Financial Modelling and Business Plan

Financial Statements Analysis 1

Income Statement, Operating Profitability
(ROS = Return On Sales) and Leverage
Degrees (Operating, Financial and Combined)
 Income Statement

• The Income Statement or the Profit and Loss Account is the

financial statement where operating profitability is analysed

• It shows the difference between the Revenues (Sales and other

Revenues) of the Company and the respective Charges for a
given year, i.e.

• Profit = Revenues – Charges

• It follows the general principle of matching, according to which

we must consider the charges incurred to attain or produce
those revenues.

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 Income Statement: Operating Revenues

• The main Operating Revenues are Sales and Services Rendered

and there also may be some additional Other Operating
Revenues.
• These Revenues were entirely realized by the business in its
operating activities; they should exclude other forms of
revenues, such as interest received from short-term financial
investments
• In our example those total operating revenues amount to
100,000€

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 Income Statement: Variable Charges
• After presenting the Total Revenues, we subtract from them the Operating
Charges or Expenses, which include the Costs of Goods Sold (COGS) and
Selling, General and Administrative Expenses (SG&A).

• First, we consider the Variable Charges, i.e., the ones that should increase
(or decrease) with revenues, which generally are assumed to be a given %
of Sales (or of revenues)

• The main variable charge is the Cost of Goods Sold = COGS. This includes
the raw materials and other direct expenses incurred to produce the goods
sold.

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 COGS and Gross Profit (Margin)

• In our example, COGS amount to 40,000€,

corresponding to 40% of Sales (or Revenues)

• Therefore, the Gross Profit = Revenues – COGS =

100,000 – 40,000 = 60,000€

• So, the Gross Profit Margin corresponds to 60% of

Sales (60,000/100,000 = 60%)

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 Other Variable Charges and Contribution
Margin
• Then, we consider the remaining operating variable charges, such as
royalties, sales commissions, transportation and distribution charges; in our
example, these amount to 10,000€, corresponding to external supplies and
services and 10% of Revenues

• Contribution Margin = Revenues – Total Operating Variable Charges = Gross

Profit – Other Operating Variable Charges = 60,000 – 10,000 = 50,000€,
corresponding to 50% of Sales

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 Cash Fixed Charges and EBITDA

• Now we consider the fixed operating charges, i.e., the

remaining Selling, General and Administrative Expenses that
are not supposed to vary whenever the level of sales changes.

• We split them between:

– the ones we have to pay (cash fixed charges), such as fixed external supplies
and services (rents, operating leases) and staff costs (wages and salaries),
– from (non-cash fixed charges) the ones we do not have to pay, like depreciation
and amortization (they were paid when we bought – or invested in the fixed
assets - the goods and services we are now depreciating or amortizing –
therefore, so we do not have to pay for them again!)

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 Cash Fixed Charges and EBITDA

• In our example, fixed external supplies and services amount to

10,000, and staff costs to 15,000, so total cash fixed charges
correspond to 25,000

• Therefore, EBITDA = Contribution Margin – Cash Fixed Costs =

50,000 – 25,000 = 25,000, and EBITDA or (Gross) Cash Flow
Margin = 25% of Sales (= 25,000/100,000), where:

• EBITDA = Earnings Before Interest, Taxes, Depreciation and

Amortization

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 Gross Value Added

• When we want to measure the contribution of a company to

GDP (Gross Domestic Product), we consider Gross Value Added

• Gross Value Added = Revenues – COGS – External Supplies and

Services (Variable and Fixed) = 100,000 – 40,000 – 20,000 =
40,000 corresponding to 40% of Sales

• Gross Value can be split among its main components, which

are staff costs, depreciation and amortization, interest
expenses, income taxes, and net profit (or net income)

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 Depreciation & Amortization
• We then subtract Depreciation and Amortization (D&A) from EBITDA

• These items (D&A) represent the fraction of the investment made in

fixed assets that we are considering as attributable to this year

• Usually, fixed assets are expensed equally during their useful life. For
example, equipment bought for 40,000€ with a useful life of 10
years is depreciated at a 10% (=1/10) rate, and its depreciation
amounts to 4,000 (=40,000*10%) per year

• This depreciation method is called straight-line depreciation to

emphasize that this expense is divided equally throughout the life of
the asset.

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 Earnings Before Interest and Taxes

• In our example, D&A amount to 10,000

• Earnings Before Interest and Taxes (EBIT) = EBITDA – D&A =
25,000 – 10,000 = 15,000
• EBIT = Operating Profit = Profit from Operations
• EBIT/Revenues = 15,000/100,000 = 15%
• This profit margin is usually called the Return On Sales (ROS),
and it shows that, on average, for every € of sales, the
company is making a 15 cent profit.
• EBIT is the most important measure of operating profitability.
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 Interest Expense
• Some companies are all equity financed; therefore, they do not have
any debt in their balance sheet (Unlevered Company => No Debt,
only Equity!)

• Others, finance their assets also using some debt; they are called
levered firms, and they borrow money to partially finance assets

• When using debt, we must pay the principal back to debt-holders

(lenders) plus the respective interest, i.e., the cost of using debt.

• Interest paid on loans is a financial expense that must be deducted

from EBIT.

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 Earnings Before Taxes (EBT)

• Earnings Before Taxes (EBT) = EBIT – Interest Expense

• In our example, the interest expense amounts to

5,000. Therefore:
EBT = 15,000 – 5,000 = 10,000€ (or 10% of Revenues =
10,000/100,000€)

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 Income Taxes and Net Income

• The company is estimating 2,500€ of Income Taxes

• As Profit Before Taxes amounted to 10,000€, the

implied income tax rate is equal to 25%
(=2,500/10,000)

• Net Income (or Net Profit, or a.k.a. Bottom Line) =

Earnings Before Taxes(EBT) – Income Taxes = 10,000 –
2,500 = 7,500€ (or 7.5% of Revenues)

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 Dividends and Retained Earnings
• The company decided to split Net Income (7,500€) in two parts:
– Dividends = 2,500€ (a dividend pay-out of 1/3 of Net Profit = 2,500/7,500)

– Retained Earnings = Net Income or Profit – Dividends = 7,500€ - 2,500€ = 5,000€ (a

retention ratio of 2/3 of Net Profit =5,000/7,500)

• Retained Earnings are reinvested in the business to help the company to

keep growing. Together with D&A, they are the main sources of the
company’s internal financing

• Internal Financing = Retained Earnings + Depreciation and Amortization

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 Project’s Cash Flow from Operations

• In our case, we were asked to determine the

operating cash flow obtained from the income
statement if the company was seen as a project.

• Projects are analysed assuming all-equity financing;

therefore, we must adjust net profit assuming that
there were no interest expenses

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 Project’s Cash Flow from Operations

• For a company with no Debt (Unlevered), EBIT and EBT are the
same

• So, the company would have a 15,000 (=EBIT) EBT

• As the Income Tax Rate is 25% (= t), Income taxes would then
amount to 3,750 (=15,000*25%)

• Therefore, Net Income should be equal to = 15,000 – 3,750 =

11,250 = 15,000*(1-25%) = 15,000*0.75 = EBIT*(1-t)

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 Project’s Cash Flow from Operations

• As Depreciations & Amortizations (D&A) are non-cash

expenses, we must add them to Net Profit to arrive at
Cash Flow

• Therefore:
Cash Flow from Operations (CFO)= Operating Cash Flow (OCF)
= EBIT(1-t) + D&A = 11,250 + 10,000 = 21,250€

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 Project’s Cash Flow from Operations

• We may also determine the Operating cash Flow with the

following alternative expression:
• OCF = CFO = EBITDA(1-t) + D&A*t = 25,000*(1-0.25) +
10,000*0.25 = 18,750 + 2,500 = 21,250€
• This second expression has the advantage of showing the
contribution of D&A for the value of the company: the tax
shield they provide = D&A (=Depreciations and Amortizations)
* t (=Income Tax rate)
• We pay less taxes as we are depreciating and/or amortizing our
Fixed Assets

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 Project’s Cash Flow from Operations
• There is even a third alternative:
CFO = Net Income + Interest Expenses after Taxes +
Depreciations & Amortizations

• CFO = OCF = 7,500 + 5,000*(1-0.25) + 10,000 = 7,500 + 3,750 + 10,000 =

21,250€

• Note that to adjust for the interest expense the company paid, we must
add it back to Net Income, but considering if after taxes, i.e., taking out the
tax shields that were created by the payment of interest (5,000*25% =
1,250, was the reduction in taxes caused by the payment of the interest
expense).

• Therefore, net income decreased by 3,750 due to the interest paid (= 5,000
– 1,250 = 3,750).

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 Break Even Analysis

• To perform What-if (or Sensitivity) Analysis, we usually make

some simplifying assumptions regarding Expenses.

• We split them into two components and assume that:

– Variable Charges are a given percentage of sales, and therefore, they
vary proportionally to Sales (or Revenues)
– While Fixed Charges are flat and do not vary with the Sales Volume (or
Level); quite the contrary, they remain constant

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 Break Even Analysis

• We start by assuming the following simplified general

expression:
Profit = Revenues – Variable Charges – Fixed Charges =
Contribution Margin – Fixed Charges =
Revenues*Contribution Margin as a % - Fixed Charges

• So, in our example, we have in general terms:

Profit = 0.5*Revenues – Fixed Charges, as the contribution
margin is 50% of Sales (or Revenues)

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 Cash and Operating Break Even

• We may find out the minimum value of Sales that makes

EBITDA = 0 => Cash Break Even
Contribution Margin = Cash Fixed (Operating Charges) Charges = 0.5*Sales
= 25,000€ => Sales = 25,000€/0.5 = 50,000€

• Or the minimum value of Sales that makes EBIT = 0 =>

Operating Break Even
Contribution Margin = Operating Fixed Charges (including Depreciation &
Amortization) = 0.5*Sales = 35,000€ (= 25,000 + 10,000) => Sales =
35,000/0.5 = 70,000€

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 (Total) Break Even

• Finally, we may also determine the minimum value of sales

that makes Net Income (or Profit) = 0 => Total Break Even, or
simply Breakeven

• Contribution Margin = Total Fixed Charges (including Interest

Expense) => 0.5*Sales = 40,000€ (=35,000 + 5,000) => Sales =
40,000/0.5 = 80,000€

• Therefore, this company can only make a (net) profit if it sells

more than 80,000€

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Margin of Safety and Maximum Drop in Sales

• The company’s Sales (S) amount to 100,000, 25% above total

break even (BE) = S/BE – 1 = 100,000/80,000 – 1 = 1.25 – 1 =
0.25 = 25%. So, the company has a 25% safety margin!

• However, the maximum drop in sales that would make the

company break even is equal to = 100% - BE/Sales = 100% -
80,000/100,000 = 100% - 80% = 20%

• Therefore, we only have a 20% error margin before incurring

losses (not 25%!)

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 Sensitivity Analysis:
Operating Leverage Degree
• One of the most useful concepts to analyse the response of profits to variations in
sales level is the leverage degree

• First, we have the Operating Leverage Degree (OLD) = (ΔEBIT/EBIT)/(ΔSales/Sales) =

The sensitivity of EBIT to Changes in Sales = Contribution Margin/EBIT (if Break Even
Analysis assumptions hold) = 50,000/15,000 = 3.(3)*, i.e. the relative variations of
EBIT correspond to 3 and 1/3 times the variations of sales

• Therefore, OLD is a magnifier and a business risk measure (associated with the
operating cost structure: their division between variable and fixed; the greater the
fixed charges, the higher the OLD), if for instance sales drop by 10%, then EBIT
should drop by 33.(3)%!

• We may also say Degree of Operating Leverage, or simply Operating Leverage.

• The concept behind this phenomenon lies in the economies of scale, due to fixed
charges dilution.
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 Sensitivity Analysis:
Financial Leverage Degree

• The Financial Leverage Degree (FLD) measures the sensitivity of

changes in Net Income or Profit due to changes of EBIT =
(ΔNP/NP)/(ΔEBIT/EBIT) = EBIT/EBT = 15,000/10,000 = 1.5 (assuming
Interest Expense remains constant, and the income tax rate is also
the same).

• So, if EBIT goes up by let us say 30%, then Net Income should go up
by 30%*1.5 = 45%.

• The Financial Leverage Degree (or the Degree of Financial Leverage)

is also a multiplier (or magnifier) and a financial risk measure.

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 Sensitivity Analysis:
Combined Leverage Degree
• Degree of Combined Leverage or Combined Leverage Degree is the
junction of the two previous leverage degrees.

• It is the sensitivity of Net Income to variations of Sales =

(ΔNP/NP)/(ΔS/S) = Contribution Margin/EBT = 50,000/10,000 = 5*. It
is a magnifier or multiplier, so if for instance sales go down by 5%,
Net Income (or Profit) should drop by 25%

• It is obtained by multiplying the operating leverage degree by the

financial leverage degree = 3.(3)*1.5 = 5. Therefore, it is a Total Risk
Measure including/combining both Business and Financial Risk

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 Short Revision Exercise-Data

• Assume that you have the following data on a

competitor of the company of our Example:
– Contribution Margin = 40% of Sales
– Cash Fixed Operating Charges = 35,000€
– Depreciation and Amortization = 15,000€
– Interest Expense = 7,000€
– Income Tax Rate = also 25%
– Current Sales Level = 160,000€

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 Short Revision Exercise-Questions

• Determine the Cash Break Even, the Operating Break

Even and the Total Break Even

• Determine the return on sales (ROS), net profit and

the leverage degrees of this competitor

• Which company do you prefer and why?

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 Solutions
• Cash Break Even = (35,000/0.4 = 87.500)
• Operating Break Even = (50,000/0.4 = 125,000)
• Total Break Even = (57,000/0.4 = 142,500)
• EBIT = 160,000*0.4 – 50,000 = 14,000 (ROS = 14,000/160,000 = 8.75%
• EBT = 14,000 – 7,000 = 7,000€
• Net Income (or Profit) = 7,000*0.75 = 5,250€
• DOL = Contribution Margin/EBIT = 64,000/14,000 = 4.57
• DFL = EBIT/EBT = 14,000/7,000 = 2
• DCL = Contribution Margin/EBT = 64,000/7,000 = 9.14
• Our original company is more interesting since it is more profitable and
bears less risk, so it seems to be the best bet

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