A large number of companies operating in cyclical sectors made a mistake by
raising their breakeven point through heavy investment. In fact, they should
have been seeking to achieve the lowest possible breakeven point and, above all,
the most flexible possible cost structure to curb the effects of major swings in
business levels on their profitability.
For instance, integration has often turned out to be a costly mistake in the
construction sector. Only companies that have maintained a lean cost structure
through a strategy of outsourcing have been able to survive the successive cycles of
boom and bust in the sector.
In highly capital-intensive sectors and those with high fixed costs (pulp, metal
tubing, cement, etc.), it is in companies’ interests to use equity financing. Such
financing does not accentuate the impact of ups and downs in their sales on their
bottom line through the leverage effect of debt, but in fact attenuates their impact
on earnings.
A breakeven analysis provides a link between financial and industrial strategy.
When a company finds itself in a tight spot, its best financial strategy is to reduce its
financial breakeven point by raising fresh equity rather than debt capital, since the
latter actually increases its breakeven point, as we have seen.
If the outlook for its market points to strong sales growth in the long term, a
company may decide to pick up the gauntlet and invest. In doing so, it raises its
breakeven point, while retaining substantial room for manoeuvre. It may thus
decide to take on additional debt.

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What are the various aspects of capital expenditure??

It is fairly common for major investments (e.g., the construction of a new plant) to
depress operating performance and even lead to operating losses during the first
few years after they enter service.
For instance, the construction of a new plant generally leads to:

1)additional general and administrative costs, such as R&D and launch costs,
professional fees, etc;

2)financial charges that are not matched by any corresponding operating
revenues until the investment comes on stream (this is a common phenomenon
in the hotel sector given the length of the payback periods on investments). In
certain cases, they may be capitalised and added to the cost of fixed assets, but
this is even more dangerous;

3)additional personnel cost deriving from the early recruitment of line staff and
managers, who have to be in place by the time the new plant enters service;

4)lower productivity owing both to the time it takes to get the new plant and
equipment running and the inexperience of staff at the new production
facilities.
As a result of these factors, some of the investment spending finds its way onto the
income statement, which is thus weighed down considerably by the implications of
the investment programme.

Conversely, a company may deliberately decide to pursue a policy of under-
investment to enhance its bottom line (so as to be sold at an inflated price) and to
maximise the profitability of investments it carried out some time ago. But this type
of strategy of maximising margins jeopardises its scope for value creation in the
future (it will not create any new products, it will not train sufficient staff to prepare
for changes in its business, etc.)

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Accruals are used to recognise revenues and costs booked in one period but relating
to another period

The main categories of accruals are:

1)Prepaid costs; i.e., charges relating to goods or services to be supplied later. For
instance, three-quarters of a rental charge payable in advance for a 12-month
period on 1 October each year will be recorded under prepaid costs on the asset
side of the balance sheet at 31 December

2)Prepaid income; i.e., income accounted for before the corresponding goods
or services have been delivered or carried out. For instance, a cable
company records three-quarters of the annual subscription payments it receives
on 1 October under prepaid income on the liabilities side of its balance sheet at
31 December
We should also cite accrued income and cost, which work in the same way as
prepaid income and cost, only in reverse.

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These primarily encompass startup costs, capitalised development costs, patents,
licences, concessions and similar rights, leasehold rights, brands, market share,
software and goodwill arising on acquisitions
Under IAS, a company is required to recognise an intangible asset (at cost) if
and only if:

1)it is probable that the future economic benefits that are attributable to the asset
will flow to the company; and if

2)the cost of the asset can be reliably measured.
Internally generated goodwill, brands, mastheads, publishing titles, customer lists
should not be recognized as intangible assets.

Internally generated goodwill is
expensed as incurred. Costs on starting up a business, on training, on advertising,
on relocating or reorganizing a company receive the same treatment.
This line item requires special attention since companies have some degree of
latitude in treating these items that now represent a significant portion of
companies’ balance sheets.

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Since consolidation consists of aggregating accounts, give or take some adjust-
ments, it is important to ensure that the accounting data used are consistent;
i.e., based on the same principles.

Usually, the valuation methods used in individual company accounts are
determined by accounting or tax issues specific to each subsidiary, especially
when some of them are located outside the group’s home country. This is particu-
larly true for provisions, depreciation and amortisation, fixed assets, inventories
and work in progress, deferred charges and shareholders’ equity.
These differences need to be eliminated upon consolidation. This process is
facilitated by the fact that most of the time consolidated accounts are not prepared
to calculate taxable income, so groups may disregard the prevailing tax regulations.

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It may seem strange to talk about net financial income for an industrial or service
company whose activities are not primarily geared towards generating financial
income. Since finance is merely supposed to be a form of financing a company’s
operating assets, financial items should normally show a negative balance, and this
is generally the case. That said, some companies, particularly large groups generating substantial negative working capital (like big retailers, for instance), have financial aspirations and generate net financial income, to which the financial

income makes a good contribution.
Net financial expense thus equates to financial expense less financial income.
Where financial income is greater than financial expense, we naturally refer to it as
net financial income.
Financial income includes:

1)income from other securities and from loans recorded as fixed assets. This
covers all income received from investments other than participating
interests – i.e., dividends and interest on loans;

2)other interest and related income – i.e., income from commercial and other
loans, income from marketable securities, discounts obtained from suppliers,
other financial income;

3)write backs of certain provisions and charges transferred – i.e., write backs of
provisions for financial liabilities and charges, of impairment losses on
financial items and, lastly, write backs of financial charges transferred;

4)foreign exchange gains on debt;

5)net income on the disposal of marketable securities – i.e., capital gains on the
disposal of marketable securities.

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What does The Stability Principle state?

This principle holds that a company’s earnings are much more stable than we
would expect. Net income is frequently a modest amount that remains when
charges are offset against revenues. Net income represents an equilibrium that is
not necessarily upset by external factors. Let’s consider, for instance, a supermarket
chain, whose net income is roughly equal to its net financial income. It would be a
mistake to say that if interest rates decline the company’s earnings will be wiped
out. The key issue here is whether the company will be able to slightly raise its
prices to offset the impact of lower interest rates, without eroding its competitive-
ness. It probably will be able to do so if all its rivals are in the same boat. But the
company may be doomed to fail if more efficient distribution channels exist.
The situation is very similar for champagne houses. A poor harvest drives up
the cost of grapes and pushes up the selling price of champagne bottles. Here the
key issue is when prices should be increased in view of the competition from
sparkling wines, the likely emergence of an alternative product at some point in
the future and consumers’ ability to make do without champagne, if it is too
expensive.
It is important not to repeat the common mistake of establishing a direct link
between two parameters and explaining one by trends in the other.

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Particularly when it was high (e.g., during the 1970s and the early 1980s), inflation
distorts company earnings because it acts as an incentive for them to over invest and
overproduce.

Should a company planning to expand the capacity of a plant around
4 years in the future decide to build it immediately, it would save 30–40% of its cost
in nominal terms, giving it a competitive advantage in terms of accounting costs.

Building up excess inventories is another temptation in high-inflation environments
because time increases the value of inventories, thereby offsetting the financial
expense involved in carrying them and giving rise to inflation gains in the accounts.
Inflation gives rise to a whole series of similar temptations of artificial gains,
and any players opting for a more cautious approach during such periods of
madness may find themselves steamrollered out of existence.

By refusing to build
up their inventories to an excessively high level and missing out on inflation gains,
they are unable to pass on a portion of them to consumers, as their competitors do.
Consequently, during periods of inflation:

1)depreciation and amortisation are in most cases insufficient to cover the
replacement cost of an investment, the price of which has risen;

2)inventories yield especially large nominal inflation gains where they are slow-
moving.

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Operating costs differ from operating payments in the same way that operating revenues differ from operating receipts. Operating payments are the same as operating costs for a given period only when adjusted for:

1)timing differences arising from the company’s payment terms (credit granted by its suppliers, etc.);

2)the fact that some purchases are not used during the same period. The difference between purchases made and purchases used is adjusted for through change in inventories of raw materials.

These timing differences give rise to:

1)changes in trade payables in the first case;

2)discrepancy between raw materials used and purchases made, which is equal to
change in inventories of raw materials and goods for resale.

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Balance Sheet Liquidity Analysis  requires classification of balance sheet. A classification of the balance sheet items needs to be carried out prior to the
liquidity analysis. Liabilities are classified in the order in which they fall due for
repayment. Since balance sheets are published annually, a distinction between the
short term and long term turns on whether a liability is due in less than or more
than 1 year. Accordingly, liabilities are classified into those due in the short term
(less than 1 year), in the medium and long term (i.e., in more than 1 year) and those
that are not due for repayment.
Likewise, what the company owns can also be classified by duration as follows:

1)assets that will have disappeared from the balance sheet by the following year,
which comprise current assets in the vast majority of cases;

2)assets that will still appear on the balance sheet the following year, which
comprise fixed assets in the vast majority of cases.

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