Disclosure of APMs, purpose, uses, reconciliations, limitations

Novartis AG – Annual report – 31 December 2017

Industry: pharmaceuticals

Financial Report (extract 1)

Results of operations

In evaluating the Group’s performance, we consider not only the IFRS results, but also certain non-IFRS measures, including core results and constant currency results. These measures assist us in evaluating our ongoing performance from year to year and we believe this additional information is useful to investors in understanding the performance of our business.

The Group’s core results – including core operating income, core net income and core earnings per share – exclude fully the amortization and impairment charges of intangible assets except software, and certain acquisition-related items. The following items that exceed a threshold of USD 25 million are also excluded: integration and divestment related income and expenses, divestment gains and losses, restructuring charges/releases and related items, legal related items, impairments of property, plant and equipment and financial assets, as well as income and expense items that management deems exceptional and that are or are expected to accumulate within the year to be over a USD 25 million threshold. A reconciliation between IFRS results and core results is shown on pages 181-183.

We present information about our net sales and other key figures relating to operating and net income in constant currencies (cc). We calculate constant currency net sales and operating income by applying the prior-year average exchange rates to current financial data expressed in local currencies in order to estimate an elimination of the impact of foreign exchange rate movements.

The core results, constant currencies and other non-IFRS measures are explained in more detail starting on page 179 and are not intended to be substitutes for the equivalent measures of financial performance prepared in accordance with IFRS. These measures may differ from similarly titled non-IFRS measures of other companies.

Financial Report (extract 2 from page 179)

Non-IFRS measures as defined by Novartis

Novartis uses certain non-IFRS metrics when measuring performance, especially when measuring current year results against prior periods, including core results, constant currencies, free cash flow and net debt.

Despite the use of these measures by management in setting goals and measuring the Group’s performance, these are non-IFRS measures that have no standardized meaning prescribed by IFRS. As a result, such measures have limits in their usefulness to investors.

Because of their non-standardized definitions, the non-IFRS measures (unlike IFRS measures) may not be comparable to the calculation of similar measures of other companies. These non-IFRS measures are presented solely to permit investors to more fully understand how the Group’s management assesses underlying performance. These non-IFRS measures are not, and should not be viewed as, a substitute for IFRS measures.

As an internal measure of Group performance, these non-IFRS measures have limitations, and the Group’s performance management process is not solely restricted to these metrics.

Core results

The Group’s core results – including core operating income, core net income and core earnings per share – exclude fully the amortization and impairment charges of intangible assets, except software, and certain acquisition-related items. The following items that exceed a threshold of USD 25 million are also excluded: integration and divestment related income and expenses, divestment gains and losses, restructuring charges/releases and related items, legal related items, impairments of property, plant and equipment and financial assets, as well as income and expense items that management deems exceptional and that are or are expected to accumulate within the year to be over a USD 25 million threshold.

Novartis believes that investor understanding of the Group’s performance is enhanced by disclosing core measures of performance since they exclude items that can vary significantly from year to year, the core measures enable better comparison of business performance across years. For this same reason, Novartis uses these core measures in addition to IFRS and other measures as important factors in assessing the Group’s performance.

The following are examples of how these core measures are utilized:

  • In addition to monthly reports containing financial information prepared under IFRS, senior management receives a monthly analysis incorporating these core measures.
  • Annual budgets are prepared for both IFRS and core measures.

A limitation of the core measures is that they provide a view of the Group’s operations without including all events during a period, such as the effects of an acquisition, divestments, or amortization/impairments of purchased intangible assets and restructurings.

Constant currencies

Changes in the relative values of non-US currencies to the US dollar can affect the Group’s financial results and financial position. To provide additional information that may be useful to investors, including changes in sales volume, we present information about our net sales and various values relating to operating and net income that are adjusted for such foreign currency effects.

Constant currency calculations have the goal of eliminating two exchange rate effects so that an estimate can be made of underlying changes in the consolidated income statement excluding the impact of fluctuations in exchange rates:

  • The impact of translating the income statements of consolidated entities from their non-USD functional currencies to USD
  • The impact of exchange rate movements on the major transactions of consolidated entities performed in currencies other than their functional currency

We calculate constant currency measures by translating the current year’s foreign currency values for sales and other income statement items into USD, using the average exchange rates from the prior year and comparing them to the prior year values in USD.

We use these constant currency measures in evaluating the Group’s performance, since they may assist us in evaluating our ongoing performance from year to year. However, in performing our evaluation, we also consider equivalent measures of performance that are not affected by changes in the relative value of currencies.

Growth rate calculation

For ease of understanding, Novartis uses a sign convention for its growth rates such that a reduction in operating expenses or losses compared to the prior year is shown as a positive growth.

Free cash flow

Free cash flow is presented as additional information because management believes it is a useful supplemental indicator of the Group’s ability to operate without reliance on additional borrowing or use of existing cash. Free cash flow is a measure of the net cash generated that is available for debt repayment, investment in strategic opportunities and for returning to shareholders. Free cash flow is a non-IFRS measure, which means it should not be interpreted as a measure determined under IFRS. Free cash flow is not intended to be a substitute measure for cash flow from operating activities as determined under IFRS.

Novartis defines free cash flow as cash flow from operating activities and cash flow associated with the purchase or sale of property, plant and equipment, as well as intangible, other non-current and financial assets, excluding marketable securities. The definition of free cash flow used by Novartis does not include amounts related to changes in investments in associated companies or related acquisitions or divestments of subsidiaries.

Net debt

Net debt is presented as additional information because management believes it is a useful supplemental indicator of the Group’s ability to pay dividends, to meet financial commitments and to invest in new strategic opportunities, including strengthening its balance sheet. Net debt is a non-IFRS measure, which means it should not be interpreted as a measure determined under IFRS.

Novartis defines net debt as current and non-current financial debt less cash and cash equivalents, current investments and derivative financial instruments.

Novartis Cash Value Added

Novartis Cash Value Added (NCVA) is a metric that is based on what the company assesses to be its cash flow return less a capital charge on gross operating assets. NCVA is used as the primary internal financial measure for determining payouts under the Long-Term Performance Plan introduced in 2014. More information on NCVA is presented as part of the Compensation Report on page 130.

Additional information

EBITDA

Novartis defines earnings before interest, tax, depreciation and amortization (EBITDA) as operating income from continuing operations excluding depreciation of property, plant and equipment (including any related impairment charges) and amortization of intangible assets (including any related impairment charges).

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Enterprise value

Enterprise value represents the total amount that shareholders and debt holders have invested in Novartis, less the Group’s liquidity.

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1 Adjusted for charges of USD 0.3 billion in 2016 related mainly to devaluation losses in Venezuela.

2 Earnings per share (EPS) is calculated on the amount of net income attributable to shareholders of Novartis AG.

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1 Amortization of intangible assets: Cost of goods sold includes recurring amortization of acquired rights to in-market products and other production-related intangible assets; Research & Development includes the recurring amortization of acquired rights for technology platforms; Income from associated companies includes USD 376 million for the Novartis share of the estimated Roche core items.

2 Impairments: Cost of goods sold and Research & Development include impairment charges related to intangible assets; Research & Development and Other expense include impairment charges related to financial assets; Research & Development, Other income and Other expense include reversals and charges related to the impairment of property, plant and equipment.

3 Acquisition or divestment of businesses and related items, including restructuring and integration charges: Other income and Other expense include transitional service-fee income and expenses and other items related to the portfolio transformation.

4 Other items: Cost of goods sold, Other Income and Other expense include net restructuring and other charges related to the Group-wide rationalization of manufacturing sites; Cost of goods sold, Research & Development, General & Administration, Other income and Other expense include other restructuring income and charges and related items; Marketing & Sales includes an income from the release of a provision; Research & Development includes fair value adjustments to contingent consideration liabilities; Other income and Other expense include legal-related items; Other income also includes a gain from a Swiss pension plan amendment, product and financial asset divestment gains, a partial reversal of a prior period charge, an income from a settlement of a contract dispute and a fair value adjustment to contingent consideration sales milestone receivables; Other expense also includes a provision for contract termination costs, a charge for onerous contracts and an amendment to the Swiss Pension Plan; Income from associated companies includes an adjustment of USD 150 million for the Novartis share of the estimated GSK Consumer Healthcare Holdings Ltd. core items.

5 Taxes on the adjustments between IFRS and core results take into account, for each individual item included in the adjustment, the tax rate that will finally be applicable to the item based on the jurisdiction where the adjustment will finally have a tax impact. Generally, this results in amortization and impairment of intangible assets and acquisition-related restructuring and integration items having a full tax impact. There is usually a tax impact on other items, although this is not always the case for items arising from legal settlements in certain jurisdictions. Adjustments related to income from associated companies are recorded net of any related tax effect. Due to these factors and the differing effective tax rates in the various jurisdictions, the tax on the total adjustments of USD 4.4 billion to arrive at the core results before tax amounts to USD 760 million. The average tax rate on the adjustments is 17.1%.

6 Earnings per share (EPS) is calculated on the amount of net income attributable to shareholders of Novartis AG.novar5

1 Amortization of intangible assets: Cost of goods sold includes recurring amortization of acquired rights to in-market products and other production-related intangible assets; Research & Development includes the recurring amortization of acquired rights for technology platforms; Income from associated companies includes USD 296 million for the Novartis share of the estimated Roche core items.

2 Impairments: Cost of goods sold and Research & Development include impairment charges related to intangible assets; Other income includes impairment reversals of property, plant and equipment; Other expense includes impairment charges related to property, plant and equipment, and financial assets.

3 Acquisition or divestment of businesses and related items, including restructuring and integration charges: Other income and Other expense include transitional service-fee income and expenses and other items related to the portfolio transformation; Other income also includes a gain from the revaluation of a previously held financial investment in a newly acquired company.

4 Other items: Other revenues include an early release of deferred income associated with a collaboration agreement; Cost of goods sold, Other income and Other expense include net restructuring and other charges related to the Group-wide rationalization of manufacturing sites; Research & Development, Marketing & Sales, Other income and Other expense include other restructuring income and charges; Cost of goods sold and Research & Development include adjustments of contingent considerations; General & Administration, Other income and Other expense include items related to setup costs for Novartis Business Services; Other income and Other expense also include legal settlements and changes in provisions; Other income also includes gains from product divestments, other income related to the portfolio transformation and a gain related to the sale of real estate; Other expense also includes a charge as a result of a pension plan amendment, a charge for an indirect tax settlement and other costs; Income from associated companies includes USD 135 million for the Novartis share of the estimated GSK Consumer Healthcare Holdings Ltd. core items; Other financial income and expense relates mainly to devaluation losses in Venezuela.

5 Taxes on the adjustments between IFRS and core results take into account, for each individual item included in the adjustment, the tax rate that will finally be applicable to the item based on the jurisdiction where the adjustment will finally have a tax impact. Generally, this results in amortization and impairment of intangible assets and acquisition-related restructuring and integration items having a full tax impact. There is usually a tax impact on other items, although this is not always the case for items arising from legal settlements in certain jurisdictions. Adjustments related to income from associated companies are recorded net of any related tax effect. Due to these factors and the differing effective tax rates in the various jurisdictions, the tax on the total adjustments for continuing operations of USD 5.5 billion to arrive at the core results before tax amounts to USD 882 million. The average tax rate on the adjustments is 16.0%.

6 Earnings per share (EPS) is calculated on the amount of net income attributable to shareholders of Novartis AG.

Financial Report (extract 3)

Free cash flow

Novartis defines free cash flow as cash flow from operating activities and cash flow associated with the Purchase or sale of property, plant and equipment, intangible assets, other non-current assets and financial assets, excluding marketable securities. Cash flows in connection with the acquisition or divestment of subsidiaries, associated companies and non-controlling interests in subsidiaries are not taken into account to determine free cash flow. The free cash flow measure, which is a non-IFRS measure, is discussed more on page 180. The following is a summary of the free cash flow:

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