Trinity Business School

Advanced Analysis (2)

• Growth analysis
• Liquidity analysis
• Compensation-oriented stakeholders
 Example: Satair

Revenue, invested capital and equity have all increased on average

by 10-21% annually (although growth is slowing). But net earnings,
operating profit and FCF are falling.
So, is Satair a growth company?
• Can see that Satair has destroyed value for its shareholders from years 2 –
4. From a shareholder’s perspective, Satair is not a growth business.
 So how can Satair grow its EVA?

In general, EVA growth can be obtained by:

– Optimising existing operations – ok in the short-term but
there are limits on this
– Growth in invested capital if growth is profitable (i.e. ROIC
> WACC) – the best long-term solution, i.e. investment in
profitable long-term projects.
– Reducing the cost of capital (WACC) – difficult to do, in
theory and in practice

– Imagine that Satair had been able to maintain the same

ROIC.
Growth in EVA assuming a constant ROIC

Satair: EVA calculation at a constant ROIC

 Quality of EVA growth
• EVA can grow due to growth in core business, or due to
transitory items.
• Earnings from a firm’s core business are generally considered
more attractive, as they are expected to be recurring.
• Can be optimised by:
• Introducing a more profitable pricing strategy
• Selling fewer but more profitable products
• Using more efficient production methods
• Changing the marketing approach
• Optimising invested capital (e.g. a reduction in
inventories)
 Transitory items

• These may increase EVA, but they are either transitory in

nature, or merely reflective of an artificial increase in the
underlying operations, e.g.:
• Gains and losses on sale of non-current assets
• Restructuring costs
• Discontinued operations
• Change in the corporation tax rate
• Changes in accounting estimates
• Changes in accounting policies
The impact of changes in accounting estimates on growth

Assume that the above assumptions remain constant in future periods.

Growth in EVA before change in accounting estimates:
Now assume the co. changes its accounting estimates in year 4 for new investments. It
decides to extend the useful life of non-currents assets from 2 to 3 years.
 Growth and liquidity

• Growth is often associated with cash

consumption, as it requires investment in non-
current assets and working capital.

• Therefore it is important that growth is

accompanied by close monitoring of cash flows.
 Liquidity risk analysis
• Liquidity is vital for any business. Without liquidity, a
business cannot pay its bills or carry out
investments.
• Short-term liquidity risk is defined as a firm’s ability
to pay all short term obligations
• Long-term liquidity risk is defined as a firm’s ability
to pay all long term obligations.
 Potential stakeholders affected by
a company’s liquidity risk

• Investors: Potential loss on investment

• Creditors: Potential loss on loans
• Suppliers: Potential loss on customer balances
• Customers: Risk of shortage of supply
• Employees : Risk of losing job / lack of job security.
Short-term liquidity risk analysis
• Different to current ratio, as it uses actual cash flows
generated from operations rather than current and
potential cash flow resources (current assets).
• Therefore, it avoids the convertibility-to-cash problem
of current assets.
• Always expressed as a %, but difficult to interpret
without benchmarks.
• Typically used on firms with negative earnings or start-ups.
• Measures how long a company is able to fund projected costs
without any further cash contribution from shareholders or
creditors.
• Its usefulness depends on the ability to estimate future costs
and revenues.
• Expressed in months, e.g. on the next slide Genmab has cash
for 27 months of operations in year 2.
Cash burn rate for selected biotech companies
 Long-term liquidity risk analysis
• Solvency: Company’s ability to meet its long-term debt
obligations.
• Two types of commonly used solvency ratios:
1. Leverage ratios
• Focus on the balance sheet
• Measure relative amount of debt in the company’s capital
structure
2. Coverage ratios
• Focus on the income statement and cash flows
• Measure the ability of a company to cover its debt-related
payments
 Leverage and coverage ratios
Solvency Ratios Numerator Denominator
Leverage ratios
Debt-to-assets ratio Total debt Total assets
Total debt + Total shareholders’
Debt-to-capital ratio Total debt equity

Debt-to-equity ratio Total debt Total shareholders’ equity

Financial leverage ratio Average total assets Average shareholders’ equity

Coverage ratios

Interest coverage ratio EBIT Interest payments

Interest payments + Lease
Fixed charge coverage ratio EBIT + Lease payments payments
 Strengths and weaknesses of financial ratios
measuring short- and long-term liquidity risk
Strengths:
•Easy to calculate
•Cost efficient way to rank companies based on their (liquidity)
risk.
Weaknesses:
•Based on historical accounting information and, thus,
backward-looking
•Only describes parts of a company’s financial position – less
useful if they are not used together
•Less useful in the absence of an appropriate benchmark
•Financial ratios are based on accounting data – it is therefore
important that accounting quality is taken into account.