9789144084893

Mikael Runsten is PhD in business administration from Stockholm School of Economics. He is founding partner of Bild & Runsten AB, that provides training for financial specialists as well as general managers. He also frequently contributes as lecturer in executive programs. He has received several Best Teacher awards from MBA and executive students.

Goals, relationships, and measurement methods The purpose of this book is to describe and explain the concepts, measures and relationships which are fundamental to the process of setting financial goals and controlling the fulfilment of these goals at various levels of management responsibilities.

The book describes how rates of return on assets, capital employed and shareholders’ equity are measured; how the relationship among these measures is dependent upon how the operation is financed; how the financial capacity to grow can be analysed; and how the ratios can be linked to cash-flow and equity valuation; all within a comprehensive system of financial ratios.

The book focuses on the use of accounting information and is essential reading for students and academics in accounting and finance. It is also valuable for professionals (CFOs, controllers, accountants, managers, etc.)

This classic book on financial statement analysis, first published in 1987, is in our mind the best Swedish text book in business administration ever.

It is easy to be impressed by how much knowledge the authors have managed to include ... Complicated relationships are explained in a pedagogical way.

| The Profitability, Financing, and Growth of the Firm

The Profitability, Financing, and Growth of the Firm

Sven-Erik Johansson Mikael Runsten

Sven-Erik Johansson is Professor Emeritus in business administration (accounting and managerial finance) at the Stockholm School of Economics.

He has extensive experience as auditor and consultant on accounting and financial issues. Sven-Erik has also been very influential on Swedish accounting practice, among other things as chairman for different Swedish accounting bodies (e.g. Redovisningsrådet).

InvestingByTheBooks, June 2, 2013

www.studentlitteratur.se

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Art No 6887

2nd ed.

Second edition

ROCE ROCE CAPITAL TURNOVER CAPITAL TURNOVER GROWTH GROWTH ROIC ROIC LEVERAGE LEVERAGE D/E D/E ROE ROE MARGIN MARGIN VALUE CREATION VALUE CREATION EBIT EBIT ND/E ND/E ROA ROA WACC WACC EVA EVA Goals, relationships, and measurement methods CTO CTO EBITDA EBITDA SURVIVAL SURVIVAL ND/EBITDA ND/EBITDA RISK RISK CAPITAL CAPITAL MARKET-TO-BOOK MARKET-TO-BOOK SALES SALES CASH FLOW CASH FLOW EQUITY EQUITY LIABILITY LIABILITY COST OF EQUITY COST OF EQUITY CAPITAL EMPLOYED CAPITAL EMPLOYED DIVIDEND DIVIDEND EXCESS PROFIT EXCESS PROFIT FINANCIAL STRENGTH FINANCIAL STRENGTH OPERATIONS OPERATIONS FINANCE FINANCE Sven-Erik Johansson GEARING GEARING Mikael Runsten COST OF DEBT COST OF DEBT RETURN RETURN PROFITABILITY PROFITABILITY MARKET PRICE MARKET PRICE EARNINGS EARNINGS PROFIT PROFIT

The Profitability, Financing, and Growth of the Firm

2014-06-03 08:18

Copying prohibited All rights reserved. No part of this publication may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, recording, or any information storage and retrieval system, without permission in writing from the publisher.

The papers and inks used in this product are eco-friendly.

Art. No 6887 ISBN 978-91-44-08489-3 Second edition 2:1 Š Studentlitteratur 2014 www.studentlitteratur.se Studentlitteratur AB, Lund Cover design: Francisco Ortega Printed by Eurographic Danmark A/S, Denmark 2014

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CONTENTS

Preface to the first edition 7 Preface to the second English edition 9 1 Conceptual Framework 11 2 Profit, rate of return, and growth as conditions for the survival of the firm 15

2.1 2.2 2.3 2.4

Profit is no measure of profitability 15 The market price of capital 16 Relationships between the market price of equity capital and the return on equity 17 Relationships between growth, return, and equity ratio 26

3 Measures of return and the liability-to-equity ratio: simplified analysis 31

3.1 3.2 3.3

Measures of return on capital 31 Relationships between different return measures 33 Relationships when the values of variables change 36

4 The rate of return, the liability-to-equity ratio, and risk 41

4.1 4.2 4.3 4.4 4.5

Introduction 41 Financial policy considerations and risk 42 Financial policy as a problem of risk 44 Valuation of risk and selection of liability-to-equity ratio 47 The interest coverage ratio 51

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Contents

5 Calculation of the rate of return and taxation 53

5.1 5.2 5.3 5.4

Introduction 53 No temporary or permanent differences 55 Only temporary differences 56 Only permanent differences 59

6 Rate of Return and Debt-Equity Ratio: in-depth Analysis 63

6.1 6.2

The split of ROA into a margin and capital turnover component 63 Capital employed and Invested Capital as the capital basis 71

7 The relationships between growth and rate of return keeping a constant liability-to-equity ratio 85

7.1 7.2 7.3 7.4

Introduction 85 Balanced financial growth 86 Growth of equity 89 A few measurement issues 97

8 Summary of financial relationships 101

8.1 8.2

Summary of relationships with total assets as a capital basis 102 Capital employed and invested capital as capital basis 105

9 Financial growth and cash-flow 109

9.1 9.2 9.3 9.4 9.5 9.6

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Issues 109 Assumptions in the main example 110 Cash-flow analysis 110 Cash-flow and targets for return, growth and leverage 111 Investment capacity at set financial targets 115 Loan repayment required by a ND/EBITDA covenant 118

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Contents

10 Unbalanced financial growth 125

10.1 10.2 10.3

Planned continuous changes 125 Unplanned continuous changes 129 Planned changes of non-recurring nature 130

11 Controlling return and growth of divisions 133

11.1 11.2 11.3 11.4

Control via targets for ROCE and financially stable growth 134 The relationship between ROCE and capacity for growth 137 Control of ROCE and free cash-flow 141 Control of excess profit vs. ROIC 142

12 Returns, growth and equity valuation 145

12.1 12.2 12.2.1 12.2.2 12.2.3 12.2.4 12.2.5 12.3

Introduction 145 Present Value of Expected Future Performance 149 Future dividends 149 Equity and excess profit 152 Future free cash-flow 154 Invested Capital and future excess profit 158 A simple benchmark-model 160 Summary 165

13 Pitfalls of using financial key ratios 167

13.1 13.2 13.2.1 13.2.2 13.2.3 13.2.4 13.2.5

Introduction 167 Origin of problems 168 Unrealized appreciation of value in fixed assets 169 Expensed intangible investments 170 Growth by acquisition 175 Stakeholders with multiple roles 175 Deliberate improvements 177

Symbols/Definitions References 185 Index 187 © S T U D E N T L I T T E R AT U R

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PREFACE TO THE FIRST EDITION (somewhat shortened)

In 1969 a listed Swedish company invited me to an internal top-management seminar on dividend policy. I presented an analysis, showing that dividend policy, defined for instance as the ratio of dividends to net earnings, is only one component of a comprehensive financial goal system including goals for other key performance indicators, KPIs, such as return, leverage, and growth of sales and assets. The practical usefulness of a model based on accounting data and financial ratios soon became apparent. Consequently, the model was further developed, and played a pivotal role in the training of students in accounting and managerial finance at the Stockholm School of Economics and in an empirical research program, initiated in the early seventies, on asset growth, capital structure, and returns. The practical relevance and usefulness has been tested in executive seminars and training programs since then. This book started out as notes and documentation for my lectures.

The purpose of this book is to describe and explain the concepts, measures, and relationships which are fundamental to the process of setting financial goals and monitoring the realization of these goals at various levels of management responsibility. The ambition is to demonstrate the importance and purpose of accounting-based financial ratios. Although the book focuses on the use rather than the preparation of accounting information, the reader should be familiar with basic accounting concepts. .

The book also describes how returns on assets, capital employed, and shareholders’ equity are measured, how the interrelationships among these measures are dependent upon the method by which operations are financed, and how the financial capacity to grow is analyzed within a comprehensive financial goal system. The mathematical relationships are presented in a Š S T U D E N T L I T T E R AT U R

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Preface to the first edition

simple way and illustrated numerically in one ‘main example’ throughout the book. Publishing financial goals in terms of returns, leverage ratios, etc. used to be a rather unique feature of Swedish reporting practice.

Only a few references are made to research reports on various aspects of financial ratios and financial goals. The formulation of these goals and the way in which they discipline management’s use of financial resources have been explored excellently by Professor Gordon Donaldson in his book (1984), “Managing Corporate Wealth, The Operation of a Comprehensive Financial Goals System” (Praeger Publishers). The use of accounting information and the related measurement problems within a comprehensive system of financial management control have been analyzed in Sven-Erik Johansson and Lars Östman (1995), “Accounting theory, Integrating Behaviour and Measurement” (Pitman Publishing).

Stockholm, October 1997 Sven-Erik Johansson

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PREFACE TO THE SECOND ENGLISH EDITION

A third edition of this book, in which Sven-Erik Johansson was joined by Mikael Runsten as a co-writer, was published in Swedish in 2005. The main structure of the book was kept unchanged, but several new chapters were added. New content areas included linking the ratio-framework of the book to cash-flow and to different equity valuation models. Absolute performance indicators, such as excess profit (EVA™), were also introduced in parallel to the book’s strong focus on return indicators. Finally a chapter was added with the purpose of acknowledging and discussing some pitfalls of using financial key ratios.

This second English edition is largely a translation of the third Swedish edition of the book. However, several sections of the book have been rewritten and updated beyond the latest Swedish edition. Eola Änggård Runsten has played an essential role in translating the book into this English edition (with the prior English version as a starting point). Her many requests for clarifications have also helped us to improve the product.

This book has played an essential role in the accounting and finance education at Stockholm School of Economics since the early 1980s. It is still commonly used at all levels – Bachelor, Master as well as on Executive programs. The many teachers and students that have used and read the book, have had a significant impact both on content and structure of the book.

A warm thank you to all old readers and to all colleagues at “b-sektionen”.

The first edition of this book was written after a period of high inflation, high interest rates, high corporate tax rates and diminishing financial strength of many companies. Since then inflation, interest and tax rates have dropped significantly. The aim of balancing debt and risk as a means for independence and survival of a company has been challenged by numerous © S T U D E N T L I T T E R AT U R

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The profitability, financing, and growth of the firm

investors and management teams attempting to use as much debt financing as possible (supporting an aggressive growth strategy and utilizing cheap financing). It may also be noted that a trend of strong shareholder value focus has to some extent overshadowed a broader stakeholder value focus (with long-term survival a basic goal). The financial crisis of individual companies and whole nations in the last decade highlights the importance of being aware of the interdependencies of growth, profitability, and financial strength. The dynamic financial relationships explained in this book will hopefully help to reveal these links.

Stockholm, March 2014 Sven-Erik Johansson   Mikael Runsten

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CHAPTER 3

Measures of return and the liability-to-equity ratio: simplified analysis

This chapter will define some basic return measures, and then introduce the link between return on assets (ROA) and return on equity (ROE). The amount of liability financing (leverage) and the cost of liabilities (COL) will prove to be important components.

3.1  Measures of return on capital Return on capital is generally defined as the relationship between an accounting-based earnings measure and an accounting-based capital measure, i.e.: Return =

Earnings Capital

This relationship expresses the return which the capital generates.

Calculations of the return for a company may refer to various measures of capital, for example equity or total assets (which in turn corresponds to the sum of equity and liabilities). The choice of the earnings measure will depend on the capital measure we select. This is clarified with a simplified example. (This example will be the basis for the evolving discussion in this book, and will thus be developed in stages. The reader is therefore advised to study it closely).

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Main example 3.1

The company, which our main example describes, reports the following financial position and results, in very simplified form: Balance Sheet

Income Statement Equity 400

Assets 1,000

Earnings before interest expense (EBIE) 100 Interest expense –36 Earnings before tax (EBT) 64

Liability 600

(The amounts are denominated in millions of EUR in this example and throughout the book.)

Three useful return measures is derived from this information.

Earnings before tax 64 = Equity 400 Interest expense 36 2. Cost of liabilities (COL ) = = Liabilities 600 Earnings before interest expense 100 3. Return on assets ( ROA) = = Assets 1,000 1. Return on equity ( ROE ) =

Equity 400

ROA =

100 = 10 % 1000

Assets 1,000

ROE =

Liability 600

COL =

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64 = 16 % 400

36 =6% 600

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3 Measures of return and the liability-to-equity ratio: …

Return on equity (ROE) is calculated on the basis of the earnings after interest expense. We have so far ignored the company’s income taxes in the example.

The effect of taxes on the return measures is dealt with further in Chapter 5.

The average cost of liabilities (COL) is the return which lenders to the company obtain on average on the capital they have lent to the company.

For the time being, we will disregard the problems associated with the measurement of interest expenses, and with the criteria for selecting the liabilities to be included in the measure. We will return to these questions in Chapter 6.

Return on assets (ROA) is calculated on the basis of earnings before interest expense. This is important to note – it gives the ratio the important feature of being independent of the mix of financing the company has happened to choose. This measure of return is consequently unaffected by the company’s financial policy (defined as its choice of capital structure), but otherwise dependent upon company policy as regards pricing, product policy, market policy, investment policy, and so on.

When using the above definitions, the rate of return is expressed as a decimal, i.e. 0.1 = 10 %. In mathematical operations, it is suitable to denote it in decimal form, while in other situations it may be preferable to express it as a percentage. For the sake of simplicity, we will use the above variable names to express both decimal and percentage values.

If no liabilities and no interest expenses exist, then ROE will obviously be equal to ROA. A difference between ROE and ROA thus depends upon the presence of liabilities and the interest expenses which accompany them.

The difference between ROE and ROA thus depends upon the company’s financial policy. The relationship between these return measures is more closely analyzed in the next section.

3.2 Relationships between different return measures The return on Equity (ROE) is obviously dependent on the return on total assets (ROA), and on the average cost of total liabilities (COL) as well as the Liability-to-equity ratio (L/E). Let us examine this relationship with the help of our main example. We will call total assets A, liabilities L, and equity E.

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Main example 3.2

The income after interest expense (64) is split in the following way: one component corresponds to the return which is obtained on all assets in the company, and thus also on the assets corresponding to the equity

the other component is what the shareholders earn on borrowed capital, when it is invested within the company giving a return on total assets of 10 % at a margin of 4 % in relation to the cost of liabilities which is 6 %

ROA × E 0.10 × 400 = 40

(ROA – COL) × L (0.10 – 0.06) × 600 = 24

Equity 400

ROA =

100 = 10 % 1000

Assets 1,000

ROE =

64 = 16 % 400

Liability 600

COL =

36 =6% 600

We have now split the earnings which is assigned to equity, i.e. the earnings before tax (after interest expense, 64). In order to split return on equity (ROE) in the same way, the different income components must be divided by the amount of equity. We consequently divide both ROA × E and (ROA–COL) × L by E and get the following expressions.

ROA × E = ROA E ( ROA − COL ) × L L = ( ROA − COL ) × E E The sum of these two components must equal ROE and we thus conclude: L ROA + ( ROA − COL ) × = ROE E or with numbers: 600 10 % + (10 % − 6 %) × = 16 % 400

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3 Measures of return and the liability-to-equity ratio: …

The relationships of the return on equity (ROE), the return on total assets (ROA) and the average cost of liabilities (COL), which we have described with the example above, may thus be summarized in the following basic equation: ROE = ROA + ( ROA − COL ) ×

L (3-1) E

We call the ratio L/E the liability-to-equity ratio. In the example, it is 600/400 = 1.5, which is equivalent to an equity ratio of 0.4.

The difference between ROA and COL is defined as the financial margin on borrowed capital, or, for the sake of simplicity, the financial margin.

The financial margin multiplied by the liability-to-equity ratio renders the contribution which the borrowed capital makes to the return on equity.

In the main example, this contribution is (10 % – 6 %) × 1.5 = 6 %. We define this as the leverage contribution going forward. We will analyze the leverage contribution with respect to different types of liabilities in Chapter 6.

By way of conclusion, we return to the example and see that the return on equity (16 %) is equal to the sum of the return on total assets (10 %) and the leverage contribution (6 %).

In situations when the focus is on calculating a required return on total assets rather than explaining the return on equity, it may be appropriate to express the return on total assets (ROA) as a function of the return on equity (ROE) and the average cost of liabilities (COL). From the basic formula (3-1), we may easily derive the expression for ROA, after substituting A for (E+L): ROA = ROE ×

E L + COL × (3-2) A A

With the help of (3-2), it is easy to derive how great ROA must be in order to achieve a set target rate for ROE with a certain objective for the equity ratio (E/A), as well as satisfying lenders’ yield requirements at that equity ratio. With a known initial value for E and a known requirement for ROE, a requirement for the magnitude of the profit after interest expense may be determined. With a known L and required value for COL, the firm’s interest expenses (= lenders’ requirements for compensation) may be determined.

With this, the requirements for income before interest expense and ROA may also be determined. This chain of requirements, which begins with ROE © S T U D E N T L I T T E R AT U R

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and the “bottom line” on the income statement, may be illustrated with the help of the main example and an “upside-down” income statement and balance sheet.

Main example 3.3

The required ROE as determined by the stock-market is assumed to be 16 %, and initially the equity is 400. The target set by management for the equity ratio is 40 %, and the expected cost of liabilities (COL) is 6 %. Based on these assumptions, the required income before interest expense is derived in the following way.

Balance sheet

Required return

Income statement (required earnings)

Earnings before tax E 400 ROE = 16 % → 0.16 × 400 = → 64 L

+ Interest expense 600 COL = 6 % → 0.06 × 600 = → 36

↓

= 100/1000 ← = Earnings before interest expense 100 A 1 000 ROA = 10 % Finding that the required ROA is 10 % in this case can also be done directly using equation 3-2; note that 16% × 0.40 + 6% × 0.60 = 10 % If, in addition, there is an objective for the company’s sales – e.g. 2,000 – the earnings before interest expense (EBIE) must equal 5 % of sales. (Introducing such links to the margin is developed further in Chapter 6.)

3.3 Relationships when the values of variables change Based on the basic formula (3-1) for the relationship between different measures of return, it is also possible to precisely define the relationships between changes in the measures. With the help of the main example, we will study the relationships between changes in return on total assets, the average cost of liabilities, and the liability-to-equity ratio, and changes in the return on equity. The analysis will consist of two steps. First, we will study the effect on the return on equity of a change in the return on total assets in a situation 36

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3 Measures of return and the liability-to-equity ratio: …

where the liability-to-equity ratio and average cost of total liability remain constant. Thereafter, we will study how the return on equity is affected when the return on total assets, the liability-to-equity ratio, and the average cost of liabilities change simultaneously.

Main example 3.4

Assume that ROA increases from 10 % in the initial example to 12 %.

Assume further that L/E and COL remain unchanged.

L ROE = ROA + ( ROA − COL ) × ← basic formula E 16 = 10 + (10 – 6) × 1,5

←

initial conditions

21 = 12 + (12 – 6) × 1,5

←

ROA has increased

+ 5 + 2 + (+ 2 – 0) × 0

←

changes

+ 5 = + 2 × (1 + 1,5)

←

relationship between changes

The increase of ROA by 2 % causes ROE to increase from 16 to 21. We see that the increase in ROE (5) can be derived from the increase in ROA (2) multiplied by a factor (1 + 1.5), which is 1 + the L/E ratio.

The relationship between the changes we have studied in the example above may be expressed as:  L ∆ROE = ∆ROA ×  1 +  (3-3)  E

+ 5 = + 2 × (1 + 1.5) ←

from the example

Δ indicates change; ΔROA will accordingly be used from now on to mean the change in ROA. We consequently state that, the higher the liability-to-equity ratio, the larger the impact on ROE of a change in ROA. This is known as the leverage effect.

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Main example 3.5

In this case, we assume the following simultaneous changes in relation to the initial conditions: a) ROA increases from 10 to 12 b) L/E increases from 1.5 to 2 c) COL increases from 6 to 7 L

E

←

basic formula

16 = 10 + (10 – 6) × 1,5

←

initial conditions

22 = 12 + (12 – 7) × 2

←

ROA, L/E, COL have increased

ROE = ROA + ( ROA − COL ) ×

The changes which have come about cause ROE to increase from 16 to 22.

The increase in ROE is equal to the increase in ROA (2) plus the initial yield margin multiplied by the increase in L/E, i.e., ((+10 – 6) × 0.5), plus the increase in the yield margin multiplied by the new L/E ratio (+ (2 – 1) × 2).

With the help of symbols used earlier, this may be expressed as: L + E L L + ( ∆ROA − ∆COL ) ×  + ∆  E E

∆ROE = ∆ROA + ( ∆ROA − COL ) × ∆

(3–4)

We conclude with a graphic illustration of how the return on equity varies with the return on total assets when the liability-to-equity ratio and the average cost of total liabilities are kept constant. This relationship is shown between ROE and ROA for several values of L/E and a related assumption on COL. It is evident, from the slopes of the lines in figure 3.1, that the greater the liability-to-equity ratio (L/E), the larger the effect on the return on equity (ROE) for any given change in the return on total assets (ROA).

The following chapter considers the significance of the relationships described in the basic formula for the analysis and planning of a company’s financial policy.

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2 Profit, rate of return, and growth …

ROE = ROA + ( ROA − COL) ×

L E

L = 4; COL = 5.5% E

L = 3; COL = 5.0% E

40 % L = 2; COL = 4.5% E

35 % 30 %

L = 1; COL = 4.0% E

25 % 20 % 15 % ROE

10 % 5% 0%

–5 %

0% –5 %

5%

10 %

15 %

ROA

–10 % –15 % –20 % FIGURE 3.1 The relationship between ROE and ROA at different levels of leverage (L/E)

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Mikael Runsten is PhD in business administration from Stockholm School of Economics. He is founding partner of Bild & Runsten AB, that provides training for financial specialists as well as general managers. He also frequently contributes as lecturer in executive programs. He has received several Best Teacher awards from MBA and executive students.

Goals, relationships, and measurement methods The purpose of this book is to describe and explain the concepts, measures and relationships which are fundamental to the process of setting financial goals and controlling the fulfilment of these goals at various levels of management responsibilities.

The book describes how rates of return on assets, capital employed and shareholders’ equity are measured; how the relationship among these measures is dependent upon how the operation is financed; how the financial capacity to grow can be analysed; and how the ratios can be linked to cash-flow and equity valuation; all within a comprehensive system of financial ratios.

The book focuses on the use of accounting information and is essential reading for students and academics in accounting and finance. It is also valuable for professionals (CFOs, controllers, accountants, managers, etc.)

This classic book on financial statement analysis, first published in 1987, is in our mind the best Swedish text book in business administration ever.

It is easy to be impressed by how much knowledge the authors have managed to include ... Complicated relationships are explained in a pedagogical way.

| The Profitability, Financing, and Growth of the Firm

The Profitability, Financing, and Growth of the Firm

Sven-Erik Johansson Mikael Runsten

Sven-Erik Johansson is Professor Emeritus in business administration (accounting and managerial finance) at the Stockholm School of Economics.

He has extensive experience as auditor and consultant on accounting and financial issues. Sven-Erik has also been very influential on Swedish accounting practice, among other things as chairman for different Swedish accounting bodies (e.g. Redovisningsrådet).

InvestingByTheBooks, June 2, 2013

www.studentlitteratur.se

978-91-44-08489-3_01_cover.indd 1

Art No 6887

2nd ed.

Second edition

ROCE ROCE CAPITAL TURNOVER CAPITAL TURNOVER GROWTH GROWTH ROIC ROIC LEVERAGE LEVERAGE D/E D/E ROE ROE MARGIN MARGIN VALUE CREATION VALUE CREATION EBIT EBIT ND/E ND/E ROA ROA WACC WACC EVA EVA Goals, relationships, and measurement methods CTO CTO EBITDA EBITDA SURVIVAL SURVIVAL ND/EBITDA ND/EBITDA RISK RISK CAPITAL CAPITAL MARKET-TO-BOOK MARKET-TO-BOOK SALES SALES CASH FLOW CASH FLOW EQUITY EQUITY LIABILITY LIABILITY COST OF EQUITY COST OF EQUITY CAPITAL EMPLOYED CAPITAL EMPLOYED DIVIDEND DIVIDEND EXCESS PROFIT EXCESS PROFIT FINANCIAL STRENGTH FINANCIAL STRENGTH OPERATIONS OPERATIONS FINANCE FINANCE Sven-Erik Johansson GEARING GEARING Mikael Runsten COST OF DEBT COST OF DEBT RETURN RETURN PROFITABILITY PROFITABILITY MARKET PRICE MARKET PRICE EARNINGS EARNINGS PROFIT PROFIT

The Profitability, Financing, and Growth of the Firm

2014-06-03 08:18