Appendix 1

Values taken from company accounts are used to analyze business performance. For the vast bulk of these values there are no quibbles about their accuracy or realism. However, there are some items that are subject to a number of different interpretations. Whether one interpretation is preferred over another will affect the results of the analysis. A multitude of rules laid down by the accounting bodies, the statutory authorities, the Stock Exchange and others have a bearing in these interpretations. Some understanding of the more important of these rules provides a useful background to analysis.

The principle underlying the rules may be even more important. The overriding principle is the ‘true and fair view’ that accounts should present. This said, it is often difficult to draw up rules for specific items that will always reflect a true and fair view. It is for this reason that different interpretations can arise to give different answers to our analysis.

As external conditions change, the emphasis moves to different aspects of the accounts – from the profit and loss account to the balance sheet to the cash flow. New problems, such as fluctuating currencies, give rise to the need for new rules and so on. This appendix will address some of the more important ‘live’ issues in accounting at the present time. It will explain why they are live, what the current state of play is and how different methods of treatment would affect the analysis.

These issues are:

• goodwill
• foreign currencies
• pensions
• deferred tax
• leases
• revaluation of fixed assets
• scrip issues
• miscellaneous long funds
• EBITDA
• terminal value – SVA.

Goodwill on acquisition

When one company acquires another for a price (consideration) in excess of the fair value of its net assets, goodwill is created. This goodwill amount will appear not in the accounts of either the buyer or vendor, but in the consolidated, or, combined accounts of the two companies. Goodwill is called an intangible asset, that is an asset of no physical substance. In many ratios, calculations are based on tangible assets only, thus totally ignoring goodwill. Nevertheless, it has important effects on a company’s reported position and so an understanding of its origins and treatment is important.

First we will look at a non-goodwill situation called Scenario 1 in Figure A1.1. It will serve as a base position from which to work towards a goodwill example.

Company A has paid $100 for Company B, the balance sheet for which is shown with a net worth of $100. The entries that appear in Company A’s balance sheet are ‘Investment $100’ and the investment is balanced by an equivalent long-term loan.

When we look at the consolidated balance sheet for Scenario 1 the item ‘Investment $100’ has disappeared. The values in the following boxes are combined:

• fixed assets
• current assets
• current liabilities
• long-term loans.

The ordinary funds of Company A are unchanged in the consolidated balance sheet. Also, before consolidation, the total assets were $1000 for A and $400 for B. The combined statement is in balance with its total assets being equal to the sum of the two separate companies less the Company A $100 investment and Company B ordinary funds deducted from each side.

When we consider what has happened, we see that the investment of $100 in Company A’s balance sheet has simply been replaced by net assets of $100 ($400 assets – $300 liabilities) from Company B.

In practice, the question of ‘fair value’ of both assets acquired and consideration given would arise. It has been assumed that this is not an issue here.

Figure A1.1 Non-goodwill on acquisition

A goodwill acquisition

In Scenario 2 in Figure A1.2, the amount paid by Company A for Company B is $125. Company B is the same firm as in Scenario 1, whose net assets are $100. On consolidation, the extra consideration of $25 is not balanced by physical assets so an intangible asset of this amount must be created. The name we give to this intangible asset is goodwill. (The justification for a high acquisition price and, therefore, the goodwill element, exists in the mind of the buyer, but, logically, it has to be the expectation of extra future profit.)

	Once consideration in cash or other assets is given for goodwill a number of questions then arise: ‘How is it treated in the accounts?’ ‘How will different ways of treating it affect our analysis?’

Three ways of treating goodwill are:

• by annual charges to the profit and loss account – it can be depreciated in just the same way as any fixed assets and it will, in time, disappear from the accounts (this way out is not favoured by business people because its effect is to reduce declared profit, which will be reflected in the earnings per share figure and other measures of performance).
• by an immediate charge against reserves – assets may be reduced by the amount of goodwill and reserves by the same amount so, at a single stroke, goodwill simply disappears, totally (in the consolidated balance sheet shown in Figure A1.2, reserves of $370 would be reduced by $25 to $345, reported ordinary funds would fall by $25 to $525 and balance sheet totals go down to $1300).
• by write-off of any impairment of value – as reflected in current forecasts of operations.

Figure A1.2 Goodwill on consolidation

The effect of the second treatment is that profits are not affected and various balance sheet totals are reduced. Because of higher profits and lower assets the profitability ratios of return on total assets and return on equity will look better. The debt/equity ratio, though, will look worse because equity funds are artificially reduced. It is likely that the high return on total assets, return on equity, and market to book ratios in the sample companies are partly attributable to this treatment of goodwill.

Foreign currency

Movements in exchange rates affect company performance in various ways, principally by way of transactions in the profit and loss account and holdings of overseas assets and liabilities in the balance sheet. We often note that an increase in the value of sterling will cause a weakening in the share price of companies with substantial foreign interests, and vice versa.

In general, gains and losses arising from foreign currency exchange rate movements are treated as follows:

• profit and loss transactions are translated at average currency values for the year
• assets and liabilities in the closing balance sheet are translated at rates that applied at the date of the final accounts
• net assets of the opening balance sheet are restated at the closing rates, the difference from the previous year being taken to reserves
• exchange differences on foreign currency borrowings directly raised for, or to provide a hedge against, overseas fixed assets are taken to reserves and offset against the exchange differences on the assets
• all other gains and losses are passed through the profit and loss account.

Pensions

Capital sums invested in pension funds and annual contributions have grown so large that they can have a bearing on company performance. The pension funds themselves should not directly impinge on a company’s accounts because they are separate funds totally independent of company finances. However, the liability of a company to provide for employees’ pensions means that a shortfall in the fund has to be filled by increased annual contributions. Likewise, a surplus can allow the company to take a holiday from contributions, thereby improving its cash flow and profit results. The surplus or deficit on the fund is, therefore, of supreme importance to the value of the company.

Deferred tax

The amount of tax charged in company accounts is often considerably different from the actual tax paid. This arises from ‘timing differences that are likely to reverse in the foreseeable future’. Behind this phrase lies government legislation. To encourage investment in fixed assets, many governments give accelerated capital allowances on new plant. They allow a higher charge against profits for the writing down of the fixed assets than would be justified on the basis of a straightforward depreciation calculation.

The result to the company is a lower tax charge in the early years of an investment. However, if excess amounts are taken for depreciation early in the life of plant, there is none left for later years. The result will be heavier tax charges in these latter years. It is accepted that, for business purposes, this artificial distortion of reported profits is better avoided. Accordingly, in the early years, the full tax charge is made in the accounts and the amount not paid is put to the deferred tax account. It will be drawn down in later years. However, this said, a certain amount is left to the discretion of management to determine how much of a charge is ‘likely to crystallize in the foreseeable future’.

Finance leases

Assets in the balance sheet include only items that are owned by the company. At least, this was the fundamental rule until quite recently when a considerable amount of off-balance sheet financing came into use. By this phrase is meant that assets were being acquired which were funded by loans, but neither the asset nor the loan appeared in the accounts. In legal terms, these assets were leased, but all the risks and rewards of ownership accrued to the company. The term finance lease is now used in this situation to distinguish it from the ordinary operating lease. With a finance lease, both the asset and the funding must appear in the accounts.

Revaluation of fixed assets

High rates of inflation over two decades had resulted in a situation where the values for property in company accounts were far removed from reality. It was accepted that it was necessary to remove this anomaly and fixed assets were allowed to be shown at valuation rather than at cost.

Our interest here is to consider the effect of revaluation on the various business ratios. First we will look at the accounting treatment that is illustrated in figure A1.3. The increase in value of the fixed assets is matched by an increase in reserves.

Balance sheet values for fixed assets, total assets and ordinary funds are increased. The impact on business ratios is exactly the opposite to that which resulted from the writing off of goodwill shown earlier in this appendix.

The debt/equity ratio improves, as does the asset backing per share. However, return on total assets and return on equity will worsen. For an analysis of accounts for a series of years, spurious movements in ratios can arise simply from revaluation.

The best way to eliminate these is to back-date the revaluation to the start of the analysis period.

Scrip issue

A scrip, or, bonus issue takes place when shareholders in a company are given extra free shares in proportion to their existing holdings. For instance in a one-for-two scrip, all shareholders will have their number of shares increased by 50 per cent. From a ratio point of view, this has an effect on EPS, DPS, assets per share and, normally, market price per share. The historic values must all be moved down in proportion to the increase in number of shares.

In Figure A1.4 we show an example of a company that made a one-for-two scrip issue. From a base of 180 shares, it issued 90 extra shares free to its existing shareholders. It also transferred $90 from reserves to issued capital. The pre-scrip market price was $4.80. What is the likely post-scrip market price?

Does a scrip bring real benefit to the shareholder? The logic is that there should be no change in their overall position: they own the same fraction of the company after the scrip as before and the total value of the company has not increased. However, in practice, a scrip is a buoyant signal to the market that may improve a share’s value. The accounting entry is simply a transfer from reserves to issued capital, as shown in Figure A1.4.

Miscellaneous long-term funds

In chapter 1 it was mentioned that certain items do not fit comfortably into the structure of the five-box balance sheet. These items have been ignored throughout the analysis in this book because, in many companies, these items do not exist at all and in most others, they are of little importance from a financial analysis point of view.

However, they are mentioned here as an aside so that when they are encountered they can be dealt with appropriately. Under the heading ‘Miscellaneous long-term funds’, they lie between ordinary funds and long-term loans.

Preference shares

Preference shareholders, paradoxically, have very limited rights. They are part-owners and receive a dividend at a fixed per cent before the ordinary shareholder. At one time this was a popular form of funding, but it is now used in very limited and special circumstances. It may be for tax planning or voting control purposes for example. Preference shares will often have conversion rights into ordinary shares and, if so, they can be included with that category. For debt/equity ratio purposes, they can be treated as equity.

Minority interests

This entry occurs when the consolidated group includes subsidiaries that are less than 100 per cent owned. They are equity funds but not part of the group’s equity. Usually the amount is insignificant, but, for calculating the debt/equity ratio, they could, again, be included with equity.

Deferred tax, grants and miscellaneous provisions

Deferred tax has been discussed above. It is probably best treated as an ‘interest-free loan’ from the government and, therefore, included as debt. Grants will, in due course, move up into equity. Miscellaneous provisions could be pension funds not fully covered; they are neither debt nor equity. Both items can be ignored in the balance sheet ratios unless the amounts are significant.

EBITDA

EBITDA (earnings before interest, tax, depreciation and amortization) is the newest financial term to come into common use over recent years. It identifies cash flow measured at one particular point in the overall cash-flow cycle.

Figure A1.3 Revaluation of fixed assets

Figure A1.4 Effects of a scrip issue on the accounts

In order to identify its component parts we will first look at EBIT – earnings before interest and tax. We have seen in chapter 4 that EBIT is the first important measure of profit that we identify in a profit and loss account.

It is largely the operating or trading profit of the business (there may be minor adjustments for non-operating income, etc.). Therefore EBIT captures the total operating income and total operating cost of the business.

It is a number of enormous significance because it is from EBIT that a company generates resources to pay interest to bankers, tax to the government, dividends to shareholders, and, maybe even repay loans, etc. And in most companies it represents an ongoing, continuous source of renewable energy.

However, it is a number that is produced according to certain accounting rules, one of these rules relates to the charge that we make for depreciation. We have seen in chapter 8 the role that depreciation plays in linking profit from trading with cash flow from the same source. Depreciation, which is a non-cash cost, must be excluded from the cash flow calculation.

Amortization is the term we use in relation to the writing down of goodwill. For the moment we can consider it as simply depreciation under another name, i.e., a non-cash charge in the profit and loss account.

We add back both depreciation and amortization to EBIT to get EBITDA. It represents the cash that is thrown off from the normal trading activities of the business (before any provision has been made for reinvestment in fixed assets, working capital, etc.). It may also be adjusted for certain non-recurring, non-operating items that have been charged prior to EBIT.

After we separate out any discontinued operations, we can say that EBITDA identifies the sustainable and hopefully growing stream of cash that will flow from the trading activities of the business over the coming years, and it is a number that is largely free from some distortions that can arise from accounting policies. Operating managers and analysts like it for this reason.

We have said that amortization can be considered as another form of depreciation, but there is a significant difference between these two charges. Depreciation is a true cost related to the passage of time, even though it is not a cash cost in the current period. The fact that machines do wear out over time and have to be replaced has to be recognized in the accounts.

Amortization of goodwill, however, is a far more contentious issue. It is difficult to support the theory that it gradually wears out over time.

We can say that goodwill is the premium that one company will pay to acquire the assets of another that appears to have the capacity to earn above normal profits. The inherent value of this goodwill can change as a result of many factors, it can remain constant, it can even grow. It can disappear overnight as we have seen in the cases of telecom companies that have been taken over at extraordinary high premiums.

Therefore, if we decide to write it down by an annual charge over a fixed period of time, just as if we were writing off a regular depreciating fixed asset, we should recognize that this is an artificial charge and allow for that fact in our financial reporting.

Terminal value calculation in the SVA model

The revised method (shown in chapter 17, page 287) for calculating the terminal value of a company some years ahead illustrated one particular approach which we call the ‘annuity’ method. In this approach we take a particular cash flow, i.e. NOPAT, and we capitalize it simply by dividing by the cost of capital, WACC.

It is logical and correct to do this when we know or can assume that this is a constant cash flow that will persist for a long, indefinite period into the future.

Provided certain conditions are met, this approach to valuation is correct even if the cash flow is not constant but growing. The most important condition here is that the return generated by the company, i.e., ROIC, is exactly equal to its cost of funds, i.e., WACC.

When this condition applies then the benefits of growth in the cash flow will be entirely absorbed by the extra capital required to support the growing business. Because all the benefits of this growth are cancelled out we can ignore it and use a method of valuation that is based on a constant cash flow.

There are strong economic arguments in favour of this approach, but there are also many who argue cogently that growth into the long-term future does have an impact on value and must be allowed for.

In favour of the former position is the economic case that a company that earns profits in excess of the cost of capital will attract competition from new entrants to the market who wish to share in those excess profits. This competition will reduce profitability in the market sector. New entrants will continue to be attracted until overall profitability falls to the exact level of the cost of funds, at which stage the equilibrium is reached.

Proponents of the latter position argue that a large, well-established, well- managed company has a competitive advantage over any new entrants, and such companies can sustain indefinitely a rate of profit considerably in excess of the cost of capital. If this latter proposition is accepted, the annuity approach that we have used in chapter 17 understates the continuing value of the company, and we have to use a new formula which is difficult but more accurate.

The formula to establish the terminal value of a company with growth in a competitive advantage situation is

[NOPAT(t + 1) × (1 – g/r)]/(WACC – g)

What this formula says is that we start with final year NOPAT, and we move it forward one year at the expected growth rate, i.e., NOPAT(t + 1).

We multiply this value by (1 – g/r). The symbol ‘g’ stands for expected growth rate, and ‘r’ stands for the company’s rate of return.

Let us say that g = 8% and r = 12%. We multiply by (1 – 8/12) which reduces NOPAT to 33% of its original value.

We then divide this number by (WACC – g). Growth has already been fixed at 8%. Let us say that WACC equals 10%. The values within brackets are therefore (10% – 8%) which gives us 2%.

We will work out the values by the two different methods for a hypothetical company with a NOPAT of $100.

Annuity approach

TV	= NOPAT/WACC
	= $100/.10
	= $1000

Long-term growth approach

TV	= [NOPAT(t + 1) × (1 – g/r)]/(WACC – g)
	= [($100 × 1.08) × (1 – 8/12)]/(.10–.08)
	= $1782

This second approach has resulted in a much higher value. This value is heavily influenced by the growth rate. The reader may like to check that an assumed growth rate of 4% would give a value much closer to the annuity value, i.e., $1,144.