FSA 6 – Integration of Financial Statement Analysis Techniques

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 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.

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

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.

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.

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

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

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.

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.

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

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.

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.

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.

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.

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.

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.

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 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.

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.

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.

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

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.

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 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.

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.

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.

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.