1. EC7095 Financial Statement Analysis
Lecture 7

2. Recap – lecture 6 Shareholder/investor ratios Dividend yield EPS
Dividend cover
PE ratio
Earnings yield
Net assets per share
Balanced scorecard/Non financial performance indicators

3. Intangible Assets
An identifiable non-monetary asset without physical substance
Identifiability – may be a problem
It must be under the control of the entity
It must have expected future economic benefits
Internally generated goodwill

4. Research and Development
Research – obtaining new knowledge
Development – can be capitalised
- Technically feasible
- Intention to complete
- Ability to use or sell
- Demonstrate the existence of a market
- Ability to measure the expenditure

5. Other internally generated assets
International accounting standards prevent the recognition of: internally generated brands, publishing titles, customer lists etc.
The following costs should be expensed as incurred – start up costs, advertising costs, training costs, business relocation costs

6. Measuring intangibles in future periods
Cost model
Revaluation model
Useful life/amortisation

7. Goodwill
Is created by good relationships between a business and its customers
Inherent v. purchased
Value of purchased goodwill

8. Impairment of assets
Impairment arises where the carrying amount of the asset is greater than the “recoverable” amount
Recoverable amount is the higher of its fair value (less costs to sell) and its value in use

9. Indications of impairment
Greater than expected fall in market value
Significant change in the technological, market or economic environment of the business in which the assets are employed
An increase in cost of capital likely to affect the present value of an asset in use
Carrying amount > market capitalisation

10. Reporting financial performance
Accounting policies
Changes
Errors

11. Accounting policies Basis of preparation Depreciation
Leasing commitments
New standards

12. Segmental reporting By business sector By geographical location
Revenues, operating profits, assets and liabilities

13. Minimum disclosure Expense categories Profit after charging……….
Staff costs
Movements in property plant and equipment

14. Other information in the notes
Group companies
Half year results
5 year history

15. Other information in the financial statements
Chairman’s statement
Directors’ report
Corporate governance
Remuneration report
Auditors report

16. Directors Report Chief Executive’s review Principal activities
Strategies and objectives
Outlook and priorities
Key performance indicators
Risks and uncertainties
Employees
Social and environmental matters

17. Financial Instruments
Financial assets
Financial liabilities

18. Foreign Currency Risk
Translation risk
Economic risk
Transaction risk

19. Transaction Risk - example
A UK exporter is due to receive $1m in 3 months time
The current exchange rate is $1.40 to £1
That rate could rise or fall by up to 20% in the next 3 months

20. Terminology
Strong or weak £
Buy or sell
Spot rate

21. Spot rate example
Exchange rates on 9th March were $/£ /
Calculate the receipts from a $1m sale to a US customer
Calculate the cost of paying an invoice of $1m

22. Managing transactions risk – internal methods
Invoice in £’s
Matching
Netting
Leading
Lagging

23. Forward exchange contracts
A binding contract with a bank covering a specific amount of foreign currency at an exchange rate agreed now
Forward rate –
Forward rate /
Spot rate with premium or discount
Spot
3 month forward
US$/£ –
– premium

24. Forward rates - example
Spot rates are $/£ / and forward rates are $/£ /
Calculate the receipts from a $1m sale to a US customer due to be received in 3 months time if forward rates are used
Calculate the cost of paying an invoice of $1m in 3 months time if forward rates are used

25. Forward rates - advantages
Simple
Low up front costs
Available in many currencies
Can be available for more than 1 year ahead

26. Forward rates - disadvantages
Binding contracts
Fixed dates
Rates may be unattractive

27. Money market hedging Using the money market to avoid transaction risk
If we are due to receive dollars in the future we have a dollar asset so we match this with a dollar liability by taking out a loan in dollars
If we are due to pay dollars in the future we match that liability to an asset in $ by investing $.

28. Money market hedge - exporter
Expect $ revenue in 3 months time
Borrow in $s today

29. Money market hedge –example 1
J Ltd is due to receive $1m on 10th June.
Spot Rate $/£ is /
3 month forward rate is /
UK 3 month interest Rates 5.7% - 5.6%
US 3 month interest Rates 4.4% - 4.3%

30. Money market hedge - importer
Expect $ costs in 3 months time
$ deposit today

31. Money market hedge – 5 steps (importer)$
now
4. Withdraw £s
3. $ deposit
1. Pay $s
3 mths
5. Compare to
a forward
2. Using $
on deposit
Determines the size of the $ deposit today

32. Money market hedge –example 2
J Ltd is due to pay $1m on 10th June.
Spot Rate $/£ is /
3 month forward rate is /
UK 3 month interest Rates 5.7% - 5.6%
US 3 month interest Rates 4.4% - 4.3%

33. Money Market Hedge Advantage is greater flexibility
More complex than forward contract – no cheaper

34. Derivatives Using other “products” to avoid risk Futures contracts
Options

35. Futures contracts
Contracts that fix the exchange rate for a set amount of currency over a specified period of time
Currency futures are mainly available from the US markets such as NYBOT futures and options exchange
They are flexible – a September future can be used on any day up to the end of September
They are only available for large contract sizes
Margin payments are required

36. Currency Options
Options are contracts giving the holder the right, but not the obligation, to buy or sell a fixed amount of currency at a fixed rate in return for a premium
Option to buy is called a “call” option
Option to sell is called a “put” option
“European” options have a fixed date – “over the counter options”
“American” options can be “exercised” at any date before the end of the contract – “exchange traded options”

37. Options – simple example
It is 1st October
S plc wishes to hedge the “possible” receipt of $2m from the sale of a US subsidiary in December
Spot Rate is $1.4615
An “over the counter” option for $2m with an exercise price of $1.47 can be bought for a premium of £50000
What will be the outcome if:
(a) The exchange rate in December is 1.5 $/£
(b) The exchange rate in December is 1.4 $/£
(c) The sale does not take place

38. Exchange Traded Options
Standard contract sizes
Can be long term – quoted up to 2 years, but longer periods available
Tradable – can be sold if not needed

39. Interest Rate Risk Higher costs on existing loans
Higher costs on planned loans

40. Managing interest rate risk
NOW – Plan a loan in 3 months time
IN 3 MONTHS – Take out the loan
Interest rates may have risen

41. Managing interest rate risk - FRAs
£5m FRA at 5%
Size of loan
Start & end month
Base rate guaranteed
11.4

42. Illustration 1 - FRA
A plc is planning to take out a 6 month loan of £5m in 3 months time but is concerned about the base rate (LIBOR) rising above its current level of 5.25%
A plc has been offered a 3-9 FRA at 5.5%
A plc can borrow at 1% above LIBOR

43. Illustration 1 Continued
In 3 months time the base rate is 5.75%
A plc will take out a loan at 6.75%
Due to FRA they will receive compensation from the bank of 0.25%
The net cost is 6.5% (1% over the base rate in the FRA)

44. Illustration 1 Continued
In 3 months time the base rate is 4.5%
A plc will take out a loan at 5.5%
Due to FRA they will pay compensation from the bank of 1%
The net cost is 6.5% (1% over the base rate in the FRA)

45. Interest Rate Futures
Futures are a separate agreement from the actual transaction
They are a DERIVATIVE – their value is derived from movements in the base rate

46. Exchange traded options
An option gives the buyer the right but not the obligation to buy or sell a commodity at an agreed price on or before an agreed date in exchange for a premium.