Financial Statement Analysis PDF

FINANCIAL STATEMENT ANALYSIS - Introduction to investing and valutation - Introduction to the financial statements - Business activities and financial statements - How financial statements are used in valutation - The analysis of the balance sheet and income statements -...

FINANCIAL STATEMENT ANALYSIS - Introduction to investing and valutation - Introduction to the financial statements - Business activities and financial statements - How financial statements are used in valutation - The analysis of the balance sheet and income statements - The analysis of the cash flow statement - The analysis of profitability - The analysis of growth and sustainable earnings - The analysis of credit risk INVESTING, VALUATION AND ANALYSIS Financial Statements Users Accounting is concerned with collecting, analysing and communicating financial information. Financial information is provided mainly by Financial Statements. The purpose of accounting is to preparate financial information and reports regularly. The “ultimate” aim of accounting is to help those using financial information (Financial Statements) make more informed decisions. Financia statements (FSs) are the primary information that forms publish about themselves. Who uses FSs? Investors, Governments, Employees, Advisors, Courts, Lenders, Regulators, Suppliers, Analysts, Expert Witnesses, Competitors. Financial Statement Analysis (“FSA”) is the method by which FSs Users extract information to answer their questions. Investment styles and fundamental analysis The key questioni s: Am I trading stocks at the right place? The answer: It depens on who you are Some scenarios: - Intuitive Investor - Passive Investor - Fundamental Investor a) The right behaviour: Price is what you pay, but value is what you get b) The anchor: Get and manage the appopriate information Two main accounting relations, three meaningful ratios FINANCIAL STATEMENTS MARKET RATIOS Assets (A) = Liabilities (L) + Equity (E) Price to Earnings (P/E) (the Balance Sheet equation) Net Profit (NP) = Revenues (Sales) – Price to Sales (P/S) Expenses (the Income Statement equation)  Price to Book Value (P/BV) Where: P = Price, that is the Share’s Market Value; E= Earnings, that is Net Profit (NP); S=Sales (Revenues); BV=Book Value of the Equity (E=A-L). Balance Sheet equation: Assets Liabilities + Cash + Short term debts Price (of the Equity) + Receivables + Long term debts vs. + Inventories = Total Liabilities Book Value (of the Equity) + Property + Plants & Equipments + Intangible Assets = Total Assets Total Assets – Total Liabilities = Equity (Book Value) + Extra – Value = Price (Market Capitalisation) Fundamental analysis: a tool to face the winds of speculation The winds of speculation promote “speculative thinking” - Profits aren’t important (in any case, the quality of them doesn’t get invetsors); - Traditional FSA is no longer relevant; - Firm’s intrinsic value is related to “intangible assets” or “present values of “projects”;  - Price – to – Sales indicators take over Price – to – Earning ones; - Expected Growth Rates too high and unrealistic (especially if compared with the historical data). We have just said that simple calculations, in such cases, don’t add up. To have a betetr inside, look at the “doctom bubble”. In 1999, in the US, the so called internet companies (“dot.com” companies): - Were traded at total Market Value (Price, or Market Cap) of over $ 1 trillion, - Highlighted total Revenues (Sales) of $ 30 billion, - Registered an average Price – to – Sales (“P/S”) ratio of 33x, against a historical average P/S ratio of 1x, but they were reporting losses totalling $9 billion. Ex: Who is the manufacturer and Who is the dot.com company? The Manufacturer, typically, is a company operating in industrial or manufacturing sectors, within a business model characterized by: - Relatively stable or high cost compared to sales - Moderate or steady sales growth over time - A balanced asset/liability (A/L) ratio - Relatively low margins, as manufacturing operations are capital – intensive A Dot.com company is a company in tech or digital sector operatiing primarly online, with a business model characterized by: - Explosive sales growth - Potentialy negative or initially very low margins - Light assets (few fixed capital investments) and high market capitalization compared to equity. Alfa is dot.com company. Beta is a manufacturer. Reasons that lead to the conclusion: a) Insights from FSs figures:  - Very high growth rates in Sales for ALFA compared to BETA (this is consistent with a “new business”, which means great appeal, blind trust about the so – called future trends in the world, and changing - An 8% growth rate is consistent with a steady state picture, a lifecycle where goods are known in the market, where an operating margini s possible, but no ways to increase profits are feasible (price competition, several players); - Assets’ levels are different, higher in BETA compared to ALFA; high level of assets – mainly fixed assets- mean that you are a capital – intensive company (this is not the case for an internet company); - Profits trend: ALFA is recording losses, and its stakeholders may rely on future benefits (they willa rise when all the people are definitely aware of the intrinsic value of its business); - Profits trends: ALFA is recording net profits quite similar in their amount, proving that it is experiencing a steady state situation, where all the investments have been made, and all the efforts to catch new opportunities are made; - An extra value is recognised in ALFA compared to BETA. We don’t know what the reason is (ALFA’s know-how or brand or something else); anyway we can say that an additional extra value, not linked to the existing tangible assets, is more likely to be accounted for in a “new business” instead of an old (or traditional) one b) Insight from ratios: - P/S takes over P/E in ALFA: it is consistent with fundamentals that remain unexplained at this stage of the analysis (they could lead to saying that winds of speculations are working on ALFA or maybe that we need to get more understanding of this new business), - P/BV is different comparing ALFA and BETA since an extra – value, as discussed before, is recognised in ALFA by investors. Investors, firms, securities and capital markets Business Analysis and Financial Statement Analysis The professional analyst As types of investments vary, so do the types of professionals who serve investors. Therefore, we can distinguish between Outside Analysts and Inside Analysts: The Outside Analyst: Credit Analysis – Equity Analysis The Inside Analyst: Strategy Analysis Becaue we haven’t access to inside information, the FSA is more oriented to the Outside Analyst. The focus is on FSs, not on accounting practices, instead, it is on how accounting in formation can best be handled in valutaion analysis. The issue: “… One doesn’t buy a stock, one buys a business. If you are going to buy a business, know the business…” Some critical points: identify business model, know the firm’s products, know the technology required to bring products to market, know the firm’s knowledge base, know the industry, know the managment, know the political, legal, regulatory environment. The key question: How durable is the firm’s competitive advantage? Financial Statements and Financial Statements Analysis “ Financial statements are the lens of the business” “FSA calibrates the lens to bring the business into focus” ➔ Understanding the business is a prerequisite to valutation, but we need a way of translating these factors into measures that lead to a valutation. ➔ FSs report the numbers ➔ Therefore, we analyse the business by analysing the FSs and we evaluate the durability of competitive advantage from sequences of accounting figures ➔ To finish, FSA organizes the FSs in a way that highlights the main features of a business. Financial Statements Analysis, Forecasting and business valuation: a global picture INTRODUCTION TO FINANCIAL STATEMENTS In short, The FSs: - Aim to provide information about the financial status of a business as of a specific point in time; - Aim to provide information about the performance of a business over a specific period of time. FSs, therefore, contain information that helps the analyst infer the fundamental value of a business. A complete set of FSs is made up of at least five components: 1. Balance Sheet (“BS”), or Statement of Financial Position; 2. Profit & Loss Account (“P&L”), or Income Statement (“IS”); 3. Statement of Cash Flow (“CFS”); 4. Statement of Shareholders’Equity (“SSHE”); 5. Notes to FSs and Management Commentary. The FSs are drawn up according to the accounting standards. Accounting standards are different depending on each country (GAAP in the US, IFRS in Europe for listed companies,and so on). The Balance Sheet (“BS”) lists assets (“A”), liabilities (“L”) and shareholders’ equity (“E”). → POINT IN TIME → BS → A=L+E The Income Statement (“IS” or “P&L”) reports how Shareholders’ Equity increased or decreased over a selected period of time as a result of business activities. The bottom line measure of value added to shareholders’ equity is the Net Profit (“NP”) or the Net Loss (“NL”). → PERIOD OF TIME→ IS - NP= Revenues – Expenses >0 - NL= Revenues – Expenses < 0 The Cash Flow Statement (“CFS”) describes how the firm generated and used cash over a selected period of time → PERIOD OF TIME → Cash flows breakdown Cash from operating activities (+/-) + Cash from investment activities (+/-)+ Cash from financing activities (+/-) = Change in Cash. The Statement of Shareholders’ Equity (“SShE”) starts with beginning – of – period Equity in the BS and ends with end – of – period Equity, thus explaining how the Equity changed over the period. → POINT IN TIME/ PERIOD OF TIME → SSE → Ending E = Beginning E + NP (or – NL) – Net Payout to Shareholders. The Notes to the FSs are part of the FSs. Through the Notes we should at least undertsand: - How the accounting standards have been applied; - Some more numbers and charts related to the accounting figures. The Management Commentary (“Board Report” is a narrative report that accompanies, buti s presented outside of, the FSs, setting out managment’s explanation of the enterprise’s strategies, financial condition, changes in financial condition, results of operations and causes of changes in material line items. Stock and Flows in financial accounting: the relationship between the FSs The Balance Sheet (BS) The BS sets out the assets of the business and the claims against the business. Assets An Asset is essentially a resource held by the business as a certain time. According to accounting principles, an Asset is a resource controlled by the entity as a result of past events and from which future economic benefits are expected to flow to the entity. In short, for a particular item to be trated as an Asset, for accounting purposes, it should meet the following conditions: - A probable future economic benefit must exist - The company must have the right to control the resource, - The asset must be capable of measurement in monetary terms. Note that all of the above conditions must apply. If one of the is missing, the item will not be treated as an asset for accounting purposes and will not, therefore appear on the BS. The BS sets out the assets of the business and the claims against the business. Claims → a claim is an obligation of the business to provide cash, or some other form of benefit, to an outside party. We can select two types of claims against a firm: - Liabilities → the claims of all individuals and organisations, apart from the owners; they arise from past transactions or events (such as supplying goods or lending money) - Equity → the claim of the owners against the business. In short, any funds contributed by the owners will be seen as coming from outside the business and will appear as a claim against the business in its BS. Classifying Assets For analysis purposes, Assets can be selected and divided into Current Assets and Fixed Assets. CURRENT ASSETS are basically assets that are held for the short term. We can say that Current Assets meet any of the following conditions: - They are cash or “near” cash (easily marketable, short – term investments); - They are expected to be converted into cash within a year after the date of the BS; - They are held for trading or consumption during the business’s operating cycle FIXED ASSETS or Non-Current Assets are simply assets that do not meet the definition of Current Assets; they tend to be held for long-term operations. It is important to appreciate that how a particular Asset is classified may vary according to the nature of the business (this because the purpose for which a particular type of asset is held may differ from business to business). Classifying Claims In the same way, Liabilities can be selected and divided into Current and Non-Current Liabilities. CURRENT LIABILITIES are basically amounts due for settlement in the short term. They are liabilities that meet any of the following conditions: - They are expected to be settled within the business’s operating cycle; - They are due to be settled within a year after the date of the BS; - There is no right to defer settlement beyond a year after the date of the BS. LONG- TERM LIABILITIES represent amounts due that simply do not meet the definition of current liabilities. Classifying Assets and Liabilities A classified BS presents information about Assets, Liabilities and Shareholders’ Equity that are aggregated (“or classified”) into subcategories of accounts. We may consider two different ways of classifying assets and liabilities: The Income Statement (IS) The IS measures and reports how much profit (wealth) a business has generated over a period. Looking at a period of time, to measure profit we must identify Revenues and Costs. Revenues → is simply a measure of the inflow of economic benefits arising from the firm’s ordinary operations. These benefits will result in either an increase in assets or a decrease in liabilities. Expenses (or Costs) → represent the outflow of economic benefits arising from the firm’s ordinary operations. This loss of benefit will result in either a decrease in assets or an increase in liabilities. The IS may help in providing information on: - How effective the business has been in generating wealth; - How the Net Profit (or the Net Loss) was derived. The Income Statement layout The IS layout may vary according to the type of business to which it relates. EX 31/12/2022 2023 31/12/2023 Cash 50 Other asets 55 90 Liabilities 90 87 Share Capiatal 10 Net Profit 2022 5 Revenues 150 Expenses -152 Cash from Operating activity 10 Cash from Investing activity -50 Cash from financing activity 28 Capital incerase 30 Dividens paid -2 Stocks (31-12-2022) BS 31-12-2022 = BS (beginning as at 1-1-2023) Cash 50 Liabilities 90 Other Assets 55 Equity 15 Total Assets 105 Total L+E 105 Equity = Share capital (10) + Net Profit 2022 (5) = 15 Flows (2023) IS Revenues 150 Expenses -152 Loss 2023 -2 CFS CFF op act 10  CF inv act -50 CF fin act 28 Net change in cash 2023 -12 Cash at 31-12-22 50 Cash generated (used) -12 Cash at 31-12-23 38 SSHE At 31-12-22 Flows (2023) At 31-12-23 SC 10 SC Increase 30 SC 40 Net Profit 2022 5 Dividends paid -2 Net profit 2022 3 Loss 2023 -2 Loss 2023 -2 15 41 Stocks (31-12-2023) BS 31-12-2023 (ending BS) Cash 38 Liabilities 87 Other Assets 90 Equity 41 Total Assets 128 Total L+E 128 E=Share capital + Net Profit 2022 + Loss 2023 = Equity → 40 + 3 -2 =41 The maximum amount of dividends that the company could pay during 2023 is Since Net Profit 2022 and Net Loss 2022 = 5-2=3 The top section outlines the movement of cash, trade receivables (TR), and inventory (INV). The Net working is calculated as the sum of cash, TR and inventory. The values indicate how liquid assets fluctuate over time, affecting short-term operational capacity. A 50% mark-up is applied to the purchase price, which drives the profitability calculation. The table below calculated the cost of items purchased, applies the mark-up (50%) and determine the selling price (revenue). Profit is calculated as the difference between revenue and purchase cost. Cash Flow Generated is calculated as revenue minus costs over time. ACTIVITY → RECOGNISING ASSETS Indicate which of the following items could appear as an asset on the statement of financial position (balance sheet, BS) of a business 1) € 1000 owed to the firm by a credit customer who is unable to pay → Under normal conditions, a firm would expect a customer to pay the amount owed. Such an amount is therefore shown as an asset under the heading “trade receivable”. However, in this particular case the customer is unable to pay. As a result, the item cannot provide future economic benefits and the 1000 owing would not be regarded as an assets. It cannot be recognized as an asset because accounts receivable can only be recognized as an asset if the amount is expected to be collectible. If the customer is unable to pay (e.g., bankruot or defaulted9, this becomes a doubtful or bad debt and does not meet the criteria of an asset under the accounting framework. 2) A patent, bought from an inventor, that goves the form the right to produce a new product. Production of the new product is expected to increase profits over the period during which the patenti s held → The patent meets all the conditions set out before and would therefore be regarded as an asset. This can be classified as an asset. Purchased patents are classified as intangible assets because they provide exclusive rights to generate future economic benefits. As the paten was acquired and there is an expectation of profit, it meets the definition of an asset. 3) A recent hired marketing director who is confidently expected to increase profits by over 30% during the next three years → The new marketing director would not be considered as an asset because: the firm does not have exclusive rights of control over the director (it may have a right to the services that the drìirector provides); the value of the director cannot be measured in monetary terms with any degree of reliability. This cannot be recognized as an asset. Employees, regardless of their value to the firm, are not recognized as assets because they do not meet the definion of control or measurable future economic benefits under accounting standards. They are part of the operating costs and are not owned by the company. 4) A recently purchased machine that will save the firm € 10000 each year. The firm is already using it, buti t has been acquired on credit and is not yet paid for → The machine would be considered as an asset even though is not paid for. Once the firm has agreed to buy the machine and has accepted it, the machine represents an asset even though the payment is still outstanding (the amount outstanding will be shown as a claim). This can be recognized as an asset. The machine is a tangible asset (property, plant, and equipment) because it is being used in operations and provides future economic benefits. The fact that it was acquired on credit does not change its clasification as an asset; instead, a liability is recorded for the unpaid amount. COMPARING ASSETS AND LIABILITIES IN TWO DIFFERENT COMPANIES Carrefour S.A Business Description Carrefour SA engages in the provision of supermarkets and retail stores. It operates through the following geograpichal segments: France, Europe, Latin America. The company was founded by Marcel Fournier on July 11, 1959 and is headquartered in Massy, France. Renault S.A Business Description Renault SA engages in the design, manufacture, and sale of passenger cars and light commercial vehicles. It operates through the following business segments: Automotive, Sales, Financing and Mobility Services. The Automotive segment deals with the production of passenger cars, and light commercial vehicles and provides automotive services. The Sales Financing segment refers to the activity carried out for the distribution network and final customes by RCI Banque, its subsidiaries and investments in associates and joint ventures. The Mobility Services segment provides services for new mobilities. Its brands include Renault, Dacia, LADA, Alpine and Mobilize. The company was founded by Louis Renault in 1898 and is headquartered in Boulogne-Billancourt,France. UNIVERSAL SCREENING Si usa l’applicazione Universal Screening. Parametri qualitativi: è possibile scegliere una tra le classificazioni settoriali disponibili GICS, SIC, FactSet. Questa info la si trova nella Company/Security Tab, sezione Reference. Nella sezione Snapshot di Company/Security Tab troviamo Geografia. Nella sezione Company/Security Tab, sezione Snapshot troviamo l’informazione numero di impiegati. Aprire un Equity Screen nuovo: per aggiungere i parametri qualitativi, fare click sull’icone Browse for Criteria (icona a forma di cartella). Aggiungere un criterio alla volta: prima scegliendo la categoria sulla sinistra e poi nella sezione di destra fare click sul parametro da aggiungere e premere Add per aggiungere il parametro e infine Close. Ricordandosi di fare un check su tutte le caselle in Criteria Options per avere solo società attualmente quotate. Successivamente inserire la parola chiave e selezionare la voce. Inserita la formula, è possibile applicare l’operatore “maggiore di” per aggiungere il filtro quantitativo. Prmendo Enter vedremo che il numero di società risultanti diminuisce. Infine per scaricare la colonna di Price to Book: eventualmente aggiustare i parametri nello specchietto (es: anno fiscale di riferimento) e premere Enter. Per ordinare i valori scaricati di price to Book, fare un doppio click sull’intestazione di colonna, alternativamente, utilizzare la piccola freccia contenuta nell’intestazione di colonna > Sort. NET FINANCIAL POSITION: DEFINITION AND EXAMPLE Liabilities in the BS Financial Liabilities: Bond, Borrowings Operating Liabilities: Trade Payables, Other Payables. Assets in the BS Operating Assets: Trade Receivables, Inventories, Plants, Patents Non – Operating Assets: Building not used within the company core business activities Cash & Cash Equivalents: Cash at bank, Bank Deposit with short – term notice of withdrawn NET FINANCIAL POSITION (NFP) is calculated by subtracting Cash & Cash Equivalents from Financial Liabilities. It is used to assess the company’s overall financial position in absolute terms by including all assets and liabilities of financial nature. We define our net financial position as the difference between our total cash position (cash, cash equivalents and marketable securities) net of total financial debt (bank overdrafts, current portion of long – term debt and long – term debt). We belive our net financial position provides useful information for investors because it gives evidence of our global position either in terms of net indebtedness or net cash by measuring our capital resources based on cash, cash equivalents and marketable securities and the total level of our financial indebtedness. Items Dec 31st 2019 Cash 1242 Marketable securities 525 Total cash position 1767 Bank overdraft (48) Current portion of long – term debt (1527) Long – term debt (267) Total financial debt (1842) Net financial position (75) ACTIVITY Alfa Ltd is a new company that was created by depositing €20000 in a bank account on March 1st 2023. This amount was raised from the owner (€6000) and partly from borrowings ( aloan from bank BETA for €14000). The loan from Bank BETA will be repaid as follows: firts instalment on 4 March 2023; second instalment on 4 September 2023. Questions 1) Draw up the beginning balance sheet (“BS”) 2) Consider the transactions occurred over the year 2023 and draw up the BS after each date in which transactions have taken place 3) Classify the BS as at March, 7th, 2023 4) What have been the effect on the BS if the inventories had been sold on March, 7th, 2023 for €1000 rather than €5000? Transactions Date Description 2 March 2023 Bought a motor van for: purchase price Eur 5000, paid by bank transfer 3 March 2023 Bought goods to be sold on one month’s credit for Eur 3000 4 March 2023 Repaid Eur 2000 of the amount borrowed to the Lender (by bank transfer) 6 March 2023 Share capital increase for Eur 4000 (by bank transfer) 7 March 2023 Sold all the inventories for Eur 5000 (payment made immediately by bank transfer) Balance Sheet as at 1 March 2023 Bank Account (“Cash”) 20000 Borrowings 14000 Equity (share capital) 6000 Total Assets 20000 Total Liabilities and Equity 20000 Balance Sheet as at 2 March 2023 Bank Account (“Cash”) 15000 Borrowings 14000 Motor Van 5000 Equity 6000 Total Assets 20000 Total Liabilities and Equity 20000 Balance Sheet as at 3 March 2023 Bank Account (“Cash”) 15000 Borrowings 14000 Motor Van 5000 Equity 6000 Inventories 3000 Trade Payables 3000 Total Assets 23000 Total Liabilities and Equity 23000 Balance Sheet as at 4 March 2023 Bank Account (“Cash”) 13000 Borrowings 12000 Motor Van 5000 Equity 6000 Inventories 3000 Trade Payables 3000 Total Assets 21000 Total Liabilities and Equity 21000 Balance Sheet as at 6 March 2023 Bank Account (“Cash”) 17000 Borrowings 12000 Motor Van 5000 Equity 10000 Inventories 3000 Trade Payables 3000 Total Assets 25000 Total Liabilities and Equity 25000 Balance Sheet as at 7 March 2023 Bank Account (“Cash”) 22000 Borrowings 12000 Motor Van 5000 Equity 12000 Inventories - Trade Payables 3000 Total Assets 27000 Total Liabilities and Equity 27000 Cost of the goods bought was 3000 Revenue from the sale of the goods bought was 1000 Loss for the period -2000 Equity as at 6 March 2023 10000 Loss for the period -2000 Equity as at 7 March 2023 8000 Balance Sheet as at 7 March 2023  Bank Account (“Cash”) 18000 Borrowings 12000 Motor Van 5000 Equity 8000 Inventories - Trade Payables 3000 Total Assets 23000 Total Liabilities and Equity 23000 Classified Balance Sheet as at 7 March 2023 → FORMAT 1 Fixed Assets (FA) 5000 Current Liabilities (STL) 15000 Current Assets (CA) 22000 Non-Current Liabilities (LTL) - Equity 12000 Total Assets 27000 Total Liabilities and Equity 27000 Classified Balance Sheet as at 7 March 2023 → FORMAT 2 Fixed Assets (FA) 5000 Net Financial Position (10000) Equity 12000 Net Capital Invested 2000 Total Liabilities and Equity 2000 Classifying the BS Trade receivables 18 Long – term borrowings 30 Property 45 Trade payables 37 Share Capital 50 Cash at bank 12 Short – term borrowing 20 Net income year 2022 10 Plants & Equipments 30 Inventories 23 Motor vans 19 Assets Question 1 Question 2 Property 45 31% Plant&Equipments 30 20% Motor vans 19 13% Fixed Assets 94 64% Inventories 23 16% Trade receivables 18 12% Cash at bank 12 8% Current Assents 53 36% Total assets 147 100% Liabilities & Equity Question 1 Question 2 Short-term borrowing 20 14% Trade payables 37 25% Current Liabilities 57 39% Long – term borrowings 30 20%  Long Term Liabilities 30 20% Total liabilities 87 59% Share Capital 50 34% Net Income year 2022 10 7% Total Equity 60 41% Total equity + Liabilities 147 100% Net financial position Question 3 Cash at bank -12 Short – term borrowing 20 Long – term bowrrowings 30 NFP 38 Balance Sheet as at December 31st 2022 Fixed Assets 94 Equity 60 Net Working Capital 4 Net financial position 38 Inventories 23 Short term borrowing 20 Trade receivables 18 Long term borrowing 30 (-) Trade payables -37 (-) Cash at bank -12 Total 98 Total 98 THE INCOME STATEMENT A revenue is an inflow of economic benefits that leads to an increase of assets. Sale of goods on credit for Euro 1000. A revenue is an inflow of economic benefits that leads to a decrease of Liabilities. Sale of goods for Euro 1000: advance payment Euro 1000 on 11 Oct; delivery of the goods on 31 Oct (and related invoice issue). A cost is an outflow of economic benefits that leads to a decrease of assets. Beginning situation. Purchase of legal services for Euro 500 – Payment made by bank account transfer A revenue is an inflow of economic benefits that leads to a decrease of Liabilities Purchase of goods on credit for Euro 500 CLASSIFIED INCOME STATEMENT 24% Tax Rate is assumed EBIT/EBITDA MARGIN CASH – EXPENSES VS. NON – CASH EXPENSES A cash expense is a cost recognised in the Income Statement that entails a cash outflow (cash-out). A cash – out occurs before, simultaneously, or after the purchase. A non – cash expense is a cost reported in the Income Statement without any related cash payment (before, simultaneously, or after the cost’s recognising date). Annual depreciation of tangible and intangible assets is a non – cash expesne. THE DEPRECIATION PROCESS ALFA bought a plant in 2018: the purchase price was euro 300. The plant was purchased to be used in the production process. The useful life of the plant was stated in 3 years.Alfa assumed that the level of use is stable (unvaried). Carrying Value 300 Euro Useful life 3 Years Annual Depreciation 100 Assumptions:  1) Useful life stated in 3 years 2) Intensity of the plant use in the production processi s assumed stable In the excercise we assume that all Revenues and Costs (Cash-Expenses) are collected and paid during the year (affecting the final cash balance). 2018 BS before the transaction Cash Equity 300 300 IS Plant 300 Revenues 1.000 Annual Depreciation 100 Other costs 500 Net Profit 400 BS (end of the year) Cash 500 Equity 700 Plant 200 Retained earnings: 400 - Cash balance for transactions: 1000 (-500) 500 2019 IS Annual Depreciation 100 Revenues 1.200 Other costs 600 Net Profit 500 BS (end of the year) Cash Equity 1.100 1.200  Plant 100 - Retained earnings: 900 Cash balance for transactions: 500 1200 (-600) 1100 2020 IS Annual Depreciation 100 Revenues 900 Other costs 700 Net Profit 100 BS (end of the year) Cash 1.300 Equity 1.300 Plant - - Retained earnings: 1.000 Cash balance for transactions: 1100 900 (-700) 1300 2021 an additional event occured: Shareholders meeting in April 2021 approved a dividend distribution equal to the maximum level allowed according to the entity financial situation IS Annual Depreciation - Rev 950 Other costs 780 Net Profit 170 BS (end of the year) Cash Equity 470 470 Plant -  Retained earnings: 170 Cash balance for transactions: 1300 Cash in from revenues: 950 Cash out related to Costs: (-780) Dividends to SHs: (-1000) 470 Financing the firm_1 Since we assumed that all costs are paid and all revenues are collected → Profit generated = Net cash generated Financing the firm_2 Since we assumed that all costs are paid and all revenued are collected → Profit generated = Net cash generated Net Profit Depr Net profit (noDepr) 2018 400 100 500 2019 500 100 600 2020 100 100 200 1300 COG-COGS Example Ferrari NV (RACE_IT) €410.80 COGS means Cost of the Goods SOLD ( in other words Cost of the Sales) → COGS is different from the COG (Cost of the Goods BOUGHT). COST OF THE GOODS SOLD (COGS) VS. COST OF THE GOODS BOUGHT (COG) 1 Information Year 2018 Goods Quantity 2 units purchased (purchase Price 10 each price) Year 2019 Goods Quantity 1 units purchased (purchase Price 10 each price) Sale of the Quantity 2 units goods Price 11 each (selling price) 2 How COG and COGS Work in Financial Accounting 2.1 Legenda Inv Balance Sheet Item: Inventories (goods bought to be sold on the market) – They are Curent Assets Op Inv Income Statement item: Inventories at the beginning of the period End Inv Income Statement item: Inventories at the end of the period COG Income Stetement item: Cost of the Goods Bought (purchase price x units) COGS Income Statement item: Cost of the Goods SOLD (to customers during the period) or – that’s the same – Cost of Sales Sales revenues Income Statement item: Sales of the goods made to customers during the period (selling price x units) 2.2 Balance Sheet and Income Statement for years 2018 and 2019 BS – 1 Jan 2018 Assets Liabilities Inv 0 No goods in stock at the beginning of the period. BS - 1 Jan 2019 Assets Liabilities Inv 20 Inventories at the beginning of the period IS – Year 2018 Expenses Revenues Op Inv 0 End Inv 20 End Inv are valued at cost (purchase price) Sales COG 20 0 No sales occured during 2018 Revenues IS-Year 2019 Expenses Revenues Op Inv 20 End Inv 10 End Inv are valued at cost (purchase price) COG 10 Sales Revenues 22 A sale occured during 2019 End Inv 31 Dec 2019 Calculation End Inv 31 Dec 2019 Units Cost Total Cost Opening Inventories 2 10 20 Purchases (during 2019) 1 10 10 Sales (during 2019) -2 Ending Inventories 1 10 Av Cost BS – 31 Dec 2018 Assets Liabilities End Inv: inventories at the end of the period Inv 20 (Current Assets) BS - 31 Dec 2019 Assets Liabilities Inv 10 Interchangeable or fungible goods; no differences among goods Non – fungible goods: each goods is specific and fifferent from others (identification number) 2.3 COGS calculation COGS = Op Inv + COG – End Inv COGS calculation 2018 2019 Opening Inventories 0 20 Purchases (COG) 20 10 Ending Inventories -20 -10  COGS 0 20 2.4 COGS VS. COG: effects on Gross Profit Gross Profit 2018 2019 calculation COG 20 10 COGS 0 20 Sales Revenues 0 22 Gross Profit (COG) -20 12 Gross Profit (COGS) 0 2 Gross Profit 2018 2019 calculation COG 20 20 COGS 0 20 Sales Revenues 0 22 Gross Profit (COG) -20 2 Gross Profit (COGS) 0 2 CLASSIFYING REVENUES AND COSTS Consider the following item in the ALFA Income Statement for the year 2022: Items €/,000 Sales revenues 232,000 Salaries 34,500 Depreciation – fixturea and fittings 1,000 Depreciation – Motor Van 600 Interest on borrowing 1,100 Rent and Rates 14,200 Telephone and postage 1,200 Insurance 1,000 Interest received from investments 2,000 Cost of sales 154,000 Motor vehicle running expenses 3,400 Heat and light 7,500 Calculate Income Taxes for the period (consoder a tax rate of 24%) Items €/,000 Profit before taxation 15,500 Tax rate 24% Income taxes -3,720 Net Profit 11,780 Draw up a classified Income Statement for the Year 2022 Calculate the main levels of profit margins related to sales (Ex: 78000/232000=34%) Items €/,000 % Sales revenues 232,000 Cost of sales -154,000 Gross Profit 78,000 34% Salaries -34,500 Rent and Rates -14,200 Heat and Light -7,500 Telephone -1,200 Insurance -1,000 Motor vehicle running -3,400 Depreciation - fitting -1,000 Depreciation motor van -600 Operating profit 14,600 6% Interest received 2,000 Interest on borrowings -1,100 Profit for the period 15,500 7% Income taxes -3,720 Net Profit 11,780 5% Working with classified IS and BS The list alongside related to ALFA for the year ended 31 Dec 2022: With refernce to the companies that operate in the same ALFA’s industry (comparables) please note that: - The Average EBITDA Margin is around 20% - The Current Assets count around 45% of the Total Assets Items €/,000 Motor van running expenses 1,200 Closing inventories 3,000 Long term borrowing 10,000 Dividend received 200 Interest on borrowing 2,620 Rent and Rates 5,000 Telephone and postage 450 Share Capital 2,000 Motor van – cost less depreciation 13,050 Legal services 200 Annual depreciation 1,500 Retained earnings 100 Short term borrowing 1,000 Heat and light 900 Sales revenue 97,400 Goods purchased 68,350  Trade payable 5,000 Insurance 750 Trade receivable 500 Income taxes 3,000 Cash at bank 4,780 fShares in subsidiaries* 2,000 Salaries and wages 10,400 Taxes payable 3,000 Opening inventories 4,000 Subsidiaries work in other different and not related industries. Select Assets, Liabilities, Revenues and Costs The Classified Income Statement Sales revenues 97,400 100% Cost of sales -69,350 Gross profit 28,050 28,80% Operating expenses -20,400 Ebit 7,650 7,85% Non core business R & C 200 Interest -2,620 -2,629% Profit of the period 5,320 5,37% Taxes -3,000 28,80% Net Income 2,230 2,29% Assets Liabilities Motor van 13,050 Share capital 2,000 Shares in 2,000 Retained earnings 100 subsidiaries Fixed Assets 15,050 Earning for the Year 2,230 Trade receivables 500 Total Equity 4,330 Inventories 3,000 Cash at bank 4,780 LT Borrowings 10,000 Working Capital 8,280 Non current 10,000 liabilities ST Borrowings 1,000 Trade payable 5,000 Tax payable 3,000 Current liabilities 9,000 Total assets 23,330 Total Liabilities & 23,330 Equity NET INVESTED CAPITAL Liabilities Fixed Assets 13,050 Equity 4,330 (Operating)  Net Working Capital -4,500 Net Financial 6,220 Position Trade receivables 500 ST Borrowings 1,000 Inventories 3,000 LT Borrowings 10,000 Trade payable -5,000 Cash at bank -4,780 Tax payable -3,000 Net Operating 8,550 Assets (NOA) Fixed Assets 2,000 (Financial/Investing) INVESTED CAPITAL 10,550 FINANCIAL 10,550 SOURCES OF CAPITAL 1) First Step Recognise Assets, Liabilities, and Equity on one side and Revenues and Costs on the other. 2) Second Step Classify IS and BS 3) Third Step Calculate the primary levels of profit margins in terms of sales: what is the margin related to sales? ISSUES - IS Issue→ The Av EBITDA Margini s 20%, against 9% in the case study. Since the Gross Profit Margini s quite good (28,9%), it seems that a hogh weight of the Operating Expenses affects the Company’s Operating Profit (20,400/28,750=72%) - BS Issue → Current Assets are 35% of the Total Assets against an Av of the industry = 45%. The level of Trade Payable item seems to be a little bit high comoared with inventories and receivables: there may be some debt positions coming from previous periods. Is the company affected by any liquidity issue? We can’t say no since Cash is 4,780 but also the long-term debt is relevant: the company is recording Cash (cash balance is positive) because it has obtained a new borrowing from banks. The borrowing served as a solution for paying taxes and suppliers. ALFA and BETA operate in the same market Items ALFA BETA Trade Payable 500 500 COG (Cost of the Goods 500 600 bought) Long Term Borrowings 1,000 - Inv BEG 100 80 Long Term Government 100 100 Bonds 5% yield  Inv END 300 400 Other Operating Expenses 500 700 Net Profit - - Interest Expenses 310 30 Share Capital 3,000 500 Interest Revenues 5 5 Cash 200 150 Plants & Machinery 3,800 300 Sales 1,450 1,550 Trade Receivables 334 567 Depreciation 300 30 Short Term Borrowings 200 100 Net Profit for ALFA → Sales-COGS (Cost of Goods Sold) – Other Operating Expenses – Interest Expenses + Interest Revenues = 3,800-500-1,450-310+5=1,545 Net Profit for BETA → Sales-COGS (Cost of Goods Sold) – Other Operating Expenses – Interest Expenses + Interest Revenues = 3,600-600-1,550-30+5=1,425. IS items IS Items ALFA BETA Sales 1,450 1,550 COG (Cost of the Goods 500 600 bought) Depreciation 300 30 Inv BEG 100 80 Inv END 300 400 Other Operating Expenses 500 700 Interest Expenses 310 30 Interest Revenues 5 5 Tax Rate 24% 19% IS Items ALFA BETA Sales 1,450 1,550 COG (Cost of the Goods 500 600 bought) Gross Profit 1,150 (79%) 1,270 (82%) Operating Expenses (800) (730) (including D&A) EBIT 350 (24%) 540 (35%) Interest Expenses (310) 30 Interest Revenues 5 5 Profit before taxation 45 (3%) 515 (33%) Income Taxes (11) (98) Net profit 34 (2%) 417 (27%) EBIT 350 540  D&A 300 30 EBITDA 650 (45%) 570 (37%) BS items BS Items ALFA BETA Cash 200 150 Plants & Machinery 3,800 300 Long Term Government 100 100 Bonds 5% yield Trade Payable 500 500 Trade receivables 334 567 Long Term Borrowings 1,000 - Short Term Borrowings 200 100 Share Capital 3,000 500 Net profit 34 417 Inventories 300 400 BS Classified - 1 ALFA BETA FA 3,900 82% 400 26% CA 834 18% 1,117 74% Total Assets 4,734 100% 1,517 100% E 3,034 64% 917 60% LT Liabilities 1,000 21% - 0% ST Liabilities 700 15% 600 40% Total Liabilities + Equity 4,734 100% 1,517 100% BS Classified – 2 ALFA BETA FA 3,800 300 NWC 134 467 NOA 3,934 767 Other Non – operating Assets 100 100 Net Invested capital 4,034 867 NFP 1,000 (50) E 3,034 917 Sources of Capital 4,034 867 INTRODUCTION TO FINANCIAL STATEMENTS The Balance Sheet (“BS”) lists assets (“A”), liabilities (“L”) and shareholders’equity (“E”) → POINT IN TIME → BS→ A=L+E The IncomeStatement (“IS” or “P&L”) reports how Shareholders’ Equity increased or decreased over a selected period of time as a result of business activities. The bottom line measure of value added to shareholders’ equity is the Net Profit (“NP”) or the Net loss (“NL”) → PERIOD OF TIME → IS→ NP= revenues – Expenses>0, NL=Revenues – Expenses