Appunti AFC - Accounting, Finance & Control - prof. Lettieri

Manager and company analysis

A manager is a professional who is in charge to decide. Companies can be considered as an input-output system. The output of the companies are products and services, but the final performances at the very end are profits (revenues – costs) and cash generation (cash inflows – cash outflows) considering the short-term. In long-term we will measure the enterprise value and the entity value. The problem is to have data to make analysis.

Accountability in companies

First of all, the company must be accountable for subjects who are outside the company (External Accountability), for example the shareholders, banks, bondholders, employees, …, but also to those who are inside the company (Internal Accountability).

The key point in external accountability is disclosure: the more we tell outside the more will be the trust from our customers. But on the same side also competitors can read the financial statement, we should then find a good trade-off of how much we should tell outside.

Internal accountability refers to the use of indicator to guide management. The managers are provided with the Performance Measurement System (PMS) which is a system intended to guide the decisions and behavior of managers by providing performance and risk indicators (usually no more than 20). The PMS has two intertwined functions: decision making and motivation.

The role of the CFO

The CFO controls the Budgeting (risk analysis and mitigation in order to take actions), Measurement (risk and performance measurement of the output), and Reporting (results achieved). The CFO is not in control of the feedback actions.

Performance is the product between strategy and execution. Execution is more important than strategy because the financial reports measure the execution.

Theories on control mechanisms

Organizations are not neutral with regards to the control mechanisms. There are three theories highlighting these issues:

• Expectations theory → Parameters of evaluations are expected to be set in advance (at the beginning).
• Equity theory → You expect that the evaluations will be fair, all the employees will be evaluated in the same way.
• Goal Setting theory → The goal must be challenging (ambitious), but achievable (unless we are not motivated because we know we can’t reach it).

Financial documents’ recap

The AFC challenge’s aim is to evaluate the corporate performance (how’s the company performing), the determinants (the reasons why the company is performing well or not). With the knowledge I have from the previous years (3 years), I have to understand the outlook (how will the company perform the next year).

Outside → financial report. The enterprise is an input-output system. It uses inputs/resources (technologies, people, money, …) in order to deliver/produce outputs (products, services). The key problem connected to input is related to costs (cash outflows).

So, the performances are:

• Revenues – costs = profit / loss
• Cash inflows – cash outflows = cash generation / cash absorption

Understanding financial documents

We can hence identify three main blocks that are related to three main documents:

• Input → Balance sheet
• Profit & loss → Income statement (profit & loss account)
• Cash inflow/outflow → Cash flow statement

These three documents provide us the capability to understand both the performance and the … of the company. They don’t predict what the company will be.

Standards of financial reports

What are the standards? How are they written? IFRS / IAS are the international criteria to produce the financial report. Unfortunately, they are not adopted in all countries (USA uses US GAAP, CHINA uses CAS, JAPAN uses FASF). The financial reports are a collection of documents.

In the IAS standard, the documents required are:

• Balance sheet 2pg →
• P&L → Statement of income 2pg → is associated with “sanity”
• Cashflow statement 2pg → “At the end you are the cash you have”
• Notes to financial document 300pg → The assumptions the company made to explain the numbers
• Changes in shareholders’ rights → Company are obliged to tell who are the shareholders, owners and what are their roles.

These documents are compulsory for companies. For the companies that are listed, there are other compulsory documents:

• Management report → C-level managers are explaining the performance of the company. It is subjective because the managers try to manipulate info in order to make their company look the best in class.
• Report of the external advisors → Their role is to tell what the company is supposed to do (1pg).
• Report of auditors → They check if all the documents are reliable. 4 giants in this market: Deloitte, KPMG, Ernst & Young (EY), and PricewaterhouseCoopers (PwC).

Balance sheet

The main idea is to have an idea of the resources that the company had in the previous year. There are only the resources that can be measured with money. How to pack the resources to make the document easily readable? The international country standard’s main idea is to organize the assets along the line of liquidity.

• Assets
• Liabilities & Equity
• Tangible assets
• Non-current Intangible assets
• Equity
• Financial assets
• Bank debts, bonds
• Non-current Current inventories
• Bank debts, bonds, current
• Assets trade receivable trade payables cash liquidity collectability

Current assets are those that will be transformed into cash in the next year (From the bottom):

• Cash
• Trade receivable → cash that will become available in the company
• Inventories → raw materials that are going to be sold, becoming money
• Financial assets → shares that the company has decided to buy to get gain in a short period (a few months)

Non-current assets are those which the company has the opportunity to keep for many years (warehouse, buildings, …):

• Tangible assets (buildings, warehouses, …)
• Intangible assets (software, patents, brands, goodwill, …)
• Financial assets / equity investment (the company’s shares of other companies, in order to have control on them)

The most important figures are: Shareholders (owners of the company), banks/bend holders (provide the company with money), and suppliers (provide the company with the products). The IAS divides the Shareholders from the third part (banks and suppliers).

So, the right part of the balance sheet is divided in Equity (all the right the shareholders have on the assets) and Third part liabilities (). The equity is also called the book value. It is different from the market value, because it looks at the present and at the past while the market value looks at the future.

The right part is ordered by collectability:

• Non-current (right of stakeholders that the company has to pay back in more than 1 year)
• Bank debts
• Bonds
• Current (right of stakeholders that the company has to pay back in the following months, less than 1 year)
• Bank debts
• Bonds
• Trade payables (supplies that we didn’t pay yet)

The right side is usually called the LIABILITIES or LIABILITIES & EQUITY. IN EVERY MOMENT TOTAL ASSETS IS EQUAL TO TOTAL LIABILITIES.

The two most relevant implications that we could have directly from this document are:

• Ratio between the liabilities and equity (“Debt to equity ratio”): D/E indicates the leverage of the company →
• Ratio between the current assets and the current liabilities should be higher than 1. The money generated by the current assets should be higher than the money we have to pay in the next months (current liabilities).

Profit & losses

It’s the most important document for the manager because the salary is connected to this document. It is focused on the differences between the revenues and the costs. The idea is to understand if the company is gaining profit or losing. It is not the picture of the company taken at the end of the year (like the balance sheet), but it is a flow, so the observation period is 12 months. We need to refer to the so-called Matching principle, which is the most relevant principle to generate the P&L. It’s based on accrual perspective.

The accrual perspective is the opposite of the cash perspective (used for CF statement): when you receive/pay money, you have cash inflow/outflow. The accrual principle is not based on cash, but on invoices and transfer of properties. This principle tells that revenues must enter in the P&L when there is the invoice, whereas costs must be included in the P&L when:

1. They are “matched” with revenues. If a year I don’t sell anything, I don’t have costs! (The costs are postponed to the next year). (Product costs)
2. The utility of these resources expires in the period → we can’t bring the value of the resource in the next period. (Period costs)

Product costs are connected to the production. Period costs are costs connected to resources whose costs expires in the period. Period costs are SMAG: Sales (+ logistics), Marketing, Administration (Top managers, HR, Finance, IT), General (Canteen, Legal, Security) + R&D.

3. Part of the value of a non-current asset. The production machine in an assembly line, is a non-current asset. What is the cost that should enter in the P&L? If the machine will last 20 years, we have to divide the value with the lifetime. This is the depreciation. The value of the asset will decrease year after year with depreciation. How do we consider the depreciation of an equipment? We should include it if it is sold during the period.

If I produce 5 bottles, and I sold just one? The depreciation connected to the bottle sold will be included in the P&L, the other part must not be included. Cost = the monetary value of any resource that the company has used to achieve any goal.

Imposts → Enterprise → product/services.

There are two approaches: By nature of the costs (rent, electricity, …) or by function/destination (who’s using the resources: operation, finance department, sales, IT, …).

By nature

• → typically close to zero (i.e., Politecnico selling t-shirts)
• If we don’t consider this voice, we are not following the matching principle.
• Costs of raw materials
• Costs of labour (they consider discounts)
• Other operating costs

Where is the matching principle? Cost of raw material means cost of raw material related to products sold?

The “change in inventories of finished good” is the voice that makes the P&L compliant to the principle.

Revenues + other operating revenues + Changes in inventories of finished good = Value of Production. Cost of raw materials + costs of labour + other operating costs = Cost of production.

It’s better to build the P&L in this way:

• + Revenues
• + Other operating revenues
• - Cost of raw materials
• - Costs of labour
• - Other operating costs
• + Changes in inventories of finished good → This gives the EBITDA = Earning before interests, taxes, depreciations and amortization (depreciations of intangible assets). It is the first proxy of a cash flow statement.
• - Depreciation and amortization → This gives the EBIT = Earning before interests and taxes (Net Operating Income)
• + Financial incomes (usually close to zero)
• - Financial costs (financial interests to the banks debts) → This gives the EBT = Earning before taxes
• - Taxes → This gives the NET INCOME / PROFIT or LOSS

By function/destination

• + Revenues
• - Cost of goods sold (product cost) → This gives the GROSS PROFIT / GROSS MARGIN
• - Sales logistics
• - Marketing → these are all the offices in the company
• - Administration
• - General
• + Other revenues (typically close to zero) → This gives the EBIT

For managers it is more useful to analyse the “by function” P&L because you can see the composition of the different costs. For example, you can compare two companies in terms of costs spent on marketing.

Cashflow statement

It’s based on the Cash principle, not the matching principle.

Structure:

Cash at 1/1 + Variation of the cash = cash at the end of the year (≥ 0)

How to write the variation of the cash?

• + Cash flow from operating activities >0 Operating is not the operating cost in the P&L
• + Cash inflows → sales, financial activities Here it includes the financial income/outcome
• - Cash outflows → purchasing, paying salaries, paying utilities, paying taxes, paying interests
• + Cash flow from investing activities usually <0 → I invest to increase my capacity (to grow)
• + Cash inflows → disposal of assets (selling an asset)
• - Cash outflows → investments (CAPEX = CAPital EXpensions)
• + Cash flow from financing activities
• + Cash inflows → new shares, new bank debts, new bonds
• - Cash outflows → repaying debts, bonds, dividends, buyback (company buys shares of shareholders)

Combining operating activities (>0) and investing activities (<0), we can know what to do with the financing activities (if we need more money or if we can repay debts).

Consolidation financial statement

It is a document that combines the financial statement of different companies that belong to the same group. It is the financial statement of a group of companies in which assets, liabilities, revenues, costs, and cash flows of each organization inside the group are presented as a unique entity. A group of companies is an economic entity formed by a set of companies (separate legal entities) which are either companies controlled by the same company or the controlling company itself.

Types of arrangements

There are different types of arrangements:

• Subsidiary → when you are holding the control of the company Full consolidation
• Associate → when you have a significant influence on the company (20-30% of influence in terms of ownership)
• Joint Arrangement → when more companies are holding the same size of control

Non-controlling interests: is the minority interests that the company we are holding has. It is the portion of equity ownership in a subsidiary not attributable to the parent company. Two major principles that companies are using for consolidation (IFRS and US GAAP).

IFRS

According to IFRS control exists when:

• Power → Substantive rights to direct “relevant activities”. Voting rights or practical ability to exercise the rights
• Exposure to variable returns → Potential variability to positive or negative returns (broad definition of returns)
• Ability of the investor to affect its returns through its power → Need to determine whether the “decision-maker” is an agent of another investor

Types of joint arrangements

We have two types of Joint Arrangements:

• Joint venture → a third entity is constituted and jointly controlled by two organizations. The joint controlling companies don’t have the individual rights over the assets.
• Joint operation → there is not a third entity or there is a third entity by the joint controlling companies have the individual rights over the assets.

Consolidation methods

How to consolidate? Three ways of consolidation:

• Line by line
• Proportionate
• Equity method

Irrespectively the consolidation method adopted, these preliminary steps are required:

• Harmonization of accounting principles between the companies
• Harmonization of the accounting period (difference no longer than 3 months)
• Reporting currency (if necessary, translation must take place)
• Layout of the documents (they should be similar)
• Elimination of equity investment (together with the writing off of the equity of the controlled company) → This changes depending on how you consolidate

Example: if the subsidiary company invested 100, the holding company will put 100 in its statement. But when the consolidated statement is made (holding company + subsidiary), they must not repeat this investment.

• Elimination of intragroup transactions (same logic as above)
• Definition of the value of assets and liabilities of the group

Line by line consolidation

Given that the group is considered a separated and stand-alone entity, the balance sheet considers the fair value of all items of assets and liabilities in controlled companies. Hence, line by line, all the items are summed considering the overall amount, arriving at the consolidated value.

The steps of consolidation consist of the omission of equity participation, calculation of goodwill, and definition of the remaining items.

Steps for consolidation

STEP 1: deleting equity participation and the corresponding value of the shareholders’ equity of the controlled company.

Total market value = Market value (%control) / % of control

STEP 2: calculation of the goodwill. Goodwill = market value – book value. This approach is consistent with the principle behind the entity theory to consider the group as a third independent entity.

STEP 3: defining the value of the remaining assets and liabilities, calculated by summing, line by line, the value of each company involved.

Example: A controls B (70%) Property plant and equipment of A: 100 Property plant and equipment of B: 100 Property plant and equipment in the consolidated financial statement: 100 + 100 = 200. N.B. Liabilities and Assets should be equal (8’000 = 8’000 and 10’000 = 10’000).

Entity and parent company theory

2.1.1 Entity theory: Goodwill is an intangible asset and it is rising when it is accounting for something that is not very explicit. McDonald’s Brand is considered (and quantified) only when someone tries to buy it. Goodwill = market value 100% B – book value 100% equity B. Since 60% represents 2’500, 100% represents 4’166,666. ⟹ The book value of the company B is 1’000 (capital) + 1’000 (reserves) 2’000.

2.1.2 Parent company theory: The line by line method can be applied with the reference to parent company theory. In these cases, the calculation of the goodwill is based on the portion of shares owned by the parent rather than on the whole.