Accounting Based Indicators

-> IDEA: aim of annual report is to provide a quick and useful overview of the company’s main results (performance). Summarize information about:

• Economic profit achieved and its components (PROFITABILITY ANALYSIS);
• Status of liquidity and its “coherence” to present obligations (LIQUIDITY ANALYSIS).

❓Why are they call Accounting-Based Indicators?

-> Because the main data come from financial reports.

❓What are Accounting based indicators?

-> They are financial indicators because they are calculated on the financial statements. They are slow, eliable, accurate, produced after many months. We cannot take fast decision on the basis of these indicators, in fact they are not enough and we will see other types of indicators.

• PROFITABILITY ANALYSIS: Economic profit achieved and its components;

-> Economic balance;

• LIQUIDITY ANALYSIS: status of liquidity and its “coherence” to present obligations.

-> Cash Balance: Cash in-flows >> Cash out-flows

“Revenue is vanity, profity is sanity and cash is reality”

Charles J. Murphy

“Revenues is vanity” –> revenues are proxy of the company’s dimension, size (other indicators of size are market capitalization and number of full-time employees). Why a company wants to be big? To increase its bargaining power and the political relevance. Revenues alone are not enough.

“Profit is sanity” –> tells you if the company is profitable.

“Cash is reality” –> because what really matters is the capability to make money to invest, to grow. Without money, we need to take loans to finance the grow.

📌Next Future = next 12 months.

Financial Analysts:

• Compare present with past company’s performance (3-4 years) and define an historical trend, further investigating potential impacts of contingencies or non-ordinary events related to the company’s own activities.

-> Single year could be an exception.

-> For example, Pfizer was forced to slow down the production of some very profitable medicine to produce the vaccines. We need to understand the implications of the disruption.

• Compare the performance of the company with that of other firms (usually main competitors), further investigating potential impacts of contingencies or non-ordinary events related to the industry(ies) where the company operates.

-> SIZE: We have to consider even the size of the company. Is more difficult compare companies of different size.

-> PERIMENTER: we have to consider the perimeter of different companies. (Es: Samsung vs Apple is difficult to compare, Tesla too)

-> GEOGRAPHICAL POSITIONING: we have to consider the geographical location, it could affect the business.

⚠The perfect competitor does not exist, every company is unique⚠

COMPETITORS: company that compete in the same BA.

Accounting-Based Indicators:

-> Indicators are calculated on the three FS:

❓What are Accounting based indicators? They are financial indicators (calculated on the financial statements). They are slow, reliable, accurate, produced after many months. We cannot take fast decision on the basis of these indicators, in fact they are not enough and we will see other types of indicators.

Profitability Analysis: 3 Perspective

-> AIM: evaluate the ability of the company in making profit and to identify its main components;

-> PROSPECTIVES:

• SHAREHOLDERS’ PERSPECTIVE: assuming net profit (E) (reward of shareholders) as the main item of analysis;

🔎: Net Profit (dividends are based on that)

👥: CEO & CFO (they’re evalueated by the shareholders based on this parameter) & Senior Manager: point of contact between middle manager and shareholders.

• OVERALL COMPANY’S PERSPECTIVE: assuming operating profit (ex EBIT) as the main item of analysis;

🔎: EBIT (descrive the efficienty generate revenues from the resources they were given).

👥: Middle line manager perspective;

-> ROE: compare revenue and operating costs.

• STAKEHOLDERS’ PERSPECTIVE: analysin the effects of I (Interests) and T (Taxes) on the final net profit (E).

👥Banks, Bound Holders (interests) and Government (Taxes) but there are others.

⚠Not only financial analysts are stakeh.

-> We use it to predict what will happen the next yer (“outlook” for the next year of the company).

🧠SHAREHOLDERS‘ Perspective:

ROE, Return On Equity:

->MEASURES the “interest rate” on shareholders’ equity, i.e. how much they earned on the investment they made in the company.

⚠We can use this or some others indicators.

⚠The formula of the ROE could change companyt to company! (they customize it).

-> We use ratio to eliminate, a minimum, affection given by size, but we have to consider it when we comment it.

NET PROFIT or NET INCOME (Income Statement): amount of money remaining after deducting a company’s total expenses from its total revenue for a given accounting period (NP = Total Revenue – Total Expenses).

EQUITY (Balance Sheet): rights the shareholders have on the assets, the book value of the company, the cumulative investment made over time by the shareholders.

NPM, Net Profit Margin:

-> MEASURES the percentage of profit that shareholders can retain from revenues (i.e. the starting point of Income Statement).

• Capability of the company to transform revenues into net income.
• Give an idea about the costs.

• Tipically < 1 (could be > 1 for example in case of disposal of assets, positive taxes or other peculiar cases).

-> It is also known as “bottom line margin”

-> The impact of the operating, financial and fiscal activities on NPM should be analysed.

-> The impact of the operating, financial and fiscal activities on NPM should be analysed.

Payout Ratio (t):

-> MEASURES the percentage of net profit that is returned by cash to shareholders.

• Dividends are in the Cash Flow statement (thery’re not the cost).
• It is the only indicator that is different in the timeline.

-> It is the “real” monetary reward (remuneration) of shareholders (important for them).

… and not always the higher the better

-> If it’s 100% => Company is NOT reinvesting! Needs to take money from other people (banks)

• To judge it we have to know the context, strategy, situations behind it and because this value could mean different things.

🖐OVERALL Company’s Prospective:

-> Considering all the middle line managers as a team (that is why it is called “overall company”).

ROA, Returno On Assets:

-> MESASURES the ability of managers to generate profit by using company’s assets.

• It is also used in managers’ internal evaluation.
• Measures the good strategy execution (good strategy => 🔼 EBIT).

=> If EBIT is not superior to competitors => strategy is not producing results.

📌EBIT: is important because shows if a company is able to sustain its competitive adavantage.

• Return is EBIT (POV middle line).
• ROA evaluate middle-line managers, they should try to minimize the Assets and maximise the EBIT using strategy.

-> The assets that we include are the only one that has a monetary value, other intangible assets as creativity, innovation, leadership of employee that have not monetary value are not consider.

RETURN: Capability to differentiate revenues and costs

-> CHAR:

• If the company invest => it become lower;
• It increase by itself.
• It’s also call Returno On Investment, but are two different things. This is the commonly accepted formula, but it isn’t accepted from everyone.
• Return is EBIT (because his prospective)
• If we are able to maximise the ebit => maximise the income.

⚠️Use EBIT and not EBITDA because companies could decide not to have machinaries and to outsource (so considering EBITDA wouldn’t be fair when benchmarking).

-> Relevant because OBJ of M-L Managers is to use assets (so revenues) in an efficient way to generate high EBIT (revenues-costs).

❓If we don’t change anything, what will happen to ROA? It depends on the time. In the short term, assuming that nothing happens in the market, the ROA is increasing because EBIT is constant, and assets lose value due to depreciation. In the long term, ROA decreases because EBIT will decrease because we will lose our competitive advantage if we don’t change anything.

❓Assume that at a certain moment, the company wants to make an investment. What happens to ROA? In the short term, ROA decreases because assets are increasing while EBIT is decreasing (revenues – costs: revenues are almost constant, because it’s too soon to see the benefits of the investment and costs are increasing) In the long term, ROA increases because assets are decreasing (because of depreciation) and EBIT is increasing (because revenues are high, and costs are low)

ROI, Return On Investment Capital:

-> MEASURES the return of the capital that have been invested from the company.

• DENOMINATOR: Equity + Liabilities with explicit interest rate.

-> we consider:

• Other payables: they’re not financial debts;
• Provision;
• Employee benefits and liabilities;

-> It improve it try to refine ROA.

• E.g. not all the assets are “true” assets, in the sense that “true assets” are resources used to generate revenues.

-> On the right side of BS:

• Equity = long term investment made by the shareholders
• Liabilities = could be financial or not. To distinguish liabilities –>
  • Non-financial liabilities: are liabilities without an explicit interest rate, for example bank debts, payables (something that company doesn’t pay yet, but is not an asset).
  • Financial liabilities: used to finance the company, they have an explicit interest rate, like bank debts and bonds.

-> TOTAL ASSETs – LIABILITIES WITHOUT AN EPLICIT INTEREST RATE =

= EQUITY + FINANCIAL LIABILITIES (current & non-current) =

= Invested Capital = Actual resources invested and that managers use to greate profit.

⚠️ROI is always higher tha ROA (denominator decrease)

ROCE, Return On Capital Employed:

-> PROBLEM: current financial liabilities are usefull as investments => we could use another indicator that refines the ROI.

-> Is an alternative to ROI

-> Capital Employeed = equity + non-current financial liabilities.

📌If payables are very small => ROA = ROI. If current liabilities are very little => ROI = ROCE.

-> Is better that the ROA.

-> Is too much sophisticated.

NON-CURRENT FINANCIAL LIABILITIES:  any debts or other financial obligations that can be paid after a year. E.g.

• Long term borrowings;
• Long-term lease;
• Provisions;
• Deferred tax liabilities;
• Loans;

❓Which of the following ratios is the most used by financial analysts: ROA, ROI or ROCE?

-> They are very similar, to say which is the most relevant we need to know the industry, because it depends on the structure of the company. We should read the “management of report” to see which indicators are used by the company. Typically, ROA is the most used, because it is also connected to other indicators. According to Lettieri, the most interesting indicator is ROI.

ROA = ROS * ATR

ROS or Operating Profit Margin:

-> MEASURES the margin % that can be retained from revenues.

• Tell the capability of the company to have a price significantly higher than the cost (it measures the results of the strategy -it is a premium price strategy or a volume strategy?-)

-> or ROS, Return On Sales or EBIT margin.

• SALES: volume of sales.

-> IMPORTANT because is the first part of the NPM (check formula).

🔎EBITDA margin = EBITA/revenues (or EBITDA/total assets, but less common).

-> In many conglomerable companies (ex P&G, Auto grill shops) ROS is very important, because it represent the margin of a product

ATR, Asset Turnover Ratio:

-> IDENTIFIes the capability of the company to manage assets efficiently for generating revenues.

=> It measure EFFICIENCY = OUTPUT/INPUT.

• Capital intensive companies: company need lot of money to buy assets (e.g. manufactoring companies, chemical or oil)

TOTAL ASSETS: have assets that should rotate => They’re used a lot in order to generate revenues.

-> Higher is better (means not many assets but rotate a lot) (Assets are expensive => we don’t like asset-intensive business (capital intensive industries are chemical, oil)).

-> ROA = ROS * ATR

🌍STAKEHOLDERS‘ Perspective:

-> Perspective limited, not comprehensive and old (considers only two type of stakeholders: bank and government).

Debt-to-Equity Ratio:

-> MEASURES in which % the assets are owned by the shareholders.

• Capability of suppoprt the growth and acquisition of the assets through resources provided by third parties such as banks, not by shareholders.
• It is proxy of the risk of a company.

⚠️ DEBTS refers ot all the third-party liabilities (financial & non-financial: bank debts, payables, pensions, provisions) because we are in the accounting part of the course [Accounting 👀= liabilities/ equity; Financial 👀= liabilities/ equity].

-> Changes based on the Industry: usually the limit is 3 for a corporation without risk. E.g. soccer industry is more than 10; for Google or Zara or other family businesses is close to 0.

-> Also called Financial Leverage: the company is “leveraging” when it’s increasing this indicator, meaning that the company is acquiring new assets asking resources to banks or bond holders (instead of shareholders).

ICR, Interest Coverage Ratio:

-> MEASURES: how many times the EBIT is covering the financial expenses.

• Measure safety of business.
• Ability to payback financial expenses.

-> There are two formula:

• EBIT/Financial Expences
• EBIT/Interest Cost (among the financial cost we have to consider the banks debts)

-> IDEA: EBIT cover tinancial expenses.

-> IMPORTANT: capability of EBIT (how many time) to cover cost

•  => Net Income < 0, because EBIT is positive, but we have to pay texes.
• : company is safe, but…

If N too high => D too low => Company is not investing, is not growing!!! Don’t be happy if it’s too high.

-> INCOME STATEMENT:

• FINANCIAL EXPENSES: usually high because it’s suppose that comapny ask loans to banks to grow;
• FINANCIAL INCOME: usually close to 0 because the company use money to buy tangible and intangible assets (not gains through financial acquisitions but from operating activities).

EBT is usually lower than EBIT: financial expenses are greater than the financial incomes.

Net income usually lower than EBT except when taxes are positive (

CD, Cost of Debt:

-> MEASURE:  total interest expense owed on a debt.

• It’s the average cost of taking loans and getting money from other people.

-> CHAR:

• Interest costs are connected to banks debts or bounds (securities).
• Debts with explicit interest rate: banks debts and bonds.
• Usually compared with the ROI: e.g. CD=10%, ROI=5% => not sustainable: company collect money at higher rate than what it gain.

⚠Not really correct: CD considers bank debts while ROI considers financial liabilities and equity (the compariso still vlaid: usually liabilities are higher than equity (except family businesses).

•  interest rate or the total amount of interest that a company or individual owes on any liabilitieds, such as bonds and loans.

-> We not consider the expectation of

• Interest costs = Interest Expenses = Financial Costs (Income Statement)
• Debt with explicit interest rate = Financial debt (current liabilities) + Financial debt (non–current liabilities)

INTEREST COSTS (income statement): total interest expenses incurred by the company during a specific reporting period.

E.g. interest payments on various forms of debt, such as bonds, loans, and credit lines.

DEBT WITH EXPLICIT INTEREST RATE (income statement):  are typically bonds, loans, or other debt securities where the interest rate is clearly defined in the contract or agreement.

Effective Tax Rate:

-> MEASUREs the effective weight of taxation on the company’s profit.

• Relevnt when there is a change of the situation an the perimeter and geographical location is fixed.

• Tells the impact of taxation on profit.
• Generally doesen’t change over time.
• It’s intresting the comparison of different companies;
• In itali is 40-45% average, Croatia close to 20%, Romania and Bulgaria 10%.

Accounting’s Logics:

-> The main difference between accrual and cash basis accounting lies in the timing of when revenue and expenses are recognized.

ACCRUAL ACCOUNTING LOGIC:

-> DEF: records revenue and expenses when transactions occur but before money is received or dispensed.

• More acccurate view of a company’s health: includes accounts payable and receivable.

what I’m suppose to pay in that year => we took the one in BS;

CASH BASIS ACCOUNTING LOGIC:

-> DEF: records recenue and expenses when cash related to those transactions actually is recevied or dispensed.

-> Provides an immediate recognition of revenue and expenses;

-> Rappresent cash that goes out