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International Financial
Statement Analysis

Lecturer:
Cormac Kavanagh
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 Topic 4: Analytical Statements

• Introduction
• Analytical income statement and balance sheet
• Profitability analysis
• Growth analysis (1)

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 Introduction
• Financial ratio analysis helps us assess a firm’s profitability,
growth and risk.
• Helps us identify areas and trends which may require additional
analysis.
• We can compare ratios:
– across multiple time periods (time-series analysis)
– Across firms within the same industry (cross-sectional analysis,
benchmarking)
– With the required rate of return (e.g. compare ROE to WACC)

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 Problems with financial ratio analysis

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 Analytical income statement
• A firm consists of operating, investing and financing
activities.
• In measuring profitability, we should separate
‘operations’ and ‘investments in operations’ from
financing activities. We do this by preparing an
analytical income statement.
• Why? A firm’s operations are the primary driving force
behind value creation, and are difficult to replicate
(they make the company ‘unique’).

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 Traditional income statement (condensed)

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Analytical income statement (operating vs financial items)

The effective corporate tax rate is calculated as

Corporation tax ∙ 100 100

Tax rate = = 30 ∙ = 30%
Earnings before tax 100

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 • The traditional income statement shows EBIT, which is
operating profit before tax.
• Net operating profit after tax (NOPAT) is not shown on the
traditional income statement. Therefore, the analyst has to
calculate it.
• NOPAT = EBIT - taxes on EBIT
• Reported tax is positively affected by net financial expenses
(tax shield of interest), therefore add back the tax
advantage that financial expenses offer, i.e. 30% * 10 = 3
• Therefore, taxes on EBIT = 30 + 3 = 33

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 Analytical balance sheet
• Items marked as operating or financing on income
statement should be marked the same way on balance
sheet, i.e. be consistent.
• E.g.: if earnings from ‘share of profits of associates’ is
labelled as ‘operations’ on the income statement, then the
matching item on the balance sheet (‘investment in
associates’) must also be classified as an operating activity.

Operating assets – operating liabilities = Invested

Capital (investment perspective)
Book value equity + Net interest bearing debt =
Invested Capital (financing perspective)

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 Traditional balance sheet
Equity and liabilities (financing)
Assets (investments) Equity
Minority interests (NCI)
Non-current assets
Intangible assets Non-current liabilities
Tangible assets Provisions for pensions
Financial liabilities
Financial assets
Current assets Current liabilities
Inventories Other provisions
Financial liabilities
Receivables Accounts payable
Financial assets not held as fixed assets Tax liabilities
Cash and bank Miscellaneous liabilities

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 Analytical balance sheet
Invested capital
Assets (investments) Liabilities and equity (financing)

Operating assets + Equity

+ Minority interests
+ Non-current assets
+ Inventories Interesting bearing debt (net)
+ Mortgage debt
+ Accounts receivables
+ Bank loan
+ Operating liquidity – Excess cash
– Financial assets
– Operating liabilities – Other non operating assets
= Invested capital (net operating assets) = Invested capital (financing)

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 Example – traditional balance sheet

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 Analytical balance sheet

Summary: Invested capital may be regarded as either:

1.Net operating assets or 2. Funds used to finance operations that require a return (i.e. equity + net-interest bearing debt).
Rule : It’s a financing item if interest bearing or requires a return!

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 Profitability analysis
• Measuring profitability is one of the key areas of financial analysis.
• Profitability is important:
– for a company’s future survival
– to ensure a satisfactory return to shareholders.
– To help maintain positive relationships
– Historical profitability is an important indicator of future
expectations for the company.

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Measurements of Operating
Profitability

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 Return on invested capital (ROIC)
• Measures the profitability of operations
• ROIC disregards how a firm is financed

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 ROIC Example (from before)

• ROIC = 77/550 * 100 = 14%. Indicates that the firm is able to generate a return of 14
cents for each euro invested in operations.
• Should compare with returns from alternative investments with similar risk profile.

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 Interpreting the return on invested capital
• It is important to address the following issues:

• The level of returns:

• An estimation of the required rate of return (WACC)
• A comparison with competitors (benchmarking)

• The development (trends) of returns over time

• Stable
• Increasing
• Decreasing
• Fluctuating.
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 Assessment of the level of returns
• Is ROIC at a satisfactory level? Two ways to determine this:
1. Compare with WACC (the expected return on invested capital):

EV is A if ROIC > WACC

(ROIC – WACC ) * invested capital = Economic value added (EVA)

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 WACC Example
• ABC Ltd has the following information in its balance sheet:

€’000
Ordinary shares of 50 cent each 2,500
10% bonds 1,000

• The ordinary shares are currently quoted at €1.30 on the Irish Stock
exchange. The bonds are currently trading at €720, per €1,000 nominal.
The cost of equity is 20%, and the cost of debt is 10%.

• Calculate the Weighted Average Cost of Capital (WACC) for ABC Ltd.

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Market Values:
€’000 % Value
Equity: (2,500,000/0.5) x 1.30 6,500 90%
Debt: 1,000,000 x .720 720 10%
7,220 100%

Weighted Average Cost of Capital:

% Value Cost Proportionate Cost

Equity 90% 20% 18%
Debt 10% 10% 1%
WACC 19%

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• For listed companies, we can also identify the stock markets implicit (forward-looking)
ROIC, as long as we know the MV of equity (assuming constant growth rate and WACC).

MV of equity = BV of equity + (ROIC – WACC) * invested capital

(WACC – g)

• Rearranging this, we get:

ROIC = (MVE – BVE) * (WACC – g) + WACC
Invested capital

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 Example: Forward-looking ROIC
• The following information is available for Carlsberg (all numbers in DKK billion):

• MVE: 53.2 billion

• BVE: 55.5 billion
• Invested capital: 111.7 billion

• Organic growth has been moderate in recent years. Assume growth rate of
between 0% and 3%, and WACC between 8% and 9%.
• Based on the above, calculate the stock markets implicit expectations for ROIC for
Carlsberg.

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 Example: Forward-looking ROIC
• MVE: 53.2 billion
• BVE: 55.5 billion
• Invested capital: 111.7 billion

• E.g. @ g= 0% and WACC = 8%

ROIC = (MVE – BVE) * (WACC – g) + WACC

Invested capital
• =[(53.2 – 55.5)* 8%]/111.7 + 8%
• = 7.835%

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 Solution

WACC
8.0% 8.5% 9.0%
0% 7.8% 8.3% 8.8%
1% 7.9% 8.3% 8.8%
Growth

2% 7.9% 8.4% 8.9%

3% 7.9% 8.4% 8.9%

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 Decomposition of ROIC
• ROIC does not explain whether profitability is driven by a better revenue and expense relation,
or an improved use of capital. It is necessary to decompose the ratio into

(a) The profit margin (revenue/expense relation), (PM)

(b) The turnover rate of invested capital (capital utilisation)

Where: ROIC = PM  Turnover rate

Net operating profit after tax (NOPAT)
Profit margin = × 100
Net revenue

Net revenue
Turnover rate of invested capital =
Invested capital

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Revenues 200 Invested capital (net operating assets)
Operating expenses -90 Total assets 700
EBIT 110 Cash and cash equivalents -50
Taxes on EBIT -33 Accounts payables and tax payable -100
NOPAT (A) 77 Invested capital (net operating assets) 550

Net financial expenses -10

Tax savings from debt financing 3 Invested capital (financing)

Net financial expenses after tax (B) -7 Equity 400

Net earnings (A) + (B) 70 Loans and borrowings (non-current) 100

Loans and borrowings (current) 100
Return on invested capital: Cash and cash equivalents -50
Interest bearing debt, net 150
ROIC = 77/550 = 14.0%
PM = 77/200 = 38.5%
Turnover rate = 200/550 = 0.36
ROIC = PM x T/O rate = 38.5% x 0.36 = 14.0% Invested capital (financing) 550

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 Interpretation
• PM of 38.5% = the company generates 38.5 cent on each euro of
revenue
• Turnover rate of 0.36 means that invested capital is tied up, on average,
2.78 years
• (Divide T/O rate into 1 to convert it to days, i.e. 1/.36 = 2.78 years)
• The higher the turnover rate, the better, although it will vary by
industry.

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Decomposition of ROIC in operating margin and turnover rate

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•Heavy investment companies, e.g. pharmaceutical companies, are located in area ‘A’
– High proportion of fixed costs, and often low turnover rates
– To attract capital, must generate higher profit margins to compensate for the low turnover
rate
– The higher profit is achieved due to some special product properties that are difficult to
imitate, or competitive advantages leading to a reduction in the intensity of competition in
the industry.

•Companies that offer standard services (commodities) often operate in area ‘B’
– Significant competition leads to an upper limit to the profit margin
– Price is typically the most important parameter, as the products or services do not differ
significantly among competitors
– To attract capital, they need to generate high turnover rates.

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 Analysis of profit margin and turnover rate
• Analysis of profit margin and turnover rate of capital helps
explain whether the revenue/expense relation and the
capital utilisation efficiency have improved.
• In order to deepen our understanding of the reason for the
changes, we can decompose the two ratios further. This
can be done in two ways:

1. Indexing (trend analysis): set all items in base year to

100%. Subsequent financial statement items are
expressed as a % of the base year
2. Common-size analysis.
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 Carlsberg IS

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 1. Indexing (trend analysis) – Carlsberg

Trend analysis of Carlsberg’s revenue and operating expenses

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 Analysis

• Net revenue increased by 65% from year 4 to year 8.

• In the same period, cost of sales increased by 75%, which
affects profit margin negatively.
• Other operating expenses, e.g. sales and distribution costs,
admin expenses and depreciation & amortisation all increased
at a lower growth rate than growth in revenues.
• This indicates tight cost control.
• Index numbers show trends, but do not reveal the relative size
of each item.
• For this, we need common size analysis.

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 2. Common-size analysis – Carlsberg

Common-size analysis of Carlsberg’s revenue and operating expenses

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 Analysis
• Common-size analysis scales each item as a % of revenue.
• We can see that COS as a % of revenue grew from 45% in year 4 to
48% in year 8.
• In comparison, sales and distribution costs, admin and
depreciation/amortisation together make up 47% of revenue in
year 4 and 40% in year 8.
• Therefore, even though the most influential expense, cost of
sales, is growing at a faster rate than revenue, Carlsberg is still
able to improve profit margin through efficient control of other
operating expenses.

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 The impact of financing on profitability
(return on equity)
• ROIC only measures operating profitability, i.e. it excludes
financing items.
• Return on equity (ROE) measures the profitability taking into
account returns earned on operations plus the effect of
financial leverage:

Net earnings after tax

Return on equity = × 100
Book value of equity

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 • ROE is affected by operating profitability, net
borrowing interest rate after tax and financial
leverage. Therefore, ROE is decomposed as follows:
NIBD
Return on equity = ROIC + (ROIC - NBC) x
BVE
where

ROIC = Return on invested capital after tax

BVE = Book value of equity
NIBD = (Book value of) net interest bearing debt = the difference
between interest-bearing debt and interest-bearing assets.
NBC = Net borrowing cost after tax in percent. Be careful
interpreting this. NBC ≠ borrowing rate, as it is affected by the
difference between deposit and lending rates, and also includes
items such as currency gains/losses

Net financial expenses after tax

NBC = × 100
Net interest bearing debt

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 Return on equity (example from earlier in notes)
Revenues 200 Invested capital (net operating assets)
Operating expenses -90 Total assets 700
EBIT 110 Cash and cash equivalents -50
Taxes on EBIT -33 Accounts payables and tax payable -100
NOPAT (A) 77 Invested capital (net operating assets) 550

Net financial expenses -10

Tax savings from debt financing 3 Invested capital (financing)
Net financial expenses after tax (B) -7 Equity 400

Net earnings (A) + (B) 70 Loans and borrowings (non-current) 100

Loans and borrowings (current) 100
Return on invested capital: Cash and cash equivalents -50
ROIC = 77/550 = 14.0% Interest bearing debt, net 150
PM = 77/200 = 38.5%
Turnover rate = 200/550 = 0.36
ROIC = PM x T/O rate = 38.5% x 0.36 =
14.0% Invested capital (financing) 550

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 ROIC = 77/550 = 14.0%

PM = 77/200 = 38.5%
Turnover rate = 200/550 = 0.36
ROIC = PM x ATO = 38.5% x 0.36 = 14.0%
NBC = 7/150 = 4.7%
Net earnings after tax
Return on equity = × 100
Book value of equity
70
Return on equity =  17.5%
400
NIBD
Return on equity = ROIC + (ROIC - NBC) x
BVE
150
Return on equity = 14.0% + (14.0% - 4.7%) x =17.5%
400

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 • Remember, ROIC expresses the overall profitability of
operations.
• If ROIC > NBC, then increasing financial leverage will
improve ROE.
• If ROIC < NBC, then increasing financial leverage will reduce
ROE.
• ROIC – NBC is known as the ‘interest margin’ or ‘spread’.

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 Effect of Minority Interest on ROE
NIBD
Return on equity = ROIC + (ROIC - NBC) x [x Parents share]
BVE
Parents share vs Minority Interest Share:
•We only need to consider this if there is a minority interest or non-controlling
interest.
•This happens when investors in the parent company do not own 100% of the
company. We used total equity (both equity of the parent group and equity of
minority interest) in Invested Capital for ROIC.
•However investors don’t benefit from value creation that belongs to minority
interests therefore we should exclude it from ROE i.e. calculate only the parents
share.

Formula for parents share:

Net earnings after minority interest / Net earnings before minority interest
Equity, Parent Group / Equity, Group (Parent + Minority interest)

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 Exxon Example
Calculate the Parents share of ROE for Exxon:

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 Growth analysis
• Sales growth is seen by many as the driving force
of future progress in companies.
• Growth has many positive effects:
1. Shareholders perceive growth to be attractive as it
(allegedly) creates value
2. Lenders are interested as they believe that growth
creates a need for liquidity
3. Suppliers are keen to sell their products to growth
companies
4. Employees see growth companies as dynamic and
challenging

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 Sustainable growth rate
Indicates at what pace a company can grow its revenues whilst
maintaining its financial risk, i.e. not borrowing any more
g = ROE x (1 – PO) or if we break it down further....

where

g = Sustainable growth rate

ROIC = Return on invested capital after tax
NBC = Net borrowing cost after tax in percent
NIBD = Net interest bearing debt.
BVE = Book value of equity
PO = Payout ratio (dividend as a percentage of net profit).

.
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 Exxon Example
Calculate the Parents share of ROE for Exxon:

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 • A high sustainable growth rate indicates that a
company has chosen to reinvest most of its profits.

• From shareholder’s perspective, this will only be

attractive if reinvestments are made in value-creating
projects.
• From the lender’s perspective, a high g will decrease
risk for them, as a larger share of net profits remains
in the company. Conversely, it reduces a firm’s need
for borrowing, and therefore the bank’s market for
loans.

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 The relationship between
payout ratio and sustainable growth rate

Can see that sustainable growth rate falls as the pay-out ratio increases.
If all profits were distributed, g would be 0.
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 Relationship between ROIC and
the sustainable growth rate

Assumptions
Financial leverage = 1
NBC after tax = 5%
Payout ratio = 0%

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 • Based on these assumptions, we can see that g can
be shown as a function of ROIC (operating
profitability).
• E.g. if ROIC is 5%, then g is 5%.

• i.e. (5 + ((5-5) * 1)) * (1-0) = 5

• But if ROIC was 10%, then g would be 15%.

• i.e. (10 + ((10-5) * 1)) * (1-0)= 15
• Therefore, there is a positive association between
ROIC and g.

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 The relationship between financial leverage and the
sustainable growth rate

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 • The impact of financial leverage on g depends upon
the firm’s ability to earn ROIC > NBC.
• Example: Consider these two companies (within the
same industry)

Company I Company II
ROIC after tax = 3% 7%
NBC = 5% 5%
Payout ratio = 0% 0%

• Calculate g for each company.

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 Company 1
g = [3% +( (3% - 5%) * 1) * (1-0)] = 1%

Company II
g = [7% + ( (7% - 5%) * 1) * (1-0)] = 9%

As company 1 has a negative spread (ROIC < NBC),

financial leverage will have a negative impact on
sustainable growth. For example, had financial
leverage been 2.0, sustainable growth would have
been -1%.

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 Is growth always value creating? Growth can be
measured in many different ways
Growth in:
• Revenue
• Operating profit (EBIT)
• Net earnings
• Dividends
• Invested capital
• Economic Value Added (EVA)
• Etc.
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