Chapter 9 Analyzing Historical Performance

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Chapter 9 Analyzing Historical Performance

• Presented by Shan Li

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Organization of this chapter

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

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Reorganizing The Accounting Statements

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

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Invested Capital

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

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Invested Capital-9 items

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

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Invested Capital-9 items

• Non-interest-bearing current liabilities
• Such as accounts payable and accrued expense
• Net working capitalOperating current assets
  Non-interest-bearing current liabilities
• Net property, plant and equipment
• Is the book value of the companys fixed assets
• NPPEGross PPE Accumulated depreciation

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Invested Capital-9 items

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

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Invested Capital-9 items

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

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Invested Capital-9 items

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

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NOPLAT

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

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NOPLAT-4 items

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

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NOPLAT-4 items

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

Total income tax provision from income statement 216
Tax shield on interest expense 33
Tax on interest income 0
Tax on non-operating income (18)
Taxes on EBITA 231
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NOPLAT-4 items

• Change in deferred taxes
• Deferred taxes are the difference between the
  provision for income taxes in the income
  statement and the actual taxes paid in cash.
• Can be made by calculating the change in
  accumulated deferred income taxes on the
  companys balance sheet
• For example accumulated deferred taxes in 1995
  was 192, in 1996 was 224. Therefore, change in
  deferred taxes is 224-19232.

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NOPLAT-4 items

Net income 282
Add Increase in deferred taxes (1)
Add Goodwill amortization 15
Adjusted net income 296
Add Interest expense after-tax, net 27
Total income available to investors 323
After-tax non-operating income 0
NOPLAT 323

• Reconciliation to net income
• To ensure that nothing is missing in the
  calculation of NOPLAT
• To ensure a complete understanding of the
  companys financial statements

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ROIC

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

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Economic Profit

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

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Free Cash Flow

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

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Free Cash Flow

• FCFNOPALT-Net investment
• NOPLAT Depreciation-Net investment
  Depreciation
• Gross cash flow-Gross investment
• Where net investment is the change in invested
  capital.

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Free Cash Flow-14 items

• Depreciation
• Includes all the noncash charges deducted from
  EBITA except goodwill amortization
• Gross cash flow
• Represents the total cash flow thrown off by the
  companys operation
• It is the amount available to reinvest without
  relying on additional capital
• GCFNOPLAT Depreciation

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Free Cash Flow-14 items

• Change in operating working capital
• Is the amount the company invested in operating
  working capital during the period.
• Capital expenditure
• Include expenditures on new and replacement
  property, and equipment
• Capital expenditureincrease in net property,
  plant and equipment depreciation expenses

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Free Cash Flow-14 items

• Increase in other assets, net of liabilities
• Equals the expenditure on all other operating
  assets including deferred expense, and net of
  increases in non-current, non-interest-bearing
  liabilities
• Gross investment
• Is the sum of a companys spending for new
  capital
• Includes working capital, capital expenditures,
  and other assets
• GIchange in working capital capital
  expenditure change in other assets foreign
  currency translation effect

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Free Cash Flow-14 items

• Investment in goodwill
• Equals the expenditures to acquire other
  companies in excess of the book value of their
  net assets
• IIGnet changes in goodwill amortization of
  goodwill

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Free Cash Flow-14 items

• Non-operating cash flow
• Represents the after-tax cash flow from items not
  related to operations
• Includes cash flow from discontinued operations,
  extraordinary gain or loss, and the cash flow
  from investments in unrelated subsidiaries
• TVPV of FCF PV of After Tax Non-Operating CF
  and Marketable Securities

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Free Cash Flow-14 items

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

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Free Cash Flow-14 items

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

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Free Cash Flow-14 items

• Change in Debt
• Represents the net borrowing or repayment on all
  the companys interest-bearing debt
• Includes short-term debt and capital lease
• After-tax interest expense
• pretax interest expense x (1-marginal tax rate)

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Free Cash Flow-14 items

• Dividends
• Includes all cash dividends on common and
  preferred shares
• Share issues/repurchases
• Includes both preferred and common shares and the
  effects of conversions of debt to equity

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Breakdown ROIC

• ROIC NOPLAT
• Invested Capital
• NOPLATEBITA x (1-Cash tax rate)
• ROIC EBITA x (1-cash tax rate)
• Invested Capital

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Breakdown ROIC

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

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Credit Health and Liquidity

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

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Credit Health and Liquidity

• Debt/Total Investor Funds
• Measures the companys reliance on debt capital
• Expressed both at book value (creditors often
  use) and at market values

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Credit Health and Liquidity

• Investment Rate
• Is the ratio of investment to available funds
• Net basis Net investment / NOPLAT
• Gross basis Gross investment / Gross cash flow
• Investment rate gt 1 company is consuming more
  funds than it is generating

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Credit Health and Liquidity

• Dividend Payout Ratio
• Is total common dividends divided by income
  available to common shareholders
• Common Dividends / Net Income available to
  common
• If a company has investment rate gt1 and a high
  dividend payout ratio, it must be borrowing money
  to fund a negative free cash flow to pay
  interests and dividends.