Fahmi Ben Abdelkader ESCP, Paris Fall /23/ :47 AM 1

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1 Financial Analysis Section 4. The analytical Balance sheet: the financial view Fahmi Ben Abdelkader ESCP, Paris Fall /23/ :47 AM 1

2 The Balance Sheet date can be crucial!!!! Lists the firm s assets and liabilities Provides a snapshot of the firm s financial position at a given point in time. The Balance sheet does not reflect the firm s financial position during the year The fiscal year may differ from one country to another Seasonality factor The example of the LEGO Toy company 80% of Lego s annual sales occur between September and December. What could be the impact of the seasonality factor on some of the components of the Balance Sheet? 2

3 The Balance Sheet and the Industry Example : the industry is critical Assets Intangible assets Tangible fixed assets Financial assets Fixed assets Inventory Accounts receivable Cash and cash equivalents TOTAL ASSETS Liabilities and Equity Shareholders Equity Long-term debt Accounts payable Short term debt TOTAL LIABILITIES EUROPAGES (produces agendas and office supplies based on paper) RFM (a network radio) TOUTCONFORT (an electrical goods retailer )

4 The Balance Sheet: the traditional accounting form Example: JIT : Just-In-Time Computer Services Consolidated Statements of Financial Position Prepared According to IFRS in millions Assets Year 2 Year 1 Liabilities and Shareholders' Equity Year 2 Year 1 Goodwill 0,0 0,0 Intellectual property rights, brands and other intangible assets 41,0 14,0 Net Property, Plant and Equipment 78,7 66,9 Financial Assets (Equity in Joint ventures, investments in shares and participations, deferred tax assets, etc.) 1,0 0,0 Total Shareholders' Equity 32,2 31,2 Long-term financial debt 106,0 61,8 Total non-current assets 120,7 80,9 Non-current liabilities 106,0 61,8 Inventories 15,3 14,3 Accounts receivables 18,5 13,2 Other current assets 0,0 0,0 Short-term financial debt 9,0 11,0 Accounts payable 30,5 24,9 Asset liquidity Short-term investments 2,0 1,0 Cash and cash equivalents 21,2 19,5 Current liabilities 39,5 35,9 Maturity dates Total current assets 57,0 48,0 TOTAL NET ASSETS 177,7 128,9 TOTAL LIABILITIES AND EQUITY 177,7 128,9 4

5 Assets Liabilities Shareholders Equity 32 Fixed Assets 121 Long-Term Financial Debt 106 Current Assets: Inventory Accounts receivable 34 Current Liabilities Accounts Payable 31 Cash & short-term investments 23 Short Term Financial Debt 9 Total Assets 178 Total Liabilities 178 5

6 Assets Liabilities Shareholders Equity 32 Fixed Assets 121 Long-Term Financial Debt 106 WCN = Inventory + Accounts receivable Accounts Payable Current Assets: Inventory Accounts receivable 34 Current Liabilities Accounts Payable 31 Cash & short-term investments 23 Short Term Financial Debt 9 6

7 Assets Liabilities Shareholders Equity 32 Fixed Assets 121 WCN = Inventory + Accounts receivable Accounts Payable Current Assets: Inventory Accounts receivable 34 Long-Term Financial Debt Current Liabilities Accounts Payable Net Fin. Debt = Financial Debt LT & ST Cash & short-term investments Cash & short-term investments 23 Short Term Financial Debt 9 7

8 Shareholders Equity 32 Fixed Assets 121 Net Financial Debt 92 Working Capital 3 Capital Employed 124 Invested Capital 124 The financial simplified presentation of the balance sheet 8

9 The Balance Sheet: Accounting vs Financial Approach The Balance Sheet : Backwards looking = the Traditional Accounting Approach Assets Liabilities and Shareholders equity Long-lived Assets Assets (physical or intangible) that produce benefits for more than one year Shareholders equity Investment of Shareholders and accumulated reinvested profits Asset liquidity Inventories Accounts receivable Cash and marketable securities Items held for sale or used in the manufacture of products that will be sold amounts owed to the firm by customers who have purchased on credit short-term investments easily sold and converted to cash Long-Term Financial Debt Short-Term Financial Debt Accounts Payable Loan or debt obligation with maturities beyond one year Loan that must be repaid in one year Amounts owed to suppliers purchases made on credit Maturity dates Total Assets Liabilities + Shareholders equity 9

10 The Balance Sheet: Accounting vs Financial Approach The Balance Sheet : Forwards looking = the Financial Approach Future Cash Flows from Employed Capital Claims on Invested Capital Net Assets Present Value of future cash flows generated by investments Shareholders equity Residual claim on cash-flows Perpetual Significant role in managment Net Debt Fixed & predetermined claim on cash-flows Fixed maturity No role in managment Market Value of Employed Capital: Enterprise Value Market Value of Equity + Net Debt Firm Valuation Perspective 10

11 The Balance Sheet: Accounting vs Financial Approach What determines the value of my business? The value of a business depends primarily on the capacity of its assets to generate cash flows, and less on capital structure choices 11

12 Capital Employed vs Invested Capital Total assets do not reflect necessarily the economic real value of the firm Capital Employed (or Operating Assets) is a better indicator than Total Assets Capital Employed = Invested Capital Fixed Assets + Working Capital = Shareholders Equity + Net Fin. Debt Shareholders Equity 32 Capital Employed Fixed Assets 121 Net Financial Debt 92 Invested Capital Working Capital 3 Quick Check Question : Calculate capital employed of JIT Company (What does the money spent on)? N+1 N Fixed Assets 120,7 80,9 Working Capital 3,3 2,6 Capital Employed 124,0 83,5 N+1 N Shareholders' Equity 32,2 31,2 Net Financial Debt 91,8 52,3 Invested Capital 124,0 83,5 12

13 Book Value or Market Value of a firm s equity? The book value of a firm s equity: a reminder Shareholders equity = Total assets - Liabilities An accounting measure of a firm s net worth The book value of a firm s equity is not a good estimate of its true value Many of the assets listed on the balance sheet are valued based on their historical cost rather than their true value today Example: the value of an office building Many of the firm s valuable assets may not be captured on the balance sheet Example: the expertise of the firm s employees, the firm s reputation in the marketplace, the relationships with customers and suppliers, etc. The book value of a firm s equity could possibly be negative 13

14 Book Value or Market Value? Negative book value of Shareholders equity 14

15 Book Value or Market Value of a firm s equity? Traditional Accounting: Book value = Historical cost depreciation Problems: Historical cost current cost or value Depreciation value loss To make a long story short book values are almost meaningless New approach (IFRS): Book value = Faire Value Problems: Fair value often impossible to define or arbitrary Frequent Fluctuations should be interpreted with caution 15

16 The Market Value: an accurate assessment of the fair value The market value of a firm s equity: a company s Market Capitalization Market Capitalization = Market Price per Share x Number of Shares Outstanding Cannot be negative Does not depend on historical cost of assets Often differs substantially from book value It depends on what investors expect those assets to produce in the future Quick Check Question : On December 31, JIT had 3.6 million shares outstanding, and these shares are trading for a price of 14 per share. what was the JIT s market capitalization? How does the market capitalization compare to book value of equity? JIT s Market Cap = 3.6 million shares x 14 per share = 50.4 million The book value of equity = 32 million 16

17 The Market-to-book ratio (or Price-to-Book Ratio (PBR)) The ratio of a firm s market capitalization to the book value of stockholders equity: Market - to - Book Ratio = Market Value of Equity Book Value of Equity M/B Ratio > 1 The market value of the firm s assets exceeds their historical cost (or liquidation value) Quick Check Question : Compute the Market-to-book ratio of JIT Company? 50.4 Market - to - Book Ratio = = Investors are willing to pay one and a half times the book value of JIT s shares 17

18 The Market-to-book ratio (or Price-to-Book Ratio (PBR)) Market-to-Book Ratios in 2010 of different firms and groups Source: Berk & DeMarzo (2011), Fundamentals of Corporate Finance. Pearson Value stocks (low M/B ratios) vs growth stocks (high M/B ratios) 18

19 The enterprise Value Versus Market Capitalization Capital Employed (= Shareholders Equity + Net Financial Debt) is a good estimate of a firm s value Market value of Capital Employed = Market value of Equity + Net Financial Debt Enterprise Value = Market cap + Debt - Cash Quick Check Question : JIT s Market Cap = 50.4 million. What was the JIT s Enterprise Value in N+1? Enterprise Value = (106+9) 23.2 = million It would cost million to buy all of JIT s equity and pay off its debt 19

20 APPLE The analytical Balance sheet: the financial view 20

21 APPLE The analytical Balance sheet: the financial view Source : The Wall Street Journal 21

22 APPLE The analytical Balance sheet: the financial view August 30, 2013 Market Cap $ B Total Cash $ 42.6B Total Debt Book value per Share $ 16.9 B $ M/Book Ratio = = Enterprise Value = = $416.9 billion 22

23 Asset Structure Ratios and Capital Structure Ratios What can we learn from analyzing a firm s balance sheet (book value)? Estimate the liquidation value : the value of the firm after its assets are sold and liabilities paid Useful information on : How the firm uses its money? The ratio of fixed assets, the ratio of current assets, liquidity of assets, etc. How the money is raised? Leverage, borrowing capacity, short-term cash needs, etc. 23

24 Asset Structure Ratios: How the firm uses its money? Used to assess the weight of each asset in the operating activity Assets Structure Ratios = Asset (i) Total Assets Example of Just-In-Time Company N+1 N Accounting approach Fixed Assets Ratio = Inventory Ratio = Receivable Ratio = Cash Ratio = Fixed Assets Total Assets Inventory Total Assets Cash Total Receivable Total Assets Assets 67,9% 62,8% 8,6% 11,1% 10,4% 10,2% 13,1% 15,9% Fixed assets (I) 120,7 80,9 Financial approach Working Capital (II) 3,3 2,6 Capital Employed (I+II) 124,0 83,5 24

25 Capital Structure ratios: Where does the money come from? Used to assess the weight of the debt as a source of financing Indicate the level of dependence vis-à-vis of creditors Accounting approach Example of Just-In-Time Company N+1 N Net Debt Leverage (gearing) Ratio = Debt - Equity Ratio = Total Equity Net Debt Debt - to - Capital Ratio = Net Debt + Total Equity Long term Debt Ratio = Short term Debt Ratio = Payable Ratio = Long term Debt Total Liabilities Short term Debt Total Liabilities Payable Total Liabilities 285,1% 167,6% 74,0% 62,6% 72,9% 63,3% 6,2% 11,3% 21,0% 25,5% Financial approach Shareholders' Equity Net Fin. Debt = Financial Debt - Cash & Short term Investments Capital invested = Shareholders' Equity + Net Debt 32,2 31,2 91,8 52,3 124,0 83,5 25

26 Leverage Ratio: book value or market value? Because of the difficulty interpreting the book value of equity Example: Domino s Pizza has, based on the strength of its cash flow, consistently borrowed in excess of the book value of its assets. In 2012, it had debt of $ 1.6 billion, with a total book value of assets of only $ 600 million and an equity book value of -$ 1.4 billion it is most informative to compare the firm s debt to the market value of its equity 26

27 Concept Check and Critical Thinking 1. What is depreciation designed to capture? 2. The book value of a company s assets usually does not equal the market value of those assets. What are some reasons for this difference? 3. What does a high debt-to-equity ratio tell you? 4. What is a firm s enterprise value? 27