Preamble

Organization and rules of the game for this course

Objectives of the course

This course is an introduction to Corporate Finance, with

mainly two objectives:

 Read and interpret the Financial statements of a

company:
- Balance Sheet
- Income statement
- Cash flow statement

 Know how to use financial criteria to select an investment2

Contains of the course

 Financial statements: balance sheet, P&L and cash flow

statement
 Solvency
 Profitability (ROCE, ROE)
 Weighted Average Cost of Capital (WACC)
 Financial criteria to select an investment (NPV, IRR)
 Start Up financial management
 Bankruptcy and restructuring
 Introduction to Market Finance (stocks, bonds,
derivatives) 3
Organization of the course

They are 6 sessions of the course about finance.

Each session lasts 3 hours.
Each session is a mix between lectures and tutorial
classes.

One session (13th December) will be 100% a tutorial in

small group (35 students/group).

2 special guest from KPMG and AXA will also come (to be
confirmed) to talk about the Financial Valuation of a 4
company and Insurance companies.
Grading

Finance part will be 50% of your final grade for this

elective course.
Law will be the 50% remaining.

All your grading in the finance part will be done for the
final exam in January (1 hour for finance – 1 hour in law)

The finance part of your final exam will be composed of

theoretical and practical questions about the course.
No document. No laptop or smartphone. Calculator allowed.
5
Online course materials

The slides and documents of the lectures will all be

progressively put online on the EDUNAO platform.

6
Bibliography / References
No obligation to buy these books but they are very good references that
were used in the preparation of the course:

Corporate Finance- Pierre Vernimmen, Pascal Quiry, Yann Le Fur

 Available in French and English - The Bible in finance …

La gestion financière de l’entreprise - Christian Pierrat

 In French – a very good short book to summarize corporate finance

The Dhandho investor- Mohnish Pabrai

 In English. A non academic and original book about value investing
7
Some questions about the lectures ?

Do not hesitate to ask questions during the lectures,

at the break, or after the lectures,

or by email : [Link]@[Link]

8
 Financial statements
Introduction to the 3 main tables in Corporate finance :
Balance sheet, Income statement and Cash flow statement
Balance sheet
= a photograph of the patrimony of company at an accurate
moment (in general, at 31/12/N)
BALANCE SHEET

Assets Liabilities

=what the company owns = what the company owes

= temporary use = temporary resources

Eg: Fixed assets (machines, building) , Eg: Equity, Loans, Trade Payables, Bank
Trade Receivables, Inventories, Cash on overdraft
hand

∑ Assets = ∑ Liabilities
Income statement (P&L)
= the table to explain the result, ie. the net enrichment of
company during a period

INCOME STATEMENT
Expenses (E) Income (I)
=loss for the firm = final gain of the firm
= final and irreversible = definitive resources
uses of resources

Eg: taxes, wages, interest payments, Eg: sales, commissions received, fees
commissions paid, services purchased, received, interest earned
depreciation allowances.

Result = I – E -> Profit (if E<I)

 Expenses = Cash Expenses + Calculated Expenses

 Incomes = Cash income + Calculated Income
Cash flow statement
= the table to explain the variation of the cash asset, ie. the cash at
disposal of the company, during a period.

Cash flow statement

Cash-Out (CO) Cash-In (CI)
= cash that exits out of the company = cash that enters in the company

Eg: paid taxes, paid salaries, interests, Eg: collected sales, interest paid to the
services bought and paid company

Variation of cash asset = CI - CO

4
Balance sheet
BALANCE SHEET AT 31/12/Y
ASSETS LIABILITIES
FIXED ASSETS EQUITY:
- Tangible assets - Share capital
- Intangible assets - Reserves
- Financial assets - Result

OPERATING CURRENT ASSETS DEBTS:

- Inventories - Long term debts
- Trade receivables - Medium term debts
- Other receivables - Short term-debts
- Trade payables
CASH ASSETS
- Cash and cash equivalent

5
Balance sheet
BALANCE SHEET AT 31/12/Y
ASSETS LIABILITIES
FIXED ASSETS EQUITY:
- Tangible assets - Share capital
- Intangible assets - Reserves
- Financial assets - Result

OPERATING CURRENT ASSETS DEBTS:

- Inventories - Long-term debts
- Trade receivables - Medium-term debts
- Other receivables - Short-term debts
- Trade payable
CASH ASSETS
- Cash and cash equivalent

6
 Income statement for the year Y :
Explain how the result was formed from 01/01/Y to 31/12/Y

BALANCE SHEET AT 31/12/Y-1 BALANCE SHEET AT 31/12/Y

ASSET LIABILITIES ASSET LIABILITIES

FIXED ASSETS EQUITY: FIXED ASSETS EQUITY:

- Tangible assets - Share capital - Tangible assets - Share capital
- Intangible assets - Reserves - Intangible assets - Reserves
- Financial assets - Result - Financial assets - Result

OPERATING CURRENT ASSETS DEBTS: OPERATING CURRENT ASSETS DEBTS:

- Inventories - Long term debts - Inventories - Long term debts
- Trade receivables - Medium term debts - Trade receivables - Medium term debts
- Other receivables - Short term-debts - Other receivables - Short term-debts
- Trade payable - Trade payable
CASH ASSETS CASH ASSETS
- Cash and cash equivalent - Cash and cash equivalent

Cash flow statement for the year Y

Explain the variation of the cash assets between 31/12/Y-1 and 31/12/Y
To clarify your ideas …
The example of the Pizza Food Truck !
You launch your own Pizza food truck
Your assumptions/your needs:

 Food truck (fully equipped): 30 000 € / 5 year of life

 Ingredients: 2€/Pizza
Flour, tomatoes, ham, mushrooms …
 Inventories (ingredients) : 300 €/ all the days
 Salary : 2 000 €/month
 Cash : 200 € minimum/all the time
 Miscellaneous: 500 €/month
Advertisement, insurance, oil …
 Expected sales: 1000 pizzas/month 10 €/pizza
 Balance sheet at 01/01/2020

Asset Liability

Food truck 30 000 € Social capital 30 500 €

Inventories 300 €
Cash 200 €

TOTAL 30 500 € TOTAL 30 500 €

 Income statement- January 2020

Expenses Income

Ingredients 1 000 * 2 € = 2 000 € Sales 1 000 * 10 € = 10 000 €

Salaries 2 000 €
Miscellaneous 500 €
Depreciation allowances 500 €

Gross result 5 000 €

Corporate tax (15%) 750 €
Net result 4 250 €
Evolution of cash position - January 2020

01.01.2020 200 €

Sales + 10 000 €
Ingredients - 2 000 €
∆ = 5 500 €
Salaries - 2 000 € ≠ 4 250 €
(net result)
Miscellaneous - 500 €

31.01.2020 = 5 700 €
 Income statement- January 2020 Income statement– Full year 2020

Expenses Income Expenses Income

Ingredients 1 000 * 2 € = 2 000 € Sales 1 000 * 10 € = 10 000 € Ingredients 12 000*2 €= 24 000 € Sales 12 000 * 10 € = 120 000 €

Salaries 2 000 € Salaries 24 000 €

Miscellaneous 500 € Miscellaneous 6 000 €

Depreciation allow. 500 € Depreciation allow. 6 000 €

Gross result 5 000 € Gross result 60 000 €

C. Tax (15%) 750 € C. Tax (15%) 9 000 €

Net result 4 250 € Net result 51 000 €

x 12
Assuming that the 12 months are identical …
 Balance sheet at 01/01/2020 Balance sheet at 31/01/2020

Asset Liability Asset Liability

Food truck 30 000 € Social capital 30 500 € Food truck 30 000 € Social capital 30 500 €
Depreciation -6 000 € Net result 51 000 €

Inventories 300 € Inventories 300 €

Cash 200 € Cash ? Debt to state 9 000 €

(C. Tax)

TOTAL 30 500 € TOTAL 30 500 € TOTAL 90 500 € TOTAL 90 500 €

 Balance sheet at 01/01/2020 Balance sheet at 31/01/2020

Asset Liability Asset Liability

Food truck 30 000 € Social capital 30 500 € Food truck 30 000 € Social capital 30 500 €
Depreciation -6 000 € Net result 51 000 €

Inventories 300 € Inventories 300 €

Cash 200 € Cash 66 200 € Debt to state 9 000 €

(C. Tax)

TOTAL 30 500 € TOTAL 30 500 € TOTAL 90 500 € TOTAL 90 500 €

Evolution of cash position– Full year 2020

01.01.2020 200 €

Sales + 120 000 €

Ingredients - 24 000 €
Salaries - 24 000 €
Miscellaneous - 6 000 €

31.01.2020 = 66 200 €
 Income statement- January 2020 Income statement– Full year 2020

Expenses Income Expenses Income

Ingredients 1 000 * 2 € = 2 000 € Sales 1 000 * 10 € = 10 000 € Ingredients 12 000*2 €= 24 000 € Sales 12 000 * 10 € = 120 000 €

Salaries 2 000 € Salaries 24 000 €

Miscellaneous 500 € Miscellaneous 6 000 €

Depreciation allow. 500 € Depreciation allow. 6 000 €

Gross result 5 000 € Gross result 60 000 €

C. Tax (15%) 750 € C. Tax (15%) 9 000 €

Net result 4 250 € Net result 51 000 €

x 12
Assuming that the 12 months are identical …
 Income statement- January 2020 Income statement– Full year 2020

Expenses Income Expenses Income

100 100 1 200 1 200

Ingredients 1 000 * 2 € = 200 € Ventes 1 000 * 10 € = 1 000 € Ingredients 12 000*2 €= 2 400 € Sales 12 000 * 10 € = 12 000 €

Salaries 2 000 € Salaries 24 000 €

Miscellaneous 500 € Miscellaneous 6 000 €

Depreciation allow. 500 € Depreciation allow. 6 000 €

Gross result -2 200 € Gross result -26 400 €

Corporate tax 0€ Corporate tax 0€

Net result -2 200€ Net result -26 400 €

x 12
Assuming that the 12 months are identical …
 Balance sheet at 01/01/2020 Balance sheet at 31/12/2020

Asset Liability Asset Liability

Food truck 30 000 € Social capital 30 500 € Food truck 30 000 € Social capital 30 500 €
Depreciation -6 000 € Net result -26 400 €

Inventories 300 € Inventories 300 € Debt to state 0€

Cash 200 € Cash ?

TOTAL 30 500 € TOTAL 30 500 € TOTAL 24 300 € TOTAL 4 100 €
 Balance sheet at 01/01/2020 Balance sheet at 31/12/2020

Asset Liability Asset Liability

Food truck 30 000 € Social capital 30 500 € Food truck 30 000 € Social capital 30 500 €
Depreciation -6 000 € Net result -26 400 €

Inventories 300 € Inventories 300 € Debt to state 0€

Cash 200 € Bank overdraft 20 200 €

TOTAL 30 500 € TOTAL 30 500 € TOTAL 24 300 € TOTAL 24 300 €

 Balance sheet at 01/01/2020 Balance sheet at 31/12/2020

Asset Liability Asset Liability

Food truck 30 000 € Social capital 30 500 € Food truck 30 000 € Social capital 30 500 €
Depreciation -6 000 € Net result -26 400 €

Inventories 300 € Inventories 300 € Debt to state 0€

Cash 200 € Bank overdraft 20 200 €

TOTAL 30 500 € TOTAL 30 500 € TOTAL 24 300 € TOTAL 24 300 €

Legal obligations

 The annual accounts of each company* in France must be established each

year and send to the state: they necessarily include the Balance Sheet and
the Income statement (and the Legal Appendix which contains details
allowing their complete interpretation).

 The cash flow statement is in general not a legal obligation, but it is a very
useful statement for financial analysis.

* Some exceptions (simplifications) exist for auto entrepreneurship.

22
Traduction

English Français
Balance sheet Bilan
Asset Actif
Liability Passif
Income statement / P&L Compte de résultat
Income Produit
Expense Charge
Cash-flow statement Tableau des flux de trésorerie
Cash-in Encaissement
Cash-out Décaissement

23
 Balance sheet
What the company owns and what the company owes
 Part 1 :
General Description of Balance Sheet
Balance sheet
= a photograph of the patrimony of company at an accurate
moment (in general at 31/12/N)

BALANCE SHEET

ASSETS = Valued list of all the LIABILITIES = Valued list of all

properties and rights owned by the equity and debts that the
the company company owes

 The assets are the true values.  The liabilities specify the
“partition” of the assets.

∑ Assets = ∑ Liabilities 3
Balance sheet
f

= by implication, it is also a representation of the financial

situation of a company:

BALANCE SHEET

ASSETS = List of all the LIABILITIES = List of all the

elements acquired by the resources of capital put at
company thanks to these disposal of the company
resources of capital.

 The assets are the financials  The liabilities are the

uses. financials resources.

∑ Assets = ∑ Liabilities 4
Balance sheet
BALANCE SHEET
ASSETS LIABILITIES
EQUITY:
- Share capital
FIXED ASSETS - Reserves
- Tangible assets - Result
- Intangible assets
- Financial assets LT/MT FINANCIAL DEBTS:
- Long term debts
- Medium term debts

OPERATING CURRENT ASSETS OPERATING CURRENT LIABILITIES

- Inventories - Trade payables
- Trade receivables - Other payables
- Other receivables

CASH ASSETS CASH LIABILITIES

- Cash and cash equivalent - Short term-debts
(bank overdraft) 5
 Balance sheet
BALANCE SHEET
ASSETS LIABILITIES
EQUITY:
- Share capital
FIXED ASSETS - Reserves
- Tangible assets - Result
INCREADING LIQUIDITY

INCREASING PAYABILITY
- Intangible assets
- Financial assets LT/MT FINANCIAL DEBTS:
- Long term debts
- Medium term debts

OPERATING CURRENT ASSETS OPERATING CURRENT LIABILITIES

- Inventories - Trade payables
- Trade receivables - Other payables
- Other receivables

CASH ASSETS CASH LIABILITIES

- Cash and cash equivalent - Short term-debts
(bank overdraft) 6
 Part 2 :
The assets
What the company owns
The assets
BALANCE SHEET
ASSETS LIABILITIES
EQUITY:
- Share capital
FIXED ASSETS - Reserves
- Tangible assets - Result
- Intangible assets
- Financial assets LT/MT FINANCIAL DEBTS:
- Long term debts
- Medium term debts

OPERATING CURRENT ASSETS OPERATING CURRENT LIABILITIES

- Inventories - Trade payables
- Trade receivables - Other payables
- Other receivables

CASH ASSETS CASH LIABILITIES

- Cash and cash equivalent - Short term-debts
(bank overdraft) 8
Fixed assets
BALANCE SHEET
ASSETS LIABILITIES
EQUITY:
- Share capital
FIXED ASSETS - Reserves
- Tangible assets - Result
- Intangible assets
- Financial assets LT/MT FINANCIAL DEBTS:
- Long term debts
- Medium term debts

OPERATING CURRENT ASSETS OPERATING CURRENT LIABILITIES

- Inventories - Trade payables
- Trade receivables - Other payables
- Other receivables

CASH ASSETS CASH LIABILITIES

- Cash and cash equivalent - Short term-debts
(bank overdraft) 9
Fixed assets

Definition
The fixed assets are what the company owns for several cycles of
operation (= an investment cycle ≈ more than a year).

They are classified in 3 different categories:

 The tangible fixed assets are the physical assets
Example: Machines, lands, buildings, facilities

 The financial fixed assets are the long-term investments that the
company realized in other companies
Example: Ownership interest in other companies (subsidiary), Stocks of other companies

 The intangible fixed assets are the fixed assets that are neither
tangible nor financial assets 10
Example: Patent, brand, goodwill
Depreciations of fixed assets

The fixed assets are depreciated with the time. To take into
account these depreciations, the gross value of the assets (the
price of purchase) is indicated in the assets with a positive sign (+)
and just below the cumulated depreciation is indicated with a
minus sign (-). Thus, it is possible to deduce quickly the net value
of the asset (= gross value – accumulated depreciation).

 To go further, please have a look on the slides about

depreciations.

11
Why do companies have more or less
fixed assets than others ?

First because of their activity (eg. hairdresser vs steel

industry)

And for companies doing the same activity:

- Renting vs property
- Age of fixed assets
- Sub-contracting or not
- Location of the asset (instead of owning the asset)
12
- And above all, the volume of activity
Why do companies have more or less
fixed assets than others ?

Productivity of fixed assets:

𝑆𝑎𝑙𝑒𝑠
=
𝐹𝑖𝑥𝑒𝑑 𝑎𝑠𝑠𝑒𝑡𝑠

We want this ratio to be as high as possible

 Cf. company with 3 cars 3 taxi drivers VS 1 car 3 taxi drivers in 3*8h.

13
Operating current assets
BALANCE SHEET
ASSETS LIABILITIES
EQUITY:
- Share capital
FIXED ASSETS - Reserves
- Tangible assets - Result
- Intangible assets
- Financial assets LT/MT FINANCIAL DEBTS:
- Long term debts
- Medium term debts

OPERATING CURRENT ASSETS OPERATING CURRENT LIABILITIES

- Inventories - Trade payables
- Trade receivables - Other payables
- Other receivables

CASH ASSETS CASH LIABILITIES

- Cash and cash equivalent - Short term-debts
(bank overdraft) 14
Operating current assets
Definition
The operating current assets are composed of the assets that can be
transformed into cash in a short-term period (less than a year) in link
with the operational cycle of the company.

They can be essentially classified in 2 categories:

 The inventories
Example: finished product inventory, current manufacturing
inventory, raw material inventory
 Les operating receivables are claims that the company holds on
third parties as part of its operating cycle (this is money that the
third parties owe to the company)
They are essentially composed of trade receivables that the
clients must pay soon, but it can also be receivables from
State. 15
Inventories
Definition
The inventories are products stored by the company. These products are
supposed to be transformed or sold by the company during its operating
cycle.
Example: finished product inventory, current manufacturing inventory, raw
material inventory

Importance to check the inventory level

- Shortage during the operating cycle (sub-optimization)
- Financing the Working Capital Requirement (cf. slides on WCR)
- It can be a sign of slowdown in activity

16
Trade receivables
Definition
Trade receivables correspond to amount of money that the clients of the
company have to pay to the company. The clients had been delivered and
invoiced by the company but they benefit from a payment delay between the
reception of the invoice and the effective settlement (eg: 30 days/45
days/60 days/90 days, depending on the sector of activity and the power of
negotiation between clients and suppliers)

The mean payment delay of trade receivables can be also very different
from the country:
- Denmark: 47 days
- USA: 50 days
- Germany: 54 days
- France: 74 days
- Italy: 83 days 17

Source: Etude Euler Hermès, 2017

Cash assets
BALANCE SHEET
ASSETS LIABILITIES
EQUITY:
- Share capital
FIXED ASSETS - Reserves
- Tangible assets - Result
- Intangible assets
- Financial assets LT/MT FINANCIAL DEBTS:
- Long term debts
- Medium term debts

OPERATING CURRENT ASSETS OPERATING CURRENT LIABILITIES

- Inventories - Trade payables
- Trade receivables - Other payables
- Other receivables

CASH ASSETS CASH LIABILITIES

- Cash and cash equivalent - Short term-debts
(bank overdraft) 18
Cash assets

Definition

The cash assets correspond to the assets that are very liquid (ie.
already in form of cash or that can be transformed quickly into cash).
They can be split in 2 categories:

Short-term investments or marketable securities are financial

securities that companies acquire with their surplus cash. This is for
companies to obtain a correct rate of return in the short term by
investing these surplus cash. These securities must be very liquid, ie.
exchangeable for cash quickly.
Example: treasury bills less than a year.

Cash on hand consists of cash held in physical cash (banknote and

coins) and positive amounts held in the company's current bank
accounts. 19
 Part 3 :
The liabilities
What the company owes
The liabilities
BALANCE SHEET
ASSETS LIABILITIES
EQUITY:
- Share capital
FIXED ASSETS - Reserves
- Tangible assets - Result
- Intangible assets « Stable resources »
- Financial assets LT/MT FINANCIAL DEBTS:
- Long term debts
- Medium term debts

OPERATING CURRENT ASSETS OPERATING CURRENT LIABILITIES

- Inventories - Trade payables
- Trade receivables - Other payables
- Other receivables

CASH ASSETS CASH LIABILITIES

- Cash and cash equivalent - Short term-debts
(bank overdraft) 21
Equity
BALANCE SHEET
ASSETS LIABILITIES
EQUITY:
- Share capital
FIXED ASSETS - Reserves
- Tangible assets - Result
- Intangible assets
- Financial assets LT/MT FINANCIAL DEBTS:
- Long term debts
- Medium term debts

OPERATING CURRENT ASSETS OPERATING CURRENT LIABILITIES

- Inventories - Trade payables
- Trade receivables - Other payables
- Other receivables

CASH ASSETS CASH LIABILITIES

- Cash and cash equivalent - Short term-debts
(bank overdraft) 22
Equity
Definition
Equity represents the money brought by the shareholders to the
creation of the company or latter, or left at the disposal of the
company as undistributed profits.

Equity consists in the following elements:

 Share capital: the money brought by shareholders at the creation of the
company or later in case of increase of social capital
 Reserves / Retained earnings: results of previous years that have not
been distributed as dividends to shareholders
 Result/profit: this is the net result of the year covered by the balance
sheet

Equity is a stable resource that can finance investments and many

operating cycles.
23
LT/MT financial debts
BALANCE SHEET
ASSETS LIABILITIES
EQUITY:
- Share capital
FIXED ASSETS - Reserves
- Tangible assets - Result
- Intangible assets
- Financial assets LT/MT FINANCIAL DEBTS:
- Long term debts
- Medium term debts

OPERATING CURRENT ASSETS OPERATING CURRENT LIABILITIES

- Inventories - Trade payables
- Trade receivables - Other payables
- Other receivables

CASH ASSETS CASH LIABILITIES

- Cash and cash equivalent - Short term-debts
(bank overdraft) 24
LT/MT financial debts
Definition
Financial debts are loans that a company subscribes to lenders to finance its
activity. These loans are made in exchange of a remuneration of the lenders
(the interest rate) and a promise to reimburse the capital.
MT / LT financial debts include medium-term (1 to 7 years) and long-term (over
7 years) financial debts.
NB: the short-term financial debts (<1 year) are by definition not considered in
the MT / LT debts but in the cash liabilities.
Characteristics
In addition to their duration, the loans are differentiated by:
 The interest rate: variable or fixed
 The number of lenders: classic borrowing from a single lender (usually a
bank) or from several lenders (bond issues raised on the financial markets)
 The terms of repayment of capital: in fine (the capital is repaid in one time
25
at the end) or gradually amortized (by constant amortized capital or by
constant annuity)
LT/MT financial debts

Example 1: Loan of a capital of 100 000 €. Interest rate = 5% constant.

Reimbursement in fine (=bullet loan).

Year 1 2 3 4 5
Remaining capital at the beginning of the 100 000 € 100 000 € 100 000 € 100 000 € 100 000 €
year Y

Annual capital reimbursement 0€ 0€ 0€ 0 € 100 000 €

Annual interest 5 000 € 5 000 € 5 000 € 5 000 € 5 000 €

Total annuity 5 000 € 5 000 € 5 000 € 5 000 € 105 000 €

26
LT/MT financial debts

Example 2: Loan of a capital of 100 000 €. Interest rate = 5% constant.

Repayment with constant amortization of capital.

Year 1 2 3 4 5
Remaining capital at the beginning of the 100 000 € 80 000 € 60 000€ 40 000€ 20 000€
year Y

Annual capital reimbursement 20 000€ 20 000€ 20 000€ 20 000€ 20 000€

Annual interest 5 000 € 4 000 € 3 000 € 2 000 € 1 000 €

Total annuity 25 000 € 24 000 € 23 000 € 22 000 € 21 000 €

27
LT/MT financial debts

Example 3: Loan of a capital of 100 000 €. Interest rate = 5% constant.

Repayment with constant total annuities.

Year 1 2 3 4 5
Remaining capital at the beginning of the 100 000 € 81 903 € 62 900 € 42 948 € 21 998 €
year Y

Annual capital reimbursement 18 097 € 19 002 € 19 952 € 20 950 € 21 998 €

Annual interest 5 000 € 4 095 € 3 145 € 2 147 € 1 100 €

Total annuity 23 097 € 23 097 € 23 097 € 23 097 € 23 097 €

28
Operating current liabilities
BALANCE SHEET
ASSETS LIABILITIES
EQUITY:
- Share capital
FIXED ASSETS - Reserves
- Tangible assets - Result
- Intangible assets
- Financial assets LT/MT FINANCIAL DEBTS:
- Long term debts
- Medium term debts

OPERATING CURRENT ASSETS OPERATING CURRENT LIABILITIES

- Inventories - Trade payables
- Trade receivables - Other payables
- Other receivables

CASH ASSETS CASH LIABILITIES

- Cash and cash equivalent - Short term-debts
(bank overdraft) 29
Operating current liabilities
Definition
Operating current liabilities, as their name indicates, are the debts
related to the operating cycle of the company.
They consist in particular of:
 Trade payables, since the company usually has a payment period
between receipt of the invoice and effective settlement. This is
usually the biggest item of operating current liabilities.
 Tax and social debts
 Any advances received from customers.
Unlike financial debts, these are "free" debts (ie, with no interest to
be paid) for the company, provided that the settlement is done in
due time, respecting the deadlines.
30
Cash liabilities
BALANCE SHEET
ASSETS LIABILITIES
EQUITY:
- Share capital
FIXED ASSETS - Reserves
- Tangible assets - Result
- Intangible assets
- Financial assets LT/MT FINANCIAL DEBTS:
- Long term debts
- Medium term debts

OPERATING CURRENT ASSETS OPERATING CURRENT LIABILITIES

- Inventories - Trade payables
- Trade receivables - Other payables
- Other receivables

CASH ASSETS CASH LIABILITIES

- Cash and cash equivalent - Short term-debts
(bank overdraft) 31
Cash liabilities

Definition

These are the short-term financial debts of the company.

They consist of bank overdrafts allowed by the bank of the company.

NB: Like all financial debts, these short-term financial debts result in the
payment of interest (sometimes called agios or penalties, for bank
overdraft).

32
 Exercise
Guess which company it is
N°1
Exercise: Guess which company it is
Companies to find: BNP, Pernod-Ricard, Carrefour, RTE
A B C D
Assets
Intangible assets 1% 27% 33% 12%
Tangible assets 86% 31% 13% 1%
Financial assets 0% 3% 1% 1%
Inventories 1% 14% 33% 0%
Trade receivables and other r. 9% 17% 18% 58%
Cash 3% 8% 2% 28%
100% 100% 100% 100%

Liabilities
Equity 35% 24% 39% 4%
Provisions 3% 5% 5% 0%
Financial debts 50% 24% 43% 27%
Trade payables and other p. 12% 47% 14%
Advances to customers 69%
100% 100% 100% 100%
Exercise: Guess which company it is
Companies to find: BNP, Pernod-Ricard, Carrefour, RTE
A B C D
Assets
Intangible assets 1% 27% 33% 12%
Tangible assets 86% 31% 13% 1%
Financial assets 0% 3% 1% 1%
Inventories 1% 14% 33% 0%
Trade receivables and other r. 9% 17% 18% 58%
Cash 3% 8% 2% 28%
100% 100% 100% 100%

Liabilities
Equity 35% 24% 39% 4%
Provisions 3% 5% 5% 0%
Financial debts 50% 24% 43% 27%
Trade payables and other p. 12% 47% 14%
Advances to customers 69%
100% 100% 100% 100%
 Exercise
Guess which company it is
N° 2
These 4 balance sheets belong to the following 4 companies::
 Mc Donald’s Corporation, a US-based fast food restaurant chain, famous for its
burgers.
Did you know it? In the United States (its country of origin and one of the biggest
market) the group owns the buildings of its own restaurants.
 Carrefour, French group in the large-retail sector (hypermarkets, supermarkets
and convenience stores).
Did you know it? Since 1999, Carrefour has been Europe's large retailer number one.
 L’Oréal, large French group specializing in cosmetics. The Bettencourt family
owns 33% of the group's shares.
Did you know it? The group owns a multitude of patents in this sector and holds
stakes in numerous companies including Sanofi (a world leader in the
pharmaceutical sector).
 Laurent Perrier, is a company that produces and markets the famous brand of the
same name of champagne
Did you know it? The champagne is sold at the earliest three to five years after the
harvest, the minimum time required to obtain a quality sparkling wine. 37
Exercise: Guess which company it is
Companies to find: McDonald’s, Carrefour, L’Oreal, Laurent Perrier
A B C D
Intangible assets 23% 31% 3% 17%
Tangible assets 30% 10% 25% 68%
Financial assets 1% 28% 0% 6%
Deferred taxe assets and other 16% 3% 1% 0%
Inventories 16% 7% 64% 0%

Trade receivables and other receiv. 6% 14% 4% 5%

Cash assets 8% 7% 3% 4%
TOTAL ASSETS 100% 100% 100% 100%

Equity 25% 63% 43% 35%

Provisions 9% 7% 0% 2%
Financial Debt 21% 10% 39% 62%

Trade payables and other payables 36% 11% 10% 1%

Unearned revenue and other 9% 9% 8% 0%
TOTAL LIABILITIES 100% 100% 100% 100%
 Part 4 :
WCR
Working Capital Requirement
Balance sheet
BALANCE SHEET
ASSETS LIABILITIES
EQUITY:
- Share capital
FIXED ASSETS - Reserves
- Tangible assets - Result
- Intangible assets
- Financial assets LT/MT FINANCIAL DEBTS:
- Long term debts
- Medium term debts

OPERATING CURRENT ASSETS OPERATING CURRENT LIABILITIES

- Inventories - Trade payables
- Trade receivables - Other payables
- Other receivables

CASH ASSETS CASH LIABILITIES

- Cash and cash equivalent - Short term-debts
(bank overdraft) 40
If you invest in a fixed asset, it will be in your company for several years.
To acquire it, common sense will naturally make you finance this
investment by stable resources that will be there for several years
(equity or medium-long term financial debt) because it will be a
permanent need.

But, fixed assets are not the only permanent need that you will have to
finance ... there is also the WCR !

41
Working Capital Requirement (WCR)

For the moment, to have an overview without formula :

The production process of an industrial company requires the

acquisition of raw materials (the suppliers send their invoices that
must be paid within a delay). These raw materials will be
transformed into current manufacturing products, then turn into
stock of finished products. These finished products will be sold:
first delivered with invoiced, then paid after a delay of payment
for the company's clients.

 The company will therefore have spent euros to pay its

suppliers and have its inventories even before receiving the first
cash payments from its sales. This permanent gap of time, linked
to the operating cycle of the company, therefore requires an
investment of the company. It is measured using the Working
Capital Requirement: the WCR. 42
 WCR
BALANCE SHEET
ASSETS LIABILITIES
EQUITY:
- Share capital
FIXED ASSETS - Reserves
- Tangible assets - Result
- Intangible assets
- Financial assets LT/MT FINANCIAL DEBTS:
- Long term debts
- Medium term debts

OPERATING CURRENT ASSETS OPERATING CURRENT LIABILITIES

WCR - Inventories - Trade payables
- Trade receivables - Other payables
- Other receivables

CASH ASSETS CASH LIABILITIES

- Cash and cash equivalent - Short term-debts
(bank overdraft) 43
Working Capital Requirement (WCR)
Formula:

𝑊𝐶𝑅 = 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠– 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

𝑊𝐶𝑅 = 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑖𝑒𝑠 + 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 – 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑝𝑎𝑦𝑎𝑏𝑙𝑒𝑠

𝑊𝐶𝑅 ≈ 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑖𝑒𝑠 + 𝑇𝑟𝑎𝑑𝑒 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 – 𝑇𝑟𝑎𝑑𝑒 𝑝𝑎𝑦𝑎𝑏𝑙𝑒𝑠

This last formula is an approximation, considering that trade receivables and trade
payables represent the most important part of the operating receivables and of the
operating payables.

Key-attribute:
While each of these one-to-one elements has a short life span linked
to the operating cycle, their aggregate via the WCR formula is
relatively stable in time : this characterizes a permanent need for 44
the company.
Working Capital Requirement (WCR)

The WCR therefore needs to be financed. This is a key parameter to

watch for a company, as its impact on cash is important if it is not
properly funded.

To illustrate this:

 Just after this slides, the « the twin companies » examples …

… or how to die while you were in an excellent health !

45
 Balance sheet Company A

Asset (k€) Y Y+1 Liability (k€) Y Y+1

Machine 100 170 Capital 30 40

Inventory 20 40 Result 10 20
Trade receivables 10 20 Trade payables 100 200

Cash 10 30

TOTAL 140 260 TOTAL 140 260

 Balance sheet Company B

Asset (k€) Y Y+1 Liability (k€) Y Y+1

Machine 100 170 Capital 240 270

Inventory 90 180 Result 30 60
Trade receivables 80 160 Trade payables 10 20

Cash 10 Bank overdraft 160

TOTAL 280 510 TOTAL 280 510

 Balance sheet Company B

Asset (k€) Y Y+1 Liability (k€) Y Y+1

Machine 100 170 Capital 240 270

Inventory 90 180 Result 30 60
Trade receivables 80 160 Trade payables 10 20

Cash 10 Bank overdraft 160

TOTAL 280 510 TOTAL 280 510

 Balance sheet Company A
Asset (k€) Y Y+1 Liability (k€) Y Y+1

Machine 100 170 Capital 30 40

Inventory 20 40 Result 10 20
Trade receivables 10 20 Trade payables 100 200

Cash 10 30

TOTAL 140 260 TOTAL 140 260

WCR -70 -140
The WCR is negative… Here, it is not a requirement (need), it is a resource for the company !
 Balance sheet Company B
Asset (k€) Y Y+1 Liability (k€) Y Y+1

Machine 100 170 Capital 240 270

Inventory 90 180 Result 30 60
Trade receivables 80 160 Trade payables 10 20

Cash 10 Bank overdraft 160

TOTAL 280 510 TOTAL 280 510

WCR 160 320
WCR is positive … The increase of activity generates an increase of this requirement (need) that was not
properly financed here.
Conclusions about this example (1/2)
If you manage a company, you will probably be tempted into the to
realize one or more of the following three actions:
- Increase your inventories (to avoid a shortage and a stop in your
production plan)
- Increase the delay of payment of your clients (so that they
appreciate you)
- Reduce the delay of payment of your suppliers (so that they
appreciate you)

Each of these 3 actions will have an unfavorable effect on your

WCR, and therefore on your cash position.
So each time, there is a compromise to find.
And if you choose to do these kinds of actions, you have to think
about financing this increase in WCR (which has a cost). 51
Conclusions about WCR (2/2)

In addition, if your WCR is positive (classic case for industrial

companies), any strong rise in activity will generate a strong rise of the
WCR ... which must be financed, otherwise you will be soon short of cash
(cf. example of “the twin companies” ).

52
Why do companies have more or less
WCR than others?

First depending on their activities (ex: Airbus vs. a supermarket)

And for companies doing the same activity:

- Delay of payments
- Inventory management
- And above all, the volume of activity

53
Why do companies have more or less
WCR than others?

Productivity of WCR:

𝑆𝑎𝑙𝑒𝑠
=
𝑊𝐶𝑅

We want this ratio to be as high as possible.

54
Ratio about WCR
Frequently used to transform in « days » the WCR elements:

𝑊𝐶𝑅
∗ 365
𝐴𝑛𝑛𝑢𝑎𝑙 𝑠𝑎𝑙𝑒𝑠 (𝑒𝑥𝑐𝑙. 𝑉𝐴𝑇)

𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
∗ 365
𝐴𝑛𝑛𝑢𝑎𝑙 𝑠𝑎𝑙𝑒𝑠 (𝑒𝑥𝑐𝑙. 𝑉𝐴𝑇)

𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠
∗ 365
𝐴𝑛𝑛𝑢𝑎𝑙 𝑠𝑎𝑙𝑒𝑠 (𝑖𝑛𝑐𝑙. 𝑉𝐴𝑇)

𝑃𝑎𝑦𝑎𝑏𝑙𝑒𝑠
∗ 365
𝐴𝑛𝑛𝑢𝑎𝑙 𝑝𝑢𝑟𝑐ℎ𝑎𝑠𝑒𝑠 (𝑖𝑛𝑐𝑙. 𝑉𝐴𝑇) 55
Exercise – ratio about WCR
The following date about the WCR of a company over 5 years are:
In M€ 1 2 3 4 5

Inventory (finished goods) 6,1 7,4 9,1 13 15,4

Operating receivables 6,4 8,9 10,5 11,1 11,6

Operating payables 2,1 3,5 3,5 3,8 3,4

And you get or calculate the following data from the income statement:
In M€ 1 2 3 4 5

Sales (excl. VAT) 32,8 44,7 49,4 48,9 50

Sales (incl. VAT) 38,9 52,6 58,1 57,4 57,2

Purchases (incl. VAT) 12,5 19,2 19,6 20,9 20,4

56
Calculate the different ratios of the WCR. What do you deduce?
Exercise – ratio about WCR
Correction
1 2 3 4 5
WCR (M€) –rough estimation 10,4 12,8 16,1 20,3 23,6
WCR (days) 116 105 119 152 172
Inventories (days) 68 60 67 97 112
Receivables (days) 60 62 66 71 74
Payables (days) 61 67 65 66 61

1 2 3 4 5
Sales– Purchases
incl. VAT (M€) 26,4 33,4 38,5 36,5 36,8

57
Exercise – ratio about WCR
Correction
1 2 3 4 5
WCR (M€) 10,4 12,8 16,1 20,3 23,6
WCR (days) 116 105 119 152 172
Inventories (days) 68 60 67 97 112
Receivables (days) 60 62 66 71 74
Payables (days) 61 67 65 66 61

1 2 3 4 5
Sales– Purchases
incl. VAT (M€) 26,4 33,4 38,5 36,5 36,8
The company is experiencing a difficult situation, it is struggling to sell its
inventories of finished products that increase. To avoid a decline in sales and margins
(sales-purchases), it has an accommodating policy towards its customers by
increasing the average duration of payment of receivables. All this is reflected on
the WCR, which has increased considerably over the period. To maintain an
attractive income statement, the company "sacrifices" its balance sheet. It can only
last a while. 58
 Part 5 :
Capital-employed analysis of the
balance sheet
From accounting to economic vision

The objective is to start from the accounting balance sheet, little

economically speaking, to build a balance sheet in "economic vision",
called “capital-employed balance sheet”.

60
The balance sheet in accounting (reminder)

BALANCE SHEET
ASSETS LIABILITIES
EQUITY:
- Share capital
FIXED ASSETS - Reserves
- Tangible assets - Result
- Intangible assets
- Financial assets LT/MT FINANCIAL DEBTS:
- Long term debts
- Medium term debts

OPERATING CURRENT ASSETS OPERATING CURRENT LIABILITIES

- Inventories - Trade payables
- Trade receivables - Other payables
- Other receivables

CASH ASSETS CASH LIABILITIES

- Cash and cash equivalent - Short term-debts
(bank overdraft) 61
What do you think of the situation of this company?

A company has a high level of trade receivables that represent nearly 75

days of sales including VAT.

Trade payables represent 90 days of the purchases made (incl. VAT).

Possible answers:
 It is not a big issue
 That is a problem
 I do not know
62
What do you think of the situation of this company?

A company has a high level of trade receivables that represent nearly 75

days of sales including VAT.

Trade payables represent 90 days of the purchases made (incl. VAT).

Possible answers:
 It is not a big issue
 That is a problem
 I do not know
63
What do you think of the situation of this company?

A company has a high level of trade receivables that represent nearly 75

days of sales including VAT.

Trade payables represent 90 days of the purchases made (incl. VAT).

It is the WCR that matters and not the absolute
level of each of these 3 components.
The WCR needs to be financed, as an investment
on the assets side.
In economic vision, the WCR is represented on the
Possible answers: assets side of the balance sheet.
 It is not a big issue The economic asset also called “capital
employed” becomes equal to fixed assets + WCR.
 That is a problem On the liabilities side, there remains only equity
 I do not know and financial debts, that is, "paying" resources;
Operating debts that were "free" were included in
64
the WCR on the asset side.
Transforming Balance sheet to an economic vision
BALANCE SHEET
ASSETS LIABILITIES
EQUITY:
- Share capital
FIXED ASSETS - Reserves
- Tangible assets - Result
- Intangible assets
- Financial assets LT/MT FINANCIAL DEBTS:
- Long term debts
- Medium term debts

OPERATING CURRENT ASSETS OPERATING CURRENT LIABILITIES

- Inventories - Trade payables
- Trade receivables - Other payables
- Other receivables

CASH ASSETS CASH LIABILITIES

- Cash and cash equivalent - Short term-debts
(bank overdraft) 65
Transforming Balance sheet to an economic vision
BALANCE SHEET
ASSETS LIABILITIES
EQUITY:
- Share capital
FIXED ASSETS - Reserves
- Tangible assets - Result
- Intangible assets
- Financial assets LT/MT FINANCIAL DEBTS:
- Long term debts
- Medium term debts

WCR
= Inventories + Operating
receivables – Operating payables

CASH LIABILITIES
CASH ASSETS
- Short term-debts
- Cash and cash equivalent
(bank overdraft)
66
 Transforming Balance sheet to an economic vision
BALANCE SHEET
ASSETS LIABILITIES
EQUITY:
- Share capital
FIXED ASSETS - Reserves
- Tangible assets - Result
- Intangible assets
- Financial assets
Capital employed is
CAPITAL LT/MT FINANCIAL DEBTS:
- Long term debts
composed of Fixed
EMPLOYED assets and WCR.
- Medium term debts

WCR
= Inventories + Operating
receivables – Operating payables

CASH LIABILITIES
CASH ASSETS
- Short term-debts
- Cash and cash equivalent
(bank overdraft)
67
What do you think about the debt level of this company?

BALANCE SHEET
Equity 10
Financial debts 90
TOTAL ASSETS 100 TOTAL LIBILITIES 100

Possible answers: The debt level is:

 Too high
 High
 Medium
 Low
 Very low
68
 I do not know
What do you think about the debt level of this company?

BALANCE SHEET
Fixed assets + WCR 15 Equity 10
Cash assets 85 Financial debts 90
TOTAL ASSETS 100 TOTAL LIBILITIES 100

Possible answers: The debt level is:

 Too high
 High
 Medium
 Low
 Very low
69
 I do not know
What do you think about the debt level of this company?

BALANCE SHEET
Fixed assets + WCR 15 Equity 10
Cash assets 85 Financial debts 90
TOTAL ASSETS 100 TOTAL LIBILITIES 100

Possible answers: The debt level is:

It is the net debt (= financial
 Too high debts - cash assets) which make it
possible to judge the debt level
 High and not the financial debts alone!
 Medium
 Low
 Very low
70
 I do not know
 Transforming Balance sheet to an economic vision
BALANCE SHEET
ASSETS LIABILITIES
EQUITY:
- Share capital
FIXED ASSETS - Reserves
- Tangible assets - Result
- Intangible assets
CAPITAL - Financial assets LT/MT FINANCIAL DEBTS:
EMPLOYED - Long term debts
- Medium term debts

WCR
= Inventories + Operating
receivables – Operating payables

CASH LIABILITIES
CASH ASSETS
- Short term-debts
- Cash and cash equivalent
(bank overdraft)
71
 Transforming Balance sheet to an economic vision
BALANCE SHEET
ASSETS LIABILITIES
EQUITY:
- Share capital
FIXED ASSETS - Reserves
- Tangible assets - Result
- Intangible assets
CAPITAL - Financial assets
EMPLOYED

FINANCIAL DEBTS:
WCR - Long term debts
= Inventories + Operating - Medium term debts
receivables – Operating payables - Short term-debts
(bank overdraft)
CASH ASSETS
- Cash and cash equivalent
72
 Transforming Balance sheet to an economic vision
BALANCE SHEET
ASSETS LIABILITIES
EQUITY:
- Share capital
FIXED ASSETS - Reserves
- Tangible assets - Result
- Intangible assets
CAPITAL - Financial assets
EMPLOYED

FINANCIAL DEBTS:
WCR - Long term debts
= Inventories + Operating - Medium term debts
receivables – Operating payables - Short term-debts
(bank overdraft)
CASH ASSETS
- Cash and cash equivalent
73
 Transforming Balance sheet to an economic vision
BALANCE SHEET
ASSETS LIABILITIES
EQUITY:
- Share capital
FIXED ASSETS - Reserves
- Tangible assets - Result
- Intangible assets
CAPITAL - Financial assets
EMPLOYED

WCR
NET DEBT
= Inventories + Operating
= Financial debts – Cash assets
receivables – Operating payables

74
 Transforming Balance sheet to an economic vision
BALANCE SHEET
ASSETS LIABILITIES

FIXED ASSETS EQUITY:

- Tangible assets - Share capital
- Intangible assets - Reserves
CAPITAL - Financial assets - Result
EMPLOYED

WCR NET DEBT

= Inventories + Operating = Financial debts – Cash assets
receivables – Operating payables

75
 Transforming Balance sheet to an economic vision
BALANCE SHEET
ASSETS LIABILITIES

FIXED ASSETS EQUITY:

- Tangible assets - Share capital
- Intangible assets - Reserves
CAPITAL - Financial assets - Result
EMPLOYED INVESTED
CAPITAL
WCR NET DEBT
= Inventories + Operating = Financial debts – Cash assets
receivables – Operating payables

76
 Economic vision :
The capital-employed analysis of balance sheet

BALANCE SHEET
ASSETS LIABILITIES

FIXED ASSETS EQUITY

CAPITAL INVESTED
EMPLOYED CAPITAL
WCR NET DEBT

77
Financial structure ratios
They show the breakdown of the invested capital to finance capital
employed between shareholders and lenders. These ratios can be
significantly different depending on the business sector (ie the "guarantee"
that lenders bring to the economic asset).

Either we look at the splitting :

𝐸𝑞𝑢𝑖𝑡𝑦
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑
𝑁𝑒𝑡 𝑑𝑒𝑏𝑡
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑
The sum of these 2 ratios is necessarly eaqual to 100%

Either we look at the gearing (financial leverage effect) :

𝑁𝑒𝑡 𝑑𝑒𝑏𝑡
𝐸𝑞𝑢𝑖𝑡𝑦 78
Financial structure ratios

Exercise – it’s up to you !

Put yourself in the shoes of a banker. A company comes to you to ask for
a loan. What is the order of magnitude the percentage you are willing to
𝑁𝑒𝑡 𝑑𝑒𝑏𝑡
accept for the ratio if the business company is:
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑

- A car dealer 70%-80%

- A pharmaceutical laboratory 20%-30%
- A start-up (internet platform) 0%-5%
- A real estate company 80%-95%
- An oil research company 0%
Source: La gestion financière de l’entreprise. Christian Pierrat
79
Financial structure ratios

Exercise – correction

Put yourself in the shoes of a banker. A company comes to you to ask for
a loan. What is the order of magnitude the percentage you are willing to
𝑁𝑒𝑡 𝑑𝑒𝑏𝑡
accept for the ratio if the business company is:
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑

- A car dealer 70%-80%

- A pharmaceutical laboratory 20%-30%
- A start-up (internet platform) 0%-5%
- A real estate company 80%-95%
- An oil research company 0%
Source: La gestion financière de l’entreprise. Christian Pierrat
80
EXERCISES
Exercise 1 : Balance sheet
Item Value at 31/12/Y in €
Fixed asset depreciations 4 000
Advance paid to suppliers 2 500
Treasury bill ( Cash assets) 1 500
Cash on hand 1 000
Capital (social capital + retained earnings) 12 000
Trade receivables 6 000
Bank overdraft 6 000
Medium term debts 6 500
Trade payables 8 000
Gross fixed assets 20 000
Net profit of year Y 3 500
Bank deposit 2 000
Inventories 7 000
 Question 1 : Realize the (accounting) balance sheet.
 Question 2: Calculate the Working Capital Requirement 82

 Question 3 : Transform the balance sheet in economic vision (capital-employed

analysis of balance sheet)
Exercise 1 Question 1 Accounting balance sheet
ASSETS LIABILITIES
Fixed assets Equity
Gross fixed assets 20 000 Capital 12 000
Stable
Depreciations -4 000 Net profit of year Y 3 500
resources
Operating current assets MT/LT Debt
Inventories 7 000 Medium-term debt 6 500

Advanced paid to suppliers 2 500 Operating current liabilities

Trade receivables 6 000 Trade payables 8 000

Cash assets Cash liabilities

Treasury bills 1 500 Bank overdraft 6 000

Bank (deposit) 2 000

Cash on hand 1 000

TOTAL ASSETS 36 000 TOTAL LIABILITIES 36 000

 Question 2: Calculate the Working Capital Requirement

83
 Question 3 : Transform the balance sheet in economic vision (capital-
employed analysis of balance sheet)
Exercise 1 Question 2 Working Capital
ASSETS LIABILITIES
Fixed assets Equity
Gross fixed assets 20 000 Capital 12 000
Stable
Depreciations -4 000 Net profit of year Y 3 500
resources
Operating current assets MT/LT Debt
Inventories 7 000 Medium-term debt 6 500

Advanced paid to suppliers 2 500 Operating current liabilities

Trade receivables 6 000 Trade payables 8 000

Cash assets Cash liabilities

Treasury bills 1 500 Bank overdraft 6 000

Bank (deposit) 2 000

Cash on hand 1 000

TOTAL ASSETS 36 000 TOTAL LIABILITIES 36 000

 WCR= Operating current assets – Operating current liabilities = 7500 € 84

Exercise 1 Question 3 – Capital-employed analysis of balance sheet

ASSETS LIABILITIES
Fixed assets 16 000 Equity 15 500
WCR 7 500 Net debt 8 000
CAPITAL EMPLOYED 23 500 INVESTED CAPITAL 23 500

 WCR= Operating current assets – Operating current liabilities = 7500 €

 Net debt = MT/LT debt + Cash liabilities –Cash assets = 8000 €

85
Exercise 1
Bonus (after the lecture about solvency)

MEDIUM TERM SOLVENCY

 Stables resources /Capital employed = 22 000 / 23 500 = 94 % >> 70%

 No solvency problem for this company on medium term !

86
 Income statement
Definitive gains and losses to explain the result on a period of time
 Part 1 :
Introduction to income statement
Income statement

The income statement records over a period the

creation of wealth (income=revenues) and
destruction of wealth (expenses=costs) to deduce the
net creation of wealth (profit=earnings) over this
period.

3
Question: Is there creation or destruction of wealth for you when:
- You buy a land at a fair price, neglecting transaction fees (notarial
costs)?
No. I turn cash into fixed assets. If I bought the land at the fair price, I can convert
this asset into cash for the same amount.
- Same question if you include transaction fees (notarial costs)
Still not for the purchase of the land itself. But, the transaction costs (notary fees)
correspond to a loss, ie. a destruction of wealth for you.
- If you borrow 200 000 €
No. I get 200 000 € cash against a commitment to repay (= a debt) of 200 000 €.
- If you repay each year 10% of this borrowed capital, or 20 000 € / year
over 10 years.
No. I return 20 000 € cash against a reduction of commitment to repay (= a debt) of
the same amount.
- If you pay each year 2% of the borrowed amount as interest
The interest paid corresponds to a loss, a destruction of wealth for you 4
(but a creation of wealth for the bank).
Income statement (P&L)
= the table to explain the result, ie. the net enrichment of
company during a period

INCOME STATEMENT
Expenses (E) Income (I)
=loss for the firm = final gain of the firm
= final and irreversible = definitive resources
uses of resources

Eg: taxes, wages, interest payments, Eg: sales, commissions received, fees
commissions paid, services purchased, received, interest earned
depreciation allowances.

Result = I – E -> Profit (if E<I)

 Expenses = Cash Expenses + Calculated Expenses

 Incomes = Cash income + Calculated Income
Income statement (P&L)
 Expenses = Cash Expenses + Calculated Expenses

Cash expenses: a negative impact on the result but also on cash

Ex: Wages, taxes, raw material purchase…

Calculated expenses: a negative impact on the result but NOT on

cash
Ex: depreciation in the value of assets, provision for a risk

Income = Cashable income + Calculated Income

Cashable income: a positive impact on the result but also on cash
Ex: sales of finished products

Calculated income: a positive impact on the result but NOT on cash

Ex: when you cancelled a provision for a risk
 Cash expenses Calculated expenses

Depreciation
allowances and
provision
allowances

Salaries, interests to pay to

the bank, rentals, purchase
of raw material...
Income statement
INCOME STATEMENT
Expenses (E) Income (I)

Result (Profit) = I-E (if I>E)

INCOME STATEMENT
Expenses (E) Income (I)

Result (Loss) = E-I (if I<E)

8
 Part 2 :
General organization
of the income statement
Income statement: general organization
INCOME STATEMENT
Operating expenses: Operating income:
- -
- -

Financial expenses: Financial income:

- -
- -

Non-recurring expenses: Non-recurring income:

- -
- -

----------------------------------------------
(Gross result: - )

Corporate tax:
10

Net result:
Income statement: general organization
INCOME STATEMENT FOR YEAR N
Operating income
-Operating expenses
=Operating result (1)

+Financial income
-Financial expenses
=Financial result (2)

+ Non-recurring income
-Non-recurring expenses
=Exceptional result(3)

- Corporate income tax (4)

=Net Result = Net income = Profit for the year = (1 +2 +3 -4)

Income statement: general organization
INCOME STATEMENT FOR YEAR N
Operating income
-Operating expenses
=Operating result (1)

+Financial income
-Financial expenses
=Financial result (2)

+ Non-recurring income
-Non-recurring expenses
=Non-recurring result(3)

- Corporate income tax (4)

=Net Result = Net income = Profit for the year = (1 +2 +3 -4)

Operating result
The operating result (also called EBIT) is the result realized by a company through
the usual exploitation of its only factors of production.

𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝒓𝒆𝒔𝒖𝒍𝒕 = 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝒊𝒏𝒄𝒐𝒎𝒆 – 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝒆𝒙𝒑𝒆𝒏𝒔𝒆𝒔

Operating incomes are composed of:

 Sales of manufactured products, services, goods
 Inventoried production (finished products manufactured but not yet sold)
 Capitalized production (production of the company for itself)

NB: The sum of all the sales of goods and services invoiced by the company over a
period is called the turnover of the company.
13
Operating result
The operating result means the result realized by a company through the usual
exploitation of its only factors of production.

𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝒓𝒆𝒔𝒖𝒍𝒕 = 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝒊𝒏𝒄𝒐𝒎𝒆 – 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝒆𝒙𝒑𝒆𝒏𝒔𝒆𝒔

Operating expenses are composed of:

 Consumption of raw materials
 External expenses (rents, insurance, maintenance ...)
 Taxes (excluding corporate tax)
 Staff costs (salaries and social security contributions)
 Depreciation allowances and operating provision allowances

14
Operating result
The operating result means the result realized by a company through the usual
exploitation of its only factors of production.

𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝒓𝒆𝒔𝒖𝒍𝒕 = 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝒊𝒏𝒄𝒐𝒎𝒆 – 𝑶𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝒆𝒙𝒑𝒆𝒏𝒔𝒆𝒔

Operating expenses are composed of:

 Consumption of raw materials
 External expenses (rents, insurance, maintenance ...)
 Taxes (excluding corporation tax)
 Staff costs (salaries and social security contributions)
 Depreciation allowances and operating provision allowances

15
Question : in order of magnitude, in France, how much will a
student earn each year by leaving CentraleSupelec?

«Super-gross» salary: 60 000 €

Employer’s Social Security
Contributions
Gross salary: 40 000 €
Employee’s Social Security
Contributions
Net salary: 30 000 €

… net salary to which the income tax will have to be

deducted (~ 2 500 € with such a salary)
Social Security Contributions (payroll taxes) are paid directly
by your employer.

They finance in particular:

- Health care insurance
- Pensions (retirement)
- Unemployment insurance
- Child benefit – Children allowance
Income statement: general organization
INCOME STATEMENT FOR YEAR N
Operating income
-Operating expenses
=Operating result (1)

+Financial income
- Financial expenses
=Financial result (2)

+ Non-recurring income
-Non-recurring expenses
=Non-recurring result(3 result(3)

- Corporate income tax (4)

=Net Result = Net income = Profit for the year = (1 +2 +3 -4)

Financial result
The financial result reflects the cost of the net debt of the company.

𝑭𝒊𝒏𝒂𝒏𝒄𝒊𝒂𝒍 𝒓𝒆𝒔𝒖𝒍𝒕 = 𝑭𝒊𝒏𝒂𝒏𝒄𝒊𝒂𝒍 𝒊𝒏𝒄𝒐𝒎𝒆 – 𝑭𝒊𝒏𝒂𝒏𝒄𝒊𝒂𝒍 𝒆𝒙𝒑𝒆𝒏𝒔𝒆𝒔

Financial income is the income earned on the company's financial investments

(eg. treasury bond interests paid to the company by states or other companies).

Financial expenses are the expenses that the company incurs in respect of its
debt commitment (these are the interest that the company must pay to its
lenders).

NB: the pre-tax current result is the sum of the operating result and the financial
result.
19
Income statement: general organization
INCOME STATEMENT FOR YEAR N
Operating income
-Operating expenses
=Operating result (1)

+Financial income
-Financial expenses
=Financial result (2)

+ Non-recurring income
-Non-recurring expenses
=Non-recurring result(3)

- Corporate income tax (4)

=Net Result = Net income = Profit for the year = (1 +2 +3 -4)

Non-recurring result
The non-recurring result is the part of the result of a company on a period due to
non-recurring events (exceptional events) that occurred during this period.

𝑵𝒐𝒏 𝒓𝒆𝒄𝒖𝒓𝒓𝒊𝒏𝒈 𝒓𝒆𝒔𝒖𝒍𝒕 = 𝑵𝒐𝒏 𝒓𝒆𝒄𝒖𝒓𝒓𝒊𝒏𝒈 𝒊𝒏𝒄𝒐𝒎𝒆 – 𝑵𝒐𝒏 𝒓𝒆𝒄𝒖𝒓𝒓𝒊𝒏𝒈 𝒆𝒙𝒑𝒆𝒏𝒔𝒆𝒔

Example of non-recurring income: capital gain on the resale of the head office
Example of non-recurring expenses: loss related to a disaster (storm, fire ...)

Be careful if these non-recurring items are really non-recurring. Otherwise, it is

better to put them in the operating items.
Several accounting standards recognize non-recurring income and expenses (eg.
French accounting standard) but IFRS do not recognize non-recurring items since the
90s and US GAAP since 2015. In those case, “non-recurring events” are included in
operating or financing items, depending on what is relevant. 21
Income statement: general organization
INCOME STATEMENT FOR YEAR N
Operating income
-Operating expenses
=Operating result (1)

+Financial income
-Financial expenses
=Financial result (2)

+ Non-recurring income
-Non-recurring expenses
=Non-recurring result(3)

- Corporate income tax (4)

=Net Result = Net income = Profit for the year = (1 +2 +3 -4)

Result
Gross result is the result of the company before corporate tax.

𝑮𝒓𝒐𝒔𝒔 𝒓𝒆𝒔𝒖𝒍𝒕 = 𝒐𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝒓𝒆𝒔𝒖𝒍𝒕

+ 𝒇𝒊𝒏𝒂𝒏𝒄𝒊𝒂𝒍 𝒓𝒆𝒔𝒖𝒍𝒕 + 𝒏𝒐𝒏 𝒓𝒆𝒄𝒖𝒓𝒓𝒊𝒏𝒈 𝒓𝒆𝒔𝒖𝒍𝒕

The corporate tax is calculated on the basis of the gross result. The normal
rate was 33.33% in France; but the government of E. Philippe wants to
gradually decrease it to 25% by 2022. Corporate tax rate for small
companies is 15%.

The net result is the result attributable to the shareholders, any

expenses deducted :

𝑵𝒆𝒕 𝒓𝒆𝒔𝒖𝒍𝒕 = 𝑮𝒓𝒐𝒔𝒔 𝒓𝒆𝒔𝒖𝒍𝒕 − 𝑪𝒐𝒓𝒑𝒐𝒓𝒂𝒕𝒆 𝒕𝒂𝒙 23

 Part 3 :
Income statement
By-nature format and by-function format
Presentation by nature and by function
Impact of each method
These two types of presentation only affect the calculation of the
operating result (EBIT) by two different decompositions.
The operating result calculated by the two methods is of course the
same whatever the method.

Geographic difference of use

The presentation by nature has historically predominated in continental
Europe.
The presentation by function predominates in the Anglo-Saxon world.

25
By-function format
The presentation by function looks in the operating income only the
realized sales, that is to say the turnover (without considering the
variations of stocks of finished products) and the operating expenses
divided into:
- Costs of Goods Sold (COGS): cost of production of products sold, for
example time of worker to produce it, raw materials incorporated in good
solds.

- Sales, General and Administration (SG&A), for example the cost of

marketing, the salaries of sales people, accountants and HR, the cost of
insurance, electricity, etc.

Sometimes, if it's relevant to the company in question, a Research and

Development function (R&D) is isolated.
Historically, this presentation by function splits depreciations and
provisions on the items above. Increasingly, the Anglo-Saxon companies are
isolating this item on a new function Depreciation and Amortization (D&A). 26
By-function format
Advantages
Synthetic, very simple reading, easy to access

Drawbacks
Difficulty during construction to break down costs between different
functions.
Synthetic but sometimes too much to carry out some analysis (it is
necessary to see in the appendix for more details)

27
By-nature format
Operating incomes presented by nature are composed of:
 Sales of manufactured products, services, goods
 Inventoried production (finished products manufactured but not yet
sold)
 Capitalized production (production of the company for itself)

Operating expenses presented by nature are composed of:

 Consumption of raw materials
 External expenses (rents, insurance, maintenance ...)
 Taxes (excluding corporation tax)
 Staff costs (salaries and social security contributions)
 Depreciation allowances and operating provision allowances
28
Technical point about inventory change in the presentation by
nature (only)
In the income statement, expenses are recorded when they are invoiced
and not when they are consumed.
In order to make appear the real consumption (ie. wealth destruction) in
the "expenses" column of the income statement, the inventory change of
raw materials (= initial stock - final stock = Si – Sf ) must be added.
The sum of purchases of raw materials and the inventory change of raw
materials gives the consumption of raw materials over the period.
Similarly, the incomes (=wealth creation) include the sales of finished
products and the inventory change of finish products over the period (=
final stock - initial stock = Sf-Si). The stored finished products are valued
at their variable cost of production (including staff costs and raw material
costs).

29
Example of the bar

Imagine that you are the boss of a bar.

Your supplier sells bottles of table wine (very mediocre) at 1 € per bottle.
At the beginning of the month you have an initial inventory of 200 bottles of
wine (Si = 200 €).
Your supplier invoiced you and delivered this month 300 bottles (L = 300 €).
At the end of the month, you have 150 bottles in inventory (Sf = 150 €).
What was your consumption of raw material during the month?

Consumptions = Si + L – Sf
Consumptions = L + (Si-Sf)
Consumptions = 300 + (200 – 150)
Consumptions = 350 €
Aaaaaaaaaaaaaaaaaah!
I feel so educated now
 We would like to directly register in the ... But, as the invoice received from the
“expenses” column the consumption of raw purchase of raw materials is directly
materials (RW) which corresponds to the registered in the income statement, it is
real "destruction of wealth" ... necessary to add the inventory change of
RW to obtain the consumption of RW

Expenses Income Expenses Income

Consumptions RW: 350 Purchase RW: 300

Inventory decrease: 50
(Si – Sf)
Example for an industrial company
It produced 110 units in one month, 100 of which were sold that same month.
Production cost: 6 €/unit
Selling price: 10 €/unit

Similarly for the incomes, the production Expenses Incomes

over a period is equal to the sold production
(sum of the invoiced sales) and the
inventory increase of finished products (=
Invoiced sales: 1 000
Sf-Si).

Sold finished products are valued at the Inventory increase of

selling price. finished products
(Sf – Si): 60
Inventories of finished products not yet sold
are valued at the unit variable cost of
production (and not at the price of
anticipated sales).
 SYNTHESE ENTRE PRESENTATION PAR NATURE ET PAR FONCTION
By-nature format By-function format
Sales Sales (Turnover)
+ Change of inventories in
finished goods

= Production - COGS
- Purchase of raw materials and - SG&A
change in inventory of raw (- R&D )
materials (- D&A )
- Services
- Staff expenses
- Taxes other than corporate taxe

= EBITDA
- Depreciation and amortization
(D&A)
= Operating result (EBIT)
- Net financial expenses

= Profit before corporate tax

and non-reccurent items
+ Non-recurring items
- Corporate income tax 34

= Net profit
 SYNTHESE ENTRE PRESENTATION PAR NATURE ET PAR FONCTION
By-nature format By-function format
Sales Sales (Turnover)
+ Change of inventories in
finished goods

= Production - COGS
- Purchase of raw materials and - SG&A
change in inventory of raw (- R&D )
materials (- D&A )
- Services
- Staff expenses
- Taxes other than corporate taxe

= EBITDA
- Depreciation and amortization
(D&A)
= Operating result (EBIT)
- Net financial expenses

= Profit before corporate tax

and non-reccurent items
+ Non-recurring items
- Corporate income tax 35

= Net profit
 SYNTHESIS : PRESENTATION BY NATURE AND BY FUNCTION

 Do exercise n°2 at the end of the slides about the presentation by nature and
by function of the company Fever Tech

36
Part 4 :
Margins
Margin

A margin (in absolute terms) corresponds to the a part of the income

(eg. sales) from which a part of the costs are subtracted.

We have already seen 4 margins:

- EBITDA: earnings before interest, taxes and depreciation allowances
- EBIT : earnings before interests and taxes, also called operating result
- Gross result : result before corporate income tax
- Net result also called net profit, the profit after corporate tax

There are many others. For instance, the added-value (= sales – all the
external costs) that represents the value created by the company and
available for employees (wage), states (tax), debtholders (interest) and
shareholders (net result).
38
Margin
A (relative) margin corresponds to the (absolute) margin divided by
the turnover.

𝐴𝑏𝑠𝑜𝑙𝑢𝑡𝑒 𝑚𝑎𝑟𝑔𝑖𝑛
𝑅𝑒𝑙𝑎𝑡𝑖𝑣𝑒 𝑚𝑎𝑟𝑔𝑖𝑛 =
𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟

The relative margins are useful notably to understand the relative

power of pricing of a company (for instance net profit/turnover) and
to be compared with its peers.

39
 Part 5 :
Some keys to analyze
the income statement
Evolution of sales
One of the first things to look at is the evolution over time of
the turnover of the company (turnover = sales made by the
company: it is the largest component of the income) to
understand in which context operates the business (growth of
turnover, stagnation, decline in turnover).
The evolution of the turnover (sales) has 3 main types of causes,
sometimes combined and that one must try to understand:
- Evolution of prices
- Evolution of volumes
- Evolution in the scope of the company (acquisition of other
companies, selling/stopping a part of the business)

41
Evolution of the operating profit
After looking at the evolution over time of the turnover, we must
look at the evolution over time of the profit and in particular of
the operating profit (EBIT), obtained by the activity of the
company. In particular, it is important to look at the relative
evolution of the operating result in relation to turnover (does it
evolve more favorably, in the same way in %, or less favorably?).
There are 2 parameters then to understand in details in order to
analyze this relative evolution of the result compared to the
sales:
- The scissors effect
- The break-even point

42
Scissors effect
Operating profit= operating income – operating expenses
Operating profit ≈ sales – operating expenses

The scissors effect consists in analyzing the evolution of the operating

result by looking at the evolution of the turnover relative to the evolution
of the expenses.
In a situation of inflation on the expenses (eg: increase of the price of
kerosene for an airline), the company is able to pass on this increase on
the price paid by its customers without lowering the volumes sold (eg:
airline ticket reservations)?
The analysis of the scissors effect shows the force of the position of the
company in its market.
43
Scissors effect

44

Source: Finance d’entreprise. P. Vernimmen

Break-even point

The break-even point is the level of turnover (sales) to reach in

order that the incomes cover the expenses : if the turnover is above
the break-even point, the result will be positive; below, it will be
negative.

In microeconomics, the notion of “profitability threshold” is

sometimes used instead of “break-even point” (it is the same
definition).

45
Break-even point
The incomes are proportional to the number of sales.

The expenses can be divided into two categories:

- Variable costs (eg. raw materials), depending on the level of
production
- Fixed costs (eg. structure costs, depreciation charges)

The higher your fixed costs, the higher your break-even point.

46
Break-even point
Notations:

PV : Selling price
Break-even point
CVu : Per unit variable cost

CFT : Total fixed cost

X* : Critical quantity

CA* : Critical turnover

Quantity (sales) From X* sales per month,

The company realizes a postive
result.
Break-even point
The break-even point is the level of turnover (sales) to reach in
order that the incomes cover the expenses : if the turnover is above
the break-even point, the result will be positive; below, it will be
negative.

𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠
𝐵𝑟𝑒𝑎𝑘𝑒𝑣𝑒𝑛 𝑝𝑜𝑖𝑛𝑡 =
𝑚𝑎𝑟𝑔𝑖𝑛 𝑜𝑛 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡 𝑖𝑛 %

𝑠𝑎𝑙𝑒𝑠–𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡𝑠
With : 𝑚𝑎𝑟𝑔𝑖𝑛 𝑜𝑛 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡 𝑖𝑛 % =
𝑠𝑎𝑙𝑒𝑠

48
Break-even point

Be careful:
- We look at a given moment considering that certain expenses are
fixed and other variables whereas in the very long term all the
expenses are variable (the break-even point which one calculates
depends on that)
- There are several breakeven points depending on whether we look
only at operating expenses (operating break-even point) or operating
expenses and financial expenses (breakeven after financial
expenses)

49
Beak-even point
Sales in 2008 Net profit in 2008
(% evolution compared (% evolution compared
to sales in 2007) to net profit in 2007)

TESCO 53 Md£ 3,0 Md£

(+12%) (+13%)

SEB 3230 M€ 280 M€

(+12%) (+18%)

IBERIA 5464 M€ 75 M€
(-1%) (-82%)

50
Beak-even point

In M€ Sales in 2008 Net profit in 2008

(% evolution compared (% evolution compared
to sales in 2007) to net profit in 2007)

RENAULT 37 800 -117

(-7 %) (-109%)

PEUGEOT 54 400 550

(-7%) (-68%)

51
Break-even point
2 important conclusions:

1- The proximity of the turnover of the break-even point depends on

the sector in which the company works: the sectors with many fixed
costs (ex: aviation) will have a result very sensitive to a fall of the
activity (turnover) while sectors with low fixed costs and variable costs
will feel a lower impact.
2- Do not be fooled: a sharp rise in a company's earnings from one year
to the next does not necessarily mean a dramatic increase in the
performance of a company ... maybe it's just that its turnover business
is close to a break-even point!
The more the turnover of a company is higher than its breakeven point,
the more it will easily support a cyclical slowdown of its activity.

52
 EXERCISES ABOUT
INCOME STATEMENT
 Item at 31/12/Y Value in
€ Exercise 1
Financial income 36 000
Exceptional expenses on management operations 9 000 Question 1
Maintenance works 18 000
Realize the income statement at 31/12/Y
Goods sales 460 000
with the by-nature format
Raw material purchases 450 000
Taxes (Local) 50 000 NB:
Discount on good sales 2 000 Corporate tax rate: 34 %
Loan interests 10 000 v

Rentals 45 000
Question 2
Discount on raw material purchase 5 000
Fixed assets depreciation allowance 70 000 Calculate:
Income from ancillary activities 170 000
- EBITDA
Payroll taxes (social security contributions) 140 000
Exceptional income on management operations 13 000 - EBIT
Finished product sales 820 000 - Financial result
Good purchase 195 000
- Non-recurring result
Staff salaries 290 000
- Gross result
(€) 01/01/Y 31/12/Y
Raw material inventories 50 000 70 000 - Net result
Finished products inventories 25 000 40 000
Goods inventories 30 000 0
 Item at 31/12/Y Value in
€ Exercise 1
Financial income 36 000
Exceptional expenses on management operations 9 000 Question 1
Maintenance works 18 000
Realize the income statement at 31/12/Y
Goods sales 460 000
with the by-nature format
Raw material purchases 450 000
Taxes (Local) 50 000 NB:
Discount on good sales 2 000 Corporate tax rate: 34 %
Loan interests 10 000 v

Rentals 45 000
Question 2
Discount on raw material purchase 5 000
Fixed assets depreciation allowance 70 000 Calculate:
Income from ancillary activities 170 000
- EBITDA
Payroll taxes (social security contributions) 140 000
Exceptional income on management operations 13 000 - EBIT
Finished product sales 820 000 - Financial result
Good purchase 195 000
- Non-recurring result
Staff salaries 290 000
- Gross result
(€) 01/01/Y 31/12/Y
Raw material inventories 50 000 70 000 - Net result
Finished products inventories 25 000 40 000
Goods inventories 30 000 0
 Item at 31/12/Y Value in
€ Exercise 1
Financial income 36 000
Exceptional expenses on management operations 9 000 Question 1
Maintenance works 18 000
Realize the income statement at 31/12/Y
Goods sales 460 000
with the by-nature format
Raw material purchases 450 000
Taxes (Local) 50 000 NB:
Discount on good sales 2 000 Corporate tax rate: 34 %
Loan interests 10 000 v

Rentals 45 000
Question 2
Discount on raw material purchase 5 000
Fixed assets depreciation allowance 70 000 Calculate:
Income from ancillary activities 170 000
- EBITDA
Payroll taxes (social security contributions) 140 000
Exceptional income on management operations 13 000 - EBIT
Finished product sales 820 000 - Financial result
Good purchase 195 000
- Non-recurring result
Staff salaries 290 000
- Gross result
(€) 01/01/Y 31/12/Y
Raw material inventories 50 000 70 000 - Net result
Finished products inventories 25 000 40 000
Goods inventories 30 000 0
 Item at 31/12/Y Value in
€ Exercise 1
Financial income 36 000
Exceptional expenses on management operations 9 000 Question 1
Maintenance works 18 000
Realize the income statement at 31/12/Y
Goods sales 460 000
with the by-nature format
Raw material purchases 450 000
Taxes (Local) 50 000 NB:
Discount on good sales 2 000 Corporate tax rate: 34 %
Loan interests 10 000 v

Rentals 45 000
Question 2
Discount on raw material purchase 5 000
Fixed assets depreciation allowance 70 000 Calculate:
Income from ancillary activities 170 000
- EBITDA
Payroll taxes (social security contributions) 140 000
Exceptional income on management operations 13 000 - EBIT
Finished product sales 820 000 - Financial result
Good purchase 195 000
- Non-recurring result
Staff salaries 290 000
- Gross result
(€) 01/01/Y 31/12/Y
Raw material inventories 50 000 70 000 - Net result
Finished products inventories 25 000 40 000
Goods inventories 30 000 0
 EXPENSES INCOME
Operating expenses Operating income
Question 1 Correction
Goods purchase 195 000 Goods sales 460 000 Realize the income
Goods inventory variation: Si-Sf 30 000 Discount on goods sales -2 000 statement at 31/12/Y
Raw material purchase 450 000 Finished product sales 820 000 NB:
Discount on raw material purchase -5 000 Finished product inventory variation: Sf-Si 15 000
Corporate taxe rate: 34 %
Raw material inventory variation: Si-Sf -20 000 Income from ancillary activities 170 000
v

Maintenance works 18 000 Question 2

Rentals 45 000
Staff salaries 290 000
Calculate:
Payroll taxes 140 000 - EBITDA
Local taxes 50 000
- EBIT
Fixed asset depreciation allowances 70 000
Financial expenses Financial income - Financial result
Loan interest 10 000 Financial income 36 000
- Non-recurring result
Non-recurring expenses Non-recurring income
- Gross result
Exceptional expenses on m. operations 9 000 Exceptional income on m. operations 13 000
- Net result
Total expenses (before corporate tax) 1 282 000 Total Income (before corporate tax) 1 512 000
Gross result 230 000
Corporate tax (34%) 78 200
Net profit 151 800
TOTAL DEBIT 1 512 000 TOTAL CREDIT 1 512 000
 Question 1
EBITDA= operating income – all the operating expenses except
calculated expenses (here only depreciation allowances) Realize the income
EBITDA= 270 000 € statement at 31/12/Y
NB:
EBIT= operating income – operating expenses
Or EBIT= EBITDA – calculated expenses (here only depreciation Corporate tax rate: 34 %
allowances) v

EBIT= 200 000 € Question 2 Correction

Calculate:
Financial result= Financial income – financial expenses
Financial income = 26 000 € - EBITDA
- EBIT
Non-recurring result = Non–recurring income – Non–recurring expenses
Non-recurring result = 4 000 € - Financial result
- Non-recurring result
Gross result = Operating result (EBIT) + Financial result + Non-recurring
result - Gross result
Gross result = 230 000 € - Net result

Net result = Gross result – Corporate tax

Net result = 151 800 €
 Initial Final
Components Price inventory inventory
Housing 50 5 13

Exercice 2 – Fever tech Motherboard

Processor
200
300
8
4
2
11
RAM 100 6 4
Graphic card 50 1 13
Source : Finance d’Entreprise – P. Vernimmen Hard disk 150 5 10
Screen 200 3 3
Blue ray player 50 7 19
Fever tech, computer assembler, has produced 240 computers
this year. Its final inventory of finished products is composed of Questions:
27 units, its initial inventory is composed of 14 units. The
selling price of a unit is 1500 €. The list of used components 1/ Realize the income statement
and inventory variations is provided. of the year by function, splitting
During the exercise, Fever tech paid its employees € 60,000 the operation expenses in only
and paid € 30,000 in employer’s social security contributions. COGS and D&A.

At the end of the year, the company sells for € 230,000 its 2/ Realize the income statement
premises (including industrial machines) bought € 200,000 by nature.
three years ago, and that it amortized over a period of 40
years. The company will occupy next year other premises that 3/ What is the wealth increase
the company will rent. The company has a loan of € 12,000 at for shareholders on the year?
5% interest that it has fully paid off at the end of the year. Same question for debtholders?

The Corporate tax rate is 35%.

Exercise 2 – Fever tech -correction
Income statement: by-function format Income statement: by-nature format

Sales 340 500 Production sold 340 500

+Variation inventory of finished products 19 175
-raw material consumption* 264 000
-COGS 334 825 - staff costs 90 000
-D&A 5 000 -D&A 5 000
EBIT 675 EBIT 675
Financial income - Financial income -
-Financial expenses 600 -Financial expenses 600
Financial result - 600 Financial result - 600
Non-recurring income 45 000 Non-recurring income 45 000
-Non-recurring expenses - -Non-recurring expenses -
Non-recurring result 45 000 Non-recurring result 45 000
-Corporate tax 15 776 -Corporate tax 15 776
Net profit 29 299 Net profit 29 299
* : Normally, the income statement by nature indicates the purchases
COGS = 227 sold units * cost of components of raw materials and the change in stocks of raw materials to deduce
+ staff costs * (227 sold units/240 produced units) the consumption of raw materials. Here it is simpler to directly
deduce the consumption (240 units produced * component cost)
Exercise 2 – Fever tech - correction

Shareholders’ wealth increase = net result = 29 299 €

Debt holders’ wealth increase = financial expenses paid by the company = 600 €

62
Exercise 3 – Evezard (Source: Finance d’entreprise P. Vernimmen)

(1/2)
The company Evezard has in January of year 0 the following provisional data:

Provisional data 0 1 2 3
Sales 70,2 106,0 132,0 161,0
Raw material consumption 29,4 35,4 44,3 53,8
Staff costs 22,2 29,4 36,7 41,1
Local taxes 0,5 0,7 0,7 0,8
Other external services 13,7 19,8 24,6 30,5
Subcontracting costs 2,5 8,9 11,2 11,3
Depreciation allowances 1,4 2,7 3,6 5,0
Question 1: calculate the operating breakeven point for each of the 4 years, given that the cost
structure is as follows:
- Variable costs: raw material consumption, outsourcing, 50% of the other external services
- Fixed costs: all other costs
Exercise 3 – Evezard (Source: Finance d’entreprise P. Vernimmen)

(2/2)
Question 2
Evezard is considering the implementation of an investment program to triple its production
capacity. This program, which is realized in years 0 and 1, consists in the creation of 4 factories
and the launch of new products. The projected income statements provided for years 1, 2 and 3
include the consequences of these investments.
What do you think about it?

Question 3
This investment program creates a financing requirement of around 30 M€ after self-financing to
be incurred from year 1. The financing costs before this investment amount to 1.6 M€ and
Evezard intends to finance this new project exclusively with the issuance of new debts with an
average cost of debt of 10%. What is the breakeven point of years 1, 2, 3 after integration of
financial expenses?
What do you think?
NB: For simplicity, you can neglect the impact of corporate tax in your reasoning
Exercise 3 – Evezard - Correction
Question 1

Year 0 1 2 3
Sales (M€) 70,2 106 132 161
Fixed costs (M€) 30,95 42,7 53,3 62,15
Variable costs (M€) 38,75 54,2 67,8 80,35
Margin on variable costs (M€) 31,45 51,8 64,2 80,65
Margin on variable costs (%) 45% 49% 49% 50%
Operating break-even point(M€) 69,1 87,4 109,6 124,1
Sales in % of break-even point 102% 121% 120% 130%

65
Exercise 3 – Evezard - Correction
Question 2
Year 0 1 2 3
Sales 70,2 106 132 161
Sales increase Y/Y-1 en % N/A 51% 25% 22%
Operating result (EBIT) 0,5 9,1 10,9 18,5
EBIT increase Y/Y-1 in % N/A 1720% 20% 70%

The investment allows a sharp rise in the operating result (EBIT), particularly strong in% between year
0 and year 1 (1720%: the company was close to its breakeven point at year 0, just 2% above) .
The investment doubles the fixed costs while the triple production capacity: the company moves away
from its break-even point, which is an excellent operation.
Provided that this forecast is fair, the investment seems to be a very good operation.

66
Exercise 3 – Evezard - Correction
Question 3
The financial expenses before the investment (ie. in year 0) are 1,6 M€/year to which are added from
the year 1: 3 M€/year (= 30M€ * 10%), ie. 4,6 M€/year:

Year 0 1 2 3
Financial expenses (M€) 1,6 4,6 4,6 4,6

So the break-even point after financial expenses (that are fixed costs):
Year 0 1 2 3
Sales (M€) 70,2 106,0 132,0 161,0
Fixed costs including financial exp.(M€) 32,6 47,3 57,9 66,8
Variable costs (M€) 38,8 54,2 67,8 80,4
Margin on variable costs (M€) 31,5 51,8 64,2 80,7
Margin on variable costs (%) 0,4 0,5 0,5 0,5
Breakeven point after financial exp. (M€) 72,7 96,8 119,0 133,3
Sales in % of breakeven point after f. exp. 97% 110% 111% 121%

The cost of debt increases the breakeven point and therefore the risk for the company in the event of
a decline in activity. 67
 Depreciations
and provisions
Their impacts on Balance Sheet and Income Statement
The calculated expenses

Calculated expenses are expenses (ie. destruction of wealth)

with no impact on the cash position.

They can be classified in 2 categories:

- Depreciation allowances (= amortization allowances)
- Provision allowances

2
 Your company buys for 10 000 € a car at the end
of year 0 for a depreciation period of 5 years.

Year 0 1 2 3 4 5

Net fixed asset value

10 000 8 000 6 000 4 000 2 000 0
(Balance Sheet at 31/12)
Result (impact through
- 2 000 - 2 000 - 2 000 - 2 000 - 2 000
depreciation allowances)
Cash -10 000
Depreciation/amortization
Definition

Thus a depreciation/amortization is 1 concept that can

be considered with 3 different points of view:
1. This is the accounting recognition of the impairment
of assets that necessarily depreciate over time (->
Loss of value of an asset in the balance sheet)
2. This is a process of cost allocation of an investment in
the expenses of various exercises corresponding to its
life (depreciation allowance/expenses = calculated
expenses in the income statement, without cash
going out the company)
3. This is also a financing method for the renewal of
investments. 4
 Cash expenses Calculated expenses

Depreciation
allowances and
provision
allowances

Salaries, interest to pay to

the bank, rentals, purchase
of raw material...
Depreciation

You have to distinguish:

- The "depreciation allowance", which corresponds to the

impairment of the asset in a single year, and which appears as
an expense in the income statement. (NB: these expenses lead
to a decrease in the result and therefore in the corporate tax).

- The “accumulated depreciation", sometimes abbreviated just

as "depreciation", which corresponds to the impairment loss of
the asset since it was put into service until the considered
accounting closing date. It is therefore the sum of depreciation
expenses since the commissioning until the accounting closing
date looked at. This accumulated depreciation appears on the
balance sheet:
 on the assets side of the balance sheet, under the gross value of
the asset concerned but with a negative sign, allowing to know at 6
a glance the net value (= gross value – accumulated depreciation)
 Your company buys for 10 000 € a car at the end
of year 0 for a depreciation period of 5 years.

Year 0 1 2 3 4 5

Net fixed asset value

10 000 8 000 6 000 4 000 2 000 0
(Balance Sheet at 31/12)
Result (impact through
- 2 000 - 2 000 - 2 000 - 2 000 - 2 000
depreciation allowances)
Cash -10 000
 Your company buys for 10 000 € a car at the end
of year 0 for a depreciation period of 5 years.

Year 0 1 2 3 4 5

Gross fixed asset value

10 000 10 000 10 000 10 000 10 000 10 000
(Balance Sheet at 31/12)
Accumulated depreciation
- 2 000 - 4 000 - 6 000 - 8 000 - 10 000
(Balance Sheet at 31/12)
Depreciation allowance 2 000 2 000
2 000 2 000 2 000
(Income statement of year Y)
Cash -10 000
Provisions

Definition

A provision corresponds to a probable loss (risk) that a

company will have to cope with in a more or less close future
and for an amount that is estimable but not known
definitively.

Examples
- Provisions for doubtful trade receivable: if the company
has strong doubts about the ability of a client in financial
difficulty to pay his claim.
- Provisions registered by a company engaged in a lawsuit 9
with a risk to lose.
Provisions

Here too, you have to distinguish between:

- Provision allowances, which corresponds to an
expense in the income statement.
- Provisions on the balance sheet :
 Either on the asset side, under the depreciated asset with a
negative sign if you can identify a problematic asset
 Or on the liabilities side (equity) with a positive sign, if the
risk is global for the company

10
Provisions

Accounting registration at the end

Once we know if the risk associated with the provision

materialized or not, in all cases:
- In Balance sheet, provisions are cancelled
- In Income statement, an income is registered called
“provisions reversal” that cancel the provision.

If the risk has not materialized, we leave it there.

If the risk has materialized, the corresponding definitive loss

11
is registered as an expense in the income statement.
Difference between depreciation and provision

The two concepts are quite similar; both are calculated

expenses. The difference is based on the fact that:

- A depreciation is a certain, unavoidable loss (impairment

due to time, obsolescence)

- - A provision is likely to happen but not certain. The risk

and its associated provision may be cancelled in case of
a favourable outcome.

12
Cash flow statement
Cash is king !
Reminder

We have already seen the importance of Net Cash for the solvency of the
company:

Net cash = Cash asset – Cash liabilities

Net cash = Stable resources – 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑

𝑆𝑡𝑎𝑏𝑙𝑒 𝑟𝑒𝑠𝑜𝑢𝑟𝑐𝑒𝑠
And the ratio is one of the best predictor ratios for
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑
bankruptcy

In fact, it is the absence of cash (ie. cash assets) to cope with the
payability of liabilities that causes the cessation of payment, that is to
say the bankruptcy of a company. 2
Cash flow statement
= the table to explain the variation of the cash asset, ie. the cash at
disposal of the company, during a period.

Cash flow statement

Cash-Out (CO) Cash-In (CI)
= cash that exits out of the company = cash that enters in the company

Eg: paid taxes, paid salaries, interests, Eg: collected sales, interest paid to the
services bought and paid company

Variation of cash asset = CI - CO

3
The importance of cash
BALANCE SHEET
ASSETS LIABILITIES
… Result: 400
… …
… …
… …
… …
… …
Cash assets: 90 …

Questions:
- Point out where the cash is.
- With what can I buy a fixed asset at 75?
4
- With what can I reimburse a debt of 40?
What is a bankruptcy ?

A company in bankruptcy is a company that is in the process of

collective proceedings, resulting in a judicial reorganization or a
judicial liquidation.

It is the cessation of payments that marks the entry into the

reorganization or liquidation procedure, ie. the fact that the
company can not immediately cope with its liabilities due with
its available assets (not enough cash to honor its commitments).

During the declaration of the company's cessation of payments to

the commercial court, the company mentions at the moment t
the list of its assets and its liabilities, so its balance sheet, that
is why in French this event is called “dépôt de bilan”.
5
The importance of cash

"The result is partly virtual." Examples:

 Incomes contain sales invoiced but not yet paid
 Expenses include calculated expenses (depreciation
expenses, without cash-out and depending on
accounting choice)

"The cash is real, it is an asset.

It's the ability of a company to make new investments. "

6
The importance of cash

"The result: Positive, the patrimony gains weight.

Negative, the patrimony is losing weight.

Cash: if it runs out, it's death.”

7
 Income statement for the year Y :
Explain how the result was formed from 01/01/Y-1 to 31/12/Y

BALANCE SHEET AT 31/12/Y-1 BALANCE SHEET AT 31/12/Y

ASSET LIABILITIES ASSET LIABILITIES

FIXED ASSETS EQUITY: FIXED ASSETS EQUITY:

- Tangible assets - Share capital - Tangible assets - Share capital
- Intangible assets - Reserves - Intangible assets - Reserves
- Financial assets - Result - Financial assets - Result

OPERATING CURRENT ASSETS DEBTS: OPERATING CURRENT ASSETS DEBTS:

- Inventories - Long term debts - Inventories - Long term debts
- Trade receivables - Medium term debts - Trade receivables - Medium term debts
- Other receivables - Short term-debts - Other receivables - Short term-debts
- Trade payable - Trade payable
CASH ASSETS CASH ASSETS
- Cash and cash equivalent - Cash and cash equivalent

Cash flow statement for the year Y

Explain the variation of the cash assets between 31/12/Y-1 and 31/12/Y
Variation of cash assets

We want to explain:

𝑉𝑎𝑟𝑖𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝑐𝑎𝑠ℎ 𝑎𝑠𝑠𝑒𝑡𝑠 𝑜𝑛 𝑎 𝑝𝑒𝑟𝑖𝑜𝑑

= 𝐶𝑎𝑠ℎ 𝑎𝑠𝑠𝑒𝑡𝑠 𝑎𝑡 𝑐𝑙𝑜𝑠𝑖𝑛𝑔 – 𝐶𝑎𝑠ℎ 𝑎𝑠𝑠𝑒𝑡𝑠 𝑎𝑡 𝑜𝑝𝑒𝑛𝑖𝑛𝑔

The variation of cash assets on a period can be fully explained by 3

types of cash flows
- Operating cash flows
- Investment cash flows
- Financing cash flows

9
Variation of cash assets

Cash flow statement

(A): Cash flows from operating activities (operating flows)
(B): Cash flow from investment activities (investment flows)
(C): Cash flow from financing activities (financing flows = funding flows)
Variation of cash assets = (A) + (B) + (C) = (1) – (2)
(1) Cash assets at the closing
(2) Cash assets at the opening

10
Operating flows

Operating flows
Operating cash-in (payments from clients)
- Operating cash-out (payment to suppliers, payments of salaries, etc.)
= Net operating flows

Direct method.

11
Operating flows

Operating flows
+ Net profit
+ Depreciation and provision allowances (D&A)
- WCR increase
= Net operating flows (after financial interests paid)

Indirect method.

12
Operating flows
1) The operating flows correspond to the difference between the
cash-in from operation (income transformed into cash-in) and the
cash-out from operation (expenses transformed into cash-out).

2) The sum of net profit and D&A measures the difference

between cashable income and cashable expenses.

The difference between (2) and (1) is explained by :

- An increase in operating receivables
- An increase in inventories
- A decrease in operating payables
 That is to say, an increase of Working Capital Requirement on 13
the period.
Investment flows

Investment flows
- Acquisitions of fixed assets
+ Disposals of fixed assets
= Net investment flows

Investment flows correspond to investments in new fixed assets, minus the

disposals of fixed assets (sale of fixed assets) made during the period.

14
Free Cash Flow
Free Cash Flow to the Firm (FCFF) is the sum of operating cash flow and
investment cash flow.

𝐹𝐶𝐹𝐹 = 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑓𝑙𝑜𝑤𝑠 + 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑓𝑙𝑜𝑤𝑠

It is therefore the cash flows that the company has at its disposal once
the necessary investments have been paid. The company can do what it
wants: repay debts, pay a dividend, increase its cash assets for
investment in a future year ...

The free cash flow are useful for two things: measure the financial
capacity of a company (to repay its debt for instance), and calculate its
value from the discounting of free cash flow flows (attention, take the
FCFF before financial interests in this case).
15
Financing flows
Funding flows
+ New loan emission
- Loan capital reimbursement
- Interest payment
+ Social capital increase
- Social capital decrease
- Dividends
= Net financing flows
Financing flows are flows from or to capital providers: lenders (new loans,
repayment of loans) and shareholders (increase or decrease of capital,
dividend).
Be careful: in the presentation of the cash flow statement made here, the
remuneration of the lenders (interest) has already been included in the
calculation of the CAF via the net result, so it does not have to be counted
twice. On the other hand, the remuneration of the shareholders 16
(dividends) has not yet been taken into account and is therefore here.
 Cash flow statement
+ Operating cash-in (payments from clients)
- Operating cash-out (payment to suppliers, payments of salaries, etc.)
= Net operating flows (A)
- Acquisitions of fixed assets
+ Disposals of fixed assets
= Net investment flows (B)
(A) + (B) = Free Cash Flows
+ New loan emission
- Loan capital reimbursement
- Interest payment
+ Social capital increase
- Social capital decrease
- Dividends
= Net financing flows (C)
Variation of cash assets = (A) + (B) + (C) = (1) – (2)
(1) Cash assets at the closing
(2) Cash assets at the opening
 Cash flow statement
+ Net profit
+ Depreciation and provision allowances
- WCR increase
= Net operating flows after interest paid (A)
- Acquisitions of fixed assets
+ Disposals of fixed assets
= Net investment flows (B)
(A) + (B) = Free Cash Flows after interest paid
+ New loan emission
- Loan capital reimbursement
+ Social capital increase
- Social capital decrease
- Dividends
= Net financing flows (C)
Variation of cash assets = (A) + (B) + (C) = (1) – (2)
(1) Cash assets at the closing
(2) Cash assets at the opening
Example: Arcelor Mittal
en M$ 2016
Net profit 1734
+ Provision and depreciation allowances 2771
- WCR Increase 1000
Net operating flows after financial interests (A) 3505
-Investment in tangible and intangible assets 2444
+Disposal of tangible and intangible assets 119
-Investment in financial assets 0
+Disposal of financial assets 1182
Net investment flows (B) -1143
Free Cash Flow after financial expenses (A)+(B) 2362
+Capital increase 3115
-Dividends paid 61
-Capital repayment of financial debt 8429
+Issuance of new debts 1526
Net financing flows (C) -3849
Variation of Cash assets: (A)+(B)+(C) = (2) - (1) -1487
Cash assets at the opening (1) 4102
Cash assets at the closing (2) 2615
Example: Arcelor Mittal
en M$ 2016
Net profit 1734
+ Provision and depreciation allowances 2771 We have to deal with a
- WCR Increase 1000 company that, while
Net operating flows after financial interests (A) 3505 investing in tangible and
-Investment in tangible and intangible assets 2444 intangible fixed assets,
+Disposal of tangible and intangible assets 119 made the choice of
-Investment in financial assets 0 deleveraging (reducing its
+Disposal of financial assets 1182 debts) in 2016:
Net investment flows (B) -1143 - Using some of the
Free Cash Flow after financial expenses (A)+(B) 2362 flows generated by his
activity
+Capital increase 3115
- By generating cash
-Dividends paid 61
through the sale of
-Capital repayment of financial debt 8429
financial fixed assets
+Issuance of new debts 1526 - By increasing its
Net financing flows (C) -3849 capital
Variation of Cash assets: (A)+(B)+(C) = (2) - (1) -1487
Cash assets at the opening (1) 4102
Cash assets at the closing (2) 2615
 Cash flow statement
+ Net profit
+ Depreciation and provision allowances
- WCR increase
= Net operating flows after interest paid (A)
- Acquisitions of fixed assets
+ Disposals of fixed assets
= Net investment flows (B)
(A) + (B) = Free Cash Flows after interest paid
+ New loan emission
- Loan capital reimbursement
+ Social capital increase
- Social capital decrease
- Dividends
= Net financing flows (C)
Variation of cash assets = (A) + (B) + (C) = (1) – (2)
(1) Cash assets at the closing
(2) Cash assets at the opening
Possible presentations
The cash flow statement presented in the previous
slide is a commonly used form and it is easy to start
from the net result for arrival to the operating flows
generated by the activity.

The problem is that this presentation includes the

financial expenses (interest) in the net result whereas
the purists would prefer that they be attached in the
funding flows (which makes the most sense).

So we also find the presentation of the type of the next

slide, less common, but all the more logical.
22
 Cash flow statement
+ EBITDA
- Corporate tax (with calculation based on EBIT)
- WCR increase
= Operating flows(A) [without financial interest polluting the analysis]
- Acquisitions of fixed assets
+ Disposals of fixed assets
= Net investment flows (B)
(A) + (B) = FCFF = Free cash flows to Firm [without financial interest polluting the analysis]
+ New loan emission
- Loan capital reimbursement
- Financial interest cost (integrating tax effect)
+ Social capital increase
- Social capital decrease
- Dividends
= Net financing flows (C) [logically integrating the real financial interest cost]
Variation of cash assets = (A) + (B) + (C) = (1) – (2)
(1) Cash assets at the closing
(2) Cash assets at the opening
 Cash flow statement
+ EBITDA
- Corporate tax (with calculation based on EBIT)
- WCR increase
= Operating flows(A)
- Acquisitions of fixed assets
+ Disposals of fixed assets
= Net investment flows (B)
(A) + (B) = FCFF = Free cash flows to Firm
+ New loan emission
- Loan capital reimbursement
- Financial interest cost (integrating tax effect)
+ Social capital increase
- Social capital decrease
- Dividends
= Net financing flows (C)
Variation of cash assets = (A) + (B) + (C) = (1) – (2)
(1) Cash assets at the closing
(2) Cash assets at the opening
Exercise - ENGIE

You will find on the following slide the cash flow statement of ENGIE for
the year 2015.

Question 1: How to explain that despite a negative net result, ENGIE

generates more than 10 billion cash from its activity?

Question 2: What are the main uses of the cash flows generated by the
operations?

Question 3: How much are the Engie FCFFs in 2015?

Question 4: How are FCFFs distributed among the capital providers?

25
 ENGIE Group - in M€ 2015
EBIT -2 948
D&A 13 890
Corporate tax paid -1 722
Decrease of WCR 1 163
Operating cash flows (A) 10 383
Tangible and intangible investments -6 459
Financial investments -500
Disposal of fixed assets 507
Other investment flows 223
Investment flows (B) -6 229
Capital increase 21
Dividends paid -3 107
Repayment of financial debts -4 846
Cash-in due to new loans 5 834
Financial interest paid -1 545
Financial interest received from cash asset 126
Financing flows (C) -3 517
Variation of cash asset : (A)+(B)+(C) = (2) - (1) 637
26
Cash assets at the beginning of the period (1) 8 546
Cash Assets at the end of the period (2) 9 183
Exercise – ENGIE -Correction

Question 1: How to explain that despite a negative net result, ENGIE

generates more than 10 billion cash from its activity?

Mostly (13.9 B€) because depreciation and amortizations have reduced

operating income but did not have any impact on cash flow (ie.
calculated expenses without cash going out).
To a lesser extent (1.2 B€) as Engie managed to reduce its WCR, thus
having a positive impact on the cash generated by the activity

27
Exercise – ENGIE -Correction

Question 2: What are the main uses of the cash flows generated by the
activity?
They are 3 types:
- Finance investment (60%)
- Repay and remunerate the capital providers (34%)
- Increase cash assets (6%)

M€ Percentage
Operating cash flows 10 383 100%
 Finance new investment 6 229 60%
 Repay and remunerate the capital providers 3 517 34% 28

 Increase cash assets 637 6%

Exercise – ENGIE -Correction

Question 3: How much are the Engie FCFFs in 2015?

FCFF= operating cash flows + investment cash flows
FCFF= 4 154 M€

Question 4: How are FCFFs distributed among the capital providers?

74% flow to shareholders and 10% flow to lenders (the remaining ~ 15%
increase cash flow)

M€ Percentage

FCCF 4 154 100%

Flows to shareholders 3 086 74%
Flows to debt holders 431 10% 29

Increase cash flows 637 15%

 Taxes
« In this world nothing can be said to be certain, except death and taxes»
Benjamin Franklin
VAT
VAT

The Value Added Tax (VAT) is a French invention (1954)

but has been copied in many countries around the
world.

Nearly 50% of the French state revenues come from

VAT.

3
VAT
Budget of the French State for the year 2018

Corporate
tax

25
billion €
Other
taxes 33
billion € Value Added
154
billion € Tax

72
billion €

Income
tax
4
VAT

VAT is a tax that taxes the final consumption of goods and

services.

Thus, at the end, it is the final consumer who pays for it and
not the companies.

Companies only play the role of tax collector on behalf of

the State.

5
VAT

Price including VAT = Price excluding VAT + VAT

VAT = Price excluding VAT * VAT rate

6
VAT

The company collects VAT on its sales.

The company pays VAT on its purchases that can be

deducted.

VAT to pay = Collected VAT - VAT to be deducted

7
 Final consumer

buys a cauldron 100 €

excluding VAT

But it is not possible for the

State to recover VAT directly
from the end consumer ... (too
complex in practice)

State wants to recover 20% VAT,

ie. 20 €.
 Company 1 Company 2 Final consumer
(raw materials) (manufacturing and selling)

Purchase of metal Purchase of a cauldron

40 € excluding VAT, 100 € excluding VAT,
so 48 € including VAT so 120 € including VAT

VAT to be deducted: 0 € Collected VAT: 8 € VAT to be deducted: 8 € Collected VAT: 20 €

VAT to pay: 8 € VAT to pay: 12 €

At the end, the State recovers 20€ of

VAT. And it is the final consumer who
bears this cost at the end.
VAT
Definition of the Added Value of a company (AV)
AV = Turnover - Purchases and external expenses

VAT to be paid by the company = AV * VAT rate

The term Value Added Tax therefore describes the means of

collection for the State (via companies in proportion to
their value added).
But he does not describe at all who ultimately supports this
tax: it is the final consumer and only he who supports it.
10
VAT

The different VAT rates in France:

- The normal rate: 20%

- The intermediate rate: 10% (eg. catering, passenger

transport)

- The reduced rate: 5.5% (eg basic products: food, gas,

electricity, etc.)

11
VAT

Dates taking into account to calculate VAT:

- For services: VAT is calculated on the basis of cash-in and

cash-out

- For goods: VAT is calculated on the basis of invoices

received and issued (corresponding to the delivery of the
goods)
12
VAT
In the financial statements of a company:

Income statement: As the company does not ultimately bear

the burden of VAT but only acts as a tax collector on behalf
of the State, the VAT does not appear in the income
statement. The profit and loss account is excluding VAT.

Balance sheet: VAT to pay is in the liabilities (debt to state)

or possibly in the assets if the state must reimburse the
company. Trade receivables and trade payables include VAT.

Cash flow statement: The company collects what it sells

including VAT. It pays what it buys including VAT. The transfer
of VAT to the State (VAT to pay) will result in a cash-out for
the company (or cash-in if state must reimburse the 13
company).
Other taxes
Corporate tax
The Corporate tax (CT) is a tax on the result (difference between
income and expenses) that the company succeeds to create.

CT calculations (simplified)
Gross result= Income – Expenses
CT= Gross result * CT rate
Net result = Gross result- CT

Corporate tax rate in France:

- 33.33% (classical rate until 2018)
- 25% (government’s objective for 2022)
- 15% (for SME with result<38 k€)

Corporate income tax has an impact on income statement (net

15
income)
Local tax
The French so called “CFE (Cotisation Foncière des Entreprises) is a
local tax due by companies.

It was born in 2010 following the disappearance of the so called

“taxe professionnelle”.

It is based on the cadastral property value of the land sites of the

company and the tax rate is defined by each local authority.

Local taxes have an impact on income statement (in the operation

part => EBIT)

16
Discount and factoring
Balance sheet
BALANCE SHEET
ASSETS LIABILITIES
EQUITY:
- Share capital
FIXED ASSETS - Reserves
- Tangible assets - Result
- Intangible assets
- Financial assets LT/MT FINANCIAL DEBTS:
- Long term debts
- Medium term debts

OPERATING CURRENT ASSETS OPERATING CURRENT LIABILITIES

- Inventories - Trade payables
- Trade receivables - Other payables
- Other receivables

CASH ASSETS CASH LIABILITIES

- Cash and cash equivalent - Short term-debts
(bank overdraft) 2
Let’s assume that you delivered and invoiced a client the month M for 1 000 € with 3
month as a delay of payment.

Month M Month M+1 Month M+2 Month M+3

Invoice Cash-in
1000 € 1000 €

Thus, you have for 3 months a trade receivable of 1000 €.

If you need cash for the month M+1, you can go to see your bank to give it the trade
receivable and the bank will immediately transfer to you 1 000 € in cash.
The bank will do it … but against the payment of an interest (it is a kind of short-
term loan).
This is called bank discount or commercial discount.
Month M+1
Month M Month M+2
Invoice 1000 € Cash-in 1000€ Month M+3
- interests
Bank discount
Impact on financial statements:

Income statement: you add an expense (interest to pay to the

bank)

Balance sheet: decrease of trade receivable and increase of

cash assets.

Cash flow statement: this advances the receipt of cash

corresponding to the trade receivable (+ cash-out due to the
payment of interest).

4
Bank discount and factoring
Bank discount consists in, for a company, going to see its bank
to give it a commercial effect materializing the trade
receivables he holds on one of its clients. The bank then makes
available to the company immediately the cash corresponding
to this trade receivables, in exchange of the payment of
interest. If the company's client does not pay in due-time, the
bank can then turn against the company to recover the
advance cash amount.
Factoring consists in, for a company, delivering to a specialized
institution a commercial effect materializing the trade
receivable it holds on one of its clients. The specialized
institution will immediately make available to the company the
cash corresponding to this trade receivables in exchange of the
payment of a commission and will take care of the recovery of
the receivable. If the company’s client does not pay in due
time, the specialized institution bears the risk of non-recovery.
(The charged commission is proportional to the risk of non- 5
recovery and is of course higher than bank discount cost).
Credit/Debit
And other subtleties in accounting…
 Credit / Debit
Origin Destination

Resource Use

 1 transaction (flow) = 2 registers*

ACCOUNTS DESCRIPTION + -
expenses accounts final uses Debit Credit
income accounts final resources Credit Debit
assets accounts temporary uses Debit Credit
liability accounts temporary resources Credit Debit

• To be accurate: a transaction of 500 € needs to register 500 € in credit and 500 € in debit
Credit/Debit : examples
 Creation of the “Peter’s company”. Peter (the shareholder) brings
600 000 €

Add an asset (cash) : Debit

Add a liability (equity-debts to be paid to the shareholder): Credit

Add an asset (fixed asset-machine): Debit

Remove an asset (cash to pay): Credit
Credit/Debit : examples
 Creation of the “Peter’s company”. Peter (the shareholder) brings
600 000 €

Add an asset (cash) : 600 k€ Debit

Add a liability (equity-debts to be paid to the shareholder): 600 k€ Credit
Credit/Debit : examples
nset (cash) : Debit
Ality (equity-debts to be paid to the shareholder): Credit

 Peter’s company buys an industrial machine: 70 000 €; the

company directly paid in cash

Add an asset (fixed asset-machine): Debit

Remove an asset (cash to pay): Credit
Credit/Debit : examples

 Peter’s company buys an industrial machine: 70 000 €; the

company directly paid in cash

Add an asset (fixed asset-machine): 70k€ Debit

Remove an asset (cash to pay): 70k€ Credit
Credit/Debit : examples
 Peter’s company buy another industrial machine: 100 000 €; the
company has negotiated to pay the supplier in 3 months

Add an asset (fixed asset-machine): Debit

Add a liability (trade payables): Credit

 3 months later, Peter’s company pays this supplier 100 000 €

Remove an asset (cash): Credit

Remove a liability (tarde payable): Debit
Credit/Debit : examples
 Peter’s company buy another industrial machine: 100 000 €; the
company has negotiated to pay the supplier in 3 months

Add an asset (fixed asset-machine): 100 000 € Debit

Add a liability (trade payables): 100 000 € Credit

 3 months later, Peter’s company pays this supplier 100 000 €

Remove an asset (cash): 100 000 € Credit

Remove a liability (trade payable): 100 000 € Debit
Credit/Debit : examples
 Peter’s company receives an invoice from EDF for the electricity.
The invoice has to be paid in 30 days.

Add an expenses (electricity’s invoice): Debit

Add a liability (trade payables): Credit

 One month later, Peter’s company pays this electrical invoice

Remove an asset (cash): Credit

Remove a liability (tarde payable): Debit
Credit/Debit : examples
 Peter’s company receives an invoice from EDF for the electricity.
The invoice has to be paid in 30 days.

Add an expenses (electricity’s invoice): Debit

Add a liability (trade payables): Credit

 One month later, Peter’s company pays this electrical invoice

Remove an asset (cash): Credit

Remove a liability (trade payable): Debit
Classification du Plan Général
Comptable français

11
12
Credit/Debit : examples
 Creation of the “Peter’s company”. Peter (the shareholder) brings
600 000 €

Add an asset (cash) : 600 k€ Debit

Add a liability (equity-debts to be paid to the shareholder): 600 k€ Credit
an asset (cash) : Debit
Add a liability (equity-debts to be paid to the shareholder): Credit

Debit Credit
10. Capital et réserve 600 k€
Add an asset (fixed asset-machine): Debit
53. Caisse 600 k€
Remove an asset (cash to pay): Credit
TOTAL 600 k€ 600 k€
13
Accounting standards in the world
A multitude of accounting standards are used around the world,
they are often based on the same main principles, but with
nuances. There is for example:
- In France, the French accounting standards based on the Plan
General Comptable and established by the Association des
Normes Comptables (ANC)
- In United States, the US GAPP (US Generally Accepted
Accounting Principles) is used

IFRS (International Financial Reporting Standards) was created with

the aim of providing a common accounting language that can be
used around the world, favoring an economic vision (rather than a
fiscal vision necessarily at the level of each country).

In France, French accounting standards are mandatory for the

preparation of company accounts sent to the state. All French large
or international groups also use IFRS to be understood by foreign
investors. 14
Profitability
Introduction
Profitability

Profitability is the relative measure of the obtained

profit compared to the invested capital to get this profit.

General case
𝑤𝑒𝑎𝑙𝑡ℎ 𝑐𝑟𝑒𝑎𝑡𝑖𝑜𝑛 𝑝𝑟𝑜𝑓𝑖𝑡
𝑃𝑟𝑜𝑓𝑖𝑡𝑎𝑏𝑖𝑙𝑖𝑡𝑦 =
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝑡𝑜 𝑔𝑒𝑡 𝑡ℎ𝑖𝑠 𝑔𝑎𝑖𝑛

Thus, it is a weath creation (data from the income

statement) divided by capital invested (data from
3
balance sheet)
Profitability

There are two important profitability ratios:

Economic profitability
This is the profitability generated by the entire economic
activity of the company.

Financial profitability
That is the profitability obtained by the capital providers
(shareholders ou debtholders)
4
 Part 1 :
Economic profitability
Economic profitability (ROCE)

This is the profitability generated by the entire economic activity

of the company, without considering the financial structure opted
by the company.

𝐸𝑐𝑜𝑛𝑜𝑚𝑖𝑐 𝑝𝑟𝑜𝑓𝑖𝑡 (𝑎𝑓𝑡𝑒𝑟 𝑐𝑜𝑟𝑝𝑜𝑟𝑎𝑡𝑒 𝑡𝑎𝑥)

𝐸𝑐𝑜𝑛𝑜𝑚𝑖𝑐 𝑝𝑟𝑜𝑓𝑖𝑡𝑎𝑏𝑖𝑙𝑖𝑡𝑦 =
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑

The economic profitability is also called ROCE (Return on Capital

Employed).
 You already know how to calculated capital employed (cf.
lecture about the balance sheet)
 It remains to be seen how to obtain the economic result after
6
corporation tax (IS)
Economic profitability (ROCE)

The economic result (before IS) is the result from the

operation of the company, before taking into account the
elements relating to its financial structure.

It is thus the EBIT (operating profit) minus the effect of

corporate tax (T= corporate tax rate).
NB: if there is a non-reccurring result, ajust the EBIT by adding the non-
reccurring result to the EBIT

𝐸𝑐𝑜𝑛𝑜𝑚𝑖𝑐 𝑝𝑟𝑜𝑓𝑖𝑡 𝑎𝑓𝑡𝑒𝑟 𝑐𝑜𝑟𝑝𝑜𝑟𝑎𝑡𝑒 𝑡𝑎𝑥 (𝑁𝑂𝑃𝐴𝑇) = 𝐸𝐵𝐼𝑇 ∗ (1 – 𝑇)

The economic profit after corporate tax is also called

NOPAT in English (Net Operating Profit After Taxes). 7
Economic profitability (ROCE)

𝑁𝑂𝑃𝐴𝑇
𝐸𝑐𝑜𝑛𝑜𝑚𝑖𝑐 𝑝𝑟𝑜𝑓𝑖𝑡𝑎𝑏𝑖𝑙𝑖𝑡𝑦 (𝑅𝑂𝐶𝐸) =
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑚𝑝𝑙𝑜𝑒𝑑

Usefullness of this ratio

.

This ration shows, regardless of the financial structure

between shareholders and debtholders, whether the
company creates value or destroys it.
For this, this ratio must be compared to the Weighted
Average Cost of Capital (WACC), which is the subject of a
future lecture. 8
Economic profitability (ROCE)

𝐸𝑐𝑜𝑛𝑜𝑚𝑖𝑐 𝑟𝑒𝑠𝑢𝑙𝑡 𝐸𝑐𝑜𝑛𝑜𝑚𝑖𝑐 𝑟𝑒𝑠𝑢𝑙𝑡 𝑆𝑎𝑙𝑒𝑠

= *
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑 𝑆𝑎𝑙𝑒𝑠 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑

𝑅𝑂𝐶𝐸 = 𝑚𝑎𝑟𝑔𝑖𝑛 * 𝑟𝑜𝑡𝑎𝑡𝑖𝑜𝑛

The economic profitability can be split into a margin (economic result /

sales) multiplied by a rotation of the assets (sales / capital employed).
The decomposition of economic profitability into these two factors is
very different from one economic sector to another (eg high technology
vs. mass-market retail).
9
10
11
 Roberto GOIZUETA
The Coca Cola Company
CEO (1980-1997)

12
 Part 2 :
Financial profitability
Financial profitability (ROE)

This is the profitability obtained from the shareholders’

equity (ROE = Return On Equity)

𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡
𝑅𝑂𝐸 =
𝐸𝑞𝑢𝑖𝑡𝑦

14
Financial leverage effect / gearing effect

𝑅𝑂𝐸 = 𝑅𝑂𝐶𝐸 + (𝑅𝑂𝐶𝐸 – 𝑘𝐷 ) ∗ 𝐷/𝐸

𝑅𝑂𝐸 = 𝑅𝑂𝐶𝐸 + (𝑅𝑂𝐶𝐸 – 𝑘𝐷 ) ∗ 𝐺𝑒𝑎𝑟𝑖𝑛𝑔

Avec: Financial leverage effect

- ROCE is the economic profitability after corporate tax
- ROE is the financial profitability for shareholders
- kD is the cost of net debt after taking into account the effect of corporate tax
- D is the net debt
- E is equity 15
Financial leverage effect
𝑅𝑂𝐸 = 𝑅𝑂𝐶𝐸 + (𝑅𝑂𝐶𝐸 – 𝑘𝐷) ∗ 𝐷/𝐸

Financial leverage effect

If ROCE> 𝑘𝐷 , net debt therefore boosts the return on equity thanks to the financial
leverage effect.
Be careful though, it's not an alchemist magic formula that turns lead into gold:
To get a positive financial leverage effect, the economic profitability must be greater
than the relative cost of the net debt, otherwise the financial leverage effect
becomes negative:
- In the event of an economic slowdown, ROCE dives and this negative financial
leverage effect can amplify the fall in profitability for shareholders. As usual,
there is no increase in profitability without increasing risk ...
- It should not be thought that changing the ratio D / E (gearing), the cost of debt 𝑘
𝐷 remains unchanged: the risk increases for the lender so 𝑘𝐷 increases .
Cost of net debt ratio

𝑛𝑒𝑡 𝑓𝑖𝑛𝑎𝑛𝑐𝑖𝑎𝑙 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑠 ∗ 1 − 𝑇

𝑘𝐷 = 𝑁𝑒𝑡 𝑑𝑒𝑏𝑡

With :
- Net financial expenses equal to the financial expenses (interest of
financial debts) minus the possible financial income from the cash
asset investment.
- Net debt, as defined in the lecture about the balance sheet
- T the corporate tax rate

This ratio 𝑘𝐷 is a sort of financial profitability for the debtholders,

under the point of view of the company… 17
Synthesis
 Equity
Financing
Capital
employed
Net Debt

19
 Equity
Financing
Capital
employed
Net Debt

Wealth
generation
(ROCE)

Economic
profit
(EBIT)
20
 Equity
Financing
Capital
employed
Net Debt

Wealth
generation
(ROCE)

Economic
profit
(EBIT)
21
 Equity
Financing
Capital
employed
Net Debt

Wealth
generation
(ROCE)

Net financial
Economic expenses
profit
(EBIT) Splitting
Net profit
22
 Equity
Financing
Capital
employed
Net Debt

Wealth
Return paid to Returns paid to
generation
debtholders (kD) shareholders (ROE)
(ROCE)

Net financial
Economic expenses
profit
(EBIT) Splitting
Net profit
23
 Financial need Balance Financial
resources

Capital Committed
employed capital

Capital
Economic Business providers
activities -
Company Shareholders
&
Lenders
Economic Attributed
result result

Result from
Optimize Financing cost
activities
 Solvency
« A Lannister always pays his debts. »
Solvency

Solvency : definition
The question is whether the company will be able to meet
its due liability, ie. if the company will succeed in meeting
its commitments regarding its debts.

The solvency can be read from balance sheet

The balance sheet, which details assets in order of
increasing liquidity, and liabilities in order of increasing
payability (due date), is a relevant document to study
solvency.
2
 Reminder : Balance sheet
BALANCE SHEET
ASSETS LIABILITIES
EQUITY:
- Share capital
FIXED ASSETS - Reserves
- Tangible assets - Result
INCREADING LIQUIDITY

INCREASING PAYABILITY
- Intangible assets
- Financial assets LT/MT FINANCIAL DEBTS:
- Long term debts
- Medium term debts

OPERATING CURRENT ASSETS OPERATING CURRENT LIABILITIES

- Inventories - Trade payables
- Trade receivables - Other payables
- Other receivables

CASH ASSETS CASH LIABILITIES

- Cash and cash equivalent - Short term-debts
(bank overdraft) 3
Solvency
Exercise – It’s up to you !
What do you think about the solvency of this company?

Assets Liabilities
Fixed asset (7 years) 200 Equity 100
Fixed asset (3 years) 200 Debt due in 5 years 200
Inventories (3 months) 300 Debt due in 1 years 300
Trade receivables (2 months) 100 Debt due in 1 month 400
Cash assets (1 day) 200
TOTAL 1000 TOTAL 1000

4
Solvency
Exercise – Correction
What do you think about the solvency of this company?

Assets Liabilities
Fixed asset (7 years) 200 Equity 100
Fixed asset (3 years) 200 Debt due in 5 years 200
Inventories (3 months) 300 Debt due in 1 years 300
Trade receivables (2 months) 100 Debt due in 1 month 400
Cash assets (1 day) 200
TOTAL 100 TOTAL 1000
0

Its liquidity in 1 month is not assured (lack of 400-200 = 200), nor its
liquidity in 1 year (lack of 700-600 = 100), nor at 5 years (lack of 900-800
= 100). The company will have to very quickly restructure its debt to
meet its deadlines. 5
Solvency ratios

There are two families of solvency ratios:

- Short-term ratio, also called liquidity ratio. They have some
drawbacks.
- Medium-term solvency ratio, very efficient: one of the best indicators
in terms of forecasting bankruptcies. You should remember it.

6
Short-term solvency ratios (liquidity ratios)

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡 + 𝐶𝑎𝑠ℎ 𝑎𝑠𝑠𝑒𝑡𝑠

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑟𝑎𝑡𝑖𝑜 = =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 + 𝑐𝑎𝑠ℎ 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 + 𝐶𝑎𝑠ℎ 𝑎𝑠𝑠𝑒𝑡𝑠 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠 − 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑖𝑒𝑠

𝑄𝑢𝑖𝑐𝑘 𝑟𝑎𝑡𝑖𝑜 = =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

𝐶𝑎𝑠ℎ 𝑎𝑠𝑠𝑒𝑡𝑠
Cash ratio =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

7
Short-term solvency ratios

Critical of these short-term solvency ratios:

- They measure short-term solvency (at 3 months) while the
balance sheet is available externally only ~ 3 to 6 months
after closing ...
- They are composed of volatile elements, which vary from day
to day, so they depend on the date of closing the accounts
(often 31/12) ...
- There are many counterexamples of companies in bankruptcy
while these ratios were respected, and conversely businesses
do not respect them but are still alive ...
- An increase in the WCR (mismanagement) can improve these
ratios ...
 In short, just remember their existence to know how to
beware of them  8
Net cash
Definition
Net cash = Cash assets – Cash liabilities

Meaning
Ideally, net cash should be close to zero.
Very positive, it means that there is cash that "sleeps" and is not used.
Except to have a project in sight for a certain horizon ...
The company can afford to have negative net cash, but only up to a
certain point. At some point, the bank will no longer accept the overdraft
and other facilities ... and here is the risk of bankruptcy.

9
Net cash
Definition
Net cash= Cash assets – Cash liabilities

Property
Net cash = Stable resources – Capital employed

Reminder:
- Stable resources are composed of equity and long-term/medium-
term debts
- Capital employed is composed of net fixed assets and WCR
10
Reminder : Balance sheet
BALANCE SHEET
ASSETS LIABILITIES
EQUITY:
- Share capital
FIXED ASSETS - Reserves
- Tangible assets - Result
- Intangible assets
Stable resources
- Financial assets LT/MT FINANCIAL DEBTS:
- Long term debts
- Medium term debts

OPERATING CURRENT ASSETS OPERATING CURRENT LIABILITIES

- Inventories - Trade payables
- Trade receivables - Other payables
- Other receivables

CASH ASSETS - CASH LIABILITIES

Net cash
- Cash and cash equivalent - Short term-debts
(bank overdraft) 11
Net cash
Property
Net cash = Stable resources – Capital employed

Proof
Net cash = Cash assets – Cash liabilities
Net cash= (Total assets– Fixed assets – Current operating assets)
- (Total liabilities– Equity– MT/LT Debt – Current operating liabilities)
Net cash= (Total assets– Fixed assets – (Current operating assets– Current operating liabilities)
- (Total liabilities– Equity– MT/LT debt)
Net cash= (Total assets– Fixed assets – WCR) - (Total liabilities– Equity– MT/LT debt)
Total assets and total liabilities are equal, we can thus simplify :
Net cash= ( Equity+ MT/LT Debt ) - ( Fixed assets + WCR )
Net cash= ( Stable resources )-( Capital employed ) 12
Medium-term solvency ratios

𝑁𝑒𝑡 𝑐𝑎𝑠ℎ = 𝑆𝑡𝑎𝑏𝑙𝑒 𝑟𝑒𝑠𝑜𝑢𝑟𝑐𝑒𝑠 − 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑

We understand well that the corner stone to be solvent is the net cash.
Hence the next medium-term solvency ratio:

𝑆𝑡𝑎𝑏𝑙𝑒 𝑟𝑒𝑠𝑜𝑢𝑟𝑐𝑒𝑠
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑

Or that is to say:
𝐸𝑞𝑢𝑖𝑡𝑦 + 𝑀𝑇 𝐿𝑇 𝐷𝑒𝑏𝑡𝑠
𝐹𝑖𝑥𝑒𝑑 𝑎𝑠𝑠𝑒𝑡𝑠 + 𝑊𝐶𝑅

13
Medium-term solvency ratios
𝑆𝑡𝑎𝑏𝑙𝑒 𝑟𝑒𝑠𝑜𝑢𝑟𝑐𝑒𝑠
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑

Interpretation: The critical point is at 70%.

Stable resources/ Capital employed Opinion

100% Ideal
90%-100% Very good
70%-90% Medium but acceptable
50%-70% High risk of bankruptcy
<50% R.I.P

NB: This critical point works very well for companies with positive net
debt (classic case). Beware of companies with negative net debt. By
definition, they have no risk of not paying back their financial debts (very 14
good solvency). The critical point is therefore less strict for them.
Company 1 (fool but lucky)

ASSETS Y1 Y2 LIABILITIES Y1 Y2
Machine 100 170 Capital 30 40
Inventories 20 40 Result 10 20
Trade receivables 10 20 Trade payables 100 200
Cash 10 30
TOTAL 140 260 TOTAL 140 260

WCR -70 -140

To be
SR/CE calculated To be calculated

Company 2 (fool and unlucky)

ASSETS Y1 Y2 LIABILITIES Y1 Y2
Machine 100 170 Capital 240 270
Inventories 90 180 Result 30 60
Trade receivables 80 160 Trade payables 10 20
Cash 10 Bank overdraft 160
TOTAL 280 510 TOTAL 280 510

WCR 160 320 15

To be
Company 1 (fool but lucky)

ASSETS Y1 Y2 LIABILITIES Y1 Y2
Machine 100 170 Capital 30 40
Inventories 20 40 Result 10 20
Trade receivables 10 20 Trade payables 100 200
Cash 10 30
TOTAL 140 260 TOTAL 140 260

WCR -70 -140

SR/CE 133% 200%

= (Equity + MTLT Debt)/(Fixed assets + WCR)

Company 2 (fool and unlucky)

ASSETS Y1 Y2 LIABILITIES Y1 Y2
Machine 100 170 Capital 240 270
Inventories 90 180 Result 30 60
Trade receivables 80 160 Trade payables 10 20
Cash 10 Bank overdraft 160
TOTAL 280 510 TOTAL 280 510

WCR 160 320

SR/CE 104% 67%

= (Equity + MTLT Debt)/(Fixed assets + WCR)
Other good solvency ratio
𝑁𝑒𝑡 𝑑𝑒𝑏𝑡
𝐶𝑎𝑠ℎ 𝑓𝑙𝑜𝑤𝑠 𝑓𝑟𝑜𝑚 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛𝑠

It gives an idea of how many years it takes to get out of debt if the all the
Cash Flows from Operations (CFO) are dedicated to it. It must be lower
than the average maturity of financial debts, ie. 3 years in general.
Interpretation (if maturity of debt is 3 years):
Net debt/CFO Opinion
0-1 year Excellent
1-2 year Good
2-3 year Medium but acceptable
3-5 year High risk of bankruptcy
17
>5 year R.I.P
 WACC
Weighted Average Cost of Capital

Main source: La gestion financière de l’entreprise. Ch. Pierrat

 Financial need Balance Financial
resources

Capital Committed
employed capital

Capital
Economic Business providers
activities -
Company Shareholders
&
Lenders
Economic Attributed
result result

Result from
Optimize Financing cost
activities
WACC : definition

Definition
The cost of capital is the minimum rate of return on the company’s
investments that can satisfy both shareholders (the cost of equity) and
debtholders (the cost of debt). The cost of capital is thus the company’s
total cost of financing.

Synonyms
Cost of Capital is also called WACC (Weighted Average Cost of Capital).
In French, WACC=CMPC (Coût Moyen Pondéré des Capitaux)

3
WACC : calculations

𝐸 𝐷
𝑊𝐴𝐶𝐶 = 𝑘𝐸 . + 𝑘𝐷 .
𝐷+𝐸 𝐷+𝐸
With:

E = Equity
D = Net debt= Financial debts minus the cash assets

kE = cost of equity (shareholders’ required minimum profitability)

kD = cost of net debt (after-tax effect of lenders’ required
profitability)

NB : kD corresponds to a cost after taking into account the corporation tax savings
linked to the deductibility of interest on loans: kD = kD’ . (1-T) with kD’ the average
interest rate on net debt before taking into account the tax effect and T the
corporate tax) 4
WACC : uses

WACC is a fundamental concept in Corporate Finance.

It is especially used for:

– Decision-making to determine whether an investment
should be undertaken or not (see chapter on the subject)
– Check if a company creates or destroys value (comparing
the WACC to economic profitability)
– Business valuation
 On these last two points, cf. the very simplified example
below)

5
WACC : example
Here is the simplified balance sheet of a company in economic vision
with :

TOTAL NEEDS : 100 TOTAL RESOURCES : 100

Fixed assets: 65 Equity: 60
WCR: 35 Net debt: 40

Knowing that:
- The company raises the net debt to 6%, so the cost of net debt is 4%
after taking into account the economy of corporate tax (T=33.33%).
- Shareholders demand a return on equity of 14%

Question : What is the WACC of this company?

6
CMPC : example (continuation)
Here is the simplified balance sheet of a company in economic vision with :

TOTAL NEEDS : 100 TOTAL RESOURCES : 100

Fixed assets: 65 Equity: 60
WCR: 35 Net debt: 40
𝐸 𝐷
𝑊𝐴𝐶𝐶 = 𝑘𝐸 . + 𝑘𝐷 .
𝐷+𝐸 𝐷+𝐸
Avec:
𝑘𝐸 = 14% ; 𝑘𝐷 = 4% ; E= 60 ; D= 40

60 40
𝑊𝐴𝐶𝐶 = 14% . + 4% .
60 + 40 60 + 40

7
𝑊𝐴𝐶𝐶 = 10%
WACC : example (continuation)
TOTAL NEEDS : 100 TOTAL RESOURCES : 100
Fixed assets: 65 Equity: 60
WCR: 35 Net debt: 40
With:𝑘𝐸 = 14% ; 𝑘𝐷 = 4% ; WACC= 10%

Consider the following 3 cases, with different economic result (ie. NOPAT=EBIT after corporate tax):
– Case A: The annual economic result is 10
– Case B: The annual economic result is 17
– Case C: The annual economic result is 6

In each case, indicate:

 Net profit
 Profitability for shareholders (ROE)
 Market value of Debt
 Market value of Equity
 If there is creation or destruction of wealth
8
(It will be assumed in each case that the situation is typical of the annual performance
of the company)
WACC : example (continuation – Case A)
TOTAL NEEDS : 100 TOTAL RESOURCES : 100
Fixed assets: 65 Equity: 60
WCR: 35 Net debt: 40
With:𝑘𝐸 = 14% ; 𝑘𝐷 = 4% ; WACC= 10%

Economic result : 10,0

Cost of net debt : -1,6 (=40 . 4%)
---------
Net profit : 8,4

Profitability for shareholders : 8,4/60 = 14 %

Market value of debt: 1,6/4% = 40

Market value of Equity: 8,4/14%= 60

Conclusion: Nothing to report, economic profitability (ROCE) is equal to 9

the required profitability (WACC).

WACC : example (continuation – Case B)
TOTAL NEEDS : 100 TOTAL RESOURCES : 100
Fixed assets: 65 Equity: 60
WCR: 35 Net debt: 40
With:𝑘𝐸 = 14% ; 𝑘𝐷 = 4% ; WACC= 10%

Economic result : 17,0

Cost of net debt : -1,6 (=40 . 4%)
---------
Net profit : 15,4

Profitability for shareholders : 15,4/60 = 26 % 

Market value of debt: 1,6/4% = 40

Market value of Equity: 15,4/14%= 110

Conclusion: ROCE > WACC, there is a creation of wealth with the appearance 10
of a goodwill of 50 (market value of Equity – book value of Equity = 110–60)
WACC : example (continuation – Case C)
TOTAL NEEDS : 100 TOTAL RESOURCES : 100
Fixed assets: 65 Equity: 60
WCR: 35 Net debt: 40
With:𝑘𝐸 = 14% ; 𝑘𝐷 = 4% ; WACC= 10%

Economic result : 6,0

Cost of net debt : -1,6 (=40 . 4%)
---------
Net profit : 4,4

Profitability for shareholders : 4,4/60 = 7 % 

Market value of debt: 1,6/4% = 40

Market value of Equity: 4,4/14%= 31

Conclusion: ROCE < WACC, there is a destruction of wealth with the appearance 11
of a badwill of 29 (market value of Equity – book value of Equity = 31 – 60)
WACC : example (continuation – Case C)
TOTAL NEEDS : 100 TOTAL RESOURCES : 100
Fixed assets: 65 Equity: 60
WCR: 35 Net debt: 40
With:𝑘𝐸 = 14% ; 𝑘𝐷 = 4% ; WACC= 10%

Note that there is destruction of

Economic result : 6,0 value for the shareholders even
Cost of net debt : -1,6 (=40 . 4%) though the net profit is strictly
--------- positive. A positive net profit is
not enough to create value, it is
Net profit : 4,4
necessary that the net profit
covers the requirement of
Profitability for shareholders : 4,4/60 = 26 % 
profitability with regard to the
risk borne by the shareholder.
Market value of debt: 1,6/4% = 40
Market value of Equity: 4,4/14%= 31

Conclusion: ROCE < WACC, there is a destruction of wealth with the appearance 12
of a badwill of 29 (market value of Equity – book value of Equity = 31 – 60)
Restructuring

In case of a situation where the economic profitability

(ROCE) is lower than the WACC, the company destroys the
value and must undertake a restructuring, otherwise the
investors will turn away, another company will launch a
takeover bid, etc.

How to restructure, ie. to make the economic return at

least equal to the WACC?

13
Restructuring
How to restructure, ie. to make the economic return at least equal to
the WACC?

1/ Reduce the WACC :

 Reduce the cost of Debt ?
 Reduce the cost of Equity?
 Modify the proportion between Debt and Equity?
 Is it possible and simple?

2/ Increase the economic result:

 Increase the turnover (sales) ?
 Reduce the costs?
14
Restructuring
Is it possible to modify the WACC of a company?

E D
CMPC = kE . + kD .
D+E D+E

At the same risk, do capital providers (shareholders or lenders) agree

to reduce their profitability?
 No ! (except if you improve the level of information they have on
the company because a lack of transparency can increase the level
of perceived risk ... but in general in any properly managed
company, this measure has already been taken for a long time)

If equity decreases, lenders will agree to lend at the same interest

rate?
 No ! Because the risk is then greater. 15
Restructuring
Is it possible to modify the WACC of a company?

E D
CMPC = kE . + kD .
D+E D+E

At the same risk, do capital providers (shareholders or lenders) agree

to reduce their profitability?
 No ! (except if you improve the level of information they have on
the company because a lack of transparency can increase the level
of perceived risk ... but in general in any properly managed
company, this measure has already been taken for a long time)

If equity decreases, lenders will agree to lend at the same interest

rate?
 No ! Because the risk is then greater. 16
Restructuring
Is it possible to modify the WACC of a company?

E D
WACC = kE . + kD .
D+E D+E

 In fact, contrary to what the formula might suggest, the WACC

pre-exists the financial structure of the company. We can not
move one of these parameters, the other remaining equals
elsewhere. The WACC only depends on the level of risk that the
enterprise takes in its economic activity.

 So we can reduce the WACC by reducing the risk related to the

economic activity of the company. But, doing this, the economic
profitability decreases, and we did not solve the problem of 17
having an economic profitability lower than the WACC ...
Restructuring
How to restructure, ie. to make the economic return at least equal to the
WACC?

1/ Reduce the WACC :

 Reduce the cost of Debt ?
 Reduce the cost of Equity?
 Modify the proportion between Debt and Equity?
 Very difficult, except if you succeed to improve the transparency in
financial communications provided to investors

2/ Increase the economic result:

 Increase the turnover (sales) ?
 Reduce the costs?

18
Roadmap to perform a
financial analysis
Roadmap for a financial analysis

« Wealth creation requires investment that must

be financed and provide sufficient return »

2
Plan of financial analysis

Preamble
- Understand the business model of the company, the environment in which
it operates, its strategy put in place
- Check the reliability of the accounting information provided

Financial analysis
I. Wealth creation
II. Capital employed policy (investment)
III. Financing policy
IV. Profitability

Synthesis 3
Preamble
Understand the business model of the company, the environment in which it
operates, its strategy put in place

This step is essential. Going into the calculations without understanding what
the company does is the surest way to realize an analysis disconnected from the
reality, completely useless!

The goal is to understand:

- the business model of the company, its value chain of the company (what does
it sell, with which inputs)
- the commercial environment (5 Porter’s forces) and non-commercial (PESTLE)
in which it operates
- facing the threats and opportunities of the environment, what are its strengths
and weaknesses (SWOT)
- what strategy does the company seek to apply

In short, all the toolbox and the approach that you saw during management
4
course with Thierry Godelle !
Preamble

Check the reliability of the accounting information provided

Two important and distinct things:

- Check if the data seems to be true because they have been approved by the
Auditors
- Identify the advantageous presentations of the financial settlements by the
accounting choices made by the company (what is written is true, but can hide
certain points, do not allow a clear understanding, etc. If necessary, reprocess
these advantageous presentations to have a more faithful image of reality.

5
Exercise
Question : This company provides you with the following items. What do you think?

Main financial elements

(not audited, in M$, except the stock price)
1996 1997 1998 1999 2000
Sales 13 289 20 273 31 260 40 112 100 789
Operating net income 493 515 698 957 1266
Items impacting 91 -410 5 -64 -287
comparability (non-
recurring items)
Net profit 584 105 703 893 976
Total assets 16 137 22 552 29 350 33 381 65 503
Cash flows from operating
activities* 742 276 1 873 2 228 3 010
Cash flows from 1 483 2 092 3 564 3 085 3 314
investment (CAPEX)
6
Share price $ 22 21 29 44 83
* excluding the variation of WCR
Exercise - Correction
Question : This company provides you with the following items. What do you think?
Strong growth in sales, a good increase in operating income, a sharp rise in
operating cash flow and a rising stock market price, this company seems to have
very good results.

Be careful! Several elements are however very disturbing::

- First of all, why does the company provide unaudited financial information? Is the
information reliable? There is nothing to prove it
- Some data are strange:
o The items impacting comparability, which occur almost each year, have a strong
impact on the net result. Is it really non-recurring? Is the company not trying to
improve its operating result by isolating an exceptional elements that are not so
exceptional?
o Cash flows from operations are presented (cf. footnote) excluding changes in the
WCR while the latter has a potentially strong impact on operating cash flow.
Why this presentation? What is the company trying to hide?
In fact, these are the main financial elements that Enron, one of the major groups
in the energy sector, provided in 2001. Enron filed a fraudulent bankruptcy in 2001 7
in the United States.
Financial analysis

I. Wealth creation
Analysis of sales (this evolution is linked to: price, volume, evolution of
the perimeter?)
Analysis of all margins with particular importance to be given to the
EBIT (structure, scissors effect, operating leverage)

II. Capital employed policy (investment)

Analysis of fixed assets and their evolution
Analysis of the WCR and its evolution
In both cases to look statically in the balance sheet and understand the
evolution using the cash flow statement.
Compare depreciation and new investments (does the company invest
in addition to simple renewal?) 8
Financial analysis

I. Wealth creation
Analysis of sales (this evolution is linked to: price, volume, evolution of
the perimeter?)
Analysis of all margins with particular importance to be given to the
EBIT (structure, scissors effect, break-even point…)

II. Capital employed policy (investment)

Analysis of fixed assets and their evolution
Analysis of the WCR and its evolution
In both cases to look statically in the balance sheet and understand the
evolution using the cash flow statement.
Compare depreciation and new investments (does the company invest
in addition to simple renewal?) 9
Financial analysis

I. Wealth creation
Analysis of sales (this evolution is linked to: price, volume, evolution of
the perimeter?)
Analysis of all margins with particular importance to be given to the
EBIT (structure, scissors effect, break-even point…)

II. Capital employed policy (investment)

Analysis of fixed assets and their evolution
Analysis of the WCR and its evolution
In both cases to look statically in the balance sheet and understand the
evolution using the cash flow statement.
Compare depreciation and new investments (does the company invest
in addition to simple renewal?) 10
Financial analysis

III. Financing policy

Debt / equity split (who finances the capital employed?)
What is the level of self-financing?
Analysis of solvency: will the company cope with its debts in the short
and medium term?

IV. Profitability
Economic profitability (ROCE), to understand (margin x rotation) and
to compare with the WACC: Does the company create or destroy value?
Financial profitability (ROE) and gearing effect

11
Financial analysis

III. Financing policy

Debt / equity split (who finances the capital employed?)
What is the level of self-financing?
Analysis of solvency: will the company cope with its debts in the short
and medium term?

IV. Profitability
Economic profitability (ROCE), to understand (margin x rotation) and
to compare with the WACC: Does the company create or destroy value?
Financial profitability (ROE) and gearing effect

12
Financial analysis

III. Financing policy

Debt / equity split (who finances the capital employed?)
What is the level of self-financing?
Analysis of solvency: will the company cope with its debts in the short
and medium term?

IV. Profitability
Economic profitability (ROCE), to understand (margin x rotation) and
to compare with the WACC: Does the company create or destroy value?
Financial profitability (ROE) and financial leverage effect

13
Exercise

 See the study case M6/TF1 (French television channels)

14
 NPV and IRR
… or how to decide if you launch an investment or not

Main source: Corporate Finance. P. Vernimmen, P. Quiry & al.

Reminder

The profitability/risk couple

Profitability and risk are two inseparable concepts in Corporate Finance.

The higher the risk taken by a company to undertake a project, the greater
the profitability required by investors to support the project.

Risk free interest rate

Be careful though, this does not mean that a risk-free project (assuming that
this is strictly possible) does not require remuneration for the capital
providers: they give up their money immediately in exchange for future
financial flows. They will require at least the so-called "risk-free" interest
rate, that is, the price of time.

2
Capitalization
Capitalizing income means forgoing using it immediately. It then
becomes capital, generating income in the future (capital interest with a
required rate of return i). Interest from previous periods accrues to
capital and in turn generates interest on subsequent periods ("snowball
effect")

Example with a starting capital V0=100 and an interest rate i=10%

Year 0 1 2 3 4 5 6 7 8 9 10
Capital (€) 100 110 121,0 133,1 146,4 161,1 177,2 194,9 214,4 235,8 259,4

X (1 + 10%) X (1 + 10%) X (1 + 10%) … X (1 + 10%)

X (1 + 10%)10
3
Capitalization

Capitalising income means forgoing using it immediately. It then becomes

capital, generating income in the future (capital interest with a required
rate of return i). Interest from previous periods accrues to capital and in
turn generates interest on subsequent periods ("snowball effect")

General case

Year 0 1 2 3 4 … … … … … n
Capital (€) V0 V1 V2 V3 V4 … … … … … Vn

Vn = V0 * (1+i)n

This capitalization formula reflects the future value of today's capital. 4

Discounting

To discount means to calculate the present value of a future amount.

Example with a starting capital V0=100 and an interest rate i=10%

Year 0 1 2 3 4 5 6 7 8 9 10
Capital (€) 100 110 121,0 133,1 146,4 161,1 177,2 194,9 214,4 235,8 259,4

1 1 1 … 1
X X X X
1 + 10% 1 + 10% 1 + 10% 1 + 10%

1
X 10
1 + 10%

5
Discounting
To discount means to calculate the present value of a future amount.

General case

Year 0 1 2 3 4 … … … … … n
Capital (€) V0 V1 V2 V3 V4 … … … … … Vn

𝟏
V0 = 𝑽𝒏 ∗ 𝒏
𝟏+𝒊

6
Capitalization / Discounting
Capitalization and discounting are two sides of the same phenomenon: the
price of time with regard to the risk borne which is materialized by the
required rate of return i.

Capitalization
x (1+i)n

V0 Vn
Time

1
x 𝑛
1+𝑖
7
Discounting
Discounting
𝟏
V0 = 𝑽𝒏 ∗ 𝒏
𝟏+𝒊

Consequences of the discounting formula:

- The more distant in time is the future amount, the less important is its
corresponding present value
- The higher is the discount rate (which translates the profitability
required by the investor), the lower is the present value of the future
cash flows.

8
Discounting
What is the interest of discounting to evaluate an investment?

An investment is an immediate expense in the expectation of future income.

Example: I invest today in a machine 100 k €. I hope in return an income of 25 k
€ / year for 5 years. The residual value of the machine is here supposed to be
null after 5 years.

Year 0 1 2 3 4 5
Cash flows (k€) -100 25 25 25 25 25

Positive cash flow over the period = 125 k€

Negative cash flow over the period = 100 k€
Can it be deduced from this calculation that the investment must be undertaken?

9
Discounting
Example: I invest today in a machine 100 k €. I hope in return an income of 25 k € / year for 5
years. The residual value of the machine is here supposed to be null after 5 years.
Year 0 1 2 3 4 5

Cash flows (k€) -100 25 25 25 25 25

Positive cash flow over the period = 125 k€

Negative cash flow over the period = 100 k€
Can it be deduced from this calculation that the investment must be undertaken?

NO ! Because the facial amount of a future flow in year 5 is not comparable to the facial amount
of a future flow in year 2 which itself is not comparable to the facial amount of a flow today :
- What about the risk borne? (a future cash flow is not a certainty, it is a hope)
- What about inflation? (1 € today is not equal to 1 € tomorrow)
- If the 100 k€ are not invested in this project, they are not worth 100 k € in year 5 ... because
they could have been invested on another project yielding x%
- Etc ...
In short, we can not deduce anything like that because we compare different years, that is to say
that we compare apples and oranges ! 10
Discounting
Discounting will help to solve this problem: we convert all future cash flows to the same
reference year (the initial year t0).
It is assumed here that the discount rate, ie. the rate of return required by investors for
the risk incurred by the project is 10%.

Year 0 1 2 3 4 5

Cash flows (k€) -100 25 25 25 25 25

1
X
(1 + 10%)^1

1
X
(1 + 10%)^2

1
X
(1 + 10%)^3

1
X
(1 + 10%)^4

X
1 11
(1 + 10%)^5
Discounting
Discounting will help to solve this problem: we convert all future cash flows to the same
reference year (the initial year t0).
It is assumed here that the discount rate, ie. the rate of return required by investors for
the risk incurred by the project is 10%.

Year 0 1 2 3 4 5

Cash flows (k€) -100 25 25 25 25 25

23

21

19

17

16

12
Discounting
Discounting will help to solve this problem: we convert all future cash flows to the same
reference year (the initial year t0).
It is assumed here that the discount rate, ie. the rate of return required by investors for
the risk incurred by the project is 10%.

Year 0 1 2 3 4 5

Cash flows (k€) -100 25 25 25 25 25

23

21
PV= Present Value of future cash flows
19
PV= 95 k€
17

16

13
Discounting
Discounting will help to solve this problem: we convert all future cash flows to the same
reference year (the initial year t0).
It is assumed here that the discount rate, ie. the rate of return required by investors for
the risk incurred by the project is 10%.

Year 0 1 2 3 4 5

Cash flows (k€) -100 25 25 25 25 25

23

21
NPV = Net Present Value
19 NPV = - 5 k€
17

16

14
Discounting
Discounting will help to solve this problem: we convert all future cash flows to the same
reference year (the initial year t0).
It is assumed here that the discount rate, ie. the rate of return required by investors for
the risk incurred by the project is 10%.

Year 0 1 2 3 4 5

Cash flows (k€) -100 25 25 25 25 25

23

21
NPV = Net Present Value
19 NPV = - 5 k€
17

16

The NPV is negative here.

Conclusion: The project destroys value and must not be undertaken.
15
Discounting
Sensitivity to the discount rate:

It is assumed here that the discount rate, ie. the rate of return required by investors for
the risk incurred by the project is 5%.
Year 0 1 2 3 4 5

Cash flows (k€) -100 25 25 25 25 25

24

23
NPV = Net Present Value
22 NPV = +8 k€
21

20

The NPV is positive here.

Conclusion: The project is likely to create value and can be undertaken.
16
NPV
For an investment undertaken in the year 0 generating each year k (from 1 to n) cash
flow Fk, at discount rate i :

Present Value (PV)

𝑛 𝐹𝑘
PV = 𝑘=1 (1+𝑖)𝑘

Net Present Value (NPV)

𝑛 𝐹𝑘
NPV = - V0 + 𝑘=1 (1+𝑖)𝑘

With V0 the absolute value of the initial investment.

The NPV is the best tool to know if an investment needs to be undertaken:

– If its NPV is positive, the project creates value: We can go
– If the NPV is negative, the project destroys the value: STOP!

The NPV is also a very good tool to choose between several investments: it is the one that 17
generates the best NPV that must be privileged.
Exercise 1
You have the choice between 2 mutually exclusive projects generating the
following cash flows (in k €):

Project1:
Year 0 1 2 3 4
Cash flows -40 10 12 14 16

Investors consider this type of project as little risky: the required return of 5%

Project 2:
Year 0 1 2 3 4 5
Cash flow -30 10 10 10 10 10
Investors consider this type of project as moderately risky: the required return of
7%

18
Question: Which project will you prefer?
Exercise 1
Correction (results):

Project1:

Year 0 1 2 3 4
Cash flows -40 10 12 14 16
Investors consider this type of project as little risky: the required return of 5%
NPV = 6 k€

Project 2:
Year 0 1 2 3 4 5
Cash flow -30 10 10 10 10 10
Investors consider this type of project as moderately risky: the required return of 7%
NPV = 11 k€

Conclusion: the 2 projects are creators of values (NPV> 0). The company
must privilege one (mutually exclusive), so it will be the project 2 which
generates a higher NPV. 19
NPV
What discount rate to take ?

The discount rate is the profitability required by investors.

For a "typical" project (ie. at the same risk as the average project
undertaken by the firm), the discount rate is the Weighted Average Cost
of Capital of the company.

If the company undertakes a different project in terms of the risk that

these average of conventional projects, we must take the project's
WACC. For example, if a project is more risky (difficult country, strong
technological challenge, etc.), it must take a discount rate higher than
the company's WACC.

Be careful: if a project of a company in 100% financed by debt, the

project's WACC is not the rate of the debt, because if the company
borrows on this project it is thanks to the company’s guarantees
(equity). 20
VAN
What discount rate to take? – It’s up to you !

Give an order of magnitude on the discount rate to take for:

1. A traditional high voltage line construction project in France realized
by RTE (regulated monopoly) 6%
2. A project to build a power plant in France (competitive sector) 8%
3. An industrial project in a West African country, with a partial
guarantee provided by the donors (World Bank) 17%
4. The investment you are ready to make in a start-up (first round) of a
project whose validity of the concept in terms of technical
realization and response to a market need remains to be
demonstrated. 50%
21
VAN
What discount rate to take? – It’s up to you !

Give an order of magnitude on the discount rate to take for:

1. A traditional high voltage line construction project in France realized
by RTE (regulated monopoly) 6%
2. A project to build a power plant in France (competitive sector) 8%
3. An industrial project in a West African country, with a partial
guarantee provided by the donors (World Bank) 17%
4. The investment you are ready to make in a start-up (first round) of a
project whose validity of the concept in terms of technical
realization and response to a market need remains to be
demonstrated. 50%
22
NPV
Can a company rationally undertake an investment with a
negative NPV?

It means undertaking a project that destroys value in itself

from a financial point of view.

However, it sometimes happens that a negative NPV investment

is undertaken because it appears to be strategic to protect a
position, open up new markets with high potential that are
difficult to evaluate today, etc.

But let's not fool ourselves: if its NPV is negative, it will sooner
or later be necessary for other investments with positive NPV to
23
compensate this loss of value, otherwise the company will run
out of business.
Gordon-Shapiro formulae
At k

Year 0 1 2 3 … k k+1 k+2 k+3 …

Capital (€) -F0 F1 F2 F3 … Fk Fk .(1+g) Fk .(1+g)² Fk .(1+g)3 …

If you cannot predict accurately the cash flows after a year k, you can
assume that thay will grow with a (reasonnable) rate of g each year.
In this case, if you assume that i (minimum requirement return) is above
g (perpetual growth rate), the terminal value at time k is equal to :

𝐶𝐹𝑘 .(1+𝑔) 𝐶𝐹𝑘+1

Terminal Value = =
𝑖−𝑔 𝑖−𝑔

24
IRR

Definition: The IRR (Internal Rate of Return) of an investment is the

discount rate that make the NPV (net present value) of that investment
equal to zero.

Consider a project generation the following cash flows:

Year 0 1 2 3 4 … … … … … n
Capital (€) -F0 F1 F2 F3 F4 … … … … … Fn
The IRR is the value of the discount rate i that is the solution of the
equation:
0 = NPV
Ie.:

𝑛 𝐹𝑘
IRR = i such as 0 = - F0 + 𝑘=1 (1+𝑖)𝑘 25
IRR
Vocabulary:

For capital expenditures/project decision, we talk about Internal

Rate of Return (IRR).

To evaluate financial securities, we (sometimes) talk about yield to

maturity.

But mathematically, it is the same thing: it is the internal rate of

return i that make the Net Present Value (NPV) equal to zero.

In the continuation of this course, we will just talk about Internal

Rate of Return (IRR) by choice. 26
IRR

How to use this tool ?

The IRR of an investment is calculated and compared to the rate of

return required by investors:
– If the IRR is above the required rate of return, the investment creates
value and can be between
– If the IRR is below the required rate of return, the investment
destroys value and should not be undertaken.

27
IRR

How to use this tool ?

Example:

Year 0 1 2 3 4 5
Cash flows (k€) -100 25 25 25 25 25

IRR = i such as NPV = 0  IRR = 8%

If the required profitability is 5 %, the investment should be

undertaken (IRR > 5%).

If the required profitability is 10 %, the investment should NOT be 28

undertaken (IRR < 10 %).
IRR
Advantages of IRR:

The use of IRR is frequent because the investor immediately knows a

compensation value in % and can compare it to the required rate of return in
% (the NPV gives a value in €).
The NPV and the IRR criteria lead to the same conclusion to know if an
investment should be undertaken or not (ie. is creating or destroying value).

Drawbacks of IRR:
- There are special cases where the resolution of the equation NPV = 0 does
not admit a solution (no IRR)
- There are special cases where the resolution of the equation NPV = 0 admits
several solutions (several potential IRRs)
- And above all, the IRR is a bad indicator to choose between several
mutually exclusive investments: it is necessary to privilege the NPV
29
 IRR
Examples about the drawbacks of IRR:
Consider the following projects (M€):
Year 0 1 2
Project A 4 -7 4 A: no IRR, but NPV>0
Project B -1 7,2 -7,2 B: two IRR…

4,00
3,00
2,00
NPV in M€

1,00
0,00
0%

120%
150%
180%
210%
240%
270%
300%
330%
360%
390%
420%

480%

540%

600%

660%
450%

510%

570%

630%

690%
30%
60%
90%

-1,00
-2,00
Discount rate(%) 30

Project A Project B
IRR
Examples about the drawbacks of IRR :
Consider the cash flows generated by the two following projects (M€):

Year 0 1 2 3 4 5 6 7
Project A -5 6 0,5 - - - - -
Project B -7,5 2 3 0 0 2,1 0 5,1
For both projects, the discount rate is 5%.
Results:
NPV IRR
Project A 1,17 28%
Project B 2,40 13%

Both projects create value (using NPV or IRR criteria). NPV criterion
indicates that project B is better than A. IRR criterion indicates the
contrary.
 It is the NPV criterion that gives the right conclusion by definition,
31
because this criterion mesures the value creation for each project.
NPV and IRR with EXCEL in English
Fortunately, some formulae exist under excel to calculate quickly NPV
and IRR :
-------------------
=NPV (discount rate; [value 1 : value n] )
Be careful for the starting point because the first value (value 1) is
considered by the function as being the value of year 1 and nott the
value for year 0.
-------------------
=IRR ([value 1 : value n])
Be careful, it gives only one IRR even if there are several IRR.
Or you can use:
= IRR ([value 1 : value n], estimation]
32
Which finds the IRR most proximate of the given estimation.
NPV and IRR with EXCEL in French
Fortunately, some formulae exist under excel to calculate quickly NPV
and IRR :
-------------------
=VAN (discount rate; [value 1 : value n] )
Be careful for the starting point because the first value (value 1) is
considered by the function as being the value of year 1 and nott the
value for year 0.
-------------------
=TRI ([value 1 : value n])
Be careful, it gives only one IRR even if there are several IRR.
Or you can use:
= IRR ([value 1 : value n], estimation]
33
Which finds the IRR most proximate of the given estimation.
Other selection criteria
There are a multitude of other criteria to help the decide to undertake or
not an investment, depending on the trends of the moment or the desire to
complicate or sometimes oversimplify. But none seems to combine
simplicity and efficiency of the NPV and the "good performance" of the IRR
criterion. Note however, because it is widely used in everyday language for
its simplicity:

The payback period : it is the time necassary to recover the initial outlay
on an investment.
To find it, you cumulate the cash flows including the initial one until you
get a sum eaqual to zero. Example:
Année 0 1 2 3 4 5
Flows (k€) -100 25 25 25 25 25
Cumulated flows -100 -75 -50 -25 0 25
Here, the payback period is 4 years. 34
Other selection criteria
The payback period must be compared to a reference period that depends
on each sector (arbitrary).

Its (huge) drawbacks are:

- It assigns the same value to one euro today and to one euro in the future,
which we have seen is to compare apples and oranges
- It gives a great importance to the cash flows at the beginning of the life
(liquidity) of the investment and it ignores the cash flows after the payback
period. Example (M€):
Year 0 1 2 3 Payback period NPV at 20 %

Project A -1000 500 400 600 2 years 2 months 42

Project B -1000 500 500 100 2 years -178
Exercise 2
Consider the following project (k€):

Year 0 1 2 3 4 5
Cash flows - 100 110 -30 25 50 100

Questions:
1/ Considering a 10% discount rate, what is the NPV of this project?
2/ Calculate the IRR of this project.
3/ What problem do you cope with when you calculate the payback
period?
4/ Do you think it is a project in which you should invest?

36
Exercise 2
Consider the following project (k€):

Year 0 1 2 3 4 5
Cash flows - 100 110 -30 25 50 100

Correction:
1/ 10% discount rate; NPV = 90,23 k€
2/ IRR = 42,64%
3/ We would like to answer that the payback period is a bit less than one year but the
investment is done in two parts (year 0 and year 2), so it seems difficult to define the
payback criteria here.
4/ NPV>0; IRR > discount rate= required rate for investors to invest in this project at this
level of risk: so yes, this investment creates value and should be undertaken

37
The main lines of reasoning to determine cash flows
1/ Consider free cash flows rather than accounting data
Free cash flows = Operating cash flows and investment cash flows

2/ Disregard the type of financing (debt or equity)

Because the financing impact are already included in the discount rate, do not include the financing
cash flows, otherwise you will integrate two times the same effect.

3/ Consider taxation
Because taxation impact the cash flows ( tax increase / tax credit )

4/ Reason in terms of incremental flows

Eg: The sunk costs already undertaken must not be considered. They are undertaken if there is a
« go » decision or « no go » decision.

5/ Reason in terms of opportunity

Eg: realisation of a project on a land owned but not used by the company: if the project is not
undertaken, the company can decide to sell the land.

6/ Be consistent between your assumptions

38
Eg: if the cash flows are in constant euro values (ie. excluding inflation), be sure that the
discount rate excludes inflation as well.
Exercice 3
Consider the following investment project: extension of an industrial plant
requiring a purchase of equipment of 20 M€ and set-up costs of 1.5 M€. The
useful life is 8 years, the increase of WCR is 2.5 M € (only in the first year).
The residual value is 0 M€ after 8 years.

This project increases the EBITDA by 3 M€ per year during the 8 years of use
of the new asset. The equipment is depreciated on a straight line basis over
5 years. Set-up costs can not be depreciated. The corporate tax rate is 40%.
An financial analyst told you that the minimum required rate of return is
10% with regard to the risk incurred.

Questions:
1) Draw-up the cash flow schedule for the project
2) Calculate the NPV and IRR of this project
39
3) Should this project be undertaken by the company?
 Exercise 3
Correction:
Reminder: only free cash flows: Depreciation allowances have no direct impact on cash
flows (calculated expense), but they reduce the profit, therefore the corporate tax. Do
not include interest flows to be paid because the cost of financing is taken into
account via the discount rate.

Sign Year 0 1 2 3 4 5 6 7 8
+ Increase of EBITDA 3 3 3 3 3 3 3 3
- Increase in Corporate tax -0,4 -0,4 -0,4 -0,4 -0,4 1,2 1,2 1,2
- Increase in WCR 2,5 -2,5
- Investment flows 21,5
= Increase of Free cash flows (M€) -21,5 0,9 3,4 3,4 3,4 3,4 1,8 1,8 4,3

(Discount rate= 10% = required profitability)

NPV = - 6,9 M€
IRR = 0,9 %
NPV < 0
IRR < Required profitability 40

The investment should not be undertaken.

Exercise 4
You borrow 100 000 € from your bank on 5 years with
an interest rate of 5%. This is a fully amortizing loan ,
the repayments are done each year with a constant
total annuity. What is the amount of this annuity?

41
Exercise 4
You borrow 100 000 € from your bank on 5 years with
an interest rate of 5%. This is a fully amortizing loan ,
the repayments are done each year with a constant
total annuity. What is the amount of this constant
annuity?

5 𝐶𝑜𝑛𝑠𝑡𝑎𝑛𝑡 𝑎𝑛𝑛𝑢𝑖𝑡𝑦
100 000 = 𝑘=1 (1+5%)𝑘

 Constant annuity = 23 097 €

42
Exercise 5 (bonus)
If Judas instead of throwing these 30 silver coins in 33
AD had placed them at 3%/year, what would be the
heritage of his descendants in 2019?
Same question with a 1% investment.
What do these results inspire you?

43
Exercice 5 (bonus)
Correction:
30 x (1 + interest rate)2019-33
At 3% : 9,37. 1026 silver coins
At 1% : 11,5. 109 ie. 11,2 billions of silver coins

Conclusions:
- Over very long periods, small differences in interest rates (eg.
between 3% and 1%) generated enormous differences.
- These 2 calculations, mathematically correct, forget wars,
famines, revolutions, etc. that happened over the period ...
- Before the industrial revolution (19th century), the average
growth rate of the economy was closer to 0.2% / year than 1% or
44
3% per year ... (placed at 0.2% on average : 1580 silver coins)
 Business
Valuation
6 December 2019
Jean-Baptiste Monlouis, Manager, KPMG Corporate Finance
Selma Elmadhi, Associate, KPMG Corporate FInance
1. The concept of Value
2. Valuation methods
3. Discounted Cash Flow
4. Market multiples
5. Transaction multiples
6. Revalued net asset
7. Presentation of our missions
1. The concept of
value
Enterprise Value vs. Equity Value

Equity Value

Enterprise Value

Net Financial Debt

Equity value Enterprise Value Net Financial Debt

Value vs Price
Investors
interests for
the sector

Industrial or
financial
operation

Control
premium

Standalone
Value

Earn-out
Costs
synergies

Revenues
synergies
2. Valuation methods
Presentation of Valuation Methods
Description of the method Advantages / limits

 The DCF method consists in determining the cash flow

 Allow to take into consideration company's specificities (growth
available to fund providers (shareholders and creditors) and
potential, expected improvement in margins, impact of upcoming
Discounted discounting it at a rate reflecting their required rate of return investments)
Cash Flow
 The value thus obtained corresponds to the theoretical market  Sensitivity to the assumptions in the business plan
(DCF)
value of the operating assets of the company (the Enterprise  Sensitivity to the discount rate (WACC) used that is a function of
Value, or EV) the identified risk and perpetual growth rate

 Good indicator of current market prices

 The multiples method consists in determining the value of a  Partial information / confidentiality of transactions
Transactions company based on the multiples observed in transactions  Specific context (minority, majority, control premium) of each
multiples carried out in the same sector and considered to present similar transaction
features to the Company  Financial aggregates used in the transaction / distortion of the
multiple / context / growth / learning curve

 The multiples method consists in determining the value of a  Dynamic valuation method that is a good indicator of the state of
company based on multiples observed on the market for the market and expected performances in the sector
Trading
multiples companies in the same sector based on past or anticipated  The specific features of the peers selected (size, growth rate,
financial aggregates margins, liquidity, etc.)
 Pertinent valuation only in the case of a minority interest

 The revalued net asset is a valuation method used for

 Valuation method that gives a true and fair view of the fixed
determining the value of a company that consists of analyze the
assets on the valuation date
Revaluated Net value of the different assets and liabilities of the company and
Asset
 Relevant valuation in the case of a conglomerate or holding
then adding them together. The value of the company is thus company
calculated by adding up the different asset items and
 Static valuation method
subtracting the liabilities of the company.
3. DCF Method
Principle of DCF method
The Enterprise Value is the market value of the capital employed and corresponds to the sum of future cash flows discounted at the requested rate of return
(WACC)

Enterprise Value =  Free Cash Flow to Firm

i=1 (1 + WACC)i

1 3 5
Determination of
Strategic and normative Determination of
financial analysis of assumptions and Enterprise Value
the company and its computation of and Equity Value
environment terminal value
2
4
Determination of
Free Cash Flow Determination of
over the Business Discount rate and
Plan horizon application to cash
flows and terminal
value
DCF method : free cash flow calculation (1/2)
Steps for the free cash flow calculation

Operating income
after theorical tax Cash flows from operations

+ Depreciation & Amortization

- Change in working capital Investments to maintain the Capital

Employed and ensure the expected
- Capital Expenditure growth

= Free Cash Flow to Firm

- Financial expenses

+ Tax shield Cash flows related to Net

Financial Debt

- Debt variation

= Free Cash Flow to Equity

 DCF method : free cash flow calculation (2/2)
Different types of cash-flow

FCFE
(Free Cash Flow to Equity)
FCFF Shareholders
Shareholders Cash-flow after financial expenses
(Free Cash Flow to Firm) and financial debt reimbursement
Cash-flow before financial Shareholders and
expenses and financial debt creditors
variation

FCFD
(Free Cash Flow to Debt)
Creditors
Creditors Financial expenses and financial debt
reimbursement

Which explicit horizon to retain ?

 The explicit horizon corresponds to the period after which the ROCE is considered as stable.

 The duration of this period is at least equal to the management’s business plan, if necessary the analyst can extend the business plan’s period.
 DCF method : Terminal value determination
Terminal Value calculation Definition of a normative Free Cash Flow

 The terminal value (TV) represents the enterprise value at the end
of the explicit horizon.  At the end of the explicit period the growth of the business is stable

 Long term growth must be consistent with the economic growth : sales and
working capital grow at the pace of long term inflation
Value over explicit horizon
(of n periods) Terminal Value
 ROCE (Return on Capital Employed) is stabilized

 Amortization converge towards CapEx

Long term
growth
Vn VT
V2 V 3 V ... Growth over
V1
explicit period

Normative FCFF
Terminal Value =
WACC - g
DCF method : Determination of the discount rate (1/3)

Weighted Average Cost of Capital (WACC)

 The discount rate applicable to future Free Cash Flow reflects the expected return of the funds providers (both creditors and shareholders)

 This discount rate represents the weighted average cost of capital, calculated by weighting the expected return by equity shareholders and
debt providers by their respective weights in the invested capital.

E D
WACC = Ke x + Kd (1 – T) x
D+E D+E

Ke = Cost of equity

Kd = Cost of debt

T = Corporate Income tax rate

D = Net Financial Debt

E = Equity value
DCF method : Determination of the discount rate (2/3)
Cost of equity (Ke)

 The cost of equity is the return required by shareholders.

 The standard approach used by valuation specialists is based on the CAPM (Capital Asset Pricing Model) and is calculated as follows :

Ke = Rf + β x (Rm – Rf) + Ps

 The risk free rate (Rf) corresponds to the return of an asset with a zero or quasi zero risk, for example the return of government bonds

 The beta (β) corresponds to the intrinsic risk of the company’s sector vs the stock market

 The market risk premium (Rm – Rf) reflects the additional risk of a stock investment

 A specific risk premium (Ps) can be considered in order to reflect specific additional risk : for example country risk premium or size premium
DCF Method : Determination of the discount rate (3/3)

Cost of debt (Kd)

 The cost of debt corresponds to the refinancing cost of the the long term debt under actual market conditions

 In practice, we can determine Kd :

 Based on return of comparable bonds of listed companies;
 By adding a spread to the risk free rate depending on the financial notation of the valued company which depends on profitability of default
 The risk of creditors is generally lower than the shareholders risk, the cost of debt is then lower than the cost of equity

WACC – Key matters

 The WACC is used for discouting FCFF
 It can be compared to the ROCE : if ROCE > WACC, the company creates value
 Other discount rates can be used :
 Ke : the Cost of Equity is used to discount FCFE
 IRR : Internal Rate of Return can be used to discount cash-flows in a process of investment decision making in a project / asset
DCF method : Enterprise Value calculation
Value of operating assets (DCF) :

Enterprise Value =  FCFFi

+
Terminal Valuen
i= 1 (1 + WACC) i (1 + WACC)n

Discounted FCFF – Key Matters

 Cash flows have to be discounted at the middle of the year (except particular cases, cash-flows are generated over the year)

 The terminal value have to be discounted by the last discount factor of the business plan (or the extrapolation period)
 DCF method : Enterprise Value and Equity Value calculation
Bridge between Value of operating assets and Enterprise Value

Value of Operating assets (DCF)

+ Market value of non-operating assets (where appropriate net of CIT)

+ Discounted Tax loss carry forward which are not taking into account in the
DCF

= Enterprise Value

Bridge between Enterprise Value and Equity Value

Enterprise Value

- Net Financial Debt

- Minority interests

= Equity Value
4. Market multiples
method
Method of market multiples (1/3)

1 5
Conclude on the
Determine a Value and
sample perform
sensitivity
2 4 analysis
Apply the
Adjust data from
selected market
comparable
multiple
companies and
analyze their
3 (average,
median, etc.) to
performance
the appropriate
Calculation of aggregate
market multiples
Method of market multiples (2/3)

Multiples

Enterprise Value
Equity Multiples
Multiples

EV / Revenues PER

Price to book
EV / EBITDA
ratio

EV / EBIT (before or
Depending on the industry, other specific multiples
after CIT) exist
Method of market multiples (3/3)
Enterprise Value Multiples Equity Multiples

Market capitalization = share price x number of Market capitalization = share price x number of
shares outstanding shares outstanding

+ Net financial debt at the valuation date

+ Minority interests

+ Minority interests
= Equity Value

- Non-operating assets (of which non consolidated

participations)
PER
PBR

= Enterprise Value (EV)

EV/Revenues
EV/EBITDA
EV/EBIT
5. Transaction
multiples method
Transaction multiples method (1/2)

1 4
Determine a sample
of recent Conclude on the
transactions in the Value and perform
sector 2 3 sensitivity analysis

Apply the selected

Calculate the
transaction multiple
mutiples from
(average, median,
prices paid by
etc.) to the
acquirers appropriate
aggregate

Transaction multiples may include control premiums and / or synergies paid by the acquirer
Transaction multiples method (2/2)
Example of a selection of comparable transactions in the renewable energy production sector (by wind turbines):

Selection of a panel of transactions in the same

Identification of a panel of comparable transactions in
sector of activity
the renewable energy production sector
46

Business Exclusion of companies that produce energy from other sources

(photovoltaic, hydro-electric, biogas, etc.) or which mainly build and /
38 or install energy infrastructure (Engineering, Procurement and
Construction)

% of acquisition
Exclusion of minority transactions (the contemplated transaction is
25 based on the acquisition of 100% of the shares)

Geography Exclusion of companies which are outside Europe or which are in countries with a
different subsidy scheme (Power Purchase agreement, Contract for Difference,
16 market price, etc.) than the target company

Margins
Exclusion of companies with a profitability profile different from the target
8 company (owner of lands vs. lease, internal O&M vs sub-contractor, etc.)

Number of selected
peers
6. Revalued net asset
method
Revalued net asset method
The Revalued Net Asset method also called « sum of the parts » (SotP) is a method which breaks down the value of a group
or a conglomerate by business

Business C
200 HQ costs
(300)

3 businesses with Business B

400 Equity Value
different growth and
(400)
risk levels
EV
600

Business A Net Financial Debt

300 (200)

This method is applied in particular for groups with diversified businesses

by summing the value of their different businesses from which HQ costs are subtracted
7. Presentation of our
missions
Presentation of our missions
І Investment funds and companies regularly need assistance in the context of investment / divestment opportunities or internal reorganization

Business valuation І In this context the Valuation and Business Modeling team might work with other Deal Advisory teams (M&A, transaction services, restructuring, etc.)
in the context
of a transaction І For the purpose of public operations, the Valuation and Business Modeling team can be appointed as an independent expert to perform a fairness opinion
or reorganization

І The Valuation & Business Modeling team assists companies or investment funds in the construction / update / review of complex financial models in the
Business Modelling
context of transactions, investment decisions, management of the performance or tax planning

І Accounting norms (IFRS / French GAAP) require a fair value analysis of all the assets and liabilities of the acquired company following an acquisition

І Purchase Price Allocation or « PPA » consists in : (i) identifying all the purchased assets and liabilities which have to be recognized in the balance sheet,
Purchase Price Allocation (ii) analyzing their fair value , (iii) calculating and rationalizing the residual goodwill
(“PPA”)
І The Valuation & Business Modelling team performs PPA missions for clients and PPA reviews for audit teams

Business valuation for tax І In the context of international transactions, companies need assistance in order to analyze the enterprise value of the companies acquired or divested.
purposes The valuation report is usually communicated to the tax administration

І The management packages are incentives mechanisms for executives and top management (stocks-options, preferred shares, equity warrants, etc.). In
particular, they are commonly used in LBO transactions and allow the capital gain to be shared between the financial investor and the managers
Management Packages
І The Valuation and Business Modeling team performs valuation analysis of management packages

І Under IFRS, goodwill and intangible assets with undefined useful lives must be tested for impairment purposes yearly. Impairment is recognized if the
book value of the capital employed is higher than the recoverable value (the highest value between the fair value net of disposal costs and the value in
use)
Impairment tests
І Missions related to impairment tests include estimating the fair value of all of the business units of the Group

І The Valuation & Business Modelling KPMG team performs Impairment Tests missions for clients and Impairment Tests reviews for audit teams
Thank you for your
attention !
Start-up and financing
Start-up: some features

1. Very high risk, high volatility of the

perceived value of the capital employed

2. The crucial role of the founder (s)

3. The more active role of investors

4. Need for external financing in several

rounds of financing (usually with a share
premium) 2
Start-up: what type of fund to raise?

Equity (and often only equity)

The extreme risk, weighing on a start-up and whose model has not been
proven, can often be financed only by equity.
With its regular required cash flows (interest payments and repayments of
capital), the debt is generally not compatible with the generation of
random and negative cash flows of a start-up.
Other type of funds ?
 Debt, it is rare but possible if the following conditions are respected:
• The company can generate positive and relativeley regular cash
flows
• The start-up has assets on which can be secured the loan (eg. real
estate) or the loan is guaranteed by an public/trusted organization
(eg. The Public Bank of Investment (BPI) in France)
 Business creation assistance (eg. BPI in France), honor loan (eg. France 5
Initiative), business creation contest
From whom raised equity?

In chronological order, from the creation of a start-up to its transformation

till a big company (if it has not gone bankrupt before), investors are:
1. Creators of the start-up who often invest a few k€
2. Love Money an the « 3F »: Friends, Family … and Fools, for some k€
 Crowdfunding is a key instrument today for it
3. Business Angels: often former managers and entrepreneurs. They make
available to the start-up a few tens or hundreds of k €, but also their
advice and address books to help the start-up
4. Venture capital funds: specialized in the investment of high-potential
start-ups. Ready to invest between 0.5 M € and a few tens of M €
Beyond, there are investment funds specialized in capital development or
IPO, but the company stop being a start-up!
6
Financement d’une start-up

Source: Corporate Finance. P. Vernimmen, P. Quiry, Y. Le Fur

7
Particularities to evaluate a start-up

The valuation of the accounting book value (equity) does not reflect the
value of the start-up, which depends mainly on future developments …
Thus : no

We could update the free cash flow as provided in the business plan, but it
is very unreliable (disproportionate optimism - and normal for a start-up)…
Thus : no

So what to do ?

8
Particularities to evaluate a start-up
In fact, the probable value of equity is estimated at a resale horizon of the
company or an IPO (2-7 years). For this, we take the expected result in the start-
up's business plan by this time and multiply it by the PER (Market value of
equity/Net Profit) of the same sector in the development stage corresponding to
the horizon looked.
This estimated value of equity is discounted with a discount rate that is higher as if
the company is at an early stage of development:
Stage Discounting rate Horizon
Creation 60% 7 year
First round 50% 5 year
Second round 40% 4 year

Third round 30% 3 year

Before IPO 20% 2 year
This remains a rough estimation, in absence of anything better. 9
Investing in a start-up is above all an act of faith !
Particularities to evaluate a start-up
Example

A start-up has been created and asks you to invest in it. The business plan
shows a net profit in 7 years of 8 M€. At the stage of development to which
you wish to sell (7 years), the companies of the same sector have a PER
(ratio equity / result) of 15. You believe a priori in the direction and the
success of the concept, but you wish before investing to know how much is
worth this start-up today if it succeeds this first raising of funds allowing its
creation.

10
Particularities to evaluate a start-up
Example

A start-up has been created and asks you to invest in it. The business plan
shows a net profit in 7 years of 8 M€. At the stage of development to which
you wish to sell (7 years), the companies of the same sector have a PER
(ratio equity / result) of 15. You believe a priori in the direction and the
success of the concept, but you wish before investing to know how much is
worth this start-up today if it succeeds this first raising of funds allowing its
creation.

Estimation of equity value in 7 years:

8 M€ * 15 = 120 M€

Estimated value of the start-up if it succeeds to raise funds :

120 𝑀€
= 4,5 M€ 11
1+60% 7
Bankruptcy
What is a bankruptcy?

Bankruptcy is a legal term for when a company cannot

repay their outstanding debts. The bankruptcy process
begins with a petition filed by the debtor, which is most
common, or on behalf of creditors, which is less common.

It is the cessation of payments that marks the entry into

the bankruptcy, that is to say the fact that the company
can not immediately meet its liabilities due with its
available assets.

2
 Judicial process of bankruptcy

Receivership

Cessation of Petition in Opening Observation

payment bankruptcy judgement period

Judicial
liquidation

3
Consequences of opening judgement

The opening jugement :

 Prohibits from paying claims arising before the beginning
of the proceedings
 Freeze the calculation of interest and late payment fee
 Interrupts ongoing court proceedings and prohibits new
procedures for the unpaid receivables
 Gives post-judgment creditors precedence in case of
liquidation
The entry into bankruptcy procedure “protects” the
company and the managers.
4
Petition in bankruptcy

The petition in bankruptcy is the declaration of the

company's cessation of payments to the commercial court.
The company mentions at the moment t its balance sheet
with its assets and liabilities.
In French law, managers are required to submit the petition
in bankruptcy to court no later than 45 days after the
termination of payment.

5
Receivership

The purpose of the receivership (legal redress) is, as far as

possible, to enable the company to continue its activity, to
safeguard employment and to clear the liabilities by means
of a plan adopted by court decision after a period of
observation following the entry into bankruptcy procedures.

6
Judicial liquidation

The judicial liquidation represents the death of the company

which is dissolved. The assets of the business that can be sold are,
usually in the form of an auction.

The money raised by the liquidation is then distributed to clear

the claims in an order that can be different from one country to
another. But the order of priority is in general always:
1. State
2. Creditors that fund the company after entry in bankruptcy
procedure
3. Secured creditors
4. Unsecured creditors
7
5. Shareholders
What are the causes of bankruptcy?

There are 2 causes of bankruptcies :

1. Operating difficulties (which in the second phase lead to

financial difficulties)

2. Purely financial difficulties

8
Bankruptcy law in the world

There are 2 main types of systems:

1. The law which favors the safeguarding of employment as

a priority through the continuity of the company, and
secondly the creditors
Examples: France, Italy, United-States (Chapter 11)

2. The law that favors creditors as a priority.

Exemples: Germany, United-Kingdom, Spain

9
Fraudulent bankruptcy

Fraudulent bankruptcy is a criminal offense in which the top

managers of companies engaged in collective proceedings
are guilty of serious acts.

Examples:
- Enron bankruptcy in 2001 (accounting faking)
- No respect of the 45-day period between the cessation of
payment and declaration to the court of the petition to
bankruptcy

10
Responsibilities of top managers in case
of bankruptcy
Fraudulent bankruptcy is reprehensible in any form of society.
For « classical » bankruptcies (non fraudulent), we distinguish:
- The limited companies in which the liability of the partners
is limited to the contributions of the partners (In France: SA,
SAS, SARL. In UK: Ltd.)
- The unlimited liability companies in which the liability of the
partners is unlimited (In France: Sociétés en Commandite,
Sociétés en Nom)
The vast majority of companies are limited risk companies.
Shareholders benefit from a kind of "joker", with the possibility
of “reviving”. The development of these limited liability
companies is one of the major financial innovations of the XIX
century that permitted the development of capitalism via a
facility to take risks, while having the right to another chance 11
in case of failure.
Questions about bankruptcy

1. How can bankruptcy proceedings contribute to the survival of a company?

It can allow (if the recovery is considered plausible) the implementation of
a viable debt repayment plan for the company, and force the creditors to
accept it through the intervention of justice, which does not would
probably not have been possible otherwise.
2. Why can companies surviving from a bankruptcy proceedings (receivership)
be formidable competitors?
Because some of their expenses may have been renegotiated downwards
(partial default on the debt or spreading the payment at a lower interest
rate, renegotiations of rents, staff costs, various constraints)
3. Why in France, companies coming out of bankruptcy are they rarely
formidable competitors?
Because the first concern of the public authorities is the safeguarding of
employment and the plan of continuation preserving the most jobs is likely
to be the plan retained, even if other proposals to make the company
more competitive to revive it economically have been proposed.
12
Questions about bankruptcy

1. How can bankruptcy proceedings contribute to the survival of a company?

It can allow (if the recovery is considered plausible) the implementation of
a viable debt repayment plan for the company, and force the creditors to
accept it through the intervention of justice, which does not would
probably not have been possible otherwise.
2. Why can companies surviving from a bankruptcy proceedings (receivership)
be formidable competitors?
Because some of their expenses may have been renegotiated downwards
(partial default on the debt or spreading the payment at a lower interest
rate, renegotiations of rents, staff costs, various constraints)
3. Why in France, companies coming out of bankruptcy are they rarely
formidable competitors?
Because the first concern of the public authorities is the safeguarding of
employment and the plan of continuation preserving the most jobs is likely
to be the plan retained, even if other proposals to make the company
more competitive to revive it economically have been proposed.
13
Questions about bankruptcy

4. You are shareholders of a company that has just filed for bankruptcy.
Justice decides the liquidation of the company. What percentage of your
capital contribution from the company do you have an average chance of
recovering from liquidation?
Probably close to 0% ... the shareholders are the last served after the
employees, the state and creditors. This is also why it is said that the
shareholder is the one who bears the most risk of the company.
5. Can a company that finances itself only through equity and has no debt
go bankrupt? Can it destroy value?
No: no debts, no bankruptcy! It can, however, destroy value as soon as its
ROCE is lower than its WACC. Shareholders may decide to sell or stop the
activity if it is deemed non profitable ... but it is not strictly speaking a
bankruptcy that involves a cessation of payment to creditors
6. Why can creditors agree to lend to a company during the observation
period?
Because in case of liquidation, these creditors have priority over other
creditors to be reimbursed. 14
Questions about bankruptcy

4. You are shareholders of a company that has just filed for bankruptcy.
Justice decides the liquidation of the company. What percentage of your
capital contribution from the company do you have an average chance of
recovering from liquidation?
Probably close to 0% ... the shareholders are the last served after the
employees, the state and creditors. This is also why it is said that the
shareholder is the one who bears the most risk of the company.
5. Can a company that finances itself only through equity and has no debt
go bankrupt? Can it destroy value?
No: no debts, no bankruptcy! It can, however, destroy value as soon as its
ROCE is lower than its WACC. Shareholders may decide to sell or stop the
activity if it is deemed non profitable ... but it is not strictly speaking a
bankruptcy that involves a cessation of payment to creditors
6. Why can creditors agree to lend to a company during the observation
period?
Because in case of liquidation, these creditors have priority over other
creditors to be reimbursed. 15
Introduction to
Market Finance
 Financial need Balance Financial
resources

Capital Committed
employed capital

Capital
Economic Business providers
activities -
Company Shareholders
&
Lenders
Economic Attributed
result result

Result from
Optimize Financing cost
activities
Introduction
In Finance, two different parts are often opposed:
– Corporate Finance, the subject of this course: optimizing the value of
the company over the long term, which includes decisions on the
financing of the company, the investments to be undertaken, the
remuneration of capital.
– Market Finance, which concerns the functioning and the operations
on the financial markets

However, there is a strong link between these two parts: the company
will find on the financial markets:
– Its sources of financing by issuing stocks or debt securities (bonds)
– The covering (hedging) of some of these risks (futures, options)

These few slides are intended to give you an introduction to Market

Finance, in connection with Corporate Finance.
3
Changing times!
We have gradually moved from the second world war of a bank-
based economy to a market-based economy. This move is often
dated from the first system to the second one in the 1980s in North
America and Europe, although it is a progressive and still ongoing
movement.

In a bank-based economy, the financing of companies by bank credit

predominates. Banks play a fundamental role in intermediation
between savers and borrowers.

In a market-based economy, most of the financing needs of

companies are covered by the issuance of financial securities (stocks,
bonds, etc.) subscribed directly by investors.
4
Changing times!
Be careful not to be caricatural however:
- Financial markets have existed a long time before the 1980s, but
their use was much more marginal than today
- Banking intermediation has not disappeared and continues to be
widely practiced today for households (eg. mortgage, investment in a
savings account) and for SMEs that have no way to have a direct
access to financial markets
- Many countries in the world continue to experience a bank-based
economy with poorly developed financial markets (eg. Maghreb, Sub-
Saharan Africa).

5
Financial markets
They are two main types of products:

1/ Securities:
- Equity securities: stocks
- Debt securities: bonds

2/ Derivative contracts to cover risks (or to take risk depending on

the position you have):
- Futures/forwards
- Options

6
Securities: 2 markets
Securities (stocks or bonds) depend on two distinct markets:

- The primary market where the securities are newly issued. It is

sort of the "market for new products". It is fundamental for the
company seeking to finance itself on the markets: it is in this
market that the company obtains the cash following the sale of its
securities (stocks or bonds)

- The secondary market where the securities already issued are

exchanged. At first glance, they concern less the company which
has already obtained its financing ... However, it is an important
market for the good progress of the next fund raising (if the value
of the securities collapses, who will want to advance capital on a
future issue?) and where the stocks are traded (ownership titles:
change of ownership)
7
Securities: stocks
Definition
A stock is representative of a share of equity of a company. It is
therefore a ownership title of a part of the company.

Consequences
It is a security whose repayment is not planned (exit only by "sale" if
there is a buyer - or in case of liquidation) and whose attached cash
flows are uncertain (high risk). In return, the shareholder
participates in the control of the company by the voting right
attached to the stock.

8
Securities: stocks
Value of a stock:

∞ 𝑭𝒕
V0= 𝒕=𝟎 (𝟏+𝒊)𝒕
We recognize here the Present Value with:
- Ft: the cash flows attached to the stock (free cash flows to the
firm minus cash flows for lenders)
- i: the discount rate, which depends on the risk-free rate and the
risk premium attached to the stock
- t: the actual delay between the time of calculation and the date
of the cash flow
The challenge is, of course, to correctly evaluate future cash
flows... 9
Securities: stocks
Value of a stock: questions. It’s up to you !

Following the occurrence of each of the following events, not

anticipated by the market, how does the stock price of Delta
company evolve:
1. Delta's establishment in Italy finally appears more complex than
expected, cash flows should occur later than initially expected
2. Interest rates will finally rise following the decision of the ECB
3. Delta’s competitor, Beta company, is in trouble and should
announce a refocusing of its activity outside the market where
Delta operates. Delta would almost be a monopoly in its market.
4. The company Omega launches a takeover bid on Delta. Its
acquisition aims to take advantage of synergies between the two
companies.
10
Securities: stocks
Value of a stock: questions. correction, cf. Present Value formula

Following the occurrence of each of the following events, not anticipated by the
market, how does the stock price of Delta company evolve:
1. Delta's establishment in Italy finally appears more complex than expected,
cash flows should occur later than initially expected The stock price
decreases (the futures cash flows Ft are delayed)
2. Interest rates will finally rise following the decision of the ECB The stock
price decreases (the discount rate i increases)
3. Delta’s competitor, Beta company, is in trouble and should announce a
refocusing of its activity outside the market where Delta operates. Delta
would almost be a monopoly in its market. The stock price increases (futures
cash flows Ft will probably be more important)
4. The company Omega launches a takeover bid on Delta. Its acquisition aims to
take advantage of synergies between the two companies. The stock price
increases. Omega will offer a higher price to convince the actual owner of
Omega’s stocks to sell their stocks to Omega.

11
Securities: stocks

 An example of a takeover
bid by LVMH on
Tiffany&co

12
Securities: stocks

 Xavier Niel proposed to

buy himself stocks from
other shareholders

13
Securities: bonds
Definition
A debt security is a financial instrument representing the borrower’s
obligation to the lender from whom he has received funds. If the maturity of
the security is over one year, it is called a bond.

Bond features:
- Name of the issuer
- Borrowed amount
- Interest rate (fixed or variable)
- Method of redemption (often at maturity), with a schedule of cash flow if
complex
- Date of issue (beginning)
14
- Settlement date (end)
Securities: bonds
Value of a bond:

𝑵 𝑭𝒕
V0= 𝒕=𝟎 (𝟏+𝒊)𝒕
We recognize here the Present Value with:
- Ft: the cash flows attached to the bond (capital redemption and
interests)
- i: the discount rate, which depends on the risk-free rate and the
risk premium attached to the bond
- t: the actual delay between the time of calculation and the date
of the cash flow

The future cash flows are much more easily determinable here
15
than for a stock (the schedule of cash flows is defined at issuance)
Securities: bonds
Value of a bond: questions. It’s up to you !

Following the occurrence of each of the following events,

not anticipated by the market, how does the (fixed
interest) bond price of Delta company evolve:
1. The dividend paid this year to the shareholder will
eventually be a little weaker than expected
2. Interest rates will rise following the decision of the
ECB, not anticipated beforehand
3. The rating agencies Standard & Poor's and Fitch have
just downgraded the rating of Delta from A- to BBB.
16
Securities: bonds
Value of a bond: questions. Correction

Following the occurrence of each of the following events, not

anticipated by the market, how does the (fixed interest) bond price
of Delta company evolve:
1. The dividend paid this year to the shareholder will eventually be
a little weaker than expected. No impact of the cash flows for
the lenders
2. Interest rates will rise following the decision of the ECB, not
anticipated beforehand i increases, but the Ft remains the same
(fixed rate), so the price of the bond falls. If the obligation had
been variable rate, Ft and i evolves in parallel and there is then
no impact on the value of the obligation.
3. The rating agencies Standard & Poor's and Fitch have just
downgraded the rating of Delta from A- to BBB. The risk
increases, so i increases, the value of the bond decreases
17
Securities: bonds
The bonds correspond to debt securities with a duration
of more than 1 year.

If the debt security is for less than a year, we talked

about:
- Commercial paper if the issuer is a firm
- Treasury bill if the issuer is a state

The main principles outlined in the previous slides are

generally the same for these debt securities as for bonds.
18
Derivatives
Definition
A derivative is a financial asset whose value depends on
the value of an underlying asset.

Examples of underlying assets:

- Financial asset: bond, stock, stock index, currency
- Physical asset: raw material, mining asset

19
Derivatives
Use: risk coverage
When a market player holds an asset that carries a risk, he
may want to sell that risk. If he finds another player who
wishes to carry this risk for remuneration, he gets a
guarantee of the value of his assets from this second player. It
is this guarantee contract that can take the form of a
derivative product.

Two main categories of derivatives:

- The options that are exercised only if the holder so
decides.
- The forward/futures contacts that are reciprocal
commitments that are necessarily exercised at the end
(cash or physical settlement) 20
Derivatives: options
Definition
An option is a contract that gives the holder the right
- and not the obligation - to buy (call option) or sell
(put option) on a date of exercise or for a period of
exercise an underlying asset at a strike price set at
the beginning of the contract in return for a premium
paid immediately to the seller.

NB: A distinction is made between US-style options

(the holder can exercise his right at any moment
during the exercise period) and European-style
options (the holder can only exercise his right on the
exercise date). Despite their names, they can be
21
found on both sides of the Atlantic.
Derivatives: options
Example
Today, John buys from Alexander a call option on the Heineken stock
at 90 € against the payment of a 5 € premium. This is a European
action with a maturing of 10 months.
After 10 months, John can buy at 90 € a Heineken stock from
Alexander if he wants, but he does not have to.
Of course, after 10 months, if the Heineken stock price is strictly
above 90 €, John will want to exercise the option (the option is
called "in the money").
On the other hand, if at the end of 10 months, the price of the option
is strictly lower than 90 €, John will not wish to exercise the option
(the option is called "out of the money").
Whatever the case, the 5 € Premium must be paid by John to
Alexander.
NB: John carries a risk of loss limited to the premium. Alexander
carries a very high risk of loss potentially unlimited.
22
Derivatives: options

Call

Buyer

Premium

Strike price Value of the underlying asset

Seller

23
Source: Corporate Finance. P. Vernimmen, P. Quiry, Y. Le Fur
Derivatives: options

At maturity, the value of an option is its intrinsic value (see

previous slide). Before maturity, a trend reversal is always
possible and there is a time value that is added to the intrinsic
value. This time value is stronger if the price of the underlying 24
asset fluctuates around the price of the exercise (reversal more
likely) and of course decreases as the maturity approaches
Derivatives: futures and forwards

Definition

A future or forward contract is a financial contract in

which the seller and the buyer both agree in a firm and
definitive manner to exchange an asset at an agreed
time, at an agreed price.

25
Derivatives: futures and forwards
Example
A metallurgical company fears a rise in copper prices. The copper
price is currently (spot price) of 6000 €/ton for immediate delivery.
It decides to cover this risk by buying a future contract with a date of
exercise the next 15th January for 1000 tons (T) of copper at an
agreed price of 6200 €/T.

By neglecting the transport and transaction costs, considering p the

spot price on the 15th January, the metallurgical company (buyer of
the futures contract) realizes:
- If p = 6200 €/T, a gain G equal to zero
- If p > 6200 €/T, a gain of 1000*(p-6200)
- If p < 6200 €/T, a loss of 1000*(6200-p)

Of course, for the seller of the futures contract, the position in terms 26
of gain / loss is the exact opposite as for the buyer.
Derivatives: futures and forwards

At the end
A future/forward contract can be terminated with 2
manners:
- By a physical settlement (least common case, but
this possibility always exists)
In the previous example, delivery of 1000 T of cooper by
the seller of the contract to the buyer the 15th of
January
- By a cash settlement (most common case)
In the previous example, depending on the price, it
means that the player who realizes a loss pay the player
who realize a gain, but without a physical delivery of 27
the product on the 15th of January.
Derivatives: futures and forwards
The differences between futures and forward:

Forward contracts are over-the-counter (OTC) contracts

that do not guarantee against the risk of counterparty
default. They are not standardized and are therefore
generally difficult to sell on the market.
Future contracts are traded on an organized market
(exchange market). The clearing house of this exchange
protects against counterparty risk with the obligation to
deposit an initial margin and margin calls depending on
the evolution of the price of the underlying asset.
28
Interlude: some definitions
Clearing house: a financial institution whose purpose is to
eliminate counterparty risks in the derivatives markets of
a stock exchange. In concrete terms, the clearing house is
the only counterpart of all operators. The clearing house
monitors the positions. It requires the formation in its
books of a deposit on the day of the conclusion of a
contract (initial margin). In case of potential loss of a
stakeholder, it makes margin calls.
Margin call: Mandatory payment of additional funds to the
clearing house by an operator to cover the depreciation of
its open position in the market, which must be carried out
in a relatively short time, often before the trading day the
next day, otherwise, its position is liquidated at the next
market opening. 29

 An example on the blackboard to illustrate this!

Financial risk
Market risk: exposure of a company as a
result of unfavorable price or rate changes.

Counterparty risk (also known as credit Difficult to move away

risk): risk of loss from a player with whom from one of these 3 risks
without exposing oneself
you have an agreement and who does not to the 2 others.
honor its commitment in time.
Metaphor of the "Bermuda
Triangle"
Liquidity risk: risk that when it materializes
corresponds to the impossibility at a given
moment for a company to face its cash
obligations. 30
Complex / hybrid products

With securities (stocks, bonds) and derivatives (options,

futures/forward), we have treated in the main products
that can be traded on the financial markets. However,
there are other more complex products, resulting from
combinations between the previous ones, for example:
- Preferred stock
- Convertible bonds
- Securitization (turning client loans into marketable
securities issued on the market)
- Etc…
31
Complex / hybrid products
One can get the impression by manipulating "complex"
and "sophisticated" financial products to make "high-
level finance".
Some reminders however:
- The complexity has a cost: if a company do not
succeed to raise funds with simple products, the
company can issue more complex product (against
additional guarantees...)
- We must not only look at the nominal cost of the
product but also at the overall cost, including the
borne risk (example: takeover by creditors in case of
bonds convertible into shares)
- Generally, in finance, when you invest, do only what
32
is in your circle of competencies !
Produits complexes/hybrides

Example of sophisticated products of "high-level

finance": Dexia loans to local authorities indexed
on parity between the euro and the Swiss franc ...
----

The crisis of 2008 in conclusion and opening for this

lecture on market finance?

33