2 Contents Introduction – Background for interpretation Financial structureSources of financeDividend policyWorking capital managementPerformance 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 policyEvaluation of company performanceRisk/return relationship as fundamental economic rationale
4 Figure 8.1 The risk/return relationship People need information which helps them to evaluate risks and potential returns.What kind of information do they use ?Part of their analysis will be of a qualitative nature, eg. by developing a feeling for industry trends and by trying to get a good picture of the capabilities and integrity of management (fi through contacts and interviews with company personnel). Other evaluation techniques will be of a quantitative nature, and these will rely extensively on FS information.Risk
5 Risk/return relationship Expected return =(1) Compensate inflation+ (2) Return of risk-free investment+ (3) Compensate existing riskFinancial statements provide information on past returns and financial risk as partial inputs for forecasting future risk/return opportunitiesReturn: we will look at historic performances in order to project future expectations.Risk = operational risk + financial risk (linked to financial structure)[OperationaL risk: we are producing products in a declining or saturated market]Financial risk related to financial structure : 2 aspects:1) The higher the liabilities (loans, payables), the riskier to provide more credit and external financing (relatively less Equity to pay back loans) <> EQUITY = Safety BUFFER2) The presence of financial loans has an impact on the variability of profit (interest on loan financing usually represent fixed expenses that will not decrease in periods when business does not go well and sales decline)
6 Financial structureRelative amount of debt financing (financial loans)Liquidity of assetsDividend policyComposition and management of working capitalWhich aspects of financial structure and policy can be important ?-A number of these elements are related to the structure of the BS.
7 Sources of financeShare issueLoansBondsLeasingOther methods
9 Gearing Gearing refers to the proportion of debt to equity In general: Gearing has a positive effect onFinancial riskReturn (through leverage-effect)Impact of company characteristics:Family-owned companies and private companiesSize of company (SME’s)Interest on debt is tax deductibleNo definite rules for deciding on optimal degree of debt.Leverage-effect: if we are capable of earning with all our assets a higher return than the cost of debt capital, the extra return over the return of our loan creditors willl be directly beneficial, as a surplus, to our shareholders.Interest on debt is deductible from taxable income – returns for the shareholders (dividend) are paid out of profit after taxation => this should be taken into account when comparing returns:
11 Share issue Existing shareholders subscribing to new shares Rights issueDiscount relative to market priceProspectusUnderwriting of a share issueIssuing shares on different capital markets (multiple listings)Shares:Ordinary shares : measured at nominal value (later pricing of new shares will be higher than nominal value (share premium)– different categoriesPreferent shares: fixed return – cumulatve (usually no voting power)Convertible bonds: fixed return at start (lower than market return) + possibly share return afterwardsLoans: mostly with “floating rate”, with the interest rate fluctuating according to market interest rate – usually determined as a deviation from the standard interest rate applied by the Central BankIdeally, one should get a LT loan with fixed rate when market rate is low and at variable rate if market rate is high.=> A number of important aspects of financial management is related to good management of the financing structure – point is here that the BS (and the notes) provide us with a lot of info concerning divers aspects of the financing structure.
12 Loans Long-term loans from commercial banks and merchant banks Syndicated loans provided by a group of financial institutionsFloating rate loansInterest rate in accordance with a market rate indicatorx% over minimum lending rate (e.g. Euribor)
13 Bonds Debt issued directly to the capital market Usually at a fixed interest rateStock exchange listing of debt (bond market)
14 LeasingRenting an asset with finance often supplied by the supplier of the assetAvoids the need to raise finance separately when buying new assetsFinance leases versus operating leases
15 Cost of Debt Interest on debt is deductible from taxable income Tax advantage of debt = interest expense X tax rateCost of debt after tax =Cost of debt before tax minus tax advantage of debtInterest expense * (1 – tax rate)Useful when comparing with cost of equity10 % interest on loan will cost us after tax (tax rate of 30%) only 7% and it is this rate that should be compared with the 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 debtInterest ratesFixed or floating ratesLT rates versus ST ratesCurrency riskBorrowings / debt in foreign currenciesHedgingMaturity mix = the sheduling of repayment of debt:If all loans fall due at the same time – than it may be expensive to carry out a massive refinancing in one exercice.Currency riskCan lead to considerable gains or losses if currency exchange rates are lively and variable.In some cases, debt in foreign currency will be used to HEDGE currency risk on the assets side of the BS => HEDGING
17 Hedging of currency risk- Illustration French company (reporting in €) buys a subsidiary (SUB) in the USInvestment 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 riskFluctuation of $ when translating the investment to € = currency risk
18 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€1.007m8m€0.8012m5m€1.3019.5m12.5m
19 Dividend policyIs 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 sharesAre shareholders indifferent in these matters?Different profiles of shareholdersClientele effectImpact on cash flows and financing needsWhat are shareholders interested in (you as an investor) ?* Both aspects are interrelated: what is being cashed out as dividend, will decrease the value of EQUITY and is no longer available to support future development and growth of the company. If not distributed => market value of the shares should normally increase as investors will anticipate (expectation) future higher profits (shareholders can always sell part of ther shareholdings if they really need cash).Some shareholders invest specifically to receive a constant stream of dividends => they will sustain the value of good dividend payers.A steady growing dividend is also perceived as a signal to the market, signalling good, controlled management (and this even temporally apart from movements in profits).In a period of crisis: the share price of good dividend payers gets usually less hurt than other companies.
20 Working capital management Figure 8.4 shows a simplified diagram of a working capital cycleFunds are tied up in this cycleNet working capital =Net investment of funds to keep the cycle goingWorking capital assets (current assets) – working capital liabilities (current liabilities)
21 Figure 8.4 The working capital cycle InventoryRaw materials/consumablesPurchasesProductionSalesTrade payablesInventoryWork in progress/finished goodsTrade receivablesPaymentsCash(equivalents)Receipts
22 Working capital management objectives Keeping at a minimum the cash tied up in working capital cyclePreserving sufficient cash or readily convertible current assets to meet payment demands1 = trade-off between financial and commercial policy2 = liquidity-objective2 = one should be able to free sufficient ST cash flows from inventories and receivables in order to be able to pay creditor debts on a timely basis.
23 Figure 8.5a Gross working capital AssetsFinancingFixed assetsEquityCurrent assetsDebt(financial loans)Current liabilities
24 Figure 8.5b Net working capital AssetsFinancingFixed assetsEquityNet working capitalDebtCurrent assetsCurrent liabilities
25 Working capital: trade-offs Inventory of raw materialsQuantity discounts (lower unit cost)Risk of inventory shortage (production stop)Inventory of finished goodsRisk of inventory shortage (loss of revenue)Delivery flexibility through high and easily accessible inventory level (larger market share)ReceivablesCredit period as competitive sales argumentTrade payablesCredit 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 cycleActive management of potential incoming cash flows from revenueStructural aspects of operating activities affect working capital managementWorking capital profile depends onNature of operationsNature of competitionSpecifc management techniques have been developed to manage WC, f.i.JIT – Just in time: inventory management with impact on vendor relationship => shuffles inventory to vendors.
27 Structural aspects with effect on working capital management Length of production cycleVariability of demandFlexibility of productionScale of credit salesFrequency of sale transactionsFrequency of paymentsPurchasing powerIndien groot tijdsverloop tussen aankoop GS en afwerking eindproduct => grote voorraden GS en GIBGrote variatie in vraag => grote voorraad afgewerkt product nodig – Behalve: indien productiecyclus kort en vlugge aanpassing volumes productie mogelijk.zie onder 2Indien krediet als industriestandaard => hoog volume vorderingenImpact op regelmaat van kasstromen => hoe onregelmatiger, hoe groter de noodzakelijke kasvoorraadIndien uitgaande betalingen hoog en infrequent => tussen kasstromen kunnen cash levels laag gehouden worden.Indien power hoog => lage voorraden nodig en veel levenancierskrediet mogelijk
28 Performance measurement Profitability and efficiency issuesEvaluation of performance also involves considerations which are not visible from financial statementsPerformance is judged in a relative senseShort-term and long-term profitability