CIMA F3 Notes - Financial Strategy - Chapters 1 and 2.pdf

CIMA F3 Course Notes

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CIMA F3 Financial Strategy Course Notes

By Nick Best

© Strategic Business Coaching Ltd 2013 Personal use only - not licensed for use on courses

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Chapter 1 ................ ................................. ................................... ................................... ............................4 ...........4 Formulating a financial strategy ................ .................................. ...................................4 .................4 1. 2. 3. 4. 5.

Financial vs non-financial objectives ........ ................. .................. ................. ................ ................. ............ ... 5 The three key decisions of financial strategy ......... ................. ................ ................. ................. .......... .. 6 Dividend policy ........ ................ ................. ................. ................. ................. ................. ................. ................ ............. ..... 7 External constraints on financial strategy ........ ................. ................. ................. ................. .............10 .....10 International operations ........ ................ ................. .................. ................. ................ ................. ................. .......... 11

Chapter 2 ................ ................................. ................................... ................................... .......................... ......... 13 Evaluating financial strategies ................ .................................. .................................. .................. 13 1. 2. 3. 4. 5.

Financial analysis of a company ....... ................ .................. ................. ................ ................. ................. .......... 14 Financial ratios ........ ................ ................. ................. ................. ................. ................. ................. ................ ............15 ....15 Impact of financing on financial statements and ratios............ ratios.................... ................. ........... ..20 20 Forecasting financial statements........ statements................ ................. ................. ................. ................. ................21 ........21 Cashflow forecasting ........ ................ ................. .................. ................. ................ ................ ................. ..............25 .....25

Chapter 3 ................ ................................. ................................... ................................... .......................... ......... 30 Short term finance ............... ................................ ................................... ................................. ............... 30 1. 2. 3. 4. 5.

Conservative, Aggressive and Matching strategies ........ ................. ................. ................ ............ ....31 31 Working capital management management........ ................ ................ ................. .................. ................. ................ ............ ....32 32 Management of working capital ....... ................ .................. ................. ................ ................. ................. .......... 32 Short term financing methods ........ ................ ................. .................. ................. ................ ................. ........... ..34 34 Over-trading ........ ................. ................. ................ ................. .................. ................. ................ ................ ...............37 .......37

Chapter 4 ................ ................................. ................................... ................................... .......................... ......... 40 Long term finance ................ ................................. ................................... ................................. ............... 40 1. 2. 3. 4. 5. 6. 7.

Long term finance ........ ................ ................. ................. ................. ................. ................. ................. ................41 ........41 Equity finance (or share capital) ........ ................ ................. ................. ................. ................. ................41 ........41 Debt finance ........ ................ ................. ................. ................. .................. ................. ................ ................ ...............42 .......42 Rights issues...................................................................................43 Initial public offering offering........ ................ ................. .................. ................. ................ ................ ................. ..............46 .....46 Private placement ........ ................ ................. ................. ................. ................. ................. ................. ................48 ........48 Private equity.................................................................................48

Chapter 5 ................ ................................. ................................... ................................... .......................... ......... 52 Cost of capital ................ ................................ ................................... ................................... .................... .... 52 1. 2. 3. 4. 5. 6. 7. 8.

Cost of capital ........ ................ ................ ................. .................. ................. ................ ................ ................. ..............53 .....53 Dividend growth model ........ ................ ................ ................. .................. ................. ................ ................. ........... ..54 54 Cost of preference shares ........ ................ ................ ................. ................. ................. ................. ................57 ........57 Cost of debt finance finance........ ................ ................ ................. .................. ................. ................ ................ ...............58 .......58 Weighted Average Cost of Capital (WACC) ........ ................. .................. ................. ................ ............ ....61 61 Diversification and systematic risk......... risk.................. ................. ................ ................ ................. ..............63 .....63 Capital asset pricing model ........ ................. .................. ................. ................ ................ ................. ..............64 .....64 Arbitrage pricing theory ........ ................. ................. ................. ................. ................ ................. ................. .......... 67

Chapter 6 ................ ................................. ................................... ................................... .......................... ......... 69 The efficiency efficiency of markets markets and capital structure ............... ............................. .............. 69 1. 2. 3. 4. 5. 6.

Stock markets.................................................................................70 Efficient market hypothesis (EMH).............. (EMH)....................... .................. ................. ................ ................70 ........70 The impact of capital structure structure on market market values and the Cost of Capital .......72 Treasury department ........ ................ ................. .................. ................. ................ ................ ................. ..............75 .....75 Managing the treasury department ......... ................. ................. .................. ................. ................ ............ ....76 76 Criteria for selecting sources of finance finance....... ................ ................. ................. ................. ................78 ........78


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Chapter 7 ................ ................................. ................................... ................................... .......................... ......... 80 Investment Decisions................................................ Decisions............................................................... ............... 80 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12.

Investment decisions ........ ................ ................ .................. .................. ................ ................ ................. ..............81 .....81 Relevant costing..............................................................................81 NPV ........ ................. ................. ................ ................ ................. .................. ................. ................ ................. ................. .......... 82 IRR ........ ................ ................ ................. ................. ................. ................. ................. ................. ................ ................ ........... ...84 84 Modified IRR based on terminal value ....... ................. .................. ................ ................ ................. ........... ..86 86 Payback period ........ ................ ................. ................. ................. ................. ................. ................. ................ ............86 ....86 Techniquess for cashflow in foreign currency.................. Technique currency.......................... ................. ................. .......... 87 Use of WACC ........ ................. ................. ................ ................. .................. ................. ................ ................ ...............88 .......88 Tax effects on these calculations ........ ................. .................. ................. ................ ................ ...............89 .......89 Adjusted present value ........ ................ ................ ................. .................. ................. ................ ................90 ........90 Real options................................................................................91 Recognising risk ........ ................. ................. ................ ................. ................. ................. ................. ................92 ........92

Chapter 8 ................ ................................. ................................... ................................... .......................... ......... 94 Lease vs Buy ............... ................................ ................................... .................................. ....................... ....... 94 1. 2. 3. 4.

Leasing ........ ................. ................. ................ ................ .................. .................. ................ ................ ................. ..............95 .....95 Types of leases ........ ................ ................. ................. ................. ................. ................. ................. ................ ............95 ....95 Benefits of leasing ........ ................. ................. ................. ................. ................ ................. ................. ................96 ........96 Lease vs Buy Calculations...................................................................96

Chapter 9 ................ ................................. ................................... ................................... ........................ ....... 101 Company valuations ............... ............................... .................................. ............................... ............. 101 1. 2. 3. 4. 5. 6. 7. 8. 9.

Asset based............ based.................... ................ ................ .................. .................. ................ ................ ................. ............ ... 102 Earnings based approaches approaches........ ................ ................. .................. ................. ................ ................ ............. ..... 103 Cashflow based methods........ methods................. ................. ................. ................. ................ ................. ................ ....... 104 Example.................... Example............ ................ ................ .................. .................. ................ ................ ................. ................ ....... 104 Dividend Growth Model Model and Dividend Yield ......... .................. ................. ................ ................. ......... 106 Cost of capital to use for valuations ........ ................. ................. ................. ................. ................ .......... .. 107 Comparison of valuation methods....... m ethods............... ................. .................. ................. ................ .............. ...... 108 Valuing intangible assets ........ ................. ................. ................. ................. ................. ................. .............. ...... 109 Efficient Market Hypothesis and company valuations ......... ................. ................ .............. ...... 110

Chapter 10 ................. ................................. ................................... ................................... ..................... ..... 112 Capital rationing and project project control ................ .................................. ......................... ....... 112 1. 2. 3. 4.

Single period capital rationing (not (not multiperiod) ......... .................. ................. ................ .......... .. 113 Project control for investment projects ........ ................ ................. ................. ................ .............. ...... 115 Linking investments with customer requirements and product service design. design. 117 IS/IT investments ........ ................ ................ ................. .................. ................. ................ ................. ................ ....... 118

Chapter 11 ................. ................................. ................................... ................................... ..................... ..... 120 Acquisitions ................ ................................ ................................... ................................... ..................... ..... 120 1. 2. 3. 4. 5. 6.

Mergers and aquisitions ........ ................ ................ ................. .................. ................. ................ ................ .......... 121 Interests of stakeholder groups......... groups................. ................. ................. ................ ................. ................ ....... 122 Forms and terms of consideration ........ ................ ................. ................. ................ ................ ............. ..... 123 Post acquisition integration process ........ ................. ................. ................. ................. ................ .......... .. 125 Management Buy-outs ........ ................ ................. .................. ................. ................. ................. ................ .......... .. 126 Private equity/Venture capital ........ ................ .................. .................. ................ ................. ................ ....... 128


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CIMA F3 Course Notes c

Chapter 1 Formulating a financial strategy


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Financial vs non-financial objectives

Strategy A strategy is a plan of action ac tion designed to achieve a goal or objective. The aim of a strategy is to gain some kind of competitive advantage or to help to exploit future opportunities. A strategic plan tends to be an overall over all guide to the way forward rather than a detailed step by step approach due to the tendency of the real world to be uncertain. In the example of a chess game, a ‘strategy’ provides the over-riding approach that the player will take to win the game, but the exact set of moves they undertake will vary depending on the opponent’s moves. In business a strategy will focused towards achieving objectives, which can be both financial and non-financial.

Financial objectives Maximising shareholder wealth In private sector organisations there is an over-riding objective ensure shareholder’s wealth is increased through paying divividends and increasing the value of the shareholder’s equity (for instance through a higher share price). Public sector – Value for money

Public sector organisations do not aim for profitability. Instead their focus is of the 3E’s of value: Effectiveness – achieving the goals of the organisation (e.g. education in a school) Efficiency – using resources as efficiently and productively as possible(e.g. best use of school teachers and schools) Economy – gaining resources at the lowest cost (e.g. buying books at the lowest possible cost ) Each of the 3E’s needs to be balanced to achieve the t he best overall result within the limited funds available.


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Providing a surplus

Achieving a surplus (e.g. additional cash in the bank) is a key element of financial risk reduction, as it allows for businesses to survive periods of financial difficulty while the economy or business is turned back into profit. Crucially it provides cash for times when cashflow is short.

Non-financiall objectives Non-financia Financial objectives need to balanced against non-financial objectives of a business which can include: • • • • • • • • •

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Employee welfare Customer service Ethics Increases in market share Being competitive Health and safety Environmental issues Good supplier relationships Putting up barriers to entry to the market

The three key decisions of financial strategy

A financial strategy is one key element of a business strategy str ategy as a whole. It has three key constituents

Financing decisions Businesses need funding to invest in capital (e.g. equipment, machinery, buildings etc), to pay expenses and working capital (e.g. salaries, inventories, utilities etc). Financing decisions relate to the decisions about where this money comes from, and is primarily about balancing: • • •

equity (i.e. from owners/shareholders) debt (from lenders such as banks) retained earnings.

Investment decisions Once raised the money needs to be invested, and investment i nvestment decisions help the organisation decide where to invest this money to repay debt (and interest payments) and achieve a good rate of return r eturn for shareholders.


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Strategic options are generated as part of the business strategy setting process. As part of the evaluation of the strategic options, investment decisions can be made using techniques such as: • • • •

Net present value (NPV) Internal rate of return (IRR) Payback period Return on capital employed (ROCE)

Dividend decisions Assuming investments were well made, funds can be returned to shareholders in the form of dividend payments. The directors have to balance the payment of dividends with retention of cash in the business to allow for future investment inv estment and growth.

Matching investment and financing characteristics characteristics One key link between these strategies is to ensure that investments and financing characteristics are linked. For example: •

Long term funding (e.g. equity or long term debt) for long term projects (as returns will not be available in the short term to pay short term interests payments or to pay back a shorter term loan)

•

Use of leasing for short term equipment use

•

Overdrafts for short term cashflow ca shflow shortages due to flexibility.

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Dividend policy

What is dividend policy? Dividends are the payments made to shareholders which give them a return on their investment. Dividend policy is concerned with w ith deciding on taking a decision between: • • •

paying cash dividend paying dividends in the form of shares retaining earnings in the business for investment with the aim of increasing the value of the business (e.g. the share shar e price) and ultimately paying an increased dividend at a later stage


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A dividend policy is a general statement about how dividends will be paid. For example, companies in large growth markets may ma y have a dividend policy of earnings retention and no dividends as they need to cash to invest in the business and believe shareholders returns are maximised through business growth. Conversely a large listed company may pay a set dividend each year growing at a consistent rate (irrelevant of actual earnings levels) as a signal of stability and to attract investors who want consistent returns.

Considerations when making dividend policy Key considerations when setting dividend policy are: •

shareholder expectations and desire for dividends (do they want high dividends and low investment or low dividends and increased investment (and hence higher share prices)

•

impact of dividends paid on share price

•

availability of good investments if capital is retained in the business

•

•

•

•

•

degree of risk in new investments in which retained earnings are invested the choice of debt vs equity finance an the weighted average cost of capital (WACC) [see later] cashflow availability e.g. to pay dividends

the need for cash in other parts of the business (if cash is used to to pay dividends it can not be used elsewhere) whether there are any restrictions in terms of debt finance (restrictive covenants)

There are two schools of thought about the importance impor tance of dividend policy, one argues that it is highly relevant to shareholders, the other that it is irrelevant.

Irrelevance of dividend policy Modigliani and Miller suggest that dividend policy is irrelevant. Instead the focus should be on investment decisions. If there’s a good investment to be made that delivers good returns (i.e. a positive NPV – see later) then that investment should be made. The amount of dividends paid is simply the residual amount left after all viable investments have been made. This is called the theory of residuals - dividends are residuals from the profits less funding of proposed investments.


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In summary the dividend decision should be made as follows: •

•

•

•

evaluate the available investment opportunities to determine capital expenditures needed. evaluating the amount of equity finance that would be needed for the investment to ensure the optimum debt/equity finance mix (see WACC later). use retained earnings to finance the equity element of investments (retained earnings are preferable to raising new equity capital as it is is cheaper since there are no floatation costs). If there is a surplus after the t he financing then there is distribution of dividends.

The value of the firm will not depend on the dividends paid out therefore, but, instead, the availability of good (i.e. positive NPV) investments. The dividend policy of such a kind is a passive one, and doesn't influence market price. The dividends will also fluctuate every year because of different investment opportunities every year. However, it doesn't affect the shareholders as they get compensated in the form of future capital gains.

Relevance of dividend policy While the ‘theory of residuals’ make good sense in theory, in the real world dividends policy often does make short terms impacts impact s on dividend policy, and there and so arguments can be made for its relevance. The key arguments are as follows: Information content of dividends - signalling

Dividend announcements convey information to investors regarding the firm's future prospects. Studies have shown that stock prices tend to increase when an increase in dividends is announced and tend to decrease when a decrease or omission is announced due to the information content of dividends. Shareholders perceive that when managers lack confidence in the firm's ability to generate cash flows in the future they may m ay keep dividends constant, or possibly even reduce the amount of dividends di vidends paid out. Conversely, managers that have access to information that indicates very good future prospects for the firm (e.g. a full order book) are ar e more likely to increase dividends. Investors use this knowledge about managers' behaviour to inform their decision to buy or sell the firm's stock, bidding the price up in the case of a positive dividend surprise, or selling it down when dividends do not meet expectations. © Strategic Business Coaching Ltd 2013 Personal use only - not licensed for use on courses

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This, in turn, may influence i nfluence the dividend decision as managers know that stock holders closely watch dividend announcements looking for good or bad news. As managers tend to avoid sending a negative signal to the market about the future prospects of their firm, this t his also tends to lead to a dividend policy of a steady, gradually increasing payment. Dividends reduce shareholder uncertainty

Payment of regular dividends reduce uncertainty of the shareholders and increases their perception of security. Under dividend irrelevancy policy dividends will fluctuate which will not be popular for some real-world investors. Dividend clientele

A particular pattern of dividend payments may suit one type of shareholder more than another. A retiree may prefer to invest in a firm that provides a consistently high dividend yield, whereas a person with a high income from fr om employment may prefer to avoid dividends due to their high marginal tax rate on income. If clienteles exist for particular patterns of dividend payments, a firm may be able to maximise its stock price and minimise its cost of capital by catering to a particular clientele. This model may help to explain the relatively consistent dividend policies followed by many listed companies. Conclusion

In the real world it can be argued that dividend policy is relevant, and in reality most large companies tend to retain stable dividend payout levels where possible, to keep their shareholders (or “clientele”) happy, avoid shareholder uncertainty and to ensure the right “signal” is given to the market.

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External constraints on financial strategy st rategy

There are a range of external factors that impact our 3 key financial strategy decisions (investment, funding and dividends). These include: Economic factors – impacts the availability of good investments, interest rates (on debt), inflation (impacting discount rates for investment appraisal), and exchange rates relating to funds and investments in foreign currencies.


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t he market. E.g. high up to 2007 and low Funding – availability of finance in the thereafter due to the credit crunch. Regulatory bodies - Regulated industries (e.g. utility companies, rail, telecoms, banks) can have restrictions imposed on them t hem such as limitations on prices and service levels (affecting investment decisions) and cash reserves (affecting funding decisions). Investor relations and strategy – shareholders and shareholder perceptions affect what investments can be made, availability of o f funds and levels of dividend expected. Regulation on business combinations – Most countries have legislation to stop monopolies being formed through business combinations, limiting investment decisions or merging with a cash rich ri ch company as a method of funding future operations

c ompanies, Political factors – affects availability of funds for public sector companies, or private sector companies undertaking public sector contracts. Grant availability is also an issue.

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International operations

Funding issues when operating internationally include: Political – the political situation in each market operated needs to be considered e.g. grant availability, interest rate levels set by government

i nflation rates, exchange rates and Economic – impact of interest rates, inflation funding availability in each market operated. Legal – Each country has its own o wn law and regulation which must be abided by in each new market entered e.g. rules over obtaining finance Banks and banking system – Each local market will tend to have it’s own banks and banking system, which will affect sources and terms term s of finance. Suppliers – New relationships will need to be built with new suppliers who may give credit terms as a source of low cost finance.


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CIMA F3 Course Notes c

Chapter 2 Evaluating financial strategies


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Financial analysis of a company

What is financial analysis? Financial analysis refers to an assessment of the viability, stability and profitability of a business, subsidiary or project. It is performed using ratios that make m ake use of information taken from financial statements and other reports. An example could be profit margins mar gins (profits/turnover). In financial strategy this analysis can be used for decisions such as: • • •

•

•

Whether the organisation achieved its financial objectives The viability of investment in another business Financing decisions such as issuing shares or negotiate for a bank loan to increase its working capital Make decisions regarding investing or lending capital, including creditworthiness of a customer Compliance with debt covenants.

Comparison of financial ratios Without some fair comparison the figures are themselves largely meaningless, so it is typical to compare c ompare the results with some other standard – for example: •

Past Performance - Across historical time periods for the same firm (the last 5 years for example)

•

Against budgets (were results as predicted)

•

Between similar firms or divisions.

Having done a comparison – it is crucial that possible meanings of those comparisons are evaluated. If the profit margins have risen compared with the previous year this could be due to higher prices or lower costs. If further fur ther investigation shows that costs are the same but prices have risen, this could then be due to better marketing, reduced competition, shortages in supply and so on. Further investigation is needed to acertain the reasons why so lessons can be learnt and the performance of the business bu siness understood.


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Financial ratios

The following example will be used as an example of how to apply each of the financial ratios as they are explained. Arethra is a manufacturer based in Europe. Balance Sheet

31 Dec 20X3 €m €m

31 Dec 20X2 €m €m

395

Non-current assets (net) Current assets Inventory (including Work-in-Progress) Trade receivables and accrued revenue Cash and short-term investments

59 111 1

366

47 88 7 171 566

Total assets Non-current liabilities Bank loan (repayable 20X8)

102

142 508

100 (102)

Current liabilities Trade payables and accruals Tax

71 6

(100) 46 7

(77) 387

Net assets

(53) 355

Income Statement 31 Dec 20X3 €m

Revenue Total operating costs

31 Dec 20X2 €m

516 (499)

484 (460)

Operating profit

17

24

Finance costs Tax expense

(8) (4)

(8) (6)

Profit for the period

5

10

The company has not paid a dividen d for the last 3 years. It’s current c urrent share price is €10.22. There are 1m shares in issue. The company has the following financial objectives: • • •

An operating profit margin of 8% A total earnings per share of €10 Financial gearing of less than 30%

Profitability Ratios Profitability ratios look at the profitability of the company, and hence how well prices and costs have been managed. Profit margin looks at profits compared to revenues, which you would expect to be consistent over time and against competitors. c ompetitors.


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Operating profit Revenue

20X3

20X2

17 = 3.3% 516

24 = 5.0% 484

The profit margin has reduced compared with last year, and is below the companies target of 8%. This suggests that prices have been been squeezed and/or costs have risen. A 1.4% drop is significant significant and if the company can not halt this decline they will soon become loss-making. Return on capital employed compares profit with capital. It gives a view on how well the capital is being used.

20X3 Operating profit Long term capital

18 = 3.7% 566-77

20X2 24 = 508 - 53

5.3%

(Total assets – current liabilities)

The return on capital employed has reduced significantly. This is due both to a reduction in profits with an increase i ncrease in investment, primarily in noncurrent assets. The return on capital employed is very low, and shareholders are unlikely to want to accept such a low return on their investment in the long term.

Working capital ratios Working capital management involves managing the relationship between a firm's short-term assets (inventories and receivables) and its short-term liabilities (payables). The goal of working capital management is to ensure that the firm is able to continue its operations and that it has sufficient cash flow to satisfy both maturing short-term debt and upcoming operational expenses. Inventory days measures the average number of days that inventory is in stock. The longer the inventory days the more mo re stock is available to meet customers needs, but the more capital is tied up in stock and the greater the likelihood of obsolescence and wastage.

20X3 Inventory x365days Total operating costs

59 x 365 = 43days 499

20X2 47 x 365 =37days 460

(or cost of sales if available)

Inventory days had increased. Possible reasons could be worsening inventory management, an increase in unsold items. © Strategic Business Coaching Ltd 2013 Personal use only - not licensed for use on courses

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Accounts receivable days measures the average number of days before customers pay debts. The longer the period the more free credit is being given to customers. On one hand this could help maintain good relationships with customer, but on the other it i t can mean cash receipts are delayed causing cashflow difficulties, and potentially increase the risk of bad debts.

20X3 Receivables Revenue

x365days

111 x 365 = 79 days 516

20X2 88 x 365 =66 days 484

Receivable days have risen by 13 days, so customers custom ers are taking longer to pay. This may be due to customers exerting their buyer power, and paying later, worsening credit control or Arethra extending credit terms in order to keep customer’s satisfied. Accounts payable days are the average number of days it is taking to pay creditors. Longer payables mean longer free credit being gained from suppliers, but risks worsening relationships with them.

20X3 Payables x365days Total operating costs

71 x 365 = 52 days 499

20X2 46 x 365 =37 days 460

(or cost of sales if available)

Payables days have increased by 15 days, suggesting Arethra are delaying payment to their suppliers. This reduces working capital requirements, and a nd might be legitimately due to them exerting power over ov er suppliers to extend credit terms. However it could also be a result of cashflow c ashflow difficulties, meaning they are having to delay payment. If this thi s latter situation is the case, they must be careful to ensure supplier relations are maintained to ensure security of supply. Working capital (or cash conversion) cycle - shows the total number of days credit is due for to support working capital. It represents the time difference between cash payment for raw materials and cash collection for sales. The cash conversion cycle indicates the firm's firm' s ability to convert its resources into cash. Because this number effectively corresponds cor responds to the time that the firm's cash is tied up in operations and unavailable for other activities, management generally generally aims at a low net count. count. The longer this is the greater the working capital finance that is required. req uired. Working capital cycle = Inventory days + Receivable days – Payable days

20X3 43+79-52=70days


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20X2 36+66-37=66 days


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Overall the working capital cycle has increased, which is an extra strain on the company’s cashflow position, and this must be closely managed in the future.

Liquidity ratios These ratios examine the company’s ability to pay debts as they fall due. Poor liquidity means that there is little cash and short term assets available to pay maturing short term debts. Current ratio – this measures the ration of current assets to current liabilities. The larger the ratio the greater the ability of company to be able to pay debts as they fall due:

20X3 Current assets Current liabilities

171 = 2.22 77

20X2 142 = 2.67 53

The current ratio has worsened over the year, suggesting there are fewer assets available to meet short term debts due, although it is good that assets are greater than liabilities, as this suggests that short term liabilities are covered. Quick ratio (acid test) – this is a shorter term measure of liquidity, as it recognises that inventories can not be immediately sold, so takes them out of the ratio. 20X3 20X2 Current assets - Inventory Current liabilities

171- 59 = 1.45 77

142 -47 = 1.79 53

The quick ratio has also worsened over the year, suggesting there are fewer assets available to meet short term debts due, although again it is good that assets are greater than liabilities, as this suggests that short term liabilities are covered. Overall the liquidity position of the company appears to be satisfactory, buy worsening. Both the current and quick ratios have worsened in the year, reflecting what appear to be difficult trading conditions. However both bot h values appear to be relatively healthy, and do not suggest immediately liquidity problems.


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Debt ratios The financial gearing ratio shows the level of debt to equity. Since debt means there are compulsory interest payments each year, y ear, debt is higher risk than equity, and so the higher the ratio the higher the risk. However, debt finance is also usually cheaper than equity finance (as the lender takes lower risk) and so suitable balance must be achieved. ac hieved. 20X3 Long term debt Net assets

102 = 26% 387

20X2 100 355

= 28%

Gearing has reduced in the year, largely due to an increase in non-current assets during the year, which must have been financed fi nanced out of equity since debt levels have remained similar. The company is currently below target gearing of 30%, so a level of 26%, there may be some room for further future financing secured on non-current assets (e.g. buildings), although lenders may be wary of o f lending to a company whose profits are so low, and are likely to want to see clear plans in place to demonstrate how the company aims to turn its profits around. Interest cover – this shows how easily the company is able to pay its interest payments out of current profits. The lower this figure the greater the risk on non-payment

Operating profit(before finance and tax) Interest payable (finance costs)

20X3

20X2

17 = 2.13 8

24 8

= 3

An interest cover of 2.1 is very ver y low, and the fact that this has worsened over the year, suggests that there is a significant risk on non-payment of interest in forthcoming periods, and a clear need to improve the companies cash position through improving efficiency and increased sales.

Shareholder ratios Shareholder ratios measure the returns from the point of view of the shareholder and the price they pay for shares on the th e market Dividend yield is the return on the share price from dividend’s paid

Dividend per share Share price © Strategic Business Coaching Ltd 2013 Personal use only - not licensed for use on courses

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20X3

20X2

0 =0 €10.22

0


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The lack of a dividend combined with the worsening business performance is a real concern for shareholders. It suggests the company is facing cashflow difficulties which is also supported by the earlier ratio analysis. Earnings per share shows the earning for each share. Ideally this will rise each year. 20X3

20X2

5=5 10 = 10 Earnings distributable to shareholders 1 1 Number of shares in issue This has reduced in line with the profit reduction, and a nd will be a concern for shareholders, particularly as it is now below the target EPS of €10. Price-Earnings (P/E) ratio shows the ration of share price to earnings. The higher this figure the better the market’s view v iew on company. Analysts typically compare this with the industry norm to compare how the market perceives this company against others in the industry. A low P/E ratio could indicate the company is undervalued (and a good buy) or is higher risk due to market uncertainty. Many industries have a P/E ratio r atio of around 8-12 with high growth industries of 20+.

Share price Earnings per share

€10.22 = 2.04 5

This is a very low P/E ratio, suggesting that the market believes there is significant risk from investing in Arethra, no doubt due to the poor performance and liquidity.

3. Impact of financing on financial statements and ratios New funding strategies will have an impact on the financial f inancial statements and ratios and therefore whether the company will remain within it’s financial objectives.

Example In the case of Arethra, it is considering raising €50m of new debt finance based on its non-current assets, payable at the same rate of interest as current debt. What will be the impact im pact on the companies ratios?


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Cash rise by €50m to €51, so current assets rise to €221m Bank loans (and non-current liabilities) rise to €152m Total net assets remains the same at €387m Interest rates are currently 7.8% (8/102), so interest payable will become 7.8% x 152 = $12m Interest cover will worsen – 17m/12m = 1.41 which is very low and increases risk of non-payment Financial gearing ratio = 152/397 = 38% (above the target t arget gearing levels). The current ratio would improve 221/67 = 3.30 (showing ( showing the increase in liquidity). The quick ratio would also improve (162/67 = 2.42). The key issues for Arethra are: •

•

4.

Is it willing (and able) to remove r emove the 30% financial gearing target? Is it able to raise more debt with low margins and interest cover? This may depend on the current value and availability a vailability of non-current assets to act as security.

Forecasting Fo recasting financial statements

Forecasting financial statements is the process of taking one set of financial results and based on changes and assumptions for the forthcoming year, producing a forecast set of financial statements. The key to this process is working through each of the changes step by step and considering what balances change on the income statement and financial statements. Note each change on the statement as you progress and then when you get to the end work out the revised balances. Do not consider cash as you progress as this t his can get complicated, instead work out the cash balance as the balancing figure on the t he balance sheet once you get to the end of the process. pr ocess.

Example Arethra are considering a range of strategies to turn tu rn the business around including a range of new products which will require investment. i nvestment. They will finance the strategies as follows: 1. Raising €50m using a rights issue (i.e. from fro m existing shareholders) by issuing 0.5m new shares. 2. Investing €40m in new manufacturing equipment © Strategic Business Coaching Ltd 2013 Personal use only - not licensed for use on courses

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3. Investing €10m in expanding inventories As a result of the new strategies the following results are expected in 20X4: 4. Revenues to grow by 3% 5. Profit margins will rise by 1% before additional depreciation costs. 6. No sales of non-current assets are planned, and the depreciation charge on those assets will remain the same at €15m. Depreciation on the new equipment will be €3m. 7. Tax will be €3m 8. The ratio of receivables to sales is expected to reduce by 5% 9. The ratio of trade payables to operating costs are ar e expected to be increased by 2% 10.Loans 10. Loans and hence Interest charges will remain the same sa me as in 20X3. Arethra’s financial data is as follows: Balance Sheet

31 Dec 20X3 €m €m

395

Non-current assets (net) Current assets Inventory (including Work-in-Progress) Trade receivables and accrued revenue Cash and short-term investments

59 111 1 171 566


102 (102)

Current liabilities Trade payables and accruals Tax

71 6 (77) 387

Net assets Equity Ordinary share capital (Ordinary shares of €100) Retained earnings

100 69 169 566

Income Statement 31 Dec 20X3 €m

Revenue Total operating costs

516 (499)

Operating profit

17


(8) (4)


5

The company has not paid a dividen d for the last 3 years. It’s current c urrent share price is €10.22. There are 1m shares in issue.


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Solution Adjustments must be made item by item: i tem: 1.

Raising €50m using a rights issue (i.e. from fro m existing shareholders).

Equity up €50m

2.

Investing €40m in new manufacturing equipment

Non-current assets up €40m

3.

Investing €5m in expanding inventories

Inventories up €5m

4.

Revenues to grow by 3%

Revenues rise by 3% x 516 = €15m to €531m

5.

Profit margins will rise by 1% before additional depreciation costs

Current profit margin 3.3% (17/516) increases to 4.3% Profits will be 4.3% of revised revenue of €531m = €23m Costs will will be €531m €531m – €23m = €508m (before any new depreciation)

6. No sales of non-current assets are planned, and the depreciation charge on those assets will remain the same at €15m. Depreciation on the new equipment will be €3m. Previous depreciation costs are already within the profit margin. However €15m needs to be taken off of non-current assets Operating costs reduced by €3m for the new depreciation. Non-current assets reduced by €3m

7. Tax will be €3m, and is paid in the following year. All previous years tax are paid in the year Tax expense €3m, and tax liability up €3m Tax liability down €6m 8.

The ratio of receivables to sales is expected to reduce by 5%

Old ratio 111/516 = 21.5%, will become 16.5% Receivables is 16.5% of revised revenue of €531m = €88m This is a change from previous years of €111m-€88m=€23m

9. The ratio of trade payables to operating costs are ar e expected to be increased by 2%


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Old ratio 71/499 = 14.2%, will become 16.2% Payables is 16.2% of revised operating costs of €508m = €82m This is a change from previous years of €82m-€71m = €11m

10.

Loans and hence Interest charges will remain the same sa me as in 20X3.

Finance charge of €8m. Final adjustments The final profit is €9m, which must be added to retained earnings. The balance sheet needs to be balanced with a cash balance of 65 (447+85+1)2-417-64-88 = 65)

Balance Sheet

31 Dec 20X4 €m €m

417

Non-current assets (net) (2) +€40m (6) -€3m -€15m Current assets Inventory (including Work-in-Progress) (3) +5m Trade receivables and accrued revenue (8) -23m Cash and short-term investments Balancing figure

31 Dec 20X3 €m €m

64 88 64

395

59 111 1 216 633


102

171 566

102 (102)

Current liabilities Trade payables and accruals (9)+11m Tax (7) +3m – 6m

82 3

(102) 71 6

(85) 446

Net assets Equity Ordinary share capital (Ordinary shares of €100) (1) +50m Retained earnings from income statement +9

150 296

(77) 387

100 287 446

387

31 Dec 20X4

31 Dec 20X3

Income Statement €m

Revenue (4) + 15m Total operating costs

Operating profit

(5) at 4.3% of revenue


(10) No change = 8m (7) =3m


(6) -€3m

(to retained earnings)


24

€m

531 (511)

516 (499)

20

17

(8) (3)

(8) (4)

9

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Analysis of the strategies You are commonly asked to analyse the impact of the strategy. In this case, if the projections are correct, the financial performance and, in particular the liquidity and cash flow position have greatly improved impr oved due to the significant improvements in working capital. If the improvements were a direct result of the capital investment, then it may be it was unnecessary to raise the funds as new equity, as the increased cash could be used to pay off a short/medium term loan which may be a better funding method if loan funding is available. Comparing with the companies financial objectives: • • •

An operating profit margin of 8% A total earnings per share of €10 Financial gearing of less than 30%

New profit margin is 3.7% after depreciation, so is still below target, but an improvement on 20X3. Continued improvement will be needed. EPS – 9/(1+0.5) = $6 – still below target, but an improvement i mprovement on €5 in 20X3. Financial gearing 102/446 = 23%, which is below target and allows opportunity to raise more debt in the future.

5.

Cashflow forecasting

Cashflow forecasting is where the cash impact of expected changes, for example to economic variables such as interest rates r ates or business variables such as volume and margin are noted and the change in cash balance calculated. If required as part of the same question as the change in financial statements, cashflow forecasts can be prepared at the same time. The cash impact of each transaction is noted. Standard cash in and out

The most simple elements of a cash forecast are basic cash and out of the t he balance sheet. This might include: loans, interest payments, receipts from shareholders, tax payments and so on. Sales

As sales are often made on credit, the t he actual sales made does not necessarily equal the amounts received. Some of the previous years sales © Strategic Business Coaching Ltd 2013 Personal use only - not licensed for use on courses

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could have been received in the year, while some of the sales towards the end of the year may not yet have been received. As such the following calculation is used to calculate receipts from sales. Sales + Opening receivables - Closing receivables Costs of sales

As purchases are often made on credit, the actual sales made does not necessarily equal the amounts received. Some of the previous years purchases could have been paid in the year, while some payments towards the end of the year may not yet have been paid. In addition if depreciation has been taken off of cost of sales, then it needs to be added back on since it is i s not a cash item. As such the following calculation is used to calculate receipts from sales. Cost of sales + Depreciation (not cash) - Opening payables + Closing payables

Example Continuing the previous example for Arethra: Cashflow forecast for 31 Dec X4

€m Original balance

1

Investment from shareholders

50

Spending on assets

(40)

Increase in inventories

(5)


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Receipts

Sales

531

+ Opening receivables

111

- Closing receivables

(88) 554

Operating costs (cost of sales)

Operating costs

(511)

+ Depreciation (not cash)

18

- Opening payables

(71)

+ Closing payables

82 (482)

Tax paid

(6)

Finance

(8) 64

Alternative cash flow forecast – comparing balance sheet values An alternative format can also be used by comparing differences in balance sheet values. This is quicker, but does not show actual cash changes as well. For assets calculate: For liabilities calculate: For equity calculate:

Previous year balance – Current year balance Current year balance – previous year balance Current year balance – previous year balance


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Example Cashflow forecast for 31 Dec X4

Non-current assets

(22)

Inventory

(5)

Receivables

23

Loan Payables Tax

0 11 (3)

Share capital

50

Retained profits

9 63

~B/f C/f

1 64


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CIMA F3 Notes - Financial Strategy - Chapters 1 and 2.pdf

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