Capital Employed and Stakeholders

Capital Employed and Stakeholders

• Capital employed is the total capital invested in a company, used to generate profits.
• Stakeholders include shareholders, creditors, suppliers, customers, management, and employees.
• The finance function optimizes resource allocation.
• All managers use capital to make investments and create value.
• Project's capital employed must have a return that is greater than cost, over the project’s duration, to create value.

Investing Capital

• Companies need capital to develop activities.
• Invest in fixed assets (tools of production) and working capital (cash conversion cycle).
• Working capital with fixed assets equals capital employed.

Cash Conversion Cycle

• Cash conversion cycle involves converting raw materials into cash through inventory, goods-in-process (GIP), and finished goods (FG).
• Account receivable days generate a need to finance working capital.
• Financing equals working capital.

Working Capital Equation

• Working capital (WC) is a use of resources.
• WC can be calculated as inventories + receivables + other receivables - (advanced payments + other payables).
• Capital employed equals fixed assets plus working capital.
• An increase in the invest amount increases the amount depreciated.

Capital Employed Turnover and Return on Capital Employed

• Capital employed turnover indicates how many dollars of sales were generated per dollar of investment (Sales / Capital Employed).
• Return on capital employed (ROCE) signifies expected net operating profits from investments.
• ROCE is a measure of profitability, reflecting how earnings are integrated with investment.

Value Creation Process

• First, establish a pro-forma (expected) income statement.
• Forecast investment needed for fixed assets and their depreciation schedule.
• Estimate delays in inventories, payments, and customer/supplier relationships.
• Determine evolution, fixed assets, net depreciation, and net fixed assets.
• Estimate the necessary working capital.

Influences On Working Capital

• Low raw materials prices increase the size of WC.
• Longer pre-processing storing for raw materials increase the size of WC.
• Faster payments to suppliers increase the size of WC.
• Increased manufacturing time increases the size of WC.
• Longer storing time for finished goods increases the size of WC.

Rule Of Three

• The rule of three has a known cost structure and defined terms.
• The purpose converts annual flow to year-end capital employed.
• Inventory product i= production cost product i x (delay/365).
• Receivables = Sales (VAT included) x (delay/365).
• Supplier payables j = Supplier j cost (VAT included) x (delay/365).

Defining Return On Capital Employed

• ROCE evaluates performance achieved by a company.
• ROCE = (Net Operating Profit after Tax) / Capital Employed.
• Another common extent when tax = non-operational element is ROCEPretax = (Net Operating Profit (EBIT) / Capital Employed.
• ROCE should be clear whether it is reported pre- or after-tax.

Key Drivers Of ROCE

• ROCE is also recognized as Return on Investment.
• ROCE has two fundamental drivers: net profit margin and investment turnover, like capital employed turnover.
• ROCE formula expansion: (Net Operating Profit/total sales) x (Total Sales/Capital Employed) = (Net Operating Profit after Tax/Capital Employed).
• ROCE is a combination of margin and asset turnover.

ROCE Margin And Asset Turnover

• If a business is characterized with a low capital employed turnover, it will require a lower operating margin rate to achieve a target ROCE.
• The goal is to achieve a balance between margin and turnover for optimal ROCE.

Finance Perspective Of P&L

• Sale minus operating expenses equals Ebitda.
• Subtracting depreciations and amortizations from Ebitda leads to Ebit (financial income and expenses).
• After deducting interest and taxes from Ebit, the result is EBT (pre-tax earnings).
• Net income is the final profit after extraordinary items and taxes.

Shortcomings Of ROCE

• ROCE does not account for account risk or project size.
• ROCE is a short-term (annual) indicator.

ROCE Tree

• ROCE is impacted by operating margin.
• Cost of sales and administration and research and development influence operating margin relative to sales.
• ROCE is also influenced by capital employed, where working capital and fixed assets are considered to sales.

Value Creation Principle

• Capital employed in a project must yield a return greater than its cost.
• Capital employed and financial resources are comprised of fixed assets plus working capital and equity plus financial debt.
• A percentage of capital employed needs a percentage of resources from its financial partners.

Financial Resources

• Financial resources include equity, which comprises capital and retained earnings from shareholders.
• Equity provides capital from raised dividends.
• Financial debt provides debt and interest from bankers and lenders.

The Cost Of Financial Resources

• A portion of capital employed needs a portion of financial resources.
• Capital is not free.
• Financial resources have a cost (WACC).
• Financial resource providers need opportunities to invest elsewhere.
• Using capital employed incurs a rental fee = capital employed x WACC = capital charge.
• The weighted average cost of capital includes the capital cost.
• The cost of debt influences the cost of the capital.
• Equity cost is the expected return, which depends on perceived risk of project/company.

NOPAT

• Return depends on operational charge.
• Companies must pay income tax.
• The impact of financial choices appears only in the cost of capital.
• NOPAT assesses the operational performance net of tax.

NOPAT Formula

• NOPAT = Operating income x (1 - tax).
• NOPAT = Net income (if no debt) = management accounting (not financial accounting).

Creating Value

• To create value, a project needs a yield greater than its cost.
• Yearly value creation = NOPAT - Capital charge, or NOPAT - (Capital Employed x WACC)

Valuing With ROCE

• Yearly Value Creation = NOPAT - (WACC x CE).
• YVC can also be expressed as (ROCE - WACC) x CE.
• To create value: NOPAT should be greater than the capital charge and ROCE should be greater than WACC.

Drivers Of NOPAT

• NOPAT is the product of (1 - tax rate) and operating income.
• Capital employed is the sum of fixed assets and working capital.
• Capital expense is a product of capital Employed and cost of capital/WACC.

Assessing Performance Utilizing ROCE

• To assess performance, ROCE is good, but it does not assess the risk and size of a project.

Time Value Of Money

• A dollar today is worth more than a dollar tomorrow.
• A guaranteed future dollar is worth more than a risky future dollar.

Discounting Techniques

• Discounting assesses the value of future money in current value.
• Discounted value measures the opportunity cost of that money, reflected by the WACC.
• Future value = Present value x (1 + discount rate)^n where 'r' is the discounted value

Yearly Value

• Need to apply the discounted value for yearly value creation.
• Discounted yearly value creation is the sum of all discounted yearly value creations.
• Overall Value Creation = Summation from i=1 to 'n' of [Yearly Value Creationi / (1 + WACC)i ] + [Terminal Value / (1 + WACC)n ]

Free Cash Flow From Income

• Generate cash flow from free cash flows.
• Free cash flow relates primarily to operation, with financing secondary.
• Corporate cash flows have components of operation, investment, and financials.
• Operating cash flow is the ability to generate income and transform into cash.
• Cash for investments is used for capital expenditure.
• Financial cash flow is the contribution of stakeholders.

Formula To Measure Free Cash Flows

• Free cash flow = operating cash flow investment in cash = FCF.
• EBIT subtracting income tax equals NOPAT; adding depreciation shows the cash in from operations.
• Add depreciation (cash in) and subtract the change in working capital (WCn+1 - WCn) to find operating cash flow.
• Subtract investment and add divestment to equals cash for investmenet.
• Free cash flow is the final result.

Equation Involving NOPAT And Other Metrics

• FCF = NOPAT + Depreciation - Change in Working Capital - Change in Investment.
• FCF = NOPAT - Change in Capital Employed.

Financial Cash Flow

• Financial cash flow looks into financials.
• Subtracts dividends (cash out) paid to shareholders.
• Adds increases in capital (cash in).
• Subtracts financial charges (cash out), like interest.
• Adds back tax savings related to interest.
• Adds changes in financial debt, subtracting debt repayment and adding new debt.

Full Cash Flow Statement

• Operating cash with financials with investment cash shows changes in yearly cash.
• The final result shows last year's cash.
• Drawbacks: the cash flows are not pure operating cash flows and financial cash flows are overestimated (interest are deducted).

Cash Flows, Forecasting, And Investing

• Take away: (+)- Income ≠ (+)- cash flow and vice versa for all the above.
• Sales are linked to investment when linked to forcasting metrics.
• Separate price and volume for separate forcasting.
• Costs involve direct and indirect costs.
• Identify different types of costs and forecast changes in costs.
• Keep in mind that variable costs evolve around volume.

Working Capital Valuation And Components

• Working capital components show value.
• Cost and revenue are specific to investment:
• Induced costs include training, installation, and testing.
• Induced income includes resale of equipment.
• Relevant periods include technology cycle.
• Volume sensitivity depends on cost structure.

Risk Analysis

• Using cash assesses projects.
• Use FCF to assess return (Net Present Value).
• Forcast yearly FCF, and define the terminal value.
• Sum the discounted FCF & terminal value.
• Negative cash appears as cash flows of year because the year is arranged by year.

Comparison Of The Formula

• NPV = summation from i to n of [FCFi / (1+r)^i].
• NPV must be calculated using CE at the beginning of the period.

Choosing Between Different Returns And Metrics

• Decision should be by using 2 metrics.
• OVC is nearer to current management approaches.
• Use communications to ease the usage of metrics for the operations manager
• Use finance when FCF is prevalent.
• EBIT is important, but doesn't account the CE
• ROCE: account CE but not CE size.
• General rule: Ratio analysis is useful for the past.

Risk Metrics

• Risk analysis for the business and partner.
• Risk is based on financials and operations.
• Risk of default comprises of the debt ratio.

Cost And Expense

• Lower activity implies lower costs and expenses.
• Cost also relates to the weight of fixed cost.
• Solvency should be factored into the ratio of equity.

Financial Solvency

• Factor back in less than one year.
• Reimbursement for less than 3 years.
• Weight of Financial Expenses when financial expense shows less than 2.5% for EBITDA
• Operating profits needs to show turnover

Break Even And Sensitivity

• For the fixed costs
• Break comes from the operational volume.
• Operations need to be taken into context to follow volatile trends.
• Operations for the company determine solvency.