Financial Statement Analysis and Security Valuation

Lecture 1
 Content of the course
o Financial accounting and financial statements
o Mainly for external purposes… but financial accounting information is also used within
companies!
o Not so much bookkeeping (technical accounting)
o First emphasis on analysis and interpretation of financial figures: IFRS, US GAAP and Non-
GAAP
o Second emphasis on how to use financial data to value firms
o Financial reporting and valuation in a global and strategic context
o Close link with practice and business press
 Course Map

o
 Companies under investigation
Comparing companies in same industries
 BMW + mercedes: comparable in
sales + asset size
 Pernod Ricard + Diageo: similar in
strategy + high valuation multiple
 Ryanair + SAS: best vs worst
performing airlines

Financial Information: Demand & Supply

 Demand for financial information by:
o Shareholders
o Investment analysts
o Lenders and bondholders (solvency)
o Employees
o Customers, suppliers and other partners (e.g., joint-ventures)
o Regulators and tax authorities

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Supply of financial information for reasons of: supply is partially regulated

o Compliance with public market regulation

o Benefits of disclosure:
 Lower cost of equity
 Lower cost of debt
o Disclosing information also involves costs:
 Preparation and dissemination
 Competitive disadvantages
o P.e. Heineken in ’90: market opened for beverages. Big profits. Competitors step in P.E.
Carlsbourg -> textbook example proprietary cost of information: be careful with what kind
of information you provide

Balance Sheet: The Accounting Equation


 Example: Mercedes’ Balance Sheet (2021 – mln EUR)
Accounts receivable: credit
period to clients: very high ->
not strange for car
manufacturers.
For car manufacturers It
makes sense to have a high (>
1/3 balance sheet) accounts receivable
o Suppose we do not know its Mercedes: conclusion: these guys are nuts. If 10% of their
clients are not able tot pay: 9 billion loss -> wipes out everything
o Financial statement analyses does not start by calculating ratios, but by looking at the
numbers

Income Statement
 An income statement reports on operating activities.
 It lists amounts for sales (and revenues) less all expenses (and costs) over a period of time.
 Sales less expenses yield the “bottom-line” net income amount.

2
 Mercedes’ Income Statement

o
o Is net income of Mercedes high or low?

Equity Statement
 The statement of stockholders’ equity reports on changes in the book value of equity and its
components.
 Its two main components are:
o Contributed capital (from stock issuances)
o Earned capital (retained earnings or reserves built up from previous periods)
 Example: Mercedes’ equity statement:

Cash Flow Statement

 The statement of cash flows reports on cash flows for operating, investing, and financing
activities over the FY.
 Example: Mercedes’ cash flow statement:


 Simple questions...
o Which measures would be indicative of firm size?
o What companies are you going to use as a peer group? What is industry?
 …often hard to answer
 …often require FS information

The Balance Sheet: Assets

 To be reported on a balance sheet, an asset must
o be owned (or controlled) by the company
o possess expected future economic benefits

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 Assets are listed in order of liquidity
o Current assets comprise assets that can be converted or are expected to be converted to
cash within a year.
 Cash and Cash Equivalents—currency, bank deposits, and investments with an original
maturity of 90 days or less.
 Marketable securities—short-term investments that can be quickly sold to raise cash,
typically with a maturity between 3 and 12 months.
 Accounts receivable, net—amounts due to the company from customers arising from
the sale of products and services on credit;
 Inventories—goods purchased or produced for sale to customers, including raw
materials and work-in-progress.
 Prepaid expenses—costs paid in advance for rent, insurance, advertising or other
services.
o Long-term assets cannot easily be, or are not expected to be, converted into cash within a
year.
 Property, plant and equipment (PPE), net—land, factory buildings, warehouses, office
buildings, machinery, motor vehicles, office equipment and other items used in
operating activities (“net” refers to subtraction of accumulated depreciation).
 Leased assets— all leased assets must be shown on the balance sheet.
 Intangible and other assets—assets without physical substance, such as patents,
trademarks, franchise rights and other costs the company incurred that provide future
benefits.
 Goodwill— the premium on top of the book value paid in acquisition activities.
 Long-term investments—investments (usually in equity and bonds) which are not
intended to be sold within a year.
 Apple’s Assets (2021)

o
 Cisco’s Assets (2021)

4
 o

 SAS’s Assets

o
 Ryanair’s Assets

5
 o
 Pernod Ricard’s Assets (2021)

o
 Diageo’s Assets (2021)

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Asset Recognition
 In general, assets are reported on the balance sheet under the principle of historical cost, also
referred to as ‘amortized cost’.
 Historical cost accounting means you are recording the value of the asset at the historical cost
price.
 Historical cost accounting is prevailing because it is:
o Objective
o Verifiable
o Predictable
 There is an important alternative: Fair value accounting
 Only include items that can be reliably measured.
o Considerable amount of “economic assets” may not be reflected on a balance sheet.
o Examples include a strong management team, attractiveness for new employees, a well-
designed supply chain, or superior technology.

 Disney’s Assets (2018)

o
 LVMH’s intangibles

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

Equity and Liabilities

 Other side of the balance sheet = equity + liabilities
 Equity consists of:
o Contributed Capital (cash raised from the issuance of shares with current and new
shareholders)
o Earned Capital (retained earnings or capital reserves built up from prior fiscal periods).
o Retained Earnings is updated each period as follows:


o Which company has the highest book equity in the world?

Liabilities
 Long-term (or Non-current) Liabilities:
o Long-term debt—borrowings from creditors to be repaid more than one year from now,
including bank loans, bonds, and other loans.
o Operating long-term liabilities—Obligations, such as accounts payable, pensions and
provisions, that are expected to be settled a year or more from now.
 Short-term (or Current) Liabilities :
o Accounts payable—amounts owed to suppliers for purchases on credit.
o Accrued liabilities—obligations for expenses that have been incurred but not yet paid;
examples are wages payable, interest payable, tax payable.
o Unearned revenues—obligations created when the company accepts payment in advance
for goods or services it will deliver in the future.
o Short-term debt—short-term debt to banks or other creditors.
o Current maturities of long-term debt—principal portion of long-term debt that is due to be
paid within one year.

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 Apple’s Liabilities and Equity

o
 Apple’s Income statement
 Homework: Why has Apple’s equity not increased despite record profits?

o
 Mercedes’ Liabilities and Equity

9
 o
 Net Working Capital – Operating Cycle
o Net working capital= current assets – current liabilities

Lecture 2
Income Statement

Important: distinction between product expenses

(direct and indirect production costs, overhead,…)
and period expenses (securities building, cleaning)
(not reported before car is sold (product expenses
are))
S, G & A in lecture 5.
EBIT= operating profit
 Apple’s Income Statement: 2010-2012

10
 o
 Format of apples income statement changes over time
 Apple’s Income Statement: 2013-2015

o
 Apple’s Income Statement: 2016-2018

 Apple’s Income Statement: 2019-2021

Income
statement
often
referred to as
P&L but not
the correct
term.

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 In 2010: apple not a big company in term of sales. Now: 365 billion dollar revenues
Change in structure: until 2018 no distinction between products (iphone, ipad,..) and
services (apple music, cloud).

o Is service business of apple profitable? Cost only 20 billion so there is a huge margin (68-20).
o Is apple an innovative company? Yes
o Do we invest lot of investment in R&D? obviously, but its only 5/10% of sales (same as an
average company) -> so they do not spend a lot of money, they spend it wisely
o S, G&A expenses: selling, general and administrative: 6/7%: not a lot. There aren’t a lot of
commercials for the company, but it’s still on the news if a new product launches
 Cisco’s Income Statement (2021)
Differences
between apple
and cisco’s
income
statements.
Cisco not nearly
as big as apple
Does cisco have
a big gross
margin? Yes,
giant. Way
better than
average
company in
economy. However does it mean its highly profitable? It is highly profitable, but not nearly
as big as 60% gross margin

o R&B en S, G & A are quite big in cisco: R&D+- 13%, S, G & A is divided in 2 parts. Unrelated to
product or service: when business goes down: stuck with it.
o 2 things: probably not a lot of debt +

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 Mercedes’ Income Statement (2021)

o
o Difference between these and the tech companies? Cost of sales are way larger, makes
sense: need to spend a lot of money before you can crunch out a car. Means that not
profitable? Are profitable, but not as much as tech companies
o Difference between Mercedes and BMW? Very much alike. Mercedes a little bigger than
BMW. 1 giant difference: R&D for Mercedes 5.4 billion. For BMW: no R&D -> BMW doesn’t
spend money on R&D? yes it does, included in other items: -> can we compare gross
margins? No we cannot: in BMW R&D subtracted, not in Mercedes
o BMW & Mercedes quite similar in cost structure.
 BMW’s Income Statement (2021)

o
 Income statement of Pernod Ricard versus Diageo (2021)
o Pernod Ricard

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 o Diageo


o Exercise at home. Look at sales: don’t use 19 153, but 12.7 billion (net sales).Make sure you
look at net sales
o Difference: accijnzen (taxes on alcohol). Pernod Ricard does not show them
o Not cost of goods manufactured, but costs of goods sold
 When are Revenues and Expenses Recognized?
o Net income does not necessarily correspond to a net cash flow. A firm could have “good
income” but “poor cash flow” or vice versa (i.e., there are two dimensions to consider).
o Earnings often differ from cash flows as they go back to the fundamental economics of what
defines what a company ‘earns’?
o Revenue Recognition Principle—revenues are recognized when they are earned, not –
necessarily – when the cash inflow occurs
o Matching Principle—recognize expenses when the companies incurs them.
o We did not see cash inflows vs cash outflows
o As soon as contract signed: even though he has not payed. Until payment where do we find
differential amount? Account receivable. (are accruals)
o 2 underpinning principles accrual accounting: see slides. Revenue Recognition Principle,
Matching Principle (match expenses with sales)
 The Principles of Accrual Accounting
1. The recognition of revenues when they are economically earned
 even if they have not yet been received in cash or
 even if they have already been received in cash
2. The matching of expenses
 when the revenues are recognized, in case there is an economic link with them
 when the expenses are incurred, in absence of such a link.
 the cash outflow of the cost is irrelevant for its recognition.
o In inventories until cars sold
 VW’s issue in 2015…
o EPS vs operating cash/ cash per share: earnings are a result of accrual accounting: tell you
much more about what is going on in a company.
o Alternative accrual accounting: cash accounting: what’s profit? Difference between income
and outcome is cash. How simple it would be to do accounting on this base? Easier. Do one
thing: print bank statements. 2 colums income and outcome. Hopefully in end of week
positive difference. Would we need auditors? Of course not. Why does corporate world
spend billions? Accrual checks economic responsibility
o Fraud case Volkswagen. Rigged their emission software, said they polluted less than they
did. Huge fraud. When scandal broke out (October 2015). Look at income statement next
page

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15
 VW’s income statement of 2015
Stock price of VW
dropped with
35% after fraud.
One of the
biggest drops.
Expect to see
crisis in 2015
numbers? Yes.
Can you spot
trouble? Not
quite a crisis in
sales/ gross
profit. In EBIT it’s noticeable. VW has a 4 billion loss on operations. Other operating
expenses are big.
Other operating expenses: no clue what it’s about -> check out what’s going on if high. See
foot note next page
 VW’s Footnote 6
Nothing to do
with litigation
expenses. None
of items except
for one at
bottom =
miscellaneous
(=other)
operating
expenses.
Number is highly negative because of 7 billion provision (= nicest example of accrual)
o Negative news included in stock price? Yes
o Also see crisis in earnings? Definitely
 VW’s Cash Flow Statement 2015
o

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o Operating cash flow is important -> went up. Even tough VW has operating loss and stock
price drop. -> why we need accrual accounting (focus on earnings instead of cash flows) ->
cash flow does not tell what’s going on

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 VW’s Cash Flow Statement 2017
In 2017
operating
cash flow
highly
negative:
change in
provision
of 9
million
(already
accounted for in 2015 (accrual))

Earnings better predictor of future cash flows than current cash flows (capture information
immediately)

Equity Statement
 Statement of Equity is a reconciliation of the beginning and ending balances of stockholders’
equity accounts.
 Main equity categories are:
o Contributed capital
o Retained earnings or reserves
 Other equity categories may include:
o Preference shares
o Share premiums
o Other comprehensive income
 Terminology differences:

Book value of equity at

time t: BVEt= BVEt-1 + Nit
–DIVt

 Apple’s Statement of Stockholders’ Equity (2021)

107 147= end 2018,
90 488 beginning
2019
Because of stock
repurchases for
billion of dollars,
Why firms
repurchase stock
rather dan

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 dividends? Dividends are expected to be sort of repeated. Repurchase stock makes a better
price.
Stock repurchases very much same as dividends.
Stock issuance: expansion equity: be aware of dilution.
How to expand equity? Issuing stock or repurchasing stock (equity decrease) BVEt= BVEt-1 +
Nit –DIVt + stock issuance – stock repurchase
o Accumulated other comprehensive income: difference in book value last year and this year

o Blue: stock repurchases

o Pink: dividends
o Dividends are less volatile.
o Stock repurchases are more volatile.

 Apple’s Comprehensive Income (2021)

o
o Change in foreign currency translation , net of tax = number 1
suppose your BMW and selling all over world. Some point in time US client who buys BMW
for 50 000 dollars. As soon as client signed contract: recognized as revenues; first translate
into euros. At that time 1 dollar = ,9 euros -> amount of recognized revenues 45 000 euros.
Suppose he pays in time 2: client pays 50 000 dollars. Suppose that currency rate between
dollar and euros has changed and 1 dollar = 1 euro and there is no hedging: cashes 50 000
euros in. historically 45 000 recognized: gain of 5 000 which you need to take in account.
Increase revenues? You cannot do that: 5 000 is not going to be visible in income statement.
Not captured in net income but creates a shock in equity -> other comprehensive income.
Suppose dollar depreciated: negatively in OCI (other comprehensive income)
o Other comprehensive income is rare.
o Change in unrealized gains/losses on derivate instruments net of tax = number 2
o Still facing potential losses (not realized yet)
o Change in unrealized gains/losses on marketable debt securities, net of tax = number 3

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Comprehensive Income Statement
 Comprehensive income equals net income (bottom of the income statement) plus other
comprehensive income.
 Other comprehensive income (OCI) contains changes (gains or losses) in the value of the equity
which are not captured in net income.

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 There are 4 main sources of OCI:
1. foreign currency translation adjustments
2. unrealized gains and losses on hedging derivatives
3. unrealized gains and losses on available-for-sale financial securities
4. unrealized gains/losses on postretirement benefit plans
 Put differently, comprehensive income consists of all of the revenues, gains, expenses, and losses
that create a shock to the value of the equity of the firm.
 unrealized gains/losses on postretirement benefit plans -> save for pensions employees: put
them in funds; funds go up and down -> in pernod Ricard you can see this on top of the slides
 Pernod Ricard’s Comprehensive Income (2021)

Cash Flow Statement

 The cash flow statement reports on cash inflows and outflows during the fiscal period
 Cash flows are reported based on the three business activities of a company:
o Cash flows from operating activities - Cash flows from the company’s transactions and
events that relate to its operations.
o Cash flows from investing activities - Cash flows from acquisitions and divestitures of
investments and long-term assets.
o Cash flows from financing activities - Cash flows from issuances of and payments toward
borrowings and equity.
o Problematic one
o 3 parts: operating, investing and financing
o Operating cashflow statement BMW: what would be in there? Whatever BMW cashes in
minus what it cashes out. No. -> see next slide
 Apple’s Cash Flow Statement (Pt. 1)

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 o EXAMEN What is item on top cashflow statement? Net income. Starts where income
statement ends. Bit silly: what was message before break? Accrual accounting is important.
o Cashflow statement: start with net income and go back to cashflow (start in civilization
(accrual accounting) and go back to stone hedge (we remove accruals))
o Cashflow statement is by far the messiest one. Least easy to interpret: think the other way
around; get rid of accrual accounting. Cashflow statements asks to do the opposite of what
you’ve been taught in accounting
o Cashflow statement apple: starts with net income, add back depreciation and amortization
(non cash expense), minus changes in working capital
o Accounts for changes in operating assets and liabilities: changes in working capital
o Changes in working capital: delta INV + delta AccRec – delta AccPay
o Share – based compensation expense: gives employees shares
o Increase in credit to clients: subtract increase from earnings to operating cashflow
o If you reconcile earnings with cashflow: take in account changes in inventories
o Apple is expanding (invest in inventories) expect changes in working capital to be positive
o Seeing positive things in cashflow statements is not perse positive
 Apple’s Cash Flow Statement (Pt. 2)

o
o Investing cash flow: 14,5 billion: economic Interpretation: completely ridiculous number:
doesn’t tell you anything about what’s going on in underlying economics
o Look at cash generated by investing activities. First 3 is cash management: to do with
banking part of apple -> do not take into account
o Items 4&5 everything to do with apples operations
o Mix of core and cash business (2 different things)
o Stock repurchases: cahs outflow apple: can absorb door positive cashflow of operations
o Which financial statement info about stock repurchases? Equity and cashflow statement
o Apples income statement quite transparent

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 Pernod Ricard’s Cash Flow Statement
Need to
understand as
much as possible
Not very clean
and clear
Much difference
between firms for
cashflow
statements
o Tax?
o Interests?
Apple does not
touch upon in
cashflow
statement; they
ignore it: they
don’t have much interest expenses; to do with financing of operations
Pernod Ricard: financial expenses is added back: makes sense? Yes, has not directly to do
with operations
o Positive change in impairment of goodwill, property, plant,.. but bad news because assets
are written of
o Decrease in working capital requirement. They don’t show you disaggregated accounts
receivable and payable as apple does.
o Tax items: absent for apple but visible for Pernod Ricard. 2 tax items on there: tax expense
and taxes paid. Taxes paid seems pretty much same as tax expense. Why tax expense added
back to net income? Is tax expense of current period (not payed yet) but of course they have
negatively affect net income.
Pay taxes on income previous period
o Self-financing capacity before financing interest and taxes: net income + taxes + interest +
depreciation/ ammortazition -> = EBITDA
 Diageo’s Cash Flow Statement
Pernod’s competitor
Messy financial statement
Similarities? Yes
Cash generated from operations
and net cash inflow from
operating activities
Figure out what true operating
cashflow is:
Interest received + interest paid:
sum 308 -> add back to ultimate
cashflow

23
24
 LVMH’s Cash Flow Statement
Cash from
operations before
changes in
working capital:
EBITDA
Where does LVMH
start cashflow
statement with?
Operating income
(previous ones
with net income)
(interest etc are already added back)

Cash Flow Statement

 Cash Flows Statement – Indirect Method

o
 Working Capital Accounts

o
 Relation of CF Statement to Income Statement and Balance Sheet

25
26
 Cash Flow Statement: Exercise 1
o Petroni Company reports the following selected results for its current calendar year:
 Net Income 130
 Depreciation expense 25
 Accounts receivable increase 10
 Accounts payable increase 6
 Prepaid expenses decrease 3
 Wages payable decrease 4
 Stock issuance 1
o What is Petroni’s Operating Cash Flow?
o EXAMEN
o Operating cash flow?
o Prepaid expense is an asset: treat it like inventories and accounts receivable
o Net income + depreciation/amortization – change in working capital
o Net income= 130, Depreciation/ amortization= 25, Change in working capital = change in
accounts receivable + change in inventories – change in accounts payable= 10 + 3 – 6
o 130 + 25 -10 + 6 + 3 - 4
o We do not take stock inssuance into account
 Cash Flow Statement: Exercise 2
o Leonidas Company reports the following selected results for its current calendar year:
 Net Income 260
 Depreciation expense 40
 Inventory increase 6
 Payment for PPE 10
 Tax payable increase 14
 Unearned revenue decrease 8
 Purchase of marketable securities30
o What is the operating cash flow of Leonidas?
o 260 + 40 - 6 + 14 - 8 + 0 = 300
o Payment PPE and purchase of marketable securities not into account
 Exercises on Lectures 1 and 2 see Toledo!!
 Nokia: A History…
o Nokia was in many industries
o Missed boat on smartphones but managed to reinvent business once again

o
o Merged with alcatel (another struggling company)

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 Income Statement of Nokia (2007)
Year before iPhone was
launched: was in great
shape; increasing sales.
Nokia got in trouble very
quickly; went almost out of
business, tried to reinvent
themselves

 Income Statement of Nokia (2018)

o
o Look at bottom half of income statement: has to do with discontinued operations.
o Companies who are doing well do not restructure
 Cash Flow Statement of Nokia (2018)
o

o Cash flow statement: negative cash on operations; then positive -> hard to analyse for
struggling companies

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29
 Income Statement of Nokia (2013)
IMPORTANT
Focus on sales
number that Nokia
realized in 2012:
15 400. in next
slide income
statement of
previous slide:
sales number is
way higher (30
176).
What explains
difference sales
number 2013 and
2012; Nokia was
reinventing
business
2013 Nokia put
part of business on sale; as soon as you put part of division on sale: take out of number and
put into discontinued operations

o 15,4 is completely fictive: what Nokia would have realized if cell phone business has already
be taken out
o Not just cell phone business which is in trouble; other one also. Comparability rule makes it
different.
 Income Statement of Nokia (2012)

o
 Sale to Microsoft (2013-2014)

30
 o
 Income statement on discontinued operations
o

31
Lecture 3
1. Profitability Analysis
o LVMH
o Bekaert
o Mercedes
2. Corporate Cash Holdings
3. Profitability Analysis: Comparison of Diageo and Pernod Ricard

 Financial Statement Analysis: 3 Pillars

o Profitability: LT and ST
o Solvency: LT
o Liquidity: ST
o More profitable firms, less liquidity issues, but not a 1/1 relation
 Disaggregation of ROE

o
o Important slide
o Nonoperating return: to do with financing operations (management)
o RNOA: return on net operating assets
o Purple: liquidity ratios (receivables turnover,…)
 Return on Equity
Not scale with last year or
this year equity, but with
an average of last year
and this year
If you scale with this years
only: a part of the
numbers is common

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 Operating Return: RNOA
o RNOA = Return on Net Operating Assets
Net Operating Profit after Tax ( NOPAT )
o RNOA =
Average Net Operating Assets(NOA)
o The income statement reflects operating activities through revenues, costs of goods sold
(COGS), R&D and selling, general and administrative expenses (SG&A).
o The balance sheet contains both operating assets and liabilities, as well as nonoperating
items.
o Cash is assumed to be NON-operating!
o Cash and cash equivalents consider as non-operating. Some firms soms cash to support
operations? Yes, but research shows that most of the cash is not there to support
operations, but is a result of operations. -> is an assumption, but a logical one
 Operating Items in the Income Statement

o
o All items above ebit operating items
o Interest expenses to do with how you finance operations, not with operations itselves.
 LVMH’s Income Statement

o
o Profit before Tax = 7,972 – 608 = 7,364
o Not most recent figures
o Don’t learn this by heart, understand!
o Start with EBIT
o Anything occurs above item is operating
o Anything below line, check whether is not operating.
o 608 non operating expense

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o Nopat: operating profit after tx: number firm would have realized if it was fully financed with
equity.
o Taxes need to be taken into account!

34
 Tax Shield
o Tax on operating profit = Tax expense that we would have, in absence of nonoperating
expense and revenue items
o Tax on operating profit = Tax expense + (Pretax nonoperating expenses x Statutory tax rate)
o Pretax nonoperating expenses x Statutory tax rate= tax shield
o NOPAT calculation for LVMH: NOPAT = 7,972 – [2,409 + (608 x 0.30)], NOPAT = 5,380.6
o Calculate implicit tax amount. That we would have to pay in case not 7364 but 7972 was tax
income
o If you have less tax deductible expenses. Pay more or less tax? More taxes because taxable
basis is higher
o Why don’t we just deduct 30% of 7972? Almost get the same number, but assume all EBIT is
subject to taxes but is not always the case.
 Operating Assets and Liabilities
o Operating assets include:
 Receivables
 Inventories
 Intangible assets
 Goodwill
 Property, plant and equipment (PPE)
 Lease assets
o Operating assets exclude:
 Cash (and cash equivalents)
 Short-term and long-term investments
 Other financial assets and investments
o Operating liabilities = All liabilities EXCEPT:
 Long-term Debt
 Short-term Debt
 Lease liabilities (!)
o Net Operating Assets (NOA) = Operating Assets minus Operating Liabilities
o What is main non-operating item on balance sheet? Cash and cash equivalents: need to be
taken out.
o Don’t learn by heart. Just think. What are operating liabilities? Credit form suppliers;
accounts payable. What does it mean to have accounts payable? Free credit from suppliers;
suppliers finance your business.
Net operating assets: what you
need to invest in operations.
Right of use assets: leasing
Investments in joint ventures
and associates: operating
(investments by itselves not
operating)
Cash take out of operating asset
calculation

35
 o
o Substract all of operating liabilities.
o Accounts payable: leverancierskrediet

 NOA for LVMH  RNOA of LVMH

o NOA = Operating Assets – Operating o RNOA = NOPAT / Av. NOA
Liabilities o RNOA = 5,380.6 / 67,208.5 = 8.01%
o Operating Assets (2020) = 87,969 o Interpretation of the RNOA?
o Operating Liabilities (2020) = 21,320 o Clean measure of operating
o NOA (2020) = 87,969 – 21,320 = 66,649 profitability
o We usually consider average NOA o What would ROE be if LVMH would
o NOA (2019) = 89,919 – 22,151 = 67,768 be fully financed with equity?
o NOA (av.) = 67,208.5
o Why we have gone through all the trouble for this 8%? Only number in which everything to
do with operations is included and financing operations is excluded -> pure figure showing
how profitable the company is on his business.
o ROE if fully finances with equity? 8.01%!!
 Bekaert Income Statement (2021)

RNOA= NOPAT/NOA
Where to start? Operating profit before tax
(EBIT) 513 086
Need EBIT after tax: tax amount minus tax
shield.

36
 Bekaert Assets

o
o Balance sheet: cash is non operating! Check cash amount
 Bekaert Liabilities and Equity

o
 RNOA and ROE of Bekaert (2021)
o RNOA = NOPAT/av. NOA = 370,703 / 2,340,135 = 15.84%
o Operating Profit (EBIT) = 513,086
 Tax expense = 133,296
 Nonoperating expense = 36,790 = (44,480 - 3,260 - 4,430)
 Statutory Tax Rate = 24.7%
o Operating Tax = 142,383 = [133,296 + (0.247 x 36,790)]
o NOPAT = 370,703
o Operating Assets (2021) = 4,084,625 (4,843,756 - 1,803 - 677,270 - 80,058)
o Operating Liabilities (2021) = 1,551,909 (77,659 + 23,311 + 844 + 51,979 + 1,062,185 +
177,159 + 4,392 + 86,131 + 68,249)
o NOA (2021) = 2,532,716
o NOA (2020) = 2,147,553
 Av. NOA = 2,340,135
o ROE = Net profit / Av. Equity = 343,000 / 1,817,789 = 18.87%
o Operating assets look at balance sheet
o 80,058 short term deposits

37
 o Operating liabilities deduct from operating assets
o Trying to get to the economic number for a company to make It work.
o 15,84% only number to compare how profitable Beckaert is
o ROE is shareholder return. Difference between ROE en RNOA has to do with financing of
operations. Show whether they efficiently used debt? They used it efficiently, but not to a
large extent.
 Disaggregation of RNOA

o
o NOPM: sales is scalor (divided by sales). Only uses items from income statement
o NOAT: ‘turnover’: sales is numerator
 Net Operating Profit Margin (NOPM)
o Net operating profit margin (NOPM) reveals how much operating profit the company earns
from each sales dollar/euro.
o NOPM is affected by (among others):
 Industry type
 Degree of competition
 Extent to which customers want to pay a premium
 Cost efficiency – economies of scale
o For LVMH (2020):
 NOPM = NOPAT / Revenues
 NOPM = 5,380.6 / 44,651 = 12.05%
o This result means that for each 100 euro of sales at LVMH, the company earns 12.1 euro of
profit after all operating expenses and tax.
o For Bekaert (2021): NOPM = 370,703 / 4,839,659 = 7.66%
 Net Operating Asset Turnover (NOAT)
o Net operating asset turnover (NOAT) measures the productivity of the company’s net
operating assets.
o NOAT measures efficiency of operating asset use.
o This metric reveals the level of sales the company realizes from each euro/dollar invested in
the firm’s operating assets.
o All things equal, a higher NOAT is preferable.
o For LVMH (2020):
 NOAT = Revenues / NOA
 NOAT = 44,651 / 67,208.5 = 0.66
o This result means that for each euro invested in net operating assets, LVMH realizes 66 euro
cents in sales.
o For Bekaert (2021): NOAT = 4,839,659/2,340,135 = 2.07
 Shows efficiency/ productivity. Shows for every 100 euros invested in firm how much
sales company had been able to realize for investment.
 Industry Comparison of NOPM and NOAT
o Profitability position of LVMH looks like:
 RNOA = 8%
 NOPM = 12%

38
  NOAT = 0.66
o What is your advice to the firm under these scenarios?
o Scenario 1  Luxury industry looks like:
 Industry RNOA = 8%
 Industry NOPM = 10%
 Industry NOAT = 0.80
o Scenario 2  Luxury industry looks like:
 Industry RNOA = 8%
 Industry NOPM = 25%
 Industry NOAT = 0.32
o Makes sense to further divide RNOA? Yes, but only if you compare business in same
industry.
o Doesn’t make sense to compare profit margin Apple and BMW and asset turnover in both
companies.
o Scenario 1 and 2 have the same RNOA so you wouldn’t be able to give much advise on
industry
o Scenario 1: LVMH better on margin part, less good on activities part. Advise: not to work on
margin but work on asset turnover (productivity asset use)
o Scenario 2: average profit margin 25% and asset turnover of ,32. Better in productivity but
worse in profit margin. Need to improve profit margin.
o Take a look at supermarket business: carrefour vs Aldi. Calculate RNOA companies is almost
same. But disaggregation you see vast differences. Aldi: cheap: not able to get high margin
NOPM is much lower. Carrefour had lot of trouble to attract people: invest more in shops to
generate sales: NOAT is worse.
o Suppose you don’t know strategy and high profit margin and lower asset turnover: likely
company like carrefour, LVMH; goes to a lot of trouble to sell to someone.
o H&M clearly work on high asset turnover because high profit margin is not possible
 Return on Equity

o
 Simple Example:

1. Base situation: no debt 2. We take on 500 of debt against cost of 7%

 Equity = 1000  Equity = 1000
 RNOA = 20%  RNOA = 20%
 Profit = 200 (no taxes)  Profit = 300 (20% of 1500) – 35 (7% of 500) = 265
 ROE = 200/1000= 20%  ROE = 265/1000 = 26.5%
 ROE = RNOA + [FLEV x SPREAD] = 20%  ROE = RNOA + [FLEV x SPREAD]
+ 0 = 20%  ROE = 20% +
 FLEV = Debt/Equity
 SPREAD = RNOA – Cost of Debt

39
 o FLEV= financial leverage: extent to which you have debt over equity.
o SPREAD: RNOA(20%) minus cost of debt (7%)
o Suppose debt= 1 000, interest expense is 7%; what we now have: invested 2000. RNOA of
400 (20%2000) net income of 330. ROE is 330/1000=33% further managed to increase
return for shareholders (20 to 33% (financial leverage*SPREAD))
o Principle of Modligiami and miller.
 Nonoperating Return
Very important slide!!
NNO: not quite debt but sounds a little like debt
Equity: on balance sheet
Cash considered as negative debt.
ROE before or after tax? After
Nopat before or after tax? AT= after tax
-> you need after tax on right side. Operating
expenses are before taxes. So we are going to
net them from taxes.

 LVMH’s Income Statement

o
o 608 is non operating expense (gross amount), but we need net amount.

o
 Nonoperating Liabilities (2020) = 48,522

40
o
 Nonoperating Assets (2020) = 20,702
o Nonoperating Return of LVMH (2020)
 ROE = 4,955 / 38,597 = 0.12837 = 12.84%
 RNOA = 8.01%
 NNO (2020) = 48,522-20,702 = 27,820, NNO (2019) = 35,991-6,588 = 29,403
 Av. NNO = 28,611.5
 Av. Equity = 38,597
 NNE = 425.6= (1 - tax rate) x Nonoperating Expense = (1 - 0.30) x (608) = (NOPAT - Net
Income) = (5,380.6 – 4,955)
 ROE = 0.08006 + 28,611.5/38,597x (0.08006 – 425.6/28,611.5)
 ROE = 0.08006 + (0.7413 x 0.0518) = 0.1284 = 12.84%
 CHECK!! -> ROE = 4,955 / 38,597 = 12.84%
 Non-operating expense was before tax.
 Has used debt efficiently because he was able to lever (lift up) return on equity
 Sufficient enough debt for high spread to increase return from 8 to 12,84%
o Nonoperating Return of Bekaert (2021)
 ROE = 343,000 / 1,817,789 = 18.87%
 RNOA = 15.84% (see before for details)
 NNO (2021) = 432,142, NNO (2020) = 612,498
 Av. NNO = 522,320
 Av. Equity = 1,817,789
 NNE = 27,703 = (1 - tax rate) x (Nonoperating Expense) = (1 - 0.247) x (36,790) = (NOPAT
- Net Income) = (370,703 – 343,000)
 ROE = 0.1584 + 522,320/1,817,789x (0.1584 – 27,703/522,320)
 ROE = 0.1584 + 0.03027 = 0.1887
 CHECK!! -> ROE = 343,000 / 1,817,789 = 18.87%
 Conclusion: Leverage effect fails to kick in because of low FLEV. Roe is still high, because
of a high RNOA. Bekaert seems to offset operational risk with lower financial risk.
 AT HOME: 2 potential reasons: does not use a lot of debt OR company uses lot of
debt but had high cost of debt so spread is high
 Cost of debt is actually quite low for Bekaert
 High operational risk firms will not take on a lot of financial risk
o BMW’s RNOA and ROE (2016)
 RNOA = NOPAT/av. NOA = 7,022.27 / 122,969 = 5.71%
 Operating Profit = 9,827 (9,386 + 441)
 Tax expense = 2,755
 Nonoperating expense = 162
 Statutory Tax Rate = 30.7%

41
  Operating Tax = 2,755 + (0.307 x 162)
 NOPAT = 7,022.27
 Operating Assets (2016) = 170,325 (188,535 – 7,880 – 7,065 – 2,705 – 560)
 Operating Liabilities (2016) = 43,441 (4,587 + 5,039 + 2,795 + 5,357 + 5,879 +
1,074 + 8,512 + 10,198)
 NOA (2016) = 126,884
 NOA (2015) = 119,054
 Av. NOA = 122,969
 ROE = Net profit / Av. Equity = 6,910 / 45,063.5 = 15.33%
o BMW’s Nonoperating Return (2016)
 RNOA = 0.057106
 NNO (2015) = 42,326 + 55,405 – 7,880 – 7,065 – 2,705 – 560 = 79,521, NNO (2015) =
76,290
 Av. NNO = 77,905.5
 Av. Equity = 45,063.5
 NNE = 112,27 = (NOPAT - Net Income) = (1 - tax rate) x Nonoperating Expense
 = (1 - 0.307) x (489 - 131 - 196)
 ROE = 0.057106 + 77,905.5/45,063.5 x (0.057106 – 112.27/77,905.5)
 ROE = 0.057106 + 0.09623 = 0.1533 = 15.33%
 ROE = 6,910 / 45,063.5 = 0.1533 = 15.33%
 Conclusion? Very big leverage effect for BMW because of high debt level (FLEV) as well
as high SPREAD.
o ROE Disaggregation – Cisco (2017)
 NOPAT = 11,973 – (2,678 + (-314) x 0.35) = 9,404.9
 NOA (2017) = 59,326 – 29,964 = 29,362, NOA (2016) = 55,896 – 29,424 = 26,472
 Av. NOA = 27,917
 RNOA = 0.3369 = 33.7%
 NNO (2017) = 33,717 – 70,492 = -36,775, NNO (2016) = 28,643 – 65,756 = -37,113
 Av. NNO = -36,944
 Av. Equity = 64,861
 NNE = (-314)x(1-0.35) = -204.1
 ROE = 0.3369 + (-36,944)/64,861x (0.3369 – (-204.1)/(-36,944) )
 ROE = 0.3369 + (-0.18875) = 0.14815 = 14.8%
 CHECK -> ROE = 9,609 / 64,861 = 0.14815 = 14.8%
 Look at result for RNOA disaggregation for Cisco. Sky high operating return (tech
company). Yet look at bottom of slide: ROE is much lower than RNOA. You
automatically know that nonoperating return must be negative
 Perhaps company had high cost of debt? Correct way of thinking but not the case here.
We see net non operating expenses are economically zero. Cost of debt is zero
 Debt over equity (if you have negative equity: financial leverage become negative). Not
happening in Ciscos case
 -> nothing to do with SPREAD or equity being negative.
 Debt: non operating.. Net of debt. What happens if you have more cash dan debt? Net
debt becomes negative and non operating return becomes negative
 Good reasons why some firms hold onto a lot of cash.

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 Hoarding cash – WHY?
1. Precautionary motives (buffer)
2. Financial flexibility
3. Offset operational leverage / risk
4. No (attractive) investment opportunities
5. Easier to consume private control benefits
6. Tax purposes

o
 Profitability Analysis: Pernod Ricard versus Diageo for 2019

 Pernod Ricard  Diageo

o ROE = 9.5 % o ROE = 30.5 % (3,337/10,934.5)
o RNOA = 8.0 % o RNOA = 16.0 % (3,432.2/21,259.5)
 NOPM = 18.5 % (ζ=20%)
 NOAT = 0.43  NOPM = 26.7 %
o Nonoperating return = 1.5 %  NOAT = 0.61
  FLEV = 0.36 o Nonoperating return = 14.4 %
  Spread = 4.2%   FLEV = 0.94
  Spread = 15.2%
o Same business
o BMW and Mercedes: similar in financing etc. why we focus in Pernod Ricard and Diageo:
similar in business, strategy and size, but financing is different.
 Un-doing the COVID-19 impact for Pernod Ricard versus Diageo for 2020

Pernod Ricard Diageo

 ROE = 1,251.1/15,196.5 = 8.2%  ROE = 2,765.4/9,298 = 29.7%
 NOPAT= 2,260 – [(1,283+366)*0.3+258] = 1,507.3  RNOA = 2,840.4/21,736.5 = 13.07%
 RNOA = 1,507.3/21,722 = 6.94% o NOPM = 2,840.4/11,752 =
o NOPM = 1,507.3/8,448 = 17.8% 24.2%
o NOAT = 8,448/21,722 = 0.39 o NOAT = 11,752/21,736.5 =0.54
 Nonoperating return:  Nonoperating return:
o FLEV = 0.4294 (NNO 2020=7,845; NNO o FLEV = 1.339
2019=5,205) o Spread = 12.466%

43
 o Spread = 3.014%
o In COVID: lot of bars closed so sales decreased
 Profitability Analysis Pernod Ricard versus Diageo for 2021

Pernod Ricard Diageo

 ROE = 1,318/14,643 = 9.0%  ROE = 2,799/8,435.5 = 33.2%
 NOPAT = 2,423 –  RNOA = 3,086.2/21,355 = 14.5%
[(62+371)*0.3+667] = 1,626.1 (EBIT=4,065)
 RNOA = 1,626.1/21,943 = 7.4% o NOPM = 3,086.2 /12,733 = 24.2%
o NOPM = 1,626.1/8,824 = 18.4% o NOAT = 12,733/21,355 = 0.60
o NOAT = 8,824/21,943 = 0.40  Leverage effect = big (18.7%)
 Leverage effect = small (2.59%)  -> Firm uses a lot of debt at a low interest
 -> Firm does not use a lot of debt rate
o Pernod Ricard
 ROE= earnings/equity, RNOA is quite low, Profit margin is quite high (18,4%), Asset
turnover is low (,4)
 Pernod Ricard need to invest a lot in his business to generate profits.
o Diageo:
 ROE is 3*higher, RNOA is also higher, Profit margin is high, Asset turnover is much
higher
o Diageo is outperforming Ricard in term of operations and uses a lot of debt which increases
ROE -> better in all fronts
o Let’s have a look at balance sheets Pernod Ricard and Diageo
o NOPM is Nopat divided by sales so nothing of balance sheet is in ratio -> Diageo still
performs better but not to extent which RNOA figures seem to show you.
 Operating assets for Pernod Ricard vs Diageo
o Pernod Ricard


 These bottles are biggest revenues; have been bought by company; explains why it has
a lot of intangibles and goodwill (55% of operating assets) -> get into denominator
RNOA -> makes RNOA go down
 Because of accounting; cannot compare RNOA (internally generated not on balance
sheet, purchased are)

44
 o Diageo


 Not a lot of brands on balance sheet; lot have always been part of business; only three
on the left part of operating assets (38% of operating assets)
 Net operating profits will be lot higher if you use other accounting principles
 Additional remarks on Profitability Analysis
1. “Other” items are usually operating items.
2. Joint-ventures is an operating item.
3. Leased assets are operating while lease liabilities are nonoperating!
4. For Noncontrolling interests (or minority interest) it is advisable to ignore them, i.e.:
 Include NCIs in Net income (do not use the parent’s share)
 Include NCIs in Equity (use total equity)
 See the example of Walmart in the extra exercises.
5. Ignore discontinued operations, i.e., do not treat them as operating or nonoperating; or
treat them as nonoperating if they are immaterial.

45
Lecture 4
 In this lecture
o Concept of credit risk
o Solvency Analysis: Ratios + Examples
o Accounting in Debt Contracts: Covenants
o Credit ratings
o Case study: Kinepolis vs Cineworld
o Case study on airlines: Homework
 Solvency = credit risk
 Show link covenants with solvency and accounting
 Case study on airlines not as relevant anymore as 2 years ago. But good to look at is
 Solvency: Concept
o Solvency (or credit risk) refers to the ability of the firm to meet its debt obligations.
o Credit risk is the risk creditors bear vis-à-vis their borrower reflecting the probability that the
creditor will be able to fulfill the lending terms.
o A very much related concept is “bankruptcy risk” which is the probability a firm will expire or
fail.
o Solvency is largely unrelated to a firm’s operations and usually focuses on the long run.
o If you don’t have any debt, little solvency risk/ credit risk
o Distictions between operations and how operations are financed. Solvency relates to how
operations are financed; not just on operations.
o Credit risk relates to long term; liquidity is a short term problem
 Solvency Problems at Cineworld

o Company on the verge of bankruptcy

o Cineworld is second biggest cinema; now shares are almost worth zero
o Cineworld invested a lot before covid.
o Kinepolis one of the biggest in Europe but smaller than Cineworld; kinepolis is also in trouble
but not as bad as cineworld
 Solvency Problems at SAS Airlines
o Sas was sort of okay 3 years ago, but now it’s also on the verge of bankruptcy.
o Few years ago: signs of trouble in solvency

46
47
 Solvency Ratios
o Static solvency ratios are based on only liability and equity items:
 Liabilities-to-equity ratio
 Book Leverage
 Market Leverage
o Dynamic solvency ratios are based on a mix of balance sheet items and income statement
or cash flow items:
 Times interests earned ratio
 (Net) Debt-to-EBIT(DA)
o Static: only input from balance sheet: uses stock variables; do not involve anything from
income statement
 Liabilities-to-equity
o Measured as: Total liabilities / Equity
o Threshold: Should not be much larger than 2
o Inverse ratio is also frequently used:
 -> Equity / [Equity + Liabilities]
 -> Should be no less than 30% (rule-of-thumb)
o Equivalent ratio:
 -> Total Liabilities / [Equity + Liabilities]
o Mercedes (2021):
 Liabilities-to-equity = 186,664 / 73,167 = 2.55
 Equity-to-total assets = 73,167 / 259,831 = 28%
o BMW (2021):
 Liabilities-to-equity = 154,395 / 75,132 = 2.05
 Equity-to-total assets = 75,132 / 229,527 = 33%
o Apple (2021):
 Liabilities-to-equity = 287,912 / 63,090 = 4.56
 Does Apple have a worse solvency position than BMW or Mercedes?
o Is a bad ratio: do not spend much time on
o Mercedes: lot of liabilities; substantial amount of equity
o BMW: slightly less liabilities, substantial equity
o Expect apple to do better? Obviously; most profitable, most valuable etc. but does worse.
But does not have a worse solvency position; is only because ratio is problematic. Liabilities
is accounts payable(good thing; credit you get for free) and credit you get from bank and
bondholders. Apple gets lot of credit from suppliers so that’s high.

48
 Book leverage for Pernod Ricard
(¿ debt +ST debt)
o Book leverage =
( Book value of equity +¿ debt +ST debt)

o
(9,300+ 301)
o Book Leverage = = 39%
(9,601+15,075)
o Advantage? Clean and robust metric
o Drawback? Less timely and relevant than market leverage
o What is your conclusion on the debt level of Pernod-R.?
o What about the debt structure?
o Second static solvency ratio: book leverage
o Why is this better ratio? Only non-operating items in numerator and denomerator; clearer
ratio.
o Widely used in financial statement textbooks etc
o Pernod Ricard: pretty steady business; able to have more financial risk
o 39% is book leverage; compare with average: Pernod Ricard does not average finance with
debt; less than average in sector
o Credit risk also seems to be pretty low
o Robust: does not use mrket value but uses book value (only changes once a year)
o Conclusion debt leven: unlike expected; pretty low given operating risk is also pretty low
o Debt structure? Type of debt: public vs private (bonds vs bank loans) and long term vs short
term. Average maturity loan: 5 or 10 years. Maturity 7 years: expect 1/7 of debt to be payed
within the year. You expect to short term debt in between 10/20% of long term debt. Short
term debt is extremely small (less than 5%). Gets more long term credit. Good outlook in
terms of solvency? Yes!
o Public (bonds) vs private (to bank) -> pernod Ricard has bonds. Good or bad news? Only best
and biggest firms get access to bonds. Is much cheaper. Pernod Ricard only

49
 Market leverage for Pernod Ricard
(¿ debt +ST debt)
o Market leverage =
( Market value of equity+ ¿ debt+ ST debt)
o Market value of equity= [# Shares outstanding x Price per share at FYE]
9.601
o Market leverage =
[9,601+( 261.5 x 187.2)]
o Advantage? More timely and economically relevant measure
o QUESTION: Market leverage is less frequently used than book leverage. Why? -> It is a more
volatile metric!
o What is your conclusion on the debt level of Pernod-Ricard?
o The denominator = ???? Value
o Market leverage: only one thing changes: don’t use book value of equity, but market value
of equity. Why would we do it? More timely measure. Evolves according to how the
company is doing
o 261,5 is numbers of shares outstanding 187,2= price shares outstanding
o Is pernod Ricard is listed on Belgian stock exchange: will be second biggest company
o Market leverage looks very low. 16% of total value of company consists of debt
o 84% is for shareholders.
o Despite fact pernod does not have lot of operation risk: not a lot of financing in debt but
financing in operations
o Family business: keeps a lot of capital within company: grow less but less probability of
bankruptcy
o Market leverage less used: more timely but also more volatile.
o The denominator: market cap of equity plus debt = firm/entreprise value.
 Book and Market leverage
Company Book equity Shares Stock Price Market cap LT Debt ST Debt Book Leverage Market Leverage

Pernod Ricard 15,075 262 210 55,073 9,300 301 38.9% 14.8%

Diageo 8,431 2,337 40 94,321 13,249 2,119 64.6% 14.0%

Mercedes 73,167 1,070 69 73,498 75,351 58,297 64.6% 64.5%

BMW 75,132 602 91 54,981 62,342 41,121 57.9% 65.3%

Apple 63,090 16,701 143 2,384,942 109,106 15,613 66.4% 5.0%

o What are your conclusions regarding these firms’ solvency?
 BMW and Mercedes have similar operations and similar capital structures while Pernod
Ricard and Diageo have very different capital structures, Diageo being the one showing
substantially more credit risk, despite similar operations.
 Book leverage is less prone to market sentiment… but more affected by accounting
conservatism (i.e. not all economic assets are included in book equity, which is very
clear for Apple)
o Apple: first ratio was not good. Book leverage and market leverage better ratios: can see
that apple is a better company
o Pernod Ricard has a different market leverage ratio than in slides. He chose a different
market cap (fiscal year end price vs 2 or 3 months after year end).

50
 o Diageo: takes on much more debt than equity. Pernod Ricard: more equity than debt.
Diageo must have a very big market value of equity.
o Mercedes and BMW are very similar. Market leverage is almost the same
o These firms had lower operational risk but with evolving technology it increased
o Apple not high in book leverage. Apple does not have much debt at all (see market leverage
of 5%).
 Times interests earned
o TIE = Operating Profit (EBIT) / Interest Expense
o TIE measures the number of times operating income (or EBIT) covers the interest expense.
o If less than 1  insolvency may be close-by
o The ratio can be low because of:
 High leverage
 High interest rates
 Low operating profits
o Equivalent ratio: Fixed charge coverage ratio (including lease payments and rental expense,
besides interest expense).
o Dynamic ratio. Shows you number of times you earn your interests. Interest coverage ratio
is same thing
o Interest expense; but not what you cover of the loan
o Threshold value 1, is above: sufficient operating income. Does not mean you can pay
principle of debt. Used to be very popular. Now lost a bit of its relevance
o Mercedes (2021):
 TIE = 16,028 / 429 = 37 times
o BMW (2021):
 TIE = 13,400 / 165 = 81 times
o -> Despite having a lot of debt, BMW and Daimler do not show signs of solvency problems
based on this ratio.
o Pernod Ricard (2021):
 TIE = 2,361 / 410 = 6 times
o Diageo (2021):
 TIE = 3,731 / 651 = 6 times
o Apple (2021):
 TIE = 108,949 / 2,687 = many times
o This ratio lost some of its relevance because of historically low interest rates. It remains
relevant for struggling firms…
o … and it may regain some of its relevance…
o Cannot really say that BMW performs better than Mercedes
o Numbers don’t really mean very much in this ratio, you just need to be above the threshold
of 1. above 5 you’re definitely fine. Between 1-5, struggling
o Apple: did not calculate because number is very big. Operating income covers … many times
o Insufficient ratio to only focus analysis on
 Debt-to-EBIT(DA)
o (Short-Term Debt + Long-Term Debt) / EBITDA
o EBITDA = Earnings before interests, taxes, depreciation and amortization
o Less than 2 is considered to be safe; higher than 7 is considered to be indicative of solvency
problems and very high credit risk. Some use 5 as the threshold for a red flag signal.
o Probably, the most widely used solvency ratio in practice

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o Related (similar) ratios:
 Debt / Cash Flow from Operations
 Debt / Operating Income (NOPAT or EBIT)
o Most widely used solvency ratio in general. Good one? Yes, only debt above
o As long as you have higher: not necessary in trouble, just need to see wheter banks will still
finance
o If under 5: not necessary doing great: was airline company which went bankrupt with one of
4,5
o Take thresholds with grain of salt
o Current cashflow tells little about future cashflows.
o Operating cash does not tell you a whole lot about future cash
o Do not take operating cash
o For Daimler (2021):
 EBITDA = 16,028 + 6,980 = 23,008
 Debt-to-EBITDA = 133,648 / 23,008 = 5.8
o For BMW (2021):
 Debt-to-EBITDA = Debt / EBITDA 2005-2021
103,463 / 19,895 = 5.2 25
o Conclusions?
 Credit risk looks high. 20
 And volatile!
o QUESTIONS: 15

 How come this

10
situation is
sustainable? 5
 What explains the
spikes for Daimler? 0
o Mercedes has a lot of debt; 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19 20 21
20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20
luckily also a good EBITDA
Mercedes BMW
o Spikes: used to be
problematic; if you see a spike: debt increased or EBITDA decreased. Flow variable is much
more volatile (EBITDA); debt level stayed the same -> was not super probmatic for
Mercedes; banks still had a lot of trust in this firm because of its size etc
o BMW also a lot of debt; not a lot of firms with that amount of debt
o For Pernod Ricard (2021):
 Debt-to-EBITDA = 9,601/2,806 = 3.4
o For Diageo (2021):
 Debt-to-EBITDA = 15,459/4,178 = 3.7
o Conclusions:
 Diageo is more profitable, but also carries a bit more credit risk.
 Credit risk remains low for both firms.
o For Pernod Ricard: Debt-to-EBITDA in 2020 was 4.3, Debt-to-EBITDA in 2019 was 2.9
o Question: What do you think happened with the credit rating of Pernod Ricard received
from S&P during the pandemic?
o Pernod Ricard need to have 3,4 of current EBITDA to serve entire debt. Question is of course
if EBITDA is going to stay on the same level.
o Credit rating: will have worsened; solvency had worsened

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53
 Net Debt
o Net debt = [Financial liabilities] minus [cash and cash equiv.]
o Net debt can be negative!
o Debatable whether to include ST investments other than cash.
o Widely used credit ratios are Net Debt / EBITDA; Net Debt / CFO; Net Debt / Operating
Income (EBIT)
o Net Debt / EBITDA in 2021 for:
 Mercedes = (75,351+58,297-23,120) / 23,008 = 4.8
 BMW = 87,454 / 19,895 = 4.4
 Pernod Ricard = 7,523 / 2,806 = 2.7
 Diageo = 12,710 / 4,178 = 3.0
 Apple = 89,779 / 109,207  0
o Conclusions?
o What is cash and equivalents? What to do with short term investments? Sort of cash but not
really cash -> not one way to calculate cash equivalents.
o Diageo little higher credit risk than pernod ricard
 Net Debt for Unilever

o
o Huge takeover bid they did
o Medium term debt: 5 years
o Four times net debt to ebitda (to show it also comes in the paper)
 Net Debt for Danone

o
o Net debt should not be reported by firms.
o Something good and something bad here
o Debt is always financial (no such thing as financial debt)

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 Net Debt
o Voluntary disclosure of Net Debt for WM Morrison Supermarkets (UK):
Also talk about
analysis net debt in
foot note
Net debt is negative
(stands between
brackets). More cash
than debt: number is
negative -> in this
case firm does not
have more cash than
debt.
Net debt is highly
positive. But UK firms
do a little different; if they have positive number rapports negative number because he have
a positive net debt.
 Accounting in debt contracts
o Lenders have several options to impose control over the borrower’s behavior:
 Collateral
 Interest rate
 Maturity
 Covenants
o Covenants are contract terms negotiated between borrowers (firms) and lenders (one or
several banks).
o Most big lending contracts (especially in the syndicated loan market) contain one or several
covenants.
o Violating a covenant triggers rights for the lender.
o Borrowers have incentive to prevent violating a covenant.
o Before shareholder invest in home: check future benefits
o Bank managers not interested in what profits you make in future. Suppose you are bank
manager and need to decide to provide a loan or not
o If shareholder invests: see what future economic benefits are. Bank manager not interested
in future profits, but interest if you make just enough profits to pay back the loan without
taking too much risk
o Which options does lenders have to protect themselves. First thing: collateral; banks can
only ask for collateral for a limited amount. There are 2 conditions that need to be met:
borrower willing to provide collateral; before bank can ask for collateral; there needs to be
collateral. Collateral is always tangible.
o Covenants needs to make sure that managers not only handle in interest of shareholders
but also of bondholder.
o Incentives lenders are different of the one of the shareholders
o Covenants are mechanisms that enable lender to steer behavior of his client; to take on less
risk
 Two main types of covenants:
o Negative covenants place restrictions on the borrower’s actions

55
  Dividend restrictions
 Capital expenditure restrictions
 Limitation on top management salaries
 Bringing organizational change in consultation with the bank
o Financial covenants do not (directly) place restrictions but impose financial boundaries the
borrower must respect.
 Credit rating-based covenants (e.g., S&P, Moody’s ratings)
 Capital-based covenants (e.g., debt-to-equity ratio, leverage ratio, net worth minimum,
tangible net worth minimum…)
 Performance-based covenants (e.g., debt-to-EBITDA, interest coverage ratio, fixed
charge coverage ratio, gross margin…)
o HIGLY RELEVANT
o Dividend restrictions is a contract in which they limit the amount that can be given to
shareholders -> to limit risk taking managers are doing
o Negative covenants restrain behavior
o Financial covenants: types. First one based on credit ratings. Second and third are capital
based covenants
o Capital –based:
o Performance-based: solvency ratio’s

o
o Questions:
 Suppose the company currently has a debt/EBITDA ratio of 3.75. What is the price of
the loan in this case?
 What is the covenant slack the borrowing company has in this case?
 What is the benefit of the lower spread when the borrower’s solvency position
improves: a. for the borrower? And b. for the lender?
o Interest rate in contracts not expressed as a percentage but in LIBOR (bases plus 325 bases
points is 3,25 percent)
o debt/EBITDA of 3.75. price of loan is LIBOR plus 2.75%
o Covenant slack: where you currently are vs nearest threshold 275 vs 250 -> 0.25 EBITDA is
slack
o Benefit lower spread: borrowers solvency position increases; effect for borrower: borrower
gets rewarded (can finance themselves more cheaply)
o Effect for lender: want this in contract to secure their money. What happens if client
improved solvency position. Borrower will say: paying too much and get out of contract and
go to competing bank; can negotiate another term. With this clausule in contract less risk
that borrower goes to someone else.
 Debt covenants for Pernod Ricard
o On p. 222 of their annual report:

56
 o
o Need to understand relevance covenants!!
o Solvency ratio is net debt/EBITDA (can calculate It the way they want)
o You can see how far Pernod Ricard is from violating covenant. Currently the number is 2.7 ->
very far from violating.
o Covenant slack is very big (2.55 EBITDA)
 Credit Ratings

o
o Look similar but not the same.
o red line is psychological border: you want to be above the red line. If below: high risk (in
speculative rate)
o Apple policy: does not want to invest in companies below the red line
 What Financial Ratios Matter for Credit Ratings?

o What are your main conclusions from these correlations?

o What is surprising?
o MOST IMPORTANT SLIDE ON CREDIT RATINGS
o He calculated correlation as a percentage between each of these variables and the firms
credit rating. The higher the correlation: the more important relation between firm
characteristic and credit rating.
o There is a credit rating oddity which matters a lot: they are assessing credit risk. 4 ratios pick
up credit risk. Do they? Yes high correlations with firms credit risk. What is firm
characteristic that correlates most with credit risk? Firm size. Has he put it in there? Which
firms get high credit rating? Not only ones with high EBITDA over .. But the ones who are big
(in terms of assets,…) -> size does matter

57
 o Biggest firms lowest credit risk despite fact they are highly indebted
 Ratings for Stellantis – Fiat – PSA
o Peugeot: BB+; Fiat: BB- -> merged into Stellantis: BBB-
o Credit rating Peugeot before merger BB + (below red line), Fiat was even worse (also below
line). BBB- is just above red line -> firms like apple will now have Stellantis on their radar;
one of the reasons why firms merges.
 Ratings for Pernod Ricard and Diageo
o For Pernod Ricard (2019): the credit ratings sought by Pernod Ricard from rating agencies on
its long- and short- term debt are Baa2/P2 from Moody’s and BBB/A2 from Standard &
Poor’s respectively
o For Pernod Ricard (2020): The credit ratings sought by Pernod Ricard from rating agencies
on its long- and short-term debt are Baa1/P2 from Moody’s and BBB+/A2 from Standard &
Poor’s respectively
o For Pernod Ricard (2021): The credit ratings sought by Pernod Ricard form rating agencies
on its long- and short- term debt are Baa1/P2 from Moody’s and BBB+/A2 from Standard &
Poor’s respectively
o For Diageo (2019, 2020 and 2021):

o
o Credit rating Pernod Ricard during pandemic: increase in credit risk from 2,9 to 4,3. (see
previous slides)
o In 2019 credit rating above red line
o You may feat that credit rating got worse because they got more debt but exactly the
opposite happened. Despite fact debt/EBITDA went up, credit risk went down. Sales took a
big hit
o Diageo is doing better than Pernod Ricard in terms of credit rating. Not our conclusion form
ratios we calculated.
o How do credit rating agencies make business? Companies that are rated pay them to get a
rating.
 Credit Ratings: Conclusions
o The strengths of credit ratings are:
 Agencies do the job for you
 Agencies have access to proprietary information
o The disadvantages and drawbacks are:
 Questionable business model as the clients pay the rating agencies to get a rating…
 Seem to be stale and rusty sometimes… Not timely enough
 Black box on how ratings are compiled and changed

58
Case Study 1: Cineworld vs Kinepolis
 Context:
o Both firms heavily affected by the Covid-crisis
o Cineworld, the world’s second biggest cinema chain, is on the verge of bankruptcy
 Assignment: Investigate and compare these companies’ solvency position in 2021.
 Cineworld is almost bankrupt so you should see it at the solvency ratios
 Kinepolis vs Cineworld: inputs

Key financial inputs Kinepolis Cineworld

Unit Mln EUR Mln USD
Period 2021 2021
Sales 266.00 1,805.00
Equity 121 -345
ST Debt 108 717
LT Debt 833 8,512
Cash and Eq. 75 354
Operating Income -6.55 15.80
D&A 81.00 535.00
OCF 88.90 555.00
Interest Exp. 25.70 899.20
Stock Price Dec-31-2021 54.75 0.32
# Shares (mln.) 27 1,373
Market Cap (Dec 31, 2021) 1,498 439
Market Cap (Sep 12, 2022) 1,180 40
o Important that you can get this numbers yourselves
o Kinepolis is considerably smaller than Cineworld (6* kinepolis revenues)
o What is equity? Book value of equity: lots of losses carried over and outweighed equity so its
negative equity -> signal on itself that it goes very bad
o Long term debt of kinepolis is quite high (ratios are not going to be very bright either)
o D&A: depreciation and amortization
o Stock price * number of shares is market cap
o Market cap kinepolis is much higher than Cineworld: investors still have faith in kinepolis
o Kinepolis market cap is 6*sales
 Kinepolis vs Cineworld: ratios

Key ratios and numbers Kinepolis Cineworld

Net Debt 866 8,876
Net Debt / Equity 7.18 -25.73
Book Leverage 0.89 1.04
Market Leverage 0.39 0.95
Times Interest Earned -0.3 0.0
Debt / EBITDA 12.64 16.76
Debt / EBIT -143.62 584.16
Debt / OCF 10.58 16.63
Market-to-Book 12.42 -1.27

59
 o Book leverage kinepolis looks bad (89% is in debt). Market leverage kinepolis is way better;
almost same as pernod Ricard
o Debt/EBIT is negative so you can’t interpret number. Those numbers are not permanent;
people expect that to be positive again in the future
 Kinepolis vs Cineworld: ratio interpretations
Conclusions:
Sky-high debt levels
for Cineworld
without profits.
Investors lose faith
in the survival of
the firm.
High debt levels for
Kinepolis, but
investors continue
to believe in the long-run survival of the firm and return to profitability

o Green: good news, Orange: somewhere in between, Pink: cannot interpret

o Things do not look very bright for kinepolis; especially related to their debt levels
o Mixed picture for kinepolis, Market – to – book quite high
o Few months before Cineworld went bankrupt; ratios are indeed picking up credit risk
because everything is red

Case Study 2: Credit risk in the airline industry

 Case study / exercise on:
o Credit risk analysis
o Credit risk interpretation
o Credit risk prediction
 Four companies in the airline industry:
1. Ryanair
2. SAS
3. Norwegian
4. Thomas Cook
 Assignment:
o Calculate and interpret relevant credit ratios based on the 2018-2019 financial statements.
o Make a conclusion and prediction for the likelihood of insolvency in the near future.
 Ryanair: Income Statement

60
o

61
 Ryanair: Balance Sheet

o
 SAS: Income Statement
o

62
 SAS: Balance sheet

 Norwegian: Income Statement

o
 Norwegian: Balance Sheet

63
 o

o
 Thomas Cook: Income Statement

o
 Thomas Cook: Assets

64
 o

o
 Credit Risk of Airlines: inputs

Key financial inputs Ryanair SAS Norwegian Thomas Cook

Unit Mln EUR Mln SEK Mln NOK Mln GBP

Period Apr18-Mar19 Nov18-Oct19 2018 Oct17-Sep18

Sales (in Mln EUR) 7,697.40 4,486.66 4,026.55 10,925.76

Equity 5,214.90 5,372 1,704.40 291

ST Debt 499.1 1,833 12,668.50 218

LT Debt 3,343 9,450 22,568.10 1,210

65
Cash and Equivalents 1,675.60 8,763 1,921.70 1,039

Operating Income 1,016.80 1,166 -3,850.60 97

Depreciation & Amortization 640.5 1,924 1,667.60 264

OCF 2017.5 3,318 462.7 139

Interest Expense 59.1 544 1,159.50 150

Market Capitalization 13,391.56 5,829.22 7,807.35 53

 Credit Risk of Airlines: ratios

Key ratios and numbers Ryanair SAS Norwegian Thomas Cook

Net Debt 2,167 2,520 33,315 389

Net Debt / Equity 0.42 0.47 19.55 1.34

Book Leverage 0.42 0.68 0.95 0.83

Market Leverage 0.22 0.66 0.82 0.96

Times Interest Earned 17.2 2.1 <0 0.6

Debt / EBITDA 2.32 3.65 <0 3.96

Debt / EBIT 3.78 9.68 <0 14.72

Debt / OCF 1.90 3.40 76.15 10.27

Market-to-Book 2.57 1.09 4.58 0.18

 Conclusions per Firm

o Ryanair:
 Ratios indicate a low credit risk
 Scores well on every indicator
 Credit rating of BBB+ (one of the highest in the industry) confirms our analyses
o SAS:
 Ratios indicate a medium credit risk
 Scores favorable on many indicators, except for Debt/EBIT.
 Profitability seems rather low compared to the debt level.
 Very low credit rating of B+ does not entirely align with our analyses
o Norwegian:
 Ratios indicate a very high credit risk
 Insolvency seems just around the corner
 Very low credit rating of B- is in line with our analyses.
o Thomas Cook:

66
  Ratios indicate a high credit risk.
 The problem seems to lie more with the lack of profitability rather than excessive
amount of debt
 Prior to its failure, the company got a B+ credit rating, same as SAS.
 Thomas Cook: Credit Ratings

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 General Conclusion of the Case
o Ryanair faces the lowest credit risk, followed by SAS. Norwegian and Thomas Cook face
substantial credit risk based on several indicators.
o For Thomas Cook, we find that some indicators, including widely used ones such as
Debt/EBITDA, are not informative about credit risk.
o Debt/EBIT is the only frequently used credit risk metric that predicted trouble for SAS.
 Solvency and Credit Risk: Conclusion
o Credit risk captures the extent to which a firm is likely to meet its financial liabilities.
o The most widely used solvency ratios are debt-to-EBITDA and book leverage ratio.
o The most important concept regarding credit risk is net debt, or economic debt.
o Credit risk can be controlled by lenders in debt contracts by means of covenants
o Bankruptcy prediction models suffer from misspecification and a lack of explanatory power.
o Credit rating agencies rate credit risk of public companies thereby relying on indicators of
firm size, profitability, cash flow and solvency ratios.

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