Transcript Document

CHAPTER 8
A framework for interpretation
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Contents
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Introduction – Background for
interpretation
Financial structure
Sources of finance
Dividend policy
Working capital management
Performance measurement
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Interpretative framework
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What are the ground rules against
which to judge company behaviour?
Two central lines of enquiry:
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2.
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Evaluation of financial structure and financial
policy
Evaluation of company performance
Risk/return relationship as
fundamental economic rationale
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© 2005 Peter Walton and Walter Aerts
Figure 8.1 The risk/return relationship
Return
Risk
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© 2005 Peter Walton and Walter Aerts
Risk/return relationship
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Expected return =
(1) Compensate inflation
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+ (2) Return of risk-free investment
+ (3) Compensate existing risk
Financial statements provide information on
past returns and financial risk as partial inputs
for forecasting future risk/return opportunities
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Financial structure
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Relative amount of debt financing
(financial loans)
Liquidity of assets
Dividend policy
Composition and management of
working capital
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Sources of finance
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Share issue
Loans
Bonds
Leasing
Other methods
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Figure 8.2 Financial structure
Assets
Productive capacity
(fixed assets)
Working capital:
inventory,
trade receivables,
cash
Financing
Long-term financing
from owners
Long-term financing
from lenders
Working capital: trade
payables
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Gearing
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Gearing refers to the proportion of debt to
equity
In general: Gearing has a positive effect on
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Impact of company characteristics:
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Financial risk
Return (through leverage-effect)
Family-owned companies and private companies
Size of company (SME’s)
Interest on debt is tax deductible
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Figure 8.3 Gearing
Assets
Financing
Non-current assets
(fixed assets)
Equity
(long-term financing
from owners)
Gearing
Current assets
(inventory, trade
receivables,
cash)
Debt
(long-term financing from
lenders)
Current liabilities
(trade payables)
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Share issue
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Existing shareholders subscribing to
new shares
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Rights issue
Discount relative to market price
Prospectus
Underwriting of a share issue
Issuing shares on different capital
markets (multiple listings)
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© 2005 Peter Walton and Walter Aerts
Loans
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Long-term loans from commercial banks
and merchant banks
Syndicated loans provided by a group of
financial institutions
Floating rate loans
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Interest rate in accordance with a market rate
indicator
x% over minimum lending rate (e.g. Euribor)
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© 2005 Peter Walton and Walter Aerts
Bonds
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Debt issued directly to the capital
market
Usually at a fixed interest rate
Stock exchange listing of debt (bond
market)
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© 2005 Peter Walton and Walter Aerts
Leasing
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Renting an asset with finance often
supplied by the supplier of the asset
Avoids the need to raise finance
separately when buying new assets
Finance leases versus operating leases
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© 2005 Peter Walton and Walter Aerts
Cost of Debt
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Interest on debt is deductible from taxable
income
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Tax advantage of debt = interest expense X tax rate
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Cost of debt after tax =
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Cost of debt before tax minus tax advantage of debt
Interest expense * (1 – tax rate)
Useful when comparing with cost of equity
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Financial debt: other considerations
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Structure of ‘maturity mix’
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Interest rates
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Dates of repayments of debt?
Usual to spread out the maturity dates of debt
Fixed or floating rates
LT rates versus ST rates
Currency risk
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Borrowings / debt in foreign currencies
Hedging
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Hedging of currency risk- Illustration
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French company (reporting in €) buys a subsidiary
(SUB) in the US
Investment in SUB is expressed in US $ (reporting
currency of SUB = US $)
Acquisition is financed by loan in €
= investment with double risk:
1)
2)
Performance of SUB as such (return in $) =
commercial or industrial risk
Fluctuation of $ when translating the investment to
€ = currency risk
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© 2005 Peter Walton and Walter Aerts
Table 8.1 Impact of exchange rate
changes
Investment = $100m - Annual return = 15%
Exchange rate $1 = €1 (at date of acquisition of SUB)
French loan €100m – Interest rate= 7%
US profit
$
Rate
French profit
1$ =
€
(on BS date)
(pre-tax)
Interest
€
Net result
€
15m
€1.00
15m
7m
8m
15m
€0.80
12m
7m
5m
15m
€1.30
19.5m
7m
12.5m
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© 2005 Peter Walton and Walter Aerts
Dividend policy
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Is the dividend policy relevant when evaluating
the financial position and performance of a
company ?
Link with shareholder value ?
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Are shareholders indifferent in these matters?
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Dividends versus increase in stock market value of
shares
Different profiles of shareholders
Clientele effect
Impact on cash flows and financing needs
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© 2005 Peter Walton and Walter Aerts
Working capital management
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Figure 8.4 shows a simplified diagram
of a working capital cycle
Funds are tied up in this cycle
Net working capital =
 Net
investment of funds to keep the cycle
going
 Working capital assets (current assets) –
working capital liabilities (current liabilities)
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Figure 8.4 The working capital cycle
Inventory
Raw materials/
consumables
Purchases
Trade
payables
Payments
Production
Inventory
Work in
progress/finished
goods
Cash
(equivalents)
Sales
Trade
receivables
Receipts
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Working capital management
objectives
1)
2)
Keeping at a minimum the cash tied up
in working capital cycle
Preserving sufficient cash or readily
convertible current assets to meet
payment demands
1 = trade-off between financial and commercial policy
2 = liquidity-objective
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Figure 8.5a Gross working capital
Assets
Fixed assets
Current assets
Financing
Equity
Debt
(financial loans)
Current liabilities
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Figure 8.5b Net working capital
Assets
Fixed assets
Net working capital
Current assets
Financing
Equity
Debt
Current liabilities
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Working capital: trade-offs
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Inventory of raw materials
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Inventory of finished goods
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Risk of inventory shortage (loss of revenue)
Delivery flexibility through high and easily accessible
inventory level (larger market share)
Receivables
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Quantity discounts (lower unit cost)
Risk of inventory shortage (production stop)
Credit period as competitive sales argument
Trade payables
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Credit versus lower unit price or higher product quality
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© 2005 Peter Walton and Walter Aerts
Liquidity objective of working capital
management
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Planning of cash outflows and cash
inflows related to working capital cycle
Active management of potential
incoming cash flows from revenue
Structural aspects of operating activities
affect working capital management
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Structural aspects with effect on working
capital management
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Length of production cycle
Variability of demand
Flexibility of production
Scale of credit sales
Frequency of sale transactions
Frequency of payments
Purchasing power
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts
Performance measurement
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Profitability and efficiency issues
Evaluation of performance also involves
considerations which are not visible
from financial statements
Performance is judged in a relative
sense
Short-term and long-term profitability
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5
© 2005 Peter Walton and Walter Aerts