Accounting & Financial Statement Analysis 3310 Notes PDF
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These notes cover Accounting & Financial Statement Analysis 3310, including lectures, seminars, and pre-assignments. Topics discussed include financial reporting, cash flow statements, and the relationship between profitability and cash flow.
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Accounting & Financial Statement Analysis 3310 Lecture 1 Lecture 2 Seminar 1 - Pre-assignment Notes from Seminar 1 Lecture 3 Lecture 4 Notes from Seminar 2 Lecture 5 Lecture 6 Notes from Seminar 3 Notes Seminar 4 Lecture 7 Lecture 8 Key ratios: Robinson et al. Lecture 9 Notes from Seminar 5 Note...
Accounting & Financial Statement Analysis 3310 Lecture 1 Lecture 2 Seminar 1 - Pre-assignment Notes from Seminar 1 Lecture 3 Lecture 4 Notes from Seminar 2 Lecture 5 Lecture 6 Notes from Seminar 3 Notes Seminar 4 Lecture 7 Lecture 8 Key ratios: Robinson et al. Lecture 9 Notes from Seminar 5 Notes from Seminar 6 Lecture 10 Notes from Seminar 7 Lecture 11 Notes from seminar 8 Exam Questions: Lecture 1 Lecture 2 - General perspective - - Performance measurement - Should we use cash flow or profit in order to measure performance? (e.g. Lorry example) - The accrual method: - Accrual accounting principles are decision rules that tell preparers when to recognize revenue and expense consequences of cash flows and other events - The balance sheet captures the accrued assets and accrued liabilities that arise due to differences between recognized profit and actual cash flows - Accrual = Periodisering (svenska) - Cash flow and profit - some reflections - Over the total life of the firm, profits and cash flows converge. They differ only as regards the time of recognition. The recording of revenues and expenses in the ‘right’ accounting periods is both the strength and weakness of the accrual method. - The weakness is connected to the income statement being subject to earnings management/ managers discretion. - Projection of future cash flows - Should we use cash flow or profit as a basis for forecasts of future cash flows? - Profit measurement, based on the accrual accounting concept, generally provides a better indication of the future ability to generate cash flow than cash accounting - Financial reporting from a capital markets perspective (1) - Why are financial statements useful? → Help capital providers make better decisions - Capturing the impact of business activities on profitability, financial strenght and liquidity (cash flows) - Approximation of economic reality - Selective reporting: - must consider relevance [materiality] and reliability [uncertainty reduction] - Alternative accounting methods: - capture economic substance [has been international harmonization, global standards (IFRS)] - Estimates: - necessary for measurement - Time lags: - relates to the degree of certainty - Financial reporting from a capital markets perspective (2) - Who are the primary users? - Equity investor - Long-term earning power - Growth Potential - Dividend payments - Creditors - Immediate liquidity [short term credit] - Assurance of the payment of interest [long term, e.g. corporate bonds] - Asset position The owners bear the main risk - residual risk of the business. Creditors have a contract and our “guaranteed” compensation. - The role of managers - Management prepares financial statments and is responsible for their form and content - Preparers’ regulatory environment - Compliance with legislation and financial reporting standards - Generally Accepted Accounting Principles (GAAP) - Choice of accounting methods - Accounting estimates - Preparers’ incentives in different environment - Sweden has historically been more of a Country A but is perhaps moving towards a Country B situation. - Valuation and profit measurement - International financial reporting - IFRS Standards [important part of international harmonization] - 1973-2000: IAS 1 - IAS 41 - International Accounting Standards (IAS) issued by the international Accounting Standards Committee (IASC) - 2001- : IFRS 1 - - International Financial Reporting Standards (IFRS) issued by the International Accounting Standards Board (IASB) - Other issued documents: - IFRS for SMEs, Conceptual Framework (CF), IFRIC/SIC Interpretations, Practice statements. Non current or current assets classification depends on intention. While Non current or current liabilities depend on time (12 months). - Transactions-based accounting and prudence imply.. - Low valuation of assets - High valuation of liabilities - Late recording of revenues - Early recording of expenses - Late recording or revenues - Example: - Early recording of expenses - Example: - The role of auditors - The auditor must agree that management’s choice of accounting principles is appropriate and that estimates made are reasonable. The financial statements shall conform with GAAP - The auditor provides reasonable assurance as to whether the financial statements are free from material misstatement → The independent auditor’s report - Can be “clean”, e.g. standard format - Can be modified, e.g. there is a discrepancy - What characterizes financial reporting standards that makes financial staments “easy” to audit? - Clear standards - few options - Transactions-based - Few estimates - What about fair value? - There is a long-term trend of increased emphasis on fair value in International Financial Reporting Standards (IFRS) and under U.S. GAAP. - However, the transactions-based accounting, with some added conservatism, still constitutes the dominating view on accounting for non-financial companies. - Fair value reporting is usually found for investment properties or financial instruments [will not be covered in this course]w - Why prepare a cash flow statement? - The cash flow statement is one of the primary financial statements - §4 in IAS 7 states: “A statement of cash flows, when used in conjunction with the rest of the financial statements, provides information that enables users to evaluate the changes in net assets of an entity, its financial structure (including its liquidity and solvency) and its ability to affect the amounts and timing of cash flows in order to adapt to changing circumstances and opportunities. Cash flow information is useful in assessing the ability of the entity to generate cash and cash equivalents" - (OB=opening balance, CB=closing balance) - Cash and cash equivalents - These are defined in IAS 7, §7: “Cash equivalents are held for the purpose of meeting short-term cash commitments rather than for investment or other purposes. For an investment to qualify as a cash equivalent it must be readily convertible to a known amount of cash and be subject to an insignificant risk of changes in value. Therefore, an investment normally qualifies as a cash equivalent only when it has a short maturity of, say, three months or less from the date of acquisition. Equity investments are excluded from cash equivalents unless they are, in substance, cash equivalents, for example in the case of preferred shares acquired within a short period of their maturity and with a specified redemption date.” - Three types of cash flows in the cash flow statement - Cash flows are reported in three different categories (IAS 7, §10): “The statement of cash flows shall report cash flows during the period classified by operating, investing, and financing activities.” - Cash flow statements: Direct vs. Indirect method - Cash flows from operating activities are reported by applying one of the following methods: - Direct method: the gross amounts of cash receipts and cash payments, respectively, are reported and specified for important items - Indirect method: the net profit is adjusted for transactions that have not caused receipts or payments during the period, and for income and costs that pertain to investing or financing activities - Pros & cons: - Direct method: - Easier to understand for people who are not trained in accounting - First-hand alternative in IAS 7 (IFRS) - Consistently reports payments - Indirect method: - Shows the relationship between profit and cash flow more clearly - Can be derived from other information in the annual report (Income Statement, Balance Sheets, Notes) - The Lorry II (example) - - - - Seminar 1 - Pre-assignment 1. In the cash flow statement, there is an item called “Income taxes paid” (-25,897). Use the income statement and the opening and closing balance sheets for 2023 to derive the number for income taxes paid. You will get a number that differs somewhat from -25,897. Reflect on what might be causing the difference. (ChatGPT) From seminar: “For large companies, the indirect method nearly always leads to deviations. Therefore the diff of 73Million. “ 2. In the cash flow statement, there is an item called “Dividends paid” (-31,767). What items in the balance sheet have the dividends paid affected? The dividends paid affect retained earnings in debit and cash in credit. Notes from Seminar 1 For large companies, the indirect method nearly always leads to deviations. Therefore the diff of 73Million. Sandvik cash flow statements: - - - + changes in working capital when sales increase.. - ++- changes in working capital when sales decrease. - Manipulation of cash flow statement by introducing “Change in inventories” as an item, when it is not a cash flow - Here it is adding back the change in inventory to cover a non-cash expense (write-off) in the income statement. Balanc sheet comparisons A Pernod Ricard High inventories due to "maturing" of spirits etc. / High intangible assets due to acquisitions B Telia Acquisitions historically, mchinery for infrastructure, low business risk so high ability to loan C UPM High amount of buildings&land / machinery due to forest owenrship and mills D Scania Financial fixed assets - loans to customers E Tesla F H&M Low cash receivables, leases are nowadays placed on BS through buildings/land G Accenture No inventories (consultants) and long payment terms Lecture 3 - Value creation and stakeholders - Stakeholders are presented in the following order in the Income Statement - Customers - without whom there is no influx of money → Revenue - Suppliers - → Expenses (cogs) - Employees - without them no work is done → Personell exp - Lenders - → interest - Government - provides infrastructure (roads etc., educated population, legal system) → Taxes - Shareholders → Net profit - Each stakeholder has a contract with the company → except (!) the shareholders. Who live off the expectations of future returns and dividends Since this is the case, they are the bearers of the residual risk. - Exercise: A) Sweco Low COCS, high personell-costs B) Skistar High depreciation is indicative of the large investments required for skilifts. But when they are up, relatively high value added C) Ericsson Make a lot of things themselves --> high value add. Large non-recurring item (a writeoff) D) Pernod Ricard High value add due to maturation of spirits as well as price insensitivity thanks to branding. E) UPM Typical process-industry. Low value added processes, automated (low personell) F) Skanske Low added value, the costs are subcontractors and building materials G) Axfood Low added value (reselling finsihed goods), as well as a need for employees, gives low profit margin - Income statement formats - Left format is called “Cost-by-nature” - Right format is called “Cost-by-function” (if you choose this, you must place cost-by-nature specs in the Notes) → IAS 1 says to choose one of the formats. - Performance measurement: Non-recurring items - The analysis of non-recurring items is important both for performance evaluation (feedback) and forecasts - Performance evaluation or forecasting perspective? - Non-recurring items should be considered when evaluating value creation (performance) over time. Decisions made in the past, with one-off effects today, shall not be disregarded when evaluating past performance - Non-recurring items that tend to recur should be considered in the forecast - Non-recurring items may project future cash flows (!) - In addition to non-recurring items, there are so colled “other comprehensive income” (OCI) items outside the P/L which may be relevant when evaluating performance [See Robinson et al. pp. 103-106] - Example: - New IFRS accounting standard to be adopted January 1st, 2027 P/L example: - Inventories - - Manufacturing firm - Raw materials - Work-in-process - Finished goods - Stock-in-trade (in e.g. retail, wholesale) - Measurement issues - Inventories should be measured at the lower of Cost and Net realizable value (LCNRV) Cost = input, net realizeable value = output - Example, Inventories H&M (1) (2) - Acquisition cost - Raw materials - Work-in-process - Finished goods - Stock-in-trade - What items do we measure? - FIFO, LIFO, or weighted average cost? (FIFO & weighted avg is allowed in IFRS) (US GAAP allows LIFO) - Inventories - FIFO, LIFO, average cost Scenario A - Stable prices Scenario B - Rising prices Scenario C - Declining prices - Inventories “There is another method sometimes used in large shops which have great numbers of different small items. Using this, the inventory is first counted and its total value at selling price is worked out. Clearly though, to value inventory at selling prices would be to take profit before sale. In order to avoid this, ratios of cost to price are worked out item by item or class by class and these are applied to the inventories to reduce them to cost…This is called the retail inventory method. An alternative method uses a gross profit margin, which is worked out using experience of prior years. Here, the valuation is even quicker, because the inventory cost is worked out by taking the goods bought (at cost) plus opening inventory (at cost) less the goods sold (at selling price reduced to cost by application of the gross profit margin). So no count is made. Consequently, this method should only be used as a check on other methods or where no other method is possible (e.g. to value inventory destroyed in a warehouse fire).” (Alexander & Nobes, 2020) [Financial Accounting: An international Introduction. Pearson. 7th ed. pp 220] Lecture 4 - Accounting issues: Long-lived assets - Capitalization - When firms purchase long-term tangibles and intangibles they initially need to classify their expenditures as either investments or expenses - This often involves trade-offs, e.g.: - Investment versus maintenance? (Uncertainties) - E.g. a building and the exchange of water pipes → expensed during the current period, tangible fixed asset. - Will the R&D lead to a sellable product? - Short useful life - laptops? - Robinson et al. point out the need for analysts to take differences in firm practice into account (pp. 348-353) - Example: - R&D expenditure (investment) of 210, which generates economic benefits of 80 per day during three years. - One new investment is made each year - Assume an opening all-equity-financed balance sheet with a cash balance of 200 - A dividend of 30 is paid in year 4 - Disregard taxes - By expensing the asset, you are being prudent and cautious. Which will mean lower returns initially but long term high returns since there are no assets. ROA goes up. Example Pharma, expense their R&D. - What intangible assets are recognized under IAS 38 (Intangible assets)? - Definition criteria - IAS 38 (Intangible assets) Is this an asset according to the definition? - Under IFRS, an asset is a resource controlled by an entity as a result of past events from which economic benefits are expected to flow to the entity. - An entity controls an asset if it has “the power to obtain the future economic benefits flowing from the underlying resource and to restrict the access of others to those benefits” (IAS 38, p. 13). - Paragraph 13 of IAS 38 further states (underlining added): “The capacity of an entity to control the future economic benefits from an intangible asset would normally stem from legal rights that are enforceable in a court of law. In the absence of legal rights, it is more difficult to demonstrate control. ” - An intangible asset is an identifiable non-monetary asset without physical substance. - An asset is identifiable if it either is separable or arises from contractual or other legal rights, regardless of whether those rights are separable from the entity. - Recognition criteria - IAS 38 (Intangible assets) Can i recognize this on the balance sheet? - An intangible asset shall be recognized if, and only if: (a) it is probable that the expected future benefits that are attributable to the asset will flow to the entity and (b) the cost of the asset can be measured reliably. - Specific recognition criteria for internally generated intangible assets: - No intangible asset arising from research shall be recognized (IAS 38, p. 57). - An intangible asset arising from development shall be recognized if the company can demonstrate the following: (a) technical feasibility of completing the asset so that it will be available for use or sale; (b) intention to complete the asset so that it can be sold or used; (c) ability to use or sell the asset; (d) how the asset will generate future economic benefits (e.g., existence of a market); (e) availability of technical and financial resources to complete the development and to sell or use the asset; (f) ability to measure the expenditure reliably during the development of the asset (IAS 38, p. 58). - What costs are capitalized? - IAS 38 (Intangible assets) How do I measure the value? - The cost of an internally generated asset comprises all directly attributable costs necessary to create, produce and prepare the asset to be capable of operating in the manner intended by management. Examples of directly attributable costs: - Costs of materials and services used or consumed in generating the intangible asset; - Costs of employee benefits; - Fees to register the legal right; - Amortization of patents and licences that are used to generate the intangible asset. - Internally generated intangible assets - IAS 38 (Intangible assets) - Costs that cannot be capitalized - IAS 38.69 - Even if all definition and recognition criteria for internally generated assets under IAS 38 are met, the asset may still not be recognized on the balance sheet: - IAS 38.69. In some cases, expenditure is incurred to provide future economic benefits to an entity, but no intangible asset is created that can be recognized. In the case of the supply of services, the entity recognizes the expenditure as an expense when it receives the service. - Other examples of expenditure that is recognized as an expense when it is incurred are: a) Expenditure on start-up activities (start-up costs). b) Expenditure on training activities. c) Expenditure on advertising and promotional activities. d) Expenditure on relocating or reorganizing part or all of an entity. - Tangible assets - Depreciation (1) - A distinction is sometimes made between - Accounting depreciation – the allocation of acquisition cost to the periods in which the asset is used up in order to generate revenues. - Economic depreciation –The periodic depreciation expense segregates a portion of cash flows for reinvestment, preserving that sum from distribution as dividends and taxes. - Related concepts: - Depreciation – allocation of the cost of tangible fixed assets - Amortization – allocation of the cost of intangible fixed assets - Depletion – allocation of the cost of natural resources - Depreciation (2) - Depreciation methods - The straight-line method is the dominant method - Different methods are allowed under IFRS: - Accelerated depreciation methods are common for the purpose of taxation - Depreciation (3) - Depreciable amount - = acquisition cost minus the residual (salvage) value - The residual (salvage) value is the estimated net realizable value of the asset at the end of its useful life. - Useful life: - The period over which an asset is expected to be available for use - Alternatively, the number of produced units expected to be obtained from the asset - Depreciation (4) - Impairment of long-lived assets - Why? - Some or all of the carrying value cannot be recovered from expected levels of operations.This may be due to, for example, market conditions or technology - Real event or “only accounting”? - The impairment charge reflect a decline in the ability of the asset to generate future economic benefits to the company - The impairment may signal a need for investment in improved technology - Management has some discretion with regard to timing - Impairment according to IAS 36 - An asset is impaired when its carrying amount exceeds its recoverable amount - Recoverable amount - The higher of the asset’s net selling price and its value in use - For assets in general, IAS 36 states: - “An entity shall assess at the end of each reporting period whether there is any indication that an asset may be impaired. If any such indication exists, the entity shall estimate the recoverable amount of the asset.” - Intangible assets with indefinite useful life (including also goodwill) shall be tested annually for impairment irrespective of whether there is any indication of impairment. - Age structure analysis - Average economic life (in years) - Average age (years) - Example from Unilever: - Liability - A liability is a present obligation of the entity to transfer an economic resource (a right that has the potential to produce economic benefits) as a result of past events. - Contingent liabilities: < 50% probability that it will come to fruition. - Provision: > 50% probability that the liability will come to fruition. - - Example from Scania: Notes from Seminar 2 - Inventory is written down when prices of it lower - When prices again rise, under IFRS you must report a ”write up” - aka a reversal of write-down - When prices rise (common) the FIFO assumption gives better profits → lower (historical) COGS, but you do get higher balance sheets - When prices fall (less common, but possible [see Sandvik case]) you will instead see higher COGS and lower Balance sheet. → Why then do we even have LIFO? Tax reasons… - Having higher COGS yields lesser profits on IS which leads to lower income taxes - Balance sheets can then contain decades-old inventories. - b) What is the underlying logic of reporting losses when the nickel price goes down? Don’t lower prices imply that Sandvik now buys this raw material cheaper and thus will generate a higher profit? - Since the market value of inventory (asset) is decreasing, we must correct the other side of the BS, this goes to Net income - expensed out. - The market corrects itself - with low input prices you can decrease your price against competition and keep the profit the same → All actors on the market must follow to not be priced out - It also depends on whether they operate on Cost + or Value. If the customer is pricing based on cost + commission/add-on they will be more sensitive and prices will also fall. If your customers base decisions on value, the input price of your product might not impact the price. - Surety bond: Company has made a commitment to a creditor to “step in” if one of their (usually) key suppliers would fail to pay e.g. a loan. This is done if the supplier is crucial enough. - Surety bonds usually have very low 9,5% Axfood: PM: 4,2. Capital turnover 4,8 => 22,3% Can be out in a graph, so everything on 10% line is the relationship which is needed for that level. Each dot is a year. ○ Green: H&M ○ Yellow: nokia ○ Pink: unilever ○ Black: SSAB ○ Blue: volvo ○ Purple: skistar. All high capital turnover, The stars: Inditex + H&M, have shown different strategies Other players with lower 1 business more or less failing Not enough to be in a good industry, you also have to perform in that industry. → A few years later → adding online retailers, ROCE > WACC - concept of value creation WACC: we want to create a return on capital employed that is higher than WACC if you are below, its in the corner Change of strategy Hotel companies Focus on owning hotels (properties) Change up and left in the quadrant (High PM / Low capital turnover). Operating hotel companies focus on running them. Change to the lower left quadrant (Low PM and high capital turnover). Looking at a business cycle sensitive firm like this: Red: LKAB; very varying margins Black: SSAB Blue: Volvo They are moving up and down, but also in a diagonal direction. Getting closer to end customer volatility is getting lower, as you have a little bit smaller variation ○ Steel company is in the middle ○ Volvo tries to resist increasing prices, so they are kind of squeezed in the middle. → The electric car Volvo C40 runs on fossil- free fuel, but the production of steel and other parts results in significant carbon emissions Both financial and sustainability targets One side focusing on operations and the other one focused on how to finance the operations. ○ Sales growth 8% ○ means also 8% growth in Capital employed ○ assume we have the same level of debt to equity, so it will be financially balanced growth. As CE is growing by 8% it meaning that also equity and debt are both growing by the same percentage. ○ to pay half in dividends, we need ROE of 16 %, ○ We also need to know the tax rate of 23 % and the level of debt to equity raito ○ Size of sales 127 billion ○ CE 137 billion ○ Equity: 88 billion ○ Debt: 49 billion ○ Starting point of debt to equity ration gives us 0,56 ○ Du pont analysis Focus on disciplined capital management to improve their ROCE What is the value of reducing DSO (days of sales outstanding) by 1 day? This analysis above, on the question of the value of improving A/R with 1 day: exemplifies how a firm can work with small decisions and you can follow the impact on the profitability. Missing lecture notes? Notes from Seminar 5 For Scania he wouldn't use ROIC because it takes away their business → instead use the ROCE. Exercise new Wave - Financial targets 1. Question - ROE 16% - Growth 10 % in net sales and assets. - How much can they pay in dividends if accepting an equity ratio of 40% Start - Growth in assets of 10% - calculate 40 and 60% of that into Equity as we know that the equity over assets ratio is 40% - Equity over 11936,1 ) 40%, a big drop and not financially balanced - We can solve for equity = 4774,4 → liabilities of remaining amount to sum up at the same as the asset (11936,1) - What can be the change in equity over the years and what factors will affect the change. - Net income increases - Dividends = reduction in equity + net income - Assumption: no new issues of shares! - Return on Equity = 16% → 0,16* 6588 = 1044,5 = net profit - The residual is the dividends = - 2798,1 Growth and looking into future from one balance sheet to the next = you cannot use averages 2. Question - Achieve ROE of 16% - Dividends according to policy - How much can they grow in assets? Start - We cannot start with assets - We start with equity, assuming no new issues, we know its increasing by 16% - Taking away dividends (Div/E) we have a growth in equity of 9,6 % - 6528 * 9,6% = 7154,7 - We also no the capital structure is 40 % of equity to assets. - 7154,7/A = 0,4 → 17886, 8 - Growth in assets 10851 → 17886,8 = 7035,7 → 65% growth in asset. - Assumption - no new issues - Dividends are paid in the same year as corresponding profit is earns Q3 - Find P/L items - Sales (9466*1.2) = 11359 - Ebit (11359.2 *0.2) = 2271.84 - Financial income = 10 - EBIE= 2271.85+10 = 2281.84 - Minus Interest expense (2281 / IE = 11 [Interest coverage ratio]) = -207.4 - EBT = (2281.84-207.4) = 2074.4 - Tax (2074.4*0.22) =-456.4 - Net income = 2074.4-456.4 = 1 618 Example NCC: A sensitivity analysis from the listed construction company NCC's annual report is shown on the next page. Answer the questions below: Why the is the effect on ROCE of 1% increase in operating margin larger in Building than industry / infrastructure Look at the sensitivity analysis for operating margin for NCC Building, NCC Infrastructure and NCC Industry (Three different business areas). Explain why the change of 1 percentage point has such a varying impact on return on capital employed (ROCE). What conclusions can you draw about differences across the three business areas? - Its the capital turnover - As the operating margin * Capital turnover = ROCE - Building = very high in capital intensity - Contract liabilities - A/R - Infrastructure is lower; compared to building you need - some big machines, - also som A/R - Customer are the government, and they don't giveaway big advancements (so they have contract liabilities - but they are smaller!) - And industry has the lowest capital turnover. - Factory inventory. - A/R - No Contract liabilities. → in total it must be compensated by a higher margin, Operating margin x Capital turnover = RoCE Building 1% 2.6 +2.6% Infrastructure 1% 2.0 +2.0% Industry 1% 1.3 +1.3% Provide a calculator showing how the effect is explained NCC Group has 5.5 billion SEK in shareholders' equity and the return on equity (ROE) is 18.2%. The tax rate is 22% and the equity ratio (Equity/Assets) level is 20.4%. According to the sensitivity analysis, a decrease in the equity ratio of 5 percentage points would increase ROE by 5.6 percentage points. Provide a calculation that shows how this effect may be explained! Describe the assumptions you make - We have equity of 5,5 million - E/A = 20,4% - → We can calculate assets! - Assets = 27 - -5% units - → 15,4% - Can either increase assets or reduce the Equity - We want higher return → good to decrease the Equity - Assets will be more difficult and connected to growth (fixed assets, A/R, etc) - Reducing equity - form 5,5 → 4,15 (-1,35) we can - buy back shares - paying dividends. E / A down with 5% → ROE goes up på 5.6% Pre ROE = NI/ E ROE = NI / 5.5B = 18.2% → NI = 5.5B*18.2% = 1,001B E / A = 20.4% 5.5B / A = 20.4B → A = 5.5B/20.4% = 27B L = A - E = 27B - 5.5B = 21.5B E = 5.5B NI = 1,001B ROE = 18.2% A = 27B L = 21.5B Change happens E/A= 20.4% → E/A = 15.4% [keep assets unchanged since they are more slow-moving] E / 27B = 15.4% E post = 15.4% * 27B = 4.15B ∂E = (4.15-5.5)/5.5 = -24% → Dividends or share buy-back. A 27 | E 4.15 → L = A-E= 22.85B ∂L = (22.85-21.5)/21.5 = 6.27% → financing increases NI post = E * ROE = 4.15B * (18.2%+5.6%) = 988M EBT pre = EBT * (1 - 0,22) = NI → NI / (1-0,22) = EBT = 1001B/(1-0,22) =1 283,3B EBT post = 988M /(1-0,22) = EBT = 1267B ∂EBT = (1267-1 283.3) = -16.3M = Interest payments on increase in L. Notes from Seminar 6 - For ROA, we take EBT and add back interest expenses instead of using EBIE (easier in this instance considering amount/range of financial income/expenses. - EBIE = EBT + interest expenses to get earning before interest expense. (to deal with the net financing income expense and interest income) 5 component formula DuPont ROE Formula with five components (described on page 259 in Robinson et al). - What is left after taxes [ (1-t) ] - → Interest coverage ratio (instead of COL) - Advantage of 5-component formula is that information about interest coverage is taking into consideration and its ratio can be derived from the formula. - → Profit margin - Profit Margin * Asset Turnover = ROA - → Asset turnover - Profit Margin * Asset Turnover = ROA - Advantage of 5-component formula is that we get more information about the state of the firm (e.g. asset turnover) instead of only ROA. - → “Leverage” (compared to Johansson formula which uses L/E) - A/E = 1 + L/E → can derive L. Advantage: infromationtion about interest coverage ratio as part of the formula. ways to derive at ICR/TIE with the (EBT/EBIE) ratio Advantages Separates Disadvantage Cash cycle days COGS: inventory value of the product; is it matched when you have the revenue. Cash cycle net: between supplier payment and customer payment: we want it small as it has to be financed with debt /equity. Working capital = Current assets - Non interest bearing Liabilities Prep Seminar 6 Notes brewery-exercise - What influences inventory days - Assortment of products (breadth) - Export (larger bulk shipping means large inventory build ups pror to shipping. Also prolongs status as inventory if customer doesn’t take over ownership until final delivery. - Production efficiency. - Logistics/distribution - Customers - Customers don’t want to bear risk of holding too much inventory. - Own pubs? Prolongs delivery date until consumption. - Behavioral effects - Head of Procuremetn does not want to hold too much inventory - Head of Production wants raw materials always available. - If Procurement places enough raw materials to keep Production happy, there is a risk of inventory becoming larger. - You don't want bottlenecks in production because of shortages etc. → you need to have a small buffer and build up inventory. - Sales want a large assortment and inventory to keep customers happy → not having to wait for a production run. - A lot of talk about innovation and developing new products and widening product base, but what about killing old products? Finished goods becomes larger and larger. - Overall, behavior in organization tends to make inventories grow over time. - Customers - Restaurants | Retailers | Systembolaget | Own pubs [direct customers] - Reasons for difference in number of A/R days : - Bargaining power (Carlsberg international group has large negotiation power compared to the smaller national companies) - Contracts → using the number of payable days as a competitive edge. Firm acts as a financier for the restaurants who cannot finance through loans (low credit ratings), however, this incurs credit risk. - Cash sales (e.g. in own restaurants/pubs) lowers A/R days. - Suppliers - You need supplies [malt, hops, water, sugar, bottles, cans, packaging] - These supplies often have monopolistic/low competitive markets. Bargaining power of suppliers quite strong → harder for smaller breweries. - Push vs Pull - You want to go away from the push mentality, instead teach customers to order, wait for full production run, then get product. This reduces Cash cycle (sometimes into the negative [Dell]). - Working capital definitions (!COURSE DEFINITION!) Working capital = Current assets - Non-interest bearing liabilities (NIBL) - (Johansson & Runsten) Working capital = Current assets - NIBL - Liquid assets - This implies that liquid assets are not needed to run the company (operations). - The argument is that some companies have surplus cash (not only buffer cash - which is not needed to run the business) - This is not accurate, as all companies need a cash buffer to run the business. - If you want to use some form of cash in forecasting, instead include a minimum cash level in the current assets. - (Robinson et al.) Working = Current assets - Current liabilities - Disadvantage is that you don’t separate operational and financial liabilities. - Change in working capital (in CFS) can then be influenced by e.g. short-term loans which are not part of operations. - This definition is not advisable to use. - Cash-to-sales → Liquidity measure change to annotatedSLIDE - In all liquidity measures we use the most recent figures (Closing balance) - Only in return measures (ROA, etc.) we use OB measures to see the return. - Consultancy what salaries every month, if customers stop coming, how many months can we continue to pay salaries= → requires a higher buffer. - Post-seminar 6 Assignment C Bra förklaring av ChatGPT på hur man kan räkna denna typ av uppgifter. Q:In total, T-GROUP has three financial targets: “Return on capital employed” (according to T-GROUP’s definition): 15% Return on equity: 15% Net debt to equity ratio: 75-125% Make a numerical evaluation of whether these targets are consistently defined, i.e. that they can all be achieved at the same time. Assume that the effective tax rate is 20%, that the sum of amortization and items affecting comparability amounts to an annual cost of 1% of net sales, that the cost of net debt is 5%, and that capital employed according to T- GROUP’s definition corresponds to 70% of net sales. State additional assumptions made. A: To evaluate whether T-GROUP’s financial targets are consistently defined and achievable at the same time, we need to check the relationship between the three key financial targets: 1. Return on Capital Employed (ROCE): 15% 2. Return on Equity (ROE): 15% 3. Net Debt to Equity Ratio: 75-125% We are given: Effective tax rate: 20% Amortization and items affecting comparability: 1% of net sales Cost of net debt: 5% Capital employed as a percentage of net sales: 70% Step-by-Step Approach: 1. Understanding the Relationships Between the Metrics ROCE (Return on Capital Employed) is defined as: ROCE=EBITACapital Employed=15%\text{ROCE} = \frac{\text{EBITA}}{\text{Capital Employed}} = 15\%ROCE=Capital EmployedEBITA=15% ROE (Return on Equity) is defined as: ROE=Net IncomeEquity=15%\text{ROE} = \frac{\text{Net Income}}{\text{Equity}} = 15\%ROE=EquityNet Income=15% Net Debt to Equity Ratio is defined as: \frac{\text{Net Debt}}{\text{Equity}} = \text{75% to 125%} We need to test whether the given assumptions can lead to these targets being achieved simultaneously. 2. Make Additional Assumptions We need to make assumptions for some missing values, like net sales, capital structure, and cost of debt. For simplicity, let's assume: Net Sales = 100 units (This simplifies the calculation). Capital Employed = 70% of Net Sales: This means: Capital Employed=70 units.\text{Capital Employed} = 70 \text{ units}.Capital Employed=70 units. We'll need to split capital employed into debt and equity according to the Net Debt to Equity ratio target, which will impact both debt costs and the calculation of ROE. 3. Step-by-Step Calculation Step 3.1: Calculate EBITA from ROCE Target We know that ROCE = 15%, and from the formula for ROCE: ROCE=EBITACapital Employed.\text{ROCE} = \frac{\text{EBITA}}{\text{Capital Employed}}.ROCE=Capital EmployedEBITA. Given that capital employed is 70 units: 0.15=EBITA70.0.15 = \frac{\text{EBITA}}{70}.0.15=70EBITA. Solving for EBITA: EBITA=0.15×70=10.5 units.\text{EBITA} = 0.15 \times 70 = 10.5 \text{ units}.EBITA=0.15×70=10.5 units. Step 3.2: Calculate Operating Profit (EBIT) EBITA excludes amortization and items affecting comparability, which we know amount to 1% of net sales (or 1 unit). To get EBIT: EBIT=EBITA−Amortization and Items Affecting Comparability.\text{EBIT} = \text{EBITA} - \text{Amortization and Items Affecting Comparability}.EBIT=EBITA−Amortization and Items Affecting Comparability. So, EBIT=10.5−1=9.5 units.\text{EBIT} = 10.5 - 1 = 9.5 \text{ units}.EBIT=10.5−1=9.5 units. Step 3.3: Calculate Net Income To calculate net income, we must account for interest expenses on net debt and taxes. Interest Expense: We need to calculate the net debt first. Let's assume a Net Debt to Equity ratio of 100% (the midpoint of the target range), which means Net Debt = Equity. Since capital employed consists of equity and net debt: Capital Employed=Equity+Net Debt.\text{Capital Employed} = \text{Equity} + \text{Net Debt}.Capital Employed=Equity+Net Debt. With Net Debt = Equity, this implies: Capital Employed=2×Equity.\text{Capital Employed} = 2 \times \text{Equity}.Capital Employed=2×Equity. Given that Capital Employed = 70 units, we get: 70=2×Equity⇒Equity=35 units.70 = 2 \times \text{Equity} \Rightarrow \text{Equity} = 35 \text{ units}.70=2×Equity⇒Equity=35 units. And therefore, Net Debt = 35 units. Interest Expense is 5% of Net Debt: Interest Expense=0.05×35=1.75 units.\text{Interest Expense} = 0.05 \times 35 = 1.75 \text{ units}.Interest Expense=0.05×35=1.75 units. EBT (Earnings Before Taxes): Subtract the interest expense from EBIT to get earnings before taxes: EBT=EBIT−Interest Expense=9.5−1.75=7.75 units.\text{EBT} = \text{EBIT} - \text{Interest Expense} = 9.5 - 1.75 = 7.75 \text{ units}.EBT=EBIT−Interest Expense=9.5−1.75=7.75 units. Net Income: Subtract the tax (20%) from EBT to get net income: Net Income=EBT×(1−0.20)=7.75×0.80=6.2 units.\text{Net Income} = \text{EBT} \times (1 - 0.20) = 7.75 \times 0.80 = 6.2 \text{ units}.Net Income=EBT×(1−0.20)=7.75×0.80=6.2 units. Step 3.4: Calculate ROE Now, using the Net Income and Equity values, we can calculate ROE: ROE=Net IncomeEquity=6.235=17.7%.\text{ROE} = \frac{\text{Net Income}}{\text{Equity}} = \frac{6.2}{35} = 17.7\%.ROE=EquityNet Income=356.2=17.7%. This is higher than the target of 15%, meaning the equity return is better than expected, suggesting that the financial structure supports the company's ability to meet the ROE target. Step 3.5: Evaluate Net Debt to Equity Ratio We assumed Net Debt = 35 units and Equity = 35 units, leading to a Net Debt to Equity ratio of: Net DebtEquity=3535=100%.\frac{\text{Net Debt}}{\text{Equity}} = \frac{35}{35} = 100\%.EquityNet Debt=3535=100%. This is within the target range of 75% to 125%. 4. Conclusion: Can All Targets Be Achieved Simultaneously? ROCE Target (15%): Achieved, as we calculated an EBITA of 10.5 units, corresponding to a ROCE of 15%. ROE Target (15%): Surpassed, as the calculated ROE is 17.7%, which exceeds the target of 15%. Net Debt to Equity Ratio (75-125%): Achieved, as we assumed a ratio of 100%, which is within the target range. Thus, all targets can be achieved simultaneously based on these assumptions. The company's capital structure, profitability, and debt levels seem aligned to meet or exceed the set financial goals. Lecture 10 - About mergers and acquisitions - What will be covered M&As – A frame of reference Basic principles (Schuster, ch. 1-2) Majority stakes, 100%, varying deal conditions (Schuster, ch 3-4) Goodwill impairment Synergies and integration costs Mergers (Schuster, ch. 5) Majority stakes, non-controlling interest (Schuster, ch. 6) Minority stakes (Schuster, ch. 7) Joint arrangements Why acquisitions? 1) Primary motive: Create additional shareholder value 2) Secondary motive: Corporate strategy for growth & profitability (means to achieve the primary motive) 3) Hidden motives: May not fully correspond with the primary motive Hidden motives example: 1. To buy or to be bought (fear) 2. Everyone else is buying 3. If I don’t buy, my competitor will 4. It’s the last chance to buy something 5. Creating an empire 6. Show ability to act 7. Media pressure 8. Pressure from financial intermediaries; - Corporate acquisition strategies Horizontal: acquisition of a company at the same phase(s) of a particular value chain. We have value chain with end customer and process on the way (from R&D and raw materials → production and → sales and marketing) A horizontal: buying the same part of the value chain where you are E.g Kraft - Cadbury: doing the samt thing ○ Market share is usually the main objective ○ (products/markets) ○ Economies of scale ○ Criticial mass (e.g., R&D) Vertical: acquisition of a company in an earlier or later phase of the same value chain (supplier/customer). ○ Control over critical resources ○ Higher margins later phases of the value chain Concentric: acquisition of a company in another value chain, but where there are product or market links (like the same technology or the same distribution channels). Conglomerate: acquisition of a company in a different value chain. - - Are M&As successful or not? - On the basis of a review of 93 published studies, King et al. (2004, Strategic Management Journal) conclude (emphasis added): ‘We find robust results indicating that, on average and across the most commonly studied variables, acquiring firms' performance does not positively change as a function of their acquisition activity, and is negatively affected to a modest extent.’ - In a more recent review, King et al. (2019, Mergers and Acquisitions: A Research Overview. Routledge) state (emphasis added): ‘Still, research consistently examines the effectiveness of M&A using financial or other measures of M&A outcomes. While [methodological] progress has been made through reviews (…) and meta-analysis of prior research (…), observed failure rates of M&A have not improved over the recent decades…’ → Usually not successful anymore - on average mergers do not succeed! Financial Statement affect: Parent + Subsidiaries = forms the group. - Control: “old” IFRS old IFRS: the power to govern the financial and operating policies of an entity so as to obtain benefits from its activities. >50% More than half of the entity’s voting rights – presumed control unless lack of control is demonstrated. ○ Other circumstances: If not more than half of the entity’s voting rights – control may still be obtained through agreements or board structures This is still applied in many local regulations. - Control: NEW IFRS regulation: ○ “De facto control” ○ Considers the practical “Power”, for example if you have the power to significantly impact the business thus (investee’s return), i.e 40% ownership but only small other owners of the firm, then one can argue that this fulfills the criteria of control. (Most important part). - Company vs. group - The group ( the consolidated financial statements) is the primary unit of analysis for capital providers. - However, it is important to note that it is still the company (legal entity) that signs contracts and is subject to taxation, not the group. - Dividend restrictions will refer both to the company accounts and the group accounts, depending on the country-specific legislation (often the legal - company account tend to dominate) - Example: Securitas - The group - Example: Cloetta - Cloetta is the oldest chocolate producer in the Nordic countries with traditions from the Swiss brothers Cloetta who founded the company already in 1862 in Copenhagen. Cloetta’s sales comprises chocolate confectionary (17%), sugar confectionary (59%), pastilles (12%), chewing gum (7%), nuts (3%) and other (2%). - Need to make acquisition as investment in new brands is extremely difficult. Cloetta Fazer Split: - Cloetta has a history of making acquisitions. - Scenario 1) 100% acquisition - Scenario 2) Increased price [Book-values = fair values] - We have to add also the purchase analysis: - Where we analyzze the price we pay → what do we pay for? - Starts with price, minus Fair value of Net assets [Net assets = Fair value of Assets less Fair value of Liabilities] → The difference between purchase price of net assets and fair value of net assets is called GOODWILL - Its the residual; what you cannot explain by looking at just target companies assets / laibiltiies - Not everything can be capitalized as Goodwill (e.g. Synergies & Human resources) - We get a lower ROCE because; The difference is the Goodwill of 900. Typically we don't get an impairment; so there is an incentive to pay as much as you can because it doesn't matter how much you pay for your EBIT. Acquiring a company with high EBIT margin is making the group look better, however we need to also look at the ROE because it is one of the few measures that captures the effect of the goodwill. - - - Scenario 3) Acquisition financed through New issue - Assume that Book value = Fair values - Purchase analysis do not change from the previous scenario (Goodwill 900) - Equity now changes due to New issue of shares. - Debt ot equity goes down → New issue - Equtiy to assets goes up → New issue - Interest expenses: we are financing with equity = no additional interest expenses. - By adding new equity through an issue, ROE is expected to decrease since the denominator will grow. - This scenario involves lower return but lower leverage. Trade-off between return and risk. - we get so much better bottom line - However the equity has also increased, so return on equity is affect - ROE = 7,8%, it's lower than both our previous scenarios. - EPS: old shares = 285.342, but we need to add the new shares issued. - Number of new shares = new issue of 2.2 share price to divide with → we were given the market price, and made a new issue, are they issued at market price or need to make a discount? often hear about discount - for right issue it doesnt matter because they are holding shares in proportion - 2200 / 18, 32 = 120.987 shares. - Total new shares 405.429 - Just changing the financing, we are lowering the EPS, related to both how the share is priced, and - Thus the financing method should depend on market value of equity (M cap price) or the interest rate etc. we get so much better bottom line - However the equity has also increased, so return on equity is affect ROE = 7,8%, its lower than both our previous scenarios. - Purchase method (acquisition method) (IFRS 3) - The acquisition is viewed as a transaction where the parent company indirectly acquires the subsidiary’s assets and liabilities. - formally buying the share Notes from Seminar 7 When we make an aquisiton, no matter what we pay, the numerator in ROCE will be unchanged (as long as there is no goodwill impairment charges) so EBIT will look pretty good. Scenario 4) (seminar prep) Acquisition through both Debt & New issue First step: Purchase analysis: It can also be called acquisition analysis or purchase price allocation (PPA) - Start with purchase price 2 200MSEK - Compare to Net assets - Start with Book value of Assets 2 300MSEK - Add gains/loss fair value valuations - Brands + 800MSEK - Inventory + 80MSEK (460-380) - Remove Book value liabilities - 1 000MSEK - Remove Deferred tax liability - 176MSEK (Created due to Temporary difference between tax base and financial reporting - (800*0,2) + (80*0,2) See Deferred taxes in Schuster book. - Net assets = 2004 - Difference between Purchase price and Net assets = Goodwill - 2 200 - 2004 = 196MSEK = Goodwill - What to do with Brand - Expensed for two reasons - IFRS, developing own brand, will never be capitalized, it is forbidden! - IF you have a sales / promotion campaign, which for example are seasonal, there is often a price tag attached, meaning it is a connection to revenue. → campaign generates revenue = matching principle; so the cost of the campaign is expensed, so you don't have to think of whether it is capitalized or not. - Tax value of Brands at TOMS is 0, since brand building activities are not capitalized, and therein tax deductible /already taxed through income statement historically. → Tax base = 0, IFRS Financial reporting 800 → Temporary difference → Deferred tax - We say that if the brand was sold for 800, there would be a taxable capital gain of 800. - When we acquire the asset we need to consider the temporary difference. - Exception for Goodwill: goodwill can only exist in groups, and the group is not the tax Goodwill is not taxed due toe IASB making an exception in their rulings. → No tax effects/posts/adjustments for Goodwill. Fair - Would we go through with this acquisition? - Initially all key ratios will decrease, signaling that initial effects of merger will reduce RoE, EPS, ROCE, Solvency and increase D/E. - However, if we forecast longer ahead, when integration costs are passed and we only consider the new group with its synergies and what-not, we do see increase of all ratios. - → In real life, analysts count backwards to see what level of synergies etc. are required for this to be a viable investment. Acquisition analysis - Identifiable assets & liabitiles - IFRS 3 requires that all identifiable assets (and liabilities) are separately accounted for in the the purchase price allocation if they meet the weaker recognition criteria established in 2004: - Legal control – but without separability - Separability – but low requirements regarding control - Examples of possible identifiable assets: - Purpose of IASB creating these guidelines is to reduce amount of Goodwill as much as possible. - Goodwill is by definition not identifiable. - Acquiring a company that itself has goodwill on its balance sheet does not mean that you take over that Goodwill. - Shares vs Asset deal - What are you purchasing? Shares or assets - “purchase method” assumes that you purchase all the underlying assets. - In Marconi example, we are not buying shares, but directly the underlying assets. - When we buy an asset, we can depreciate it which is tax deductible → there is no temporary difference between tax base and reported tax. - (Marconi example, the reason for Asset deal was that Ericsson didn’t want to purchase the underlying Pension provisions) - Goodwill can be created on the Legal entities balance sheet when an Asset deal is done. - Goodwill Impairment test - Acquiring another company you must remember that is is not possible to evaluate the asset on its own. - You test the business in which goodwill is included. - You start with acquisition cost: what is the price we pay for net assets. - This is then compared with the recoverable amount. - how to determine recoverable amount: - If it is lower = you recognize an impairment - Impairment charge always hits Goodwill first (write down goodwill before other assets) - Cash-generating unit: - “The smallest identifiable group of assets that generates cash inflows that are largely independent of the cash inflows from other assets or groups of assets.” - We want to test at the smallest/lowest level of analysis. - If we test at a high level, it is harder to identify a difference and therefore a smaller chance of having a Impairment charge. - If firms keep acquired firms separated as a single CGU, the impairment test method of IFRS 36 works pretty well. - However, if the acquired company is integrated into other CGUs the method of impairment tests is not as effective. - Impairment test procedure (simplified) 1) Calculate the recoverable amount of the acquired business (normally, the present value of the expected cash flows) 2) Deduct the book value (carrying amount) of the net assets of the acquired business. 3) If the difference is negative, that is, the recoverable amount is lower than the book value of the net assets, recognize an impairment charge by this amount. Lecture 11 - Acquisition date - The point in time when the acquirer gets control over the target’s net assets and operations. - Can be a long period from when the bid is announced, but you start consolidation when you actually get control of the entity. - The acquirer includes the target’s revenues, expenses, assets and liabilities in the consolidated accounts from the acquisition date. - Example: - Purchase price and Acquisition cost - Whether cast are include din consideration or not, it was before (2005), but from 2010, you dont include the cost anymore, just the prices, as the cost connected to acquisition did not fulfill the requirements of an asset. - - Purchase price in non-cash deals - How should the purchase price be established when the acquirer pays by transferring own securities to the seller? - Listed securities: Quoted price at the time of the transaction unless the volatility is remarkably high or the liquidity is so low that the quoted price does not provide a reliable fair value. - If the quoted price does not provide a reliable fair value, the price during a reasonably long time before and after the takeover was announced is taken into account. - Earlier you took the share price before acquisition was known to have it independent → now its changed in connection with 2005 → you take quotes price at time of transaction ( quated time at time when you get control). As noted, the time can be quite long, implying goodwill is not really set during the period from announcing the bid until control of the shares. - We don’t want the information/news/knowledge of pending acquisition to influence the share price, therefore a more neutral share price should be selected in the calculations. - Negative Goodwill - When the acquisition cost is lower than the fair value of the identifiable net assets, negative goodwill was previously reported under IFRS. According to IFRS 3, the following now applies in such a situation: 1) Prepare the purchase price allocation (PPA) again. The company has presumably overstated the asset values or understated the liability values. 2) If the net assets still exceed the acquisition cost after the revised PPA has been prepared, the surplus value shall immediately be reported over the income statement (“Bargain purchase”). - Negative goodwill is still reported under national GAAP in many countries and non-listed groups. - Some basic concepts: - Acquisition - one company acquires a stake in another company - Majority stakes - controlling influence - Minority stakes - significant or non-significant influence - Merger between equals - no identifiable buyer. - Accounting for M&As - Purchase method, pooling method, or fresh-start method. - Pooling method allowed in some national GAAPs - It was prohibited as it was not used in the way intended. - The company said if you take away goodwill (away the pooling method) we won't amortize goodwill anymore and they agreed to that → pooling method as removed, so there is only one method. - Example: Cloetta - TOMS: Acquisition of 75%. Scenario NCI - Same condition as scenario 2, but acquisition of 75% instead of 100%. - Purchase analysis: - Assume fair value = book value in TOMS (as in scenario 2) - Price paid: 1650 (only 75% of shares) → we compare it to75% of assets - 0.75 of assets - Deduct 0,75 of liabilities. - 1650 purchase price Less 975 Net assets = Goodwill 675. - This is the “Partial Goodwill Method”, advised by more Conservative accountants. - The “Full Goodwill Method” is advised by proponents of Fair value accounting. - This yields higher Goodwill as well as higher NCI. - NCI is then calculated at Fair value of company, which is the purchase price, instead of the book value (equity). - Balance sheet post acquisition: - Assets © As previously the assets from closetta is added. - Assets (T) As we have a controlling influence we should take all of the assets / liabilities. → Control means controlling everything. - Include 100% of TOMS assets and liabilities in our postacquisiton balance sheet. - Summing up assets and other side of BS, we will be missing something - its the minority shareholders of 25% - → NCI - Non-controlling interest (IFRS term) is found in Equity. - The 25% percentage of ownership of TOMS is sent to Equity (1300 * 0,25) 325 - Income Statement post acquisition - Use the 100% as well and sum it as previously done. - The difference is a little bit smaller debt, but other than that it is just as in scenario 2 - The impact is very small from buying 75% only (interest impact) - But we must have non controlling interest as part of the income statement. - → How much of the profit of the company is allocated to the NCI’s? - Disclose this in income statement by splitting profit statement into two groups: - Non-controlling interest 25% of TOMS = 29 = 116 * 0,25 - Parent company shareholders: 491,8 - 29 = 462,8 - Ratio calculations - Group perspective = management perspective; im reaching ROE for the group, dont care about NCI - “What is the Return on Capital of the group” - not caring about where the equity funding comes from. - Parent company may only concern about the listed share price -.- - Another perspective of calculation is then the perspective of “ROE from the parent company shareholders perspective” - Only include profit allocated to parent company (462,8) and parent company equity (5 100) - EPS: - Listed company - parent company perspective; For earnings per share we don’t have two different methods, it must be in the parent company perspective. - Non-controlling interests - The share of a subsidiary’s net assets and net profit that is not owned by the parent company. - Subsidiaries with non-controlling interests are included in the consolidated accounts at the gross amounts for revenues, expenses, assets and liabilities - Redemption of shares in subsidiaries: - National legislation often permits parent companies to redeem the minority owners’ shares at a certain level of ownership (e.g. > 90%). - Some of the minority looses right in decisions. - 10% is therefore sometimes called a coroner position, as you can block an acquirer to reach full control. - Sometime the right to call for redemption - Associated companies - When a company has significant influence, but not controlling influence, over another company. - Significant influence implies that the owner can influence strategic decisions. Significant influence - Standard from IFRS: - If the owner company owns a minimum of 20% of the voting rights in another company, it is presumed that the owner company can exercise significant influence. However, other circumstances may lead to deviations from the 20% presumption rule. - Significant influence is typically reflected in one or more of the following: - Board representation - The owner company participates in the work on strategic issues. - Significant transactions between the two companies - Exchange of senior personnel - Exchange of technical information - Volvo acquired Scania (45) but were not allowed in the board room, they had no significant influence, rather just a financial investment. - Equity method - The equity method is used when accounting for associated companies in the consolidated accounts. - At acquisition, the shares in the associated company are reported at acquisition cost. Subsequently, this value is adjusted for the owner company’s share of the change in the associated company’s net assets. - The ownership company’s income statement includes its share of the associated company’s net earnings. - Called the Equity method because it mirrors the value of equity in the associated company. - The asset side increases (+) with profit and Decreases with you get dividends - Equity method - Example: - Alfa Ltd owns 40% of the share capital (and the voting rights) in Beta Ltd. The shares were acquired for 100 on 1 January year 1. - For year 1, Beta Ltd reports a pretax profit of 15 and a net profit of 10. - At the Annual General Meeting year 2, a total dividend of 5 is decided on based on the year 1 profit. The dividend is paid out a few weeks later. - For year 2, Beta Ltd reports a pretax profit of 20 and a net profit of 15. - Exercises: 1) Calculate the impact of the above information on Alfa’s consolidated income statement and balance sheet for year 1. - Profit shares in associated companies: - take 40% of net profit (the share of the company) and put it in yout income statement. (Called a one-line consolidation) We take our share fo profit but just on one line on the income statement - This example is according to equity method, an alternative is to use the cost method; taking dividends and have that as financial income. - We are increasing the value of the assets above the costs, usually we do not write up the value fo asset like this. 2) Calculate the impact of the above information on Alfa’s consolidated income statement and balance sheet for year 2. - CocaCola Example - steady demand and purchase = steady gross profit margins, but the equity income (loss) is not as steady - so is it really a market price in the transaction… - May look at external sales etc, one must be critical, if there are related companies. that are associated - arms length transaction. - Joint arrangement - A ‘joint arrangement’ is an arrangement over which two or more parties have joint control. - The arrangement must be regulated in a contract. - Joint control: Contractually agreed sharing of control exists only when decisions about the relevant activities require the unanimous consent of the parties sharing control (you must agree). - Example of joint control over a joint venture: ICA which was ownd by the Dutch listed company Ahold and the Swedish listed company Hakon Invest. - Joint arrangements - IFRS 11 - Since 2014 (in the EU), a new standard, IFRS 11, applies. This standard starts out from a general concept of joint arrangements. According to this standard, a joint arrangement shall be classified as either: - a joint operation → Apply the proportionate consolidation method - Each party puts in its own assets in which they work together, it doesn't have to be a legal entity. or - a joint venture → Apply the equity method - Legal entity when you own the share of net assets. - Example from Bouyges Annual report - - Proportionate consolidation method (in case of a joint operation) - Proportionate consolidation implies that the owner reports its share of the joint operation’s revenues, expenses, assets and liabilities. - Owning 50% you take 50% of consolidation income statement, - 50% of each line. - Under ‘old’ IFRS, the proportionate consolidation method was the preferred accounting treatment for joint ventures in the consolidated accounts until 2013 (in the EU). The equity method was then an allowed alternative. - ICA example: 60% does not allow decision authority in this case. - French example - Acquisition cost method - Owned shares are reported at acquisition cost on the balance sheet. - In the owner’s income statement, dividends are reported as income. Notes from seminar 8 Joint arrangement - what is special: There needs to be a contract: not just about acquiring shares; all owners must agree to have joint control over the arrangement. - At least 2 members, but possible to have more. - Joint arrangement is either: - Joint venture or Joint operation. 1. Joint venture is used when a firm owns a stake in the entity's net assets. - The accounting rule will be the equity method. - Use joint venture (and EM) if you own a stake in the entity's net assets (equity). - c 2. Joint operation is used when a firm owns a stake in the entitys gross assets and liabilities. - The accounting rule will be PCM (Proportionate consolidation method), - this used to be the preferred choice of the two, but now with the new standard you use the assigned method for respective type of joint arrangement.. → however, choice is never good in relation to comparisons - Use Joint operation (and PCM) if you own a stake in entities gross assets and liabilities. - Joint operation is common in e.g. construction. - How to make the decision of classifying type of arrangement: - Joint venture: If you own a stake in the entity’s net assets (equity) → Joint venture → Equity method - If you own a stake in the entity’s gross assets and liabilities → Joint operation → Proportional Consolidation Method Joint control - other possibilities: - subsidiary: controlling influence - “significant influence” - members on the board or sharing information as technical / key employees. - If you have 20% you need some argument if you say it is not significant influence. - Significant influence = one line consilidaiton rather than 100% as in the case of - below xx(20?)%> Acquisition cost method Example → Ericsson went from significant influence to just below (19.9%) the regulation to acquisition cost. ○ WHY: losses in the associated company - with equity method you take your share, even if its a loss. For the financial method you take just dividends. even if there were no dividends in this case 0 is better than negative. → as we as analyst know, it is good to test and go from one situation into another. Sony Ericsson was formed when ERicsson had tried to develop their phone on their own, but competition forced better understanding of consumer - From Equity method to proportionate consolidation method - 1. Take out SE’s profit share (need to know how big it is) its net income * 0,5 * 9 2. - In balance sheet - - Take away net assets instead of profit because the shares mirror the level of equity, and net assets is representing that - Then add the effect of gross assets (being xxx?) → then we can calculate asset turnover. - What does analysts think of the difference between Equity Method / Proportionate Consolidation Method - You are adding profit but not sales. → distorts the profit margins. - You see net asset on asset side but not whether it assets are funded by equity or debt (leverage) - You show profit but if you have a company that never pay dividends, you are still showing profits; - The income statement (with profit shares) does not disclose whether the profit shares of the associated company is “retained earnings” that you actually can get. - Example of Telia and ~Megaphone: Lots of profit shares, but zero dividends and no way to “take out the case” → this is not shown on IS if only disclosing share of profits. - The largest problem is that the financial statement posts (financing, taxes, operations, etc.) is all pooled into a one-line item. → makes it harder to value companies including associated companies → analysts usually remove the associated companies from EM. - Analysts need to take it out and handle it separately. - Advantage of equity method: when you own more than xx?(controlling interest) you get your share of the profit rather than only seeing you share of dividends (comparing to the financial method) - Pros/cons PCM: - Advantages: doesn’t mix up the items. Keeps operations, investing, financing, etc. separate from each other. - Disadvantages: It makes it look like we have control of assets/sales → this is not really true, its a joint control situation whom we need to agree with in order to decide on what is what and what to do. Investor Gave up - Volkswagen + Scania - PGM - Start with consolidated and asset side to see what we should include, - Old assets of volkswagen - -5 billion in cash payment - Asset of Scania - Goodwill - We paid 5 billion, but only taking a part of Scania, as part of purchase analysis we take not the vote in power but the shareholder capital. → so we remove 44% of net assets in sacation (asset - liabilities) - Goodwill = 5 - 0,44(10-7) = 3,6i8 - Equity of VW - Liabilities of VW - Liabilities of Scania - And NCI of the remaining 56% so 0,56 * 3 = 1,68. - Can be more than 50% so not use term minority. - Moving on to income statement - Sales would be 118,9 - Operating expense of 111,4 etc just adding it up. - Financial income ?? according to instruction iots 2% of 5 billion. - Interest expenses can just add up. - Tax effect also 0,1 * 30 = 0,03 - 0,56 belongs to NCI and 0,44 to XX (Scania shareholders) - Shareholders vs - FGM - Balance sheet - Goodwill assuming the same market value of the share? - Income statement will be very similar to the PGM; there will not be any changes. - The shares belonging to parent company vs NCI - Profit of Scania is the same, and NCI is still 0,56% - There is no affect, unless we have goodwill impairment: - 10% of the goodwill becomes impaired. - PGM - THERE will not be a tax effect, it hits the bottom line! - The parent company shareholders take the hit, while the NCI is unaffected - PArent company are the ones who have the goodwill (44% - The NCI didn't make an acquisition. - FGM - the parent company already took the hit, so instead the NCI, valued at fair value decreases - For the parent company shareholder, the choice of method doesn't matter. Exam ABOUT EXAM - 20p Q1 core accounting - 40p Q2 & Q3 core accounting, and financial statement analysis - 20p Q4 Business combinations - Test understanding rather than learning how to solve a specific question. VIKTIGA KONCEPT Cash Flow Statement: Direct method Indirect method Income Statement: Cost by Nature Cost by Function Inventories: Raw materials/WIP/Finished goods Net realizeable value (changing inventory valuations) FIFO/LIFO/Weighted avg. Capitalization (Depreciation, amortization, impairment): R&D Tangible & Intangible assets Depreciation: Useful life / Depreciable amount Revenue recognition: Accrual basis Percentage of Completion method Completed Contract method Performance obligation / Contract asset / Worked up revenue Income taxes: Current tax Actual paid taxes Deferred taxes (taxable temporary difference) Leases: Lessee vs. Lessor perspective Finance lease (NPV & Triangle-method) Operating lease Accounts receivable: Bad debt Provisions Comparability, Full capitalization vs Full expense Loss carry-forward → Deferred tax assets Inventory-/Cash-cycle days Financial key ratios: Growth financials Johansson Leverage Formula(s) ROA/ROCE/ROIC versions DuPont ROA-formula DuPont chart analysis Deriving variables through algebra. Mergers & Acquisitions: Majority stakes 100%; comparing deal conditions Goodwill (including Impairment) Joint arrangements Equity method Acquisition cost method Course summary - Course overview - Regulations are a bit complicated: we are looking at International reporting standards, and not local. - Intended Learning Outcomes - After completing the course, the student shall be able to demonstrate her/his abilities to - 1. Quantitatively and qualitatively evaluate accounting issues that are particularly relevant in the context of financial statement analysis. - 2. Calculate, interpret and contrast financial key ratios from creditor and investor perspectives, including core financial relationships. - 3. Quantitatively and qualitatively evaluate the financial consequences of various forms of business combinations: mergers, acquisitions of majority stakes, acquisitions of minority stakes and joint arrangements Accounting wise, mergers are treated as acquisitions Can own kess than 20% but still be an associated company (as in the assignment) one or two questions where he refers to the literature. Deferred income = liability: because you have an obligation to perform to customer. Accrued expenses = liability: to pay out eg holiday, Invoiced not worked up only POC - otherwise a contract liability. Goodwill as exception of tax liability; what does he mean?? Questions: - Is depreciation/amortization “mixed in” with the other lines of an incomestatement prepared “Cost by function”? - I think so. - Okay, so we have created a deferred tax asset or liability. What happens the years after, when/how is this “emptied out”? - Bad debt: - - What is reported on Balance Sheet (CB) for A/R? Is it 0 or 30 with also the bad debt provision account?