EC7095 Financial Statement Analysis Lecture 7

Recap – lecture 6 Shareholder/investor ratios Dividend yield EPS Dividend cover PE ratio Earnings yield Net assets per share Balanced scorecard/Non financial performance indicators

Intangible Assets An identifiable non-monetary asset without physical substance Identifiability – may be a problem It must be under the control of the entity It must have expected future economic benefits Internally generated goodwill

Research and Development Research – obtaining new knowledge Development – can be capitalised - Technically feasible - Intention to complete - Ability to use or sell - Demonstrate the existence of a market - Ability to measure the expenditure

Other internally generated assets International accounting standards prevent the recognition of: internally generated brands, publishing titles, customer lists etc. The following costs should be expensed as incurred – start up costs, advertising costs, training costs, business relocation costs

Measuring intangibles in future periods Cost model Revaluation model Useful life/amortisation

Goodwill Is created by good relationships between a business and its customers Inherent v. purchased Value of purchased goodwill

Impairment of assets Impairment arises where the carrying amount of the asset is greater than the “recoverable” amount Recoverable amount is the higher of its fair value (less costs to sell) and its value in use

Indications of impairment Greater than expected fall in market value Significant change in the technological, market or economic environment of the business in which the assets are employed An increase in cost of capital likely to affect the present value of an asset in use Carrying amount > market capitalisation

Reporting financial performance Accounting policies Changes Errors

Accounting policies Basis of preparation Depreciation Leasing commitments New standards

Segmental reporting By business sector By geographical location Revenues, operating profits, assets and liabilities

Minimum disclosure Expense categories Profit after charging………. Staff costs Movements in property plant and equipment

Other information in the notes Group companies Half year results 5 year history

Other information in the financial statements Chairman’s statement Directors’ report Corporate governance Remuneration report Auditors report

Directors Report Chief Executive’s review Principal activities Strategies and objectives Outlook and priorities Key performance indicators Risks and uncertainties Employees Social and environmental matters

Financial Instruments Financial assets Financial liabilities

Foreign Currency Risk Translation risk Economic risk Transaction risk

Transaction Risk - example A UK exporter is due to receive $1m in 3 months time The current exchange rate is $1.40 to £1 That rate could rise or fall by up to 20% in the next 3 months

Terminology Strong or weak £ Buy or sell Spot rate

Spot rate example Exchange rates on 9th March were $/£ 1.4000 +/- 0.0003 Calculate the receipts from a $1m sale to a US customer Calculate the cost of paying an invoice of $1m

Managing transactions risk – internal methods Invoice in £’s Matching Netting Leading Lagging

Forward exchange contracts A binding contract with a bank covering a specific amount of foreign currency at an exchange rate agreed now Forward rate 1.3994 – 1.4006 Forward rate 1.4000 +/- 0.0006 Spot rate with premium or discount Spot 3 month forward US$/£ 1.4006 – 1.4012 0.0012 – 0.0006 premium

Forward rates - example Spot rates are $/£ 1.3996 +/- 0.0003 and forward rates are $/£ 1.3986 +/- 0.0009 Calculate the receipts from a $1m sale to a US customer due to be received in 3 months time if forward rates are used Calculate the cost of paying an invoice of $1m in 3 months time if forward rates are used

Forward rates - advantages Simple Low up front costs Available in many currencies Can be available for more than 1 year ahead

Forward rates - disadvantages Binding contracts Fixed dates Rates may be unattractive

Money market hedging Using the money market to avoid transaction risk If we are due to receive dollars in the future we have a dollar asset so we match this with a dollar liability by taking out a loan in dollars If we are due to pay dollars in the future we match that liability to an asset in $ by investing $.

Money market hedge - exporter Expect $ revenue in 3 months time Borrow in $s today

Money market hedge –example 1 J Ltd is due to receive $1m on 10th June. Spot Rate $/£ is 1.4151 +/- 0.0003 3 month forward rate is 1.4095 +/- 0.0012 UK 3 month interest Rates 5.7% - 5.6% US 3 month interest Rates 4.4% - 4.3%

Money market hedge - importer Expect $ costs in 3 months time $ deposit today

Money market hedge – 5 steps (importer) £ $ now 4. Withdraw £s 3. $ deposit 1. Pay $s 3 mths 5. Compare to a forward 2. Using $ on deposit Determines the size of the $ deposit today

Money market hedge –example 2 J Ltd is due to pay $1m on 10th June. Spot Rate $/£ is 1.4151 +/- 0.0003 3 month forward rate is 1.4095 +/- 0.0012 UK 3 month interest Rates 5.7% - 5.6% US 3 month interest Rates 4.4% - 4.3%

Money Market Hedge Advantage is greater flexibility More complex than forward contract – no cheaper

Derivatives Using other “products” to avoid risk Futures contracts Options

Futures contracts Contracts that fix the exchange rate for a set amount of currency over a specified period of time Currency futures are mainly available from the US markets such as NYBOT futures and options exchange They are flexible – a September future can be used on any day up to the end of September They are only available for large contract sizes Margin payments are required

Currency Options Options are contracts giving the holder the right, but not the obligation, to buy or sell a fixed amount of currency at a fixed rate in return for a premium Option to buy is called a “call” option Option to sell is called a “put” option “European” options have a fixed date – “over the counter options” “American” options can be “exercised” at any date before the end of the contract – “exchange traded options”

Options – simple example It is 1st October S plc wishes to hedge the “possible” receipt of $2m from the sale of a US subsidiary in December Spot Rate is $1.4615 An “over the counter” option for $2m with an exercise price of $1.47 can be bought for a premium of £50000 What will be the outcome if: (a) The exchange rate in December is 1.5 $/£ (b) The exchange rate in December is 1.4 $/£ (c) The sale does not take place

Exchange Traded Options Standard contract sizes Can be long term – quoted up to 2 years, but longer periods available Tradable – can be sold if not needed

Interest Rate Risk Higher costs on existing loans Higher costs on planned loans

Managing interest rate risk NOW – Plan a loan in 3 months time IN 3 MONTHS – Take out the loan Interest rates may have risen

Managing interest rate risk - FRAs £5m 3-9 FRA at 5% Size of loan Start & end month Base rate guaranteed 11.4

Illustration 1 - FRA A plc is planning to take out a 6 month loan of £5m in 3 months time but is concerned about the base rate (LIBOR) rising above its current level of 5.25% A plc has been offered a 3-9 FRA at 5.5% A plc can borrow at 1% above LIBOR

Illustration 1 Continued In 3 months time the base rate is 5.75% A plc will take out a loan at 6.75% Due to FRA they will receive compensation from the bank of 0.25% The net cost is 6.5% (1% over the base rate in the FRA)

Illustration 1 Continued In 3 months time the base rate is 4.5% A plc will take out a loan at 5.5% Due to FRA they will pay compensation from the bank of 1% The net cost is 6.5% (1% over the base rate in the FRA)

Interest Rate Futures Futures are a separate agreement from the actual transaction They are a DERIVATIVE – their value is derived from movements in the base rate

Exchange traded options An option gives the buyer the right but not the obligation to buy or sell a commodity at an agreed price on or before an agreed date in exchange for a premium.