lecture+2+understanding+and+analysing+financial+statements+11 12
TRANSCRIPT
Slide 2.1
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 5th Edition, © Pearson Education Limited 2010
56863 Managing Finance
Week 3 13/Oct/2010Dr. Chloe Yu-Hsuan Wu
Understanding and Analysing Financial Statements
Slide 2.2
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 5th Edition, © Pearson Education Limited 2010
Users of financial statements
Business
Competitors
Lenders
Managers
Owners Customers
Suppliers Investment analysis
Community representatives
Government
Employees and their representatives
Slide 2.3
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 5th Edition, © Pearson Education Limited 2010
Usefulness of financial information
• Reliability• Relevance
• Comparability • Timeliness
• Cost/benefit
• Useful accounting information
• Understandability
• can produce
• the lack of
• which will be limited by
Slide 2.4
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 5th Edition, © Pearson Education Limited 2010
Published annual report
•Financial statements▫Income Statement▫Balance sheet▫Cash flow statement
•Additional financial data and notes•Auditor’s report•Director’s report•Chairman’s report
Slide 2.5
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 5th Edition, © Pearson Education Limited 2010
The key stages of financial analysis
• Select and
calculate
appropriate
ratios
• Identify users and their
information
needs
• Interpret and
evaluate the
results
Slide 2.6
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 5th Edition, © Pearson Education Limited 2010
Financial statement analysis
Undertaken by•Insiders Management•Outsiders Financial analysts
Potential/existing investors
Providers of debt finance
Ratios analysis is only one way of analysing
performance using financial statements
Slide 2.7
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 5th Edition, © Pearson Education Limited 2010
Financial statement analysis
•Cross sectional analysis•Trend analysis
Note:• it’s the interpretation that is
important•be consistent!
Slide 2.8
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 5th Edition, © Pearson Education Limited 2010
Scope of ratio analysis
Ratio analysis can be applied to financial statements and similar data in order to:
• Assess performance of a company.• Determine whether company is solvent and
financially healthy.• Assess risk attached to its financial structure.• Analyse returns generated for shareholders and
other interested parties.
Slide 2.9
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 5th Edition, © Pearson Education Limited 2010
Importance of benchmarks
Ratios must be compared with benchmarks• Pre-determined targets for ratios set by the
company, i.e. ROCE > 16%• Ratios of companies of similar size who are
engaged in similar business activities• Average ratios for business sector in which a
company operates, i.e. with industrial norms• Ratios for the company from previous years,
with data adjusted for inflation, if necessary.
Slide 2.10
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 5th Edition, © Pearson Education Limited 2010
Ratio analysis
Five broad ratio categories:• Profitability ratios• Activity ratios• Liquidity ratios• Gearing ratios• Investor ratios.
Slide 2.11
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 5th Edition, © Pearson Education Limited 2010
Profitability ratios
• Return on capital employed (ROCE) (%):profit before interest and tax × 100 capital employed
• Net profit margin (%):profit before interest and tax × 100
sales
Slide 2.12
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 5th Edition, © Pearson Education Limited 2010
Profitability ratios (Continued)
• Net asset turnover (times): sales
capital employed• Gross profit margin (%):
gross profit × 100 sales
Slide 2.13
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 5th Edition, © Pearson Education Limited 2010
Activity ratios
• Receivables’ ratio or receivables days:trade receivables × 365 credit sales
• Payables’ ratio or payables days: trade payables × 365
cost of sales
Slide 2.14
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 5th Edition, © Pearson Education Limited 2010
Activity ratios (Continued)
• Inventory days: inventory × 365
cost of sales• Cash conversion cycle (days):
Inventory days + receivables days – payables days.
Slide 2.15
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 5th Edition, © Pearson Education Limited 2010
Activity ratios (Continued)
• Non-current asset turnover (times):sales or revenue
non-current assets• Sales/net working capital (times):
sales or revenue net current assets
Slide 2.16
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 5th Edition, © Pearson Education Limited 2010
Liquidity ratios
• Current ratio (times):current assets
current liabilities• Quick ratio (times):
current assets less inventorycurrent liabilities
Slide 2.17
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 5th Edition, © Pearson Education Limited 2010
Gearing ratios
• Capital gearing ratio (%): long-term debt capital × 100
capital employed• Debt/equity ratio (%):
long-term debt capital × 100share capital and reserves
Slide 2.18
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 5th Edition, © Pearson Education Limited 2010
Gearing ratios (Continued)
• Interest coverage ratio (times):profit before interest and tax
interest charges
Slide 2.19
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 5th Edition, © Pearson Education Limited 2010
Investor ratios
• Return on equity (ROE) (%):earnings after tax and preference dividends
shareholders’ funds• Dividend per share (pence):
total dividend paid to ordinary shareholdersnumber of issued ordinary shares
Slide 2.20
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 5th Edition, © Pearson Education Limited 2010
Investor ratios (Continued)
• Earnings per share (EPS) (pence):earnings after tax and preference dividends
number of issued ordinary shares• Dividend cover (times):
earnings per sharedividend per share
Slide 2.21
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 5th Edition, © Pearson Education Limited 2010
Investor ratios (Continued)
• Price/earnings ratio (P/E ratio) (times):market price of shareearnings per share
• Payout ratio (%): ordinary dividends × 100
distributable earnings
Slide 2.22
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 5th Edition, © Pearson Education Limited 2010
Investor ratios (Continued)
• Dividend yield (%): dividend per share × 100
share price• Earnings yield (%):
earnings per share × 100share price
Slide 2.23
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 5th Edition, © Pearson Education Limited 2010
Limitations with ratio analysis
•historic summarised data•symptoms not causes•changes •accounting regulations•biased information•users ability•different definitions
Slide 2.24
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 5th Edition, © Pearson Education Limited 2010
Working capital management
• Working capital concerned with short-term resources and short-term funding
• Net working capital =Current Assets - Current Liabilities
(inventory + receivables + cash - trade payables)
• The need for liquidity must be balanced against the need for profitability.
Slide 2.25
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 5th Edition, © Pearson Education Limited 2010
Working capital policies• Policies cover level of investment in working
capital and its components, and financing of working capital.▫ inventory management▫receivables management▫payables management, and ▫cash management
• Policies should take account of nature of business, credit policy, seasonal factors and manufacturing period.
Slide 2.26
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 5th Edition, © Pearson Education Limited 2010
Inventory management
Concerned with:
•financial constraints •buying opportunities•efficiency of production• legal requirements•market and customer demands, and•obsolescence of inventory
Slide 2.27
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 5th Edition, © Pearson Education Limited 2010
Inventory managementDecision criteria:
•stock ordering model•availability of discounts•uncertainty of demand
Slide 2.28
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 5th Edition, © Pearson Education Limited 2010
Inventory management (Continued)
• Seeks to minimise cost of holding inventory for production or resale.
• EOQ model calculates optimum order size if annual demand, holding cost and ordering cost are known.
• EOQ is a deterministic model, based on certainty of demand and costs.
Slide 2.29
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 5th Edition, © Pearson Education Limited 2010
Inventory management (Continued)
Economic Order Quantity: e = √ 2cd/h
Where:
•e = economic order quantity•c = order cost per order•d = annual rate of demand•h = annual holding cost per unit
Slide 2.30
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 5th Edition, © Pearson Education Limited 2010
Cash management
• Holding cash for short-term needs will incur opportunity cost of lost profit.
Concerned with
•holding sufficient cash to meet demand
• investing cash balances to maximise return
Slide 2.31
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 5th Edition, © Pearson Education Limited 2010
• Cash flow shortages can be eased by postponing expenditure, accelerating income and finding new cash resources.
• Optimum cash levels reflect liquidity needs▫ future cash needs and borrowing capability▫ efficiency of cash management▫ tolerance of risk.
Cash management (Continued)
Slide 2.32
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 5th Edition, © Pearson Education Limited 2010
• Invest short-term cash surpluses in appropriate short-term instruments.
• Must be no risk of capital loss.• Choice of investment depends on:
▫ size of the cash surplus▫ maturity of the short-term asset▫ yield required▫ any penalties for early encashment.
Cash management (Continued)
Slide 2.33
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 5th Edition, © Pearson Education Limited 2010
Receivables management
Concerned with the trade off betweenincreasing sales and profits by offering
credit
Key issues:
•the cost of carrying receivables•the risk of individual accounts•the possible cost of bad debts, and•debt collection management costs
Slide 2.34
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 5th Edition, © Pearson Education Limited 2010
Receivables management (Continued)
• Example: MB plc has £15m per year credit sales and gives 90 days credit.
• Proposal: give 3% discount if paid in 15 days, lower credit period to 60 days.
• 60% of customers will take discount.• Sales will not be affected.• Short-term borrowing is at 20%.
Slide 2.35
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 5th Edition, © Pearson Education Limited 2010
Receivables management (Continued)
Receivables now: £15m × (90/365)= £3.7mProposed receivables:£15m × 60% × (15/365) = £0.4m£15m × 40% × (60/365) = £1.0m £1.4mDecrease in receivables: £2.3m
Slide 2.36
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 5th Edition, © Pearson Education Limited 2010
Receivables management (Continued)
Finance saving = £2.3m × 0.2 = £0.5mDiscount cost = £15m × 3% × 60% = (£0.3m)Net benefit of new policy = £0.2m• Proposal is worth implementing.
Slide 2.37
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 5th Edition, © Pearson Education Limited 2010
Payables management
Concerned with:
•obtaining satisfactory credit from suppliers
•extending credit during periods of cash shortage, and
•maintaining good relations with regular and important suppliers
Slide 2.38
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 5th Edition, © Pearson Education Limited 2010
Reading•Textbook : chapter 2, 3