Finance for Non-Financial Managers

Tarek Fahim

LOGIC Executive Program LEPFinance Module

The only question with wealth is what you do with it.

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Breaking The Ice

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Are you Wondering :

• Who cares about financial statements?

• What do people mean by “top line growth”?

• What do people mean by “bottom line growth”?

• What are assets?

• What is the difference between profit and cash flow? Which one is more important?

• What is the difference between operating profit and net income?

• What is “overhead”?

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The Framework

FS Review

Financial Ratio Analysis

Time Value

Valuation

Capital Budgeting & Decision Making

Investment & Portfolio Management

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The Framework

FS Review


Time Value

Valuation



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Matches revenues with costs• Profit: revenue > cost• Loss: revenue < cost

States the results of the firm's operations

• Over a period of time• Including accounting

adjustments, e.g. depreciation

1. Profit And Loss Account

4. Notes To The Accounts

Contain explanatory information in addition to or in respect of the above statementse.g. revenue split by geography/segment, financials of acquisitions/discontinued businesses etc.

a) Lists the assets owned by the firm

b) Details how these assets are financed

• Shareholders (equity)• Lenders (liability)

Snapshot of firm’s financial position

• On the day the statement was prepared

• Cumulative - represents result of all transactions that have taken place up to that point

3. Balance Sheet

Shows the changes in cash • Over the accounting period

States actual transactions without accounting adjustments

2. Statement OfCash Flows

There are four basic components of financial statements

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predominantly quantitative

some qualitative data given

reading between the lines required

What can we get out of them?

• At the most basic level, financial statements tell you• How much it sells and at what cost• How much cash it generates• How many assets it has and whether these

are owned by banks or shareholders

• However, they also provide insight into• Who owns it/major stakeholders• How it is organised/key decision makers• Market share/growth targets• Level of concern for its employees/community• What the Chairman looks like (!)

•And if you look really hard, they may provide

• A window into the company’s strategy• Economics of the industry/competitors

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FS Review

The Profit And Loss Account

The Cash Flow Statement

The Balance Sheet

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The Infamous Profit & Loss Formula

Revenues CostsProfits

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Revenues

Gross margin

Operating profit (EBIT)

Net income

less: costs of goods sold (COGS), incl. raw materials, direct labour, ...

less: operating expenses, incl. admin, marketing, depreciation, ...

Interest (income and expense)Tax

Generation of profit

Result of sales and costs of providing

goods/services

DividendsRetained profit

Distribution of profit

StateBanks

Shareholders

Conventional form of Profit & Loss Account

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Profit measure Definition Benefits/comments

Gross margin Revenuesless: Cost Of Goods Sold

• When comparing companies, be sure to understand what’s in COGS

EBITDAEarnings before interest, tax, depreciation and amortisation

Gross marginless: operating expenses, except depreciation and amortisation

• Often used as approximation of cash flow, e.g. in Discounted Cash Flow analysis

EBITAEarnings before interest, tax and amortisation

EBITDAless: depreciation

• Safe bet when doing cross-border comparisons, given treatment of amortisation in different countries

EBITEarnings before interest and tax

EBITAless: amortisationor:Gross margin less operating expenses

• This is what most people mean when they say “operating profit"

NOPATNet operating profit after tax

EBITless: tax

• After tax measure of operating profit• Often used in financial ratios

PBTProfit before tax

EBITless: interest

• Used by some companies as key profit measure

Net income EBITless: interest and tax

• “The bottom line”• Profit that goes to shareholders• Used for earnings per share and P/E

multiples

Common profit measures

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What to look for in a P&L

TrendsTrends

By comparing one year to the next, it is possible to tell

• Whether a company is growing or contracting

• Whether or not it has improved efficiency

• How it may do in the future, based on qualitative or extrapolated values

Trends may also provide insight into

• Changes in supply or demand

• The competitive environment

• The broader economy

DiscontinuitiesDiscontinuities

These can draw your attention to areas where the company was making change or decisions. This focus can aid in understanding

• What a company’s operating strategy is

• How competitors’, suppliers’ or customers’ behaviour has affected a company

Cost and Margin structure

Cost and Margin structure

Looking at individual line items, it is possible to gain insight into the cost and margin structure of a company

• What is the breakdown between fixed and variable costs?

• How much overhead does the company carry?

• What is its operating margin?

• Does it have high interest expenses?

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P&L walk-through

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FS Review



The Balance Sheet

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Cash flows generated/paid out during the normal course of the business

• Eg receipts from customers, payments to suppliers

Total Cash Flows

2. InvestingCash Flows

3. FinancingCash Flows

1. Operating Cash Flows

Cash flows generated/paid out from dealing with investments or fixed assets

• Eg purchase of plant/machinery, proceeds from sale of investments

Cash flows associated with the funding of the assets of the business

• Eg proceeds from bank loan, dividends paid to shareholders

+

Cash Flow Statement reports inflows and outflows of cash during a period

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Difference between Cash Flow Statement and P&L

P&L adjusts by allocating income and costs to the year in which they theoretically occur:

• Fixed assets: cash flow statement registers when fixed assets are paid; P&L shows when they are used

• Taxes: cash flow statement shows when you send a cheque to the tax man; P&L shows when they are theoretically generated

• Other differences include provisions, accounts payable/receivable, ...

Companies pay taxes and are assessed for profitability based on figures in the P&L

The P&L focuses on profitability, while the cash flow statement focuses on liquidity

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Uses of the Cash Flow Statement

• Management uses a forecast of cash flows• When a company is growing, it may need more cash• When a company is in financial difficulty, it may have to convince suppliers that it will be able

to pay the bills

• Lenders want to know if cash flows are adequate to pay interest on debt and repay the principal when it becomes due

• Shareholders want to know about adequacy of cash flow to pay dividends• Private equity investors are particularly interested in cash flow!

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What to look for in a Cash Flow Statement?

• Timing of key events• The cash flow statement is the only financial statement which provides a clear picture of when

cash actually enters or exits the business• For projections, a key measure is often when a company or project becomes cash flow positive

• Mix of sources and uses of cash• Provides insight into how a company operates

– how does the company finance capacity expansions?– what are the major cash drains on the company?

• Ability to cover costs• Measures like cash flow interest coverage are useful here

• Value of the company• Many analysts will value a company based on the net present value of its cash flows

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Cash Flow Statement walk-through

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FS Review



The Balance Sheet

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The Infamous Balance Formula

Total Liabilities Total EquitiesTotal Assets

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Represents financial picture as it stands on one particular day, e.g. 31 December, 2007

Assets• Goods, property and financial

assets owned (net of depreciation)

Liabilities• Obligations or legal debts due

– Suppliers– Banks– Revenue & Customs

Balance sheet

=Shareholder’s Equity

• The amount left over after liabilities are subtracted from assets

What is owned? How is it financed?

The Balance Sheet is a snapshot of a company’s financial position

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Reven

ue

Exp

enses

Profit

Movement in the Balance Sheet can be seen in the P&L

P&L: 2007

=

Assets

Profit

Liability

Equity

Profit = Equity

Balance Sheet: 31 Dec 2007

Assets

Liability

Equity

=

Balance Sheet: 31 Dec 2006

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Cash And Cash Equivalents

Investments

Inventories

Other

Tangible

Intangible

Current

Non-current

Usually converted to cash within 12 months

Assets

Property, Plant And Equipment

Investments

Other

Receivables

Physical or intellectual/

non-physical assets

Assets can be classified into a number of different categories

+

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Interest-bearing Liabilities

Non-interest Bearing Liabilities

Contingent Liabilities

Off-balance Sheet Financing

Total Liabilities

Accounts Payable

Provisions

Deferred Income Tax Liability

Key Classification Of Liabilities

Liabilities are claims by creditors on the resources (assets) of a firm

+

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Element

Current Liabilities

Non-current Liabilities

Definition

Liabilities that will require settlement (in cash or otherwise) within 12 months of the balance sheet date

Liabilities which are longer term in nature, ie those which will not require settlement within the next 12 months

Example

Short term debtAccounts payable

Long term debtProvision for deferred tax

Like assets, liabilities can be divided into current and non-current

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Assets Liabilities Equity

Equity is the residual after all claims against the firm’s assets have been satisfied

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Microsoft Has NO Debt !

Major U.S. companies ranked by debt to total capital

Microsoft is a cash rich company able to fund itself from its own operations

Software companies typically have very low debt levels

• WC dominates software companies’ balance sheets

• Fixed asset requirements are low• Therefore, debt is minimal

The other companies all have much larger fixed costs (production facilities, branch outlets, etc.) making it difficult to rely on

equity alone.

Two key reasons Microsoft has no debt

1

2

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Balance Sheet walk-through

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P&L and Cash Flow Statement are part of the Balance Sheet

• Balance sheet is an amalgamation of many different accounts, incl. equipment, fleet, property, fuel, cash, payables, receivables, loans, shareholders’ equity ...

• Every business transaction is recorded in two accounts:

• A change in one asset must result in a change in another asset or a change in liabilities or equity

• This is called double entry book-keeping

• The majority of transactions affect either cash or shareholders’ equity

• The cash account is called Cash Flow Statement• The shareholders’ equity account is called P&L

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The Framework

FS Review


Time Value

Valuation



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Ratio Analysis can be divided into five key ‘Buckets’


Description

Purpose

How much profit is the business generating relative to its asset base?

• Earnings and assets must be consistent

How hard is the company working its assets?

How efficiently is it managing its inventories/receivables?

Does the company have enough short-term funds to finance its operating require-ments?

With what proportion of debt or shareholders’ equity is the business funding its assets?

How much profit is a business generating relative to its sales?

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Using BoY versus EoY Balance Sheet Entries Can Make a Big Difference Example: Return on Assets.

Income statement

Balance sheet 30

50

ROA based on:

BOY AVG EOY 4 4 4 30 40 50

13% 10% 8%

Which is correct? Average

“Return”

“Assets”

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Ratio Analysis (Performance Ratios)

Acronym

ROA

Title

Return on assets

Definition

Return Avg total assets

Typical values

After-tax, 3% to 25% depending on company

and industry

Comments

Expected to be stable. Increases are good. As assets age, measure may

increase without true economic gains

ROE Return on equityReturn

Avg shareholder’s equity

-5% to 30% depending on company, industry,

and leverage

Expected to be stable. Increases are good. Due to leverage, numbers are

often erratic

EVA % Percent of economic value

added (EVA Spread)

NOPAT - Cap ChrgAvg capital employed

-10% to 10% depending on company and

industry

Expected to be stable. Increases are good. As assets age, measure may

increase without true economic gains

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Ratio Analysis (Profitability Ratios)22

Acronym

GM %

Title

Gross margin percentage

Definition

Rev - COGSRevenue

Typical values

40% to 60% depending on product, company

and industry

Comments

Expected to be stable. High numbers are good. Increases are good.

Influenced by competition significantly and costs

EBITDA % Earnings before interest tax

depreciation and amor. margin

EBITDARevenue


and industry

Expected to be stable. High numbers are good. Should increase

significantly with scale. Significantly influenced by competition and costs

Op margin %

Operating margin

NOPATRevenue


and industry

Expected to be stable. High numbers are good. Should increase

significantly with scale. Significantly influenced by competition and costs

SGA % Sales

Selling general and admin as % of sales SG&A

Revenue

5% to 20% depending on product, company and

industry

Should decline significantly with scale

Net income %

Net income margin

Net IncomeRevenue

5% to 25% depending on product, company and

industry

Expected to be stable. High numbers are good. Increases are good

Influenced by competition significantly and costs

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Ratio Analysis (Productivity Ratios)33

Acronym

A/R days

Title

Account receivable days outstanding

Definition

Avg RecvRevenue

Typical Values

30-90 depending on company, industry and

country

Comments

Expected to be steady if properly managed. Decreases are good.

Usually a function of terms and active management

A/P days Account payable days outstanding Avg Payables

Purchases

20 to 65 depending on company, industry and

country

Expected to be stable. Increases are good. If number get too large the

company is having trouble and/or their suppliers are not happy

x365

x365

Inv turns

(INVx) Inventory turnsCOGS

Avg Inventory

4x to 15x depending on company and industry

Expected to be stable and decreasing. Will vary with seasonal businesses. If

too low, products get old, and or company is having sales troubles

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Return on assets

E/A ratio

Profit margin

Asset turnoverReturn on equity

Return

Shareholders’ Equity

Return

Total Assets

Return

Sales

Sales

Total Assets

Total Assets


x

x

How much earnings are being generated from sales?

What type of business is it• High volume, low margin• High margin, low volume

How hard is the business working its assets?

Depends on type of industry

How is the business financing its assets?

How much debt is the business using relative to shareholders’

funds?

DuPONT Analysis Disaggregate Key Performance Ratios Into Their Underlying Business Drivers

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DuPONT Analysis - Level 1 ROE

What return is the business generating for the funds that its shareholders have

contributed?

How are the assets being funded?

What magnification of return (or loss) do we

expect due to use of debt?

What return is the business generating from the resources

that it is using?

Return on assets

E/A ratio

Return on equity

Return


Return(1)

Total Assets

Total Assets


x

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DuPONT Analysis – Level 2 ROA

What are the costs associated with the products/ services a

company sells?

What does the company derive from its assets?

What return is the business generating from the resources

that it is using?

Return on assets

E/A ratio

Return on equity

Return


Return

Total Assets

Total Assets


x

x

Profit margin

Asset turnover

Return(

Sales

Sales

Total Assets

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Profit margin

Return

Sales

Asset turnover

Sales

Total Assets

e.g., Revenue/Unit (Price)

Receivables turnover

Sales

Average Receivables

ROA

Revenue

e.g., Cost/Unit

Costf

Inventory turnover

Cost Of Goods Sold(2)

Average Inventory

Fixed asset turnover

Sales

Average Fixed Assets

f

Ratios Can Be Cascaded Down Below The Typical DuPont Levels

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NOPAT margin (%)

Sales ($M)

Net working capital ($M)

NOPAT ($M)

Year

CAGR 23.5%

Return on capital (%)Year

Year

Year

Change (6.2) %

CAGR 11.8%

Delta 1.6%

CAGR 5.8%

CAGR N/A

CAGR 21.8%

X

+

÷

Capital employed ($M)

Total fixed capital ($M) CAGR 21.8%

Year

Growth in capital employed has significantly

outpaced profit growth

Return on capital is declining

Driven by a constant increase in fixed capital

Displaying Driver Trees Over Time Often Provides Additional Insight - Example: Profit Growth Lagging Increases in Capital Employed

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Ratio Analysis (Liquidity Ratios)44

Acronym Title Definition Typical values Comments

WC Working Capital Accts receivables + inventory

- accts payableOR

C. Assets - C. Liab

Greater than zero Not technically a ratio but related to liquidity, working capital is the margin

of current assets over current liabilities that a firm maintains

Current ratio Current Ratio

Current AssetsCurrent Liab

1.0 - 2.0

Depends on the industry and activity cycle

Measures ability to pay current liabilities from current assets. Should be stable. A higher ratio means lower risk but, too high a ratio could indicate excess inventory or failure to collect

payment

Quick ratio Quick Ratio

Cash + Marketable Securities + A/R

Current Liab.

0.2 - 1.0

Depends on the industry and activity cycle

Similar to current ratio but more accurate. Excludes less liquid assets

such as inventories. Answers the question: “if sales stopped, could this firm meet its obligations with readily

accessible assets on hand?”

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Ratio Analysis (Capital Structure Ratios)55

Acronym Title Definition Typical values Comments

D/E Debt to Equity Ratio

Balance sheet debtShareholders Equity

0.2-1.0 depending on the industry and company

Commonly used to indicate bankruptcy risk, the higher the ratio, the riskier the

company

D/A Debt to Asset Ratio

Balance sheet debtTotal Assets

0.1 - 0.5 depending on the industry and

company

Measures the proportion of a firms assets that are funded by debt

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Let’s Crunch Some Numbers: 2003-2005

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Ratio Analysis (Performance Ratios) : ROI - ROE

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Performance Analysis !!

• ROI curves are showing that both companies are doing very well, their numbers are very close to each other. Year 2004 shows a small drop for both that was recovered very soon in year 2005.

• ROE, in the contrary is very different between both companies. We can observe that ROE of Mobinil is much higher that ROE of Vodafone. The numbers in 2005 are 93% (Mobinil) and 56% (Vodafone). It is very clear that this difference is due primarily to the big financial leverage Mobinil practiced.

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Ratio Analysis (Profitability Ratios) :

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Profitability Analysis !!

• Mobinil is better managing its COGS than Vodafone (Know why ?)

• Vodafone has higher Net Income Margin than Mobinil due to its financing strategy.

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Ratio Analysis (Productivity Ratios) : A/R Days – Inv Turns X

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Productivity Analysis !!

• Days in account receivable amount is decreasing for both companies which indicates that the efficiency of the account receivable department is improving. However, this amount is much less in Mobinil than Vodafone, which either means Mobinil is doing better in collecting the money or Vodafone is using a longer credit terms.

• Vodafone is better managing its inventories while Mobinil Inventory turnover is decreasing.

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Ratio Analysis (Liquidity Ratios) : WC – Current ratio

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Liquidity Analysis !!

• It is clear from the numbers that Mobinil and Vodafone are not having much liquidity to cover their liabilities. Current ratio is below 1 and declining, acid test ratio is even below 0.5.

• It is clear from the charts that Vodafone did a better job than Mobinil to reduce this shortage in liquidity in year 2005, as their ratios improved a little bit, while Mobinil’s ratios are getting worse

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Ratio Analysis (Capital Structure Ratios) : D/A – D/E ratios

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Capital Structure Analysis !!

• From Debt/Equity chart, it is easy to tell that Mobinil is taking big risks as this ratio reached 3.2 in year 2005. Vodafone is taking less and more consistent risk.

• Mobilinil is highly leveraged compared to Vodafone.

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Ratio Analysis (Investment) : EPS – P/E ratios

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Investment Analysis !!

• Vodafone’s P/E ratio was higher than Mobinil’s on year 2003 and 2004, while Mobinil succeeded to achieve a better result in year 2005.

• P/E ratio shows how much people are willing to pay for a stock.

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Linking Financial Ratios to Balanced Scorecards (I)

• The balanced scorecard is a way for managers to view the organization from four interrelated perspectives of operational drivers for future performance:

• Financial perspective. How are we doing using traditional financial performance measures?

How do shareholders view us?

• Customer perspective. How satisfied are our customers?

• Internal perspective. What ways do we, and in what ways should we, excel?

• Innovation and improvement perspective. How can we continue to improve and create value in the future?

1

2

3

4

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Linking Financial Ratios to Balanced Scorecards (II)

• The balanced scorecard is linked to the Financial ratios and the budget process in the following ways:

• It highlights leading indicators, such as new product development, customer complaints, or direct mail response rates, instead of only sales or cost figures

• It balances the four perspectives so that, for example, pressure to develop new products doesn’t overshadow the need for quality products and customer satisfaction

• It helps management to communicate strategic goals and mission to all the stakeholders in the organization

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Balanced Scorecards 9 Steps Method

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Enron Case !!

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The Framework

FS Review


Time Value

Valuation



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Time Value of Money

Money that the firm has today is more

valuable than future payments because current money can be invested to earn

money

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Time Value of Money

Money that the firm has today is more valuable than future payments because current money can be invested to earn money

Money that the firm has today is more valuable than future payments because current money can be invested to earn money

0 1 4 5 6 72 3

Present Value

Present Value

Future Value

Future Value

Compounding

Discounting

End of Year

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The Framework

FS Review


Time Value

Valuation



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Capital Budgeting

The process of evaluating and selecting long-

term investments consistent with

the firm’s goal of owner wealth maximization

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Business Decisions

Expansion of OperationsExpansion of Operations

Other Purposes as MKTGOther Purposes as MKTG

Replacement of AssetsReplacement of Assets

Key Motives for CapEx

Key Motives for CapEx

Renewal of AssetsRenewal of Assets

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Capital Budgeting Process

Proposal Generation

Review & Analysis

Decision Making

Follow Up

Implementation

1

2

3

4

5

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Relevant Cash Flows

Initial Investment

Initial Investment

Operating Cash Flows


Terminal Cash Flow

Terminal Cash Flow

0 1 4 5 6 72 3


Initial Investment

End of Year

Terminal Cash Flow

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Time To Play !

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Payback Period

The exact amount of time required for a firm to cover its

initial investment in a project as calculated from cash inflows

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0 1 4 5 6 72 3


Initial Investment

End of Year

Terminal Cash Flow

Payback Period

Less than Acceptable Period Greater than Acceptable Period

RejectRejectAcceptAccept

Payback Decision

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Net Present Value

A sophisticated capital budgeting technique found by subtracting a project’s initial investment from

the present value of its cash inflows discounted at the firm’s

cost of capital

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0 1 4 5 6 72 3


Initial Investment

End of Year

Terminal Cash Flow

NPV

Greater than Zero Less than Zero

RejectRejectAcceptAccept

Discounted at the cost of capital

Net Present Value Decision (NPV)

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The Framework

FS Review


Time Value

Valuation



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Valuation…

Most accurateMost simple

Assets' based Valuation

Discounted Cash

Flow Valuation(DCF)

Multiples based

Valuation

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Let’s Play Again

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The Framework

FS Review


Time Value

Valuation



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The Chinese symbols for risk

The first symbol is the symbol for “danger”, while the second is the symbol for “opportunity”, making risk a mix of danger and opportunity

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Portfolio Components

LandLand

OwnershipsOwnerships

Real EstateReal Estate

Portfolio Management

Portfolio Management

CashCash

StocksStocks

BondsBonds

PartnershipsPartnerships

Mutual FundsMutual Funds

CurrenciesCurrencies CarsCars

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Portfolio Management Definition

The process of managing the assets, including choosing

and monitoring appropriate

investments and allocating funds

accordingly

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Portfolio Management Goals

Maximize Profitability of PortfolioMaximize Profitability of Portfolio

Support the Firm StrategySupport the Firm Strategy

Maximize Value of PortfolioMaximize Value of Portfolio

Portfolio ManagementPortfolio Management

Provide Balance between Risk and Return

Provide Balance between Risk and Return

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Tips & Tricks

• Diversification is a risk-management technique that mixes a wide variety of investments within a portfolio in order to minimize the impact that any one security will have on the the overall performance of the portfolio.

• Diversification lowers the risk of your portfolio.

• There are three main practices that can help you ensure the best diversification:

• Spread your portfolio among multiple investment vehicles such as cash, stocks, bonds, mutual funds and perhaps even some real estate.

• Vary the risk in your securities.• Vary your securities by industry.

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Portfolio Management Sheet

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Final Word…

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Thanks...

Finance for Non-Financial Managers

Economy & Finance

Transcript of Finance for Non-Financial Managers