CHAPTER 8 A framework for interpretation. Contents Introduction – Background for interpretation ...

Use with Global Financial Accounting and Reporting ISBN 1-84480-265-5© 2005 Peter Walton and Walter Aerts

CHAPTER 8A framework for interpretation


Contents

Introduction – Background for interpretation

Financial structure Sources of finance Dividend policy Working capital management Performance measurement


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


Figure 8.1 The risk/return relationship

Return

Risk


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


Financial structure

Relative amount of debt financing (financial loans)

Liquidity of assets Dividend policy Composition and management of

working capital


Sources of finance

Share issue Loans Bonds Leasing Other methods


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


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


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


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)


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)


Bonds

Debt issued directly to the capital market

Usually at a fixed interest rate Stock exchange listing of debt

(bond market)


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


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


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


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


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


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


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)


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)


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


Figure 8.5a Gross working capital

Assets Financing

Fixed assetsEquity

Current assets

Debt(financial loans)

Current liabilities


Figure 8.5b Net working capitalAssets Financing

Fixed assetsEquity

Net working capitalDebt

Current assetsCurrent liabilities


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


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


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


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

CHAPTER 8 A framework for interpretation. Contents Introduction – Background for interpretation ...

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