Notes - Financial Statement Analysis

KAN-CFIVO1004U Financial Statement Analysis Autumn 2021
TABLE OF CONTENTS
1 Intro to Financial Statement Analysis 3
1.1 Equity-oriented stakeholders 3
1.2 Debt-capital-oriented stakeholders 4
1.3 Compensation-oriented stakeholders 4
2 Financial Statements and Book-keeping 5
2.1 Sources of Financial Information 5
2.2 Content of the Annual Report 5
2.2.1 The Financial Statements 5
2.3 Double Entry Book-keeping 8
3 Accural-Based vs. Cash-Flow-Based Performance Measures 9
3.1 Accrual-based Performance Measures 9
3.2 Cash-flow based Performance Measures 10
3.3 Shortcomings 10
4 The Analytical Income Statement and Balance Sheet 12
4.1 The Analytical Income Statement 12
4.2 The Analytical Balance Sheet 13
5 Profitability Analysis 15
5.1 Operating Profitability (ROIC) 15
5.2 Return on Equity (ROE) 17
5.3 Overview 19
6 Growth Analysis 20
6.1 Growth in Sales 20
6.2 Different Types of Growth 21
6.3 Quality of Growth 21
6.4 Does Share Buyback Always Add Value? 22
7 Liquidity Risk Analysis 23
7.1 Measuring Long-Term Liquidity Risk 23
7.1.1 Sound Financial Structure 23
7.1.2 Sufficient Funds from Operations 25
7.1.3 Liquidity Reserves for a Rainy Day 26
7.1.4 Efficient Liquidity 26
7.2 Short-Term Liquidity Risk 26
7.3 Concluding on Liquidity Risk Analysis 27
7.3.1 Shortcomings of Financial Ratios Measuring Liquidity Risk 27
8 Forecasting 29
8.1 Pro Forma Statements 29
8.2 Issuses when Designing a Forecast Template 30
8.3 Estimation Related Aspects of Forecasting 32
9 Valuation 33
9.1 Present Value Approaches 33
9.1.1 Dividend Discount Approach 34
9.1.2 Discounted Cash Flow Approach 34
9.1.3 Excess Return Approach 35
9.1.4 Adjusted Present Value Approach 36
9.1.5 Evaluation of Present Value Approaches 36
9.2 Relative Valuation Approach (Multiples) 37
9.3 Asset-Based Value Approaches 38
10 Cost of Capital 39
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10.1 Weighted Average Cost of Capital (WACC) 39

10.1.1 Capital Structure 39
10.1.2 Estimation of Owner’s Required Rate of Return 39
10.1.3 Estimation of the Required Rate of Return on Debt (NIBL) 42
11 Credit Analysis 43
11.1 Use and Type of Loan 43
11.2 Estimating Probability of Default 44
11.3 Estimating Loss given Default 45
11.4 Estimating the Expected Loss 46
11.5 Terms of a Loan 47
12 Management Performance 48
12.1 Performance Evaluation 48
12.2 Characteristics of a well-designed accounting-based incentive plan 49
12.3 Components of an Incentive Plan 51
12.3.1 Choice of Performance Measures 51
12.3.2 Choice of Performance Standards 52
12.3.3 Choice of Pay-to-Performance 53
13 Accounting Quality and Flexibility 54
13.1 Accounting Flexibility 54
13.2 Accounting Quality and Earnings Management 56
1 INTRO TO FINANCIAL STATEMENT ANALYSIS
Petersen, Plenborg & Kinserdal (2017): Chapter 1 + Lecture 1
International Financial Reporting Standards: The following standards should be known:
⇒ IFRS (International Financial Reporting Standards): Main source, most widely recognised, issued
by IASB (International Accounting Standards Board):
⇒ IAS (International Accounting Standards): Outdated yet still existing
⇒ US GAAP: US accounting standards issued by FASB (Financial Accounting Standards Board)
Decision makers: Three groups making decisions in different analytical contexts:
(1) Equity-oriented stakeholders: Investors, firms, corporate finance analysts, etc.

(2) Debt-capital-oriented stakeholders: Banks, mortgage-credit analysts, firms, etc.
(3) Performance-oriented stakeholders: Management, the board, and investors
1.1 Equity-oriented stakeholders

Equity-oriented stakeholders focus on determining the value of the firm’s equity. Valuation models:
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(1) Present Value: The value of a firm (or asset) is estimated as the present value of future cash
flows
To apply these models, we need information on future profitability, growth rates and risk. The
financial statement analysis gives insight into historical levels and trends as a starting point for
forecasting.
With the dividend model, the market value of the equity of the firm can be calculated as
∞
¿t
P0=∑ t
t =1 ( 1+r e )
where P0 is the market price of equity, ¿t is dividends, and r e is investors’ required rate of return.
(2) Relative Valuation (Multiples): The firm value is estimated using the price of comparable firms
The comparison can be based on accounting earnings, equity, turnover, or cash flows. There is a
significant constraint on data. Accounting policies for the firms must be identical, earnings must
have the same quality, and they most have the same expectations on future profitability, growth, and
risk.
(3) Asset-based Models: The equity value is estimated by measuring value of each asset and liability.
Net Asset Value (NAV) uses the market or fair value of the assets or liabilities. This method is used
in in capital intensive industries (e.g., shipping and real estate). In these firms, the ratio between
market value of equity and NAV ( P/ NAV ) should be close to one.
Sum-of-the-parts valuation is the sum of the value of each segment of a firm. Each segment is
valued using an appropriate technique given their characteristics. Method is most used for
conglomerates
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Liquidation value is the estimated net amount for a firm if all assets were sold and liabilities settled
in a forced sales situation. Method is used by creditors to assess a firm with bankruptcy concerns.
(4) Contingent Claim Valuation: The value of a firm is estimated using real option models
Similar to present value models but offer the flexibility of valuing different states of the world
simultaneously. Used on firms and assets that share the same characteristics as options.
1.2 Debt-capital-oriented stakeholders

A credit analysis assesses a firm’s ability to pay financial obligations timely and examines the
probability that a firm may default and the potential loss in the event of default
Expected loss=Probability of default (%) ×( Exposure at default −Ultimate value of recovery )
Probability of default is estimated using an analysis of historical financial data and a forecast of cash
flows. The exposure at default (EAD) is the outstanding debt at the time of the default. Ultimate
recovery is the value of security at forced sale, i.e., the proceed the creditors receive given default.
If the ultimate recovery is expressed as a proportion of exposure at default which is recovered:
Expected loss=Probability of default × Exposure at default ×(1−Recovery rate)
1.3 Compensation-oriented stakeholders

Performance-related pay create the need for accessing performance. In theory, management’s
performance is evaluated using residual income. In the real world, some assets have no market value.
Alternative performance measure used: (1) stock return, (2) financial performance measures
(revenue, EBIT, ROIC), or (3) non-financial performance measures (customer satisfaction, market
share)
Pay-to-performance relation is how pay is tied to performance. This may be with linearity between
performance and pay, lump-sum bonuses or a minimum and maximum bonus (floors/caps). Other
things to consider is the threshold of performance triggering pay, and the accounting quality.
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2 FINANCIAL STATEMENTS AND BOOK-KEEPING

2.1 Sources of Financial Information

The external information (publicly available) used when analysing a firm is:
⇒ Official documents such as prospectus, annual reports (most reliable source), quarterly reports,
and management presentations (may be biased, but is legally true)
⇒ The firm’s internet page gives an overview of products, organisation, history, and latest news.
⇒ Press releases and stock-exchange announcements
⇒ Analyst report gives an external view of performance and buy-, hold- or sell-recommendation
⇒ Market reports prepared by industry expert firms and consultancy firms
⇒ News articles
2.2 Content of the Annual Report

All listed firms must issue an annual report including the following information
⇒ The board of directors’ report: Summary of key financial data, overview of results and
expectations, information on strategic initiatives, CSR, and corporate governance.
⇒ The financial statements: Information on financial performance and financial position. See later
⇒ The auditors’ report: Covers the scope of the audit, the responsibilities of the auditor and the
management, and the auditor’s opinion of the firm’s financial statements.
⇒ The management statement: Confirm the annual report is in accordance with current regulations
2.2.1 The Financial Statements

There are five components of financial statements according to IAS 1. These are listed below:
(1) The profit or loss statement (income statement): Discloses a firm’s profit (earnings) for a
predefined period (usually a quarter or year). In general, we have that
Revenues−Expenses=Profit
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We wish to know how the profit figure is produced, which includes (a) which revenues and expenses
are recognised (definition of elements), (b) when they are recognised (recognition criteria), (c) how
they are measured (measurement attributes), and (d) how they are presented (classification issues)
Single-step income statement: Expenses are added together and subtracted from revenue in one step
Multiple-step income statement: Shows classifications of revenues and expenses as well as subtotals
Content of the income statement: Must as a minimum include:
⇒ Revenues and finance costs
⇒ Share of profit or loss of associates and joint ventures accounted for using the equity method
⇒ Post tax profit or loss of discontinued operations
⇒ Tax expenses
IASB further has defined the following items to be disclosed:
⇒ Write-downs of inventories to net realisable value or of property, plant, and equipment to
recoverable amount, as well as reversals of such write-downs
⇒ Restructuring of the firm activities or reversals of them
⇒ Disposals of property, plant, and equipment and disposal of investments.
⇒ Discontinuing operations
⇒ Litigation settlements
⇒ Other reversals or provisions
Analysis of expenses: Expenses can either by classified by nature (raw materials, staff costs,
depreciations, etc.) or by function (cost of goods sold, distribution costs, administrative expenses,
etc.):
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The statement of comprehensive income presents all income and expense items whether they are
recognised in the income statement. Other comprehensive income (OCI) includes
⇒ Changes in the revaluation surplus
⇒ Actuarial gains and losses on defined benefit plans
⇒ Exchange differences on translating the financial statements of foreign operations
⇒ Gains and losses on re-measuring available-for-sale financial assets
⇒ Effective portion of gains and losses on hedging instruments in a cash flow hedge
⇒ Income tax relating to other comprehensive income.
(2) The Statement of Financial Position (Balance Sheet): A summary of a firm’s financial position
at a specific point in time and shows the total investments (assets) and how these assets have been
financed (liabilities and equity). The balance sheet must follow:
Assets−Liabilities=Equity
Current and non-current assets and liabilities: Classified balance sheets distinguish a current asset
from a long-term asset and a current liability from a long-term liability (measures liquidity).
For an asset to be current, it must satisfy at least one of the following:
⇒ It is expected to be realised (sale or consumption) within a normal operating cycle
⇒ It is held for the purpose of being traded
⇒ It is expected to be realised within 12 months after the reporting date.
⇒ It is cash or cash equivalent.
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For a liability to be current, it must satisfy at least one of the following:
⇒ It is expected to be settled within a normal operating cycle
⇒ It is held for the purpose of being traded
⇒ It is due to be settled within 12 months after the reporting date.
⇒ The firm does not have an unconditional right to defer settlement of the liability for at least 12
months after the reporting date
Classification of assets and liabilities: IAS 1 has a minimum of items on the balance sheet seen:
Assets Liabilities and equity
- Property, plant, and equipment - Trade and other payables

- Investment property - Provisions
- Intangible assets - Current interest-bearing liabilities
- Financial assets - Tax liabilities and tax assets
- Investments acc. for using equity method - Deferred tax liabilities
- Inventories - Non-current interest-bearing liabilities
- Trade and other receivables - Minority interests
- Cash and cash equivalents - Issued capital and reserves (equity)
(3) The Cash Flow Statement: Reports a firm’s cash receipts, cash payments, and the net change in
the firm’s cash. It should be structured (c.f., IAS 7) into cash from the firm’s operating, investing, and
financing activities. The net cash flow is the sum of cash flows from operating, investing, and
financing activities and explains the change in cash and cash equivalents during the reporting period.
(4) Statement of Changes in Equity: Reconciles equity at the beginning and end of the period.
Explains changes in the components of owners’ equity. Reports the net income and any dividends
declared during the period. It consists of:
⇒ Retained earnings (accumulation of profit over time net of dividends)
⇒ Revaluation reserves (e.g., caused by revaluing property to fair value)
⇒ Other items that bypass the income statement (currency translations and fair value adjustments)
⇒ Transactions between shareholders (e.g.. increases in share capital, share repurchases)
(5) Notes (Disclosures): A summary of significant accounting policies and other explanatory info
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2.3 Double Entry Book-keeping

The double-entry bookkeeping system is based on the principle of duality where every transaction
has two aspects which offset (balance) each other. Every transaction recorded consists of at least one
debit and one credit record, and the total amount of debits must equal the total amount of credits.
T Accounts: Each T account has a name that described the types of transactions, which is recorded on
the account, and a debt (left side) and credit (right side).
⇒ In the balance sheet, the left (debit) side is resources owned (assets) and the right (credit) side is
claims on these resources.
⇒ In the income statement, the right (credit) side is revenues representing increases in equity. The
left (debit) side is expenses and represent decreases in equity.
General Rules: The following rules for debit and credit of accounts hold:
Income, liabilities, and owner’s equity
÷ (debit) +¿ (credit)
Expenses or assets
+¿ (debit) ÷ (credit)
Accounting equations: Transactions affect the accounting equations and the financial statements
Assets=Liabilities+ Stockholders ' equity
Assets=Liabilities+Capital stock+ Retained Earnings
Assets=Liabilities+Capital stock+(Revenues−Expenses−Dividends)
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3 ACCURAL-BASED VS. CASH-FLOW-BASED

PERFORMANCE MEASURES
It is conflicted whether accrual-based or cash-flow-based performance measures are best at
estimating value creation.
3.1 Accrual-based Performance Measures

Matches revenue and expenses by transaction. Any sales in the reporting period is matched with the
cost of goods regardless of which period the cost was incurred. Further, a transaction is recognized at
the time the sale is made. Unused material at the end of a financial year is recognized as inventory.
⇒ Empirically shown to be better at measuring the earnings capacity of a firm (p. 94).
Earnings per share (EPS) is a single period, ex-post, accrual-based performance measure of last
period’s earnings capacity, i.e., backward looking.
Various accrual-based performance measures: EBITDA and EBIT gauge a firm’s operating profit,
while EBT and E include the impact of financing on earnings by subtracting net financial expenses.
Revenue
- Operating expenses excluding depreciation and amortization
= Earnings before interest, tax, depreciation, and amortization (EBITDA)
- Depreciation and amortization
= Earnings before interest and taxes (EBIT)
+/- Net financial expenses
= Earnings before tax (EBT)
+/- Corporation tax
= Net earnings (E)
+/- Transactions recognized directly on equity
= Comprehensive income
Using EBIT and EBITDA in firm valuations: The idea is that they close to cash flows from operations
and they attempt to eliminate the differences in accounting policies (tax, depreciations, etc.) between
firms and countries. Problematic as it excludes a significant portion of firm’s costs and difficult to
compare businesses that grow organically with businesses that grow through acquisitions.
3.2 Cash-flow based Performance Measures

A transaction is recognized when the cash is received from the customer, not at the time of the sale.
Purchase of material in the cash statement is a cash outflow.
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⇒ Although less informative than accrual-based performance measures, it is useful for assessment of
(a) earnings quality, (b) financial flexibility, and (c) short-term and long-term risk (p 95):
Shareholder value added (SVA) is a cash-flow-based, forward-oriented, multi-period measure of the

long-term earnings capacity of a firm, accounting for growth and risk.
Various cash-flow-based performance measures:
Operating income (EBIT)

+/- Adjustment for items in EBIT with no cash flow effects (operating, provision, etc.)
+/- Change in net working capital (inventories, receivables, and operating liabilities)
+/- Corporate tax
= Cash flow from operations
+/- Investments in non-current assets, net
= Cash flow after investments (free cash flow to the firm, FCFF)
+/- Financing items
= Net cash flow for the period (change in cash)
The net working capital (NWC) is given as

NWC=Accounts receivables+ Inventory + Prepaid expenses− Accounts payable
NWC =Current assets−Current liabilities
General cash flow rules:
⇒ Balance of an asset increases, cash flow from operations decreases (buy asset, pay cash)
⇒ Balance of an asset decreases, cash flow from operations increases (sell asset, receive cash)
⇒ Balance of a liability increases, cash flow from operations increases
⇒ Balance of a liability decreases, cash flow from operations decreases
3.3 Shortcomings
Shortcomings of accrual-based performance measures: The main disadvantages are:
⇒ Easy to manipulate (arbitrary cost allocation, accounting estimates, alternative accounting policy.
⇒ The time value of money is ignored (money now is worth more due to potential earning capacity).
Shortcomings of cash-flow-based performance measures: The main disadvantages are:
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⇒ Does not account for uncompleted transactions. Some periods may have large cash outflows, vice
versa. The ability to measure earnings capacity decreases as the length of transactions increases.
⇒ Cash flows can be manipulated
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4 THE ANALYTICAL INCOME STATEMENT AND

BALANCE SHEET
A firm consists of operating, investing, and financing activities. It is therefore beneficial to separate
operations and investments in operations (e.g., PPE) from financing activities (e.g., loans and equity.
The firm’s operation is the primary driving force behind value creation and should therefore be
isolated. This is what makes the firm unique, while the financial composition can be imitated easily
4.1 The Analytical Income Statement

Every accounting item must be classified as either operations or finance. Different measures:
⇒ Operating profit (EBIT): Shows a firm’s profit from its core business regardless of financing
(before interest and tax).
⇒ Net operating profit after tax (NOPAT): After-tax measure of earnings where an estimated tax
is deducted from EBIT.
To obtain NOPAT we must estimate the tax on EBIT. As corporation tax is positively affected by
financial expenses (interest tax shield) we must add back the tax advantage. The effective tax rate:
Paid corporation tax

Effective rax rate=
Net profit before tax
Calculating the effective tax rate is complicated, as the tax is calculated for items with varying tax
rates, deferred taxes, large non-recurring tax items, or change in taxation rules. Examples of things
considered noise are (a) adjustments for previous years, (b) special items, (c) movements in deferred
tax assets, (d) large tax settlements, (e) gains and losses from sales
Comparing accrual-based and analytical income statements:
Normal Accrual-Based Income Statement Analytical Income Statement (General Form)

Revenue Revenue
−¿ Operating costs excl. depreciations etc. −¿ Operating expenses with depreciations
¿ EBITDA incl.
−¿ Depreciation, amortisation, and ¿ Operating profit before special items

impairment losses −¿ Special items
¿ EBIT (operating earnings) ¿ EBITDA
+¿−¿ Net financial items −¿ Depreciation, amortisation, and
¿ EBT (ordinary earnings before tax) impairment losses
+¿−¿ Tax on ordinary profits ¿ Operating profit (EBIT)
¿ Ordinary earnings after tax −¿ Estimated effective taxes on EBIT

(EBIT times the effective tax rate)
+¿−¿ Extraordinary items, discontinued operations and
change in accounting policies ¿ NOPAT
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¿ Net earnings (E) −¿ Net financial expenses

+¿−¿ Transactions recognised directly in equity +¿ Tax shield from financial expenses
¿ Comprehensive income (NFE times effective tax rate)
¿ Net earnings
In the analytical income statement, everything up to NOPAT is operating expenses, and after is
financial expenses. Net earnings is the same as comprehensive income in the "regular" income
statement, so remember to use this as a sanity check!
4.2 The Analytical Balance Sheet

Items marked as operating and financing in the income statement must the same in the balance sheet.
Classification of operating and financing items: Let OA be operating assets, OL be operating

liabilities, FA be financing assets, and FL be financing liabilities. We then have
Assets Type Equity and Liabilities Type
Intangible and tangible assets OA Equity F
Total non-current assets Loans and borrowings FL
Inventories OA Provisions OL
Accounts receivable OA Total non-current liabilities
Cash and cash equivalents FA Loans and borrowings FL
Total current assets Tax payable (deferred tax liabilities) OL
Accounts payable (trade payables) OL
Accrued expenses OL
Total current liabilities
Certain accounting items are harder to classify due to their nature. The general rules:
Item Operating Financing
Non-recurring items (restructuring Usually categorised as operating. Only if the item is not regarded as a
costs, disposal of non-recurring items, part of the firm’s core business.
lease income, change in accounting
estimates)
Corporation tax and deferred tax Ideally divide into tax on operations and tax on financing
Investment in associates and related Operating if part of core business Financing if not core business
income and expenses
Receivables and payables to group Operating if the loans are a part of Usually financing as they are often
enterprises and associates usual inter-firm trading interest bearing.
Cash and cash equivalents Day-to-day cash Excess cash (for dividends,
buybacks, etc.) is a financing asset.
Prepayments and financial income as Certain firms (e.g., insurance) receive If not a part of core operation.
part of core operation prepayments as a part of the business
model. In this case, prepayments is
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an operating liability.
Exchange rate differences Hard to classify, but usually not Hedging of currency risk is a
operating. financial decision, thus financing.
Derivative financial instruments Usually tied to hedging of financial

risks, thus a financing item.
Minority interests (non-controlling Treated as financing item requiring a

interests), i.e., investment in return
subsidiaries
Pension obligations Financing activity because pension

liabilities are interest-bearing
Calculation of invested capital: The combined investment in a firm’s operating activity is called the
invested capital or the net operating assets. It represents the net amount a firm has invested in its
operating activities, and which requires a return. This is given as
Net operating assets (invested capital)=Operating assets−Operating Liabilities
Invested capital=Equity+ Financing liabilities−Financing assets
Invested capital=BVE+ NIBL
Invested capital=Non−current assets+ NWC
Invested capital / Net operating assets
Intangible and tangible assets OA
Inventories OA
Accounts receivable OA
Tax payable OL
Accounts payable OL
Alternative calculation of invested capital
Equity F
Loan and borrowings (non-current) FL
Loan and borrowings (current) FL
Cash and cash equivalents FA
Interest-bearing liabilities, net FL
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5 PROFITABILITY ANALYSIS
Satisfactory Profit: Depends on how it is made and who the user is. Reported profit varies in quality
and recurring profit is seen as more attractive than non-recurring profit. A nominal positive profit is
not equivalent to a satisfactory return. Reported profit should be equal to or exceed investors’ required
rate of return. Profit should be measured against past performance and peer performance.
5.1 Operating Profitability (ROIC)

The DuPont model is seen below giving an overview of the structure of profitability analysis
Return on invested capital (ROIC) measures operational profitability as a percentage. It accounts

for the invested capital unlike EBIT or NOPAT. This is given as:
Net operating profit after tax ( NOPAT )

ROIC (after tax)= ×100
Invested capital
EBIT
ROIC (before tax)= ×100
Invested capital
When interpreting ROIC, we must address the level of return and the trends of returns over time.
Assessment of the level of returns: Compare ROIC with the required rate of return to lenders and
shareholders, i.e., weighted average cost of capital (WACC)
NIBL MVE
WACC = × r d × ( 1−t ) + ×r e
NIBL+ MVE NIBL+ MVE
where NIBL is market value of net interest-bearing liabilities, MVE the market value of equity, r d the
interest on net interest-bearing liabilities, r e shareholders’ required return, and t the marginal tax rate.
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WACC is the expected cost of capital of financing invested capital. Subtracting WACC from ROIC
leaves an expressed of Economic Value Added (EVA), i.e., super profit:
EVA=( ROIC aftertax −WACC ) × Invested capital
Value recreation requires that the accounting profit measured as a percentage of invested capital
(ROIC) exceeds the average cost of capital (WACC) to all capital providers.
An alternative method is to compare ROIC with competitor performance via a cross-sectional analysis
Assessment of trends in ROIC: We need to assess if the ratio develops satisfactorily over time. To
calculate the stock market’s expected ROIC, use the EVA model assuming constant growth:
( ROIC after tax−WACC ) × Invested capital

MVE=BVE +
WACC−g
Assuming a constant EVA, growth rate, and required rate of return (WACC), the market value of
equity exceeds book value, if value is created in future periods ( EVA >0), i.e., if ROIC exceeds
WACC. The market’s implicit (forward looking) ROIC may be calculated as:
( MVE−BVE ) × ( WACC −g )
ROIC= +WACC
Invested capital
Pitfalls in the interpretations of ROIC: Many analysts interpret a high and positive development in
ROIC as attractive. While often true, some circumstances require an alternative interpretation:
(1) Differences in accounting policies: The applied accounting policies and estimates must be the
same over time (timeseries analysis) and across firms (cross-sectional analysis)
(2) Average age of assets: The internal rate of return (IRR) measures returns on invested capital,
showing what investors expected to earn on average each year during the lifespan of a project.
ROIC is the accounting equivalent to IRR, as it is based on realised figures, but not necessarily a
good indicator of IRR. With a progressive depreciation schema, they match each other. With a
straight-line linear depreciation, ROIC increases over time.
(3) Differences in systematic risks: Investors require compensation for bearing risks, which varies
across industries. Assuming no financial leverage, the expected return is estimates using:
Required rate of return=r f + β a × risk premium
(4) Product lifecycle: Products undergo four stages in their lifecycle: introduction, growth, maturity,
and decline. ROIC follows this pattern: negative in the early stage, peaking in the late growth
stage, then decreasing. Firms are not directly comparable with firms in a different life stage.
Decomposition of ROIC: Into operating profit margin and turnover rate of invested capital:
ROIC=Operating profit margin ×Turnover rate of invested capital
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The operating profit margin (OM) describes the revenue and expense relation and expresses
operating profit as a percentage of revenues. It is given as
NOPAT
Operating profit margin after tax = ×100
Revenues
EBIT
Operating profit margin before tax= ×100
Revenues
The turnover rate of invested capital expresses a firm’s efficiency in managing its invested capital.
E.g., a turnover rate of 2 means a firm has tied up invested capital in 180 days ( 360 ÷ 2). Given as:
Revenue
Turnover rate of invested capital=
Invested capital
The lower the profit margin (turnover rate), the higher the turnover rate (profit margin) would have to
be to maintain a satisfactory return on invested capital.
Indexing and Common size analysis of profit margin and turnover rate: Helps explain whether
the revenue/expense relation and the capital utilisation efficiency has improved over time:
(1) Indexing: Used to identify trends in revenue expense items. Recalculate the first year’s figures
as 100 and measuring all subsequent years’ figures relatively to the first year. Does not reveal
the relative size of each item (p. 162)
(2) Common-size analysis: Scales each operating item as a percentage of revenue (p. 163)
Days on hand: Calculating the number of days on hand for each item making up invested capital
gives information on the relative importance and the trend of each item. Expresses the number of days
an accounting item is consuming cash.
5.2 Return on Equity (ROE)

Return on equity (ROE) measures the profitability accounting for the effect of financial leverage. It
also measures owners’ accounting return on their investments in a firm:
Net profit after tax NIBL

ROE= ×100=ROIC + ( ROIC−NBC ) ×
BVE BVE
where BVE is the book value of equity, NIBL is the book value of net interest-bearing liabilities (net
financial items), and NBC is the borrowing costs after tax in percentage calculated as
Net financial expenses after tax

NBC= ×100
Net interest−bearingliabilities
Financial leverage is defined as
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NIBL Net interest −bearing liabilities

= ×100
BVE Book value of equity
If ROIC > NBC , an increase in financial leverage will improve ROE. If ROIC < NBC increase in
financial leverage will have a negative impact on ROE. The difference between ROIC and NBC is the
interest margin or spread.
Effect of Minority interests: A minority interest (non-controlling) arises when the parent firm does
not own 100% of a subsidiary. Investors in the parent firm do not benefit from value creation, so we
distinguish between ROE measured at the group level and ROE measured as the parent level:
Net earnings before minority interests

ROE , group= × 100
Equity , group
Net earnings after minority interests

ROE , parent= × 100
Equity , parent
When accommodating for parent’s share of return we have
(
ROE , parent= ROIC + ( ROIC−NBC ) ×
NIBL
BVE )
× Parent ' s share of return
Net earnings after minority / Net earnings before minority

Parent ' s share of return=
Equity , parent /Group equity
A parent’s share of 1 means the minority and the parent’s shareholder receive the same rate of return
on their invested capital, while a ratio greater than 1 indicates that the parents receive a higher ROE.
The residual income (RI) is the value added for owners:
Residual income=( ROE−r e ) × BVE
With financial leverage, the structure of the profitability analysis is now:
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5.3 Overview
Level of Financial ratio Definition Information about
analysis
Level I EVA (Economic value added) ( ROIC−WACC ) ∙ Invested capitalValue creation
Financial ratios describing operating profitability
Level II ROIC (Return on invested NOPAT Operating profitability measured

capital) ∙ 100 as a percentage
Invested capital
WACC (Weighted average cost NIBL Required return for the firm
of capital) ∙100 (equity plus interest bearing
NIBL+ MVE debt)
Level III OM (Operating profit margin) NOPAT Efficiency in managing its

∙ 100 revenue and expense relation
Net revenue
Turnover rate, invested capital Net revenue Efficiency in utilizing its revenue
and expense relation
Invested capital
Level IV Indexing, common-size analysis Trends and levels for revenue,

cost and invested capital
The impact of financial leverage on profitability (owner’s perspective)
Level V RI (Residual income)

( ROE−r e ) ∙ BE A shareholder’s value creation
above cost of capital
Level VI ROE, group (Return on equity) Net earnings before minority interest
Return on equity before adjusting
for minority shareholders
Group equity
NIBL
ROIC + ( ROIC−NBC ) ∙
E
ROE, Parent (Return on equity) Net earnings after minority interest

Return on equity after adjusting
for minority shareholders
Equity , parent
( ROIC +( ROIC −NBC ) ∙ GroupNIBLequity )∙ Parent ' s share of return

r e (cost of capital) Risk −free rate+ Firm' s risk premium
A shareholder’s cost of capital
Level Financial leverage NIBL A firm’s financial leverage (risk)

VIII
BVE
NBC (Net borrowing cost after Net financial expenses after tax A firm’s net borrowing rate
tax) (after tax)
NIBL
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Parent’s share of return Net earnings after minority interest

Parent shareholders share of
group returns.
Net earnings before minority interest
Equity , parent
Group equity
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6 GROWTH ANALYSIS
6.1 Growth in Sales

Growth in sales is seen as the driving force of future progress. Shareholders sees growth as attractive
as it allegedly creates value, lenders see growth as a business opportunity as it often creates the need
for liquidity, suppliers see growth as a business opportunity as it usually results in greater market
potential, and employees perceive growth firms as more attractive workplaces.
Relationship between growth, liquidity, and invested capital: Growth requires investments in non-
current operating assets (e.g., PPE) and networking capital (inventories and accounts receivable), i.e.,
invested capital. Thus, the link between growth and growth in invested capital is important with
regards to limits to growth. There is a negative correlation between sales growth and free cash flows
to the firm (FCFF), so growth should be accompanied with close monitoring of cash flows.
Limits to growth: A firm must have the means to finance its growth plans. If a firm cannot convince
shareholder to add capital or accept a higher debt-to-equity ratio, it must lower its growth ambition.
The sustainable growth rate ( g) indicates at what pace a firm can grow its revenues while preserving
its financial risk, i.e., maintain its leverage ratio despite growth. It is defined using the return on
equity after tax (ROE) and the payout ratio (PO), i.e., dividend as a percentage of net profit:
g=ROE × ( 1−PO )
There are different ways of increasing this:
(1) Dividend policy: The sustainable growth rate decreases as the payout ratio increases.
(2) Operating profitability (ROIC): ROIC and financial leverage affect the growth rate as:
[
g= ROIC ⏟ Operations + ( ROIC−NBC ) ×
NIIBL
BVE
⏟
]
Financialleverage
× (1−PO ) ⏟ Dividend Policy
where ROIC, NBC, NIBL, and BVE are based on the beginning of year balance sheet. An
improved ROIC allows for a higher sustainable growth rate. An improved revenue and expense
relationship (operating profit margin) and utilisation of invested capital (turnover rate) leads to a
higher ROIC and thereby also a higher sustainable growth rate.
(3) Financial leverage: Impact depends upon a firm’s ROIC and NBC. If the spread between ROIC
and NBC is positive, financial leverage contributes positively to the sustainable growth rate.
Should firms always aim for high sustainable growth rate? From a shareholder’s perspective it is only
attractive if reinvestments are made into profitable projects ( ROIC >WACC ). Growth should ideally
impact EVA positively, and only in such cases does growth add value for the shareholders.
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6.2 Different Types of Growth

Growth can be measured in many ways, e.g., using revenue, operating profit (EBIT), net earnings,
free cash flows, invested capital, or sustainable growth rate. Growth in EVA can be obtained by:
⇒ Optimising existing operations (i.e., improving operating profit)
⇒ Minimising the use of IC
⇒ Reducing the cost of capital (WACC)
It is limited what a firm can do to reduce its cost of capital, and it is questionable whether changes in
the capital structure reduce it. Therefore, a firm is left to reduce the underlying (systematic) risk of its
operations, and focus on optimising existing operations, and invest in profitable projects. In the short-
term, optimisation of operations contributes to the growth in EVA (to a limit). Long-term growth in
EVA must come from investments in profitable business projects.
6.3 Quality of Growth

Growth in EVA is a prerequisite for attractive growth. This may be analysed using the modified
DuPont model, demonstrating that changes in ROIC and WACC affects the growth of EVA.
Growth in EVA due to core business growth: Earnings from core business is most attractive, as
such improvements are likely to continue. Investments in core business leads to growth in EVA, if the
return exceeds the required rate of return. Ways to optimise core business:
⇒ Change pricing policy, better sales mix, using efficient production methods, or optimising
marketing, administration, and invested capital (reduce inventories)
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Growth in EVA due to non-recurring items: Accounting items that directly contribute to the
growth in EVA, but are non-recurring includes
⇒ Gains and losses from sale of non-current assets, restructuring costs, discontinued operations,
change in corporate tax, foreign exchange profit, and change in accounting estimates and policies.
Note that changes in EVA due to changes in accounting policies do not add value.
Sustainable growth: Future growth is estimated by comparing the historical growth rate in revenues
with future growth opportunities in the industry. Stability in accounting items makes it easier to
forecast future earnings. The higher the correlation between growth in revenue last year and this year,
the more stable the growth in revenue. In the short-term (3-4 years), sales growth converges to a
long-term average value. In the long-run, a firm cannot grow more than the total growth of the
economy.
Growth in Earnings per Share (EPS): Presumably, there is a positive correlation between the
growth in EPS and firm value. Assuming constant growth, the dividend discount model is
P= ¿ = EPS × Payout ratio

r e −g r e −g
From this it seems that a higher EPS will lead to a higher firm value, implying that analysts value a
firm higher if EPS is growing. It is not unproblematic to use growth in EPS as performance measure,
as it is possible to obtain growth in EPS while destroying value at the same time!
6.4 Does Share Buyback Always Add Value?

It is increasingly common for firms to buy back shares rather than pay out dividends. An argument
for share buybacks is that it improves financial ratios (EPS) and increases the value of the firm.
However, it seems illogical that share buybacks increase the value of a firm, as the effect should be
value neutral. See p. 207 for effect of share buyback on earnings per share.
It is not certain that EPS increases because of share buybacks, as they only lead to growth in EPS
when ROIC exceeds NBC. This also illustrates that management compensated by EPS may find it
advantageous to change the dividend policy to best improve EPS.
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7 LIQUIDITY RISK ANALYSIS

Liquidity is needed to pay bills and do profitable investments. It is influenced by the ability to
generate positive net cash flows. A lack of liquidity impacts firm value negatively (e.g., bankruptcy).
⇒ Long-term liquidity risk is the firm’s long-term ability to satisfy all future obligations.
⇒ Short-term liquidity risk is a firm’s risk of default in the shorter term (usually within a year)
Use of financial ratios: An assessment of liquidity risk can be based on financial ratios relying on
historical accounting figures. While they are backward looking and only describe parts of a firm’s
profitability and financial positions, they are easy to calculate
7.1 Measuring Long-Term Liquidity Risk
7.1.1 Sound Financial Structure

Looks at the balance between equity and long-term and short-term financing corresponding to the
nature of the assets and the risk of operations. If a firm has…
⇒ Primarily short-term financing: Vulnerable to illiquid funding markets and loses scaring creditors
⇒ Primarily long-term financing: Little flexibility and may increase funding costs unnecessarily
Recall the analytical balance sheet of operating non-current assets, current assets and financing assets:
Operating assets, non-current (PPE, etc.) Equity

Financing liabilities, non-current
Operating assets, current working capital
Operating liabilities, current working capital
Financing assets, liquidity reserve Financing liabilities, current
Equity: A buffer for (unexpected) losses in the short and long-term. Unlike liabilities, there is not a
fixed interest or return, and when times are bad firms do not have to pay dividends, saving liquidity.
Solvency ratios are used to assess whether firms have sound financing structure. These can be
Equity
Equity ratio=
Total assets
Total liabilities
Financial leverage=
Equity
The equity ratio is the best ratios to predict bankruptcy at an early stage. A high financial leverage and
a low equity ratio indicate a small capital buffer for unforeseen events and a high long-term liquidity
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risk. A high equity ratio does not imply that there is excess liquidity, it depends on how the assets are
invested. Remember the following when using the solvency ratios:
⇒ All financial obligations should be recognised, incl. leases and other ‘off balance’ obligations.
⇒ If market values are available, use these. However, may be misleading with firm mispricing
⇒ Ideally compare to an (industry) benchmark.
The appropriate equity ratio is at a minimum one that can absorb expected losses:
⇒ Minimum equity book level: The equity level where the risk of a negative equity due to negative
charges against book equity (e.g., net reported losses) is at an acceptable level, the tolerance level.
A typical test of the appropriate level of equity is a VaR analysis. Other relevant ratios:
Risk tolerance equity ratio: how many times equity covers the required minimum level of
equity
Equity
Risk tolerance equity ratio=
Minimumlevel of equity (at x % tolerance level )
Buffer equity ratio: the buffer of equity relative to the minimum estimated equity level:
Equity−Minimum level of equity

Buffer equity ratio=
Minimum level of equity(at x % tolerance level)
A risk tolerance equity ratio of 1 or above, or a positive buffer equity ratio, signals that the firm’s
current level of equity is sufficient to meet the required minimum level of equity.
An alternative is to measure the maximum loss the last 10 years and compare it to the current level. A
rule of thumb is that the current equity should be 2-3 times larger than actual or expected largest loss.
Equity
Modified risk tolerance equity ratio=
Largest loss last 10 years (¿ est . max loss for year )
Creditors may require a minimum level of equity or equity ratio. With equity covenants, they would
serve as the minimum level of equity, and equity buffer may be measured against this
Equity−Minimum level of equity defined by covenant

Covenant buffer ratio=
Minimumlevel of equity defined by covenant
Long-term versus short-term financing: The operating non-current assets (e.g., PPE) should be
financed with long-term financing with predictable payment schedule that matches the cash flows
from those assets. Net working capital fluctuates over the year and economic cycles meaning a 100%
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long-term financing reduces the flexibility of the firm to repay debt when NWC is low. So, only a
minimum level of NWC (the fixed element) should be financed with long-term debt. See below:
The long-term financing coverage ratio measures the proportion of non-current assets and the
minimum level of net working capital, which is financed by long-term financing. Should be near 1:
Non−current interest bearingliabilitites

Long−term financing coverage=
Operatingnon−current assets+ Minimum level of NWC−Equity
7.1.2 Sufficient Funds from Operations

Aim is to determine if the firm has sufficient cash flows to pay interest and instalments ongoingly.
Operational earnings ratio is measured as below or including only interest (as the instalments could
be refinanced ongoingly). Not commonly used, as the numbers may be hard to find:
Operational earnings after tax−Reinvestments

Operational earnings coverage ratio=
Net financial expenses plus instalments
Interest coverage ratio measures the ability to meet financial expenses. We can subtract the from the
CFO. A more stable ratio is based on operating profit. Shows how many times cash flow from
operations covers net financial expenses. The higher the ratio, the lower the long-term liquidity risk:
Interest coverage ratio(cash )=Cash flow ¿ operations ¿

Net financial expenses
Operating profit ( EBIT )

Interest coverage ratio=
Net financial expenses
Cash flow from operations to debt ratio is an indicator of firms’ long-term ability to repay loans. It
measures the extent to which current cash flows from operations are sufficient to repay liabilities. A
high ratio signals a low long-term liquidity risk. We can also only include NIBL:
CFO ¿ debt ratio=Cash flow ¿ operations ¿

Total liabilities
CFO ¿ debt ( NIBL)ratio=Cash flow ¿ operations ¿

Net interest −bearing liabilities
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Debt to EBITDA ratio measures how many times a firm has leveraged it EBITDA, giving the
approximate amount of time needed to pay of all debt. Alternatively, net interest-bearing liabilities
(NIBL) can be used. A high ratio signals high long-term liquidity risk.
Total liabilities
Debt ¿ EBITDA ratio=
EBITDA
Net interest−bearingliabilities
Debt ( NIBL) ¿ EBITDA ratio=
EBITDA
Capital expenditure ratio shows the proportion of capex a firm can fund through operations. A ratio
greater than 1 means CFO is sufficient. A capex based on reinvestments removes the impact
investment growth and shows to what extent reinvestments can be financed from internally generated
funds
Capital expenditure ratio=Cash flows ¿ operations ¿

Capital expenditure
Capital expenditure ratio (reinvest)=Cash flows ¿ operations ¿

Reinvestments
7.1.3 Liquidity Reserves for a Rainy Day

Sooner or later a firm will have unexpected losses resulting in significant cash outflows. The question
is if a firm has liquidity reserves for a rainy day. Using the analytical balance sheet, liquidity reserves
include financial assets, as they can be sold without affecting operations and operating profit.
Financial assets plus unused lines of credit

Liquidity reserve ratio=
Total liabilities
Financial assets plusunused lines of credit

Liquidity current reserve ratio=
Current liabilities
7.1.4 Efficient Liquidity

Liquidity efficiency involves the firm’s ability to collect outstanding payments timely and to benefit
from interest-free credits (e.g., accounts payable). It can be seen as the ability to keep net working
capital at a minimum. The working capital ratio shows how efficient a firm is in managing its NWC:
Net working capital

Working capital ratio=
Revenues
The liquidity cycle measures the number of days it takes to convert net working capital to cash. The
fewer days, the better the cash flow
365 365 365

Cost of goods sold Revenue Purchase , material
Liquidity cycle= + −
Inventory Accounts receivable Accounts payable
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365 365
Liquidity cycle= =
Turnover rate of NWC
( Revenue
Inventories+ Receivables + Prepaid expenses etc .−Op. liabilities )
7.2 Short-Term Liquidity Risk
Current ratio compares current assets with current liabilities. The greater the ratio, the greater the
likelihood that the proceeds from liquidation of current assets would cover current liabilities. Usually,
a ratio greater than 2 indicates low short-term liquidity risk
Current assets
Current ratio=
Current liabilities
Shortcomings are (a) doesn’t consider that current operating liabilities are continuously refinanced as
a consequence of ongoing business, (b) the book value of current assets often does not reflect the
realisation value, and (c) it may be difficult to estimate when the current ratio is adequate.
Cash flow from operations to short-term financial debt ratio is seen as the best ratio to measure
short-term liquidity risk. It uses actual cash flows from operations rather than current and potential
cash flow resources, so the problem of convertibility to cash problem of current assets is avoided.
CFO ¿ short −term financial debt ratio=Cash flow ¿ operations ¿

Current net interest−bearingliabilities
Cash burn rate is typically only used on firms with negative earnings (conservative ratio). It
measures how long a firm can fund project costs without further cash contributions:
Cash∧cash equivalents+Securities+ Receivables

Cash burn rate=
EBIT
Liquidity reserve stress test ratio shows if a liquidity reserve is sufficient to cover bad events. The
ratio should be larger than 1, i.e., the liquidity reserve should cover bad events affecting cash the next
12 months. Liquidity reserve is financial assets plus unused lines of credit
Liquidity reserve
Liquidity reserve stress test ratio= bad event ¿
Net cash outflow next 12 months due ¿
7.3 Concluding Notes and Shortcomings

The key issue is to ask what type of liquidity risk we are assessing, and then to find the most relevant
ratios for the purpose. Remember that is it difficult to evaluate whether a financial ratio is at a critical
level. Short-term and long-term liquidity risk can be merged with the following interpretations:
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Shortcomings of Financial Ratios Measuring Liquidity Risk: Financial ratios measuring liquidity
risk are (1) based on historical information and as a result backward looking, (2) only describing parts
of a firm’s financial position, (3) less useful in absence of a benchmark and when not used together.
Financial ratios relying on data from the balance sheets are based on ending balances, which provide a
more accurate picture of current financial leverage than those based on average balances.
It is important that differences in accounting quality across time and firms are adjusted.
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8 FORECASTING
A pro forma statement attempts to present the firm’s financial statements at a future state if the
present trends continue and certain assumptions hold true. The technical aspect of forecasting is the
design of the value driver setup. The estimation-related aspect of forecasting is the quality of sources
supporting the assumptions and estimates underlying the pro forma statements.
Separate operations and financing: Operations is the primary driver behind value creation.
Financing conveys information about how operations are funded and financial risks
Value drivers: Strategic value drivers are key operational actions undertaken by a firm to improve
value (e.g., new products, new markets or outsourcing of activities). Revenue growth comes from a
strategic value driver, which are industry and firm specific. A financial value driver is a financial
ratio or number measuring the firm’s financial performance and is closely related to value creation.
The financial value drivers may be viewed as the output factors from the strategic value drivers.
It is the strategic (operating) actions that affect a firm’s financial value, implying financial value
drivers do not create value per se (only if positively affected by an operational initiative, cost cutting).
8.1 Pro Forma Statements

We generally prefer a sales-driven forecasting approach reflecting that different accounting items
are driven by the expected level of activity. Pro forma statements include time periods divided into
⇒ Historical period as the basis for forecasting (e.g., past 4 years)
⇒ Explicit forecasting period where financial value drivers are not assumed to be constant
⇒ Continuing period reflecting a steady state environment where everything remains constant.
When preparing a pro forma statement, note that investments in intangibles and tangible assets is:
Intangible and tangible assets, end of period

+ Depreciation and amortization
– Intangible and tangible assets, beginning of period
Investments in intangible and tangible assets
The terminal value (TV) is the value beyond the forecast period where future cash flows can be
estimated. It assumes a business will grow at a set growth rate forever after the forecast period.
The template below for the value driver structure for creating pro forma statements does not
distinguish between types of operating expenses but focuses on key value drivers only. The second
column explains the accounting items forecast, and the fourth column explains how each item is
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calculated. See p. 260-262 for an example of proforma income statement, balance sheet and cash flow
statement.
Step Value drivers

Income statement
1 Revenue I Revenue growth
2 Operating expenses (excl. depreciation) (1 - 3)
( EBITDA
Revenue )
3 = Earnings before interest, taxes, II
depreciation, and amortization (EBITDA) EBITDA-margin:
4 Depreciation and amortization III Depreciation as a percentage of intangible assets (11)

5 = Operating profit before tax (EBIT) (3 - 4)
6 Tax on EBIT IV Tax rate
7 = Net operating profit after tax (NOPAT) (5 – 6)
8 Net financial expenses before tax V Net borrowing rate x NIBL (18)
9 Tax shield (IV) x (8)
10 = Net earnings (E) (7 – 8 + 9)
Balance sheet
Assets
11 Intangible and tangible assets VI Intangible and tangible assets as a percentage of revenue
12 Net working capital VII Net working capital as a percentage of revenue
+ Inventory
+ Receivables
- Accounts payable
- Other operating liabilities
13 Invested capital (net operating assets) (11 + 12)
Equity and liabilities
14 Equity, beginning of period
15 + Net earnings (10)
16 - Dividends (28)
17 Equity, end of period (14 + 15 – 16)
18 Net interest-bearing liabilities (NIBL) VIII NIBL as a percentage of invested capital (13)
19 Invested capital (Equity + NIBL) (17 + 18)
Cash flow statement
20 NOPAT (7)
21 + Depreciation and amortization (4)
22 - ∆ Net working capital (∆ 12)
23 - Net investments (non-current assets) (∆ 11 + 4)
24 = Free cash flow to the firm (FCFF) Also given as NOPAT plus change in invested capital
25 + ∆ Net interest-bearing (∆ 18)
liabilities
26 Net financial expenses after tax (8 – 9)
27 = Free cash flow to equity holders (FCFE) (24 +/- 25 - 26)
28 - Dividends All FCFE is paid as dividends (-27)
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29 = Cash surplus (27 – 28) = 0
8.2 Issuses when Designing a Forecast Template

Do financial value drivers in the template reflect the underlying economic relations of a firm?
Sometimes value drivers need to be modified:
(1) If a firm makes large, discrete investments mainly done years apart. If the investment plans are
known, the investment driver should be changes to reflect the expected investments each year.
(2) Depreciation and amortization should reflect new assets are acquired throughout the year:
Depreciation(¿ amortisation)=Dep. rate × Average tangible∧intangible assets
1
Dep .rate=
Useful life of assets
(3) It might be better to apply the average net interest-bearing liabilities as a deflator:
Net financial expenses=Net borrowing rate× average NIBL
(4) For firms operating with a target dividend pay-out ratio, it is best to estimate dividends as a
function of pay-out ratio and net earnings:
Dividends=Net earnings × Payout ratio
If dividends are not included in the template as a separate step (i.e., not a residual of the cash
surplus), net interest-bearing liabilities can be used as the last step:
NIBL , end of period=NIBL , beginning of period+ Cash surplus
(5) The template assumes all taxes are paid within the same year. In reality, at least some taxes are
often deferred. The deferred tax driver definition:
Deferred tax liability Deferred tax liability

,∨,
Revenue Intangible∧tangible assets
Is the level of aggregation in the template appropriate? The template does not distinguish between
different types of operating expenses. When more detailed cost structure is available, it may be useful
to apply a more refined (detailed) approach where each operating expense is forecast separately.
Net working capital is simply expressed as a percentage of revenue in the template. However, if
using a more refined approach NWC can be decomposed into the following parts:
⇒ Inventory, accounts receivable, other operating receivables, accounts payable, and other operating
liabilities – all may be expressed as a percentage of revenue.
A detailed breakdown of value drivers is seen in the table below, where the 8 value drivers from the
template have been expanded to 23. The level of aggregation is influences by the level of detailed
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information available and thereby the forecast horizon. With a short forecast horizon, there is a high
level of detail meaning a low aggregation level, and with a long forecast horizon, there is a low level
of detail meaning a high aggregation level.
8.3 Estimation Related Aspects of Forecasting

Identification of key financial value drivers: The financial driver that have the largest impact on a
firm’s value is revenue growth followed by changes in expenses (COGS etc.).
Analyzing trends in the financial statement: A historical analysis of the financial statements help
identify levels and trends in key financial drivers. Remember to consider accounting policies, misuse
of accounting flexibility, non-recurring items, new products or market, and divesting/acquisitions,
Strategic analysis: Aim is to determine if historical trends and level will continue. It also identifies
key strategic value drivers and provide insights about the growth and margin potential. Consider:
(1) Nature of the firm’s business environment: If the market is stable and the product is simple, a
simple analysis will suffice. Otherwise, a thorough analysis and scenario forecasting is needed.
(2) Macro factors influencing firm growth: Use the PEST model to indicate the impact of political,
economic, social, and technical factors impacting cash flow and risk.
(3) Industry factors influencing firm margins: Use Porter’s Five Forces (threat of entrants, rivalry,
threat of substitutes, suppliers’ bargaining power, and buyers’ bargaining power)
(4) Firm-specific factors influencing relative growth and margins: Use the following models:
⇒ Value chain analysis describing activities within and around a firm.
⇒ VIRO analysis assesses competitive advantage (value, rarity, imitability and organization).
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⇒ SWOT analysis sums up strengths, weaknesses (internal), opportunities and threats (external)
Evaluating the estimates supporting the proforma statements: Check expected performance with
past performance focusing on growth rates, EBITDA-margin and ROIC. Evaluate if key assumptions
are supported by compelling evidence and superior analysis. Lastly, do a sensitivity analysis.
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9 VALUATION
Petersen, Plenborg & Kinserdal (2017): Chapter 9 + Lecture 9-10
The value of any asset is calculated as the future income generated discounted to present value with a
discount factor that considers the time value of money and risk associated with the income.
The valuation approaches here measure either enterprise value (EV) or the market value of
shareholders’ equity. The former is the expected market value of a firm’s invested capital, where
Invested capital=Enterprise value=NIBL+ Equity
Approaches to valuation: The following are common approaches:
⇒ Present value approaches usually discounting dividend, free cash flows or excess returns.
⇒ Relative valuation approach based on the assumption that perfect substitutes have the same price.
⇒ Asset-based value approach where the value of equity is estimated by measuring the assets and
liabilities using different measurement bases.
⇒ Contingent claim valuation models, also referred to as real option model.
The attributes of an ideal valuation approach: For value attributes, we prefer precision (unbiased)
and realistic assumptions. For user attributes, we prefer user friendly with understandable output.
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9.1 Present Value Approaches

The present value approaches estimate the intrinsic value of a firm based on projections of the cash
flows of a firm and the discount factor that reflects the risk of the cash flows and time value of money.
9.1.1 Dividend Discount Approach

According to the dividend discount model, the value of a firm is the present value of future
dividends including a liquidation dividend. With an infinite dividend stream and constant discount
factor:
∞
¿t
MV of equity=∑ t
, where r e =Required rate of return on equity
t =1 ( 1+r e )
This means only future dividends and the required rate of return on equity affect the value of a firm.
A two-stage dividend discount model is often preferred. The basic idea is that the growth rate of a
firm eventually will approach the long-term growth rate of the economy (steady-state assumption).
Let n be the number of periods with non-constant growth rates (forecast horizon) and g be the long-
term stable growth rate (continuing period), then the model is
n
¿t ¿ n+1 1
MV of equity=∑ + ×
t =1 ( 1+r e )
t
r e −g ( 1+ r e )n
The continuing value accounts for a large portion of the value. The forecasting horizon should be long
enough to ensure the growth rate in the continuing period reflects the long-term industry growth rate.
Critique: Relies on no assumptions and is unbiased but requires input that are hard to generate.
9.1.2 Discounted Cash Flow Approach

The most popular present value approach. There are two approaches seen below.
The Enterprise Value Approach: The value of a firm is determined by the present value of future
free cash flows. In the case of an infinite cash flow stream, we have the following, where FCFF are
the (after tax) free cash flow to the firm and WACC is the weighted average cost of capital.
∞
FCFFt
Enterprise value=∑
t =1 ( 1+WACC )t
The two-stage DCF model is specified as:

n
FCFFt FCFF n+1 1
Enterprise value=∑ + ×
t =1 ( 1+WACC ) t
WACC−g (1+WACC )n
These models estimate the enterprise value, and it is therefore necessary to deduct the market value of
net interest-bearing liabilities from the enterprise value to obtain an estimated MV of equity.
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The Equity Value Approach: The DCF model from an equity perspective is specified as follows,
where FCFE is free cash flow to the equity and r e is the investors’ required rate of return.
∞
FCFE t
MV of equity=∑ t
t =1 ( 1+ r e )
The only difference between FCFF and FCFE is the transactions to debt holders. So, a DCF model
relying on FCFF yields and estimate of equity and net interest-bearing liabilities (NIBL), i.e., EV.
The two-stage DCF model is specified as:

n
FCFE t FCFEn +1 1
MV of equity=∑ + ×
t =1 ( 1+ r e )
t
r e −g ( 1+r e )
n
Cash Surplus Assumptions: Both DFC models assume that cash surplus is paid out as dividends or
reinvested in projects with a NPV equal to zero (i.e., return equal to the cost of capital). Remember
cash surplus is the net cash flow after accounting for cash flows from operations, investments, and
financing. If the cash surplus is reinvested as a different rate from the cost of capital, the DCF model
yields a biased result. The pro forma statements assume cash surplus is paid as dividends
⇒ It is however a fair assumption most firms comply with due to pressure on management.
9.1.3 Excess Return Approach

Both the EVA model and the RI model rely on accrual accounting data, but theoretically they are
equivalent valuation approaches to DCF and discounted dividend models.
EVA Model: Estimates enterprise value of a firm determined by the initial invested capital (book
value of equity plus NIBL) plus the present value of all future EVAs. With an expected infinite
lifetime, where EVA is the economic value added given as NOPAT t−WACC × Invested capital t −1 :
∞
EVA t
Enterprise value0=Invested capital 0 + ∑
t=1 ( 1+ WACC )t
The EVA model uses the invested capital from the last fiscal year ( t=0 ) as a starting point for
valuation. To obtain an estimated market value of equity, we must subtract the market value of net
interest-bearing liabilities from the enterprise value. The two-stage model is given as
n
EVA t EVA n+1 1
Enterprise value0=Invested capital 0 + ∑ + ×
t=1 ( 1+ WACC ) t
WACC −g ( 1+WACC )n
In the EVA model, the continuing value is less heavy than in the CF models, as EVA used invested
capital as a starting point, and only excess returns are added to invested capital. The book value of
equity equals the market value of equity if the ROIC equals the WACC. This model explicitly
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shows when a firm is traded below (PV of expected EVAs is negative) or above (PV of expected
EVAs is positive) its book value of invested capital.
Residual Income (RI) Model: Estimates equity value of a firm. Let RI t be the residual income (
Net earningst −r e × BVEt −1). Then,
∞
RI t
Market value of equity 0=Book value of equity 0 + ∑ t
t=1 ( 1+r e )
The transactions with debt holders make up the difference between the EVA and the RI model, as the
RI model measures value from an equity perspective only. The two-stage model is:
n
RI t RI n +1 1
Market value of equity 0=Book value of equity 0 + ∑ + ×
t=1 ( 1+r e )
t
r e −g ( 1+r e )n
The estimated market value of equity is above the book value of equity if the present value of
expected RIs is positive, i.e., future returns on equity exceed the cost of equity capital, etc.
Clean Surplus Assumption: The EVA and RI models equal the value from DCF models regardless
of the accounting principles applied. However, they both rely on the clean-surplus assumption, that
is all revenues, expenses, gains, and losses in the forecast period are recognised in the income
statement. If this is fulfilled, the EVA and RI models yield unbiased value estimates. It also becomes
obvious that estimated market value exceeds book value of equity when returns exceed cost of capital.
9.1.4 Adjusted Present Value Approach

The adjusted present value approach (APV) is a variant of the enterprise-value-based DCF model,
and accounts for the tax shield on NIBL separately. The discount factor excludes the impact of the tax
shield, implying that WACC, which includes the impact of the tax shield is replaced by the return rate
of return on assets r a . Let TSt be the tax shield on the net interest-bearing liabilities, then
∞
FCFF t TS t
Enterprise value0=∑ t
+ t
t =1 ( 1+r a ) ( 1+ r a )
The two-stage model is seen below:
n
FCFF t FCFF n+ 1 1
n
TS t TS n+1 1
Enterprise value0=∑ + × + ∑ + ×
t =1 ( 1+r a )
t
r a −g ( 1+ r a ) t=1 ( 1+ r a ) r a−g ( 1+ r a )
n t n
The fact that the value of the tax shield is measured separately may be considered an attractive feature
as it allows the analyst to discount the tax shield as a different rate than the rate used on operations. It
may be argued that the risk on the tax shield is lower than the risk on operations.
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9.1.5 Evaluation of Present Value Approaches

The present value approaches yield identical estimates granted (1) valuations are based on the same
pro forma statements, (2) the underlying assumptions are met, (3) the cost of capital reflects the
projected capital structure, and (4) each variable in the pro forma statements in the continuing period
grows at the same (constant) rate. Because of this, we should be indifferent when choosing between
the PV approaches. However, there may be user attributes that make a certain model preferable.
9.2 Relative Valuation Approach (Multiples)

Valuation based on multiples is popular among practitioners due to low level of complexity and its
speed. It relies on the relative pricing of peers’ earnings. Generally, the multiples are split into two
groups: (1) Enterprise-value-based multiples and (2) equity-based multiples. The main assumption is
that firms are truly comparable, i.e., share the same economic characteristics. The accounting numbers
must be based on the same accounting policies and exclude the impact of non-recurring items.
Enterprise-value-based multiples: Assuming a constant growth rate, the DCF model is
FCFF NOPAT × ( 1−reinvestment rate )

EV = =
WACC−g WACC−g
where reinvestment rate is the share of NOPAT reinvested into the business, i.e.,
( Δ NWC + Δnon−current assets ) ÷ NOPAT . This gives us the following multiples
EV ROIC × ( 1−Reinvestment rate ) ROIC −g

= =
IC WACC −g WACC−g
EV ROIC −g 1
= ×
NOPAT WACC−g ROIC
EV ROIC −g 1
= × × ( 1−t )
EBIT WACC−g ROIC
EV ROIC −g 1 Depreciation
= × × ( 1−t ) × ( 1−Dep. rate ) , Dep. rate=
EBITDA WACC−g ROIC EBITDA
EV ROIC−g 1
= × × ( 1−t ) × ( 1−Dep . rate ) × EBITDA−margin
Revenue WACC−g ROIC
Equity-based multiples: Assuming a constant growth rate, the dividend discount model is
Net earnings × Payout ratio ROE × BVE × Payout ratio

MVE= ¿ = =
r e −g r e −g r −g
If RR is the retention rate (part of net earnings ploughed back to the business), we have the following:
M MVE ROE × ( 1−RR ) ROE−g

= = =
B BVE r e −g r e −g
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P MVE ROE−g 1
= = ×
E E r e −g ROE
What Drives Multiples? The table below shows which factors that affect each multiple. This tells us
about the underlying requirements when using different multiples. Specifically, it required that the
firms compared are identical on the factors that impact the multiple.
Other Things to Remember: The following should be addressed when using multiples to value firms
⇒ Accounting differences: Compared firms must have the same accounting principles.
⇒ Normalization of earnings: Exclude non-recurring items, to reflect normal earnings better.
⇒ The use of current versus expected earnings: Use of expected earnings is recommended.
⇒ Measurement of averages: When calculating the average of multiples for comparable firms, it is
best to use the harmonic mean, as it produces most accurate values (p. 327).
⇒ Impact of trading a majority share: Premium for controlling interest, so adjust the value here.
Evaluation of Relative Valuation Approach: More restrictive assumptions complicating the

valuation, and in practice not all are usually fulfilled. The pro is that it relies on market prices that
contain relevant information (e.g., investor perception) and is less biased by the analyst’s own
expectations.
9.3 Asset-Based Value Approaches

The value of equity is estimated by measuring assets and liabilities by applying different measures.
Net Asset Value (NAV): Uses the market value (fair value) of assets. This is typically done for asset
heavy firms, where the value is represented by (relatively liquid) assets (e.g., real estate). We expect
the ratio of market value of equity and NAV to be close to one. NAV is an orderly liquidation value,
which assumes the owners have the time necessary to sell each assets to the highest possible price.
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Sum of the Parts: The firm is valued as the sum of each segment of business unit, where each
segment is valued using the different techniques. Usually used for conglomerates.
Liquidation Value: Estimated net amount for a firm if all assets were sold and liabilities settles in a
forced sales situation. This value is the minimum value of the firm. The approach is used when there
is a question of bankruptcy, and thus typically used by creditors.
Evaluations of Asset-Based Approaches: Asset-based approaches values a firm as if it was going

out of business. They only yield an unbiased value estimate when the present value approach and
multiples yield estimates below the liquidation value.
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10 COST OF CAPITAL
To be successful, a firm must accept risk. Since the stakeholders are risk averse, they want to be
compensated for bearing risks. E.g., stakeholders need to translate the underlying risk of an
investment into a cost of capital measure, that is the expected or required return on their investment.
When valuing firms, we used the required rate of return on assets r a , the required rate of return on
equity r e , and the weighted average cost of capital WACC .
10.1 Weighted Average Cost of Capital (WACC)

WACC is a weighted average of the required rate of return (cost of capital) for each type of investor.
Let NIBL be the market value of net interest-bearing liabilities (net financial items), r d and r e be the
required rate of return on NIBL and equity respectively, and t be the corporate tax rate. Then:
NIBL Equity
WACC = × r d × ( 1−t ) + × re
NIBL+ Equity NIBL+ Equity
10.1.1 Capital Structure

Capital structure should be based on market values, as they reflect the true opportunity costs of
investors and lenders. For private firms, we must estimate the market value of equity and NIBL, but
only rarely do firms disclose their long-term capital structure. Therefore, other techniques must be
used:
Option 1: Apply the capital structure of comparably traded firms
Option 2: Infer the market value using an iterative procedure, where based on forecasts, iterate until
the estimated value of equity mirrors equity in the calculation of the capital structure in WACC.
10.1.2 Required Rate of Return on Equity

The Capital Asset Pricing Model (CAPM) says that the required rate of return is defined:
r e =r f + β e (r m−r f )
where r e is required rate of return, r f is the risk-free rate, β e is the systematic risk on equity (levered
beta), and r m is the return on the market portfolio. The basic idea is that by holding a broad portfolio
of shares, investors will only pay for risk that cannot be diversified, so only systematic risk is priced.
This the security market line (SML), a relative pricing model showing the equilibrium between the
firm risk premium and the market risk premium. β (beta) indicates the relative risk of a firm
compared to the market portfolio. The risk premium is adjusted depending on the firm’s systematic
risk.
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Estimation of the risk-free interest rate (r f ): Expresses how much an investor can earn without
incurring any risk. In theory, the best estimate of the risk-free rate is the expected return on a zero-
beta portfolio. In practice, the yield curve for a government bond is used. Each projected cash flow
should ideally be discounted using a government bond with a similar duration. This implies that an
expected short-term rate that is expected to apply in each future period (forward rate) should be
applied. This is tedious, so instead we apply a single yield to maturity from a government bond that
best matches the cash flows. We prefer zero-coupon government bonds.
⇒ To handle inflation, the bond should be denominated in the same currency as the cash flows.
Estimation and interpretation of systematic risk: The cost of equity increases with systematic risk:
β e =0: Risk-free investment

β e < 1: Equity investment with less systematic risk than the market portfolio
β e =1: Equity investment with the same systematic risk as the market portfolio
β e > 1: Equity investment with greater systematic risk than the market portfolio
Usually, the estimation of the equity beta β e is based on historical stock return, as all value relevant
information is reflected in stock returns. There are a number of issues related to this approximation:
⇒ Lack of liquidity in firm shares: Low liquidity leads to an apparent relatively low volatility,
which means that the beta estimate may not reflect the underlying risk of the firm.
⇒ Lack of stability in beta over time: Beta is not stable over time, and a change in beta reflect a
change in the underlying risk of the firm or a measurement problem.
⇒ Lack of ex-ante price observations: Ex-ante stock prices (future stock prices) are not available,
so historical data is used, but the problem is that risk is not stable over time.
⇒ Lack of observations (private firms): To estimate the beta we need a lengthy time series of
historical observations, which is especially challenging for private firms.
Alternative methods of measuring the systematic risk: To address some of the shortcomings:
Estimation of equity beta from comparable firms: To overcome lack of liquidity or lack of
observations, we can use beta estimates from comparable firms. This method involves the following
steps:
(1) Identify comparable listed firms with sufficient liquidity of shares

(2) Estimate beta for each of the comparable firms
(3) Calculate the unlevered beta (asset beta) for each comparable firm (adjusted for financial risks)
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(4) Calculate the average of unlevered beta for comparable firms

(5) Calculate beta for the target firm by levering unlevered beta from comparable firms.
The unlevered beta measures the operating risk in the industry, may be calculated using:
β a=
β e+ β d ( Equity
NIBL
)
NIBL
1+
Equity
To lever the unlevered beta we need the target firm’s capital structure, we can use the following:
NIBL
β e =β a + ( β a−β d ) ×
Equity
To use comparable firms, the firms included in the analysis must have the same risk profile.
Estimation of equity beta from fundamental factors: The equity beta can be estimated by building
on the fundamental characteristics of a firm’s risk profile. The equity beta β e is a function of
operating risk ( β a) and financial risk ([ β a−β d ] × NIBL/ Equity ). So, we should consider the factors
impacting these and distinguish between the firm’s ability to affect and control risk.
⇒ Operating risk: Includes an assessment the factors that affect the volatility in operating earnings
o External risk: Outside the firm that can affect its operating earnings (e.g., GPD growth).
Within the same industry, firms are affected roughly the same by these risks.
o Strategic risk: Involves industry issues, e.g., competition, competitive advantages, few
suppliers or buyers, etc. Improvements in these lead to more stable earnings.
o Operational risk: Firm-specific factors affecting the stability of operations earnings.
⇒ Financial risk: Primarily driven by
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o Financial leverage: Systematic risk and required return increases linearly with leverage.
o Loan characteristics: Fixed/variable interest, short/long-term, repayment profile and currency
denomination affect financial risk. Mort risky are foreign short-term variable interest loans.
The overall risk assessment shows that firms try to balance operating and financial risks, meaning
that firms with high operating risks typically try to minimize financial risks. Possible to use the
MASCOPLAPEC model, see p. 360. The critique of this method is that there is no consensus about
what constitutes operating and financial risk factors, and there is a high degree of subjectivity.
Estimation of Market Portfolio Risk Premium: The risk premium can be determined using
⇒ Ex-post approach: Examines the difference between historical stock returns and historical risk-
free returns (treasury bonds) 50-100 years back. We (naively) assume the market portfolio’s
historical risk premium is a reasonable indicator of future market portfolio’s risk premium
⇒ Ex-ante approach: Assuming analysts are in consensus on earnings forecast, it attempts to infer
the market portfolio’s implicit risk premium.
CAPM and Liquidity: Refers to the costs and problems associated with converting shares for cash.
To reflect the unattractiveness of illiquidity, investors attach a liquidity premium giving:
r e =r f + β e ( r m−r f ) + Liquidity premium
10.1.3 Required Rate of Return on Debt (NIBL)

Let r d be the required rate of return on NIBL, r f be the risk-free rate, r s be the credit spread (risk
premium on NIBL), and t be the corporate tax rate. Then, the after-tax required rate of return is:
r d =(r f + r s )×(1−t )
Interest expenses are tax deductible (unlike dividends), so the corporate tax plays a role when
measuring the required rate of return on NIBL. The use of the effective tax rate rests on many
assumptions, which are hard to fulfil in practice. Therefore, we favour the use of average corporate
tax (marginal tax rate) when estimating the tax shield.
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11 CREDIT ANALYSIS
Credit analysis assesses a firm’s ability to pay its financial obligations in a timely manner.
The expected loss (EL) is defined as the probability of default times the loss given default:
Expected loss=Probability of default (%)× ( Exposure at default−Value of recovery )
Probability of default (PD) is an estimate of the likelihood that the borrowing firm may default
(different from bankruptcy). The loss given default (LGD) is the net exposure at default minus the
ultimate recovery. Exposure at default (EAD) is not the same as current debt, but the debt at the time
of the default and is equal to the maximum loss a creditor may experience. The net proceeds creditors
receive given a default is the ultimate recovery. This is the value of recovery from the collaterals
plus creditor liquidation dividends. If ultimate recovery is expressed as a proportion of the exposure at
default, we have the recovery rate (RR). Thereby, expected loss can be defined as:
EL=PD × EAD(1−RR)
The estimated expected loss is a very uncertain number based on analysis of the past of assumptions
about the future. We need to estimate probability of default, exposure at default and the recovery rate.
11.1 Use and Type of Loan

Step 1: Understanding the intended use of the loan. The size of the loan and its use is needed to
determine the type of loan required.
Step 2: Understanding the type of financing. There are different types of loans available to firms.
Loans: A bilateral loan is credit extended from a bank to the firm, while a syndicated loan is
provided by a group. In a secured loan the borrower pledges an asset as collateral for the loan. In the
event of default, the borrow takes possession of the asset. An uncommitted facility allows the lender
to renege the commitment at any time, while a committed facility has clear terms and conditions.
⇒ Open line of credit: A credit facility permitting he borrower to receive cash up to some specified
maximum for a certain term, A fee is charged for the unused credit facility.
⇒ Revolving line of credit: A credit facility that may be used if credit is needed beyond the short
run. A fee is charged for the unused credit facility.
Bonds: Corporate bonds are debt obligations issued by the borrower directly to a group of
bondholders. Bonds are usually negotiable so the ownership can be transferred without the consent of
the borrower, meaning that bonds may be highly liquid and publicly listed.
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Medium-term notes: MTNs are a flexible form of financing available to borrowers with high credit
quality. They are similar to bonds but dealers have no underwriting obligations.
Private placements: An issue of debt that is placed primarily with insurance firms.
Convertible debt: A debt instrument that can be exchanged for a specified number of shares within a
specified date and at an agreed price. Contains an equity element and is contractually subordinated.
11.2 Estimating Probability of Default
Step 3: Understanding the business risk. Identify factors that may affect cash flows negatively and
impair the ability to meet obligations. Similar to a strategic analysis, but a focuses on downside risk.
⇒ Some industries have a systematically higher default rate due to competition, low margins, etc.
⇒ Firms are (usually) influenced by economic cycles.
⇒ We should also include related persons (e.g., owners) and firms (e.g., parent firm) in the analysis
Step 4: Assessing a firm’s financial health based on historical data. There are generally three
techniques used to estimate probability of default, the best depends on the size and complexity of the
loan.
Financial Ratios: See section 7 for the financial ratios, with a brief summary below
⇒ Sound financing structure: Equity ratio, financial leverage, long-term financing coverage ratio
⇒ Funds form operations sufficient to pay debt: Interest coverage ratio, CFO to debt ratio, debt to
EBITDA ratio, capital expenditure ratio.
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⇒ Liquidity reserve for rainy days: Liquidity reserve ratio
⇒ Liquidity efficiency: Working capital ratio, liquidity cycle (days)
⇒ Short-term liquidity risk: Current ratio, CFO to short-term debt ratio
Statistical models: Can predict bankruptcy and select which financial ratios are relevant. Methods are
preferred in cases where other approaches are costly, as they allow analysis quickly and at low costs:
⇒ Univariate analysis: A study by Beaver (1966) found 6 financial ratios useful in predicting
bankruptcies (p. 382). The ratios worsen as the bankruptcy date gets closer. Distinction between
errors:
o Type 1 error – false positive: Firm classified as not likely to default when it actually does
o Type 2 error - false negative: Firm is classified as likely to default when it does not.
⇒ Multiple discriminant analysis: Statistical technique classifying an observation into one of
several a priori groupings – bankruptcy vs. non-bankruptcy group. It then attempts to derive a
linear combination of financial ratios that best distinguish the two groups. A set of discriminant
coefficients are determined, which are multiplied with selected financial ratios to get a Z-score.
o Altman (1968) found 5 relevant ratios, see p. 384.
⇒ Logit analysis: A logit regression is an alternative to discriminant analysis. It is used to estimate
the probability of bankruptcy given several predictor variables. Ohlson (1980) model predicts
bankruptcy within one year, see model p. 384). The probability of bankruptcy is:
1
Probability of bankruptcy=
1+e− y
Some deficiencies of bankruptcy models: (a) Coefficients must be estimated at industry levels to
make sense, (b) coefficients are not stable over time and must be re-estimated regularly, (c) the cut-off
score that distinguishes bankrupt from non-bankrupt is based on judgement, (d) reliance on historical
information only, and (e) not valid if assumptions aren’t fulfilled in certain situations
Credit Rating: Firms pay rating agencies like Standard & Poor’s or Moody’s to obtain an official
rating when borrowing money in the public market. The rating estimates the probability of default.
Credit rating models use selected financial ratios in the ranking of firms based on their credit risk.
⇒ Credit ratings from AAA (Aaa) to BBB- (Baa) is investment grade, while ratings below BBB-
(Baa) are a speculative grade (high yield or junk bonds).
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Step 5: Assessing a firm’s financial health based on simulation of future cash flows: Credit rating
models and financial ratios are backward looking. It is important to also project future cash flows to
assess if the CFO net of investments (FCFF) are sufficient to pay interest and instalments. It is
common to do a scenario analysis based on the findings in the strategic analysis, where each
simulation is used to evaluate whether a firm’s cash flow is sufficient to service debt.
11.3 Estimating Loss given Default

Step 6: Exposure at Default: Exposure at default is the outstanding debt including unpaid interests at
default (i.e., not the same as current debt unless there are no loan instalments). A committed facility
has a pre-defined repayment schedule where the current loan is reduced by instalments, reducing the
exposure at default over time. Banks often assume that current debt equals exposure at default.
Step 7: Ultimate recovery and recovery rate based on liquidation models. The recovery is the sum
of the value of the security and the dividend a creditor may receive after full liquidation of the firm.
Value of the security or collateral: Creditors often secure their loan by requiring a pledge on which
the borrowing is based, which ensures the lender can realize the asset to satisfy its claims if the
borrower defaults. Here it is relevant how liquid the asset is. The more liquid, the more aligned is the
book value and liquidation value. Banks use the current liquidation value as the best estimate for the
value of the collateral at the time of a future default.
Dividends from liquidation: The liquidation value is the estimated net proceeds if all assets were
sold, and liabilities settled. It can also be estimated as the gross liquidation value of all unsecured
assets before liabilities are settles. It represents the value of the alternative uses of assets.
⇒ Orderly liquidation value assumes orderly sales process and corresponds to the net asset value
⇒ Distress liquidation value assumes the sale of assets are forced within a short period of time.
An estimation of the liquidation value typically follows these steps:
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Ultimate recovery rate for different types of debt: The ultimate recovery rate is measured as the
total repayment of debt divided by the nominal value of the debt. ‘Ultimate’ as is includes all
payments to creditor. Recovery rates vary by type of debt, with secured debt having the highest.
11.4 Estimating the Expected Loss

Step 8: Summarizing the results. The results of the credit analysis can be summarized in a matrix (p.
405). Credit agencies typically summaries their analysis in a credit rating including the estimated loss.
Step 9: Caveats when estimated the expected loss: Mainly note that
⇒ The correlation between probability of default and recovery rates: Common sense tells us
that when times are bad, there is a higher probability of default and lower liquidity, which has a
negative impact on the recovery rate. I.e., a negative correlation often ignored.
⇒ Concentration risk: When a significant proportion of the total loan portfolio is concentrated into
one firm, a group of interrelated firms or to an industry, there is a high level of concentration risk.
If banks accept this, they may experience severe financial problems from just a few defaults.
11.5 Terms of a Loan

Step 10: Pricing credit risk: The pricing of a loan should be the sum of the funding cost (deposits,
borrowed funds and cost of equity), the expected loss, and the lender’s cost of administering and
servicing. The spreads increase as credit rating worsens, supporting compensation for higher credit
risk.
Step 11: Covenants: Most financing includes loan covenants, which is a condition tied to the loan
that requires the borrower to fulfil certain conditions or forbids the borrower from undertaking certain
actions (e.g., pay dividends). Violations may result in default, where penalties may apply.
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12 MANAGEMENT PERFORMANCE
12.1 Performance Evaluation

Incentive plans should align the interests of management (agent) and the owner (principal) and
ensure management acts in accordance with a firm’s strategy to maximise long-term value creation.
⇒ Agency problem: How do owners ensure managers strive to create shareholder value? The
principal may monitor the agent closely or offer the agent an incentive that aligns their interests.
How to evaluate management’s performance under perfect and complete market conditions
Fair value is the price received if selling an asset or paying to transfer a liability in an orderly
transaction between market participants, i.e., reflects the general market value of the asset. Value-in-
use is the present value of cash flows the entity expects to derive from the continuing use of an asset.
In complete and perfect markets, we may construct a balance sheet based on the fair value of all
sellable assets and liabilities, showing the value of the firm based on the average usage of those assets.
We can also measure the value-in-use of all assets based on management’s usage of the assets. The
difference between value-in-use and the fair value shows the value of management performance.
⇒ If value-in-use is higher than fair value, the market expects management to create excess returns.
Residual Income approach (RI) is based on excess returns. By replacing book value with the fair
value of all assets and liabilities in the RI approach, the value of management’s effort is measured as:
∞
RI t
Market value of Equity 0=Fair value of equity 0 + ∑ t
t=1 ( 1+r e )
where RI t =Net earningst −r e × Fair value of equity t −1. RI measures the excess return generated
by the firm relative to the generic use of the assets. Management’s performance for a period (a year)
should be measured as RI for the last year plus the change in the present value of expected RIs.
⇒ We cannot only use RI for the last year, as high RI can be obtained by avoiding investing in the
future, thus reducing the present value of future RIs.
An incentive plan ensures a balance between short-term and long-term actions. Management is
measured relative to the generic use of assets. So, an incentive plan should focus on management’s
ability to create value in excess of other firms, i.e., irrespective of the general market
upturns/downturns.
Problems in the real world: Two problems when measuring RI
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(1) While possible to measure liquid assets and liabilities at fair value, many do not have available
market values (e.g., a brand). A balance sheet based on fair value can only rarely be prepared.
(2) The value-in-use must be estimated by management, where management has private information
and may exercise discretion in its estimation.
The principal-agent relationship: Describes the difficulties of designing incentive plans that
motivate management to act in the owners’ interest. The principal-agent problem occurs when one
entity (the “agent”) makes decisions on behalf of or that impact another entity (the “principal”). The
potential dilemma is that the agent may be motivated to act in their own best interests, which may be
contrary to those of the principal, which is to maximise the value of the shares.
⇒ Asymmetric information: Management has more (inside) information, and the actions and effort
of management are not fully observable to the owners
A solution to the information asymmetry problem is to apply incentives so interests are better aligned.
An incentive plan may be linked to stock market performance, non-financial performance measures or
financial performance measures:
⇒ Non-financial performance measures: Customer satisfaction, employee satisfaction, product
and service quality, productivity, process improvements, innovation, leadership, etc.
⇒ Financial performance measures: Sales, gross profit, EBIT, EBITDA, NOPAT, net earnings,
return on invested capital (ROIC), return on equity (ROE), economic value added (EVA), etc.
12.2 Characteristics of a well-designed accounting-based incentive plan

The design of an incentive plan for management must align the interest of managers and owners,
while balancing the short-term (e.g., cost cuts) and long term (e.g., R&D) actions. The criteria are:
(1) Congruence: Refers to the degree of alignment between the objective of the shareholders and the
objective of the managers. Management should only be rewarded if they act in the interest of owners.
Due to difficulties estimating fair values and value-in-use, accounting-based performance metrics are
used as a proxy for value creation. Still, unbiased performance measures are difficult to obtain
due to (a) accounting regulation, and (b) management’s incentives to change accounting estimates
Since value is created throughout the lifetime of a firm, congruence demands managers undertake
actions that emphasise the long run (the horizon problem). Managers should invest in positive net
present value projects even though the effect on current earnings and EVA is negative.
(2) Controllability: Management should be rewarded only if their actions and effort have an impact
on firm performance. However, a variety of events cannot be controlled by management.
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Controllability ensures managers are not unmotivated by having their incentive tied to things beyond
their control.
(3) Simplicity: Simplicity suggests that measures, which are simple as well as easy to understand,
manage and communicate, should be incorporated in an incentive plan (e.g., EBIT and net earnings).
Simplicity has the potential to limit managers’ discretion and reduce the pay-to-performance gap.
Overemphasising simplicity may misalign the interests. Management tends to focus on the
performance measures that create bonuses, and disregard other important actions and measures not
included.
(4) Accounting issues: Reported figures may be a noisy measure of the true underlying performance
due to earnings management and the inclusion of non-recurring items, so it may be argued that
reported figures should be properly adjusted to better reflect the true performance.
⇒ Incentive plans explicitly addressing the consequences of non-recurring items and changes in
accounting policies and estimates on earnings are considered higher quality
Non-recurring accounting items: Earnings generated from the core business (recurring earnings) are
regarded as more valuable than earnings based on non-recurring items.
⇒ Should non-recurring items be included in performance measures? If management is paid a cash
bonus based on operating measures, special items should be included if related to core operations.
They may have a positive NPV, but a negative effect on this year. Therefore, a case-by-case basis.
⇒ Who decides if an item is non-recurring? Deciding what constitutes a non-recurring item on a
case-by-case basis is an option, but may be problematic as it is bureaucratic and complicated
How should changes in accounting policies and practices affect bonuses? We address two types of
changes: mandatory changes and voluntary changes.
⇒ Voluntary changes may have a significant effect on the reported numbers and should ideally
only affect bonuses if the changes improve accounting earnings as a measure of true performance.
The incentive plan should include clauses that describe how to account for voluntary changes.
⇒ Mandatory changes were seen when all listed EU firms had to comply with IAS/IFRS. An
incentive plan should include clauses that determine whether bonuses should be affected by
mandatory changes and may determine that it should be recalibrated in case of changes.
How should changes in accounting estimates affect bonuses? Incentive plans may have a clause that
states if changes in accounting estimates have a material effect on the performance measure, the plan
shall be recalibrated or renegotiated.
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12.3 Components of an Incentive Plan

Executive incentive plans can be categorised in terms of three basic components: (1) choice of
performance measures, (2) choice of performance standards and (3) choice of performance structure:
12.3.1 Choice of Performance Measures

The choice should support the firm’s strategy and value creation and avoid a solely short-term focus.
Single-period measures vs. multi-period measures: Single-period measures are backward looking,
and multi-period measures assess value creation throughout time, considers growth and risk
Absolute vs. relative performance measures: Different pros and cons
⇒ Absolute performance measures:
o Revenue: Pros are good if growth is important (e.g., new markets, new products, start-ups),
while cons are does not consider cost, accounting policies matter (i.e., revenue recognition)
o EBIT: Pros are measuring the outcome of a firms core business, while cons are does not
consider financing activities, how should transitory items be accounted for?
o Net earnings: Pros are capturing all income and expenses, while cons are if capital structure
changes by issuing new equity capital and repaying interest bearing debt, earnings increase
o Earnings per share (EPS): Pros are could have a positive effect on firm value, while cons
are affected by share buy-back, does not take into consideration investments
⇒ Relative performance measures:
o ROE: Pros are easy to understand, while cons are not reliable signals for value creation
o ROIC: Pros are easy to understand, while cons are not reliable signals for value creation
o EVA: Pros are reflects value creation, cost of capital becomes visible, while cons are invested
capital may not be comparable across firms
Criterion function Earnings measures (e.g., Return measures (e.g., Economic profit (e.g., EVA,
EBIT, net earnings) ROIC, ROE) RI)
Congruence
Ability to account for Low High High
invested capital
Ability to account for Low Low: Risk may be accounted High: EVA and RI take the
risk for by comparing ROIC and cost of debt and the cost of
ROE to cost of capital equity into consideration
Reliable signal of Low Low Medium: A positive EVA/RI
value creation signals value creation, but
must be combined with
calculation of present value
of estimated future EVA/RII
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Controllability Medium: Management Medium: Management Medium: Management

controls everything entering controls everything entering controls everything entering
the bottom line, but outside the bottom line, but outside the bottom line, but outside
factors are not controlled for factors are not controlled for factors are not controlled for
Simplicity High: Easy to understand and High: Easy to understand and Medium-to-low: Easy to
measure, already reported measure, typically already understand, but adjustments
reported and calculation of cost of
capital complicates it.
Number of High: Prone to earnings High: Prone to earnings High/low: If absolute
accounting issues management, accounting for management, accounting for EVA/RI is used, accounting
special items is problematic special items is problematic policies matter. If a change is
used, accounting policies
matter less.
12.3.2 Choice of Performance Standards

Includes considerations of internal and external benchmarks for bonus payment, and how and when
performance is calibrated.
Two types of performance standards: (a) internal standard and (b) external standards
⇒ Internal standards:
o Budget standards: Against the firm’s projected performance

o Prior-year standards: e.g., improvement in sales, net earnings, earnings per share
o Cost of capital: ROIC versus WACC
o Fixed standards: e.g., 8% returns on assets
o Subjective standards: e.g., assessed by the board of directors
⇒ External standards: Benchmarking against competitors on, e.g., sales, operating profits, net
earnings, ROIC, ROE, EVA, etc.

o Concerns: Finding comparable firms, peers should have the same risk profile and accounting
policies, and the existence of transitory items
Internal Standards External standards

Congruence Medium: Cost of capital is theoretically the right Medium: Beating competitors signals better
benchmark, estimation problems in calculating performance than in the industry, beating
cost of capital, beating budget or last year does competitors does not ensure value creation
not guarantee value creation
Controllability Medium: Management is responsible for and High: Common non-controllable factors are
controls everything entering the budget or last accounted for (e.g. interest rates, growth,
year’s performance. Certain market factors are inflation etc.)
outside management control.
Simplicity High: Budget or last year’s earnings are Low: The choice of peer group is problematic.
measures that are easy to understand and
communicate.
Number of Medium: Management may bias budget, prone High: Peer group financials may have to be
accounting issues to earnings management adjusted to account for differences in non-
recurring items, accounting practices and
estimates
Page 56 of 61
12.3.3 Choice of Pay-to-Performance

Concerns how to link bonus payments to performance. The types of pay to performance structure:
⇒ Linear relationship
⇒ Non-linear relationship (with floor and cap)
Linearity Non-linearity (cap/floor)

Congruence High: High management effort as bonus is not Medium: Regulates an imperfect incentive plan.
capped, little risk of earnings management Low management effort if performance is
as bonus, poor performance is penalised. above/below threshold. Risk of earnings
management. Poor performance is not penalised
Does not have a “mechanism” that reduces the
impact of imperfect incentive plans
Controllability Medium: Bonus may be too high (low) due to Medium/high: Regulates an imperfect incentive
uncontrollable events plan
Simplicity High: Direct link between performance and Low: Setting floor/cap is tedious and prone to
bonus distortion
Number of Medium/Low: No earnings management, risk High: Risk of earnings management

accounting issues that non-recurring items are not effectively
eliminated making bonus too high/low
Page 57 of 61
13 ACCOUNTING QUALITY AND FLEXIBILITY

Petersen, Plenborg & Kinserdal (2017): Chapter 13-15 + Lecture 13
13.1 Accounting Flexibility

Accounting quality: Determined by if the financial reporting is a faithful representation and relevant
⇒ Faithful representation consists of representation (reliability) and usefulness (relevance) of the
reported numbers in the financial statements.
Accounting regulation and flexibility: Reported numbers depend on the accounting regulation with
which the firm must comply (usually IFRS in EU and local GAAP in, e.g., US or China)
It’s a challenge to develop accounting standards which are (a) uniform across industries and
accounting regimes, and (b) flexible enough to provide management an opportunity to report financial
data that incorporates the proprietary information about the firm
Key accounting issues in the IFRS:
⇒ The scope of the standard, i.e., what is included
⇒ Definitions of key words and concepts used throughout the standard:
o Asset is an economic resource controlled by the firm due to past events. We cannot include
employees as an asset (which affects financial ratios), as they are not under firm control.
o Liability is defined as a present obligation to transfer an economic resource due to past events
o Equity is defined as the residual interest in the assets of the firm after deducting all liabilities
o Income is defined as increase in assets or decrease in liabilities resulting in increase in equity
o Expenses is defined as decrease in assets or increase in liabilities resulting in decrease in
equity, other than those relating to distributions to holders of equity claims
⇒ Recognition criteria, i.e., when should an event be recognized. Each IFRS normally specifies
when recognition criteria for the specific accounting item is fulfilled.
⇒ Measurement of accounting items
o Which cost items should be assigned to accounting items at initial recognition? How should
items be valued at future dates? What measurement bases should be used?
o IFRS has no preferred measurement, but the ED framework lists: (a) historical cost at the
transaction and (b) current value (fair value and value in use).
⇒ Classification of accounting items, and how detailed the classification should be.
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⇒ Disclosure of information, i.e., what kind of information and how much should be reported
Inconsistencies under IFRS: In all standards, the same term should have the same meaning.
However, the following IFRS inconsistencies exist:
⇒ Inconsistencies in asset definition and recognition: An asset can only be recognized if it is
under the control of the firm, which includes OWNED and LEASED assets). This gives the
problem that, e.g., goodwill, trademarks, R&D, marketing etc. cannot be recognized as assets if
they are generated internally. If a firm takes them over through acquisitions, they should be
recognized.
⇒ Inconsistencies in recognition of uncertain assets and liabilities. There are no clear rules on
when something can be recognized as an asset or a liability.
⇒ Inconsistencies in the recognition of liabilities
⇒ Inconsistencies in accrual accounting
⇒ Inconsistency in the measurement of loans
Mixed measurement bases under IFRS: Uncertain if fair value or historical cost is better. Comes
down to relevance (fair value) versus reliability (historical cost).
Accounting flexibility affects the following accounting areas:
⇒ Revenues: Income that arise during a firm’s ordinary (operating) activities Recognised (a) at a
point in time (e.g., when delivery is made), or (b) over time using the percentage of completion
method. Variable elements should be recognised when it is probably that it will occur.
⇒ Inventory and cost of goods sold: The value of inventory is measured as the lower of cost or net
realisable value. Inventory should be written down if products are unsellable. Methods allowed
under IFRS is FIFO and the weighted average method.
⇒ Intangible and tangible assets: Intangible assets are identifiable non-monetary assets without
physical substance controlled by the firm. Tangible assets are e.g., PPE
⇒ Capitalisation versus expenses: Intangible resources are expensed (e.g., employees), as the
firm must have control over their assets. Internally generated intangible assets (brand) are not
capitalised, unless the firm is sold/acquired in a merger.
Page 59 of 61
⇒ Depreciation and amortisation: Questions of the useful life of an asset, expected residual
value, and depreciation method (straight-line vs. diminishing balance).
⇒ Impairment: An impairment loss is expensed when carrying amount (book value) of an asset
exceeds it recoverable amount (the high of fair value and value in use).
⇒ Revaluation: Gives the option to carry a fixed asset at its revalued amount.
⇒ Lease accounting: A lease is recorded as a lease liability and a lease asset (PV of minimum lease
payment), and in each period, and interest expense is paid, slowly reducing the lease liability.
⇒ Provisions: Liabilities of uncertain timing and amount. Generally not recognised, however
contingent liabilities are generally recognised if a payment is probable.
⇒ Pensions: Difference between contribution plan and benefit plan (tied to unknown future salary)
⇒ Deferred tax liabilities and assets: Taxes to be paid as if all assets and liabilities had been sold at
book values, i.e., the difference in book and tax values multiplied by the nominal tax rate.
⇒ Foreign exchange and hedging: There are two types of hedges: (a) fair value hedge where the
hedged item is recognised in the balance sheet, and (b) cash flow hedge where gains and losses on
hedging instrument is recognised as comprehensive income.
⇒ Purchase price allocation: When acquiring a firm, how is the purchase price allocated between
different assets and liabilities acquired. There is a high level of flexibility.
⇒ Consolidation: Including the ownership in another firm. According to IFRS, a firm may include
another firm by (a) full consolidation if the firm controls the investee, (b) equity method if the
firm has significant influence, or (c) cost price if the firm does not have significant influence.
⇒ Information in disclosures: Management was much discretion in what to write here.
13.2 Accounting Quality and Earnings Management

Earnings management: An intentional deviation from a faithful presentation of financial statements.
The intention is to mislead some stakeholders about the underlying economic performance of the
company or to influence contractual outcomes that depend on reported accounting numbers
Accounting fraud: Earnings management so material that it is clearly outside the law.
Motives for earnings management: The objective is to improve, reduce or stabilise earnings due to
(1) Maximize value for owners (obtain a higher market value, increase profits or equity)
Page 60 of 61
(2) Maximize personal gains (obtain a larger bonus, hide mistakes, meet expectations)
(3) Impression management
Event specific factors for earnings management: Financial distress, capital market events (IPO’s,
seasonal offerings, expected M&A’s), change of management, change of auditors, changes in rules
and regulations, implementation of incentives for managements
Common earnings management methods:
(1) Recognizing revenue too early

(2) Related party transactions to increase gains, avoid impairments and hide debt
(3) Capitalizing instead of expensing costs
(4) Overstating assets by delaying impairments
(5) Accruing fake assets
(6) Not accruing for claims or liabilities
Key mechanisms introduced in 2001 (after a stock market crash): More detailed accounting rules,
and the discussion of “true and fair”, improved enforcement and oversight boards, stricter regulation
of auditors, and increased requirements for corporate governance.
Common patterns observed in firms that commit fraud: Firms with aggressive growth or growth
targets, firms with a large group of executives with hefty bonuses, and dominant, charismatic leaders
Page 61 of 61

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KAN-CFIVO1004U Financial Statement Analysis Autumn 2021

10.1 Weighted Average Cost of Capital (WACC) 39

by IASB (International Accounting Standards Board):

⇒ IAS (International Accounting Standards): Outdated yet still existing

⇒ US GAAP: US accounting standards issued by FASB (Financial Accounting Standards Board)

Decision makers: Three groups making decisions in different analytical contexts:

(1) Equity-oriented stakeholders: Investors, firms, corporate finance analysts, etc.

1.1 Equity-oriented stakeholders

1.2 Debt-capital-oriented stakeholders

Expected loss=Probability of default (%) ×( Exposure at default −Ultimate value of recovery )

If the ultimate recovery is expressed as a proportion of exposure at default which is recovered:

Expected loss=Probability of default × Exposure at default ×(1−Recovery rate)

1.3 Compensation-oriented stakeholders

2 FINANCIAL STATEMENTS AND BOOK-KEEPING

2.1 Sources of Financial Information

and management presentations (may be biased, but is legally true)

⇒ Press releases and stock-exchange announcements

⇒ Market reports prepared by industry expert firms and consultancy firms

2.2 Content of the Annual Report

expectations, information on strategic initiatives, CSR, and corporate governance.

management, and the auditor’s opinion of the firm’s financial statements.

2.2.1 The Financial Statements

Content of the income statement: Must as a minimum include:

⇒ Revenues and finance costs

⇒ Post tax profit or loss of discontinued operations

IASB further has defined the following items to be disclosed:

⇒ Write-downs of inventories to net realisable value or of property, plant, and equipment to

recoverable amount, as well as reversals of such write-downs

⇒ Restructuring of the firm activities or reversals of them

⇒ Disposals of property, plant, and equipment and disposal of investments.

⇒ Other reversals or provisions

⇒ Changes in the revaluation surplus

⇒ Actuarial gains and losses on defined benefit plans

⇒ Exchange differences on translating the financial statements of foreign operations

⇒ Gains and losses on re-measuring available-for-sale financial assets

⇒ Income tax relating to other comprehensive income.

For an asset to be current, it must satisfy at least one of the following:

⇒ It is expected to be realised (sale or consumption) within a normal operating cycle

⇒ It is held for the purpose of being traded

⇒ It is expected to be realised within 12 months after the reporting date.

⇒ It is cash or cash equivalent.

For a liability to be current, it must satisfy at least one of the following:

⇒ It is expected to be settled within a normal operating cycle

⇒ It is held for the purpose of being traded

⇒ It is due to be settled within 12 months after the reporting date.

months after the reporting date

Assets Liabilities and equity

- Property, plant, and equipment - Trade and other payables

⇒ Retained earnings (accumulation of profit over time net of dividends)

⇒ Revaluation reserves (e.g., caused by revaluing property to fair value)

⇒ Transactions between shareholders (e.g.. increases in share capital, share repurchases)

2.3 Double Entry Book-keeping

claims on these resources.

left (debit) side is expenses and represent decreases in equity.

Income, liabilities, and owner’s equity

Assets=Liabilities+ Stockholders ' equity

Assets=Liabilities+Capital stock+ Retained Earnings

3 ACCURAL-BASED VS. CASH-FLOW-BASED

3.1 Accrual-based Performance Measures

3.2 Cash-flow based Performance Measures

Shareholder value added (SVA) is a cash-flow-based, forward-oriented, multi-period measure of the

Various cash-flow-based performance measures:

Operating income (EBIT)