Lecture 2 - 20897_v1 PDF

Analyzing the company from a financial perspective: interpreting the financial statement and identifying the relevant cash flows Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 1  The representation of the financial dynamics of the compan...

Analyzing the company from a financial perspective: interpreting the financial statement and identifying the relevant cash flows Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 1  The representation of the financial dynamics of the company: the logic From a financial point of view, the value of any asset (an industrial plant, a stock, a bond, a company, a participation, a trademark, a patent) depends on the cash flows that it will produce in the future for the owner. Which cash flows must be discounted? (operating free cash flow, free cash flow to equity, interest, etc.) Which variable is determined? (Enterprise value, Equity value, market value of debt, etc.) Market value of the asset Time 0 It is therefore necessary to correctly identify and measure the relevant cash flows that any activity is able to generate, in order to define its "market value" or financial/economic value. Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 2  The different aims in determining the company’s cash flows Considering a company, there are different aims according to which the financial dynamics of the cash flows are determined. These purposes directly influence the characteristics and calculation schemes of the cash flows themselves: a) An informative and analytical purpose (based on historical data), which explains the different financial components that determine the "cash flow" of the company. The accounting document used for these analyses is the financial statement associated with the balance sheet, which provides a complete historical view of the relevant financial flows and their contribution to the overall financial dynamics (explaining the past) b) A planning purpose (typically, in the development of business plans), within which the financial flows are used to evaluate the sustainability and the conditions of financial equilibrium determined by the expected management variables. The time horizon, in this case, is typically prospective (predicting the future) c) A prospective evaluation and market value determination purpose, which evaluates some relevant flows (free cash flow to firm, free cash flow to equity etc.) for the determination of the market value of a specific asset (for example a project) or of a component of the overall value of the company (enterprise value, market value of debt, market value of equity) (defining a value on the basis of future expectations) Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 3  The representation of the financial dynamics of the company: the logic The complete description of the financial dynamics of the company has historically been developed through two different tools but based on the same logic: 1) Statement of sources and uses of funds (for highlighting the relevant cash flows) 2) the cash flow statement* (for identifying the nature of the relevant flows and their quantitative contribution to the overall dynamics) * The latter is now the instrument actually used as it provides a clearer vision of the financial dynamics of the company Unlike the income statement, the cash flow statement: uses monetary (cash) flows and not costs and revenues; provides a complete description of the company's financial dynamics and its determinants (both the cash flows related to operating and financial management, and the variations in the items of the company's capital structure such as debt and capital) Unlike the balance sheet, the cash flow statement: uses flows (i.e. variations) and not "stock" quantities Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 4  The logic of sources and uses of capital From an economic point of view, the balance sheet of a company represents a "static image" that highlights where the company's resources have been drawn from (Sources of capital = Liabilities and equity capital) and where they have been invested (Uses of capital = Assets, including liquidity). ASSETS LIABILITIES and EQUITY USES OF FINANCIAL = SOEURCES OF FINANCIAL CAPITAL CAPITAL Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 5  Sources and uses of capital The general framework that can be used to examine the financial dynamics of the company is the following: since the assets represent a use of cash (while liabilities represent a source of cash), every asset or positive variation of the assets represents a use, while every negative variation (which reduces the uses) represents a source of monetary resources. Conversely, since the liabilities represent a source of cash for the company, every liability or positive variation of the liabilities represents a source of liquidity, while every negative variation represents a use. Sources of cash Uses of cash Variation Variation (+) of liabilities (-) of liabilities Variation Variation (-) of assets (+) of assets Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 6  The cash flow statement: methods of elaboration An alternative way of representing the financial dynamics of the company compared to the sources-uses statement (but which is integrated into the same logic) is represented by the drafting of the financial statement The financial statement "explains" the generation or reduction of the liquidity (cash) of the company by identifying the cash flows generated within some "areas" of management. It can be elaborated through two different methodologies: 1. direct: through the analysis of the movements of the "cash" item (rarely applied and only with the availability of the company's analytical accounting); 2. indirect: through a series of adjustments made to the balance sheet and profit and loss statements (this is the one generally used and which we will use) Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 7  The "indirect" logic in elaborating the financial statement To understand the logic of the financial statement, it is sufficient to remember that the objective is to determine the liquidity flows (cash and equivalents) of the company. If we assume a simplified scheme of the balance sheet of the company: Other assets (not cash) Equity Cash and equivalents Debt Total assets Total liabilities and equity from which: Totale assets = Total liabilities and equity  Other assets + Cash = Equity + Debt that is: Cash = Equity + Debt + Other assets Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 8  The "indirect" logic in elaborating the financial statement Moving on to the annual variations, it will be: Cash0 = Equity0 + Debt0 + Other assets0 and Cash1 = Equity1 + Debt1 + Other assets1 To define the company's cash variation between year 1 and year 0, we will write: Cash1 – Cash0 = (Equity1 + Debt1 - Other assets1) - (Equity0 + Debt0 - Other assets0) (Cash) = (Equity1 - Equity0 ) + (Debt1 - Debt0) – (Other assets1 - Other assets0) (Cash) = (Equity) + (Debt) – (Other assets) Change (positive) Change (positive) Cash in liabilities in activities variation (sources) (uses) Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 9  The main cash flows identified within the financial statement Utile netto = EBITDA LIABILITIES and Depreciation ASSETS EQUITY Provisions +/- extraordinary items Capital + Financial income expenditures Intangible and tangible Net income - Financial expenses (CAPEX) fixed assets Equity Taxes Other component of equity Change in equity (different Financial fixed assets (of from net profi) capital Change in financial which: Financial debt increase/decrease fixed assets participation/holdings) Change in Change in Severance pay fund and financial debt Inventories inventories risk provisions Use of funds Change in trade Trade receivables Trade payables receivables Change in trade payables Change in other Other current assets Other current liabilities current assets Change in other Change in cash and current liabilities equivalents Cash and equivalents Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 10  Cash Flow Statement: The Overall Scheme for a company + EBITDA + net extraordinary items [if monetary] Self-financing -/+ change in inventories Current Operations Working Capital Flow -/+ change in trade receivables +/- change in trade payables -/+ change in other current assets +/- change in other current liabilities - Tax paid [monetary] - Use of funds Cash flow from current operations - Capital expenditures (CAPEX) Cash flow from operations + dividends received + Other financial revenues - Financial charges Net cash flow from operations - Investment in financial fixed assets Net financing requirement/surplus +/-Monetary capital increase/decrease - Dividends paid + Increase in financial debt  Cash flow from operating activity  Cash flow from financial interest and changes in Change in cash and equivalents financial assets/liabilities Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 11  Recognizing relevant cash flows The cash flows indicated in the previous diagram, which represent the "final determinants" of the company's cash flow, ordered according to a functional criterion, are (in blue the cash flows from the Profit and Loss Account and activities): 1) Current Operations Working Capital Flow [EBITDA] + net extraordinary items [if monetary] - Tax paid 2) Increase in current assets (Trade receivables, Inventories and Other current assets) 3) Increase in current liabilities (Trade payables and Other current liabilities) 4) Use of funds 5) Capital expenditures (CAPEX) 6) Dividends received and Other financial revenues (interest received) 7) Financial charges 8) Investment in participation and other financial fixed assets 9) Monetary capital increase/decrease 10) Dividends paid 11) Increase in financial debt = Change in cash and equivalents Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 12  How to calculate CAPEX and use of funds from the income statement and the balance sheet There are two items in the financial statement that are slightly more complicated to calculate using the income and asset/liabilities value adjustment method: a) net investments (CAPEX) and b) use of funds (Severance pay fund and risk provisions) Let's see how they can be calculated: a) In the case of CAPEX, it is possible to determine the value of fixed assets at time 1 as: FixAss1 = FixAss0 + CAPEX - Depreciation from which it is possible to derive CAPEX (with a positive sign) as: CAPEX = FixAss1 + Depreciation - FixAss0 b) In the case of Use of funds (Severance fund and risk provisions), it is possible to determine the value of Funds at time 1 as: Fund1 = Fund0 + Provisions – Use of funds from which it is possible to derive Use of funds (to be entered with a negative sign) as: Use of funds = Fund0 + Provisions – Fund1 Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 13  The contents of the financial statement In a financial statement, the following items can be identified: 1) financial flows that represent the result of the company's activity [EBITDA, net financial charges, extraordinary items, paid taxes, etc.] 2) financial flows determined by changes in the balance sheet items [change in fixed assets, change in inventories, change in trade receivables, change in trade payables, change in financial debt, etc.] From a different perspective (operating/non operating variables), the following items are identified: 1) operating variables [EBITDA, extraordinary items, paid (unlevered) taxes, investments in fixed assets, change in receivables, change in trade payables, change in inventories, etc.] 2) variables directly linked to financial assets and liabilities [net financial charges, financial income, change in shareholdings and other financial fixed assets, change in financial debt, changes in capital, etc.] The summary of the variables that can generate cash flows can be derived from the company's financial statement format. Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 14  Classification of flows in the financial statement Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 15  Operating Cash Flow: A Scheme Capital expenditures Dividends received (CAPEX) Other financial revenues Change in inventories Financial charges Change in trade receivables Taxes paid Change in other current assets Net investment in financial EBITDA [Current fixed assets Operations Working Capital Flow] + net Net Cash flow extraordinary from items [if operations monetary] Increase in financial debt Monetary capital increase/decrease Utilizzo Fondi Change in other current liabilities Change in trade payables Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 16 The financial statement: determining the current management cash flow Below are presented two schemes for determining the Current Operations Working Capital Flow, according to: a) a direct approach [top-down] b) an indirect approach [bottom-up] A complete financial statement scheme can be elaborated starting from these approaches. Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 17 The financial statement: the overall scheme by "areas" Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 18  Practical uses of the financial statement As mentioned, the cash flow statement can be used for different purposes: 1) For information/accounting purposes (historical): it analytically reconstructs the financial dynamics of the company by defining the determinants of the change in liquidity (which is the final "explained" variable) 2) For planning purposes (prospective): derived from the business plan and used to verify the needs and financial balance of the company and to define the financial policies of the company in advance 3) For evaluation purposes (prospective): it reconstructs the "relevant" flows for determining the value of the company. The flows that are reached, starting from the cash flow statement, are "partial" flows (in the sense that some components of the cash flow statement do not represent flows capable of "generating" value, such as the change in financial debt) but are relevant for the purposes of determining the value of specific components (enterprise value and equity value). For these purposes, a scheme is used that leads to the definition of two relevant flows: a) the unlevered net free cash flow (free cash flow to firm) b) the free cash flow to equity Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 19  The relevant financial flows for the firm and the shareholders This variable represents the cash flow that must be used in the evaluation of investments from an "asset side" perspective. Unlevered net free cash flow (free cash flow to firm) Free cash flow to equity (for determining equity value) Tax shield Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 20  The use of financial statements for valuation purposes With reference to the cash flows identified in the previous slide: 1) the Unlevered net free cash flow [free cash flow to firm] represents the cash flow generated by the company as a whole, without distinguishing between the part attributed to debtholders (financial charges) and the Market part attributed to the shareholders [the free cash flow to Value equity] and therefore represents the basis for of Equity determining the enterprise value (market value "asset side") Market value asset side 2) the free cash flow to equity instead represents the cash [Enterprise flow distributable to shareholders. It is generally lower value] than the free cash flow to firm because it is net of Financial financial charges (i.e. the remuneration of debtholders) debt and represents the potential cash flow of remuneration to shareholders only. This flow can be used to determine "directly" the market value of the share capital (equity) Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 21  An in-depth look at the "planned variation of debt" Operating free cash flow, as well as free cash flow to equity, are determined only by cash flows produced by the operating activity (from EBITDA, which represents an intermediate income result). In this way, all investments (change in NWC + CAPEX) use the cash flow produced by management as a "source", thus reducing the flow available to shareholders. Following this logic, all investments are "financed" (at least initially) with recourse to profit, or to the change in equity (if no dividends are distributed, the equity in year 1 is equal to the equity in year 0 to which the net profit is added). If, instead, we assume that the financial leverage at book values (but also at market values, since it is demonstrated that, under certain hypotheses, the two conditions coincide) remains constant, it is correct to consider (within the flows) that the debt grows in proportion to the equity and, therefore, the partial coverage of investments through a variation of financial debt that allows the financial leverage to be kept constant. The variation of financial debt obviously increases the flow available to shareholders, keeping the financial structure of the company constant. The "adjustment" to the variation of financial debt represents, in fact, the "planned" variation of financial debt and is part of the free cash flow to equity or of the distributable profit without modifying the financial structure of the company, considering the level of investments. Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 22  Comparative analysis of financial flow determination schemes Complete scheme for information/accounting purposes Scheme for evaluation purposes Alessandro Nova - Advanced Corporate Finance for Managers - Università Bocconi 23