Financial strategy

formulation

Prepared by: Shahria Khalid-Mautante, MS FS, MBM

Assessing corporate performance
1.1 Ratios
Profitability ratios
Profitability ratios are a class of financial measurements
that are used to evaluate a company's capacity to generate profits
in relation to its revenue, operating costs, balance sheet assets, or
shareholders' equity over time.
PBIT
Return on Capital Employed (ROCE) =
Capital employed

Capital employed = Shareholders' funds plus payables: amounts

falling due after more than one year plus any long-term provisions
for liabilities and charges = Total assets less current liabilities
Assessing corporate performance
When interpreting ROCE look for the following.
● How risky is the business?
● How capital-intensive is it?
● What ROCE do similar businesses have?
● How does it compare with current market
borrowing rates; is it earning enough to be able to
cover the costs of extra borrowing?
Return on equity (ROE) is the measure of a company's net income
divided by its shareholders' equity.

Net Income
Return on equity =
Shareholders ‘equity
This gives a more restricted view of capital than ROCE, but the same
principles apply.

Net Sales
Asset turnover =
Average total Assets
This measures how efficiently the assets have been used. Amend to just
non-current assets for capital-intensive businesses
Net profit margin

• Sales expenses in relation to sales levels

• Administrative expenses, including salary levels
• Distribution expenses in relation to sales levels

Liquidity ratios

Current ratio
Current asset
Current ratio =
Current liabilities

Quick ratio (acid test)

Current assets - inventory
Quick ratio (acid test) =
Current liabilities

Payables payment period

Trade payables
Payables payment period =
Purchases
Cash operating cycle
= Average time raw materials are in inventory
– Period of credit taken from suppliers
+ Time taken to produce goods.
+ Time taken by customers to pay for goods.
Reasons for changes in liquidity
• Credit control efficiency altered.
• Altering the payment period of suppliers as a source
of funding
• Reducing inventory holdings to maintain liquidity.
Shareholders investment ratios

Dividend per share

Dividend yield = % 100
Market price per share

The dividend yield is generally less than the interest yield.

Shareholders will expect price rises and wish for returns
(dividends + capital gains) to exceed the return investors
get from fixed-interest securities.
Shareholders investment ratios

Dividend per share

Dividend yield = %
Market price per share

The dividend yield is generally less than the interest yield. Shareholders will expect price rises and wish for returns (dividends
+ capital gains) to exceed the return investors get from fixed-interest securities.

Profits distributable to ordinary shareholders

Earnings per share (EPS) =
Number of ordinary shares issued

Investors look for growth; earnings levels need to be sustained to pay dividends and invest in the business. For comparisons
over time to be valid, there must be a consistent basis for calculation. EPS can be manipulated.

Debt-to-equity ratio
Total Debt
Debt to equity ratio =
Shareholders’ Equity
 Uses of ratio analysis
The key to obtaining meaningful information from ratio analysis is a
comparison: comparing ratios over time within the same business to establish
whether the business is improving or declining and comparing ratios between
similar businesses to see whether the company you are analyzing is better or
worse than average within its business sector.
A vital element in effective ratio analysis is understanding the needs of the
person for whom the ratio analysis is being undertaken.
(a) Investors will be interested in the risk and return relating to their investment,
so will be concerned with dividends, market prices, level of debt vs equity, etc.
(b) Suppliers and lenders are interested in receiving the payments due to them,
so will want to know how liquid the business is.
(c) Managers are interested in ratios that indicate how well the business is being
run, and how the business is doing in relation to its competitors.
about
1.1.2 Limitations of ratio analysis Although ratio analysis can
be a very useful technique, it is important to realize its
limitations.
(a) Availability of comparable information
(b) Use of historical/out-of-date information
(c) Ratios are not definitive
(d) Need for careful interpretation
(e) Manipulation
(f) Other information
1.1.3 Other information as well as ratios, and other financial and non-
financial information can give valuable indicators of a company's
performance and position.
(a) The revaluation of non-current assets
(b) Share capital and reserves
(c) Loans and other liabilities
(d) Contingencies
(e) Events after the statement of financial position date
Trends
The use of trends is a popular method of assessing corporate performance. This allows
users to spot significant changes in major financial categories such as non-current assets and
revenue.
2. Other information from companies' accounts
As well as ratios, other information can be used to analyze a company's performance
and identify possible problem areas. This will include information relating to non-current
assets and financial obligations, contingencies, and events after the reporting period.
2.1. The revaluation of non-current assets
Non-current assets may be stated in the statement of financial position at cost less
accumulated depreciation. They may also be revalued from time to time to a current market
value to avoid understatement of current value. When this happens:
(a) The increase in the statement of financial position value of the non-current asset is matched
by an increase in the revaluation reserve.
(b) Depreciation in subsequent years is based on the revalued amount of the asset, its
estimated residual value, and its estimated remaining useful life
2.2. Share capital and share issues.
The capital and reserves section of a company's accounts contains information that appears to be mainly
the concern of the various classes of shareholders. However, because the shareholders' interest in the business acts
as a buffer for the creditors in the event of any financial problems, this section is also of some importance to creditors.

2.3. Financial obligations

The financial obligations of a company may also be significant, and the timescale over which these
become or could become repayable should be considered.
Examples are: (a) Levels of redeemable debt
(b) Earn out arrangements
(c) Potential or contingent liabilities, such as liabilities under unresolved legal cases or insurance
claims
(d) Long-term commitments (eg the Private Finance Initiative in the UK)

2.4. Debentures, loans, and other liabilities

Two points of interest about debentures, loans, and other liabilities are:

• Whether or not loans are secured

• The redemption dates of loans
For debentures and loan stock which are secured, the details of the security are usually included in the terms of a trust
deed. Details of any fixed or floating charges against assets must be disclosed in a note to the accounts.
In analyzing a set of accounts, particular attention should be paid to some significant features concerning
debenture or loan stock redemption. These are:
(a) The closeness of the redemption date would indicate how much finance the company must find in the
immediate future to repay its loans. It is not unusual, however, to repay one loan by taking out another, so a
company does not necessarily have to find the money to repay a loan from its own resources.
(b) The percentage interest rate on the loans being redeemed, compared with the current market rate of interest.
This would give some idea, if a company decides to replace loans by taking out new loans, of the likely
increase (or reduction) in interest costs that it might face, and how easily it might accommodate any interest
cost increase.
2.5 Contingencies
Contingencies are conditions that exist at the balance sheet date where the outcome will be confirmed only
on the occurrence or non-occurrence of one or more uncertain future events.
Contingencies can result in contingent gains or contingent losses. The fact that the condition exists at the
statement of financial position date distinguishes a contingency from a post-balance sheet event.
Some of the typical types of contingencies disclosed by companies are as follows:
• Guarantees were given by the company.
• Discounted bills of exchange
• Uncalled liabilities on shares or loan stock
• Lawsuits or claims pending
• Tax on profits where the basis on which the tax should be computed is unclear.
2.6 Events after the reporting period
Events after the reporting period are those events both favorable and unfavorable which occur between the
statement of financial position date and the date on which the financial statements are approved by the board of
directors.

3. Optimal capital structure

3.1 The capital structure decision
Suppose that a company has decided to expand its operations and has decided that the expansion will take
place through organic growth rather than by acquiring another company. The company has therefore decided to expand
its operation by increasing its productive capacity. This entails investment in plant and machinery. The increase in
productive capacity needs to generate cash flows that will increase the value of the firm.

3.2 Sources of finance

The main sources of finance for corporations are:
(a) Retained earnings
(b) Proceeds from the issue of new ordinary shares to existing or new shareholders
(c) Proceeds from a flotation of a company
(d) Preference shares
(e) Debt
3.3 The choice between debt and equity
3.3.1 Advantages of debt

a. Debt is a cheaper form of finance than shares, as debt interest is tax deductible in most tax
regimes.

b. Debt should be more attractive to investors because it will be secured against the assets of the
company.

c. Debtholders rank above shareholders in the event of a liquidation.

d. Issue costs are normally lower for debt than for shares.

e. There is no immediate change in the existing structure of control, although this may change
over time if the bonds are convertible to shares.

f. There is no immediate dilution in earnings and dividends per share.

g. Lenders do not participate in high profits compared with shares.

3.3.2 Disadvantages of debt
a) Interest must be paid on a debt no matter what the company's profits in a year are. In
particular, the company may find itself locked into long-term debt at unfavorable rates of
interest. The company is not legally obliged to pay dividends.

b) Money must be made available for redemption or repayment of debt. However, redemption
values will fall in real terms during a time of inflation.

c) Heavy borrowing increases the financial risks for ordinary shareholders. A company must
be able to pay the interest charges and eventually repay the debt from its cash resources,
and at the same time maintain a healthy balance sheet that does not deter would-be
lenders. There might be insufficient security for a new loan.

d) Shareholders may demand a higher rate of return because an increased interest burden
increases the risks that dividends will not be paid.

e) There might be restrictions on a company's power to borrow. The company's constitution

may limit borrowing. These borrowing limits cannot be altered except with the approval of
the shareholders at a general meeting of the company. Trust deeds of existing loan stock
may limit borrowing. These limits can only be overcome by redeeming the loan stock risk
3.4 Debt instruments
3.4.1 Types of corporate debt
(a) Debentures are secure loan capital secured either by a floating charge on all assets of the company or by a fixed
charge on specific assets of the company.
(b) Unsecured loan stock is a debt that is not secured on any of the assets of the company, and it carries a higher
interest.
(c) Deep discount bonds are bonds offered at a large discount on the face value of the debt so that a significant
proportion of the return to the investor comes by way of a capital gain on redemption, rather than through interest
payment.
(d) Zero coupon bonds are bonds offering no interest payments, all investor returns being gained through capital
appreciation. They are issued at a discount to their redemption value, and the investor gains from the difference
between the issue price and the redemption value.
(e) Convertible unsecured debt is a debt instrument that gives the option to the holder to convert them into equity at
some time in the future at a predetermined price.
(f) Mezzanine debt is debt with conversion options. It is a subordinated debt because it ranks in terms of seniority of
claims below straight debt like debentures and it requires a higher rate of return. Mezzanine debt is the preferred way of
financing leveraged buy-outs.
(g) Leasing is used for the financing of certain assets such as buildings, ships and aircraft.
(h) Eurobonds are bonds denominated in a currency other than that of the issuer, usually dollar, yen or euro, and trade in
the international financial markets.
3.4.2 Trust deed
A loan note (or debenture) is a written acknowledgment of a debt by a company, usually given
under its seal and normally containing provisions as to payment of interest and the terms of repayment of
principal. A loan note may be secured on some or all the assets of the company or its subsidiaries.
A trust deed would empower a trustee (such as an insurance company or a bank) to
intervene on behalf of loan note holders if the conditions of borrowing under which the debentures were
issued are not being fulfilled. This might involve:
(a) Failure to pay interest on the due dates
(b) An attempt by the company to sell off important assets contrary to the terms of the loan
(c) A company taking out additional loans and thereby exceeding previously agreed borrowing limits
established either by its constitution or by the terms of the loan note trust deed (a trust deed might
place restrictions on the company's ability to borrow more from elsewhere until the loan notes have
been redeemed)
3.4.3 Issuing corporate bonds
A company that wants to issue corporate bonds will need to appoint an investment bank as the
lead manager. The lead manager in turn sets up an underwriting syndicate which purchases the entire
issue at an agreed price. The price reflects the coupon of the bond and the credit rating of the bond. The
syndicate will then sell the issue to final buyers who are normally clients of the investment banks involved
or other investment banks.Corporate Bonds
3.5 Preference shares
3.5.1 Characteristics of Preference Shares
Preference shares carry priority over ordinary shareholders with regard to dividend payments.
They do not carry voting rights. They may be attractive to corporate investors, as (unlike interest
receipts) dividends received are generally not subject to tax. However, for the issuing company,
dividend payments (unlike interest payments) are generally not tax deductible.
Preference shares are shares carrying a fixed rate of dividends, the holders of which, subject
to the conditions of issue, have a prior claim to any company profits available for distribution. They
are an example of prior charge capital.

3.5.2 Types of Preference Shares

Cumulative preference shares are preference shares where any arrears of dividends are
carried forward. When eventually the company decides to pay a dividend, the cumulative preference
shareholders are entitled to all their arrears before ordinary shareholders are paid a dividend.
Participating preference shares are shares that have an additional entitlement to dividends
over and above their specified rate. Participating preferred shareholders are entitled to participate
along with ordinary shareholders in available profits, normally once the ordinary shareholders have
themselves received a specified level of dividend.
Convertible preference shares are shares that can be converted into ordinary shares
about
3.5.3 Advantages and disadvantages of preference shares
From the company's point of view, preference shares have some positive features.

(a) Dividends do not have to be paid in a year in which profits are poor, while this is not the case with interest
payments on long-term debt.
(b) Since they do not normally carry voting rights, preferred shares avoid diluting the control of existing shareholders,
while an issue of equity shares would not.
(c) Unless they are redeemable, issuing preference shares will lower the company's gearing. Redeemable preference
shares are normally treated as debt when gearing is calculated.
(d) The issue of preference shares does not restrict the company's borrowing power, at least in the sense that
preferred share capital is not secured against assets of the business.
(e) The non-payment of dividend does not give the preferred shareholders the right to appoint a receiver, a right
which is normally given to debenture holders.
From the point of view of the investor, preference shares are less attractive than loan stock because:
a) They cannot be secured on the company's assets.
b) The dividend yields traditionally offered on preferred dividends has been much too low to provide an attractive
investment compared with the interest yields on loan stock in view of the additional risk involved.
c) Dividend payments on preference shares may not be tax deductible in the way that interest payments on
debt are. Furthermore, for preference shares to be attractive to investors, the level of payment needs to be higher
than for interest on debt to compensate for the additional risks
3.5.4 Cost of preference shares
The key feature of preference shares is the constant interest that they pay to investors. The cost of preference shares
should therefore be calculated in the same way as the cost of corporate bonds.
3.6 Retained earnings.
Advantages of using retentions
Retentions are a flexible source of finance; companies are not tied to specific amounts or specific repayment patterns.
Using retentions does not involve a change in the pattern of shareholdings.
Disadvantages of using retentions
Shareholders may be sensitive to the loss of dividends that will result from retention for reinvestment, rather than
paying dividends.
3.6.1 Cost of retained earnings.
Retained profits are not a cost-free method of obtaining funds. There is an opportunity cost in that if
dividends were paid, the cash received could be invested by shareholders to earn a return. The cost of retained earnings
is the rate of return that stockholders require on equity capital that the company has obtained by retaining profits.

The shareholders could have received these earnings as dividends and invested them elsewhere, therefore
the company needs to earn at least as good a return as the investors could have received elsewhere for comparable risk.
If the company cannot achieve this return, it should return the funds to the shareholders and let them invest them
elsewhere.
3.7 Cost of equity. 4. Dividend policy
There are three alternatives for calculating the 4.1 Is dividend policy irrelevant?
cost of retained earnings.
(a) Theoretical models such as the Capital The dividend policy of a company
Asset Pricing Model (CAPM) or the refers to the decision taken by the
Arbitrage Pricing Theory (APT) management of the company about
(b) The bond yield plus premium approach. how much of a company's earnings
This is a model used where analysts do not will be distributed to shareholders
have confidence in the CAPM or the APT and how much will be retained within
approach; they instead simply add a the firm.
judgmental risk premium to the interest rate
on the firm's own long-term debt
(c) Market-implied estimates using variants of
the discounted cash flow approach;
however, this model is based on
assumption on the growth rate of earning
of the company.
4.2 Ways of paying dividend
4.3 Dividend capacity
Companies have many ways of returning money to the
shareholders. The main ones are: The dividend capacity of a
(a) Cash dividends. This is the most common way of paying corporation determines how much of
dividends by corporations. These dividends are paid in a company's income can be paid out
cash, usually quarterly. Companies can declare both as dividend. The dividend capacity of
regular and 'extra' dividends. Regular dividends usually the company is also known as the
remain unchanged in the future, but 'extraordinary' or
free cash flow to equity (FCFE).
'special' dividends are unlikely to be repeated.
(b) Dividends in the form of shares. These are paid instead
of cash dividends by allocating shares of equivalent value
to existing shareholders. Shareholders receive new
shares in the corporation in the form of a dividend. Like a
'share split', the number of shares increases, but no cash
changes hands.
(c) Share repurchases. This is an alternative way to
distribute cash to shareholders. The firm buys back its
shares. This can be done on the open market, by tender
offer, or by buying stock from major shareholders. Cash
dividends
4.4 Theories of dividend policy
The Modigliani and Miller argument that dividend policy is irrelevant should have led to a random pattern
of dividend payments. In practice, dividend payments tend to be smoothed over time. In this section, we review
some of the reasons that have been put forward as explanations for the payment of dividends.

4.4.1 The residual theory of dividend payments

According to this theory, firms will only pay dividends if all the profitable investment opportunities have
been funded. This theory assumes that internal funds are the cheapest source of financing, and the company
will resort to external financing only if the available internal funds and current and retained earnings have been
exhausted.

4.4.2 Target payout ratio

According to the target payout theory, companies pay out as dividends a fixed proportion of their
earnings. Firms have long-run target dividend payout ratios.
(a) ture companies with stable earnings usually have a higher dividend payout ratio than growth companies.
(b) Managers focus more on dividend changes than absolute amounts.
(c) Transitory changes in earnings usually do not affect dividend payouts.
(d) Only long-term shifts in earnings can be followed by changes in dividends.
(e) Managers are reluctant to change dividend payout ratios due to the potential signals that such changes
may send to the markets.
4.4.3 Dividends as signals
Dividends can be used to convey
good (or bad) information. A firm that
increases its dividend payout ratio may be
signaling that it expects future cash flows
to increase, as this ratio tends to remain
steady over time. Bad firms can also
increase dividends to try to convince the
markets that they too are expecting
increased future cash flows. However, this
increase may be unsustainable if the
promised increases do not occur and the
inevitable reduction in dividend payout ratio
will mean heavy penalties from the
markets.Signals
4.4.4 Agency Theory
Dividend payments can be an
instrument to monitor managers.
When firms pay dividends, they often
need to subsequently go to the capital
markets to fund the projects. When
firms go to the financial markets, they
will be scrutinized by different market
participants. For instance, investors
will require an analysis of the
creditworthiness of the firm.
Companies often announce dividend
payments in conjunction with trying to
raise new capital.
4.4.5 Dividends and taxes
A final theory explaining dividend payments is based on the presence of
different corporate and personal taxes on one hand and of different income and
capital gains taxes on the other. Modigliani and Miller assume that there are no
personal taxes. Taxes on dividends (ordinary income) are higher than taxes on capital
gains. Thus, under the presence of personal taxes, companies should not pay
dividends because investors require a higher return from companies that pay
dividends. If payments are to be made to shareholders, the company should opt for
other alternatives, such as share repurchases. This is true if taxes on dividend income
are higher than taxes on capital gains.

5 Risk management
Risk management is the process through which the company determines the
risk/return combination that is consistent with the company's risk appetite. Risk
management requires the identification, measurement, and transfer of risks.
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