BALANCE SHEET AND CAPITAL A financial – practical oriented approach
INTRODUCTION • In this study we present an integrated case-study for a small business initiated in the food services field. • The small business implies buying and operating a food-truck which will allow preparing and selling organic street food for different clients and in different locations. • Firstly, we have analyzed the proposed business on an ex-ante basis, approaching the initial investment decision, using specific decision instruments (net present value, internal rate of return and discounted payback period). • Secondly, after verifying and confirming the eligibility and efficiency of the investment we have proceeded to analyze the efficiency, profitability and liquidity aspects using an ex-post approach under three scenarios: basic, worst-case (pessimistic) and optimistic.
INTRODUCTION • Thirdly, we have performed a cost-volume-profit analysis for a more in-depth approach of the proposed business. • This allows establishing the break-even point and its implications for business management under four scenarios, including possible effects of granting discounts to potential clients to support company sales growth. • All the analysis is done from a financial perspective, respectively one which supports reaching the main objective of sustainable increase in company value, using concepts such as investments, cost of capital, cash flows, capital intensity, break-even point. • We start our presentation by introducing a new perspective upon the main financial situations of the company, balance sheet and profit and loss account.
SMALL BUSINESS SPECIFICS • Besides employees (which exist for virtually all businesses) a business has another two important categories of actors: managers and investors (owners/shareholders and financial creditors). • Managers and investors are two separate categories, which nevertheless (along with employees) should follow the same objective of sustainable increase of company value (SICV). • For medium and large businesses there is a clear separation between managers and investors. Managers are hired by investors, with a clear mandate to efficiently and transparently run the businesses. • This makes easier for the investors to follow and evaluate the action of managers. • Managers can support the objective of SICV by promoting new efficient investments (investments which generate enough profit to cover both operating and financing costs) and by ensuring a profitable operation of existing assets (the result of past investments).
SMALL BUSINESS SPECIFICS • For small businesses there is a specificity: the manager, owner and even the employee are sometimes the one and the same person… • In a small business the owner (shareholder) acts often as manager and even as an employee. • Acting also as a manager, the owner can sometime forget (or treat in a looser manner...) some principles of an efficient business. • One aspect may refer to considering equity as cost-free capital and using it to finance the business, without expecting a proper compensation for its use. • In other instances, the manager may be satisfied with covering material and salary costs, interests and taxes and obtaining a small amount of profit, which may induce the impression of efficiency and profitability.
SMALL BUSINESS SPECIFICS • However, if a company obtains an annual net profit of say 1,000 Euros and its owner invested 50,000 Euros, it means the business generates only 2% return on the capital invested by its owner. • 2% return on equity is not a very good performance, as it is quite close to the return offered by safe financial investments (government bonds or even banking deposits). • Another example of actions which can affect return on equity and future investment prospects is when manager offers high level client discounts (for example 15% discounts). High discounts, even if boosting current sales, might impair future investments by compromising company self-financing capacity. • However, no matter if it is a small business or if the owner it is the same person with the manager, principles for a successful business are the same: equity capital has to be rewarded at a competitive level, sales on credit must be offered to liquid and serious clients, the company should create a solid self-financing capacity for new investments.
BALANCE SHEET – in the financial approach • It is an essential financial situation used an instrument to support the company’s financial management • It depicts the financial situation of the company at a certain moment in time (usually December 31-st), as result of the economic and financial events which occurred in company life during the respective year • It has two sides: the ASSETS side and the CAPITAL and LIABILITIES side
BALANCE SHEET - ASSETS SIDE • The assets are the result of investments made by the company during its existence, until present time (time of the B/S). We have two types of Assets, result of two types of investments: • - FIXED ASSETS are the main result of company investments, respectively of LONG-TERM INVESTMENTS, which generate production and sales capacities: equipment, machinery, buildings, land, transportation means. • Except for the land, fixed assets transfer a part of their value into the current products/services via DEPRECIATION – for tangible assets, respectively via AMORTIZATION – for intangible fixed assets. • - CURRENT ASSETS are the result of the other type of investment, respectively the SHORTTERM INVESTMENT. Short-term means usually less than one year. The main types of Current Assets are Inventories, Accounts Receivable and Cash and short-term investments
BALANCE SHEET ASSETS SIDE – FIXED ASSETS • The value of FIXED ASSETS (reflected by the B/S in amounts net of accumulated depreciation) DECREASES over time (aspect reflecting both the accounting decrease of value – the depreciation - and their physical alteration – due to wear and tear) ; • Most of the times depreciation corresponds to the physical alteration of fixed assets and induces the need for their REPLACEMENT • The REPLACEMENT of existing fixed assets require a new INVESTMENT, which needs to be financed from a corresponding amount of CAPITAL; the other type of long-term investment are the DEVELOPMENT investments (which allows the company to expand its activities, produce and sell more or produce and sell products with a higher value added) • The money for a new investments comes from INVESTORS, i.e. Shareholders (new contributions of equity and the undistributed net profit), Financial Creditors (Banks, general public, leasing companies) and from other sources (state subsidies, European financing programs)
BALANCE SHEET - ASSETS SIDE • Investors will agree to finance a REPLACEMENT or DEVELOPMENT investment only if they feel that the company uses efficiently its ASSETS (fixed and current). • The efficiency in using company assets can be appreciated via financial measures, grouped into several categories, respectively EFFICIENCY, PROFITABILITY and LIQUIDITY measures • Among the EFFICIENCY group we find measures which connect the investment made by the company (resulting in both Fixed and Current Assets) to the Sales generated using these respective assets, such as Number of uses, Sales for 1000 Lei of Assets, CAPITAL INTENSITY (the most interesting and relevant measure here) as well as the measures reflecting the efficiency in using CURRENT ASSETS.
ASSETS SIDE – EFFICIENCY MEASURES FOR TOTAL ASSETS • 1. Number of uses (NU): • The measures shows how many times the company manages to use its assets during one year to generate its annual sales. • The company shows an increased efficiency in using if assets, if the Number of uses registered in 2017 is higher compared to Number of uses from 2016 (The index of number of uses or is higher than one:
ASSETS SIDE – EFFICIENCY MEASURES FOR TOTAL ASSETS • 2. Sales for 1000 lei of Assets is an efficiency measure which shows how much sales the company generates investing 1000 Euros in Assets (fixed and current): • Intuitively, the level of this measure should be higher than 1000, respectively the company generates more than 1000 Euro of Sales investing 1000 Euros in its Assets • Increase in efficiency requires an increase in the level of this measure, i.e. in 2017 we have for example 1,200 as compared to 2016 when the level was 1,150. This is equivalent to having an index of this measure higher than one:
ASSETS SIDE – FOR TOTAL ASSETS
EFFICIENCY MEASURES
• 3. Capital Intensity (CI) is the most interesting and important assets’ efficiency measure (it expresses financial performances of the company): • It shows how much does a company need to invest in its assets to generate 1000 Euros of Sales. Intuitively, the level of CI should be lower than 1000 (a company should invest less than 1000 in its assets to generate 1000 Euros of Sales). • The increase in assets’ efficiency requires a decrease in the level of CI (the level from 2017 should be lower than the one from 2016, corresponding to a lower than one index:
A SMALL BUSINESS – ACTIVITY ANALYSIS • An investor is considering opening a small business offering organic street fast-food. • For this venture he buys a second-hand truck equipped with fast-food preparing machines for 20,000 Euros. • The truck has 5 years left of economic and operating life. 10,000 Euros originate from investor’s own funds are 10,000 Euros from a 5 years bank loan. • The efficiency of such a investment can be evaluated in two different contexts, respectively on an Ex-ante basis, using discounted cash flow instruments, such as Net Present Value, Internal Rate of Return and Payback Period and on an Ex-post perspective, using measures grouped into Efficiency, Profitability and Liquidity categories.
A SMALL BUSINESS – ACTIVITY ANALYSIS • To offer his services he also needs to buy some ingredients for his first week of sales, worth of 1,000 Euros. He employs two vendors to operate his food truck in two shifts, paid with 700 Euros per month each, employers’ contributions included. • The annual local taxes and operating licenses are 800 Euros worth and the profit tax is 16%. He has monthly sales worth of 6,500 Euros and the other operating expenses are 300 Euros worth each month. 1,000 Euros are sales on credit, cashable in 30 days.
EX-ANTE EVALUATION USING PRESENT VALUE CRITERION
NET
• The business project is subject to an initial evaluation which is meant to ensure the investors that the project is worth considering and undertaking. • The initial investment is worth 20,000 Euros (a vending truck with food preparing equipment). • The initial investment is financed by the owner (10,000 Euros), respectively from a 5 years banking loan of 10,000 Euros. • The cost of equity is 10% per year, whereas the interest rate for the loan is 8% per year.
Net Present Value (NPV) formula • The net present value criterion compares the initial investment with the discounted value (because of time-value of money, which usually decreases in time) of future cash flows generated by that investment.
•, • Where DCFi – discounted cash flow from year i • n – the number of years of operating the investment • With
• dr – discount rate, usually obtained as a weighted average of the cost of capital used for financing the initial investment
• Inv – initial investment in fixed and current assets
NPV formula – discount rate • For example if the initial investment is financed 50% from equity (with a cost of 10% per year) and 50% from a banking loan, (demanding an interest rate of 8% per year), then the discount rate (dr) used to bring future cash flows at the same purchasing power as the initial investment will be calculated as: • For the years when the company estimates to register a profit and if interest is deductible for income tax-calculation, then the formula becomes: • We notice that cost of debt and implicitly the discount rate is lower when we use the net cost of debt, or interest rate(1 – t), with t – income tax rate (currently 16% in Romania). However, the use of the net cost of debt is contingent upon registering profit in the respective year.
NPV formula – Cash flow calculation • The yearly cash flows generated by the investment can be calculated considering the cashable part of the profits and the eventual supplementary investments in current assets (when sales increase that usually demands an increase in current assets – inventories and accounts receivables - to support that increase in sales. • That supplementary investment in operating current assets (OCA) can be partially offset by an increase in operating current liabilities (OCL). • The supplementary (or delta) net investment in current operating assets (NIOCA) compared to the previous year’s investment can be determined: •
NPV formula – Cash flow calculation • The cash flows of each year (CFi) can be then determined as: • Where EBIT represents the operating profit before tax, usually determined as the difference between sales and operating expenditures (depreciation included), t – income tax rate • Depr – annual depreciation of fixed assets • - variation of the net investment in current operating assets. When sales increase they usually attract a higher investment in current assets, lowering the respective year’s cash flow
INITIAL EVALUATION USING NET PRESENT VALUE CRITERION (assuming 5 years of operations) – figures in Euros Measure 1. Investment in fixed assets 2. Net Investment in current assets
2017
2018
2019
2020
2021
2022
20,000 1,000
1,500
2,000
2,500
2,500
4. Operating revenues
78,000
85,800
90,090
94,594
99,324
5. Operating expenditures
73,200
81,984
86,083
91,247
96,722
6. EBIT
4,800
3,816
4,007
3,347
2,602
7. EBIT after tax = EBIT(1 – t)
4,032
3205
3,366
2,811
2,186
8. Depreciation
4000
4,000
4,000
4,000
4,000
9. Cash flow = “7” + “8” – NICA
7,032
6,705
6,866
6,311
6,186
10. Discounted OCF (discount rate 8.36%)
6,489
5,711
5,397
4,576
4,139
3. Total investment
20,000
NPV - calculation • Based on latter calculations we can now estimate NPV of the project, using the following data: • Initial investment = 20,000 Euros • Discount rate = Weighted average cost of capital = 8.36% • Residual value = 1,000 Euros (the disposal value of the food-truck in five years time) with a discounted value of 669 Euros • Discounted cash flows = 6,489; 5,711; 5,397; 4,576; 4,139 • NPV = 6,489 + 5,711 + 5,397 + 4,576 + 4,139 + 669 – 20,000 = 6,981 Euros • This amount represents estimated net earnings of the equity owners, respectively they recover their initial investment and obtain a 6,981 Euros real profit
Internal rate of return – another measure of investments’ efficiency • Sometimes it is easier to understand percentage expressed measures instead of absolute values measures such as Net Present Value. • This can be achieved using two measures, Internal rate of return and profitability index. • Internal rate of return (IRR) represents the internal specific profitability of any given investment project. Being expressed in percentage terms it can be easily compared to other relevant percentage measures, such as the cost of capital (the discount rate), inflation rate, interest rate for risk-free assets.
Internal rate of return - calculus • Internal rate of return (irr) can be determined if we can find that specific discount rate which makes equal the initial investment and the nominal project cash flows, resulting in an NPV equal to zero: • or • In our example, we can find this value using an Excel spreadsheet and the IRR financial function, respectively irr of our project is of 20.95%. • If we do not include the 1,000 Euro residual value of the truck, then the internal rate of return is of only 20%.
Internal rate of return - interpretation • The value of 20.95% for the internal rate of return can be compared with the cost of capital, of 8.36%. • The positive difference of 12.59% represents a safety margin for the equity investors, respectively a margin which allows the continuation of the project even if initial estimations are not confirmed (something deteriorates compared to initial forecasting – higher salaries, lower sales, higher interest rates, lower selling prices, stronger competitors and so on) • However, if we do not include the residual value in the calculus (of 1,000 Euros or 669 Euros in discounted values), the internal return rate decreases to 20% and leaves a 11.64% safety margin to continue the project.
Discounted Payback period • The discounted payback period represents the period of time in which the investors recover their initial investment via the cash flows generated by the project (in real or constant purchasing power terms). • The discounted payback period of a given investment helps investors decide whether to undertake the investment project, as they usually prefer shorter periods of recovering their capital. • The discounted payback period cannot represent the only tool of assessing the efficiency of an investment as there are investments which may take longer to recover yet they provide the biggest overall profits in excess of invested capital. • For our investment the calculus of discounted payback period reads:
Discounted payback - calculus and interpretation Measure
2017 20,000
Total investment Discounted cash flows Unrecovered investment 20,000 Discount payback period
2018
2019
2020
2021
2022
6,489
5,711
5,397
4,576
4,139
13,511
7,800
2,403
----------3 years and 192 days into the fourth year
We can notice that the initial investment of 20,000 Euros can be recovered in 3 years and approximately 6 months. This means that the remaining one year and six months will represent the period in which investors will make their real profits in excess of the initial investment
EX POST ANALYSIS – operating the investment. Three scenarios • We will perform our ex-post analysis of the investment under three scenarios, respectively the base one, the optimistic and the pessimistic (worst-case) one. • For each scenario we have presented the corresponding balance sheet and the profit and loss account, which will generate three types of measures: activity (efficiency), profitability and liquidity measures. • We will calculate the levels of the measures and interpret the results, with suggestions for improving the financial situation of the company.
BALANCE SHEET of the new small business, as of December 31-st, first year of operations, BASE SCENARIO ASSETS (in Euros) ITEM FIXED ASSETS (LAND, PROPERTY, EQUIPMENT) CURRENT ASSETS: INVENTORIES ACCOUNTS RECEIVABLES CASH TOTAL
VALUE
CAPITAL AND LIABILITIES (in Euros) ITEM VALUE 16,000 OWNER’s EQUITY
1,000 1,000 2,500 20,500
LONG TERM LOANS SALARIES AND SOCIAL CONTRIBUTIONS SUPPLIERS TAXES TOTAL
10,000 8,000 1,400 600 500 20,500
PROFIT AND LOSS ACCOUNT for the first year of operations, BASE SCENARIO ITEM
VALUE
SALES
78,000
OPERATING EXPENDITURES:
73,200
- SALARIES AND SOCIAL CONTRIBUTIONS
16,800 (1,400 X 12)
- MATERIAL EXPENDITURES
48,000 (4,000 X 12)
- LOCAL TAXES AND LICENSES - OTHER OPERATING EXPENSES
800 3,600 (300 x 12)
- DEPRECIATION
4,000
OPERATING PROFIT
4,800
INTEREST PAID GROSS PROFIT BEFORE TAX PROFIT TAX (16% OF THE GROSS PROFIT)
800 4,000 640
NET PROFIT AFTER TAX
3,360
Dividends paid to equity owner
1,360
Worst-case scenario • The salaries of two vendors increase to 800 Euros per month each due to recent labor-market regulations (an increase by 100 Euros per month, respectively by 14.28% compared to the base scenario) • Monthly sales amount to only 6,200 Euros (a decrease by 300 Euros per month, respectively by 4.61% compared to the base scenario) • The other financial conditions remain the same
BALANCE SHEET, as of December 31-st, first year of operations, WORST CASE SCENARIO ASSETS (in Euros) ITEM FIXED ASSETS (LAND, PROPERTY, EQUIPMENT) CURRENT ASSETS: INVENTORIES
VALUE 16,000
ACCOUNTS RECEIVABLES CASH TOTAL
1,000 900 18,650
750
CAPITAL AND LIABILITIES (in Euros) ITEM VALUE OWNER’s EQUITY 8,000 (10,000-2,000 net loss) LONG TERM LOANS 8,000 SALARIES AND SOCIAL 1,600 CONTRIBUTIONS SUPPLIERS 550 TAXES 500 TOTAL 18,650
PROFIT AND LOSS ACCOUNT for the first year of operations – WORST CASE SCENARIO ITEM SALES OPERATING EXPENDITURES:
VALUE 74,400 (6,200 x 12) 75,600
- SALARIES AND SOCIAL CONTRIBUTIONS
19,200 (1600 X 12)
- MATERIAL EXPENDITURES
48,000 (4,000 X 12)
- LOCAL TAXES AND LICENSES - OTHER OPERATING EXPENSES
800 3,600 (300 x 12)
- DEPRECIATION
4,000
OPERATING PROFIT
-1,200
INTEREST PAID GROSS PROFIT BEFORE TAX PROFIT TAX (16% OF THE GROSS PROFIT) NET PROFIT AFTER TAX
800 -2,000 0 -2,000
OPTIMISTIC SCENARIO • Monthly sales amount to 7,500 Euros per month (an increase by 1,000 Euros per month, respectively by 15.38% compared to the base scenario) • As a result, material expenditures will increase by the same rate,15.38% to 4,615 Euros per month • The other operating expenses will increase by only 10%, from 300 to 330 Euros per month • The salary expenses, as well as the other items will keep their initial levels
BALANCE SHEET, as of December 31-st, first year of operations, OPTIMISTIC SCENARIO ASSETS (in Euros) ITEM FIXED ASSETS (LAND, PROPERTY, EQUIPMENT) CURRENT ASSETS: INVENTORIES
VALUE 16,000
ACCOUNTS RECEIVABLES CASH TOTAL
2,000 3,500 24,000
2,500
CAPITAL AND LIABILITIES (in Euros) ITEM VALUE OWNER’s EQUITY 13,000 (10,000 + 3,000) LONG TERM LOANS SALARIES AND SOCIAL CONTRIBUTIONS SUPPLIERS TAXES TOTAL
8,000 1,400 1,100 500 24.000
PROFIT AND LOSS ACCOUNT for the first year of operations – OPTIMISTIC SCENARIO ITEM SALES
VALUE 90,000 (7,500 x 12)
OPERATING EXPENDITURES: - SALARIES AND SOCIAL CONTRIBUTIONS
16.800 (1400 X 12)
- MATERIAL EXPENDITURES
55,380 (4,615 X 12)
- LOCAL TAXES AND LICENSES - OTHER OPERATING EXPENSES
800 3,960 (330 x 12)
- DEPRECIATION
4,000
OPERATING PROFIT (EBIT)
9,060
INTEREST PAID
1.000
GROSS PROFIT BEFORE TAX (EBT)
8,060
PROFIT TAX (16% OF THE GROSS PROFIT)
1,289.6
NET PROFIT AFTER TAX
6770.4
Dividends paid to Owner
1,770
EX POST ANALYSIS – ACTIVITY ANALYSIS •• In this context we will analyze and interpret the levels of some activity (efficiency) ratios, respectively measures for assets (total, fixed and current assets) and labor productivity, under the three scenarios.
• 1. TOTAL ASSETS’ EFFICIENCY.
This measure has three forms of expressions, each with his meaning and use. • 1.A) Number of uses (NU) shows how many times the company manages to employ its assets during one year in order to generate its annual sales. • NU can be determined as: • For this measure, bigger means better, as the company manages to make a better use of its assets and put them to productive use more times during one year. It is equivalent to getting more sales with the same investment in total assets.
1.A. Number of uses – calculus and interpretation • a) Base scenario: • It means that under the base scenario the company manages to put to productive use its assets for 3.80 times during one year • b) Worst case (pessimistic) scenario: • c) Optimistic scenario:
1.A. Number of uses – calculus and interpretation • The value registered in the pessimistic scenario, (3.99 times) is higher than for the other scenarios (3.80 times, respectively 3.75 times), are an exception which is due to the decrease of company assets as a result of the losses registered in the worst-case scenario. • Normally a higher number of uses expresses a better situation (sales increase at a higher pace compared with total assets). • The exception (the number of uses in worst-case scenario being higher compared to the other scenarios) does not express a better situation (a higher efficiency). • This originates mainly from having much less cash (900 Euros) in the worst case scenario as compared to the base scenario (2,500 Euros) which generates a smaller level of total assets (and hence a higher number of uses, since total assets resides in the denominator of the ratio).
TOTAL ASSETS’ EFFICIENCY • 1.B. Sales at 1,000 Euros of Total Assets. This measures expresses the level of sales the company has when investing 1,000 Euros in total assets. • Obviously, the level of this measure should be higher than 1,000 (Sales should in excess of 1,000 Euros when investing 1,000 Euros in total assets). • Level for base scenario: • Level for worst-case scenario:
TOTAL ASSETS’ EFFICIENCY •• Optimistic scenario: • Apparently the best efficiency is obtained in the worst-case scenario, when the company registers sales worth of 3,989 Euros for 1,000 Euros invested in its assets. • There is a peculiarity in the results, where efficiency seems to be higher for the worst-case scenario as compared to the other scenarios. • However, this is due only to the fact that the company generates less cash in this situation (900 Euros against 2,500 Euros in the base scenario) and not because it has a better financial situation. This will be adjusted in the coming periods, when cash shortage in the worst-case scenario will impede investments and lower sales.
TOTAL ASSETS’ EFFICIENCY - Total assets at 1,000 Euros of Sales • 1.C. Total assets at 1,000 Euros of Sales • This measure (also known as capital intensity) is one of the most important measure for company performances, as it has a development which accurately describes the financial performance of the company. • As a general rule, the level of this measure should be located below 1,000, meaning the company needs an investment of less than 1,000 Euros to obtain sales worth of 1,000 Euros. • The increase in efficiency requires a lower level of this measure in the analyzed year as compared to the previous or the base year. For example, in 2017 the company needs 600 Euros invested in total assets as compared to 620 Euros, the level of this measure from 2016.
Total assets at 1,000 Euros of Sales – calculus and interpretation • a) Base scenario: • The company invests 262.82 Euros in total assets to generate 1,000 Euros of sales. It is a good performance, however we must keep in mind that this is not a capitalintensive business • b) Worst-case scenario: • The company invests 250.67 Euros in total assets to generate 1,000 Euros of sales, which would be a good performance, however it is not the case since it is due to a bad economic performance which produced losses and a low amount of cash.
Total assets at 1,000 Euros of Sales – calculus and interpretation • c) Optimistic scenario: • This represents indeed a good performance since it is accompanied by increased profits and higher cash on hand
EX POST ANALYSIS – CURRENT ASSETS’ EFFICIENCY • 2. CURRENT ASSETS’ EFFICIENCY.
Current assets are an important component of company investments, since they produce short-term consequences and they can significantly enhance or, on the contrary, deteriorate the financial position of the company.
• The efficiency of using current assets can be assessed via several measures, presented below.
• 2.A. Number of cycles (NC) shows how many times the company manages to put to use its current assets to generate its annual sales.
• The measure shows how many times the company manages to productively use (to generate sales and profits) its current assets during one year. The higher the level the better, since sales and profits associated with one cycle of using the current assets are relatively constant.
2.A. Number of cycles (NC): calculus and interpretation • a) Base scenario: • complete cycles • The company manages to use its current assets 17.33 times during one year (a complete cycle of the current assets means: cash-inventories-accounts receivable-cash). • b) Worst-case scenario: • complete cycles • In this scenario, the company has 28 complete cycles of using its current assets, however this is not due to an increase of sales which has overpassed the increase in current assets, buth rather to a decrease in current assets, due to a nonprofitable activity
2.A. Number of cycles (NC): calculus and interpretation • Optimistic scenario: • 11.25 complete cycles • Apparently, the situation is worse in this scenario compared to the other two scenarios, since the company manages to turn its current assets only 11.25 times. This is due to the limitations of this measure, which does not account for what happened to profit or cash flows of the company.
EX POST ANALYSIS – CURRENT ASSETS’ EFFICIENCY • 2.B. Number of operating cycles (NOC). This measure is even more important than number of complete cycles, since operating is the most important activity of any given company, which generates most sales and most profit. • Instead of absolute values for operating current assets we can also use, when possible, average values, or (initial + year-end values).5 • The higher the number the better the company is concerning the efficiency of its current operating assets.
2.B. Number of operating cycles (NOC). Calculus and interpretation •• Base scenario: • operating cycles
• Worst-case scenario: • operating cycles • Optimistic scenario: • 20 operating cycles • Even if a higher number is better (as sales and profit are relatively constant for one operating cycle), this measure has also limitations, as it does not account for profit or cash flows. • In our case, it would imply that the company does better in the worst-case scenario, as it runs more operating cycles. The problem is the company cannot cover its operating expenditures in this scenario, so more operating cycles means actually more losses.
CURRENT ASSETS’ EFFICIENCY • 2.C. Duration of an operating cycle (DOC) represents the period which is marked on one-side by the acquisition of raw materials and on the other side by cashing the sales from the clients (either on spot or on term for sales on credit).
• As it represents the period in which the company invests its financial resources in current assets, waiting for its production/services to convert into sales, cash and profits, it should be as short as possible. • Where Average (Inventories + Accounts receivable) is given by the simple average between the beginning of the year balance and the end of the year balance for the two categories of current assets.
Duration of the operating Calculus and interpretation
cycle
(DOC).
• For the base scenario: • 9.35 days (in this case we used absolute values instead of average since it was the first year of operations). The company takes 9.35 days to acquire its raw materials, produce and sell its products to its customers, respectively cash-in its sales on credit.
• For the worst-case scenario: • 8.58 days
• For the optimistic scenario: • 18.25 days • The situation appears as best for the worst-case scenario (the smallest number of days to complete an operating cycle), but we have to keep in mind that in this scenario the company registers losses for each cycle.
CURRENT ASSETS’ EFFICIENCY • 2.D. Inventory conversion period (ICP). Represents the period in which the company transforms its raw materials into products sold to its clients and it is also a short-term investment (the company invests money into inventories which, converted into final products, will generate sales and profits. It should be as short as possible (without compromising the quality of the final products). • 2.E. Accounts receivable conversion period (ARCP). Represents the period in which the company waits for cashing-in the invoices issued to its clients for the merchandise it sold to them on commercial credit. In the financial approach it represents the investment the company makes in some of its clients (which otherwise would not be able/would not be willing to buy company products) to secure higher sales and profits.
CURRENT ASSETS’ EFFICIENCY •• 2.F. Payables conversion period (PCP) represents the period for which the company finances its operating cycle using the commercial credit that its suppliers, employees and state budgets offer in the normal course of its business. • 2.G. Cash conversion cycle (CCC) is the most important component of the operating cycle and it expresses the period financed by the company with money from its owners (Equity capital, rewarded with dividends) or from financial creditors (rewarded with interest payments). As a result, companies try to minimize this period in an attempt to pay less for financing its operations (and as such improving its financial performances). • Cash conversion cycle = Duration of operating cycle – Payables conversion period
CURRENT ASSETS’ EFFICIENCY – operating cycle, calculus and interpretation • For the base scenario: • 4.68 days • It takes the company 4.68 days to buy raw materials, store them, produce and sell its products • 4.68 days • As the company sell its products to institutional clients as well, which pay after some time from buying the products, it has an average collection period of 4.68 days. • Cash conversion cycle (CCC) = 9.35 days – 11.7 days = -2.35 days. The company does not need to find external financing sources from its owners or from financial creditors (such as banks) in each operating cycle. The high level of operating current liabilities and the specifics of the business (selling mostly on spot, against cash) allow the company to avoid external costly financing.
CURRENT ASSETS’ EFFICIENCY – operating cycle, calculus and interpretation • For the worst-case scenario: • 3.68 days • It takes the company 8.58 days to buy raw materials, store them, produce and sell its products • 4.91 days • As the company sell its products to institutional clients as well, which pay after some time from buying the products, it has an average collection period of 7.35 days • 13 days • CCC = 8.59 days – 13 days = - 4.41 days. • Apparently, the company is in a very good situation, since it does not need external sources to finance its operating cycle. However, in this case this actually represents a considerable operational risk, as it finances entirely in the short term its operating activity and it registers operating loss in each cycle.
CURRENT ASSETS’ EFFICIENCY – operating cycle, calculus and interpretation •• For the optimistic scenario: • 10.14 days • It takes the company 10.14 days to buy raw materials, store them, produce and sell its products • 8.11 days • As the company sell its products to institutional clients as well, which pay after some time from buying the products, it has an average collection period of 8.11 days • 12.16 days • CCC = 18.25 days – 12.16 days = 6.09 days. • The company needs to find external financing sources from its owners or from financial creditors (such as banks) for 6.09 days in each operating cycle. For these sources the company will have to pay compensations as dividends or interest.
EX POST ANALYSIS – ACTIVITY ANALYSIS • 3. LABOUR PRODUCTIVITY is one of the most important measures of company efficiency, which directly or indirectly influences the levels of other performance measures. • Labor productivity (Lp) can be calculated as annual and hourly, according to the expression of the working time (Wt) consumed in order to generate the annual income (sales turnover – ST -, operating revenues – OR - and other forms of useful effects, such as value added – VA - or profit – PR): • For example, the annual labor productivity (Alp) can be obtained if we divide the annual sales turnover (ST) by the average number of employees used by the company: •
ACTIVITY ANALYSIS – Labor productivity • • • • •
The hourly labor productivity (Hlp) can be calculated: , Where - average number of employees for the year; - average number of days worked by one employee during that year; - average number of hours worked by one employee during a day.
• For the hourly labor productivity the correlation should be followed with average hourly salary (or salary expenditures): • Index of Hourly labor productivity > Index of Hourly salary • To check this correlation for our small business we would need data from two (consecutive) years.
EX POST ANALYSIS – LABOR PRODUCTIVITY • In order to have a positive contribution to efficiency and performances, any company should observe the following correlation: • Index of labor productivity > Index of average salary expenses. • For example, if salaries increase by 10%, then labor productivity should increase by more than that (by 12%, for example). If the company observes this correlation, then unit cost of its products can decrease and competitiveness increases (for our company it could lower the cost of one sandwich by 5%, increasing either unit profit margin or sales volume if we correspondingly lower the price based on that reduction in unit cost). • If the company does not observe this correlation, then its competitiveness will decrease, with a negative impact upon profit and especially upon self-financing capacity (which influences new investments and company development prospects).
EX-POST ANALYSIS - PROFITABILITY • Activity analysis or efficiency analysis is very useful for company management and it can provide many perspectives for increased efficiency and making better use of company assets. • However, they have an important limitation, they usually do not include the expenditure part and hence the profit in the analysis. • Profitability can be analyzed from two perspectives: in absolute terms and as ratios. • Profitability in absolute terms compares useful effects (such as operating revenues or sales) to corresponding expenditures (such as operating expenditures or current operational expenditures) thereby generating measures such operating profit, current operational profit, profit before tax or net profit.
EX-POST ANALYSIS – PROFITABILITY in absolute terms • 1.A. Operating profit, also found as Earnings before interest and tax (EBIT) is one of the most important forms of profit, as it represent the profit before taxes generated by the main activity of any company (operating activity). It is calculated as: • EBIT = Sales – Operating expenditures (depreciation included) • It is meant to support commitments such as interest, profit tax, dividends, self-financing capacity (especially development investments) and installment payments for existing loans • 1.B. Potential operating cash flow, also known as Earnings before depreciation, interest and tax (EBDIT or EBITDA) is a form of cash flow, however determined before addressing commitments such as the investment in current assets and profit tax. Compared to EBIT, it is also the source of replacement investments (and of course for development investments, just as EBIT). It is calculated as: • EBDIT = EBIT + Depreciation and amortization
EX-POST terms
ANALYSIS
–
PROFITABILITY
in
absolute
• 1.C. Profit before tax (also found as Earnings before tax – EBT) is actually a sum between the gross operating profit (or EBIT) and the financial result (FR, the difference between Financial revenues and financial expenditures, such as interest payments and fees): • EBT = EBIT + FR • EBT is the base for calculating profit tax and determining the net profit after tax, which can be effectively used by the company. • 1.D. Net profit after tax is the ultimate interest of equity owners, since it is the object of their decision to appropriate it as dividends or to reinvest it (mostly for development investments). • The distribution of net profit as dividends or reinvestment is very important for future sustainability of dividends as well as for the company (a company which currently distributes too many dividends will not only compromise its potential to do the same in the future, but its own existence).
PROFITABILITY in absolute terms – calculus and interpretation • Base scenario: • EBIT = 4,800 Euros • EBDIT = 4,800 + 4,000 = 8,800 Euros • EBT = 4,000 Euros • Net profit = 3,360 Euros, of which 1,360 Euros distributed as dividends and 2,000 Euros allocated as installment payments for the five years, 10,000 Euros loan • Worst-case scenario: • EBIT = -1,200 Euros • EBDIT = 2,800 Euros • EBT = -2,000 Euros • NET PROFIT AFTER TAX = -2,000 Euros. • This means company cannot pay dividends, cannot pay installment for the loan. Moreover, the Owner Equity position in the Balance sheet is diminished with the amount of net loss, from 10,000 Euros to 8,000 Euros
PROFITABILITY in absolute terms – calculus and interpretation • Optimistic scenario: • EBIT = 9,060 Euros • EBDIT = 13,060 Euros • EBT = 8,060 Euros • NET PROFIT AFTER TAX = 6770.4 Euros, allocated as Dividends 1,770 Euros, 2,000 Euros for installment payments for the loan and 3,000 Euros for reinvestment (increase of Equity Owner). • This is obviously the best situation for the company as it allows covering all current financial commitments, paying interest and installment for the loans, as well as putting money aside for future investments and development
PROFITABILITY RATIOS • The profitability margins presented before represent an important landmark in the ex-post analysis of a company activity. • However, they take into consideration only one type of resource consumption used for the generation of useful effects (the different types of expenditures, operating, financial and other types). • In order to get a more clear picture about the overall company efficiency it is necessary to compare the different types of profit with diferent types of assets and capital sources which were invested to create the profit. • This comparison allows more types of benchmarking, such as the one against inflation rate, economic growth rate, interest rate, cost of equity and others percentage expressed landmarks. • There are several types of profitability ratios, respectively return on assets, return on equity and return on invested capital.
PROFITABILITY RATIOS – RETURN ON ASSETS • Return on Assets (ROA) describes the most synthetic form of efficiency in using company assets. It is actually an economic indicator, as it compares operating profit (before or after tax) and total assets, the economic means at the disposal of the company. • ROA should be higher than interest rate in order to generate a bonus value for equity-holders (when using debt in financing company assets). • Also, ROA should be higher than the average cost of total assets in order to provide the company a surplus which can be used for future growth and new investments.
RETURN ON ASSETS – calculus and interpretation • Base scenario: • = 23.41% • Obviously ROA is higher than interest rate and average cost of total assets, which allows the company to continue its development and generate a surplus for equity owners
• Worst-case scenario: • = -6.43% • As EBIT is negative in this scenario, it also determines a negative ROA, which is obviously a bad performance. The economic and financial perspectives of the company are not good.
RETURN ON ASSETS – calculus and interpretation • Optimistic scenario: • = 37.75% • The economic performance of the company is very good in this case, as the generous value of EBIT allows covering all financial commitments (interest, installment payments and dividends) and offers co-financing capacity for new investments.
PROFITABILITY RATIOS – RETURN ON EQUITY • Return on Equity (ROE) expresses the percentage compensation of equity owners, respectively the ratio between net profit after tax and equity from the balance sheet. • • ROE is predominantly a financial measure and in this capacity can be compared to cost of equity (seen otherwise as a minimum required level of ROE), to interest rate and to ROA. • When ROE is higher than cost of equity the company manages to ensure a surplus for equity owners compared to what they require and usually generates an increase in company value. • When ROE is higher than ROA it also usually generates an increase in company value, as equity owners, the residual owners of the company, which assume most risks, are better rewarded compared to the other investors (mostly financial creditors), which assume lower risks.
RETURN ON EQUITY – calculus and interpretation • Base scenario: • = 33.6% • We can notice that ROE is higher than interest rate (8%) and also higher than ROA in this case (of 23.41%), which means equity owners are properly compensated for their investment, according to the level of risk they assume • Worst-case scenario: • = -25% • The situation is quite bad in this scenario for equity owners since they do not only receive no compensation whatsoever for the capital they invested, but they see their capital diminished with the amount of the net loss incurred by the company (they assume most of the risks and support the prejudice).
RETURN ON EQUITY – calculus and interpretation • Optimistic scenario: • = 52.08% • This value of ROE is very good and ensures that ROE is significantly higher than the cost of equity, interest rate or any other relevant financial landmark. • In this situation, the value of the company will most likely increase as it offers confidence for existing and prospective equity owners that the company offers a proper compensation for invested capital.
EX POST ANALYSIS – LIQUIDITY ANALYSIS • Liquidity represent another important feature of company’s financial analysis and a complement to efficiency and profitability. • A liquid company expresses an efficient activity, with a good financial management, especially in what concerns current assets’ management (inventories, accounts receivable and cash). • A proper acquisition policy, quality inventories, a good production process, dedicated and motivated employees and an efficient commercial credit policy are all prerequisites for company liquidity and solvency. • Liquidity measure a company's ability to pay its current financial obligations (operating and non-operating) and its margin of safety in case of financial distress. • There are several forms of liquidity, expressed either in absolute values or as a ratios.
EX POST ANALYSIS – LIQUIDITY ANALYSIS • Liquidity in absolute values is represented mainly by net current assets, or the difference between current assets and current liabilities. • Net current assets (Working capital) = Current assets – Current liabilities • If positive, this difference allows the company to overcome some difficult periods, when clients delay their payment or other unexpected unfavorable situations may occur. • Other types of absolute values liquidity include operating cash flow, operational cash flow and free-cash flow to equity. • Liquidity ratios include among others, current liquidity ratio and quick ratio.
LIQUIDITY ANALYSIS – liquidity ratios • • This ratio should have a value above one, which would mean that the company has enough assets to cover its short-term obligations as they come due. • There are two limitations in the analysis of this current ratio. • The first limitation refers to having a too high value. For example, if the ratio has a value equal to 3, this could mean an over-investment in current assets (a miss-placement of valuable investment resources, which normally should be directed toward fixed-assets productivity investments). • The second limitation, valid especially for new businesses refers to the quality of current assets (inventories and accounts receivable). The company may have a level of current assets above one, yet the situation may be unsatisfactory due to a lower quality of inventories, of accounts receivable or of both.
LIQUIDITY ANALYSIS – liquidity ratios • • The level of this ratio should be at least 0.5, with levels close to 1 being generally considered as more reassuring. • The level of this ratio should be at least 0.2, with levels above 0.5 being generally considered as more reassuring. • • The solvency ratio indicates whether a company’s cash flow is sufficient to meet its short-term and long-term liabilities. The lower a company's solvency ratio, the greater the probability that it will default on its debt obligations.
LIQUIDITY ANALYSIS – calculus and interpretation • Base scenario: • Working capital = Current assets – Current liabilities = 4,500 – 2,500 = +2,000 Euros • Current ratio = Current assets/Current liabilities = 4,500/2,500 = 1.8 • Both working capital and current ratio express the same thing, a very good level of current liquidity • The level of the acid-test ratio is very good, almost too high for this measure, of 1.4
LIQUIDITY ANALYSIS – interpretation, base scenario
calculus
and
• = 2,500/2,500 = 1 • The situation is quite good for the company, it can settle all current liabilities based on cash reserves, without even making appeal to future cash (inventories + A/R). • = 0.70. • If using all cash flow of the year, the company can cover 70% of all its total debt, or it would take 1/0.7 = 1.42 years to cover all debt using this year’s cash flow
LIQUIDITY ANALYSIS – calculus and interpretation • Worst-case scenario: • Working capital = Current assets – Current liabilities = 2,650 – 2,650 = 0 • Current ratio = Current assets/ Current liabilities = 4,500/2,500 = 1 • Both working capital and current ratio apparently express an acceptable level of current liquidity. However, correlated with the operating loss it does not show a favorable financial position • The level of the acid-test ratio (0.71) is not bad, yet we have to correlate this with the operating loss of the scenario
LIQUIDITY ANALYSIS – calculus interpretation, worst-case scenario
and
• = 900/2,650 = 0.34 • Even if the level of cash ratio is not very high, the situation would not be so bad for the company if only it would register operating and total net profit. • = 0.1877
• If using all cash flow of the year, the company can cover only 18.77% of all its total debt, or it would take 1/0.1877 = 5.32 years to cover all debt using this year’s cash flow. The result is not very good for the company
LIQUIDITY ANALYSIS – calculus and interpretation • Optimistic scenario: • Working capital = Current assets – Current liabilities = 8,000 – 3,000 = +5,000 Euros • Current ratio = Current assets/ Current liabilities = 8,000/3,000 = 2.67 • Both working capital and current ratio present the same picture, a very high level of current liquidity, close to over-investing (keeping too much capital invested in current assets instead of using it for long-term productive development investments) • The level of the acid-test ratio is quite high (1.83), reflects a very low insolvency risk, however close to expressing an over-investing in current assets
LIQUIDITY ANALYSIS – calculus interpretation, optimistic scenario
and
• = 3,500/3,000 = 1.16 • The situation very good for the company, it can settle all current liabilities based on cash reserves, without even making appeal to future cash (inventories + A/R). However, keeping too much cash on hand, not-invested in more productive assets can induce significant opportunity costs for the company • = 0.97. • If using all cash flow of the year, the company can cover 97% of all its total debt, or it would take about one year to cover all debt using this year’s cash flow. The situation reflects a very good financial position of the company.
LIQUIDITY ANALYSIS – Cash flow • Cash flow is a financial measure which is much more instrumental for the financial management compared to accounting profit, as it represents actual money the company can use to cover its financial commitments (salaries, taxes, suppliers, utilities) as they come due. • According to the daily succession of these commitments, the company can plan the use of its financial resources as to avoid payment and liquidity problems. • For the periods in which the level of cumulated financial commitments is higher than the level of existing cash balances the company can make appeal to short-term banking loans or to net working capital originating from the shareholders. • The main forms of the cash flow are operating cash flow, operational cash flow, free cash flow to equity.
LIQUIDITY ANALYSIS – Cash flow • Operating cash flow (OCF) is the result of the operating activity, the main activity for any kind of company. It is the counterpart of the operating profit after taxes (EBIAT) and it is very important as it represents the main source for: • - replacement investments (the investments the company makes to replace its productive fixed assets when they become physically or morally fully used and preferably fully depreciated). • - payment of interest expenses for the loans contracted from the banks and other financial institutions; • - payment of dividends toward shareholders for their investment; • - development investments (the investments the company makes to develop and extend its operations and increase the sales volume); • - paying the installments connected with previously contracted loans; • - other destinations, such as creating the source for financial investments.
Operating cash flow - definition •• OCF = EBIT(1 – t) + D,A - , • Where: • EBIT – operating profit before interest and taxes (calculated as Sales minus Operating expenditures); • t – income tax rate; • D,A – depreciation for tangible fixed assets (D) and amortization for intangible fixed assets (A); • – the variation of the net investment in current assets, calculated as difference between current year’s and previous year’s net investment in current operating assets (the net investment in current operating assets is the difference between inventories plus account receivables and the outstanding debt toward employees, suppliers, state budgets, utility providers); • Usually an increase in volume of sales generates an increase in the level of this investment and hence (given the minus sign) temporarily decreases operating cash flow, whereas a decrease in sales diminishes the investment in net operating current assets and has a positive impact upon operating cash flow (it increases it).
Operational cash flow - COCF •• Operational cash flow (COCF) differs from operating cash flow (OCF) as it also includes the cash flow from financial activity (financial revenues and financial expenditures). • It is the counterpart of the Profit (Loss) from Continuing Operations after tax of the accounting perspective. • Usually it has a lower level compared to operating cash flow, since most of the companies do not have a positive financial result (they have higher financial expenditures compared to financial revenues). • Where: • FR – financial revenues (receipts originating from various financial assets); • FE – financial expenditures (mostly interest payments from outstanding loans contracted with financial creditors) • t – income tax rate.
Free cash flow to equity - FCFE • Free cash flow to equity (FCFE) expresses the amount of funds which are at the disposal of shareholders (equity owners), after the main economic and financial commitments of the company (such as investing in current assets, compensating the financial creditors and investing in fixed assets) have been covered. • FCFE can be directed toward dividend payments toward shareholders, reimbursing outstanding loans (or contracting new ones), transfers to or from shareholders (returning them equity contributions or receiving new contributions) and self-financing capacity (mainly for financial investments, since the other investments have been covered by operating cash flow). • FCFE = COCF – Investment in fixed assets + Net transfers with Shareholders (SH) + Net transfers with Financial Creditors (FCr) = OCF + Financial Cash Flow – Investment in fixed assets + Net SH transfers + Net FCr transfers • Net transfers with SH = New SH contributions – Returning contribution to SH • Net transfer with FCr = New Loans from FCr - Reimbursements of outstanding loans to FCr
Cash flow – calculus and interpretation. Base scenario • 1. Operating cash flow (OCF) • OCF = 4800(1 – 0,16) + 4000 – (2000 – 2500) – 0 = 4032 + 4000 + 500 = 8,532 Euros • The level of operating cash flow is quite significant, however 4,000 of the 8,532 Euros are represented by depreciation, whose main destination is creating a fund to replace the main fixed assets when they become fully used/depreciated. • The company may temporarily use depreciation funds for other purposes, even for development investments (provided that it replenishes the depreciation fund from future higher profits or from new funds from shareholders). • The other component of the OCF (and especially the net operating profit, in amount of 4,032 Euros) is meant to repay the investors (shareholders with dividends and financial creditors with interest and installment payments) and to secure future company development via new investments.
Cash flow – calculus and interpretation. Base scenario • 2. Operational cash flow (COCF) • COCF = OCF + (FR – FE)(1 – t) = 8,532 + (0 – 800)(1 – 0.16) = 7,860 Euros • The amount can be used to settle capital transfers with shareholders and financial creditors, to cover dividend payments toward shareholders and to make financial investments (if there remains an excess amount over the payment of dividends). • 3. Free cash flow to equity (FCFE) • FCFE = COCF - Investment in fixed assets + Capital transfers with SH + Capital transfers with FCr (reimbursement of one installment payment for the 10,000 Euros loan) = • = 7,860 – 0 – 2,000 = 5,860 Euros • It is a good performance of the company since shareholders are left with 5,860 Euros, meant for dividends (1,360 Euros) and cash increase/future financial investments (4,500 Euros). However, 4,000 Euros of these money originate from depreciation and the company did not make any new investments.
Cash flow – calculus and interpretation. Worst-case scenario • 1. Operating cash flow (OCF) • OCF = -1,200 + 4000 – [(1750 – 2650) – 0] = 2,800 + 900 = 3,700 Euros • The level of OCF may seem acceptable at first look, but when we acknowledge that 4000 Euros (out of 3700 Euros!) originate from depreciation we can appreciate that the situation is quite bad. Also, here is an apparent bonus from the net investment in current assets, which is negative (of – 900 Euros) so it increases the operating cash flow. In this situation this is not a favorable situation since financing that much from current operating liabilities can increase bankruptcy risks when sales are not at a corresponding level. • The company can pay interest and installments keeping to existing loans (out of depreciation, whose asset replacement fund will be compromised), but no dividends and obviously no development investments.
Cash flow – calculus and interpretation. Worst case scenario •• 2. Operational cash flow (COCF) • 3,700 – 800 = 2,900 Euros
• This amount is obviously not satisfactory since from it the company has to cover installment payments in amount of 2,000 Euros. Also, in this case the company cannot make use of the interest tax shield, since there is no profit, and bears the entire burden of the interest payments, of 800 Euros • 3. Free cash flow to equity (FCFE) • FCFE = COCF + Capital transfers with SH + Capital transfers with FCr = 2,900 – 2,000 = 900 Euros • Situation may appear as acceptable, yet is not the case, sine this positive amount of 900 Euros comes from the use of depreciation amount, of 4,000 Euros, to cover the pressing financial commitments (interest, installment payments and others alike). • When the company will need to replace its fixed assets it will find that there are no funds available for this purpose and the waste of shareholders’ wealth will be more visible (beside the fact it offers no dividends for them).
Cash flow – calculus and interpretation. Optimistic scenario • 1. Operating cash flow (OCF) • OCF = 9,060(1 – 0,16) + 4000 – [(4,500 – 3,000) – 0] = 7,610 + 4000 + -1,500 = 10,110 Euros • The result is impressive, however compared with the base scenario, it is only about 1,500 Euros higher. This is due to higher investment in current assets (when sales increase, the company has to invest more in inventories and account receivables to support this increase). • 2. Operational cash flow (COCF) • COCF = OCF + (FR – FE)(1 – t) = 10,110 + (0 – 1,000)(1 – 0.16) = 9,270 Euros • The amount seems to be enough to settle capital transfers with shareholders and financial creditors, to cover dividend payments toward shareholders and to make financial investments.
Cash flow – calculus and interpretation. Optimistic scenario • 3. Free cash flow to equity (FCFE) • FCFE = COCF – Net investments in Fixed assets + Capital transfers with SH + Capital transfers with FCr (reimbursement of one installment payment for the 10,000 Euros loan) = • = 9,270 – 0 – 2,000 = 7,270 Euros • It is a good performance of the company since shareholders are left with 7,270 Euros, meant for dividends (1,770 Euros) and cash increase/future financial investments (5,500 Euros). • However, as for all the other scenarios, we have to take into account that the company did not spend any money on replacement/development investments. It means that 4,000 Euros of these funds account for the depreciation/amortization and have a reserved future use. • The company (its shareholders more precisely) is left actually with 1,500 Euros after dividends and replacement/investment fund are allocated.
EX-POST ANALYSIS. RELATIONSHIP
VOLUME-COST
• Whenever possible, it is very useful to employ a more analytical tool, respectively the volume-cost analysis, which allows more precise actions to ensure reaching the sales and profit targets. • To apply this analysis for our small business we will use table 2 below. • One of the main points of interests of this analysis is to determine the break-even point (BEP), in two forms, respectively physical (the number of units sold) and sales (Euros amount of sales) which ensure covering all company costs, fixed and variable. • The Break-even point is an important tool to manage operational risks, as by comparing the actual volume of sales with the volume of sales pertaining to the BEP (actually a safety margin) the company may take preventive actions to keep this safety margin positive.
Break-even point • The break-even point is very important in configuring the production and commercial policy and strategy of any company. • After a company reaches the break-even point it is more easy to devise future selling, discount and commercial credit policies. • We analyze the break-even point in two cases, respectively treating salaries as a variable cost (in the first case) and approaching them as a fixed cost (in the second case).
Break-even point • As a variable cost, salaries will move in a correlated way with the volume of sales (increase when sales increase, respectively decreasing to a certain level when sales decrease, which could be seen as granting bonuses when sales increase and not granting them when sales are at a lower level). • As a fixed cost, salaries will not depend upon the evolution of the volume of sales (even when sales increase or decrease, the salaries will remain the same). In this case, the company may encounter problems when the volume of sales decreases significantly and the variable cost margin (the difference between sales and variable costs) will not be any longer able to cover the fixed costs.
Break even point • The physical BEP (number of units to be sold to cover all costs) can be calculated as: • For example, if physical BEP is 1,000 it means the company should produce and sell 1,000 units to cover all its costs and start making profits • The value BEP (The level of sales turnover which cover all costs) can be determined as: • For example if Sales BEP is 10,000 Euros, the company sales turnover should be of this amount to cover all costs and start making profits
Break-even point • We will analyze the break-even point (BEP) in four scenarios. • The first scenario includes salaries as a variable cost, which presents some benefits for the company (the workforce will be hired progressively, as the volume of sales increase and also salaries will be somehow correlated with the volume of sales – as the volume of sales increase the company may also offer a bonus for the employees). In this scenario the BEP will have a lower level, and the company will find it easier to start making profits. • The second scenario includes salaries as a fixed cost. • As such, the two employees will be hired since the start of company activity and they will receive pretty much the same salary for the entire period, without any variation due to modifications in the volume of sales. In this case, the BEP will have a higher level (the company will register profits at a higher level of sales).
Break-even point. Third scenario – granting discount in the scenario with salaries as a variable cost • The third scenario presents the situation in which the company offers discounts to support the increase of quantity sold after a certain threshold (17,000 units sold when treating salaries as a variable cost). • This action decreases the unit margin or preserves it compared to the situation when company sold a lesser number of units. • There is a limit for the amount of discount the company can offer to its clients to support the growth of sales. If the discount is too big it can affect the selffinancing capacity of the company for the new investments needed to further support the increase in the volume of sales.
Break-even point. Fourth scenario – granting discount in the scenario with salaries as a fixed cost • The scenario with salaries as a fixed cost is more restrictive, since in this situation the Break-even point is taking place at a higher volume of sales (the company has a bigger amount of fixed costs to be covered from the variable cost margin – the difference between price and variable costs). • In this fourth scenario, the company will start offer discounts starting with 18,000 units. Below this value, the company cannot grant discounts since it would register operating losses.
Break-even point. First scenario – salaries as variable cost (1) Production volume
(2) Fixed costs
(3) Variable costs
(4) Total costs (2) +(3)
(5) AFC (2) : (1)
(6) AVC (3) : (1)
(7) ATC (5) +(6)
(8) Unit Selling price
(9) Unit profit margin (8) – (7)
(10) Total profit (1) X (9)
9,500
4,800
33,323
38,123
0.5053
3.5077
4.01
4
-0.01
-95
9,600
4,800
33,674
38,474
0.5
3.5077
4.0
4
0
0
12,000
4,800
42,092
46,892
0.4
3.5077
3.9077
4
0.0923
1,107
13,000
4,800
45,600
50,400
0.3692
3.5077
3.8769
4
0.1231
1,600
14,000
4,800
49,108
53,908
0.3429
3.5077
3.8506
4
0.1494
2092
15,000
4,800
52,615
57,415
0.32
3.5077
3.8277
4
0.1723
2,585
16,000
4,800
56,123
60,923
0.3
3.5077
3.8077
4
0.1923
3,077
17,000
4,800
59,630
64,430
0.2824
3.5077
3.7901
4
0.2099
3,568
18,000
4,800
63,139
67,939
0.2667
3.5077
3.7744
4
0.2256
4,061
19,500
4,800
68,400
73,200
0.2462
3.5077
3.7539
4
0.2461
4,799
Break-even point. First scenario, salaries as variable cost • From previous table we can notice that our company has a physical BEP of 9,600 units, respectively a sales BEP of 38,474 Euros. • That means the company should sell at least 9,600 units, respectively to have sales of at least 38,474 Euros. • Reaching the BEP points allows the company to more easily configure its further activity, respectively to offer discounts and sales on credit to further increase its sales and profits. • Obviously, offering discounts helps the company (and its clients) to sell more to its existing clients or to a wider variety of clients. • However, granting too much discount can be counter-productive for the company as it may impair its future self-financing capacity (co-financing capacity of its expansion investments). • It is one thing to offer a 5 to 10% discount to boost sales, but a very different thing to offer a 20% discount (even if sales increase, total profits and future self-financing capacity may decrease).
Break-even point. Second scenario – salaries as a fixed cost (1) Production volume
(2) Fixed costs
(3) Variable costs
(4) Total costs (2) +(3)
(5) AFC (2) : (1)
(6) AVC (3) : (1)
(7) ATC (5) +(6)
(8) Unit Selling price
(9) Unit profit margin (8) – (7)
(10) Total profit (1) X (9)
9,500
21,600
25,175
46,775
2.27
2.65
4.92
4
-0.92
-8,740
9,600
21,600
25,440
47,040
2.25
2.65
4.90
4
-0.90
-8,640
12,000
21,600
31,800
53,400
1.8
2.65
4.45
4
-0.45
-5,400
13,000
21,600
34,450
56,050
1.66
2.65
4.31
4
-0.31
-4,030
14,000
21,600
37,100
58,700
1.54
2.65
4.19
4
-0.19
-2,660
15,000
21,600
39,750
61,350
1.44
2.65
4.09
4
-0.09
-1,350
16,000
21,600
42,400
64,000
1.35
2.65
4
4
0
0
17,000
21,600
45,050
66,650
1.27
2.65
3.92
4
0.08
1,360
18,000
21,600
47,700
69,300
1.2
2.65
3.85
4
0.15
2,700
19,500
21,600
51,600
73,200
1.11
2.65
3.76
4
0.24
4,680
Break-even point. Second scenario – salaries as a fixed cost, interpretation • We can notice that in this case, BEP is set at a much higher level (of 16,000 units needed to be sold, respectively to sales worth of 64,000 Euros), as the company has to cover, from its variable cost margin (the difference between Sales turnover and total variable cost) a much higher level of total fixed costs (21,600 Euros instead of 4,800 Euros in the first case). • However, total profit is almost the same for the two cases (salaries included as variable costs, respectively as fixed costs), of 4,799 Euros as compared to 4,680 Euros.
Break-even point. Second scenario – salaries as a fixed cost, interpretation • The difference resides in the risks associated with the two cases. In the first case (salaries as a variable cost), the risks are much lower, since profit starts almost from the beginning of the estimations (as soon as 9,600 units sold). • In the second case (salaries treated as a fixed cost), the risks are much more present, since profit is registered only at sales in excess of 16,000 units. • The second case seems more realistic however (employees are payed probably the same amount of salary, without too much variations as to the level of sales), which means the business faces a significant amount of risks, which should be managed within a coherent strategy.
Break-even point. Third (salaries as variable cost)
scenario,
granting
discounts
(1) Production volume
(2) Fixed costs
(3) Variable costs
(4) Total costs (2) +(3)
(5) AFC (2) : (1)
(6) AVC (3) : (1)
(7) ATC (5) +(6)
(8) Unit Selling price
(9) Unit profit margin (8) – (7)
(10) Total profit (1) X (9)
9,500
4,800
33,323
38,123
0.5053
3.5077
4.01
4
-0.01
-95
9,600
4,800
33,674
38,474
0.5
3.5077
4.0
4
0
0
12,000
4,800
42,092
46,892
0.4
3.5077
3.9077
4
0.0923
1,107
13,000
4,800
45,600
50,400
0.3692
3.5077
3.8769
4
0.1231
1,600
14,000
4,800
49,108
53,908
0.3429
3.5077
3.8506
4
0.1494
2092
15,000
4,800
52,615
57,415
0.32
3.5077
3.8277
4
0.1723
2,585
16,000
4,800
56,123
60,923
0.3
3.5077
3.8077
4
0.1923
3,077
17,000
4,800
59,630
64,430
0.2824
3.5077
3.7901
0.1299
2,208
18,000
4,800
63,139
67,939
0.2667
3.5077
3.7744
0.1456
2,621
19,500
4,800
68,400
73,200
0.2462
3.5077
3.7539
3.92 (2% discount) 3.92 (2% discount) 3.88 (3% discount)
0.1261
2,459
Break-even point. Third discounts (salaries as interpretation
scenario, variable
granting cost) -
• When considering salaries as a variable cost, the BEP happens at a lower point of sales (at 9,600 units sold), which creates the possibility for the company to offer some discounts to encourage sales beyond a certain point. • In our example, the company offers a 2% discount at 17,000 units sold. However, this will decrease the unit profit margin to 0.1299 Euros (as compared to 0.2099 in the previous situation, when it did not offer discounts) and total profit to 2,208 Euros (as compared to 3,568 Euros when it did not offer discounts). • Further, when sales increase to 19,500 units the company can consider granting a 3% discount to further support sales growth and stabilize its client portfolio. However, this will lower unit profit margin to 0.1261 Euros and total profit to 2,459 Euros.
Break-even point. Fourth scenario, discounts (salaries as a fixed cost)
granting
(1) Production volume
(2) Fixed costs
(3) Variable costs
(4) Total costs (2) +(3)
(5) AFC (2) : (1)
(6) AVC (3) : (1)
(7) ATC (5) +(6)
(8) Unit Selling price
(10) Total profit (1) X (9)
9,500 9,600 12,000 13,000 14,000 15,000 16,000 17,000 18,000
21,600 21,600 21,600 21,600 21,600 21,600 21,600 21,600 21,600
25,175 25,440 31,800 34,450 37,100 39,750 42,400 45,050 47,700
46,775 47,040 53,400 56,050 58,700 61,350 64,000 66,650 69,300
2.27 2.25 1.8 1.66 1.54 1.44 1.35 1.27 1.2
2.65 2.65 2.65 2.65 2.65 2.65 2.65 2.65 2.65
4.92 4.90 4.45 4.31 4.19 4.09 4 3.92 3.85
-0.92 -0.90 -0.45 -0.31 -0.19 -0.09 0 0.08 0.07
-8,740 -8,640 -5,400 -4,030 -2,660 -1,350 0 1,360 1,260
19,500
21,600
51,600
73,200
1.11
2.65
3.76
4 4 4 4 4 4 4 4 3.92 (2% discount) 3.88 (3% discount)
(9) Unit profit margin (8) – (7)
0.12
2,340
Break-even point. Fourth scenario, granting discounts (salaries as a fixed cost) - interpretation • In this scenario, as the Break-even point of sales happens at a high level, of 16,000 units, the company offers a discount of 2% of its selling price of 4 Euros only at 18,000 units. • However, this action lowers unit profit margin to 7 Eurocents and total profit to 1,260 Euros. • At 19,500 units sold, this scenario allows for a 3% discount and generates a 0.12 Euros unit margin and a 2,340 Euros total profit. • In this scenario, as salaries are a fixed cost and they also contribute to the operational leverage effect, it is probably more recommended to offer discount and get higher sales. • That happens since after overcoming the BEP of 16,000 units sold, the company will enjoy a sharper increase in profits compared to the other scenario, where salaries