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Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts
CHAPTER 8A framework for interpretation
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts
Contents
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 What are the ground rules against
which to judge company behaviour? Two central lines of enquiry:
1. Evaluation of financial structure and financial policy
2. Evaluation of company performance
Risk/return relationship as fundamental economic rationale
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts
Figure 8.1 The risk/return relationship
Return
Risk
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts
Risk/return relationship
Expected return =
(1) Compensate inflation
+ (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
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
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 FinancingProductive capacity
(fixed assets)Long-term financing
from owners
Working capital:inventory,
trade receivables, cash
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 Gearing refers to the proportion of debt to
equity In general: Gearing has a positive effect on
Financial risk Return (through leverage-effect)
Impact of company characteristics: 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
Equity(long-term financing
from owners)
Current liabilities(trade payables)
Debt(long-term financing
from lenders)
FinancingNon-current
assets(fixed assets)
Current assets (inventory, trade
receivables, cash)
Assets
Gearing
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts
Share issue
Existing shareholders subscribing to new shares Rights issue Discount relative to market price Prospectus
Underwriting of a share issue Issuing shares on different capital
markets (multiple listings)
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts
Loans
Long-term loans from commercial banks and merchant banks
Syndicated loans provided by a group of financial institutions
Floating rate loans Interest rate in accordance with a market
rate indicator x% over minimum lending rate (e.g. Euribor)
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts
Bonds
Debt issued directly to the capital market
Usually at a fixed interest rate Stock exchange listing of debt
(bond market)
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts
Leasing
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
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts
Cost of Debt
Interest on debt is deductible from taxable income Tax advantage of debt = interest expense X
tax rate Cost of debt after tax =
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
Structure of ‘maturity mix’ Dates of repayments of debt? Usual to spread out the maturity dates of debt
Interest rates Fixed or floating rates LT rates versus ST rates
Currency risk Borrowings / debt in foreign currencies Hedging
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts
Hedging of currency risk- Illustration
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) Performance of SUB as such (return in $) = commercial or industrial risk
2) Fluctuation of $ when translating the investment to € = currency risk
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 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
$Rate 1$ = (on BS date)
French profit
€ (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
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts
Dividend policy Is the dividend policy relevant when evaluating
the financial position and performance of a company ?
Link with shareholder value ? Dividends versus increase in stock market value of
shares Are shareholders indifferent in these matters?
Different profiles of shareholders Clientele effect
Impact on cash flows and financing needs
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts
Working capital management 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
InventoryRaw materials/ consumables
Production Sales
ReceiptsPayments
Purchases
Trade payables
InventoryWork in
progress/finished goods
Trade receivables
Cash (equivalents)
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts
Working capital management objectives
1) Keeping at a minimum the cash tied up in working capital cycle
2) 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 Financing
Fixed assetsEquity
Current assets
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 capitalAssets Financing
Fixed assetsEquity
Net working capitalDebt
Current assetsCurrent liabilities
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts
Working capital: trade-offs Inventory of raw materials
Quantity discounts (lower unit cost) Risk of inventory shortage (production stop)
Inventory of finished goods Risk of inventory shortage (loss of revenue) Delivery flexibility through high and easily accessible
inventory level (larger market share) Receivables
Credit period as competitive sales argument Trade payables
Credit versus lower unit price or higher product quality
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts
Liquidity objective of working capital management
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
1. Length of production cycle2. Variability of demand3. Flexibility of production4. Scale of credit sales5. Frequency of sale transactions6. Frequency of payments7. Purchasing power
Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts
Performance measurement
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