Frequently Asked Questions: Financial analysis

Question 1: What is the correct definition of Free Cash Flow and is it useful to compare a company’s performance from one year to the next, on the basis of Free Cash Flow and the way it changes?

Question 2: On Deutsche Telecom’s balance sheet there is one line item for deferred tax assets and one for deferred tax liabilities. What’s the difference?

Question 3: Could you give me a definition of return on capital employed?

Question 4: I want to calculate the leverage of the parent company Endesa (on the basis of its annual accounts), but these include a tax loss carryforward, and your formula assumes after tax figures!

Question 5: What is the exact definition of Free Cash Flow? Should dividends be deducted or not?

Question 6: I’d like to know how the leverage effect can be used in a mass market retail company.

Question 7: Could you give me more information on the notion of EBITDA and the advantages it presents?

Question 8: Could you explain the notion of normative?

Question 9: How does the accountant’s definition of “depreciation” differ from that of financial analysts and economists.

Question 10: Is working capital counted in number of days sales excluding tax or including tax? Which figure is more relevant? Why?

Question 11: Should factoring receivables be restated as a discounted outstanding bill?

Question 12: Should working capital for the year or change in working capital be taken into consideration in the cash flow cascade?

Question 13: Do we put capital gains on marketable securities on the income statement?

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Question 1:

What is the correct definition of Free Cash Flow and is it useful to compare a company’s performance from one year to the next, on the basis of Free Cash Flow and the way it changes?

Answer:

Free cash flow after tax measures the cash flow generated by capital employed. It is calculated as follows:

EBITDA
- Change in working capital
- Theoretical tax rate (equal to operating profit multiplied by the corporate income tax rate)
- Net capital expenditure
= After-tax free cash flow

It is difficult to use free cash flow to make comparisons year after year, especially for small and medium companies, as capital expenditures may be strong one year (due to a plant expansion for example) and weak the following years as the company will not expand its production capacity every year. Consequently free cash flow will be weak one year and stronger the following years independently of the company's performances.

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Question 2:

On Deutsche Telecom’s balance sheet there is one line item for deferred tax assets and one for deferred tax liabilities. What’s the difference?

Answer:

Before it listed, DT recorded impairment losses on its fixed assets. This resulted in tax savings which was recorded in the consolidated accounts as an asset under the heading deferred tax asset. In addition, the restatement of the period over which assets were depreciated at the time of consolidation, resulted in the creation of a latent tax liability called a deferred tax liability.

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Question 3:

Could you give me a definition of return on capital employed?

Answer:

ROCE (return on capital employed) is the return on operating assets independently of the way they were financed.

It is calculated by dividing operating profits by capital employed. Capital employed is the sum of a company’s working capital and its fixed assets, or, which works out to the same thing, the sum of equity and net debt.

It can be calculated before tax, like previously, or after, by multiplying the previous result by (1 – tax rate).

For more information check out the site glossary or chapter 13.

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Question 4:

I want to calculate the leverage of the parent company Endesa (on the basis of its annual accounts), but these include a tax loss carryforward, and your formula assumes after tax figures!

Answer:

The sort of problems that you’ve observed at Endesa, always arise when a parent company has two functions – to be an operating company for its own account and a holding company for its subsidiaries. It is an illusory and vainglorious exercise to calculate the leverage or the returns on a company level, which only reflect a part of the group’s activity. For example, if Endesa had a new subsidiary, only the dividends paid would be seen on the company’s books, and earnings in reserve would not appear. It is thus impossible and of no interest to calculate returns at this level.

The only relevant figures are the consolidated figures which reflect the activity of the whole group. The rest is just arithmetic, which introduces the problem of methodology, of which the financial and economic significance is nil.

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Question 5:

What is the exact definition of Free Cash Flow? Should dividends be deducted or not?

Answer:

Free cash flow corresponds to cash generated by operations after expenditure needed to ensure that the company maintains or improves its production facilities. It is thus the cash flows that the company has at its disposal, once all necessary investments have been made, to do with as it wishes – pay back debts, pay out an exceptional dividend or not, buy back its own shares, invest in diversification, increase the size of its kitty, etc.

Free cash flows are used for two purposes: measuring a company’s room for financial manoeuvre and calculating its value by discounting the free cash flows. It is calculated as follows:
EBITDA
- Change in working capital
- Corporate Income tax
- Net capital expenditure

Dividends are not deducted from free cash flows because a dividend payout is one of the things free cash flows can be used for.

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Question 6:

I’d like to know how the leverage effect can be used in a mass market retail company.

Answer:

The leverage effect comes into play regardless of the sector. Taking out a loan at 3% after tax, the sort of rate available on the market at the moment, and putting the money into capital employed at a rate of say 10%, will increase the return on equity to more than 10%. On the other hand, taking out a loan at 3% and getting 0% on the funds will reduce return on equity to below 10%. For more information, see chapter 13 of the Vernimmen.

Because of the way the mass market retail segment works, with negative working capital, which is a source of cash, companies operating on this segment do not, in theory, need to take out banking loans, which means that the leverage effect does not come into play. This is only the theory however, as a mass market retail company could well decide to borrow to finance a major acquisition, for example, which exceeded its cash provided by its negative working capital. This brings us back to the general situation described in the first part of the answer.

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Question 7:

Could you give me more information on the notion of EBITDA and the advantages it presents?

Answer:

EBITDA stands for Earnings Before Interest, Taxes, Depreciation and Amortisation. It is used for measuring wealth creation before depreciation and amortisation. Profit sharing falls under EBITDA in the US since it is a part of a company’s payroll costs, but in France, it is booked after EBITDA. The same goes for some restructuring charges. Financial analysts use the EBITDA multiple for valuing companies within the same sector, in order to eliminate the differences in accounting treatment from one company to the next. You should always remember though that EBITDA does not factor in how capital intensive an activity is, unlike EBIT (Earnings Before Interest and Taxes).

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Question 8:

Could you explain the notion of normative?

Answer:

In finance, normative means recurrent, in the normal course of business, without any exceptional events. A normative margin is the sort of margin a company can expect to make on a regular basis. A normative profit is the profit from which the exceptional items have been deducted.

A company often uses normative profits for presenting better results than its current profits if these have been impacted by an exceptional event which would penalise it. Always make sure the truth has not been embellished without any real basis, just to create a good impression!

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Question 9:

How does the accountant’s definition of “depreciation” differ from that of financial analysts and economists.

Answer:

For the accountant, depreciation is the economic wear and tear of an asset that has to be converted into monetary terms in order to reflect a fair result and a fair amount on the balance sheet, without any overvaluation of assets.

For the financial analyst, and in a slightly provocative way, depreciation is not of great importance as it is not a cash flow! The financial analyst seeks to maximise depreciation in the short term, in order to shift the tax burden forward in time, thus saving money given the time value of money.

In terms of valuation, depreciation is becoming less and less of an issue because current practice is to value companies using the EBITDA multiple, although more so in some sectors (media, utilities) than in others, but there is a clear trend.

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Question 10:

Is working capital counted in number of days sales excluding tax or including tax? Which figure is more relevant? Why?

Answer:

Working capital is usually counted in number of days sales is what happens in practice, rather than an academic principle. The figure recorded under Sales on the income statement excludes tax, as does the figure under Inventories, while Trade receivables and Trade payables are inclusive of tax. As working capital does not treat VAT in a standardised way, the ratio between working capital and sales excluding VAT is not standardised either.

However, when calculating ratios for customer and supplier payment periods and inventories, it is possible to have a much more standardised practice.

For more information, see chapter 11 of the Vernimmen.

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Question 11:

Should factoring receivables be restated as a discounted outstanding bill?

Answer:

Yes, definitely, as they work on the same logic – an asset is removed from the balance sheet (permanently, although with discounting this may be temporary) in order to obtain financing, which is evidence of financial and commercial practice that deserves to be taken into consideration.

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Question 12:

Should working capital for the year or change in working capital be taken into consideration in the cash flow cascade?

Answer:

Working capital is a sum of outstanding items on the balance sheet, while change in working capital is a flow of entries and exits (inventories sold, new inventories of finished goods, payments made, etc.) and accordingly, only change in working capital should be taken into account in the cash flow cascade.

For more information, see chapter 5 of the Vernimmen.

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Question 13:

Do we put capital gains on marketable securities on the income statement?

Answer:

Capital gains on marketable securities are recorded at year-end as financial income and not as extraordinary gains like capital gains on the sale of a subsidiary.

For more information, see chapter 9 of the Vernimmen.

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