CORPORATE FINANCIAL ANALYSIS: CHECK-LIST



CORPORATE FINANCIAL ANALYSIS: CHECK-LIST

Dominique JACQUET

* Build the Financial Balance Sheet

* Calculate WACC and EVA

* Evaluate the company on a Business-As-Usual basis or using a two-stage model

* Relate MVA and EVA

* Calculate the profitability, productivity and financial structure ratios

* Compare sustainable and actual growth in the Capital Employed

* Identify and analyze the sources of financing in the long run, splitting internal and external sources.

1/ BUILD THE FINANCIAL BALANCE SHEET

The financial balance sheet splits Capital Employed and Net Financial Resources.

CE = E + D

Where: CE = Capital Employed

E = Shareholders’ Equity

D = Net Financial Debt.

Capital Employed = Net Fixed Assets + Working Capital Requirement – Other Long Term

Liabilities

Net Fixed Assets include Tangible, Intangible and Financial Fixed Assets

Working Capital Requirement:

WCR = Non-financial current assets – Non-financial current liabilities

Other Long Term Liabilities include mainly long term provisions, such as Pension Funds, Risks and Charges, long term Deferred Taxes. These are non-financial long-term liabilities.

Equity includes mostly Capital, Premiums, Retained Earnings and Treasury Shares (reduction of Equity) and translation adjustments. When some Minority Interests (which represent the value of the shares of 100% integrated companies still held by minority shareholders) appear, it is more convenient to add them up to Equity, as the rest of the Balance Sheet is “integrated”.

Net Financial Debt includes all the interest-bearing liabilities (long and short term debts, commercial papers, straight and convertible bonds, bank debt, notes payable,…) net of Cash and Cash Equivalents (cash, short-term investment in securities,…).

To have a useful picture of a company and its evolution, a minimum of 5 years is required. Of course, 10 or more years may give a more accurate picture, keeping in mind that companies change quickly and that it is sometimes not relevant at all to study a company on a too long period.

2/ CALCULATE WACC AND EVA

To calculate the WACC, it is necessary to know:

1- The risk-free rate: long term government bond rate

2- The Market Risk Premium: in North America, take 6%

3- The beta: use available data bases (internet, books, brokers’ reports,…) and add-up your knowledge of the business and its future systematic risk

4- Eventual specific risk to add-up: lack of liquidity (2 to 4%), bankruptcy risk,…

5- The debt interest rate: either take the apparent interest rate (=interest expense divided by average debt) or take prime rate or inter-bank rate plus a premium that depends on the size and the risk of the company (for large and safe company, the premium is zero)

6- The Corporate Tax Rate: take the apparent tax rate (=corporate tax divided by earnings before taxes) or the legal one

7- The relative share of equity and debt in the total financing: in theory, current market values of equity and debt are used. But, it should also reflect the future financing policy of the firm. Then, if the company has a negative D, take zero for D, as a company should not have more cash than financial debt in the long run, the relative share of equity becoming 100%.

The EVA is directly deducted from EBIT, WACC and CE.

It is necessary to calculate a WACC and EVA for each year.

3/ EVALUATE THE COMPANY

To estimate the “intrinsic” value of the firm, it is recommended to use the Free Cash-Flows method.

If the company is on a relatively mature market, the relevant formula is:

Value of CE = FCFo * (1 + g) / (k – g)

The WACC (k) has been calculated earlier.

The growth factor has to be estimated according to the average evolution of the market (and the market share of the company) in the long run.

It is not cautious to take for FCFo the last one generated by the company:

1- the EBIT must be checked (is the last one really representative of the average profitability of the company ?) ;

2- for Delta WCR, take WCR * g

3- for Investments, take Sales * [Average Industrial Investments/Sales ratio (last 3 to 5 years)], as the investment policy may be relatively volatile.

If the company and/or the market is not mature, a two-step process must be implemented. It is the case of fast-growing companies and restructuring companies. In both cases, the first FCFs are generally low, even negative, as the business consumes more cash than it generates through operating profitability. What is critical is to estimate the future FCF profile of the company, once it has reached some maturity. It is recommended to estimate, first, sales, EBITDA and industrial investments of the company during the next years and use the formulas presented in the “Corporate Valuation” note. This exercise may be extremely hazardous when analyzing very fast growing firms that generate only losses (e.g. the so-called “internet companies”).

4/ RELATE MVA AND EVA

Once the EVA is calculated, it is possible to confront the current profitability (EVA) and the stock price.

MVA is calculated as the difference between the value of the Capital Employed and the book value of the CE. Accountants name that the goodwill when positive and the badwill when negative. Generally speaking the MVA is calculated from Equity, not from CE.

One often considers that the value of the debt is the figure that appears in the Balance Sheet (which is, in most cases, a good approximation).

We have then: Value of CE = Value of Equity + D

But: CE = E + D

Then: MVA = Value of CE – CE = Value of Equity – Book Equity

In practice, it is recommended to calculate “Value of Equity” as the number of shares outstanding multiplied by the stock price (end-of-the-year or year-average) and to subtract the Equity of the Balance Sheet to calculate the MVA.

Once the MVA is calculated, the relation between EVA and MVA appears in two calculations and questions:

1- What is the implicit long term growth in the EVA that is consistent with the stock price, i.e. the calculated MVA ?

2- What is the implicit EVA (% and $) that should grow at the rate of g% per year in the long run to generate the MVA that has been calculated ?

The formulas are:

1- implicit g = WACC - EVA/MVA

2- implicit EVA = MVA * (WACC - estimated g).

The analyst must then comment on the business feasibility of both implicit growth and implicit profitability. Can the firm sustain this growth and profitability in the long run? what about the competitive situation of the company ? is it safely protected by high barriers to entry ? etc…

Of course, if the EVA is negative and the MVA is positive, the implicit g that is given by the formula is greater than the WACC, which is a non-sense. It would mean that a value creation –a positive MVA- comes from a fast growing economic loss! In that case, only the implicit EVA is meaningful, as it calculates which recovered profitability is anticipated by the stock market.

5/ RATIO ANALYSIS

The main ratios that should be calculated are:

1- Return(s) On Sales: EAT/Sales and EBIT (and/or EBITDA)/Sales

2- Return On Capital Employed: ROCE = EBIT\CE

3- Return On Equity: ROE = EAT/Equity

4- Gearing: D/E

5- Assets Turn-Over: ATO = Sales/CE.

These ratios are first used in the leverage analysis. The leverage formula is:

ROE = ROCE * (1 – CTR) + (ROCE – Id) * (1 – CTR) * D/E

It is very delicate to re-compute the whole formula. Thus, it is recommended to:

1- calculate the ROE

2- calculate the ROCE * (1 – CTR)

3- deduct the leverage effect by subtracting the economic profitability from the ROE.

Then, it is interesting to calculate, year by year, what percentage of the ROE comes from the after-taxes ROCE and what percentage comes from the leverage effect. The question behind that is: does the financial profitability come from the operations or from the financing?

Roughly speaking, there are 3 categories of companies:

* Category I companies generate a ROCE lower than the debt interest rate; then, debt is “bad”, as it lowers the ROE while increasing the risk of the company;

* Category II companies generate a ROCE greater than the interest rate, but close to it; then, again, debt is “bad”, as it requires a lot of debt, thus a lot of risk, to increase just a little bit the ROE: high risk for a low return is “bad news”;

* Category III companies generate a ROCE which is significantly greater than the debt interest rate; then, a “reasonable” increase in the leverage has a significant positive impact on the ROE; this debt is “good” for the company, as it creates a “low risk-high return” situation.

Thus, debt is “good” only for category III companies. It does not mean that these firms will select a high leverage, as they eventually prefer to stay under-leveraged for a while, keeping their financial and strategic flexibility for external growth.

In addition, the analyst must estimate the debt capacity of the firm (negatively correlated with the operating risk of the company), compare ROCE and Id to estimate if the company can really profit from the leverage effect and comment about the actual use of debt in the financing: could and should the company be more leveraged ? should the company stay under-leveraged to keep a high growth financing flexibility ? etc…

The Dupont-de-Nemours formula is, then, computed:

ROE = EAT/Sales * ATO * (1 + D/E)

The “added-value” of the formula is the focus on the industrial productivity reflected in the ATO. It is important to remember that:

ATO = Sales / (Net Fixed Assets + Inventories + A/Receivable – A/Payable +/- others)

The following questions should be addressed:

* what is the evolution of the ATO ?

* is the business capital intensive or not ?

* what is the evolution of all the items of the CE against sales, e.g. what is the evolution of inventories as a percentage of sales or how many dollars of sales are generated by one dollar of tangible fixed assets ?

* what is the “influence” of the ATO on the strategy of the firm (e.g. Mc Donald’s and Corning) ?

6/ SUSTAINABLE VS. ACTUAL GROWTH

The sustainable growth rate is calculated. It is, by definition, “the maximum growth rate in the Capital Employed that a company can afford without deteriorating its financial structure and without issuing new shares”.

The formula is:

Gs = ROE * (1 – d)

Where d is the dividend pay-out ratio, i.e. Dividends / Net Earnings.

The analyst calculates the geometric average of the sustainable growth rate during the period which is analyzed and compare it with the geometric average of the actual CE growth rate for the same period.

Two possibilities:

1- Gs < actual growth of the CE. Then, the company issued shares and/or increased its leverage and/or decreased its dividend pay-out and/or…

2- Gs > actual growth of the CE. Then, the company increased d and/or repurchased its shares and/or accumulated cash (to do what ?) and/or…

The key point is to make the link between the financing policy of the company and its business strategy that impacted the CE.

7/ FINANCING INSTRUMENTS

Which instruments have been selected by the company is critical in the analysis of its corporate financial policy.

The first step is to split the financing of the period which is analyzed.

Calculate, first, the difference between the CE at the end vs. at the beginning of the period, e.g. “the CE have increased by 2 billions”.

Calculate the difference between Equity end vs. beginning and split between Retained Earnings and Issues of shares, e.g. “the Equity has increased by 1.2 billion, of which 1 billion is retained earnings and 200 millions is a shares issue in year 19XY”.

Calculate the difference between the net financial debt end vs. beginning and describe the financing instruments, e.g. “the D has increased by 800 millions, of which 600 millions are a Convertible Bond issued in year 19XY and 200 millions are an increase in the bank debt”.

Describe the issues: shares (ordinary vs. preferred, issue price,…), convertibles, warrants, …

Answer to the following question: “a few years after, were these issues “good” or not for the investors and for the company (the issuer) ?”.

GOOD LUCK!

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