Financial Performance and Working Capital

8/8/2019 Financial Performance and Working Capital

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Financial Performance

1

Analysis and

Interpretation of FinancialInformation


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2

Before we begin lets have a

look at the recentfinancials of Ryanair


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Comments


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Financial Control

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Main topics

Analysis and

interpretation

of financial

statements

Financial ratios

Limitations of

ratio analysis

Financial ratio

classificationThe need for

comparison

The key steps in

financial ratio

analysis

The ratios

calculated

Profitability

GearingInvestment ratios

Trend analysis

Ratios and

prediction

models

The Effects

of GearingInvestment

ratiosIndustry

Comparison


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Financial Control

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Financial Ratios

A relatively quick and simple way of analysing a firm is to

calculate ratios based on freely available information in the

accounts.

We will be learning how to extract pertinent information from

accounts and how to interpret that information. We will also

examine how to measure the financial performance of the firm

using a number of different metrics.

The following slide mentions the main classes of ratios:

Ratio Analysis


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Financial Control

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Financial Ratio Classification

Categories

Profitability

Shareholder

Gearing / Financial

Structure

Working Capital

Liquidity


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Financial Control

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Ratios and Comparison

Ratios are just numbers until compared in a meaningful way

with something. Therefore we require benchmarks. This

may be:

1. Similar data from other firms within an industry

2. Company data from previous accounting periods

3. Some planned performance targets.

Key Steps in Financial Ratios

In module 1 we focused on accounting as being primarily an

information system that should take its users needs into

account. Interpretation of accounts and the preparation of

ratios should follow similar principles:


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Financial Control

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1. Identification of user group and their information needs

2. Calculation of appropriate ratios

3. Interpretation and Evaluation of resulting ratios

As with any system, its success depends on carrying out each of

the steps correctly. Misidentifying user needs may lead to

poor ratio analysis. The final step can be subjective and

would require judgement and knowledge of the business

being examined.

Financial Ratio Analysis: the key steps

Calculate

required

ratios

Identify

users and

their

information

needs

Interpret

and

evaluate

results


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Financial Control

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These ratios indicate levels of profitability after different

levels of costs are included. The allow us to identify where

margins are improving and where cost control is an issue.

Accounting texts tend to generalise these ratios and provide

formulas that depend on financial terms. The key thing to

remember is that the most important profit figures are

towards the bottom of the income statement. Each ratio is a

profit figure as a % of sales.

Gross Profit

Operating Profit

Earnings / Profit before interest and tax

Earnings / Profit after interest and tax

Profitability Ratios

1

100Pr xSales

ofitGross

1

100Prx

Sales

ofitOperating

1

100xSales

EBIT

1

100x

Sales

EAIT


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Financial Control

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These ratios reflect the capital structure of a firm, or the

makeup of its long term funding and the risks arising thereof.

Capital Gearing Ratio

This gives the proportion of debt as a percentage of the capital

employed. Anything greater than 50% would be considered

high.

Long Term Debt / Capital Employed x 100/1

Where capital employed is Total Assets less Current Liabilities

Interest Cover

This indicates how many times a company can cover its

existing interest payments out of current profits. The higher the

safer.

EBIT / Interest

Gearing / Financial Structure Ratios


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The effect of financial gearing


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Used by investors and analysts to evaluate companies and their

performance. They relate to returns received in relation to what

was paid for those returns (The Share Price).

Earnings Per Share (EPS) =Where TSO is total ordinary shares outstanding

Dividend Per Share (DPS) = EPS x Payout RatioWhere payout ratio is the dividend paid as a percentage of earnings attributable to

ordinary shareholders

Price Earnings Ratio =

Market to Book Value =

Dividend Yield =

Return on Equity =

Return on Capital =

Employed

Investor / Shareholder Ratios

1

100

xTSO

dividendpreferenceEAIT

EPSiceShare Pr

erShareBookValueP

iceSharePr

1

100

Pr

xiceShare

DPS

1

100x

talEquityCapi

EAIT

1

100x

loyedCapitalEmp

EBIT


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Dividend Yield Ratios

By Industrial Group

0

1

2

6

5

4

3

Constructi

on

Chemic

als

Engine

erin

g

Pharm

aceuticals

Tobacco

Leisurea

ndhotels

Electricity

Water

Banks

Media

Foodre

tai l

ers


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Financial Control

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Price/Earnings Ratios

By Industrial Group

0

45

40

Constructi

on

Chemicals

Engineering

Pharmace

uticals

Tobacco

Leisureand

hote

ls

Electricity

Water

Banks

Media

Foodretai l

ers

35

30

25

20

15

10

5

50


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Financial Control

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Trend Analysis

Plotting ratios over time on a graph can be a useful aid for

detecting trends or changes over time. Take the following

Example:

Plotting Ratios Against Time

Current

ratio

Time

2000 200320022001 2004

Printer

Ltd

Industry

average


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Financial Control

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Ratios and Prediction or Forecasting

When forecasting future figures, many firms find it helpful to

use ratio analysis as a starting point and to then extrapolate

forward. In some cases ratios have been developed as proxies

for predicting whether for example a company is vulnerable to

takeover.

Uses and Limitations of Ratio Analysis

Ratio analysis can provide useful information to investors,

company management and financial institutions. Further

information is available from financial databases.

Ratios on their own mean little: they must be compared with

benchmarks, such as target ratios, ratios of similar companies,

industrial norms or ratios from previous years.

A systematic approach to ratio analysis could look at ratios

concerned with profitability, activity, liquidity, gearing and

investment, always remembering to compare like with like.


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Problems with ratio analysis include:

That balance sheet figures are static

That similar companies for comparison are hard to find

That accounting policies may be different

That creative accounting may have been used together with

complex financing methods.

Newer Performance Metrics

In recent years a number of firms and consultancies have

brought forward models that attempt to measure the

performance of a firm and to use these to tie in with

managerial remuneration.

The best known of these is Economic Value Added orEVA.


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Working Capital Management


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Financial Control

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Working Capital Management

Main topics

The

management

of working

capital

Ratios for

Working Capital

Management

The Nature andPurpose of

Working Capital

The

Management of

Debtors

Working Capital

Policies

The Cash

Conversion

Cycle

The

Management of

Cash

The

Management of

Trade Creditors


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Financial Control

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The Nature & Purpose of Working Capital

Major elements Major element

Prepayments

Trade debtors

Cash (in hand

and at

bank)

Trade

creditors

lessequals

Currentliabilities

Workingcapital Currentassets


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Financial Control

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What is Working Capital?

It is usually defined as current assets less current liabilities. By

current we mean amounts realisable or due within 12 months.

These figures will include cash, debtors, prepayments creditors

amounts due etc... These items will appear in the balance sheet

and should be familiar to you.

The size and composition of working capital will vary widely

between industries and companies. Oracle unlike a

manufacturing firm doesnt hold stock as a current asset. Now

lets take a quick look at Oracles working capital...

Why is it Important?

Decisions taken regarding the items in our current assets and

current liabilities can have a large impact on the survival and

profitability of a firm.

The dual objectives of working capital management areprofitability and liquidity.

Companies may adopt aggressive, moderate or conservative

working capital policies regarding the level and financing of

working of capital.


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Financial Control

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Level ofWorkingCapitalInvestment

Conservative

Moderate

Aggressive

Turnover ()

Each of these three types of policy reflect different attitudestowards risk and return


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Conservative

Carry a level of working capital in excess of the firms needs.This will have an additional cost in financial terms

Moderate

Commensurate with the level of business of the firm

Aggressive

Use working capital as source of finance. Effectively

overtrading on purpose.

Working Capital Policies


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This is the movement of money and resources through the

production cycle from purchases to sales and back into

cash.

The Working Capital Cycle

CashTrade

debtorsTrade

creditors

Sales Product

Cycle

Purchase

s


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Overtrading

Overtrading is defined as carrying on a level of business in

excess of the companies financing ability.

Overtrading can lead to business failure and must be corrected

if found. Corrective measures could include

1. Introducing new capital

2. Improving working capital management

3. Reducing business activity

Because there can be significant amounts of cash tied up in

financing the business items like cash and debtors. These

areas need to be managed carefully.

Management of Cash

Companies should attempt to optimise the amount of cash held.

Cash problems can be minimised by the forecasting of cashneeds with cash flow forecasts and cash budgets. Any surplus

cash should be invested to earn a return in short-term

instruments such as money market deposits, treasury bills and

certificates of deposit.


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Why hold Cash?

Cash may be held for the following reasons:

1. Transaction - The primary reason to facilitate

business. Cash flow needs etc...

2. Precautionary - As a buffer against unforeseen

circumstances or to allow the firm flexibility to exploit

new opportunities

3. Speculative - This is the opposite of hedging. It involves

taking bets on future exchange rates, interest rates etc...

Done well it can dramatically increase profits. Done

poorly it can bankrupt the firm. Examples of bad

speculation include Orange County in California


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Risks

(1) Renewal

It may need to be continually renegotiated, with the risk that

changing circumstances may make this difficult. There is also

the cost of negotiation.

(2) Interest Rate Stability

Changing interest rates will affect a company having to renew

funding.

Which approach?

The overall approach is down to firm type, management; and it

may be determined by industry-wide factors.

Short Term Finance


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Objectives of Short Tern Investment

Liquidity

Safety

Profitability

Illiquidity

Essential Payments

Interest on loans

Wages/Salaries Revenue Commissioners


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Which customers should receive credit?

The five Cs of credit

Capital

Capacity

Collateral

Conditions

Character


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1: Capital

The customer must appear to be financially sound before any

credit is extended. Where possible, an examination of the

customers accounts should be carried out with particular

regard being given to liquidity and profitability. Theirfinancial commitments should also be taken into account.

2: Capacity

Must be able to make payments. Where possible their payment

record to date should be examined. The value of goods

they wish to buy on credit and their total financial

resources are also relevant.

3: Collateral

It may be necessary to ask for some security on certain

occasions.

4: Conditions

The general and firm specific economic conditions should beexamined. In addition some stress testing would be

desirable.

5: Character

The character of the customer honesty and integrity. In the

case of limited firms the character of the directors is also

important.


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Credit Policy Requires the following:

1. Use of trade references

2. Bank references

3. Credit agencies

4. Salesmens reports

5. Information within industry

6. Financial statements

7. Credit Scoring (systematic approach to granting credit)

Length of Credit Period

The terms offered to customers will have an impact on both

sales and profitability and may vary between customers,

firms and industries.


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Factors include:

1. Typical industry terms

2. Degree of competition within the industry

3. Relative bargaining power customer and supplier

4. Default Risk (Credit Risk)

5. Capacity of the business to offer credit.

6. Marketing factors.

Cash Discounts

Cash Discounts may be offered to encourage prompt payment.The costs and benefits of such discounts should be

weighed up carefully taking particular account of the costs

of financing versus the explicit cost of the discount.

Collection Policies

An efficient collection policy requires an efficient accountingsystem. Modern systems have simplified this function

considerably. Ratios can be used to determine whether

this function is being efficiently managed. An aged

schedule may be produced to check up on individual

accounts.


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1: Factoring

A factoring firm may, take over clients ledgers, offer 100%bad debts protection or advance client firm money with the

debts as collateral

2: Undisclosed Factoring

In this case the factoring company will use the client as a debt

collection agent.

3: Invoice Discounting

Advances money based on a % of sales invoices. Firm has

recourse to client in event of bad debts

Debtor Financing


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Many companies regard trade credit as an important source of

finance. It has been described as a spontaneous source as ittends to increase in line with increases in sales. This reasoning

has led many firms to regard it as a free source of finance and

therefore a good thing for a business to use. There are costs

however. This includes reputation effects as well as the costs of

foregoing favorable payment terms (discounts).

In the same way as with debtors, the costs and benefits of using

credit or extending payment should be examined. Ratios can

also be used to examine whether the amount of time taken to

pay creditors is increasing or decreasing.

The Management of Creditors


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Working Capital Ratios can be divided into two sections;

1: Activity Ratios which measure the working capital

function, and,

2: Liquidity Ratios which are a measure of short term

solvency.

Working Capital Ratios


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Financial Control

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Activity Ratios

These show how short term capital is being managed and are

also linked to liquidity and working capital.

Debtors Ratio or debtor days

This gives the average period of credit being taken by

customers, the lower the better since debtors have to be

financed at a cost to the company.

Debtors / Credit Sales (Sales) x 365 / 1

Creditors Ratio or creditor days

This gives the average period your suppliers must wait for

payment, creditors are a form of finance, however both of these

ratios need to be examined in terms of opportunity cost as there

may be interest charges or discounts foregone.

Creditors / Credit Purchases (Cost of Sales) x 365 x 1


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Financial Control

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Stock Turnover

Shows how long it takes a company to turn stocks into sales,

the shorter the period the lower the costs to the company. It will

vary with the nature of the companies business.

Stock / Cost of Sales x 365 / l

The Cash Conversion Cycle

This gives some indication of the amount of working capital

financing that is needed. It is given by

Stock Turnover + Debtors Days - Creditors Days


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Financial Control

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The Cash Conversion Cycle

Purchase

of goodson credit

Paymentfor

goods

Sale of

goodson credit

Cash

receivedfrom

debtors

Stockholding

period

Cash

Conversion

Cycle


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Financial Control

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Calculating the Cash Conversion Cycle

equals

plus

Operating cash cycle

Average payment period for

creditors

Average settlement period for

debtors

plus

Average stockholding period


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Liquidity Ratios

These ratios are used to determine if a company will be able to

meet its financial obligations as they fall due and are therefore a

proxy for the financial strength and level of risk attached to a

firm.

The Current Ratio

This measures a companies ability to meet its debts as they fall

due. The textbook level is two but again this may vary with the

type of business a firm is involved in.

Current Assets / Current Liabilities

The Quick (Acid Test) Ratio

A more stringent guide since it realistically doesnt include

items already paid for or stock, since neither of these

necessarily constitutes ready cash

Current Assets Stock and Prepayments / Current Liabilities


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Financing the

Enterprise


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Financial Control

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For most SMEs, finance will consist of a mix of funding from

a number of sources. Since growth requires finance, small

firms will be reliant on the suppliers of finance that are

available to them. Relationship management is therefore

an important consideration.

Finance can generally be classified as either Equity (implies

ownership) or Debt. When considering the forms of

finance to use, there are three key characteristics. These

are:

1. Cost

2. Risk

3. Timescale

In terms of the timescale , the main sources of finance can be

classified as short term (less than 1 year) and medium

term (generally 1 5 years)

The following figure lists the main forms of finance that are

available to SMEs:


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Financial Control

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Figure 1: Main sources of short and medium term finance


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Debt Finance

Each of the aforementioned forms of finance are essentially

debt. In general, this implies both interest and capital

repayments. The interest represents the cost of the debt finance

while the capital repayment relates to the intrinsic value of

what was borrowed.

Cost and Riskiness of Debt

Debt is generally less expensive than equity finance given that

from an investors perspective it is less risky. This relates to the

fact that there debt carries legal guarantees in terms of priority

whereas equity finance has no such conditions. The investor

will therefore require a lower return.

The riskiness of the borrower is therefore the primary

consideration in terms of the cost of the debt. It is therefore in

the interests of the borrower to present the lowest risk profile

possible when seeking to raise debt finance.

Another issue for the borrower is the underlying business risk

they face since repayments continue irrespective of business

environment. Higher debt levels therefore constitute a risk to

the existence of the firm. This will be demonstrated in the case

study later in the course.


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Bank Borrowing

Why use it?

It is quick

It is flexible

It is available to firms of all sizes including smaller firms

Administration and legal costs are low

Factors to consider when borrowing

Is there are arrangement fee?

This may be of the order of 1% although it may be bargaineddown or away depending on the relative bargaining

strength of the lender and borrower

Should fixed or variable (floating) rate be used

Floating rate loans will change as the underlying interest rate

(EURIBOR) fluctuates. Therefore the borrower should

form a view on interest rate changes and their probableeffects and weigh that against the additional costs of

fixed rate finance.

The interest rate being paid

Ideally the borrower can negotiate a favourable rate.


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Financial Control

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Information Asymmetry and Security

The bank is aware that they do not have all of the information

required to judge the riskiness of the proposed borrower.

They less information they have, the more risky the loan.

Banks will therefore charge a premium that is directly

related to the ability of the borrower to assuage the banks

worries about the riskiness of the proposed loan.Information flow between the borrower and the bank is

therefore crucial both at the initial stages and during the

course of the loan.

Collateral

Sometimes the bank will require security in the form of

collateral that covers the bank in the event of a default.Either a fixed charge (relating to specific assets) or a

floating charge (general) may be applied. In terms of

priority the fixed charge is higher. This simply means the

a bank with a fixed charge gets paid before a bank with a

floating charge.

Covenants

These are restrictions on managerial actions that the bank may

require of the borrower. They are designed to reduce the

risk of default during the life of a loan


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Personal Guarantees

The bank may in certain cases require directors or shareholders

of the firm to go guarantor. This means that the private

assets of a director/shareholder may be used as collateral.

This bypasses the limited liability clause and may be a

necessary condition for smaller firms to raise debt

finance.

Repayment Considerations

The firm should give serious thought to their ability to repay

both interest and capital and schedule the loan in a way

that is compatible with the probable future cash flows of

the company. This may require some flexibility being

built into the loan agreement.

Main Types of Finance

Overdraft

Term Loan

Trade Credit

Factoring


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Overdraft

An overdraft is a permit to overdraw on an account up to a

stated limit. The advantages are flexibility and low cost.

The Drawbacks are that the bank retains the right to withdraw

the facility at short notice and that security will be required in

most cases

Term Loan

A term loan is a loan of a fixed amount for an agreed time and

on specified terms. The.typical timeframe is three to seven

Years. They may be flexibly scheduled in terms of repaymentsespecially if the loan is for a particular project. Similarly the

drawdown of funds may be spread out to meet funding

requirements.

Trade Credit

Given by suppliers where payment for goods is deferred a setnumber of days. Usually requires that trade and bank

references be supplied. Un satisfactory receipt trade credit may

be advanced in line with usual industry terms.


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Overdraft or Trade Credit?

Example - Invoice

Option 2 Paying in 60 days

Where d = daily interest and i = annual interest

Assume that annual APR interest on overdraft is 10% then we

have:

Interest Charge for 46 days

or 1.208%

Settlement Terms 217.3

2.5% discount may be deducted for payment

within 14 days of invoice date, otherwise due

30 days strictly nett 255.33

( )

1)1(

11

365

365

+

+=+

i

id

00026116.01)1.01(365 =+

Option 1 - Discount for early payment

217.30 x 0.025 5.43

( ) 01208.000026116.01 46 =+


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Financial Control

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Interest Charge for 46 days is:

Since the interest cost is less than the value of the discount it

would be advantageous to take the discount and finance

the early payment with an overdraft

Note however that not all suppliers will offer a discount for

early payment which encourages the use of trade credit.

The problem with over reliance on trade credit is

reputation effects as many suppliers will soon tire of a

persistent late payer.

( ) 02.301208.043.533.255 = x


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Financial Control

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Factoring

The provision of finance

Sales ledger administration

Credit insurance

Recourse and non-recourse

Invoice discounting

Factoring is essentially the provision of finance at a rate similar

to overdraft rates (depending on borrower) on the basis of

the working capital needs of a firm (stock and debtors)

Factoring is generally offered as a service by the clearing banks

so in Ireland it is handled by companies such as

Enterprise Finance Europe (A Bank of Ireland subsidiary)

among others.


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Financial Control

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Other Forms

Leasing and Hire Purchase

These are broadly similar in terms of their advantages to

business. The key advantages are:

Small initial outlay

Certainty

Availability

Fixed Costs

Tax relief

Transfer of obsolescence risk (for operating leases)

Bills of Exchange

Primarily for export sales. Basically a legal commitment to pay

a sum at some future date. (like an IOU). They are

generally discounted with a discount house who advances

money (e.g. 90% of the value of the bill) and charges an

interest rate.


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Financial Control

Equity Finance

Equity finance has a different set of characteristics from the

firms perspective. Its low risk in that

Owners/Shareholders earn only the residual income of the

firm and have no legal rights in terms of insisting on a

return.

The downside of equity is related to control. The more equity

finance is used, the more control of the firm that is ceded

assuming that the equity finance raised is not coming

from the current owners / shareholders.

Finally, although equity finance is low risk from the

perspective of the firm, it is relatively high risk from the

investors perspective. They will therefore require a high

return in order to consider putting their money into a

business. An additional consideration is that lenders

generally look more favorably on projects where the

investor is prepared to risk his/her own money as this is apositive signal of their view of the project.

Financial Performance and Working Capital

Documents