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BALANCE SHEET RECLASSIFICATION

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1 BALANCE SHEET RECLASSIFICATION
RATIONALE AND METHODS

2 Premise Financial accounts prepared according to the law have the advantage of being understandable in different countries However they do not allow for an easy and coherent understanding of the firm’s financial results. Aggregation of items hinders some relevant features of firm’s financial position BS and PL account reclassification is aimed at grouping items into homogeneous categories

3 There exist two criteria for BL and PL account reclassification
BS PL Liquidity Management areas Sales and cost of goods sold Production and value added

4 BS reclassification – Liquidity/Maturity
According to the liquidity/maturity criteria BS items are grouped as function of the time required to be transformed into cash Liquidity: decreasing assets’ liquidity Maturity: increasing liabilities maturity It controls for correlation between assets and liabilities maturities

5 BS reclassification – Liquidity/Maturity
Liqudity Cash balances, short term securities Deferred liquidity Trade credit Disposables Inventories Tangible assets Plants, equippements Intangibles assets Trademarks, know-how, licenses Financial investments Participations, Long term securities Bank debt Bank overdrafts Debt Suppliers, tax debt, short term debt Long maturing liab Mortgages, Bonds Other long term debt Retirement Own funds (equity) Equity capital Reserves Profit/Loss Short lived asstes Long lived assets Short term debt Long term debt E

6 BS reclassification-Liquidity/Maturity
Well Balanced Poorly Balanced Strongly Unbalanced Liqud assets – L 25% Disposables – D 27% Fixed assets –FA 48% Short Term Liab - STL Long term Liab LTL - 22% Equity – E 53% L 25% D 27% FA 48% STL 42% LTL 14% E 44% L 25% D 27% FA 48% STL 55% LTL - 30% E - 15% L=STL L+D>2xSTL E>FA L+D>STL+LTL LTL<1/2FA L<STL L+D<2xSTL E<FA L+D<STL+LTL LTL<1/2FA L<STL L+D<2xSTL E<FA L+D<STL+LTL LTL>1/2FA

7 Reclassification according to operations
BS items are grouped according to the area they belong to (current operations vs non current operations) Current management comprises all typical business activities according to the specific business sector of the firm. It comprises purchases (raw materials), transformation and sale. Items: Trade credit Trade debt Inventories Fixed assets: they are operational assets not belonging to current operations Cash balances and interest bearing liabilities?

8 Reclassification according to the operations
Trade credits Inventories Other current assets Operational tangibles Operational Intangibles Operational financial invetsments Trade debt Other current liab (retirement, Tax debt) Bank debt (mortgages..) Bonds Other non current liab. Equity Equity capital Reserves Profit/Losses Operational current assets Operational non current fixed assets Current liabilities Non current liabilities Cash balances Non operational assets Non current

9 Reclassification according to operations
Trade credits Inventories Other current assets Operational tangibles Operational Intangibles Operational financial invetsments Trade debt Other current liab (retirement, Tax debt) Bank debt (mortgages..) Bonds Other non current liab. Equity Equity capital Reserves Profit/Losses Current operational assets Operational non current assets Current liabilities Non current liabilities Cash balances Non current, non operational assets Non operational fixed assets Non operational assets The Firm might run businesses outside the core business (ie. Renting a plant to a firm operating in another sector). Since such assets do not contribute to firm’s operations, they are included in non-operational assets

10 Reclassification according to operations
On a financial perspective, reclassifying balance sheet items according to the area they belong to is particularly important. It is useful for the purpose of analysing the dynamics in capital invested In particular, it allows to gain understanding of changes in: Commercial working capital (CCCN) Operational net invested capital (ONIC) Net invested capital (NIC)

11 Reclassification according to operations
CURRENT ASSETS OPERATIONAL FIXED ASSETS CURRENT LIABILITIES FINANCIAL LIABILITIES EQUITY CASH BALANCES NON OPERATIONAL FIXED ASSETS CCCN WK + Operational net fixed assets = ONIC ONIC + Non operational fixed assets = NIC

12 Reclassification according to operations
OFA CL FL E C NOFA CA OFA CL FL E C NOFA CCCN (+) CCCN (-) CCCN positive Lowering firm’s liquidity Limited ability to timely monetize revenues Limited ability to delay payments CCCN negative Improving firm’s liquidity Good ability to timely monetize revenues Good ability to delay payments

13 Reclassification according to operations
CURRENT ASSETS (CA) OPERATIONAL FIXED ASSTES (OFA) CURRENT LIABILITIES (CL) FINANCIAL LIABILITIES (FL) EQUITY (E) CASH BALANCES (C) NON OPERATIONAL FIXED ASSTES (NOFA) FINANCIAL LIABILITIES - CASH BALANCES = NFP positive FL>C NFP negative FL<C Net Financial Position (NFP)

14 Reclassification according to operations
ASSETS (A) (INVESTMENTS) DEBT (D) EQUITY (E) According to a synthetic view, in the BS might be represented, through a single item, the total investments In such a representation CL are deducted from CA On the right side, there remain financial sources represented by NFP and (equity) CCCN A=CCCN + Fixed assets D=NFP=FL-C

15 Example Assets Liabilities Inventory-Goods 190
Liabilities Inventory-Goods 190 Bank debt (Maturing Installment) 7000 Trade Credits 8800 Earnings of the fiscal year 2800 Cheques 100 Extraordinary reserves 9000 Licenses, Rights 1200 Equity capital 20000 Property and Plants (non operational) 1000 Bonds (Short term) 50 Property and Plants (operational) Tax provisions 400 Other credits 1300 Reserves 612 Bank current account 115 Trade Debt 12205 Other securities Bonds (Long Term) 1850 Equipment 26000 Bank debt (installments due in coming years) 11000 Trade credit (due next years) Retairment provisions 2000 Credits (subsidiaries) –Short term 3500 Bank overdrafts Shares in controlled firms 16215 Tax debt 1900 Advances (credit) 1400 Advances (debit) 3 Shares held in other firm's equity capital (non strategic) Total Asset 69820 Total Liabilities

16 Reclassification-Liquidity/Maturity
Assets Liabilities Current Assets 16005 Current Liabilities 22558 Liquidity 215 Tax provisions 400 Bank current account 115 Bonds (Short term) 50 Cheques 100 Bank overdrafts 1000 Deferred Liquidity 15600 Bank debt (Maturing Installment) 7000 Trade Credits 8800 Trade Debt 12205 Credits (subsidiaries) 3500 Advances (debit) 3 Shares held in other firm's equity capital (non strategic) Tax debt 1900 Other securities Long Term Liab 14850 Other credits 1300 Bonds (Long Term) 1850 Disposables 190 Bank debt (installments due in coming years) 11000 Inventory-Goods Retairment provisions 2000 Fixed Assets 53815 Own Funds 32412 Property and Plants (non operational) Equity capital 20000 Property and Plants (operational) Reserves 612 Equippment 26000 Extraordinary reserves 9000 Licenses, Rights 1200 Earnings of the fiscal year 2800 Shares in controlled firms 16215 Trade credit (due next years) Advances (credit) 1400 Total Asset 69820 Total Liabilities Treasury Margin=Liquidity+Def. Liq-Curr. Liab=-6743 Structure Margin=Own Funds-Fixed Assets=-21403

17 Reclassification according to operations
Assets Liabilities Operational Working Capital 282 NFP 20685 Trade Credits 8800 Bonds (Short term) 50 Trade credit (due next years) 1000 Bank overdrafts Credits (subsidiaries) 3500 Bank debt (Maturing Installment) 7000 Inventory-Goods 190 Bonds (Long Term) 1850 Other credits 1300 Bank debt (installments due in coming years) 11000 (-)Tax Provision -400 (-)Bank current account -115 (-)Trade Debt -12205 (-)Cheques -100 (-)Advances (debit) -3 Own Funds 32412 (-)Tax debt -1900 Equity capital 20000 Fixed Assets (net) 49815 Reserves 612 Property and Plants (operational) Extraordinary reserves 9000 Equipment 26000 Earnings of the fiscal year 2800 Licenses, Rights 1200 Shares in controlled firms 16215 Advances (credit) 1400 (-)Retairment provisions -2000 NonOperational Fixed Assets 3000 Property and Plants (non operational) Shares held in other firm's equity capital (non strategic) Other securities Net Invested Capital 53097 Total Financing Sources

18 PL account reclassification – Sales and cost of goods sold
Reclassification here distinguishes between revenues (and cost) belonging to current operations (core business) from non current operations Precisely, such a criteria allows to calculate a few relevant margins In particular, (Ebit): operational revenues- operational costs. Before it we can calculate the industrial gross margin All items after Ebit belong to non current operations. We can find a few balances: Balance of financial management Balance of accessory management

19 PL account reclassification – Sales and costs of goods sold
(+) REVENUES (-) COST OF GOODS SOLD (+)Inventory (begin of the year) (+) Purchases (raw materials) (+) Energy (+) Employee expenses (+) Amortisation (+)Leasing (+) Other industrial costs (-) Inventory (final) (=) GROSS INDUSTRIAL MARGIN (-) General/administrative costs (-) Commercial/distribution costs (=) EBIT (-) Financial expenses (+) Financial revenues (+) Other revenues (supplementary activities) (-) Other costs (supplementary activities) (=) INCOME BEFORE EXTR. ITEMS (+/-) Extraordinary items (=) INCOME BEFORE TAXES (-) Taxes (=) NET INCOME INDUSTRIAL OPERATIONS CURRENT OPERATIONS Non industrial management area FINANCIAL ACTIVITIES SUPPLEMENTARY ACTIVITIES NON CURRENT OPERATIONS NON-RECURRING ACTIVITIES TAX MANAGEMENT AREA

20 PL account reclassification – Production and value added
Such a criteria is aimed at measuring the value of production that the firm carried on in the fiscal year. Two relevant margins are calculated Value of production. Corresponds to the value of all has been manufactured by the firm. Obtained subtracting to sales the cost of goods to be sold which didn’t benefit (in terms of value added) from firm’s production process Value Added(VA). Value of production net of consumes (productive factors needed to feed production) Abovementioned margins are gross of employee expenses and amortization. Net of these items we obtain: Ebitda: it is the VA net of employee expenses. It is a good proxy of firm’s performance Ebit: Ebit net of amortization. It provides the better representation of the accounting performance of the firm

21 PL account reclassification – Production and value added
(+) SALES (+/-)Changes in inventories (goods manufactured) (+)Value of works (economy) (-) Purchases of goods to be exchanged (=) PRODUCTION IN THE FISCAL YEAR (-) Purchases (raw materials) (-) Other purchasing costs (+/-)Changes in inventory (raw materials) (=) VA (-) Employee costs (=) EBITDA (-) Amortization (=) EBIT (-) Financial expenses (+) Financial revenues (+) Revenues (supplementary activities) (-) Costs (supplementary activities) (=) INCOME BEFORE EXTR. ITEMS (+/-) Extraordinary items (=) INCOME BEFORE TAXES (-) Taxes (=) NET INCOME

22 Two ways of analyzing the balance sheet
capital-employed perspective vs a solvency-and-liquidity perspective Ce perspective: the Bs shows all the uses of funds and analyses the origin of its sources of funds. 3 purposes: to understand how a company finances its operating assets; to compute the rate of return either on capital employed or on equity and as a first step to valuing the equity of a company as a going concern In a solvency-and-liquidity analysis, a business is regarded as a set of assets and liabilities, the difference between them representing the book value of the equity. Three purposes: to measure the solvency of a company; to measure the liquidity of a company; and as a first step to valuing its equity in a bankruptcy scenario

23 Two ways of analyzing the balance sheet
The purpose of a capital-employed analysis of the balance sheet is to analyse the capital employed in the operating cycle and how this capital is financed Fiscal year t-1 Fiscal year t Fixed Assets A Inventories + Account receivables - Accounts payables = Operating WK + Non operating WK = WK (B) CAPITAL EMPLOYED (A+B) Equity (C) Short, medium and long term borrowing - Marketable securities - Cash equivalent =Net debt (D) INVESTED CAPITAL (C+D)=CAPITAL EMPLOYED (A+B)

24 Book value of equity This is a solvency-oriented concept that attempts to compute the funds invested by shareholders It is an accounting, rather than financial, concept BV equity: Fixed Assets+Current Assets-Borrowings of any kind When a company is sold, the buyer will be keen to adopt an even stricter approach: by factoring in contingent liabilities (which do not appear on the balance sheet); by excluding worthless assets

25 ROE ROE = ROA x Leverage x Contribution of rev/expenses outside operations ROE = EBIT/TA x TA/E x NI/EBIT It shows the contribution of: Operations (ROA) Capital structure, reflected by the leverage ratio, TA/CN, which exerts a multiplicative effect on the operational margin and on NI/EBIT The contribution of revenues/expenses outside operations (NI/EBIT), such as interest expenses The effect of capital structure decisions is not clearly identified being splt into two indicators

26 The contribution of operations
ROA = ROS x TURNOVER Efficiency in the use of capital Economic efficiency

27 ROE-An alternative approach
ROE = [ ROA + (ROA – I) x D/E ] x NI/CI D = Debt E = Equity NI = Net income CI = Current income = Operational margin – Interest expenses (IE) I = IE/D = respresents an accounting estimate of the cost of debt

28 ROE-an alternative approach
NI = [EBIT - IE] (NI/CI) NI/E = [EBIT/E - IE/E] (NI/CI) ROE = [EBIT/TA * TA/E - IE/D * D/E] (NI/CI) ROE = [ROA * (D+E)/E - IE/D * D/E] (NI/CI) ROE = [ROA * (D/E + E/E) - IE/D * D/E] (NI/CI) ROE = [ROA*E/E + ROA * D/E - IE/D*D/E] (NI/CI) ROE = [ROA + ( ROA - I )* D/E] (NI/CI)

29 ROE-An alternative approach
ROE = [ ROA + (ROA – I) x D/E ] x NI/CI ROE depends on: operations (ROA) Capital structure: cost of debt and leverage ratio Income items outside operations: NI/CI. Excluding extraordinary revenues/expenses, the ratio becomes 1-T, where T is the tax rate ROE = [ ROA + (ROA – I) x D/E ] x (1-T)

30 Economic income vs accounting income
An important topic in financial analysis pertains to the distinction between realized and unrealized income Suppose you your assets, net of liab., are worth 120k € at the end of the period (100k at the beginning) and you receive 70k in wages in the period What your income? Many people would say 90k… …but not the accountant, according to whom your income is just 70k (he recognize only realized gains rather than paper gains) A non-accontant, by contrast, would say that your spending power, ignoring inflation, is the commonsense 90k (after all, if you sell your assets you could realize those 20k)

31 Economic income vs accounting incomr
€ in millions Accountant Economist Operating Income 173.2 IE 20.4 Other nonoperating expenses (1.5) Cost of Equity 98.4 Income before taxes 154.3 55.9 Provision for taxes 47.1 - Accounting earnings 107.2 - Economic earnings 8.8

32 ROE ROE = [ ROA+ ( ROA - IE/D ) x D /E ] x NI / CI Return on equity
Contribution from operations Contribution of Capital structure Contribution of Other businesses

33 CASE 1 200 IE 16 300 EBIT 30 E 100 NI 7 IE/D 8% ROA 10% T 50% ROE 7% D
CE 300 EBIT 30 E 100 NI 7 T 50% ROE 7%

34 ROE-Breakdown ROE = [ ROA x E + ( ROA - I ) x D] x NI / CI E E

35 ROE-Breakdown ROA-i=2% D/E=2
ROE = [ ROA x E ( ROA - I ) x D ] x NI / CI 8% 10% 100 200 E 2% E = 10% + 4% 50% 7%

36 CASE 2 250 IE 23 300 EBIT 30 E 50 NI 3.5 IE/D 9.2% ROA 10% T 50% ROE
CE 300 EBIT 30 E 50 NI 3.5 T 50% ROE 7%

37 ROE-Breakdown ROA-i=0.8% D/E=5
ROE = [ ROA x E ( ROA - I ) x D ] x NI / CI 8% 10% 50 250 E 0.8% E = 10% + 4% 50% 7%

38 CASE 3 100 IE 8 300 EBIT 36 E 200 NI 14 IE/D 8% ROA 12% T 50% ROE 7% D
CE 300 EBIT 36 E 200 NI 14 T 50% ROE 7%

39 ROE-Breakdown ROA-i=4% D/E=0.5
ROE = [ ROA x E ( ROA - I ) x D ] x NI/ CI 8% 12% 200 100 E 4% E = 12% + 2% 50% 7%

40 But: negative effects on risk!!
ROE: focus on leverage ROE = [ ROA + (ROA – I) x D/E ] x NI/CI Leverage: if (ROA - I) > 0 Rising the leverage ratio (D/E) allows pushing up ROE But: negative effects on risk!!

41 ROE breakdown: an extension
ROE = ROA + D=Financial debt [(ROA - IE/D) X D/E + NFD=Non-financial debt (ROA - 0/NFD) X NFD/E] X (1-K) X (1-T) ROE = [ROA +(ROA-I) D/E + ROA X NFD/E] X (1-K) X (1-T) K = (CI – EBT) / CI T = (EBT - NI) / EBT Impact of other businesses CI = EBIT - IE Impact of taxes on the firm’s income

42 ROE Is it a good indicator of the return on equity?
A company A with an higher ROE than company B, is for sure a better company? Is an improvement in ROE inequivaocally a sign of improved performance? Actually, ROE has three weaknesses as a performance indicator: The problem of time The problem of risk The value problem

43 The problem of risk The risk problem reflects the traditional risk-return trade-off The ROE says nothing on the risk levels that a company assumes Let consider the following example. Which of the two companies is the better? A (Risky business) B (Low risk business) ROA 6% 10% TA/E 5 2 ROE 30% 20% To overcome the distortionary effects of leverage on ROE and ROA, its better to rely on the ROCE

44 ROCE: benefits Let consider the following companies, identical except for their capital structure Which judgement on ROE, ROA and ROCE? Company A Company B interest rate 900 E 100 1000 TA=CE EBIT 120 (-) IE 90 EBT 30 (-) 12 48 Net earnings 18 72 ROE 18% 7.2% ROCE 12%

45 The problem of value ROE: based on the book value of equity
What if using the market value of equity? Let suppose Net earnings=107.2 Book value of equity=983.8 Market value of equity=1821.8 BV=107.2/983.8=10.9% Earning yield=107.2/1821.8=5.9%

46 EBIT/IE It is a ratio expressing financial fragility
Example: EBIT/IE=3; the firm has a 3 € margin to pay one € of IEs Strengths: Clear and unambiguous signals It jointly considers both the economic and financial profiles of the firms A low value for the ratio reveals financial fragility Low operational margins? Too high leverage?

47 Average accounting cost of debt
EBIT/IE (EBIT/IE)=[(EBIT/S)*(S/D)]/(IE/D) Return on Sales Ratio of sales on debt Average accounting cost of debt EBIT/S S/D IE/D EBIT/IE CASE 1 0.6 0.2 6.0% 2 CASE 2 0.625 0.256 8.0% CASE 3 0.8 0.15 CASE 4 0.3 5% 0.9 CASE 5 13.3% CASE 1 CASE 2 CASE 3 CASE 4 CASE 5 EBIT 30 40 48 18 40.8 S 50 64 60 68 IE 15 20 24 45.33 D 250 400 340

48 IE/S Can be used as a signal of finacila fragility
It is the ratio of interest expenses on sales Actually, it is a «poor» substitute of the EBIT/IE ratio Why?

49 IE/S EXAMPLE: 5% IE/S ratio could alternatively be acceptable or too high Let suppose a company having EBIT/S=10%... …or, alternatively, =2%... EBIT/IE is significant and immediately expressive of a firm’s financial soundness Year x X+1 X+2 IE/S 5% 5.5% 6% EBIT/IE 3 3.2 3.4 EBIT/S 0.15 0.176 0.204 The ratio of IEs on sales increases…but against an increase in operational margins as well


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