Management Engineering - Accounting, Finance & Control

Completed notes of the course

Complete course

INDEX 0. Introduction ................................ ................................ ................................ ............................ 4 1. Financial analysis ................................ ................................ ................................ .................... 6 1.1 Sources selection and data “triangulation” ................................ ................................ ...................... 6 1.1.1 Income statement ................................ ................................ ................................ ................................ ............ 8 1.1.2 Balance sheet ................................ ................................ ................................ ................................ ................... 9 1.1.3 Cash flow statement ................................ ................................ ................................ ................................ ...... 11 1.1.4 Changes in equity ................................ ................................ ................................ ................................ ........... 13 1.2 Segmental analysis ................................ ................................ ................................ ........................ 14 1.3 Common size analysis ................................ ................................ ................................ .................... 14 1.4 Benchmarking ................................ ................................ ................................ ............................... 18 1.4.1 Identify strategic objectives ................................ ................................ ................................ ........................... 19 1.4.2 Sample selection ................................ ................................ ................................ ................................ ............ 19 1.4 .3 Involvement modality ................................ ................................ ................................ ................................ .... 20 1.4.4 Performances choice for the comparison ................................ ................................ ................................ ...... 20 1.4.5 Data correction ................................ ................................ ................................ ................................ ............... 20 1.5 Reclassification and adjustments ................................ ................................ ................................ ... 22 1.5.1 Reclassification of the Balance Sheet ................................ ................................ ................................ ............. 22 1.5.2 Reclassification of the income st atement reclassification ................................ ................................ ............. 25 1.5.3 Adjustments ................................ ................................ ................................ ................................ ................... 26 1.6 Exercises on financial statement recap ................................ ................................ .......................... 27 2. Financial Statement Consolidation ................................ ................................ ........................ 31 2.1 What is consolidation ................................ ................................ ................................ .................... 31 2.1.1 Definition of group of companies ................................ ................................ ................................ ................... 31 2.1.2 Group accounting ................................ ................................ ................................ ................................ ........... 32 2.2 When is required ................................ ................................ ................................ ........................... 33 2.2.1 Control ................................ ................................ ................................ ................................ ............................ 33 2.2.2 Joint control ................................ ................................ ................................ ................................ ................... 33 2.3 Full consolidation method (line by line) ................................ ................................ ......................... 34 2.3.1 Pre - consolidation adjustments ................................ ................................ ................................ ...................... 34 2.3.2 Consolidation adjustments ................................ ................................ ................................ ............................. 35 2.4 Equity method ................................ ................................ ................................ ............................... 40 3. Accounting - based indicators ................................ ................................ ................................ .. 41 3.1 Profitability analysis ................................ ................................ ................................ ...................... 41 3.1.1 Shareholders’ perspective ................................ ................................ ................................ .............................. 42 3.1.2 Overall company’s perspective – middle line managers’ perspective ................................ ........................... 43 3.1.3 Stakeholders’ perspective ................................ ................................ ................................ .............................. 46 3.1.4 Risk/Operational Efficiency Matrix ................................ ................................ ................................ ................. 47 3.2 Liquidity analysis ................................ ................................ ................................ ........................... 49 3.2.1 Balance Sheet Perspective ................................ ................................ ................................ ............................. 49 3.2.2 Cash Flow statement perspective ................................ ................................ ................................ .................. 52 3.3 Absolute indicators ................................ ................................ ................................ ....................... 53 3.3.1 Residual income ................................ ................................ ................................ ................................ ............. 53 3.3.2 Cash Flow ROI ................................ ................................ ................................ ................................ ................. 54 3.4 Conclusions ................................ ................................ ................................ ................................ ... 54 4. Cost of capital ................................ ................................ ................................ ....................... 55 4.1 Cost of Equity Ke ................................ ................................ ................................ ........................... 56 4.1.1 Risk free rate rf ................................ ................................ ................................ ................................ ............... 56 4.1.2 Market return rm ................................ ................................ ................................ ................................ ........... 57 4.1.3 Beta levered β L (equity beta) ................................ ................................ ................................ ......................... 58 4.1.4 Case study ................................ ................................ ................................ ................................ ...................... 60 4.2 Cost of the debt Kd ................................ ................................ ................................ ........................ 61 5. Analysis of the Leverage ................................ ................................ ................................ ........ 64 5.1 Du Pont Approach ................................ ................................ ................................ ......................... 65 5.2 Financial Analyst approach ................................ ................................ ................................ ............ 66 5.2.1 Simplified version ................................ ................................ ................................ ................................ ........... 66 5.2.2 Real life version ................................ ................................ ................................ ................................ .............. 67 5.3 Theoretical approach ................................ ................................ ................................ ..................... 67 Exercises on Accounting - based Indicators ................................ ................................ .................. 69 6. Enterprise value (EV ) & Equity value (E) ................................ ................................ ................. 71 6.1 Cash generation cycle ................................ ................................ ................................ .................... 71 6.2 Enterprise value (assets - side perspective) ................................ ................................ ..................... 73 6.3 Equity value (equity side) ................................ ................................ ................................ .............. 75 6.4 Exercise ................................ ................................ ................................ ................................ ......... 77 7. Value dr ivers and scorecards ................................ ................................ ................................ . 79 7.1 Value Drivers ................................ ................................ ................................ ................................ . 79 Performance drivers ................................ ................................ ................................ ................................ ................ 82 Resource drivers ................................ ................................ ................................ ................................ ...................... 84 Key Risk Indicators (KRIs) ................................ ................................ ................................ ................................ ........ 85 Characteristics of value drivers ................................ ................................ ................................ ............................... 85 7.2 Balanced Scorecards ................................ ................................ ................................ ...................... 86 8. Relative valuation ................................ ................................ ................................ ................. 89 8.1 Relative Valuation: main steps ................................ ................................ ................................ ...... 89 8.1.1 Defining comparable companies ................................ ................................ ................................ .................... 89 8.1.2 Defining possible multiples ................................ ................................ ................................ ............................ 90 8.1.3 Analyze multiples ................................ ................................ ................................ ................................ ........... 94 9. Target Setting & Budgeting ................................ ................................ ................................ ... 98 9.1 Plan and control cycle ................................ ................................ ................................ ................... 99 9.2 Budgeting system ................................ ................................ ................................ ........................ 101 9.3 Case study part I: Operating Budgeting ................................ ................................ ........................ 103 9.4 Case study part II: Capital expenditure budgets and Financial budgets ................................ ........ 110 10. Financial Planning ................................ ................................ ................................ ............. 118 10.1 Bank loans (short and long term) ................................ ................................ ............................... 118 10.2 Syndicated bank loans or bridge bank loans (short and long term) ................................ ............ 119 10.3 Corporate bonds (long term) ................................ ................................ ................................ ..... 120 10.4 Leasing (long term) ................................ ................................ ................................ .................... 122 10.5 Factoring (short term) ................................ ................................ ................................ ............... 123 10.6 Lines of credit (short term) ................................ ................................ ................................ ........ 124 11. Management Reporting ................................ ................................ ................................ .... 126 11.1 Definition ................................ ................................ ................................ ................................ .. 127 11.2 Responsibility centers and reporting framework ................................ ................................ ....... 128 11.3 Reporting requirements ................................ ................................ ................................ ............ 130 11.4 How to organize the management reporting process ................................ ................................ . 132 11.5 Reporting at the Corporate level ................................ ................................ ............................... 132 Periodic Management Reporting ................................ ................................ ................................ .......................... 133 12. Management Reporting at the BU level: Transfer Pricing ................................ .................. 134 12.1 The Business Unit Level ................................ ................................ ................................ ............. 134 Two issues to breakdown corporate’s EBIT into business units’ EBIT ................................ ................................ ... 135 12.2 BU exchanges and transfer price ................................ ................................ ................................ 136 Case study on Transfer Prices ................................ ................................ ................................ ............................... 137 12.3 Transfer Pricing methods ................................ ................................ ................................ ........... 139 12.3.1 Market - based transfer prices ................................ ................................ ................................ ..................... 139 12.3.2 Cost - based + markup transfer prices ................................ ................................ ................................ ......... 139 12.3.3 Negotiated transfer prices ................................ ................................ ................................ ......................... 140 12.3.4 Dual transfer prices ................................ ................................ ................................ ................................ .... 140 12.4 Exercise ................................ ................................ ................................ ................................ ..... 141 13. Management reporting at the BU level: Cost Allocation ................................ .................... 144 13.1 Segment Margin ................................ ................................ ................................ ........................ 144 13.2 Corporate Costs ................................ ................................ ................................ ......................... 147 14. Reporting at the Responsibility Centers level ................................ ................................ ..... 150 14.1 Indicators for Responsibility Centers ................................ ................................ ......................... 150 Example ................................ ................................ ................................ ................................ ................................ . 151 14.2 Short case about a Cost Center ................................ ................................ ................................ .. 152 1 4 /09/ 2022 0 . Introduction Financial accounting: • It provides the “numbers” we normally hear about a company (revenues, profit, assets value, ...) : financial accounting enables to beyond the “numbers” and to understand the connection between those numbers . • It is a fundamental part of company evaluation , i.e., it contributes (together with “expectations”) to determine for example: o T he shares’ p rice and market capitalization 1 of a company in the day - by - day trading (financial analysis) . The problem with the stock market is that it is influenced by the environment around the company itself, so it is not strictly connected to how the company is actually doing. o T he target price in an M&A (due diligence) . Ex. Tiffany was evaluated x10 more than what was written on the balance sheet, because of the value of their brand. o T he selling price of shares in an Initial Public Offering IPO (due diligence) o T h e credit stability (rating services) : it talks about the stability of the company. 3 “numbers” that are fundamental in a financial statement: • R evenues -- > understand how big the company is. • N et income -- > how profitable the company is . • C ash from continuous operations -- > how well the company is doing, about the real situation of the company . Cash is important because These numbers give us an initial understanding of a company. Annual report analysis sheds light on certain aspects of the company b ut at the very end is the analyst who has to provide his/her own interpretation. In fact, not all the indicators have the same relevance and indicators pose questions more than providing answers . Ex. Continuous operations = core operations of the compa ny. From this example, we can see that revenues ¯ , net income ­ , cash ¯ -- > controversial numbers , these numbers are just the starting point . 1 Market capitalization = current market price per share * total number of outstanding shares. From this example, we can see that they are making money from the media, rather than from the parks, experiences , etc. So, we could understand where to invest, what to optimize, etc. 1. Financial analysis Financial analysis is a process of selecting, evaluating , and interpreting financial data, along with other pertinent information , in order to formulate an assessment of a company’s present and future financial condition and performance. Inputs of the financial analysis: • Market data : information about the industry in general -- > the environment around the company, including the maj or clients, the economical situation, etc. • Financial disclosures : investor relations (public traded companies are obliged to publish those data, so they can be found on the website of the company ; instead, private companies are not obliged to disclose thes e information ) . • Economic data : economic information about the industry (not sure?) The financial analysis depends on the aim we want to achieve . Financial analysis is more than calculating indicators, and it requires the following steps: 1. Sources selection and data “triangulation” 2. Segmental analysis 3. Common size analysis 4. Reclassification and adjustments 5. Benchmarking 6. Accounting based indicators (selection) 7. Interpretation 1.1 Sources selection and data “triangulation” T riangulation means putting data together : we need to find the information that will help us . Type of information used: • Financial disclosures : consolidated financial statements, shareholder letter and segmental analysis. We could also add all the presentations for the investors. * • Non - financial disclosures : sustainability report and country report. • Market data : market price of stock, volume traded (you can understand how many shareholders are stable , so the volatility of the company or the market ) and value of the bonds . • Industry and economic data : information about the industry in which the company is operating, like the pharmaceutical industry for AstraZeneca . *Financial disclosure: SEC filing is a financial statement submitted to SEC (US Securities and Exchange Commi ssion) by publicly traded corporations. There are different types of formats: o Form 10 - K : audited financial statement. Audited means validated by an audit. o Form 10 - Q: unaudited financial statement . o Form 20 - F : annual financial statement filed by a non - US company that has listed equity shares in the US. POLLEV ABOUT THE FIRST LESSON 1) Financial accounting is a fundamental of company evaluation, what for? a) To determine the price during due diligence for IPO, M&A, shares’ price . b) To acknowledge its credit rating . c) Together with market expectations to see the complete picture at a certain moment . d) All the answers are correct . The major goal of financial accounting is a), specifically when we are talking about overall company evaluation. C) is true because external expectations can have an influence . 2) Financial analysis is triangulation of: a) Market and sustainability data b) Economic data and financial documentation c) Financial, market and economic data d) All the information the financial analysis can find The major information in the triangulation is: financial documentation, market documentation and economic data. D) is not correct because if we use all the information, we can find we will never end. 3) The financial documents are: a) Income s tatement, balance sheet, cash flow statement, changes in equity and notes. 19/09/2022 RECAP OF FINANCIAL STATEMENTS 1.1.1 Income statement The 2 major information are revenues and net profit/income , so we can have an understanding of the dimension and the profitability of the company. The IS is divided into 3 parts: 1. Operations : revenues and cost of sales are due to operations -- > this is the only part that changes based on the type of IS we chose. The application of one method or the other depends on what the company wants to highlight. 2. Financing : financial incomes, financial interests , income from investments, interest payable and similar expenses , income receivables and similar incomes , value adjustments of financial assets, etc. 3. Taxation : taxes . There are 2 alternatives of how to represent information in the IS: by nature, or by function. Method 1: cost of sales (also called “by function”) Costs are provided based on their function, as marketing costs, R&D costs, distribution costs , etc. Companies that provide an IS by function are obliged to provide the disclosure of the costs by nature in the notes. For example, one of the major costs for 3M is R&D costs, so they will probably show t he IS by function. Method 2: by nature Costs are divided based on their nature, as cost of raw materials, cost of staff (wages, etc.), cost of production, etc. If we have depreciation and amortization , they are due to long term assets. For example, b anks show costs by nature. Ex. IS by function Consolidated = means that the financial statement refers to the profit of the whole group (so more than 1 company). When we are consolidating, it means that we are managing the other companies o f the group. Net profit before minority interests = this happens when some businesses of the group are not 100% owned by the group (for example the Barilla group could own only 95% of another company). It is important to compute the net profit before minor ity interests because we need to subtract t he minority interest , so that part of of the profit which will go to the remaining owners of the company. We will talk about it in the lesson about consolidation. Ex. Reclassified consolidated IS by nature EBITDA = proxy of the cash flow if we are talking about an asset company . EBIT = proxy of the cash flow if we are talking about a service company . Ex. A straZeneca, IS by function -- > if we look at the notes, we will also have the disclosure of the costs by nature. Their business is based on R&D -- > significant cost. 1.1.2 Balance sheet The major information are assets, equity , and liabilities . ASSETS = how we are producing . EQUITY + LIABILITIES = how we are financing the production. ASSETS = EQUITY + LIABILITIES ASSETS Non - current assets : long term, over 12 months. • PPE: property, plant , and equipment. • Rights of use : patents, etc. • Intangible assets : not physical assets. • Financial investments • Investment property • Goodwill -- > when we acquire another company, we could have to pay a “ plus ” for the brand’s name, reputation , etc. The goodwill is the difference between the price paid (market price) and the value on the BS. We will talk about it in the lesson about consolidation. Current assets : short term, within 12 months, they could be transformed into money within 12 months. • Cash and cash equivalent • Inventories • Trade r ec eivables • Current f inancial assets EQUITY Shareholders’ rights Equity • Attributable to the parent • Attributable to non - controlling interests Retained earnings (come from the net income from the IS) = sum of all the net income of the previous years LIABILITIES Debt holders’ rights (banks, market, government, employees, suppliers) Non - current liabilities • Lease liability = means that the company is renting something to produce their products • Provisions • Pensions • Financial debt • Tax liabilities Current liabilities • Lease liability • Financial debt • Tax liabilities The assets part of the BS tells us if the company is a production company or a service company : ® If PPE is very high with respect to the other assets -- > production company . Other costs that could be relevant for a production company are patents and intangible assets. Usually, for a company, non - current assets are higher than the current ones. For re - selling companies like Amazon, the current assets can be higher than the non - current assets. POLLEV 1) What can you tell about this company? a) This is a service company, as goodwill is higher than all other voices b) This company produce a product that requires both assets and human resources c) This company lives only through M&A d) This company will fail soon, as the goodwill is higher than PPE D. is wrong because we don’t know anything about the cash so we cannot say if the company will fail only based on the BS. C. is half right, because goodwill is very high so they company is growing through M&A (mergers and acquisitions), but the company does not live only through it. A. is wrong because goodwill does not concern if the company is a production company or a service one. B. is correct because they have high PPE , and they have high intangible assets so they will probably are knowledge - intensive . 2) Shareholders' equity is always placed before liabilities on the statement of financial position (Balance sheet). FALSE, in EU companies we place equity before liabilities (non - current before current), in American companies they start from current liabilities, then noncurrent liabilities, then equity. 1.1. 3 Cash flow statemen t The most important information is the net cash from continuous operations . This could be benchmarked with EBIT (or EBITDA if the company is capital - intensive) because EBIT (or EBITDA) is proxy of the cash. The CF statement is important in the budgeting process because from this document we can see if there are some areas in which we have to i nvest more or less. 3 parts concerning cash in and cash out: 1. Operational : this part could be different + 2. Investments : purchases of PPE, proceeds from sale of equipment + 3. Financing : proceeds from issuance of common stock, of long - term debt, dividends pai d = = Net increase/decrease in cash + Cash at the beginning of the period = Cash at the end of the period (will be written also in the BS in the current assets) 2 methods: direct and indirect -- > difference only in the operational part . It depends on wha t the companies what to show. • Direct flow : cash logic, we record inflows and outflows: so, cash receipts, cash paid to suppliers, employees, interests paid (interests on the debt that we took in order to produce, for example to buy machineries , therefore i s due to production and so it’s inside the operational part ), income tax paid, etc. • Indirect flow : accrual logic, we start from the EBIT ( net profit before interests and taxes , IS), and we make some adjustments: - Gain on sale of facility (different from “proceeds from sale of equipment” because gain on sale of facility was not planned so it is a non - recurring operation) + Depreciation and amortization (due to long term assets) : these are not real cash outflows; we are putting money aside t o make up for the loss of value of our assets. + Provisions for losses on accounts receivable - Increase in trade receivables + Decrease in inventories • Decrease in trade payables POLLEV 1) The company announces great results & an increase in cash. You exami ne the cash flow & see an outflow from operating activities & inflow from investing & financing activities. Does the statement support company's announcement? No, because the inflows of cash do not come from the operating activities, so their recurrent act ivities, but from the financing activities. The company did not good because they do not have an inflow of the operations , which is their core business . 2) LINK BETWEEN FINANCIAL STATEMENTS • Net income from IS goes to the Retained Earnings in the equity part of the BS and also in the CF at the beginning of the operating activities (if the CF is made with the indirect method) . • Long term assets in the BS are connected to the IS by nature and also present in the CF (indirect method) among the operating activities and/or among the investing activities as “capital expenditures”. • Current assets from the asset part in the BS is connected with the beginning cash and the ending cash in the CF . 1.1.4 Changes in equity This document is important for the potential future investors and the shareholders because this document shows them the potential changes in volumes of the shares and estimate if it a safe position for them. Also, this document shows if the company want to diminish or incr ease the n° of stocks on the market. In fact, u sually companies are motivating C - level managers by giving them the “stock option” : they can decide whether to acquire the share or to take a bonus (money). This money will be taken from the retained earnings (so from the “equity” part of the BS). ( This document does not show the price of the shares, which is defined by the market, not by the company . ) We have some information: • Number of shares : • Legal reserve: • Retained earnings: • Stock option reserve • T reasury shares • Non - controlling interests : % of the shares not due to the company POLLEV What would be a company’s ending retained earnings if the following amounts were given: Ending retained earnings = opening retained earnings + income (revenues – tota l expenses) – dividends paid = 6200 + (102500 – 98500) – 5000 = 5200$ Gains from revaluating investments -- > not connected to the changes in equity Issue of shares -- > is not part of the retained earnings, it’s part of the capital 21/09/2022 1. 2 Segmental analysis Once we gathered all the data, we can analyze the company from different perspectives. Whenever we have the consolidated financial statements, we have the “aggregated information” , so we need to be able to take decisions -- > segmental an alysis provide further information that will allow us to take informed decisions. Ex. Segmental analysis of the revenues from a geographical perspective : w here should LVMH develop? Asia, because now it is the biggest portion of their market share (29% of t otal revenue) . Also U nited S tates is quite a big market . We should also have information about the saturation of these markets. Ex . Segmental analysis of the revenues from a sector perspective: w hich sector should we invest in ? We should have more informat ion to answer this question as it depends also on how we imagine the future to be , and not only on the growth of the specific sector . T his table is useful to understand how the company is constructed and how each sector is doing (for example here we don’t have problematic divisions). They actually decided to invest in selective retailing because they believed this would become a very important channel . Ex. Segmental analysis of the revenue s from a sector perspective : Volkswagen group. We can see that s ome divisions are negative (so they are not doing good , like SEAT ) but the group will not close them because they are used for their brand positioning, for the brand picture, not to gain profi t. S egmenta l analysis is crucial whenever we are doing the benchmarking of a company . The more similar the companies, the better the competitor analysis we can make. It is difficult to compare the segment of the companies because companies provide “aggreg ated” data, not data about each sector ( as they are not obliged to publish them) . For example, LVMH can be compared to Kering, however LVMH has some parts that Kering doesn’t have. When choosing a competitor, we should think about the geographical are a an d about the products, are they similar? 1. 3 C ommon size analysis This analysis provides a snapshot of the company and help us to understand many things. This is the first analysis we see, and it is the basis for identification for the real things we have to investigate on. Common - size analysis is the restatement of financial statement information in a standardized form. • Vertical common - size analysis uses the aggregate value in a financial statemen t for a given year as the base, and each account’s amount is restated as a percentage of the aggregate. • Balance sheet: Aggregate amount is total assets. • Income statement: Aggregate amount is revenues or sales. • Horizontal common - size analysis uses the am ounts in accounts in a specified year as the base, and subsequent years’ amounts are stated as a percentage of the base value. Useful when comparing growth of different accounts over time. Usually for both analysis we take 5 years . Vertical common size H orizonal common size or trend analysis APPLIED TO BS, IS (but can also be done for the CF statement) Any document TIME FRAME We analyze 1 specific year , but we compare with what has happened in the previous year s. At least 3 years because we need to look for trends . HOW In the IS, w e take the net sales /revenues as 100%. We transform € in % by dividing each element by the revenues for the IS and the total assets in the BS. We take a certain year as the baseline, so every value of t his year is 100%. O ECTIVE In the IS, we can see which % of the revenues is the net income (usually around 10%). In the BS, we can see the distribution of the assets (which % of the total assets are current, non - current, etc.) . We can compute EBITDA mar gin and EBIT margin (found in IS by nature). We want to see how each voice changes over the years . Ex. Vertical common analysis of an IS It’s important to understand how the company is changing throughout the years: is the company able to minimize some of the crucial points? For example, is the company able to minimize the cost of goods sold? Ex. Vertical common analysis of the BS From the vertical analysis of the assets part of the BS , we can see that: • PPE are increasing so this is good because hopefully (if nothing else changes) it means that we are producing more, so we have more revenues, so more net income. This is a production company (asset - heavy company) and they were able to maintain almost the s ame configuration. This analysis allows us to see if a company has reconfigured its business. Ex. Horizontal analysis of the same BS : we can see the element that has grown the most is PPE (we could see also if the company decreased some assets) -- > we can see the decisions management has taken in those years . Ex. Vertical analysis: the relevance of the industry . Different types of companies have a different distribution of the assets. • ENI: 70% are non - current assets because the company is a production company (they mostly have PPE) . More RIGID company. • Facebook: 50% - 50% because the goodwill is very high (they have acquired many companies). • IMA: 62% are current assets because their business is much faster -- > for them is more important to be E LASTIC. If we look at the incidence of the operating costs : for Facebook, the major cost is R&D; for IMA is raw materials; for ENI is purchases, services and other so they are quite dependent on their supplier. Ex. Vertical analysis The company with the highest income is B (893$). The company in w hic h the net income is a higher % of the net sales is A (A 5,7% - B 4,8% ) , so A is managing better their costs ( it’s more efficient) . Attention: the absolute numbers give us the idea of the dimen sion so when comparing different companies, we should consider that. In fact, bigger companies have to manage more complexity, so they will probably be less efficient. Percentages ( margin ratio indicators) help us compare different companies, but we should not forget the fact that they could have a different dimension. POLLEV 1) The objectives of segment reporting are : a) For a better understanding of the performance and evaluation of the organization’s results b) To provide information to the stakeholders ab out the important units of the organization to evaluate and make decisions about investments c) To analyze the most profitable or less - making units d) To make better decisions by taking in mind the business from different segments e) All of the above 2) Margin ratios are product of: VERTICAL ANALYSIS . 1. 4 Benchmarking Ex. Eni 2017 results -- > positive net profit, so the company is gaining something. B ut how is the company performing ? We don’t have the horizontal common analysis , so we don’t know if in the previous years it was better or no t -- > we could benchmark it, so compare the company with the industry and competitors. ROE = 7% 2 . How can we explain this value? Is this a contingency , is it a market trend? Looking at competitors can be helpful : A lower EBIT and a higher net profit means that the earning coming from operations is not high and a lot of profit comes from non - operating activities (look at TOTAL). Instead, ENI and BP ha ve a higher EBIT than the net profit , so this means that their operations are doing good. According also to the dimension of the company (looking at the total assets), ENI is doing quite well. These companies are also compared based on the ROA because these companies are asset heavy. Ex. Automotive sector. Why Volkswagen had a drop in 2015? They cheated so this led to a drastic situation. So, if we look at trend analysis and competitor analysis we can see if some major events happened. What is benchmarking? It’s a process that companies apply in order to under stand the real performance of the company by comparing it with other companies in the industry. “The continuous process of measuring its own products, services, practices against the toughest competitors or those companies recognized as industry leaders ” . Benchmarking never ... 1) ... ends : it is a continuous process that needs recalibration in the perspective of continuous improvement 2) ... copies : information learned is not copied but adapted to the specificities of context (company’s history, needs, culture, structure, ....) 3) ... cheats : it should be an honest, legal , and virtuous analysis. Benchmarking process 1. Identify strategic objectives : we need to have an idea about what we want to achieve. 2. Sample selection : 5 - 10 competitors is a good number ( with similar strategic objectives) 3. Involvement modality : how do we communicate with competitors. 4. Performances choice for the comparison 5. Data correction 2 ROE = net income/equity. This value takes into account the major investors: shareholders are the most vulnerable of all investors, because if a company goes bankruptcy, they will be the last to be paid. Shareholders look at this value. 1.4.1 Identify strategic objectives 2 perspectives: performance or process. Usually, we do the benchmarking by performance because it’s a little bit easier to calculate the performances, rather than comparing processes . • Performance : we are looking for the best practices in terms of some indicators , like flexibility, timeliness, quality, c osts, etc. We are comparing financial and non - financial indicators. Problems: o No guarantee that the various best practices are comparable o Tradeoff between the benchmarked performances and the others o Possibility of a time lag between performance and processes • Process : comparison of the processes , best practices in terms of organizational structure, responsibilities, technologies , etc . o Processes include a variety of factors, so difficulty of focusing the analysis on competitive differential o Difficulty to link processes and performance 1.4.2 Sample selection Different options exist : 1) Leader Benchmarking : benchmarking on a specific performance or process . We are comparing the company with the leader of the market. • (performance) Fincantieri benchmarked itself against Boeing on its quality - focused strategy • (process) IBM benchmarked itself against Federal Express on its logistics system 2) Sector Benchmarking : benchmarking with companies that act within the same industry . 3) Internal Benchmarking : benchmarking with different units of the same company . The performances that we need to be looking for are those important for the company in terms of how the company will imagine its e l f /want to be in the future. In the case of controlling management , the sector benchmarking is the most suitable approach: reasonable and feasible goals, without being under - stimulating . We are going to compare AstraZeneca mainly based on the financial performance (we could do a leader benchmarking or do a sector analysis compare for example the sustainability). 1.4.3 Involvement modality Two different ways: 1) Unconscious -- > Indirect involvement of competitors (data can be found on external resources) Information is gathered through web sites, publications, magazines, employees, customers and vendors, suppliers, databases, reverse engineering, balance sheets and other institutional public documents. 2) Conscious -- > Direct involvement of the competitors , which provide the needed information . Best and more precise results BUT : n ecessity of the organizations approval and n ecessity of reveal the own data. 1.4.4 Performances choice for the comparison 1) Definition of the scope : identification of the areas of the company that need to be benchmarked . Examples : • Whole company • Some products/services (only finished goods, service features, ...) • Work processes (manufacturing, supply, logistics, ... • Support Functions (HR, Marketing, ...) 2) Definition of the measurement s ystem : definition of indicators for comparison • ROE, ROA, • M ore specific indicators depending on the objectives : like the incidence of intangible assets and the number of patents to understand if the company is innovative, etc. 1.4.5 Data correction The best practices may descend from two different reasons: 1) Better management : to be individualize through benchmarking . 2) Difference in the conditions of the context : to be eliminated to make companies comparable. Factors influencing context include: • Scale ( for example, Barilla and Nestlé: Nestlé is much bigger so we would need to scale it down ) . • Strategy (efficiency vs. effectiveness) (for example mission and vision could be different, so we can look for them in the L etter to the shareholders and stakeholders ). • Market expectations and perception ( difficult to quantify) • Product itself in Leader Benchmarking (for example, different companies could be leaders in different areas, so it could be difficult to compare companies, like Apple and Samsung). Conclusion : the first thing is to identify the strategy of the company and understand which will be the goals. To do so, we should p erform the common analysis to understand the major voices and how the company is constructed -- > this will help in the sample selection to choose the competitors . 26/09/2022 POLLEV 1) Common size analy sis of IS reveals : a) The structure of the company -- > wrong, it is in the BS b) The best performing unit s of the company -- > wrong, we see this in the notes (most likely) c) The dimension of the company -- > wrong, common size analysis is about percentages and % don’t show dimension ( to know the dimension we need the absolute numbers) d) The most important expenses of the company -- > correct , if the IS is by nature 2) Horizontal & vertical analysis : a) I t does not provide us eful managerial information -- > wrong, trends are very important. b) I t is an initial step in a company’s analysis to identify the most problematic points in the financial statements c) I t is part of the budgeting process -- > wrong 3) The benchmarking analysis is done for : a) U nder standing the company about which the benchmarking is done -- > yes b) Understanding the competitors -- > no, the objective is not to understand the competitors (the benchmarking could also be done internally) c) T o understand the market -- > no, the benchmarking is much more specific. 4) Internal benchmarking : a) it is not a crucial analysis to the company’s performance -- > not true always, it depends on the dimension of the company. Y es, for smaller companies. For big conglomerates, it is actually important . b) it is the easiest and most commonly performance -- > yes , easy to compare the units inside a company. c) it is usually focused on the process , rather than of performance -- > not true 5) C ompany performing sector benchmarking : a) is looking for innovation -- > no , leader benchmarking is looking for innovation. b) is positioning itself on the market -- > yes c) is searching for the best processes -- > it depends on the type of analysis d) requires a lot o f time -- > it is not the major characteristic 1.5 Reclassification and adjust m ents Ex. LVMH, IS by function: we can find the “ Diluted EPS ” means including all the shares that most probably will be issued (so, also stock options and potential additional shares). Basic EPS > Diluted EPS (the denominator is greater in the case of diluted EPS). The n° of shares will be present in the Changes o f Equity Statement. Reclassification and adjustments are done to provide more readable and more comprehensi v e information about the company for the final users , so the stakeholders and shareholders . In fact, if we took a financial document and we computed some KPIs, like ROE, we would probably have a different figure with respect to what is written on the document -- > this is due to the reclassification and adjustments . Accounting principles might dif fer between organizations. Accounting choices can vary from one organization to another . Reclassification and adjustments aim to reorganize financial statement in order to: • Increase their readability • Underline key financial results • Improve the comparabi lity between different enterprises What is object of reclassification and adjustments? • Balance Sheet • Income statement • Usually , we DO NOT reclassify the Cash Flow statement. 1.5.1 Reclassification of the Balance Sheet The purpose of the Balance Sheet reclassification is to highlight : • FC: Fixed Capital -- > assets that we use in the long - run (non - current assets) • NWC: Net Working Capital • NFD: Net Financial Debt In this way we can compare different companies by looking at these values. Fixed capita l Net working capital The definition of Net Working Capital is linked to the notion of working capital cycle NWC . Net Working Capital is a measure of the operating liquidity (€) of a company and represents the amount of the liquidity necessary to run the business during the working capital cycle (time) . The working capital cycle 3 is defined as the average time it takes to acquire materials , services and labour, manufacture the product, sell the product and collect the proceeds from customers . The NW C takes into account: • r eceivable s , • p ayables , • i nventories . NWC underlines the ability of an organization in managing the operating cycle (receivable, payables, inventories): In practice there are different labels and formulas that are used to compute the NWC, for example we can use the following simplified formula: Net Working Capital = Current assets – Current liabilities Is it better to have a high or low NWC? There is not a universal answer. It depends on the company dimension and on the product . If 2 companies produce the same product, it is interesting the compare the amount of money they need to complete the production cycle. Normally, liabilities are cheaper than equity because shareholders have a high risk, instead stakeholders have a lower risk. Ex. Fincantieri : d ue to an increase in Trade Payables, we have a change in the N WC of the company. If a company has a negative NW C, it ’s not good , because it is good when the current assets are higher than the current liabilities (because it means that we would be able to repay our debts) . T he problem is that that the trade receivables have diminished. Having a negative NWC DOESN’T MEAN that the company is failing, it could be for example that the company made a big investment, therefore they had less cash. The important thing is that overall, there is a positive trend. If the NWC is negative, we should investigate and understand the reason behind it. 3 The working capital cycle can be 1 day or even a couple of years , it depends on the company . For pharma companies, patents have to be disclosed within 5 years (by law). So, the Working Capital is all the money needed for production (it is represented by all the cash out flows in the operating part of the cash flow statement). The NWC is the Working capital, minus the liabilities within the 12 months pe riod. Net working capital = working capital (receivables, inventories) – liabilities (tax, payables) = = current assets (minus cash) – current liabilities (minus debt) Net financial debts NFD NFD consist of the total debts (bonds * , ba n k debts and other financial liabilities ; both current and non - current ) of the company less available cash and cash equivalent . *B onds are securities issued by the company. In the debt we are NOT taking into account taxes, employees, etc. It can be conside red as a driver about the ability of the enterprise to reimburse its debts if they were all due today . It is calculated by adding short - term and long - term debt and subtracting all cash and cash equivalents. We subtract cash and cash equivalent because that amount could be immediately used to pay back the debts . Is better to have a high or low NFD? Having a debt is a strategic decision (short or long term, to cover what) so when comparing the NFD of different companies we need to take into account their strategy and their structure : Financial leverage = total debt/ equity (< = 3 , but it depends on the industr y ) So, the NFD depends on the industry and on how the company is operating : the company could be mostly financed by the debt or by the equity -- > the NFD could be negative if the cash is much bigger than the debt. If NFD is negative, it means that the management of operations is quite good. Ex. Henkel . 2014: negative amount. The financial debt increased (because they acquired other companies) but the cash remained similar . W as it a good or bad decision? We need to know more information, like the income , to say if it was an improvement or not. NET DEBT = NET FINANCIAL POSITION Example of a RECLASSIFIED CONSOLIDATED STATEMENT OF FINANCIAL POSITION : For example, this company is majorly financed by the equity (83,8%). 1.5.2 Reclassification of the i ncome statement reclassification The objective of the reclassification of the IS is to highlight: • Value added = revenues – raw materials – G&A expenses = which type of actions the company performs to add value to the final product • EBITDA = value added – personnel costs (HR costs) • EBIT = EBITDA – depreciation & amortization • EBT (e arnings before tax and extraordinary items ) = EBIT – net financial expenses EBIT and EBITDA give more information about how the company is doing (more than the net income) , because they show the real results of the company due to the operations . Ex. Fincantieri: we can see the EBITDA and the EBIT margin 1.5.3 Adjustments Reclassifying m eans changing the structure of financial documents to highlight some elements (the “ building blocks ” are the same). Adjustment : the structure is the same, but we decide if we want to ADD/REMOVE some of the building blocks. So, a djustments refer to the ame ndment of an item (number) disclosed in annual reports. ® Why adjustment ? When unexpected events occurred or when accounting principles have changed over the years, the disclosed numbers in annual reports can be revised to provide a fair representation of the current situation ® What is adjusted? EBIT, EBITDA, Operating profit , net profit , (more rarely current assets ) ... are typical items that can be adjusted . Adjusted EBIT = excludes certain adjustements from net profit from continuing operations includin g gain/losses on: disposal of investments, restructuring, impairm e nts, asset write - offs and unusual. Adjusted EBIT is used for : • I nternal reporting to assess performance • As part of the budgeting and decision making processes • To provide additional transparency to the Group’s core operations. 28/09/2022 POLLEV 1) Reclassification is not done for: a) Increasing the readability b) Underlining key financial results -- > false, the key financial results underlined are the fixed capital FC, the net working capital NWC and the financial debt NFD. c) Income statement d) Cash flow statement 2) Adjustment of the operating profit is: a) Yearly procedure done by all companies to increase readability of the IS -- > no, it is not done yearly , it is done when extraordinary events happen (like Covid) b) Barely done by any company c) A fair representation of the current situation d) Requiring specific external conditions -- > no , t he unexpected events could also be internal 3) NWC is not: A. Current assets – current liabilities -- > wrong , this is a formula for NWC B. Current assets (less cash) – current liabilities (less debt) -- > wrong, this is a simplified formula C. Accounts receivable + inventories – receivables D. Accounts receivable – receivables -- > YES , this is NOT a formula for NWC 4) NFD : a) Is a financial liquidity metric that measures a company’s ability to pay all its debts If they were due today b) Consists of the total bonds less available cash -- > wrong, it misses bank debts c) Is the sum of leasing and bank debt excluding cash and cash equivalent -- > wrong, leases are not included 1.6 E xercises on financial statement recap Solution SOLUTION See excel spreadsheet for ex. 4 and 5. https://polimi365 - my.sharepoint.com/:x:/g/personal/10811096_polimi_it/EcZtWKv1NbREnd9O yW106ugBENX3saoI64tm19k wene_ - w?e=KBy2QN 03/10/2022 2. Financial Statement Consolidation Consolidation is the basis to understand how big companies are organized. 2.1 What is consolidation Consolidation mean s putting t ogether all the data from the companies of the group in a single set of financial documents that represent all the companies as one . The consolidated financial statement combines a set of financial documents : • Balance sheet • Income statement • Cash flow statement • Statement of changes in equity • Notes to the financial statements of separated legal entities that are controlled by a parent company (hence a group ) and present them as a unique entity. A consolidated financial sta tement is the financial statement of a group of companies in which assets, liabilities, revenues, costs and cash flows of each organization inside the group are presented as a unique entity. It provides external accountability for a group rather than for a single company. It has direct connection to the price of the shares of the group , so it is important or external accountability . The problem with aggregated information is that we don’t know the performance of each single company, we see just the overall final result. 2.1.1 Definition of group of companies • A group of companies is an economic entity formed by a set of companies (se parate legal entities) which are either companies controlled by the same company, or the controlling company itself -- > there are different representations . • Different possible types of relationships : o Holding + other companies , the holding just manages and do not perform any operating activity. o Head company + other companies : the head company manages and also perform operating activities . The other companies could be related to the parent entity in different ways: • Subsidiaries : fully controlled by another e ntity (the parent), more than 50% of the shares of the company (at least 50% + 1 share, so the parent has the majority of voting rights.) • Associate : the parent has significant influence (between 20% and 50%) on their activities. • Joint arrangement : 2 compan ies decide to create a joint company, 2 or more parties have joint control. The rules of consolidation will be different based on the type of relationship between the parent and the other companies: SUBSIDIARIES ASSOCIATES JOINT ARRANGEMENT Criteria Control Significant influence Joint control Example of indicator > 50 % > 20% n/a Accounting method Full consolidation (line by line) Equity method Depends on type For the other investments in other companies : financial instruments (IFRS 9/39). 2.1.2 Group accounting When we provide information about a company, we can have different types of companies. We want to show how the company is organized, so group accounting is needed to : 1) P rovide more reliable information about the composition of assets and liabilities . Example: company B’ has long - term assets, instead B’’ has current assets (B’ and B’’ have the same value). Which company is actually represented by the consolidated statement? 2) Provide more reliable information about the income of the group From a group point of view, an entity cannot recognize revenue (and related profit) from sales to itself; all sales must be to external entities. I nfra - group transactions are eliminated . Within the notes of the group, it is specified how the subsidiaries a