Embed Size (px)
Citation preview
MACQUARIE UNIVERSITY APPLIED FINANCE CENTRE
AFCP 801: PORTFOLIO MANAGEMENT AND VALUATION
2015
TOPIC 0: FINANCIAL STATEMENTS1 2
This introductory topic is an important stepping stone to the financial statement analysis that will occur in the Portfolio Management and Valuation unit and in the Corporate Finance unit. The objective is not to build a comprehensive understanding of accounting principles and financial reporting but to achieve familiarity with the key financial statements.
This introduction refers to the Wesfarmers 2012 Income Statement, Balance Sheet and Cashflow Statement (an extract is attached at the end of this document). In addition to the extract you should also access the Wesfarmers website to see the full Annual report and Financial Statements. Click on this link to go to the website: Wesfarmers website – select “Investor Centre” then 2012 Annual Report.
There are some exercises throughout this topic. Answers to these are located at the end of the topic notes. Questions on this material can be posted onto the course forum.
1The main reference for this introduction is: Ross, Westerfield & Jaffe, Corporate Corporate Finance, McGraw-Hill/Irwin, 9th edition 2010, Chapters 2.1 to 2.3.
2 These notes are written by Anthony Carlton.
0.1 Introduction The objective of this section is to introduce the key concepts used in understanding a company’s financial statements. These statements are produced for external and internal audiences. Although the nature of reports used for these audiences differ significantly, the principles underlying the preparation of financial statements are common. Using Financial Statements Information Financial Statements are a critical part of many Investment and Corporate Finance applications. Some examples include: External investors, financial statements are a key input into their efforts to evaluate historical performance and form views about future prospects. Equity analysts will need to be able to understand and interpret a company’s financial statements. Fundamental equity analysts would usually prepare forecast financial statements for the company they are evaluating and use these in their valuation; M&A transactions, will usually involve the preparation of pro‐forma financial statements to demonstrate the financial impact of a proposed transaction. Similarly, major financing transactions would see pro‐formas being prepared; Credit analysis, “classic” credit analysis involves the analysis of an individual company and its ability to service debts. The preparation of forecast financial statements and financial ratios are a critical part of this. Credit rating agencies are heavy users of financial statements and the famous Altman ‘Z‐Score’ model uses ratios to predict bankruptcy; Financial modelling and valuation: any DCF valuation will involve the preparation of forecast cash flows. Good models will also include forecast financial statements as the basis for the cash flows, and also for the calculation of ratios which are important to help test the robustness of the forecasts; Business analysis: to understand the historical performance and prospects of a business involves assessing financial results, using for example, ratio analysis.
Financial statements provide key inputs into investors’ valuation models. Security analysts therefore need to be able to understand and interpret a company’s financial statements. Internally, company management also use financial information to help make commercial decisions relating to the operating and financial performance of the business, as well as for internal control. However, this topic will focus primarily on the external perspective. External financial statements – a closer look In Australia, external financial reports are generally produced on a six monthly basis. The company’s Annual report includes financial statements as well as management commentary on results and near term prospects. These financial reports must be prepared in line with legal requirements as to content and principles used in their preparation. As a result of legal disclosure requirements, companies are also required to disclose information which might be price sensitive to the market on a timely basis. In addition companies make available to the public the presentations which are made to major shareholders and investors throughout the year. These announcements and presentations are a useful, and more timely, source of information on company performance and prospects. They are available on company websites, and can generally also be accessed through the ASX website as well, ie at: www.asx.com.au. For some examples of such presentations you should refer to the corporate website of the companies you are interested in following. Financial reporting is based on the preparation of five inter‐related financial statements: o Balance Sheet, which presents a snapshot of the financial position of a
business at a point in time. The financial position is measured by determining the value of assets, liabilities and shareholder’s equity at the balance date;
o Income Statement, which reports the results of revenue and expenses
over a particular reporting period;
o Statement of Comprehensive Income, which represents the change in Equity during a period, OTHER THAN changes resulting from transactions with owners in their capacity as owners (i.e. this would exclude the impact of equity raisings and dividends);
o Statement of Changes in Equity, which shows the change in
Shareholder’s Equity from all sources i.e. INCLUDING equity raisings, dividends, share repurchases and the issuance of options;
o Cash Flow Statement, which reports those transactions that had an
impact on the company’s cash balance during the reporting period.
The Income Statement is a subset of the Statement of Comprehensive Income, which is itself a subset of the Statement of Changes in Equity. The Income Statement is focussed on operating performance in a period. In this topic we will focus on the Balance Sheet and Income Statement, although the Cash Flow Statement will also be encountered in the Portfolio Management and Valuation unit. An extract of the major financial statements for Wesfarmers are included at the end of these notes. Notes to the financial statements In addition to these financial statements a company’s financial report will include a section entitled “Notes to the financial statements”. This includes the following: o “Summary of Significant Accounting Policies” which details the
accounting policies adopted by the company in question. In the Wesfarmers full Financial Statements (located on their web site) these are included in Note 2, pages 93 – 108. For example, paragraph (d) in these accounts highlights the particular areas where subjective judgements have had a material impact on the accounts;
o Breakdown on major items in Balance Sheet and Income Statement, and reconciliations etc. The high level financial statements are, obviously, highly summarised. Especially for complex companies like Wesfarmers, it is oftentimes necessary to examine the notes to find out what is behind major financial items.
In addition to the financial report, a company’s annual report will include a Management Discussion and Analysis, where an effort is made to explain the performance of the business, communicate strategies and some sense of future direction.
Reading material
Internal financial reports Internal financial reports are generally produced on a monthly basis, and will differ significantly in format and content from external reports. For example, internal reports should generally contain: o more information on the actual operating performance of the business, in
addition to financial measures; o diagnostic performance measures, such as efficiency and productivity
measures as well as comparisons against budget; o forecast performance and results. Most companies would include
updated forecasts of current year performance, in addition to actual results;
o more detail about segmental performance, showing much greater detail
on performance of individual segments or products within a company;
o generally easier to follow.
Internal reports are not required to meet legal accounting standards so it would not be uncommon for companies to use unique definitions and calculation bases for calculating financial performance. If using internal reports in a transaction context it will be important to understand precisely the basis of preparation eg internal transfer pricing.
0.2 Overview of selected key accounting principles Before examining the key financial statements in more detail it is important to describe some general principles which underlie their preparation. Financial statements are prepared in accordance with what are described as Generally Accepted Accounting Principles. These principles are reflected in Accounting Standards. It is a legal requirement for companies to use these standards in the preparation of accounts. Until recently individual countries used accounting standards which were country specific however, in an effort to achieve harmonisation of financial reporting, many countries are working towards adopting a uniform set of international standards, known as International Financial Reporting Standards (“IFRS”). The Australian Accounting Standards Board (“AASB”) made the adoption of these standards obligatory from 1st January 2005.3 There are currently more than fifty standards, covering virtually all aspects of commercial transactions, including Revenue and Expense Recognition, Construction Contracts and Interests in Joint Ventures. A full listing of standards is available at the AASB website www.aasb.gov.au . In spite of all the standards there is still a degree of subjectivity incorporated into what a company reports as its annual profit. Many commentators would also argue that financial statements have become increasingly difficult to comprehend. It is therefore important to understand the basis on which a set of financial statements have been prepared. Different accounting treatments can have a material effect on the key results, such as Profits and Earnings per Share. These can include such fundamental issues as “when do we recognise revenues in the profit statement?” and “does the balance sheet include all of the company liabilities?”4
3 The other major regulatory change to external reporting has been the adoption of stricter and more prescriptive governance standards in most countries. These mainly involve guidelines relating to Board composition, risk management processes and various disclosures. Adapting internal organisational processes in order to ensure compliance with these standards has had a significant impact on organisations. In Australia these guidelines can be reviewed on the ASX website www.asx.com.au\ccccc. The United States equivalent is the well known Sarbannes Oxley Act. Although not directly relevant to Australian companies it is a requirement of foreign companies to meet these requirements if they wish to raise funds in the US public markets.
4 Clearly there are a number of detailed accounting issues which cannot be addressed in this introductory topic.
Underlying these individual standards is a series of conventions which provide a framework for deciding how to reflect transactions in financial reports. It is important to be aware of some of these: Matching principle, also known as accrual accounting The matching principle is necessary because we are trying to measure performance for a financial period, which is a subset of a project’s or business’s life. The objective is to allocate expenses to the period in which the revenue is recognised, to ensure that the profit fairly reflects performance for that period. Examples of the matching principle include:
o Depreciation: depreciation represents the allocation of the original cost of a capital asset over its expected useful life. The depreciation in each year is recognised as an expense in calculating profit even though the cash was outlaid when the asset purchased;
o Inventory: even though product may have been produced during a particular financial period, and incurred cash expenses, it will not be recognised as an expense because the revenue has yet to be earned. Instead it is treated as an asset, and charged as an expense when sold;
o Accruals and prepayments which you will see on virtually all company balance sheets.
The matching principle is one reason why cash flow will be different to profit. Historic Cost convention This convention requires that, when calculating the balance sheet of an entity, that asset items be recorded at the original cost (minus accumulated depreciation) and liabilities be recorded at face value. Thus the balance sheet does not attempt to display the market value of the business, but rather the sum outlaid or received. This reflects the initial purpose of accounting which was directed at stewardship.
This convention has been under challenge in recent years and while still an overriding principle there are a number of exceptions:
o Lower of cost or market: where an assets recoverable value is less than its original (historic) cost then the balance sheet must be reduced by this impairment loss;
o In Australia companies revalue their land and buildings to market values periodically;
o Certain financial institutions are able to value assets and liabilities at current market values.
Going Concern assumption Assumes the entity being reported will continue to operate. In fact directors must act if they consider the business is unable to meet debts as and when they fall due. In accounting terms violation of this assumption would require the company to be valued on a liquidation basis (eg refer to pages 172 and 173 of the Wesfarmers Financial Report to see the types of declarations required by directors and auditors). Consolidated Financial reports Most modern organisations will comprise a number of legal entities, with the parent company investing in a number of subsidiaries. These subsidiaries may represent different lines of business or different geographical entities. Although these are separate legal entities, financial statements are prepared on a consolidated basis, as if all the entities are one. There are conditions which must be met to allow for this however virtually all listed organisations meet these. However when lending to individual entities within a group it is important to understand the financial position of that entity, as the assets of the consolidated group may not be available to service debts of that subsidiary entity. Where a parent company consolidates a partly owned subsidiary it leads to the creation of minority interests.
Consistency It is generally accepted that once a company has selected a particular accounting policy it should use this consistently across the company for all similar transactions, and consistently over time. When a company changes its accounting treatment, that can be a signal that an analyst may have to investigate further to establish consistent interpretation. Prudence or conservatism This principle states that when choosing between two alternative treatments for a transaction the accountant should choose the one that results in the lower value for net income or net assets. This leads to a bias to recognise potential losses (eg through the use of provisions) but not the recognition of potential gains. An example of this would be the “lower of cost or market” rule applied to inventory. If the market value of inventory is less than cost, then the value should be written down to the market value, however if the market value is greater than cost than the gain in value is not recognised (of course the gain will be recorded when the inventory is sold).
0.3 Overview of Financial Statements
We will now review key terms typically found in Financial Statements. You should refer to the Wesfarmers report for an actual example. It is recommended you refer to these statements as you proceed through this section. For each report we will firstly explain the key terms and concepts as they are commonly used, and then discuss issues that need to be considered in using and interpreting these reports.
0.3.1 The Balance Sheet The balance sheet represents the company’s financial position at a point in time by reporting assets, liabilities and shareholder’s equity. The balance sheet is based on the following identity:
ASSETS = LIABILITIES + EQUITY This can also be described in term of Net Assets as follows:
NET ASSETS = ASSETS – LIABILITIES = EQUITY Refer to the Wesfarmers report and complete the following table, which shows the high level summary results.
Wesfarmers major financial quantities [AUD, Million; 2012]
TOTAL ASSETS
= LIABILITIES + EQUITY = LIABILITIES + EQUITY
While these high level quantities give an indication of total size and the net financial position of the organisation it is usually necessary to examine components of these high level quantities in order to draw meaningful conclusions about performance, or the state of the business’s financial health.
Within the broad categories of ‘Asset’ and ‘Liability’ individual items will be classified as either short term, or current, and long term, or non‐current. The distinction here is simply whether the item in question is likely to be realised within a twelve month period following the reporting date. Using this distinction a highly summarised form of Balance Sheet can be prepared. Refer to the Wesfarmers Balance Sheet and complete the following summary Balance Sheet:
SUMMARISED WESFARMERS BALANCE SHEET Based on current / non‐current distinction
[AUD, Million]
ASSETS 2012 2011 LIABILITIES & EQUITY
2012 2011
Current Assets Current Liabilities
Non – current assets
Non‐current Liabilities
Total Equity
TOTAL ASSETS LIABILITIES PLUS EQUITY
EXERCISE 0.1 Comment on the overall structure of the Wesfarmers Balance Sheet and how it has changed over the year.
In the following sections we will review what makes up each of these major components of the Balance Sheet.
Current Assets Complete the following table for Wesfarmers current assets, and refer to the notes for details of what these numbers comprise. Some introductory comments are summarised below:
Wesfarmers CURRENT ASSETS
2012 2011
Cash and cash equivalents
Receivables
Inventories
Derivatives
Investments backing insurance contracts
Other
TOTAL
Receivables Financial statements recognise that a sale has occurred when delivery takes place. However, unless the sale has been on cash terms, then payment will usually be delayed in accordance with the credit terms. The balance outstanding is represented by the Receivable balance. It measures how much the company has funds tied up in providing credit to customers. An allowance for non payment of amounts owing can be recognised as the Provision for doubtful receivables (or debts). Inventories This item shows the balance held invested in materials which are required to support production or sales activities, so it includes raw materials used in the production process as well as finished product waiting to be sold. The balance shown in inventories is usually measured in cost terms, unless its market value is considered lower than cost. This is known as the “lower of cost or market” rule, a general principle applying to all balance sheet items. Companies are required to write down inventories if they assess Net realisable value is less than cost.
The cost of inventory includes not only the raw materials and consumables but also the costs incurred in producing or processing product held at the end of the reporting period. Methods chosen can have a significant impact on a company’s reported profit. There are several methods for carrying out these calculations. Probably the main decision is the choice of the either the Last In/First Out, First in/First out or average cost method. Derivative Financial Instruments This item refers to the company’s use of forward cover and option contracts. Resource companies will commonly enter into such transactions to lock in commodity prices, exchange rates or interest rates on debt. Accounting for these contracts is one of the more complicated areas of accounting.
Non Current assets Complete the following table for Wesfarmers non current assets:
Wesfarmers NON CURRENT ASSETS
2012 2011
Receivables
Available for sale investments
Investment in associates
Deferred tax assets
Property
Plant and equipment
Intangible assets
Goodwill
Derivatives
Investments backing insurance contracts
Other
Total
Investment in Associates Where a company owns less than 50% of another company but is deemed to have significant influence then the company is known as an associate. The parent company therefore includes it share of the profits of that associate in the income statement and includes its share of any changes in the net assets since the investment, usually in the Statement of Comprehensive Income. This type of income recognition is known as equity accounting. If the investment was deemed to be NOT an associate (i.e. just a normal marketable investment) then the parent company would simply include its share of dividends in income, and account for the investment on a cost basis. Deferred Tax assets This represents the difference between taxes actually due and what is calculated as tax expense in the financial statements. Property, Plant & Equipment This is Net cost of plant and equipment purchased by the company. The Gross Fixed Cost is the original cost of the plant. Every reporting period the company claims depreciation expense in the Income Statement; the ‘balancing item’ here is that this depreciation expense is accumulated each year and offset against the original cost to give the ‘net fixed asset’ amount. The movement in Net Fixed Assets can be explained (in simplified form) by this equation. You should refer to Note 15 of the Wesfarmers Financial Statements for the extensive details. Net Fixed Assetst
= Net Fixed Assetst‐1
+ Capital Expendituret
‐ Depreciation Expenset
‐ Book Value of Assets soldt
Another way to think about the amount of Net Fixed Assets is to note that:
Net Fixed Assetst
= Gross Fixed Assetst
‐ Provision for Accumulated Depreciationt
Identifiable intangible assets As the name implies, this represents the accumulated expenditure which can be attributed to specific intangible assets; typical examples are software and brand names. Note, as with plant and equipment these items do not represent an assessment of value but are simply a statement of costs incurred on a particular item. This is an application of the historic cost convention noted earlier. Goodwill This usually arises on an acquisition. When a company acquires another company at a price in excess of the book value then the question arises as to how to treat this excess in the balance sheet of the acquirer. You cannot simply restate the value of the tangible assets, again in accordance with historic cost idea. The difference between the purchase price of the acquired company and the book value of the company’s tangible assets is known as goodwill. EXERCISE 0.2
What observation can you make about the composition of Wesfarmers Non Current Assets? Do the notes reveal further information relevant to understanding the resources employed by Wesfarmers?
Current Liabilities Complete the following table for Wesfarmers current liabilities:
Wesfarmers CURRENT LIABILITIES
2012 2011
Trade and other payables
Interest bearing loans and borrowings
Income Tax payable
Provisions
Insurance Liabilities
Derivatives
Other
Total
Interest bearing loans and borrowings This item shows interest bearing debt due within twelve months. It will include actual short term debt as well as long term debt maturing within the next twelve months. Provisions Provisions are not actually liabilities but represent ‘highly probable’ future obligations and are therefore recognised. Note 20 shows a typical list of provisions; other examples would include provision for product liability and warranty claims. Provisions are described in more detail in Section 0.6.
Non Current Liabilities Complete the following table for Wesfarmers noncurrent liabilities:
Wesfarmers NON CURRENT LIABILITIES
2012 2011
Payables
Interest bearing loans and borrowings
Provisions
Insurance Liabilities
Derivatives
Total
Note the terms here closely follow those used for current liabilities, so the difference relates to the time frame over which these obligations are expected to fall due i.e. greater than twelve months. EXERCISE 0.3 Refer to Note 19. Discuss the nature of Wesfarmers borrowing sources and how it has changed over the last twelve months.
Equity The Equity balance represents the net investment made by shareholders in the business. Equity is the residual, which is why it is calculated as Assets – Liabilities. Complete the following table for Wesfarmers Equity:
Wesfarmers EQUITY
2012 2011
Issued Capital
Employee Reserved Shares
Retained Earnings
Reserves
Total
Issued Capital Represents the equity capital contributed by shareholders. It is the amount raised by the company issuing new shares. This will be made up of a par value per share and a premium per share. The sum of par and premium represents the actual price for which the shares were sold to investors. Retained Earnings This shows the profits accumulated from when the business was incorporated less any dividends paid out. It does not represent cash but rather the amount of profits retained within the company and reinvested in the business.
EXERCISE 0.4 Comment on the overall mix of Wesfarmers equity It is important to remember that the value for Equity shown in the Balance Sheet represents that value of funds invested by shareholders (commonly described as ‘Book Value’) at the time the shares were issued – ie not the market value. The following exercise demonstrates the difference between the two concepts. EXERCISE 0.5
1. Refer to the Balance Sheet and note the value of ‘Total Equity’ in the
Balance Sheet;
2. Refer to Note 23, which gives details of the number of shares outstanding. Note that Wesfarmers has two types of ordinary shares:
Ordinary shares (Ticker: WES), and Partially Protected Ordinary shares (Ticker: WESN). These have
some long term optionality;
3. At 30th June, 2012
Share Price at 30 June 2012
WES $29.90
WESN $31.56
4. Using this data calculate the market capitalisation of Wesfarmers. How
does it compare to the ‘Total Equity’ value you found in 1. above. Consider why they are different.
0.3.2 Explaining Balance Sheet items Each balance sheet item can be described by a general expression:
Closing balance = Opening balance + Increases – Decreases Increases and decreases might be cash or non cash transactions. To understand details of most balance sheet items you will need to refer to detailed notes which are provided. From these you should be able to: o understand what the key components of each balance sheet item. For
example, by referring to Note 19 of the Wesfarmers report you can see how the structure of Wesfarmers borrowing facilities; and
o understand movements in each balance sheet item. For example, by
referring to Note 15 of the Wesfarmer’s report you can observe the main sources of change in the balance sheet value for Property, Plant and Equipment.
Limitations of the Balance Sheet The balance sheet is the basis for much financial analysis. Given that it represents the amount invested in the business it is the basis for many metrics which measure the quality of earnings, such as Return on Investment. However there are a number of limitations in the Balance Sheet, as traditionally published. One example relates to “Other omitted liabilities”. Organisations may have other commitments which are not formally recognised as liabilities which however should, at a minimum, be reviewed by the analyst to ensure they are either recognised as a liability or at least included in a risk analysis. The Wesfarmers Financial report includes some relevant examples here in Note 28, which includes:
o non‐cancellable operating leases;
o contracted capital expenditure; and
o ‘Contingent liabilities’ describes a series of guarantees provided to third parties. Again the risk inherent would need to be assessed. Contingent liabilities, by their very definition, are deemed to be unlikely.
0.3.3 Income Statement The income statement reports the results of transactions arising from the company’s operations over the reporting period. A stylised Income Statement is set out in the following table, however you should also refer to the Wesfarmers Income Statement to see how they are really presented. Capital transactions such as asset purchases or new borrowings are not included in the Income Statement, however the annual costs of these, represented by depreciation and interest expense, are included. There are a variety of ways of reporting profits. We will review the major components of profit and then describe the different ways of analysing profit.
Revenue
STYLISED INCOME STATEMENT
- Cost of Goods Sold Raw materials, labour, energy costs etc
= GROSS PROFIT
- Selling & Admin Would include other expenses, overheads for eg
= EBITDA
- Depreciation Allocation of capital cost over life of asset
= EBITA
- Amortisation Of Intangibles – less common these days
= EBIT
- Interest Interest Paid on Borrowings
= Profit Before Tax
- Tax Expense Not always the same as Tax Paid
= Profit after tax
- Minority Interests Share of profits attributable to minority shareholders where parent owns greater than 50% of jointly owned companies
= Profit attributable to parent company
- Dividends
= Change in Retained Earnings
Revenue The bulk of a company’s revenue will be derived from sale of products and services. It should be noted that revenue is recorded when the goods and services are delivered to the customer, not when the customer actually pays – this reflects the accrual basis of accounting described earlier. Cost of Goods Sold Usually the largest component of costs this represents all costs incurred in the production process to convert raw materials to finished product. In the context of the Wesfarmer’s Income Statement, this item is entitled “Raw materials and inventory”. It will include direct costs of manufacture, i.e. those raw material and labour costs that are directly traceable to a particular product, and manufacturing overhead, which are costs not directly traceable to a particular product. The inclusion of overheads in product costs is called absorption costing. The cost of goods sold is the result of allocating production costs between product sold during the period and finished goods (and work in progress) still in inventory. Where the unit cost of production changes over time then the allocation method will affect the determination of income between periods. It is therefore important to understand the process used to allocate costs and how it might affect reported income. The method of allocation is usually a choice between the following: first in, first out; last in, first out and average cost method. The choice of method will usually be described in a company’s Notes to the accounts, usually in the section describing Inventories. The relationship between physical quantities of inventory and dollar amounts as shown in the income statement is summarised in the following expressions.
In physical terms we have:
Inventory QtyCBt = Inventory QtyOBt + Units Producedt – Units Soldt
In dollar terms we have:
Inventory $CBt = Inventory $OBt + Cost of Productiont – Cost of Goods Soldt
Using Average Cost method: [Inventory $OBt + Cost of Productiont]
Cost of Goods Soldt = x Units Soldt
Inventory QtyOBt + Units Producedt]
Other operating costs These will include costs not directly involved in producing product but which are necessary for the continued operation of the business. This category includes sales and marketing expenses, research and development costs and finance and administrative expenses. Income tax expense The calculation and reporting of income tax is one of the more complicated areas of financial analysis. For our purposes we are interested in one outcome – what are the actual and forecast levels of taxes paid by an organisation or division. However tax paid will not usually equal tax expense. For example in the case of Wesfarmers tax expense, as per the profit statement, was $918m, whereas actual tax paid was $943 million. The differences result from the fact that calculation of income for accounting purposes does not have to follow the same ‘rules’ as the calculation of taxable income. Taxable income is calculated in accordance with tax legislation which may give specific rules for treatment of particular items. These differences give rise to “tax effect accounting” and such balance sheet items as assets and liabilities.
Minority Interests We noted earlier that financial statements are produced on a consolidated basis. They therefore include the assets and liabilities of entities which may be partially owned by the parent company. To be consolidated, the parent must own 50.1% and/or have substantial influence and control over the subsidiary. Consolidation means that 100% of the profits of the subsidiary are included in the Income Statement (i.e. revenue, costs etc), and 100% of the assets and liabilities are included in the balance sheet, even though the subsidiary is only partly owned. An adjustment therefore needs to be made so that profit available to parent company shareholders only represents the share of profits attributable to the parent company. The following adjustments are therefore made: o The Minority Interest item in the Income Statement represents the share of
profits of partly owned subsidiaries attributable to the minority shareholders in these entities, and is deducted from profits;
o There is a corresponding item for Minority Interests in the equity portion of
the balance sheet (but not shown in Wesfarmers as they do not have any partly owned subsidiaries). The value of Net Assets attributable to outside shareholders is identified as a separate source of equity, different to the “equity attributable to the equity holders of the parent”.
0.3.4 Explaining key Income Statement items
As with the balance sheet, to get behind individual items we need to refer to detailed notes provided. It is interesting to note that in the Wesfarmers Income Statement, the largest individual cost item “Raw Materials and Inventory purchased” (which is their expression for Cost of Goods Sold) has no further detail provided in an easy summary! However the following are worth noting:
o Note 3 gives segment results for Wesfarmers;
o Note 4 gives some detail on cost items;
o Note 5 gives detailed data on Income Tax, and the difference between accounting Income Tax and actual Tax expense;
The many definitions of profit…. The profit number most referred to in the press is probably a company’s Profit after tax. This reports the profits available for shareholders after deducting the claims of all other stakeholders including tax, financing costs and minority interest. It is therefore, appropriately, the ultimate measure of performance from the shareholders perspective. However, most analysts will utilise a number of alternative profit definitions, mainly because of the different perspective they give on different aspects of performance. For example, consider two companies that are identical in all aspects of operations but have different depreciation policies, different financing strategies or even different tax strategies. In this case the companies will report different Profits after tax, however if we are interested in better understanding the drivers of the business’ underlying performance, which will be the ultimate driver of long term performance and therefore value, we need to break up Profit into component parts. Common profit definitions used in practice are described below. None of these is, a priori, superior to the other; the usefulness of each one depends on the purpose of the analysis being undertaken. o Contribution margin: is defined as Revenue minus Variable costs. This measures
the contribution which an additional unit makes towards covering fixed costs. Fixed costs will usually include the ‘Other operating costs’ described earlier, as well as manufacturing fixed costs. The contribution margin is often used to estimate the breakeven level of sales volume; the volume of sales required to return a zero net profit. This will be discussed in more detail later in this module;
o Gross profit: The objective of such a measure is to measure performance of
manufacturing activity; the suggested definition is Revenue less Cost of Goods Sold; the precise definition can vary;
o EBITDA: Earnings before Interest, taxes depreciation and amortisation. This adds
back depreciation and amortisation, partly to get closer to cash flow and to minimise the impact of distortions caused by different depreciation policies. The main problem with this particular measure is that it does not incorporate all the real costs of operating a business – including importantly working capital and replacement of assets – and materially overstates any realistic concept of cash flow;
o EBIT: Earnings before Interest and taxes, measures a business’s income before it is divided among creditors, owners and tax payments. It is therefore a useful measure of underlying profit performance, not distorted by a number of ‘corporate’ level cost items;
o Net Profit is usually the ‘headline’ results number. It represents profit available to shareholders after deducting all other claims on income, including taxes and interest expense. The share of income attributable to minority interest will also be deducted, leaving the profit available for shareholders in the parent company. In the Wesfarmers Income Statement this is described as “Profit attributable to members of the parent”.
EXERCISE 0.6 Refer to Wesfarmers Income Statement. o Calculate Wesfarmers’ EBIT; o How has this EBIT been allocated between Income tax, Interest Expense,
Minority Interests and the Wesfarmers’ shareholders?
Solutions to Exercises
EXERCISE 0.1
The table below has the relevant numbers from the Wesfarmer’s balance sheet.
SUMMARISED WESFARMERS BALANCE SHEET
Based on current / non‐current distinction
[AUD, Million]
ASSETS 2012 2011 LIABILITIES & EQUITY
2012 2011
Current Assets 10,911 10,218 Current Liabilities 10,747 8,722
Non – current assets
31,401 30,596 Non‐current Liabilities
5,938 6,763
Total Equity 25,627 25,329
TOTAL ASSETS 42,312 40,814 LIABILITIES PLUS EQUITY
42,312 40,814
We can make the following observations:
o Wesfarmers’ balance sheet size increased by approximately $1.5bn from $40.8bn
in 2011 to $42.3bn in 2012. This is approximately a 4% increase over the 2012 year
(eg compared to the revenue increase of approximately 6%);
o The asset structure has not changed materially. Current assets represent a quarter
of and non‐current assets represent three quarters of the total assets. These
proportions have been maintained over the year.
o The liability structure has changed slightly. Current Liabilities, as a percentage of
the total balance sheet has increased from 21% to 25%.
o Equity is the most significant component of capital – ie representing 61% of total
assets. Equity increased by approximately $300m over the year ‐ attributable to
retained earnings.
EXERCISE 0.2
The table below has the relevant numbers from the Wesfarmers’ Balance
Sheet
Wesfarmers NON CURRENT ASSETS
[AUD, Million]
2012 2011
Receivables 33 9
Available for sale investments 15 17
Investment in associates 429 471
Deferred tax assets 475 437
Property 2,631 2,148
Plant & equipment 6,832 6,154
Identifiable intangible assets 4,393 4,353
Goodwill 16,097 16,227
Derivatives 233 233
Investments backing insurance 193 471
Other 70 76
Total 31,401 30,596
We can make the following observations:
o The most significant observation is the size of the “goodwill” and
“identifiable intangible assets” which together total in excess of $20bn,
and make up 65% of Non Current Assets. This indicates that much of
Wesfarmers asset base has been established via acquisition. (Note 16
located in Wesfarmers full financial statements on their web site shows
the detail of this item: of the $20.5bn in total intangible assets, about
$13bn relates to the acquisition of Coles by Wesfarmers in 2007).
The “Goodwill” item is essentially measures the difference between the
cost of acquiring a company and the book value of net assets acquired.
A company which grows ‘organically’ (i.e. by building businesses
internally) will have a low level of goodwill.
o We can also observe that Wesfarmers has $9.4bn of Property, Plant &
Equipment – this is the NET BOOK VALUE of fixed assets owned by
Wesfarmers. Note 15 shows this is comprised of:
Original Cost (i.e. Gross Book Value) $14.2bn
Less:
Accumulated Depreciation ($4.8bn)
Gives:
Net Book Value $9.4bn
o If we look further in Note 15 we can see for each component how
much of the movement in fixed asset values was due to additional
capital expenditure, disposals etc – to demonstrate this have a look at
the reconciliation of movement in “Net carrying amount at beginning
of year” and “Net carrying amount at end of year” for any of the
components of PP&E (eg ‘Plant, vehicles and equipment);
o If we check Note 28, we can see that Wesfarmers also has non
capitalised operating lease commitments of $12.5bn over the next five
years. This is predominantly lease payments on retail sites (Coles,
Bunnings etc), and so are critical to the operations of the business.
These lease rentals are conceptually the same as fixed assets (eg
property, plant and equipment) and should arguably be capitalised on
the balance sheet alongside the assets that are owned – ratings
agencies already capitalise non capitalised operating leases, and
accounting standards are generally moving towards such a
requirement;
o “Investments in Associates” represents the book value of investments
where Wesfarmers owns less than 50% AND does not have effective
control. Note 14 reveals major investments in the Bunning Warehouse
Property Trust and Gresham Private Equity.
EXERCISE 0.3
As at 30 June 2012 Wesfarmers had $5,502m interest bearing debt outstanding.
This was comprised of:
2012 2011
Short term debt: $1,621m $266m
Long term borrowings; $3,881m $4,613m
Total Interest Bearing Debt $5,502m $4,879m
We are particularly interested in Interest Bearing Debt because (along with
equity) that shows the finance raised from capital markets. It is different to
trade creditors which is provided by suppliers and is therefore debt which is
provided in the normal course of operations. It is also different to most
provisions which are conceptually internally financed.
Overall, the debt raised from capital markets has increased by $623m over the
year and the composition is shifting to shorter term debt (ie from 5% of total
interest bearing debt to 30% in June 2012).
Looking at the details in Note 19, we can make the following observations:
What is the composition of debt in terms of bank loans and bond issues?
Banks Loans: $1,539m (YEJ2010: $2,014m). Banks loans are raised via loans and
underwriting with individual banks groups of banks lending through a combined
facility;
Bond issues: $3,866m (YEJ2010: $2,800m);
Commercial paper: $97m (YEJ2010: $65m).
Note 19 contains an extensive discussion of Wesfarmers borrowing
arrangements. Investors find this helpful to understand refinancing risk (i.e.
does Wesfarmers have significant debt rollovers in the short term that it may
not be able to refinance? Is it dependent on a narrow source of funding
techniques or does it have access to a range of markets? The mix of bonds and
bank loans informs an opinion for this second point.
What is the amount of unused debt facilities?
$2,298m. Unused debt facilities represent commitments provided by banks to
lend funds at a future date, subject to conditions. Wesfarmers would pay a
commitment fee for the right to draw down these funds. The term of these
facilities would range between 1 and 5 years.
How did the composition of Wesfarmers’ debt change during 2012?
During the year 2011 Wesfarmers debt structure changed dramatically:
o Debt was increase by approximately $623m;
o Bonds increased by a net $1,066m, which was substantially the effect of a
new bond issue. Bank loans were reduced by about $475m;
o Short term debt has increased to become a more significant proportion
of debt;
Note that we have not included derivatives here but a good argument can be
made for doing so. Were we to incorporate derivatives we would need to refer
to Note 27 and include only those derivative contracts that were traceable to
interest bearing debt. The table below summarises how this might be done:
Assets Liabilities
Interest rate swaps – current 13 38
Interest rate swaps – non current
20 6
Cross currency interest rate swap – current
‐ 63
Cross currency interest rate swap – non current
70 109
Total 103 216
Net 113
So we would add $113m to the value for interest bearing debt. The argument
for excluding them is that the balance sheet values for debt show historic face
value, not market values, whereas the value of derivatives in the balance sheet
is a mark to market, so we are not adding like with like.
EXERCISE 0.4
Wesfarmers Equity
[AUD, Million]
2012 2011
Issued capital 23,286 23,286
Employee Reserved Shares (31) (41)
Retained Earnings 2,103 1,774
Reserves 269 310
Total 25,627 25,329
Wesfarmers has a relatively simple equity structure. No minority interests and
relatively small reserves, so equity basically comprises Issued Capital (proceeds
from issuance of new shares) and Retained Earnings. Issued Capital is by far the
largest source of equity capital. This was boosted in previous years by
substantial issues of equity in relation the Coles acquisition and the subsequent
refinancing.
EXERCISE 0.5
The equity market capitalisation of Wesfarmers is calculated in the
following table.
Wesfarmers Equity Market Capitalisation
Share No of shares (at 30 June 2012)*
Price at 30 June 2012
Market Value at 30 June 2012
WES 1,006,509 $29.90 30,094,619
WESN 150,563 $31.56 4,751,768
Total 34,846,387
Using this market value data we can now compare market values and book
values:
This table shows that Wesfarmers have contributed approximately $25.6bn
of equity, through share issues and retained earnings, and this is now worth
$34.8bn, so $9.2bn of value has been created, over and above any dividends
received by shareholders.
Item $m Source
Book Value of equity as at 30 June 2012
25,627 From Balance Sheet
Market Value of equity as at 30 June 2012
34,846 From above
Market Value added 9,219 By calculation
EXERCISE 0.6
The table shows the calculation of EBIT and EBITDA.
Item 2012 2011
Published Net Profit $2,126m $1,922m
Plus: Income Tax Expense $918m $784m
Plus: Finance Costs $505m $526m
Earnings before Interest and Taxes [EBIT]
$3,549m $3,232m
Plus: Depreciation and Amortisation $995m $923m
Earnings before Interest, Taxes, depreciation and amortisation [EBITDA]
$4,544m $4,155m
There are a number of observations:
o This calculation also includes interest revenue. Many analysts would
exclude this as they regard interest income as an offset to interest
expense; this is the equivalent to the idea of net debt. If you are using
net debt (where cash is offset against debt) then you should also use
Net Interest (where the interest income is offset against the interest
income). This ensures that you are being internally consistent in your
measures;
o Refer to Note 3 of the financial statements “segment information” and
footnote 4. This shows a number of items which have been included in
the calculation of EBITDA and EBIT which are mainly one off or capital in
nature. Many analysts would exclude these from their calculation
because they are trying to focus on underlying operational performance
– this leads to the idea of normalised earnings;
o If you started with “Net profit after minority interests” then you would
ADD BACK minority interest as well, as EBIT and EBITDA are measures
which show the performance of the asset, and should therefore be
based on 100% of the asset.
90 Wesfarmers Annual Report 2012
Balance sheetas at 30 June 2012 – Wesfarmers Limited and its controlled entities
CONSOLIDATED
2012 2011Note $m $m
ASSETS
1,127 897
2,384 2,149
5,006 4,987
164 184
1,690 1,543
540 458
10,911 10,218
33 9
15 17
429 471
475 437
2,631 2,148
6,832 6,154
4,393 4,353
16,097 16,227
233 233
193 471
70 76
31,401 30,596
42,312 40,814
5,420 5,059
1,621 266
455 345
1,289 1,166
1,635 1,532
126 96
201 258
10,747 8,722
20 24
3,881 4,613
1,206 1,092
682 803
116 208
33 23
5,938 6,763
16,685 15,485
25,627 25,329
23,286 23,286
(31) (41)
2,103 1,774
269 310
25,627 25,329
Current assetsCash and cash equivalents 8
Trade and other receivables 9
Inventories 10
Derivatives 27
Investments backing insurance contracts, reinsurance and other recoveries 11
Other 12
Total current assets
Non-current assetsReceivables 9
Available-for-sale investments 13
Investment in associates 14
Deferred tax assets 5
Property 15
Plant and equipment 15
Intangible assets 16
Goodwill 16
Derivatives 27
Investments backing insurance contracts, reinsurance and other recoveries 11
Other 17
Total non-current assets Total assets
LIABILITIESCurrent liabilitiesTrade and other payables 18
Interest-bearing loans and borrowings 19
Income tax payable
Provisions 20
Insurance liabilities 21
Derivatives 27
Other 22
Total current liabilities
Non-current liabilitiesPayables 18
Interest-bearing loans and borrowings 19
Provisions 20
Insurance liabilities 21
Derivatives 27
Other 22
Total non-current liabilities Total liabilitiesNet assets
EQUITYEquity attributable to equity holders of the parentIssued capital 23
Employee reserved shares 23
Retained earnings 24
Reserves 25
Total equity
88 Wesfarmers Annual Report 2012
Income statementfor the year ended 30 June 2012 – Wesfarmers Limited and its controlled entities
CONSOLIDATED
2012 2011Note $m $m
55,897 52,891
1,788 1,622
144 145
251 217
58,080 54,875
(38,406) (36,515)
(7,496) (7,116)
(1,413) (1,283)
(946) (895)
(2,232) (2,151)
(995) (923)
(197) (27)
(3,213) (2,977)
(54,898) (51,887)
383 259
(505) (526)
(16) (15)
3,044 2,706
(918) (784)
2,126 1,922
184.2 166.7
183.9 166.3
RevenueSale of goods
Rendering of services
Interest – other
Other
Expenses Raw materials and inventory
Employee benefits expense 4
Net insurance claims, reinsurance and commissions
Freight and other related expenses
Occupancy-related expenses 4
Depreciation and amortisation 4
Impairment expenses 4
Other expenses 4
Other income 4
Finance costs 4
Share of losses of associates 14
Profit before income taxIncome tax expense 5
Profit attributable to members of the parent
Earnings per share (cents per share) 6
– basic for profit for the period attributable to ordinary equity holders of the parent
– diluted for profit for the period attributable to ordinary equity holders of the parent
Wesfarmers Annual Report 2012 91
Cash flow statementfor the year ended 30 June 2012 – Wesfarmers Limited and its controlled entities
CONSOLIDATED
2012 2011Note $m $m
Cash flows from operating activities62,620 58,408
(57,865) (54,661)
22 20
144 149
(445) (472)
(835) (527)
3,641 2,917
(164) 76
(2,626) (2,062)
275 216
402 20
(4) (38)
(52) (88)
(2,169) (1,876)
1,443 3,291
(901) (3,523)
5 5
(1,789) (1,557)
(1,242) (1,784)
230 (743)
897 1,640
1,127 897
Receipts from customers
Payments to suppliers and employees
Dividends and distributions received from associates
Interest received
Borrowing costs
Income tax paid
Net cash flows from operating activities 8
Cash flows from investing activitiesNet acquisition of insurance deposits
Payments for property, plant and equipment and intangibles 8
Proceeds from sale of property, plant and equipment and intangibles 8
Proceeds from sale of controlled entities
Net investments in associates and joint ventures
Acquisition of subsidiaries, net of cash acquired
Net cash flows used in investing activities
Cash flows from financing activitiesProceeds from borrowings
Repayment of borrowings
Proceeds from exercise of in-substance options under the employee share plan 23
Equity dividends paid
Net cash flows used in financing activities
Net increase/(decrease) in cash and cash equivalents
Cash and cash equivalents at beginning of year
Cash and cash equivalents at end of year 8
