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 Total income tax provision from income statement 216 Tax shield on interest expense 33 Tax on interest income 0 Tax on non-operating income (18) Taxes on EBITA 231

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 Net income282 Add: Increase in deferred taxes(1) Add: Goodwill amortization15 Adjusted net income296 Add: Interest expense after-tax, net27 Total income available to investors323 After-tax non-operating income0 NOPLAT323

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.