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Chapter 9 Analyzing Historical Performance

Chapter 9 Analyzing Historical Performance. Presented by Shan Li. Organization of this chapter. Reorganizing the accounting statements to gain greater analytical insights and to calculate ROIC and economic profit Calculate free cash flow

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Chapter 9 Analyzing Historical Performance

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  1. Chapter 9 Analyzing Historical Performance Presented by Shan Li

  2. Organization of this chapter • Reorganizing the accounting statements to gain greater analytical insights and to calculate ROIC and economic profit • Calculate free cash flow • Breaking down ROIC and Developing an integrated perspective • Analyzing credit health and liquidity • Dealing with more advanced issues in analyzing financial performance

  3. Reorganizing The Accounting Statements • The purpose of reorganization of accounting statements is to calculate Invested Capital, NOPLAT,ROIC and Economic Profit. • ROIC and Economic Profit reflect more of an economic than accounting view of the company. For example: distinguish operating from non-operating assets.

  4. Invested Capital • Need to reorganize the balance sheet. • It reflect how much of the capital has been invested in operating activities and other non-operating activities. • Operating invested capital: the amount invested in the operation of the business. OIC = operating working capital + net property, plant and equipment + net other assets

  5. Invested Capital-9 items • Operating current assets • Comprise all current assets used in or necessary for the operation of the business. • OCA= cash balance + trade accounts receivables + inventories. • Specifically excluded are cash and marketable securities greater than the operational needs of the business.

  6. Invested Capital-9 items • Non-interest-bearing current liabilities • Such as accounts payable and accrued expense • Net working capital=Operating current assets – Non-interest-bearing current liabilities • Net property, plant and equipment • Is the book value of the company’s fixed assets • NPPE=Gross PPE – Accumulated depreciation

  7. Invested Capital-9 items • Other operating assets, net of other liabilities • Any other assets or non-interest-bearing liabilities related to the operation of business • Non-operating assets • Any assets not included in operating invested capital should be added when total investor funds. • For example: Goodwill, Excess cash and securities, Non-operating investments.

  8. Invested Capital-9 items • Equity • Is the sum of all common equity accounts • Such as paid-in capital and retain earnings, preferred shares, and minority interest in consolidated subsidiaries • Quasi-equity items • Accounts recorded as liabilities for accounting purpose, but should be treated as equity to determine how much capital the shareholder have invested. • For example: deferred income taxes

  9. Invested Capital-9 items • Adjusted equity • Is the sum of all equity accounts plus all quasi-equity accounts • Interest-bearing debt • Includes long-term debt, short-term debt, current maturities of long-term debt, and capital lease

  10. NOPLAT • NOPLAT-Net Operating Profit Less Adjusted Taxes • Need to reorganize income statement • Represents the after-tax operating profits of the company after adjusting the taxes to a cash basis

  11. NOPLAT-4 items • EBITA • EBITA-Earning Before Interest, Taxes and Amortization of goodwill • Is the pretax operating income that a company would earned if it had no debt and no goodwill amortization • Includes all types of operating income, including most revenues and expenses • Excludes interest income and expense, gain or loss from discontinued items, extraordinary income or loss, investment income from non-operating invests

  12. NOPLAT-4 items • Taxes on EBITA • Represent the income taxes that are attributable to EBITA • Are taxes the company would pay if it had no debt, cash above operating needs, or non-operating income or expenses

  13. NOPLAT-4 items • Change in deferred taxes • Deferred taxes are the difference between the provision for income taxes in the income statement and the actual taxes paid in cash. • Can be made by calculating the change in accumulated deferred income taxes on the company’s balance sheet • For example: accumulated deferred taxes in 1995 was 192, in 1996 was 224. Therefore, change in deferred taxes is 224-192=32.

  14. NOPLAT-4 items • Reconciliation to net income • To ensure that nothing is missing in the calculation of NOPLAT • To ensure a complete understanding of the company’s financial statements

  15. ROIC • ROIC-Return On Invested Capital • ROIC= Net operating profit less adjusted taxes Invested capital • Invested capital is generally measured at the beginning of the period or as an average of the beginning and end of the period. • ROIC is a better analytical tool because it focuses on the true operating performance of the company.

  16. Economic Profit • It measures the dollars of economic value created by a company in a single year. • Economic profit=Invested capital x (ROIC-WACC) or • Economic profit=NOPLAT-Capital charge or • Economic profit=NOPLAT-(Invested capital x WACC) • Economic profit combines spread and size of company into dollar performance

  17. Free Cash Flow • Free cash flow is a company’s true operating cash flow. • It is the total after-tax cash flow generated by the company that is available to all providers of the company’s capital, both creditors and shareholders. • Free cash flow is before financing and therefore not affect by the company’s financial structure.

  18. Free Cash Flow • FCF=NOPALT-Net investment =[NOPLAT + Depreciation]-[Net investment + Depreciation] =Gross cash flow-Gross investment Where net investment is the change in invested capital.

  19. Free Cash Flow-14 items • Depreciation • Includes all the noncash charges deducted from EBITA except goodwill amortization • Gross cash flow • Represents the total cash flow thrown off by the company’s operation • It is the amount available to reinvest without relying on additional capital • GCF=NOPLAT + Depreciation

  20. Free Cash Flow-14 items • Change in operating working capital • Is the amount the company invested in operating working capital during the period. • Capital expenditure • Include expenditures on new and replacement property, and equipment • Capital expenditure=increase in net property, plant and equipment + depreciation expenses

  21. Free Cash Flow-14 items • Increase in other assets, net of liabilities • Equals the expenditure on all other operating assets including deferred expense, and net of increases in non-current, non-interest-bearing liabilities • Gross investment • Is the sum of a company’s spending for new capital • Includes working capital, capital expenditures, and other assets • GI=change in working capital + capital expenditure + change in other assets + foreign currency translation effect

  22. Free Cash Flow-14 items • Investment in goodwill • Equals the expenditures to acquire other companies in excess of the book value of their net assets • IIG=net changes in goodwill + amortization of goodwill

  23. Free Cash Flow-14 items • Non-operating cash flow • Represents the after-tax cash flow from items not related to operations • Includes cash flow from discontinued operations, extraordinary gain or loss, and the cash flow from investments in unrelated subsidiaries • TV=PV of FCF + PV of After Tax Non-Operating CF and Marketable Securities

  24. Free Cash Flow-14 items • Change in excess marketable securities • Excess marketable securities are the short-term investments that the company holds above its target balance to support operation. • The change in excess marketable securities can be treated as non-operating cash flow or as financing cash flows.

  25. Free Cash Flow-14 items • Foreign Currency translation effect • Is driven by the changes in translation rates applies to both assets and debt • Treat this gain or loss as non-operating cash flow • Total funds available to investor • =FCF + all non-operating items

  26. Free Cash Flow-14 items • Change in Debt • Represents the net borrowing or repayment on all the company’s interest-bearing debt • Includes short-term debt and capital lease • After-tax interest expense • =pretax interest expense x (1-marginal tax rate)

  27. Free Cash Flow-14 items • Dividends • Includes all cash dividends on common and preferred shares • Share issues/repurchases • Includes both preferred and common shares and the effects of conversions of debt to equity

  28. Breakdown ROIC ROIC = NOPLAT Invested Capital NOPLAT=EBITA x (1-Cash tax rate) ROIC= EBITA x (1-cash tax rate) Invested Capital

  29. Breakdown ROIC EBITA EBITA Revenues Invested Capital = Revenues x Invested Capital • Operating Margin (EBITA/Revenues) measures how effectively the company converts revenues into profits. • Capital turnover ( Revenue/Invested capital) measures how effectively the company employs its invested capital.

  30. Credit Health and Liquidity • Interest Coverage • Is the amount of earnings available to pay interest expense • It provides a sense of how far operating profits could fall before the company would have difficulty servicing its debt. • Measures the company’s financial cushion • Interest Coverage= EBIT/Interest expense

  31. Credit Health and Liquidity • Debt/Total Investor Funds • Measures the company’s reliance on debt capital • Expressed both at book value (creditors often use) and at market values

  32. Credit Health and Liquidity • Investment Rate • Is the ratio of investment to available funds • Net basis : Net investment / NOPLAT • Gross basis: Gross investment / Gross cash flow • Investment rate > 1 : company is consuming more funds than it is generating

  33. Credit Health and Liquidity • Dividend Payout Ratio • Is total common dividends divided by income available to common shareholders • = Common Dividends / Net Income available to common • If a company has investment rate >1 and a high dividend payout ratio, it must be borrowing money to fund a negative free cash flow to pay interests and dividends.

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