Financial Statement Analysis

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Financial Statement Analysis
Valuation • Credit analysis • Executive compensation

Christian V. Petersen
and
Thomas Plenborg

Financial Times
Prentice Hall
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First published 2012

© Christian V. Petersen and Thomas Plenborg 2012

The rights of Christian V. Petersen and Thomas Plenborg to be identified as authors of this work
have been asserted by them in accordance with the Copyright, Designs and Patents Act 1988.

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ISBN: 978-0-273-75235-6

British Library Cataloguing-in-Publication Data

A catalogue record for this book is available from the British Library

Library of Congress Cataloging-in-Publication Data

Petersen, Christian V.
Financial statement analysis : valuation, credit analysis and executive compensation / Christian V.
Petersen and Thomas Plenborg.
p. cm.
Includes bibliographical references and index.
ISBN 978-0-273-75235-6 (pbk.)
1. Financial statements. 2. Corporations—Finance. I. Plenborg, Thomas. II. Title.
HG4028.B2P48 2012
657'.3—dc23
2011030723

10 9 8 7 6 5 4 3 2 1
14 13 12 11

Typeset in 10/12pt Sabon by 73

Printed and bound by Ashford Colour Press Ltd, Gosport
This book is dedicated to our families
Thomas: my wife, Susanne, and children, Peter, Frederikke and Karl Emil
Christian: my wife, Susanne, and children, Sofie, Katrine and Sebastian
We love you!
 Contents

Preface xiii
Publisher's acknowledgements xvii

1 Introduction to financial statement analysis 1

Learning outcomes 1
Introduction to financial statement analysis 1
International Financial Reporting Standards 2
Decisions and decision models 3
Outline of the book 13
Conclusions 17
Review questions 18
Notes 18
References 18

Part 1 ACCOUNTING DATA 19

Introduction to Part 1 21

2 Introduction to financial statements and bookkeeping 22

Learning outcomes 22
Introduction to financial statements and bookkeeping 22
The income statement and statement of comprehensive income 23
Balance sheet 27
Cash flow statement 30
Statement of changes in owners' equity 32
Recording transactions and preparing financial statements 32
Transaction analysis illustrated 37
Financial statements 43
Conclusions 45
Review questions 46
Appendix 2.1 46

3 Accrual-based versus cash-flow-based performance measures 47

Learning outcomes 47
Accrual-based versus cash-flow-based performance measures 47
 The distinction between accrual-based and cash-flow-based
performance measures 48
Conclusions 59
Review questions 59
References 59

Part 2 FINANCIAL ANALYSIS 61

Introduction to Part 2 63

4 The analytical income statement and balance sheet 68

Learning outcomes 68
The analytical income statement and balance sheet 68
Carlsberg's NOPAT and invested capital 79
Conclusions 91
Review questions 92

5 Profitability analysis 93
Learning outcomes 93
Profitability analysis 93
Measurement of operating profitability 94
Alternative interpretations of the return on invested capital 99
Decomposition of return on invested capital 107
Analysis of profit margin and turnover rate of invested capital 111
Return on equity 117
Conclusions 120
Review questions 122
Appendix 5.1 122

6 Growth analysis 127

Learning outcomes 127
Growth 127
Sustainable growth rate 128
Is growth always value creating? 131
What is the quality of growth? 1 34
Is growth sustainable? 1 37
Is growth in earnings per share (EPS) always value creating? 140
Does growth in financial ratios caused by share buy-back always add value? 141
The relationship between growth and liquidity 147
Conclusions 148
Review questions 148
Notes 149
References 149

7 Liquidity risk analysis 150

Learning outcomes 150
Liquidity risk 150
 Measuring short-term liquidity risk 153
Measuring long-term liquidity risk 158
Shortcomings of financial ratios measuring the short- and long-term liquidity risk 165
Conclusions 165
Review questions 166
Appendix 7.1 166
Notes 170

Part 3 DECISION MAKING 171

I n t r o d u c t i o n to Part 3 173

8 Forecasting 174
Learning outcomes 1 74
Forecasting 174
The design of pro forma statements 1 75
Designing a template for forecasting 181
The estimation of financial value drivers 187
Financial statement analysis 194
Conclusions 199
Review questions 200
Appendix 8.1 200

9 Valuation 208
Learning outcomes 208
Valuation 208
Approaches to valuation 210
The attributes of an ideal valuation approach 212
Present value approaches 212
The relative valuation approach (multiples) 226
The liquidation approach 235
Conclusions 237
Review questions 237
Appendix 9.1 238
Note 244
References 244

10 Cost of capital 245

Learning outcomes 245
Cost of capital 245
Weighted average cost of capital (WACC) 246
Alternative methods of measuring the systematic risk (β e ) 254
Conclusions 266
Review questions 267
Appendix 10.1 267
Note 270
References 270
11 Credit analysis 271
Learning outcomes 271
Corporate credit analysis 271
The fundamental credit analysis approach 272
Pricing credit risk 291
Prediction of corporate default using statistical models 292
Conclusions 297
Review questions 297
Note 297
References 298

12 Accounting-based bonus plans for executives 299

Learning outcomes 299
Introduction to executive compensation 299
Characteristics of an effective bonus plan 301
Components of a bonus plan 306
Choice of performance measures 307
Choice of performance standards 314
Choice of pay to performance structure 318
EVA-based bonus contract - a feasible solution
to accounting-based performance measures 322
Conclusions 327
Review questions 327
Note 327
References 328

Part 4 ASSESSMENT OF A C C O U N T I N G DATA 329

Introduction to Part 4 331

13 Accounting quality 333

Learning outcomes 333
Accounting quality 333
The purpose of financial statement analysis and good accounting quality 336
Assessment of accounting quality 338
Total assessment of accounting quality 370
Conclusions 371
Review questions 371
Note 372
References 372

14 Accounting flexibility in the income statement 373

Learning outcomes 373
Accounting flexibility in the income statement 373
Accounting regulation and flexibility 375
Accounting flexibility in the income statement 380
Accounting flexibility and economic consequences 394
 Accounting issues in valuation 396
Accounting issues in credit analysis 404
Accounting issues in executive compensation 406
Conclusions 408
Review questions 408
Appendix 14.1 409
Appendix 14.2 409
Notes 410
Reference 410

15 Accounting flexibility in the balance sheet 411

Learning outcomes 411
Accounting flexibility in the balance sheet 411
Assets, liabilities and related expenses 411
Accounting flexibility and economic consequences 433
Accounting issues in valuation 433
Accounting issues in credit analysis 444
Accounting issues in executive compensation 450
Conclusions 454
Review questions 455
Appendix 15.1 455
Notes 456
References 457

Glossary 458
Index 467
 Preface

Financial statement analysis has proven to be useful in a wide range of business deci-
sions. Equity analysts use it as a foundation for their projection of the earnings poten-
tial of a company. Credit analysts use it as a tool to analyse operating and financial
risks and to determine whether loans should be extended. Consultants apply it as part
of their strategic analysis. Management uses it in monitoring competitors and in estab-
lishing a 'best practice' in an/their industry. Investment bankers and private equity
funds apply financial statement analysis as basis for analysing potential mergers and
acquisitions.
The course 'financial statement analysis' is therefore in demand at business schools
worldwide. It provides business students with a framework for analysing financial
statements for different analytical purposes. It is our ambition that the framework laid
out in this book will provide business students and practitioners with a unique insight
into financial statement analysis.

Vision of the book

Most textbooks on financial statement analysis primarily focus on investors. This
implies that the analysis aims at supporting a valuation perspective. This book differs
from other books by introducing and developing a framework for financial statement
analysis that takes a wider user perspective. In addition to valuation we also focus
on credit analysis and design of accounting-based bonus plans for executives. This
implies that the book takes the view point of an equity analyst, credit analyst and
compensation analyst, respectively. This book recognises that these three users make
decisions in different contexts using different aspects of financial statements. So, to
make optimum decisions, we focus on each of these contexts separately using different
accounting information and applying different sets of ratios.

Overview
An important premise when reading this textbook is that although a firm's finan-
cial statement serves as an important source of information it is crucial that addi-
tional information is collected and analysed. This includes an understanding of
the firm's strategy and its competitors and the markets which it serves. Thereby
it is possible to analyse the financials much more intelligently and generate more
powerful analyses.
 The book is divided into four parts which, when combined, give you an excellent
insight into financial statement analysis. Each part represents a theme that includes
information on:
• Part 1 - Accounting data
• Part 2 - Financial analysis
• Part 3 - Decision making
• Part 4 - Assessment of accounting data
In Part 1 - Accounting data we present the different financial statements in the annual
report. Needless to say, familiarity with the components of the annual report is an
essential prerequisite for understanding the other parts of this book. Based on our
experience many students as well as practitioners have only limited knowledge on
how firms record (double-entry bookkeeping) transactions and enter them into dif-
ferent financial statements. We therefore also revisit the double-entry bookkeeping
system.
In Part 2 - Financial analysis we discuss in details how to measure and analyse a
firm's profitability, growth and risk. Good profitability is important for a company's
future survival and to ensure a satisfactory return to shareholders. The historical prof-
itability is also an important element in defining the future expectations for a com-
pany. Growth is seen by many as the driving force for future progress in companies. It
is therefore essential to measure growth and ensure that it is profitable. The monitor-
ing of the liquidity risk is central to any business. Without liquidity a company cannot
pay its bills or carry out profitable investments and in extreme cases lack of liquidity
leads to bankruptcy. An analysis of short- and long-term liquidity risk is therefore
crucial.
In Part 3 - Decision making we apply the financial analysis on different decision
contexts:
• Forecasting
• Valuation
• Cost of capital
• Credit analysis
• Accounting-based bonus plans for executives
Forecasting (pro forma statements) serves as the foundation for many business deci-
sions. An understanding of how to build pro forma statements and ensuring that they
are based on reasonable assumptions is therefore essential. The chapter on valuation
gives an overview of the valuation techniques available and we discuss in detail how to
apply the most popular valuation techniques including the present value approaches
such as the discounted cash flow model and the economic value added model, mul-
tiples such as the P/E ratio and EV/EBIT ratio and the liquidation approach. Cost of
capital is a concept used across different decision contexts. For example, cost of capital
serves as the discount factor in valuation and as a performance standard (threshold) in
compensation schemes. Consequently, we discuss how to estimate the cost of capital.
The chapter on credit analysis aims at assessing a company's ability and willingness to
pay its financial obligations in a timely manner. It also examines the probability that
a company defaults and the potential loss in case of a default. Finally, the chapter on
accounting-based bonus plans for executives addresses some of the financial issues
when designing an executive's compensation contract.
In the first three parts we have taken reported financial data at face value. In the
final part, Part 4 - Assessment of accounting data, we challenge the accounting data
used in the financial analysis. The concept of 'accounting quality' is defined, and we
document that management has some flexibility and discretion in producing financial
statements. We therefore discuss accounting policies and flexibility and how they have
an impact on firm valuation, credit analysis and the design of accounting-based bonus
plans for executives.

Target group
This book is intended for people interested in financial statement analysis. Many of
the techniques discussed in this book can be used in relation to valuation of compa-
nies, assessment of creditworthiness and the design of accounting-based bonus plans
for executives. However, people interested in related matters such as financial man-
agement and risk management may also find inspiration in this book. The book is
designed so that it can be used in financial statement analysis for a variety of settings
including MBA, Master in Accounting and Finance, executive courses, and under-
graduate courses in Accounting and Finance. Furthermore, the book is suitable for
practitioners with an interest in financial statement analysis.

Prerequisites
Since financial statements typically serve as the primary source of data in financial
statement analysis, it is important that students and practitioners have a basic knowl-
edge of financial accounting. Although the book can be read with minor or with no
prior knowledge of financial accounting and reporting, to gain full benefit from read-
ing the text, we do recommend that students as well as practitioners, have a basic
understanding of financial accounting. Furthermore, knowledge of financial and stra-
tegic issues is also useful as we draw on both disciplines throughout our book.

Acknowledgement
We are grateful to the following colleagues who gave us valuable feedback in writing
this book: Rune Dalgaard, Jens Østrup and Morten Jensen.
 Publisher's acknowledgements

We are grateful to the following for permission to reproduce copyright material:

Figures
Figures 6.5, 6.6 and 6.7 from Data Source: Compustat ® , Copyright © 2011 The
McGraw-Hill Companies, Inc. Standard & Poor's, including its subsidiary corpora-
tions (S&P), is a division of The McGraw-Hill Companies, Inc. Figures 8.5 and 8.6
from Competitive Advantage: Creating and Sustaining Superior Performance (Porter,
Michael E.) Copyright © 1985, 1998 by Michael E. Porter, reprinted with the permis-
sion of Free Press, a Division of Simon & Schuster, Inc. All rights reserved; Figure 9.3
from Issues in valuation of privately-held firms, Journal of Private Equity, Vol. 10 (1),
pp. 34-48 (Petersen, C., Plenborg, T. and Schøler, F., 2006), reproduced with permis-
sion of Euromoney Institutional Investor plc in the format textbook via Copyright
Clearance Center; Figure 11.2 from Financial ratios as predictors of failure, Journal
of Accounting Research, Supplemental, Empirical Research in Accounting: Selected
Studies, p. 82 (Beaver, W., 1966), Copyright © 1966 Blackwell Publishing, repro-
duced with permission of Blackwell Publishing Ltd; Figure 13.2 from GAAP versus
the street: An empirical assessment of two alternative definitions of earnings, Journal
of Accounting Research, 1, pp. 41-66 (Bradshaw, M.T. and Sloan, R.G., 2002), with
permission of John Wiley & Sons via Copyright Clearance Center.

Tables
Tables 2.2, 2.4, 2.5, 2.6 and 2.7 from Annual Report 2008, Ericsson, used with per-
mission of Telefonaktiebolaget L. M. Ericsson; Table 3.2 from Annual Report 2008,
Carlsberg Group, p. 77; Table 4.1 from Annual Report 2008, Carlsberg Group p. 72;
Table 4.2 from Annual Report 2008, Carlsberg Group, p. 74; Tables 4.3, 4.8 from
Annual Reports, Carlsberg Breweries A/S; Tables 4.9 and 4.12 from Annual Report
2008, Carlsberg Group, p. 85; Table 4.10 from Annual Report 2008, Carlsberg Group,
p. 98; Table 4.13 from Annual Report 2008, Carlsberg Group, p. 99; Table 4.14
from Annual Report 2008, Carlsberg Group, p. 112; Table 4.15 from Annual Report
2008, Carlsberg Group, p. 118; Table 6.6 from Data Source: Compustat ® , Copyright
© 2 0 1 1 The McGraw-Hill Companies, Inc. Standard & Poor's including its subsidi-
ary corporations (S&P), is a division of The McGraw-Hill Companies, Inc. Table 7.4
from William Demant Holding's Annual Reports, http://www.demant.com/annuals.
cfm; Table 8.7 from FactSet Estimates; Table 9.16 from Annual Reports, http://www.
ab-inbev.com/go/investors.cfm; Table 10.2 from Betas used by professors: a survey
with 2,500 answers, Working Paper, IESE Business School (Fernandez, P., 2009) May,
Table 5, used with permission of the author; Table 10.6 from Betas used by professors:
a survey with 2,500 answers, Working Paper, IESE Business School (Fernandez,
P., 2009) May, Table 7, used with permission of the author; Table 10.7 from Market
risk premium used in 2008 by professors: a survey with 1,400 answers, Working
Paper, IESE Business School (Fernandez, P., 2009) April, Table 2, used with permission
of the author; Table 10.8 from Market risk premium used in 2008 by professors: a sur-
vey with 1,400 answers, Working Paper, IESE Business School (Fernandez, P., 2009)
April, Table 7, used with permission of the author; Table 11.9 from Fundamentals of
Corporate Credit Analysis, McGraw-Hill (Ganguin, B. and Bilardello, J., 2004) p. 302,
Table 11.4, reproduced with permission of McGraw-Hill Companies, Inc. - Books in the
format tradebook via Copyright Clearance Center; Table 11.12 from Fundamentals of
Corporate Credit Analysis, McGraw-Hill (Ganguin, B. and Bilardello, J., 2004) p. 298,
Table 11.2, reproduced with permission of McGraw-Hill Companies, Inc. - Books in
the format tradebook via Copyright Clearance Center; Table 11.14 from Financial
ratios as predictors of failure, Journal of Accounting Research, Supplemental, Empirical
Research in Accounting: Selected Studies, p. 90 (Beaver, W., 1966), Copyright ©
1966 Blackwell Publishing, reproduced with permission of Blackwell Publishing Ltd;
Table 13.2 from Geschäftsbericht 2009, Annual Report 2009, Bayer Group, p. 273,
Table 1.2; Table 13.4 from Geschäftsbericht 2009, Annual Report 2009, Bayer
Group, p. 74, Table 3.16; Table 13.5 from Annual Report 2009, Wolseley plc, p. 94;
Table 13.6 from Annual Report 2009, Wolseley plc, p. 139; Table 13.8 from Annual
Report 2006, SABMiller plc, p. 129; Table 13.9 from Annual Report 2006, SABMiller
plc, p. 142; Table 13.12 from DSV A/S; Table 14.2 from Annual Report 2009,
Carlsberg Group, p. 72; Table 15.15 from Annual Report 2008, E.ON AG, p. 115.

Text
Appendix 2.1 from International Financial Reporting and Analysis, 4th ed., Cengage
Learning (Alexander, D., Britton, A. and Jorissen, A., 2009) p. 16; Appendix 5.1 from
Annual Reports, www.heineken.com, © Heineken N.V., Tweede Weteringplantsoen
2 1 , 1017 ZD Amsterdam; Appendix 14.1 from PricewaterhouseCoopers, http://
www.pwc.com/gx/en/ifrs-reporting/ifrs-local-gaap-similarities-and-diferrences.jhtml;
Appendix 14.2 from The Financial Numbers Game: Detecting Creative Accounting
Practices, John Wiley & Sons, Inc. (Mulford, C.W. and Comiskey, E.E., 2002) p. 65,
Copyright © John Wiley & Sons, Inc. 2002, reproduced with permission of John
Wiley & Sons, Inc.
In some instances we have been unable to trace the owners of copyright material, and
we would appreciate any information that would enable us to do so.
 CHAPTER 1

Introduction to financial statement analysis

Learning outcomes
After reading this chapter you should be able to:
• Understand the three user perspectives applied in this book
• Identify the different decision models available for valuation and credit
analysis
• Identify the financial performance measures available in executives' compensation
schemes
• Recognise that accounting information is treated differently in different decision
contexts
• Understand the structure of this book

Introduction to financial statement analysis

Consider this scenario:

A company's inventory is destroyed in a fire and the company recognises a sub-

stantial loss on its income statement because it was under-insured. How should
this loss influence a financial statement analysis? Would you deduct this loss when
determining the income of the company? Why or why not?
These sorts of decisions are at the heart of financial statement analysis. In fact, the
purpose for financial statement analysis is to help people make better decisions. But it
is not always as straightforward as it initially appears.
For instance, if we continue with the above scenario and add a bit of context,
your decision about how the loss should influence a financial statement analysis might
change:
First, assume that the purpose of the analysis is to determine the market value
of equity. If management corrects the under-insurance problem, then, for equity
valuation purposes, the loss can be considered transitory - in other words 'noise' -
and should be excluded when extrapolating from past income in order to forecast
future income.
On the other hand, if the objective is to determine the amount that manage-
ment will receive in bonus income, then it probably makes sense to include the loss
when determining the income. This is because management has failed adequately
to insure inventory and this failure caused a loss to the owners as a consequence
of the fire.
 The case above demonstrates that the decision - the reason for doing the analysis -
drives the information needed and used in the analysis.
There are many different decision contexts and types of decision makers, but this
book focuses on three important groups: equity-oriented stakeholders, debt-capital-
oriented stakeholders and compensation-oriented stakeholders. To get a sense of who
might be in each group, take a look at Table 1.1.

Table 1.1
Equity-oriented Debt-capital-oriented Compensation-oriented
stakeholders stakeholders stakeholders

• Investors • Banks • Management

• Companies • Mortgage-credit institutes • The board
• Corporate finance analysts • Companies • Investors

• Pension funds • Providers of mezzanine capital

• Venture capital providers

• Private equity providers

These groups receive guidance from analysts. Equity analysts value the residual
return in a company after all other claims have been satisfied, with the goal of deter-
mining the level of investment in the firm. Credit analysts assess a company's ability
to repay its existing or new debts, with goals pertaining to the amount and terms of
credit to be extended to the firm. Compensation analysts, including company board
members, use a company's financial statements to determine performance-based man-
agement compensation.
These three groups make decisions in different contexts using different aspects of
financial statements. Therefore, we treat these analytical contexts separately. We will
introduce different decision models for each group and show what accounting infor-
mation is required in each instance.

International Financial Reporting Standards

This book is written for users of financial statements prepared under different sets
of accounting standards. However, we primarily rely on International Financial
Reporting Standards (IFRS) and only to a minor extent on the US accounting stand-
ards (US GAAP). As we consider specific topics, we mainly discuss definitions, rec-
ognition issues, measurement criteria and classification issues as set forth under IFRS
as developed by the International Accounting Standards Board (IASB). IFRS are used
in many parts of the world, including the European Union, Hong Kong, Australia,
Malaysia, Pakistan, GCC countries, Russia, South Africa, Singapore and Turkey.
More than 110 countries around the world, including all of Europe, currently require
or permit IFRS reporting. Approximately 85 of those countries require IFRS reporting
for all domestic, listed companies.
More recently, the US Securities and Exchange Commission (SEC) has begun
to accept the IFRS financial statements of non-US companies, thus allowing these
 companies to issue stocks and bonds in American capital markets. American compa-
nies are not yet required to apply IFRS. In fact, initially, non-US companies may apply
either IFRS or US accounting standards, whereas American companies are allowed
to report under US standards only. The US accounting standards are often referred to
as generally accepted accounting principles, or 'GAAP', as the Financial Accounting
Standards Board (FASB) calls them.
It has become increasingly challenging to analyse financial statements because of
the trend toward measuring assets and liabilities at fair value. Clearly, the objective of
fair value financial statements is admirable: to measure company assets and liabilities
at their economic value. But with fair value, both the producer (i.e. management of
the firm) and the user of the information take on additional responsibilities. With
fair value, managers must look beyond simplistic historical cost accounting methods
to choose among the measurement techniques allowed by IFRS (and other standard
setters). Users, on the other hand, read the financial disclosures with an eye toward
discerning the 'truth'. The truth, it turns out, depends on the context of the question
being asked. For instance:
1 What is the value of the residual equity in the business?
2 Can the firm repay new or existing debt?
3 What is the firm's performance for management compensation purposes?
IFRS standards require both producers and users to exercise considerable judgement.
Consider, for example, the IFRS standard that requires assets to be tested for impair-
ment. An impairment test essentially requires that management estimate the value of
an asset or group of assets (a cash generating unit, or CGU). If the value of an asset or
group of assets is below the carrying value, they need to be written down. The result
of the impairment test can have a large impact on the firm's earnings and financial
ratios. However, there is plenty of room for management discretion in this decision,
since outsiders cannot see all inputs that management uses. Both management and the
user know that the quality of accounting information depends on management faith-
fully to convey useful information. Because of this, the user will ask key questions like:
'To what extent do I trust the information provided by management?' and 'Is there
any need to make adjustment to the reported accounting data?'
Facing this situation, management's reporting decision is likely to depend on the
relative importance of existing and future contracts based on financial statement
information. Managers of firms with stringent contracts, such as debt covenants, are
likely to choose measurements that avoid breach of such covenants. On the other
hand, managers are more likely to be truthful if the financial information is being
provided to informed users who are not bound by existing long-term contracts based
on financial information. Ultimately, whether the financial statements faithfully reflect
firm economics depends on these contractual incentives, management's innate integ-
rity, and the firm's internal and external control systems.

Decisions and decision models

Users should keep focused on the reason for the financial analysis - the decision at
hand. In the midst of information overload, users can lose sight of the purpose of
their analysis, and this often results in a well-informed answer to the wrong ques-
tion. For this reason we encourage analysts to specify, and write down, the decision
 at hand before digging into the data and analysis. Here are a few examples of business
decisions:
1 Should our bank lend a firm €10 million at 7% per annum for three years?
2 Determine comparable returns on equity in a recent accounting period for two
firms in the same industry in order to allocate €5 million in equity capital.
3 In the most recent quarter, how much profit was generated from operations under
the authority of the executive responsible for Asian operations?
By clearly defining the decision from the outset, the analyst will be able to stay focused
on the relevant information and will be more likely to make the right choice.
Now let's explore in more depth the three sets of decision makers mentioned earlier:
equity-oriented stakeholders, debt-capital-oriented stakeholders and compensation-
oriented stakeholders.

Equity-oriented stakeholders
In general, equity-oriented stakeholders use financial information to assess the intrin-
sic value of a company. Investors decide whether to buy, hold or sell residual equity
(e.g. shares of stock). Stock analysts tend to work within specific industry segments in
order to gain superior knowledge of an industry and therefore a competitive advan-
tage. For instance, analysts often specialise in segments such as biotech, information
technology or food and beverages. A stock analyst typically gathers information based
on an industry's history and expected performance prior to focusing on a specific
firm. Once an industry's outlook has been assessed, the analyst will assess a firm's
historical performance and form an opinion of the expected earnings potential of
the company. Conversely, an analyst in a corporate finance department advises the
company concerning financial matters of a company such as merger and acquisi-
tions, issues concerning initial public offerings (IPOs), choice of capital structure and
the achievement of debt capital. From both sides of the coin, there are similarities
between the work carried out by a stock analyst and an analyst in a corporate finance
department - both aim to assess the value of the company.
Investors who buy the analyses from the stock analysts often invest according to
some predefined criteria. For instance, they may invest in certain industries such as
biotech or information technology or within a specific country or region (e.g. Russia,
South America or Asia). Investors may also self-select into clienteles based on the
desire for 'value' or 'growth' investing. Though investors and their analysts work in
different ways and spend different amounts of time on valuation, they all try to assess
the future earnings potential of a company.
The techniques used to value equity are increasingly being employed outside of
traditional stock analysis. In the mid-1980s Professor Alfred Rappaport popularised
the concept of value-based management. The concept was soon followed by a large
number of consultancy firms including Stern Stewart (the EVA concept), McKinsey &
Co., Boston Consulting Group and PA Consulting. The basic principle of the concept
of value-based management is to systematise, quantify and evaluate strategic action
plans. The concept is therefore an extension of the strategy literature since it quantifies
the economic values of different strategic plans of action.
Stock-based compensation schemes are popular throughout the world as a means
of aligning the interests of management and shareholders, while conserving cash
available for managers to invest. In addition, a large number of unlisted companies,
especially within the biotech and information technology industries, compensate key
employees with promises of 'a share of the action', or equity. In deciding whether
to enter into these contracts, both employees and management need to assess the value
of the compensation contract.
Impairment test of goodwill is one of the latest examples of an area in which the
techniques of valuation are applicable. The accountant has to reassess the value
of goodwill in order to identify a possible impairment loss. This requires knowledge of
the market value of the cash generating unit being assessed.
As the above examples illustrate, valuation of companies are used in a number of
contexts.

Valuation models
Equity-oriented stakeholders focus on determining the 'true' value of firms' equity
since investors who correctly value a firm's stock can make money if the market value
is different. Underpriced shares can be purchased to return a profit when the market
value corrects. Conversely, overpriced shares can be sold short, and the investor will
make money as long as the market value reflects the true potential of the firm during
the period in which the investor holds the position.1
There are a number of different valuation models. Figure 1.1 categorises valuation
models into four distinct groups. We will now briefly elaborate on each approach, in
order to show that the different valuation approaches require different inputs, which
affect how we design our financial statement analysis. In Chapter 9 we will explain in
more detail how to use each approach for valuation purposes.

Present value models

The first group of valuation models is named present value approaches. These models
share the same characteristics: the value of a firm (or asset) is estimated as the present
value of future cash flows. The estimated market value of equity is found by discount-
ing expected cash flows by the owners' required rate of return taking into account the
time value of money and the underlying risk of the income streams.
With the dividend models as the point of departure, the market value of the equity
of a company can be calculated as:

In order to apply the present value models, information about future profitability,
growth rates and risk is needed. It is therefore necessary to estimate the future eco-
nomic potential of a company to be able to apply a present value model. The financial
statement analysis is in this context an important element since it gives an insight
into the historical profitability, growth rates and risk. The financial statement analysis
thus establishes (historical) levels and trends in the economic performance of the firm,
which is a good starting point for making forecasts.
Figure 1.1 Overview of valuation approaches

As part of a historical financial statement analysis the analysts will consider the quality
of the reported accounting data. For example, the analysts need to distinguish between
permanent (recurring) and transitory (non-recurring) accounting items. Transitory items,
for example gains or losses on the sale of non-current assets, are those that are not likely
to recur; or only with large time intervals. Therefore, when predicting the future earnings
potential of a company, analysts will typically exclude transitory items from the historical
data and analyses. Furthermore, it is important to check that historical data is based on
unchanged accounting policies. This ensures that any observed trend is caused by under-
lying changes in operations rather than by changes in accounting policies.

Relative valuation models

Relative valuation models are often referred to as multiples. In these models the value
of a company is estimated by comparing with the price of comparable (peer group)
companies based on reported or expected accounting earnings, equity, turnover or
cash flows. Example 1.1 illustrates the application of multiples.
Example 1.1 Assume that a pharmaceutical company located in Europe is planning to buy an Australian
competitor which is doing research within the central nervous system (CNS). The Australian
competitor which is not listed has announced that the outlook for the coming fiscal year are
favourable. Thus, a 20% increase in earnings is expected. As a result net earnings increase to
€200 million. Currently, most pharmaceutical companies, specialising in CNS, are traded at a
P/E multiple2 around 1 7. Assuming that it is fair to pay €1 7 per every euro of net income for
a company within the CNS industry, the value of the Australian competitor can be estimated
to be €3.4 billion (€200 million × 1 7). •

The example demonstrates that the use of multiples assumes that accounting data can
be compared across firms. Thus, the use of multiples makes significant constraints on
the data. First, the accounting policies for the companies that are compared have to
be identical. Second, earnings of the companies which are compared have to have the
same 'quality'. This implies that a distinction between permanent (recurring) or tran-
sitory (non-recurring) earnings have to be made. Finally, applying the same multiple
across different companies implies that they have the same expectation about future
profitability, growth and risk.

Liquidation models
In liquidation models the value of a company is estimated by assessing the value of
the assets and the liabilities if the firm is liquidated. The liquidation value (break-up
value) is calculated by subtracting the liquidation value of all liabilities from the liqui-
dation value of all assets.
The data requirements of the liquidation approach are rather substantial since
all (economic) assets and liabilities have to be recognised in the balance sheet.
Furthermore, the book value of assets and liabilities has to be a reasonable proxy
for the proceeds obtainable through a liquidated sale. This is only rarely the case.
For instance the annual report is prepared assuming a 'going concern', i.e. assuming
continuing operations. This raises a measurement problem that the analyst has to
overcome. The analyst, thus, has a considerable amount of work in identifying and
reassessing the value of all assets and liabilities when using the liquidation model, as
illustrated in Table 1.2.
The first step in applying the liquidation approach is to recognise assets and liabilities
that have not previously been identified. The second step is to measure each asset and
liability as if the firm liquidates. In the example in Table 1.2 non-recognised liabilities
of 50 are now included. This could be, for instance, a possible loss related to an unset-
tled lawsuit or an obligation to clean up a piece of polluted land. Furthermore, all assets
and liabilities are measured at liquidation value which reduces the value of assets by 245
and increases the value of liabilities by 5. Thus, the impact on net assets is minus 250
(245 + 5). The example shows that in the case of liquidation all equity is lost.

Contingent claim valuation models

Contingent claim models, contingency models, also defined as real option models,
are the fourth and last group of models. They are related to the present value mod-
els. Present value models can be thought of as static as they value only one scenario
at a time. Contingent claim models also include the value of flexibility. The method
is applicable to companies and assets that share the same characteristics as options.
Biotech companies, for instance, are free to abandon research projects if they do not
turn out to be commercially viable. This flexibility is valuable and should have a
 Table 1.2 Valuation based on the liquidation approach

Liquidation model (example)

Book Liquidation Book Liquidation
value value value value

Intangible assets 100 10 Equity 300 0

Tangible assets 250 195 Provisions 20 20
Financial assets 50 0 Interest-bearing debt 290 295
Non-current assets 400 205 Operating liabilities 95 95
Non-recognised liabilities 0 50
Inventories 150 120 Liabilities 405 460
Receivables 140 120
Cash and securities 15 15
Current assets 305 255
Assets 705 460 Equity and liabilities 705 460

positive effect on the estimated value of the firm. Since contingent claim models sim-
ply add the value of flexibility to the firm value estimate based on the present value
models, the requirements for the accounting data are identical for the two types of
valuation models.
In order to understand the equity-oriented stakeholders' need for information, it is
necessary to learn the methods applied for valuation of companies. Each set of valua-
tion methods requires its own set of assumptions and input.

Debt-capital-oriented stakeholders
Debt-capital-oriented stakeholders aim to value the creditworthiness of a company as
well as the possible extension of business relations with that company. The assessment
of the creditworthiness of companies enjoys increasing attention by financial institu-
tions as a consequence of the financial crisis as well as rules that entail that banks and
mortgage-credit institutions have to weight their loans by risk.
Banks and mortgage-credit institutions have an economic interest in developing
enhanced models for assessment of creditworthiness, as, ultimately, they are expected
to lead to:

• More efficient credit processing

• Better forecasting of possibly bad loans
• More correct pricing of credit contracts
• Better allocation of capital through a better registration of risk.

Companies make assessments of the creditworthiness of both customers and suppli-

ers. The creditworthiness of the customer is estimated in order to be able to assess the
customer's ability to pay its bills. In the same way, assessing the creditworthiness of
suppliers helps firms to avoid doing business with firms that may not be able to deliver
according to their contractual terms.
Methods for assessment of creditworthiness of companies
To understand the information needs of the providers of debt, an understanding of the
models that are used for assessment of creditworthiness is required. There are several
methods for judging creditworthiness. Financial institutions often have their own way of
assessing credit risk, and therefore it is difficult to codify current practice. In Figure 1.2
the most prevalent methods for assessing creditworthiness are shown.

Figure 1.2 Grouping of methods for creditworthiness of companies

We will now briefly elaborate on each method. Again, you will see that the different
credit approaches require different inputs, which affect how we design our financial
statement analysis. In Chapter 11 we will explain in more detail how to use each
approach for assessment of a company's creditworthiness simultaneously.

Credit rating models

Credit rating models have long been used by rating agencies such as Moody's and
Standard & Poor's. Among banks and credit institutions, credit rating models are used
as an operational tool for assessing the creditworthiness of a large number of companies.
Table 1.3 is a simplified example of a credit rating model. The example shows the
credit rating model tailored to industrials and various financial ratios are used for
assessing the creditworthiness and ranking the companies. AAA is the highest rating

Table 1.3 Credit rating of industrials

Adjusted key industrial financial ratios
US industrial long-term debt

Three years median AAA AA A BBB BB B CCC

EBIT interest cover (x) 21.4 10.1 6.1 3.7 2.1 0.8 0.1

EBITDA interest cover (x) 26.5 12.9 9.1 5.8 3.4 1.8 1.3

Free operating cash flow/total debt (%) 84.2 25.2 15.0 8.5 2.6 -3.2 -12.9

FFO/total debt (%) 128.8 55.4 43.2 30.8 18.8 7.8 1.6

Return on capital (%) 34.9 21.7 19.4 13.6 11.6 6.6 1.0

Operating income/revenue (%) 27.0 22.1 18.6 15.4 15.9 11.9 11.9

Long-term debt/capital (%) 13.3 28.2 33.9 42.5 57.2 69.7 68.8

Total debt/capital (%) 22.9 37.7 42.5 48.2 62.6 74.8 87.7
Number of companies 8 29 136 218 273 281 22
while CCC is the lowest rating in the example. A risk premium based on the rating is
added to the risk-free interest rate so that the rate of interest firms have to pay on their
debt (risk-free rate of return + risk premium) reflects the risk of the individual com-
pany. In relation to the final credit rating other factors are included as well. Among
these are the strategic positioning of the company, the attractiveness of the industry
and the quality of management. The structure of credit rating procedure is shown in
Figure 1.3.

Figure 1.3 Example of steps in a credit analysis process

Source: Adapted and based on data from Standard & Poor's website

The annual report and the financial ratios form an essential base in a typical credit
rating model. It is therefore important that past financial ratios are good indicators of
future trends. It is necessary that the annual report provides the relevant information,
so that the quality of the annual report can be assessed. Since credit rating models
compare companies within the same industry, there is an underlying data requirement
that the companies apply the same accounting policies.

Forecasting models
An alternative, but more time consuming, method for assessment of creditworthiness
is forecasting. The forecasting method assesses the ability for firms to repay debt. In
contrast to the credit rating models that are more oriented towards the past, the fore-
casting method is oriented towards the future. As for the present value approaches the
analyst prepares a budget (pro forma statements), including an estimate of the free cash
flow, to assess the analysed firm's ability to service its debt. The data requirements are
therefore the same as for present value approaches detailed in earlier paragraphs.
Modifications of the forecasting method are the so-called value at risk (VaR) analyses.
The forecasting method, as described above, operates with only one scenario. In value
at risk analyses a budget is made up for every scenario in order to estimate the likeli-
hood of default of payments. This idea is illustrated in Figure 1.4 where three sce-
narios are shown in which the cash flows for supporting debt fall short of interest
payments and instalments. The likelihood of default of payments is thus in this exam-
ple estimated as being 4% ( 1 % + 1% + 2%).

Liquidation models
The liquidation method is typically used to estimate the ability of a firm to repay its
debt assuming that the company is not able to continue operations (worst case sce-
nario). The methodology and the data requirement therefore resemble those previously
described. In the example in Table 1.2 this method was illustrated and it was shown
that while the owners lost their investment, banks and mortgage-credit institutions and
other creditors would have their outstanding claims covered in case of liquidation.
While the credit rating method and the forecasting method are used for estimating
the likelihood of suspension of payments the liquidation method is used for estimating the
likelihood of a loss in case of defaults of payments.
 Figure 1.4 An illustration of the probability of default based on simulations

Remuneration-oriented stakeholders
Performance-related pay makes up an increasing part of total management remunera-
tion. Examples of performance-related pay include stock options and cash bonuses.
The interesting aspects of this subject are: (a) which measure of performance triggers
the bonus or the stock option scheme, (b) the relation between performance measures
and bonuses, (c) which performance standard to apply (bonus threshold), and in case
of accounting-based bonus plans, (d) how to address transitory items and changes in
applied accounting policies and tax rates (accounting quality).
We will now elaborate on each aspect to illustrate some of the analytical accounting
issues when designing an accounting-based bonus plan. In Chapter 12 we discuss the
topic in greater detail.

Performance measures
As for models for assessment of creditworthiness there is no complete list of the deci-
sion models used in relation to performance-based remuneration. However, most fre-
quently one of the three categories of performance measures shown in Figure 1.5 are
used in compensation contracts.

Figure 1.5 Performance measures used in compensation contracts

 All three performance measures are frequently applied by listed firms. Since
quoted market prices are not available for privately held firms they tend to apply
financial and non-financial performance measures in performance-related com-
pensation contracts. Examples of financial performance measures include revenue
(growth), earnings before interest and taxes (EBIT), net earnings (E) and return on
invested capital (ROIC). Customer satisfaction, employee satisfaction, service qual-
ity and market share are examples of non-financial measures. Ideally, the chosen
performance measure(s) support the firm's strategy and the underlying value crea-
tion of the firm.

Pay-to-performance relation
An open question in designing a compensation contract is how should pay be tied to
performance. The following list represents likely candidates:
• Linearity between performance and pay
• Lump-sum bonuses
• A minimum and maximum bonus (floors/caps).
The compensation literature generally favours a linear pay-to-performance structure
since it mitigates the incentive to manage the performance measure (Holmstrom and
Milgrom 1987). Non-linear bonus plans such as a lump-sum bonus or a minimum
and maximum bonus provide the executives with an incentive to manage earnings.
For example, if the year-to-date performance indicates that annual performance will
exceed that required to achieve the bonus cap, executives have incentives to either
withhold effort or 'move' current earnings to future periods.

Performance standards
An important aspect of a compensation contract is the threshold of performance;
i.e. what level of performance that triggers a bonus. Generally, a distinction is made
between internal and external performance standards. Examples of internal perform-
ance standards are last year's performance and internal budgets. Peers' performance
is an example of an external performance standard. There are pros and cons to each
performance standard. For example, Murphy (2000) finds support for the use of
external standards. He finds that income smoothing is prevalent in companies using
internal standards (e.g. budgets and last year's result), but not in companies using
external standards.

Accounting quality
Bonus plans that rely on accounting-based performance measures must consider the
quality of accounting data. For instance, earnings generated from the core business
(permanent earnings) are regarded as more valuable than earnings based on transitory
items (i.e. the impact of changes in accounting policies and unusual accounting items
recognised as part of core earnings). The consequences of changes in accounting poli-
cies and tax rates on earnings also need to be eliminated in order to capture the 'true'
underlying value creation.
It is clear, based on the above discussion, that financial statement analysis needs to
be modified according to (a) the purpose of the analysis and (b) the decision model
applied.
 Outline of the book
The purpose of this book is to provide you with an insight into how financial state-
ment analysis can be used by decision makers in valuing firms, assessing a firm's
creditworthiness and designing accounting-based bonus contracts (executive
compensation).
The book is divided into four parts as follows (and as shown in Table 1.4):

• Part 1 provides an overview of the content of the annual report (accounting

data).
• Part 2 discusses how a firm's profitability, growth and risk can be assessed and
measured by the use of various financial ratios.
• Part 3 presents the different decision models used in equity valuation, credit analy-
sis and compensation.
• Part 4 elaborates on the concept of accounting quality.

Table 1.4 Contents of the book

Part 1 Part 2 Part 3 Part 4

Accounting data Financial analysis Decision making Assessment of
accounting data
Chapter 2 Chapter 4 Chapter 8 Chapter 13
Introduction to The analytical Forecasting Accounting quality
financial statements income statement Chapter 9 Chapter 14
and bookkeeping and balance sheet Valuation Accounting
Chapter 3 Chapter 5 Chapter 10 flexibility in the
Accrual-based versus Profitability analysis Cost of capital income statement
cash-flow-based Chapter 6 Chapter 15
Chapter 11
performance measures Growth analysis Accounting
Credit analysis
Chapter 7 flexibility in the
Chapter 12
Liquidity risk analysis balance sheet
Accounting-based
bonus plans for
executives

The contents of each of these four parts are briefly described below.

Part 1 - Accounting data

In the first part of the book the purpose of financial statement analysis is discussed.
For readers with no or little accounting background, the chapter on recording transac-
tions and preparing financial statements based on those transactions will be helpful.
The advantages and disadvantages of cash-flow-based and accounting-based perform-
ance measures are discussed in the subsequent chapter and provides an insight into
how these two measures deviate.
 Chapter 2 - Introduction to financial statements and bookkeeping
This chapter is intended for students with little or no background in accounting.
The chapter highlights how transactions are recorded (essentially, basic debit-credit
entries) and how these transactions enter into the financial statements. The income
statement, balance sheet, statement of changes of equity, and cash flow statement is
presented alongside other essential aspects of the annual reports. Finally, it is shown
how these different statements articulate (i.e. relate to each other).
This chapter is crucially important, as the annual report contains the primary
data used in financial statement analysis. The familiarity with the components of the
annual report is therefore an essential prerequisite for understanding the other chap-
ters of this book.

Chapter 3 - Accrual-based versus cash-flow-based performance measures

This chapter focuses on various measures of performance derived from the income
statement and cash flow statement. It discusses whether cash-flow-based measures of
performance give a better estimation of a firm's underlying performance than the ones
based on accounting data. Furthermore, other analytical contexts where cash flows
can be used are addressed.

Part 2 - Financial analysis

Part 2 covers a cornerstone in financial statement analysis. Before carrying out an
analysis, the financial statements must be reformulated for analytical purposes.
Having prepared the analytical financial statements, the analyst is ready to assess a
firm's profitability, growth and risk. A common way of assessing profitability, growth
and risk is to calculate a variety of financial ratios. This part of the book provides
numerous examples of how to define, calculate and interpret such financial ratios.

Chapter 4 - The analytical income statement and balance sheet

This chapter discusses how the income statement and the balance sheet can be pre-
pared for analytical purposes. Specifically there is a distinction between accounting
items related to operations and accounting items related to financing activities. This
distinction is relevant when the financial statement analysis of past performance
is used as an input to the development of pro forma statements. By distinguishing
sharply between accounting items related to operations and those related to financing
it is also possible to identify value generating and value destroying operating activities
of a company.

Chapter 5 - Profitability analysis

Financial ratios describing the profitability of companies are presented. The chapter
distinguishes between financial ratios measuring the profitability of operating and
financing activities, respectively. Measuring the profitability of a company is one of
the most important subjects of financial statement analysis. Superior profitability is
crucial in generating value for shareholders and ensures the survival of the company. It
signals economic health and strengthens the possibilities for contracting with the com-
pany's stakeholders such as customers, suppliers and banks. Moreover, the level and
trend in the historical profitability are important elements when forecasting future
earnings of the company.
 Chapter 6 - Growth analysis
This chapter distinguishes between different ways to assess growth and introduces
financial growth measures which are aligned with shareholder value creation. It also
focuses on important growth issues such as (a) how fast a company can grow while
ensuring that the financial balance is maintained, (b) the quality of growth and (c) the
association between growth and liquidity. Analyses of growth appear in a number of
analytical contexts. For instance, investors use analyses of growth in relation to mak-
ing forecasts, while creditors use them for assessing the need for liquidity.

Chapter 7 - Liquidity risk analysis

This chapter focuses on liquidity risk. Analysis of liquidity risk is relevant for instance
in assessing a firm's creditworthiness and the risk of default on its outstanding debt.
The difficulties of estimating risk stem from the fact that in most cases (the majority
of firms are privately held) there is not an active market for trading a firm's equity
and liabilities. Risk is therefore not measured on a continuous basis (e.g. on a stock
market). The individual stakeholders (and analysts) are, thus, left to measuring risk on
their own, which creates considerable uncertainty.

Part 3 - Decision making

The third part of the book concerns decision making. In this part of the book it is
demonstrated how financial statement analysis supports forecasting and valuation
(Chapters 8 and 9). Since risk plays a major role in valuing a firm or measuring
whether value has been created within a period, a separate chapter is devoted to cal-
culating the cost of capital (Chapter 10). The application of credit analysis is the topic
of Chapter 11. Finally, issues in the design of accounting-based bonus plans for execu-
tives are discussed in Chapter 12. Thus, Part 3 gives you the opportunity to apply
what you have learned from Parts 1 and 2 to real-life business situations.

Chapter 8 - Forecasting
Valuation of firms and credit analysis are often based on a forecast of future earnings
or cash flows. Therefore, in order to value a firm or conduct a proper credit analysis,
future earnings and cash flows must be forecasted. Chapter 8 addresses three core
issues in forecasting. The first issue is how to technically develop pro forma statements
(i.e. how to ensure that the forecasted income statement, balance sheet and cash flow
statement articulate). The second issue concerns how to add realism into the projected
earnings and cash flow measures. Obviously, financial statement analysis as laid out
in previous chapters will be drawn upon as well as a strategic analysis of the industry,
the market and the target firm and its peers. The third issue concerns the use of budget
control and sensitivity analyses in order to evaluate the quality (realism) of the pro
forma statements. The chapter is rich in examples of forecasting.

Chapter 9 - Valuation
This chapter discusses different types of valuation models with an emphasis on present
value approaches (e.g. the DCF model), multiples (e.g. P/E), and the liquidation
approach. The chapter highlights similarities and differences between each of the valu-
ation approaches and the merits and demerits of each type. In addition, the chapter
illustrates the different valuation techniques through a number of examples.
 Chapter 10 - Cost of capital
Cost of capital is used in a variety of contexts in financial statement analysis. For
instance, cost of capital must be estimated in order to value companies using present
value approaches. Since the value of a firm is quite sensitive to the discount factor
(cost of capital), it's important that resources are devoted to estimating risk.
Furthermore, cost of capital is an important factor when evaluating the performance
of a firm within a short period of time (e.g. 12 months). The board can use the cost
of capital as a threshold for good performance. The management may be rewarded
bonuses based on its ability to create economic value (i.e. returns on invested capital
that exceed cost of capital).

Chapter 11 - Credit analysis

This chapter demonstrates different models for credit analysis including forecasting
and financial ratio analysis. The advantages and disadvantages of each approach are
discussed. For instance, ratio analysis (i.e. rating a firm's economic well-being based
on financial ratios) is simple to apply and less costly than other methods. On the other
hand, the method is based on past performance and depends upon a number of under-
lying assumptions which must be fulfilled for the method to be useful. The chapter
contains a list of illustrative examples.

Chapter 12 - Accounting-based bonus plans for executives

Executives, among others, may receive bonuses based on stock prices, financial perform-
ance measures and non-financial measures. This chapter focuses on accounting-based
bonus plans and discusses the choice of performance measure, the pay-to-performance
relation and the choice of performance standard. In addition, accounting issues like
the treatment of transitory items and changes in accounting policies are addressed in
relation to accounting-based bonus plans.

Part 4 - Assessment of accounting data

The final part of the book covers accounting quality. So far the book has used reported
accounting figures without assessing the realism of those figures. However, as will
be clear from this part of the book, it is important to look into the quality of the
reported accounting figures. Recognition, measurement and classification of account-
ing items are highly subjective, even within IFRS, leaving room for earnings manage-
ment. A proper assessment of accounting data and accounting policies is a must. In
this way the analyst makes sure that possible changes in a firm's performance and
financial ratios are caused by changes in the underlying operations of the firm and not
by changes in accounting policies.

Chapter 13 - Accounting quality

'Good accounting quality' is defined and a number of issues in assessing accounting
quality are listed and discussed. Specifically the following subjects are addressed:
• Management's incentives for manipulating reported financial data
• The quality (realism) of applied accounting policies
• Permanent (recurring) versus transitory (non-recurring) items
• The information level in the annual reports
• Identification of 'red flags'.
 The concept of accounting quality is thoroughly analysed with respect to the different
users (decision makers) of accounting information.

Chapter 14 - Accounting flexibility in the income statement

In the previous chapters reported financial data was taken at face value. However,
reported financial statements may be noisy measures of the underlying 'true' revenues,
expenses, assets or liabilities. This is so because there is inherent flexibility in reported
accounting numbers, as these are based on a firm's accounting policies and estimates
made by management.
In Chapter 14 accounting flexibility in the income statement is discussed in order to
identify specific areas where accounting noise may appear frequently. The accounting
issues which are analysed are:

• Changes in accounting policies

• Revenue recognition criteria
• Non-recurring and special items
• Non-capitalisation of expenses.
In addition, the chapter specifically explores the impact of accounting flexibility on
valuation, credit analysis and executive compensation.

Chapter 15 - Accounting flexibility in the balance sheet

This chapter explores accounting flexibility in the balance sheet. More specifically, the
following items are discussed:
• Inventory accounting
• Intangible and tangible assets
• Lease accounting
• Provisions
• Deferred tax liabilities.
As in Chapter 14 the potential economic consequences of accounting flexibility are
discussed.

Conclusions
The aim of this chapter has been to introduce you to the world of 'financial state-
ment analysis'. We have emphasised that the annual report is used in a number of
analytical contexts as an important source of data, and the use of different decision
models entails different requirements to the financial statement analysis. It is therefore
a fundamental principle in this book that the financial statement analysis should be
interpreted with the purpose of the analysis in mind. Depending on the objective of
the analysis a number of different decision models are available. We hope that by the
time you have worked your way through this book, you will have gained the confi-
dence and knowledge to analyse and look for data that best support the requirements
of the underlying decision model which you use. Good luck!
Review questions
• Who are the users of financial statements?
• What kinds of approaches are available for valuation?
• Is the data requirement identical across the different valuation approaches?
• What kinds of approaches are available for credit evaluation?
• Is the data requirement identical across the different approaches available for cre<
analysis?
• What are the challenges in designing an accounting-based bonus plan?
• What are the four parts of this book?

Notes 1 'Sold short' refers to the practice of borrowing shares, selling them, and subsequently repur-
chasing the shares and returning the repurchased shares to the lender.
2 The multiple P/E expresses the current share price as a number of times of its earnings per
share. That is how many euros investors are willing to pay for one euro in earnings.

References Holmstrom, B. and P. Milgrom (1987) Aggregation and linearity in the provision of intertempo-
ral incentives, Econometrica, 55, 303-28.
Murphy, K. (2000) Performance standards in executive contracts. Journal of Accounting and
Economics, 30, 245-78.
 PART 1

Accounting data

Introduction to Part 1
2 Introduction to financial statements and bookkeeping
3 Accrual-based versus cash-flow-based performance measures
 Introduction to Part 1

The annual report is the primary document in financial statement analysis. Chapters 2
and 3 discuss the accounting information available in the annual report.
Chapter 2 highlights how transactions are recorded and financial statements are
prepared based on those bookkeeping transactions. The income statement recog-
nises a firm's revenues, and expenses gains and losses. The balance sheet represents
a firm's assets, liabilities and equity. Statement of changes in equity highlights how
equity changes from the beginning of the period to the end of the period. Finally, the
cash flow statement shows cash flows from operating, investing and financing activi-
ties (transactions) and how those cash flows are related to the income statement and
balance sheet.
Chapter 3 elaborates on the accrual accounting concept and explains the differ-
ence between accrual and cash-flow-based performance measures. The chapter dis-
cusses whether the accrual or the cash-flow-based performance measures appear more
informative from an investor perspective. The chapter also considers under which ana-
lytical circumstances the cash-flow-based performance measures appear most useful.
 CHAPTER 2

Introduction to financial statements

and bookkeeping

Learning outcomes

After reading this chapter you should be able to:

• Understand the purpose of the income statement and identify its parts
• Understand the purpose of the balance sheet and identify its parts
• Understand the purpose of the statement of changes in owners' equity and
identify its parts
• Understand the purpose of the cash flow statement and identify its parts
• Record business transactions
• Produce financial statements based on recorded transactions
• Make adjustments to financial statements

Introduction to financial statements and bookkeeping

This chapter introduces the different financial statements which firms must produce
and gives an overview of how transactions are recorded (double-entry bookkeep-
ing) and entered into the different financial statements.
The annual report contains the primary data used in the financial statements, ena-
bling users to estimate a firm's growth, profitability and risk. It provides information
about the following accounting elements:

The annual report will also include a management's review, and potential supplemen-
tary reports.
In addition to the annual report, firms must supply a statement of changes in
owners' equity. To give a fuller financial picture, firms provide notes alongside this
statement. This includes a summary of significant accounting policies, estimates and
other explanatory information.
 The key elements of financial statements - consisting of the income statement and
statement of comprehensive income, balance sheet, cash flow statement and statement
of changes in owners' equity - are discussed below.

The income statement and statement of comprehensive income

The income statement discloses a firm's earnings for a predefined period, which in the
annual report is 12 months. In its basic form the income statement includes a firm's
earnings, calculated as the difference between revenue and expenses. Revenues are
income from selling a firm's products or services, while expenses consist of a variety of
items including depreciation and amortisation:

But simply calculating earnings as above - the difference between revenues and
expenses - tells us very little about the financial health of a company. This is because
there is no story behind the figures. We do not know, for example, whether develop-
ment costs are recognised as expenses or assets (i.e. costs are capitalised).
Thus, financial statement users want to know how the earnings figure has been
produced. This includes in particular:

As we mentioned in Chapter 1, international financial reporting standards reflect this

need to standardise how a company recognises, measures and classifies expenses and
revenues. The delimitation of which revenues and expenses must be recognised in the
income statement can be found in IASB's Conceptual Framework (paragraph F70):
Income is increases in economic benefits during the accounting period in the form of
inflows or enhancements of assets or decreases of liabilities that result in increases
in equity, other than those relating to contributions from equity participants.
Expenses are decreases in economic benefits during the accounting period in
the form of outflows or depletions of assets or incurrences of liabilities that
result in decreases in equity, other than those relating to distributions to equity
participants.
According to IAS 1: 'Presentation of Financial Statements' all income and expenses
recognised in a period shall be included in the income statement unless a Standard or
an Interpretation requires otherwise (paragraph 78).
The income statement shall include as a minimum the following items:
• Revenues
• Finance costs
• Share of the profit or loss of associates and joint ventures accounted for using the
equity method
• Post tax profit or loss of discontinued operations
• Tax expenses.
Yet, these minimum requirements are hardly, if ever, sufficient. IASB acknowledges
this by requiring that additional line items shall be added when such a presentation is
relevant to an understanding of the firm's financial performance. Certain items must
be disclosed either on the face of the income statement or in the notes, if material,
including:
• Write-downs of inventories to net realisable value or of property, plant and equip-
ment to recoverable amount, as well as reversals of such write-downs
• Restructurings of the activities of an entity and reversals of any provisions for the
costs of restructuring
• Disposals of items of property, plant and equipment
• Disposals of investments
• Discontinuing operations
• Litigation settlements
Other reversals of provisions.
An enterprise shall present an analysis of expenses, classifying them either by nature
(raw materials, staff costs, depreciation, etc.) or by function (cost of goods sold, dis-
tribution costs, administrative expenses, etc.), whichever provides information that
is reliable and relevant. It is not a prerequisite that the information (analysis) is pre-
sented on the face of the income statement, but it is encouraged (IAS 1.88). An exam-
ple of classification comparing the nature of expense method and function of expense
method is provided in Table 2.1.

Table 2.1 Income statement nature of expense vs function of expense method

Nature of expense method Function of expense method

Revenue X Revenue X
Other income X Cost of sales X
Changes in inventories of finished X Gross profit X
goods and work in progress
Employee benefits expenses X Selling and distribution costs X
Depreciation and amortisation expenses X Administrative expenses X
Other expenses X Other income X
Total expenses X Other expenses X
Profit (net earnings) X Profit (net earnings) X

Enterprises that classify items by function shall disclose additional information on

the nature of expenses, including depreciation, amortisation and employee benefits
expenses. This is to ensure that there is sufficient information for users to make accu-
rate assessments of the financial state of a company.
To illustrate how firms report income statements, an extract of Ericsson's con-
solidated income statement is provided in Table 2.2. It shows that Ericsson classifies
expenses based on their function (e.g. selling and administrative expenses). This is a com-
mon method - using the expense by function method - but other firms choose the alter-
native way of classifying expenses, as shown in Table 2.3.
Table 2.2 Consolidated income statement for Ericsson

SEK million Year 8 Year 7 Year 6

Net sales 208,930 187,780 1 79,821
Cost of sales -134,661 -114,059 -104,875
Gross income 74,269 73,721 74,946

Gross margin % 35.50% 39.30% 41.70%

Research and development expenses -33,584 -28,842 -27,533
Selling and administrative expenses -26,974 -23,199 -21,422
Operating expenses -60,558 -52,041 -48,955

Other operating income and expenses 2,977 1,734 3,903

Share in earnings of joint ventures and -436 7,232 5,934
associated companies
Operating income 16,252 30,646 35,828

Operating margin % 7.80% 16.30% 19.90%

Financial income 3,458 1,778 1,954
Financial expenses -2,484 -1,695 -1,789
Income after financial items 17,226 30,729 35,993
Taxes -5,559 -8,594 -9,557

Net income 11,667 22,135 26,436

Table 2.3 Consolidated income statement for Cosmo Pharmaceuticals S.p.A.

EUR (1,000) Year 7 Year 6

Revenue 21,900 15,158

Other income 516 4,934
Changes in inventories of finished goods and work in progress 380 -110
Raw materials and consumables used -6,642 -5,387
Personnel expenses -6,629 -4,910
Depreciation and amortisation -1,460 -1,492
Other operating expenses -8,313 -6,818
Operating result -248 1,375
Financial income 870 112
Financial expenses -469 -983

Profit before taxes 153 504

Income tax expenses -37 -848

Profit for the period 116 -344

 The example shows that Cosmo Pharmaceuticals has separate line items for each
(major) type of expense. For instance personnel expenses (salaries and pensions) and
depreciation and amortisation are shown separately. Since depreciation and amortisa-
tion expenses are non-cash flows items, an analyst may wish to separate these items
from other items. However, if the expense by function method is applied, the analyst
must look in the notes for information about depreciation and amortisation, since
these items are included in several accounting items (cost of sales, research and devel-
opment expenses and selling and administrative expenses).
Even though reported profit is unaffected by the choice of classification (by
nature or function), it plays an important role how a firm specifies its revenues,
expenses, assets and liabilities. The level of detail may have an impact on, for
example, the degree of detail an analyst uses in preparing budgets for valuation
purposes. For instance, a specification of costs into variable and fixed costs will
enable the analysts to use the contribution ratio as a key value driver. In addition,
time-series and cross-sectional analyses are difficult to make when items are classi-
fied differently. Finally, note that it would be more difficult and time consuming to
carry out a time-series analysis if a firm switches from one method of classification
to the other.
The statement of comprehensive income presents all income and expense items,
whether or not these are recognised in the income statement. Elements of comprehen-
sive income include:
• Changes in revaluation surplus
• Actuarial gains and losses on defined benefit plans
• Exchange differences (gains and losses) on translating the financial statements of
foreign operations
• Gains and losses on re-measuring available-for-sale financial assets
• The effective portion of gains and losses on hedging instruments in a cash flow hedge
• Income tax relating to other comprehensive income.
Firms may either present a statement of comprehensive income separately or as part
of two linked statements. If the firm uses two linked statements, one must display the
income statement and the other statement must begin with profit or loss for the year
(bottom line in the income statement) and then show all items included in 'other com-
prehensive income'.
Table 2.4 shows Ericsson's comprehensive income. Ericsson labels the statement of
comprehensive income for the period 'Consolidated Statement of Recognised Income
and Expense'. Total income and expense recognised for the period amount to SEK
14,615 million of which SEK 11,667 million has been recognised in the income state-
ment (net income) and SEK 2,948 million as transactions reported directly in equity.

Table 2.4 Consolidated statement of recognised income and expense, Ericsson

SEK million Year 8 Year 7 Year 6

Income and expense recognised directly in equity

Actuarial gains and losses related to pensions -4,015 1,208 440
Revaluation of other investments in shares and participations
Fair value re-measurement reported in equity -7 2 -1
 SEK million Year 8 Year 7 Year 6
Cash flow hedges
Fair value re-measurement of derivatives reported in equity -5,080 584 4,100
Transferred to income statement for the period 1,192 -1,390 -1,990
Transferred to balance sheet for the period - - 99
Changes in cumulative translation adjustments 8,528 -797 -3,119
Tax on items reported directly in/or transferred from equity 2,330 -73 -769
Total transactions reported directly in equity 2,948 -466 -1,240
Net income 11,667 22,135 26,436
Total income and expense recognised for the period 14,615 21,669 25,196

Attributable to:
Stockholders of the parent company 13,988 21,371 25,101
Minority interest 627 298 95

Balance sheet
A balance sheet is a summary of a company's financial position at a specific point in
time and shows a summary of a firm's total investments (assets) and how these assets
have been financed (liabilities and equity). In its simplest form, the balance sheet
looks like this:

Similarly to what we saw above, this formula without any context is of little use to users.
To understand the real story, financial statement users need insight into which assets and
liabilities are recognised, how those items are measured, and how they are presented.
Assets and liabilities are classified into current and non-current assets, and current
and non-current liabilities, respectively. Current assets are those that satisfy one or
more of the following criteria:
• It is expected to be realised in, or is intended for sale or consumption within a
normal operating cycle
• It is held primarily for the purpose of being traded
It is expected to be realised within 12 months after the reporting date
• It is cash or a cash equivalent.
Assets that do not meet any of these criteria shall be classified as non-current assets.
Current liabilities are those that satisfy any of the following criteria:
• It is expected to be settled within a normal operation cycle
• It is held primarily for the purpose of being traded
• It is due to be settled within 12 months after the reporting date
• The firm does not have an unconditional right to defer settlement of the liability for
at least 12 months after the reporting date.
All other liabilities shall be classified as non-current liabilities.
IAS 1 does not prescribe the order or format in which items must be presented.
It does, however, stipulate that as a minimum, the face of the balance sheet should
include line items which present each of the amounts shown in Table 2.5. In addi-
tion the balance sheet shall also include line items that present the following
amounts:
• The total of assets classified as held for sale and assets included in disposal
groups
• Liabilities included in disposal groups.

Table 2.5 Classification of assets and liabilities

Assets
Property, plant and equipment
Investment property
Intangible assets
Financial assets
Investments accounted for using the equity method
Biological assets
Inventories
Trade and other receivables
Cash and cash equivalents
Liabilities and shareholders' equity
Trade and other payables
Provisions
Current interest-bearing liabilities
Tax liabilities and tax assets
Deferred tax liabilities
Non-current interest-bearing liabilities
Minority interests
Issued capital and reserves

As illustrated in Table 2.5 the balance sheet is fairly detailed - despite the basic
formula outlined above. An entity must disclose further sub-classifications of the line
items presented in a manner appropriate to the entity's operations. This reflects that
various industries may need to present information differently. An accountant must
choose whether to present additional items separately based on:
• The nature and liquidity of assets
• The function of the assets within the entity
• The amounts, nature and timing of liabilities.
 The use of different measurement bases for different classes of assets suggest that
their nature or function differs and, therefore, that classes of assets should be pre-
sented as separate line items. For example, different classes of property, plant and
equipment can be carried at cost or revalued amounts in accordance with IAS 16
Property, Plant and Equipment.
Ericsson's balance sheet is shown in Table 2.6. Assets as well as liabilities are clas-
sified as current and non-current, respectively. This makes it possible for analysts to
separate items that generate cash inflows (assets) and cash outflows (liabilities) within
a firm's operating cycle from items that do not.

Table 2.6 Consolidated balance sheet for Ericsson

SEK million Year 8 Year 7

ASSETS

Non-current assets

Intangible assets

Capitalised development expenses 2,782 3,661

Goodwill 24,877 22,826

Intellectual property rights, brands and other intangible assets 20,587 23,958

Property, plant and equipment 9,995 9,304

Financial assets

Equity in joint ventures and associated companies 7,988 10,903

Other investments in shares and participations 309 738

Customer finance, non-current 846 1,012

Other financial assets, non-current 4,917 2,918

Deferred tax assets 14,858 11,690

Total non-current assets 87,159 87,010

Current assets

Inventories 27,836 22,475

Trade receivables 75,891 60,492

Customer finance, current 1,975 2,362

Other current receivables 17,818 15,062

Short-term investments 37,192 29,406

Cash and cash equivalents 37,813 28,310

Total current assets 198,525 158,107

Total assets 285,684 245,117

 Table 2.6 (continued)
Equity and liabilities Year 8 Year 7

Equity

Stockholders' equity 140,823 134,112

Minority interest in equity of subsidiaries 1,261 940
142,084 135,052
Non-current liabilities
Post-employment benefits 9,873 6,188
Provisions, non-current 311 368
Deferred tax liabilities 2,738 2,799
Borrowings, non-current 24,939 21,320
Other non-current liabilities 1,622 1,714

39,483 32,389
Current liabilities
Provisions, current 14,039 9,358
Borrowings, current 5,542 5,896
Trade payables 23,504 17,427
Other current liabilities 61,032 44,995
104,117 77,676
Total equity and liabilities 285,684 245,117

Cash flow statement

Cash flow statements report a company's cash receipts, cash payments, and the net
change in the company's cash resulting from a company's operating, investing and
financing activities for the period it is prepared for. Cash flow statements provide
users of financial statements the basis for assessing a company's ability to generate
cash and how cash is used.
Cash flow statements can be used in many contexts, for example in credit analysis,
in valuation, and in assessing a firm's financial resources - all issues which will be
addressed in later chapters. In the financial statement analysis cash flow statements
can be used to gauge the quality of earnings, as earnings and cash flows should be cor-
related if measured over an extended period of time.
Ericsson's cash flow statement is shown in Table 2.7. As the table illustrates, Ericsson's
cash in year 8 amounted to SEK 37,813 million compared to SEK 28,310 million at the
beginning of the year. Thus, during the year Ericsson's cash balance increased by SEK
9,503 million (37,813 - 28,310).
Table 2.7 Consolidated statement of cash flows for Ericsson

SEK million Year 8 Year 7 Year 6

Operating activities
Net income 11,667 22,135 26,436
Adjustments to reconcile net income to cash 14,318 7,172 6,060

25,985 29,307 32,496

Changes in operating net assets
Inventories -3,927 -445 -2,553
Customer finance, current and non-current 549 365 1,186
Trade receivables -11,434 -7,467 -10,563
Provisions and post-employment benefits 3,830 -4,401 -3,729
Other operating assets and liabilities, net 8,997 1,851 1,652
-1,985 -10,097 -14,007

Cash flow from operating activities 24,000 19,210 18,489

Investing activities
Investments in property, plant and equipment -4,133 -4,319 -3,827
Sales of property, plant and equipment 1,373 152 185
Acquisitions of subsidiaries and other operations -74 -26,292 -18,078
Divestments of subsidiaries and other operations 1,910 84 3,086
Product development -1,409 -1,053 -1,353
Other investing activities 944 396 -1,070
Short-term investments -7,155 3,499 6,180

Cash flow from investing activities -8,544 -27,533 -14,877

Cash flow before financing activities 15,456 -8,323 3,612

Financing activities
Proceeds from issuance of borrowings 5,245 15,587 1,290
Repayment of borrowings -4,216 -1,291 -9,510
Sale of own stock and options exercised 3 94 124
Dividends paid -8,240 -8,132 -7,343

Cash flow from financing activities -7,208 6,258 -15,439

Effect of exchange rate changes on cash 1,255 406 58

Net change in cash 9,503 -1,659 -11,769

Cash and cash equivalents, beginning of period 28,310 29,969 41,738

Cash and cash equivalents, end of period 37,813 28,310 29,969

Statement of changes in owners' equity
The statement of changes in equity reconciles equity at the beginning of the period
with equity at the end of the period. The change in equity consists of a number of
significant items. Usually the most significant item is retained earnings, i.e. the accu-
mulation of profit (and losses) over time net of dividends. Another item is revaluation
reserves (for instance caused by revaluing property to fair value). In addition, other
items which bypass the income statement like certain currency translations and fair
value adjustments are recognised as part of (changes in) equity. Finally, changes in
equity includes items which are not part of operations but which are only a matter
between shareholders, such as increases in share capital and share repurchase.
In relation to financial statement analysis, changes in equity are relevant because
they show to what extent equity includes items that violate the so-called clean surplus
assumption. That is, some items may bypass the income statement and be recognised
directly as equity. Such items may have to be reclassified as part of operating income.
Furthermore, scrutiny of the changes in equity reveals whether the development in
equity and the market value of the company can be assigned to operations (retained
earnings) or if it is due to transactions with the owners.
In Table 2.8, Ericsson includes transactions in the changes in shareholders' equity,
which have not been recognised as part of earnings. For instance, cash flow hedges
have a positive effect on reported equity by SEK 569 million.
Ericsson's financial statements are based on an enormous number of transactions,
which are recorded in Ericsson's bookkeeping system. Every item in the financial state-
ments is, thus, the sum of a vast number of underlying transactions. For example, rev-
enue (the top line in the income statement) includes the total amount of every single
sales (or services) transaction Ericsson's has made during a one-year period.
In the next section, we provide a short introduction to the double-entry bookkeep-
ing system. We show how transactions are recorded and how they ultimately enter
into the financial statements. If you are unfamiliar with bookkeeping, you may find it
useful to consult introductory financial accounting textbooks.
A simple example (Example 2.1, From transactions to financial statements (page 37))
is provided to show how financial statements may be reformulated so they can be used
for analytical purposes. If you, as an analyst, find it difficult to carry out the analy-
sis at hand, you might find it valuable to go back to the simplified example to get a
picture of the link the entire way from recording transactions to calculating financial
ratios based on the analytical financial statements.

Recording transactions and preparing financial statements

Financial statements - the income statement, balance sheet, statement of cash flows,
and statement of changes in owners' equity - are based on a firm's transactions (eco-
nomic events) during a period of time. The number of transactions may be few for
privately owned firms, whereas conglomerates with subsidiaries scattered around the
world may report financial statements based on millions of economic events.
All transactions are recorded in the double-entry bookkeeping system, which
dates back to 1494. The system is based on the principle of duality - the idea is
that every recorded economic event has two aspects which offset or balance each
other. Every transaction that is recorded consists of at least one debit and one credit
Table 2.8 Changes in stockholders' equity, Ericsson
SEK million Capital Additional Investments Cash Cumulative Retained Stock- Minority Total
stock paid in in shares flow translation earnings holders' interests equity
Year 8
capital and hedges adjustments equity
participations

1 January, Year 8 16,132 24,731 5 307 -6,345 99,282 134,112 940 135,052

Actuarial gains and losses related to pensions

Croup - - - - - -4,019 -4,019 - -4,019

j o i n t ventures and associates - - - - - 4 4 4

Revaluation of other investments in shares and participations

Fair value measurement reported in equity

Croup - - -6 - - - -6 - 6

joint ventures and associates - - -1 - - - -1 - -1

Cash flow hedges

Fair value remeasurement of derivatives reported in equity

Croup - - - -5,116 - - -5,116 - -5,116

joint ventures and associates - - - 36 - - 36 - 36

Transferred to income statement for the period - - - 1,192 - - 1,192 - 1,192

Changes in cumulative translation adjustments

Group - - - - 7,081 - 7,081 233 7,314

Joint ventures and associates - - - - 1,214 - 1,214 - 1,214

Tax on items reported directly in/or transferred f r o m equity - - 1 1,225 174 930 2,330 - 2,330

Total transactions reported directly in equity - - -6 -2,663 8,469 -3,085 2,715 233 2,948

N e t income

Group - - - - - 11,564 11,564 394 11,958

Joint ventures and associates - - - - - -291 -291 - -291

Total income and expenses recognised for the period - - -6 -2,663 8,469 8,188 1 3,988 627 14,615

Stock issue 100 - - - - - 100 100

Sale of o w n shares - - - - - 88 88 - 88

Repurchase of o w n shares - - - - - -100 -100 - -100

Stock purchase and stock o p t i o n plans

Croup - - - - - 589 589 - 589

Joint ventures and associates - - - - - - - - -

Dividends paid - - - - - -7,954 -7,954 -286 -8,240

Business combinations - - - - - - - -20 -20

31 December, Year 8 16,232 24,731 -1 -2,356 2,124 100,093 140,823 1,261 142,084
 record, and the total amount of debits must equal the total amount of credits for
each transaction.
Financial statement analysis often requires adjustments to the financial statements
(e.g. converting operating leases to financial leases) in order to eliminate 'noise' or to
make accounting data comparable over time or across firms. Thus, analysts need to
have a basic knowledge of the double-entry bookkeeping system.
In this section, we describes overall rules for recording transactions and illustrate
how these transactions enter into the different financial statements. In addition, we
include a simple example, which shows how financial statements relate to underlying
business transactions and how the financial statements interrelate (articulate). We will
use this same example in later chapters as an ongoing case. The idea is that this basic
example makes it easier for the reader to understand more complicated issues, which
naturally arise when we introduce real-life firms such as Carlsberg and Heineken and
their financial statements.

Recording transactions
The general rules for recording transactions, in the double-entry bookkeeping system,
can be illustrated by using the so-called 'T-accounts'. Each T account has a name that
describes the types of transactions, which is recorded on the account, and a debit (left
side) and credit (right side) as shown below:

In the balance sheet, the left side represents resources owned by the firm, whereas
the right side represents claims from owners or third parties (e.g. banks) on these
resources. In contrast, the income statement shows revenues on the right (credit) side
and represents increases in owners' equity arising from increases in assets received in
exchange for delivery of goods or services to customers. Items on the left hand (debit)
side are expenses, and represent decreases in owners' equity that arise as goods or
services are delivered (sold) to customers.
The following simple examples illustrate how transactions are recorded:
• Transaction 1: The firm incurs insurance expenses and pay on account

The firm records an increase in expenses of 200 (insurance account is debited) and
a related increase in the amount owed to suppliers (accounts payable is credited by
200).
• Transaction 2: The firm sells its product and the customer pays in cash:
 The firm records revenues of 1,000 (revenues account is credited) and a related
increase of the cash balance (cash is debited by 1,000).

General rules illustrated

The following example highlights how typical transactions enter into the income state-
ment and balance sheet, respectively.
• Recording expenses or assets:
A firm rents an office for 100 and pays either in cash (a) or alternatively on account
(b). The recording becomes:

Whether rents are paid in cash (a) or on account (b), the firm recognises an
expense of 100 (debit transaction). The corresponding credit transaction is either
(a) a draw on a cash account (decrease in an asset account) or (b) an increase in
amounts owed to creditors (an increase in a liability account). Thus, it should be
clear (we hope) that an expense is followed by a decrease in assets or an increase in
liabilities. In both cases net assets (equity), decrease by 100. This is hardly surpris-
ing, as it is a concept that most of us encounter in our personal lives. For instance,
if you pay rent on your flat, either your cash balance decreases or you owe more
money to your bank. In any case your equity, i.e. your financial fortune, suffers.
• Similarly, if a firm buys inventory, it may do so by paying in cash (a) or on account
(b). If the firm purchase inventory for 400, the records become:

Thus, inventory increases (an increase in an asset account). As with the expense
example above, the corresponding credit transaction is either (a) a draw on a cash
account (a decrease in an asset account) or (b) an increase in amounts owed to
creditors (an increase in a liability account).
• Recording income (revenues, other income, gains etc.), liabilities and owners'
equity:
A firm sells a product for 200 to a customer, who either pays in cash (a) or alter-
natively on account (b). The recording becomes:

Whether customers pay in cash (a) or buy on account (b), the firm recognises
revenue of 200 (credit transaction). The corresponding debit transaction is either
(a) an increase in cash (increase in an asset account) or (b) an increase in amounts
owed by customers (an increase in an asset account). Thus, it should be clear that
income is followed by an increase in assets.
 • If the firm borrows 50 in order to have cash in hand, the transaction is recorded as
follows:

In this case cash increases by 50 (debit to an asset account), while the firm bor­
rows (additional) 50 (credit to a liability account). Net assets from this transaction
is zero (50 - 50 = 0). The firm's equity remains unchanged. Please notice that
in this case, the transaction has no effect on the income statement. The firm's net
worth is not affected.
• Finally, if the investors pay-in additional share capital of 100, the recording becomes
(disregarding transaction costs):

In this case cash increases by 100 (debit to an asset account), while share capital
increases by the same amount (credit to an equity account). The firm's net assets
and equity increases by 100.

Summarising
Based on the above, simple transactions, the rules for using T accounts may be sum­
marised as follows:

Thus, an increase in expenses (costs and losses) and assets are debit entries, while
an increase in income (revenues and gains) and liabilities and owners' equity are credit
entries. These general rules always hold true. For example, any increase in assets, say,
purchase of inventory is debited to an asset account.
The above rules are summarised in the table below:

Increases recorded by

Accounting item Debit Credit

Revenues (or income) √
Expenses (or losses) √
Assets √
Liabilities and owners' equity √
 Transaction analysis illustrated
In the previous section, we shared general guidelines for recording transactions. In
this section, we demonstrate how a number of transactions, which typically occur in
a retail company, are recorded. Based on those transactions the firm's financial state-
ments are prepared. We also illustrate the relation between the different statements -
income statement, balance sheet, statement of owners' equity and cash flow statement.
These statements must, as Example 2.1 shows, always relate in a certain way. That is
they must articulate. For instance, equity at the beginning of the year plus comprehen-
sive income minus dividends must equal equity at year end.

Example 2.1 From transactions to financial statements

For simplicity reasons, value added tax (VAT), sales tax etc. are disregarded in the following
example. These taxes are collected on behalf of public authorities and paid back at different
intervals (depending on the country). VAT and similar duties have no effect on the income
statement.
The example is illustrative and the basic principles for recording the transactions can be
applied to other transactions and firms in different industries.
A number of investors start a business in the retail industry as of 1 January, year 1. The
firm is named Goods4U. The investors paid-in share capital amounts to 365; with the addi-
tion of a bank loan of 100, invested capital becomes 465. The bank loan includes a bank
overdraft account. The capital invested in the firm at start-up is used to buy the following
assets:

• Purchase of warehouse: 200

• Purchase of equipment: 50
• Purchase of inventory: 200
Cash in hand: 5
• Cash deposited in a banking account: 10

The opening balance sheet becomes:

Balance sheet, 1 January, year 1 for Goods4U

Assets
Warehouse 200
Equipment 50
Inventories 200
Cash and cash equivalents 15
Total assets 465

Liabilities and shareholders' equity

Equity 365
Loans and borrowings 100
Total liabilities and shareholders' equity 465
During year 1 a huge number of transactions are recorded. Those transactions can be sum-
marised as follows (numbers in the first column refer to the transaction numbers):

No. Transactions*

1 Sales paid in cash 80

2 Sales on account 120
3 Salaries to employees paid by increasing bank loan 10
4 Advertising and promotion expenses paid in cash 6
5 Utility expenses paid in cash 2
6 Maintenance expenses paid in cash 4
7 Insurance expenses paid by increasing bank loan 1
8 Other operating expenses paid in cash 3
9 Purchase of equipment paid on account 50
10 Purchase of inventory paid by increasing bank loan (130) and 300
on account (1 70)
11 Interest income 5
12 Interest expenses paid by increasing bank loan 15
13 Payments made by customers, who bought on account 6
(payment reduces bank loan)
14 Payments made to suppliers for purchases made on account 50
(paid by increasing bank loan)

Adjusting and closing entries at year end:

15 Inventory at year end 450
16 Depreciation of warehouse (4) and equipment (10) 14
17 Corporation tax 30

*Each transaction shall be regarded as the total (sum) of all similar transactions. For instance,
Coods4U may have had a large number of sales transactions, which have been paid in cash
by customers, amounting to a total of 80.

The bookkeeping of the above transactions (items 1-17) is as follows:

1 Sales paid in cash 80

Recording of item 1 Debit Credit
Net revenue (income statement, increase in income) 80
Cash/bank account (balance sheet, increase in assets) 80

Sales constitute a firm's income from its core business. As shown above an increase in revenues
is a credit. Since customers pay in cash, the cash balance increases by 80.

2 Sales on account 120

Recording of item 2 Debit Credit
Net revenue (income statement, increase in income) 120
Accounts receivable (balance sheet, increase in assets) 120
Even though customers pay on account, Goods4U still recognises 120 as revenue. This high-
lights that financial statements (in this case the income statement) differ from cash flow state-
ments. Revenues and expenses are recognised even if payment has not been made. Since
customers pay on account, accounts receivable increases by 120.

3 Salaries to employees paid by increasing bank loan 10

Recording of item 3 Debit Credit
Personnel expenses (income statement, increase in expenses) 10
Bank loan (balance sheet, increase liability) 10

Employees are paid cash (often on a monthly basis, thus, transaction 3 could in reality be 12
transactions of approximately 0.83 each). This, of course, represents an expense, with a relat-
ing increase in liabilities.

4 Advertising and promotion expenses paid in cash 6

Recording of item 4 Debit Credit
Advertising expenses (income statement, increase in expenses) 6
Cash/bank account (balance sheet, decrease in assets) 6

Advertising and promotion are expenses. Since they are paid in cash, the relating entry is a
decrease in assets.
Utility, maintenance, insurance and other operating expenses all represent expenses. The
corresponding entries depend on whether the expenses are (a) paid in cash (or similarly
deducted from a bank account) or (b) paid on account.

5 Utility expenses paid in cash 2

6 Maintenance expenses paid in cash 4
7 Insurance expenses paid by increasing bank loan 1
8 Other operating expenses paid in cash 3

The entries are shown below:

Recording of items 5-8 Debit Credit

Utility expenses (income statement, increase in expenses) 2
Cash/bank account (balance sheet, decrease in assets) 2
Maintenance expenses (income statement, increase in expenses) 4
Cash/bank account (balance sheet, decrease in assets) 4
Insurance expenses (income statement, increase in expenses) 1
Bank loan (balance sheet, increase in liability) 1
Other operating expenses (income statement, increase in expenses) 3
Cash/bank account (balance sheet, decrease in assets) 3

All the above expenses are operating expenses.

 9 Purchase of equipment paid on account 50
Recording of item 9 Debit Credit
Equipment (balance sheet, increase in assets) 50
Accounts payable (balance sheet, increase in liabilities) 50

Purchase of equipment represents two entries to the balance sheet. First, equipment increases,
while Goods4U at the same time must recognise a liability as the equipment has not yet been
paid for.
Since assets and liabilities increase by the same amount, equity is unchanged (equity =
assets - liabilities).

10 Purchase of inventory paid by increasing bank loan (130) 300

and on account (170)
Recording of item 10 Debit Credit
Inventory (balance sheet, increase in assets) 300
Accounts payable (balance sheet, increase in liabilities) 170
Bank loan (balance sheet, increase in liabilities) 130

Purchase of inventories represents three entries in this particular case. First, inventory increases
by 300. This entry is perfectly offset by an increase in accounts payable (170) and an increase
in borrowing (130). Thus, as a result of transaction 10, Goods4U recognises a simultaneous
increase in an asset account and an increase in two liability accounts by the same amount.
Equity remains unchanged. Note that the income statement is not affected. Recognition in
the income statement will not happen until the goods are sold or written-off if impaired (e.g.
due to obsolescence).

11 Interest income 5
Recording of item 11 Debit Credit
Interest received (income statement, increase in financial income) 5
Cash/bank account (balance sheet, increase in assets) 5

Goods4U earns interests on its deposits in the bank (and on securities such as bonds).
Interest income is recognised as financial income. Interest received have nothing to do
with Goods4U core business - selling various products - and should not be recognised as
revenue.

12 Interest expenses paid by increasing bank loan 15

Recording of item 12 Debit Credit
Interest paid (income statement, increase in financial expenses) 15
Bank loan (balance sheet, increase in liability) 15

Goods4U pays interests on its bank loans. Interest expenses are recognised as financial
expenses. Just like interest received, interest paid is not related to Goods4U's core business
and should, consequently, be recognised as financial expenses.
 13 Payment made by customers, who bought on account 6
Recording of item 13 Debit Credit
Bank loan (balance sheet, decrease in liabilities) 6
Accounts receivable (balance sheet, decrease in assets) 6

Some of the customers who did not pay cash on delivery have paid subsequently (by bank
transfer) during the financial year. Due to this the balance on Goods4U's bank loan decreases,
while accounts receivable decreases. Customers owe less to Goods4U.
Again, Goods4U's equity remains unchanged. The firm has just converted one asset
(accounts receivable) to another fully liquid asset (increase in a bank balance). Naturally, the
risk associated with the fully liquid asset is less than the risk on the amount owed by the firm's
customers. We will discuss the concept of risk later in the text.

14 Payment made to suppliers for purchases made on account 50

Recording of item 14 Debit Credit
Accounts payable (balance sheet, decrease in liabilities) 50
Cash/bank loan (balance sheet, decrease in assets) 50

Some suppliers are paid during the financial year. Due to this the balance on Goods4U's
bank account decreases, while accounts payable decrease. The net worth (equity) of Goods4U
is unaffected. The firm reduced its liabilities (accounts payable) and assets (bank account) by
the exact same amount.

Adjusting transactions
At year end there will almost always be a number of adjusting and closing entries. Therefore,
before preparing the financial statements, Goods4U need to make some final entries into the
bookkeeping system. We describe the closing entries for Goods4U below.
First, Goods4U needs to calculate cost of goods sold. In other words, they must determine
the costs of the inventory which have been sold to customers. Usually, Goods4U would do this
by physically counting inventory in hand at year end. Each piece of inventory is valued at cost.
So if a firm has, say, 4 pieces in hand at a price of 10 per piece, and 12 pieces in hand at a price
of 5 per piece, the carrying amount of inventory amounts to 100 (4 × 10 + 12 × 5 = 100).
Cost of goods sold is calculated as:

15 Ending inventory at 31 December 450

Beginning inventory at 1 January 200
10 + Inventory purchased during the year 300
= Inventory available for sale 500
15 - Ending inventory at 31 December -450
- Cost of goods sold (COGS) 50

COGS are the costs associated with the sales of Goods4U's products. This represents an
expense in the income statement, with a corresponding decrease in inventory in hand. Note,
however, that a firm's COGS is often known even if inventory has not been counted at year
end, since at the point of sales the goods, which have been sold, are automatically recognised
by a bar code.
 The recording of transaction 15 becomes:

Recording of item 15 Debit Credit

Cost of goods sold (income statement, increase in expenses) 50
Inventory (balance sheet, decrease in assets) 50

Second, tangible assets need to be depreciated. Warehouses, machinery, equipment, auto-

mobiles and other tangible assets are prone to wear and tear. Eventually those assets are worn
out, or technological obsolete, so they must be depreciated. Warehouses (and property in
general) has fairly long estimated useful lifetimes, whereas machinery and equipment mostly
have a much shorter lifetime.

16 Depreciation of warehouse and equipment 14

Recording of item 16 Debit Credit
Depreciation of warehouse (income statement, increase in expenses) 4
Warehouse, depreciated (balance sheet, decrease in assets) 4
Depreciation of equipment (income statement, increase in expenses) 10
Equipment, depreciated (balance sheet, decrease in assets) 10

Goods4U estimates the lifetime of the warehouse to be 50 years, and the useful lifetime of
equipment to be 10 years on average. The depreciation method is straight-line. Depreciation
is calculated as:

Equipment amounted to 50 at the beginning of the year. With a purchase during the year
of 50, total costs for equipment amounts to 100. In practice, purchases during the year are
only depreciated proportionally. For instance, if equipment of 50 was bought at mid-year the
depreciation of these costs would only be 50/10 × ½ = 2.5 in Year 1 and 50/10 = 5 in subse-
quent years. The example assumes that the assets have no salvage value.
Furthermore, Goods4U needs to pay tax on its income. A firm's taxable income differs in
several respects from the accounting income as reported in the annual report. Tax payable
(and deferred taxes) cannot be calculated until the annual report has been finalised. For
the sake of simplicity, assume that Goods4U reported accounting earnings equal its taxable
income. This means that there are no deferred taxes (for a discussion of deferred taxes please
refer to Chapter 15). Assuming a tax rate of 30%, the tax expense becomes:

17 Corporation tax 30
Recording of item 17 Debit Credit
Corporation tax (income statement, increase in expenses) 30
Tax payable (balance sheet, increase in liabilities) 30

•
As illustrated in the above example, tax is an expense like any other expense. Since
tax has not been paid yet, it becomes a liability. In reality, firms may have to pay tax
during the year. In this case, tax payable is reduced accordingly.
 In reality, the number of actual transactions would normally be much higher
than 17 as in the example. For instance, employees would generally receive sala-
ries (at least) 12 times per year. But the principles are the same regardless of the
number of transactions, so you should be confident that these concepts of double-
entry bookkeeping apply regardless of the size of the company - or the number of
transactions.
Based on the transactions, accountants prepare financial statements. We illustrate
these statements below in a condensed form.

Financial statements
After the above transactions have been recorded, accountants enter them into the
financial statements as shown below. After each item in the financial statements, we
show the transaction number(s) associated with that item. This should make it easy
for you to see how transactions and financial statement items are linked.

Income statement in condensed form Total Transaction(s)

Net revenue 200 1,2

Cost of goods sold -50 15
Gross profit 150
Operating expenses (excluding depreciation and amortisation) -26 3, 4, 5, 6, 7, 8

Earnings before interest, tax, depreciation 124

and amortisation (EBITDA)
Depreciation -14 16
Earnings before interest and tax (EBIT) 110
Financial income 5 11
Financial expenses -15 12

Earnings before tax (EBT) 100

Corporation tax -30 17

Net earnings (E) 1 70

1
Sometimes labelled net profit. See glossary in Appendix 2.1 for commonly used accounting terms or
expressions.

Balance sheet in condensed form

Assets 1 Jan., Dr. Cr. 31 Dec., Transaction(s)

year 1 year 1

Warehouse 200 0 4 196 16

Equipment 50 50 10 90 9, 16
Inventories 200 300 50 450 10, 15
Accounts receivable 0 120 6 114 2, 13
Cash and cash equivalents1 15 85 15 85 1, 4, 5, 6, 8, 11
Total assets 465 555 85 935
(continued)
Liabilities and shareholders' 1 Jan., Dr. Cr. 31 Dec., Transaction(s)
equity year 1 year 1
Equity 365 70 435
Tax payable 0 30 30 17
Accounts payable 0 50 220 170 9, 10, 14
Loans and borrowings 100 6 206 300 3, 7, 10, 12, 13, 14
(bank accounts)
Total liabilities 465 500
Total liabilities and 465 56 526 935
shareholders' equity
1
By the end of the day cash sales are deposited in a savings account. A little cash (petty cash) is left
over. Cash and cash equivalents include petty cash and cash deposited in a savings account.

To see how these statements articulate, the cash flow statement is provided below.

Cash flow statement in condensed form

Cash flow from operating activities
Net earnings 70
Depreciation of non-current assets (Note 1) 14
Movements in working capital (Note 2):
(lncrease)/decrease in accounts receivable -114
(lncrease)/decrease in inventories -250
lncrease/(decrease) in accounts payable 170
lncrease/(decrease) in tax payables 30
Net cash generated by operating activities (A) -80
Cash flow from investing activities
Purchase of equipment (B) -50
Cash flow from financing activities
Proceeds from borrowing (C) 200
Net increase in cash and cash equivalents (A + B + C) 70
Cash and cash equivalents at the beginning of the year 15
Cash and cash equivalents at the end of the year 85

Note 1
Depreciation (and amortisation and impairment losses) of assets are added to net earnings,
as these expenses have been subtracted from earnings but have no cash flow consequences.
Note 2
In order to calculate the total cash flow from operations, changes in net working capital must
be taken into account. An increase in assets (e.g. inventory and accounts receivable) has a
negative effect on the cash flow. Likewise, a decrease in liabilities (e.g. accounts payable) has
a negative effect on the cash flow.
For instance, in the above example, inventories increase from 200 at the beginning
of the year to 450 at year end. The difference (increase of an asset) of 250 reduces the
cash flow by this amount.
 The different financial statements as shown above must articulate (be related to one
another in a certain way). As the example demonstrates:

Equity at the beginning of the financial year 365

+ Net earnings 70
= Equity at the end of the financial year 435
Total assets at year end 935
- Total liabilities at year end 500
= Equity at year end 435

Equity calculated in these two different ways must match. Likewise, cash and cash
equivalents at financial year end must equal cash in hand at the beginning of the finan-
cial year plus all cash flows related to operating, investing and financing activities
during the financial year:

Cash and cash equivalents at the beginning of the financial year 15

+ / - Cash flow from operating activities -80
+ / - Cash flow from investing activities -50
+ / - Cash flow from financing activities 200
= Cash and cash equivalents at the end of the financial year 85

Analysts often need to prepare pro forma financial statement - for instance, in valu-
ing companies - using present value approaches. In such valuation tasks, the analyst
should make sure those pro forma financial statements (including cash flow statements)
articulate as described in this chapter. We discuss this issue further in Chapters 8 and 9.

Conclusions
In this chapter, we have highlighted how transactions are recorded and financial state-
ments are prepared based on bookkeeping transactions. All transactions must include
(at least) one debit and (at least) one credit record. Each transaction must balance in
the sense that the amount(s) debited must match the amount(s) credited. Income (rev-
enues, other income and gains), liabilities and equity are credit transactions. Expenses
(costs and losses) and assets are debit transactions.
Financial statements summarise all recorded transactions. The income statement
measures a firm's earnings capacity over a period of time: the difference between
income and expenses. The balance sheet represents a firm's assets, liabilities and equity
at a point in time. Statement of changes in equity highlights how equity changes from
the beginning of the period to the end of the period. Finally, the cash flow statement
shows cash flows from operating, investing and financing activities (transactions) and
how those cash flows are related to the income statement and balance sheet. Just as all
transactions must balance, that is debit entries equal credit entries, the financial state-
ments must relate to each other in a certain way. The statements must articulate.
We included examples of how to record transactions and how these transactions
entered into the different financial statements. However, we disregarded certain items.
 For example, when customers buy a firm's product, they pay value added tax (VAT),
but the firm only recognises sales net of VAT. The VAT is simply collected on behalf of
a third party and does not become part of sales.
A thorough knowledge of bookkeeping is paramount in order to carry out a finan-
cial statements analysis. In later chapters, we discuss how analysts may need to make
adjustments to the financial statements before carrying out the analysis. These adjust-
ments are essentially bookkeeping records. Without knowing, say, how capitalising
rather than expensing development costs affects the financial statements, the analyst
will not be able to make such adjustments, and will, therefore, not be able to make
proper decisions.

Review questions
• How many formats of the income statement does IASB allow?
• What are the main components of an income statement?
• What is the distinction between current and non-current assets?
• What is the distinction between current and non-current liabilities?
• What are the three main categories of a cash flow statement?
• Why is knowledge of bookkeeping a useful skill for an analyst?
• A payment from a customer must be credited to the bank account - true or false?
• An investment in property, plant and equipment must be debited assets - true or false?

APPENDIX 2.1

Accounting terms: IASB, UK and USA (see Alexander et al. (2009) International
Financial Reporting and Analysis, 4th edn, page 16).

IASB UK USA

Inventory Stock Inventory

Shares Shares Stock
Treasury shares O w n shares Treasury stock
Receivables Debtors Receivables
Payables Creditors Payables
Finance lease Finance lease Capital lease
Sales (or revenue) Turnover Sales (or revenue)
Acquisitions Purchase Purchase
Uniting of interest Merger Pooling of interest
Non-current assets Fixed assets Non-current assets
Income statement Profit and loss account Income statement
 CHAPTER 3

Accrual-based versus cash-flow-based

performance measures

Learning outcomes
After reading this chapter you should be able to:
• Make a distinction between common accrual- and cash-flow-based performance
measures
• Explain the differences between accrual- and cash-flow-based performance
measures
• Understand the differences between single-period and multi-period performance
measures
• Understand the concept of a firm's earnings capacity
• Discuss the information content of accrual- and cash-flow-based performance
measures
• Understand in which analytical contexts that cash-flow measures can be used

Accrual-based versus cash-flow-based performance measures

F inancial statement analysis helps you identify a company's ability to create value
for its shareholders. In this context it is often debatable whether accrual-based
performance measures like EBIT and net earnings give a good description of a
company's underlying operations and, thus, is a good starting point for forecasting
future performance. Arguments like 'historically oriented' and 'prone to manipula-
tion' are used against accrual-based performance measures. The finance literature
recommends valuations based on cash flows, rather than accrual-based performance
measures. Cash flows are perceived as an objective outcome that cannot be manipu-
lated and some even argue that 'cash is king'. The following sections discuss to what
extent the two types of performance measures are suitable for measuring the value
creation in a company.
Both North American (FASB) and international accounting regulation (IASB) argue
that information on cash inflows and cash outflows enhances users' ability to assess
the following aspects of a company:
• Future cash flows
• Liquidity (short-term liquidity risk)
• Solvency (long-term liquidity risk)
• Financial flexibility.
While the FASB was among the first to implement the cash flow statement as an inte-
grated part of financial statements, FASB still sees the (accrual) income statement as
 being superior to the cash flow statement for measuring a company's value creation
(earnings capacity) within a given period.
Many researchers and practitioners disagree with the above view. In the past few
decades, advocates have focused on cash flows as an alternative way to measure a
firm's earnings capacity; i.e. its ability to create value within a given period such as a
financial year. The most eager proponents of 'cash is king' in this debate are a group of
people who suggest that the cash flow statement should replace the traditional finan-
cial statements (income statement and balance sheet). Ijiri (1978), Lawson (1985) and
Lee (1985) have all developed systems of alternative cash flow statements to replace
the traditional financial statements. The management literature has advocated for
the measurement of value creation through cash flows. Among stock analysts there
has also been an increased focus on measuring earnings capacity through cash flows.
As a result, there is some conflict between researchers and practitioners, as to whether
accrual-based or cash-flow-based performance measures are best at estimating a firm's
value creation.

The distinction between accrual-based and cash-flow-based

performance measures
In the following section, we demonstrate the distinction between accrual- and cash-
flow-based performance measures. To help you understand the conceptual difference
between the two, consider a firm which must record the following seven transactions
in period 0 (P0):

P = Purchase, PCR = Payment to creditor, S = Sales, PCU = Payment from customer

 Based on the seven transactions, we have measured the performance of the com-
pany in P0 using both accrual and cash flow accounting.
The accrual-based earnings generated in P0 can be calculated as follows:

Revenue (transactions 1, 3, 4, 5) 2,600 + 4,800 + 6,000 + 1,400 14,800

Cost of goods sold (transactions 1, 3, 4, 5) 1,000 + 2,500 + 3,100 + 1,000 7,600
Accrual based earnings 7,200

The cash flow generated in period P0 is calculated as follows:

Cash inflow (transactions 1, 2, 3, 4) 2,600 + 200 + 4,800 + 6,000 1 3,600

Cash outflow (transactions 1, 4, 5, 6) 1,000 + 3,100 + 1,000 + 3,000 8,100
Cash flow P0 5,500

As you can see from this example, accrual-based earnings is 7,200, while net cash
inflow amounts to 5,500. Although accrual accounting matches revenue and expenses
from the same transaction, a similar match is not made in the cash flow statement.
This is because in an accrual accounting regime unused purchases at the end of a
financial year is recognised as inventory. Thus, inventory serves as a 'parking place' for
unused purchases waiting to be recognised in the income statement as cost of goods
sold. Cash flow accounting, on the other hand, recognises purchases in the cash flow
statement in the year that the purchase has been paid for. Therefore, the same transac-
tion can be treated differently in the income statement and cash flow statement.
To help make the difference between the accrual- (accounting) based earnings of
7,200 and the net cash inflows of 5,500 more explicit, we have calculated a traditional
cash flow statement based on the seven transactions:

Accrual-based earnings in period P0 7,200

Begin End
Inventory 5,600 6,900 -1,300
Accounts receivable 200 1,400 -1,200
Accounts payable (creditors) 3,100 3,900 800
Cash flow P0 5,500

In the above example, the differences between accrual-based earnings and cash
flows are made up by changes in net working capital, i.e. inventory, accounts receiv-
able and accounts payable. As noted above, inventory helps matching revenue with
expenses from the same transaction. In the example, accrual accounting is moving
purchases of 1,300 to future periods where the sales will take place. On the other
hand, cash flow accounting recognises all 1,300 as a cash outflow in P0. Accounts
receivable are growing by 1,200 indicating that accrual-based earnings recognises
1,200 as sales in P0 that is still not recognised in the cash flow statement (since no
cash has been received). As you can see from the example, accrual accounting recog-
nises a transaction at the time when a sale is made rather than when cash is received
from the customer. In contrast, cash flow accounting is more prudent as it does not
recognise a transaction until cash has been received from customers, i.e. when a trans-
action results in an inflow of cash. Finally, accounts payable are growing by 800. Cash
flow accounting acknowledges that not all purchases are paid in P0.
 Different accrual- and cash-flow-based performance measures are reported by com-
panies and used by analysts. In Table 3.1 we have highlighted the most important ones
in bold.

Table 3.1 Various accrual-based performance measures

Revenue
- Operating costs excluding depreciations and write-downs
= Operating earnings before depreciation, amortisation and impairment losses (EBITDA)
- Depreciation, amortisation and impairment losses
= Operating earnings (EB1T)
+ / - Net financial items
= Ordinary earnings before tax (EBT)
+ / - Tax on ordinary profit
= Ordinary earnings after tax
+ / - Extraordinary items, discontinued operations and change in accounting policies
= Net earnings (E)
+ / - Transactions recognised directly in equity
= Comprehensive income

As Table 3.1 illustrates, four accrual-based performance measures are typically dis-
closed: operating earnings (before and after depreciation, amortisation and impair-
ment losses), ordinary earnings, net earnings and comprehensive income. Operating
earnings and comprehensive income are considered as two extremes among the
accrual-based performance measures. Essentially, operating earnings measure the part
of earnings which are likely to recur from period to period (permanent portion of
earnings), while comprehensive income measures both the permanent part of earnings
as well as the part of earnings that do not occur often or regularly. Net earnings are in
between operating earnings and comprehensive income.
Table 3.2 shows each accrual-based performance measure on Carlsberg - one of the
world's largest breweries. Looking at the table it is interesting to note the deviation
between comprehensive income and net income. While net earnings equal DKK 3.2 bil-
lion, comprehensive income equals DKK 9.2 billion. A closer look at Carlsberg's net
amount recognised directly in equity reveals that value adjustment on acquisition of

Table 3.2 The accrual-based performance measures of Carlsberg

DKKm Year 8
Net revenue 59,944
Operating expenses excluding depreciation and amortisation -49,815
Operating earnings before depreciation and amortisation (EBITDA) 10,129
Depreciation and amortisation -3.771
Earnings before interest and tax (EBIT) 6,358
Net financial expenses -3,456
Earnings before tax (EBT) 2,902
Corporation tax 304
Net earnings (E) 3,206
Net amount recognised directly in equity 6,000
Comprehensive income 9,206
 subsidiaries, foreign exchange adjustments and value adjustments of hedging instru-
ments and securities explain the difference.
The most widespread cash-flow-based performance measures (marked in bold),
and the relationship between them, are shown in Table 3.3.

Table 3.3 The relationship between cash-flow-based performance measures

Operating income (EBIT)
+ / - Adjustment for items with no cash flow effects (depreciation, provision, etc.)
+ / - Change in net working capital (inventories, receivables and operating liabilities)
+ / - Corporate tax
= Cash flow from operating activities
+ / - Investments in non-current assets, net
= Cash flow after investments (free cash flow, FCF)
+ /- Financing items
= Net cash flow for the period (change in cash)

Cash flow from operations and free cash flows are the most frequently used cash
flow measures by analysts. Net cash for the period are rarely used as a stand-alone per-
formance measure. The cash-flow-based performance measures shown for Carlsberg
are shown in Table 3.4. Carlsberg's cash flow from operation is clearly not sufficient
to cover investments in non-current assets of DKK 57.2 billion. Carlsberg, therefore,
has to rely on cash flow from financing activities (borrowing) to support the heavy
investments made in non-current assets.

Table 3.4 Cash-flow-based performance measures for Carlsberg

DKKm Year 8
Cash flow from operating activities 7,812
Cash flow from investing activities (non-current assets) -57,153
Free cash flow -49,341
Cash flow from financing activities 50,084
Net cash flow 743

Measuring earnings capacity

It is important to distinguish between the measurement of a firm's earnings capacity in
the short term and long term when comparing accrual- and cash-flow-based performance
measures. As we cannot predict what is going to happen in the future, it is not possible
for us to measure earnings capacity over the entire lifetime of a company. Therefore,
measurement of earnings capacity changes from being forward looking to being (partly)
backward looking. Typically, earnings capacity is measured over relative short time inter-
vals (on a quarterly, semi-annual or annual basis) because users of financial statements
in a world of uncertainty need continuous updates of a firm's performance and financial
position. Users, thus, have opportunities constantly to revise their view of a company.
Among certain cash flow proponents there is a tendency to confuse the concepts of short-
and long-term earnings capacity, i.e. comparing single-period performance measures
measuring short-term performance with multi-period performance measures measuring
long-term performance. For example, accrual-based earnings per share (EPS) has been
compared to a cash-flow-based multi-period shareholder value added (SVA) measure.
 Figure 3.1 Example on the use of a multi-period performance measure (SVA)

Figure 3.1 illustrates the SVA concept and how it is measured. The present value
of future cash flows is measured at the beginning and at the end of the measurement
period. In this example, the present value of cash flows increases by 55. Moreover, in
the period a free cash flow of 25 has been generated, which added to the increase in
present value gives 80. If there were no transactions with owners, the 80 would reflect
value created during the period. However, the owners contributed 10 in the period, so
the real value creation (SVA) is only 70.
Obviously, comparing an ex-post single-period performance measure as EPS with
a (forward looking) multi-period performance measure as SVA is not very useful. EPS
and SVA serve two very distinct and different purposes. While EPS is a short-term per-
formance measure of last year's performance SVA is multi-period performance meas-
ure measuring the long-term earnings capacity of a company.
The distinction between EPS and SVA is highlighted in Figure 3.2. The single-period
accrual-based EPS is (partly) backward looking and measures value creation for short-
term intervals. This is in contrast to the cash-flow-based SVA-concept, which is forward
looking, takes growth and risk into consideration and measures value creation through-
out a firm's lifetime. Thus, the cash-flow-based SVA concept will appear to be a superior
performance measure of earnings capacity in the long term compared to the accrual-
based EPS. However, to make a real comparison of accrual- and cash-flow-based per-
formance measures requires a separation of the short- and long-term earnings capacity.

Figure 3.2 Single-period versus multi-period performance measure

Shortcomings of accrual-based and cash-flow-based performance concepts

As shown above, there is some disagreement about the usefulness of accrual- and cash-
flow-based performance measures. Part of the explanation for this divergence is that
both accrual- and cash-flow-based performance measures suffer from shortcomings
when measuring the earnings capacity in the short term. Overall, the criticism of the
accrual-based performance measures can be summarised into the following points:
• Accrual problems:
- Arbitrary cost allocation and accounting estimates
- Alternative accounting policies
• Time value of money is ignored.
One of the main disadvantages of accrual-based performance measures is the intro-
duction of concepts such as (arbitrary) cost allocation (e.g. amortisation of intangible
assets), accounting estimates (e.g. estimating uncollectible accounts receivable) and
alternative accounting policies (e.g. first in, first out (FIFO) versus average costs for
inventory accounting). As a consequence of these concepts the preparer of financial
statements (management) obtain some flexibility in reported earnings numbers. In
accounting literature it is well documented that when accruals are abnormally high,
the quality of reported earnings is generally low and less suitable for predictive pur-
poses (Sloan 1996). The concepts of abnormal accruals and earnings quality are dis-
cussed in further detail in Chapter 13. Another potential disadvantage of accrual-based
performance measures is that they do not take into account the time value of money.
This problem is particularly prone during periods of rapid price changes (inflation).
Since revenue is measured at current prices and operating expenses are measured at
historical prices (costs), a firm's earnings capacity will generally be overvalued in times
of (large) inflation.
However, cash-flow-based performance measures are also problematic. Criticism of
cash-flow-based performance measures can be summarised as follows:

• Failure to account for uncompleted transactions

• Cash flows can be manipulated.
One of the main problems with cash-flow-based performance measures is that they
do not match cash inflows with cash outflows from the same transactions. While cash
outflows are significant at times of new investments cash inflows from those invest-
ments are typically significant in subsequent periods. The magnitude of this problem
typically increases with the number of uncompleted transactions in a given period.
For example, engineering, consultancy firms, and shipyards are all characterised by
transactions that may span several periods. Thus, the proportion of uncompleted
transactions within the measurement period is typically significant for these types of
companies. Conversely, supermarkets are characterised by many completed transac-
tions and the proportion of uncompleted transactions within the measurement period
is modest. Thus, the information content of cash flows is expected to decrease with
the length of a firm's transactions (operating cycle).
Based on data from commercial, service and manufacturing industries we examine
the accrual- and cash-flow-based performance measures' ability to measure a firm's
earnings capacity for different length of operating cycles. In this context an operat-
ing cycle is defined as the number of days it takes from the purchase of raw materials
until the customer pays for the finished good. As an estimate for earnings capacity
stock returns are used. The analysis is carried out in a two-step process. In the first
step, each performance measure (accrual- and cash-flow-based performance measures,
respectively) are correlated with stock returns for the same period. The correlation
coefficient describes the individual performance measure's ability to gauge a firm's
earnings capacity. In the second step, the correlation coefficient (i.e. the proxy for a
firm's earnings capacity) of each performance measure is correlated with the length
of the operating cycle. If the correlation coefficient from this test is close to zero and
insignificant, the performance measure's ability to measure a firm's earnings capacity
is not affected by the length of the operating cycle. However, if the correlation coef-
ficient is negative (and significant) it indicates that the longer the operating cycle (in
days), the poorer the performance measure's ability to gauge the earnings capacity of a
firm. The correlation coefficients are presented in Table 3.5. As is clear from the table
the correlation coefficient for net earnings is close to zero and insignificant. However,
there is a significant negative correlation between the ability to measure the earnings
capacity and the length of the operating cycle for the two cash-flow-based perform-
ance measures. That is, the longer the period from the purchase of raw materials and
until the customer pays in cash, the worse the cash-flow-based performance measures
ability to gauge the underlying economic performance.

Table 3.5 The correlation between a firm's earnings capacity and the length of
the operating cycle
Net earnings Cash flow from operations Free cash flow
4% -27% -43%
(Insignificant) (Significant at the 5% level) (Significant at the 5% level)

A commonly overlooked problem with cash-flow-based performance measures is

that they can be manipulated by management just as the accrual-based performance
measures can be manipulated. For example, cash flows from operations increase if a
firm sells some of its accounts receivable (factoring) or defer purchases of inventory.
However, from an economic point of view, factoring may be expensive and a short-
age of inventory may make customers look for alternative products. Cash flow from
operations also increases by cuts in research and development activities or marketing
expenses. Cash flow measured net of investments can be improved by postponing
investments. Again, this may improve short-term cash flows at the expense of long-
term earnings and cash flows. Cash-flow-based performance measures are, thus, in
many respects like accrual-based performance measures not a perfect measure of a
firm's earnings capacity. In the following section, we explore the information content
of accrual- and cash-flow-based performance measures in greater detail.

The information content of accrual-based and cash-flow-based

performance measures
As shown above, it is not possible to infer the performance measure which seems to be
most suitable for measuring profitability for any given measurement period. A number
of studies, however, have been designed to assess the information content of accrual-
based as well as cash-flow-based performance measures; i.e. how useful they are in
explaining the earnings capacity of a firm. If a performance measure is valuable to
investors, it means that the performance measure is able to measure the entire earnings
capacity, or portions thereof. In these studies the information content of accrual- and
cash-flow-based performance measures are assessed as changes in investors' assess-
ment of the probability distribution of future returns (measured by stock returns).
These studies can be divided into two groups. The first group considers accrual-
and cash-flow-based performance measures as competing measures and examines
which is best suited to measuring earnings capacity for a given period - typically one
year. The second group considers accrual- and cash-flow-based performance meas-
ures as complementary performance measures, and examines whether the use of both
performance measures simultaneously increases the ability to measure the earnings
capacity as opposed to only using one of the two measures. Figure 3.3 illustrates some
of the possible outcomes of such studies.

Figure 3.3 The information content of accrual- and cash-flow-based performance

measures. (A) Accrual-based performance measure. (B) Cash-flow-based performance
measure. (C) The market's total set of information
The rectangular boxes labelled C in Figure 3.3 represent the total information
available on the market at any given time. In Figure 3.3(a) both types of performance
measures are equally informative and the information content is increased by using
both of them. Figure 3.3(b) shows a case where both measures are equally informa-
tive, but where information content is not increased by using both of them. Finally,
Figure 3.3(c) shows a case where the accrual-based performance measure is relatively
more informative than the cash-flow-based performance measure and the value of
information does not increase by using the cash-flow-based performance measure
together with the accrual-based performance measure.
The investigation shows that accrual-based performance measures is better at meas-
uring the earnings capacity of a firm (see Dechow (1994), Ali and Pope (1995) and
Plenborg (1999)). In Figure 3.4 we show some of the results from these studies. As
illustrated in the figure, net earnings are able to explain about 1 1 % of the price move-
ments within a year, while operating cash flows are only able to explain about 4 % . In
the same measurement period, there is no correlation between stock returns and the
free cash flow. These results support that accrual-based performance measures gauge
earnings capacity better than the cash-flow-based performance measures.

Figure 3.4 The information content of performance measures (measurement period:

1 year)

Generally, it is expected that the longer the measurement period, the better the
accrual- and cash-flow-based performance measures are at explaining a firm's earn-
ings capacity. This is due to the fact that more transactions are completed within the
measurement period. In Figure 3.5, the above findings have been reproduced with a
change to the measurement period, which has been adjusted to four years. As shown,

Figure 3.5 The information content of performance measures (measurement period:

four years)
the performance measures net earnings and operating cash flow improve the ability
to measure a firm's earnings capacity. However, there is no correlation between stock
returns and free cash flows over a four-year measurement period. This suggests that
the measurement window should be expanded significantly until the free cash flow
measure is able to gauge a firm's earnings capacity. This finding is elaborated on when
we discuss firm valuation in Chapter 9.
The empirical results support the illustration in Figure 3.3(c). The findings also
contradict the cash flow proponents, who suggest that cash-flow-based performance
measures are superior at explaining a firm's earnings capacity compared to accrual-
based performance measures.
Based on the empirical results it cannot be ruled out that cash-flow-based perform-
ance measures contain information on important aspects of a firm's earnings capacity
not included in accrual-based performance measures. As mentioned above standard-
setting bodies find that the cash flow statement contains important information about
long- and short-term liquidity risk. Empirical studies (see for example Livnat and
Zarowin (1990), Plenborg (1999) and Charitou et al. (2000)) support this assump-
tion. They find that cash flows are useful together with the accrual-based performance
measures. These results support the illustration in Figure 3.3(a).
The above empirical findings indicate that while cash flows are less informative
than accrual-based performance measures they do provide useful information for
the analyst. Below we move on to discuss areas where reported cash flow numbers are
expected to be useful in financial statement analysis:
1 Assessment of earnings quality
2 Assessment of financial flexibility
3 Assessment of short- and long-term liquidity risk.

Assessment of earnings quality

Accounting earnings are characterised by a greater degree of subjectivity than cash
flows. This means that in some cases analysts may doubt the credibility of reported
figures. By comparison, there is a greater degree of credibility to reported cash flow
numbers. Over a longer period of time, there should be a closer association between
accumulated accounting profit and cumulative cash flow. If it is not possible to iden-
tify this association, analysts must question the quality of the reported accounting
figures. In Chapter 13 the method is discussed in further detail.

Assessment of financial flexibility

Cash flow statements are also useful for assessing a company's financial flexibil-
ity. Questions that can be answered by analysing the cash flow statement include
(a) whether a company generates sufficient cash to finance its growth or whether it
needs additional capital and (b) what sources of financing (debt or equity) that a com-
pany relies on when additional capital is needed.

Assessment of short- and long-term liquidity risk

Cash flow statements are often used as input for calculation of financial ratios used
to assessing short- and long-term liquidity risk. Analysts can also choose to forecast
future cash flows in order to assess the short- and long-term liquidity risk. Financial
ratios and forecasting of future cash flows are discussed in greater details in subse-
quent chapters.
Approximations to cash flows
In recent years it has become popular to focus on accounting concepts such as EBITDA
(earnings before interest, taxes, depreciation and amortisation) and EBITA (earnings
before interest, taxes and amortisation) when making a credit rating or a firm valua-
tion. For example, the multiple EV/EBITDA is often used to valuing companies. The
rationale for the use of EBITDA and EBITA is that both accounting measures are
believed to be closer to a firm's cash flows from operations than for instance net earn-
ings. At the same time as a result of not including depreciation (and amortisation),
differences in depreciation policies do not affect the performance measure. The same
is true with regard to tax. By excluding tax analysts avoid the impact of estimates
related to deferred tax. In conclusion, concepts like EBITDA and EBITA are used in an
attempt to eliminate differences in accounting policies between companies and across
national borders.
Using EBITDA as a measure of cash flow is, however, problematic. First, it is
difficult to justify that a significant portion of a firm's costs is excluded from opera-
tions. Depreciation is a proxy for the use of resources (e.g. property, plant and equip-
ment) that is needed in generating earnings. Thus, EBITDA includes the benefits
(revenue) from those resources but excludes the related costs.
Second, if EBITDA is used as a performance measure it will be difficult to compare
businesses which grow organically and businesses which are growing through acquisi-
tions. For example, businesses that generate goodwill internally must expense those
goodwill outlays due to measurement problems. Companies which acquire other busi-
nesses or activities, on the other hand, must capitalise goodwill, while the consump-
tion of goodwill (goodwill impairment losses) is not recognised in EBITDA.
Third, there has been a change in accounting regulation from expensing investment
in intangible assets to the capitalisation of intangible assets. For example, develop-
ment costs, as a general rule, must be capitalised. Previously, this accounting item
was expensed as incurred. This also implies that development costs, which used to
be included in EBITDA, are now excluded. A further problem in this context is that
some companies fail to capitalise development costs. The following example of Novo
Nordisk, which is a healthcare company and a world leader in diabetes care, illustrates
this. The extract is taken from Novo Nordisk's Annual Report (note 1 - summary of
significant accounting policies).
Research and development
Due to the long development period and significant uncertainties relating to the
development of new products, including risks regarding clinical trials and regula-
tory approval, it is concluded that the Group's internal development costs in general
do not meet the capitalisation criteria in IAS 38 'Intangible Assets'. Consequently,
the technical feasibility criteria of IAS 38 are not considered fulfilled before regula-
tory approval is obtained. Therefore, all internal research and development costs
are expensed in the Income statement as incurred.
Novo Nordisk chooses to expense development costs using the argument that the
group's development costs do not meet the requirements for capitalisation. When ana-
lysts compare EBITDA across firms, which treat development costs differently, they
face the risk of drawing wrong conclusions; unless these differences are adjusted for.
Examples of wrong conclusions are misleading credit ratings or share price estimates.
Finally, even if it were possible to take into account the above points, EBITDA and
EBITA are far from ideal cash flow measures. Neither of the two measures account for
 investments in non-current assets nor for investments in working capital. Furthermore,
they do not take into account non-cash items included in operating earnings such as
provisions relating to restructuring, etc.
This shows that you should be cautious in applying approximations to cash flow
measures such as EBITDA and EBITA. It seems more natural to use real cash flow meas-
ures; especially bearing in mind that these must be reported by companies.

Conclusions
There has been much debate about the use of accrual- and cash-flow-based per-
formance measures as proxies for a firm's earnings capacity within a given period.
Despite the fact that accrual-based performance measures are historically oriented
and prone to manipulation, they seem to be better at measuring value creation in a
given period than cash-flow-based performance measures.
However, you should also bear in mind that cash flows offer value relevant infor-
mation in addition to the information contained in reported accrual-based earn-
ings measures. For example, cash-flow-based performance measures are often used
in determining the short- and long-term liquidity risk, the assessment of accounting
quality and financial flexibility. Some of these aspects will be further elucidated in
subsequent chapters.

Review questions
• What is the distinction between accrual-based and cash-flow-based performance measures?
• What are the most important subtotals from the income statement?
• What are the most important subtotals from the cash flow statement?
• How is shareholder value added measured?
• What is the distinction between a multi-period and a single-period performance measure?
• What are the advantages and disadvantages of accrual-based and cash-flow-based per-
formance measures?
• Do the cash-flow-based performance measures appear more useful than accrual-based
performance measures?
• In which analytical settings does the cash flow appear useful?
• Is EBITDA a useful proxy of cash flow from operation?

References Ali, A. and P. Pope (1995) 'The incremental information content of earnings, working capi-
tal from operations, and cash flows: The UK evidence', Journal of Business, Finance and
Accounting, Vol. 22, 19-34.
Charitou, A., C. Clubb and A. Andreou (2000) 'The value relevance of earnings and cash
flows: Empirical evidence for Japan', Journal of International Financial Management and
Accounting, Vol. 11, No. 1, Spring, 1-22.
Dechow, P. (1994) 'Accounting earnings and cash flow as measures of firm performance: The
role of accounting accruals', Journal of Accounting and Economics, Vol. 18, 3-42.
Ijiri, Y. (1978) 'Cash flow accounting and its structure', Journal of Accounting, Auditing and
Finance, Summer, 331-48.
Lawson, G.H. (1985) 'The measurement of corporate performance on a cash flow basis: A reply
to Mr. Egginton', Accounting and Business Research, Spring, 99-108.
Lee, T.A. (1985) 'Cash flow accounting, profit and performance measurement: A response to a
challenge', Accounting and Business Research, Spring, 93-7.
Livnat, J. and P. Zarowin (1990) 'The incremental information content of cash flow components',
Journal of Accounting and Economics, Vol. 13, 25-46.
Plenborg, T. (1999) 'An examination of the information content of Danish earnings and cash
flows', Accounting and Business Research, Vol. 30, No. 1, 43-55.
Sloan, R. (1996) 'Do stock prices reflect information in accruals and cash flows about future
earnings', Accounting Review, Vol. 7 1 , No. 3, 289-315.
 PART 2

Financial analysis

Introduction to Part 2
4 The analytical income statement and balance sheet
5 Profitability analysis
6 Growth analysis
7 Liquidity risk analysis
 Introduction to Part 2

The previous chapters outlined the information available in the annual reports.
Chapters 4 to 7 discuss how a firm's financial performance and position can be ana-
lysed using a number of different financial ratios.
Chapter 4 describes how the income statement and balance sheet can be refor-
mulated for analytical purposes. Chapter 5 presents financial ratios which illustrate
a firm's profitability. Chapter 6 discusses different methods for measuring growth.
Chapter 7 focuses on short- and long-term liquidity risk.

Introduction to financial ratio analysis

Financial ratio analysis is a useful tool for mapping a firm's economic well-being, and
uncovering different aspects of its performance and financial position, for example:

• Profitability
• Growth
• Risk.

The primary tool for evaluating a firm's financial health is the calculation of a variety
of financial ratios, which are important indicators of a firm's financial performance.
Financial ratios help you to identify areas that may require additional analysis. A finan-
cial ratio analysis enables you to compare a firm's financial ratios:

• Across multiple periods (time-series analysis)

• Across firms within the same industry (cross-sectional analysis, benchmarking)
• With the proper required rate of return (e.g. WACC).

Financial ratios describe the level and trend in a firm's profitability, growth and risk.
It is therefore possible to evaluate if there is a positive trend in profitability as a conse-
quence of, for example, an improved profit margin.
In financial statement analysis a time-series analysis or a cross-sectional analy-
sis is usually employed. In a time-series analysis the efficiency of a firm's strategy
across time can be measured. Time-series analysis is an important tool in forecasting
as the historical levels and trends in financial ratios (value drivers) are used as input
to forecasting.
The purpose of cross-sectional analysis is to examine the relative performance of
a firm within an industry. Cross-sectional analysis is used as inspirational analysis in
examining operating performance. Valuable information can be found by analysing
the most profitable firms within an industry. Gathering information from competitors
in order to identify 'best practice' in the industry may prove beneficial.
 An alternative way to benchmark is to compare financial ratios with the appro-
priate required rate of return. Obvious examples include return on invested capital
(ROIC) and return on equity (ROE). For both of these ratios it is possible to estimate
a required rate of return from primary financial data. If a firm generates returns in
excess of the required rate of return, it achieves above normal profit (economic profit).
This is illustrated below by benchmarking return on invested capital (ROIC) with the
weighted average cost of capital (WACC) and return on equity (ROE) with investors'
required rate of return (re), respectively:

Some consulting firms provide advice on using these financial ratios. Stern Stewart uses
the term 'Economic Value Added' (EVA™), while the Boston Consulting Group labels
it 'Economic Profit' (EP). Both concepts are equivalent to excess return.

Pitfalls in financial ratio analysis

A major premise in a time-series and cross-sectional analysis is that financial ratios
provide signals and pieces of information that the decision maker can act upon.
Consequently, it is important that information obtained from these financial ratios do
not contain 'noise' that is that they faithfully represent a firm's underlying perform-
ance. Sources of noise should be controlled prior to calculating and analysing financial
data and ratios since not doing so could lead to misinterpretations and false conclu-
sions. The following table lists sources of noise that should be considered when carry-
ing out time-series and cross-sectional analyses, respectively.

Sources of noise in time-series and cross-sectional analysis

Time-series analysis Cross-sectional analysis

1 Different accounting policies across time 1 Different accounting policies across firms
2 Special and unusual items 2 Special and unusual items
3 Acquisitions and disposing of lines of 3 Comparison of different types of firms
business, SBUs etc. (differences in risk)
4 New products/markets (change in risk 4 Different definitions of financial ratios
profile) across firms

The purpose of a time-series analysis is to analyse the level and trend in a firm's operat-
ing performance. It is, therefore, important to eliminate any noise in the signals from
the time-series analysis.
Accounting policies over time
One source of noise is the impact of changes in accounting policies. In analysing key
financial ratios, it is important to separate the effect of changes in accounting policies
from changes in the underlying operations across time.

Impact of special and unusual items

A second source of noise is the impact of special and unusual items on performance. A
key issue is whether to include or exclude special and unusual items from the analysis.
As pointed out earlier, this depends upon the purpose of the analysis. For example, if
the objective of the analysis is to forecast financial statements, those items are likely to
be excluded in calculating financial ratios, while in assessing management's perform-
ance (in the past) they are more likely to be included.

Acquisition and disposal of business units

A third source of noise in a time-series analysis is the impact of acquisitions and dis-
posal of business units on financial ratios. In the case that a firm has changed its opera-
tional characteristics in the analysed period, financial ratios may have limited relevance
if compared across time. For instance, if a firm has acquired a new line of business
with another risk profile than the existing business, changes in profitability may be due
to the acquired business segment and/or changes in the original business, which reduces
the information content of the financial ratios considerably. For example, consider that
the risk in the new line of business is much higher than in the existing business, the
required rate of return would therefore be higher.

Change in underling risk

A similar type of noise in a time-series analysis is the impact of an introduction of new
products, or introduction of existing products on new markets, on financial ratios.
Carlsberg's operation in Eastern Europe may increase profitability, but the focus on
markets in Eastern Europe may also increase total risk in Carlsberg, as investments
take place in countries with less political stability (for instance Russia). Thus, if the risk
profile of the company has changed over time it is necessary to adjust the required rate
of return accordingly.

Peer group companies

Cross-sectional analyses involve many of the same considerations. In comparing finan-
cial ratios across firms, it is important that financial statements are based on the same
accounting policies and special and unusual items must be treated uniformly across firms.
A further requirement in cross-sectional analyses is that firms that are benchmarked
are comparable. A cross-sectional analysis of Carlsberg, therefore, should be based on
comparing Carlsberg with other breweries and not with firms from other industries. If
Carlsberg is compared with firms from other industries, with a different risk profile,
a comparison of the firms' return on invested capital (ROIC), or similar performance
measures, will not be appropriate. Alternative interpretations will reduce the relevance
of financial ratios. It should be pointed out that even within the same industry the risk
can be quite different across firms; for instance, if they operate on different markets.
Different terminology of financial ratios
An additional source of noise in cross-sectional studies is that firms may define finan-
cial ratios differently. As illustrated in subsequent chapters, the same financial ratio
may be calculated differently, as there are no uniform definitions of financial ratios. If a
financial ratio from two comparable firms has been defined differently, they might have
different interpretations, which reduces the value of the information inherent in the key
ratio. This issue is often problematic in using financial ratios from industry reports and
databases, where definitions are not made public.

Requirements for financial ratio analysis

In order to analyse the trend in the financial ratios, data from the last three to seven
years will be required. The length of the time period examined will be determined by:
• The availability of data
• The continuity in the analysed firm
• The length of a typical business cycle.
In deciding how long a period to include in the analysis, the analysts would ideally have
access to data that covers an entire business cycle, but may be restricted to fewer data,
for instance because the firm has only existed for a few years.
Over time growth, profitability and risk often vary substantially. To get a sense of
those fluctuations and an assessment of the underlying level of profitability a longer
time-series is needed; an entire business cycle is recommended as the historic analysis
thereby covers upturns as well as downturns. This provides the analysts with valuable
information about the analysed firm's ability to adapt to changes in the economic
climate. It further prevents a wrong basis for forecasting. This point is illustrated in
Figure P.2.1, where the example shows realised earnings and budgeted earnings for
two hypothetical firms. If analysts or potential investors are not aware that firms have
a business cycle, they risk forecasting earnings that are either too high (Company 1)
or too low (Company 2).

Figure P.2.1 Example of two otherwise identical firms in different stages of a business cycle
 By studying the performance of a firm over a business cycle the analyst obtains
useful information about the firm's ability to adapt to upturns as well as downturns.
Furthermore, it gives some insights as to where in the business cycle the firm is cur-
rently located. If analysts ignore these aspects they may draw incorrect conclusions as
to the earnings potential of the firm being analysed.
A short time-series may prove more useful in cases where the structure of the firm
has changed significantly. A spin-off of a business unit or the acquisition of a new
business unit may imply that historical accounting data are of limited use. Sometimes
financial information is only available for a few years. For start-up firms with no or
little history, financial ratios can be calculated for a short time period only; as finan-
cial information may not be available.
In the following chapters a number of financial ratios, which illustrate a firm's
growth, profitability and risk, are presented. An important premise in Chapters 4
to 7 is that data quality, including accounting policies, is not questioned. Thus, the
examples are based on raw, unadjusted accounting figures. Assessment of the quality
of financial data is an issue that is dealt with separately in Chapters 13 to 15.
 CHAPTER 4

The analytical income statement

and balance sheet

Learning outcomes
After reading this chapter you should be able to:
• Understand that operations is the primary driving force behind the value creation
in a firm
• Separate operating income and expenses from financial income and expenses
• Make a distinction between operating and financial assets and liabilities
• Prepare an income statement and balance sheet for analytical purposes
• Define and measure net operating profit after tax (NOPAT) and invested capital,
respectively

The analytical income statement and balance sheet

A firm consists of operating, investing and financing activities. When you calculate
financial ratios to measure a firm's profitability, it is beneficial to separate 'opera-
tions' and 'investments in operations' from financing activities. For example, property,
plant and equipment and inventory are operating items, while bank loans and equity
are financing items.
The reason why operating items should be separated from financing items is that the
company's operations is the primary driving force behind value creation and therefore
important to isolate. Furthermore, a company's operation is what makes the company
unique and difficult to 'copy', whereas the financial composition is much easier to
replicate. Financial items, on the other hand, convey how operations (including invest-
ments in operations) are financed. In financial statements, the distinction between
operating items and financial items is not always easy to see due to several factors:
• The definition of operations is not clear-cut
• The classification of items in the income statement and the balance sheet do not
clearly distinguish between operating and financing items
• The notes are not sufficiently informative.
To determine which activities to include in operations depends on the business
model and the characteristics of the firm. Items that are sometimes categorised as
belonging to 'operations' may at other times be classified as belonging to 'financing'.
Example 4.1 illustrates this issue.
Example 4.1 The NTR Group, a listed company at OMX NASDAQ, stated in their annual report for year 1
that the associated firm Bahrain Precast Concrete (BPC) was outside the group's focus. This
indicates that the associated company might be divested in the future. It is, thus, relevant to
discuss whether the ownership interest should be classified as part of financial assets. If so the
share of profit from BPC shall be reclassified as part of financial income and the investments
in BPC as a financing activity.
In the following period the NTR Group undergoes significant changes with disposal of
nearly all its core lines of businesses.
In the annual report for year 5, the chairman of the board of directors stated that:
Over the last few years, the NTR group has implemented a number of adjustments, dispos-
ing of various activities to focus on one single, clearly defined business area. The board of
directors is gratified to find that this aim has now been achieved, and NTR will in future
concentrate on developing and extending the precast concrete panel activities in the coun-
tries around the Arabian Gulf. The respective countries are still seeing substantial growth,
and by virtue of heavy oil and gas reserves this growth would seem secured for many years
hence. For a number of years, the group results have been adversely affected by the dis-
continuation of the previous contractor activities in Germany. The winding up has not yet
been finished but this year did carry us a solid step in the right direction and through the
adjustments of the group, NTR has secured a good basis for continuing and completing the
winding up . . .

Within a period of five years, the associated firm (BPC) in the Middle East has changed status
from being outside the scope of NTR's core business to become the group's only core busi-
ness. There is no doubt that today the associated company BPC Group is the primary activity
in the NTR Group. •

As noted in Chapter 2, IAS 1 does not require a detailed income statement; only
a few items must be included. In most cases, however, the income statement pro-
vided by companies is fairly detailed. Carlsberg, as shown in Table 4.1, is a case in
point. If a comparison is made between Carlsberg's income statement and the mini-
mum requirement as laid out in IAS 1, it is obvious that Carlsberg provides a much
more detailed income statement. It includes subtotals such as gross profit and operat-
ing profit and also provides information on 'special items'.
As shown in Chapter 2, an entity must normally present a classified balance sheet,
separating current assets and liabilities from non-current assets and liabilities. The
current/non-current split may only be disregarded if a presentation based on liquidity
provides information that is reliable and more relevant. In either case, notes that sepa-
rate the non-current assets and liabilities (above 12 months) from the current assets
and liabilities (maximum 12 months) are required.
Current assets include cash, cash equivalents, accounts receivable and inventories.
All other assets are non-current. Examples include property, plant and equipment.
Current liabilities are to be settled within the enterprise's normal operating cycle, or
which are due within 12 months, those held for trading, and those for which the entity
does not have an unconditional right to defer payment beyond 12 months. Other
liabilities are non-current. Examples include borrowings and provisions.
In the balance sheet non-current assets are classified separately from current assets
and non-current liabilities are separated from current liabilities. Thus, the balance
 Table 4.1 Carlsberg Group's consolidated income statement

Income statement (DKKm) Year 7 Year 8

Revenue 60,111 76,557
Excise duties on beer and soft drinks etc. -15,361 -16,613
Net revenue 44,750 59,944

Cost of sales -22,423 -31,248

Gross profit 22,327 28,696

Sales and distribution costs -14,528 -17,592

Administrative expenses -3,123 -3,934
Other operating income 933 1,178
Other operating expenses -448 -450
Share of profit after tax, associates 101 81
Operating profit before special items 5,262 7,979

Special items, income 0 0

Special items, costs -427 -1,641
Operating profit 4,835 6,338

Financial income 651 1,310

Financial expenses -1,852 -4,766
Profit before tax 3,634 2,882

Corporation tax -1,038 324

Consolidated profit 2,596 3,206

sheet does not specifically distinguish between operating assets and financial assets
nor does it separate operating liabilities from financial liabilities. To illustrate this
point, Carlsberg's balance sheet is shown in Table 4.2. Carlsberg's non-current assets,
current assets, non-current liabilities and current liabilities may all contain operating
as well as financing items. For example, current liabilities include operating (e.g. trade
payables) as well as financing activities (e.g. borrowings).

The analytical Income statement

The analytical income statement requires every accounting item to be classified as
belonging to either 'operations' or 'finance'. The purpose of dividing the accounting
items in this way is to obtain a better knowledge of the different sources of value crea-
tion in a firm. For example, investors consider operating profit as the primary source
of value creation and in most cases they value operations separately from finance
activities. Lenders consider operating profit as the primary source to support servicing
of debt. Thus, analysts spend time on reformulating the income statement and balance
Table 4.2 Carlsberg Group's balance sheet

Assets (DKKm) Year 7 Year 8

Non-current assets
Intangible assets 21,205 84,678
Property, plant and equipment 22,109 34,043
Investments in associates 622 2,224
Securities 123 118
Receivables 1,476 1,707
Deferred tax assets 733 1,254
Retirement benefit plan assets 11 2
Total non-current assets 46,279 124,026

Current assets
Inventories 3,818 5,317
Trade receivables 6,341 6,369
Tax receivables 62 262
Other receivables 1,453 3,095
Prepayments 950 1,211
Securities 34 7
Cash and cash equivalents 2,249 2,857
Receivables from associates
Total current assets 14,907 19,118

Assets held for sale 34 162

Total assets 61,220 143,306

Equity and liabilities (DKKm)

Equity
Share capital 1,526 3,051
Reserves 17,095 52,470
Equity, shareholders in Carlsberg A/S 18,621 55,521

Minority interests 1,323 5,230

Total equity 19,944 60,751
 Table 4.2 (continued)
Equity and liabilities (DKKm) Year 7 Year 8
Non-current liabilities
Borrowings 19,385 43,230
Retirement benefit obligations 2,220 1,793
Deferred tax liabilities 2,191 9,803
Provisions 249 1,498
Other liabilities 20 263
Total non-current liabilities 24,065 56,587

Current liabilities
Borrowings 3,869 5,291
Borrowings from associates
Trade payables 5,833 7,993
Deposits on returnable packaging 1,207 1,455
Provisions 494 677
Corporation tax 197 279
Other liabilities etc. 5,611 9,905
Total current liabilities 17,211 25,600

Liabilities, assets held for sale 368

Total liabilities 41,276 82,555

Total equity and liabilities 61,220 143,306

sheet so that they reflect the contribution from operating and financing activities,
respectively. This idea is illustrated in Table 4.3. The financial data in the tabulation is
also used in Chapter 2 (see page 43) and the analytical income statement and balance
sheet can be followed all the way back to the bookkeeping transactions shown there.

Table 4.3
Income statement
Revenues 200
Operating expenses -90
Earnings before interest and taxes (EBIT) 110
Financial income 5
Financial expenses -15
Earnings before tax (EBT) 100
Corporation tax -30
Net earnings 70
 Operating earnings is a key performance measure, as it shows a firm's profit from
its core business regardless of how it has been financed. Generally, operating earnings
can be measured both before and after tax. While earnings before interest and tax
(EBIT) measures operating profit before tax, net operating profit after tax (NOPAT)
is an after tax measure.
While EBIT is reported in the example, NOPAT is not disclosed. This implies that
the analyst has to deduct tax on EBIT to obtain NOPAT. Since reported tax is posi-
tively affected by net financial expenses (i.e. a firm pays less in taxes as financial
expenses are tax deductible) it is necessary to add back the tax advantage that the
net financial expenses offer (tax shield). This is highlighted in Table 4.4. The effective
corporate tax rate is calculated as

Table 4.4

Effective corporate tax rate, t 30.0%

Revenues 200

Operating expenses -90

EBIT 110

Taxes on EBIT -33

NOPAT 77

Net financial expenses -10

Tax savings from debt financing 3

Net financial expenses after tax -7

Net earnings (operating earnings after tax + net financial expenses after tax) 70

As illustrated in the example, tax savings from net financial expenses amounts to 3 (tax
rate × net financial expenses). Thus, taxes on EBIT equal 33 (30 + 3). Alternatively,
tax on operating earnings can be calculated as 110 × 30% = 33.

The analytical balance sheet

In order to match the items in the analytical income statement with the related items
in the analytical balance sheet, items marked as operating ('O') and financing ('F')
activities, in the income statement, must be marked the same way in the balance sheet.
For example, if earnings from 'share of profit of associates' are labelled as 'operations'
in the income statement the matching item 'investments in associates' in the balance
sheet must also be classified as an operating activity.
The combined investment in a company's operating activities is denoted 'invested
capital' or 'net operating assets' and equals the sum of operating assets minus oper-
ating liabilities. Operating liabilities such as trade payables reduce the need for
(interest-bearing) debt and are therefore deducted from operating assets. Invested
capital is defined as follows:
Invested capital represents the amount a firm has invested in its operating activities
and which requires a return.
The calculation of invested capital is illustrated in Table 4.5. You can see from the
example that the accounting item 'cash and cash equivalents' is treated as finance,
while the remaining assets are considered as operating assets. Furthermore, 'accounts
Table 4.5
Assets (average figures) Type
Intangible and tangible assets 268 O
Total non-current assets 268
Inventories 325 O
Accounts receivables 57 O
Cash and cash equivalents 50 F
Total current assets 432
Total assets 700

Equity and liabilities (average figures)

Equity 400 F
Loans and borrowings 100 F
Total non-current liabilities 100
Loans and borrowings 100 F
Tax payable 15 O
Accounts payable 85 O
Total current liabilities 200
Total equity and liabilities 700

Invested capital
Total assets 700
Cash and cash equivalents -50
Accounts payables and tax payable -100
Invested capital (net operating assets) 550

Invested capital
Equity 400
Loans and borrowings (non-current) 100
Loans and borrowings (current) 100
Cash and cash equivalents -50
Interest-bearing debt net 150
Invested capital (financing) 550
Note: O = operations, F = financing
payable' and 'tax payable' are operating liabilities that are considered as 'interest free
loans', which can be subtracted from the operating assets. The deduction of operat-
ing liabilities from operating assets envision that the need for financing is reduced;
the higher the amount of operating liabilities the less a firm needs to borrow to
finance its activities. This is also reflected when examining the two sources used to
financing invested capital. Only shareholders equity and (net) interest-bearing debt
are included as financing items - both sources of financing that require a return. In
summary, invested capital may either be regarded as net operating assets or funds
used to finance operations, which is the sum of equity and net interest-bearing debt.

Classification of accounting items when defining invested capital

While the majority of accounting items are easily classified as either being part of
operations or part of financing, a number of accounting items need to be carefully
considered before you can decide whether they belong to operations or finance. Those
items include:
• Special items
• Tax on ordinary activities
• Investment in associates and related income and expenses from associates
• Receivables and payables to group enterprises and associated firms
• Cash and cash equivalents
• Prepayment and financial income as part of core operation
• Exchange rate differences
• Derivative financial instruments
• Minority interests
• Retirement benefits
Tax payable.
In practice, a number of different accounting items fall within the categories
just listed. However, at the same time, similar deliberations can be applied to other
accounting items not included in the list.
We will now look at the accounting items individually and discuss the classification
issues below.

Special items (other income and expenses)

This accounting item includes activities that are indirectly part of a firm's core busi-
ness. A study of accounting practices shows that special items typically contain a
number of different sources of income and expenses including:
• Gains and losses from sale of non-current assets
• Royalty/licence income
• Restructuring costs
• Rent income and expenses from property (lease income and expenses)
• Write-down (impairment) of assets
• Other (unspecified).
From an analytical point of view special items raise two fundamental issues. First, it must
be decided whether an item should be categorised as part of operations or finance. In
most cases, we believe, special items should be categorised under operations. However,
there are examples where special items should be treated as a financing activity. For
example, if property is not regarded as part of a firm's core business, it could be argued
that an alternative to investing in this property is to invest in securities, in which case the
accounting item 'lease income' should be classified as a financing activity.
Second, the analyst must decide whether the accounting item is unusual or if it is
part of the firm's normal operations. Analysts should ask themselves if, for example,
gains of disposal of assets and restructuring costs are a necessary part of a firm's day-
to-day operations. It's hard to imagine that a firm does not have to adjust its organisa-
tion to changing market conditions, general upturns and downturns etc. This explains
why restructuring costs must be expected to recur frequently; although not necessar-
ily every year. From this point of view it seems reasonable to classify (most) 'special
items' as part of core operation. This issue is discussed further in Chapter 13.

Tax on ordinary activities (operating profit)

The accounting item corporation tax (income tax expense) relates to operating as
well as financing items. Since accounting practice does not distinguish between tax on
operations and tax on financial items, there is a need to divide income tax expenses
into tax on operations and tax on financing. This segregation may be accomplished by
estimating the tax shield from net financial expenses. Tax benefits from net financial
expenses can be calculated as follows:

In determining the tax shield the analyst has to decide whether to use the marginal
tax rate or the effective tax rate as a proxy for the corporate tax rate. Since the tax
shield is based on the marginal tax rate it is tempting to suggest the marginal tax rate.
However, borrowing in a subsidiary in a foreign country with a different local tax rate
will affect the value of the tax shield. In this case it may be relevant to use the local
marginal tax rate on the part of debt belonging to the foreign subsidiary. Information
about debt in foreign entities is hardly ever available for outsiders (analysts) and the
analysts have to accept the inaccuracy by using the home country's corporate tax rate.
Alternatively the effective tax rate may be used. It expresses the average tax rate levied
on all income in the firm and reflects different tax rates within the group. Therefore,
if the effective tax rate is used the analyst assumes that operating income as well as
financial income are taxed by the same rate.

Investment in associates and related income and expenses from associates

If investments in associates are regarded as part of a firm's core business, the related
income and expenses should be included in operating income. Furthermore, invest-
ments in associates should be included in invested capital. This may be the case if, for
example, the associated company is a subcontractor or a sales unit that sells the group's
products. To the contrary, if an investment in an associate is not regarded as a part of
the core business, it should be considered as a financial item (excess cash not needed to
operate the firm) and it should be subtracted in calculating net interest-bearing debt.

Receivables and payables to group enterprises and associated firms

Loans provided by associated firms are often interest-bearing and should be classified
as part of financing activities. However, if debt is part of usual intercompany trading,
the accounting item should be classified as capital invested in operations.

Cash and cash equivalents

Cash and cash equivalents are often considered as excess cash, which in reality can
either be paid out as dividends, used to buy back own shares, or used to repay debt
without affecting the underlying operations. Reported cash (and cash equivalents),
however, may include cash that is needed in day-to-day operations (i.e. operating
cash). Thus, cash can be separated into operating cash and excess cash. Cash and
cash equivalents reported in firms' balance sheets do not distinguish between operat-
ing cash and excess cash. In practice, different rules of thumbs are used to estimate
operating cash. However, it must be acknowledged that these rules lead to imprecise
and vast different results. The analysts must rely on their own knowledge, and on any
additional information supplied by the firm in question, to estimate operating cash in
practice.
We argue that the consequences of reclassification of operating cash are likely to be
modest in most cases. If the cash position remains stable across time it seems fair to
treat cash and cash equivalents as excess cash.

Prepayment and financial income as part of core operation

Some firms like insurance companies and travel agents are characterised by receiving
prepayment for their services. Likewise, their products are priced to reflect the return
on the prepaid cash. Their ability to earn a return on prepayments is an important ele-
ment in assessing operations of such companies.
Some firms within trade, service and manufacturing use a similar model. As part
of their business model they receive large prepayments. Since the 'cost' of prepay-
ment (if any) is already reflected in the reported operating profit (through lower
margins) we classify prepayment as an operating liability. In addition, we con-
sider reclassifying financial income (if any) from prepayment as part of operating
income. However, typically prepayment will be tied up in inventories and operating
expenses.
In a similar vein, in the car industry cheap loans are offered to customers support-
ing the sale of their products. Since these loans are offered to stimulate sales it seems
reasonable to classify these receivables as part of invested capital and the related inter-
est income as part of operating profit, given that it is a part of their core and ongoing
business model.

Exchange rate differences

IAS 21 'The Effects of Changes in Foreign Exchange Rates' states that:
Exchange differences arising on the settlement of monetary items or on translating
monetary items at rates different from those at which they were translated on initial
recognition during the period or in previous financial statements shall be recog-
nised in profit or loss in the period in which they arise.
Exchange rate differences are mostly recognised in the income statement as part of
financial income and expenses. Since exchange rate differences are related to both oper-
ating and financing activities it could be argued that exchange rate differences should
be separated into an operating and a financial component, respectively. Exchange rate
differences from operations are not reported separately from exchange rate differences
related to finance, which makes it difficult to make such a distinction.
If a firm faces a currency risk it may choose to hedge the risk using financial instru-
ments. Alternatively, the firm may choose not to hedge the currency risk. In this case,
the firm 'net' that the underlying exchange rate is moving in a favourable direction
from the time of the transaction and until the date of the payment. Whether a firm
hedges the currency risk depends upon its financial policies. In this light it seems rea-
sonable to classify exchange rate gains and losses as a finance activity. As exchange
rate gains and losses are already classified as financial items, there is no need to make
reclassifications.

Derivative financial instruments

A further issue related to financial items is gains - and losses on derivative financial
instruments. Derivative financial instruments are used to hedge financial risks includ-
ing exchange rate risks, as noted above, and interest rate risks. Derivatives are meas-
ured at cost at first recognition. Subsequently, they are measured at fair value, and
value adjustments are primarily recognised in the income statement. (An exception
is hedge accounting (IAS 39 'Financial Instruments: Recognition and Measurement').
IAS 39.46 lists the exceptions to using fair value as the measurement attribute.)
Often gains and losses from financial instruments (derivatives and debt instru-
ments) are tied to hedging of financial risks. Hedging of operating risks may occur
by, for example, hedging price movements on raw materials or hedging of next year's
sales revenues in foreign currencies. It's open to discussion whether gains and losses
from using derivatives should be divided into operating- and finance-related hedges,
respectively. Such a separation, however, is not recommended in practice. First, all
operating and finance hedges are regarded as being financial decisions. For the same
reason, gains and losses from derivatives should also be treated as part of financing
activities. Second, the accounting item 'gains and losses from hedging financial instru-
ments' hardly ever separate operating from financing activities, making it impossible
to divide the item in practice.

Minority interests
Minority interests represent the investment in subsidiaries not fully owned by the par-
ent company; that is the parent company owns less than 100% of the subsidiaries.
Minority interests share of profit or loss is reported on an after tax basis.
Minority interests must be recognised in the group accounts in some form or
another, as all assets and liabilities shall be recognised in full. From an analytical
perspective it is not the question if the accounting item is linked to operations, but
rather if minority interests should be included in interest-bearing debt or as a part
of equity.
There are strong arguments in favour of treating minority interests as equity capi-
tal. In valuation of firms the required rate of return from minority interests will be
different from the interest rate on debt, but likely to be close to the return required
by the other investors. In credit analysis minority interests are ranked alongside
investors in the parent company, and in case the firm goes bankrupt they will split
the remaining cash (after debt has been repaid) with investors in the parent com-
pany. Thus, minority interests are treated as equity capital. This view is modified in
Chapter 9.

Retirement benefits
For defined benefit plans an actuarial calculation is made of the present value of
future benefits under such a plan. The present value is determined on the basis of
assumptions about the future development in variables such as salary, interest rates,
inflation and mortality. The actuarial present value less the fair value of any plan
assets is recognised in the balance sheet. For example, if a firm's defined benefit plan is
underfunded, the underfunded part must be recognised as a liability. Since recognised
 retirement benefits are interest bearing (discounted to present value) it seems reason-
able to treat retirement benefits as a financing activity, i.e. as interest-bearing debt.

Tax payable
In the analytical example above, tax payable is regarded as an operating liability. Tax pay-
able arises because a firm pays too little in tax on account (for example, because realised
earnings are higher than expected) during the fiscal year. If the tax authorities impose an
interest charge on tax payable, when tax payable should be regarded as a financial item.

Carlsberg's NOPAT and invested capital

In this section, Carlsberg Group's annual accounts for a six-year period are reformu-
lated based on the above considerations. To help show this, Carlsberg Group's reported
income statements and balance sheets for the period are shown in Table 4.6.

Table 4.6 Carlsberg Group's income statements and balance sheets

Income statement (DKKm) Year 3 Year 4 Year 5 Year 6 Year 7 Year 8

Revenue 47,345 49,690 51,847 55,753 60,111 76,557
Excise duties on beer and soft drinks etc. -12,719 -13,406 -1 3,800 -14,670 -15,361 -16,613
Net revenue 34,626 36,284 38,047 41,083 44,750 59,944

Cost of sales -16,989 -18,065 -18,879 -20,151 -22,423 -31,248

Gross profit 17,637 18,219 19,168 20,932 22,327 28,696

Sales and distribution costs -12,172 -12,833 -13,332 -14,173 -14,528 -17,592
Administrative expenses -2,712 -2,807 -2,961 -3,065 -3,123 -3,934
Other operating income 575 612 876 660 933 1,178
Other operating expenses -465 -393 -448 -450
Share of profit after tax, associates 236 210 232 85 101 81
Operating profit before special items 3,564 3,401 3,518 4,046 5,262 7,979

Special items, income 0 0 0 602 0 0

Special items, costs -401 -598 -386 -762 -427 -1,641
Operating profit 3,163 2,803 3,132 3,886 4,835 6,338

Financial income 416 666 548 725 651 1,310

Financial expenses -891 -1,818 -1,788 -1,582 -1,852 -4,766
Profit before tax 2,688 1,651 1,892 3,029 3,634 2,882

Corporation tax -590 -382 -521 -858 -1,038 324

Consolidated profit 2,098 1,269 1,371 2,171 2,596 3,206
Table 4.6 (continued)
Assets (DKKm) Year 3 Year 4 Year 5 Year 6 Year 7 Year 8
Non-current assets
Intangible assets 5,661 19,489 20,672 21,279 21,205 84,678
Property, plant and equipment 19,131 20,435 20,355 20,367 22,109 34,043
Investments in associates 1,630 1,750 1,105 579 622 2,224
Securities 672 524 2,710 170 123 118
Receivables 2,136 1,290 1,235 1,139 1,476 1,707
Deferred tax assets 732 867 1,005 822 733 1,254
Retirement benefit plan assets 0 0 21 14 11 2
Total non-current assets 29,962 44,355 47,103 44,370 46,279 124,026

Current assets
Inventories 2,675 2,883 2,866 3,220 3,818 5,317
Trade receivables 6,212 6,290 5,979 6,108 6,341 6,369
Tax receivables 82 132 84 62 262
Other receivables 1,751 1,370 3,015 1,145 1,453 3,095
Prepayments 620 610 587 917 950 1,211
Securities 71 109 8 34 7
Cash and cash equivalents 5,165 1,758 2,240 2,490 2,249 2,857
Receivables from associates 327
Total current assets 16,750 13,064 14,928 13,972 14,907 19,118

Assets held for sale 0 279 328 109 34 162

Total assets 46,712 57,698 62,359 58,451 61,220 143,306

Equity and liabilities (DKKm) Year 3 Year 4 Year 5 Year 6 Year 7 Year 8
Equity
Share capital 1,278 1,526 1,526 1,526 1,526 3,051
Reserves 9,998 13,558 1 6,442 16,071 1 7,095 52,470
Equity, shareholders in Carlsberg A/S 11,276 15,084 17,968 17,597 18,621 55,521

Minority interests 6,630 1,708 1,528 1,390 1,323 5,230

Total equity 17,906 16,792 19,496 18,987 19,944 60,751

Non-current liabilities
Borrowings 10,883 21,708 17,765 16,241 19,385 43,230
Retirement benefit obligations 600 1,889 2,061 2,006 2,220 1,793
Deferred tax liabilities 1,167 2,334 2,362 2,425 2,191 9,803
Equity and liabilities (DKKm) Year 3 Year 4 Year 5 Year 6 Year 7 Year 8

Provisions 360 189 195 366 249 1,498

Other liabilities 212 18 65 54 20 263
Total non-current liabilities 13,222 26,138 22,448 21,092 24,065 56,587

Current liabilities
Borrowings 4,985 3,357 8,213 6,556 3,869 5,291
Borrowings from associates 14
Trade payables 4,173 4,074 4,513 5,147 5,833 7,993
Deposits on returnable packaging 1,234 1,260 1,224 1,159 1,207 1,455
Provisions 141 481 561 466 494 677
Corporation tax 464 710 720 187 197 279
Other liabilities etc. 4,573 4,886 5,174 4,856 5,611 9,905
Total current liabilities 15,584 14,768 20,405 18,371 17,211 25,600

Liabilities, assets held for sale 10 1 368

Total liabilities 28,806 40,906 42,863 39,464 41,276 82,555
Total equity and liabilities 46,712 57,698 62,359 58,451 61,220 143,306

You can see from Table 4.6 that Carlsberg's classification of accounting items in the
income statement and balance sheet, does to a large extent, separate operating items
from financing items, but adjustments still need to be made. For example, total cor-
poration tax relates to operating as well as financing activities. Also, provisions and
other liabilities etc. may be classified as operating debt and/or interest-bearing debt
depending on the actual content of those accounting items.
In Table 4.7 we have presented the reformulated income statement and balance
sheet for Carlsberg Group are provided. The notes next to selected accounting items
are references to the discussion that follows.

Table 4.7 Carlsberg Group's analytical income statement and balance sheet
Analytical income statement
Notes Income statement (DKKm) Year 3 Year 4 Year 5 Year 6 Year 7 Year 8
Revenue 47,345 49,690 51,847 55,753 60,111 76,557
Excise duties on beer and soft -12,719 -13,406 -13,800 -14,670 -15,361 -16,613
drinks etc.
Net revenue 34,626 36,284 38,047 41,083 44,750 59,944

1 Cost of sales -15,527 -16,465 -17,218 -18,426 -20,787 -28,756

Gross profit 19,099 19,819 20,829 22,657 23,963 31,188

1 Sales and distribution costs -11,298 -12,095 -12,623 -13,317 -13,668 -16,814
Table 4.7 (continued)

Analytical income statement

Notes Income statement (DKKm) Year 3 Year 4 Year 5 Year 6 Year 7 Year 8
1 Administrative expenses -2,533 -2,596 -2,777 -2,913 -2,969 -3,765
Other operating income 575 612 876 660 933 1,178
Other operating expenses 0 0 -465 -393 -448 -450
3 Share of profit after tax, associates 236 210 232 85 101 81
3 Tax on profit from associates 101 90 90 33 34 27
Operating profit before special 6,180 6,040 6,162 6,812 7,946 11,445
items

2 Special items, income 0 0 0 602 0 0

1,2 Special items, costs -382 -583 -386 -560 -324 -1,309
EBITDA 5,798 5,457 5,776 6,854 7,622 10,136

1 Depreciation and amortisation -2,534 -2,564 -2,554 -2,935 -2,753 -3,771

EBIT 3,264 2,893 3,222 3,919 4,869 6,365

Corporation tax -590 -382 -521 -858 -1,038 324

3 Tax on profit from associates -101 -90 -90 -33 -34 -27
4 Tax shield, net financial expenses -143 -346 -347 -240 -300 -864
NOPAT 2,431 2,075 2,264 2,788 3,497 5,798

Financial income 416 666 548 725 651 1,310

Financial expenses -891 -1,818 -1,788 -1,582 -1,852 -4,766
4 Tax on net financial expenses 143 346 347 240 300 864
Net financial expenses -333 -806 -893 -617 -901 -2,592
Group profit after tax 2,098 1,269 1,371 2,171 2,596 3,206
Invested capital (DKKm)
Non-current assets
Intangible assets 5,661 19,489 20,672 21,279 21,205 84,678
Property, plant and equipment 19,131 20,435 20,355 20,367 22,109 34,043
3 Investments in associates 1,630 1,750 1,105 579 622 2,224
Receivables 2,136 1,290 1,235 1,139 1,476 1,707
4 Deferred tax assets 732 867 1,005 822 733 1,254
Total non-current assets 29,290 43,831 44,372 44,186 46,145 123,906

Current assets
Inventories 2,675 2,883 2,866 3,220 3,818 5,317
6 Trade receivables 6,212 6,290 5,979 6,108 6,341 6,369
4 Tax receivables 0 82 132 84 62 262
 Analytical income statement
Notes Invested capital (DKKm) Year 3 Year 4 Year 5 Year 6 Year 7 Year 8
6 Other receivables 1,751 1,370 3,015 1,145 1,453 3,095
3 Receivables from associates 327 0 0 0 0 0
Prepayments 620 610 587 917 950 1,211
Total current assets 11,585 11,235 12,579 11,474 12,624 16,254

Non-interest-bearing debt
4 Deferred tax liabilities 1,167 2,334 2,362 2,425 2,191 9,803
Provisions 360 189 195 366 249 1,498
Other liabilities 212 18 65 54 20 263
Trade payables 4,173 4,074 4,513 5,147 5,833 7,993
Deposits on returnable packaging 1,234 1,260 1,224 1,159 1,207 1,455
Provisions 141 481 561 466 494 677
Corporation tax 464 710 720 187 197 279
7 Other liabilities etc. 4,374 3,828 4,043 4,157 4,687 6,497
3 Borrowings from associates 14 0 0 0 0 0
Total non-interest-bearing debt 12,139 12,894 13,683 13,961 14,878 28,465

Invested capital (net operating 28,736 42,172 43,268 41,699 43,891 111,695
assets)
Total equity 17,906 16,792 19,496 18,987 19,944 60,751

Net-interest-bearing debt
Borrowings 10,883 21,708 1 7,765 16,241 19,385 43,230
8 Retirement benefit plan obligations 600 1,889 2,061 2,006 2,220 1,793
Borrowings 4,985 3,357 8,213 6,556 3,869 5,291
9 Liabilities, assets held for sale - - 10 1 - 368
7 Interest payable 199 425 526 337 321 681
7 Derivatives - 633 605 362 603 2,727
Interest-bearing debt 16,667 28,012 29,180 25,503 26,398 54,090

Securities 672 524 2,710 170 123 118

8 Retirement benefit plan assets - - 21 14 11 2
Securities - 71 109 8 34 7
5 Cash and cash equivalents 5,165 1,758 2,240 2,490 2,249 2,857
9 Assets held for sale - 279 328 109 34 162
Interest-bearing assets 5,837 2,632 5,408 2,791 2,451 3,146

Net-interest-bearing debt 10,830 25,380 23,772 22,712 23,947 50,944

Invested capital 28,736 42,172 43,268 41,699 43,891 111,695

Note 1: Depreciation, amortisation and impairment losses - property, plant and equipment
and intangible assets
In the Carlsberg Group's income statement depreciation, amortisation and impairment losses
are recognised in the function to which they belong. In the notes depreciation and impair-
ment losses are specified for a six-year period as shown in Table 4.8. By reclassifying deprecia-
tion, amortisation and impairment losses (in the analytical income statements) it is possible to
calculate earnings before interests, taxes, depreciations and amortisation (EBITDA). This earn-
ings measure is useful in calculating the cash flow statement. Likewise, EBITDA is a popular
earnings measure in valuation of firms and credit analysis. Thus, cost of sales, sales and distri-
bution costs, administrative expenses and special items in the analytical income statement are
exclusive of depreciation, amortisation and impairment losses.

Table 4.8 Carlsberg Group's annual report - note on depreciation, amortisation

and impairment

DKKm Year 3 Year 4 Year 5 Year 6 Year 7 Year 8

Cost of sales 1,462 1,600 1,661 1,725 1,636 2,492

Sales and distribution expenses 874 738 709 856 860 778
Administrative expenses 179 211 184 152 154 169
Special items 19 15 0 202 103 332
Total 2,534 2,564 2,554 2,935 2,753 3,771

Note 2: Special items, net

Special items vary substantially across time. In year 7 special items amounted to minus
DKK 427 million (DKK 324 million exclusive of depreciation and impairment losses), while
in year 8 special items represented a net expense of DKK 1,641 million (net expense of DKK
1,309 million exclusive of depreciation and impairment losses). In accounting policies applied
Carlsberg states that:
The use of special items entails Management judgement in the separation from other items in
the income statement, cf. the accounting policies. When using special items, it is crucial that
these constitute significant items of income and expenses which cannot be attributed directly to
the Group's ordinary operating activities but concern fundamental structural or process-related
changes in the Group and any associated gains or losses on disposal. Management carefully
considers such changes in order to ensure the correct distinction between the Group's operat-
ing activities and restructuring of the Group made to enhance the Group's future earnings
potential. Special items also include other significant non-recurring items, such as impairment
of goodwill.

Special items are specified in Carlsberg Group's annual report as shown in Table 4.9, and,
as shown in the notes, special items in year 7 and year 8 include impairment expenses and
restructuring costs. It could be argued that those items should be included in earnings from
operations and not separately classified as special items. For instance, every firm needs to
adjust its organisation and restructure, in order to stay competitive. This suggests that restruc-
turing should be classified as an operating expense. Accordingly, none of the items classified
as special items should be classified as part of financial income or expenses.
The note for special items provides information about which function those special items
relate to. Thus, in year 8, cost of goods sold would be negatively affected by DKK 919 mil-
lion if special items were reclassified as part of recurring operation. This issue will be further
discussed in the chapters concerning accounting quality.
Table 4.9 Carlsberg Croup's annual report- note on special items

NOTE 7 SPECIAL ITEMS

DKKm Year 8 Year 7

Impairment, Türk Tuborg - -100

Impairment of Leeds Brewery, Carlsberg UK -197 -
Impairment of Braunschweig Brewery, Carlsberg Deutschland -135 -
Impairment losses and expenses relating to withdrawal from the market - 7
for discount soft drinks in Denmark (year 7: reversal of provision)
Loss on disposal of Türk Tuborg -232 -
Provision for onerous malt contracts -245 -
Relocation costs, termination benefits and impairment of non-current -19 14
assets in connection with new production structure in Denmark
(year 7: reversal of provision)
Termination benefits and impairment of non-current assets in -30 -3
connection with new production structure at Sinebrychoff, Finland
Termination benefits etc. in connection with Operational Excellence -150 -190
programmes
Termination benefits and expenses, transfer of activities to Accounting -16 -29
Shared Service Centre in Poland
Restructuring, Carlsberg Italia -93 -67
Restructuring, Brasseries Kronenbourg, France -291 -
Restructuring, Ringnes, Norway -26 -
Costs in connection with outsourcing of distribution, Carlsberg Sverige - -26
Other restructuring costs etc., other entities -138 -33
Integration costs related to acquisition of part of the activities in S&N -69 -
Special items, net -1,641 -427
If special items had been recognised in operating profit before special
items, they would have been included in the following items:
Cost of sales -919 -145
Sales and distribution expenses -114 -135
Administrative expenses -226 -44
Other operating income 27 29
Other operating expenses -409 -126
-1,641 -421
Impairment of goodwill - -6
Special items, net -1,641 -427
Special items constitute significant items that cannot be attributed directly
to the Group's ordinary operating activities and are significant over time
 Note 3: Investments in associates (including tax on profits)
Based on Carlsberg Group's financial reporting most associated companies seem to be involved
in brewery-related activities. Carlsberg also classify 'share of profit after tax, associates' as part
of operating profit before special items. This supports the idea that income from associates
(Table 4.10) should be classified as part of operating profit. Accordingly, investments in asso-
ciated firms, from the balance sheet, should be classified as part of operation.

Table 4.10 Carlsberg Group's annual report - note on associates

NOTE 18 ASSOCIATES
Carlsberg Group share, Year 8
DKKm Revenue Profit Assets Liabilities Ownership Profit Equity
for the interest for the
year year
after tax after tax
Key figures for associates:
Tibet Lhasa Brewery Co. 217 50 375 23 33% 16 127
Lanzhou Huanghe Jianjiang 333 18 377 118 30% 5 82
Brewery Company
Hanoi Beer Company _ - - - 16.00% 11 578
Chongqing Brewery - - - - 1 7.50% - 1,013
Other associates, Asia 382 44 351 155 30-49.8% 21 85
International Breweries 342 -60 671 449 16% -11 35
Nuuk Imeq A/S 153 27 230 85 31.90% 9 16
Other 941 195 1,857 1,347 20-25% 30 288
81 2,224

Since Carlsberg's share of profit from associates is measured after tax we need to calculate
'tax on profit from associates'. This allows us to calculate operating profit before and after tax,
respectively, on income from associates. In Table 4.11 we use the marginal corporate tax rate
for Carlsberg from year 3 to year 8.

Table 4.11 Carlsberg's share of profit, associates

DKKm Year 3 Year 4 Year 5 Year 6 Year 7 Year 8

Corporation tax, marginal 30% 30% 28% 28% 25% 25%

Share of profit after tax, associates 236 210 232 85 101 81

Tax on profit from associates 101 90 90 33 34 27

Share of profit before tax, associates 337 300 322 118 135 108

Note 4: Taxes
In Carlsberg's annual report corporation tax (income tax) is recognised as a single item in
the income statement. Corporate tax is related to operating as well as financial items (financial
income and financial expenses). The analysts must therefore estimate taxes from operating
income and net financial expenses. As mentioned above, this estimate may be based on dif-
ferent assumptions. Typically the analyst must choose between using the effective tax rate and
the marginal tax rate. Since Carlsberg's taxable income is sufficiently large to cover net finan-
cial expenses, the marginal tax rate seems to be the right choice. However, there are some
caveats in the case of Carlsberg. First, the company may have borrowed in countries with tax
rates that differ from Carlsberg's domestic corporate tax rate (25% in recent years). Second,
financial items include income and expenses other than just interest expenses (or income).
As seen from the notes on financial income and financial expenses (Table 4.12), account-
ing items such as dividends, foreign exchange gains (and losses), fair value adjustments,
impairment of financial assets and other financial income and expenses are also recognised as
financial items. The notes do not disclose whether such financial items are taxable, and if so

Table 4,12 Carlsberg's financial income and expenses

NOTE 8 FINANCIAL INCOME
DKKm Year 8 Year 7
1
Interest income 249 186
Dividends from securities 21 19
Fair value adjustments of financial instruments, net, cf. note 36 556 -
Foreign exchange gains, net - 55
Realised gains on disposal of associates and securities 126 43
Expected return on plan assets, defined benefit plans 308 321
Other financial income 50 27
Total 1,310 651
1
Interest income relates to interest from cash and cash equivalents.

NOTE 9 FINANCIAL EXPENSES

DKKm Year 8 Year 7
Interest expenses 2,635 1,262
Fair value adjustments of financial instruments, net, cf. note 36 - 65
Realised foreign exchange losses, net 1,358 -
Realised losses on disposal of securities 5 20
Impairment of financial assets 3 4
Interest cost on obligations, defined benefit plans 340 323
Loss on other financial instruments - 73
Other financial expenses 425 105
Total 4,766 1,852
In addition, fair value adjustments of financial instruments were affected by DKK 110 million
related to the inefficient part of the currency options acquired to hedge the GBP exposure
on the S&N transaction.
Other financial expenses consist mainly of payment to establish credit facilities and fees for
unutilised draws on these facilities. Approximately DKK 315 million relates to up-front and
commitment fees etc. from establishing of financing related to the acquisition of part of the
activities in S&N.
at which tax rate. As no other information is provided in the financial statements, we use the
marginal tax rate when estimating the tax shield.
Generally, deferred tax assets arise from tax loss carry forwards or assets (liabilities) that are
recognised at a lower (higher) value in the balance sheet than for tax purposes. According to the
annual report, DKK 3,106 million out of DKK 3,590 million relates to tax loss carry forwards.
Carlsberg does not provide information that enables the analyst to decide if tax loss carry
forwards are linked to operations or financing. In most cases, however, tax assets are directly
related to operations (differences between valuing assets and liabilities for accounting pur-
poses and tax purposes), even though tax deficits may arise from financial activities like losses
from disposal of securities or financial expenses that cannot be contained within positive
earnings from operation. Deferred tax assets will be classified as operations. Notice, however,
that Carlsberg do not include deferred tax assets in their definition of invested capital.
Deferred tax liabilities are likewise treated as operating items, arising as a consequence of
temporary differences between book values and tax values. If we refer to the consolidated
financial statements in Carlsberg's annual report, it is evident that deferred tax liabilities relate
to intangible and tangible assets, and, thus, should be treated as an operating liability.
Note 5: Cash and cash equivalents
Firms need operating cash that can be used to finance upcoming investments, build up inven-
tories or to pay unforeseen bills. The share of cash holdings that is needed for operations is
not disclosed. However, Carlsberg treats cash and cash equivalent as excess cash when defin-
ing their invested capital for reporting purposes. This indicates that cash and cash equivalents
should be treated as excess cash.
A closer look at Carlsberg's cash and cash equivalents reveal that they remain lower at
year-end (fourth quarter) than in most other quarters. This indicates that cash and cash
equivalents at year end are not invested in operating assets during the financial year. It seems,
therefore, reasonable to classify all cash and cash equivalents at year-end as excess cash.

Note 6: Trade receivables and other receivables

Receivables are specified in Carlsberg Group's annual report, note 20 (Table 4.1 3).

Table 4.13 Group's annual report year 8 - note on receivables

NOTE 20 RECEIVABLES
DKKm Year 8 Year 7
Receivables are included in the balance sheet as follows:
Trade receivables 6,369 6,341
Other receivables 3,095 1,453
Total current receivables 9,464 7,794
Non-current receivables 1,707 1,476
Total 11,171 9,270

Trade receivables comprise invoiced goods and services as well as short-term loans to
customers in the on-trade.
Other receivables comprise VAT receivables, loans to associates, interest receivables and
other financial receivables.
Non-current receivables consist mainly of on-trade loans. Non-current receivables fall due
more than one year from the balance sheet date, of which DKK 1 71 million (year 7: DKK
478 million) falls due more than five years from the balance sheet date.
 Trade receivables comprise invoiced goods and services plus short-term loans to custom-
ers. Non-current receivables consist mainly of on-trade loans falling due more than one year
from the balance sheet date. When studying the applied accounting policies more closely it
becomes clear that Carlsberg considers on-trade loans as operating in nature. This implies
that the interest on these loans should be recognised in (other) operating income. However,
this piece of information is not disclosed in the annual report.
Other receivables comprise VAT receivables, loans to associates, interest receivables and
other financial receivables. While VAT receivables are part of operations, loans to associates,
interest receivables, and other financial receivables are likely candidates for being treated
as interest bearing (i.e. financial items). However, without further notes on other receivables
it is not possible to separate VAT receivables from loans to associates, interest receivables, and
other financial receivables. In this case, analysts must make their own assumptions. In the
example, we treat other receivables as operating assets.

Note 7: Other liabilities, etc.

The accounting item other liabilities consists of excise duties and VAT payable, staff costs pay-
able, interest payable, fair value of hedging instruments, liabilities related to the acquisition of
entities, amounts owed to associates, deferred income and 'other' (see Table 4.14).

Table 4.14 Group's annual report - note on other liabilities

NOTE 29 OTHER LIABILITIES ETC.

DKKm Year 8 Year 7
Other liabilities are recognised in the balance sheet as follows:
Non-current liabilities 263 20
Current liabilities 9,905 5,611
Total 10,168 5,631

Other liabilities by origin:

Excise duties and VAT payable 1,953 1,889
Staff costs payable 1,434 980
Interest payable 681 321
Fair value of hedging instruments (derivatives) 2,727 603
Liabilities related to the acquisition of entities 215 90
Amounts owed to associates 2 2
Deferred income 1,172 171
Other 1,984 1,575
Total 10,168 5,631

Interest payable and fair value of hedging instruments are financial liabilities (i.e. included in
interest-bearing debt). The remaining other liabilities are classified as capital invested in opera-
tions. This implies that we treat 'other liabilities' under this heading as operating liabilities.
Note 8: Retirement benefit plan assets and obligations
Retirement benefit plans relate to defined benefit plans. For those plans Carlsberg bears the
risk associated with future developments in inflation, interest rates, mortality and disability.
 Retirement benefit costs from defined benefit plans are recognised in the income statement
as staff costs (amounting to DKK 139 million in year 8 and DKK 162 million in year 7).
Ideally, if the benefit plans were fully funded, net obligations (present value of funded
plans less fair value of plan assets) should amount to zero. As benefit plan assets is a way of
funding Carlsberg's pension obligations and the pension liabilities are interest bearing (dis-
counted to present value), it is logical to treat benefit plan assets and obligations as part of
financing activities.
Note 9: Assets held for sale
Carlsberg classifies assets held for sale and the associated liabilities as separate items in the
balance sheet.
We would classify assets held for sale as a financial item (reduction of net interest-bearing
debt), as the disposal of those assets will reduce Carlsberg's borrowings (or increase cash and
cash equivalents). Therefore, we exclude assets held for sale and related liabilities from opera-
tion and treat them as part of financing.

Carlsberg's invested capital

For comparison purposes invested capital as reported by Carlsberg in year 8 is com-
pared with our calculation of invested capital for the same year (Table 4.15). As
can be seen we calculate a lower invested capital than Carlsberg. Roughly three
accounting items explain the difference: (a) deferred tax, (b) other receivables, and
(c) provisions.

(a) Carlsberg excludes deferred tax assets from invested capital while we regard
deferred tax assets as operating assets. Furthermore, they do not treat deferred tax
liabilities as an operating liability as we do. One explanation for these differences
can be that Carlsberg considers deferred tax assets and liabilities as equity equiva-
lents. The basic idea is that deferred taxes will never have to be paid and as such
should not be considered as an asset or liability but rather as an equity equivalent
item. This issue will be further discussed in Chapters 14 and 15.
(b) As may be recalled we did not have the information necessary to separate other
receivables into operating and financing activities, respectively. According to
Carlsberg's calculation of invested capital loan to associates (6) and interest
income from receivables (1,470) make up 1,476. In our calculation of invested
capital we did not exclude these assets from other receivables.
(c) Carlsberg excludes restructuring from provisions (603). From an analytical stand-
point is it not clear why restructuring is treated differently from other types of
provisions such as losses in connection with Carlsberg UK's outsourcing of the
servicing of draught beer equipment, warranty obligations, onerous contracts,
ongoing disputes, lawsuits etc.

On the whole, reformulating financial statements for analytical purposes can be a

daunting task. As shown in the above example, invested capital (and the split between
operating earnings after tax (NOPAT) and net financial expenses after tax for that
matter) may be different depending upon the underlying assumptions. In the case of
Carlsberg, the notes were relatively detailed and Carlsberg did calculate and specify
invested capital. Such detailed information is often not available, and analysts are left
to make judgements based on their own knowledge.
 Table 4.15 Carlsberg Group's invested capital

Carlsberg Group's invested capital year 8

DKKm Carlsberg's Our Differences

calculation calculations

Total assets 143,306 143,306 0

Deferred tax -1,254 -1,254

Loan to associates -6 -6

Interest income receivables etc. -1,470 -1,470

Securities -125 -125 0

Cash and cash equivalents -2,857 -2,857 0

Assets held for sale -162 -162 0

Retirement benefit plan assets -2 2

Total operating assets 137,432 140,160 -2,728

Trade payables -7,993 -7,993 0

Deposits on returning packaging -1,455 -1,455 0

Provisions, excluding restructuring -1,572 -2,175 603

Corporation tax -279 -279 0

Deferred income -1,172 -1,172 0

Finance lease liabilities, in borrowings -47 -47

Other liabilities -5,588 -5,588 0

Deferred tax liabilities -9,803 9,803

Total operating liabilities -18,106 -28,465 10,359

Invested capital 119,326 111,695 7,631

Conclusions
The purpose of separating accounting items into operation and financing is to high-
light the sources of value creation, which will be useful to most of a firm's stakehold-
ers. For equity - and debt capital providers - forecasting will be easier and the board
of directors will be able to measure value creation in a given period in order to deter-
mine performance related bonuses etc.
The most important problems in dividing accounting items into operation and
financing are:
• The definition of core operation is not unequivocal
• The income statement and balance sheet do not distinguish clearly between operat-
ing and financing activities
• The notes are not sufficiently informative.
 The two basic rules to remember are:
1 Items in the income statements should match the items in the balance sheet. For
example, if 'investments in associates' are classified as an operating activity, so must
'profit from associates'.
2 Invested capital should be defined consistently over time and across firms.
It is worth noting here that additional matters of dispute may arise in relation to
dividing accounting items into operating and financing activities. As with any adjust-
ments to the accounts, a reclassification should only be made if the analyst experiences
higher information content as a result.

Review questions
• What are the three analytical areas where ratio analysis appears useful?
• What are the typical sources of noise in a time-series analysis?
• What are the typical sources of noise in a cross-sectional analysis?
• Why is it important to make a distinction between operating and financing activities?
• What is NOPAT?
• How is invested capital defined?
• What challenges does an analyst typically face when measuring NOPAT and invested
capital?
 CHAPTER 5

Profitability analysis

Learning outcomes
After reading this chapter you should be able to:
• Understand the structure of the profitability analysis
• Define, calculate and interpret key financial ratios such as return on invested
capital, profit margin and turnover rate of invested capital
• Identify the limitations in using return on invested capital
• Understand the importance of trends and levels in key financial ratios
• Recognise that benchmarking is typically based on a comparison with the required
rate of return or competitors
• Prepare a common-size analysis as well as a trend analysis (index numbers)
• Understand the impact of financial leverage on profitability
• Recognise when financial ratios should be measured before and after tax

Profitability analysis

M easuring a company's profitability is one of the key areas of financial analysis.

Profitability is important for a company's future survival and to ensure a satis-
factory return to shareholders. Sound profitability is a signal of economic strength and
helps a firm maintain positive relationships with both customers and suppliers. The
historical profitability is an important element in defining the future expectations for
a company.
This chapter presents a number of key figures and tables used to illustrate and
measure profitability. We will consider the following areas:
• Measurement of operating profitability
• Alternative interpretations of the return on invested capital
• Decomposition of return on invested capital
• Analysis of profit margin and turnover rate of invested capital
• Return on equity.
Measurement of operating profitability
The structure for profitability analysis and inter-relationships of ratios linked to opera-
tion is illustrated in Figure 5.1. In the following section, the profitability ratios will be
defined and their inter-relationships described. The definitions of profitability ratios
linked to operation are based on the analytical income statement and balance sheet as
described in the previous chapter.

Figure 5.1 Structure of profitability analysis - Du Pont model

Return on invested capital (ROIC) is the overall profitability measure for opera-
tions. The ratio expresses the return on capital invested in a firm's net operating assets
as a percentage; and should be compared with returns from alternative investments
with a similar risk profile. ROIC measured after tax is defined as:

Return on invested capital is an important ratio. In a valuation context it is a signifi-

cant factor, since a higher rate of return will lead, ceteris paribus, to a higher (esti-
mated) value. In connection with lending it will be more attractive to provide loans
to a company with a high ROIC. The company will accordingly be able to obtain
cheaper financing.
 Below we use the simple numerical example outlined in Chapters 2 and 4 to show
how ROIC (after tax) is calculated.

Example 5.1 Revenues 200 Invested capital (net operating assets)

Operating expenses -90 Total assets 700
EBIT 110 Cash and cash equivalents -50
Taxes on EBIT -33 Accounts payables and tax payable -100
NOPAT 77 Invested capital (net operating assets) 550

Net financial expenses -10

Tax savings from debt fi nancing 3 Invested capital (financing)
Net financial expenses after tax -7 Equity 400

Net earnings 70 Loans and borrowings (non-current) 100

Loans and borrowings (current) 100
Cash and cash equivalents -50
Interest bearing debt, net 150

Invested capital (financing) 550

A ROIC of 14.0% indicates that the business is able to generate a return of 14 cents for each
euro invested in operations. •

To see how it works in real-life cases, we have calculated Carlsberg's rate of return
on invested capital for the past five years. The results are shown in Figure 5.2. The

Figure 5.2 Return on invested capital for Carlsberg

 calculation is based on the reformulated income statement and balance sheet as
described in Chapter 4. It should be noted that the calculations are based on averages
for invested capital. This calculation works best if there is a steady development in
invested capital over the year. It is considered the most accurate method. However, it
may provide a noisy measure of ROIC, if there is an extraordinary high activity. For
example, a divestiture of business units at year-end means that average invested capi-
tal would be too low.
When interpreting the return on invested capital, and other key ratios in general, it
is important to address the following issues:
The level of returns
The development of returns over time.

Assessment of the level of returns

An important element in evaluating the return on invested capital is whether the ratio
is at a satisfactory level. There are two ways to determine this:
• An estimation of the required rate of return (WACC)
A comparison with competitors (benchmarking).
As you can see from the analytical balance sheet, invested capital consists of net
operating assets or alternatively net interest-bearing debt plus shareholders' equity.
In order to estimate cost of capital, which reflects the required (expected) return on
invested capital, it is necessary to know the
net interest-bearing debt
shareholders' equity
interest rate on debt after tax
shareholders' required rate of return.
This total required rate of return is called the weighted average cost of capital (WACC)
and is calculated as:

where
NIBD = Market value of net interest-bearing debt
MVE = Market value of equity
rd = Interest rate on net interest-bearing debt
re = Shareholders' required rate of return
t= The company's marginal tax rate
The calculation of WACC is addressed in further details in Chapter 10. Subtracting
WACC from ROIC leaves an expression of Economic Value Added (EVA). As men-
tioned earlier, EVA is synonymous with super profit, economic rents, above normal
profit and economic profits:
WACC is the expected return on invested capital. If ROIC exceeds WACC a com-
pany creates excess return or Economic Value Added; i.e. value for its shareholders.
Accounting profit (operating profit) is not necessarily value creating. It requires that
accounting (operating) profit, measured as a percentage of invested capital (ROIC)
exceeds the average cost of capital to debt-holders and equity-holders (WACC).
Assuming that Carlsberg's WACC was 8% in the past, it is clear that Carlsberg is
only creating value for its shareholders in year 7. This is illustrated in Figure 5.3.

Figure 5.3 Return on invested capital versus WACC for Carlsberg

An alternative method of assessing the level of return on invested capital is to com-

pare it with the competitors' performance. Such a comparison is called cross-sectional
analysis and must take into account the issues referred to in the Introduction to Part 2
about cross-sectional analysis.
To illustrate how a cross-sectional analysis may be carried out, a comparison of
Carlsberg and Heineken is provided in Figure 5.4. Both companies focus on the

Figure 5.4 Comparison of the return on invested capital for Carlsberg and Heineken
 production and sale of beverages and they are among the top-five players in the
brewery sector worldwide. From this perspective, they are comparable. Heineken's
reformulated income statements and balance sheets are shown in Appendix 5.1 on
page 122.
Carlsberg is only able to generate a ROIC that exceeds Heineken's in year 8. This
indicates that Carlsberg's level of profitability is generally below Heineken's in the
period examined.
The comparison of profitability between Carlsberg and Heineken illustrates that
the method is also suitable for identification of best practice. Some companies take
advantage of the opportunity to gather information and inspiration by analysing
competitors' ability to create value. By identifying the most profitable businesses and
understand the strategy behind their success, it is possible to find inspiration.

Assessment of trends in financial ratios

Another important element in evaluating the return on invested capital, and other
key financial ratios is whether the ratio develops satisfactorily over time. In practice,
such an assessment is primarily carried out by measuring the development of the ratio
relative to comparable companies. Figure 5.4 illustrates the evolution of the return on
invested capital for Carlsberg and Heineken. As noted above, Heineken is generally
more profitable than Carlsberg. However, Heineken experiences a decreasing ROIC
while Carlsberg is able to improve ROIC from year 4 to year 8. In fact, in year 8
Carlsberg's ROIC exceeds Heineken's, To summarise, while Carlsberg's profitability is
generally below Heineken's, Carlsberg are able to improve ROIC over time.
For listed companies where the market value of the company is known, the implicit
forecast (expectation) of the development of profitability can be calculated. This kind
of analysis provides management with guidance about the market's outlook of the
company's future profitability. This method is illustrated based on Carlsberg's annual
reports and market value. To calculate the stock market's implicit ROIC, a valuation
model is required. The EVA model is applied as follows:

In the above formula, g denotes growth in EVA. It shows that the market value
of equity exceeds book value, if value is created in future periods (EVA > 0); this
requires that ROIC is greater than WACC. Assuming a constant growth rate and a
constant required rate of return (WACC) the stock market's implicit (forward looking)
ROIC may be calculated as:

where

MVE = market value of equity

BVE = book value of equity
 Both market capitalisation and the book value of equity are available for Carlsberg:

Market value of equity (MVE) - DKK 53.2 billion

Book value of equity (BVE) = DKK 55.5 billion
Invested capital = DKK 111.7 billion

Carlsberg's organic growth has been moderate in recent years. We assume a growth
rate of between 0% and 3% and a required rate of return (WACC) of between 8%
and 9%. Based on the above assumptions the stock market's implicit expectations for
return on invested capital for Carlsberg are calculated.
This is illustrated in Table 5.1. For instance, with an assumed growth rate of 2%
and a WACC of 8%, the market expects Carlsberg to earn a return on invested capi-
tal (ROIC) of 7.9% in perpetuity. With a ROIC of 7.9% in perpetuity, the market
value of equity would amount to DKK 53.2 billion. As shown in the figure the mar-
ket's implicit expectations for return on invested capital for Carlsberg is in the range
7.8-8.9%.

Table 5.1
WACC
8.0% 8.5% 9.0%
0% 7.8% 8.3% 8.8%
1% 7.9% 8.3% 8.8%
Growth
2% 7.9% 8.4% 8.9%
3% 7.9% 8.4% 8.9%

This should be compared with an average realised return (ROIC) of 6.7% in years 4 to
8. Carlsberg's return shows an increasing trend. The return on invested capital is 7.5%
in the last financial year 8. Thus, the market expects a slight improvement in return
on invested capital in the coming years. Please note that since Carlsberg's market value
of equity is almost identical to the book value of equity, growth does not matter. This
explains the lack of variation of implicit ROIC across different growth rates.
Analysts may find it beneficial to estimate the implicit rate of return because it clari-
fies the implicit expectations about future profitability. In the case of Carlsberg the
analyst must assess whether it is likely that Carlsberg will be able to improve ROIC
from 7.5% to 7.8%-8.9%. A firm's management may use the information embedded
in the implicit rate of return to assess whether the chosen strategy is appropriate and/
or if they need to improve information to the stock market so that there is a higher
degree of coherence between the stock market's and the company's own outlook for
the future.

Alternative interpretations of the return on invested capital

When evaluating the return on invested capital, it is important to understand the
information that can be inferred from the ratio. Many analysts associate high and
positive developments in the return on invested capital as attractive, because it
signals increasing value creation in the company. In practice it will often be true,
 but there are circumstances with alternative interpretations. For example, ROIC is
affected by:

• Differences in accounting policies

• The average age of assets
• Differences in operating risks
• Product lifecycle.

Each of these issues is now discussed in turn.

Differences in accounting policies

It is important that accounting policies are the same over time (time-series analysis)
and across firms (cross-sectional analysis). This ensures that differences in return on
invested capital over time or across firms are not attributed to changes in accounting
policies but rather to changes in the underlying profitability of operation.
In Chapters 13 to 15 we discuss the concept of earnings quality and selected
accounting items. These chapters examine the quality of data available for analyses
and explore the analytical problems of changes in accounting policies.

The average age of assets

In financial theory the internal rate of return (IRR) is used as a financial ratio for
measuring return on invested capital. The IRR shows what investors can expect to
earn on average each year (expressed as a percentage) during the entire lifetime of the
project. In order to calculate IRR, all future cash flows must be estimated by the ana-
lyst (since they are unknown) and, thus, IRR changes from being known and sure to
being an estimate. The method is shown in the following example.
An investor intends to invest in a wind turbine. The total investment amounts to
€100 million and the expected lifetime of the wind turbine is 20 years. The annual net
payments from the investment are expected to be €11.75 million. Based on this data,
it is possible to estimate IRR to 10%:

The formula demonstrates that the wind turbine investment in each of the next 20
years will provide an annual return of 10%. ROIC is the accounting equivalent to
the IRR. In practice, ROIC is often used because the IRR is based on prospects,
while the ROIC is based on realised figures, making the ratio more reliable and
easier to estimate. It does not, however, mean that ROIC is necessarily a good indi-
cator of the IRR. By using the above information from the wind turbine project, it
is actually possible to estimate the annual rate of return (ROIC) so it matches the
IRR (Table 5.2).
As shown in the example, depreciation must increase over time. To ensure that IRR
equals ROIC, a progressive depreciation scheme must be adopted. In reality, most
firms use linear depreciation for external reporting purposes. Changing from pro-
gressive to straight-line depreciation gives a more realistic picture of actual reporting
 Table 5.2 Estimation of IRR
1 2 3 4 5

(1-2) (4-2) (3/4)

Year Net-cash Depreciation EBIT Invested capital ROIC = IRR

inflow (end of year)

0 100
1 11.75 1.7 10.0 98 10.0%
2 11.75 1.9 9.8 96 10.0%
3 11.75 2.1 9.6 94 10.0%
4 11.75 2.3 9.4 92 10.0%
5 11.75 2.6 9.2 89 10.0%
6 11.75 2.8 8.9 87 10.0%
7 11.75 3.1 8.7 83 10.0%
8 11.75 3.4 8.3 80 10.0%
9 11.75 3.7 8.0 76 10.0%
10 11.75 4.1 7.6 72 10.0%
11 11.75 4.5 7.2 68 10.0%
12 11.75 5.0 6.8 63 10.0%
13 11.75 5.5 6.3 57 10.0%
14 11.75 6.0 5.7 51 10.0%
15 11.75 6.6 5.1 45 10.0%
16 11.75 7.3 4.5 37 10.0%
17 11.75 8.0 3.7 29 10.0%
18 11.75 8.8 2.9 20 10.0%
19 11.75 9.7 2.0 11 10.0%
20 11.75 10.7 1.1 0 10.0%

practices. Using straight-line depreciation ROIC increases over time as shown in

Table 5.3.
The difference between the IRR and ROIC (the accounting equivalent to the IRR),
is illustrated in Figure 5.5.
At the beginning of the project ROIC is typically below the 'true' return (IRR),
while the opposite is true at the end of the project. Apart from the period between year
6 and year 10, where ROIC is a reasonable indicator of the underlying IRR of 10%,
the decision maker risks making irrational decisions. The information which can be
inferred from ROIC for additional periods, i.e. in years 1-5 and 11-20, is quite simply
misleading.
The above example fits well for start-up firms or firms under liquidation. Other
companies which have been in business for some time will find that depreciation is
superseded by new investments, so for these companies ROIC is often a reasonable
indicator of the underlying IRR.
 Table 5.3 Estimation of the return on invested capital
1 2 3 4 5

(1-2) (4-2) (3/4)

Year Net-cash Depreciation EBIT Invested capital ROIC

inflows (end of year)
0 100
1 11.75 5.0 6.7 95 6.7%
2 11.75 5.0 6.7 90 7.1%
3 11.75 5.0 6.7 85 7.5%
4 11.75 5.0 6.7 80 7.9%
5 11.75 5.0 6.7 75 8.4%
6 11.75 5.0 6.7 70 9.0%
7 11.75 5.0 6.7 65 9.6%
8 11.75 5.0 6.7 60 10.4%
9 11.75 5.0 6.7 55 11.2%
10 11.75 5.0 6.7 50 12.3%
11 11.75 5.0 6.7 45 1 3.5%
12 11.75 5.0 6.7 40 15.0%
13 11.75 5.0 6.7 35 16.9%
14 11.75 5.0 6.7 30 19.3%
15 11.75 5.0 6.7 25 22.5%
16 11.75 5.0 6.7 20 27.0%
17 11.75 5.0 6.7 15 33.7%
18 11.75 5.0 6.7 10 45.0%
19 11.75 5.0 6.7 5 67.5%
20 11.75 5.0 6.7 0 1 34.9%

Figure 5.5 A comparison of the IRR and return on invested capital for a project with
finite lifetime
Differences in operating risks
A further explanation for alternative interpretations of return on invested capital is
differences in operating risk. According to economic theory investors require compen­
sation for bearing greater risks. In Table 5.4 the expected rate of return from the oper­
ation for a significant number of different industries is shown. Assuming no financial
leverage the expected, return is estimated by using the following relationship:

where
rf = Risk-free interest rate
βa = Systematic risk on assets; i.e. operating risk (unlevered beta)

Table 5.4 Projected operating earnings in different industries based on European data
Industry name Number of Unlevered β Expected operating
firms returns

Financial Svcs. (Div.) 294 0.44 6.0%

Bank 504 0.48 6.2%
Thrift 234 0.49 6.2%
Natural Gas Utility 26 0.52 6.3%
Oil/Gas Distribution 15 0.52 6.3%
Property Management 12 0.52 6.4%
Water Utility 16 0.58 6.6%
Maritime 52 0.59 6.7%
Food Wholesalers 19 0.60 6.7%
Electric Utility (Central) 25 0.61 6.7%
Electric Utility (West) 17 0.62 6.8%
Electric Utility (East) 27 0.63 6.9%
Bank (Canadian) 8 0.64 6.9%
R.E.I.T. 147 0.64 6.9%
Bank (Midwest) 38 0.66 7.0%
Tobacco 11 0.66 7.0%
Food Processing 123 0.67 7.0%
Paper/Forest Products 39 0.69 7.1%
Investment Co. 18 0.71 7.2%
Environmental 89 0.71 7.2%
Canadian Energy 13 0.71 7.2%
Natural Gas (Div.) 31 0.75 7.4%
Toiletries/Cosmetics 21 0.75 7.4%
Apparel 57 0.76 7.4%
Trucking 32 0.78 7.5%
Packaging & Container 35 0.79 7.6%
Table 5.4 (continued)

Industry name Number of Unlevered j8 Expected operating

firms returns

Household Products 28 0.80 7.6%

Electrical Equipment 86 0.80 7.6%
Home Appliance 11 0.81 7.6%
Beverage 44 0.81 7.6%
Grocery 15 0.81 7.7%
Healthcare Information 38 0.82 7.7%
Homebuilding 36 0.83 7.7%
Restaurant 75 0.83 7.8%
Securities Brokerage 31 0.85 7.8%
Petroleum (Producing) 186 0.86 7.9%
Building Materials 49 0.87 7.9%
Newspaper IS 0.87 7.9%
Auto & Truck 28 0.88 8.0%
Insurance (Prop/Cas.) 87 0.88 8.0%
Fum/Home Furnishings 39 0.89 8.0%
Insurance (Life) 40 0.89 8.0%
Diversified Co. 107 0.92 8.1%
Office Equip/Supplies 25 0.92 8.1%
Chemical (Specialty) 90 0.93 8.2%
Medical Services 178 0.95 8.3%
Foreign Electronics 10 0.95 8.3%
Hotel/Gaming 75 0.96 8.3%
Reinsurance 11 0.96 8.3%
Petroleum (Integrated) 26 0.97 8.4%
Information Services 38 0.97 8.4%
Utility (Foreign) 6 0.98 8.4%
Retail Store 42 0.98 8.4%
Pharmacy Services 19 0.99 8.5%
Metals & Mining (Div.) 78 0.99 8.5%
Air Transport 49 1.00 8.5%
Machinery 126 1.01 8.5%
Oilfield Svcs/Equip. 113 1.01 8.5%
Industrial Services 196 1.02 8.6%
Telecom Services 152 1.03 8.6%
Precious Metals 84 1.04 8.7%
Railroad 16 1.04 8.7%
Auto Parts 56 1.05 8.7%
Industry name Number of Un levered β Expected operating
firms returns
Publishing 40 1.05 8.7%
Chemical (Diversified) 37 1.05 8.7%
Cable TV 23 1.06 8.8%
Aerospace/Defence 69 1.06 8.8%
Retail Building Supply 9 1.10 8.9%
Metal Fabricating 37 1.10 8.9%
Retail (Special Lines) 164 1.15 9.2%
Entertainment 93 1.17 9.3%
Electronics 179 1.17 9.3%
Advertising 40 1.19 9.4%
Heavy Construction 12 1.21 9.5%
Retail Automotive 16 1.24 9.6%
Recreation 73 1.25 9.6%
Educational Services 39 1.26 9.7%
Human Resources 35 1.30 9.9%
Investment Co. (Foreign) 15 1.31 9.9%
Medical Supplies 274 1.34 10.0%
Chemical (Basic) 19 1.35 10.1%
Biotechnology 103 1.38 10.2%
Shoe 20 1.44 10.5%
Computer Software/Svcs 376 1.51 10.8%
Coal 18 1.52 10.8%
Precision Instrument 103 1.53 10.9%
Steel (General) 26 1.59 11.1%
Drug 368 1.66 11.5%
Power 58 1.69 11.6%
Manuf. Housing/RV 18 1.71 11.7%
Steel (Integrated) 14 1.73 11.8%
Computers/Peripherals 144 1.77 12.0%
Telecom Equipment 124 1.89 12.5%
Internet 266 1.94 12.7%
Wireless Networking 74 1.96 12.8%
Entertainment Tech 38 2.01 13.0%
E-Commerce 56 2.02 13.1%
Semiconductor Equip 16 2.35 14.6%
Semiconductor 138 2.49 15.2%
Market 7,364 1.03 8.6%
(Source: Damodaran, NYU)
 Under the assumption that operating risk is (fairly) identical within industries, the
expected return on operation can be calculated for any company within an industry.
With a risk-free interest rate of 4% and a risk premium of 4.5% the required rate of
return on the operation may be calculated. In Chapter 10, the methodology behind
the estimation of the required rate of return on operation is looked at in greater
detail.
As shown in Table 5.4, there is a large gap between the return which will satisfy
investors. Within the energy sector (water and electricity) the expected required rate
of return is around 6.5%. In contrast, investors find there is significant risk involved
in investing in the semiconductor industry (semiconductor). An investment in this sec-
tor will result in a required rate of return on operations of 15%. A comparison of the
profitability of the two industries would be meaningless due to significant differences
in operating risks.

Product lifecycle
Products undergo various stages of time, and similar considerations can be made for
businesses in general. The following description illustrates the lifecycle at the product
level, but the considerations can be used at the enterprise level as well.
Products undergo roughly four stages in their lifecycle: introduction, growth,
maturity and decline. At the launch of the product the focus is on investment in
research and development, marketing, building sales organisations, etc. In the growth
phase the organisation is geared to handle the growth, which is usually capital inten-
sive. In both the introductory and growth stage, there is uncertainty as to whether the
product will be accepted by customers in the market and if the organisation can han-
dle the transition from introduction to growth. When the product passes into a more
moderate growth pace, and has been accepted in the market, the product 'matures'.
At this stage companies are reaping the gains of the previous phases of investments.
There is often no need for greater investments and there is potential for a nice return
on invested capital. Often the lower growth in the mature phase of a product's life-
cycle initiates increased competition. As the organic growth is modest at this stage,
it is often possible to achieve further growth only by capturing market shares from
competitors. An often used parameter to achieve this goal is to reduce the price of
the product or offer more features on the product. This increased competition will
gradually lead to pressure on profit margins and thus the return on invested capital.
As the technological development makes products obsolete in the mature stage, the
demand decreases and the products will be phased out gradually as they become
unprofitable.
The above ideas are illustrated in Figure 5.6 and, as shown, return on invested
capital develops from being negative in the early stage of the product lifecycle to peak
in the last part of the growth phase and in the first part of the mature phase. Then,
return on invested capital decreases over time and becomes negative, unless the prod-
uct has been phased out in time and replaced by a newer product with more attractive
features.
If this philosophy is transferred to company level, it is clear that companies in the
early stage of their lifecycle are not directly comparable with those companies later
in their lifecycle. This applies even if firms are within the same industry. Although
a comparison of return on invested capital for companies at different stages in their
lifecycle does not immediately make sense, an analyst might often find inspiration by
 Figure 5.6 Return on invested capital at different stages of the product lifecycle

examining the profitability level of firms later in their lifecycle. For an assessment of
an early stage firm it would be appropriate to look at companies later in their lifecycle
in order to assess the future earnings potential.

Decomposition of return on invested capital

Return on invested capital measures a firm's return on capital invested in operation.
ROIC, however, is not able to explain whether profitability is driven by a better rev-
enue and expense relation or an improved capital utilisation. To be able to answer this
question, it is necessary to decompose the ratio into (a) the profit margin and (b) the
turnover rate of invested capital:

Profit margin after tax is defined as:

Profit margin before tax is defined as:

The profit margin is sometimes named the operating profit margin.

Profit margin describes the revenue and expense relation and expresses, operating
income as a percentage of net revenue. All things being equal, it is attractive with a
high profit margin.
 Based on the simple numerical example profit margin is calculated as:

A profit margin of 38.5% expresses that the company generates 38.5 cents on each
euro of net revenue.
The turnover rate of invested capital is defined as:

The turnover rate expresses a company's ability to utilise invested capital. A turnover
rate of 2 conveys that a firm has tied up invested capital in 180 days (360 days divided
by 2) or alternatively, that for each euro the firm has invested in operation (net operat-
ing assets), a sale of 2 euro is generated. All things being equal, it is attractive to have
a high turnover rate of invested capital.
Based on the simple numerical example the turnover rate of invested capital is cal-
culated as:

A turnover rate of 0.36 indicates that invested capital is tied up in two years and
280 days on average (360/0.36). (You may apply 365 days in the numerator as this
is the number of days in a year.)
The level of the profit margin and turnover rate describes quite well the type of busi-
ness being analysed. Service industries are typically characterised by having few invest-
ments and a high turnover rate. On the other hand, it is difficult to maintain a high
profit margin because the price is often a major competitive parameter. Pharmaceutical
companies are investing heavily and characterised by relatively low turnover rates. In
contrast, the price is not in the same way an important competitive parameter. Here
the product's ability to help patients with life threatening illnesses is the decisive com-
petitive factor. Therefore, it is possible to maintain a high profit margin. These consid-
erations are generalised in Figure 5.7.

Figure 5.7 Decomposition of ROIC in profit margin and turnover rate

 Heavy investment companies like pharmaceutical companies, which are charac-
terised by a high proportion of fixed costs, often have low turnover rates. To be able
to attract capital to the industry, it is necessary to generate higher profit margins to
compensate for the low turnover rate. The higher profit is achieved usually because
the product has special properties that are difficult to imitate or other competitive
advantages which affect the market share positively. These companies are located in
area A in Figure 5.7.
Companies that offer standard services (commodities), often operate in areas
affected by significant competition. Within these industries, there is an upper limit to
the profit margin. Price is typically the most important parameter, as the products or
services do not differ significantly among competitors. To be able to attract capital
for such undertakings, they need to generate high turnover rates. A high turnover rate
is achieved by tight cost control throughout the value chain, while invested capital is
held at a minimum. These companies are located in area B in Figure 5.7.
Most enterprises or industries lie in between A and B on the curve. The above
examples are some of the extremities. The same arguments as presented above can
apply to any other industry or firm. The lower the operating profit margin (turnover
rate) achieved in an industry, the higher the turnover rate (profit margin) would have
to be to maintain a satisfactory return on invested capital. In practice, there are indus-
tries where it is difficult to achieve a satisfactory return (ROIC). It is typical mature
industries where demand is waning.
The following example illustrates the link between the profit margin and turnover
rate and how changes in these ratios affect the value creation. The example rests on
the following assumptions:

Based on these figures it is possible to calculate various financial ratios. In addition,

the economic consequences of good or poor cash management (i.e. cash tied up in
invested capital) can be calculated. The starting point, based on the above assump-
tions, is a turnover rate of 1.0 (revenue/invested capital), which corresponds to a firm
having invested capital tied up for one year on average (360/1).
To see how management may improve value creation have a look at Table 5.5. The
example illustrates the points made in Figure 5.7. Suppose the company is able to
reduce cash tied up in invested capital by 60 days from 360 to 300 days. This would
improve the overall profitability, as measured by EVA, from 0 to 16.7, as shown in
Table 5.5. The calculations behind the example are:

Thus, EVA becomes: (ROIC - WACC) × Invested capital = (12% - 10%) × 833.3 = 16.7.
It is also possible to calculate how much the operating margin needs to improve by,
to have the same effect on profitability (EVA) as the reduction of 60 days in cash tied
 up in invested capital. In this example, a reduction in cash tied up by 60 days is equiv-
alent to an improvement in the operating margin from 10.0 to 1 1 . 7 % - a n increase of
close to 17%. The underlying calculations are:

Therefore, profit margin (PM) becomes:

In other words, an improvement in the profit margin from 10.0% to 11.7% has the
same effect on value creation (i.e. EVA improves by 16.7) as a reduction in cash tied
up in invested capital by 60 days. This is illustrated in Table 5.5.

Table 5.5 The relationship between financial ratios and value added (EVA)

Invested Revenue NOPAT Profit Invested Turnover Cost of EVA Effect Change
capital tied-up margin capital rate, capital on in profit
No. of days invested (WACC) profit margin
capital margin
60 1000.0 100.0 10.0% 167 6.00 16.7 83.3 18.3% 83.3%
120 1000.0 100.0 10.0% 333 3.00 33.3 66.7 16.7% 66.7%
180 1000.0 100.0 10.0% 500 2.00 50.0 50.0 15.0% 50.0%
240 1000.0 100.0 10.0% 667 1.50 66.7 33.3 13.3% 33.3%
300 1000.0 100.0 10.0% 833 1.20 83.3 16.7 11.7% 16.7%
360 1000.0 100.0 10.0% 1000 1 100.0 0.0 10.0% 0.0%
420 1000.0 100.0 10.0% 1167 0.86 116.7 -16.7 8.3% -16.7%
480 1000.0 100.0 10.0% 1333 0.75 133.3 -33.3 6.7% -33.3%
540 1000.0 100.0 10.0% 1500 0.67 150.0 -50.0 5.0% -50.0%
600 1000.0 100.0 10.0% 1667 0.60 166.7 -66.7 3.3% -66.7%
660 1000.0 100.0 10.0% 1833 0.55 183.3 -83.3 1.7% -83.3%
720 1000.0 100.0 10.0% 2000 0.50 200.0 -100.0 0.0% -100.0%

The example in Table 5.5 illustrates how the profit margin and the turnover rate on
invested capital affect value creation of a firm.
In Figure 5.8 the profit margin is calculated for Carlsberg and Heineken. As shown
by the comparison in Figure 5.8, Carlsberg's profit margin increases from 5.7% to
9.7% from year 4 to year 8. On the other hand, Heineken experiences a decreasing
profit margin. By year 8 Carlsberg's profit margin exceeds Heineken's.
Figure 5.9 compares the turnover rate of invested capital for the two breweries.
While both breweries experience a decreasing turnover rate, Heineken's consistently
exceeds Carlsberg's. However, the differences in turnover rate diminish over time.
 Figure 5.8 Comparison of profit margin of Heineken and Carlsberg

Figure 5.9 Comparison of turnover rate for Heineken and Carlsberg

The decomposition of ROIC into the profit margin and the turnover rate reveals
that Carlsberg's increase in ROIC is purely driven by an improvement in the revenue
and expense relation (profit margin). On the other hand, Heineken's declining ROIC
is explained by a reduced revenue and expense relation as well as a reduced utilisation
of invested capital (turnover rate).

Analysis of profit margin and turnover rate of invested capital

An analysis of the profit margin and turnover rate of capital helps to explain whether
the revenue/expense relation and the capital utilisation efficiency have improved or
deteriorated over time. The analysis of the two ratios is, however, vague in their descrip-
tion of why the ratios have evolved as they have. In order to deepen our understanding
of the evolution of the revenue/expense relation and the capital utilisation efficiency, it
is necessary to decompose the two ratios further. This can be done in two ways:
• Indexing (trend analysis)
• Common-size analysis.
Indexing and common-size analysis of revenue and expenses
Indexing is a suitable method to quickly identify trends in various revenue and expense
items. We have calculated index numbers for Carlsberg. From an analytical point of
view, it would be useful if comparable figures for Heineken were available. However,
Carlsberg reports expenses by function and Heineken reports expenses by nature
making a comparison of the expenses less suitable (Table 5.6).

Table 5.6 Trend analysis of Carlsberg's revenue and operating expenses

Income statement (DKKm) Year 4 Year 5 Year 6 Year 7 Year 8
Net revenue 100 105 113 123 165

Cost of sales 100 105 112 126 175

Gross profit 100 105 114 121 157

Sales and distribution costs 100 104 110 113 139

Administrative expenses 100 107 112 114 145
Other operating income 100 143 108 152 192
Other operating expenses na 100 85 96 97
Share of profit after tax, associates 100 110 40 48 39
Tax on profit from associates 100 100 37 37 30
Operating profit before special items 100 102 113 132 189

Special items, income na na na na na

Special items, costs 100 66 96 56 225
EBITDA 100 106 126 140 186

Depreciation and amortisation 100 100 114 107 147

EBIT 100 111 135 168 220

Corporation tax 100 136 225 272 -85

Tax on profit from associates 100 100 37 37 30
Tax shield, net financial expenses 100 100 69 87 250
NOPAT 100 109 134 168 279

Carlsberg's net revenue increases by 65% from year 4 to year 8. In the same period,
cost of sales increases by 75%, and this affects Carlsberg's profit margin negatively. Other
operating expenses such as sales and distribution costs, administrative expenses and depre-
ciation and amortisation expenses all increase at a lower rate than growth in revenues.
This indicates that Carlsberg is able to manage these expenses relatively tightly.
Index numbers show the trend in important operating items. However, index num-
bers do not reveal the relative size of each item. For this purpose, common size analy-
sis is more useful. Common-size analysis scales each item as a percentage of revenue
and is demonstrated using Carlsberg as an example (Table 5.7).
The common-size analysis shows that cost of sales as a percentage of net revenue
has grown from 4 5 % in year 4 to 48% in year 8. In comparison sales and distribution
 Table 5.7 Common-size analysis of Carlsberg's revenue and operating expenses
Income statement (DKKm) Year 4 Year 5 Year 6 Year 7 Year 8
Net revenue 100% 100% 100% 100% 100%

Cost of sales -45% -45% -45% -46% -48%

Gross profit 55% 55% 55% 54% 52%

Sales and distribution costs -33% -33% -32% -31% -28%

Administrative expenses -7% -7% -7% -7% -6%
Other operating income 2% 2% 2% 2% 2%
Other operating expenses 0% -1% -1% -1% -1%
Share of profit after tax, associates 1% 1% 0% 0% 0%
Tax on profit from associates 0% 0% 0% 0% 0%
Operating profit before special items 17% 16% 17% 18% 19%
0% 0% 0% 0% 0%
Special items, income 0% 0% 1% 0% 0%
Special items, costs -2% -1% -1% -1% -2%
EBITDA 15% 15% 17% 17% 17%
0% 0% 0% 0% 0%
Depreciation and amortisation -7% -7% -7% -6% -6%
EBIT 8% 8% 10% 11% 11%
0% 0% 0% 0% 0%
Corporation tax -1% -1% -2% -2% 1%
Tax on profit from associates 0% 0% 0% 0% 0%
Tax shield, net financial expenses -1% -1% -1% -1% -1%
NOPAT 6% 6% 7% 8% 10%

costs, administrative expenses and depreciation and amortisation expenses together

make up 47% of revenue in year 4 and 40% in year 8. Thus, even though the most
influential expense, cost of sales, is growing at a faster rate than net revenue Carlsberg
is able to improve profit margin through an efficient control of other operating
expenses. However, the analysis clearly highlights a cost saving potential by managing
cost of sales more efficiently.

Indexing and common-size analysis of invested capital

The analysis of the turnover rate of invested capital (see Figure 5.9 above) revealed a
decrease over time from 1.02 in year 4 to 0.77 in year 8. This implies that Carlsberg
has tied up invested capital in an additional 117 days or, alternatively, Carlsberg needs
to finance €1 of invested capital in 474 days in year 8 in comparison to 357 days in
year 4. (Days on hand is defined as follows: 360/turnover rate of invested capital.)
We apply both index numbers and common size analysis to gain a better under-
standing of the development in capital utilisation. Since both breweries use roughly
 the same classification of assets and liabilities in the balance sheet, we include both
companies in the analyses. This allows us to compare the efficiency in utilising invested
capital across the two breweries (see Table 5.8).

Table 5.8 Trend analysis of invested capital for Carlsberg and Heineken, respectively
Carlsberg index numbers Heineken
Year Year Year Year Year Invested capital Year Year Year Year Year
4 5 6 7 8 4 5 6 7 8
Non-current assets
100 160 167 169 421 Intangible assets 100 141 162 153 309
Tangible assets 100 0 0 0 0
100 103 103 107 142 Property, plant and equipment 100 206 210 201 230
100 84 50 36 84 Investments in associates 100 228 267 804 1,520
100 74 69 76 93 Receivables
Loans to customers 0 0 100 149 143
Advances to customers 0 0 0 100 266
100 117 114 97 124 Deferred tax assets 100 206 253 264 214
100 121 121 124 233 Total non-current assets 100 113 123 127 181

Current assets
100 103 109 127 164 Inventories 100 103 110 110 132
100 98 97 100 102 Trade receivables 100 113 122 122 141
100 261 263 178 395 Tax receivables
100 140 133 83 146 Other receivables
100 0 0 0 0 Receivables from associates
100 97 122 152 176 Prepayments 0 0 0 100 310
100 104 105 106 127 Total current assets 100 110 118 120 145

Non-interest-bearing debt
100 134 137 132 343 Deferred tax liabilities 100 202 225 234 277
100 70 102 112 318 Provisions 100 34 31 24 30
100 36 52 32 123 Other liabilities

Current liabilities 100 0 0 0 0

100 104 117 133 168 Trade payables 100 218 241 246 309
100 100 96 95 107 Deposits on returnable packaging
100 168 165 154 188 Provisions 100 333 516 616 700
100 122 77 33 41 Corporation tax 100 570 967 733 520
100 96 100 108 136 Other liabilities etc.
100 0 0 0 0 Borrowings from associates
100 106 110 115 173 Total non-interest-bearing debt 100 86 96 96 117

100 120 120 121 219 Invested capital 100 130 139 144 208
 Both Carlsberg and Heineken have more than doubled the size of invested capital
over the analysed period. Carlsberg's invested capital increases by 119% from year 4
to year 8, which is on par with an increase of 108% for Heineken. As noted above,
Carlsberg's net revenue only increases by 65% in the same period leading to a lower
turnover rate of invested capital. Heineken's net revenue grows by 4 2 % also lead-
ing to a lower turnover rate. For Carlsberg, investments in intangible assets (prima-
rily goodwill) seem to be the main explanation for the increase in invested capital.
Investments in associates and intangible assets seem to explain the increase in invested
capital for Heineken. A drawback of using index numbers, when analysing invested
capital, is that the importance of each item is not obvious.
We generally prefer to apply a variation of common-size analysis to address this
issue. By calculating the number of days on hand for each item making up invested
capital, we obtain useful information on both the relative importance (weight) and the
trend of each item. This is attractive from an analytical perspective. In Table 5.9 we
report the days on hand for each item making up invested capital for both breweries.
The days on hand is found by using the following ratio:
Days on hand (for each item): 360/turnover rate (of each item)
Days on hand express the number of days that an accounting item is consuming cash.
For example, in year 8 trade receivables in Carlsberg equal 39 days. This implies that
Carlsberg is offering customers on average 39 days of credit which increases working
capital and invested capital. On the other hand, in year 8 trade payables are negative
by 42 days. This indicates that Carlsberg obtains 42 days of credit from its suppliers
reducing the need for invested capital. Days on hand indicate how well invested capi-
tal and its components have been managed.
A comparison of days on hand for both breweries reveals some interesting findings.
First, Carlsberg has made significant investments in intangible assets. In year 4 intangible
assets explain 126 days of the 357 days that Carlsberg has invested capital in hand. In
year 8 intangible assets explain 322 days of the 474 days that Carlsberg has invested cap-
ital on hand. Alternatively, while invested capital increases by 117 days intangible assets
increase by 196 days. This indicates that investments in intangible assets are the sole
explanation for the deterioration in the turnover rate of invested capital for Carlsberg. In
fact, the days on hand for other items such as property, plant and equipment, receivables,
trade receivables, and deferred tax liabilities improve significantly. For example, the days
that trade receivables are on hand in Carlsberg are reduced by 24 days (63 days minus
39 days) from year 4 to year 8. Therefore, despite the negative trend in days on hand
for invested capital, Carlsberg seems to manage most of its capital more efficiently over
time. After analysing the data, we believe that the main concern for an analyst is whether
the acquisitions (and thereby the related intangible assets such as goodwill) made by
Carlsberg are too expensive. Only time will show if this is the case.
Second, Carlsberg has invested capital tied up for 474 days in comparison to
Heineken's 284 days. Differences in the level of investments in intangible assets explain
this gap. While Carlsberg has intangible assets 322 days on hand in year 8 Heineken
only has intangible assets tied up for 117. If we analyse other items of invested capi-
tal than intangible assets, we find that Carlsberg is generally performing worse than
Heineken in year 4. For example, current assets are 115 days on hand in Carlsberg as
compared to Heineken's 84 days. In spite of this, over time Carlsberg is able to utilise
other items of invested capital than intangible assets more efficiently. In fact, if we
ignore intangible assets Carlsberg is able to improve the number of days that other
Table 5.9 Days on hand of invested capital for Carlsberg and Heineken, respectively
Carlsberg Days on hand Heineken
Year Year Year Year Year Invested capital Year Year Year Year Year
4 5 6 7 8 4 5 6 7 8
Non-current assets
126 193 186 173 322 Intangible assets 54 71 75 74 117
Tangible assets 91 0 0 0 0
199 196 181 173 171 Property, plant and equipment 87 166 154 156 140
17 14 7 5 9 Investments in associates 2 5 6 17 26
17 12 11 11 10 Receivables
Loans to customers 0 0 5 8 6
Advances to customers 0 0 0 3 7
8 9 8 6 6 Deferred tax assets 5 9 11 12 7
368 423 393 368 518 Total non-current assets 239 252 250 270 304

Current assets
28 28 27 29 28 Inventories 29 28 27 29 27
63 59 54 51 39 Trade receivables 55 58 57 60 54
0 1 1 1 1 Tax receivables
16 21 18 11 14 Other receivables
2 0 0 0 0 Receivables from associates
6 6 7 8 7 Prepayments 0 0 0 2 4
115 114 107 98 88 Total current assets 84 86 85 90 86

Non-interest-bearing debt
-18 -23 -21 -19 - 37 Deferred tax liabilities -7 -13 -13 -15 -14
-3 -2 -2 -3 -5 Provisions -30 -10 -8 -6 -6
-1 0 1 0 -1 Other liabilities

Current liabilities -53 0 0 0 0

-41 -41 -43 -45 -42 Trade payables -37 -75 -75 -81 -80
-13 -12 -11 -10 -8 Deposits on returnable
packaging
-3 -5 -5 -4 -4 Provisions -1 -2 -3 -4 --4
-6 -7 -4 -2 -1 Corporation tax 1 -3 -4 -4 -2
-41 -38 -36 -36 -34 Other liabilities etc.
0 0 0 0 0 Borrowings from associates
-126 -127 -123 -118 -132 Total non-interest-bearing debt - 1 2 8 -103 -104 -110 -106

357 410 377 349 474 Invested capital 195 236 230 251 284
 items of invested capital are on hand by 79 days (231 days in year 4 minus 151 days
in year 8). In comparison, Heineken increases the number of days that other items
of invested capital than intangible assets are on hand by 16 days (141 days in year 4
minus 167 days in year 8). Therefore, over time Carlsberg seems to manage invested
capital (except for intangible assets) more efficiently.

Return on equity
In the previous sections, the focus was on measurement of operating profitability. In this
section we examine the impact of financial leverage on profitability. Return on equity
(ROE) measures the profitability taking into account both operating and financial
leverage:

Return on equity measures owners' accounting return on their investments in a

company. Based on the simple numerical example from Chapter 2 (page 43) and
Chapter 4 (page 74) we calculate ROE as follows:

The following factors affect the level and trend in ROE:

• Operating profitability
• Net borrowing interest rate after tax
• Financial leverage.
This can be shown by a relationship, which will always apply:

Net borrowing cost (NBC) is defined as:

NBC rarely matches a firm's borrowing rate. First, NBC will be affected by the differ-
ence between deposit and lending rates. Second, other financial items such as currency
gains and losses on securities are included in financial income and expenses. Thus,
from an analytical point of view NBC should be interpreted with care.
Financial leverage is defined as:

Net interest-bearing debt is measured as the difference between interest-bearing debt

and interest-bearing assets (e.g. cash and securities) pursuant to Chapter 4. Based on
the simple numerical example the various components of the ROE relation are calcu-
lated as follows:

The first step in determining ROE is ROIC, which expresses the overall profit-
ability of operations. The second part shows the effect of financial leverage on overall
profitability. If the difference between ROIC and NBC is positive, an increase in finan-
cial leverage will improve ROE. However, financial leverage has a negative impact on
ROE if ROIC is lower than NBC. The difference between ROIC and NBC is often
defined as 'the interest margin' or 'spread'. The effect of financial leverage on return
to shareholders (ROE) can be shown, as illustrated in Figure 5.10.

Figure 5.10 The relationship between financial leverage and return on equity

The graph is depicting changes in return on equity assuming a constant ROIC of

10%, varying interest rates (net) at 6-14% and an increasing financial leverage. With
a fixed spread between ROIC and NBC, ROE develops linearly as a function of finan-
cial leverage. For example, if the spread between ROIC and NBC is positive, ROE
increases linearly with financial leverage. Further, the variation in ROE increases as
financial leverage goes up. However, this also indicates that risk escalates as financial
leverage goes up. We elaborate on this point in Chapter 10.

Effect of minority interests on return on equity

A minority interest arises when the parent company does not own 100% of the
shares in a subsidiary. In calculating invested capital, minority interests were classified
together with the remaining equity. Investors in the parent company do not, however,
benefit from the value creation which belongs to the minority interests. Thus, a dis-
tinction should be made between return on equity measured at the group level and
return on equity measured at the parent level:
The ROE relation can also be expanded to accommodate for minority shareholders'
share of return.

where parent's share of return is calculated as:

The following simple example illustrates the interpretation of the parent's share of
return. The example is based on the following assumptions:

Based on these figures, it is shown how the parent's ROE varies according to different
shares of return belonging to minority interests and the parent, respectively:

Net earnings after minority interests 100 95 90 85 80

Minority interests' share of profit 0 5 10 15 20
Parent's share of return 1.11 1.06 1.00 0.94 0.89
Return on equity, group 10.0% 10.0% 10.0% 10.0% 10.0%
Return on equity, parent 11.1% 10.6% 10.0% 9.4% 8.9%
Return on equity, minority interests 0.0% 5.0% 10.0% 15.0% 20.0%

A parent's share of 1.0 implies that the minority shareholders and the parent's
shareholders receive the same rate of return on their invested capital. A ratio greater
than 1.0 indicates that the parent's shareholders receive a higher ROE than the minor-
ity shareholders.
An assessment of the level and development of ROE can be made using the same
criteria as for ROIC. The measure of the level of equity should not be based on a com-
parison with WACC, but with the owners' required rate of return; i.e. cost of equity.
This is due to the fact that the cost of debt capital has already been taken into consid-
eration when calculating ROE. By deducting owners' required rate (re) from ROE it is
possible to calculate value added for the owners (also defined as residual income (RI)):

In order to accommodate for financial leverage, the structure of profitability, origi-

nally shown in Figure 5.1 above, must be modified as shown in Figure 5.11.
The natural starting point is the value added that owners achieve (residual income).
Furthermore, ROE is shown as a function of ROIC, NBC and financial leverage. The
remaining structure of profitability analysis is the same as shown in Figure 5.1.
In Table 5.10 we calculate ROE and its components for Carlsberg and Heineken.
Carlsberg's ROE is significantly lower than Heineken's in the first four years (years 1-3
not shown). This applies at both group and parent level. A decomposition of ROE
shows that the higher return in Heineken can be attributed to a higher ROIC. In fact,
if Heineken adopted a financial leverage similar to Carlsberg in year 4 to year 7 it would
experience a significantly higher ROE than actually realised. In year 8 Heineken's
ROE is suffering due to a sharp decline in ROIC.
Figure 5.11 Structure of profitability analysis

Table 5.10 The decomposition of ROE for Carlsberg and Heineken

Carlsberg Heineken
Year 4 Year 5 Year 6 Year 7 Year 8 Ratios Year 4 Year 5 Year 6 Year 7 Year 8
5.9% 5.3% 6.6% 8.2% 7.5% Return on invested 18.0% 1 3.8% 19.3% 13.0% 6.5%
capital (ROIC)
1.04 1.35 1.21 1.20 0.93 Financial leverage 0.41 0.69 0.49 0.38 1.13
(NIBD/BVE)
4.5% 3.6% 2.7% 3.9% 6.9% Net borrowing cost 15.0% 3.2% 4.0% 3.7% 6.4%
after tax (NBC)
7.3% 7.6% 11.3% 1 3.3% 7.9% Return on equity 19.2% 21.1% 26.8% 16.5% 6.6%
(ROE), group
1.14 0.89 0.94 0.95 0.89 Parent's share of return 1.04 1.00 1.01 0.94 0.64
8.3% 6.7% 10.6% 12.7% 7.1% Return on equity 20.0% 21.1% 27.0% 15.5% 4.2%
(ROE), parent

Conclusions
Monitoring a firm's profitability is a key issue in financial statement analysis. The
profitability analysis reveals important information about the trend and level of key
ratios describing different aspects of a firm's profitability. This is useful information
if you want to evaluate the performance of the management or develop your own
assumptions about the future profitability.
The chapter introduces a number of key figures to describe profitability and presents
a structure for a profound profitability analysis. Table 5.11 defines and summarises all
the significant financial ratios that have been discussed in this chapter.
Table 5.11
 Review questions
• Explain the structure in a profitability analysis.
• What is the definition of ROIC, profit margin and turnover rate of invested capital?
• When is it useful to define ROIC before and after tax, respectively?
• A company experiences a drop in ROIC from 12% in year 1 to 5% in year 4. Provide
potential explanations for the drop in ROIC of 7 percentage points.
• What is the appropriate benchmark for ROIC?
• What actions can a management take to improve the profit margin?
• A company that realises a turnover rate of invested capital of 4 has invested capital 180
days on hand - true or false?
• What actions can the management take to improve the turnover rate of invested capital?
• Explain the similarities and differences of indexing and common-size analyses.
• What is the definition of ROE?
• How does financial leverage affect the return to shareholders?
• What is the appropriate benchmark for ROE?

APPENDIX 5.1

Heineken original and reformulated financial statements

Reported financial statements

Income statement (€m) Year 3 Year 4 YearS Year 6 Year 7 Year 8
Net turnover 9,255 10,062 10,796 11,829 11,245 14,319
Other income 379 28 32

Raw materials, consumables -5,557 -6,101 -6,657 -7,376 -7,320 -9,548

and services
Staff costs -1,832 -1,957 -2,180 -2,241 -1,951 -2,415
Amortisation/depreciation and -644 -656 -710 -786 -638 -1,206
value adjustments
Total operating expenses -8,033 -8,714 -9,547 -10,403 -9,909 -13,169
Operating profit 1,222 1,348 1,249 1,805 1,364 1,182
Income statement ( € m ) Year 3 Year 4 YearS Year 6 Year 7 Year 8
Share of profit of associates and joint 101 21 34 27 54 -102
ventures after tax
Interests expenses -140 -243 -199 -185 -155 -469
Interests income 78 52 64 91
Other net financing income (expenses) -165 60 11 -107
25 -4

Profit before tax 1,183 1,039 1,169 1,710 1,323 595

Corporation tax -319 -306 -300 -365 -394 -248

Group profit after tax 864 733 869 1,345 929 347

Minority interests -66 -91 -108 -134 -122 -138

Net profit to parent's shareholders 798 642 761 1,211 807 209

Assets ( € m ) Year 3 Year 4 YearS Year 6 Year 7 Year 8

Non-current assets
Intangible assets 1,151 1,837 2,380 2,449 2,110 7,109
Tangible assets 4,995
Financial assets 1,122
Property, plant and equipment 4,773 5,067 4,944 4,673 6,314
Investments in associates 134 172 186 892 1,145
Other investments 632 646 786 397 641
Deferred tax assets 269 286 395 316 259
Advances to customers 209 346
Total non-current assets 7,268 7,645 8,551 8,760 8,597 15,814

Short-term assets
Inventories 834 782 883 893 883 1,246
Trade and other receivables 1,379 1,646 1,787 1,917 1,769 2,504
Investments/secu rities 76 26 23 12 14 14
Cash 1,340 678 585 1,374 560 698
Payments and accrued income 110 231
Assets classified for sale 41 21 56
Total current assets 3,629 3,132 3,278 4,237 3,357 4,749
Total assets 10,897 10,777 11,829 12,997 11,954 20,563

Equity & liabilities ( € m )

Group equity
Shareholder's equity 3,167
Issued capital 784 784 784 784 784
Reserves 354 568 666 692 -74
Equity & liabilities (€m) Year 3 Year 4 YearS Year 6 Year 7 Year 8
Retained earnings 2,118 2,617 3,559 3,928 3,761
Minority interests in other group 732 477 545 511 307 281
companies
Total group equity 3,899 3,733 4,514 5,520 5,711 4,752

Liabilities
Non-current liabilities
Long-term borrowings 2,721
Interest bearing loans and borrowings 2,615 2,195 2,091 1,295 9,084
Other non-current liabilities 23 38
Employee benefits 680 664 665 586 688
Provisions long-term 1,367 298 273 242 158 344
Deferred tax liabilities 384 393 471 427 637
Total non-current liabilities 4,088 4,000 3,563 3,469 2,466 10,753

Current liabilities
Bank overdraft 517 351 747 251 94
Interest bearing loans and borrowings 429 709 494 787 875
Trade and other payables 2,025 2,451 2,496 2,525 3,846
Income tax payable 30 141 149 71 85
Provisions short-term 43 100 122 143 158
Total current liabilities 2,910 3,044 3,752 4,008 3,777 5,058

Total liabilities 6,998 7,044 7,315 7,477 6,243 15,811

Total equity and liabilities 10,897 10,777 11,829 12,997 11,954 20,563

Analytical financial statements

Analytical income statement (€m) Year 3 Year 4 YearS Year 6 Year 7 Year 8

Net turnover 9,255 10,062 10,796 11,829 11,245 14,319

Other income 0 0 0 379 28 32

Raw materials, consumables and services -5,557 -6,101 -6,657 -7,376 -7,320 -9,548
Staff costs -1,832 -1,931 -2,161 -2,234 -1,947 -2,398

Income from loans to customers less 11 5 6

impairment losses
Share of profit of associates and joint 101 21 34 27 54 -102
ventures after tax
Analytical income statement ( € m ) Year 3 Year 4 Year 5 Year 6 Year 7 Year 8
Tax on profit from associates and joint 53 11 16 11 18 -35
ventures
EBITDA 2,020 2,062 2,028 2,647 2,083 2,274
Amortisation/depreciation and value -644 -656 -710 -786 -638 -1,206
adjustments
Operating profit (EBIT) 1,376 1,406 1,318 1,861 1,445 1,068

Corporation tax -319 -306 -300 -365 -394 -248

Tax shield, net financial expenses -48 -123 -42 -41 -27 -130
Tax on profit from associates and joint -53 -11 -16 -11 -18 35
ventures
Net operating profit after tax (NOPAT) 956 966 960 1,444 1,006 725

Interests expenses -140 -243 -199 -185 -155 -468

Interests income 0 78 60 41 59 84
Other net financing income (expenses) 0 -191 6 4 -8 -124
Net financial expenses -140 -356 -133 -140 -104 -508
Tax on net financial expenses 48 123 42 41 27 130
Group profit after tax 864 733 869 1,345 929 347

Minority interests -66 -91 -108 -134 -122 -138

Net profit to parent's shareholders 798 642 761 1,211 807 209

Analytical balance sheet ( € m )

Assets
Intangible assets 1,151 1,837 2,380 2,449 2,110 7,109
Tangible assets 4,995
Property, plant and equipment 4,773 5,067 4,944 4,673 6,314
Loans to customers 329 161 310
Deferred tax asset 269 286 395 316 259
Investments in associates 134 172 186 892 1,145
Total non-current assets 6,146 7,013 7,905 8,303 8,152 15,137

Current assets
Inventories 834 782 883 893 883 1,246
Trade and other receivables 1,379 1,646 1,787 1,917 1,769 2,504
Payments and accrued income 110 231
Total current assets 2,213 2,428 2,670 2,810 2,762 3,981
Provisions
Provisions long-term 1,367 298 273 242 158 344
Total provisions 1,367 341 373 364 301 502
Analytical balance sheet (€m) Year 3 Year 4 YearS Year 6 Year 7 Year 8
Non-interest-bearing debt
Current liabilities 2,910
Trade and other payables 2,025 2,389 2,486 2,504 3,759
Provisions short-term 43 100 122 143 158
Income tax payable 30 141 149 71 85
Deferred tax liabilities 384 393 471 427 637
Total non-interest-bearing debt 2,910 2,482 3,023 3,228 3,145 4,639

Invested capital 4,082 6,661 7,279 7,643 7,611 14,135

Group equity
Shareholder's equity 3,167
Issued capital 784 784 784 784 784
Reserves 354 568 666 692 -74
Retained earnings 2,118 2,617 3,559 3,928 3,761
Minority interests in other group 732 477 545 511 307 281
companies
Total group equity 3,899 3,733 4,514 5,520 5,711 4,752

Interest-bearing liabilities
Long-term borrowings 2,721
Interest-bearing loans and borrowings 2,615 2,195 2,091 1,295 9,084
Other non-current liabilities 23 38
Employee benefits 680 664 665 586 688
Bank overdraft 517 351 747 251 94
Derivatives used for hedging - - 62 10 21 87
Interest-bearing loans and borrowings 429 709 494 787 875
Total interest-bearing liabilities 2,721 4,264 4,019 4,007 2,940 10,828

Interest-bearing assets
Financial assets 1,122
Other Investments 632 646 457 236 331
Advances to customers 209 346
Investments/securities 76 26 23 12 14 14
Cash 1,340 678 585 1,374 560 698
Assets classified for sale 41 21 56
Total interest-bearing assets 2,538 1,336 1,254 1,884 1,040 1,445

Total invested capital 4,082 6,661 7,279 7,643 7,611 14,135

 CHAPTER 6

Growth analysis

Learning outcomes
After reading this chapter you should be able to:
• Measure how fast a company can grow while maintaining the financial risk at the
same level
• Recognise that there are many ways to measure growth but only one way to
measure if growth is value creating
• Evaluate the quality of growth
• Assess if growth is sustainable
• Understand whether growth induced by share buy-back adds value
• Understand the importance of liquidity when growing a business

Growth

G rowth in sales is seen by many as the driving force of future progress in enter-
prises. Growth is associated with value creation, but as shown in this chapter, it
is not always the case. However, it is clear that growth in businesses has secondary
effects that influence a company's stakeholders, for example:

• Shareholders perceive growth to be attractive as it allegedly creates value

• Lenders are interested as growth creates a need for liquidity
• Suppliers are keen to sell their products to growth companies
• Employees see growth companies as dynamic and challenging: an appealing work
environment.

A company can make a comparison with competitors' growth rates. This is done to
assess its relative performance, identify major competitors and to recognise future
growth opportunities. It is therefore no surprise that growth analysis is a key concept
in the accounting literature.
A firm's growth is a function of many factors including market growth and inten-
sity of competition. Measurement of growth in key financial data is therefore a mirror
image of how a company performs relative to its competitors. For the same reason,
growth-related financial ratios should never stand alone, but should be supplemented
with information on strategy, competitor information, information on market growth
and market share, etc.
 This chapter focuses on the measurement of growth from a financial perspective.
Specifically, the chapter aims at answering the following key questions about growth:
• How fast can a company grow, while maintaining the financial risk at the same
level (sustainable growth rate)?
Is growth always value creating?
What is the quality of growth?
• Is growth sustainable?
• Is growth in earnings per share (EPS) always value creating?
• Does growth in financial ratios caused by share buy-back always add value?
• What is the relationship between growth and liquidity?
We will discuss each of these issues in further detail below.

Sustainable growth rate

Companies may have set strategic objectives for market share and growth, but may be
unable to fund these objectives through internally generated cash. In this case, a firm
has a number of ways to finance its strategy. It can issue new shares, increase financial
leverage (borrow) or reduce dividends payments. Alternatively, a firm may reduce its
ambitions and adjust its strategy to reflect the firm's financial capacity.
A firm's sustainable growth rate is a useful growth measure. It indicates at what
pace a company can grow its revenues while preserving its financial risk; i.e. maintain-
ing its financial leverage at the same level despite growth. Knowledge about the sus-
tainable growth rate is also important in valuing companies and credit rating. Analysis
of the sustainable growth rate can also be used to identify the different sources of
growth, including operating and financial factors. This knowledge is important when
assessing the quality of growth.
The sustainable growth rate is calculated as:

where
g Sustainable growth rate
ROIC Return on invested capital after tax (based on the beginning of the
year balance sheet)
NBC Net borrowing cost after tax in per cent (based on the beginning
of year balance sheet)
NIBD Net interest-bearing debt
E Equity
PO Payout ratio (dividend as a percentage of net profit)
As shown in the formula for the sustainable growth rate, return on equity and the
payout ratio comes into play:
Figure 6.1 The relationship between the payout ratio and the sustainable growth rate

Return on equity is further dealt with in Chapter 5. The payout ratio is calculated
as the proportion of net earnings that is distributed to shareholders. From the above
equation it is evident that a company's dividend policy affects the sustainable growth
rate. Figure 6.1 illustrates how this is the case. Suppose a company's return on equity
is 20%. Based on this, it can be shown that the company's sustainable growth rate is a
function of a firm's dividend policy (payout ratio).
As shown in Figure 6.1 the sustainable growth rate decreases as the payout ratio
increases. In the extreme case where the entire profits are distributed to shareholders,
the sustainable growth rate becomes 0%. The example also shows that a company
that relies on a constant debt to equity ratio cannot grow faster than return on equity.
Based on the equation for the sustainable growth rate another point can be made.
Improved profitability allows for a higher sustainable growth rate. Suppose a com-
pany has the following characteristics:
Financial leverage = 1
Net borrowing cost after tax in per cent = 5%
Payout ratio = 0%
Based on these assumptions, the company's sustainable growth rate can be shown
as a function of operating profitability (return on invested capital after tax) as illus-
trated in Figure 6.2. For example, if ROIC is 5% or alternatively 10%, the sustainable
growth rate becomes:

As shown in Figure 6.2, there is a positive association between the return on invested
capital and a firm's sustainable growth rate.
The impact of financial leverage on the sustainable growth rate depends upon a
firm's ability to earn a return on invested capital in excess of its net borrowing rate.
 Figure 6.2 The relationship between return on invested capital and sustainable
growth rate

To the extent that the spread between return on invested capital and the net borrow-
ing rate is positive, financial leverage contributes positively to the sustainable growth
rate. This is illustrated in Example 6.1.

Example 6.1 Two companies within the same industry have the following characteristics:

Financial ratio Company 1 Company 2

Return on invested capital after tax 3% 7%
Net borrowing cost after tax 5% 5%
Minority interests share 1.0 1.0
Payout ratio 0% 0%

Based on these assumptions, the sustainable growth rate is a function of financial leverage as illus-
trated in Figure 6.3. When the return on invested capital exceeds the net borrowing rate, finan-
cial leverage contributes positively to the sustainable growth rate. On the other hand financial
leverage has a negative effect on the sustainable growth rate if the net borrowing rate exceeds
the return on invested capital.

For the two companies, the sustainable growth rate is calculated as:
 Figure 6.3 The relationship between financial leverage and sustainable growth rate

As Company 1 has a negative spread (ROIC - NBC < 0), financial leverage has a negative
impact on the sustainable growth rate. For example, had financial leverage been 2.0, the
sustainable growth would have been - 1 % .
In summary, we have identified three sources that affect the sustainable growth rate: oper-
ating profitability, financial leverage and dividend policies. Now, take a moment to consider
the following question:
Should companies always strive to obtain a high sustainable growth rate? •

A high sustainable growth rate indicates that a company has chosen to reinvest most
of its accounting profit and thus decided not to distribute it to its shareholders as divi-
dends or share buy-backs. From a shareholder's perspective, this is only attractive if
reinvestments derived from the accounting profit will be invested in profitable projects, i.e.
projects which create value. From the lender's standpoint, a high sustainable growth rate,
ceteris paribus, decrease the risk of the existing loan arrangements, since a larger share
of net profit remains in the company. Conversely, it reduces a firm's need for borrowing,
and thus banks' market for loans. Often a firm's dividend policy becomes part of the loan
terms (debt covenants). If a firm violates the debt covenants - for example, exceeds some
pre-defined limits for selected financial ratios - the banks can influence a firm's dividend
policy in order to increase the available collaterals in their lending commitments.

Is growth always value creating?

In addition to sustainable growth rate, many other growth measures are used, for
example, growth in:
• Revenue
• Operating profit (EBIT)
 • Net earnings
• Free cash flows
• Dividends
• Invested capital
• Economic value added (EVA).
In Table 6.1 Satair has been used to illustrate the effect of growth in selected account-
ing items, which are often used by analysts. Satair is one of the world's leading distribu-
tors of spare parts for aircraft and is listed on the OMX Nasdaq Stock Exchange.

Table 6.1 Satair: Growth in selected accounting items and performance measures
Year 1 Year 2 Year 3 Year 4 Avg
Revenue 20% 2% 3% 17% 10%
EBIT 34% -40% -21% -6% -8%
Net earnings 34% -65% 22% -24% -8%
Invested capital 69% 0% -12% 26% 21%
Owners' equity 29% 8% -8% 19% 12%
Free cash flow -199% -126% 368% -186% -36%
Sustainable growth rate 33% 7% 9% 6% 14%

A comparison of Satair's different growth rates reveals a disparate picture of

growth. Revenues, invested capital and equity increase on average by 1 0 - 2 1 %
annually, although growth is slowing. Moreover, the sustainable growth rate aver-
aged 14%. These figures indicate that Satair is a growth business. Another picture of
Satair appears when growth in accounting-based performance measures are analysed.
The average growth rate of net earnings and operating profit amount to minus 8%.
Similarly, there is a significant negative growth rate in the free cash flows, partly due
to investment in non-current assets. Therefore, based on the above, is Satair a growth
business?
The increase in accounting numbers such as revenue and invested capital demon-
strate that this is apparently the case. On the other hand, the trends in the perform-
ance measures indicate that Satair is rather a company with negative growth.
Chapter 5 shows that from a shareholder's perspective it is not sufficient that
accounting earnings are positive. Value creation is only obtained if accounting returns
(ROIC) exceed the required rate of return (WACC) or alternatively if return on equity
(ROE) exceeds investors required rate of return (re). As noted earlier this can be shown
in one of two ways:

These two measures provide the same results. A positive value added measure is a suf-
ficient condition to ensure that value is created from a shareholder's perspective. In a
growth context, it means that growth is only interesting if EVA (or residual income)
increases.
 Satair's EVA develops as shown in Table 6.2. WACC is assumed to be a constant
at 9% in all years. As shown, the development of EVA is negative in years 1 to 4.
From generating DKK 43.6 million in EVA in year 1, EVA becomes negative in
each of the following years. Satair, therefore, destroys value for its shareholders
over the period years 2-4. It is clear from the above calculations that growth in
revenue and invested capital has not created value. On the contrary, in contrast to
the growth in Satair's revenue and invested capital, EVA has become negative. From
a shareholder's perspective, Satair is not a growth business. The company seems to
experience negative growth based on the development in EVA. Shareholders have
also reacted negatively. The share price has almost dropped by 50% during the
four-year period.

Table 6.2 Satair: EVA calculations based on annual reports

DKKm Year 1 Year 2 Year 3 Year 4
Return on invested capital after tax 24.7% 8.9% 6.9% 7.4%
WACC 9.0% 9.0% 9.0% 9.0%
Invested capital 276.7 466.5 468.6 412.6
EVA 43.6 -0.6 -9.6 -6.5
Growth in EVA -101% -1,465% 32%
Share price 220 133 108 119

In general growth in EVA can be obtained by:

• Optimising existing operations (improving return on invested capital)

• Growth in invested capital if growth is profitable (ROIC > WACC)
• Reducing the cost of capital (WACC).

The actions a company can take to reduce its cost of capital are rather limited. Both
lenders and owners operate in a competitive market and are likely to offer financ-
ing on market terms, i.e. at competitive rates that reflect the underlying risk of the
company. This means that a firm can reduce the required rate of return from capital
providers (WACC) only by changing the capital structure. Both theoretically and in
practice, it is questionable whether changes in the capital structure reduce the costs of
capital (Parum 2001). In most cases, a company is therefore left to focus on optimis-
ing existing operations and invest in profitable business projects.
In the short term, optimisation of operations contributes to the growth in EVA.
There is, however, a limit as to how much companies can optimise operations.
Accordingly, long-term growth in EVA must come from investments in profitable busi-
ness projects.
Suppose Satair in years 2-4 had been able to maintain the same rate of return on
invested capital (24.7%) as in year 1. Under this assumption Satair's EVA would have
been positive and have grown, as shown in Table 6.3.
EVA would grow from DKK 43.6 million to DKK 64.9 million just like invested
capital increase during the period. The example illustrates that long-term growth in
EVA must come from investments in profitable projects.
 Table 6.3 Satair: EVA calculation at a constant ROIC
DKKm Year 1 Year 2 Year 3 Year 4
ROIC (beginning) 24.7% 24.7% 24.7% 24.7%
WACC 9.0% 9.0% 9.0% 9.0%
Invested capital, beginning 276.7 466.5 468.6 412.6
EVA 43.6 73.4 73.8 64.9
Growth in EVA 69% 0% -12%

What is the quality of growth?

An analysis of growth in EVA is important to prevent any faulty reasoning. It is appro-
priate to ask the question:
What is the underlying reason for the growth in EVA?

In this section, we present and discuss some of the financial factors that drive growth.
To provide a structure for growth analysis, the DuPont model introduced in Chapter
5 comes into play. This model is shown in a modified form in Figure 6.4.

Figure 6.4 Structure of the analysis of growth in EVA - DuPont model

The modified model demonstrates that it is changes in profitability (return on

invested capital) and cost of capital (WACC), which affects the growth in EVA. As
pointed out in the previous section, a company has few opportunities to affect the
cost of capital. Therefore, this section focuses on changes in operating profitability.
Furthest to right in Figure 6.4 several possible explanations for improvements in
 operating ratios, and hence growth in EVA, are provided. In this context it is impor-
tant to assess the sustainability of growth. It is more attractive if changes (improve-
ments) in financial ratios are persistent, i.e. recurring.

Growth in EVA due to growth in core business

Generally, it is assumed that earnings from a firm's core business are more attractive
than earnings of transitory nature, as earnings from core business to a greater extent
are expected to be recurring. Optimisation of earnings from core business may be
obtained in several ways:
• Introducing a more profitable pricing policy
• Selling fewer but more profitable products
• Using more efficient production methods, including outsourcing to countries with
low wages
• Changing the marketing approach
• Optimising administration
• Optimising invested capital (e.g. a reduction in inventories).
As shown in the Satair example, investments in existing businesses or new businesses
may lead to growth in EVA if the return on new investments exceeds the required rate
of return.
A change in the tax rate will have a lasting impact on future EVAs. For example,
in many countries the corporate tax rate is substantially lower today than just a few
decades ago. The lower tax rate has had a positive effect on EVA.

Growth in EVA due to transitory items

Accounting items, which all directly contribute to the growth in EVA, but which are
either transitory in nature, or merely reflective of an artificial increase in the underly-
ing operations, include:
• Gains and losses on sale of non-current assets
• Restructuring costs
• Discontinued operations
• Change in the corporate tax rate
• Changes in accounting estimates
• Changes in accounting policies.
Gains and losses on disposal of non-current assets, restructuring cost and discon-
tinued operations are accounting entries that are transitory by nature. The effect is
not long-lasting and the change in EVA attributable to these items is only temporary.
The impact of changes in the tax rate on earnings contains elements that are both
recurring and transitory by nature. On the one hand, a change in the tax rate will
have an impact on future earnings and the effect is therefore recurring in nature. On
the other hand, a change in the tax rate will affect the value of deferred tax liabilities
(deferred tax assets) which results in a gain if the tax rate decreases and a loss if the
tax rate increases. These gains and losses are non-recurring and therefore transitory.
At first sight changes in accounting policies and accounting estimates express a
sustained change, as it can be assumed that changes in accounting policies apply in the
 future. A closer analysis, however, demonstrates that this is not the case. First, changes
in EVA caused by changes in accounting policies or accounting estimates do not add
value as such. There is no association between the change in EVA and trends in the
underlying performance of the business. Second, it can be shown that any progress
in EVA prompted by, say, an expansion of the estimated lifetime of depreciable, non-
current assets is only temporary. This is illustrated in Example 6.2.

Example 6.2 Change of accounting estimate

An entity is characterised by the following financial characteristics:

Other assumptions:
• Non-current assets are identical to invested capital
• No growth in investments
Based on these assumptions NOPAT becomes:

EBITDA 1,200
Depreciation and amortisation -1,000
EBIT 200
Taxes (50%) -100
NOPAT 100

Assuming that the above assumptions remain constant in future periods, growth in the com-
pany's EVA can be calculated as shown in Table 6.4, and, as shown, there is no growth in EVA.
Operating profit after tax and costs of capital are constant over time.

Table 6.4 Growth in EVA before change in accounting estimates

Year 1 2 3 4 5 6

NOPAT 100 100 100 100 100 100

Non-current assets, end of year 500 500 500 500 500 500
Cost of capital -50 -50 -50 -50 -50 -50
EVA 50 50 50 50 50 50
Growth in EVA 0% 0% 0% 0% 0%

Now assume that the company changes its accounting estimates in year 4 for new invest-
ments, so that the expected useful life of its non-current (tangible and intangible) assets is
extended from two years to three years for all future investments. It affects in the short run
the accounting figures used to calculate EVA. This is shown in Table 6.5, and, as is evident,
depreciation is lower in years 4 and 5 due to the change in the estimated lifetime for non-
current assets. Also, the cost of capital increases due to the increase in book value of invested
 Table 6.5 Growth in EVA after change in accounting estimates
Changes in estimates
Year 1 2 3 4 5 6 7
WACC 10%
EBITDA 1,200 1,200 1,200 1,200 1,200 1,200 1,200
Depreciation and -1,000 -1,000 -1,000 -833 -667 -1,000 -1,000
amortisation
EBIT 200 200 200 367 533 200 200
Taxes (50%) -100 -100 -100 -183 -267 -100 -100
NOPAT 100 100 100 183 267 100 100
Non-current assets 500 500 500 667 1,000 1,000 1,000
Cost of capital -50 -50 -50 -67 -100 -100 -100
EVA 50 50 50 117 167 0 0
Growth in EVA 0% 0% 133% 43% -100% 0%

capital (non-current assets). The total effect is that EVA changes from 50 in year 1 to 167
in year 5. Looking further ahead EVA reverses to a 'permanent' level of 0 (zero). Growth in
EVA caused by changes in accounting estimates is, hence, non-lasting. It fades away, when
changes in applied accounting policies (accounting estimates) are fully normalised. Value
creation is - not surprisingly - unaffected as changes in accounting estimates have no cash
flow effects. •

In conclusion, growth in EVA caused by an improvement in the core business is

preferable. This is so because it must be expected that such an improvement is more
likely to continue (recurring) than improvements based on the disposal of assets or
changes in accounting estimates (i.e. transitory items). The above example illustrates
the importance of analysing the quality of growth in EVA. The concept of accounting
quality will be discussed further in Chapter 13.

Is growth sustainable?
One of the purposes of a growth analysis is to estimate future growth. This is done by
comparing the historical growth rate in revenues with future growth opportunities in
the industry. The potential growth will be affected by the underlying market growth,
for example, rivalry among competitors, threats from potential entrants and the rela-
tive competitive strengths.
It was argued above that growth caused by an improvement in the core business is
longer lasting than growth based on transitory accounting items. The question is how
stable each accounting item and financial ratio is over time. Stability in accounting
items makes it easier to forecast future earnings. Below, we examine the stability in a
number of financial ratios for US firms over a 50-year period. Specifically, we exam-
ine how accounting items and financial ratios correlate over time. For example, in
Table 6.6 we show how growth in revenue in year 0 is correlated with growth in
revenue in the following five years. The higher the correlation, the more stable the
growth in revenue.
Table 6.6 Measurement of the stability of selected financial ratios (correlation
coefficients)

Year relative to first year (year 0) 1 2 3 4 5

Growth in revenue 3230 15.44 12.53 10.90 11.87
EBITDA margin 97.25 93.91 90.64 89.01 85.75
EBIT margin 96.90 92.06 88.59 86.41 83.40
Special items/revenue 47.07 36.25 29.48 23.17 20.96
Tangible assets/revenue 89.14 80.82 78.68 77.68 74.71
ROIC 77.19 65.04 58.39 54.20 51.00
Source: Compustat®, Copyright © 2011 The McGraw-Hill Companies, Inc. Standard & Poor's, including
its subsidiary corporations (S&P), is a division of The McGraw-Hill Companies, Inc. Reproduction of this
Work in any form is prohibited without S&P's prior written permission.

As shown in Table 6.6, the correlation between growth in revenue last year and this
year (1) is only 32.3%. This shows a limited stability. This is also supported by the
development of growth in revenue as illustrated in Figure 6.5, where all companies
are divided into 10 portfolios in year 1 based on their growth in revenue. Thus, each
line in the figure represents one portfolio of companies with similar growth rates.
Each company remains in the same portfolio in the five subsequent years. As shown,
there is a clear tendency that an atypically high or low revenue growth rate for a port-
folio of companies is quickly followed by more normal growth rates. After no more
than three or four years, sales growth converges towards a long-term average value.

Figure 6.5 Stability (sustainability) in sales growth

Source: Compustat®, Copyright © 2011 The McGraw-Hill Companies, Inc. Standard & Poor's, including
its subsidiary corporations (S&P), is a division of The McGraw-Hill Companies, Inc. Reproduction of this
Work in any form is prohibited without S&P's prior written permission.

Table 6.6 also reports the correlation coefficients for margins, (the inverse of) turn-
over rate of tangible assets and ROIC. These correlation coefficients reveal that margins
and turnover rates remain stable and at a high level over time. For example, the correla-
tion coefficient between the EBIT margin today and six years ago is 83%. We have also
calculated a margin that only consists of special items; i.e. primarily transitory items.
The correlation coefficient between that margin today and six years ago was only 2 1 % .
 A comparison of ROIC inclusive of permanent and transitory accounting items
and transitory accounting items only, reveals larger correlation coefficients for ROIC
when calculated on both permanent and transitory accounting items together. To illus-
trate these results the relative development of the return on invested capital (including
both permanent and transitory items) and return on invested capital calculated solely
on transitory items are shown in Figures 6.6 and 6.7.

Figure 6.6 Return on invested capital (including both permanent and transitory items)
Source: Compustat®, Copyright © 2011 The McGraw-Hill Companies, Inc. Standard & Poor's, including
its subsidiary corporations (S&P), is a division of The McGraw-Hill Companies, Inc. Reproduction of this
Work in any form is prohibited without S&P's prior written permission.

Figure 6.7 Return on invested capital (including only transitory items)

Source: Compustat®, Copyright © 2011 The McGraw-Hill Companies, Inc. Standard & Poor's, including
its subsidiary corporations (S&P), is a division of The McGraw-Hill Companies, Inc. Reproduction of this
Work in any form is prohibited without S&P's prior written permission.
 As shown, both ratios converge towards a long-term average value. This pattern
is particularly noticeable for return on invested capital which is based on transitory
items only. The above findings support the importance of distinguishing between tran-
sitory and permanent items. The results also support economic theory. For example,
it seems impossible to maintain high growth rates in the long run. There is a tendency
for accounting items to converge towards a long-term mean value. This is a crucial
point when we discuss forecasting in Chapter 8.

Is growth in earnings per share (EPS) always value creating?

Analysts, managers and boards of directors often use the performance measure earn-
ings per share (EPS) in different contexts. Analysts use the growth in EPS in valuing
businesses. Presumably, there is a positive correlation between the growth in EPS and
firm value. This is illustrated by reference to the dividend discount model. Under the
assumption of constant growth the dividend discount model can be expressed as:

where
P = Estimated value of equity per share
Div = Dividends per share
re = Owners' required rate of return
g= Growth in dividends
Since dividends equals EPS × Payout ratio, the dividend model can be rewritten as follows:

Therefore, from the modified dividend discount model it seems that higher EPS will
lead to higher firm value. This implies that analysts will value a company at a higher
rate if EPS is growing.
Accordingly, boards may use EPS to determine management's bonus based on the
idea that an improved EPS will lead to higher firm value. Consider Example 6.3.

Example 6.3
Marks and Spencer has given a hint of the tough High Street environment, lowering the
profits the firm has to make for directors to earn bonuses.
Top executives will achieve a maximum payout if earnings per share grow by more than
8% above inflation, compared with a 12% target the previous year.
But M&S said the new target was 'at least as challenging' in the current economic climate.
Source: BBC News, 6 June 2008

•
As shown in the example, the top executives of Marks and Spencer are awarded
bonuses depending on the growth rate in earnings per share (EPS). Last year EPS had
to grow by more than 12% above inflation, while this year growth in EPS had to
exceed inflation by at least 8% for executives to earn bonuses.
However, it is not unproblematic to use the growth in EPS as a performance meas-
ure in bonus contracts. As illustrated in Example 6.4, it is possible to obtain growth in
EPS while destroying value at the same time, which makes accounting figures like EPS
questionable to use as performance measures.
Example 6.4 Earnings per share
In Table 6.7 it is assumed that the company is 100% equity financed and the number of shares
is constant. This implies that operating profit after tax equals net earnings. Furthermore,
investors' required rate of return is assumed to be 10%.

Table 6.7 Example of the growth in EPS and EVA

Year 1 2 3 4 5 6
Net operating profit after tax 100.0 115.0 132.3 152.1 174.9 201.1
(NOPAT)
Growth in EPS 15% 15% 15% 15% 15%
Invested capital 1,000.0 1,250.0 1,562.5 1,953.1 2,441.4 3,051.8
Growth in invested capital 25% 25% 25% 25% 25%
Cost of capital 100.0 125.0 156.3 195.3 244.1 305.2
Economic Value Added (EVA) 0.0 -10.0 -24.0 -43.2 -69.2 -104.0
Growth in Economic Value n.a. -140% -80% -60% -50%
Added (EVA)

As shown in Table 6.7, EPS grows by 15% annually. This immediately indicates a strong
progress and if the figures represented earnings' trends in Marks and Spencer, the company's
top executives would be awarded a bonus (unless inflation is above 15% - 8% = 7%).
However, growth in EPS (15%) is less than growth in invested capital (25%). This reduces the
overall profitability of the company. Apart from the starting point (year 1), EVA is negative
and increasingly so. The example illustrates that economic decisions, which are based on EPS,
and ignores investments, may lead to irrational behaviour. In the above example top execu-
tives would have received a bonus, despite the fact that they destroy value throughout the
analysed period. It is therefore essential to be cautious in applying growth in EPS as an indica-
tor of management's performance. •

Does growth in financial ratios caused by share

buy-back always add value?
It has become increasingly common for companies to buy back their own shares,
rather than using excess cash to pay out dividends. An argument for share buy-backs
is that it improves financial ratios, including EPS, and thereby supposedly increases
the value of the company.
Consider share buy-backs in Holland in recent years. As listed in Table 6.8 a
number of Dutch firms have had share buy-back programmes. Philips, for example,
bought back their own shares five times during a four-year period. Similar share buy-
back programmes are also prevalent in many other countries.
Figure 6.8 provides additional evidence on the increased use of share buy-back
programmes. Based on US data in the period from 1977 to 2004, it is evident that
investors in the beginning of the period earned a return almost entirely by means of
dividends (and price appreciation of the shares). In later years, however, the pay-off
to investors is almost equally split between dividends and share buy-backs. In fact, in
2004 share buy-backs represented a larger part of pay-off than dividends.
Table 6.8 Share buy-back in the Netherlands over a four-year period

Company Date Amount (EUR m) % of market cap

ABN AMRO 28 Jun 05 2,200 3.00%
ABN AMRO 8 Feb 07 1,000 1.40%
Aegon 10 Aug 06 170.7 0.70%
Aegon 1 Mar 07 117.4 0.50%
ASML 19 Apr 06 400 5.25%
ASML 9 Oct 06 180 3.00%
ASML 14 Feb 07 152 1.65%
ASML 28 Mar 07 30.00%
BE Semiconductor 27 Feb 07 5 3.00%
Beter Bed Holding 9 Mar 07 5 1.00%
CSM 17 May 05 90 5.00%
CSM 29 Sep 06 190 9.00-10.00%
DSM 27 Sep 06 750 10.00%
Fugro 28 Jun 05 12.2 0.50%
Hagemeyer 29 Jun 05 10.8 0.50%
Heineken 28 Jun 05 20.4
Heineken 1 Jan 07 8.74
Hunter Douglas 25 Nov 03 65.8 4.00%
ING 28 Jun 05 142 0.21%
KPN 28 Jun 04 500 3.00%
KPN 26 Jun 05 500 3.00%
KPN 1 Mar 05 985 6.70%
KPN 9 Aug 05 250 1.60%
KPN 7 Feb 06 1,515 6.5-7.0%
KPN 6 Feb 07 1,000 4.50%
Macintosh 28 Jun 05 7.4 1.1 3%
New skies satellites 1 May 03 49.8 6.67%
Nutreco 22 Jun 06 50 2.77%
Philips 27 Jan 05 500 2.00%
Philips 15 Aug 05 1,500 5.00%
Philips 17 Jul 06 1,500 4.0-4.5%
Philips 16 Oct 06 2,320 7.0-7.5%
Philips 9 Jan 07 1,630 5.00%
Reed Elsevier 16 Feb 06 870 5.00%
Royal Dutch Shell 29 Apr 04 1,300 1.90%
Royal Dutch Shell 4 Feb 05 5,000 2.5-4.5%
Stork 26 Jul 06 70 5.45%
Telegraaf 16 Mar 06 54.4 5.00%
TNT 6 Dec 05 1,000 10.00%
TNT 6 Nov 06 415 4.15%
TNT 6 Nov 06 585 5.85%
Unilever 10 Feb 05 500 1.80%
Unilever 8 Feb 07 750 2.03%
Vastned Offices/Industrial 15 Dec 05 16.6 3.87%
Vastned Retail 13 Sep 06 15.7 1.23%
Wereldhave 28 Jun 05 39.32 2.00%
Wolters Kluwer 27 Mar 07 475
Source: Annual reports, Bloomberg, Thomson OneBanker and Dealogic M&A analytics
 Figure 6.8 Dividends vs share buy-backs in the USA
Source: Mauboussin, 2006

On the face of it, it seems illogical that share buy-backs increase the value
of a company. The shares are purchased in free trade, i.e. at the current market
price and financed by drawing on cash balances or increasing interest-bearing debt.
The effect should be value-neutral. Net interest-bearing debt increases by exactly the
same amount as the reduction in equity due to the share buy-back. The investors have
therefore not gained any value from the share buy-back. Example 6.5 clarifies this
issue further.

Example 6.5 Effect of share buy-back on earnings per share (EPS)

This example is based on a firm that operates on a mature market without growth.
Competition is moderate, which ensures that return on invested capital equals cost of capital.
Due to lack of growth opportunities the firm is overcapitalised. As a consequence, equity
amounts to four times net interest bearing debt. During a board meeting it is decided to buy
back 300 shares. The share repurchase is financed by issuing new debt equivalent to 30,000.
The motive for the share repurchase programme is that the CFO of the firm has announced
that EPS and ROE will grow considerably, which is expected to have a positive impact on the
market value of the firm.
To make calculations simpler taxes are ignored. In Table 6.9 accounting items and financial
ratios are provided both before and after the share repurchase programme.
As shown in Table 6.10, the company buys back 300 of their own shares by issuing new
debt (increasing from 20,000 to 50,000). Consequently, EPS grows from 11.25 (9,000/800)
to 15.00 (7,500/500) representing a growth rate of 33.3%. Likewise, return on equity (ROE)
increases from 11.3% to 15.0%. After the share buy-back programme, EPS and ROE will
remain at 15.0% and 15.0%, respectively. As a result, there is a permanent change in the
level of EPS and ROE - evidence that firm value should increase.
Table 6.9 Impact on EPS by a share buy-back programme

Accounting items Before share repurchase After share repurchase

Invested capital 100,000 100,000
Net interest bearing debt 20,000 50,000
Equity 80,000 50,000
Number of shares 800 500
Financial leverage 0.25 1.00

EBIT 10,000 10,000

Interest expenses (5%) -1,000 -2,500
Net earnings 9,000 7,500

Financial ratios
EPS 11.25 15.00
EPS growth 33.3%
ROIC 10.0% 10.0%
ROE 11.3% 15.0%

Table 6.10 The impact of share buy-back on the required rate of return,
EVA, P/E and firm value
Cost of capital Before share repurchase After share repurchase
Risk free interest rate 4.0% 4.0%
β assets (business risk) 1.5 1.5
β debt (financial risk) 0.25 0.25
β equity 1.8 2.75
Risk premium 4.0% 4.0%
Equity cost of capital 11.3% 15.0%
WACC 10.0% 10.0%
Financial leverage 0.25 1.00

Valuation:
Invested capital 100,000 100,000
EVA 0 0
Enterprise value 100,000 100,000
Net interest bearing debt 20,000 50,000
Estimated value of equity 80,000 50,000
Estimated price per share 100 100
P/E 8.9 6.7
 However, ROIC remains at 10%, which is not surprising, as share buy-backs only affect the
capital structure not the firm's underlying operations and performance. This shows that the
firm value remains unchanged. In order to gain a deeper understanding of a share buy-back's
potential impact on firm value, consider the required rate of return both before and after the
share buy-back programme to show potential effects. The calculations follow.
They show that WACC remains constant at 10% (taxes and risk of bankruptcy are not con­
sidered). For instance, before the repurchase WACC is calculated as:

An unchanged WACC signals that a change in the capital structure does not create value for
shareholders.
As a consequence of the increased financial leverage (changes from 0.25 to 1.0) equity
owners require further compensation. The adjustment to equity cost of capital is calculated
as follows:1

Before repurchase:

where
βa = Systematic risk on assets; i.e. operating risk (unlevered beta)
βd = Systematic risk on debt
NIBD/E = Target firm's capital structure based on market values (net interest-bearing debt
to equity ratio)
With a higher systematic risk on equity (βe) of 2.75, cost of equity based on CAPM can be
calculated as:
Before repurchase:

Therefore, with the change in capital structure the equity cost of capital increases from 11.3%
to 15.0%. Cost of capital on the remaining equity, thus, neutralises the improvement in
return on equity. As a result, the firm does not create additional value due to changes in the
capital structure:

Enterprise value is left at 100,000 and the value of equity is 50,000 (enterprise value of
100,000 minus net interest bearing debt of 50,000).
If the firm is valued based on the P/E ratio, the firm appears cheap. This is further supported
by the fact that ROE has grown to 15%. The lower P/E, however, simply expresses the increased
risk in investing in the firm. As noted above, shareholders demand a higher return as a com­
pensation for the higher financial leverage. It can also be shown by the following P/E relation:2
P/E decreases from 8.9 to 6.7 due to the higher cost of capital of 15%. The market value of
equity based on the P/E relation equals 50,000 (6.7 × 7,500). Before share buy-backs the
market value of equity was 8.9 × 9,000 = 80,000.
In conclusion, share repurchases are equivalent to a change in the capital structure. The
underlying business is not affected by share repurchases.3 •

In Example 6.5 EPS grows by 3 3 % . It is, however, not certain that EPS increases as
a result of share buy-backs. Share buy-backs only lead to growth in EPS when return
on invested capital exceeds the net borrowing rate. Likewise, the consequences of
share buy-backs on EPS are negative if the net borrowing rate is higher than ROIC.
This is illustrated in Table 6.11 which exemplifies that a positive growth in financial

Table 6.11 The impact of share buy-backs on EPS assuming different relations between
ROIC and the net borrowing rate
ROIC < ROIC = ROIC >
Interest rate Interest rate Interest rate

Before share buy-back

EBIT 3,000 5,000 7,000
Financial expenses -1,000 -1,000 -1,000
Net result 2,000 4,000 6,000
Number shares 800 800 800
EPS 2.5 5.0 7.5

Equity 80,000 80,000 80,000

Net interest-bearing debt 20,000 20,000 20,000
Invested capital 100,000 100,000 100,000
ROIC 3% 5% 7%

After share buy-back

EBIT 3,000 5,000 7,000
Financial expenses -2,500 -2,500 -2,500
Net earnings 500 2,500 4,500
Number of shares 500 500 500
EPS 1.0 5.0 9.0

Equity 50,000 50,000 50,000

Net interest-bearing debt 50,000 50,000 50,000
Invested capital 100,000 100,000 100,000
ROIC 3% 5% 7%

Growth in EPS -60% 0% 20%

 ratios, including EPS, caused by share buy-backs requires a ROIC that exceeds the net
borrowing rate. The example further demonstrates that firms where management is
compensated based on EPS, or similar financial measures, may find it advantageous to
change the dividend policy so that dividends are paid to shareholders by means of the
firm buying back their own shares. This may explain why more firms buy back shares
as opposed to paying out dividends to shareholders.

I The relationship between growth and liquidity

Growth is often associated with cash consumption, as it requires investment in non-
current assets such as property, plant and equipment. Moreover, working capital usu-
ally increases with growth. Finally, higher sales are typically associated with higher
accounts receivable and inventories.
An examination of the correlation between sales growth and the free cash flow to
the firm for a large sample of European firms shows that it is highly negative. This
supports that sales growth is associated with cash consumption. It is therefore impor-
tant that growth is accompanied by close monitoring of cash flows. If there is a lack of
cash management, growth companies may eventually have to suspend their payments.
Table 6.12 illustrates what happens when a growth company runs short of cash.
Bioscan used to develop and manufacture bio-refineries, which collate and convert
organic waste such as manure, municipal waste, waste from food industry, organic
sludge and wastewater to:
• Clean water
• Green energy
• Fertiliser.

Table 6.12 The development in key financial data for Bioscan

Year 1 Year 2 Year 3 Year 4 Year 5 Accumulated

Revenue 2,748 1 7,976 23,396 32,422 16,247 92,789
Operating -5,935 -23,245 -41,396 2,408 -29,466 -97,634
earnings (EBIT)
FCF -18,356 -35,894 -25,725 -10,838 -10,293 -101,106
Market value 339,015 417,782 57,669 42,733 98,502
of equity

At first sight it seemed like a good idea to convert waste to clean water, energy and fer-
tiliser. The trend in Bioscan's revenue also supports this view. Bioscan is growing from
modest revenue of barely DKK 3 million in year 1 to revenues of DKK 32 million in
year 4. However, despite strong sales growth, earnings cannot keep pace and with the
exception of year 4, operating earnings are negative. At the same time, cash flow after
investments (the free cash flow) is negative in all years, and overall there is a financing
gap (negative cash flows) of approximately DKK 101 million. The above figures indi-
cate that this is a company with a serious liquidity problem. In year 3, Bioscan had
to let its German subsidiary suspend payments. Already at this point of time Bioscan's
future survival was questioned. The share price of Bioscan also fell sharply during the
period. The market value dropped from DKK 339 million in year 1 to barely DKK
 43 million in year 4. The market value, however, increased to approximately DKK 99
million in year 5. The stock market was seemed to be sceptical of Bioscan's business
model. The stock market was proved right. Bioscan suspended payments a few years
later and went bankrupt shortly thereafter.
As the example of Bioscan shows it is not sufficient to generate growth in revenue.
If growth does not generate sufficient profit (and ultimately) cash and management of
non-current assets and net working capital (invested capital) is inadequate, the conse-
quences on the firm's liquidity are negative.

Conclusions
The main points to remember are as follows:
• A company cannot grow faster than the sustainable growth rate if it wants to pre-
serve its financial risk. The company may affect the sustainable growth rate in three
ways. It may improve operating performance, enhance earnings from debt capital
(increase the interest spread and/or financial leverage) or reduce the payout ratio.
• Growth is not always value creating. For instance, growth in EPS and growth in
financial ratios induced by the purchase of own shares are not necessarily value
creating.
• It is rare that high sales growth can be maintained in the long run. Empirical evidence
supports that sales growth converges towards a long-term average after four to five
years. In this context it is important to distinguish between growth based on recur-
rent (permanent) and non-recurring (transitory) items. Growth based on the former
has considerably longer sustainability.
• Growth firms often consume cash and therefore it is important to closely monitor
the liquidity of these firms. Firms can generally improve liquidity by improving
the income-expense relation (profit margin) and the utilisation of invested capital
(invested capital turnover).
While this chapter primarily focuses on the historical growth, it is important to note
that the purpose of the historical growth analysis is often to predict future growth.
The historical growth analysis in this context provides valuable insight about future
growth, but will never stand alone. The historical analysis should be combined with
an in-depth knowledge of the market, the industry and the firm being analysed in
order to determine the future growth potential. Finally, we note that growth shall not
be maximised but optimised.

Review questions
• How is a firm's sustainable growth rate measured?
• What types of information can be retrieved from the sustainable growth rate?
• What factors affect a firm's sustainable growth rate?
• A firm's sustainable growth rate should be as high as possible - true or false?
• How should a firm's growth rate be measured if value creation is a key objective?
• Growth is always of the same quality - true or false?
 • Growth in EPS is always value creating - true or false?
• Does a share buy-back programme always result in an improved EPS?
• What is the relation between a firm's growth rate and its liquidity?

Notes 1 In Chapter 10 we elaborate in further details on the beta relations applied in this chapter.
2 Please refer to Chapter 9 for an elaboration of the applied P/E relation.
3 In the literature and among practitioners other arguments support share repurchases. Jensen
(1986) argues that firms that are high on cash may be tempted to carry out investments
that might often prove unprofitable. By paying out excess cash, firms (management) do not
have this option. It is also argued that share buy-back improves the underlying liquidity
in the stock. This argument seems, however, to be short sighted, as the number of shares
after share buy-back and cancellation of shares is fewer than before the share buy-back
programme.

References
Jensen, M.C. (1986) 'Agency costs of Free Cash Flow, Corporate Finance and Takeovers', The
American Economic Review, Vol. 76, 323-9.
Mauboussin, M. J. (2006) 'Clear Thinking about Share Repurchase', Legg Mason Capital
Management, 10 January 2006.
Parum, C. (2001) 'Corporate Finance', Lawyer and Økonomforbundets Publishing.
 CHAPTER 7

Liquidity risk analysis

Learning outcomes
After reading this chapter you should be able to:
• Recognise the importance of liquidity (cash)
• Understand the concept of short-term and long-term liquidity risk
• Calculate and interpret financial ratios used to measure short-term and long-term
liquidity risk
• Understand the merits and demerits of the financial ratios used to calculate
liquidity risk
• Recognise that using financial ratios is one of several ways of measuring
liquidity risk

Liquidity risk

L iquidity is a crucial subject for any business. Without liquidity a company cannot
pay its bills or carry out profitable investments and in certain cases lack of liquid-
ity leads to bankruptcy. Therefore, it is important to analyse short- and long-term
liquidity risk. Analysis of the short-term liquidity risk uncovers a company's ability to
satisfy (pay) all short-term obligations as they fall due. The long-term liquidity risk,
also defined as the solvency risk, refers to the company's long-term financial health
and ability to satisfy (pay) all future obligations. The short- and long-term liquidity
risk also serve as important input when evaluating the credit risk of a company.
A firm's liquidity risk is influenced by its ability to generate positive net cash flows
in both the short- and long-term. The ability to meet all short- and long-term com-
mitments is essential for any company to be able to act freely and exploit profitable
business opportunities.
Lack of liquidity may:
• Limit management's freedom of action
• Reduce the potential for profitable investment opportunities
• Force managers to divest profitable businesses with a substantial discount
• Increase financial expenses
• Lead to suspension of payment and possible bankruptcy.
As you can see, the lack of liquidity often affects a company's profitability negatively. It
is particularly damaging for shareholders because of their (bad) standing in the prior-
ity order in case of bankruptcy. Other stakeholders are also affected by a bankruptcy,
 for example, creditors lose on loan commitments and miss out on future business
opportunities, suppliers experience losses on their receivables and a potential lack of
sales outlets, customers face the risk of a shortage of supply and employees may lose
their jobs. Consequently, stakeholders have an interest in conducting a proper analysis
to identify both the short- and long-term liquidity risk.
A quantitative assessment of the short- and long-term liquidity risk can generally
be based on financial ratios, which rely on historical accounting figures, and various
forecasting techniques that predict the short- and long-term cash flows. In this chapter,
we purely focus on calculating and interpreting financial ratios measuring the short-
and long-term liquidity risk. In Chapter 8, we expand the analysis and explore how
cash flows can be forecast and in Chapter 11 we examine in further detail the credit
risk relying on both financial ratios and forecasting.
Financial ratios are often used to predict a company's short- and long-term liquid-
ity risk. For example, rating agencies rely on financial ratios when determining the
credit risk of a firm. Financial institutions often include financial ratios as covenants
in debt contracts and many companies evaluate their customers and suppliers based
on only a few financial ratios. While financial ratios are based on historical figures
and often describe parts of a company's profitability and financial position only, they
offer the advantage of being easy to calculate. This implies that many companies can
be analysed with only modest effort. Financial ratios have, therefore, proven to be a
cost-efficient way to rank businesses based on their liquidity risk.
In this chapter we use Rörvik Timber AB (Rörvik Timber) to illustrate the abili-
ties of financial ratios in predicting the short- and long-term liquidity risk. Rörvik
Timber is a Swedish company involved in the processing of wood. It is a spinoff of
the former RörvikGruppen and used to be listed on the Stockholm Stock Exchange.
A short description of Rörvik Timber including abstracts of management commen-
taries from the latest annual reports and a summary of key financial figures and
ratios is provided in Example 7.1. In Appendix 7.1 at the end of this chapter you will
find comprehensive income statements, balance sheets and cash flow statements from
year 1 to year 6.

Example 7.1
Rörvik Timber AB
Previously Rörvik Timber was involved in other business areas within the foresting and wood
industry and owned power and heating plants. Eight years ago a new strategy emerged and
the new long-term focus for the company should be the sawmill operations. Unrelated busi-
ness areas were divested and extensive structural programmes were initiated. The new strategy
focused on increased processing of products in order to create greater value for the customers
and the development of products should be made in close cooperation with the customers.
These initiatives and an expansion of the enterprise should make Rörvik Timber a preferred
long-term partner for other companies within the industry. Despite these initiatives Rörvik
Timber suspended its payments in year 7. The following abstracts from the annual report from
year 3 to year 6 briefly describe the management view of the business.

Management commentary year 3

Year 3 was overwhelmingly influenced by the hurricane that hit southern Sweden in
January. The hurricane Gudrun hit southern Sweden with extensive damage as a conse-
quence. In total, it is estimated that approximately 70 million forest cubic metres fell or
were damaged. The group industries moved up previously planned production increases.
These in order, to the fullest extent possible, utilise the increased inward shipments of
storm-felled timber and to minimise the significant financial damage that the storm caused.
The average price level on the timber products supplied was approximately 3% lower than
the previous year. The large quantity of timber on offer due to the storm meant substan-
tially lower price levels for raw material. The cost level for purchased timber during the year
fell by 2 5 % . The saw production during the year increased to 678 timber cubic metres,
largely due to the storm.

Management commentary year 4

Year 4 was characterised by a continued strong market and increased prices for sawn w o o d
products. The year's profit is the best in the group's history. Demand gradually increased dur-
ing the year. The market for sawn w o o d products has been strong in Europe, North Africa
and Asia. The market in the US has, on the other hand, weakened, primarily because of the
decreased pace of housing construction. During the year, Swedish export prices have risen by
approximately 18%.

Management commentary year 5

Profits after financial gains/losses increased by SEK 146 million to SEK 237 million. This is
the best net income in the history of the group. The profit was influenced in a positive man-
ner during the year by increased volumes and higher prices for sawn w o o d products and
by-products. The business segment 'Timber' has, thanks to this, shown an improvement in
operating profits to SEK 273 million . . . Year 6 has started with continued weak deliveries.
We expect to see a gradual seasonal recovery and a reduction in warehouse stores during the
second quarter. In a longer-term perspective, the market prospects for w o o d products look
quite positive.

Management commentary year 6

Year 6 is a year that is heavily affected by the financial crisis . . . For a long time many thought
that Europe would not be affected by the financial crisis that the United States had already
experienced in year 5. Today, we know the consequences of the financial crisis that has proven
to be both dramatic and have severe consequences . . . Profit before tax amounted to negative
SEK 293 million (237) . . . The weak market conditions have affected the sales negatively and
worsen the payment conditions. These difficulties have affected the cash flow negatively and
consequently, the company is facing difficulties in meeting future obligations .. .29 April year 7,
the company suspended its payments. . . The company has developed a reconstruction plan
that aims at improving the company's result and financial position.
Since the restructuring plan has not been completed, the auditor cannot confirm that
Rörvik Timber has sufficient liquidity to support its business. The auditor, therefore, questions
the going concern of Rörvik Timber in the annual report from year 6. The verbal description
retrieved from the management commentary and audit report from year 6 show that Rörvik
Timber has severe financial problems.
Table 7.1 gives a summary of the key financial figures and ratios for Rörvik Timber are dis-
closed. These financial figures and ratios indicate that Rörvik Timber is doing quite well until
year 5. In fact, growth rates are two-digits in most years and ROIC continuously improves
from year 1 to year 5 indicating that the company is generating more profit from operations.
However, a dramatic change is taking place in year 6. ROIC is negative and Rörvik Timber's
equity decreases by almost 5 0 % . Net interest-bearing debt (interest-bearing debt minus
excess cash) is peaking that year and equals SEK 885 million.
Table 7.1 Key financial figures and ratios (end of year balances) of Rdrvik Timber, year 1 to year 6
Income statement (SEKm) Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
Revenue 1,306.9 1,434.0 1,879.1 2,113.0 2,641.8 2,390.4
Net operating profit after tax 17.2 20.7 52.1 77.1 191.5 -167.9
Net income 7.6 2.3 42.6 65.2 169.4 -211.2

Balance sheet (SEKm) Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

Invested capital 535 521 574 697 1,203 1,109
Book value of equity 201 205 243 314 466 215
Net interest bearing debt 334 316 331 383 737 895

Cash flow statement (SEKm) Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
Cash flow from operations 10.1 61.3 75.5 14.0 -112.1 47.4
Cash flow from investments -65.1 -18.7 -55.2 -59.0 -166.8 -83.7
Cash flow from financing 51.5 -47.8 -3.4 24.9 278.3 36.1

Financial ratios Year 1 Year 2 Year 3 Year 4 YearS Year 6

Revenue growth 7.8% 9.7% 31.0% 12.4% 25.0% -9.5%
ROIC 3.2% 4.0% 9.1% 11.1% 15.9% -15.1%
Turnover ratio (invested capital) 2.4 2.8 3.3 3.0 2.2 2.2
NOPAT margin 1.3% 1.4% 2.8% 3.6% 7.2% -7.0%
Financial leverage 1.7 1.5 1.4 1.2 1.6 4.2
Return on equity 3.8% 1.1% 1 7.5% 20.7% 36.4% -98.3%

•
We will now examine whether financial ratios would have revealed that Rörvik
Timber eventually had to suspend payments.

Measuring short-term liquidity risk

In the following section, we describe some of the key financial ratios that can be used
to assess short-term liquidity risk. To help illustrate this, we use Rörvik Timber and
other firms as examples.

Liquidity cycle
An indicator of the short-term liquidity risk is the number of days it takes to convert
working capital to cash, also defined as the liquidity cycle or cash cycle. The basic idea
is that inventory and accounts receivable consume cash while accounts payable gener-
ate cash. The fewer days it takes to convert working capital into cash the better the
cash flow. The liquidity cycle is calculated as follows:
Consider a company with the following funds tied-up in working capital:
Days inventory in hand 35 days
Days accounts receivable in hand 42 days
Days accounts payable in hand -27 days
Liquidity cycle (measured in days) 50 days

Based on this simple numerical example, the liquidity cycle is 50 days. This indicates
that it takes 50 days to convert working capital into cash and that the turnover rate
for net working capital is approximately 7.3 (365/50). All other things being equal,
companies should strive to reduce the length of the liquidity cycle since it improves
its cash flows. This can be done by a tight control of inventory and receivables, or by
obtaining further credit from the company's suppliers.
By dividing the number of days in a year (365) with the turnover rate of net work-
ing capital we obtain an approximate value of the liquidity cycle:

Turnover rate of net working capital is defined as:

In Table 7.2 Rörvik Timber's liquidity cycle (days) is calculated for year 1 to year 6.
For instance, in year 1 net working capital consists of:

Accounting item Amount (SEKm)

Stocks on hand (i.e. inventory) 296.1
Short-term receivables (i.e. accounts receivable) 163.3
Accounts payable -126.7
Other liabilities, short-term -9.4
Accrued expenses and prepaid income -54.5
Net working capital 268.8

Table 7.2 Rörvik Timber's liquidity cycle (end of year balances) 1

Rörvik Timber (SEKm) Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

Net turnover 1,307 1,434 1,879 2,113 2,642 2,390
Net working capital 269 233 258 355 682 355
Liquidity cycle (days) 75 59 50 61 94 54
Net working capital, liqu idity 180 197 258 290 363 328
cycle = 50 days
1
Since we want the latest possible data, the financial ratios are based on end of year balances.

In year 1, the turnover rate for net working capital becomes 1,307/269 = 4.86 and
the liquidity is therefore 365/4.86 = 75 days.
As shown, Rörvik Timber's liquidity cycle improves from year 1 to year 3 by
25 days (75 days minus 50 days). From year 3, Rörvik Timber's liquidity cycle wors-
ens and in year 5 the liquidity cycle is 94 days. The development in the liquidity cycle
from year 3 to year 5 affects the cash flow negatively. If Rörvik Timber had been able to
 maintain its liquidity cycle of 50 days from year 3 until year 5 the net working capital
would equal SEK 363 million (682 × 50/94) compared to a realised net working capi-
tal equal to SEK 682 million in year 5. This difference corresponds to a negative cash
impact of SEK 319 million in year 5, which Rörvik Timber needs to get funded from
other sources, such as financial institutions and shareholders. Assuming a funding rate
of 8%, the funding cost of SEK 319 million equals SEK 25.5 million annually.
It is important to stress that the liquidity cycle only describes a fraction of a com-
pany's overall liquidity. Important elements, for example, operating income and
expenses and capital expenditures are not included in the financial ratio. Furthermore,
an appropriate benchmark is needed to fully utilise the potential of the liquidity cycle.
Despite these shortcomings the analysis of Rörvik Timber's liquidity cycle indicates
potential liquidity problems.

Example 7.2 End of year versus average balances

Financial ratios, which rely on data from the balance sheets, are based on ending balances
rather than the average of the beginning and ending balances. This is motivated by a desire
to work with the most updated data. To illustrate the point we have calculated the financial
leverage of Rörvik Timber in year 6 based on ending balance and the average of the begin-
ning and ending balances.

Rörvik Timber Year 6

Financial leverage, book values, end 6.45
Financial leverage, book values, average 3.96

Calculating financial leverage based on an ending balance provides a more accurate

picture of current financial leverage. Financial leverage based on average balances tends to
even out changes in the balance sheet. We acknowledge, however, that financial ratios based
on average balances may also serve a purpose when measuring liquidity risk as it evens out
temporarily events on the balance sheet. •

Current ratio
The current ratio is an alternative measure for the short-term liquidity risk:

The current ratio sometimes excludes the impact of inventory. This variation of the
current ratio is also defined as the quick ratio. The basic idea of the quick ratio is that
only the most liquid current assets are included.

Since the quick ratio includes only the most liquid current assets, it is perceived to be a
relatively more conservative indicator of the short-term liquidity risk than the current
ratio. Even so, both ratios attempt to answer the following question:
What is the likelihood that current assets cover current liabilities in the event
of liquidaion?
The basic idea is that the larger the ratio, the greater the likelihood that the sale of
current assets are able to cover current liabilities. Different rules of thumb are used to
assess the level of the current ratio. Some argue that a current ratio greater than 2.0 is
an indication of low (short-term) liquidity risk. However, as we illustrate below, it is
difficult to apply these rules of thumb across different industries and firms.
The usefulness of the current ratio (and quick ratio) depends on its ability to predict
future cash flow needs. As with the liquidity cycle, the current ratio relies on financial
data describing the net working capital position. Many aspects of a company's finan-
cial position are, therefore, not covered by the ratio. Moreover, it is doubtful whether
current net working capital is able to predict the development of future cash tied up
in working capital. The level of activities in an enterprise seems to be a much better
indicator of the development in working capital. For example, accounts receivable is
a function of revenue (and credit terms). Furthermore, greater activity leads to greater
purchases of materials (and thus a higher level of accounts payable) and inventories.
In the event of liquidation, it is doubtful whether assets can be realised at book
value. For example, inventory is recognised in the balance sheet at costs, which is
rarely a good indicator of the liquidation value. Assume that the inventory consists
of IT equipment, where (1) rapid obsolescence is inherent and (2) prices tend to fall
sharply for the same, or similar, products over time. In such cases, the purchase price
is typically a poor indicator of the actual realisable value and most likely overesti-
mates the realisable value. Furthermore, the realisation of accounts receivable is in
some ways equivalent to factoring. In case of factoring, financial institutions require
a discount to reflect the risk (bad debt) and the time value of money. In summary, the
book value of current assets often does not reflect the realisation value.
Finally, it may be difficult to estimate when the current ratio is at an adequate
level. As mentioned above, it is argued that a current ratio greater than 2.0 signals
low short-term liquidity risk. It is, however, not possible to operate with a general
rule of thumb across different business types or industries. Manufacturing firms often
have large inventories and accounts receivable, which substantially exceed operating
liabilities. Conversely, service companies are typically characterised by low levels of
inventory. In fact, for service companies' current liabilities often exceed current assets.
To illustrate this point, consider Getinge, a leading manufacturer of medical devices,
and ISS, one of the world's largest commercial providers of facility services.
Current ratio Year 1 Year 2
Getinge 2.11 2.13
ISS 1.00 0.96
Getinge's current ratio is twice as high as ISS's, which indicates that Getinge has a sig-
nificantly lower short-term liquidity risk than ISS. This difference is, however, driven
by differences in the business model of the two types of businesses. A capital intensive
business with delivery of physical goods, like Getinge, naturally has a relatively higher
current ratio compared to less capital intensive firms like ISS, which delivers services.
The example illustrates that it is important to adjust for differences in the operational
structure before interpreting the current ratio.
With this in mind, the current ratio for Rörvik Timber (end of year balances) is
calculated as:
Current ratio (SEKm) Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
Total short-term assets 469 425 646 796 1,181 846
Total short-term liabilities 211 367 596.1 635.9 802.4 980
Current ratio 2.22 1.16 1.08 1.25 1.47 0.86
 As shown, Rörvik Timber experiences a decline in the current ratio. In year 1 the
current ratio is a comfortable 2.22. Five years later the current ratio dropped to 0.86
indicating that current liabilities exceed current assets. As Rörvik Timber is a manu-
facturing company, you would expect a significantly higher current ratio. The decrease
in the current ratio over time along with the level of the current ratio in year 6 signals
high short-term liquidity risks. More interestingly, the most significant drop in the
current ratio is at the time when the annual report for year 2 is released, which is four
years before Rörvik Timber's suspension of payments. Therefore, despite some of the
shortcomings outlined above, the current ratio signals a potential liquidity problem
four years before Rörvik Timber suspended its payments.

Cash flow from operations to short-term debt ratio

The cash flow from operations (CFO) to short-term debt (current liabilities) ratio is
another financial ratio used to measure the short-term liquidity risk:

The CFO to short-term debt ratio deviates from the current ratio by using the actual
cash flows generated from operations rather than current and potential cash flow
resources (current assets). By replacing current assets with cash flow from operations,
the convertibility-to-cash problem of current assets is avoided. Furthermore, cash flow
from operations seems to be a better indicator of the cash available to serve cur-
rent liabilities on an ongoing basis than current assets. The following tabulation
shows the CFO to short-term debt ratio for Rörvik Timber (end of year balances)
from year 1 to year 6.

CFO to short-term debt ratio Year 1 Year 2 Year 3 Year 4 YearS Year 6
Cash flow from operations 10 61 76 14 -112 47
Current liabilities 211 367 596 636 802 980
CFO to short-term debt ratio 5% 17% 13% 2% -14% 5%

In most of the years, the cash flow from operations ratio is 5% or lower. A CFO
to short-term debt ratio of only 5% seems low. This indicates that Rörvik can only
pay 5% of its current liabilities from its operating cash flows on an annual basis; i.e.
it takes 20 years to repay current liabilities. However, as with some of the other ratios
the CFO to short-term debt ratio is difficult to interpret in the absence of a proper
benchmark.

Cash burn rate

The cash burn rate is one of the most conservative financial ratios used to measure
short-term liquidity risk and is typically only used on companies with negative earn-
ings. The ratio measures how long a company is able to fund projected costs without
any further cash contribution from shareholders or creditors. The ratio is defined as:
 The cash burn rate is typically used in businesses which do not yet have a proper level
of earnings. Start-up companies, biotech companies and similar types of businesses
are characterised by significant investments (cash outlays) and little or no earnings.
This implies that operating profit (EBIT) often equals operating costs for these types
of companies. In Table 7.3 the cash burn rate for four biotech companies have been
calculated.
The cash burn rate is calculated in months. This shows how many months the
biotech companies can continue operations assuming the current performance and
without additional funding from shareholders or debt-holders. The table shows that
Angel Biotechnology has 'easy converted to cash assets' (cash) for three months of
operations in year 2. In comparison, Genmab has cash for 27 months of operations
in year 2.
The usefulness of the ratio depends on the ability to estimate future costs as well
as revenues. In the above example we used EBIT from the last fiscal year. It may
prove to be a poor proxy for future cash needs. For example, Genmab doubled its
expenses from year 1 to year 2, which significantly worsened the cash burn rate in
year 2.

Measuring long-term liquidity risk

There are a variety of ratios that measure a firm's long-term liquidity risk. We intro-
duce some of the most frequently applied ratios. Financial ratios measuring the
long-term liquidity possess the same strengths and weaknesses as the financial ratios
measuring the short-term liquidity risk. For example, all of them rely on historical
accounting data and therefore are backward looking.

Financial leverage
An indicator of the long-term liquidity risk is financial leverage which can be meas-
ured in different ways:

A variation of financial leverage is the solvency ratio:

The financial leverage and the solvency ratio provide identical information about the
long-term liquidity risk. Generally, a high financial leverage and a low solvency ratio
indicate high long-term liquidity risk. In determining the financial leverage and the
solvency ratio, it is important that all financial obligations are recognised in the bal-
ance sheet including leases and other contractual obligations, which are 'off balance'.
The same is true for equity. All values should be included when determining equity. In
this context, it is important to determine whether the ratios should be based on book
values or market values. If market values are available it is generally recommended
that they are used. Market values are closer to the realisable value.
Table 7.3 Cash burn rate for selected biotech companies
Genmab (DK) Medarex (US) 4SC (GER) Angel Biotech. (UK) Neurosearch (DK)
DKK (000) USD (000) Euros(000) GPB DKK (000)
Year 1 Year 2 Year 1 Year 2 Year 1 Year 2 Year 1 Year 2 Year 1 Year 2

Accounts receivable 217,139 161,461 29,013 21,793 131 580 126,687 199,392 17,741 18,515

Other financial assets 3,561,690 1,691,999 311,437 281,186 6,858 14,687 127,711 218,790

Cash and cash equivalents 131,753 70,013 37,335 72,482 10,335 7,346 42,034 73,233 727,527 237,125

Easy converted to cash assets, total 3,910,582 1,923,473 377,785 375,461 17,324 22,613 168,721 272,625 872,979 474,430

EBIT -437,133 -869,998 -195,884 -186,955 -8,303 -12,695 -1,208,399 - 1,057,548 253,455 366,000

Cash burn rate (no. of months) 107 27 23 24 25 21 2 3 41 16

 Table 7.4 William Demant Holding's financial leverage and solvency ratio
William Demant Holding (DKKm) Year 1 Year 2
Equity, market value 28,063 12,718
Equity book value 435 541
Liabilities, total 3,726 3,926
Financial leverage, market values 0.1 0.3
Financial leverage, book values 8.6 7.3
Solvency ratio, market values 0.9 0.8
Solvency ratio, book values 0.1 0.1

To illustrate this point in Table 7.4 we have calculated the financial leverage and
solvency ratio based on both book values and market values for one of the leading
hearing aid manufacturers William Demant Holding.
The reported financial ratios based on book values and market values, respectively,
provide a different picture of William Demant Holding's long-term liquidity risk.
While the financial leverage and solvency ratio based on book values indicate that
the long-term liquidity risk is high for William Demant Holding the same ratios based
on market values provide opposite signals; i.e. that the long-term liquidity risk is low.
These opposite signals are driven by the difference in market value and book value of
equity. For example, in year 2 the market value of equity exceeds book value of equity
by a multiple of 23.5. If book values are used to evaluate the liquidity risk of William
Demant Holding, it is very likely that incorrect conclusions are drawn.
Given these considerations, Rörvik Timber's financial leverage and solvency ratio
based on book values and market values are shown in Table 7.5.

Table 7.5 Rörvik Timber's financial leverage and solvency ratio (end of year balances)
Rörvik Timber (SEKm) Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
Equity, market values 151 143 261 610 769 140
Equity, book values 201 205 243 314 466 215
Liabilities, total 567 544 759 875 1,309 1,386
Shareholders' equity and total 768 749 1,002 1,189 1,775 1,601
liabilities

Financial leverage, market values 3.75 3.81 2.91 1.43 1.70 9.90
Financial leverage, book values 2.82 2.66 3.12 2.78 2.81 6.45
Solvency ratio, market values 0.20 0.19 0.26 0.51 0.43 0.09
Solvency ratio, book values 0.26 0.27 0.24 0.26 0.26 0.13

Ideally both ratios should be compared to an industry benchmark. Given this caveat
the financial leverage based on book value appears to be moderate to high and the sol-
vency ratio appears accordingly to be moderate to low in the first five years. For exam-
ple, the financial leverage based on book values fluctuates in between 2.7 and 3.1. In
year 6 the financial leverage increases dramatically. The financial leverage gets close to
10. This clearly indicates that the long-term liquidity risk of Rörvik Timber is high. The
 example requires a few additional comments. First, in the case of Rörvik Timber, ana-
lysts would not be better off using market values. In fact, if they apply market values,
financial leverage decreases from 3.75 in year 1 to 1.70 in year 5 indicating a decreas-
ing liquidity risk at the company. This indicates the deficiencies of using market values.
If the market does not capture the fundamental value of the company it may provide
misleading signals. Second, as noted previously it is difficult to interpret both financial
leverage and the solvency ratio in the absence of a proper benchmark. Finally, neither
financial leverage nor the solvency ratio provide any clear signal of a dramatic change
in the long-term liquidity risk until the suspension of payments takes place.

Interest coverage ratio

The interest coverage ratio is an alternative financial ratio measuring the long-term
liquidity risk:

The interest coverage ratio measures a company's ability to meet its net financial
expenses. More specifically, the ratio shows how many times operating profit covers
net financial expenses. The higher the ratio, the lower the long-term liquidity risk.
Since EBIT is not a cash flow measure some analysts prefer to replace EBIT with cash
flow from operations:

There are different rules of thumb for what characterises an appropriate level of the
interest coverage ratio. However, due to different levels of the interest coverage ratio
across industries there is no common practice.
Table 7.6 illustrates Rörvik Timber's interest coverage ratio covering a six-year
period. The interest coverage ratio based on EBIT improves gradually from year 1 to
year 5, which indicates a decrease in the long-term liquidity risk. In year 6 the inter-
est coverage ratio is negative which supports a high long-term liquidity risk. It is sig-
nificant to note that the interest coverage ratio based on cash flow from operations is
negative in year 5. In the example of Rörvik Timber an interest coverage ratio based
on cash flows therefore provides more timely information about the liquidity risk than
an interest coverage ratio based on EBIT.

Table 7.6 Rörvik Timber's interest coverage ratio

Rörvik Timber (SEKm) Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
Operating profit/loss 26.2 11.7 73.2 107.8 267.7 -233.1
Cash flow from operations 10.1 61.3 75.5 14.0 -112.1 47.4
Net financial expenses 16.0 13.4 14.4 16.6 30.9 60.2
Interest coverage ratio 1.6 0.9 5.1 6.5 8.7 -3.9
Interest coverage ratio (cash) 0.6 4.6 5.2 0.8 -3.6 0.8
Cash flow from operations to debt ratio
The cash flow from operations to debt ratio is another financial ratio measuring the
long-term liquidity risk. It is defined as follows:

The CFO to debt ratio measures the extent to which current cash flow from operations
are sufficient to repay liabilities. A high CFO to debt ratio signals a low long-term
liquidity risk, as the company has sufficient cash to repay its liabilities. In comparison
to the CFO to short-term liabilities ratio, CFO to liabilities ratio also includes all non-
current liabilities.

Capital expenditure ratio

The capital expenditure ratio is yet another ratio, which intends to measure the long-
term liquidity risk. It is defined as follows:

The ratio shows the proportion of capital expenditure a company is able to fund
through its operations. A ratio greater than 1.0 indicates that cash flows from opera-
tions are sufficient to support capital expenditures. Since capital expenditures vary
across a company's lifecycle the ratio will naturally vary accordingly. For that pur-
pose, you may choose to include reinvestment as a proxy for capital expenditure:

A capital expenditure ratio based on reinvestments removes the impact of growth in

investments and show to what extent a company is able to finance reinvestments from
internally generated funds. In other words, a capital expenditure ratio based on reinvest-
ments provides evidence on the sustainability of the business model. If the capital expend-
iture ratio based on reinvestments in general is below 1.0 this is a sign that the company
does not have a sustainable business model. Often companies do not disclose the level
of reinvestments. In these instances, depreciation may serve as proxy for reinvestments.
Rörvik Timber's CFO to debt ratio and the capital expenditure ratio are reported
in Table 7.7. If we ignore year 1, the CFO to debt ratio is decreasing over time and

Table 7.7 Rörvik Timber's CFO to debt ratio and capital expenditure ratio (end-of-year balances)
Rörvik Timber Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Average
Cash flows from operating activities 10.1 61.3 75.5 14.0 -112.1 47.4
Liabilities, total 566.8 544.2 759.0 874.8 1,308.8 1 ,385.9
CFO to debt ratio 0.02 0.11 0.10 0.02 -0.09 0.03 0.02

Net investments in non-current assets 61.9 17.9 37.0 46.7 88.3 74.5
Depreciations (reinvestments) 35.0 35.0 36.0 40.5 48.1 59.6
Capital expenditure ratio 0.16 3.42 2.04 0.30 -1.27 0.64 0.29
Capital expenditure ratio (reinvest) 0.29 1.75 2.10 0.35 -2.33 0.80 0.38
 is disturbingly close to zero. The average CFO to debt ratio is only 0.02. 1 Therefore,
based on the cash flow generation from operations in the years 1-6, it would take
Rörvik Timber 50 years to repay its debt. The capital expenditure ratio is also
decreasing over time and more importantly, Rörvik Timber has problems financing
its capital expenditure through its internally generated funds. The capital expenditure
ratio based on reinvestments is on average 0.38, 2 indicating that Rörvik Timber is
only able to finance 38% of its reinvestments from cash flows from operations. This
indicates that Rörvik Timber's business model is not sustainable. Both the CFO to
debt ratio and the capital expenditure ratio indicate a high liquidity risk in Rörvik
Timber.
In Table 7.8 the different financial ratios measuring Rörvik Timber's short- and
long-term liquidity risk are summarised. If the financial ratios serve their purpose they
should be able to predict the suspension of payments well before year 7. In the last
column in Table 7.8, we indicate which annual report the financial ratio may signal
a potential liquidity problem. If the level of financial ratio is critically low or if the
financial ratio is developing in the wrong direction it signals liquidity problems. As
we have noted several times, it is difficult to evaluate whether the level of a financial
ratio is at a critical level without a proper benchmark. Therefore, the above interpreta-
tion is highly subjective. Given this caveat it appears that financial ratios measuring
the short-term liquidity risk are timelier than financial ratios measuring the long-term
liquidity risk. Furthermore, four financial ratios signal potential liquidity problems
several years prior to the suspension of payments. However, financial leverage and
the interest coverage ratio do not provide any indication of liquidity problems before
Rörvik Timber suspends its payments. This indicates that these financial ratios are not
timely indicators of liquidity risk; at least in the case of Rörvik Timber. In summary,
the example highlights the importance of using more than just one financial ratio
when analysing the liquidity risk of a company.

Table 7.8 A summary of the financial ratios measuring the liquidity risk of Rörvik Timber
Ratio Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year of signal
Short-term liquidity risk
Liquidity cycle (days) 75 59 50 61 94 54 Year 5
Current ratio 2.22 1.16 1.08 1.25 1.47 0.86 Year 2
CFO to short-term debt ratio 5% 17% 13% 2% -14% 5% Year 1 /4
Long-term liquidity risk
Financial leverage, market values 3.8 3.8 2.9 1.4 1.7 9.9 Year 6
Financial leverage, book values 2.8 2.7 3.1 2.8 2.8 6.5 Year 6
Interest coverage ratio 1.6 0.9 5.1 6.5 8.7 -3.9 Year 6
Interest coverage ratio (cash) 0.6 4.6 5.2 0.8 -3.6 0.8 Year 4
CFO to debt ratio 0.02 0.11 0.10 0.02 -0.09 0.03 Year 1/4
Capital expenditure ratio (reinvest) 0.3 1.8 2.1 0.3 -2.3 0.8 Year 1/4

Figure 7.1 offers an example of how to merge the two types of liquidity risk. Scenarios
that deserve attention are when companies are facing either short-term liquidity risk,
long-term liquidity risk or both. If a company is primarily facing short-term liquidity
Figure 7.1 Overall assessment of the short- and long-term liquidity risk

problems it should take necessary steps to overcome these problems. Lack of funding
until the launch of a new collection is an example of a short-term liquidity problem.
A convincing action plan to overcome short-term funding problems will most likely
convince shareholders and lenders to provide the necessary funding. Long-term liquid-
ity problems are often more challenging. Examples include the expiration of a patent
or increased competition on core markets, which deteriorates profit. Timely and con-
vincing restructuring plans need to be developed and implemented in time to meet the
problem of sufficient funding in the long run. If the necessary steps are not taken in
time, the company is facing the risk of bankruptcy. Companies tackling both short-
and long-term liquidity risk are likely bankruptcy candidates.
If companies are using measures, similar to the ones discussed in this chapter, to
evaluate the probability that a customer (or supplier) suspends its payment and the
likely economic consequence of a suspension of payments, a risk map may prove use-
ful. Figure 7.2 provides an example of a risk map.

Figure 7.2 Risk map of customers

There is only a low probability that customer A suspends its payments. Even in
cases where it suspends its payment the financial consequences are low. Customer B
 is also attractive in the sense that the probability that it suspends its payment is low.
However, in case it suspends its payments the financial consequences may be severe.
Customer D is the least attractive customer on the risk map. There is a high probabil-
ity that it suspends its payment. Furthermore, the financial consequences are high in
the event of a suspension of payments.

Shortcomings of financial ratios measuring the short- and

long-term liquidity risk
As noted previously, financial ratios measuring liquidity risk are:
• Based on historical accounting information and, as a result, backward-looking
• Only describing parts of a company's financial position
• Less useful in the absence of an appropriate benchmark
• Less useful if they are not used together.
Furthermore, since the financial ratios rely on accounting data it is important that
differences in accounting quality across time and across companies are adjusted for.
For example, reported EBIT may be affected by a gain or a loss that is transitory in
nature. Reported EBIT is therefore not sustainable in the future and adjustments need
to be made accordingly. In Chapter 13 we discuss the concept of accounting quality
in further detail.
For these reasons we generally suggest that the analysis is supplemented with a
comprehensive analysis that uncovers all important aspects of a company's financial
position. In addition to the financial analysis outlined in this chapter, it should include
a strategic analysis which encompasses an assessment of the industry attractiveness
and the competitive edge of the company being analysed relative to its peers. Ideally,
the financial analysis and the strategic analysis should be merged into a quantitative
assessment of the future cash flow potential of the company; i.e. a forecast of the
short- and long-term cash flow. In Chapters 8 and 11 we discuss these issues in greater
detail. In Chapter 8 we examine various forecasting techniques and in Chapter 11 we
elaborate further on how to assess the credit risk of a company using both financial
ratios, rating models and forecasting of cash flows.

Conclusions
This chapter focuses on estimation of the short- and long-term liquidity risk. The
essential points to remember include:
• Knowledge of the company's liquidity is important, as lack of liquidity may lead to
loss of business opportunities and, in a worst case, suspension of payments.
• Financial ratios offer the advantage of being easy to calculate. This implies that
many companies can be analysed with only modest effort. Financial ratios are
therefore a cost-efficient way to rank businesses based on their liquidity risk. This
also explains why rating agencies rely on financial ratios when evaluating compa-
nies' credit risk. Rating models are explained in greater detail in Chapter 11.
• Despite the appealing nature of financial ratios they should be used with caution.
Financial ratios are usually based on historical figures and often describe only
parts of a company's result and financial position. Since the financial ratios rely on
 accounting data the concept of accounting quality needs to be taken into account
before calculating and interpreting financial ratios measuring the short- and long-
term liquidity risk. Furthermore, in the absence of a proper benchmark the useful-
ness of financial ratios decreases.
• A combination of a qualitative and a quantitative assessment leading to reliable
forecast of the short- and long-term cash flow potential is expected to offer the
best estimate for the short- and long-term liquidity risk. While Chapter 8 discusses
forecasting in further detail, Chapter 11 addresses different ways to estimate the
credit risk. You may find it useful to re-visit this chapter when reading Chapter 11
on credit risk.

Review questions
• Why is it important to monitor the short- and long-term liquidity closely?
• Provide examples of financial ratios measuring the short-term liquidity.
• Provide examples of financial ratios measuring the long-term liquidity.
• What are the potential shortcomings of financial ratios?
• How can these shortcomings be addressed?

APPENDIX 7.1

Rörvik Timber's financial statements

Income statement (SEKm) Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

Net turnover 1,306.9 1,434.0 1,879.1 2,113.0 2,641.8 2,390.4
Cost of goods sold -1,245.3 -1,350.3 -1,712.1 -1,925.4 -2,273.6 -2,488.7
Gross profit/loss 61.6 83.7 167.0 187.6 368.2 -98.3

Selling expenses -28.0 -39.6 -42.8 -51.6 -51.8

Administrative expenses -44.1 -50.1 -54.4 -56.0 -65.8
Other operating income 7.0 8.5 28.1 20.8 71.0
Other operating expenses 0.0 -6.9 -12.6 -10.7 -13.7 -88.2
Depreciations and write-downs -35.4
of fixed assets
Operating profit/loss 26.2 11.7 73.2 107.8 267.7 -233.1
Income statement (SEKm) Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
Profit/loss from interests in group 1.4 3.0 1.0 0.0 0.0 0.0
companies
Interest income and similar income 0.7 0.4 0.9 0.4 0.0 0.0
Interest expenses and similar -16.7 -13.8 -15.3 -17.0 -30.9 -60.2
expenses
Profit/loss after financial income 11.6 1.3 59.8 91.2 236.8 -293.3
and expense
Transfers to /from untaxed reserves 0.0 0.0 0.0 0.0 0.0 0.0
Profit/loss before tax 11.6 1.3 59.8 91.2 236.8 -293.3

Taxes -4.0 1.0 -17.2 -26.0 -67.4 82.1

Net profit/loss 7.6 2.3 42.6 65.2 169.4 -211.2

(The terminology as in Rörvik Timber's annual report is adopted)

Assets (SEKm) Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

Long-term assets
Intangible assets
Goodwill 4.7 4.7 30.4 42.7 125.7 140.5
Other intangible assets 5.4
Total intangible assets 4.7 4.7 30.4 42.7 125.7 145.9

Tangible assets
Buildings and land 93.4 99.6 109.8 113.0 149.8 160.1
Plant and machinery 167.4 191.6 191.9 210.3 259.4 382.1
Equipment, tools and installations 7.1 7.1 13.0 14.8 19.9 27.4
New plant in progress 19.4 6.3 10.7 12.4 37.8 16.8
Total tangible assets 287.3 304.6 325.4 350.5 466.9 586.4

Financial assets
Interests in associated companies 4.3 6.4 - - - -
Other long-term securities 2.4 0.1 - - - -
Deferred tax receivables - 0.8 0.5 - - 21.7
Other long-term receivables - 7.2 0.4 - 0.6 1.2
Total financial assets 6.7 14.5 0.9 - 0.6 22.9

Total long-term assets 298.7 323.8 356.7 393.2 593.2 755.2

Assets (SEKm) Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
Short-term assets
Stocks on hand and related items
Stocks on hand 296.1 268.7 379.0 396.2 742.4 478.8
Total stocks on hand and related items 296.1 268.7 379.0 396.2 742.4 478.8

Short-term receivables
Accounts receivable from customers 111.3 107.0 170.0 272.3 279.1 314.1
Tax receivables 3.6 2.6 3.7 4.2 - 1.1
Other receivables 24.2 17.7 31.2 79.5 108.4 3.8
Prepaid expenses and deferred income 24.2 24.7 40.4 42.4 50.8 47.2
Total short-term receivables 163.3 152.0 245.3 398.4 438.3 366.2

Cash on hand and bank deposites 9.7 4.5 21.4 1.3 0.7 0.5

Total short-term assets 469.1 425.2 645.7 795.9 1,181.4 845.5

Total assets 767.8 749.0 1,002.4 1,189.1 1,774.6 1,600.7

Shareholders equity and liabilities Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
(SEKm)
Shareholder equity
Share capital 138.6 138.6 138.6 138.6 138.6 138.6
Other accrued restricted reserves/ 101.9 94.4 94.4 94.4 94.4 94.4
statutory reserves
Other reserves 1.5 -2.5 3.2 -0.8 -0.8
Retained profits -47.1 -32.0 -29.7 12.9 64.2 193.8
Net profit/loss for the year 7.6 2.3 42.6 65.2 169.4 -211.2
Total shareholder equity 201.0 204.8 243.4 314.3 465.8 214.8

Long-term liabilities
Deferred tax liabilities 29.5 28.5 40.2 50.8 71.3 -
Bank overdraft 220.5
Other liabilities and credit institutions 97.6 111.5 91.3 150.0 364.0 249.0
Financial leasing agreements 8.2 37.2 28.9 38.1 61.1 146.1
Other liabilities - long-term - - 2.5 - 10.0 10.8

Total long-term liabilities 355.8 177.2 162.9 238.9 506.4 405.9

 Shareholders equity and liabilities Year 1 Year 2 Year 3 Year 4 YearS Year 6
(SEKm)
Short-term liabilities
Bank overdrafts/credit line 178.1 211.1 186.1 289.3 346.2
Accounts payable 126.7 128.5 236.9 295.9 317.6 321.8
Taxes due 0.3 0.7 5.3 - 36.7 43.9
Other obligations to credit institutions 20.1 0.8 18.8 10.0 14.0 144.1
Other liabilities-short-term 9.4 10.9 14.6 56.3 68.1 12.3
Accrued expenses and prepaid income 54.5 48.0 109.4 87.6 76.7 111.7
Total short-term liabilities 211.0 367.0 596.1 635.9 802.4 980.0

Total shareholders equity and liabilities 767.8 749.0 1,002.4 1,189.1 1,774.6 1,600.7

Invested capital (assets) Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

Goodwill 5 5 30 43 126 141
Other intangible assets 0 0 0 0 0 5
Buildings and land 93 100 110 113 150 160
Plant and machinery 167 192 192 210 259 382
Equipment, tools and installations 7 7 13 15 20 27
New plant in progress 19 6 11 12 38 17
Interests in associated companies 4 6 0 0 0 0
Deferred tax receivables 0 1 1 0 0 22
Stocks on hand 296 269 379 396 742 479
Accounts receivable from customers 111 107 170 272 279 314
Tax receivables 4 3 4 4 0 1
Other receivables 24 18 31 80 108 4
Prepaid expenses and deferred income 24 25 40 42 51 47
Assets, operating 756 737 981 1,188 1,773 1,599

Non-interest bearing debt

Deferred tax liabilities 30 29 40 51 71 0
Accounts payable 127 129 237 296 318 322
Taxes due 0 1 5 0 37 44
Other liabilities - short-term 9 11 15 56 68 12
Accrued expenses and prepaid income 55 48 109 88 77 112
Non-interest-bearing debt, total 220 217 406 491 570 490

Invested capital (net operating assets) 535 521 574 697 1,203 1,109
Invested capital (liabilities) Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
Equity
Share capital 139 139 139 139 139 139
Other accrued restricted reserves/statutory 102 94 94 94 94 94
reserves
Other reserves 0 2 -3 3 -1 -1
Retained profits -47 -32 -30 13 64 194
Net profit/loss for the year 8 2 43 65 169 211
Equity, total 201 205 243 314 466 215

Net interest-bearing debt

Other long-term securities 2 0 0 0 0 0
Other long-term receivables 0 7 0 0 1 1
Cash on hand and bank deposites 10 5 21 1 1 1

Other liabilities - long-term 0 0 3 0 10 11

Bank overdraft 221 0 0 0 0 0
Other liabilities and credit institutions 98 112 91 150 364 249
Financial leasing agreements 8 37 29 38 61 146
Bank overdrafts/credit line 0 178 211 186 289 346
Other obligations to credit institutions 20 1 19 10 14 144

Net interest-bearing debt 334 316 331 383 737 895

Invested capital (equity and NIBD) 535 521 574 697 1,203 1,109

Notes 1 The average CFO to debt ratio is calculated as:

2 The average capital expenditure ratio is calculated as:

 PART 3

Decision making

Introduction to Part 3
8 Forecasting
9 Valuation
10 Cost of capital
11 Credit analysis
12 Accounting-based bonus plans for executives
 Introduction to Part 3

The previous chapters described the information available in the annual reports and
how to measure a firm's historical profitability, growth and liquidity risk. Chapters 8
to 12 apply the accounting information and the historical analysis in different decision
contexts.
Chapter 8 describes how to build pro forma statements that articulate; that is
they relate to each other in a certain way. It identifies key strategic and financial
value drivers and provides guidance on how to develop your own value driver map.
Furthermore, the steps involved in developing reliable estimates are addressed and dif-
ferent techniques are introduced to evaluate the achievability of forecasts.
Chapter 9 provides an overview of firm valuation techniques. Present value mod-
els such as the discounted cash flow model (DCF model) and the economic value
added model (EVA model) are presented and the chapter illustrates under which con-
ditions the different present value approaches yield identical value estimates. Popular
multiples including the P/E multiple and the EV/EBIT multiple are presented and the
theoretical link to present value approaches is established. Finally, the liquidation
approach is introduced and the distinction between an orderly liquidation and a dis-
tress liquidation is discussed.
Chapter 10 highlights why the cost of capital plays a central role in many deci-
sion contexts including valuation and compensation. Weighted average cost of capital
(WACC) is defined and the chapter elaborates on how to estimate the components of
WACC. The estimation of a firm's capital structure and its required rate of return on
equity and debt are discussed.
Chapter 11 focuses on credit analysis and discusses the importance of estimat-
ing exposure at default, probability of default, and probability of recovery in case of
default. It explains the difference between the fundamental analysis approach and the
statistical approach in credit analysis. The chapter illustrates how to conduct a credit
analysis based on fundamental analysis. An introduction to ratings from credit agen-
cies is provided and the distinction between an investment grade and a speculative
grade are shown. Finally, the chapter gives a short introduction to some of the statisti-
cal approaches available for credit analysis.
Chapter 12 addresses a number of analytical issues when designing an accounting-
based bonus plan for executives. The chapter discusses the choice of performance
measure, the pay to performance relation and the choice of performance standard.
Furthermore, accounting issues such as the treatment of transitory items and changes
in accounting policies in bonus contracts are addressed.
CHAPTER 8

Forecasting

Learning outcomes
After reading this chapter you should be able to:
• Identify key strategic and financial value drivers
• Design your own value driver map
• Prepare pro forma financial statements that articulate
• Develop reliable forecasts based on a strategic as well as a financial statement
analysis
• Evaluate whether forecasts are realistic
• Understand the challenges of forecasting

Forecasting

S o far we have focused on accounting data and the measurement of historical prof-
itability, growth and risk. In this chapter the lens changes from a historical view
to a forward-looking view and demonstrates how to develop a company's pro forma
income statement, balance sheet and cash flow statement. The development of pro
forma statements is at the heart of financial statement analysis. Investors typically
prepare pro forma statements with the purpose of valuing a business. They may also
analyse a firm's future cash position in order to evaluate the need for infusion of
capital. Lenders usually prepare pro forma statements with the purpose of evaluating
a customer's (business's) ability to service its debt. In addition, they may explore the
future business potential. As a final example, management prepares pro forma state-
ments for planning purposes and to provide performance targets.
We will build on the foundation laid out in Chapters 4 and 5 and separate operating
activities from financing activities, when forecasting future earnings and cash flows.
As noted in Chapter 4 operations (including investment in operations) is the primary
driving force behind a firm's value creation and, therefore, important to monitor and
measure. Financing, on the other hand, conveys information on how operations are
funded and provide useful information about a firm's financial risks.
In this chapter we make a distinction between the technical and the estimation-
related aspects of forecasting. By technical aspects we refer to the design of the value
driver setup and to the fact that pro forma statements must articulate; i.e. that the
bookkeeping is performed properly. By estimation related aspects we refer to the qual-
ity of the sources and analyses supporting the assumptions and estimates underlying
the pro forma statements. It is important to emphasise that the approach adopted in
this chapter rests on the assumption that the analyst is an 'outsider' and therefore has
 access to publicly available information only. If internal information is available, a
more refined forecasting approach can be developed.
In this chapter we refer to the term 'value driver'. We make a distinction between
strategic and financial value drivers. A strategic value driver is a strategic or an opera-
tional initiative that can be undertaken by a company with the purpose of improving
value. Examples of strategic drivers are: development of new products, entrance to
new markets and outsourcing of production or back-office activities. Strategic drivers
are industry and company specific. A strategic driver is sometimes referred to as an
executional driver. A financial value driver is a financial ratio or number that mir-
rors the company's underlying performance and is closely related to value creation.
Examples of financial value drivers are growth, margins and investment ratios. The
linkage between strategic and financial value drivers is illustrated here.

The linkage between strategic and financial value drivers suggests that it is the stra-
tegic and operating performance of a company that affects the financial value drivers.
This implies that financial value drivers do not create value per se. However, if a finan-
cial value driver is positively affected by an operational initiative, such as cost cutting,
it affects cash flows and value positively.

i The design of pro forma statements

There are many ways to design a forecasting system that ensures that the underlying
bookkeeping is performed properly; i.e. that debit and credit balance. Some prefer a
'line-item' approach where each accounting item is forecast without reference to the
expected level of activity. Others prefer a sales-driven forecasting approach reflecting
that different accounting items such as operating expenses and investments are driven
by the expected level of activity (i.e. sales growth). In this chapter we favour a sales
driven approach as we believe it ensures a better link between the level of activity in a
company and the related expenses and investments than a line-item approach.
In Table 8.1 we have designed a template in accordance with the sales-driven
approach. As the purpose of the template is to illustrate the design of pro forma
statements, which articulate, it is kept relatively simple. The template relies on eight
value drivers only and the level of aggregation is consequently high. For example,
Table 8.1 The value driver structure for creating simple pro forma statements
the template does not distinguish between different types of operating expenses;
only total operating expenses are forecast. Later in this chapter we discuss how
you might expand the template to comprehend more value drivers and thereby also
more accounting variables. The first column in Table 8.1 explains the number of
steps that need to be taken before you have prepared a pro forma income statement,
balance sheet and cash flow statement. The second column explains the account-
ing items that are forecast. The third column highlights the eight financial value
drivers that need to be forecast and finally the fourth column explains how each
accounting item is calculated. The basic idea of the template is that if you follow
all 29 steps, the result will be a set of comprehensive pro forma income statements,
balance sheets and cash flow statements which articulate. In that regard it is just like
following the recipe in a cookery book - except that the outcome has to be digested
in a different way!
This section demonstrates how the template can be used to prepare pro forma
statements. By relying on a simple numerical example as outlined in Table 8.2, we
make a distinction between the historical period, the explicit forecasting period and
the terminal period. The historical period is used as a foundation for our forecasts
and provides insights about the trends and levels of the eight financial value drivers
listed in Table 8.1. The explicit forecasting period reflects the period where financial
value drivers are not assumed to be constant; i.e. it is possible to change the level and
direction of each of the eight financial value drivers. The terminal period reflects a
'steady state' environment and assumes that everything remains constant; i.e. it is not
possible to change the level or direction of any of the financial value drivers subse-
quent to the first year of the terminal period. Accordingly, every forecast item grows
by the same constant in the terminal period.
As seen in the upper half of Table 8.2 the eight financial value drivers remain con-
stant during the last four years. Assuming the business environment remains stable
in the future, we extrapolate the historical performance into the explicit forecasting
period. Therefore, the value drivers in the explicit forecasting period exactly mir-
ror the realised value drivers. In the terminal period we assume that the growth rate
drops to 2% reflecting the expected long-term growth in the economy as a whole.
Other value drivers remain unchanged in the terminal period. Based on these forecast
assumptions we have developed a pro forma income statement, balance sheet and cash
flow statement that articulate as shown in Table 8.2.
In Table 8.3 we show how the projected financial data in Table 8.2 have been
calculated (allowing for rounding errors). We follow the same steps as in Table 8.1.
For example, step 1 in Table 8.3 is calculated as last year's revenue × 1 + the growth
rate (121.6 × (1 + 0.05) = 127.6). While most accounting items in Table 8.3 are self-
explanatory we elaborate on the estimation of investments in intangible and tangible
assets and net financial expenses. Investments in intangible and tangible assets are
calculated as the difference between intangible and tangible assets at the end and at
the beginning of the period plus depreciation and amortisation during that period.
Depreciation and amortisation are added back since they do not have any cash impact.

Intangible and tangible assets, end of period

+ Depreciation and amortisation
- Intangible and tangible assets, beginning of period
= Investments in intangible and tangible assets
Table 8.2 An example of a pro forma income statement, balance sheet and cash flow statement
Forecast assumptions Historical period Explicit forecasting period (forecast horizon) Terminal period
-4 -3 -2 -1 0 1 2 3 4 5 6 7
Revenue growth 5% 5% 5% 5% 5% 5% 5% 5% 5% 2% 2%
EBITDA/revenue 30% 30% 30% 30% 30% 30% 30% 30% 30% 30% 30%
Depreciation/intangible and 20% 20% 20% 20% 20% 20% 20% 20% 20% 20% 20%
tangible assets
Interest rate 8% 8% 8% 8% 8% 8% 8% 8% 8% 8% 8%
Tax rate 25% 25% 25% 25% 25% 25% 25% 25% 25% 25% 25%
Intangible and tangible 60% 60% 60% 60% 60% 60% 60% 60% 60% 60% 60%
assets/revenue
Net working capital/revenue 40% 40% 40% 40% 40% 40% 40% 40% 40% 40% 40%
Net interest bearing debt/ 50% 50% 50% 50% 50% 50% 50% 50% 50% 50% 50%
invested capital

Income statement -4 -3 -2 -1 0 1 2 3 4 5 6 7
Revenue 100.0 105.0 110.3 115.8 121.6 127.6 134.0 140.7 147.7 155.1 158.2 161.4
Operating expenses -70.0 -73.5 -77.2 -81.0 -85.1 -89.3 -93.8 -98.5 -103.4 -108.6 -110.8 -113.0
EBITDA 30.0 31.5 33.1 34.7 36.5 38.3 40.2 42.2 44.3 46.5 47.5 48.4
Depreciation and -12.0 -12.6 -13.2 -13.9 -14.6 -15.3 -16.1 -16.9 -17.7 -18.6 -19.0 -19.4
amortisation
EBIT 18.0 18.9 19.8 20.8 21.9 23.0 24.1 25.3 26.6 27.9 28.5 29.1
Tax on EBIT -4.5 -4.7 -5.0 -5.2 -5.5 -5.7 -6.0 -6.3 -6.6 -7.0 -7.1 -7.3
NOPAT 13.5 14.2 14.9 15.6 16.4 17.2 18.1 19.0 19.9 20.9 21.4 21.8
Net financial expenses, -3.8 -4.0 -4.2 -4.4 -4.6 -4.9 -5.1 -5.4 -5.6 -5.9 -6.2 -6.3
beginning of year NIBD
Tax shield 1.0 1.0 1.1 1.1 1.2 1.2 1.3 1.3 1.4 1.5 1.6 1.6
Net earnings 10.7 11.2 11.7 12.3 12.9 13.6 14.3 15.0 15.7 16.5 16.7 17.0

Balance sheet
Intangible and tangible assets 60.0 63.0 66.2 69.5 72.9 76.6 80.4 84.4 88.6 93.1 94.9 96.8
Net working capital 40.0 42.0 44.1 46.3 48.6 51.1 53.6 56.3 59.1 62.1 63.3 64.6
Invested capital (net 100.0 105.0 110.3 115.8 121.6 127.6 134.0 140.7 147.7 155.1 158.2 161.4
operating assets)
Equity, begin 50.0 52.5 55.1 57.9 60.8 63.8 67.0 70.4 73.9 77.6 79.1
Net earnings 11.2 11.7 12.3 12.9 13.6 14.3 15.0 15.7 16.5 16.7 17.0
Dividends -8.7 -9.1 -9.6 -10.0 -10.5 -11.1 -11.6 -12.2 -12.8 -15.2 -15.5
Equity, end 50.0 52.5 55.1 57.9 60.8 63.8 67.0 70.4 73.9 77.6 79.1 80.7

Net interest-bearing debt 50.0 52.5 55.1 57.9 60.8 63.8 67.0 70.4 73.9 77.6 79.1 80.7
(NIBD)
Invested capital (equity 100.0 105.0 110.3 115.8 121.6 127.6 134.0 140.7 147.7 155.1 158.2 161.4
and NIBD)

Cash flow statement

NOPAT 14.2 14.9 15.6 16.4 17.2 18.1 19.0 19.9 20.9 21.4 21.8
Depreciation and 12.6 13.2 13.9 14.6 15.3 16.1 16.9 17.7 18.6 19.0 19.4
amortisation
Net working capital -2.0 -2.1 -2.2 -2.3 -2.4 -2.6 -2.7 -2.8 -3.0 -1.2 -1.3
Investments, intangible and -15.6 -16.4 -17.2 -18.1 -19.0 -19.9 -20.9 -22.0 -23.0 -20.8 -21.3
tangible assets
Free cash flow to the firm 9.2 9.6 10.1 10.6 11.2 11.7 12.3 12.9 13.6 18.3 18.6
(FCFF)
Net interest-bearing debt 2.5 2.6 2.8 2.9 3.0 3.2 3.4 3.5 3.7 1.6 1.6
(NIBD)
Net financial expenses, -4.0 -4.2 -4.4 -4.6 -4.9 -5.1 -5.4 -5.6 -5.9 -6.2 -6.3
beginning of year debt
Tax shield 1.0 1.1 1.1 1.2 1.2 1.3 1.3 1.4 1.5 1.6 1.6
Free cash flow to equity 8.7 9.1 9.6 10.0 10.5 11.1 11.6 12.2 12.8 15.2 15.5
(FCFE)
Dividends -8.7 -9.1 -9.6 -10.0 -10.5 -11.1 -11.6 -12.2 -12.8 -15.2 -15.5
Cash surplus 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0
Please note that rounding errors may occur.
Table 8.3 An elaboration of the first forecasting year in Table 8.2 (rounding errors may occur)

Step Value drivers Calculations (year 1)

Income statement
1 Revenue I 121.6 × (1 + 5 % ) - 127.6
2 Operating expenses (excl. depreciation) 127.6 - 38.3 = 89.3
3 = Earnings before interest, taxes, II 127.6 × 3 0 % = 38.3
depreciation and amortisation (EBITDA)
4 Depreciation and amortisation III 76.6 × 20% = 15.3
5 Operating income before tax (EBIT) 38.3 - 15.3 = 23.0
6 Tax on EBIT IV 23.0 × 25% = 5.7
7 = Net operating profit after tax (NOPAT) 23.0 - 5.7 = 17.2
8 Net financial expenses before tax V 8% × 60.8 (beginning of year
NIBD) = 4.9
9 Tax shield 4.9 × 25% = 1.2
10 = Net income 17.2 - 5.1 + 1.3 = 13.6

Balance sheet
Assets
11 Intangible and tangible assets VI 127.6 × 6 0 % = 76.6
12 Net working capital VII 127.6 × 40% = 51.1
- Inventory
- Accounts receivable
- Accounts payable
- Other operating liabilities
13 Invested capital (net operating assets) 76.6 + 51.1 = 127.6

Liabilities
14 Equity, beginning of period 60.8
15 Net income 13.6
16 Dividends -10.5
17 = Equity, end of period 63.8
18 Net interest-bearing debt (NIBD) VIII 127.6 × 50% = 63.8
19 Invested capital (Equity + NIBD) 63.8 + 63.8 = 127.6

Cash flow statement

20 NOPAT 17.2
21 + Depreciation and amortisation 15.3
22 Net working capital 48.6 - 51.1 = - 2 . 4
23 Net investments (fixed assets) 72.9 - 7 6 . 6 - 15.3 = -19.0
24 = Free cash flow to the firm (FCFF) 17.2 + 15.3 - 2 . 4 - 19.0 = 11.2
25 New net financial obligation 63.8 - 60.8 = 3.0
26 Net financial expenses after tax - 4 . 9 + 1.2 = - 3 . 7
27 = Free cash flow to equity holders (FCFE) 11.2 + 3.0 - 3.7 = 10.5
28 - Dividends -10.5
29 = Cash surplus 10.5 - 10.5 = 0.0
Table 8.4 Calculation of investments in intangible and tangible assets (rounding errors may occur)

Forecast year

Investments, intangible 1 2 3 4 5 6 7
and tangible assets

Intangible and tangible assets, end 76.6 80.4 84.4 88.6 93.1 94.9 96.8
of period
Depreciation 15.3 16.1 16.9 17.7 18.6 19.0 19.4
Intangible and tangible assets, -72.9 -76.6 -80.4 -84.4 -88.6 -93.1 -94.9
beginning of period

Investments, intangible 19.0 19.9 20.9 22.0 23.0 20.8 21.3

and tangible assets

In Table 8.4 we show how investments in intangible and tangible assets are calcu-
lated for each forecast year. Net financial expenses are measured as the net borrow-
ing rate multiplied by net interest-bearing debt at the beginning of the year. Since we
intend to apply the example for valuation purposes in the next chapter it is useful to
apply the net interest-bearing debt at the beginning of the year when calculating net
financial expenses.
The template outlined in Table 8.1 - and exemplified in Tables 8.2, 8.3 and
8.4 - is a powerful tool to obtain an understanding of how to develop pro forma
financial statements which articulate. For example, it stresses the importance of
forecasting all accounting items, as this is the only way to ensure that the pro
forma statements articulate. The template also highlights the financial value driv-
ers that need to be forecast and illustrate the internal coherence of the different
statements. It demonstrates that it is possible to develop a pro forma income state-
ment, balance sheet and cash flow statement based on only a few financial value
drivers.
It is important to note that the template rests on a number of assumptions that
may not necessarily reflect the underlying economics of a company. For example, we
assume that all cash surpluses are paid out as dividends. This may be a poor description
of a company's de facto dividend policy. It may therefore be necessary to modify the
template accordingly. In the next section we address some of the modifications that
you may consider when refining the template.

Designing a template for forecasting

When you design your own template for forecasting purposes there are many issues
that need to be taken into account. Some of these issues are discussed in this section.
Specifically we raise and discuss the following questions:
• Do the financial value drivers in the template reflect the underlying economics of a
company?
• Are all relevant value drivers included?
• Is the level of aggregation of the financial value drivers appropriate?
Do financial value drivers in the template reflect
the underlying economics of a company?
Even though each financial value driver in the template has been carefully designed
to reflect the underlying economics of a company there may be circumstances where
a value driver needs to be modified. The following three examples illustrate this
issue.
First, the template assumes a linear relationship between intangible and tangible
assets and revenue. While this is a fair description for firms that gradually invest in
such assets according to the level of activity, it may also be a poor description if invest-
ments are more discrete in nature and mainly done years apart. For example, airports
only invest in a new terminal maybe every tenth or twentieth year. Therefore, airports
serve as a prime example of an industry where investments are only carried out with
large time intervals. This idea is illustrated in Figure 8.1.

Figure 8.1 Intangible and tangible assets as a percentage of revenue

The coloured line reflects a company that gradually invests in intangible and tan-
gible assets according to the level of activity whereas the black line mirrors a com-
pany that invests every fifth year. The illustration highlights the lack of stability in the
investment driver (value driver VI in the template) when investments take place years
apart. If a company's investment plans are known or if the investments reflect the
latter case described above it may be more useful to change the investment driver to
simply reflect the expected level of investments each year.
Second, in the template net financial expenses are calculated as the net borrowing
rate × the net interest-bearing debt (NIBD) by the end of each forecast year while
in the example net financial expenses are based on net interest-bearing debt at the
beginning of each forecast year. Assuming a steady growth in net interest-bearing
debt during each forecast year it appears more appropriate to apply the average net
interest-bearing debt as deflator. This is, however, easy to integrate in the template by
simply calculating net financial expenses as follows:
 Third, in the template dividends are a function of the cash surplus earned during
each forecast year; i.e. the cash not consumed in operations, investments and financ-
ing. However, some companies operate with a target pay-out ratio. In those cases it
may be more appropriate to estimate dividends as a function of the pay-out ratio and
net earnings:

Dividends = Net earnings × payout ratio

In case dividends are no longer a residual of the cash surplus, and thereby violate the
final step in the template, it is necessary to modify the template accordingly. It may
therefore be useful to consider net interest-bearing debt as a final step ('plug') in the
template that ensures an articulation of the pro forma statements. Net interest-bearing
debt is then estimated as follows:

Net interest-bearing debt, end of period

= Net interest-bearing debt, beginning of period + cash surplus

Are all value drivers in the template included?

There may be aspects of a company's economy that are not properly addressed in the
template for reasons of simplicity. For example, the template assumes that all taxes are
paid as earnings are generated (e.g. all taxes on earnings generated in year 1 are paid in
year 1). This is a heroic assumption since companies are mostly able to defer taxes into
future periods due to an attractive tax driven depreciation scheme. Therefore, for those
companies it is important to add deferred tax liability as an additional value driver in
the template, as net cash inflows will otherwise be underestimated. Assuming deferred
tax liabilities are a function of the activity in a company the deferred tax driver can
either be defined as:

Deferred tax liability

Revenue
or

Deferred tax liability

Intangible and tangible assets
A more exact estimation of deferred tax liability requires information about the future
taxable income. We ask you to refer to Chapter 14 if you want further information on
how deferred tax liabilities are calculated.

Is the level of aggregation in the template appropriate?

As noted previously the template is based on a high level of aggregation. For exam-
ple, operating expenses are estimated as the residual of the EBITDA margin (e.g. if
the EBITDA margin is estimated at 5%, operating expenses amount to 95% of rev-
enues). This implies that the template does not distinguish between the different types
of (operating) expenses and therefore does not allow you to forecast each type of
expenses separately. In cases where more detailed information about the cost structure
is available, it may be useful to apply a more refined approach allowing each operating
expense to be forecast separately. The following tabulation provides an example of an
alternative value driver setup for operating expenses for companies reporting expenses
by function.

Cost of goods sold = Cost of goods sold as a percentage of revenue

Sales and distribution costs = Sales and distribution costs as a percentage of revenue
Administration cost = Administration as a percentage of revenue
R&D expenses = R&D as a percentage of revenue
Special items, net = Special items as a percentage of revenue

In this modified value driver setup the EBITDA margin becomes a residual; i.e. a result
of revenue minus operating expenses. Obviously, the proposed value driver setup for
operating expenses should be modified for companies reporting expenses by nature.
Net working capital as a percentage of revenue serves as another example of a
high level of aggregation. Net working capital can be decomposed into the following
variables:
• Inventory
• Accounts receivable
• Other operating receivables
• Accounts payable
• Other operating liabilities.
It is even possible to decompose those variables further. For example, other operating
liabilities can be decomposed into tax payable, VAT, salaries due to employees, etc.
Often it makes sense to apply a more refined approach when predicting net working
capital. Companies take initiatives to strengthen different components of net working
capital and this must be reflected in the pro forma statements. An example of a more
refined approach is the one outlined below.

Inventory = Inventory as a percentage of revenue

Accounts receivable = Accounts receivable as a percentage of revenue
Other receivables = Other receivables as a percentage of revenue
Accounts payable = Accounts payable as a percentage of revenue
Other operating liabilities = Other operating liabilities as a percentage of revenue

In this modified value driver setup net working capital is a function of inventory,
accounts receivable, other receivables, accounts payable and other operating liabilities
and is expressed as a percentage of revenue.
Figure 8.2 illustrates how the eight financial value drivers listed in the template in
Table 8.1 can be further refined to accommodate these observations. It shows that it
Figure 8.2 Expanded value driver map
is possible to expand the financial value driver map considerably allowing the analyst
a greater degree of flexibility. The number of value drivers has been expanded from 8
to 23. In Appendix 8.1 we apply elements of the more refined value driver setup when
preparing pro forma statements for Carlsberg.
The design of the value drivers and thereby the level of aggregation is influenced
by a number of factors that need to be taken into account. For example, if detailed
information is available such as internal information it seems useful to apply a more
refined value driver approach. If the purpose of the analysis is short-term forecasting
such as predicting next year's earnings, a more refined value driver approach also
seems useful as more information tends to be available. However, if the purpose of
the analysis is long-term forecasting, it is likely that a more aggregated value driver
setup such as the one in Table 8.1 is more appropriate. This is mainly due to the fact
that information tends to become cruder and less accurate the further in advance
forecasts are made. In these cases analysts tend to focus on the long-term behaviour
of key financial value drivers such as growth and EBITDA margins. This is illustrated
in Figure 8.3.

Figure 8.3 Factors influencing the level of aggregation of accounting data and value
driver setup

The coloured line reflects the level and the accuracy of information available at a
given point in time and the black line illustrates the recommended level of aggregation
of value driver setup relative to time. The figure suggests that as analysts forecast more
than just a few years into the forecast horizon, the quality of information available
typically do not justify a refined value driver setup in line with the expanded value
driver map in Figure 8.2. In these cases analysts are usually better off applying indus-
try specific levels and trends on aggregated financial value drivers such as growth and
margins. These financial value drivers tend to revert towards a mean for the industry.
In summary, analysts are probably better off working with a more refined set of value
drivers for short-term forecasting and a more aggregated set of value drivers for long-
term forecasting.
 The estimation of financial value drivers
So far we have focused on designing a financial value driver map that describes funda-
mental aspects of the underlying economics of a company and developing pro forma
statements that articulate. While it is relatively simple to design a value driver map and
develop pro forma statements that articulate it is more time consuming and challeng-
ing to develop estimates for each financial value driver. It requires that each estimate
in the pro forma statements is supported by useful sources and carefully conducted
analyses. The GIGO principle also applies in this context, i.e. garbage in garbage out.
It is therefore essential that the analyst can 'see' into the future with a high degree
of visibility. In the following sections we discuss how a strategic analysis as well as a
financial statement analysis help the analyst in generating better forecasts.

Strategic analysis
The strategic literature provides guidance on the structure and types of analyses that
analysts can follow to cover important aspects of a company's cash flow potential and
risk. In this section we suggest a top-down approach that aims at understanding:
• The nature of the company's business environment
• Macro factors influencing the company's cash flow potential and risks
• Industry factors influencing the company's cash flow potential and risks
• Company specific factors influencing the cash flow generation and risks
• Value chain analysis
• A company's Strength, Weakness, Opportunities and Threats.
In the following we describe each of these steps involved in a top-down approach.

The nature of a company's business environment

It may be useful to take an initial view of the stability of the company's business envi-
ronment and uncover the complexity and dynamics of the industry. This helps the
analyst to decide on the appropriate level of analysis.
Dynamics and complexity refer to the stability of the market and simplicity of the
product or services being delivered to customers, respectively. The perception is that if
the market is stable or even static and the products are simple, the analyst only needs
to conduct the analysis on a historical basis as a means of forecasting future outcomes.
On the other hand, if the market is dynamic and/or if the product(s) or service(s) are
complex, it makes less sense to rely purely on historical information. The competition
may rapidly change or new products or services may be introduced which change the
competitive landscape. In these cases it is important to obtain a fundamental under-
standing about the underlying drivers of the market and the next generation of prod-
ucts or services. These thoughts are illustrated in Figure 8.4.
The first step of the strategic analysis sets the scope of the analysis. If the market
is stable and the product or service is fairly simple, the analysts will most likely
make a relatively plain analysis relying to a large extent on past performance. On the
other hand, if the market is not stable or if the product or service tends to become
more complicated over time, the analyst will tend to make a more thorough analy-
sis dealing with the uncertainties of the market and the products or services being
offered. Historical data will no longer satisfy the analyst. The analyst will search
for information that provides insights about the market and the next generation of
Figure 8.4 The dynamic of the market and the complexity of the product

products or services being offered. Furthermore, the forecasting is most likely based
on scenarios.

Macro factors influencing the company's cash flow potential and risk
The primary objective of the macro analysis is to detect macro factors that may affect
a company's cash flow potential and risk. In Table 8.5 a number of macro factors are
listed. The model is also known as the PEST model indicating the impact of political,
economic, social and technical factors on cash flow and risk. It is important to stress
that the list of macro factors is not exhaustive.

Table 8.5 PEST analysis of environmental influences

Political/legal Economic factors

• Monopolies legislation • Business cycles
• Environmental protection laws • GNP trends
• Taxation policy • Interest rates
• Foreign trade regulations • Money supply
• Employment law • Inflation
• Government stability • Unemployment
• Disposable income
• Energy availability and cost

Sociocultural factors Technological

• Population demographics • Government spending on research

• Income distribution • Government and industry focus of
• Social mobility technological effort
• Lifestyle changes • New discoveries/development
• Attitudes to work and leisure • Speed of technology transfer
• Consumerism • Rates of obsolescence
• Levels of education

Legislation and environmental protection laws are examples of political factors

affecting the condition under which companies operate. Business cycles and employ-
ment rates are economic factors affecting the demand of companies' products and
services. Similarly, sociocultural factors such as population demographics and
lifestyle changes affect the underlying demand for companies' products and services.
Finally, technological factors such as government spending on research and the speed
of new technology have an impact on companies' opportunities to offer products and
services timely to the market.
Macro factors affect industries and companies differently and it is therefore impor-
tant that analysts understand which macro factors are likely to affect a company's
cash flows and risks and which of those factors that are currently the most important
ones and which are potentially more important in the future.

Industry factors influencing the company's cash flow potential and risks
The attractiveness of an industry is ultimately a result of the possibility of earning
acceptable returns, i.e. returns equal to or above the cost of capital. There are differ-
ent drivers that affect the attractiveness of an industry, but in general it seems well
accepted that more competition reduces the chances of obtaining abnormal returns,
i.e. returns that exceed the cost of capital. In order to understand the competition in an
industry the 'five forces' approach serves as a useful checklist. The five forces analysis
approach illustrated in Figure 8.5 highlights different forces affecting the competition
in an industry and the possibility to earn attractive returns. In the following section,
we briefly describe each of the five forces.
An analysis of potential entrants provides the analyst with an understanding of the
threats of new players in the industry. New entrants generally bring new capacity and
a desire to gain market shares which ultimately affect returns negatively. Typical bar-
riers to entry (which protect the returns in an industry) include:
• Economies of scale
• Product differentiation
• Capital requirements

Figure 8.5 Five forces analysis

• Switching costs
• Access to distribution channels
• Government policy.
An analysis of the rivalry among existing competitors provides the analyst with an
understanding of the level of competition. If competition is tough it will tend to affect
returns negatively. Competition or rivalry occurs because one or more competitors
either feel the pressure or see the opportunity to improve the position on the market.
Competition can go from sparse or gentle to intense or warlike. The level and type of
competition is a result of a number of interacting structural factors. In general, com-
petition tends to get intense if the industry is characterised by:
• Slow industry growth
• Numerous competitors
• Customers that perceive the product as commodities
• Overcapacity
• High fixed cost
• High exit barriers.
An analysis of the potential pressure from substituting products provides the ana-
lyst with an understanding of the potential risk of substituting products on the mar-
ket. Substitutes limit the potential returns of an industry as high returns in an industry
will make substitutes more attractive. The possible risk of substituting products vary
across industries, but substituting products deserve more attention if they:
• Have the potential to improve the price-performance relative to current products in
the industry
• Are produced by industries earning high returns.
An analysis of the bargaining power of buyers provides the analyst with an under-
standing of the relative strength between buyers and the industry. If buyers possess a
high bargaining power it typically limits the potential returns in an industry. Buyers
tend to be powerful if:
• A large portion of sales in an industry is purchased by a given buyer
• The products purchased from the industry are commodities
• The switching costs are low
• They experience low returns.
An analysis of the bargaining power of suppliers provides the analysts with an
understanding of the relative strength of suppliers relative to the industry. If suppliers
have the bargaining power over the participants in an industry they can squeeze prof-
itability of the industry by raising the prices or lowering the quality of the products or
services being offered. Suppliers are powerful if:
• They are more concentrated than the industry
• The industry is not an important outlet for the suppliers
• The products or services being offered are important to the industry
• The industry faces high switching costs.

Company specific factors influencing the cash flow generation and risks
The macro and industry analyses describe the opportunities and threats that a company
experiences. The external analyses ideally provide the analysts with an understanding
of the market potential; i.e. the market size, market growth and the opportunity to
earn attractive returns. It is not clear, however, what share of the market that the
company will gain. Furthermore, a sense of achievable margins or returns cannot be
obtained without an analysis of the company's competences relative to its peers. An
analysis of a company's competitive advantage is therefore crucial.
When assessing a company's competitive advantage it is useful to consider its avail-
able resources and the uniqueness of those resources. The analyst wants to assess the
nature of the resource base, the strength of those resources, and the extent to which
the resources are unique and difficult to imitate. A company's resources can be divided
into the following types:
• Physical resources (e.g. location, quality and utilisation of property, plant and
equipment)
• Human resources (e.g. adaptability, skills)
• Financial resources (e.g. financial leverage, ability to generate profit)
• Intangibles (e.g. brand names, image, relationship with key players in the industry).
Not all resources are equally important and analysts should therefore focus on under-
standing the strength and uniqueness of the most critical resources. A benchmark-
ing of the most important resources with peers is a powerful way of examining the
strength and uniqueness of key resources.

Value chain analysis

A value chain analysis is a means of describing the activities within and around a com-
pany and relating them to an assessment of the competitive strength of the company
relative to its peers. Figure 8.6 provides an example of a value chain analysis.
The value chain describes both the primary and supporting activities of a com-
pany. The identification and understanding of the primary activities are crucial when
determining the competitive advantage of a company, i.e. the possibility of obtaining
attractive market shares and margins. An understanding of how efficient a company

Figure 8.6 Value chain analysis

Figure 8.7 An adapted value chain analysis

is in managing its support activities and how well they support the primary activities
is equally important. A value chain analysis combined with a benchmarking analy-
sis provides the analyst with an efficient tool to evaluate the competitive advan-
tage of a company. The following example illustrates how analysts may apply an
adapted value chain analysis combined with benchmarking purely based on external
information.
The adapted value chain analysis (see Figure 8.7) informs the analyst about the cost
efficiency of peers in the industry. In the figure, company x is more cost efficient in
each function except for R&D. The operating expenses make up 85% of revenue in
company x and 94% in company y. The analysis also reveals that cost of goods sold
and sales and distribution (S&D) are the most important functions to monitor for
the analysts as they make up the majority of operating expenses. Finally, company y
spends less of its revenue on R&D compared to company x, which may affect future
revenue negatively. Based on the adapted value chain analysis it seems safe to conclude
that company x is in a position to gain higher market shares and better margins than
company y.

A company's Strengths, Weaknesses, Opportunities and Threats (SWOT)

The last aspect of a strategic analysis is the identification of key issues (strategic drivers)
based on the external and internal analyses. It is only at this stage of the analysis that
a sensible assessment can be made of the opportunities and threats and strengths and
weaknesses. External analyses such as the PEST analysis and Porter's Five Forces lead
to a better understanding of a company's opportunities and threats and ultimately the
attractiveness of the industry. Internal analyses of a company's resources and compe-
tences lead to a better understanding of its strengths and weaknesses and thereby its
competitive advantage relative to its peers. The critical factors identified in the external
and internal analyses can be summarised in a SWOT matrix. Table 8.6 provides an
example of a SWOT matrix which summarises the strengths, weaknesses, opportuni-
ties and threats.
Figure 8.8 is an attractiveness matrix which is a different way of summarising the
findings from the external and internal analyses. It positions the company based on
the industry attractiveness and its competitive advantage relative to its peers. The com-
pany's and its competitors' current position in the matrix is visualised by the circle. The
size of the circle is an indicator of the current market share and the arrow indicates the
company's expected future position in the attractiveness map. For example, company
 Table 8.6 SWOT matrix

External factors

Opportunities Threats
• Market size • Cyclically
• Market growth rate • Inflation
• Barriers to entry • Regulation
• Bargaining power of suppliers • Workforce availability
• Bargaining power of buyers • Environmental issues
• Subsidies • Substitutes

Internal factors
Strengths Weaknesses
• Management • Distribution
• Financial resources • Administration
• R&D • Image
• Production • Brands
• Profitability • Social responsibility

Figure 8.8 Attractiveness matrix

3 (C3) has currently the biggest market share and appears more competitive than its
peers C1 and C2. Furthermore, the analysis indicates that C3 will be more competitive
than C1 and C2 in the future. This suggests that C3 is likely to experience higher growth
rates and margins in the future than C1 and C2 - information that is indeed useful when
projecting these value drivers.
It is important that the strategic analysis leads to a better understanding of the key
strategic value drivers; i.e. the strategic and operational factors influencing the financial
value drivers. Furthermore, it should give the analyst a first-class sense of the growth
and margin potential of the industry and company being specifically analysed.
Financial statement analysis
The financial statement analysis offers the analyst insights about the historical levels
and trends in key financial value drivers. It is therefore a useful foundation when devel-
oping reliable projections of a company's earnings capacity, investment requirements
and financing needs. In this section we discuss briefly the different steps involved in
developing reliable historical levels and trends on each financial value driver. It draws
on the material covered in previous chapters.
Since the objective is a time series analysis, the analyst needs to address the fol-
lowing issues before calculating and interpreting financial value drivers for a specific
company.

• Are accounting policies the same over time?

• Are reported earnings affected by special items?
• Has the company introduced new products or entered new market(s) with a differ-
ent risk profile?
• Has the company acquired or divested businesses, which have changed the levels
and trends in key financial value drivers?
The purpose of a time series analysis is to identify and analyse the levels and trends in
the underlying performance of a company. It is, therefore, important to eliminate any
noise in the signals from the time series analysis. In Chapters 13-15 we discuss each of
the above issues in further detail.
The next step is to calculate the financial value drivers. The historical financial
value drivers provide useful information to the analyst about the level and trend in
each driver. If a long time series is available the analyst obtains information about
the behaviour of the financial drivers in periods of both recovery and recession.
Furthermore, the historical analysis gives the analyst an understanding of the average
level and the maximum and minimum value of each financial value driver. This idea is
represented in Figure 8.9.
In the example the EBITDA margin fluctuates between 4% and 6% during the past
eight years and the average EBITDA margin is close to 5%. This information provides

Figure 8.9 Time series behaviour of EBITDA-margin

 the analyst with much greater comfort when forecasting the future EBITDA margin.
Assuming a stable competitive environment, it seems reasonable to expect an EBITDA
margin within a band of 4% to 6% in the explicit forecasting period and an EBITDA
margin close to 5% in the terminal period. The estimation and analysis of the histori-
cal financial value drivers therefore provide the analyst with an interval within which
the drivers typically fluctuate.
In summary, the strategic analysis identifies key strategic value drivers. Furthermore,
it provides insights about the growth and margin potential. The financial statement
analysis informs us about the historical levels and trends in key financial value driv-
ers. If the information that can be extracted from the strategic and financial statement
analysis is combined it serves as a powerful means to generate reliable estimates of
each financial value driver. The value driver map in Figure 8.2 has been modified
to accommodate these observations and is shown in Figure 8.10. It summarises the
results from the strategic analysis and financial statement analysis. In the modified
value driver map we have included numbers for illustrative purposes. For example,
growth fluctuates between 2% and 6% and is decreasing over time. Furthermore,
growth is primarily organically driven. The strategic analysis shows what initiatives
the company has taken to support future growth. These pieces of information together
with an understanding of the market attractiveness form an analyst's expectation
about future growth.

An evaluation of the estimates supporting

the pro forma statements
It is important that the required performance to support the estimates underlying the
pro forma statements is achievable. A crucial step in the forecasting process is there-
fore an evaluation of the estimates and the pro forma statements. In this section we
briefly discuss different methods to evaluate the quality of the estimates underlying
pro forma statements.
The first method compares expected performance with current and past perform-
ance. As noted in Chapter 5, ROIC is the overall profitability measure of a firm's
operations and it is therefore recommended to apply ROIC for this purpose. The basic
idea of the approach is illustrated in Figure 8.11. In this example, past performance
(ROIC) fluctuates around 8-10%. Assuming a stable competitive environment, it
seems reasonable to assume a ROIC within the same interval in the forecasting period.
As a result, a long-term ROIC around 9% seems achievable. The scenario is therefore
dubbed 'realistic' in the figure. In the optimistic scenario we assume a long-term ROIC
of 14% which is well above past performance. If you are to believe this scenario the
analyst must provide compelling evidence such as a successful launch of a new prod-
uct or a successful entrance into a new and more profitable market. Even if the analyst
is able to provide compelling evidence you may still not be convinced. As you may
recall from Chapter 6, ROIC tends to revert towards a long-term mean which is the
opposite of the time series behaviour of the optimistic scenario.
A complementary approach is to evaluate the quality of the analytical work and
the supporting evidence. If the key assumptions are not supported by compelling evi-
dence and superior analyses the estimates appear less reliable. On the other hand, if
key assumptions are supported by hard evidence and proper analyses we tend to have
Figure 8.10 Modified value driver map reflecting financial and strategic value drivers
Figure 8.11 ROIC as a tool to evaluate the quality of the pro forma statement

greater faith in the estimates and pro forma statements. These ideas are captured in
the evidence-relevance model illustrated in Figure 8.12.
The evidence-relevance model gives an easy overview of the supporting evidence of
the different assumptions. For example, Figure 8.12(a) is a case where key assump-
tions (highest relevance) are supported by strong (the highest level of) evidence and

Figure 8.12 Examples of the evidence-relevance model

 analyses. Examples of key assumptions include revenue growth and EBITDA margin
and an assessment of the market potential and a company's competitive advantage
relative to peers. In Figure 8.12(b) key assumptions are only supported by weak evi-
dence and analyses which question the reliability of the estimates and the pro forma
statements.
As a final step it is important that the analyst obtains an understanding of the sensi-
tivity of the projected financiais. We therefore recommend that the analyst conducts a
sensitivity analysis exploring how an adjustment of key financial value drivers affects
financial measures such as the FCF (free cash flow), ROIC, and the interest coverage
ratio. In this context the identification of strategic value drivers can also be used as a
means to develop scenarios. This topic is further discussed in Chapters 9 and 11.

The challenges of forecasting

To illustrate the challenges of forecasting Table 8.7 shows analysts' estimates of
Carlsberg's and Heineken's EPS one and two years ahead. The basic idea of the exam-
ple is to demonstrate that even among well-educated analysts, who have access to

Table 8.7 Analysts' two-year forecast of Carlsberg's (DKK) and Heineken's (euro) EPS
Carlsberg +1 +2 Heineken +1 +2
Davy Stockbrokers 29.9 Evolution Securities 2.5 2.8
Jyske Bank 28.3 33.2 Deutsche Bank Research 2.5 2.9
Credit Suisse 30.8 34.2 Société Générale 2.7 2.9
ESN-Danske Markets Equities 34.9 43.5 ING Wholesale Banking 2.4 2.9
SEB Enskilda Research 27.7 32.1 Petercam 2.5 2.6
Bernstein Research 35.2 40.2 Davy Stockbrokers 2.4
ABG Sundal Collier 30.1 36.5 Bernstein Research 2.7 3.0
Nordea Markets 27.4 33.1 Rabo Securities 2.5 2.9
Swedbank 29.6 34.3 KBC Securities 2.4 2.7
Evolution Securities 28.4 35.2 Natixis Securities 2.7 3.2
Natixis Securities 33.7 42.1 Credit Suisse 2.1 2.3
Nomura Equity Research 31.2 35.8 Oddo Securities 2.4 2.7
ING Wholesale Banking 32.8 39.2 Fortis Bank Nederland 2.4 2.7
Carnegie 33.1 Kepler Capital Markets 2.4 2.7
Société Générale 31.9 37.8 Nomura Equity Research 2.3 2.6
Deutsche Bank Research 30.6 34.3 CA Cheuvreux 2.3
Kepler Capital Markets 28.7 33.7 Keijser Securities 2.2
CA Cheuvreux 28.7 31.1 ESN-SNS Securities 2.7 2.9
Mean 30.7 36.0 Mean 2.4 2.8
Median 30.6 35.2 Median 2.4 2.8
High 35.2 43.5 High 2.7 3.2
Low 27.4 32.1 Low 2.1 2.3
Std. dev. 2.4 3.6 Std. dev. 0.2 0.2
 the same pieces of information, and who are capable of performing the same type of
analyses there is a disagreement about the earnings potential of a given company.
As seen from Table 8.7 there is a disagreement among analysts about the earnings
potential of both breweries. For example, next year's ( + 1) EPS for Carlsberg fluctu-
ates between DKK 27.4 and DKK 35.2 and for Heineken it fluctuates between €2.1
and €2.7. Furthermore, the analysts' forecast dispersion increase as the forecast hori-
zon expands. For example, the standard deviation and the distance between the lowest
and highest estimate of Carlsberg's EPS widens as analysts expand the forecast horizon
from one to two years. The estimates of Heineken's EPS provide similar tendencies.
The example illustrates the challenges of forecasting and stresses the importance of
providing supporting evidence behind each estimate. It is therefore crucial to devote
the necessary time and effort in developing estimates that are supported by useful
sources and excellent analyses. Extrapolations of past performance or simply pure
guesswork are not attractive alternatives. In these cases the underlying value drivers
are not properly understood and will most likely lead to greater biases in the estimates
underlying the pro forma statements.

Conclusions
This chapter focuses on forecasting. The most important points to keep in mind are:
• Identification of key strategic and financial value drivers is crucial when developing
reliable estimates.
• The pro forma income statement, balance sheet and cash flow statement must
always articulate.
• It is important that the chosen value driver map reflects the underlying economics
of the company being analysed. Analysts are probably better off working with a
more refined set of value drivers for short-term forecasting and a more aggregated
set of value drivers for long-term forecasting.
• A strategic analysis provides the analyst with useful information about an indus-
try's attractiveness and the company's competitive advantage relative to its peers.
Furthermore, it identifies key strategic value drivers that have significant impact
on the financiais. Financial statement analysis provides the analyst with useful
information about the levels and trends in key financial value drivers. Together, the
strategic analysis and the financial statement analysis serve as efficient means to
generate reliable estimates.
• It is crucial that the estimates supporting the pro forma statements appear achiev-
able. A comparison of expected performance with current and past performance is
one way to evaluate the estimates. The evidence-relevance model is another way of
examining the estimates. The evidence-relevance model evaluates the quality of the
analytical work and supporting evidence on relevant factors influencing cash flows
and risk.
• The developed pro forma statements reflect just one out of many outcomes. It is
therefore important that the analyst obtain an understanding of the sensitivity of
the financiais. Sensitivity analyses should always be a part of forecasting.
• Forecasting is not an easy task. We demonstrate that even among well-educated
analysts that have access to the same pieces of information there are disagreements
about the earnings potential for the same company. It stresses the importance of
 collecting the most useful information and conducting the necessary analyses to
develop reliable estimates. In short, the analyst must be dedicated to deliver the best
possible estimates.

Review questions
• What does it mean that pro forma statements articulate?
• How do you ensure that pro forma statements articulate?
• Describe the eight value drivers in the value driver map.
• Describe factors affecting the eight value drivers.
• Which elements are contained in a strategic analysis?
• What is the structure of a financial statement analysis?
• Do you prefer an aggregated value driver setup or a more refined one when developing
pro forma statements?
• How do you judge if estimates appear achievable?

APPENDIX 8.1

Carlsberg case
In this appendix we demonstrate the forecasting of Carlsberg's income statement, bal-
ance sheet and cash flow statement. With some modifications we rely on the value
driver map discussed in Figure 8.2.
The income statement, balance sheet and cash flow statements are therefore in
most cases derived from revenue forecasts. Furthermore, the pro forma statements
clearly distinguish between operating and financing activities. This implies that the
chosen reporting format mirrors the analytical format outlined in Chapters 4 and 5.
In the following section the estimation of each forecast assumption is discussed. An
overview of the historical and forecast value drivers is provided in Table 8.8.

Revenue
Revenue is a function of the underlying market growth and Carlsberg's ability to
deliver competitive products relative to peers. Carlsberg divides its markets into three
areas: Northern and Western Europe, Eastern Europe and Asia. While the Northern
and Western European markets are mature and experience growth rates close to
0% at best, the other two markets are characterised as growth markets. Carlsberg
has grown on average 10% in the last five years of which half is driven by organic
growth. In most recent years Carlsberg's organic growth has improved due to the
Table 8.8 Carlsberg: forecast assumptions

Historical value drivers Forecast value drivers

Year 4 Year 5 Year 6 Year 7 Year 8 Year E1 Year E2 Year E3 Year E4

Financial value drivers

Growth drivers

Organic g r o w t h -2.0% 3.0% 6.4% 10.0% 8.0%

Revenue g r o w t h 5.0% 4.3% 7.5% 7.8% 27.4% 5.0% 5.0% 4.0% 3.0%
Cost drivers (margins)

Cost of sales as a percentage 45.4% 45.3% 44.9% 46.5% 48.0% 47.0% 46.5% 46.0% 45.0%
of revenue

Sales and distribution costs 33.3% 33.2% 32.4% 30.5% 28.0% 28.0% 28.0% 28.0% 28.0%
as a percentage of revenue

Administration as a percentage 7.2% 7.3% 7.1% 6.6% 6.3% 6.3% 6.3% 6.3% 6.3%
of revenue

Other income and expenses 1.7% 1.1% 0.6% 1.1% 1.2% 1.1% 1.1% 1.1% 1.1%
as a percentage of revenue

Income before tax from 0.8% 0.8% 0.3% 0.3% 0.2% 0.2% 0.2% 0.2% 0.2%
associates as a percentage
of revenue

EBITDA margin (excluding special 16.6% 16.2% 16.6% 17.8% 19.7% 19.8% 20.3% 20.8% 21.8%
items)

Special items -1.6% -1.0% 0.1% -0.7% -2.2% -1.1% -1.1% -1.1% -1.1%

EBITDA margin (including special 15.0% 15.2% 16.7% 17.0% 16.9% 18.7% 19.2% 19.7% 20.7%
items)

Depreciation as a percentage 12.5% 12.5% 14.4% 12.5% 11.1% 12.0% 12.0% 12.0% 12.0%
of PPE

EBIT margin 8.0% 8.5% 9.5% 7 0.9% 7 0.6% 12.3% 12.8% 73.3% 14.4%

Tax rate 23.1% 27.5% 28.3% 28.6% -11.2% 25.0% 25.0% 25.0% 25.0%

NOPAT margin 5.7% 6.0% 6.8% 7.8% 9.7% 9.2% 9.6% 10.0% 10.8%

Investment drivers

Intangible assets as a 53.7% 54.3% 51.8% 47.4% 141.3%

percentage of revenue

Property, plant and equipment 56.3% 53.5% 49.6% 49.4% 56.8% 55.0% 55.0% 55.0% 54.0%
as a percentage of revenue

Other non-current assets 10.8% 8.8% 6.2% 6.3% 8.6% 8.0% 8.0% 8.0% 8.0%

Non-current assets as a 120.8% 116.6% 107.6% 103.7% 206.7% 63.0% 63.0% 63.0% 62.0%
percentage of revenue

Net working capital decomposed

into:

Inventories as a percentage of 7.9% 7.5% 7.8% 8.5% 8.9% 8.9% 8.8% 8.7% 8.5%
revenue
Table 8.8 (continued)

Historical value drivers Forecast value drivers

Year 4 Year 5 Year 6 Year 7 Year 8 Year E1 Year E2 Year E3 Year E4

Trade receivables as a 1 7.3% 15.7% 14.9% 14.2% 10.6% 11.0% 11.0% 11.0% 11.0%
percentage of revenue

Other current assets as a 5.7% 9.8% 5.2% 5.5% 7.6% 7.0% 7.0% 7.0% 7.0%
percentage of revenue

Deferred tax liabilities as a 6.4% 6.2% 5.9% 4.9% 16.4% 16.0% 16.0% 16.0% 16.0%
percentage of revenue
Trade payables as a percentage 11.2% 11.9% 12.5% 1 3.0% 1 3.3% 1 3.0% 1 3.0% 13.0% 13.0%
of revenue

Other liabilities as a percentage 1 7.9% 17.9% 15.6% 15.3% 17.8% 1 7.5% 17.5% 17.5% 1 7.5%
of revenue
Net working capital as a -4.6% -2.9% -6.7% -5.0% -20.4% -19.6% -19.7% -19.8% -20.0%
percentage of revenue

Financing drivers

NIBD as a percentage of 111.9% 105.2% 111.2% 105.6% 188.6% 180.0% 175.0% 1 70.0% 170.0%
invested capital excl. Intangibles

Net financial expenses as a 10.6% 4.9% 3.6% 5.3% 14.4% 7.0% 7.0% 7.0% 7.0%
percentage of NIBD

acquisition of Russian breweries. We expect that Carlsberg is able to grow 5 % annu-

ally the next two years and will have reached its long-term growth rate of 3 % in year
E5. It may look conservative based on the last three years' organic growth. However,
the important Russian market is currently under pressure due to higher duties on
beers and the Northern and Western European markets show no sign of growth. The
estimates ignore the impact of acquisitions. As a first step, we generally recommend
that you develop pro forma statements without the impact of acquisitions. It gives
you a much clearer view of a company's profitability and financial sustainability. For
example, a company that grows organically in line with the economy should be able
to generate sufficient cash flow to repay debt. As a second step, you can add acquisi-
tions to explore their impact on a company's profitability and financial sustainability.

Operating expenses
Carlsberg has continuously improved the relation between operating expenses and
revenue (EBITDA margin) since year 4. This is mainly driven by the excellence pro-
grammes initiated during the last five to eight years, but also influenced by the syner-
gies obtained from acquisitions. Carlsberg has not yet reached its full potential and
expects to improve the operating expense to revenue relation (i.e. its profit margin)
gradually during the next five years. Specifically, we expect that Carlsberg is able to
improve its cost of sales to revenue relation from 4 8 % to 4 5 % during the next five
years. Other cost drivers remain unchanged from the last fiscal year.
Income from associates
After the acquisitions of the Russian breweries the ratio 'income from associates as a
percentage of revenue' has dropped to 0.2%. We conjecture that associates will grow
with the same speed as Carlsberg's main activities and estimate the income from asso-
ciates to be 0.2% of revenue going forward.

Special items, net

Special items are typically transitory in nature. However, since year 4 special items
make up —1.1% of revenue on average. It indicates that special items are recurring.
We therefore predict that special items remain at the same level as the historical aver-
age; i.e. —1.1% of revenue.

Depreciation
Intangible assets consist almost entirely of goodwill and trademarks; items which are
tested for impairment. Since year 4 the management of Carlsberg has assessed that
the value of those assets can be maintained for an indefinite period. We predict that
Carlsberg can maintain its track-record and do therefore not incorporate any impair-
ment losses on goodwill and trademarks in the forecast period.
Depreciation on property, plant and equipment (PPE) has fluctuated between 8%
and 14%. We assume that depreciation remains constant as a percentage of PPE and
predict 12% in line with the depreciation rate in most recent years.

Borrowing rate
We estimate a borrowing rate of 7%. It reflects the impact that the acquisition pro-
gramme has had on Carlsberg's credit rating, but also the expansion in the credit
spreads in the light of the financial crisis.

Tax rate
With the exception of year 8 Carlsberg's efficient tax rate has been close to the mar-
ginal tax rate. Since the corporate tax rate has been reduced to 2 5 % in Denmark,
we tax Carlsberg's income with 2 5 % , while we acknowledge that actual cash taxes
are somewhat lower due to deferred taxes. We apply the same tax rate on operating
income and (net) financial expenses.

Non-current assets
As noted above we only include organic growth in our estimates. This implies that we
only forecast PPE and other non-current assets. Intangible assets are assumed constant
in the forecasting period. Before the acquisition of the Russian breweries Carlsberg
had steadily improved the relation between PPE and revenue from 56% to 49%. After
the acquisition the relationship between PPE and revenue increased to 57%. Based
on past experience and statements from the management, we expect that Carlsberg
gradually improves the relation between PPE and revenue to 54% in year E5. Other
non-current assets are expected to make up 8% of revenue.
Net working capital
After the acquisition of the Russian brewery the relation between the different com-
ponents of net working capital and revenue changed dramatically. Our estimates for
net working capital reflect the new structure, and we believe that Carlsberg is able
to maintain approximately the same level of efficiency in the forecast horizon as in
year 8.

Net interest-bearing debt

Net interest-bearing debt is measured as a percentage of invested capital exclud-
ing intangible assets. As noted above we assume that intangible assets remain con-
stant in the forecasting period. It does therefore not make much sense to measure
net interest-bearing debt against a constant (i.e. intangible assets). Furthermore,
excluding intangible assets from invested capital makes the valuation much easier in
Chapter 9.
Carlsberg has announced that it will reduce its net interest-bearing debt relative
to invested capital (excluding intangible assets). We expect that Carlsberg in the long
run will finance 170% of invested capital (excluding intangible assets) by net interest-
bearing debt.

Dividends
Dividends are estimated as the residual of the excess cash. Thus, cash which is not
consumed in operations, investments or financing is assumed paid out as dividends to
the shareholders. Although dividends are normally paid out after the general assem-
bly, i.e. three to five months after the fiscal year end, we assume that dividends have
a cash impact at the fiscal year-end. The year 8 accounts have been modified accord-
ingly. This implies that the dividend in year 8 is assumed to be paid to shareholders
at the fiscal year-end reducing shareholders equity and increasing net interest bearing
debt by DKK 534 million.
Tables 8.9, 8.10 and 8.11 show the resulting pro forma income statements, balance
sheets and cash flow statements for Carlsberg.

An evaluation of the estimates supporting the pro forma statements

In Table 8.12 we assess whether the estimates appear achievable. The key ratio in
our assessment is ROIC. The ratio is measured before-tax to avoid the influence of
different corporate tax rates across time. The significant investments in the Russian
breweries affect ROIC negatively in the short run. However, in line with management
we believe that Carlsberg is able to re-establish the profitability at the level prior to
the acquisition. Our predictions indicate that Carlsberg's long run ROIC is just above
9%. Overall, the ratios indicate that the estimates underlying the pro forma state-
ments appear achievable. However, the estimates do not leave much room for slack.
The improvement in ROIC is primarily driven by a significantly higher EBIT margin
and any mismanagement will affect Carlsberg's profitability negatively and thereby
make the estimates less achievable.
Table 8.9 Carlsberg: pro forma income statement

Historical Forecast

Income statement (DKKm) Year 8 Year E1 Year E2 Year E3 Year E4 Year E5

Net revenue 59,944 62,941 66,088 68,732 70,794 72,918

Cost of sales -28,756 -29,582 -30,731 -31,617 -31,857 -32,813

Gross profit 31,188 33,359 35,357 37,115 38,937 40,105

Sales and distribution costs -16,814 -17,655 -18,537 -19,279 -19,857 -20,453
Administrative expenses -3,765 -3,953 -4,151 -4,317 -4,446 -4,580
Net other operating income 728 692 727 756 779 802
Share of profit before tax, 108 126 132 137 142 146
associates
Operating profit before special 11,445 12,569 13,528 14,413 15,553 16,020
items

Net special items -1,309 -683 -717 -746 -768 -791

EBITDA 10,136 11,886 12,811 13,667 14,785 15,228

Depreciation and amortisation -3,771 -4,154 -4,362 -4,536 -4,587 -4,725

EBIT 6,365 7,732 8,449 9,131 10,197 10,503

Tax on EBIT -567 -1,933 -2,112 -2,283 -2,549 -2,626

NOPAT 5,798 5,799 6,337 6,848 7,648 7,877

Net financial expenses before tax -3,456 -3,603 -3,442 -3,505 -3,533 -3,538
Tax on net financial expenses 864 901 860 876 883 885

Net financial expenses -2,592 -2,703 -2,581 -2,629 -2,650 -2,654

Croup profit after tax 3,206 3,096 3,755 4,219 4,998 5,224
Table 8.10 Carlsberg: pro forma balance sheet

Historical Forecast

Invested capital (DKKm) Year 8 Year E1 Year E2 Year E3 Year E4 Year E5

Non-current assets
Intangible assets 84,678 84,678 84,678 84,678 84,678 84,678
Property, plant and equipment 34,043 34,618 36,349 37,802 38,229 39,375
Other non-current assets 5,185 5,035 5,287 5,499 5,663 5,833
Total non-current assets 123,906 124,331 126,314 127,979 128,570 129,887

Current assets
Inventories 5,317 5,602 5,816 5,980 6,017 6,198
Trade receivables 6,369 6,924 7,270 7,560 7,787 8,021
Other current assets 4,568 4,406 4,626 4,811 4,956 5,104
Total current assets 16,254 16,931 17,712 18,351 18,760 19,323

Non-interest-bearing debt
Deferred tax liabilities 9,803 10,071 10,574 10,997 11,327 11,667
Trade payables 7,993 8,182 8,591 8,935 9,203 9,479

Other operating liabilities 10,669 11,015 11,565 12,028 12,389 12,761

Total non-interest-bearing
debt 28,465 29,268 30,731 31,960 32,919 33,907

Invested capital (net

operating assets) 111,695 111,994 113,294 114,370 114,411 115,303

Historical Forecast
Invested capital (DKKm) Year 8 Year E1 Year E2 Year E3 Year E4 Year E5

Equity
Total equity begin 60,217 62,825 63,216 63,894 63,865
Group profit after tax 3,096 3,755 4,219 4,998 5,224
Dividends/issues of new shares 534 -488 -3,364 -3,541 -5,027 -5,848
Total equity end 60,217 62,825 63,216 63,894 63,865 63,240

Net interest-bearing debt

(NIBD) 50,944
Dividend adjustment 534
Net interest-bearing debt 51,478 49,170 50,078 50,477 50,547 52,063
(NIBD)
Invested capital 111,695 111,994 113,294 114,370 114,411 115,303
Table 8.11 Carlsberg: pro forma cash flow statement

Forecast

Cash flow statement (DKKm) Year E1 Year E2 Year E3 Year E4 Year E5

NOPAT 5,799 6,337 6,848 7,648 7,877

Depreciation and amortisation 4,154 4,362 4,536 4,587 4,725
Changes in inventories -285 -214 -164 -38 -181
Changes in trade receivables -555 -346 -291 -227 -234
Changes in other current assets 162 -220 -185 -144 -149
Changes in deferred tax liabilities 268 504 423 330 340
Changes in trade payables 189 409 344 268 276
Changes in other operating liabilities 346 551 463 361 372
Cash flow from operations 10,078 11,381 11,974 12,785 13,027
Investments, non-current assets -4,579 -6,344 -6,202 -5,179 -6,042
Free cash flow to the firm 5,499 5,037 5,772 7,607 6,985
Net financial expenses after tax -2,703 -2,581 -2,629 -2,650 -2,654
Changes in NIBD -2,308 909 398 70 1,516
Free cash flow to equity holders 488 3,364 3,541 5,027 5,848
Dividends/issues of new shares -488 3,364 -3,541 -5,027 -5,848
Cash surplus 0 0 0 0 0

Table 8.12 Carlsberg: assessment of forecast assumptions

Historical Forecast

Budget
evaluation Year 4 Year 5 Year 6 Year 7 Year 8 Year E1 Year E2 Year E3 Year E4 Year E5

Growth, -2.0% 3.0% 6.4% 10.0% 8.0% 5.0% 5.0% 4.0% 3.0% 3.0%
organic
ROIC before 8.1% 7.5% 9.2% 11.4% 8.2% 6.9% 7.5% 8.0% 8.9% 9.1%
tax
EBIT margin 7.9% 8.4% 9.5% 10.9% 10.6% 12.3% 12.8% 13.3% 14.4% 14.4%
Turnover 1.02 0.89 0.97 1.05 0.77 0.56 0.59 0.60 0.62 0.63
ratio,
invested
capital
 CHAPTER 9

Valuation

Learning outcomes
After reading this chapter you should be able to:
• Make a distinction between the different approaches available for valuation
• Conduct a valuation based on the present value approach
• Understand the theoretical equivalence of the different present value models
• Conduct a valuation based on multiples
• Understand the prerequisites for using multiples
• Conduct a valuation based on the liquidation approach
• Understand when a liquidation approach appears more suitable for valuation than
the present value approach and multiples

Valuation

T he value of any asset (or liability for that matter) is calculated as the future income
generated by the asset discounted to present value with a discount factor which
takes into consideration the time value of money and risk associated with the income
generated by the asset.
To value an asset the following factors need to be known:
Future income - typically cash flows - and a proper discount rate
For fixed income streams such as bonds this is fairly straight forward, if the bonds are
held to maturity. However, for most assets future income is only known with perfect hind-
sight. Also, the discount factor must be estimated and as with all estimates this requires
judgement. This is why so many finance textbooks have been devoted to calculating risk
(and the discount factor). In this chapter, we discuss and present how a company can be
valued using various valuation models. The techniques may seem quite complicated at
first. However, keep in mind that valuing a firm is essentially no different from valuing
any asset: we need to forecast the future income stream and estimate a discount rate.
Valuation of companies is carried out in a variety of different contexts. Below we
have listed examples of areas where valuation techniques are used:
• Merger and acquisitions
- Generational successions
- Hostile takeovers
- Spin-offs
• Initial public offerings (IPOs)
• Stock issues
• Stock analyses
• Tax purposes (transactions between closely related parties)
• Management tools (value-based management)
• Compensation (stock options)
• Privatisations
• Fairness opinions
• Impairment tests.
Valuation is typically associated with topics such as merger and acquisitions and stock
analyses. However, as the list indicates the different valuation techniques are applied
in many other circumstances. Examples include value-based management, impairment
tests and fairness opinions. In this chapter, we address commonly used valuation mod-
els. This implies that special valuation approaches are not the focus of this chapter.
For example, in some countries tax authorities have developed their own valuation
techniques to examine the possibility that a transaction between closely related parties
reflects market values. Such techniques are not discussed.
We have made a distinction between technical and economical aspects of valuation.
By technical aspects we refer to the basic understanding of the different valuation
approaches including what drives value and how those approaches are related. By eco-
nomical aspects we refer to the quality of input (forecast assumptions). In this chapter,
we have emphasised the technical aspects of valuation, as the economical aspect of
valuation has been covered in the previous chapter on forecasting.
Moreover, an understanding of the technical issues of valuation is essential for sev-
eral reasons. First, it is important that the analyst understands the basic concepts of
the most frequently applied valuation approaches and the level of computational skills
needed. Second, it is equally important that the analysts understand to what extent valu-
ation models are theoretical equivalent and therefore (ought to) yield identical value
estimates. This piece of information is useful when selecting between different valuation
approaches. Furthermore, by using two or more equivalent valuation approaches, the
analyst ensures that valuation is unbiased in the sense that it does not contain any tech-
nical errors. Third, it is important that the analysts understand how the different valua-
tion approaches can be used in interaction. By using different valuation approaches the
analyst can stress test the value estimate from different valuation perspectives.
The valuation approaches discussed in this chapter measures either enterprise
value (EV) or market value of shareholders' equity. Enterprise value is the expected
market value of a company's invested capital; i.e. the market value of its operations.
Enterprise value therefore includes both the estimated market value of equity and
the estimated market value of net interest-bearing debt, as reflected in Figure 9.1.

Figure 9.1 The distinction between enterprise value and shareholders' equity
 Net interest-bearing debt (NIBD) is the difference between enterprise value and
shareholders' equity.

Approaches to valuation
The number of different valuation approaches can be quite overwhelming, however,
they can generally be classified into four groups as shown in Figure 9.2. The first group
of valuation approaches is based on discounting future income streams or cash flows.
We refer to these models as present value approaches. The type of income stream that
is discounted varies across the different present value approaches but most commonly
dividends, free cash flows and excess returns are discounted.

Figure 9.2 Overview of valuation approaches

 The relative valuation approach, often referred to as multiples, is the second group
of valuation approaches. Using these techniques, the value of a company can be esti-
mated by applying the price of a comparable company relative to a variety of account-
ing items such as revenue, EBITDA, EBIT, net income, cash flow or book value of
equity.
The liquidation approach is the third category of valuation approaches. Here the
value of a company's equity is estimated by measuring the net proceeds that a com-
pany can obtain if it liquidates all its assets and settle all its liabilities.
Contingent claim valuation models - also referred to as real option models - is the
fourth category of valuation approaches and applies option pricing models to measure
the value of companies that share option characteristics.
Several surveys have found that practitioners favour the present value approach
and multiples when valuing a company. Figure 9.3 reports the results of a survey
(Petersen et al. 2006) which examines how analysts' value privately held companies.
The present value approach and multiples are adopted in almost all cases. Financial
analysts use the liquidation approach in less than 20% of the cases and the real option
approach is hardly ever used.

Figure 9.3 Frequency by which practitioners apply a valuation approach

The four different approaches address valuation from different perspectives and it
is important that the analyst understands the merits and demerits of each approach
when choosing a valuation model. In this chapter, we discuss the present value
approaches, multiples and the liquidation approach in further detail. Although the
real option approach has appealing characteristics it is rarely ever used by practition-
ers. The complexity of the valuation approach and challenges of providing reliable
estimates explain the limited use.
The attributes of an ideal valuation approach
In this section, we describe four attributes that characterise an ideal valuation
approach, to develop a set of criteria that can be used to differentiate between the
various valuation approaches:
• Value attributes:
- Precision (unbiased estimates)
- Realistic assumptions
• User attributes
- User friendly
- Understandable output.
First, the precision of the valuation approach is obviously important. Assuming a fore-
cast with perfect hindsight, the valuation approach must yield an unbiased estimate.
For example, the dividend discount model is assumed to be a theoretically consistent
valuation approach and therefore yield unbiased value estimates. Second, the valuation
must be based on realistic assumptions; i.e. assumptions that are well founded, for
instance with reference to past performance. The second attribute is very much related
to the first attribute. If an analyst is not able to comply with the underlying assump-
tions of a valuation approach, the value estimate will be biased. The first two attributes
address the accuracy of a valuation approach and are referred to as 'value attributes'.
Third, a valuation approach should be user friendly. This implies that it is character-
ised by a low level of complexity, easy access to input data and not time consuming to
use. Finally, ideally the value estimate can be communicated in laymen terms. For exam-
ple, it is regarded as informative if the valuation approach is able to explain any devia-
tion in the value estimate from the book value of equity. The third and fourth attributes
are also referred to as 'user characteristics'. In the following part, the four attributes
are used to evaluate each of the valuation approaches described in subsequent sections.

Present value approaches

The present value approaches estimate the intrinsic value of a company based on ana-
lysts' projections of the cash flows of a company and the discount factor that reflects
risk in the cash flow and the time value of money. A basic premise of present value
approaches is that they are all derived from the dividend discount model. Therefore,
as we demonstrate in this section, the different present value approaches are theo-
retically equivalent. This implies that if they are based on the same input they shall
yield identical value estimates. In Appendix 9.1, we apply the different present value
approaches on Carlsberg. To illustrate how to estimate the value of a company using
different present value approaches, we apply the pro forma statements which were
prepared in the previous chapter. Table 9.1 provides a summary of the key figures
from the pro forma statements.
Due to the nature of the various present value approaches, we require different
measures of cost of capital also defined as discount rates. More specifically, we need
input to estimate the following cost of capital expressions:
• Required rate of return on assets (ra)
• Required rate of return on net interest-bearing debt (NIBD) (rd)
Table 9.1 Summary of key financial data
Last fiscal Explicit forecasting period Terminal
year (forecast horizon) period
Summary of key data 0 1 2 3 4 5 6 7
Revenue growth 5.0% 5.0% 5.0% 5.0% 5.0% 5.0% 2.0% 2.0%
NOPAT 16.4 17.2 18.1 19.0 19.9 20.9 21.4 21.8
Net financial expenses -4.6 -4.9 -5.1 -5.4 -5.6 -5.9 -6.2 -6.3
Tax shield 1.2 1.2 1.3 1.3 1.4 1.5 1.6 1.6
Net earnings 12.9 13.6 14.3 15.0 15.7 16.5 16.7 17.0
Invested capital (net operating
assets) 121.6 127.6 134.0 140.7 147.7 155.1 158.2 161.4
Equity, end 60.8 63.8 67.0 70.4 73.9 77.6 79.1 80.7
Free cash flow to the
firm (FCFF) 10.6 11.2 11.7 12.3 12.9 13.6 18.3 18.6
Free cash flow to equity (FCFE) 10.0 10.5 11.1 11.6 12.2 12.8 15.2 15.5
Dividends 10.0 10.5 11.1 11.6 12.2 12.8 15.2 15.5

Table 9.2 Different measures on cost of capital

Forecast horizon Terminal period
Cost of capital 1 2 3 4 5 6 7
Debt/equity 0.333 0.339 0.345 0.352 0.359 0.359 0.359
Required rate of return on assets (ra) 8.750% 8.750% 8.750% 8.750% 8.750% 8.750% 8.750%
Required rate of return on debt, after
tax (rd) 6.0% 6.0% 6.0% 6.0% 6.0% 6.0% 6.0%
Required rate of return on equity (re) 8.996% 9.000% 9.004% 9.009% 9.014% 9.019% 9.019%
WACC 8.256% 8.250% 8.243% 8.237% 8.229% 8.221% 8.221%

• Required rate of return on equity (re)

• Weighted average cost of capital (WACC).
In Table 9.2 we therefore report estimates for the different measures on cost of
capital that allow us to show that the various present value approaches yield identical
value estimates based on the pro forma statements summarised in Table 9.1.
We allow the required rate of return on equity and WACC to fluctuate with any
changes in the capital structure. This is a prerequisite ensuring that the different
present value approaches yield identical values. In Chapter 10 we provide additional
information on how the different measures of cost of capital are estimated and how
they relate to each other.

The dividend discount approach

Although the dividend discount model is not the most popular of the present value
approaches, it serves as the basis for the other present value approaches. This explains
why the dividend discount model is the first approach discussed in this chapter.
According to the dividend discount model the value of a company is the present value
of all future dividends. In case of an infinite dividend stream and a constant discount
factor (re) the dividend discount model is specified as:

where
re = Required rate of return on equity
According to the dividend discount model only future dividends and the required rate
of return on equity affect the market value of a company. This implies that firm value
is positively affected by higher future dividends and a lower required rate of return on
equity. Since projection of dividends to infinity is almost impossible, and indeed time
consuming, a two-stage dividend discount model is often preferred.

where
n = Number of periods with extraordinary growth rates (forecast horizon)
g = The long-term stable growth rate (terminal period)
The two-stage dividend discount model divides the projections of dividends into two
periods: an explicit forecast period (forecast horizon) where growth in dividends devi-
ates from the long-term growth rate and a terminal period where growth in dividends
is assumed constant.
The basic idea of the two-stage dividend discount model is that the growth rate of a
company will eventually approach the long-term growth rate of the economy in which
the company operates. Since companies are not at the same stage in their lifecycle, the
forecast horizon deviates between companies. For high growth companies the forecast
horizon is typically longer than for more mature companies with growth rates close to
the long-term growth rate. The assumption that growth remains constant to infinity in
the terminal period may seem heroic. However, it is a pragmatic solution to a tedious
and time-consuming projection of dividends to infinity. While it is acknowledged that
hardly any company will grow at a constant rate to infinity the underlying assumption
is that the growth rate fluctuates around a long-term mean. The specification applied
to calculate the terminal value is also referred to as the Gordon's growth model. There
are a few issues that need to be addressed when calculating the terminal value. First,
since the terminal value usually accounts for 60-80% of the entire value of a company
it is crucial that careful attention is dedicated to the estimation of each of the param-
eters entering into the calculation. Therefore, careful considerations must be made
when estimating the parameters in the terminal value formula; the entry value of divi-
dends, the required rate of return on equity and the expected long-term growth rate
of dividends. Second, it is crucial that the forecasting horizon is sufficiently long to
ensure that the growth rate in the terminal period reflects the long-term growth rate of
the industry in which the company operates.
In Table 9.3 we have illustrated how to estimate the value of a company using the
dividend discount model by relying on the summary of key financial data reported in
Table 9.1 and the required rate of return on equity in Table 9.2.
Table .93 Dividend discount model
Dividend discount model 1 2 3 4 5 6 7
(rounding errors may occur)
Dividends 10.54 11.07 11.63 12.21 12.82 15.16 15.46
Required rate of return on 8.996% 9.000% 9.004% 9.009% 9.014% 9.019% 9.019%
equity (re)
Discount factor 0.917 0.842 0.772 0.708 0.650 0.596
Present value of dividends 9.7 9.3 9.0 8.6 8.3 9.0
Present value of dividends in 54.0
forecast horizon
Present value of dividends in 131.3
terminal period
Estimated market value 185.2
of equity

The present value of dividends in the forecast horizon amounts to 54.0. The terminal
value is 131.3 and is calculated as:

In the example the terminal value makes up approximately 7 1 % of the estimated

market value of equity which underlines the importance of the terminal value term.
Under normal circumstances the numbers would be reported with only one decimal
place. However, by allowing more than just one decimal place it is easier to replicate
the estimated market value of 185.2. Furthermore, as mentioned above the cost of cap-
ital is not assumed constant across time, which reflects that the capital structure based
on market values is not constant in the forecast horizon. Finally, the terminal value cal-
culation (Gordon's growth model) rests on a steady-state assumption; i.e. that all items
in the pro forma statements grow at the same rate. Due to the nature of the value driver
setup we must forecast two years into the terminal period to ensure that we comply
with the steady state assumption. This implies that the present value of dividends in the
forecast horizon include six years and that dividends in year 7 serves as entry value in
the calculation of the terminal value.
Except for forecast assumptions that are prerequisites for any present value approach
the dividend discount model does not rely on any other assumptions. Consequently, it
yields unbiased value estimates (assuming forecasts with perfect hindsight). Therefore,
based on the value attributes the dividend discount model is attractive. While the divi-
dend discount model is technically a relatively simple valuation approach it requires
inputs that are usually based on many different sources and which are time consuming
to generate. Furthermore, laymen often consider the book value of equity as the likely
value of equity. In cases where the estimated market value of equity deviates from the
book value of equity the dividend discount model does not offer any intuitive explana-
tion for this discrepancy. Consequently, while the dividend discount model yields an
unbiased value estimate it does not necessarily have attractive user attributes. Finally,
while the value of a firm is calculated as the present value of all future dividends, divi-
dends are merely distribution of value created and do not reveal anything about how
value is created (i.e. dividends tell nothing about a firm's underlying operations except
for the signalling effect). This is what is called the dividend conundrum.
The discounted cash flow approach
The discounted cash flow model is undoubtedly the most popular of the present value
approaches. It is widely adopted by practitioners and entire textbooks are based on
this valuation approach. The discounted cash flow model can be specified in two
ways. One approach is used to estimate the enterprise value of a company and another
approach estimates the equity value of a company. In the following section we discuss
both approaches.

The enterprise value approach

According to the discounted cash flow model the value of a company is determined by
the present value of future free cash flows. In case of an infinite cash flow stream the
discounted cash flow model can be specified as:

where
FCFFt = Free cash flow to the firm in time period t.
WACC = Weighted average cost of capital
According to the discounted cash flow model only the free cash flows to the firm and
WACC affect the market value of a company. This implies that firm value is positively
affected by higher free cash flows and a lower WACC.
The discounted cash flow model can also be specified as a two-stage model:

As you can see from the above specifications, the discounted cash flow model shares
many of the same characteristics as the dividend discount model. However, the dis-
counted cash flow model as specified above estimates enterprise value as opposed
to market value of equity. It is therefore necessary to deduct the market value of net
interest-bearing debt from the enterprise value to obtain an estimated market value
of equity.
Based on the data reported in Tables 9.1 and 9.2, respectively, we show how to
calculate the value of a company using the discounted cash flow model in Table 9.4.
The present value of FCFF in the forecast horizon amounts to 59.9. The terminal
value is 186.2 and is calculated as:

The 18.62 is the free cash flow in year 7 (as shown in Table 9.4), which is expected to
grow by 2% (g = 2%) in perpetuity. WACC is 8.221% from year 7 and in perpetuity.
Finally, 0.622 is the result of:
Table 9.4 Discounted cash flow model - an enterprise value approach
Discounted cash flow model 1 2 3 4 5 6 7
(allowing for rounding errors)
Free cash flow to the firm (FCFF) 11.2 11.7 12.3 12.9 13.6 18.3 18.6
WACC 8.256% 8.250% 8.243% 8.237% 8.229% 8.221% 8.221%
Discount factor 0.924 0.853 0.788 0.728 0.673 0.622
Present value, FCFF 10.3 10.0 9.7 9.4 9.1 11.4

Present value of FCFF in forecast

horizon 59.9
Present value of FCFF in terminal
period 186.2
Estimated enterprise value 246.0
Net interest-bearing debt -60.8
Estimated market value of equity 185.2

This part of the equation is used to discount the value of the free cash flow in the
terminal period to present value. It should be noted that the number of years used for
discounting is six and not seven. The reason for this is that the expression

is an annuity in perpetuity, which already discounts back the cash flow by one period
(this can be shown mathematically).
In this example the terminal value accounts for approximately 76% of the estimated
enterprise value, which once again underlines the importance of the parameters support-
ing the terminal value. As you can see from the numerical examples both the dividend
discount model and the discounted cash flow model yield identical value estimates.

The equity value approach

The discounted cash flow model from an equity perspective is specified as:

where
FCFEt = Free cash flow to the equity in time period t
re = Investors required rate of return
As you may recall from the previous chapter the only difference between FCFF and
FCFE is the transactions with debt holders. Since FCFE accounts for transactions with
debt holders the discounted cash flow model based on FCFE yields a value estimate
of the equity. As shown above, the discounted cash flow model which relies on FCFF
yields a value estimate of both equity and net interest-bearing debt, i.e. enterprise value.
The approach can also be specified as a two-stage model:
Table 9.5 Discounted cash flow model - an equity approach
Discounted cash flow model 1 2 3 4 5 6 7
(allowing for rounding
errors)
Free cash flow to equity (FCFE) 10.5 11.1 11.6 12.2 12.8 15.2 15.5
Required rate of return on 8.996% 9.000% 9.004% 9.009% 9.014% 9.019% 9.019%
equity (re)
Discount factor 0.917 0.842 0.772 0.708 0.650 0.596
Present value, FCFE 9.7 9.3 9.0 8.6 8.3 9.0

Present value of FCFE in 54.0

forecast horizon
Present value of FCFE in 131.3
terminal period
Estimated market value of 185.2
equity

Using the data from Tables 9.1 and 9.2 we have shown how to calculate the value of a
company using the discounted cash flow model from an equity perspective (Table 9.5).
As you may have noticed the numbers are exactly the same as in the dividend discount
model. This is due to the fact that FCFE is assumed to be paid out as dividends in the
pro forma statements developed in the previous chapter. The value estimate is accord-
ingly identical to the value estimates of the dividend discount model.

Assumptions
Both cash flow models rest on the assumption that cash surpluses are paid out
as dividends or reinvested in projects with a net present value equal to zero (i.e.
returns earned on investments equal the cost of capital). In the previous chapter on
forecasting we defined cash surplus as the net cash flow after taking into account
cash flows from operations, investments and financing. The following example illus-
trates the implications of deviation from the assumption. It is based on the follow-
ing data:
• An investment project with an expected lifetime of one year
• No initial cash outlay
• The investment project is 100% equity financed
• The investment generates a FCFF of 1,000 by the end of the first forecast year
• The FCFF of 1,000 is paid out as dividends with 500 in the first forecast year and
the remaining amount in the second forecast year
• Cash surplus after the first forecast year is 500
• Cost of capital is 10%.
Relying on these assumptions the value of the investment project is 909.1 based on the
discounted cash flow model (DCF):
 Assuming that the cash surplus of 500 after the first forecast year is reinvested at a
rate equal to the cost of capital of 10%, the dividend discount model (DDM) yields
a value estimate identical to the discounted cash flow model:

thus the investment should be carried out if it costs less than 909.1.
The cash flow in year 2 is 550 since the cash surplus of 500 earns a return of 10%.
Now assume that the cash surplus is invested in a project that only returns 5% but
where the cost of capital is still 10%. In this case, the dividend discount model yields
a value estimate of 888.4, which deviates from the value estimate based on the dis-
counted cash flow model:

The above illustrates that if cash surplus is reinvested at a rate (in the example 5%)
different from the cost of capital (in the example 10%) the discounted cash flow
model yields a biased value estimate. In the example, the discounted cash flow model
overestimates the value of the project as cash surplus is reinvested at a rate below the
cost of capital.
The pro forma statements prepared in the previous chapter and summarised in
Table 9.1 assumes that cash surplus is paid out as dividends. This feature ensures that
the cash flow projections are in compliance with the assumption underlying the dis-
counted cash flow models. This also explains why both cash flow models in the above
examples yield a value estimate identical to the dividend discount model.
In summary, if the analyst complies with the underlying assumption the discounted
cash flow models yield an unbiased value estimate. Since there is a strong pressure on
management to pay out excess cash as dividends (or buy back shares) in most com-
panies, it seems fair to argue that it is a realistic assumption that cash surplus earns a
return equal to cost of capital; i.e. an assumption that most companies comply with.
Therefore, based on the value attributes the discounted cash flow model appears as an
attractive valuation approach.
Although both discounted cash flow models are technically relatively simple valua-
tion approaches they require inputs that are time consuming to generate. Furthermore,
the discounted cash flow models do not provide any intuitive explanation to laymen
why the value estimate deviates from the book value of equity. In conclusion, the dis-
counted cash flow models provide unbiased value estimates. However, the valuation
approach is time consuming to use and does not necessarily generate a value estimate
that is easv to communicate to laymen.

Excess return approach

Excess return approaches such as the Economic Value Added (EVA) model and the
Residual Income (RI) model have gained increasing attention in recent years. Both
the EVA model and the RI model rely on accrual accounting data as opposed to the
dividend discount model and the discounted cash flow models that rely on cash flow
data. Despite this difference they are theoretically equivalent valuation approaches.
The excess return approach can be specified in two ways. The EVA model estimates
the enterprise value of a company, while the RI model estimates the equity value of a
company. In the following section we discuss both approaches.
 The EVA model
According to the EVA model the value of a company is determined by the initial invested
capital (book value of equity plus net interest-bearing debt) plus the present value of all
future EVAs. In the case of an expected infinite lifetime the EVA model can be specified as:

where
EVAt = Economic Value Added (NOPATt - WACC X invested capital t-1 )
The EVA model uses the invested capital from the last fiscal year (t = 0) as a starting
point for valuation. It then adds the present value of all future EVAs, which yields the
enterprise value of a company. Based on the EVA model firm value is therefore posi-
tively affected by higher future EVAs and a lower WACC.
The EVA model can also be specified as a two-stage model:

The two-stage EVA model consists of three terms: the invested capital from the last
fiscal year, the present value of EVAs in the forecast horizon and the present value of
EVAs in the terminal period. When using the EVA model it is necessary to subtract
the market value of net interest-bearing debt from the enterprise value to obtain an
estimated market value of equity.
Based on the numerical example in Tables 9.1 and 9.2 we show how to calculate
the value of a company using the EVA model (Table 9.6).

Table 9.6 The Economic Value Added model

Economic Value Added model 1 2 3 4 5 6 7
(allowing for rounding errors)
NOPAT 17.2 18.1 19.0 19.9 20.9 21.4 21.8
Invested capital, beginning of 121.6 127.6 134.0 140.7 147.7 155.1 158.2
period
WACC 8.256% 8.250% 8.243% 8.237% 8.229% 8.221% 8.221%
Cost of capital 10.0 10.5 11.0 11.6 12.2 12.8 13.0
EVA 7.2 7.6 7.9 8.4 8.8 8.6 8.8
Discount factor 0.924 0.853 0.788 0.728 0.673 0.622
Present value of EVA 6.6 6.5 6.3 6.1 5.9 5.4
Invested capital, beginning 121.6
of period
Present value of EVA in forecast
horizon 36.7
Present value of EVA in terminal 87.8
period
Estimated enterprise value 246.0
Net interest-bearing debt -60.8
Estimated market value of equity 185.2
 Invested capital from the last fiscal year is 121.6. The present value of EVAs in the
forecast horizon is 36.7 and the present value of EVAs in the terminal period is 87.8
and is calculated as:

In the example the terminal value makes up 36% of the estimated enterprise value which
is less than the terminal value in the cash flow models. This difference is due to the fact
that the EVA model uses invested capital as a starting point. Only excess returns are
added to invested capital. In the extreme case where future excess returns equal zero the
terminal value makes up 0% of the enterprise value. Excess returns equal zero if ROIC =
WACC. In other words, book value of equity equals market value of equity if, and only
if, the return on invested capital equals the weighted average cost of capital.
This brings us to one of the interesting features of the EVA model. It explicitly shows
when a company is traded below or above its book value of invested capital. The esti-
mated market value of a company is above the book value of invested capital when
the present value of expected EVAs is positive and below when the present value of
expected EVAs is negative. Only in the scenario where return on invested capital equals
the cost of capital is the market value equal to the book value of invested capital.
Finally, as illustrated in the numerical example the EVA model yields a value esti-
mate identical to the dividend discount model and the discounted cash flow models,
which underlines the equivalence of the different present value models.

The residual income (RI) model

The RI model measures firm value from an equity perspective and is defined as:

where
RIt = Residual income [(return on equity t - re) × book value of equity t-1 ] in
time period t
The transactions with debt holders make up the difference between the EVA model and
the RI model. While the EVA model measures value from both an equity and debt per-
spective (enterprise value) the RI model measures value from an equity perspective only.
The RI model can also be specified as a two-stage model:

Relying on the data in Tables 9.1 and 9.2 we show how to calculate the value of a
company using the RI model (Table 9.7).
The estimated market value of equity based on the RI model consists of three terms:
the book value of equity from last fiscal year (60.8), the present value of RI in the
forecast horizon (40.4) and the present value of RI in the terminal period (84.1). The
terminal value is calculated as:
Table 9.7 The Residual Income model
Residual Income model 1 2 3 4 5 6 7
(allowing for rounding errors)
Net earnings 13.6 14.3 15.0 15.7 16.5 16.7 17.0
Equity, beginning of period 60.8 63.8 67.0 70.4 73.9 77.6 79.1
Required rate of return on 8.996% 9.000% 9.004% 9.009% 9.014% 9.019% 9.019%
equity (re)
Cost of capital 5.5 5.7 6.0 6.3 6.7 7.0 7.1
Residual income 8.1 8.5 8.9 9.4 9.9 9.7 9.9
Discount factor 0.917 0.842 0.772 0.708 0.650 0.596
Present value of residual income 7.4 7.2 6.9 6.6 6.4 5.8

Equity, beginning of period 60.8

Present value of Rl in forecast 40.4
horizon
Present value of Rl in terminal 84.1
period
Estimated market value of equity 185.2

The RI model shows that the estimated market value of equity is above the book value
of equity only in the scenario where the present value of expected RIs is positive; i.e.
future returns on equity exceed the cost of equity capital. The estimated market value
of equity is below the book value of equity in a scenario where the present value of
expected RIs is negative. The expected market value of equity is exactly equal to the
book value of equity when the present value of expected RIs is zero.

Assumption
Both the EVA model and the RI model rest on the clean-surplus assumption; i.e. that
all revenues, expenses, gains and losses in the forecast period are recognised in the
income statement. This implies that neither revenues nor expenses are allowed to
bypass the income statement in the pro forma statements. The following two exam-
ples illustrate the implications of violating the clean-surplus assumption.

Example 9.1 Assumption fulfilled

• A company expects an infinite annual income of 100
• Pay-out ratio is 100%; i.e. dividends is equal to 100
• Year 1 is the first year in the forecast period
• The book value of equity by the end of year 0 is 1,000
• The company is 100% equity financed which implies that EVA is equal to Rl
• The company's cost of capital is 10%.
On the basis of these assumptions the value of the company is 1,000 based on both the divi-
dend discount model and the excess return approach.
Example 9.2 Assumption violated
In this example, the company recognises expenses of 500, which in the first example was
recognised as expense in the income statement, directly on equity in the first forecast year.
This is obviously a violation of the clean-surplus assumption and implies that the expected
income in year 1 is 600 (100 + 500). Other assumptions remain unchanged from the first
example. Since dividends are still 100 in each forecast year the value based on the dividend
discount model is 1,000. However, the value based on the excess return approach changes as
a consequence of the violation of the clean surplus assumption.

The estimated market value is 1,454.5 or 454.5 more than the properly estimated value. This
corresponds exactly to the present value of the 500 that bypasses the income statement. The
excess return approach therefore yields biased value estimates when revenues or expenses
bypass the income statement. •

In summary, if an analyst complies with the clean-surplus assumption the EVA and
the RI models yield unbiased value estimates. Since clean-surplus behaviour is natural
when preparing pro forma statements, i.e. recognising all revenues and expenses in
the income statement, the assumption appears realistic.1 Therefore, based on the value
attributes the EVA and RI models are attractive valuation approaches.
The EVA and RI models rely on the same set of data as the dividend discount model
and the discounted cash flow models. They are therefore just as time consuming to use
as the cash driven valuation approaches. However, both the EVA and the RI model
generate value estimates that appear easier to understand. When using the EVA or RI
model it becomes obvious that the estimated market value exceeds the book value of
equity only when returns exceed cost of capital. We believe that this is an attractive
feature, as it makes the value estimate easier to understand.

Adjusted present value approach

The adjusted present value approach (APV) is a variant of the enterprise-value-based
DCF model, as it accounts for the tax shield on net interest-bearing debt separately. It
calculates the value of the company as the sum of the present value of FCFF and the
tax shields of interests on net interest-bearing debt, respectively. Since the value of the
tax shield of interests is valued separately the discount factor excludes the impact of
the tax shield. This implies that WACC, which include the impact of the tax shield on
interests, is replaced by the required rate of return on assets (ra).

where
TSt = Tax shield on net interest-bearing debt in time period t
ra = Required rate of return on assets
The first term of the APV approach expresses the value of a company without the
value of the tax shields from debt; i.e. the value of a company's operations. The sec-
ond term of the APV approach adds the present value of the tax benefits from net
interest-bearing debt.
 The APV approach can also be specified as a two-stage model:

As you can see from the above specifications, the two-stage APV approach shares the
same characteristics as other discounted cash flow models. However, the impact of the
tax shield on firm value is valued separately.
We illustrate how to apply the APV approach (Table 9.8) in calculating the value of
a company using the data from Tables 9.1 and 9.2.

Table 9.8 The adjusted present value approach

Adjusted present value (allowing for 1 2 3 4 5 6 7
rounding errors)
Free cash flow to the firm (FCFF) 11.2 11.7 12.3 12.9 13.6 18.3 18.6
Tax shield on net interest-bearing debt 1.2 1.3 1.3 1.4 1.5 1.6 1.6
Required return on assets (ra) 8.75% 8.75% 8.75% 8.75% 8.75% 8.75% 8.75%
Discount factor 0.920 0.846 0.778 0.715 0.657 0.605
Present value of FCFF 10.3 9.9 9.6 9.2 8.9 11.0
Present value of tax shield 1.1 1.1 1.0 1.0 1.0 0.9

Present value of FCFF in forecast horizon 58.9

Present value of FCFF in terminal period 166.8
Estimated market value of operations (A) 225.7

Present value of tax shield in forecast 6.2

horizon
Present value of tax shield in terminal 14.2
period
Estimated market value of tax shield (B) 20.3

Estimated enterprise value (A + B) 246.0

Net interest-bearing debt -60.8
Estimated market value of equity 185.2

The value estimate consists of four terms. The first term measures the present value
of FCFF in the forecast horizon and yields 58.9. The second term measures the present
value of FCFF in the terminal period and yields 166.8 and is measured as:

The sum of the first two terms yields the value of the operations and is equal to 225.7.
The third term measures the present value of the tax shield in the forecast horizon and
the final term measures the value of the tax shield in the terminal period:
 The sum of the third and fourth terms equals 20.3 (6.2 + 14.2) and measures the
present value of the tax benefit from net interest-bearing debt. The value estimate
based on the APV approach shows that the tax benefit from borrowing amounts to
8% (20.3/246.0) of the estimated enterprise value.
In summary, the APV approach is a variation of the discounted cash flow approach
where the value of the tax shield is measured separately. This may be considered an
attractive feature as it allows the analyst to discount the tax shield at a rate different
from the rate used on operations. Some may argue that the risk on the tax shield is
lower than the risk on operations. Except for this difference, the APV approach shares
the same characteristics as the discounted cash flow model and rests on the assump-
tion that cash surplus is paid out as dividends or reinvested in projects that yield a net
present value of zero.

An evaluation of the present value approaches

The different present value approaches are deduced from the dividend discount model
and yield identical value estimates. This implies that when they are used on real busi-
ness cases they should yield identical values. There are a few premises that the analysts
must meet (and understand) to ensure that the present value approaches yield identical
value estimates. They are:

• The valuations must be based on the same set of pro forma statements, which must
articulate.
• The analyst complies with the underlying assumption(s) of each present value
approach.
• The cost of capital reflects the projected capital structure.
• Each variable in the pro forma statements in the terminal period grows at the same
(constant) rate ensuring the steady-state assumption. Due to the nature of the value
driver setup and the way some of the present value approaches are defined, it is
typically necessary to forecast more than just one year into the terminal period
before each variable grows at the same rate. In our example from Chapter 8 we
forecast two years into the terminal period which ensures that we comply with the
steady-state assumption.
• The implementation of a valuation approach in a spreadsheet is free of errors. This
implies that the spreadsheet does not contain any errors such as wrong signs (for
instance it would be wrong if an increase in inventories would have a positive effect
on the free cash flow) or incorrect cell references.

Unless the analysts deviate from any of these premises they would be indifferent when
choosing between the various present value approaches as they all yield identical value
estimates as just demonstrated.
There may, however, be user attributes that make an analyst prefer one model over
the other. For example, some analysts may find it a useful that the value approach is
explicit in explaining why a value estimate deviates from the book value of equity. In
such cases an excess return model is superior. Other analysts may find it useful that
the valuation approach measures the impact of the tax shield on firm value separately.
In such cases an APV model is superior.
 The relative valuation approach (multiples)
Valuation based on multiples is often popular among practitioners. One explanation
for the popularity is the apparently low level of complexity and the speed by which
a valuation can be performed. However, a thorough valuation based on multiples is
both quite complicated and time consuming. In this section we discuss some of the
most frequently applied multiples, but also introduce multiples that are only rarely
used. We also show that multiples can be deduced from the present value approach.
This implies that multiples ideally yield value estimates that are equivalent with the
present value approaches. In reality, however, this only happens by chance. One expla-
nation is that short-cuts are made when multiples are applied. Another explanation is
that the analyst's forecast may deviate from the general market expectations.
In this section we demonstrate how multiples can be used for valuation purposes and
highlight some of the crucial assumptions underlying multiples. In Appendix 9.1, we
show how multiples can be used to value Carlsberg.

How are multiples applied for valuation purposes?

A valuation based on multiples relies on the relative pricing of peers' earnings. The
following examples illustrate different ways that multiples can be used for valuation
purposes.

Example 9.3 Applying multiples from peers

An analyst values a publicly traded company. Based on the current market price the enterprise
value is 120 and the expected EBIT next year is 10. The company is therefore traded at an
EV/EBIT multiple of 12. In order to evaluate the current market value, the analyst finds five
companies from within the same industry that are also publicly traded. Their EV/EBIT multi-
ples are reported as follows:

EV/EBIT
Peer 1 7.0
Peer 2 12.0
Peer 3 8.0
Peer 4 9.0
Peer 5 6.0
Mean 8.4
Median 8.0

The mean and the median EV/EBIT is 8.4 and 8.0, respectively, which is well below 12. The
comparison informs the analyst that the company being valued is on average approximately
50% more expensive than peers in the industry. This indicates that the company is either cur-
rently overvalued relative to its peers or has better prospects. •

Stress test of valuation

ExampleThe
9.4
analyst decides to make a valuation based on the discounted cash flow approach. Based
on the analyst's own projections of future cash flows she obtains an enterprise value of
 100, which corresponds to an EV/EBIT multiple of 10. She now wants to stress test her cash
flow based valuation and compares the EV/EBIT multiple of 10 with peers relative valuation
(median EV/EBIT = 8). That comparison shows that the company is on average 25% more
valuable than its peers. Therefore, either the projections on which the cash flow valuation is
based are too optimistic, indicating that the company is overvalued, or the company has bet-
ter prospects than the peers and therefore traded at a higher EV/EBIT multiple. •

Example 9.5 Valuing privately held firms

A privately held firm wants to be listed on a stock exchange. The company expects to earn
an EBIT of 50 next year. To derive an estimated market value, when the firm becomes listed
on the stock exchange, management applies multiples from peers. Based on the EV/EBIT
multiples from peers listed in Example 9.3 the following value estimates are calculated.

EV/EBIT Estimated Expected

(peers) EBIT enterprise value
Mean 8.4 50 420
Median 8.0 50 400
Low 6.0 50 300
High 12.0 50 600

Based on mean and median values of peers the EV/EBIT value is between 400 (8 × 50) and
420 (8.4 × 50). On the other hand, if the privately held company is priced according to the
lowest EV/EBIT among the peers the value is 300 (6 × 50) and if priced according to the high-
est EV/EBIT the value is 600 (12 × 50). •

These three examples illustrate different ways that multiples can be used. In
Example 9.3, multiples of peers are compared. Example 9.4 illustrates how to apply
multiples to stress test a valuation based on another approach. Finally, Example 9.5
illustrates how to apply multiples in valuing privately held companies.
In the above examples the EV/EBIT multiple has been applied. In reality, however,
there are a wide range of multiples available. Figure 9.2 lists some of the most popular
multiples applied by analysts. The multiples are divided into two groups. One set of
multiples estimates the enterprise value of the company and includes multiples such as
EV/EBITDA and EV/EBIT. Another set of multiples estimates the value of the equity
and includes multiples such as P/E and M/B.
A valuation based on multiples critically relies on the assumption that companies
which are compared are truly comparable; i.e. share the same economic characteristics
and outlook. Furthermore, the accounting numbers must be based on the same qual-
ity; i.e. based on the same set of accounting policies and excludes the impact of transi-
tory items. In the following section, we address each of these issues.

What drives multiples?

In this section we look at how multiples relate to the present value approach, to obtain
a deeper understanding on the fundamental value drivers that influence multiples. This
information is useful when selecting comparable companies for valuation purposes
and in Box 9.1 we derive a range of multiples from the present value approaches.
Box 9.1 The equivalence between the present value approach and multiples

The relative valuation approach can be divided into one set of multiples used to estimate
the enterprise value and another set of multiples aimed at estimating the market value of
equity. Below we deduce a range of multiples from the discounted cash flow model in order
to estimate enterprise value (EV). Subsequently, we infer equity-based multiples from the
dividend discount model.

En terprise- value-based m ul ti ples

Assuming a constant growth rate the discounted cash flow can be expressed as:

By replacing FCFF with NOPAT × (1 - reinvestment rate) we obtain the following expression:

where reinvestment rate is the share of NOPAT that is reinvested in the business and is equal to:
(change in net working capita! + change in non-current assets) / NOPAT.
Substituting NOPAT with ROIC × invested capital and dividing the equation with invested
capital yields an EV/IC multiple:

where IC is invested capital.

By multiplying the denominator in

Substituting NOPAT with EBIT × (1 - f) and multiplying the equation with (1 - t) results in
the well-known EV/EBIT multiple:

where t equals the corporate tax rate.

If we replace EBIT with EBITDA × (1 - depreciation rate) and multiply the equation with
(1 - depreciation rate) we obtain an expression for the EV/EBITDA multiple:

where the depreciation rate is defined as:

 Finally, substituting EBITDA with revenue × EBITDA margin and multiplying the equa-
tion with the EBITDA-margin yields the EV/Revenue multiple:

Equity-based multiples
Assuming a constant growth rate the dividend discount model can be expressed as:

where MVE equals the market value of equity.

Replacing dividends with net earnings × payout ratio:

and substituting net earnings with ROE × BVE we get:

where BVE is the book value of equity. Replacing the payout ratio with (1 - RR) and
dividing the equation with BVE yields an expression for the M/B multiple:

where BVE is the book value of equity and RR is the retention rate; i.e. the share of net
earnings that is ploughed back into the business.
By multiplying the denominator in

with ROE we obtain an expression for the P/E multiple:

Based on the expressions derived in Box 9.1 we find that different factors affect
multiples and these factors are summarised in Table 9.9. It is useful as it informs
the analyst about the underlying requirements when using different multiples. For
example, a valuation based on equity-based multiples requires that the companies that
are compared have identical expected growth rates, cost of capital and profitability.
Furthermore, the analyst faces additional requirements if some of the enterprise value
based multiples are used. A valuation based on the EV/EBIT multiple requires that
the expected tax rate is identical across companies which are compared. This assump-
tion may be challenged if cross-country multiples are applied. A valuation that relies
on the EV/EBITDA multiple requires in addition that the expected depreciation rate
remains identical across companies that are compared. Although the capital intensity
tends to be similar within an industry there may still be differences due to variations
 Table 9.9 Factors influencing the multiples
Equity-based multiples
P/E ROE re g
M/B ROE re g
Enterprise-value-based multiples
EV/NOPAT ROIC WACC g
EV/EBIT ROIC WACC g Tax rate
EV/EBITDA ROIC WACC g Tax rate Depreciation rate
EV/Revenue ROIC WACC g Tax rate Depreciation rate EBITDA margin
EV/IIC ROIC WACC g

in the adopted strategies. One company may in-source its production while another
may outsource its production. This difference will affect the depreciation rate and
will make a comparison more difficult. Finally, a valuation that uses the EV/Revenue
multiple requires an identical expected EBITDA margin across the companies being
compared.
The multiples derived in Box 9.1 can also be used to explain why some companies
are traded at a multiple below peers, while others are traded at a multiple above peers.
In the following example we demonstrate what characterises companies traded at a
low and a high P/E and M/B, respectively.

The illustrations in this example are based on companies that share many of the same charac-
Example 9.6
teristics. They have the same cost of capital (10%) and the expected growth rate is either 2%
(g1) or 4% (g2). The only difference is the expected profitability, where expected ROE varies
from 5% for Company A to 15% for Company C.

Based on the derived M/B multiple

the following M/B values can be calculated for the three companies.
 Company A is earning a return below its cost of capital and is consequently traded below
its book value of equity. Company B is earning a return at its cost of capital and is traded
at its book value of equity Finally, Company C is earning a return above its cost of capital and
is therefore traded above its book value of equity. The example illustrates that the relation
between return on equity and the cost of capital is the deciding factor for the M/B multiple.
The following generic rule applies for the M/B multiple.

Example 9.6 also illustrates that growth is only interesting if it earns a return above the
cost of capital. In the scenario where ROE is below the cost of capital the M/B drops from
0.38 to 0.1 7 when the expected growth rate increases from 2% to 4%. On the other hand,
in the scenario where ROE exceeds cost of capital the M/B goes from 1.63 to 1.83 when the
expected growth rate increases from 2% to 4%.
If we apply the derived P/E multiple

on the assumptions in this example, we obtain the following P/E multiples for the three
companies.

Company B earns a return similar to the cost of capital and obtains a P/E of 10. This corre-
sponds to the reciprocal value of cost of capital (1 /cost of capital) and is also referred to as the
normalised P/E ratio. Company A earns a return below its cost of capital and is traded below
its normalised P/E. Company C, on the other hand, earns a return above its cost of capital and
is traded above its normalised P/E.
Example 9.6 also illustrates that growth adds to value only when a firm earns a return
above its cost of capital. Only company C earns a return above its cost of capital and experi-
ences an increasing P/E multiple as growth increases. This questions the general perception
that growth in EPS leads to a higher P/E multiple. A prerequisite is that growth in EPS is profit-
able; i.e. that a company earns a return above the cost of capital. •

(continued)
Example 9.5
In Example 9.5 above we estimated the value of a privately held company based on multiples
from its peers. The estimated value ranged from 300 to 600 depending on the peer chosen.
This is obviously a wide range that needs to be narrowed further. A comparison of the funda-
mental value drivers of the privately held company with its peers would help to reduce the
wide value range. Assuming that the company's fundamental value drivers mirror those of
 peers 3 and 4 it seems reasonable to apply the EV/EBIT multiples from these peers. As the EV/
EBIT multiples from peers 3 and 4 are traded in the range of 8 to 9 it yields an enterprise value
between 400 and 450 (assuming an expected EBIT of 50 as in the example). •

Accounting differences
In Chapters 13, 14 and 15 we show how different accounting principles lead to different
financial statements. A valuation based on multiples is also a comparison of account-
ing numbers between related companies. This implies that accounting numbers from
the companies being compared must be based on the same set of accounting principles.
Otherwise noise is introduced in the valuation. Today, many countries are adopting
IFRS. This implies that the accounting principles are increasingly harmonised across
countries, which reduces the problem. However, IFRS are typically adopted by listed
companies whereas privately held companies tend to use local GAAP. Since local GAAP
in many countries are not identical to IFRS, it makes valuation of privately held com-
panies more challenging. In addition, the vast majority of all companies are non-listed.
Even within IFRS there is some degree of flexibility. For example, IFRS increasingly
relies on accounting standards that involve the management's judgement; especially as
fair value is increasingly used as a measurement basis. This implies that a comparison
of two sets of accounting numbers (financial statements) that are both based on IFRS
needs to be scrutinised for any differences before they are used for valuation purposes.
As discussed in Chapters 13, 14 and 15 items such as gains and losses from divestment
of assets and restructuring charges are typically transitory in nature. We therefore recom-
mend that they are excluded from the accounting numbers used for valuation purposes.
By excluding the impact of transitory items the valuation is purely based on recurrent (per-
manent) items which reflect the earnings potential much better than non-recurrent items.
In reality, a transitory item is primarily a problem if realised accounting numbers are used
as opposed to projected accounting numbers that tend to be based on recurrent items.

Example 9.5 (continued)

The privately held company being valued complies with local GAAP. It deviates from IFRS
which the peers have adopted. A comparison of the two sets of accounting practices reveals
the following two major differences.

1 Goodwill is recognised and amortised over 1 0 years according to local GAAP, whereas
goodwill is tested for impairment, at least on an annual basis, according to IFRS. The
privately held company has amortised goodwill of 20 in the first forecast year. The impair-
ment tests conducted by the peers have not revealed any need for recognising impairment
losses of goodwill.
2 According to local GAAP the fair value of the warrants at grant date is recognised directly on
an equity account over the vesting period. According to IFRS the fair value of the warrants
at grant date is recognised as an expense in the income statement over the vesting period.
The privately held company has recognised 5 directly on equity in the first forecast year.
In order to compare the two sets of accounting numbers we adjust the accounting numbers
of the privately held company so that they are in compliance with IFRS.

EBIT according to local GAAP 50

Amortisation of goodwill, added back +20
Fair value of warrants at grant date -5
EBIT according to IFRS 65
 Assuming no need for impairment of goodwill we add back the amortisation of goodwill
of 20 and expense, 5, from the warrant programme which yield an adjusted EBIT of 65
and a modified value estimate of 520-585 using an EV/EBIT multiple between 8 and 9.
The example shows that any bias in the EBIT estimate due to accounting differences is
multiplied by the EV/EBIT multiple. It is therefore crucial that any accounting differences are
adjusted for when accounting numbers are used for valuation purposes. In the example, the
impact of the accounting differences on expected EBIT is 15 (65 - 50) and the difference in
value estimate (noise) is between 120 and 1 35 due to the multiplier effect from the EV/EBIT
multiple (8-9). •

Additional considerations
There are a few additional considerations that need to be addressed when valuing
companies using multiples. These include:
• Normalisation of earnings
• The use of current versus expected earnings
• The measurement of averages
• Impact of trading a majority share.

Normalisation of earnings
In privately held firms there are cases where earnings are biased and therefore do not
reflect the 'true' earnings of the company. This is typically the case where the owner
serves as the CEO and receives a salary that deviates from the market norm or when
the company is paying for services that are not returning any benefits. An example
includes pocket money to spouses paid by the company. It is, however, important
that the earnings used for valuation is adjusted for such issues; i.e. normalised. By
normalising earnings the valuation reflects the true value potential of the company
and is not influenced by an atypical salary to the owner or the private consumption
of the owner.

The use of current versus expected earnings

Analysts are typically confronted with the choice of using current earnings, trail-
ing earnings (earnings accumulated over the last four quarters) or expected earn-
ings as denominator in the multiple. Since current earnings and trailing earnings
inform about past performance, which is not necessarily a good indicator of future
performance, we recommend the use of expected earnings. This recommendation is
also supported by research. For example, Liu et al. (2002) find that multiples based
on expected earnings yield more accurate value estimates than multiples based on
current earnings.

The measurement of averages

When the sample of potential comparable companies has been limited to companies
with similar characteristics an average of the multiples of these companies is often
calculated. This begs the question whether the average should be based on the mean,
the value weighted mean, the harmonic mean or the median. The difference between
the measures is shown in Example 9.7.
Example 9.7 Value weight Multiple
Peer 1 0.10 55.0
Peer 2 0.20 10.0
Peer 3 0.30 9.0
Peer 4 0.15 20.0
Peer 5 0.15 14.0
Peer 6 0.10 8.0
Mean 19.3
Median 12.0
Value-weighted mean 16.1
Harmonic mean 12.6

The mean is a simple average of the multiples of the six peers. The median constitutes
the middle value of the ordered set of multiples. The value-weighted mean uses the rela-
tive market value of each peer when measuring the mean. Finally, the harmonic mean is
calculated as:

Where n is the number of peers. Both the median and the harmonic mean avoid the impact
of extreme multiples. In the example, Peer 1 is traded at a multiple of 55 which domi-
nates the simple mean estimate. Excluding that observation results in a mean of 12.2 which
is close to both the median and harmonic mean. Research generally supports the use of
harmonic means. For example, Baker and Ruback (1999) find that the harmonic mean
generates more accurate value estimates than multiples based on mean, median, and a
value-weighted mean. •

Impact of trading a majority share on firm value

An investor is typically willing to pay a premium for a controlling interest in a com-
pany. This is due to the fact that a controlling interest allows the investor to make
changes in the operating activities and thereby improve firm value. As multiples
obtained from listed companies are based on trading of minority shares it is necessary
to adjust the value estimate in cases where a controlling interest is traded. The control
premium fluctuates but the historical average is approximately 30% and it is therefore
essential to adjust the value estimates accordingly.

An evaluation of the relative valuation approach

A valuation based on multiples appears technically simple and easy to perform.
However, a valuation based on multiples relies on a number of restrictive assump-
tions that complicate the valuation and makes it time consuming. Unless the ana-
lyst complies with these assumptions the relative valuation approach yields a biased
 value estimate. When applied in practice there is a tendency that all assumptions are
not necessarily fulfilled (for instance it's time consuming to adjust for differences in
accounting policies) which lead to biased value estimates. Despite this shortcoming
multiples also have appealing features. Most of all, the approach relies on market
prices which contain value relevant information (assuming an efficient market). A
multiple expressing the price to earnings ratio reflects the opinions of investors and
how much they are willing to pay for earnings in a company or an industry and offer,
therefore, useful complementary information to the present value approach, which to
a large degree relies on the analyst's own expectations (forecasts).

The liquidation approach

The liquidation value is the estimated amount that a company could be sold for if all
assets were sold and liabilities settled (paid off). The liquidation value represents the
value of the alternative uses of assets. In a healthy industry with attractive growth
rates and healthy returns, a company's liquidation value is typically less than its
value as a going concern. In an industry with negative outlooks and poor returns,
a company's liquidation value may exceed its value as a going concern. There are
two types of liquidation values, depending on the time available for the liquidation
process:

• The orderly liquidation value assumes an orderly sale process. It assumes that the
owners have the time necessary to sell each asset in its appropriate season and
through channels that yield the highest price achievable.
• The distress liquidation value assumes that an orderly sale process is not an option
and that the sale of assets has to be 'pushed through the system' due to time
constraints.
Due to the nature of the sale process the orderly liquidation value exceeds the distress
liquidation value. Depending on the type of assets and the sale process chosen, the
difference between the two values can be substantial. An estimation of the liquidation
value typically follows these steps:

Book value of equity

+/- The difference between the liquidation value and book value of assets
+/- The difference between the liquidation value and book value of liabilities
+/- The liquidation value of off-balance sheet items
- Fees to lawyers, auditors, etc.
= Liquidation value

Book value of equity serves as a starting point for the estimation of the liquidation
value. The next step is to adjust the value of recognised assets, so that they reflect the
liquidation value. The adjustment of the book value of assets depends on a range of
factors including:
• The measurement basis used
• Alternative uses of assets
 • The level of maintenance
• The number of potential buyers
• The time available for the sales process.
The third step is to adjust the value of recognised liabilities, so that they reflect the
liquidation value. The adjustment of the book value of liabilities depends on a range
of factors including:
• The measurement basis used
• Terms of the liabilities
• Time available for the sales process
• The possibility to make arrangements with lenders.
The fourth step is to include the liquidation value of off-balance sheet items; i.e. items
not recognised on the balance sheet. They may include law suits, disputes, leasing,
guarantees for loans and capital commitment agreed to be made at a later date than
the balance sheet date. Finally, the liquidation value is adjusted for fees to advisers
involved in the liquidation process such as lawyers and auditors.

Example 9.8 The owners of the Dyeing Corporation want to sell its business and due to the bleak outlook
of the industry they have decided to estimate the value of its business based on the liquida-
tion approach. The book value of equity is 100.
Experts believe that the liquidation value of the assets is 30 below the book value of those
assets. Further, an assessment of liabilities recognised in the balance sheet indicates that the
book value underestimates the liquidation value by 15. The company is also involved in a law-
suit where a competitor is sued for 50 for violating one of the company's patents. The lawyer
expects that there is 40% probability that the court will rule in favour of Dyeing Corporation.
As the company has not recognised the potential benefits from the law suit on the balance
sheet the liquidation value is positively affected by 20 (40% of 50). The estimated fees to
advisers including lawyers and other experts are 10. The liquidation value, which yields 65, is
summarised in the following tabulation.

Book value of equity 100

The difference between the liquidation value and book value of assets -30
The difference between the liquidation value and book value of liabilities -15
The liquidation value of off-balance sheet items (lawsuit) + 20
Fees to lawyers, auditors, etc. -10
Liquidation value 65

An evaluation of the liquidation approach

The liquidation approach is fundamentally different from the present value approach
and multiples. It values a company as if it were to go out of business. The liqui-
dation approach yields an unbiased value estimate only in cases where the present
value approach and multiples yield estimates below the liquidation value. This implies
that the approach is best suited when the going concern of a business is questioned
and when alternative uses of the assets would yield a higher return. From a user per-
spective the liquidation approach has some appealing features. It is relatively easy
to apply and the value estimate is easy to communicate to laymen. Furthermore, as
 owners would not accept a price below the liquidation value the approach informs
about the minimum value of a business. Analysts may therefore use the approach to
establish the minimum value of a business.

Conclusions
There are four approaches available for valuation:

• The present value approach

• The relative valuation approach
• The liquidation approach
• The contingent claim approach.

The present value models are derived from the dividend discount model. This
implies that they yield identical value estimates. Therefore, from a valuation per-
spective analysts should be indifferent when choosing between the various present
approaches. There may, however, be user attributes that make a present value model
more appealing than others. For example, an excess return approach such as the EVA
model is informative about when a company is traded above and below its book value
of equity. We argue that this is an attractive feature as it makes communication of
value estimates to laymen easier.
A valuation based on multiples appears technically simple and easy to perform.
However, a valuation based on multiples relies on a number of restrictive assump-
tions that complicate the valuation and makes it time consuming. This implies that
the approach only yields unbiased value estimates under very restrictive assumptions.
Despite this shortcoming multiples should be seen as a complementary valuation
approach to the present value approach. For example, multiples rely on market
prices that reflect the opinions of many investors as opposed to the present value
approach which mainly relies on the analyst's own expectations. Multiples therefore
serve as a useful method to stress test value estimates based on the present value
approach.
The liquidation approach values a company as if it were to go out of business. The
liquidation approach is therefore best suited when the going concern of a business is
questioned and when alternative uses of assets would yield a higher return.

Review questions
• Which approaches can be used for valuing a firm?

• What are the attributes of an ¡deal valuation approach?

• What is the theoretically correct model for valuing firms?

• Why do present value models yield identical values?

• What are multiples?

• What are major assumptions which must be fulfilled in order to apply multiples?

• What is the rationale behind using the liquidation model?

 APPENDIX 9.1

Carlsberg case
In this appendix we value Carlsberg based on the present value approach and multiples.
The valuation relies on projections of Carlsberg's financiAis prepared in Appendix 8.1.
A summary of the key financial figures are listed in Table 9.10.

Table 9.10 A summary of Carlsberg's key financial figures

Summary of key financial Forecast Terminal period
figures (DKKm) Year E1 Year E2 Year E3 Year E4 Year E5
Revenue growth 5.0% 5.0% 4.0% 3.0% 3.0%
NOPAT 5,799 6,337 6,848 7,648 7,877
Invested capital excluding intangibles,
beginning of the year 27,017 27,316 28,616 29,692 29,733
Free cash flow to the firm (FCFF) 5,499 5,037 5,772 7,607 6,985
Tax shield on net interest-bearing debt 901 860 876 883 885
Dividends 488 3,364 3,541 5,027 5,848

In Table 9.11 we report estimates for the different measures on Carlsberg's cost of
capital that give us the opportunity to show the value estimates based on different
present value approaches. We allow the different cost of capital measures to fluctu-
ate with any changes in the capital structure. As noted previously this is a prereq-
uisite ensuring that the different present value approaches yield identical values. In
Appendix 10.1 we provide additional information on how the different measures on
cost of capital have been estimated.

Table 9.11 Different measures on Carlsberg's cost of capital

Estimation of cost of capital Forecast Terminal
Year E1 Year E2 Year E3 Year E4 period Year E5
Debt/equity 0.525 0.509 0.489 0.473 0.473
Required rate of return on assets (ra) 8.00% 8.00% 8.00% 8.00% 8.00%
Required rate of return on debt, after tax (rd) 5.25% 5.25% 5.25% 5.25% 5.25%
Required rate of return on equity (re) 8.59% 8.52% 8.51% 8.49% 8.47%
WACC 7.35% 7.40% 7.41% 7.42% 7.44%

Based on the estimates summarised in Tables 9.10 and 9.11, respectively, we cal-
culate the value of Carlsberg and we apply four of the present value models discussed
previously in Tables 9.12, 9.13, 9.14 and 9.15.
Table 9.12 An estimated market value of Carlsberg based on the dividend discount model
Dividend discount model (DKKm) Forecast horizon Terminal period
Year E1 Year E2 Year E3 Year E4 Year E5
Dividends 488 3,364 3,541 5,027 5,848
Discount factor 0.921 0.849 0.782 0.721
Present value of dividends 450 2,855 2,769 3,623

Present value of dividends in 9,697

forecast horizon
Present value of dividends in 77,019
terminal period
Expected market value of group 86,716
equity
Estimated market value of minority 7,532
interests
Expected market value of equity 79,185

Table 9.13 An estimated market value of Carlsberg based on the discounted cash flow model
Discounted cash flow model (DKKm) Forecast horizon Terminal period
Year E1 Year E2 Year E3 Year E4 Year E5
Free cash flow to the firm (FCFF) 5,499 5,037 5,772 7,607 6,985
Discount factor 0.932 0.867 0.808 0.752
Present value of FCFF 5,123 4,369 4,661 5,718

Value of FCFF in forecast horizon 19,871

Value of FCFF in terminal period 118,323
Estimated enterprise value 138,194
Net interest-bearing debt 51,478
Expected market value of group equity 86,716
Estimated market to book 1.44
Book value of minority interests 5,230
Estimated market value of minority 7,532
interests
Expected market value of equity 79,185

Table 9.14 An estimated market value of Carlsberg based on the economic value added model
Economic value added Forecast horizon Terminal period
model (DKKm) Year E1 Year E2 Year E3 Year E4 Year E5
NOPAT 5,799 6,337 6,848 7,648 7,877
Invested capital, beginning of
period, excluding intangibles 27,017 27,316 28,616 29,692 29,733
WACC 7.35% 7.40% 7.41% 7.42% 7.44%
Table 9.14 (continued)
Economic value added Forecast horizon Terminal period
model (DKKm) Year E1 Year E2 Year E3 Year E4 Year E5
Cost of capital 1,985 2,021 2,120 2,205 2,212
EVA 3,814 4,316 4,728 5,443 5,666
Discount factor 0.932 0.867 0.808 0.752
Present value of EVA 3,553 3,744 3,818 4,092
Invested capital, beginning of
period, excluding intangibles 27,017
Value of EVA in forecast horizon 15,206
Value of EVA in terminal period 95,971
Estimated enterprise value 138,194
Net interest-bearing debt 51,478
Expected market value of group 86,716
equity
Estimated market to book 1.44
Book value of minority interests 5,230
Estimated market value of 7,532
minority interests
Expected market value of equity 79,185

Table 9.15 An estimated market value of Carlsberg based on the adjusted present value model
Adjusted present value model (DKKm) Forecast horizon Terminal period
Year E1 Year E2 Year E3 Year E4 Year E5
Free cash flow to the firm (FCFF) 5,499 5,037 5,772 7,607 6,985
Tax shield on net interest-bearing debt 901 860 876 883 885
Required rate of return on assets (ra) 8.00% 8.00% 8.00% 8.00%
Discount factor 0.926 0.857 0.794 0.735
Present value of FCFF 5,092 4,318 4,582 5,591
Present value of tax shield 834 738 696 649
Present value of FCFF in forecast horizon 19,584
Present value of FCFF in terminal period 102,690
Estimated market value of operations (A) 122,274
Present value of tax shield in forecast horizon 2,917
Present value of tax shield in terminal period 1 3,004
Estimated market value of tax shield (B) 15,920
Estimated enterprise value (A + B) 138,194
Net interest-bearing debt 51,478
Expected market value of group equity 86,716
Estimated market value of minority interests 7,532
Expected market value of equity 79,185
 The different present value models yield an identical value estimate of Carlsberg.
In the following section, we will briefly discuss some of the premises that each value
estimate is based on. First, invested capital used in the EVA model excludes the impact
of intangibles. By excluding intangibles, which is assumed constant in the pro forma
statements, we ensure that the EVA is growing at a constant rate in the terminal period.
Second, we assume that the book value of net interest-bearing debt is a good proxy for
the market value of net interest-bearing debt. Finally, we estimate the market value of
minority interests by using the group's estimated market to book of 1.44:
Estimated market value of minority interests: 7,532 = 1.44 × 5,230
The estimated value of Carlsberg's equity is DKK 79,185 million, which is well above
the current market value of DKK 57,394 million. In order to examine the robustness
of that value estimate we conduct:
• A sensitivity analysis and
• A multiple valuation.

Sensitivity analysis
A valuation should always be accompanied by a sensitivity analysis that examines the
valuation consequences of changing some of the key value drivers. Ideally, the sensitiv-
ity analysis is inspired by the fundamental analysis that is the foundation of the pro
forma statements. In Table 9.16 we explore the valuation consequences of changing
the growth rate and the EBITDA margin by + / - 1 . 0 percentage-point.

Table 9.16 Sensitivity analysis - impact of the value estimate of Carlsberg

Growth rate
-1.0% -0.5% 0.0% 0.5% 1.0%
-1.0% 53,650 61,228 70,326 81,449 95,357
-0.5% 57,305 65,236 74,755 86,394 100,946
0.0% 60,961 69,243 79,185 91,339 106,536
0.5% 64,617 73,250 83,614 96,284 112,126
1.0%
EBITDA margin 68,272 77,257 88,043 101,229 117,716

The sensitivity analysis reveals that the value estimate is sensitive to changes in the
growth rate as well as the EBITDA margin. For example, by changing the growth rate
as well as the EBITDA margin by +1 percentage-point annually in the pro forma state-
ments the value estimate improves from DKK 79,185 million to DKK 117,716 million.
It demonstrates that a value estimate based on the present value approach is indeed
sensitive to changes in key value drivers and underlines the importance of devoting the
time necessary to prepare realistic pro forma statements.

Multiple valuation
As peers for the multiple valuation we have chosen Heineken, SabMiller and AB
Inbew (Table 9.17). They are all global players such as Carlsberg and based on market
shares they are, together with Carlsberg, some of the biggest breweries in the world.
Table 9.17 provides a summary of key financial numbers which are used to calculate
a range of multiples. Transitory (non-recurring) items are removed from the financiais
Table 9.17 A summary of the peers' key financial figures including market values
Key figures (million) Carlsberg Heineken AB InBew SabMiller
DKK euro euro US$
Revenue 59,944 14,319 16,102 21,410
EBITDA excluding transitory items 11,438 2,242 5,333 4,598
EBIT excluding transitory items 7,667 1,036 4,022 3,560
NOPAT 6,808 604 3,318 2,391
Net earnings excluding transitory items and
minority interests (E) 3,793 190 2,433 2,098
Expected net earnings (E+1) 4,434 1,096 3,374 2,772
Invested capital (IC) 111,695 14,135 60,382 27,455
Book value of equity 55,521 4,471 16,126 1 7,545

Market cap (equity) 57,394 16,084 32,059 83,632

NIBD 50,944 9,383 42,827 9,211
Minority interests in equity 5,230 281 1,429 699
Enterprise value (EV) 113,568 25,748 76,315 93,542

and, thus, earnings measures only consist of recurrent (permanent) items. We calculate
multiples based on both Carlsberg's current market value and the value estimate of 79,185
obtained from the present value models. The estimated multiples are shown in Table 9.18.

Table 9.18 Multiples and fundamental value drivers of the four breweries
Carlsberg
Multiples Current Present Heineken AB SabMiller Harmonic
market value InBew mean (excl.
value estimate Carlsberg)
EV/NOPAT 16.7 20.2 42.6 23.0 39.1 32.4
EV/EBIT 14.8 18.0 24.9 19.0 26.3 22.9
EV/EBITDA 9.9 12.0 11.5 14.3 20.3 14.6
EV/Revenue 1.9 2.3 1.8 4.7 4.4 3.0
EV/IC 1.0 1.2 1.8 1.3 3.4 1.8
P/E 15.1 20.9 84.5 13.2 39.9 26.6
P/E+1 12.9 17.9 14.7 9.5 30.2 14.5
M/B 1.0 1.4 3.6 2.0 4.8 3.0

ROE after tax 6.8% 4.3% 15.1% 12.0% 7.8%

ROIC after tax 6.1% 4.3% 5.5% 8.7% 5.7%
Expected growth in EPS next five years 14.8% 10.0% 18.0% 1 3.5% 13.1%
Beta (risk) 1.29 0.84 0.82 0.97 0.87
Efficient tax rate 11.2% 41.7% 1 7.5% 32.8% 26.9%
Depreciation rate 33.0% 53.8% 24.6% 22.6% 29.0%
EBITDA margin 19.1 15.7% 33.1% 21.5% 21.3%
 A comparison of multiples that are based on the current market value reveals that
Carlsberg is traded at a discount relative to most of its peers. For example, Carlsberg's
EV/EBIT multiple is 35% below the harmonic mean of the three peers. If we apply the
value estimate of 79,185 from the present value approach as numerator in the multi­
ples, Carlsberg is traded at a discount relative to its peers only if realised accounting
numbers are used. However, as noted previously multiples based on forward look­
ing information yield on average more accurate value estimates. A comparison of the
P/E+1 multiple indicates that Carlsberg is traded at a premium of 2 3 % relative to its
peers. This indicates that the present value estimate of 79,185 may be too optimistic.
As noted before, a valuation based on multiples requires that the companies, which
are compared, have identical expected growth rates, cost of capital and profitability.
In Table 9.18 a comparison of different measures for profitability, growth and risk are
provided. A comparison of ROIC and ROE indicates that Carlsberg's profitability is
similar to its peers. For example, Carlsberg's ROIC is almost identical with the har­
monic mean of its peers. Further, analysts' consensus forecast of Carlsberg's expected
growth rate for the next five years is also similar to the peers' expected growth rate.
While Carlsberg's expected growth rate is 14.8% the peers expected growth rate is
13.1%. Carlsberg's β is 1.29 and well-above average β of the peers. This indicates that
Carlsberg's risk exceeds the risk of the peers and supports that Carlsberg ought to be
traded at a discount relative to its peers.
Even though all four breweries comply with IFRS there may still be accounting differ­
ences, which make a valuation based on multiples less applicable. In Table 9.19 we there­
fore compare some of the critical estimates used in the annual report of the four breweries.
A comparison of the accounting estimates applied shows that they are reasonably
similar across the different breweries. In a few cases where differences occur they can
be ascribed to the category of 'natural differences'. For example, Carlsberg's discount

Table 9.19 A comparison of critical accounting estimates

GAAP Carlsberg Heineken AB InBew SabMiller
IFRS IFRS IFRS IFRS
Amortisation and depreciation Useful lives (years):
Strategic brands 40-50
Other brands Max 20 15-25 3-18 10-40
Customer related intangibles Max 20 5-30 3-18 10-15
Buildings 20-40 30-40 20-33 20-50
PPE 5-15 5-30 5-15 2-30
Returnable packaging 3-10 5-10 1-10
IT 3-5 3-5
Impairment tests Pre-tax Post-tax WACC:
risk free rate
Western Europe 3.9-13.3% 7.6% na 7-12.6%
Eastern Europe incl. Russia 7.9-16.1% 9.6-14.1% na 7-12.6%
The Americas 8.2-13.1% na 7.1-13.7%
Africa and Middle East 7.6% na 10.7-20.4%
Asia 4.5-10.9% na 10.7-20.4%
Table 9.19 (continued)
GAAP Carlsberg Heineken AB InBew SabMiller
IFRS IFRS IFRS IFRS

Impairment tests Growth rates:

Western Europe 1.5% 2.1% na 1.5-2.0%

Eastern Europe incl. Russia 2.5% 2.9% na 1.5-2.0%
The Americas 1.7-7.3% na 1.5%
Africa and Middle East 3.1-7.4% na 3.0-1.0%
Asia 1-5% na 3.0-4.0%

Defined benefit plan (weighted average):

Discount rate 4.6% 5.6-6.7% 4.9% 4.8-6.5%
Expected return on plan assets 4.6% 5.7-5.9% 4.2% n.a.
Future salary increases 2.6% 3.0-4.0% 3.1% 2.5-3.5%
Future retirement benefit increases 1.6% 1.5-2.8% 1.8% 2.5-4.0%
Operating leasing (million)
One-year leases 774 66 72 69
Total future lease payments 2,651 378 1,132 294
One-year leases as percentage of EBITDA 6.8% 2.9% 1.4% 1.5%
Total leases as percentage of invested capital 0.7% 0.5% 0.1% 0.3%

factor used for impairment is in general lower than its peers. However, according to IAS
36 Carlsberg adjusts for risk in the cash flow and therefore apply a risk-free rate as a
discount factor as opposed to the three peers that adjust for risk in the discount factor.
Table 9.19 also shows that operating leasing plays a more important role as a source of
financing in Carlsberg than is the case in the three other breweries. Since operating leasing
affects EBIT and EBITDA more negatively than financial leasing (or buying the assets) it
seems reasonable to argue that Carlsberg's EBIT and EBITDA are slightly undervalued rela-
tive to its peers. In summary, a comparison of the accounting practice of the four breweries
does not reveal a 'smoking gun'; i.e. differences that affect the multiple valuation materially.

Summary
The present value approach yields a value estimate of DKK 79,185 million which
is approximately 38% above Carlsberg's current market value. The multiple valua-
tions show that Carlsberg estimated market value is between its current value of DKK
57,394 million and the present value estimate of DKK 79,185 million.

Note 1 Items which are recognised as directly on equity (comprehensive income) are hardly ever fore-
cast. A case in point: A currency translation difference in subsidiaries is an example of a compre-
hensive income item. The best bet on the currency rate in the future is the rate of today (random
walk). Thus, it is hard to imagine that firms forecast such currency translation differences.

References Baker, M. and R. Ruback (1999) 'Estimating Industry Multiples', Working paper, Harvard
University, Cambridge, MA.
Liu, J., D. Nissim and J. Thomas (2002) 'Equity valuation using multiples', Journal of
Accounting Research, No. 1, March, 135-72.
Petersen, C., T. Plenborg and E Schøler (2006) 'Issues in valuation of privately-held firms',
Journal of Private Equity, Winter, 1-16.
 CHAPTER 10

Cost of capital

Learning outcomes
After reading this chapter you should be able to:
• Understand why the cost of capital is useful for analytical purposes including
performance measurement, valuation and credit analysis
• Measure the weighted average cost of capital (WACC)
• Measure the required rate of return on equity
• Identify appropriate proxies for the risk-free rate
• Apply different techniques for measuring equity risk including the systematic risk
and risk premium
• Understand that although advanced techniques are available in estimating the cost
of capital it still involves a great deal of judgement

Cost of capital

C ost of capital is a central concept in financial analysis and is applied in many differ-
ent contexts. In Chapter 5 we used the cost of capital as a benchmark when calcu-
lating economic valued added (EVA); i.e. value is added when returns exceed the cost of
capital. In Chapter 9 we applied the cost of capital as a discount factor when calculating
the present value of future cash flows. In Chapter 11 we touch upon the cost of capital
from a lender's perspective and finally, in Chapter 12 we apply the cost of capital as a
performance standard (benchmark) when designing an accounting-based bonus plan.
To be successful, a company must accept risk. Successful organisations take calcu-
lated risks to achieve their objectives. For example, a biotech company spends con-
siderable resources on research and development projects hoping to develop effective
(profitable) products. Shipping companies make large investments in vessels believing
that there will be a demand for transportation of cargo across countries and continents.
Companies design and market clothing trusting that there will be demand for their
collections. Risk is therefore inevitable in running a business.
Since a company's stakeholders are risk averse, they want to be compensated for bear-
ing risks. Banks and equity investors, for example, expect to be compensated for provid-
ing funds to risky projects. Consequently, stakeholders need to translate the underlying
risk of an investment project into a cost of capital measure. The estimation of cost of
capital, however, is challenging at best. Furthermore, lenders and shareholders do not
necessarily agree on a common standard for measuring cost of capital. Each stakeholder
is left to themselves in measuring cost of capital. This creates considerable uncertainty
surrounding the estimation of cost of capital.
 It is important that analysts are aware of the different methods of measuring cost of
capital and apply a suitable one in their analysis. In Chapter 9 we applied the follow-
ing measures of cost of capital when valuing a company:
• Required rate of return on assets (ra)
• Required rate of return on equity (re)
• Weighted average cost of capital (WACC).
When analysts apply the adjusted present value (APV) model they use the required
rate of return on assets to discount the free cash flow to the firm (FCFF) and the tax
shield. Further, in order to use the DCF model and the EVA model analysts use WACC
to discount the free cash flow to the firm (FCFF) and EVA, respectively. And when
analysts apply the dividend discount model and the residual income model they use
the required rate of return on equity as the discount factor.
Since the required rate of return on equity (re) and assets (ra) are either directly or
indirectly embedded in WACC, we focus on explaining and estimating the components
of WACC in the next section. In Appendix 10.1 we estimate WACC for Carlsberg.

Weighted average cost of capital (WACC)

WACC is a weighted average of the required rate of return (cost of capital) for each
type of investor. The following formula for WACC includes equity and net interest-
bearing debt:

where
NIBD = (Market value of) net interest-bearing debt
E = (Market value of) equity
rd = Required rate of return on NIBD
re = Required rate of return on equity
t = Corporate tax rate
It is possible to extend WACC to include other forms of financing, for example,
minority interests and hybrid forms of financing such as convertible bonds. This is
done simply by adding additional sources of financing, and their respective weights, in
the WACC expression. The components of WACC are discussed in the remaining part
of this chapter. We focus on methodologies which can be used to estimate the capital
structure (the proportion of debt and equity) and the required rate of return on equity.
We will only briefly address the estimation of the required rate of return on debt, as it
is discussed in further detail in Chapter 11.

Capital structure
Market values reflect the true opportunity costs of investors (equity) or lenders (debt).
Consequently, the capital structure must be based on market values. This causes a prob-
lem since most companies, as mentioned earlier, are privately held. For privately held
firms, it is therefore necessary to estimate the market value of equity and net interest-
bearing debt. Only rarely do companies disclose their long-term capital structure; i.e.
their target capital structure. In fact, we would argue that only a modest number of
companies have a clear policy for their target capital structure. This implies that ana-
lysts must rely on alternative techniques in estimating a firm's capital structure, so it is
based on market values (and not book values, which are of course known).
One option would be to apply the capital structure of comparable traded companies.
However, this means finding companies that are truly comparable, which may prove
difficult in countries where only a modest number of companies are listed. One way to
address this problem is to expand the sample size by building on companies listed on
other major stock markets. This increases the chances of finding comparable companies.
The analyst should, however, be aware of any institutional differences which may affect
the debt to equity ratio in a given country. The capital structure for selected industries is
shown in Table 10.1. The data are based on publicly traded European companies.
Suppose you want to calculate WACC for a company within the air transportation
industry Based on the average from the industry the proportion of net interest-bearing
debt and equity are 32.5% and 67.5%, as highlighted in Table 10.1.
Another method used to estimate the capital structure based on market values is
to infer it using an iteration procedure. This method is typically used in connection
with valuation and requires that comprehensive forecasts have been prepared. Based
on the forecasts, iterations are made until the estimated value of equity mirrors the
value of equity used in the calculation of the capital structure in the WACC expression.
In Chapter 9, we applied the iteration procedure to ensure that the capital structure in

Table 10.1 Proportion of debt and equity among selected industries

Industry Number of firms E/(NIBD + E) NIBD/(NIBD + E)

Investment Co. (Foreign) 15 100.00% 0.00%

Investment Co. 18 99.46% 0.54%

Insurance (Prop/Cas.) 87 98.80% 1.20%

Educational Services 39 98.66% 1.34%

Internet 266 98.20% 1.80%

Shoe 20 97.44% 2.56%

Entertainment Tech 38 97.29% 2.71%

Utility (Foreign) 6 97.00% 3.00%

E-Commerce 56 96.74% 3.26%

Computer Software/Svcs 376 96.68% 3.32%

Heavy Construction 12 96.53% 3.47%

Semiconductor 138 95.67% 4.33%

Telecom. Equipment 124 94.78% 5.22%

Computers/Peripherals 144 94.55% 5.45%

Bank (Canadian) 8 94.42% 5.58%

Reinsurance 11 93.94% 6.06%

Metals & Mining (Div.) 78 93.84% 6.16%

Precious Metals 84 93.29% 6.71%

Table 10.1 (continued)
Industry Number of firms E/(NIBD + E) NIBD/(NIBD + E)

Human Resources 35 93.01% 6.99%

Tobacco 11 92.99% 7.01%
Drug 368 92.77% 7.23%
Petroleum (Integrated) 26 92.62% 7.38%
Medical Supplies 274 92.56% 7.44%
Insurance (Life) 40 92.27% 7.73%
Semiconductor Equip 16 91.82% 8.18%
Biotechnology 103 91.66% 8.34%
Pharmacy Services 19 91.08% 8.92%
Information Services 38 90.86% 9.14%
Metal Fabricating 37 90.77% 9.23%
Precision Instrument 103 90.58% 9.42%
Steel (General) 26 90.08% 9.92%
Oilfield Svcs/Equip. 113 89.88% 10.12%
Beverage 44 89.70% 10.30%
Market 7,364 79.93% 20.07%
Air Transport 49 67.50% 32.50%
Food Wholesalers 19 67.43% 32.57%
Trucking 32 67.21% 32.79%
Newspaper 18 66.65% 33.35%
Maritime 52 66.36% 33.64%
Water Utility 16 66.25% 33.75%
Packaging & Container 35 65.58% 34.42%
Cable TV 23 62.56% 37.44%
Electric Utility (West) 17 62.38% 37.62%
Natural Gas Utility 26 60.12% 39.88%
Electric Util. (Central) 25 57.90% 42.10%
Electrical Equipment 86 55.29% 44.71%
Property Management 12 53.43% 46.57%
Auto & Truck 28 50.46% 49.54%
Securities Brokerage 31 44.81 % 55.19%
Homebuilding 36 43.70% 56.30%
Financial Svcs. (Div.) 294 34.07% 65.93%
Source: Damodoran
 the projected balance sheet mirrored the capital structure used in calculating WACC.
When forecasts are available the iteration method is relatively easy to use and has the
advantage that data from comparable companies are not needed. Generally, we suggest
that analysts rely on the capital structure of comparable companies as well as the itera­
tion method. The two methods provide useful information about the capital structure
and by relying on both methods potential measurement errors may be reduced.

Estimation of owners' required rate of return

Most financial textbooks suggest using the Capital Asset Pricing Model (CAPM) when
estimating the investors' required rate of return. According to CAPM the investors'
required rate of return is defined as:

where
re = Investors' required rate of return
rf = Risk-free interest rate
βe = Systematic risk on equity (levered beta)
rm = Return on market portfolio
The basic idea of CAPM is that by holding a sufficiently broad portfolio of shares,
investors will only pay for the risk that cannot be diversified away. It is only the
systematic risk (β) which is priced.
The equation for the required rate of return (re) is also labelled the security market
line (SML) and is a relative pricing model showing the equilibrium between the risk
premium of a company and the risk premium of the market portfolio. The return on
the market portfolio is ideally based on the return on all types of assets; but is usually
based on stock returns for companies listed on a stock exchange.
The risk premium is based on the market portfolio's risk premium (the difference
between rm and rf). β indicates the relative risk of a company in relation to the market
portfolio. The risk premium is adjusted up or down depending on the systematic risk
(βe) in a company. The method is graphically illustrated in Figure 10.1.
In the following section, we discuss different methods that can be used in estimating
the risk-free interest rate, the systematic risk (β) and the risk premium.

Estimation of the risk-free interest rate (rf)

The risk-free interest rate expresses how much an investor can earn without incurring
any risk. Theoretically, the best estimate of the risk-free rate would be the expected
return on a zero-β portfolio. Due to the cost and problems in constructing a zero-β
portfolio this method has proven not to be useful in practice. Instead a government
bond is usually used as proxy for the risk-free rate. The underlying assumption is that
a government bond is risk free. The use of the yield curve from a government bond
as proxy for the risk interest rate may be a reasonable proxy in most cases. However,
there are examples where the government bond has proven to be risky and it should
therefore be used with care.
Each projected cash flow should ideally be discounted using a government bond
with a similar duration. This implies that an expected short-term rate that is expected
to apply in each future period (forward rate) should be applied. However, this is tedi­
ous and would require a recalculation of the cost of capital in each forecast year.
Furthermore, most valuations are based on the two-stage present value approach
Figure 10.1 Security market line

where all parameters in the terminal period are assumed to be constant. In spite of
this, as shown in Figure 10.2 the UK yield is not stable at any point in time. This
leaves the analyst with the question which yield to apply in the terminal period. For
these reasons most analysts apply a single yield to maturity from a government bond
that best matches the cash flows being valued or analysed. Although there are differ-
ent government bonds to choose from, we prefer a zero-coupon government bond.

Figure 10.2 Yields on different zero-coupon government bonds

Source: Data Stream
They are also known as stripped bonds or strips. This is motivated by the fact that the
maturity is better established than alternative bonds and reinvestment risk is avoided.
For valuation purposes, where the time horizon is often infinite a zero-coupon rate
based on a 10-year or 30-year government bond is applied.1 While the 30-year gov-
ernment bond often matches the underlying cash flow better, it may also suffer from
illiquidity which affects the yields. To handle issues such as inflation, it is important
that the government bond is denominated in the same currency as the underlying cash
flows. This implies that local government bonds should be applied.
In Figure 10.2 we report the yield to maturity on zero-coupon government bonds from
the UK, the USA and Japan versus their years to maturity. This curve is also referred to
as the yield curve or term structure of interest rates. As of February 2010, the 10-year
UK and US government bonds yield close to 4.2%. On the other hand, the 10-year
Japanese bond yields approximately 1.6%, which is considerably lower than the UK
and the US bonds. The difference is explained by an expectation of a rising exchange
rate of Japanese yen vis-à-vis the US dollar (USD) and the British pound (GBP).

Estimation and interpretation of systematic risk (β e )

A key lesson from looking at Figure 10.1 is that the owners' required rate of return
increases if systematic risk increases. This seems intuitively right. The higher the
systematic risk, the more investors require in compensation for investing in a com­
pany. These considerations are combined as follows:
βe = 0 Risk-free investment
βe < 1 Equity investment with less systematic risk than the market portfolio
βe = 1 Equity investment with the same systematic risk as the market portfolio
βe > 1 Equity investments with greater systematic risk than the market portfolio
Usually, estimation of βe is based on historical stock returns. Basically, all value-
relevant information is reflected in stock returns. Any fluctuations in stock returns
will reflect the uncertainty of the investors. Specifically, βe measures the co-variation
between the company-specific returns and the market portfolio's stock returns.
Figures 10.3, 10.4 and 10.5 illustrate the co-variation between company specific
stock returns and market portfolio returns.

Figure 10.3 β greater than 1

Figure 10.4 β equal to 1

Figure 10.5 β less than 1

Figure 10.3 illustrates that the volatility in stock returns for the company is greater
than the volatility in the market portfolio. Estimation of βe is greater than 1 in this
scenario. In Figure 10.4 the volatility of stock returns is identical for both the com­
pany and the market portfolio (equity market). βe in this scenario equals 1. Finally, in
Figure 10.5 the volatility of the company's equity is lower than the volatility of equity
returns of the market portfolio. Therefore, βe in this scenario is lower than 1.
The above approximation of β suffers from a number of weaknesses including:
• Lack of liquidity in the company's shares
• Lack of stability in β across time
• Lack of ex-ante price observations
• Lack of observations (privately held firms).
Lack of liquidity in a company's shares leads to an (apparent) relatively stable devel­
opment of stock returns and, hence, a low volatility. This implies a low β estimate that
does not necessarily reflect the underlying risk of the company. Therefore, companies
that are not traded frequently will often suffer from these deficiencies; indicating that
the β estimate may not reflect the underlying risk of the company.
Furthermore, β is often not stable across time. While a change in β may reflect a
change in the underlying risk of the company, it may also reflect measurement prob­
lems. For example, the interval between each observation (daily, weekly or monthly
returns) that is used to estimate the systematic risk, and the period used (12 months,
3 years, 5 years), have proven to affect the β estimate and sometimes quite considerably.
An estimation of the systematic risk requires a long time series of historical observa­
tions. This may be problematic for most companies. Observations for companies with
only a short track record are limited. For privately held companies it is obviously a prob­
lem and the method is, therefore, not directly applicable to the majority of companies,
since they are privately held. In most countries the number of companies listed on a stock
exchange is less than 1%. In other words about 99% of all companies do not meet the
data requirements of CAPM. Later in this chapter this issue is discussed in more depth.
As with other input data to valuation, CAPM ideally warrants the use of ex-ante stock
prices (i.e. future stock prices). These are obviously not available, which is why historical
stock prices are used in most cases. However, it is doubtful whether such an extrapolation
from historical data is meaningful. The underlying assumption is that the risk of a com­
pany remains stable over time. This is hardly the case for all companies. Companies that
change their strategy or acquire a new business may face a different risk profile over time.
Table 10.2, obtained from Fernandez (2009a), illustrates the uncertainty of β esti­
mates. The example shows β estimates of Coca-Cola, Disney and Wal-Mart stores

Table 10.2 Beta estimates of three companies according to most used websites
and databases
Databases Coca-Cola Walt Disney Wal Mart stores
Bloomberg 0.79 1.06 0.58
Cnbc 0.60 1.00 0.30
Damodaran 0.61 0.88 0.19
Datastream 0.31 0.72 0.13
Ft.Com 0.80 1.06 0.57
Google Finance 0.60 1.03 0.26
Hoovers 0.60 1.00 0.20
Infomercados 0.33 1.39 0.31
Msn Moneycentral 0.54 1.03 0.16
Quote 0.54 1.13 0.19
Reuters 0.53 1.01 0.17
Smartmoney 0.61 1.03 0.26
Thomson Banker 0.55 1.09 0.38
Value Line 0.55 1.00 0.60
Vernimmen website - 1.08 0.71
Yahoo Finance 0.63 0.99 0.28
Max 0.80 1.39 0.71
Min 0.31 0.72 0.13
Source: Fernandez 2009a
 based on the most used websites and databases and illustrates a large dispersion in the
beta estimates:
• The β estimates of Coca-Cola range from 0.31 to 0.80
• The β estimates of Disney range from 0.72 to 1.39
• The β estimates of Wal-Mart stores range from 0.13 to 0.71.
The lack of homogeneity in β estimates reflect the different ways that can be used to
measure β. But it is also a symptom of measurement problems, and analysts will need
to overcome these in order to provide a solid estimate of systematic risk. Typically
analysts will use the average of different estimates in the hope that measurement
errors cancel each other out. However, often they will also rely on alternative methods
when estimating systematic risk. Two such methods are discussed in further detail in
the next section.

Alternative methods of measuring the systematic risk ( β e )

This section discusses two methods used in addressing both the potential measure­
ment problems of β and the lack of (price) observations (i.e. for privately held
companies). First, we describe the use of βe from comparable companies and sub­
sequently, we discuss the estimation of βe based on a company's fundamental risk
factors.

Estimation of βe from comparable companies

One way to get beyond the lack of liquidity or lack of observations is to use β esti­
mates from comparable companies. Assuming an efficient capital market and ade­
quate liquidity in the comparable companies' shares, many of the above estimation
problems of β could be avoided.
The method includes the following steps:
1 Identify comparable listed companies (peer groups) with sufficient liquidity (trad­
ing) of shares.
2 Estimate β for each of the comparable companies.
3 Calculate the unlevered β (β asset) for each of the comparable companies (adjust­
ments for financial risks).
4 Calculate the average of unlevered βs for comparable firms.
5 Calculate β for the target company by levering unlevered β from comparable
companies.
Often there will be differences in financial leverage between the comparable compa­
nies and the company to be assessed. It is necessary that adjustments are made for
those differences. This is done in steps 3 and 5 above. By calculating an unlevered β,
the effect of financial leverage on β is removed. The following β relation may be used
for this purpose:
 where
βa = Systematic risk on assets; i.e. operating risk (unlevered β)
βd = Systematic risk on debt
NIBD/E = Target firm's capital structure based on market values
(net interest-bearing debt to equity ratio)

The unlevered β, also defined as β asset, measures the operating risk in the industry.
To estimate the systematic risk, we must lever the unlevered β using the company's
capital structure. This is done through the following β relation:

The levered β is a function of operating risk (unlevered β) and financial risk (capital
structure of the target company). In Chapter 5, we provide estimates of the unlevered
β for different industries. For instance, the average unlevered β for companies in the
beverage industry is 0.81. Assuming a β debt of 0.6 and a financial leverage of 1
(i.e. net interest-bearing debt equals equity) result in the following systematic risk for
Carlsberg:

In this example, Carlsberg's systematic risk is close to the market average of 1, indi­
cating that Carlsberg has a risk profile similar to the average company on the stock
market.
Determining the systematic risk based on comparable companies is not unprob-
lematic. In addition to the general estimation problems with β as described above,
a crucial requirement for the application of the method is that companies which are
included in the analysis have the same risk profile. In this respect, it is not always a
sufficient condition that the companies belong to the same industry. The adaptation of
different business models may lead to different operating risks. For example, one com­
pany may use a large number of subcontractors, which may lead to a more flexible
cost structure, while another company may in-source all major components, which
may lead to a less flexible cost structure. Obviously, a more flexible cost structure, all
things being equal, leads to lower operating risks.

Estimation of βe from fundamental factors

An alternative method for estimation of β e is to build on the fundamental char­
acteristics of a firm's risk profile. Analysts will often have the insights needed for
using this method, as they should possess detailed knowledge of the company. A
creditor builds up a relationship with its customer (company) over a long time
period and obtains valuable knowledge about the company. Equity analysts usually
analyse the same companies over longer time periods and build a unique knowledge
about the companies they cover in their analysis. Even in cases where the credi­
tor or equity analyst has no prior knowledge of the analysed company, they will,
through a thorough analysis, accumulate facts that could be useful in a comprehen­
sive risk assessment.
 There are many ways to structure a risk assessment based on fundamental factors.
Above it was shown that βe is a function of operating and financial risks:

The first part, βa, measures operating risk, while the second part, (βa - βd) × NIBD/E,
measures financial risk. It is therefore relevant to consider the factors affecting operat-
ing and financial risks. A distinction is further made between the firm's ability to affect
and control risk. Generally, we believe that risks, which the company can influence
or control, are more 'attractive' than risks which the company cannot influence or
control.
The boundary between what can be influenced or controlled varies across firms.
Political and socio-economic conditions are examples of areas where the company has
little or no influence and control. The company's reputation, competition and regula-
tion are areas where the company has some degree of influence but no control. Finally,
operating aspects such as internal control systems and the choice of cost structures are
areas where the company has considerable influence as well as control.
Below we discuss risk factors related to a company's operating and financing activi-
ties, and we assess the extent to which a company has the ability to affect or control
the various risk indicators.

Operating risk
When assessing operating risk, the focus is on factors affecting the volatility in operat-
ing earnings, and we now discuss the following three categories of risk factor:
• External risks
• Strategic risks
• Operational risks.
Each of the risk indicators are briefly discussed in the following section.

External risks
External risks are conditions outside a company that can affect a firm's operating earn-
ings. Examples of external risks are the evolution of commodity prices, GDP growth,
political stability and commercial law. Typically, companies have little or no ability
to influence or control those risks. Within the same industry, companies are affected
roughly equally by these risk factors. Rising commodity prices naturally affect every-
one in the industry, and it is possible for a firm to hedge risk in the short term only by
using financial instruments (derivatives). For example, when the price of aviation fuel
increases, it significantly affects the airlines' earnings, since fuel is a major expense for
airlines. To the extent that airlines cannot transfer rising commodity prices to higher
ticket prices, operating profits could be affected substantially.
Growth in GDP and business cycles in general hit earnings differently. Cyclical
companies such as producers of luxury goods are particularly dependent on the pur-
chasing power of their customers because their products on the functional level can
be easily replaced by substantially cheaper products. Conversely, pharmaceutical com-
panies are typically independent of the stage in the business cycle. Their products are
protected by patents and for many customers (patients) and the products are necessi-
ties for survival or for improving quality of life. Overall, operating earnings are less
stable for cyclical companies and operating risks correspondingly higher.

Strategic risks
Assessment of strategic risks typically involves industry issues. Examples of indicators
of a company's strategic risks are:
• Intense competition in the industry
• Relative competitive advantages
• Reliance on one or a few suppliers
• Reliance on one or a few customers
• The risk of technological innovations from competing companies
• Ability to adjust prices to rising commodity prices.
An improvement in these indicators of operating risk will generally lead to more stable
earnings. Therefore, a reduction of dependence on only a few customers or suppliers
will, other things being equal, stabilise earnings and consequently reduce operating
risk. Similarly, an improved ability to adjust prices to rising commodity prices reduces
operating risk.

Operationai risks
In assessing the operating risks focus is on company-specific factors that may affect
the stability of operating earnings. Operational risks will vary between companies
and a significant risk factor for one type of business can be an insignificant factor for
another company. Examples of indicators of a company's operating risks are:
• The firm's lifecycle
• Choice of cost structure
• Success in research and development
• Product quality and innovation
• Brand name awareness
• Quality/usefulness of information systems
• Utilisation of production facilities and equipment (efficiency)
• Quality of management/staff
• Quality of internal control systems.
Generally, an improvement of the operating factors reduces operating risk. For exam-
ple, the longer a company has existed, the greater the sustainability of the business
model. This position will affect investors and creditors in assessing operating risk.
This is illustrated in Figure 10.6, which shows that risk is decreasing during the firm's
lifecycle. Until the company reaches the maturity phase, the risk gradually decreases as
a result of greater faith in the business model. This is rewarded by investors and credi-
tors as they require a lower rate of return.
Similarly, better information technology leads to better and more timely informa-
tion, which should improve decision making and reduce the risk of making inappro-
priate decisions. Furthermore, a more flexible cost structure will, other things being
equal, reduce operating risk.
In summary, a company has various possibilities to control and influence external,
strategic and operating risks. Generally, the company's management has to deal with all
three types of operating risk factors. Managers are expected to adapt the organisation
Figure 10.6 A company's cost of capital over its lifecycle

to the current economic situation and exploit market opportunities. In assessing oper­
ating risks analysts must cope with risks in the market, in which the firm competes, and
evaluate how skilled the executives are in managing the various types of operating risk.
Table 10.3 gives an example of how the operating risk can be assessed.

Financial risk
Analysis of financial risk aims at assessing the effect of debt on financial risk. Since
equity investors receive their claims after debt holders, they require a higher rate of
return than debt holders. This implies that financial leverage affects equity investors'
perception of risk. Loan characteristics may also affect the financial risk of a com­
pany. We now briefly elaborate on the impact of financial leverage and loan charac­
teristics on financial risk.

Financial leverage
Financial leverage measures the size of net interest-bearing debt relative to equity.
If a company is financed entirely with equity, there will not be any financial risks.
However, most companies use debt as a financing source. Also shown previously, debt
affects the systematic risk on equity (βe) through the following β relation:
Table 10.3 Overall assessment of operating risks

Types of operating risk Low, medium The firm's ability to manage

or high risk operating risks
External risk Reasonable
Market conditions Medium Is affected by the business cycle
Legislation High The firm tries to affect public opinion by
debating, advertisements etc.
Strategic risk Not sufficient
Rivalry among competitors High Management has not been able to
Suppliers power Low overcome the negative growth
Customers power High Considerable customer concentration with
related downward pressure on prices
Market growth High
High risk of lower and more instable
Substitute products High operating earnings
Operational risk Not sufficient
Exploiting production High Management has not adapted production
facilities capacity to the negative growth
Quality of management High High level of fixed costs
Choice of cost structure High

Total assessment of operating risk: high

The firm's market and earnings are under severe pressure
Management seems to handle external risks in a sensible manner, but there is insufficient
attention to the strategic and operational risk indicators

The β relation is exemplified in Table 10.4 and is based on the following assumptions:

Risk-free interest rate = 5%

Risk premium = 5%
βa = 0.8
βd = 0.0
Corporate tax rate = 30%

By allowing financial leverage to vary the relation between systematic risk and
the owners' required rate of return is as shown in Table 10.4. The systematic risk
and the owners' required rate of return increase linearly with financial leverage.
Investors are expected to be compensated for higher financial leverage.

Table 10.4 Relation between financial leveraqe and owners' required rate of return
NIBD to EV (Equity+ NIBD) 0% 50% 67% 75% 80% 83%
Financial leverage (NIBD/equity) 0 1.0 2.0 3.0 4.0 5.0
Systematic risk (βe) 0.8 1.6 2.4 3.2 4.0 4.8
Owners' required rate of return 9% 13% 17% 21% 25% 29%
Loan characteristics
By using debt a company has a number of options, all of which affect financial risk.
Specifically, analysts should assess the following aspects of a firm's loan portfolio:
• Fixed or variable interest rates
• Short- or long-term loans (duration)
• Repayment profile
• Local currency or foreign currency.

A fixed-rate loan guarantees a known payment profile. There is no risk on the pay-
ments (interest expense) on these types of loans. However, the value of a fixed-rate
loan changes if interest rates change (balance sheet risk). The opposite is true for loans
with variable interest rates. For these types of loans there is a significant earnings risk
as the payments and related interest expenses change with variations in the interest
rates. This leads to more volatile earnings. In contrast, there is no risk on the market
and book value of the loans (balance sheet risk).
Fixed-rate loans may be short or long term. The duration of the loan affects the
interest rate. Typically, the yield curve has a positive slope indicating that the interest
rate increases with the term of maturity. The higher interest rate compensates for the
duration of risk and is, therefore, a premium paid by companies to lock the interest
rate for a longer time period. Companies that choose loans with short maturities typi-
cally obtain a lower interest rate, but assume at the same time a refinancing risk, since
refinancing may be at a higher interest rate.
It is possible to borrow in foreign currencies. Loans in foreign currencies are typically
chosen to hedge cash inflows from the same foreign currency, but can also be selected
for more speculative reasons. In Figure 10.2 we showed the yield structures on govern-
ment bonds issued in the USA, UK and Japan. The interest rate on a Japanese govern-
ment bond is lower than similar bonds in the USA and the UK. The difference in interest
rates embraces different expectations about the trend in these currencies. Therefore,
there is an implicit expectation of a rising exchange rate of Japanese yen compared to
US dollars and British pounds. Companies borrowing in Japanese yen achieve a lower
interest rate, but at the expense of assuming currency risks.
Generally, businesses that use short-term loans with variable interest rates in foreign
currencies are prone to considerable financial risks. However, in assessing the finan-
cial risk of a firm the analysis should take the specific circumstances into account. For
instance, a foreign currency loan intended to hedge future revenues in the same cur-
rency is a financial transaction, which intends to reduce a firm's total risk in a sensible
and affordable manner.
It is important to note that financial risk cannot be assessed independently of oper-
ating risk. Companies may purposely choose a high level of financial risk because
they have the necessary financial flexibility. But if the financial risk is derived from
economic problems (low operating earnings), this kind of risk has a negative impact
on the future room to manoeuvre and, ultimately, the survival of a company.
Companies have significant opportunities to influence and control financial risk.
For financially viable firms, the use of debt may reflect a desire to grow and enhance
profitability. Companies that are financially troubled, however, use debt to ensure its
survival. In such cases the company has fewer opportunities to influence and control
financial risk.
An overall assessment of the financial risk may be carried out as illustrated in
Table 10.5.
 Table 10.5 Overall assessments of the financial risks
Types of financial risk Assessment The company's ability to handle financial
of risk level risks
Financial leverage High Reasonable Insufficient
Its choice of high financial leverage is
historically conditioned. As the operating
earnings are under pressure, the high
financial leverage should be monitored
closely. Managers do not seem to be
aware of this
Loan characteristics: Reasonable Insufficient
1 Variable interest rate High As a result of the increased pressure on
2 Short term to maturity High operating earnings, it is assessed as being
risky to use variable rates with short maturity
3 Primarily in euro (foreign
currency) Low Most of its revenue billed in euros
Total assessment: high financial risk

Overall risk assessment (β e )

Generally, companies try to balance operating and financial risks. Companies
with high operating risks typically try to minimise financial risks. Empirical evi­
dence seems to support this. Based on publicly traded companies the link between
operating risk (β a ) and financial risk (debt to equity ratio) can be shown as in
Figure 10.7.
As is evident from the figure, there is a negative correlation between the estimates
of operating risk (β asset) and financial risks (financial leverage). For instance, it is
clear that companies with high operating risks have a low level of debt.

Figure 10.7 Financial leverage and operating risk

 Table 10.6 Conversion of a qualitative assessment of risk to an estimate of βe
Operating risk Financial risk Total risk β equity (β e )
Low Low Very low 0.40-0.60
Low Neutral Low 0.60-0.85
Low High Neutral 0.85-1.15
Neutral Low Low 0.60-0.85
Neutral Neutral Neutral 0.85-1.15
Neutral High High 1.15-1.40
High Low Neutral 0.85-1.15
High Neutral High 1.15-1.40
High High Very high 1.40

Table 10.6 is an example of how the qualitative assessment of the operating and
financial risk can be converted to a β estimate. A qualitative assessment of operating
and financial risks can be summarised in many different ways and the method out­
lined here is just one of several techniques that can be used. For example, Fernandez
(2009a) provides an alternative method, which he names the 'MASCOFLAPEC'
method (based on the first letter of each risk indicator) as shown in Table 10.7.

Table 10.7 The 'MASCOFLAPEC method for assessing systematic risk

Weight Low Average Substantial High Very high Weighted
1 2 3 4 5 risk

10% M Management 1 0.10

25% A Assets: business/industry/ 5 1.25

products

3% S Strategy 4 0.12

15% C Country risk 4 0.60

10% O Operational leverage 4 0.40

15% F Financial leverage 2 0.30

5% L Liquidity of investment 5 0.25

5% A Access to sources of funds 3 0.15

2% P Partners 4 0.08

5% E Exposure to other risks 2 0.10

5% C Cash flow stability 3 0.15

100% 3.50

β equity = 3.5 × 0.5 = 1.75

Source: Fernandez 2009a

 As can be seen from Table 10.7, many of the same risk indicators are included
in the qualitative risk assessment. In the example, the weighted risk of 3.5 is multi­
plied by 0.5 to obtain an estimate for β equity. The adjustment factor of 0.5 is based
on calibration, but is ultimately subjectively determined. In summary, the qualitative
methods simply add to common sense and in combination with CAPM may prove to
be a powerful method in estimating systematic risk.
We would like to note, however, that the estimation of risk based on qualitative fac­
tors is not unproblematic. First, there is no consensus on what affects operating and
financial risk. Second, estimation of the overall risk is associated with a high degree of
subjectivity. Two analysts may therefore estimate the risk differently despite identical
information. Finally, the method does not distinguish between the systematic (non-
diversified) and unsystematic (diversified) risk. By applying the method analysts may
unintentionally blend systematic and unsystematic risk. Consequently, a qualitative
assessment of risk based on the company's fundamental risks factors does also suffer
from measurement problems.

Estimation of market portfolio risk premium

The market portfolio's risk premium is the difference between market returns and
returns from risk-free investments. There are typically two ways in which the risk
premium can be determined:
• Ex-post approach
• Ex-ante approach.
The ex-post approach examines the difference between the historical returns on the
stock market and the historical returns on risk-free investments (usually approxi­
mated by the yield on a treasury bond) 50 to 100 years back in time. The assumption
behind the method is that the market portfolio's historical risk premium is a reason­
able indicator of the future market portfolio's risk premium. It could be argued that an
assumption is unlikely to hold. Jorion and Goetzmann (2000) provide an example of
the ex-post method. They find that the market risk premium in the USA is (approxi­
mately) 4.3%.
The ex-ante method attempts, on the basis of analysts' consensus earnings forecast,
to infer the market portfolio's implicit risk premium. Claus and Thomas (2001) pro­
vide an example of the ex-ante method and find a market risk premium of around 3%
in the USA.
Table 10.8 lists examples of market risk premiums used by 884 professors in dif­
ferent countries. As the table shows, there is no consensus about the magnitude of
the risk premium. In the European countries the average risk premium is 5.3%. In
the USA the risk premium is 6.3% and in other countries the risk premium is 7.9%.
Furthermore, the risk premium varies considerably within each region. The risk pre­
mium is in most cases justified by references to books or articles. Only 22 professors
calculate their own risk premium. Table 10.9 reveals the five most popular references
used to justify the risk premium.
The diversity in the market portfolio's risk premium, detailed in Table 10.8 reflects
different risk perceptions of the different markets but also masks significant meth­
odological estimation problems. First, estimating the market portfolio risk premium
depends on the time period used. For example, Jorion and Goetzmann (2000, p. 8)
point out that the risk premium is sensitive to survivorship bias. They point out that
Table 10.8 Market risk premium used by 884 professors
Average USA Europe UK Canada Australia Other Total
63% 5.3% 5.5% 5,4% 5.9% 7.9%

St. dev. 2.2% 1.5% 1.9% 1.3% 1.4% 3.9%

Maximum 19.0% 10.0% 10.0% 8.0% 7.5% 27.0%

Market risk Q3 7.2% 6.0% 7.0% 6.0% 7.0% 10.0%

premium
Median 6.0% 5.0% 5.0% 5.1% 6.0% 7.0%
used in 2008
Q1 5.0% 4.1% 4.0% 5.0% 6.0% 5.5%

Minimum 0.8% 1.0% 3.0% 2.0% 2.0% 2.0%

Number 487 224 54 29 23 67 884

The risk premium is justified by:

I do not justify the number 93 53 20 6 2 21 195

Reference to books or articles 151 138 28 14 11 27 369

Historic data 87 14 3 6 8 9 127

O w n research/calculations 8 7 3 3 0 1 22

Do not answer 14 11 0 0 2 8 35

Source: Fernandez 2009b

Table 10.9 References to justify the market risk premium used

References USA Europe UK Canada Australia Other Total

Ibbotson 53 9 3 2 1 3 71

Dimson, Marsh and 11 23 9 1 4 1 49

Staunton

Damodaran 15 21 0 2 1 3 42

Brealey and Myers 16 12 2 0 1 4 35

Fernandez 3 18 1 0 0 0 22
Source: Fernandez 2009b

both Sweden and the United States were only mildly affected by the Second World
War. By comparison, Japan was hit hard. The average risk premium on the mar-
ket portfolio was - 0 . 3 4 % in Japan during the period 1921-1944. In the post-war
period (from 1949-1996) the market portfolio risk premium in Japan was 5.5%.
Furthermore, there is the issue whether to use arithmetic or geometric averages. For
example, Copeland et al. (2000) finds that the size of market portfolio risk premium
varies considerably depending on whether the risk premium is estimated based on
the arithmetic or geometric mean. They find that the geometric mean is, as expected,
lower than the arithmetic mean.
In summary, it can be concluded that there is uncertainty about which method(s)
to use when determining the risk premium. In addition, there is uncertainty about the
true level of the risk premium.
CAPM and liquidity
Liquidity refers to the costs and problems associated with converting stocks or assets for
cash. A marketable ownership is considered attractive since it conveys the ability quickly
to convert assets (shares) to cash, with minimum transaction costs and with a high degree
of certainty of realising the expected net proceeds. Equity traders have long recognised
the importance of liquidity in stocks and empirical studies seem to support that inves-
tors demand a discount for investing in stocks with limited or no liquidity. For example,
Petersen et al. (2006) find that investors adjust the required rate of return to account for
the lack of liquidity. Investors attach a liquidity premium of up to 3-5 percentage points.
The required rate of return on equity which includes a liquidity premium is calculated as:

Therefore, the liquidity premium is simply added to the required rate of return on equity.

Estimation of the interest rate on debt

In the following section, we will briefly discuss how to estimate the interest rate on
debt. In general terms the cost of debt after tax is calculated as:

where
rd = Required rate of return on net interest-bearing debt (NIBD)
rf = Risk-free interest rate
rs = Credit spread (risk premium on debt)
t = Corporate tax rate
The required rate of return on NIBD consists of three variables: the risk-free rate, the
credit spread, which is equivalent to the risk premium on debt, and the corporate tax
rate. Since the risk-free rate has already been discussed, and the different techniques in
estimating the credit spread will be discussed in further detail in Chapter 11, we will
only elaborate on the corporate tax rate.

Corporation tax
An estimation of the borrowing rate after tax requires knowledge of the corporate tax
rate. To the extent that operating profits exceed borrowing costs, the corporate
tax rate shall be applied. For companies with operations abroad, it is necessary to
examine the local corporate tax rates, and the proportion of total borrowing costs
that relate to loans in foreign subsidiaries. For groups with a number of subsidiaries
this information can be difficult to obtain. Based on the view that the effective corpo-
rate tax rate is a weighted average of the group's different corporate tax rates, it may
be argued that the effective corporate tax rate should be used. The use of the effective
tax rate, however, rests on a large number of assumptions, which may be difficult to
fulfil in practice. For example, the use of the effective corporate tax rate assumes that
the company's borrowing costs are distributed in the same way as the firm's operating
earnings. Moreover, the effective corporate tax rate is affected by different tax depre-
ciation schemes for different types of assets. For these reasons we generally favour the
use of the corporate tax when estimating the tax shield.
 Table 10.10 Calculation of the WACC with and without corporate tax (tax shield)

Debt ratio 0% 50% 67% 75% 80% 83%

Financial leverage (debt/equity) 0 1 2 3 4 5
Systematic risk (βe) 0.8 1.6 2.4 3.2 4 4.8
Owners required rate of return 9% 13% 17% 21% 25% 29%
WACC (without corporate tax) 9.0% 9.0% 9.0% 9.0% 9.0% 9.0%
WACC (with corporate tax) 9.0% 8.3% 8.0% 7.9% 7.8% 7.8%

Following the example given in Table 10.4, WACC may be calculated as shown in
Table 10.10. As the table shows, WACC is constant at 9% when excluding tax. This
implies that when the tax advantage of debt is ignored WACC becomes a function
of the risk-free rate and operating risk (βa). When the tax benefits of debt are intro­
duced (tax shield), WACC is, however, reduced if the debt proportion increases. In
Table 10.10 WACC changes from 9% to 7.8% at a debt ratio of 83%. This decrease
is often less in practice. First, the example does not take investor taxes into account.
The finance literature shows that it will only be possible to use the tax shield fully
when investors are taxed similarly on returns from debt and equity capital, respec­
tively. Second, the example does not consider the risk of bankruptcy. Therefore, it is
expected that lending rates will gradually increase with financial leverage. This will
reduce the advantage of using debt.

Conclusions
This chapter focuses on estimation of the components of WACC. The key points to
remember include:
• Cost of capital is fundamental in financial analysis and is used in areas such as per­
formance measurement, valuation, credit analysis and executive compensation.
• An estimation of WACC requires knowledge of the company's long-term capital
structure and lenders' and owners' required rate of return.
• The capital structure is based on market values. The capital structure of compara­
ble companies and the iteration method can be used when market values are not
observable.
• The risk-free rate is usually based on a zero-coupon government bond.
• Owners' required rate of return is typically estimated based on the Capital Asset
Pricing Model (CAPM).
• The market premium varies across countries.
• Estimates from comparable companies and from a qualitative assessment of the
company's operating and financial risk factors may prove useful when estimating
the systematic risk.
We would like to emphasise that estimation of cost of capital is a challenging task.
While it may be tempting to rely purely on the quantitative methodologies outlined in
this chapter, we highly recommend that qualitative factors are included as well when
estimating the different components of cost of capital.
Review questions
• Why is cost of capital a useful concept in financial statement analysis?
• What is meant by the capital structure?
• What is the interpretation of a company with a β of 2.0?
• Which fundamental factors should be considered when measuring β?
• How is WACC measured?
• How is the required rate of return on equity measured?
• What are appropriate proxies for the risk-free interest rate?
• How can the market risk premium be measured?

APPENDIX 10.1

Carlsberg case
In Appendix 9.1 we valued Carlsberg by applying different present value approaches.
As part of the valuation different cost of capital expressions were used:

Valuation model applying required rate of return on equity

Dividend discount model

Valuation models applying WACC

Discounted cash flow (to firm) model
Economic value added model

Valuation model applying required rate of return on assets

Adjusted present value model

In the following section, we discuss the estimation of the required rate of return on
assets, the required rate of return on equity and WACC, respectively.

Required rate of return on assets

The required rate of return on assets is defined as follows:

Since the cash flow is measured in DKK we apply the yield on a Danish govern­
ment bond as proxy for the risk-free rate. A 10-year zero-coupon Danish government
 bond yields 4 % . (Ideally, we should apply the yield curve. However, with the purpose
of keeping things simple we apply the yield on a 10-year zero-coupon government
bond.)
Because the unlevered β is not directly observable we unlever the levered β (system­
atic risk on equity) applying the following β relation

Based on the systematic risk on equity and debt and the capital structure from peers
we are able to calculate the unlevered β for the industry. We rely on estimates from
peers to reduce the impact of measurement errors (Table 10.11).

Table 10.11 β estimates and capital structure

βe βd D/E βa
Heineken 0.84 0.50 0.58 0.72
AB InBew 0.82 0.70 0.34 0.79
SabMiller 0.97 0.40 0.11 0.91
Mean 0.88 0.53 0.34 0.81
Source: Damodaran

These β estimates of debt are based on a subjective assessment of the credit risk of
each of the peers. We elaborate further on credit risk in Chapter 11. The mean value
of the unlevered β is approximately 0.8.
In Table 10.8 we list different risk premiums used across different countries. We
apply a risk premium of 5% which is close to the average risk premium used in
Europe. Based on these estimates we calculate the required rate of return on assets for
Carlsberg as 8% (4% + 0.8 × 5% = 8%).

Required rate of return on equity

The required rate of return on equity is defined as follows:

Since estimates are available for the risk-free rate and the risk premium we only need
an estimate for the systematic risk on equity.
By leveraging the unlevered β (0.8) we obtain an estimate of the systematic risk on
equity. We apply the following β relation to obtain an estimate for the systematic risk
on equity:
 Using the iteration procedure we obtain the following capital structure by the begin­
ning of the first forecast year (see Appendix 9.1):

Please note that we apply the beginning of year capital structure when leveraging the
unlevered β. As proxy for β debt we apply 0.6. This estimate is based on a credit
rating of Carlsberg and is further discussed in Chapter 11. This yields the following
estimate for the levered β for Carlsberg:

Further, the required rate of return on equity is 8.6% (reported as 8.59% in Table 10.12):

Table 10.12 Carlsberg's cost of capital

Forecast horizon
Estimation of cost of capital Terminal
period
Year 6 Year E1 Year E2 Year E3 Year E4 Year E5
Tax rate 25.00% 25.00% 25.00% 25.00% 25.00%
β asset 0.80 0.80 0.80 0.80 0.80
β debt 0.60 0.60 0.60 0.60 0.60
β equity 0.92 0.90 0.90 0.90 0.89
Estimated market value of equity 86,716 93,680 98,301 103,125 106,853 110,059
Net interest-bearing debt (NIBD) 51,478 49,1 70 50,078 50,477 50,547 52,063
Debt/equity (NIBD/E) 0.59 0.52 0.51 0.49 0.47 0.47
Risk-free rate (default free bond 4.00% 4.00% 4.00% 4.00% 4.00%
10 year)
Risk premium 5.00% 5.00% 5.00% 5.00% 5.00%
Required rate of return on 8.00% 8.00% 8.00% 8.00% 8.00%
assets (ra)
Required rate of return on 7.00% 7.00% 7.00% 7.00% 7.00%
debt, before tax (rd)
Required rate of return on debt, 5.25% 5.25% 5.25% 5.25% 5.25%
after tax
Required rate of return on equity 8.59% 8.52% 8.51% 8.49% 8.47%
(re)
WACC 7.35% 7.40% 7.41% 7.42% 7.44%
WACC
WACC is defined as follows:

Assuming a tax rate of 2 5 % and a required rate of return on debt of 7% ( 4 % + 0.6 ×

5% = 7%) Carlsberg's W A C C in the first forecast year is 7 . 3 5 % :

In Table 10.12 we report the expected annual cost of capital for Carlsberg. Using the
iteration procedure we allow the capital structure to vary across time. This implies
that a new estimate for the systematic risk on equity, required rate of return on equity
and WACC are provided each year. As shown in this example, the systematic risk on
equity, the required rate of return on equity and W A C C vary only modestly due to
changes in the capital structure. This also indicates that the use of a variable WACC
only makes sense when the changes in the capital structure are material over time.

Note 1 The 10-year is a geometric weighted average estimate of the expected short-term rates (for-
ward rates).

References Claus, J. and J. Thomas (2001) 'Equity premia as low as three percent? Evidence from analysts'
earnings forecasts for domestic and international stock markets', The Journal of Finance,
October.
Copeland, T., T. Koller and J. Murrin (2000) Valuation: Measuring and managing the value of
companies, John Wiley & Sons.
Fernandez, P. (2009a) 'Betas used by professors: a survey with 2,500 answers', Working Paper,
IESE Business School, May.
Fernandez, P. (2009b) 'Market risk premium used in 2008 by professors: a survey with 1,400
answers', Working Paper, IESE Business School, April.
Jorion, P. and W. N. Goetzmann (2000) 'A century of global stock markets', Working Paper 7565,
National Bureau of Economic Research.
Petersen, C., T. Plenborg and F. Schiøler (2006) 'Issues in valuation of privately held firms',
Journal of Private Equity, Winter.
 CHAPTER 11

Credit analysis

Learning outcomes
After reading this chapter you should be able to:
• Make a distinction between the different approaches available for credit analysis
• Recognise that credit analysis is an art and not a science
• Estimate the expected loss if a firm goes bankrupt
• Understand the difference between exposure at default, probability of default, and
probability of recovery in case of default
• Conduct a credit analysis based on the fundamental analysis approach (expert-
based approach)
• Understand ratings from credit agencies and the distinction between an
investment grade and a speculative grade, respectively
• Calculate the value at risk based on the fundamental credit analysis approach
• Recognise the key differences between the fundamental credit analysis approach
and the statistical models in credit analysis

Corporate credit analysis

C redit analysis provides the answer to this question, by assessing a company's abil-
ity to pay its financial obligations in a timely manner. It examines the probability
that a company may default, and the potential loss in the event of default.
Most lending institutions are involved in credit analysis, whether banks or insti-
tutional investors such as insurance companies and pension funds. Banks extend
loans to companies and use credit analysis to make distinctions between financially
healthy companies and companies which are likely to default. Institutional investors
use credit analysis to find out whether debt securities are sound investments. Credit
analysis is, however, not limited to banks and institutional investors. Companies
assess the credit quality of their customers. Customers assess the credit quality of
their suppliers to ensure that they will provide warranty services, replacement parts
and product updates. Auditors examine whether a company is a going concern.
Competitors examine the consequences of the potential financial distress of the key
competitor.
Credit analysis is an art, not a science. This means that credit decisions are highly
subjective in nature. However, it does not mean that there is not a framework that can
be useful in making credit decisions. At least two frameworks are available for credit
 analyses. Fundamental credit analysis, also referred to as an expert-based approach, is
a framework, where the analyst carefully scrutinises the target firm by asking insight-
ful questions and leaves no stones unturned. Statistical models serve as another frame-
work for credit analysis. The underlying assumption of these models is that statistically
meaningful behaviour in the financial ratios can be identified allowing the analysts to
predict the probability of a default. In this chapter, we emphasise the fundamental
credit analysis approach. We will also briefly elaborate on the statistical models for
credit analysis at the end of the chapter.
Credit analysis aims at estimating the expected loss in the event of a default. The
expected loss is defined as follows:
Expected loss = exposure at default × probability of default
× (1 - probability of recovery)
Exposure at default expresses the potential loss in case of a default and is equal to
the maximum loss that a creditor may experience. The probability of default is an
estimate of the likelihood that a company may default. The probability of recovery
measures the degree to which a company is able to meet its obligation in the event of
defaulting. The following example illustrates the concept of expected loss.

Example 11.1 Assume that a company owes 1,000. Therefore, the exposure at default is 1,000. The prob-
ability of default is 25% and the probability of recovery is 100%. In this example the expected
loss, which the lender may experience, is zero as the probability of recovery is 100%.

Expected loss = 1,000 × 25% × (1 - 100%) = 0 •

In order to estimate the expected loss, it is necessary to provide estimates for the
following variables:
1 Exposure at default
2 Probability of default
3 Probability of recovery.
The credit analysis must cover each of these issues. While the estimation of a com-
pany's exposure at default is relatively straightforward, it is much more challenging
to provide estimates of the probability of default and recovery. In this chapter, we
present an outline of the different steps involved in credit analysis using the funda-
mental credit analysis approach. While not all credit analyses follow the same pro-
cess, the steps are representative of typical approaches. Moreover, it provides a useful
insight into estimating the expected loss.

The fundamental credit analysis approach

Fundamental credit analysis is essentially a systematic and comprehensive analysis
of a company's ability to repay its liabilities (debt) on time and in full. It typically
includes the following eight steps:
Assessing the exposure at default
1 An understanding of the intended use of the loan
2 An understanding of the type of financing (loan).
 Estimating probability of default
3 A strategic analysis of the firm
4 An analysis of the firm's accounting quality
5 An assessment of the firm's financial health based on financial ratios
6 A simulation of future cash flows to evaluate the firm's ability to service debt.
Estimating probability of recovery
7 Available security and collaterals and its liquidation value in case of financial
default.
Estimating the expected loss
8 Summarising the results of the credit analysis (credit rating).
A thorough credit analysis should include not only the analysed firm but also related
persons or firms. A related person is someone who has either control or joint con-
trol over the analysed firm, has significant influence over the analysed firm or is a
member of the key management personnel of the analysed firm. A related firm is
basically a firm which is a member of the same group as the analysed firm. IAS 24
requires firms to make related party disclosures to ensure that an entity's financial
statements contain the disclosures necessary to draw attention to the possibility that
its financial position and profit or loss may have been affected by the existence of
related parties and by transactions and outstanding balances with such parties. For
example, an owner's financial problems may affect an otherwise financially healthy
company. The owner may use the ownership as a pledge for private loans and in
cases, where the owner is not able to meet his or her obligations on private loans,
the bank may force a realisation of the collateral; i.e. the ownership of the com-
pany. This typically has negative implications for the company, thereby affecting its
creditworthiness.
Similar concerns should be raised for firms belonging to the same group. Financial
problems in a parent company may affect a subsidiary negatively. The subsidi-
ary may be forced to pay extraordinary high dividends to the parent, which has a
negative impact on the subsidiary's ability to invest in the future. The subsidiary
may also guarantee for some of the parent's obligations. In either case it affects the
creditworthiness of the company negatively. It is therefore important that the credit
analysis carefully considers those parties as well when assessing the credit risk of
a firm.
We now elaborate on each of the eight steps outlined above.

Step 1: An understanding of the intended use of the loan

It is essential in a proper credit analysis that the analyst understands the intended use
of the loan. The analyst needs to know the size of the loan, and what it will be used
for, to help determine the type of loan required. A retailer, which expands its business,
needs short-term financing such as an open line of credit or a working capital loan
to finance inventory and receivables. A real estate investor, on the other hand, needs
long-term financing such as a mortgage loan and other similar committed facilities to
finance property investments.
An understanding of the intended use of the loan provides the analyst with a deeper
knowledge of the inherent risk of the entire loan arrangement. For example, the risk
involved in an open line credit offered to a mature and financially healthy company
 is much less than the risk in an open line credit offered to a company with no track-
record and poor financial performance.
The size of the loan must also be established, as it gives the analyst an insight about
the business potential and information about the potential risk.

Step 2: An understanding of the type of financing (loan)

The type of financing offered is typically a function of the intended use and the
financial health of the borrower. In the following section, we describe different types
of loans available to firms. It is important to stress that the list is not exhaustive.
In fact, today it is possible to design essentially any type of loan requested by a
borrower.

Loan
Corporate loans are typically extended by banks and take two forms, bilateral and
syndications. A bilateral loan is the most simple and is usually found in small and
medium-sized companies, where banks are willing to take a large counterparty
exposure. In syndicated loans, borrowers typically select one or more banks to act
as arrangers, with one member of the group typically being appointed as the agent
bank. The agent coordinates all negotiations, payments and administration between
the parties during the life of the transaction. Other banks are invited to participate in
the loan.
It is essential to differentiate between uncommitted and committed facilities. An
uncommitted facility allows the lender to renege a commitment at any time. A com-
mitted facility, on the other hand, commits the lender to engage its capital during the
entire lending period. It is well-known that loans can take many forms. Below we list
some of the common types of loans:
• Open line credit - a credit facility that permits the borrower to receive cash up to
some specified maximum for a specified term, typically one year. A fee is charged
on the unused credit facility.
• Revolving line of credit - a credit facility that may be used if credit is needed beyond
the short run. A fee is charged for the unused credit facility.
• Working capital loan - a credit facility used to finance inventory and receivables.
• Mortgage loan - a credit facility used to finance real estate. It is typically long term.
• Lease financing.

Bond
Corporate bonds, also referred to as notes, are debt obligations issued by the bor-
rower directly into the public fixed income markets. Their tenure can extend up to
30 years and there are even some perpetual fixed-income instruments. A company
issuing bonds typically selects a lead underwriter, who arranges the placement of the
bonds with investors. As bonds are placed with retail investors in the public markets,
the requirements for disclosure are more demanding than for loans.

Medium-term notes
Medium-term notes, also referred to as MTNs, are a flexible form of financing available
to borrowers with high credit quality. Firms with high credit quality register MTN pro-
grammes with dealers acting as agents, who distribute the programmes in the markets.
 They share many of the same characteristics as bonds, but the difference is the fact that
dealers have no underwriting obligations and distribute MTNs on best effort basis.

Private placement
Private placements are an issue of debt that is placed primarily with insurance com-
panies. Their term is typically of longer duration and up to 30 years. Documentation
and disclosure are negotiated with the parties involved. Companies may see private
placement as a way of diversifying their sources of financing, but may also be seen as
the only financing available in case of financial problems.

Convertible debt and other hybrid instrument

Convertible debt is a debt instrument that can be exchanged for a specified number
of shares within a specified date and at an agreed price (strike price). Since convert-
ible debt contains an equity element, it is contractually subordinated to most other
types of debt. Companies may rely on convertible bonds as a source of financing
if the alternative is issuance of new stocks. For many years the finance community
has devoted considerable resources to the development of new and more innovative
hybrid instruments. Today there is a wide range of hybrid instruments available and
they can essentially be designed to match the needs of any company. This includes the
option to convert debt to equity, different degrees of maturity and flexible payment
of interests including the option to defer interest payments in case of cash shortage.
Steps 1 and 2 provide the analyst with an understanding of the exposure at default,
and will help answer the following questions:
• Who is the borrower?
• What is the intended use of the proceeds?
• What is the debt amount requested?
• What is the currency?
• What are the price and the coupon?
• What is the maturity?
• What are the interest payment dates?
• What is the rank of debt obligations?

Step 3: A strategic analysis of the firm

The purpose of the strategic analysis is to identify and assess credit risk; i.e. factors
that have a potential to affect cash flows negatively and eventually impair a com-
pany's ability to meet its obligations. In Chapter 8 on forecasting we discussed how
the strategic literature provides guidance on the structure and types of analyses, which
analysts can follow to cover important aspects of a company's cash flow potential and
risk. In Chapter 10 on the cost of capital we discussed risk factors related to a com-
pany's operating and financing activities, and assessed to what extent a company has
the ability to influence and control various risk indicators.
The strategic analyses discussed in both chapters are overlapping and are useful in
identifying and assessing factors, which have a potential to affect the future cash flow
generation negatively, and thereby increase the risk that a company will not be able
to meet its future obligations. As with any type of analyses the strategic analysis is no
better than the data available and the analysis performed. It is therefore crucial that
 the analyst devotes the necessary time and resources in collecting useful information
and performing the analysis.

Step 4: An analysis of a firm's accounting quality

The objective is to examine whether reported accounting numbers are influenced
or even manipulated by management with the purpose of portraying the company
as being financially healthier than the underlying economics justify. In Chapter 13,
we discuss the concept of accounting quality and the steps involved in examining
the accounting quality of a firm. Building on the foundation laid out in Chapter 13
we provide a checklist on accounting issues which can be used to evaluate the account-
ing quality of a company as part of a credit assessment. The checklist is as follows:
• Which GAAP is used?
• Is the audit opinion clean?
• Has there been a recent change in external auditors?
• Has the company faced any recent regulatory actions, including restatements and
amended filings?
• Have there been any recent changes in measurement method, estimates or reclas-
sifications among accounts?
• Do the accounting policies appear realistic as compared to peers?
• Has there been a change in the accounting period?
• Are the reported earnings numbers primarily driven by recurrent or non-recurrent items?
• Are there accounting items which are not yet recognised (off-balance sheet items),
but which have a potential to affect the cash flow?
Does the annual report contain any 'red flags'?
An analysis of the accounting quality should give the analyst comfort in the reported
accounting numbers. However, if the analysis of the accounting quality reveals any
inconsistencies it will, on the other hand, question the quality of the reported account-
ing numbers. The analyst should therefore adjust the accounting numbers along the
guidelines given in Chapters 14 and 15. If it is not possible to make adjustments, for
instance because the necessary information is not available and applying assumptions
and estimates would make accounting numbers too unreliable, the analyst should
interpret the accounting numbers with care.

Step 5: An assessment of a firm's financial health based on financial ratios

Companies assessing the credit risk of their suppliers or customers usually use account-
ing numbers from financial reports (e.g. the annual report). They rely on financial
ratios similar to the ones discussed in Chapters 5-7. In Chapter 5 we describe finan-
cial ratios measuring the profitability of a company, Chapter 6 outlines financial
ratios measuring growth, and finally Chapter 7 discusses financial ratios measuring
the short-term and long-term liquidity risk. Each of these financial ratios describes
important aspects of a firm's financial health.
Banks and other financial institutions often rely on credit rating models similar
to the ones adopted by credit agencies like Standard & Poor's and Moody's. Credit
rating models use selected financial ratios in the ranking of companies based on their
credit risk. The financial ratios are selected based on statistical tests and those tests'
ability to rank companies according to their credit risk. Table 11.1 lists financial ratios
Table 11.1 Credit rating of industrials

Adjusted key industrial financial ratios

US industrial long-term debt

High Rating Low

Three years median AAA AA A BBB BB B CCC

EBIT Interest cover (×) 21.4 10.1 6.1 3.7 2.1 0.8 0.1

EBITDA interest cover (×) 26.5 12.9 9.1 5.8 3.4 1.8 1.3

Free operating cash flow/total debt (%) 84.2 25.2 15.0 8.5 2.6 -3.2 -12.9

FFO/total debt (%) 128.8 55.4 43.2 30.8 18.8 7.8 1.6

Return on capital (%) 34.9 21.7 19.4 13.6 11.6 6.6 1.0

Operating income/revenue (%) 27.0 22.1 18.6 15.4 15.9 11.9 11.9

Long-term debt/capital (%) 13.3 28.2 33.9 42.5 57.2 69.7 68.8

Total debt/capital (%) 22.9 37.7 42.5 48.2 62.6 74.8 87.7

Number of companies 8 29 136 218 273 281 22

for industrials and, as reported in the table, a number of key financial ratios, which
describe different aspects of a company's profitability and risk, are used. Return on
capital (return on invested capital) and operating income as a percentage of revenue
(profit margin) are profitability ratios, while the other ratios focus on a company's
risk factors. The ranking shows what is required for industrial firms to achieve a
given rating. For example, operating income (EBIT) must be at least 21.4 times inter-
est expenses or return on invested capital (return on capital) must be greater than
34.9% to achieve the best possible rating (AAA). It is important to emphasise that the
thresholds vary between industries and may change over time and among industries.
The key ratios in Table 11.1 apply to US industrial firms only.
An explanation of the different ratings is provided in Table 11.2. Credit ratings
from 'AAA' to 'BBB-' correspond to an investment grade. Ratings below 'BBB-' are
equivalent to a speculative grade (also known as high yield or junk bonds). Obviously,
credit ratings have to be industry-specific as the financial structure varies across indus-
tries. As we noted in Chapter 5, companies, which for example offer standard com-
modities, often operate in areas characterised by significant competition. Within these
industries, there is an upper limit to the profit margin. To be able to attract capital for
such entities, they need to generate high turnover rates (e.g. inventory turnover). The
industry-specific ratings take such issues into consideration.
Moody is another well-respected rating agency whose credit rating model is
illustrated in Table 11.3. Moody's uses slightly more (and different) financial
ratios than the rating in Table 11.1. For example, whereas this requires an EBIT of
21.4 × interest expenses to achieve the highest possible rating, Moody's requires
EBITA (where 'A' is amortisation of intangible assets) to be at least 17.0 × interest
Table 11.2 Explanation of the different ratings

'AAA' Extremely strong capacity to meet financial commitments. Highest rating

'AA' Very strong capacity to meet financial commitments
'A' Strong capacity to meet financial commitments, but somewhat
susceptible to adverse economic conditions and changes in circumstances.
'BBB' Adequate capacity to meet financial commitments, but more subject to adverse
Investment economic conditions
grade 'BBB-' Considered lowest investment grade by market participants
Speculative 'BB+' Considered highest speculative grade by market participants
grade 'BB' Less vulnerable in the near-term but faces major ongoing uncertainties to
adverse business, financial and economic conditions
'B' More vulnerable to adverse business, financial and economic
conditions but currently has the capacity to meet financial commitments
'CCC' Currently vulnerable and dependent on favourable business, financial and
economic conditions to meet financial commitments
'CC' Currently highly vulnerable
'C' A bankruptcy petition has been filed or similar action taken, but payments of
financial commitments are continued
'D' Payment default on financial commitments
Ratings from 'AA' to ' C C C ' may be modified by the addition of a plus ( + ) or minus ( - ) sign to show
relative standing within the major rating categories

Table 11.3 Ratings for non-financial corporations

Credit rating Aaa Aa A Baa Ba B Caa-C

EBITA/Average AT 15.3% 15.6% 12.5% 10.1% 9.6% 7.3% 2.0%
Operating margin 14.9% 1 7.0% 1 3.8% 12.6% 12.2% 8.5% 1.6%
EBITA margin 14.8% 1 7.5% 15.2% 13.9% 1 3.4% 9.4% 2.4%
EBITA/IntExp 17.0 13.7 8.2 5.1 3.4 1.5 0.3
(FFO + lntExp)/lntExp 15.5 15.5 9.6 6.6 4.7 2.6 1.5
Debt/EBITDA 0.9 1.0 1.7 2.4 3.3 5.0 6.3
Debt/BookCap 22.7% 32.5% 39.1% 44.8% 53.5% 70.2% 92.5%
FFO/Debt 117.3% 68.4% 43.8% 29.2% 21.8% 12.0% 4.3%
RCF/NetDebt 96.3% 38.4% 38.7% 27.7% 20.0% 11.7% 4.6%
CAPEX/DepExp 1.6 1.4 1.3 1.2 1.2 1.1 0.9
Rev Vol 5.6 4.4 5.5 7.2 10.7 9.2 11.1

Source: Moody's Financial Metrics™

 expenses. Therefore, Moody's uses operating earnings before amortisation expenses
(a non-cash item) in calculating the interest coverage ratio.
Tables 11.1 and 11.3 apply a slightly different notation for the various ratings.
Moody's ratings between 'Aaa' and 'Baa' are equivalent to an 'investment grade',
while ratings below Baa are labelled 'speculative grade'. However, note that the finan-
cial ratios applied in both ratings cover essentially the same aspects of a company's
profitability and risk.
In the following example, we use Rörvik Timber to exemplify the rating of industri-
als given in Table 11.1. As you may recall from Chapter 7, Rörvik Timber suspended
its payments in year 7.

In Table 11.4 a credit rating is provided for Rörvik Timber covering years 1 - 6 . In each year
Example the
11.2
performance of a selected financial ratio is translated into a credit rating. For example,

Table 11.4 Credit rating of Rörvik Timber based on a rating (threshold) of industrials

Credit rating (year 6) AAA AA A BBB BB B CCC <ccc

EBIT interest cover (×) X
EBITDA interest cover (×) X
FOCF/Total debt (%) X
FFO/TotaL debt (%) X
Return on capital (%) X
Operating income/Revenue (%) X
Long-term debt/Capital (%) X
Total debt/Capital (%) X

Credit rating (year 5) AAA AA A BBB BB B CCC <ccc

EBIT interest cover (×) X
EBITDA interest cover (×) X
FOCF/Total debt (%) X
FFO/Total debt (%) X
Return on capital (%) X
Operating income/Revenue (%) X
Long-term debt/Capital (%) X
Total debt/Capital (%) X

Credit rating (year 4) AAA AA A BBB BB B CCC <ccc

EBIT interest cover (×) X
EBITDA interest cover (×) X
FOCF/Total debt (%) X
Table 11.4 (continued)

Credit rating (year 4) AAA AA A BBB BB B CCC <ccc

FFO/Total debt (%) X
Return on capital (%) X
Operating income/Revenue (%) X
Long-term debt/Capital (%) X
Total debt/Capital (%) X

Credit rating (year 3) AAA AA A BBB BB B CCC <ccc

EBIT interest cover (×) X
EBITDA interest cover (×) X
FOCF/Total debt (%) X
FFO/Total debt (%) X
Return on capital (%) X
Operating income/Revenue (%) X
Long-term debt/Capital (%) X
Total debt/Capital (%) X

Credit rating (year 2) AAA AA A BBB BB B CCC <ccc

EBIT interest cover (×) X
EBITDA interest cover (×) X
FOCF/Total debt (%) X
FFO/Total debt (%) X
Return on capital (%) X
Operating income/Revenue (%) X
Long-term debt/Capital (%) X
Total debt/Capital (%) X

Credit rating (year 1) AAA AA A BBB BB B CCC <ccc

EBIT interest cover (×) X
EBITDA interest cover (×) X
FOCF/Total debt (%) X
FFO/Total debt (%) X
Return on capital (%) X
Operating income/Revenue (%) X
Long-term debt/Capital (%) X
Total debt/Capital (%) X
 in year 1 the EBIT interest cover of Rörvik Timber translates into a 'B' rating. In some
cases, the level of a financial ratio is so poor that it does not even meet a 'CCC' rating.
An example is the operating income/revenue ratio in year 1. These cases are classified as
'<CCC'.
The credit rating of Rörvik Timber reveals a gradual improvement in the credit risk until
year 5. In fact, many of the financial ratios of Rörvik Timber in year 5 correspond to an 'A'
rating or better. However, in year 6 the picture changes completely. Five out of eight finan-
cial ratios lead to a rating worse than 'CCC', which indicates that Rörvik Timber has severe
financial problems. The example illustrates that financial ratios may be useful in assessing the
credit risk of a company. However, it also shows that financial ratios are not necessarily timely
indicators of credit risk as in the case of Rörvik Timber. As noted above, Rörvik Timber sus-
pended its payments in the spring of year 7, which corresponds with the release of the annual
report for year 6. •

Step 6: A simulation of future cash flows to evaluate

the firm's ability to service debt
One of the problems of credit rating models and financial ratios in general is that they
are backward-looking and do not incorporate information about the future cash flow
potential. It is therefore useful to project cash flows. The concept of forecasting, which
is presented in Chapter 8, is a useful foundation for the projections of cash flows. As
noted previously it is important that the analyst can 'see' into the future with a high
degree of visibility. The strategic analysis as well as the financial statement analysis
literature offer 'lenses' that analysts can use to make more reliable forecasts of each
financial value driver.
Based on likely scenarios identified in the strategic analysis it is possible to evalu-
ate the probability that a company can meet its future obligations. The simulation
of future cash flows can be based on different levels of sophistication. The sim-
plest approach is probably a simulation of cash flows based on a 'worst case', a
'base case' and a 'best case' scenario. Each of these simulations is used to evaluate
whether a firm's cash flow is sufficient to service debt (i.e. paying instalments and
interests on the loan). Let's illustrate the method in the next three examples using
Rörvik Timber.

Example 11.3 Worst case scenario

Rörvik Timber's performance in year 6 was bad. As a worst case scenario we predict that
Rörvik Timber is not able to improve its performance from year 6. Furthermore, we assume
zero growth in all future years. The forecast assumptions and the derived cash flows are
shown in Table 11.5. The cash flow from operating activities and the cash flow from investing
activities are negative in every single year in the forecast period. This implies that there is no
cash available to service the debt (payment of interest expenses and repayment of debt). In
fact, in years E1-E5 shareholders need to provide SEK 1,109 million in additional capital to
support operations.
Table 11.5 Worst case scenario: projections of Rörvik Timber's cash flows

Average Forecast assumptions

Years 1-6 Year 6 Year E1 Year E2 Year E3 Year E4 Year E5

Revenue growth 12.8% -9.5% 0.0% 0.0% 0.0% 0.0% 0.0%

EBITDA margin 4.2% -7.2% -7.2% -7.2% -7.2% -7.2% -7.2%

Interest rate 8.0% 8.0% 8.0% 8.0% 8.0%

Tax rate, efficient 11.9% 28.0% 28.0% 28.0% 28.0% 28.0% 28.0%
Depreciation as a percentage of 10.0% 8.2% 8.2% 8.2% 8.2% 8.2% 8.2%
intangible and tangible assets
Intangible and tangible assets 22.4% 30.6% 30.6% 30.6% 30.6% 30.6% 30.6%
as a percentage of revenue
Deferred tax receivable 21.7 0.0% 0.0% 0.0% 0.0% 0.0%
Inventories as a percentage 21.4% 20.0% 20.0% 20.0% 20.0% 20.0% 20.0%
of revenue
Receivables as a percentage 14.5% 15.3% 15.3% 15.3% 15.3% 15.3% 15.3%
of revenue
Operating liabilities as a 1 7.9% 20.5% 20.5% 20.5% 20.5% 20.5% 20.5%
percentage of revenue
Interest-bearing debt as a 62.9% 80.6% 80.6% 80.6% 80.6% 80.6% 80.6%
percentage of invested capital

Years 1-6 Year E1 Year E2 Year E3 Year E4 Year E5

Cash flow from operating -107.9 -107.9 -107.9 -107.9 -107.9
activities
Cash flow from investing activities -60.0 -60.0 -60.0 -60.0 -60.0
Cash flow from financing activities -68.0 -50.5 -50.5 -50.5 -50.5
Cash flow infusion (+) or 235.9 218.4 218.4 218.4 218.4
dividends ( - )

ROIC 4.7% -15.3% - 1 5 . 4 % -15.4% -15.4% -15.4%

Example 11.4 Base case scenario

In the base case scenario we assume that Rörvik Timber is able to recover its EBITDA margin
to 4.2% corresponding to the average operating performance in years 1-6. Furthermore, we
assume that intangible and tangible assets, as a percentage of revenue, gradually approach
the average level from years 1-6 of 22%. The adjustment of these forecast assumptions results
in the estimates shown in Table 11.6.
ROIC improves to 4.8% in year E5, which is close to the average ROIC of 4.7% in the
past six years. Due to the expected improvement in the EBITDA margin and the assumed
Table 11.6 Base case scenario: projections of Rörvik Timber's cash flow

Average Forecast assumptions

Years 1-6 Year 6 Year E1 Year E2 Year E3 Year E4 Year E5

Revenue growth 12.8% -9.5% 0.0% 0.0% 0.0% 0.0% 0.0%

EBITDA margin 4.2% -7.2% 4.2% 4.2% 4.2% 4.2% 4.2%
Interest rate 8.0% 8.0% 8.0% 8.0% 8.0%
Tax rate, efficient 11.9% 28.0% 28.0% 28.0% 28.0% 28.0% 28.0%
Depreciation as a percentage of 10.0% 8.2% 8.2% 8.2% 8.2% 8.2% 8.2%
intangible and tangible assets
Intangible and tangible assets 22.4% 30.6% 28.0% 26.0% 24.0% 22.0% 22.0%
as a percentage of revenue
Deferred tax receivable 21.7 0.0% 0.0% 0.0% 0.0% 0.0%
Inventories as a percentage 21.4% 20.0% 20.0% 20.0% 20.0% 20.0% 20.0%
of revenue
Receivables as a percentage 14.5% 15.3% 15.3% 15.3% 15.3% 15.3% 15.3%
of revenue
Operating liabilities as a 17.9% 20.5% 20.5% 20.5% 20.5% 20.5% 20.5%
percentage of revenue
Interest-bearing debt as a 62.9% 80.6% 80.6% 80.6% 80.6% 80.6% 80.6%
percentage of invested capital

Years 1-6 Year E1 Year E2 Year E3 Year E4 Year E5

Cash flow from operating 88.5 87.4 86.3 85.2 85.2
activities
Cash flow from investing 8.1 -3.1 0.8 4.7 -43.1
activities
Cash flow from financing -115.9 -83.9 -81.7 -79.5 -40.9
activities
Cash flow infusion (+) or 19.2 -0.4 -5.4 -10.4 -1.2
dividends ( - )
ROIC 4.7% 3.2% 3.6% 4.1% 4.7% 4.8%

improvement in the utilisation of intangible and tangible assets, the projected cash flows in
years E2-E5 are just sufficient to meet financial obligations. •

Example 11.5 Best case scenario

The best case scenario rests on the assumption of an annual growth rate of 5%, the EBITDA
margin improves to 6%, and intangible and tangible assets as a percentage of revenue
improves gradually to 22% in year E5 (Table 11.7).
Table 11.7 Best case scenario: projections of Rörvik Timber's cash flow
Average Forecast assumptions
Years 1-6 Year 6 Year E1 Year E2 Year E3 Year E4 Year E5
Revenue growth 12.8% -9.5% 5.0% 5.0% 5.0% 5.0% 5.0%
EBITDA margin 4.2% -7.2% 6.0% 6.0% 6.0% 6.0% 6.0%
Interest rate 8.0% 8.0% 8.0% 8.0% 8.0%
Tax rate, efficient 11.9% 28.0% 28.0% 28.0% 28.0% 28.0% 28.0%
Depreciation as a percentage of 10.0% 8.2% 8.2% 8.2% 8.2% 8.2% 8.2%
intangible and tangible assets
Intangible and tangible assets 22.4% 30.6% 28.0% 26.0% 24.0% 22.0% 22.0%
as a percentage of revenue
Deferred tax receivable 21.7 0.0% 0.0% 0.0% 0.0% 0.0%
Inventories as a percentage 21.4% 20.0% 20.0% 20.0% 20.0% 20.0% 20.0%
of revenue
Receivables as a percentage 14.5% 15.3% 15.3% 15.3% 15.3% 15.3% 15.3%
of revenue
Operating liabilities as a 1 7.9% 20.5% 20.5% 20.5% 20.5% 20.5% 20.5%
percentage of revenue
Interest-bearing debt as a 62.9% 80.6% 80.6% 80.6% 80.6% 80.6% 80.6%
percentage of invested capital

Years 1-6 Year E1 Year E2 Year E3 Year E4 Year E5

Cash flow from operating 106.8 110.9 115.2 119.6 125.6

activities
Cash flow from investing -28.1 -38.6 -33.3 -27.5 -87.0
activities
Cash flow from financing -77.0 -49.2 -51.2 -53.3 -9.1
activities
Cash flow infusion (+) or -1.8 -23.2 -30.7 -38.9 -29.6
dividends ( - )
ROIC 4.7% 6.1% 6.8% 7.5% 8.2% 8.4%

In the best case scenario ROIC improves to 8.4%, which is well above the historical aver-
age of 4.7%. Cash flow in each forecast year is sufficient to meet the financial obligations. In
fact, in the best case scenario Rörvik Timber is able to pay dividends to its shareholders. •

Ideally, probabilities are attached to each scenario, which gives the analyst a better
impression of the likelihood of a default. Figure 11.1 provides an example of an out-
come of such a simulation process. It provides an excellent overview of the likelihood
that a company defaults based on the probabilities of each scenario. In the examples,
the three scenarios result in a default. This is equivalent to a 4% ( 1 % + 1% +2%)
chance that the company defaults.
 Figure 11.1 An illustration of the probability of default based on simulations

There are more advanced simulation methods available than the relatively sim-
ple approach outlined above. They include among others Monte Carlo simulations,
which are stochastic techniques relying on random numbers and probability statistics
to determine the probability of corporate default. Before considering adopting the
more advanced simulation approaches it is, however, important that solid pro forma
statements that articulate have been developed and likely outcomes identified.
Steps 3-6 provide the analyst with an understanding of the probability of a corporate
default. Some of the questions that Steps 3-6 should be able to answer include:
Which of the identified strategic factors are most likely to affect the cash flows in
the future?
• Are the financial statements of high quality?
• Do the financial ratios indicate any financial problems?
• Do simulations of cash flows indicate any financial problems?
• What is the probability of corporate default?

Step 7: Available security and collaterals and its liquidation

value in case of financial default
Unless loans are short term and the borrower exposes the lender to minimal default
risk, security or collateral is usually required. Creditors often secure their loans by
requiring a pledge in the asset on which the borrowing is based. The pledge ensures
that if the borrower defaults, the lender can realise the asset (collateral) to satisfy its
claims against the borrower. The challenge from a lender's perspective is to ensure that
the collateral is of such quality that it ensures a full recovery in case a default is likely.
In Table 11.8, we describe different types of collateral and their respective liquidity
and quality. Liquidity refers to how easy it is to convert an asset to cash. Quality refers
to how well the book values reflect the liquidation value of assets.
 Table 11.8 Types and quality of collaterals

Type of collateral Liquidity and quality

Goodwill and brands Low

Contracts and concessions Low

Intangible
Patents and rights Low

Property Low to medium

Plant Low

ofEquipment
TypeTangible
asset Low

Inventory Low to medium

Receivables Medium to high

Traded securities High

Cash and bank

Financial
accounts High

The most liquid assets like cash and traded securities are typically the assets where
the book values and liquidation values are also most aligned. For the least liquid
assets, like intangible assets, there is a greater uncertainty as to whether book values
reflect liquidation values. Many of the thoughts outlined in Chapter 9 on the calcula-
tion of the liquidation value can be used to examine the quality of assets (collateral).
This includes issues such as the measurement basis, alternative uses of the assets, the
level of maintenance, the number of potential buyers, and the time available for the
liquidation process.
There are other ways to obtain security than having a pledge in an asset. For exam-
ple, a guarantee from the parent company or a subsidiary is another way of obtaining
the same type of security. Obviously, the quality of such securities depends on the
parent company's or subsidiary's ability to meet potential obligations. Recovery rate
averages in case of a corporate default are reported in Table 11.9.
The table reveals that secured debt yields the highest recovery rates. For example,
the recovery rate for secured bank debt is 7 4 . 1 % and only 2.5% for junior subor-
dinated bonds. The statistics also reveal that the recovery rate is on average below
100% for all types of debt. These numbers indicate that the book value of an asset is
not necessarily a good proxy for the liquidation value.
Some of the questions that Step 7 should be able to answer include:
• What is the collateral?
• What is the liquidity of the collateral?
• What is the quality of the collateral?
• What is the recovery prospect?
Step 7 provides the analyst with an estimate of the recovery prospects in case of a
corporate default.
 Table 11.9 Ultimate recovery rate averages from S&Ps, reported in Ganguin
and Bilardello (2004)
Instrument type Average ultimate Standard Observations
recovery (%) deviation
Secured bank debt 74.1 32.4 331
Senior secured bonds 45.8 36.5 42
Senior unsecured bonds 36.8 35.1 198
Senior subordinated bonds 21.3 30.8 116
Subordinated bonds 15.0 24.7 55
Junior subordinated bonds 2.5 4.1 4

Step 8: Summarising the results of the credit analysis (credit rating)

Steps 1-7 provide the analyst with an understanding of the exposure at default, the
probability of default and an estimate of the recovery prospects. Each step in the credit
analysis process therefore provides valuable information to the analyst. Assuming that
the analyst is able to obtain reliable estimates of the exposure at default, the prob-
ability of default and the probability of recovery, it is possible to estimate the expected
loss. For example, assume that the analysis of Rörvik Timber shows that the exposure
at default is SEK 100 million. The expected probability of default is between 40% and
50% and the probability of recovery is between 70% and 80% in case of a corporate
default. On the basis of these estimates the expected loss on Rörvik Timber is between
SEK 8 million and SEK 15 million:

Expected loss = SEK 100 million × 40% × (1 - 80%) = SEK 8 million

Expected loss = SEK 100 million × 50% × (1 - 70%) = SEK 15 million

Banks and credit agencies typically summarise their analyses in a credit rating.
Table 11.10 provides an example of such a credit rating and summarises the results of
the different steps involved in the credit analysis including the strategic analysis, the
financial ratio analysis, the simulation of future cash flows, and the value of the collat-
eral. A weight is assigned to each of these four factors. The weights can be established
subjectively, but in most cases they are based on statistical analyses. In the example,
the financial ratio analysis is assigned a weight of 20% of the final credit score reflect-
ing that it is primarily based on historical information. Simulation of cash flows based
on different scenarios is assigned a higher weight of 30%, as it reflects an ex-ante
perspective. It is interesting to observe that the indicated rating in the example is 'BBB'
while the actual rating is 'A'. The difference reflects an expected improvement in some
of the four factors within the next 12 months, which justifies a better rating than cur-
rent performance supports.
In Table 11.11 we provide an example of a summary of Moody's rating of
Carlsberg. The credit rating consists of four factors. The strategic factors are assigned
a weight of 4 5 % (22.5% + 22.5%) and the financial factors are assigned a weight
of 5 5 % (19% + 36%). Carlsberg's indicative rating is 'Ba', which is equivalent to
Table 11.10 Summary of a credit rating (example)
Industry/company name AAA AA A BBB BB B CCC

Factor 1: Strategic analysis (20%)

(a) External risk X

(b) Strategic risk X

(c) Operation risk X

(d) Financial risk X

Factor 2: Financial ratio analysis (20%)

(a) EBIT interest cover (×) X

(b) EBITDA interest cover X

(c) Free operating cash flow/total debt (%) X

(d) FFO/total debt (%) X

(e) Return on capital (%) X

(f) Operating income/revenue (%) X

(g) Long-term debt/capital (%) X

(h) Total debt/capital (%) X

Factor 3: Simulation (30%)

(a) Scenario 1 X

(b) Scenario 2 X

(c) Scenario 3 X

Factor 4: Recovery (30%)

(a) Orderly liquidation value X

(b) Distress liquidation value X

Rating:
(a) Indicated rating from methodology X

(b) Actual rating assigned X

a speculative grade. However, the actual rating is 'Baa', which is equivalent to the
lowest rating within investment grades. According to Moody's they expect Carlsberg
to meet the following credit metrics by the end of the year and to maintain them:
RCF 1 to Net Debt above 18% and the Debt to EBITDA ratio below 3.5. Currently,
Carlsberg RCF to Debt is 11.3% and Debt to EBITDA ratio is 4.8. This implies that
if Carlsberg cannot meet these thresholds at year end they will most likely receive a
speculative grade ('Bal').
Table 11.11 Moody's credit rating of Carlsberg

Alcoholic beverage industry Aaa Aa A Baa Ba B Caa

Factor 1: Scale and diversification (22.5%)

(a) Global net sales US$11.8
(b) Diversification by market X

(c) Product/brand diversification X

Factor 2: Franchise strength and growth

potential (22.5%)
(a) Efficiency of distribution infrastructure X

(b) Quality of brand portfolio and market X

position
(c) Innovation and organic revenue growth X

Factor 3: Profitability and efficiency (19%)

(a) Efficiency/potential for cost reduction X

(b) Profitability (EBITA margin) 13.70%

(c) Return on avg. assets (EBITA/avg. assets) 8.7%

Factor 4: Financial policy and credit

metrics (36%)
(a) Financial policy X

(b) FFO/net debt 13.20%

(c) Debt/EBITDA 4.8
(d) RCF/net debt 11.30%
(e) EBIT/interest expense 2.4
(f) Free cash flow/debt 1.40%

Rating:
(a) Indicated rating from methodology Ba1
(b) Actual rating assigned Baa3
Source: Carlsberg's website.

In Table 11.12 we report the cumulative default rates across different classes of
risk. The analysis shows that there is a clear correlation between ratings and default
rates. For example, none of the companies (0.00%), which have obtained an 'AAA'
credit rating, defaulted in the first year after the rating. On the other hand, 30.95% of
the companies assigned a ' C C C ' rating defaulted after the first year of a credit rating.
The statistics reported in Table 11.12 reveal that the probability of default increases
rapidly in the early years of a credit rating. In summary, the default rates reported
justify that credit analysis in line with the eight steps matters.
Table 11.12 Cumulative default rates (%) by year after credit rating has been assigned

Year1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Year 11 Year 12 Year 13 Year 14 Year 15

AAA 0.00 0.00 0.03 0.07 0.11 0.20 0.30 0.47 0.54 0.61 0.61 0.61 0.61 0.75 0.92

AA 0.01 0.03 0.08 0.17 0.28 0.42 0.61 0.77 0.90 1.06 1.20 1.37 1.51 1.63 1.77

A 0.05 0.15 0.30 0.48 0.71 0.94 1.19 1.46 1.78 2.10 2.37 2.60 2.84 3.08 3.460

BBB 0.36 0.96 1.61 2.58 3.53 4.49 5.33 6.10 6.77 7.60 8.48 9.34 10.22 11.28 12.44

BB 1.47 4.49 8.18 11.69 14.77 17.99 50.43 22.63 24.85 26.61 28.47 29.76 30.99 31.70 32.56

B 6.72 14.99 22.19 27.83 31.99 35.37 38.56 41.25 42.90 44.59 45.84 46.92 47.71 48.68 49.57

CCC 30.95 40.35 46.43 51.25 56.77 58.74 59.46 59.85 61.57 62.92 63.41 63.41 63.41 64.25 64.25

Source: Ganguin and Bilardello, 2004.

 Pricing credit risk
In this section we briefly discuss how credit risk translates into risk premiums. In gen-
eral, the pricing of a loan is affected by the lender's cost of administering and servicing
the loan and a premium for the exposure to default risk. (Factors like the lender's cost
of borrowed funds and a return on the equity necessary to support the lending opera-
tion also affect the risk premium.)
In Table 11.13 we report the spreads (risk premiums) measured over a two-year
period across different credit ratings. The spread covers a premium for the exposure to
default risk and the administration and service cost. As shown in the table the spreads
increase as the credit rating worsens. For example, an 'AAA' rating results in a spread
between 0.6% and 1.9% whereas a 'B' rating results in a spread between 2.6% and
13.1%. So if US Treasury 10-year bonds had an interest rate of 3.38% firms with a
'B' grade had to pay up to 3.38% + 13.1% = 16.48%. It supports that lenders and
investors require a compensation for higher credit risk.
The large deviation of spreads within a rating reflects the uncertainty on the credit
markets due to the financial turmoil in 2008 and 2009. For example, the spread of a
'B'-rated obligation has fluctuated between 3.2% and 13.1%. It is, however, also an
indication that spreads do not remain constant over time.

Table 11.13 US industrial ratings and 10-year spread

Adjusted key industrial financial ratios

US industrial long-term debt

Three years median AAA AA A BBB BB B CCC

EBIT interest cover (x) 21.4 10.1 6.1 3.7 2.1 0.8 0.1
EBITDA interest cover (x) 26.5 12.9 9.1 5.8 3.4 1.8 1.3
Free operating cash flow/total 84.2 25.2 15.0 8.5 2.6 -3.2 -12.9
debt (%)
FFO/total debt (%) 128.8 55.4 43.2 30.8 18.8 7.8 1.6
Return on capital (%) 34.9 21.7 19.4 13.6 11.6 6.6 1.0
Operating income/revenue (%) 27.0 22.1 18.6 15.4 15.9 11.9 11.9
Long-term debt/capital (%) 13.3 28.2 33.9 42.5 57.2 69.7 68.8
Total debt/capital (%) 22.9 37.7 42.5 48.2 62.6 74.8 87.7
Number of companies 8 29 136 218 273 281 22

US industrial 10-year spread (two-year high/low) to US Treasury, 10 year

US Treasury, 10 year AAA AA A BBB BB B
3.38% 1.9 2.4 3.6 4.7 11.2 13.1
3.38% 0.6 0.7 0.8 1.3 2.6 3.2
Source: Bloomberg
 Carlsberg obtained a 'Baa3' rating based on Moody's terminology, which is equiva-
lent to the lowest rating within investment grades. This corresponds to a 'BBB' rating
according to the terminology in Table 11.1. The expected 10-year spread on a 'BBB'
rated obligation has fluctuated between 1.3% and 4.7% within the last two years
with an average of 3% ((1.3% + 4.7%)/2).

Prediction of corporate default using statistical models

This chapter has so far discussed the various steps involved in a fundamental credit
analysis approach, where analysts carefully scrutinise important aspects of a firm's
financial health. As noted in the introduction statistical models serve as another frame-
work for credit analysis. In this section we will briefly discuss some of the arguments
in favour of the statistical models and provide a few examples. For a deeper insight
into the statistical models on credit risk, which are also dubbed bankruptcy models,
you should consult the relevant literature (see References, page 298).
The prediction of bankruptcies is a complicated process that involves hard work
and analytical skills as outlined in Steps 1-8 above. We believe that the prediction of a
corporate default based on statistical models cannot substitute for hard work and ana-
lytical skills. However, the statistical models are useful in selecting financial ratios for
the analysis of corporate defaults. An example of this is the financial ratios used in rat-
ing models. Furthermore, the statistical approach may be preferred in cases where the
fundamental analysis approach is too costly. Using statistical methods enables lenders
to analyse a large number of firms quickly.
The underlying assumption of the statistical models is that meaningful behaviours
in financial ratios can be identified allowing the analysts to calculate the probability
of a corporate default. In the following section, we describe three different types of
statistical models used to predict bankruptcy.

Univariate analysis
Out of 30 financial ratios Beaver (1966) finds six that are useful in predicting the
bankruptcy of a firm. The development of these six financial ratios during a five-year
period prior to bankruptcy is reported in Figure 11.2. In each graph the average ratio
for bankrupt firms is compared with those of comparable firms that did not go bank-
rupt. Bankrupt firms are depicted with a full drawn line. As shown in the figure the
performance of bankrupt firms is poor relative to non-bankrupt firms. For example,
the financial ratios are persistently lower for bankrupt firms than for non-bankrupt
firms. Furthermore, the financial ratios worsen as the bankruptcy date gets closer. The
levels and development of the financial ratios support that they contain useful infor-
mation in the prediction of a corporate default.
The bankruptcy studies make a distinction between two types of error. A type 1
error classifies a firm as not likely to default when it actually does default. A type 2
error classifies a firm as likely to default when it does not default. Both types of errors
are associated with costs to the lender. A type 1 error is costly as the lender risks losing
the total debt outstanding. A type 2 error is costly as the lender loses profitable cus-
tomers and businesses to other lenders.
Type 1 and type 2 errors in Beaver's study are reported in Table 11.14. Five years
prior to the bankruptcy there is a 4 3 % (29/(29 + 33)) chance of a type 1 error; i.e.
 Figure 11.2 Comparison of mean values of six selected financial ratios for bankruptcy
firms and non-bankruptcy firms five years prior to bankruptcy
Source: Beaver (1966).

that the lender classifies a firm as not likely to default when it actually defaults. This
is not much better than flipping a coin. However, as the bankruptcy date gets closer,
type 1 errors are reduced to 22% (17/(17 + 62)). Type 2 errors fluctuate between
3 % (2/(2 + 64)) and 8% (6/(6 + 69)).

Multiple discriminant analysis

Multiple discriminant analysis is a statistical technique used to classify an observation
into one of several a priori groupings - in this case bankruptcy versus non-bankruptcy
groups. A multiple discriminant analysis attempts to derive a linear combination of
financial ratios which best distinguish between the bankruptcy and non-bankruptcy
firms. Based on a sample of firms that went bankrupt in the past and a random sam-
ple of firms that did not, the analysis determines a set of discriminant coefficients.
These coefficients are then multiplied on selected financial ratios to obtain a so-called
Z-score.
Table 11.14 Classifications of bankruptcy and non-bankruptcy firms based on the cash flow to total
debt ratio
Predicted Failed Non-failed Non-failed Failed
outcome
Failed Failed Non-failed Non-failed Total Correct Type 1 Type 2

1 62 17 75 4 158 87% 22% 5%

2 50 26 71 6 153 79% 34% 8%
3 47 28 69 6 150 77% 37% 8%
4 33 29 64 2 128 76% 47% 3%
5 31 23 60 3 117 78% 43% 5%
Source: Beaver (1966)

Altman (1968) find that from the original list of 22 financial ratios, five are selected
as doing the best job in combination of predicting corporate bankruptcy. Altman esti-
mates the following coefficients on each of the five financial ratios:

Altman (1968) finds that firms obtaining a Z-score below 1.81 have a high probabil-
ity of going bankrupt. On the other hand, firms with a Z-score above 2.99 have a low
probability of going bankrupt. Firms with a Z-score in between 1.81 and 2.99 are in a
grey area, and therefore need to be analysed further.
The Z-score classifies 9 5 % of the observations correctly one year prior to the bank-
ruptcy. There is a 6% chance of a type 1 error and a 3% chance of a type 2 error one
year prior the bankruptcy, which supports that the model is doing fairly well. The
model has subsequently been further improved (Altman 1983).

Logit analysis
Logit regression is an alternative method to the multiple discriminant analysis. It has
the advantage of estimating probabilities of bankruptcy. Ohlson (1980) is one of the
first attempts using the logit approach. The logit model defines the probability of
bankruptcy as follows:

where
e equals 2.718282
 Ohlson's model that predicts bankruptcy within one year defines y as follows:

where dummy 1 is 1 if net income was negative for the last two years and zero other-
wise and dummy2 is 1 if total liabilities exceeded total assets and zero otherwise.
The cut-off which minimises the sum of errors is 3.8%. This implies that for values
below 3.8% there is a low probability of bankruptcy and for values above 3.8% there
is an increased probability of bankruptcy. At the cut-off rate of 3.8%, there is 17.4%
chance of a type 1 error and 12.5% chance of a type 2 error.
In Table 11.15 we report the probability of bankruptcy of Rörvik Timber using
both Altman's Z-score model and Ohlson's logit model. The Z-score is above the criti-
cal level of 2.99 in years 3-5 indicating a low probability of bankruptcy. In year 6, the
Z-score is below the critical threshold of 1.81 indicating a high probability of bank-
ruptcy. This supports that the Z-score approach is able to differentiate between high
and low probabilities of bankruptcy. However, in the example of Rörvik Timber the
signal of a high probability of bankruptcy is not available until the company actually
suspends its payments. In that regard, the Z-score model suffers from the same defi-
ciencies as the financial ratios used to measure the short- and long-term liquidity risk
in Chapter 7; the signal(s) come too late.
The probability of bankruptcy is well above the cut-off point of 3.5% in the entire
period using the Ohlson's logit model, which is an indication of a high probability
of bankruptcy. One explanation for the high probability of bankruptcy in the entire
period is due to the size variable. In Ohlson's model size plays an important role.
Large companies have a lower probability of bankruptcy than smaller companies.
Since Rörvik Timber is a relatively small company compared to its US counterparts it
biases the probabilities of bankruptcy upwards.
In summary, bankruptcy models as discussed in this section are useful approaches
in measuring bankruptcy risk where other methods such as the fundamental credit
analysis approach appears too costly. They are also useful in selecting financial
ratios for the analysis of bankruptcy. However, they also suffer from deficiencies, for
example:
• As demonstrated, financial ratios ought to be compared with peers from the same
industry. This implies that coefficients must be estimated at industry levels.
• The studies reported in this section were produced quite a while ago and assuming
that the coefficients are not stable across time, it is necessary to generate a new set
of coefficients on a regular basis,
• The cut-off score that best distinguishes bankrupt from non-bankrupt firms is based
on judgements. Thus, two persons may arrive at different conclusions even if they
Table 11.15 Application of the Z-score model and the logit model to Rörvik Timber

Altman's Z-score model Year 2 Year 3 Year 4 Year 5 Year 6

Working capital/total assets 0.68 0.77 0.80 0.80 0.63

Retained earnings/total assets 0.00 0.06 0.06 0.12 -0.18
EBIT/total assets 0.05 0.24 0.30 0.50 -0.48
Market value of equity/book
value of liabilities 0.16 0.21 0.42 0.35 0.06
Sales/total assets 1.91 1.87 1.78 1.49 1.49
Z-score 2.81 3.15 3.36 3.26 1.52
Probability of bankruptcy Medium Low Low Low High

Ohlsson's logit model Year 2 Year 3 Year 4 Year 5 Year 6

Size (natural logarithm) -1.17 -1.22 -1.25 -1.32 -1.30
Total liabilities/total assets 4.38 4.57 4.44 4.45 5.22
(Current assets - current
liabilities)/total assets -0.11 -0.07 -0.19 -0.31 0.12
Current liabilities/current assets 0.09 0.08 0.10 0.11 0.07
Net income/total assets -0.01 -0.10 -0.13 -0.23 0.31
Funds from operations/total
liabilities -0.21 -0.18 -0.03 0.16 -0.06
Dummy1 0.00 0.00 0.00 0.00 2.85
Dummy2 0.00 0.00 0.00 0.00 0.00
Change in net income /(|Net 0.28 -0.47 -0.11 -0.23 4.74
incomet| + |Net incomet-1|)
Intercept -1.32 -1.32 -1.32 -1.32 -1.32

Value of y 1.93 1.29 1.50 1.31 10.63

Probability of bankruptcy 87% 78% 82% 79% 100%

rely on the same dataset. Further, the cut-score may not be stable across time and
may need to be re-calibrated.
• The bankruptcy models purely rely on historical information and do not include
forward-looking information. Further, the bankruptcy models do not include quali-
tative information that inform about the financial health of a company. This is a
problem in cases where the qualitative information is not included in the financial
ratios. This may involve information about a licence or a patent that is about to
expire and which will affect the cash flow negatively.
• Each statistical approach relies on setup assumptions that appear more or less real-
istic. In cases, where some of these assumptions are violated it may question the
validity of the model.
Conclusions
This chapter focuses on corporate credit analysis. The most important points to
remember are:
• The expected loss is estimated as exposure at default × probability of default ×
(1 - probability of recovery).
• The fundamental credit analysis approach presents the building blocks that help
in analysing a company's ability to pay instalments and interests on its debt in a
timely manner. It also includes estimation of the recovery prospects. You should
be in a position to identify all essential risks related to a particular company and
to measure them through strategic analyses, ratio analysis including benchmark-
ing with peers and through financial forecasts including simulation of different
scenarios.
• The prediction of a corporate default involves hard work, analytical skills and a
great deal of judgement. It is therefore important to emphasise that corporate credit
analysis is an art and not an exact science.
• Credit agencies have created scoring systems to rank credit risk along a continuum,
with grades ranging from almost no risk to high risk (firm unable to service its
debt). By assigning ratings on a predetermined scale, analysts can benchmark the
credit quality across companies from different industries. A particular rating also
provides an indication of the premium that would be required for a particular risk,
assuming that the market is efficient. The higher risk, the higher the reward will be.
• The statistical models are useful in selecting financial ratios for the analysis of cor-
porate defaults. Further, the statistical approach may be preferred in cases where
the fundamental analysis approach appears too costly.

Review questions
• What are the different approaches available for credit analysis?
• How can the potential loss if a firm goes bankrupt be estimated?
• What is meant by exposure at default, probability of default, and probability of recovery
in case of default?
• What types of loans are available for companies?
• What are the steps in the fundamental analysis approach (expert-based approach)?
• How do credit agencies rate debt?
• What are the advantages and disadvantages of a fundamental credit analysis approach?
• What are the advantages and disadvantages of using statistical models in credit analysis?
• Why is credit analysis an art and not an exact science?

Note 1 According to Moody's RCF equals funds from operations (cash flow from operations) less
preferred dividends less common dividends less minority dividends.
References Altman, E.I. (1968) 'Financial ratios, discriminant analysis and the prediction of corporate
bankruptcy', Journal of Finance, September.
Altman, E.I. (1983) Corporate Financial Distress, John Wiley & Sons.
Beaver, W. (1966) 'Financial ratios as predictors of failure', Journal of Accounting Research,
Supplemental, Empirical research in accounting: Selected studies.
Ganguin, B. and J. Bilardello (2004) Fundamentals of Corporate Credit Analysis, McGraw-Hill.
Ohlson, J. (1980) 'Financial ratios and the probabilistic prediction of bankruptcy', Journal of
Accounting Research, Spring.
 CHAPTER 12

Accounting-based bonus plans

for executives

Learning outcomes

After reading this chapter you should be able to:

• List major issues in designing bonus plans
• Discuss choice of performance measure(s), accounting issues, link between
performance and bonus, and bonus threshold
• Discuss accounting issues in designing bonus contracts
• Understand how bonus contracts should incorporate transitory items
• Understand how bonus contracts must take into consideration changes
in accounting policies
• Identify the most appropriate measure of performance
• Discuss the most appropriate target level of performance
• Recognise how rewards should be linked to performance

Introduction to executive compensation

M odern corporations are run by managers who typically own only a small fraction
of the company's shares. This leads to the well-known agency problem: how do
investors (principal) ensure that managers (agent) strive to create shareholder value?
Basically, two approaches may come into play. First, the principal may monitor the
agent closely. Second, the principal may offer the incentive of compensation. This
chapter discusses the second approach or more specifically:
What constitutes an appropriate accounting-based bonus plan?
Executive compensation, including bonus plans, has been a topic of considerable
controversy in academia and business communities for a number of years. Many find
that exorbitant bonuses are unfair. However, the fundamental idea behind bonus plans
(executive compensation) is quite straightforward. Bonus plans should align the inter-
ests of management (agent) and the owners (principal) and ensure that management
act in accordance with a firm's strategy in order to maximise long-term value creation.
Bonus plans come in different formats and may be linked to stock market per-
formance, non-financial performance measures or financial performance measures, as
depicted in Figure 12.1.
Compensation may be linked to a firm's performance on the stock market.
Management may be rewarded options or warrants, which are directly related to the
stock price or a cash bonus if the stock price increases to a predefined level as determined
Figure 12.1 Performance measures used in bonus plans

by the bonus contract. Linking rewards to the stock price provides a direct link between
management's effort and value creation.
Financial performance measures include numerous absolute earnings measures
such as sales, gross profit, EBIT, EBITDA, NOPAT and net earnings as well as relative
performance measures such as return on invested capital (ROIC), return on equity
(ROE), economic value added (EVA) or similar metrics. Financial performance meas-
ures also include various measures of cash flows including the free cash flow and cash
flow return on investment (CFROI).
Finally, non-financial performance measures include a variety of measures includ-
ing, but not limited to, customer satisfaction, employee satisfaction, product and
service quality, productivity, process improvements, innovation, leadership and a host
of other non-financial measures. Bonus contracts may include several of these non-
financial performance measures. In addition, such performance measures are often
used in combination with financial performance measures.
As our book examines how accounting is used for decision-making purposes, the
focus in this chapter is on bonus contracts based on accounting-based performance
measures (i.e. financial performance measures). We discuss specific issues that are rel-
evant in designing and understanding accounting-based bonus plans. For those who
are interested in bonuses based on stock prices and non-financial performance meas-
ures, there is a rich literature on these topics. Also, while executive compensation is
often based on stock options and warrants, such bonus contracts require that mar-
ket data (i.e. stock prices and stock returns) are available. The majority of firms in
most, if not all countries, are non-listed, so such market data are simply not available.
Furthermore, stock prices do not provide a good line of sight below top management
levels; that is middle management and other employees have little or no control over
the bottom line in the income statement and, therefore, the associated cash flows,
which ultimately determine firm value and stock prices.
Since managers are often compensated with a base salary and a bonus, firms have
to offer a competitive package that offers these components. The bonus should offer
managers sufficient compensation to work long hours, take calculated risks and make
the necessary unpleasant decisions in order to maximise shareholder value. Stated dif-
ferently, in order to attract, retain and motivate talented people firms must pay a
total remuneration package, which will retain management even during times with
poor performance due to market and industry factors. If, for example, performance
is poor due to a financial crisis, but management is doing better than expected (say,
compared to peers), the firm should try to retain management. Consequently, without
a proper compensation package there is a risk that managers choose to leave the firm.
 An appropriate bonus plan provides sufficient compensation to retain managers, who
achieve above-average relative performance.
This chapter continues as follows: in the next section, we discuss the features of a
well-designed bonus plan, followed by a section, which describes and discusses the
components of a bonus plan in more detail. An important element in this section is an
analysis of the merits and demerits of various accounting metrics used in bonus plans.
Finally, a section is devoted to describing various EVA bonus plans; such plans have
some desirable characteristics as discussed in this chapter.

Characteristics of an effective bonus plan

As a starting point it should be noted that a one-size-fits-all bonus plan does not exist.
Nonetheless, bearing in mind that bonus plans aim at attracting and retaining man-
agement, the remuneration board (and managers) should take the following issues
into consideration in designing a bonus contract of high quality:
• Congruence (criterion 1)
• Controllability (criterion 2)
• Simplicity (criterion 3)
• Accounting issues (criterion 4).
These criteria are discussed below.

Congruence
A crucial part of a bonus plan is to align the interests of management (agent) and
owners (principal). Management should only be awarded a bonus to the extent that
they act in the interest of the owners. As a result, the degree of alignment between the
objective of the shareholders and the objective of the managers, that is congruence,
is a major issue to clarify in a compensation system. Accounting-based performance
measures used in bonus plans should support corporate strategy in order to maxim-
ise shareholder value and, therefore, reflect (true) economic income. Ideally, bonus
should reflect value created by management. Value created during a financial year is
measured as the difference between firm value at year end and firm value at the begin-
ning of the year plus dividends paid to shareholders. For example, if the stock price is
100 at 1 January, year 1 and 120 at 31 December, year 1 management has been able to
create 20 in value. 1 This is naturally under the condition that investors have not paid
in additional share capital or received dividends during year 1.
However, unless a firm is listed on a stock exchange, firm value is not known at
any date. To determine firm value and calculate value created during a financial year
would require that the present value of all future cash flows are estimated every year at
year end. Naturally, forecasting the amount, timing and risk of such cash flows is at
best a difficult task, as we saw in Chapter 8. In addition, reporting poor performance
(i.e. a decrease in firm value during a financial year), so that no bonus should be
awarded, could be avoided simply by being a bit more optimistic in making the cash
flow forecasts. Due to the difficulties in estimating cash flows, various accounting-
based performance metrics are used as a proxy for value creation. In accounting
language the above implies that a congruent performance measure shall account for
earnings, investments (e.g. future cash flows include investments in non-current assets
 and working capital), account for risk (the cost of capital), and represent unbiased
accounting (e.g. cash flows eliminate potential accounting noise for example by add-
ing back depreciation). If so the performance measure(s) becomes a reliable and accu-
rate signal of value creation.
However, unbiased accounting may be difficult to obtain. First, accounting regula-
tion may introduce biases in the reported accounting measures. An example includes
the use of FIFO versus average costs when measuring the value of inventory. Second,
bonuses based on various earnings measures give management an incentive to change
accounting policies and estimates in order to increase bonuses. For instanec, manage-
ment may be tempted to write-off large amounts on assets in periods where they will
not be able to meet bonus targets anyway. In that case expenses are charged to current
year's income, while making it easier to reach targets in future periods.
Since value is created throughout the lifetime of a company, congruence also
demands that managers undertake actions which emphasise the long run. For instance,
managers should invest in research and development projects (with a positive net
present value) even though the effect on earnings and EVA is negative when the invest-
ments are initially made. In practice, obtaining congruence is far more difficult than it
sounds as discussed throughout this chapter.
Congruence is paramount in any bonus contract. The other characteristics of a
well-designed bonus plan are to no avail, if the bonus plan does not support investors'
interest. For instance, a performance measure may be controllable and simple, but if it
is not congruent with value creation, such a measure is of little or no use.

Controllability
An important premise in any bonus plan is that there is a strict link between man-
agement's efforts and the performance measure bonus is based on. In other words,
management should be rewarded only to the extent that they have an impact on
firm performance. However, a variety of events cannot be 'controlled' by manage-
ment. Controllability ensures that managers will not become unmotivated having
their pay tied to things beyond their control. Terror, earth quakes, tax rates, inter-
est rates, political inference etc. are just a few examples of events that may affect
a firm's performance. A case in point is interest rates that are dependent upon a
number of macroeconomic factors beyond management's control. Or consider the
corporate tax rate which may change and have changed considerably over time
in most countries. How can this be controlled in a bonus contract? Who decides
which events are uncontrollable by management? Is it possible at all to separate
the (economic) effects from such events? These open questions indicate that the
effects of 'uncontrollable events' on bonus should be decided by the compensation
committee on a case by case basis.
By eliminating random factors beyond managers' control, managers' actions are
measured based on what they can control. Random factors may be removed by adjust-
ing the performance measure(s). However, this may be at the expense of simplicity and
introduce adverse effects.

Simplicity
Simplicity suggests that measures, which are simple as well as easy to understand,
manage and communicate, should be incorporated into a bonus contract.
 Measures actually used by firms, as for instance EBIT and net earnings, are simple
and easily understood measures. Such targets are easily tracked. Simple targets may
reinforce managers' focus and can be used by compensation committees and inves-
tors to monitor managers' actions and to identify their contribution to the success or
failure of the firm. Simplicity, therefore, has the potential to limit managers' discretion
and reduce the pay to performance gap.
However, overemphasising simplicity may misalign the interests of agent and prin-
cipal. For instance, simple performance measures like operating profit (EBIT) have
several flaws. Growth in EBIT, or similar accounting-based metrics, are not in itself
a guarantee of value creation. Also, such measures have a short-term focus and dis-
regard the long-term effects.

Accounting issues
Since reported figures may be a noisy measure of the true underlying performance
due to earnings management and/or the inclusion of 'special items', 'transitory items'
and the like, it may be argued that reported figures should be properly adjusted to
better reflect the 'true' performance. Therefore, in spite of the fact that the calcula-
tion of the financial performance measures (e.g. EBIT, ROIC) is fairly simple, such
performance measures raise a number of questions on which the decision makers
have to take a stance. For instance, should management be awarded or punished as
a consequence of:
(a) Transitory or special accounting items such as gains and losses from the sale of
fixed assets?
(b) Changes in accounting policies?
(c) Changes in accounting estimates?
Bonus plans that explicitly address the consequences of unusual items and changes
in accounting policies and estimates on earnings are considered to be of higher quality
than other contracts.

(a) Transitory accounting items

One dollar of earnings is valued differently by shareholders. Earnings generated from
the core business (permanent earnings) are regarded as more valuable than earnings
based on transitory items (i.e. the impact of changes in accounting principles and
unusual accounting items recognised as part of earnings). Examples of elements, which
are often labelled 'special items', 'transitory items' or the like, include gains and losses
from disposal of assets, restructuring charges, discontinued activities, etc. The treat-
ment of those items raises at least two questions in relation to compensation:
1 Should transitory items affect compensation?
2 Who decides what is considered a transitory item?
These issues are discussed below.

1 Should transitory items be included in performance measures?

If management are paid a cash bonus based on operating measures (e.g. EBIT), it
might be argued that 'special items' should be included at least to the extent they
are related to core operations. The problem is that it may have a positive NPV (net
present value), but a negative effect on this year's performance measure. For example,
 restructuring or reorganising a firm to better meet the challenge of changing market
conditions is clearly an ongoing part of running a business. However, as the following
examples illustrate, there is a need to consider these items on a case by case basis.

Example 12.1 Transitory item should be included in the performance measure

A group has sold its packaging division after an attractive offer from a competitor. The account-
ing profit amounts to €250 million. The board (and management) find that they have made
an excellent deal, as they believe that they will never be able to get a satisfactory return (that is
at least equal to the WACC) on the proceeds from the disposal of the packaging division. The
board estimates that the transaction has improved the value of the firm by €100 million. The
question is whether the €250 million should be recognised in the accounting measure that
bonus is based on. There is no doubt that the accounting profit of €250 million is a transitory
item. At the same time investors' real profit is less than €250 million (€100 million). However,
management has created value for the investors by selling off the packaging division. Thus,
the accounting-based performance measure used in a bonus contract should reflect the profit
from disposing of the packaging division. Alternatively, management might be awarded a
separate bonus for divestment of the packaging division. •

Example 12.2 Transitory item should not be included in the performance measure
There are, however, also transitory accounting items that should not be included in the per-
formance measure. A paint producer has just closed down a production line and accordingly
experienced a loss of €25 million due to restructuring costs. However, as the expected cost
savings are €15 million per year for the next 10 years the total effect is a positive NPV of
€67 million (assuming a WACC of 10%). If management does not close down the production
line, the owners will forego a profit of €67 million.
The issue here is also a horizon problem - management should act as to secure long-term
profitability of the firm. This can be obtained by measuring EBIT exclusive of transitory items
that have an effect on future years' performance. Another way to mitigate the horizon prob-
lem would be to award management a separate bonus based on the expected profit from
closing down the production line. Finally, the horizon problem may be overcome by using
multi-period performance measures. •

2 Who decides if an item is transitory?

A further complication is the question of who eventually decides whether an item
is 'transitory' or 'permanent' - the bonus committee or management. A solution to
this problem may be to list every transitory item in the bonus contract. However, it
seems a daunting task to imagine every possible transaction or event that might be
characterised as 'transitory'. Deciding what constitutes a transitory item on a case by
case basis is an alternative solution. This solution is also problematic for a number of
reasons. For example, it's bureaucratic, and against the principle of simplicity, since it
(potentially) leaves the bonus committee and management with an ongoing discussion
of which items are truly transitory. Therefore, it is difficult to provide a general recom-
mendation on transitory items.

(b) How should changes in accounting policies affect bonuses?

Changes in accounting policies may take place for several reasons. The question is
how such changes should be accounted for in bonus contracts. We address two types
of changes: mandatory changes and voluntary changes.
 Financial statement information shall contain relevant and reliable information and
give a 'true-and-fair-view' of a firm's earnings and financial position. This leaves room
for management's discretion. Voluntary changes in accounting practices (e.g. change
in its income recognition policy from the point of sale to the percentage of comple-
tion method) may have a significant effect on the reported numbers. Ideally, voluntary
changes should only affect bonuses if it improves accounting earnings as a measure of
'true' performance. If the changes distort the measurement of the 'true' underlying per-
formance of the firm, the changes should not affect bonus. At the least, the bonus con-
tract should include clauses that describe how voluntary changes should be accounted
for. Since earnings management can be used to increase the validity of earnings meas-
ures (by using proprietary information) or manipulate earnings (e.g. paint a rosy picture
of the firm), it is not a simple task to control for voluntary changes in a bonus contract.
A prominent example of mandatory changes in accounting policies is that all listed
companies within the EU must comply with the international financial reporting stand-
ards (IAS/IFRS) as of 1 January 2005. Changing from local regulation (e.g. UK GAAP)
to international standards had, in many cases, a significant effect on reported earn-
ings. For instance, as a result of the change from amortising goodwill over its useful
lifetime to an impairment test only approach companies with significant amounts rec-
ognised as goodwill experienced a substantial increase in reported earnings. A bonus
plan should include clauses that determine whether and how the bonus should be
affected by mandatory changes. For instance, the contract may determine that the
bonus plan shall be recalibrated in case of changes in accounting policies.

(c) How should changes in accounting estimates affect bonuses?

Accounting estimates may be changed for a variety of reasons. A few examples are:
• The estimated lifetime of depreciable assets change due to the emergence of new
technology
• The write-down of accounts receivables becomes much larger due to a financial crisis.
Should the bonus contract be renegotiated or recalibrated if accounting estimates
change? A bonus contract may have a clause that states whether changes in account-
ing estimates have a material effect on the performance measure, then the contract
shall be re-negotiated. This raises the obvious question. When is a change material?
If a contract has various clauses which call for recalibration or renegotiation, it may
be at the expense of simplicity. If, as a result of the change, the performance measure
becomes more in line with value creation, it could be argued that no recalibration of
the contract is needed. This raises the obvious question of how the bonus should be
affected in the period, where the estimates have been changed.
In summary, a well-designed bonus plan should make managers work in the best
interest of the owners. Bonuses should reflect managerial effort and performance,
while being simple to understand and communicate to the involved parties. A well-
designed bonus plan should also help retain managerial talent at a fair cost and prefer-
ably applicable to various market conditions and stages in a firm's lifecycle. Naturally,
no single measure of performance satisfies all four criteria. But this provides a useful
framework for understanding and designing bonus contracts and points to the fact
that it is essential to strike the right balance between the different characteristics, as
they may not be in agreement with each other.
These overall guidelines for designing a bonus contract are considered further, as
part of the discussion on the components of a bonus plan.
Components of a bonus plan
Executive bonus plans can be categorised in terms of three basic components: (1) choice
of performance measure(s), (2) choice of performance standards and (3) choice of
performance structure (see, for example, Murphy (2001)).
1 Choice of performance measure(s)
(a) Does it support the firm's strategy?
(b) How can it be avoided that management focus solely on short-term
performance?
(c) Should a bonus plan be based on one or multiple performance measures?
2 Choice of performance standards
(a) Should performance be based on internal or external standards?
(b) Should bonuses be based on reported earnings, budgets or some other meas-
ures, when internal standards are used?
(c) What are proper benchmarks for external standards?
(d) What are the pros and cons of internal and external standards?
(e) How and when should the performance standard be calibrated?
3 Choice of pay to performance structure
(a) Should bonus be linearly tied to performance without an upper/lower limit?
(b) Should bonus be non-linear with a minimum (floor) and a maximum (cap)?
(c) Should bonus be paid as a lump sum?
Essentially, this means that compensation committees at each level of organisational
responsibility should address these basic issues:
• What is the most appropriate measure of performance?
• What is the most appropriate benchmark of performance?
• How should bonus be linked to performance?
These issues are discussed in separate sections below. We believe that bonus commit-
tees and executives should consider these issues carefully when writing bonus con-
tracts. The issues listed above are often case specific, which makes it difficult to make
general recommendations. It is, however, our intention to pinpoint major problems
that parties involved in designing bonus contracts may use as a checklist when writing
bonus contracts.

Example 12.3 A bonus plan

To illustrate the above issues, consider this simplified example of a fictitious bonus plan. The
board of directors wishes to implement a bonus plan for the newly appointed CEO. The
firm is in a turnaround position and has experienced huge losses in the past. The board of
directors has a strong focus on improving operating performance. How could a bonus con-
tract be designed, which takes into consideration that the CEO should pay particular atten-
tion to operations? Here is a simple suggestion.

Performance measure
Since the CEO should focus on improving operations, the board of directors decides that EBIT
is a proper accounting-based performance measure. By linking bonus to EBIT, the CEO will
presumably focus on improving operating performance and pay less attention to how operat-
ing activities have been financed.
 Performance standard
Once EBIT has been chosen as the performance measure, a proper benchmark or threshold
must be decided. The strong focus on improving operating performance made the board of
directors choose projected EBIT (an internal standard) as the benchmark.

Performance structure
The board of directors decide that a lump sum of €0.8 million is paid in case that realised
EBIT is in excess of projected EBIT.

Accounting issues
The bonus contract states that in case of material changes in accounting policies or account-
ing estimates, EBIT shall be adjusted. •

Is this a well-designed accounting-based bonus plan? Think about this for a few min-
utes before reading on. We will get back to the example after a discussion on choice of
performance measures, performance standards, performance structure and accounting
issues.

Choice of performance measures

Choice of performance measures are critical since it has been empirically shown that 'you
get what you measure and reward', that is, managers take actions consistent with incentives
from those performance measures. Therefore, the performance measure should be tightly
correlated to firm value. The right performance measure should influence management
decisions and create incentives to pursue the right decisions. Performance measures may
be absolute measures ranging from the top line to the bottom line in the income state-
ment and a number of in-between measures such as gross profit, EBIT, EBITDA and EBT
Alternatively, performance measures may be relative measures including such metrics as
ROIC, ROE, EVA or benchmarking against a peer group.
Ideally, in an annual bonus plan the performance measure should reflect value created
during the year. This would require that the firm's value is estimated at the beginning of
the year and at year end. The difference between the two would be value created during
the period. Obviously, comparing an ex-post single-period performance measure such as
EBIT, ROIC, EVA etc. with a (forward looking) multi-period performance measure such
as shareholder value added (SVA) is not very useful. EBIT (etc.) and SVA serve two very
distinct and different purposes. While EBIT, and similar measures, are short-term per-
formance measures measuring last year's performance, SVA is multi-period performance
measure measuring the long-term earnings capacity of a company.
The distinction between EBIT etc. (labelled performance measure in the figure) and
SVA is highlighted in Figure 12.2.

Figure 12.2 Single-period versus multi-period performance measures

 The single-period accrual-based performance measure(s) are (partly) backward-
looking and measure value creation for short-term intervals. This is in contrast to
the cash-flow-based SVA concept, which is both forward looking, takes growth and
risk into consideration and measures value creation throughout a firm's lifetime.
Therefore, the cash-flow-based SVA concept will emerge as a superior performance
measure of earnings capacity in the long term compared to the accrual-based EBIT etc.
The choice of accounting-based performance measures raises some concerns.
Accounting-based performance measures provide management with incentives to
focus on short-term performance, which in the compensation literature is defined as
the 'horizon problem'. Value creation, however, is a long-term phenomenon. Looking
at a single year reveals little about the long-term cash-generating ability of a business.
Lengthening the performance measurement horizon reduces short-term bias. The hori-
zon issue is especially problematic if management is close to retirement or plan to quit.
Management, close to retiring or leaving office, may focus on short-term earnings by,
for example, postponing investments in R&D and marketing and avoiding restructur-
ing plans that affect current-year's earnings negatively, but has a positive effect on
earnings in future years. As a result, by initiating restructuring, executives may be
punished (accounting earnings are lower) even though restructuring is (presumably)
sound from an economic point of view.
A related issue is whether one or several measures should be used. Performance
measures are frequently incomplete or imperfect representations of the economic con-
sequences of the manager's action. Therefore, the choice of performance measure is
not obvious. To avoid that management focuses on short-term profit, one periodic
performance measures (e.g. net earnings) might be replaced by a multiple periodic
(financial) measure. The use of a bonus bank where bonuses are allocated over a
number of years may also mitigate the horizon problem. Finally, the bonus contract
may include several non-financial measures.
Feltham and Xie (1994) recommend the use of only one performance measure if,
and only if, the performance measure is perfectly congruent and noiseless. In other
cases, more than one performance measure is recommended. They suggest that
increasing the number of performance measures may, first, lead to a rise in the set
of workable actions, which may increase the likelihood that a more preferred action
will be implemented and, second, may reduce the risk imposed on the agent to make
a particular action. Essentially, a multi-dimensional performance measure system may
represent a more accurate definition of the organisation's goals.
On the other hand, it is recommended to use only one or a few simple measures in
a bonus plan. Using simple targets makes it easier for management to stay focused, for
investors or compensation committees to monitor managers' actions, and to identify
a manager's success in creating value. Simplicity, therefore, has the potential to limit
management discretion and reduce the pay to performance gap. In contrast, complex
measures or standards may make managers misallocate effort across tasks or over-
complicate the decision-making process. Complexity, therefore, may dilute manager's
incentives, encourage management discretion, and widen the pay-to-performance gap.
As many different accounting performance measures are used in compensation con-
tracts, we will move on to discuss the pros and cons of commonly used absolute per-
formance measures such as turnover, EBIT, net earnings and earnings per share (EPS).
In addition, we also examine the pros and cons of relative performance measures such
as return on invested capital (ROIC) and economic value added (EVA).
Absolute performance measures
Measures based on accounting numbers have some helpful characteristics that make
them useable in bonus plans and explain their prominent role in performance evalu-
ation and compensation. First, management should strive to increase earnings since
firm value depends on future earnings (eventually turned into cash flows) (criterion 1).
Second, earnings are generally controlled by management. All actions undertaken or
initiated by management affect earnings and top management is responsible for 'the
bottom line' (criterion 2). Third, earnings are simple measures already reported by
firms. Accounting data are easy to communicate and widely understood. By simply
studying interim reports or internal reports managers are consistently updated on how
their day-to-day actions affect profitability. Fourth, accounting data are verifiable and
subject to a variety of internal (internal audit) and external controls (external audit-
ing). Finally, they integrate the results of all organisational activities into a single logi-
cal measure.
However, absolute performance measures also have some disadvantages. It is impor-
tant to note at least four fundamental problems with accounting-based measures of
performance. First, earnings are single-period measures whereas economic value is
driven by the cash flows generated over the lifetime of the firm or asset. Second, even
over a single period earnings correspond poorly to cash flows, since they omit invest-
ments in working capital and non-current assets. By ignoring capital investments,
earnings do not include total cost required to produce earnings and therefore is not a
proper measure of value creation. Third, earnings do not account for risk. As a result,
reported earnings of similar size may be of different quality due to differences in risk.
Finally, accounting-based performance measures can easily be manipulated (earnings
management), questioning their effectiveness as objective measures of management
performance.

Net turnover
If growth is desired, for instance because a firm wants to penetrate new markets, turn-
over might be a relevant performance measure (i.e. management is rewarded based
on growth in turnover). The advantage of this measure is that it is unaffected by
classification of costs and capitalisation versus expensing of certain forward looking
expenses. It might even be argued that turnover is unaffected by accounting policies,
so that earnings management is not an issue. On the other hand, it could be argued
that accounting policies do matter. Approximately 40% of all accounting restatements
in the USA concern revenue recognition. Furthermore, turnover does not account for
costs, invested capital and risk. For instance, by acquiring a new company turnover
will increase 'automatically', when the two companies merge.

EBIT
EBIT is a highly relevant performance measure, as it measures the outcome of a firm's
core business (before tax) regardless of how the company has financed its activities.
However, it raises several issues including (but not limited to):
• Should R&D and other forward-looking costs (e.g. marketing costs) be expensed or
capitalised?
• How should transitory items be accounted for?
• How should changes in accounting estimates affect compensation?
 It is paramount for biotech and high tech firms to invest in R&D to become com-
mercially successful. For those firms recognising investments in R&D as expenses as
incurred may make it difficult for management to achieve their bonuses especially for
new firms, if they are based on earnings measures such as EBIT.
A further complication is the fact that EBIT only partially accounts for investments
(e.g. depreciation and amortisation are expensed). For instance, EBIT growth may
be obtained simply by raising additional share capital or increasing interest-bearing
debt and investing the proceeds in assets with a return below its cost of capital even
though this destroys value (negative NPV).

Net earnings
Net earnings as a performance measure has the advantage that it captures all income and
expenses no matter how these items are classified in the income statement. (It should be
noted though that some items (also labelled dirty surplus items) bypass the income state-
ment but are included in comprehensive income.) Nonetheless, it raises the same concerns
as listed under EBIT. In addition, the effects of capital structure and taxes come into play.
A firm may often have a policy of maintaining a certain capital structure leaving little dis-
cretion to management. On the other hand, if the capital structure is changed by issuing
new capital and repaying interest-bearing debt, earnings increase (cost of capital to the
owners is not shown as an expense in the income statement). Should this improvement
in earnings affect bonus? If not, how should it be accounted for in the bonus contract?
The corporate tax rate has declined considerably over time in most countries, which
has had a positive effect on net earnings. Management has no control over the devel-
opment in corporate tax rates questioning the wisdom of measuring performance on
an after-tax basis.

Earnings per share (EPS)

A popular measure of performance is EPS. This number is also reported consistently
in the business press. At first glance it looks like an excellent measure of performance.
Naturally, shareholders prefer to earn as much as possible for each share invested in a
company. If earnings per share increase, this should increase shareholder value.
However, EPS does not take into account risk, investments and time value of money.
In addition, EPS depends on applied accounting policies and does not consider the
opportunity cost of capital: if maximisation of EPS is the objective, then every invest-
ment pays, as long as it generates a return above the lending rate. In fact, in Chapter 6
we demonstrate that firms may be able to grow EPS, while firm value does not increase.

Relative performance measures

Relative performance measures make it possible to link bonus more directly to value
creation. EVA is a prime example. As illustrated in Chapter 9 on valuation, firm value
(enterprise value) can be expressed as invested capital plus the net present value of all
future EVAs. Therefore, EVA is directly linked to value (criterion 1). Other relative
measures include return on invested capital (ROIC) and return on equity (ROE).
Relative performance measures have the advantage of being self-correcting. For
example, an extension of the amortisation period for intangible assets results in a higher
EBIT (lower amortisation costs) but also in higher invested capital. Accordingly, both
the numerator and denominator increase. As another example, consider that leases are
reclassified as finance leases: part of the lease payment becomes financial expenses,
so EBIT improves compared to treating leases as operating leases. However, invested
capital also increases as a lease asset is recognised. In EVA calculations [(ROIC -
WAAC) × Invested capital] there are therefore two effects which tend to level each
other out. EBIT (or NOPAT) increases (the numerator in ROIC calculations), but so
does invested capital (the denominator in ROIC calculations). The exact impact on
ROIC, and EVA, depends on the terms in the lease contract such as the duration of the
contract, the lifetime of the leased assets and the implicit discount factor.
Using peer performance as a relative performance measure has the further advan-
tage that it protects management from common risk. For example, during a recession
firms within a given industry are all hurt the same way. For instance, firms selling con-
sumer durables (cyclical firms) are all likely to experience a huge decline in demands
for their products. By benchmarking against competitors, management may still be
able to earn a bonus even if performance is 'bad' (but 'good' compared to the indus-
try). This should help in retaining management even in bad times. Also, a bonus plan
based on benchmarking against peers is likely to be robust to various market condi-
tions in the sense that common risk factors are controlled for (criterion 2). No calibra-
tion of the bonus plan is necessary, since all firms in a peer group face common risk
and rewards (whether an upswing or downturn), so these factors are 'filtered-out'.
However, a comparison with a peer group requires that firms are comparable on
accounting policies and risk. If they are not adjustments need to be made. As discussed
extensively above such adjustments may not be easy to make and must most likely
be based on a number of assumptions. Thus the criterion of simplicity (criterion 3) is
hardly fulfilled.
More importantly, relative performance measures are single-period measures of
performance, and have the same inherent problems as other performance measures
that do not consider the long-term effects of management's actions.

ROIC and ROE

Financial ratios such as ROIC and ROE have the advantage that they are easily under-
stood. In comparison to absolute performance measures, they have an additional use-
ful feature: they account for investments (invested capital and shareholders' equity,
respectively), but these ratios are still single-period measures and fail to account for
risk, which is the cost of capital. By ignoring the cost of capital, accounting measures
fail to give an indication of the company's ability to create value. To take risk into
account ROIC and ROE may be measured net of cost of capital, which is equivalent
to measure EVA.
On the downside, in itself, ROIC and ROE are not reliable signals of value crea-
tion. First, returns are single-period earnings measures based on historical book val-
ues. Second, these ratios do not account for risk (cost of capital). The level of ROIC
and ROE must be compared to the proper cost of capital before it can be determined
if value has been created. Third, even if these factors are considered, the problem is
that ROIC and ROE measures investors return on book value of assets and equity,
respectively, while investors want a fair return on their investments measured at market
values. Obviously, book values and market values may differ significantly. For instance,
in a law firm the most valuable assets are the employees of the firm. The value of
employees is not recognised in the balance sheet. This makes it fairly easy for law firms
to obtain high returns on book value of assets, without necessarily earning a nice return
on the market value of the firm's true assets. Finally, accounting returns are prone to
accounting distortion just like absolute performance measures. It is also problematic
 that managers may choose not to initiate investments, which have positive net present
value, but reduces ROIC or ROE in the short term. Example 12.4 illustrates this point.

Example 12.4 A firm's ROIC is currently 15%, while WACC is assumed to be 10%. These figures tell us that
the firm's EVA is positive, so that managers create value. Invested capital amounts to 1,000.
Management faces a new business opportunity. They can invest 500 with an expected return
of 60; that is ROIC is 12% on the project. Should such a project be undertaken?
Assume that the risk of the project is on par with the risk of the company's existing projects;
that is WACC is 10%. Evidently since ROIC = 12% > WACC = 10%, value is created. What
happens to ROIC?
As demonstrated in Table 12.1, investment in the new project has a negative effect on
ROIC. The combined ROIC becomes 2/3 × 15% + 1/3 × 12% = 14%, a decrease of
exactly 1%. In conclusion, if managers are rewarded based on the level of or improvement in
ROIC or similar measures, they may choose to reject projects with positive NPV.

Table 12.1 The effect on ROIC when adding projects

Existing New Combined
project project projects
Invested capital 1,000 500 1,500
Return 150 60 210
ROIC 15% 2% 14%
•
EVA (Economic Value Added)
In its pure form, EVA seems to be the ideal performance measure. Economic profit
(economic value added) is not obtained until all capital providers have been compen-
sated. Therefore, unlike accounting measures of earnings, EVA measures economic
profit by reducing profit with the cost of debt and cost of equity. The popularity of
EVA as a performance measure is probably due to the alleged advantages of EVA
compared to other accounting-based performance measures (e.g. EBIT). Advantages
of EVA include:
• Consistent with value creation
• Motivates management to invest in projects with rates of return above the cost of
capital
• Cost of capital becomes visible for management
•Objective measurability ex-post
• General applicability (firm level, divisional level etc.)
• Simple to communicate.
EVA is claimed to be the best surrogate for or the predictor of future share price
performance; an increase in EVA should therefore result in an increase in firm value. As
illustrated in Chapter 9 on valuation, firm value equals invested capital plus the present
value of future EVAs. Therefore maximising EVAs is equivalent to the maximisation of
discounted cash flows and firm value. That is EVA is directly linked to value creation.
However, unlike DCF, which is inherently an ex-ante measure, EVA can be used as
an ex-post measure. This should lead to goal congruence between equity holders and
managers.
 Even though EVA from a theoretical point of view has its merits as a measure of a
firm's value creation (economic profit), it's not a perfect measure. First, it needs to be
recognised that EVA remains a historic income measure and does not anticipate future
earnings or losses. Second, EVA is prone to accounting distortion. In fact, the EVA
literature recommends a host of accounting adjustments (more than 150!) before cal-
culating EVA. For instance, EVA adjustments include capitalisation of certain expenses
(marketing costs and research and development costs), adding back of amortised good-
will, and adding deferred tax liabilities to equity. At best it is a daunting task to make
an assortment of adjustments so that EVA becomes an economic meaningful perform-
ance indicator.
To avoid this tedious task of adjustments, bonus may, alternatively, be based on
the change in EVA from year to year. In this case, a low (high) initial invested capital
due to, say, conservative (aggressive) accounting initially produces high (low) EVA
figures. A positive change in EVA, consequently, requires an even higher future level
of EVA, whether or not current EVA is low (aggressive accounting policies) or high
(conservative accounting policies). If you reward management for improving EVA, it
really doesn't matter what value you assign to the assets. This implies that rewarding
growth in EVA is not prone to accounting distortion.
Second, EVA does not take the horizon problem (single- vs multiple-period
performance measures) into consideration in the sense that it only considers the
effects of transactions on the current year's financial statements and cannot accu-
rately reflect the impact of decisions that may have implications over several peri-
ods. Restructuring costs, for example, have a negative effect on the current year's
EVA (unless these costs are capitalised in which case the effect is less) even though
future periods' EVA may improve, so that initiating restructuring costs has a posi-
tive effect on firm value (the project's NPV is positive). In fact, findings in extant
EVA literature question whether EVA is a better measure of value creation than
(various) earnings figures. For instance, Biddle et al. (1996) find that on average
EVA does not dominate earnings as a performance measure in explaining stock price
developments.
Furthermore, it can easily be shown that capital investment decisions that have a
positive net present value (NPV) and which should add value to the firm do not neces-
sarily yield positive accounting profits, return on investments or EVA in every period
of the project's life. The only way to ensure such an outcome would be to value the
assets (investment) at net present value of their expected cash flows. Although this is
acceptable in economic decision-making terms, it is not feasible from the viewpoint of
reporting performance, and as such measures would be overly subjective. For exam-
ple, a manager could improve reported performance merely by making slightly opti-
mistic estimates of the outcome of future events. Second, when multiple periods are
considered, historical earnings only represent the true growth in value of a business
if the assets it possesses are valued in terms of future expectations rather than histori-
cal costs. That is, GAAPs would have to be cast aside and assets valued at the NPV
of their future cash flows. At the very least, such an approach requires a great deal
of subjective judgement on the part of managers, and is therefore open to significant
manipulation.
In summary, accounting-based performance measures have the characteristics
shown in Table 12.2. Based on the table, the conclusion is fairly clear. Metrics such as
EVA and residual income, which aim at measuring economic profit, appear superior
to other accounting-based measures of performance.
Table 12.2 Characteristics of accounting-based performance measures
Criterion function Earnings measures Return measures Economic profit
(e.g. EBIT, net earnings) (e.g. ROIC, ROE) (e.g. EVA, Rl)
Congruence
Ability to account Low High High
for invested capital
Ability to account Low Low High
for risk Risk may be accounted EVA takes the cost of debt
for by comparing and the cost of equity into
ROIC and ROE to cost consideration
of capital, but this is
equivalent to measuring
economic profit (EVA, Rl)
Reliable signal of Low Low Medium
value creation EVA is a signal of value creation,
but projects with positive NPVs
may have negative EVAs in
some years
Controllability Medium Medium Medium
Management has control Management has control Management has control over
over everything that over everything that everything that enters the
enters the bottom line enters the bottom line bottom line but outside factors
but outside factors are but outside factors are are not controlled for (e.g. a
not controlled for (e.g. a not controlled for (e.g. recession)
recession) a recession)
Simplicity High High Medium to low
Easy to understand and Easy to understand and Generally easy to understand,
measure measure but adjustments and
Already reported by the Typically reported by the calculation of cost of capital
firm firm complicates the calculation of
economic profit
Requires a substantial
communication effort
No. of accounting High High High/Low
issues Prone to earnings Prone to earnings If absolute EVA is used,
management management accounting policies matter
Accounting for special Accounting for special a great deal
items is problematic items is problematic If change in EVA is used,
accounting policies and estimates
matter to a lesses extent

Choice of performance standards

After the performance measure(s) has been established, a threshold to gauge per-
formance against must be set. Murphy (2001) argues that bonuses in practice are
based on performance measured relative to a performance standard; i.e. a benchmark.
 Arguably, a high level of, say, turnover or EBIT does not in itself suggest that value is
created neither in the short term nor in the long term. For performance measures to
be useful there must be a standard of comparison, for example past performance or
performance of comparable firms or industries (peer-groups). Performance standards
typically correspond to 'expected performance' or, more precisely, the level of per-
formance required for a bonus to be earned, the so-called 'target bonus'.
Benchmarking may be based on two types of standards:
• Internal standards
• External standards.
These two types of standards are discussed below.

Internal standards
'Internally determined' standards are directly affected by management actions in the
current or prior year. Internal standards are standards where the performance meas-
ure is compared to an internal performance measure. 'Budget standards' include bonus
plans based on performance measured against the firm's projected performance. 'Prior-
year standards' is another example and include plans based on an improvement in real-
ised sales, operating earnings, net earnings, earnings per share (EPS) etc. from last year.
A third example of an internal standard is a comparison of realised earnings with the
cost of capital. For instance, EBIT (return on invested capital, ROIC) may be compared
to the weighted average cost of capital (WACC). Alternatively, net earnings (return on
equity, ROE) may be compared to investors' cost of capital. Furthermore, 'discretionary
standards' include plans where the performance targets are set subjectively by the board
of directors following a review of the company's business plan, prior-year performance,
projected performance, and a subjective evaluation of the difficulty in achieving pro-
jected performance. Finally, 'timeless standards' include plans measuring performance
relative to a fixed standard (such as an 8% return on assets, where the ' 8 % ' is constant
across years, or moves in a predetermined way independent of actual performance, say,
it must increase by 0.1% per year). This leaves the following five internal standards:

• Budget standards
• Prior-year standards
• Realised earnings versus cost of capital
• Discretionary standards
• Timeless standards.
A short discussion of these standards merits and demerits follow below.

Budget standards
Comparing performance to an approved budget seems to be a proper performance
standard. For instance, if market penetration is high on the agenda, turnover may
be the relevant performance measure. A measure for turnover could be the approved
budget effectively linking bonus to growth in turnover. Likewise, EBIT or other earn-
ings measures could be linked to budget.
There are many downsides of using budgets. First, if market conditions change
dramatically it may be difficult for management to reach budget target(s). Second,
performance standards cause problems whenever managers, whose performance are
measured relative to the standard, have an influence over the standard-setting process
as with budgets. This may encourage them to bias the budget downwards to make it
easier to beat the budget. Third, if management realise that budget cannot be reached,
they may engage in earnings management. If management performs well below budget
next year's budget may reflect past year's actual performance (which is poor due to
earnings management) making it easier for management to fulfil the budget next year.
Similarly, standards based on budgeted performance lead to earnings management,
since managers know that good current performance will be penalised in the next
period through an increased performance standard. This may make managers avoid
actions this year that might have an undesirable effect on next year's budget. Finally,
using budgets as a standard almost inevitably lead to discussions about performance
targets. This makes the budget process unnecessarily bureaucratic.

Prior-year standards
From a pure criterion of costs (cost-benefit analysis) associated with measuring per-
formance, standards based on past performance should be preferred since historical
performance data are easily available.
Past performance may, however, be a poor standard to gauge performance against.
Evidently, during an economic upturn past performance is easier to 'beat', while dur-
ing downturns it is hard or impossible for management to improve past performance.
A further pitfall of using prior years' performance as a benchmark is that management
may engage in earnings management. For example, if management realises that the
past year's performance cannot be beaten, they may be tempted to take a 'big bath'.
They do not receive a bonus anyway, but they increase the likelihood of obtaining a
bonus next year. This is due to the fact that this year's performance is going to be poor
(as a result of the 'big bath'), but also due to the fact that future expenses have been
recognised this year (another consequence of the 'big bath').

Realised earnings versus cost of capital

Essentially, these measures quantify value creation by calculating EVA. For example,
net earnings (return on equity, ROE) may be compared to investors' cost of capital
(required rate of return, re). If ROE > re, residual income is positive. Alternatively,
ROIC may be compared to WACC; if ROIC exceeds WACC, EVA is positive.
Therefore, using cost of capital as a benchmark introduces the same issues (benefits
and pitfalls) as using EVA or other measures of economic income.
A major problem in using cost of capital as a benchmark is that it has to be calcu-
lated. Investors' cost of capital (investors' required rate of return) is not known, and this
is also why investors' cost of capital is not recognised in the income statement. Cost of
capital must therefore be estimated. As discussed in Chapter 10 on cost of capital, cal-
culating cost of capital hinges on a number of assumptions and estimates. Also, ideally,
cost of capital should be calculated for each new project, if these projects have a risk
profile which is material different from the risk profile of a firm's remaining businesses.
A related issue is how cost of capital shall reflect changes in interest rates or other eco-
nomic conditions. For example, should WACC or investors' required rate of return be
adjusted to accommodate for changes in interest rates? Finally, using cost of capital as a
benchmark may trigger discussions among business units or divisions. Management of
such units would probably argue that they have a low cost of capital.

Discretionary standards
'Discretionary standards' have a great advantage. They are flexible and can be
altered to reflect various business and market conditions. During a financial crisis
 the performance target may be substantially lower than under a boom. If the board
wants to pursue a higher market share, albeit at the expense of lower current earnings,
they may reward management based on sales growth. The problem with discretionary
standards is that they are very subjective and may not be transparent for management;
i.e. it is difficult for management to identify the performance criteria.

Timeless standards
Timeless standards are not as easily influenced by the participants in the bonus plan,
which is a valid argument for using such standards.
However, even these standards are influenced to some degree, such as when
the timeless standards are initially set or the external peer group initially defined.
Furthermore, timeless standards may be disconnected to the real world due to changes
in a firm's risk profile or the level of interest rates.

External standards
External standards are standards that are defined in relation to elements outside the
firm and include benchmarking against competitors. 'Peer group' standards include
performance measured relative to other companies in the industry or market; often
a self-selected group of peer companies. Such performance measures include, but are
not limited to, sales, operating earnings, net earnings, ROIC, ROE or EVA. A ben-
efit of this comparison is that macroeconomic factors are 'evened out'. If ROIC, for
example, is at an all time high due to an economic upturn, competitors are also likely
to perform exceptionally well, effectively limiting the size of bonus. Murphy (2001)
finds support for the use of external standards. He finds that income smoothing is
prevalent in companies using internal standards (e.g. budget and last year's result),
but not in companies using external standards. This suggests that bonus plans based
on external standards better capture the value contribution of management.
Even though external standards have its merits, the use of such standards raises some
concerns. For instance, which firms can be regarded as truly comparable firms? Since
management (or bonus committees) has some discretion in picking the peer group,
there is a risk that firms which perform well below the industry norm are chosen.
Furthermore, using external standards hardly makes performance contracts simple
(criterion 3) and it may be costly to measure performance. The reason why contracts
based on benchmarking against peers are not simple is the fact that these peers shall
have the same risk profile and comparable accounting policies. If not, adjustments
need to be made. In addition, comparable firms are also likely to recognise income
and expenses, which should be regarded as transitory (and therefore excluded before
making the comparison). Who decides which items to classify as transitory? Taking
care of such items requires that peer group financials are properly adjusted making the
bonus contract costly and complicated. If the use of external standards becomes too
complicated, there is a risk that the incentive from the bonus plan vanishes. Ultimately,
it may result in a bonus plan that does not motivate the management.
In summary, internal and external standards have the characteristics shown in
Table 12.3. Based on the table it is difficult to recommend the use of one of the types
of standards at the expense of the other. Controllability seems to favour the use of
external standards, but they are not as simple to understand and communicate as
internal standards. Furthermore, differences in what is regarded as transitory items
and accounting practices need to be adjusted for.
Table 12.3 Characteristics of internal and external standards
Internal standards External standards
Congruence Medium Medium
Cost of capital is theoretically the right Beating competitors signals better
benchmark performance than in the industry
Estimation problems in calculating Beating competitors does not ensure
cost of capital value creation
Beating budget or last year's earnings
does not guarantee value creation
Controllability Medium High
Management is responsible for and Common non-controllable factors
controls everything that enters into are accounted for (e.g. interest rates,
the budget or last year's performance growth, inflation etc.)
Whether budget or last year's
performance is used certain market
factors are outside management control
Simplicity High Low
Budget or last year's earnings are The choice of peer group is
measures that are easy to understand problematic. For example, what if
and communicate the firm is a conglomerate?
No. of accounting issues Medium High
Management may bias budget Peer group financials may have to be
Prone to earnings management adjusted to account for differences
in transitory items and accounting
practices

Choice of pay to performance structure

An open question in designing bonus contracts is how bonus should be tied to per-
formance. For instance, should a bonus be linear in the sense that there is no upper or
lower limit to the size of the bonus or should it be non-linear with a cap and a floor, so
that bonuses are restricted to fall within a certain interval? The following represents
pay-to-performance structure contracts:
1 Linearity between performance and bonus.
2 Non-linearity with a minimum and a maximum bonus.
3 A lump sum bonus.
These issues are discussed below.

Linearity between performance and bonus

At first glance, linearity seems to be the proper way to link bonus to performance.
The better the performance (in whatever way it's measured), the higher the awarded
compensation. In fact, extant literature suggests that the pay-to-performance struc-
ture should be linear since it mitigates the incentive to manage the performance
measure. Figure 12.3 illustrates a simple pay-off profile. Based on this figure there
is no upper limit to the bonus that management may be rewarded. But the plan also
 Figure 12.3 A simple pay-off profile

dictates that if performance falls well short of target performance (negative bonus),
management may have to pay back their salaries in part or in full. For example, in
Figure 12.3 the actual bonus would be negative. It is highly unlikely that anyone
would enter such a contract.
In addition, compensation committees must consider issues such as: Is it reasonable
that compensation may be exorbitant if performance is excellent due to a bull market?
What if the performance is excellent, but the main competitors are performing even
better? What if the company has negative earnings? Does this imply that bonus should
be negative? In this case should the negative bonus be off-set against future positive
bonuses (bonus bank)? If so would it be at the expense of increased retention risk?

Non-linearity
Another possibility is to limit the bonus to a certain range (floor and cap), so that it
is capped. In between the minimum and maximum bonus, the correlation between
performance and bonus is linear (but could in principle be concave, convex or any
other form). The advantage of such a method is that it regulates a non-perfect bonus
contract (criteria 1, 2 and 4), while it should still be possible to pay a competitive sal-
ary, if the bonus contract is properly calibrated. For instance, during a boom perform-
ance may be excellent due to an extraordinary high demand for the firm's products. By
capping the bonus it does not become exorbitant due to factors outside management's
control. Also, these thresholds (floor and cap) do help to avoid certain undesirable
behaviours (exploitation of the system in the short term) but also encourage others
(smoothing of performance from one year to the next), as described shortly.
To illustrate a non-linear pay-to-performance structure, consider Figure 12.4. Under
a typical plan, no bonus is paid until a threshold performance (usually expressed as a
percentage of the performance standard) is achieved, and a 'minimum bonus' (usually
Figure 12.4 Pay-to-performance structure

expressed as a percentage of the target bonus) is paid at the threshold performance.

Target bonuses are paid for achieving the performance standard, and there is typically
a 'cap' on bonuses paid (again expressed as a percentage or multiple of the target
bonus). The range between the threshold (floor) and cap is labelled the 'incentive
zone', indicating the range of performance achievement where marginal improvement
in performance corresponds to marginal improvement in bonuses. In summary, a typi-
cal bonus plan with a cap and a floor has these elements:
1 A target bonus plan for achieving target financial performance, for example pro-
jected operating profit.
2 A threshold level of performance that must be attained before any bonus is earned
(floor).
3 A cap on the bonus payout.
Since bonuses are based on cumulative annual performance (e.g. EBIT, budget realisa-
tion), and since managers can revise their daily effort and investment decisions based
on assessments of year-to-date performance, the non-linearities in the typical bonus
plan cause predictable incentive problems. Non-linear bonus plans provide the execu-
tives with an incentive to manage earnings. In particular, if year-to-date performance
suggests that annual performance will exceed that required to achieve the bonus cap,
as depicted by 'B' in Figure 12.4, managers will withhold effort and will attempt to
'inventory' earnings for use in a subsequent year (Healy 1985).
If, on the other hand, year-to-date performance suggests that performance will
be far below the floor, depicted by 'A' in Figure 12.4, management may be tempted
to take a 'big bath' (e.g. make too large provisions for restructuring, depreciate and
amortise assets too quickly etc. in order to improve future profitability). Since man-
agers have no incentive to work hard they may even plan to reduce the performance
further, in order to lower the budget standard (or any other benchmark used in the
bonus plan) in the following year. Research documents that floors and caps on bonus
contracts provide incentives to shift reported earnings between periods (Healy 1985).
 Finally, when expected performance is moderately below the incentive zone, the dis-
continuity in bonus payments at threshold yields strong incentives to achieve the perform-
ance threshold (through counterproductive earnings manipulation as well as through
hard work), because the pay-performance slope at the threshold is effectively infinite.

Lump sum
Alternatively, bonus may be paid out as a lump sum, if management are able to per-
form as stipulated in the bonus contract. It is critical in this respect that if executives
during the year find it hard to reach their target, they may not be motivated to work
in the best interest of the company's owners. When it becomes obvious that the year-
to-date performance suggests that annual performance will exceed that required to
achieve the maximum bonus, managers may withhold effort and try to store earnings
for use in subsequent years, for example by delaying sales efforts, incurring restructur-
ing expenses that could have waited until next year, investing heavily in R&D projects
at year end or recognising impairment losses by using conservative estimates. Lump
sum bonuses thus have the same problems as non-linear bonus plans.
In summary, the pay-to-performance structure has the characteristics outlined in
Table 12.4. Does the summary in the table suggest that a bonus contract should be
capped (non-linear) or uncapped (linear)? Congruence favours linearity since manage-
ment should keep up the good work even if performance is above target and there is
little risk of earnings management since there is no need to keep performance within a
band (cap and floor). Simplicity and accounting issues also seem to point to the use of
linearity in the bonus contract. Controllability issues seem to favour a non-linear bonus
plan. Furthermore, imperfect bonus plans suggest that bonus should be capped.

Table 12.4 Characteristics of the pay-to-performance structure

Linearity Non-linearity (cap/floor)
Congruence High Medium
High management effort as bonus is not Regulates an imperfect contract
capped Low management effort if
Little risk of earnings management as performance is above/below
bonus is not capped even if performance is threshold
extremely high Risk of gaming/earnings
Poor performance is penalised management
Does not have a 'mechanism' that reduces Poor performance is not
the impact of imperfect bonus plans penalised
Controllability Medium Medium/high
Bonus may be too high (low) due to Regulates a non-perfect
uncontrollable events contract
Simplicity High Low
Direct link between performance and bonus Setting floor/cap is tedious and
prone to distortion
No. of accounting Medium/Low High
issues No earnings management Risk of earnings management
Risk that transitory items are not effectively
eliminated making bonus too high/low
 EVA-based bonus contract - a feasible solution
to accounting-based performance measures
Before discussing EVA as a performance measure let us revisit Example 12.3 (p. 306).
While the contract outlined in the beginning of the chapter may seem reasonable it
opens a number of issues including:
• EBIT does not take invested capital or risk into consideration.
• The CEO may be able to bias target performance (projected EBIT).
• The CEO is rewarded and punished for factors outside his or her control (business
conditions, inflation, etc.).
• The CEO may engage in earnings management if there is a risk that realised earn-
ings become far in excess of or far below forecast EBIT.
• The contract does not consider the effects of special items or changes in accounting
policies and estimates.
In summary, it is not as good a bonus contract as initially believed. It is easy to under-
stand and communicate but has several shortcomings including a lack of alignment of
the interests of management and owners.
As discussed above EVA-based bonus plans, while not perfect, are commonly used
and probably a reasonable bet if accounting-based performance measures are to be
used in bonus plans. EVA bonus plans come in many flavours. We do not intend to
illustrate all of them, but concentrate on two of the popular ones named the xy plan
and the modern bonus plan, respectively.

The xy plan
In the xy plan bonus consists of two components. A bonus calculated as a percentage
of the change in EVA during a financial year (x component), no matter whether the
bonus becomes negative or positive, and an additional bonus calculated as a percent-
age of actual EVA, but only if EVA is positive (y component). We have illustrated the
xy plan by using a simple example.

Example 12.4 An illustration of an xy plan

Bonus = x% × change in EVA + y% × EVA

x = A percentage change in EVA, no matter whether the change is positive or
negative
y = A percentage of EVA, if EVA is positive, and 0% if EVA is negative

Assume that x is 10% and y is 5%. Bonus over a 5-year period may be calculated as shown
in Table 12.5. If managers improve EVA, there is an immediate reward (bonus) coming from
the first term. This is the case even if EVA is negative. Therefore, even during bad times or
following a recession, management may be awarded a bonus if they can improve profitability
(a positive change in EVA) even if EVA has still not become positive. EVA improvement goals
give incentives to restructure the company without discouraging the manager. They repre-
sent the achievable improvements.
Table 12.5 xy bonus plan
Year1 Year 2 Year 3 Year 4 Year 5
EVA last year 10.0 12.0 15.0 10.0 -10.0
EVA this year 12.0 15.0 10.0 -10.0 31.0
Change in EVA 2.0 3.0 -0.5 -20.0 41.0

x: 10% × ΔEVA 0.2 0.3 -0.5 -2.0 4.1

y: 5% × EVA 0.6 0.8 0.5 0.0 1.6
Total bonus 0.8 1.1 0.0 -2.0 5.7

The second term ensures that management is compensated for sustaining EVA. For
instance, in year 2 the reward from y becomes 0.75 (rounded to 0.8 in Table 12.5) due to
the level of EVA. The above contract rewards both the level of and development in EVA over
time. Of course, if EVA falls, there is also an immediate and sustained penalty, as the bonus
becomes negative. It is unlikely that management in that case is willing to forgo (or pay back)
base salary. To overcome this problem a bonus bank may be used as discussed below.
As long as EVA is negative y is zero. In this case, x should make managers concentrate all
their effort on improving business performance, since they can only obtain their bonus based
on a positive change in EVA and not on the level of EVA. In practice, x and y are set in accord-
ance with the fundamentals of the business and the target levels of compensation for the
participating managers. •

The implementation of bonus contracts may require the use of a 'bonus bank'
(deferred compensation as further illustrated below) to take account of 'negative
bonuses' and to create long-term incentives (extending managerial horizon). Banking
strikes the optimal balance between short-term and long-term goals of the firm. For
instance, in year 4 (see Table 12.5) total bonus would be negative ( - 2.0) without
a bonus bank. This would mean that managers had to repay bonuses (or salaries)
earned in the past. Not a very feasible solution in practice.
A bonus bank separates the calculation of the bonus from its actual payment. The
basic idea is that bonuses are not being paid in full unless a satisfactory performance is
obtained in subsequent years. While bonuses are calculated for each period (typically
a year), the bonus bank levels the bonus out in accordance with the time frame used in
the bonus bank (e.g. every year, one-third of the accumulated bonuses will be paid if
the bank functions on a three-year basis). Table 12.6 illustrates this mechanism.

Table 12.6 An example of a bonus bank

Year1 Year 2 Year 3 Year 4 Year 5 Total
Bank beginning of period 100.0 80.0 80.0 60.0 60.0 100.0
Bonus earned 20.0 40.0 10.0 30.0 0.0 100.0
Available for payout 120.0 120.0 90.0 90.0 60.0 200.0
Payout (ratio one-third) 40.0 40.0 30.0 30.0 20.0 160.0
Bank end of period 80.0 80.0 60.0 60.0 40.0 40.0
 Before any bonus is paid out, the bonus must pass through a bank account that
starts with an opening balance, which in this case is 100. The initial credit in the
bank corresponds to a fictitious amount granted to management and subsequently
to accumulated funds not yet paid. Without an opening balance, a negative bonus
in year 1 would mean that the bank was underfunded. This opening balance may
arise in three different ways. First, it may just be part of the formula that deter-
mines the bonus, but is unfunded (i.e. no money is deposited in the bank account).
Second, it may be contributed by managers who participate in the bonus plan and
put at risk, essentially meaning that they could lose the 100 just as investors can
lose their entire investment. Finally, the firm may loan the 100 to the managers'
bank account subject to amortisation over, say, 5 years. Then in each of the first 5
years of the bonus plan, 20 of the bonus amount that would otherwise be paid are
retained to pay off the loan of 100. By the end of year 5, 100 of equity will have
accumulated in the bank account to replace the debt. This is basically equivalent to
a leveraged buyout.
In each year, the bonus available for payout is calculated as the opening balance
plus the bonus earned during the year. In the illustrative plan in Table 12.6 one-third
is paid out and the remaining is banked forward. For example, in year 1 the total
amount available for payout was 120 consisting of 100 (the opening balance) plus 20
(bonus earned during the year). With a payout ratio of one-third, managers are paid
40 leaving 80 in the bank account. This procedure continues in the following year and
so on. The idea behind the bonus bank is multi-stringed:
• Smoothing of bonus payments (less fluctuation in strongly volatile industries)
• Bonus is based on long-term value creation since profits out of a project are not
paid out immediately and can be offset by negative profits in later periods
• Good performance is rewarded
• Bad performance is penalised.
The banking of the bonus helps to align the interests between agent and principal in
the long term. Suppose that management may perform according to target ('target
year'), overperform ('good year') or underperform ('bad year'). These three scenarios
are illustrated in Table 12.7.

Table 12.7 Bonus bank: different scenarios

Target year Good year Bad year
Bank beginning of period 100.0 100.0 100.0
Bonus earned 25.0 100.0 -50.0
Available for payout 125.0 200.0 50.0
Bonus paid (ratio one-third) 41.7 66.7 16.7
Bank end of period 83.3 133.3 33.3

As is evident, bonus paid and the balance on the bank account is vastly differ-
ent depending upon the performance. For example, in a bad year bonus is still being
paid, since the bank balance before payout is still positive, but lower due to the nega-
tive bonus earned. This is equivalent to shareholders experiencing capital losses.
Furthermore, actual bonus paid (16.7) is much lower than under a 'normal year'
 (target year). Again, a comparison to shareholders' returns in a bad year can be made.
The lower bonus payout mimics a cut in dividends.
Good calibration of a bonus system is obviously a determining factor. Successive
mediocre performance results can stem from a recession affecting all firms in an indus-
try, so that managers running the firm are not to blame. That is why such contracts
often include discretionary exit clauses, to prevent the relevant managers from leav-
ing. Managers who leave the firm on their own will not necessarily be paid the accu-
mulated amounts in their bank account. Broadly speaking a bonus bank is similar to
having some accumulated stocks in the company and receiving some dividends related
to performance.

The modern EVA bonus plan

More recently the xy bonus plan has been modified, leaving the following modern
EVA bonus plan (or so it is called in the literature). According to the plan, bonus
consists of a target bonus paid if a predetermined target is obtained plus an additional
bonus for improvement in EVA in excess of an expected increase in EVA:

In this plan, the performance measure is excess EVA improvement. There are several
reasons for the popularity of this plan. For instance, EVA improvement is a meas-
ure that applies to all companies, not just companies with positive EVA. Also, EVA
improvements provide a more direct link to excess returns, the ultimate measure of
wealth creation. Whenever a company's market value includes the value of future
growth (and not just the value of current operations), EVA improvements are neces-
sary for a firm's investors to earn a cost-of-capital return. The bonus earned is the
sum of a target bonus plus a fixed percentage of EVA improvement, which can be
positive or negative.
A target bonus is necessary to make the bonus plan consistent with the labour mar-
ket practice of paying a substantial bonus for normal or expected performance, thus
limiting retention risk. The bonus earned can be negative and is uncapped on both
the upside and downside. In addition, the bonus earned is credited to a bonus bank,
and the bonus bank balance, rather than the current year bonus earned, determines
the bonus paid. Typically, the payout rule for the bonus bank is 100% of the bonus
bank balance (if positive), up to the amount of the target bonus, plus one-third of the
bank balance in excess of the target bonus. When the bonus bank balance is negative,
no bonus is paid. Table 12.8 illustrates how it works.
In years 1 and 2 management has been able to obtain at least 'expected EVA
improvement' and are therefore rewarded their target bonus plus a bonus of 2% of
excess EVA improvement. In year 2 management has exactly performed according
to target (an expected EVA improvement of 50) and hence receive their target bonus
of 2.0, but no bonus for excess EVA improvement. Without a bonus bank, manage-
ment should repay 2.0 in year 3 and 1.0 in year 4. This is one of the reasons why a
Table 12.8 Modern bonus plan
Year1 Year 2 Year 3 Year 4 Year 5 Total
EVA last year -250.0 -150.0 -100.0 -150.0 -150.0 -250.0
EVA this year -150.0 -100.0 -150.0 -150.0 0.0 0.0
EVA improvement (ΔEVA) 100.0 50.0 -50.0 0.0 150.0 250.0
Expected EVA improvement (El) 50.0 50.0 50.0 50.0 50.0 250.0
Excess EVA improvement ΔEVA - El 50.0 0.0 -100.0 -50.0 100.0 0.0

Target bonus (A) 2.0 2.0 0.0 0.0 2.0 6.0

2% of (ΔEVA - EI)(B) 1.0 0.0 -2.0 -1.0 2.0 0.0

Total bonus (A) + (B) 3.0 2.0 -2.0 -1.0 4.0 6.0

bonus bank enjoys popularity. It's hardly likely that management would accept to be
charged for a negative bonus. In fact, they would probably leave office before year-
end. Depending upon the contract, this might end up as a battle in court.
Total bonus over the 5-year period amounts to 6.0 and consists of target bonus of
6 (target is achieved in three out of five years) and a bonus of 0, as EVA has improved
by 250 over the 5-year period, which exactly offsets expected improvements of 250.
However, in year 3 and year 4, EVA improvement is less than expected, so that the 'y
component' becomes negative, which means that management must pay in some way
or another. Here the bonus bank comes into play. If bonuses calculated in Table 12.8
are being 'banked', the bonus bank may look as shown in Table 12.9, which highlights
a number of issues in bonus banks:
• Should the bonus bank have a starting balance to avoid its depletion in year 1 ?
• What happens if the bonus bank becomes negative?
• Should the balance in bonus bank be paid out to managers who leave?
These issues should be carefully considered if a bonus bank is introduced in a bonus
contract.

Table 12.9 Bonus bank

Year 1 Year 2 Year 3 Year 4 Year 5 Total

Bank beginning of period 0.0 0.7 0.4 -1.6 -2.6 0.0
Target bonus 2.0 2.0 0.0 0.0 2.0 6.0
Bonus for excess EVA improvement 1.0 0.0 -2.0 -1.0 2.0 0.0
Available for payout 3.0 2.7 -1.6 -2.6 1.4 6.0
Payout 1 2.3 2.2 0.0 0.0 1.4 6.0
Bank end of period 0.7 0.4 -1.6 -2.6 0.0 0.0
1
Payout is calculated as target bonus + one-third of remaining bank balance
Conclusions
When designing bonus contracts the parties involved should pay close attention to the
choice of performance measure(s), performance standard and performance structure.
In choosing performance measure, standard and structure, the compensation commit-
tee and managers should consider the following issues:
• Does the contract align the interest of management and investors (congruence)?
• Can management control the performance measure that bonus is based on
(controllability)?
• Is the bonus contract easy to understand and communicate (simplicity)?
• What are the accounting issues that need to be considered in a bonus contract?
While we discuss design issues in preparing bonus contracts, we do not provide
clear-cut answers as how to control for all these issues. In fact, we raise a number of
questions that bonus committees as a minimum should consider when writing bonus
contracts. We hope that a thorough discussion of those issues prior to writing bonus
contracts may prevent intense interpretations once the contract has been issued. It all
adds up to establishing a bonus contract that aligns the interest of management and
owners.

Review questions
• Which performance measures can be used in bonus plans?
• What characterises an effective bonus plan?
• What are the components of a bonus plan?
• What are absolute performance measures?
• What are relative performance measures?
• How should transitory items be treated in a bonus plan?
• How should changes in accounting policies or estimates be treated in a bonus plan?
• What are the pros and cons of accounting-based performance measures such as EBIT,
EBITDA, net earnings etc.
• Is economic value added (EVA) a perfect performance measure?
• What are internal performance standards?
• What are external performance standards?
• What are the issues in linearity between performance and bonuses?
• What is a bonus bank?

Note 1 It should be pointed out that during a boom, value creation may have taken place even if
management did a poor job. That is value is not necessarily created by excellent management.
References Biddle, G., R.M. Bown and J.S. Wallace (1996) 'Evidence on the relative and incremental infor-
mation content of EVA, residual income, earnings and operating cash flow', Working paper,
University of Washington, Seattle, WA.
Feltham, G.A. and J. Xie (1994) 'Performance measure congruity and diversity in multi-task
principal/agent relations', Accounting Review, 69.
Healy, P. (1985) 'The effect of bonus schemes on accounting decisions', Journal of Accounting
and Economics, 7, 85-107.
Murphy, K. (2001) 'Performance standards in executive contracts', Journal of Accounting and
Economics, 30, 245-78.
 PART 4

Assessment of accounting data

Introduction to Part 4
13 Accounting quality
14 Accounting flexibility in the income statement
15 Accounting flexibility in the balance sheet
 Introduction to Part 4

In this book, we have not so far challenged the quality of accounting. Accounting data
has been used uncritically to calculate financial ratios, and ultimately shed light on a
firm's growth, profitability and risk.
In the following three chapters, the focus is directed towards the quality of account-
ing data. As will become evident during these chapters, definition, recognition,
measurement and classification of accounting items are associated with a number of
accounting policy choices, estimates and judgements that open up for possible manip-
ulation of reported accounting numbers. Even in those cases where management does
not intend to manage reported accounting numbers, noise in financial data may be
inevitable. This will be the case if, for instance, a firm must change accounting poli-
cies due to new or revised reporting regulations. This makes it difficult to separate the
consequences of changes in applied accounting policies and real changes in a firm's
underlying operations, which is problematic in making time-series analyses or bench-
marking against competitors. The point to remember is: The annual report should not
be used uncritical in calculating financial ratios etc.
In order to assess accounting quality the following issues should be kept in mind:
1 Several different accounting regimes (including IFRS and US GAAP) exist.
2 Even within a given accounting regime (e.g. IFRS) some flexibility is inherent.
3 The number of estimates to be made by management has increased due to the
extended use of fair value as a measurement basis.
A short discussion of these issues is provided below.

Different accounting regimes

Generally, a proper financial statement analysis requires that a firm uses the same
accounting policies over time (time-series analysis) or that firms which are compared
have identical accounting policies (cross-sectional analysis). This may not always be
the case. For instance, if a firm in the UK is compared to a US firm, these two firms
prepare financial statements based on IFRS and US GAAP, respectively.
In addition, the discretion that management may exert varies considerably within
different accounting regimes. The conjecture is that the two major accounting regimes -
IFRS and US GAAP - are fundamentally different. It is acknowledged that there is an
ongoing convergence project, which aims at aligning IFRS with US GAAP. US GAAP
is believed to be rule-based, while IFRS standards are principle based. The key point
to remember is that, as an analyst, you must be aware of the fact that management
exercises judgements and makes a number of estimates in preparing financial state-
ments. As a consequence, managers may behave either opportunistically (use earnings
 management to manipulate earnings) or provide highly relevant data by reporting
financial data, which takes into account management's proprietary knowledge about
the company as an insider.

Flexibility within accounting regimes

Even within the same accounting regime, firms may not be comparable. Listed firms
in the EU, for example, must comply with IFRS, while non-listed firms generally have
to comply with domestic accounting regulation (e.g. UK GAAP). For example, this
makes a comparison between two UK-based firms problematic since the financial
statements for the two firms may be based on different accounting regulation.

Increasing number of estimates made by management

In preparing financial statements, management need to make a number of estimates.
Typical examples include estimation of the useful life of depreciable assets and uncol-
lectable receivables. In recent years, fair value measurement has become more preva-
lent. This requires further estimates to be made. A prime example is impairment tests.
Management needs to estimate future cash flows and the cost of capital to calculate
if, say machinery, is impaired (i.e. the carrying amount of machinery is greater than its
value in use). As is well known (see Chapters 8-10), estimating cash flows and cost of
capital is a daunting task.

While this book is not about accounting regulation per se, accounting quality plays a
major role in any financial statement analysis. Assessing accounting quality is at the
heart of financial analysis and will be discussed fully in this part of the book.
Chapter 13 defines the concept of accounting quality. The purpose of the chapter is
to provide insight into issues which should be examined in order to assess the quality
of accounting numbers. In Chapters 14 and 15 financial statements are discussed in
order to identify possible sources of noise in annual reports due to accounting flexibil-
ity. The chapters include a lengthy discussion and analysis of analytical issues related
to definition, recognition, measurement and classification of accounting items and
discuss potential economic consequences of inherent accounting flexibility in financial
statements.
 CHAPTER 13

Accounting quality

Learning outcomes
After reading this chapter you should be able to:
• Define and understand the concept of accounting quality
• Identify the steps involved in examining the accounting quality
• Understand the motives for accounting manipulation
• Assess the quality of applied accounting policies
• Discuss the importance of separating transitory from permanent items
• Evaluate the quality of information in the annual report
• Identify red flags
• Discuss and analyse the economic consequences of differences in applied
accounting policies

Accounting quality

W hat do firms such as Enron, Tyco, Qwest International, Xerox, Waste

Management HIH, World Com and Parmalet have in common?
They are all being accused of manipulating financial statements to make themselves
look healthier than they really are. Accounting quality in these firms is viewed by ana-
lysts as poor, and in many cases management has been sued for manipulating reported
accounting numbers.
In this book reported accounting numbers have so far been used as reported.
However, as the statement above indicates, it is important to examine the quality
of reported accounting numbers. Accounting quality is a central concept in finan-
cial statement analysis. In practice, reported accounting numbers, which are used in
calculating financial ratios, should be adjusted to make them comparable over time
or across firms. This ensures that changes in financial ratios reflect changes in a
firm's underlying operations and financial position and not changes or differences in
accounting policies. A number of issues may cause noise in accounting numbers:
• Application of accounting policies
• Accounting estimates
• Classification of accounting items
• Accounting items or events which are regarded as permanent versus transitory.
This chapter defines good accounting quality and elaborates on the reasons why firms
over time and across firms may not be comparable. Chapters 14 and 15 focus on
 analytical issues and economic consequences of reported financial data in order to
identify items that are likely to become sources of noise in carrying out financial state-
ment analysis.

Definition of good accounting quality

There is no universal definition of good accounting quality in the literature or among
practitioners. Naser (1993, p. 59) speaks about the concept accounting quality by
defining creative accounting as:
The process of manipulating accounting figures by taking advantage of the loop-
holes in accounting rules and the choices of measurement and disclosure practices
in them to transform financial statements from what they should be, to what pre-
parers would prefer to see reported, and the process by which transactions are
structured so as to produce the required accounting results rather than reporting
transactions in a neutral and consistent way.
This definition of creative accounting suggests that good accounting quality is char-
acterised by financial statements that provide an objective (neutral) picture of a firm's
financial position and is free of manipulation.
Among analysts, earnings quality is sometimes used as an indicator of the quality
of financial statements. For example, Penman (2010) defines earnings quality in this
way:
Quality of earnings is the degree to which current earnings serves as an indicator of
future earnings.
In Penman's definition of earnings quality, permanent (recurring) accounting items are
characterised as having high quality. Transitory items (e.g. one-time items or 'special
items' which are not permanent accounting items) are considered of lower quality.
Compared to Penman's narrow definition, this book has a broader perspective on
accounting quality. In our view, the analyst must keep in mind the purpose of the
analysis and the decision model applied before assessing accounting quality. As illus-
trated in previous chapters, different stakeholders use a variety of decision models
and will therefore also require different types of accounting information and data. To
demonstrate our viewpoint, consider an analyst who wants to value a firm based on a
present value model (e.g. the EVA model). In that case, an analysis of historical earn-
ings is used as input to forecasting the level and trend of future earnings. The analysts
will therefore regard accounting quality as the extent to which past earnings is a good
indicator of future earnings (Penman's definition). In addition, the analyst might find
helpful information by studying management's review and discussion. For instance,
how does management see the future? Has management been able to perform as pre-
dicted in their outlook? Even though such information is not necessarily quantitative,
they may supplement financial data when assessing a firm's prospects.
Now look at accounting from a lender's perspective. Lenders are interested in assess-
ing the liquidity and solvency of a firm. Lenders need to examine whether the firm has
debt or potential debt, which is not recognised in the balance sheet, and which requires
future cash outflows. To examine whether a firm has such debt, lenders need to look
at a firm's accounting policies and read the notes carefully. Or consider a worst case
scenario, a liquidation of the firm. In this case good accounting quality would be if all
assets and liabilities were recognised in the balance sheet at liquidation value since the
firm's ability to repay debt would depend upon the net proceeds from selling the assets
and settling the liabilities. Again, lenders need to read the section on accounting poli-
cies carefully to find out how assets and liabilities are measured (valued).
Executive compensation may be linked to various accounting-based performance
measures. Since some items may be transitory in nature and outside management's
control, performance measures used in bonus contracts should probably exclude such
items. In respect to executive compensation good accounting quality is characterised
by financial statements, which clearly distinguish between permanent and transitory
accounting items.
In summary, an assessment of accounting quality requires a thorough investigation
of financial statements, applied accounting policies and notes, management's discus-
sion and supplementary reports. It is rarely sufficient just to examine the financial
statements. The above considerations are illustrated in Figure 13.1. Based on the
above discussion, our book defines accounting quality as follows:
Good accounting quality is defined as the financial reporting that provides the
input which best supports the decision models used.
An annual report that provides accounting information which enables users to make
rational economic decisions is regarded as having high quality.

Figure 13.1 Structure for assessing good accounting quality

 The purpose of financial statement analysis
and good accounting quality
As illustrated in the previous section, the purpose of financial statement analysis will
affect the type of accounting information that users demand. In fact, the assessment of
accounting quality cannot be made without knowing the type of accounting user. In
this section, good accounting quality is discussed based on three different accounting
users: equity focused accounting users such as financial analysts, corporate finance
employees and investors, debt capital focused accounting users including lenders, sup-
pliers and customers and compensation focused accounting users such as the board of
directors, compensation committees and consultants.

Equity oriented stakeholders

Equity focused stakeholders need to estimate firm value. In Chapter 9, we discussed
the following valuation methods (decision models):
• Present value method
• Multiples
• Liquidation method.
These decision models are discussed below.

Present value method

The present value method includes an array of models. One such model is the eco-
nomic value added (EVA) model. Under the assumption of a constant required rate of
return (WACC), firm value at time zero is expressed as:

As is evident from the EVA model, future profitability (return on invested capital,
ROIC) must be forecast in order to estimate firm value. The analysts rely on historical
accounting numbers to determine the level and possible trends in future profitability.
Hence, good accounting quality is characterised by reported earnings that clearly dis-
tinguish between transitory (need not to be forecast) and permanent accounting items
and are based on identical accounting policies over time. If accounting policies change
over time, changes in a firm's performance may simply reflect changes in a firm's
accounting policies.

Multiples
To value a firm using multiples, a comparison is made between firms within the same
industry. Based on this comparison, it must be decided whether a firm should be valued
at the average multiple for the industry or a higher or lower multiple. In Chapter 9, we
saw how the value of the firm is estimated by multiplying a firm's earnings such as
EBIT or net earnings with a proper earnings capitalisation factor. However, before
using multiples a number of issues must be assessed. First, applied accounting poli-
cies must be comparable for the firms that are compared. In addition, earnings in
the comparable firms must be of the same 'quality'. It does not make sense from an
 analytical point of view to compare a firm, whose earnings are primarily based on
permanent sources of income, with earnings which are mostly transitory in nature.
Good accounting quality is, consequently, characterised by accounting policies that
are identical across firms and reported earnings that make it possible for analysts to
separate transitory from permanent accounting items.

Liquidation method
As discussed in Chapter 9, the liquidation method aims at estimating the realisable
value of assets and liabilities of a firm. In this context good accounting quality is char-
acterised by the recognition of all accounting items in the balance sheet and measuring
those items at the break-up value (liquidation value). As noted in Chapter 9, net assets
are unlikely to be measured at liquidation value as financial statements are prepared
under the assumption of 'going concern' unless otherwise stated.

Debt capital oriented stakeholders

Lenders, such as financial institutions, apply different decision models as described in
Chapter 11. The following three types of decision models are now discussed:
• Forecasting method
• Credit rating method
• Liquidation method.

Forecasting method
The forecasting method requires that the future economic development of a firm is
projected in order to evaluate its ability to repay debt or its need for borrowing in the
future (potential business opportunities seen from the lenders point of view), and iden-
tifying the call for further collaterals. Good accounting quality for debt capital provid-
ers is, therefore, characterised by financial statements that clearly separate permanent
earnings from transitory earnings, which are based on identical accounting policies
over time, and thereby more effectively signal the valuation creation and financial
position of the firm being evaluated.

Credit rating method

As shown in Chapter 11, the credit rating method is based on a number of finan-
cial ratios. Those ratios each describe different aspects of a firm's profitability and
risk. The credit rating model is relatively more static than the forecasting method in
assessing credit risk. This puts heavy constraints on the underlying data (financial
statements). A requirement of the underlying data is that the current financial ratios
are a fair representation of the future level of those financial ratios. Good accounting
quality is therefore characterised by financial statements that contain sufficient infor-
mation for creditor to assess the 'stability' in the financial ratios. Furthermore, since
credit rating models compare companies, the accounting policies should be identical
across companies which are being compared.

Liquidation method
Lenders may use the liquidation method to examine a firm's ability to repay debt in
case it suspends its payments. As for equity stakeholders, good accounting quality
 for loan providers is characterised by financial statements that recognise all asset and
liabilities (also the ones not previously recognised such as operating lease contracts
and law suits) at a value close to the liquidation value.

Compensation oriented stakeholders

Executive compensation may be based on financial performance measures as illus-
trated in Chapter 12. Earnings measures such as EBITDA, EBIT, EBT or net earn-
ings (E) are among the most popular earnings measures in determining executives'
performance-related bonuses. If a firm's objective is to maximise investors' welfare,
the selected earnings measure should reflect this. Thus, there should be a strong link
between the selected earnings measure and firm value.
Empirical evidence indicates that earnings measures used in bonus contracts do not
seem to distinguish clearly between permanent and transitory accounting items. In
respect to accounting-based bonus plans there are reasons to include certain transitory
accounting items in measuring performance. For example, in Chapter 12, we argued
that a loss due to under-insurance should be included in the performance measure
used in calculating bonus. The following example considers Royal Unibrew.

Example 13.1 On 28 December, year 1, Royal Unibrew issues the following announcement:

Royal Unibrew has decided to try to sell the Group's English Brewery Robert Cain & Co.
Ltd . . . In relation to the decision to divest Robert Cain & Co. Ltd impairment of assets,
provisions and the like of approx. € 6 - 7 million are expected to be recognised in the
income statement for year 1 . . . On a yearly basis the disposal of Robert Cain & Co. Ltd is
expected to improve Royal Unibrew's core earnings (EBIT) by approx. €3 million.

As shown in the announcement, Royal Unibrew will report a loss of € 6 - 7 million in year 1.
On the other hand, EBIT will increase by approximately €3 million in subsequent years. Even
though the divestment of Robert Cain & Co. Ltd seems reasonable from an economic point
of view, management will be penalised in year 1, if their bonus is based on a single-period
earnings measure such as EBIT or net earnings. •

In summary, good accounting quality clarifies those issues allowing the analyst or
compensation committee to make informed decisions.
As illustrated by the three stakeholder groups, accounting users have differ-
ent objectives and use different decision models (depending on the purpose of the
analysis), which affect the conception of good accounting quality. This issue is dis-
cussed in greater detail in Chapters 14 and 15.

Assessment of accounting quality

A general analysis of accounting quality is a time consuming task as many areas must
be explored. Below, we present a list of issues which accounting users should examine
in order to assess accounting quality:
• Motives for accounting manipulation
• The quality of applied accounting policies
• Permanent (recurring) versus transitory (non-recurring) accounting items
 • The level of information in the financial statements
• Identification of 'red flags'.
The list is not exhaustive, but covers substantial issues which analysts should consider
carefully. Each of the issues is discussed in greater detail below.

Motives for accounting manipulation

To identify whether accounting manipulation is an issue, the analysts should be aware
of the specific motives management may have to exploit the flexibility in accounting
regulation. Flexibility in accounting regulation can be exploited more or less aggres-
sively and in some cases management may be tempted to circumvent current account-
ing rules. Motives management may have to promote explicit interests include the
following.
Blurring of poor management. Management may choose accounting policies
that enhance job security. This may happen by selecting accounting policies that
do not provide a true and fair view of a firm's profitability and financial position.
Management which has been under pressure for an extended period of time may espe-
cially be tempted to exploit the flexibility in accounting regulation to promote their
own interests. Management has a number of possibilities to 'beautify' the financial
position of a firm. Management might for instance reduce forward looking expenses
such as research and development costs and marketing expenses or change accounting
estimates for non-current assets (i.e. change the expected lifetime of depreciable assets)
and hereby extend the accounting lifetime of those assets, which reduces accounting
depreciations. In all cases it has a positive effect on current earnings.
Performance related pay. A related area is management compensation. As shown
in Chapter 12, a variety of accounting-based performance measures are used in bonus
contracts. This type of compensation promotes management's motives to apply
accounting policies, and estimates, in order to maximise its own welfare. Management
may be tempted, for example, to recognise impairment losses in periods where per-
formance is so poor that management will not achieve a bonus anyway. In such cases,
current earnings include future costs. Management has thereby made it easier to reach
future bonus targets.
Debt-covenants. In debt financing, the contract between borrower and lender often
include the so-called debt-covenants. A debt covenant is an agreement that the bor-
rower has to deliver a minimum performance on certain financial ratios such as the
interest coverage ratio and financial leverage. In the event that the borrower's per-
formance results in a breach of the covenants, the lender may require a renegotiation
of the terms or call the debt. This may prove costly for the firm and they may therefore
be tempted to choose accounting policies, and estimates, which reduce the likelihood
of violation of the covenants. Gramlich et al. (2001) find that American firms reclas-
sify debt on the balance sheet to avoid breaching debt-covenants. For example, they
find that short-term debt is reclassified as long-term debt so as to improve the acid test
ratio or similar measures of short-term risk.
Political (regulation) considerations. Firms that are prone to supervision from
various public authorities have motives to manage reported accounting numbers in
a desired direction. Firms, which have a dominating market position, will often be
closely monitored by public authorities. For example, most countries have a dominat-
ing player in the telecom market. In Germany, Deutsche Telecom has a dominating
position and, in Spain, Telefónica, S.A. has a dominating position. As a consequence,
 various public authorities oversee different aspects of the firms' finances, including
their price policies and reported earnings. In case these analyses indicate that the tele-
com firms use their dominant positions on the telecom market to earn excess profit,
authorities may intervene and regulate in favour of their competitors. Therefore, firms
with a dominating market position may have an incentive to hide the economic advan-
tages by applying accounting policies, and estimates, in their favour.
Competitive issues. Certain competitive considerations may also affect a firm's
reporting practice. Firms may choose not to reveal profitable areas by not disclosing
segment information or choose accounting policies, which affect accounting numbers
in a desired direction.
Capital market issues. Firms that consider raising capital on a stock exchange or
are about to be acquired have a special interest in appearing as profitable and finan-
cially sound as possible. Gramlich and Sørensen (2004) examine 58 firms one year
subsequent to their initial public offerings. They find that the firms in general use
accounting policies that either improve income or reduce expenses in order to align
with expected earnings.
The above examples show that there are various motives for accounting manipula-
tion. It is therefore important to assess the quality of the financial statements, as we
shall now show.

The quality of applied accounting policies

In assessing applied accounting principles several issues should be examined in order
to assess the quality of the reported accounting numbers. As stated in Chapter 14,
management has some discretion in choosing accounting policies. In addition, man-
agement needs to make a number of estimates. For example, estimating the useful
lifetime of non-current assets often involve a great deal of judgement. Even if there
is a relatively detailed regulation, management can by their actions affect the income
statement, the balance sheet and the cash flow statement in a number of ways. For
instance, management may postpone or advance planned investments in areas such
as marketing and research and development. In the following section, the impact of
applied accounting policies on reported accounting measures is examined. We have
separated this issue into the following two topics:
1 Are the firm's financial statements based on conservative or liberal accounting
policies?
2 Does management use accounting policies to promote their own interests?

1 Conservative versus liberal accounting policies

Often a distinction is made between conservative and liberal accounting policies.
Conservative accounting policies are characterised by the prudent measurement of
assets. Expensing development costs as incurred is evidence of conservative account-
ing policies, while capitalisation of development costs is an indication of relatively
more liberal accounting policies. Even though accounting regulation allows fewer
choices for recognition and measurement of accounting items, international account-
ing regulation leaves room for alternatives. Conservative accounting policies are by
many believed to be synonymous with good accounting quality. The idea is that for
lenders and equity investors, conservative accounting policies are a safeguard against
losses on loans and investments, respectively.
 The use of liberal versus conservative accounting policies may have a large effect on
invested capital and financial ratios including return on invested capital. Obviously, this
may have economic consequences as financial ratios are used in decision models and
in various contracts (e.g. debt-covenants and bonus contracts). Thereby, applied
accounting policies may affect firm value or a firm's borrowing capacity. This is not
appropriate as it is the underlying performance, ultimately expressed as cash flows,
which should affect the value or loan capacity of a firm; not the choice of account-
ing policies. Example 13.2 illustrates the possible economic consequences of choos-
ing conservative accounting policies or estimates versus liberal accounting policies
or estimates. This should help answering the question: are conservative accounting
policies of higher quality than liberal accounting policies? While the example focuses
on different estimates (judgements), the example could just as well have focused on
different accounting policies per se such as capitalisation of development costs versus
expensing such costs as incurred or the choice of FIFO versus average costs for inven-
tory accounting.

Example 13.2 Conservative versus liberal accounting policies

Two firms within the same industry produce the exact same products. Historically, both firms
have had an EBITDA of 1 31,680 each year and yearly investments of 100,000. Risks have
also been on a par for the two firms with a required rate of return of 10%. The only differ-
ence between the two firms is that they estimate the lifetime of depreciable assets differently.
One firm depreciates non-current assets over two years (a conservative accounting estimate),
while the same assets are depreciated over a four-year period in the other firm (a liberal
accounting estimate). Both firms are 100% equity financed and they depreciate by the full
rate in year 1, year 2 etc. On the basis of these assumptions the following numbers and ratios
can be calculated as shown in Table 13.1.

Table 13.1 Conservative versus liberal accounting policies

Accounting practice Conservative Liberal

EBITDA 131,680 131,680
Depreciation and amortisation -100,000 -100,000
EBIT 31,680 31,680
Non-current assets beginning of period 50,000 150,000
Investment per year 100,000 100,000
Depreciation per year -100,000 -100,000
Non-current assets end of period 50,000 150,000
Free cash flow 31,680 31,680
Return on invested capital (ROIC) 63.4% 21.1%
Required rate of return 10% 10%

In this example, it is assumed that 'steady state' has been reached, which signals all account-
ing numbers, financial ratios and cash flows are exactly the same in all future periods. As
illustrated, EBIT is identical for the two firms but non-current assets are measured differently
 due to differences in depreciation policies. For the conservative firm non-current assets are
calculated as follows:

Investment Book value Book value Book value Book value Book value Total
Year 1 Year 2 Year 3 Year 4 Year 5 book value

Year 1 50,000 0 0 0 0 50,000

Year 2 0 50,000 0 0 0 50,000
Year 3 0 0 50,000 0 0 50,000
Year 4 0 0 0 50,000 0 50,000
Year 5 0 0 0 0 50,000 50,000

For example, in year 3 book value of non-current assets becomes 50,000 and relates to the
investment made in year 3 only. The reason is that investments made in year 1 was fully
depreciated by the end of year 2, while the investment made in year 2 was fully depreciated
by the end of year 3 (by 50% in year 2 + 50% in year 3). Note that book value at the end of
each year becomes constant at 50,000. Depreciation also becomes constant at 100,000. In
year 3, the depreciation expense consists of 50,000 in depreciation of investments made in
year 2 plus 50,000 in depreciation of investments made in year 3. In year 4, depreciation is
calculated as 50,000 related to the investment in year 3 plus 50,000 related to the investment
made in year 4 and so on for the subsequent years.
For the liberal firm non-current assets are calculated as follows:

Investment Book value Book value Book value Book value Book value Total
Year 1 Year 2 Year 3 Year 4 Year 5 book value
Year 1 75,000 0 0 0 0 75,000
Year 2 50,000 75,000 0 0 0 125,000
Year 3 25,000 50,000 75,000 0 0 150,000
Year 4 0 25,000 50,000 75,000 0 150,000
Year 5 0 0 25,000 50,000 75,000 150,000

Note that for the liberal firm non-current assets become constant at 150,000 consisting of
assets with a value of 25,000, 50,000 and 75,000, respectively. Every year from year 3 this will
be the case, since book value will be the sum of assets not yet fully depreciated. Furthermore,
depreciation becomes a constant 100,000 from year 4. This is due to the fact that in year 4
four assets (investments) are depreciated by 25,000 each, namely the assets acquired in years
1, 2, 3 and 4. By the beginning of year 5, the investment made in year 1 is fully depreciated
(by 25% in years 1, 2, 3 and 4), but another investment of 100,000 is made. This invest-
ment is depreciated by 25,000. Thus depreciation in year 5 again becomes 100,000; 25,000
related to each investment made in years 2, 3, 4 and 5.
Contrary to what many may have believed, ROIC is substantially higher at 63.4% for the
firm applying conservative accounting policies versus 21.1 % for the firm with liberal account-
ing policies. This is due to the fact that earnings are the same for the conservative firm and
liberal firm (in the 'steady-state' phase), while the conservative firm has less invested capital.
As cash flow is unaffected by differences in applied accounting policies or estimates, the free
cash flow is identical for both firms. In the following section the potential economic conse-
quences of differences in accounting estimates are illustrated.

Valuation
In this section, both firms are valued based on the EVA model. It is assumed that both firms'
financials and applied accounting policies remain identical across time. Invested capital, ROIC
and risk, as shown in Table 13.1, are consequently used as estimates of the future economic
development in the two firms. Based on these assumptions and the EVA model, value for the
two firms can be calculated as:1

As demonstrated, the value of the two firms is identical even though they report vastly dif-
ferent accounting numbers. The firm, which applies conservative accounting policies, reports
invested capital of 50,000. In comparison, invested capital amounts to 150,000 in the firm
that uses liberal accounting policies. In spite of different starting points for valuation, the
higher return on invested capital in the firm with conservative accounting policies compen-
sates exactly for the firm's lower invested capital. The result should not come as a surprise.
The two firms generate identical free cash flows and assuming identical risks across the two
firms, they should have identical values.
An alternative valuation model is the discounted cash flow model (DCF model), which
should yield the same value for the two firms, since the cash flows are identical. In the DCF
model future cash flows are converted to present value by discounting the cash flows by an
appropriate discount factor. In our example, the free cash flows amount to 31,680 (in perpe-
tuity) and the proper discount factor is 10%. Since cash flows are constant, the present value
of future free cash flows is calculated as an annuity in perpetuity:

Since the conservative and liberal firms have the same cash flows, they are both valued at
316,800; just as they were if the EVA model was used as illustrated above.
In summary, accounting policies do not affect firm value if present value models are
applied. Therefore, if present value models are used it cannot be concluded that financials
based on conservative accounting policies (or estimates) are of higher quality than financials
based on liberal accounting policies.
Now suppose that valuation is based on the multiple price to book (P/B). (Price to book
is defined as the market value of equity divided by book value of equity.) The firm with lib-
eral accounting policies wishes to be listed on a stock exchange. To estimate firm value it is
compared with the firm applying conservative accounting policies, which is already listed on
a major stock exchange. Assume that this listed (conservative) firm is traded at a P/B ratio =
316,800/50,000 = 6.3. That is, the market value of equity (P) is more than six times the book
value of equity.
 The value of the firm, applying liberal accounting policies, can accordingly be calculated
as 6.3 × 150,000 = 945,000, which is three times the price of the firm applying conserva-
tive accounting policies. The difference in value is due to differences in accounting policies
between the two firms. As a consequence of differences in the accounting policies, equity
is recognised at a value that is three times as large in the firm that uses liberal accounting
policies.
As a result of using multiples for valuation purposes, estimated firm value is sensitive to
applied accounting policies. This example further illustrates that financial statements based
on conservative accounting policies are not necessarily of higher quality than financial state-
ments based on liberal accounting policies if multiples are used. Rather, good account-
ing quality is characterised by identical accounting policies across firms (peers) used as
benchmarks.
Finally, the consequences of conservative and liberal accounting policies on firm value are
illustrated assuming the liquidation method is used. The assumptions and data are as before.
Total assets and equity for the two firms amount to:

Accounting policies Conservative Liberal

Assets 50,000 150,000

Equity 50,000 150,000

It is evident that assets are valued differently due to different accounting policies for non-
current assets. In a worst case scenario, the liquidation value determines the value of the
firm, and ultimately whether investors and bankers have lost their investments in the firm.
Neithre conservative accounting policies nor liberal accounting policies are likely to provide
an unbiased estimate of the value of individual assets or liabilities. Liberal accounting policies
signal a liquidation value, which is significantly higher than the one based on conservative
accounting policies. This may give the lenders the impression that the liquidation value (worst
case scenario) is much higher than will be the case if liquidation of the firm does take place.

Credit rating
Taken at face value, the balance sheet numbers (book value of equity is three times as high
for the liberal firm) further suggest that the firm which uses conservative accounting policies
has less collateral to put up and therefore is a more risky investment opportunity (other things
being equal) than the firm using liberal accounting policies. On the other hand, credit risk will
(presumably) be lower, if lenders base their loan commitments on a conservative valuation
of non-current assets. It is questionable, however, if conservative accounting policies are of
higher quality (seen from a lender's or a creditor's point of view) than liberal accounting poli-
cies. The effect of conservative accounting policies may well be a loss of profitable business
opportunities; that is a lender may decline to provide further funding due to the apparently
low value of assets.
The credit rating system is also affected by applied accounting policies. In this example,
ROIC is substantially different for the two firms:

Accounting policies Conservative Liberal

Return on invested capital 63.4% 21.1%
ROIC is three times higher for the firm applying conservative accounting policies. If ROIC is
considered in isolation, the firm applying conservative accounting policies would achieve an
AAA rating on the rating system shown in Table 11.1. In comparison the firm that chooses lib-
eral accounting policies would obtain only an A rating. The difference in rating, considering
ROIC only, triggers a higher borrowing rate (cost of capital) for the firm with liberal account-
ing policies.
The above exemplifies that the choice of a decision model influences the requirement for
types of accounting information. The example, in addition, illustrates that accounting poli-
cies (conservative/liberal accounting policies) affect decision models differently. For instance,
equity-based decision models such as the EVA model are immune to applied accounting
policies, while decision models such as multiples and the liquidation method are affected by
accounting policies including the use of conservative versus liberal accounting practice. Firms
applying conservative accounting policies are often regarded as being prudent when measur-
ing profitability, growth and risks, implying that lenders risks are reduced. However, as the
example indicates, reported financial statements based on conservative accounting policies
are not necessarily of higher quality than financial statements applying liberal accounting
policies. •

2 Use of accounting policies to promote special interests

As indicated above, there are a number of reasons why management uses account-
ing policies to promote particular interests. Schipper (1989, p. 92) proposes a repre-
sentative academic definition of earnings manipulation that she refers to as 'earnings
management':

A purposeful intervention in the external financial reporting process, with the intent
of obtaining some private gain.

It is therefore important to uncover potential management motives and to examine the

accounting policies carefully.
'Big Bath' accounting is the process where corporations write-off or write-down
certain assets from their balance sheets or recognise large chunks of restructuring
costs. The write-off removes or reduces the carrying value of asset and results in lower
net income. The objective is to 'take one big bath' in a single year so future years will
show improved earnings numbers. This technique is often employed in a year when
sales are down as a result of external factors, when the company would report a loss
in any event or after a change in top management. Corporations will often wait until a
bad year to employ this 'big bath' technique to 'clean up' the balance sheet. Although
the process is discouraged by auditors, it is still used.
The following is a typical example of 'big bath' accounting.

Example 13.3 A listed company sacks their CEO and shortly after his successor is appointed. A few months
after taking office the new CEO recognises an impairment loss on development projects of
approximately €12 million, which is almost a 50% write-off. Assuming an amortisation period
of 10 years, future earnings will increase by €1.2 million per year in the coming 10-year
period.
In this scenario, the newly appointed CEO is likely to report higher future earnings as the
likelihood of having to report an impairment loss is heavily reduced (development projects
are written-off by 50%). •
Permanent versus transitory accounting items (earnings persistence)
Financial statement analysis often includes forecasting future earnins. In predicting
future accounting numbers, past financial statements provide valuable information
that can be used to establish the level and trends in future accounting numbers. An
examination of historical financial statements also helps the analysts to distinguish
between permanent and transitory accounting items.
Accounting users may find guidance in accounting regulation and reporting prac-
tices. For instance, transitory accounting items are often classified and disclosed sepa-
rately from recurring accounting items. The following provides a list of a number
accounting items, which may be transitory in nature:

• Special items
• Discontinued operations
• Restructuring costs
• Changes in accounting estimates
• Changes in accounting policies
• Gains and losses that are not part of core business
• Impairment losses on non-current assets.
In the following section, these accounting items are discussed and exemplified.

Special items
IFRS no longer permit firms to classify items in the income statement as extraordinary
items. This is in contrast to US GAAP, where extraordinary items are permitted but
restricted to infrequent, unusual and rare items that affect profit and loss. In light
of this it raises an important issue: how shall IFRS firms classify and disclose items,
which used to be reported as extraordinary items? The answer to this question is that
firms choose to label items that are irregular as 'special items', 'exceptional items' or
the like.
Some events are clearly irregular and caused by events outside firms' control. Such
events include:
• Expropriation
• Hurricanes, flooding and other natural disasters.
Under US GAAP such items are classified as extraordinary items, while IFRS firms are
left with the choice of including them as a separate line item in the income statement
and make the necessary disclosure.
There is also a number of accounting items, which may be classified as special items
by firms, but which are normally part of ordinary activities. These items include, but
are not limited to:

• Write-down of inventories
• Write-down of accounts receivable
• Impairment of non-current assets
• Reversal of impairment losses and provisions
• Restructuring costs
• Disposal of non-current assets
• Law suits (litigations)
• Corrections of errors related to prior years.
 Arguably, the above list represents typical events that are within the scope of a firm's
normal operating activities. For example, that a firm divests assets or business units
or has to recognise an impairment loss on non-current assets, inventory or accounts
receivable is part of the risk inherent in running a business. Nonetheless, disclosing the
above items separately may be useful for financial statement users; at least if they are
material. This makes it possible for users to make their own stance on 'special items';
that is how to treat such items in an analysis.

Example 13.4 Bayer Group

To illustrate special items, consider the Bayer Group (see Table 13.2). Bayer is a global enter-
prise with core competencies in the fields of healthcare, nutrition and high-tech materials.

Table 13.2 Bayer Group annual report - five-year financial summary

Bayer Group Year 5 Year 6 Year 7 Year 8 Year 9

€ million € million € million € million € million

Sales 24,701 28,956 32,385 32,918 31,168
Sales outside Germany 84.4% 84.4% 85.1% 85.4% 86.7%
EBIT 2,514 2,762 3,154 3,544 3,006
EBIT before special items 3,047 3,479 4,287 4,342 3,772
EBITDA 4,122 4,675 5,866 6,266 5,815
EBITDA before special items 4,602 5,584 6,777 6,931 6,472
Income before income taxes 1,912 1,980 2,234 2,356 1,870
Income after taxes 1,595 1,695 4,716 1,724 1,359

Based on the above, the effect of special items can be calculated. For example, in year 9 spe-
cial items amount to €3,772 million - €3,006 million = €766 million or approximately 25%
of EBIT. Bayer Group's special items are summarised in Table 1 3.3.
Bayer Group reconciles special items as shown in Table 1 3.4.

Table 13.3 Bayer Group annual report - five-year financial summary

Year 5 Year 6 Year 7 Year 8 Year 9

€ million € million € million € million € million

Special items, EBIT 533 717 1,133 798 766
Special items, as a 21% 26% 36% 23% 25%
percentage of EBIT
Special items, EBITDA 480 909 911 665 657
Special items, as a 12% 19% 16% 11% 11%
percentage of EBITDA
Table 13.4 Bayer Group Annual report - reconciliation of special items

EBIT EBIT EBITDA EBITDA

Year 8 Year 9 Year 8 Year 9

€ million € million € million € million

After special items 3,544 3,006 6,266 5,815

HealthCare 583 372 465 320

Schering PPA effects 208 0 208 0

Schering integration costs 157 87 111 79

of which gain from -69 -114 -6 -114

divestitures

Write-downs 98 32 26 0

Restructuring 0 47 0 35

Litigations 106 180 106 180

Additional funding for the pension 0 26 0 26

assurance association

Other 14 0 14 0

CropScience 166 219 153 197

Restructuring 166 177 153 155

Litigations 0 35 0 35

Additional funding for the pension 0 7 0 7

assurance association

MaterialScience 49 140 47 105

Restructuring 49 130 47 95

Additional funding for the pension 0 10 0 10

assurance association

Reconciliation 0 35 0 35

Litigations 0 10 0 10

Additional funding for the pension 0 25 0 25

assurance association

Total special items 798 766 665 657

Before special items 4,342 3,772 6,931 6,472

 Further, Bayer Group explains:
Although EBIT before special items and EBITDA before special items are not defined in the
international Financial Reporting Standards, they represent key performance indicators
for the Bayer Group. The special items comprise effects that are non-recurring or do not
regularly recur or attain similar magnitudes. EBITDA is the EBIT as reported in the income
statement plus amortisation and write-downs of intangible assets and depreciation and
write-downs of property, plant and equipment.

As the reconciliation reveals Bayer Group's special items include restructuring costs and
litigation expenses. Arguably, such expenses are part of a firm's operating business.
Restructuring is necessary for a firm to stay competitive. The risk of being sued (litigations)
is something that many firms, if not all firms, experience. Therefore, though Bayer Group
classifies restructuring and litigation as special items, analysts must carefully consider if they
need to be included in forecasting earnings. It is noteworthy that special items are recognised
every single year, are always negative (expenses) and are roughly between €500 million
and €1,100 million. This indicates that special items are recurring and should be included
in forecasting earnings. While these items may be hard to predict, a fair bet would be to
use the average figure for the past three to five years. For Bayer Group this would mean
that projected operating expenses should include special items of around €800 million
per year.
Likewise, if managers are rewarded a bonus based on financial performance it raises the
question if they should be punished (or rewarded) for special items. A closer look at Bayer
Group's annual report exposes that the board of management are entitled to bonuses as
follows:

The short-term incentive award for management is calculated according to the Group's
EBITDA margin before special items and the weighted average target attainment of
the Healthcare, CropScience and MaterialScience subgroups. The Supervisory Board
can adjust this award according to individual performance. The target attainment
of the subgroups is measured chiefly in terms of their EBITDA before special items.
A qualitative appraisal in relation to the market and competitors is also taken into
account.

Source: Bayer annual report, combined management report

As illustrated, Bayer Group has decided that management compensation should

be based on a performance measure excluding special items. It is an open question
whether this is a wise decision. Again, it is worth noting that special items are consistently
negative. •

Discontinued operations
For most, if not all, firms the organisation must be adjusted continuously by selling-
off (unprofitable) business units or acquiring new businesses. This fact complicates
an analyst's work in several ways. First, it introduces noise in a time-series analysis,
as changes in the underlying profitability may be caused by changes in the underly-
ing risk. A change in the risk profile has an effect on cost of capital and ultimately
firm value and loan terms. This will be the case if, for instance, a business unit with a
different risk profile than the remaining business units is divested. Second, it compli-
cates the analyst's work in connection with forecasting. The analysts make forecasts
 based on the remaining part of the business. This requires that it is possible to adjust
accounting numbers back in time in order to use them as a base for forecasting. This
kind of information is seldom available.
According to IFRS 5: 'Non-current Assets Held for Sale and Discontinued
Operations', a firm has to disclose a variety of information about discontinuing opera-
tions. The data that has to be revealed include:

On the face of the income statement a single amount comprising the sum of the
post-tax profit or loss of the discontinued operation and the post-tax gain or loss
recognised on the measurement to fair value less costs to sell or on the disposal of
the assets (or disposal group).
An analysis of the amount above must be presented either on the face of the
income statement or in the notes. This analysis must include revenue, expenses,
pre-tax profit or loss and related income taxes in a section distinct from continu-
ing operations and prior periods are re-presented so that the disclosures relate to
all operations classified as discontinued by the latest balance sheet date.
The net cash flows attributable to the operating, investing, and financing activi-
ties of a discontinued operation must be presented separately on the face of the cash
flow statement or disclosed in the notes and is required for prior periods.

In addition, comparative figures in the financial statements must be restated. In

reality, firms often adjust accounting numbers from the previous financial year only.
As a longer time-series than two years is necessary in order to identify the level and
trends in key financial ratios, the analysts will face the dilemma that reported account-
ing numbers for past years include the effects of continuing as well as discontinuing
operations making past numbers less useful for forecasting purposes. Analysts must
judge to what extent this creates noise in the analysis. Subsequently, analysts must
consider the impact discontinued operations has on accounting numbers that have not
been adjusted. If qualified estimates on historical growth, profitability and risk for the
continuing operations are impossible, the analysts must settle for accounting numbers
for the past two years.

Example 13.5 Wolseley

Wolseley is a specialist trade distributor of plumbing and heating products to professional
contractors and a leading supplier of building materials to the professional market with
approximately 47,000 employees and 4,400 branches worldwide. Wolseley is quite informa-
tive about discontinued operations. For example, note 9 to their annual report for year 5
provides the information displayed in Table 13.5.
In addition, Wolseley discloses separately the results of continuing from the results discon-
tinuing operations in its five-year summary, which prevent noise in a time-series analysis (see
Table 1 3.6). As seen in Table 1 3.6, Wolseley has separated out discontinued operations for
the current year plus the past four years. Wolseley presents detail in excess of what is required
by IAS. In doing so, Wolseley provides analysts with the necessary information to examine
past performance as a benchmark for future performance. Naturally, the five-year summary
is not as detailed as a normal income statement, so analysts may still need to make informed
estimates and judgements.
Table 13.5 Wolseley, annual report

9. Discontinued operations

On 6 May, the Group completed the sale of Stock Building Supply Holdings LLC which comprised the
majority of its US Building Materials segment. In accordance with IFRS 5, 'Non-current assets held for sale
and discontinued operations', this business has been classified as discontinued and prior periods have been
restated on a consistent basis.

(a) The results of the discontinued operations, which have been included in the consolidated income
statement, are as follows:

Year 5 Year 5 Year 5 Year 4 Year 4 Year 4

Before Exceptional Total Before Exceptional Total
exceptional items exceptional items
items items
£m £m £m £m £m £m

Revenue 1,140 - 1,140 1,735 - 1,735

Cost of sales -896 - -896 -1,330 - -1,330

Gross profit 244 - 244 405 - 405

Operating expenses:

amortisation of -12 - -12 -30 - -30

acquired intangibles

impairment of -288 - -288 -114 - -114

acquired intangibles

other -361 -156 -517 -509 -6 -515

Operating expenses: -661 -156 -817 -653 -6 -659

total

Operating loss -417 -156 -573 -248 -6 -254

before tax

Tax credit 152 61 213 84 2 86

Loss on disposal of - -159 -159 - - -

stock

Tax credit on loss on - 78 78 - - -

disposal of stock

Loss from discontinued -265 -176 -441 -164 -4 -168

operations
Table 13.6 Wolseley annual report - five-year summary
Five-year summary Year 5 Year 4 Year 3 Year 2 Year 1
(restated) (restated) (restated) (restated)
£m £m £m £m £m
Revenue from continuing operations
UK and Ireland 2,699 3,203 3,171 2,690 2,351
France 2,144 2,116 1,872 1,725 1,644
Nordic 2,113 2,290 1,670 - -
Central and Eastern Europe 965 908 846 735 642
Europe 7,921 8,517 7,559 5,150 4,637
US plumbing and heating 5,820 5,613 5,685 5,396 3,858
Canada 700 684 619 646 512
North America 6,520 6,297 6,304 6,042 4,370
14,441 14,814 13,863 11,192 9,007
Trading profit from continuing operations
UK and Ireland 55 176 211 201 183
France 32 103 101 91 98
Nordic 96 159 102 - -
Central and Eastern Europe - - 32 31 30
Europe central costs -4 -10 -13 -7 -4
Europe 179 428 433 316 307
US plumbing and heating 317 397 411 378 260
Canada 32 39 42 44 36
North America plumbing and heating 349 436 453 422 296
North America loan services -24 -19 -5 -3 -2
North America central costs -8 -8 -10 -11 -1
North America 317 409 438 408 293
Group central costs -49 -50 -43 -37 -25
447 787 828 687 575
Amortisation of acquired intangibles -105 -105 -88 -24 -4
Impairment of acquired intangibles -490 -57 - - -
Exceptional items -458 -70 - - -
Operating (loss)/profit from continuing -606 555 740 663 571
operations
Net interest payable -145 -156 -119 -65 -37
Share of after tax loss of associate -15 - - - -
(Loss)/profit on ordinary activities before tax -766 399 621 598 534
from continuing operations
Tax credit/(charge) 34 -157 -159 -214 -144
(Loss)/profit on ordinary activities after tax -732 242 462 384 390
from continuing operations
(Loss)/profit from discontinued operations -441 -168 12 153 89
(Loss)/profit attributable to equity shareholders -1,173 74 474 537 479
Ordinary dividends -74 -211 -186 -155
•
 Restructuring costs
Restructuring costs are an accounting item that frequently appears in the income
statement. Firms need to adapt their existing business to prevailing market conditions
or integrate newly acquired activities or firms. In these cases, firms must recognise
expenses such as salaries to employees who are dismissed, costs related to termination
of lease contracts, etc. Restructuring costs reflect planned actions and provisions that
are made to cover those costs. The accounting item is consequently based on manage-
ment estimates and judgements. The analysts must carefully consider and monitor the
accounting item, as it may be used to smooth earnings across time or write-off large
amounts (earnings management) so future earnings improve.
Smoothing earnings can be accomplished by, for instance, making provisions
in excess of what is actually needed. This provides a firm with the opportunity to
reverse (recognise as a reduction of future costs) the provision in subsequent years.
Thereby a firm's earnings appear more stable than the underlying operations seem to
dictate. Restructuring costs often occur in connection with a change in top manage-
ment. Management taking office makes use of the opportunity to 'take a big bath' and
makes significant provisions for that purpose. If provisions prove to be too large, they
are reversed and recognised as income in future years making future earnings higher.
Even if provisions made for restructuring are not too large, future earnings are likely
to increase. For example, restructuring may include job cuts (lower future personnel
expenses) or write-down of assets (lower future depreciation expenses).
In Example 13.6, the Swedish telecom company Ericsson is used to illustrate
restructuring charges.

Example 13.6 Ericsson

Total announced job cuts are now about 6,500, generating huge restructuring charges with
the intention of bringing equally huge cost savings. The Swedish telecom giant said that
sales had dropped owing to cuts in investment by mobile phone operators in a number
of markets, including in developing nations in central Europe, the Middle East and Africa.
In a sign of the impact of the economic crisis on the telecom industry, Ericsson's net profit
plunged by 92% to 314 million Swedish Kronor (€30.7 million, $43.4 million) between
October and December. That was in contrast to a net profit of 3.89 billion Swedish Kronor
in the same period last year, the company said in a statement. The profit margin was much
lower than expected as analysts polled by Dow Jones Newswires had forecast a net profit of
3.23 billion Swedish Kronor. Restructuring costs nearly doubled to 4.3 billion Swedish Kronor
in the fourth quarter, compared to 2.3 billion Swedish Kronor in the same period last year,
and for the full year the charges totalled 11.3 billion Swedish Kronor, the company said.
The company estimates that its restructuring programme will cost up to 14 billion Swedish
Kronor and bring annual savings of between 15 billion and 16 billion Swedish Kronor.
'When the initial (restructuring) programme was announced, it was anticipated that the
actions would result in a reduction of the number of employees by some 5,000, of which
about 1,000 in Sweden', Ericsson said.
The 5,000 has been exceeded and is estimated to reach approximately 6,500', the com-
pany said in the statement. Ericsson has also suffered from the difficulties at its two joint
ventures, Sony Ericsson and ST-Ericsson, which together chalked up charges of 1.46 billion
Swedish Kronor. Sales fell by 1 3% to 58.3 billion Swedish Kronor in the fourth quarter in the
wake of the global economic crisis and growing competition from telecom equipment indus-
try with the rise of China's Huawei. Ericsson said the anticipated decline in sales of older GSM
networks had accelerated owing to the economic crisis, but was not yet offset by the growth
in mobile broadband and investments in next-generation IP networks.
'During the second half of the year Networks' sales were impacted by reduced operator
spending in a number of markets', chief executive Hans Vestberg said in a statement. 'During
the year, operators in a number of developing markets, especially central Europe, Middle East
and Africa, became increasingly cautious with investments', he said. 'Meanwhile, other mar-
kets including China, India and the US continued to show good development with major net-
work buildouts', Vestberg said. Ericsson shares opened 2.6% lower at 70.05 Swedish Kronor
at the Stockholm stock exchange after the company announced its results.
Source: http://swedishwire.com/
•
Management may be tempted to 'clean up' in the so-called forward-looking expenses,
and as a consequence real future costs are recognised this year. Therefore, it is more
likely that future earnings improve. As the provisions for restructuring cover planned
initiatives and are based on estimates, the analyst should be particularly on the alert.

Changes in accounting estimates

A number of items in the financial statements are based on estimates and judgements,
which require that management in reporting financial data expresses the most likely
economic outcome of future events based on the information available at the date
the annual report is endorsed. IAS 8 provides a number of examples on accounting
estimates:
• The size of expected losses on receivables
• The size of net realisable value for inventories
• The expected lifetime and thereby depreciation period for intangible and tangible
non-current assets
• Depreciation methods (e.g. straight-line depreciation)
• Measurement of deferred tax assets
• The size of warranty provisions on sold goods
• The size of pension provisions.
Accounting estimates are likely to be one of the sources that make the most 'noise'
in the annual accounts. This is mainly due to the fact that management has some
discretion in determining the size of expected losses on receivables or the expected
lifetime of an asset. The above list provides just a few examples of accounting items
that require management to make estimates. In reality, most accounting items require
estimates to be made. For example, the use of percentage-of-completion method as the
recognition criteria for income is to some extent based on accounting estimates (e.g.
calculating the percentage of completion). An accounting user should be careful in
assessing accounting items that require substantial judgements (accounting estimates).
Unfortunately, in many instances, it may be difficult to track changes in accounting
estimates.
A change in an accounting estimate is an adjustment of the carrying amount of
an asset or a liability. Changes in accounting estimates result from new information
related to internal or external factors. The effect of changes in accounting estimates are
identified retrospectively by recognising the impact in the income statement as follows:
• In the period of the change, if the change affects that period only; or
• In the period of the change and future periods, if the change affects both.
 A firm shall disclose the nature and amount of changes in accounting estimates that
has an effect in the current period or is expected to have an effect in future periods.
However, if the amount of the effect in future periods is not disclosed because esti-
mating it is impracticable, an entity shall disclose that fact.
Source: IAS 8, paras 39, 40

The following three examples (JJB Sports plc, ThyssenKrupp AG and Woodside) illus-
trate the analytical problems associated with changes in accounting estimates.

Example 13.7 JJB Sports plc

JJB Sports plc, a leading UK sports retailer, improved operating earnings by £7.6 million
(according to their annual report) by reducing depreciation expenses, resulting from a
review of the useful economic lives. The details are provided in JJB Sports Annual Report
note 5:

Following an impairment review on the value of goodwill in the Balance sheet a further
review was carried out on the useful economic lives of property, plant and equipment. It
was found that many items of property, plant and equipment had useful economic lives
that more closely matched the length of the short-term lease of the property in which they
were constructed rather than the 10-year economic life which had formed the basis of the
depreciation charge in previous accounting periods. The useful economic lives of these
items of property, plant and equipment have been restated with effect from 31 January
and the rates have been changed as follows:

The annual rate of depreciation for freehold land and buildings has been reduced from
2.5 per cent to 2.0 per cent.
The annual rate of depreciation for the costs of mezzanine floors within the Distribution
Centre, together with other costs associated with the structure of the distribution centre
and head office buildings, has been reduced from 10.0 per cent to 2.0 per cent. Both the
distribution centre and head office are freehold.
The annual rate of depreciation on certain categories of costs within the health clubs,
retail stores, head office and distribution centre have been reduced from 10.0 per cent
to 4.0 per cent (or a percentage relative to the period of the lease of which the assets are
situated, if lower than 25 years). These categories of costs include electrical, air condition-
ing, plumbing and mechanical assets and the construction costs relating to swimming
pools.
Source: JJB Sports Annual Report

An explanation for the change in the useful lives was given in JJB's Interim report for a 26-week
period. The chairman and chief executive argue that:

While undertaking the impairment review on the value of goodwill in the balance sheet
for the introduction of IFRS, the Board also considered the carrying value of property,
plant and equipment. The review found that many items of property, plant and equip-
ment within our operating units, have useful economic lives that more closely match the
length of the short-term lease of the property in which they are constructed, rather than
the 10-year economic life which had formed the basis of the depreciation charge in previ-
ous accounting periods. The useful economic lives of these items of property, plant and
equipment have been restated with effect from 31 January and the consequent effect
 upon the income statement for the 26 weeks to 31 July is to reduce the charge for depre-
ciation by £4.3 million.

Source: JJB Sports Interim Report

JJB Sports operating profit fell sharply from approximately £62 million in year 5 to £34 mil-
lion in year 6. The drop in profit would have been even higher, if JJB Sports had not extended
the useful lifetime of its depreciable assets (see Table 13.7).

Table 13.7 JJB Sports operating profit

Consolidated income statement 52 weeks to 53 weeks to

for the 52 weeks to 29 January 29 January 30 January

Year 6 Year 5
(restated)
£000 £000

Continuing operations

Revenue 745,238 773,339

Cost of sales -393,075 -402,082

Cross profit 352,163 371,257

Other operating income 3,177 3,079

Distribution expenses -21,722 -19,272

Administration expenses -30,705 -31,637

Selling expenses -268,564 -261,321

Operating profit 34,349 62,106

Whether the extended lifetime of the assets can be justified is hard to tell. However, the
explanation that the transition to IFRS had led to rethinking the useful lifetime seems ques-
tionable. Depreciable assets should be depreciated over their useful lives, whether IFRS or
local GAAP is applied.
The improved profitability (higher operating earnings) may have economic consequences.
For instance, JJB Sports may receive a better credit rating, and, therefore, obtain better financ-
ing terms, since solvency ratios improves due to the higher assets base. Also, if manage-
ment obtains bonuses based on earnings, they may have a motive to manage earnings (e.g.
utilise accounting policies and estimates which increase earnings). In fact, JJB do have bonus
schemes:

Performance related bonus

The Executive Directors are entitled to a performance related bonus scheme to which
members of the Associate Director Board of JJB are also entitled. This bonus takes the form
of an annual payment, calculated as a percentage of basic salary, based upon the annual
pre-tax profits of the Group but dependent upon profit targets being achieved.

Source: JJB Sports Annual Report

•
 Naturally, even though management have bonus schemes or may obtain cheaper
funding it does not mean that they manipulate earnings. However, it is important to
emphasise that as an analyst, you should be on the alert that if a firm makes changes
in accounting estimates then reported earnings may not be taken at face value.

Example 13.8 ThyssenKrupp AG

A company with negative taxable income may carry this loss forward and offset it against
future taxable income. Therefore, tax loss carry-forwards represents an asset (i.e. it is recog-
nised as a deferred tax asset), as future income taxes will become smaller. A firm may not be
able to fully recover the tax loss carry-forwards. In this case, the asset related to tax loss carry-
forwards should not be recognised in full.
To illustrate tax loss carry-forwards, have a closer look at ThyssenKrupp AG. In their annual
report they note:
For deferred tax assets, a valuation allowance of euro 60 (last year: 20) million was
established for tax loss carry-forwards. In general, deferred tax assets are recognised to
the extent it is considered more likely than not that such benefits will be realised in future
years. Management believes that, based on a number of factors, the available evidence
creates sufficient uncertainty regarding the ability to realise tax loss carry-forwards. In
determining this valuation allowance, all positive and negative factors, also including pro-
spective results were taken into consideration in determining whether sufficient income
would be generated to realise deferred tax assets. •

Just by reading ThyssenKrupp's criteria for recognising tax assets, including tax loss
carry-forwards, it is evident that a great deal of judgement must be exercised by man-
agement. The value of the deferred tax asset and the related valuation allowance
depends on prospective results.

Example 13.9 Woodside

Woodside is Australia's largest publicly traded oil and gas exploration and production com-
pany. In its annual report 'Summary of significant accounting policies', the firm states:
Changes in accounting estimates
During the year, the Group re-evaluated its estimate of the costs to restore operating
facilities, taking into account changes in the method of restoration. The change in esti-
mate associated with the change in the method of restoration resulted in a decrease
to the provision for restoration of $779 million and a decrease in the related assets of
$779 million. •

A decrease in assets improves future profitability, as total depreciation expenses are

reduced by $779 million. For an analyst, it is difficult to judge whether the change is
warranted or due to earnings management. Restoration of operating facilities far into
the future requires a great deal of judgement concerning the timing of the restoration
and the costs of restoring the facilities.

Changes in accounting policies

Changes in accounting policies (sometimes labelled accounting principles) may be
mandatory or voluntary. For example, all listed groups in the EU had to apply inter-
national financial reporting standards as of 1 January 2005 (mandatory change). In
these cases, when the applied accounting policies are adjusted to comply with new
regulation, firms are taken to act in good faith. Changes in applied accounting poli-
cies, however, create comparison problems in a time-series analysis.
IAS 8 requires that the accumulated changes in applied accounting policies by the
beginning of the year are recognised directly in equity and that comparatives must be
restated to reflect the new practice. As an illustration of the effects of transition to
IFRS consider SABMiller, one of the world's leading breweries. In their annual report
ending 31 March, they report reconciliation of profit as shown in Table 13.8.

Table 13.8 SABMiller's annual report, note 30

Reconciliation of profit for the year ended 31 March

UK UK
GAAP to IFRS IFRS
US$m US$m US$m
Revenue 12,901 - 12,901
Net operating expenses -11,152 798 -10,354
Operating profit 1,749 798 2,547
Operating profit before exceptional items 1,705 427 2,132
Exceptional items 44 371 415

Exceptional items recognised after operating profit 366 -366 -

Net finance costs -167 24 -143

Interest payable and similar charges -263 24 239
Interest receivable 96 - 96

Share of post-tax results of associates 246 -98 148

Profit before taxation 2,194 358 2,552
Taxation -850 27 -823
Profit after taxation 1,344 385 1,729

As can be seen from SABMiller's financial statements, the firm's operating profit
increases from US$1,749 million to US$2,547 million after the transition from UK
CAAP to IFRS, an increase of US$798 million or 4 6 % . Net earnings increase by
US$385 million (from US$1,344 million to US$1,729 million), which is an increase
of approximately 2 6 % . The major reason for this significant increase in earnings can
be attributed to goodwill. Note (a) to SABMiller's note 30 explains:
Notes to the reconciliations
(a) Goodwill
Under UK GAAP, goodwill was amortised over its estimated useful life (the group
typically applied a 20-year life to goodwill, with the exception of goodwill in
Amalgamated Beverage Industries (ABI) which has an indefinite life and was sub-
ject to annual impairment reviews). Under IFRS, the amortisation of goodwill is
no longer permitted and goodwill is reviewed for impairment on an annual basis.
 As a result the amortisation charge of US$366 million was reversed and, as a con-
sequence of this change, the profit attributable to minority interests also increased
by US$22 million.
As explained in the note, the effects of avoiding amortisation of goodwill amounts to
an increase in operating profit of US$366 million. This leaves analysts on their own
to restate accounting numbers for past periods, as if goodwill had never been amor-
tised. Naturally, financial statements from prior years are not based on IFRS. These
annual reports have been published in the past in compliance with UK GAAP, and the
only way analysts can restate accounting numbers to reflect IFRS standards is to do it
manually. For example, to adjust for the effects of changes in accounting policies for
goodwill in the above SABMiller example, analysts are required to try to carry out
impairment tests for each of the comparable years. In other words, they must restate
historical accounting numbers for goodwill as if impairment tests had been carried out
in the past. This is not likely to improve the information content of the comparable
figures. Simply restating accounting numbers as if goodwill had not been amortised
historically seems more appropriate. Hereby, the accounting policies become reason-
ably identical in the analysed period. Unfortunately, turning to the financial review
does not provide much help. The comparative figures in the five-year financial review
are simply not restated, as shown in Table 13.9.
The above examples illustrate areas that are influenced by the applied account-
ing policies. There are other areas that should be included as well, for instance, the
extent to which applied accounting policies ensure recognition of all accounting items,
including debt in the balance sheet. This is important in a credit assessment.
Analysts need to be aware of changes in accounting principles. Firms must disclose
whether they change accounting principles, so analysts should always look out for this
information, and assess the accounting consequences of such a change. For example,
changing accounting principles introduces noise in a time-series analysis. Is an improve-
ment in profitability due to an improvement in the underlying true performance of a
firm or is it due to changes in accounting principles? This is difficult to tell if account-
ing principles change over time. In valuing firms, multiples like the EV/EBIT ratio are
often used. If SABMiller is valued at, say, 10 times EBIT, the lack of goodwill amor-
tisation of US$366 million would improve estimated firm value by US$3,660 million
(10 × US$366 million). Credit analysts should also consider the effects of changes in
accounting principles. Non-amortisation of goodwill strengthens the balance sheet
and allows the firm to look healthier (higher solvency). However, in a worst case
scenario (i.e. liquidation of the firm), the value of goodwill is zero.

Gains and losses that are not part of core business

A gain or loss from disposal of a non-current asset is measured as the difference
between the sales price (less costs to sell) and the book value on the date of disposal.
Gains or losses are recognised as part of operations. In reality, such gains and losses
are often included as part of depreciation expenses, as they basically express that prior
years depreciation expenses have been either too high (a gain on disposal is recog-
nised) or too low (a loss on disposal is recognised).
A gain or loss from disposal of non-current assets is transitory of nature, since it is
not possible to generate future income from the disposed assets. It is therefore impor-
tant to distinguish gains and losses from operating income and expenses; especially if
large parts of a firm's assets are sold.
Table 13.9 SABMiller's annual report: Five-year financial review
Five-year financial review for the years ended 31 March

The information included in the five-year summary for the years ended 31 March year 2 to 31 March year 4
is as published under UK GAAP and has not been restated to IFRS. The main adjustments in changing to
IFRS are as explained in note 31. Also as explained in note 31, IAS32 and IAS39, which deal with financial
instruments, are being applied from 1 April year 5 and consequently the figures for the year ended
31 March year 5 do not reflect the impact of those standards.

IFRS IFRS UK GAAP UK GAAP UK GAAP UK GAAP

Year 6 Year 5 Year 5 Year 4 Year 3 Year 2

US$m US$m US$m US$m US$m US$m

Income statements
Revenue (including associates' 1 7,081 14,543 14,543 12,645 8,984 4,364
share)
Revenue (excluding associates' 15,307 12,901 12,901 11,366 8,167 3,717
share)
Operating profit 2,575 2,547 2,104 1,383 803 619
Net finance costs -299 -143 -143 -152 -142 -83
Share of associates' post-tax 177 148 159 115 79 49
results
Taxation -779 -823 -776 -534 -319 -187
Minority interests -234 -208 -203 -167 -125 -105
Profit for the year 1,440 1,521 1,141 645 296 293
Adjusted earnings 1,497 1,224 1,251 925 581 350

Balance sheets
Non-current assets 23,951 12,869 12,287 11,483 10,431 4,758
Current assets 2,825 2,778 2,941 2,316 1,819 933
Total assets 26,776 15,647 15,228 13,799 12,250 5,691
Derivative financial instruments -178
Borrowings -7,582 -3,340 -3,339 -3,707 -3,523 -1,535
Other liabilities and provisions 5,417 -3,552 -3,586 -3,108 -2,377 -1,102
Total liabilities -13,177 -6,892 -6,925 -6,815 -5,900 -2,637
Net assets 13,599 8,755 8,303 6,984 6,350 3,054
Total shareholders' equity 13,045 8,077 7,665 6,165 5,572 2,309
Minority interests in equity 554 678 638 819 778 745
Total equity 13,599 8,755 8,303 6,984 6,350 3,054
Example 13.10 FLSmidth
FLSmidth is a global engineering group employing approximately 10,500 people in
42 countries worldwide. During an extended period of time, the firm has reduced
its number of business units. Gains and losses of disposal of business units and other
non-current assets comprise a substantial contribution to FLSmidth's (reported) earnings. In
Table 13.10 the contribution from disposal of assets (business units) for FLSmidth is provided.
For comparison purposes, earnings both excluding and including gains and losses from dis-
posal of non-current assets are reported.

Table 13.10 FLSmidth - earnings effects of gains and losses on disposal of non-current asset

FLSmidth Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Average

Gains/losses from 99 115 1,357 108 121 -517 714 285

disposal

Earnings before tax 1,019 1,032 1,399 621 -133 -830 -3,264 -22
excluded gains/losses

Earnings before tax 1,118 1,147 2,756 729 -12 -1,347 -2,550 263

As expected, the contribution from gains and losses varies considerably over time.
Furthermore, average earnings during the seven year period were a deficit of 22 million, if
gains and losses from disposal of non-current assets were excluded. This clearly indicates that
FLSmidth on average only reports positive earnings numbers due to gains from disposal of
assets. From an analytical point of view reported earnings appears to be of low quality as it
almost entirely consists of gains and losses from disposal of non-current items; i.e. items that
are transitory items in nature. •

Impairment losses on non-current assets

According to IAS 16 and IAS 36 non-current assets must be written-down if net real-
isable value is lower than book value; that is if assets are impaired. Assets may be
impaired for a variety of reasons including:
• Damage of the asset
• Technical obsolescence
• Discontinuation of production
• Reduced profitability for the produced products.

A write-off of a non-current asset reduces future depreciation and amortisation

expenses making it easier for management to improve profitability in future periods.
Alternatively, a write-off may be regarded as an adjustment to previous year's amorti-
sation and depreciation expenses. In this case, management has either misjudged the
true lifetime of depreciable and amortisable assets or has engaged in earnings man-
agement. Most firms need to write down assets from time to time. The analytical
problem arises when a firm decides to write off large amounts. The following example
illustrates this.
Example 13.11 World Com
World Com, a former American phone company recognised a write-off of goodwill and other
assets of approximately US$80 billion in March 2003. From an analytical point of view, it is
fair to assume that the impairment is not due to a sudden value destruction of the assets;
the sheer magnitude of the impairment loss makes this hard to believe. Prior years reported
earnings are obviously overvalued and accounting quality appears to be low. The problem
in World Corn's is that the impairment loss is arguably recognised too late. In fact, shortly
after the impairment loss is reported, World Com is declared bankrupt. Analysts need to get
access to information or signals, which have a material impact on the assessment of growth,
profitability and risk, as soon as possible. In the case of World Com, the signal came too late.
The above assessment of transitory accounting items illustrates that many types of such
items are likely to be found in annual reports. Bradshaw and Sloan (2002) found in an
American study that the so-called 'special items' (transitory items) are increasing over time.
The results of this study are shown in Figure 1 3.2. •

Figure 13.2 Development in transitory accounting items in the period 1985-1997

As is evident, transitory accounting items have the greatest impact in the fourth
quarter, which indicates that management uses these accounting items in order to
manage earnings. In this way, management may for instance be able to report earnings
that are on a par with analysts' earnings forecasts.
Generally, accounting users should be wary of accounting items classified as transi-
tory. The critical accounting user needs to examine the extent to which accounting
items are truly transitory. The analyst might ask the obvious question: is it the case
that transitory accounting items are likely to be recurring in nature and mainly include
items that reduce earnings (i.e. items are expenses or losses)? Could it not be that
items and events that are labelled transitory vary across time and firms?
It has been confirmed by a number of studies that transitory items in many cases
are truly permanent, though it may be acknowledged that such items fluctuate sub-
stantially over time making them hard to forecast. Doyle et al. (2003), for instance,
find that accounting items, which are classified as transitory items, in reality are often
permanent. Even more interestingly, analysts seem to ignore this issue. Doyle et al.
demonstrate that analysts, who exclude (in earnings) the so-called transitory items,
tend to overrate a firm's future cash flow potential.
 In case the analysed firm is characterised by a high number of transitory accounting
items, these items should be carefully considered in, for instance, forecasting. The task is
not an easy one, as the amount and the events recognised as transitory accounting items
may vary greatly over time. Analysts may try to circumvent the problem by averaging
special items, which are considered permanent by analysts. For example, Bayer Group
has reported special items (regarded by analysts as being permanent) amounting to
€533 million, €717 million, €1,133 million, €798 million and €766 million, respectively
during the past five years. Analysts may wish to forecast such items using the average
amount of €789 million. By not separating permanent from transitory accounting items
in forecasting, accounting users commit an (unintentional) error and may consequently
miscalculate the future cash flow potential of the analysed firm.

The level of information in financial statements

An important issue in assessing accounting quality is to evaluate whether the level of
information is satisfactory. The level of information can be assessed along at least two
dimensions: (1) The availability of information and (2) the quality of information.
The availability of information refers to whether the analysts have sufficient data to
make potential adjustments. As discussed, analysts need to separate transitory from
permanent accounting items. It is therefore important that firms provide the data that
are needed to make a qualified distinction between these types of accounting items. As
illustrated above, Bayer Group discloses special items separately, which makes it pos-
sible for analysts to make their own judgements.
The other dimension is the quality of the data that firms provide. To be useful, infor-
mation should be reliable and relevant. It may prove difficult to measure the quality of
the reported data. The following examples illustrate how analysts might assess the reli-
ability of information provided by management in financial reports. In order to measure
management's credibility, outlook (e.g. earnings forecasts) may be compared to realised
results. This comparison is made for Hartmann and DSV Group for the past years.

Example 13.12 Hartmann

Hartmann is among the three largest manufacturers of moulded-fibre egg packaging in the
world and also manufactures moulded-fibre industrial packaging. Hartmann has adjusted
earnings forecasts downward seven times in five years and during this period of time, the firm
overestimated EBIT by approximately DKK 30 million per year. It is on average an overestima-
tion of EBIT by approximately 40%. See Table 13.11.

Table 13.11 Stock exchange announcements from Hartmann - downward adjustments by Hartmann

Year 1 Year 2 Year 3 Year 3 Year 4 Year 4 Year 5

Downward Downward Downward Downward Downward Downward Downward

adjustment adjustment adjustment adjustment adjustment adjustment adjustment
of EBIT from of EBIT from of EBIT from of EBIT from of EBIT from of EBIT from of EBIT from
101 DKKm to 49 DKKm to 105 DKKm 70 DKKm to 8 0 - 9 0 DKKm 70 DKKm to -15 DKKKm to
80-85 DKKm 25-35 DKKm to 70 DKKm 60 DKKm to 70 DKKm 40 DKKm -65 DKm

•
Example 13.13 DSV
For another example, consider the DSV Group. The DSV Group offers end-to-end transport and
logistics solutions worldwide. Table 13.12 compares management's outlook in the annual report
with realised earnings. Even though the budget deviations vary over time, the total budget dis-
crepancy is only DKK 11 million or approximately DKK 2 million per year. It is a budget discrep-
ancy of less than 1% compared to Hartmann's budget discrepancy of 40%.

Table 13.12 Budgeted and realised earnings before tax for DSV Group
DSV Group (DDK million) Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Total
Budgeted earnings before tax 111 137 182 310 539 539 1.818
Realised earnings before tax 117 144 195 315 507 529 1.807
Budget difference 6 7 13 5 -32 -10 -11

•
The above comparison clearly indicates that information provided by the DSV
Group is of higher quality than data provided by Hartmann; at least as far as earnings
forecasts are concerned.

Example 13.14 Danisco

Danisco is a leading manufacturer of ingredients. Below Danisco's financial target for its most
important division, Ingredients and Sweetener, is shown in Figure 13.3. As the graph illus-
trates, Danisco has a target ROIC of 15%. By comparing the financial target of a ROIC of
15% with realised returns for the period year 1 to year 5, a substantial difference is apparent.
Danisco did not hit its target during the analysed five-year period. ROIC fluctuates around
9-10% in the period; far from the target of 15%. Thus, Danisco's own financial target seems
to be too ambitious. Analysts most likely overestimate the potential in the division Ingredients
and Sweetener if a ROIC of 15% is used as a starting point for forecasting. •

Figure 13.3 Comparison of realised and target ROIC

 Another important indicator of quality of data in the annual report is the audi-
tors' report. These reports may contain valuable information as illustrated in
Example 13.15.

Example 13.15 Valence Technology

Valence Technology, which is listed on NASDAQ, is an international leader in the develop-
ment, manufacturing and supply of lithium phosphate energy storage solutions. The firm
received an audit opinion containing a 'going concern' qualification, as illustrated in the fol-
lowing quotation from the report.

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Shareholders of Valence Technology, Inc. and Subsidiaries
Austin, Texas.

We have audited the accompanying consolidated statements of operations and compre-

hensive loss, stockholders' deficit, and cash flows of Valence Technology Inc. and sub-
sidiaries (the 'Company') for the year ended March 31, Year 6. These financial statements
are the responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements based on our audit.

We conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial statements
are free of material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by management,
as well as evaluating the overall financial statement presentation. We believe that our audit
provides a reasonable basis for our opinion.

In our opinion, such consolidated financial statements present fairly, in all material respects,
the results of operations, comprehensive loss, and cash flows of the Company for the years
ended March 31, Year 6 in conformity with accounting principles generally accepted in
the United States of America.

As discussed in Note 3 to the consolidated financial statements the Company adopted

SFAS 123R during the year ended March 31, Year 7.

The accompanying consolidated financial statements have been prepared assuming that
the Company will continue as a going concern. As discussed in Note 2 to the consolidated
financial statements, the Company's recurring losses from operations, negative cash flows
from operations and net stockholders' capital deficiency raise substantial doubt about its
ability to continue as a going concern. Management's plans concerning these matters are
also described in Note 2. The consolidated financial statements do not include any adjust-
ments that might result from the outcome of this uncertainty.

We also have audited, in accordance with the standards of the Public Company Accounting
Oversight Board (United States), the Company's internal control over financial report-
ing as of March 31, Year 8, based on criteria established in Internal Control - Integrated
Framework issued by the Committee of Sponsoring Organizations of the Treadwayomission
 (COSO) and our report dated June 16, Year 8 expressed an adverse opinion on the effec-
tiveness of the Company's internal control over financial reporting.

PMB HELIN DONOVAN, LLP

Austin, Texas

June 16, Year 8

The Auditors' report states that Valence's financial statements present fairly the results of
operations, comprehensive loss and cash flow. However, they also state:
As discussed in Note 2 to the consolidated financial statements, the Company's recur-
ring losses from operations, negative cash flows from operations and net stockholders'
capital deficiency raise substantial doubt about its ability to continue as a going concern.
Management's plans concerning these matters are also described in Note 2. The con-
solidated financial statements do not include any adjustments that might result from the
outcome of this uncertainty. •

The auditors therefore question Valence's ability to continue its businesses as a

going concern. Analysts should thoroughly consider the reported accounting num-
bers. For instance, if it is questionable whether the company is able to continue as
a going concern, lenders may have to call the debt. In that case, what matters is the
liquidation value of Valence's assets and liabilities, whose values are generally not
reflected in the annual report except for items marked-to-market (fair value) such as
cash and securities.
Often, information in the financial statements is not sufficient to make the adjust-
ments that are necessary to obtain identical accounting policies over time or across of
firms. The analyst may therefore consider to what extent it affects financial ratios. If
valuable information is left out of the annual report, the analyst should be sceptical.
Reported earnings are assessed to be of lower quality, if important pieces of informa-
tion related to earnings are not disclosed.

Identification of 'red flags'

Analysts may identify various issues and problems in carrying out financial statement
analysis. Such issues are often named 'red flags'. In the previous sections, a large
number of factors used in assessing accounting quality have been discussed. All those
factors are considered in identifying red flags. In addition, certain conditions relating
to the firm's financial position may indicate a red flag (the list is not exhaustive):
• The quality of a firm's business model
• Unsatisfactory development in accounting numbers and financial ratios
• The firm's ability to convert accounting income to cash flows.

Quality of a firm's business model

When assessing the quality of a firm's business model, it is crucial that operations have
proved its sustainability. Often, it is suggested that a historical financial statement
analysis should cover a five-year period. In assessing the quality of the firm's busi-
ness model, it is often a good idea to examine operating earnings over an even longer
 period of time. This requires that the underlying business model is fairly identical
throughout the analysed period.

Example 13.16 Andersen & Martini

Since the mid-1980s Andersen & Martini has been listed on the Copenhagen Stock Exchange.
The firm sells automobiles. As illustrated in Figure 13.4, Andersen & Martini has had operat-
ing earnings circling around zero. Average operating earnings (EBIT) over the period is close
to a deficit of DKK 1 million. In comparison, net earnings before tax average DKK 7 million
annually. This implies that Andersen & Martini has had average annual earnings of approxi-
mately DKK 8 million from activities that are outside the scope of its core business. There is
hardly any doubt that Andersen & Martini's business model is not sustainable in the long run
and unless analysts observe significant strategic changes, the firm's long-term survival may be
questioned. It should be noted that earnings not related to Andersen & Martini's core busi-
ness basically consisted of interest earned on the firm's securities (bonds). •

Figure 13.4 Assessment of Andersen & Martin's business model

Unsatisfactory development in accounting numbers and financial ratios

An unsatisfactory level and trend in accounting numbers and financial ratios often
expose problems related to a firm's economic position - within vital areas of profit-
ability, risk or growth. Table 13.13 highlights key figures for the past five years for
Oki Electric Industry, a company listed on the Tokyo Stock Exchange. A quick look at
Oki's financials reveals the following.
During the past five years, sales decreased by approximately 2 1 % (from Yen 688,542
million to Yen 545,680 million). Total assets fell by even more (almost 35%), indicat-
ing that Oki improved asset turnover. However, gross profit deteriorated by 27%. Net
earnings show the same negative trend except for a substantial improvement in year
8, but net income in year 8 was barely positive. Not surprisingly, Oki reports poor
financial ratios. For instance, return on equity changed from 8.6% (11,174/130,040)
Table 13.13 Oki Electric Industry-five-year summary (from annual report)

Five-year summary
Oki Electric Industry Co., Ltd and consolidated subsidiaries
Years ended March 31
Millions of yen
Year 9 Year 8 Year 7 Year 6 Year 5
For the year:
Net sales 545,680 719,677 718,767 680,526 688,542
Cost of sales 410,658 554,343 560,817 514,483 504,340
Gross profit 135,021 165,334 157,949 166,043 184,202
Operating income (loss) 410 6,200 (5,410) 10,593 27,220
Other income (expenses), net -36,810 -1,337 -10,720 -133 -8,920
Income (loss) before income taxes, -36,400 4,863 -16,130 10,460 18,299
minority interests and equity in earnings
(losses) of affiliates
Net income (loss) -45,011 567 -36,446 5,058 11,174

At year end:
Total current assets 275,247 374,334 405,161 379,135 374,278
Total investments and long-term 34,423 33,653 58,025 71,052 61,492
receivables
Property, plant and equipment, net 61,170 125,788 129,696 125,223 126,470
Other assets 26,121 37,043 35,515 43,244 44,996
Total assets 396,963 570,819 628,398 618,655 607,237
Total current liabilities 205,965 311,180 318,996 295,865 313,828
Total long-term liabilities 132,313 158,262 193,428 182,770 163,369
Total net assets 58,683 101,376 115,973 140,019 130,040
Common stock 76,940 76,940 76,940 67,882 67,877

in year 5 to - 7 7 % (-45,011/58,683) in year 9. The debt-to-equity ratio increased from

3.7 (477,197/130,040) in year 5 to 5.8 (338,278/58,683) in year 9. In conclusion,
Oki's growth and profitability deteriorated substantially over the five-year period. At
the same time, financial risk increased.
The stock market did not appreciate the development in Oki. During the period
the stock price fell sharply from approximately 500 to under 100 - a decrease of more
than 80%.
In case the analysis indicates the occurrence of red flags, it will most likely affect the
value of the firm negatively. Lenders will likewise seek compensation for the greater
risk by charging a higher price (interest rate).
The firm's ability to convert accounting earnings to cash flows
Accounting-based earnings measures are indicators of how much cash that has been
created in a given period. However, in some cases, accounting-based earnings may not
materialise in cash flows. Creative bookkeeping and accounting manipulation may
cause a discrepancy between accounting-based earnings and cash flows. Even though
cash flows and earnings in the long run should be of the same magnitude, there are
some natural exceptions. Firms, which grow substantially, often need to make huge
investments (in working capital and non-current assets) and therefore report negative
cash flows. However, over the lifetime of a firm accumulated accounting earnings
and accumulated cash flows ought to match. If earnings and cash flows do not cor-
relate in the long run, analysts should be critical of the validity of reported earnings.
Ultimately, the analyst may find that accounting-based performance measures (e.g.
EBIT) are inappropriate in assessing a firm's future earnings potential.
To assess a firm's ability to convert earnings to cash flows, the cash conversion rate
is a useful tool:

where
FCFE = The free cash flow to equity, where investments in non-current assets equal
reinvestments (reinvestments = depreciation + amortisation expenses)
The cash conversion rate eliminates the effect of acquired growth and expresses, in
per cent, the part of net earnings, which is converted to cash. As reinvestments are
typically not reported by companies, analysts have to apply proxies for reinvestments.
One possibility is to use depreciation and amortisation as a proxy for reinvestments.
To illustrate the idea the cash conversion rate for ISS, one of the largest facility services
companies in the world, is shown in Table 13.14.

Table 13.14 Cash conversion rate for ISS

(All amounts in DKKm) Year 1 Year 2 Year 3 Year 4 Year 5

FCF 460 795 874 1,058 1,739
Net earnings 487 622 830 898 1,115
Cash conversion rate 94% 128% 105% 118% 156%

The level as well as the trend in the cash conversion rate is positive in ISS. With
the exception of year 1 the cash conversion rate is in excess of 100%, which indicates
good cash management. DKK 1 million in core earnings (before goodwill amortisa-
tion) is converted to cash in excess of DKK 1 million. An immediate interpretation is
that accounting earnings are of high quality.
Sloan (1996) shows in an American study that the closer the association between
cash flows and accounting-based earnings, the better accounting-based earnings are in
signalling next year's earnings. In addition, Sloan demonstrates that investors to some
extent ignore that certain firms use accruals to affect reported accounting earnings.
It seems as though investors overvalue next year's earnings in firms that use accru-
als to improve reported earnings (earnings management). By avoiding these types of
 firms and buying shares in firms, where there is a close link between cash flows and
accounting earnings excessive returns may be obtained. Sloan's research supports that
accounting earnings, at some point in time, must be converted to cash flows. If this
does not happen, the value of reported accounting earnings is of limited relevance,
i.e. of low quality.

Total assessment of accounting quality

The analysts should make a total assessment of accounting quality. This assessment
may be used to make the necessary precautions before calculating financial ratios.
A total evaluation of accounting quality may also be used to rank firms against
one another. A firm that achieves the best rating will, other things being equal, be a
more attractive investment opportunity or a likely candidate for offering credit facili-
ties. In Table 13.15 we demonstrate how a simple rating of accounting quality may be
carried out.

Table 13.15 Total assessment of accounting quality

Assessment of the following statements: True False

1 2 3 4 5

Analysis of accounting quality has generally shown:

Few motives for accounting manipulation X

A high degree of quality in accounting policies X
A high degree of recurring accounting items X
A high level of information in the annual report X
Few 'red flags' in the financial statements X
Total appraisal 1,6

As seen in the table, a low value is synonymous with a high level of accounting
quality, while a high value signifies low accounting quality. The analysts may make
the same assessment of firms they cover. As an example, consider the assessment of
the accounting quality of four firms within the same industry shown in Table 13.16.

Table 13.16 Example on rating

of the accounting quality of four
firms within the same industry

Firm 3 1.6
Firm 1 2.4
Firm 2 2.8
Firm 4 4.0
 'Firm 3' is characterised by financial statements of substantially higher quality
than 'firm 4'. In case both firms report identical accounting figures and financial
ratios, greater credibility is assigned to the accounting numbers and financial ratios
reported by 'firm 3'. This will most likely result in a more efficient pricing of the
firm's shares reducing investors required rate of return. On the other hand, a firm
that manipulates accounting figures may also cheat in other areas. In this case, the
pricing on the firm's shares is affected negatively reflecting that investors require a
higher rate of return.
The above analysis is based on the five areas that are all part of assessing account-
ing quality in this book. There is nothing preventing an analyst in choosing other
areas than those discussed in this book. The crucial point is that accounting quality is
examined carefully. Furthermore, each of the five areas is weighted equally. The ana-
lysts may choose to assign a different weight to each area. For example, by assessing
earnings quality the extent of recurring earnings may be considered more important
than the general level of information in the annual report.

Conclusions
When assessing a firm's accounting quality the analysts will hardly ever obtain a con-
sistent and neutral assessment of a firm's growth, profitability and risk. It's difficult to
see through every accounting entry and often reported (financial) data are insufficient
in respect of assessing accounting quality of the analysed firm. Additionally, making
adjustments to the financial statements requires that the analysts make a number of
estimates and judgements. This also implies that the results of the analysts' efforts in
assessing accounting quality are indicative only. The fathers of fundamental analysis,
Graham and Dodd (1934, p. 352), express it as follows: 'It must always be remem-
bered that the truth which the analyst uncovers is first of all not the whole truth and,
secondly, not the immutable truth. The result of his study is only a more nearly correct
version of the past.'
Detailed insight into the analysed firm, including its accounting policies, is needed.
Furthermore, there is a need to compare accounting policies across comparable firms
in order to determine industry norms. There might be a need for further clarifica-
tion of various accounting items, which often requires that management is contacted.
Experience indicates that listed firms often respond to such requests, while non-listed
firms do not find that they are obliged to do so.
Most importantly, you must remember that uncritical use of accounting informa-
tion may cause losses for the lender, investor and other users of financial statements.
Due care must be taken in carrying out financial statement analysis.

Review questions
• What is meant by accounting quality?
• Why might management be interested in managing or manipulating earnings?
• What are the steps in examining accounting quality?
• How is the quality of accounting policies assessed?
 • Why should analysts care about transitory items?
• How can the analysts evaluate the quality of information in the annual report?
• What are 'red flags'?
• What are the economic consequences of differences in applied accounting policies?

Note 1 Assuming 'steady-state' in financial ratios in all future periods, the EVA model can be
shown as:

The second term is an annuity in perpetuity.

References Bradshaw, M.T. and R.G. Sloan (2002) 'GAAP versus the street: An empirical assessment of
two alternative definitions of earnings', Journal of Accounting Research, No. 1: 41-66.
Doyle, J.T., R J . Lundholm and M.T. Soliman (2003) 'The predictive value of expenses excluded
from pro forma earnings', Review of Accounting Studies, No. 8: 145-74.
Graham, B. and D. Dodd (1934) Security Analysis, McGraw-Hill.
Gramlich, J., M.L. McAnally and J. Thomas (2001) 'Balance sheet management: The case
of short-term obligations reclassified as long term debt', Journal of Accounting Research,
No. 2: 283-95.
Gramlich, J. and O. Sørensen (2004) 'Voluntary management earnings forecasts and
discretionary accruals: Evidence from Danish IPOs', European Accounting Review, vol. 13,
2: 235-59.
Naser, K.H.M. (1993) Creative Financial Accounting: Its Nature and Use, Prentice Hall.
Penman, S. (2010) Financial Statement Analysis and Security Valuation, 4th edn, McGraw-Hill.
Schipper, K. (1989) 'Commentary on earnings management', Accounting Horizons, 3: 91-102.
Sloan, R.G. (1996) 'Do stock prices fully reflect information in accruals and cash flows about
future earnings?', The Accounting Review, No. 3: 289-315.
 CHAPTER 14

Accounting flexibility in the income

statement

Learning outcomes

After reading this chapter you should be able to:

• Discuss and understand a firm's accounting policies
• Understand how changes in a firm's accounting policies affect the financial
statements
• Understand the potential impact of accounting flexibility on revenue recognition,
non-recurring and special items and non-capitalisation of expenses
Map economic consequences due to accounting flexibility
• Comprehend management's potential discretion on reported accounting numbers
and chosen disclosure policy
• Make adjustments to financial statements so they can be used as input to decision
models

Accounting flexibility in the income statement

S o far we have taken reported financial data at face value. For instance, in reformu-
lating the financial statements for analytical purposes, we discussed how to sepa-
rate operating from financing items. However, we did not make any adjustments to
firms' reported numbers. Why might accounting numbers need to be adjusted as part
of the analysis? Consider the following statement.

Financial data and various financial ratios serve as input to decision models (e.g.
the DCF model). Based on the decision model, the analyst makes his or her
recommendations and a decision is made (e.g. whether to buy or sell shares). This
process is depicted as follows:

Financial data and financial ratios Decision models Economic decisions

It is noteworthy that reported financial data is based on (1) a firm's accounting poli-
cies (flexibility in choosing between alternative accounting methods) and (2) a number
of subjective estimates (management discretion). As a result, reported financial data,
used for decision purposes, may vary greatly depending upon who is preparing the
financial statements. For example, imagine that 10 CFOs (or auditors) were asked to
prepare financial statements for an IT firm, which produces hardware and develops
and sells software and business solutions. Would they report the same accounting
numbers? Highly unlikely. Just consider a few issues:
If the firm sells computer equipment with two years of 'free' support and software
updates how much should be recognised as revenue each year? Should inventory
be accounted for using the FIFO method or some other method? Should R&D
be expensed as incurred or capitalised? What is the expected lifetime of the firm's
property, plant and equipment? How much of accounts receivable is uncollectable?
Is goodwill impaired and needs to be written down? And so on.
Answers to such questions depend upon the accounting policies used by the firm and
estimates and underlying assumptions made by the preparer of the financial state-
ments (e.g. expected useful lifetime for intangible and tangible assets). Furthermore,
even in those cases where management does not intend to affect reported accounting
figures in a desired direction, biased accounting information (noise) may be inevit-
able. This will be the case if, for instance, a firm must change accounting policies
due to new or revised reporting regulation. An example is the mandatory use of IFRS
for all listed groups in the EU from 2005. If these groups do not adjust the historical
accounting numbers retrospectively, it is at best difficult to separate the consequences
of changes in applied accounting policies and real changes in a firm's underlying oper-
ations. This is problematic in a time-series analysis or when benchmarking against
competitors. Therefore, financial statements are likely to contain measurement errors
even if the CFOs have the best intentions to portray the true underlying perform-
ance of the firm. To produce unbiased financial data would require perfect foresight,
which nobody has. In conclusion, since recorded data depend upon accounting pol-
icy choices and estimates, reported financial data depend upon who is preparing the
financial statements.
In this and the following chapter, we go behind reported numbers to assess account-
ing flexibility and how it may distort the analysis. If not properly accounted for, the
distortion may have (severe) economic consequences. An overview of the two chapters
is provided below:

Chapter 14: Accounting flexibility Chapter 15: Accounting flexibility

in the income statement in the balance sheet
Changes in accounting policies Inventory accounting
Revenue recognition criteria Intangible and tangible assets
Non-recurring and special items Lease accounting
Non-capitalisation of expenses Provisions
Deferred tax liabilities

It should be pointed out that other accounting issues can be found in practice.
However, a thorough understanding of the issues listed above should help analysts
to assess other accounting items, and evaluate how firms' accounting policies and
estimates for those items affect various decision models. It should be noted that items
listed above do not always cause 'noise' in the analysis. For instance, if a firm is
valued based on discounting its projected cash flows, depreciation and amortisa-
tion expenses (related to the item 'Intangible and tangible assets' above) should not
matter. 1
 In the next section we make a short introduction to accounting regulation in an
attempt to highlight major characteristics across accounting regimes followed by a
description of accounting flexibility. Finally, we discuss potential economic conse-
quences of the inherent flexibility in reporting financial statements.

Accounting regulation and flexibility

Firms must provide financial information that can be used by a variety of users for
decision-making purposes. To be useful, financial data should be relevant, reliable
and comparable. Annual accounts are generally audited (depending on local account-
ing regulation) by independent auditors. Nonetheless, reported financial data would
depend upon not only accounting policy choices and estimates but also the accounting
regulation which the firm must comply with.
Accounting regulation around the world differs (see Figure 14.1); as a consequence,
reported numbers (financial statements) depend upon the accounting regulation a
firm must comply with. A prime, and often used, example is Daimler Benz. In 1994,
Daimler Benz reported profits of approximately US$ 100 million according to what is
believed to be conservative German accounting rules. In comparison, under US GAAP,
Daimler Benz reported a US$ 1 billion loss. Even within the same country, firms may
have to apply different accounting standards. For instance, in the EU listed groups
must comply with IFRS, but non-listed firms follow local GAAP.3

Accounting regimes

IFRS Local GAAP

Mandatory for EU listed firms and a host of (e.g. US GAAP, German GAAP etc.)
other countries outside of the EU
The government in a country decides
Less strict rules for SMEs
if IFRS may be used for SMEs
(small and medium-sized enterprises)

Figure 14.1 Differences in accounting regimes

Accounting regulators, whether IASB, FASB or other local accounting regimes, face
some serious challenges as they should develop accounting standards which:
• Are the same over time, across industries and across accounting regimes
• Are strict and detailed, with little flexibility, to avoid earnings management, but
• Are also flexible enough to provide management the opportunity to report financial
data which incorporates their propriety information about the company.
Uniform accounting standards attempt to mitigate managements' ability to record
similar economic transactions in a dissimilar way over time or across companies. Even
if standards become universal, measurement issues are still not eliminated. The uses
of fair value as a measurement attribute and impairment tests involve a great deal of
judgement, which may hinder comparability across firms. Even the most rigid and
strict rules do not, and probably should not, prevent management using judgements
and estimates in preparing financial statements. A simple example can be used to illus-
trate this point.
Example 14.1Accounting regulation around the world requires firms to amortise intangible assets over
their useful lives, unless those intangibles have an indefinite lifetime.4 However, regulation
is not so strict as to determine the useful lifetime of such assets. It would make no sense
to make a standard which requires all intangible assets to be amortised over a predeter-
mined period of time, say, five years. The actual lifetime of those assets hinges on numer-
ous assumptions, which may vary greatly across industries and time. For instance, if a firm
that produces different kinds of drugs capitalises development expenses, the amortisation
period for these expenses should match the period the drugs are being sold on the market.
This period would often be difficult to estimate (maybe unless the firm has a patent on the
drugs), as cheaper or better drugs may come to the market and leave a prior blockbuster
almost worthless. •

It should be noted that there is an ongoing convergence project that aims at align-
ing IFRS with US GAAP. In addition, over time more countries have selected to apply
IFRS. Therefore, in the long run a set of universal acceptable accounting standards
may occur.5 However, these standards are likely to be mandatory for listed firms
only. Since the majority of firms in every country are non-listed there may still be
major differences between accounting regulation for listed versus non-listed firms.
Even if only one set of accounting standards is considered, major differences in
reported numbers are likely to occur for identical firms. This is due to the fact that
management needs to make estimates, judgements (assumptions) and predictions
(forecast) as underlying premises for producing financial statements. For example,
management need to make impairment tests. This requires forecasts (predictions)
of the assets' future net cash inflows. If the assets cannot generate sufficient cash
inflows (i.e. if book value exceeds the present value of the future cash flows),6 then
the assets are impaired and an impairment loss must be recognised as an expense.
Changing the forecasts and/or the discount rate slightly may mean that an impair-
ment loss that should have been recognised is avoided or vice versa. This implies
that a firm may not recognise an impairment loss, which they should have recog-
nised. Why management may wish to 'colour' the financial statements has been
discussed in Chapter 13.
Accounting flexibility also includes lack of regulation. Naturally, regulation cannot
foresee every business transaction, which needs to be recorded today or sometimes in
the distant future. As a result, this accounting regulation has little to say or may be
silent on how to account for various complex transactions. The IAS T/B considers this
in IAS 8:

In the absence of a Standard or an Interpretation that specifically applies to a trans-

action, other event or condition, management must use its judgement in developing
and applying an accounting policy that results in information that is relevant and
reliable, IAS 8.10. In making that judgement, management must refer to, and con-
sider the applicability of, the following sources in descending order:

• The requirements and guidance in IASB standards and interpretations dealing

with similar and related issues.
• The definitions, recognition criteria and measurement concepts for assets, liabili-
ties, income and expenses in the Framework. [IAS 8.11]
Source: www.iasplus.com
 It is ultimately left to research and practice to examine whether accounting stand-
ards that have strict rules are preferable in the sense that they provide the best data
for decision making. On the one hand, having strict rules makes it more difficult for
managers to manage earnings, for instance, in an attempt to meet bonus targets or
analysts' forecasts. On the other hand, management has a detailed understanding of
their company's business model and factors that affect profitability, growth and risk.
Therefore, requiring strict rules with little discretion may mean that management is
not able to report numbers which takes into consideration the proprietary informa-
tion that they hold.

Conceptual framework
Standard setters such as IASB and FASB have developed a conceptual framework and
a number of standards, which prescribe how firms deal with the definition, recogni-
tion and measurement of the elements of financial statements, how elements are pre-
sented (classification) and which information needs to be disclosed. These issues are
discussed below.

Definition of elements
For example:
• Which transactions to recognise?
• Which items qualify as assets and which as expenses?
• Which items qualify as revenue and which as liabilities or equity?

Recognition criteria
For example:
• When should items be recognised?
• What conditions must be met for items to be recognised?

Measurement issues
For example:
• Which measurement attributes should be assigned to accounting items at initial
recognition?
• How should items be valued at future dates?

Classification issues
For example:
• How should items be classified in the financial statements?
• How detailed should items be classified?

Disclosure issues
For example:
• What other kind of information is needed?
• How much voluntary information is provided?
 The following simple examples are used to illustrate why definition, recognition,
measurement, classification and disclosure issues should be considered in any finan-
cial statement analysis.

Example 14.2 Definition of assets

According to IFRS, assets are defined as resources under an entity's control, as a result
of a past event and from which the firm is likely to obtain future economic benefits. The
following two examples illustrate how the definition of assets has an impact on the financial
data:

• If a firm launches a huge marketing campaign it is likely to increase future sales (future eco-
nomic benefits), but marketing costs are not capitalised. This implies that a proper match
between revenue and costs is impossible due to the definition of assets.
• Human capital is the most valuable resource for many firms. A law firm may have acquired
an office building, office furniture, cars and information technology. All such assets are
easily replaceable and recognised as assets. However, the most important resources, the
employees of the law firm, are not recognised as assets, since employees do not meet
the definition of an asset. They are not under the firm's control, but are generally free to
leave with fairly short notice. This will have an impact on reported invested capital and
thereby also on financial ratios such as ROIC and profit margin. •

Example 14.3 Recognition of development costs - assets or expenses

To qualify as an asset, three conditions must be met. Assets are resources (1) controlled by an
entity, (2) as a result of a past event, and (3) future economic benefits from these resources
are expected to flow to the entity. Furthermore, to be recognised in the balance sheet, assets
must pass the recognition criteria, which is that the value (costs) of asset(s) can be measured
reliable.
In some industries, for example the biotech industry, firms are highly dependent upon suc-
cessful R&D projects. It is not unusual in such industries that R&D amounts to 20% to 25% of
revenue (turnover). IAS 38 on intangible assets states:

• Charge all research costs to the income statement.

• Development costs shall be capitalised only after technical and commercial feasibility of
the asset for sale or use have been established. This means that the entity must intend and
be able to complete the intangible asset and be able to demonstrate how the asset will
generate future economic benefits.

Furthermore, if an entity cannot distinguish the research phase of an internal project (used
to create an intangible asset) from the development phase, the entity treats the costs for the
entire project as if it was incurred in the research phase only (i.e. all costs are expensed as
incurred).
This raises two fundamental issues from an analytical point of view:

1 How much of a firm's R&D activities should be related to the development phase?
2 Should development costs be expensed or capitalised (recognised as assets)?

Naturally, it has a significant effect on reported numbers to which extent costs related to
R&D activities are considered to be development costs, and if these costs are expensed as
incurred or capitalised. Knowing that historically perhaps only one out of 10 R&D projects
becomes commercially successful, you could ask: should a firm capitalise only one out of every
 10 projects (and, if so, which one?) or should it capitalise 1 0 % of all development costs, as a
firm would presumably not carry out any new R&D projects without believing that some of
them will eventually become successful? •

Example 14.4 Measurement - turnover

A firm specialises in selling unsold hotel rooms on the Internet. The firm charges 5% of the
price as a fee for providing this service. If a customer buys five nights for, say, € 1 , 0 0 0 , the
agent receives a fee of € 5 0 , while the hotel gets the remaining € 9 5 0 . Should the agent rec-
ognise revenue of € 1 , 0 0 0 and costs of € 9 5 0 or only the fee of € 5 0 as revenue?
Some firms sell products with an extended warranty period. Kia Motors, for instance, sells
cars in many countries with a seven-year warranty. The obvious question to ask is: how much
of the revenue from selling cars should be deferred to future periods to match the costs
associated with repairing cars under the warranty? Or, alternatively, how much should Kia
recognise as provisions for the extended warranty obligations the firm faces? •

Example 14.S S u b s e q u e n t m e a s u r e m e n t of assets

A firm buys highly specialised equipment to be used in its chemical production process. At
year end, this equipment must be recognised as assets, but at what value? Possible measure-
ment attributes include:

• Historical costs less depreciation, amortisation and impairment losses

• Amortised costs
• Replaceable value
• Liquidation value
• Fair value
• Value in use
• Insured value
• Tax-based value
• Etc.

Some would argue that assets should be measured at their 'true' value. But what is the 'true'
value? Naturally, there is no unequivocal answer to this question. For instance, if the analyst
wants to make a valuation of assets based on a present value approach, the present value of
future earnings (cash flows) from using the equipment (along with other assets) would be
the relevant value. However, if the firm is financially troubled, valuation may be based on
the liquidation model (worst case scenario). In this case, the liquidation value would be the
preferred measurement attribute. •

Example 14.6 Classification

Accounting items may be classified in different ways. For instance, restructuring costs may
be included in production costs (and, therefore, part of a firm's core operations, i.e. included
in EBIT), while other firms choose to highlight restructuring and similar costs in a separate
line item by labelling them 'special items', 'abnormal items', 'unusual items', 'extraordinary
items' 7 or the like.
Analysts need to be able to single out transitory items. For example, in forecasting
future earnings (and cash flows) transitory items should be disregarded. They therefore
prefer t h a t restructuring and similar costs are classified as a separate line item in the
income statement. •
 Example 14.7 Disclosure
In order for users of financial statements to get a deeper understanding of the reported num-
bers, firms must disclose a wide range of information in the notes to the financial statements.
The Framework for the Preparation and Presentation of Financial Statements (Framework)
paragraph F.21 notes that:
The financial statements also contain notes, supplementary data and other information that
(a) Explain items in the balance sheet and income statement
(b) Disclose the risks and uncertainties affecting the entity
(c) Explain any resources and obligations not recognised in the balance sheet.
This may sound as though disclosure is a safe bet. By reading the notes, the analyst should be
well-informed about numbers entered into the financial statements. While it is true that you,
as an analyst, should read the notes and other supplementary material in the annual report
carefully, disclosure still poses some challenges.
First, it is up to management to decide how much information they want to reveal. As
shown above, notes and other supplemental information should explain or disclose account-
ing items and risk factors affecting a firm. Expressions such as explain and disclose are some-
what vague leaving much discretion to management.
Second, as an analyst, you will often need to separate out non-recurring items. Such infor-
mation may be found on the face of the income statement as items marked, for example,
'special items' or 'unusual items'. However, non-recurring items may not be shown as sepa-
rate line items leaving the analyst to be looking elsewhere; i.e. in the notes and supplemen-
tary information.
Finally, the amount of time you devote to reading the notes and other supplemental infor-
mation depends on the purpose of your analysis and the decision model that you use; be sure
to apply a cost-benefit analysis before getting carried away reading everything in the annual
report. •

Accounting flexibility in the income statement

Before carrying out financial statement analysis, an analyst should reflect upon the
quality of the data available. As discussed throughout this book, the quality of data
cannot be defined without reference to the purpose of the analysis and the decision
model applied. At the general level, analysts should be aware that biased accounting
numbers are more likely to occur under the following circumstances:

• When transactions span a long time horizon (e.g. construction contracts)

• When transactions are complex (e.g. derivatives)
• When accounting standards lack clarity and are complex (e.g. IFRS 3)
• When a great deal of judgement is needed in applying the standard (e.g. impairment
tests)
When management may choose between different accounting methods (e.g. inven-
tory accounting based on FIFO versus average costs).
Analysts need to consider if data are biased, which may make it necessary to adjust
reported financial data as part of the analysis. As a starting point, the analyst might
get an indication of the quality of the financial data by considering the business
model, the industry in which the firm operates and the accounting policies applied
 in the annual report. Knowing the firm's accounting policies, business model and
the industry help the analyst to identify whether accounting data are likely to create
noise. For example, if the firm operates within the retail industry accounting flex-
ibility and measurement errors should not be big issues. Sales and cash receipts take
place simultaneously and most expenses are directly related to sales. Measurement
problems basically relate to non-current assets and inventory. On the other hand,
firms in construction industries (e.g. shipyards) are prone to measurement errors.
The earnings process takes place as production progresses, and analysts have hardly
any chance to assess whether the estimated percentage of completion, and, therefore,
revenue, is unbiased.
In the following sections and in Chapter 15, we focus on how accounting flexibil-
ity affects financial statements and discuss potential economic consequences. When
assessing analytical issues an analyst should ask questions such as:

• What characterises the industry?

• What major accounting method choices are made by management?
• Are accounting policies the same as for other firms within the industry?
• Have accounting policies changed over time?
• What are the major estimation issues?
• What are the key limitations in the information provided in the financial state-
ments, notes and supplementary reports?
The answers to such questions help the analyst to decide whether adjustments need to
be made to the data at hand. A thorough knowledge of the business and insight into
accounting flexibility is definitely warranted before the analyst carries out his or her
analysis.

Changes in accounting policies and estimates

Since the trend and levels of past earnings serve as indicators for future earnings, ana-
lysts should be aware of changes in a firm's accounting policies, as they are likely to
introduce noise in a time-series analysis. Changes in accounting policies can happen
for two main reasons:
1 Voluntary changes. Management find that a change is needed for financial state-
ments better to reflect the underlying performance and financial position of the
firm.
2 Mandatory changes. Firms are required to adopt new accounting standards or may
have to comply with a new accounting regime.
An analyst should try to dig further into why a firm changes its accounting poli-
cies and assesses the effects on financial statements. While the comparable figures in
the financial statements have been changed, for instance, in reporting 2005 financial
data according to IFRS, the comparable figures for 2004 must be based on IFRS as
well, key figures in the financial summary are often not restated. Certainly, if analysts
look at annual reports from before 2004 they are still based on local GAAP. Consider
accounting for goodwill. Prior to applying IFRS most countries required goodwill to
be amortised over its useful lifetime. IFRS does not allow amortisation of goodwill,
but goodwill shall be tested for impairment at least annually or whenever there is an
indication that goodwill is impaired.
 Table 14.1 Amortisation vs non-amortisation of goodwill
Year 1 Year 2 Year 3 Year 4 Year E1 Year E2
Revenue 200,000 200,000 200,000 200,000 200,000 200,000
EBITDA 60,000 60,000 60,000 60,000 60,000 60,000
Goodwill amortisation 20,000 20,000 0 0 0 0
Goodwill impairment 0 0 0 0 ? ?

EBIT 40,000 40,000 60,000 60,000 ? ?

EBIT margin 20% 20% 30% 30% ? ?

Invested capital 100,000 80,000 80,000 80,000 80,000 80,000

ROIC NA 44.4% 75.0% 75.0% ? ?

Table 14.1 illustrates the effects for a firm switching to IFRS in year 4. 8 Suppose
that the firm used to amortise goodwill over a five-year period, but ceases to amortise
goodwill in year 4. The firm restates the numbers for year 3. That is, goodwill amor-
tisation is added back, as if no goodwill amortisation took place in year 3. By the end
of year 4, the analyst wants to value the firm. The analyst uses the EBIT margin as an
important value driver. Apparently, the EBIT margin improves from 20% in years 1
and 2 to 30% in years 3 and 4. Should the analyst forecast the EBIT margin at 20%
or 30% or some other figure? Well, why not 30%? As illustrated in the Table 14.1,
by the question mark, the firm may have to recognise an impairment loss on good-
will in the forecast period (since goodwill is no longer amortised), but it has no cash
flow consequences, so 30% should be a safe bet? Probably not - Goodwill represents
future abnormal earnings. According to economic theory, abnormal earnings cease
to exist in the long run. Assume that the firm was right in amortising goodwill over
a five-year period. As a result, to keep revenue and EBIT at a high level (maintain
abnormal profit), the firm needs to invest in goodwill on a continuous basis. In the
example, goodwill has no value (produces no future cash flows) after five years (by the
end of year E1). Therefore, if the analyst fails to recognise this, he or she does not take
into account that investments in goodwill are necessary in the future; just as the firm
needs to reinvest in tangible assets. In conclusion, in the Table 14.1 example, a future
EBIT margin of 20% is probably a fair or reasonable estimate.

Revenue recognition criteria

Management has a strong focus on revenue (sometimes labelled turnover or sales),
the top line in the income statement, and so should analysts. The performance of
a firm is critically dependent upon its ability to generate future sales. In fact, most
other value drivers are affected by the sales growth as discussed extensively in the
chapter on forecasting. Also, it has been documented that approximately 40% of
accounting restatements in the USA are related to improper recognition of revenues.
Finally, accounting regulation contains little guidance as how to account for income
(revenue and gains). 9
In this section, we discuss accounting for revenue arising from the sale of goods, ren-
dering of services and construction contracts. The major issues in revenue recognition
relate to when revenue shall be recognised (timing of recognition) and to a lesser
extent by which amount revenue shall be recognised (measurement). Recognition and
measurement are discussed in subsequent sections, but first we turn to a short discus-
sion of the definition of revenue.

Definition of revenue
IAS 18 'Revenue' defines revenue as follows:
Revenue is the gross inflow of economic benefits during the period arising in
the course of the ordinary activities of an entity when those inflows result in
increases in equity, other than increases relating to contributions from equity
participants.
This definition means that inflows of economic benefits are only recognised as revenue
to the extent that they result in an increase in equity. As a consequence, revenue shall
be net of sales taxes, goods and service taxes, duties and value added taxes. Such taxes
do not represent an increase in equity. They are just collected on behalf of third parties
and have to be paid eventually in cash by the company. Similarly, discounts, rebates
etc. should be subtracted from revenue, as they do not represent economic benefits.
This is also why revenue is labelled net revenue or net turnover by some companies.
From an analytical point of view, compliance with the definition should not pose any
serious challenges. Nonetheless, analysts should read the note on accounting policies
related to revenue to make sure that firms comply with the definition. For instance,
in bad times, management could be tempted to include gains on sales of securities or
property, plant and equipment as part of revenue in order to boost the top line in the
income statement.

Timing of recognition
The time at which revenue shall be recognised is often a complex issue. As illustrated
in Figure 14.2, revenue can be recognised at different points in time ranging from the
date of an order from a customer and until warranty expires. The question is: at what
point of time should revenue be recognised?

When should revenue be recognised?

Order Production Sales/invoice Payments from Expiration of Expiration of

customers right of return time warranty

Figure 14.2 Recognition of revenue

It could be argued that revenue should be recognised, when a firm receives an order.
At this time the stock price is likely to go up (if the stock market believes that it's
a profitable order). Since the stock price increases, recognising revenue at this time
seems to provide relevant information to investors. However, accounting regulation
(whether IFRS or US GAAP) does not permit recognition at the date of an order; the
conditions that need to be fulfilled are simply not met.
At the other extreme, recognition could be delayed until warranty expires. Here
there is simply no more uncertainty attached to the transaction. Revenue can be
measured reliably albeit at the expense of relevance. However, only under very rare
circumstances would a firm postpone revenue recognition until warranty expires.
For a vast number of companies the timing of when sales are recognised should
not be problematic. Retail stores, for instance, buy goods from its vendors and store
it (no pre-orders and no production process). When customers make their purchases,
they pick up the goods in the store, pay at the cash register and get a receipt. Sales,
invoicing and payment take place simultaneously, and if there are no warranty or
other after-market promises (e.g. right of returns), recognition of sales for retail stores
should not pose a problem from an analytical point of view. For other types of firm,
the time from when a customer places an order and to when warranty expires may
span several years; in such cases the analyst should be particularly careful in interpret-
ing firms' performance.
When revenue shall in fact be recognised, and by which amount, depends on several
factors. First, pricing contingencies (e.g. extended warranty) may affect the timing of
recognition. Second, if transactions include multiple elements or deliveries, revenues
should be allocated to the different components. This requires a thorough knowledge
of the business model and the industry to which the firm belongs. Finally, a distinc-
tion should be made between sales of goods and rendering of services and construc-
tion contracts, since services and construction contracts may span multiple periods
and revenue is recognised according to a separate standard: IAS 11 'Construction
Contracts'.
In summary, recognition of revenues is fact and industry dependent and analysts
need to possess knowledge of the analysed firm's sales policies and industry charac-
teristics. Below, we extend the discussion of timing issues further by dividing it into
three parts:

1 Pricing contingencies
2 Multiple elements and deliveries
3 Rendering of services and construction contracts.

Pricing contingencies
For revenue to qualify for recognition, IAS 18 set forth a number of criteria that
must be met (IAS 18.14). One of the criteria is that 'the entity has transferred to
the buyer the significant risks and rewards of ownership of the goods'. In practice,
enterprises may retain significant risks in a number of cases. In those cases, the firm
shall defer revenue or recognise a provision, for example because the firm offers its
customers:

• A price guarantee
• The right to return goods
• Extended warranty
• Extended credit terms.
The analyst needs to take into account how firms recognise such pricing contin-
gencies. Management may try to boost revenue by offering unusual terms, by, say
extending warranty to cover a five-year period. This requires that firms either defer
revenue or make provisions for the potential future costs of repairs covered by the
warranty. Unless the extended warranty is priced separately, management has a
great deal of discretion in recognising and measuring deferred revenue and warranty
provisions.
Price and return agreements
A firm may offer its customers a price guarantee for instance by paying the difference
if customers are able to find the firm's products at lower prices in other stores or to
return products within a period with a full cash refund. In such cases, a firm should
recognise a liability, which reflects such agreements. A simplified example illustrates
how return agreements are accounted for. Suppose that on average 5% of all goods
sold are returned to firms that have return policies, which allow customers to return
products within two weeks. Furthermore, assume that all customers pay in cash. If
firm A recognises that customers do return products, while firm B does not take this
into account in their financial statements, the two firms would report as follows (the
data reflects sales from year 1 only):

Firm A Firm B

Year 1 Year 2 Year 1 Year 2

Revenue 100 0 100 0

Cost of returned goods 5 0 0 5
Net revenue 95 0 100 -5
Provision for returned goods 5 -5 0 0
Cash 100 -5 100 -5

By not recognising that customers return products, firm B overstates earnings by

5 in year 1 (no expense related to returned goods is recognised), but understates it in
year 2 by the same 5 if we look at one transaction only. If sales are fairly constant,
accounting policies for price and return agreements make little difference. Assume in
the above example that sales in year 2 amount to 100. Firm A would again recognise
sales, net of warranty expenses of, 95. Firm B would also recognise sales net of war-
ranty costs of 95 - namely the sales of 100 in year 2 less the returned products from
year 1 of 5.
Accounting regulation requires firms to recognise a provision for goods (likely) to
be returned as does firm A in the simplified example. No revenue is deferred as the
costs incurred or to be incurred in respect of the transaction can be measured reliably.
The costs yet to be incurred (returned goods) can be measured reliably, for example,
based on experiences from prior years. However, if there is a significant amount of
unpredictable returns of goods, revenue should be deferred. Of course, the amount
that has to be deferred needs to be estimated by management again leaving leeway for
management discretion.

Extended warranty
If a firm sells products with extended warranties, part of revenues might have to be
deferred since the sales price includes the pricing of the extended warranty, and it is
questionable if revenue related to warranty has been earned.
Assume that a firm sells for 100 in year 1. They offer an extended three-year war-
ranty on their products. The firm estimates that 6% of the total sales price relates to
warranty. Costs of goods sold (COGS) excluding estimated warranty expenses amount
to 54. How should revenue be recognised?
 Alternative 1 Year 1 Year 2 Year 3 Year 4 Total
Revenue 94 2 2 2 100
COGS -54 -54
Warranty expenses -2 -2 -2 -6
Gross profit 40 0 0 0 40

Alternative 2
Revenue 100 0 0 0 100
COGS -54 -54
Warranty expenses -6 0 0 0 -6
Gross profit 40 0 0 0 40
Provisions (liability) 6 4 2 0 NA
Note: It is assumed that sales take place at year end. Thus, no revenue related to warranty is
recognised in year 1.

Alternative 1 better reflects the 'true' earnings process, as revenue related to warranty
is deferred and recognised during the warranty period. In alternative 2, revenue is
overstated in year 1 since the entire proceeds from sales are recognised.
Both alternatives provide management with opportunities to manage earnings.
How much income they defer or how much they recognise as a provision to cover
future repairs depends upon their best estimate of the price customers would have
paid for the extended warranty and the amount of future warranty expenses, respec-
tively. If they overestimate (underestimate) future warranty expenses, gross profit in
year 1 would be too low (high) and future gross profit too high. Both ways of account-
ing for warranty expenses are probably within the boundaries of generally accepted
accounting principles (GAAP).

Multiple elements or deliveries

Often, a sales transaction may involve several elements or deliveries. In such cases,
the sales transaction should be separated into its different components, which permits
management great flexibility as of how much revenue to relate to each component.
Examples of special areas where revenue recognition issues are complex and deserve
some attention include:
1 Vouchers
2 Subscriptions to publications
3 Advertising revenues
4 Installation fees
5 Up-front fees
6 Software and hardware.
The list is not exhaustive.
Vouchers are used extensively in the retail sector. For example, if a 'two for the
price of one' product promotion is offered; the question is whether it is appropriate
to recognise the revenue from the sale of both products with the free element being
recorded as a cost? It could be argued that vouchers should be treated like discounts
or rebates as a reduction in revenue. However, IAS 18 is not explicit on this point.
 Subscriptions to publications (newspapers, magazines etc.) are not actually earned until
the newspapers or magazines are published. Cash received prior to issuing the publica-
tions shall be classified as deferred income (unearned income) and classified as a liability.
The issue in recognising advertising revenue is to establish when revenue has been
earned. Is it earned when the advertising is complete (e.g. ready for publication or
TV)? Normal practice is to recognise the revenue as the production process proceeds
or when the advertising is made public.
The treatment of installation fees depends upon whether the installation fees are
significant. For instance, sellers of hi-fi equipment and TV sets may offer to install
TVs in their customers' homes at no extra costs. If such installation is not a significant
part of the total revenue, then the firm should merely include the fees in the sales price
of the TVs. Therefore the time of the revenue recognition will be that for the sale of
goods, which is normally at the time of delivery.
For up-front fees, the critical event will still be the provision of the service/goods.
Membership fees in a golf club or fitness centre are examples of up-front fees. If
the revenue has not been earned then up-front fees are, in essence, deferred income.
Arguably, the membership fees should be allocated to the period over which the mem-
bers are expected to stay members.
Technology firms often enter contracts with several elements. Each of these ele-
ments should be valued, and recognised as revenue, separately. Software contracts
often contain both installation of the software on computers and additional services
like online support, software upgrades for a period of time and inhouse training in
how to using the software. The initial part of the contract (that relates to the software)
can be recognised immediately, but the other components shall be recognised as the
services are rendered. Unless the contract specifies how much the customer pays for
the software and additional services respectively, management has discretion in how
to allocate the revenue to each component of the contract.
Likewise sales of hardware may include several components; for instance, instal-
lation of software, online-support, and onsite repairs. Each component accounts for
part of the revenue agreed upon in the contract. This leaves much room for manage-
ment to allocate revenue to each component as they see fit, unless the contract clearly
specifies the price for each element.

Rendering of services and construction contracts

Architects, auditors, lawyers and consulting firms, who offer services, and construc-
tion companies, who offer products, use IAS 11 'Construction Contracts' for revenue
recognition purposes. According to IAS 11, revenues are recognised as the orders are
produced (or services rendered), since production of, say a ship or an office building,
constitute the firm's earnings process. Revenue is recognised based on the percentage
of completion method. The following example illustrates how construction contracts
are accounted for.

Example 14.8 Construction contracts

A large cruise ship is ordered by a firm offering cruises in the Mediterranean Sea. Assume that
the following information is provided:
• The agreed price is €800 million (excluding VAT)
• The costs of building the ship are estimated to €600 million (excluding VAT)
• The shipyard expects to complete 25% of the ship every year (years 1-4)
• The buyer approves the ship at the date of delivery.
How is this transaction recorded in the shipyard's account, if the percentage of completion
method is used?

Year 1 Year 2 Year 3 Year 4 Total

Realised accumulated completion 25% 50% 75% 100%

Revenue 200 200 200 200 800
Costs 150 150 150 150 600
Profit 50 50 50 50 200

Not surprisingly, revenue and earnings are recognised as building the ship progresses. In year 1,
25% of the ship has been built. Since the price of the ship is 800, 25% × 800 = 200 is recog-
nised as revenue, and 50 (25% × 200) is recognised as profit. How does the shipyard (or the
auditors) know the percentage of completion? There are several ways of estimating comple-
tion. They can inspect the ship to get an idea of the progress. More often they use costs as a
measure. In the above example, if the shipyard has spent 150 in year 1, it indicates that 25%
(150/600) of the ship has been built.
In year 3, the shipyard realises that the cost of building the ship is going to skyrocket from
600 to 900. Expenses for years 1 and 2 were 150 annually. For year 3 and 4 the shipyard fore-
casts expenses of 300 annually. How shall this additional information be recorded?

Percentage of completion Year 1 Year 2 Year 3 Year 4 Total

Forecast 25% 50% 75% 1 00%

Revised 16.7% 33.3% 75.0% 100.0%

Revenue 200 200 200 200 800

Costs 150 150 400 200 900

Profit 50 50 -200 0 -100

The shipyard now faces a loss of 100 (800 - 900). Since the firm already recognised a profit
of 100 (50 in both year 1 and year 2), the firm must recognise a loss of 200 in year 3 accord-
ing to generally accepted accounting principles. •

Example 14.8 illustrates that reporting revenues and earnings based on the percent-
age of completion is like selling rubber by the metre. Once again, analysts should be
on the alert if the firm they analyse uses IAS 11 on construction contracts.

Measurement
From an analytical perspective, measurement of revenue (the amount to be recognised
as revenue) includes a variety of issues, which should be considered. For instance:
• How much revenue should be recognised if the firm acts as an agent?
• How shall barter transactions be accounted for?
• How shall revenues from sales abroad (receipts in foreign currencies) be accounted
for?

These issues are discussed below.

Agents
Some agents specialise in selling unsold tickets (e.g. flights and hotel rooms) on the
internet. Assume that a travel agent receives a commission fee of 5% for selling other-
wise unsold tickets to overseas flights. Essentially, the travel agent could recognise
revenue in one of two ways:

Alternative 1 Alternative 2
Revenue 200 -
Commissions, revenue - 10
Cost of airline tickets -190 0
Profit 10 10

Agents should only recognise the commission fees as revenue, as they represent
increases in equity. Also, if the agent is unable to sell those tickets they just go unsold
and the agent bears no risk. Practically speaking the agent has no inventory and there-
fore no risk. Consequently, If the agent sells tickets totalling 200, the agent ought to
recognise revenue of 10 (5% × 200). The agent may be tempted to recognise sales
of 200 and expenses of 190 to boost the top-line (earnings are unaffected). Analysts
should be aware of such tricks, by carefully reading the note on applied accounting
policies.

Barter transaction
During the 'dot com' era many internet companies had negative earnings, but inves-
tors believed there was still potential for incredible growth rates and future earnings.
These companies were often engaged in barter transactions (i.e. exchange services or
goods). For instance, two firms (A and B) may agree upon making links to each other's
internet sites. They agree that such advertising should be priced at 100. Here is how
many firms recorded such a transaction:

Firm A Firm B

Revenue 100 100

Marketing expenses -100 -100
EBIT 0 0

The operating profit from making such transactions was zero for both companies. If
the firms agreed upon a new and similar barter transaction next year, but now at a price
of 120, it would seem like those firms were enjoying huge growth rates. According to
current IFRS, firms may not account for barter transactions as just described.

Sales abroad
Currency fluctuations related to sales abroad may affect revenue considerably. Novo
Nordisk states in its annual report for year 8, that:
. . . One obvious example of the impact that currency developments had on Novo
Nordisk in year 8 was the impact on sales growth. In year 8, Novo Nordisk
 achieved sales growth of 12% when adjusted for the impact of currencies. However,
in reported terms sales growth was 9% due to negative exchange rate impact com-
pared to the Danish kroner of approximately 3%, or more than DKK 1 billion.
Such currency fluctuations make sales forecasting (or forecasting expenses if goods
are purchased in foreign countries) difficult. It does require that the analyst is able
to separate the effect of the number of items sold from the effects of exchange rates
changes. For analytical purposes (e.g. forecasting), an analysis of the historical growth
rates should reflect that the real growth rate in year 8 was 9%. The analyst has to look
carefully in the annual report for the currency effects on revenue growth, as growth
rates are an important value driver in any firm.

Detection of aggressive revenue recognition policies

Sales are the bread and butter of any firm. Boosting revenues lead to higher earnings.
Therefore, it is hardly surprising that accounting restatements are often related to
sales. How can analysts detect if a firm's revenue recognition policies are too aggres-
sive? There are several signs, which may be an indication of such improper (or crea-
tive) accounting policies. For example:
• Does the firm properly disclose its revenue recognition policies?
• Has the firm changed its revenue recognition policies lately?
• Are the firm's revenue recognition policies comparable to its main competitors?
• Does accounts receivable increase more than sales?
• Is there evidence of significant related party revenues?
• How do measures such as revenue per employee, revenue per euro of invested capi-
tal, revenue per euro of property, plant and equipment or similar metrics compare
with the industry?
• Is there a strong link between sales (or operating earnings) and cash flows from
sales (or operating cash flows) over time?
It is important to point out that these are only indicators. A decrease in accounts
receivable turnover, for example, may be due to the fact that the firm purposely
extended its credit terms to customers in an attempt to increase sales.

Non-recurring and special items

As discussed extensively in Chapter 13, analysts need to be able to separate transitory
(or non-recurring) items from permanent (or recurring items). There is no universal
definition of such items. Examples of non-recurring items that are often labelled 'spe-
cial items', 'unusual items' and the like (indicating they are non-recurring) include:

• Prior-period adjustments
• Net operating loss carry forwards
• Restructuring charges
• Gains or losses on the sale of assets
• Effects of a strike or of an extended period in which critical raw materials are
unavailable
• Effects of abnormal price fluctuations
• Write-offs and other expenses related to acquisitions
• Uncollectable accounts receivable in excess of what is normal (in the industry)
 • Gains or losses from settling lawsuits
• Other non-recurring items.
Analysts should be aware of the classification of such items. If they are truly non-
recurring they should be disregarded in forecasting future earnings. However, they may
have to be regarded as part of core earnings. For instance, firms may spend considera-
ble amounts on restructuring on a continuous basis in order to stay competitive. In this
case, restructuring costs should probably be included in forecasting future expenses.
A separate issue to consider is by what amount such expenses should be forecast.
A workable solution would be to average the restructuring costs over, say, the past five
years and use this average for forecasting purposes. Forecasting the amount may be the
truly difficult issue, as restructuring charges usually fluctuate substantially over time.
Again, in assessing special items the analyst should read any information about such
items in the annual report with great interest. An understanding of the industry should
also help the analyst. For example, firms within the fashion industry may have to
recognise large write-downs on inventory, since collections may fail from time to time
making them unsaleable. If firms classify such write downs as special items, the analyst
should carefully consider how to include them in their analysis.

Non-capitalisation of expenses
A major issue in financial reporting is the extent to which certain costs should be rec-
ognised as expenses or capitalised and recognised as assets subject to depreciation (or
amortisation) and impairment tests. Below, we discuss capitalisation versus expensing
of costs (i.e. whether certain expenses warrant recognition in the balance sheet). A
discussion of recognition seems warranted as there is often a fine line between recog-
nising versus not recognising certain items in the balance sheet. Depending on how
such expenses are accounted for, the effects on reported data and financial ratios may
be quite large.
Many intangible resources (assets) are expensed. A number of studies find that
such resources represent assets and therefore ought to be capitalised. However, the
measurement of assets (and liabilities) often requires the estimation of future amounts.
GAAP requires that these assets can be measured with some minimum level of reli-
ability. If this is not possible, such assets are not recognised but expensed as incurred.
Consequently, most internally generated intangibles, including assets such as brands,
master heads, publishing titles, customer lists, goodwill and items similar in substance,
must be expensed immediately. Likewise, marketing expenses and other forward look-
ing costs are expensed as incurred.
An exception to this rule is research and development expenses (R&D). Research
costs cannot be capitalised, but development costs shall be capitalised if some strict
conditions are met. For instance, technical and commercial feasibility of the intangible
asset for sale or use must be established. In reality, this means that the entity must
intend to and be able to complete the intangible asset and demonstrate how the asset
will generate future economic benefits.
This raises two fundamental questions: (1) when does a firm enter the devel-
opment phase of R&D projects and (2) in the development stage, when is there
sufficient evidence to support capitalisation of development costs? Consider the fol-
lowing example, which shows the effects of capitalisation versus expensing of R&D
projects.
Example 14.9 Expensing versus capitalisation
A firm has the option to capitalise development costs. How would capitalisation of such costs
affect reported numbers and financial ratios? Assume the following pieces of information:

Price per p r o j e c t - annual investments in R&D 100

projects at the beginning of the year

Return per year per project at year end (cash flow) 30

Useful lifetime of each project 5 years

Internal rate of return per project (IRR) 15.2%

Note: In the following examples full depreciation in the year
of the investment is assumed.

If the firm recognises R&D costs as incurred, it would report the following numbers in the
income statement (extract):

Income statement (extract) Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

EBITDA (excluding development costs) 30 60 90 120 150 150

R&D costs -100 -100 -100 -100 -100 -100
EBIT -70 -40 -10 20 50 50
Income statement - development costs expensed as incurred

From year 5 EBIT becomes constant. Each year, a new project, which costs 100 and earns
30 per year for five years, is added, while an ' o l d ' project expires. For instance, in year 5 the
project undertaken in year 1 has expired and provides no returns in subsequent years.
Had the firm chosen to capitalise development expenses, the development assets would
be calculated as follows:

Capitalisation of development costs

Financial year Investment Acc. inv. Depreciation Acc. deprec. Book value
Year 1 100 100 20 20 80
Year 2 100 200 40 60 140
Year 3 100 300 60 120 180
Year 4 100 400 80 200 200
Year 5 100 500 100 300 200
Year 6 100 600 100 400 200
Year 7 100 700 100 500 200
Year 8 100 800 100 600 200
Year 9 100 900 100 700 200
Year 10 100 1,000 100 800 200

From year 5 book value becomes constant at 200. Every year a new investment of 100 is capi-
talised (adding 100 to book value), but at the same time 100 is recognised as a depreciation
(amortisation) expense, namely five projects amortised by 20 each.
 If the firm capitalises development costs as just illustrated, it would, therefore, report the
following numbers in the income statement (extract):

Income statement (extract) Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

EBITDA 30 60 90 120 150 150
Amortisation of R&D assets -20 -40 -60 -80 -100 -100
EBIT 10 20 30 40 50 50

•
As is evident from Example 14.9, when the firm reaches steady state, reported
EBIT would be the same whether the firm expenses or capitalises development costs.
However, there are major differences between the two reporting practices for develop
ment costs. First, consider EBITDA, which is used for instance in valuing firms based
on the EV/EBITDA multiple. The firm would report these EBITDA numbers, depend-
ing on its accounting policies for development costs:

Income statement (extract) Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

EBITDA, R&D costs capitalised 30 60 90 120 150 150
EBITDA, R&D costs expensed -70 -40 -10 20 50 50
as incurred

If R&D costs are expensed as incurred, EBITDA would be 100 less compared to an
accounting policy of capitalising R&D expenses. This is due to the simple fact that the
entire investment (100) is subtracted from EBITDA. However, EBITDA (or EBITA) is
not affected if R&D costs are capitalised subject to amortisation.
Second, the balance sheet would look different:

Balance sheet, assets (extract) Year 1 Year 2 Year 3 Year 4 Year 5 Year 6
R&D costs expensed 0 0 0 0 0 0
R&D costs capitalised 80 140 180 200 200 200

By expensing R&D costs, no related assets are recognised in the balance sheet, so total
assets would be higher for firms that capitalise R&D expenses or other forward look-
ing costs.
Several conclusions can be drawn based on the above simplified example. First, in
early years, firms that are conservative (and expense R&D costs as incurred) would
report lower earnings, since the entire investments are expensed immediately. Second,
in later years, reported earnings would be approximately 10 the same whether R&D
costs are expensed as incurred or capitalised (subject to amortisation). Third, since
assets related to R&D activities are not recognised if R&D costs are expensed, ROIC
would be higher than if the firm had capitalised such costs (see Figure 14.3). Fourth,
subtotals such as EBITDA and EBIT are affected differently. Finally, non-recognition
of R&D assets would result in a lower solvency (e.g. debt-to-equity ratio).
The effect of capitalising versus expensing R&D costs on ROIC is shown in Figure 14.3.
The assumptions are the same as in the example above, except that the firm in addition
has other assets of 200, which earn a return of 10% per year. Without other assets, the
firm would have a ROIC of infinity, if all R&D costs were expensed as incurred.
 Figure 14.3 ROIC based on expensing versus capitalising R&D

If all costs are expensed as incurred, ROIC is clearly downward biased in early peri-
ods, but upward biased in later periods. On the other hand, if all expenses are capi-
talised and depreciated over the expected useful lifetime of five years, ROIC is fairly
constant over time, as it should be considering the underlying assumptions.
Notice IFRS allows development costs to be capitalised. Research costs must be
expensed as incurred. Analysts, however, are free to make any adjustments they seem
fit (like capitalising all R&D expenses) to get the necessary quality in the data they use
as input to their decision models.
In a time-series analysis failing to capitalise R&D outlays would make an interpre-
tation of ROIC difficult. If R&D are expensed as incurred, while the returns (cash
flows) from such projects keep coming several years after (five years in the example),
income and expenses are not properly matched. As illustrated in Figure 14.3 the huge
increase in ROIC over time should not be interpreted as an improvement in profitabil-
ity. On the other hand, if R&D expenses are capitalised the analyst is faced with esti-
mation issues related to determining the useful life of such assets and the recognition
of impairment losses. Again, this illustrates that financial ratios should be interpreted
with care.

Accounting flexibility and economic consequences

It should not come as a surprise that reported accounting numbers have economic
consequences; after all, financial statements are intended to help users make (eco-
nomic) decisions. Also, firms typically enter into various contracts, which are based
on accounting data. Prominent examples are debt covenants and accounting-based
bonus plans.
We will now move on to examine the following issue:
What are the potential economic consequences of reported accounting data, which
to a large extent depends on accounting policies and management's subjective
estimates and assumptions?
 As a starting point, consider the following illustrative examples:

Example 14.10 Assume that two comparable firms, within the same industry, estimate the useful lives of tan-
gible assets differently. Firm A depreciates these assets over a 10-year period, while firm B, like
most other firms in the industry, depreciates similar assets over a five-year period. What are
the accounting issues an analyst following firm A should consider?
Well, if the analyst wants to value firm A based on a cash flow model (e.g. DCF model),
he or she needs not be concerned. Depreciation has no cash flow effects.11 However, if the
analyst wants to use multiples, say, EV/EBIT, to value firm A and uses firm B (and other firms
within the same industry) as a benchmark, he or she needs to make adjustments to the finan-
cial statements to make the firms truly comparable. •

Example 14.11 Or look at credit analysis. Naturally, differences in accounting estimates (in this case the
depreciation scheme) will affect financial ratios, and, thus, ultimately the cost of debt, if the
credit analyst (e.g. loan officer) applies rating models such as the one provided in Table 11.1;
that is unless the analyst makes the necessary adjustments. In a worst case scenario, the loan
officer may consider calling in the loan with liquidation of the firm as a result. In this case, the
bank needs to know the fair value of all the firm's assets and liabilities to assess whether the
firm is able to repay the bank loan. Thereafter, for the loan officer, good accounting quality
would be the extent to which reported assets and liabilities reflect the fair value (sales price)
and settlement amounts of those items. Naturally, with a depreciation scheme for firm A, which
is quite different from other firms in the industry, book value of tangible assets in firm A may
be far from fair value. In this case accounting quality is low. •

Example 14.12 Finally, consider bonus plans. Assume that bonuses are rewarded by benchmarking firm A's
operating performance (e.g. EBIT) against competitors performance. Management in firm A
may obtain higher operating earnings, and receive a bonus due to the fact that they apply
aggressive accounting policies by simply extending the estimated lifetime of depreciable
assets. •

In the following three sections, we discuss accounting policies and flexibility in

reporting financial data and how they have an impact on:

• Firm value
• Credit rating
• Accounting-based bonus plans.

Put more bluntly: what are the economic consequences of a firm's flexibility in
reporting financial data, which critically depends upon management's application of
GAAP? For each of the three purposes (firm valuation, credit rating and accounting-
based bonus plans) we keep the decision model in mind. As discussed throughout
this book, we cannot assess accounting quality, carry out financial statement analy-
sis and make informed decisions without knowing the purpose of the analysis and
the method or model we wish to apply. If the financial data reported by firms are
inadequate for our analysis, we may have to make the proper adjustments. In this
respect, an important point needs to be made: before carrying out the analysis, an
analyst should carefully consider materiality and the cost of making the analysis ver-
sus the likely benefits. Uncritically making a variety of adjustments, without taking
due care of the costs (time spend) of the analysis and benefits, should be avoided by
all means.
 Accounting issues in valuation
As stated in Chapter 9, the value of an asset or a firm is the present value of the net
cash flows generated by the asset/firm. Therefore, any present value model implicitly
requires an estimate of future cash flows. In the discounted cash flow approach (and
similar present value approaches), cash flows are calculated based on the projection
of the income statement (accrual-based earnings) and the balance sheet. Multiples, as
the name implies, are used to estimate firm value by multiplying an accounting-based
measure of performance (e.g. EBIT, EBITDA) by a proper capitalisation factor; the
basic justification is that accounting earnings eventually convert to cash flows. Finally,
using the liquidation approach, the value of the firm is simply the net proceeds (cash)
from selling the assets and settling the liabilities recognised in the firm's balance sheet
and off-balance. In conclusion, all valuation models hinge on accounting data, as cash
flows are derived from current or projected accounting numbers. Eventually, noise in
financial data may have an impact on estimated firm value if the analyst (or potential
investor) does not recognise this.

Present value approach

It stands to reason that management may be tempted to adopt accounting policies,
which allow the outlook of the firm to look rosier, since higher future returns increase
value based on cash flows.12 However, at the outset DCF, EVA and similar present
value approaches depend on future (economic) income - so past accounting policies
should not matter? Take the EVA model; it relies on the underlying assumption of
'clean surplus'. 13 If this requirement is met past accounting numbers do not matter as
shown in Chapters 9 and 13. If a firm is conservative (aggressive) in applying account-
ing policies, and, therefore, reports low values on its investments (overstates asset val-
ues), this is simply reflected in future EVAs. For a firm with conservative accounting
policies future EVAs would account for substantially more enterprise value as opposed
to a firm applying aggressive accounting policies for financial reporting purposes.
Cash flow models (e.g. the DCF model) rely on future cash flows - so, apparently,
accounting policies should not matter in this case either.
However, since good accounting quality is characterised by the extent to which
past earnings is a good indicator of future earnings and clearly distinguishes between
recurring (permanent) and non-recurring (transitory) items, measurement errors in
accounting data might provide biased estimates of future earnings. In general, estima-
tion errors increase for transactions spanning multiple periods and with the complex-
ity of the transactions; so the estimated firm value may be affected by accounting
policy choices. In applying present value approaches, an analyst needs to consider a
variety of issues including:
1 Revenue recognition
2 Non-recurring and special items.
These issues are discussed below.

1 Revenue recognition
As discussed extensively in Chapter 8 on forecasting, growth in revenue represents the
most important value driver. This is intuitively easy to understand. An extra dollar of
revenue increases performance measures like EBITDA, EBIT and EBT by up to one
dollar. More importantly, as we demonstrated in Chapter 8, costs are typically directly
linked to revenue (forecasting profit margins like EBIT or EBITDA margins), and so
are investments.
Not surprisingly, an analyst should therefore consider a firm's revenue recognition
policies and related notes carefully as part of valuing a firm. Analysts should be aware
of techniques used to boosting revenues or otherwise reporting biased sales. Bias in
reported revenues can happen for a variety of reasons.
While the list is not exhaustive, the following are examples of transactions and
special cases an analyst should be looking for:

• Barter transactions (grossing up revenue)

• Sale and lease back transactions
• Channel stuffing
• Multiple deliveries
• Extended warranty
• Seller financing
• Construction contracts
• Bill and hold arrangements
• Consignment sales
• Selling to affiliates.

Revenue recognition is considered conservative if a firm does not recognise revenue

until all risks have passed to the buyer. For example, if a firm offers extended warranty,
the full revenue would not be recognised until warranty expires. Revenue recognition
policies may also be aggressive if revenue is recognised although risk remains. For exam-
ple, recognising revenue immediately for a service contract spanning several years would
be aggressive accounting, and likely outside the boundaries of IFRS. Analysts should
assess whether a firm seems overly aggressive or conservative in revenue recognition.
There are several ways of detecting aggressive revenue recognition policies including:
• Comparing revenue recognition policies with industry norms
• Looking for the trend in accounts receivable turnover (number of days)
• Examining if the firm change its revenue recognition policies.
Revenue recognition policies that depart from industry norms may be a sign of aggres-
sive (or conservative for that matter) recognition policies. The analyst should look
into such matters by examining why the firm deviates, and ask whether the firm pro-
vides compelling reasons for its accounting policies in its annual report?
Another way to detect aggressive accounting policies would be to calculate vari-
ous financial ratios. Obviously, looking at the trend in accounts receivable turnover
could give an indication of a firm's accounting policies. A decrease in the turnover
ratio might be a sign of aggressive accounting policies. Maybe the firm provides cheap
financing to customers who are not creditworthy? Or maybe revenues for multiple
deliveries are recognised too soon? This would increase accounts receivable, since cus-
tomers would not have to pay until some future date.
If not explicitly stated in the notes, revenue recognition policies are unchanged
from last year. Firms in financial distress especially may be tempted to change revenue
recognition policies to look more profitable. If a firm changes its accounting policies,
the analyst should consider the effects and the rationale behind such changes. If ana-
lysts do not consider changes in revenue recognition policies they may be misled by
the reported growth rate. Therefore, estimated firm value may be biased.
Example 14.13 Sales in foreign currencies
Assume that a UK firm has a significant proportion of its sales made in dollars (USD),
while all other transactions are denoted in British pounds (GBP). It does not use any
hedging instruments. The UK firm assumes that annual growth in the coming three to
five years is going to be around 10% (measured in dollars).
In January year 9 an analyst wishes to value the UK firm by projecting future sales (and
earnings) based on past sales. Assume that sales in the US market during year 8 amounted
to GBP 10 million. Furthermore, suppose that the average USD/GBP ratio was 1.8 for
sales transactions in year 8 and that the USD/GBP ratio by the end of year 8 is 1.5.
The analyst believes that the firm's sales forecasts are realistic, but is unaware of
and have not considered the development in the exchange rate between US dollars and
British pounds. Based on the belief that sales in the USA will grow by 10% in year 9,
the analyst makes the following sales forecast for year 9 in GBP:
Projected sales for year 9 in the US market:

Is this a realistic sales projection? Assuming that valuation is carried out shortly after
the end of the last financial year (year 8) and the dollar remains at a level of approxi-
mately USD/GBP = 1 . 5 throughout year 9, it is evident that estimated sales in GBP
will be strongly downward biased. The estimated value of the company will therefore,
other things being equal, also be downward biased. The error in the budget is that sales
forecast in the USA (sales in USD) are effectively converted to GBP based on the average
USD/GBP exchange rate for all transactions taking place in year 8 and not on the cur-
rent much higher exchange rate. It is generally assumed that foreign exchange markets
are efficient, particularly for highly liquid currencies. Presuming that the current USD/
GPB exchange rate of 1.5 is a better indicator of the year 9 exchange rate than the aver-
age rate of 1.8 in year 8, the forecast sales in the USA for first budget year (year 9) is

This is a significantly higher amount than the projected sales of GBP 11.0 million,
which did not consider the effects of exchange rate changes. Ideally, for firms with
large sales in foreign currencies, information about the average exchange rate and net
position would be valuable.

2 Non-recurring and special items (transitory items)

Generally, transitory items should be disregarded in forecasting future earnings. This
begs the question: what characterises such non-recurring items? Firms applying IFRS
are no longer permitted to classify items as extraordinary items. As an alternative,
many firms recognise a variety of items in the income statement labelling them 'special
items', 'unusual items' etc., probably in an attempt to convince investors and lenders
that such items should be disregarded in assessing the firm's performance. From an
analytical point of view, the problem is that special items contain a vast number of dif-
ferent transactions and neither IFRS nor US GAAP define special items or specify how
they should be classified. It is entirely up to the management's discretion to decide
which items and events to include as special items.
If non-recurring or special items are merely prior years' expenses (note that special
items are mainly costs) recognised too late or future expenses recognised too early, then
the practice of ignoring non-recurring items and focusing on recurring operating income
 results in noise in the assessment of a firm's earnings potential. For forecasting pur-
poses these items may, therefore, have to be included. Furthermore, a variety of differ-
ent charges, which really are recurring, may be labelled special items. As exemplified by
Carlsberg (see Table 14.2) such special items tend to occur every single year.14 For exem-
plification purposes, consider termination and restructuring charges. Restructuring has
become a 'catch-all' for expenses that firms wish analysts should disregard in assessing

Table 14.2 Carlsberg annual report

NOTE 7 Special items
(DKK million) Year 9 Year 8
Cain on sale of Braunschweig Brauerei and fighter brand activities, Carlsberg 49 -135
Deutschland (2008: impairment of brewery)
Impairment of finite brands -37 -
Impairment (year 8) and restructuring of Leeds Brewery, Carlsberg UK -67 -197
Loss on disposal of Türk Tuborg - -232
Relocation costs, termination benefits and impairment of non-current assets -40 -19
in connection with new production structure in Denmark
Termination benefits and impairment of non-current assets in connection with new -20 -30
production structure at Sinebrychoff, Finland
Provision for onerous procurement contracts -175 -245
Termination benefits etc. in connection with operational excellence programmes -31 -150
Termination benefits in connection with restructuring of sales force etc., Carlsberg UK -34 -
Termination benefits etc., Carlsberg Italia -56 -93
Termination benefits etc. in connection with restructuring, Brasseries Kronenbourg, -95 -291
France
Termination benefits in connection with restructuring, Carlsberg Deutschland -72 -
Restructuring, Ringnes, Norway - -26
Other restructuring costs etc., other entities -100 -154
Integration costs related to acquisition of part of the activities in S&N -17 -69
Special items, net -695 -1,641
If special items had been recognised in operating profit before special items,
they would have been included in the following items:
Cost of sales -353 -919
Sales and distribution expenses -157 -114
Administrative expenses -179 -226
Other operating income 94 27
Other operating expenses -100 -409
-695 -1,641
Impairment of goodwill - -
Special items, net -695 -1,641
Special items constitute significant items that cannot be attributed directly to the
group's ordinary operating activities and are significant over time.
 core operations and risk. The term has a positive undertone implying that the firms have
taken due care of their poor operations or businesses and therefore have a bright future.
Disregarding restructuring charges may create too rosy a picture of past performance and
should be considered carefully in forecasting future earnings.
Arguably, restructuring charges in a broad sense are part of core operations, as
every firm needs to adjust its businesses to changing market conditions. Labelling
costs associated with tuning the company to make it stay competitive should not pre-
vent an analyst from including such costs in forecasting future earnings. Restructuring
charges and other special items, however, may fluctuate substantially over time mak-
ing such costs difficult to forecast. For forecasting purposes, analysts might estimate
such future expenses by, for instance, calculating the average of restructuring charges
recognised during the past five years. Notice once again that financial statement anal-
ysis is not an exact science. There is no way of knowing the amount of future special
items; all analysts can do is to forecast earnings based on available information and
realistic assumptions.

Multiples
Valuation based on multiples is also prone to accounting distortion. Again, as an ana-
lyst, you must consider the data needed for your analysis. In other words, what con-
stitutes high accounting quality if multiples are used? As discussed in Chapter 9, the
use of multiples requires that firms are truly comparable in the sense they have the
same accounting policies, growth opportunities, profitability and risk. A variety of
multiples are used to estimate firm value - both enterprise value and market value of
equity - including:
• Enterprise value-based multiples
- EV/Revenue
- EV/EBIT
- EV/EBITDA
- EV/NOPAT
- EV/IC
• Equity-based multiples
- P/E
- M/B
The different multiples and their merits and demerits are discussed in Chapter 9 on
valuation. In the following sections, we discuss the economic consequences of account-
ing method choices and accounting judgements (assumptions) in valuing firms based
on several of the above multiples.

EV/Revenue multiples
Some would argue that EV/Revenue is the best multiple in the sense that it is basically
unaffected by accounting policies, since accounting method choices and estimates for
inventory, depreciation policies, deferred taxes etc. can be disregarded. However, the
multiple also disregards all costs. Therefore, if firms have different cost structures or
differ in respect to their income-expense relation, the EV/Sales multiple may result in
biased firm value estimates. Due to the heavy reliance on revenue, analysts should be
aware of accounting policies for revenue recognition. It's a good idea that you read
the section on accounting policies for revenues carefully. Sales multiples may be a bad
valuation multiple because:
• Firms in the industry use different accounting method choices for revenue, for
example in regard to extended warranty, multiple deliveries and service or con-
struction contracts.
• Firms may engage in barter transactions and recognise exchanging goods or serv-
ices as revenue.
• Firms may have intercompany sales and boost earnings by selling products or serv-
ices within a group.
Sales may be boosted by selling at a price below or near costs.
• Discounts, duties, rebates, value added tax, sales tax etc. are recognised as costs
rather than a reduction in revenue.
Revenues are recognised prematurely using channel stuffing or other questionable
methods.
• Revenues are positively affected by a favourable exchange rate, which is non-lasting.
Suffice it to say that sales multiples should be used with extreme care.

EV/EBITDA, EV/EBIT and EV/NOPAT multiples

Other analysts favour multiples such as EV/EBITDA and EV/EBIT. For example, the
popularity of using EBITDA is that it is presumably a proxy for the cash flow. A pre-
requisite for applying multiples is that the firm being valued applies accounting poli-
cies and uses estimates which are comparable to its competitors. Accounting policies
may vary across firms for a variety of items, and if differences in accounting policies
and estimates have a material effect on reported financial data, the analyst needs to
make adjustments to make data across firms truly comparable. Common accounting
issues in applying multiples in the income statement, which may require adjustments
to reported figures to be made, include:

Accounting item Issue

Non-recurring and special items Are special items recognised as part of operating
income or classified after EBIT?
Non-capitalisation of expenses Are costs which truly represent assets expensed
(investments) as incurred?
When do firms capitalise capital expenditures?
What kind of costs are capitalised?

We discuss these issues below. The important point to remember is: if firms uses dif-
ferent accounting method choices or estimates and these differences are material, then
adjustments need to be made before applying multiples.

Non-recurring and special items

Naturally, items that a firm labels 'special items' need to be scrutinised by the analyst.
Should such items be part of EBIT (or EBITDA, or whichever operating performance
measure that is used)? Ideally, EBIT should represent future permanent earnings as the
main source of free cash flows. The analyst must examine the annual report carefully to
single out items that are truly non-recurring as such items should be excluded from EBIT.
Non-capitalisation of expenses
Unsurprisingly, it is quite likely that valuation based on multiples also requires adjust-
ments to financial statements by capitalising development costs or other forward look-
ing expenses to make firms comparable on accounting policies. Even though high-tech
firms, biotech companies etc. are dependent upon successful research projects, they
may have different accounting policies regarding capitalisation of development costs.
If development costs are capitalised by some firms but not by other firms in the
peer group, adjustments need to be made. This is especially important if EBITDA
multiples are used. For firms that capitalise development costs subject to amortisation
and impairment losses, amortisation expenses and impairment losses are recognised
after EBITDA, while development costs which are expensed as incurred become part
of EBITDA.
Even if EBIT is used there might be significant differences in reported EBIT between
capitalising versus non-capitalising firms. Consider two identical firms that differ only
in so far as the way they recognise development costs. For the past three years, the
firms have spent the following amounts on a single development project, which starts
producing cash inflows from year 3, as illustrated in Table 14.3.

Table 14.3 Capitalising versus expensing development costs

Year 1 Year 2 Year 3
Development expenses 20 25 30
Income statement (excerpt)

Capitalising firm
EBITDA before development costs 30 40 50
Development costs 0 0 0
EBITDA 30 40 50
Amortisation of development costs 0 0 15
Depreciation expenses 5 6 7
EBIT 25 34 28

Expensing f i r m
EBITDA before development costs 30 40 50
Development costs 20 25 30
EBITDA 10 15 20
Amortisation of development costs 0 0 0
Depreciation expenses 5 6 7
EBIT 5 9 13

It is assumed that the capitalising firm amortises development projects using

straight-line depreciation and an estimated lifetime of five years. Therefore, in year
3, the amortisation expense becomes [(20 + 25 + 30)/5] = 15. In years 1 and 2 the
development expenses have been capitalised with no amortisation since the project
was still being developed. For the expensing firm, development costs are expensed as
incurred. Since development expenses are fairly high in the example (as is often the
case with high-tech companies in the biotech industry), EBIT is materially lower for the
expensing firm. However, at some future point of time, capitalising firms 'catch-up',
as those firms need to amortise their development projects over their useful lifetime.
In fact, over the entire lifetime of a development project total expenses recognised by
expensing firms and capitalising firms must match.
The same is not true for EBITDA. Since the capitalising firm will classify develop-
ment projects after EBITDA (as opposed to expensing firms which expense develop-
ment projects as incurred) they will always report a higher EBITDA. For instance, in
year 3 EBITDA is 150% ((50 - 20)/20) higher for the capitalising firm than for the
expensing firm.
To adjust for differences, an analyst may need to adjust capitalisation to non-
capitalisation or vice-versa depending on whether the peer group uses the one or the
other accounting method. This is done as shown in Tables 14.4 and 14.5.

Table 14.4 Adjustment from capitalising to expensing development costs

Income statement (excerpt) Year 1 Year 2 Year 3
Costs of development projects 20 25 30

Capitalising to expensing
EBITDA as reported 30 40 50
Deduct development costs 20 25 30
EBITDA 10 15 20
Amortisation of development costs 0 0 15
Add back amortisation of development costs 0 0 -15
Depreciation expenses 5 6 7
EBIT 5 9 13

Table 14.5 Adjustment from expensing to capitalising development costs

Expensing to capitalising Year 1 Year 2 Year 3
EBITDA before development costs 30 40 50
Development costs 20 25 30
Add back development costs -20 -25 -30
EBITDA 30 40 50
Amortisation of development costs 0 0 15
Depreciation expenses 5 6 7
EBIT 25 34 28

In practice, the exercise is likely to be a bit more difficult. For example, in adjust-
ing from expensing to capitalisation, the analyst needs to make highly subjective
assumptions: how much of the total development expenses should be capitalised?
What is the estimated lifetime of the project? When should amortisation begin, that
is when is the project completed? Should amortisation be on a straight-line basis or
should some other method be applied? Answers to such questions are most likely
found by monitoring peers' adopted accounting policies and estimates.
 P/E and M/B multiples
P/E and M/B both aim at estimating market value of equity based on net earnings
and book value of equity, respectively. Some argue that the P/E multiple is preferable
as classification of income and expenses do not matter. Earnings, the bottom line,
capture it all regardless of how items have been classified. Likewise, classification of
assets and liabilities should not matter, as book value of equity is simply the differ-
ence between total assets and total liabilities. However, when applying the P/E and
M/B multiples analysts face many of the same accounting issues as discussed above.
In addition, the only difference between enterprise-based multiples (like EV/EBIT)
and equity-based multiples like P/E is the effect of financial leverage. Two firms,
which are identical on all parameters (accounting policies, growth and profitability)
except for financial leverage (i.e. the capital structure), shall be priced at a different
multiple.
Consider the M/B ratio. The denominator in this ratio is book value of equity. Since
book value of equity captures the difference between total assets and total liabilities,
recognition criteria for (every group of) assets and (every group of) liabilities have
an effect on the market-to-book ratio. Evidently, if a firm capitalises development
costs, while competitors do not, applying the M/B ratio would bias the capitalising
firm's value upward (book value of equity would be higher due to the capitalisation
of expenses).

Accounting issues in credit analysis

Financial institutions (banks, mortgage institutions etc.) employ models (credit rating
models and forecasting including value at risk analyses) to rank potential and existing
customers according to risk. Lenders will charge interest on loans according to their
risk. But higher interest rates are not the only method used by lenders to compensate
for risk. Protective debt covenants are written into loan agreements that allow the
lender some controls of actions undertaken by the borrower. Such covenants may for
instance:
• Allow for monitoring the debt by requiring audits and monthly reports.
• Decide when the lender can call the loan; i.e. when financial ratios are below a
threshold (e.g. if the interest coverage ratio is below a predefined target).
• Limit the borrower's ability to weaken its balance sheet (e.g. by requiring a debt-
equity ratio below 3.0).
• Restrict the ability to pay out dividends or carry out investments above a certain
threshold.
Generally speaking, according to such contracts debt becomes cheaper if a firm is able
to improve profitability (e.g. EBIT and ROIC) and/or reduce risk (e.g. an increase in
the interest coverage ratio or a decrease in the debt-to-equity ratio).
In the following sections, we discuss the economic consequences of differences in
accounting policies and estimates depending on the credit rating model applied. How
does regulatory flexibility and management discretion (as described in Chapter 13)
affect the various credit rating models, and what are the potential economic conse-
quences? From a lender's point of view, the economic consequences can be severe if
flexibility in accounting is not uncovered because management may be tempted to
exploit accounting flexibility to obtain debt financing, if the firm is in need of cash.
 The lender may say 'no' when in fact they should say 'yes' (loss of business opportuni-
ties). This is often labelled a type 2 error. However, it is more likely that lenders may
grant loans they should not have granted (labelled a type 1 error).

Credit rating models and financial ratios

Violation of debt covenants may have severe economic consequences for a firm includ-
ing increases in interest rates paid on loans, calls for repayment of debt or a require-
ment that the firm put up (additional) collaterals. In a worst case scenario, the firm
may not be able to comply with its debt covenants and may have to close down due
to lack of liquidity. It is evident that management, to avoid default on debt, may
be tempted to exploit loopholes in accounting regulation and/or make estimates and
assumptions which improve financial ratios, so that lenders cannot call the debt. For
example, if management is able to reclassify finance leases as operating leases, debt is
kept off-balance making the balance sheet look healthier.
Lenders should basically consider any and all accounting policy choices and esti-
mates, since everything that has an impact on accounting numbers has an impact
on financial ratios. Below, we discuss one of these issues, namely accounting policy
changes and accounting changes.

Accounting policy choices and accounting changes

Financial ratios used for credit rating purposes are clearly affected by a firm's account-
ing policies. For example, as discussed in Chapter 15, we find that ROIC is overstated
for mature firms, if development costs are expensed as incurred, while risk measures
such as the debt-equity ratio would be downward biased due to the lack of recognis-
ing R&D assets.
Accounting changes may be voluntary or mandatory. In covenants, the bank needs
to specify that GAAP is to be consistently applied. If not, a change in financials
included in covenants may be attributed to a change in a firm's profitability and risk
or to accounting changes, whether mandatory or voluntary. Naturally, debt covenant
violations from accounting changes would hurt a firm. Likewise, lower interest rates
on borrowing due to apparently improved profitability and risk would be unfair, if it
is based on accounting changes and not real changes in the underlying risk and per-
formance of a firm.
To ensure that accounting policies do not have economic consequences in the sense
that it affects interest rates or lenders opportunity to recall debt, accounting method
choices should be the same within an industry. This is recognised by large rating agen-
cies such as Standard & Poor's and Moody's. For instance, Standard & Poor's includes
deferred tax in permanent capital (invested capital) in the calculation of ROI (return
on capital) (Standard & Poor's 'Formulas for Key Ratios' Corporate Ratings Criteria
and Standard & Poor's 2003 'Corporate Ratings Criteria').

Forecasting (value-at-risk analysis)

Lenders should make a careful assessment of budgets prepared by a firm's manage-
ment. To assess the quality of budgets, lenders may use budget control in line with
the recommendations in Chapter 8. For instance, how is ROIC in future periods com-
pared to ROIC historically? Also, historical financial data may be noisy measures
 of future earnings and cash flows if accounting policies and estimates have changed
over time. Budgets prepared for negotiating financing with lenders do not have to
follow IFRS, US GAAP or whichever accounting regime the firm complies with. As
a consequence, lenders need to make sure that the budget is based on the same set
of accounting policies and estimates as in the past. If not lenders should examine,
why accounting policies or estimates have changed and how it affects growth, profit-
ability and risk. Since value-at-risk analysis requires forecasting future cash flows, the
issues raised in the discussion of present value approaches also apply to issues that
should be considered in any value-at-risk analysis.

Liquidation models
Good accounting quality in using the liquidation model for credit rating purposes
(worst case scenario) has the following characteristics:
• All assets and liabilities are measured at fair value, which they are generally not if a
firm is perceived as a going concern.
• All items which represent inflow or outflow of economic benefits in a liquidation
should be recognised as assets and liabilities in the financial statements.
The liquidation model represents firm value in a worst case scenario. If a firm is
not able to service its debt, the lender may call the debt. As discussed in Chapter
9 on valuation, the proceeds the investor (or in this case the lender) will eventually
receive depend on how quickly the firm needs to sell the assets and settle the liabili-
ties. A forced liquidation will most likely result in lower net proceeds. In any event,
what do the financial statements tell us about the potential break-up value of a firm?
Reverting back to Chapter 13 on accounting quality, remember that good account-
ing quality is the extent to which all assets and liabilities are recognised in the bal-
ance sheet and measured at fair value (which is hardly ever the case). The liquidation
method is thoroughly discussed in Chapter 15 where accounting flexibility in the
balance sheet is examined.

Accounting issues in executive compensation

Bonuses based on financial performance measures also have some inherent problems
to be considered by the analyst. Typically, cash bonuses are based on one or more
of several different performance measures such as revenue, EBIT, EBITDA, ROIC,
EVA, and other similar metrics. Consider a cash bonus based on reported EBIT.
Management can simply enhance the chance of getting a bonus merely by extending
the estimated lifetime of depreciable assets, and, therefore, charge the income state-
ment, and EBIT, with a lower depreciation expense.
In this section, the focus is on how accounting flexibility may affect bonuses. Since
accounting-based bonuses are directly linked to accounting measures of performance,
measurement errors (bias) and flexibility in choosing between alternative accounting
policies (e.g. FIFO versus average costs) have economic consequences. We now discuss
two types of accounting-based performance measures:
1 Absolute performance measures (e.g. revenue, EBIT, EBITDA, EBT)
2 Relative performance measures (e.g. ROIC, EVA).
Absolute performance measures (financial measures)
The use of revenue EBIT, EBITDA or similar metrics as a performance measure in
bonus plans has the advantage that management compensation is tied to a firm's oper-
ating performance. Furthermore, EBITDA has the alleged advantage that management
cannot increase bonuses for example by simply changing the estimated lifetime of
depreciable assets. Nonetheless, certain accounting issues should be considered.

Revenue
To the extent that bonus compensation is based on growth in net sales it can be
debated whether directors should be rewarded (punished) for a favourable (unfavour-
able) development of the exchange rate.
A remuneration committee should consider whether executives deserve credit
for growth due to positive changes in the price of foreign currencies. An argument
for including exchange rate differences (gains or losses) in performance measures
used in bonus plans might be that management has focused on the adverse effects
on exchange rate risk, and therefore takes the necessary steps to avoid losses, for
instance, by using financial instruments or (if possible) to make sales and purchases
in the same currency. On the other hand, in reality, it is at best difficult to make a
perfect hedge. This would require perfect prediction of future transactions (e.g. sales)
in foreign currencies.
Other analytical issues raised previously on revenue should also be considered.
These include, among other things, barter transactions, channel stuffing, multiple
deliveries, extended warranty, construction contracts and consignment sales.

Non-capitalisation of expenses
In certain industries, such as biotech and high-tech industries, huge investments in
research and development projects are essential for firms' survival in the long run.
If such investments are expensed as incurred, it would be difficult for managers to
obtain a bonus in relatively young firms when bonuses are based on realised operating
earnings.
For mature companies, EBIT is largely unaffected by whether development projects
are capitalised and amortised or expensed as incurred. As invested capital is lower for
firms that expense development costs as incurred, management in companies where
bonuses are based on financial ratios, e.g. return on invested capital, have a greater
opportunity to obtain a bonus when development projects are expensed.

Relative performance measures (e.g. ROIC, EVA)

Relative performance measures have the inherent advantage that potential accounting
distortion due to the flexibility in reporting financial statements are 'self-correcting'. For
example, the mandatory change in accounting for goodwill for firms which switched
to IFRS had two effects, which tend to level each other out. On the one hand, operat-
ing earnings (and net earnings) increased (the numerator in ROIC calculations), but so
did invested capital (the denominator), as goodwill is no longer amortised.
Nonetheless, changes in accounting policies and non-capitalisation of expenses
may have economic consequences and should be considered in a bonus contract. For
instance, for start-up firms huge investments in R&D penalise earnings. Even though
invested capital also becomes lower, the total effect will most likely be a lower ROIC
 and EVA compared to if the firm had capitalised such costs. Furthermore, the horizon
problem (i.e. expenses or investments and the related income appear in different finan-
cial years) comes into play, since R&D is expensed as incurred while the potential
return on R&D investments are recognised in subsequent years.

Conclusions
In assessing a firm's growth, profitability and risk, the analysts may not obtain a
complete and objective assessment of a firm's performance by taking the financial
statements at face value. The way a firm defines, recognises, measures, classifies and
discloses accounting items affects the reported accounting numbers. Therefore, ana-
lysts must be critical of reported financial data and may have to make adjustments to
those numbers before carrying out the analysis.
Essentially, measurement issues are at the heart of financial statement analysis. The
combination of different estimates and assumptions combined with different measure-
ment bases is the reason why financial statements may look quite different across time
or across firms; even if the underlying transactions are the same.
It's difficult to see through every accounting entry and often the (financial) data are
insufficient in respect to assessing earnings quality of the analysed firm. Furthermore,
in making adjustments to reported financial data requires that the analyst makes
a number of estimates and assumptions. To make such adjustments is a craft that
requires expertise and hard work.
Some of the lessons to be learned are:
• Applied accounting policies should be carefully studied
• Changes in accounting policies or estimates may have severe economic consequences
• Growth in revenue is an important value driver and analysts should consider
carefully the effects of aggressive, conservative or unusual accounting policies for
revenue
• A huge variety of items and events may be recognised as special items. Analysts
should carefully consider the treatment of such items in their analysis.
Most importantly, remember that uncritical use of accounting information may cause
losses for the lender, investor and other users of financial statements. Therefore, due
care must be taken in carrying out financial statement analysis.

Review questions
• What is regulatory flexibility?
• What is meant by management discretion?
• List examples of accounting items where some flexibility in choices of accounting
methods is allowed due to regulatory flexibility.
• List examples of accounting items which require that management uses its discretion.
• Why do a firm's accounting policies matter?
• Discuss some of the analytical issues when analysing a company's revenue?
APPENDIX 14.1

PricewaterhouseCoopers has a number of publications comparing local GAAP with

IFRS including:
• Comparison of IFRS and Australian FRS 2005
• Comparison of IFRS, US GAAP and Belgian GAAP 2006
• Comparison of IFRS and Hong Kong FRS 2008
• Comparison of IFRS, US GAAP and Indian GAAP 2009
• Comparison of IFRS, Indonesian GAAP and US GAAP 2005
• Comparison of IFRS, US GAAP and Italian GAAP 2008
• Comparison of IFRS and US GAAP for investment companies
• Comparison of IFRS, US GAAP and JP GAAP 2009
• Comparison of IFRS, US GAAP and JP GAAP 2008
• Comparison of IFRS and Korean GAAP 2008
• Comparison of IFRS and Luxembourg GAAP 2004
• Comparison of IFRS and Malaysian FRS
• Comparison of IFRS and Malaysian PERS
• Comparison of IFRS, US GAAP and Mexican GAAP 2009
• Comparison of IFRS and UK GAAP 2007
• Comparison of IFRS and US GAAP 2009
• Slovak Accounting Act No 431/2002 (New), Accounting Act No 563/1991 (Old)
and IAS
Source: www.pwc.com

APPENDIX 14.2

Estimates within the boundaries of GAAP:

• Changing depreciation methods
• Changing the useful lives used for depreciation purposes
• Changing estimates of salvage value used for depreciation purposes
• Determining the allowance required for uncollectable accounts or loans receivable
• Determining the allowance required for warranty expenses
• Deciding on the valuation allowance required for deferred tax assets
• Determining the presence of impaired assets and any necessary loss accrual
• Estimating the stage of completion for percentage-of-completion contracts
• Estimating the likelihood of realisation of contract claims
• Estimating write-downs required for certain investments
• Estimating the amount of restructuring accruals
• Judging the need for and amount of inventory write-downs
• Estimating environmental obligation accruals
• Making or changing pension accrual assumptions
• Determining the portion of the price of a purchase transaction to be assigned to
acquired in-process research and development
• Determining or changing the amortisation periods for intangibles
 • Deciding the extent to which various costs such as landfill development, direct-
response advertising, and software development should be capitalised
• Deciding the proper hedge-classification of financial derivative
• Determining whether an investment permits the exercise of significant influence
over the investee company
• Deciding whether a decline in the market value of an investment is other than temporary
Source: Mulford and Comiskey, 2002 (p. 65)

Notes 1 However, depreciation might matter depending upon the value driver setup. For instance, in
a firm using liberal accounting policies, investments may be too low (e.g. forecasts do not
recognise that investments need to be made if non-current assets are not fully depreciated).
2 It may seem counter-intuitive that Daimler Benz reported a profit in a conservative accounting
regime. What should be kept in mind, however, is that conservative accounting principles
'allow' for making reserves in good times and use these reserves to inflate earnings in bad times.
3 IFRS have even rules for SME (small and medium-sized) enterprises. It depends on accounting
regulation in each country whether or not non-listed firms shall or may comply with IFRS.
4 In this case intangible assets must be tested for impairment at least on an annual basis.
5 As seen in Appendix 14.1, there are still differences to be settled. PwC and other major
accounting firms have devoted considerable resources in explaining differences between
GAAP regimes.
6 Impairment losses need not be recognised even if book value exceeds net present value of the
future cash flow generated by the asset(s). This is the case if the market price of the asset(s)
exceeds book value. However, for tangible (depreciable) assets market values are often not
available.
7 It should be noted that IFRS does not permit classification of items in the income statement
as 'extraordinary items'. Nonetheless, firms may wish to classify transactions in a separate
line item, if the firms believe those transactions require special attention; for instance if they
are non-recurring events.
8 Naturally, there might be a number of other items that are affected when firms comply with
another set of standards (i.e. IFRS). In Table 14.1 only the effects of the change in accounting
for goodwill is shown.
9 It should be noted that IAS/IFRS standards in addition to IAS 18 contain a number of standards
which relate to specific types of income. Those standards include IAS 11 'Construction
Contracts', IAS 17 'Leases', IAS 28 'Investments in Associates', IAS 39 'Financial Instruments',
IAS 41 'Agriculture' and IFRS 6 'Exploration for and Evaluation of Mineral Resources'. For
most firms, however, the relevant standard for recognition of income is IAS 18.
10 In practice, firms would grow investments at times and have negative growth at other times (e.g.
due to a financial crisis). In these cases reported earnings would only be approximately the same.
11 While it is generally the case that depreciation has no effect on earnings capitalisation models
like the DCF-model, this is not always true. It depends upon the value driver setup. For
instance, a too long (short) depreciation period may have as a consequence the fact that
investments in the forecast period become too low (high).
12 Unless the potential investor/buyer is able to see through the window dressing.
13 Clean surplus means that all income and expense items are recognised as part of earnings.
14 It should be noted that Carlsberg also reported special items in prior years (i.e. special items
are recognised every year).

Reference Mulford and Comiskey (2002) The Financial Numbers Game: Detecting Creative Accounting
Practices, Wiley.
 CHAPTER 15

Accounting flexibility in the balance sheet

Learning outcomes
After reading this chapter you should be able to:
• Understand how a firm's accounting policies regarding asset and liability
recognition affect the financial statements
• Understand the potential impact of management discretion on reported
accounting numbers
• Discuss potential economic consequences of firms' accounting choices and
estimates regarding inventory accounting, intangible and tangible assets, lease
accounting and deferred tax liabilities
• Make adjustments to financial statements so they can be used as inputs to decision
models

Accounting flexibility in the balance sheet

I
n this second part on accounting flexibility we discuss analytical issues related to
assets and liability recognition and the related income and expenses. As in the previ-
ous chapter, we have provided numerous examples on why accounting flexibility may
have severe economic consequences.

Assets, liabilities and related expenses

Inventory accounting
Inventory is an accounting item that is treated differently in different jurisdictions.
Despite the convergence project aimed at aligning US GAAP with IFRS, regulation
on inventory accounting differs. IFRS allows valuing inventory using either the flow
assumption1 FIFO (First in First Out) or weighted average costs, but, unlike in the USA,
LIFO (Last in First Out) is prohibited. The consequences for gross profit and inventory
of the three different accounting methods for inventory are shown in Table 15.1.
The example rests on the assumptions made in the table, where details about inventory
are provided for a firm experiencing increases in costs over time (Firm A), and a firm
(Firm B) with costs of inventories decreasing over time. The effect on earnings and
assets of using FIFO, LIFO and average cost, respectively for the two firms are shown
in Table 15.2.
Table 15.1 Accounting for inventory (example)

Firm A: Retail store Firm B: Computer chips

No. of Price Costs/ No. of Price Costs/
units per Sales units per Sales
unit unit

Beginning inventory 10 5 50 20 14 280

Purchase 1 10 7 70 20 12 240
Purchase 2 10 7 70 20 10 200
Purchase 3 10 9 90 20 8 160
Total available 40 7 280 80 11 880
Sold -20 -20
Ending inventory 20 60

Revenue 20 12 240 20 15 300

Note: It is assumed that beginning inventory is the same regardless of whether the firm uses FIFO,
LIFO or average cost. In practice beginning inventory would be different depending upon the cost
assumption. However, this has no bearing on the conclusions.

Table 15.2 Accounting for inventory (example, continued)

Firm A Firm B
FIFO
Sales 240 300
Cost of goods sold -120 -280
Gross profit 120 20
Closing inventory 160 600

LIFO
Sales 240 300
Cost of goods sold -160 -160
Gross profit 80 140
Closing inventory 120 720

Average cost
Sales 240 300
Cost of goods sold -140 -220
Gross profit 100 80
Closing inventory 140 660
 Table 15.3 Unbiased accounting for inventory

Firm A Firm B

Cost of goods sold (COGS) 180 160

Gross profit 60 140
Inventory 180 480

How would the numbers in Table 15.2 have looked if they were to represent fair
values? Table 15.3 shows us. For firm A the fair value of inventory would be 20 units
of 9 apiece = 180, since current costs are 9 for each unit. Incidentally, fair value of
costs of goods sold (COGS) would also be 180, since 20 units have been sold. For firm
B the unbiased numbers would be 160 for COGS (20 units of 8 apiece) and 480 for
inventory (60 units of 8 apiece).
A closer look at Table 15.2 shows that neither FIFO, LIFO nor average cost repre-
sents unbiased values. For example, if gross profit should represent the profit of buy-
ing and selling goods at current prices, firm A would have sales of 240 (as reported),
but cost of goods sold would be 180 (20 units of 9). Therefore, gross profit of 120
(FIFO) is upward biased by 60. Closing inventory (160) on the other hand is down-
ward biased, as inventory at current prices would amount to 180.
Under LIFO gross profit amounts to an unbiased 140 for firm B. However, LIFO is
not allowed according to IFRS (but is used in the USA). Furthermore, the only reason
why gross profit is unbiased is the fact that the number of units sold (20) matches the
latest purchase. Therefore, COGS represents the cost of the most recent purchase.
Finally, if closing inventory should be measured at fair value, it must reflect current
prices. For firm B, this would mean that inventory needs to be valued at 480 (60 units
at 8 apiece).
A further issue to be considered is that IFRS and US GAAP require inventory to be
written down to net realisable value.2 This is required, for instance, if the cost of inven-
tory is not recoverable due to damage, slow moving items or simply downward pressure
on prices. In such cases, the use of LIFO or average cost may depress earnings substan-
tially. For instance, as illustrated in Table 15.2 closing inventory for firm B amounts to
720 under LIFO, while current cost is much lower at 480. In all likelihood firm B needs
to take a hit on earnings by writing down inventory to its net realisable value.
In conclusion, inventory cost accounting is an example of an accounting method
choice that results in either a fair indicator of the performance of a firm (gross profit),
or a good measure of the fair value of inventory or vice versa.
Finally, it should be noted that the choice of accounting method for inventory may
have direct economic consequences. In some countries, taxable income is (partly)
based on accounting numbers. The USA is a case in point. If US firms use LIFO and
prices are rising, gross profit and hence earnings and taxable income would be lower
than if FIFO was used.

Intangible and tangible assets

Depreciation and amortisation

Depreciation and amortisation methods are another example of flexibility in account-
ing method choices. Firms must depreciate their tangible and intangible assets in
a systematic manner over the useful lifetime of those assets. Neither IFRS nor US
GAAP require a specific method. Firms may use the straight-line method (constant
charge over the useful life unless the asset's residual value changes), the diminish-
ing balance method (decreasing charge over time), the units of production method
(charge based on the expected use or output) or similar methods that most closely
reflect the expected pattern of consumption of the future economic benefits embod-
ied in the asset.
Under IFRS, firms may use the revaluation model as an alternative to the cost
model for property, plant and equipment (PPE). The revaluation model requires a firm
to value PPE at fair value at the date of the revaluation less any subsequent accumu-
lated depreciation and accumulated impairment losses. Intangible assets are generally
accounted for using the cost model (intangibles measured at cost less any accumu-
lated amortisation and any accumulated impairment losses). However, the revaluation
model is also applicable to intangible assets, but only if fair value can be determined by
reference to an active market. In reality, the use of the revaluation model for intangible
assets is likely to be limited. An example of an intangible asset traded on an active
market is carbon dioxide (CO 2 ). US GAAP, on the other hand, generally requires that
non-financial assets are measured at historical costs (less depreciation/amortisation
and impairment losses). Therefore, major differences in valuing non-financial assets
may exist between firms complying with IFRS (cost versus revaluation model) as well
as between IFRS firms and firms using US GAAP.
Management has a great deal of flexibility in accounting for non-financial, non-
current assets (tangible and intangible assets). First, management needs to estimate
how long such assets are productive, as they must be depreciated over their useful
lifetime.3 Second, those assets must pass impairment tests. If the recoverable amount is
less than its carrying amount, an impairment loss should be recognised in the income
statement. Estimating the recoverable amount involves a great deal of judgement.
Finally, if firms choose to use the revaluation model, judgement must be exercised to
estimate fair value.
Ideally, the depreciation/amortisation method of tangible and intangible assets
should reflect the flow of future benefits generated by those assets. However, imple-
menting this method would require that future benefits could be forecast with cer-
tainty. So accounting regulation sacrifices relevance for reliability by requiring firms to
follow a predetermined amortisation schedule4 with the most common method being
straight-line depreciation/amortisation.
A firm faces several issues in their choice of depreciation method:
1 What is the cost of the asset?
2 What is the estimated useful life of the asset (which can be quite different from its
physical life and technological life)?
3 What is the expected salvage value by the end of the asset's useful life?
4 What is the pattern of benefits derived from the asset likely to be?
While determining the cost of the asset is usually quite straightforward, indirect pro-
duction costs leave room for judgements on the part of management. Estimating the
useful life and salvage value is more complicated and depends on a number of factors
including type of assets and usage.
Nonetheless, management must exercise their best estimate in calculating the
annual depreciation charge. The pattern of benefits has a bearing on the deprecia-
tion method applied. If an asset's productivity is declining over time, it indicates that
 depreciation charges should be high in early years, but lower in subsequent years.
In reality, a number of depreciation methods may be used including the straight-
line method, reducing balance method, sum of the year's digits method and out-
put or usage method. IAS simply states the depreciable amount (cost less residual
value) must be allocated on a systematic basis over the asset's useful life, and the
depreciation method used should reflect the pattern in which the asset's economic
benefits are consumed by the entity. While these different methods have different
implications, Example 15.1 discusses the impact of the highly uncertain and subjec-
tive estimate of the useful lifetime on financial statements. The arguments raised in
the example could easily be adapted to differences in depreciation methods for non-
current assets.
Since accounting data and financial ratios are used in a variety of contexts and con-
tracts, financial statements' ability to reflect the true underlying performance and risk
of a company is paramount. For instance, if financial ratios are severely biased, a firm
risk paying too much interest on its debt or if accounting data paint too rosy a picture
of risk and performance, a bank may provide funds to a firm at rates that are too low
(i.e. not profitable for the bank).
While a great number of financial ratios and other measures of performance are
used for valuation purposes, in credit rating models and in bonus plans, return on
invested capital (ROIC) is maybe the most important one, as it reflects the total return
on a firm's operations. Therefore, to illustrate the effects on various assumptions
about the lifetime of depreciable and amortisable assets, our focus is on ROIC. For
ROIC to be an unbiased estimate of the underlying performance of a firm, it should be
a fair proxy of the internal rate of return (IRR).5
To illustrate the consequences of different estimates of and judgements about the
useful lifetime of depreciable (or amortisable) assets, various earnings measures and
financial ratios are calculated based on unbiased, conservative (depreciating too
quickly) and aggressive estimates (depreciating too slowly) of the useful life of depreci-
able assets. In all cases, straight-line depreciation is used. Example 15.1 rests on the
major assumptions listed at its start.

Example 15.1 The consequences of depreciation, revaluation and impairment policies

Price per project - annual investments in depreciable assets at the 100,000

beginning of the year
Return per year per project at year end (EBITDA) 18,744
Useful lifetime of each project 8 years
Internal rate of return per project 10%
Note: In the following examples full depreciation in the year of the investment is assumed (e.g. 12.5%
in year 1, if lifetime is assumed to be 8 years).

The internal rate of return is calculated as:

First, consider that the firm depreciates its investments over an eight-year period, so the
depreciation period perfectly matches the actual lifetime of each project (investment). If the
firm uses straight-line depreciation, it would report the financials6 shown in Table 15.4. From
year 8 ROIC becomes constant and close to the internal rate of return of 10%, while in the
early years ROIC is somewhat low compared to the internal rate of return of 10%. This ought
to be expected, as ROIC is the accounting-based measure of IRR, and unbiased accounting
should reflect the true underlying performance of a firm. As stated above, it is assumed that
the investments are depreciated by a full year in the year of the investment.7

Table 15.4 Financial data and ratios based on depreciation over the actual lifetime
of projects
Depreciation schedule: 8-year, straight-line
Year EBITDA Depreciation EBIT Book value ROIC
at beginning
of period

1 18,744 12,500 6,244 100,000 6.2%

2 37,489 25,000 12,489 187,500 6.7%

3 56,233 37,500 18,733 262,500 7.1%

4 74,978 50,000 24,978 325,000 7.7%

5 93,722 62,500 31,222 375,000 8.3%

6 112,467 75,000 37,467 412,500 9.1%

7 131,211 87,500 43,711 437,500 10.0%

8 149,955 100,000 49,955 450,000 11.1%

9 149,955 100,000 49,955 450,000 11.1%

10 149,955 100,000 49,955 450,000 11.1%

15 149,955 100,000 49,955 450,000 11.1%

20 149,955 100,000 49,955 450,000 11.1%

In year 8 and all future years, EBITDA becomes 8 × 18,744 = 149,955 (allowing for round-
ing errors), since one project expires and is replaced by a new one. Depreciation becomes
constant 8 × 12,500 = 100,000 as eight projects are depreciated by 12,500 each. Finally,
the carrying value of the projects amounts to 450,000 as there are eight projects with a (yet)
non-depreciated value as shown in Table 15.5.
Unbiased accounting requires perfect foresight. The problem is that in real life we do
not have this information. That is why the useful lifetime may be estimated differently by
different firms. In addition, even if management had absolute knowledge of the lifetime of
assets, they may still want to apply aggressive or conservative estimates to increase their
performance-based bonuses or otherwise obtain a favourable outcome of their reporting.
What happens if the firm applies a conservative estimate of the useful lifetime believing that
a four-year period reflects the economic lifetime of each project? In this case the accounting
Table 15.5 Calculation of book value

Project Book value at

beginning of
the year

1: Depreciated by 7 times 12.5%. Remaining value 12.5% 12,500

2: Depreciated by 6 times 12.5%. Remaining value 25.0% 25,000

3: Depreciated by 5 times 12.5%. Remaining value 37.5% 37,500

4: Depreciated by 4 times 12.5%. Remaining value 5 0 . 0 % 50,000

5: Depreciated by 3 times 12.5%. Remaining value 62.5% 62,500

6: Depreciated by 2 times 12.5%. Remaining value 75.0% 75,000

7: Depreciated by 1 times 12.5%. Remaining value 87.5% 87,500

8: Investment made at the beginning of the year 100,000

Total 450,000

Table 15.6 Financial data and ratios based on conservative accounting

Depreciation schedule: 4-year, straight-line

Year EBITDA Depreciation EBIT Book value ROIC

at beginning
of period

1 18,744 25,000 -6,256 100,000 -6.3%

2 37,489 50,000 -12,511 1 75,000 -7.1%
3 56,233 75,000 -18,767 225,000 -8.3%
4 74,978 100,000 -25,022 250,000 -10.0%
5 93,722 100,000 -6,278 250,000 -2.5%
6 112,467 100,000 12,467 250,000 5.0%
7 131,211 100,000 31,211 250,000 12.5%
8 149,955 100,000 49,955 250,000 20.0%
9 149,955 100,000 49,955 250,000 20.0%
10 149,955 100,000 49,955 250,000 20.0%
15 149,955 100,000 49,955 250,000 20.0%
20 149,955 100,000 49,955 250,000 20.0%

figures and related financial ratios become as shown in Table 15.6. As before, notice that
EBITDA becomes constant after eight years. Perhaps more surprisingly, depreciation also
becomes constant at 100,000. This is because four projects are depreciated by 25,000 (25%
p.a.) each. But in contrast to the previous example, depreciation is constant from year 4, not
year 8. Invested capital also comes into steady-state in year 4. Invested capital of 250,000
consists of the value of projects not fully depreciated (four projects with remaining values
of 25,000, 50,000, 75,000 and 100,000 respectively). ROIC is clearly understated in early
years, but overstated in later years (20.0% compared to IRR of 10%). Again, the actual ROIC
depends on the depreciation schedule (including whether depreciation is made in full in year 1)
and method (here assumed to be straight-line).
Finally, Table 15.7 illustrates the consequences of a depreciation period of 12 years, which
is far longer than the true lifetime of each project of eight years. Not surprisingly, ROIC is
much higher than for conservative and unbiased accounting, in the early years and even
significantly higher than IRR especially in year 8. Depreciation charges are clearly too low,
and even though invested capital is too high, the end result is a higher ROIC (the denomina-
tor dominates the numerator). However, from year 11 ROIC is downward biased. EBIT and
invested capital have become constant, but invested capital consists of assets, which should
have been fully depreciated.

Table 15.7 Financial data and ratios based on aggressive accounting

Depreciation schedule: 12-year, straight-line

Year EBITDA Depreciation EBIT Book value at ROIC

beginning of
period

1 18,744 8,333 10,411 100,000 10.4%

2 37,489 16,667 20,822 191,667 10.9%
3 56,233 25,000 31,233 275,000 11.4%
4 74,978 33,333 41,644 350,000 11.9%
5 93,722 41,667 52,056 416,667 12.5%
6 112,467 50,000 62,467 475,000 13.2%
7 131,211 58,333 72,878 525,000 13.9%
8 149,955 66,667 83,289 566,667 14.7%
9 149,955 75,000 74,955 600,000 12.5%
10 149,955 83,333 66,622 625,000 10.7%
12 149,955 100,000 49,955 650,000 7.7%
20 149,955 100,000 49,955 650,000 7.7%

•
Based on the above examples it can be concluded that the relation between ROIC
and IRR is as follows:

• For firms which have been in business for a few years only, ROIC is significantly
lower than IRR, unless the depreciation policy is liberal (aggressive).
• For mature firms the relation between ROIC and IRR depends upon the deprecia-
tion policy:
- Unbiased depreciation policies: ROIC is a fair proxy for IRR
- Conservative accounting policies: ROIC overstates IRR
- Aggressive accounting policies: ROIC understates IRR.
As a result of measurement errors from depreciating/amortising too quickly, book
values (invested capital) become undervalued - therefore, ROIC and other meas-
ures of performance are upward biased. One consequence of this is the so-called
'old plant trap'. Firms with old plant, property and equipment, which have been
(almost) entirely depreciated, will have low carrying values and relatively high rates
of accounting returns (e.g. ROIC and ROE). But when these assets are replaced by
new ones, book values will increase substantially, causing accounting rates of return
to decrease. The old plant trap is sprung when investors mistake the high accounting
rates of return for firms with old plants for high economic rates of return. The inter-
pretation of ROIC should be taken with care, as it is heavily influenced by a firm's
accounting policies.
Naturally, a number of other financial ratios are affected as well. The economic
consequences of accounting policies may be severe, depending on the extent to which
these ratios are used in credit rating, bonus contracts or valuation based on multiples.

Impairment losses
Even though most tangible and intangible assets are depreciated8 additional expenses
shall be recognised if those assets are impaired. An impairment loss is expensed when
the carrying amount (book value) of an asset exceeds its recoverable amount. The recov-
erable amount is the higher of an asset's fair value less costs to sell (sometimes called net
selling price) and its value in use. According to IAS 36.6 value in use is the present value
of the future cash flows expected to be derived from the asset. In other words, if the sell-
ing price of an asset is not known (which is presumably the case for most (specialised)
assets used in production), a firm shall use valuation techniques for measuring value in
use. Measuring value in use is therefore highly subjective.
According to US GAAP, the carrying amount is compared with the undiscounted
cash flows. If the carrying amount is lower than the undiscounted cash flows, no
impairment loss is recognised. Therefore, the analysts need to be aware that impair-
ment losses are more likely to occur for firms using IFRS standards (cash flows are
discounted) compared to firms using US GAAP.
The consequences of impairment losses on selected earnings measures and financial
ratios are depicted in Table 15.8, which builds on the assumptions in Table 15.4.
Due to the impairment losses, invested capital is reduced by 80,000 in year 9.
For the remaining four years of the assets' lifetime, depreciation is lower by 20,000
(80,000/4 = 20,000) annually due to a lower investment base. As a result, ROIC is
negative in year 9, where the impairment loss is recognised, but high in subsequent
years. ROIC is positively affected by both an increase in the numerator (adjusted
EBIT) and a decrease in the denominator (adjusted invested capital). Naturally, the
impairment loss could reflect a general economic recession or simply a bad business
climate within the industry. In such cases, the impairment loss reflects (correctly) that
future cash flows are expected to be lower than originally forecast. Alternatively, the
impairment loss might be an example of management playing the earnings manage-
ment game ('big bath' accounting). By taking a big hit on earnings in year 9 with a
huge impairment charge (maybe it's a bad year anyway) future earnings increase.
It is difficult for analysts to determine if impairment tests and the related (potential)
recognition of impairment losses provide an unbiased estimate of assets (net of impair-
ment write-offs) and earnings or if management uses the judgements and estimates
inherent in carrying out impairment tests to manage earnings. Unless fair value can be
established with reference to an active market or a bid for the asset, impairment tests
Table 15.8 Financial data and ratios after recognition of impairment losses

Year 8 Year 9 Year 10 Year 11 Year 12 Year 13 Year 14

EBITDA 149,955 149,955 149,955 149,955 149,955 149,955 149,955

Depreciation and -100,000 -100,000 -100,000 -100,000 -100,000 -100,000 -100,000
amortisation
EBIT (unadjusted) 49,955 49,955 49,955 49,955 49,955 49,955 49,955
Impairment losses 0 -80,000 0 0 0 0 0
Adjustments to 0 0 20,000 20,000 20,000 20,000 0
depreciation
EBIT (adjusted) 49,955 -30,045 69,955 69,955 69,955 69,955 49,955

Invested capital 450,000 450,000 450,000 450,000 450,000 450,000 450,000

Impairments 0 -80,000 -60,000 -40,000 -20,000 0 0
Invested capital, 450,000 470,000 490,000 410,000 430,000 450,000 450,000
adjusted
ROIC (unadjusted) 11.1% 11.1% 11.1% 11.1% 11.1% 11.1% 11.1%
ROIC, adjusted NA -6.7% 18.9% 17.9% 17.1% 16.3% 11.1%

require that the value in use is calculated. To calculate value in use, management needs
to forecast future economic benefits (cash flows) and apply a proper discount rate.
This leaves much room for management to manage earnings. Analysts are left with
two choices, in order to assess whether earnings management is taking place. They
may dig up information in the annual report about the assumptions underlying the
impairment tests, and they may find inspiration in assessing the realism in the tests by
comparison with assumptions made by competitors.

Revaluation
A firm's property, plant and equipment may be revalued if fair value can be measured
reliably. For instance, the fair value (market value) of an office building can be deter-
mined by independent realtors. If two professional realtors end up with an estimate
of the value of the office building of 105,000 and 115,000 respectively, the firm may
choose to revalue the office building from its current book value of, say, 100,000 to
the average value of the realtors' estimate (105,000 + 115,000)/2 = 110,000. Since
the revaluation reserve of 10,000 is credited to equity and not recognised as income,
it becomes a comprehensive income item; unless the firm is in the investment property
business. In that case IAS 40 applies, and gains or losses arising from changes in the
fair value of investment property must be included in net profit or loss.
Using the above example and assuming that investments are depreciated over its
useful lifetime (as illustrated in Table 15.4), we exemplify the effects of a revaluation
in year 9 (accounting items have reached steady-state). The example is analogous to
the impairment loss example: instead of an impairment loss of 80,000 a revaluation of
80,000 (on depreciable assets) is recognised (see Table 15.9).
Here we assume that the revalued assets have an estimated remaining (average) life-
time of four years. Operating profit (EBIT) does not increase as a consequence of the
Table 15.9 Financial data and ratios after revaluation

Year 8 Year 9 Year 10 Year 11 Year 12 Year 13 Year 14

EBITDA 149,955 149,955 149,955 149,955 149,955 149,955 149,955

Depreciation and -100,000 -100,000 -100,000 -100,000 -100,000 -100,000 -100,000
amortisation
EBIT (unadjusted) 49,955 49,955 49,955 49,955 49,955 49,955 49,955
Depreciation on 0 0 -20,000 -20,000 -20,000 -20,000 0
revaluations
EBIT (adjusted) 49,955 49,955 29,955 29,955 29,955 29,955 49,955

Invested capital 450,000 450,000 450,000 450,000 450,000 450,000 450,000

Revaluations 0 80,000 60,000 40,000 20,000 0 0
Invested capital, 450,000 530,000 510,000 490,000 470,000 450,000 450,000
adjusted
ROIC 11.1% 11.1% 11.1% 11.1% 11.1% 11.1% 11.1%
ROIC, adjusted NA 11.1% 5.7% 5.9% 6.1% 6.4% 11.1%

revalued amount. On the contrary, depreciation expenses related to property increase

proportionally to the increase in the gross value of the depreciable assets. As a result
ROIC is downward biased (until the revalued amount has been fully depreciated).
In addition, revaluation shall be made with sufficient regularity to ensure that book
value does not differ materially from fair value at the balance sheet date. A further
increase in the market value of the assets will, therefore, require even higher deprecia-
tion charges in the future. While ROIC is downward biased, the balance sheet better
reflects fair value. Risk measures such as the debt-equity ratio improves. Again, how
analysts relate to revaluation depends on the purpose of their analysis and the decision
model they intend to use.

Accounting for leases

Leases may be accounted for using two vastly distinct methods. If lease contracts are
classified as operating leases, lease obligations are not recognised in the balance sheet
(and nor are lease assets), but the contract is disclosed as a contingent liability. On the
other hand, finance leases (or capital leases as they are called in the USA), the alterna-
tive to operating leases, are recognised as lease assets with an offsetting lease liability.
Lease is a prime example of assets and liabilities that may or may not be recognised
depending upon the contract as discussed previously. Consider that firm A enters a
lease contract with the following characteristics:

Lease payment per year (constant) 22,961

Lease period 6 years
Internal rate of return (discount rate) 10%
Salvage value after year 6 Zero
 Firm A recognises leases as operating leases. In this case, the yearly lease pay-
ment is recognised as an expense in measuring EBIT. However, had firm A recog-
nised the contract as a finance lease (capital lease), the firm would have to capitalise
the lease payments and recognise leased assets and corresponding lease liabilities in
the balance sheet. To do so the value of the leased assets and corresponding lease
liability must be calculated at the inception of the lease contract. According to gen-
erally accepted accounting principles (GAAP), the lease assets should be recognised
as the present value of the future minimum lease payments as set forth in the lease
contract. In the above example, the leased assets, and the lease obligation, is meas-
ured as:

The effect on the financial statements would be as shown in Tables 15.10 and 15.13.
The leased assets and lease obligations are quite simply recorded as if the assets had
been purchased on account. The assets are depreciated over their useful lifetime on
(in this example) a straight-line basis. Every year depreciation expenses of 16,667 are
recognised in the income statement, while the leased assets are gradually being depre-
ciated to zero by the end of year 6 (salvage value is considered to be zero). Notice that
the depreciation expense is unrelated to the yearly lease payment of 22,961.

Table 15.10 Reported lease assets after converting to finance leases

Book value at beginning Depreciation Book value at
of period end of period
Year 1 100,000 16,667 83,333
Year 2 83,333 16,667 66,667
Year 3 66,667 16,667 50,000
Year 4 50,000 16,667 33,333
Year 5 33,333 16,667 16,667
Year 6 16,667 16,667 0
Total 100,000

The lease payments are related to the lease obligations. If the firm had bought the
leased assets on account, outstanding debt would be recorded as shown in Table 15.11.
For instance, the lease payment in year 1 would consist of an interest expense of
10,000 (10% × 100,000), while the remaining 12,961 (22,961 - 10,000) would be
an instalment (amortisation of the lease obligation). After six years, the lease obliga-
tion has been repaid in full as reflected in Table 15.11. If the value of the leased assets
and the lease obligation do not add up to zero by the end of year 6, the calculations
are flawed. Therefore, analysts can control their calculations if they convert operating
leases to finance leases for analytical purposes.
Assume that firm A has a constant EBITDA of 32,000 over time and net finan-
cial expenses (excluding interest on lease obligations) of 3,000. The income statement
 Table 15.11 Reported lease obligations after converting to finance leases

Lease Interest Payment Amortisation Lease

obligation expense obligation
beginning end of
of period period
Year 1 100,000 10,000 22,961 12,961 87,039
Year 2 87,039 8,704 22,961 14,257 72.782
Year 3 72,782 7,278 22,961 15,682 57,100
Year 4 57,100 5,710 22,961 17,251 39,849
Year 5 39,849 3,985 22,961 18,976 20,873
Year 5 20,873 2,087 22,961 20,873 0
Total 37,764 137,764 100,000

Table 15.12 Income statements with leases classified as operating leases

Operating lease Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Total

Income statement (excerpt)

Turnover 82,000 82,000 82,000 82,000 82,000 82,000 492,000
Operating expenses 50,000 50,000 50,000 50,000 50,000 50,000 300,000
excluding leases
Lease payments 22,961 22,961 22,961 22,961 22,961 22,961 137,764
EBIT 9,039 9,039 9,039 9,039 9,039 9,039 54,236
Financial expenses, net 3,000 3,000 3,000 3,000 3,000 3,000 18,000
(excluding interest on lease debt)
Interest on lease debt 0 0 0 0 0 0 0
Earnings before tax 6,039 6,039 6,039 6,039 6,039 6,039 36,236

would be quite different depending on how leases are accounted for as illustrated in
Table 15.12 (classification as operating leases) and Table 15.13 (leases classified as
finance leases).
If leases are classified as operating leases, the entire payment would be recognised
as an operating expense. No balance sheet entries should be made (except for the
cash payments which reduces a firm's cash balance or bank deposit), and no financial
expenses would be recognised.
On the other hand, in a finance lease the lease contract affects both sides in the
balance sheet as lease assets and lease obligations, respectively. The effect on income
would be twofold: an increase in the depreciation expense (depreciation of lease assets)
and an increase in financial expenses (interest on leasing debt).
Table 15.13 Income statements after converting to finance leases

Finance lease Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Total

Income statement (excerpt)

Turnover 82,000 82,000 82,000 82,000 82,000 82,000 492,000
Operating expenses excluding leases 50,000 50,000 50,000 50,000 50,000 50,000 300,000
Depreciation on leased assets 16,667 16,667 16,667 16,667 16.667 16,667 100,000
EBIT 15,333 15,333 15,333 15,333 15,333 15,333 92,000
Financial expenses, net 3,000 3,000 3,000 3,000 3,000 3,000 18,000
(excluding interest on lease debt)
Interest on lease debt 10,000 8,704 7,278 5,710 3,985 2,087 37,764
Earnings before tax 2,333 3,629 5,355 6,623 8,348 10,246 36,236

In year 1 the effect on EBIT after reclassifying the lease contracts would be:

Reported EBIT 9,039

+ Add back lease payment (leases recognised as operating leases) + 22,961
- Subtract depreciation on leased assets -16,667
Adjusted EBIT 15,333

Unsurprisingly, the total effect on earnings before taxes (EBT) over time of recog-
nising leases as finance as opposed to operating leases is zero. The total expense
recognised is equivalent to the total payments made; no more, no less. However,
the effect on EBITDA, EBIT, net financial expenses and earnings before taxes (EBT)
within each financial year varies between the two ways leases may be accounted for.
For instance, in years 1 and 6, the expense related to the lease contract is as shown
in Table 15.14.
It should be noted that a new standard on accounting for leases is currently being
considered. IASB is running a project on leases to ensure that the assets and liabili-
ties arising from lease contracts are recognised in the statement of financial position.
However, at the moment leases may still be accounted for as operating leases.

Table 15.14 Income effects of operating versus finance leases

Operating leases Finance leases

Year 1 Year 6 Year 1 Year 6
EBIT -22,961 -22,961 -16,667 -16,667
Financial expenses 0 0 - 10,000 - 2,087
EBT -22,961 -22,961 -26,667 -18,754
Provisions
An important issue in reporting financials is whether all liabilities are recognised in
the financial statements or kept off balance. It must often be judged whether a certain
item or event requires recognition as a liability, disclosure as a contingent liability or
should be disregarded (i.e. no information provided in the annual report at all).
A liability is a current obligation of an entity arising from past events, the settlement
of which is expected to result in outflow from the entity of resources embodying eco-
nomic benefits. Most liabilities pose no problems from an analytical point of view, as
they contain little uncertainty. Many liabilities have fixed payment dates and amounts
set by a contract. Borrowing arrangements (e.g. bank loans) and accounts payable fall
into this category. An amortisation schedule specifies the timing and amount of inter-
ests and principal payments.
At the other extreme some liabilities may be highly uncertain. A frequently used
example is unsettled lawsuits. Such liabilities are (mostly) recognised as contingent
liabilities. In between the two extremes are liabilities where the firm must estimate the
timing and/or the amount of payment. Restructuring charges and deferred tax liabili-
ties are prominent examples.
These differences in uncertainty are reflected in accounting regulation, which have
three separate categories of liabilities: liabilities, provisions and contingent liabilities.
As noted above, a liability is a present obligation of an entity arising from past events,
the settlement of which is expected to result in outflow from the entity of resources
embodying economic benefits. Provisions are liabilities of uncertain timing or amount.
Finally, contingent liabilities are defined as obligations that arise from past events
and whose existence will be confirmed by occurrence or non-occurrence of one or
more future events not wholly within the control of the entity. A contingent liability is
also defined as a present obligation that arises from past events but is not recognised
because it is not probable that an outflow of resources embodying economic benefits
will be required to settle the obligation or the amount of the obligation cannot be
measured with sufficient reliability.
Provisions may be hard to separate from contingent liabilities, as illustrated below:

Provisions Contingent liabilities

A present obligation from past events A present obligation from past events
existence of which depends on future
events and/or
A probably outflow of economic benefits Outflow of economic benefits is not
probable and/or
An evaluation of timing and amount A reliable estimate of outflow cannot be
made

A liability is recognised as a provision if there is a probable outflow of economic ben-

efits. Naturally, this requires judgement on the part of management that is responsible
for producing the annual report. If the outflow of economic benefits is not probable
or cannot be estimated reliably, the liability is no longer a provision but a contingent
liability. Finally, if the possibility of an outflow of resources is remote no liability is
recognised or disclosed. As is apparent there might often be a thin line between provi-
sions and contingent liabilities. From an analytical point of view, however, it may have
 a huge impact on earnings and financial ratios how liabilities are incorporated in the
financial statement.

Type of obligation Financial statement treatment

Liabilities Recognised as current and non-current liabilities,

respectively
Provisions Recognised as a separate item under current and
non-current liabilities, respectively
Contingent liabilities Disclosed. Not recognised in the balance sheet
Remote possibility of outflow No information provided in the annual report
of economic benefits

An analyst should be aware of these subtle differences between different types of lia-
bilities. Contingent liabilities like pending lawsuits and operating lease contracts may
represent potential large future outflows of cash. This underlines the point that an
analyst should read the annual report and notes carefully, and remember what he or
she already knows about the business and industry.
Provisions shall be measured at fair value if discounting is material. Provisions may
be quite large and of a different nature. In year 8 the E.ON Group - one of the world's
largest investor-owned power and gas companies - reported the provisions shown in
the excerpt from its annual report in Table 15.15.

Table 15.15 E.ON Group Miscellaneous Provisions (Annual Report, note 25)

(25) Miscellaneous Provisions

The following table lists the miscellaneous provisions as of the dates indicated:
€ in millions 31 December, Year 8 31 December, Year 7
Current Non-current Current Non-current
Non-contractual obligations for nuclear waste 127 9,138 133 10,022
management
Contractual obligations for nuclear waste 161 3,931 300 3,335
management
Personnel obligations 633 716 593 690
Other asset retirement obligations 290 1,193 301 943
Supplier-related obligations 309 320 451 290
Customer-related obligations 458 141 296 80
Environmental remediation and similar 45 557 32 456
obligations
Other 2,237 3,202 1,886 2,257
Total 4,260 19,198 3,992 18,073
 As E.ON's miscellaneous provisions amounted to €23,458 million (19,198 + 4,260)
and reported equity was €38,427 million, provisions must be considered material.
Furthermore, note 9 in the annual report discloses that 'Other interest expense
includes the accretion of provisions for asset retirement obligations in the amount
of €759 million'. This amount reflects the discounting of provisions. Since another
year has passed the present value of the provisions increases (in the E.ON example
by €759 million).
Provisions are prone to distortion since a great deal of subjectivity is involved: what
are the costs associated with settling the provision (amount)? when shall the provi-
sion be settled (settlement date)? and what rate of interest (discount factor) should be
applied in order to determine the present value of the provision? Even though it has
become harder to use provisions as a tool for income smoothing or earnings manage-
ment, 9 provisions still involve a great deal of judgement. To illustrate the impact of
provisions on financial statements, the following example demonstrates how different
assumptions and estimates concerning provisions affect financial statements.

Example 15.2 Provisions

A firm has recognised large provisions, due to a major restructuring of its operations. Part of
these restructuring costs is related to an environmental clean-up (land contamination) in year 4.
The assumptions behind this provision are as follows:

Financial year Year 1

Nominal provision 13,310

Settlement date (end of year) Year 4

Discount rate (before tax) 10%

Recognition of this provision in the income statement and the balance sheet is as follows:

Year 1 Year 2 Year 3 Year 4 Total

Operating expenses 10,000 0 0 0 10,000

Financial expenses 0 1,000 1,100 1,210 3,310

Total expenses 10,000 1,000 1,100 1,210 13,310

Provisions 10,000 11,000 12,100 0

Cash 0 0 0 -13,310 -13,310

•
In Example 15.2, the recognised provision by the end of year 1 is calculated as
13,310/(1 + 0.10) 3 = 10,000. The difference between the nominal provision to
be paid by the end of year 4 (13,310) and the operating expense recognised in year 1
(10,000) is recognised as financial expenses in years 2, 3 and 4. These expenses
simply reflect the changes in the present value of the provision as the settlement
date gets closer.
 Since provisions are subject to a number of estimates and assumptions, an analyst
should be aware of the consequences of changing the underlying assumptions. The
effect of changing (1) the nominal provision, (2) the settlement date and (3) the dis-
count rate are discussed next.

1 Change in nominal provision

Assume that by the end of year 2, the firm's best estimate of the provision changes
from 13,310 to 16,638 at the settlement date in year 4.

Year 1 Year 2 Year 3 Year 4 Total

Operating expenses (change 0 2,750 0 0 12,750

in nominal provision)
Financial expenses 1,000 1,375 1,513 3,888
Total expenses 10,000 3,750 1,375 1,513 16,638
Provisions 10,000 13,750 15,125 0
Cash (settlement of provision) 0 0 0 -16,638 -16,638

The change in the estimated provision of 16,638 - 13,310 = 3,328 has an effect
on operating expenses in year 2, as they increase by 3,328/(1 + 0.10) 2 = 2,750
(allowing for rounding errors). The total change in provisions in year 2 is hereafter
3,750 calculated as operating expenses of 2,750 plus financial expenses of 10% of
10,000 = 1,000.

2 Settlement date (date provision has to be paid for)

The present value of the nominal provision increases every year as the settlement date
gets closer. The change in the present value of the provision is recognised as a finan-
cial expense. If the estimate of when the provision shall be settled changes, a financial
expense or financial income must be recognised in the income statement.
In year 2 the firm changes its estimate of the settlement date for the provision, as it
finds that production may be extended by a year before land contamination is needed.
The consequences for the financial statements become:

Year 1 Year 2 Year 3 Year 4 Year 5 Total

Operating expenses 10,000 0 0 0 0 10,000
Financial expenses 0 1,000 1,000 1,100 1,210 4,310
Financial income 0 1,000 0 0 0 1,000
(change in settlement
date)
Total expenses 10,000 0 1,000 1,100 1,210 13,310
Provisions 10,000 10,000 11,000 12,100
Cash 0 0 0 0 -13,310 -13,310
 As seen in this example, income/expenses due to a change in the settle-
ment date are recognised as financial income and expenses. The provision is
unchanged in year 2. This is explained by two opposite effects. Financial expenses
increase by 10% × 10,000 = 1,000, as the settlement date has become one
year closer. At the same time financial income of 1,000 is recognised, as the set-
tlement date has been postponed by a year. This financial income is calculated as:
13,310/(1 + 0.10) 2 - 13,310/(1 + 0.10) 3 = 11,000 - 10,000 = 1,000.

3 Discount factor
Recognition of provisions at fair value requires discounting of the nominal amount
to be paid in the future. Discounting shall take the time value of money and risk into
consideration. Fair value is measured as the amount a firm would have to pay in order
to settle the recorded provision at the financial year end.
Changes in the discount factor, for example, due to changes in the general interest
level or inflation has an impact on the present value of the provision. The difference
between the capitalised value of the provision before and after the change in the dis-
count rate shall be recognised in the income statement as a financial item.
Assume that the discount factor is being reassessed by the firm and is now esti-
mated to be 15% due to higher perceived risk. The consequences are:

Discount rate: 15% Year 1 Year 2 Year 3 Year 4 Total

Operating expenses 8,752 0 0 0 8,752

Financial expenses 1,313 1,510 1,736 4,558

Total expenses 8,752 1,313 1,510 1,736 13,310

Provisions 8,752 10,064 11,574 0

Cash -13,310 -13,310

Financial expenses increases to 1,313 in year 2 and are calculated as 8,752 × 15%. In
total financial expenses amount to 4,558 compared to 3,310 if a discount rate of 10%
was used. Unsurprisingly, the example highlights that as a consequence of an increase
in the discount rate, financial expenses are at a higher level in each period. It should be
pointed out that higher interest rates are likely to reflect an increase in inflation, which
may affect the nominal provision upward.
Assuming that no provisions have been recognised prior to year 1, the example
illustrates that the discount factor has a huge impact on allocation of the provision
between operations (EBIT) and net financial expenses. The above examples are sum-
marised in Table 15.16.
In summary, the total effect on net earnings (before tax) is the same in the two
examples, namely accumulated expenses of 13,310. With a discount rate of 10%
operating expenses are considerably higher than if a 15% discount rate was used,
while financial expenses (interests) are correspondingly lower. The choice of discount
factor consequently has a great impact on reported operating earnings (EBIT, EBITDA
and NOPAT etc.) and financial expenses.
Table 15.16 Accounting treatment of provisions if assumptions change

Effects on the income statement and balance sheet

Changes in
Assumptions assumptions Income statement Balance sheet

Increases Operating expense increases Provision increases

2
(Increase in depreciation charge ) (Related assets increase2)
Amount Interest expenses increase
(Nominal
provision) Decreases Operating expenses decrease Provision decreases
2
(Decrease in depreciation charge ) (Related assets decrease2)
Interest expenses decrease

Later Interest expenses, net decrease Provision decreases

(Related assets decrease2)
Settlement date
Sooner Interest expenses, net increase Provision increases
(Related assets increase2)

Higher Operating expenses decreases1 Provision decreases

2
(Decrease in depreciation charge ) (Related assets decrease2)
Interest expenses increase
Discount rate
Lower Operating expenses increases1 Provision increases
2
(Increase in depreciation charge ) (Related assets increase2)
Interest expenses decrease

Notes
1
Operating expenses are only affected at initial recognition.
2
For certain provisions the off-setting (debit) entry is an addition to assets, which affects the depreciation expense.
Likewise, if provisions decrease (debit-entry), assets decrease (credit-entry) with a lower depreciation charge as a
consequence. For example, provisions related to restoration of a site (e.g. removing oil rig and cleaning-up) would be
capitalised and added to the cost of the assets (subject to depreciation).

Deferred tax liabilities

Another provision which should be carefully considered by the analyst is deferred tax
liabilities. Deferred tax liabilities arise due to differences between taxable income and
accounting earnings. Accounting earnings are calculated based on IFRS, US GAAP or
local GAAP, while taxable income is the result of applying tax regulations. For most
countries accounting profit and taxable income are based on entirely different sets of
rules. Example 15.3 shows how deferred tax liabilities are calculated (see Table 15.17)
and recognised in the financial statements.
Example 15.3 Calculation of deferred tax liabilities

Assumptions:

Investment in equipment 100

Estimated useful lifetime, years 10

Salvage value 0

Accounting depreciation, straight-line 1 0 % per year

Depreciation, taxable income, straight-line 2 5 % per year

Corporate tax rate (flat rate) 30%

•
Table 15.17 Calculation of deferred tax liabilities

Carrying Tax base Difference Balance sheet Income statement

value (accumulated (change in deferred
deferred tax tax liability)
liability)

Year 1 90 75 15 3 0 % × 15 = 4.5 Tax expense: 4.5

Year 2 80 50 30 3 0 % × 30 = 9.0 Tax expense: 4.5

Year 3 70 25 45 3 0 % × 45 = 1 3.5 Tax expense: 4.5

Year 4 60 0 60 3 0 % × 60 = 18.0 Tax expense: 4.5

Year 5 50 0 50 3 0 % × 50 = 15.0 Tax income: 3.0

Year 6 40 0 40 3 0 % × 40 = 12.0 Tax income: 3.0

Year 7 30 0 30 3 0 % × 30 = 9.0 Tax income: 3.0

Year 8 20 0 20 3 0 % × 20 = 6.0 Tax income: 3.0

Year 9 10 0 10 3 0 % × 10 = 3.0 Tax income: 3.0

Year 10 0 0 0 3 0 % × 0 = 0.0 Tax income: 3.0

Total effect by the end of year 10 0 0

This example is simplified as only one asset is included. In addition, the tax rate is
considered constant over time. Firms typically make investments on a continuous
basis, and corporate tax rates have changed significantly over time. Nonetheless,
Example 15.3 helps to illustrate a major analytical issue: are deferred tax liabilities
true liabilities, and if not, what are they? The example indicates that deferred tax
liabilities are overstated. For instance, by the end of year 4 a total deferred tax expense
of 18 has been recognised with an off-setting liability of 18. These expenses have not
yet been paid (that is why they are called deferred). Since these tax liabilities are paid
at a future date (maybe far into the future or never) if firms make new investments, it
would be obvious to discount them to present value.
Table 15.18 Calculation of deferred tax liabilities (continued)

Carrying Tax base Difference Balance sheet Income statement

value (book (accumulated deferred (change in deferred
value) tax liability) tax liability)

Year 1 90 75 15 3 0 % × 15 = 4.5 Tax expense: 4.5

Year 2
Investment 1 80 50 30
Investment 2 90 75 15

Total year 2 170 125 45 3 0 % × 45 = 13.5 Tax expense: 9.0

Year 3
Investment 1 70 25 45
Investment 2 80 50 30
Investment 3 90 75 15

Total year 3 240 150 90 3 0 % × 90 = 27.0 Tax expense: 13.5

Year 4
Investment 1 60 0 60
Investment 2 70 25 45
Investment 3 80 50 30
Investment 4 90 75 15

Total year 4 300 150 150 3 0 % × 150 = 45.0 Tax expense: 18.0
Year 5
Investment 1 50 0 50
Investment 2 60 0 60
Investment 3 70 25 45
Investment 4 80 50 30
Investment 5 90 75 15

Total year 5 350 150 200 3 0 % × 200 = 60.0 Tax expense: 15.0
Year 6
Investment 1 40 0 40
Investment 2 50 0 50
Investment 3 60 0 60
Investment 4 70 25 45
Investment 5 80 50 30
Investment 6 90 75 15

Total year 6 390 150 240 3 0 % × 240 = 72.0 Tax expense: 12.0
Total year 7 420 150 270 3 0 % × 270 = 8 1 . 0 Tax expense: 9.0
Total year 8 440 150 290 3 0 % × 290 = 87.0 Tax expense: 6.0
Total year 9 450 150 300 3 0 % × 300 = 90.0 Tax expense: 3.0
Total year 10 450 150 300 3 0 % × 300 = 90.0 Tax expense: 0.0
 Why are deferred tax liabilities regarded as a provision? Provisions are character-
ised by uncertainty regarding the timing or amount used to settle the liability. The
actual amount paid to settle deferred tax liabilities, sometimes in the future, depends
upon the corporate tax rate at that point in time, which may be different from the tax
rate as of today (uncertainty related to the amount), and the settlement date depends
upon a firm's future investments (creates uncertainty regarding the timing). To illus-
trate this point, look at Table 15.18, which is an extension of Table 15.17. Now
assume that the firm invests 100 in equipment in all future years. Often firms grow by
a factor which reflects inflation and real growth. An investment of 100 every year is
therefore a conservative estimate.
Table 15.18 demonstrates that if a firm invests a constant amount annually, deferred
tax liabilities may never have to be paid. In the example the deferred tax liability
increases steadily over time until year 9. From year 9 and forward the deferred tax
liability stabilises at 90. The firm has recognised a total tax expense of 90 (change in
deferred tax liability) over time. This expense, however, has never been paid and will
not be paid in the foreseeable future, if the firm stays in business. Even if the deferred
tax liability is going to be settled eventually, for instance, when or if the firm closes
down, the present value of this liability may be negligible, implying that no deferred
tax expense should be recognised. IAS 12 does not allow firms to discount deferred
tax liabilities. For analytical purposes there might be good reasons for doing so or dis-
regarding deferred tax liabilities all together. This is why Stewart (1991), and others
who use similar metrics, suggest treating deferred tax liabilities as quasi equity (i.e. the
deferred tax liability does not represent outflow of economic benefits).

Accounting flexibility and economic consequences

In the following section, we focus on how the accounting for inventory, intangible
and tangible assets, leases, provisions, deferred liabilities and pensions may distort the
financial data that are used by different decision models in different decision contexts.

Accounting issues in valuation

Present value approaches

We will now discuss how inventory accounting, intangible and tangible assets and
deferred tax liabilities may influence the value obtained from using present value
approaches.

Inventory accounting
Inventory accounting policies may have direct economic consequences. In the USA
for instance, firms that use LIFO in the annual report must also apply LIFO for tax
purposes. If costs of inventory are increasing, LIFO would reduce a firm's earnings
compared to FIFO, since cost of goods sold is based on the most recent acquisitions.
As a result, tax payable would be lower for firms using LIFO.
Even without this direct connection between inventory accounting and cash flows (lower
taxes), the accounting choice for inventory accounting may have an effect on estimated
firm value. It depends on the actual value driver setup used for forecasting, if, and to what
extent, accounting policies affect the estimated value of a firm. Suppose that a firm uses the
EBIT margin and asset turnover ratio as two important value drivers since the product of
the two equals ROIC. The consequences of using FIFO versus average costs are illustrated
in Tables 15.19 and 15.20 and built on Table 15.1.

Table 15.19 FIFO versus average costs

No. of units Price per unit Costs/sales

Beginning inventory 10 5 50
Purchase 1 10 7 70
Purchase 2 10 7 70
Purchase 3 10 9 90

Total available 40 7 280

Sold -20
Ending inventory 20
Revenue 20 12 240
Note: It is assumed that beginning inventory is the same regardless of whether the firm uses FIFO or
average costs

If firm A uses FIFO ending inventory becomes 160 (10 units at 7 + 10 units at
9) and cost of goods sold (COGS) becomes 280 - 160 = 120. COGS are calculated
as: Beginning inventory + purchases - ending inventory = 50 + 230 - 160 = 120.
If average costs are used, ending inventory becomes 140 calculated as 20 units at an
average price of 7, and COGS amounts to 280 - 140 = 140.
Furthermore, assume that the income statement and balance sheet (excerpt) would
be as shown in Table 15.20, depending on whether the firm uses FIFO or average costs.
As can be seen in Table 15.20, the financial ratios indicate that the profitability
is apparently higher, and the risk apparently lower if firm A uses FIFO. The reason
is that under FIFO, gross profit is higher since cost of goods sold are based on past
(lower) inventory costs. Moreover, risk is lower as inventory is carried at recent costs,
which is higher than past costs (since prices are increasing). It should be noted that
ROIC does not necessarily increase if FIFO is applied, as both the numerator (EBIT)
and denominator (invested capital) increases. Had inventory costs decreased over
time, profit margin and risk measures would have improved if average costs were used
for inventory accounting.
When valuing a firm, analysts should be aware that the choice of inventory account-
ing does affect important value drivers (e.g. EBIT margins and asset turnover) and
potentially the estimated firm value.

Intangible and tangible assets

Even though depreciation, amortisation and impairment losses have no cash flow
consequences, they may still have an impact on firm value. First, impairment losses
are a signal of expected poor future performance or indicate that depreciation and
amortisation expenses in the past have been insufficient. The exception is impairment
losses on goodwill and intangible assets with indefinite lifetimes. These assets are not
Table 15.20 Income statement and balance sheet

Income statement (excerpt) Firm A Firm A

FIFO Average
costs
Sales 240 240
Cost of goods sold -120 -140

Gross profit 120 100

Other operating costs including depreciation -60 -60
EBIT 60 40
Net financial expenses -20 -20
Earnings before taxes (EBT) 40 20
Corporate tax -16 -8
Net earnings 24 12

Balance sheet (excerpt)

Non-current assets (operating assets) 120 120
Inventory 160 140
Other current assets (operating assets) 20 20
Total assets 300 280

Equity 124 112

Non-current liabilities, interest-bearing 100 100
Current liabilities, non-interest-bearing 76 68
Total equity and liabilities 300 280

Revenue 240 240

Invested capital 224 212
EBIT margin 25% 17%
Asset turnover 1.07 1.13
ROIC (before tax) 26.8% 18.9%
Solvency, debt-equity ratio 1.4 1.5
Note: It is assumed that invested capital is constant over time.

amortised but subject to impairment tests at least annually. Therefore, it cannot be

stated that past amortisation expenses have been insufficient for such assets. More
interestingly, despite that, asset impairments more likely reflect a flawed business
model, recognising impairment losses today results in increased earnings and finan-
cial ratios like ROIC, in future periods. If an asset impairment is recorded every time
management makes a bad investment, it stands to reason that net income excluding
impairment losses will always look better, since income excludes the effects of all the
bad investments.
Second, when impairment losses are recognised, firms may report them as 'restruc-
turing charges' or use a similar classification to correct overvalued assets. If analysts
disregard impairment losses for valuation purposes believing they are non-recurring,
and, therefore, need not be forecast, they risk getting forecasts and value estimates
that are too optimistic. This is because impairment losses may represent an adjust-
ment of insufficient depreciation of assets, so the impairment charges simply correct a
systematic overstatement of past earnings. In such cases, analysts should be aware of
how the earnings trend may be distorted.
Companies continually replace plant and equipment in line with the emergence of
new technology or physical wear and tear. Lack of specification (notes) on gains and
losses on the sale or scrapping of these assets is problematic for at least two reasons:
1 Should such gains and losses be regarded as recurring or non-recurring items?
2 Do such gains and losses reflect that the firm's depreciation policies are overly
aggressive or overly conservative?
Gains and losses resulting from disposing of assets are often considered non-recurring
and the inclusion of such gains or losses in reported income lowers the quality of
earnings, as they make noise in forecasting future earnings. However, if such gains
and losses occur frequently, it is difficult to argue that they should be considered as
non-recurring.
Consistently reporting gains (losses) indicate that a firm is applying conservative
(aggressive) accounting policies for depreciable and amortisable assets. To assess if
gains (losses) are due to overly conservative (aggressive) accounting policies and esti-
mates, a firm's accounting policies and estimates may be compared with the ones
reported by other firms within the same industry. For forecasting purposes, analysts
might level gains/losses out by forecasting them as the average of past gains/losses over
a period of time. The analyst may have to look carefully in the annual report for infor-
mation on such items. Past gains/losses may be recognised as part of the depreciation
expense or otherwise be unspecified (e.g. because they are part of 'special items' or
other income/expenses without further specification), in which case it may be difficult
to assess the level of such items. If a firm's accounting policies and estimates are overly
conservative (aggressive), maybe management is overly conservative (aggressive) on
other accounting items as well. As discussed in Chapter 13, it cannot be concluded
that conservative accounting policies provide higher accounting quality.

Deferred tax liabilities

Taxes play an important role when valuing a company. Depending on the jurisdic-
tion, corporate tax rates may vary substantially. Taxes are an expense, which must be
treated like other expenses in valuing a company. Tax recognised in the income state-
ment consists of tax payable plus the change in deferred tax during the fiscal year, that
is part of taxes not yet payable.
Without access to income tax returns, the analyst may attempt to assess the impact
of taxes on future earnings by a closer examination of the following elements:
• Accounting versus tax depreciation rates
• The company's projected growth (investment)
• Permanent differences
• Non-recognised tax assets.
Essentially, the larger the difference between accounting depreciation and tax depreci-
ation and the higher future investments (growth), the greater the accumulated deferred
tax liabilities. If an increase in deferred tax liabilities in the forecasting period is not
taken into consideration, the estimated tax payable (cash outflow) will be too high
and accordingly, the estimated firm value will be downward biased.
Permanent differences are income and expenses, which enter the income statement
but are not included in taxable income or vice versa. In contrast temporary differ-
ences, such as differences in accounting depreciation and depreciation for tax pur-
poses, reverses over time. For example, in many tax jurisdictions fines and expenses
resulting from violations of law may be expensed in the income statement, but they
are not tax deductible. Permanent differences should be analysed. Are they fairly con-
stant over time or do they fluctuate substantially? In general, there is not much an
analyst can do about such differences. To fully incorporate them would also mean that
the analyst is up-to-date with current tax legislation. Nonetheless, if permanent dif-
ferences have a large impact on the tax rate, say, the corporate tax rate is 20%, while
the effective tax rate fluctuates around 2 5 % , analysts might forecast the tax rate at
2 5 % and thereby reduce the estimated cash flow too much. We examine this in greater
detail below.
Analysts should also consider non-recognised tax assets. Firms operating at a loss
may have large tax deficits, which can be offset against future taxable income. 10 If
it is not likely that the firm is going to have positive earnings and taxable income
in the future, these tax deficits do not represent future cash flows (tax savings). If,
however, the analysts anticipate that the firm is going to be profitable, the tax deficits
from prior years, not yet recognised, represent true economic benefits (future tax
savings) and should be included in the forecast cash flows. For example, if a firm has
€100 million in accumulated tax deficits, and the corporate tax rate is 2 5 % , the
analyst may add €25 million to the estimated firm value; or some smaller amount,
which takes into effect that the tax deficits may be utilised over more than one period
(i.e. taxable income in the first forecast year is not sufficient to recover the entire tax
deficits), so that the unrecognised tax asset needs to be discounted to reflect present
value.
It should be evident from the previous paragraphs that an assessment of future tax
rates is an extremely complex issue, and the tax rates must be evaluated in the context
of the analysed company. Even if the analyst has great knowledge of the company, he
or she still doesn't have access to the firm's income tax returns.
Nonetheless, when valuing a firm, forecast earnings must be net of corporate tax.
This raises the question of what the forecast tax rate should be. At least three tax rates
are likely candidates:
1 The effective tax rate from the past
2 The firm's marginal tax rate in the jurisdiction to which it belongs
3 Tax payable (i.e. deferred tax is disregarded).
If the firm's effective tax rate in the past is fairly constant it could be used as a proxy
for forecasting future tax rates.
A number of factors explain why the effective tax rate may differ substantially
from the marginal corporate tax rate. These factors include permanent differences
between accounting income and taxable income, tax-losses carry forwards, write-offs
of deferred tax assets, limitations in how tax losses may be utilised across jurisdic-
tions, and adjustments to tax paid in prior year(s). Since such factors are hard to
 forecast, it could be argued that the corporate tax rate (i.e. the firm's marginal tax
rate) should be used in forecasting earnings.
Finally, since only cash flows matter, forecast tax expenses for valuation purposes
should only consist of taxes to be paid; i.e. deferred tax liabilities should be disre-
garded. This would require that the analyst has access to the firm's income tax returns,
which they do not unless they are insiders. Therefore, analysts have no other alterna-
tive than assuming that forecast taxes are paid as recognised in the forecast income
statement. This does not take into account the fact that forecast tax comprises both
tax payable and deferred tax liabilities, but it is probably the most pragmatic solu-
tion. As a general rule this would lead to an estimated firm value that is downward
biased; tax expenses recognised are higher than tax payable. For high growth firms
the difference between tax payable and taxes recognised in the income statement may
be substantial. For these firms, we therefore recommend the estimation of deferred tax
liabilities.

Multiples

EV/EBITDA, EV/EBIT and EV/NOPAT multiples

As noted in Chapter 9 and in the previous chapter, a prerequisite for applying multi-
ples is that the firm being valued apply accounting policies and uses estimates which
are comparable to its competitors. Accounting policies may vary across firms for a
variety of items, and if differences in accounting policies and estimates have a material
effect on reported financial data, the analyst needs to make adjustments to make data
across firms truly comparable. Common accounting issues, which may require adjust-
ments to be made to reported figures, are listed in Table 15.21.

Inventory accounting
As inventory costs are rising (falling), firms using FIFO appear to be more profit-
able (less profitable) than firm's using either LIFO or average costs. EBIT, EBITDA

Table 15.21 Accounting issues in applying multiples

Accounting item Issue

Inventory accounting Do the firms use the same cost assumptions (e.g. FIFO,
LIFO or average costs)?
Depreciation, amortisation Do the firms assume the same lifetime for depreciable
and impairment and amortisable assets?
Do they apply the same depreciation and amortisation
method?
Are the assumptions underlying impairment tests
comparable across firms?
Leases Are leases contracts recognised as operating or financial
leases?
Provisions Are provisions discounted?
Are discounts factors comparable across firms?
and other measures of profitability are higher (lower) for FIFO firms for the simple
fact that cost of goods sold are based on past, lower costs of inventory (more recent,
higher costs of inventory).
Fortunately, US firms using LIFO must disclose a LIFO reserve account. The LIFO
reserve is the difference between the carrying amount of inventory using LIFO and
the amount (current or replacement cost) that would have been reported had the firm
used FIFO. LIFO inventory contain older costs, which may have little relationship to
current costs. In fact, if costs are increasing rapidly, inventory based on LIFO (inven-
tory are measured at past, lower costs) may be significantly lower than current costs.
In Example 15.4, we illustrate how a LIFO reserve can be used to translate EBIT
based on LIFO to EBIT based on FIFO.

Example 15.4 LIFO versus FIFO

Assume that a US firm, which uses LIFO, recognises the following book value of inventory and
discloses the following LIFO reserve in the footnotes for the past four years:

Year 0 Year 1 Year 2 Year 3

Inventory at LIFO 30 35 37 40
LIFO reserve 10 7 12 20

This illustrates that had the firm used FIFO the carrying value (book value) of inventory would
have been higher. For instance, book value of inventory would have been 40 (30 + 10) in
Year 0.
Suppose the firm's reported operating income for the years 1-3 is as shown in Table 15.22. If
comparable firms - which comply with IFRS - use FIFO, how should the US firm's EBIT be
adjusted to take care of accounting differences?11 This is illustrated in Table 15.23. By refer-
ring to the footnotes tabulation at the beginning of Example 15.4, it is possible to calculate
the change in the LIFO reserve. For instance, in year 3 the LIFO reserve increases from 12
at year end 2 to 20 at year end 3, an increase of 8. Since ending inventory in year 3 would
be higher by 8 if FIFO is used, cost of goods sold (COGS) would be 8 lower. This is because
COGS = Beginning inventory + Purchases - Ending inventory.
EBIT as if the firm had used FIFO would, therefore, become as shown in Table 15.24.
Especially, in year 3 the difference between LIFO and FIFO is significant. The difference is
[(8 × 100)/30] = 26.7%. If comparable firms applying FIFO are valued at 10 times EBIT,

Table 15.22 Income statement, inventory accounting using LIFO

Income statement (excerpt) Year 1 Year 2 Year 3

Sales 240 280 220

Cost of goods sold -140 -170 -150
Gross profit 100 110 70
Other operating costs incl. depreciation -60 -50 -40

EBIT 40 60 30
Table 15.23 Adjustment from LIFO to FIFO

Year 1 Year 2 Year 3

Inventories carried at LIFO 35 37 40

LIFO reserve 7 12 20
Inventories adjusted to FIFO 42 49 60

Cost of goods sold at LIFO 140 170 150

Change in LIFO reserve 3 -5 -8
Cost of goods sold at FIFO 143 165 142

Table 15.24 Income statement, inventory accounting using FIFO as opposed to LIFO

Income statement (excerpt) Year 1 Year 2 Year 3 Total

Sales 240 280 220 740

Cost of goods sold -143 -165 -142 -450

Gross profit 97 115 78 290

Other operating costs including -60 -50 -40 -150

depreciation

EBIT using FIFO 37 65 38 140

EBIT using LIFO 40 60 30 130

Difference in EBIT -3 5 8 10

failing to adjust for differences in inventory accounting would affect estimated firm value
by 10 × 8 based on the most recent EBIT. That is the owners of the US firm would obtain a
price which is 80 below what it should have been if the necessary adjustments are not made.
Table 15.24 also illustrates that the total increase in EBIT by applying FIFO amounts to 10;
the difference between the LIFO reserve in year 0 (10) and year 3 (20), as shown in the tabu-
lation at the beginning of Example 15.4.
If the firm that needs to be valued and the comparable firms all comply with IFRS, and they
use different cost assumptions for inventory accounting (FIFO for some firms and average
costs for other firms), the analyst has no way of knowing the effect on EBIT since no reserve
has to be disclosed for firms using average costs. This complicates the task for the analyst, as
he or she may try to assess the magnitude on EBIT on different inventory cost assumptions by
looking at how prices (costs) have developed within the industry. If costs are relatively stable
over time, it is probably not necessary to make adjustments. However, in some industries,
costs may change dramatically over time. For example, prices on computer chips and related
high-tech components have deteriorated substantially over time. In such cases, adjustments
may have to be made before applying the multiple. •
Depreciation, amortisation and impairment
Adjusting for differences in accounting policies is sometimes more problematic than it
sounds. To illustrate this, take a closer look at the following example. Firm A is being
valued. The average (mean) EV/EBIT for three comparable firms (firms B, C and D) is
assumed to be 10. This means that if there were no differences in accounting policies
between the firms A, B, C and D, firm A's enterprise value would be 10 times EBIT.
(Chapter 9 also discusses whether the multiple should be based on the median, the
mean, the value weighted mean or the harmonic mean. It should be noted that the
difference between these measures can be quite substantial.) Assume that an analysis
of the firms indicates that the firms' accounting policies and estimates are comparable
except for depreciation schedules as shown in Table 15.25.

Table 15.25 Accounting policies for peer companies

Accounting item Firm A Firm B Firm C Firm D

Depreciation period for machinery and 3-5 2-10 5-10 5-8

equipment, number of years

As can be seen in Table 15.25, the depreciation period is stated as an interval for all
firms. This is normal practice as firms employ a number of assets with different useful
lifetimes. However, this raises the fundamental question as to whether firm A, B, C
and D depreciates similar assets over dissimilar periods of time. If so it will be neces-
sary to making adjustments before applying the multiple.
At least two reasons might explain why the firms use different depreciation periods.
First, management in the four firms may have different perceptions about the useful
lifetime of similar assets (even though based on experience they probably should be
able to get a fair estimate of the lifetime). Second, the differences may reflect differ-
ences in the firm's asset bases. For instance, firms B and C (with longer expected life-
times of their assets) may have a larger part of tangible assets with a fairly long useful
lifetime.
It is problematic whether the differences shown in Table 15.25 reflect the fact that
some firms are overly conservative in their estimates (i.e. depreciating and amortis-
ing assets too quickly) or overly aggressive (i.e. depreciating too slowly). The diligent
analysts may try to take care of the problem in various ways. For instance, if the firms
have recognised large impairment losses in the past, this may be an indication that
assets are depreciated too slowly. Likewise, gains on the disposal of machinery and
equipment may indicate that a firm depreciates too quickly. Even if such signals are
not obtainable, the analyst might include in his or her report that the value estimate
based on the EV/EBIT multiple may contain noise. Furthermore, including a sensitiv-
ity analysis would give the analyst an indication of the magnitude on value of differ-
ences in accounting estimates. Finally, an analyst could estimate the average age of the
assets and the average depreciable lives as follows:
Table 15.26 Reported depreciation
Investment Depreciation Accumulated Book value
expense depreciation

Year 1 200 20 20 180

Year 2 0 20 40 160

Year 3 0 20 60 140

Year 4 0 20 80 120

Assume that a firm states an interval for depreciation. In addition to this, the firm
reports the following (excerpt) as shown in Table 15.26. In this case the assets average
age and depreciable life are calculated as follows:

As illustrated, the average age of the assets is four years and the average depreciable
life is 10 years. The firm will need to depreciate the investment of 200 for another
six years.
If the average age of the assets or the average depreciable life in firm A differs
substantially from those of the comparable firms, adjustments may need to be made
before applying the multiples. For example, a low average depreciable life of the assets
in firm A may indicate that assets are depreciated too quickly. Therefore, before apply-
ing a multiple like the EV/EBIT, EBIT for firm A may have to be adjusted upward to
reflect that recorded depreciation expenses are too high. In practice, such fine distinc-
tions are hardly ever made. In any event, before carrying out the analysis, an analyst
should carefully consider materiality and the cost of making the analysis versus the
likely benefits.

Leases
Leases pose another problem as described in Chapter 14. The total expenses recog-
nised under operating leases and finance (capital) leases are the same over time but
different amounts are charged within a year and classified differently in the income
statement. Dependent on the nature of the leased assets, operating lease expenses
may be recognised as part of production costs (e.g. lease of machinery and equip-
ment), sales and distribution costs (e.g. lease of car fleet to sales representatives) or
administrative expenses (e.g. lease of office equipment or executive cars to the CEO
and CFO).
Assume that a firm has the opportunity to buy assets at a price of 100,000 with an
estimated lifetime of six years. The firm can borrow at 10%. Alternatively, the firm may
lease the assets paying 22,961 annually for six years. Referring to the example on leases
outlined earlier in this chapter (see page 424), we have calculated the amounts outlined in
Table 15.27.
Table 15.27 Operating vs finance leases

Operating leases Finance leases

Year 1 Year 6 Year 1 Year 6

Production costs and/or
Sales and distribution costs and/or -22,961 -22,961 16,667 -16,667
Administration costs
EBIT -22,961 -22,961 -16,667 -16,667
Financial expenses 0 0 -10,000 -2,087
Earnings before tax (EBT) -22,961 -22,961 -26,667 -18,754

In the case of finance leases the costs of 16,667 is the depreciation of the assets
(machinery, equipment etc.). With an EV/EBIT multiple of 10 the effect on the esti-
mated value by reclassifying leases from operating leases to financial leases would be
an increase in value of 62,940 [10 × (22,961 - 16,667)].

Provisions
Management has great discretion in the recognition of provisions. The absolute
amount of the provision, the time to settlement and the discount rate used to measure
provisions at fair value (present value) may all have a significant effect on the total
expense recognised in the income statement and how the expense is divided between
operating expenses and financial expenses. If multiples such as EV/EBITDA and
EV/EBIT are used, the analyst must consider the assumptions and estimates made by
management carefully. Consider two identical firms, which both recognise a provision
of 133.1 to be paid in three full years from now. Firm A uses a discount factor of 10%,
while firm B discounts the provision to present value by using a discount rate of 5%.
Example 15.5 illustrates how the two firms would report operating earnings.

Example 15.5 How different assumptions on provisions affect the income statement
First, the provision recognised in year 1 is the present value of the estimated amount to be
paid by the end of year 4. If the discount factor is 10% (5%), this amount is calculated as

as illustrated in Table 15.28.

Table 15.28 Discounting of provisions - book value of provisions

Discounting of provisions, Year 1 Year 2 Year 3 Year 4

NPV at year end

Firm A: Discount factor 10% 100.0 110.0 121.0 133.1

Firm A: Discount factor 5% 115.0 120.7 126.8 133.1
 Table 15.29 Effects of discounting provisions by 10%

Firm A Year 1 Year 2 Year 3 Year 4 Total

EBIT excluding provisions 200.0 200.0 200.0 200.0 800.0

Provisions (an operating expense) 100.0 0.0 0.0 0.0 100.0
EBIT 100.0 200.0 200.0 200.0 700.0
Financial expenses 0.0 10.0 11.0 12.1 33.1
Earninqs before taxes, EBT 100.0 190.0 189.0 187.9 666.9

Table 15.30 Effects of discounting provisions by 5%

Firm B Year 1 Year 2 Year 3 Year 4 Total

EBIT excluding provisions 200.0 200.0 200.0 200.0 800.0

Provisions (an operating expense) 115.0 0.0 0.0 0.0 115.0
EBIT 85.0 200.0 200.0 200.0 685.0
Financial expenses 0.0 5.7 6.0 6.3 18.1

Earnings before taxes, EBT 85.0 194.3 194.0 193.7 666.9

Second, the financial expenses for firm A would be 10 in year 2 (110 - 100 = 10) and for
firm B financial expenses would amount to 5.7 in year 2 (120.7 - 115 = 5.7) and so on for
the coming years. Therefore, reported income for the two firms is as shown in Tables 15.29
and 15.30.
Note that total earnings before taxes would be the same for the two firms. This shouldn't
come as a surprise. Naturally, the total expense that is recognised is exactly 133.1, which
is what the two firms will have to pay to settle the liability. However, the two firms differ in
respect to how much they recognise provision as operating expenses (firm A: 100; firm B:
115) and financial expenses (firm A: 33.1; firm B: 18.1). If firm value is based on an EBIT(DA)
multiple, firm A appears more valuable in year 1. That is unless the analyst looks through the
accounting differences and makes the necessary adjustments. •

Accounting issues in credit analysis

Credit rating models and financial ratios

Violation of debt covenants may have severe economic consequences for a firm includ-
ing higher costs of borrowing, calls for repayment of debt or a requirement that the
firm put up collaterals. In a worst case scenario, the firm may not be able to comply
with its debt covenants and may have to close down due to lack of liquidity. It is
evident that management, to avoid default on debt, may be tempted to exploit loop-
holes in accounting regulation and/or make estimates and assumptions that improve
 financial ratios, so that lenders cannot call the debt. For example, if management is
able to reclassify finance leases as operating leases, debt is kept off-balance making the
balance sheet look healthier.
Lenders should basically consider any and all accounting policy choices and esti-
mates, since everything that has an impact on accounting numbers has an impact on
financial ratios. We now discuss a few of these issues.
• Intangible and tangible assets (depreciation and revaluation)
• Leases.

Depreciation and revaluation

Revaluations improve a company's solvency ratio. To the extent that debt covenants
contain a solvency ratio, revaluation could mean that a firm obtains less strict loan
terms. The same is true in connection with mortgage lending, where cost of borrow-
ing depends on the collaterals. A higher valuation makes the loan more secure, which
means that borrowing costs will be lower. It should be pointed out that mortgage
lenders usually make their own assessments, and revaluations in the financial state-
ments do not directly affect the loan terms.
Revaluations lead to a decrease in return on invested capital (ROIC). Invested
capital (the denominator) increases by the revalued amounts (net of depreciation),
while operating income decreases (the numerator), since it's the revalued assets
which are depreciated. Whether the overall result of the revaluation - improved
solvency but a deterioration of profitability - leads to lower borrowing costs cannot
be answered with certainty as borrowing costs ultimately depends upon numerous
financial ratios.

Leases
Operating leasing is an example of off balance sheet financing, since large liabilities
(finance lease obligations) are not recognised in the balance sheet. As a result, solvency
ratios show that financial risk is less for firms classifying leases as operating leases.
A company's borrowing costs (interest rates, fees, commissions etc.) depend on the
risk the lender (e.g. a bank) assumes in providing a loan. Standard & Poor's rates com-
panies in categories AAA-CCC (a total of seven categories), where class AAA is the best
rating, meaning it includes companies which are very creditworthy. For example, S&P
requires that total debt is less than 5% of total capital for industrial firms to deserve an
AAA classification.
Standard & Poor's financial ratios are adjusted to take into account that manage-
ment may have an interest in classifying leases as operating leases. Standard & Poor's
states in their 'Credit Stats: Adjusted Key U.S. Industrial Financial Ratios' that finan-
cial ratios shall be adjusted, so that operating leases are capitalised; i.e. recognised as
finance leases.

Liquidation models
The liquidation model represents firm value in a worst case scenario. If a firm is not
able to service its debt, the lender may call the debt. As discussed in Chapter 9 on
valuation, the proceeds the investor (or in this case the lender) will eventually receive
depend upon how quickly the firm needs to sell the assets and settle the liabilities.
Table 15.31 Measurement attributes for common assets according to IFRS

Type of assets Measurement basis Comments

Intangible assets Cost less accumulated Measurement to fair value requires

amortisation and an active market for intangibles.
impairment losses; Goodwill cannot be sold as a separate
alternatively fair value asset and is worth zero if a firm is
(in rare cases) liquidated

Tangible assets Cost less accumulated Historical cost less depreciation is

depreciation and a mechanic way of allocating cost
impairment losses (cost (depreciation) to matching income
model); alternatively fair generated by the assets. Unless the
value (revaluation model) alternative method of revaluation is used,
book value of tangible assets is only by
chance a good proxy of fair value

Financial assets Amortised costs If interest rates fluctuate substantially,

held to maturity fair value may be far from book value
(amortised costs)

Financial assets Fair value These assets often have quoted market
held for trading prices

Leases (finance) Fair value (present value See comments on tangible assets
of future lease payments)
less depreciation

Inventories Costs A firm may use several methods including

FIFO and average costs. If FIFO is used,
book value of inventory could be
materially different from fair value

Accounts Amortised costs Book value may not be a good indicator

receivable of fair value if insufficient allowance for
uncollectability has been made

Contingent assets Not recognised Law suits, contingent tax assets etc. May
have a potential value

A forced liquidation will most likely result in lower net proceeds. In any event, what
do the financial statements tell us about the potential break-up value of a firm?
Consider the measurement of common assets and liabilities as provided in Tables 15.31 and
15.32. Whether book values of assets and liabilities are good indicators of the fair value
depends primarily on the type of assets and liabilities recognised in the balance sheet, the
firm's accounting policy choices, including its recognition policies for assets and liabilities,
and management's estimates and judgements.
While it is not possible to illustrate every combination of accounting policies,
Example 15.6 should give the analyst a thorough understanding of how accounting
policies and judgements by management are related to the liquidation value of the
firm.
 Table 15.32 Measurement attributes for common liabilities according to IFRS

Type of liability Measurement basis Comments

Financial liabilities Amortised costs If interest rates fluctuate substantially,

held to maturity fair value may be far from book value
(amortised costs)

Financial liabilities Fair value These liabilities often have quoted

held for trading market prices

Finance leases Fair value less repayment If a firm is liquidated, lease obligations
of lease obligations still have to be paid regardless of
whether the leased assets can be used

Provisions Expenditure required to Actual cash outflows to settle provisions

settle liability. Present may be high compared to book value
value if time value of since provisions are discounted*
money is material

Deferred tax Tax rate enacted by the If a firm sells its assets for less than
end of the reporting book value, deferred tax liabilities are
period. Discounting is not overstated
allowed

Accounts payable Amortised costs If accounts payable fall due within

a few months, book value should
represent fair value

Contingent Not recognised, but Operating leases. Payments on lease

liabilities disclosed in the notes contracts still have to be made, even if
the firm discontinues its operations.
Law suits. Often kept off-balance to
avoid admitting 'guilt'

* For instance a firm may have to pay for cleaning-up (removing plants, removing chemicals in
the ground), when the firm closes down. These costs shall be recognised today, even if the firm
anticipates paying them in the far future, and are discounted to reflect the present value of the
provision.

Example 15.6 The impact of accounting policies and management judgements on the
liquidation value
Consider firm A and its latest balance sheet in condensed form in Table 15.33. Furthermore,
assume that the firm pays a flat tax rate of 4 0 % on all income. 1 2 Finally, from the notes in the
annual report, you will realise that the deferred tax liabilities are related to tangible and intan-
gible assets only.
If you are a credit analyst (maybe a loan officer in a major bank) and consider calling the
loan because of violation of debt covenants, for instance, because the interest coverage ratios
exceeded the threshold set forth in the contract, then:

Do you believe that firm A is able to recover its debt in case of a suspension of
payments?

Take a short break to consider the question . . .

In order to answer such a question, you need to understand the alternative uses of firm
A's assets (and liabilities). For instance, they might be valuable for other firms in the industry.
 Table 15.33 Balance sheet for firm A

Accounting item Book values

Tangible assets 500

Intangible assets 100
Financial assets 220
Inventories 120
Accounts receivable 230
Other assets 40
Financial liabilities, bank loans -600
Deferred tax liabilities -200
Other liabilities -40

Book value of equity 370

Note: The firm pays a flat corporate tax rate of 40%

Since our focus is on accounting issues, we consider accounting issues related to estimating
break-up value (liquidation value) of the firm:
• What accounting method choices has firm A applied?
• Does the firm use conservative or aggressive accounting policies?
• What are the measurement basis for assets and liabilities?
• Does the firm have assets and liabilities, which are not recognised in the balance sheet?
You can assess a firm's accounting choices in several ways. First, you might compare its
accounting policies with the ones from other firms within the same industry. To do so, you
need to read the notes on accounting policies carefully and evaluate whether firm A's account-
ing policies are materially different from industry practice.
Second, an analysis of gains (losses) reported by firm A in the past gives an indication of
whether the firm uses conservative or aggressive accounting policies. If firm A has reported
gains (losses) on disposal of non-current assets in the past (selling machinery, office equip-
ment, company cars etc.), it suggests that management has been conservative (liberal) in
applying depreciation and amortisation policies. Third, the note on accounting policies pro-
vide you the answers regarding how assets and liabilities are measured (e.g. historical costs
or fair value). Finally, studying the annual report and industry characteristics should help you
find out if there are any indications that firm A may have unrecognised assets and liabilities
such as deferred tax assets, in process R&D, unsettled law suits, operating leases and erro-
neous contracts. While information about operating leases can be found in the notes (they
are disclosed as contingent liabilities) other non-recognised items may not be disclosed in
the annual report. For instance, certain industries are known for having numerous pending
lawsuits. If firm A operates in, say, the biotech industry it is likely to have pending lawsuits,
as companies in such industries go to great lengths in protecting their patents. The potential
compensation (future economic benefits) from these lawsuits is not likely to be recognised
as assets and may not even be disclosed due to the great uncertainty about the outcome (if
disclosed they are regarded as contingent assets).
Now assume that the estimated market value of the tangible assets for firm A would be
100 (compared to book value of 500), while intangible assets would have a market value of
 zero (compared to book value of 100). Market values are far below book values. This could
be the case, for example, because tangible assets consist of specialised items, with little or no
alternative use, and intangible assets of goodwill, which is a non-separable asset.
Furthermore, suppose that all assets, except tangible and intangible assets, on average
could be sold at book value, while book value of financial liabilities and other liabilities are
stated at fair value (i.e. these liabilities could be settled by paying book value). Would com-
pany A be able to repay its loans? If we look at the information already provided, the answer
is apparently 'No'.
The market value of net assets is minus 130, as illustrated in Table 15.34, which indicates
that the lender would have to recognise a potential loss on the bank loan of 130 (unless the
bank has collaterals). The loss may be even larger as legal fees also need to be considered or
the loss could turn out to be lower if it is 'shared' with other liabilities. However, as argued
below, an analyst must consider all facts and possess great knowledge about how financial
statements are produced. The bank is actually likely to be paid in full. The reason for this is
that as tangible assets are sold at less than book value, the related deferred tax liability would
change as shown in Table 15.35.

Table 15.34 Market value of assets for firm A

Accounting item Estimated proceeds

from liquidation

Book value of equity 370

Loss on tangible assets, depreciable (500 - 100) -400
Loss on intangible assets, depreciable (100 - 0) -100
Difference between market value and book value
for all other assets and liabilities 0

Total market value of net assets -130

Table 15.35 Fair value of tax liability for firm A

Book Tax rate Book value Calculate Solve for Y Fair value
value of (flat) of deferred tax base (tax value/ of tax liability
depreciable tax liability of tangible tax base)
assets assets, Y

Firm A 600 40% 200 (600 - Y) × Y = 100 (Sales price - tax

0.4 = 200 value) ×
t = (100 - 100) ×
40% = 0

The deferred tax liability (book value is 200) is calculated as the difference between book
values and tax values multiplied by the corporate tax rate. Since the tax rate is 40% and the
deferred tax liability is 200, the difference between the book value of tangible assets and its
tax value must be 500 (200/0.4). Therefore, by selling assets booked at 600 for only 100, the
fair value of the tax liability becomes 0 as compared to the book value of 200. Another way
of making this calculation is to acknowledge that tangible assets sell for 500 less than book
value. As a result, the gain for tax purposes is 500 less. Accordingly, firm A can settle its tax
 Table 15.36 Estimated net proceeds for firm A

Accounting item Estimated market values

Tangible assets 100

Intangible assets 0
Financial assets 220
Inventories 120
Accounts receivable 230
Other assets 40

Other liabilities -40

Deferred tax liabilities 0
Estimated proceeds to pay off bank loans 670
Financial liabilities, bank loans -600

Estimated net proceeds after repaying all debt 70

liability by paying 0, that is 200 (500 × 40%) less than book value (book value of deferred
tax liability is 200). In conclusion, the firm can settle its tax liability without paying the tax
authorities, even though the book value was 200.
Now you realise - see Table 15.36 - that firm A should be able to repay the debt. This is
the opposite answer we came to before! In fact, 70 is left in cash to pay consultants, legal
fees etc. •

In conclusion, a thorough estimation of liquidation values of assets and liabilities

requires knowledge about how accounting items are measured in the balance sheet.
Financial assets and liabilities in general pose no problems, but most other assets,
which are not measured at fair value, do. It could be argued that a lender should not
care about the book value of assets and liabilities. What matters is the proceeds that
can be obtained from selling the firm's assets and settling the liabilities. However, the
analysts (in this case a lender) need to estimate the likely net cash inflow from liqui-
dating the firm, before he or she calls the debt. If the proceeds are estimated to be low,
the lender may wish to continue providing finance hoping for better times.

Accounting issues in executive compensation

Bonuses based on financial performance measures also have some inherent problems
to be considered by the analyst. Typically, cash bonuses are based on one or more
of several different performance measures such as revenue, EBIT, EBITDA, ROIC,
EVA, and other similar metrics. Consider a cash bonus based on reported EBIT.
Management can simply enhance the chance of getting a bonus merely by extending
the estimated lifetime of depreciable assets, and, thus, charge the income statement,
and EBIT, with a lower depreciation expense.
In this section, focus is on how accounting flexibility may affect bonuses. Since
accounting-based bonuses are directly linked to accounting measures of performance,
measurement errors (bias) and flexibility in choosing between alternative accounting
 policies (e.g. FIFO versus average costs) have economic consequences. We examine
two types of accounting-based performance measures:
1 Absolute performance measures (e.g. revenue, EBIT, EBITDA, EBT)
2 Relative performance measures (e.g. ROIC, EVA)
These are discussed below.

Absolute performance measures

The use of EBIT, EBITDA or similar metrics as a performance measure in bonus plans
has the advantage that management compensation is tied to a firm's operating per-
formance. Furthermore, EBITDA has the alleged advantage that management cannot
increase bonuses, for example, by simply changing the estimated lifetime of depreci-
able assets. Nonetheless, certain accounting issues should be considered.

Intangible and tangible assets (depreciation and amortisation)

The role of depreciation and amortisation in bonus contracts depends on how bonus
contracts are designed. By now it should be clear that conservative or liberal account-
ing affects earnings levels, invested capital and financial ratios.
A need for recognising impairment of goodwill is apparently profound if new man-
agement takes office. The new management team could hardly be blamed, they would
argue, that goodwill has to be written down due to events happening before they were
in charge. In such a case though, their bonuses would probably not be affected.
If the company permanently amortises too quickly (too slowly), gains (losses) on
sale of assets will frequently occur. Liberal (conservative) accounting policies improve
(reduce) the bottom line. Managers who achieve bonuses based on an absolute per-
formance measure may therefore be interested in pursuing liberal accounting policies.
Managers who are rewarded bonuses based on a relative performance measure may
on the other hand, be more interested in pursuing conservative accounting policies.
For example, a company that has a fairly constant level of investment, achieves a
higher ROIC, once it has reached steady-state, since a shorter amortisation period
reduces invested capital.

Leases
Accounting policies for leases will be important in the context of bonus compensa-
tion. The choice of classifying leases as either operating or financial leases has an
impact on operating earnings, net financial expenses, interest-bearing debt, invested
capital and financial ratios. Since we concentrate here on absolute performance
measures, the question is, how accounting policies for leases affect various earnings
measures.
By reporting leases as financial leases (capital leases), part of the lease expense
is recognised as a financial expense that is after operating earnings. This provides
management with incentives to capitalise leases, if their bonuses are based on EBIT,
EBITDA, NOPAT or similar measures of operating earnings. Lease accounting has a
large effect on EBITDA and EBIT. If a firm uses operating leases, the entire lease pay-
ment is charged against EBIT or EBITDA. However, if leases are recognised as finance
leases, part of the expenses are recognised as financial expenses that are not included
in EBIT or EBITDA. As a result, bonuses based on operating performance measures
such as EBIT, are higher if leases are recognised as financial leases.
Relative performance measures

Provisions
Even though it has become more difficult for management to use 'big bath' account-
ing, recognising provisions is still prone to earnings management. Management may
be tempted to recognise large restructuring costs. For example:
• Restructuring costs are often perceived to be non-recurring, and management might
argue such expenses should be disregarded in performance measures used in bonus
plans.
• Future earnings are likely to improve since future costs are recognised today. For
instance, restructuring costs may include impairment losses, and as a result future
depreciation expenses become lower.
Discounting of provisions is particularly problematic, in relation to the distinction
between operating and financing items. By discounting provisions, part of provisions
becomes interest expenses. The larger the discount factor, the larger the portion of
provisions is regarded as financial expenses. For the sake of consistency in the data,
a compensation committee can choose from two options for including provisions in
bonus plans (EVA).
1 Reclassifying the interest element of provisions in the income statement as operat-
ing expenses, or
2 Reclassify provisions (in the balance sheet) as interest bearing (and include the
interest part as financial expenses in the income statement).

Deferred taxes
In the context of performance measurement, deferred taxes are often considered as an
equity component ('quasi' equity). For example, deferred taxes are generally added to
equity in EVA calculations. Copeland et al. (2000) includes deferred tax in invested
capital. They justify it by arguing that investors expect a firm to earn a return on all
capital invested in the firm, and deferred tax liabilities are available in the sense they
are not paid and may never have to be paid as demonstrated in this chapter. This also
implies that taxes on earnings should only include tax payable and not the deferred
tax liabilities.
As illustrated in Chapter 14, deferred tax liabilities may be deferred far into
the future or may never have to be paid. Therefore, arguably, deferred tax liabili-
ties should be regarded as an equity component. Here is how the adjustments
need to be made.

Example 15.7 Converting tax liabilities to equity in EVA calculations

Table 15.37 illustrates a standard analytical income statement and balance sheet (excerpt).
Return On Invested Capital is calculated as

In the example, NOPAT = EBIT - tax on EBIT. Invested capital is the average capital.
Table 15.37 Condensed analytical financial statements

Year 0 Year 1 Year 2 Year 3

Operating earnings, EBIT 100 103 111

Net financial expenses -15 -13 -11
Earnings before taxes, EBT 85 90 100
Taxes -34 -36 -40
Net earnings, E 51 54 60

EBIT 100 103 111

Taxes on EBIT -40 -41 -44
NOPAT 60 62 67

Operating assets 510 546 572 618

Operating liabilities excluding deferred taxes -100 -100 -100 -100
Deferred taxes -20 -25 -17 -23
Invested capital 390 421 455 495

Equity 230 281 335 395

Net interest-bearing debt 160 140 120 100
Invested capital 390 421 455 495

Return on invested capital 14.8% 14.1% 14.0%

Therefore, for year 1, ROIC becomes:

The average invested capital in year 1 amounts to (390 + 421 )/2 = 405.5 so ROIC
becomes

Now if deferred taxes are regarded as an equity component, the calculations of ROIC would
change as shown in Table 15.38.
In year 0, equity and invested capital increase by 20 since deferred tax liabilities are
regarded as equity. In years 1, 2 and 3, tax in the income statement is net of the deferred
tax component (that is the change in the differed tax liability) and equity changes by an
 Table 15.38 Calculation of ROIC, deferred tax regarded as equity

Year 0 Year 1 Year 2 Year 3

Operating earnings, EBIT 100 103 111

Net financial expenses -15 -13 -11

Earnings before taxes, EBT 85 90 100

Tax payable -34 -36 -40

Add back change in deferred taxes 5 -8 6

Net earnings, E 56 46 66

EBIT 100 103 111

Taxes on EBIT -40 -41 -44

Add back change in deferred taxes 5 -8 6

NOPAT 65 54 73

Operating assets 510 546 572 618

Operating liabilities excluding deferred taxes -100 -100 -100 -100

Deferred taxes 0 0 0 0

Invested capital 410 446 472 518

Equity 250 306 352 418

Net interest-bearing debt 160 140 120 100

Invested capital 410 446 472 518

Return On Invested Capital 15.2% 11.7% 14.7%

equal amount. For instance, in year 1, the deferred tax liability increases by 5 from 20 to 25.
Therefore, to reverse the effects, tax on EBIT is reduced by 5 and equity increases by 5. This
is, obviously, under the assumption that deferred taxes are related to operations only. It is
often the case that deferred taxes are related to differences in accounting depreciation and
depreciation for tax purposes (i.e. operations).
Assume that WACC is 12%. In this case, EVA would be positive for all years (ROIC > 12%)
before adjusting for deferred tax. If deferred tax is regarded as equity, EVA would be slightly
negative in year 2 since ROIC is 11.7% as shown in Table 15.38. •

Conclusions
This chapter highlights potential economic consequences of a firm's accounting
choices and management discretion in producing financial statements. As illustrated,
accounting policies and accounting flexibility may have a large impact on financial
data and ratios. Since accounting data are used as input to numerous decision models,
firm valuation, credit analysis and bonuses are affected by a firm's (management's)
accounting policies and estimates.
 Some of the lessons to be learned are:
• Applied accounting policies and estimates should be carefully studied
• Changes in accounting policies or estimates may have severe economic consequences
• Inventory accounting methods have direct cash flow consequences, if the method
used for accounting purposes is applied for tax purposes as well
• Depreciation and amortisation policies may have economic consequences even
though a firm's underlying cash flows are unaffected
• Impairment losses have no cash flow consequences but may reflect a flawed busi-
ness model or aggressive amortisation policies
• Lease contracts may be recognised as operating leases or finance leases. The effect
on operating earnings, debt and financial ratios differs substantially between the
two methods
• Deferred taxes are problematic, but should be considered as they are likely to affect
valuation, bonuses and credit rating.
Any financial statement analysis should include a careful examination of a firm's
major accounting policies and management's estimates and assumptions.

Review questions
• List examples of accounting items where some flexibility in accounting methods choices
are allowed due to regulatory flexibility.
• List examples of accounting items, which requires management uses its discretion.
• Give examples of accounting items, which are based on management's estimates.
• How does revaluation affect a firm's ROIC and other financial ratios?
• What is the distinction between a liability, a provision and a contingent liability?
• Discuss why deferred tax liabilities may be considered as 'quasi equity'.
• What is the effect of a change in the discount rate used in measuring provisions?

APPENDIX 15.1

Overview of the purposes of financial statement analysis

Purpose of analysis Decision model or method Examples of accounting issues ('noise')

Valuation (estimating Present value approach Changes in accounting method choices (e.g.
enterprise value or (DDM model, DCF model, from FIFO to average cost)
market value of equity) EVA model and APV model) Changes in accounting estimates
Non-disclosed transitory items
Aggressive versus conservative accounting
policies
(continued)
Multiples Differences in accounting policies across firms
Different definitions of transitory items (special
items, abnormal items etc.) across firms

Liquidation model Overvalued assets due to insufficient recognition

of impairment losses
Non-recognised assets and liabilities (e.g.
pending lawsuits, operating leases)

Credit analysis Forecasting and value-at-risk Changes in accounting method choices (e.g.
from FIFO to average cost)
Changes in accounting estimates
Non-disclosed transitory items
Aggressive versus conservative accounting
policies

Financial ratios (rating Changes in accounting method choices (e.g.

model) from FIFO to average cost)
Changes in accounting estimates
Non-disclosed transitory items
Aggressive versus conservative accounting
policies
Liquidation model Overvalued assets due to insufficient recognition
of impairment losses
Non-recognised assets and liabilities (e.g.
pending lawsuits, operating leases

Bonus contracts Choice of performance Restructuring charges, development costs and

measures (relative and other forward looking costs (expensed today but
absolute performance with a positive NPV)
measures) Changes in accounting estimates
Non-disclosed transitory items
Aggressive versus conservative accounting
policies

Notes 1 If it isn't possible to register the physical flow of inventories, a firm needs to make an assump-
tion about which goods are being sold. FIFO (LIFO) assumes that the goods bought first
(last) are the first (last) being sold. So, FIFO (LIFO) value ending inventory at current prices
(historical prices).
2 According to US GAAP inventory is carried at the lower of cost and market with market
generally meaning replacement cost. This is slightly different than IFRS since net realisable
value is the market price less cost necessary for completion and sales cost (e.g. marketing
expenses).
3 Intangible assets are, strictly speaking, amortised. In the following the term depreciation is
used to embrace both depreciation and amortisation.
 4 However, IFRS standards allow some assets to be revalued at fair value as an alternative to
recognising those assets at historical costs less depreciation and impairment losses.
5 IRR is the internal rate of return. It is measured as the return (in percentage), which makes
the net present value of the investment and all future cash flows equal to zero.
6 Depreciating over the useful lifetime is not exactly the same as unbiased accounting. Unbiased
accounting would mean that IRR = ROIC for all periods. For this to happen, the firm had to
use a progressive depreciation scheme.
7 In reality, investments are depreciated depending on the actual date these investments are
made. From an analytical point of view, the best bet would be to depreciate by only half of
the deprecation rate (e.g. if the useful lifetime of the assets is 10 years, depreciation in year 1
would be 5%).
8 An exception is intangible assets with an indefinite lifetime (e.g. goodwill). Such assets are
not amortised but subject to impairment tests annually and whenever there is an indication
that the intangible asset may be impaired.
9 For instance, a firm cannot recognise a provision on the grounds it wants to be prudent
(conservative). Accounting for restructuring costs illustrates this point. According to GAAP
a provision for restructuring shall only be recognised after a detailed formal plan is adopted
and has been promulgated. A board decision is not sufficient.
10 In some jurisdictions, tax losses can even be carried back and offset against past (positive)
taxable income.
11 In the example it is assumed that no other material differences between US GAAP and IFRS
exist in arriving at EBIT.
12 Corporate tax rates differ substantially across countries and over time. Moreover, it may
or it may not be flat depending on the jurisdiction. Finally, some countries use accelerated
depreciation, while other countries require other methods for depreciation of tangible and
intangible assets for tax purposes. Suffice is to say that large differences exist between
different tax jurisdictions. However, the point made in the example can equally well be made
for firms in countries with corporate taxes which are not flat rate.

References Copeland, T., T. Roller and J. Murrin (2000) Valuation: Measuring and Managing the Value of
Companies, 3rd edn, John Wiley & Sons.
Stewart, G. B. (1991) The Quest for Value, Harper Business.
 Glossary

Chapter 1 maintaining generally accepted accounting

Accounting standards Definitive statements of standards for professional accountants.
best practice issued by a body having suitable Forecasting The process of making statements
authority. (in financial terms) about events whose actual
Book value The value at which an asset outcomes have not yet been observed.
or liability is carried at on a balance sheet. GAAP Generally Accepted Accounting
Compensation analyst Uses a company's Principles.
financial statements to determine performance- IASB International Accounting Standards
based management compensation. Board, an independent body that sets accounting
Contingency models A group of valuation standards (IFRS) accepted as a basis for
models that calculate the value of a company accounting in many countries.
by applying option pricing models. IFRS International Financial Reporting
Credit analyst Assesses a company's ability Standards.
to repay its obligations (liabilities), with goals Intangible assets Defined as identifiable
pertaining to the amount and terms of credit non-monetary assets that cannot be seen,
to be extended to the firm. touched or physically measured and that are
Credit rating Estimates the creditworthiness identifiable as a separate asset.
of an individual, company or even a country. Interest-bearing debt A liability that carries an
Current assets Cash and other assets expected interest.
to be converted to cash, sold or consumed Inventories The raw materials, work-in-process
either in a year or in the operating cycle goods and completely finished goods that are
(whichever is longer). considered to be the portion of a business's
Current liabilities Liabilities which are due assets that are ready or will be ready for sale.
within 12 months after the reporting date. Investors' required rate of return The return an
Equity Defined as the book value of total investor expects from investing in a company. It
assets minus book value of total liabilities. is also referred to as the investors' hurdle rate or
Equity analyst Values the residual return in opportunity cost.
the company after all claims have been satisfied. Liquidation models A group of valuation
Fair value The amount at which an asset or models used to calculate the value of a company
liability can be exchanged in an arm's-length by measuring the net proceeds that a company
transaction between a willing buyer and a can obtain if it liquidates all its assets and settle
willing seller. all its liabilities.
FASB Financial Accounting Standard Board, Liquidation value The net proceeds that a
USA. It is a non-governmental body, which company can obtain if it liquidates all its assets
the US SEC has charged with establishing and and settle all its liabilities.
Non-current assets Assets which are not settled Cash flow from investing activities Measures
within 12 months after the reporting date. the cash impact from investment in non-current
Non-current liabilities Liabilities which are assets.
not settled within 12 months after the reporting Cash flow from operating activities Measures
date. the cash generated in the operations.
Operating liabilities Liabilities that are Cash flow statement Reports a company's
non-interest bearing such as accounts payable. cash receipts, cash payments, and the net
Present value models A group of valuation change in the company's cash resulting from the
models used to calculate the value of a company company's operating, investing and financing
by discounting future cash flows. activities.
Provisions A liability where the amount Classification Refers to how accounting items
to be settled and/or timing are uncertain. are classified in the financial statements.
Double-entry bookkeeping Based on the
Receivables Money owed to a company by its
principle of duality, which means that every
clients and shown in its accounts as an asset.
economic event that is recorded has two aspects
Relative valuation models A group of which offset or balance each other (labelled
valuation models used to estimate the value debit and credit entries).
of a company by applying the price of a
Expenses Decrease in economic benefits
comparable company relative to a variety
during the accounting period in the form of
of accounting items such as revenue, EBITDA,
outflows or depletion of assets or occurrence
EBIT or net income.
of liabilities that result in decrease in equity,
Securities Generally a fungible, negotiable other than those relating to distributions to
financial instrument representing financial value. equity participants.
Securities are broadly categorised into debt
Financial statements Documents such as
securities and equity securities.
income statements and balance sheets presenting
Standard & Poor's A credit rating agency. accounting information which are expected to
Tangible assets Tangible assets are those be useful for a variety of decision purposes.
that have a physical substance and can be Function of expense method Operating
touched, such as buildings, real estate, vehicles, expenses are classified according to the function
production facilities and equipment. to which they belong such as production, sales
Value at risk (VaR) The expected mark-to- and distribution and administration.
market loss on a portfolio at a given probability Income An increase in economic benefits
(assuming normal markets and no trading in the during the accounting period in the form of
portfolio). If a portfolio of assets has a one-day inflows or enhancements of assets or decrease of
95% VaR of $1 million, a loss of $1 million or liabilities that result in increases in equity, other
more on this portfolio is expected on 1 day in 20. than those relating to contributions from equity
participants.
Chapter 2 Income statement Discloses a firm's earnings
Assets The rights or other access to future for a predefined period, which in the annual
economic benefits controlled by an entity as a report is 12 months.
result of past transactions or events. Liabilities An entity's obligations to transfer
Balance sheet A summary of a company's economic benefits as a result of past transactions
financial position at a specific point in time. or events.
Cash flow from financing activities Measures Measurement Refers to how accounting items
the cash impact from transactions with debt are measured. Typical measurement attributes
holders and shareholders. include historical cost and fair value.
Nature of expense method Operating expenses Shareholder value added (SVA) A multi-
are classified according to the nature of the period performance measure. It is defined as the
expense. difference between the present value of future
Recognition Refers to when a transaction is cash flows at the end and at the beginning of
recognised in the financial statements. the measurement period plus the free cash flow
generated in the measurement period.
Statement of changes in owners' equity
Reconciles equity at the beginning of the period
Chapter 4
with equity at the end of the period.
Analytical balance sheet Requires that every
Statement of comprehensive income Includes
accounting item is classified as belonging to
all income and expense items recognised in the
either 'operations' or 'financing'.
income statement and all other income and
expense items, which have not been recognised Analytical income statement Requires that
in the income statement. every accounting item is classified as either an
'operating' or 'financing' item.
Chapter 3 Invested capital Represents the amount a firm
Accounts payable An amount due for payment has invested in its operating activities and which
to a supplier of goods or services. requires a return.
Accrual-based performance measure An Net financial expenses after tax (Financial
accounting-based performance measure. It expenses — financial income) × (1 — corporate
generally allows the recognition of a transaction tax rate).
before it has had its cash impact. An example is Net operating profit after tax (NOPAT) EBIT
net earnings. × (1 — corporate tax rate).
Cash-flow-based performance measure A cash-
flow-based performance measure. For example, Chapter 5
cash flow from operations. Benchmarking A comparison of different
Comprehensive income Includes net earnings companies - typically within the same
plus all changes in equity except those resulting industry.
from investment by or distribution to owners. Common-size analysis Scales each accounting
E Net earnings. item as a percentage of a key figure. Typically,
balance sheet items are measured as a percentage
Earnings capacity Reflects a company's value
of total assets (or invested capital) and income
creation with given measurement period (e.g.
statement items are measured as percentages of
one year).
revenue.
Earnings per share (EPS) Net income/number
Days on hand of invested capital 365/turnover
of shares outstanding.
rate of invested capital.
EBIT Earnings before interests and taxes.
Economic Value Added (ROIC - WACC) ×
EBITDA Earnings before interests, taxes, invested capital.
depreciation and amortisation.
Financial leverage Net interest-bearing debt
EBT Earnings before tax. divided by book value of equity.
Net earnings It is the bottom line in the income Indexing Measure the magnitude of changes
statement and reflects the accounting profit to over time (for example in revenue). Because
shareholders. index numbers work in a similar way to
Operating income Shows the accounting profit percentages they make such changes easier to
from a company's operations. EBIT or operating compare. The base equals 100 and the index
earnings are alternative terms for operating number is usually expressed as 100 × the ratio
income. to the base value.
Internal rate of return (IRR) The discount Interest coverage ratio EBIT/net financial
factor that results in a net present value equal to expenses.
zero for a project. IRR shows what investors can Interest coverage ratio (cash) Cash flow from
expect to earn on average each year (expressed operations/net financial expenses.
as a percentage) during the entire lifetime of a
Liquidity cycle Represents the number of
project.
days it takes to convert inventory to cash. An
Net borrowing costs (NBC) Net financial approximate value of the liquidity cycle is 365
expenses after tax/net interest bearing debt. divided by the turnover rate of net working capital.
Profit margin Operating income/revenue. Long-term liquidity risk Refers to a company's
Residual income (RI) (ROE - cost of equity) × ability to satisfy (pay) all long-term obligations.
book value of equity. Net working capital Inventory + receivables +
Return on equity (ROE) Net income/book prepaid expenses — operating liabilities.
value of equity. Quick ratio (Cash + securities + receivables)/
Return on invested capital (ROIC) Operating current liabilities.
income as a percentage of invested capital, Short-term liquidity risk Refers to a company's
Trend analysis A comparison of the same ability to satisfy (pay) all short-term obligations.
company across time. Solvency ratio Book value of equity/(total
Turnover rate Revenue/invested capital. liabilities + book value of equity).
Weighted average cost of capital (WACC) Turnover rate of net working capital Revenue/
Represents the average cost of equity and net working capital.
net interest-bearing debt.
Chapter 8
Chapter 6
Evidence-relevance model Gives an overview
Payout ratio Dividends/net income. of the supporting evidence of the different
Share buy-backs An alternative way of forecasting assumptions.
distributing profits to shareholders. Financial value driver A financial ratio that
Sustainable growth rate Indicates how fast a mirrors the company's underlying performance
company can grow while preserving its financial and is closely related to value creation.
leverage. Five forces analysis An industry analysis
Transitory items Earnings which are non- covering five different forces affecting an
recurrent in nature. industry's attractiveness.
Free cash flow to equity holders (FCFE) FCFF
Chapter 7
minus transactions with debt holders (new debt/
Capital expenditure ratio Cash flow from repayment of debt and net financial expenses).
operations/capital expenditure.
Free cash flow to the firm (FCFF) Cash flow
Cash burn rate (Cash and cash equivalents + from operations minus cash flow from investing
securities + receivables)/EBIT. activities,
CFO to debt ratio Cash flow from operations/ PEST analysis A strategic analysis of
total liabilities. macro factors including Political, Economic,
CFO to short-term debt ratio Cash flow from Sociocultural and Technological factors.
operations divided by current liabilities. Pro forma statements Projected financial
Current ratio Current assets divided by current statements such as the income statement,
liabilities. balance sheet and cash flow statement.
Financial leverage Total liabilities/book value Sales driven forecasting approach The
of equity. forecasting of different accounting item such as
operating expenses and investments are driven Multiple A relative valuation model. For
by the expected level of activity (sales). instance, an EV/EBIT = 1 0 tells that investors
Strategic analysis An analysis of the strength are willing to pay 10 EUR for each EUR of
of a business's position and understanding the operating earnings.
important external factors that may influence P/E multiples (or ratios) Price divided by EPS.
that position. P/E multiples are popular in part due to their
Strategic value driver Strategic or an wide availability.
operational initiative that can be undertaken Present value models Valuation of firms by
by a company with the purpose of improving discounting future dividends, earnings or cash
value. flows.
SWOT analysis An analysis of a company's Relative valuation models (multiples)
Strengths, Weaknesses, Opportunities and Valuation using multiples is a method for
Threats. determining the current value of a company by
Value chain analysis An assessment analysis examining and comparing the financial ratios
of both primary and supporting activities of a of relevant peer groups, also often described
company. as comparable company analysis. One of the
most widely used multiples is the price-earnings
Value driver map Illustrates the relationship
ratio (P/E ratio or PER) of stocks in a similar
between different value drivers. industry.
Residual income model Market value of
Chapter 9 equity is estimated by adding the present value
Adjusted present value approach Enterprise of future residual income (earnings in excess of
value is estimated by discounting the free cash investors' required rate of return) to book value
flows to the firm by the required rate of return of equity.
on assets plus the value of the tax shield on net Valuation approaches The value of firms (or
interest-bearing debt. any asset) may be based on a variety of different
Contingent claim models Models which price models including present value models, relative
firms based on complex option models. Such valuation models (multiples), liquidation models
models are seldom used in practice. and contingent claim models.
Enterprise value The value of a firm's invested
capital (net operating assets) or alternatively Chapter 10
equity plus net interest-bearing debt. Determined Capital structure In finance, capital structure
by discounting the free cash flows to the firm by refers to the way a corporation finances its
the weighted average cost of capital (WACC). assets through some combination of equity, debt
EVA-model Enterprise value is estimated by or hybrid securities. A firm's capital structure
adding the present value of future economic is then the composition or 'structure' of its
profit (EVA) to book value of invested capital. liabilities.
Liquidation models In law, liquidation is Cost of capital The price investors or bankers
the process by which a company (or part of a ask for supplying capital/cash. The price of
company) is brought to an end, and the assets capital depends on the risk involved in supplying
and property of the company redistributed. The funds to a firm and the time value of money.
value of a firm using the liquidation model is Financial risk Analysis of financial risk aims at
the difference between the amount obtained by assessing the effect of debt on financial risk. Since
selling the assets and settling the liabilities. equity investors receive their claims after debt
Market value of equity Estimated by holders, they require a higher rate of return than
discounting the free cash flows to equity holders debt holders. This implies that financial leverage
by the investors' required rate of return. affects equity investors' perception of risk.
Operational risks In assessing the Corporate bonds, also referred to as notes, are
operating risks focus is on company-specific debt obligations issued by the borrower directly
factors that may affect the stability of operating into the public fixed income markets.
earnings. Collateral Creditors often secure their loans
Owners' required rate of return The by requiring a pledge in the asset on which the
shareholders' required return is the minimum borrowing is based. The pledge ensures that if
return that investors expect for providing capital the borrower defaults, the lender can realise the
to the company, thus setting a benchmark or asset (collateral) to satisfy its claims against the
hurdle rate that a new project has to meet. borrower.
Risk-free interest rate The risk-free interest Convertible debt and other hybrid instruments
rate expresses how much an investor can earn Convertible debt is a debt instrument that can
without incurring any risk. Theoretically, the be exchanged for a specified number of shares
best estimate of the risk-free rate would be the within a specified date and at an agreed price
expected return on a zero-β portfolio. (strike price).
Systematic risk (β) In finance, systematic risk, Expected loss Exposure at default ×
sometimes called market risk, aggregate risk or probability of default × (1 — probability of
undiversifiable risk, is the risk associated with recovery).
aggregate market returns. Fundamental credit analysis Analysis of a
WACC The minimum return that a company firm's credit risk using thorough financial
must earn on an existing asset base to satisfy statement analysis.
its debt holders, owners and other providers of Logit analysis Logit regression is an alternative
capital. Companies raise money from a number method to the multiple discriminant analysis. It
of sources: common equity, preferred equity, has the advantage of estimating probabilities of
straight debt, convertible debt, exchangeable bankruptcy.
debt, warrants, options, pension liabilities,
Medium-term notes Medium-term notes, also
executive stock options, and so on. Different
referred to as MTNs, are a flexible form of
securities, which represent different sources
of finance, are expected to generate different financing available to borrowers with high credit
returns. WACC is calculated taking into quality.
account the relative weights of each component Multiple discriminant analysis A statistical
of the capital structure. The more complex technique used to classify an observation into
the company's capital structure, the more one of several a priori groupings - in this case
labourious it is to calculate WACC. bankruptcy versus non-bankruptcy groups. A
multiple discriminant analysis attempts to derive
Chapter 11 a linear combination of financial ratios which
best distinguish between the bankruptcy and
A credit score A credit score is a numerical
non-bankruptcy firms,
expression based on a statistical analysis
of a firm's (or person's) financial data and Private placement Private placements are
other information used to assess the firm's an issue of debt that is placed primarily with
creditworthiness. insurance companies. Their term is typically of
longer duration and up to 30 years.
Altman's Z-score A credit score (Z-score)
formula for predicting bankruptcy. The Statistical models Statistical models used to
formula may be used to predict the probability assess credit risk includes univariate analysis,
that a firm will go into bankruptcy within one multiple discriminant analysis and logit
to five years. analysis.
Bonds A bond is a formal contract to repay Univariate analysis A statistical model used to
borrowed money with interest at fixed intervals. predict bankruptcy based on a large sample.
Chapter 12 Chapter 13
Absolute performance measures Measure Accounting quality Refers to the overall
based on absolute (financial) numbers such as reasonableness of reported financial numbers.
EBIT or net earnings. Conservative accounting policies Prudent
Bonus bank Bonus banks may be used to defer accounting. For example, choosing an
compensation, to take account of 'negative 'accelerated' depreciation method, or one that
bonuses' and to create long-term incentives allocates a large amount of depreciation expense
(extending managerial horizon). at the beginning of an asset's useful life, signals
Bonus plans Contracts which prescribe how to conservatism.
compensate employees for their efforts. Bonuses Liberal accounting policies Aggressive
may be based on stock prices (options and accounting policies. For example, depreciating
warrants), financial performance measures and non-current assets over extended periods of time
non-financial performance measures. is a signal of aggressive accounting.
Congruence A crucial part of a bonus plan is Red flags A signal that 'something is wrong'
to align the interests of management (agent) and and accounting quality low.
owners (principal). Management should only be
awarded a bonus to the extent that they act in Chapter 14
the interest of the owners. Accounting flexibility Within GAAP
Modern EVA bonus plan According to the management has discretion in reporting financial
plan, bonus consists of a target bonus paid numbers.
if a predetermined target is obtained plus an Accounting regulation The laws and rules
additional bonus for improvement in EVA in which guide firms in how to report financial
excess of expected increase in EVA. data.
Multi-period performance measures A Classification The way different accounting
performance measure which spans more than items are shown in the financial statements.
one period.
Conceptual framework A coherent system
Performance measure A measure of how well of inter-related objectives and fundamentals
a firm is run measured in financial terms (e.g. that should lead to consistent standards that
EBIT). prescribe the nature, function and limits of
Performance standard This may be internal financial accounting and financial statements.
(e.g. budgets) or external (e.g. benchmarking Definition of accounting items In order to
against competitors). be recognised, accounting items must meet the
Performance structure The way compensation definition criteria. For example, an asset is a
is linked to performance. Compensation may be resource controlled by the entity as a result of
uncapped or there may be an upper limit ('cap') past events and from which future economic
and lower limit ('floor') on the bonus. benefits are expected to flow to the entity.
Relative performance measures Measures such Disclosure The purpose of accounting
as EVA, ROIC etc. disclosure is to inform both current and
XY bonus plan In the XY plan bonus consists potential investors of the accounting strategies
of two components. A bonus calculated as and methods used when developing periodic
a percentage of the change in EVA during corporate financial statements. These financial
a financial year (X component), no matter statements include, but are not limited to, the
whether the bonus becomes negative or balance sheet, the statement of cash flows,
positive, and an additional bonus calculated as the income statement, and the statement
a percentage of actual EVA, but only if EVA is of stockholders' equity. The full disclosure
positive (Y component). principle requires that any event that would
have an impact on the financial statements Deferred tax liabilities The obligation to pay
should be disclosed. tax is deferred (postponed) to some future
Measurement Accounting items may date due to differences in how earnings are
be measured using a number of different determined for accounting purposes and tax
measurement attributes including amortised purposes, respectively.
costs, historical costs, fair value etc. Leases Leasing is a process by which a firm can
obtain the use of a certain fixed assets for which
Chapter 15 it must pay a series of contractual, periodic
Contingent liabilities Liabilities that are not payments.
recognised in the balance sheet because they Provisions A liability where the amount to be
depend upon some future (uncertain) event(s). settled and/or timing are uncertain.
 Index

Glossary items are shown in bold

AB Inbew 241-4 acid test ratio 339

accounting acquisitions 58, 65, 67, 202, 208, 309
accrual 48-9, 53 adjusted present value approach 223-5, 240,
'big bath' 345, 353, 4 1 9 , 4 5 2 246, 462
hedge 78 advertising revenue 387
terms: IASB, UK and US 46 agency problem 299
see also flexibility; quality agents and revenue recognition 389
accounting standards 2 - 3 , 375-80, 458 aggressive accounting see liberal accounting
FASB 3, 47-8, 375, 377, 458 airlines/airports 182, 256
IASB 23, 24, 46, 47, 346, 375, 377, Ali, A. 55
424, 458 Altman's Z-score 293-4, 295-6, 463
International Accounting Standards amortisation 44, 58, 84, 310, 313
see separate entry accounting
International Financial Reporting Standards accrual 53
see separate entry flexibility 374, 376, 381-2, 402-3, 413-19,
US GAAP see GAAP under United States 4 3 6 ,4 4 1 - 2 ,4 4 8 ,451
accounts payable 74-5, 460 quality 345, 358-9, 360, 361
cash cycle 153-5 IFRS: goodwill 305, 358-9, 360, 381-2
cash flow and 49 impairment 345, 361, 382
current ratio 156, 461 Andersen & Martini 367
accounts receivable 147, 305, 390 Angel Biotechnology 158
cash cycle 153-5 assets 27-30, 459
cash flow and 49, 54 cash flow and increase in 44
current ratio 156, 461 collateral 285-6, 445, 463
factoring 54, 156 current 27, 69-70, 156, 458
operating items and financial items definition of 378
88-9,90 double-entry bookkeeping 34, 35, 36, 40,
accrual-based performance measures 47-8, 4 1 ,459
59, 460 gains/losses on disposal of 6, 76, 135,
approximations to cash flows 58-9 303, 304, 338, 359-61, 436, 441,
distinction between cash-flow-based 448,451
and 48-9 held for sale 90
earnings per share (EPS) 51-2, 460 measurement 446, 459
information content 54-7 specialised assets 379
operating cycle 53-4 (net) realisable value 156, 413
relationship to cash-flow-based non-current see separate entry
measures 51 operating items and financial items see under
shortcomings of 52-3 balance sheet
single-period and multi-period pro forma statements 177, 181, 182, 461
measures 51-2 associates 76, 86, 203
types of 50-1 auditors' report 365-6
Baker, M. 234 pay to performance structure 12, 306, 307,
balance sheet 27-30, 43-4, 45, 459 318,321
accounting flexibility see under flexibility linearity 318-19
operating items and financial items 68-70, lump sum 321
73-9, 91 non-linearity 319-21
example 79-91 performance measures 11-12, 299-300, 306,
matching 73, 92 307-8, 314, 338, 349, 464
two basic rules 92 absolute 309-10, 407, 451, 464
pro forma see forecasting multi-dimensional 308
barter transactions 389, 401, 407 relative 310-14, 407-8, 452-4, 463
Bayer Group 347-9, 363 performance standards 12, 306, 307, 314-15,
Beaver, W. 292-3 318,464
benchmarking 63-4, 344, 374, 460 external 317
bonus plans 307, 311, 314-18 internal 315-17
credit quality 297 simplicity 302-3, 308
financial leverage 160, 161, 460 bookkeeping see double-entry
liquidity risk analysis 163, 165, 166 Boston Consulting Group 4, 64
profitability analysis 96, 97-8 Bradshaw, M.T. 362
resources 191 business cycle 66-7, 256-7
value chain analysis and 192, 462 business model 366-7, 380-1, 435
best practice 63, 98
beta (β) 1 0 3 - 5 , 1 4 5 , 243, 249, 251-4, Capital Asset Pricing Model (CAPM) 145,
268, 269 249-65, 266
comparable companies 254-5 capital expenditure ratio 162-3, 461
fundamental factors 255-61 capital markets 340
overall risk assessment 261-3 capitalisation vs expensing: development costs 58,
Biddle, G. 313 340, 341, 378-9, 391-4, 402-3, 404, 405,
'big bath' accounting 345, 353, 419, 452 407-8
Bioscan 147 car industry 77
biotech companies 5, 7, 158, 1 5 9 , 245, 310, 378, Carlsberg 5 0 - 1 , 5 1 , 65, 69, 70, 71-2, 95-6, 97-9,
407, 448 1 1 0 - 1 1 , 1 1 2 - 1 7 , 1 1 9 , 1 2 0 , 186, 198-9,
bonds 274, 463 200-7, 212, 238-44, 255, 267-9, 287-8, 289,
bonus plans for executives 4-5, 299-301, 327 292, 399
accounting cash burn rate 157-8, 461
flexibility 395, 406-8, 415, 416, 450-4 cash and cash equivalents 74
issues 302, 303-5, 307, 309, 311, 313, operating items and financial items 76-7, 88
316,3 1 7 ,3 2 1 ,339 cash flow
quality 12, 335, 338, 349, 356-7 conversion of earnings to 57, 369-70
bonus bank 308, 323-6, 464 credit analysis: simulation of future 281-5
characteristics of effective 301-3, 313-14, from operations (CFO) 5 1 , 56-7
317-18, 321 to liabilities ratio 162
committees 304, 306, 308, 317, 319, to short-term debt 157
327, 407 growth and liquidity 147-8
components of 306-7 return on investment (CFROI) 300
congruence 301-2, 464 cash flow statement 3 0 - 1 , 44, 45, 459
earnings per share (EPS) 140-1, 147, calculating 48-9
310,460 FASB 47-8, 458
EVA-based 322-5 pro forma see forecasting
discretionary exit clause 325 cash-flow-based performance measures 47-8,
modern plan 325-6 59, 460
horizon problem 308, 313 approximations to cash flows 58-9
multi-period performance measures 304, distinction between accrual-based and 48-9
307-8, 313, 464 information content 54-7
 operating cycle 53-4 estimation of owners' required rate of
shareholder value added (SVA) 51-2, 460 return 249, 268-9
shortcomings of 52-4 liquidity 265
single-period and multi-period measures 51-2 market portfolio risk premium 263-4
types of 51 risk-free interest rate 249-51, 463
usefulness of 57 systematic risk 145, 251-63, 463
Charitou, A. 57 present value models 212-13, 215,
Claus, J. 263 225, 462
Coca-Cola 253-4 relative valuation models/multiples 231, 462
collateral 285-6, 445, 463 share buy-backs 145, 461
commodities 109, 277 see also WACC
common-size analysis 111, 460 cost of goods sold (COGS) 41-2
invested capital 1 1 3 - 1 4 , 1 1 5 - 1 7 , 460 cost-benefit 380, 395, 442
revenue/expense relation 112-13 credit analysis 271-2, 297, 337-8, 359
compensation-oriented stakeholders 2 , 1 1 - 1 2 , 338 accounting flexibility 395, 404-6, 415,
see also bonus plans 444-50
competitors 271, 340 credit rating models 9-10, 276-81, 337, 344-5,
comparison with 127, 420 405, 415, 444-5
benchmarking see separate entry expected loss 272, 273, 463
five forces analysis 1 8 9 - 9 0 , 1 9 2 , 461 credit rating 287-90
comprehensive income 26-7, 5 0 - 1 , 244, 460 exposure at default 272
computer chips 440 intended use of loan 273-4
congruence 301-2, 464 type of loan 274-5
conservative accounting policies/estimates 321, 397, forecasting 10, 281-5, 337, 405-6
416-18,4 3 6 ,4 5 1 ,464 investment grade 277, 278, 279
vs liberal 340-5 minority interests 78
construction contracts 380, 387-8, 407 pricing credit risk 291-2
consultancy firms 53, 387 probability of default 272, 273
contingent assets 448 accounting quality 276
contingent claim valuation models 7-8, 211 financial ratios 276-81
contingent liabilities 421, 425-6, 448, 465 simulation of future cash flows 281-5
contribution ratio 26 strategic analysis 275-6
control premium 234 probability of recovery if default 272, 273
convertible debt 246, 275, 463 available security and liquidation value 285-7,
Copeland, T. 264, 452 334-5, 337-8, 406
corporate bonds 274 rating agencies 9 - 1 0 , 1 5 1 , 1 6 5 , 276-81,
corporation tax 42, 203 287-90, 297, 345, 445
bonus plans 310 related parties 273
cost of capital speculative grade 277, 278, 279
borrowing rate after tax 265-6 statistical models 272, 292-6, 463
deferred tax see separate entry cross-sectional analysis 26, 63
EVA and tax rate 135 accounting policies 65, 100
financial expenses: tax shield 73, 76, 223-5, example 97-8
265-6 sources of noise 6 4 - 6 , 1 0 0
marginal or effective tax rate 76, 86-7, 437-8 currency
operating item or financial item 73, 76, 79, 86-8 fluctuations on sales abroad 389-90,
tax payable 75, 79 398,401
Cosmo Pharmaceuticals 25, 26 gains/losses and bonus plans 407
cost of capital 245-6, 266, 349, 462 loans in foreign 260
bonus plans 310, 311, 312, 315, 316, 464 risk 77-8, 407
conservative vs liberal accounting current assets 27, 69-70, 156, 458
estimates 345 current liabilities 27, 69-70, 458
estimation of interest rate on debt 265-6 current ratio 155-7, 461
customers 271, 390 dividends 131, 147, 1 8 1 , 1 8 3 , 204
bargaining power 190 payout ratio (PO) 1 2 8 , 1 2 9 , 1 8 3 , 461
liquidity: risk map of 164-5 Dodd, D. 371
cyclical firms 256-7, 311 double-entry bookkeeping 32-4, 45, 46, 459
adjusting and closing entries 41-2
Daimler Benz 375 example 37-43
Danisco 364 T accounts 34-6
debt covenants 3, 1 3 1 , 1 5 1 , 339, 404, 405, to financial statements 43-5
444-5 Doyle, J.T. 362
debt-capital-oriented stakeholders 2, 8-11, 337-8 DSV Group 364
see also lenders DuPont model 94, 134
Dechow, P. 55
decision at hand 3-4 earnings per share (EPS) 51-2, 460
deferred tax 58, 430-3 bonus plans 140-1, 147, 310, 464
assets 88, 90, 357 share buy-backs and 143-7, 461
bonus plans 452-4 value creation and growth in 140-1, 310
calculation 430-2 EBIT (earnings before interest and taxes) 50, 73,
changes in tax rate 135 132,165
credit analysis 447, 449-50 bonus plans 300, 303, 304, 306-8, 309-11, 315,
Economic Value Added 313 322, 407, 450-1, 464
invested capital 88, 90, 405, 460 credit ratings 277
liabilities 88, 9 0 , 1 8 3 , 313, 425, 430-3, 459 expensing vs capitalisation 392-3, 402-3
operations or financing 88, 90 IFRS: goodwill 382
quasi equity 433 leases 244, 424
valuation 436-8 provisions 429, 459
value driver 183 relationship to cash-flow-based performance
depreciation 42, 44, 58, 84, 203 measures 51
accounting flexibility 374, 395, 413-19, 436, revaluation 420-1
441-2, 445, 448, 451 revenue recognition 396-7
bonus plans 305, 451, 464 EBITA (earnings before interest, taxes and
changes in accounting estimates 136-7, amortisation) 58-9, 277-9, 393
3 3 9 ,355-7 EBITDA (earnings before interest, taxes,
conservative vs liberal estimates 341-5 depreciation and amortisation) 50, 58-9, 84,
EVA and change in expected useful life 136-7 416-17
gains/losses on disposal 359 bonus plans 300, 307, 349, 407, 450-1, 464
impairment 361, 436 expensing vs capitalisation 402, 403
methods 100-2, 414-15 IFRS: goodwill 393
'old plant trap' 419 leases 244, 422-4
progressive and linear 100-2 provisions 429
revaluation 420-1 revenue recognition 396-7
ROIC and IRR 100-2 EBT (earnings before tax) 50, 307, 396-7,
derivative financial instruments 78, 380 424, 450
development costs see research and development Economic Profit (EP) 64
disclosure 363-6, 380, 464-5 Economic Value Added (EVATM) 4, 64, 96-7,
discontinued operations/disposals of business units 98, 460
9 6 , 1 3 5 , 303, 304, 338, 347, 349-52, accounting
359-61 flexibility 396, 407-8
time-series analysis 65, 67, 349 quality 134-7, 336, 343, 345
discounted cash flow model 216-19, 223-5, 239, bonus plans 300, 307, 310, 310-11, 312-13, 316,
246, 343, 374, 395, 396 317, 322-6, 452-4
Disney 253-4 growth analysis 132-5, 137
dividend discount model 140, 212, 213-15, core business 135
217, 218, 219, 221, 237, 239, 246 earnings per share 141, 460
dividend conundrum 215 share buy-backs 143-5, 461
 structure for 134 financial leverage 158-61, 258-9, 261, 404,
tax rate 135 421, 460
transitory items 135-7, 461 end of year vs average balances 155
relationship between financial ratios and profitability and 117-19
109-10 share buy-backs 145, 461
valuation of companies 219-21, 222-3, 237, sustainable growth rate 128-31, 461
239-40, 241, 246 financial ratio analysis 63-4
engineering 53 pitfalls in 64-6
enterprise value see under valuation requirements for 66-7
E.ON Group 426-7 financial risk 128, 255, 258-61, 462
equity value see under valuation operating risk and 260, 261-3
equity-oriented stakeholders 2, 4-8, 336-7 five forces analysis 1 8 9 - 9 0 , 1 9 2 , 461
see also shareholders fixed and variable costs 26
Ericsson 24, 25, 26-7, 3 0 - 1 , 32, 33, 353-4 FL Smidth 361
European Union 305, 357, 374, 375 flexibility, accounting 53, 57, 373-5, 408, 454-5
EV/EBIT multiple 228, 229, 232, 233, 243, 359, 395, balance sheet 374, 411
401, 404, 438-44 deferred tax liabilities 430-3
EV/EBITDA multiple 58, 228, 229-30, 393, 401, intangible and tangible assets 413-21
438-44 inventory 411-13
EV/IC multiple 228 leases 421-4
EV/NOPAT multiple 228, 401, 438-44 provisions 425-30
EV/Revenue multiple 229, 230, 400-1 credit analysis 395, 404-6, 415, 444-50
evidence-relevance model 195-8, 461 economic consequences 394-5, 411, 433, 454-5
excess return 64 credit analysis 395, 404-6, 415, 444-50
Economic Value Added see separate entry executive compensation 395, 406-8, 415, 416,
exchange rate differences 77-8 450-4
see also currency valuation 374, 395-404, 433-44
executive compensation see bonus plans executive compensation 395, 406-8, 415, 416,
expenses 23, 459 450-4
accrual accounting 49 income statement 374, 380-1
capitalisation vs expensing: development costs 58, changes in accounting policies and estimates
340, 341, 378-9, 391-4, 402-3, 404, 405, 381-2
407-8 non-recurring and special items 390-1
double-entry bookkeeping 34, 35, 36, 39, 40, 459 revenue recognition 382-90
income statement: analysis of 24-6 non-capitalisation of expenses 58, 340, 341, 378-9,
extraordinary items 346, 398 391-4, 402-3, 404, 405, 407-8
regulation and 375-80
factoring 54, 156 valuation 374, 395-404, 433-44
fair value 3, 32, 232, 366, 419-20, 446, 458 forecasting 63, 66, 91, 1 4 0 , 1 7 4 - 5 , 199-200,
derivatives 78 379, 458
inventory 413 challenges of 198-9, 349-50, 363, 390,
property, plant and equipment 414, 419-20 399-400, 436
provisions 426, 429, 459 credit analysis 10, 281-5, 337, 405-6
FCF see free cash flow definitions
Feltham, G.A. 308 strategic and financial value drivers 175
Fernandez, P. 253-4, 262 design of pro-forma statements 175-81
Financial Accounting Standards Board (FASB) 3, additional value drivers 183
47-8, 375, 377 articulate 174, 1 7 7 , 1 8 1
financial expenses 182 financial value drivers and company
tax shield 73, 76, 223-5, 265-6 economics 182-3
see also interest level of aggregation 183-6
financial instruments estimation related and technical aspects 174-5
currency risk 77, 407 evaluation of estimates 195-8, 204, 363-4, 405-6
derivative 78 example 200-7
forecasting (continued) sustainable growth rate 1 2 8 - 3 1 , 1 4 8 , 461
explicit forecasting period 177, 214 value creation and growth 1 3 1 - 4 , 1 4 8
financial statement analysis 194-5 guarantees 286
GIGO principle 187
historical period 177, 194-5 harmonic mean 233-4
line-item approach 175 Hartmann 363-4
long-term 186 Healy, P. 320
map of value drivers 185, 196 hedging 77, 78, 89, 260, 407
outsider assumption 174-5 Heineken 9 7 - 8 , 1 1 0 - 1 1 , 1 1 2 , 1 1 3 - 1 7 , 1 1 9 , 1 2 0 ,
sales-driven approach 175 1 2 2 - 6 , 1 9 8 - 9 , 241-4
sensitivity analysis 198 Holmstrom, B. 12
short-term 186
strategic analysis 1 6 5 , 1 8 7 - 9 3 , 195, 462 Ijiri, Y. 48
business environment 187-8 impairment 361-3
company specific factors 190-1 losses 203, 361-2, 414, 419-20, 434-6
industry factors 189-90 analytical income statement 84
macro factors 188-9 cash flow statement 44
SWOT 192-3, 462 change in accounting policy on goodwill 382
value chain analysis 191-2, 462 depreciating too slowly 434-5, 441
terminal period 177, 214-15, 221, 225 EBITDA 58, 402
foreign currencies see currency new management 345, 451
free cash flow (FCF) 51, 5 6 - 7 , 1 3 2 , 216, 343 performance-related pay 321, 339
bonus plans 300 special items 347, 362
sales growth and 147 tests 3, 5, 305, 358-9, 376, 380, 414, 419-20
at least annually 381, 434-5
gearing see financial leverage income statement 23-6, 43, 45, 459
Genmab 158 accounting flexibility see under flexibility
Getinge 156 accrual accounting 49
Goetzmann, W.N. 263-4 analytical 68-73, 75-9, 91, 460
going concern 7, 337, 366 example 79-91
goodwill 58, 232-3, 305, 313, 358-9, 381-2, 391, matching 73, 92
4 0 7 , 4 3 4 - 5 , 449 two basic rules 92
Gordon's growth model 214-15 FASB 47-8, 458
government bonds 249-51, 260, 291 income 23, 459
Graham, B. 371 operating items and financial items 68-73,
Gramlich, J. 339, 340 75-9, 91
groups example 79-91
cost of capital 265 matching 73, 92
credit analysis 273 two basic rules 92
guarantees 286 pro forma see forecasting
intercompany sales/debts 76, 401 indexing/trend analysis 111, 1 1 2 , 1 1 3 - 1 5 , 460
minority interests 78, 246 inflation 53, 251, 429, 433
return on equity 118-19 information 3
growth analysis 1 2 7 - 8 , 1 4 8 disclosure 363-6, 380, 464-5
earnings per share (EPS) 140-1, 460 installation fees 387
share buy-backs 143-7, 461 insurance companies 77
liquidity and growth 147-8 intangible assets 5 8 , 1 7 7 , 1 8 1 , 1 8 2 , 310, 376, 378,
long-term average 1 3 8 - 4 0 , 1 9 5 , 214 434-6, 458
optimise growth 148 amortisation see separate entry
quality of growth 134-7 impairment see separate entry
share buy-backs 141-3, 461 revaluation 414
earnings per share 143-7, 460 see also goodwill; research and development
sustainability of growth 1 3 7 - 4 0 , 1 4 8 intercompany sales/debts 76, 401
interest cash flow 54
cost of capital 462 cost of goods sold (COGS) 41-2
estimation of required interest rate 265-6 current ratio 156, 461
risk-free rate 249-51 double-entry bookkeeping 35, 40, 459
coverage ratio 161, 277-81, 404 invested capital 73-5, 419, 460
double-entry bookkeeping 40 classification of accounting items 75-9, 88, 90,
level and discount factor 429 405, 452
operating items and financial items 77, 89 definition 74, 92
derivatives and interest rate risks 78 of assets 378
tax shield 73, 76, 223-5, 265-6 example 79-91
interest-bearing debt, net 7 5 , 1 1 7 , 1 4 3 , 1 8 2 , 183, ROIC see return on invested capital
204, 210 investment in associates 76, 86
internal rate of return (IRR) 100-2, 415-19, 461 ISS 156, 369
International Accounting Standards Board (IASB) 2,
24, 47, 346, 375, 424 Jensen, M. 149
accounting terms 46 JJB Sports plc 355-7
Framework 23, 377, 380 Jorion, P. 263-4
International Accounting Standards (IASs) junk bonds 277
IAS 1:23, 2 4 , 2 8 , 69
IAS 8: 354, 355, 358, 376 Kia Motors 379
IAS 11: 384, 387, 388
IAS 12: 433 law firms 311, 378, 387
IAS 16: 29, 361 Lawson, G.H. 48
IAS 18: 383, 384, 386 lease/rent income 75-6
IAS 21: 77 leases 244, 310-11, 405, 421-4, 426, 442-3, 445,
IAS 24: 273 448, 451, 465
IAS 32: 360 Lee, T.A. 48
IAS 36: 244, 361, 419 lenders 2, 8 - 1 1 , 1 3 3 , 174, 337-8, 415
IAS 38: 58, 378 accounting quality 276, 285-7, 334-5, 337-8,
IAS 39: 78, 360 344-5
IAS 40: 420 cost of capital 245
International Financial Reporting Standards (IFRS) credit analysis see separate entry
2 - 3 , 23, 232, 243 debt covenants 3 , 1 3 1 , 151, 339, 404, 405, 444-5
IFRS 3: 380 financial risk and characteristics of loans 260
IFRS 5: 350 sustainable growth rate, high 131
barter transactions 389 types of loans 274-5
convergence project 376 leverage see financial leverage
definition of assets 378 liabilities 27-30, 425-6, 447, 459
depreciation 414, 415 accounts payable 49, 74-5
European Union 305, 357, 374, 375 cash flow and decrease in 44
examples of transition to 358-9, 360, 381-2, 407 current 27, 69-70, 458
extraordinary items 346, 398 double-entry bookkeeping 34, 35, 36, 4 1 , 459
impairment losses 419 operating items and financial items see under
inventory 411, 413 balance sheet
management judgement 232 other 89
research and development costs 394 liberal accounting policies/estimates 390, 397,
revaluation 414 416-18,4 3 6 ,4 5 1 ,464
revenue recognition 383, 397 vs conservative 340-5
inventories 147, 380, 381, 391, 458 lifecycle
accounting policies 53, 302, 341, 411-13, 433-4, companies 106-7, 162, 214
438-40 product 1 0 6 , 1 0 7
accrual accounting 49 liquidation, companies in 359
cash cycle 153-5 ROIC and IRR 101
liquidation models/value 7 , 8 , 1 0 , 156, 211, 235-7, net cash flow for period 51
344, 366, 445-50, 458 net earnings (E) 5 0 - 1 , 54, 56-7, 460
value if loan default 285-7, 334-5, 337-8, 406 bonus plans 300, 303, 308, 310, 315,
liquidity and CAPM 265 316,317
liquidity risk 1 5 0 - 3 , 1 6 5 - 6 growth analysis 132
action plan 164 net interest-bearing debt (NIBD) 7 5 , 1 1 7 , 1 4 3 , 182,
customers, risk map of 164-5 183,2 0 4 ,210
end of year vs average balances 155 net operating assets see invested capital
growth and 147-8 net turnover 309
long-term 1 5 0 , 1 5 8 , 1 6 3 - 4 Nissim, D. 233
capital expenditure ratio 162-3, 461 non-current assets 2 7 , 1 4 7 , 1 4 8 , 203, 339, 340,
cash flow from operations to liabilities ratio 162 3 8 1 ,459
cash flow statement 47, 57, 459 conservative vs liberal estimates 341-5
financial leverage 1 5 8 - 6 1 , 1 6 3 , 393, 460 EBITDA and EBITA 58-9
interest coverage ratio 1 6 1 , 1 6 3 , 461 gains/losses on disposal of 6, 7 6 , 1 3 5 , 303, 304,
shortcomings of ratios 165 338, 359-61, 436, 441, 448, 451
short-term 1 5 0 , 1 6 3 - 4 , 339 growth in EVA 1 3 5 , 1 3 6 - 7
cash burn rate 157-8, 461 impairment see separate entry
cash flow from operations (CFO) to short-term intangible assets see separate entry
debt ratio 157 tangible assets see separate entry
cash flow statement 47, 57, 459 non-current liabilities 28, 459
current ratio 155-7, 461 non-current receivables 88-9
liquidity cycle 153-5, 461 NOPAT (net operating profit after tax) 73, 429, 451
shortcomings of ratios 165 bonus plans 300
litigation example 79-88, 90
expenses 349 normalisation of earnings 233
unsettled 425, 426, 448 Novo Nordisk 58, 389-90
Liu, J. 233 NTR Group 69
Livnat, J. 57
loans see lenders off-balance sheet items 158, 236, 359, 405, 421-4,
logit analysis 294-6, 463 425, 445
luxury goods 256 Ohlson, J. 294-5
Oki Electric Industry 367-8
M/B (P/B) multiple 229, 2 3 0 - 1 , 343-4, 404 operating cycle
marked-to-market 366 accrual- and cash-based performance measures
marketing costs 308, 313, 339, 378, 391 53-4
Marls & Spencer 140 definition 53
'MASCOFLAPEC' method 262 operating profit margin see profit margin
mean or median 233-4 operating risk 255, 256-8, 259
medium-term notes (MTNs) 274-5, 463 differences in 103-6
Milgrom, P. 12 financial risk and 260, 261-3
minority interests 78, 246 option pricing models
return on equity 118-19 contingent claim valuation 7-8, 211
Moody's 9, 276, 277-9, 287-8, 289, 292, 405
motives for accounting manipulation 339-40 P/B (M/B) multiple 229, 230-1, 343-4, 404
multi-period performance measures 51-2, 304, P/E ratio 229, 231, 235, 243, 404, 462
307-8, 313, 464 share buy-backs 145-6
multiple discriminant analysis 293-4, 463 Parum, C. 133
multiples see relative valuation models payout ratio (PO) 128, 1 2 9 , 1 8 3 , 461
Murphy, K. 12, 314, 317 peer group companies
cross-sectional analysis 65
Naser, K.H.M. 334 Penman, S. 334
net borrowing cost (NBC) 117, 118, PEST model 1 8 8 - 9 , 1 9 2 , 461
119,461 Petersen, C. 211, 265
pharmaceutical companies 7, 1 0 8 , 1 0 9 , 256-7 assessment of 338-9
Philips 141 applied accounting policies 340-5
Plenborg, T. 56, 57 business model 366-7
political considerations 339-40 changes in accounting policies 357-9
Pope, P. 55 changes in estimates 135-7, 354-7
Porter's Five Forces analysis 189-90, 192 discontinued operations 349-52
prepayments 77 earnings to cash flows 57, 369-70
present value models 5-6, 210, 211, 212-13, 237, impairment of non-current assets 361-2
238-41, 336, 343, 462 level of information 363-6
accounting flexibility 396-400, 433-8 level and trend in numbers/ratios 367-8
APV approach 223-5, 240, 246 motives 339-40
discounted cash flow 216-19, 223-5, 239, 246, non-core gains/losses 359-61
343, 374, 395, 396 permanent vs transitory items 6, 7, 346-63
dividend discount model 212, 213-15, 217, 218, 'red flags' 366, 464
219, 221, 237, 239, 246 restructuring costs 353-4
evaluation 225 compensation-oriented stakeholders 338
excess return approach 219-23, 225, 237, debt-capital-oriented stakeholders
239-40, 241 credit analysis 276, 285-7, 334-5, 337-8,
pro-forma financial statements: articulate 45, 225 344-5
price guarantee 385 definition 334-5
private placements 275, 463 Economic Value Added model 134-7, 336
privately held companies equity-oriented stakeholders 336-7
cost of capital multiples 227, 232-3, 336-7, 343-4, 359
capital structure 246-9, 462 permanent and transitory items 12, 135-7, 334,
systematic risk 253, 254-61, 463 335, 336, 337, 338
valuation 227, 231-2 total assessment of 370-1
accounting differences 232-3 quick ratio 155-6, 461
normalisation of earnings 233
pro forma statements see forecasting real option/contingent claim valuation models
product lifecycle 106, 107 7-8,211
profit margin 107-11, 277, 378, 434, 461 receivables 459
calculation 108 other 88-90, 90
common-size analysis 111, 112-13, 460 trade see accounts receivable
definition 107 'red flags' 366, 464
growth and liquidity 148 related parties 273
trend analysis 111-12, 461 relative valuation models/multiples 6-7, 58, 211, 226,
profitability analysis 63, 93, 120 2 3 7 ,2 4 1 - 4 ,4 6 2
common-size analysis see separate entry accounting differences 232-3, 336-7, 343-4, 359,
level and development of returns 96-9, 119 393, 395, 400-4, 438-44
overview of ratios 121 additional considerations 233-4
residual income see separate entry evaluation 234-5
return on equity see separate entry examples of use 226-7
return on invested capital see separate entry present value approaches and 227-32
structure of 94, 120 remuneration-oriented stakeholders 2, 11-12, 338
trend analysis/indexing see separate entry see also bonus plans
provisions 425-30, 443-4, 452, 459 research and development (R&D) 58, 302, 308, 310,
see also deferred tax 313, 321, 339, 345
prudent accounting see conservative accounting amortisation see separate entry
policies/estimates expensing vs capitalisation 58, 340, 341, 378-9,
purchase of own shares 141-3, 149 391-4, 402-3, 404, 405, 407-8
earnings per share 143-7 impairment see separate entry
research phase 378, 394
quality, accounting 53, 100, 1 6 5 , 1 6 6 , 333-4, residual income (RI) model 119, 132, 145, 219,
336, 371 221-3, 246, 313, 462
restructuring 425 interpretation 96
costs 59, 313, 321 alternative 99-107
'big bath' accounting 345, 353, 452 level of returns 96-8
'catch-all' 399-400 trends 98-9
classification 379 lifecycle 106-7
example 353-4 listed companies: implicit/forward looking 98-9
forecasting 391 long-term average 1 3 8 - 4 0 , 1 9 5
impairment losses 436 operating risks 103-6
part of normal operations 75-6, 84, 349 pro forma statements and 195, 197, 204, 461
transitory 135, 232, 303, 304 revaluation
plans 164, 308 intangible assets 414, 458
provisions 90, 425, 427 property, plant and equipment 414, 420-1, 445
retail industry 53, 381, 384, 386 reserves 32
retained earnings 32 revenue/turnover 379
retirement benefits 78-9, 89-90 double-entry bookkeeping 34-5, 36, 38-9, 459
return agreements 385 recognition 382-90, 396-8, 400-1, 407, 408
return on equity (ROE) 6 4 , 1 2 8 , 132, 231, percentage-of-completion method 354, 387-8
2 4 3 ,461 risk
bonus plans 300, 307, 310, 311-12, 315, currency 77-8, 407
316,317 financial 128, 255, 258-61, 462
calculation 117-18 operating risk and 260, 261-3
definition 117 map: suspension of payments by customer 164-5
financial leverage and 117-18, 119, 460 operating see separate entry
minority interests 118-19 pricing credit 291-2
share buy-backs 143-6, 461 systematic see beta
return on invested capital (ROIC) 64, 65, 243, risk profile of company 65, 349
378, 461 bonus plans 317, 464
accounting policies/estimates 100, 393-4, 405, ROIC see return on invested capital
407-8, 434 R ö r v i k Timber A B 1 5 1 - 3 , 1 5 4 - 5 , 1 5 6 - 7 , 1 6 0 - 3 ,
conservative vs liberal estimates 342, 343, 166-70, 279-81, 295, 296
344-5, 451 Royal Unibrew 338
deferred tax 452-4 Ruback, R. 234
depreciation and amortisation 415-19
impairment losses 419-20, 435-6 SabMiller 241-4, 358-9, 360
revaluation 421, 445 Satair 1 3 2 - 4 , 1 3 5
average age of assets 100-2 scenarios 1 0 , 1 9 8 , 281-5
bonus plans 300, 307, 310-12, 315, 316, 317, 451, Schipper, K. 345
452-4, 464 sensitivity analysis 198, 241, 441
calculation 95-6 service industries 108
common-size analysis 111, 460 share buy-backs 1 4 1 - 3 , 1 4 9 , 461
invested capital 1 1 3 - 1 4 , 1 1 5 - 1 7 , 460 earnings per share 143-7, 460
revenue/expense relation 112-13 share capital
decomposition of 107-11 double-entry bookkeeping 36
common-size analysis 111, 112-14, 115-17, 460 shareholder value added (SVA) 51-2, 307-8, 460
indexing/trend analysis 111, 1 1 2 , 1 1 3 - 1 5 , 460 shareholders 150
definition 94 cost of capital 245
growth analysis 132-4 negative growth and share price 133
share buy-backs 145-7, 461 return to see return on equity
sustainability of growth 138-40 sustainable growth rate, high 131
sustainable growth rate 129-30, 461 shipyards 53, 381
indexing/trend analysis 111, 460 single-period performance measures 51-2
invested capital 113-15, 460 Sloan, R.G. 53, 362, 369-70
revenue/expense relation 112 solvency ratio 158-61, 393, 445, 461
internal rate of return and 100-2, 461 solvency risk see long-term under liquidity risk
Sørensen, O. 340 systematic risk 463
special and unusual items 65, 203 beta see separate entry
accounting
flexibility 390-1, 398-400, 401, 408 T accounts 34-6
quality 346-9, 362-3 tangible assets 177, 1 8 1 , 1 8 2 , 434-6, 459
bonus plans for executives 303-4 depreciation see separate entry
classification as 379 impairment see separate entry
disclosure 380, 436 property, plant and equipment 414, 419, 420-1, 445
growth in EVA 135-7 specialised items 379, 449
operating items and financial items 75-6 taxation
example 84-5 corporation tax see separate entry
see also discontinued operations; impairment; deferred tax see separate entry
restructuring tax payable 75, 79
spreadsheets 225 value added tax (VAT) 37, 46, 383
stakeholders 2 technology firms 387
bankruptcy 150-1 telecoms 339-40
cost of capital 245 terminology
debt-capital-oriented 2, 8-11, 337-8 financial ratios 66
equity-oriented 2, 4 - 8 , 336-7 IASB, UK and US accounting terms 46
remuneration-oriented 2, 11-12, 338 Thomas, J. 233, 263
see also lenders; shareholders ThyssenKrupp AG 357
Standard & Poor's, 10, 276, 405, 459 time value of money
start-up firms 67, 407-8 accrual-based performance measures 53
cash burn rate 158, 461 time-series analysis 26, 63, 194
ROIC and IRR 101 accounting policies 65, 100, 358, 374, 394
statement of changes in owners' equity 32, business cycle 66-7
45, 460 sources of noise 64-5, 100, 349, 350, 359
statement of comprehensive income 26-7, 5 0 - 1 , trade receivables see accounts receivable
244, 460 transactions
statistical models 292-6, 463 recording 32-6
Stern Stewart 4, 64 example 37-43
Stewart, G.B. 433 to financial statements 43-5
stock see inventories transitory items 6, 7, 334, 336, 346-63, 461
strategic analysis 1 6 5 , 1 8 7 - 9 3 , 195, 281 bonus plans for executives 12, 303-4, 335,
business environment 187-8 338, 349
company specific factors 190-1 changes in accounting estimates 135-7,
credit analysis 275-6 354-7
industry factors 189-90 changes in accounting policies 357-9
macro factors 188-9 discontinued operations see separate entry
SWOT 192-3, 462 growth in EVA due to 135-7
value chain analysis 191-2, 462 impairment of non-current assets 361-3
see also financial risk; operating risk non-core business: gains and losses 359-61
subscriptions to publications 387 restructuring see separate entry
subsidiaries 273 special and unusual items see separate entry
cost of capital 265 travel agents 77
currency translation difference 244 trend analysis/indexing 111, 112, 113-15, 461
guarantees 286 turnover see revenue
minority interests 78 turnover rate of invested capital 107,
return on equity 118-19 108-11,434
tax on operations and on financing of foreign 76 calculation 108
supermarkets 53 common-size analysis 1 1 3 - 1 4 , 1 1 5 - 1 7 , 460
suppliers 271 definition 108
bargaining power 190 growth and liquidity 148
SWOT analysis 192-3, 462 trend analysis 113-15, 461
United States 251, 260, 264, 309, 339, 382 additional considerations 233-4
accounting terms 46 evaluation 234-5
FASB 3, 47-8, 375, 377, 458 examples of use 226-7
GAAP 2, 3, 346, 375, 376, 383, 398, 414, present value approaches and 227-32
419,458 sensitivity analysis 241, 441
inventory 411, 413, 439 stress test 226-7, 237
Securities and Exchange Commission value added tax (VAT) 37, 46, 383
(SEC) 2-3 value chain analysis 191-2, 462
share buy-backs 1 4 1 , 1 4 3 , 461 value drivers 63
univariate analysis 292-3, 463 variable and fixed costs 26
up-front fees 387 vouchers 386

Valence Technology 365-6 WACC (weighted average cost of capital) 63, 64,
valuation 208-10 9 6 - 8 , 1 3 2 , 1 3 3 , 213, 463
accounting flexibility 374, 395-404, 433-44 bonus plans 315, 316, 464
contingent claim models 7-8, 211 capital structure 145, 246-9, 269, 462
enterprise value (EV) 209-10, 462 cost of capital see separate entry
equity value 209-10 definition 96, 246, 270
ideal approach 212 discounted cash flow 216
liquidation models 7, 8, 1 0 , 1 5 6 , 211, 235-6, 337, share buy-backs 145, 461
344, 445-50, 458 Wal-Mart Stores 253-4
evaluation 236-7 warrants 232-3
overview of approaches to 5-8, 210-11 warranty periods 379, 383-4, 385-6,
present value models 5-6, 45, 210, 211, 212-13, 397, 407
237, 238-41, 336, 343, 462 William Demant Holding 160
accounting flexibility 396-400, 433-8 Wolseley 350-2
APV approach 223-5, 240, 246 Woodside 357
discounted cash flow 216-19, 223-5, 239, 246, working capital 1 4 7 , 1 8 4 , 204, 274
343, 374, 395, 396 cash cycle 153-5
dividend discount model 212, 213-15, 217, 218, cash flows and changes in net 49, 148
219, 221, 237, 239, 246 current ratio 156, 461
evaluation 225 EBITDA and EBITA 58-9
excess return approach 219-23, 225, 237, WorldCom 362
239-40, 241
relative valuation models/multiples 6-7, 58, 211, Xie, J. 308
226, 237, 241-4, 462
accounting differences 232-3, 336-7, 343-4, Z-score 293-4, 295-6
359, 393, 3 9 5 , 4 0 0 - 4 , 438-44 Zarowin, P. 57