ECFS 865: INVESTMENTS

Transcription

1 MACQUARIE UNIVERSITY APPLIED FINANCE CENTRE ECFS 865: INVESTMENTS 2013 TOPIC 0: FINANCIAL STATEMENTS 1 2 This intrductry tpic is an imprtant stepping stne t the financial statement analysis that will ccur in the Investments and the Crprate Finance units. The bjective is nt t build a cmprehensive understanding f accunting principles and financial reprting but t achieve familiarity with the key financial statements. This intrductin refers t the Wesfarmers 2012 Incme Statement, Balance Sheet and Cashflw Statement (an extract is attached at the end f this dcument). In additin t the extract yu shuld als access the Wesfarmers website t see the full Annual reprt and Financial Statements. Click n this link t g t the website: Wesfarmers website select Investr Centre then 2012 Annual Reprt. There are sme exercises thrughut this tpic. Answers t these are lcated at the end f the tpic ntes. Questins n this material can be psted nt the curse frum. 1 The main reference fr this intrductin is: Rss, Westerfield & Jaffe, Crprate Crprate Finance, McGraw-Hill/Irwin, 9th editin 2010, Chapters 2.1 t These ntes are written by Anthny Carltn.

2 0.1 Intrductin The bjective f this sectin is t intrduce the key cncepts used in understanding a cmpany s financial statements. These statements are prduced fr external and internal audiences. Althugh the nature f reprts used fr these audiences differ significantly, the principles underlying the preparatin f financial statements are cmmn. Using Financial Statements Infrmatin Financial Statements are a critical part f many Investment and Crprate Finance applicatins. Sme examples include: External investrs, financial statements are a key input int their effrts t evaluate histrical perfrmance and frm views abut future prspects. Equity analysts will need t be able t understand and interpret a cmpany s financial statements. Fundamental equity analysts wuld usually prepare frecast financial statements fr the cmpany they are evaluating and use these in their valuatin; M&A transactins, will usually invlve the preparatin f pr-frma financial statements t demnstrate the financial impact f a prpsed transactin. Similarly, majr financing transactins wuld see pr-frmas being prepared; Credit analysis, classic credit analysis invlves the analysis f an individual cmpany and its ability t service debts. The preparatin f frecast financial statements and financial ratis are a critical part f this. Credit rating agencies are heavy users f financial statements and the famus Altman Z- Scre mdel uses ratis t predict bankruptcy; Financial mdelling and valuatin: any DCF valuatin will invlve the preparatin f frecast cash flws. Gd mdels will als include frecast financial statements as the basis fr the cash flws, and als fr the calculatin f ratis which are imprtant t help test the rbustness f the frecasts; Business analysis: t understand the histrical perfrmance and prspects f a business invlves assessing financial results, using fr example, rati analysis.

3 Financial statements prvide key inputs int investrs valuatin mdels. Security analysts therefre need t be able t understand and interpret a cmpany s financial statements. Internally, cmpany management als use financial infrmatin t help make cmmercial decisins relating t the perating and financial perfrmance f the business, as well as fr internal cntrl. Hwever, this tpic will fcus primarily n the external perspective. External financial statements a clser lk In Australia, external financial reprts are generally prduced n a six mnthly basis. The cmpany s Annual reprt includes financial statements as well as management cmmentary n results and near term prspects. These financial reprts must be prepared in line with legal requirements as t cntent and principles used in their preparatin. As a result f legal disclsure requirements, cmpanies are als required t disclse infrmatin which might be price sensitive t the market n a timely basis. In additin cmpanies make available t the public the presentatins which are made t majr sharehlders and investrs thrughut the year. These annuncements and presentatins are a useful, and mre timely, surce f infrmatin n cmpany perfrmance and prspects. They are available n cmpany websites, and can generally als be accessed thrugh the ASX website as well, ie at: Fr sme examples f such presentatins yu shuld refer t the crprate website f the cmpanies yu are interested in fllwing. Financial reprting is based n the preparatin f five inter-related financial statements: Balance Sheet, which presents a snapsht f the financial psitin f a business at a pint in time. The financial psitin is measured by determining the value f assets, liabilities and sharehlder s equity at the balance date; Incme Statement, which reprts the results f revenue and expenses ver a particular reprting perid; Statement f Cmprehensive Incme, which represents the change in Equity during a perid, OTHER THAN changes resulting frm transactins with wners in their capacity as wners (i.e. this wuld exclude the impact f equity raisings and dividends);

4 Statement f Changes in Equity, which shws the change in Sharehlder s Equity frm all surces i.e. INCLUDING equity raisings, dividends, share repurchases and the issuance f ptins; Cash Flw Statement, which reprts thse transactins that had an impact n the cmpany s cash balance during the reprting perid. The Incme Statement is a subset f the Statement f Cmprehensive Incme, which is itself a subset f the Statement f Changes in Equity. The Incme Statement is fcussed n perating perfrmance in a perid. In this tpic we will fcus n the Balance Sheet and Incme Statement, althugh the Cash Flw Statement will als be encuntered in the Investments unit. Reading material An extract f the majr financial statements fr Wesfarmers are included at the end f these ntes. Ntes t the financial statements In additin t these financial statements a cmpany s financial reprt will include a sectin entitled Ntes t the financial statements. This includes the fllwing: Summary f Significant Accunting Plicies which details the accunting plicies adpted by the cmpany in questin. In the Wesfarmers full Financial Statements (lcated n their web site) these are included in Nte 2, pages Fr example, paragraph (d) in these accunts highlights the particular areas where subjective judgements have had a material impact n the accunts; Breakdwn n majr items in Balance Sheet and Incme Statement, and recnciliatins etc. The high level financial statements are, bviusly, highly summarised. Especially fr cmplex cmpanies like Wesfarmers, it is ftentimes necessary t examine the ntes t find ut what is behind majr financial items. In additin t the financial reprt, a cmpany s annual reprt will include a Management Discussin and Analysis, where an effrt is made t explain the perfrmance f the business, cmmunicate strategies and sme sense f future directin.

5 Internal financial reprts Internal financial reprts are generally prduced n a mnthly basis, and will differ significantly in frmat and cntent frm external reprts. Fr example, internal reprts shuld generally cntain: mre infrmatin n the actual perating perfrmance f the business, in additin t financial measures; diagnstic perfrmance measures, such as efficiency and prductivity measures as well as cmparisns against budget; frecast perfrmance and results. Mst cmpanies wuld include updated frecasts f current year perfrmance, in additin t actual results; mre detail abut segmental perfrmance, shwing much greater detail n perfrmance f individual segments r prducts within a cmpany; generally easier t fllw. Internal reprts are nt required t meet legal accunting standards s it wuld nt be uncmmn fr cmpanies t use unique definitins and calculatin bases fr calculating financial perfrmance. If using internal reprts in a transactin cntext it will be imprtant t understand precisely the basis f preparatin eg internal transfer pricing.

6 0.2 Overview f selected key accunting principles Befre examining the key financial statements in mre detail it is imprtant t describe sme general principles which underlie their preparatin. Financial statements are prepared in accrdance with what are described as Generally Accepted Accunting Principles. These principles are reflected in Accunting Standards. It is a legal requirement fr cmpanies t use these standards in the preparatin f accunts. Until recently individual cuntries used accunting standards which were cuntry specific hwever, in an effrt t achieve harmnisatin f financial reprting, many cuntries are wrking twards adpting a unifrm set f internatinal standards, knwn as Internatinal Financial Reprting Standards ( IFRS ). The Australian Accunting Standards Bard ( AASB ) made the adptin f these standards bligatry frm 1 st January There are currently mre than fifty standards, cvering virtually all aspects f cmmercial transactins, including Revenue and Expense Recgnitin, Cnstructin Cntracts and Interests in Jint Ventures. A full listing f standards is available at the AASB website In spite f all the standards there is still a degree f subjectivity incrprated int what a cmpany reprts as its annual prfit. Many cmmentatrs wuld als argue that financial statements have becme increasingly difficult t cmprehend. It is therefre imprtant t understand the basis n which a set f financial statements have been prepared. Different accunting treatments can have a material effect n the key results, such as Prfits and Earnings per Share. These can include such fundamental issues as when d we recgnise revenues in the prfit statement? and des the balance sheet include all f the cmpany liabilities? 4 3 The ther majr regulatry change t external reprting has been the adptin f stricter and mre prescriptive gvernance standards in mst cuntries. These mainly invlve guidelines relating t Bard cmpsitin, risk management prcesses and varius disclsures. Adapting internal rganisatinal prcesses in rder t ensure cmpliance with these standards has had a significant impact n rganisatins. In Australia these guidelines can be reviewed n the ASX website The United States equivalent is the well knwn Sarbannes Oxley Act. Althugh nt directly relevant t Australian cmpanies it is a requirement f freign cmpanies t meet these requirements if they wish t raise funds in the US public markets. 4 Clearly there are a number f detailed accunting issues which cannt be addressed in this intrductry tpic.

7 Underlying these individual standards is a series f cnventins which prvide a framewrk fr deciding hw t reflect transactins in financial reprts. It is imprtant t be aware f sme f these: Matching principle, als knwn as accrual accunting The matching principle is necessary because we are trying t measure perfrmance fr a financial perid, which is a subset f a prject s r business s life. The bjective is t allcate expenses t the perid in which the revenue is recgnised, t ensure that the prfit fairly reflects perfrmance fr that perid. Examples f the matching principle include: Depreciatin: depreciatin represents the allcatin f the riginal cst f a capital asset ver its expected useful life. The depreciatin in each year is recgnised as an expense in calculating prfit even thugh the cash was utlaid when the asset purchased; Inventry: even thugh prduct may have been prduced during a particular financial perid, and incurred cash expenses, it will nt be recgnised as an expense because the revenue has yet t be earned. Instead it is treated as an asset, and charged as an expense when sld; Accruals and prepayments which yu will see n virtually all cmpany balance sheets. The matching principle is ne reasn why cash flw will be different t prfit. Histric Cst cnventin This cnventin requires that, when calculating the balance sheet f an entity, that asset items be recrded at the riginal cst (minus accumulated depreciatin) and liabilities be recrded at face value. Thus the balance sheet des nt attempt t display the market value f the business, but rather the sum utlaid r received. This reflects the initial purpse f accunting which was directed at stewardship.

8 This cnventin has been under challenge in recent years and while still an verriding principle there are a number f exceptins: Lwer f cst r market: where an assets recverable value is less than its riginal (histric) cst then the balance sheet must be reduced by this impairment lss; In Australia cmpanies revalue their land and buildings t market values peridically; Certain financial institutins are able t value assets and liabilities at current market values. Ging Cncern assumptin Assumes the entity being reprted will cntinue t perate. In fact directrs must act if they cnsider the business is unable t meet debts as and when they fall due. In accunting terms vilatin f this assumptin wuld require the cmpany t be valued n a liquidatin basis (eg refer t pages 172 and 173 f the Wesfarmers Financial Reprt t see the types f declaratins required by directrs and auditrs). Cnslidated Financial reprts Mst mdern rganisatins will cmprise a number f legal entities, with the parent cmpany investing in a number f subsidiaries. These subsidiaries may represent different lines f business r different gegraphical entities. Althugh these are separate legal entities, financial statements are prepared n a cnslidated basis, as if all the entities are ne. There are cnditins which must be met t allw fr this hwever virtually all listed rganisatins meet these. Hwever when lending t individual entities within a grup it is imprtant t understand the financial psitin f that entity, as the assets f the cnslidated grup may nt be available t service debts f that subsidiary entity. Where a parent cmpany cnslidates a partly wned subsidiary it leads t the creatin f minrity interests.

9 Cnsistency It is generally accepted that nce a cmpany has selected a particular accunting plicy it shuld use this cnsistently acrss the cmpany fr all similar transactins, and cnsistently ver time. When a cmpany changes its accunting treatment, that can be a signal that an analyst may have t investigate further t establish cnsistent interpretatin. Prudence r cnservatism This principle states that when chsing between tw alternative treatments fr a transactin the accuntant shuld chse the ne that results in the lwer value fr net incme r net assets. This leads t a bias t recgnise ptential lsses (eg thrugh the use f prvisins) but nt the recgnitin f ptential gains. An example f this wuld be the lwer f cst r market rule applied t inventry. If the market value f inventry is less than cst, then the value shuld be written dwn t the market value, hwever if the market value is greater than cst than the gain in value is nt recgnised (f curse the gain will be recrded when the inventry is sld).

10 0.3 Overview f Financial Statements We will nw review key terms typically fund in Financial Statements. Yu shuld refer t the Wesfarmers reprt fr an actual example. It is recmmended yu refer t these statements as yu prceed thrugh this sectin. Fr each reprt we will firstly explain the key terms and cncepts as they are cmmnly used, and then discuss issues that need t be cnsidered in using and interpreting these reprts The Balance Sheet The balance sheet represents the cmpany s financial psitin at a pint in time by reprting assets, liabilities and sharehlder s equity. The balance sheet is based n the fllwing identity: ASSETS = LIABILITIES + EQUITY This can als be described in term f Net Assets as fllws: NET ASSETS = ASSETS LIABILITIES = EQUITY Refer t the Wesfarmers reprt and cmplete the fllwing table, which shws the high level summary results. Wesfarmers majr financial quantities [AUD, Millin; 2012] TOTAL ASSETS = LIABILITIES + EQUITY = LIABILITIES + EQUITY While these high level quantities give an indicatin f ttal size and the net financial psitin f the rganisatin it is usually necessary t examine cmpnents f these high level quantities in rder t draw meaningful cnclusins abut perfrmance, r the state f the business s financial health.

11 Within the brad categries f Asset and Liability individual items will be classified as either shrt term, r current, and lng term, r nn-current. The distinctin here is simply whether the item in questin is likely t be realised within a twelve mnth perid fllwing the reprting date. Using this distinctin a highly summarised frm f Balance Sheet can be prepared. Refer t the Wesfarmers Balance Sheet and cmplete the fllwing summary Balance Sheet: SUMMARISED WESFARMERS BALANCE SHEET Based n current / nn-current distinctin [AUD, Millin] ASSETS LIABILITIES & EQUITY Current Assets Nn current assets TOTAL ASSETS Current Liabilities Nn-current Liabilities Ttal Equity LIABILITIES PLUS EQUITY EXERCISE 0.1 Cmment n the verall structure f the Wesfarmers Balance Sheet and hw it has changed ver the year. In the fllwing sectins we will review what makes up each f these majr cmpnents f the Balance Sheet.

12 Current Assets Cmplete the fllwing table fr Wesfarmers current assets, and refer t the ntes fr details f what these numbers cmprise. Sme intrductry cmments are summarised belw: Wesfarmers CURRENT ASSETS Cash and cash equivalents Receivables Inventries Derivatives Investments backing insurance cntracts Other TOTAL Receivables Financial statements recgnise that a sale has ccurred when delivery takes place. Hwever, unless the sale has been n cash terms, then payment will usually be delayed in accrdance with the credit terms. The balance utstanding is represented by the Receivable balance. It measures hw much the cmpany has funds tied up in prviding credit t custmers. An allwance fr nn payment f amunts wing can be recgnised as the Prvisin fr dubtful receivables (r debts). Inventries This item shws the balance held invested in materials which are required t supprt prductin r sales activities, s it includes raw materials used in the prductin prcess as well as finished prduct waiting t be sld. The balance shwn in inventries is usually measured in cst terms, unless its market value is cnsidered lwer than cst. This is knwn as the lwer f cst r market rule, a general principle applying t all balance sheet items. Cmpanies are required t write dwn inventries if they assess Net realisable value is less than cst.

13 The cst f inventry includes nt nly the raw materials and cnsumables but als the csts incurred in prducing r prcessing prduct held at the end f the reprting perid. Methds chsen can have a significant impact n a cmpany s reprted prfit. There are several methds fr carrying ut these calculatins. Prbably the main decisin is the chice f the either the Last In/First Out, First in/first ut r average cst methd. Derivative Financial Instruments This item refers t the cmpany s use f frward cver and ptin cntracts. Resurce cmpanies will cmmnly enter int such transactins t lck in cmmdity prices, exchange rates r interest rates n debt. Accunting fr these cntracts is ne f the mre cmplicated areas f accunting. Nn Current assets Cmplete the fllwing table fr Wesfarmers nn current assets: Wesfarmers NON CURRENT ASSETS Receivables Available fr sale investments Investment in assciates Deferred tax assets Prperty Plant and equipment Intangible assets Gdwill Derivatives Investments backing insurance cntracts Other Ttal

14 Investment in Assciates Where a cmpany wns less than 50% f anther cmpany but is deemed t have significant influence then the cmpany is knwn as an assciate. The parent cmpany therefre includes it share f the prfits f that assciate in the incme statement and includes its share f any changes in the net assets since the investment, usually in the Statement f Cmprehensive Incme. This type f incme recgnitin is knwn as equity accunting. If the investment was deemed t be NOT an assciate (i.e. just a nrmal marketable investment) then the parent cmpany wuld simply include its share f dividends in incme, and accunt fr the investment n a cst basis. Deferred Tax assets This represents the difference between taxes actually due and what is calculated as tax expense in the financial statements. Prperty, Plant & Equipment This is Net cst f plant and equipment purchased by the cmpany. The Grss Fixed Cst is the riginal cst f the plant. Every reprting perid the cmpany claims depreciatin expense in the Incme Statement; the balancing item here is that this depreciatin expense is accumulated each year and ffset against the riginal cst t give the net fixed asset amunt. The mvement in Net Fixed Assets can be explained (in simplified frm) by this equatin. Yu shuld refer t Nte 15 f the Wesfarmers Financial Statements fr the extensive details. Net Fixed Assets t = Net Fixed Assets t-1 + Capital Expenditure t - Depreciatin Expense t - Bk Value f Assets sld t Anther way t think abut the amunt f Net Fixed Assets is t nte that: Net Fixed Assets t = Grss Fixed Assets t - Prvisin fr Accumulated Depreciatin t

15 Identifiable intangible assets As the name implies, this represents the accumulated expenditure which can be attributed t specific intangible assets; typical examples are sftware and brand names. Nte, as with plant and equipment these items d nt represent an assessment f value but are simply a statement f csts incurred n a particular item. This is an applicatin f the histric cst cnventin nted earlier. Gdwill This usually arises n an acquisitin. When a cmpany acquires anther cmpany at a price in excess f the bk value then the questin arises as t hw t treat this excess in the balance sheet f the acquirer. Yu cannt simply restate the value f the tangible assets, again in accrdance with histric cst idea. The difference between the purchase price f the acquired cmpany and the bk value f the cmpany s tangible assets is knwn as gdwill. EXERCISE 0.2 What bservatin can yu make abut the cmpsitin f Wesfarmers Nn Current Assets? D the ntes reveal further infrmatin relevant t understanding the resurces emplyed by Wesfarmers?

16 Current Liabilities Cmplete the fllwing table fr Wesfarmers current liabilities: Wesfarmers CURRENT LIABILITIES Trade and ther payables Interest bearing lans and brrwings Incme Tax payable Prvisins Insurance Liabilities Derivatives Other Ttal Interest bearing lans and brrwings This item shws interest bearing debt due within twelve mnths. It will include actual shrt term debt as well as lng term debt maturing within the next twelve mnths. Prvisins Prvisins are nt actually liabilities but represent highly prbable future bligatins and are therefre recgnised. Nte 20 shws a typical list f prvisins; ther examples wuld include prvisin fr prduct liability and warranty claims. Prvisins are described in mre detail in Sectin 0.6.

17 Nn Current Liabilities Cmplete the fllwing table fr Wesfarmers nncurrent liabilities: Wesfarmers NON CURRENT LIABILITIES Payables Interest bearing lans and brrwings Prvisins Insurance Liabilities Derivatives Ttal Nte the terms here clsely fllw thse used fr current liabilities, s the difference relates t the time frame ver which these bligatins are expected t fall due i.e. greater than twelve mnths. EXERCISE 0.3 Refer t Nte 19. Discuss the nature f Wesfarmers brrwing surces and hw it has changed ver the last twelve mnths.

18 Equity The Equity balance represents the net investment made by sharehlders in the business. Equity is the residual, which is why it is calculated as Assets Liabilities. Cmplete the fllwing table fr Wesfarmers Equity: Wesfarmers EQUITY Issued Capital Emplyee Reserved Shares Retained Earnings Reserves Ttal Issued Capital Represents the equity capital cntributed by sharehlders. It is the amunt raised by the cmpany issuing new shares. This will be made up f a par value per share and a premium per share. The sum f par and premium represents the actual price fr which the shares were sld t investrs. Retained Earnings This shws the prfits accumulated frm when the business was incrprated less any dividends paid ut. It des nt represent cash but rather the amunt f prfits retained within the cmpany and reinvested in the business.

19 EXERCISE 0.4 Cmment n the verall mix f Wesfarmers equity It is imprtant t remember that the value fr Equity shwn in the Balance Sheet represents that value f funds invested by sharehlders (cmmnly described as Bk Value ) at the time the shares were issued ie nt the market value. The fllwing exercise demnstrates the difference between the tw cncepts. EXERCISE Refer t the Balance Sheet and nte the value f Ttal Equity in the Balance Sheet; 2. Refer t Nte 23, which gives details f the number f shares utstanding. Nte that Wesfarmers has tw types f rdinary shares: Ordinary shares (Ticker: WES), and Partially Prtected Ordinary shares (Ticker: WESN). These have sme lng term ptinality; 3. At 30 th June, 2012 Share Price at 30 June 2012 WES $29.90 WESN $ Using this data calculate the market capitalisatin f Wesfarmers. Hw des it cmpare t the Ttal Equity value yu fund in 1. abve. Cnsider why they are different.

20 0.3.2 Explaining Balance Sheet items Each balance sheet item can be described by a general expressin: Clsing balance = Opening balance + Increases Decreases Increases and decreases might be cash r nn cash transactins. T understand details f mst balance sheet items yu will need t refer t detailed ntes which are prvided. Frm these yu shuld be able t: understand what the key cmpnents f each balance sheet item. Fr example, by referring t Nte 19 f the Wesfarmers reprt yu can see hw the structure f Wesfarmers brrwing facilities; and understand mvements in each balance sheet item. Fr example, by referring t Nte 15 f the Wesfarmer s reprt yu can bserve the main surces f change in the balance sheet value fr Prperty, Plant and Equipment. Limitatins f the Balance Sheet The balance sheet is the basis fr much financial analysis. Given that it represents the amunt invested in the business it is the basis fr many metrics which measure the quality f earnings, such as Return n Investment. Hwever there are a number f limitatins in the Balance Sheet, as traditinally published. One example relates t Other mitted liabilities. Organisatins may have ther cmmitments which are nt frmally recgnised as liabilities which hwever shuld, at a minimum, be reviewed by the analyst t ensure they are either recgnised as a liability r at least included in a risk analysis. The Wesfarmers Financial reprt includes sme relevant examples here in Nte 28, which includes: nn-cancellable perating leases; cntracted capital expenditure; and Cntingent liabilities describes a series f guarantees prvided t third parties. Again the risk inherent wuld need t be assessed. Cntingent liabilities, by their very definitin, are deemed t be unlikely.

21 0.3.3 Incme Statement The incme statement reprts the results f transactins arising frm the cmpany s peratins ver the reprting perid. A stylised Incme Statement is set ut in the fllwing table, hwever yu shuld als refer t the Wesfarmers Incme Statement t see hw they are really presented. Capital transactins such as asset purchases r new brrwings are nt included in the Incme Statement, hwever the annual csts f these, represented by depreciatin and interest expense, are included. There are a variety f ways f reprting prfits. We will review the majr cmpnents f prfit and then describe the different ways f analysing prfit.

22 Revenue STYLISED INCOME STATEMENT - Cst f Gds Sld Raw materials, labur, energy csts etc = GROSS PROFIT - Selling & Admin Wuld include ther expenses, verheads fr eg = EBITDA - Depreciatin Allcatin f capital cst ver life f asset = EBITA - Amrtisatin Of Intangibles less cmmn these days = EBIT - Interest Interest Paid n Brrwings = Prfit Befre Tax - Tax Expense Nt always the same as Tax Paid = Prfit after tax - Minrity Interests Share f prfits attributable t minrity sharehlders where parent wns greater than 50% f jintly wned cmpanies = Prfit attributable t parent cmpany - Dividends = Change in Retained Earnings

23 Revenue The bulk f a cmpany s revenue will be derived frm sale f prducts and services. It shuld be nted that revenue is recrded when the gds and services are delivered t the custmer, nt when the custmer actually pays this reflects the accrual basis f accunting described earlier. Cst f Gds Sld Usually the largest cmpnent f csts this represents all csts incurred in the prductin prcess t cnvert raw materials t finished prduct. In the cntext f the Wesfarmer s Incme Statement, this item is entitled Raw materials and inventry. It will include direct csts f manufacture, i.e. thse raw material and labur csts that are directly traceable t a particular prduct, and manufacturing verhead, which are csts nt directly traceable t a particular prduct. The inclusin f verheads in prduct csts is called absrptin csting. The cst f gds sld is the result f allcating prductin csts between prduct sld during the perid and finished gds (and wrk in prgress) still in inventry. Where the unit cst f prductin changes ver time then the allcatin methd will affect the determinatin f incme between perids. It is therefre imprtant t understand the prcess used t allcate csts and hw it might affect reprted incme. The methd f allcatin is usually a chice between the fllwing: first in, first ut; last in, first ut and average cst methd. The chice f methd will usually be described in a cmpany s Ntes t the accunts, usually in the sectin describing Inventries. The relatinship between physical quantities f inventry and dllar amunts as shwn in the incme statement is summarised in the fllwing expressins.

24 In physical terms we have: Inventry Qty CBt = Inventry Qty OBt + Units Prduced t Units Sld t In dllar terms we have: Inventry $ CBt = Inventry $ OBt + Cst f Prductin t Cst f Gds Sld t Using Average Cst methd: Cst f Gds Sld t = [Inventry $ OBt + Cst f Prductin t ] Inventry Qty OBt + Units Prduced t ] x Units Sld t Other perating csts These will include csts nt directly invlved in prducing prduct but which are necessary fr the cntinued peratin f the business. This categry includes sales and marketing expenses, research and develpment csts and finance and administrative expenses. Incme tax expense The calculatin and reprting f incme tax is ne f the mre cmplicated areas f financial analysis. Fr ur purpses we are interested in ne utcme what are the actual and frecast levels f taxes paid by an rganisatin r divisin. Hwever tax paid will nt usually equal tax expense. Fr example in the case f Wesfarmers tax expense, as per the prfit statement, was $918m, whereas actual tax paid was $943 millin. The differences result frm the fact that calculatin f incme fr accunting purpses des nt have t fllw the same rules as the calculatin f taxable incme. Taxable incme is calculated in accrdance with tax legislatin which may give specific rules fr treatment f particular items. These differences give rise t tax effect accunting and such balance sheet items as assets and liabilities.

25 Minrity Interests We nted earlier that financial statements are prduced n a cnslidated basis. They therefre include the assets and liabilities f entities which may be partially wned by the parent cmpany. T be cnslidated, the parent must wn 50.1% and/r have substantial influence and cntrl ver the subsidiary. Cnslidatin means that 100% f the prfits f the subsidiary are included in the Incme Statement (i.e. revenue, csts etc), and 100% f the assets and liabilities are included in the balance sheet, even thugh the subsidiary is nly partly wned. An adjustment therefre needs t be made s that prfit available t parent cmpany sharehlders nly represents the share f prfits attributable t the parent cmpany. The fllwing adjustments are therefre made: The Minrity Interest item in the Incme Statement represents the share f prfits f partly wned subsidiaries attributable t the minrity sharehlders in these entities, and is deducted frm prfits; There is a crrespnding item fr Minrity Interests in the equity prtin f the balance sheet (but nt shwn in Wesfarmers as they d nt have any partly wned subsidiaries). The value f Net Assets attributable t utside sharehlders is identified as a separate surce f equity, different t the equity attributable t the equity hlders f the parent Explaining key Incme Statement items As with the balance sheet, t get behind individual items we need t refer t detailed ntes prvided. It is interesting t nte that in the Wesfarmers Incme Statement, the largest individual cst item Raw Materials and Inventry purchased (which is their expressin fr Cst f Gds Sld) has n further detail prvided in an easy summary! Hwever the fllwing are wrth nting: Nte 3 gives segment results fr Wesfarmers; Nte 4 gives sme detail n cst items; Nte 5 gives detailed data n Incme Tax, and the difference between accunting Incme Tax and actual Tax expense;

26 The many definitins f prfit. The prfit number mst referred t in the press is prbably a cmpany s Prfit after tax. This reprts the prfits available fr sharehlders after deducting the claims f all ther stakehlders including tax, financing csts and minrity interest. It is therefre, apprpriately, the ultimate measure f perfrmance frm the sharehlders perspective. Hwever, mst analysts will utilise a number f alternative prfit definitins, mainly because f the different perspective they give n different aspects f perfrmance. Fr example, cnsider tw cmpanies that are identical in all aspects f peratins but have different depreciatin plicies, different financing strategies r even different tax strategies. In this case the cmpanies will reprt different Prfits after tax, hwever if we are interested in better understanding the drivers f the business underlying perfrmance, which will be the ultimate driver f lng term perfrmance and therefre value, we need t break up Prfit int cmpnent parts. Cmmn prfit definitins used in practice are described belw. Nne f these is, a priri, superir t the ther; the usefulness f each ne depends n the purpse f the analysis being undertaken. Cntributin margin: is defined as Revenue minus Variable csts. This measures the cntributin which an additinal unit makes twards cvering fixed csts. Fixed csts will usually include the Other perating csts described earlier, as well as manufacturing fixed csts. The cntributin margin is ften used t estimate the breakeven level f sales vlume; the vlume f sales required t return a zer net prfit. This will be discussed in mre detail later in this mdule; Grss prfit: The bjective f such a measure is t measure perfrmance f manufacturing activity; the suggested definitin is Revenue less Cst f Gds Sld; the precise definitin can vary; EBITDA: Earnings befre Interest, taxes depreciatin and amrtisatin. This adds back depreciatin and amrtisatin, partly t get clser t cash flw and t minimise the impact f distrtins caused by different depreciatin plicies. The main prblem with this particular measure is that it des nt incrprate all the real csts f perating a business including imprtantly wrking capital and replacement f assets and materially verstates any realistic cncept f cash flw;

27 EBIT: Earnings befre Interest and taxes, measures a business s incme befre it is divided amng creditrs, wners and tax payments. It is therefre a useful measure f underlying prfit perfrmance, nt distrted by a number f crprate level cst items; Net Prfit is usually the headline results number. It represents prfit available t sharehlders after deducting all ther claims n incme, including taxes and interest expense. The share f incme attributable t minrity interest will als be deducted, leaving the prfit available fr sharehlders in the parent cmpany. In the Wesfarmers Incme Statement this is described as Prfit attributable t members f the parent. EXERCISE 0.6 Refer t Wesfarmers Incme Statement. Calculate Wesfarmers EBIT; Hw has this EBIT been allcated between Incme tax, Interest Expense, Minrity Interests and the Wesfarmers sharehlders?

28 Slutins t Exercises EXERCISE 0.1 The table belw has the relevant numbers frm the Wesfarmer s balance sheet. SUMMARISED WESFARMERS BALANCE SHEET Based n current / nn-current distinctin [AUD, Millin] ASSETS LIABILITIES & EQUITY Current Assets 10,911 10,218 Current Liabilities 10,747 8,722 Nn current assets 31,401 30,596 Nn-current Liabilities TOTAL ASSETS 42,312 40,814 LIABILITIES PLUS EQUITY 5,938 6,763 Ttal Equity 25,627 25,329 42,312 40,814 We can make the fllwing bservatins: Wesfarmers balance sheet size increased by apprximately $1.5bn frm $40.8bn in 2011 t $42.3bn in This is apprximately a 4% increase ver the 2012 year (eg cmpared t the revenue increase f apprximately 6%); The asset structure has nt changed materially. Current assets represent a quarter f and nn-current assets represent three quarters f the ttal assets. These prprtins have been maintained ver the year. The liability structure has changed slightly. Current Liabilities, as a percentage f the ttal balance sheet has increased frm 21% t 25%. Equity is the mst significant cmpnent f capital ie representing 61% f ttal assets. Equity increased by apprximately $300m ver the year - attributable t retained earnings.

29 EXERCISE 0.2 The table belw has the relevant numbers frm the Wesfarmers Balance Sheet Wesfarmers NON CURRENT ASSETS [AUD, Millin] Receivables 33 9 Available fr sale investments Investment in assciates Deferred tax assets Prperty 2,631 2,148 Plant & equipment 6,832 6,154 Identifiable intangible assets 4,393 4,353 Gdwill 16,097 16,227 Derivatives Investments backing insurance Other Ttal 31,401 30,596 We can make the fllwing bservatins: The mst significant bservatin is the size f the gdwill and identifiable intangible assets which tgether ttal in excess f $20bn, and make up 65% f Nn Current Assets. This indicates that much f Wesfarmers asset base has been established via acquisitin. (Nte 16 lcated in Wesfarmers full financial statements n their web site shws the detail f this item: f the $20.5bn in ttal intangible assets, abut $13bn relates t the acquisitin f Cles by Wesfarmers in 2007). The Gdwill item is essentially measures the difference between the cst f acquiring a cmpany and the bk value f net assets acquired.

30 A cmpany which grws rganically (i.e. by building businesses internally) will have a lw level f gdwill. We can als bserve that Wesfarmers has $9.4bn f Prperty, Plant & Equipment this is the NET BOOK VALUE f fixed assets wned by Wesfarmers. Nte 15 shws this is cmprised f: Original Cst (i.e. Grss Bk Value) Less: Accumulated Depreciatin Gives: Net Bk Value $14.2bn ($4.8bn) $9.4bn If we lk further in Nte 15 we can see fr each cmpnent hw much f the mvement in fixed asset values was due t additinal capital expenditure, dispsals etc t demnstrate this have a lk at the recnciliatin f mvement in Net carrying amunt at beginning f year and Net carrying amunt at end f year fr any f the cmpnents f PP&E (eg Plant, vehicles and equipment); If we check Nte 28, we can see that Wesfarmers als has nn capitalised perating lease cmmitments f $12.5bn ver the next five years. This is predminantly lease payments n retail sites (Cles, Bunnings etc), and s are critical t the peratins f the business. These lease rentals are cnceptually the same as fixed assets (eg prperty, plant and equipment) and shuld arguably be capitalised n the balance sheet alngside the assets that are wned ratings agencies already capitalise nn capitalised perating leases, and accunting standards are generally mving twards such a requirement; Investments in Assciates represents the bk value f investments where Wesfarmers wns less than 50% AND des nt have effective cntrl. Nte 14 reveals majr investments in the Bunning Warehuse Prperty Trust and Gresham Private Equity.

31 EXERCISE 0.3 As at 30 June 2012 Wesfarmers had $5,502m interest bearing debt utstanding. This was cmprised f: Shrt term debt: $1,621m $266m Lng term brrwings; $3,881m $4,613m Ttal Interest Bearing Debt $5,502m $4,879m We are particularly interested in Interest Bearing Debt because (alng with equity) that shws the finance raised frm capital markets. It is different t trade creditrs which is prvided by suppliers and is therefre debt which is prvided in the nrmal curse f peratins. It is als different t mst prvisins which are cnceptually internally financed. Overall, the debt raised frm capital markets has increased by $623m ver the year and the cmpsitin is shifting t shrter term debt (ie frm 5% f ttal interest bearing debt t 30% in June 2012). Lking at the details in Nte 19, we can make the fllwing bservatins: What is the cmpsitin f debt in terms f bank lans and bnd issues? Banks Lans: $1,539m (YEJ2010: $2,014m). Banks lans are raised via lans and underwriting with individual banks grups f banks lending thrugh a cmbined facility; Bnd issues: $3,866m (YEJ2010: $2,800m); Cmmercial paper: $97m (YEJ2010: $65m).

32 Nte 19 cntains an extensive discussin f Wesfarmers brrwing arrangements. Investrs find this helpful t understand refinancing risk (i.e. des Wesfarmers have significant debt rllvers in the shrt term that it may nt be able t refinance? Is it dependent n a narrw surce f funding techniques r des it have access t a range f markets? The mix f bnds and bank lans infrms an pinin fr this secnd pint. What is the amunt f unused debt facilities? $2,298m. Unused debt facilities represent cmmitments prvided by banks t lend funds at a future date, subject t cnditins. Wesfarmers wuld pay a cmmitment fee fr the right t draw dwn these funds. The term f these facilities wuld range between 1 and 5 years. Hw did the cmpsitin f Wesfarmers debt change during 2012? During the year 2011 Wesfarmers debt structure changed dramatically: Debt was increase by apprximately $623m; Bnds increased by a net $1,066m, which was substantially the effect f a new bnd issue. Bank lans were reduced by abut $475m; Shrt term debt has increased t becme a mre significant prprtin f debt; Nte that we have nt included derivatives here but a gd argument can be made fr ding s. Were we t incrprate derivatives we wuld need t refer t Nte 27 and include nly thse derivative cntracts that were traceable t interest bearing debt. The table belw summarises hw this might be dne:

33 Assets Liabilities Interest rate swaps current Interest rate swaps nn 20 6 current Crss currency interest rate - 63 swap current Crss currency interest rate swap nn current Ttal Net 113 S we wuld add $113m t the value fr interest bearing debt. The argument fr excluding them is that the balance sheet values fr debt shw histric face value, nt market values, whereas the value f derivatives in the balance sheet is a mark t market, s we are nt adding like with like. EXERCISE 0.4 Wesfarmers Equity [AUD, Millin] Issued capital 23,286 23,286 Emplyee Reserved Shares (31) (41) Retained Earnings 2,103 1,774 Reserves Ttal 25,627 25,329 Wesfarmers has a relatively simple equity structure. N minrity interests and relatively small reserves, s equity basically cmprises Issued Capital (prceeds frm issuance f new shares) and Retained Earnings. Issued Capital is by far the largest surce f equity capital. This was bsted in previus years by substantial issues f equity in relatin the Cles acquisitin and the subsequent refinancing.

34 EXERCISE 0.5 The equity market capitalisatin f Wesfarmers is calculated in the fllwing table. Wesfarmers Equity Market Capitalisatin Share N f shares (at 30 June 2012)* Price at 30 June 2012 Market Value at 30 June 2012 WES 1,006,509 $ ,094,619 WESN 150,563 $ ,751,768 Ttal 34,846,387 Using this market value data we can nw cmpare market values and bk values: Item $m Surce Bk Value f equity as at 30 June 2012 Market Value f equity as at 30 June ,627 Frm Balance Sheet 34,846 Frm abve Market Value added 9,219 By calculatin This table shws that Wesfarmers have cntributed apprximately $25.6bn f equity, thrugh share issues and retained earnings, and this is nw wrth $34.8bn, s $9.2bn f value has been created, ver and abve any dividends received by sharehlders.

35 EXERCISE 0.6 The table shws the calculatin f EBIT and EBITDA. Item Published Net Prfit $2,126m $1,922m Plus: Incme Tax Expense $918m $784m Plus: Finance Csts $505m $526m Earnings befre Interest and Taxes [EBIT] $3,549m $3,232m Plus: Depreciatin and Amrtisatin $995m $923m Earnings befre Interest, Taxes, depreciatin and amrtisatin [EBITDA] $4,544m $4,155m There are a number f bservatins: This calculatin als includes interest revenue. Many analysts wuld exclude this as they regard interest incme as an ffset t interest expense; this is the equivalent t the idea f net debt. If yu are using net debt (where cash is ffset against debt) then yu shuld als use Net Interest (where the interest incme is ffset against the interest incme). This ensures that yu are being internally cnsistent in yur measures; Refer t Nte 3 f the financial statements segment infrmatin and ftnte 4. This shws a number f items which have been included in the calculatin f EBITDA and EBIT which are mainly ne ff r capital in nature. Many analysts wuld exclude these frm their calculatin because they are trying t fcus n underlying peratinal perfrmance this leads t the idea f nrmalised earnings; If yu started with Net prfit after minrity interests then yu wuld ADD BACK minrity interest as well, as EBIT and EBITDA are measures which shw the perfrmance f the asset, and shuld therefre be based n 100% f the asset.

36 Balance sheet as at 30 June 2012 Wesfarmers Limited and its cntrlled entities CONSOLIDATED Nte $m $m ASSETS Current assets Cash and cash equivalents 8 Trade and ther receivables 9 Inventries 10 Derivatives 27 Investments backing insurance cntracts, reinsurance and ther recveries 11 Other 12 Ttal current assets Nn-current assets Receivables 9 Available-fr-sale investments 13 Investment in assciates 14 Deferred tax assets 5 Prperty 15 Plant and equipment 15 Intangible assets 16 Gdwill 16 Derivatives 27 Investments backing insurance cntracts, reinsurance and ther recveries 11 Other 17 Ttal nn-current assets Ttal assets LIABILITIES Current liabilities Trade and ther payables 18 Interest-bearing lans and brrwings 19 Incme tax payable Prvisins 20 Insurance liabilities 21 Derivatives 27 Other 22 Ttal current liabilities Nn-current liabilities Payables 18 Interest-bearing lans and brrwings 19 Prvisins 20 Insurance liabilities 21 Derivatives 27 Other 22 Ttal nn-current liabilities Ttal liabilities Net assets EQUITY Equity attributable t equity hlders f the parent Issued capital 23 Emplyee reserved shares 23 Retained earnings 24 Reserves 25 Ttal equity 1, ,384 2,149 5,006 4, ,690 1, ,911 10, ,631 2,148 6,832 6,154 4,393 4,353 16,097 16, ,401 30,596 42,312 40,814 5,420 5,059 1, ,289 1,166 1,635 1, ,747 8, ,881 4,613 1,206 1, ,938 6,763 16,685 15,485 25,627 25,329 23,286 23,286 (31) (41) 2,103 1, ,627 25, Wesfarmers Annual Reprt 2012

37 Incme statement fr the year ended 30 June 2012 Wesfarmers Limited and its cntrlled entities CONSOLIDATED Nte $m $m Revenue Sale f gds Rendering f services Interest ther Other Expenses Raw materials and inventry Emplyee benefits expense 4 Net insurance claims, reinsurance and cmmissins Freight and ther related expenses Occupancy-related expenses 4 Depreciatin and amrtisatin 4 Impairment expenses 4 Other expenses 4 Other incme 4 Finance csts 4 Share f lsses f assciates 14 Prfit befre incme tax Incme tax expense 5 Prfit attributable t members f the parent 55,897 52,891 1,788 1, ,080 54,875 (38,406) (36,515) (7,496) (7,116) (1,413) (1,283) (946) (895) (2,232) (2,151) (995) (923) (197) (27) (3,213) (2,977) (54,898) (51,887) (505) (526) (16) (15) 3,044 2,706 (918) (784) 2,126 1,922 Earnings per share (cents per share) 6 basic fr prfit fr the perid attributable t rdinary equity hlders f the parent diluted fr prfit fr the perid attributable t rdinary equity hlders f the parent Wesfarmers Annual Reprt 2012

38 Cash flw statement fr the year ended 30 June 2012 Wesfarmers Limited and its cntrlled entities CONSOLIDATED Nte $m $m Cash flws frm perating activities Receipts frm custmers Payments t suppliers and emplyees Dividends and distributins received frm assciates Interest received Brrwing csts Incme tax paid Net cash flws frm perating activities 8 Cash flws frm investing activities Net acquisitin f insurance depsits Payments fr prperty, plant and equipment and intangibles 8 Prceeds frm sale f prperty, plant and equipment and intangibles 8 Prceeds frm sale f cntrlled entities Net investments in assciates and jint ventures Acquisitin f subsidiaries, net f cash acquired Net cash flws used in investing activities Cash flws frm financing activities Prceeds frm brrwings Repayment f brrwings Prceeds frm exercise f in-substance ptins under the emplyee share plan 23 Equity dividends paid Net cash flws used in financing activities 62,620 58,408 (57,865) (54,661) (445) (472) (835) (527) 3,641 2,917 (164) 76 (2,626) (2,062) (4) (38) (52) (88) (2,169) (1,876) 1,443 3,291 (901) (3,523) 5 5 (1,789) (1,557) (1,242) (1,784) Net increase/(decrease) in cash and cash equivalents Cash and cash equivalents at beginning f year Cash and cash equivalents at end f year (743) 897 1,640 1, Wesfarmers Annual Reprt