EDHEC M1 BM Financial Statement Analysis year 2017-18 S1

SESSION 8.3 -DISAGGREGATING ROE

Application: the Inditex Case study years 2003-2004
Key words: ROE, NOPAT margin, OROA (=RNOA), Financial leverage and Spread

Inditex SA (Industria de Diseno Textil )is a Spain-based parent company of a large number of clothing
design, manufacturing and retail subsidiaries. It was founded by Amancio Ortega Gaono as a way to
bring high fashion apparel to the market at affordabale price.
In the 1980s, a computer expert joined the company to design a highly responsive supply chain that
could quickly produce the latest fashions. Sophisticated information system would allow the
designers, factories, warehouses, and stores to communicate with each other rapidly.
The major features of this vertically integrated business model are:
- privileged short production cycles, and quickly renewed fashion lines,
- focus on design,
- no inventory back logs, and quick stock turnarounds,
- quick and efficient supply chain.

Through the 1990s, Inditex expanded internationnally and diversified its brand portfolio. By 2000,
35% of Inditex 's stores were located outside Spain. In 2001, Chairman Ortega said "International
expansion is the inevitable objective".
Through the 2000s, Inditex continued to expand aggressively, accross Europe, Asia, the Americas,
and the Middle East. It also continued its brand diversification. In 2003, they opened a Zara Home
store and launched an initimate apparel brand Oysho

You are provided with the standardized and adjusted income statements and balance sheet for
Inditex for the years ended Jan. 31, 2004 and 2005.

REQUIREMENT :
1) Decompose Inditex's return on Equity in 2003 and 2004 using the traditional approach
2) Calculate Inditex's NOPAT, operating working capital, net-non current assets, net debt and net
assets in 2003 and 2004. (Use the effective tax rate to calculate NOPAT).
3) Decompose Inditex's return on Equity in 2003 and 2004 using the alternative approach.
What explains the difference between Inditex's ROA and its RNOA?
4) Analyse the underlying drivers of the change in Inditex's ROE.
Hint : structure your answer around (i) operating management, (ii) investing management and (iii)
financial management (store productivity, cost control, pricing and leverage).

This is a reminder of the ROE analysis structure :

M1BM - FINANCIAL STAT. ANALYSIS

SESSION 5.1 : Decomposing ROE - Inditex Case study

(adapted from Financial Accounting and Reporting: a global persepctive - Stolowy, Lebas and Ding)

Standardized and adjusted balance sheet Standardized and adjusted income statement
INDITEX (€ millions) 2004 2003 INDITEX (€ millions) 2004 2003
ASSETS Sales 5,674 4,602
Non-Current Tangible Assets 1,903 1,599 Cost of materials -2,636 -2,293
Non-Current Intangible Assets 542 467 Personnel expenses -821 -678
Deferred Charges 21 18 Depreciation and amortization -276 -221
Other Non-Current Assets 360 106 Other operating expenses -1,016 -782
Total non-current assets 2,827 2,189 Operating profit 924 627
Interests income 47 48
Trade Receivables 282 329 Interest expense -86 -62
Inventories 514 486 Profit before taxes 886 613
Other Current Assets 112 59 Tax expense -248 -165
Cash and Marketable Securities 473 446 Net income 638 449
Total current assets 1,382 1,321 Minority interest -10 -2
Net income attributable to the
TOTAL ASSETS 4,209 3,510
controlling company 628 446
LIABILITIES & SHAREHOLDERS’ EQUITY
Shareholders’ equity 2,503 2,106
Minority Interest 36 27

Non-Current Debt 307 357

Deferred tax (non interest bearing) 86 75
Other Non-Current Liabilities (non interest
bearing) 108 52
Total non-current liabilities 502 484

Current Debt 361 181

Trade Payables 784 652

Other Current Liabilities (non interest bearing) 24 59

Total current liabilities 1,169 893

TOTAL LIABILITIES AND SHAREHOLDERS’

EQUITY 4,209 3,510
M1BM - FSA

INDITEX Case - Answer sheet (€ millions or % or units)

1) Q1 : Decomposing ROE using Traditional approach: ROE = ROA X Financial leverage

2004 2003 Show your workings
…………………………….. ………………… ………………… ………………………………………………….
…………………………….. ………………… ………………… ………………………………………………….

= ROA ………………… ………………… ………………………………………………….

…………………………….. ………………… ………………… ………………………………………………….

= ROE ………………… ………………… ………………………………………………….
………………… ………………… ………………………………………………….

2) Q2 : Preparatory calculation
2004 2003 Show your workings

net interest expense after tax ………………… ………………… ………………………………………………….

NOPAT ………………… ………………… ………………………………………………….

Operating Working Capital ………………… ………………… ………………………………………………….

Net non-current assets ………………… ………………… ………………………………………………….

Net debt ………………… ………………… ………………………………………………….

net operating assets ………………… ………………… ………………………………………………….

3) Q3 : ROE calculation usIng the alternative approach

2004 2003 Show your workings
NOPAT margin ………………… ………………… ………………………………………………….

NOAT ………………… ………………… ………………………………………………….

RNOA ………………… ………………… ………………………………………………….

Effective interest rate after tax ………………… ………………… ………………………………………………….

Spread ………………… ………………… ………………………………………………….

Net fin leverage ………………… ………………… ………………………………………………….

ROE ………………… ………………… ………………………………………………….

Interpretation? ………………… ………………… ………………………………………………….

…………………………………………………………………………………………………………………………………………………….

4) Q4 : Explanation
4.1. Assessing operating management: decomposing net profit margins
2004 2003 Your analysis

Sales 100% 100% ………………………………………………….

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…………………………………………………. ………………… ………………… ………………………………………………….

Net profit ………………… ………………… ………………………………………………….

M1BM - FSA

4.2. Assessing investing management: asset turnover ratios expressed in times and/or days
2004 2003 Your analysis
…………………………………………………. ………………… ………………… ………………………………………………….

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4.3. Assessing financing management:

2004 2003 Your analysis
Effective interest rate after tax
net interest expense after tax ………………… ………………… ………………………………………………….
net debt ………………… ………………… ………………………………………………….

………………… ………………… ………………………………………………….

Current Debt ………………… ………………… ………………………………………………….
Non-Current Debt ………………… ………………… ………………………………………………….
Cash and Marketable Securities ………………… ………………… ………………………………………………….

Net fin. Leverage gain

…………………………………………………. ………………… ………………… ………………………………………………….

…………………………………………………. ………………… ………………… ………………………………………………….

 INDITEX Case - SOLUTION (€ millions or % or units)

0.1) Reminder of the ROE analysis approach

(a) ROE relates net income to the amount invested by shareholders: it is a measure of the efficiency
with which the shareholders' investment through their original capital contributions and earnings
retained in the business have been used.

(b) The traditional decomposition approach (DuPont) separates a company's ROE into three
factors: ROE = ROS x Asset T/O x Financial leverage.

These three factors are levers available to managers to improve performance :

- ROS-Profit margins operating profitability
- Asset turnover  investing efficiency
- Financial leverage  financing efficiency
The first two drivers unable analysts and managers to assess the return on assets (ROA) of the
company. The purpose of ROA is that after you've figured out how to get a better profit margin,
you figure out how to do it with fewer assets.

Limitations: the traditional DuPont method aggregates operating return from nonoperating reurn
(namely financing activities). Assets includes cash and cash equivalents and Net income include
financial income (expense), which is not "operating".

(c) The alternative desaggregating approach of ROE enables a more accurate analysis:
ROE = Operating return + Nonoperating return,
ROE = RNOA + Financial Leverage gain,
ROE = RNOA + (Leverage x Spread).

- The Return on Net Operating Assets (RNOA)measures how profitably the company deployed its
operating assets to generate operating profits. It can decomposed into NOPAT (how profitable are
the sales from an operating perspective), and how efficiciently is the company using its operating
assets.
- The financial leverage gain measures the effects of borrowing which combines:
* Spread = RNOA - Cost of debt
* Financial leverage = Debte/Equity.
ROE is increased by adding financial leverage so long as RNOA is higher than the weighted
average cost of capital. That is, if the firm can earn a return on operating assets which is greater
than the cost of the capital used to finance the purchase of those assets, then shareholders are
better off adding debt to increase operating assets. More, the effect of this positive spread is
magnified by the extent of the Debt/Equity.

(d) To go further :
Equity is the book value on the balance sheet. However, the true value is the market
capitalisation of a company's stock. The ROE approaches use the book value of equity, not the
market value, which may be different. If the book value is lower than the market value, managers
might thing getting a ROE of 10% while investors think their return is a lot less.
0.2) About "Minority interests" - glossary
Minority interest has to do with consolidated statements, which have to do with merger.

Merger: a merger is a business combination whereby two ofrmore companies combine to form a
single legal entity. If the parent company has control over the acquired firm, the assets and the
liabilities of the latter are merged (=added) into those of the former, and similarly with the stocks,
as well as with the revenues and with the costs.

Parent company: owns the controlling share, but not all, of the equity of another company called
subsidiary (generally more than 50%).
The consolidated financial statements of the parent company (called Group) include the financial
statements of the parent strictly speaking + the financial statements of all subsidiaries under its
control.

Subsidiary: partially owned

Minority interest: also called non controlling interest : portion of the subsidiary’s shareholder’s
equity which is owned by the minority “outside” shareholders equity and income statement which
belong to the minority shareholders must be shown as separate line items.
 INDITEX Case - SOLUTION (€ millions or % or units)
25.08% 21.20%
1) Q1 : Decomposing ROE using Traditional approach
2004 2003
ROS 11.1% 9.7% 2004 Return On Sale (ROS) is 140 pb (basic points) higher 2003's one
x Assets turnover 1.348 1.311 =sales/total assets
= ROA 14.91% 12.72%
x Fin. Leverage 1.68 1.67 =total assets/Shareholders' Equity
= ROE 25.08% 21.20%
Note : it would be more accurate to use average equity and average assets as they are numbers at a particular point in time whereas
whereas numerator is derived over a period of time (one year).
For instance, average equity can be calculated as [(Beginning Equity + Ending Equity)/2].
Here, for lack of more information, we calculate ratios using end year equity and end year assets (as of December, 31).
Note that using beginning equity (such as January, 31) and beginning assets would be more accurate.

2) Q2 : Decomposing ROE using Alternative approach

Reminder :
ROE = RNOA + Financial Leverage gain
where RNOA = NOPAT margin x Operating Assets T/O
and Financial leverage gain = Spread x Net Financial Leverage

Prerequisite calculation (€ million) 2004 2003

effective tax rate 28.0% 26.9% Average interest tax rate = tax expense/profit before tax
net interest expense after tax 28 10 = (interest expense-interest income) x (1-effective tax rate)
NOPAT 655 456 =net profit + net interest expense after tax
= WCN= Curr Assets without cash Less Curr Liab. without interest-bearing liabilties. Inditex
Operating Working Capital (a) 101 163 Operating working capital is a consequence of its business model
Net non-current assets (b) 2,597 2,035 NC Assets Less Non-interest bearing LT liabilities (inc minority interest)
Net debt 195 92 =Total debt (interest-bearing) Less Cash & cash equivalent
net operating assets = (a)+(b)=(c) 2,698 2,198 =Operating Working Capital + Net non-current assets

Calculation of the ROE using Alternative approach

NOPAT margin (=Nopat/Sales revenue) 11.55% 9.92% Better operating managt : sales grew faster than operating expenses
x Operating assets T/0 (=Sales revenue/(c)) 2.10 2.09 Better investing mangt : reflects business model: choice of highly responsive supply chain

=RNOA (also called OROA ) (1) 24.30% 20.76% High RNOA : due to a strict management of assets combined with operating efficiency

Effective interest rate after tax (2) 14.29% 10.90% Net interest expense after tax / net debt; in 2004: 14.29%=28/195
Spread: (3) = (1) less (2)] 10.00% 9.86% =RNOA - Effective interest rate after tax.
Net financial leverage (4) 0.08 0.04 =Net debt/Shareholder'sEquity (Notice that different from the Fin. Leverage used in Traditional
Approach). The financial leverage increases ROE so long as the spread is positive which
is the case here.
Financial leverage gain = (3)x(4) 0.78% 0.43% = Non operating return has increased because of the increase in fin. leverage
ROE 25.08% 21.19%

Net operating assets < Total assets: due to large cash holdings and large amount of trade payables; Cash holdings are non
RNOA > ROA (2004 : 24.30%>14.91%)
oeparting assets.

Now: to explain the increase in ROE,look at the evolution of each of the ROE's components and calculate more ratios to further explain their evolution

3) Q3 : Explanation
3.1. Assessing operating management: decomposing net profit margins

Evolution NOPAT 2004 2003

Sales growth of 23% as a result of 9% organic increase and 19% due to incease in selling
100.0% 100.0%
Sales surface areas. At constant exchange rates: +25% growth
Cost of materials 46.5% 49.8% Better purchase management and/or inventory management

14.5% 14.7% Stable

Personnel expenses
Depreciation and amortization 4.9% 4.8%
Other operating expenses 17.9% 17.0%
Operating profit 16.3% 13.6% Operating margin significantly growing
Interest income 0.8% 1.0%
-1.5% -1.3%
Interest expense which leads to a decrease in the operating profit margin and consequently the NOPAT margin
Profit before taxes 15.6% 13.3%
Tax expense -4.4% -3.6%
Profit after taxes 11.2% 9.7% No extraordinary items here : otherwise separate analysis is required
Minority interest -0.2% 0.0%
Net profit 11.1% 9.7%

TO GO FURTHER : look for more financial information provided by the company in order to:
- Decompose sales revenue in business segments (here different commercial format stores) and geographical segments ; this is required by IFRS.
- Decompose sales revenue into sales in company-managed stores and sales to franchises (source of royalties), which helps understand the risks that Inditex faces

- Identify changes in the consolidation perimeter: geographical and brand diversification. For example, Zara Home ans Oysho were launched in 2013 >>> we should also asses sales
growth at constant perimeter

- Assess the exchange rate risk, particularly relating to the US dollar, but also Mexican peso, Yen, £ etc..Assess the like-for-like Sales growth amount (that is at constant exchange rate)
- Assess the credit risk: assess the provision made for the impairment of trade receivables
3.2. Assessing investing management: asset turnover ratios

Operating assets turnover 2004 2003

OWC turnover 56.36 28.17 The operating assets are used more efficiently or more productively
Accounts receivables turnover 20.09 13.99 The operating assets are used more efficiently or more productively
Accounts payables turnover 3.36 3.51
Inventories turnover 5.13 4.71 The operating assets are used more efficiently or more productively
Net non-current assets turnover 2.19 2.26
PPE turnover 2.01 2.10
Days' receivables (A) 18.17 26.09 The company is less flexible in collecting money from customers (365/Accounts receivable turnove

Days' payables 108.58 103.85 Significant bargaining power

Days' inventories 71.17 77.43 Inditex obviouly monitors its inventory management
A negative CCC means that the money inflow is quicker than the money outflow (i.e. money is
Cash Conversion Cycle (B) -19.23 -0.34
collected from customers before paying suppliers).See session 6

(A) Trade receivables mainly correspond to debit/credit card payments pending collection. Part of the group's activity is carried out through franchised stores.
Turnover is an important measure of the quality of current assets such as receivables and inventories : the faster the turnover, the smaller the likelihood of loss on ultimate
realization of these assets.
(B) The cash conversion cycle is negative, which means that the operating cycle is a source of financing.

In an assessment of the overall liquidity of a company’s current assets, the trend of sales is an important factor. Since it takes sales to convert inventory into receivables and/or
cash, an uptrend in sales indicates that the conversion of inventories into more liquid assets will be easier to achieve than when sales remain constant. Declining sales, on the
other hand, will retard the conversion of inventories into cash and, consequently, impair a company’s liquidity.

Remember that Inditex's business model is characterized by the search for flexibility in adapting production to market demand by controlling the supply chain.

3.3. Assessing financing management:

Effective interest rate after tax↑
2004 2003
net interest expense after tax 28 10 The net interest expense is proportionally low

net debt 195 92

Current Debt 361 181
Non-Current Debt 307 357 Look for further indication in terms of maturity
Cash and Marketable Securities 473 446

Net fin. Leverage ↓ 0.08 0.04

net debt 195 92 Net fin. Leverage is very low. The company is more relying on its business model (Cash
Shareholders' equity 2,503 2,106 conversion cycle) and Equity to make cash, than on debt

Net debt to Equity ratio 0.078 0.044

Financial leverage is the result of borrowing and incurring fixed obligations for interest and principal payments. The owners of a successful business that requires funds may not
want to dilute their ownership of the business by issuing additional equity. Instead, they can "trade on the equity" by borrowing the funds required, using their equity capital as a
borrowing base. Financial leverage is advantageous when the rate of return on net operating assets exceeds the net after-tax interest cost paid on debt. An additional advantage
provided by financial leverage is that interest expense is tax deductible while dividend payments are not.

The Group does not seem to be exposed to liquidity risk, as it maintains significant cash and cash equivalents for the purpose of international expansion.
Itwould be interesting to anlyse liquidity ratios (session 6).