Historical Analysis in Times of High Inflation  499 Historical Analysis in Times of High Inflation In countries experiencing extreme inflation (more than 25 percent per year), companies often report in year-end currency. In the income statement, items such as revenues and costs that were booked throughout the year are restated at year-end purchasing power. Otherwise, the addition of these items would have no relevance. The balance sheet usually has adjustments to fixed assets, inventory, and equity; the accounts payable and receivables are already in year-end terms. In most countries, however, financial statements are not adjusted to reflect the effects of inflation. High inflation leads to distortions in the balance sheet and income statement. In the balance sheet, nonmonetary assets, such as in- ventories and PP&E, are shown at values far below current replacement value. In the income statement, depreciation charges are too low relative to current replacement costs. Sales and costs in December and January of the same year are typically added as if they represented the same purchasing power. As a result, many financial indicators typically used in historical analy- ses can be distorted when calculated directly from the financial statements in high-inflation economies. In such circumstances, companies often index their internal management accounts to overcome these issues. If they do not, or if you are conducting an outside-in analysis, at least correct for the following distortions: • Growth is overstated in times of inflation, so restate it in real terms by deflating with an annual inflation index if sales are evenly spread across the year. If sales are not spread evenly, use quarterly or monthly infla- tion indexes to deflate the sales in each corresponding interval. • Capital turnover is typically overstated because operating assets are carried at historical costs. You can approximate the current costs of long-lived assets by adjusting their reported values with an inflation index for their estimated average lifetimes. Or consider developing ratios of real sales relative to physical-capacity indicators appropriate for the sector—for example, sales per square meter in consumer retail. Inventory levels also need restating if turnover is low and inflation is very high. • Operating margins (operating profit divided by sales) can be overstated because depreciation is too low and slow-moving inventories make large nominal holding gains. Corrections for depreciation charges follow from adjustments to PP&E. You can estimate cash operating expenses at current-cost basis by inflating the reported costs for the average time held in inventory. Alternatively, use historical EBITDA-to-sales ratios to assess the company’s performance relative to peers; these ratios at least do not suffer from any depreciation-induced bias. 500  Inflation • Credit ratios and other indicators of capital structure health become distorted and require cautious interpretation. Distortions are especially significant in solvency ratios such as debt to equity or total assets, be- cause long-lived assets are understated relative to replacement costs, and floating-rate debt is expressed in current currency units. As Chapter 33 advises, use coverage ratios such as EBITDA to interest expense.10 These are less exposed to accounting distortions, because depreciation has no impact on them and debt financing is mostly at floating rates or in foreign currency when inflation is persistent. Financial Projections in Real and Nominal Terms When you make financial projections of income statements and balance sheets for a valuation in a high-inflation environment, keep in mind that accounting adjustments should not affect free cash flow. Projections are typically made in either nominal or real terms, but high-inflation environments require a hybrid approach because each single approach has different strengths, as Exhibit 26.5 shows. On the one hand, projecting in real terms makes it difficult to calculate taxes correctly, as tax charges are often based on nominal financial statements. Furthermore, you need to project explicitly the effects of working-capital changes on cash flow, because these do not automatically follow from the an- nual change in real-terms working capital. On the other hand, using nominal cash flows makes future capital expenditures difficult to project, because the typically stable relationship between revenues and fixed assets does not hold in times of high inflation. This means it will also be difficult to project depre- ciation charges and EBITA. 10 Distortions occur in the ratio of EBITA to interest coverage if operating profit is overstated due to low depreciation charges and low costs of procured materials. EXHIBIT 26.5  Combining Real and Nominal Approaches to Financial Modeling ✓✓ Preferred Application Modeling approach Estimates Real Nominal Operational performance Sales ✓✓ ✓ EBITDA ✓✓ ✓ EBITA ✓✓ – Capital expenditures ✓✓ – Investments in working capital ✓✓1 ✓ Other Income taxes – ✓✓ Financial statements ✓2 ✓✓ Continuing value ✓✓1 ✓✓ 1 If inflation impact on investments in working capital is explicitly included. 2 If inflation corrections are separately modeled and included in income statement and balance sheet.