PowerpointPresentation Chapter 9

Corporate FINANCE.
Theory and practice
Chapter 9
MARGIN ANALYSIS: STRUCTURE
P. Quiry,
M. Dallocchio, Y. LeFur, A. Salvi
Corporate Finance. Theory and Practice
John Wiley & Sons, London, 2009
Corporate FINANCE. Theory and practice Chapter 9– MARGIN ANALYSIS: STRUCTURE
TOPICS
•Margin analysis
•Components of operating profit
•Allocation of operating profit
•Comprehensive income
•Financial assessment
•The scissors effect
© 2009 - John Wiley & Sons 2

Quiry, Dallocchio, LeFur, Salvi - Corporate Finance. Theory and Practice
MARGIN ANALYSIS
A company that fails to sell its products or services

to its customers at above their cost is doomed
 The company’s margin analysis is the first step in

any financial analysis
Margin analysis:
analysis
1. examination of the accounting practices used by the

company to draw up its income statement
2. trend analysis based on examination or the revenues

and charges

MARGIN ANALYSIS
The purposes of the margin analysis are:
• to calculate the rate of change in revenue and costs to
examine their respective trends and
• to account for the relative change in the margins over the
period
Margin trends are a reflection of a company’s:

• strategic position  scissors effect
• risk profile  breakeven effect
A company’s strategic position directly influences

the size of its margins and its profitability
HOW OPERATING PROFIT IS FORMED

Sales
Sales growth needs to be analysed in terms of:
• organic and acquisition-led growth
 impact of changes in the scope of consolidation on sales
• volume and price trends
 volume growth = overall increase in sales
– increase in selling price
 impact of inflation, currency fluctuations and changes in
the product mix
Trends should be compared with growth rates in the market or

the sector and price indices
Sales growth sets operating costs and
financial requirements trends

Production
SALES (at selling price)

+ CHANGE IN INVENTORIES OF FINISHED GOODS
AND WORK IN PROGRESS (at cost price)
+ PRODUCTION FOR OWN USE (at cost price)
= PRODUCTION
It depends on the level of unsold products and on the

accounting methods used to value inventories
If the growth rate in production is higher than that in sales, it

can be the result of:
• overproduction
• overstatement of inventories’ value


Gross trading profit
SELLING PRICE OF GOODS FOR RESALE

– PURCHASE COST OF GOODS FOR RESALE
= GROSS TRADING PROFIT
It is useful only in the retail and wholesale sectors
Usually, it is more stable than its components


Raw materials and other operating costs
To calculate productivity ratios for raw materials and other

operating costs, they need to be:
1. broken down into their main components and
2. analysed in terms of their quantities and costs trends
Sustained differences between the rate of growth:

• of raw material and other operating costs and that in
production (by-nature income statement) or
• in cost of sales and that in net sales (by-function income
statement)
are attributable to changes in the product manufactured or in
the production process

Value added
GROSS TRADING PROFIT OPERATING PROFIT
+ PROFIT ON RAW + DEPRECIATION, AMORTISATION
MATERIAL + PERSONNEL COSTS
− OTHER OPERATING + TAX OTHER THAN CORPORATE
COSTS INCOME TAX
= VALUE ADDED = VALUE ADDED
It represents the value added by the company

to goods and services purchased from third parties
through its activities
It is of interest only insofar it provides valuable insight regarding

the degree of a company’s integration within its sector

Personnel cost
In a short-term perspective, it represents a fixed cost
Personnel expense
Cost control indicator:
Average headcount
Workforce’s productivity ratios:
Sales Production Value added

Average headcount Average headcount Average headcount
It is a very inert cost


EBITDA
OPERATING PROFIT
+ DEPRECIATION, AMORTISATION AND
IMPAIRMENT LOSSES ON FIXED ASSETS
= EBITDA
VALUE ADDED
− TAX OTHER THAN CORPORATE INCOME TAX
− PERSONNEL COST AND PAYROLL CHARGES
− IMPAIRMENT LOSSES ON CURRENT ASSETS AND ADDITION
TO PROVISIONS FOR OPERATING LIABILITIES AND CHARGES
+ OTHER OPERATING REVENUES
− OTHER OPERATING COSTS
= EBITDA

EBITDA
EBITDA is unaffected by non-cash charges
EBITDA
EBITDA margin =
Sales
Changes in EBITDA margin are attributable to:

• an overrun of production costs
• personnel cost
• the price effect on sales
Depreciation, Amortisation
It is independent of the operating cycle in a given period
It depends on the company’s investment policy

EBIT
EBITDA
− DEPRECIATION AND AMORTISATION
+ WRITEBACKS OF DEPRECIATION AND
= AMORTISATION
EBIT
SALES
− COST OF SALES
− SELLING, GENERAL AND ADMINISTRATIVE COSTS
− RESEARCH AND DEVELOPMENT COSTS
± OTHER OPERATING INCOME AND COSTS
= EBIT

HOW OPERATING PROFIT IS ALLOCATED

Net financial expense/income
Financial items reflect the company’s financial policy and the
level of interest rate
They normally show a negative balance
FINANCIAL EXPENSE
− FINANCIAL INCOME
= NET FINANCIAL EXPENSE
Net financial expense is not directly related to the operating cycle
Profit before tax and nonrecurring items
EBIT
− NET FINANCIAL EXPENSE
= PROFIT BEFORE TAX AND NONRECURRING ITEMS
HOW OPERATING PROFIT IS ALLOCATED

Income from associates, minority interests, income tax
If the share of income from associates are consistent, they
should be either:
• broken down into operating, financial and nonrecurring items
• examined by mean of a separate financial analysis
Analysis of minority interests highlights which subsidiaries they

relate to and which share of the profits/losses they represent
Analysis of corporate income tax assess how well the company
has managed its tax affairs
Nonrecurring items
They are defined on a case-by-case basis
The purpose of their analysis is the understanding of their origin
It is not possible (and nonsense) to predict their future trend
COMPREHENSIVE INCOME
• In 2007, IASB published revised requirements in presenting

results.5 The IASB leaves the option either to replace the
income statement by a “statement of comprehensive income”
or present that statement in addition to the traditional
income statement.
• Comprehensive Income is defined as the periodic change in equity capital,

excluding any dealings with shareholders, ie, payment of dividends and
capital increases/decreases. It includes, in addition to net income in its IFRS
version, all unrealised foreign exchange gains and losses, asset revaluations,
cash flow hedging, changes in the fair value of financial instruments intended
to be sold, and actuarial gains and losses (if any) relating to pension fund
commitments.
THE SCISSORS EFFECT

The scissors effect is what takes place when revenues and
costs move in different or diverging directions.
It accounts for trends in profits
The scissors effect

Amount
Charges
Revenues
Time
Profits Losses

THE SCISSORS EFFECT

Ranging
Rangingfrom
fromcarelessness
carelessness…
…
The
Therate
rate
ofof
revenue
revenue growth
growth
The
Thecompany
company
loses
loses
itsits
grip
grip
onon
costs
costs decreases
decreasesbut
but
the
therate
rate
charges
chargesgrowth
growth
remains
remainsunchanged
unchanged
charges
charges charges
charges
revenues
revenues revenues
revenues
The
Thecost
cost
ofof
aaproduction
productionfactor
factor
Revenues
Revenues fall
fall
slightly
slightly
while
while
increases
increasessignificantly
significantly
while
while
revenues
revenues
charges
chargesremain
remainunchanged
unchanged
are
are
slower
slowertoto
increase
increaseowing
owingtoto
inertia
inertia
charges
charges
revenues
revenues charges
charges
revenues
revenues
......to
toexcellence
excellence
Revenues
Revenuespost
poststrong
strong growth
growth Revenues
Revenuespost
postslow
slowgrowth
growth while
while
exceeding
exceedingthat
thatinincharges
charges charges
chargesdecline
declineslightly
slightly
revenues
revenues
revenues
revenues
charges
charges
charges
charges

FINANCIAL ASSESSMENT
The scissors effect
The scissors effect may be attributable to failures in the
market in which the company operates, such as:
• economic rents
• monopolies
• regulatory changes
• pre-emptive action
• inertia
They reflect the higher or lower quality of the company’s

strategic position in its market

The stability principle holds that a company’s earnings are
much more stable than we would expect and are not necessarily
upset by external factors.
But a company’s margins also depend to a great extent on those
of its rivals. The purpose of financial analysis is to understand
why they are above or below those of its rivals
Regulatory changes are controls imposed on a company by an

authority that modifies the direction in which it is moving
External factors are changes imposed on the company that are

specific to the company’s sector of activity

Pre-emptive actions occurs when a company immediately
reflects expectations of an increase in the cost of a production
factor by charging higher selling prices
Inertia effects lead to a delay before a fluctuation in the cost

of a production factors is passed on to the company’s customers
by a raise in the selling price
Inflation acts as an incentive for companies to overinvest and

overproduce, thus distorting their earnings
During periods of inflation:
• depreciation and amortisation are usually insufficient to cover
the replacement cost of an investment, whose price has risen
• inventories yield especially large nominal inflation gains where
they are slow-moving
Generally, capital expenditure depresses operating

performance during the first years after they enter service
In fact, investments initially lead to:
• additional general and administrative costs
• financial charges not related to operating revenues
• additional personnel cost deriving from the early recruitment of
line staff and managers
• lower productivity
A company may decide to pursue a policy of underinvestment to

enhance its bottom line

CONCLUSIONS
The first step in any financial analysis is to analyse the

company’s margins.
This encompasses the calculation and the examination of
the trend of margins, that need to be compared to those
of companies operating in the same sector of activity.
The central figure in income statement analysis is the
operating profit: analysts have to look at how it is formed
and how it is allocated.
Diverging trends in revenues and charges produce a
scissors effect. It is very useful to establish its causes,
thus enabling to understand why the company generates
a profit/loss and what are its future prospects


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Corporate FINANCE.

Theory and practice

MARGIN ANALYSIS: STRUCTURE

•Components of operating profit

•Allocation of operating profit

•The scissors effect

© 2009 - John Wiley & Sons 2

A company that fails to sell its products or services

 The company’s margin analysis is the first step in

1. examination of the accounting practices used by the

2. trend analysis based on examination or the revenues

© 2009 - John Wiley & Sons 3

Margin trends are a reflection of a company’s:

A company’s strategic position directly influences

HOW OPERATING PROFIT IS FORMED

Trends should be compared with growth rates in the market or

HOW OPERATING PROFIT IS FORMED

SALES (at selling price)

It depends on the level of unsold products and on the

If the growth rate in production is higher than that in sales, it

© 2009 - John Wiley & Sons 6

HOW OPERATING PROFIT IS FORMED

SELLING PRICE OF GOODS FOR RESALE

It is useful only in the retail and wholesale sectors

Usually, it is more stable than its components

© 2009 - John Wiley & Sons 7

HOW OPERATING PROFIT IS FORMED

To calculate productivity ratios for raw materials and other

Sustained differences between the rate of growth:

HOW OPERATING PROFIT IS FORMED

It represents the value added by the company

It is of interest only insofar it provides valuable insight regarding

HOW OPERATING PROFIT IS FORMED

Workforce’s productivity ratios:

Sales Production Value added

It is a very inert cost

© 2009 - John Wiley & Sons 10

HOW OPERATING PROFIT IS FORMED

HOW OPERATING PROFIT IS FORMED

Changes in EBITDA margin are attributable to:

HOW OPERATING PROFIT IS FORMED

© 2009 - John Wiley & Sons 13

HOW OPERATING PROFIT IS ALLOCATED

HOW OPERATING PROFIT IS ALLOCATED

Analysis of minority interests highlights which subsidiaries they

• In 2007, IASB published revised requirements in presenting

• Comprehensive Income is defined as the periodic change in equity capital,

THE SCISSORS EFFECT

The scissors effect

© 2009 - John Wiley & Sons 17

THE SCISSORS EFFECT

© 2009 - John Wiley & Sons 18

They reflect the higher or lower quality of the company’s

© 2009 - John Wiley & Sons 19

Regulatory changes are controls imposed on a company by an

External factors are changes imposed on the company that are

© 2009 - John Wiley & Sons 20

Inertia effects lead to a delay before a fluctuation in the cost

Inflation acts as an incentive for companies to overinvest and

Generally, capital expenditure depresses operating

A company may decide to pursue a policy of underinvestment to

© 2009 - John Wiley & Sons 22