1. L ESSON 7 – S UMMARY – L IQUIDITY & S OLVENCY AND ROIC Financial Analysis The concept of Cash Flows vs. Earnings Generating Cash Flows: relationship between Earnings and Working Capital A new profitability measure: ROIC The concept of Invested Capital ROIC analysis 01 FF - LE/LFC/LG/LGM – 2013/2014

2. T HE O PERATING C ASH F LOWS (1/3) Let us think about the concept of EBITDA. In practice it represents the difference between payable income and expense (remember that depreciation are a cost that is not considered in the EBITDA calculation because it represents no payment). The question is whether we can say that the value of the EBITDA of a given year represents the money (cash) that is released by the company's activity on that year. The answer is no. Indeed, in that year there is some of the income that will not be received (going to Trade Receivables) and some from the previous year that will now be received. Similarly, there are costs that will only be paid in the following year (in Trade Payables) and some from the previous year that the company will now have to pay. 02 FF - LE/LFC/LG/LGM - 2013/2014

3. T HE O PERATING C ASH F LOWS (2/3) Thus, there isn't a coincidence between the economic flows (operating income and costs: earnings) and the operating cash flows (cash inflows and outflows). However, it is possible to establish a relationship between those two realities by recalling the concept of Working Capital (WC). Indeed, the WC represents the retention of economic operating earnings that have not been yet turned into cash inflows or outflows (for example, the trade receivables are the amount of revenues that have not been yet received). 03 FF - LE/LFC/LG/LGM - 2013/2014

4. T HE O PERATING C ASH F LOWS (3/3) As we already know, the change in the WC in one period represents the monetary value that is invested (or is available, if the change is negative) in the operating activity. This link is expressed by the following formula: Operating Free Cash Flow = EBITDA - ∆ WC Note that we use the EBITDA, which does not include Depreciation, precisely because this last is a cost that doesn't generate any payment. 04 FF - LE/LFC/LG/LGM - 2013/2014

5. O PERATING F REE C ASH F LOW - E XAMPLE (1/7) 05 FF - LE/LFC/LG/LGM - 2013/2014 Balance Sheet in 31/12/N Non-current Assets200,000Equity156,000 Inventory50,000Non-current Liabilities180,000 Trade Receivables150,000Trade Payables60,000 Tax Payables (VAT)4,000 Operating Data for N+1 Revenues787,500 Cost of Goods Sold630,000 External supplies12,000 Other Costs108,000 EBITDA37,500 Other Information Receivables Average Term 3 months PAT (CGS and ES)1 month Duration Inventory1 month VAT Tax and PAT20% e 2 months The other costs are not subject to VAT and are paid without credit

6. O PERATING F REE C ASH F LOW – E XAMPLE (2/7) Working Capital calculation for N+1 Trade Receivables = 787,500 x 1.2 / 12 x 3 = 236,250 Inventory = 630,000 / 12 x 1 = 52,500 Trade Payables = (632,500* + 12,000**) x 1.2 / 12 x 1 = 64,450 *Purchases = Cost of Goods Sold + Final Inventory – Initial Inventory  Purchases = 630,000 + 52,500 – 50,000 = 632,500 **External Supplies = 12,000 06 FF - LE/LFC/LG/LGM - 2013/2014

7. O PERATING F REE CASH F LOW – E XAMPLE (3/7) VAT VAT charged to customers (payable) = 787,500 x 0.2 = 157,500 VAT charged to the firm (deductable) = (632,500 + 12,000) x 0.2 = 128,900 VAT to pay = 157,500 – 128,900 = 28,600 VAT Payable = 28,600 x 2 /12 = 4,767 * Amounts taken from Balance Sheet of year N 07 FF - LE/LFC/LG/LGM - 2013/2014 Working CapitalN*N+1 Trade Receivables150,000236,250 Inventory50,00052,500 Trade Payables(60,000)(64,450) VAT Payable(4,000)(4,767) WC136,000219,533 Δ WC83,533

8. O PERATING F REE CASH F LOW – E XAMPLE (4/7) We can finally compute the Operating Free Cash Flow: Operating Free Cash Flow = EBITDA - ∆ WC Operating Free Cash Flow = 37,500 – 83,533 = (46,033) 08 FF - LE/LFC/LG/LGM - 2013/2014

9. O PERATING F REE C ASH F LOW – E XAMPLE (5/7) Let's see now if we can arrive to the same outcome but with a pure cash flow (inflow - outflow) point of view. For this purpose we will calculate the operating inflows and outflows that occurred in N + 1: OPERATING INFLOWS Revenues Received = Revenues with VAT – Trade Receivables N+1 + Trade Receivables N 945,000 - 236,250 + 150,000 = 858,750 09 FF - LE/LFC/LG/LGM - 2013/2014

10. O PERATING F REE C ASH F LOW – E XAMPLE (6/7) 10 FF - LE/LFC/LG/LGM - 2013/2014 OPERATING OUTFLOWS Purchases and ES Paid = Purchases with VAT + ES with VAT – Trade Payables N+1 + Trade Payables N 759,000 + 14,400 – 64,450 + 60,000 = 768,950 Other Costs Paid 108,000 (paid without any credit) VAT Paid = VAT to pay – Tax Payable N + 1 + Tax Payable N 28,600 – 4,767 + 4,000 = 27,833 Total of Operating Outflows = 768,950 + 108,000 + 27,833 = 904,783

11. O PERATING F REE C ASH F LOW – E XAMPLE (7/7) OPERATING FREE CASH FLOW OPERATING INFLOWS - OPERATING OUTFLOWS = 858,750 – 904,783 = (46,033) Thus, we have obtained the same outcome as the obtained by doing EBITDA - ∆ WC. 11 FF - LE/LFC/LG/LGM - 2013/2014

12. A NEW CONCEPT OF PROFITABILITY: RETURN ON INVESTED CAPITAL (ROIC) (1/3) 12 FF - LE/LFC/LG/LGM - 2013/2014 The ROIC develops a concept of profitability of the activity of a company that, such as the GROSS ROA, intends to ignore the financing dimension, but which adds two additional elements: Firstly, taking into account the fiscal dimension; so, instead of using the EBIT uses the NOPLAT (this represents the net profit the firm would have if it ignored the finance costs); Secondly, instead of using the Asset, uses the concept of operating Invested Capital.

13. A NEW CONCEPT OF PROFITABILITY: RETURN ON INVESTED CAPITAL (ROIC) (2/3) 13 FF - LE/LFC/LG/LGM - 2013/2014 The concept of Operating Invested Capital Considers only the operating assets, i.e., excludes all assets that are not operating, i.e., that are not necessary to the business (for example, a warehouse owned by the firm but which is rented, a speculative inventory, financial investments, etc.); To this operating Asset it is subtracted all the operating resources generated on the business; Thus, the operating Invested Capital represents the capital that is necessary to invest (in net terms, of the resources) for the company to develop its business. It is calculated: Operating Invested Capital = Operating Asset – Operating Resources Or, the same : Operating Invested Capital = Operating Non-current Assets + WC

14. A NEW CONCEPT OF PROFITABILITY : RETURN ON INVESTED CAPITAL (ROIC) (3/3) 14 FF - LE/LFC/LG/LGM - 2013/2014 Finally, the ROIC is calculated: The ROIC represents the net profitability of the firm's business, taking into account the investment made for it, but not taking into account how that investment was funded.