1. EC7095 Financial Statement Analysis
Lecture 2

2. Lecture 1 Recap.
Course Text – “Using and Interpreting Company Accounts” by Wendy McKenzie (4th Edition)
Accounting principles and assumptions
Elements
Balance sheets (financial position)
Income statements

3. EC7095 Assignment Is now on the web page for this module
To be submitted (hard copy) by 12pm on Tuesday 6th December
Individual and original!

4. Sources of Finance Equity Debt Internally generated funds
From owners – shares
Reinvested profits
External funds
Bank loans
Debentures
Lease finance
Short term credit

5. Issuing Shares Share capital and share premium
Rights issue – an issue to existing shareholders that is usually at a price lower than the current market price
Using the stock market

6. Rights Issues Raises new finance (equity issue will reduce gearing)
No changes in control if rights taken up
Rights can be sold
Probably the cheapest way for a company to raise new share capital
All of benefits to existing shareholders

7. Rights Issues – What price?
ABC plc has the following capital structure:
Share Capital (£1 shares) £4m
Retained Earnings 6m
10m
The directors propose to raise an additional £2.4m from a rights issue. They expect to continue to earn a return (after tax) on equity capital of 20%. If the current market price of a share is £4 what price should they issue the new shares at?

8. Rights Issue – What Price?
Existing shares
New shares
Total shares
Existing earnings
New earnings
Total earnings
EPS
Pre new issue 4m -
10m x 20% = 2m 2m
50p

9. Rights Issue – What Price?
Existing shares
New shares
Total shares
Existing earnings
New earnings
Total earnings
EPS
Pre new issue 4m -
10m x 20% = 2m 2m
50p
@ £2
1.2m
5.2m

10. Rights Issue – What Price?
Existing shares
New shares
Total shares
Existing earnings
New earnings
Total earnings
EPS
Pre new issue 4m -
10m x 20% = 2m 2m
50p
@ £2
1.2m
5.2m
o.48m
2.48m
47.7p

11. Rights Issue – What Price?
Existing shares
New shares
Total shares
Existing earnings
New earnings
Total earnings
EPS
Pre new issue 4m -
10m x 20% = 2m 2m
50p
@ £2
1.2m
5.2m
o.48m
2.48m
47.7p
@£2.50
0.96m
4.96m
0.48m

12. Rights Issue – What Price?
Existing shares
New shares
Total shares
Existing earnings
New earnings
Total earnings
EPS
Pre new issue 4m -
10m x 20% = 2m 2m
50p
@ £2
1.2m
5.2m
o.48m
2.48m
47.7p
@£2.50
0.96m
4.96m
0.48m
@£3
0.8m
4.8m
51.7p

13. Rights issue – post issue price
What will happen to the market price of the shares after the rights issue?
Theoretical ex rights price (TERP)
Using the previous example with an issue at £3 – so 0.8m new shares would be issued – a 1 for 5 issue
For every 5 old shares one new share is available at £3

14. TERP For a shareholder with 5 shares before the rights issue
5 shares at £4 £20
1 new share at £3 £3
Now has 6 shares £23
TERP = 23/6 = £3.83
In theory the market price of the shares will fall from £4 to £3.83

15. Effect on shareholder wealth
Pre Rights issue
Ex rights issue
Wealth = 5 shares at £4 = £20
6 shares at £3.83 = £23
Paid for rights = (£3)
Wealth £20
Wealth (in theory) is unaffected by the rights issue

16. Selling rights
A shareholder who does not wish to buy the new shares can sell their “rights”
In theory the rights could be sold for 83p (£ £3)
The shareholder would now have a smaller (proportionately) stake in the company but in theory wealth would not be affected
Before 5 shares at £4 = £20
After 5 shares at £ cash of 83p = £20

17. Shareholder options Take up or “exercise” the rights
“Renounce” the rights and sell them
Renounce part of the rights and take up the remainder
Do nothing – shareholders gain some protection from Stock Exchange rules. Any shares not taken up must be sold to new subscribers for the benefit of the shareholders who were entitled to the rights

18. Using the stock market - advantages
Access to wider pool of finance
Improved marketability of shares
Enhanced public image
Easier to seek growth by acquisition

19. Using the stock market - disadvantages
Greater public regulation, accountability and scrutiny
More demanding investors
Additional costs of issues – brokerage and underwriting fees

20. Issuing shares on the stock market - IPO
Initial Public Offer – is an invitation to apply for shares in a company based on information contained in a prospectus
A means of selling shares to the public at large
Common when companies “go public” for the first time (floatation)

21. Issuing shares on the stock market - placing
A placing is an arrangement whereby the issue is not offered to the public but is bought by a small number of investors – usually institutional investors
Placings are cheaper and quicker
Placings have less disclosure of information
But institutional investors may gain control
Maximum placing = 75%

22. Debt – Short Term Sources
Bank loan or overdraft
Leases - finance or operating
Taking extended credit
Factoring
Invoice discounting

23. Debt – Long Term Sources
Bank loan
Leases – finance or sale and leaseback
Bonds, loan notes, debentures

24. Bonds, loan notes and debentures
Redeemable or irredeemable
Fixed or floating rate
Coupon rates
Convertible

25. Bonds, loan notes and debentures
Factors influencing choice
Availability
Duration (matching)
Expectations of interest rate movements
Security and covenants

26. Venture Capital
High risk capital, normally provided in return for an equity stake
Expect a very high return in a relatively short period
Pre determined exit route
75% of requests rejected on first screening
3% of requests successful
Minimum finance £0.5m

27. Financial Structure and Risk
Co A is financed entirely by equity of £2m and Co B is financed by £1m equity and £1m debt at 10%
£’000s (A)
£’000s (B)
PBIT
200
Interest
PBT
Tax (30%) 60
PAT
140
Return to Shareholders 7%

28. Financial Structure and Risk
Co A is financed entirely by equity of £2m and Co B is financed by £1m equity and £1m debt at 10%
£’000s (A)
£’000s (B)
PBIT
200
Interest
100
PBT
Tax (30%) 60 30
PAT
140 70
Return to Shareholders 7%

29. Financial Structure and Risk
Co A is financed entirely by equity of £2m and Co B is financed by £1m equity and £1m debt at 10%
£’000s (A)
£’000s (B)
PBIT
200
400
Interest
100
PBT
Tax (30%) 60 30
120
PAT
140 70
280
Return to Shareholders 7%
14%

30. Financial Structure and Risk
Co A is financed entirely by equity of £2m and Co B is financed by £1m equity and £1m debt at 10%
£’000s (A)
£’000s (B)
PBIT
200
400
Interest
100
PBT
300
Tax (30%) 60 30
120 90
PAT
140 70
280
210
Return to Shareholders 7%
14%
21%

31. Financial Structure and Risk
Co A is financed entirely by equity of £2m and Co B is financed by £1m equity and £1m debt at 10%
£’000s (A)
£’000s (B)
PBIT
200
400
100
Interest
PBT
300
Tax (30%) 60 30
120 90
PAT
140 70
280
210
Return to Shareholders 7%
14%
21%
3.5%

32. Financial Structure and Risk
Co A is financed entirely by equity of £2m and Co B is financed by £1m equity and £1m debt at 10%
£’000s (A)
£’000s (B)
PBIT
200
400
100
Interest
PBT
300
Tax (30%) 60 30
120 90
PAT
140 70
280
210
Return to Shareholders 7%
14%
21%
3.5% 0%

33. Risk
Is measured in term of fluctuations – the greater the potential to fluctuate the greater the risk. More debt usually means more risk for shareholders.
Debt providers face less risk than shareholders
- security
- legal payments
- fixed return
Debt providers will accept a lower return than shareholders (debt is cheaper than equity)

34. Order of payment in liquidation
Secured creditors
Liquidator
Preferential creditors
Unsecured creditors
Shareholders

35. Cash is King! Making profits does not ensure a healthy bank balance
Not having enough cash is the major reason for companies going into liquidation

36. Simple example
A new company is started with £100k of capital from its owners
In the first month they buy a machine for £60k which is expected to last for 5 years
Raw materials are purchased for £30k in cash
Goods are manufactured incurring further costs of £30k (labour and overheads)
These goods are sold on credit for £120k

37. Example cont. Income Statement Cash at Bank £k Sales 120 Materials
(30)
Other costs
Depreciation
(1)
PROFIT 59 £k
Capital
100
Machine
(60)
Materials
(30)
Other costs
BALANCE
(20)

38. Profit ≠ Cash
The difference needs to be explained to shareholders in the financial statements
Cash flow statements

39. Cash Flow Statement - proforma
Profit before interest and tax X
Add: Depreciation X
Loss/(profit) on sale of non current assets X/(X)
(Increase)/decrease in inventories X/(X)
(Increase)/decrease in receivables X/(X)
Increase/(decrease) in payables X/(X)
Cash generated from operations X/(X)
Interest (paid)/received X/(X)
Income taxes paid (X)
Net cash flows from operating activities X/(X)
Cash flows from investing activities X/(X)
Cash flows from financing activities X/(X)
Net increase/(decrease) in cash X/(X)
Cash at beginning of period X/(X)
Cash at end of period X/(X)

40. Changes in working capital
Sales 2,000
Receivables at start of the year 300
Total cash “receivable” 2,300
Receivables at the end of the year 500
Therefore cash “RECEIVED” 1800 OR
Increase in receivables ( ) (200)
Cash received

41. Simple Cash flow statement
Cash generated from operations
Profit for the year
Add back non cash items:
Depreciation
Changes in working capital
Increase in debtors (120)
____
Net cash outflow from operations (60)
Sources of cash – new capital 100
Uses of cash – new machine (60)
Net decrease in cash (20)

42. Next plc revisited
The balance sheet for Next plc that we saw last week for 2011 showed cash and short term deposits falling from £107m to £49.3m
The income statement showed an operating profit of £574.8m

43. Next plc 2011 2010 Notes £m £m Cash flows from operating activities
Notes £m £m
Cash flows from operating activities
Operating profit
Depreciation and amortisation
Impairment
Loss on disposal of property, plant & equipment
Share option charge
Share of undistributed profit of associates (1.1) (0.5)
Exchange movement (2.6) (1.6)
(Increase)/decrease in inventories (59.3) 9.7
(Increase)/decrease in trade and other receivables (29.0) 6.0
Increase in trade and other payables
Pension contributions less income statement charge (40.9) (32.2)
Cash generated from operations
Corporation taxes paid (141.9) (115.2)
Net cash from operating activities

44. Next plc cont. Cash flows from investing activities
Proceeds from sale of property, plant and equipment
Acquisition of property, plant and equipment (120.6) (98.6)
Payment of deferred consideration (19.4) –
Net cash from investing activities (138.1) (98.2)
Cash flows from financing activities
Repurchase of own shares (221.6) (101.8)
Purchase of shares by ESOT (99.7) (39.2)
Proceeds from disposal of shares by ESOT
Proceeds/(repayment) of unsecured bank loans (75.0)
Repurchase of corporate bonds (51.3) (46.6)
Interest paid (21.6) (32.1)
Interest received
Payment of finance lease liabilities (0.3) (0.4)
Dividends paid (129.6) (108.5)
Net cash from financing activities (377.2) (369.0)

45. Next plc cont.
Net (decrease)/increase in cash and cash equivalents (63.3)
Opening cash and cash equivalents
Effect of exchange rate fluctuations on cash held (3.5)
Closing cash and cash equivalents

46. Decision making under historic cost accounting
Assets in a balance sheet are shown at original cost
In times of rising prices this can lead to sub optimal decisions being made by those who use the historic data
Companies can consistently make profits but still run out of cash

47. Financial Accounting and decision making
FA Ltd
£2k
Cash £1k

48. Financial Accounting and decision making
FA Ltd
£2k
Profit £200
Cash £3200
Cash £1k

49. Financial Accounting and decision making
FA Ltd
£3k
£2k
Profit £200
Cash £3200
Cash £200
Cash £1k

50. Financial Accounting and decision making
FA Ltd
£3k
£2k
Profit £200
Cash £3200
Cash £200
Cash £1k
The company has made a profit
The assets have grown (£3k to £3.2k)
The shareholders will be happy!

51. Management Accounting and decision making
MA Ltd
£2k
Cash £1k

52. Management Accounting and decision making
MA Ltd
£2k
Profit £0
Cash £1000
Cash £1k

53. Management Accounting and decision making
MA Ltd
£2k
£2k
Profit £0
Cash £1000
Cash £1000
Cash £1k

54. Management Accounting and decision making
MA Ltd
£2k
£2k
Profit £0
Cash £1000
Cash £1000
Cash £1k
The company has made no profit
The assets have not grown
The shareholders will not be happy!

55. But………….
FA Ltd has gone from having a pile of stock and £1000 to an identical pile of stock and £200
MA Ltd has a pile of stock and £1000!
Which would you rather be the owner of?
If FA continues to make decisions based on historic costs they may run out of cash and end up in liquidation (despite showing profits in their income statement and growth in their assets in the balance sheet)

56. Cost of Sales
The trading profit of a retailer is not simply Sales less Purchases
If we buy 100 items and sell 90 of them in an accounting period we only account for the cost of the goods actually sold in that period
Cost of sales (cost of goods sold) = Opening stock + purchases – closing stock

57. Inventory Valuation
Inventory (stock) should be valued at the lower of cost and net realisable value
The cost should reflect all costs in bringing the items to their present location and condition – this should include a share of factory overheads
This can lead to another problem with financial accounts……..

58. Another problem with financial accounts
ABC Ltd (approaching the year end) - forecast income statement
£000’s
Sales £10)
Cost of goods manufactured £5) 50
Other factory costs (e.g. rent) 40
Total costs
Profit
Jim the factory manager needs a profit of £25K to get a bonus – What can he do if there are no more sales to be made?

59. Solution Sales (10,000 @£10) 100k Cost of goods sold
Manufactured £5 = 100k
Other factory costs 40k
Total cost of units 140k
Still in stock (not sold) 70k
Therefore cost of goods SOLD 70k
Profit is now 30k

60. What next?
Financial accounting is based on subjective concepts and policies giving scope for “creativity”
Company financial statements are prepared under “minimum disclosure requirements”
We need to be flexible in our analysis
Over the next weeks we will analyse financial statements in 4 areas – Profitability, Liquidity (solvency), Gearing and Shareholder Interests