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CHAPTER 8 A framework for interpretation

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1 CHAPTER 8 A 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
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 risk Financial statements provide information on past returns and financial risk as partial inputs for forecasting future risk/return opportunities Return: 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 BUFFER 2) 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 structure Relative amount of debt financing (financial loans) Liquidity of assets Dividend policy Composition and management of working capital Which 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 finance Share issue Loans Bonds Leasing Other methods

8 Figure 8.2 Financial structure
Assets Financing Productive capacity (fixed assets) Long-term financing from owners Working capital: inventory, trade receivables, cash from lenders Working capital: trade payables

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 No 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:

10 Figure 8.3 Gearing Financing Assets Equity Non-current assets
(long-term financing from owners) Current liabilities (trade payables) Debt (long-term financing from lenders) Financing Non-current assets (fixed assets) Current assets (inventory, trade receivables, cash) Assets 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) Shares: Ordinary shares : measured at nominal value (later pricing of new shares will be higher than nominal value (share premium)– different categories Preferent shares: fixed return – cumulatve (usually no voting power) Convertible bonds: fixed return at start (lower than market return) + possibly share return afterwards Loans: 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 Bank Ideally, 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 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 10 % 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 debt Interest rates Fixed or floating rates LT rates versus ST rates Currency risk Borrowings / debt in foreign currencies Hedging Maturity 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 risk Can 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 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
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 7m 8m €0.80 12m 5m €1.30 19.5m 12.5m

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 What 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 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 Purchases Production Sales Trade payables Inventory Work in progress/finished goods Trade receivables Payments Cash (equivalents) Receipts

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 2 = 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
Assets Financing Fixed assets Equity Current assets Debt (financial loans) Current liabilities

24 Figure 8.5b Net working capital
Assets Financing Fixed assets Equity Net working capital Debt Current assets Current liabilities

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 Working capital profile depends on Nature of operations Nature of competition Specifc 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 cycle Variability of demand Flexibility of production Scale of credit sales Frequency of sale transactions Frequency of payments Purchasing power Indien groot tijdsverloop tussen aankoop GS en afwerking eindproduct => grote voorraden GS en GIB Grote variatie in vraag => grote voorraad afgewerkt product nodig – Behalve: indien productiecyclus kort en vlugge aanpassing volumes productie mogelijk. zie onder 2 Indien krediet als industriestandaard => hoog volume vorderingen Impact op regelmaat van kasstromen => hoe onregelmatiger, hoe groter de noodzakelijke kasvoorraad Indien 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 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

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