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Financial Statements and
Valuation Techniques
Financial Management
Financial Statement Analysis
The existence of a company directly or indirectly affects various stakeholders, including managers, shareholders, creditors, employees, suppliers, customers, and governments. Each of these stakeholders requires accurate and reliable information about the company to make the best decisions. This information can have different types and formats, depending on the dimension to be analyzed and the purpose of the information.
When it comes to financial decisions, there are different information sets that can be used, but the primary source of data is the set of financial statements produced by the company's accounting systems.
Financial Accounting Information
Financial accounting information is just the tip of the iceberg when it comes to understanding a company. To have a complete overview, additional information is needed, such as the company's strategy and mission, economic data, financial markets data, and management accounting information. Any information about the company can potentially contribute to the decision-making of various stakeholders.
The economic activities and transactions that occur within the company are recorded by the financial accounting systems, which are composed of people, processes, and technology. These systems have the primary role of registering everything that happens in the company from a financial perspective.
The financial statements summarize this financial information and are made available to different stakeholders at a pre-determined frequency, typically quarterly for listed companies and at least annually for non-listed private companies.
Balance Sheet
The balance sheet is a key financial statement as it represents the picture of a company at a specific moment in time, reporting everything the company owns (assets) and how it was financed (liabilities and equity).
Assets
The assets section of the balance sheet includes the registered value of all existing resources owned and controlled by the company. These assets are the basis for the company to achieve future economic benefits and fulfill its mission.
Assets are divided into current assets and non-current assets, with the difference being the level of liquidity (the ability of an asset to be converted into cash without losing value).
Current assets are more liquid and include cash and cash equivalents, accounts receivable, inventories, and other current assets. Non-current assets are not easily converted into cash within 12 months and include equipment, buildings and land, and intangible assets.
Liabilities
Liabilities represent the existing obligations of the company arising from past events, which are expected to result in an outflow of resources from the company. Like assets, liabilities are divided into current liabilities and non- current liabilities based on their maturity.
Current liabilities include accounts payable, the short-term portion of financial debt, and other current liabilities. Non-current liabilities include the long-term portion of financial debt and other creditors.
Equity
Equity represents the residual portion of the company's assets after deducting its liabilities. It reflects the initial funding by the shareholders and the accumulated retained earnings or losses.
Contributed capital reflects the capital injections made by the shareholders, while retained earnings or losses represent the profits or losses generated by the company that have been retained or distributed to the shareholders.
Income Statement / Profit and Loss Statement
The income statement reports the profit or loss generated by the company during a specific period. It follows a top-down approach, starting with the major source of income (revenues) and then subtracting all the expenses to reach the net income.
The key components of the income statement include:
Revenues: The total amount of sales of goods or services, presented without value-added tax (VAT). Cost of Sales: The direct and variable costs associated with the sales. Gross Profit: Revenues minus Cost of Sales, representing the direct contribution of individual sales to the overall profit.
Includes the net cash flow from the issuance and repurchase of equity, the respective dividend payments, and the money that comes from the issue and repayment of debt.
Financial Ratios
Financial ratios are a convenient way to analyze financial statements, especially because they allow for comparison over time and with peer companies. The most common financial ratios are divided into 6 categories:
1. Liquidity Ratios
Focus on the ability of a company to meet its short-term obligations given its liquid assets. Current Ratio: Divides current assets by current liabilities. A ratio higher than 1 indicates the company can meet its short-term obligations. Quick Ratio: Similar to the current ratio, but subtracts inventories from current assets. A more conservative approach. Cash Ratio: The most conservative metric, focusing only on cash to cover current liabilities.
2. Solvency Ratios
Assess the ability of the company to pay its debt and other long-term obligations. Debt-to-Assets Ratio: Measures the weight of liabilities on total assets. Debt-to-Equity Ratio: Focuses on financial debt only, measuring the relative contribution of debt funding compared to equity funding. Interest Coverage Ratio: Compares operating income or EBIT with interest expenses to see if the company can generate sufficient profit to compensate lenders. Net Debt to EBITDA: Measures the ability of the company to pay its debt principal, comparing net debt (gross debt minus cash) to EBITDA (a proxy for operating cash flow).
3. Efficiency Ratios
Compare the amount of revenues with the amount of assets of the company. Asset Turnover Ratio: Measures the production efficiency of the company while using its assets. Days to Sell Inventory: Compares the average inventory with the daily cost of sales or cost of goods sold. Accounts Receivable Turnover: Measures how quickly the company collects its receivables. Accounts Payable Turnover: Measures how quickly the company pays its payables.
4. Profitability Ratios
Assess the company's ability to generate profits. Gross Profit Margin: Measures the percentage of revenue that remains after deducting the cost of goods sold. Operating Profit Margin: Measures the percentage of revenue that remains after deducting operating expenses. Net Profit Margin: Measures the percentage of revenue that remains after deducting all expenses, including taxes. Return on Assets (ROA): Measures the company's ability to generate profits from its assets. Return on Equity (ROE): Measures the company's ability to generate profits from its equity.
5. Market Ratios
Evaluate the company's stock performance and valuation. Earnings per Share (EPS): Measures the amount of net income earned per share of common stock. Price-to-Earnings (P/E) Ratio: Measures the company's stock price relative to its earnings. Dividend Yield: Measures the annual dividend payments per share relative to the stock price.
6. Growth Ratios
Assess the company's ability to grow over time. Revenue Growth Rate: Measures the year-over-year change in revenue. Earnings Growth Rate: Measures the year-over-year change in earnings. Asset Growth Rate: Measures the year-over-year change in total assets.
Time Value of Money
Basic Concepts
The analysis of financial information relies heavily on future cash flows. When evaluating investment decisions, it is necessary to estimate the future cash flows that will be generated. Time is an important factor in this context, as one euro today is worth more than one euro 3 years from now or 10 years from now. This difference is due to the concept of opportunity cost - the possibility of investing the capital in an alternative investment right now.
1. Computing Future Value: One-Period Case
To illustrate the concept of future value, consider a simple investment case such as a bank deposit. We can visualize the timeline of the cash outflow (initial capital) and the cash inflow (initial capital plus interest) after one year.
C0 * (1 + r)^T
This allows us to calculate the future value of an investment after any number of periods, as long as the interest rate remains the same.
Compounding Effect
The compounding effect refers to the fact that interest is earned on interest. In the simple interest case, the interest payment is always the same (10% of the initial capital).
In the compounding interest case, the interest payment grows over time. In the first year, the interest is 10% of the initial capital (100). In the second year, the interest is 10% of the new capital (1100), which is 110.
The compounding effect leads to a higher total interest earned over the investment period compared to the simple interest case. The longer the investment period and the higher the interest rate, the larger the compounding effect.
Present Value
To calculate the present value of a future cash flow, we can use the formula:
Present Value = Future Cash Flow / (1 + r)^T
Where: - Future Cash Flow is the amount to be received in the future - r is the discount rate - T is the number of periods until the cash flow is received
The discount rate reflects the opportunity cost of the investment, which includes: - The real interest rate, reflecting market conditions and the preference for consumption now vs. later - The inflation rate, as prices change over time - A risk premium, accounting for the uncertainty in the future cash flow
By discounting the future cash flow to the present, we can compare different investment opportunities with varying cash flows and timings.
Present Value Examples
Comparing different alternatives: Option 1: 10,000 now Option 2: 16,000 in 5 years, with a 10% interest rate By discounting the 16,000 to present value, it becomes 9,934.74, making Option 1 more valuable.
Alternatively, we can calculate the future value of Option 1 to be 16,105.10 in 5 years, again showing Option 1 as the better choice.
Investment analysis:
Accounting profit of 20,000, with a 5% discount rate
The net present value of the cash inflows and outflows is -27,000, indicating a bad project that should be rejected. Alternatively, we can compare the future value of the 200, investment at 5% per year (255,000) to the 220,000 cash inflow, again showing the investment is not economically viable.
Other Present and Future Value Analysis
The formulas relating future value and present value can also be used to find the unknown variable, such as the interest rate or the time period, if the other three variables are known.
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Interest Rates
Time Value of Money and Interest Rates
Time value of money is measured through interest rates, which can have different types and compounding effects. Differences in interest rates can arise from: Compounding: Some interest rates consider compounding effects over time, while others do not. Respective periodicity: Most interest rates are reported annually, but the interest payments may have a different frequency (e.g., semi- annual, quarterly, monthly).
Interest Rates without Compounding
If interest payments are made without compounding, the stated annual rate can be calculated by multiplying the periodic rate by the number of periods in a year. For example, if the bank offers a 2% semi-annual rate without compounding, the stated annual rate would be 4% (2% × 2). Conversely, to find the periodic rate from a stated annual rate, the annual rate is divided by the number of periods in a year.
Interest Rates with Compounding
When interest payments include compounding effects, the effective annual rate (EAR) will be higher than the stated annual rate. The formula to calculate the EAR is: EAR = (1 + r/m)^m - 1, where r is the stated annual rate, and m is the number of compounding periods in a year. For example, if the bank offers a 2% semi-annual rate with compounding, the EAR would be 4.04% ((1 + 0.02)^2 - 1).
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Perpetuities and Annuities
Perpetuities
Perpetuities are streams of constant cash flows that continue indefinitely into the future. The formula to calculate the present value of a perpetuity is: Present Value = Cash Flow / Discount Rate For example, if an asset generates €100 per year in perpetuity, and the discount rate is 5%, the present value of the asset would be €2, (€100 / 0.05). Even though the buyer may be willing to pay less than €2,000, the seller would not sell the asset for anything below €2,000, as this is the equilibrium price between the buyer's willingness to pay and the seller's willingness to receive.
Annuities
Annuities are streams of constant cash flows that are limited in time, unlike perpetuities. The formula to calculate the present value of an annuity is: Present Value = Cash Flow × [(1 - (1 / (1 + Discount Rate)^N)) / Discount Rate] where N is the number of cash flows in the stream. This formula is derived from the perpetuity formula, and it can be used to evaluate assets and projects with a finite number of expected future cash flows. When using these formulas, it's important to consider the timing of the first cash flow, as well as the consistency between the frequency of the cash flows and the discount rate. If the cash flows are growing at a constant rate, the formula uses the first cash flow in the stream, and the growth rate is incorporated into the calculation.
Adjustments and Considerations
If the first cash flow in the stream starts at a later time, the present value calculated using the formulas needs to be discounted accordingly. The formulas assume that the cash flows and discount rates have the same frequency (e.g., annual cash flows and annual discount rate). Consistency between the frequency of cash flows and discount rates is crucial. The formulas work well for streams of cash flows that fit the perpetuity or annuity models. If the cash flows do not follow a constant or growing pattern, the present value must be calculated by discounting each individual cash flow.
Loan Example
Loans can be analyzed using the annuity formula, as the installments paid by the borrower can be viewed as a stream of constant cash flows. The loan amount is equal to the present value of the installments, calculated using the annuity formula with the loan's interest rate and number of installments. Each installment is composed of two parts: the interest payment and the principal repayment. The interest payment decreases over time, while the principal repayment increases.
Savings Plan Example
Savings plans can also be analyzed using the annuity formula, as the deposits made by the saver can be viewed as a stream of constant (or growing) cash flows. The present value of the savings plan can be calculated using the growing annuity formula, with the initial deposit amount, the growth rate, the discount rate, and the number of deposits. To find the future value of the savings plan, the present value calculated using the formula can be compounded forward using the discount rate.
Project Valuation
Cash-Flows
The text discusses the basic valuation technique of the discounted cash flow method. The enterprise value reflects all expected future cash flows in the company, which in turn depends on the investment decisions that managers make. Every investment the company undergoes will have some financial impact now and in the future. This means that the decision of a go or no-go into a project must have in-depth financial analysis that considers all benefits and costs of the decision.
The text mentions that this is a key topic for any manager, even if their future role in the company is not directly related to finance. It will cover the capital budgeting technique and financial model structure that can be applied in investment decisions.
The scope of financial modeling lies in evaluating specific projects focused on a narrow set of assets, such as replacing a machine, building another plant, or developing a new product. The general cash flow profile has a negative cash flow in the beginning to reflect the initial investment, followed by the benefits of such investment in the following years.
The technical analysis discussed is also applicable to corporate valuation, where the company is a sum of many assets already in place and under a more complex strategy. In this case, there may not necessarily be a negative cash flow at the beginning, as the company was already developed, and
Finally, the text discusses the characteristics of cash flows that will determine the technical aspects of the financial model:
Focus on Cash Flows, not Accounting Profit : The financial model will use the structure of the income statement but adapt it to convert earnings into cash flows, as some items in the income statement do not represent actual cash flows.
Focus on Incremental Cash Flows : The financial model should focus only on the cash flows that exist due to the investment decision at stake, excluding sunk costs and considering potential positive or negative side effects (synergies).
Financial Analysis of Marketing Campaigns
Positive Impacts on Other Products
When conducting the financial analysis of a marketing campaign for a new burger, it is important to consider the potential positive impacts on the sales of other products sold at McDonald's. The advertising campaign may not only drive sales of the new burger, but also lead to increased sales of complementary products such as ice creams and Happy Meals.
The new burger may attract customers who will also purchase ice creams or Happy Meals, leading to revenue synergies. The advertising campaign can generate sales not only for the new burger, but also for other products that customers may purchase in addition to or as a result of the new burger.
Cannibalization and Erosion Effects
However, it is also necessary to consider the potential negative impacts, such as cannibalization and erosion effects, when opening a new restaurant in a region with existing McDonald's locations.
When a new restaurant is opened, some customers may shift their purchases from the existing restaurants to the new one, leading to a decrease in revenue for the existing restaurants. This is known as the cannibalization or erosion effect. Even though the new restaurant generates additional revenue, some of this revenue may come at the expense of the existing restaurants, resulting in a net decrease in overall revenue.
Opportunity Costs
Another key consideration is the opportunity cost associated with the use of assets. For example, if a manufacturing company has land that could be sold for $200,000, but instead decides to build a new plant on that land, the opportunity cost of the land should be included as an investment of $200,000, even though the company is not literally spending that amount.
Inflation and Taxes
When estimating cash flows, it is important to consider the impact of inflation and taxes:
Inflation can affect both the prices of products and the costs of the business, and these changes should be reflected in the cash flow projections. Taxes, such as income tax and indirect taxes like value-added tax (VAT), can have a significant impact on the cash flows generated by a project.
Illustrative Example: Manufacturing Plant
To illustrate the concepts, consider the example of building a new manufacturing plant:
The initial investment involves purchasing land, machinery, and raw materials, which may require raising capital from shareholders and obtaining a loan. Once the plant is operational, the company will generate revenues from selling the manufactured products, incur operational expenses (e.g., salaries, maintenance, taxes), and make payments on the loan (interest and principal). This cycle of investment, operations, and financing will continue over the life of the project.
The financial analysis should focus on estimating the investment and operational cash flows, while the financing cash flows can be considered separately later in the course.
Operational Cash Flow Calculation
To calculate the operational cash flow, the following steps can be followed:
Estimate the revenues based on the projected quantities sold and the respective prices. Deduct the variable costs, such as the cost of raw materials, to arrive at the gross profit. Subtract the fixed costs, such as salaries and rent, to obtain the EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). Deduct the depreciation expense to arrive at the EBIT (Earnings Before Interest and Taxes). Subtract the applicable income taxes to calculate the net income. Add back the non-cash expense of depreciation to arrive at the operational cash flow.
By following these steps, the financial analysis can capture the key elements that contribute to the cash flows generated by the project, taking into account the various factors discussed, such as cannibalization, opportunity costs, inflation, and taxes.
Net Working Capital
Another thing that is reflected as an investment is related to net working capital. Net working capital is equal to current assets minus current liabilities, and when evaluating a project, we focus on the operating components of the net working capital. Therefore, we exclude cash and financial liabilities such as loans out of the current assets and current liabilities. The typical items under the operating net working capital are inventories and receivables as current assets and payables as current liabilities.
Inventories
Setting up a business is not only about building up non-current assets, but you also need current assets such as inventories. In the previous example, you would need the raw materials to feed the production in your new plant. If you are opening a clothing store, you need to have the store, the shelves, computers, all non-current assets, but you also need to have the clothes on the shelves, which represent inventories that will be there for the customers to come by. This is why we need to include inventories in the calculation of investment cash flows; they also represent cash flows that we need to spend money on, and in some businesses, this is especially relevant.
Receivables
When we are building the operating cash flows, we are doing it based on the income statement. We adjusted for depreciation because it is not a cash outflow, but there are other items on the income statement that are not necessarily cash flows as well: take revenues for example. The fact that you sell products does not mean that you collect the cash immediately. If you are giving credit to customers, you are increasing receivables. And increasing receivables is similar to an investment: you include the revenues as a source of cash, but since you are not collecting it and instead you are accumulating receivables, you are investing by not collecting the cash, and you need to subtract the amount that was invested in receivables from the free cash flow of the project.
Payables
Payables follow the same rationale as receivables, but in the opposite direction. In the expenses considered in the operating cash flows, you might have subtracted expenses that you do not pay immediately because suppliers are allowing you to pay later. In a way, suppliers are financing your operation, and that is why accumulating payables has a positive impact on the free cash flow, at least for a while, because you are not paying yet, you are postponing the payments into the future.
As we can see, items such as inventories, receivables, and payables might influence cash flows over time, and assessing their impact is important, especially in businesses and projects where the cash conversion cycle management is a critical dimension. Technically, we should calculate the
level of net working capital for each year in our forecasting period, and then the change in net working capital will be the impact on the investment cash flow. If net working capital increases by 10,000, there will be a negative cash flow associated with 10,000; if working capital decreases by 20,000, that will be a cash inflow of 20,000.
Financial Modeling Example
The provided information includes a short briefing with all the relevant information for this specific case. It is a simple example, so the information is quite straightforward. We will focus on how we should act after we get this information and how we should calculate cash flows based on such information.
Project Duration
The first information is about what the company will do, and the most relevant thing for the financial model itself is the duration - here we know that these projects will last five years. So, when we are building the financial model, we should bear in mind that the company will do something now, and then cash flows will exist over the next five years.
Quantities and Prices
The second piece of information is about the quantities expected to be sold, so the company will invest in some machinery, and this machinery will produce something that the company will sell, some products based on this production. We have the information for each year about the certain quantity. This will be relevant for revenues - based on this quantity, we are going to get a number for the revenues.
We also have information about the price, namely we have the price for the first year and then the growth rate of that price for the next few years, which is 2% per year. So, this is also relevant for revenue - with these two things together, we should get the revenue amount for each year in euros.
Costs
Next, we have information about the cost of sales, namely we know how much it costs to produce one unit of whatever the company is selling - and in this case, it is €5 per unit. Together with the quantities, we are going to get the cost of sales or cost of goods sold or variable costs.
Then we have information about fixed costs - this is the amount of €25, demanded they were going to spend every year in operating expenses to run this project, which is independent from the quantity you sell.
Taxes
We also have the tax rate, which will be relevant for the taxes. As we saw previously, taxes are necessary to be calculated in the financial model
cash flows. Splitting inputs and calculations is a best practice that we should follow - here we have divided the same spreadsheet into two sections, and in more complex models, we can have a couple of spreadsheets for inputs and a few other spreadsheets for calculations and outputs. The main idea behind splitting is that it helps later adjustments and analysis on the model. The financial model will not give a linear and single answer at the first try, we need to continuously update it because either we get more information or because we want to check alternative scenarios - if we have the input section isolated, it is easier to perform those analyses.
In the input section, the information that was presented in the briefing is organized into different items and cells so we can build a financial model in Excel - for each item, we have a row, and then for each column, we have a year. Year 0 represents right now, it's the moment when you are deciding and when you are launching the project, and you have one column for each of the following five years since the project will last five years.
The cash flows calculation follows the structure that we saw before, we have both the operational cash flows and investment cash flows.
For the operational cash flows, we are using all the technical aspects that we saw before - we have revenues, we started off by calculating revenues based on prices and quantities, then we have the costs, so out of these revenues, we subtract costs to get the EBITDA. Here we have both types of costs: variable costs and fixed costs.
Project Valuation - Investment Decision Rules
Net Present Value
The net present value (NPV) is the most relevant metric for investment decision-making. It involves summing all the cash flows, both inflows and outflows, starting from today, and discounting them at the appropriate discount rate.
To calculate the NPV, we need to:
Determine the stream of free cash flows expected from the project. Identify the appropriate discount rate for the project.
The NPV represents the added value of the project. It shows how the market value of the firm is expected to change with the implementation of the project. The key decision rule is:
If the NPV is positive, the project should be undertaken as the cash flows compensate the investment and the opportunity cost of capital. If the NPV is negative, the project should not be undertaken as the investor would be better off investing the capital in an alternative investment that provides the return represented by the discount rate.
The NPV rule can also be used to compare mutually exclusive projects, where only one project can be selected. In this case, the project with the higher NPV should be chosen.
Example: - The project requires an initial expenditure of $20. - It generates cash flows of $15 in year 1, $30 in year 2, and $25 in year 3. - The discount rate is 10%. - The NPV is $37.21, which is positive. Therefore, the project should be undertaken.
Internal Rate of Return
The internal rate of return (IRR) is another investment decision metric that converts the value of the project into a percentage, representing a return rate. The IRR is the discount rate that sets the NPV to zero.
To calculate the IRR, we use the NPV formula with an unknown discount rate and find the rate that makes the NPV equal to zero.
The key decision rule for the IRR is:
If the IRR is positive and above the discount rate, the project should be undertaken as the return rate is higher than the opportunity cost of capital. If the IRR is positive but below the discount rate, the project should not be undertaken as the investor would be better off investing the capital in an alternative investment.
The IRR provides a return rate perspective on the investment, which can be useful for decision-making.
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Project Valuation Metrics
Internal Rate of Return (IRR)
Even though the internal rate of return (IRR) is a useful metric due to converting the value into the common language of rate of return, it might have some limitations:
In more complex projects where the cash flows might have some unusual patterns and switching between free cash inflows and free cash outflows in consecutive years, mathematically you get more than one internal rate of return, and the interpretation might be misleading.
Another limitation is that it does not allow for comparison across projects mostly due to the scale effect. The IRR favors smaller projects over larger projects, even though most often it is better to do a larger project.
