Analyze financial results for Economic Profit

Separating finance from operations in economic profit analysis

Financial statements are normally prepared in a format which complies with accounting disclosure requirements. Unfortunately, this format does not distinguish between finance and operations. The traditional approach Most financial statements reflect a format consistent with the following formula: EQUITY = (current assets – current liabilities) + (non-current assets – non-current liabilities). The debt financing components are included in current liabilities and non-current liabilities. Financial analysis Financial analysis demands a change in the format by separating all funding components from operating components. The following format needs to be considered: EQUITY + DEBT = (current assets – current liabilities) + non-current assets. In essence all funding is removed from the operating side of the equation. The net working capital is redefined by removing the cash on hand and at the bank and the bank overdraft from the right hand side of the equation. The same principal would apply to all forms of funding. This means that the end result would give rise to the following format: DEBT + EQUITY = WORKING CAPITAL + NON CURRENT ASSETS. TOTAL CAPITAL EMPLOYED = TOTAL NET OPERATING ASSETS. FINANCE = OPERATIONS. The great equivalence A sequence of events ties together the operating and finance approach. * A company raises a mix of debt and equity. * The funds are then invested in operating assets (working capital and non-current assets). * The business begins to generate sales and incurs operating expenses and taxes. * The funds remaining in the form of net operating profit after tax but before interest (NOPAT) are available for distribution to financiers of both debt and equity. * Lenders receive interest as a reward while shareholders receive dividends and an increase in the value of their investment. The point is that whatever the business can earn from investing in net operating assets must be the total cash available to reward those who supported the initial mix of debt and equity. Investors remain at last call. This implies that if management can manage the net operating assets effectively to maximise return then investors can be rewarded. The net operating profit after tax but before interest (NOPAT) reflects the separation of funding from operating concepts. This introduces the interface between the profit and loss and the balance sheet based on the matching concept. The message is that changes which occur in the mix of debt and equity have no impact on the operating performance of the business. Leverage strategy needs to be separate from operating strategy, both being equally important. The DuPont or return on capital employed model The DuPont model applies the separation of finance from operations. It has three primary components: Profitability. PROFITABILITY % =  Earnings before interest and tax (EBIT) / SALES This measurement represents the operating performance of a business entity expressed as a return on sales. It also provides a measurement of operational efficiency in the profit and loss account, void of finance costs. Activity. ACTIVITY = SALES/TOTAL NET ASSETS This measurement reflects balance sheet efficiency in terms of the utilization of scarce resources. ROCE – Return on capital employed. ROCE is a dynamic measurement which integrates the activities of the profit and loss and balance sheet in one calculation. ROCE =PROFITABILITY x ACTIVITY ROCE= EBIT / TNA ROCE provides a measurement of the operational return on the investment in total net assets (TNA). This is also the return on net assets (RONA) or the return on investment (ROI) due to the equivalence concept derived from separating finance from operations. ROCE would have to at least equal the average weighted cost of borrowing to avoid reverse leverage taking place. This is the erosion of equity as a result of too little EBIT being generated to service the cost of borrowing. Limitations of the model. * It is a short term measurement. * It is a before tax measurement. * Setting a target for a good ROCE is difficult. * It does not link to the cost of capital. * It does not link to the time value of money. * It does not link to value. Return on capital An overview Return on capital takes account of the impact of taxation as a cost of doing business. The components of computing a return on capital need to be defined carefully. NOPAT: (Net operating profit after tax) NOPAT is an operating performance measurement after taking account of taxation but before financing cost. (i.e. interest is excluded). NOPAT requires further adjustments for non-cash accounting entries. These adjustments are known as equity equivalents which are applied in the calculation of NOPAT. Equity equivalents adjust reported earnings to show true economic earnings. NOPAT provides a more realistic measurement of the actual cash yield generated from recurring business activities. NOPAT is EBIT adjusted for the impact of taxation. The purpose of this is to arrive at taxation on operating income which is then deducted from EBIT. Interest is totally excluded as the concept of separating finance from operations must be taken into account. NOPAT / REVENUE = NOPAT % The NOPAT % is the return on revenue and represents the first component of return on capital. Capital employed Capital employed consists of a mix between debt and equity funding. Based upon the concept of separating finance from operations we will remember that: DEBT + EQUITY = TOTAL NET ASSETS The return on capital employed is also the return on operating assets. The capital employed should be adjusted to include any equity equivalents. The result of these adjustments is to “gross up” the capital employed to reflect the economic investment in the business. Some common equity equivalent adjustments are as follows: * Goodwill amortized. * The present value of leases not capitalised. * Research and development written off. * Provisions which are a recurring part of the business and fluctuate with business activity. * Capitalized interest. * Deferred tax reserves. * Cumulative unusual losses or gains. * Deferred income reserves. The capital employed as reflected in the financial statements needs to be adjusted by including equity equivalents with the period to period changes being taken into NOPAT. These adjustments convert capital into a more accurate measure of the base upon which investors expect returns to accrue. Capital turnover can now be measured by applying the following formula: REVENUE / (OPENING CAPITAL EMPLOYED) = OPENING CAPITAL TURNOVER This is the second component in the computation of return on capital. The above explanations aim at illustrating the importance of equivalence between the financial sources and operating uses of capital; and between the NOPAT that is earned in the business and the cash that is available to reward all of the entity’s financiers. The formula: Return on capital (r) r = NOPAT / CAPITAL or r = NOPAT% x CAPITAL TURNOVER r = (NOPAT / REVENUE) x (REVENUE / CAPITAL) Return on capital in its final form is really the economic return on capital because it measures the cash return in the form of cash profits on the capital invested by stakeholders. EcROCE % = NOPAT % x Capital Turnover This provides a measurement of the productivity of capital employed. Some business entities use opening capital instead of average capital because they are dependent on non-current assets where the investment will take time to generate cash returns. In summary EcROCE% can be defined as a return on capital employed (average or opening) regardless of the financial forms in which capital has been obtained. It is a measurement of the financial productivity of the business. Cost of capital Overview. The cost of capital is the combined rate of return required by both lenders and shareholders. It is the minimum acceptable return on economic investment as a cut-off rate required for value creation. The cost of capital has four primary applications: * As the discount rate to bring projected free cash flow to its present value. * As the capital charge rate for calculating economic profit (or economic value added). * As a hurdle rate for assessing return on capital employed. * As a minimum target rate for accepting new projects. The cost of capital “drivers” are all about the trade off between risk and reward. The greater the risk the greater the required return and the cost of capital. In summary, the cost of capital is the return on capital required to have sufficient funds to: * Pay interest after tax on debt. * Provide an acceptable return on equity. The cost of debt The after tax rate the business would have to pay in the current market to obtain new long term debt capital Cost of equity This component of cost of capital is more abstract as it is based upon alternative investment yields of comparable risk. The leading question is how much compensation do investors require over and above the return provided by government bonds to compensate them for bearing the risk. The concluding thought Managers need to understand that capital employed in a business entity is not free of cost. The weighted cost of capital provides a means of evaluating rates of return on new capital projects. It uses the financing side of the balance sheet in the form of the targeted debt to capital ratio which provides a basis for weighting the cost of debt and equity capital. Economic Profit (EP) / Economic Value Added Overview One of the most dynamic performance measurements to account properly for all ways in which value can be added or lost is EP. Note: Economic Profit (EP) and Economic Value Added are synonymous. Economic profit is a residual income measurement which subtracts the cost of capital from net operating profits after tax generated in the business. Economic profit will increase if: * New capital is invested in any project that earns more than the cost of capital. * Capital is diverted or liquidated from business activities which do not cover the cost of capital. * NOPAT increases without increasing the economic capital employed. Economic profit’s advantage is that it is the only performance measurement which links directly with the intrinsic value of the business. The formula EP=(r – c*) x Capital employed EP= r = economic profit r = economic rate of return c* = cost of capital Example: Total capital employed = $2000 c* = 10% r = 12.5% EP = (12.5% – 10%) x 2000 EP = $50.00 Note that r = NOPAT / CAPITAL = EcROCE% EcROCE % = NOPAT % x Capital Turnover Economic Profit as a valuation methodology An overview Many businesses have mission statements which state that their major objective is to maximise shareholder wealth. While this is a noble objective and very few people would disagree with it, how this mission should be achieved is much less certain. Firstly, how are returns to shareholders measured? Generally, these are represented by returns to shareholders via dividends and increases in the value of the market price of their shares. For many years, managers and shareholders have believed that growth in annual earnings per share and increases in return on equity were the best measures for maximizing shareholder wealth. However, more recently there has been a growing awareness that these conventional accounting measures are not reliably linked to increasing the value of the company’s shares. This occurs because earnings do not reflect changes in risk and inflation, nor do they take account of the cost of additional capital invested to finance growth. There are a number of other reasons why earnings fail to measure changes in the economic value of the business. These are: * Alternative accounting methods may be employed. * Dividend policy is not considered. * The time value of money is ignored. The value of companies shares will only increase if management can earn a rate of return on new investments which is greater than the rate investors expect to earn by investing in alternative, equally risky companies. Since the concept of “maximizing shareholder wealth” was developed in the 1970’s, more and more enlightened managers are focusing on strategies which maximise economic returns for shareholders, as measured by dividends plus the increase in the company’s share price. One way of viewing the “shareholder value” approach is to value the business using economic profit as a valuation methodology. Market value added (MVA) The market value of a business at a point in time is an approximation of the fair value of the business’s entire debt and equity capitalization . This can be arrived at by taking the number of shares and multiplying by the share price and adding the book value of long and short term loans net of any cash deposits. Theoretically, market value at a point in time is equal to the total capital employed plus or minus the net present value of all future economic profits. Therefore, market value is maximized by maximizing the present value of future economic profits. Consequently, if we prepare a projection of annual economic profits into the future and discount these projections to the present value, at the cost of capital, we get an estimation of market value that management has added to or subtracted from the total capital employed in the business. This present value of all future economic profits is theoretically equal to market value added, MVA. Therefore the market value of a business is: Market value = MVA + capital employed. Advantages of Market Value Added (MVA) / EP as a performance measurement * By forecasting economic profit for each year it shows how much value will be added to the capital employed each year. * It is the only method that can clearly connect capital budgeting and strategic investment decisions with a methodology for subsequent evaluation of actual performance. * By forecasting economic profit amounts it automatically produces a series of targets for management to achieve in order to justify the valuation. * It can be readily communicated to and understood by operational management. * Through the computation of economic profit amounts economic profit creates a meaningful performance measurement which can be used to judge subsequent performance. (The cash flow performance of one business just cannot be compared with another). * For a project to be favorably considered, market value added must be positive. On the other hand free cash flow may fluctuate from positive to negative and back again over the life of the project. * Economic profit focuses managements attention on the fundamental three ways to create value. These are:- * Improve profits without making a further investment in additional capital. * Only invest in projects where earnings exceed the cost of capital. * Dis-invest from projects where the savings on the capital cost exceeds earnings foregone. Discounting the benefits of these strategies in free cash flow terms makes them difficult to understand. * Because economic profit is a powerful overall measurement of managements performance, it is an ideal method for setting corporate goals, management incentives and the payment of performance bonuses. This cannot be achieved with cash flow. * It links planning to performance…..and performance to value. Conclusion The creation of wealth can be achieved in the real world through the use of economic profit as a performance measurement linking strategy to value. The managers of many well known international corporations have succeeded in substantially increasing the value of their business entities by using this valuable tool. Some examples are Coca Cola, AT&T, Quaker Oats, Briggs & Stratton, CSX and many others. In New Zealand, Fernz Corporation Limited has used EP and MVA in order to accomplish its mission statement. The dynamics of using economic profit and market value added have a very powerful application in every business entity, irrespective of size or industry. The economic profit methodology can be applied to create wealth for the owners of businesses from the size of the corner store to that of the multi-national corporations. It is now up to us as business executives and advisers to assist owners with the implementation of business strategies which are consistent with the principle of economic profit. We are now able to use economic profit as a performance measurement which directly links strategy to value and is therefore the key to wealth creation. Strategic Focus provides management and advisors with an effective approach to financial analysis and business valuations. It is designed to guide you through the financial analysis and business valuation processes easily, professionally and accurately. Return to Strategic Focus overview