1. Vietnam Master in Management – HCMC dec 2003 Profitability How to Use the Financial Plan Make it simple w Regroup all the inputs Sensibilities Studies Set of different Cases w Base Case w Best and Worst Cases (external influence) w Strategic Decisions (internal) Synthesis and Graphic Presentation

2. Vietnam Master in Management – HCMC dec 2003 Profitability Input Data Improvement It is useful to bring all the input data together w Easier to make sensibilities studies BPcons.xls - SENSIB!A182

3. Vietnam Master in Management – HCMC dec 2003 Profitability Sensibilities studies Goals w To cover a broad scope of possible futures w To identify the business drivers Most important factors to determine the future w To measure the risks Usually a few major scenarios w Base Case (or Management Case) w Best and Worst Case w Influence of major capex decisions

4. Vietnam Master in Management – HCMC dec 2003 Profitability Saigon Hotel Sensibilities Unit rateOccupancyCapex new rooms Capex chain license BaseDip in 03-04 (60-65 US$) Dip in 03-06 (50%-65%) BestLower dip (65-70 US$) Reduced dip (70%-75%) WorstLonger dip (till 2005) Longer dip (till 2006) ExtensionAs in Base Slower recov 4 MioUS$ (2003-04) ChainBetter than Base 1 MioUS$ (2003)

5. Vietnam Master in Management – HCMC dec 2003 Profitability How to analyze sensibilities studies Analyze most important indicators w Profit and loss Revenues EBITDA EAT w Balance Sheet Equity Debt w Ratios ROCE ROE Debt/equity ratio Use graphs

6. Vietnam Master in Management – HCMC dec 2003 Profitability Saigon Hotel Revenues

7. Vietnam Master in Management – HCMC dec 2003 Profitability Saigon Hotel EBITDA

8. Vietnam Master in Management – HCMC dec 2003 Profitability Saigon Hotel EAT

9. Vietnam Master in Management – HCMC dec 2003 Profitability Saigon Hotel Cash Flow

10. Vietnam Master in Management – HCMC dec 2003 Profitability Saigon Hotel Equity

11. Vietnam Master in Management – HCMC dec 2003 Profitability Saigon Hotel Financial Debt

12. Vietnam Master in Management – HCMC dec 2003 Profitability Saigon Hotel : ROCE

13. Vietnam Master in Management – HCMC dec 2003 Profitability Saigon Hotel ROE

14. Vietnam Master in Management – HCMC dec 2003 Profitability Financial analysis and leverage Necessity to have a quick vision of the financial situation of a company w common language w comparability Profitability ratios w to measure the efficiency and the profitability Leverage ratios w to measure the indebtness

15. Vietnam Master in Management – HCMC dec 2003 Profitability Financial analysis and leverage Coverage ratios w how are the debt and the interests covered by the cash-flow ? Liquidity ratios w how liquid is the company ? Distribution ratio w what does the company distribute to the shareholders ?

16. Vietnam Master in Management – HCMC dec 2003 Profitability Necessity of the Financial Analysis Who needs the financial analysis ? w the banker to assess a new loan or to maintain a credit line w the supplier to be sure to be paid by his customers w the customer to be sure that his supplier will stay in the business w the market (stock exchange) to assess companies to valuate companies

17. Vietnam Master in Management – HCMC dec 2003 Profitability What is important for the analysis ? To be able to compare... w different companies with the same activity (hotels, airlines, etc.) with different activities w one company across the time... everyone must use the same indicators w necessity of a common language no discussion on the facts but discussion on the interpretation of the facts

18. Vietnam Master in Management – HCMC dec 2003 Profitability What is important for the analysis ? Limits to the comparability w differences in accounting rules and practices in different countries (laws, fiscal regulations, accounting rules) inside the countries (internal practices of the companies) depreciation period research & development brands w leads to a growing standardization of the rules BUT … the practices remain different

19. Vietnam Master in Management – HCMC dec 2003 Profitability What is important for the analysis ? Trust in the figures w published by the companies themselves w the Board of Directors is responsible Risks w “window dressing” w “cover-up” Remedies w external auditors w market authorities w stock price w complains by shareholders the “Swissair Case : Accounts of 2000” the “Enron Case”

20. Vietnam Master in Management – HCMC dec 2003 Profitability The Swissair Case Accounts 2000 Underestimation of the losses of subsidiaries w Sabena, AOM-Air Liberté Underestimation of committed reinvestments w Sabena, AOM-Air Liberté, LTU Hidden commitments w put options given to other shareholders in joint-ventures

21. Vietnam Master in Management – HCMC dec 2003 Profitability The Enron Case Underestimation of “off-balance” items w Additional investments committed False profits on asset sales w Assets were sold by Enron to Enron funded companies Over-estimation of turn-over / activities w Enron controlled only fees on turn-over and NOT turn-over Finally … destruction of documents and files w by the company … w … and its external auditors

22. Vietnam Master in Management – HCMC dec 2003 Profitability Profitability Ratios : the ROE The key concept : Return on equity w ROE  Rfin  EAT/EQ Key concept for the shareholder w profitability of their investment in shares of this company compared to alternate financial assets w other shares w fixed rates bonds (of companies or government) How to measure the equity ? w book-value or... w...market price w the difference can be huge for listed companies

23. Vietnam Master in Management – HCMC dec 2003 Profitability Drivers of the ROE What are the drivers of the ROE ? The profit margin on Sales The productvity of capital employed w all the assets used by the company w fixed assets w working capital w cash The financial structure of the company w level of debt vs. equity

24. Vietnam Master in Management – HCMC dec 2003 Profitability Profitability Ratios : ROCE The Return On Capital Employed (ROCE) measures what the company earns (before interest and tax) per unit of capital employed w ROA  ROCE  EBIT/Assets w ROCE = EBIT/(FIX+WC+CASH) w in the practice the total Assets of the Balance Sheet are often used w this ratio is not influenced by the financial structure of the company because we use the EBIT w is also called Return On Investment (ROI) or Return On Assets (ROA)

25. Vietnam Master in Management – HCMC dec 2003 Profitability ROCE after taxes It can be useful to calculate the ROCE after taxes w ROCE* = ROCE.(1-T c ) w where T c is the average tax rate

26. Vietnam Master in Management – HCMC dec 2003 Profitability Relation between ROE and ROA If the company has no financial debt w ROE = ROCE* = ROCE.(1-T c ) w for the demonstration please see in a finance reference book w this is logical because in this case the total of assets is equal to the equity and no interest is paid The higher the ROCE the higher the ROE The lower the tax rate the higher the ROE

27. Vietnam Master in Management – HCMC dec 2003 Profitability Relation between ROE and ROA If the company has financial debt w ROE = ROCE.(1-Tc) + (ROCE-id).(1-Tc).Dfin/EQ w where id is the average rate of interest on the debt w for the demonstration see in the book The ROCE should be higher than the interest rate w if ROCE > id then ROE > ROCE* w if the ROCE is higher than the interest rate on the debt then the ROE is higher than the ROA after taxes w if ROCE < id then ROE < ROCE*

28. Vietnam Master in Management – HCMC dec 2003 Profitability Leverage Effect This equation is very important in finance w ROE = ROCE.(1-T c ) + (ROCE-i d ).(1-T c ).D fin /EQ The higher the ROCE the higher the ROE The lower the tax rate the higher the ROE The higher the debt (D fin ) vs. equity (EQ) the higher the ROE w if the ROCE is higher than the interest rate This is called the Leverage Effect

29. Vietnam Master in Management – HCMC dec 2003 Profitability Leverage Effect It means that the ROE can be improved by increasing the debt level w if and only if the ROCE is higher than the interest rate How far can the Equity be reduced and the financial debt increased ? w the company must find a bank to bring the debt w the bank will look at the risks not to be repaid ­ higher risks will be compensated by higher interest rates ­ higher interest rates will reduce the Leverage effect

30. Vietnam Master in Management – HCMC dec 2003 Profitability Risks of the Leverage Effect The company can be in a bad situation w if the interest rate increases w if the future Free Cash flows are lower than expected less business additional unexpected investments to do change in economic conditions – tax rate – exchange rate w if the shareholders want more dividends w if the bankers become nervous

31. Vietnam Master in Management – HCMC dec 2003 Profitability Leverage effect : example

32. Vietnam Master in Management – HCMC dec 2003 Profitability Saigon Hotel – Leverage Effect Case 1 : Extension with initial capital structure w 4 Mio US$ capex and 4 Mio US$ debt Case 2 : Extension with more equity w 2 Mio US$ equity and 2 Mio US$ debt Case 3 : As Case 1 but continued adverse circumstances w Unit rate and occupancy Case 4 : As Case 2 but continued adverse circumstances

33. Vietnam Master in Management – HCMC dec 2003 Profitability Saigon Hotel leverage : ROCE

34. Vietnam Master in Management – HCMC dec 2003 Profitability Reference levels for ROCE and ROE What is a sound level for the ROCE ? w higher than the interest rate w in the range 10%-18% in western economies w the level is a reference for expected profitability of new capital expenditures What is a sound level for the ROE ? w in the range 12%-25% w depends on the risk of the business activity related risks (high tech vs. low tech) maturity of the business (start up vs. mature) financial structure (highly leveraged vs. standard)

35. Vietnam Master in Management – HCMC dec 2003 Profitability Saigon Hotel leverage : ROE

36. Vietnam Master in Management – HCMC dec 2003 Profitability Saigon Hotel leverage : D/E ratio 0,0 0,5 1,0 1,5 2,0 2,5 3,0 200220032004200520062007 extensionworstequity worst

37. Vietnam Master in Management – HCMC dec 2003 Profitability Leverage ratios The indebtness of a company can be measured by the debt-equity ratio ( ) w debt-equity ratio   Dfin/EQ w be sure the leases are included in the debt Alternate : the debt ratio w debt ratio  Dfin/(Dfin+EQ) Some authors use only the medium and long term financial debt (DMLT) w we prefer all the financial debts (possibility of switch between DMLT and DSTfin)

38. Vietnam Master in Management – HCMC dec 2003 Profitability Reference level for the debt-equity ratio It must be sustainable for the company w payment of interests w reimbursement of the debt Consequently it will be different from company to company depending on : w the projected Cash flows and Free Cash flows w the sensibility to outside factors ­ general economic situation ­ influence of new competitors ­ etc.

39. Vietnam Master in Management – HCMC dec 2003 Profitability Liquidity ratios These ratios measure how liquid is the company Current ratio w current ratio  currents assets / current liabilities w current ratio  (S+R+CASH) / (D op +D fin,short term ) Acid test (Quick test) w this ratio reflects the fact that some current assets are less liquid (inventories) w acid test  (R+CASH) / (D op +D fin,short term )

40. Vietnam Master in Management – HCMC dec 2003 Profitability Reference levels for liquidity ratios All these ratios depend on the industry Current ratio w if possible, higher than 1 Acid test w if possible, higher than 0.7 / 0.8

41. Vietnam Master in Management – HCMC dec 2003 Profitability Distribution ratio The pay-out ratio measures the share of the net result distributed to the shareholders w pay-out  DIV / EAT Reference level w depends on the financial needs of the company w for listed companies : expectations of the markets w standard for mature companies : 40% to 60%

42. Vietnam Master in Management – HCMC dec 2003 Profitability General remark on the calculations of ratios For the P&L no doubt : use the year figures For the Balance Sheet which figures ? w at the end of the year ? w at the end of last year ? w another figure ? Correct calculation : daily average Use the average (end of the year/end of last year) w best estimate of the reality Be always coherent

43. Vietnam Master in Management – HCMC dec 2003 Profitability Conclusions of the lesson The Sensibilities studies are useful w To look at the different possible futures w To identify the business drivers w To identify the risks The financial ratios are quick tools to analyze the financial situation of companies By using the financial ratios one can compare w different companies w across the time Limits of the financial ratios w can we trust the Balance Sheet & Profit &Loss ? w reference levels depend of the industry