CHAPTER 8 A framework for interpretation

1. CHAPTER 8A framework for interpretation

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

3. 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

4. Figure 8.1 The risk/return relationship Return Risk

5. 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

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

7. Sources of finance • Share issue • Loans • Bonds • Leasing • Other methods

8. Figure 8.2 Financial structure

9. 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

10. 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) Figure 8.3 Gearing

11. 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)

12. 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)

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

14. 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

15. 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

16. 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

17. 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

18. Table 8.1 Impact of exchange rate changes

19. 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

20. 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)

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

22. 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

23. Figure 8.5a Gross working capital

24. Figure 8.5b Net working capital

25. 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

26. 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

27. Structural aspects with effect on working capital management • Length of production cycle • Variability of demand • Flexibility of production • Scale of credit sales • Frequency of sale transactions • Frequency of payments • Purchasing power

28. 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