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Topic 2

FINANCIAL STATEMENT EVALUATION

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OUTLINE

1. The fin.& nonfinancial objectives for org.

2. 3 key financial management3. Benefits of matching characteristics

of investment and financing in the longer term

4. Dividend decisions.5. External and internal constraint

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A.Formulation of F. Strategy 2. Evaluate the financial strategies and

objectives of an organisation and the extent of their attainment

(a) identify an organisation’s objectives in financial terms (b) evaluate the attainment of an organisation’s financial

objectives (c) evaluate current and forecast performance taking account

of potential variations in economic and business factors (d) evaluate alternative financial strategies for an

organisation taking account of external assessment of the organisation by financiers and other stakeholders, including likely changes to such assessment in the light of developments in reporting.

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Summary for Formulation of FS PART 21. Economic forces in FS formulation-int, taxes, exc

rates.2. Assessing attainment-using ratios etc.3. External assessment-credit worthiness &

compliance with agreement etc.4. Modeling & forecasting cash flow/ f. statements

given set of scenarios.5. Sensitivity to changes.6. Implications to other objectives eg. Dividends7. Current or emerging issues eg. Environmental

reporting etc.

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Evaluating financial strategies

Attainment Current using financial

ratios Forecasts forecast financial

statements: Alternatives P&L, F. Position & CF variation & fin

factors WC

management

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Performance appraisal

Ratios ExamplesProfitability Profit margin, ROE, ROCE, Assets turnover

Liquidity Current, Quick, Inventory turnover, Receivables turnover,

Gearing Capital gearing/debt ratio, interest cover

Stock market Market price, EPS, P/E ratio, earnings yield, dividend yield

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Ratio Indication

Liquidity CR, Acid Test CA/CL, C+MS+Rec/ CL ST debt paying ability

Rec TO, Rec collectionInv TO, Inv selling period

Net c.sales/A.A/R, 365/Rec TOCOGS/ A.INV, 365/Inv TO

Liquidity of assets

Profitability GPMargin Gprofit/Rev * 100 High PM is good

ROCE O.profit/Cap employed *100

Mgt efficiency in

ROE Net profit/Equity *100 generating profit

Assets TO Rev/ Cap E or Rev/ NCAssets

How much rev generated with

Gearing Cap.gearing Debt/E *100 or Debt/Debt+E*100

Measure of risks

Interest cover PBIT/Int payable Creditor protection

Debt ratio LTDebt/TA ..

MKT P/E ratio Current price/EPS Investor confidence

Earnings yield EPS/SP Future earnings power

Div yield, Div cover

DPS/SP, EPS/DPS Return & coverage

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Working capital managementWorking capital capital available to conduct day to day

operations of an entity.

Working capital management Managing of working capital is the

administration of current assets and current liabilities.

Effective management of working capital ensures that the organisation is running efficiently and therefore saving on costs.

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Liquidity vs profitability in WC managementASSETS/ LIABILITY

Benefits of Benefits of

CASH High cash levelAvailable cash for sudden surgeEasy to pay debts

Low cash levelMore cash can be invested High profitability

RECEIVABLES

Longer credit termCustomer would like, increase potential sales & profitability

shorter credit termHigh turnover, increase liquidity

INVENTORY High inventory level:Few stock outsGood for sales, profitability

Low inventory level:Less cash tied up in inventory costs, high cash liquidity

PAYABLES Taking extended creditPreserves own cash & cheap financing, high liquidityLenders may be unhappy

Adhere to termLenders are content-good relationship & few disruption

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Policies for WC management3 types of policies exist:

1. Conservative policyFunding: All permanent current assets & fluctuation in current assets are financed by long-term funding.-have large inventory.

2. Aggressive policyFunding: short term fund for all fluctuation & permanent part of current assets.-Hold minimal inventory

3. Moderate policy- In between

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Comparison between WCM approachesBenefits : Aggressive approach

Conservative approach

1. Lower level CA->lower fin costs.

1. Lower liquidity risk.

2. Lower fin const-> better profitability.

2. Greater ability to meet sudden surge in sales demand

3. Quicker cash t/over -> allow more reinvestment.

3. More relaxed credit policy may improve sales.

4. More reinvestment ->expand quickly.

***The more conservative the approach, the lower the risk, but higher the cost in terms of money tied up in working capital.

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Measuring WC cycle

Length of cycle Time between paying out cash for

purchases to receiving cash in sales, calculated as:

Av. Inv + Av. Receivables - Av. Payables

holding collection payment

period period period

***The longer the operating cycle, the more financial resources the entity needs.

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Decision on WCMDecision on WCM depends1. Industry & firms –customer expectation.2. Type of product sold- perishable vs durable3.Manufactured or. ready made manufacturing firm have higher level of inv.4. Level of sales5. Inventory management***Balancing between profitability & liquidity:Shortening o.cycle may improve liquidity but can reduce profitability

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Ways to shortened o.cycle

1. Reduce raw material stocking.

2. Obtain more financing from suppliers by delaying payments.3. Reduce WIP

4. Reduce FG Inventory

5.Reduce credit given to customers

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Overtrading (OT)

Condition when entity enters into commitment in excess of its available short term resources. This can arise even an entity is trading profitably & is typically caused by financing constrains imposed by a lengthy operating cycle or production cycle.

Undercapitalised new entities are prone to suffer from OT.

Can result in failure of a company.

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Symptoms of OT

1. Fall in liquidity ratios2. Rapid increase in revenue3. Sharp increase in Sales/non- current assets

ratio.4. Increase in inventory in relation to revenue5.Increase in A.rec6. Increase in acct. payable period7. Increase in s/term borrowing and a decline in

cash balances8. Increases in gearing9. Decrease in profit margin.

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Potential remedies for OT1. Introduce new capital

Ex. Overdraft, negotiable but can be risky, issue new shares or Long term loan

2. Reduce distribution

Not welcome by shareholders,Less salary/bonus

3.Cut cost Ex. Reduce expensesDelaying capital expenditures

4.Factoring/ discounting Acct. Receivables

Quick cash but lesser amount.

Lease or hire purchase assets

Alternatively can have a sales and leaseback agreement.

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Multinational WCM

Objectives:1. Ensure fast collection of cash2. Take longer to pay out cash3.Optimise cash flow within the entity4. Generate best return on cash

surpluses.Other risks involved:Default, interest, exchange, political

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Financing options

Long term financing

Short term financing

1. Equity 1. Bank overdraft2. Preference shares

2. Term loan

3. Loans/bonds/ sukuk

3. Money market borrowings4. Revolving credit facilities5. Supplier credits, supply chain financing6. CP, debt factoring