Financial Statement Analysis

Valuation ∙ Credit analysis ∙ Evaluating performance

Growth analysis

Chapter 6

1
How far have we come?

2
 Learning objectives

After the lesson you should be able to:

• Understand the importance of liquidity when growing a business

• Measure how fast a company can grow while maintaining the financial risk at the
same level
• Recognise that there are many ways in measuring growth, but only one way to
measure if growth is value creating
• Evaluate the quality of growth
• Assess if growth is sustainable
• Understand whether growth induced by share buy-back adds value

3
The relationship between growth, liquidity and
invested capital (cash flows)

4
 Objective: 20% growth rate
Requirement of profit margin to ensure financial stability
Year 1 2 3 4 5
Revenue 1,000.0 1,200.0 1,440.0 1,728.0 2,073.6
Operating expenses -850.0 -1,020.0 -1,224.0 -1,468.8 -1,762.6
Net operating earnings (EBIT) 150.0 180.0 216.0 259.2 311.0
Financial expenses -25.0 -30.0 -36.0 -43.2 -51.8
Earnings before tax 125.0 150.0 180.0 216.0 259.2
Tax -37.5 -45.0 -54.0 -64.8 -77.8
Net earnings 87.5 105.0 126.0 151.2 181.4
Dividends -17.5 -21.0 -25.2 -30.2 -36.3
Retained earnings 70.0 84.0 100.8 121.0 145.2

Operating profit (EBIT) 150.0 180.0 216.0 259.2 311.0

Corporate tax -37.5 -45.0 -54.0 -64.8 -77.8
Tax shield from debt financing (reversed) -7.5 -9.0 -10.8 -13.0 -15.6
Change in invested capital -170.0 -204.0 -244.8 -293.8 -352.5
FCFF (enterprise) -65.0 -78.0 -93.6 -112.3 -134.8
Financial expenses after tax -17.5 -21.0 -25.2 -30.2 -36.3
Dividends -17.5 -21.0 -25.2 -30.2 -36.3
Change in liquidity during the year -100.0 -120.0 -144.0 -172.8 -207.4

Net interest bearing liabilities, beginning of year 500.0 600.0 720.0 864.0 1,036.8
Net interest bearing liabilities, end of year 600.0 720.0 864.0 1,036.8 1,244.2

Invested capital 850.0 1,020.0 1,224.0 1,468.8 1,762.6 2,115.1

Equity 350.0 420.0 504.0 604.8 725.8 870.9
Net interest bearing liabilities 500.0 600.0 720.0 864.0 1,036.8 1,244.2
Financial leverage 1.4 1.4 1.4 1.4 1.4 1.4

Return on invested capital (ROIC) 17.6% 17.6% 17.6% 17.6% 17.6%

Profit margin 15.0% 15.0% 15.0% 15.0% 15.0%
Invested capital turnover 1.2 1.2 1.2 1.2 1.2
Return on equity (ROE) 25.0% 25.0% 25.0% 25.0% 25.0%
Sustainable growth rate 20.0% 20.0% 20.0% 20.0%

5
Financial consequences of unprofitable growth
(decreasing profit margin)

Decreasing profit margin 1 2 3 4 5

Operating profit (EBIT) 200.0 192.0 172.8 138.2 82.9
Corporate tax -52.5 -49.0 -41.6 -28.7 -8.5
Tax shield from debt financing (reversed) -7.5 -8.6 -10.3 -12.8 -16.4
Change in invested capital -170.0 -204.0 -244.8 -293.8 -352.5
FCFF (enterprise) -30.0 -69.6 -123.8 -197.0 -294.5
Financial expenses after tax -17.5 -20.0 -24.0 -29.8 -38.2
Dividends -24.5 -22.9 -19.4 -13.4 -4.0
Change in liquidity during the year -72.0 -112.5 -167.2 -240.2 -336.6
Net interest bearing liabilities, beginning of
year 500.0 572.0 684.5 851.7 1,091.9
Net interest bearing liabilities, end of year 572.0 684.5 851.7 1,091.9 1,428.5

Invested capital 850.0 1,020.0 1,224.0 1,468.8 1,762.6 2,115.1

Equity 350.0 448.0 539.5 617.1 670.7 686.5
Net interest bearing liabilities 500.0 572.0 684.5 851.7 1,091.9 1,428.5
Financial leverage 1.43 1.28 1.27 1.38 1.63 2.08

Return on invested capital (ROIC) 23.5% 18.8% 14.1% 9.4% 4.7%

Profit margin 20.0% 16.0% 12.0% 8.0% 4.0%
Invested capital turnover 1.2 1.2 1.2 1.2 1.2
Return on equity (ROE) 35.0% 25.5% 18.0% 10.9% 3.0%
Sustainable growth rate 20.4% 14.4% 8.7% 2.4%

6
 The impact of unprofitable growth on liquidity
Example: Bioscan

The company’s core product was to convert waste into a) clean water,
b)energy and c) fertiliser.

Year 1 Year 2 Year 3 Year 4 Year 5 Accumulated

Revenue 2,748 17,976 23,396 32,422 16,247 92,789
Operat ing profit (EBIT) -5,935 -23,245 -41,396 2,408 -29,466 -97,634
FCFF -18,356 -35,894 -25,725 -10,838 -10,293 -101,106
Market value of equity 339,015 417,782 57,669 42,733 98,502

The company eventually went bankrupt

7
Different capital intensity implies that growth affects
cash differently

Simcorp (asset light) is a software provider and has grown revenue by

50% in the past five years
Alfa Laval (asset heavy) is global supplier of products and solutions for
heat transfer and has grown its revenue by 60% in the past five years
8
Limits to growth: Sustainable growth rate

9
 Sustainable growth rate

• The sustainable growth rate indicates at what pace a firm can

grow its business while preserving its financial risk , i.e.
maintain its financial leverage (debt to equity ratio) at the
same level despite growth
• In its simplest form the sustainable growth rate can be shown
as:
g = ROE x (1 – PO)
where
– g = Sustainable growth rate
– ROE = Return on equity after tax
– PO = Payout ratio (dividend as a percentage of net profit)

10
 Sustainable growth rate

NIBL
g  [ROIC  (ROIC - NBC)  ]  (1  PO)
E
Return on equity (ROE)

g = Sustainable growth rate (based on the beginning balance sheet)

ROIC = Return on invested capital (based on the beginning balance sheet)
NBC = Net borrowing costs in percent (based on the beginning balance sheet)
NIBL = Net interest-bearing liabilities
E = Equity
PO = Payout ratio (dividends as a percentage of net earnings)

11
 The association between
payout ratio and the sustainable growth rate

25%
Sustainable growth rate

20%

15%

10%

5%

0%
0 20% 40% 60% 80% 100%
Payout ratio

Assumption:
Based on ROE=20% and different payout ratios g is calculated
12
The association between ROIC and
the sustainable growth rate
20%

15%

10%

Sustainable growth rate 5%

0%
-10% -5% 0% 5% 10%
-5%

-10%

-15%

-20%

-25%

-30%
ROIC after tax

Assumptions:
Financial leverage =1
NBC = 5%
Payout ratio = 0%
13
The association between financial leverage and the
sustainable growth rate
12,0%

Sustainable growth rate 10,0%

8,0%

6,0%

4,0%

2,0%

0,0%
0 0,5 1 1,5 2
-2,0%
Financial leverage

Company I Company II

Company I Company II
ROIC after tax = 3% 7%
NBC = 5% 5%
Payout ratio = 0% 0%
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 The impact of operating performance, financial
leverage and payout ratio on the sustainable growth
rate

NIBL
g  [ROIC  (ROIC - NBC)  ]  (1  PO)
E

Operating Financial leverage Dividend

performance policy

15
Is growth always value creating?

16
Growth can be measured in many different ways

Growth in
• Revenue
• Operating profit (EBIT)
• Net earnings
• Free cash flows
• Dividends
• Invested capital
• Economic Value Added (EVA)
• Etc

17
 Growth in selected performance measures
Example: Satair

Is Satair a growth company?

Has Satair’s growth been profitable?

18
 Growth in Economic Value Added (EVA)
Example: Satair

Is Satair a growth company?

Has Satair’s growth been profitable?

19
Growth in EVA assuming a constant ROIC
Example: Satair

20
The modified DuPont model:
Underlying sources of growth

21
Is growth recurring (permanent)?

22
 The stability (sustainability) in sales growth

Source: American companies retrieved from Compustat

23
ROIC (including both recurring and non-recurring items)

Source: American companies retrieved from Compustat

24
 ROIC (including only non-recurring items)

Source: American companies retrieved from Compustat

25
Is growth in earnings per share (EPS)
always value creating?

26
 ‘Growth in EPS’ is used in several contexts
Example: Compensation
Marks and Spencer has given a hint of the tough High Street environment
by reducing the profits the firm has to make in order for directors to be
able to earn bonuses.

Top executives will achieve a maximum payout if earnings per share grow
by more than 8% above inflation, compared with a 12% target the
previous year.

But M&S said the new target was "at least as challenging" in the current
economic climate.

27
 Is growth in EPS always value creating?

The example rests on the following assumptions:

100% equity financed
Required rate of return = 10%

28
Does growth caused by share buyback
always add value?

29
 Dividends versus share buybacks

Source: aswathdamodaran.blogspot.com/2019/02/
30
The impact of share buybacks on
EPS, financial ratios and firm value

31
The impact of share buybacks on
EPS, financial ratios and firm value

NIBL
β equity  β assets  (β assets  β debt )   1.5  (1.5  0.25) ·1  2.75
Equity
32
 The impact of share buybacks on
EPS, financial ratios and firm value

Economic Value Added (EVA) = (10% - 10%)  100,000 = 0

No value creation from share

buyback
Residual income (RI) = (15% - 15%)  50,000 = 0

P ROE  g 0.1125 - 0.0

Before share buyback :    8.9
E ROE  (ke  g) 0.1125  (0.1125  0.0)

P ROE  g 0.15 0.0

After share buyback :    6.7
E ROE  (ke  g) 0.15 (0.15 0.0)

33
The impact of share buybacks on EPS

34
 Conclusions

• Growth firms often consume cash and therefore, it is important to closely monitor
the liquidity of these firms

• A firm cannot grow faster than the sustainable growth rate if it wants to preserve
the financial risk

• Growth is not always value creating. A prerequisite for growth being value creating
is that ROIC exceeds the cost of capital (WACC)

• It is rare that high sales growth can be maintained in the long run

• It is important to analyse the quality of growth - growth from recurring business is

more sustainable than growth from non-recurring business

35