Financial Statement Analysis

Financial Performance & Management Control - TUHH Institute of Management Accounting & Simulation, Hamburg · part of my Technology Management MBA · study notes for revision.

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The chapters so far built the statements: the balance sheet, the income statement, the IFRS rules that shape them and the awkward items like PPE and inventories. This chapter turns the tables. Instead of producing the numbers we now stand outside the company, as an investor, a bank or a competitor, and ask what the numbers are telling us.

The tool for that is ratio analysis. A figure like “operating income 4,050 million” says almost nothing on its own; divided by sales, by total assets or by the capital tied up in the business it becomes a statement about how the company really works. The chapter runs one long example: four anonymous companies from the same year and the same industry, pushed through the same set of ratios until a clear picture of winners and losers appears - and only then are the names revealed.

Tip

The one idea to carry through. A ratio is a question in disguise. Every ratio in this chapter answers one of two questions - how is the company financed? (financial analysis) or is the company profitable? (profitability analysis) - and you only reach a verdict by asking both and reading the answers in context: same industry, same year, same definitions. On its own, a number is just a number.

1 · Why bother reading statements at all?

The course opens with a famous investor who, asked how he became so successful, answered that his firm reads hundreds and hundreds of annual reports every year. His other line is the one to remember: accounting numbers are the beginning of valuing a business, not the end. They are the raw material, not the answer.

The payoff for us is the same. If you learn to read and interpret financial statements, you get a deep feel for how real companies operate and make (or lose) money - what the course calls the “economics of a company”. Four questions frame the chapter:

• What does a typical financial statement analysis look like?
• What are the main ratios, and what does each one mean?
• Why combine a financial analysis with a profitability analysis?
• How do you build one overall picture out of a dozen separate ratios?

2 · The introductory example - four anonymous companies

Four sets of accounts, same industry, same year (2006), all in millions of euros. No names yet. The whole chapter is about reading these tables until they talk.

Line (m euros, 2006)	Co. 1	Co. 2	Co. 3	Co. 4
Intangibles	5,312	2,448	250	7,193
Property, plant and equipment	11,285	34,021	1,178	20,340
Investments	14,103	42,959	4,966	41,775
Inventories	6,794	17,750	594	12,463
Receivables	36,576	59,693	1,889	28,475
Cash and equivalents	1,336	13,121	4,038	14,458
Deferred taxes / other	3,651	20,030	1,715	11,899
Total assets	79,057	190,022	14,630	136,603
Equity	19,126	34,155	5,373	26,904
Minorities	4	663	4	55
Provisions	10,553	46,261	2,300	23,536
Long-term borrowing	18,800	78,518	3,534	30,469
Short-term payables	21,393	21,509	1,709	38,213
Deferred taxes / other	9,181	8,916	1,710	17,426
Sales	49,226	151,589	7,123	104,875
Cost of sales	-45,176	-148,212	-5,291	-102,866
Operating income	4,050	3,377	1,832	2,009
Interest expense	-857	-913	-199	-1,586
Net income	2,874	3,227	1,393	2,750
WACC (from analyst reports)	7.4%	8.0%	7.2%	6.8%

Step one: standardise (“common-size” statements)

The raw figures are hard to compare because the companies are wildly different in size - total assets run from about 15 billion to 190 billion. The fix is to standardise: express every balance-sheet line as a percentage of total assets and every P&L line as a percentage of sales. The result is a common-size statement, and suddenly structure jumps out that absolute numbers hide.

Common-size line	Co. 1	Co. 2	Co. 3	Co. 4
Receivables (% of assets)	46	31	13	21
Cash (% of assets)	2	7	28	11
Investments (% of assets)	18	23	34	31
Equity (% of assets)	24	18	37	20
Provisions (% of assets)	13	24	16	17
Long-term borrowing (% of assets)	24	41	24	22
Short-term payables (% of assets)	27	11	12	28
Cost of sales (% of sales)	-92	-98	-74	-98
Operating income (% of sales)	8	2	26	2
Net income (% of sales)	6	2	20	3

Already the story is forming: company 3 sits on a cash pile (28% of assets), funds 37% of itself with equity and keeps 26 cents of every sales euro as operating profit; companies 2 and 4 keep about 2 cents. Company 1 has almost no cash and nearly half its assets tied up in receivables. Ratios simply sharpen what common-size statements first show.

3 · What the analysis is for, and the two families of ratios

The purpose is to help external users (investors, lenders, analysts) reach a judgement about the company’s profitability and its future prospects. There is no single standardised procedure - different analysts pick different ratios - but there is a widely shared set of suggested ratios, and they fall into two families.

Financial analysis how is the company financed?

• Debt-to-equity (gearing) and equity-to-assets - the capital structure
• Cash ratio and current ratio - short-run liquidity
• Interest coverage - can operating profit carry the interest bill?
• Tells you about risk and survival

Profitability analysis is the company profitable?

• Return on assets and return on equity
• Asset turnover and profit margin - the two engines of return
• ROCE against WACC - is value created or destroyed?
• Tells you about reward

Why combine them? Because each family alone can mislead. A company with excellent margins but financed on a knife edge can still be sunk by one bad year of interest payments; a rock-solid, equity-rich company that earns less than its cost of capital quietly destroys its owners’ wealth. Financial analysis tells you whether the company will be there; profitability analysis tells you whether it is worth being there. The rest of the chapter runs both families over the four companies.

Statementsbalance sheet + P&L

→standardise

Common-size% of assets, % of sales

→ask “how financed?”

Financial analysisgearing, liquidity, coverage

→ask “is it profitable?”

Profitability analysisROA, ROE, ROCE vs WACC

→combine + context

Verdictinvest, lend, avoid?

The general procedure of a financial statement analysis. No fixed recipe exists, but this sequence - standardise, check the financing, check the returns, then judge in context - is what the course walks through.

4 · Financial analysis - how is the company financed?

Capital structure: gearing and equity-to-assets

Debt-to-equity (gearing) measures how far the company leans on borrowed money. Note the definition used here: the “debt” is all long-term borrowings including provisions (pension provisions are a big, long-lived source of financing for German industrial groups), and the equity excludes minorities. Equity-to-assets is the mirror image: what share of everything the company owns is funded by its owners.

Debt-to-equity (gearing)(long-term borrowings + provisions) ÷ equity excl. minorities → Co. 1: (18,800 + 10,553) ÷ 19,126 = 153%

Equity-to-assetsequity excl. minorities ÷ total assets → Co. 1: 19,126 ÷ 79,057 = 24%

Liquidity: cash ratio and current ratio

Both ask the same kind of question - how many times over can I pay what falls due soon? - with a narrower or wider definition of what I can pay it with. The cash ratio uses cash alone. The current ratio uses all current assets (here defined as cash + receivables + inventories).

Cash ratiocash ÷ short-term liabilities → Co. 1: 1,336 ÷ 21,393 = 0.06

Current ratio(cash + receivables + inventories) ÷ short-term liabilities → Co. 1: (1,336 + 36,576 + 6,794) ÷ 21,393 = 2.09

Caution

A definitional trap. In the example the borrowings are not split into short-term and long-term parts, so the short-term liabilities contain only the trade payables. Normally you must split borrowings, put the short-term slice into the denominator, and then the cash and current ratios come out much lower. Always check what a ratio’s denominator actually contains before you compare it with anything.

Interest coverage

How many times does operating profit cover the interest bill? A ratio close to 1 means almost every euro of operating profit is eaten by interest - one weak year and the company cannot service its debt.

Interest coverageoperating profit ÷ interest charges → Co. 1: 4,050 ÷ 857 = 4.73

The financial-analysis scorecard

Ratio	Question it answers	Co. 1	Co. 2	Co. 3	Co. 4
Debt-to-equity (gearing)	how much long-term debt per euro of equity?	153%	365%	109%	201%
Equity-to-assets	what share of the assets do the owners fund?	24%	18%	37%	20%
Cash ratio	how often does cash alone cover short-term liabilities?	0.06	0.61	2.36	0.38
Current ratio	how often do current assets cover short-term liabilities?	2.09	4.21	3.82	1.45
Interest coverage	how often does operating profit cover interest?	4.73	3.70	9.21	1.27

Verdict on financing. Companies 1 and 3 are well financed: relatively less debt than 2 and 4, and they carry their interest charges comfortably (4.7 and 9.2 times). Company 2 is the most heavily geared of all (365%). Company 4 struggles to cover its interest - operating profit is only 1.27 times the interest bill, which is uncomfortably thin. On liquidity, all four can meet their short-term liabilities from cash or other current assets, so no short-run liquidity problem is visible in any of them.

5 · Profitability analysis - is the company profitable?

Return on assets and return on equity

Return on assets (ROA) asks what all the capital in the business earns, so it uses operating income (before interest, so that the way of financing does not distort the answer). Return on equity (ROE) asks what the owners earn, so it uses net income (after interest and tax) over equity only.

Return on assetsoperating income ÷ (average) total assets → Co. 1: 4,050 ÷ 79,057 = 5.12%

Return on equitynet income ÷ (average) equity → Co. 1: 2,874 ÷ 19,126 = 15.03%

Strictly the denominator should be the average assets or equity over the year, because the income was earned continuously across the year, not only with the capital that happened to be on the books on 31 December. The course uses year-end values as a deliberate simplification - not correct, but necessary for a one-year example.

Asset turnover and profit margin

These two are the engines behind the return. Asset turnover asks how many euros of sales each euro of assets generates per year (a measure of how hard the assets work). Profit margin asks how much operating profit one more euro of sales brings in (a measure of pricing power and cost control). Turnover ratios can be built with any asset class - fixed assets, inventory, receivables, payables - not only with total assets.

Asset turnoversales ÷ total assets → Co. 1: 49,226 ÷ 79,057 = 0.62

Profit marginoperating income ÷ sales → Co. 1: 4,050 ÷ 49,226 = 8.23%

ROCE and WACC - the return earned versus the return required

Return on capital employed (ROCE) narrows the denominator to the long-term capital actually invested: equity plus minorities plus provisions plus long-term borrowings. The numerator is income before interest on that long-term debt - in practice EBIT. It answers: what does the money the long-term investors put in actually earn?

The weighted average cost of capital (WACC) is the other side of the coin: the return those investors require for handing over their money - the cost of equity weighted by the equity share plus the cost of debt weighted by the debt share. In the course the WACCs were not calculated but taken from an investment bank’s equity research reports.

ROCEEBIT ÷ capital employed (= equity + minorities + provisions + long-term borrowings) → Co. 1: 4,050 ÷ (19,126 + 4 + 10,553 + 18,800) = 4,050 ÷ 48,483 = 8.35%

WACC(equity share × cost of equity) + (debt share × cost of debt) → given: 7.4% / 8.0% / 7.2% / 6.8%

The profitability scorecard

Ratio	Question it answers	Co. 1	Co. 2	Co. 3	Co. 4
Return on assets	what does all the capital earn?	5.12%	1.78%	12.52%	1.47%
Return on equity	what do the owners earn?	15.03%	9.45%	25.93%	10.22%
Asset turnover	euros of sales per euro of assets per year	0.62	0.80	0.49	0.77
Profit margin	operating profit per euro of sales	8.23%	2.23%	25.72%	1.92%
ROCE	what does the long-term capital earn?	8.35%	2.12%	16.34%	2.48%
WACC	what do the investors require?	7.4%	8.0%	7.2%	6.8%

6 · Spread and value added - does the company create value?

Put ROCE and WACC side by side and the most important number of the chapter falls out. The spread is the actual return minus the required return; multiply it by the capital employed and you get the value added - the euros of wealth created (or destroyed) in the year on top of what investors demanded.

ROCEreturn actually earned

→minus

WACCreturn investors require

→equals

Spreadpositive = beating the bar

→× capital employed

Value addedwealth created in the year

Value creation in one line: (ROCE - WACC) × capital employed. A negative spread means the business earns less than its capital costs - it is destroying value even if it reports a profit.

For company 1: (8.35% - 7.4%) × 48,483 = 462m euros of value added.

	Co. 1	Co. 2	Co. 3	Co. 4
Spread (ROCE - WACC)	1.0%	-5.9%	9.1%	-4.3%
Value added (m euros)	462	-9,391	1,025	-3,497

Two of the four companies destroyed billions of euros of value in the year even though every one of them reported a positive net income. That is exactly why a profit figure alone is not enough.

Segment example: a diversified steel and technology group

Value added works below group level too. The course shows the 2005/06 figures (unaudited) of ThyssenKrupp, a diversified German steel and technology group, per segment. The group earned an EBIT of 3,044m on 17,056m of capital employed, a ROCE of 17.9% against a 9.0% WACC:

Segment (m euros)	Capital employed	ROCE	WACC	Spread	Value added
Group	17,056	17.9%	9.0%	8.9%	1,510
Steel	5,937	24.9%	9.5%	15.4%	913
Stainless	3,048	16.0%	9.5%	6.5%	199
Automotive	2,938	-1.8%	9.5%	-11.3%	-331
Technologies	1,427	31.6%	9.5%	22.1%	316
Elevator	1,876	22.6%	8.5%	14.1%	264
Services	2,884	19.2%	9.0%	10.2%	294

The lesson: a healthy group total (1,510m created) can hide a segment that is actively destroying value - automotive lost 331m on its 2,938m of capital - while steel alone contributed 913m. Segment-level spreads tell management where to invest and where to fix or exit. Note also that each segment gets its own WACC (elevator 8.5%, steel 9.5%) because the risk differs.

7 · Turnover × margin - where does the return come from?

The single most useful decomposition in the chapter: a return is always the product of how hard the capital works and how much each euro of sales keeps. Multiply asset turnover by profit margin and the sales cancel out, leaving operating profit over assets.

Decomposition(sales ÷ capital) × (operating profit ÷ sales) = operating profit ÷ capital

With total assets asset turnover × profit margin = return on assets

With capital employed turnover on capital employed × profit margin = ROCE

Company	Asset turnover	× Profit margin	= Return on assets
1	0.62	8.23%	5.12%
2	0.80	2.23%	1.78%
3	0.49	25.72%	12.52%
4	0.77	1.92%	1.47%

Plot turnover on one axis and margin on the other and every level of ROCE becomes a curve (an iso-ROCE curve, like an isoquant): all the combinations of turnover and margin that give the same return. A company can reach a given ROCE either by turning its capital over fast on thin margins (a supermarket) or slowly on fat margins (a luxury brand).

The insight for the four companies: their turnover ratios are similar (0.49 to 0.80), so they all utilise their assets about equally well. The huge differences in ROCE do not come from asset utilisation or overcapacity - they come almost entirely from the profit margin, i.e. from price and cost advantages: company 3 keeps 26 cents of each sales euro, companies 2 and 4 keep 2 cents. They apparently produce at higher cost relative to the prices their market allows.

8 · The verdict, and the reveal

Company 1 solid, but not yet creating value

• Well financed, interest covered 4.7 times
• ROCE 8.35% barely clears WACC 7.4% - spread 1.0%, value added 462m
• Decent margin (8%), the runner-up

Company 2 large, geared, value-destroying

• Highest gearing (365%), thin coverage (3.7)
• Margin 2%, ROA 1.8%, ROCE 2.1% against WACC 8.0%
• Destroyed 9,391m of value in one year

Company 4 the weakest of the four

• Interest coverage only 1.27 - real debt-service strain
• Margin 1.9%, ROCE 2.5% against WACC 6.8%
• Destroyed 3,497m of value

Company 3 the star

• Least debt (109%), 37% equity, cash covers payables 2.4 times, coverage 9.2
• Margin 26%, ROA 12.5%, ROE 25.9%, ROCE 16.3% against WACC 7.2%
• Spread 9.1%, value added 1,025m - on a business a tenth the size of company 2

Profitability verdict. As in the financial analysis, companies 2 and 4 come out worst: neither creates value, and their ROA and ROE are unacceptably low. Company 1 does better but still does not create much value. The poor results are not caused by overcapacity - the asset turnover is in line with the others - but by low profitability, presumably higher costs than the prices their markets allow. Company 3 wins on every single ratio. Asked “which company would you invest in?”, the answer from both families is the same.

The reveal. All four are German car manufacturers, accounts of the year 2006 - one of them the then Daimler-Chrysler group. The course does not name the others and neither will I; the point is that the ratios told the whole story before any badge was attached.

9 · Lessons learned

• Ratios need context. Never interpret one ratio alone: read it next to the other numbers, the industry, the year and the definition used. A cash ratio of 0.06 means something different for a car maker with a captive finance arm than for a corner shop.
• Combine the two families. Which ratios are used varies from analyst to analyst, but a combination of financial and profitability analysis is always recommended - risk and reward together.
• Leverage cuts both ways. Borrowing raises return on equity (company 1: ROA 5% but ROE 15%) - and raises risk at the same time, because interest has to be paid whether or not profits show up (company 4’s coverage of 1.27).
• Statements describe the past. Every ratio is built from accounts of a year already gone; the judgement you want is about the future.
• Averages versus year-end. Return ratios should use average capital over the year; using year-end values, as here, is a simplification you should name when you present a result.

standardise firsthow is it financed?is it profitable?ROCE minus WACC = the verdict

Worked example

Borussia Dortmund, financial year 2015/16 (simplified, all figures in thousand euros). The listed football club is a nice contrast to the car makers - a completely different balance sheet, same toolkit. WACC taken from a financial data website: 3.27%.

Assets (k euros)		Financing and P&L (k euros)
Intangibles	65,278	Equity	309,542
Property, plant and equipment	188,423	Provisions	1,372
Investments / other	49,064	Long-term borrowing	36,192
Inventories	10,158	Payables (short-term)	14,635
Receivables	51,072	Other current liabilities	62,804
Cash and equivalents	51,722	Total liabilities	424,545
Other current assets	8,828	Sales	379,767
Total assets	424,545	Cost of sales	343,337
		Operating income	36,430
		Interest expense	2,226
		Net income	29,436

1. Capital structure. Debt-to-equity = (36,192 + 1,372) ÷ 309,542 = 37,564 ÷ 309,542 ≈ 0.12 (12%). Equity-to-assets = 309,542 ÷ 424,545 ≈ 0.73. Almost three quarters of the club is owner-funded.

2. Liquidity. The solution uses the trade payables (14,635) as the short-term liabilities. Cash ratio = 51,722 ÷ 14,635 ≈ 3.53. Quick ratio = (51,722 + 51,072) ÷ 14,635 = 102,794 ÷ 14,635 ≈ 7.02. Current ratio = (51,722 + 51,072 + 10,158) ÷ 14,635 = 112,952 ÷ 14,635 ≈ 7.72.

3. Interest coverage. 36,430 ÷ 2,226 ≈ 16.4 - operating profit covers the interest bill more than sixteen times over. (For the actual interest paid you would look at the cash flow statement.)

4. Returns. ROA = 36,430 ÷ 424,545 ≈ 8.6%. ROE = 29,436 ÷ 309,542 ≈ 9.5%.

5. The two engines. Asset turnover = 379,767 ÷ 424,545 ≈ 0.89. Profit margin = 36,430 ÷ 379,767 ≈ 9.6%. Check: 0.89 × 9.6% ≈ 8.6% = ROA.

6. ROCE, spread, value added. Capital employed = 309,542 + 1,372 + 36,192 = 347,106. ROCE = 36,430 ÷ 347,106 ≈ 10.5%. Spread = 10.5% - 3.27% ≈ 7.2 percentage points. Value added ≈ 7.2% × 347,106 ≈ 25,000 thousand euros, roughly 25 million euros created in the year.

Gearing(36,192 + 1,372) ÷ 309,542 ≈ 0.12

Cash ratio51,722 ÷ 14,635 ≈ 3.53

ROCE → spread36,430 ÷ (309,542 + 1,372 + 36,192) ≈ 10.5% → 10.5% - 3.27% ≈ 7.2%

Ratio	BVB 2016	Reading
Debt-to-equity	0.12	very little long-term debt
Equity-to-assets	0.73	equity-heavy
Cash ratio	3.53	cash alone pays the payables three and a half times
Quick ratio	7.02	cash + receivables, seven times
Current ratio	7.72	extremely liquid
Interest coverage	16.4	interest is not a worry
Return on assets	8.6%	healthy operating return
Return on equity	9.5%	only slightly above ROA - see below
Asset turnover	0.89	about 0.9 euros of sales per euro of assets
Profit margin	9.6%	keeps just under 10 cents per sales euro
ROCE	10.5%	well above the 3.27% WACC
Spread	7.2%	clearly value-creating

Interpretation. The club is equity-heavy (73% equity, gearing 12%), extremely liquid (cash alone covers the payables 3.5 times) and comfortably able to pay its interest. Its ROCE of 10.5% sits far above a very low WACC of 3.27%, so it creates value - about 25 million euros in the year on 347 million of capital employed.

The leverage question. Why is ROE (9.5%) only a whisker above ROA (8.6%), when company 1 in the car example had an ROE three times its ROA? Because the leverage effect needs debt to work. ROE rises above ROA when a company earns more on borrowed money than the interest it pays, and the gap grows with the amount borrowed. With only 12% gearing there is almost nothing to lever: equity is nearly the whole balance sheet, so the return to owners is nearly the return on all assets, minus the small bite of interest and tax that separates net income from operating income. Low leverage means a small ROE boost - and also very little financial risk.

Caution

Definitions drive the result. The solution counts only the trade payables (14,635) as short-term liabilities. Add the 62,804 of other current liabilities and the cash ratio falls to about 0.67 and the current ratio to about 1.46 - still healthy, but a completely different picture. Whenever you quote a liquidity ratio, say what you put in the denominator.

Case corner

The four car makers. Before any name was attached, the ratios had already sorted them. Financial analysis said: 1 and 3 are prudently financed and cover their interest easily; 2 is the most heavily geared; 4 barely covers its interest; none has a liquidity problem. Profitability analysis said: 3 earns a 26% margin and 16% ROCE and creates 1,025m of value; 1 clears its cost of capital by a hair; 2 and 4 earn 2% margins and destroy 9,391m and 3,497m respectively. The decomposition explained why: similar turnover, so it is not about capacity, it is about price and cost. The reveal (German car makers, 2006, one of them Daimler-Chrysler) only confirmed that a ratio sheet can describe a business you have never seen.

The football club. Borussia Dortmund’s ratios look nothing like a manufacturer’s, and that is the point of the exercise. The intangibles line (65m) is mainly the registrations of players the club bought - a football club’s key “assets” walk around on the pitch. The cash pile of 52m is large relative to a mere 15m of payables, so liquidity ratios explode to 3.5 and 7.7. Long-term debt is tiny (36m against 310m of equity), so gearing is 12% and the leverage effect barely exists. And the WACC (3.27%) is far below a car maker’s 7 to 8%, so even a modest 10.5% ROCE translates into a wide spread. Same ratios, different industry, different reading - lesson one of the chapter in action.

Key terms

Term	What it means in plain words
Common-size statement	A statement where every line is a percentage of total assets (balance sheet) or of sales (P&L), so companies of different sizes can be compared
Financial analysis vs profitability analysis	The two families of ratios: “how is the company financed?” (risk) and “is it profitable?” (reward); use both
Debt-to-equity (gearing)	Long-term borrowings including provisions, divided by equity excluding minorities; how much debt per euro of owners’ money
Equity-to-assets	Equity divided by total assets; the share of the company the owners fund
Liquidity ratios (cash, quick, current)	How many times cash alone, cash plus receivables, or all current assets cover the short-term liabilities
Interest coverage	Operating profit divided by interest charges; how many times the interest bill is earned
Return on assets (ROA)	Operating income divided by (average) total assets; what all the capital earns before financing effects
Return on equity (ROE)	Net income divided by (average) equity; what the owners earn after interest and tax
Asset turnover	Sales divided by assets; euros of sales generated per euro of assets in a year, i.e. how hard the assets work
Profit margin	Operating income divided by sales; cents of profit kept per euro of sales
ROCE	EBIT divided by capital employed (equity + minorities + provisions + long-term borrowings); the return on the long-term money invested
WACC	The weighted average return that lenders and shareholders require on the capital employed; the hurdle a company must beat
Spread and value added	Spread = ROCE minus WACC; value added = spread times capital employed, the wealth created or destroyed in a year
Leverage effect	Borrowing lifts ROE above ROA when the return on assets beats the interest rate, but makes profits and survival riskier

Test yourself

1. Company 1 shows long-term borrowing of 18,800, provisions of 10,553, equity of 19,126, minorities of 4 and total assets of 79,057 (m euros). Calculate the debt-to-equity ratio and the equity-to-assets ratio and say what each tells you.
2. Company 4 has operating income of 2,009, interest expense of 1,586, cash of 14,458 and short-term payables of 38,213. Compute interest coverage and cash ratio. Does the company have a liquidity problem, a debt-service problem, or both?
3. Company 3 reports equity 5,373, minorities 4, provisions 2,300, long-term borrowing 3,534 and operating income 1,832, with a WACC of 7.2%. Calculate capital employed, ROCE, the spread and the value added.
4. The four car makers have similar asset turnover but very different margins. What does that tell you about where the difference in returns comes from, and which explanation does it rule out?
5. Why does the course insist on combining financial analysis with profitability analysis? Give one situation where each family on its own would mislead you.
6. Borussia Dortmund’s ROE (9.5%) is only slightly above its ROA (8.6%), while company 1’s ROE (15.0%) is almost three times its ROA (5.1%). Explain this with the leverage effect, and name the price that comes with it.

Answers

1. Gearing = (18,800 + 10,553) ÷ 19,126 = 153%: the company carries about 1.5 euros of long-term debt (including provisions) for every euro of equity. Equity-to-assets = 19,126 ÷ 79,057 = 24%: owners fund roughly a quarter of the assets, the rest is debt, provisions and payables.
2. Interest coverage = 2,009 ÷ 1,586 = 1.27; cash ratio = 14,458 ÷ 38,213 = 0.38. No acute liquidity problem (cash plus receivables and inventories cover current liabilities 1.45 times), but a real debt-service problem: nearly all operating profit goes on interest, so one weak year would leave it unable to pay.
3. Capital employed = 5,373 + 4 + 2,300 + 3,534 = 11,211. ROCE = 1,832 ÷ 11,211 = 16.3%. Spread = 16.3% - 7.2% = 9.1%. Value added = 9.1% × 11,211 ≈ 1,025m euros.
4. Because ROCE = turnover × margin and the turnovers are alike, the gap in returns comes from the margin, i.e. from price and cost advantages. It rules out asset utilisation or overcapacity as the explanation: the weak companies use their assets as intensively as the strong one, they just earn far less on each euro of sales.
5. Financial analysis shows risk (financing, liquidity, interest burden); profitability analysis shows reward (returns versus cost of capital). A highly profitable but over-geared company can be sunk by interest in one bad year; a safely financed company earning less than its WACC steadily destroys owner wealth. Only together do they answer “is it worth investing, and will it survive?”.
6. Leverage lifts ROE above ROA when borrowed money earns more than it costs, and the lift grows with the amount of debt. Company 1 is geared 153%, so a 5% return on all assets becomes 15% on the owners’ slice; Dortmund is geared only 12%, so there is almost nothing to lever and ROE stays close to ROA. The price is risk: interest must be paid regardless of profits, so higher gearing means larger swings in ROE and a thinner interest coverage.

Revision summary

Tip

The one-minute recap

• Motivation: accounting numbers are the beginning of valuation, not the end; reading statements teaches the economics of a company.
• Standardise first: common-size statements (% of assets, % of sales) make companies of different sizes comparable.
• Two families, always combined: financial analysis (“how is it financed?” - gearing, equity-to-assets, cash and current ratio, interest coverage) and profitability analysis (“is it profitable?” - ROA, ROE, asset turnover, profit margin, ROCE).
• Gearing = (long-term borrowings + provisions) ÷ equity excl. minorities; equity-to-assets = equity ÷ assets; cash ratio = cash ÷ short-term liabilities; current ratio = (cash + receivables + inventories) ÷ short-term liabilities; interest coverage = operating profit ÷ interest.
• ROA = operating income ÷ assets; ROE = net income ÷ equity; turnover = sales ÷ assets; margin = operating income ÷ sales; ROCE = EBIT ÷ (equity + minorities + provisions + long-term borrowings). Averages are correct, year-end values are the simplification.
• Value creation: spread = ROCE - WACC; value added = spread × capital employed. Company 3: 9.1% spread, 1,025m created; company 2: -5.9%, 9,391m destroyed. Segments of a group can create and destroy value at the same time.
• ROCE = turnover × margin: the four car makers had similar turnover, so the difference was all margin - price and cost, not asset use.
• Verdict: 3 the star, 1 solid but barely value-creating, 2 and 4 value-destroying; 4 can barely pay its interest. All four: German car makers, 2006.
• Lessons: ratios need context; combine both families; leverage raises ROE and risk; statements describe the past.
• Borussia Dortmund 2016: gearing 0.12, equity-to-assets 0.73, cash ratio 3.5, current ratio 7.7, coverage 16, ROA 8.6%, ROE 9.5%, ROCE 10.5% vs WACC 3.27%, spread 7.2% - equity-heavy, extremely liquid, value-creating, tiny leverage effect.

Next: Management Accounting & Cost Concepts → - switching from reporting to the outside world to steering from the inside.