As one journey ends, another probably starts

By the time you complete a financial analysis, you must be able to answer the following two questions that served as the starting point for your investigations:

• Will the company be solvent? That is, will it be able to repay any loans it raised?
• Will it generate a higher rate of return than that required by those that have provided it with funds? That is, will it be able to create value?

Value creation and solvency are obviously not without links. A firm that creates value will most often be solvent and a company will most likely be insolvent because it has not succeeded in creating value.

Section 14.1 Solvency

Here we return to the concept that we first introduced in Chapter 4.

Since, by definition, a company does not undertake to repay its shareholders, its equity represents a kind of life raft that will help keep it above water in the event of liquidation by absorbing any capital losses on assets and extraordinary losses.

Solvency thus depends on:

• the break-up value of a company’s assets;
• the size of its debts.

Do assets have a value that is independent of a company’s operations? The answer is probably “yes” for the showroom of a carmaker on 5th Avenue in New York and probably “no” as far as the tools and equipment at a heavy engineering plant are concerned.

Is there a secondary market for such assets? Here, the answer is affirmative for the fleet of cars owned by a car rental company, but probably negative for the technical installations of a foundry. To put things another way, will a company’s assets fetch their book value or less? The second of these situations is the most common. It implies capital losses on top of liquidation costs (redundancy costs, etc.) that will eat into shareholders’ equity and frequently push it into negative territory. In this case, lenders will be able to lay their hands on only a portion of what they are owed. As a result, they suffer a capital loss.

The solvency of a company thus depends on the level of shareholders’ equity restated from a liquidation standpoint relative to the company’s commitments and the nature of its business risks.

A loss-making company no longer benefits from the tax shield provided by debt.¹ As a result, it has to bear the full brunt of financial expense, which thus makes losses even deeper. Very frequently, companies raise additional debt to offset the decrease in their equity. Additional debt then increases financial expense and exacerbates losses, giving rise to the cumulative effects we referred to above.

If we measure solvency using the debt/equity ratio, we note that a company’s solvency deteriorates very rapidly in the event of a crisis.

Let’s consider a company with debt equal to its shareholders’ equity. The market value of its debt and shareholders’ equity is equal to their book value because its return on capital employed is the same as its cost of capital of 10%.

As a result of a crisis, the return on capital employed declines, leading to the following situation:

The company’s evolution does not come as a surprise. The market value of capital employed falls by 45% at its lowest point because the previously normal return on capital employed turns negative. The market value of debt declines (from 100% to 75% of its nominal value) since the risk of non-repayment increases with the decline in return on capital employed and the growing size of its debt. Lastly, the market value of shareholders’ equity collapses (by 70%).

Each year, the company has to increase its debt to cover the loss recorded in the previous year, to keep its capital employed at the same level. From 1 at the start of our model, gearing soars to 3 by the end of year 5. In this scenario, its equity gets smaller and smaller, and its lenders will be very lucky to get their hands on the original amounts that they invested. This scenario shows how debt can spiral in the event of a crisis! Some restructuring of equity and liabilities or, worse still, bankruptcy is bound to ensue with the additional losses caused by the disruption.

Imagine a second company with the same operating characteristics as the first one but debt-free when the crisis began. Its financial performance would have been entirely different, as shown by the following table:

At the end of year 4, the second company returns to profit and its shareholders’ equity has been dented only moderately by the crisis.

Consequently, the first company, which is comparable to the second in all respects from an economic perspective, will not be able to secure financing and is thus probably doomed to failure as an independent economic entity.

For a long time, net assets, i.e. the difference between assets and total liabilities or assets net of debt, was the focal point for financial analysis. Net assets are thus an indicator that corresponds to shareholders’ equity and are analysed in comparison to the company’s total commitments.

Some financial analysts calculate net assets by subtracting goodwill (or even all intangible fixed assets), adding back unrealised capital gains (which may not be accounted for owing to the conservatism principle), with inventories possibly being valued at their replacement cost.

Broadly speaking, calculating net assets is an even trickier task with consolidated accounts owing to minority interests (which group assets do they own?) and goodwill (what assets does it relate to and what value, if any, does it have?). Consequently, we recommend that readers should work using the individual accounts of the various entities forming the group and then consolidate the net asset figures using the proportional method.

Section 14.2 Value creation

A company will be able to create value during a given period if the return on capital employed (after tax) that it generates exceeds the cost of the capital (i.e. equity and net debt) that it has raised to finance capital employed.

Readers will have to remain patient for a little while yet because we still have to explain how the rate of return required by shareholders and lenders can be measured. This subject is dealt with in Section III of this book. Chapter 26 covers the concept of value creation in greater depth, while Chapter 27 illustrates how it can be measured.

Section 14.3 Financial analysis without the relevant accounting documents

When a company’s accounting documents are not available in due time (less than three months after year end), it is a sign that the business is in trouble. In many cases, the role of an analyst will then be to assess the scale of a company’s losses to see whether it can be turned around or whether their size will doom it to failure.

In this case, the analysts will attempt to establish what proportion of the company’s loans the lenders can hope to recover. We saw in Chapter 5 that cash flow statements establish a vital link between net income and the net decrease in debt.

It may perhaps surprise some readers to see that we have often used cash flow statements in reverse, i.e. to gauge the level of earnings by working back from the net decrease in debt.

It is essential to bear in mind the long period of time that may elapse before accounting information becomes available for companies in difficulty. In addition to the usual time lag, the information systems of struggling companies may be deficient and take even longer to produce accounting statements, which are obsolete by the time they are published because the company’s difficulties have worsened in the meantime.

Consequently, the cash flow statement is a particularly useful tool for making rapid and timely assessments about the scale of a company’s losses, which is the crux of the matter.

It is very easy to calculate the company’s net debt. The components of working capital are easily determined (receivables and payables can be estimated from the balances of customer and supplier accounts, and inventories can be estimated based on a stock count). Capital expenditure, increases in cash and asset disposals can also be established very rapidly, even in a sub-par accounting system. We can thus prepare the cash flow statement in reverse to give an estimate of earnings.

A reverse cash flow statement can be used to provide a very rough estimate of a company’s earnings, even before they have been reported.

When cash starts declining and the fall is not attributable to either heavy capital expenditure that is not financed by debt capital or a capital increase, to the repayment of borrowings, to an exceptional dividend distribution or to a change in the business environment, the company is operating at a loss, whether or not this is concealed by overstating inventories, reducing customer payment periods, etc.

Section 14.4 Case study: ArcelorMittal

Is ArcelorMittal solvent? Yes, given its book equity at the close of 2015 ($23.4bn), which is much higher than goodwill ($5.6bn) and inventories ($13.4bn), which are the two items on the asset side of the balance sheet whose value is the most uncertain. Goodwill, although reduced to $5.6bn compared with $14.1bn in 2011, because there may be doubts about its market value given the group’s very low ROCE over several years. Inventories, because further price falls on the market due to surplus production capacities could undermine their value.

Is ArcelorMittal creating value? No, because with an average ROCE of close to 0% over the last four years, the group is not providing its investors with their required rate of return. Return on equity (−8.6%) is of course well below the cost of equity (around 15%). The destruction of value is reflected in the group’s market capitalisation, which is well below the amount of its book equity, as we shall see in more detail in Chapter 22.

Summary