Vietnam Master in Management – HCMC dec 2003 Profitability How to Use the Financial Plan Make it simple w Regroup all the inputs Sensibilities Studies

Vietnam Master in Management – HCMC dec 2003Profitability

How to Use the Financial Plan

• Make it simple Regroup all the inputs

• Sensibilities Studies• Set of different Cases

Base Case Best and Worst Cases (external influence) Strategic Decisions (internal)

• Synthesis and Graphic Presentation


Input Data Improvement

• It is useful to bring all the input data together Easier to make

sensibilities studies

BPcons.xls - SENSIB!A182


Sensibilities studies

• Goals To cover a broad scope of possible futures To identify the business drivers

• Most important factors to determine the future To measure the risks

• Usually a few major scenarios Base Case (or Management Case) Best and Worst Case Influence of major capex decisions


Saigon Hotel Sensibilities

Unit rate Occupancy Capex new rooms

Capex chain license

Base Dip in 03-04(60-65 US$)

Dip in 03-06(50%-65%)

Best Lower dip(65-70 US$)

Reduced dip(70%-75%)

Worst Longer dip(till 2005)

Longer dip(till 2006)

Extension As in Base As in BaseSlower recov

4 MioUS$(2003-04)

Chain Better than Base

Better than Base

1 MioUS$(2003)


How to analyze sensibilities studies

• Analyze most important indicators Profit and loss

• Revenues• EBITDA• EAT

Balance Sheet• Equity• Debt

Ratios• ROCE• ROE• Debt/equity ratio

• Use graphs


Saigon Hotel Revenues

REVENUES

0

500

1.000

1.500

2.000

2.500

3.000

3.500

4.000

2002 2003 2004 2005 2006 2007

base best worst extension chain


Saigon Hotel EBITDA

0

500

1.000

1.500

2.000

2.500

2002 2003 2004 2005 2006 2007



Saigon Hotel EAT

-1.400

-1.200

-1.000

-800

-600

-400

-200

0

200

400

600

800

2002 2003 2004 2005 2006 2007



Saigon Hotel Cash Flow

CASH FLOW FROM OPERATIONS

0

500

1.000

1.500

2.000

2.500

2002 2003 2004 2005 2006 2007



Saigon Hotel Equity

EQUITY

0

1.000

2.000

3.000

4.000

5.000

6.000

7.000

2002 2003 2004 2005 2006 2007



Saigon Hotel Financial Debt

FINANCIAL DEBT

0

1.000

2.000

3.000

4.000

5.000

6.000

7.000

8.000

9.000

2002 2003 2004 2005 2006 2007



Saigon Hotel : ROCE

ROCE

-10%

-5%

0%

5%

10%

15%

2002 2003 2004 2005 2006 2007



Saigon Hotel ROE

ROE

-35%

-30%

-25%

-20%

-15%

-10%

-5%

0%

5%

10%

15%

2002 2003 2004 2005 2006 2007



Financial analysis and leverage

• Necessity to have a quick vision of the financial situation of a company common language comparability

• Profitability ratios to measure the efficiency and the profitability

• Leverage ratios to measure the indebtness


Financial analysis and leverage

• Coverage ratios how are the debt and the interests covered by the cash-

flow ?

• Liquidity ratios how liquid is the company ?

• Distribution ratio what does the company distribute to the shareholders ?


Necessity of the Financial Analysis

• Who needs the financial analysis ? the banker

• to assess a new loan or to maintain a credit line the supplier

• to be sure to be paid by his customers the customer

• to be sure that his supplier will stay in the business the market (stock exchange)

• to assess companies• to valuate companies


What is important for the analysis ?

• To be able to compare ... different companies

• with the same activity (hotels, airlines, etc.) • with different activities

one company across the time

• . . . everyone must use the same indicators necessity of a common language

• no discussion on the facts• but discussion on the interpretation of the facts



• Limits to the comparability differences in accounting rules and practices

• in different countries (laws, fiscal regulations, accounting rules)

• inside the countries (internal practices of the companies)

• depreciation period• research & development• brands

leads to a growing standardization of the rules• BUT … the practices remain different



• Trust in the figures published by the companies themselves the Board of Directors is responsible

• Risks “window dressing” “cover-up”

• Remedies external auditors market authorities stock price complains by shareholders

• the “Swissair Case : Accounts of 2000”• the “Enron Case”


The Swissair CaseAccounts 2000

• Underestimation of the losses of subsidiaries Sabena, AOM-Air Liberté

• Underestimation of committed reinvestments Sabena, AOM-Air Liberté, LTU

• Hidden commitments put options given to other shareholders in joint-ventures


The Enron Case

• Underestimation of “off-balance” items Additional investments committed

• False profits on asset sales Assets were sold by Enron to Enron funded companies

• Over-estimation of turn-over / activities Enron controlled only fees on turn-over and NOT turn-

over

• Finally … destruction of documents and files by the company … … and its external auditors


Profitability Ratios : the ROE

• The key concept : Return on equity ROE Rfin EAT/EQ

• Key concept for the shareholder profitability of their investment in shares of this company

compared to alternate financial assets other shares fixed rates bonds (of companies or government)

• How to measure the equity ? book-value or... ...market price the difference can be huge for listed companies


Drivers of the ROE

• What are the drivers of the ROE ?• The profit margin on Sales• The productvity of capital employed

all the assets used by the company fixed assets working capital cash

• The financial structure of the company level of debt vs. equity


Profitability Ratios : ROCE

• The Return On Capital Employed (ROCE) measures what the company earns (before interest and tax) per unit of capital employed ROA ROCE EBIT/Assets ROCE = EBIT/(FIX+WC+CASH) in the practice the total Assets of the Balance Sheet are

often used this ratio is not influenced by the financial structure of

the company • because we use the EBIT

is also called Return On Investment (ROI) or Return On Assets (ROA)


ROCE after taxes

• It can be useful to calculate the ROCE after taxes ROCE* = ROCE.(1-Tc) where Tc is the average tax rate


Relation between ROE and ROA

• If the company has no financial debt ROE = ROCE* = ROCE.(1-Tc) for the demonstration please see in a finance reference

book this is logical because in this case the total of assets is

equal to the equity and no interest is paid

• The higher the ROCE the higher the ROE• The lower the tax rate the higher the ROE


Relation between ROE and ROA

• If the company has financial debt ROE = ROCE.(1-Tc) + (ROCE-id).(1-Tc).Dfin/EQ where id is the average rate of interest on the debt for the demonstration see in the book

• The ROCE should be higher than the interest rate if ROCE > id then ROE > ROCE* if the ROCE is higher than the interest rate on the debt

then the ROE is higher than the ROA after taxes if ROCE < id then ROE < ROCE*


Leverage Effect

• This equation is very important in finance ROE = ROCE.(1-Tc) + (ROCE-id).(1-Tc).Dfin/EQ

• The higher the ROCE the higher the ROE• The lower the tax rate the higher the ROE• The higher the debt (Dfin) vs. equity (EQ) the

higher the ROE if the ROCE is higher than the interest rate

• This is called the Leverage Effect


Leverage Effect

• It means that the ROE can be improved by increasing the debt level if and only if the ROCE is higher than the interest

rate

• How far can the Equity be reduced and the financial debt increased ? the company must find a bank to bring the debt the bank will look at the risks not to be repaid

higher risks will be compensated by higher interest rates

higher interest rates will reduce the Leverage effect


Risks of the Leverage Effect

• The company can be in a bad situation if the interest rate increases if the future Free Cash flows are lower than expected

• less business• additional unexpected investments to do• change in economic conditions

– tax rate– exchange rate

if the shareholders want more dividends if the bankers become nervous


Leverage effect : example

No debt 50% debt 75% debt

AssetsEBITTaxation rateInterest rate

100 $20 $50%10%

100 $20 $50%10%

10020 $50%10%

Equitydebt

100 $0 $

50 $50 $

25 $75 $

RESROAROE

10 $20%10%


Saigon Hotel – Leverage Effect

• Case 1 : Extension with initial capital structure 4 Mio US$ capex and 4 Mio US$ debt

• Case 2 : Extension with more equity 2 Mio US$ equity and 2 Mio US$ debt

• Case 3 : As Case 1 but continued adverse circumstances Unit rate and occupancy

• Case 4 : As Case 2 but continued adverse circumstances


Saigon Hotel leverage : ROCE

-10%

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

10%

2002 2003 2004 2005 2006 2007

base extension equity worst equity worst


Reference levels for ROCE and ROE

• What is a sound level for the ROCE ? higher than the interest rate in the range 10%-18% in western economies the level is a reference for expected profitability of new

capital expenditures

• What is a sound level for the ROE ? in the range 12%-25% depends on the risk of the business

• activity related risks (high tech vs. low tech)• maturity of the business (start up vs. mature)• financial structure (highly leveraged vs. standard)


Saigon Hotel leverage : ROE

-35%

-30%

-25%

-20%

-15%

-10%

-5%

0%

5%

10%

15%

2002 2003 2004 2005 2006 2007

extension worst equity worst


Saigon Hotel leverage : D/E ratio

0,0

0,5

1,0

1,5

2,0

2,5

3,0

2002 2003 2004 2005 2006 2007

extension worst equity worst


Leverage ratios

• The indebtness of a company can be measured by the debt-equity ratio () debt-equity ratio Dfin/EQ be sure the leases are included in the debt

• Alternate : the debt ratio debt ratio Dfin/(Dfin+EQ)

• Some authors use only the medium and long term financial debt (DMLT) we prefer all the financial debts (possibility of switch between

DMLT and DSTfin)


Reference level for the debt-equity ratio

• It must be sustainable for the company payment of interests reimbursement of the debt

• Consequently it will be different from company to company depending on : the projected Cash flows and Free Cash flows the sensibility to outside factors

general economic situation influence of new competitors etc.


Liquidity ratios

• These ratios measure how liquid is the company• Current ratio

current ratio currents assets / current liabilities current ratio (S+R+CASH) / (Dop+Dfin,short term)

• Acid test (Quick test) this ratio reflects the fact that some current assets are

less liquid (inventories) acid test (R+CASH) / (Dop+Dfin,short term)


Reference levels for liquidity ratios

• All these ratios depend on the industry• Current ratio

if possible, higher than 1

• Acid test if possible, higher than 0.7 / 0.8


Distribution ratio

• The pay-out ratio measures the share of the net result distributed to the shareholders pay-out DIV / EAT

• Reference level depends on the financial needs of the company for listed companies : expectations of the markets standard for mature companies : 40% to 60%


General remark on the calculations of ratios

• For the P&L no doubt : use the year figures• For the Balance Sheet which figures ?

at the end of the year ? at the end of last year ? another figure ?

• Correct calculation : daily average• Use the average (end of the year/end of last year)

best estimate of the reality

• Be always coherent


Conclusions of the lesson

• The Sensibilities studies are useful To look at the different possible futures To identify the business drivers To identify the risks

• The financial ratios are quick tools to analyze the financial situation of companies

• By using the financial ratios one can compare different companies across the time

• Limits of the financial ratios can we trust the Balance Sheet & Profit &Loss ? reference levels depend of the industry

Documents

Vietnam Master in Management – HCMC dec 2003 Profitability How to Use the Financial Plan Make it simple w Regroup all the inputs Sensibilities Studies