Activity Liquidity, Solvency, and Profitability (PDF)

3 ACTIVITY LIQUIDITY, SOLVENCY AND PROFITABILTY Intermediate balances of management Principles gross Margin Added Value Production of the exercise Earning Before Interest, Taxes Depreciation and Amortization (EBITDA) Current Income Before Tax (RCAI) Net Income Capital gain or losses on asset disposa...

3 ACTIVITY LIQUIDITY, SOLVENCY AND PROFITABILTY Intermediate balances of management Principles gross Margin Added Value Production of the exercise Earning Before Interest, Taxes Depreciation and Amortization (EBITDA) Current Income Before Tax (RCAI) Net Income Capital gain or losses on asset disposal Earning Before Interest and Taxes (EBIT) Exceptional Income The PCG does not reveal the financial result 51 Intermediate balances of management N1 N-1 % N N % Evolution N/N-1 en % Sales of goods - Cost of Purchased sold goods Purchases of goods +/- Change in inventories of goods = GROSS MARGIN Sold production + Stored production + Fixed production = PRODUCTION OF THE EXERCISE 100 100 - Consumption of row materials Purchases of row materials +/- Change in inventories of row materials - Others purchases and external expenses = ADDED VALUE 52 Intermediate balances of management N-1 N-1 % N N % Evolution N/N-1 en % = ADDED VALUE + Operating subsidies - Taxes - Staff expenses = EARNING BEFORE INTEREST TAXES DEPRECIATION and AMORTIZATION (EBITDA) - DAP (operational) + RAP and external Transfer + Others operational revenues - Others operational expenses = EARNING BEFORE INTEREST and TAXES (EBIT) 53 Intermediate balances of management = EARNING BEFORE INTEREST and TAXES (EBIT) + Financial revenues - Financial expenses = CURRENT INCOME BEFORE TAX (RCAI) + Exceptional revenues - Exceptional expenses = EXCEPTIONAL INCOME - Employee participation - Corporate Income Tax Attention the exceptional income is calculated separately = NET INCOME OF THE EXERCISE Revenues of sold fixed assets (PCEA) - Net Book Value of sold fixed assets (VNCEAC) = CAPITAL GAIN OR LOSSES (ON ASSET DISPOSAL) 54 Intermediate balances of management Operating Analysis The Gross Margin is only calculated in commercial companies and in industrial companies which insure a trade activity. Represent the surplus of the amount of sales on the cost of sold goods. The production of the exercise Indicator which measures best the level of activity of processing of the company, whoever is the spell of the products of this activity (sale, storage, fixed). However, it is not an homogeneous balance: the sold production is valued in the sale price while the stored production and the fixed production are valued in the production cost. 55 Intermediate balances of management Operating Analysis The Added Value (VA) Measures the surplus of wealth created by the company during the exercice. Surplus distributed between the employees (personnel expenses), the State (tax), the lenders (financial expenses) and the shareholders (net income). For a country, the sum of the added values of the set of the economic agents establishes its gross domestic product (GDP). 56 Intermediate balances of management Operating Analysis Personnel costs Wages and social security costs Added Value Equipement renewal (+operating subsidy taxes) Depreciation(amortization) Lenders Financial expenses EBITDA Capital Remuneration State (Tax) Distribution of the Added Value Reinvested Net income Reserves 57 Intermediate balances of management Operating Analysis EARNING BEFORE INTEREST TAXES DEPRECIATION and AMORTIZATION (EBITDA) Represents the residual resource generated by exploitation : this potential resource of treasury is intended to pay invested capitals and to maintain or to increase the production capacity of the company. Calculated before amortization policy, financial policy and the exceptional elements: it allows the comparison between companies within the same sector. 58 Intermediate balances of management Operating Analysis EARNING BEFORE INTEREST and TAXES (EBIT) Measures the performance of the company on a commercial and industrial level : this balance takes into account the policy of depreciations of the company; it takes into account neither financial revenues and expenses, neither the exceptional revenues and expenses, nor the employee participation in the profits of the company, nor the Corporate income tax. Indicator frequently used to appreciate the intrinsic economic performance of a company because it is not influenced by the financial policy or the exceptional events. 59 Intermediate balances of management Others Results Current Income before Tax (RCAI) Balance calculated before the exceptional elements but after the financial elements: result "normally" obtained considering the financial structure of the company, that means the relation between Shareholders equity and financial debts in the balance sheet. It is a “current income“ (heading ”operational" + heading "financial") as opposed to the exceptional result which, by definition, is not recurrent Thus the financial elements are a part of the "current": financial expenses result from debts intended to finance assets which serve themselves to generate a turnover. 60 Intermediate balances of management Others Results Exceptional Income Autonomous balance including all the operations which are not connected to the current activity and which do not present a repetitive character. Fluctuating indicator which cannot be used for forecasting and comparative study. Capital Operations Sales of fixed assets (lands, buildings, Management Operations Abandons of receivables machines, securities) Penalties Flow related to the subsidies of Reminders of taxes investment. 61 Analysis ratios 62 A. Ratios of evolution of the activity Ratio of variation of Turnover (CA) = Turnover excluding taxN – Turnover excluding taxN-1 Turnover excluding taxN-1 This ratio allows to analyse the development or not of the activity. This appreciation must be compared with the sectorial ratio. Ratio of variation of Added Value (AV) = AVN – AVN-1 AVN-1 The rate of variation of the added value compared with the rate of variation of activity (production of the exercise and\or the sales of goods) reports the evolution of the sale price compared to the purchasing cost or to the production cost and of the control of purchases and other external expenses. Analysis Ratios 63 B. Ratios of profitability Ratio of Gross Margin = Gross Margin Turnover excluding tax The rate of sales margin compared with that of the companies of the sector highlights the performance or the commercial efficiency of the company. Ratio of Profit Margin= Net Income Turnover excluding tax It gives the net income released by one euro of turnover. Analysis Ratios C. Ratios of Distribution of the Added Value Personnel expenses / added value DAP / Added value Financial expenses / Added value Weight of financial expenses = Financial expenses EBITDA The Free Cash Flow The free cash flow represents all of the internal resources (released by the ordinary activity) which the company could dedicate to the self-financing. Free Cash flow = cash-in revenues (Except revenues of sold fixed assets) – cash-out expenses Two calculation methods 65 The Free Cash Flow EBITDA Calculation from the EBITDA (substractive method) + Transfers of operating expenses + Other operating revenues - Other operating expenses ± Share in earnings of common operations + Financial revenues - Financial expenses + Exceptional revenues - Exceptional expenses - Employee Participation - Corporate Income tax = FREE CASH FLOW OF THE EXERCISE 66 The Free Cash Flow Net Income Calculation from the Net Income of the exercise (Additive method) + DAP - RAP + NBV of sold assets (VNCEAC) - Revenues of sold assets (PCEA) - Share of the subsidies of investment transferred to the Net income of the exercise = FREE CASH FLOW OF THE EXERCISE 67 The Free Cash Flow. The level of the free cash flow compares in turnovers Calculate the growth of the Free Cash Flow over several periods and compare it with the growth of the turnover. For the average/long term lenders, the FCF is an essential element because it assures the refund of loans.. The capacity of repayment of the company is thus a fundamental ratio of the financial analysis. Capacity of repayment = Financial Debts / Free Cash Flow We admit that this ratio can not exceed 4 68 69 Liquidity and solvency The balance sheet FIXED +1 year EQUITY ASSETS Increasing liquidity +1 year Investment capital Increasing payability Long and mid term DEBTS current -1 year ASSETS Short term DEBTS -1 year Liquidity et solvency 70 Liquidity ratios ØThe liquidity of the balance sheet is defined by the fact that assets within one year are superior than liabilities within one year. Current ratio = Assets within one year / Liabilities within one year Current ratio must be superior to 1. Ratio of reduced liquidity = (receivables within one year + availability) / liabilities within one year Ratio of immediate liquidity = Availability (including marketable securities) / Liabilities within one year Liquidity and solvency Solvency ratios ØThe company is solvent as far as the real asset is sufficient to allow to pay all debts. Ratio of general solvency = Total of assets/ Total of debts Equity ratio = Equity / Total of liabilities This ratio is also called capitalization ratio If it is lower than 33 %, it is admitted that the company is “under capitalized”. 71 Static analysis of the balance sheet The functional balance sheet Investme nt Function Assets or Uses Liabilities or Resources Stable uses (gross value): Stable resources: Intangible fixed assets Equity Tangible fixed assets Financial fixed assets Amortization and depreciation Provisions Financial debts Current Assets (gross value): Operatin g Function Debts: Operating debts Operating Current assets Non operating Current assets Non operating Debts Treasury assets Treasury liabilities Financin g Function ? Operatin g Function In a functional balance sheet, the resources and uses are estimated at 72 their value of origin (gross value) Static analysis of the balance sheet Working Capital Working capital = Stable resources – Stable uses Ø The Working Capital (WC) measures the company capacity to cover the needs for the investment cycle. Ø The Working Capital (WC) is a stable resource put at the disposal of the company for financing a part of the current assets. Ø Why do current assets need a stable financing? Ø Circulate physically (turn), but they are renewed: * Minimum level of Inventories * Receivables = granted advance Static analysis of the balance sheet Working Capital àNet income (profit) àIncrease of equity ä Increase of stable resources Increase of working capital æ àFinancial debts àZero dividend Decrease of fixed assets àUnder-investment àDisposal of assets àNet income (Loss) ä Decrease of stable resources Decrease of working capital æ àFinancial deleveraging (repayment by anticipation) àDistribution Increase of fixed assets àAcquisitions 74 Static analysis of the balance sheet Working Capital These ratios concerning the financial structure of the company allow to study the financing strategy of the company. The ratios of financial equilibrium are built from the functional balance sheet. Evolution of Working Capital = Working Capital * 360 days Turnover excluding Tax We try to measure the financial safety margin in number of days of the turnover. Cover of stable uses = Stable resources Stable uses This ratio should be upper 1, what corresponds to a positive Working Capital. Static analysis of the balance sheet Working Capital Need Sales Cash inflow Supplier Debts Need for Capital Time Customers Receivables Payment Inventory of goods. Positiv working capital Need absorbs resources. Negative working capital Need releases resources The WCN is the amount of the resources necessary for the financing of the operational cycle, mainly to finance inventories and gap between the payments to the suppliers and cash inflow related to sales. 76 Static analysis of the balance sheet Working capital requirement Working Capital Need = Inventories + short term receivables (non financial ) – short term debts (non financial) Positiv WCN Negative WCN Absorbs resources Releases resources 77 Static analysis of the balance sheet 78 Working Capital Need The factors of evolution of the WCN Level of inventory Cost / price Level of receivables Volumes Level of debts Deadlines The company is not always aware of the possible exchange of the BFR: Possible gap between planned and real deadlines of regulation (cf. part on the ratios). Static analysis of the balance sheet Net cash Treasury asset Marketable securities Availability Treasury Liabilities Bank overdrafts Short-term banks borrowings Commercial Discount (EENE off Balance sheet) Cash Relation => Net cash= WC – WCN 79 Analyse statique du bilan Analysis The analysis of big financial equilibrium supposes a time-varying comparison of WC, WCN and NC evolutions. Working Capital Liquidity Working Capital Need N.C. > 0 Working Capital Need 80 Working Capital Need Net Cash Working Capital Working Capital N.C. < 0 Lack of liquidity Profitability & Leverage The concept of profitability Capacity of the company to pay durably invested capitals or relation between a result and the necessary capital to make this profit The accounting profitability is the relation between the increase of wealth (income) and the necessary invested capitals to make this income. Profitability: return on an investment; different from the notion of result which is a balance; the profitability is a ratio. Do not confuse MARGIN and PROFITABILITY. The margin is the relation between a result and a volume of activity. 81 Principles The economic balance sheet Economic assets = Net fixed assets + Working Capital Need + Availabilities Invested Capital Equity (included Provisions for risks and charges) Financial debts Financial debts (Long / Mid / short Term) Economic assets = Net fixed assets + WCN + availabilities = Equity + Financial debts 82 Principles Two profitabilities The economic profitability “ROCE” represents the return of capital economically employed without taking into account their origin. The financial profitability “ROE” is a performance indicator for the shareholders. It represents the return on the only shareholders equity. Profitability in market value Two measures Accounting profitability 83 Principles 84 Two profitabilities Accounting profitability Profitability observed (realized) Economic profitability ROCE = Economic Income / Economic assets EA : Economic assets E : Equity Financial profitability ROE= Net Income / Equity EI : Economic Income NI : Net Income Principles Two profitabilities Equity Economic assets Financing Secretion of wealth (Economic profitability after tax) ROCE Economic income after tax Net debts Remuneration of lenders (cost of the debt after tax) Equity remuneration (profitability of equity) ROE Financial expenses (after tax) Distribution Net Income Source : Vernimmen P., « Finance d’entreprise » 2014, p. 290. 85 Principles Leverage effect To understand the leverage effect, let’s imagine the both following cases : 1. Mr. Alpha possesses a capital of 20 000-€, his bank proposes him an investment in 6 %. 2. Mr. Gamma is willing to lend 10 000 € to 3 % to his friend Mr. Alpha which places this money at his banker. Calculate the profit of Mr. Alpha at the end of period in both cases. 86 Principles Leverage effect Case n°1 : resources uses Saving = 20 000 € Investment= 20 000 € Profitability of M. Alpha’s savings : 6% Profitability of the investment : 6 % Net Income = 1 200 € 87 Principles Leverage effect Case n°2 : Net Income (30 000 x 0,06) 1 800 - Interest payable (10 000 x 0,03) - 300 = Alpha’s profit = 1 500 resources uses Saving = 20 000 € Investment= 30 000 € Profitability of the savings of Mr. Alpha = 1 500 / 20 000 = 7,5% Loan = 10 000 € Profitability of the investment: 6 % Net Income = 1 800 € 88 Financial profitability Leverage effect : example 2 Balance sheet (in €) Net fixed assets WCN Total 380 000 Equity 300 000 70 000 Net Financial debts (NFD) 150 000 450 000 Total 450 000 Cost of the debt (id) = 8% Corporate Income Rate = 40% Hypothesis: 1. Hypothesis 1: Economic Income before tax = 75 000 € 2. Hypothesis 2: Economic Income before tax = 30 000 € Calculate and compare the ROCE and ROE Same question supposing that Equity = 150 000 et NFD = 300 000 89 Financial profitability Leverage effect : example 2 ROCE ROCE = Economic Income * (1 – Corporate income rate) / Economic Assets = 75 000 * 60% / 450 000 = 10% Net Income Net Income = [Economic Income – Cost of debt] (after corporate income) Net Income = [75 000 – (150 000 * 8%)] * 60% = 37 800 Financial profitability ROE = Net Income / Equity = 37 800 / 300 000 = 12,6 % ROE > ROCE => ROE = ROCE + «Leverage Effect » 12,6% = 10% + 2,6% 90 Financial profitability Leverage effect : example 2 b. Modification of the Financial structure Economic profitability ROCE = 10 % Net Income Net Income = [75 000 – (300 000 * 8%)] * 60% = 30 600 Financial profitability ROE = Net Income / Equity = 30 600 / 150 000 = 20,4 % The increase of the part of the debts in invested capitals Increases the gap between ROCE and ROE 91 Financial profitability Leverage effect : example 2 Economic profitability ROCE = Economic Income * (1 – Corporate Income rate) / Economic assets = 30 000*60% / 450 000 = 4 % Net Income Net Income = [30 000 – (150 000 * 8%)] * 60% = 10 800 Financial profitability ROE = Net Income / Equity = 10 800 / 300 000 = 3,6 % ROE < ROCE => ROE = ROCE + « sledgehammer blow » Cause : The ROCE is less than the cost of the debts 92 Financial profitability Leverage effect : example 2 b. Modification of the Financial structure Economic profitability ROCE = 4 % Net Income Net Income = [30 000 – (300 000 * 8%)] * 60% = 3 600 Financial profitability ROE = Net Income / Equity = 3 600 / 150 000 = 2,4 % The increase of the part of the debts in invested capitals causes a fall of the financial profitability 93 Financial profitability Leverage effect Definition We call leverage effect the impact of the debts of the company on the profitability of equity. It is equal to the difference between the profitability of equity (ROE) and the economic profitability (ROCE). Principle When a company gets into debt and invests funds borrowed in its economic asset (industrial and commercial facilities), it obtains an economic result, normally upper to financial expenses resulting from the loan (otherwise it is not necessary to invest): the realized surplus is thus the difference between the economic result and the financial expenses, this surplus returns to the shareholders and it comes to inflate the financial profitability of the company. Interest One interest Þ Know the origin of a good profitability of equity: is it the operational performance or the pure financial construction (leverage effect)? 94