Engineering Economics - fenix.tecnico.ulisboa.pt

Engineering Economics

Professor António Quintino & Cândido Peres

Created Based on Prof. Isabel Pedro’s Materials


3. Planning and Financial Analysis

3. Planning and Financial Analysis

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3.1 Working with Financial Statements

3.2 Ratio analysis

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DR(NATUREZA)-IncomeStatementbyNatureVendas e serviços prestados Sales and services

Outros rendimentos e ganhos operacionais Other operating income

Variação nos inventários de produtos acabados e em curso Variation in inventories of finished goods and in progress

Outros rendimentos e ganhos financeiros Other income and financial gains

Total de rendimentos e ganhos (A) Total income and gains (A)

Custo das merc. vendidas e mat. consumidas Cost of goods sold and materials consumed

Fornecimentos e serviços externos Supplies and services

Gastos com o pessoal wages costs

Gastos de depreciação e de amortização Depreciation and amortization costs

Provisões e perdas por imparidade e suas reversões (em

ativos fixos, inventários, clientes)Provisions and impairment losses and their reversals (in

fixed assets, inventories, customers)

Outros gastos e perdas operacionais Other operating costs and losses

Juros e outros gastos e perdas financeiros Interest and other financial costs and losses

Total de gastos e perdas (B) Total costs and losses (B)

Resultado antes de impostos (A) - (B) Earnings before tax (A) - (B)

Imposto sobre o rendimento Tax

Resultado líquido do período Earnings after tax (net profit)


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Balanço - Balance SheetACTIVO – ASSETS CAPITAL PRÓPRIO - SHAREHOLDERS’ EQUITY

Activo não corrente – Non current Assets Capital– Capital

Investimentos Financeiros - Financial Investments Reservas legais - Legal reserves

Activos fixos tangíveis –Tangible Fixed Assets Resultados transitados – Retained Earnings

Activos fixos intangíveis – Intangible Fixed Assets Resultado líquido do período – Net profit

Activo corrente – Current Assets PASSIVO – LIABILITIES

Inventários - Inventory Passivo não corrente – Non current Liabilities

Clientes – Accounts Receivable Provisões – Long term Provisions

Estado e outros entes públicos – State and other public bodies Financiamentos obtidos – Long-term debt (bank loans and bonds)

Outras contas a receber - Other current assets Outras contas a pagar – Other non current liabilities

Diferimentos - Deferrals Passivo corrente – Current Liabilities

Caixa e depósitos bancários – Cash and Bank Deposits Fornecedores - Suppliers

Estado e outros entes públicos – State and other public bodies

Financiamentos obtidos – Short-term debt (bank loans and bonds)

Outras contas a pagar – Other current liabilities

Diferimentos - Deferrals

• As a relationship between two quantities, they provide more adequate information than

indicators in absolute value / Monetary units (eg EBITDA or EBIT);

• They are essentially ways of summarizing financial data and comparing companies'

performance;

• They help to ask the right questions but by themselves they don't provide the answers;

• Similar Ratios can translate into different situations: 2 companies with 40 equal Ratios will

hardly be equal.

• May lead to false comparability (different accounting practices / policies);

Some preliminary questions about financial ratios

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1st Step

Conversion of Financial Statements

In a first phase, the Income Statement by Nature, originating from the Financial Accounting,

must be reconverted into a simplified one, identifying variable and fixed expenses, payable and

non-payable.

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Sales

Variable expenses

Gross Margin (Contribution Margin)

Disbursable Fixed Expenses

EBITDA

Non-Disbursable Fixed Expenses

Operating Income (EBIT)

Financing Financial Expenses

Earnings Before Taxes (EBT)

Income tax

Net Income (Net Income)

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2nd Step

Identification of types of results and their impacts

The indicators to be analyzed must be selected depending on the

variable to be tested.

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3rd Step

Selection of the means used to build the indicators

You have to choose between accounting and non-accounting

information.

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3.2 Ratio analysis

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3.2 Ratio analysis

•Ratio analysis compares line-item data from a company's financial

statements to reveal insights regarding profitability, liquidity,

operational efficiency, and solvency.

•Ratio analysis can mark how a company is performing over time, while

comparing a company to another within the same industry or sector.

•While ratios offer useful insight into a company, they should be paired

with other metrics, to obtain a broader picture of a company's financial

health.

Types of Ratios

• Financial Ratios - appreciate the balance of the balance sheet assets

Exp.: Financial Autonomy = Equity / Assets

• Economic Ratios - assess the company's profitability through the relationship betweenelements of the Income Statement

Exp.: Net return on sales = Net Profit / Sales

• Economic-Financial Ratios – analyze economic-financial relationships, integrating thevalues of the Income Statement and the balance sheet

Exp.: Return on Equity = ROE = Net Profit / Equity

• Technical Ratios - depict aspects related to the company's production and general activity

Exp.: Productivity per worker = Quantity produced/No. of workers

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3.2 Ratio analysis

Types of Ratios

(According to Brealey and Myers – Chapter 27 – Corporate Finance)

Indebtedness ratios – essentially medium / long term perspective;

Liquidity ratios – essentially short-term ratios, seek to assess the repayment capacity of

short-term liabilities;

Profitability or efficiency ratios – assessment of the level of efficiency in the management

of resources used;

Market value ratios – incorporate external elements (eg PER, EPS, Dividend Yield)

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3.2 Ratio analysis

It relates two magnitudes, one economic or financial

and the other patrimonial, associated with the

concepts of return and evaluation of efficiency or

performance.

It uses, as basic elements, the income statements

combined with other accounting and extra-accounting

elements

Since it is a ratio, it should be interpreted not in

isolation but by comparison with theoretical standards,

between periods and companies, in relation to the

sector, against the expectations of investors, etc...

Results obtained

Means Used

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3.2 Ratio analysis

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3.2 Ratio analysis

1.Price/Earnings or PE Ratio = Price per share / Earnings per share (EPS)

2.Earnings per Share (EPS) = Net Profit (Earnings) / total number of shares outstanding in the market

3.Cash Earnings per Share (CEPS) = Net Profit + Non-cash items / outstanding shares in the market.

4.Book Value per Share = (Shareholder’s Equity – Preference stock) / Outstanding numbers of shares.

5.Market Value per Share = Market Capitalization / Outstanding shares in the market.

6.Dividend Yield= Total dividend paid in a year / Number of shares outstanding.

7.Market to Book ratio = Price of one share / Book value of one share

8.Market Value Added = Market Capitalization – Equity Value of the Company

Market Value ratios – only for public companies

https://efinancemanagement.com/financial-accounting/net-profit

Profitability - Economic Vs Financial

Economic profitability

Indifferent to the capital structure and its costs - it does not separate equity from others,

remunerated from unremunerated, etc...

E.g.: ROA, NP%, EBIT%, etc...

Financial profitability

Directly influenced by the structure and costs of capital – there is a clear separation of capital as a

function of its origin and the calculation is influenced by the financial costs of financing.

E.g.: ROE, ROCE, etc...

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3.2 Ratio analysis

3.2 Ratio analysis

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Net profit margin =Net profit

Net sales

Return on assets (ROA) =Net Income

Total assets

Operating profit margin or Return on Sales =Operating Income

Net Sales

Return on equity (ROE) =Net income

Average Shareholders Equity

Profitability Ratios

Return on Capital Employed (ROCE) =EBIT

Total assets

3.2 Ratio analysis

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Vendas e Prestação de serviços – Sales and services rendered 14,367,563

Custo das vendas e prestação de serviços – Cost of sales and

services provided

- 6,667,327

RESULTADOS BRUTOS – GROSS INCOME 7,700,236

Out. Rendimentos Operacionais – Other operating income and gains 31,993

Gastos de distribuição – Distribution Costs -3,267,384

Gastos administrativos – Administrative Expenses -3,285,128

Out. Gastos Operacionais – Other operating costs and losses -771,205

RESULTADOS OPERACIONAIS – OPERATING INCOME – EBIT –

EARNINGS BEFORE INTEREST AND TAXES 408,512

Juros e rendimentos similares obtidos - Interest revenues 50,000

Juros e gastos similares pagos – Interest paid -108,249

RES. ANTES DE IMPOSTOS – EBT – EARNINGS BEFORE TAXES 350,263

Imposto sobre o rend. do período - Taxes -120,754

RESULTADO LÍQ. DO PERÍODO – NET PROFIT/LOSS 229,510

Rendibilidade operacional vendas (Return on Sales)= EBIT / Sales and services rendered= 408,512/14,367,563 = 2.8%

Rendibilidade líquida vendas (Net profit margin)= Net Profit / Sales and servicesrendered= 229,510/14,367,563 = 1.6%

3.2 Ratio analysis

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Sales and services rendered 14,367,563

Cost of sales and services provided - 6,667,327

GROSS INCOME 7,700,236

Other operating income and gains 31,993

Distribution Costs -3,267,384

Administrative Expenses -3,285,128

Other operating costs and losses -771,205

OPERATING INCOME – EBIT – EARNINGS BEFORE

INTEREST AND TAXES

408,512



EBT – EARNINGS BEFORE TAXES 350,263

Taxes -120,754

NET PROFIT/LOSS 229,510

ASSETS SHAREHOLDERS’ EQUITY

NON CURRENT ASSETS Capital 650,000

Financial investments 998 Legal reserves 13,145

Tangible Fixed assets 1,752,356 Other reserves 1,206,578

Intangible fixed assets 113,445 Retained earnings -72,980

CURRENT ASSETS Net profit 229,510

Inventory 1,747,280 TOTAL EQUITY 2,026,253

Accounts Receivable 3,575,620 LIABILITIES

Marketable securities 102,815 NONCURRENT LIABILITIES

Deferrals 60,279 Long term Provisions 0

Cash and bank deposits 720,444 Debt

MLT 1,739,790

CURRENT LIABILITIES

ST – Suppliers 2,055,897

ST – Other current liabilities 1,702,536

Deferrals 548,761

TOTAL LIABILITIES 6,046,984

TOTAL ASSETS 8,073,237 TOTAL LIABILITIES + EQUITY 8,073,237

%3.11Próprios Capitais

Líquidos ResultadosPróprios Capitais dos adeRentabilid ==

Return on equity (ROE) =Net profit

Equity=11.3%

3.2 Ratio analysis

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Liquidity Ratios

Quick ratio =cash + marketable securities+ receivables

current liabilities

Cash ratio =cash + marketable securities

current liabilities

Current ratio =current assets

current liabilities

Net working capital = Current assets - Current liabilities

Current Ratio

Assesses the ability to meet short-term commitments

Advantage over working capital given that it is a relative and not an absolute value

Limitations - it is a "static" indicator, it must be completed with others (e.g. average terms - that

assess the degree of liquidity and enforceability)

Minimum financial balance rule

CR ≥ 1

2 companies with the same CR will be quite different depending on the composition of their short-term assets and liabilities

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Current ratio =current assets

current liabilities

3.2 Ratio analysis

3.2 Ratio analysis

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Inventário/Inventory 1,747,280

Clientes/Receivables 3,575,620

Caixa/Cash 823,259

Activo Corrente/Current assets 6,146,159

Fornecedores/Short-term debt 2,055,897

Out. Dívidas CP/Other current liabilities 1,702,536

Passivo Corrente/Current liabilities 3,758,433

Fundo de Maneio/Net working capital 2,387,726












MLT 1,739,790

CURRENT LIABILITIES



Deferrals 548,761



3.2 Ratio analysis

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MLT 1,739,790

CURRENT LIABILITIES



Deferrals 548,761



Activo corrente

(Current Assets)6,146,159

Passivo corrente

(Current liabilities)3,758,433

Liquidez Geral (Current ratio) 1.6

Activo corrente – Inventário

(Current Assets – Inventory)4,398,879

Passivo corrente 3,758,433

Liquidez Reduzida (Acid test) 1.2

Activo corrente – Inventário –

Clientes (Current Assets –

Inventory – Receivables)

823,259

Passivo corrente (Current

Liabilities)3,758,433

Liquidez Imediata (Cash ratio) 0.2

Financial autonomy =

Solvency =

Equity

Total Assets

Equity

Debt

Financial Balance (Medium and Long Term):

Identifies the level of commitment of the partners in the organization

Observe the relationship between the partners' capital and the level of indebtedness

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3.2 Ratio analysis

100% Equity

▪ Exposure to operational risks only;

▪ Maximum flexibility;

▪ Stability;

Debt

▪ Reduction of the tax burden;

▪ Fixed costs, then financial risk (default and possible

bankruptcy);

▪ Potentially, more profitability for shareholders (if

contracted at rates lower than the return on invested

capital – financial leverage);

It is not enough to have growth opportunities:

It is also necessary for growth to create value…

… and that is financed in a way that creates (at least, not destroys) value;

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3.2 Ratio analysis

3.2 Ratio analysis

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Leverage Ratios

Total debt ratio =Total Liabilities

Total Assets

Long- term debt ratio =Long - term Debt

Total Assets

Debt to equity =Liabilities or (Long term debt + Values of Leases)

Average Shareholders Equity

Times interest earned ratio =EBIT

Anual Interest Expense

3.2 Ratio analysis

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MLT 1,739,790

CURRENT LIABILITIES



Deferrals 548,761



Rácio de endividamento (total debt ratio)

= Total Liabilities / Total Assets

= 6,046,984 / 8,073,237 =75%

Debt to equity ratio

= Total Liabilities / Equity

= 6,046,984 / 2,026,253

= 2.98

3.2 Ratio analysis

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Efficiency Ratios

Asset turnover ratio =Net Sales

Total assetsProductivity =

Gross Added Value

Number of workers

Inventory turnover ratio =Cost of goods sold

Average Inventory

Average Collection Period =Receivables

Net Sales*12

Average Payment Period =Accounts Payable

Purchases*12

3.2 Ratio analysis

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Sales and services rendered 14,367,563

Cost of sales and services provided - 6,667,327

GROSS INCOME 7,700,236

Other operating income and gains 31,993

Distribution Costs -3,267,384

Administrative Expenses -3,285,128

Other operating costs and losses -771,205

OPERATING INCOME – EBIT – EARNINGS BEFORE

INTEREST AND TAXES

408,512



EBT – EARNINGS BEFORE TAXES 350,263

Taxes -120,754

NET PROFIT/LOSS 229,510












MLT 1,739,790

CURRENT LIABILITIES



Deferrals 548,761



Clientes/Receivables 3,575,620

Vendas/Sales 14,367,563

Prazo Médio de Recebimento (em dias)

Average Collection Period (number of days)90.8

Custos de vendas/Cost of goods sold 6,667,327

Inventário/Inventory 1,747,280

Rotação de Stocks/ Inventory turnover ratio 3.8

∆ média ∆ médiaACTIVO

Activo não corrente -27% 51% -7% 34%

Activo corrente -29% 49% -20% 66%

Total do activo -28% 100% -15% 100%

CAPITAL PRÓPRIO E PASSIVO

Total do capital próprio -59% 25% -2% 31%

Passivo

Passivo não corrente 27% 25% -12% 18%

Passivo corrente -31% 50% -24% 52%

Total do Passivo -14% 75% -21% 69%

Total do capital próprio e do passivo -28% 100% -15% 100%

SectorEmpresa

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3.2 Ratio analysis

Company Sector

AssetsNon Current AssetsCurrent Assets

Total Assets

EquityTotal Equity

DebtNon Current DebtCurrent Debt

Total DebtTotal Equity and Debt

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3.2 Ratio analysis

Accounts Payable Weight

Cash and Equivalents WeightCompany

Company

Traditional Ratio Analysis

Aceitavel Ideal

Autonomia Financeira ≥ 25% ≥ 33%

Solvabilidade ≥ 33% ≥ 50%

Liquidez Geral ≥ 1,3 ≥ 2

Empresa

Autonomia Financeira 25%

Solvabilidade 51%

Liquidez Geral 0,98

Sector

31%

59%

1,2834

3.2 Ratio analysis

Financial AutonomySolvencyCurrent Ratio

Financial AutonomySolvencyCurrent Ratio

Aceptable Ideal

Company

Multivariate Discriminant Analysis

Carvalho das Neves (2012) Model

Score= -0,950+2,518X1+1,076X2+5,566X3-0,00254X4+0,156X5

Ponto de Corte: Score≥0,3735

3.2 Ratio analysis

X1 = Retain Results / Total Assets

X2 = Current Assets / Total Assets

X3 = Cashflow / Total Assets

X4 = State and Other Public Bodies Liquid / Sales * 365

X5 = Financial Debt / Current Assets

Separation point

Previsão de Falência Empresarial

– O Modelo de Carvalho das Neves (2012)

2010 2011 2012 2013 média

Sector NF NF NF NF NF

Empresa F F F F F

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3.2 Ratio analysis

Multivariate Discriminant Analysis

Altman (2002) Model

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3.2 Ratio analysis

X1 = Working Capital / Total Assets

X2 = Retain Results / Total Assets

X3 = Earnings Before Tax / Total Assets

X4 = Equity / Total Debt

Separation point: Score = 0

Z’’ = 3,25 + 6,56X1+ 3,26X2 + 6,72X3 + 1,05X4

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3.2 Ratio analysis

Combining the ratios into a single score can separate the creditworthy firms from thestruggling firms, in terms of default probability.

For example, William Beaver, Maureen McNichols, and Jung-Wu Rhie, concluded thatthe chance of failing their financial compromises (i.e., defaulting) during the next yearrelative to the chance of not failing was reasonably good estimated by the followingequation:

Log (L, relative chance of failure)

= −6.445 − 1.192 ROA + 2.307 Liabilities/Assets − 0.346 EBITDA/Liabilities

Relative chance of failure = 𝑒L

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3.2 Ratio analysisScore

(Z'')

Rating

(S&P)

Rating

(Moodys)

Rating

(Finch)

8,15 AAA Aaa AAA Prime

7,60 AA+ Aa1 AA+

High Grade7,30 AA Aa2 AA

7,00 AA- Aa3 AA-

6,85 A+ A1 A+Upper Medium

Grade6,65 A A2 A

6,40 A- A3 A-

6,25 BBB+ Baa1 BBB+Lower Medium

Grade5,85 BBB Baa2 BBB

5,65 BBB- Baa3 BBB-

5,25 BB+ Ba1 BB+Non-Investment

Grade speculative4,95 BB Ba2 BB

4,75 BB- Ba3 BB-

4,50 B+ B1 B+

High speculative4,15 B B2 B

3,75 B- B3 B-

3,20 CCC+ Caa1 CCC Substantial Risk

2,50CCC Caa2

Extremely

Speculative

1,75

CCC- Caa3 Default Iminente

with little prospect

of recoveryCC

CaCC

C C

0,00 D C D in Default

For each of these scoring grades, each rating company associates a proprietary default probability.

Source: Brealey & Myers 40

Shareholder value also depends on good financing decisions. Again, there are obvious questions: Is theavailable financing sufficient? The firm cannot grow unless financing is available. Is the financing strategyprudent? The financial manager should not put the firm’s assets and operations at risk by operating at adangerously high debt ratio. Does the firm have sufficient liquidity?

3.3 Economic Value Added (EVA)

EVA→ is concerned in measuring shareholder value.

As EVA is a composite and plural indicator, it is at the top of the pyramid of economic-financial

analysis logic.

Registered trademark of Stern Stewart & Co., for many, is nothing more than the rename of an

old concept – The Residual Result.

One of the first references is due to Alfred Marshall in 1890 who defined it as “what is left of the

profits after deducting the interest on its capital at the rate in force...”.

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When accountants draw up an income statement, they start with revenues and thendeduct operating and other costs. But one important cost is not included: the cost ofthe capital that the company has raised from investors.

Therefore, to see whether the firm has truly created value, we need to measurewhether it has earned a profit after deducting all costs, including its cost of capital.

The cost of capital is the minimum acceptable rate of return on capital investment. It isan opportunity cost of capital, because it equals the expected rate of return-on-investment opportunities open to investors in financial markets.

The firm creates value for investors only if it can earn more than its cost of capital, thatis, more than its investors can earn by investing on their own.

The profit after deducting all costs, including the cost of capital, is called the company’seconomic value added or EVA.

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Source: Brealey & Myers

To compute EVA, adjustments must be made; accounting standards distort the concept of true

economic and financial performance.

Stern Stewart & Co. has identified more than 160 fixes. Several authors, who consider that most of

them aren’t relevant or only have a marginal effect.

Typically 10 to 15 adjustments are made.

The most common concern:

• Goodwill

• Adjustments (provisions)

• Operating leasing transactions Meaningless with IFRS 16

• Deferred taxes

• Research and development expenses

• Valuation criteria (LIFO) Meaningless with the SNC

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EVA = NOPAT – Capital Charge = EBIT * (1-t) – Capital Charge

• NOPAT = Net Operating Profit After Taxes = EBIT*(1-t) = NOP + Interest*(1-t)

• EBIT= Earnings Before Interest and Taxes

• Capital Charge = Invested Capital * k = (Equity + Long Term debt) * k

• k – Funding rate of the Invested Capital (WACC); t = corporate tax rate

→ Different rates according to the nature of the invested capital and its risk

→ Differentiated rates according to the operational risk of the business units

→Is there a debt or not? And if so how much?

Usually, k=WACC, Weighted average cost of capital (to be explained later)

EVA measures how many dollars a business is earning after deducting the

cost of capital.44


EVA = EBIT*(1-t) – Capital Charge

Another way to write EVA is:

The return on capital (or ROC) is equal to the total profits that the company has

earned (NOPAT) divided by the amount of money that they have contributed (Equity

+ Long Term Debt). If the company earns a higher return on its capital than

investors require, EVA is positive.

Other things equal, the more assets the manager has to work with, the greater the

opportunity to generate a large EVA.45



= EBIT*(1-t)

• The company has had an excellent operational performance. In relation to absolute values;

Positive EVA variationbetween two periods

• Indicates that although value creation is taking place, the investorshould pay attention to the actions carried out by the investee andverify the causes that led to a decrease in performance;

Positive EVA but withnegative evolution

• there is a destruction of value and indicates that there was an effortby the company to recover and create wealth;

Negative EVA but withpositive evolution

• indicates that a destruction of wealth has occurred. The investor must analyze what strategies and actions are being adopted by thecompany to reverse the situation.

Negative EVA withnegative evolution

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Accounting measures of company performance, June 2013 (dollar values in millions). Companies are ranked by economic value added (EVA)


If the company earns a lower return on its capital(ROC) than investors require (WACC), EVA is negative.

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Limitations of Rate of Return and Economic Value Added (EVA):

• Rate of return and economic value are based on book (balance sheet) values for

assets. Debt and equity are also book values, so often they not reflect the market

value of the company.

• Investment over the years is not shown on the balance sheet and cannot be

measured exactly.

• Balance sheet does not show the current market values of the firm’s assets. Older

assets may be grossly undervalued in today’s market conditions and prices.

• A high return on assets indicates that the business has performed well by making

profitable investments in the past, but it does not necessarily mean that you could

buy the same assets today at their reported book values.

• Conversely a low return suggests some poor decisions in the past, but it does not

always mean that today the assets could be employed better elsewhere.

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Engineering Economics - fenix.tecnico.ulisboa.pt