Accounting Prof Riccardo Tiscini Training Course Material A

  • Slides: 48
Download presentation
Accounting Prof. Riccardo Tiscini Training Course Material A. A. 2014 -2015

Accounting Prof. Riccardo Tiscini Training Course Material A. A. 2014 -2015

Stages of Firms life FIRMS LIFE 1 st STAGE START-UP 2 nd STAGE GOING

Stages of Firms life FIRMS LIFE 1 st STAGE START-UP 2 nd STAGE GOING CONCERN 3 rd STAGE DISCONTINUANCE v Business idea v Organisation v M&A, Divestures v Location v Management v Winding up v Size v Information v Bankruptcy v Institutional aspects LEGAL STATUS, BYLAWS & GOVERNANCE Prof. Riccardo Tiscini Introduction to Business Economics 2

Performance Analysis FIRM PURPOSE VALUE CREATION Performance analysis Prof. Riccardo Tiscini Introduction to Business

Performance Analysis FIRM PURPOSE VALUE CREATION Performance analysis Prof. Riccardo Tiscini Introduction to Business Economics 3

Performance Analysis FIRM PURPOSE MAXIMISE SHAREHOLDERS’ VALUE Maximise future income Prof. Riccardo Tiscini +

Performance Analysis FIRM PURPOSE MAXIMISE SHAREHOLDERS’ VALUE Maximise future income Prof. Riccardo Tiscini + Introduction to Business Economics Control risk 4

Performance Analysis: Financial Ratios ANALYSIS SOLVENCY PROFITABILITY Financial equilibrium: capacity to repay obligations Economic

Performance Analysis: Financial Ratios ANALYSIS SOLVENCY PROFITABILITY Financial equilibrium: capacity to repay obligations Economic equilibrium: capacity to generate profit Prof. Riccardo Tiscini Introduction to Business Economics 5

BS and IS Structure for Solvency Analysis LIABILITIES ASSETS FIXED (NON CURRENT) ASSETS CURRENT

BS and IS Structure for Solvency Analysis LIABILITIES ASSETS FIXED (NON CURRENT) ASSETS CURRENT ASSETS Prof. Riccardo Tiscini o tangible o intangible o financial o inventory o trade receivables o liquidity EQUITY o Shareholders’ Equity NON CURRENT LIABILITIES q Long-term Financial Debt o Long-term Trade payables CURRENT LIABILITIES q Short-term Financial Debt o Short-term Trade payables Introduction to Business Economics 6

Solvency Analysis FIXED ASSETS (FA) CURRENT ASSETS (CA) EQUITY (E) + NON CURRENT LIABILITIES

Solvency Analysis FIXED ASSETS (FA) CURRENT ASSETS (CA) EQUITY (E) + NON CURRENT LIABILITIES (NCL) CURRENT LIABILITIES (CL) FIXED ASSETS FINANCING RATIOS: E/FA or (E+NCL)/FA To verify if FA are correctly financed with E or NCL CURRENT RATIO: CA/CL To verify if CL are covered by CA (and hence CL does not finance FA) Furthermore, : DEBT/EQUITY RATIO: FD/E Prof. Riccardo Tiscini To verify the viability of financial structure (i. e. financing choices) in terms of repayment risk and reinvestment autonomy. Only Financial Debts are considered because they bring higher risk and dependence from financers (much more than Trade Debts) Introduction to Business Economics 7

BS and IS Structure for Profitability Analysis SOURCES INVESTMENTS EQUITY (E) NET OPERATING INVESTED

BS and IS Structure for Profitability Analysis SOURCES INVESTMENTS EQUITY (E) NET OPERATING INVESTED CAPITAL (NOIC) Fixed Assets + Inventory + Trade receivables - Trade payables - Unearned revenues NET FINANCIAL POSITION (NFP) Shareholders Equity Financial Debts -Liquidity (& Financial Current Assets) - Financial Fixed Assets INCOME STATEMENT SALES (S) – OPERATING COSTS (OC) = EBIT - NET FINANCIAL EXPENSES/(Revenues) (NFE) = EARNINGS BEFORE TAX (EBT) - INCOME TAX (T) = NET PROFIT/(Loss) (NP) Prof. Riccardo Tiscini Introduction to Business Economics 8

BS and IS Structure for Profitability Analysis Deeper in the INCOME STATEMENT for Profitability

BS and IS Structure for Profitability Analysis Deeper in the INCOME STATEMENT for Profitability Analysis: Sales - Variable Costs (raw mat. & oth. ) = CONTRIBUTION MARGIN - Fixed Services & Employee costs = EBITDA - Depreciation & Amortization = EBIT - Net interests expense (revenue) = EBT - Income Taxes = NET PROFIT (LOSS) Prof. Riccardo Tiscini Introduction to Business Economics 9

Profitability analysis Profitability factors The Income Statement shows the final result (profit/loss for the

Profitability analysis Profitability factors The Income Statement shows the final result (profit/loss for the period). Net profit shall be distributed to shareholders (dividend) or retained in the comany (increase in the value of the shares). Shareholders will then appreciated if their return is satisfactory compared with the capital invested. Profit PROFITABILITY Prof. Riccardo Tiscini Capital Introduction to Business Economics 10

Profitability Analysis: Return on Equity PROFITABILITY of Shareholders’ Equity ROE NET PROFIT/EQUITY Prof. Riccardo

Profitability Analysis: Return on Equity PROFITABILITY of Shareholders’ Equity ROE NET PROFIT/EQUITY Prof. Riccardo Tiscini Introduction to Business Economics 11

Profitability Analysis: Return on Equity To establish if net profits are satisfactory or not,

Profitability Analysis: Return on Equity To establish if net profits are satisfactory or not, it is necessary to evaluate the risks of the business and the return on risk-free assets. Fair ROE = rf + rp rf = risk-free return (i. e. government bonds) → presently about 4% rp = risk premium related to business risk → strongly depend on business, on average about 6% Fair ROE is the opportunity cost of equity capital for shareholders. Below a Fair ROE, the company is underperforming. It does not create value for shareholders nor attract equity capital financing. Above a Fair ROE, the company is creating value for shareholders, giving them a return they couldn’t find elsewhere. Prof. Riccardo Tiscini Introduction to Business Economics 12

Profitability Analysis: Return on Equity Net Profit Key Factors Operating revenues and expenses (ordinary

Profitability Analysis: Return on Equity Net Profit Key Factors Operating revenues and expenses (ordinary business) Financial revenues and expenses Extraordinary revenues and expenses (non recurring) ROE Key Factors Return on operating investments Prof. Riccardo Tiscini Financial structure effect Introduction to Business Economics Extraordinary items 13

Profitability Analysis: Return on Investments PROFITABILITY ROI Net Operating Invested Capital EBIT/ NET OPERATING

Profitability Analysis: Return on Investments PROFITABILITY ROI Net Operating Invested Capital EBIT/ NET OPERATING INVESTMENTS Where: EBIT = Operating Income = Sales – Operating Costs Prof. Riccardo Tiscini Introduction to Business Economics 14

Profitability Analysis: Return on Investments ROI Key Factors Operating leverage effect Rotation of fixed

Profitability Analysis: Return on Investments ROI Key Factors Operating leverage effect Rotation of fixed assets Working capital cycle Operating income (EBIT) influenced by changes in sales and cost structure Analysis of revenue generated by fixed assets Average inventory period + Average clients collection period Average suppliers payment period Prof. Riccardo Tiscini Introduction to Business Economics 15

Profitability Analysis: Operating leverage SALES OPERATING COST OF SALES EBIT Earning before interests and

Profitability Analysis: Operating leverage SALES OPERATING COST OF SALES EBIT Earning before interests and taxes EBIT and any other factors impacting on it are key to analyse the operating leverage effect (Cost-Volume-Profit Analysis) Analysis Prof. Riccardo Tiscini Introduction to Business Economics 16

Profitability Analysis: Operating leverage COSTS FIXED VARIABLE Do not depend on sales volume changes

Profitability Analysis: Operating leverage COSTS FIXED VARIABLE Do not depend on sales volume changes and do not vary accordingly Vary in proportion to sales volume changes Prof. Riccardo Tiscini Introduction to Business Economics 17

Profitability Analysis: Operating leverage FIXED COSTS VARIABLE COSTS Total fixed costs Total variable costs

Profitability Analysis: Operating leverage FIXED COSTS VARIABLE COSTS Total fixed costs Total variable costs Y = vq Y = FC FC = total fixed costs Prof. Riccardo Tiscini Sales volume v = variable unit cost q = sales volume Introduction to Business Economics Sales volume 18

Profitability Analysis: Operating leverage FIXED COSTS v This function shows total fixed costs incurred

Profitability Analysis: Operating leverage FIXED COSTS v This function shows total fixed costs incurred by the company. v FIXED UNIT COSTS, meaning per sales/production unit, vary according to the business volume (Fixed unit costs = FC/q). This means that as the volume sold/produced increases, fixed unit costs decrease (all other conditions being equal). Prof. Riccardo Tiscini Introduction to Business Economics 19

Profitability Analysis: Operating leverage VARIABLE COSTS v This function shows total variable costs incurred

Profitability Analysis: Operating leverage VARIABLE COSTS v This function shows total variable costs incurred by the company. v Please note that VARIABLE UNIT COSTS (v), meaning per sales/production unit, do not vary along with business volume, all other conditions being equal. On their turn, variable unit costs depend on the number and quantities of required production factors (“INTERNAL” EFFICIENCY) and on the purchase prices (“EXTERNAL” EFFICIENCY). Prof. Riccardo Tiscini Introduction to Business Economics 20

Profitability Analysis: Operating leverage FIXED & VARIABLE COSTS v This is a ‘relative’ distinction

Profitability Analysis: Operating leverage FIXED & VARIABLE COSTS v This is a ‘relative’ distinction because it depends on the productive capacity utilization, the time horizon and the conditions of operating plans (all operating costs decrease in the long-term). v In other words, fixed costs remain unchanged only within certain intervals of productive capacity (up to saturation), and only for the period to which operating plans refer. v Some costs can be classified as “semi-variable” (partially fixed and partially variable: i. e. electricity). Prof. Riccardo Tiscini Introduction to Business Economics 21

Profitability Analysis: Operating leverage FIXED & VARIABLE COSTS v Fixed costs can be classified

Profitability Analysis: Operating leverage FIXED & VARIABLE COSTS v Fixed costs can be classified as structural costs (technical, production, sales force, etc. ) and planned costs (resulting from annual management discretionary decisions, i. e. R&D, advertising); the former can’t be decreased in the short run, the latter do. v Fixed costs may record a ‘stop-go’ variability (i. e. stairs shape function). v The variabiliy of variable costs can follow different trends (proportional, progressive, digressive, regressive). Prof. Riccardo Tiscini Introduction to Business Economics 22

Profitability Analysis: Operating leverage TOTAL COSTS Total costs REVENUES TC = FC + vq

Profitability Analysis: Operating leverage TOTAL COSTS Total costs REVENUES TC = FC + vq Revenue Sales volume Prof. Riccardo Tiscini Introduction to Business Economics Sales volume 23

Profitability Analysis: Operating leverage BREAK-EVEN ANALYSIS Analyses the changes in the operating result as

Profitability Analysis: Operating leverage BREAK-EVEN ANALYSIS Analyses the changes in the operating result as sales volume vary Identifies the break-even point generated by sales prices, fixed costs, variable unit costs Prof. Riccardo Tiscini Introduction to Business Economics Compares different price and cost structures with a view to finding the best solution in terms of expected operating result 24

Profitability Analysis: Operating leverage Total costs PROFIT AREA Break-even point LOSS AREA Sales volume

Profitability Analysis: Operating leverage Total costs PROFIT AREA Break-even point LOSS AREA Sales volume Prof. Riccardo Tiscini Introduction to Business Economics 25

Profitability Analysis: Operating leverage Total costs Break-even point TR = TC; TR = FC+VC;

Profitability Analysis: Operating leverage Total costs Break-even point TR = TC; TR = FC+VC; p*q = FC + v*q; p*q - v*q = FC; q*(p-v) = FC Sales volume q = FC/ (p-v) CONTRIBUTION MARGIN Prof. Riccardo Tiscini Introduction to Business Economics 26

Profitability Analysis: Operating leverage The distinction between fixed and variable costs sets the stage

Profitability Analysis: Operating leverage The distinction between fixed and variable costs sets the stage for the analysis of the OPERATING LEVERAGE the extent to which operating income (Ebit) is influenced by changes in production and sales. Prof. Riccardo Tiscini Introduction to Business Economics 27

Profitability Analysis: Operating leverage OPERATING LEVERAGE HIGH OPERATING LEVERAGE DEGREE LOW OPERATING LEVERAGE DEGREE

Profitability Analysis: Operating leverage OPERATING LEVERAGE HIGH OPERATING LEVERAGE DEGREE LOW OPERATING LEVERAGE DEGREE High sensitivity of EBIT as production and sales vary Low sensitivity of EBIT as production and sales vary FOCUS ON VOLUMES FOCUS ON MARGINS Prof. Riccardo Tiscini Introduction to Business Economics 28

Profitability Analysis: Operating leverage CONCLUSIONS v High operating leverage businesses have higher sensistivity of

Profitability Analysis: Operating leverage CONCLUSIONS v High operating leverage businesses have higher sensistivity of EBIT to changhes in sales. v This is due to a more rigid cost structure, with higher proportion of fixed costs and lower proportion of variable costs. v Hence, operating leverage degree is a measure of Operating Risk (EBIT volatility), meaning a higher income-generating capacity in sales increasing situations, but also higher income reductions when sales decrease. v These conclusions are true if: ü there are no changes in cost structure and business efficiency (i. e. no changes in fixed costs amount and variable costs percentage on sales); ü there are no changes in production capacity (not to have steps in the fixed costs). Prof. Riccardo Tiscini Introduction to Business Economics 29

Profitability Analysis: Operating leverage OPERATING LEVERAGE The DEGREE OF OPERATIVE LEVERAGE gives an ex-post

Profitability Analysis: Operating leverage OPERATING LEVERAGE The DEGREE OF OPERATIVE LEVERAGE gives an ex-post measurement of this sensitivity: O. L. D. = Δ% Operating income Prof. Riccardo Tiscini Δ% Sales The same ex-ante measurement can be obtained with the following ratio: O. L. D. = Contribution margin Operating income Introduction to Business Economics 30

Profitability Analysis: Fixed assets turnover FIXED ASSETS TURNOVER (ROTATION OF FIXED ASSETS) SALES FIXED

Profitability Analysis: Fixed assets turnover FIXED ASSETS TURNOVER (ROTATION OF FIXED ASSETS) SALES FIXED ASSETS Shows the adequacy of fixed assets with respect to sales Prof. Riccardo Tiscini To be compared with average ratios for the sector Introduction to Business Economics A bad (low) value can result from a surplus of fixed assets or inadequacy of sales, with respect to the market potential 31

Profitability Analysis: Working Capital Cycle The Working Capital Cycle corresponds to the average time

Profitability Analysis: Working Capital Cycle The Working Capital Cycle corresponds to the average time elapsed between cash payments to purchase production factors and cash collectings generated by the sales of goods or services. Average inventory period + Average clients collection period Average suppliers payment period = DURATION OF THE WORKING CAPITAL CYCLE Prof. Riccardo Tiscini This index is useful to assess liquidity problems due to mismatches between expenses and revenues cash flows. Introduction to Business Economics 32

Profitability Analysis: Working Capital Cycle EXAMPLE A Purchase of materials Suppliers payment Avg. inventory

Profitability Analysis: Working Capital Cycle EXAMPLE A Purchase of materials Suppliers payment Avg. inventory period 90 days Sales Avg. collection period granted to customers 60 days EXAMPLE B Purchase of materials Avg. suppliers payment period 45 days Avg. inventory period 120 days Duration of the working capital cycle 105 days Sales Debt collection Clients collection High Working Capital Investment, High Financial needs Prof. Riccardo Tiscini Avg. collection period granted to customers 60 days Debt collection Introduction to Business Economics Avg. suppliers payment period 210 days Low Working Capital Investments. Low Financial needs Duration of the working capital cycle -30 days 33

Profitability Analysis: Working Capital Cycle Too a long Working Capital Cycle (example A) can

Profitability Analysis: Working Capital Cycle Too a long Working Capital Cycle (example A) can have two different negative effects: A PROBLEM OF PROFITABILITY High working capital: Capital invested at low returns A PROBLEM OF LIQUIDITY Failing clients collection, increasing financial needs are generated to pay suppliers INCREASING FINANCIAL DEBT BURDEN Prof. Riccardo Tiscini Introduction to Business Economics 34

Profitability Analysis: ROS and CT ROE Main indicator of cost control = ROS =

Profitability Analysis: ROS and CT ROE Main indicator of cost control = ROS = CAPITAL TURN OVER = ROI Main indicator of sales development Main indicator of operating profitability Prof. Riccardo Tiscini Introduction to Business Economics 35

Profitability Analysis: ROS and CT ROI ROS EBIT/ SALES/ NET OPERATING INVESTMENTS Influenced by:

Profitability Analysis: ROS and CT ROI ROS EBIT/ SALES/ NET OPERATING INVESTMENTS Influenced by: ü Sales üOperating costs Prof. Riccardo Tiscini CT X FIXED COST VARIABLE UNIT COST ü Sales IN FIXED ASSETS üOperating investments IN NET WORKING CAPITAL Introduction to Business Economics 36

Profitability Analysis: Financial leverage The effect of financing activities on ROE depends on: i

Profitability Analysis: Financial leverage The effect of financing activities on ROE depends on: i FINANCIAL DEBT/EQUITY & Cost of financial debt Debt/equity ratio Limit value = 1, 1. 5 Prof. Riccardo Tiscini Introduction to Business Economics 37

Profitability Analysis: Financial leverage HP 1 HP 2 Net Operating Invested Cap. : 1.

Profitability Analysis: Financial leverage HP 1 HP 2 Net Operating Invested Cap. : 1. 000 Equity: 1. 000 ROI: 15% No net borrowing No effect of extraordinary items No taxes (analysis of ROE before tax) Net Operating Invested Cap. : 2, 000 Equity: 1, 000 Net Financial Position: 1, 000 i: 10% ROI: 15% EBIT = 300 Net Interests = 100 EBIT = 150 ROI = EBIT/NOIC ROE = NP/E Prof. Riccardo Tiscini 15%=150/1000 ROI=EBIT/NOIC 15%=300/2000 ROE = NP/E = 200/1000 = EBIT/NOIC = 15% - Introduction to Business Economics ROE= 20% 38

Profitability Analysis: Financial leverage HP 3 Net Operating Invested Cap. : 3, 000 Equity:

Profitability Analysis: Financial leverage HP 3 Net Operating Invested Cap. : 3, 000 Equity: 1, 000 Net Financial Position: 2, 000 i: 10% ROI: 15% EBIT = 450 Net Interests = 200 ROI=EBIT/NOIC 15%=450/3000 ROE = NP/E = 250/1000 ROE= Prof. Riccardo Tiscini 25% Introduction to Business Economics 39

Profitability Analysis: Financial leverage HP 1 ROI = 15% ROE = 15% ROI =

Profitability Analysis: Financial leverage HP 1 ROI = 15% ROE = 15% ROI = ROE HP 2 ROI = 15% ROE = 20% ROI = ROE + 5% HP 3 ROI = 15% ROE = 25% ROI = ROE + 5%*2 Prof. Riccardo Tiscini Introduction to Business Economics 40

Profitability Analysis: Financial leverage The Financial Leverage effect is demonstrated as follows: With taxation

Profitability Analysis: Financial leverage The Financial Leverage effect is demonstrated as follows: With taxation the effect changes as follows: In the following slides, we will consider absence of Financial Investment, so that Net Financial Position is equal to Financial Debt: (NFD = D). Prof. Riccardo Tiscini Introduction to Business Economics 41

Profitability Analysis: Financial leverage Financial Leverage effect The effect of debt increase on ROE

Profitability Analysis: Financial leverage Financial Leverage effect The effect of debt increase on ROE is the so-called FINANCIAL LEVERAGE EFFECT (or GEARING EFFECT) Prof. Riccardo Tiscini Introduction to Business Economics 42

Profitability Analysis: Financial leverage Cost of debt Tax rate Debt/equity ratio ROI-i > 0

Profitability Analysis: Financial leverage Cost of debt Tax rate Debt/equity ratio ROI-i > 0 POSITIVE FINANCIAL LEVERAGE ROI-i < 0 NEGATIVE FINANCIAL LEVERAGE Prof. Riccardo Tiscini Introduction to Business Economics 43

Profitability Analysis: Financial leverage All other conditions being equal: As ROI increases As ROI

Profitability Analysis: Financial leverage All other conditions being equal: As ROI increases As ROI decreases ROE increases ROE decreases As i increases As i decreases ROE increases As D/E decreases Prof. Riccardo Tiscini (ROI-i)>0 (ROI-i)<0 ROE increases ROE decreases ROE increases Introduction to Business Economics 44

Profitability Analysis: Financial leverage CONCLUSIONS v High financial leverage businesses (with high D/E ratio)

Profitability Analysis: Financial leverage CONCLUSIONS v High financial leverage businesses (with high D/E ratio) have higher sensistivity of ROE to changhes in ROI and i. v This is due to the multiplying effect of the D/E ratio, so that effects on shareholders of changes in operating profitability and in cost of debt are amplifyied (because the proportion of the invested capital not financed by them is higher). v Hence, financial leverage degree is a measure of Financial Risk (ROE volatility), meaning a higher shareholder returns generating capacity in high operating profitability situations, but also higher ROE reductions when the spread (ROI-i) decreases. v This means that excessive financial leverage is never healthy because: ü companies can never be sure that their ROI will keep above their i; ü anyway, high financial risk bring to higher Fair ROE expected by shareholders (making it possible to have higher ROE and lower value creation for shareholders). Prof. Riccardo Tiscini Introduction to Business Economics 45

Stages of Firms life FIRMS LIFE 1 st STAGE START-UP 2 nd STAGE GOING

Stages of Firms life FIRMS LIFE 1 st STAGE START-UP 2 nd STAGE GOING CONCERN 3 rd STAGE DISCONTINUANCE v Business idea v Organisation v M&A, Divestures v Location v Management v Winding up v Size v Information v Bankruptcy v Institutional aspects LEGAL STATUS, BYLAWS & GOVERNANCE Prof. Riccardo Tiscini Introduction to Business Economics 46

Stages of Firms life DISCONTINUANCE (FINAL STAGE) ABSOLUTE RELATIVE Shutdown Radical change in corporate

Stages of Firms life DISCONTINUANCE (FINAL STAGE) ABSOLUTE RELATIVE Shutdown Radical change in corporate structure or business The firm is no more in life The firm is still in life Prof. Riccardo Tiscini Introduction to Business Economics 47

Stages of Firms life DISONTINUANCE (FINAL STAGE) ABSOLUTE RELATIVE v change of legal status

Stages of Firms life DISONTINUANCE (FINAL STAGE) ABSOLUTE RELATIVE v change of legal status v spin off Voluntary Winding-up or Liquidation: Shareholders’ decision Prof. Riccardo Tiscini Forced Bankruptcy or other insolvency procedure: Legal regulation v mergers v acquisitions v other business combinations Introduction to Business Economics 48