The Art of Reading Financial Statements - Practitioner Level

1. Introduction: Hello and welcome to my training. The other reading financial statements, My name is Kenny Kara. I'm a value investor and also independent border actor. It took me nearly two years to write this course. And the reason for that is that going into financial statements and trying to share with you, the key is on how to read financial statements is already linked to the fact that financial statements sometimes appear very complex and even long to understand and to read and even to dissect. The intention is really through this training to give you the necessary reading keys that you are able to dissect, to interpret, to analyze financial statements in a way that you become, in fact flu and uncomfortable with it. So as part of cause of any type of training, we will, there are some learning objectives that are linked to the training. I'm showing them here to you. So this ten learning objectives, and I hope that at the end of the training you'll be able to tick off all those learning objectives. And of course, learning objectives have to come with practical examples. So we will be discussing a lot of companies. We will be looking deeply at the financial statements of Mercedes and Kellogg's throughout the whole training. But I will complement those reading elements by discussing further companies like 3M and Ron, Google Meet and Microsoft's Telefonica ever ground-level nova, etc. And of course they are throughout the complete straining certain amount of assignments that you can do for yourself and you can also send them to me if you want me to review it. And at the very end of the training, you will have the possibility to do a complete project. So I have, of course, put on the Skillshare platform, the project assignment details, so that hopefully you will be enjoying this training and through that you will become much more fluent and comfortable reading financial statements. So talk to you in the next lecture. Thank you. 2. History & purpose: Welcome back in this lecture. So first lecture of Chapter number one. I want first introduced bits before we discuss financial statements and the structure of it where they're coming from a little bit, the history, and then we go into purpose and also look at a concrete example when we look at reporting obligations. First of all, when we are discussing financial statements. And in fact, it started with the principles of bookkeeping. And the principles of bookkeeping are not new. There, as you can see in the slides. I mean, more than 7,000 years ago in Mesopotamia, which is like basically today, Iran, Iraq, where we had in fact the first, we do have the first records Accounting. And at that time, and money did not exist. So at the most more about accounting and keeping track of goods and services being exchanged. So what we call it bartering as well. So basically, the concept of a ledger, which is a book collection, that is a recording various transactions appeared. And today we are speaking about account ledgers. When we speak about financial statements, then nothing is. Second important step was around the medieval Renaissance period where Italy was very strong evidence from a cultural and scientific perspective as well. There was an Italian mathematician called Luca Bartolome de Pacioli. I'm not sure if the spelling is correct. In fact, introduced at least there is a record of the introduction of the double bookkeeping techniques because at that time Italy, I mean, they were very strong from, let's say, a world exploration perspective. And there were a lot of goods and services being traded as well, even though already money was already existing. And the double entry bookkeeping principle that this fry in fact introduced is an important element when you think about financial statements. And again, it's not an accounting course you, because the fact of having a double entry bookkeeping system is in fact a fundamental principle to avoid mistakes when recording transaction. And it's a principle that still exist or is being used today specifically when we look at financial statements and the accounts that from a bottom-up perspective constitute financial statements. Which means that basically, what is the principle of double double entry bookkeeping principle is that basically any transaction has two sides to the transaction, e.g. if there is, let's take the example of eggs exchange for money. There is an outflow of money and an inflow of x. And those true in fact, I have always to be imbalanced in equilibrium. So that's one of the fundamental, That's it, Principles of Accounting. This double entry bookkeeping system on top of the existence of account ledgers. And without going into the details, I'm just giving as it is not an accounting course, I'm just giving a very quick, quick example here about we do have this concept of debit entries and credit entries. And typically we have this, I mean, we'll discuss later on, but we have sources of capital. So the ones that are bringing the capital into the company, that's the liability side of things. Then we have what those, what the capital is being transformed into, That's assets. And cash is a way you can have a person that brings in 10 million OF US dollar as a shareholder. And it only sits in the bank account for a certain period of time. So that's an asset. That asset, of course, we'll add a certain moment in time be transformed into a productive asset that will probably generate profits. That's the intention of how companies in fact work. So keep always in mind that this double entry bookkeeping system is one of the fundamental principles with the account ledgers that makes that we speak about the balance sheets so that a sheet which summarizes the, let's say the financial status of a company or the wealth of the company. It, as it always has two sides to it. And both sides have to be in equilibrium, they have to be in balance. When we speak about having laid down those fundamental principles. When we speak about why, what's the purpose of accounting? What's the purpose of having this financial reporting? Amazingly, there are many purposes to it. One is if you are internal to the company and the company is complex, it's a big company with many subsidiaries, is having an understanding what is going on in the company. Where does the company stands? From an inventory of assets, the sources of capital or those kind of things or performance of the company. If you're an external person while you are maybe interested in having an access to those financial reports because maybe you are an existing shareholder and you're not Management. You'd like to have a view on what is going on in the company. You're maybe thinking about investing into the company. Maybe you have been providing alone or bank has provided a loan to the company and the bank wants to know on e.g. a. Yearly basis how the company is performing. You may have the tax authorities as well. We want to know if the company is making profits, what kind of assets they have to be able to let say, find out what is the appropriate level of tax treatment that accompany deserves. In fact, there are many, many, let's say, implications that are linked in fact to the existence of accounting and also financial reporting. One strong statement here, I already made in the introduction a very strong statement about the order, how to read financial statements, but no one very strong 70. And please keep this all the time in mind when you look at financial reports, is that financial statements, financial reports are not perfect. They constitute a simplification. And of course, when it is a one man or one woman company, I mean, obviously the financial statements wouldn't be very close to the reality. But when you're speaking about large corporations, the financial statements, or does a simplification of a view on complex business processes. And you're going to see this throughout the cosmos. We will be discussing this, but just keep this in mind. And having said that, it means that there is no financial seminar which is perfect. So that's definitely something that you need to keep in mind. So as I already said, the objective of financial reporting is really to support internal and external stakeholders. It is on decision-making. If it is for putting in money, extracting money, charging taxes, charging loans and those kind of things through to the company. And on top of, let's say that's general objective, that general purpose financial reporting there is of course, a need for comparability as well. And we will be discussing accounting standards in the next lecture if I'm not mistaken. But there isn't enough comparability enabled to, to compare. If you're an external investor, you want to be able to compare a Unilever with the Procter and Gamble e.g. so comparability is important. Comparability over multiple periods of time. If you're Unilever shareholder, you want to be able to compare one fiscal year, let's say 2020, 2021, e.g. and of course, the underlying and we will be discussing accounting principles. The main underlying accounting principles is of course the financial statements should not be distorted to the largest extent possible. There should not be material mistakes. We will be discussing what material means or misrepresentation of those financial statements specifically for external stakeholders. So that's the kind of thing we'll be digging deeper into during the, during this course in fact. So at the very end of the day, I was mentioning examples of producing financial reports in the interests of external stakeholders, which could be a potential new investors. So there is like an exchange. I mean, why does a company provide financial reports? And we will be discussing if it is obliged to do this. But there is a purpose that companies, very often, the people in the company's management, they have ideas but they don't have the money, so they need to go to equity, bring us, to, bring us to banks, to external shareholders, to raise money from the public, which basically allows them afterwards to, let's say, put into music the ideas that they have into assets that they buy through those assets to generate profits and then they give a return back, true? Hopefully the shareholders or the credit told us. So that's basically the purpose of this financial reporting is that companies that need money, they provide us information. I will not say as a guarantee, but at least in terms of being more transparent to difference, bring us of capital, which could be, that bring us, which could be also shareholders. That's how an intention we have this exchange of information versus money that goes then into the company. And also one important, I'm speaking this in the stock market for beginners training, which is one of my trainings. One thing also that we need to keep in mind is that have, I mean, companies are either private companies or potentially listed companies, what we call secondary market are publicly listed companies. And obviously, the reporting obligations, they differ. I mean, first of all, they differ from one country to another. But they also may differ between private companies and public companies. They may differ on the size of the company. If you are a one man, one woman show, you will not have an external statutory auditor. We will speak about the role of the external statutory auditor because you cannot afford is I mean, there is a cost that company needs to carry for having the external audit. But maybe the government says, I'm giving one concrete example of a country which I knew very well, which is Luxembourg. If you had more than e.g. 8 million of assets on the balance sheet. If you have more than 4 million of revenue, if you had more than 50 employees, you are obliged to have an external statutory audit or below that. I mean, there were some, let's say, levels in terms of what was mandatory when we speak about publicly listed companies are developed and mature markets like the New York Stock Exchange, the European Stock Exchange, or the European stock exchanges like Frankfurt, London, Paris, Madrid, et cetera. There are in fact, the reporting obligations are really, really deep and strong one, this is something that you need to understand as well. Because I was mentioning comparability. But of course it depends if you are trying to compare a one man, one woman show company and looking at their financial statements versus a publicly listed company like Procter and Gamble in the US. I mean, there's gonna be a universe of information difference between the two. Because on the one hand side, you may only have on the very small company that is incorporated, just the balance sheet and an income statement, but no cash-flow statement while on the even know financial report with nodes, etc. While on Proctor and Gamble, you're going to have a 300 pages documents. So that's the kind of thing where I want also to hopefully to share with you, to teach you how to read and how to understand why when you are looking into companies, they are maybe levels of information that will be different. So if we take now, they're ready. I will start with the primary market. So primary market, so depending on the geography, the regulatory requirements, the size of the company, like the size of the balance sheet, the amount of billed revenue per year, the number of employees. I mean, the obligations will change from one country to another. Of course, there is a tendency to normalize things typically inside Europe, others to changes on it. When you look at secondary markets, were there, if I take the example of the US, that is very clear, the Securities and Exchange Commission, which is one of the regulators specifically for publicly listed companies. They are expecting from the companies at ten q report, which is an unaudited an unaudited quarterly reports with notes, etc. And they obliged companies to publish an audited, fully audited external, fully audited, externally audited report on a yearly basis, which is called the ten K report. The company has to follow some rules in order to avoid information asymmetry so that some people would have information to other people who would not, which would give, in fact, those people that have information a competitive advantage in order to potentially buy or sell shares while the other ones would not have any information, they would have a disadvantage. So the SEC for us listed public companies is obliging as well a certain amount of things to report obligations of reporting, not just the quarterly on audited, not just the yearly audited, but some e.g. very important events to the company have to be reported and cannot wait. The quarterly report, that's the eight K disclosure report. E.g. changes in company ownerships, changes in company directors have to be reported. That's the 34.5. Let's say that's number of the forms at the SEC is expecting from companies to report when those things happen, the company is not allowed to wait for the next quarterly report in order to file and communicate publicly about this and there is a delay. I mean, they cannot wait a week for that. I mean, for a lot of things like 24 h or 48 h that they have to report when the event has happened. Otherwise, the SEC may take legal action against the company who has forgotten to do this because it creates this information asymmetry or imbalance. So you can go on the SEC website. I've put here one of the latest press releases of them and there you see, in fact, what are the type of disclosure requirements that companies that are listed on? E.g. the nasdaq, the New York Stock Exchange, which is those are marketplaces that are regulated by the SEC. What are the reporting obligation of this company? And of course, this changes over time. You need just to be aware that reporting obligations are there, but they may evolve over time as well, due to whatever new requirements, changes in industry, but also scandals and potential frauds that have happened. What about Europe? I mean, I'm speaking now about US publicly listed companies. Well, in Europe, we have similar things. So companies have, since 2004, what is called a Transparency Directive, which has been implemented into local laws for companies that are listed on European stock markets. And already an example here in Europe, companies do not provide a quarterly unaudited report. They have to provide this on a six-month spaces and then of course, a yearly audit, it fully audited financial reports. So you're going to see, I mean, I'm Michelle, minority shareholder, but I'm Cheryl of some European companies, what happens on a quarterly basis while they provide a sales update, but you will not see the balance sheet, you will not see the cashless and you will not see the income statement. So there are some, some, some changes. One of the things as well that we miss in Europe compared to the US. In the US, if you want to know, what are the latest filings of a publicly listed companies were speaking secondary market here you can go on this edgar website, which is the electronic data gathering, analysis and retrieving website. I've put the URL here. While in Europe, we don't have a central source that collects all the filing obligations of publicly listed European companies. There is work going on it, which is called the European single access point project, the East bar, but we're not there yet. What about other markets? Well, that's again very market specific. I know e.g. in Japan, Japan market specialists, I do not know whether they have a single potent. I would need to look this up. But e.g. one thing that I've seen is e.g. the way how Japanese companies report the first page is always the same. They have this table format where they provide in fact the same way because I analyze once Nippon telecom, Nintendo, Sony. So you see that the format is pretty similar between Japanese companies when they do the report. So be aware, I think the important message here is be aware that they are finding obligations. And defining obligations depends, first of all, if it's private markets. So primary market versus public. So secondary markets are publicly listed companies. And then depending on the size as well, the geography, the revenue, the size of the balance sheet, the number of employees. In each jurisdiction where the company is incorporated, the filing requirements will differ. It's not that they may differ. They will differ. So we need to have somebody if you're incorporating a company in e.g. the Bahamas or in Argentina, obviously, you need to know what are the funding obligations, even as a private company or a public company, and what are the thresholds so that you of course, remain compliant with the law. Now, having said that, let's go into concrete example I want to show you for company where I'm also a shareholder, which is three m, of course minority shareholder. But accompany of 3M where you can concretely see how I use the edgar website to see the latest filings because one of the things I always recommend to people, actually, I could have mentioned this in the previous slide, is that when you buy shares of a company, is that basically you subscribe to the investor relations website. If they have one public listed companies, they normally, they tend to have at least four Japanese, European, US companies. For private companies, of course you will not have that. But on the edgar website, I'm giving you a second example. If you would have forgotten to subscribe to investor relations site, there is, at least, we're not having this for Europe. This S bar, European single access points are portal that doesn't exist for the time being, at least I'm not aware of. But this edgar website, this electronic platform of exchange, you can see here and I'm gonna give you the example for 3M. So this is the, I've put the URL earlier, slide 43. Here can go on the website of the SEC and just type in 3M. You're seeing this here on the screen. And you see that there is one company called 3M co with the ticker, stock ticker, which is triple M, which is basically the company 3M that we're speaking here about, very well-known company. And you'll see that the Edgar search results come up with a company identification. And it says that basically three m CO is a company which is active in surgical and medical instruments, but it's not the only company that starts with 3M. So of course you need to pick and choose the right company will then when you click on the filings, you see that here? And this is all that. It's always the latest one that is being on top. You see that e.g. the latest filing is from October sorry, from December 20. I mean, I took the screenshots end of the year, maybe they have filed something new in the meantime. You see the different types of filings. So remember, I was saying in the reporting obligations of the SEC, we have the ten q. Ten K ten q being unaudited financial quarterly reports, ten. K being the annual ones, audited reports, eight, K are very important events and these 34.5 forms of filings are when there are changes in ownership that have to be reported. And you see basically here just on the first page, you have this eight K filings. You have a couple of filings that are changes to ownership of of security. That's the findings which are carrying the number four. There is one note is about Iran. Okay. I haven't read what it is about. And there is 110 q which is from the 25th of October 2022, which is the latest on audited quarterly report from 3M at that time. So let's click on that, on that link. And then you see here going down that basically it gives you access to a certain amount of documents. You have the HTML documents, which is basically the report, but you have, I mean, if your data provider or data collector, you have as well. This what is called XBRL. That's like an XML taxonomy, how reports have to be structured. When you click on the HTML file, you see here that's the ten K report. We are ten q report. My apologies. So we see it's 3M Company. The company is incorporated in Delaware, the headquarters is in San Paul, Minnesota. And then of course, we will not do it now, but I'm just showing you how you can, just for the edgar website, have an access to the latest findings of a company. As I said earlier, you can also subscribe to the investor relations website, at least publicly listed companies, they do have Investor Relations website. Here I'm showing you the example. I've put the URL down here in this slide. You see in fact, where 3M, how the investor relations site looks like. And there, if you go on the financials and you're going to SEC filings specifically. You're going to see, in fact, the same filings that you can find through the edgar website? It's not for all companies the same. Sometimes in the I mean, normally when there's a section as you see findings, it has to match what is on the edgar website, but you never know. So I tend indeed to rely more on Investor Relations website, but I know that I can use the edgar website. And you would wonder, why am I making the same? And I rely on Investor Relations website because I have the file on a PDF format on the edgar website, it's an HTML file. I prefer for printing purposes and for reading purposes to have a PDF file that I can download, which is ten q ten K report on eight K report, then having an HTML file through Attica. But okay, that's me. But I think the important thing here through the example is that showing you how for us publicly listed companies, companies like 3M, either through the edgar website, you can have access to all the reporting obligations of the company, but also this company is making this available through an investor relations website or sub website of their corporate website where you can have access to the same level of inflammation. Here you see the PDF. In fact, what I was mentioning, it's the same, I mean, it's obviously the same format than HTML, but I tend to prefer because I also, I like to save the PDF format because comparability of things. So the companies I'm invested into, sometimes I need to go back to earlier reports to understand what has happened because that may happen. I want to look back five years ago. The latest report is not showing the five-years ago figure, so I tend to archive myself the ten q and ten K reports, at least for the companies I'm invested into, what are the seeds for the history and purpose. So I think it's also important to set the scene about, as I said, what we're reporting came from this underlying principles of a ledger, this double entry bookkeeping mechanisms to avoid errors. And then also, I think the most important statement is that financial statements are not perfect and really simplification of complex business processes. And then you have to understand again, summarizing here what we just discussed. Depending on the geography, the regulatory obligations, the size of the company, the number of employees. If it is a public or private company, that the reporting obligations will differ and that's normal because the cost to do quarterly on audit reports, I mean, you need to be able to carry those cause and for one man, one woman shop, that's definitely not possible. So keep that in mind when we think about financial statements. With that, to talk to you in the next lecture where we go and discuss Reporting Standards. So talk to you in the next one. Thank you. 3. Reporting standards: Alright, next lecture, chapter number one, still introducing financial statements, language, vocabulary, lingo, whatever you call it. Now we need to discuss reporting standards we discussed in the previous chapter. Chapter, sorry, reporting obligations, how they can differ, etc. Now we need to discuss reporting standards because you may remember that one of the principles I introduced is comparability. So is there a way to compare a US company with European company? Do they report in the same way? That's something from a fundamental perspective you need to understand. So let's go into reporting standards. And I will try to make it very effective here so that we can really go then afterwards into reading financial statements because that's the purpose of the course. I will make it simple. There are three ways of looking at financial statements. So when you get to financial reports, either the report is done under IFRS, the International Financial Reporting Standards. There is an international organization which is called the USB, which is International Accounting Standards Board. I've put you the URL here. If you want to have a look at it. Us companies, they do not follow IFRS. They follow US GAAP, which is US generally accepted accounting principles. And you're going to see the differences between one and the other. Or third option is that the company is not obliged to report neither in IFRS nor in US gap and is reporting on the local gap because e.g. the company is not publicly listed. And that was the case e.g. some of the companies I had, e.g. in Luxemburg or here in Spain. I mean, I'm not doing an IFRS financial report or US GAAP financial report, but I'm obliged to follow local law and we will be discussing this in the next slide. So I'm reporting in lux gaps or Luxembourg generally accepted accounting principles, Spanish gap, e.g. so that's already, again, strong statement. So keep in mind and I will show you through the examples of Mercedes and Kellogg's, how you can find out on which, let's say a standard format the company is reporting. Why is there I mean, one of the fundamental question is, why is there a difference between IFRS or let's say, sorry. Some countries that report on IFRS and the US at Repos on the US gap? Well, basically it's history. I mean today, nearly the whole world, I think with less than ten countries report on the IFRS. And I really mean for, at least for publicly listed companies in the US, US public listed company is a report on the US gap. There not obliged to report on the IFRS. And that's the reason why you're going to see what are the differences and there are even differences in the way how things are accounted for and treated for between IFRS and US GAAP is now a willingness to converge. Yes, Kind of, but it's still not the case. So there are indeed differences between IFRS and US GAAP. But keep in mind that less than ten countries throughout the world, I'm speaking here and I'll publicly listed companies and markets. They do not follow IFRS, but most of the countries that have, at least companies that follow that are listed on publicly listed local market as they follow IFRS, but they are there differences in it? E.g. there are ways in the way how the balance sheet, which is basically a report and we will be discussing this that shows the world that has been accumulated by the company since day one, since inception day. The difference is just in the order how e.g. the balance sheets is listing the assets of the liabilities. That's a very big difference between IFRS and US GAAP. So you need to, I mean, of course, and this is the purpose of this training. I'm trying to train your eye on seeing those kinds of differences, the differences in accounting treatments. I will not discuss it now in detail, but about how assets, fixed assets, extraordinary items, impairment, losses, etc. How e.g. inventory is done. So you may have accounting differences between IFRS and US GAAP. So you need to be aware of this that they may that treatments may differ accounting treatments may differ between both those other major standards in the world. One of the things when we look at IFRS and we will be going into the depth of the balance sheet. We'll go into the income statement, cash flow statement you have in fact for, let's say, each of the big categories of assets, of liabilities. You're going to have specific documents that explain the role of those standardization bodies like the USB for IFRS or the FASB for the US gap. They are in fact documenting what the rules are. And basically you have the accountants, the statutory auditors, they take those standards. And here I'm giving you the example of IFRS. So the standards of follow a certain numbering model. I was the first one. We have e.g. IA, S1, which is a presentation of financial statements. I asked two is inventories. And then afterwards that's history. It was called initially IAS, then it became IFRS. What you have in fact, the way how to do the accounting treatments for specific items in the company financial statements. It's explained how to deal with that. And we will be e.g. we will be discussing IFRS 16 on operating leases that were initially only that we're not showing up in the balance sheet e.g. but hold your horses on this. We will discuss it later on as a concrete example when I will walk you in detail through the balance sheet. What about Europe? While Europe in 2013 actually came out with the directive where it says you sitting on the right-hand side in the red frame, then on the EU rules, European Union rules. So obviously UK is now extracted from this, sorry, for the UK people. So the rules may differ for UK people that basically any company in the European Union that is a publicly listed company has to report on the IFRS. That's what the red frame actually states. So you may have companies that are not publicly listed companies where they may follow local gap only it's not an obligation to follow IFRS. That's what European Union saying, but you may have a country says, no, I still want to have for smaller companies that are not publicly listed or whatnot still follow IFRS, that's a choice, but you need to be attentive that this has a cost to the organization as well. In the US, we have the FASB. So remember that India's is the Fosbury who is taking care of, let's say standardizing US gap. Well, they have a website, I've put you here, the URL where you can actually see as well various definitions and what is called the codification of, let's say the financial accounting, financial statements of a company. And one of the important things that have to be codified is the chart of accounts, e.g. so basically you have, remember, I wasn't in the previous lecture or the lecture before we were discussing about the Mesopotamia where the ledgers, the first bartering ledgers appeared and then they become accounting ledgers with double booking, with double-entry bookkeeping mechanisms. So basically, in order to avoid that, one company calls the cash account, the pink account, and the other company calls it the ABC account, and the other company calls it the one zero-zero account. So you have in fact a local bodies and sometimes international bodies that have also, that came up with a codification of the account numbering as well, which is called the chart of accounts. And you have this for balance sheet accounts. You have this income statement accounts. And if I've taken here the example, I mean, you have it for US, gap, That's what the FASB is taking care of. Looking back at slide 60, but you have it as well. E.g. for Luxembourg, Luxembourg has a standard chart of accounts. I've put here the, this is law. So companies have to follow this thing. They cannot e.g. if I'm looking at inventory, if they have raw materials in their inventory, a company cannot decide that that account is prefixed by number nine, e.g. it has to be prefixed by a number three. Spanish local gap is the same. They have the Spanish National chart of accounts. And what is interesting is that you see in Europe, even with the US gap, the numbering of the accounts is pretty similar. So we have this what is called category one, category to category three up two categories seven accounts. Very often they do not differ too much between countries, but again, they can differ. I mean, this is you see that this is not specific in IFRS. Ifrs is not providing a chart of accounts. It's really local authorities that provides the local chart of accounts in US GAAP. Indeed, the FASB is providing a chart of accounts. You have it here also I have put here you see that this is the law, so this is the Treasury Department and the Bureau of the fiscal service. They are publishing the US standard general ledger. So it's not just the FASB. The FASB is just taking law has decided and law has decided. The US Treasury Department with their Bureau of the fiscal service, that's guys in the US. We're going to have this four digits US standard general ledger accounts and they have to be classified like this. I think it's good because we need a minimum of codification. Otherwise, we may end up having financial statements. Remember that we are seeking and searching for comparability between financial statements. You may end up having to US companies where one is calling the acids are 1,000 account and the other company is calling the assets, are prefixing the assets category as a 4,000 account. That's extremely messy and that will create chaos. That's why there has been. Certain level of codification. We have IFRS, US gap, local gap. And then in fact we have indeed countries who clearly state what is the chart of accounts watch? How shall it look like? And we are providing a numbering system and indexing system for the account and how the accounts shall be treated. So as I promised you in the introduction of this lecture, I'm showing you here when you have, when you're looking at a financial statement of a company, how you can figure out if a company's typically we're looking at public listed company is following IFRS, US gap. Well here I've extracted from one of the latest Mercedes, It's August 2020, 1020 annual report. But here you see, in fact, we'll be discussing Main Accounting Principles and accounting policies. But in this section of the significant accounting policies, Mercedes is clearly stating that you sit in the red frame. The basis of preparation of their financial statements is IFRS. Let's read the sentence. So the chapter on the significant accounting policies is called a basis of preparation. The subtitle is applied IFRS, and it says the accounting policies applied in the consolidated financial statements comply with the IFRS required to be applied in the European Union as of December 31, 2020? Well, then, you know, that's Mercedes will follow in their financial statements, IFRS and all the let's say treatments, accounting treatments that come with IFRS, let's say obligations and expectations. How do we see this for the US company, I've taken the example of Kellogg's. I was invested into Kellogg's. I have divestment, nice solid for a nice premium. So here e.g. in this is a I think it was a ten K reports or the audited annual report, but even in an unaudited you will see here under the notes, the consolidated financial statements on the account accounting policies very similar to the EU. They speak about accounting policies. There is a subtitle called a basis of presentation. And in the red frame you can read the preparation of financial statements in conformity with accounting principles generally accepted in the United States of America. It does not stay US gap. But it just explicitly mentioned that It's following accounting principles generally accepted in the US. And that's your ascap. They're not putting the acronym of the abbreviation you as a gap. But this is US GAAP treatment that they applying to their financial statements. So I hope that we are building this up. I hope that you understand that. I mean, where we're coming from. So we were discussing accounting, the appearance of account ledgers, double entry bookkeeping system to avoid errors in recording transactions so that they have to be balanced always the accounts we have now discussed IFRS versus US, GAAP versus local gap. And you'll see things, we see differences. You see that also the chart of accounts is laid down in, in most of them, let's say, developed with all due respect for what we call emergent counties. But I'm not a specialist of that, but at least for developed countries where I'm looking into those markets, you have a general ledger which is laid down by law. You have standardization bodies who then explain what the treatments should be and with, with huge documents that explain what the accounting treatments should be of various liability in various assets. Now, in the next chapter we will be discussing in fact, because I already introduced a little bit the balance sheet, income statement, cash flow statement. So you are hearing me speak about various things you saw in the Mercedes report. They're speaking about the consolidated financial statements. Again, we're in chapter number one. I'm trying to gradually build up your understanding of the language of business as Warren Buffett was mentioning it. So the language of financial statements and in the next chapter I'm going to introduce you to the different types of financial statements, the various reports that you can see and how they are structured, and what's the intention and the meaning of them. So talk to you in the next lecture. Thank you. 4. Financial Statement Types: Alright, welcome back, next lecture and in chapter number one, so introducing you to the language of financial reporting on the financial statements. As I said in the closing of the previous lecture, I want now to introduce you to the type of reports and how information is structured. Of course, keeping into account what we said earlier is like there may be differences between IFRS and US GAAP or local gap, e.g. but the principles are mostly the same for any country. So first of all, when we speak about financial statements, is that those should be the records. Remember, we are coming from history ledgers, account ledger that appeared with the double entry bookkeeping systems for the variance accounts and recording transactions trying to avoid mistakes. So we have this double entry bookkeeping system. So the idea of financial statements, and I introduce you who is interested in financial statements earlier, is really to, let's say, summarise what the company has been doing in terms of business activities and the performance of the company. So as I said already in the introduction, please keep in mind that financial statements can not be perfect. They are an imperfect representation, a simplified representation of a company. The more complex the company would say that the chances are high that the level of error will be higher versus a one man or one woman company, of course. And the financial statements very often in most of the cases that's also part of the business language, are prepared under the assumption that the company will not go bankrupt. This is called the going concern. And even sometimes in the nodes, you find that the base of preparation isn't only asserting that it's IFRS and US GAAP, but the reporting has been prepared on a going concern so that the company will continue to operate. Of course, there are risks associated to it, but the company continues to operate. We are not in a e.g. Chapter 11 thing where the company is being disrupted and the company has to file for bankruptcy. So of course, the financial statements, the way how they are presented, as we saw in the previous lecture, they follow IFRS or US GAAP or local gap. And as already sets, again repeating myself, that there is a serious interest by investors to potentially invest into companies and they want to have access to the financial statements. But this is a butter and I'm sharing this with you also being an independent director, sitting at two board of directors. When you are, we can not only speak about publicly listed companies, but when you are a serious investor, you cannot just look at financial statement and make an opinion about the company. You, serious investors, they may look at other elements and may look at net promoter score at when employees are saying about the company, what customers are saying about the company, what's surprising about the company? You may look at the rating that is done by those rating agencies. When they look at the depth of the company, you may look at industry benchmarks. If you are venture capitalists or private equity investor, before putting your money into a company, you will do due diligence. So I do remember having lowered at, at inserts, the professor was sharing as the finance professor was sharing with us. That's Blackstone, which is a very well-known company that the CEO of Blackstone said that one of the success criteria of Blackstone when doing an acquisition, 40% of the success is happening. You do, or through the due diligence. So it's very important to do a good due diligence. It is illegal customer supplier due diligence of the intangible asset of the loans of the company, etc. So that's the kind of thing, of course, when your mind the venture capital error specifically for early startups, I mean, I mean, of course you have to do due diligence, but the scope of the business will be smaller. So you may more rely on the competence of the team if they already have some customers that are what's the revenue streams, etc. So obviously, you need to think more than just financial statements. Create or to build and create yourself an opinion about the company. And of course, the mother company is mature, the more complex it is. But the more information you will have, the smaller the company, less information you will have. But it will also may be very probably be easier to look transparently through the company because operations or as complex as you know what? Ifrs and the IASB E, which is the International Accounting Standards Board, the FASB for US gap is doing. Remember we were discussing codification, so yes, there is also qualification for how financial statements shall be presented in IFRS. You sit on the left-hand side, they say a complete set of financial statements, in fact, should include our shall include a statement of financial position, which is basically the balance sheet, but they call it the statement of financial position, statement of profit or loss of other comprehensive income, statement of changes in equity and the statement of cashflows and then supplemental notes. Us gap FASB says, Well, presentation of financial statements, I really put a screenshot of the websites of USB and phos B. You see that they say, the presentation of financial statements shall carry a balance sheet, statement of shareholders equity in income statements for Crump other comprehensive income and discuss what that is and standard income, irregular income statement, statement of cashflows and also notes to the financial statements. So it's interesting already here to see that basically they have the same requirements, but they don't use the same vocabulary. When you would be looking at an IFRS financial statement and you're looking for the term balance sheet, you may not find the term balance sheet. You will find a term, a consolidated statement of financial position, e.g. what does it mean? A financial position is a balance sheet. Why does IFRS prefer to use the term financial position? Because probably it's, goes more into the philosophy that a balance sheet is the position, is a financial position of the company since its inception, since day one. So they decided to go for this vocabulary instead of using the term balance sheet, but it's the same. But you see that between IFRS and US GAAP, there are differences already in the vocabulary. When we look at the US e.g. because it is a very mature market, if you remember, they had this edgar website where Europe does not have the time be the single access portal for information of public listed company is that they have to report on IFRS, e.g. in the US. And I've put you again the URL that you can read and make yourself knowledgeable about this. The US Securities and Exchange Commission is expecting on top of the balance sheet the income statement and comprehensive income repo, the cashflow statement, supplemental notes. They even setting the requirements in terms of what has to be included in a ten q and ten K report. Remember ten q is unaudited quarterly report for publicly listed companies in the US. Ten K is the audited annual report for US listed companies. They say there has to be on top of balance sheets, equity statement, income statement, comprehensive income statement, cashflow statements, and nodes. The nodes have to be structured part one, please describe to the external shell as the business, the risk factors, etc, etc. You can see it here, part two. There are certain amounts of data that you have to provide. Part three, who other directors, the Executive Officers, what's the corporate governance, how the directors and executive officers are compensated? Then part four is everything that is exhibits and also the schedule of financial statements. So you see that there I like investing in US companies. It doesn't mean that they will never be a scandal or fraud. I mean, those things happen. We will discuss it later, later on. But at least the SEC has been pushing US listed companies to be much more assertive and explicit on describing things. I mean, again, I want to make a statement here when they speak about risk factors and allow me to be 1 s little bit crude in my vocabulary. A lot of the financial reports I read, the risk factors are very often a cover your *** statements. So sorry for the language, but it's true. I mean, because what has happened and we will be discussing scandals later on over the last decades they have been scandals. The SEC e.g. has requested that for the US listed companies unaudited quarterly reports and audited yearly reports have to be signed off by the CEO and CFO, so by executive officer, so they are liable as well, which means that the SEC can take legal action against those people as well, and not just against the Board of Directors, e.g. so what's the tendency sometimes I'm not saying that's the case for all companies. But the tendency is like, okay, if me as a CEO and CFO, I'm reliable, I'm going to cover my bag and write everything that is possible unimaginable in the risk factor so that I'm not exposed to any legal action because I forgot to mention one specific very minor risk. So again, you have to find the right balance. And you need to imagine the cost of having to write all those chapters. And CEO and CFO, they're assigning this off. This has a cost to the organization. I think it's good. I think that sometimes we have some, let's say executive officers who are more in a cover your *** thing and you end up with reports of 400 pages at, at the very end of the day, do not help minority shareholders because they do not know how to read those reports. Are there just like overwhelmed by the amount of pages of having to read the quarterly report of 400 pages. I mean, that's just impossible. Let's be very fair about it. That's basically why I'm doing this course. I'm giving you my way of looking at financial statements. I'm not saying that you shall not read the risk factors. I do read them. I mean, depending on the company, some companies have this style of making like 20 pages of risk factors and you are just so overwhelmed. And it's really like corporate blah, blah, and the variant of the day, you are not more intelligent versus how you were before. So you need to, That's why I'm doing this course. You need to be able to read through those financial reports and just guessing. But if the company is having 57 pages of risk factors, is the company serious to me as a small minority shareholder, external shareholder? Is that not overwhelming? Maybe not, maybe there's a good reason that they're rather 57 pages, part only on risk factors or chapter on risk factors. Maybe they're just trying to drown the fish and they don't want you to extract the essence of what is going on. So that's the kind of thing that you need to be attentive and make your own code. That's why also the course is called the art of reading financial statements because it's subjective. You need at a certain point in time to bring in human judgment for you as an investor, as an accountant, as an analyst into what's your feeling about and then taking just one step back when you're reading you're reading financial report of 450 pages. I mean, guys and gals, that kind of report exist. I feel overwhelmed by this. And again, you need to strike the right balance and make a judgment call and do an arbitration. That's why the course is also called the art of because human judgment is required. Right? So when we are looking into IFRS or US gap and the differences between the two, the companies have to present the financial statements according to certain legal requirements are laid down in law and order by the standardization bodies. So typically when analyzing a firm, what investors want to know is the type of assets. So assets are in fact, how do they find an asset or elements that can generate a profit? You have different types of assets. We're going to discuss this in depth. The balance sheet, parts that are tangible assets or material assets. Intangible assets, like a brand intellectual property, you may have very liquid assets like cash and very illiquid assets like a building. I mean, you will not sell the building tomorrow. What also investors want to know is the type of claims and liabilities that are on those assets. Because those assets have not created out of thin air. They have been created by sources of capital, by people, accompanies excellent companies that brought in money or capital or even physical assets. So those external people have a claim on those assets if something goes, goes bad. You also know, you also want to know as an investor, what's the value of the assets? Are they carried at cost? What's the, I mean, if it is an investment into a company and the share price is changing, what's the fair valuation of that assets? There's gonna be a certain degree of uncertainty. We will be discussing k examples on inventory and valuation of inventory and impairment or on inventory. But what's the degree of uncertainty on it? And also you want to, I mean, investors want to know and I want to know how good the companies are generating profits from those assets and how good they are at collecting cash as well from their daily and business operations. And again, reminding you that's any kind of financial statement is imperfect. It's a simplified view of the world. So keep this in mind. Now, what kind of financial statement types exit? So most of the people, and I'm going to start with the balance sheet already was introducing a little bit the balance sheet in the introduction, but most of the people know three types of financial statement tabs. The first one is the balance sheet, but a lot of people do not understand the difference between a balance sheet and income statement and cashflow statement y. Let me explain you here. I'm bringing up here this diagram on the right-hand side, a balance sheet, as already said earlier. Remember, IFRS does not call it the balance sheet, but a statement of financial position is in fact, the financial position, the stock of wealth, the accumulation of wealth of the company since inception, since the day one, since company creation. I've rest calls it the statement of financial position. You as GOP calls it the balance sheet. So that's one major thing when you read the balance sheet. And you remember I said in the very first introductory lecture, I said when I asked my opinion about a company or one, I have to do myself. I'm being part of a due diligence. The first financial statement type I read is the balance sheet, the income statement because why? It gives me what has happened to the company from a financial perspective, from a financial position perspective since day one, I don't have is in the income statement, the cash flow statement. So that's one thing. Then a lot of people know, of course, income and earnings same. And you remember in the introduction that sets a lot of analysts look at over performance. If the company has met analyst's consensus on earnings, earnings per share, et cetera. So that's the income and earnings statements. And the cashflow statements, why are there different? And I'm going to explain you through concrete example on an asset Enron. So first of all, the income Same is the flow of wealth that has flown into the company has gone out. So revenue and expense of the company. What differs from the balance sheet is that the income statement, you're looking at a subset at a period of time and the period of time can be daily, can be a quarter, can be a year. The balance sheets does not have that attribute when you look at the balance sheet at any moment in time in a calendar year, it shows the stock of wealth, what the company has accumulated since day one. Because it's not looking at a period. It looks at the period from day one to now. Whenever you look at the balance sheet, the income statement, while you're looking at a specific period of time from t zero to t and that can be 30 days, 27 days annual, quarterly, monthly. Cash-flow statement is the same. What differs between cashflow and income? And we're gonna be discussing this, is that cashflow only looks at cash inflows and outflows. Why earnings? I'm already giving a very simple concrete example that we will be discussing later on in this course is like when you as a company, imagine you're a consulting company. You have produced a consulting service to one of your customers. You have executed, you have finished the mission. The final report has been delivered. You're closing the financial sorry, the consulting report. The customer agrees to it. You will send out the invoice, but you have not immediately collected the cash. Maybe you're gonna give 30 day payment terms to the customer because you want to be kind to the customer. This is where in the income statement and I will show you later on as well. You will not look at the cash treatment of the revenue, but you're going to say, I have finished my consulting mission. Customers happy with it. I'm going to send him an invoice or hurt an invoice, are going to record the fact that I've created those services. But in the cashflow statement, you will not see the inflow of cash because the customer has 30 days to potentially pay that inverse that you have sent out on. This is where we see a difference in treatment between an income statement and the cash flow state because cashflow statement only look at inflows of cash and outflows of cash. Concrete examples we are discussing the three main financial statement, tides, balance sheet, income statement, cash flow statement. So here you see the example of Mercedes I've extracted here, of course, that the screenshots you see already, it's IFRS. It says consolidate the similar financial position. We're going to discuss consolidation later on. So consider this as the balance sheet of the whole Mercedes group. This is the incomes in the middle. Bullet point number two of the earnings statements of the whole merciless group. And on the right-hand side, the cashflow statement. And you'll see that the lines categories and how information is presented, obviously they're not the same. Kellogg's the same. You see consolidated balance sheet, you see it's US GAAP as well, because financial statements have to be presented using the term balance sheet in the US and not financial position, saving of income and statement of cashflows. So 123, the same. Now, I was already giving you the example of an invoice on a consulting service. And there are other reasons why there are differences between income and cash flow. And remember that, I forgot to mention it two slides ago that cashflow follows the same logic than income statement. You're looking at a subset of time. You want to know how much cash the company has collected since inception, you need to look at normally the balance sheet, because the balance sheet is the one that looks at the accumulation of wealth or the accumulation of cash since inception. But I'm going to dig into this in upcoming slides. But first, I want to again share with you another, not only from a invoicing perspective, different you're sending on inverse to customer. The customer has 30 days to pay. You may recognize the revenue when you send out the invoice, but you have not collected the cash yet. So there's gonna be a difference between the income same and the cashflow statements at the very end of the day. Except if you're looking at now, very narrow time periods. But after three months, since the moment you have sent out the inverse of the customer and since the customer, the customer has 30 days of payment term, the customer will have paid. Actually the income statement and the cash flow statement show the same you have. Let's imagine it's an inverse of $100,000. You have sent out the invoice revenue of $100,000 and then let's say 37 days later on you have collected that invoice. Well, basically, cashflow and earnings have converged because you have the same amount that has been treated as revenue and the same amount that has seen an inflow of cash when the cosmos did the wire transfer those $100,000. There is another thing where income and cash differ. It's not using the delay when cash is collected and paid. But they're also things like what is called the precision amortization of assets. I wanna give you a very concrete example on this. Let me show you this, this diagram you see here limousine on the right-hand side. So limousine is what we call a. We're going to discuss tangible assets when we will go deep into the balance sheet. So limousine is a physical assets that, and imagine that you as a company, you're not in the consulting business, you are in the business transporting VIPs from one place to another. So we're looking here at the difference between income treatment and cash treatment. So imagine the following thing. You have two options for this limousine. You can either decide by the limousine or you can also rent limos. When you ran the limousine. Normally, they will not be too much difference between the cashflow statement and the income statement. And you'll see this on the top of this slide, is that basically, lets imagine that you will subscribe or sign a five-year renting agreement with Mercedes, e.g. and you are renting the car for certain cost, fixed cost over five years. That's the red parts of what is below. Then you have those five years, that's a time, Let's say scale that you have. And you hope that this asset will generate a certain amount of revenue and of cash collection. This is why you see the cashflow and the income statement. So to make it simple, as you are not buying but you are renting the car will be except with a delay in e.g. a. Customer paying your invoice, they will not be a difference in terms of income spent with us cashflow statement because that car, you do not own it, you are renting it as, let's say an assets, but you don't have the ownership of property of it. So basically, there is no difference between income and cash flow. The only difference that may happen is that when you send out the invoice, but maybe the VIP person taking care of paying the VIP service maybe has 60 days of payment terms and maybe if if you're sending the invoice on the 15th of December, when you're looking at the ends position of the cashier and the income statement at December 31st. Well, there indeed you may have not collected the cash yet, so there's gonna be different, but in the next period, let's imagine in February, again, cash and income would have converged because the customer will have paid the invoice. So that's the only way we're renting. You may have things that differ. Now, where income and cash may differ is when you are e.g. buying the assets. What happened is the following. So let's imagine that you, I mean, you are the company owner, you decide not to rent the Mercedes car, but wherever, for whatever reason you decide to buy the car. So you are buying an asset from the cash that you have received from the shareholders, or maybe you are the shareholder. Now there's gonna be a strong difference between the cashflow treatments and the income statement. Why? When you're buying the car, except if you're financing the car, let's keep this option 1 s aside, but the seller of the car will ask you to pay immediately the whole amount of the car. Let's imagine the car has a cost of $100,000. You will have in year one and outflow of those $100,000. But that asset, you are keeping it for five years. You know that this asset will generate the revenue hopefully over the next five years. So, but how do we, what's the difference? Well, this is where the income same and the cashflow statement differ. In the cashflow stem, you have to report cash inflows and cash outflows. So you will report minus $100,000 for the purchase of the car. And you will only report a register the influence of cash for your one-year, two-year, three-year, four-year five. So you're seeing the car purchasing the cashflow statement, that there is a timing difference between the two because we have now to spend the money. But you will only have written on the money over the next five years, which is not the case for the renting model, or maybe potentially the financing model. But from an income statement perspective, you are allowed by law. Let's imagine that this asset has, we will discuss useful lifetime later on. But law is allowing us because law understands that this asset will generate profits over a five-year period. Let's assume that this is the useful lifetime of this asset, five years. In varying the income statement, you will, you are allowed only to expanse the Ahmad the yearly amortization, depreciation of that asset, which would be if it is linear, we will clearly have those conversations. If it is linear, depreciation would be if the asset cost 100 thousands and the acid has a five-year useful lifetime, you can depreciate and if it is linear, 20,000 per year. So basically this is what I'm showing you. The temperature is in the bottom. You will have -20,000 every year for the next five years in the income statement. So here you see that the income statements, you'll see that the income statement is in fact showing a difference. With the cashflow in year one, in year one you're going to have the full cash outflow, one in the incomes and you will only incur the expense of depreciation, which is of 20,000. But over time, coming back to what I said, after five years, cashflow and income would have converged. And that's where you cannot trick the figures at a certain moment in time. Because cash and income will converge and Shell converge over time, they will converge after five years. After five years, total amount of cash outflows will have been 100,000 and the total amount of depreciation would have been 100 -100 thousands. So you see that the convergence, is it there? Well also important thing that people do not understand or attentive to is that the three main financial statements are linked together. So if you look at the profits, e.g. you're going to see the profits also at a certain point in time appear in the balance sheet. They're going to be added potentially into retained earnings. The end position of cash in the cashflows thin, which is normally at the very bottom, has to appear in the balance sheet in the cash position. And this is what I'm showing you here. It's in a simplified way. There's sometimes a little bit of differences, but basically it's like the income same and the cashflows in which is a subset over time, the results of the income statement and cashflow statement, they have to, let's say, flow back into the balance sheet, into the financial position. My apologies. And you have this year from our cities. And yeah, the same for Kellogg's. So this may already tell you why I'm starting with a balance sheet, because the balance sheets, everything comes together into the balance sheet. And I'm looking at the balance sheets on what the company has been doing since day one, where in the caches even an income statement, of course, I look into them as well, but after having understood what the company is being made out of, when I read the balance sheet. All right, so that's the three main financial statement type. So balance sheet or IFRS calls it the statement of financial position, the income statement of earnings statement, and the cash flow statements. But they are in fact more than those. If you recall, when we were looking at the IFRS and the FASB slide, they have spoken about an equity statement of comprehensive income statements. And on top of that, there are nodes and it's so essential, as already said earlier, you cannot just build an accredited yourself no peanut butter company by not reading at least the main and major financial statement notes that come with the financial statement types of reports with the figures. There you need to read the verbatim as well. So when we look at the, in fact, mostly five financial statements types, and I promise you not a lot of people, even I mean, not a lot of people go beyond the income and earnings. Remember what I said in the introduction? I believe that a good investor at least is able to read balance sheet income statement, and cashflow statement. I think those are really and when I do webinars with my students, I practice with, with people. Those are the three essential ones. Then you have the equity statement. Equity same is a detailed report on what are the changes that have happened over a period of time, again, a period of time in terms of changes to the company equity from the opening balance to the end of period balance. And this can be the dividends, withdrawal of equity movements in treasury stocks that's ready to, to, sorry, to share buybacks. So that's the equity statement because sometimes in the balance sheet, the equity is really one line and you need much more detail. Then you have the comprehensive income statement. That's an income same, but it's specific one for things that are very specific. And I'll give you three examples. When I will give you a very concrete example, I think it's in chapter four about being able to read and earning statements. Unrealized versus unrealized losses with Berkshire Hathaway, which is the company Warren Buffett. Warren Buffett, if I take this example or even myself, I do own a lot of shares in publicly listed companies. You know that share prices fluctuate. But how shall I value the fluctuations specifically if I would need oh, I'm in Berkshire has to do a yearly and quarterly income statements. And as they have to do a fair valuation, they have to report, even if they do not sell the securities, they have to report. If today on the fibrillation they have made a loss versus when they purchased the, the securities of those companies. But as long as they do not sell, as they will, neither on capital gain or capital loss on those equities and those security that they bought from Coca-Cola, from Apple, etc. But accounting treatments is expecting that even unrealized losses shall be reported. And this is done in the comprehensive income statement. That's very specific one. Again, please stay with me in chapter four. I'm going to show you very concretely on Berkshire Hathaway, I think it was the latest ten q report of dura mater. It was made of November 2022. I'm going to concretely show you how to read realize versus unrealized losses. Comprehensive income statement and where this is coming from, there hasn't been a change in accounting treatment. I think it was 2016. If I'm not mistaken, that unrealized losses should be reported as well. And you will read and hear also from me what Warren Buffett's position and mine as well, it will be on that. So more about that in chapter four. When you look now, I'm taking a step back looking at the consolidated financial statements are in receipt is indeed I mean, they are showing a comprehensive income loss statement. They are showing also a statement of changes in equity plus the notes, the consolidated financial statements. So you see that there is basically five types of financial statements, balance sheets or financial position, as it calls it now for us, but let's say a balance sheet income statement, cash flow statement, equity statement, and comprehensive income plus the nodes. So basically we have six elements when reading financial statements that should be at least for publicly listed companies in their financial reports. And indeed, I'm showing you here, you already saw the financial position and comes to him in and catch we're sitting for Mercedes, but here you see they have a consolidated symptom of financial position and they have a consolidated statement of changes in equity which flow together. The consolidated statement of income, as well as links to the consolidated statement of comprehensive income loss. With those, I'm just speaking here for the time being about the unrealized gains and losses, e.g. so we've seen that, let's say those elements, those five financial types are linked together. So balance sheet, income statement, comprehensive income cashflow statement, and the equity statement. But at the very end of the day, everything comes together into the balance sheet. Hope this makes you understand why I'm always starting with a balance sheet because the balance sheet is giving me the, I would say the accumulation of, well, what's the position of the company since inception, since day one? Kellogg's US gap company listed in the US. It's the same. I mean, I'm just taking an extract here. This was a ten carry period. I don't remember when it was done in 21 could be. I'm looking for find a date now here. It was the fiscal year 2021. So you see they have consolidated statement of income, comprehensive income balance sheet statement of equity is M of cashflows plus a note to consolidate financial statements. So we see, or you see that we have those five statements, the notes. And that's already a way of how to read a financial statement is the structure of the financial statements. Again, I already showed you this 123 thing and you'll see that the consolidated balance sheet links to the consolidate and similar of equity, which is going much more into details of it. And also the income statement, which links also to the comprehensive income statements. Alright, so we have those five types of financial statements, as I said earlier, be aware that they exist, maybe are interested in looking at the equity movements. Maybe you're interested in looking at realized versus the unrealized loss because you have invested into Berkshire Hathaway. The minimum for me as a reasonable investor as reasonable, let's say a person that is interested in the finances of a company doing your due diligence, looking at the balance sheet, income statement, and cashflow, same even exists. Last point before we go into the notes. Very often in smaller size companies, they don't have a cashflow statements. So very often they only have a balance sheet and income statements. Is that goods, while it depends, depends really on what the accounting treatment is on cash. I like to have, even for privately owned companies, the three statements, balance sheet, income statement and cashflow statement, and of course, being audited by an external statutory auditor. We will speak about that role in the next chapter. Now, as I said, five plus 15 times plus the nodes. The nodes are very important. I said that the financial statements, I mean specifically for publicly listed companies, you cannot create an opinion just by reading the balance sheet, e.g. yes. I mean, you got to have when you practice a lot, you're going to have, let's say, I'm going to share with you one example on Villanova at the very end of Chapter number five. How I read the balance sheet. And already just by reading the balance sheet, I was expecting some things that happened to the company. And I was then looking specifically for that in the notes to the financial statements which I then indeed found, which confirmed what my guts feeling was telling me. But again, that's in chapter number five is the last example where we will look at the Villanova acquisition they did, and what was the impact on the equity of the company? But as I said, very few people read the notes. The nose, they do provide very interesting insights and they do carry important information. So we need to be attentive to the notes as well. Now, as a final thing, we're going to stop here. So we discuss IFRS versus US, GAAP versus local gap. You understood that there are, I'll call it is five plus one. The minimum is that you have a company that has a three plus one. So three is balance sheet income statement, cash 5. Reporting Accounting Principles: Alright, welcome back. Next lecture is the last lecture of Chapter number one. So we're still introducing the language and the vocabulary around financial statements. This last lecture is a very important one because we will be, I will be walking you through the main accounting principles and that's something also very important. And when you read financial statements that you keep in mind, what are the accounting principles behind? So we're gonna be discussing these in the upcoming minutes before that. And just my experience. I mean, I'm I'm teaching value investing company variation now since a couple of years. And when doing the webinars and even talking to people around me when we were discussing about companies, I realized something that may feel maybe stupid, allow me to say like this. But people doing wrong valuation of companies because they will not look incorrectly at the financial statement, units and currencies being used and through that making a material errors. In fact, when doing the evaluation of the company. Before we go into the accounting principles, which is basically the main thing in this lecture, I just want to really remind everybody that also this is something very, very important when you read financial statements that you are clear about the units and currencies that you're looking into. The first thing is important here. So basically financial reports, they do carry units and currencies. So if the company we were discussing what Mercedes, if the company is reporting through, let's say German, let's say legislation because their headquarters is in Germany and they are publishing figures in the financial statements. Very probably the unit being used is you are the currency being used is euros. But then you need to figure out what kinds of, let's say order of magnitudes of euros are being used when you're looking at the financial statements. Is it euros? Euros or thousands of euros? Millions of euros, billions of euros. And of course, your valuation, the analysis you're gonna do may differ if you're making a mistake on understanding the order of magnitude of currencies and units that are being used. So that's the typical source, or those are the typical sources of mistakes that I saw even when running webinars with students, where they were in fact mismatching or comparing eggs and potatoes. They were looking at billions and comparing buildings with million units and the financial figures in the number of outstanding shares, e.g. so be attentive when you're looking at foreign currency companies, e.g. if you're looking at Japanese companies, the figures that you're going to be seeing there are yen. So if you want to invest into the company where maybe you need to convert the yen into US dollars. So you have to think, if you're putting maybe $100,000 thousand US dollars and you want to invest into, I have no clue. Nintendo, e.g. if you are doing the valuation of the company, you are maybe not seeing US dollar reports the same with, with Chinese companies. Sometimes the foreign companies, they do provide us the conversion or Euro conversion. I've seen a lot of Chinese companies providing USD conversion, but you need to be attentive to that as well. Also a typical source of mistake. I'm giving a very concrete example. I'm saying it's now five years, six years, a shareholder of Telefonica, which is the largest telco operator in Spain. They have also other telco operations throughout the world. I think Germany they have, they have UK as well. But I've decided many years ago to buy and I continue buying Telefonica through the US markets. What the reason is mostly tax related because the amount of the tax treatment on dividends on the US market is less than in Spain, e.g. and as I can by Telefonica through the US market on buying what is called an American deposit. I don't remember what the, what the R is. So the ADR is the equivalent of Telefonica that is proposed by a broker in the US. So it's the equivalent of the European share of Telefonica in the US. And you need sometimes to be attentive. That's when you have those mechanisms that you have an American depository receipt that is made available on the US market by Broca. They are not obliged to mirror exactly a one-to-one conversion of the original share in Europe. It is the case for Telefonica. So one European share, e.g. in the Madrid stock exchange of Telefonica. And if you buy the equivalent ADR through a US Broca, it's an exact one-to-one conversion of the Spanish share. But I have seen companies and students making mistakes when doing the valuation of the company because they were looking at the European share. But the ADR had e.g. a, four to one conversion rate. So let's imagine that the European share, you can buy it at €100. So that's the price of one single share. You look at the ADR and the idea e.g. is 25, Let's consider that the conversion rate between US dollar is one-to-one for 1 s. But the ADR is listed at $25 per share. Is 25, is that cheaper versus the €100 in Europe? Well, in this case, the example I'm telling you here at The answer is no because there is a conversion. So you need to have for ADRs to mirror one share of the dividends will be prorated as well. So be attentive to those kinds of things as well. And be attentive to the currents and units that you're using. One of the things I'm looking here at the Mercedes consolidated balance sheets. So in IFRS, you know, now this is called the consolidated statement of financial position or the statement of financial position. We're going to be discussing what concentrated means later on. So here I'm really pointing you that the figures that you are looking here into millions of Euros, where you need to be attentive as well is US companies. They tend to use the comma as 1,000 separator and the dot as a decimal separator. Very often European companies, they use the dot as 1,000 separator and the comma as a decimal separator. So you need to be attentive to those kind of things. Here you see it on the Kellogg's consolidated balance sheet. You see e.g. that they are stating that the figures are in millions and they are setting except the share data. And you see below in the balance sheet, they're listing the amount of shares outstanding. And you see that you see that the comma is here being used as 1,000 separator. You see e.g. in 2020 that Kellogg's so that's bullet point number two, had funded 20,962,092 shares outstanding of common stock. And you see e.g. that just in the same, let's say red frame. You see that the par value at the time of the common stock was up 025. So that's a decimal point, the par value of one common stock. So that's the kind of thing where when you are interpreting figures, you need to be clear about what's the currency, the unit that is being used and do not making mistakes on order of magnitude that you're comparing. And keep in mind that sometimes a chroma means 1,000 separator and simply chroma means the decimal point depending on which country you're looking into. That's, let's say, I'll call it the first warning or first reminder to be attentive to that because too often I saw those kind of mistakes. And I want to be very fair. Over the last 25 years, it happened to me as well that I did the valuation of the company to decide if I would buy or divest from the company. And I had some weird outcomes like this cannot be. So I rechecked what I was just stating now and I saw that I made the material mistake on one unit e.g. so that's the kind of thing that you need to be attentive. And by experience, it, I would say that it may happen still to me as well when doing this kind of valuation, but I tried to be attentive to those kind of things. Alright, having said that, now, when we look at and we add the introduction of financial statements, when we look at the presentation of financial statements, of course, the units, currencies that are linked with the comma, the dot thing. But a certain amount of, let's say general, let's say financial accounting principles. That's actually also describing the standards. Here I'm looking at IFRS standards as well, and I tried to bring them together. And I will walk you through the most important of them that you always keep in mind. What are the underlying principles when companies do provide or they report on their financial position? So the first thing is the fair presentation and going concern. I will take already one very quickly, which is going concern. I was discussing this in the previous lecture. So typically, when a company reports financial statements, we are considering that the company is not going bankrupt, and this is what is called a going concern principle. An entity shall prepare the financial statements on a going concern basis, except if management has different perspective on it. And then of course, it has to be explicitly mentioned. Normally most of the companies, or let's say mature company is publicly listed companies, they do state and even in companies where I'm sitting at the board of directors, we do state in our financial reports that the preparation or the underlying principle of preparation of the financial statements has been done on a going concern basis, meaning that we are not expecting the company to go bankrupt. This is what going concern means. The second thing is a fair presentation. So what do we mean by fair presentation is that everything that is being presented, it is the balance sheet, the financial performance, the cash flows of the company. They should be presented in a way that is fair. And you can interpret in many ways what fair means, but it's something that you need to consider as a, like an underlying, a value from an ethical perspective. That management should present things in a way that are faithful, that people can really believe and they can base their opinion on what is being presented so that it is a fair representation of, let's say, complex business processes. As we were saying, this is something that is fundamental. And of course, and I think I was discussing couple of lectures ago, if there is fraud involved in a company. And this was the case what happened with Enron, MCI, WorldCom. This is where e.g. the SEC and the regulator and the US requested sins. Now couple of years after the Sarbanes-Oxley Regulation to have CEO and CFO sign off is that they're making even the statement of fair representation even stronger by having CEO and CFO sign off the financial reports, e.g. quarterly, unaudited, or yearly audited, in the sense that yes, we commit as CEO and CFO, what is being presented here is a fair and represents indeed a fair representation of faithful representation of our, let's say, our business processes or business transactions. Alright, then when we discuss the fair representation, and I'm gonna go one level deeper because you have, let's say, elements in the company that are difficult to evaluate. I mean, when you have a bank accounts and you have cash on that bank accounts and you have, I don't know, 10 million of cash in your bank account. That's 10 million is 10 million. I mean, there is no let's say question about how should we fairly represent that a bank account, because 10 million is 10 million and you can easily, Let's say transform that's 10 million and buy an asset that is worth those 10 million. But you may have assets. That's where the valuation of the assets requires judgments. And this, again, why this course is called the art of reading financial statements because odd requires human judgment. When we look at assets, remember, one of the underlying principles of accompanies that you have people that bring in capital, a, the cash or the brain physical assets into the company. It can be shareholders, can be external credit toilets like a bank. So you have this sources of capital and those sources of capital are transformed into assets. So they will probably not be sitting there as cash, but you're gonna do something with that cash and hopefully generate a profit out of the cap of that is broadly and we're gonna be discussing the value creation circle later on we will be discussing return on invested capital weighted average cost of capital, the capital much later in this training. Well, having said that, when a company buys an assets with a capital that has been brought in, they are already from an accounting principle, two ways of representing the value of that asset that you need to know. One way of representing the asset is the historical cost. One way of representing the asset is the current valuation of the cost. I've got to give a concrete example. When you have and on the historical cost, There's always one type of asset, which is when the company has bought land. So this is the property plan and equipment, but the company has bought land. In fact, very often in most of the cases, land is carried at cost, which is, and we will not go into valuation conversations here. But normally lands, if the company has land in its balance sheet, it very probably means that, that lands is an undervalued assets. So you could basically, when you look at the book value of the company, you could increase the book value of the company by re-evaluating the land that is being used by the company. Because if the land has been bought 30 years ago, if they would sell that land, the land would be worth maybe 345 times how the land is currently. Let's say carry it at cost independent sheet, then you have current value. And this is something complex because let's imagine, I mean cash is cash. There is no conversation about the current value is basically equivalent to what you have sitting in the bank account. But let's imagine you're Warren Buffet. You have bought into accompany, you have bought shares of that company. And that company you have the market that is making prices fluctuate over time. When you have to report on the financial statements, how do you value? The three have brought both e.g. 1 million shares of Coca-Cola. How do we evaluate those 1 million shares? Are you valuing them at cost? Are you telling them at the latest market price that the market is giving you? So here it is worth, let's say, looking at a little bit deeper on the fair value, fair value measurement and evaluation of some of those assets. They are in fact, differences between IFRS and GAAP. You may have assets that can be re-evaluated in IFRS that may not be allowed under US gap to be reevaluate it. If I look at IFRS, there is a standard which is IFRS 13, which is the fair value measurement standard, which basically explains how to look at e.g. typically financial instruments. Here I'm going to go now a little bit more technical here. This is something that you see in financial reports. So the company, when they have those types of financial instruments, which is a subsets of cash and cash equivalents. The company has to explain how they have been doing the valuation of those assets because those assets are represented in the balance sheet. So if you have e.g. cashes, cash, that's very easy. If you have bought shares of Coca-Cola, That's very easy. You can just look at the stock market and you see how the market is valuing it, that asset that share that you have, and then you multiply it by 1 million. If you have bought 1 million, obviously the asset will change over time. And we will be discussing this one. We will be discussing realized and unrealized gains and losses with Warren Buffett at the, I think it's the end of chapter four in fact. So when you have to evaluate, this is an underlying accounting principle. When you have a balance sheet where you have the sources of capital on the right-hand side, debt and equity bring us. And you have assets, tangible and intangible assets. You have when you are the companies, the management, when they have to do the reporting, they have to make sure that they provide a fair representation of those assets. Cashes, cash, that's very easy. Buying shares that are very liquid on a market, that's very easy as well. You can just take the principal, you look on the market, what is the share price of the company? And then you multiply the share price of the current. Let's imagine it's the summer 31st closing. You then multiply the 1 million shares of Coca-Cola with the latest closing price of Coca-Cola on December 31st, that will give evaluation. Sometimes this what I just mentioned, that's called the level one input for determining the fair value. And so this is where you have to look at the stock market. But sometimes you may have companies that are not listed privately, Let's say a privately owned companies. How do you do that? You own a company. But the company, you can look on the stock market, it's not listed on the New York Stock Exchange, is not listed on the German, on the Frankfurt DAX, it's not listed on Euronext. So there you need to look at what this code level of evaluation which is observed observable information. So that's maybe from similar items are similar, let's say even markets where you can then potentially take an assumption how to value that asset. This can e.g. happened for buildings. If you are unable to and you have decided that the accounting treatment on a building has to follow e.g. what the building is worth. And you're owning a building in New York, maybe you can use the average square meter of building to value that assets because you have a building in New York, in Manhattan. You do not know. I mean, you don't want to sell that building, but you need to present a fair value of that building in your assets because your corporate headquarter offices are e.g. in New York. Well, there in order to value that assets, are you keeping it at cost? A building is not land. Land will be capped at cost, but the building you will value fairly. You cannot go out there and go on the stock exchange, but maybe you can have observable information by looking at, well, your neighbors. I mean, there has been a recent transaction from a neighbor in Manhattan. And then with that, you can do a fair evaluation of your building in Manhattan, e.g. then you have level three fibrillation inputs. So that's really where there is no markets. It's very illiquid. So they're in fact, he's like, I got to be a little bit brutal. It's like a thumbs-up looking for from where the wind is coming and trying to guess. And that's really highly subjective on how to do them the valuation and this can happen. E.g. here we're speaking about financial instruments. I will not go into the sub prime crisis thing. What happens with the instruments that were securitized during the subprime crisis. But there are in fact, how do you value very complex financial instruments, stock options, e.g. so there are methods for that, but it becomes, the more complex it gets, the more you see that there is a risk of over or under valuation. Now obviously this potentially has an impact because it increases or decreases the liquidity of the company because cash is cash, cash is super liquids. You can buy immediately an asset for the amount of cash that you have on the bank account. If you have in terms of your cash equivalents, you have stocks, shares of companies who I mentioned in Coca-Cola. Coca-cola is very liquid. You're going to find this afternoon somebody on the US market is willing to buy your 1 million of shares of Coca-Cola, right? I think that's very liquid. But of course, if the price fluctuates, you are selling or buying at the wrong time, that has an impact on the liquidity of the company. Then if you are buying or if you want to sell. Illiquid assets like a privately owned company, I'm on the private equity space. I mean, those assets are less liquid. It will take you more time to find a buyer or seller, e.g. so you need to have those things. You need to keep in mind that when you're looking at the assets in the balance sheet of the company and the financial position. If I use IFRS terminology, that the assets carry the principle of fair representation. But fair representation will be different for cash, for very liquid instruments, but for very illiquid instruments are for things that are, let's say, very subjective. I mean, you already see here that there is risks of misrepresentation of very, let's say, complex to value assets are difficult to value assets. So keep that in mind. Specifically when you're looking at companies. I'll take the example. With all due respect of banks, companies like BlackRock, They don't carry a lot of physical assets. They carry a lot of, let's say, financial instruments. So they're really recommend looking at the financial report. They're gonna be explaining how much of their financial instruments are being reported at fair value with level one, level two, and number three measures. So there's something that you have to keep in mind. I'm sorry, you cannot just say financial instrument is there and it's correctly reported. So because it carries a certain amount of risks, That's the kind of thing. What happened with the subprime crisis, where at a certain point in time, at the balance sheet is worthless because in fact, assets that were thoughts being very highly values are in fact worthless. So you maybe have just destroyed because of the market situation, 90% of your balance sheet. So keep that in mind. And in the financial reports when the company carries those financial instruments, even for land, property, plant, and equipment. You're going to see in the financial reporting, in the accounting policies, you're going to see inflammation, how they have been valuing their assets at cost. Fair valuation maybe marked to market. So that's the Coca-Cola example, just looking at the share price, that's the level one e.g. evaluation. But maybe there are also level two and level three evaluations that are happening. So that's I think, two fundamental things. So consider that the company typically goes concern. So the financial statements are prepared on going concern basis and there is a fair representation of the valuation of those assets. The molecule they are, the easier it is, the more complex they are, the higher the probability of, let's say, uncertainty and error. Is there? A third very important underlying principle when preparing financial statements is the accrual basis of accounting. And I will explain, in fact, I already explained a little bit earlier in previous lectures the thing about the difference between operating expenses and capital expenditures. So when you do a direct cash out, what's the impact on the income statement versus the cashflow statement? So here, That's something very important when you, let's say record. So remember, we were having a conversation about the accounting ledger, the double entry bookkeeping, a system when you record a transaction. In fact, there are two ways of accounting for the transaction. One is the accrual accounting, and the other one is the cash accounting. What does that mean? The accrual accounting is the following. And that was giving the example of the limousine service. If you have provided the service, you're saying sending out an invoice to your customer. The customer may have 30 days to pay that invoice. You will already recognize in your income statement and your earnings statement, the invoice that you're sending out to the customer, even though you have not collected yet the cache of the payments of that invoice. That's accrual accounting. This works for expenses as well. If you have been incurring a cost that is associated to that revenue, you already will record that cost even before the payment of the cost has occurred. That's accrual accounting is a little bit more complex and you can imagine that by being creative, where some companies may play in the way how they record revenue and how they record expenses by potentially having an impact on the earnings may be inflating the earnings by recognizing revenue that they should not have recognized. In fact, this happens in private companies and this happens in public companies. Then you have the second accounting method, which is cash accounting. That's a very simple one, is basically you only record revenue when the cash transaction has occurred, meaning that the customer has paid the invoice. You only incur the cash outflow when the payment, when the wire transfer to the supply has been done. That's cash accounting. This is when you come back to what we were discussing between income statement and cashflow statement. This is the reason the income statement follows basically accrual accounting method on the cashflow statement follows cash accounting methods. Remember I said clearly at the very end of the day and I was taking the example of the limousine that this Mercedes limousine that we bought at $100,000, we we're expensing it at 20,000 years old as per year because it had the useful lifetime of five years. And in the cashflow statement, we had in year one already the cash outflow of $100,000. But after five years, the total amount of expenses was equivalent to the cash-out of year one. So remember that cash and accrual have to converge at the very end of the day. Otherwise, somebody is manipulating and cooking the books. But accounting allows it. One important thing here is that if you record revenue, you need to record the expense that follows that is linked to that revenue. You cannot say that I recorded revenue in the year 2022, but that revenue has a certain, let's say a cost to it. Like I have subcontracted to somebody something. You're not allowed to record the expense. So the subcontracting in 2023, I mean, you have recorded revenue on December 17th for 100,000 and you had a sub-contracting costs of 37,000, that has to be on the same day. So that's also an underlying principle. Of course, auditors, we're gonna be discussing the role of the auditors. Auditors are there to test that when companies do accrual accounting and everybody is doing it, obviously, that indeed expenses follow revenue as well. So here making a, giving you a summary table that you can read up in the way you can see the difference between accrual and deferral revenue and also accrual and deferred expenses. Basically, what we were discussing, accrued revenue is u. So u basically recognize the revenue in the income statement before the payment is received. Deferred revenue is indeed, in fact, the what is happening is that it aims at decreasing the revenue in the income statement while the payment already has been receiving the cash flow statement, when does this happen as well? You may see position of deferred revenue where e.g. a. Customer is willing to pay for project, but the customer has a lot of cash and of December because my cells are gone already pay you now, even though I'm only expecting that you execute a project in 2023 because I do have cash available, you're not allow them to record this as revenue. You have to record this as deferred revenue. So it means that you have received the cash payments, but I mean, you have to report this or not deferred revenue in the sense that an external investor, if an external stakeholder looking at the financial statements, will recognize that, okay, this is an upfront cash payments, but the services or the products have not been delivered yet. It's allowed because sometimes you have customers. I experienced myself customers that had cash available in December and they wanted to buy something or ready for the next year, but you're not allowed to record this as revenue. So that's the kind of thing that you need to be attentive and the same goes with expenses as well. Alright? Another forth, very important principle is materiality and aggregation. So what is materiality? And I think I mentioned a couple of lectures ago, I was using the term immaterial mistake, material error. When we look at financial statements, remember that I said that financial statements are a simplification of complex business processes and auditors. We're going to be discussing what is the role of the audit. So but even financial people, financial managers that are preparing the financial statements for the auditor's for senior management, they cannot always test everything. I mean, you can I mean, the world is imperfect. It's not perfect in financial statements. What is important is that when we were discussing fairer presentation, that they are not huge mistakes in one is what is being represented. Understood about the level one, level two, level three valuation that sometimes it can be complex, e.g. complex financial instruments. How to do the evaluation when there are no, there is no observable market on it, but it's the same one. E.g. you have to make the valuation of inventory. How do you value that inventory? So one of the principles and we will be discussing inventory specifically when I will walk you through the balance sheet here I want to introduce the vocabulary, the term of materiality. So you need to think that when there is a representation through figures by in the financial statements that are representing either assets, liabilities, shareholders, whatever that you want to avoid to your management, to your external stakeholders, various external investors, if it is shareholders, if it is banks that have been providing loans, if it is the public analysts, journalists, you want to avoid huge mistakes in how you represent the financial statements. This is where the elements of materiality comes into play. There's something very important, e.g. when I'm sitting in the two companies, I'm sitting at the Board of Directors. I'm luckily a part of in both companies of the finance and audit committee. So I'm the one seeing the financial statements being prepared by management, being reviewed by the statutory auditor before they go to the board for approval. And one of the things that we typically look into when you're part of the finance and audit committee is and you discuss this with the auditor, how far did they go? And they have methods of testing to avoid that there are material errors, material mistakes. What is material means basically a substantial, huge mistakes. And so there has been a case we are going to discuss, be discussing later on which is Kraft Heinz. Kraft Heinz in fact made mistakes and how they represented the figures and they had to do a post-mortem, a retroactive restatement of previous years financial statements are I think it was three years of financial savings that they had to correct back. And so when we look at what does represent a substantial mistake and what does not here typically. And this is again, experience we typically, and that's like a thumb rule. We can say that. And I will share how I looked into it when there is a probability that there is a mistake in the financial statements or misrepresentation that is less than 5%, I consider this to be immaterial. So imagine that you have a balance sheet where the total of the balance sheet is 100 million. If there is a mistake that is below five millions, like Okay, it's not perfect. But it does not change the complete story very probably, of the balance sheet because it's less than five per cent. And we can argue, is it five, is it three? So that's a kind of a thumb rule that I use. When it's more than ten per cent, I would consider that this isn't material, this has a material impact, a substantial impact on the way how you look at the balance sheet. So if you have a balance sheet that is worth 100 million and they are e.g. 10 million missing in the balance sheet. Or maybe 10 million of overstatement of an asset in the balance sheet are going to consider this to be substantial. So I will be challenging the auditor senior management about I mean, if they are sure about it and I may ask potentially too, have a revision of how they value e.g. an. Assets. Because or maybe I'm going to ask that a and more explicit nodes is put into the financial report as well. Then judgement is required. For me, typically 5-10%. So this thing about fair presentation and what potentially could be a material mistake, a material misstatements obviously is something that specifically when you're sitting at a board of directors, is something that you have to think about. And obviously as an external investor, you expecting the board of directors, you expecting the external auditor. We're gonna be discussing this to be very attentive at avoiding material mistakes. I was taking the example of craft times later in the course, we will be discussing about the wildcard, where in fact, I think they had like a, was it a 4 billion or 3 billion balance sheet? And there was 4 billion balance sheet. And out of those 4 billion, they were like 2 billion of cash and cash equivalents that were sitting somewhere in a subsidiary in Asia. And suddenly the latest audit reports actually said that that cash was not existing. I think it was one or 2 billion, if I'm not mistaken. So basically they had just shaved, shaved off 25 to 50 per cent of the balance sheet. That's a material misrepresentation of the balance sheets of wildcards. So obviously there was something linked to fraud behind it. We will be discussing why cut later on, but that's the material mistake by the auditors when they, when they mentioned that indeed Wildcard had, let's assume it was 2 billion of cash and cash equivalents. And that money was not sitting in a bank account in Asia. That's a material misrepresentation of the cash and cash equivalents of wire card. If that is 25% of the balance sheet or even 20%. I mean, that has a huge impact and this changes the perception of investors. I mean, this is not building up trust of the investments towards management in this case, wildcard was clearly fraud. Kraft Heinz we can discuss. I mean, it was not fraud, but there was a chemist representation of, let's say, other financial statements that had to be corrected. So when those misrepresentation happened, I mean, I in my case as well, I had one situation where when discussing with the auditor, they actually looked back at the year before and they said, well, we're not sure if they were presented. It was correct. There is an opportunity to do a restating of previous financial statement. It's allowed to do this. Obviously, this is not building up trust, but there is a possibility to do a restatement of previously reported and published financial statements that was the case for Kraft Heinz. So when you think about materiality, we'll be discussing as well vertical analysis later on because I think that's one of the techniques when I go into a company that I really like to have a big picture of how the company is structured and what it carries in terms of, let's say, assets and liabilities. We will be discussing vertical analysis tool. But one of the things that is interesting is when you take a balance sheet of the company, and here I put the Mercedes balance sheet of the assets, the Kellogg's balance sheet assets. I normalize them into an Excel file and there's an extra file that comes with this course as well. I just put the percentage to show you that way of looking at, let's say, materiality is also looking at how big are various assets towards the total balance sheet. And if you look e.g. here, if I look at cash and cash equivalents, e.g. Mercedes has eight or at the time of the day, I think this is a 2020 or 2021 report. That's a Mercedes was carrying eight dot 1% of cash and cash equivalents in the balance sheet. Well, Kellogg's only had two dot four per cent receivable receivables from financial services, e.g. you see that Kellogg's has zero, but e.g. Mercedes is fine and seeing the purchase of the renting of cars to their customers. So you see that, well, 14, 9% of receivables from financial services is an important figure, that's material figure that's here are speaking about current assets. We're gonna be discussing this as 6. Fundamentals in Corporate Law & Consolidation: Alright, welcome back. Start of Chapter number two, where we will be discussing the main elements of corporate governance and in the bodies of corporate governance that I want you to be knowledgeable about without being an expert, will be discussing the company by itself as being a moral person. So that's the first lecture about corporate law and also consolidation because we have not discussed yet, but consolidation means, but also I think the three main bodies that you need to understand when looking at financial statements are shareholders, board of directors, and the role of the external statutory auditors. So we'll come to that during this chapter, before then in Chapter three, really going deep into looking at the balance sheet, e.g. and what is part of the balance sheet? Alright, so first things first, I think when we discussed about companies, I think it's essential to understand. Because you're looking at the financial statements of a company. Very often when you look at publicly listed companies, it's not one company that you're looking into, but as a complete universe of companies that are owned By the headquarters. This I think, and I don't want to be too much legal here. I'm not a legal expert, but that's the kind of thing that I have to deal with as well as understanding the fundamentals of corporate law. So basically, corporate law is often referred to as the company or company creation of company formation law. And there is a very good article from Harvard Business School is called the essential elements of corporate law. What is corporate law? That I really recommend you to read if you're interested in corporate law. But basically we consider five basic characteristics, characteristics of a business corporation. It's legal personality, limit liability, transferability of shares, delegated management on the board structure, the board of directors or board of managers, and also the investor ownership and the principle function, the principal role of corporate law is really to provide companies a legal form. And that legal form, and again, we will not go too much here, but that legal form, first of all, accompany acts as what? There's something I learned and read from this article. I believe that when you try to define a company, it's in fact a central point of contact to do business transactions. If it is selling products, buying services, subcontracting things, taking a loan, buying a building. So having the company being this legal, legal entity, the company has a form of a person, but not a physical person as you and me, but as a, what is called a moral person, but it acts basically a company acts as a moral person, as, as a center of a lot of business transactions. And obviously, corporate law not only deals with this, providing services to customers, buying things, buying products, buying services from subcontractors, taking a loan, and dealing with this with the company, but also corporate law has to deal with the launch phase of the company, the decline of bankruptcy of the company, the growth has a maturity phase of the company. So the corporate law also takes care of acquisitions, of restructuring, of insolvency, litigation's those kind of things. So it's a subset, let's say, of law in general. So you have this specific corporate law domain. And as already mentioned when we speak and we'll go through those five legal characteristics very quickly. It's important that, that indeed you understand that a company has legal personality. It's called a moral person or legal person versus a physical person in the eyes of the law, the company is a central point, is central connection point of contracts to customers where you are the supplier or the company is a supplier, also where you are the customer and you're buying from subcontractors. And the company. Then instead of having the senior managers sign the contracts directly on the behalf of the senior managers, on behalf of the physical persons with the subcontractors, with the customers. In fact, customers are signing the contract with the company as a counter parties, subcontractors are signing the contracts with the company as a counter party. I forgot to mention employees need I sit here in this slide, employees as well. I mean, they provide a service to accompany than not a subcontractor, but then on the customer, but they do provide a certain service and want to receive some money for it. I mean, it's not the senior management or the board of directors who will sign individual employee contracts. It will be the role of the legal person, of the company, of the moral person to act as this connection between a person and physical person. That is in fact providing a service to the company and the company will be the counterparty from a contractual perspective. This is really, the main contribution of corporate law, is really allowing the firm to act as a single contracting party. It does not mean that they will not be physical people signing on behalf of the company. We will discuss this in delegated management thing. But indeed, it gives really the company. Let's say a useful life and the company can engage in things with customers, suppliers, and employees. Also, another fundamental attributes of this legal personality is that it creates a like a frontier, like a border on the assets. The elements that the company owns, which are maybe have, maybe they have been brought in by shareholders or by credit told us, but they are owned by the company, which means that people, contractors, maybe customers, maybe suppliers may be employees. They may have some claims on those assets as well. Even tax authorities. So that's the kind of thing where even assets, if something physical, immaterial can be a trademark, is brought into the company, is transferred into the company. Maybe for cost, maybe not for free. That asset becomes part of the inventory of the company assets. So it is linked in terms of ownership to the moral person who does the company because it has been transferred, maybe from another moral person, from another physical person to the company. This is what is called separate bathroom. And you're going to be discussing this afternoon. We'll be discussing as well shielding principle. I will not go into the details here. I just picked up three countries and I'll let you read what the different types of companies most commonly used. If it isn't the US, we typically have limited liability company or the incorporation. In India, you have private limited company, public limited company, one person company, unlimited company in the UK typically have as well the private limited companies and public limited company, the PLC. So again, I will not go into the details of it. Just be aware that they are for various means that variant forms of companies and those various forms of companies come with different, let's say, way of functioning. And it will be discussing it around transferability of shares, those kind of thing. It's not part of this course, but I just want again to just give a small subset of elements that you know that the different types of companies that serve a specific purpose. I will then stop here. One concrete example. I was part of limited liability companies, but also of other companies that are in corporate companies. In a limited liability company, I was part of the board of managers. There isn't a board of directors In the principle is the same, but it was a fully privately owned company, incorporated company, independent of the number of external shareholders, they're currently I'm sitting attitude board of directors. So there are differences and the differences in the way that e.g. we will discuss transferability of shares, how shares can be freely transferred or not, those kind of things. We will discuss this later on. So one of the important elements as well when we discuss about corporate law is what is called entity shielding and more specifically, the priority rule and liquidation protection. And it will make it very simple here. You will see in the next chapter, in chapter number three, when I will walk you through the balance sheet, the main items of a balance sheet, that there is a certain order to it. And the reason for that, so not only the assets that e.g. sit in the company are owned by the company and no longer by the people who brought them in because it has been a transfer of ownership. But also, you may have if the company goes bankrupt, there are some things where external creditors, e.g. it may have a claim on the firm's assets prior to the claims of the firm owners, the company owners. So that's a priority rules. So in case of liquidation, Let's assume you need to pay back suppliers, employees, bank loans. And then at the very end of the day, shareholders, well, if the company goes bankrupt, well very probably forgot tax authority as well, which may have claims on the company assets were very probably first, there will be maybe suppliers, employees, tax authorities may be bank loans come afterwards and then you have maybe corporate obligation owners. And then last but not least, you will only have a firm owners. This I mean, there are some priority rules and you need to know them. And I will not say that they differ from one country to the other. But you need to understand that in a very summarized way. Credit toddlers will always come before shareholders. That's it. Full stop. We'll discuss a little bit depth instruments when we will discuss the balance sheet liability side. And you will see that even in credit TO loss. So that told us that even there's different, let's say way of looking at it is collateralized, unsecured debt that is brought in by shareholders. There also we have a priority rules in case of liquidation, e.g. we mentioned already authority. So as we said that corporate law gives an illegal body, gives the legal person to accompany moral person. It means that the company has the authority to buy and potentially sell assets. But there may be some rules. And sometimes we call it reserved matters where even the company management is not allowed to do without the approval of the shareholders, e.g. so there are things where the company may. So we will be discussing this one here. It'd be discussing one tier, two tier, both structures where e.g. in management is authorized to e.g. buy assets up to $10 million. After the $10 million, they have to be two signatures from the board of directors and beyond 100 million if the company goes into liquidation and tasks to be I have no clue. 75 per cent of the shower does it have to agree to the liquidation, e.g. a. Voluntary liquidation, we're speaking here. So you have reserved methods, reserve methods that management cannot do that go to the board of directors. And sometimes you have reserved matters that the board of directors cannot do that. They have to go to e.g. the shower done. Last but not least, of course, corporate law as well, brings an elements on how to take legal action against the company, e.g. if the company has been misbehaving, how to take legal action, civil legal action, commercial legal action against the company. So those kind of procedures a plaintiff elements are in fact, let's say, laid down as well in corporate law. Let's go into a case study and I want to speak about limited liability here and we'll be discussing about asset partitioning. So I'll give you the following example. Let's imagine that this could be me. You have a woman here that owns, is 100% private owner of a private real estate. Now the same time that woman is 20% shareholder of company a. And there are other, let's say, shoulder colleagues that own the other 80 per cent. There is an external, it could be a bank that has a 2 million claims. So the bank has given e.g. a 2 million loan with interest to the company a, and the company has a claim equivalent to 2 million on the company assets. Obviously. Now, imagine that company a is, the assets of the company are worth one dot 5 million and the real estates of this woman that we will call Karen is worth 1 million. And you're ready to hear the problem if there would be a liquidation, Let's imagine this and the company a would not go very well and there is liquidation. What happens to the fact that the external creditor, which could be a bank, has given a loan worth 2 million, but company a only has assets worth 1.5 million. And at the same time, Karen, who's a 20% shareholder, owns real estate that is worth 1 million. How does that come together? Here we come to the asset partitioning shielding mechanism between companies. So if the company would have to be liquidated. If, let's imagine there is only an external claim of one company, which is company. So this bank then has given these 2 million loan to company a. If the company a only has one, not 5 million of assets and it's able to sell those assets, transform them into cash. The company A's only able to pay back on that 5 million to the external the loan provider. Let's imagine it's the bank. The other half million. So the bank can not go after and cannot do a claim on the private assets of Charon, that's not possible. This is what is called the shilling mechanism, the asset partitioning. That's also one of the elements that of course, you need to be attentive to. That. I mean, specifically if you are being alone bring because this happens also in private equity that e.g. you have a friend. That friend is saying, yeah, I mean, maybe you're called Richard. Richard. I have this company. I want to set up a shop for organic juices, orange juices. I have no clue. I want to bring in I mean, this is my business plan. Are you willing to bring in 1 million and this will be adapt. And a half that half, you're going to own 50% of the company and the other half, 500,000 will be put as adapt here so that you are in the parameter. Will you come first when the company goes bankrupt? I mean, even though it's your friends and your friend has a 10 million real estate, you cannot claim. If you have lost money on the company, on, on your friends real estate, if that is privately owned. So here of course, just be attentive and this is where we will not go too far into it. But you may have collateral, Collateralized depths. You may say, No, I will not bring in 1 million because there is a two high-risk for me. I want to have maybe more depth versus equity. I want to have a claim on your real estate, so I want you to bring in part of your real estate into the company assets as well, just to protect myself as a lone bring on. So that's the kind of thing when companies are incorporated so that when they are launched, when they are growing, where you need to be attentive to on this Shiley mechanism as it partitioning. And I've been using already for a couple of lectures the term of shareholder and what I mean, why are we discussing about chairs? And sometimes I'm not saying mixing up, but I'm using either shareholder, equity holder as the same term, which is true in fact, sometimes as referred to in the slide, even the term stockholder is being used. So basically, those three terms are the same. Shareholder stockholder equity are the same. What is the share? Share basic? I mean, remember that companies are created by either people or other companies bringing in capitals. Capitals can be brought in through cash, can be brought in also through physical assets. You bring a car into the company to start a taxi service. E.g. capitals can be brought in as well as through bank loan, e.g. when we speak about we're not speaking about external credit toddlers that come first. The priority will define corporate law. But we're speaking about equity holders or the people that are the capital owners of the entity. We often use a term of shares. And shares in fact, are a unit of capital that cannot be further divided. That defines what expresses ownership relationship between the company and this external person. If you're a Kellogg shareholder, even if you own one share, you own one share, which is maybe very privileged minimum percentage, but you own a little bit of Kellogg's. So you are part, you actually own a part of that company. And when we split our share capital, that's really the sum of all the shares that exist when we speak about shareholder. Well, that's a person, either a physical person on now you know what the moral person is. That in fact, is considered a legal owner of a part of the totality of the capital of a corporation. And you can also refer to shareholders or stockholders, equity holders. Now, you remember that we said that a company has its own legal personality and corporate law deals with the lounge, the growth and maturity and decline, and even the liquidation phase of this moral person. And there are a couple of problems that come up when we speak about shares. Is that first of all, the company needs to know at any moment in time who are the shareholders of the company. So there is a requirement by law to have at least a private register that is being managed by the company about WHO other shareholders. Because as I said earlier, you may have decisions that require 75% approval from the shareholders. If you don't know who your shareholders are, that's very problematic and you may be in compliance with law. So this is what we will discuss later on the shared register. But the first thing is the company has to keep up-to-date or share register of the company shareholders. The second thing that is expected by corporate law as well is that even if one of the shareholder dies, the company needs to continue its operation even if ownership changes. And this, I mean, I know when I was at Microsoft, I had one of our German partners are very unfortunate events where our Microsoft partner, the, the founder who was 100% shareholder, died, unfortunately at a young age. But the company needs to survive such an event. Obviously, what happens with the ownership of the company while automatically it will be transferred to, in this case, either the wife or the children of the shareholder. But the company continues to operate. It's not because the main shareholder has died, that the company stops its operation. That's also from an, a specific, let's say shielding perspective. You have the fact that corporate law, let's say, has laid down the foundation that accompany continues to work, even if e.g. there are changes in ownership. As already said on the first problem, there has to be a shoulder registry and somebody defined as being the registrar. So the owner of the registry, either it's kept in-house, but you can also outsource, outsource this. And I'm giving the example of the most known for publicly listed companies, share registrar, which is in fact a computer shirt, which is an Australian company. They're actually even listed on the stock exchange. They haven't founded in Melbourne in 1978. And they are one of the most famous share registrars in the world because a lot of, a lot of the companies, I mean, when you look at You remember in one of the previous lecture that it was giving the example of Kellogg's with 420 million plus shares. You're going to have changes every day in those shares. So what you don't want, maybe because maybe you as a company, It's not your core business. Even though you have a legal obligation to keep this share registry, you're going to ask, in fact, somebody professional in maintaining all the daily fluctuations in show leadership changes. Then the second problem, which is about the company needs to continue its business even if owner, if owner has changed, including potentially for owners die. So this implies some extent the transferability of shares in ownership as well. We'll not go too much into the details of it, but here we have also between limited or privately owned companies and publicly listed companies. You have elements of freely tradable shares. I mean, if I want to buy a share of Coca-Cola this afternoon on the US market. I don't need to ask other shareholders if they allow me to buy a share. So those shares are freely tradable. But maybe in limited liability companies are in privately owned. Incorporates its companies where maybe there is a shareholder agreement that is only known to the shareholders. Which says that, let's imagine there are two Shao allows a more shallow wants to exit, that there are some rules that this willing to exit Sheldon has to follow and this is laid down in the shareholder agreements. And one of the examples, one of the rules could be that this second shoulder that wants to exit. And let's imagine it's 5050 situation that this extra, that this shareholder wants to exit the company who owns 50 per cent county of the company? Can I just sell the shares of the company to anybody? There is maybe a first rule that says that he or she has to go first to the other party, that ON 50 per cent that will send the company. And maybe they have already in the shell agreement laid down a price in terms of if the first shareholder has the money, that's this shareholder, he or she may be able to buy the second 50 per cent at a specific price. So we have in terms of the has to be transferability elements that are laid down by, by law related to the transferability of shares. But you may have differences between privately owned companies and public listed companies and publicly listed companies. I mean, very probably, except we have class a, class B shares of preferred and common shares, but a family owned shares. And we will discuss it later on that the voting rights are different vessels come and shares. But normally, those shares are freely tradable for publicly listed companies. For privately owned companies will be very probably have to deal with the Shareholder Agreement with elements. Typically, when we're speaking about startups, right of first refusal around the first offer, fund or rather first offer, etcetera, etcetera. So those are things that indeed will be laid down in a shareholder agreements, even for private companies. They may also use for publicly listed companies to some extent. But again, you may have companies that say 80 per cent of our shares are owned by a single Cheryl and 20 per cent of freely tradable. So one of the rise of the remaining 20 per cent shower or so can they vote because they're always minority shareholders. So that's the kind of thing that are laid down as well through there. Even actually different types of shell agreements will not go into the detail here. So just be aware of that. My asked to you here is, well, as we have understood now that the company has a moral person, but you have companies that are publicly listed and other companies that are privately owned, where transferability of shares may be less liquid than freely tradable shares on New York Stock Exchange, Frankfurt, DAX, Euronext, etc. Try to think and maybe pause the video here and give examples of public versus private corporations. And so if you resume the video, I'm gonna give you now myself examples. If you look at public companies, I mean, you dummy, which is one of the patterns where I'm publishing my courses. They are, they are public listed company, Kellogg's is publicly listed company, US company, nestle, the Swiss multinational around foods, etc. There are public lists, but you have private companies. Example, Skillshare is also one of the platforms on publishing my courses. They have not gone public yet. Ferrero, which is a candy provider. They, I mean, they provide chocolate, those kind of things there and sweets. I mean, they are still owned, I don't know the exact percentage, but they are largely owned by an Italian family. There is called Ferraro See's Candies, which is also a Swedish provider, could be a potential competitor in the US or Ferrero. They are fully owned by Berkshire Hathaway. They are not publicly listed. So again, just keep in mind also the difference between publicly listed companies and privately listed companies. Now, when we discuss about this, and again, it's not the matter And it's not the purpose of doing now illegal course, but there is one very important elements. I have to introduce the element of moral personality. I had to, to bring in the element of segregation of assets, the partitioning of assets or how assets are shielded when they are owned by the corporation vs. Individuals. But one of the elements, which is an element of risk when reading financial statements that you need to be aware of and need to be a minimum fluid is minimum. Fluent in is the element of consolidation and non consolidation. And I will explain this. You may remember that when I was showing you the first financial statements of Mercedes of Kellogg's, you had this consolidated balance sheet are consolidated statement of financial position for IFRS Mercedes, you had consolidated statement of cash flow, consolidated income statement? I did not explain. I said please stay with me. I will not at that moment explain. It was more important to discuss what is balanced but isn't income statement is the cashflow statement and then the other ones, equity statement and comprehensive income or other comprehensive income. But conservation is something very important and I will give you after it's through the example of Enron, also a very clear example of, let's say, fraud that happens. So when we speak about preparing financial statements, one of the elements that is clear is that, well, when you look at the example of Unilever, Unilever's multinational, they not only, they're not just one legal entity, they own many, many, many different legal entities. And this creates complexity. I will not speak but FTX, but FTX has been, let's say, complex transactions elements between who was shown of FTX and what went into Alameda Research. And if you just look at the amount of companies that were in the universe of fdx. I mean, this this rings my alarm bells already. But the fact is that you have situations where you need to incorporate companies locally in order to be able to sell. And if you look at food industry, that's very often the case. Because if you're selling food in Argentina, you may need, and again, I will not go into corporate law and commercial law here, but you may need a license to sell food to Argentina and consumers, e.g. here. For that, you need to have a local company which may be a subsidiary of Unilever. But you need to incorporate that company in Argentina, right? Because also then potentially the Argentinian government has tax claims on that company because that company is charging VAT, is claiming VAT. Lets say two customers from suppliers. So it's normal that big multinationals have various legal entities, specifically in the various geographies that they're operating in. And this is what where you need to understand the elements of consolidation. So here again, the Mercedes example, consolidated financial income and cash flow. And this is important because in fact, not all investments, not all subsidiaries or 100% owns. When we speak about, let's take the example of multinationals. Their specific roles in China. That I'm not a China specialist, but I certainly in time in order to be able to operate the business in China, you could only be, was it 49 of 50 per cent owner of the company in China, the other 50 per cent hair to be owned by a local company of person. I have this situation of one company in Dubai where I'm involved in where for that, for that specific business, there has to be 50, 1% Sorry. There has to be 51% owner of Dubai, citizen of Dubai that owns that company and a foreign person cannot own more than 50, 51% of more than 49% in fact, of the company. So there are some times a, the legal obligations are, there are some very good reasons, e.g. that, let's imagine Kellogg's and I have no clue Ferrero wanna do a joint venture and they do 5050 joint venture just to protect the interests of both parties. So not all investments are 100% owned now, and that's the problem. How will this be reflected? Because you want to read one financial statement. Let's imagine that you're looking at the company who has 172 subsidiaries. I mean, seriously, you don't have the time to read 172 different financial statements. What you're expecting from management, from auditor's is that you've got a summarized view at headquarters level of what those 172 subsidiaries with some that maybe are not 100% 0 and represent from a financial position perspective. This is why you need to understand the consolidation methods and this is part of the vocabulary as well of financial statements. So basically there are four ways of consolidating companies into financial statement, into the balance sheet. E.g. you have Ada, the company is fully consolidated because you own the company 100 per cent. So the cash account of the subsidiary can flow into the casual count of the headquarters, e.g. you don't need to make a difference there. But you might have situations where the company is not fully owns. So you may have your own. I mean, I had those situations also with Microsoft partners and Luxembourg where they bought another IT company. And the first three years the new shell only bought, let's say, 80 per cent of the company and 20 per cent was still owned by the founders of the company. And after three years then, they had an agreement that after three years, if everything was fine, the founder could exit and then sell the remaining 20 per cent. But during the first three years, how do we report those 80 per cent of ownership? While you can in fact consolidate, because you own more than 50 per cent, you can consolidate the whole company into your balance sheet, but you will need to report what is called non-controlling interests. Those are in fact external shareholders. And you need to give to them, of course, are certain amount of the profits. Because if that subsidiary is making 1 million profits and you only own 80 per cent of that. And you have decided to distribute that profit to all shareholders. Well, 20% of that 1 million has to flow back to the minority shares of 20 per cent, then you have the equity method, Consolidation method. That's typically when you own 20-50%. So you're a minority shareholder, but still you're a substantial minority shareholder, then you carry at cost of potentially fair evaluation. We're going to discuss later on, where you own less than 20 per cent of the company. Alright, so what does consolidate it mean is, as already said, when you are in fact the when it is sorry, I forgot to say when it is fully consolidated, 100 per cent owns. I mean, there is no conversation about it. You fully consolidate everything into your various categories. Accounting when it is more than 50%, but less than 100%, you can still consolidate. But do we need at a certain point in time to reflect the remaining shareholders who are not part of the parent company. Examples here, if you look at Kellogg's and I'm showing this here, you have a part of the income and a part of the equity that is in fact not owned by Kellogg's. So how does this show up in a consolidated balance sheet and the consolidated statement of income, first of all, in the consolidated balance sheet, you see a line that is called non-controlling interests. So those are external shareholders that in fact, Kellogg's does not own. And they have indeed to report. That's part of the consolidated balance sheet, is in fact not fully owned by Kellogg's. The same is e.g. if you look at the consolidated statement of income, so the earnings statements, you see that in 2020 they had this is in millions of US dollars. So from the total income, $13 million were, was in fact income that was flowing back that was assignable are attributable to non-controlling interests. This is basically what it means. It's not more complex than that, but when you are not used reading financial statements and you see it is like, what is this non-controlling interest thing and why is there between net income? Why there is Lambda is called net income attributable to non-controlling interests, and then that amount is deducted. The net income that remains for common shareholders. Well, it's because part of the profit is going to people where you do not own 100 per cent of their entity, but you have fully consolidated the entity in your financial statements because you are allowed to do this more than 50%, then you have the other methods, which is the equity method, as I said, is like 22, 50 per cent and the cost method, What is less than 20%? Then you have here as well in the Mercedes one, you have the equity method investment weight cases that this is an equity method investments. You have even the mix in the Mercedes balance sheet where you have part of the balance sheet. That is, you have investments that are carried with the equity method, 20-50% ownership have non-controlling interests, which means that there are probably subsidiaries that are owned by Mercedes at more than 50 per cent. They are fully consolidate or they are consolidated in the balance sheet. But the residual plot has been, has to be declared as non-controlling interests. Then of course, I mean, they have the companies, they have to report when they speak about consolidation. What are the entities here? I took the example of Mercedes. You see indeed that Mercedes has 381 consolidated subsidiaries, 82 unconsolidated subsidiaries. They have companies that are associated, accounted for using the equity method. They have some joint, joint ventures that are accounted for at the cost methods. And in total they have 528 legal entities. Of those 528, only 381 or consolidated subsidiaries. All the rest is, let's say, reported a lot through the equity equity or the cost method. Obviously, this creates complexity, right? Yes. And I promised you this creates complexity, but remember that there are some good reasons for it. Maybe imagine here for the joint ventures that Mercedes has a research project with BMW and it's 5050 investments. Well, I mean, they can consolidate the activity of that company, but obviously a very probably the company is a small company, so it doesn't have a material, we're coming back to materiality does not have a material impact on the consolidated balance sheets. So that's the kind of thing that you need to be aware when you're looking at financial statements is that what does consolidate it mean and consolidate it? You need to understand the differences between the four consolidation methods of fully consolidated, 100% consolidated with non-controlling interests. That's above 50. Equity method, 20 to 50% and cost method when it is below 20% of it will be discussing fair valuation when there is a level one fibrillation possibility. Continuing in the example because you need to practice your eye. You see here that in the consolidated subsidiaries they're providing a list and you see the percentage of ownership by Mercedes, e.g. there is one company in Turkey where they own 66%, 91% they allowed to consolidate it, but this will create a non-controlling interests. They have Mercedes China where they went 75% and 5% is owned by somebody else. That will create a non-controlling interests line in the balance sheet and also in the income statement. Because 25% of the profits of merciless China will probably, if they are distributed, we'll go back to the Chinese shareholder. I assume it's a Chinese shower behind this, but it's only 25% of the Chinese. Let's assume that the Chinese market, but they have some many businesses at the very end of those 25 per cent on the consolidated scope maybe only represent one to 2% of the income. This is what you were seeing with Kellogg's where from the full net income, only 13 million. We're going back to people where Kellogg's is not earning 100 per cent of those entities. Mercedes and listening is listening as we 7. Shareholders: Welcome back. In this lecture we are discussing what shareholders are. In fact, when we speak about Charles, you already, you may remember that we discussed about we defined what a Sherry's, which is this on-device portion of companies capital. And I'm giving you an example what I mean today's shares that are traded in electronic way. But many years ago when you were a shareholder, you were receiving this certificate. I've put an example of a Facebook certificate award, business certificate and Netflix dummy certificates. But today, I mean, as the, let's say the holding period of shares is actually a couple of minutes. I mean, not for me as a value investor. I mean, I do have a company that I keep for many years in my portfolio, like Warren Buffett's. But most of the people are trading shares. So the cost of printing those certificates, sending the certificates, the moment the certificate Kate, has reached your your postal office, your postal mail, your home address. You already maybe have sold it if you're a trader, speculator, I'm not speaking about serious investors here or value investors at least. But as I said already in lecture goes like even if you own one singular share of Kellogg's, you own one share represents a certain very small percentage, but you own part of the Kellogg's company. And so when we speak about shareholder ship. So being shareholder, there are two key elements that come that are linked to the ownership of a firm, which is the first one is the right to control the firm. Which basically is giving an, I'm putting this as a general principle, is giving voting rights to who represents you at the board of directors are part of managers if it's a limited liability company and also potentially reserve matters that you don't even delegate to the board of directors that require the necessary, let's say, percentage of approval of the shareholders. Well, that's what's shoulder ship comes with. Is this in the ownership of a firm? Not you have first of all, a right to control the firm and this is why you have him for publicly listed companies, you have those annual shareholder meetings where some elements like what is the amount of dividends that will be paid out to shareholders? Election of new board of director members. I mean, this has to go on the go vote of the annual shareholder meeting with probably a certain percentage or certain quorum of votes that have to be there. Second element that comes with the ownership of a firm is that you have a claim on the profits of the company. We're not speaking here about liquidation and the residual claim if all credit holders have been paid off. I really mean here, if the company is generating profits, you have a right to receive a parts proportionate to your percentage, very probably a part of those profits. And this can be done under the form of a cash dividend, e.g. but it's not the only way it can be share buybacks as well. Again, it's not part of this course, but that's the kind of thing where those two key elements linked to the ownership or they come with the ownership of a firm. So being a shareholder is, I mean gives you those riots. And if they are reserved methods like things that have to be voted at the annual shareholder meeting on the profits. I mean, managing will come with a proposal, but you may disagree as shell of a company. Of course, if you only own one share of 520 million shares in Kellogg's, I mean, you're single vote will not push the needle obviously. But if you own 25% of the votes and for very specific decisions, the shell agreement says that 100 per cent unanimity has to be found on a specific decision. You could block e.g. such a decision and maybe you need to find a consensus with the other shareholders. So typically, it's always like this, but typically the amount of power is proportional to the amount of capital that you have contributed to. So if you own 1% of the company, you typically have 1% of, let's say, control rights of earning rights. But it's not always the same. And I'll give you examples with various type of shack classes. So in some companies, when happens is that for whatever reason maybe the founders have decided to create two classes of shares, class a, class B, you also often hear the term preferred versus common shares. It may happen as well. That's shower loss. And I was giving the example of when you were speaking about the shielding and the partitioning of assets that e.g. an investor does not want to bring in everything as a shareholder. But on the 1 million Hoffman who will sit as depth because there's this priority rule. In case of liquidation, the debt holders will be paid first before the shareholders. And maybe the other half million, that is Berlin will be brought in as capitals. So we have also. The mechanisms where e.g. shareholders bring in money by either a pure depth vehicle, but also convertible debt in the sense that they can decide the rules associated to it. A specific process, specific threshold, specific events where the shareholder who has brought in half million as depth convertible into shares and half million directly as equity as shares may have the right to convert the other half million or 20 per cent of that into shares, which will change then the ownership, the equity ownership of the company, again, is not the purpose of going into depth into that, but that's the kind of thing that can happen when we speak about shares and shareholders? Well, there are some main questions that you need to think linked to the elements of control and or receiving part of the profits of the company. So when you are creating a company or when your shoulder, you need to think about, do I have one single class of shares? And everybody has the same amount of voting rights depending on the percentage they own. How much shares as am I creating? Because if I'm a startup and I'm thinking about IPO ing. So going public in ten years. I mean, I cannot start a company with ten shares because it will be very complex to bring in excellent investors. How much control I am giving, maybe I, I'm better off creating, let's say for the first five years, two types of shares. One share that has voting rights and the other is giving a percentage of profits. But those guys and those guys don't have voting rights because I'm the founder. I want to have full ownership on the decisions that I'm taking. And also how much from the profit that the company has generated. How much are we giving in terms of profit back to the shareholders versus maybe reinvesting the money into the business, e.g. and buying new assets, e.g. so those are fundamental question that shareholders have to think about. What is often forgotten and even when I meant or startups, even when you have companies that are doing Series a, series B, etc. Or at least people that are external to this. They believe that all the things that can happen to company are ruled by the articles of constitution. So basically the articles of constitution or the articles that have given legal personality to the companies that have created a moral person. Indeed, the articles of constitution, let's say, contain a lot of elements that explain things that are linked to the life of the company. But there may be things that's because the articles of constitution have to be published. There is a cost for publishing the articles of constitution in most of the countries. And this is legal process. And you may potentially don't want as a shareholder, each time you have a shadow that's changes, or you want to change something new. That each time you need to incur a cost for publishing the articles of constitution. But there are elements where you need to modify the articles of constitution, of course as well. But the articles e.g. when the company has minority shareholders and how voting rights work, how, what happens when minority shows want to share, to sell their shares? I mean, those are things that will not be stated in Article IV constitution. And you will have this in a separate private document that is called a shareholder agreement. There is no legal requirement to have those shareholder agreements, and there is no one, there is no silver bullets or one size fits all agreement. But the typical provisions, typical attributes of those shared agreements are how profits are shared. The voting rights to liquidation rights through those famous reserve methods, as I call them. E.g. when a series a, you're bringing in a new shareholder and the size of the board of directors. And if you're bringing in 20 per cent, well, that new shareholder may require that initial agreement. It stated that as long as he or she as new shareholder has 20% ownership from the three directors. One, even though 20 per cent is not one-third, but one of the directors of the boat is from these new shareholder. That's something that will not be written down in the articles of the constitution. That's something that will be put very probably in a shareholder agreement in writing that will be considered as legal document that is not public, but that is signed by all involved parties. Imagine to found us plus a new series, a investor e.g. again, I'm just showing here a couple of examples like the board composition, that's typical things that you haven't shared agreements, e.g. the quorum, what is the amount of percentage that has to be in favor of rescission to pass that decision. So here's an example where it says 70 per cent, e.g. you may have reserved methods to the shareholders where you need to have this 70% voting. Let's say equivalent courtroom to make any fundamental change the nature of the business of the company, e.g. to liquidate the company. That's something that shareholders senior management cannot do. And that's typically written down in the shallow agreement. And this is what is called reserve methods. So you have on those reserve manners to make it clear and simple. You have things that shower that delegate to the board of directors will be discussing this and things that the board of directors delegate to senior management. Otherwise, senior management cannot operate the company without each time going back to the board of directors. Board of directors represents the shareholders. That's the role of the board of directors. And we will be discussing this in the upcoming lectures as well. So basically you have in this three actors, in those three bodies, senior management board of directors and shareholders. You have reserve matters for the board of directors and management cannot do. We have reserved matters that are very probably written down in written down in a shell agreement that board of directors cannot do without the approval of certain percentage, maybe 100% of the shareholders. Keep this in mind in the way how companies function. As already gave the example. You may have different type of shares as well. And if you're investing or if you're analyzing a company, I mean, you need to understand that. We need to understand first of all, why company has different type of shares and what is the impact on the way how the company is governed and potentially if that is positive or negative for you. So when you speak about types of shares or categories of shares, you have this, I mean, the obvious one is the ordinary or common shares where one votes are typically one share carries one vote and the percentage of votes is proportional to the percentage of shares that are owned by the various shareholders. We have preferred shares. Mercedes knows not to have, but I have a friend of mine or my best friend has BMW as shareholder. And BMW has two types of shares, preferred and common shares. The preferred shares get a little bit premium on the dividends, but the preferred shares don't carry any voting rights. I will not criticize BMW. But when you own one share, two shares of BMW, You will not change the outcome of a annual shareholder meeting vote. So what BMW basically says, you can agree or disagree with this. We're gonna give a small premium on top of the typical common shared dividends to the preferred share. Holders are arenas, but they will not vote. They're not buying the silence of those shareholders. Some people would argue yet they are buying the signs of the shadows. I'm saying no, but I understand the point. If you're very small shareholder, you will not push the needle on a very important decision at the annual shareholder meeting. Alright? So you have those preferred shares that sometimes don't carry voting rights. We have indeed non-voting shares, that's very explicit. The preferred shares typically carry dividend plus non voting rights. But you may have shares that don't have nonvoting rights and that's basically it. They may be issued e.g. to employees to pay for remuneration. You may have redeemable, redeemable shares. So those are shares that are issued on terms that company will buy them back at a future date. E.g. we have shares that are specific for management e.g. and they can give confirmed Vector Management much more voting power. So let's imagine that there are 100 shares in the company, ten shares or for management and the other 94, I don't know, external investors, the company may have structured the ten management chairs that they have. One chair has ten times the voting power of the other. 90 shares, equivalent. So you end up in, even though only 10% of the shares are owned by management and 90% of the shares owned by excellent investors. Those ten per cent have in fact, a power equivalent to 100s versus the 90 only have a power equivalent to 90. So at the very end of the day, with such a set of a management chairs, management has more than 50% voting power at e.g. annual shareholder meeting. And then potential, of course, setting up the board of directors with the amount of seats. There is e.g. five seats in a 100 to 90 situation. Very probably management is saying, I want to have three people of the five sitting at the board of directors and the other two can be other from the 90 Representative independent directors. And the example, I mean, we do have this for alphabet e.g. so the former Google, they do have, and I'm showing this here. They have in fact, three classes of shares have class a, class B, and class C. If you look at the amount of total equity, and I will look into the latest ten q reports of I think it was q43 2022 doesn't matter. At that time they had 5.9 billion shares plus a six dots, 086000000000 of shares class C and 884 million shares of Class B, the voting rights. So that's the graph on the right-hand side below the class C, zero voting rights, That's non-voting shares Class V. This is why you see those. Very probably management shares 884, which is compared to the four or 59 billion, is like, I mean, this is like a sixth, a fifth, more or less, more like a sixth. Seventh of the class a amounts. But they have 5096 per cent of voting rights and cluster a have 44. So the residual amounts. And so those setups, they really exist. So alphabet decided that the people, probably the founders management, who owned the Class B shares, they don't want to leave. At the proportionate level, the voting rights, the class a share, owners or shareholders. You can agree or disagree to this. And I would say, if you agree, fine, you know how this goes. And tomorrow, you may be exposed to decisions where you disagree because 60% of 1,506% of the voting rights in the hands of people that you do not own an even as a class a and you earn, you have five times more class Asia as well as the Class B shares amount. You cannot do anything about it. And if you disagree, well then either you don't buy the company and you exit the company. That's basically this is how it works. Really small, I invested into very small Swiss luxury group. In fact, they are owned by a South African family. And they have very, very strong luxury brands in diamonds, in watches, et cetera, in fashion. And they are in fact, again the same scheme. Reshma does have. Class a and Class B shares. Cluster Asia as represent more than 90% of the equity. Class B shares represent less than 10% of the equity. But Class B shares owned by the Reshma family and faith not the rich more families don't remember the name of the South African family. My apologies for that. But there is there isn't a name to that. To the family, of course. And they still own 50% of the company, even though they own less than ten per cent of the total shares. And the class a shareholders in there, they represent more than 90% of the equity. In terms of voting rights they only have, or they have exactly 50 per cent. Is this good or bad? I can tell you, at least from my experience, I Robot families, I see it now. It's a robot family That's the owners, the family that is behind Reshma. I'm not saying it's bad because normally, family owned businesses normally are run in a very prudent way, much more prudent than businesses where the founders are no longer there and the current senior management doesn't have a counterbalance from, let's say, founding members of the family that owns a business and you have a couple of those family owned and family run businesses where you may disagree that there is this, this balance between the amount of shares representing percentage of equity versus the voting rights. But that's the reality. So again, if it is, if you're an investor and you investing into private company, a public company, I mean, those are the kind of things you need to be aware of. I mean, they they mentioned it in the financial report. This is not hidden from investors. But let a lot of people don't look at this, they overlook those things. And maybe I'm giving the example of BMW. You're not interested in having any kind of voting, right? Because you will never vote and you will never go to an annual shareholder meeting in Munich where those typical BMW annual shareholder meetings take place. So maybe your goods with a preferred share and you don't care about a common share. But at least what I've seen running webinars teaching people. Some people don't understand what's the difference between a common and preferred share. And then I'm not saying that preferred shares are always our cash dividend carrying and non voting rights carrying shares. But people don't read, they don't understand what they are buying. And through that they create, are they expose themselves to unnecessary risk? And that's the purpose as well of teaching you. Hopefully, I hope that it's positive for you, but teaching you to understand why companies have different types of shares and what is the right type of share that you want to invest into? Because there may be attributes with class a, class B, class C, class D shares that better feature investments. So just be aware of that. Because you may be a Class B shareholder which has different trials than a class a shareholder. That's what I wanted to share with you in this lecture. In the next lecture, we will be discussing the role of the board of directors. You already understood, I mean, already alike made a summary of it between management as a governance body, the board of directors as bad as governance body representing the shoulders and childless with reserve matters that may only be voted by a certain amount or an unanimous decision by the shareholders or even the board of directors cannot decide. So we will be discussing in the next lecture the role of the board of directors and how this works. A one-tail versus two-tier board of directors. So talk to you in the next lecture. Thank you. 8. Board of Directors: Welcome back. In this lecture, we are discussing, in fact, the board of directors. We're not discussing board of managers that's considered Board of Managers for limited liability companies similar to Board of Directors, more or less, we'll speak about board of directors. And the purpose of this lecture is really to, let's say, make a knowledgeable about what you can expect from them, but other actors, why they are there, what's the difference? 13-2 tier board of directors. So corporate law, coming back to the legal personality, you may remember or sorry, to the five attributes that come with corporate law link to companies we discussed the first one being legal personality. Limited liability is the transferability of shares if there are changes in ownership of the shareholders or if Charlotte's e.g. even die. One of the five fundamental attributes that corporate law lays down is really the delegated management on the board structure. And typically when we were speaking about authority, you understood in the previous lecture the authority of shareholders. They have a right to control the firm and they have a ride on a claim on the profits of the company. When you think about delegated management, the authority is basically that when you are a shareholder, even you or me, we are selling BMW, Mercedes, Kellogg's. We're not involved in daily operations. We are delegating this as shareholders to management's. Very often what people don't understand is that we're not speaking about management here, but we are delegating the management of the company to a body that takes care of the corporate affairs of the company, which is represented by the board of directors. We will speak about management senior management CEO, CFO later on in couple of minutes. So shareholders, typically, when they don't want to run the company, they lacked a select directors that represent them at the board of directors or board of managers. This is how management is delegated from the shareholders into the company by this body. Sometimes it's also called a supervisory body, a supervisory non-executive buddy. Board of directors is a corporate governance structure that carries a couple of attributes. And one of the attributes or was very discussing in the first lecture, in the previous lecture, sorry, is that in a typical company you have three, let's say body is around corporate governance. You have shareholders. You have the delegated management of the shareholders to a board of directors or board of managers. And you have some times the board of directors that delegate daily operational tasks to senior management or to management. So we have those three bodies. And we already discussed in the previous lecture, when we discussed them transferability of shares. That there may be reserved matters that shareholders don't want to delegate to board of directors. And there may be a reserved method of the board of directors does not want to delegate to the lead managers of the company. Sometimes this is written down, my apologies for reserve methods between shareholders and board of directors in the reserve methods of shareholder agreement as an example, or even between shareholders. And you have e.g. between Board of Directors and senior management, you have something that is called delegation of authority matrix, where you can say management is allowed to do via trends up to 1 million e.g. US dollars or euros e.g. above that, or buying a car, buying a building, signing a contract that engages the company for more than ten years, more than 50 million. This is a reserve matter that we don't want CEO CFO to sign. They have to come to the board of directors. If the shareholders, of course, agree to that. The board of directors carries, when you think about the board of directors. So this body in the middle carries four basic, let's say, attributes, characteristics. The first one is a separation from company's operation managers normally, and I will be discussing cultural difference between US companies and European companies. Typically, people sitting at the board of directors don't run the company. This is when we speak about a two tiered model, another one tier model. And please stay with me, I think in the next slide on the upcoming slides, we will be discussing about it. Board of directors are elected by the shareholders, typically not coming back to the representation of the shower. If it is proportional to the percentage of shower ship or e.g. if there's a series, a investor coming in and they negotiate, even though they only 10% or 20% owner, they negotiate one of the three seats at the board of directors level. So that's something that is, as I said earlier in previous lecture, that is managed by the shareholder agreements. They normally board of directors, they shouldn't, they shall not, they should differ from the company owners. It's not always the case since be very fair. It happens that the shoulder sits as well in the board of directors because you have these four founders. Where the founder continuous to he or she wants to have a say on matters that are reserved for the board of directors and doesn't only want to sit there as a shell for reserve methods that only limited to shallow agreements decision. Typically, a board has multiple members. I mean, it doesn't make sense of board of directors if it is for having to found a sitting them to follow us have 5050, that doesn't make sense. But typically you create a board of directors to have complimentary skills, complimentary competencies, where I'm sitting at the board of directors without any arrogance. I believe that I have my expertise, which is more digital, which is more obviously financial statements, which is more cybersecurity. Operation risk management strategy is something that every or any board of director carries in my opinion. But you have e.g. I'm not the expert on sustainability. I'm not the expert on human resources, on compensation plans so that we have other people that are very good in that. Obviously, having a strong board supports the shareholders. Because the shareholders elect people into the board that bring in scales that today do not exist in the company and also the shoulder does not have. This creates, of course, strength and various opinions and perspectives on things. So coming back to this 33 body governance things. So management, board of directors and shareholders. I going to structure here, I'm going to split the balance sheet into, to bring here in the scheme on this slide, you see that we have the equity, shareholders and creditors, the ones that are bringing in capital into the company. Let capital typically is transformed into assets that generate profits, right? So typically, the company is only owned by the equity holders, the ones that bring in equity. The credit told us don't have a claim on the profits on the company, but they have a claim on the liquidation order of the assets of the company will go bankrupt, e.g. so remember this priority would, that was part of, let's say, how corporate law looks at credit told us are external credit told us loan bring us e.g. versus equity holders. So credit told us have a claim on the assets if there's liquidation and they can be for shareholders, are the owners of the firm, equity, and creditors don't have a claim on the profits. Equity holders have a claim on the profits and they have a claim on liquid on the residual liquidation of the assets of the company if all the creditors have been paid off, this is how it works. The typical cycle is that capitalist brought in by credit told us equity holders and is transformed into assets and hopefully generate profits. Typically, shareholders not credit told us, credit tunnels don't appoint anybody to the supervisory, but that's not how it works. Shareholders, so the equity holders, so the stockholders, they appoint people to the board of managers, of board of directors. So to the supervisory boards. And the intention here I'm ready bringing in a notion of two-tier governance model is that Board of Directors appoints senior management CEO, CFO, Chief HR Officer, Chief Revenue Officer, etc, chief marketing officer, etc. And the board of directors has a responsibility on behalf of the shareholders to hire and fire those people and also evaluate the performance, determined the compensation incentive schemes of senior management. And now I have to bring in this one here at versus two-tier governance model. It's true that when you look at companies in the US versus Europe, probability versus publicly owned companies that there are discrepancies. There are some things that are linked to culture. We always wanted like this. I'm not saying that one model or the other is good or bad. I will just share my honest opinion how I look at one-tail versus two-tail governance models. Once your model is that CEO and CFO are sitting at the board of directors. As executive directors, they have voting rights at the board of directors. This is typical American, this is what is called the unified board. But you have very senior management people that sit with the independent non-executive directors at the board of directors. And I will give you examples in a couple of minutes. In Europe, very often you have to check governance models where we clearly make a separation between, I'm saying we because I'm European, first of all, where even the chairman cannot be the CEO in the US, you see companies and with all due respect for Microsoft today, microsoft, such an Angela, if I'm not mistaken, is the chairman of Microsoft, of the board of directors at the same time he is CEO. I mean, you can argue. That is good or bad. I don't like it. I believe that Chairman has to have an independent role of the CEO of the company, but that's me. Who am I to say this? I probably don't have 1000000th of a competence of such an umbrella, but I don't like that very often. A very, very honestly, I like that there was a clear separation between executive managers of the company that are sitting in senior management and the board of directors is separate and is look with a chairman is separates. He or she. And the board of directors is supervising what executive management is doing and not having executive management sitting at the board of directors. Executive management may sit us for information purposes, for observation purposes at the board of directors, but they should not have voting rights to the book of Acts. That's my honors and brutal opinion. Let's go into case study. A two-tier governance model for public listed company Mercedes. Mercedes has a supervisory board and the board of management. So they have the executive committee or senior leadership team with all our K1 use who is the CEO and the chairman of the board of management, then you have the supervisory board where they have a chairman of the supervisory boards. So here you clearly see there is a two-tier governance model with Mercedes. That's typical European. I, I honestly like it's because I want to have this independence between the two bodies. At Kellogg's. Kellogg's, you see that the Board of Directors, it's, it's a big board of directors of public, typically for publicly listed companies. So we have like 15 directors. From the 15, we have three that are executive ones. We have the CEO was at the same time chairman of the board. You have the CFO was a senior vice president who is also sitting at the board. And you have also the what is it, the corporate controller. So the accounting office also sits at the bottom. Directors. So this is more a want governance model. Do I like it? Well, no, I don't like it, but okay. That's typical you as an American. And I believe that the Chairman of the Board has been independent person. Personally. I want to share my personal experience. I mean, we are 2023 and I'm now since a couple of years sitting at two companies. And this information is public. The first one is Luxembourg Institute of Science and Technology, which is a 700 people research and technology organization, which is basically owned by the government, Luxembourg government. It's a public research institutes. And there, in fact, we have a board of directors of nine people. And we don't have senior management, so we have a CEO, CFO, directors of departments, chief HR officer, etc. They do not sit at the board of directors, but they may be invited. They I mean, obviously the CEO is always part of the board of directors, but he does not have voting rights. And this is, I mean, we have articles of constitution. These are articles of constitution that are in fact, a lot of public law. And public law clearly says the amount of directors of the company so that the organization has and what are the roles of senior management versus the rows of the Board of Directors, e.g. and it works very well. I'll do like two-tier governance models, but at the same time, obviously, we as a board of directors, need to support the CEO and also give feedback to the CEO, but also evaluate the performance of the CEO. Another company I'm sitting at the board of directors now for three years is mosaic global holding in Dubai, which is a private equity and VC holding company. And we have a one-tail governance model. So we do have CEO and CFO who are managing directors as it is called. So they are executive directors and we have three people, so we have the shareholder, we have our chairman are ruined from India and myself who are the other directors that are not operation in the company. So again, don't need to be an expert on corporate governance, but I think it's good when you look at companies. And specifically, I'm going to take now a very brutal example, the example of FTX. You remember this structure of very complex setup on FTX. You can think about what went wrong. And I'm saying there were two things who went wrong on FTX. The first thing is, how can you as an as a statutory auditor, let's say, and we will be discussing this in the next chapter. How can you certify the accounts of FTX with what we have seen has happened now and the reports that are becoming public, of course, fdx is not a publicly listed company. Could you put your money into f dx? But FTX was not regulated, e.g. at the SEC. I'm not saying that if they would have been regulated by the SEC, that they would not have been the scandal. So first failure on FTX is just the lack of oversight of the statutory auditor. With all. Let's do the legal I mean, let's leave it up to legal people to enter a judge to decide What's the role of the statutory auditor with all due respect, again, I'm not a lawyer here, but I consider that there is a failure of the role of the statutory auditor in the FTX case. Then the second one is the role of the board of directors. I mean, I don't have all the details, but if I'm not mistaken, the board of directors of FTX were three people, the founder, girlfriend or ex-girlfriend of the founder and a friend of the founder. How can you have independence series, independence of the board of directors with such a setup? So just those two things is for me a clear failure. I will even say a total disaster sounds and fair corporate governance. I leave it up to the judges, to the sides. I maybe wrong. And we will see history will tell as Warren Buffet says. But I think that's, I mean, when you look at companies, when you think about investing into companies, and this is where I'm trying to tell you. It's not just about reading a financial statement, is also understanding the attributes that build up the financial statements like the accounting principles, but also how the company is governed. But you can expect from the buddies around and we will be discussing this in the next lecture. We will be discussing also the role of the statutory auditors because they do play a fundamental role. And I will also already there make a very strong statements about who should pay the external statutory auditor. I don't like that the company has paid the statutory audit. I would prefer that government would pay this Editorial Editor, but okay, we'll discuss in the next lecture. So you see that I'm very passionate about this because I'm seriously involved into investing our family money into companies, but also I'm part of board of directors and I have my opinion how companies should be run in a fair and truthful way and avoid disasters like, amongst others, the FDX, this also with all due respect. And again, history will tell what the outcome of the legal trial will be without stopping here and talk to you in the next lecture, which is about the statutory audit us thank you again for tuning in. 9. Auditors: Welcome back. Last lecture of Chapter number two, we are discussing the role of external audits and statutory auditors. As also we could say, an external governance body within the ecosystem of Shaoul as Board of Directors and senior management. If you recall, in the very beginning of the introduction or even Chapter number one, I was explaining what is the general purpose of financial reporting and amongst comparability between fiscal years, companies, industries, countries, and markets. I also mentioned very briefly that the intention of financial reporting is to avoid distortion, incompleteness, bias, or misrepresentation that will impact the decision making process of stakeholders. Stakeholders can be investors, amongst others, or loan providers or credit told us, the example of a bank providing a loan to the company. And how can this distortion, completeness buyers misrepresented, misrepresentation be avoided. If you don't have a neutral, external third party that is taking care of this, right? Because potentially, and we will be discussing incentive schemes. If you completely trust blindly trust management, you will very probably end up at a certain point in time in a biased or misrepresents its financial statements. And coming back to the various governance bodies, we said that we have the capital bring us that are either capital bring us that are not owners of the company, which are the creditor laws, but then the shareholders, they typically, the shareholders, equity holders, they typically appoint directors to the board of directors. And the intention is that the capitals that is brought into the company actually generates a profit, creates value for the shareholders, the equity holders. And again, I'm not speaking here about philanthropy. I'm really speaking here about people who haven't economic interests into pudding or providing that capital. They asked, let's say, a cache of physical assets into Company. And hopefully those assets will generate the profit that they will see a return on that. But the, your member as well, That's when I will not go back into the one tier, two tier governance model, models of management. But typically when you have the board of directors appointing CEO, CFO senior management, for running the daily operations of a company in order to somehow guarantee that this return, because the Board of Directors represents the shareholders in order that the written there is expected by the shareholders. And we'll discuss return on invested capital and weighted average cost of capital much later at the end of Chapter number for the board of directors, they define and design the incentive and compensation remuneration schemes for senior management and other only by doing this because they want to have a stick so that they make sure that senior management is seriously motivated. And very often those sticks or cash bonuses, stock options, those kind of things. Obviously those incentives schemes, they carry intrinsically some risks with them because sometimes the amount of bonuses that are, let's say, given a promise to senior management for achieving a certain return on the capital that is being invested? Well, that may, I mean, there are risks because potentially managing would misbehave to, by all means, achieve the performance that is expected by the board of directors. So hence, this behavior and this, let's say, not correct behavior management, if that would happen, that obviously carries reputational risk, damage risk for the company. And at the very end of the day when you speak about damage for the company, it means damage for the board of directors and of course, damage and reputation risk also for the shareholders. This is where a certain point in time, and we're speaking about money. I'll make it simple. Let's leave 1 s physical assets aside. We're speaking here about money that flows from external investors into companies. And this inflow of capital is not just, let's say, local people, but you have also a lot of foreign capital that flows into the US, e.g. we see this in use in the next slides. So most of, let's say, the governments that operate in, in markets that allow inflows and outflows of capital, including foreign capital. They have laid down, they have defined a set of audit requirements in order to reduce those risks. That's not that appear when senior management has incentives in order to generate profits for the capital that they have received from showered us through the board of directors. And the intention of laying down this audit requirements in regulations in the law of each local country is really to reduce risk and increase the level of confidence. That's foreign investors and even domestic investors, or even protecting external and also domestic credit, bring us on that market and make sure that this confidence level is kept in this. The reason why audit requirements are laid down in most of the legal systems in the world? I was mentioning the inflows and outflows of investors. I mean, just look at this is 2018 figure. So the foreign direct investment in the US in 2,018 h of $275,000,000,000 as in China, 136 billion Luxembourg six dots six in Spain, 19, not 1 billion. So that's a lot of money. Those are a lot of inflows of capital. And obviously what you don't want as a government is that this inflow no longer happens because that inflow of money obviously is creating jobs and makes the economy and all the economical processes, the whole economic cycle sustainable. So you are interested in being a country that is considered confidence also for foreign investors. When we were discussing the financial obligations, reporting obligations a couple of lectures ago, you may recall that I was using the example of Luxembourg, where in fact, I said that e.g. in Luxembourg. And we're speaking here not about publicly listed companies because for those, you remember I gave the example of the SEC with the ten K ten q8k 345 form repository, as you see, makes monetary. We were discussing European publicly listed companies. But here we're speaking, but also, also on top of public listed company is privately owned companies where depending and I was mentioning depending on some attributes of the size of the company and the size can be the balance sheet of the company, that turnover the company. And so the annual turnover and, or the number of employees, if you pass some of those thresholds, or you are obliged by law to have an external statutory auditor execute an audit to create that environment of trust and have confidence for investors, for external, so if it is foreign investors, so when I say external is external to the company, foreign investors or external domestic investors as well. And so through this legal obligation, there has been a lot of companies that provide those statutory audit services to the, let's say, commercial companies and also to governments. Because also governments and its ministries also audited. And this also is laid down, let's say, in the texts of law. And you have on top of those bodies of standardization on Accounting Reporting Standards we were discussing IFRS, US gap with a USB and the FASB bodies. You have also on top of those accounting standards bodies, you have bodies that are specialized on, Let's say, auditing. Companies that are, and you will see in those bodies, some are really laying down the rules, the best practices, the standards, and the auditing. When again, you can go back when we were discussing the accounting principles, I mentioned the materiality accounting principle. I was referring to either 320 without mentioning it explicitly, but in eyes. So the eyes are standard, which uses the international standards and auditing 320 is in fact explaining how auditors shall look at Material events or material elements versus immaterial. And you have throughout the world for certifying the account, you have International Federation of Accountants, which like compasses, around 180 member Local Federation of Accountants. The US has also its own, which is called the AICPA, which is American Institute of Certified Public Accountants. Then also audit us when they, because they will play a role in giving this external view to investors about how the company, how the financial statements are representing the company. It's not just about auditing the accounting systems or the business transactions. We will briefly discuss what enterprise risk management, obviously goods. Statutory auditors will also audits all the elements that support building up the financial statements of the company, e.g. the IT systems that support the accounting system, the security and information security, e.g. around the accounting IT systems, what is called an ERP, Enterprise Resource Planning. And you have tools like SAP, Oracle, Microsoft Dynamics, who are those tools that allow to recall all the transactions, build the balance sheet, the income statement, the cashflow statement, etc. You need to look at the permissions, the authorizations, how those systems are secured. Because if there is, let's say, a weakness in how those systems are secured, also, the financial statements will potentially be carrying errors and we'll misrepresent the reality of the company, which then again, does not build up trust and confidence towards external investors if it is foreign investors or domestic investors, but external to the company. So this is where, when we were discussing the SEC thing, I mentioned that in the US company is publicly listed, companies have to report on a quarterly basis on audit reports. And you see this in this slide tunnel and two, you see that it says unaudited. So obviously it means that on a quarterly basis because there is a cost and an amount of time that comes with lesser auditing accompany. What is mandatory in the US is a yearly audit, the same for Europe. In the US, you have a quarterly unaudited report that is, let's say, prepared by management and by internal audits, very probably. In Europe, you have a half-year on audit report and a yearly auditor reports, and every quarter when it is not an unaudited report. In Europe, most of the public listed companies, they provide a sales update. And so one of the conversations were discussing about the external audits that is performed by those statutory auditor. So statutory just very quickly, why do we call them statutory? Because it's laid down in Los through the statutes of the company, of the creation of the incorporation of the company auditor. So this is mandatory by law. That's why the auditor's, the excellent auditors are called statutory auditors because they audit indeed through the obligation that is laid down by the government in local laws and regulations. One of the problems that I believe we still have today, and I will give you examples of scandals that happens is there are, let's say, there's a lot of conversation going on about the independence of the auditors and e.g. after the Enron MCI WorldCom cases, there were conversations about how much consultancy can be external auditor provides if the external auditor is as well being the one who does the statutory audit and certifies the accounts. And indeed before Sarbanes-Oxley, e.g. in the US, let's say that the rules of how much Consulting, which is also revenue to the consulting and audit firm. And you have those big firms like KPMG, Deloitte, Ernst and Young, PricewaterhouseCoopers video, etc. So obviously, I mean, if they are only auditing the company, that's a certain amount of money. And if they are not allowed to provide consultancy to that company while they cannot generate revenue. And those companies are as well commercial companies. This is what the whole problem of conflict of interests appears. How much consultancy can you do without interfering, without having a conflict of interest with the role of statutory auditor that you have. And this is where the conversation came up. How often shell as well. So first of all, what is the percentage of maximum consulting that the statutory auditor can shall provide. But also is are there any rules in order to change the auditor on a regular basis? And I gave you one example here, that's for me at least rings, rings a bell. So when we were looking a lot at Mercedes and Kellogg's and in e.g. in the Mercedes reports, they do use KPMG as an statutory auditor. And this was the 2,000.20020 annual report which was published in 2021. And you see that in fact, in the financial report they were mentioning that KPMG has been the auditor of diamond at the time. They were not called Mercedes, but they will call Dymola without interruption since the financial in 1998. So that means that they were auditors for more than 20 years at Mercedes. For Kellogg's. They do have PwC, PricewaterhouseCoopers as a external statutory auditor. And they mentioned in the 2020 and a report and I just looked up the 2021 and report, it has not changed. So they are they are the audit of Kellogg's since 1937, which means that they are near. Nearly now for a century, the auditor of the firm. What is my opinion about that? And my opinion is that I tend to have a problem with this and we will be discussing this when we will be discussing audit rotation. But first of all, is you can and I want to practice your eye when you go into the financial reports, you can read who is the auditor and since when they are audit and let's just keep for one for a couple of minutes. Let's pause on the question. And the Commonwealth already made that I do have a problem when a company has been auditor for eight years and years or even 20 years, I'm open about that. We will discuss it when we will be discussing audit rotation in a couple of slides. Before that. What also vary in terms of governance bodies happens is that we will be discussing scandals, we will discuss Wells Fargo, I think we'll be discussing why our cards, maybe FTX as well. But typically in terms of governance bodies, so we have the shareholders, the board of directors, senior management, they have now the external auditor that comes on top. And typically the external auditor reports into the finance and audit committee or the audit committee of the board of directors. So typically board of directors, because board of directors typically are, I mean, for big public companies, you've seen it when we're discussing Mercedes, Kellogg's like 12, 15, 20 people, it does not make sense to have those 20 people have to deal with audit, let's say process details. That's something that management and the audit committee, which carries a subset of the board of directors. So you see that the people sitting at the audit committee, they should have certain competence in finance and audit matters. And as I mentioned earlier, I have the chance, and at the same time, it's a very important responsibility that in both companies I'm sitting at the board of directors. I'm in both part of the finance and audit committee. And that's has been a request from the shareholders and the audit committee. They in fact, as I mentioned, they deal with everything is ready to accounting, financial reporting, and they deal with the annual audit. So the annual audit is prepared by management. The excellent auditor has to look at it. The external auditor provides an opinion. It will be discussing this in upcoming minutes, and the audit committee has to deal with that opinion and then give a recommendation to the board of directors and also requests from management to comment if they are recommendations are weaknesses that have appeared through the statutory audit, that they provide, comments, feedback, and potentially implementation of changes. I mean, that's the role of the Audit Committee to give that recommendation to the board of directors? The board of directors agrees to the recommendation of the Audit Committee and then obviously management has e.g. to implement supplemental controls and board of directors needs to make sure that management, of course, gets the means if there's money means resources, human capital, in order to implement those changes to reduce the amount of versus low-risk e.g. at the company carries. And giving you a concrete example about the audit committee here in Mercedes. See the supervisory board, we are discussing it. And so you have members of the supervisory board, they're just regular members but you have 54 people, sorry. They are members of the audit committee. And so those are the people together with the external audits. So the external auditor reports to them. The external auditor does not report to senior management, so they will deal with all those, let's say with the whole process of sanitary audits which controls have been audited, what other recommendations that come out from the statutory audit? What other recommendation that the auditor is giving, what other recommendation that management is giving and then giving a recommendation as the Audit Committee to the complete board of directors because at the very end of the day, the whole board of directors is responsible for not just the audit committee for the preparation of the financial statements. And in e.g. the Mercedes annual report, I mean, the audit committee provides a report. I'll let you read this report is pretty interesting on how they explain how they deal with audit matters and with the external auditor. For Kellogg's, it's the same. They do not mention explicitly here in this management responsibility for financial statements, but they said the board of directors of the company has an audit committee composed of six non management directors. And here you see e.g. when we were discussing one tier, two tier, we see that the audit committee here, there is really no conflict of interests. Management cannot be part of the audit committee because that would be a clear conflict of interests if you have CEO CFO, which would be members of the audit committee. Last but not least, a supplemental body that I want to introduce. So we have shareholders, board of directors, senior management, we have now the external statutory auditor. But obviously you cannot. I mean, they're in big corporations, so many processes that you cannot only rely on the external auditor. And very often, the audit committee will create also an internal audits, let's say team. The internal audit team. Report into the audit committee. They have to be independent from senior management. Of course, in a management is dealing with them on a daily basis because that's not the role of audit committee to become operational. But the internal audits is completely independent from senior management and they report into the audit committee. They will typically, I will not go into the details, provide a plenary annual plan. That's something that you will not see in the financial statements. But consider that internal audits. I mean, there is a risk register that the company, very often a minute mature companies have a list of risks with there is that they want to tackle there is that they accept and then probably average that they don't want. I mean, as residual risk are risks that they want to be mitigated, that of course, controls and processes linked to that. And the role of the internal audit is to make sure that the risks that have to be mitigated with those controls and processes, that they effectively work those risk mitigation, let's say means. Then they discussed it with the audit committee. Typically what happens? They propose a very often men from my experience, a three-year pleura annual audit plan. That audit plan is agreed with the audit committee and then the audit committee gives a recommendation to the board of directors to execute the pleura annual audit plan and then the audit reports also float back. The internal audit reports also flew back to the audit committee and they flow back to the board of directors as well, just to know what is the amount of residual risks that the company carries and if anything has changed, will not go too much into the details. But just to make clear that you understand it when financial statements mentioned that they are unaudited, it's unaudited from an external statutory audit perspective. It may be that the quarterly financial statements have been potentially audited by the internal audit. But from a legal perspective, that does not play a role. And very often internal audits, I mean, from my experience as well, internal audit may audit. I will audit ERP, so accounting IT systems as well. But the very end of the day, what counts for external investors, If it as foreign or domestic investors, is really the position of the external statutory audit. But as set as the cost, the external cost is very high. It's always good to have also an internal audit body and you're going to have this. What then happens typically is that those audit bodies, the external statutory auditor and the internal audits, are the internal auditor. But typically in big companies that's a team of many people. They provide an opinion report to the audit committee and then that report is done, let's say, validated or disgust with the external or the internal audits are and then provide it to the Board of Directors for approval. And then obviously this, this is available to the investors and even potentially to bank. Banks who want to provide a loan to the company, they may answering your due diligence, the latest audited financial report, e.g. so that they can read also the audit opinion of the external statutory auditor. When we speak about an opinion, again, very briefly to discuss and this is you remember was discussing international standards on auditing. So we were discussing IFRS and US GAAP, but as I mentioned, iser. So I saw 324 materiality and there is an eyes or 700 standards on audit opinions. And the audit opinion has four financial statements to either be unqualified, which means that there are no material issues or if there are issues there, immaterial. This is what the diagram on the bottom left is showing you here. And potentially there may be audit issues or financial statement issues, and if the auditor has a qualified opinion. And again, this is about having the right vocabulary. I want to first vote to be able to read. I want you to read the auditor's, the excellent auditor's opinion when you invest into a company. But then you need to have the right vocabulary to, let's say the crypts. What an unqualified versus a qualified opinion means. Qualified means that there's probably some kind of risk wanting associated to either the financial statements or audit issues. And sometimes it may happen that there is really a disclaimer or an adverse opinion. That's a really very important thing. And you need to be, of course, super attentive, even auditor. And to be fair, it doesn't happen very often if an auditor is putting a disclaimer, is giving an adverse opinion about financial statements. I mean, that's a very, very big red sign. Alarm bells should go off in your brain with this. But again, now how many people read the audit opinion in finance, in the financial statements when they invest into company is seriously and not a lot of people do this. And this is an example of an auditor's opinion because they do provide an opinion and the opinion is written down in the financial report. So typically the annual Audited financial report because you remember there's only one audited report that's one's peer. And you see here e.g. that's the auditor of Daimler Mercedes, which is KPMG. They don't have any reservations on the financial statements and the management reports for Kellogg's? The same they say in our opinion, the consolidated financial statements referred to above presents fairly in all material respects the financial position of the company. You see they mentioned the causal as well because the Enterprise Risk Management Framework. So they go beyond just looking at the figures and the accounting they go out as well, as well as information security controls, authorizations on ERP systems, those kind of things, which is normal. But still despite the role of statutory auditors. And I wanna be here very fair with a statutory auditors, you have a lot of people who are very zeros now it's able to experience as well serious people, sometimes people who are maybe, let's say, less precise. But at the very end of the day, while stating that most of the auditors and the audit partners are very serious. They mean they have big experiences in auditing companies. It doesn't mean because we have an unqualified opinion by an external statutory auditor is KPMG Deloitte, Ernst and Young, PwC video, etc, even Arthur Andersen that was wiped out after the Enron scandal. And they will also involve an MCI, WorldCom do not remember. You still have a lot of frauds and scandals that appear now, just took it from Wikipedia because it was very interesting. Wikipedia has listed some of those, let's say scandals. And you'll see the company, the audit firm that was involved and the country as well. And I mean here, the Wikipedia when I was extracting the screenshot, was not even speaking about FTX was already mentioning wildcards in Germany. But they have been, unfortunately there have been scandals throughout the world and every single year. Why I want to be fair with the statutory auditors is that this is let's consider the tip of the iceberg, but I will not look at it as the tip of the iceberg is that you have hundreds of millions, probably of companies that exist throughout the world that are audited every year. And only a couple of them indeed have problems or generate scandals or involved in fraud. So I would say that 99.9% of the companies that undergoes sanitary audits are done in a serious way. But unfortunately, as always, people tends, they have this bias of really focusing on the scanners that come out. And then they said the whole sanitary audits profession is not, let's say truthful and fat, etc. So just be attentive to that. But again, it's not because there is an unqualified opinion. That's where I want to tell you is it's not because you have that unqualified opinion, that that is not a guarantee for fair and accurate representation of the financial statements. Example was Wells Fargo. We were discussing the incentive schemes that are designed and defined by the Board of Directors for senior management to make sure that the profits that shareholders and the returns that Charles I expecting. So the value creation indeed to somehow, let's say, incentivize towards management. Or Wells Fargo was involved in a huge scandal where they were in fact, those incentive schemes, they were creating fake accounts and forging signatures of the customers. I mean, I you may have heard about it. I let you go into the details of Wells Fargo, but the incentive schemes of even designed by senior management towards middle management and lower management. They really created this whole frauds. And obviously this does not create trust in the company. And of course, how many reputational damage, how many customers will never and no more, trust them money to Wells Fargo. So that's the kind of thing that completely can wipe out a company. I mean, what's progress still existing, but obviously, I mean, there is some mistrust towards a frog or when this happened a couple of years ago in Germany, we were discussing Mercedes. I'm I mean, it's small but I have a big position. And Mercedes as a shareholder, another Volkswagen shareholder, I have a friend who's BMW, but you may recall that German car manufacturers were involved in a scandal about emissions and how to trick certification lapse when they were looking at the emission. So pushing the emissions of gases, in fact, to, let's say, to lower levels versus what the reality was for diesel engines. And of course, I mean, the financial statements we're okay. The audit report from the external statutory auditor opinions were okay. But still, you had this behavior inside the company which wasn't unethical behavior and this cost to a lot of people, their management and even. At the board of directors level their positions because there was a lack of supervisory supervision on those matters and you didn't have the right culture in the company to avoid those kind of behaviors. One of those that I mentioned as well a couple of lectures ago was the wildcard one where in fact you had on a 2 billion cash position on the balance sheet, 1 billion that in fact was fake, was not existing, but how can it be that next term? Statutory auditor. My apologies. How can it be that an external statutory auditor does not get the right level of guarantees from the banks. This one That €1 billion is seriously and really sitting in the bank account somewhere in Asia. So I will not go into the details of it, but wildcard is clearly a case of fraud. And with all due respect for the audit partner who did it and the audit firm. Indeed, you can wander, you can ask yourself, how how correctly and efficiently Have they been doing their job as excellent statutory audit because I can tell you when we I mean, when I talk to the external auditors, when we speak about the balance sheet, when when the company has cash positions. There are always two things that I ask every single year the audit us if they have received from the banks confirmation of the outstanding bank balance or bank account balances of our companies as well. I'm expecting from the external auditors and I explicitly ask them, have you reviewed Who are the people who are allowed to do wire transfers on the company's bank accounts. And I want them to be able to tell me, yes, we have verified this and that it is in line with the people that are still in the company in that there is no discrepancy in that. So that's the kind of thing e.g. I'm giving you a behind the scenes and that's the kind of conversation I do have when statutory excellent statutory auditors are coming with the first opinion report to the audit committee will review. And that's always the thing about I'm always worried about who has access to the money. When I'm sitting at the one I'm sitting for the board of directors in the audit and finance committee. Last one. Before we go into audit firm rotation conversation is FTX. Fdx is I'm already mentioned, I think was last lecture, the lecture before. That is for me a total failure, not just from a governance perspective who is at the board of directors of that company? Again, I had people asking me What's your opinion. And I said, at the very end of the day, FTX has not been regulated by the SEC. So that's, that's one thing that has been clearly sets. You have a lot of people who put their money into f dx and hoping that's, let's say governance principles or governance requirements that apply for publicly listed companies as well, applied to company that is not listed in the US. It is registered, incorporated in the Bahamas. And those people, I mean, you have Hollywood stars who invested into FTX. They have not even thought about what's the board of directors looking like. Then I will add here, we're speaking here about the auditor's when the lecture, but the statutory auditor might I mean, with all due respect. But for me, it's a complete failure of the audit firm. And they have been even there has been a picture that came out that they were like, and we can discuss about conflict of interest here. But they were, let's say claiming saying that they were happy to have with the FTX, senior management and board of directors participating jointly at a baseball game in the US, etc. I mean, I have always been extremely prudent, even at my time at Microsoft, of really trying to avoid any kind of conflict of interest between e.g. and it happened to me that I was invited to concerts, to soccer games, to those kind of things. And I was extremely attentive always to turn down those things because at the very end of the day, that may create a conflict of interests. And that's the kind of thing that absolutely you need to avoid. Here. I mean, for me, the FTX, It's from a board of directors setup. It's, I mean, it's something that's investors should have thought about, but investors thought FTX probably carry the same reporting and compliance requirements that are publicly listed companies. They were not regulated by the SEC, So do not be surprised about it. And then the statutory auditor, they did not do their work. I'm sorry. They really did not do their work about what was happening with the transactions between e.g. FTX and animator. But let's, let's the judges, those a try going unless the judges take care of that. Last point before we wrap up, chapter number two is about audit firm rotation. So I mentioned a couple of minutes ago that one of the things I do not like is when the auditor is there. And is therefore 2030, 40, 50 years. I honestly believe it's not a good practice to have auditor's sitting there for such long periods. And I'm elaborate here. And I had those kind of conversations also in the firm's I'm involved in. I mean, it's clear that if you rotate, so if you change the auditor every year, you as an excellent investor will not get the depth and the insider knowledge that's an external auditor has to have. But understanding the business and the business processes of the company. So changing every year is not a good option, but not changing the auditor for 80 years. That's for me as well, not a good option. So condensation that is still happening now with all of those scandals and there has been evolution over the last decade as well as about audit firm rotation. And what is being asked is that for Europe, e.g. that every ten years for public interests enterprise. So those are companies that are publicly listed that there is an audit firm rotation every ten years. And for for the US that there is a conversation about the audit firm and the audit partner rotation for the time being, there is an expectation that the lead partner, and we'll make it simple. I'll let you read this, that the lead partner has to change every five years because he is he or she is the one that is also then signing off individually as a person on behalf of the audit firm, the financial reports. So he or she is as well putting his or her personal reputation on the table. And the last thing I want to add here is even if this audit firm rotation happens and becomes mandatory in, let's say in very mature markets like Europe and in the US, I still believe there is one problem, which is that the audit firms and the audit, the audit process, the external statutory audit is paid by the firm that is being audited. Me personally, I would really prefer that the external audit be paid by the taxpayers. And this will be part of a, let's say, a corporate tax that companies have to carry. And depending on the size, they get a certain budget. And the audit firm then charges indeed the, let's say the government directly and not the company. I know it's a complex matter, but I still believe there is an opportunity for even making statutory audits even more independent as they are today. Last point here, there is an assignment. Well, what I want you to do, as I said earlier, not a lot of people. I mean, nearly nobody reads the audit opinion. What I want you to do is the following thing. I want, as in an earlier assignment that you take your favorite company, that you download the latest audited annual reports, which carries, of course, a report by the audit committee and the report by the external statutory auditor. I want you to understand if the company is being run in a one here. So mixing up senior management and board of directors or in a tweet your governance model as we were discussing earlier. And I want you to look up in the annual audited reports, the auditor's the extra and statutory auditors reports that you read the opinion and that you understand if it is a qualified or unqualified opinion, and potentially that you read through if there are any comments or 10. Balance sheet structure and Value Creation Cycle: Welcome back, Starting Chapter number three. So let's just pause here a second and just rethink what we have been doing so far in Chapter number one and number two very quickly before going to Chapter three. So chapter 1.2, they were basically there to really lay down if it is the base vocabulary that understand the main governance bodies of a company. Because I think it's essential that you understand as well the governance bodies around the company and within a company, but also the right vocabulary before looking into financial statements. So basically now, chapter number three is really about going deep and we will start with the balance sheet as I told you that when I assess companies and when I look into companies are always start first with a balance sheet. Remember that when we're discussing the different types of financial statements. Statements, the balance sheet is really the accumulation of wealth since inception, so since day one. So we will start in fact the chapter by, I'll first introduce really in detail the balance sheet. Then I'll explain what's, what's the purpose of vertical analysis and horizontal analysis. Then we will really go through all the sources of capital. We'll start with the equity, So with the shareholders bringing in capital, what you will find in the financial report, we will go as well into different types of adaptive this short-term debt or long-term debt. When we have finished the sources of capital, we will go in fact and look into the main categories of assets. And again, it's not intention and it's just not possible to have an exhaustive course. But normally walking you through the main categories of equity, the main categories of depth, and the main categories of assets. So how the capital has been transformed into if it is tangible assets, intangible assets. This will really allow you to be able to understand, I think, 80 per cent of any type of a balance sheet of a normal company. So of course you will need to. I mean, if there are very specific categories that are not covered here, you will obviously have to look up and there's so many, let's say, information available on the Internet in books about very specific categories. But you will see that we will cover the most important elements if it is in equity and in-depth. So the sources of capital. And then also looking really in detail in all the different main types of assets when we look at the balance sheet. Alright, so the first lecture in chapter three, when we called the chapter the inventory of company resources. So company assets and capital we go, we'll start with the balance sheet structure and understands the value creation cycle of the company. And so, I mean, we already have looked a little bit into the balance sheet. The balance sheet or what is called an IFRS, the statement of financial position. So the current financial position of the company, which is the accumulation of wealth since inception. You basically have two parts to it. And you remember when we were discussing history of accounting and financial statements, we were discussing the ledger and more specifically the double entry bookkeeping system. And we have basically here two sides, which are on the one hand side, the liabilities of the company to, let's say, third parties and then the assets. And you remember that we said that both of course, have to be imbalanced. That's why the, let's say this sheet, this financial position is called in accounting terms, the balance sheet or the balanced sheet. So acids in some of assets has to be equivalent to the sum of liabilities. And this is because of the double, double entry bookkeeping system mechanism that appeared around, let's say medieval times. So n has already set That's very important. Again, even myself, when I was a student, I did not understand them in what I had accounting, let's say lessons and with all due respect for my old teachers, they will not explaining to me the key is how to read the balance sheet. I did not even understand. E.g. the balance sheet was the accumulation of wealth since they won. And that income statement and cashflow statement, we're looking at a specific period of time. One of the things that I missed as well when when going into accounting and finance, let's say courses. Was that even during my MBA, I mean, they were not explaining to me that liabilities were in fact the sources of capital and they were considered as why they will consider liability to the company. Because if the company, let's say either generates a profit or is liquidated, I mean, the people that have brought in capital, they have to be paid back. And the intention of the liabilities are the sources of capital. The capital bring us is that those sources of capital are transformed into assets. And you remember that we said that assets, I mean, most of the people bring in capital in terms of money. Money means, but you can also bring in assets directly, let's say physical assets into company like a car, a laptop, those kind of things. And an accountant will estimate the value of that asset. So you don't have the cash to asset conversion cycle. You immediately go from capital and you bring in this physical asset with a certain fair value into the asset side of the balance sheet or the financial position for using IFRS terminology. So basically, the balance sheet is very easy, very easy to understand. It's the sources of capital that equity. And the use of those sources of capital, the use of that capital will sit in the financial position in the balance sheet as assets and various types of assets that obviously we will be discussing. Also and billing this up. I already was discussing this in the introduction, but here I want to be very clear. Dept is typically something that is considered as external capital in the sense that it's not linked to the owners of the company. Why equity is typically, I will call it internal capital is really linked to the owners of the company. So to the shareholders, to the people who hold shares of the company. And that's really the main difference while you have debt and equity, but both are in fact sources of capital that can then be used to, let's say, create, transform into assets with the hope that those assets we generate properties. What we'll be discussing in the value creation cycle, which now comes here. And so I would say in the middle between the sources of capital and how does that capital is allocated into assets you typically have, to some extent, the board of directors are representing the shareholders or the shareholder, and obviously senior management with the CEO. And again, we will not discuss further here, warranty versus Twitter governance we discussed in the previous lecture. So the one company is and we will not discuss profitability here we will discuss is when we will look into the income statement, we will be discussing also cost of capital and also profitability. But I mean, I will already introduce the first time a first, Let's say layer first, level of depth on the value creation cycle. So let's imagine that you split the balance sheet into two. You have on the right-hand side, what you see here on the diagram, the capitals sources. So liabilities, if this dapp told us which can be a bank bringing in alone, it can be as well. E.g. you owe money to the suppliers. It can be also, of course, shareholders. And you have on the left-hand side of the asset. So we're splitting the balance sheet into two. What typically happens is that we take the assumption that those liability haulers, they in fact bring in capital through a certain, let's say cash. And we will not discuss suppliers and employees because they are also part of short-term debt holders because you own them money. But here we will be really speaking about those sources of capitalist bring in cash like a bank loan, e.g. I can shout, that brings 10 million into the company. That cash, that comes from a cash lenders of, from investors, from shareholders. The intention is that, that cash regenerate the written in the future. And with that, and we will be discussing this when we will be discussing cost of capital in a chapter number four. To some extent, money has never been for free. We're not discussing Philanthropy here, but typically money never comes for free. So money typically carries a certain cost to it. It can be an opportunity cost and we will be discussing later on, as I said, about cost of capital as well. So it means that typically accepted, if you are a philanthropist, if you are giving money to accompany, you are buying a share of a company, are buying 1,000 shares of a company, giving a loan to a company. You want to have a return on the money that you are lending to the company, either as a loan provider but also as a shareholder. It's kind of a loan that you're giving to the company. So just keep in mind for the time being. We will, in Chapter four, I'll explain to you how to look at the cost of capital and wealth because of expectations. But just consider that when somebody gives money to a company, that, that money intrinsically carries a certain cost of capital and a certain amount of return expectations. And then of course, in order to generate the profit, the money cannot just sit there passively. Obviously, the intention is that very latest, either board of directors or senior management, that they take that cash and they invest into real assets. And those assets can be financial instruments, e.g. if I look at our family holding, this is what we are doing. We don't have a lot of physical assets in our family holding, but it can also be investing into occur, remember the limousine service investing into a retail shop because you are selling organic orange juices. I have no clue, but that's the kind of thing. So you want to take that cash and you're giving kind of a promise of written to the cache, to the capital providers. And you're going to transform that cash into real assets. And of course, those real assets, they continued to carry the certain cost of capital expectations and return expectation that come with. The intention is that the assets that came from the cache and the cache that has been converted into physical assets, that, that cash transform into assets. And those assets now themselves generate new cash. That's really the expectation. So that's. There is fresh cash that is generated from the operations and the operation of those assets, of those real assets. And if there is a profits, basically in the value creation cycle, senior management and board of directors, they have basically three options. And if you look here at the structure of the balance sheet, they can take the new cash generated from the assets and just say, we're going to reinvest all the profits into our company operations to grow even more the value of our balance sheet of our financial position, we're going to buy new assets, new shops, new cars, and external operations. We may go into new geographies or we may address new customer segments. And then you have on the right-hand side to other options. I mean, if not, if none are, not, all of the cash generated by those assets. So it's basically a profit that's not the whole profit of the operations is injected into company operations and there is maybe all of its remaining are part of it. Well, there indeed senior management and the board of directors, they have two other options which are here, the flows for a and for B. Either. I mean, they have potential to pay back first the loan, loans, e.g. or maybe suppliers, employees. So that's something that they have to pay back to the credit dollars depending on the terms and conditions are e.g. loans that have been, let's say, contracted by the company. And at the very end of the day, potentially the company is paying back cash to the investors through e.g. a, cash dividend or through share buybacks. So those are, just keep this in mind when you look at financial statements and we'll be looking at the cashflow statement as well. There are three ways of providing cash back to the liability side of the company. So to bring us, which is pink of dept, and reducing the amount of debt that the company owes external creditors, also giving a return that will exit the balance sheet of the company to e.g. shareholders if there's a cash dividends, but could also be share buybacks and that stays. And we will see this when we will be looking into the equity part of the balance sheet, you will see how the share buyback mechanism really is reflected in the balance sheet. So those are the three options. Company hopefully generates a profit from those assets. It's either reinvest it into operations to expand. Its either used to pay off debt and or last but not least, it's potentially used to give a return to the shareholders. Alright? So when we look at and you saw how the balance sheet, and there is a cycle around the balance sheet, how that works. Remember when we were discussing IFRS and US GAAP, that indeed, I wasn't really mentioning that the balance sheet follows a certain order. And I will show you explicitly five rows and you ask what are the main differences? So that's why it was important that you understand. First of all, when you are looking at the balance sheet, you will see with Tommy will no longer look at the accounting policies to see the balance sheet is done on the IFRS and US GAAP. You will immediately know if it is IFRS or you ask app. But typically, the balance sheet follows a certain order. And one of the things that follows on the asset side of things is the liquidity of the assets, how fast the asset can be converted into cash. And on the liability side, it will follow you remember the priority rule when we're discussing the accounting policies, so it follows the priority priority rule would always comes with short-term debt providers, long-term debt providers first, and then it goes only to shareholders. And if you look here at a, this is like simplified view of a balance sheet that follows IFRS. So you have this, let's say, the sources of capital and the use of capital. So you see that on the liability side you have equity on the top, on the bottom, and assets on the left-hand side. If you would look at the liability side first, the sources of capital, while shareholders are really the ones that have the lowest priority in terms of claims on the company assets. So they will come on the very top. If we're looking at an IFRS balance sheet, then we have long-term debt holders that come between equity and then short-term debt that comes in fact, at the very bottom of an IFRS balance sheet. On the asset side of things, you're going to have e.g. a. Bank accounts, cash and cash equivalents. They will be in fact at the very bottom in IFRS. And it will go from a very liquid assets into assets that are really not very liquid, like intangible, goodwill, patents, trademarks, those kind of things. So this is how it works in IFRS and US GAAP. It's in fact the other way around. You're going to have very liquid assets like cash and cash equivalents that come first. You're going to have less liquid tangible resources like buildings. Manufacturing plants that come somewhere in the middle, those are fixed long-term assets. And then you have those long-term intangible assets that are the very bottom, like goodwill and those kind of things. And on the right-hand side, in terms of liabilities, it will start with short-term debts. So typically like suppliers, employees, tax authorities, when everything is below 12 months. And then it goes by order by this priority group. By order of priority, you will go into long-term credit haulers. And then at the very bottom, you will have in fact the equity holders. Why you will see this section of, let's say everything that is capital retained earnings. We will be discussing this in the next lecture. One of the things that when we discuss this also priority rule, I mean, one of the questions I sometimes get from students is, why are people in fact investing into companies versus debt instruments and fixed income instruments? And it's very valid question because I mean, as you have understood that through this priority rule in case the company goes bankrupt, it's the liability in the sense of the credit told us that come first before the shareholders. But when you provide a loan to a company, you will only get what is called the coupon. You will only get a fixed rate, a fixed income for a certain period of time, plus the principal amount of money that you have provided to the company. So let's imagine you're giving a loan to a friend who wants to create this organic orange juice orange juice shop. You providing 100 K US dollar loan to him or to her, You will probably negotiate 100 K. You have to pay back 100 K after ten years plus a, I don't know, eight per cent written on a yearly basis. So that's the coupon rate. But you're, you will earn eight per cent as a fixed income every year. Of course, if the company is able to pay back that loan and you will, after ten years get your 100 K back. The advantage of investing into company shares is you remember that the shareholders have a claim on the profits of the company, is that if the company is creating more and more wealth, the balance sheet is growing more and more. You will in fact be able to become more wealthy than by providing loan. Because as the balance sheet grows, the value of one single share will grow as well. We will be discussing or book value also in the upcoming lectures. So you will be able in fact, if you would sell the company, as a company becomes bigger, you would then earn, Let's say, a huge profits on the appreciation of, let's say, of the share price or the value. And potentially you will also have received something like a fixed income through dividends, but they are always less predictable than e.g. a. Coupon rate on a corporate obligation or bank loan e.g. but that's what I'm doing. E.g. I'm always having those, let's say trying to buy great companies at very cheap prices. But that i'm, I want to have something similar to fixed income. So I really want to make sure that the company is able to provide me a return yearly basis through its cash dividends or through share buybacks. So that's little bit my investment style as a value investor. In the next lectures, we will be discussing and looking at all the items that in fact compose the balance sheet. And that includes not only the asset side, but also the liability side. We will be discussing this in the upcoming lectures. And you see already, I mean, I didn't go into the details of it, but now you able to read a balance sheet, at least understand what consolidated means, what financial position versus balance sheet means. One is IFRS, the other one is US gap one. And you'll see e.g. on if I look at the Mercedes on the left-hand side, you see e.g. in the assets that they have, in fact, cash and cash equivalents that are at the very, very close to very liquid assets at the very bottom of the asset side. And the last asset that is listed on the Mercedes balance sheet is intangible assets. If we look at the Kellogg's one, you have current assets. You have cash and cash equivalents or come first. And the last asset is really other intangibles, goodwill investment in unconsolidated entities. So those are really long term intangible assets. So you see that they are in fact the IFRS versus US gap. All that is different and the same on if you look on Mercedes, the bottom part. So the second half of the balance sheet of financial position, if I use IFRS terminology, you see that equity comes first. Why in the Kellogg's balance sheet, equity comes last, and current liability has come last in IFRS, while current liabilities come first in the second half of the Kellogg's balance sheet. So keep this in mind. It does not change the priority rule is just that in IFRS, it goes the other way around from less liquids to very liquids, from lowest priority to highest priority. Why? In a while in US gap it goes from extremely liquid to very illiquid assets. And from priorities are very high priority. So short, short-term depth told us to very low priority liabilities. So that's really than the shareholders at the very end of the day. So I have also an assignment for you here. What I want you to do is the following. I want you to take your favorite company. Obviously that company has to have some kind of annual reports. Or you can even use a quarterly because the quarterly also reflects always latest accumulation of wealth and inception. So since they won look at the latest, I would recommend you to look at rate is annual report and look for the balance sheet of the company. What I want you to do is I want you to find the biggest item in the asset side of your company balance sheets and the biggest item, so the one that has most, let's say, that is worth the most on the liability side of the balance sheet as well. So that's the way I want you to practice your eye as the B, a very quick assignment. So go on your favorite companies, probably investor relations site. Download the latest annual report, look at the balance sheet of financial position because IFRS or versus US gap. And look at what is the biggest item in the balance sheet on the asset side and the biggest item in the balance sheet on the liability side. So start practicing your eye on this. And in the next lecture, we will start looking indeed at capturing the essence of the balance sheet. So stay with me. I will explain to you how to do a vertical analysis and I will explain to you also the companion Excel file that comes with this training as well. To be able to grasp very rapidly when you look at a balance sheet, what is the, what are the material elements that make the substance of the balance sheet? So more on that in the next lecture. Thank you. 11. Vertical and Horizontal Analysis: Alright, next lecture in chapter number three. So before we go into the various items of the equity, of the depths, but also of the assets in the balance sheet so that we understand what the company is made out of. We will, and I want you first to understand how to capture very quickly the asset of the balance sheet. And that's something I think it's in Chapter five. We will be doing this with Villanova, where I already show you now how you can kind of get a first guts feeling of what the company is made out of by really looking at the essentials of a balance sheet. So why are we discussing this? Because the problem is that in the balance sheets, if I use US GAAP terminology on a financial position, if I use IFRS terminology, there are many, many items. There is on top of that, there are many changes that happen to accounting standards. You remember that? I was mentioning IFRS 16 on operating leases. We will be discussing this when we look at assets. And there has to be some kind of efficient approach to looking at a balance sheet without being now these certified accounts and that knows everything in terms of how things work. But I mean, me sitting on the board of directors, me being a value investor, I need to be able to grasp the essence of a company by looking at the essence of a balance sheet as well in efficient way and not spending four months and trying to read all the new standards that are coming out. So this is what I'm trying to show you here. And when we look at balance sheet and I took out here from the 2020 annual report of Mercedes. Something that is very interesting is that they provide are really some kind of helicopter view on how the balance sheet is structured. So you see the amount of assets, non-current assets, current assets, the liquidity, and the same on equity and liability side. So you have also the current liabilities, non-current liabilities and equity. And what is interesting in the Mercedes report is that they show the difference 20192000-20. I think it's great to be very fair. So kudos to the Mercedes management and board of directors that they provide this because it quickly shows you what is going on with the balance sheet from a global perspective on this helicopter view. And this is why I'm bringing in the approach of horizontal and vertical analysis. So the intention is falling and there is a companion sheet where you will see in a number showing here also the screenshot you will have, in fact, the possibility of taking an annual reports and the main categories are put in the actual font and you can just fill them up if it is on the assets or liability side. You can do this for two companies. And for each company, it automatically calculates the percentage, the weights that a certain balance sheet item, if it is an asset item or a liability item, how how what the weight, what is the weight of that item versus the total balance sheet? Because remember, assets and liabilities or total have to be the same. This is what i'm, I'm showing you here in the companion sheets. So you take a company like Mercedes or Kellogg's, you fill in the actual file and automatically it will calculate what the weight is of that specific item. And that's what is called a vertical analysis. Vertical analysis is a method of financial statement analysis in which each line item is listed as a percentage of the base figure of the total of the balance sheet, which makes in fact the analysis of the balance sheet. You can do the same even for income similar, cashless them. It makes really that analysis much easier to understand because you are correlating through percentages. One item with a bottom-line with the total of the balance sheet and the horizontal analysis. That's something in fact that let me put it this way. Vertical analysis, I do not often see this in financial statements of the company is already doing this for the investors or for the external stakeholders are interested in reading financial statements. Horizontal analysis happens very often. Why? Remember that IFRS and US GAAP make it mandatory to have at least two comparative periods. So an horizontal analysis is what is the method of analysis where you compare historical data. And this can be like comparing the cash and cash equivalents position in the asset side of thousand 19 with the cash and cash equivalent position of 2020. So we're comparing one period with another periods. And that's, as I said in IFRS and US GAAP, it is mandatory to do that as well. Sometimes, sometimes, but it is interesting indeed is a combination of the two. And that gives you an interesting, let's say, analysis of what has happened to the company, presented it to the cash position. You had a cash position. That was we're presenting 15% of the total balance sheets in 2019. And when you compare. The evolution of the balance sheet. So 2000, 19,020 you see at the cash position has been divided by ten. And then you can look into the percentage from a vertical analysis perspective. What is the percentage in 2020 of that cash and cash equivalent position versus the total balance sheet. Maybe there has been an acquisition and goodwill has gone up. Maybe it has been an acquisition and tangible fixed assets have gone up. So that's the kind of thing that you will be able to analyze as well when you do a combination of vertical and horizontal analysis. Nothing of that. Not too many people do this. I mean, I would nonetheless say that a lot of people do the horizontal analysis. They compare one period versus the other. And that's something that you typically hear when people look at earnings, they compare the earnings of the previous period to the earnings of the current period. So about vertical analysis is definitely something that I use to really get me very quickly an efficient way of having a guts feeding on what's happening in the company's financial statement is the balance sheet income statement, cash flow statements. So let's look at the example of Mercedes. So if you look at Mercedes, I've highlighted here in the red frame through, I'm doing here a vertical analysis. I've highlighted, in fact, what are the biggest items in terms of proportionality, in terms of percentage versus the total balance sheet. The balance sheet of Mercedes, I mean, I think this is 2020 report was €285 million. And you see that the biggest item in the asset side is the receivables from financial services because they finance customers, that they provide loan provider to customers that want to buy or mess it up. So you see that this is the biggest portion of the assets, then you have 16 or six per cent this equipment on operating leases. We'll discuss what that is later on. You have another asset That's receivable from financial services, but that's long-term. 149, which in fact, if you make the math, it means that more than 32, 33 per cent. So it means that one-third of Mercedes balance sheets are in fact, let's say if a financing or financial services money that they provide in advance to customers to buy a Mercedes cars so that we can discuss if it is risky or not. But that's I mean, Mercedes and I think common factors in general aren't doing this. Then you have property, plant, and equipment with 12 or three per cent. Obviously, Mercedes being a car manufacturer, even though they outsource a lot. But probably they do own a lot of buildings, have manufacturing plants, and then you have like inventory is 9.3%. So of course it was half stock, eight per cent in cash and cash equivalents, which is, which is okay, which is a good position. E.g. five, that's seven per cent and intangible assets. So you see that just with those six items, you already have understood three-quarters of the balance sheet of Mercedes. To give you an example how vertical analysis can tell you. So if you, as an investor, you want to understand what's the balance sheet is mostly made out of. You see that? It's mostly made out of what? Of financial services or financial means provided upfront to customers, Mercedes customers. You have a lot of buildings. So that's property plant equipment, and also criminal operating leases. So that's those are buildings that they do not own. Another 30%. And then you have some cash and also inventories. So their goods and services mostly good. So cars that they already manufactured and they probably are having on stock to be sold. So that represents three-quarters of the balance sheet. Do I need to be a CPA to get the essence of the Mercedes balance sheet know by doing this vertical analysis, use very rapidly get the essence of the balance sheet. Kellogg's here. It's even more interesting when by using this vertical analysis method is that 55 of the balance sheet items from the asset side represents nine tenths, nine out of $10 on the balance sheet. So 90% of the assets, what are the biggest items? You have goodwill, 3202 per cent. We will be discussing what goodwill is, but this is what comes from acquisitions. That's a third of premium they paid on acquisitions. You have 26 per cent. Kellogg's again, being a food manufacturer or they have a lot of buildings, all have manufacturing plants. So one-fifth of the balance sheet of Kellogg's is property, plant, and equipment. They have 38% of intangible assets. That's probably trademarks, copyrights, those kind of things patterns as well. Then you have trade receivables with a dot five per cent. They have inventories as well, which are high probably they are able to pre-produced products as well to avoid any stock-outs. So that's the kind of thing that you see also industry specificities when you look at the Kellogg's, let's say balance sheet versus mercy does. Kellogg's does not provide financing to their customers, but Mercedes does as a car manufacturer. So already you see by practicing this vertical analysis with a couple of items, you get the essence of the balance sheet already of Kellogg's and Mercedes. And this is where I believe it's a very strong method is vertical analysis is a very strong method that not enough investors in fact use when looking at companies. I really mean here retail investors. And one of the things as well that you can look into is of course, not just the asset sides. By doing a vertical analysis on the liability side, you have here in a very similar way, the same you have for Mercedes. I've put in red, red frames. What are interesting items? You see e.g. or Mercedes, 31% of the liability side of the source of capital is linked to long-term dept. You have e.g. for the 3% that's indeed account payable. So they probably have to pay suppliers. When you look at Kellogg's, see e.g. that 37%, 5% of their balance sheet is linked to long-term debt. And 13 at seven per cent is linked to account payables. Can discuss subcategories of equity. I see that equity in a very similar way between Kellogg's and Mercedes represents 20%, more or less 2020, 1% of the whole balance sheets. And that non-current liabilities represent 40 to 50 per cent, including long-term debt, which is rough cut a third of the whole balance sheet. So this tells you how the company has been so far being financed. Immediately understand through the vertical analysis applied to the liability side of the balance sheet that you have rough cut. A third of, let's say the worth of the company, of the assets of the company that have been financed through adapt. And fifth of the company that has been financed, indeed through, let's say equity, so through shower that and also retained earnings. And you'll see that there is a big difference on the written earnings from Kellogg's versus, versus Mercedes. And that's the intention of the, the vertical analysis and this tool or vertical analysis. Here I want to give you an example of horizontal analysis that I'm doing. And it's about a company that I already disclose it, that I'm a shareholder, minority, of course shareholder, but I have a big position in vf cooperation. So those are that's a clothing brands that owns vans, Dickey, I think the north face they owe and they earned some cool brand like supreme as well. And so it's not just about vertical analysis, but here I want to show you horizontal analysis. I did that. I mean, I was discussing with my best friends some months ago about because he's also invested into vf cooperation. And about they had a let's say, not so good previous quarter. And I looked at the balance sheets and I looked into what has changed from one period to the other. And basically, I'm looking here now just at inventories, is that the company has, in fact, in their balance sheet on the asset sides, carries much more inventories versus the position in September 2020, 1022, September 2022. So they carry two dots, $7 billion of inventory versus in average, they will always add one dot for. And why is the horizontal analysis here interesting? Because I could potentially explain the less earnings, that's VFC events Vanity Fair Corporation did in the previous quarter because for one or the other reason, I had not even read the notes. They have they had had more inventory in the balance sheet. So it could mean that a that they have prepared, they have pre-produced inventory that will be sold in the next quarter. We're going to see the earnings grow in the next quarter, or they were able to sell less. And with that, in fact, inventories, they are stuck with too much inventory, but they have, let's say, burned cash to create those inventories. And that's really just by doing this horizontal analysis and also looking at the percentage on how much inventory is we're versus the previous total balance sheet, total assets. Before you see that the has, something has happened. So obviously, just by looking at the financial position of the company. So the balance sheet, I already was kind of understanding and expecting to read specific nodes. And I was really looking than specifically for an explanation for management. Why our inventories so high. What went wrong? Either they have not sold and they have pre-produced too much inventory, or management has maybe an explanation that I should be able to find in the earnings statement, in the financial statements, maybe they have just sets while. Okay. We understand that we may have pre-produced much more inventory and we have burns. $123 billion of cash. Very probably because you also see the cash position in horizontal analysis that went from one dot 2022 to 552 million. But we know I mean, we're just looking at a quarterly statement here. We know that we will be able to sell that inventory the next quarter, and that's a very valid explanation for managing potentially. We'll see the next quarterly report. Events is not out. We have high-inflation, So people are maybe less, or let's say more prudent in spending on clothing and on those cool brands. So we will see, but inventory is there and we will discuss much later on how, I mean, how to value fair value the inventory, because the value of that inventory may degrade and may go down over time. But that's for a later one where we will discuss about impairment and depreciation of inventory. But here just by using vertical and horizontal analysis, horizontal analysis, I was able to see, okay, They have, they have burned like 700 million of cash and they have won the 3 billion more of inventories. So something has happened to some changes have happened. Maybe there have been some management decisions that were good or bad. I'm, I'm expecting now an explanation from manager on this. This is how I'm looking at financial statements when I use the horizontal and vertical analysis combined methods. And even just the horizontal analysis would have helped you to see the differences just by comparing one period with another period. So now what I want you to do is the following. I have why wrapping up this lecture, I have the following assignment for you. So again, you take, are you stick with your favorite company that you use already for the previous assignment where I told you I want you to download the latest annual report. I want you to look at the latest balance sheet and that you spot the biggest item from an asset side's perspective and the biggest liability in the balance sheet. Now what I want you to do is I want you to use the companion Excel file. And you do it for just one company. As I showed you, you have two companies that you can put them then compare one company with the other as I did from a citizen Kellogg's. But use the companion balance sheet and put the items of the balance sheet into the companion Excel file as a totally, it will automatically calculate the percentage of total. What I want you to do is to analyze and do an interpretation of what the percentages mean. So the weights of the various items, if it isn't the assets and the liabilities. And get a sense of what are the main, what are the material items in the assets and in the liability side of the balance sheet. As I was showing you, you for Mercedes and Kellogg's or even for Vanity Fair cooperation. There is a way of getting a gut feeling of what is the essence of the balance sheet of the financial position of a company? And this is why I want you to practice. Take this latest balance sheet, put it into the companion Excel file, and look at the percentages and try to make yourself, let's say knowledgeable on the stand. Why is that position representing a third of the balance sheet? Does that make sense in the business that the company in the industry, the company that you are using are analyzing in the business. Does that make sense? The company is operating in to have that, Let's say repartition that splits in the assets and in the liability side. With that, we are wrapping up this lecture and in the next lectures, we will now really go deep into all those, into the main at least balance sheet items. If it is equity depth as sources of capital first, and then also the assets that in normally they should be there to generate profits. And that's what we will be doing for the rest of this chapter number three, and that will be pretty long. There are many slides on it, but you're not obliged to all of them. But I will really want to give you the main elements that you understand, e.g. how to look at long-term data, how to look at different taxes, at different income, at equity as well. How to look at intangible assets like goodwill, like inventories, the fair valuation of inventory. So I think those are really essential things that are good investor has to know. So yeah, we will discuss this in the upcoming lectures. So stay with me on that. Thanks for tuning in. 12. Equity: All right, Welcome back. In this next lecture, chapter number three, discussing the inventory of company resources and capital. And you remember that we are starting first with the sources of capital. You remember in the previous lecture I was showing you how to split the balance sheet. So we have the sources of capital in the right-hand side of the balance sheet or the financial position if you're using IFRS terminology. And with Deb told us and equity holders and on the left-hand side is what has been done with the capital that has been brought in either by depth toddlers or equity or shareholders. That's the asset parts of the inventory of the company resources. So first we start as a totally with the source of capitate and then we will start with, let's say the shareholders, a typical shareholders at bringing capital into the company. Then fact, we will, and this lecture, which is pretty long lecture, we'll really, and I will do my best to make you understand all the various lines that you find in the equity part of the balance sheet because you will not just find one single line item in the balance sheet when you look at the equity part, if it is an IFRS report or US gap report, there's gonna be more to it and I will walk you through and through concrete examples on Mercedes and Kellogg's. I will build it up through a, let's say, simplified examples that you really understand the process. What happens with equity and when the company exists for multiple years. So stay with me on that. So first things first as far as explaining, so the equity part is an amazing year. The US GAAP structure, but I've read would be other way round. So the equity would be on the top. I like the Gap presentation. So the equity is really the, let's say, what remains of the company if all the assets of the company would be liquidated and all deaf toddlers will be paid back. That's basically what remains in terms of equity. Of course, when the company has started at inception date, if the company has started with 10 million of of capital that has been brought in by e.g. one single shareholder that 10 million sets for the time being as cash and there is no depth. Obviously the equity is equivalent to the cash. Remember that assets and liabilities have to be balanced. So the sum of the two sides is always equal. When you speak about the, I'll call it the residual value or the equity value of the company. We also, and you will often use or hear the term book value. And so one of the things that you need to be attentive, and I will be showing you in a couple of slides, a very important slide that I created myself that people not necessarily understand. And I will bring this back and correlate this with the accounting principles we have been discussing when you look at the book value of the company. So the equity value, so what remains in case all liabilities have been paid back. This is what remains for the shareholders. Typically, you remember that we have been discussing about financial statements being prepared on a going concern basis. Going concern basis means it's the financial statements are prepared in a way that management's is assuming and the board of directors is assuming that the company will continue to go on with normal operations. There is no discussion about bankruptcy. One of the things that you need to be attentive here is that in case there would be an urgent liquidation of the company, the value of the assets that you have on the left-hand side is all those assets are valued at following a going concern basis, so there would not be an urgent liquidation. I will explain this to you in a couple of slides. If you take, let's say assets that you immediately need to, let's say convert into cash. You will be giving a discount to find very quickly a buyer. So just be attentive that the book value represents what the company is worth after having paid off the complete adapts holders of the company. But on a going concern basis, not in case of an urgent liquidation. And we will come I will come back to that in a couple of minutes. Equity I mean, we already discussed it. So you can use the term equity or the book value of the company. And we have been discussing as well, that equity in fact is other claims on the residual interests of the assets after deducting all liability, equity is basically what remains when all depth TO lawsuit is bank loans, employees, suppliers, tax authorities. When all those depth told us having paid off, remember that they have priority before the shareholders. So when that has happened and there's still money left, e.g. in case of liquidation, then that's actually what remains for the shareholders. And of course, when we discuss the book value of the equity value of the company, we very quickly go into the conversation of company valuation and actually book value is way on how to estimate. It's one of the measures of evaluating a company. I will not go deep pyramid. I'm giving a specific course that is called the art of company valuation when I'm explaining all the various methods for doing valuation of company, either through book value, through the dividends. There are methods related to discounted free cash flow to the firm, Free Cash Flow to Equity, those kind of things. So it's not the purpose here, but just keep in mind when we speak about the book value, It's a way indeed, of valuing what the company is in fact worth to shareholders. And then of course, bringing this back to a book value per share. This allows you potentially to compare the book value per share. If we're speaking about the public listed companies with the market share price that you would receive from the open market. Just last pointer. And again, I'm not I don't want to go into the valuation conversation here is normally when you discuss the book value or when you think about buying a company, you don't buy the value. You don't, you don't buy the company for the value of the assets of the company. You buy the company for profits that those assets will generate over a certain period of time. Again, it's not the purpose of going here into the conversation, but just be attentive that when you compare the book value per share it with them, with the share price on the market. I mean, the share price on an open market is reflecting as well as the future streams of profits that the company will generate on the assets that are currently carried in the balance sheet. So just be attentive to that, that you don't mix up things. But again, it's not the purpose of this training. Explain to you how to be let's say looking and calculating company valuation for that, I have other specific courses that are taking care of that. So equity. So on left-hand side, Mercedes, on the right-hand side, Kellogg's, we have on the left-hand side, the consolidated statement of financial position, which is basically the IFRS balance sheet on Kellogg's, which is following US GAAP, you have the equity. Again, you see the order in the right hand side on Kellogg's. You see that the equity comes at last. So at the bottom of the liability side. And in the IFRS balance sheets of financial position, which is basically Mercedes here you see that equity comes first. So you see in fact that they are a couple of lines here. Let's zoom in on this slide, you see e.g. that former cities, we have share capital capital reserves, retained earnings, other reserves, and you have equity attributable to Cheryl's of diamond or gay and non-controlling interests. And then the total of equity, Kellogg's, we have equity, common stock capital in excess of par value, retained earnings, treasury stock, and accumulated other comprehensive income or loss. You have totally Kellogg company equity and have non-controlling interests and total equity. So you see that you find similarities in the way how equity is, let's say, described in the balance sheet of an IFRS company. I mean, IFRS reporting company like Mercedes and US, GAAP reporting company like Kellogg's. But not the complete vocabulary is the same. And I will walk you through, in fact, through those various lands that you really understand. What do those lines in fact mean? The first thing as well, I'm applying your vertical analysis. Remember going to the companion sheet is that I'm looking as well here very quickly at the vertical analysis of the total liability side. So the right hand side of the balance sheet of Mercedes and Kellogg's, and it's coincidence, but the equity represents rough cuts, a fifth, so 20% of the total amount of liabilities. One thing that is clearly different, look at bullet point number one is retained earnings. So you see that Mercedes, I would say, only has €47 billion of retained earnings in the equity parts. And we will discuss what retained earnings is and I will walk you through and it will build this up with a very simple example. While Kellogg's in fact, 46% is, in fact, let's say linked to retained earnings. And they have a lot of treasury stock which morsitans does not have. And we will explain what that means in fact, so retained earnings and treasury stock. But at the very end of the day, if you look at the total equity, indeed, non-controlling interests are pretty similar. But the total equity represents between 2020, 1% of the total balance sheets over the total liability side of the balance sheet. Again, I want to come back to this going concern basis versus liquidation scenarios. So remember we're discussing here about valuing the equity of the company. Remember that the equity is the residual amounts of value of the company that would remain to shareholders if the company would have paid off, completes all the depth dollars, the complete in-depth at the company carries. As I said, bank loans, corporate obligations, suppliers, employees, tax authorities, et cetera. Remember they compress my priority rule. One thing that I also mentioned is that remember that when you look at the balance sheet, you're looking at the balance sheet from a going concern basis perspective. So normally the company, I think I mentioned this in the Kellogg's example when we were discussing the accounting principle of going concern, that Kellogg's was explicitly mentioning that the financial reports have been prepared on a going concern basis. Most of the companies, even the companies I'm sitting in. When we build up the financial report, we clearly mentioned that the financial report has been built up on a going concern basis. But you need just to be attentive that in case you would be in an exception scenario, the company has to be liquidated, which is basically the worst-case scenario that can happen to company. While depending on how much time is available to, let's say to liquidate us, to liquidate the company assets. And what does liquidation mean? It means taking assets and transforming them into very liquid asset, which is basically cash, right? So you're taking a factory, a car, a laptop, and inventory, and you're transforming or selling this off and collecting the cash to pay off the debt TO loss and then the cash that remains is then available to shareholders. This is an exceptional scenario, but just be attentive that there is an, I call this the adjustment ratio to book value when, I mean, when you have a lot of cash on the balance sheet, on the asset side, cash is easily convertible to cash. It's a one-on-one conversion rate. I call it 100% adjustment ratio to book value. When you have more marketable securities and cash equivalents, very probably you're going to be very close to one-to-one conversion from the assets to cash, e.g. inventories. Well, if you are I mean, if you have less time and there is an urgent liquidation, you I mean, maybe the valuation that should be represented on a going concern basis. If you're an urgent liquidation, the inventory will be worth less than 100 per cent of the value that is carrying the balance sheet. Understand the principle of liquidation and liquidity. Liquidity in fact, means and you have here the definition refers to the ease of converting into cash without affecting the book value or the price of, let's say, of a company. But it's, I mean, it's not always as easy as that too. Otherwise, you would have a line where indeed all the assets would be able to be converted one-to-one between the valuation on a going concern basis in the balance sheet versus what is this will have an impact potentially on the equity. So on the book value of the company, it doesn't happen very often, but just in case there isn't, the company is looking out for money and is unable to raise fresh money from shareholders, from banks, e.g. it will have to liquidate its assets and that will vary probably have an impact because acids will be liquidated at a discount. And through that probably there's gonna be a value that will be destroyed too, I mean, towards shareholders, first of all, because the book value will be reduced in fact. Alright. Now, I will walk you through now the next minutes through what in fact, you will find inequity when we speak about activity, we will start with a very easy one, which is common shares. I will walk you through retained earnings, share buybacks, share issuance, non-controlling interests and other comprehensive income. So let's start with very simple things, common shares. So remember, we were discussing, when we were defining shareholders, what is a share? Is a unit of equal parts that is basically representing, let's say, the capital of the company. And you may have companies that have hundred millions of shares and other companies that have 100 shares. But it's, you remember that chairs are giving rights to control the company and also a claim on the profits of the company which credit told us don't have. That's why creditors are liquidated first. You remember very briefly here we were and I was introducing when we are discussing about chairs, different types of shares, ordinary or what is also called common shares, preferred shares, very often preferred shares don't carry a vote, voting rights, but they have a higher incentive on cash dividends, e.g. you have shares that do not provide voting rights, e.g. for employees and you have management chair. So you remember we were discussing wish more. We were discussing as well. What was it, The second example, alphabet. So the google holding company. And one definition I need to add here is the term par value. If you look back at the slide of Mercedes and Kellogg's. They mentioned, I think it's Kellogg's that is mentioning par value. Par value is also called face value or nominal value of a share. So what does that mean? So the par value is basically the book value at inception of the company. Let's imagine that the company is created with 1,000 chairs. And those 1,000 shares. At the inception of the creation of the company, the founders of the company say that, well, as we are bringing in 1,000 shares and we are bringing in those 1,000 shares, which basically represent €1,000 of capital, $1,000 of capital. Let's imagine it's a very small startup. We're going to decide that every share is worth basically €1 because we have, we're bringing in €1,000 of capital and we have decided to create 1,000 shares. So the par value at inception of each share is €1. And which is basically the poverty is there because basically it's the lowest legal price which a corporation should sell its shares. Another term on top of poverty that you will often, you will nearly every time find it in publicly listed companies is the basic amount of outstanding shares versus the diluted amount of outstanding shares. So the basic amount of outstanding shares is very easy, is the current number of shares that are available. Typically on the secondary market, if we speak about publicly listed companies, right? So there are maybe 100,100 million of shares that are freely tradable. Well, that amount of shares is the basic amount of shares outstanding. And then very often you find in financial reports the term diluted. Diluted is in fact a figure that is normally higher than the basic one. And dilute it includes dilution mechanism of shares, e.g. convertible depths, maybe stock options preferred to as those kind of things. And that's why I'm saying nominee dilutes. It is, let's say, always higher than basic. Because if you are starting to calculate earnings per share, you should always calculate the earnings per shares with the amount of shares being, or dividing the earnings by the total amount of shares diluted, which is a bigger number. The basic one. Because probably people like employees. I mean, if the company has 100 million shares basic and they have promised 100,000 or maybe 1 million of shares to the employees for stock options. And they will, they will vest over time, let's say over the next two years, three years, five years. Well, you may end up having a total amount of shares, which is 101 million, e.g. and not just 100 million, which was the basic amount. So I'm always taking, and I'm always in other courses telling my students and other investors, always take the worst-case is take the bigger number, which is diluted number to divide. So to use the earnings and to divide the earnings to come up with an earnings per share, e.g. again, giving other examples on top of alphabet that we discuss a couple of lectures ago. Reshma, you have the same with Berkshire Hathaway, where e.g. Berkshire Hathaway. Couple of decades ago they started to have Berkshire Hathaway Class a and Class B share, where in fact the differences on the right, e.g. one and a share is in fact, giving different voting rights versus a B chef. E.g. BMW has the same button, did not create a class a class B Shia. They created preferred shares and common shares. And in fact on the preferred shares, they are giving a little bit higher dividends because in fact, the preferred agents do not have voting rights while the ordinary shares they do have voting rights. So let's go with a concrete example. I will show it to you after some Mercedes and Kellogg's, we will come back to this, but I really want to build this up in a very simplistic way. So allow me to use a very simplistic model. So I was giving the example that accompany a startup is created. The startup, the farmers are bringing in €1,000 of capital to start. It's a theoretical example. They decided that the par value of the company is €1, which means that one share is in fact €1 in terms of par value. It may happen. Let's be very clear and you will see it on the Mercedes case that the company is in fact not defining the par value of the company. So you will have an indication of the amount of shares, but you will not have the par value of the a company, of one share of the company. Why are some companies, or why did some companies do this? Because they didn't want to credit a liability towards shareholders if e.g. the sediment and they want to sell and e.g. the market price would even be below the par value. So that's already a little bit technical. But consider that in most of the cases, actually when the starting capital has been brought in, that starting capitalist will divide it in chairs and those shares will carry a par value or face value or nominal value for each share. And remember, you're going to have a shell or register where in fact all shareholders will be, of course, listed. Right? So if we have this situation, we can, through that example, already calculated what, what's the book value of one singular share? What basically is, if the total amount of the balance sheet at the inception of the company is €1,000 divided by 1,000 chairs. So the book value of the company at that moment in time is equivalent to the par value, which is the value at creation of the company. It's €1 per share. But this is now very simplistic. This is at the inception, at the creation of the company at day one, you're going to see there's gonna be things happening in the future. Do we see this? So there's very easy principle of par value and book value per share. Do we see it? Citizen Kellogg's? Well, please look here. So indeed, in their cities, it's called share capital. So they carry 330, €70 billion of share capital. And what is interesting is that you see in yellow highlighted is they, they said that the Czech capital is divided into no par value shares. On the other hand, Kellogg's, they say, Well, indeed they have not call it check happily call it common stock. And they clearly say that the common stock, each share has $1.00, 25, so $0.25, $1 of value. And, and that's indeed at creation of the company that 1 billion shares have been authorized and for the time being, 4200009602092 shares in 2020. I do not know another 21.22 figures, but probably it has evolved. But that's the amount of shares that are currently outstanding. So you see that there are differences, first of all, in the vocabulary. So Kellogg's has a shack capital of 105. This is probably millions of US dollars, while Mercedes has 3,000,000,070 of share, capital one with par value at $0.25 a share. And Mercedes said, No, we don't have a par value, so our share capital is no-par value. But they have an amount of shares that is equivalent to 1,000,000,070. So they have 1,000.70 million of outstanding shares. This is also something that they share here in the report in the equity section in the equity note of the financial report of Mercedes. So first assignments here. I want you to take your favorite company. I want you to look into the latest audited annual reports. And I would like to I would like from you that you find out the amount of outstanding shares, the term Many of the company has only one class of common shares. Or potentially if they have multiple class of shares, by looking at the equity statement and the equity notes of the company. So make yourself, let's say confortable into reading and understanding the, let's say, share structure of the company. So please take your favorite company, look at the latest annual audited annual report and figure out the amount of outstanding shares. And what's the share structure if they have one single class or multiple classes of shares, maybe look as well. If the company is mentioning if there is a par value or no-par value on it. So that's so common share, so very easy and I will walk you through this. I will build up on this very easy example, startup that has created with €1,000. That's a theoretical example, a one-year of par value per share. So the book value at inception is of one year or this year or per share. But now the company has probably taken that capital, has invested into assets. And as you remember in the value creation cycle, hopefully the company has been generating a profit. This we won't be discussing here. And this is where indeed there has to be a mechanism where if the company exists for ten years, there has to be a mechanism where the earnings of the quarter of the year are reported through, but also the accumulated amount of losses and profits is reflected. And I'm in for the yearly or quarterly profit, That's very easy. That's the income statement or the earnings statement and it will be discussing profitability in chapter number number four. But if you remember, I'm taking back a slide I have been using in the very beginning of the course, which is this slide where we're saying, and I was introducing the main financial statement types that income and cash flow statement. They look at, you remember, cash accounting and accrual accounting. That's the difference between income and cash flow statement. But basically income and cash flow look at the period of time. The balance sheet does not. So having said that, it means that, well, at the end of each fiscal periods of each year, if we consider that each fiscal period is one calendar year. Or maybe the fiscal year starts July 1st and end of June, e.g. that's the case for Microsoft, e.g. the results of that, so the results of the income statement, so either the profit or the loss of the company to some extent has to flow back into the balance sheet. And yes, that's the case. And this is where I'm seeing why the balance sheet is so important because it sums up, it accumulates all the profits and losses of multiple years, of multiple income streams of multiple yearly income statements into the balance sheet. And we're in the balance sheet. Well, in the retained earnings and or losses. So retained earnings and losses are in fact a very important contribution to equity because they add up all the profits, hopefully all the profits that the company has been generating over many, many, many years, if it is already more mature company. And this is not share capital that is brought in, is just that the profits, in fact, add up to the book value of the company because the company has more assets, the company is serving more customers. The company maybe has more inventory, more buildings, while the that's on the asset side. But on the right-hand side, on the liability side there, in fact, it sits in the retained earnings. So let's give here a concrete example. So we had this startup that started with €1,000 of capital with one shot at €1 par value per share. The company exists now for a one through three cycles, three fiscal years. And interestingly, the company in the first year has been generating €100 of profits in the second year, 250 years of profit, and in the third year €500 of profit. So where is this sitting? Where it sits in the retained earnings and losses item in the equity. It means that you're going to have share capital on that company. If I will show with Mercedes and Kellogg's what you're going to have an hour, very simple company. You're going to have €1,000 sitting in share capital and you're going to have €850 after the third fiscal year sitting in retained earnings slash losses. So it's a positive number. What happens to the book value, to the equity value of the company? Remember as liabilities have to be in balance while the equity has grown from €1,000 to 1,850. So the 1000s capital at the beginning plus the accumulated profits that are retained earnings. Which means that if we recalculate our book value per share, it was at one year old par value in the beginning and now it is at €185 share. Why? Because as the company has been generating profits, it's honestly, it's a lot of profits for 1000-year of capital, but it's just a theoretical example here. The book value of the company has grown from one year or two on your own. One year or 85. This is an example where credit told us they don't have the acclaim on those profits while shower loss happened. That's my I'm a value investor because in fact, if I would have been in this situation, if I would sell the shares, I would probably at least sell them for twice the amount that I bought. I brought in capital into the company. That's something that you don't have as a credit taller when you provide a loan to the company. This effect, e.g. here, multiplying by two after three fiscal periods. How does this look like in reality now for Mercedes and Kellogg's, and this is very interesting. We had shack capital at 3,000,000,070 former cities. We had 105 million of common stock, which is shack capital in Kellogg's. And you have both companies are reporting retained earnings. And it's interesting because Mercedes has €47 billion of retained earnings and Kellogg's has 8 billion of retained earnings. Just look at the proportionality between Czech capital and retained earnings. So here you are immediately see that basically the, the worth of the company, the book value of the company has grown. Because probably the company was able to accumulate many, many years of profits. And this increases the equity value of the company. And of course, for that equity value of one single share as well, if you are maybe smaller minority shareholder. And obviously we like that because if we are investing into company, we hope that the company will invest into the correct assets when they take capital allocation decisions. And that those assets are generating profits. And those profits will allow us to grow, continuously, grow the well of the company. And this will have an impact on the equity side, specifically in the retained earnings. Now, share buybacks and treasury shares, that's also a very important topic. So we have an asset that we have common shares at inception and then we have retained earnings, which is in fact the sum of accumulated. Earnings and potentially losses as well. So you see, as well as the company has been destroying and generating a loss. I mean, the accumulated amount of losses will then be summed up to the common shares. So if the common shares, if you started with €1,000 of starting capital and you would have had three fiscal periods of minus €850. Your book value would only now be €150 to make it simple, okay? So the next one, share buybacks and treasury shares. Why do I have to speak about this? Because in fact, over the last ten to 20 years, there has been a trend for tax reasons too, for a lot of companies to pay, let's say, less back through cash dividends to shareholders, but increase the book value of the shares by the company using cash from its operations, even cash from its profits to buy its own shares from the market. This is what is called a share buyback. So as I'm sitting here, is the repurchase decision by the company to buy back its own shares. In fact, it's a, there is a tax reasons for this, but it goes well. I'll use the term tricky. Let me use this term to artificially increase the percentage of the equity percentage, the equity stake of the remaining shareholders will not go into the detail here. But indeed, if the company is buying back ten per cent of all the basic outstanding shares and you are having a 10% owner. Well, if the company has removed 10% of the shares, your 10% is now worth much more because you're ten per cent on, let's say 100 million of shares. So ten per cent means 10 million of shares. There are now only 90 million of shares out there. While you're 10 million of shares are now worth more because it's 10 million divided no longer by 100 million of shares, but 10000000/90000000 shares. That's the principle of share buyback. And it's considered by a lot of shower loss as a reward in fact, and it's part of what is called the Free Cash Flow to Equity. And I'm showing you a graph by the SAP. So indeed it has become much more common since a couple of decades, so 12 decades to do share buybacks also for tax reasons. How does this work? So, imagine that the company has generated profits. Remember in the value creation cycle that the company has a choice of either re-injecting the profits into the operations, having more assets. But the company may also decide to take a part of the totality of the profits to pay off depth. But also they may decide to pay out a cash dividend to shareholders. Or they can also buy, do a share buyback. So buy-back shares, its own shares from the market, e.g. to increase the book value of the company. And I'm giving you a concrete example. So we started this startup with one-thousandths euro capital. There's €1,000 of capital was divided into 1,000 shares of €1 par value. Let's imagine on the very simple example that the company has generated the profits. And the company is Eva, or decides to buy back 50 shares of its own amount of shares. So the equity in fact is being, let's say, reduce with this because basically the company only has now 950 outstanding shares because it, it brought its bought back. In fact 50 shares which are carried and called treasury shares. So that's the effect of a share buyback. And in fact, you could calculate what is the yield, the return on this. And again, it's not the purpose of going here into this conversation. That's my value investing and company valuation conversation. But basically, you would have, if the company has one common share that is worth €1 par value. By doing this 50 share buyback, or this 50 shares buyback, actually generating a 5% yield towards the shareholders. And how is this done represented? Well, basically you're going to have a negative figure of treasury shares that is carried in the equity part of the balance sheet. And let's really calculation and you'll understand what happens. So you remember we had 1,000 shares that were created at one year of par value, right? We have €850 of accumulated earnings and losses. And the company decides to buy back shares at 50 shares at a price of somebody's willing to sell to the company those 50 shares at one dot €8 per cost, which is in fact basically the new book value. So what happens in fact, true to the equity and the book value per share of the company. Well, in the beginning, you remember that. We had the book value that was at around one dot €8 per share. And the company has to reflect that bought back its own shares so they are less shares available. The effect, and it will show this to you through Telefonica is what I mean. When the treasury shares and I had actually a student a couple of months ago asked me this, but if the treasury shares are carried in the balance sheet, is there a risk that the company will decide to re-sell those shares? And the answer is what theoretically, yes. And as long as the company has not canceled, avoided those shares. In fact, there could always be a risk that the company would sell those shares and buy that having again and equity dilution effect. I give you here the example of Telefonica. So let's imagine that Telefonica has in fact been doing this. Of course, at a bigger size in terms of amount of shares. What they decided to do and this happened 2021. They in fact, imagine that they bought back in 2020 a certain amount of shares and 2021 they decided to cancel those shares and that was representing 165% of the share capital. I mean, what is the, why is this important to shower us? Because they're the risk of selling again, those shares that they bought back from the market then is completely avoided because the company then, as they cancelled out those shares, indeed, your book value. This is what I'm showing here in the example after the cancellation of the shares is that the book value of the company, they are now only 950 shares that are available plus 100 a plus €850 of retained earnings. And now you divide, after canceling out those 50 shares, you divide by the 950 total amount of shares. Your book value has gone up to €89 per share. So you see that this is generating a yield on the book value per share for the shower loss. That's why treasury shares, also interesting and actually for you as a shallow you're not expert to taxes for the time being, but that conversation is going on also to tax share buybacks. Given here, as I said, the example of Telefonica, because it's interesting to see that this is a concrete example of Treasury shack cancellation. How does this look like on the balance sheet? First of all, let's start with Mercedes concrete now example. Mercedes in fact, for the time being, if you see they don't carry share buybacks in the in the balance sheet. So it says that there is a specific chapter that speaks about treasury shares. So the theorization granted annual shareholder meeting on April 2050 to acquire and use treasury shares expired on March 2020, but has not been utilized. So they have the approval of the annual shareholder meetings. So the majority of the shareholders, but they have not been using this right to buy back shares from the market. Now, in 2020 at the annual shareholder meeting, the board of management has again been authorized by 13. Introduction to Debt And Financial Debt: Welcome back investors. So in this next lecture, in chapter number three, we are looking at inventory of company resources, so assets and the sources of capital. In the previous lecture, we were looking at equity as one of the sources of capital that is obviously linked to equity holders. So to shareholders have claims on the company in terms of voting rights and ownership. And now we will be in this lecture actually I decided to divide the lecture into two. We will start the lecture with looking at our college, typical or general Dept as one of the sources of capital and how to do the interpretation about how much debt the company carriers versus equity, e.g. and the second part of this lecture, we will still be looking at depths, but I will call it the other depth. So other liabilities. Because otherwise the lecture would be too long. So that's what we will be discussing in the upcoming two lectures. So again, just reminding that when we look at the balance sheet, so we have started analyzing the balance sheet, looking at the right-hand side of the balance sheets or the liability side of the balance sheet with the two sources of capital, which are equity and debt to asset. Previous lecture equity. Now we are looking at dept instruments, of course, as already explained, those sources of capital or that capital is taken transform into assets. With yogurt, those assets would generate a profit. Alright? So when we speak about sources of financing and set them mainly two sources of financing. You have equity funding. I mean, that's really where you have shown us bringing in either tangible assets, a car, laptop, but also cash. And that cash probably will be transformed into some, let's say, tangible assets to generate some kind of profits. But that is also a source of financing. And it's, and you will often see companies, they actually mix up the true sources. So they take up some depths and they take up some equity in order not always to go back and ask the shareholders for fresh money if they need to raise fresh, fresh cash to do whatever investments, those kind of things. And as always, any source of financing intrinsically carriers always two elements. There is a cost associated to it and some claims are right on the resources. And we will be discussing, I think it's next slide, but I can run introduce it here. The fate of priority when I will walk you through, when you look at a balance sheet is US GAAP or IFRS balance sheet, that's the order or the priority of claims and already will state it here. Depth TO loss will always come before equity holders. That's the reason why some people prefer to give a loan to company than becoming a shareholder of the company. So that's one thing we'll discuss later on when I will walk you through the order. Why you have e.g. in US GAAP, you have that it comes before equity and IFRS, of course, it's the other way round. There is a cost associated to it we will discuss is much later in this course. I will introduce the element of weighted average cost of capital. If you're interested, I have a specific quick take a course on capital structure. And I will not go as far as that course in this specific course, but I will just make it simple here. When the company raises capital from equity, we saw this in the previous lecture. There is a cost associated to it that leaves an opportunity cost. And the shoulder has some expectations in terms of giving that money to the company, becoming an owner of the company. But normally exhibitions, philanthropy, the owner wants to have a written on that. So that's basically the expected return on equity or the cost of equity. But you have the same for dept for that as well. If you are a bank, you're giving a loan to your friend, e.g. because your friends came to you as a banker and wants to raise money to do, I don't know, a brick-and-mortar shop on organic bio juices, orange juices. Well, you as a bank will not give that loan for free away. So you want to have, so you will put on that debt instruments, the amount of money that you are lending to your friend or to your customer. And you want maybe after ten years to see the whole amount back. And every year you're going to charge for that loan a certain cost. That's the cost of that, or basically can also call it the return expectations on that. And what is interesting as well, and we have this conversation is some people say, Well, which one is basically the cheapest? Because, I mean, you obviously understand if my assets are generating a ten per cent profit and I have a loan that they have to pay back 12% every year. I'm very probably destroying value, which is true. So it happens sometimes, it depends. Currently, we are February 2023, so interest rates are pretty high because of inflation. The Fed, in the US and federal reserve, a European Central Bank. They are having interest rates pretty high in order to bring down the amount of inflation. Because basically central banks want to have more or less 2% of yearly inflation. And this is where they will then actually adjust the interest rates to make sure that they keep close with this 2% inflation every year. And we will be discussing this in the value creation. So just keep that as an introduction. That's, that has also a cost as equity has a cost as well. Then you have different, let's say that owners are claimants. I mean, first of all, and we will see this in the balance sheet. We have short-term debt and long-term dept. I mean, if you have an employee that is working for you and the employee has been working, let's say now the whole month of January for you and you're only paying out the salary on the first week of February, that's a short-term liability that you have towards your employees, right? So those are claimants. So salaries are in fact claims on the company as well. Then you have long-term that I was giving the example of the bank loan for ten, running for ten years, e.g. and we're going to see this. It's the same on the balance sheet, on the asset side where we have the current assets. Those are, let's say, short-term assets and long-term assets. That's typically more than 12 months. We have the same effect on we will be looking at liabilities and the balance sheet. You're going to have short-term debt or short-term liabilities, those liabilities that have to be paid back within the next 12 months. And you have long-term liabilities which have a longer, let's say a claim, a period like a bank loan e.g. and you're going to see how that works when we will be looking at the balance sheet. Again just before we move forward. So assets depth is a source of financing as well. And of course there are some conversations that not all depths link or is linked to loans. You may have suppliers where you carry the depth of those suppliers because they have provided maybe goods and, or services to you, but you have not paid them back yet. So they have a claim on the goods that they have delivered to accompany that are sitting already now on the asset side of your balance sheet, maybe in inventory, e.g. so that is also a source of financing, even though it's a short term sources of financing. But remember when we were discussing cash conversion cycles, That's basically if you give ten days to your customers to pay and your suppliers, you will pay them back only 60, 60 days, sorry, there's 50 days in payment terms difference is a source of financing because Ringo's 50 days, you can take the money that you owe to the supplier and do something with it, maybe just generate a 1% profit on it. So it's also a source of financing and we're going to see that short-term assets and short-term liabilities, we will bring in the, the element of working capital. So that's really working capital will be discussed when we were looking at profitability analysis. Because what companies want to make it simple is that companies want to have a lot of accounts payable and not a lot of accounts receivable is an asset, so all customers pay very quickly. The company takes time to pay back the suppliers. I'm making it simple and just looking and working capital S, the difference or the balance between short-term assets. So accounts receivable and accounts payable, which are short-term suppliers. When I was briefly mentioning it, why are people making, making loans to companies, e.g. but there are some advantages to adapt. That's equity holders e.g. do not have one of the main elements and already introduce a couple of minutes ago, is that if the company would have to be liquidated, debt holders will always be paid first before shareholders. That's one of the reasons why debt instruments are considered a less risky investments compared to equity holders. We're gonna be, I will show you in a couple of slides as well, the risk curve as well versus a return curve. And it's, let's say typical for that. Let's put here, blue-chip companies have very strong companies that are financially very solid that you're going to have when you are, when they are raising money or when you're making to them alone, they can finance their debt instruments at very cheap cost. And because that will be liquidated first, typically the debt instruments will have a lower yield and e.g. the cash dividends. Because the risk of, in case of liquidation of seeing the complete investment as a shareholder will be higher. Because maybe at the moment the company is liquidated after having paid off all the debt. There is nothing that for shareholders, That's real scenario and I will show you this to you also in Chapter five. I have added a second example, which is a company that is called cure rate, which is a publicly listed company in the US. And I had actually a person who asked me to do and let's say financial statement analysis of the company. And we will look disgusting because the company is not very, I mean, doesn't have a solid financial base. So I will share this with in chapter number five. But the company potentially, if the company is liquidated, all debt is paid off after liquidation. There's maybe nothing left for the shallow. So what is the, the share price worth of one single share? So what is the market? And the market in fact has divided by ten, the amount. So let's say the value of a share price for that company. And there was also some disadvantages to adapt is that investments, they do not want the investment of depth to be used to repay existing dept. So that's definitely something investors so shallows, they typically want their investment if they bring in capital into the company, that capital is transformed into assets to generate profits. But it may happen typically in the case of liquidation or very close to bankruptcy. That and I think we have now this with what's called Bed Bath and Beyond in the US that they have yesterday, I think so we are eighth of February. They have announced that they would probably have to raise fresh money from shareholders, which has an equity dilution effects just to avoid bankruptcy. And of course, this investment will be partially used. I mean, I haven't looked at the financial statements, but what I understood is that that investment will partially used to pay off some depth because they are really there apparently carrying too much debt. So that's the kind of thing. Obviously you shall loss. They hate to bring in money to pay off and give that money to credit TO loss. The investors, shareholders want that money to be employed into creating acids and generating profits from those assets. Something as well. I was discussing yesterday evening with this investor about the different types of depth investments we have, the senior or collateralized dept. So it may happen for companies where the bank or an external loner is not, let's say, or lender is, I mean, doesn't want to take too much risk. The loan may be linked to some assets. And so the, actually the senior collateralized debt instruments or the thirst that have the highest priority in case of liquidation. And they're often linked, in fact to some assets. And then you have other instruments like mezzanine, mezzanine depths. You have junior unsecured debts. So that is subordinated to men's an in-depth and mezzanine debt is subordinated to senior debt. So there is a priority. And obviously the priority comes with risks, and obviously the risk comes with a cost linked to that risk or risk premium. So obviously, if you're giving a loan to a company and your loan is considered as a collateralized with assets may be a senior debt instruments. The you will not be able to ask the same amount of interest rates compared to e.g. a. Junior unsecured steps because they are the risk is high, it's not collateralized with any assets in the balance sheet, e.g. typically e.g. when you are maybe startup company or small businesses. Businesses. I mean, they do not get I mean, they cannot collateralize it absolute very often they will get a junior debt, maybe by the bank instead of a senior debt, because there are nearly no assets in a startup. So that's the kind of thing. Obviously that you also need to be clear about what are the expectations. And obviously if the company does not carry a lot of assets, the, the lender things about what happens in case of liquidation where basically they are not a lot of assets. So it's really very high risk loan that I'm giving to this company. So obviously, the higher the risk, the higher the written expectations. So the cost of giving that loan to the company will be. So you may end up having an unsecured debts on an unsecured loan that will carry maybe 89 per cent yearly interest rate, while maybe a senior collateralized depth may carry two to three per cent. And we will be discussing also credit rating agencies. And you'll understand how the interest coverage ratio has an impact on the rating agencies. Let's say, score that they give to companies. And through that, what is the cost of financing through debt instruments for the company? So stay with me. It seemed little bit complex, but you will see it's pretty, pretty easy. And sometimes you have also in debt instruments, what is called covenants. Covenants is lack of promise in agreement or contract between two parties. You may have positive and negative covenants is where part is basically agree on certain activities to be carried out or not. It can be e.g. that the company is not allowed to pay out cash dividends to shareholders until maybe 50% of the loan is paid off. E.g. you may e.g. have to do a certain amount of things, create reserves until e.g. a certain debt to assets ratio is achieved, or let's say threshold is achieved. So covenants can be very creative and that's obviously something important when you're a shareholder. And I'm not speaking in our private equity. When you're a shareholder, you want to invest into private equity companies are privately owned company and the company is carrying some debt instruments. Obviously, you need to look at what are the debt instruments, what does the interest rates and the yearly coupon on those debt instruments and any potential covenants that you, even though you are investing as shareholders, you becoming an equity holder. But you will be exposed to this because maybe the covenant carries certain elements that will not allow certain things towards shareholders until maybe the depth is fully paid back, e.g. so just be aware that those instruments and kind of agreements exist, then you have hybrid investments as well. And even myself, I have experienced e.g. a. Subsidiary that comes and asks the holding company for money. And then obviously S, as board of directors or shoulder, we will be analyzing our giving. Are we investing money, supplemental money as shareholders, but as the equity dilution factor on that. But maybe as already mentioned, as debt instruments have a priority in case of liquidation towards the company. Well, maybe we will provide a shareholder loan or maybe a hybrid instrument, which is we're going to provide shoulder learn that can be converted into equity at our full discretion, e.g. so those are the kind of things where you have hybrid instruments. And the reason why those hybrid instruments exist is really because depths in terms of when liquidation happens, we'll have first priority on equity holders. And you may have shallows who say, I will just do hybrid instrument. I gonna give a shout alone, which is the lowest one in terms of priority. In case of liquidation in the depth subcategory. And I'm leaving myself, if the company is growing to transform that Shaoul alone, this debt instrument into equity. So by that I'm increasing the stake in the company. So that's the kind of thing that you may have. In fact, it happens even sometimes at the shoulder says, I'm taking a very easy example. A company, a subsidiary is coming to you as a holding company, and it's asking for 2 million of money, you may, as a holding company S majority shallows decides to take 1 million as a shareholder loan and 1 million as equity so as capital investment. So I mean, it can be half-a-million and one-and-a-half million. So just be aware that the hybrid investments, hybrid instruments, Xist on convertibility. But sometimes it's a hybrid in the sense that the money comes into the company through true instruments. One being a debt instrument and the other one being an equity instrument. Now, let's practice our eye so that you become fluent with this. And as always, I will start with looking at the Mercedes and Kellogg's. And I will walk you through how to analyze and how to see the W, Let's say items in the balance sheet on the liability side. So remember that Mercedes is reporting under IFRS and that Kellogg's is reporting on a US gap. Remember, as already said, is that I'm showing you here a US gap example on the right-hand side that the balance sheet has a certain order. And typically, the main categories of assets are listed by the most liquid. So cash comes first and US GAAP and intangible assets like sorry, like trademarks, IP, those kind of things good where they come last because it's very, it's much more complex to transform them into cash so to make them liquids. So illiquid assets in US, GAAP and IFRS, it's the other way round. You're going to have very illiquid assets like intangibles on the top, and very liquid assets like cash, which is the most liquid one. Cash is cash. I mean, when you convert cash into cash, when you convert euro into euro, I mean, that's extremely liquid. There is a one-to-one conversion between the two. So in AI presents the other way around. So the most liquid will come at the very bottom. In fact, is the same for liabilities. So liabilities, they follow a certain order. We will start with US GAAP, you're going to have current liabilities. Yeah, and I forgot to mention on the asset side of the balance sheet, you have current assets first and then you have a non-current asset. So that's the below 12 months. To be converted into, easily converted into liquidities and beyond 12 months in liabilities is the Senior side with current liabilities, those are things that the company has to pay back within the next 12 months, very probably. Then you have non-current liabilities. Those are long-term liabilities, which include long-term debt instruments and equity because equity is considered a long term liability. In fact, as I said, so there is a priority. So it always starts typically with suppliers for us, but it's called accounts payable. Then it goes to lenders like banks, private bond length as this kind of things. Then of course, it ends with equity in US GAAP and IFRS. It's the other way around. So let's look here at Mercedes and Kellogg's, and I tried to put it in parallel. You see them? And this is a sequential balance sheet because typically companies, they do not do this left right view, but they do a sequential so they often start with assets and then they put the liability is below. So let's see on the left-hand side, IFRS, the very bottom, it starts with current liabilities and it goes into non-current liabilities and then equity, the right hand. So that's IFRS on the right-hand side, Kellogg's, it's US gap. So after the asset, so you see after the total assets line, the current liabilities where you have accounts payable, this kind of thing that we'll be analyzing this specifically for those two companies and other companies as well. Then you have long-term liabilities and then it ends with equity, which is also a long-term liability but as shareholders. So remember that the order is reversed between IFRS and US GAAP. Now, let's practice on doing a vertical analysis. And when you look, so I tried to normalize Mercedes and Kellogg's into our vertical analysis and Remo, there isn't an Excel file companion sheet where you can do this for any company and it will calculate the relative percentage to the total amount of equity and liabilities to total assets. It's basically the same. So we see e.g. between a Kellogg's and Mercedes that the non-current liabilities represents for Mercedes, 4323 per cent of the total amount of equity and liabilities and 57% of the total amount of equity and liabilities for Kellogg's. We see that on total current liabilities, Mercedes has 39% of current liabilities versus total of the balance sheet, and Kellogg's has 29.1%. And then obviously and we will be discussing this, will go into the details of it because already here, I mean, I'm not highlighting it. What you see e.g. if you look at long-term dept, you see that e.g. Mercedes has 31% that is linked to long-term debt, while Kellogg's, that's 37 node five per cent. So it looks like they're making it easy here. It looks like that Kellogg's carries more depth in terms of proportionality, long term debt Mercedes. But when you look at financing liabilities and the current liabilities, you see that Kellogg's only cares about 1% of, let's say, short-term depth. Why Mercedes carries 28%. So at the very end of the day, Mercedes seems to carry in total mode apps versus the balance sheet combat to explain something. Now, you see here in this slide of all the topics that we will be discussing in this lecture only discussing long-term debt and financing liabilities because I think it's one of the most important ones. And you're going to see with a few exceptions that most of the companies, when you do a vertical analysis, that long-term and short-term debt and financing liabilities are the biggest proportion with equity of the liability side of the balance sheet. Of course, and that will be part of the next lecture. So the second part of this dept lecture, we're gonna be discussing pension and other employee obligations, accounts payables, contract liabilities, and deferred income, operating lease liabilities, deferred taxes, and other liabilities because I want to walk you through the main items of, let's say liabilities and here specifically the depth part of liabilities. But very prevalently, you, when you will be reading financial statements, you will come across the biggest portion of debt is linked to what we'll be discussing now in the upcoming minutes, which is long-term debt financing liabilities. So let's go into that. So as already said, so corporate depths, as I call it, is really very often the major position of liability elements in the balance sheet. I'm leaving aside banks that have a specific balance sheet, and let's say specific investment holdings, et cetera. But you're gonna see a typical company will have depth as one of the major portions of the balance sheet in fact, and of course it depends on as well on the industry that you're in. When you had companies that were producing software and they were not running data centers where it probably they did not have a lot of fixed assets and we're probably they did not have a lot of depth as well. So tech companies tend to be less depth carrying versus e.g. manufacturing industry, automotive industry. Remember we have short-term portion of the debt and long-term portion of abnormally both actually to be added together to understand what is the amount of debt that the company carries. And typically as investors and myself and I was discussing this yesterday evening with this person in the US that I was explaining are let's say trying to work the persons for the cure rates. Which will be a chapter five example that we're working through as well. So working the person through the cure rate financial statements, obviously as an investor, I was looking at the size of financing liabilities of the company carries when the reimbursements have to be done because there is a maturity, there is a schedule. And you will see this through examples like a grand day and other companies that will be looking into Mercedes and Kellogg's. There is also something very important is that as I said, that's when you take a loan from somebody. That loan is not for free. That Loan carries a cost. It's the same like or shallow and the shallow brings in capitals. The shareholder has some written expectations. It means that capital that is brought in by the shareholder carries a cost. The capital that is brought in by a lender carries across as well. Remember that it comes frozen liquid in case of liquidation, debt holders will be paid for us before equity holders. But there is also a cost to serve at that depth with what is called interest expense. And it's something you're going to see in the financial statements. You will always have line which is the interest expense, that's the amount of money that the company has to pay back to debt holders. As cash dividends is the amount of money that is being paid back to shareholders. Interests expense is the amount of money, typically yearly amount of money or quantity amount of money that has to be paid back. Deb told us can be a bank loan, e.g. that carries a certain interest rate. So a cost on that loan will be, and that's very, very important measure. We will be looking at interest coverage ratio. Again, this course is not about financial ratios, but that's something very important, is understanding the amount of debt that the company carries. Looking at the proportion between debt and equity, and looking as well on the interests expanse and looking at comparing the interest expense, e.g. the yearly interest expense with the yearly profits. And seeing by doing that, and that's what is called the interest coverage ratio. How much of the yearly profit has to be spent on just paying off the depths in the sense of interests expense, not the reimbursement of the depth of the principal, but really just an interest expense. And this is where we will be discussing interest coverage ratio. So a couple of examples I've already mentioned a couple of minutes ago. Obviously, when you look here at long-term debt and financing liabilities, you see that in fact, Mercedes carries much more depths. Because also remember that they do provide, let's say they finance and they get finance as well when they produce stock, e.g. and on Kellogg's, you see that they have less adapt when you add long term debt and short term adapt. So here there is something that is different that in the Bismol of Mercedes, they do finance customers and they vary, probably outsource those loans to a bank and buy that. Obviously they carry a lot of, let's say, receivables in terms of financing, but also a lot of financing liabilities short-term, and also to some extent the long term and this of course on the long term they have also that for their manufacturing plants, etc, Kellogg's being in the food industry. Well, they don't have to finance the customers and they don't probably have to finance a lot of their suppliers so that obviously the total amount of debt is lower compared to Mercedes. Here we're going to be looking at a couple of examples. So we'll be looking at Mercedes. Obviously. We'll be looking at Kellogg's of a grand day and we'll be looking at Bank of America. So I want you to practice your eye and we're going to afford the full companies. I will walk you through the same analysis of the adapt. So if you remember, in, I think it was two slides ago, I mentioned that typically invest as this shall look, they shall look at three things. Size of the financing liabilities. So how much leverage the company carries. For that, we will be looking at debt to equity ratio we were looking at and that's tapped the maturity of liabilities. So what is the term, the reimbursement schedule of the depths and also the cost to serve those dept liabilities. There'll be discussing interest coverage ratio and ready put you the formula. Interest coverage ratio is basically the earnings before interest and taxes divided by the interest expense that will give you a ratio where it is below two. And I put here below one, that's fine, but below to the company, you need to imagine the interpretation of this ratio means that From the profits of the company before taxes. If you have an interest coverage ratio of one, it means that 100% of your profits are being used to pay back the interest expense. That's dramatic. I mean, the company, if the company is not generating any profits in the future, they still have to pay back debts. I mean, the company may go bankrupt. I can already share here. We'll be looking at it when we will be discussing rating agencies scores. But of course, above aids, e.g. meaning that if the company is generating 8 billion of profits and 1 billion is used to pay off interest expense. The company still has 7 billion that can be employed for buying new assets. Buying new company is giving a cash dividend back to shareholders. Just adding so you saw retained earnings just keeping maybe half of those 7 million and adding to the book value of the company. So that's the decision process, obviously that the board of directors and shareholders have to take. So this is where when we look at, well, when we want to analyze dept, hence the solvency. So how solvent the company is, we need to bring in. And this is a curve I very often use in many of my courses, which is the risk to expect a return curve. I'm making it here is linear. So basically, there is no miracle to it is depending on the amount of risk that the instrument that you're investing into, that you want to invest into the amount of risk that the instrument carries. You're going to have some written expectations. The higher the risk investing into startup, it will be expecting a maybe 35 per cent written every year. If you're investing into a US treasury bonds, there obviously, the US will not go bankrupt tomorrow. And that's another conversation. What happens in three years but short-term, they will not go bankrupt. So if you are investing into a short-term, one month, three months, US treasury bonds, 10-year or five-year. Obviously the written that you will, that you can ask the US governments and what they're willing to pay you for taking the money from you as loan will be lower. This is where in that curve we go from business and just to venture capital to private equity, to non-investment grade bonds, that's junk bonds, to maybe small cap equity investments to investment-grade bonds like investing into. I don't know. If you take Kellogg's, Kellogg's will be considered investment-grade. It will be, I will show you a table how rating agencies rate investment versus non investment grade bonds. Then you may have long-term treasury notes, That's the T3. So 30 years US government, ten years US government. Then you have like the short-term nodes which are one month, three months commercial papers. So when we speak about because somebody has to say if a neutral party, if the company will be discussing cure rate, we were looking at Kellogg's or my status. What is the solvency risk of that company? Is it an investment? Is it necessary Is it an investment-grade dept or is it non-investment grade dept for that rating agencies. So I have two kids. They're not the only ones, but the three major ones which are standards and Poor, Moody's and Fitch Ratings, they have those, you have probably have heard about those triple a ratings, double a, triple B. So you see that it changes between rating agencies. And so the rating agencies, or on a regular basis, I'm calculating the solvency of companies. Specifically publicly listed companies are giving a rating that is known to the market. I mean, you can look up, you can go on the Fitch Ratings website, on the moon's websites. I'm doing this and I did it yesterday, e.g. as well for the cure rate company and I'm looking at what are those rating agencies have. They analyse the depth of that company and other giving a rating on the depth. And that's an external third party opinion about the depth. So the solvency of the company. This is where you may wonder, well, how do they end up in giving? You see here that the table is split in two. So we have investment-grade with some subcategories, top-level, very high-quality, High-quality, good-quality. Then you have non-investment grade. That's the gray zone with speculative, speculative, very high-risk, close to default and in default, which means that the company is going bankrupt. And how they, how do they end up giving that rating? Well, to make it simple, and I've put here the site of us what the modal run, who is one of the most known value valuation experts? Word, his teaching at the Stern Business School at the New York University. He has a website and basically he links the rating, the rating of the agency for companies, but also for countries because countries are raising depth as well, what is called a sovereign dept, linked to the interest coverage ratio. So I'll make it very simple. You may remember when I introduced the interest coverage ratio, there was mentioning if it is below one, that five, the company is will struggle in paying back the interest expense. But then I said when it is above a is the company doesn't have a problem paying even on 8 billion of profits, 1 billion of interests expense. And this is how in fact, the ratings are. To make it simple calculated based on the interest coverage ratio. You see on the right hand sides. If it is for non-financial service firms, for small and riskier firm. So rating agencies, banks, they look at this and if you are a startup and you want to have a loan from a bank, well, you will not be considered a triple a rating. It means that you will have to pay a lot of money because you will be considered if I come back to my career fair, you will be considered non-investment grade Dept. Borrower if I'm the lender or the borrower. And because of that, I will very probably charged and 885, 9% interest rate, yearly interest rate. By that, obviously, I'm covering myself of defaults. This is what you see in the right-hand side on the spreader. So I see e.g. that when I make it very simply when you will be calculating the cost to take up alone. So to borrow money from a bank, you're going to have the zero free rate. Let's consider it's the teeth 30 of the US government. So let's imagine the T3 sits at around 4%. So if you're taking a loan and you have an interest coverage ratio that is beyond h dot 50. I mean, you need to add a risk premium of zero dot 69%. This is what it means, how you calculate it. If you have an interest coverage ratio, e.g. that sits at true or below two. You see that the spreads because there is a lot of risk associated to it, the risk premiums become very high. Lambda will charge a very high cost on giving you a low, and this is what it means. So if e.g. today the T3 is at 4% and you have an interest coverage ratio of one dot five, where you will add followed 86%, at least on the spreads on the T3 e.g. so tha 14. Other Types of Debt: Alright, welcome back Investors, welcome back financial analysts and students. So in this second part, you remember we are looking at the liability side of the balance sheet and more specifically the various debt instruments. Remember, in the first lecture, I really focused and it was already pretty long lecture of more than an hour just on the financial liabilities, short-term and long-term. And I walk you through a couple of examples. And as I said, the second part of looking at the dept instruments that sit in the liability side of the balance sheet as looking at other types of debts that the company or companies in fact carrying a balance sheet. And I think for if you have financial analysts, if you're a value investor, if your investor, you want to understand the fundamentals of the company. I mean, it's not just looking at the financing liability. Of course, a financing liability will be one of the bigger ones. But it's not the only one that may potentially represents maybe 51020 per cent of the balance sheet. So it's good that I'll try to walk you through a couple of other type of depth instruments at the company carriers in other companies carry it in their balance sheet. So you remember, we introduced vertical analysis or here I'm showing you here e.g. gonna be speaking in the first let's say the first topic will be about pensions and other employee obligations. Josie, e.g. where I flattens Mercedes and Kellogg's introvert analysis sheet. So remember you have the companion access file so that you see that the provisions for pension obligations are in fact the amounts and unimportant is really the materiality here. How much do they weigh in the total balance sheet? So for Mercedes is photo two per cent and Kellogg's for the 3%. But it's interesting to understand what is behind this in fact, because I mean, for four to five per cent, that's still a lot of money. I mean, look for Mercedes, that's like 12 billion and for Kellogg's that's 769 million. So first thing to understand is why do companies carry those pension obligations and potentially other implement benefits? I'm not speaking here about stock-based compensation. So that's something else. I mean, looking at specifically pension and other maybe even post a retirement, I'll post employment obligations. So what you have to, again, do not want to speak too much about social aspects here, but there are differences between countries. And we're going to see this. Remember in the Mercedes example, you gotta see this in a couple of minutes in the slides where Mercedes e.g. as multinational, they have operations everywhere in the world, but everywhere in the world, the social protection system is not the same. The public health care system does not function in the same way. If I am in, I'm based in Europe. I was born in Europe. Amused that in Europe you get a lot of things for free. In fact, for free, because everybody is paying taxes for that. But you have other countries like e.g. in the US, where the way how the health care system works is just different versus Europe. So imagine a company like Mercedes who has operations in Europe, well as operation in the US. Well, and you're going to see this. They have to account if they want to have more or less the same amount of benefits or the same incentives in, let's say in both continents for their employees, for their staff. I mean, potentially they have to account for having similar benefits in a different way for their employees. That's basically what you have when we look at now post employment benefit plans because that's basically one of the most important, let's say, long term liabilities that company have. If we speak about salaries. So short-term wages, that's not a liability because I mean, every month the company is paying out the liability link to salaries that are linked to the services that stuff being produced provides the company. So that's something that you're going to see in the income statement. As an operation expands, you're going to see things like sales, general administration, e.g. those kind of things. Whether salaries, the short-term sellers of the people are, that does not have to be carried on the balance sheet because those are liabilities that are gonna be waived every month basically because let's say typically every company pays off that depth every month. Now here we are speaking about analyzing the balance sheet. As I said, we don't have salaries in the balance sheet, but we do have long-term liabilities that the company carries in the balance sheet like e.g. typically post employment benefit plans. There are basically to make it simple, two types of plans that company in fact can set up for the employees as an incentive to hire people, to make it attractive, also for those people, but also to retain the people. So the two terms that called defined contribution plans disappear or defined benefit plans and just to give an exam in 2019. So I looked this up. Thing was at KPMG study that only in 2019, only 16% of private sector workers in the US and access to a TBP. Why 64% and have access to defined contribution plan? What is the, let's say the discrepancy, the difference between the two. A defined benefit plan in fact, is much stricter. And really, I mean, the company takes accountability on defining exactly e.g. what people will get when they retire. And there is a problem to the defined benefit plans is that the costs of defined benefit plans, they actually increase. And there is, I give you one variable of uncertainty, which is, how long will a person that has worked e.g. for Mercedes in the US for the last 40 years, how long would that person live in terms of retirement if the person and sorry, I mean, I'm a very human and empathic person. I hope so. I come across like this. But if you look at it from a pure financial perspective, and that's the same conversation with social systems. And sorry, I mean, please just do not judgment what I say here. I'm just looking at it from a financial perspective for 1 s. Of course, it's in the interest of governments that fund those social security plans, but also of companies that have to fund those post employment benefit plans. That people when they retire, that they die very rapidly because if they live forever, that has a cost to the company, of course, right? And of course, you bring in demographics, probability calculation, those kind of things. But the problem with defined benefit plans is that as life expectancy, which is great, we live longer because life expectancy is, amongst others, increasing. Well, the reason for that is that the impact of that is that defined benefit plans become more and more expensive to companies because life expectancy is growing hands how they were calculating an average retirement benefits for an average person in the company now has been growing, which increases the size of the liability. That's why you have less defined benefit plans or even hybrids. But people or companies, a company management tend to go for defined contribution. So just a small aperture, the URL where I found this. I mean, I'm not in a pension expert, but I found it interesting for you guys as well to share with you what's different, the main difference between defined benefit and defined contribution. So basically, send a defined benefits is the stronger one it's in. It's beneficial to the employees. Well, the defined contribution is more beneficial to the employer. And there is of course, defined contribution plans. So DCP is they carry a certain amount of uncertainty for the employee, less for the employer. Alright, so when we look at defined benefit plans, again, I don't want to go into all the details. There's very interesting KPMG document that I looked up for you guys that was published in 2019. Remember I have been working on this course for more than a year. And you remember that we want discussing accounting standards. So between IFRS and US GAAP, they are in fact the differences. But I think what you need to understand when you look at different benefits plans and you will see this in concrete examples that basically you have. The step number one is to determine the present value of the defined benefit obligation. And obviously an obligation a very probably the company has put money aside to some extent and you need them to counterbalance the total benefit obligation with a fair valuation of the assets of the company carriers. So we're coming back to level one, level two, level three, valuation of those assets. What are the assets the company has invested into? Basically to support the liability of the pose unemployment benefits and employees. That differences between US GAAP and IFRS, e.g. I mean, you're going to see how discount rates as we need to bring back the defined benefit obligation to the present value, e.g. the way how discount rates are selected, you're going to see this concretely in the screenshots for Mercedes in Kellogg's, differences between IFRS and US GAAP, e.g. IFRS and poses an asset sitting US GAAP does not e.g. if you are incurring unrealized losses or gains on the asset side of the assets that will in the future funds. The benefit plans. I mean, the way how those unrealized gains and losses are reflected, a difference between US GAAP and IFRS, e.g. so also the way I mean, if those assets generate income in IFRS or the standard is IS 19, the income will be limited really to the interest income of those assets mine the US gap. Do you actually can reflect total returns and not just the interest income. So you'll see me, I will not go into all the details of it. If you're really interested in understanding nepa, what is there. I mean, I really encourage you to go into this document and read it is a very well done well we will be interested in is the practicing our eye looking concretely how this looks like. This looks like from a citizen Kellogg's. And also understanding the difference between the liability side. But also as you have seen here in the accounting steps are defined benefit plans. There isn't an asset side of it. So you're going to have in fact, in the balance sheet, assets that support. The liability. And we're again, we're not speaking about salaries here because that's short-term every month they are basically liability is removed and paid out to employees were speaking about long-term employment liabilities. So when, when, Also, before we go into the details and already Let's start practicing our eye when we look at pension obligations. We of course have to understand also from a priority perspective, liquidation. You remember I told you that if it is on the asset side or on the liability side of the balance sheet, there's a certain order on the asset side is how fast things can be converted into cash. So the level of liquidity, and of course it starts with cash because cash doesn't have to be converted to cash. So that's a one-to-one conversion. And intangible assets are the lowest one. So that's always much more difficult to convert them into cash. Now on the liability side, remember, IFRS, if flips, so the order is flipped with US GAAP, US GAAP, you're going to have current liabilities and non-current liabilities and equity and IFRS going to be the other way round, you see it here. Equity will be first, then comes, then come current and long-term liabilities and non-current. So short-term liabilities. See in fact, when you look at Kellogg's and Mercedes, you remember we're speaking about like four dots for the 3% of the balance sheet, the liability side that is linked to pension liabilities. So it seemed like that they carry. In fact, lambda is called provisions for pension and similar obligations that comes just before the equity. So unnecessary SAT is just after the equity line. Remember IFRS starts with long-term liabilities versus short-term liabilities and you ask gifts the other way around, short-term liabilities versus long-term liabilities. And here you see also at the pension liability just comes before equity. In fact, what does this mean in terms of order of liquidation, if the company would go bankrupt, That's employee benefits are the last liabilities that will be paid out if cash is remaining in case of liquidation before showered us get paid out. And I don't speak here about preferred shares are misspeak about common shareholders. It means that a credit taller, so banks, tax administration suppliers, they will have priority before the employee is in case of liquidation. That's something important to know. Specifically when you are in systems where you never know the company goes bankrupt and you have been counting on the benefits of the company for your retirement. The company goes bankrupt and then liquidation. There is nothing left on this liability potentially. So what happens then? This is where also, I mean, we were going to look at the asset side of things because nominee assets are linked to those liabilities as well to a certain extent, it will not be 100% coverage of the liabilities that will be funded by assets. You remember, we looked at the materiality of it. So in this 2020 Mercedes annual report, so the 12 billion out of 185 we're representing follow two per cent of the total amounts. And again, be curious, read the notes and when you read the nose. So the chapter or the paragraph, consolidated financial statements. So notice 22. While you have tables that explain what is the amount of provisions for pension benefits, that provision for other post employment benefits that could be, I don't know, salaries, e.g. complimentary salary. Then you have as well the discount rates because remember that's also the obligation has to be brought back to a present value. And you see e.g. if you look at the books, the red box number one here, it says that the dominant group, so in the meantime they have renamed themselves and Mercedes group. Defined benefit obligations exist as well, too small extent defined contribution pension obligation. So this is what I was telling you, this deep BP and DCP obligations which are different. And again, here you see what I already mentioned specific to the various countries. In addition, health care benefit obligations are recognized outside of Germany. So this, again, I mean, when you are multinational, HR departments are exposed to just the legislations a different way. How companies contribute to social security, to health benefits are different. The health systems are different in a lot of countries. So take these into account when you look at those pension and similar obligations, then on the discount rates, e.g. you see they put the percentage in the Table, D5, D6. What is the percentage that they're using for the German plans, for the non-German plants. And also they put some assumptions. And this is where it becomes complex because calculating pantheons require us to take into account some assumptions if it is discount rate, but also the expected increase in cost of living. Now being February 2023, you can imagine how this will impact high inflation, inflationary environment. How will this impact as well the liability side. So this specific liability of long-term post employment obligations. Because remember, salaries, you're going to sit them in the income statement, but they are so short term that you will not see them in the balance sheet to make it simple. Alright? What else do we have? So here, as I told you, we looked at the materiality. So pensions, so divided by the total balance sheet, so plus equity. So we have Photo 2% of the balance sheet that is really linked to pension liabilities. Whereas interesting here as well is, as I remember when we were looking at Defined Benefit Plans, I was giving the steps to look into it. The first step is indeed to recognize the present value of the obligation, but also then, Let's say counterbalance that obligation with some assets because the company has to a certain extent, has to fund and put money aside or to put assets aside to fund those obligations in the future, otherwise, the balance sheet would be unbalanced. So that's why you have to the, let's say the depth instrument of pendulum, other obligation you have two sides that you have to adapt. And I'm going to do it through the depths. But it's gonna be an asset side. When you look at the Mercedes report of thousand 20, they need we're showing nodes D 53. So they were calculating the present value of the defined benefit obligation. It was like 39 dots 8 billion. But you see just below, they recognize the fair value of the assets that support the liability. And the fair value at that time was in fact, of 29 billion, which basically shows that there is an unfunded balance of at least on the DB piece. So undefined benefit obligations of 11 billion. So that's, that's basically, let's put it this way. This could be considered like a risk to the company. Remember that when you look back at the balances of Mercedes, Mercedes must not only carrying defined benefit obligation, that was the biggest part, but they will also carrying, I'm a post other peasant plan and benefits. And there are in fact, the unfunded status was of one is 1,000,000,023. So their intake, they have the present value of the obligation, but there isn't no fair value of reimbursement rights. So when you add up those two numbers, so bullet point number three, which is 11,047.1000000023. That's the so that makes our total liability of 12,000,000,070. That's the balance in fact, between assets and liability. And this is what you will see. In fact, if you go back to the balance sheet of Mercedes, you will see in fact that the provisions for pension obligations are sitting at 12 billion 070, which is in fact the unfunded status between the DPPs and the other person prime and benefits. So that's the sum of 11,000,000,047.1000000023, which basically tells you that the funding ratio of Mercedes is rough cut 74% if you look at the total. So they have two obligations of 40 billion, but they haven't unfunded balance of 12 billion. So for that they have to think about, okay, what is the liability that we have? And then also a bill of provisions, one, Kellogg's in a similar way so that the materiality is afforded to per cent. That's 769 million on 17.996 billion of two balance sheets. So that's nearly the same light. Mercedes. Mercedes was also a photo at something. And so again here in the consolidated financial statement of Kellogg's, you see that they are explaining what the pension benefits are. So they explained the company sponsors number of US and foreign pension plans provide retirement benefits for its employees. The majority of those of these plants are funded or unfunded. Defined benefit plans receive a camera, they're using GBP here. You clearly see it. And then they also right behind the company does participant in unlimited number of multi employer or other defined contribution plans for certain employee groups. And you see also in the assumptions they have, the discount rate. You see it's different from the one that most citizens using. And you also see that they explicitly mentioned also long-term rate of compensation increase. What's the long-term rate of return on plan assets, e.g. and you see that 2018-2020, it went down 7-74268. Same principle here. What is the balance between funded so between the liabilities and the assets? So you have is documented as well, again in the Kellogg's consolidate financial statement, even though this is US gap, you see they follow the same logic like Mercedes, which is IFRS. You see that you can see through the table on the right-hand side that the obligation funded state. So they have end-of-year obligations worth of 56 billion. They have a fair valuation of the assets, which is five dots to so basically they have an unfunded status of 164. In fact. Yeah. And through that, in fact, you can again calculate the funding ratio. So you see that basically Kellogg's has a little bit better funding ratio versus Mercedes. Mercedes was sitting at 70% while the Kellogg's was sitting at 80%, right? So that's about pension and other employee obligations. The next one that we have is about accounts on trade payables. So here we are speaking now about a short-term liability, so less than 12 months. And again, there are two sides to it. You have the accounts receivable and accounts payable. That's something also that you need to understand and we'll start looking at it from a depth perspective. First of all, let's look at the materiality of it's doing a vertical analysis. You'll see that the trade account payables for Mercedes are sitting at photo three per cent and that vocalic, they're sitting at 37 per cent of the total balance sheet, of course, so that's the vertical analysis we're doing. Why? Why are they important? Why our trade payables important? Remember when I was introducing the two types of accounting methods, you can do accrual accounting, but you can also do cash accounting. When you look at the income statements, remember that what will happen very often is that you're going to prepare your suppliers. Let's take that assumption. You're going to prepare your suppliers to produce goods and services for you, or semi-finished goods that you're going to, let's say transform into finished goods, sell this to your customers. But depending on the business that you're in, you need to provide money. You need to pay your suppliers first before receiving the money from your customers. That's why trade receivables and trade payables are in fact part of the working capital. And when we look here at trade payables. So it measures in facts. And specifically when you look at being a part of the working capital, I'm already introducing their working capital. Working capital measures the short-term liquidity, so the short-term capacity, the short-term financial health of the company. Of course, if you have the current assets that are bigger than current liabilities, mean you don't need to fund that because of current assets are funding the short-term liability. So that's always good to have a positive working capital so that the current assets are higher at the current liabilities. And you don't need to raise depth for that. But e.g. if the other way round, if you have to pay upfront all your suppliers and you have to wait 60 days or 90 days for your customers to pay. Well, that's potentially an issue to the company because maybe your current liabilities, in fact, are higher than your current assets to certain extents. That is creating a problem. And I would not even speaking about profit margin here, of course. So that's the kind of thing is how fast can you then recognize that revenue so that your current assets, even though you have not collected the accounts receivables yet, but you have those outstanding versus the current liabilities. We're looking here, this is an operating item. In the previous item we're looking at long-term financial depth. In this lecture, we started looking at long-term post employment obligations like pension plans. But here when you look at trade receivables, so sorry, trade payables. Those are really short-term liabilities that the company in fact carries. And this is where I, again, just to summarize, but I think it's important that you understand the two sides of the story between accounts receivable and accounts payable. So this is where we speak about also the cash conversion cycle. So we have to think that if you are a company, you're sitting between customers and suppliers. What you want to have is that customers pay first and then you pay your suppliers. That's a perfect example. And what you need to understand in that scenario. So that's also the way how you convert, in fact, your goods and services into cash is that when you're able to do this? Well, it depends the industry that you're in. If you are a retailer, you are selling, I have no clue. You're selling orange juices to customers. When the customer walks out of your shop of your bar, the customer has immediately paid and you may have agreed with your supplier payment term of 30 days for the oranges, e.g. because you're only transforming the oranges into juice and sugar, etc, etc. So that's a nice thing about retail because retail, e.g. they, I mean, they have, let's say, a good working capital in the sense that customers pay fors and then only suppliers are paid. But in other industries is the other way around is that you have to pay your suppliers to get all the goods. Maybe have to even pay them upfront before they started production process. And you may have your goods and services sitting in the inventory. And maybe only, I don't know, a year later, customers will potentially be paying you. So this is where the needs of in terms of working capital, they vary between industries and also how management, managers, because I have seen companies where the manager, specifically startups, they will not managing very well the payment terms between them and the supplier. So they were given just too much time to the suppliers. And I'm sorry in the sense that they were giving too much time to the customers, but they had very short term payment. Let's say liabilities. And the timeline to pay back the suppliers was very short. E.g. if you're giving your customers 60 days to pay your invoices and your suppliers are asking you to pay upfront when they have working capital issue? Very probably. So. Again, that's the kind of thing. Also as manager of a company that you have to be attentive to. Of course, I mean, I will not speak too much about strategy here, but of course we're thinking about Michael Porter's five forces model, where of course, the bargaining power of suppliers and the bargaining power of buyers plays a role. If you are the only supplier, of course, you are able towards your customers to negotiate very strong payment terms that are in your favor. But if your customers have a lot of choices, I mean, they have bargaining power as buyer as well, they will probably impose you, let's say, more difficult payment terms. So you don't have the muscle power to negotiate a stricter payment terms with your customers. So this is where understanding, I mean, if you interested look at Michael Porter, Five Forces model, it's not the only one in terms of strategy. You have to look at Mintzberg as well as emergent strategies. But this model is still very valid and it definitely plays a role when you look at financial statements as well on working capital cash conversion cycle and the payment terms specifically in the industry or for the company that potentially that you're interested in. Terms that also will appear not just in the cash conversion cycle, or not just the cash conversion cycle, but also the days sales outstanding, the days in inventory. Of course, I started with days in inventory if you're asking too much inventory, so you are placing too much orders at your suppliers to endure sitting on too much inventory. That has a cost as well, because you're going to have a cash outflow very probably to your suppliers for producing that inventory. But then the question comes, how fast can you convert that inventory into, into revenue and setting this to customers. I mean, if you have perishable goods, that's very complicated because the value of the inventory will decrease over time as well. You may have to scrap. I don't know, 30% of your inventory if you have produced too much. So you see that there are problems as well on how to manage. Let's say the supply chain inventories. Not asking too much, but enough in order if there is demand on the customer side to transform this into revenue and then of course into cash. And if it is retail revenue is very close to cash conversion. This is where I will not go into the details, but look, if you're interested at just in time and vendor management Inventory VMI, is that something that in supply chain management is often used where in fact, when you have really your whole supply chain, that e.g. the supplies of raw materials they want to see actually what is happening four to five steps, four to five companies down the road in the supply chain, maybe half access to the inventory of the retail shop and not Joseph, the wholesaler and the shipping company, et cetera. So that's when we speak about just in time, but also vendor management inventory, that's the kind of thing that you have to look into supply chain management. And the reason for that is really to make it as effective as possible, the whole cash conversion cycle. So when we look at Mercedes and Kellogg's, so you see that Mercedes on the left-hand side, remember IFRS, they have to do payables of 12 to 3 billion. I mean, that was the summer 2020, where in the consolidated balance sheet of Kellogg's they were carrying two dot 4 billion. So you see, remember that the materiality value for the trade payables was in fact for three per cent from a citizen, 137 per cent for Kellogg's. The reason for that is remember that the companies are in different businesses, merciless producing cars while the Kellogg's is produced is in the food industry, right? One thing as well, which I think is worth mentioning, is that what can happen is I've taken me the extra bit of Kellogg's. So the yellow one. It may happen that in order to accelerate, if a company is eager to get cash. It may happen that if the company has payment obligations that they, that they give us to third-party financial institutions, e.g. and it's the other way around as well. If the company has accounts receivables that the company does not want to care about. What is called credit collections of collection of accounts receivables. And is giving this to a third-party financial institution and they're going to change the customers to pay. In fact, the accounts receivables, but the account receivables in fact are no longer sitting in the balance sheet of the company. But as they have outsource this to the third-party financial institution, the third party financial institution has taken a cut on the total accounts receivable, but has given immediately the cashflow. Imagine that if the company has accounts receivable for 100 million, that's the company is selling those accounts receivable for 90 million of cash because there is a risk that maybe not all of them will be converted. And so those accounts receivable are zero and the company has already collected 90 million, but they lost in the operation 10 million. It can be done in the same way for trade payables as well. But I think what is important when you look at traits payables and trade receivable is the story about the working capital and also the payment terms that hopefully if you are a business owner, that you have very short payment terms between you and your customers, except if you're in retail there. When people leave your shop, you're going to have the cash very probably that with your suppliers that you have a little bit longer payment terms so that in fact your working capital is positive on the asset side versus a liability sat, right. Next one, contract liabilities and deferred income. And we're speaking here about revenue and how to convert revenue into cash. There's also one thing that has to be taken into account is that you may have, let's say, customers that potentially, I mean, you are building an asset for them over four to five years, e.g. or you may have customers that in fact, it happened even to me that it's the summer 31st, they still have cash available. They want to get rid of that cash and they placed an order with you, but the delivery of that order will only be executed in the next fiscal year. How do you recognize that? Can you recognize it as revenue? No. You are not allowed to do this and this is what we will be discussing when we are speaking about contract liabilities and deferred income. So let's start with contract liabilities. So of course, there are IFRS standards and of course, Accounting Standards, qualifications for US GAAP, which explain how to recognize specifically also revenue from contracts with customers. And that's something that's appeared, let's say around 2018, where in fact you had different, let's say industries where it was not so clear how to recognize revenue. Because those maybe revenue was linked to some, let's say performance obligations. I mean, sometimes you hear about service level agreements that carry penalty. So if there is a breach on I don't know what the availability of the data center and their breaches happening because a customer has done with you a 10-year contract. How do you recognize that revenue? You are not allowed already make your stem you're not allowed to recognize 100% of the revenue on a yearly basis. Maybe you need also to show that you have a certain potential liability in case you do not meet the performance obligations. So that's something that is I mean, where over the last couple of years where the accountants and the regulators asked that this is reflected in a better way. As an example, in telecommunication companies. For construction company, there were discussing ever Grundy in the previous lecture, just have a look at the average run the balance sheet. So you're going to see in fact that they carry assets and liabilities that span over multiple periods. So how will this be reflected? Well, that's a little bit what we're discussing in fact here. So as I said, similar to trade payables, there is trade receivables, accounts payable account receivables. We are the same for contracts. You have contract assets and contract liabilities. So contract assets, they in fact appear on the balance sheet when the company has performed some work for customer. But they have not yet issued the invoice. So this wouldn't be defined as accrued income, right? But you may have contract liabilities as well. So they appear in fact when the company invoice the customer, I was giving you the example that the customer has cash available, wants to buy a car, says, I'm gonna give you already the money because I have it now. December 31st, it's closing of my fiscal year. But I mean, you have received the money, but you, as a company, have not delivered that car. So that will be considered as a deferred income, e.g. so you are not allowed as a company according to accounting standards to recognize that as revenue. Because there are no cost, even cost associated to it. Remember that revenue have to follow costs. What you're gonna do is in fact, and here we are in fact looking at the accrual income or deferred income. So when you get the cash payments from a customer, you have not even provided all the services. You're not allowed to recognize this as revenue with profits, etc, because it would actually artificially inflate the earnings of the company, but you have to declare it as deferred income. And I've seen I mean, in companies, I've seen those practices where cash payments were considered as revenue just before closing of the quota. So that's the kind of thing that of course, is not allowed to do this. Um, of course, when we speak about, and here, of course I'm ready like introducing that when we speak about accrued income and deferred income. If you have accountants that our notes, let's say very fair or management is not very fair. You see that there could be ways of inflating short-term income or short-term profits by playing around. This is where the standards come in, understand as gifts. I would say strong guidance. What are the steps e.g. in revenue, revenue recognition, e.g. has to be linked with a very specific customer. The performance obligations have to be clearly identified. There has to be determination of the price for the underlying transaction. There is also the price has to match to the performance obligatio 15. Introduction to assets: Alright, welcome back. Last lecture of this chapter number three, which is a pretty long chapter. I do recognize that, but I think it's important that I walked you through the main items there it is on the liability and equity side of the balance sheet. And now we're going to focus on the assets. Remember, I mean, I know that I'm repeating myself, but it's important that you keep this always in mind. This cycle of the liability side of the balance sheet is showing the sources of capital. I walked you through the main items of equity and debt. And the intention is of course, that sources of capital or financing so that the capital is used to finance assets and those assets will generate profits. That's the only intention of a company, or at least how I am when I look at the balance sheet. So this cycle of where the, let's say the money, if we speak about capital being money, but it can also be tangible assets. Then those assets, I'll put on the left-hand side of the balance sheet and with the hope that they are generating a profit. So remember also, when we are speaking about corporate governance, that's if those assets generate profits. Of course, what happens with the profits that the company has generated through this operating cycle and operating side can be a quarter a month, a year. And then there is a decision that has to be taken at them on the board of directors or by the shareholders about, are we reinvesting the complete profits? Are 40% of the profits of 53% of the profits, just as an example. And we're buying new assets, new trucks, new airplanes, new manufacturing plants, or ar and or are we paying off the amount of depth that we have? Or are we giving a written to our shareholders by e.g. paying out cash dividends, doing share buybacks. Remember, I mean, do not forget this is very important that you understand. So here you have like the board of directors or supervisory board, sometimes the shareholders or sit in-between the liability side of the company and the asset side. When the asset generate profits, what is the company doing in fact, with the outcome, with the results of this operating cycle, which is relying in fact on the assets of the company. And one of the things that's, again, I will not go into the details of it. But when economists, they look at, when we speak about assets, of course they are looking at, let's say, four type of resources that can be involved in the production process. So typically, they, economists say that it is lands, which I call more property, plant and equipment, labor, capital. Of course, you need to do something and the idea is that really there isn't. I mean, you take those resources and those resources that will generate a dot products or services. Of course, entrepreneurship. So let's say the management of the company having the right ideas, the right strategy, of course, plays an important role as well in the factors of production. If you look at it from a clinical perspective, one of the things before we go into the asset as well, I want to remind you, we discussed it when we were looking at the accounting principles. If you remember, I will not walk you through all of them, but one important thing, and that is very important when you look at the balance sheet is the following two and again, not later than last week when I was discussing with an investor from Florida and we were discussing about Sky West Airlines. I again insisted specifically on this that when you look at the balance sheet, there are two extremely important elements that you have to think at the figures that you are looking at. The first one is fair presentation. So the intention of the accountants, of the statutory auditor is that the valuation of the assets and the liabilities are as close to possible to the reality of it. So they have to present financial statements, have to present in a fair in a correct way, not overstated, understated the real financial position, the financial performance and the cashflows of the company. And the second one is, this is done on a going concern basis. Remember I introduced this term going concern, which is one of the fundamental accounting principles. Going concern means that there is no intention to liquidate the entity or to seize the business of the company. And this is where sometimes even in the financial statement you're going to see when the first node is about the accounting policies. You're going to see that the sentence very often which says that the financial statements of the company have prepared on a going concern basis, which means that the company was I mean, it's the intention of management and the shareholders of the company wants to be around for a long time. We're not in a scenario of bankruptcy or liquidation. So remember those two things because it will be important when we will be looking at we will be discussing fair valuation of the assets. And also I'll give you an example of going concern. And in fact, when I mean, when you look at the assets of a company and remember, I wasn't producing when we were discussing equity. That's equity. So the source of capital, which is equity, e.g. at the inception of the company, a shareholder typically brings in money, but a shout on owner of the company, he or she could bring in a laptop, a car. So there are two ways basically. So that's tangible assets. It's a fixed asset. It's not money. And you may remember that I said, Well, how do you, if, if the owner brings in a car, how do you value that car? And you may recall that I said, well, typically there's gonna be an accountant is going to say, Well, show me the inverse of that car. And when was the cardboard? Maybe he or she will add some precision to it. And then he will reflect this in the balance sheet and say, well, this asset that has been brought by the shareholder or shareholders is worth this amount of money. And it's not just about tangible assets, the different types of assets that can be brought in. It can be if it is an investment company, it can be stocks, e.g. so equity instruments. So just keep in mind the following thing. There are two ways of measuring the fair valuation of an asset. It's either historical cost, which basically reflects the price of the transaction, which basically created the asset. Current value, which is then looking at conditions. At the moment you are making the other accountants and making the reports. Can you look at the market? Of course, if you're buying Coca-Cola stock, what is if evolution of Coca-Cola, I mean, we will not go to details, too much detail into it, but could be what is called a level one fair valuation. So just look at the market and you look at the share price of Coca-Cola and you know how to value today when you're doing the report, those equity instruments that you carry in the asset side of the balance sheet. But what happens if you are buying shares of a private company? There is no public stock markets. How do you how do you do the valuation of that? That would be more like a lever three types of evaluation. So I mean, I know we will be discussing this, but the valuation of assets, again, we'll follow a going concern basis, so we're not looking at the liquidation scenario. Typically. I mean, I'm discussing this training that is called the other value investing in the company valuation in those two trainings, one is more fundamental than the other, one is already more advanced. So I have seen typically that you're going to see this as well. If you look at land, e.g. which is part of property, plant, and equipment. Land is always carried at historical cost. And very often me as an investor, I'm interested in how much land the company owns. We're not speaking about operating lease assets. Land that is rented early speaking about land that is owned by the company. If the company, I mean, not speaking about chemical plants that would need treatment of the soil, etc. But very often lands on a going concern basis will be carried at historical cost. You're going to read this in the financial statements. It is clearly and explicitly mentioned. This is the way how you increase the book value of the company. Because, I mean, if the land has been both 30 years ago, I promise you. I mean, except if there are, let's say, problems with the soil and this all has to be recycled, treated, etc. But it is normal lands, I promise you that you can increase the book value of the company just by, let's say, doing a current valuation of the land that the company curves in the PP&E. Again, I will stop here. Maybe the same with trademarks. Trademarks. It happens sometimes that trademarks either overvalued by the company, but also very often for me as a value investor, I look at trademarks and most specifically, brand valuation. Because very often the company carries a trademark at the very low cost. But let's say marketing agency, there are those global brands, marketing agencies. They look at the value of the brands. And even sometimes that's the intangible asset, which is trademark, is in fact ten times more worth than what is reported in the balance sheet. So fair valuation of the assets is really something important that you need to understand when you're looking at the figures of the asset side of the balance sheet to make the explanation complete. I mean, I already mentioned cup of times a going concern basis. I think my explanation would be incomplete. If I will not show you and explain to you why we are discussing about going concern And why is it important? Remember that when we were discussing about what the company is worth in the sense of the book value of the company. So the equity value is basically the assets are all converted into cash. And that casual be used to pay off debt if there is any depth and what is left is then really what remains for the shower loss. That's basically very easy principle on how you calculate the value of a company, so its book value. And again, remember I said there's really a couple of terms. Normally investors, they don't buy the company for its book value. They buy the company for the profits that the assets on a going concern basis we generate for the next whatever 102030 years. I'd specifically look. The tendency to look at 30 years because I invest into large cap and mega cap companies. But what may happen as well is that the company gets into trouble and has to be liquidated. So what you need to understand from a valuation perspective are those assets is the following, is that there is an adjustment ratio that you have to apply to the assets. And this is a graph that I created myself. That's why there is no source to it, because it's myself who created this to make it visible. And this isn't, I mean, it's illustrative to make it visible how you have to adjust the evaluation of an asset versus how liquid asset is. Cash is extremely easy. I mean, cash is already a liquid. So if the company has 1 million of cash in its bank accounts, while it's worth 1 million, there is a one-to-one conversion. There is no conversion because cash is already liquid, but it basically means that cash will not have to be adjusted. We are speaking here not about on a going concern basis, but in case of liquidation scenario. But e.g. if you look at accounts receivables and the company isn't a hurry to collect the cash of the customers that have not paid yet. The company will not be able to convert 100% of the outstanding invoices that have been unpaid so far. So maybe the adjustment ratio is 95%, so maybe they're going to lose because they are not undergoing concern, but they are under an emergency situation. They may in fact even sell off the accounts receivable to a collection firm and they will pay, let's say, like a premium of 5%. Which will basically then transform the total amount of accounts receivable but to 95% of what is reported in the balance sheet in a liquidation scenario. Same for inventories are going to explain this to you later on when we will be looking at inventories and also impairments and inventories work. But it may happen indeed that if the company isn't a liquidation scenario, that you will not be able to sell inventories at the price that they are fairly valued on a going concern basis in the balance sheet. Inventory, this will vary, probably have to carry a discount so that you're able to liquidate. And very, very rapidly, the central property, plant and equipment. And then the ones that are, let's say most, let's say irrational is really the intangible assets and the goodwill. So we will discuss intangible assets and goodwill later on in this lecture. And of course I've put in red the ones that's e.g. could have an adjustment duration that is above one, which is e.g. lands, land may be very illiquid. But as it is carried at costs, normally it's always carried at cost in the balance sheet if it's an IFRS and US GAAP. Well, if you are selling a big portion of lands, I mean, you may end up and you have both this, this land 30 years ago. Maybe you can multiply the value of the land even in liquidation scenario by 30. Ip related assets. You may have assets like trademarks where maybe the inventories that comes receivables are property, plant equipment of the company in case B, collision or not worth a lot. But the brand is really worth a lot. And maybe you're going to find a buyer in case of liquidation or the liquid data may find a buyer is willing to pay more than the amount that is carrying the balance sheet for those intellectual property related assets, e.g. trademarks. So always think here again before we move now into the assets that we're looking at, fair valuation on a going concern basis. And in the fair valuation, you may have assets that are carried at cost. Typically it is land and you have other assets that will be carried at current value. But how do you do this if you're earning a lot of offices, how do you do if evaluation of the office space that you own? I'm not speaking here about random error is speaking about ownership of real estate, of office space. What about trucks? What about equity instruments and hybrids, complex investments, instruments and securities. So this is something, keep it in mind. And just keep in mind as well that liquidation is something that may happen, but normally the finance teams are always prepared on a going concern basis. Alright, so let's go into the assets. One thing again, just to remind you, that's typically if it isn't IFRS or US gap, remember that's the reporting order is flipped that you're going to have, in fact, current assets and non-current assets. Current assets are typically used day-to-day operations. They are typically kept for less than 12 months. And use of current assets is typically that to generate the cashflow and they can quickly be liquidated. In fact, then you got to have noncurrent assets. Those are assets of the company hosts for longer periods than 12 months. I mean, you already get the idea is that property plan and equipment, those are long-term assets, those are non-current assets. You may have a trademark, Coca-Cola, which has created a trademark over the last 30 years. I mean, that's a long term asset. That's not a short-term asset. So keep in mind that even though I will walk you through those asset categories, we're going to start with Kevin financial instruments. I'll walk you through accounts receivables, even though we already discussed accounts payables in the liability side, inventory, very important. I'm going to introduce you also how to value inventory and also impairments testing on inventory with a very interesting example, I think I have at least the Microsoft example. Maybe there's a second one. I think there's a van, Vanity Fair Corporation example as well. Property Plant Equipment, very interesting one we're gonna be discussing equity method investments as well, which is one of the four methods, how you can, let's say consolidate companies in a balance sheet. And then we're going to be discussing intangible assets and goodwill as well, because a lot of people do not understand what goodwill is. Deferred tax asset shows a quick reminder, we just discuss it in the last lecture of this chapter where we were, I was exploring deferred tax liabilities. And then also something very important that you need to be attentive to as an investor is those assets that are held for sales and discontinued operations. So more about that. Later on. 16. Main current assets: Alright, so let's get started with a couple of current assets. Are those assets that will be probably used and consumed within the next 12 months or within a year and fight of the organization, then we're going to go into, in fact, non-current assets. So we're gonna start with cash, financial instruments, accounts receivable, inventory. So those are current assets. And then we're gonna go for those long-term ones like PP&E, equity method, investments, intangible assets, et cetera. So let's start with Calvin and financial instruments. You remember, we have been discussing this, but that typically have the sources of capital. So the capital bring us can either be shareholders, equity holders, but it can also be like a bank loan or credit toddlers that are bringing in money. So that told us, and typically what happens in the, let's say the circulatory system of, let's say the capital that comes in is that capital is being used. And let's consider that the capitalists bring, is brought in as cash. Cache will not sit, will not continue to sit in the balance sheet, in the asset side of the balance sheet as casual, will be transformed into an asset that will start generating profits. Hopefully that's the intention. Can be buying a car with that cash, can be buying a building, providing office space to your employees that you're hiring because you're consulting company, a manufacturing plant, retail shop, whatever does cash is cash value-creating assets normally not. What happens. And you're going to see this and I'm gonna show you the difference between cash and cash equivalents, which includes short-term financial instruments that you may have or the company may have what is called access cache. And the company is not giving this cash back to the shareholders because it would have the opportunity of doing it. But for whatever the reason they're not doing it, maybe they are pairing up cash for an acquisition e.g. that will happen in three months time. And this axis cash. Well, sometimes companies, they do invest into short-term financial instruments. So those instruments carry a certain amount of risk more than just having the cash sit in a bank, bank cash accounts. And of course there is an element of risk to it, so also an element of valuation to it. And this is where we will be discussing how when you look at the cash and cash equivalent position and balance sheet, I want you to understand what is behind and we're going to have a quick conversation about what is the right amount of cash to have in the balance sheet. Remember, I'm bringing this slide back that we already discussed in the very, very beginning when we were looking at the accounting principles, when we're discussing fair valuation. Specifically here, we're discussing fair valuation of an asset category which is cash and cash equivalents, where we have international standards and US GAAP standards who oblige us in fact, to think, if it is not cash, they're sitting in a bank account, but it's a cash equivalent like a short-term financial instruments. How do I value that assets? And remember that we were discussing level one, level two, level three, fair valuation. So everyone is typically there is there is a market for it. So you go to the market, you just observe the price and you know what, how to fair value that asset level two is. There is not a direct real-time market for it, but from time to time, they are transactions that happen that you can use. A level three is purely subjective, so there is no observable market and no observable transactions. So you really have, this is guesswork that you have to do when valuating such an asset. So I will not go into the details of when we look at cash liquidity ratios discussing working capital here. I think what you can, of course look it up. There are some interesting ratios when we discussed about cash. What is the right amount of cash that the company has to have to cover e.g. the operating activities. So when we look at corporate finance and ratio analysis, you're going to hear typical ratios like cash ratio, current ratio, and quick ratio. And what is important here in this conversation, I said it's not a corporate finance course. It's really that you understand how to read the balance sheet and obviously you're reading cash is easy. Now we'll start with the first comments. I mean, you may recall the wildcard scandal and I mentioned it a couple of lectures ago, where in fact, I mean, I said a couple of minutes ago that normally cash is cash, it's cashless sitting in a bank account and the statutory auditor in his or her responsibility as statutory auditor, is that to confirm that every year the the bank accounts and confirm with the bank institute to the banking organizations. That's the cash accounts and the balance, the outstanding balance is confirmed by those banks. I mean, if you look at the why our cards don't know exactly how much it was. Was it one-and-a-half to 2 billion of a 4 billion plus a balance sheet, that just was wiped out because in the statutory auditor, in my humble opinion, they did not do their work of confirming what was in the cash account button. We can consider that the pure cash accounts are pure cash position or cash item in the balance sheet. Normally there are no risk associated to it, but the wildcard scandal. Good learning also for people that felt that caches cache, but no, I mean, there was a lot of cash that was missing in the wild card balance sheet. Now, when we discuss cache, as I said earlier, is that if the company has too much cash, shallows tends to become nervous because this is what we call excess cash. This means opportunity because I'm in shell as investors, they invest into company at a certain point in time to get in an outflow to them of cash. In fact, that's why they are investing into a company that's typically behavior of an investor. They want to add a second time, extract cash from the company they have invested into. And so when the company sits on a huge pile of cash they showed us tend to get nervous because the company, company management could just give that cash back to shareholders and they're not doing it. So understanding the timing as well, because sometimes I'm hearing analysts, investors who say Yeah, but Warren Buffett is sitting on just two big mountain of cash and then not employing it. Of course, management then gets a lot of pressure also of external journalists and press and shareholders to do something with that cash. But there has to be also the right opportunity to it. And I will not go into the conversation. Again, detailed conversation about cost of capital. And of course, if there is no good opportunity to invest and the company would be destroying value by putting that cash into a bad investment. While then there is, the company should keep that cash or maybe invest into cash equivalents which are maybe very low risk. But at least they are, their instruments, financial instruments that are giving some kind of financial return. So just keep in mind, what is the right, right ratio of cashflow company? There's no good answer to that. I would say of course, there has to be enough cash to cover the operations. So ping out salaries paying our short-term, the suppliers. I mean, those kind of things so that you don't need, so that the company doesn't need to raise depth for those short-term cycles and short-term operations. But otherwise, indeed the amount of cash should not be very, very high. So some people, you hear sometimes I mentioned like 2%, 3% of the balance sheet should be in cash as a cash reserve. I mean, I'm sitting myself in some companies in the board of directors. We also have like ratios where we keep a certain amount of months of salary if something goes wrong so that we can continue paying out the salaries of employees. If e.g. a. Customer would not pay that we would be expecting would be a big customer. So that's the kind of thing that you have to think about cash management and also about access cache. If there is no good opportunity to invest that cash into something, well then potentially the company has to take the decision to say, well, I mean, we want our nonetheless generate some kind of return because we know inflation is then and will be destroying what we don't do anything with it. So sometimes if, let's say operations are covered, the company may decide, I'm giving you three examples to invest into short-term investments. Investments are very, very illiquid. And here e.g. I'm taking the example of Costco, was a wholesaler. And they have like 10 billion in cash and cash equivalents and the hair-like short-term investments of 846 million, which is not a lot. But they do have how to do the interpretation of this. And again, be curious, reads, go into the financial statements, read the notes, and just by looking into short-term investments, you're going to see that those 846 million are in fact divided into two. There are some government and agency securities, very probably those are debt instruments. There are certificates of deposit or CDs, or basically it's a savings product where you'll give your money to a bank and you don't touch that money for a certain period of time and the bank is guaranteeing you a certain return on that amount. And if you touch the money, you're going to incur a penalty basically from so they turn it 460529 in let's say it's treatable, tradable securities and 317, which are certificates of deposit. Now when we discuss about, because what I want you to understand is what is the risk? Because remember, we're discussing level one, level two, level three. Of course when you have a level one instrument. And I will not discuss subprime crisis here and CDS and those kind of things. But basically a level one instrument, there is a market for it and if the market is going concern, So it's normal operations. Well, normally you can immediately imagine that there is no risk associated to it because if there is a real-time market, you could potentially sell off all your position and get and transform that short-term investment into cash. And here we see if you look at the node three of Costco when, because they have to provide a fair value measurement for those short-term investments so that investors understand what is the risk associated to it? Is 846 a fair valuation of those assets? You see, in fact, that they are mentioning that there are. That they're doing laboratory valuation of those assets. So basically they're saying we don't have, we don't hold as a company and the level of one nor lovers be financial assets. But those assets, Those 529, are in fact true. So there are observable from time to time, which is typical, e.g. for local or regional government in the US debt instruments where there is no direct market, but they happen from time to time. What is interesting as well, I was telling you the intention of not having access cash and the minimum of the companies should do is take that cash and invest it into short-term investments that carry very, very low risk that at least they tried to cover, at least something that is close to inflation, is that those instruments, they generate an income as well. And you see it here for Costco, e.g. as other income. What is interesting is they have a higher interest income versus an interest expense. So their cost of servicing, their long-term dept is lower versus what? Those financial instruments that they have put their money into our generating terms of income, which is very positive. Of course, this is great because this gives also the company that capability to race further adapt in the future. What about more cities? This one is more complex. So Mercedes, in fact, when you look, they have what is called the cash to total assets ratio of 8%. So they have like 23 billion of cash and cash equivalents end of 2020. They have also on that list I mentioned in the balance sheet on the asset side 503, €56 billion of multiple depth security and similar investments. Here, I will say it's a little bit more complex. I mean, when you go into the notes, so you read the accompanying notes. So it starts with a paragraph 15 when they're mentioning the market or debt securities, you have this in the red frame on the right-hand side with a carrying amount. So that's the cost of those instruments at 06:03 billion. And there are varying the doing the evaluation at 501C3, which is basically 1 billion less. Then they're saying for further information, you can go into node 32 and I looked up no, 32. So they are mentioning as well. Because even though it's not the US gap company, it's an IFRS company. They follow level one, level two, level three, this is what you have in the yellow highlighted in the extract of the nodes in yellow. And then you have a table which is Table D 71. Why you see in fact how they are splitting for their securities, equity instruments or dept instruments, how they're doing the evaluation of level through level one, level two, level three, you see that they do carry some level three investments, which is really like guesswork. So I mean, there is no observable market even not from time-to-time. So again, the intention is that you understand how to read cash and cash equivalents and the more level three and let's put the wire Cards Scandal aside because, I mean, they had they were reporting certain amount of cash, not even casual equivalent about cash and that cash, half of it was missing. But my statement here is the following. The mole level three valuation you have in the cash and cash equivalents. The higher the risk because there is no observable market for it, the closer you are to level one. And again, forget 1 s for the subprime crisis than the CDS type of securities. But basically, if that would not have happened, of course, when you would have looked at the balance sheet of those banks, they would have probably all set there is an observer market because I can trade those subprime instruments on the market and they are AAA rated, et cetera. But I certainly Tom I mean, there was a risk even for the level one fair valuation of those assets during the subprime crisis. But basically, if it is, let's say, reasonable instruments like a company, stocks, if it has governments are debt securities, I'm in level one is always the most safest one and level three is the riskiest one. So you have to think, do I need to adjust the evaluation that the company is giving me? Looking at the risk level three, the highest risk, because this is really guesswork. So a lot of assumptions are behind that. You don't have an observable market for it. So for Kellogg's last example, so they have indeed in the 2020 and report, they have like a phone or 35 million of cash and cash equivalents. They're not mentioning short-term investments, but when they don't have a specific node but just a comment they say, for cash and cash equivalents, highly liquid investments with the remaining stated maturity of three months or less, one purchase are considered cash equivalent and record it at cost. Again, you need to think about materiality here. 435 million out of a balance sheet of 17 billion. Even if this would go to zero. You are not changing completely new material, weigh the balance sheet of the company. Of course, if cash and cash equivalents would be, let's say 4 billion out of 17.9 billion. And those four billions suddenly have to be adjusted and become 400 million. While the balance sheet is taking a hit of minors, let's say 3.5 billion. That's material impact on the balance sheet and through that, the retained earnings as well. So what I want you to do in terms of assignments, is I want you to take your favorite company. And I want you to look at how much cash the company carries and if they have cash equivalents. So if they are finance, financial instruments, macular securities, debt instruments. And I want you to find out in the report how much of that is level one versus two versus the, let's say, the highest risk, which is basically in principle level three relations. And also what I want you to do is that you take maybe the last five years and you look at how could the cash position has been evolving versus the total balance sheet versus the amount of total assets that you calculate this percentage for the last five years for your favorite company where you probably already have downloaded their financial reports and annual reports. So accounts receivable, That's the next one. So kinda similar. You remember when we were discussing sources of financing, we were looking also at short-term source of financing, which is basically accounts payables. So if you delay the payment ago, suppliers mean that money is available maybe to do something with it short-term. So it's a short-term. It's not, I mean, I do not consider this as capitalists Joseph, short-term way of financing operations if you delay the payment of your suppliers. Remember when we look at accounts receivable of what our accounts receivable is, revenue that you have earned. So we have sent the invoice to your customers, but customers have not paid yet. So you are reporting in the balance sheet, what is the amount of, let's say, revenue that you hope to collect and, or to convert into cash. That's basically accounts receivable. Of course, what is interesting and important when you look at accounts receivable is that account receivable are not becoming bigger. So the, the better you are at converting your revenue into cash, the better. In fact, your operations will be finance basically because you don't need to raise any adapts. And UK, you can even potentially pay immediately your suppliers and your supplies will be happy with you as well. Remember one thing also that we discussed when we're looking at the importance of cash. It's not just about the cash collection cycle, but also that you may need cash to pay your suppliers. You may need cash to create inventory as well. So you have to think about things like what does the cash burn rate and how much cash you need to keep also to fund your operations. And at the very end of the day that you may, when you start analyzing the cash conversion cycle of the company, the amount of accounts receivable versus accounts payable. Not only are we discussing about payment terms, but also about payment terms from the customers to you bought from you to your suppliers as well. That there are differences between industries you may have and you're going to have in retail, e.g. accounts receivable normally a very, very small and we're going to see this, I think later on, on the Kellogg's example. Why? Because when somebody gets out of the retail shop while they have paid, you cannot go home with a Kellogg's box without having paid at the cashier, that's just not possible. But when you buy a car while maybe you going to finance it. But specifically, if I look at consulting service, I mean, the company that is providing you those consulting services is incurring costs. And potentially you're delaying the payments of those consulting services for whatever reasons, for performance reasons, etc. So that's the kind of thing that you have to be attentive. That there are differences depending on the type of business that the company is involved in. So here, e.g. when we look at Mercedes, they do have 12 billion rough cuts of net carrying amount of trade receivables. And they speak about loss allowances. So they calculate kind of receivables that they will not be able to convert. So that's the kind of thing that may happen. Of course, it should be, it shall be immaterial, should, should not be substantial. But there are some risks associated to it. You may have, So you may have provided services to customer and that customer goes bankrupt. And you will not be able to collect the convert to cash, the revenue that you basically deserve from that customer. For Kellogg's, they have, of course, as I said, the accounts receivable that are, that are smaller. Remember that they are in a food business. So they may of course provides to the retailers some extended terms and maybe to their suppliers. But basically keep in mind that Kellogg's isn't a different business. And Mercedes, Kellogg's, when people have bought a Kellogg's box, food box when they have collected the cash. So this of course, facilitates the way how operations convert revenue into cash. In fact, inventory, that's a very important one as well. Why? Because inventory, I mean, when we are discussing about working capital, so working capital to make it short, It's accounts payable on the short-term liability side, and it's accounts receivable and inventory on the short-term assets or two on the current assets. Why isn't Venter important? Because inventory is very probably the elements that you are selling, that you will be able to sell to your customers. So those are in fact, inventory is a primary source of revenue generation for company. No, not speaking here about services companies, forget 1 s consulting companies, they don't have inventory normally. Or I mean, it's very, very small because they're providing intellectual, intellectual services to their customers. But when you're speaking about goods, products, inventory is the last step before revenue is generated, then of course, revenue has to be converted into cash. So that's a typical step. So then what is important to understand inventory as well? The different types of inventories you have inventories which are raw materials. Imagine we were discussing more citizen, I'm going to show it to you later on. That's Mercedes. They receive aluminum, steel, they receive raw materials to build their cars. The males get semi-finished goods, maybe the display for the cockpit of the car. We'll driving wheel e.g. and they assemble all those things together. They transform the raw materials into the shape of the car. And then in fact, in inventory, they will have finished goods. And we're going to see the three types of inventories that indeed Mercedes has. And they're not able to sell raw materials are I mean, that's not the purpose. They're not able to sell semi-finished goods. What they will be able to sell our finished goods. So those are the goods that will generate the revenue. And of course, the company will earn a profit because there is a margin on, let's say on the raw materials and the production process. There are costs associated to it, so they want to generate some profit on that, on, of course, this is what we sometimes called the fully loaded price. There has to be a difference between the price at which the company is selling Mercedes car e.g. versus the sum of all the costs that are related to it. It is taxes, internal direct costs. So cost of goods sold, the cost of R&D. Maybe there are external costs associated to it, like raw materials also the cause of marketing, sales, general administration, etc. So again, I'm giving you just the example of Starbucks as well that you see e.g. when Starbucks is selling a grantee lata in China, that was an article that was in the Wall Street Journal. So they are selling it at 481 of that is profit, it's 18%. So from $4 AT that they're selling in China at that time they were selling a Starbucks run. The latte 085 was in fact a profit, but they had raw materials, so they have to have some kind of inventory as well for those raw materials like milk, e.g. coffee beans, those kind of things. When we discussed about inventory, that I think two things that are important to inventory when you as an analyst and investor, you want to understand inventory. The first thing is the valuation of inventory. So when you look at the financial reports and there is invent there is an inventory item to it, which in e.g. in the consulting world, does not happen. They don't carry inventory. Normally. In a pure consulting services play you, you don't have inventory. But otherwise if you are in manufacturing goods, selling products, Those kind of things, you're going to have inventory and there are different ways of doing the evaluation. Remember, when you look at assets there, as matter of fact, it's one of the fundamental accounting principles, is doing a fair valuation of those assets. And to inventory. There are in fact, three ways, three methods of doing the valuation of inventory. It's the last-in-first-out, the first-in-first-out, and the average cost, the Last-In First-Out is basically the last unit to arrive is being is being sold first. The first-in-first-out is basically the oldest unit that has come in is the first one being sold, which feels like kind of logical. Then there's an average cost to it as well. Because sometimes as raw materials may change when e.g. let's imagine more cities will discuss Myanmar cities. If they are bringing in raw materials from stdin manufacturer, aluminum manufacturer, and they are buying. I have no clue. 1,000 pounds or 1,000 kg of aluminium at a certain cost. And then the week after they are buying the same amount of aluminium at a different cost, how do they value that inventory? So very often what is done is an average cost method is being used. So it depends. So that's one thing that is important to how to think about the valuation of the inventory as well. And then you're gonna, I'm gonna show this to you in very concrete examples. The second very important thing that people sometimes forget is not just about how to devaluation of the inventory or let's say the evolution of inventory. Choosing a specific method. Life will fight for average cost. But is that basically inventory has to be re-evaluated, reassessed at least once per year. And potentially there could be an impact on, let's say, the profitability of the company. There has to be an adjustment to the inventory that has to be done specifically when there isn't a ride down, what it's called, It's an imagined that inventory was carried at 100s and the statutory auditors come in and the corporate finance team looks at the inventory and they say, Well, we have been carrying the inventory is 100, but we believe that we cannot sell it at 100s, that we will have to give a 5% discount to Sally's inventory. So basically they have them to adjust the balance sheet inventory to 95 minus five, write down will have an impact on the income statement. And I will be showing this to you in a couple of seconds. So let's look at concrete financial reports here we have Mercedes. So indeed, remember, I was mentioning that when you look at inventories, you have raw materials, semi-finished goods. So that's a work in progress goes and then you have finished goods. So imagine that Mercedes, of course, raw materials, manufacturing supplies. Typically they're going to buy steel, aluminum pieces may be carbon-fiber. Those kind of things work in progress. That's already things that are being transformed but cannot be sold to end-customers of Mercedes. And then you have finished goods where they can sell either parts, spare parts to the garages, to the retailers, or even just a complete car which is also finished goods. So you see that they carry 29 dots, 7 billion of inventories. And you see that from the 29, that's seven, there are 21.9 billion which are finished goods. Basically. When you read the nodes 18, they are mentioning that there has been a ride on of inventories that has been done and that was worth 413 million. Isn't material, is it substantial? Know, I mean, out of an inventory of 29 dots, 7 billion, this is like a couple of percent, so it's small. It's like trying to make it simple is like 2% ride down. But that's the kind of thing that they have to review and that's also the role of statutory auditors to push management and CFO and finance teams to make sure that the evolution of inventory is being done and there is not an overstatement of inventory value that has been done. And I'm going to show this to you through the Microsoft example. Kellogg's. They have inventories of one dots 2 billion. They have raw materials from the 38. You see this in the red box on the top right. They have 946 million of finished goods and materials in process. And inventory is what is interesting in the Kellogg's report is that you will not find the details nodes, but inventories. They're just mentioning that inventories are valued at the lower of cost or net realizable value because it's determined on an average cost basis. So you see how, what kind of method that they are using does this mean? Because they don't have further explanation that they are hiding something from investors. The answer is no. You have to think that Kellogg's is in the food business. So of course they have inventory, but they, of course they have some kind of perishable goods, but they don't have perishable goods that are perishing day plus one after manufacturing. So you, I mean, for sure Kellogg's has, I don't know the details of it, but I'm expecting that Kellogg's has goods that's expire maybe within the next 24 months. So for them, having ride downtown inventor is probably something that is not happening very often. So I believe that for them also, it's less important than e.g. for Mercedes because if you're sitting and you're going to see this in the Microsoft example. If you're sitting on an Mercedes car that nobody wants, I mean, you will have to give a 30, 40, 50 per cent discount on that cop, potentially for selling it. So that will have an impact on the profit because maybe the car had a production cost of, I have no clue of, let's say €50,000. You hope to sell it at 70,000, but you're giving 50% is can your selling the car 35,000. So that's -15,000 on the cost of the car. That's problematic. I think the best example that I at least I do remember when we are discussing about not just the valuation of inventory is remember the lifo, fifo or average cost methods. But it's really about the write-down conversation. It's the Microsoft example. And at that time actually I was also working at Microsoft, not involved in this business. And what also surprised me is that suddenly at remember exactly when it was, I think was closing of the fiscal year 2013 where Max have had to do a write off of nearly 1 billion of their Surface RT device at that time. I think that wants a device that was running on ARM chips, if I'm not mistaken, doesn't matter, that's important. So what happened is that basically they had generated or created inventory at a certain cost. And they were hoping to sell the inventory at a natural realizable value. What happened is that probably there was not enough demand for those Surface RT devices and they could not hold the position of how much they were valuing inventory. And they had very probably to either scrapped inventory or giving you the way adds a certain discounts. Of course, when you're giving away, when you're setting inventory at a certain discount, this will hit the evaluation of your inventory. And this is where Microsoft had to do a write-down or write-off of nearly 1 billion for the surface or T devices. And definitely, I mean, this has an impact if you're scrapping inventory or if you're giving discounts and the discount. So at the very end of the sales price of inventory or the products that you're selling that are sitting in inventory or below your production costs. This will have an immediate impact on the income of course, at that time and you can read it. This was an extract of the ten K report of the fiscal year 13 Q4, where they were commenting that indeed the earnings were including a charge for Surface RT Inventory Adjustments recorded in the fourth-quarter fiscal year 2013, which decreased operating income by 900 million in net income by 596 million and diluted earnings per share by zero does 07, so $0.07 dollar per share. So of course, when you are having a business, at that time it was 77 billion of revenue. I mean, 900 million. I mean, that hurts. And of course that's specifically hard also the Surface RT division. So you can imagine the consequences also for management on this and also for the finance teams of nuts having, let's say, being proactive and efficiently managing the inventories that were a little bit of surprise, that number was really expecting. So inventory is important and I just wanted to add one more thing before we go into the last example which has many defect cooperation. I just want to open your, your thought process here and this is food for thought. When we discussed inventories, you have to think that it's very difficult for companies to manage inventory and there are risks associated to it. One of the risks, and I remember I went into code, it's now nearly 15, 20 years ago. At NCAR was an executive education training on supply chain management. Why I learned what the bullwhip effect is. When you have companies that are generating, let's say products. I mean, you have companies that are not the ones that are directly in contact with the end-customer. And you're going to have intermediates. They're like wholesalers, retailers, etc. What happens if inventory is badly managed is that you may end up having what is called the bullwhip effect is that you're going to have an exponential growth of the demand to you as a manufacturer. Because at each step, the wholesaler being in contact with the distributors, Distributors being in contact with the retailers, retailers being in contact with the customers. Everybody is being positive and they are adding in fact to the demands. So let me imagine here you see this in the grant that the real customer demand is 12 units. With a bullwhip effect, you may end up having an manufacturing requests for 60 units. So that's a problem. And this is where things like vendor management, inventory of vendor managed inventory or VMI. I think effective supply chains being able to, I mean, the closer you are to the end-customer and you see what is being sold in the shops, the better you're going to be in fact at avoiding inventory and through that, having to do inventory write-offs because you're just produce too much and there is no demand for buying this big amounts of inventory. One of the things as well. There's an example I caught because I'm also a shareholder of Vanity Fair corporation. So VFC is when they reported their September 22 figures where I was looking specifically at inventory. So the results were not fantastic. And I saw that in fact, there was one. I was doing a vertical and horizontal analysis. So basically that the assets have not changed when you look at the asset September 2022 versus margin September 2021. So the total asset demand was close to, let's say 14 billion. But there have been shifts and you see e.g. that inventory went up and cash went down. I was like, Okay, why? I mean, there's a cost to the organization of increasing inventories. And I see immediately here that cash has gone down by 700 million. So what has happened? Of course, I want it and this is where you need to practice. You are you need to be curious and you need to go into the report and try to understand what management has been doing. Because when you look at the income statement, you see in fact that the revenues of VFC were unchanged. Why have they been producing so much inventory? There has to be a good explanation by management to it. And indeed, you see when you look at also the cashflows from operating activities, that's indeed there has been a change in inventory, so they actually added 1 billion of inventory and that's why also the cash position went down. And of course this has a cost of the organization. The risk is always when you have, when you're sitting on too much inventory, that you will not be able to sell this inventory. So of course now in the next quarter's, even me as a shareholder of VFC, 17. Main non-current assets: Now we're gonna be looking at long-term assets and we're going to start with property plant equipment, equity method investments, intangible assets, goodwill, and also deferred tax assets. And one last one, which is also important that I believe lot of people understand are those long-term assets that are being sold by the company. In fact, let's start with property, plant, and equipment. So this is also sometimes called fixed assets. Those are assets that are indeed purchased with the right of ownership. And those assets are generating hopefully profits and are contributing to the operations but over a long period of time. So you remember when we're discussing difference between cash accounting and accrual accounting, when, when you're buying a fixed asset, of course, you will very probably accepted your financing it. You will have to do the full cash out in a certain period. Let's say now, I was giving you the example of buying a car that is providing a service for the next five years, you will have to pay those $100,000 to the car retailer. But that car, that fixed asset will generate profits and revenues for the next five years. So this is when facts, when we are discussing property, plant and equipment, or those fixed assets are long lived assets. We will have to think about what's the useful life of those assets and thinking about number of years of economic value that those assets will provide to the company. There we will bring in the concept of depreciation in the sense that we will try to match the useful life of that asset with the revenues and incur non-cash costs. So when we speak about depreciation, those are non-cash items. It's pure accounting where we will, just then, as I was explaining with a car, will bring this, there is a casual 100,000. But if that asset has a useful life of five years, we're going to do a straight-line depreciation and they're gonna give you an example. And we will incur in the income statement -20,000 of depreciation costs every year for the acid, because acid we generate revenue for those five years. So this is where we haven't difference between accrual accounting and cash accounting. This is what I'm showing you here where I was giving an example of this Mercedes car that has a cost of 100,000 and how you do the depreciation. Here we were doing linear depreciation over five years, but they're different. And I think what is important here to understand is the different types of assets. I mean, a car. I took the example that the car is being depreciated over five years. You may have trucks. What's the, depending on how many kilometres your drivers are driving those strikes, maybe the useful life is three years or seven years. Airplanes, airplanes typically fly, Let's say for 15, 20 years, at least buildings, ten to 50 years, machinery, office equipment like a laptop. This is more like three years. I mean, you cannot depreciate laptop over 20 years. There's so much change in technology. What about land? Land is a fixed assets. How do you value land as well? This is why you have to think. And there are different ways of doing the depreciation is what is the useful life. And I will show you in the upcoming, let's say, minutes how to read this in the financial reports. But I want to show you here is how to calculate the depreciation and let's say the value, the residual value of an asset. If you are looking at the financial reporting U1 and U2 in year three and year four. So let's imagine that you are buying an asset as 100,000, that's the Mercedes car. Let's imagine. Now the company has decided that those cars have useful lifetime or four years and they have a scrap value of 10%. So 10,000 there will always be able to sell this Mercedes S class adds €10,000. As an example, they're not going for five-year linen, the Precision Mat for four year. So how to calculate the book value? The book value is what is carried in the balance sheet. So the very beginning, they're gonna carry, of course, the asset at the amount that they bought, the assets 100,000. But after you won as using straight-line depreciation, they will use the 90,000 because there is a scrap value of 10,000. They're gonna divide the 90,000 by four, which is then 190000/4 is 22.5. And they're going to remove subtract from the initial asset value of 100,000, the first year of depreciation. So when you would be looking at the financial report of year one, you would see in the balance sheet and assets that is carried in the balance sheet at 77, not five. Year two, it's straight-line depreciation. So linear depreciation, that asset that after U1 is worth 7075 is now worth 77.5 -22.5. After year three, that asset same story is going down, 55-22, 0.5, which is three to five. Year four, we are ending at scrap value. This is how the depreciation works. Remember that depreciation is a non-cash item. You will not see this in the cash outflow because the cash outflow, so that happened in year zero in the cashflow statement. So the company has bought that car for €100,000 or US dollars. Speaking about financing here we are speaking about doing a full cash out. But in the income statement, you're going to see in fact, those non-cash items. You're going to see them appearing in the income stream. And this is when you look at the cashflow statement, the reconciliation between cash and non-cash items have to happen in the operating cashflow. What is also important? And here I'll go 1 s back to the IFRS versus US gap is that in IFRS, assets normally are valued at cost, but it's allowed a certain point in time to re-evaluate them up or down to market value. In Gap, e.g. long-lived assets such as buildings, furniture, equipment, they will be valid at historic cost and they're gonna be depreciated appropriately. There is a way and I'm not discussing here now company valuation, I have specific training for that. But when you look at US GAAP companies, very often they carry lands at cost. But we all know that land that has been bought three years ago, that's land is, is okay from an environmental perspective, that land is worth much more versus the value that is carried at costs in the balance sheet. That's a way of also how to increase the book value of a company is to understand what does the company carry in property, plant, and equipment. And I'm discussing this in the other value investing, the out of company variation trainings is like that. Doing an adjusted readjustment of the PP&E for some assets where the company is carrying those assets at cost. But in reality they're worth much more versus what they are being valued independent sheet. And you haven't given me an example of Mercedes. I was speaking about the useful life of PP&E. You see that basically they are telling you that e.g. buildings, they are carrying them 50 years technical equipment, machinery. If after 25-year-olds, other equipment, three to 30 years, they're giving you a sense on how they are depreciating and how they judge the useful life of different types of assets or fixed assets of long lived assets. Depending on the type of asset that we are talking about. It haven't even to myself, reviewing a financial report that I I asked our CFO to review how we were reporting the useful life of a specific asset because I did not feel comfortable as a board member how we were let's say doing the depreciation. So that's the kind of thing. Not only as an independent director that you have to be attentive to, but of course, I mean, you have to understand when you're an investor, how the company is doing the valuation and the depreciation of those assets. The same in the Kellogg's reports, so they don't have a table like Mercedes, what you're seeing here, but they are having it in text in the property part or the property paragraph of the Kellogg's financial report. What I mentioning that the major property categories are depreciated over various periods of time. Manufacturing and machinery is e.g. 15.30, look at Mercedes, mentioning that equipment and machinery is five to 25-year-olds. So we see that companies have specific judgments on how they look at at e.g. a, various type of assets, building structures, the state here ten to 50 Mercedes if you'd go back, they also mentioned building and site improvements tend to 50 billion components. Kellogg says, we're depreciate over 20 years. We don't do more than that. So you see here e.g. when you look at property net, so that's the value of the fixed assets of Kellogg's minus the amount of depreciation that they have. A net PP&E of three dot 7 billion in the last fiscal year. Where I extracted this, these values from one of the last things and if you remember, I was discussing this when we were discussing operating leases, is that over the last years and at a certain time it was a tendency by CFOs to try to show better return on fixed assets by just having less fixed assets and just showing operational expenses for leased assets. There has been also a tendency because there is also more macro economical uncertainty to have some flexibility in capacity on the fixed assets. So, let's say it has become more, more usual that companies, They do. Assets instead of buying them. And of course, when you lease assets, you don't have the ownership of those assets and you incur a cost on that. And again, if you do not remember, go back to the lesson where I was discussing about operating leases, where I was discussing the liability side and also the asset side of it. You remember was discussing the IFRS 16 change that was announced in 2016, FASB the same where they said, well, when you are leasing a long-term asset, even though you're not only of it, we as accountants and accounting boards, account Standard Board's, we want to see this in the balance sheet. We want to see this in the liability side, and we want to see this also in the asset side, even though you don't own those assets as accompany. This is basically what happens. And again, this is an extract I've been discussing. There's a couple of lectures ago where I was showing you the operating lease right-of-use assets and then the operating lease liabilities for Kellogg's and former cities. That will seem nothing. And you're going to see this. If you look at Airlines, you're going to see that they carry a lot of airlines that they own themselves, but they have some kind of flexible capacity. And the lease airplanes, because they want to be flexible in terms of capacity planning for those fixed assets. Alright, equity method investments. That's the next Assets type that we're going to be discussing. Here. I need to come back. And again, I will not spend too much time on this when we were looking at how companies can consolidate subsidiaries into their consolidated financial statements. And remember, there were four methods. There was a fully consolidate, I mean, when a company and the subsidiary 100%, it's really consolidated. What is more than 50%? It will be fully consolidated, but you're going to see a line in the equity part of the balance sheet that is called non-controlling interests. Equity is when the company owns subsidiary 20 to 50%. The company will not consolidate it in the consolidated financial statements, but we'll carry it as an equity investments. And then you have, of course, when you have less than 10% ownership, it will be carried at cost. So we already discussed this when we were discussing consolidation. And what consolidation means wine financial statements. You'll see the term consolidated financial statements. Remember those four methods? I will not go into the details of it, but just keep in mind that you're going to see, you're going to have, if the company has subsidiaries that are not fully consolidated, you're going to have lines like here using the Mercedes financial report in the balance sheet, you see an equity method investment that is carried at 59. Again, be curious, look at the nodes. I mean, they are mentioning here that there is node number 13 that is explaining the equity method investments. And look here, they're showing you here exactly what I was telling you. That's the equity methods for Mercedes. They have three companies, VBAC, BAC, and th BV, where you see that they own 49% stake, 9.6 per cent second, 29 at 7% stake in the company. This is what you've seen in the red frame. And those are companies. One is linked to our link to China. So they, they are not having full ownership. They cannot consolidate because it's in the above 50%. So the company, I mean, but it's still a big investment. So it's carried as an asset because potentially they could decide to sell this asset and that will generate a onetime profit. And maybe those companies are generating dividends as well and profits. So this also is a source of income to Mercedes, but not in a consolidated way. This is where indeed you're going to see things like the amount of equity investment that the results, and also things like the dividends that are paid to Dymola or so to Mercedes. They changed the name from Donald Trump or cities. And you're going to see in fact that e.g. in the cashflow statement, you're going to see dividends received from equity method investments. And you're going to see in fact that the company, indeed, this subsidiary that is not consolidated in the sense of it's not owned by more than 50 per cent Balmer series, so they're not allowed to consolidate it. It's less than 50, but more than 20. They are writing it here as an equity investment methods. So the VBAC at 49% of ownership, the company has generated one dot 2 billion of dividends to Mercedes. So this is, this is nice, nice amount of money that has to be shown to the investors as well. And the company can do something with that. And you see this in the right hand side in the consolidated statement of cashflows. You see that indeed, Mercedes is reporting the dividends that have been received by that. So in total from the equity method investments that were worth one.20, €2 billion in 2019. So that's what equity method investments. But sometimes you have companies that carry a big portion of the balance sheet, which are equity method investments, right? The next one isn't very interesting one, and it's more difficult one to understand is two things, intangible assets and goodwill. So when we speak about intangible asset and goodwill, we are, of course, they're looking at long-term assets. And of course, in intangible assets, we're going to have trademarks, we're going to have intellectual property. And a lot of people, they don't understand what goodwill is. So I wanted to create some clarity about what also goodwill is and how to calculate goodwill. Remember when when we look at intangible assets, when you speak about typically trademarks, intellectual property, those kind of things. I'm not speaking goodwill here. That's a very specific category of intangible assets that I want really to separate from the other intangible assets like patents, trademarks, copyrights, So what is called intellectual property. So keep these two really separated. So you have intangible assets that are intellectual property, trademarks, patents, copyrights, goodwill and I will explain what goodwill is. Intangible assets are something that is very interesting because when me as an investor, I do valuation of a company. It happens very often that the company is carrying the brand's value of lack of Coca-Cola, e.g. at a very low measure, fat affair measurements of the intellectual property, which gives me the opportunity to readjust them to a higher value, to hire book value, the value of the brand, e.g. so typically when intangible assets are recognized, like trademarks are patterns, they are. There's a choice at the moment that they are recognized to either measure them at cost, all to reevaluate them on a regular basis, which is called the re-evaluation methods. And this is something that you have to read in the Financial nodes. And very often I have seen this for what are called blue-chip companies. So very big companies that have a lot of brand strength and customers are willing to pay premiums for those brands that very often the companies are carrying the trademarks at cost. But if you look at branding marketing agencies, that very often the brand value is 10203050 times more than what the value is shown in the balance sheet, which is an opportunity similar to the land PP&E that you can reevaluate, which is a way of adjusting the value of the book value of the company. So that's one thing. But there is another one. And the one, the one is that it's a very special case. It's goodwill. And I must say that's not a lot of people discuss about patents, trademarks, copyrights. It's just, I would say, very investors who really like to look at intangible assets which are not goodwill. Just to look if there is a way if a company is worth more versus what is being shown in the balance sheet. But goodwill is something that has been discussed a lot over the last one to two decades because goodwill is something that is linked to the acquisition of, let's say, external companies that are becoming part Consolidated of, let's say the company that is acquiring those companies. Let me explain you what goodwill is. So basically goodwill is the portion of the premium and I'm going to show the calculation. The company the acquiring company has paid on top of what the book value of the acquired company is worth. So let's imagine, let's walk through a concrete example. That's Company B has lot of money and is buying company a. And company a has the following balance sheet, 58 billion in assets to that 7 billion in depth and three dot 1 billion in equity. So you see it's a balanced balance sheet with five aids in assets and five dots in liabilities with, let's say, rough cuts, more or less 40% and 60% of equity, which is, which is good to the debt to equity ratio is nice. The company, of course, the acquiring company, company B. The transaction happens at 6.5 billion. So you see that already the company is paying 700 million on top of the book value of the company, the balance sheet value of the company. So the company has 5.8 billion in assets. The goodwill now something and it has not to be forgotten, is that the company B that is acquiring company a is becoming 100% shareholder. Remember the four ways of consolidating companies. So company a will now be fully consolidated in company B financial statements. By doing that, you're going to have on the right-hand side, this consolidated balance sheet where The of course the company be assets, liabilities, debt and equity, Ostia there. And company B that has a quiet company a, will add the assets. You've seen in the color-coding, the 5.8 billion of assets of a that are now fully consolidated. The two dots, 7 billion of depth, because you are acquiring the company B's acquiring the depth of company a, and also adding the equity of three dot 1 billion is the goodwill. The 700 million know, the goodwill will be the following thing. There is something missing here because the company has been paying 6.5 billion. The goodwill in fact is worth three dots 4 billion. So it's the amount paid plus the liabilities that company B, which is the acquirer, is assuming is taking over minus the assets acquired. The goodwill is in fact of three dots 4 billion, and the goodwill has to be carried in the balance sheet as well. So of course, I mean, you'd say, well, that's great. I would say, Yeah, that's great. But of course, the hope is that when a company like company B acquires company a, that it regenerates a lot of profits in the future. Otherwise, company B would not have a quiet company. A. This is where you need to understand the difference between intangible assets. Goodwill, because lot of people don't understand what goodwill is and how to calculate Goodwill intangible assets. Remember that typically brand trademarks, patents, copyrights. Imagine your dismay. I mean, you have a lot of patterns of trademarks, copyrights on Star Wars, on, on, on, on Mickey Mouse and those kind of things. So look at the Mercedes consolidated financial position. I mean, they do carry 59 billion of intangible assets. You have to read. So there is no number ten. You can see that indeed, they are explaining how those intangible assets, I mean how they are divided into mentioning in addition, other intangible assets with the carrying amount of tunnel 73 million are not amortized. And they say e.g. this non amortizing intangible assets, our distribution rights and the vehicle segments with indefinite useful lives, as well as trademarks and damaged truck segment within different useful lives, et cetera, et cetera. It looks like that Mercedes is giving some licenses to people as well. And of course, this has a value of this asset has a value. You can see as well here. I mean, when you look at intangible assets, you can see that Mercedes in the table F15, they're giving much more details there showing the split between. Because if you look back at the balance sheet here, they have put in intangible assets. There is no line goodwill. I was like, Wait, I'm sure that Marcellus has been doing some acquisitions. So I went into the node and I see here in this table that's, so, remember that the total is 15.978 billion. That this 15, 978 billion. In fact, you have three types of intangible assets. You have goodwill. It's not a lot, but they have one dot 2 billion of goodwill. They have 12.5 billion of development costs. That's probably R&D in the sense of patents, trademarks, those kind of things that have been internally generated. Then they have other intangible assets and having acquired worth 2 billion. So you see that from the rough cut, €16 billion of intangible assets, 12 dot five are really linked to the development cost of the brand of Mercedes, of the trademarks, of the copyrights of the patterns of Mercedes. And they carry a very small amount. I mean, if you remember, the total balance sheet was to hundreds, don't remember the exact amount, but I think it was total 255 billion of total assets current and non-current. And there's just one dot 2 billion of goodwill. So it's very, very small thing you see that having said that, Mercedes is not a company that has grown through goodwill. So through acquisitions. When you look at Kellogg's, so they have two lines, they are speaking about goodwill with five, that's 7 billion and other intangible assets net at two dots 4 billion. Here you can compare. If you compare with Mercedes, you see that Kellogg's is carrying a little bit more. It's like rough cut. It's a quarter of their balance sheet that is linked to goodwill. So I read through this that Kellogg's as they are today, the moment I was analyzing them and up 2020, that's a big part of the assets that they have in the balance sheet is there because also they did a lot of acquisitions, which is not the case for Mercedes. Does that make sense? Well, probably they have been buying probably smaller food brands that they have been consolidating into their into their food business? Yes, very probably. Then here you see again, they're giving details about the intangible assets and the goodwill. Also split it by, by region. So again, just be curious, reads and try to understand the business behind. And specifically here if we're looking at intangible assets and goodwill. Now, two interesting examples I wanted to share with you, and I mentioned earlier that in the last year as it has been, I would say a national sports to really grow through acquisition then I think there are two companies that are examples. I will not say good or bad exams, but are examples of having been growing through acquisitions which are basically Cisco and meet us are formerly Facebook. Cisco just look at their balance sheet. So they have a balance sheet. This is the October 29th, 2022 balance sheet. Their total assets of 93,000,000,090, 3 billion. They had 38 billion of goodwill. So that means that they have spent a lot of money on acquiring probably other companies, other technologies that are now part of the Cisco portfolio. Am I surprised by this? No, because I knew that Cisco has been growing a lot by external acquisitions and less internal growth. And it's a way of growing at a certain point in time. Somebody will of course have to carry the cost for that because, I mean, this is a cost to the organization. When you look at meta, the most famous example of meat acquisitions being Instagram, how much money they paid for Instagram? When the company was less, I think less than 100 or less than 20 employees. Don't remember exact details. When you look at the Meta, September 30th, closing 2022 balance sheet. So the total assets of Meta we're at 170, eight.89, $4 billion. And they had like 20 billion of goodwill as big as Cisco when you look at it from a materiality perspective. Because Cisco is like 40 plus percent of their balance sheet, which is goodwill. But Meta. Nonetheless, it's not small if you compare it to Mercedes, which has one dot 2 billion out over 255 billion balance sheet. So this tells you as well. When you look at Goodwill, this tells you how the company has been growing. It has been growing internally or externally. And again, do not mix up intangible assets with goodwill. Goodwill is an intangible asset, but that's the premium that the company has been paying on top for acquiring external companies that are now probably 100% consolidated in the consolidated financial statements of the company, right? Nearly, nearly done with the asset side. We have deferred tax assets. Remember again, this will be a quick one. I was showing you when we were discussing also short-term sources of financing, uneven long term sources of financing that you may have governments that you have deferred tax liabilities and deferred tax assets. Liabilities is typically where the company has generated a profit and the company is already now creating provision for paying out to putting money aside for paying out a certain amount of taxes that the government will claim maybe in one year and two years and three years, four years. That's what I was discussing with you a couple of lectures ago when we were discussing different tax liabilities, deferred tax assets. I will share that with you as well. Is that sometimes depending on the size of the company, that the tax authorities that they are already asking for prepayments of taxes without knowing what the company will be generating a profit over fiscal year or not. Those are deferred tax assets in fact, and at a certain point in time, of course, this will reconcile between the deferred tax assets, deferred tax liabilities and at the very end, net-net, the company will only pay the taxes that really they have to incur. So the tax treatment will be will be correct in fact. But just keep in mind that when you look at deferred taxes are always two sides to it. Deferred tax liabilities. The government has not claimed the taxes yet, but the company has very probably the company has generated a profit, is already putting money aside, is creating a provision for future cash claim on the income maybe one to three fiscal years in advance and deferred tax assets is the other way round is that the government of the tax authorities already claiming money without knowing exactly if the company will have to pay taxes to the tax administration. Then the last one, it's not an unimportant one. It's one also that I realized talking with students, investor as analysts, friends that they don't understand what what it is. And it's something that I do look into as well because it happens and it will not say it's a red flag, but it happens that the company tries to make their profits look better by selling long-term assets. And it's a specific category of assets. Remember, I'm in here, I'm looking at long-lived assets. So those fixed assets, remember that a company can decide either to acquire another company. So bringing in those long-lived assets of the acquired company. But the company can also decide to sell long-lived assets. What is the impact of that is that of course, the company will collect some cash, which is great, which will look very good. But the assets has gone. Of course, if it is an asset that was not generating any profits, I would say thanks God that management took the decision to sell that long lived asset that was not profit-generating. I'm not value-creating to maybe another company where there was a better fits between amine versus what the company that is selling. Now this asset has been doing in terms of core business. But you see some times that indeed you have long, long-lived assets that are being sold. I even see this very regularly in companies that are being in financial trouble when they sell the long lived assets. And they ran them back at the cost, they actually pushing. So they get the collecting short-term cash and they are paying more, but over a longer period of time. Is that great? To be honest? I do not like that too much and I'm always very prudent when I see that the company is selling off long lived assets, fixed assets, it looks good short-term, but you need to be attentive that those assets will not generate profits in the long run because those assets are gone. In fact, The companies have to disclose, in fact, already in advance if they are holding assets for sale or that they will discontinue those assets. So it's something that they have to describe. And that's something that's indeed, you're going to see in for some companies and some financial reports where you've seen, I'm giving you the example of Mercedes, very complete. In 2019. They did not have any assets that were held for sale. But in thousand 18, they had 531 min It's not a lot on the total balance sheet. Thanks God, I would say. But still, and they will have to explain why. What's the reason why they're keeping those assets and what those assets are in fact, so here they were explaining that indeed there was a reason. So look at bullet point number one, that the disposal group assets than amounted to 531 million and the liabilities, of course. So not only just selling the assets both to the liability side at 212 million. And sometimes, I mean, they have to sell assets because you have anti-trust authorities that are saying no, you have a too strong competitive position on the market. We obliged, as a regulator, as a government to sell a part of the assets so that we have fair competition on the market that may happen. Sometimes it's just the management who says they're going to sell those assets. They are not fitting my core business. So the company has to report this. So you see an example of Mercedes that it happens from time to time. Sometimes it's externally driven by anti-trust authorities, but sometimes it can be, in most cases, will be driven by management decisions when they are sometimes called reshuffling the strategic portfolio or the core priorities of the company. And they say this is now, this is not core and we'll try to find somebody to sell this. This happened e.g. I don't remember if it was Coca-Cola or Pepsi. I think selling the water business and they were trying to find a buyer for that water business, saying that's not strategic for us, e.g. there is an example there. Again, please forgive me, I'm not trivia is Coca-Cola. Pepsi, but you have sometimes those shifts, you have this in the food industry where they're saying this is strategically score, but we are reviewing our strategic portfolio. This is now not strategic and we're selling eight of this market. So this geography, this customer segment, or this product portfolio. And then of course, they have to declare that this is the amount of assets that they are holding for sale or that will be disposed in fact. And sometimes it makes sense, do not get me wrong. I'm not saying it's a bad thing. The only thing that I'm trying to tell you here is I want you to be extremely attentive that first of all, understand that those things happen. E.g. Kellogg's was not carrying anything receptors, very small thing it, but it was not material versus the total balance sheet. But sometimes I've seen companies that they were really trying to collect cash because they were struggling in their cash management by selling their long-lived assets and either renting them back over a longer period of time. I have one example in mind which was cure rate, which is a, remember the name of the thing, it's Liberty group spin-off, where indeed you see the latest financial reports that they are, let's say, selling off their fixed assets. They are reducing the amount of PP&E in the balance sheet, but they are leasing them back. I don't like to match those kind of scenarios because somebody will carry the cost and I promise you it's not the company that is renting back those assets that is carrying the cost because the cost normally when you the accumulation because it will be higher versus the sales price of the fixed assets. But sometimes it definitely makes sense because there is no strategic fits with the future of the company. And it's better to get written out over those fixed assets until they have a goods. Value. And maybe there is a buyer who is interested in putting a nice price on it. So it definitely makes sense, but I'm always very attentive when I see that company is selling fixed assets. When it does not make sense, or when they are leasing them back. Or it's just a way of quickly collecting cash and showing adjusted earnings and in reality are not adjusted earnings or adjusted also cache cashflow. And I'm very attentive to those things. But again, sometimes it makes sense because those assets, they're not generating any profits or any value. And sometimes they're not a strategic fit for the company, but just be attentive. And when you read the balance sheet, if you have those assets that are holds for sale or that are being disposed, you're going to have an inflow of cash, but that's just short-term because those assets are gone. So just be attentive when you, when you read those, those Balanchine and financial statements, or specifically the cash flow in the investing activities, investing cashflow, that you may have a positive investing cashflow. Yes, that happens, but the company has then been selling of fixed assets. So just be attentive that this is a short-term effects that will not last for longer periods, so be attentive to that. So with that, uh, wrapping up here, the asset sides, I said, I mean, it's something tangible, being exhaustive. But in the asset side, I wanted really to start with the three main type of current assets, which are cash, inventory, accounts, receivables. Then we went into the typical long-term assets, of course, with PP&E. So the fixed, long-lived assets, we have now understood the very end. How to think about long lived assets are potentially being sold, sold off as well. But also we discussed other long-lived assets. Intangible assets are trademarks, patents, copyrights, and then also goodwill. I hope that you understand now also How to Read a big position of goodwill or smaller position of goodwill and the balance sheet. What does that mean? In fact, if a company has been growing organically or has been growing by external growth, by acquisition, mergers and acquisitions. So wrapping up here, this, this chapter, so it wasn't a long one, I must say, and it's just a practitioner level. So I hope that with that it's just wrapping up that you understood that you have the sources of capillary bed is depth bring us over this shadow loss of equity holders. And that typically when they bring in assets, very often in the form of cash, that cash should not sit there, but to be transformed into assets. 18. Income: Alright, welcome back. Chapter number four. We're gonna be starting and discussing everything that is written to value creation, profitability, making sure that you understand that as well when you read financial statements that you're able to see how to interpret profitability as well. We're going to be discussing return invested capitals. So let's start first with revenues and net income and make sure, I'm making sure that we have the right vocabulary understanding when we speak about revenues, how to look at the revenues in the financial statements and also what the difference is between us, the top line revenue and net income. So again, I'm repeating myself here. I already mentioned a couple of Tampa. It's important to understand that obviously, we are not discussing Philanthropy here, but typically the purpose of commercial companies israeli to generate profits and profits, they do not come out of thin air. The company has to carry a certain amount of assets to generate those profits. So the assets in fact, they carry an intrinsic value. And the assets not just only have an intrinsic value, but they will normally be the productive elements, productive engines that will generate profits. So the profits can come on a different form. So bring in cash, reduce expenses, improve sales, increase operational efficiency, those kind of things. And also what you need to understand when you're looking at assets is that the assets change over time. And you have seen this when we were looking at the balance sheet and the details of the various assets. Again, remember, it's super important and I know I'm repeating it at least 234 time, but you really need to understand this. This is really super fundamental. That you have the sources of capital on the right-hand side, typically the deaf to bring us and the shareholders. So the equity bring us and those sorts of capital. They found typically that capital is being used to fund the assets and those assets to generate profits. So this is what I'm showing you here. So the first flow is capital coming from investors, lenders. So the query told us, are the shareholders, the capital typically is invested into real assets are normally it does not make sense to keep that capital under just a cash form that is not yielding any kind of return. So the objective is making sure that the asset generate a productive and generate some profits. This is what I'm showing you here in the third flow that the company operations, they generate, hopefully some profits that are generated by those assets. Obviously, the company will keep, as we have been discussing when we are discussing cash and cash equivalents company will keep a certain amount of cash available. Then the question of course comes is, okay, we need to look at the financial statements and be able to see how much revenue. So how much, let's say economic activity the company has generated and how much profit the company is able to keep to remain from that economic activity. And this is basically when we're looking at the different definition of revenue or income, is what we'd call this economic activity. There is one thing that you, that you need to understand is that a company, and you may recall when we were discussing revenue recognition as well as an economic activity is not necessarily cash. So you remember was discussing examples of your consulting firm and you have reached the first milestone of a project. And the commercial conditions are your terms and conditions that payment terms allow you to invoice the first milestone of the project. Well, that first milestone you're gonna be sending on industrial customer, but you're not necessarily directly correcting the connect, collecting the cash. So generating revenue can sometimes be, I would say summarize to generating invoices, but none of those invoices have been collected in the form of cash. Remember, was giving the example as well of retail. In the retail business, typically when the customer or the consumer gets out of the retail shop, if it is a coffee shop and orange job shop, grocery store, well, the company at the store has already collected the cash because otherwise the consumer will not be able to exit the shop. So then also when we discuss about revenue or income, which means the same thing, the fundamental income to understand is the operating income. So typically, you remember we had this cycle, capital coming in, capital invested into real assets. And those assets should generate some kind of profit. The operating income is the activity that is generated by the operating assets of the business. And you're going to see specifically when also we will be looking at the cashflows are the three types of cashflows. What's difference between operating and investing and financing activity of a company. Because you may have assets like short-term financial instruments that are generating revenue as well, but their revenue is not to be considered as an operating income. Except of course, if you are an investment company, which is your core business, but otherwise it's not part of the operating assets. Also, one thing that is interesting is when you look at revenue, so the top part is also called the top line, the income of a company. So the economic activity, hm, money, how much sales have been generated by the company and the operating cycle is. And so if it is in IFRS and US GAAP, the company has to provide some supplemental reporting about the segments. And of course, they have the flexibility to decide how much information that the company wants to give to shower loss to external stakeholders. Remember that, of course, competitors are looking at as well. So the company that is reporting has to strike the right balance between yeah, there is some obligation of gifts, some supplemental information about reporting. And how much is the company giving away so that it doesn't provide a competitive insight to its competitors. So typically you may find a new, we're going to see this in concrete examples. Ifrs report of Mercedes and the US gap report of Kellogg's, that you may, that you will see in fact, some companies doing reporting per customer segments, B2B, B2C, B2C, enterprise versus consumer retail versus online. You may have companies that provide the reporting per product or product category, like software, cloud services. Hardware entail e.g. if you look at entire cooperation, they have like the typical microprocessors that they're selling related to the PC business. But they may also have like Foundry services that they provide to other companies that want create their own microchips. You may have also reporting that happens per geography can be per continent, Europe, Asia, Americas. You may have it per country as well. You may also have it per business unit or line of business. If you look at the Microsoft reports, you're gonna see that it's mixed between product and business unit. You're going to have a business unit that is more like everything that is Cloud and Azure or the other one is more like business productivity, where you're going to see everything that is Office receives C5, etc. So it provides interesting insights. I will be showing this to you in the next couple of slides, concrete examples how to read those financial reports. So the first thing we have for the time being only looking at the economic activity. So revenue or income here, e.g. you see on the left-hand side you have the Mercedes IFRS reports of 2020. You see that they have generated €154 billion of revenue. What on the right-hand side on Kellogg's, you see that they have been generating 2020, 137 billion of revenues. So here basically you see just from an order of magnitude is that Mercedes is ten times in terms of economic activity, the economic activity of Kellogg's. Now when you look, remember we're saying that companies are obliged to provide a little bit more information, even though it's not always super clear how much information they have to give away. But here e.g. you see, I was mentioning examples where companies provide reports per product category or geography. In fact, Mercedes is providing both. You see this in the table. It's part of the financial statements where you see at that time. So it was the 2020 annual report. You see that you had a segment. So when you look at bullet number one, you have the per product or per segment, which is like Mercedes-Benz cars and vans, trucks and buses, which in the meantime has been sold, has been a joint venture that has been done with Volvo cars, abdominal mobility, total segments. So this is in fact splitting up. You see the amount on the bottom right in the table of 154 billion. That's the amount that we were having in the previous slide, 154309. So you see how this is now split it. And then what is interesting is that Mercedes is showing the split as well per geography, which is bullet number two. So basically having a matrix which splits completely up the 154309. So the €154 billion of revenue for 2020. You can see e.g. if you just look at from a business perspective, you see e.g. that Europe and Asia are very big markets they have then another region is called other markets. You see that North America is not a small, let's say geography, but you see a little bit where activities and the revenues are coming from. And remember, we're only looking here at the top line revenue. So the economic activity we're not looking at, at profitability. When you look at Kellogg's in the financial statements, again, this is not part of the consolidated income statement. This is part of the footnotes that come with the revenues. So you need to be curious and go into the node that explaining this. Well, you see in fact that Kellogg's is showing information per big product categories. So they have snacks, cereal, and frozen. And they are showing them as well per geography, That's bullet point number two where you see the splits. So the total net say is the 13.5 billion, if you remember the other splitted between North America, Europe, Latin America, and Asia, Middle East. So you'll see that North America is more than half, so it's rough cut 60% of the total revenues in 2020. While you see in fact, that Europe is, let's say Ralph, attorney, 20 per cent, more or less, a little bit more. And a little bit less salary and the same portion is Asia and Middle East. So you see more or less, in fact, the proportion is, and what are the big customer segments from a geography perspective that you have for Kellogg's. And then you see as well in terms of the product categories between snack cereal and frozen. So I think what is important here is not necessarily, I don't want you to analyse now what is the detail of Kellogg's and Mercedes? I want you to understand that by being curious by going beyond the consolidated income statement where you see the economic activity being called a there. Total sales or total revenue, or total income. That if you go into the footnote that comes with revenue, not only will you understand how revenue is recognized, the revenue recognition policy, but also you will have some information about customer segments, product categories, geographies, this kind of thing. It will diverge between companies, but it's interesting nonetheless to have a look at it so that you have a better understanding as maybe an investor, as a financial analyst. But you have a better understanding of how the company is generating the economic activity. So the top line revenues from its operational assets. Then there is, we're discussing we were discussing revenue and income. Then we come into another term which is called net income or earnings, which is also called the bottom line. So basically it is the revenue, so the income minus the expenses, that's the net income or the profit that the company in fact has generated. Again, I'm insisting on this. Remember that earnings are fictive. So if I send out an invoice, that earning is only fictive will only be able to pay expenses until I was able to collect the invoice that I sent out to my customers and I'm able to collect the cash from that. So you have to understand, and if you do not remember, go back to the example where I was showing the example between buying an asset that was the limousine at $100,000 that was depreciated over five years while you were saying the difference between the cashflows and the expenses from the income statement perspective. So basically here it's the same. Then there will be a difference between the moment you send out the inverse and maybe the customer is paying 60, 90 days later at the very end of the day, except if the company is cooking the books are manipulating the figures. The earnings will correlate with in and outflows of cash. Specifically the earnings will, we'll be correlated with an inflow of cash from, because the inverse is should nominate all be collected. So what is interesting when you look at net income, it gives you in fact, so remember that net income is income minus expenses or revenue minus expenses. So it's the first, let's say it gives you the possibility to analyze the profitability of the company, how the formula is very easy. You take in fact, the net income divided by the total income or the net income divided by the total revenue. If you're generating $100 or invoice, and you have a profit of ten while you have a ten per cent profitability. So this is how to calculate it and I'm gonna be showing it to you in concrete examples in the upcoming slides. Also, a notion that you will see very often when looking at financial statements is what is called the notepad, the net operating profit after taxes. So a lot of people look at No, no paths. Instead of looking at the total net income because it removes cost of financing, currency exchange exposure, onetime effects on long-lived assets, etc. It's more easier to allow comparison between companies specifically it's net operating profits. So you're only looking at the profits that have been generated from the operating cycle between companies. So you may argue on various things if that is good or not good. But a lot of even when you look at corporate finance courses that using the term notes, notepads, which has a net operating profit after taxes. So before we go into the concrete examples, I want to show you now the drill down. So remember, when we were discussing income or revenue, we were looking at the top line, which is called the top lines. That's really the economic activity before any expenses, before any cost that has been generated by the company. And remember, there cannot be any economic activity if there are no assets. So remember that's typically assets are the ones that are generating the economic activity. An extreme case, I'm giving an example of drop shipping. Well, you're going to have necessarily own assets, but you're just taking assets, playing the role of a broker, taking the assets and sending them somewhere else. But you have nonetheless, your asset is really the, let's say the operation processes that you put in drop shipping, that's also part of an asset. Alright, so the typical vocabulary that you're going to see when you will be looking at from income to net income are the following. So typically it starts with revenue from sales or total income, or total revenues. And then typically, what is subtracted from the top line is what is called the cost of a product's cost of goods, cost of goods and services sold, which is typically the abbreviation COGS, is something that will appear very often. In cogs, you have companies that typically also add the direct expenses. So sometimes it's direct R&D expenses, direct marketing expenses, which really directly linked to the product. This may differ from one company to the other. Direct costs of production that are linked to the economic activity normally will sit in the cost of goods and services sold. When you subtract the cost from the revenue, you end up with what is called the gross profits. That's, let's say finance term that is typically use. And then typically you're going to see in the income statements of the companies, in the financial reports, you're going to see what is called SG&A sales general administration. That's more often all the indirect costs that are not directly linked to the generation of the sales of a product or service. I'm all, let's say of general, let's say activity. So the support functions of the company like IT services as well or HR. So that's part of administration and January. So this is where typically you're going to have. So I mean, Cox is direct costs and SG&A sales general administration is indirect costs, but the company has those costs. The company has, of course, if you want to go from revenue to profitability, has to deduct after having deducted, Cox has to deduct SG&A as well, where we typically then ends when deducting SG&A after the gross profit, we end with what is called EBITDA. So that's the earnings before interest, taxes, depreciation, amortization. You remove the precision amortization. Remember that's a non-cash item, then you end up with EBIT, which is the earnings before interests and taxes. You remove the interests, you end up with earnings before taxes. You remove the taxes, you end up with the earnings after taxes. And then remember when we were discussing consolidation of subsidiaries, you may have companies where the company that you are looking at has not 100%, but more than 50% and is fully consolidating the assets and debt and the equity of the company in its balance sheet. But there is a small portion, maybe 5%, 10%, which is owned by external shareholders. Remember that you have a non-controlling interests line in the balance sheet in the equity, you will see the same in the income statement as well. So you will then in fact see an earnings, total earnings after taxes for all the shower loss. But then the company that you are looking at you're analyzing has to remove the earnings or go to those minority shareholders where the company, your company that you're looking at has fully consolidated its assets in the balance sheet. This is where in fact, you remove the earnings are attributable to those non-minority, to those minority non-controlling shareholders. And then you end up into really the net, what I call the net, net income is really the earnings attributable to the shareholders. And so typically the earnings after taxes is called the net income or net profit. Just be attentive, you will not see for every company non-controlling interests, stakes than the earnings after tax is the same than the earnings attributable to shareholders. But you invest in, if you're investing into company and you are trying to value the company, if the company has minority shower and those assets are fully consolidate in the balance sheet, you have to not look at earnings after tax, but you have to look at the earnings attributable to shareholders, which is, which will be smaller. So basically you are running the company on a smaller amount compared to earnings after taxes. Here, practicing our eye, looking at nodes D zero-one in the merciless repos. Remember we had earlier the top line revenue of 154, €309,000,000,000. And you see here the net profit, which is of 4 billion Kellogg side. Remember we had bullet point number one. On the right-hand side, we have the net sales of 13.7 billion. And you see that the net income attributable to Kellogg's company shareholders is one dot $251 billion. So what you can already see is that Mercedes has generated for billing of profits out of 154 of economic activity. And Kellogg's has generated one dots 2 billion of profits out of 137 in terms of profitability. And one of the things that I was telling you when we're looking at different types of revenues as you not only have revenues that are coming from operational activity. So the company may be sitting on a pile of cash and doesn't know what to do with the cash, there isn't a good investment opportunity. The company may decide, in fact, to invest into financial instruments that are, that are generating also some kind of income. So you may see, and I'm showing this here in the Mercedes report. You may see in fact that the company has different types of income sources. The direct, Let's say, the core business, That's the revenue line. But you see in the bullet points 234.5 that the company indeed may have other sources of income. Example, Bullet point number two, read the footnotes could be subsidies by the government as an example, that's also a source of income. Bullet, bullet point number three, those are subsidiaries and are not consolidated, e.g. so merciless may have them. Those companies, though subsidiaries that are not consolidated so less than 50%, while they may nonetheless generate some dividends. So that's the dividends that you're getting from minority stake in another company? Well, that's known that as a revenue and an income that you are receiving from this company. So it has to be reported from a consolidated perspective. You may have other financial income, expenses and interests income because maybe the company, as I said, has invested into debt instruments. And instead of keeping it in cash and the company is out of that generating some income as well. So of course, and you see it here. It's, remember when we were discussing materiality, it's not substantial here. I mean, the biggest part of the income is 154 billion. That is really the core activity of Mercedes. But nonetheless, you can see that you can end up like two to 3 billion on top of the 154 billion. Thanks to other types, other sources of income. Kellogg's, a little bit the same is little bit more simple. But you'll see that again, the top line, 13.7 billion, you see at the company has some interest income as well. So that's coming typically from financial instruments that the company has Transform to cash into financial instruments and he's getting some revenue on that as well. Right? So having said that, we have looked at revenue, income, the top line. So the net sales, total sales that have been generated by the economic activity you have seen that they may be complemented by some other sources. You have seen how to calculate the net profits. Normally net profit attributable to the shareholders of the company in case of company has non-controlling interests right here. In fact, if we look at the Mercedes example, remember we had this 154 billion, €3 billion. The non-profit was 4 billion, but the profit attributable to the shareholders after removing all the expenses is in fact 36 billion. So remember that I said that one of the first things when you have income and net income is you can calculate the profitability and compare it with the profitability of other companies. So here, if we take three dots, €627 billion, we divide it by the total activity of 100,543 billion. You end up with the profitability of two dot four per cent Kellogg's. So it says the net income attributable to the Kellogg's company is 1,000,000,251. Bullet point number two on the right-hand side, you divide this figure by the 13th, 770 billion US dollars, you end up with a profitability of nine per cent. So what's the story behind those two percentages? Can you, let's say, start doing interpretation? Well, yes, you could do an interpretation. The first interpretation would be, in fact that, well, Kellogg's seems to be much more profitable because it is able to generate a higher profitability. So 91% versus a Mercedes, which at that reporting period, 2020, was only in generating two dots, four per cent. You now need to be attentive before you are taking shortcuts saying you're, Kellogg's is more profitable than Mercedes. You could say, yes, it's true that Kellogg's is more profitable than Mercedes. On the other hand, you need to be attentive that sometimes you cannot compare companies that are not in the same industry. Why? Because the capital structure, the property plan and equipment structure, the asset structure is just different. Very probably Mercedes has being in the automotive industry, being a car manufacturer, has very probably a much higher capital intensity in the sense it has to invest more to keep the pace of innovation of the automotive industry, specifically money out. Now moving away from thermal energy into electrical vehicles or hybrid vehicles, They have probably been, have to invest much more. While Kellogg's is a pretty, let's say, a standard business in the food industry. So that may explain that you have fluctuations as well in the profitability. So please keep this in mind per default, you could say, yes, Kellogg's is more profitable than Mercedes. It's true. Remember that you have the capital structure and the capital intensity of those two companies may really be different. So you need to be attentive as well. Some analysts would say, it's better to compare a Mercedes or BMW or Audi or with their chrysler with General Motors and with fort while yes, of course, that would make sense. But when you are an investor and I will be discussing value creation later on and return on invested capital. And you like both businesses? Well, yes, it's true that if you look only at the year 2020, very probably you will have a preference to invest into Kellogg's because the profitability is higher. And if you would look at the balance sheet, probably the company carries less assets because it's food industry versus Mercedes, which is very probably much more asset heavy, so high are in terms of capital intensity. And also, capital intensity means that it has probably to invest in a regular basis much more of its profits into new assets to keep those assets fresh and fight where maybe Kellogg's has that less. When we look at that. Indeed, one of the metrics that financial analysts like to look into our investors is how effective is management at converting, in fact, fixed assets into sales? And this is another term, and again, it's on a corporate finance course where we discuss where you're going to see the metric of the term called asset turnover. So what is asset turnover is basically the revenues divided by the average fixed assets. So you're seeing the revenues are in fact the net sales. So it's an income statement figure that you're dividing by a balance sheet figure. When you're looking at profitability, we were taking the net profit divided by the net income, divided by total revenues. So that's an income statement figure divided by an income statement figure. Asset turnover, that's an income statement figure. So the revenues divided by the average fixed assets. We're going to see later on that I have, and I will show you also, that's also something that McKinsey says most of the investors, serious investors, they do not look, they look less at asset turnover. They're going to be looking at return on invested capital. And they have a preference of looking at ROIC, of asset turnover and profitability. Roic is really for me and I was not later than last week. And then a training at inserts for the RDP where we had again a corporate finance training where again, the conversation came out at ROIC is really the measure to look into not even return on equity. But I will be explaining this in a couple of minutes. And the advantage of crises that you can benchmark within the same industry. You can benchmark across industries. You can benchmark against any type of asset class. You can, you could compare ROIC from an equity investment versus cash savings account versus debt instruments. So that's the advantage of ROIC. But again, it's not the purpose here of being a corporate finance course, but we're gonna be discussing RIC a little bit later. Now, wrapping up this first lecture of Chapter number four, what I want you to do in terms of assignment, I want you to take your favorite company, maybe just continue using the company that you have already been using in the previous assignments. And I want you to look in the financial statements that you find, the node or the node that I explaining how the revenue is bit a the PR segment per product or per geography that you not only look at the consolidated income statement, you have an idea about how big the company is in terms of economic activity. But try to figure out what are the main sources of economic activity. You saw this for Kellogg's where they had like what was it? Cereal you good frozen categories. You have this one Mercedes, But you were looking at cars and vans, trucks, mobility, and other stuff. So that's the first thing. I would say. A second level of understanding on whether revenues of the company are coming from, then a supplemental assignment is bullet point number three here, I want you to calculate the profitability. So please take the net income attributable to the shareholder. So remove the non-controlling interests. If your favorite company has non-controlling interests, if it doesn't have, you just take the net income and you divide it by the revenue. And I want you to calculate the percentage and that you understand how good the company is generating profits after having deducted all the costs, financial costs, tax costs, etc, by its economic activity, by the revenue and start to interpret the results of the profitability. Is it negative? Is it one or two per cent? Is it's ten per cent, is it 15 per cent? The only thing I will tell you here is normally, I mean, good companies or companies that have high profitability. High typically means like above 67, 8%. And this consecutively during many years, if the company is able to generate that kind of profitability, it's really good. You will not find companies that generate 30, 40% of profitability over a year. I mean, probably is maybe one or two exceptions outside there, but normally that's not the case. So have a look and try to understand the profitability and also the, the revenue, how the split in terms of sources of revenue either per product, geography or segments. Without wrapping up here the first lecture of Chapter number four. And in the next one we will go little bit deeper into understanding net income and cash flows as well. So talk to you in the next lecture. 19. Net income and cash flow: Alright, welcome back, second lecture of Chapter number four. So we're gonna go a little bit deeper into understanding net income and cash flow and the various types of cashflows that you understand. And you're able to differentiate what is really coming from the operating cycle versus investment cycle versus the financing cycle. So again, it's so important that if you're not getting it after my car is, I do not know how to teach it to you, but this is really the thing that you have to run. I can only show you the way, but again, this is so important capital sources. The capital sources if it is credit. So adept toddlers or shower loss, also called equity owners, they bring in capital capitalist invest into real assets and those assets typically generate profits. Now, what is super-important now? And this is where we will be looking now further on how to analyze what is being done with the profits. So basically the company and typically the shareholder representatives, sometimes the shadows, it depends on, remember, we were discussing reserve methods when we were discussing about corporate governance. So depending on what has been delegated either to the board of directors or what has been delegated to senior management. There are some, let's say options now, that's the shoulder representatives. Half for the profit that have been generated from the assets are typically there are three options. The first one is building out the asset position in the balance sheet. So basically we are from the profits that have been generated. We are adding new assets, a new manufacturing plant, new cars, new airplanes, new trucks, new buildings. And you're going to see how this affects the balance sheet. Second option is reducing the amount of depth. So we're paying off the debt holders, they're going to be happy. And the third option is basically we are providing a cash flow to our shareholders also to have them happy. What I'm showing here with, let's say with the various arrows and with the bullet points that are numbered, we have bullet point number four. Remember, the flow number one is capital that is from the investors and the credit totals given to management, management decides to invest into real assets flow. Number two for number three is hopefully the company has generated some profit from its assets and now the company has three options flow number for the company, the cash that has been generated or the profit that has been generated is reinvested into the company. Or the company is reducing the amount of depth and, or the company is returning cash to its shareholders. So this is very important because in the cycle of value creation, this is what is called strategic capital allocation decision. And that's typically that's something that the board of directors senior management take. Sometimes even the shareholders because they don't delegate some reserve matters to the Board of Directors and senior management. First first conversation, what happens to the balance sheet if we inflow number four, so profit haven't generated company says, I going to reinvest the profit into the company and build out my my amount of assets that I carry in the company. You are adding new assets on the left-hand side, what is the effect? The balance sheet, remember, balance sheet has to be balanced on the right-hand side of the retained earnings are growing. So basically, by adding assets to the balance sheet, you are increasing the book value. So the equity value of the company, that's gonna be the effect. If you're adding, I'm just taking out the assumption 10 million of assets, you're going to add 10 min of retained earnings. Remember that retained earnings are not necessarily cash, right? So casual morning Tom transforming into those 10 million of assets. Of course, at a certain point in time the profit generated the 10 million of profit of the previous year. You're going to see them sitting in cash. But then typically you, the company has to take a decision how much cash it keeps. Let's imagine the company takes us ten men and transform them, transforms them into assets. So what is the beauty of this is that you increase retained earnings, you increase the amount of assets, but the same amount, the balance sheet of the company. So the book value of the company is increasing. For number five, that is in fact a cash outflow. So you're reducing the amount of cash that the company has. And you are potentially reducing the depth, the amount of debt that is outstanding, but that you're basically reducing the balance sheet of the company. So imagine company has generated 10 min of profits. You're going to see in fact, this 10 million be sitting in the cash and cash equivalents at a certain moment in time. So that would be retained earnings. So at a certain point in time, the company says, I going to pay out those 10 million to the credit TO lost the 10 million, there is an outflow from your bank account. So you are reducing the balance sheet by those 10 million and the credits. So the depths Imagine is the long term that has been reduced by those 10 million. So you are reducing also the liability side of the balance sheet. That's what happens with flow number five. So there is a real outflow of cash of the company that is flowing outside of the company's balance sheet. Flow number six, UN facts or management or board of directors and the shareholders decides to provide a cash flow to the shareholders. Same thing. Let's imagine 10 million of profits have been generated. They sit at a certain moment in time as supplemental cash in the bank account, the retained earnings have gone up by 10 million. Now, the company management or the board of directors whomever decides that we're going to take those 10 million and pay out cash dividends equivalent. Or the total amount would be 10 million to all the shareholders. So each shareholder will receive, depending on the amount of outstanding shares, its than 10 million divided by the amount of outstanding shares. Imagine it's 1 million outstanding shares. So everybody would then get $10 or €10 per share of cash dividend pre-tax. Again, same with like flow number five at a certain time of those 10 million that are sitting in the bank account will be destroyed. Outflow will flow out of the company's balance sheet and it will flow to the company shareholders. So by that you are reducing the balance sheet and you're reducing the retained earnings. Same principle. So one first thing to understand in terms of interpretation, reducing the size of the balance sheet is not necessarily negative. Some people do not understand. They say, it's only great when the company is increasing its balance sheet. I'm saying, well, it depends. And I give you a concrete example. If you're adding depth to the balance sheet, the balance sheet is increasing. At the same time, you're increasing the amount of data of the company and the amount of leverage is that goods? Well, it depends. Here what I'm trying to show you that the flows 5.6, which are the outflows of cash to credit, told us to reduce the amount of depth on outflow of cash to the shareholders to pay out cash dividends and share buybacks. It's not because the balance sheet is being reduced, that it's necessarily negative. Because if you're reducing the amount of depth, the book value of the company may also grow. In fact, you need of course, to be able to understand and interpret what it means. That's why I'm showing you how those flows 45.6 work. Alright? So when we were discussing profits, in fact, I said a couple of minutes ago cash. And in fact, I was biased saying this because it's true that when you only look at net income, so profits or profitability, it's only effective until the company was able to collect the cash, right? So I tend to look and to like understanding the cashflows as an alternative performance metric to net income. And I think it's important that you understand that because earnings, net income, they can be effective and not just the profit can be effective for a company, but also the losses are gonna give you a concrete example with a, I think it's a ten K, ten K reports from Warren Buffett Berkshire, where you're going to see the impact of unrealized losses on the equity investments that they have and their earnings. Earning loss has not materialized. Because accounting worlds that's oblige Warren Buffet to declare a loss, even though they have not sold the equity where they are having an unrealized loss. So remember that earnings can be fictive, so can losses be as well? Also one thing to be attentive? And again, it's not the purpose of the level one course is that you may have when you start looking at earnings, you may have creative vocabulary that the company that is reporting is using like adjusted earnings or non gap or non IFRS earnings. I will not say that per default, every time you're going to sit this vocabulary, they are negative intentions. You need to understand why are they giving a gap earnings measure and a non-GAAP earnings measure? An example could be there is an extraordinary sales of a long term fixed assets. What of course it will short-term increase the gap earnings. So maybe the company is saying, okay, but we need to be attentive that this is a one of effect. We also giving you what it would have been without this one effect. So just be attentive on those things when you start seeing vocabulary of adjusted our non-GAAP or non IFRS earnings. I'm not saying that per default there is somebody who tries to manipulate the figures, but you need to understand what is the intention, why are they providing an alternative performance measure versus the, let's say, official and regulatory accounting measure, right? And then, so that's the first thing that I want to add here. So remember we have revenue income, that's the top line. We have net income earnings that are attributable to the shareholders. That's really the bottom line after having deducted all the costs. So you now know that sometimes you're going to see adjusted net income, adjusted earnings. Try to understand why are they adjusting things. Are they trying to manipulate you and 3D, it's a beauty contest at trying to show you things that really are worse and they're trying to tell you no, no, but they're not as bad as you think they would be. So we're giving you an adjusted figure. Remember that revenues are fictive until they have the cash collection has taken place. And that's why I was telling you that I do like to look at cashflows as well as an alternative performance metric for a company or measure for company as well. There is a tendency by financial analysts and by Wall Street to look at earnings and not often look at cash and what has happened with cash. This is where I want now to give you a different perspective on how to look at financial statements, but giving you a perspective on looking at cashflows as well. And I will be explaining to you the differences between, i will already list your numerator. In fact, three types of cashflows that you're going to see in IFRS and US GAAP statements, which are the operating cycle, the investing cycle, and the financing cycle. So let's go into that. So bring him back here. 1 s the conversation to remember that if the company is generating profits, you have now understood that profits are effective until they have been transformed into cash. But let's imagine that those profits are equivalent to cash. The company has then three options reinvest into operations flow number for increasing the asset side of things of the balance sheet that increases retained earnings, doing a cash outflow, reducing the amount of debt that's good for the company as well as deleveraging the company or making shareholders happy providing them as well a cashflow to them by either paying out cash dividend or doing a shout buyback. You need to understand those strategic capital allocation decisions. How do you see them? Of course, you could read the footnotes sometimes accompanies explaining this. But basically you don't need the footnotes, you just need to be able to read the cashflow statement. And this is what I will be explaining in the upcoming minutes by having said that, remember, I think it was one of my first slide in this training are saying that basically I start by reading the balance sheet because this shows me the accumulation of wealth since inception, since day one of the company. And then I go into the cashflow state because I want to understand the capital allocation decision that the company is taking. And then only I look at the income statement. So as already said, it's I'm not saying that the income is not important because you can look at profitability. But of course we're going to see how good the companies are generating profits from its assets. Where we will be discussing, when we will be discussing return on invested capital. But remember that my order is different. I started with the balance sheet. I look at cashflow statement on us and capital allocation decisions. So these four, five-six flows, I hope that you now understand why is this important? And then only I look at the income, seem to understand the profitability of it. So what are those cashflows? So I said there are three I was mentioning a couple of seconds ago. So you have cashflows, outflows and inflows from the operating cycle, that's the cash collected from the customers. The cash collected from subsidies, state aids, donations, but you also have in the cash flow from operating activity, the cash outflows. We are building up inventory. You are paying your suppliers, e.g. you are paying your salary. So that's all potential cash outflows that you have. You're gonna have cash inflows and outflows from the investment cycle, which will be, I'm creating, I'm buying new fixed assets and you're building a new approach, a new truck. I may potentially also being selling off those fixed assets. I'm selling a car, I'm sending manufacturing plants. And then you have the financing cycle. So that's basically the cash that is either collected from the shareholders or that is being paid out, the shower loss. But it can also be the cash collected from credit TO loss or the cash that is also paid out to those credit totals like bank, banks, e.g. that are having a bank loan. So this is why I'm showing you here. This is the Mercedes cashflow statement, the consolidated cash flow statement. And you see here that those three sections, operating, investing, financing, you see them here, bullet point number 12.3. In fact, it's clearly divided. I know it's interesting when you look at the Kellogg's one, in fact, between IFRS and US GAAP, they follow the same order. Remember that the balance sheets, the order is flipped between IFRS and US GAAP. While here on the cashflow statement is the same order operating first, investing seconds, financing thirds. So what is operating? Well, that's basically what is the cash that has been generated from the assets. So if you look at the cycle, it's what is happening between flow number two, number three. For number two, we give capital to the operations and we hope that the operations are generating, in fact. Profit from that. So how good the company is generating profit is what you're going to see from the operating cashflow. Investing is basically flow number for that we were discussing earlier. So the company has generated a profit hopefully, and then deciding to invest into long-term assets. So increasing the size of the balance sheet, the financing activity, So the cash flow from financing activities, those are the flows 5.6 that we were discussing earlier. So that's really the casual is going or coming from the credit tellers and it's the cash that is going or coming from the showers. So let's look into it. So let's start with the cash from operating activities and how I do the interpretation of it. The first thing when I look at the cashflow statement, the very first thing is, my first question is, was the company able to generate the profit from its operations? It's as easy as that. So I hope to see you look at bullet point number one, that's a Mercedes cashflow statement. I have extracted just the operating cash flow. You see that the company was able to generate 22 dots, 3 billion of cash. So it's a positive cash balance from its operating activities. What I also do immediately is I compared with the previous reporting period. Here, I'm comparing it with the previous year. So you see that between 2019 or comparing 2019 to 2020, you see in fact that the cash provided by operating activities has been roughly multiply it by 2.5 times so in the year before. So the reporting period before, which was a yearly annual one, the company was able to generate seven or 8 billion of cash from its operating activities in 2020 was able to generate 22 to 3 billion from its opening or theta. So that's good news. In fact, that's already the first interpretation that we can do. Then what we have of course to understand is remember that when you look at net, net income, at a certain moment in time, you need to take into account that there is non-cash items like depreciation, amortization. The need to correlate the balance in inventory is because building up inventory, you're destroying basically cash for doing it. But if you are tapping into inventory and generating sales from it, you are in fact reducing the amount of inventory. So basically, you are collecting cash without having spent cash to your suppliers. So this is what you're going to see in fact, typically in a cash flow from operating activity. So the first thing is you have the income and then you're going to have non-cash items which are then corrected like depreciation, amortization. Because remember, look at the example of the limousine cover 100,000 cash outflow has already happened in the past. So you have your correcting this because you need to correlate income with cash, then you have the change in operating assets and liabilities are changes in inventories, changes in receivables, changes in payables. So between one period and the other one, then you end up, of course, with cash provided by operating activities. So the most easy example is if you were able to generate revenue and you have collected the cash from the revenue, while basically your trade receivables are zero, there is no variation. But e.g. if you have generated revenue and you have not collected the cash, you're going to see difference between the net income and the trade receivables. And it will be the same for supplies and inventory. So make yourself knowledgeable. And remember, the, what is called the working capital, typically inventory accounts payables, accounts receivables. That's typically working capital. There are in fact, in the cashflow, you will only see the cash variations from one period to the other. Again. Practice this, look at inventory taking. That's another easy example. If the company had in the year before 99 million of inventory. Well here in fact it's the, let's say the variation of the previous year. But let's imagine a company has 1 billion of inventory. And inventory after the period has gone to zero, the company has not consumed cash, regenerate sales. So it means that in fact, that tapping into the inventory without having to go to your suppliers actually is you're increasing the amount of cash because in fact that inventory has been paid potentially in the previous periods. So then the cash outflow to the suppliers happens. So you see where cash collections reconciles with income. So very often as I'm stating here, I really summarize the reading of the character from operational activities to is operating activity positive and how does it compare with the previous reporting periods? Are ready that you are doing. A lot of things that not many people are doing. So trying to understand how good the company has been compared to the previous period and is the cashflow from operating activities positive? Normally, if a company is having a negative cash from operating activities, that's not good because normally the company is always able, should always be able to generate a profit from its operating activities are positive cash inflow from operating activities, otherwise it has a problem. The second thing is how, what has the company decided in terms of capital allocation decisions? So this flow number four, there is a profit, so there is cash available. And I'm now taking decisions to reinvest into, into my own company. This is what the cash flow from investing activities is providing. So the second thing I do after having read the cash flow from operations, I look into the investing. I want to understand what the company has been doing. And typically, typically not always the cash flow from investing activities shall be or should be negative. Why? Because the company is spending money to buy new assets. It may happen that the cash flow from investing is positive. Now, maybe, I'm going to ask you a question. When can this happen? Maybe pause 1 s the lecture here, and think, when can a cash from investing activities? Investing activities be positive, knowing that typically it will be negative because we are spending cash for investing, for buying new fixed assets. So pause here, then resume when you are ready with the answer. Now if your resume and you have thought about it, hopefully you have understood that a cash flow from investing can be positive if the company is typically selling fixed assets. So the company is selling a manufacturing plant, that's a cash inflow because you're going to collect cash from a buyer, that assets is no longer available in the balance sheet. So it's a one-off positive effects of cash inflow. But those assets are no longer there to generate profits in the future. So having a casual for investing activity, a positive cash flow from investing activity may appear great. But be attentive that in order to generate profits, you need to have assets. If the company is selling off all its fixed assets, there are no assets left to generate profits in the future. So that's not necessarily good. This is what you're going to see. In fact, in when you look, when you read the section of cashews from investing activities, you're going to see various lines and let me walk you through here. So the first one is Bullet point number one is the company summer cities were looking at the Mercedes cashflow statement. The company has spent six dot 4 billion net. So they have span six or 4 billion on investing activities. But now there are a couple of lines. So let's read that the most important lines, bullet point number two on the top right. You see here it's called additions from property, plant and equipment. What does this mean? Is that the company has added five dots, 7 billion of fixed assets of PP&E. A typical investing activity. You see e.g. a. Bullet point number three, the company has spent 661 million in buying other companies, but it won't number for the company has spent three dot 7 billion in buying debt securities and other financial instruments. And at the same time, the line below, the company has sold debt securities and other similar financial instruments for 5.9 billion. So when you do the sum of all those lines, you end up at a negative figure of six dots for 21. So that's, I would say, what would it be expecting? So if you go back to the cash flow from operating, mercedes was able to collect 22 dot 3 billion of cash from operating activities and it's spending here six dot for on investing. So if you think back on cycle number for, the company has basically spends a little bit more than a third. A third, a quarter on investing from the cancer has been collected from operating activities. Which means that if you and you're probably not understand, if you calculate cash from operating and you add to it the cash from investing, you ending up at a figure which is 22.3 billion plus, minus six dots for which is rough cuts where there's this 16, more or less, let's say 16 billion of cash that remains available for the flows 5.6, which are the financing flows, right? So again, the cash flow from operating activities is the cash that the company was able to generate from its assets, its current assets, it has, it was able to generate 22 dot 3 billion. Now that money which is available, the company has three choices for number four, adding fixed assets are selling even fixed assets. Row number five, ping of depths are collecting ducts, paying of money to the shareholders, collecting money from the shower law. So that's flow 5.6. So here we see that company has rally on for number four, invested six dots 4 billion. Now, when you look now at the cash flow from financing activities, so those are the flows 5.6 on the right-hand side of the balance sheet. So to or from the sources of capital. So to the capital bring us. You see that's just read the cash flow from financing activities statements. You see that on bullet point number three that the company has in fact spends 107 billion of cash. So if we, and I've tried to summarize it here, what does this mean? What I'm trying to understand now, the first thing I'm trying to understand the operating cashflow, is it positive? Is it better than the previous reporting period of the previous year in this case? The second one is yes, I'd like to see the company investing into its assets in order to increase its balance sheet in order to maybe gain market share. Here, if you compare bullet point number three, you see that the previous year, Mercedes Benz template 6 billion DC, they spend six dot 4 billion, okay? So it's good. So typically the cashflow, sorry. So typically the cash from, the cash flow from investing activities should be negative numbers. So you add both operating and investing, and this gives you the amount of money that is available for the credit toddlers and for the shareholders. Now we have to interpret it in facts. I mean, you're gonna see in a couple of seconds, how does this ten dot €747 billion? How is it, is it splitted? But first thing is, how much money has went into the flows 5.6. And of course, you will have to look as well. And this is now a little bit more technical, but typically what you see, in fact, when you add up 22 dots, 3,000,000,006.4 billion negative. So the company has 159 billion available and then it decides to spend 1,007 billion on investing. So the company still has €5.1 billion of casualties has collected. Then you have foreign exchange rates so that the company had in fact a negative effect of -1 billion. So the company net-net has or was able in 2020 to increase the amount of cash of by an amount of folded 1 billion, which is basically great. In fact, the company had starting position. You see this after bullet points 5.4 had an initial cash position in 2020 on January 1 of 1,808 billion. And it's adding those folded 1 billion and now has a cash position of 23 dot zero billion. So by that, of course, retained earnings are growing. The company has more cash available. Right? What I wanna know now, I didn't go yet into the details of the financing activity. I only show the total and how cash, let's say ads. If the company has not spent all the cash from operating into investing, into financing, and there is something left, which is the case here. The company has basically added from the 22 billion after the flows for investing after the flows 5.6, which is Bullet point number one here, the company was able in fact, to keep an after foreign exchange rates. Let's say changes. Company was able to add 4 billion on its balance sheet, which is great. Now, what I want you in this gonna be a little bit more technical. I want you to look now on the flows 5.6, what the company has been doing. In fact, in the flows 5.6. So we need to look, remember, this is a financing activity, cash flow, cash inflow and cash outflow. So I'm going to start with, I want to really understand how much went to the dapp taller so that the credit toward us and how much went to the shareholders. Here, what is important? And we'll start with bullet point number one. So that's very specific for Mercedes. They are also providing the financing service for the car buyers of Mercedes car. So that's why the amounts appear very high. But basically what you see in fact is that the amount of liabilities has gone down. So there is a monastery bidding on the short-term financing and -59 billion. And the amount of long-term debt has increased by 53. So net-net, this is a minus, what is it? -62 plus 53. So it's a minus -9 billion. So they have reduced the amount of that by -9 billion. This is what you're going to see in the balance sheet. So that's, that's the flow number father is going to the credit told us. Remember, Mercedes is specifically do have big amounts because they are providing financing to their customers to buy cars as well. Because customers, they want to receive a financing directly from Mercedes. Mercedes has a subsidiary that is called I think it's called Mercedes financials and Mercedes pay payment, whatever. But they do provide financing like a Bank to provide loans to their customers directly without having to go to a bank. Right? Then you want to look at flow number six, how much money went to the shareholders in terms of dividends paid? Has the company been spending money on acquiring undoing share buybacks? This is what you see basically on bullet point number two. You see in fact that the company has been paying dividends to the shareholders for 963 million and has been paying out dividends to also non-controlling interests. That's normal because there are some minority shareholders for 282 million, The company has had an inflow of capital of 31 million that's on the road. So they have printed new shares, but it's not material. And they are quiet for 30 billion of the need for 30 billion, yeah, sorry, not 30 billion, €30 million of shan't buybacks. So that's the amount that they spend. It's a negative amount. So it's a cash outflow for doing share buybacks from the free float. So the shares that are freely tradable on the market. So this is basically what I'm, what I want you to understand is that in the cash flow from financing activities, you're going to have cash outflows. Those are the negative figures. So that's cash that is flowing out of the balance sheet of the company, but you're going to have as well cash inflows. This is what you see here with the bullet point number one and bullet point number two, which are inflows from new depth and inflows from creating new shares. In fact, what you hope nonetheless, is that the amount of inflows, normally, in my opinion, should be lower than the amount of output. What we want specifically when we look at Dept, is we want in fact, depth to go down. I hate when a company has too much depth. And what we want as well as shareholders is we want to receive a return from the company as shallow. So either in form of cash dividends, pre-tax, or another form of treasury shares where the company spends its own cache to reduce the amount of shares that are traded on the market and buy that increasing the book value of one single share. So for me, it will have a positive effect as a shareholder. Remember, when we are discussing about, and you're going to see this in the Villanova k is in the last chapter where we will be practicing completely how to analyze financial reports with a couple of examples. What I want you to understand as well, I'm bringing in also vocabulary here, which is called equity dilution, equity concentration. So remember in the very, very beginning of this training was telling you that typically it's not the purpose of this course, but you typically have a company cycle which is the launch phase, growth, shakeout phase, the maturity phase, and then potentially decline with a strategic inflection point. If that one is miss, the company will go into the decline. So typically what happens is when a company, I mean, when it is a startup, what you're going to have is equity dilution. So it's pre-IPO. So pre initial public offering or direct public offering, the company, with each round of financing will print new shares by that, Historically, shower or loss will get the equity diluted. That's the purpose of a startup, is to go off, to go through rounds of financing where in fact they're collecting, so they have an inflow of fresh capital to fund new assets on the balance sheet. But when a company is mature, what typically happens is that you may have equity dilution still, but normally the company is only printing new shares by remunerate eating. I'm always saying that two typical examples, after company is mature, when you have inflows of capital, it is basically on your equity is being diluted as a company is creating shares because they have to pay part of the employee salaries by giving stock options to employees that, that hasn't equity dilution effects. So the company is printing new shares out of thin air. And potentially also the company is asking the existing shareholders or new shower loss because the company has an issue to bring in new money, new cash because the company is in need of cash. Those two scenarios will create equity dilution. So if you want historic good shareholder, your percentage ownership of the company will be reduced, will be diluted. That's equity dilution. Typically what happens with mature companies? You're going to have equity concentration. What does it mean that after having IPO, the company has so much cash, that is in fact buying back shares from the market. So by that, if you weren't historical shout of the company and the company is removing shares from the market. Your percentage of ownership is basically going up because they are less shares available on the market to be freely traded. There is what is called equity concentration. So just keep that in mind. At which moment in time it typically have equity concentration, equity dilution normally. Before company IPOs, you will not have equity concentration. This is typical effect when the company is buying back shares from the market. And you may have some kind of equity dilution when the company is either in the need of raising fresh money, fresh capital, and, or the company is paying salaries to its employees. Another form of stock options. So another form of stock, they have to print those stocks, those shares out of thin air. And then this is when equity dilution happens, after all, when the company is already mature company. So I hope that with that you understand in fact, before I explain to you what is the assignment for this lecture, I hope that you understand why I really have a different order when I analyze a company that I started with the balance sheet to understand the accumulation of wealth in the inception, I do look at the cashflow statement to understand, is the company profitable on its assets? That's a cash flow from operating. And what is it doing? Is it reinvesting into the, into its balance sheets, into fixed assets. That's the flow number for this we're going to see in the cash flow from investing activity. And what is it doing with the money that is still left? If money is left, that's the flows 5.6. They're inflows or outflows to the credit totals are the inflows or outflows to the shareholders. And only after that I really look at the profitability of company because I want to understand what are the strategic capital allocation decision that the company is taking? Only the cashflow statement is telling me this. You will 20. Realized and unrealized losses: Alright, next lecture where we will be discussing and I hope that you will understand difference between realized and unrealized is earnings and all losses. I think it will be pretty easy. I'll show it to you through an example of Berkshire Hathaway. So from Warren Buffett and Charlie Munger, company, holding company. But it's something that you need to understand as well. Because I was showing you in the previous two lectures how to look at income, net income profitability. Why? Also looking at the cashflow statement is important. Operational cash flow, the investing cycle and then also the financing cycle to creditors and shareholders. But sometimes, and I've seen this practicing with also students that they do not necessarily understand when they're reading earnings, how much is coming from realize versus unrealized earnings? And that's something that I'll show you concretely in this lecture. So we remember that I said that earnings basically affective until they are not transformed into cash, the cash inflow, cash outflow. You remember that we will not spend too much time on this. And the tendency that indeed Wall Street's analysts, they tend to spend a lot of time on looking at earnings, earnings per share. And there was a consensus, but a lot of analysts, and if that consensus has been beaten or not by the company from a performance perspective. You remember that I was showing you that how to interpret and look at the cashflow statement as well. Now what I want to tell you is the following. When you look at earnings, I already said that earnings are in fact fictive. I going to add a supplemental layer of effectiveness, if I may say, which is the following in 2016, if it was a the IFRS or the FASB. So the USB, that is for IFRS, standardization of accounting standards under FASB, which is for US GAAP, standardization of accounting standards. They brought in the following, which is in fact that companies that have financial instruments, they have to report at each reporting periods. If not only the fair valuation of the assets on the balance sheet, but if they would incur a loss or gain, when they would sell or buy those assets, even though they have not effectively sold are both those assets. So let me explain this to you. So the FASB and IFRS. So the first bit was 2016 and it was the change that was reported as 201601. And you have the seminar for us which is nine. So the company had to elect a donation investment to present subsequent changes of fair valuation in other comprehensive income. Remember then we were discussing the main types of financial reports are totally its balance sheet, cash flow statement, the income same, but you are, if you remember, go back into I think was Chapter Two or one where I was telling you, you have also the other comprehensive income and the changes in equity, so the consolidated statement of equity as well. So then fact basically five plus the footnotes. And what happens is that here, the accounting standard change that has been brought into by IFRS and FASB is something that has to be reported since it has been officially announced 2016 and has to be reported, in fact, through the other comprehensive income. So let me give you the explanation through a very concrete example of the Berkshire Hathaway. Remember that Berkshire Hathaway? So here we're discussing November 2022. They published the latest ten q report in November 2022 when I was preparing this course. And Warren Buffett being a 100 million in the US, there is a regulation if you have more than 100 million of assets under management, you have to provide also three-and-a-half reports on a quarterly basis related what is it 45 days after the closing of the quarter, you have to report the changes in the investments that you're holding, and of course, they have to provide a quarterly report, which is a ten q on audited reports. So they provided this ten K report in November 2022. And you will you'll understand why I'm discussing here realized unrealized losses. So I'm showing you a snip or two snips from the press where they were, in fact are in November 2022 saying, yeah, Berkshire Hathaway, he has been losing money. It's a disaster. So everybody was kind of negative about Warren Buffett. So like, oh my god, I mean, everybody was shocked. And if you just read those snips and you have no clue about financial statements, you have no clue about accounting. You are basically telling your spouse, your husband's your friends are Berkshire has been losing money. Well, no, I'll explain to you why this realized unrealized loss is important. Let's look at the ten Q2 report that came out on October 26th. So if you look, I mean, you are now able to read hopefully consolidated income statement. You'll see that the company has been generating more revenues versus 2021 if it was on a nine months basis or on the quota basis on the quarter you can see in the, was it the third quarter of 2021, the company generated 75 billion of revenue as in the third quarter of 2022, the company generated 7,069 billion of revenues. There is a line below which says investment and derivative contract gains losses. So the company in 2021 generated for the non billions of profits from its investments. I mean, berkshire Hathaway is an investment company and now in the third quarter of 2022, degenerate to the loss of 13.4 billion. When you look at the earnings, the earnings in fact are negative. So that's pretty shocking, isn't it? So they have in fact destroyed for dot 5 billion of earnings. And if you look at a nine month perspective, it's even worse. They have destroyed 40 billion of earnings. The first nine months of 2020 to one in the first thousand and 21, they had generated in fact, 59 billion of profits. This is crazy, right? I mean, this is a very, very bad figures, but there is more to it. And what you need to understand is the following. Warren Buffett has been complaining about this accounting change and let's just read Buffett's opinion. So I'm quoting Warren Buffett, you a couple of years ago he said, We believe that investment and derivative gains and losses, whether realized from this position to this position, it means selling or unrealized from changes in market price of equity securities because the market is fluctuating, quotes are generally meaningless in understanding, are reported quarterly or annual results are in evaluating the economic performance of our businesses, these gains and losses have caused and will continue to cause significant volatility now a periodic earnings. So what does this mean when you look at these 13 billion of losses for the quarter, the third quarter thousand 22, those IN fact, unrealized losses. What does that mean? It means that Warren Buffett is holding equity investments. I'm having the same with our family investments that I may have investments at a certain moment in time. If I would sell them, I would sell them below what I bought them. Right. And so I would incur a loss at that moment in time. But if I'm not selling them, I'm not incurring this loss, but it would be considered as an unrealized loss. This basically what it means. So this is, I mean, you see here the extract of the 2017 shareholder letter where again, in fact, Warren Buffett was explaining you as my showers need to be attentive that we are increasing the book value of the company. You may see a loss, but it's an unrealized loss. The loss has not materials because we are not saying those investments just that the market is fluctuating and we expect it to fair value of the assets that we hold, our investments and evaluation, we're doing a level one fair valuation. So we're looking to the market. Well, and the value has gone down by 15 per cent. So we basically need to declare a -15% unrealized loss. The loss has not materialized and that's something that you really need to understand and just read the extra warm buffalo saying 2017. I must first tell you about the new accounting rules. Generally accepted accounting principle because he's under US GAAP, but it will severely distort Berkshire has net income figures and mislead commentators and investors. The new rule says that unrealized investment gains and losses must be included in all net income that will produce some truly wall and capricious swings in our GAAP bottom line. So he's saying for analytical processes, our bottom line will be useless. So this is where hopefully now you understand that the 13 billion loss on investments and the the the net earnings which is negative, attributable to Berkshire Hathaway. Go back to this slide 546, which is two, that's 6 billion. In fact, it's coming from unrealized losses. So how do we interpret this? So going back to this, remember that this new change in accounting that has been brought in by the FASB and the IASB in 2016 and so on, the 201601 and IFRS nine for financial instruments. Well, during the same period of time, we are looking here at Warren Buffett's. The market has gone down. If it is the Dow Jones, if it is a standard and poor. So what actually happened is indeed that the evaluation of the investments that Warren Buffett is holding has been reduced. Is that normal? What very probably if they're swings up and down in the market, Warren Buffett being an investment company, you're going to see those swings up and down in the market. But as long as he is not selling, he will not incur the loss. So that's what you really have to think. Why does fluctuations are happening and why you need to also to be able to read what is a realized loss versus an unrealized loss. So let's, let's compare in fact, and let's look e.g. at the cashflow statement from Warren Buffett that you will see and I will try to prove to you that in fact, Warren Buffett has been able to generate much more profits in looking at November 2022 versus the previous periods. So it does look here. We're looking at the cashflow statement. The cashflow statements. You able to see that from the first six months in 2092 to the first nine months of 2020 to the cash flow from operating has been improved by 11.6 billion from 14 dot three year to date. So for the first six months, after nine months, it went 1503-27 zeros. So that's rough cuts. A little bit more than $1,111 billion of supplemental cash that the company, Berkshire Hathaway has received. In terms of investing, you see that the company has been spending a lot of money on buying US Treasury bills and fixed maturity securities. It was already at the period of high inflation. In terms of financing, they did not do a lot. So that's typical for Berkshire Hathaway. They're not spending a lot on they're not spending money on cash dividends. You see that the sale of equity securities, they sold 66 dots 2 billion, so they sold 5 billion more. And they purchased eight. So the employed 8 billion to acquire new equity securities from that perspective, they have in fact sold 15, 0, 3 billion of treasury bills more versus the previous quarter. And they have in purchasing 39 billion of supplemental job security. So that's the difference after six months of 100 million and after nine months of 139. So in the last three months, so the quarter in-between those two first six months versus first nine months, the company spent 39 billion on US Treasury bills and similar, Let's say it's probably dept instruments. And in terms of share buybacks, The company has been spending 1 billion more. So in, after the first six months they had spans photo at 1 billion of share buybacks. After the first nine months they spent 1 billion more. So the total for the year, year-to-date was $5 to 2 billion. This is again another example where you need to be attentive about this unrealized losses and you need to be able to interpret that potentially. Just look back at the income statement that the company in fact has to report a loss. But if you don't read the financial statement, if you are unable to understand, there has been a change in accounting rules of 2016 Pacific if accompanies that holds financial instruments, and that's typical case for Berkshire Hathaway. It may be the case for Black Rock, it may be the case for, I don't know, other type of those big investment holding companies. It's the case for our family investments as well. You may you may have those swings up and down in terms of fair valuation. So level one evaluation and the swing, if it is a loss, even an unrealized loss will have to be reported on the other comprehensive income and net income as well. And there it is. Again, you're going to see actually this going up, but it's an unrealized gain because potentially you are not selling the asset, so the balance sheet is increasing and of course the bench, it has to be balanced. You have the net income that is increasing as well, but it's an unrealized gain. So be attentive, not only looking at profitability, not only looking at cashflows, but be attentive as well on understanding specifically for companies that have big financial instruments, how this change in accounting may impact the, let's say the earnings of the company because of those unrealized gains and unrealized losses. So that's another example. What I do care about the balance sheet and the cashflow statement before the income statement. And I really have to think which losses or gains are realized versus which losses or gains unrealized. So be attentive to that as well. Alright, wrapping up the third lecture of Chapter number four. And in the next one, which is the last one, I will only be coming back to the value creation in general, taking a step back and bringing in the concept of return on invested capital and how to calculate the cost of capital. So talk to you in the next lecture. 21. Value creation & ROIC: Alright, last lecture, chapter number four, where we are understanding hopefully how value is created for companies. So those cycles 123 and then profits are generated and then for reinvested into assets 5.6, reducing depth or inflows of depth reducing or giving a cash flow to the shareholders are taking in money from the shareholders. Again, chapter number five, it will be really practicing this on three companies. Now as the last lecture of Chapter number four, you remember when we were discussing profitability, asset turnover, I said that what Shao serious investors look into, even a serious analysts, they look at return on invested capital. And actually, if you listened to Warren Buffet, he also says that return on invested capital is one of the most important measures and how value is created by a company. So again, remember that's company generate profits from its assets. So assets are a productive falls or productive anion to generate profits. Hopefully, you see that typically the profits that are generated from the assets, you're going to see them typically also in the cash flow from operating activities if the cache is then collected. And we remember when we were discussing income and net income or revenue versus earnings. Again, leaving now the unrealized gains and losses, unrealized profit and loss sides. So if we're speaking about realized gains and losses, of course, you remember that I brought in the first profitability measure, which was basically taking the net income for the shareholders of the company and dividing it by the total amount of sales that gives you a first, you remember we were discussing is for Mercedes, I think wants to dot four per cent and Kellogg's, it was 9.1% in the first lecture of this chapter. So go back if you do not remember. So that's a first profitability calculation, the first performance metric. But it's not just about profitability. What we miss in when we are just taking the revenues or the earnings and dividing it by the revenues, we are missing e.g. how good the company is at generating profits from its sources of capital. This is something so it's not just about the amount of profits, but also the quality of profit that the company is able to generate. And this is where sometimes, I mean, specifically when I was, have been mentoring startups, young entrepreneurs and sometimes management, they tend to forget that shareholders have options. They have options of not putting their money into your company. So they have other asset classes, like keeping the money in their bank account and not giving it or not investing it to him company. That's something where shallows, they have an intrinsic perception. I already brought this in. When was the first time bring in the cycle of value creation? Cheryl does have an intrinsic perception of what is the return that they expecting from their money. And that is called cost of capital. And this is what we'll be discussing here. Because you have to keep this in mind. That's also has an investors and analysts. It's not just about profitability, but also the quality of the profits. And also if there are better opportunities to invest your money versus your cost expectation as invested that you have cost of capital expectations. This is what I'm trying to show you here. Well, typically you have a risk versus written balanced and there's something I'm using also in other trainings where you as an investor, male or female or as a company. I mean, depending on the type of asset class you're investing into, you have certain expectations of return. If you have venture capitalists, if your business angels, of course, you have very high expectations of return, but the risk, of course, is also very high. If you are investing into a US treasury bonds, were there the risk? And again, let's just take the same as it is. The risk of default of the US government is in fact low because it will be able to print money, etc. etc. And with that, of course, I mean, your written expectations are proportional as well. So they are low then as well. So an investor that potentially could put money into your company has various options, can invest into US treasury bond and not put the money into the company. Keep the money in the bank savings account, can invest into another company, can invest into real estate. So can invest into corporate obligation, which is not the US treasury bonds, but maybe a corporate obligations from a company like Mercedes or Kellogg's, e.g. if they're raising money through corporate debts. So that's the kind of opportunities that investors have. So do not be fooled that when you're looking at companies and specifically profitability, and it will be discussing return on invested capital. Investors, if the profitability and the return on invested capital is not high enough versus the investor's cost of capital expectation the investor will go somewhere else and extract the money from the company where the profitability is not good. So this is where we are bringing in fact, return on invested capital. Why? Because what I was saying is that when you look at profitability, you're not looking at, I'll call it the size of the balance sheet. What is the size of the balance sheet? You're not looking at how much assets the company carries, how much money has been brought in by the two sources of capital, which are adept and shareholders. And I'm giving you the concrete following example. Imagine that the company has generated 10 million of profits and 100 million of revenues. So the company has ten per cent of profitability, right? You have another company that has generated 10 min of profits and 100 million of revenues, you're going to say profitability is equivalent. Now going to be challenging you. I would say, well, it depends. If the second company has double the amount of assets to generate the same, say it's on the same profits. It's not the same efficiency that the company has. So managements in the second company for the same revenue, the same amount of profits is half as performance as a company, even though the profitability is twice ten per cent. But the second company has two times the amount of assets of the company. This is why I'm showing you here now that's looking at just profitability is not good enough. You need to look at another measure which is taking into account the size of the balance sheet. And this is where I'm bringing the notion of return on invested capital and not return on equity Because return on equity, you would only take capital that has been brought in by the shareholders, but you are missing. The pattern has been brought in by credit totals. This is y, and this was called return on invested capital. This is the most important performance measure, is that you take the profitability, So the earnings of the company and you divide it by the total amount of equity and debt of the company. That's what ROIC is. So this is really the most important performance measure when we're looking at value creation and value creation, not just for the company, but when you're an investor, you have other opportunities, other investment vehicles. This is where you will be able to measure how good the company is at giving you a return. So that's the most important performance measure merlin system on this. How does this work? So let's look here again. We're looking at net profits of Mercedes on its revenue. So remember, we're doing the same with Kellogg. So I brought in that profitability of Mercedes wants to dot four and counselors nine, not one. But let's imagine the percentage would be the same. We need to look at the sounds of the balance sheet because the company, I mean, the profitability versus the assets that the company has will tell you how effective management and how efficient management is at using the assets to generate maybe the same amount of profit in the same amount of revenues. Here. In fact, I'm bringing in return on invested capital, which is basically, I'm taking the profitability of the company and dividing it by, I'll make it easy by the sounds of the balance sheet. In reality, you need to be a little bit more precise. You will need to remove cash from invested capital. If you're taking shortcuts, you would need to calculate the average and S capital. Again, it's not the purpose of being a corporate finance course here. But a quick shortcut is return on invested capital is nuts profit after taxes, and you divide it by the size of the balance sheet. And here you see that the reuptake of Mercedes of one dot 2% and the risk of Kellogg's of 6%, 95%. Now, this is giving you very clearly an indication which management is better at least for the year 2020. And hear you, now You hear you can have a clear statement. The Kellogg's management, with the amount of assets that the company has is more profitable than Mercedes. But again, do not forget that between industries that may be different because the capital intensity maybe different, right? So as I said as well, normally when you discuss a written invest capital, invested capital, you deduct cash and cash equivalents from the invested capital because it's not really capital that has been invested into operating assets. That's why typically, RIC, you say it's NOPAT net operating profit after taxes here, looking at the operating profit from the operating assets and the operating assets have been funded by debt and equity. So we should remove all the Tax liabilities that you have, all those tax assets, those kind of things. And you should remove cash and cash equivalents because that's not capital that has been invested basically. I mean, I'm not speaking about investment company like Berkshire, Hathaway or BlackRock. I'm really speaking about a typical retail consumer business company, even a tech company that would be how to interpret invested capitals you should deduct, in fact, cash and cash equivalents, right? So then as well what we can do, I mean we're always allowed to multiply it by one. So we can in fact split up the ROIC calculation, which is no path divided by invested capital minus cash and cash equivalents. Who could actually multiply by revenue and dividing by revenue, which is multiplying by one. Splitting this, you're going to have other performance measures. And I will explain here where you could say, well, when you look at NOPAT divided by revenue, the company can then be good at managing the overheads, direct costs, cos on goods and services by the suppliers. So this is the way how the company can improve the ROIC is by specifically looking at bullet point number one here the left frame, where the company, if they are better, if they agree to purchase raw materials at cheaper prices, while they will be able to have a higher profit for the same revenue. So by that, in fact, the RIC will go up, of course, for the same amount of assets, that's bullet point number two, the small frame on revenue. If the company is able to generate more sales with the same amount of assets, of course, that will increase ROIC. That's a measure of effective management. And then of course, last but not least, if the company has a smaller balance sheet, so smaller sources of capital. So the company has less depths and with the same amount of note, with the same amount of that with less depth and equity versus the previous year is able to generate the same profits and the same revenue versus previous year. Well, that means that the company is using its capital in a much more effective way. So it's using its assets in a much more effective way because it has paid off depths. And what is remaining in terms of debt and equity is generating the same amount of profits and revenue. So with that ROIC is going up, those are the measures that management can take to improve the performance of the company, right? I mean, there is a companion sheets with this training. And in the companion sheet, you're going to see one of the sheets where I'm showing you how to calculate the percentages. Because what you can look already here is the gross profit of Mercedes versus Kellogg's. Mercedes has a higher direct costs on its revenue. It only keeps 658%. It means that €100 of revenue, only 6.8 are remaining for paying off the rest of the costs at Kellogg's. For every $100 of revenue of cereals, yogurts, frozen products, they keep $34, so 34 or 33%. This way of course, you see the cascades where you can then calculate things like return on assets, return on invested capital. Return on assets is the profitability on all the assets. Return on invested capital is the total assets. But you are removing cash and cash equivalents, of course. So you're dividing by debt and equity sources. Then you also have, That's also measure that I tend to look into is called the runtime and run the written on net tangible assets. So you are taking out intangible assets as well. You're only taking productive assets, but not trademarks, goodwill, those kind of things. Those are alternative performance measures as well. Again, it's not a corporate finance course, but I just want to introduce those concepts for me if you have one to retain and to remind, is really the ROIC, the return on invested capital, remove cash and cash equivalents from debt and equity. And this will give you in fact, fair performance measure also between other competing with other investment classes. So as I said, so yes, Now you can say that Kellogg's is better because you are comparing the profitability of Kellogg's with the size of its balance sheet. So the size of the amount of capital that is using versus Mercedes. So remember that what I said is in this cycle of value creation that when the credit TO loss and the equity holders are bringing in money, They are having already some expectations on the written that they are expecting. This is called the cost of capital. The big conversation and not later than last week in San Francisco, I had colleagues of inserts that with all due respect, maybe a little bit less fluent in corporate finance. They were asking the professor, what is cost of capital and how is it? How can you decide what is the right amount, so the right percentage of cost of capital. So in fact, they were asking on cost of equity, but you really will understand why I'm discussing this. So first thing is. What is a good return on invested capital? Well, the easy answer is, if the company is able to generate profits, so return on invested capital above the cost of capital that the shareholders and creditors are expecting, the company is creating value. That's in the one simple formula, that's value creation. If ROIC is above cost of capital, the company is creating value for its shareholders and creditors. It's as easy as that. And of course, normally cost of capital has to be above risk-free rate. So the 30-year US inflation, which is considered a little bit the benchmark of let's say, risk-free investment class. And of course, it has to be above inflation, otherwise, you are destroying wealth. And of course, if the RIC is below cost of capital, you wouldn't have investors that they will withdraw the money from the company they're going to invest into another investment class. That's something that as I said earlier, some entrepreneurs, they do not understand that if the written is not there, the cabinet, the shareholder will just say, sorry, but I'm gonna withdraw. I'm gonna put my money somewhere else where I'm having at least that company or that asset class provide me the minimum expectation that I have in terms of cost of capital. Roic in an industry when ROIC is below cost of capital, you're going to see the amount of competitors is being reduced because it's an unprofitable industry. So you're going to have concentration of the market. And if you have ROIC profitability in industry that is very high risk because of capillary gonna see new entrants coming in because they want to also have part of a share of the cake as well. So remember, value creation is if ROIC is above cost of capital, the company is creating value for its shareholders. Now, cost of capital. How do we determine cost of capital? Or basically, cost of capital is subdivided into two sources of capital. Now you will understand why I was insisting many times that you have the sources of capital in the balance sheet on the right-hand side, you have the credit told us, which is a source of capital. So the dapp told us, you have the equity or shareholders, which is another source of capital. Those are the owners of the company. Basically cost of capital depending on how much you finance from depths and how much you finance from equity. This in fact, so I mean, it's an formula. Here's what is called the WACC, the weighted average cost of capital, basically half what is the cost of capital for the company. So of course, if you are having zero equity and everything is fine and adapt, the cause of death will be equivalent to the cost, the weighted average cost of capital, because there isn't a weighted average cost of capital because of that is equivalent to 100 per cent of the cost of capital. But if you're having 50 per cent and you having a, I have no clue. Five per cent cause of depth. And you having 50% of the sources of capital of the company is coming from shareholders. Of course, and the cost of equity of the shell as they have a ten per cent expectation, the average cost of capital of 7.5 per cent. So this is how it works. So this is a very easy calculation. If your company, again, if your company is being funded 50 per cent by dept and the depth has a cost of five per cent on the bank loan. The company has been financed 50 per cent through equity capital. And that capital has a cost of equity that the shirtless has the, has decided being ten per cent. So 50 per cent at 10%, 50 per cent, five per cent. The average of that is 75% because it's 50.50 per cent of 10.50 per cent of five. It's not always 5050, of course, it's 30707030, etc. So that's the cost of capital. Because of depth is very easy and I'm giving you another calculation where it will be more complex calculation where you have like 37%. So you have a balance sheet where 37% of the capital has been brought in by equity holders and 63% of the capital has been brought in by debtholders. The depth TO laws are bringing in a course or they're saying the cost for lending you money or you guys accompany you are borrowing money from me. That has 4% in terms of cost. The equity holders are saying, yeah, if I give you money, it's also a liability. I will have charged per cent return, right? So the weighted average cost of capital would be of 696 per cent in this case. I hope that you understand why understanding the sources of capital is important, but as well, they come with a certain expectation by the sources of capital bring ours if this depth dollars or equity holders, they come with an intrinsic expectation of return, that's the cost of capital. One of the conversations we're having very often as well before we go into a give you a concrete way how to look at cost of equity and cost of debt. Depending if you're investing as a VC venture capitalists or into mature, a very mature company. The conversation is also the following. Very often, depth is cheaper than equity. And I mean, when you're not experienced, you may have a tendency to think, oh, that's great. Because then I will only find as my company through depths and nothing through equity and that's not true. So I'm giving you here what is called the gearing ratio. I will not go into the details of it because this is corporate finance. But typically if you're only finding, seeing your company through dept, the risk is so high for the credit told us that they're going to ask cause of capillary that is very, very high. This is what the diagram in 12.3 is showing on the right hand side. So you have to strike the right balance between equity contribution as source of capital versus depth contribution as sources, source of capital. There is an equilibrium to find. It depends sometimes on industry, depends on macro economic elements. This is where then your weighted average cost of capital will be the lowest. But if you're only findings in your company through dept, the risk is so high for the credit toddlers going to have a very bad rating even from credit rating agencies, from the bank if it is a private loan, I mean, you're gonna be having a cost of capital that will be extremely, extremely, extremely high. So this is what the diagram and this gearing ratio actually means. If you're interested, look it up a little bit further. Again, it's not the purpose of being corporate finance course here, but that's a notion when you look at corporate finance. I don't want, the point here is I don't want you to think that as very often cost of debt is low. That it's best to finance everything by external depth and nothing through capital. That will not be the case. Because then if the ratio of that becomes too high, the risk for the creditors becomes also very high. Because of that, it will be much higher than the cost of equity. That's what you have to keep in mind when you think about what is the right proportion of debt versus equity, right? So remember when we were, I mean, we're speaking here about companies who invested into the company as shareholders potentially, and we're analyzing the financial statements. So remember that I was discussing and mentioning that sometimes even young entrepreneurs forget, is that the, the money of the investor is, if you are the manager of the company, you are in competition with other asset classes and then your investor may decide to go somewhere else. And this is what I'm trying to tell you. How can you concretely and I mean, it's worth what it is worth, but for me, it's one of the basic ways of determining the cost of capital. There's a guy that is called as what the Moderna is, a professor of corporate finance and valuation. Maybe you see it behind here. I have no actually, I have the book I have the book of us what the moat around about corporate variation behind me. This is McKinsey book I have here in front of me on valuation. And he is really considered like really one of the best worldwide specialists in doing company valuations and what he's doing and he's providing for free. I've put the URL here. He's providing for fretting on a quarterly basis or twice per year, if I'm not mistaken. The external benchmark on cost of capital. And so he's providing information on the cost of debt, the cost of equity by analyzing various companies, various industries, various geographies. So basically what he's telling you here is following, is that the cost of capital is basically depending on the industry average. There is also a company rating spread. So depending on the gearing ratio, so how much debt versus equity the company has, then there's also country-specific risks that's more like geopolitical risk. And what I'm showing you here. Remember that I've prepared this course since more than one-and-a-half years. It took me a really, a lot of time, right this course. And to be selective on what I wanted to share with you. Here, I was extracting in January 2021 that the average industry cost of capital cost across all industries, across any type of gearing ratios between debt and equity was at that time 584 per cent. Now probably with inflation, it will be probably somewhere at eight or nine per cent. And you remember that in the formula, it depends also on the how, what is the solvency of the company? If the solvency of the company is bad, of course, the risk spreads. And you remember we, when we're discussing interest coverage ratios and this triple a ratings, investment-grade bonds versus junk bonds which are not non-investment grade. Then, then the risk spread, the premium is increasing, so you have to add that as well. So if you come back to slide 580, you could say, my minimum return as an investor that I'm expecting is the industry average. So let's say 584 per cent now would be more. Plus depending on the company I'm investing into. I mean, if the company has too much leverage, I will need to add, I have no clue five per cent of risk spreads on the depth. So you already like at 12:13 percent, plus you're going to add a country-specific risks as well. Here typically you, I mean, this is very often linked to geopolitics. If look at Luxembourg, where I was living before Luxembourg. Luxembourg has always had a triple a rating from those rating agencies because the sovereign debt of Luxembourg is super secure. So there will be no country risk premium, so the country risk is zero. If I look at Spain, e.g. When I did this analysis, so this was January 2021 when I was preparing those specific slides. As you can see that Spain, e.g. they are not having a triple a rating. They have a BWA one rating by Moody's. And because of that, they are having a supplemental country risk premium of one, not 55 per cent that you need to add. So if you investing into Spanish company, you at least have to take the industry average plus the rating of the company. The risk spreads on the depth, on the solvency of the company plus the country risk. And this gives you then, when you add those three figures together, this gives you basically the cost of equity of the company or the cost of capitals, sorry, of the company. Then of course, depending on the amount of debt and equity, of course you can look up, I mean, for the cost of depth is just if you're raising 100 million from a bank, at what rate with the bank gives you that loan? With the bank lend you that money. So that would be then the cost of depth. Specifically. That's how you can calculate. So the industry average includes both. It's basically the weighted average cost of capital plus than the rating spread of the company. Aaa company, it will be very low risk premium if it is a junk company like we had with other grandly, with all due respect for our grand day, then probably you're going to have a huge accompany ratings spread that will be added to the cost, to the industry average cost of capital. And then it's gonna be a country-specific risks as well, which is more linked to geopolitics and sovereign debt and solvency of the country as well. So that's very valid for public markets. So secondary markets are listed companies, but what happens in the private equity world? How do you estimate cost of? So the weighted average cost of capital, or basically my benchmark. And I've realized that not a lot of people are aware of is my benchmark has been at least for the US. The you have the Pepperdine University grad CARTO School of Business and Management that is actually publishing every year a report. They are serving banks, business angels, venture capitalists on what is the written expectations that those people have, depending if it is a first round investment, if it is seed investing, it is mezzanine investing. You see actually are so I just extracted. So it's a very long report where they explain the methodology and how they survey those market professionals, those financing professionals. And of course you see that and it's normal that angel investors. So that's very, I mean, if I come back to my curve, business, angels, they have, they carry the highest risks, so they are written expectations are the highest. Well, this basically what you see here on the right-hand side of the 2020 report that was serving 2019. You see in fact that the angel investors have the highest return expectations. Then come venture capitalists and you have private equity, then you have mezzanine investments. Those are, let's say the laws investments before going IPO. Then depending on bank loans as well, on the amount of the bank. When you see this is typically cost of debt, that's not cost of equity, where you see that bank loans obviously are the lowest. So again, with that, if you take in my opinion, as what does the model runs, public information for publicly listed companies where he's freely making all those figures available, you can calculate weighted average cost of capital. And if you take the Pepperdine Gaziano reports, you have also perspective on private equity markets. It's worth something, it's a benchmark. Well with that you could actually, for your company or the investments that you want to take, you can have an idea about what is a fair valuation of the cost of capital. And you may have an investor that I mean, if you're a private company and you are, I have no clue, a expansion later stage company. So this is how VCs would look at you. And you have somebody who comes in and is asking for a 75% written, you're going to say, Sorry, but that's not the right the right thing in terms of cost of equity that you are asking from me at the very end of the day. What you need to keep in mind is that value creation is when the company generates profits, return on invested capital, return invest capital looks at the sources of capital. Capital is called the capital structure of the company. If that is higher than the weighted average cost of capital where I showed you now how to do it for public markets and for private markets. And if that is above inflation, then the company is creating value for its shareholders. If the ROIC is below the WACC, the company is a string value and very probably you and I having the risk that investors will withdraw the capital from the company, right? So that's something that you have to keep in mind. The last thing I wanted to add here is this is, I mean, you can look at this from a perspective that we're looking at companies that are generating profits. But what happens for companies that are making losses? Because early-stage companies, it is, let's say startups, early-stage companies that have not IPOs and the private equity space. I mean, how do you be an investor? How do you look at value creation where basically a lot of those investors, they look at the exponential growth of the company. So how much market share that those companies are gaining? Look at the examples of Spotify, spotify or Huber. They are not being profitable. But what investors are looking into is how much market share do those company, companies have? So how strong are they? And then they hope that at a certain point in time and the company will become so on top of the curve with the company will become more mature. Then if there would be a selling the company or the company will generate profits, then indeed they will look at ROIC being above WACC. But in the beginning and typically in after the fourth industrial revolution that started 2016, you have a lot of those platform companies where it is really a winner, takes it all approach is really about market share, which is a temporary measure of value creation for the shareholders. They will only materialize value creation the day that the company is either going IPO or that the company is in fact becoming profitable, or they are selling their stake in the company and the share price has gone up a lot in fact. So just keep this in mind. It's a little bit specific when the company is writing losses. And again, I just wanted to emphasize that ROIC is very important. And it's not just me saying this is, I mean, I already said that in corporate finance courses, not it's done last week in San Francisco we're discussing but impotent of RIC and that ROC is a better measure than return on equity, e.g. because it takes also the depth sources of capital. And you have your nautical of McKinsey. I've put you the URL below as well. Where again, they are again claiming what I am telling you that too many people, too many analysts, they focus too much on earnings per share. But the real return to shareholders is ROIC, is return on invested capital. So those are the real, and of course, revenue growth. If you remember how I spit ROIC when I multiplied and divided by revenue, revenue growth. So those are the fundamental drivers of value creation. It's not earnings per share, so we need to be attentive to that, right? So, um, so yeah, so I think in terms of wrapping up here, what I'm asking you here as an insomnia is the following. I would like you to take two companies that you like within the same industry, so please use them the same industry if it is Kellogg's, maybe take, I have no clue. Mondelez International, if you like Nestle in Europe, maybe compare it with Kellogg's. If you're like, if you like the automotive industry maybe compare Mercedes or BMW, or you are comparing Ford with General Motors, e.g. you're comparing, I have no clue. Maybe Microsoft and with Amazon you're going to have the retail partners. That's not a good comparison. Maybe you compare it with Google, e.g. with Adobe. So what I want you to do is take two companies that you like within the same industry. I want you to download the latest annual report and I want you to calculate the ROIC. Roic is the profitability divided by invested capital. And if you can, if you want to remove cash and cash equivalents when you're doing the calculation of invested capital. And I want you to analyze and comment for both companies how you feel about the ROIC that has been generated by those companies, right? So remember, ROIC is a measure of profitability that's coming from the income statement divided by the sources of capital which are sitting in the balance sheet. So there we have the right measure of value creation. I'm not even asking you to compare with a whack. I'm just asking you to look at the ROIC of the company. I can give you some kind of interpretation here, as I have learned also from Warren Buffett, is the following. So Warren Buffett has always been saying, if you have an ROIC That is above 8910 per cent and this is regular for the last five to ten years. Very probably that company has a competitive advantage and very probably that company for a member of the macro Porter's five forces model. Very probably that company has the capabilities to push very high prices and has pricing power as it is called, towards its customers. So high measure of ROIC close to 10%. And this for many years in the row, very probably showing that the company has a strong, what is called a strong mode, has pricing power very probably, or maybe also very good operational efficiency as well. So that's something I'm discussing in another cause which is called the other value investing. But here, just keep this in mind as a quick benchmark. If the ROIC is high compared to competitors, very probably the company has either pricing power as good at operation efficiency of using the assets of the company has available to generate the profits. So this one I want you to do is take those two companies download the latest annual report and calculate the RIC with the formula I've been explaining, right, wrapping up here. So we have ended chapter number four. So now chapter number five is pretty easy. I will only be. So everything that we have been seeing so far, we've been looking at the balance sheet, looking at the cashless, even looking at the income statement. I will be now clearly showing you from the bottom-up how I analyze companies and those are concrete companies that I have been asked to analyze. Monrovia in Germany curating the US guy was airlines in the US. Are going to concretely show you and walk you through, if I would do the analysis and interpretation. What I found out when analyzing the financial stems of ANOVA curate and Sky West. And then we will conclude Chapter five and cooked with the complete training. Thank you for listening in and talk to you in the next chapter. 22. Full Example - Vonovia: All right, Welcome back. Last chapter. This is only a chapter outside the last lecture, which is about concluding thoughts, final thoughts. The other three lectures are just practical, practical examples where I will be practicing concretely what we have learned over the previous four chapters on three companies were no via German real estate, cure rate, which is like a online commerce digital platform in the US. And then Sky West Airlines, which is already, as I said, an airline company. So let's start with Villanova. So the type of questions that I will be walking you through in the example of ANOVA are the following. Is, the first question will be the following. Which report shows the variation in wealthy over here? Which report shows us how money has been important came from etc. So let's practice those ten questions concretely on the example of Villanova. Villanova is, as I said, German real-estate company. They own a lot of assets and they have a lot of people that are living in those assets, so they earn money from the rental of those assets. So the first question to you is, let's imagine. I mean, I hope that you went through all the chapters here is which repurchase variation in wealthier over here, posterior? If you do not know the answer, think about it. Which report shows the variation in wealthy over here? The answer will be the balance sheet, because the balance sheet shows you what has been the variation in wealth creation from one year over the other. The second one is Rich report shows how money has been employed and money came from posterior resume when you are ready, the answer will be, of course, the cashflow statements. So this is where we will be looking into and I want you to see what has happening in the company Villanova. And again, how did I come across Monrovia? It's front of mine. Who told me I can never do anything but Genova, is it the right investment or not? So I started so I went into the Villanova annual report. You have here, the xor and I started as I have been exploring in this course, I started with the balance sheet. I wanted to have a guts feeling. One has the company in terms of assets, what are the sources of capital? So another question yeah, I want you to practice is, why are the current assets listed after the non-current assets? Question number three. Pause. Resume when you're ready because it's an IFRS company, it's not the US gap company. So the current assets they elicit after the non-current assets, remember that the order is flipped with US GAAP. Now what I want you to do is you have here the screenshots. I want you to analyse and comment the big differences. And we will be doing this and we're looking at the balance sheet and IFRS balance sheet of a German company. I do not know if they have assets outside of Germany, but I think most of their business is in Germany. So I want you to look and you need to be attentive that the left column is the ending position 2020 and the right column is the ending position 2021. So I have a UVA via variation which is left to right. So I want you to analyze and comment the big differences. So pause here, have a look. Look at start with the assets. Start maybe with the balance sheets. And I will walk you how I looked into this concretely. And now this also is something I've been discussing in one of my webinars with my students when we were discussing valuation of ANOVA. So the first thing that I look into when I analyze the balance sheet of the company is just the totals. Remember that we learned that the increase of the balance sheet is not necessarily negative thing and also not necessarily a positive thing. But I mean, I'm trying to get a gut feeling. And I do see just by looking at one figure, what you see in the red frame that the balance sheet of ANOVA has increased by 70% from 2020, 2021, the total balance to a €62.4 billion. And the December 31, 2021 balance sheet is 106 dots three was like, Oh wow. Just by looking at the figure is something has happened. So I need to understand what has happened. So I went further and I said, Okay, let me look now at the various line items on the asset side. So you see I'm not even taking capital source of capital, I'm just looking at what does the company have in terms of assets. I do see e.g. let's start with bullet point number two. So that's investment properties as the third line. That the company has went from 58 billion of investment properties to 94 billion of investment properties. Remember, the business of ANOVA is owning property, so it's a real estate company. So basically the company, just by looking at two figures, I already see that the company has added 44 billion to its balance sheets. And 36 billion of those, 44 billion are coming because the company has increased the amount of investment properties, which is huge, of course. And you can go further. You can look at intangible assets, bullet point number three, while they went up by one dot 4 billion. Why I'm looking at intangible assets, because I'm looking at Goodwill. It's I mean, if we know that probably does not have R&D patterns, those kind of things, It's very, allow me to say conventional business. So just by looking at that slide, they doubled the amount of intangible assets. This could be goodwill. So this is already telling me there is maybe something linked to an acquisition here. Then what else? I looked at the financial assets, short-term and long-term. So this is what you have on the bullet point number four, I see that the amount of cash has increased, the financial assets have increased. And I see also some financial assets long term that's below the bullet point number two, that have also increased so that we have like 3 billion more. I see also that there are some assets that are held for sale that I've increased from 164.9 million. So that's bullet point number five. I have now increased to 7 billion. Okay? So just by looking at those figures, I have actually covered 98% of my variation year over year in the balance sheets. Remember the variation year over year. The balance sheet was 44 billion rough cut what we saw on the previous slides. So I already have the storyline here. The storyline is that basically the company has added a huge amount of properties. And I'm not sure if it's through an acquisition. I do see that they are selling off some long-term assets. But really the big part is bullet point number two, they have added 3,036 billion investment properties. So then my next question was, how did the company finances? Because this is huge. So increasing the budget by 70% are in somebody has to carry that cost. So is there what are the sources of capital for this? And then I looked into the liability side of the balance sheet. So keep in mind that the company has added €43.9 billion to its balance sheet. And we see here, in fact, on the right-hand side, the sources of capital. Because I want to understand the full storyline. Who has paid for this increased investment property? So remember, a company has added 36 billion investment properties. So we see that the capital reserves have increased by 6 billion and retained earnings have grown by three dots, 6 billion. Okay. What is this telling me? Specifically retained earnings. This is already telling me that they were unable to fund the growth of the balance sheet by the profits of the previous year because retained earnings have only increased by 3 billion. So they have this array telling me they have probably either raised APTT and all raised capital. And this is what the capital reserves in fact also mean to some extent, is that they have kept certain amounts also of capital. They have as well. And you see it on the bullet point number two. They have as well added. What is called non-derivative financial ability is to just look at the amount they have. The one from 22 dots 3 billion to 41 billion of non-derivative financial liabilities. And then also those are the long-term, long-term portion. Remember that here we're looking at long-term assets when i for a long-term liabilities when I first report and the current portion went up from one.72, 68. So when you do the math, basically, you see that they have increased the amount of depth by 22.9 billion. Then we have as well non-controlling interests and have increased by 2.4 billion. That's bullet point number three. And we have deferred tax liability that have increased by 77 billion. That's really weird because normally I should not look at deferred tax liabilities, but I was surprised to see deferred tax liabilities that went up 109-18 dot six. So that's a source of financing as well. So we'll have to cash out this amount of money at any time when the tax administrations will come and claim those 800s, six minima for the time being, they were able to use it to finance part of the acquisitions on the asset side of the balance sheet. So we see in fact that they have indeed. So basically what we see here is that they have, they were able to increase the amount of investment properties by raising depth and by increasing the asking money to the shareholders and also keeping a little bit of the profits of the previous year. But it was not just the profits of the previously they were able to finance this. So that's basically already, you see just by looking at the balance sheet, how I'm able to do an interpretation what has happened from one year over the other. So remember here is what we call horizontal analysis. We have been practicing this is not a vertical analysis, but it's horizontal analysis that I've been doing here. Now, I want to look at strategic capital allocation decisions. I'm looking at the cashflow statements. So again here, my next question from the ten questions to you and please pause before you resume is analyze and interpret the big differences in the cashflow statements. Remember the cashflows that we have operating, investing, or financing. So please pause and when you're ready, when you have looked into the main differences, please resume the lecture. Now, resuming, what are the big things that have changed? So if you look at the cash flow from operating, I've did not even highlight it. You see that the cash flow from operating, as I told you in the previous chapter. So they have added 400 million to the cash flow from operating. So they had one dot for 35, 1,000, €530 million. So it's 1430, €5 billion last year. And this is the cash flow from operating is 1823, €9,000,000,000. So they have added basically if 100 million to the cash flow from operating. Then look at number one, which is now we're looking at investing activities. Remember that once these famous flow number four is like from the profits we are then investing into the company to new assets. Here you see that they paid 17 billion payments. So just read the line payments for acquisition of shares and consolidated companies and new conservation of liquid funds. They have in fact spend 17 billion into merger and acquisition. This is what it means into consolidated companies now companies that are now consolidated. Then look at bullet point number two. Now we are in the I mean, if you look at the total from sorry, I should have said that earlier, the character for investing activities in 2021 is minus €19 billion. So mine is 191158. So let's say 90% is coming from an acquisition. So they have spent 17 billion on an acquisition. That basically what I can read from the investing activity. Then obviously I will need to understand, but where I already had an idea when I was doing the horizontal analysis in the balance sheet on the liability side, I have seen that the amounts of capital has increased, the retained earnings have increased. I've seen that the short-term and long-term non-derivative financing liabilities have increased by a huge amount. Do I have confirmation of it? Isn't the cashflow statement. Let's start with bullet point number two. So the frame, red frame tool on the right-hand side, you see that the cash paid by hybrid capital investors, the proceeds from issuing financial abilities and the cash repayments of financing liabilities. You have big numbers there compared to the previous year. So we see that they have raised, this is what the second line means. In frame number two, they have raced 23 dot €9 billion of depths, remembering the balance due. We're seeing this at the short-term and long-term, they've had increased. So we clearly see here in the cash flow from financing activity that there was a huge inflow of money, of cash into the company by raising fresh that this is what the line proceeds from issuing financial liabilities means. Lastly, they only raised 4 billion of that. This year they raised 23 billion, nearly 242-030-9453, 24 billion of cash. Through depths. They repaid 11.5 billion. So net-net, they kept 12 billion. And then bullet point number three, they raised 8 billion of capital from the shallow. So just read the line, it says capital contributions on the issue of new shares including premium. So they have, you can see here the storyline. So they have financed already immediately see here they have financed the increase in investment properties by raising dept net 12,000,000,000.8 billion of new shares. When I hear, of course, new shares, what does it mean? Well, it means an impact to the historical shallows. There is probably some kind of equity dilution effect, but let's let's keep that for later on. So what we see is basically that the company has in fact added fresh capital, 24 billion in depths and 8 billion in capital that has been paid in. And of course, they reimbursed 11 billion. Financing liabilities as well. So the capital really spanned net-net has been of 17 billion. This is what you see in the cash from investing activity. So the repaid 11 billion and then it has been 1 billion that has been in fact paid back to the hybrid capital investors. Alright? So again, insisting on what I said here, when we speak about an issuance of new shares, what do we as investors have to do and to think, why do we have to think? And please pause you that probably there is an equity dilution effect. So very quick way of looking at how much, if I would have been in historical investor, how much my equity has been diluted is just look at the income statement now going to show you a shortcut of how to do this. So if you consider that the amount of shares has been constant year over year, you can in fact compare the earnings ratio. So if you look at the profit for the period in the income statement, you see that the company has reported in the previous year 303 €40 billion of profit and thousand and 21, it has reported to dot €839 billion of profits. So we can basically see that the earnings ratio year over year, so it has decreased by six and percent. The earnings per share ratio is of 076, and this is what you see below. So the company in the income statement is telling us that while the earnings per share last year were five dot €50 per share, this here they are for 22. When you do the math between the two, that's 076. So what has happened? Even 2020, 3 billion, €340 million divided by the amount of shares is giving us a €550 per share. So we are trying to reverse calculate x is in fact 607 million. So basically, that's the amount of shares that have been used to divide the amount of 3340 to end up at an earnings per share value of five dots 50 for 2021. If you would consider that there was no equity dilution, we would take the profits to a 39, so 2,830,000,900 thousands. And you would divide by the same amount of shares which we just calculated, which is 670 million, we would end up at photos 66, earnings per share. But wait, if the shares are constants. I should have an earnings per share with a profit of 2839 of 14, 66. But the company is selling me, That's the earnings per share of 422, or basically that's the equity dilution effect. So basically what the company did is they added 10% of shares. So how do I calculate this? Is I take the foot 22/466, so I take the real the effective earnings per share that they're reporting for the year 2020, 100 is for 22 divided by the one that I calculated in case the amount of shares would have remained constant, which is not the case. I end up with a ratio of 095, so 0.90, 905. So basically I have an equity dilution effect of 10%. So it means that if I would have been a, let's say, 50% shareholder, which is huge, of course, but I would have been 50 per cent Cheryl, theoretically speaking, in 2020. Now, I was not able to continue paying in capital, would have seen my equity stake without doing anything being diluted by ten per cent. So I would have gone from 50% ownership in the company to 45. How the company has now decided to fund this acquisition. Do I see this? Well, yes, I see this again, practicing our eye in page 183 of them ANOVA report when they were calculating or they were explaining how they calculate the earnings per share. I mean, we do see the figures that they have been using to calculate those shares. Remember that I said that rough cut. I was at 607. If the amount would have been constant. They're telling me that the total amounts that they are using from 2,000.20021 went from 587 weighted average number of shares to 626 millions of shares. They have a very specific capitals structure. So I mean, I do not end up with the same figures that I had. What is important here is not the figure that I reversed calculated is the dilution effects. 587000000-626. That's rough cut ten per cent. That's exactly what I was telling you. By looking at the income statements, I was able to calculate this because remember they have hybrid instruments. The calculation little bit more complex. But I came to the same conclusion. They have diluted the shallow loss by 10% from 2,000.20021. Is that something I like? No. But potentially I have the opportunity to at the moment they raised money to if I did not want to get diluted, indeed, to pay in money to keep the same amount of equity or even increase it. And of course then I'm saying, but if they have raised capital, they cannot do this. They have to raise or to report this. They have to raise a prospectus. Was like, is that prospectus at what's amount of money having the raising capitals. So indeed, you have here the capital increased prospectus. So this is what is called a subscription offer. Who were the underwriting banks as well? I mean, you can look into it. So they indeed raised new shares at a price of €40 and subscription price. And that was done between November and December 2021. Just by looking into that, I do see indeed, I get the storyline. I clear storyline is that the company has grown through acquisition around 70 per cent. And the acquisition has been funded partially BY adapt, new adapts, and partially by raising fresh money from the shareholders. And this is a subscription offer that I see and they raised money at €40 a new share. So why do, what do I need a shell to do to what is equity inclusion? And how do you interpret this as shareholder? So again, pause and think about it. I will resume now here. So I hate equity dilution. We're speaking about a mature company. I understand that. Maybe they had they had the opportunity of buying Deutsche Vodafone, which was, I think even a competitor to Villanova. So let's set, we're going to acquire them at this amount of money and probably pay the premium on it. And we're going to finance the operations of acquisition partially by dept. And partially by asking fresh money to the existing shareholders or to new shareholders on Q7. What do I need to know? What do I need to do as shareholder toward equity dilution. I need to have the cash available to continue to buy new shares, otherwise, my percentage will go down. How do I interpret this as a shareholder while I do not necessarily like it. And most specifically, I've extracted from Morningstar, the financials from Villanova in a graphical way, but you would find this out as well. What I see is they are growing indeed. I mean, let's say by raising money from the shareholders. How do I see this? I see this below. In fact, when I just calculate the amount of diluted weighted average shares outstanding, the amount is growing every year since this is what, six years. So every year, if I'm today a certain percentage owner of ANOVA, in the way how management treats its shareholders and probably minority shareholders. I will be exposed to equity dilution. That's something I do not like as a as a shower as an existing shareholders. So I need to have cash available to continue buying in new shares if I want to avoid the equity dilution effect. Now, managing will tell you, yeah, but okay. We are diluting the equity, but you are having more assets and those assets will generate more profits. So even though your equity is diluted for the same amount of shares, you're going to see profits increase because we are adding new assets to the company. That's very probably the storyline from novel, novel, novel. And I'm not judging you if it's good or bad. I'm just hitting, generally speaking, growing by acquisition is something that's being able to find synergies and increase the profits from acquisitions. Those are also, of course, capital allocation, strategic decisions. Not all companies are good ads. So this would require a little bit more understanding how good has been in terms of track record in the past. Because I see here that they have been diluting the equity every single year for the last five to six to seven years. I really need to understand if they are good at finding those synergies or if it isn't over promise from the management. This is basically what it means. And then of course I will not do it here. But typically, what, what has to be done is to do an intrinsic value calculations. So what is a share of the company Villanova worth? Again, I refer here to another cause which is called the other value investing where you can then calculate. And you would be also able to see that when doing an earnings and net income assumption. And that's something that you have to take into account as well. Is that the company and you have this on page 163 of the annual report of ANOVA. The company has only report it, I think was nine months. So not a full year of earnings and net income. So of course, you need to be attentive when an acquisition takes place. And let's imagine the company starts its financial year on January 1st and the acquisition takes place on July 1st. You will only see in the year of acquisition, maybe six months or nine months, or three months, or 2.5 months on 26 days or 193 days of revenue and income. So you need to be attentive specifically if you're trying to do a valuation of the company, the company has maybe only partially, and that's the case if we know via partially consolidated the company in its financial statements from income perspective, the assets are all there now, but from an income and earnings perspective, it's not fully there. So that's basically what the nodes is explaining. So this is where again, you need to read the notes specifically here in scenario where MANOVA did a huge acquisition through, by raising new shares. So capital from equity holders and raising money from financing instruments so through depths. And that in the income statement, it has not been 12 months that the company, so Deutsche Vodafone Group has been incorporated to Villanova. So we need to be attentive because I wouldn't have an impact on the intrinsic value calculation. Alright, that was the first example. How just by looking at a couple of statements. And most specifically by looking at this famous or down balance sheet cash flow statement, income statement, more specifically banjo and cashflow statement. I was able to very quickly to capture the essence of what has happened 2000-20021 for company like Villanova. Next example is a online digital platform company called curator. I think it's a spinoff from Liberty group, where also will be looking at the financial statements of that company. So it's again, it's a full practice example here and we'll try to make a quick interpretation of what is going on with this company by looking at the financial statements. So talk to you in the next lecture about this. 23. Full Example - Qurate: Alright, the next example we're going to be practicing in chapter number five is the curates, which is a online shopping company to spin up of liberty. We go little bit deeper versus the previous example of ANOVA. You will see I will also read the Auditor statements. So again, trying to bring together the various things that we learned, the various previous chapter so far. Alright, so first of all, what I did not do with ANOVA or one very quickly through it, I just said that Villanova is a real estate company and they rent a lot of properties to two people that are living and paying a rant to one of yeah, Now I'm gonna be, I'm gonna show you how I go little bit deeper when analyzing companies and specifically companies had, I not necessarily am aware of. So curates is a retail companies. It's called curated retail and it's a group of companies have subsidiaries that are engaged in video and online commerce. In fact, so basically they're doing shopping and they have online also e-commerce websites. There are various segments. So they have one segment that is called QX age, which includes QVC you as an HSM. So they are selling products. Consumer products in the US primarily is through today shopping, so televised shopping programs, but also through the internet. You can find a couple of those channels as well online and through mobile apps. Then they have QVC International, which selling to foreign countries outside of the US. Absolutely. Who is selling consumer products in the US and also several countries including Japan, Germany, and other countries. Then they have what they call cornerstone Brands. So those are for interactive aspiration home and apparati lifestyle brands, which include gardens here, Gras Indian Road, front gate and Ballard Designs. So he would Google them up. You would find those websites where you can see the type of products that cure rate in fact cells for those specific brands. Alright, so here are just a quick snip of what I was telling you. So this is how it concretely looks like you have on the top left side, those are the that's a teller shopping experience that you can find on the Internet. Then you have Julie and on the right-hand side you have those four cornerstone Brands, which looks like those are brands that they own and they sell in fact, the products that come with those brands. So you see basically it's a B2C business and they have various distribution channels, platforms, and how to sell the products. Okay, very good. So one of the things that I of course look as well when analyzing companies that something on discussing and the other value investing training is also how people feel about the company. So I look at the net promoter score of buyers and also about internal people. So you can see that for cure, right? I look this up as well. It's not necessarily part of their reading financial statements cores, but that's definitely something I do as an investor. I look at the internal promoter score of employees, how people feel about the company and also the external one. So we see that the NPS score, which is a marketing term, It's pretty positive for QVC and HSM in the US. Now. So that's just for the context. So it looks like those are well-known brands. People are pretty positive about it. Employees are more or less overall, okay, about the company as well. And I have a quick understanding about what their business is about. So now let's look at the financial statements because it's really looking, It's really about looking at the financial statements. So the first thing I did not do specifically for ANOVA, but I will do now here for cure rate is I want to understand, first of all, I'm going to read what the auditor is doing and stating specifically about about a cure rate. So here what we can find out, and again, you have to read the financial report. Of course, we are reading here the ten K latest report because it ten q remember is unaudited. So we learn in fact that KPMG, which is one of the big four statutory auditors in the world, has been auditor since 1995. You remember what my comment was about having such long tenors as an auditor? And this is disclosing the latest ten K. And you see what I've highlighted here in yellow. Basically, KPMG is saying, in our opinion, the consolidated financial statements present fairly in all material. So in all substantial matters, the financial of the company as of December 2020, 1020. Nonetheless, the list and critical audit matter, that's also interesting that you are aware of if you are potentially willing to invest into the company or if you're already an existing shareholder. And you can read this below. I've taken the extract of it, which is the critical audit matter, relate to the sufficiency of audit evidence of a revenue. So let's just read what they're stating here. The auditor says, even though it's not something that's according to them, should change the opinion of the auditor, but they're saying that. We identified the evaluation of the sufficiency of audit evidence of our revenues are critical audit matter. Evaluating the sufficiency of audit evidence required subjective auditor judgment if the number of revenue streams and the highly automated nature of certain processes to record the revenue. So you see, I mean, just stopping here 1 s, you'll see that this is related to revenue recognition. So it looks like they have a small doubts about how revenue is recognized, but they are saying that it's not material enough to change their opinion about the financial statements of the company. And this is also linked to, and if you continue reading the end of the third line and the yellow paragraph, the very bottom is they're stating the complexity of the IT environment require the involvement of IT professionals with specialized skills and knowledge. They have a small doubts about given the complexity of the IT systems, that potentially there could be an inaccuracy, which means a the understatement of overstatement of revenues that cure rate is reporting. But again, their judgment as excellent auditor is that it's not material enough to change their opinion about the financial position of the company, but it's still a critical audit matter they disclosed. So that's something to be attentive about. Right? Then, of course, when there is a critical audit matter, normally management has to comment on it or they're taking action, etc. So you see in fact an item for and the financial consolidated financial statements. So this is part of the ten K reports because it's only linked to the auditor's report, not to the unaudited quarterly one. So you see that management is making a statement. Based on that evaluation, the executives concluded that the company is disclosure controls and procedures, but not effective as of September 30, 2022 because of the material weakness in its internal controls over financial reporting. That is described in material weaknesses and internal control over financial reporting. So basically they are saying that there is a need material weakness. They acknowledge what KPMG is stating and we'll take you can read them the upcoming paragraphs. They are taking actions to try to correct this. What does this mean is that there is a immaterial risk of error in the financial statements that we are looking into now and they're taking action. So normally, this should be resolved over time. Hopefully if the controls put in place by management are effective so that they're removing or reducing the risks so that it becomes really not worth even commenting by the external statutory auditor. Alright, so that's the first thing. So I like always. And again, I did not do it on purpose for MANOVA but here on cure rate is like just making you understand because I did not no cure it when I was asked to analyze cure rate, what's the business about structuring this? And then I started with reading the auditor's opinion. So immediately know like I'm pointing into one thing which could be an important immaterial matter. And here it seems that they are not reporting any material elements, but there is an a critical audit matter that is raised nonetheless by the excellent statutory auditor where management seems to take actions on it. Let's see how effective it will be in the upcoming reports. Now the second thing I do afterwards, it's also something I did not do for ANOVA, but I'm doing it here for cure rate. So you see them adding little bit of complexity is I want to understand the capital structure of curates. And I was interested in that because if I'm a potential investor or existing investor, I want to know what is going on with the company and here. So if you take the latest ten q reports, I did not take the latest audited one, but the audit on audited one. I'm looking at the first page of the ten K ten q report where, if you remember, we see what are the triggers that are traded publicly on stock exchanges. And here, what I can see, there are a couple of things that have to be discussed here, and this obviously makes the thing little bit more complex, but it's important to understand. The company has, when you look at the first page of the ten cure report, they have in fact three tickers that are listed there. So you have curates a, is that the Series a common stock? You have curated B, which is a Series B common stock. And you have curate p, which is, and I'm just reading the title of that class. It says in the ten q report, eight per cent series, a cumulative redeemable preferred stock. So it looks like we have two categories of common stock and one category of preferred stock. But that's not enough. So I went further and I realize in fact, that they have three classes of common stock. That's something that I found in the balance sheet. I'm showing this here on slide 637. They have in fact new cities in the balance sheet, you sit here in bullet point number one, they have three times of common stock. They have Series a, common stock, Series B, those are the ones that are publicly traded. So your TA and TB and half Series C, but it doesn't show the preferred stock and equity. And indeed, you will see later on that they are classifying the preferred stock as they adapt liability and not an equity liability. What is also important to understand is the following, is, what are the, what is the power of voting? I mean, when you're having such a complex set of, let's say, equity. So Class a, B, and C. You see this here in the balance sheet. You see in fact that series a on the oh, sorry, On September 30, 2022, they had 373,833,469 shares outstanding. And for series B, 8,373,512 shares outstanding. So you see basically that the Series a much more shares and series a, series B. So if you do the math and I did the math for you, I mean, you see that the percentage of difference is really huge in terms of percentage of total equity. Just like a couple of percent for the Class B shares versus the Class a shares and Class C are issued. So you also see these in the first page of the ten q report. It's not listed as a ticker symbol, could have been accused PTC, but there isn't. Because, and this is what we see in the balance sheet. You see that the amount you sit here in the red frame, the amount of shares issued for the series, see common stock is no shares issued but they're authorized boundary million. Now, the important thing to understand here is not just the amount of shares and the various classes and keep the preferred stock compensation or addressed that in a couple of minutes. It's also the voting rights. Because remember that what is important when you have 8 billion, 8 million of shares B versus 373 min of class a shares. You need to of course, understand and you have understood from strategic decisions, reserve matters to the board need to understand. Are the voting rights equivalent? So if you take 88 million on 373, so that's basically you have like 380 million of shares. I mean, you have like 90, 90 plus percent, 95% of the voting rights. If one common share would have one vote for Class I and Class B, you would have, let's say around 98 per cent of class Asia votes and two per cent, it's basically two dots, two per cent of Class B shares. But you need to be attentive because here in fact, on the 382 million of common shares that have been issued so far, the voting rights are not equivalent. And the voting rights here, what we clearly see when we go a little bit deeper into the nodes and we look at the nodes number seven, where they speak about the voting rights. We can see on the, on the nodes, on the website of curative put the URL here that in fact the voting rights are not linear. And basically, what we learn from this is that the Class a shares, even though they represent 98% of the total shares of common stock that have been issued. Only carries 77% of the voting rights, while the Class B shares at only represented two dots, two per cent of the total amount of common stock that has been issued. They represent 22 dots, four per cent. So what we see is that the Class B shares have to make it simple. Ten votes. So one share of Class B has ten votes per share, while a class Asia only carries one vote per share. So we see that the Class B shares at ten times more powerful per-share versus class Asia as this is how you end up having class B shares owning 22.4% of the voting power. And obviously this is important because to understand who is behind the Class B shares. And you may have reserved matters where I don't know you need at least I have no clue. You need at least 90% of the votes, while then it's not enough to have all the class, the class a share voters vote for one decision. You need also the approval of the class be shareholders. So that's the kind of thing where the voting dynamics and the management dynamics, even of reserve matters to the board of directors, to the shareholders. They may in fact change because the voting rights are not equivalent between Class I and Class B shares. Remember there is no class seizure issued for the time being here on the company. Alright, then going now to the preferred thing. So we have three types of common shares with the cluster seizure being issued and then we have the preferred share. And again, I looked at the nodes, is, what is this preferred stock? In fact, if you remember in the balance sheet, they're not carrying the preferred stock as equity, they are carrying it in fact, above, in node seven, you see this here on slide 639, where you see that it's part of the liabilities section of the balance sheet and not the equity part of the balance sheet. They refer immediately to node seven. So let's read what the node seven is all about. So here you see in the red frame. These preferred shares are publicly traded at secured TP ticker. So they're basically mentioning that the queue rates retail company has issued eight per cent series, a cumulative redeemable preferred stock. There are certain par value and they have been 13,500,000 of those preferred stock then having authorized, and for the time being, we have 12,671,984 shares of preferred stock that has been issued and outstanding on September sorry, on September 30th, 2022. So how shall I interpret this? And you see there's also here in the balance sheet. I mean, I looked at 2019 report and indeed there was no preferred stock that was reported. So this is the issued in fact, in 2020 they issued money by what is called, this is probably a convertible debt instruments. And what is specific to this instrument is that the instrument is accumulating 8% dividends. And what happens? Remember when we were discussing in the balance sheet, the order of liquidation, if the company would get into financial trouble, the company would need to be liquidated. Remember that liability whole laws are always liquidated before they receive the money. If money is left before the equity holders, the preferred stockholders have here an advantage is they may not be able to vote at the annual shareholder meeting, but they have the first thing they have been preferred stock. If liquidation happens, they are going to see the money before the equity holders. So before the other, was it 382 million of outstanding share shares? And the shareholders that are behind those 382 series a and series become stuck shares. So what is interesting as well, and you need to read the note is that the the preferred stock in fact, is not only considered as a liability, but it increases every year as well in the sense that that's why it is called an 8% cumulative redeemable preferred stock is that if the company is unable to, let's say payback is eight per cent, like a cash dividend every year. Very latest, 2031, it has to be, let's say, liquidated. So they have to reimburse as one dot for how do I calculate one node 4 billion is because I'm adding 8% to the initial liability. So it means that the 8% cash dividends actually accumulated every single year. So in 2031, the liability will have grown 1000000249-1, rough cut, one dot $4 billion. So again, as in terms of all of liquidation comes with for equity holders, those preferred stockholders in case of financial trouble, will have priority on common stock. Hold us. Again, how do we look into this? Is the interpretation that you have to do is why does the company raised preferred stock and it's giving a promise of 8% cumulative dividends. Remember when we were discussing risk premiums and this is considered an classified as adept. Here. They did not go to a bank to ask for a loan, but they went to shareholders and telling her shoulders, we're giving you preferred stock with eight per cent. If you nothing it presents. We are here at, if it would be equivalent to cooperate that we are ratings or we're looking at loan that is not necessarily investment-grade. Otherwise, it would not make sense that the company would give them 8% cumulative redeemable dividends on those, on that instrument, on the preferred stock insulin. So this is how you need to do the interpretation. And of course, you, I mean, if you look at the 2019, 2020, a cashflow statements, specifically the investing activity you're going to see in fact, the how they were paying out dividends as well, which was surprising and also how they borrowed money. So these are equivalent, one dot 3 billion how they borrowed money from from external credit providers. And in this case, that's the preferred stock instrument that they have been raising money from. Then of course, I mean, I was looking into I mean, here we are only looking at the capital structure. So between depths, the three types of common stock. So there is depths being preferred stock. So I wanted to understand what is going on just by reading this and again on this page 641, you can read, in fact, what they were paying out in terms of cash dividends. And so it was surprising that they were paying out a special cash dividend and then bringing this back as kind of preferred stock. I had the feeling, my first gut feeling was telling me there is something going on with the company. So let's see if the balance sheet is kind of confusing is because again, why I'm having this guts feeling when I see company that is raising money with an 8% annual interest rates and classifying these as preferred stock. It means that they would not have been able to raise common stock potentially because maybe there is not enough trust on the market. So that's why they went probably for a preferred stock, which is kind of a hybrid debt instruments here until 2031 and the cumulative cash dividend of 8% every year. So this is telling me that the risk is probably high and that something is going on. So let's look now at the balance sheet. What is the balance sheet telling? You? See here with the vanilla example, what I did different or what I added in terms of complexity. I looked first of all at what's the business of the company because I did not no cure rate. And then secondly is I looked at the auditor statement which I did not do for one of yeah. Now, having done that, I looked at the capital structure. So I looked into the company having what types of shack classes does it have? So a, B, C, but C is issued, so nothing has been printed and they have this preferred stock, 8%, which is a bigger mountain. Nonetheless, it will grow to one not forbidden up to 2031, where they have in fact the obligation to liquidate the preferred stock liability and it's not considered as equity right now. Now we're going to do like with Villanova, we're gonna do a horizontal analysis on the balance sheet. So we're taking the September 2022 and comparing it with the 31st of December 2021. We do see. And you remember that predictable. It doesn't mean that it's negative. But we do see at the company has been reducing its balance sheet by folded 4 billion. Actually they have reduced their balanced by a quarter. So that's a lot. So they had a balanced tree that was worth 62 billion tons of assets. And now the company has total asset amount of 117 billion. That's okay. I my first reaction is what has happened. But just looking like with ANOVA, just the total asset variation year over year period over period. We are seeing something, but we need to go a little bit further to understand what is going on, right? So that's what we're doing here. So like with one OVR, we're going to look at the variations year over year. But on the line items in the asset side, I did not start looking at the balance sheet liability side of things. So let's start with bullet point number two. Interesting, we see that property plan and equipment went down from 1 billion 032594. That's a signal that's eight-and-a-half divested something or they have been selling fixed assets. So let's keep this in mind. 1 s bullet point number three is we see that goodwill, they have taken the hits. So probability impairment testing on goodwill and we see that goodwill went down $6-339 billion, 234. So basically they have nearly divided by two the amount of goodwill. That's normally that's not good because that means that they probably mispriced and acquisition and they took a hit on the, let's say, re-evaluation of the premium that they paid on acquisition. Bullet point number four, we see that the accounts receivables went down from one dot 6 billion to 1 billion. So that's a $652,000,000 difference. So they probably were good at collecting cash. Here are the two things that I will keep in my mind is I want to understand why there was an impairment on goodwill and why PP&E is decreasing. Let's continue this story. Let's look now at the liability side of the balance sheet. We see here. That's on the total current liabilities. They went down 4-2 from four dot two to $4 billion to 734. We see that the main variations accounts payable as well went down. Accrued liabilities one down. There is current portion of that, that one down, Okay, That's working capital. Nothing that I'm too much worried about. Then I looked at bullet point number three. And I do see in fact, that is now the biggest one is that retained earnings went down from $925 billion to 387 million. So they have destroyed in fact, two dots, $6 billion over the last nine months in terms of retained earnings. And the equity by that, of course, because retained earnings is part of the total equity, the equity went down from $2,986 billion to $348 million. So that's not good. So the bullet point number two, they have improved working capital, fine. They have reduced the amount of accounts receivable as well. But what worries me that why why have retained earnings being destroyed? So this is probably, amongst others, linked to PP&E who went down. And also the goodwill is specifically who went down because he was speaking about two dots, two dots, five to $6 billion. That's nearly the exact amount of goodwill impairment that they took. So in terms of long-term debts, I mean, that's also something I look as well as the long-term debt has been reduced from five dash $674 billion to fund or 30, $3 billion. So we see in fact that here the depth is high. You are more interested about is the proportion. Here, I'm using a methodology of vertical analysis, not horizontal. I'm looking at the proportion of 5303. I could even add the current portion of that picture 603. So rough cut a half $66 billion of depths of financial depth versus a total balance sheet size of 117. So what I realized is that they have a little bit more than half of the balance sheet that is in fact depths. So that's also something that's important to know as we progress in the analysis of cure rate. In the companion sheets. I mean, you could put the numbers in the companionship. You have this template so you could put the numbers and understand from a vertical perspective what are the big things. You will see that cash and cash equivalents is farther 3% account receivable is eight at seven per cent inventories is 14, not seven. So that's a lot, while a lot, but they have there an opportunity to tap into to generate cash. Pp&e is 5% only, goodwill is 29 at 1%. And other intangible assets, which are trademarks and patents, is 23 per cent. So you see in fact that those intangible, long-term assets, which are goodwill and other intangible assets. They represent rough cut 50 to 1% of the total balance sheet. On the liability side, you have accounts payable eight or three per cent provisions, 8% you have long-term that 45% provisions for preferred stock is turfed or three and preferred stock is 10.7%. So you see that indeed there is, I mean, when you analyze it from a vertical perspective, there are a couple of items like 56 items, which make the big part of the balance sheet. Now, as you see how I'm starting to analyze and you see that the balance sheet has been, or let's say photo dot 4 billion has been shaved off the balance sheet as of December 31, 2021 to go down 16000000000-7 billion. I want to understand what has happened. I have understood that it's linked to goodwill and PP&E. So let's analyze this. So we see in fact, in the changes in intangible assets when you read the data in the financial statement, this is when I'm flagging here with a bullet point number one, the red dot is they have indeed taken an impairment of intangible assets that it described, that is described in node five of 3,000,000,081. So of course, having an impairment on intangible assets, they have to report it somewhere, so they're destroying retained earnings. By doing that. That's how to counterbalance and impairment of intangible assets is to compensate that so that the balance sheet remains balanced. They are doing this on the retained earnings sides. This is one of the retained earnings is going down from what was it? Two dot 9,000,000,380 something. Right? So what does this mean as well is that if now we have this negative effect of impairments, probably and I did not do the analysis, but probably they have been overstating earnings and retained earnings in the past when they have written into the balance sheet the six dots 3 billion of goodwill that they were carrying on December 31st. So you see at the very end of the day, they over time and probably the statutory auditor, I had also to make an opinion about this because they have to look at intangible assets. Somebody has said, Well, we thought it was worth six to 3 billion, but it's no longer worth 6.3 billion. So we are considering that is now worth 333 dots, three dots. I'm just check the number three dots $430 billion. So various methods I will not explain how to do the valuation of intangible assets, but there are ways of doing this with royalty method, those kind of things. I will not go into the conversation that will really bring us too far. Now, again, following the process that I explained to you, so I started with reading the opinion of the statutory auditor. Well, first of all, understood. Tried to understand the business than reading the pin-up statutory auditor. Then indeed looking at the capital structure. So understanding what type of stocks of tickers they had. There was no external corporate debt ticker, but they have this preferred stock ticker, the q t p, with this 8% cumulative dividends every year to be liquidity 2031. And then I looked at the balance sheet, did the horizontal analysis, vertical analysis. So I already get a little bit the storyline PP&E has, when it has gone down, there wasn't impairments of 3 billion, which explains to a big part of what is going on with the company. But now I want to look at cash and cash flows. Remember that's after looking at the balance sheet, the next one. Here, of course, a look at cash from operational activities. You'll see that it is negative for the nine months of 2022. It has been positive -715. And i'm I need to see of course, what has happened. And if you look at bullet point number one, we clearly see the impairment of intangible assets again appearing here as a non-cash item. So it means that again, if you look at the first line of the cashflow statement, it shows that they have made a net earnings, in this case, a net loss between brackets of 2.5 billion for the first nine months of 2022. And then they are adjusting to reconcile the earnings or the losses for non-cash items. An impairment of an intangible asset is a non-cash item. So adding back there's impairments. In reality, they have not made a loss of 2.5 billion is just a fictive loss from a cash perspective. But they're adding back the 3 billion of impairments in order to reconcile earnings with cash than we see in bullet point number two, we indeed see the decrease in accounts payable. We see also a decrease, an increase in inventory. We see also a decrease in accrued and other liability. So you see again this is the variation thing. Accounts receivable have also decreased by 583. So this is what already we saw in the balance sheet whenever you're doing the horizontal analysis. So in investing, we could look into investing as well. We will do that later on, but let's keep just 1 s our eye on the big things we already see also in the cash flow from financing, we see big movement in terms of borrowing of depth and repayment of the app. So they paid back to that 5 billion and they borrowed 2 billion of that. So basically net-net, this means they have reduced the amount of debt of the company by 500 million. This is what we see as well in the balance sheet, okay? So when the company takes such an impairment loss, I mean, it's half of their intangible assets. We need, of course, to understand what's the reasoning behind him in management has to explain why they are dividing by two the amount of goodwill and remember goodwill, go back to what it was at Chapter number three. We are when we are discussing goodwill, that's the premium that the company has paid on top of the book value of the company after reducing, after deducting depth that they are taking over as well. So here in terms of impairments, in fact, it is linked to a couple of brands that they have acquired. So they have in facts and I'll let you read the details, but they have re-evaluated the fair value of Q, Q, x h, and x2. Lilly. And they said, Well, we believe that they're no longer worth as much as we thought they would be before in fact. So this is basically what they had to do, was like, okay, so they bought it acquisition of those run, that's why there has goodwill. Then indeed, I, of course, Google this up. I've put here the URL. And indeed we see that QVC in 2018, they completed, so probably they were already minority shareholder, but they complete it for two dot 1,000,000,000 acquisition of h as n, which is then. So probably when they did this, there was good, we'll relate it to it. And then of course, when you look at the nose, but you need to go back into the financial reports. You can see in fact, when the acquisitions of HSM and the other brand luxury Lilly has taken place, you see how they calculated an allocate the purchase price for HSM. So you see that that's time bullet point number one. That's when they consolidated balance sheet of HSM into the cure rate balance sheet. You see specifically on goodwill that the goodwill was estimated at $936 million and facility it was considered at $917 million. And then they were trademark 676 million for HSM and 874. So Lily. Okay. So we understand here that's part of the impairment which is a non-cash item. Coming in from reduction on nearly dividing by two the amount of goodwill. So we have part of the story. But as I was I was discussing with investor that was asking me for my opinion about curate. This is a non-cash thing. The only thing which is unfair towards the shallow loss is that probably in the past, over the last year as they have in fact, increase the net income by doing those acquisitions and stating that the balance sheet became so much bigger. And by that they were increasing the book value of the company by increasing the retained earnings and now they're taking a hit. So by that, of course, retained earnings are again back, back to normal very probably. So the problem is not here because here it's a non-cash impact. But the problem is that in the past the company's book value has been overstated very probably. Now, changes in PP&E, you remember that was the second one where we saw that property plant equipment went down from 1 billion, $30 million to $594 million. And that's, that's that's I will not say a red flag for me, but that's nonetheless and attention for it because when I see that PP&E, first of all, I see that the balance sheet has been reduced by 25 to 30%. And I see that PP&E is decreasing. You remember that I always said in this training that company profits are generated from assets. I mean, if you don't have assets, you cannot generate profit. So I was worried to see the company has divided by two, it's assets. So obviously, I wanted to have confirmation of this and the cashflow statements because remember, when the company is in fact, let's say divesting from, from its fixed assets. That's a cash inflow. This is indeed something that we see here. What was interesting is that they consider this to be an operating activity and not a investing activity. That was weird to me. But you see that on bullet point number one that indeed they have sold. So it's a gain on the brackets, again, on the sales of fixed assets nets. So rough cut they sold, they had a cash inflow or 520 million. So it wasn't like, okay, 11 seconds. So let's look at the cash and cash equivalents position between December 31st and September 30, 2022. Let's look, let's just read the numbers. In December, the cash and cash equivalents position as a 587 million, ends on September 30th is 624 to rough cut the same weights they have sold for 520 million of fixed assets and the cash position is constant. So what was this telling me is that the company is running out of cash, which would explain why they're selling of property, plant and equipment. This would also then explain to me that why they had to raise preferred stock with an eight per cent, which is this is not investment-grade dept, instruments of preferred stock that is accumulating every year eight per cent on to 2031. So this was already kind of giving you the storyline. While at the same time to be respectful of cure rates, they were I mean, this goodwill impairment of 3 billion, that was a non-cash item. So I mean, it was not as bad as it was, but nonetheless, when you look here, if here the storyline is falling, if they would not have sold in 2022 4,520 million of fixed assets, they would have been nearly out of cash. And that's not very good news. I mean, just do the math. 624 -20, that's 104 million of cash. We would need to look how much inventory they generate. Every, every, etc. But 104 is really not a lot. 24. Full Example - Skywest Airlines: Alright, welcome back. This is the third concrete example I'm going to walk you through. So we already looked at the vanilla example. We look at the example. In this example, what I will do. In fact, I will even use different methods because in the two previous ones, they were actually prepared. So you saw that I had to Paul ponds already prepared with the extract. Here. I'm going to add a difficulty into it is I'm going to follow the same flow of analysis, but I will only be looking at the ten K report so that you concretely see how to scroll in a PDF file, which is a ten K reports of Sky West Airlines to extract the information that in the previous two examples I was showing you or even in the whole course, I was showing you by really preparing the screenshots and chunk them into PowerPoint. And here it will be a live demonstration of how I going to do this. So this format as well, you see that I'm doing the recording. So on the left-hand side, of course you see me presenting. On the right-hand side. You will see in fact, the the PDF file, which is a ten K report from Sky West Airlines that I downloaded from their investor relations website. You will be seeing me scrolling here through the report. Remember, we are looking at the latest ten K reports. So this is December 31, 22. So it's basically the last report that we have available and it's an annual report which is also audited. So they published The remember what it was like February, if I'm not mistaken that they publish these reports. So first things first, what we're going to start is first of all, understanding the business of Sky West Airlines. What are they doing for that? I will be it's a ten K reports. I will be looking in fact into page number four, which is in part one, and this is mandatory structure part one, item one is the business of the company. So I mean, I had a customer who asked me to analyze guy was airlines. That's why I'm using this example, but again, not prepared through PowerPoint, but really looking at the ten K report. So part one, item 1/10 K report is expanding the business. I did not know Sky West Airlines. So when I was looking into Skype as l, I was like, I've never heard about the company. It's an airline indeed. Try to understand since when they existed and what's their business model. So what you can see here very quickly when you browse through the business part, you see in fact that indeed they offer a scheduled passenger service to destination in the US, Canada, and Mexico. So it's a, let's call it a regional airline in North America. And the second sentence says substantially all of our floods operated as United express, delta connection, American Eagle, or Alaska Airlines flights on the co-chair arrangements. So it looks like that It's a passenger airline that operates in the US, Canada, and Mexico. And actually they are a subcontractor to those big airlines which are United, Delta american, and Alaska Airlines. Maybe they have a little bit more. So you see here, as of December 31st, thousand 22, they offered 1620 daily departures, of which approximately 600 were united express flights. For fan of 30 well, delta connection, Flood Street, 30 American Eagle, and 160 were Alaska Airlines flight. So we see that business is the US and from the US going to Canada and Mexico, it looks like when we continue reading in the business part operation are connected principally at airports like Chicago O'Hare, Dallas, and what? Detroit, Houston, us Angeles, Minneapolis, Phoenix, Salt Lake City, San Francisco, and Seattle. We get the first feeling about what's the business of Sky West Airlines. In the item is in part one, item one, they said that sky was exist since 1972. And very interesting, first interesting table of their peers already is they are sharing in fact what their fleet is about. So we clearly see here that which are the airplanes that fly for United, Delta american, and Alaska. You see that already here they have 625 airplanes. That's a total fleet that is reported on the ten K report from which it looks like that 40 airplanes or leaves to third parties. And they have 68 let's say, airplanes that are used for other customers that are not united, delta American, Alaska. And you clearly see that from the feed of 625 rough cuts. A third is for united around, let's say 20, 20% is for Delta Airlines and Americans. We see already here from a customer understanding that you understand, which mean that customers, they have for big customers. So it's clearly a B2B business. They operate on behalf of those airlines. So those anions are subcontracting capacity to Sky West Airlines. You know the geography of where they are operating, which is basically United States or the app has that they were sharing here. What I'm highlighting here, we understand that they are in fact having part of their fleet less than 10%, which is least to third parties. And we see also from the type of airplane that they have this umbrella and bombard year. Those are indeed smaller jets. So there are no big Boeing airplanes, no big Airbus airplanes. So those are indeed regional smaller airplanes were probably the seating capacity is between, I have no clue, 50.100 people, something like this. Probably we will be able to find that information later on. Or by the way, I hit is information. Just by scrolling down. They explain the seat configuration of the emperor's is like 70 to 76. The bombard here is the same one by 765 to 70 and the 200 series is 50. So you see this is like smaller, mid-sized air plane. So it's not the big airplanes with 200, 300, 500 people. Which makes sense in the sense of they're expanding that there are regional business. Okay? So what we understand is we are honest and from where they're operating, from, which countries they are serving, which are their customers. So they are very concentrated on for customers, with the other being really a small part. And, and of course probably they have some arrangements how the the revenue of the contracting is being done with those four customers. Because obviously the risk is when you have such a concentrated customer base, if they lose united, they have 220. So they have a third of their property, plant and equipment of their fleet, which actually is then potentially sitting there in idle modes and they would need to find somebody else. So I hope that their risk managing with trying to find that later, find that out later on. But I hope that they are managing the risk as the customer music, extremely concentrated, good, That's the first thing. The second thing, when we analyzing a company, and this is a public listed company, this is not private equity, is a ten K reports. I'm looking into what kind of Ticker of stock exits. So for that, I'm going to do two things. The first thing I'm looking at the first page of the ten K report and I see that there is one ticket that is called Sky w, which they are listed on the nasdaq global select markets, and it's a common stock. So as I did for the other cases of specific indicators of cure rate, I want to understand the shoulder structure. So I'm going to go into the balance sheet and see if there is any other class of inflammation. So in a ten K reports, tan K naught, ten q times pod, you're going to find the consolidated financial statements in part to item eight. It's always the same. You see item made its financial statements and supplementary data. So let's look in the balance sheet. Let's see. Yeah, we will come back to the auditor's opinion later on. Let's look in the balance sheet. If we have any indication this is a balance sheet in the equity side of the balance sheet, this is the asset side. If we have different classes of stock. So we see that indeed there are two classes of stocks that is common stock with 120 million shares authorized. 82 million are actually issued on December 31st. Thousand 22. We immediately see here compared to the previous year that there are more shares outstanding. So 82,000,005.92 refers to December closing December 2000 22.90. 2335 refers to December 31st, thousand 21. So they have added around 200,000 shares to 160,000 shares. It's not huge in terms of equity dilution metabolism. Interesting, there is preferred stock, so yes, there is preferred stock. So they are authorized to issue, the company is authorized to issue 5 million of preferred stock shares. But you clearly see here on the balance sheet the indication is none is issued. And that's then also the reason why if I go to page one, let me scroll back to page one. You only see the common stock with this guy W ticker. So the preferred stock actually is not tradable and as you have seen, there are no Sheldon has been traded, so pretty easy shareholder ship structure. No preferred shares issued today though some are authorised when we only have common stock that has been issued. So that we have understood. Now, I want to understand is as well. Remember, I want to understand the audit opinion. So where do I find the audit opinion if I go to part two, financial statements and supplementary data. So item eight of part two, I can read, in fact, as it's the ten K report, the report of the statutory auditor. First of all, let's see who the statutory auditor is. Statutory auditor is Ernst and Young. So again, one of the big force. They have served the company as companies auditor since 2003, so basically 20 years. In one thing also the company's guy was is incorporated in Salt Lake City as well. If I'm if I remember well, you can see this on page one. Let me go back. So you see here that the company is incorporated under laws of Utah. And this is the headquarters address in St. George. Probably it's a suburb of Salt Lake City. My apologies for the people from Utah. I do not know where St. George is. I would need to Google that up. But it looks like I mean, for sure the company is incorporated in Utah. So going back to part two, item eight, reading the auditor's opinion before we go further, trying to understand why the company is structured. So here are, as always, I'm reading the opinion on the financial statements. Of course it says blah, blah, blah. We have audited the accompanying consolidated balance sheet of sky wears and subsidiaries for 20 to 2021. And what is important is the following. In our opinion, the consolidated financial statements present fairly in all material respects the financial position for the periods 2000, 20,021. So I could basically also highlight this. So this is the auditor's opinion. So the auditor are saying that the financial statements represent the company operations in a fair way in all material respects. So it's an unqualified opinion, so they are happy and to sign off in fact the financial statements. Alright? So of course they explain the basis for opinion. And then as I did and as I've been explaining this to you, I'm reading if there is any critical audit matter and yes, there is a disclosure of critical audit matter that you can see here. What is it about? It's about the valuation of fixed overhead, deferred revenue. So I have to read this. So there is deferred revenue apparently. So deferred revenue is remember, it's revenue that the company, So payments that the company has received and that are not recognized as revenue is revenue that we've come around here. In fact, the audit icing that the company has an unbuilt revenue balance of 19 million, of which 9 million was presented as a current asset and 10 million printed as long-term asset on the balance sheet. As disco discussing note one of the to manage them, the company's capacity purchase agreement. The company is paid a fixed amount per aircraft each month over the contract term. So what is this telling me? So remember the company has four big airlines as customers. So it was united, delta, American Eagle, and Alaskan Airlines. It looks like just by reading the audit matter from the auditor, that the company indeed is receiving kind of a fixed prepaid amount for each aircraft over the contract term. So here there is a conversation about how the revenue is recognized. If you read, there are. So there's maybe complexity on how the revenue is recognized because the auditor says the company's deferred revenue balance of 113 million of which five to 2 million rows presented as a component of current liabilities and Orlando at eight as long term liabilities, the balance sheet. So there is a conversation, I do not know currently, what is the total amount of revenue? So let me just have a gut feeling. What are we speaking about? Because this should be an immaterial matter. So when I go into the income statement of Sky West and I'm showing this you live here because I do not know what is the income we are having here. In fact, the consolidated statement, That's a comprehensive income, that's not the one they should have. Let me just scroll down further. What do they have? This is the cashflow statement. So maybe they have mixed the comprehensive and the income statement. That could be the case, yes. Okay. So let me go back. So we have in fact here one income statement, which is this one. So we see in fact that from a revenue perspective. So from income perspective, the company has a rough cut, 3 billion of total revenues for the year 2022. We can already see here that it has been growing too. So this is in what, in thousands. So 2 billion in 2020, 2,000,000,007, 2021, 3 billion in, in 2022. So we see that the revenues are growing and we see that the biggest part of the revenue or the flying arrangements, so they have a little bit of leaves and airport services and other. But that's really not substantial. I mean, if you do the ratio 105 to $3 billion, That's what is this? This is a couple of percent, so it's really immaterial. And on the flying agreement it was to that 9 billion 2022. So if we go back to the critical audit matter, we have now an idea that the total amount of revenue is 3 billion. The audit matter is we are discussing about deferred position of 113 million. So that's again a couple of percentage. And you see it's below this famous five per cent threshold. It's immaterial on the revenue perspective versus the total amount of revenue. So it's nonetheless an audit matter that is being disclosed, but still the It doesn't change the opinion that the consolidated financial statements are presenting in a fair way with all let's say in all material respects. So from a substantial perspective, everything appears fine according to the statutory auditor. But we know there is a conversation about deferred revenue. So what is interesting here is, I understand that the company is getting something like pre prepayments for the airlines during the contract term, which is good because then the let's say probably the expenses of the airline or protected during the contract term. And the company Sky West is receiving cash payments in advanced from the airlines that subcontract to Sky West part of their fleet in fact, so that's a good thing to know already. Alright. So the audit opinion seems okay. There is one matter, about 113 million out of 3 billion of revenue. Or probably we will see this in the balance sheet as well. Specifically in, let me see it here. In the liability side of things. I'm checking if we can see this somewhere here. If it is stated somewhere. I do not see directly, so probably it's somewhere, I would not say drowns, but it's somewhere in the balance sheet, in fact, because I see her deferred income taxes payable, but I do not see it could be. I'm not sure where they have put it into the balance sheet. It's not very clear, in fact, anyhow. Alright, so we have a feeling 3 billion of revenue. We know which segments, which products that they're offering. So those are small airplanes, 50-76 seat configuration. For categories. We have a fleet of 625 planes with 40 that are least, we're having kind of a gut feeling about what the company is doing, the audit opinion fields, okay, we already have seen that the revenues are growing year over year. Now what we want to know, I will be looking at the balance sheets. The balance sheet is here. And again, remember this is an audited balance sheet. It does not stay audited, but it does not state unaudited, which means that it is an audited consolidated balance sheet as remember, the ten K report is signed off by the statutory auditor. So what do we see? First of all, let's look at the cash position. So we see that the company from 2021 they had like if we add the marketable securities, they had 858 million of US dollars between cash, cash equivalence and marketable securities in the summer 31st thousand 22, they have more. In fact, they went from 800,582 billion 47. So they have added a couple of hundreds of millions in terms of cash, cash equivalence and marketable securities, what has changed is they have less cash, probably unemployed, so they went down from 258,100.2. But we see that the increase the amount of marketable securities, 601000000-944. So that's already one thing. You remember that normally. Also what you start looking into and look at the balance sheet is you just check the variation year over year. So you do a horizontal analysis. We see that the balance sheet has grown by 300 million, so 7125-7000000414 in December 2022. So we need to understand what is the variation coming from. You're ready see at the current assets have grown by 300 million. And in fact, when you add those together, you have here a variation of 344 and here you have a decrease of 150. So you see that already part of the variation is coming in fact from the current assets. Then obviously we want to understand what are the assets? The current assets normally, I mean, except inventory and receivables, those are cash generating assets. But normally the income is coming from the fixed assets. So how does the property, plant, and equipment fixed assets of the company look like? Here we already seen that the company has on a total balance sheet of $7.4 billion. The company has a total property, plant, and equipment minus depreciation. So PP&E net of 5.5 billion. So if you do the ratio, so now I'm using a vertical analysis method. You see in fact that farm, that 5 billion out of 74 billion, that's rough cut two-thirds, at least of the total balance sheet of the asset side of the company is PP&E. We see that they have most of the PP&E is aircraft and spare parts. That's normal. They have a little bit of buildings and grounds equipment. So the company we clearly see here when you remove the depreciation. So the company has two-thirds, at least, if not 75%, of the balance sheet. It's aircraft and spare parts. It's as easy as that. The buildings are small. It's 265 million in 2022 out of 74 billion. That's basically like two-three percent of the total balance sheet. But the big part is the total PP&E nuts removing depreciation. That's a rough cuts, 75 per cent. So we do the math 5548/7414. So it gives us a sense, indeed, the assets, the company is pretty capital intensive in the sense that it's about aircrafts. So this is where we understand, and obviously we understand that aircrafts have as fixed assets, a certain useful life expectancy, which will have to look into it probably is at least 20 to 30 years. It means that also the airlines have to be replaced with probably the company incurs costs for spare parts for maintenance, but also for replacement of the aircrafts when the aircrafts are totally depreciated. Good, this is already what we see from the asset side. Let's go into the liability side. I want to understand the capitals structure. So let's keep the current liabilities. We will not look too much into it because it's working capital. Well, we're going to look into as long-term debt and equity. So we have the same amount of balance sheet on the liability side as we have learned throughout this training. And we see in fact that the long-term dept is 2,000,000,009. And we see in fact that the total equity is 2,000,000,003. And we see also that the company has treasury stock, so the company has been doing share buybacks. That's great. And we see already here in the retained earnings. Remember that when the company keeps profits from the previous year, the retained earnings are growing, so the book value is growing. We see that the company has increased retained earnings by rough cuts, 70 million. So the retained earnings have increased. So that's always a good sign already when you do the horizontal analysis on retained earnings looking at the balance sheet, so the liability side of the balance sheet, we indeed see that the company, this means that the company did a profit in 2021 under the profit has been kept Into, has been kept in the company. And also here already what we can see is that the debt to equity ratio, and I'm just looking at depths. So long-term debt that will not count the current portion of the debt which is here, which is fun with 38, I could add it up. So it would be like 3.3 billion on two dot 3 billion of equity. You have a debt to equity ratio which is a little bit above one. This would probably bow, what's something like one dot, one dot three, which is, okay, I must say it's really not bad at all to have a debt to equity ratio, which is as long as that's an also one thing that you can analyze is the long-term debt versus the cash position. So remember that the company has rough cut, 1,000,000,047. So it's the amount of cash and marketable securities. It's 1,000,000,047. That means that one rough cut, one-third of the long-term dept could be in fact covered just by the current very liquid position that the company has between cash, cash equivalence and marketable securities. Of course, I would need to look at what is the risk related to the marketable securities. I taught you this during the training, is at level one, level two, level three, fair valuation. What is the risk associated to it at the marketable securities with in fact not be worth 944 million goods. So we understand already know that the company has a 7.4 billion total balance sheet. We have seen that 5.5 billion net of so after depreciation, amortization is linked to aircrafts, the company has rough cut 1 billion of cash, cash equivalence and marketable securities. And there are, there is a small portion. I think I did not mention it, but let me point it out here. There is a small portion of operating lease, right-of-use asset. So those are probably the airlines that are not owned. But I'll leave. So probably also the company derisk a little bit their balance sheet by renting some airplanes instead of buying the whole fleet. Of course, you will have. In the liability side, you can have the counterpart of the operating lease liabilities. In fact, you have it. In fact, your current maturities of operating lease liability is $71 million. And probably here and the other long-term liabilities, non-current operating lease liability is 88. So you see here, this is what 159 160 versus assets worth 151. So you see it, you remember I explained this in the course is very often very close to one to one. But we want to see those assets that are generating profits even though they are not owned by the company and the long-term commitment on the liability side. If you do not remember, please go back to the lecture where I'm walking you through all the type of debts that the company may face, and specifically what I'm discussing, the operating lease accounting changes. Alright. And then of course, again, remember to summarize it, we see the depth of the company rough cuts to 9 billion long term. You can add fun of 38 and we have two dot 3 billion of equity. So we have a ratio which is not too far away from one. So that's pretty good, I must say. Okay, now what we want to know. We'll just scroll down and go into the income same I could do the cashflow statement for us, but I want to just understand how profitable the company is. So we are having already commented, we have the top line where we see that the company has generated 3 billion of sales last year, with 9 billion coming from flying agreements, 105 million coming from Lee's apertures and other because the leaves themselves also to other customers, their airplanes. When we look at operating income is 181 million. And we see that last year they made a profit of 72 dot $9 million. So you can do the math. This is a very low profitable business. If you do the math of let me just do it very quickly. 729000000/3000000000 of sales. That's the profitability of two dot three per cent. So it's pretty low and that's normal for such a business. And of course they are subcontractors to United Delta Airlines. So probably somewhere. The customers that are flying with united, united will it take? And probably delta does the same part of the profitability. And only a part of the margin of those customers is flying, is flowing back to Sky West. You see it's low, low profitability business. We see that lastly, they made 111 million of profit and the year before 2020 they made a loss. Reason is remember there was COVID, so probably they were not flying a lot, so, but they still generated 2 billion of revenues and they were nearly break-even, which is not too bad. Um, as I think you had a lot of companies that had big issues during COVID. I think they came out strong of the COVID. So let's look at the cash flows because that's more interesting to look at the cashflow statements. So we have, remember the cashflow three segments, the operating, investing and financing. The operating. What do we see is that the company is generating profits from his operations. That's good. They of course have a high amount of depreciation, amortization and they have high PP&E are fathered 5 billion. And of course, I mean, those airlines are those airplanes, sorry, they are depreciated every year. So of course they have a big non-cash cost of depreciation and amortization. But what is positive is we see that the operating profits is always positive, so that's the minimum. Now we look at investing. So what is, remember this flow number four, what is the company reinvesting into the assets of the company operations. So we see that the numbers are negative. So the company is systematically reinvesting into its assets. And what are the big portions here? I think. I mean, I would have been of course I'm expecting to see a refresh of aircraft and buying snap parts. This is the line here. Aircraft and routable spare parts, this one. So see that every year and it's increasing. They have spent in 2000 2020, they have spent 425 million, 2021, 537 million, and in 2022 they spent 632 million on aircraft. So they acquiring property, plant and equipment. Are they selling? They're selling a little bit. That's the proceeds from the sale. So that's why it is positive because that's an inflow of cash. They're selling a little bit of their PP&E. But there is another substantial number, two substantial llamas. It's this in fact, so even though it's not the core business of the company, we said that the company has been selling marketable securities and buying purchasing marketable securities. That's why you saw, when you go back, let me go back here to the balance sheet. You saw in fact, when doing an horizontal analysis. Let me show it back here. When you are discussing cash and cash equivalents and marketable securities that were below. In fact here that they have spent 343,342 million more year over year because the amount of macro securities has grown 601-944. So if you go back to the cashflow statement, you basically see the difference between the two. So let me show this to you again how this works with the cashflow statements. And again, this is really how I analyze the report without preparing any PowerPoints. So you see basically here, if you make the math and I'll do the calculation for you guys. If you make the math of 1834 minus 1488, that's 346 million of macro securities that they have added. So they have spent 346. That's the nuts of those 246 million supplemental magnet securities. And that's rough cut what you see in fact in the balance sheet difference between six. So keep in mind 346 million. If I go back to the balance sheet to show you how this correlates. If you do the sorry, I have to go to the asset side. Of course. If you're difference between those two, It's nearly the same amount. There is small difference can be a timing when they purchased it, etc. But when you do 944231 minus 601 989, that's 342 million. So we have a small difference of 4 million. I don't know what it is this 1% difference. But rough cut. You see how the impact of spending more on macro securities appears in the balance sheet and it's normal, there is a cash outflow. So nets, net-net, there is more cash outflow and inflow and macro securities and these of course, appears in the balance sheet because it's the accumulation, the stock of wealth and inception of the company. So this is how you can interpret the 134.1 448. So we see that in terms of investing. So yeah, it's true that the investors see under 60,032 million into aircraft and spare parts. But they spent a lot of money on buying securities from the market. And at the same time they counterbalanced this with selling nearly one not 5 billion Macro Security is good. Of course. Now what we are can already see is that if you add 180 and plus -904, we see that the company has invested more versus the cash that has been provided by the operational cycle. So except if they have cached in from a financing activity, but otherwise would have destroyed cashier over here. So let's see. We can already do the math here. If you do find with a t plus -904. So they have, in fact, between operating and investing, they have burned for 124 million of cash right? Now, of course, we have to look into what did they do from a financing activity. So remember those are the flows 5.6. So here what we see is first of all, the flow five, which is to the debt holders. Those are the two lines that we have here. I'm going to tag with them in red. See seen fact that they have that they have paid back 415 million of long term debt and they have raised 684 million of fresh depths. So you see that they had higher inflow of cash coming from creditors versus a lower outflow of cash. So repayments of long-term debt, that was only 415 million. Here already they have had nuts plus 200 rough cut plus 270 million of cash inflow between the repayments and the issuance of depths. Did they pay they pay any cash dividends? We have the line here. No. The last year that they paid cash dividends was 2020. They did not pay in 21, 22. So it means that there is no flow six from a casting perspective, did they do any share buybacks? So that's the purchase of treasury stock the same they did in 2020. They didn't do anything 21.22. So they prefer preserve their cash. And they did not provide any return to the shareholders in terms of either a cash dividends or share buybacks. That's the two lines that I've tagged here. In fact, that you see here with the cursor. Did they issue new stock in the sense of did they create equity dilution? Yes, a little bit. And that's like 2 million, so that's probably employee stock compensation. And I see that here they have been paying taxes on vested shares. So, but it's really not a lot. So it's really a couple of million that's really not substantial on the 269, that would be like, I don't know, less than 1%. So there's little bit of equity dilution. And remember we saw this. How did I see the equity dilution? I was commenting on it before. Maybe you can think why I'm scrolling. I saw it here in the balance sheet. I saw that in the common stock, the amount of shares from one year, so 82,592,830, that refers to December 31st, thousand 22, and the 82,000,235, 970 refers to December 31, 2021. This is how you should read the balance sheet and specifically the common stock line item in the balance sheet, in the equity part of the balance sheet. So what does this mean? I mean, you just do the math. So you take 820005902830 -80 2335. So rough cut. The company has issued last year 200, 260, 255,000 shares. So the equity dilution you could calculate it is like I just said, 255,000 shares, rough cuts. Let me do the math correctly. 802-59-2830. That's the current amount of shares on December 31, 2022 -82 335970. So it's 256,000. So that's the difference between those two numbers. Let me tag them here. That's 256,860. If you now calculate this number and you divide it by 802-59-2830. Wait 1 s, I'm on the, let me do this calculation here. So if we take 256 60 divided by the total amount of shares, 802-59-2830. The dilution effect is of zero to three per cent, so it's, it's small. There is a little bit of equity dilution, but it's pretty small. So what else can we if we go back to the cashflow statement, I think I had finished in fact, with a little bit of equity dilution on a zero to 3%. This is basically what we see here, and the company is paying for the employee stock options, they're paying the taxes. So this is what you are seeing here. Now, net-net, we see them in the company as the only operating in Canada, US, and Mexico on their only having US, American customers. They don't have any foreign exchange exposure. So there is no line as e.g. if you remember in the Mercedes or Kellogg's report where they had potentially either gains or losses from foreign exchange conversions. Here we see in fact that they have net-net, they have destroyed 155 million of cash. So how do I see this or how is this impacting the balance sheets? So keep in mind, 155 was number. You go back to the asset side of the balance sheet. And remember the very first liquid in the US gap, it's where is it? In the asset side, of course, here you see that you make the math to 58 -102. That's the 155 million that they have destroyed in cash. So you see the impacts of the cashflow statement. You see it here. So mine is 155, that's 258 -102. So you see how the cashflow, so let's say the cash balance or the destruction of cash of sky was last year, is showing up in the balance sheet in the asset sat on cash and cash equivalents. Remember that's the cashflow statement correlates back with a balance sheet as well. Alright, What else? One of the things I'm also interested in is, of course, I mean, we have seen that the debt to equity is at 12123. So that was a two dot nine. If you remember going back to the two dot 9 billion on to 347, if you do the calculation, let me use my calculator here. So to 941/2347, that's a debt to equity ratio of 12053 in fact, so it's okay ish. But nonetheless, what I'm interested in as well, if you remember, we were discussing the interest coverage ratio. So I want to know how much from the earnings before interest and taxes in fact, use to serve as just the cost of the depths. Here we need to look at income statements. So we already calculated that the profitability, So that's 72 million out of 3 billion, that was like two dots something presents. What we know also, what we're interested in is understanding what is the amount. So if we take the earnings before interest and taxes, so that would be, let's call it the operating income. We have here, nets, nets 110 million of intere 25. Conclusion: Writing essays and then his students, this is the final lectures, it's the concluding lecture. Concluding thoughts about this long training is called the reading financial statements. This is just a practitioner level. So again, maybe just summarizing, just taking a step back, everything that I tried to share with you from my experience as an independent board director, but also as an investment for more than 25 years. So I really tried and I hope that you're able to through the various chapters together, the most important elements when you read financial statements, this first of all, understanding what's the difference between knife rather, you ask about local Gap Report, the main tablet financial statements, that is the balance sheet, the cashflow statement, the income statement, but also the supplemental elements that are linked to the accounting principles like the prudence principle, the going concern principle, fair valuation principle, and the other ones that we have been discussing. I tried as well to share with you the main elements of corporate governance that you understand. What is the role of shareholders, rest of the board of directors versus senior management. And also that you understand what the difference is in terms of corporate governance tearing models between a one tier where management sits together as executive directors with a non-executive directors and the board. Versus two-tier models where management is really separate it from the board of directors or the shallow representatives. Also making you understand hopefully the rule of statutory audit or being able to read an opinion of a statutory auditor, what does it mean? Being able to also understand what is a tenor? So how long the statutory auditor is there. Also, we discussed very important the scope of consolidation and consolidation of the company, the various ways of consolidating fully consolidated, partially consolidating through equity method investments in the balance sheets. And also how this reflects with the non-controlling interests when you have minority shareholders of companies that you've fully consolidated into your balance sheet. Also very important and you saw this already from the practice examples of these closing chapter, how I combine vertical analysis and horizontal analysis to quickly find our differences if it is on when Ovianne curious on Sky West Airlines, extremely important is when we were discussing a Lemons of the sources of capital, which were the depth, of course, the financial debt, but also the sources, the source of capital which is coming from the shareholders, which are the equity holders, which is equity in fact, and including how the mechanism of retained earnings works as well. For that specifically, interest coverage ratio, I gave you a couple of examples and the late, one of the greatest examples was the example is in chapter five about curates. Why you see again how you can link cost of capital expectations with the risk premiums have come with the interest coverage ratio and the rating that you can calculate through the Oswald them what around tables and also through the external rating agencies that they have had. Confirm for curates what my calculation was as well about the grades of investment or non-investment of cure rate as a depth investments. Very, very important as well. I hope that you understood that companies create value if the return on invested capital is above cost of capital. And how cost of capital is divided into the cost of equity and cost of debt, and how the gearing ratio works between debt and equity. We also discussed income, net income. I explained to you the differences between realized and unrealized losses or gains. This was again practice with cure rate where they had a non-cash impairment on goodwill, e.g. and also remember when we were discussing this famous cycle of value creation between sources that come in from the capital bring us, if it is credit tall as equity holders, the caches investment to assets with the hope that the acids are generating a profit. And then we had those three flows, flow 45.6 flow, which is basically adding, increasing the balance sheet by adding new assets and investing into new assets for the company to expand its operations. And all flow five, which is paying off debt and bringing in money from the creditor dollars and flew six which is paying back return to share loss rate or shampoo banks or dividends, or potentially having an intake of fresh capillary, which was what we saw with the synovial example in this chapter number five. And through that, you understand how this value creation cycle works. So that return on invested capital is a better measure as well versus profitability. Because profitability does not take into account the balance sheet and the invested capital of the company. So you may have to companies that generate the same amount of sales, the same amount of profitability. But one has two times the amount of balance sheet versus the other one. So which one is the better one? Of course, the one with the smaller balance sheet. Then of course we look into various vocabulary elements like earnings, notepad, EBT, net income. So I hope that you are fluent with that. But you have understood that my way of looking at when analyzing companies, I just started with the auditor's opinion. I mean, no, sorry. First of all, I have to say I start with understanding what is the business of the company, then look at the auditor's opinion. Then I look typically also add the structure of shares, the voting power of the various shares if there are debt instruments as well. So the capital structure of the company debt versus equity. Then indeed, I look to the balance sheet. I do horizontal analysis to understand what is happening between two reporting periods of vertical analysis. What are the big things in the balance sheet? I start with the asset side, then look into the liability side. Then indeed, I go into the cashflow to see those flows 45.6 how they materialize in the cashflow statement because those are strategic capital allocation decision that has to be taken through that. I'm trying to elaborate an opinion about the company. And then indeed at the end, I look at the income statement and the consistency of the income statement versus the rest versus what I saw in the cashflow statement and the balance sheet. So again, what I think you have to understand is, of course this is just a practitioner level one course on reading financial statements. Already the cause it's hugely, I mean, it's a very, very big cost, is pretty extensive, but I cannot cover everything. I think that what you, what you have to look into when you're analyzing this balance sheet, cash flow statement and income statement. When you need to, there are some flags that you need to think about. The company carries too much goodwill when the days of receivables is increasing, when the inventory is rising faster than profits when the company is borrowing too much money. When the company has just too much cash lying there and is not being used. And there's an explanation, my management that's typically going to look in the balance sheet when you look at the income statement as well. I mean, the typical red flags or when research and development expenses are capitalized, so they're increasing the balance sheet instead of expensing them. They are big extraordinary charges when the company is selling of fixed assets. I mean, I like to read the table, but there are a couple of things that you need to be attentive, which are could be red flags, not necessarily systematically, but could be red flags. I mean, I'm just picking up the last one which is bored, lacking experience, or with conflict of interests. Just look what happened to FDX. I mean, it was a girlfriend of the founder and then another friend at the board of directors. How can those three people have fair and zeros oversight over what is going on in the operation and exercise that fiduciary duty as it said. So that's something that probably has not worked out and that's what is going on with FTX and the crisis situation with FTX. So I will not go into the details of level through training. It's a course that I have not started yet to write, but it's something I definitely think about writing. So this will be really like going really much deeper into onetime events, changes in accounting policies of balance sheet items, what is called contingent liabilities and provision. So that's everything that is related to risk warranty exposure, subsequent events, after the reporting has been done. So that's the kind of thing that I would definitely like. Also that you'll become fluent in so that you are attentive to those kind of things. But that will be for the level two more, let's say advanced training on how to read financial statements. As always, if you have questions, feel free to post them on the Q&A section of the platform or to direct message me. You have also here my e-mail address. You can follow me on LinkedIn as well. And of course I have a YouTube channel where from time to time I published videos that are also educational content. And I hope that you will become a better investor. But analysts, that you have now a certain amount of keys to read financial statements and that you are able to practice. And I think what is important is it really, if I can give you a concluding recommendations that you practice, practice, practice, this is how you will become fluent in reading financial statements. So with that, thanks so much for the patients of going through this whole training and assets. Do not hesitate to reach out to me and talk to you, hopefully in either one of my webinars or either through email or potentially in another training that you will take from me. Thanks so much and talk to you very soon.