24%25%30%29%32%32%
Media21%23%22%20%20%20%21%20%21%22%
Medtech & Services12%18%19%19%20%20%22%21%22%23%
Mining35%23%14%19%19%19%18%26%27%24%
Oil & Gas16%16%14%13%15%15%16%18%17%19%
Paper & Packaging25%14%13%16%16%19%18%18%19%19%
Software29%33%31%31%29%31%29%30%26%28%
Steel13%9%7%9%10%10%6%2%9%10%
Telecom Operators35%32%28%29%30%30%33%35%35%36%
Transport & Infrastructure12%14%14%14%14%14%16%10%15%17%
Utilities22%20%15%17%16%18%20%19%20%20%

Source: Exane BNP Paribas

Section 9.2 HOW OPERATING PROFIT IS ALLOCATED

EBIT is divided up among the company’s providers of funds: financial earnings for the lenders, net income for the shareholders and corporation tax for the government, which although it does not provide funds, creates and maintains infrastructure and a favourable environment; without forgetting non-recurrent items.

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.

Section 9.3 STANDARD INCOME STATEMENTS (INDIVIDUAL AND CONSOLIDATED ACCOUNTS)

The following tables show two model income statements. The first has been adapted to the needs of non-consolidated (individual) company accounts and is based on the by-nature format. The second is based on the by-function format as it is used in the ArcelorMittal group’s consolidated accounts.

BY-NATURE INCOME STATEMENT – INDIVIDUAL COMPANY ACCOUNTS

Periods201820192020
NET SALES   
+ Changes in inventories of finished goods and work in progress
+ Production for own use
   
PRODUCTION   
− Raw materials used
− Cost of goods for resale sold
= GROSS MARGIN or GROSS TRADING PROFIT
− Other purchases and external charges
   
VALUE ADDED   
− Personnel cost (incl. employee profit-sharing and incentives)
− Taxes other than on net income
+ Operating subsidies
− Change in operating provisions5
+ Other operating income and cost
   
EBITDA   
− Depreciation and amortisation   
EBIT (OPERATING PROFIT) (A)   
Financial expense
− Financial income
− Net capital gains/(losses) on the disposal of marketable securities
+ Change in financial provisions
   
NET FINANCIAL EXPENSE (B)
(A) − (B) = PROFIT BEFORE TAX AND NON-RECURRING ITEMS
   
+/− Non-recurring items including impairment losses on fixed assets
− Corporate income tax
NET INCOME (net profit)
   

BY-FUNCTION INCOME STATEMENT – CONSOLIDATED ACCOUNTS

 20162017201820192020
 M$%M$%M$%M$%M$%
NET SALES56,791100.0%68,679100.0%76,033100.0%70,615100.0%53,270100.0%
− Cost of sales50,22388.4%60,87688.6%67,02588.2%67,05895.0%50,79795.4%
= GROSS MARGIN6,56811.6%7,80311.4%9,00811.8%3,5575.0%2,4734.6%
− Selling and marketing costs6image2,2023.9%2,3693.4%2,4693.2%2,3553.3%2,0223.8%
− General and administrative costs6
± Other operating income and expense6
= RECURRING OPERATING PROFIT4,3667.7%5,4347.9%6,5398.6%1,2021.7%4510.8%
− Net financial expenses2,0563.6%8751.3%2,2102.9%1,5542.2%1,1902.2%
= CURRENT PROFIT BEFORE TAX2,3104.1%4,5596.6%4,3295.7%(352)−0.5%(739)−1.4%
± Income from associates6151.1%4480.7%6520.9%3470.5%2340.4%
± Non-recurring items(205)−0.4%0.0% 0.0%(1,927)−2.7%1,5933.0%
− Goodwill depreciation0.0%0.0% 0.0% 0.0% 0.0%
− Income Tax9861.7%4320.6%(349)−0.5%4590.7%1,6663.1%
= Net PROFIT1,7343.1%4,5756.7%5,3307.0%(2,391)−3.4%(578)−1.1%
− Minority interests(45)−0.1%70.0%1810.2%630.1%1550.3%
= NET PROFIT ATTRIBUTABLE TO SHAREHOLDERS1,7793.1%4,5686.7%5,1496.8%(2,454)−3.5%(733)−1.4%
Employees199,000 197,000 209,000 191,000 168,000 

Lines in blue are found only in consolidated accounts.

Section 9.4 FINANCIAL ASSESSMENT

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.

(b) Regulatory changes

These are controls imposed on a company by an authority (usually the government) that generally restricts the “natural” direction in which the company is moving. Examples include an aggressive devaluation, the introduction of a shorter working week or measures to reduce the opening hours of shops.

(c) External factors

Like regulatory changes, these are imposed on the company. That said, they are more common and are specific to the company’s sector of activity, e.g. pressures in a market, arrival (or sudden reawakening) of a very powerful competitor or changes to a collective bargaining agreement.

(d) Pre-emptive action

Pre-emptive action is where a company immediately reflects expectations of an increase in the cost of a production factor by charging higher selling prices. This occurs in the champagne sector where the build-up of pressure in the raw materials market following a poor grape harvest very soon leads to an increase in prices per bottle. Such action is taken even though it will be another two or three years before the champagne comes onto the marketplace.

(e) Inertia effects

Inertia effects are much more common than those we have just described, and they work in the opposite direction. Owing to inertia, a company may struggle to pass on fluctuations in the cost of its production factors by upping its selling prices. For instance, in a sector that is as competitive and has such low barriers to entry as the road haulage business, there is usually a delay before an increase in diesel fuel prices is passed on to customers in the form of higher shipping charges.

(f) Inflation effects

Inflation distorts company earnings because it acts as an incentive for overinvestment and overproduction, particularly when it is high (e.g. during the 1970s and the early 1980s). A company that plans to expand the capacity of a plant four years in the future should decide to build it immediately; it will then save 30–40% of its cost in nominal terms, giving it a competitive advantage in terms of accounting costs. Building up excess inventories is another temptation in high-inflation environments because time increases the value of inventories, thereby offsetting the financial expense involved in carrying them and giving rise to inflation gains in the accounts.

Inflation gives rise to a whole series of similar temptations for artificial gains, and any players opting for a more cautious approach during such periods of madness may find themselves steamrollered out of existence. By refusing to build up their inventories to an excessively high level and missing out on inflation gains, they are unable to pass on a portion of them to consumers, as their competitors do. Consequently, during periods of inflation:

  • depreciation and amortisation are in most cases insufficient to cover the replacement cost of an investment, the price of which has risen;
  • inventories yield especially large nominal inflation gains where they are slow moving.

Deflation leads to the opposite results.

(g) Capital expenditure and restructuring

It is fairly common for major investments (e.g. the construction of a new plant) to depress operating performance and even lead to operating losses during the first few years after they enter service.

For instance, the construction of a new plant generally leads to:

  • additional general and administrative costs such as R&D and launch costs, professional fees, etc.;
  • financial costs that are not matched by any corresponding operating revenue until the investment comes on stream (this is a common phenomenon in the hotel sector given the length of the payback periods on investments). In certain cases, they may be capitalised and added to the cost of fixed assets but this is even more dangerous;
  • additional personnel cost deriving from the early recruitment of line staff and managers, who have to be in place by the time the new plant enters service;
  • lower productivity owing both to the time it takes to get the new plant and equipment running and the inexperience of staff at the new production facilities.

As a result of these factors, some of the investment spending finds its way onto the income statement, which is thus weighed down considerably by the implications of the investment programme.

Conversely, a company may deliberately decide to pursue a policy of underinvestment to enhance its bottom line (so they can be sold at an inflated price) and to maximise the profitability of investments it carried out some time ago. But this type of strategy of maximising margins jeopardises its scope for value creation in the future (it will not create any new product, it will not train sufficient staff to prepare for changes in its business, etc.).

Section 9.5 CASE STUDY: ARCELORMITTAL

Volumes sold by ArcelorMittal were stable from 2016 to 2019 (at 84.6 Mt) but sales varied much more due to variations in the price of steel, and to a lesser extent to the change in scope. This is typical of an industry with high fixed costs in which the slightest imbalance between demand and supply generates major price variations: –10% in 2016, +19% and +13% in 2017 and 2018, –8% in 2019. In 2020 the volumes are down by 18% to 69.1 Mt. This decrease is explained for the most part by the Covid-19 crisis in the first half of 2020, but also for 2.4% by the disposals made by the group. Sales fell by 25%, with prices continuing to fall by 8% in a context of overproduction compared to demand.

The year 2016 marked a turning point compared to the early 2000s with a drop in Chinese steel exports, which was sharply accentuated in 2017, 2018 and then 2019 (62 Mt), under the effect of major capacity reductions, a revival of Chinese domestic demand and the implementation of anti-dumping customs taxes in Europe and the United States. In 2020, the market was totally destabilized by the Covid-19 crisis and the fall in demand.

From 2016 to 2018, ArcelorMittal benefited from a positive scissor effect, the result of the major restructuring undertaken in that year (17% reduction in personnel costs), the evolution of steel sales prices, and its partial integration upstream, which partly protected it from increases in the price of iron ore and coking coal. The operating margin, which was zero in 2015, therefore recovered to 8.6% in 2018.

However, it falls back to 1.7% in 2019 due to a once again negative scissor effect with a stable cost of sales and a 7% decline in sales. The 2019 operating margin is double that of 2015 for identical sales volumes, which shows the productivity gains made. In 2020, ArcelorMittal will save the day by maintaining a marginally positive operating result thanks to drastic cost-cutting measures.

SUMMARY

QUESTIONS

EXERCISES