## How to calculate series: financial stability ratios

Calculating financial ratios by itself does not necessarily create a lot of insight, with the true value-accretive steps being the interpretation of said data-points. I covered the definition and interpretation of financial ratios in depth in my book, however I noticed that readers often find it challenging to extract the correct figures from actual financial statement. This is no surprise since no financial statement looks quite like the other and often varying terms are used for one and the same accounting item. This is why this “how to calculate series” focuses squarely on the “calculation” part of the problem, using real financial statements and is mainly aimed at beginners and intermediate readers.

#### Calculating financial stability ratios

• Equity ratio
• Gearing
• Dynamic gearing
• Cash burn rate

#### Case study: Union Pacific

We will use the 2019 financial statement of Union Pacific, one of North America’s largest railroads, to show how to calculate the aforementioned financial stability ratios. Here is what the balance sheet looked like for fiscal year 2019:

The equity ratio is calculated by dividing total common shareholders’ equity of 18,128m USD by the balance sheet total of 61,673m USD, equating to 29.4 %. (In case there is any non-controlling interest included in the shareholders’ equity, this should be exluded when calculating the equity ratio since this part does not belong to the holders of the common stock).

The gearing is calculated by dividing the net financial debt by total shareholders’ equity. Net financial debt is the sum of Union Pacific’s financial debt less its cash and cash equivalents. The latter amount to 831m USD, where the financial debt equals 1,257m USD (“debt due within one year”) plus 23,943m USD (“debt due after one year”). In total this equates to net debt of 24,369m USD. Divided by total common shareholders’ equity of 18,128m USD gives a gearing of 134.4 %.

Equity ratio and gearing both yield static numbers. Dynamic gearing states the number of years necessary to delever the business completely on a cash basis by dividing the net financial debt by the annual free cashflow. We already obtained the net financial debt of 24,369m USD above. Free cashflow is calculating by simply subtracting net capex (in this case 3,453m USD – 74m USD = 3,379m USD) from the operating cashflows of 8,609m USD, yielding a free cashflow figure of 5,230m USD. Based on these numbers we can calculate the dynamic gearing or the time it would take to delever the business in full at 4.6 years (24,369m USD / 5,230m USD).

#### Case study : Nikola

There are different definitions for the cash burn rate, but the most common looks at the relationship between (negative) free cashflow and total shareholders equity. Another feasible calculation would be to look at (negative) free cashflow as a percentage of cash equivalents. Going with the former definition we need to obtain total shareholders equity as well as free cashflow for Nikola. Shareholders’ equity before non-controlling interest amounts to 881.5m USD as per 30 June 2020:

For the half-year 2020, the company shows operating cashflows of -45.7m USD as well as CAPEX of -3.8m and -2.4m USD, giving a free cash(out)flow of -51.9m USD.

This free cash(out)flow figure has of course to be annualized in order to calculate the cash burn rate with: 881.5m USD / -103.8m USD = -8.5 years. This means that if the free cashflow remains steady around -103.8m USD, the company would burn through its shareholders’ equity base with eight to nine years.

## Using EV/EBITDA under IFRS 16: pitfalls and solutions

I already discussed the impact of IFRS16 on the P&L and cashflow statement. Through the capitalization of operating leases as a ‘right-of-use’ asset together with an accompanying lease liability, IFRS16 also has an – at times material – impact on the balance sheet. This makes calculating a company’s EV/EBITDA tricky.

#### Pitfalls

In most cases the application of IFRS16 will increase both EBITDA as well as net debt. EBITDA increases since a part of the former lease expenses will be treated as a depreciation. Net debt increases since a lease liability is recognized for the first time on the balance sheet.

This creates a problem: Normally the (simplified) enterprise value of a company is calculated as market capitalization + net financial debt. Divided by the reported EBITDA figure yields the current EV/EBITDA of the stock.

Since both nominator and denominator are affected by IFRS16, it is paramount to either use pre-IFRS16 figures for both EBITDA and net debt or to include the lease liabilities in the net debt figure. Let us take a look at how and why.

#### Solutions

The following excerpt shows the impact of IFRS16 on the liabilities of Brenntag Group, the world’s largest chemical distributor based in Germany:

For year-end 2018 the calculation of the enterprise value is straight-forward: Simpy add the financial liabilities of 256.1m EUR + 1,899.6m EUR less cash and cash equivalents of 393,8m EUR to the then prevailing market capitalization and your are done. For year-end 2019 (the first year including the IFRS16 effect) the equation gets a bit more complicated, as the corresponding lease liabilities will have to be included in the net debt figure. Recognizing 520.3m EUR in cash and cash equivalents the relevant net debt figure for 2019 equates to -520.3m EUR + 224.2m EUR + 100.5m EUR + 1,936.4m EUR + 319.7m EUR = 2,060.5m EUR. As per October 2020, the company’s market capitalization amounts to 8,380m EUR, which yields an enterprise value of 10.441m EUR. The inclusion of the lease liabilities is crucial in order to compare EBITDA and enterprise value on a like-for-like basis. The company gives the EBITDA pre and post IFRS16 as follows:

The correct way to calculate EV/EBITDA in this case is to divide the enterprise value (including lease liabilities) of 10.441m EUR by the reported EBITDA of 1,001.5m EUR for an EV/EBITDA of 10.4. As you notice, both the nominator and the denominator have been increased by IFRS16, hence cancelling the distorting effect on this valuation metric largely out.

Many analysts these days do not get this effect and still calculate enterprise value the traditional way but ‘reap’ the benefits on the EBITDA side, hence wrongly obtaining too low valuation metrics.

#### Be aware the high-street

The effect mentioned above can be dramatic for companies that make extensive use of leasing contracts such as high-street retailers. Take a look at the below excerpt of Inditex’s profit and loss statement for the year 2019:

The sharp increase in EBITDA (by a whopping 2,141m EUR) should by now not come as a surprise anymore, neither should the accompanying increase in depreciation of 1,726m EUR. Comparing this IFRS16-inflated EBITDA to the company’s enterprise value obviously only makes sense when also taking into account the increase in liabilities. Whereas Inditex would have shown only a mere 38m EUR in gross financial debt in 2019 using the traditional formula, its gross debt increases to 6,850m EUR:

For investors not aware of this effect, the divergence in results can be startling: Calculating EV/EBITDA without taking into account the lease liabilities would yield a multiple of 9.6 as per October 2020. However correcting for the lease liabilities increases the EV/EBITDA to 10.5 with only the latter value reflecting the true economic reality.

#### The end of EBITDA?

This begs the question: Does it make sense to use EBITDA as a measure of profit and EV/EBITDA as a valuation metric anymore? Well, its difficult: On the one hand the EV/EBITDA measure can still be calculated correctly as long as the effects outlined above are correctly reflected in the calculation. On the other hand, EBITDA has always been a lousy profit metric to start with since depreciation and amortization are true costs to any business. Given the distortions of IFRS16 many companies have started to change their KPIs from EBITDA to EBIT, see here for example LafargeHolcim’s excellent CFO Géraldine Picaud explaining the thinking:

In closing, be aware of the new pitfalls and complexities introduced with the application of IFRS16, as the above-mentioned example of LafargeHolcim though demonstrates, IFRS16 might actually end up enhancing the financial reporting under IFRS as more companies will move away from EBITDA as the key performance measure.

## How to calculate series: profit margins

Calculating financial ratios by itself does not necessarily create a lot of insight, with the true value-accretive steps being the interpretation of said data-points. I covered the definition and interpretation of financial ratios in depth in my book, however I noticed that readers often find it challenging to extract the correct figures from actual financial statement. This is no surprise since no financial statement looks quite like the other and often varying terms are used for one and the same accounting item. In my book I tried to solve this issue by presenting the raw financial statement data as true-to-reality as possible, but I feel that a blog – with the ability to display the actual financial statement excerpts – might be a real value add. This is why this “how to calculate series” focuses squarely on the “calculation” part of the problem, using real financial statements and is mainly aimed at beginners and intermediate readers.

#### Calculating profit margins

• Gross profit margin
• EBITDA margin
• EBIT margin
• Net profit margin

We will use two real-life examples below to calculate the different profit margins listed above.

#### Case study: Alphabet

Google’s holding company Alphabet shows the following profit & loss statement for fiscal year 2019:

The gross profit margin is defined as gross profit divided by revenues. In this case the gross profit is not shown directly in the profit and loss statement, but can be derived easily by subtracting the cost of revenues from the revenue line. This yields a gross profit of 161,857m USD – 71,896m USD = 89,961m USD. Dividing this figure by the stated revenues yields a gross profit margin of 89,961m USD / 161,857m USD = 55.6 %.

The EBITDA margin is defined as EBITDA divided by revenues. In order to calculate the EBITDA margin we first have to calculate the EBITDA figure. Our starting point is the reported EBIT, which in this case is reported as “income from operations” of 34,231m USD. To this we need to add the depreciation and amortization expense (the “DA” part of EBITDA) which in the case of Alphabet has been allocated towards the different expense categories and hence cannot be found directly in the profit and loss statement. However, being a non-cash expense, the depreciation and amortization number can be easily found in the cash flow statement, in this case 10,856m USD and 925m USD respectively:

Adding EBIT to depreciation and amortization yields an EBITDA of 46,012m USD, which results in an EBITDA margin of 28.4 %.

Given the EBITDA margin derivation makes calculating the EBIT margin straight forward: simply divide the stated EBIT (“Income from operations”) by the revenues, et volia: 34,231m USD / 161,857m USD = 21.1 %.

Finally, the net profit margin is defined as net profit dividend by revenues, which in this case means dividing the net profit of 34,343m USD by total revenues of 161,857m USD, giving a net profit margins of 21.2 %. Note that in this unusual case the net profit margin exceeds the EBIT margin because of the significant “other income” line below EBIT.

#### Case study: Heineken

Heineken, the world’s second largest brewer, reports the following profit and loss statement for fiscal year 2019:

Heineken is an interesting case study to see how calculating profit margins can be straight forward and yet still might need some explaining. In this case one might wonder whether to use the “revenue” or the “net revenue” line as the denominator. Most beverage companies report their revenue including and excluding excise tax, in order to get consistent results it is usually advisable to use the net revenue as the denominator, since only these revenues are truly available to the company in order to pay its various expenses.

Since the gross profit is not stated directly in this profit and loss statement, it has to be derived by subtracting the cost of goods sold (in this case “raw materials, consumables and services”) from net revenues, i.e. 23,969m EUR – 14,592m EUR = 9,377m EUR. Dividing this numbers by the net revenues yields a gross profit margin of 39.1 %.

The EBITDA margin is easy to calculate since the EBIT (“operating profit”) as well as the depreciation and amortization expenses are given directly in the profit and loss statement. Adding back the 1,959m EUR to the EBIT of 3,633m EUR yields an EBITDA of 5,592m EUR, divided by the net revenues yields an EBITDA margin of 23.3 %.

Accordingly, the EBIT margin can be obtained by dividing the operating profit of 3,633m EUR by net revenues of 23,969m EUR = 15.2 %.

The net profit margin could cause some questions in this case, since 208m EUR of the stated net profit of 2,374m EUR is attributable to non-controlling interest. If we were to calcuate the earnings per share attributable to shareholders of Heineken, 2,166m EUR would be the correct number, since only this profit is available to the holders of the company’s common stock. However when calculating the profit margins, the stated net profit of 2,374m EUR has to be sued. Why? Since the non-controlling interests are not just included in the net profit, but also in the net revenue line. Hence in order to get a like-for-like comparison, the full net profit has to be compared to the net revenues. This yields a net profit margin of 2,374m EUR / 23,969m EUR = 9.9 %.

## Free cashflow calculation in a post IFRS 16 world

With the adoption of IFRS 16 on 1st January 2019, calculating the free cashflow for some firms has gotten quite a bit trickier with several pitfalls to be navigated depending on the individual case – let’s take a look.

#### What happened?

Simply put, under IFRS 16 a company has to recognize leased assets on its balance sheet (as a right-of-use asset with a corresponding liability) if it has control (or the right to use) of said asset. In the past, these leases (so called operating lease) were usually carried off-balance sheet.

For companies that make use of a substantial amount of longer term leases the implementation of IFRS 16 can cause quite a bit of change to the balance sheet, P&L, and also the cash flow statement. To be clear: The actual cash flows paid on these lease contracts do not change, however their accounting treatment and presentation does.

#### Changes to the balance sheet and profit & loss statement

Without going into too much detail, the balance sheet expands since the long-term leases are recognized as an right-of-use asset on the asset side of the balance sheet. Correspondingly, a lease obligation is recognized on the liability side. This impacts the profit & loss statement (P&L) as well: Whereas in a pre-IFRS 16 world one would have simply seen a lease or rent expense in the P&L equal to the actual periodic lease payment, this is now replaced by a depreciation of the newly recognized right-of-use asset as well as an assumed interest expense on the lease liability. This all sounds pretty complex and slightly confusing, and it is at first glance. Take a look the following set of numbers presented by Brenntag, the worlds largest chemical distributor for fiscal year 2019:

At first glance an increase in EBITDA of 134.8m EUR or 15.7 % looks impressive, however depreciation expenses increased by a similar amount, almost offsetting the increase on an EBIT level. This effect is almost entirely due to the company adopting IFRS 16 for the first time in 2019. EBITDA figures can hence be a misleading indicator under IFRS 16, especially when compared to pre-IFRS 16 numbers. Now let’s look at the cash flow statement.

#### Calculating free cashflow under IFRS 16

Normally, calculating free cashflow is a straight forward matter: We simply deduct the cash paid for property, plant and equipment as well as intangibles (short “CAPEX”) from the operating cashflow et voilà: we have our free cashflow figure. However, under IFRS 16 this changes slightly for two reasons:

1. The cashflow from operating activities will be “overstated” given the increase in depreciation
2. Parts of the lease payments might be accounted for in the cashflow from financing activities as a repayment of debt

Let`s take a look at these points using the aboved mentioned example of Brenntag. First off the operating cashflow. Here we see a strong increase from 375.3m EUR to 879.3m EUR, which is partly explained by much better working capital management in 2019, but also by the increase in depreciation due to IFRS 16:

The cashflow from investing activities does not change materially due to IFRS 16, in this case the CAPEX can be taken directly from the cash flow statement at -204.0m EUR:

Normally, we would simply calculate the free cashflow for 2019 as 879.3m EUR minus 204.0m EUR and be done at this point. However, this is where IFRS 16 creates an issue: As can be seen in the excerpt of the operating cashflow above, the application of IFRS 16 clearly increased that number. Hence something gotta give – in this case, the cash flow from financing activities:

Included in the 290.2m EUR of repayments of borrowings are 120.7m EUR of lease repayments. How do we know? – Unfortunately this number can not be found in the financial statement, but Brenntag discloses the figure thankfully in the descriptive part of the annual report.

Summing it all up the new free cashflow figure can be derived as 879.3m EUR – 290.2m EUR – 120.7m EUR = 468.4m EUR.

Not all companies financial statements are affected to this degree by IFRS 16 and some also provide more information to easier assess the impact. Lindt & Sprüngli’s balance sheet for example clearly shows an impact from IFRS 16:

And so does its cashflow from operations with a corresponding increase in depreciation:

However, the company makes it easy to properly calculate its free cashflow by providing the lease liability repayment as a separate line item in its cashflow from financing activities:

Accordingly, the free cashflow amounts to 529.0m CHF (830.9m CHF – 209.4m CHF – 25.8m CHF – 66.7m CHF).

#### The bottom line

The main takeaway is that the introduction of IFRS 16 changes the calculation of free cashflow figures since (contrary to the usual approach) repayments on lease liabilities have to be taken into account. On the other hand, IFRS 16 will have little impact on companies that do not make use of a substantial amount of longer-term leases for which the changes are negligible.

## Starting off: what to expect

Today the new German edition of my book on company valuation has been released (the 2014 English version can be found here).

With this new edition of the book I am also launching this website which is designed to accompany the book and give readers even more real-life examples. Whilst the scope of this blog is meant to be broad, I intend to use the next few months to cover basic company valuation and financial statement analysis issues first.

To start off, I will:

• Launch the “how to calculate” series; and
• Cover current topics in company valuation.

Once these topics are covered we will dive deeper into various valuation topics, loosely following the structure of the book.

## Welcome to lawbitrage.xyz

Suppose the owner of a local business in your hometown offers you to buy his company, giving you four weeks to come up with a binding bid. How would you go about valuing the business?

Would you get to know the management team, understand the corporate culture, test the products and talk to suppliers and customers? Or would you rather find a suitable group of comparable listed companies, regress their share price against an arbitrary index and thus derive the business risk based on this metric? – Common sense of course advises the former, whereas academia usually – and sadly – opts for the latter.

#### Common sense and common stocks

This divergence between what investors should and what they often actually end up doing can probably be traced back to business school and academia with its urge to let the field of company valuation and investing appear as a science, when it really is an art. That is why I subtitled my book on the topic with “the art of company valuation“, painting a more nuanced and hopefully more honest picture of the field. This blog will hence take a fresh look at many valuation and investment topics, always pragmatic with a focus on quality.

In essence, we will try to take a look under the hood: understanding a business from the ground up. This is of course also done by analyzing the financial statements, but calculating ratios is not an end in itself. It is rather the starting point to combine quantitative figures with qualitative insights to arrive at a judgment about the quality and value of a business.

#### Why .xyz?

This is not a one-topic blog, but rather an exploration of my circle of competence: the world of (company) valuation, legal and economic issues in sovereign debt restructurings, recommended literature, and other related topics from the domain of decision making under uncertainty.

To start off, the focus of the blog will be on providing additional and updated information on the book “The Art of Company Valuation and Financial Statement Analysis: A Value Investor’s Guide with Real-life Case Studies” and up-to-date valuation topics.