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WARWICK BUSINESS SCHOOL

Financial Statement Analysis Shahed Imam Key Formulae used

Reformulation: Profit and loss account or Income statement: NOPAT- Interest after tax = Net income NOPAT can be also termed as operating income after tax or profit before interest but after tax on operations. Net Income can also be termed as profit for the period.

Balance sheet: NOA – ND = BVE Where, NOA is net operating assets, ND is net debt and BVE is book value equity. Sometimes it is called CSE (common stock equity) or simply equity capital. ND is also called NFO or net financial obligations. NOA equals Operating assets minus operating liabilities. It can also be shown in reformulated balance sheet as Net long term operating asset plus working capital. ND equals financial liabilities (FL) minus financial assets (FA). If the firm has more financial asset, then it is termed as NFA (net financial asset) which equals to FA –FL.

Cash flow statement: Free cash flow (FCF) = Cash flow from operation (after tax) – Capital expenditure Cash flow from operation (after tax before interest) can be termed as CFO and capital expenditure as ‘I’. In this case, Capital expenditure is Investment in operating activities (excl. Investment in financial assets). Also, the use of FCF can be expressed as, FCF= NFE – Change in net debt + dividend

Key Ratios ROE

=

NI : return on equity BVE

RNOA = NOPAT : return on net operating assets NOA FLEV = ND : financial leverage BVE NIR

= NIE ND

: net interest rate after tax

ATO

= Sales : asset turnover NOA

NOPM = NOPAT : net operating profit margin Sales

ROE = RNOA + FLEV * (RNOA – NIR) Here RNOA – NIR is also called operating spread or only spread. Note that it is only balance sheet items (book value equity, net debt, NOA) where we can use average or beginning. For profit and loss items (Net income, NOPAT, Sales) it is always ending figure you need to use. Also ending figure for last year is beginning figure for this year. Ending figure for this year is beginning figure for next year.

Sustainable growth: g = ROE*b where ROE is return on equity and b is retention rate. So if the firm’s earnings is £100, but pays £40 as dividend, it is retaining £60 or 60%. So b is 60% in this case which is also called retained earnings. It is the amount the company retains after paying off dividends from earnings.

Valuation models Dividend discount model (DDM): D t 1 Dt 2 Pt   ......   (1   ) (1   )2



 1D   t i

i

i 1

Here ‘D’ is net dividend, ρ is cost of equity capital which sometimes is denoted by ‘r’ or ‘k’. It can be mentioned as required return on equity capital. Terminal value is your terminal year dividend divided by (ρ- g) where g is growth in dividend. Remember, at terminal year growth in dividend, abnormal earnings, abnormal operating profit, free cash flow is equal to sale growth. AMEC valuation exercise is an evidence of this. Also do not forget to discount that value back to the present by (1+ ρ) in case of dividend or abnormal earnings model and (1+WACC) in case of abnormal operating profit and free cash flow modes. In all cases, the power should be T-1, where T is total number of forecast year. So if we have three forecast year, the power would be 3-1= 2. In Excel, I am sure you will have problems with brackets! Keep trying.

Clean surplus relationship: Ending book value equity = Beginning book value equity + Earnings for the year – net dividend for the year. So, BVE (ending) = BVE (Beginning) + E –D Net dividend includes dividend, share issue and share repurchase which is termed by ‘D’. If we mention in terms of per share, the equation will be: Bps (ending) = Bps (beginning) + Eps for the year –Dps for the year Where Bps is book value per share, Eps is earnings per share, Dps is dividend per share. Also remember that any ending figure of last period is beginning for this year. So book value per share (ending) of 2009 is book value per share of 2010 beginning. Remember, in this equation earnings is comprehensive earnings or income; so any dirty surplus item which hasn’t gone through earnings, needs to be adjusted (see Morrison annual report). Usually you will get these items in Statement of Recognised Income and Expenses (SORE) or shareholder’s equity statement till 2009 annual reports. From 2010, you will get the information either within Profit and loss account (in comprehensive income section) or as a separate statement called ‘Statement of Comprehensive Income’.

Abnormal earnings model: Abnormal earnings is:

AEt i  Et i  Bt i 1 Here AE is abnormal earnings. Abnormal earnings is also known as residual earnings (RE) or residual income (RI). E is earnings, ρ is cost of equity capital, B is book vale of beginning equity (which can be termed as BVE or CSE). Another form of this AE is:

AE = (ROE – ρ) BVEBeg.

i.e. Difference between ROE and cost of equity capital multiplied by beginning book value of equity is AE since ROE is earnings over BVE and we will leave with the same equation as before since BVE cancels out.

AEt i  Et i  Bt i 1 

Pt  Bt   i1

AEt i 1   i

So, in this equation, equity value equals beginning book value of equity for the forecast year or ending of the last year plus present value of expected abnormal earnings. The terminal value calculation is exactly the same as dividend model.

Abnormal operating profit model Abnormal operating profit is:

AOPt i  NOPATt i  WACC * NOA t i1 Here AOP is abnormal operating profit, NOPAT is net operating profit after tax, WACC is weighted average cost of capital, NOA is beginning net operating assets. Abnormal operating profit is also known as residual operating income or profit. Another form of this AOP is:

AOP = (RNOA – WACC) NOAbeg

i.e. Difference between RNOA and WACC multiplied by beginning NOA is AOP since RNOA is NOPAT over NOA and we will leave with the same equation as before since NOA cancels out.

AOPt i  NOPATt i  WACC * NOA t i1 

A t  NOA t 

 i1

AOPt i 1  WACCi

So, in this equation, value of business or operations (terms as A) is beginning NOA for the forecast year or ending of the last year plus present value of expected abnormal operating profit. The terminal value calculation is exactly the same as other models.

Free cash flow model: Just like clean surplus relationship FCF can be as follows: FCFt i  NOPATt i  (NOA t i  NOA t i1)

Here FCF equals NOPAT minus change in NOA. FCF model is then as follows:



At   i 1

[ FCFt i ] (1  WACC )i

You just need to calculate present value of all expected future free cash flow. Remember only in abnormal operating profit and FCF model we use WACC (also called as cost of capital) and in dividend and Abnormal earnings model we use cost of equity capital (also known as ρ). Terminal value calculation is same, just you need to be careful whether it is WACC or ρ and again---: T-1!

Value of Business – Value of Net Debt = Value of Equity It can be written as: A – L = P Here A is value of business, L is net debt, P is value of equity. If the firm has net financial asset (NFA), you need to add back NFA rather than subtracting it like ND (also called NFO or net financial obligations)....