FSA 6 – Integration of Financial Statement Analysis Techniques | 04 Financial Statement Analysis

Everything you have studied so far in financial reporting has been a technique: adjusting for inventory methods, unwinding capitalised interest, converting a foreign subsidiary, testing pension assumptions. This reading is different. It contains almost no new technique. What it teaches is selection and sequence: which tools to reach for, in what order, and when to stop. Financial analysis is a means to an end, and the end is an economic decision. Applying every available tool to every situation is not thoroughness, it is a failure to think about the question.

The organising device is a six-phase framework. Each phase names the information you need and the output you should produce, so that at any moment you can say what you are doing and why.

The six phases of a financial statement analysis

FSA 6 – Integration of Financial Statement Analysis Techniques — table 1
Phase	Where the information comes from	What the phase should produce
1. Define the purpose and context	The nature of the assignment (equity valuation, debt appraisal, assigning a rating); discussion with the client or supervisor; institutional guidelines on work product	A written objective; a list of specific questions the work must answer; the form of the report; a timetable and a resource budget
2. Collect input data	Financial statements and other financial data; industry and macroeconomic data; questionnaires; conversations with management, suppliers, customers and competitors; site visits	Organised financial statements, financial data tables and completed questionnaires
3. Process the data into analytically useful form	The data assembled in Phase 2	Adjusted statements, common-size statements, ratios, graphs and forecasts
4. Analyse and interpret the processed data	Both the raw inputs and the processed outputs	Analytical results
5. Develop and communicate conclusions	The analytical results, earlier reports, and house rules for published research	A report that answers the Phase 1 questions and a recommendation on the decision that prompted the work
6. Follow up	Information gathered by repeating the earlier phases periodically	Updated reports and revised recommendations

Figure 1: The framework as a loop, not a line

Phases 3 and 4 carry most of the workload and are usually done together. The dashed return path is what makes the framework a discipline rather than a checklist: the recommendation is revisited each reporting period.

The case that runs through this reading

The rest of the reading is a single extended case, and the numbers repay close attention because the examination will test them in exactly this form. A portfolio manager responsible for the food sector at a large public employee pension fund wants a long-term equity position in a listed food company. She has become interested in Nestlé S.A. after reading the group 2014 annual report, in which management set out long-term goals covering organic growth, improvement in margins and in earnings per share, and more efficient use of capital, and described an ambition to become the reference point for the nutrition, health and wellness industry rather than merely its largest participant. She asks an analyst to assess Nestlé as a possible large core holding.

She raises three concerns, and these become the Phase 1 questions:

Sources and sustainability of earnings growth. Where does the growth actually come from, do the reported earnings represent economic reality, and can the performance last for the five to ten years the fund would hold the stock?
The link between earnings and cash flow. Over a long horizon, earnings quality is judged by whether reported profit converts into cash.
The strength of the balance sheet. Having started her career as a lending officer, she wants to know whether the balance sheet captures the full rights and obligations of the business and whether the capital structure can support future operations and strategy. Write-downs of assets or newly recognised legal liabilities make sustained profitability difficult, because the company must first repair its financial position. Worse for an existing shareholder, if repairing the balance sheet requires issuing stock, the repair is paid for through dilution.

Phase 1 output. The analyst states the purpose as identifying the factors that have driven Nestlé financial success, assessing whether those factors are sustainable, and identifying the risks to that sustainability.

Phase 2 output. Several years of annual reports are collected from the company website and organised for processing.

The plan for Phases 3 and 4. The analyst sets out seven pieces of work: a DuPont decomposition of return on equity; an examination of the composition of the asset base; an analysis of the capital structure; a study of segments and how capital is allocated among them; a review of accruals as they affect earnings quality; a study of cash flows and their adequacy; and a decomposition of the market valuation. The order is not a rule. Another analyst might begin with a time-series common-size income statement if trends in revenue and expense categories mattered more than the sources of shareholder return. The starting point follows from the question.

Before any ratio is computed, the periods being compared must be built on the same accounting. A trend calculated across an accounting change measures the change, not the business. Nestlé adopted two standards in 2013 and restated comparatives back to 1 January 2012 only. The analyst wants four years of balance sheet data, so he pushes the 1 January 2012 adjustments back onto the 31 December 2011 balance sheet himself, using the restatement note in the 2013 annual report.

What the two standards did

IFRS 11, Joint Arrangements. Nestlé had been proportionately consolidating two joint arrangements, Cereal Partners Worldwide and Galderma. The standard removed that option and required the equity method. Proportionate consolidation brings a share of every line of the venture into the group accounts; the equity method replaces all of those lines with a single net investment on the balance sheet and a single net income line. Assets and liabilities therefore fall, revenue falls, and the investment in associates rises.
IAS 19 revised, Employee Benefits. This changed the measurement of defined benefit obligations, altering the employee benefits liability and the related deferred tax.

Analyst revisions to the 31 December 2011 balance sheet (CHF millions)

FSA 6 – Integration of Financial Statement Analysis Techniques — table 2
Item	2011 as reported	Effect of IAS 19	Effect of IFRS 11	2011 revised
Total current assets	33,324	nil	(786)	32,538
Property, plant and equipment	23,971	nil	(511)	23,460
Goodwill	29,008	nil	(395)	28,613
Intangible assets	9,356	nil	(571)	8,785
Investments in associates and joint ventures	8,629	nil	1,688	10,317
Deferred tax assets	2,476	(5)	(63)	2,408
Total non-current assets	80,767	(5)	140	80,902
Total assets	114,091	(5)	(646)	113,440
Total current liabilities	35,232	nil	(377)	34,855
Employee benefits liabilities	7,105	(91)	(102)	6,912
Deferred tax liabilities	2,060	18	(104)	1,974
Total non-current liabilities	20,585	(73)	(269)	20,243
Total liabilities	55,817	(73)	(646)	55,098
Retained earnings and other reserves	80,116	68	nil	80,184
Total equity	58,274	68	nil	58,342

An entry of nil in an effect column means no adjustment was recorded against that line.

Example 1 · Worked

Use the revision table above to answer the following.

1. Quantify the effect of the restatement on total assets, total liabilities and total equity, and show what it does to the 2011 current ratio and to the financial leverage ratio measured as total assets divided by total equity.

Solution. Totals first.

Total assets: 113,440 − 114,091 = −651, made up of −5 from IAS 19 and −646 from IFRS 11.
Total liabilities: 55,098 − 55,817 = −719, made up of −73 and −646.
Total equity: 58,342 − 58,274 = +68, entirely from IAS 19 through retained earnings.

Current ratio, as reported: 33,324 ÷ 35,232 = 0.9459. Revised: 32,538 ÷ 34,855 = 0.93. Deconsolidating the joint arrangements removed current assets of 786 and current liabilities of 377, and because the venture carried proportionately more current assets than current liabilities, the ratio falls slightly.

Leverage, as reported: 114,091 ÷ 58,274 = 1.958. Revised: 113,440 ÷ 58,342 = 1.944. Assets fall while equity rises marginally, so measured leverage improves.

Note the offsetting entry inside non-current assets: the investment in associates rises by 1,688, from 8,629 to 10,317, because the two ventures move onto one net line. Total non-current assets actually rise by 135, from 80,767 to 80,902, even though total assets fall, because the IFRS 11 effect on that subtotal is a positive 140.

Why this matters beyond the arithmetic

A move from proportionate consolidation to the equity method is a textbook example of an accounting change that leaves economic substance untouched but moves almost every ratio. Revenue and total assets both shrink, so asset turnover can move in either direction depending on which shrinks proportionately more. Net income is unchanged, so the net profit margin rises mechanically because the same profit is divided by smaller revenue. Liabilities fall more than equity, so leverage measures improve. An analyst who compares a pre-change year with a post-change year and reports a margin improvement has reported an accounting artefact.

The same logic applies to the second concession the analyst is forced to make later. Nestlé did not carry the IFRS 11 change back into segment disclosures before 2012, so segment comparisons are limited to three years. He accepts the limit rather than compare incompatible figures.

The analyst begins with a DuPont decomposition, because the fund would buy common stock and DuPont analysis separates the components that drive the return earned on common equity. The wider principle behind it is worth stating plainly: never accept a reported figure at the level at which it is presented. Disaggregate until the drivers are visible. A single reported line can hide a weak operation behind a strong one, and only disaggregation reveals which is which. That habit, sometimes called seeking granularity, is also what opens a useful conversation with management.

The problem the income statement presents

Reading the Nestlé income statement, the analyst notices a large line called income from associates and joint ventures. In 2014 it was CHF8,003 million, which is 53.7 percent of profit for the year of CHF14,904 million. Two features make it awkward. It is a pure net income figure, struck after tax, and it has no matching revenue anywhere in the income statement. So it inflates the numerator of any margin while adding nothing to the denominator.

Nestlé S.A. income statement, 2014 to 2012 (CHF millions)

FSA 6 – Integration of Financial Statement Analysis Techniques — table 3
Line	2014	2013	2012 (restated)
Sales	91,612	92,158	89,721
Other revenue	253	215	210
Cost of goods sold	(47,553)	(48,111)	(47,500)
Distribution	(8,217)	(8,156)	(8,017)
Marketing and administration	(19,651)	(19,711)	(19,041)
Research and development	(1,628)	(1,503)	(1,413)
Other trading income	110	120	141
Other trading expenses	(907)	(965)	(637)
Trading operating profit	14,019	14,047	13,464
Other operating income	154	616	146
Other operating expenses	(3,268)	(1,595)	(222)
EBIT (operating profit)	10,905	13,068	13,388
Finance income	135	219	120
Finance expense	(772)	(850)	(825)
EBT (profit before taxes and associates)	10,268	12,437	12,683
Taxes	(3,367)	(3,256)	(3,259)
Associates and joint ventures: share of income	8,003	1,264	1,253
Profit for the year	14,904	10,445	10,677
Of which non-controlling interests	448	430	449
Of which parent shareholders (net profit)	14,456	10,015	10,228
Basic earnings per share	4.54	3.14	3.21
Diluted earnings per share	4.52	3.13	3.20

Selected note disclosures. Unusual charges inside trading operating profit: restructuring (257), (274), (88); impairment of property, plant and equipment (136), (109), (74); impairment of intangibles other than goodwill (23), (34), nil; litigation and onerous contracts (411), (380), (369); total (827), (797), (531). Depreciation of property, plant and equipment (2,782), (2,867), (2,655) and amortisation of intangibles (276), (301), (394), together (3,058), (3,168), (3,049). Impairment of goodwill inside other operating expenses (1,908), (114), (14). The 2012 column was restated by Nestlé for IFRS 11 and IAS 19 revised.

Where the associates income came from

Much of the associates line reflects a 23.4 percent stock holding in L’Oréal, the French cosmetics group. Because the holding confers significant influence but not control, it is equity accounted, so Nestlé recognises a share of L’Oréal net income each year. In 2014 three separate events ran through the line:

Nestlé sold 48.5 million L’Oréal shares back to L’Oréal and received in exchange full ownership of Galderma, a venture the two companies had held jointly. The partial disposal produced a net gain of CHF4,569 million.
Nestlé had owned 50 percent of Galderma. On buying the other half, the original 50 percent stake was remeasured to fair value based on the price paid, producing a revaluation gain of CHF2,817 million. From July 2014 Galderma became a fully consolidated affiliate.
The share of results of other associated companies contributed CHF828 million.

Two of these three items are transaction gains that will not recur. If they are left inside net income when margins and returns are computed, the 2014 figures will look like an improvement in the food business, which they are not.

The adjustment

The analyst therefore strips the associates out of both statements. From the income statement he subtracts income from associates from profit for the year, leaving the profit produced by assets Nestlé actually controls. From the balance sheet he subtracts the carrying amount of investments in associates and joint ventures from total assets, leaving the asset base Nestlé actually operates. The two adjustments must be made together: removing the earnings but not the assets, or the reverse, produces a worse distortion than leaving both in.

Figure 2: Two different businesses inside one set of statements

The associates contribute net income with no revenue and a net asset with no operations. Leaving them in commingles two different businesses in every ratio, so both the earnings and the assets are removed together before margins and turnover are computed.

Data assembled for the DuPont analysis (CHF millions)

FSA 6 – Integration of Financial Statement Analysis Techniques — table 4
Item	2014	2013	2012	2011
Sales	91,612	92,158	89,721
EBIT (operating profit)	10,905	13,068	13,388
EBT (profit before taxes and associates)	10,268	12,437	12,683
Profit for the year	14,904	10,445	10,677
Associates and joint ventures: share of income	8,003	1,264	1,253
Profit net of that share	6,901	9,181	9,424
Total assets	133,450	120,442	125,877	113,440
Associates and joint ventures: carrying amount	8,649	12,315	11,586	10,317
Total assets net of that carrying amount	124,801	108,127	114,291	103,123
Total equity	71,884	64,139	62,664	58,342
Total equity net of that carrying amount	63,235	51,824	51,078	48,025

Example 2 · Worked

Use the data table above for 2014 and 2013.

1. Compute the Nestlé-only net profit margin and the Nestlé-only total asset turnover for 2014, then compute total asset turnover on unadjusted figures and quantify the effect of the associates on turnover.

Solution. Profit excluding associates is 14,904 − 8,003 = 6,901.

Nestlé-only net profit margin = 6,901 ÷ 91,612 = 7.53%.

For turnover, average the adjusted asset base over the year: (108,127 + 124,801) ÷ 2 = 116,464.
Nestlé-only total asset turnover = 91,612 ÷ 116,464 = 0.787.

On unadjusted figures, average total assets are (120,442 + 133,450) ÷ 2 = 126,946.
Total asset turnover = 91,612 ÷ 126,946 = 0.722.

The associates therefore reduce measured asset turnover by 0.787 − 0.722 = 0.065. The investment sits in the denominator producing no sales at all, so it can only drag turnover down. In 2013 the same calculation gives a drag of 0.081 and in 2012 a drag of 0.075.

Notice how differently the two adjustments behave. Removing associates from earnings lowers the margin, because the associates income is pure profit. Removing associates from assets raises turnover, because the investment generates no sales. The two effects run in opposite directions, which is precisely why the decomposition is needed: the aggregate return on assets conceals both.

Return on equity can be decomposed at three levels of detail. Each level is the previous one with a factor split in two.

The five-way form. Tax burden and interest burden each show what survives one deduction.

The three components of the net profit margin are defined as follows, using the Nestlé line items and excluding associates where the analyst has adjusted:

Figure 3: The five-way decomposition as a tree

Each level multiplies back to the level above. Adjusting the analysis for associates touches only the two boxes on the left branch, the margin and the turnover, and deliberately leaves the leverage box alone.

Expanded DuPont analysis, Nestlé 2014 to 2012

FSA 6 – Integration of Financial Statement Analysis Techniques — table 5
Component	2014	2013	2012
Tax burden (excluding associates)	67.21%	73.82%	74.30%
× Interest burden	94.16%	95.17%	94.73%
× EBIT margin	11.90%	14.18%	14.92%
= Net profit margin (excluding associates)	7.53%	9.96%	10.50%
× Effect of associates on net profit margin	216.07%	113.76%	113.33%
= Net profit margin	16.27%	11.33%	11.90%
Total asset turnover (excluding associates)	0.787	0.829	0.825
Effect of the investment in associates on turnover	(0.065)	(0.081)	(0.075)
× Total asset turnover	0.722	0.748	0.750
= Return on assets	11.75%	8.47%	8.93%
× Leverage	1.87	1.94	1.98
= Return on equity	21.97%	16.44%	17.67%
Traditional ROE: net income (CHF millions)	14,904	10,445	10,677
Traditional ROE: average total equity	68,012	63,402	60,503
Traditional ROE	21.91%	16.47%	17.65%

The decomposed and traditional ROE figures differ in the second decimal because the components are rounded before they are multiplied.

Example 3 · Worked

Work through the 2014 column from the underlying statement figures.

1. Build the five-way decomposition for 2014, add the associates effect, and reconcile the result with a direct calculation of return on equity.

Solution. Take the three margin components first, using profit excluding associates of 6,901.

Tax burden = 6,901 ÷ 10,268 = 67.21%. Only 67.21 percent of pre-tax core profit survives tax, against 73.82 percent in 2013 and 74.30 percent in 2012.
Interest burden = 10,268 ÷ 10,905 = 94.16%.
EBIT margin = 10,905 ÷ 91,612 = 11.90%.

Multiply the three: 0.6721 × 0.9416 × 0.1190 = 7.53%, the Nestlé-only net profit margin, which agrees with 6,901 ÷ 91,612.

Now the reported margin: 14,904 ÷ 91,612 = 16.27%. The associates effect is the ratio of the two: 16.27% ÷ 7.53% = 216.07%. Read it as a multiplier. Including the associates income more than doubles the apparent margin, adding 116.07 percent on top of the core margin, since (100.00% + 116.07%) × 7.53% = 16.27%.

Return on assets = 16.27% × 0.722 = 11.75%.

Leverage = average total assets ÷ average total equity = 126,946 ÷ 68,012 = 1.87.

Return on equity = 11.75% × 1.87 = 21.97%.

Direct check: 14,904 ÷ 68,012 = 21.91%. The six basis point gap is rounding in the chain, not an error. Always reconcile the decomposition to the direct figure; a large gap means a component has been defined inconsistently.

What the columns say

Read across the table and the story is uncomfortable. The reported net profit margin jumps from 11.90 percent in 2012 and 11.33 percent in 2013 to 16.27 percent in 2014, and reported ROE rises from 17.67 percent to 21.97 percent. Strip the associates out and the direction reverses: the core margin falls in each year, from 10.50 percent to 9.96 percent to 7.53 percent. Core asset turnover is flat to slightly lower, at 0.825, 0.829 and 0.787. The EBIT margin falls in each year, from 14.92 percent to 14.18 percent to 11.90 percent, and the tax burden ratio falls sharply in 2014, meaning tax took a larger bite out of a smaller pre-tax core profit.

Why the leverage component is left unadjusted

It is tempting to be consistent and subtract the investment in associates from both total assets and total equity in the leverage ratio, exactly as it was subtracted from the margin and turnover components. The analyst deliberately does not. Margin and turnover are operating measures: the core assets and the associates each generate their own pre-tax return, so separating them isolates two genuinely different earning streams. Leverage is a financing measure, and financing is raised at the group level and not earmarked to particular assets. The working assumption is that the same blend of debt and equity funds the investment in associates as funds everything else, and that the capital structure will not change. Under that assumption the group leverage ratio is the correct multiplier for both the adjusted and the unadjusted returns, which is also what makes the Nestlé-only ROE and the reported ROE directly comparable.

A core margin that falls three years running demands an explanation. Searching the income statement and the notes, the analyst finds two recurring drags. Nestlé recorded goodwill impairments in each year, with a very large one of CHF1,908 million in 2014 arising from acquisitions of ice cream and pizza businesses in the United States. It also recorded provisions each year for restructuring, environmental liabilities, litigation and other matters. He groups these together and calls them unusual charges for convenience of presentation.

Profitability adjusted for provisions and impairment charges (CHF millions)

FSA 6 – Integration of Financial Statement Analysis Techniques — table 6
Item	2014	2013	2012
Sales	91,612	92,158	89,721
Profit excluding income from associates	6,901	9,181	9,424
Add back: impairment of goodwill	1,908	114	14
Add back: provisions for restructuring, environmental, litigation and other	920	862	618
Profit adjusted for unusual charges	9,729	10,157	10,056
Net profit margin excluding associates, unusual charges included	7.53%	9.96%	10.50%
Net profit margin excluding associates and unusual charges	10.62%	11.02%	11.21%
Margin consumed by unusual charges	3.09%	1.06%	0.71%

The provisions are added back gross, on the assumption that they were not deductible in the year of recognition.

Example 4 · Worked

Use the table above.

1. Show how the 2014 adjusted profit and adjusted margin are built, and state how much of the margin decline from 2012 to 2014 the unusual charges account for.

Solution. Adjusted profit for 2014 = 6,901 + 1,908 + 920 = 9,729.

Adjusted net profit margin = 9,729 ÷ 91,612 = 10.62%.

Margin consumed by the charges = 10.62% − 7.53% = 3.09%, against 1.06 percent in 2013 and 0.71 percent in 2012.

Now the decomposition of the decline. The unadjusted core margin fell from 10.50 percent to 7.53 percent, a drop of 2.97 percentage points. The adjusted core margin fell from 11.21 percent to 10.62 percent, a drop of 0.59 percentage points. So the growing weight of unusual charges explains 2.38 percentage points of the fall, and 0.59 percentage points is genuine underlying erosion.

The check on the arithmetic: the charge burden rose from 0.71 percent to 3.09 percent, an increase of 2.38 percentage points, which is exactly the gap between the two declines.

The judgement call, and it goes the other way

Having quantified the effect, the analyst decides not to rebuild the DuPont analysis on charge-free numbers. His reasoning is worth memorising because it is the kind of judgement the examination rewards. The charges arise from decisions management made. They recur every year rather than appearing once. And they reduce the returns actually available to shareholders. Excluding them would flatter management for the consequences of its own choices. The adjusted figures are computed and reported as supplementary information, not substituted for the reported ones.

That said, the adjusted series does carry information. Adjusted profits and adjusted margins are considerably more stable across the three years than the unadjusted ones, which confirms that the charges, not the trading business, drive most of the year-to-year swing. But both series decline over the period, so the charges do not explain everything away.

Splitting return on equity between the two businesses

The Nestlé-only ROE is built by multiplying the core margin by the core turnover by the unadjusted leverage. The difference between it and reported ROE is the contribution of the associates.

Return on equity attributable to the investment in associates

FSA 6 – Integration of Financial Statement Analysis Techniques — table 7
Measure	2014 (%)	2013 (%)	2012 (%)
ROE including associates	21.97	16.44	17.67
Less Nestlé-only ROE	11.08	16.02	17.15
Contribution of associates to ROE	10.89	0.42	0.52

Example 5 · Worked

Use the DuPont components from the previous section and the adjusted margins above.

1. Compute the Nestlé-only ROE for 2014 on reported core margins, and again on core margins with unusual charges removed. Comment on level and trend.

Solution. On reported core margins: 7.53% × 0.787 × 1.87 = 11.08%.

Reported ROE was 21.97 percent, so the associates contributed 21.97 − 11.08 = 10.89 percentage points, almost half of the total. In 2013 and 2012 the same contribution was only 0.42 and 0.52 percentage points. Virtually all of the 2014 improvement in headline ROE came from the L’Oréal disposal and the Galderma remeasurement.

On charge-free core margins: 10.62% × 0.787 × 1.87 = 15.63%. Applying the same method to the earlier years gives 11.02% × 0.829 × 1.94 = 17.73% for 2013 and 11.21% × 0.825 × 1.98 = 18.31% for 2012.

Comment. Removing the charges lifts the level of core ROE substantially, by more than four percentage points in 2014, but it does not change the direction: 18.31, then 17.73, then 15.63. The core business is earning less on shareholder capital each year whichever way the charges are treated. That is the finding the analyst carries forward, because the biggest part of the entity ought to be the biggest driver of returns.

Spread between reported and core net profit margin

FSA 6 – Integration of Financial Statement Analysis Techniques — table 8
Measure	2014	2013	2012
Consolidated net profit margin, as reported	16.27%	11.33%	11.90%
Nestlé-only net profit margin	7.53%	9.96%	10.50%
Spread	8.74%	1.37%	1.40%

The spread is the cleanest single summary of the problem. In 2012 and 2013 the reported margin overstated the core margin by about 1.4 percentage points. In 2014 the overstatement was 8.74 percentage points. Reported profitability and core profitability have separated, and every additional franc of the gap comes from something outside management operating control.

Falling turnover in the DuPont chain points at the asset base, so the analyst next examines what Nestlé owns and how the mix has shifted. A common-size balance sheet, with every line expressed as a percentage of total assets, is the right instrument.

Asset composition as a percentage of total assets

FSA 6 – Integration of Financial Statement Analysis Techniques — table 9
Category	2014 (%)	2013 (%)	2012 (%)	2011 (%)
Cash and equivalents	5.6	5.3	4.5	4.2
Short-term investments	1.1	0.5	2.8	2.7
Inventories	6.9	7.0	7.1	8.0
Receivables, trade and other	10.1	10.1	10.4	11.5
Other current items	1.8	2.0	2.2	2.4
Total current assets	25.5	24.9	27.0	28.8
Property, plant and equipment, net	21.3	22.3	21.1	20.7
Goodwill	25.9	25.8	26.0	25.2
Intangible assets	14.8	10.5	10.3	7.7
Other non-current	12.5	16.4	15.6	17.7
Total	100.0	99.9	100.0	100.1

The 2013 and 2011 columns do not total exactly 100 percent because each component is rounded to one decimal place.

For a food manufacturer and marketer, heavy inventory and plant balances are expected. What is not expected is the weight of purchased intangibles. Goodwill and intangible assets together were 40.7 percent of total assets at the end of 2014, up from 32.9 percent at the end of 2011. Almost all of the increase is in the intangibles line, which nearly doubled as a share of assets, from 7.7 percent to 14.8 percent. Goodwill on its own barely moved as a percentage, from 25.2 to 25.9. Those are the fingerprints of a growth-by-acquisition strategy, and they mean that a meaningful part of Nestlé future success depends on whether the acquisitions were good ones.

Investing activities, 2012 to 2014 (CHF millions)

FSA 6 – Integration of Financial Statement Analysis Techniques — table 10
Line	Three-year total	2014	2013	2012
Purchases of property, plant and equipment	(14,115)	(3,914)	(4,928)	(5,273)
Purchases of intangible assets	(1,236)	(509)	(402)	(325)
Businesses acquired	(13,223)	(1,986)	(321)	(10,916)
Businesses disposed	884	321	421	142
Associates and joint ventures, investments net of divestments	3,851	3,958	(28)	(79)
Non-current treasury investments, outflows	(573)	(137)	(244)	(192)
Non-current treasury investments, inflows	4,460	255	2,644	1,561
Short-term treasury investments, net	115	(962)	400	677
Other investing activities	668	(98)	852	(86)
Cash flow from investing activities	(19,169)	(3,072)	(1,606)	(14,491)
Acquisitions as a percentage of total investing outflow	69.0%	64.6%	20.0%	75.3%

Across the three years, 69.0 percent of the cash devoted to investing went into buying businesses rather than into the existing asset base. Only 2013, at 20.0 percent, was a quiet year. The single largest transaction was the 2012 purchase of the Wyeth nutritional business for CHF10,846 million, which absorbed 74.8 percent of that year investing cash outflow of 14,491. A company that spends two-thirds of its investment budget on acquisitions over three years has, in effect, outsourced its growth, and the return on that spending is the central question for the rest of the analysis.

The DuPont leverage ratio moved within a narrow band, from 1.98 to 1.94 to 1.87, which on its own would suggest a stable and even improving financial position. That is the weakness of a single leverage multiple: it says nothing about the character of the obligations. A bond indenture and an employee benefit obligation are both liabilities, but default on the first has consequences that default on the second does not. The analyst therefore builds a common-size view of long-term capital.

Composition of long-term capital (percent)

FSA 6 – Integration of Financial Statement Analysis Techniques — table 11
Component	2014	2013	2012	2011
Long-term financial liabilities	12.3	11.8	10.3	7.8
Other long-term liabilities	16.2	14.9	17.9	17.9
Total equity	71.5	73.3	71.8	74.2
Total long-term capital	100.0	100.0	100.0	99.9

The 2011 column does not total exactly 100 percent because each component is rounded to one decimal place. Other long-term liabilities are mainly employee benefit obligations and provisions.

The aggregate multiple was steady, but the mix became riskier. Equity financing fell from 74.2 percent of long-term capital in 2011 to 71.5 percent in 2014. Long-term financial liabilities, the genuinely contractual borrowings, rose from 7.8 percent to 12.3 percent, an increase of well over half in four years. The softer category, other long-term liabilities, fell from 17.9 percent to 16.2 percent. So Nestlé has substituted hard debt for both equity and soft obligations while the headline leverage ratio was falling. This is a good illustration of why one ratio is never enough.

Liquidity and the working capital cycle

If long-term leverage is rising, the analyst wants to see whether short-term resilience has been maintained.

Working capital ratios, 2011 to 2014

FSA 6 – Integration of Financial Statement Analysis Techniques — table 12
Ratio	2014	2013	2012	2011
Current ratio	1.03	0.91	0.88	0.93
Quick ratio	0.68	0.59	0.58	0.60
Defensive interval ratio (days)	106.6	91.9	110.0	110.5
Days sales outstanding	51.1	50.0	53.0	54.7
Days on hand of inventory	67.4	65.7	69.3	70.4
Number of days of payables	(126.5)	(117.8)	(108.6)	(105.3)
Cash conversion cycle	(8.0)	(2.1)	13.7	19.8

Daily cash expenditure is total cash operating and financial costs, stripped of non-cash charges, divided by 365.

Example 6 · Worked

Use the 2014 income statement and its notes.

1. Compute the 2014 defensive interval ratio from first principles.

Solution. Start with the numerator, the quickly available resources: cash 7,448 + short-term investments 1,433 + trade and other receivables 13,459 = 22,340. That is also the numerator of the quick ratio, so the quick ratio is 22,340 ÷ 32,895 = 0.68.

Now the denominator. Take the cash operating and financial costs and remove every non-cash element:

Cost of goods sold 47,553 + distribution 8,217 + marketing and administration 19,651 + research and development 1,628
− depreciation and amortisation (2,782 + 276) = 3,058
+ net other trading expenses (907 − 110) = 797
− impairment of property, plant and equipment and of intangibles (136 + 23) = 159
+ net other operating expenses excluding goodwill impairment (3,268 − 154 − 1,908), which is 3,114 − 1,908 = 1,206
+ net financial expenses (772 − 135) = 637

Sum: 47,553 + 8,217 + 19,651 + 1,628 − 3,058 + 797 − 159 + 1,206 + 637 = 76,472.
Daily cash expenditure = 76,472 ÷ 365 = 209.5.

Defensive interval ratio = 22,340 ÷ 209.5 = 106.6 days. Nestlé could meet its cash costs for about 106 days from liquid resources alone, before any further sales.

Example 7 · Worked

Balances required: receivables 13,459 and 12,206; inventories 9,172 and 8,382; trade and other payables 17,437 and 16,072 for 2014 and 2013. Sales in 2014 were 91,612 and cost of goods sold 47,553.

1. Compute days sales outstanding, days on hand of inventory, days of payables and the cash conversion cycle for 2014, using average balances and a 365-day year.

Solution. Average receivables = (13,459 + 12,206) ÷ 2 = 12,832.5.
DSO = (12,832.5 ÷ 91,612) × 365 = 51.1 days.

Average inventory = (9,172 + 8,382) ÷ 2 = 8,777.
DOH = (8,777 ÷ 47,553) × 365 = 67.4 days.

For payables the correct denominator is purchases, not cost of goods sold. Purchases = cost of goods sold + closing inventory − opening inventory = 47,553 + 9,172 − 8,382 = 48,343.
Average payables = (17,437 + 16,072) ÷ 2 = 16,754.5.
Days of payables = (16,754.5 ÷ 48,343) × 365 = 126.5 days.

Cash conversion cycle = 51.1 + 67.4 − 126.5 = −8.0 days.

Using cost of goods sold instead of purchases would give about 128.6 days of payables and a cycle of roughly −10 days. In a year when inventory rises, purchases exceed cost of goods sold and the payables measure falls, so the choice of denominator is not cosmetic.

Current and quick ratios improved modestly in 2014 after three flat years, and the defensive interval recovered to 106.6 days after dipping to 91.9 in 2013. Given the rise in long-term leverage the analyst had hoped for a larger liquidity cushion. He finds it instead in the speed of the cycle. Since 2011, days sales outstanding has fallen from 54.7 to 51.1 and days on hand of inventory from 70.4 to 67.4, while days of payables has stretched from 105.3 to 126.5. The cash conversion cycle has gone from positive 19.8 days to negative 8.0 days. Nestlé now collects the cash from its working capital roughly eight days before it has to hand that cash to suppliers, and the great majority of the improvement comes from paying vendors more slowly rather than from operating faster.

Figure 4: The cycle crossing into negative territory

The upper bar in each pair is days on hand of inventory plus days sales outstanding. When the lower payables bar extends past it, the company is being financed by its suppliers and the cash conversion cycle turns negative.

DuPont analysis tells you that returns are falling. It cannot tell you where inside the business the problem is, or whether management is directing money towards the parts that earn most. For that the analyst turns to the segment note, which is the only place where the internal structure of a group becomes visible.

Two limitations have to be accepted first. Nestlé defines segments by management responsibility and geography combined, not by geography alone, so a segment is not a clean regional unit. And because IFRS 11 was not applied retrospectively to segment data before 2012, comparison is limited to three years; the earlier figures included proportionate shares of joint venture sales and profits and are not comparable.

Sales and trading operating profit by segment (CHF millions)

FSA 6 – Integration of Financial Statement Analysis Techniques — table 13
Segment	Sales 2014	% total	Sales 2013	% total	Sales 2012	% total	2014 change	2013 change
Europe	15,175	16.6	15,567	16.9	15,388	17.2	−2.5	1.2
Americas	27,277	29.8	28,358	30.8	28,613	31.9	−3.8	−0.9
Asia, Oceania and Africa	18,272	19.9	18,851	20.5	18,875	21.0	−3.1	−0.1
Nestlé Waters	7,390	8.1	7,257	7.9	7,174	8.0	1.8	1.2
Nestlé Nutrition	9,614	10.5	9,826	10.7	7,858	8.8	−2.2	25.0
Other businesses	13,884	15.2	12,299	13.3	11,813	13.2	12.9	4.1
Total	91,612	100.0	92,158	100.0	89,721	100.0

FSA 6 – Integration of Financial Statement Analysis Techniques — table 14
Segment	Profit 2014	% total	Profit 2013	% total	Profit 2012	% total	2014 change	2013 change
Europe	2,327	16.6	2,331	16.6	2,363	17.6	−0.2	−1.4
Americas	5,117	36.5	5,162	36.7	5,346	39.7	−0.9	−3.4
Asia, Oceania and Africa	3,408	24.3	3,562	25.4	3,579	26.6	−4.3	−0.5
Nestlé Waters	714	5.1	665	4.7	640	4.8	7.4	3.9
Nestlé Nutrition	1,997	14.2	1,961	14.0	1,509	11.2	1.8	30.0
Other businesses	2,654	18.9	2,175	15.5	2,064	15.3	22.0	5.4
Unallocated items	(2,198)	−15.7	(1,809)	−12.9	(2,037)	−15.1	21.5	−11.2
Total	14,019	100.0	14,047	100.0	13,464	100.0

Other businesses mainly comprises Nespresso, Nestlé Professional, Nestlé Health Science and Nestlé Skin Health. Change columns are year-on-year percentage movements in the amount.

The three geographic segments are shrinking in relative importance. Together they generated 66.3 percent of 2014 revenue, down from 70.1 percent in 2012, and 77.4 percent of trading operating profit, down from 83.9 percent. Each of the three fell in absolute sales in 2014, by 2.5 percent, 3.8 percent and 3.1 percent respectively, and each also fell in operating profit in both 2013 and 2014. Nestlé Waters, the smallest unit and not a geographic one, grew modestly and contributed almost the same share of sales and profit in 2014 as in 2012.

The two growing units are Nestlé Nutrition, which supplied 10.5 percent of sales in 2014 against 8.8 percent in 2012 and 14.2 percent of total trading operating profit against 11.2 percent, and Other businesses, which supplied 15.2 percent of sales against 13.2 percent and 18.9 percent of trading operating profit against 15.3 percent. The Nutrition jump traces to the 2012 Wyeth acquisition, whose first full-year effect shows in the 25.0 percent sales increase in 2013. The Other businesses jump in 2014, 12.9 percent on sales and 22.0 percent on profit, follows from taking full control of Galderma.

The analyst is frustrated by the disclosure itself. Nestlé Waters and Other businesses plainly operate across the same geographies as the three regional segments, yet their results are pulled out separately, so the regional figures do not describe the regions. Other businesses alone is close to 19 percent of trading operating profit and bundles coffee systems, professional food service, health care and skin care, activities unlikely to share distribution channels, margins or growth rates. Reporting them as one line destroys information exactly where more of it is needed.

Where the capital is going

Segment assets and capital expenditure (CHF millions)

FSA 6 – Integration of Financial Statement Analysis Techniques — table 15
Segment	Assets 2014	Assets 2013	Assets 2012	Capex 2014	Capex 2013	Capex 2012
Europe	11,308	11,779	11,804	747	964	1,019
Americas	20,915	21,243	22,485	1,039	1,019	1,073
Asia, Oceania and Africa	15,095	14,165	14,329	697	1,280	1,564
Nestlé Waters	6,202	6,046	6,369	308	377	407
Nestlé Nutrition	24,448	22,517	24,279	363	430	426
Other businesses	21,345	9,564	9,081	573	642	550
Total	99,313	85,314	88,347	3,727	4,712	5,039

Segment assets do not sum to balance sheet total assets because of inter-segment and non-segment items.

EBIT margin, asset share and capital expenditure share, ranked by 2014 margin

FSA 6 – Integration of Financial Statement Analysis Techniques — table 16
Segment	EBIT margin 2014	2013	2012	% of assets 2014	2013	2012	% of capex 2014	2013	2012
Nestlé Nutrition	20.77	19.96	19.20	24.6	26.4	27.5	9.7	9.1	8.5
Other businesses	19.12	17.68	17.47	21.5	11.2	10.3	15.4	13.6	10.9
Americas	18.76	18.20	18.68	21.1	24.9	25.5	27.9	21.6	21.3
Asia, Oceania and Africa	18.65	18.90	18.96	15.2	16.6	16.2	18.7	27.2	31.0
Europe	15.33	14.97	15.36	11.4	13.8	13.4	20.0	20.5	20.2
Nestlé Waters	9.66	9.16	8.92	6.2	7.1	7.2	8.3	8.0	8.1

Margins are trading operating profit divided by segment sales. The 2012 asset shares total 100.1 percent because of rounding.

The test the analyst applies is simple. If a segment holds a given share of the assets, a neutral capital policy would give it about the same share of the capital expenditure. Divide the capital expenditure share by the asset share and a ratio of 1 means neutral, below 1 means the segment is being allowed to shrink, and above 1 means it is receiving a growth allocation.

Ratio of capital expenditure share to asset share, ranked by 2014 EBIT margin

FSA 6 – Integration of Financial Statement Analysis Techniques — table 17
Segment	EBIT margin 2014	Ratio 2014	Ratio 2013	Ratio 2012
Nestlé Nutrition	20.77	0.39	0.34	0.31
Other businesses	19.12	0.72	1.21	1.06
Americas	18.76	1.32	0.87	0.84
Asia, Oceania and Africa	18.65	1.23	1.64	1.91
Europe	15.33	1.75	1.49	1.51
Nestlé Waters	9.66	1.34	1.13	1.13

Each ratio is the segment share of capital expenditure divided by its share of assets in the same year. For Nestlé Waters in 2012, 8.1 percent of capital expenditure against 7.2 percent of assets gives 1.13.

Example 8 · Worked

Use the segment asset and capital expenditure table for 2014.

1. Compute the allocation ratio for Nestlé Nutrition and for Europe, and comment on what the comparison with EBIT margin implies.

Solution. Nestlé Nutrition. Asset share = 24,448 ÷ 99,313 = 24.6%. Capital expenditure share = 363 ÷ 3,727 = 9.7%. Allocation ratio = 9.7 ÷ 24.6 = 0.39.

Europe. Asset share = 11,308 ÷ 99,313 = 11.4%. Capital expenditure share = 747 ÷ 3,727 = 20.0%. Allocation ratio = 20.0 ÷ 11.4 = 1.75.

Comment. On EBIT margin alone the allocation looks perverse. Nestlé Nutrition earns the highest margin of the six segments, 20.77 percent, yet it receives the smallest allocation, and the ratio has been below 0.4 in all three years. Europe earns the second lowest margin, 15.33 percent, and receives the largest allocation in every year. Nestlé Waters, with much the lowest margin at 9.66 percent, also gets a growth allocation of 1.34. Four of the six segments, the Americas, Asia, Oceania and Africa, Europe and Nestlé Waters, had ratios above 1 in 2014.

There is a partial defence for Nutrition: the segment has been grown by acquisition, notably Wyeth in 2012, and acquisition spending does not appear in capital expenditure. Even so, a much larger operation would normally require more maintenance spending, and Nutrition capital expenditure has moved from 426 in 2012 to 430 in 2013 and then down to 363 in 2014, so it has fallen rather than grown with the business.

Ranking on cash instead of accrual profit

EBIT is an accrual measure, and the analyst knows accrual profitability can diverge from the ability to generate cash. Segment cash flow is not disclosed, so he approximates it by adding back segment depreciation and amortisation to segment trading operating profit, and relates that to average segment assets. The result is a rough cash return on the capital tied up in each unit.

Segment depreciation, approximated cash generation and average assets (CHF millions)

FSA 6 – Integration of Financial Statement Analysis Techniques — table 18
Segment	D&A 2014	D&A 2013	D&A 2012	Cash generation 2014	2013	2012	Average assets 2014	2013	2012
Europe	473	517	533	2,800	2,848	2,896	11,544	11,792	11,683
Americas	681	769	899	5,798	5,931	6,245	21,079	21,864	22,783
Asia, Oceania and Africa	510	520	553	3,918	4,082	4,132	14,630	14,247	14,068
Nestlé Waters	403	442	491	1,117	1,107	1,131	6,124	6,208	6,486
Nestlé Nutrition	330	337	176	2,327	2,298	1,685	23,483	23,398	18,564
Other businesses	525	437	295	3,179	2,612	2,359	15,455	9,323	10,009

The 2012 averages include 2011 segment assets prepared before IFRS 11, for which no restatement is available. The analyst accepts that averaging dilutes the inconsistency and will disregard any 2012 figure that behaves like an outlier.

Segment cash operating return on average assets, ranked by 2014 allocation ratio

FSA 6 – Integration of Financial Statement Analysis Techniques — table 19
Segment	Allocation ratio 2014	EBIT margin 2014 (%)	Cash return 2014 (%)	2013 (%)	2012 (%)
Europe	1.75	15.3	24.3	24.2	24.8
Nestlé Waters	1.34	9.7	18.2	17.8	17.4
Americas	1.32	18.8	27.5	27.1	27.4
Asia, Oceania and Africa	1.23	18.7	26.8	28.7	29.4
Other businesses	0.72	19.1	20.6	28.0	23.6
Nestlé Nutrition	0.39	20.8	9.9	9.8	9.1

The ranking inverts. Nestlé Nutrition, which had the highest EBIT margin, has by far the lowest cash return on assets, under 10 percent in each of the three years. Europe, which had the second lowest margin, produces cash returns above 24 percent in every year, comfortably ahead of Nestlé Waters and Nestlé Nutrition. Nestlé Waters, unattractive on margin, generates 18.2 percent. The Americas and Asia, Oceania and Africa are the two strongest on cash return in 2012 and 2014; in 2013 Asia, Oceania and Africa leads at 28.7 percent with Other businesses at 28.0 percent just ahead of the Americas at 27.1 percent.

Seen this way the allocation is defensible. The segments receiving growth allocations are, with the exception of Nestlé Waters, the ones producing the strongest cash returns, and the segment starved of capital expenditure is the one that converts its asset base into cash least efficiently. Where the capital budgeting decision is taken on cash flow, it is only fair to grade the outcome on cash flow as well.

Why the two rankings disagree so violently

EBIT margin measures profit per franc of sales. Cash return on assets measures cash per franc of assets. A segment built by acquisition carries goodwill and purchased intangibles that inflate its asset base without generating sales, so it can show an excellent margin and a poor return on capital at the same time. Nestlé Nutrition holds 24.6 percent of segment assets while producing only 10.5 percent of sales, which is why its cash return is under 10 percent. Europe is the mirror image: 11.4 percent of assets producing 16.6 percent of sales on a long-owned, largely depreciated asset base. The lesson generalises. Margin ranks operating efficiency; return on capital ranks investment quality; and for judging whether an acquisition programme is creating value, only the second one answers the question.

Nestlé also discloses results by product group, which cuts the business a second way. The disclosure is thinner: there is no capital expenditure by product group, so the allocation ratio cannot be repeated, and assets are reported on an average basis for product groups but on a year-end basis for segments, so the two asset totals are not comparable. There is also no unallocated asset amount by product group, whereas a substantial amount is unallocated in the segment presentation. The analyst works with what is available.

Sales, EBIT and EBIT margin by product group, ranked by 2014 margin (CHF millions)

FSA 6 – Integration of Financial Statement Analysis Techniques — table 20
Product group	Sales 2014	% total	EBIT 2014	% total	Margin 2014	Margin 2013	Margin 2012
Powdered and Liquid Beverages	20,302	22.2	4,685	33.4	23.1%	22.7%	22.0%
Nutrition and Health Science	13,046	14.2	2,723	19.4	20.9%	18.8%	18.3%
Pet Care	11,339	12.4	2,246	16.0	19.8%	19.2%	19.8%
Milk Products and Ice Cream	16,743	18.3	2,701	19.3	16.1%	15.2%	15.6%
Confectionery	9,769	10.7	1,344	9.6	13.8%	15.9%	16.9%
Prepared Dishes and Cooking Aids	13,538	14.8	1,808	12.9	13.4%	13.2%	14.1%
Water	6,875	7.5	710	5.1	10.3%	10.0%	9.4%
Unallocated items			(2,198)	−15.7
Total	91,612	100.0	14,019	100.0	15.3%	15.2%	15.0%

Sales growth in 2014 was 10.2 percent for Nutrition and Health Science and 1.5 percent for Water; every other group except Pet Care, at 0.9 percent, declined. EBIT for Nutrition and Health Science rose 22.2 percent in 2014 after 25.3 percent in 2013.

Nutrition and Health Science is the only product group with meaningful growth in either sales or EBIT, which is unsurprising since it is where the acquisitions have been made. Its margin has improved in each of the last two years, from 18.3 to 18.8 to 20.9 percent, and it is among the highest in the group. But Powdered and Liquid Beverages has beaten it on margin in all three years, and Water has been the weakest throughout at 10.3, 10.0 and 9.4 percent.

Average assets, EBIT return on assets and asset share by product group, ranked by 2014 return

FSA 6 – Integration of Financial Statement Analysis Techniques — table 21
Product group	Average assets 2014	2013	2012	EBIT return 2014	2013	2012	% of assets 2014	2013	2012
Powdered and Liquid Beverages	11,599	11,044	10,844	40.4%	42.1%	41.0%	11.6%	11.5%	12.4%
Milk Products and Ice Cream	14,387	14,805	14,995	18.8%	17.8%	18.0%	14.4%	15.4%	17.1%
Confectionery	7,860	8,190	8,343	17.1%	19.9%	21.2%	7.9%	8.5%	9.5%
Pet Care	14,344	14,064	13,996	15.7%	15.4%	15.3%	14.4%	14.6%	16.0%
Prepared Dishes and Cooking Aids	13,220	13,289	13,479	13.7%	14.1%	15.1%	13.3%	13.8%	15.4%
Water	5,928	6,209	6,442	12.0%	10.9%	9.9%	6.0%	6.4%	7.4%
Nutrition and Health Science	32,245	28,699	19,469	8.4%	7.8%	9.1%	32.4%	29.8%	22.2%
Total	99,583	96,300	87,568	14.1%	14.6%	15.4%	100.0%	100.0%	100.0%

Example 9 · Worked

Use the product group tables for 2014.

1. Compute the EBIT return on average assets for Nutrition and Health Science and for Powdered and Liquid Beverages, compare each with the group figure, and explain what the contrast implies about the acquisition programme.

Solution. Nutrition and Health Science: 2,723 ÷ 32,245 = 8.4%.
Powdered and Liquid Beverages: 4,685 ÷ 11,599 = 40.4%.
Whole company: 14,019 ÷ 99,583 = 14.1%.

Nutrition and Health Science earns 8.4 percent against a company average of 14.1 percent, and the same comparison in the two earlier years is 7.8 percent against 14.6 percent and 9.1 percent against 15.4 percent. It is below the company average in all three years, and it is below even Water, the group with the weakest margin, in all three years, 8.4 against 12.0, 7.8 against 10.9 and 9.1 against 9.9.

At the same time its share of average assets has climbed from 22.2 percent to 29.8 percent to 32.4 percent, so it is the largest single user of capital in the company. A dilutive return that grows as a proportion of the base pulls the company return down arithmetically, and indeed the total EBIT return on assets fell from 15.4 to 14.6 to 14.1 percent.

Powdered and Liquid Beverages is the opposite case: the highest EBIT margin, 23.1 percent, the highest return on assets, 40.4 percent, and only 11.6 percent of the asset base. If capital could be moved towards it, returns would rise.

Implication. The acquisitions have been concentrated in the product group with the weakest return on assets. That raises the question of whether management has been paying too much for the businesses it buys, and the CHF1,908 million goodwill impairment taken in 2014 is direct evidence on the same point: an impairment is an admission that an earlier purchase price is no longer supported by the cash the acquired business is expected to produce.

Nothing so far has raised the analyst enthusiasm. That prompts a harder question, and it is the question every equity analyst should ask when operating performance disappoints: could weak results be dressed up through the accounting? Reporting choices and estimates offer scope for that, and the standard first screen is the level and trend of accruals.

Accruals are the part of reported earnings not backed by cash movements. They are unavoidable and mostly benign, since accrual accounting exists precisely to report economic events before the cash arrives. They become a warning when they are large relative to the asset base or when they climb persistently, because both patterns suggest earnings are being carried by estimates rather than by transactions. Two ratios are computed, one from the balance sheet and one from the cash flow statement. Agreement between them is reassuring; disagreement is itself a signal.

NOA is net operating assets, NI is net income, CFO is operating cash flow and CFI is investing cash flow.

Net operating assets are built by stripping financing items from both sides of the balance sheet. Operating assets are total assets less cash and short-term investments. Operating liabilities are total liabilities less long-term debt and debt in current liabilities. The difference is the capital genuinely tied up in operations.

Inputs to the accruals ratios (CHF millions)

FSA 6 – Integration of Financial Statement Analysis Techniques — table 22
Item	2014	2013	2012	2011
Total assets	133,450	120,442	125,877	113,440
Less: cash and short-term investments	8,881	7,053	9,296	7,782
Operating assets (A)	124,569	113,389	116,581	105,658
Total liabilities	61,566	56,303	63,213	55,098
Less: long-term debt	12,396	10,363	9,008	6,165
Less: debt within current liabilities	8,810	11,380	18,408	15,945
Operating liabilities (B)	40,360	34,560	35,797	32,988
Net operating assets, (A) − (B)	84,209	78,829	80,784	72,670
Aggregate accruals from the balance sheet, being the change in NOA	5,380	(1,955)	8,114	6,218
Average NOA	81,519	79,807	76,727	69,561
Profit from continuing operations	14,904	10,445	10,677
Operating cash flow	(14,700)	(14,992)	(15,668)
Investing cash flow	3,072	1,606	14,491
Cash-flow-based aggregate accruals	3,276	(2,941)	9,500

In the final block the signs of the two cash flow lines are reversed because they are being deducted from net income.

Accruals ratios

FSA 6 – Integration of Financial Statement Analysis Techniques — table 23
Measure	2014	2013	2012
Aggregate accruals, balance sheet basis	5,380	(1,955)	8,114
Average NOA, the denominator	81,519	79,807	76,727
Accruals ratio, balance sheet basis	6.6%	−2.4%	10.6%
Aggregate accruals, cash flow basis	3,276	(2,941)	9,500
Average NOA, the same denominator	81,519	79,807	76,727
Accruals ratio, cash flow basis	4.0%	−3.7%	12.4%

Example 10 · Worked

Use the input table above.

1. Compute both accruals ratios for 2014 from the underlying balance sheet and cash flow figures, and interpret the three-year pattern.

Solution. Net operating assets first.

2014: operating assets = 133,450 − (7,448 + 1,433) = 133,450 − 8,881 = 124,569. Operating liabilities = 61,566 − 12,396 − 8,810 = 40,360. NOA = 124,569 − 40,360 = 84,209.
2013: operating assets = 120,442 − 7,053 = 113,389. Operating liabilities = 56,303 − 10,363 − 11,380 = 34,560. NOA = 78,829.

Aggregate accruals from the balance sheet = 84,209 − 78,829 = 5,380. Average NOA = (84,209 + 78,829) ÷ 2 = 81,519.
Balance sheet accruals ratio = 5,380 ÷ 81,519 = 6.6%.

Aggregate accruals from the cash flow statement = net income − (operating cash flow + investing cash flow) = 14,904 − (14,700 − 3,072) = 14,904 − 11,628 = 3,276.
Cash flow accruals ratio = 3,276 ÷ 81,519 = 4.0%.

Interpretation. Both ratios are modest in absolute terms relative to an operating asset base of roughly CHF124 billion, and both fell sharply from 2012, when they stood at 10.6 percent and 12.4 percent. In 2013 both were negative, at −2.4 percent and −3.7 percent, because net operating assets actually shrank. There is no persistent upward drift, which is the pattern that would worry an analyst most. The two measures also agree in sign and broad size in every year, which is itself a mark of consistency between the two statements. Accruals are not doing the work in these results.

A note on the mechanics. The balance sheet measure looks at how much operating capital the company added; the cash flow measure looks at how far reported income exceeded the cash produced net of the cash invested. They are two routes to the same quantity and, absent unusual items, they should tell the same story. Where they diverge sharply, the usual culprits are acquisitions and disposals that change net operating assets without passing through operating or investing cash flow in the same period, and currency translation. Nestlé is acquisitive, so the gap between 6.6 percent and 4.0 percent in 2014 is unremarkable rather than suspicious.

One warning about reading these ratios. A low accruals ratio does not mean the earnings are good, only that they are not obviously manufactured. Nestlé passes this screen while the substantive concerns raised by the DuPont and segment work remain entirely intact. Screening for reporting quality and judging economic performance are separate exercises, and passing the first tells you nothing about the second.

The accruals screen was a negative test: nothing wrong found. The analyst now runs the positive test, which is whether reported profit actually converts into cash, and whether that cash is sufficient for reinvestment and for the debt.

Statement of cash flows, 2012 to 2014 (CHF millions)

FSA 6 – Integration of Financial Statement Analysis Techniques — table 24
Line	2014	2013	2012
Operating profit	10,905	13,068	13,388
Non-cash income and expense items	6,323	4,352	3,217
Cash flow before working capital movements	17,228	17,420	16,605
Working capital movement	(114)	1,360	2,015
Movement in other operating balances	85	(574)	(95)
Cash generated from operations	17,199	18,206	18,525
Treasury activities, net	(356)	(351)	(324)
Taxes paid	(2,859)	(3,520)	(3,118)
Dividends and interest received from associates	716	657	585
Operating cash flow	14,700	14,992	15,668
Cash flow from investing activities	(3,072)	(1,606)	(14,491)
Dividends to parent shareholders	(6,863)	(6,552)	(6,213)
Dividends to non-controlling interests	(356)	(328)	(204)
Non-controlling interests bought, net of disposals	(49)	(337)	(165)
Treasury shares bought	(1,721)	(481)	(532)
Treasury shares sold	104	60	1,199
Bonds and other non-current debt issued	2,202	3,814	5,226
Bonds and other non-current debt repaid	(1,969)	(2,271)	(1,650)
Current financial debt, net	(1,985)	(6,063)	2,325
Cash flow from financing activities	(10,637)	(12,158)	(14)
Currency retranslations	42	(526)	(219)
Increase in cash for the year	1,033	702	944
Closing cash and equivalents	7,448	6,415	5,713

Does cash back the operating profit

The natural comparison is cash generated from operations against operating profit, because the two measure the same activity on different bases. Cash generated from operations is struck before treasury flows and tax, which keeps it comparable with operating profit.

Cash generated from operations against operating profit (CHF millions)

FSA 6 – Integration of Financial Statement Analysis Techniques — table 25
Measure	2014	2013	2012
Cash generated from operations	17,199	18,206	18,525
Operating profit	10,905	13,068	13,388
Ratio	1.58	1.39	1.38

Cash comfortably exceeded operating profit in each year. A ratio persistently below 1 would be the warning sign, because it would mean reported operating profit was not being realised in cash. The rise to 1.58 in 2014 is not an improvement in trading: it is largely the goodwill impairment of 1,908, a non-cash charge that reduces operating profit without touching cash and therefore inflates the ratio. Read the ratio together with what caused it.

Cash return on total assets (CHF millions)

FSA 6 – Integration of Financial Statement Analysis Techniques — table 26
Measure	2014	2013	2012
Cash generated from operations	17,199	18,206	18,525
Average total assets	126,946	123,160	119,659
Cash return on total assets	13.5%	14.8%	15.5%

Here the story matches everything found so far. A 13.5 percent cash return on the whole asset base is a high return by any standard, but it has fallen in each of the two years, from 15.5 percent. Total assets record the accumulated effect of every allocation decision management has made, and cash generated is the test of whether those decisions worked. A declining cash return means the assets added recently are producing less than the assets already held, which points straight back at the goodwill impairment and the weak return on assets in Nutrition and Health Science.

Cash flow against reinvestment, debt and interest (CHF millions)

FSA 6 – Integration of Financial Statement Analysis Techniques — table 27
Measure	2014	2013	2012
Cash generated from operations	17,199	18,206	18,525
Capital expenditure	3,914	4,928	5,273
Expenditure on intangible assets	509	402	325
Total reinvestment spending	4,423	5,330	5,598
Ratio of cash flow to reinvestment	3.89	3.42	3.31
Current debt	8,810	11,380	18,408
Current derivative liabilities	757	381	423
Long-term debt	12,396	10,363	9,008
Total debt	21,963	22,124	27,839
Ratio of cash flow to total debt	78.3%	82.3%	66.5%
Cash interest paid	518	505	559
Cash flow interest coverage	33.2	36.1	33.1

Example 11 · Worked

Use the coverage table for 2014.

1. Compute the ratio of cash flow to reinvestment, the ratio of cash flow to total debt and cash flow interest coverage, then estimate how long it would take to repay all debt from operating cash while continuing to reinvest at the current rate.

Solution. Reinvestment = capital expenditure 3,914 + intangible expenditure 509 = 4,423.
Cash flow to reinvestment = 17,199 ÷ 4,423 = 3.89, against 3.42 in 2013 and 3.31 in 2012. Operations generate close to four times the cash the asset base currently absorbs, and the coverage is improving.

Total debt = current debt 8,810 + current derivative liabilities 757 + long-term debt 12,396 = 21,963.
Cash flow to total debt = 17,199 ÷ 21,963 = 78.3%, against 82.3 percent in 2013 and 66.5 percent in 2012. One year of operating cash covers close to four-fifths of the entire debt stack.

Cash flow interest coverage = 17,199 ÷ 518 = 33.2 times, against 36.1 and 33.1.

Time to repay while still reinvesting: cash left after reinvestment is 17,199 − 4,423 = 12,776. Debt of 21,963 ÷ 12,776 = 1.7 years, that is roughly two years.

Every one of these measures says the same thing. Nestlé is not financially constrained. If a genuinely attractive investment appeared, the company could borrow to fund it without difficulty. The problem identified in this analysis is not capacity to invest; it is the returns being earned on what has already been invested.

One question is left. The analyst has separated Nestlé operations from the associates throughout the analysis of performance. Consistency demands the same separation in the valuation, because the L’Oréal holding is priced every day on the Paris exchange and its market value may bear no relation to the value embedded in the Nestlé share price. Comparing a group price-to-earnings multiple with a market multiple while the group contains a large listed stake is comparing two different things.

Nestlé market value with and without L’Oréal at 31 December 2014 (millions, except per share amounts)

FSA 6 – Integration of Financial Statement Analysis Techniques — table 28
Item	Amount
L’Oréal share price at 31 December 2014	€139.30
L’Oréal shares held by Nestlé	129.881
Value of the holding in euros	€18,092
CHF per EUR at 31 December	1.202
Value of the holding in francs	CHF21,747
Nestlé share price at 29 December 2014	CHF72.95
Nestlé shares outstanding	3,168.400
Nestlé market capitalisation	CHF231,135
Less value of the L’Oréal holding	(21,747)
Implied value of Nestlé operations	CHF209,388
L’Oréal share of market value	9.4%
Nestlé share of market value	90.6%

Nestlé earnings without L’Oréal, 2014 (CHF millions)

FSA 6 – Integration of Financial Statement Analysis Techniques — table 29
Item	2014
Consolidated earnings	14,904
Less: earnings of the L’Oréal stake	(934)
Standalone Nestlé earnings	13,970
Less: non-controlling interests	(448)
Standalone earnings to parent shareholders	13,522

Example 12 · Worked

Use the two tables above. The S&P 500 Index traded at a price-to-earnings multiple of 19.9 at the end of 2014.

1. Build the L’Oréal carve-out from the share price upwards, compute the three price-to-earnings ratios, and state the discount of each Nestlé measure to the index.

Solution. Value of the stake: €139.30 × 129.881 million shares = €18,092 million. Converting at 1.202 francs per euro: 18,092 × 1.202 = CHF21,747 million.

Nestlé market capitalisation: CHF72.95 × 3,168.400 million shares = CHF231,135 million.
Implied value of the operations: 231,135 − 21,747 = CHF209,388 million. The stake is 21,747 ÷ 231,135 = 9.4% of market value, leaving 90.6 percent.

Earnings: L’Oréal contributed CHF934 million, disclosed in the annual report. Group earnings attributable to parent shareholders were 14,904 − 448 = 14,456. Removing L’Oréal from consolidated earnings gives 14,904 − 934 = 13,970, and after non-controlling interests, 13,970 − 448 = CHF13,522 million. L’Oréal is 934 ÷ 14,456 = 6.5% of shareholder earnings, leaving 93.5 percent.

The three multiples:
L’Oréal stake: 21,747 ÷ 934 = 23.3.
Implied Nestlé-only: 209,388 ÷ 13,522 = 15.5.
Whole group: 231,135 ÷ 14,456 = 16.0.

Against an index multiple of 19.9, the group trades at a discount of 20 percent and the implied Nestlé-only business at a steeper discount of 22 percent. The carve-out therefore makes the discount larger, not smaller: the stake is 9.4 percent of the value but only 6.5 percent of the earnings, so it is carried at a higher multiple than the rest and its removal lowers the multiple on what is left.

Decomposed Nestlé earnings and price-to-earnings ratios

FSA 6 – Integration of Financial Statement Analysis Techniques — table 30
Component	Market value (CHF millions)	Earnings at group shareholder level	Price-to-earnings ratio	Share of market value	Share of earnings
L’Oréal	21,747	934	23.3	9.4%	6.5%
Implied Nestlé-only	209,388	13,522	15.5	90.6%	93.5%
Earnings available to Nestlé parent shareholders	231,135	14,456	16.0	100.0%	100.0%

Figure 5: Value and earnings do not split in the same proportion

The L’Oréal stake carries a larger share of market value than of earnings, so it is priced on a higher multiple, 23.3 against 15.5 for the implied Nestlé business. Removing it widens rather than narrows the discount to the market.

The analyst is initially surprised. A company with consistent cash generation and low financial leverage trading two-tenths below the market multiple is unusual. He concludes the most likely explanation is the one his own work has uncovered: investors have begun to take a sceptical view of the deteriorating core profitability.

Phase 5: conclusions and recommendation

The findings sort into two lists.

Support for buying the shares.

Financial stability is not in question. Liquidity and cash flow are more than sufficient for the existing operations and for the acquisition strategy. Leverage is low, and the capital structure can support the plans management has described.
Operating cash flow has exceeded operating earnings in each year, at 1.58, 1.39 and 1.38 times, which supports the quality of the reported profit. Coverage of reinvestment, of total debt and of interest all indicate financial strength.
On a decomposed valuation the implied Nestlé-only business trades at 15.5 times earnings, below both the L’Oréal stake at 23.3 times and the market at 19.9 times. Given demonstrated cash generation and low leverage, that gap is at least arguably an opportunity.

Causes for concern.

Despite world-class brands and global reach, the core business has become less profitable over the period. The ROE decomposition shows it plainly, and the decline survives the removal of unusual items: adjusted Nestlé-only ROE still falls from 18.31 percent to 17.73 percent to 15.63 percent.
Cash return on total assets has fallen in each year since 2012, from 15.5 percent to 13.5 percent.
The acquisitions in Nutrition and Health Science do not build on traditional strengths and have not arrested the erosion in core profitability.
Capital allocation priorities are questionable. Nestlé Nutrition as a segment and Nutrition and Health Science as a product group both show strong EBIT margins yet rank at the bottom on return on assets, which raises the possibility that management has been overpaying for what it buys.
Writing down goodwill from earlier acquisitions while continuing to make new ones is a troubling combination and may itself signal ineffective allocation of capital.

The analyst recommendation is that Nestlé is not clearly an attractive investment at this point, and that the fund should wait for either a deeper discount or evidence of operating improvement.

Phase 6: follow-up

The portfolio manager does not accept the recommendation in full. She believes the discount justifies a purchase and that the problems are temporary, so she commits the fund to a cautious holding, smaller than the core position originally contemplated, precisely because the analyst work on resource allocation troubles her. She asks for continuous re-evaluation and updates to the research at each reporting period, with emphasis on the accruals tests, on the cash flow support for earnings and above all on return on assets. Unproductive capital spending would be a trigger to exit.

That disagreement is the right note to end on. The framework does not make the decision. It ensures that the decision, whoever makes it, is made with the drivers visible, the risks named and the trigger for reconsideration written down in advance.

Check yourself

1. A group reports net income of 14,904 and income from equity-accounted associates of 8,003 on sales of 91,612. Total assets are 133,450, of which 8,649 is the carrying amount of associates; prior-year figures are 120,442 and 12,315. Why does removing the associates lower the net profit margin but raise asset turnover?

The associates income is a pure after-tax profit with no matching revenue, so it sits in the numerator of the margin and nowhere in the denominator; removing it cuts the margin from 16.27 percent to 7.53 percent. The investment in associates is an asset that generates no sales, so it sits in the denominator of turnover and nowhere in the numerator; removing it raises turnover from 0.722 to 0.787. Both adjustments must be made together, or the return on assets becomes a mixture of two different businesses.

2. A candidate adjusts margin and asset turnover to exclude associates and then also adjusts the leverage ratio by subtracting the investment in associates from both total assets and total equity. Why is that a mistake in this framework?

Margin and turnover are operating measures, so isolating the assets that produce operating returns is meaningful. Leverage is a financing measure, and financing is raised at group level rather than assigned to individual assets. The working assumption is that the same mix of debt and equity funds the associates investment as funds everything else and that the capital structure will not change, so the group leverage multiple applies to both the adjusted and unadjusted returns. Leaving it unadjusted is also what allows Nestlé-only ROE and reported ROE to be compared directly.

3. Core net profit margin falls from 10.50 percent to 7.53 percent over two years, while the margin adjusted for goodwill impairments and provisions falls from 11.21 percent to 10.62 percent. What do you conclude, and should the DuPont analysis be rebuilt on the adjusted figures?

Of the 2.97 percentage point decline, 2.38 points come from the growing burden of the charges and 0.59 points from underlying erosion, since the charge burden rose from 0.71 percent to 3.09 percent of sales. The charges therefore explain most but not all of the fall. They should not replace the reported figures in the main analysis: they arise from management decisions, they recur every year, and they reduce the returns actually available to shareholders. Compute them as supplementary information and report both series.

4. A segment holds 24.6 percent of segment assets, receives 9.7 percent of capital expenditure and reports the highest EBIT margin in the group at 20.77 percent. Is the company misallocating capital?

Not necessarily. The allocation ratio is 9.7 divided by 24.6, or 0.39, which on margin alone looks perverse. But EBIT margin measures profit per franc of sales, not return on the capital employed, and this segment was built by acquisition, so its asset base carries goodwill and purchased intangibles. On approximate cash return on average assets it earns under 10 percent, the weakest of the six segments, while the segments receiving growth allocations earn between 18 and 28 percent. Judged on return on capital rather than on margin, the low allocation is rational. Note also that acquisition spending does not appear in capital expenditure at all.

5. Net operating assets are 84,209 and 78,829 at the two year ends. Net income is 14,904, operating cash flow 14,700 and investing cash flow negative 3,072. Compute both accruals ratios and say what would have to be true for you to treat them as a warning.

Average net operating assets are 81,519. The balance-sheet-based ratio is (84,209 − 78,829) divided by 81,519, which is 6.6 percent. The cash-flow-based ratio is [14,904 − (14,700 − 3,072)] divided by 81,519, which is 3,276 divided by 81,519, or 4.0 percent. Neither the absolute level nor the trend is alarming here, since both measures fell from 10.6 percent and 12.4 percent two years earlier and were negative in the intervening year. A warning would require a high absolute level, or a persistent upward trend, or a large and unexplained gap between the two measures.

6. Cash generated from operations rises from 1.38 to 1.39 to 1.58 times operating profit, while cash return on average total assets falls from 15.5 percent to 14.8 percent to 13.5 percent. Reconcile the two trends.

They are not in conflict. The ratio to operating profit rose mainly because operating profit was reduced by a non-cash goodwill impairment of 1,908, which does not touch cash, so the denominator shrank. The cash return on assets fell because the asset base grew through acquisitions faster than the cash those assets generate. The first ratio comments on the quality of reported profit; the second comments on the quality of the investment decisions. A company can pass the first test while failing the second, and that is exactly what the figures show.

7. A group has a market capitalisation of 231,135 and shareholder earnings of 14,456, including a listed associate worth 21,747 that contributed 934 of earnings. The market trades at 19.9 times. Does carving out the associate make the shares look cheaper or dearer?

Cheaper. The group multiple is 231,135 divided by 14,456, or 16.0, a discount of 20 percent to the market. The associate is priced at 21,747 divided by 934, or 23.3, above the market multiple. Removing it leaves 209,388 of value against 13,522 of earnings, a multiple of 15.5 and a discount of 22 percent. Because the stake is 9.4 percent of value but only 6.5 percent of earnings, it is the more expensively rated component, so the residual business is cheaper than the headline multiple suggests.

FSA 6 – Integration of Financial Statement Analysis Techniques

A framework for financial statement analysis

The case that runs through this reading

Restating prior periods for changes in accounting standards

What the two standards did

Why this matters beyond the arithmetic

Isolating the core business from investments in associates

The problem the income statement presents

Where the associates income came from

The adjustment

The expanded DuPont decomposition

What the columns say

Normalising earnings for unusual charges

The judgement call, and it goes the other way

Splitting return on equity between the two businesses

Composition of the asset base and the acquisition record

Capital structure and working capital

Liquidity and the working capital cycle

Segment analysis and the allocation of capital

Where the capital is going

Ranking on cash instead of accrual profit

Product group analysis and return on assets

Accruals and the quality of reported earnings

Cash flow relationships, coverage and debt-servicing capacity

Does cash back the operating profit

Valuation decomposition, conclusions and follow-up

Phase 5: conclusions and recommendation

Phase 6: follow-up

FSA 6 – Integration of Financial Statement Analysis Techniques

A framework for financial statement analysis

The case that runs through this reading

Restating prior periods for changes in accounting standards

What the two standards did

Why this matters beyond the arithmetic

Isolating the core business from investments in associates

The problem the income statement presents

Where the associates income came from

The adjustment

The expanded DuPont decomposition

What the columns say

Normalising earnings for unusual charges

The judgement call, and it goes the other way

Splitting return on equity between the two businesses

Composition of the asset base and the acquisition record

Capital structure and working capital

Liquidity and the working capital cycle

Segment analysis and the allocation of capital

Where the capital is going

Ranking on cash instead of accrual profit

Product group analysis and return on assets

Accruals and the quality of reported earnings

Cash flow relationships, coverage and debt-servicing capacity

Does cash back the operating profit

Valuation decomposition, conclusions and follow-up

Phase 5: conclusions and recommendation

Phase 6: follow-up

Related lessons