Lecture+2+Understanding+and+Analysing+Financial+Statements+11 12
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Transcript of Lecture+2+Understanding+and+Analysing+Financial+Statements+11 12
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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
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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
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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
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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
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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
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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
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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!
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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.
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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.
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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.
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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
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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
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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
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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.
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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.
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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.
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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
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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
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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.
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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
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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
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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)
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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)
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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
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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%.
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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
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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.
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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
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Slide 2.38
Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 5th Edition, © Pearson Education Limited 2010
Reading•Textbook : chapter 2, 3