Reorganising Financial Statements

This section is devoted to reorganising the accounting statements by separating financing and operating activities. Through this process, an analytical balance sheet and income statement is created that better reflect the capital invested in, and cash generated from firm operations. Further, additional adjustments regarding the treatment of R&D expenses and operating leases will be discussed. A balance sheet line item classification list following the outlining below is seen in appendix 3 and corresponding analytical financial statements for both Volvo and the peer group companies are seen in appendices 4 – 10.

7.2.1 Analytical Balance Sheet

The purpose of restating the balance sheet, through the separation of operating items from non-operating (financial) items, is to create a statement that show the assets and liabilities attributable to firm operations. This procedure will create two sides of the analytical balance sheet; one operational and one financial.

In the operating analytical balance sheet, operating working capital is obtained by subtracting operating current liabilities from operating current assets. The operating current liabilities are subtracted because it reduces the investment need and is seen as a free source of funding. Further, by subtracting total operating liabilities from total operating assets, invested capital (IC) is obtained. Invested capital is defined as the amount of capital a firm has invested in operations that requires a return (Petersen & Plenborg, 2012). In the financial analytical balance sheet, net bearing debt (NIBD) is obtained by subtracting interest-bearing assets from interest-interest-bearing debt. In turn, invested capital is obtained by adding total equity to net interest-bearing debt (Petersen & Plenborg, 2012).

Operating Analytical Balance Sheet

▪ Operating current assets are defined as the sum of working cash, inventories, accounts receivable, current tax asset and other current assets. Cash and cash equivalents is separated into two components, working and excess cash. As implied by this definition, only the proportion of total cash defined as working cash is deemed necessary for operations and thus accounted for in operating current assets. Volvo has held a cash and cash equivalents to turnover ratio of between

53 10-20% for the past five years. Failing to acknowledge the excess proportion will wrongfully depress the company’s ROIC. Koller et al. (2005) estimated a minimum cash to sales ratio of non-financial companies in the S&P 500 to 2%, which is deemed a valid proxy.

▪ Operating current liabilities are defined as the sum of trade (accounts) payables, current provisions, current tax liability, advance payments from customers and other current liabilities. Other current liabilities are broken down in notes to disclose and account for any hidden financial items.

▪ Non-current operating assets are defined as the sum of property, plant, and equipment (PP&E), intangible assets, investments in joint ventures and associates, deferred tax asset and other non-current assets. Intangible assets comprise capitalised product and development costs, software, trademark and other intangible assets which all are considered instrumental to operations (Volvo Cars, 2015). Investments in associates and joint ventures are seen as part of operations. This as it is an important means for industry participants in order to tap into new sources of growth and technologies such as car sharing and joint R&D efforts. Further, in order to manufacture and sell on the Chinese market, industry participants are mandated by law to collaborate with a Chinese entity. Other non-current assets are broken down by investigating notes, thus separating operational and interest-bearing assets. In line with Petersen and Plenborg (2012), the deferred tax asset is defined as an operating item due to the vast majority of the deferred tax asset consisting of tax loss carry forwards and by not being able to distinguish whether the origin is financial or operational.

▪ Non-current operating liabilities consist of items such as other current provisions, other non-current liabilities and the deferred tax liability. The deferred tax liability is considered an operating liability following the same logic as the corresponding asset, thus ensuring consistency. Non-current provisions are recognised on the balance sheet as a response of a past legal or constructive obligation which is found probable to generate a material resource outflow in the future. This is deemed operational as it generally consists of warranty provisions to customers as well as being interest rate free (Petersen & Plenborg, 2012).

Financial Analytical Balance Sheet

▪ Total equity generally consists of share capital and minority interests. Minority interests arise when the parent company own less than 100% of the subsidiary. Petersen and Plenborg (2012) argue that minority interests are to be treated as equity capital as opposed to debt due to the higher required rate of return when valuing companies. They continue by highlighting the fact that in case of default, minority interests are ranked alongside equity holders, thus minority interests will be treated as equity.

▪ Interest-Bearing Debt. The most notable items are usually short and long-term debt. Often times financial items are hidden in other current and non-current liabilities, thus one has to break down those into notes to find items such as hedging instruments, interest payables and derivative

54 liabilities. Further, items such as retirement benefit plans and provisions for post-employments benefits exist due to that the company bearing the risk associated with future pay-outs. If these plans and benefits were fully funded, the corresponding asset would net them out to zero, but if they exist they are interest bearing and is therefore treated as financial items (Petersen & Plenborg, 2012).

▪ Interest-Bearing Assets. The most notable items are excess cash and cash equivalents, marketable securities and other long-term securities holdings. In addition, financial posts are often times included in other current and non-current assets and are treated as interest-bearing assets.

7.2.2 Analytical Income Statement

The analytical income statement is created by separating operating items from non-recurring and financing obtained to support the core business. The historical measures obtained, EBIT, EBITDA and net operating profit less amortisation and tax (NOPLAT), reflect the firms operating activities. By adjusting for capital expenditures (CAPEX), D&A and change in operating working capital, free cash flow to the firm (FCFF) is obtained.

Non-recurring events often times come in the form of restructuring costs, legal fees, impairment and the sale of investment assets and have to be adjusted for. Following the argumentation in the previous section, income from JV and associates is classified as operational. Further, when calculating the operating tax on the income statement one can either use the effective tax rate or the marginal tax rate. In the case of Volvo and its peers, the taxable income is sufficiently large (in most cases) to cover net financial expenses, thus the marginal tax approach is chosen to calculate operating tax (Petersen & Plenborg, 2012). However, often times, the corporate tax stated on the income statement includes tax shields from net financial expenses, which has to be corrected for in the analytical income statement. The tax shield is estimated by multiplying the net financial expense by the marginal tax rate for each individual company. Since Volvo and its peers all operate on a global scale, the global average tax rate of 23,62%.

7.2.3 Adjustments

When evaluating a company’s performance from the outside, there are generally two adjustments that needs to be accounted for; operating lease payments and R&D expenses (Koller et al., 2005).

Operating leases represent the most common form of off-balance sheet debt (Koller et al., 2005).

When firms choose to lease instead of borrowing and purchasing the asset, it only records the periodic rent associated with the lease on the income statement instead of recognising debt and assets on the balance sheet and interest payments on the income statement. This will lead to an artificially low operating profit and a corresponding artificially low value of the balance sheet. Therefore, to properly compare a company’s

55 performance across companies and over time, it is critical (for consistency) to convert any operating leases to assets and debt (Koller et al., 2005).

R&D expenses are treated differently by different accounting standards; according to U.S SFAS 2 they are treated as expenses, whereas the development proportion of the expense is allowed to be capitalised according to IFRS. The reasoning behind treating R&D costs as expenses is that the outcome is very uncertain, and implicitly much riskier than investments in fixed assets which is allowed to be capitalised.

However, the reason for the expense is no different than CAPEX, namely, to generate future economic benefits. Therefore, treating CAPEX and R&D expenditures differently in an technology intensive industry such as the automobile, will lead to an underestimated value of invested capital and thus overestimated ROIC as well as poor estimations of future growth (Damodaran A. , 2002). Though the reclassification leads to the removal of R&D expense on the income statement and adjusted amortisation added, it should not affect operating taxes since the R&D tax shield is real and directly related to operations. Thus the procedure will have no real effect on free cash flows and no influence in the valuation except in changing the perception of future growth opportunities (Koller et al., 2005). In addition to better metrics for valuation purposes, capitalising R&D expenses for the companies’ subject to analysis offers a correction for the inconsistency generated by different accounting standards.

Recognising that these adjustments yield a more accurate measure of value and value creation, the lack of information (as often involved when valuing private companies) restricts the realisation of these adjustments. The fact that Volvo, offers three years of financial data with no information on future lease payments, the process of adjusting operating leases as discussed above is not possible. Hence, by not recognising operating leases in debt, there is no need to adjust free cash flow for operating leases, which results in consistency between free cash flow and the cost of capital. As capitalising intangible assets requires subjective assessments on amortisation periods, the limited availability of financial statements evidently imposes a problem on the assumed amortisation period. The relatively long product-life cycle in the industry would argue for an amortisation period longer than three years, which would clearly yield more valid adjustments. Hence, the results presented are raw results without the capitalising of R&D and operating leases. As a result, return on invested capital (ROIC) will be up-ward biased given that the automobile industry has significant intangible assets. The effect of not capitalising operating leases is the same, though likely to a less extent as the requirements for classification of leases into operating or finance leases are conceptually similar under both account standards (IFRS and U.S. GAAP) (Koller et al., 2005). In summary, in this context, the drawbacks of not adjusting for these items across the whole group of companies are considered superior than converting and adjusting for a few.

56

7.3 Financial Ratio Analysis