Business

Finance
BRAINNEST
ROBINA BUKHARI
 Financial Statements

• Balance Sheet
• Assets
• Current and non Current
• Working Capital (ref slide #5)
FINANCIAL • Liabilities
• Equity
PLANNING & •
•
Income Statement
Owner’s Equity Statement
• Cash Flow Statement
CONTROL
• Market Information
(Financial The par value of the ordinary shares is EUR0.10 per share, so as at 31 December 20X2
there were 224,150,000 shares in issue. The share price on 31 December 20X2 was

Fundamentals) EUR1.50, and on 31 December 20X1 it was EUR1.20.

• Miscellaneous;
1. ‘Receivables’ is an equivalent term to ‘Debtors’
2. ‘Inventory’ is an equivalent term to ‘Stock’
3. ‘Payables’ is an equivalent terms to ‘Creditors’
FINANCIAL
PLANNING &
CONTROL
(Financial
Fundamentals)
FINANCIAL
PLANNING &
CONTROL
(Financial
Fundamentals)
 1. Working Capital
• Current Asset- Current Liabilities
• It is the investment that has to be made in the company in order for it
to trade normally.
• the classic ‘asset conversion cycle’ that can be summed up as

FINANCIAL 2.
inventories plus receivables less payables.

Capital Employed

PLANNING & • Total Equity +Net Debt

Total Equity= Share capital +reserves +share premium + Retained
CONTROL Earning
• When calculating these ratios the equity value may be taken as either
the book value or as the market value
(Financial • When the ratios are used for financial decision making purposes
(such as project evaluation) it is usual to take market values for both
debt and equity when calculating these ratios, Thus in this context
Fundamentals) ‘equity’ means market capitalisation
• when used in start up situations such as leveraged buy outs and
when monitoring compliance with financial covenants it is always the
accounting (‘book’) values of debt and equity that are used Loan
documents commonly include performance measures called
‘financial covenants’.
 1. Net Debt

• Total Debt – Cash and cash Equivalent

• Total Debt= Current + Non-Current Borrowings

2. Gearing & Leveraging

FINANCIAL • Gearing and leverage measure how much of the company is financed by debt and is a
very quick way of assessing the financial risk of the business.
PLANNING & •
•
high gearing together with variable profits are a risky combination
Most companies should usually benefit from an element of debt in their capital

CONTROL •
•
structure (subject to availability and cost of debt, e.g. in the credit crunch)
Debt is cheaper than equity
Also, the interest on debt is tax deductible

(Financial
Fundamentals)
 Financial Ratios

• Financial statements provide a common format for the

FINANCIAL assessment of businesses but are difficult to read in their raw
form. Financial ratios allow interpretation of financial statements,
PLANNING & to get a better understanding of the financial health of a
business.
CONTROL • Ratios can be applied historically and to budget or forecast

(Financial accounts and can be useful both to internal and external

analysts of the business

Ratio • For internal purposes, ratios can be useful in planning, setting

goals, and evaluating the performance of managers.
Analysis and • External users of financial information use ratios to decide
Financial whether to extend credit (for example whether to provide a bank
loan), to decide whether to invest in the company and to monitor
Profiling) and to forecast financial performance.
 Key ratios and performance measures

Performance measures:
FINANCIAL • Return on capital employed (ROCE)
Operating Profit/ Capital Employed(Share Capital and reserves Plus net debt)
TIP:

PLANNING & ROCE must be

more than the
average risk
adjusted rate of

CONTROL return required by

capital providers
if shareholder
value is to be

(Financial created.
Strictly, operating
profit should be
suitably adjusted

Ratio for tax, as will

become apparent
when studying
Shareholder

Analysis and Value Analysis.

The capital
employed figure
should be close to

Financial • Operating profit margin and asset turnover

market values for
the ROCE
calculation to be
meaningful.

Profiling) Operating profit margin: operating profits  revenue

Asset turnover: revenue  capital employed

Multiplying the two ratios together gives the formula for ROCE because the revenue
figures cancels out.
 • Operating profit margin and asset turnover

FINANCIAL
PLANNING &
CONTROL
(Financial
Ratio
Analysis and • Return on equity
Profit for the year  total equity

Financial TIP:
it is measured post-
interest, thus stripping

Profiling) out debt providers’

rewards and is post-
tax so that the net
return on total equity
can be seen .
 Liquidity and solvency ;
• Debt/ EBITDA
Net Debt  Earnings before Interest, Tax, Depreciation and Amortisation

FINANCIAL
PLANNING &
CONTROL
(Financial
Ratio
Analysis and
Financial
Profiling)
 Liquidity/solvency

• Current ratio
FINANCIAL Total current assets  total current liabilities

PLANNING &
CONTROL
(Financial
Ratio
• Acid test (‘Quick’ ratio)
Analysis and Total current assets less inventory  current liabilities

Financial
Profiling)
 Liquidity/solvency

• Working capital
FINANCIAL It is the investment that has to be made in the company in order for it to trade
normally. For a manufacturer that means the investment to buy and stock raw
materials in order to complete the manufacturing process and to be able to wait for
PLANNING & the final customer to pay his invoice
– the classic ‘asset conversion cycle’ that can be summed up as inventories plus
receivables less payables.
CONTROL
(Financial
Ratio
Analysis and
Financial • Trade receivable days / Trade payables (liability) days
Trade receivable days: Trade receivables  average sales per day (sales/365)
Trade payables days: trade payables  average cost of sales per day
Profiling) • Inventory days
Inventory  cost of sales per day (cost of sales/365)

Capital Structure ; Gearing/leverage

Gearing: Debt  Equity or Leverage: Debt  (Debt + Equity)
 Tip:
When calculating
these ratios the
• Capital Structure: - Gearing/leverage equity value may be
taken as either the
Gearing: Debt  Equity or Leverage: Debt  (Debt + Equity) book value or as the

FINANCIAL market value.

• for financial
decision making
purposes (such

PLANNING & as project

evaluation) it is
usual to take
market values

CONTROL for both debt

and equity.
Thus. equity’
means market

(Financial capitalisation,
rather than
shareholders’
funds

Ratio • However, for

start up
situations such
as leveraged

Analysis and buy outs,

monitoring
compliance with
financial

Financial covenants it is
always the
accounting
• Interest cover
Profiling) Earnings (Profit) before interest and tax (EBIT)  interest charge
(‘book’) values
of debt and
equity that are
used coz of the
Earnings (Profit) before interest, tax depreciation and amortisation (EBITDA)  volatility
attached to mkt
interest charge data.
• A ratio of less than 2, however, is likely to raise the risk of difficulties for nearly all businesses
 Shareholder and market measures;
• Earnings per share (EPS)
Profit attributable to ordinary shareholders  weighted average number of
FINANCIAL shares in issue during the year

PLANNING &
CONTROL
(Financial
Ratio • Dividend cover
Profit attributable to ordinary shareholders  dividends
Analysis and
Financial
Profiling)
 Shareholder and market measures

• Dividend yield
FINANCIAL Dividend per share  current share price

PLANNING &
CONTROL
(Financial
Ratio
Analysis and
Financial
Profiling) An actual or potential investor in a company will want to know what return on their
investment they will receive.
 Shareholder and market measures

• Price to earnings ratio, (P/E, PER)

FINANCIAL Current share price  earnings per share

PLANNING &
CONTROL
(Financial
Ratio A high P/E ratio (relative to the stock market average) indicates that the market expects
relatively rapid growth in earnings from the company.
• Market/book ratio
Analysis and Market value of the company’s equity  Total equity

Financial
Profiling)
 Financial Profiling

The term ‘financial profiling’ means the selective use of financial data, ratios and other
FINANCIAL measures to summarise the key characteristics of a business. Essential includes;

• Analyse changes and trends over a number of reporting periods.

PLANNING & • Analyse the relationships between the changes in related ratios.

CONTROL • Compare ratios with appropriate benchmark figures, including those for other firms
in similar business sectors.

(Financial • Gain a thorough understanding of the non-financial characteristics of the business.

Ratio • Link the financial ratio analysis with the analysis of the non-financial characteristics
of the business

Analysis and A financial profiling framework will have broad headings for investigation in order to
produce an integrated picture of the financial performance of the company.
Those headings might include:
Financial • Sales growth
• Profitability and cost structure
Profiling) •
•
Capital intensity: Working capital and fixed capital
Extent of capital expenditure: Historic and expected future
• Capital structure
 Financial Profiling

To demonstrate the point about profiling, contrast the two following

FINANCIAL descriptive summaries of the same company:

PLANNING & a) The current and quick ratios stand at 0.9 and 0.1 respectively,
demonstrating poor liquidity. Stock days stand at 15 and creditor
CONTROL days at 45. Gearing is on the high side with a debt/equity ratio
of 80%. Profit margins are low at 8%, pre-tax return on capital is

(Financial 20% and after-tax return on equity is 25%. EPS increased by

20% last year.
b) This fast-growing retailer has maintained a satisfactory cash flow
Ratio balance, between cash generated from operations and cash
consumed by capital expenditure, assisted by a lag in tax
Analysis and payments. Margins are low, typical for this sector, but return on
assets is good, partly because of the better than average control
Financial of stocks and the use of creditors. Working capital intensity is
low, which strengthens cash flow.
Profiling)
 Financial Profiling

To be cont. for b)Fixed capital intensity is high because of freehold

FINANCIAL properties; borrowing is comfortably secured by the fixed charge on
the properties, given the high quality and conservative valuation of
PLANNING & the freeholds. In addition, interest is well covered. The P/E ratio of
20 reflects continuing growth expectations for this low-yielding
CONTROL stock.

(Financial Summary:
Note that (b) demonstrates that the analyst is not merely reporting
Ratio the results of calculations – but is applying those results to the type
of business being analysed, incorporating a general understanding
Analysis and of what the business is and how it works, Clearly the summary in
(b) is more useful than that in (a).
Financial
Profiling)
 Financial Profiling (Example)

Here is a normalised set of data for 4 companies. The data is set out in three groups;
FINANCIAL the P&L Account shows staff cost, profitability and interest cost as a proportion of sales
the balance sheet shows a selection of balance sheet items all as a proportion of total
assets
PLANNING & a selection of ratios

CONTROL The four companies are:

1. an integrated oil company

(Financial 2. a pharmaceutical company

3. a food processor and
4. a water utility

Ratio Try to determine which is which before going on to the solution to see how the evidence
is tailored to the relevant characteristics of the businesses involved.

Analysis and Company 1 Company 2 Company 3 Company 4

Financial P&L Account

Sales

Staff Costs
100.0%

3.4%
All as % Sales

100.0%

13.4%
100.0%

14.0%
100.0%

26.8%

Profiling) PBIT

Interest Paid
9.9%

0.4%
34.3%

14.0%
7.1%

1.0%
30.8%

3.5%

PBT 9.5% 20.2% 6.1% 27.3%

 Financial Profiling (Example)

Balance Sheet All as % Total Assets

FINANCIAL Land & Buildings

Plant & Equipment
2.1%
43.1%
34.4%
39.1%
18.5%
20.5%
15.3%
9.3%

PLANNING & Stock

Debtors
Creditors
7.4%
15.5%
17.7%
0.6%
4.4%
7.5%
15.1%
12.4%
15.6%
10.3%
15.9%
15.4%

CONTROL ST Debt
LT Debt
Shareholders’ Funds
6.9%
7.7%
40.4%
9.8%
37.2%
31.1%
7.6%
8.9%
56.2%
2.4%
38.7%
21.1%

(Financial Total Ass/Liabilities 100.0% 100.0% 100.0% 100.0%

Ratio Ratios
Sales/Total Assets
Sales / Employee (£'000s)
158.2%
1,915.4
22.9%
272.5
102.5%
96.2
61.8%
240.8

Analysis and Staff Costs/Employee (£'000s)

PBIT / Employee (£'000s)
65.2
189.6
36.6
93.3
13.5
6.8
64.5
74.2

Financial PBIT % Sales

PBIT % Cap Employed
9.9%
28.5%
34.3%
10.0%
7.1%
10.0%
30.8%
30.6%

Profiling)
P&E % Sales 27.3% 170.9% 20.0% 15.0%
P&E/Employee (£'000s) 522.1 465.7 19.2 36.0
Working Capital % sales 3.3% -10.7% 11.6% 17.4%
Debt % Capital Employed 26.5% 60.2% 22.7% 66.1%
P/E Ratio 15.0 17.4 17.9 13.8
Market Cap % Book value 227% 98% 127% 771%
 Financial Profiling (Example)
Solution

FINANCIAL Company 1: Integrated Oil

PLANNING & Picture an oil refinery and the impression is of a very capital intensive business with a
high value product flowing through the plant with relatively little human intervention.
Translating that into what we see from the financial picture we get the following.

CONTROL The integrated oil business has highest proportion in our sample of plant and
equipment in the balance sheet and asset turnover is very high at 158%, in other words
(Financial we have a lot of plant and equipment, but the value of sales going through that plant in
a year is even more valuable. The relatively few staff is reflected in staff costs that are
low as a percentage of sales, but high as a cost per employee. Sales per employee are
Ratio very high at £1.9m.

Given what we know about the way the business works, the working capital % sales
Analysis and ratio is kept to a low level by offsetting stock and debtors with high creditors.

Financial Given what we know about the profitability of the business, PBIT % sales is relatively
modest at 9.5% but the market/book ratio is good at over 200% showing that the
market values their assets highly – they are generating value.

Profiling)
 Financial Profiling (Example)

Company 2: Water Utility

FINANCIAL Picture the assets of a water utility – reservoirs, land and water treatment plants.
Again, there is a lot of value there, but compared with an oil company, less capital
PLANNING & intensive and with a lower value product. This is exactly what we see: the highest
proportion of land and buildings in our sample, high plant and equipment with only a

CONTROL fraction of the asset turnover of the other high P&E business, integrated oil.
Again, we expect relatively few staff so sales/employee and profit/employee should be
high. Other ‘per employee’ measures also show that staff here are lower paid than oil

(Financial refinery staff, as expected, but still generate good profitability.

From what we know about the water business, we know that most people pay their bills
Ratio by direct debit on time and so we should expect debtors to be low, with low value stock
(mostly water!) but given the power of the company over its suppliers we should expect
some creditors. What we actually see is just that: working capital is highly negative (-
Analysis and 10.7% of sales) with low debtors and almost no stock.
We would also expect a utility business to be very stable, allowing high gearing; this is
the highest geared of our sample with 48% of the balance sheet in short or long term
Financial debt. High gearing and a stable business do go together, but with price regulation for
the long term the need to have the lowest cost of capital is paramount. The issues here

Profiling) will be covered later in this manual.

The low market/book ratio of just under 1 seems to give the market’s view that, with
utility price regulation, it will be really hard to generate real value here.

The giveaway for any “pure” utility is the very low market risk – the business is very
stable – but that is an issue for later in this manual. The measure to show market
 Financial Profiling (Example)
risk (not given here) is called ‘beta’ and it will be covered later in this manual. It is a

FINANCIAL major factor in the cost of equity.

Company 3: Food processing

PLANNING & This is perhaps the hardest to characterise of the sample. Picturing the business
seems harder because it is less outstanding in any single area – you probably wouldn’t
CONTROL notice a factory as you drove past it. But we know that there is likely to be a lot of
relatively low value machinery to put peas in tins or boiling baked beans and canning
them. There will be quite a few staff about who are likely to be relatively low paid.
(Financial Finally, of the sample, this is likely to be the business with least market power relative to
its buyers (who may be mainly supermarkets or other large retailers). This would
indicate that they will be restricted to medium profitability because they will always be
Ratio under pressure on price.

Analysis and T his is reflected in the relatively high stock levels and debtors suggesting that their
customers have significant power resulting in the need to hold stocks of a wide product
mix available for call-off.

Financial Plant and equipment is the lowest of this sample. Staff costs at 14% of sales translate
to £13,500 per employee, again the lowest of the sample.
Profiling) The market/book ratio shows that modest profitability / value creation is expected to
continue.
 Financial Profiling (Example)

Company 4: Pharmaceuticals
FINANCIAL When we think of the big pharmaceutical companies, we think of
PLANNING & marketing and drug research expenditure rather than big factories.
This is reflected here with lowest level of plant and equipment of the
sample. We also think of high profitability and highly qualified staff,
CONTROL mainly research scientists, and what we see is a high staff cost as a
proportion of sales and the highest profitability on sales.
(Financial
Because of their need to hold stocks and the nature of their buyers,
Ratio there is high stock and debtors that are not offset by
correspondingly high creditors, but then their purchases are not
Analysis and likely to be high value. The result is a very high level of working
capital.
Financial The market / book ratio confirms that this is a high value creation
Profiling) business, the highest of the sample.
 Profit measures

Although profits do matter, they are not the best measure of a company’s
achievements.

(a) Accounting profits are not the same as ‘economic’ profits. Accounting
profits can be smoothed to some extent by choices of accounting policies. For
example:

FINANCIAL - Provisions, such as provisions for depreciation or anticipated losses

- The capitalisation of various expenses, such as development costs.

PLANNING & (b) Profit does not take account of risk. Shareholders will be very interested in
the level of risk, and maximising profits may be achieved by increasing risk to
CONTROL unacceptable levels.

(c) Profits on their own take no account of the volume of investment that it
has taken to earn the profit. Profits must be related to the volume of
investment to have any real meaning.

(d) Profits are reported every year (with half-year interim results for quoted
companies). They are measures of short-term historic performance, whereas
a company’s valuation is commonly judged by considering its future
performance potential.
FINANCIAL PLANNING &
CONTROL
Other financial targets

In addition to targets for earnings, EPS and dividend per share, a company might set other financial targets, such as:

(a) A restriction on the company’s level of gearing, or debt. For example, a company’s management might decide:

(i) The ratio of long-term debt capital to equity capital should never exceed, say, 1:1.

(ii) The cost of interest payments should never be higher than, say, 25% of total profits before interest and tax.

(b) A target for profit retentions. For example, management might set a target that dividend cover (the ratio of distributable profits to dividends
actually distributed) should not be less than, say, 2.5 times.

(c) A target for operating profitability. For example, management might set a target for the profit/sales ratio (say, a minimum of 10%) or for a return
on capital employed (say, a minimum ROCE of 20%).

These financial targets are not primary financial objectives, but they can act as subsidiary targets or constraints which should help a company to
achieve its main financial objective without incurring excessive risks. They are usually measured over a year rather than over the long term.

Remember, however, that short-term measures of return can encourage a company to pursue short-term objectives at the expense of long-term
ones, for example by deferring new capital investments, or spending only small amounts on research and development and on training. A major
problem with setting a number of different financial targets, either primary targets or supporting secondary targets, is that they might not all be
consistent with each other. When this happens, some compromises will have to be accepted.
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