CHAPTER 8 A framework for interpretation

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CHAPTER 8A framework for interpretation
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Contents

• Introduction Background for interpretation
• Financial structure
• Sources of finance
• Dividend policy
• Working capital management
• Performance measurement

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Interpretative framework

• What are the ground rules against which to judge
  company behaviour?
• Two central lines of enquiry
• Evaluation of financial structure and financial
  policy
• Evaluation of company performance
• Risk/return relationship as fundamental economic
  rationale

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Figure 8.1 The risk/return relationship
Return
Risk
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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

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Financial structure

• Relative amount of debt financing (financial
  loans)
• Liquidity of assets
• Dividend policy
• Composition and management of working capital

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Sources of finance

• Share issue
• Loans
• Bonds
• Leasing
• Other methods

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Figure 8.2 Financial structure
Assets Financing
Productive capacity (fixed assets) Long-term financing from owners
Working capitalinventory, trade receivables, cash Long-term financing from owners
Working capitalinventory, trade receivables, cash Long-term financing from lenders
Working capitalinventory, trade receivables, cash Long-term financing from lenders
Working capitalinventory, trade receivables, cash Long-term financing from lenders
Working capitalinventory, trade receivables, cash Working capital trade payables
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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 (SMEs)
• Interest on debt is tax deductible

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Figure 8.3 Gearing
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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)

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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)

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Bonds

• Debt issued directly to the capital market
• Usually at a fixed interest rate
• Stock exchange listing of debt (bond market)

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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

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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

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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

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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
• Performance of SUB as such (return in )
  commercial or industrial risk
• Fluctuation of when translating the investment
  to currency risk

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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 Investment 100m - Annual return 15 Exchange rate 1 1 (at date of acquisition of SUB) French loan 100m Interest rate 7 Investment 100m - Annual return 15 Exchange rate 1 1 (at date of acquisition of SUB) French loan 100m Interest rate 7 Investment 100m - Annual return 15 Exchange rate 1 1 (at date of acquisition of SUB) French loan 100m Interest rate 7 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
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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

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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)

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Figure 8.4 The working capital cycle
Inventory Raw materials/ consumables
Production
Sales
Purchases
Trade payables
Inventory Work in progress/finished goods
Trade receivables
Payments
Receipts
Cash (equivalents)
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Working capital management objectives

• 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

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Figure 8.5a Gross working capital
Assets Financing
Fixed assets Equity
Current assets Equity
Current assets Debt (financial loans)
Current assets Debt (financial loans)
Current assets Debt (financial loans)
Current assets Current liabilities
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Figure 8.5b Net working capital
Assets Financing
Fixed assets Equity
Fixed assets Equity
Net working capital Equity
Net working capital Debt
Net working capital Debt
Current assets Current liabilities
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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

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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

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Structural aspects with effect on working capital
management

1. Length of production cycle
2. Variability of demand
3. Flexibility of production
4. Scale of credit sales
5. Frequency of sale transactions
6. Frequency of payments
7. Purchasing power

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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