Finance Basic Principles 1

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FinanceThe Basic Principles

• Financial Statements
• Balance sheet
• Profit and loss
• Working Capital
• how to calculate it
• how to finance it
• Cash Flow
• Cash Flow from operating activities
• Cash Flow from investing activities
• Cash Flow from financing activities
• Cash Flow Statement
• Free Cash flow
• Financial ratios

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Balance Sheet

• The Balance Sheet is a photography
• At one moment
• of what the company owns
• Assets
• Buildings, equipments, patterns, etc. (fixed
  assets)
• Inventories
• Receivables from customers
• Cash Treasury
• and what the company owes to third parties
• Liabilities or debts
• Equity (debt to shareholders)
• Provisions (potential or probable debts)
• Financial debts (loans from banks and
  individuals)
• Current (operating) debts to suppliers,
  personnel, fiscal authorities

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Saigon Hotel Balance Sheet
INITIAL BALANCE
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Balance SheetAssets Liabilities

• Total Assets Total Liabilities
• Total Assets Fixed Assets (net) Current
  Assets
• Assets Fixed Assets Inventories Receivables
  Cash
• TOT FIX S R CASH
• Total Liabilities Debts Equity
• Equity Total Assets - Debts
• Debts Provisions Financial Debts Current
  Debts Other Debts
• TOT EQ PROV Dfin Dop Doth
• TOT EQ PROV DLTfin Dop DSTfin Doth

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Structure of the Balance Sheet

• Each industry have some financial specificities
• Fixed assets intensive companies
• steel, electricity, .
• Inventories intensive companies
• retail, .
• Provisions intensive companies
• insurance
• Cash / Treasury intensive companies
• banks

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Profit Loss

• Net result Earning before interests and taxes -
  interests on debt - taxes
• RES EAT EBIT - Cfin - TAX
• EBIT includes 2 components
• from operating (current) activities (EBITop)
• extraordinary (EBITx)
• EBIT EBITop EBITx

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Profit Loss

• Non-cash expenses
• depreciation and amortization (DAM)
• change of provisions (?PROV)
• Cash expenses
• cost of sales (COS)
• wages, cost of goods services (PERS, GS)
• interests (Cfin)
• taxes (TAX)

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Profit Loss

• EBITDA EBIT non-cash expenses
• EBITDA EBIT DAM ?PROV
• EBITDA Revenues - Cost of sales - goods
  services - Wages
• EBITDA REV - COS - GS - PERS
• Margin Difference between sales cost of sales
• Margin Revenues - Cost of sales
• MAR REV - COS

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Saigon Hotel Profit Loss
PROFIT LOSS
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Working capital

• Let us come back to the BS equation
• FIX S R CASH
• EQ PROV Dfin Dop
  Doth
• Let us regroup current assets and current debts
  (Working Capital)
• Working Capital is the amount of money devoted
  to finance the operations of the company
• WC S R - Dop
• We can modify the BS equation using Working
  Capital
• FIX WC CASH EQ PROV Dfin Doth

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Saigon Hotel Working Capital
WORKING CAPITAL
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Working capital

• What happens if the working capital is positive?
• it has to be financed by
• equity
• financial debt (long or short term)
• What happens if the working capital is negative?
• it can be used to finance fixed assets
• Working capital can represent important financial
  needs for the company !!

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Limits of Balance Sheet PL

• What is important for the financial director of a
  company ?
• to know what are the financial needs
• to understand why they change
• to determine how to cover these financial needs
• Are these informations given by the Balance Sheet
  (BS) and the Profit Loss (PL) ?
• no the BS is only a photography at one moment
• no the interactions between BS PL are not
  visible

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Limits of Balance Sheet PL

• What do we really need ?
• Figures or Statements giving us information on
  all the financial flows during one year
• Knowledge of the sources of these financial
  flows
• Knowledge of the uses of these financial flows
• If possible, a synthetic vision of these tables

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Basic Definition of Cash FlowCash Flow from
operating activities

• The Cash Flow generated by is the true measure of
  the financial health of the company
• Difference between finance accounting
• Basic definition of Cash flow from operating
  activities
• Cash generated during one period and available
• to be reinvested
• to be distributed to the shareholders
• Cash flow Net result Depreciation
  amortization Change of provisions - Change of
  Working Capital
• CFop EAT DAM ?PROV - ?WC

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Basic Definition of Cash FlowCash Flow from
operating activities

• Comments on basic definition
• After interests on debt
• After taxes
• But before dividend
• What is important in this definition ?
• Through the Working Capital it takes into
  account the differences of timing between
  accounting registrations and cash movements
• Customers do not pay immediately
• Debtors are not paid immediately
• Changes in inventories
• Cash Flow depends of financial structure
• interests

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Saigon HotelCash Flow from Operating activities
CASH FLOW OPERATIONS
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Cash Flow Statement

• It would be useful to have a Table presenting all
  the financial flows of the company
• Cash Flow from operating activities
• Cash Flow from investing activities
• Capital expenditures (cash out)
• Asset sales (cash in)
• Cash Flow from financing activities
• New debt
• Reimbursment of debt
• New capital
• Dividend paid

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Cash flow Statement

• This Table is the Cash flow Statement
• Today most companies present this Statement
• together with Balance Sheet and PL
• The Cash flow Statement can be built from
• the BS equation
• the PL
• the capital expenditures and asset sales
• the dividends paid

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Building the Cash flow Statement

• Let us remind the Balance Sheet equation
• FIX WC CASH EQ PROV Dfin Doth
• Let us modify this equation with the definition
  of equity
• EQ paid-in capital retained earnings K
  RE
• FIX WC CASH K RE PROV Dfin Doth
• This relation is always true
• Consequently we can write
• ?FIX ?WC ?CASH
  ?K ?RE
  ?PROV ?Dfin ?Doth

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Building the Cash Flow Statement

• Some terms of this equation are flows of funds,
  other accounting definitions not directly related
  to flows of funds
• ?FIX ?WC ?CASH
  ?K ?RE
  ?PROV ?Dfin ?Doth
• these flows of funds are corresponding to the
  financing of the company
• capital increase (?K)
• new debts or reimbursement of debts (?Dfin,
  ?Doth)
• changes in the cash position (?CASH )

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Building the Cash flow Statement

• Using this equation
• ?FIX ?WC ?CASH
  ?K ?RE
  ?PROV ?Dfin ?Doth
• We can regroup on one side all the terms
  corresponding to accounting definitions and on
  the other side all the terms corresponding to
  flows of funds
• ?RE ?PROV - ?FIX - ?WC
  - ?K - ?Dfin
  ?CASH - ?Dvar

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Building the Cash flow Statement

• We will modify again this equation
• ?RE ?PROV - ?FIX - ?WC
  - ?K - ?Dfin
  ?CASH - ?Doth
• Let us recall that
• ?RE EAT - DIV
• ?FIX capital expenditures in fixed assets -
  depreciation
• CAPEX - DAM
• Doth DIV and then ?Doth DIV - DIV-1
• The equation can be rewritten
• EAT - DIV ?PROV - CAPEX DAM - ?WC
  - ?K - ?Dfin ?CASH - DIV
  DIV-1

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Building the Cash Flow Statement

• We can then write
• EAT DAM ?PROV - CAPEX - ?WC - DIV-1
  - ?K - ?Dfin ?CASH
• CFop - CAPEX - DIV-1 - ?K - ?Dfin ?CASH
• What does this equation mean ?
• On the left side that the financial flow
  available is equal to the Cash Flow from
  operating activities less the capital
  expenditures and the dividend paid for last year
• On the right side what is done with this
  financial flow (if positive) or how is it
  financed (if negative)

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Building the Cash flow Statement

• We can also split the equation in three parts
  corresponding to
• the operating activities of the company
• the investing activities of the company
• the financing activities of the company
• The equation becomes
• CFop -CAPEX ?K?Dfin-DIV-1 ?CASH

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The Cash flow Statement

• We have now the possibility to represent all the
  financial flows of the company by separating them
  in three different Cash Flows according to their
  nature
• the Cash flow from operating activities (CFop)
• the Cash flow from investing acrivities (CFinv
  ? - CAPEX)
• the Cash flow from financing activities (CFfin
  ? ?K?Dfin-DIV-1)

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Saigon Hotel Cash Flow Statement
CASH FLOW STATEMENT
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Free Cash Flow

• We will now summarize the Cash Flow Statement
  with the concept of Free Cash Flow
• the Free Cash Flow is equal to the financial
  flow generated by the activities of the company
  and not reinvested in capital expenditures
• with the assumption that the company is fully
  financed by equity
• FCF ? EBIT(1-Tc) DAM CAPEX
• EBIT(1-Tc) NOPAT
• Net operating profit after tax
• FCF ? NOPAT DAM CAPEX

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Saigon Hotel Free Cash Flow
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Financial analysis and ratios

• Necessity to have a quick vision of the financial
  situation of a company
• common language
• comparability
• Profitability ratios
• to measure the efficiency and the profitability
• Leverage ratios
• to measure the indebtness
• Coverage ratios
• how are the debt and the interests covered by
  the cash-flow ?
• Liquidity ratios
• how liquid is the company ?
• Distribution ratio
• what does the company distribute to the
  shareholders ?

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Necessity of the Financial Analysis

• Who needs the financial analysis ?
• the banker
• to assess a new loan or to maintain a credit
  line
• the supplier
• to be sure to be paid by his customers
• the customer
• to be sure that his supplier will stay in the
  business
• the market (stock exchange) or the shareholders
  in a JSC
• to assess companies
• to valuate companies

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What is important for the analysis ?

• To be able to compare ...
• different companies
• with the same activity (hotels, airlines, etc.)
• with different activities
• one company across the time
• . . . everyone must use the same indicators
• necessity of a common language
• no discussion on the facts
• but discussion on the interpretation of the
  facts

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What is important for the analysis ?

• Limits to the comparability
• differences in accounting rules and practices
• in different countries (laws, fiscal
  regulations, accounting rules)
• inside the countries (internal practices of the
  companies)
• depreciation period
• research development
• brands
• leads to a growing standardization of the rules
• IAS (International Accounting Standards)
• BUT the practices remain different

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What is important for the analysis ?

• Trust in the figures
• published by the companies themselves
• the Board of Directors is responsible
• Risks
• window dressing
• cover-up
• Remedies
• external auditors
• market authorities
• stock price
• complains by shareholders

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Profitability Ratios Profit Margin
Profitability of Sales

• Profit Margin
• Measures the margin generated by each sale
• Profit Margin ? EBIT/REVENUE
• Profitability of Sales
• Measures the final net result by each sale
• Profitability of Sales ? EAT/REVENUE

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Profitability Ratios the ROE

• The key concept Return on equity
• ROE ? Rfin ? EAT/EQ
• Key concept for the shareholder
• profitability of their investment in shares of
  this company compared to alternate financial
  assets
• other shares
• fixed rates bonds (of companies or government)
• How to measure the equity ?
• book-value or...
• ...market price
• the difference can be huge for listed companies

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Profitability Ratios ROCE

• The Return On Capital Employed (ROCE) measures
  what the company earns (before interest and tax)
  per unit of capital employed
• ROA ? ROCE ? EBIT/Assets
• ROCE EBIT/(FIXWCCASH)
• in the practice the total Assets of the Balance
  Sheet are sometimes used
• this ratio is not influenced by the financial
  structure of the company
• because we use the EBIT
• is also called Return On Investment (ROI) or
  Return On Assets (ROA)
• It can be useful to calculate the ROCE after
  taxes
• ROCE ROCE.(1-Tc)
• where Tc is the average tax rate

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Reference levels for ROCE and ROE

• What is a sound level for the ROCE ?
• higher than the interest rate
• in the range 8-14 in western economies
• the level is a reference for expected
  profitability of new capital expenditures
• What is a sound level for the ROE ?
• in the range 12-25
• depends on the risk of the business
• activity related risks (high tech vs. low tech)
• maturity of the business (start up vs. mature)
• financial structure (highly leveraged vs.
  standard)

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Leverage ratios

• The indebtness of a company can be measured by
  the debt-equity ratio (?)
• debt-equity ratio ? ? ? Dfin/EQ
• be sure the leases are included in the debt
• Alternate the debt ratio
• debt ratio ? Dfin/(DfinEQ)
• Some authors use only the medium and long term
  financial debt (DLTfin)
• we prefer all the financial debts (possibility of
  switch between DLTfin and DSTfin)

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Liquidity ratios

• These ratios measure how liquid is the company
• Current ratio
• current ratio ? currents assets / current
  liabilities
• current ratio ? (SRCASH) / (DopDSTfin)
• Acid test (Quick test)
• this ratio reflects the fact that some current
  assets are less liquid (inventories)
• acid test ? (RCASH) / (DopDSTfin)

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Solvability ratios

• These ratios measure how the company can cover
  its debt commitments
• Cover of interests
• this ratio reflects how much Cash Flow directly
  generated by the operations is available to pay
  the financial charges
• cover of interests ? EBITDA / Cfin
• Cover of debts
• this ratio reflects the number of years to repay
  the total net debt if all Cash Flow directly
  generated by the operations is used to repay the
  debt
• cover of debt ? (Dfin CASH) / EBITDA

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Reference levels for liquidity solvability
ratios

• All these ratios depend on the industry
• Current ratio
• if possible, higher than 1
• Acid test
• if possible, higher than 0.7 / 0.8
• Cover of interests
• If possible, higher than 3 / 4
• Cover of debt
• Never longer than the average lifetime of fixed
  assets

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Distribution ratio

• The pay-out ratio measures the share of the net
  result distributed to the shareholders
• pay-out ? DIV / EAT
• Reference level
• depends on the financial needs of the company
• for listed companies expectations of the
  markets
• standard for mature companies 40 to 60

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General remark on the calculations of ratios

• For the PL no doubt use the year figures
• For the Balance Sheet which figures ?
• at the end of the year ?
• at the end of last year ?
• another figure ?
• Correct calculation daily average
• Use the average (end of the year/end of last
  year)
• best estimate of the reality
• Be always coherent

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Hotel Saigon Financial Ratios
FINANCIAL RATIOS
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Conclusions of the lesson

• The Balance Sheet and PL does not give a
  complete image of the financial situation
• Never forget the difference between cash
  non-cash expenses
• Introducing the Working Capital
• The Working Capital can represent huge financial
  amounts

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Conclusions of the lesson

• There are many definitions of Cash Flow
• CF (all operating activities but no change in
  WC)
• CFop (all operating activities with changes in
  WC)
• The Cash Flow Statement is based on the Balance
  Sheet identity and gives a complete vision of the
  financial flows of a company
• The Free Cash Flow summarizes the Cash Flow
  Statement
• The Financial ratios give a quick information to
  analyze and compare the financial situation of a
  company