Test of Professional Skills Pre-Course Study Advanced Finance 2015 The following material must be covered before classes start: Module 10 Analysis of Financial Statements Module 11 Raising Finance CA Education uniquely trains and examines all students of ICAS.
TPS Advanced Finance Module 10 Module 10 Analysis of Financial Statements 1 Copyright ICAS 2015 Analysis of Financial Statements Assumed knowledge or revision area Concentrate on relationships between ratios Usually one third of allotted marks are for calculation while two thirds are for interpretation 2 Copyright ICAS 2015 Analysis of Financial Statements Ratio analysis can help identify the main issues in respect of the profitability, liquidity, efficiency and risk of the organisation No accounting standards on the subject You can calculate any ratios you want to You must be consistent and you must compare like with like Different stakeholders will be interested in different ratios 3 Copyright ICAS 2015 1
TPS Advanced Finance Module 10 Chinette Ltd Statement of profit and loss Statement of financial position Notes AFIN used only IFRS formats and terminology. Summary of different terminology included in Appendix 1. 4 Copyright ICAS 2015 Profitability Ratios Return on capital employed Return on equity Net profit margin Asset turnover Gross margin 5 Copyright ICAS 2015 Return on Capital Employed ( ROCE ) Profit before finance costs and tax ( PBIT ) x 100% Capital Employed ROCE gives an indication as to how efficient the organisation is at generating profits from its capital. Also known as primary ratio. 6 Copyright ICAS 2015 2
TPS Advanced Finance Module 10 Potential Problems 1. Different definitions - capital employed refers to the funds provided by shareholders, long-term lenders and minority interests. We will use: Capital employed = total assets less current liabilities 2. Sensitive to the valuation of the organisation s non-current assets 3. Bank overdrafts include in non-current liabilities if used as long-term finance. 7 Copyright ICAS 2015 ROCE of Chinette 20X5 732 550 x 100 2,243 1,701 20X4 x 100 =33% =32% ROCE well above commercial borrowing rates. 8 Copyright ICAS 2015 Return on Equity Profit for the period x 100% Total equity 9 Copyright ICAS 2015 3
TPS Advanced Finance Module 10 Return on Equity of Chinette 20X5 543 411 x 100 1,974 1,431 20X4 x 100 =28% =29% To determine whether this ratio is as healthy as it appears it would be necessary to compare the above percentages with the equivalent for competitors and the industry average. 10 Copyright ICAS 2015 ROCE breakdown Net Profit Margin Profit before finance costs and tax ( PBIT ) x 100% Revenue Considers PBIT as a percentage of revenue Asset Turnover Revenue Capital Employed Provides information about the efficiency of the company at generating revenue from its capital. 11 Copyright ICAS 2015 ROCE breakdown These two ratios together make up ROCE: ROCE = Net profit margin x Asset Turnover PBIT x 100 = PBIT x 100 x Revenue Capital employed Revenue Capital employed 12 Copyright ICAS 2015 4
TPS Advanced Finance Module 10 Interpretation of ROCE Company X Company Y Capital employed 100 100 Revenue 500 200 PBIT 50 50 ROCE 50% 50% Net profit margin 10% 25% Asset turnover 5 2 Although X has a lower profit margin than Y, X uses its assets more efficiently. Y will make a greater profit per item sold but will sell fewer goods during the year. 13 Copyright ICAS 2015 Net Profit Margin of Chinette 20X5 732 550 x 100 6,200 5,800 20X4 x 100 =12% =9% Asset Turnover of Chinette 20X5 20X4 6,200 5,800 2,243 1,701 =2.8 =3.4 14 Copyright ICAS 2015 Gross Margin Gross Profit x 100% Revenue Measures the ability of the business to sell goods for more than they cost to make Expect this ratio to remain fairly stable over time and for competitors to show similar gross margins. 15 Copyright ICAS 2015 5
TPS Advanced Finance Module 10 Gross Margin of Chinette 20X5 1,400 1,200 x 100 6,200 5,800 20X4 x 100 =23% =21% Gross margin of Chinette has improved by nearly 10% An explanation of this increase would probably be referred to in either the operating and financial review or the Chairman s statement. 16 Copyright ICAS 2015 Liquidity Ratios Current ratio Quick ratio 17 Copyright ICAS 2015 Current Ratio Current assets Current liabilities Assesses the organisation s ability to meet its short-term debts Important to consider the trend of the ratio over time If continually falling this could mean that the company is, in the worst case, heading for insolvency 18 Copyright ICAS 2015 6
TPS Advanced Finance Module 10 Current ratio of Chinette 20X5 20X4 *2,183 *2,097 1,585 1,790 =1.4 =1.2 * Excludes the trade receivables due after one year. Current ratio of Chinette appears reasonable Increase in the ratio however hides the fact that Chinette has considerably less cash this year than last year as apparent from the balance sheet 19 Copyright ICAS 2015 Quick Ratio Current assets inventory Current liabilities Also known as the acid test ; and Inventory is excluded as it is not always considered liquid. Quick Ratio of Chinette 20X5 20X4 1,783 1,747 1,585 1,790 1.1 1.0 20 Copyright ICAS 2015 Management / Activity Ratios Designed to provide information about the efficiency of management at controlling elements of an organisation s working capital. For example: days trade receivables days trade payables inventory turnover or days inventory 21 Copyright ICAS 2015 7
TPS Advanced Finance Module 10 Days Trade Receivables Trade receivables x 365 Credit sales Measures the effectiveness of the business in collecting its debts Caution re VAT Trend important if the ratio is seen to be continually increasing over time this could indicate problems with credit control and bad debts Compare to credit terms offered to customers. 22 Copyright ICAS 2015 Days Trade Receivables of Chinette 20X5 *1,615 *1,617 x 365 **7,440 **6,960 20X4 x 365 79 days 85 days * Including trade receivables due after one year. ** grossing up sales to include VAT. 23 Copyright ICAS 2015 Useful Calculation How much cash could be released if days trade receivables were reduced, that is, if Chinette reduced their days trade receivables from 79 days to 60 days. 1. take year end trade receivables balance of 1,615 2. divide by 79 (= value of 1 days worth of trade receivables) 3. multiply by 19 (= value of 19 days worth of trade receivables) 1,615 x 19 = 388 79 Thus Chinette could free up approximately 388,000 if they reduce days trade receivables to 60. 24 Copyright ICAS 2015 8
TPS Advanced Finance Module 10 Days Trade Payables Trade payables x 365 Credit purchases and overheads* * Cost of sales often used as denominator. A steady increase in the ratio may highlight the fact that the company is making better use of interest free credit or it could be because the organisation has no cash with which to pay its supplier. Compare to credit terms offered by suppliers. 25 Copyright ICAS 2015 Days Trade Payables of Chinette 20X5 1,200 1,090 x 365 *5,760 *5,520 20X4 x 365 76 days 72 days * Grossed up cost of sales to include VAT. Chinette are taking longer to collect debts than to pay their own debts and thus Chinette is a net provider of funds. 26 Copyright ICAS 2015 Inventory Turnover Cost of sales Inventory This ratio calculates an approximation of the number of times inventory was sold during the year. Days inventory which calculates the number of days inventory is held for, is essentially the inverse of the above: Inventory x 365 Cost of Sales Adding together the number of days receivables and days inventory you should get a rough idea of the length of time it takes the organisation to convert inventory into cash. 27 Copyright ICAS 2015 9
TPS Advanced Finance Module 10 Inventory Turnover of Chinette 20X5 20X4 4,800 4,600 400 350 12 times 13 times Again the effect of inventory turnover increasing by 1 could be quantified. That is: 4,800 = 369 13 Therefore, inventory would be 369k as opposed to 400k if inventory turnover had been in line with the previous year. 28 Copyright ICAS 2015 Risk Ratios Gearing Ratio [Long-term debt + preference shares] x 100 Total equity OR [Long-term debt + preference shares] x 100 Capital employed 29 Copyright ICAS 2015 Gearing Ratio of Chinette 20X5 270 270 x 100 1,973 1,431 20X4 x 100 14% 19% 30 Copyright ICAS 2015 10
TPS Advanced Finance Module 10 Debt Ratio Total debt x 100% Total assets As a very general rule 50% is thought to be an acceptable level in the UK. A debt ratio of 50% is essentially saying that half the assets of the organisation have been financed by debt. 20X5 1,855 2,060 x 100 3,828 3,491 20X4 x 100 48% 59% 31 Copyright ICAS 2015 Interest Cover PBIT Interest charges* * Use interest charges and not net finance costs. Interest Cover for Chinette 20X5 20X4 732 550 47 40 15.6 times 13.8 times 32 Copyright ICAS 2015 Conclusions Chinette is a fairly healthy company. Shareholders are getting a good return on their investment Profitability is strong and improving and consequently, as the company has relatively little long-term debt, it can afford the interest payments comfortably Working capital is an area for concern. In particular days receivables appear high and given the level of days payable Chinette is a net provider of funds. 33 Copyright ICAS 2015 11
TPS Advanced Finance Module 10 Other Ratios Potential shareholders are interested in: The security of any investment The return of that investment Use other ratios to evaluate investments. 34 Copyright ICAS 2015 Earnings per Share Earnings per share is traditionally calculated as: Profit attributable to ordinary shareholders Number of ordinary shares in issue Complications when new shares are issued, when other financing tools, such as debentures, are converted, etc. 35 Copyright ICAS 2015 PE Ratio Share price Earnings per share Shows how many times the earnings per share an investor is prepared to pay to buy a share. Useful to compare across different companies. Inverse of PE ratio = earnings yield 36 Copyright ICAS 2015 12
TPS Advanced Finance Module 10 Dividend Cover A measure of how many times the dividends actually paid out divide into the profits that could have been paid out: Profits available to ordinary shareholders Dividends paid Important indicator for a potential investor Shows what size of dividend an investor might expect to receive Indicates how far earnings would have to fall before the dividend paid out by the company would be reduced 37 Copyright ICAS 2015 Debt Provider Ratios Asset cover Compares the amount that could be raised from a forced sale of the company s assets with the amount to be lent by the bank. Cash flow cover Cash flow cover ratio compares the net cash flow to the interest and principal repayments. Banks would look for both ratios to be greater than 1. 38 Copyright ICAS 2015 Sources of Ratios Industry comparisons can be sourced from: Financial Times Financial Analysis Made Easy (on CD Rom at libraries) Dun & Bradstreet Extel Internet It is VITAL that you know the bases for these calculations before you use them in order to check that you are comparing like with like. 39 Copyright ICAS 2015 13
TPS Advanced Finance Module 10 Indicators of Financial Distress Ratio analysis Ratio analysis is often used to determine whether the financial performance of a company indicates any potential financial distress issues. Other relevant pieces of information - Management - Audit report - Employees - Directors remuneration - Loans - Provision for liabilities and charges - Intangible assets and revaluation reserve 40 Copyright ICAS 2015 Z-Score The Altman Z-Score is calculated as follows: Z = 1.2(net working capital / total assets) + 1.4(retained earnings / total assets) + 3.3(profit before interest and tax / total assets) + 0.6(market capitalisation / total liabilities) + 1.0(revenue/ total assets) On formula sheet. Sign of health = >3, possible signs of distress = <3 41 Copyright ICAS 2015 A-Score Makes use of a list of questions which have associated scores If the company scores more than 25 it could be heading for failure A-Score questions are divided into three sections concerned with defects, mistakes and symptoms 42 Copyright ICAS 2015 14
Contents ANALYSIS OF FINANCIAL STATEMENTS 10.1 INTRODUCTION... 3 10.2 LEARNING OBJECTIVES... 3 10.3 THE PURPOSE OF RATIO ANALYSIS... 3 10.4 PROFITABILITY RATIOS... 6 10.4.1 Return on Capital Employed ( ROCE )... 7 10.4.2 Return on Equity ( ROE )... 8 10.4.3 Net Profit Margin and Asset Turnover... 8 10.4.4 Gross Margin... 10 10.5 LIQUIDITY RATIOS... 10 10.5.1 Current Ratio... 11 10.5.2 Quick Ratio... 11 10.6 MANAGEMENT/ACTIVITY RATIOS... 12 10.6.1 Days trade receivables... 12 10.6.2 Days trade payables... 14 10.6.3 Inventory Turnover... 15 10.7 CAPITAL RISK RATIOS... 16 10.7.1 Gearing Ratio... 16 10.7.2 Debt Ratio... 17 10.7.3 Interest Cover... 18 10.7.4 Summary of Chinette s Ratio Analysis... 18 10.8 OTHER RATIOS... 20 10.8.1 Shareholder Ratios... 20 10.8.1.1 Earnings Per Share... 20 10.8.1.2 PE Ratio... 20 10.8.2 Debt Provider Ratios... 21 10.8.3 Other... 22 10.8.4 Sources of Ratios... 22 10.9 LIMITATIONS OF RATIO ANALYSIS... 23 10.10 INDICATORS OF FINANCIAL DISTRESS... 24 10.10.1 Ratio Analysis... 24 10.10.2 Z-Score... 25 10.10.3 A-Score... 26 10.11 SUMMARY AND REVIEW... 27 Appendix 1... 29 ICAS 2015
ANALYSIS OF FINANCIAL STATEMENTS Notes 10.1 INTRODUCTION Students should already be familiar with the financial analysis either from their degree or from the Test of Competence Finance course. In this module, although a lot of the material will be revision, the emphasis will be on the interpretation of ratios. The calculation of ratios is relatively straightforward, but their interpretation can be quite difficult and therefore in exams, more marks are usually awarded for interpretation rather than the calculation of the ratios. Completion of this module in conjunction with Modules 4 and 5, 8, 9, 19 and 20 achieves learning outcome 1 of the syllabus to evaluate the plans, actions and financial position of clients. Note that during this course only IFRS compliant financial statement formats will be used. A summary of some of the differences in the terminology that can be used is included in Appendix 1. 10.2 LEARNING OBJECTIVES On completion of this module you should be able to: 1. calculate ratios based a set of financial statements; 2. select ratios that would be of interest to particular stakeholders in a business; 3. evaluate accounting ratios; and 4. consider the indicators of financial distress. 10.3 THE PURPOSE OF RATIO ANALYSIS The financial statements of an organisation can provide a lot of financial information that is difficult to interpret. The statement of profit or loss may show an increase in pre-tax profits over the last year but this does not necessarily mean that the organisation is making optimum use of its capital base. Ratio analysis has the following uses: to review the performance of an organisation over time (common size analysis); to compare the performance of the organisation with specific competitors; to compare the performance of the organisation with published industry averages; to use the analysis of past performance to help forecast future performance; and to highlight problems in a company and recommend corrective action. TPS Advanced Finance Module 10 3
Notes A common factor in the above list is that ratios are used for the purpose of comparison. This means that you must have a benchmark with which to compare the calculated ratios. This benchmark could be: ratios calculated from previous years financial statements; industry average ratios; ratios calculated from the financial statements of competitors; and expected values based on the common sense and experience of the analyst. Ratio analysis is a useful tool for any of the stakeholders in an organisation. A supplier will want to ensure that its new customer can pay for goods, so will be interested in the liquidity of the business. Potential shareholders will be interested in the efficiency of the organisation at generating profits as they will want to ensure that their investment in the organisation provides a better return than that of a bank deposit. Lenders and shareholders will be interested in the risk of the organisation to assess the security of their investment. Management will obviously be interested in all aspects but may be particularly interested in the ratios that highlight the efficiency of the business. We can group the accounting ratios into four categories: profitability ratios; liquidity ratios; management or activity ratios; and risk ratios. To illustrate the calculation and interpretation of the ratios an extract from the draft accounts of Chinette Ltd ( Chinette ) will be used. Chinette is a company that makes luxury confectionery. Chinette Ltd Statement of profit or loss for the year ended 30 June 20X5 20X5 20X4 Note 000 000 Revenue 6,200 5,800 Cost of sales (4,800) (4,600) Gross profit 1,400 1,200 Administration expenses (668) (650) Operating profit 732 550 Net finance costs 1 (45) (30) Profit before tax 687 520 Tax expense (144) (109) Profit for the period 543 411 4 TPS Advanced Finance Module 10
A dividend of 41,000 was declared in 20X5. Notes Chinette Ltd Statement of financial position as at 30 June 20X5 20X5 20X4 Note 000 000 Assets Non-current assets Intangible assets 200 200 Property, plant and equipment 1,400 1,100 1,600 1,300 Current assets Inventories 400 350 Trade receivables 2 1,825 1,721 Cash and cash equivalents 3 120 2,228 2,191 Total assets 3,828 3,491 Equity and liabilities Equity attributable to equity holders Share capital 450 450 Share premium 120 120 Retained earnings 1,403 861 Total equity 1,973 1,431 Non-current liabilities 12% Debentures 20X7 270 270 Current liabilities Trade payables 1,200 1,090 Other payables 385 700 1,585 1,790 Total liabilities 1,855 2,060 Total equity and liabilities 3,828 3,491 Notes to the Accounts 1. Finance costs Payable on bank overdrafts and other loans 17 10 Payable on debenture stock 30 30 47 40 Receivable on short-term deposits (2) (10) 45 30 TPS Advanced Finance Module 10 5
Notes 2. Trade Receivables 20X5 000 20X4 000 Amounts falling due within one year: Trade receivables 1,590 1,537 Prepayments and accrued income 190 90 1,780 1,627 Amounts falling due after one year: Trade receivables 25 80 Prepayments 20 14 45 94 Total 1,825 1,721 When analysing the financial performance of organisations it is often necessary to make use of the notes to the accounts as well as the statement of profit or loss and the statement of financial position. One approach to analysing company performance is to perform a line-by-line comparison of the accounts with those of the previous year. This is sometimes called common size analysis. However, ratios provide a useful means of relating individual items in the financial statements to each other. Ratios will give a better analysis if the numbers used in their calculation are meaningful, for example, days trade receivables should only include trade receivables. There are no agreed definitions for any of the ratios. No accounting standards have ever been published on the subject. If you refer to text books on ratio analysis you may find different definitions for ratios of the same name. The important issue is to ensure that when calculating ratios you are consistent, and when comparing ratios you are comparing like with like and that the ratio is relevant. Note, in exam questions usually one third of the allocated marks are for the calculation of ratios, while two thirds of the marks are for interpretation. 10.4 PROFITABILITY RATIOS The most commonly calculated ratios that consider the profitability of organisations are: return on capital employed; return on equity; net profit margin; asset turnover; and gross margin. 6 TPS Advanced Finance Module 10
These ratios are designed to give an indication of the efficiency of the company at generating profits or revenue from available resources. Notes 10.4.1 Return on Capital Employed ( ROCE ) Profit before finance costs and tax (PBIT) x 100% Capital employed Sometimes known as the primary ratio, this ratio measures the return made by the organisation from the amount of available capital. ROCE gives an indication as to how efficient the organisation is at generating profits from its capital. PBIT is also known as operating profit. Capital employed refers to the funds provided by shareholders, long-term lenders and minority interests. Note therefore, that capital employed is equal to total assets less current liabilities. One major problem with ROCE is that it is particularly sensitive to the valuation of noncurrent assets. A company can appear to have a very high ROCE but this may be due to the fact that its non-current assets are recorded at original cost on the statement of financial position. By revaluing these assets to their higher market value then the ROCE will automatically fall. When comparing ROCE s of different companies it is essential to adjust for any differences in the valuation policies. Consider also whether the bank overdraft of a company is being used to fund its longterm activities. If this is the case then although the overdraft is accounted for as a current liability, it should be treated as an non-current liability within the ROCE calculation. As well as looking at the movement from previous years and comparing it with other organisations, the analyst may compare the calculated ROCE with commercial depositing rates. If the ROCE is higher, then the company is making a better return from trading activities than it would if it had invested its capital in deposit accounts. ROCE of Chinette: 20X5 20X4 732 550 x 100 2,243 1,701 x 100 =33% =32% ROCE is well above commercial borrowing rates which indicates that an investment in this organisation gives a higher return than from a deposit account. However, we have no further information on the property values within the financial extracts. ROCE may be overvalued if the non-current assets are undervalued. TPS Advanced Finance Module 10 7
Notes 10.4.2 Return on Equity ( ROE ) Similar to ROCE but specifically looking at the profits made by the organisation for the shareholders. The ROE is calculated as: Profit for the period x 100% Total equity Note that non-current debt and its costs are excluded from both the top and bottom line of this ratio. ROE of Chinette: 20X5 20X4 543 411 x 100 1,973 1,431 x 100 =28% =29% Shareholders should be satisfied with what appears to be a healthy return on their invested capital. To determine whether this ROE is as healthy as it appears it would be necessary to compare the above percentages with the equivalent for competitors and the industry average. 10.4.3 Net Profit Margin and Asset Turnover Net profit margin = PBIT x 100% Revenue The net profit margin ratio simply considers PBIT as a percentage of revenue. Although a low margin may indicate that the business is suffering from high costs this is not necessarily the case. Before interpreting the calculated net profit margin you should first calculate the asset turnover ratio: Asset turnover = Revenue Capital employed The asset turnover ratio provides useful information about the efficiency of the company at generating revenue from its capital. These two ratios together make up ROCE: ROCE = Net profit margin x Asset turnover PBIT PBIT x Revenue = Capital employed Revenue Capital employed 8 TPS Advanced Finance Module 10
Two separate companies could have the same ROCE but quite different profit margins and asset turnovers. Consider the following: Notes Example Company X Company Y Capital employed 100 100 Revenue 500 200 PBIT 50 50 ROCE 50% 50% Net profit margin 10% 25% Asset turnover 5 2 Although X has a lower profit margin than Y, X uses its assets more efficiently. Y will make a greater profit per item sold but will sell fewer goods during the year. The above example is typical of food retailers. X could be an example of one of the supermarket multiples whereas Y could be a specialist food shop with relatively few outlets. From the above example you can see the trade-off between net profit margin and asset turnover. Consequently, some companies can afford to squeeze their profit margins if they are certain they can achieve a consistent and high level of sales. Net profit margin of Chinette: 20X5 20X4 732 550 x 100 6,200 5,800 x 100 =12% =9% Asset turnover of Chinette: 20X5 20X4 6,200 5,800 2,243 1,701 2.8 3.4 The improved net profit margin has been offset by a 17.6% fall in the asset turnover. The increase in the available capital has not been matched with the equivalent increase in revenue. The efficiency of management at generating revenue from available resources has fallen over the last year. But on the basis of the higher revenue that has been made, Chinette has improved its profit per item sold. If ROCE moves from one year to the next you should calculate net profit margin and asset turnover to provide more information. TPS Advanced Finance Module 10 9
Notes 10.4.4 Gross Margin Gross profit x 100% Revenue It is not always possible to be able to calculate this ratio given the information published in the statutory financial accounts. It is a useful ratio however, as it measures the ability of the business to sell goods for more than they cost to make. You might expect this ratio to remain fairly stable over time and for competitors to show similar gross margins. If the organisation is experiencing a fall in the percentage this may mean that the company is unable to control its production costs or achieve optimum selling prices or quantities. Gross margin of Chinette: 20X5 20X4 1,400 1,200 x 100 6,200 5,800 x 100 =23% =21% The gross margin of Chinette has improved by nearly 10% between 20X4 and 20X5. This is quite a large increase which may have arisen from the rationalisation of production costs or perhaps a lucrative sales contract with higher than usual sales value. An explanation of this increase would probably be referred to in either the operating and financial review or the Chairman s statement. It will also be interesting to see, in future years, whether the 23% gross margin can be maintained. 10.5 LIQUIDITY RATIOS The two ratios most often calculated when assessing the liquidity of an organisation are: current ratio; and quick ratio / acid test. These ratios are designed to provide information regarding the company s ability to pay for its liabilities. They can highlight the fact that a company may not be able to pay its debts as they fall due. Liquidity is crucial for the survival of an organisation. Organisations can still exist if they make losses (at least in the short to medium term) but an organisation cannot exist without cash. 10 TPS Advanced Finance Module 10
10.5.1 Current Ratio Notes Current assets Current liabilities This ratio looks at the working capital of the organisation. It assesses the organisation s ability to meet it short-term debts as, in theory, the organisation could sell its current assets to pay for its current liabilities. There is no particular ideal level for the current ratio. Some publications will suggest that the current ratio should be about 1.5 but the ideal level will depend on the industry. The supermarket multiples have been operating comfortably with a current ratio of less than 0.5 for many years (retailers have very low trade receivables as transactions are settled in cash immediately). On the other hand, companies involved in heavy engineering may operate with a current ratio in excess of 2.5 because of high levels of work in progress. Rather than focusing on the actual number it is more important to consider the trend of the ratio over time. If the number is continually falling this could mean that the company is, in the worst case, heading for insolvency. If the number is continually rising management may not be properly managing the working capital of the organisation. Too much money tied up in inventory and/or trade receivables can result in the unnecessary costs of deteriorating and obsolete inventory and bad debts. Current ratio of Chinette: 20X5 20X4 * 2,183 * 2,097 1,585 1,790 =1.4 =1.2 * Excludes the trade receivables and prepayments due after one year. The current ratios of Chinette appear reasonable. The increase in the ratio however hides the fact that Chinette has considerably less cash this year than last year. The analyst should also review the cash flow statement to see if there are any potential problems with the movement of Chinette s cash reserves. 10.5.2 Quick Ratio Current assets - inventory Current liabilities Also known as the acid test, this ratio is a better measure of the organisation s liquidity. In this ratio, inventory is excluded as it is not always considered liquid. A TPS Advanced Finance Module 10 11
Notes heavy engineering company is unlikely to be able to turn inventory into cash at short notice. Some publications say that the acid test should be at least 0.8. However, as with the current ratio, different industries will operate successfully at different levels of quick ratios. The acid test of some supermarket multiples is around 0.15. Quick ratio of Chinette: 20X5 20X4 1,783 1,747 1,585 1,790 =1.1 =1.0 As with the current ratio there is nothing to suggest that Chinette has any liquidity problems. One area that neither of the above liquidity ratios consider is the extent of the organisation s overdraft limit. The fact that the organisation can have immediate access to funds (which are not evident from the statement of financial position) can significantly change the overall view of the organisation s liquidity. 10.6 MANAGEMENT/ACTIVITY RATIOS Management ratios are designed to provide information about the efficiency of management at controlling the business. The following ratios are some of the more helpful ratios at assessing the efficiency of management: days trade receivables; days trade payables; and inventory turnover or days inventory. 10.6.1 Days Trade Receivables Trade receivables x 365 Credit sales This ratio measures the effectiveness of the business in collecting its debts. The ratio calculates the approximate number of days that credit customers are taking to pay their debts. There should be a relationship between days trade receivables and the numbers of days credit offered by a business. VAT must be considered when calculating days trade receivables. Unless the question tells you to ignore VAT you should either strip the VAT out of your trade receivables (by multiplying by 5/6) or else gross up credit sales to include VAT (by multiplying by 1.2). This assumes that revenue and purchases are standard rated 12 TPS Advanced Finance Module 10
assume this unless told otherwise. If the question tells you to ignore VAT then this step does not need to be taken. Notes The trend of this number is important and if the ratio is seen to be continually increasing over time without an organisation extending its credit terms this could indicate problems with credit control and bad debts. The problems that can arise in the calculation of the days trade receivables ratio include the decision to use: average receivables or year-end receivables; credit sales or total revenue; and total trade receivables or only those due within one year. The decisions will depend on the availability of information and how the benchmarks have been calculated. Days trade receivables of Chinette: 20X5 20X4 * 1,615 * 1,617 x 365 ** 7,440 6,960 x 365 =79 days =85 days * Including trade receivables due after one year. ** Grossing up sales to include VAT at 20%. Even if the long-term trade receivable amount is adjusted for, the days trade receivables number appears rather high (although this level must be compared with the credit terms offered by Chinette and with the industry as a whole). Although there is an improvement from the previous year Chinette seems to have poor credit control. This may also mean that they have significant bad debts. A useful calculation to make at this point is to work out how much cash could be released if days trade receivables were reduced, that is, if Chinette reduced their days trade receivables from 79 days to 60 days how much cash would be freed up? Take the year end trade receivable balance of 1,615 and divide by 79 to give the value of one day s trade receivables and multiply by 19 days. 1,615 x 19 = 388 79 Thus Chinette could free up approximately 388,000 if they reduced days trade receivables to 60. It is more meaningful to advise a company by telling them the TPS Advanced Finance Module 10 13
Notes impact in cash terms of taking specific action rather than just saying cut days trade receivables from 79 to 60. This will always earn you marks in the exams. 10.6.2 Days Trade Payables Trade payables x 365 Credit purchases and overheads* * Cost of sales often used as denominator. In theory, this ratio calculates an approximation of the number of days credit the business is taking from its suppliers. However, given the information available from the financial statements, it is very difficult to calculate this ratio meaningfully. The value for purchases can be calculated as cost of sales - opening stock + closing stock. The value for credit overheads may be impossible to obtain. The trend in the days trade payables ratio is important. A steady increase may highlight the fact that the company is making better use of interest free credit or it could be because the organisation has no cash with which to pay its suppliers. It may also indicate that the business is taking longer to pay its debts and therefore risking its credit worthiness. The problems given above for the calculation of days trade receivables are also applicable to the calculation of days trade payables. The statement of financial position figure of trade payables will include VAT whereas the statement of profit or loss figures of credit purchases, overheads and cost of sales will not. Days trade payables of Chinette: 20X5 20X4 1,200 1,090 x 365 * 5,760 * 5,520 x 365 =76 days =72 days * Grossed up cost of sales to include VAT at 20% This is a very approximate calculation, as cost of sales has been used as the denominator, but the important issue is the fact that the value is increasing and this could indicate problems with suppliers. Another point worth considering is that Chinette is taking longer to collect debts than to pay its debts and thus Chinette is a net provider of funds. This is not good working capital management. Again it would be beneficial to quantify any changes in days trade payables in cash terms. 14 TPS Advanced Finance Module 10
Note: Notes Module 2 provides information on the Late Payment of Commercial Debts (Interest) Act 1998 which may be applied to all overdue accounts. 10.6.3 Inventory Turnover Cost of sales Inventory This ratio calculates an approximation of the number of times inventory was sold during the year. The number used for inventory in the ratio can be either the year-end value or the average value. Different industries will show very different numbers for inventory turnover. A heavy engineering business may have inventory turnover of less than one. A retail business may have inventory turnover greater than 10. Once again, the trend of this number over time is important. A decrease in the ratio may highlight a slowdown in trading or a build-up of inventory levels. This may indicate that management have an excessive amount of money tied up in inventory. Inventory days, which calculates the number of days inventory is held for, is essentially the inverse of the above: Inventory x 365 Cost of sales By adding together the number of days trade receivables and days inventory you should get a rough idea of the length of time it takes the organisation to convert inventory into cash. A continual increase in this number could indicate liquidity problems. Inventory turnover of Chinette: 20X5 20X4 4,800 4,600 400 350 12 times 13 times Inventory turnover has fallen over the last year. This could be the result of a one-off event during the year, for example, a product recall because of a health scare. The fall could also be the result of a slow-down in demand for luxury confectionery. If this ratio continues to fall this could indicate serious problems for the company. TPS Advanced Finance Module 10 15
Notes Again, as with the previous two efficiency ratios, the effect of the inventory turnover movement could be quantified. That is: 4,800 = 369 13 Therefore inventory would be 369k as opposed to 400k if inventory turnover had been in line with the previous year. 10.7 CAPITAL RISK RATIOS Shareholders and lenders will be particularly interested in ratios that provide a measure of risk. The more debt a company has, the greater is its exposure to risk. This is because interest must be paid irrespective of whether the organisation is making profits or not. The three risk ratios of most importance are: gearing (leverage) ratio; debt ratio; and interest cover. 10.7.1 Gearing Ratio Long-term debt + preference shares x 100% Total equity or Long-term debt + preference shares x 100% Capital employed Gearing, which is concerned with the capital structure of the organisation, has many definitions. The gearing ratio shows what proportion of the assets of the company (i.e., non-current assets and net current assets) have been financed by lenders rather than shareholders. The higher the level of gearing, the greater the risk that there will be insufficient profits available to pay dividends to the shareholders. Highly geared companies are more sensitive to changes in interest rates. The profits of a highly geared company will suffer the most if interest rates are increased, but shareholders gain with highly geared companies in periods of low interest rates. In the above definitions, preference shares have essentially been classified as debt rather than equity. While preference shares are not debt, their owners do have priority on the profits and net assets of the organisation. The preference shares have been classified in this way because the gearing ratio is designed to show the ordinary shareholders the risks that they are exposed to. Preference shares should be classified as debt if they are redeemable. 16 TPS Advanced Finance Module 10
There is an argument that when preference shares are irredeemable, or are convertible to ordinary shares then they should be treated as equity and not debt, and should be excluded from the gearing calculation. Notes There is no defined level above which an organisation is deemed risky as many other factors must be taken into account. Certain organisations can operate safely at relatively high levels of gearing, for example, those with steady profits and substantial tangible assets which can be used as fixed security for loans. Gearing ratio (Debt/Equity) of Chinette: 20X5 20X4 270 270 x 100 1,973 1,431 x 100 =14% =19% The gearing of Chinette has fallen because there has been a very small reduction in long-term liabilities and an increase in the overall level of equity. Given the above levels Chinette is exposed to relatively little risk and consequently the company could probably secure additional loans fairly easily should the need arise. Note: In exams you will be told whether gearing should be calculated as (debt/equity) or (debt/debt + equity). 10.7.2 Debt Ratio Total debt x 100% Total assets Total debt includes non-current and current liabilities and total assets includes noncurrent and current assets. As a very general rule, 50% debt is thought to be an acceptable level in the UK. A debt ratio of 50% is essentially saying that half the assets of the organisation have been financed by debt. Although this is a useful benchmark, companies can operate quite safely at debt ratios higher than this. If an organisation s debt ratio is already high and increasing further then this may give cause for concern. Debt ratio of Chinette: 20X5 20X4 1,855 2,060 x 100 3,828 3,491 =48% x =59% 100 TPS Advanced Finance Module 10 17
Notes The debt ratio of Chinette is quite high because of the level of current liabilities. Given the gearing ratio (as calculated above) and the fact that the debt ratio has fallen there are few grounds for concern in this area. 10.7.3 Interest Cover PBIT Interest charges (nb: not net finance costs) The ability of a company to operate safely at relatively high levels of debt depends on it being able to afford the interest payments. High debt and gearing ratios are not automatically a problem if the company can easily cover all interest charges. The interest cover ratio determines the number of times that the company can afford to pay its interest charges. The ratio shows how much profits can fluctuate before interest payments are threatened. The ideal level of cover depends on the current economic conditions. If the economy is in decline then interest cover should be higher than when the economy is stable or in a state of growth. Interest cover of Chinette 20X5 20X4 732 550 47 40 =15.6 times =13.8 times Chinette is exposed to very little risk. It can easily afford the interest charges and profits would have to fall considerably before the company was in danger of defaulting on its interest payments. 10.7.4 Summary of Chinette s Ratio Analysis The table below summarises Chinette s ratios: Ratio 20X5 20X4 ROCE 33% 32% ROE 28% 29% Net profit margin 12% 9% Asset turnover 2.8 times 3.4 times Gross margin 23% 21% Current ratio 1.4 1.2 Quick ratio 1.1 1.0 Days trade receivables 79 days 85 days Days trade payables 76 days 72 days Inventory turnover 12 times 13 times 18 TPS Advanced Finance Module 10
Gearing ratio 14% 19% Debt ratio 48% 59% Interest cover 15.6 times 13.8 times Notes The above ratios, when reviewed together, allow the analyst to build up a picture of the company s main strengths and weaknesses. The analyst should be aware that the ratios interlink and ensure that any conclusions reached take all relevant ratios into account. Before drawing any conclusions, the analyst should remember the following: The ratios have been calculated for only two years and therefore it is impossible to determine whether the movement in the ratios, as summarised above, is part of an overall trend or a one-off movement; Other sources of information, which are not available, could provide further details to support conclusions; and Industry averages have not been given. Chinette appears to be a fairly healthy company. In comparison with commercial borrowing rates, shareholders are getting a good return on their investment. However this may not be a fair reflection as the non-current assets of the company may not have been revalued and this could alter the ROCE and ROE considerably. Profitability is strong and improving and consequently, as the company has relatively little long-term debt, it can afford interest payments comfortably. However the increased profitability has resulted in a relative fall in asset turnover which means that the company s efficiency at generating revenue has fallen. In addition to this, inventory turnover has fallen perhaps because of increased prices. Although the movement in these numbers is not great, this is an area that needs to be monitored in the future. One area for concern, however, is working capital as failure to manage it may mean the company is not sustainable. In particular, days trade receivables appear high and, given the level of days trade payables, Chinette is a net provider of funds (although only just). This is poor working capital management. As the management of working capital is fundamental to any organisation this is an area that requires further scrutiny. Fortunately as profits are good, the company is currently able to cope with bad debt expenses but this may not be possible in the future. Profits, liquidity and gearing appear to be in good health but the company needs to reassess its management of working capital. This is an area that can lead to the collapse of otherwise successful companies. TPS Advanced Finance Module 10 19
Notes 10.8 OTHER RATIOS The ratios calculated above provide an overall picture of a company that might be of use to a variety of stakeholders in a business. However some stakeholders will be more interested in specific parts of the business than others. 10.8.1 Shareholder Ratios A potential shareholder in a company will be interested primarily in: 1. the security of any investment; and 2. the return on that investment. In addition to the ratios previously mentioned, a potential shareholder will be interested in: 10.8.1.1 Earnings Per Share Earnings per share is traditionally calculated as: Profit attributable to ordinary shareholders Number of ordinary shares in issue Profit attributable to ordinary shareholders is a company s profit after tax and after any preference dividends. There are a number of scenarios which could affect the calculation of this key ratio. These will include when new shares are issued or when other financing tools (such as debentures) are converted into ordinary shares. You will cover this in detail in the Financial Reporting course. 10.8.1.2 PE Ratio It is calculated as: Share price Earnings per share and indicates the value of the share price as a multiple of the earnings per share. It shows how many times the earnings per share an investor is prepared to pay to buy a company share and is a useful comparison across different companies. The higher the PE, the more valuable the earnings of the company. 10.8.1.3 Earnings Yield The earnings yield is the inverse of the PE ratio. 1 = Earnings per share PE Share price 20 TPS Advanced Finance Module 10
10.8.1.4 Dividend Cover Notes Dividend cover is a measure of how many times the dividends actually paid divide into the profits that could have been paid out as a dividend by the company. Profits available for distribution to ordinary shareholders Dividends paid It is an important indicator for a potential investor as it shows what size of dividend an investor might expect to receive, given a specific level of company profits. Alternatively it indicates how far earnings would have to fall before the dividend paid out by the company would be reduced. 10.8.1.5 Dividend Yield The dividend yield measures the annual return received in dividends as a percentage of the current share price. Remember, it is not a measure of the total return to the shareholder because: it ignores the growth in capital value of the share; and it is based on the current share price which is not necessarily the same price that the shareholder paid to obtain the share. The formula is set out below: Dividend per share x 100% Share price 10.8.1.6 Internal Rate of Return ( IRR ) The internal rate of return on a particular project may be defined as the discount rate required to equate the present value of future returns with the outlay needed to secure them. A shareholder will review the IRR of the potential investment and ensure that it is high enough for them to consider investing. If you are unfamiliar with the term, refer back to your Test of Competence or university notes. IRR will be covered in more detail in Advanced Finance module 19. 10.8.2 Debt Provider Ratios Banks are usually prepared to lend to businesses that show good profitability, liquidity and reasonable levels of gearing. The lender will also be interested in the security of their debt and in the cash flow of the business. They will therefore also review: TPS Advanced Finance Module 10 21
Notes 10.8.2.1 Asset Cover A bank will want to ensure that, should the company to which they have lent go into liquidation, the bank has security over enough of the assets of the business that the debt can be repaid. The asset cover ratio will compare the amount that could be raised from a forced sale of the company s assets with the amount to be lent by the bank. The ratio should be at least 1 to ensure that the bank can get its money back. 10.8.2.2 Cash flow Cover A bank will review the forecast cashflows of the company to ensure that both the capital repayments and interest payments can be repaid comfortably. The cash flow cover ratio compares the net cash flow in a specific period to the interest and principal repayments during that period. A ratio greater than 1 ensures that the payments could be made but a bank will look for better coverage than this, usually 1.5 to 3. 10.8.3 Other You may calculate any ratios that you wish. You may wish to analyse utilisation of the factory (for example revenue per square metre) or employee statistics (average wage per employee, turnover per employee). However, ensure that you have a clear purpose behind any calculation that you perform and are comparing your ratios to something meaningful. 10.8.4 Sources of Ratios Industry comparisons can be sourced from: Financial Times; Financial Analysis made easy (on CD Rom at libraries); Dun & Bradstreet; Extel; and Internet. It is VITAL that you know the basis upon which the industry averages have been calculated before you use them in order to check that you are comparing like with like. You should now be able to achieve learning objectives 1 and 2. 22 TPS Advanced Finance Module 10
10.9 LIMITATIONS OF RATIO ANALYSIS Notes Ratio analysis should be used with care. It does not provide the answers to all the questions that the analyst will have. Instead, ratio analysis will highlight the areas that require further investigation. When using ratios to analyse the financial performance of an organisation it is very important that you are aware of their limitations. These limitations should always be taken into consideration when making use of ratio analysis: Ratios do not provide an accurate picture of financial performance, they are only useful guidelines; Ratios are calculated using statement of financial position information that is only applicable to one day in the year; seasonal variations may be missed altogether; The financial statements from which ratios are calculated contain assumptions and estimates which can be very subjective; Ratios are calculated using information that is historic. Inflationary effects may need to be taken into account; Organisations can adjust their payment patterns towards their year-end to improve the appearance of their ratios; Computation of certain ratios and their comparison can be complicated by the treatment of corporate taxation and VAT; It can be difficult to access sufficient information to calculate meaningful ratios as such information tends to be summarised and selective; When analysing the ratios of different companies, the companies must be comparable, for example it would be pointless to compare certain ratios of, say Marks and Spencer with Reuters as they operate in different industries. Also, it would be pointless to compare certain ratios of Marks and Spencer with those from a small corner shop as they will have significantly different bargaining power with their suppliers; When comparing the ratios of different organisations you must allow for different accounting policies; When comparing the ratios of organisations you need to be aware of any difference in the categorisation of costs. For example, one organisation may include a particular cost within cost of sales whereas another may include the same cost within operating costs; The introduction of new accounting standards can make the comparison with previous periods ratios difficult without recalculating the previous periods ratios; When interpreting ratios you must take all other relevant factors into account. For example, if the organisation has been the subject of a recent takeover, a reduction in costs may be a result of the takeover rather than an improvement in the efficiency of management of the existing business; and It can be very difficult to produce a meaningful analysis of consolidated financial statements using ratio analysis if the group includes companies from a variety TPS Advanced Finance Module 10 23
Notes of industries. The same could be said of a company with a number of different divisions. In addition, when reviewing the calculated ratios their interpretation should always take into account other sources of information such as: Operating and financial review; Chairman s statement; Company s future plans; Qualifications in the auditors report; Recent articles in business journals or newspapers; and Recent changes in inflation and taxation rates that have affected the company. You should now be able to achieve learning objective 3. 10.10 INDICATORS OF FINANCIAL DISTRESS A number of methods have been devised in an attempt to predict financial distress and corporate insolvency. It is important to use at least two different methods and common sense before reaching any conclusions. 10.10.1 Ratio Analysis Ratio analysis is often used to determine whether the financial performance of a company indicates any potential financial distress issues. If profitability and liquidity ratios are falling, management ratios show a reduction in efficiency and the risk of the company is gradually increasing, the company may not have long to survive. Ratio analysis is probably the best tool to use as a first step in gauging the health of an organisation. Few directors will admit that their company is in trouble. Any forecasts that they prepare will probably show an improving situation and consequently these documents will be of limited use. More reliable information will be gained from analysing the financial statements of the business. Using ratios to analyse the financial statements will show the trends of profitability and liquidity, etc. When calculating the ratios the analyst should also bear in mind the following points: Management have there been significant changes recently? If the company has an unsuccessful history then unless there are substantial changes in management it would be unrealistic to assume that sudden improvements are about to take place. Are monthly management accounts available and are actions taken on review of these reports? Audit report is there a going concern qualification in the last audited financial statements? Have the auditors been changed recently? A change in auditors 24 TPS Advanced Finance Module 10
may indicate that there was a disagreement with the previous firm over a possible qualification of the audit report; Employees what is the level of staff morale like? Employees will obviously be concerned for their jobs if they can sense that there are problems with the business. Are the employees moving with the times and keen to accept changes in both management and production techniques? Directors remuneration are the directors taking a cut in their salaries while the company gets back on its feet? Are the level of dividends paid commensurate with the profits the company is making? Loans has the company taken out loans recently to finance unnecessary or plush premises or extravagant vehicles? Are management aware of their capital structure and its consequences? Do management conscientiously match borrowings to the assets for which they are required? Is the company close top defaulting on any of its borrowings or breaching its overdraft limit? Provisions for liabilities and charges has the business committed itself by providing guarantees for other ailing ventures? and Intangible assets and revaluation reserve the creation of either of these accounts on the statement of financial position may indicate that management are desperate to improve the appearance of the business s financial position. Notes 10.10.2 Z-Score In 1968 Professor Altman devised the Z-score which is designed to overcome some of the basic difficulties of the accounting ratios. The Z-score is calculated by adding together a number of ratios, each ratio having been weighted according to its usefulness as a failure predictor. This is known as multivariate analysis as it considers a number of ratios simultaneously. The Altman Z-Score is calculated as follows: Z = 1.2 (net working capital / total assets) + 1.4 (retained earnings / total assets) + 3.3 (profit before interest and tax / total assets) + 0.6 (market capitalisation / total liabilities) + 1.0 (revenue / total assets) Note, this formula is included in your supplementary booklet. If the result is above 3.0 then this is a sign of health, whereas if the result is less than 1.8 this could mean the company is heading for insolvency. Taking the Chinette example and assuming a market capitalisation of 1.5 million, a Z-score greater than 3 TPS Advanced Finance Module 10 25
Notes is computed, suggesting that Chinette is healthy. Based on 20X5 figures, this is calculated as follows: Z-score of Chinette = 1.2 (643/3,828) + 1.4 (1,404/3,828) + 3.3 (732/3,828) + 0.6 (1,500/1,854) + 1.0 (6,200/3,828) = 3.45 The Z-score is used in practice by banks, investment institutions, local authorities and businesses for assessing the risk of their customers/suppliers/clients. However the user must consider the following limitations with this model: different companies may classify similar items differently; there is a lack of specified time frame within which the assessed company is deemed safe ; and the model is not scientifically proven even though it seems to work; and the data upon which the Z-score is calculated is historic. If the analyst wishes for further comfort before concluding the worst for the company he may wish to consider the A-Score. 10.10.3 A-Score A-score uses a different method to predict corporate failure and therefore avoids the problem of the previous two ratio based methods. The A-score makes use of a list of questions which have associated scores. Depending on the answers the company could score up to 100. If the company scores more than 25 it could be heading for failure. The A-score questions are divided into three sections concerned with defects, mistakes and symptoms of failure. Defects deal with management, accounting and reaction to change, mistakes deal with gearing and trading levels and symptoms with the results of ratio analysis. It is important to note that the use of Z and A scores is not commonplace. Accountants are more likely to be guided by the results of ratio analysis and general observations made about the company, (e.g., company not paying their debts; equipment deteriorating and not being replaced; staff leaving). It is important however that you are aware of such score-card approaches as they are certainly used to analyse company performance in certain industries. Please note it is not expected that you should be able to calculate the A-score for the purposes of your TPS Advanced Finance exam, but you should be able to calculate the Z-score. The formula for the Z-score is included in your supplementary booklet. You should now be able to achieve the final learning objective. 26 TPS Advanced Finance Module 10
10.11 SUMMARY AND REVIEW Notes Ratio analysis is a very important tool that can be used by the stakeholders of a company to analyse the profitability, liquidity, management and risk of the company using its financial statements. Exam technique - Remember to be consistent when calculating ratios - Show formulas (which must be learnt) and workings - Watch presentation - Be aware of the limitations of ratio analysis - Calculate the most relevant ratios for the party you are advising (if not asked for specific ratios) Return on capital employed - Watch out for revaluation of non-current assets revaluation depresses ROCE - Watch out for use of bank overdraft as a long term source of finance include in capital employed - Analyse movements in terms of net profit margin and asset turnover Current ratio - Ratio is deteriorating perhaps suggests liquidity problems - Ratio is increasing perhaps suggests poor working capital management Days trade receivables and payables - Compare to establish if net provider of funds (days trade receivables > days trade payables) or net recipient of funds (days trade payables > days trade receivables) Indicators of Financial Distress - Be aware of possible indicators of financial distress when reading questions. - Ask yourself do the ratios suggest performance is deteriorating? - Be able to explain how the A and Z scores work and the principles behind them - Be able to use the formula provided to calculate the Z-score. Interpretation of ratios - This is where to spend most of your time! - Remember no ideal ratio better comparison is industry average and trend of the ratio over time - Don t analyse each category in isolation consider ratios collectively to give a more complete picture - Ask yourself what factors could have caused the movement in ratios - If asked for advice on how to improve, then provide advice, tailored to the needs of the business and the specific problems you have been asked to address - Quantify the impact of reducing days trade receivables and inventory days and increasing days trade payables TPS Advanced Finance Module 10 27
Notes Having read this module, you should be able to meet all of the learning objectives. Re-read the appropriate section(s) of the notes until you can. 28 TPS Advanced Finance Module 10
Appendix 1 Notes Differences in Terminology Below is a summary of the most important terms you are likely to come across, together with their international equivalents: UK term Profit and loss account Balance sheet Profit and loss reserve (in statement of financial position) Turnover Debtors (e.g., debtors have increased ) Creditors (e.g., creditors have increased ) Stock Fixed asset Long-term liability International term Statement of profit or loss Statement of financial position Retained earnings Revenue Trade receivables Trade payables Inventory Non-current asset (generally). Tangible fixed assets are also referred to as property, plant and equipment. Non-current liability TPS Advanced Finance Module 10 29
Workshop Exercise 1 Rascal Ltd has traded profitably for several years in a competitive segment of the electronic components industry but has experienced a steadily increasing bank overdraft. The bank has now written to the company requesting that the overdraft should be substantially reduced in the short term. The directors have provided the following information extracted from the management accounts: 1. Statement of profit or loss Years ended 31 March 20X3 20X4 20X5 000 000 000 Revenue 3,825 4,100 4,550 Cost of sales 2,563 2,788 3,185 Gross profit 1,262 1,312 1,365 Administrative expenses 450 495 545 Distribution costs 150 160 178 Finance costs 80 105 140 680 760 863 Profit before taxation 582 552 502 Taxation 122 116 105 Profit for year 460 436 397 2. Statement of financial position As at 31 March 20X3 20X4 20X5 000 000 000 Non-current assets Property, plant and equipment 900 983 1,036 Current assets Inventory 700 850 1,100 Trade receivables 740 920 1,105 Cash 20 30 35 1,460 1,800 2,240 Total assets 2,360 2,783 3,276 (cont d) TPS Advanced Finance Module 10 1
(cont d) As at 31 March 20X3 20X4 20X5 000 000 000 Equity and liabilities Equity Share capital 300 300 300 Retained earnings 610 890 1,132 910 1,190 1,432 Non-current liabilities Deferred taxation 110 120 150 Current liabilities Trade payables 400 415 425 Bank overdraft 720 828 1,019 Current tax 220 230 250 1,340 1,473 1,694 Total equity and liabilities 2,360 2,783 3,276 In discussion with the directors you have obtained the undernoted additional information: a) Property has a current market value of 800,000. It is reflected in the 20X5 statement of financial position at its book value of 286,000; b) The bank overdraft is secured by a floating charge over the assets of the company; c) New production machinery costing 200,000 is required to increase capacity; and d) There are no contingent liabilities. Required 1. Construct a ratio analysis highlighting the factors that have led to the deteriorating liquidity position. (12 marks) 2. Consider what corrective action might be taken. 3. Identify alternative types of funding which should be considered. (4 marks) (4 marks) (21 marks) Note: Ignore VAT. 2 TPS Advanced Finance Module 10
Workshop Exercise 2 Alac Ltd is a company engaged in building construction and renovation, principally for private sector customers. Despite a good order book position, the company is currently experiencing considerable cash flow problems and has approached its bankers for an extension of overdraft facilities. This request has been turned down until the reasons for the cash flow problems have been established and an action plan for recovery prepared. Extracts from the management accounts for the last three years are as follows: As at 30 April 20X3 20X4 20X5 000 000 000 Non-current assets 84 96 128 Current assets Inventory 28 24 30 Work in progress 620 740 640 Less: Payments on account (500) (530) (300) Trade receivables and prepayments 250 190 260 398 424 630 Current liabilities Trade payables and accruals 298 274 396 Bank overdraft 140 60 158 438 334 554 Net current assets (liabilities) (40) 90 76 Total assets less current liabilities 44 186 204 Summarised results for the three years ended 30 April are: 20X3 20X4 20X5 000 000 000 Sales New houses 1,150 796 604 Commercial developments 400 856 1,146 1,550 1,652 1,750 Cost of sales Materials 656 690 740 Labour 486 540 716 Overheads and subcontractors 154 166 190 1,296 1,396 1,646 Gross profit 254 256 104 Administration overheads 90 98 88 164 158 16 Finance costs 21 10 23 Profit/(loss) before tax 143 148 (7) TPS Advanced Finance Module 10 3
The following additional information has been provided by the directors: 1. Non-current assets comprise a farm building converted to offices and stores, an adjoining dwelling house which is rented to a tenant, and plant, machinery and vehicles. The property was recently revalued at an amount 40,000 in excess of its book value, but this has not been incorporated into the accounts; 2. A land bank for private house development comprising 18 acres on two sites is owned by the company; and 3. The bank overdraft facility is 130,000 secured by a floating charge. Required Advise on the possible reasons for Alac s cash flow problems together with the points which that should be included in the action plan for recovery. (17 marks) Note: Ignore VAT. 4 TPS Advanced Finance Module 10
Workshop Exercise 3 Your client, Metal Ltd ( Metal ) is a canning company based in the West of Scotland. John Smith, managing director, has recently reviewed the management accounts for 20X3 to 20X5. He is concerned that revenue cannot continue at its current level without increased borrowing. Metal Ltd Statement of profit or loss For the year ending 31 March 20X3 20X4 20X5 Revenue 3,315,000 3,442,500 3,570,000 Cost of sales (2,652,000) (2,754,000) (2,856,000) Gross profit 663,000 688,500 714,000 Administrative expenses (255,000) (280,500) (306,000) Depreciation (102,000) (127,500) (153,000) Miscellaneous expenses (51,000) (107,100) (153,000) Operating profit 255,000 173,400 102,000 Tax expense (53,550) (36,414) (21,420) Profit for the period 201,450 136,986 80,580 Metal Ltd Statement of financial position as at 31 March 20X3 20X4 20X5 Non-current assets Property, plant and equipment 285,600 321,300 288,100 Current assets Inventories 382,500 637,500 1,032,800 Trade receivables 306,000 346,800 484,500 Cash and cash equivalents 76,500 35,700 25,500 765,000 1,020,000 1,542,800 Total assets 1,050,600 1,341,300 1,830,900 (cont d) TPS Advanced Finance Module 10 5
(cont d) 20X3 20X4 20X5 Equity and liabilities Share capital 459,000 459,000 459,000 Retained earnings 351,900 438,600 489,600 Total equity 810,900 897,600 948,600 Non-current liabilities 56,100 51,000 45,900 Current liabilities Accruals 61,200 71,400 96,900 Trade payables 122,400 193,800 382,500 Bank overdraft - 127,500 357,000 Total equity and liabilities 1,050,600 1,341,300 1,830,900 Canning Industry Ratios** Quick ratio 1.0 Current ratio 2.7 Inventory turnover* 7.0 x Days trade receivables 32 days Revenue / non-current assets* 13.0 Revenue / total assets* 2.6 Return on total assets 19.0% Return on capital employed 36.0% Debt ratio 50.0% Net profit margin 7.0% (*Based on year-end statement of financial position figures. ** Industry ratios have been constant for the past three years.) Required Construct a report to John Smith analysing the financial position of Metal in light of the industry averages and advise him of the firm s strengths and weaknesses. (restricted to 18 marks) Note: Ignore VAT. 6 TPS Advanced Finance Module 10
Workshop Exercise 4 Set out below is certain summarised information on Beta Ltd ( Beta ): Statement of profit or loss For the year ended 31 March 20X5 000 Revenue 1,000 Cost of sales (750) Gross profit 250 Administration expenses (200) Operating profit 50 Finance costs (12) Profit before tax 38 Tax expense (8) Profit for the period 30 Statement of financial position as at 31 March Note 20X5 20X4 000 000 Non-current assets 1 276 250 Current assets Cash and cash equivalents 3 - Inventories 51 46 Trade receivables 8 2 Other receivables 5 10 67 58 Total assets 343 308 Equity and liabilities Ordinary shares of 1 each 50 50 Retained earnings 91 61 Total equity 141 111 Non-current liabilities Bank loan 2 120 120 Current liabilities Trade payables 45 28 Other payables 37 38 Loans and overdraft - 11 Total liabilities 202 197 Total equity and liabilities 343 308 TPS Advanced Finance Module 10 7
Note: 1. Capital expenditure of 75,000 was made in the year ended 31 March 20X5. 2. The long-term bank loan carries interest at 10%. Required 1. Calculate the following ratios for the year ended 31 March 20X5: a) Profitability ratios: Gross margin; Net margin; Return on capital employed; and Return on equity. b) Liquidity ratios: Acid test or quick ratio; and Current ratio. c) Activity ratios: Inventory turnover; Days trade receivables; and Days trade payables. d) Risk ratios: Gearing; and Interest cover. 2. Explain the purpose of ratio analysis and its shortfalls. 3. Consider the limitations of the return on capital employed ratio in the context of Beta. 4. State which of the following sectors you think Beta is in; giving your reasons: a) General engineering; b) Whisky distilling; c) Food retailing; and d) House-building. (2 marks) (1 mark) (1½ marks) (1 mark) (6 marks) (3 marks) (3 marks) (17½ marks) 8 TPS Advanced Finance Module 10
Workshop Exercise 5 Question 1 What are the four categories of accounting ratios? Question 2 What is the formula for ROE? Question 3 Why might an overdraft distort ROCE? Question 4 What does asset turnover show about a company's performance? Question 5 What is an ideal current ratio? Question 6 What is the formula for inventory turnover and what does it show? Question 7 Which ratios are used to measure risk from an investor s point of view? Question 8 What is the earnings yield? Question 9 What two specific ratios could a debt provider look at? Question 10 What is the Z score? TPS Advanced Finance Module 10 9
Solution to Workshop Exercise 1 1. Current Situation Revenue has increased by 19% over the three years. (1 mark) Profitability has fallen over the three years ended 31 March 20X5. The ROCE has dropped from 65% in 20X3 to 41% in 20X5. (1 mark) The gross profit percentage has fallen from 33% to 30% over the three years whilst administration and distribution costs have remained constant at between 15.7% and 16.0% of revenue. (1 mark) In absolute terms, the profit before taxation and the profits retained have been less in 20X4 and 20X5 than in the previous year. (½ mark) Reinforcing the reduction in profitability, the activity or efficiency of operations as measured by activity ratios has been deteriorating, as indicated as follows. (½ mark) Inventory turnover has fallen from 3.7 times to 2.9 times from 20X3 to 20X5, that is, inventory held at 31 March 20X5 represented over four months cost of sales. Given the weekly cost of sales average of some 61,250 in 20X5, a reduction in inventory to a turnover of four would release cash in the order of 300,000. (1 mark) (Calculated as 3,185k /4 = 796k compared to 1.1m) Control over trade receivables has deteriorated from 71 days revenue outstanding to 89 days. (1 mark) This is an unacceptable high level of trade receivables. With revenue running at just under 90,000 a week in 20X5, stricter control reducing debtors to the 20X3 level would release approximately 220,000. (1 mark) Trade payables are currently being paid at an earlier date (49 days) than in previous years (57 days in 20X3 and 54 in 20X4). (1 mark) This may be due in part to suppliers suspecting the company s current cash flow position and pushing hard for their money but could simply be lack of control in the company because the bank has not been limiting its funding. (1 mark) The current liquidity of the company, as seen by the current ratio and quick ratio, is showing a gradual improvement. It reflects however, increasing inventory and trade receivables being financed by an increasing overdraft. (1 mark) The gearing of the company has decreased over the period and currently stands at a debt/equity of 71%. (1 mark) If the revaluation of the premises were incorporated into the books then the gearing would be lowered to 52%. (1 mark) TPS Advanced Finance Module 10 1
2. Corrective Action Over the following few months the company should: a) instigate an aggressive marketing policy to sell surplus inventory; (½ mark) b) improve inventory control procedures and maintain inventory levels (eg at 3 months, i.e., inventory turnover of four); (½ mark) c) improve control over trade receivables and bring the average outstanding down (eg to 70 days) over time (and in the longer term aim for a lower level); and (½ mark) d) meet with bank manager to discuss reduction in overdraft using the following information. (½ mark) Statement of financial position 20X5 Revaluation uplift Improvement In control 20X5 revised 000 000 000 000 Non-current assets Property 286 514-800 Plant and machinery 750 - - 750 1,036 514-1,550 Current assets Inventory 1,100 - (300) 800 Trade receivables 1,105 - (220) 885 Cash 35 - - 35 2,240 - (520) 1,720 Current liabilities Trade payables 425 - - 425 Bank overdraft 1,019-520 499 Other payables 250 - - 250 1,694-520 1,174 Deferred tax 150 - - 150 Share capital and reserves 1,432 514-1,946 Thus a bank overdraft of 499,000 could be secured by a floating charge on assets totalling 3,235,000 ( 1,550,000 + 800,000 + 885,000), and asset cover of over 6 times. (1 mark) Plant costing 200,000 is required to increase capacity. Given the above achievement this 200,000 may well be negotiated from the bank as the resultant 719,000 overdraft would have an asset cover in excess of 4 times. If not, leasing or hire purchase could be considered.(1 mark) 3. Types of funding: a) Loan; (½ mark) b) Hire purchase; (½ mark) c) Leasing; and (½ mark) d) Shareholders. (½ mark) Description of above per notes. (½ each) 2 TPS Advanced Finance Module 10
Solution to Workshop Exercise 2 Possible reasons for Alac s cash flow problems: 1. Increase in revenue between 20X3 and 20X5 is only 13% yet increase in cost of sales over the same period is double that at 27%. Costs are thus increasing disproportionately to revenue. Had revenue income increases kept pace with cost of sales, then revenue would have been 1,969,000. (2 marks) 2. Tied in with cost of sales, an analysis reveals a large increase in labour cost. Labour costs have risen over the period between 20X3 and 20X5 by 47%. This is excessive and is partly responsible for reducing the gross margin by 64% over the period from 16.4% to 5.9%. (1 mark) 3. There has been a marked increase in non-current assets which have increased by 44,000 (52%) over the period. (1 mark) 4. Builders Ltd has a heavy investment in work in progress. Payments on account in relation to this work in progress have reduced sharply in 20X5. (1 mark) 5. The bank overdraft is excessive, and appears to be used for long term finance as it is noted that at no time during the period under review does a cash/bank amount appear in current assets. The overdraft results in heavy interest payable amounting to around 15%. (1 mark) 6. Collection of trade receivables appears fairly lax, ranging from 59 days in 20X3 to 54 days in 20X5 though trade payables have to wait lengthier periods before they are paid (88 days (note, this figure is approximate as it includes labour)). (2 marks) 7. The effect of the disproportionate increase in revenue in relation to costs means that earnings before interest and tax have fallen from 164,000 to 16,000 over the period, this represents a substantial fall (90%) in earnings. (1 mark) Recovery Plan 1. Reduce commitment in work in progress, this may be difficult in view of the product (buildings) being produced. Obtain better payments on account facilities. (1 mark) 2. With the agreement of the bank which holds a floating charge, sell the property which is rented to a tenant. This will bring a substantial flow of funds into the firm. The bank would insist this be used to reduce the overdraft facility and thus reduce the interest payments. (1 mark) 3. Reducing the commitment in work in progress and trade receivables would have a knock-on effect with regard to the overdraft, and this would then be reduced (using funds from sale of property). For example, reducing debtor days from 54 to 40 would achieve a release of cash worth 67,000. (1 mark) 4. Cut the cost of labour, a 10% cut would save 72,000. (1 mark) 5. Review the materials buying policy, again a reduction of 10% would save 74,000. (1 mark) 6. Analyse overheads and carry out a cost cutting exercise. A reduction of 5% would save 9,500. (1 mark) 7. The nature of the business appears to be changing; therefore the link between the changing pattern of progress payments with the change from domestic to commercial property should be investigated. (1 mark) 8. As there appears to be a slump in the domestic house market, investigations should be made into the land bank can it be sold or even rented out as farm land? (1 mark) TPS Advanced Finance Module 10 3
Solution to Workshop Exercise 3 Report to: John Smith Re: Financial Position of Metal Ltd Prepared by: A N Other Accountants Summary and Recommendations A review of Metal s results over the last three years shows declining profitability and liquidity and a sharp increase in gearing. (1 mark) Weaknesses in working capital management and control over expenses are identified as being the major factors in the decline. (1 mark) The proposed increase in borrowings to maintain current sales levels should not proceed. (1 mark) Instead the company should actively pursue a policy of reducing borrowings by considering ways of improving collection of trade receivables balances and introducing tighter inventory control polices. (1 mark) Review of Results A review of Metal s results is given by an analysis of key ratios over the last three years compared with the industry averages. The ratios are summarised in Appendix A. 1. Liquidity Calculation of the current ratio highlights a drop of 57% in liquidity between 20X3 and 20X5 and a figure 33% below the industry average. (½ mark) The liquidity problems have arisen due to company weakness in the management of working capital. (½ mark) More specifically the average collection period of debtors has risen by almost 50%, to 50 days in 20X4, which compares very unfavourably with the industrial average of 32 days. (1 mark) Inventory turnover at 2.8, compared with an industrial average 7.0 indicates, even more significantly than the decline in trade receivables collection that the resources of the business are being tied up in working capital without contributing to an increase in the level of activity. The company should consider ways of improving trade receivables collection, perhaps offering customers prompt payment discount or changing credit control procedures. In addition a tighter inventory control policy must be introduced to reduce inventory levels. (2 marks) 4 TPS Advanced Finance Module 10
2. Performance Return on capital employed has dropped from 29.4% in 20X3 to 10.3% in 20X5. This key measure of performance can be analysed further between net profit and asset turnover. (1 mark) The net profit margin has declined from a healthy 7.7% in 20X3 (above industry value of 7.0%) to only 2.9% in 20X5. Given that the gross profit margin has been constant the last three years at 20% this decline can be attributed to a rise in expenses. (1 mark) Further analysis of the detail behind these expenses is recommended to discover why they have risen by 50% between 20X3 and 20X5 and revenue has only risen by 8%. Increased depreciation is obviously a factor as is increased charges on the bank overdraft. (1 mark) A detailed review of expenses should be conducted and attempts made to keep them in line with activity levels, thus improving overall company performance. (1 mark) Non-current asset turnover has improved over the last three years and is in line with the industry average. Total asset turnover has, however, dropped by 41% indicating that there is a weakness in working capital management. 3. Overdraft The company s overdraft has risen between 20X3 and 20X5. This overdraft is being used to fund the company s weaknesses in working capital management and should be reduced by improving the elements of working capital. (1 mark) TPS Advanced Finance Module 10 5
Appendix A: Key Ratios Assumption 20X3 20X4 20X5 Industry Quick ratio (½ mark) 2.1 1.0 0.6 1.0 Current ratio (½ mark) 4.2 2.6 1.8 2.7 Inventory turnover (½ mark) 1 6.9x 4.3x 2.8x 7.0x Days receivable (½ mark) 34 37 50 32 Revenue / non-current assets (½ mark) 11.6 10.7 12.4 13.0 Revenue / Total asset (½ mark) 3.2 2.6 1.9 2.6 Return on total assets (½ mark) 2, 3 24.3% 12.9% 5.6% 19.0% Return on capital employed (ROCE) (½ mark) 2, 3 29.4% 18.3% 10.3% 36.0% Debt ratio (total liabilities/total assets) (½ mark) 22.8% 33.1% 48.2% 50.0% Net profit margin (½ mark) 7.7% 5.0% 2.9% 7.0% Gross profit margin (½ mark) 20% 20% 20% - Assumptions: 1. Return on total assets and ROCE are computed by reference to pre-tax profit; and 2. Finance costs cannot be added back to profit in computing return on total assets or ROCE because no finance cost figure is given. Operating profit has therefore been used as the closest available figure to PBIT. 6 TPS Advanced Finance Module 10
Beta Ltd Solution to Workshop Exercise 4 1. a) Profitability Beta Ltd Gross margin: Gross profit x 100% Revenue 250 / 1,000 x 100% = 25% (½ mark) Net margin: Profit before finance costs and tax x 100% Revenue 50 / 1,000 x 100% = 5% (½ mark) Return on capital employed: Profit before finance costs and tax x 100% Capital employed (Total equity and non-current liabilities) 50 / 261 x 100 = 19.2% (½ mark) Capital employed equates to total assets less current liabilities, representing funds provided by shareholders and long term borrowings. Return on equity: Profit after tax x 100% Total equity 30 / 141 x 100% = 21.3% (½ mark) b) Liquidity ratios Beta Ltd Acid test: Current assets inventory Current liabilities 67 51 = 0.20 82 (½ mark) Current ratio: Current assets Current liabilities 67 = 0.82 82 (½ mark) TPS Advanced Finance Module 10 7
c) Activity ratios Beta Ltd Inventory turnover: Cost of sales Inventory 750 = 14.7 51 (½ mark) Days trade receivables: Trade receivables x 365 Revenue 8 x 5 x 365 = 2.4 1,000 6 (½ mark) Days trade payables: Trade payables x 365 Purchases (cost of sales + closing stock opening stock) 45 x 5 x 365 = 18.1 755 6 (½ mark) d) Risk ratios Gearing: Long term debt x 100% Total equity 120 x 100% = 85.1% 141 (½ mark) Interest cover: Profit before finance costs and tax Finance costs 50 = 4.2 12 (½ mark) 2. Ratio analysis is used as an aid to gaining useful information from financial statements. (1 mark) It can be used to measure an entity s performance over time, against competitors and industry averages providing they have all been calculated on a consistent basis. (1 mark) Ratio analysis of a single company s performance of one year does not provide much useful information. The raw data only becomes useful when it is compared with other analysis. (1 mark) Ratio analysis can be used to help in forecasting future performance and highlight any areas of current problems. (1 mark) There are several shortfalls to ratio analysis. Ratios are calculated on historical data which may not always reflect future performance and in the case of statement of financial position information may reflect or miss seasonal peaks and troughs. (½ mark) Financial statements can also summarise information making it difficult to determine the information needed for good ratio analysis. (½ mark) 8 TPS Advanced Finance Module 10
Using ratio analysis to compare organisations has several limitations. Factors such as accounting policies, cost classification, size of the organisation, industry sector, taxation, changes in accounting standards can all affect ratio analysis and would need to be taken into consideration. (1 mark) 3. Return on Capital Employed (ROCE) is dependent on the valuation of an organisation s assets, in particular fixed assets. (1 mark) Beta has made a substantial addition to fixed assets in the year. This may have reduced the ROCE which might have improved substantially without this capital expenditure. It should be ascertained if this expenditure is in line with Beta s normal policy. (1 mark) Note that the capital employed figure may be made up of a number of different types of capital which individually can have different effects on the company. For example, if the capital employed is largely debt, the company will be more risky. The ROCE will not highlight this. (1 mark) 4. Beta is most likely to be in food retailing (1 mark) as it has very low debtors days reflecting the fact that customers typically pay in cash or with credit/debit cards. (1 mark) Also food has a short life and therefore requires to be turned over more rapidly than the other industry choices, explaining high inventory turnover. (1 mark) TPS Advanced Finance Module 10 9
Solution to Workshop Exercise 5 1. Profitability Liquidity Management / activity Risk 2. Profit after tax x 100% Total equity 3. An overdraft will reduce the capital employed (total assets less current liabilities). This may actually have a positive effect on the ratio when in reality the overdraft is part of the capital employed. If the overdraft is being used as permanent finance it should be considered within long term debt for the purpose of ratio analysis. 4. Asset turnover = Revenue Capital employed This tells us how efficient a company is at generating revenue from its capital. 5. The 'ideal' current ratio depends upon the industry. Supermarkets have current ratios of less than one, whereas industrial or engineering companies may have ratios over 2. A ratio of less than 1 should lead you to question liquidity, but be aware of the industry norms. As with all ratios, you must always consider trends over time. 6. Cost of sales Inventory Inventory turnover calculates the number of times inventory was sold during the year. The same information can be obtained from the inventory days ratio, but this is an alternative way of expressing it. 7. Gearing: Long term debt x 100% Debt + equity or Long term debt x 100% Equity Debt ratio: Total debt (including trade payables) x 100% Total assets Interest cover: PBIT Interest charges 8. EPS Share Price = 1 PE ratio 10 TPS Advanced Finance Module 10
9. Asset cover is there security over enough assets should the company go into liquidation? Cashflow cover to ensure that interest and capital payments can be made comfortably. 10. The Z score was developed in 1968 to provide an indication of possible business failure. It is a weighted average of five ratios and if the result is below 1.8 it could mean the company is heading for insolvency. A results greater than 3.0 is a sign of health. TPS Advanced Finance Module 10 11
TPS Advanced Finance Module 11 Module 11 Raising Finance 1 Copyright ICAS 2015 Forming a Financial Strategy Good strategy founded on good information Consequences of incorrectly estimating the finance requirement can have much more significant consequences than getting the investment decisions wrong 2 Copyright ICAS 2015 Answers Provided by Cash Flow How much cash is required? When is it required? For how long is it required? What is the most appropriate type/source? The overall objective of short term finance is to ensure the company s liquidity 3 Copyright ICAS 2015 1
TPS Advanced Finance Module 11 Basic Principles Matching Attempt to match the life of the funding with the life of the asset being funded Relationship between risk and return Higher risk = higher return 4 Copyright ICAS 2015 Financing Priorities 1. Liquidity 2. Flexibility 3. Risk diversification 4. Cost 5 Copyright ICAS 2015 The Request for Finance Business Plan The finance request: market rather than a product focus track record recognition of lender s needs management control projections 6 Copyright ICAS 2015 2
TPS Advanced Finance Module 11 Sources of Finance Knowing the use of funds Long/ medium/ short Knowing the alternative types of funds 7 Copyright ICAS 2015 Sources of Finance Shareholder Funds Equity Preference shares Retained profits and reserves Debt Funding that has to be repaid 8 Copyright ICAS 2015 Equity Funding Ordinary Share Capital Primary risk capital of a company Last to be paid in liquidation so high risk Voting rights Rewards through dividends and capital growth 9 Copyright ICAS 2015 3
TPS Advanced Finance Module 11 Debt Non-equity capital obligation of a company Pays interest at pre-arranged regular periods Repayment of principle at pre-agreed date(s) Privilege of seniority 10 Copyright ICAS 2015 Subordinated Debt Winding-up payment after senior debt Increasing use e.g., leveraged buy-outs 11 Copyright ICAS 2015 Investors and Cost of Debt Providers: Banks Individuals Institutions Cost: perceived risk supply & demand market rates tax rates 12 Copyright ICAS 2015 4
TPS Advanced Finance Module 11 Leasing and Hire Purchase Advantages of leasing tax Flexibility / cash flow Advantages of Hire Purchase ease of access fixed rate finance tax certainty 13 Copyright ICAS 2015 Preference Shares Rights fixed annual dividend priority in liquidation usually no voting rights Benefits to investors to company Convertible usually when company is about to list Redeemable really a form of subordinated debt 14 Copyright ICAS 2015 Quasi-equity Issues Hybrids between debt and equity Facilitate issuance of debt at a lower cost Types: convertible loan stock bonds with equity warrants 15 Copyright ICAS 2015 5
TPS Advanced Finance Module 11 Convertibles Features: debt instrument issued first right or option to exchange for shares Price has two elements: debt portion relating to value of coupon second portion relating to value of right to convert Usually unsecured Lower risk than straight equity Attraction for investor/ for issuer 16 Copyright ICAS 2015 Bonds with Equity Warrants Traded separately warrants attached but are separable New finance raised if warrants exercised Debt levels remain unchanged 17 Copyright ICAS 2015 Business Life Cycle Stage 1 Introduction Stage 2 Take-off Stage 3 Slow down Stage 4 Maturity Stage 5 Decline 18 Copyright ICAS 2015 6
TPS Advanced Finance Module 11 Issues Facing Small Businesses Management expertise Under-capitalisation Knowing the sources Correct mix of debt maturities Planning & control Over-trading The finance gap Security 19 Copyright ICAS 2015 Sources of Finance Shareholder Funding Personal funds Venture capital Corporate venturing Business angels Retained profits and reserves 20 Copyright ICAS 2015 Debt Funding Bank loans and overdrafts Enterprise Finance Guarantee Grants Soft loans H.P./ leasing Factoring LEC 21 Copyright ICAS 2015 7
TPS Advanced Finance Module 11 Crowdfunding Large number of people invest small amounts Online Three different types Benefits Risks Regulation 22 Copyright ICAS 2015 Islamic Finance More and more prevalent Basic principles Differences to western finance 23 Copyright ICAS 2015 8
Contents RAISING FINANCE... 2 11.1 INTRODUCTION... 2 11.2 LEARNING OBJECTIVES... 2 11.3 FORMING A FINANCIAL STRATEGY... 2 11.4 PRINCIPLES OF RAISING FINANCE AND FINANCING PRIORITIES... 3 11.4.1 Principles of Raising Finance... 3 11.4.2 Financing Priorities... 4 11.5 BUSINESS PLANS AND THE REQUEST FOR FINANCE... 5 11.6 SOURCES OF FINANCE... 7 11.6.1 Purpose of Funds... 7 11.6.2 Types of Funding... 7 11.7 EQUITY FUNDING... 8 11.7.1 Investors in Ordinary Shares... 8 11.7.2 Capital Growth and Dividend Income... 8 11.8 DEBT... 9 11.8.1 Subordinated Debt... 9 11.8.2 Investors and Cost of Debt... 9 11.8.3 Investors Rights in Debt Instruments... 10 11.9 LEASING & HIRE PURCHASE... 10 11.9.1 Leasing... 10 11.9.2 Hire Purchase... 12 11.10 PREFERENCE SHARES... 12 11.10.1 Types of Preference Shares... 13 11.11 QUASI-EQUITY AND EQUITY-LINKED INSTRUMENTS... 14 11.11.1 Convertibles... 14 11.11.2 Bonds with Equity Warrants... 15 11.12 BUSINESS LIFE CYCLE... 15 11.13 ISSUES FACING NEW AND SMALL BUSINESSES... 17 11.13.1 Issues Facing New and Small Businesses... 18 11.13.2 Shareholder Funding for Start-ups... 20 11.13.3 Debt Funding... 21 11.14 CROWDFUNDING... 25 11.15 ISLAMIC FINANCE... 25 11.16 SUMMARY AND REVIEW... 27 Appendix 1... 30 Appendix 2... 31 ICAS 2015
Notes RAISING FINANCE 11.1 INTRODUCTION This module develops your knowledge of the funding sources available to a business. You will also learn how to apply that knowledge in order to advise a business on the ideal structure of its financing requirement and how to go about raising that finance. It is essential that you have a sound grasp of the basics of this topic before reading this module. Therefore, you should ensure that you are thoroughly familiar with your Test of Competence Finance or university notes. Many areas in this module are covered in more detail in later modules during the Advanced Finance course.. Completion of this module in conjunction with Modules 6, 7, 12, 16, 17 and 20 addresses learning outcomes 2 and 3 of the syllabus to advise clients on relevant sources of finance and funding methods and advise clients on investment products suitable for companies. 11.2 LEARNING OBJECTIVES On completion of this module you should be able to: 1. explain how a finance strategy is developed; 2. apply the principles of raising finance and financing priorities; 3. advise on the contents of a business plan and the request for finance; 4. evaluate the various sources of finance; 5. describe the life cycle of a business; 6. analyse the issues facing small and growing businesses (including unincorporated entities) and describe the sources of funding appropriate for them; and 7. describe the fundamentals of Islamic finance. 11.3 FORMING A FINANCIAL STRATEGY The financing decisions made by a business entity are a crucial area for the owners and managers of that business. Particularly at key times in the development of a business, the quality of these decisions has a profound influence on the future success or failure of that business. A financing strategy is founded on the forecast cash requirements of the business. The quality of the forecast information will be reflected in the quality of the financing 2 TPS Advanced Finance Module 11
decision made. A good cash flow forecast is therefore essential. You will learn about cash flow forecasts in Module 5. Notes In most businesses the consequences of incorrectly estimating (especially understating) the financing requirement can have significant consequences. For this reason it is essential that an appropriate financing strategy is in place. The cash flow forecast will assist in providing answers to these questions: How much cash is required? When is it required? For how long is it required? What is the most appropriate type/source? These questions are often hardest to answer in a business start-up scenario, as there is no track record to rely on or assumptions to use and therefore base the forecasted numbers on. This is why business start-ups find it so hard to obtain funding. Banks are notoriously reluctant to provide significant levels of funding to new businesses. We will consider business start-ups later in this module. You should now be able to achieve the first learning objective. 11.4 PRINCIPLES OF RAISING FINANCE AND FINANCING PRIORITIES 11.4.1 Principles of Raising Finance You should remember from TC Finance or your university notes that the following principles should always be considered by the financial manager when raising finance: 1. Matching Businesses should attempt to match the life of the funding with the life of the asset being funded. If the funding lasts for longer than the asset, then the business will end up paying for an asset that it no longer possesses. On the other hand, if the funding is for a shorter length of time than the life of the asset, then the repayment instalments may be higher than the income the asset is able to generate, causing a cash outflow in the early part of the asset s life. 2. Relationship between risk and return The higher the risk that an investor has to take in lending money, the higher the return they will expect to receive on that money. If the borrowing company can pledge security to the lender (e.g., by a charge/security over a building) then the return that the lender will expect to receive will fall, as there is less risk in investing the money. TPS Advanced Finance Module 11 3
Notes The principles of financing apply to all businesses. You should understand them and be able to apply them to different scenarios. Remember that the finance raised by one company is the investment for another business. Accordingly the principles of investment and borrowing are very similar. Exam Tip You should note that your role in an exam question is not always that of a financial controller or business advisor, you may be a venture capitalist or a bank manager. It is imperative that you are able to adapt your answer to suit these roles. 11.4.2 Financing Priorities These are as follows: 1. Liquidity; 2. Flexibility; 3. Diversification of sources; and 4. Cost. These are discussed in more detail below: 1. Liquidity Many businesses rely on short-term borrowings to meet some or all of their liquidity or working capital needs. Such borrowings are a reliable source of liquidity only if there is some assurance that the funds will be available when required. 2. Flexibility Cash flows are inherently uncertain and for this reason a degree of flexibility is an important element of a financing strategy. Flexibility is the ability to tailor the funding available to a business to its exact needs. The shorter the term of the borrowing, the more flexible the facility needs to be. There is a price to be paid for this flexibility which will be reflected in a higher cost of the borrowing. Example 1 A company may have a seasonal business. In some months it will need a large amount of finance, in others it might not need any finance. Taking a long-term loan for the maximum annual amount required is an expensive method of ensuring that the company will have access to the exact amount it needs at any one time. 4 TPS Advanced Finance Module 11
Notes 3. Diversification of sources A key element in achieving the above two priorities is to have a variety of sources of funding available to the business. Reliance on only one source of funding is fraught with danger and there have been many funding crises caused by a breakdown in the relationship between the borrower and the provider of funds. There can be a positive element to this strategy in that competition between lenders may reduce the cost of borrowing for the recipient. 4. Cost As referred to above, the cost of finance reflects a combination of three factors - liquidity, flexibility, and diversification. A profitable, well managed business that enjoys a good relationship with its funds provider will obtain cheaper funding than an unprofitable, poorly managed business that has a poor relationship with its provider of funds. You should now be able to achieve the second learning objective. 11.5 BUSINESS PLANS AND THE REQUEST FOR FINANCE A company looking for funding should give serious thought as to how it plans to request the finance. Remember that lenders are not under any obligation to lend and need to be persuaded that lending the money makes good commercial sense. The company should prepare a business plan. This is a document that details the structure of the business in both financial and operational terms. It should describe the company, the management, the product(s), the market, growth potential, aims and objectives, financial forecasts, reasons for funding, funding requirements and investor returns. Business plans were covered in Module 9 of TC Finance. The preparer of a business plan should consider the concerns of the lender which are covered in more detail in Module 16: A market rather than a product focus Lenders want to sense that the business is run by people who understand what their business can do best, and who are prepared to concentrate on making a success of it. This is more attractive than the business that produces a wide variety of products with no apparent focus or market niche. Some track record TPS Advanced Finance Module 11 5
Notes If the business cannot demonstrate that it already has customers who are happy with its product, it has the added problem of convincing the lender that the product will have a market. Recognition of lender's needs A business looking for funding will need to show in the business plan how lenders or investors are to get the results they require. Security is extremely important to a lender, especially over a longer term. The bank will review the value that they could obtain on forced sale of the assets that they have security over. Providing that this is higher (sometimes twice as high) than the value of the funding required, the bank is likely to be satisfied. This is known as the asset cover ratio. The security may be in two forms, either fixed or floating charges and this is covered in more detail in Module 2. Providers of debt capital will be looking for security to back the loan and near certainty that they will get their money back, as well as interest at a rate that reflects their risk. Venture capital firms may want a substantial shareholding in the firm and representation on the Board. In addition, if an investor is looking for returns over the longer term they will want information on future profitability and the basis of the dividend policy. Another consideration is the exit route, such as the possibility of a future listing on the AIM (covered later in this module). Management control An innovative product will attract lenders, but without a credible description of how performance is to be monitored and controlled they are inevitably going to back away from the deal. Credible projections Some would suggest that a firm should produce two business plans: a conservative one to present to lenders (which they are confident of achieving) and a more ambitious one for management to use as a set of targets. There are a number of potential dangers in this approach, but there is some truth in the suggestion that figures presented to lenders should be rooted in reality rather than being over-ambitious. You should now be able to achieve the third learning objective. 6 TPS Advanced Finance Module 11
11.6 SOURCES OF FINANCE Notes 11.6.1 Purpose of Funds Before advising a business on the most appropriate financing package, a number of factors must be considered, such as the type of business/industry, the stage of development and the size of the operation. The financing of a fast growing high-tech business will have different factors to consider when compared to a business that is struggling to sell a product that is out of fashion and needs emergency funding. Clarity is also needed as to the proposed application of the funds. Finance can be broken into long, medium and short term. It is important to consider a range of options. A crisis may be overcome by simply arranging for suppliers to accept a short delay in receiving their payment. If enough goodwill has been developed with a supplier or banker, a liquidity shortage might easily be overcome without resorting to a long-term and expensive funding package that gives away some control over the business. In structuring the financial package for a business the priority is to minimise the cost and the risk to the business. From these perspectives it is vital that an application of funds is matched with the appropriate source of funds. A table summarising the types of finance can be found in Appendix 1. 11.6.2 Types of Funding There are two main categories of funds which you will have met before and which will be covered in further detail later in this module: 1. Shareholders Funds Shareholders funds comprise equity, preference shares (covered later in this module) and retained profits and reserves. Equity funding is ownership capital. It is provided in the form of owning a share of a business. The owners normally carry the most risk and should receive the highest return. This return will be either in the form of a dividend, capital gain or both. 2. Debt Debt is funding that has to be repaid. Repayments usually take the form of an annual interest charge until the repayment of the capital (principal). The capital is sometimes only repaid at the end of the term or may be repaid in instalments. Debt is usually less expensive than equity since debt can be secured on the assets of the company receiving the debt and interest is paid out to debt TPS Advanced Finance Module 11 7
Notes providers before dividends are paid out to the owners of the business (see Module 2 Insolvency). Interest is also tax deductible. These sources of finance will now be considered in more detail. 11.7 EQUITY FUNDING Equity (or ordinary shares) is the primary risk capital of a company. In liquidation, the shareholders are last in line to be paid. Conversely they stand to receive the rewards, if the company is a success, through a continuing stream of dividends and/or capital growth of their shares. This section examines equity funding in larger companies. Only the largest companies are listed on the Stock Exchange. Private limited companies (Ltd) restrict the free transfer of shares and therefore cannot be listed on a stock exchange. The majority of public limited companies (plc) are not listed on any stock market. The voting rights are typically one per share, but different classes of ordinary share can be issued, which may have different voting rights. These shares might be differentiated into ordinary A s and B s etc, and rights could be designated, for example, B s have no voting rights (non voting shares), or half those of A s. Shares may also carry different rights for dividend purposes. Ordinary shares may be preferred or deferred, indicating their ranking for dividend purposes. Founders shares may receive a dividend only after all other categories of equity shares have received fixed rates of dividends. 11.7.1 Investors in Ordinary Shares Institutional investors account for approximately 75% of the total market capitalisation of the UK stock market. Companies looking to raise equity funding should be aware of the aims of the majority of institutions investing in the stock market, which are to achieve real growth and to achieve an increment over the returns available on risk-free instruments. 11.7.2 Capital Growth and Dividend Income Capital growth and dividend income will be of different levels of importance to investors at different stages of a company s development. A company which is at an early stage of its development may have insufficient earnings to pay dividends, or may need to retain its earnings to finance the ongoing investment required to build its business. Investors will seek their return through increases in the share price over time, reflecting the expected successful establishment of the company in its field. A company, which operates in a mature industry where only relatively small increases in 8 TPS Advanced Finance Module 11
earnings can be achieved, will need to reward investors through a greater emphasis on dividends rather than capital growth. Notes Dividends are an explicit cost of equity. A company must give careful consideration to the amount of dividend it can afford on a sustainable basis, balancing a fair return to shareholders against the need to retain cash in the business to finance further growth. Unexpected changes in a dividend policy can have a significant, negative impact on market sentiment towards a company because it creates more risk due to the variability of dividends. This is discussed in Module 9. The issue of equity shares and stock exchange regulation are covered in Modules 12 and 13 respectively. 11.8 DEBT Debt is a non-equity capital obligation of a company on which interest rather than dividends is paid to its providers. Key terms in the provision of debt capital include payments of interest at pre-agreed regular periods and the repayment of the principal on pre-agreed dates. Providers of debt capital do not have a right to vote at general meetings, which is the prerogative only of the ordinary shareholders (and, in certain circumstances, the preference shareholders). Debt providers enjoy the privilege of seniority, which means in the event of a winding-up of the company the senior debt holders will be repaid (if funds are available) ahead of ordinary shareholders, preference shareholders and other lenders whose claims rank behind theirs. Debt can take several forms from overdrafts and term loans to bonds. 11.8.1 Subordinated Debt Subordinated debt is a type of debt where, in a winding-up, lenders only have the right to payment of interest and repayment of principal after the senior debt has been repaid in full. Its significance and usage has increased in recent years, particularly in companies which have been the subject of a leveraged buy-out (discussed in more detail in module 15) or which are, for business reasons, heavily geared. Banks also issue subordinated debt. 11.8.2 Investors and Cost of Debt Providers of debt capital to companies are not only banks but can be both UK and foreign individuals who buy bonds, or institutions like pension funds and insurance companies who can also buy bonds either publicly or through private placements. Each investor will have its own appetite for the risk it is willing to take in a particular investment and the return it will seek. Clearly the higher the risk, the higher will be the required return. TPS Advanced Finance Module 11 9
Notes Debt is cheaper than equity as interest is a tax deductible expense. Therefore the after-tax cost of debt capital, rather than the pre-tax cost, is a more important measure for a company. The absolute cost of debt to a company will depend on a variety of factors among which some of the most important are: the company s perceived credit risk; the supply and demand for credit; the market level of interest rates and margins; and prevailing tax rates. The level of leverage of the company contributes to the risk of its equity and therefore to the cost of its equity. This is discussed in more detail in Module 8. 11.8.3 Investors Rights in Debt Instruments A provider of debt capital will have the right to receive full repayment of the principal and accrued interest if certain events occur which could be detrimental to the company s ability to continue as a going concern. The rights are contained in the legal agreement between the company and the lender(s). Typically, the longer the term for which the debt is committed, the more rights the investor will require to protect his position. The company undertakes to meet certain continuing conditions such as the provision of information and the maintenance of certain financial ratios. This will be covered in further detail in Module 16, Banks and bank credit, Module 17, Corporate debt securities and Module 18, Loan documentation. 11.9 LEASING & HIRE PURCHASE 11.9.1 Leasing A lease is an arrangement that you should have met before. A lease allows a lessee to use an asset in return for making regular payments to the owner of the equipment, the lessor. 11.9.1.1 Types of Lease There are two main types of lease: finance leases and operating leases. Finance lease A finance lease transfers substantially all the risks and rewards of ownership to the lessee. 10 TPS Advanced Finance Module 11
The usual test for a finance lease is: Notes present value of rentals asset value; primary contract period approximately equals asset life; and return is higher than the lessor s cost of funds reflecting the credit risk of the contract. The main motivation of the lessor in a finance lease is to make a profit by financing the asset. Such lessors are usually financial institutions. Operating lease Operating leases will fail the finance lease tests, that is: present value of rentals < asset value; non-cancellable period < asset life; return is in part based on associated revenues (e.g., sale of paper if a copying machine) or residual value. Operating leases are a sales aid for the product manufacturer/distributor. However, if the manufacturer does not have the capacity to act as lessor it may engage the services of a financial institution to act on its behalf. 11.9.1.2 Advantages of Leasing There are two significant reasons for a company to lease assets rather than buying outright. Tax benefits; and Flexibility/cash flow. Tax benefits: Lessor Legal ownership of a qualifying asset entitles the owner (e.g., a bank) to amortise the capital cost over the life of the asset for tax purposes. Tax benefits: Lessee The ability of lessors to pass on capital allowance tax benefits to lessees in the form of reduced lease rentals makes leasing very attractive for entities which have no tax capacity themselves for example, loss making business which are still credit worthy or start up projects which may not move into profit for a number of years. Flexibility/Cash Flow Lease structures can be flexible and innovative and the payment schedules can be tailored to fit the projected cash flow arising from the underlying business. TPS Advanced Finance Module 11 11
Notes 11.9.2 Hire Purchase With hire purchase the finance ( HP ) company buys the equipment that the borrowing firm (the hiree ) requires and allows the hiree to use the equipment in return for a series of regular payments. 11.9.2.1 Features of Hire Purchase Payments cover interest and contribute to paying off principal. HP company remains the legal owner until all payments have been repaid and can therefore repossess the asset if the hiree defaults on payment. 11.9.2.2 Advantages of Hire Purchase Small initial outlay (but set against relatively high interest charges and costs of maintenance and insurance). Easy to arrange often available when other sources of finance are not. Certainty finance cannot be withdrawn providing contractual payments are made. However can be costly to prematurely terminate the agreement. Fixed rate finance. Whilst the interest rate will not vary with the general interest rate throughout the agreement, the HP company may quote a flat rate which may be significantly lower than the true annual percentage rate. 11.9.2.3 Tax Relief The hiree qualifies for tax relief in two ways: 1. The asset can be subject to a writing down allowance ( WDA ) on the capital expenditure; and 2. Interest payments are deductible when calculating profits. 11.10 PREFERENCE SHARES Preference shares are part of shareholders funds but are not equity share capital. The holders are not usually able to benefit from any good performance of the company in the form of higher dividends. Preference shares have preferential rights over ordinary shares. typically: These rights are a fixed dividend, paid annually, although this can increase if the preference shares are participating; reimbursement of the principal value of the share in a company liquidation in priority to the ordinary shareholders; and usually no voting rights unless for instance, the preference dividend was in arrears or if the company were to propose an act, which constituted a variation in the rights of the preference shareholder. 12 TPS Advanced Finance Module 11
Preference shares are attractive to some investors because they offer a regular income at a higher rate than that available on debt. The higher return is due to a higher risk level since the dividend is not guaranteed and they rank after debt holders in liquidation. Notes The benefits to a business of this form of funding are: lower effect on gearing than debt as dividends do not have to be paid where there is insufficient profit. The treatment of preference shares in the gearing ratio is discussed in more detail in module 8 and 10; where there is super-profit in a business, the preference shareholders dividend is still limited, unless it is a participating preference share; fixed dividend payments allow management more flexibility; and less influence over management since the preference shareholders do not usually have voting rights. Management should remember that: preference dividends are not tax deductible; and the cost of preference share capital is normally higher than that required by the debt providers. 11.10.1 Types of Preference Shares There are variations on the simple form of preference shares for instance, the dividend may be cumulative. If it is not paid one year due to insufficient profits, the amount due will accumulate and the accumulated amount is paid when there are sufficient profits. Accumulated preference dividends would have to be paid before ordinary dividends could be. Preference shares tend to be issued in particular circumstances. For example, a family-run or small company may wish to raise share capital without relinquishing voting control. Alternatively, a company contemplating a stock market quotation may, to encourage initial investor demand, issue preference shares or convertible preference shares that will give the investor priority on the full listing. The convertible element will ultimately convert the preference shares into ordinary shares at specific dates and on pre-set terms. The attraction of participating in the growth in value of ordinary shares means the yield on the preference shares may be lower. Listed companies expressly issue some preference shares as redeemable, the purpose frequently being to strengthen the capital base without diluting the interest of ordinary shareholders. The business needs to arrange the finance for this redemption. Many international markets view these shares as debt. TPS Advanced Finance Module 11 13
Notes 11.11 QUASI-EQUITY AND EQUITY-LINKED INSTRUMENTS Quasi-equity issues are hybrids between debt and equity. This means the cost to the issuing company is more than the cost of debt but less than the cost of equity. Quasi-equity issues come in many forms, such as convertible loan stock, convertible bond issues and bonds with equity warrants. 11.11.1 Convertibles Convertibles are variations on a theme in that a debt instrument is issued first, but attached to it or embedded within it, is a right or option to exchange that debt instrument for shares in the company. The price at which such exchange or conversion takes place is usually at a premium to the current share price (at the time of issue) and may be into ordinary shares or preference shares, which may or may not include voting rights. The variations are numerous but whatever combination is selected, it will be reflected in the price of the initial debt instrument. The attraction of convertibles is that they offer the opportunity to raise funds at a lower interest rate than a straight non-convertible debentures due to the expectation of a capital gain on conversion. Convertible loan stock is usually an unsecured obligation and in a liquidation the holder will rank ahead of ordinary and preference shareholders, behind senior debt providers and pari passu to all unsecured creditors. Conversion also depends on the performance of the underlying share price. The attraction of convertible issues for the investor is that they enable the investor to participate in the growth in value of the underlying shares into which they are convertible, but at a reduced risk (due to the higher yield available on the instrument and its priority in ranking to the equity in the event of liquidation). Convertible debt, as part of an investment package, is a way of attracting venture capital. The advantages to the business of convertibles are: investors accept a lower interest rate due to the potential of converting; interest payments reduce taxable profit; if converted, the company does not have to fund the repayment of the borrowing; more flexibility for management due to less need to secure the debt or to impose restrictions on management; and 14 TPS Advanced Finance Module 11
interim way of raising equity capital at a time that share prices are unusually low. Notes 11.11.2 Bonds with Equity Warrants The other common type of hybrid is a bond with equity warrants - a company issues a bond with a fixed rate of interest with a fixed maturity. Accompanying each bond is one or more warrants, which entitle the holder to purchase a fixed number of ordinary shares at a fixed price (exercise price) for a fixed period. The bonds and warrants are separate and are attractive to different types of investor. Example 2 Consider a 100m bond and warrant issue with bond denominations of 1,000 when the company s current share price is 250 pence. The warrant issued with each 1,000 bond entitles the holder to subscribe for 400 ordinary shares at a price of 275 pence (i.e., a premium of 10% over the ordinary share price at the time of issue). The essential difference between a convertible and a bond with equity warrants is that on conversion of a convertible, an investor will surrender loan stock in return for new shares; (thus a company s debt is reduced and its equity increased simultaneously and no new money is raised), whereas an investor in a bond with equity warrants surrenders the warrant with cash (to purchase shares) separately from the bond. This increases the company s equity and raises new cash whilst its debt remains unchanged. Corporate debt securities are covered in further detail in Module 17. You should now be able to achieve learning objective 4. 11.12 BUSINESS LIFE CYCLE The financial needs of any business will vary during the different stages of its life. The experiences of all businesses differ but there is a general pattern. This general pattern can be described best using a graph of the life cycle of a business as follows: TPS Advanced Finance Module 11 15
Notes Stage 1 Introduction In the introductory phase of a business, the company will need a significant amount of cash for both research and development, and for setting up the business installing plant and machinery, recruiting staff, buying premises, computer equipment etc. It will have low revenue and low profits. The company will need start-up capital, usually the owners personal money and possibly some venture capital. If the equity funding can be found, then debt funding, usually in the form of bank loans and overdrafts can be investigated. These loans will require security either from the owner personally or, in some cases, from the government. Other financing options will include leasing or hire purchase of assets or factoring of debts. Stage 2 Take-off In this phase of the business, the company will need to spend a significant amount of cash to market the business and its products. The business should have improved revenue and profits compared with Stage 1 and will be growing rapidly. 16 TPS Advanced Finance Module 11
Stage 3 Slow down Notes The market for the products of the company reaches a steady level of demand. Growth of revenue will be slower and profits could be static. Financing for Stages 2 and 3 of the business will come from similar sources to the introductory phase but will also include retained earnings. The business will look for further bank loans and specialist financial instruments or government schemes. To rely only on retained earnings would seriously restrict growth. Stage 4 Maturity This is a period of consolidation for the business. Revenue will be static, as will profits. The company is increasingly reliant on existing customers to make replacement purchases. At this point the company will have a history of funding and will therefore be in a better position to either obtain further funding from banks or other institutions or to buy and sell shares to the public. Stage 5 Decline If the company has not used its funding from Stage 4 to good effect it may find that competitors produce improved products or respond quicker to technological change. Demand for the company's product may be lower due to the increased competition and servicing the increased capital costs will diminish the profits. You should now be able to achieve learning objective 5. 11.13 ISSUES FACING NEW AND SMALL BUSINESSES Much of this module has concentrated on funding for larger companies. This section will briefly review the funding available to recently started/small businesses and onwards through their period of growth. This section applies to unincorporated (sole traders and partnerships) as well as incorporated businesses. Exam Tip Remember that in exams you should be tailoring any finance advice you provide to the size of the client in the scenario. It is important that you appreciate what types of fiance suit the different sizes of organisations. A summary on this is included in Appendix 2 to this module. TPS Advanced Finance Module 11 17
Notes 11.13.1 Issues Facing New and Small Businesses It is important that the owner-manager is aware of a spread of funding sources. The failure rate in business start-ups is very high. Only a small percentage of new startups survive to the fifth year of trading. Businesses that remain small also face particular problems as well as opportunities. Some of the issues that face small businesses include: 1. Lack of financial management expertise In the very early stages of a business, the founder is often the only manager of that business and has technical expertise in relation to the company's products but has little or no financial management skills. It is imperative that business founders either employ (even initially on a parttime or contract basis) an individual or firm to provide advice in financing both at start-up and at later stages on an in the business developments. 2. Under-capitalisation A business that is undercapitalised has an insufficient capital base to allow it to operate effectively. As a result it may go out of business, as it is unable to fund either the non-current or current assets needed. It is therefore important to obtain sufficient funding in a sensible proportion of debt to equity. This can be relatively difficult for new business owners if they are ignorant of the sources of finance available and reluctant to lose 100% control of the business by giving shares to an external party. As a result, the amount of equity issued is limited to the personal funds available to the owner. The most obvious alternative is bank borrowing which means that the business will be very highly geared meaning that the costs of servicing the finance are high. This is a heavy burden to a new business. Equity funding does not place the same burden on the business since outflows of dividends can be delayed and capital does not have to be repaid. 3. Ignorant of sources of finance A business that is ignorant of the sources of funding available to it, runs the risk of selecting a source of finance which is not flexible enough, liquid enough or secure enough for its requirements. It also may not achieve the best rates of interest available to it. Typically, a non-financial owner manager will tend to approach only the local bank manager who may not know or advise on the most appropriate funding source. 18 TPS Advanced Finance Module 11
Notes 4. Incorrect mixture of debt maturities A business that has the wrong mix of short-term and long-term debt will be unable to manage its cash effectively. A business with too high a proportion of long-term debt will not have the same flexibility in its financial management. To reschedule the debt when interest rates fall can be very expensive. A business that has too much short-term debt runs the risk of being crippled by having to repay the principal. The administration and set-up costs of frequent, short-term packages are detrimental to the business. 5. Ignorant of need for cash planning and financial control A small business, due to its lack of financial expertise, may be ignorant of the need for cash planning and financial control. It risks running out of cash and being unable to continue to trade. It will be unable to ensure that its financial systems provide the accurate financial information to enable management to make appropriate funding decisions. 6. Overtrading If a small business is very successful it may grow at a rate at which its demand for funds exceeds its supply of funds. This is known as overtrading and usually occurs when revenue grows but there are insufficient long-term funds available. A fast growing business needs an adequate administrative set-up to handle the extra work of managing extra inventory and trade receivables. Cash collection can lag behind the cash outflow. Management will have to forecast its working capital requirement in order that sufficient cash may be brought into the company to cope with demand. Control over working capital must be tight (see Module 5). 7. The finance gap The finance gap is a term used to describe the shortage of funds available for small businesses. It is often difficult for smaller businesses to raise capital even though they may be able to offer good security. This is because debt and equity providers take the view that a small business has greater risk of failure and are therefore less keen to invest in it. Additionally, capital providers will have a fixed administrative cost element to any loan, which will make it more expensive for the size of loan which smaller companies will require. The size of the finance gap is always changing but is frequently referred to when a business needs between 50,000 and 200,000. TPS Advanced Finance Module 11 19
Notes 8. Lack of security Many new businesses lack the security necessary to obtain bank funding due to the lack of assets belonging to the business. This may be overcome by pledging the owner s personal cash or security or by using the government s Enterprise Finance Guarantee ( EFG ). This scheme allows a business to borrow up to 1.2m for up to 10 years. The loan is arranged through a bank but the government guarantees 75% of it. A premium of 2% is added to the normal rate charged by the bank. 11.13.2 Shareholder Funding for Start-ups A new business can look to a variety of sources for initial share capital. As the business grows there is likely to be a demand for increased investment by the owners, or for external investment (e.g., venture capital). At this later stage retained profits may also be available to support the business. 1. Personal Funds This is the most common type of business funding, particularly for start-ups. If personal money is being used it is important to recognise that there is always an opportunity cost. Frequently, the family and friends are also included in the early funding needs along with that of the owner. 2. Venture capital These funds may be invested in smaller businesses depending on the venture capital company's view of whether or not that business is a sensible investment. Venture capitalists usually provide equity funding and therefore seek a share of dividends and profits. Not many venture capitalists will invest in a very new company, the majority will prefer to inject finance into a company with a trading record. A venture capitalist that chooses to invest in a small business will be making an investment with a high level of risk. It will therefore charge a high level of interest and want to maintain a watchful eye over the business. Often, this is undertaken by introducing a representative to the board of directors, usually in a non-executive capacity. It will also want an exit for its investment that is, an opportunity to remove its investment in three to five years from its introduction. This means that the investee company should be very fast growing (generating returns of over 30% per annum) and should be able to be sold (a trade sale) or listed on a stock market. A smaller business looking for equity will have 20 TPS Advanced Finance Module 11
difficulty persuading any of the recognised venture capitalists to invest if the required sum is less than 300,000. The average investment is between 1m and 2m. Venture capital funding may take a long time to arrange. Notes 3. Corporate Venturing A large company with an excess of cash and an interest in the products/services of a smaller business may choose to buy a minority shareholding in the small company. 4. Business Angel A business angel is an individual or group of individuals who invest their personal money in a business. While they will expect to receive a relatively high return on their investment, they will often offer to assist the business by providing expertise and industry knowledge to the business. This can be a vital key to the growth of a new business. Example 3 In the BBC Two series, Dragons Den, the judges, Peter Jones and Richard Farleigh paid Levi Roots 25,000 each in return for a 20% stake in his business. Mr Roots Reggae Reggae Sauce is now on sale in 600 Sainsbury s stores. 5. Internally generated funds/retained profits and reserves At a later stage of the business, profits will provide the resources for further investment. In a start-up scenario a business is unlikely to be cash generative from the outset, so other sources will be required. The working capital cycle of a business can generate (and consume) funds. Assessing the cost of this funding is not straightforward as there are many aspects to the calculation should discounts be offered to customers for early settlement, should they be taken from suppliers, will sales be lost if the right level of inventory is not available? Care needs to be taken to ensure that future requirements for working capital have been considered, particularly in a very seasonal or fast growing businesses. Asset purchases and dividends should be funded from profits and from longer term funding. 11.13.3 Debt Funding This section covers the type of finance which might be available to new and small businesses. As the business grows it will make increasing demands on the bank TPS Advanced Finance Module 11 21
Notes overdraft for working capital and may require further bank loans to acquire capital items needed to sustain growth. Effective working capital management (covered in Module 5) becomes increasingly important as the business matures. 1. Bank borrowing A bank loan is the simplest form of borrowing for a small business and often the cheapest. The usual source is the company's own bank. The bank will charge interest and will usually require security for the loan. This type of finance is most frequently used for the purchase of capital items. An overdraft is another simple form of bank borrowing and tends to charge a higher rate of interest than a bank loan but is always repayable on demand and subject to periodic review. Bank borrowing will be discussed in more detail in Module 16 and Module 18. 2. Enterprise Finance Guarantee ( EFG ) This scheme was introduced by the Government to help small organisations with a sound business proposition but which were finding it difficult to obtain funding due to a lack of security. In broad terms, the Department for Business, Enterprise and Regulatory Reform ( BERR ) will guarantee 75% of a bank loan up to 1.2m for an interest premium of 2% on the loan. Note that the business must have an annual turnover of less than 41m. 3. Government grants The level of funding that was once available to UK businesses through Regional Grants has declined. However, funds are still available for companies wishing to set up in areas where jobs are scarce. These are split into Regional Enterprise Grants (usually for investment in non-current assets) and Regional Selective Assistance (usually for creating or safeguarding employment). Grant funding is valuable to a business and other potential funders will see additional support of this nature as an indication of faith in the business. Grants are free and not usually repayable. 4. Soft Loans It may be possible for a new business to obtain a loan from one of its main suppliers for example, pubs often secure loans from brewers. These loans are known as soft because they are often provided in circumstances that no other lender would be prepared to lend for example, with a lack of security available or at a lower rate of interest. 22 TPS Advanced Finance Module 11
Notes 5. Hire Purchase/Leasing Most of the major banks will provide this type of funding especially for fixed assets. These can be assets such as cars and lorries, plant and machinery, office furniture and equipment including computers. The period of finance would typically be set to match or be shorter (more likely) than the expected useful life of the asset. The finance company would expect a deposit of between 10 and 25% of the cost of the asset and the balance (including the cost of finance) is then paid on a monthly or quarterly basis over the remainder of the term. This spreading of payments can be a great help in terms of managing the businesses fluctuating ability to pay for an asset. This type of finance will often be available to new businesses. 6. Factoring Particularly in a fast growing business, factoring is one of the few viable methods of financing. Factoring can provide finance on the security of trade debts, relieving the business of the cost of sales ledger administration and often providing credit insurance. Factoring is covered in more detail in Module 5 and Module 7. 7. Local Enterprise Companies There are a number of local enterprise companies that will assist new businesses in setting up. You are not expected to know them all but simply to be able to advise a client to contact their Local Enterprise Company. 11.15 CROWDFUNDING Crowdfunding is a financing method that involves funding a business with relatively small contributions from a large group of individuals, rather than seeking substantial sums from a small number of investors. The funding campaign and transactions are typically conducted online through dedicated crowdfunding sites, often in conjunction with social networking sites. The crowdfunding industry is expected to top 1bn by 2016. Aberdeen-based brewer BrewDog used crowdfunding for the third time to raise 4.25m by offering shares to the public in 2013. The Caterham F1 team also used crowdfunding in 2014 as a way of raising finance to save an ailing business and avoid insolvency. There are three different types of crowdfunding: TPS Advanced Finance Module 11 23
Notes Donation crowdfunding this is where people invest because they believe in the cause. Rewards can be offered (also referred to as reward crowdfunding) such as acknowledgements on an album cover, tickets to an event and free gifts. This has been used for motion picture promotion, scientific research and software development in the past. Debt crowdfunding in this form, investors receive their money back with interest. Returns are financial, but investors also have the benefit of having contributed to the success of an idea they believe in. This has become more popular since 2012. Borrowers must therefore demonstrate creditworthiness and the capability to repay the debt, therefore this form of finance is less suitable for start-ups. Equity crowdfunding in this type, money is exchanged for shares. If the venture is successful the value of the shares increases. The highest reported funding by a crowdfunded project at 30 November 2014 was Star Citizen, an online space trading and combat video game, which claims to have raised $61m. There are hundreds of crowdfunding platforms. Project creators need to perform due diligence in order to choose which platform is the most suitable. Crowdfunding campaigns provide a number of benefits, in addition to the finance raised. These campaign benefits include an increased profile, useful marketing feedback and information and a forum whereby project initiators can interact and engage with the public. However, there are a number of potential risks: - Reputational risk if there is a failure to achieve the target finance levels, or if target finance levels are achieved but the project is unsuccessful. - There is the risk of idea theft and the possibility that intellectual property may be copied if it is publicly announced. - There is the risk that funds will run out if the same investors are targeted repeatedly to fund new business ideas. - There is also the risk that potential investors will not invest as they are wary of scams or the possibility of abuse of funds. In the UK, the Financial Conduct Authority ( FCA ), which is covered in Module 23, is concerned by the number of new firms that fail and it has introduced legislation that requires crowdfunding firms to advertise responsibly and highlight risks. There are now also rules on who can invest money in 24 TPS Advanced Finance Module 11
crowdfunding in order to offer some protection and ensure that investors are aware of the risks involved. Notes Example 4 In November 2014, a British consortium started a crowdfunding campaign on Kickstarter with the aim of landing a robotic probe on the South Pole of the Moon in the next ten years. By analysing material from the moon, the team hopes to shed light on the origins of the Moon and Earth. The team hopes to raise 600,000 with the help of the general public to fund the initial phase of the project with an overall aim of 500m. In return for public donations, the organisers pledge to bury a digital memory box for all funders on the moon during the mission. For a donation of around 200, funders also have the option of sending up a strand of hair into space. You should now be able to achieve the sixth learning objective. 11.15 ISLAMIC FINANCE Islamic finance is becoming more and more prevalent, not only in the UAE and the Middle East, but also in the West. Is it now estimated to be worth over $1 trillion with projected growth of 10% to 15% per annum. Islamic finance is governed by basic principles which have been for the last 1,500 years across the modern Muslim. The basic premise is that money has no value itself and there should be no charge for its use, rather, Islamic finance is asset based. Therefore an investment is structured on exchange or ownership of assets, money is simply the payment mechanism to affect the transaction. Modern Islamic finance originated in the 1960 s when the Islamic Development Bank was formed to promote acceptable financial practices according to Islam. While many banks originating in the Middle East strictly follow these principles many also follow Western practices of finance with a number following both practices to cater for both markets. Many of the larger banks (e.g., HSBC, UBS and Citigroup) have Islamic banking arms. The main principles of Islamic Finance include: taking or receiving interest at exorbitant rates (Riba) is not allowed, but this does not preclude a rate of return on investment; risk in any transaction must be shared so that the provider of capital and the entrepreneur share the business risk in return for a share in profit; and speculative behaviour (Gharar) is not allowed, meaning that gambling (Maysir) and extreme uncertainty or risk is prohibited. This also restricts traditional derivatives. TPS Advanced Finance Module 11 25
Notes With these principles dictated by Islamic Finance, the way in which transactions are undertaken differs to those based on Western philosophies. The main instruments are: Shariah Compliant Current and Saving Accounts In the absence of interest, there needs to be some incentive to save and this is done through a profit sharing exercise whereby at the end of the year, banks allocate profit to the account holders, which may be equivalent to, but not the same as, a conventional savings rate. Also, since an overdraft facility would amount to charging interest, banks may offer interest free loans (Quard-Hassan) to customers on specific request. Murabaha (Cost-plus sale) Murabaha is essentially undertaking a trade with a markup and is used for short-term financing, similar in form to purchase finance. For example, a bank would purchase a tangible asset from a supplier. The asset s resale price would be based on the cost plus an agreed mark-up. This is often used to finance property, as the bank would not be allowed to charge interest on a loan. Once covenants are in place between a bank and the customer, payments can beginand would continue until a completion point where the asset is transferred to the customer. What exactly is the difference between Islamic Finance and Western thought Finance? The payments might be the same under Islamic processes as for the standard western practice. The difference is that the rate of return is based on the asset transaction and not based on interest on money loaned. The difference is in the approach and not necessarily on the financial impact. The intention is to avoid injustice and unfair enrichment at the expense of another party. Recent examples of Islamic Finance are the funding of the Dubai Ports World takeover of P&O. Emirates Airline regularly uses Islamic Finance to finance its fleet s expansion. Also, high street banks such as HSBC and Lloyds are offering Islamic mortgages in the UK. There are a growing number of non-muslims taking up Islamic Finance. In the Middle East, this may be due to the fact that there may not be a viable cost effective alternative to following the traditional approach. But in other parts of the world, the increase may be due to diversification, availability and pricing. You should now be able to achieve the final learning objective. 26 TPS Advanced Finance Module 11
11.16 SUMMARY AND REVIEW Notes This module reviewed the issues surrounding the raising of finance for a business. It considered the need to understand the stage of development of the business and the use the funds could be put to. Alternative sources of funds were considered as well as the principle considerations of borrowers. A contrast was made between debt and equity funding. Key elements of this module are: Basic principles in a finance decision: - Need some information on which to base a finance decision, including cash flow forecasts; - Consider the matching concept; - Higher the risk, the higher the return the lender requires; - What security can be offered?; - The need to prepare a business plan; - Liquidity having the assurance that funds will be available; - Flexibility ability to tailor funding to business needs; - Diversification having a wide variety of sources of finance; and - Cost will primarily reflect the lender s assessment of risk of the borrower. Sources of Finance - Appropriate sources of finance will depend on: The type of business; The stage in the business life cycle; and The size of the business be aware of the specific issues affecting small businesses. - Different types: Equity; Preference shares; Debt; and Quasi-equity (convertibles and warrants). Equity - Shareholders own the company; - Control the company through voting rights; - Return is in the form of dividends (which may not be paid) and capital growth; - Dividend is not tax deductible; - Last to be paid on liquidation of company; and - Take on highest risk in the company, therefore expect highest return (most expensive source of finance for the company). TPS Advanced Finance Module 11 27
Notes Preference shares. - Do not own the company; - Usually no voting rights; - Preferential rights over ordinary shareholders in event of liquidation; - Fixed annual dividend (paid before ordinary shareholders; not paid if insufficient profits); - Dividend is not tax deductible; and - Different types include participating, cumulative, convertible, redeemable. Debt - Do not own the company; - No voting rights; - Can control the company by taking a security over assets and through use of covenants (refer Module 18); - Fixed interest (paid before preference and ordinary shareholders) which must be paid; - Interest is tax deductible; - May be senior or subordinated; - Paid before shareholders in event of liquidation; and - Cheaper source of finance compared with equity due to lower risk of debt Quasi-equity - Exhibit features of both debt and equity: Convertibles: Debt is converted into equity, so that debt disappears and is replaced with equity; Conversion is at a fixed price, the conversion price, which will be at a premium to current share price; If converted, company does not need to fund redemption of debt; No new finance is raised on conversion; and Lower interest rate offered on debt portion due to potential of converting. Bonds with equity warrants: Bond is issued as a package with equity warrants; Equity warrants give the right to buy shares at a fixed price (the exercise price); The exercise price is usually at a premium to the current share price; Bonds and warrants are detachable and can be traded separately New money is raised if warrants are exercised; and The debt (bond) remains (i.e., is unaffected if warrants are exercised). This module also considered the five stages of the business life cycle and how to fund through it. 28 TPS Advanced Finance Module 11
This module also considered the issues facing smaller businesses (including unincorporated businesses) and possible sources of finance available to them. Notes Finally, this module introduced and explained crowdfuning and Islamic Finance. Having read this module, you should be able to meet all of the learning objectives. Re-read the appropriate section(s) of the notes until you can. TPS Advanced Finance Module 11 29
Notes Appendix 1 Summary of Financing Options This list should not be considered exhaustive. Type Shareholder Funding Equity Ordinary Shares Preferred /Deferred Ordinary Shares Share Warrants Principal Module(s) 11 and 12 Preference Shares Long Term Debt Medium Term Debt Short Term Debt International Funding Retained Earnings Bank loan Debenture (bond) Unsecured loan stock Convertible unsecured loan stock Syndicated loan Eurobonds Bank Loan Medium Term Notes (MTN) Mezzanine Finance Leasing Hire Purchase Trade credit Overdraft Factoring Commercial paper Bill of exchange Acceptance credit (bank bill) Export Finance Countertrade Forfaiting 11, 16, 17 11, 15, 16, 17 5, 6, 7, 16, 7 30 TPS Advanced Finance Module 11
Appendix 2 Notes Summary of Financing Options (2) Features of firm Short Term Sources Medium Term Sources Small Firm Medium Firm Large Firm -shorter term loans -have more -in some cases these available negotiating power are larger and better -banks will favour than small co s, and credit risks than the floating rate may be able to obtain banks they borrow -required security better terms from (fixed/floating) -also have more -are large enough to -may require personal potential sources of make effective use of guarantees finance available overseas finances -may require key person insurance. -overdraft facility -As for small, plus the -As for medium, plus -bankers acceptance following: the following: facility -committed facility -commercial paper -debt factoring (fixed term) (unsecured, mostly < -take periods of credit 1 year, bearer, issued -retained earnings at discount) -bank loan As for small -medium term notes -leasing/hire purchase -(commercial paper -government assistant for up to 5 years) (grants) -loan guarantee scheme -venture capital -mezzanine finance Long -mortgage -debentures fixed/ -Eurobonds term -long term loan floating -syndicated loans sources -sale and leaseback -deep discount bonds -leasing -equity -possibly equity -preference shares -government assistance -convertibles (grants) -warrants as a sweetener This list should not be considered exhaustive. Note that some of the items listed above will be covered in more detail in other modules of the Advanced Finance course. TPS Advanced Finance Module 11 31
Notes 32 TPS Advanced Finance Module 11
Workshop Exercise 1 A recent study by a venture capitalist has shown that many small businesses are: 1. under-capitalised; (2 marks) 2. burdened with the wrong mix of short and long term debt; (5 marks) 3. ignorant of sources of finance open to them; (2 marks) 4. ignorant of the real need for adequate cash planning and financial control; and (3 marks) 5. over-trading (3 marks) Required Consider the risks the business may face as a consequence of each of the above issues. Recommend how such risks should be minimised. Total (15 marks) TPS Advanced Finance Module 11 1
Workshop Exercise 2 A client has asked your practice manager for advice on their need for extra long-term funds since they are always near their overdraft limit of 20,000. The founder of the business not only acts as the designer of the company s only product but as the Finance Director as well. He has no idea why they are always fire-fighting in relation to funds. Your manager has asked you to meet the client and find out as much relevant information as possible to enable the manager to begin to provide a solution to the funding problems. Required Prepare a list of questions and issues you would like clarified during your meeting with the client in order to prepare your manager to provide advice on financing for the company. (8 marks) 2 TPS Advanced Finance Module 11
Workshop Exercise 3 Danube Ltd has been overtrading. Required: 1. Consider overtrading and how it is identified in a business. (3 marks) 2. Analyse the accounting information provided in Appendix 1 that evidences the causes and results of over-trading. 3. Advise the directors of Danube Ltd how they might remedy the situation of overtrading. (11 marks) (3 marks) Total (17 marks) Note: Ignore VAT TPS Advanced Finance Module 11 3
Appendix 1 Extracts from management accounts Statement of financial position as at 31 December 20X4 20X5 000 000 Non-current assets 410 500 Current assets Inventories 170 210 Trade receivables 180 285 Cash and cash equivalent 5-355 495 Total assets 765 995 Equity and liabilities Equity attributable to equity holders Share capital 200 200 Retained earnings 225 265 Total equity 425 465 Non-current liabilities Bank loan 100 100 Current liabilities Trade and other payables 170 305 Bank overdrafts and loan 70 125 240 430 Total liabilities 340 530 Total equity and liabilities 765 995 Statement of profit or loss for the years ended 31 December 20X4 20X5 000 000 Revenue 900 1,450 Cost of sales (795) (1,320) Gross profit 105 130 Administrative expenses (45) (50) Profit before tax 60 80 Tax expense (13) (17) Profit for the period 47 63 Note: Dividend payments were as follows 20 23 4 TPS Advanced Finance Module 11
Workshop Exercise 4 (Note this WSE incorporates some elements of Module 12) Assume you are a newly recruited junior consultant with Q, Y and R, a large international firm of accountants and financial consultants. A number of its clients are currently examining the methods available for financing or re-financing their businesses. You have been asked to review two of Q, Y and R s clients. Only brief details are available at present. These are given below. Client number 1: ABC Ltd ABC Ltd is a software house in the south of England. The company was established four years ago by five telecommunications specialists who had been made redundant. The initial investment was 250,000 in equity and a bank loan of 250,000 repayable over 10 years at fixed rate of interest of 12%. The original five shareholders are still the only shareholders. The company was formed to develop and market a range of specialist software for the telecommunications industry. At present, the company s main customers are in the UK and parts of western Europe. Extracts from the company s management accounts for last year and forecast for the current year are as follows. Statement of profit or loss for years 20X8 20X9 Actual Forecast 000 000 Revenue 2,350 3,250 Profit after tax 485 763 Note: Dividends were 440,000 in 20X8 and 563,000 in 20X9 TPS Advanced Finance Module 11 5
Statement of financial position (extracts) at end of year 20X8 20X9 Actual Forecast 000 000 Non-current assets 250 350 Current assets 1,093 1,472 Total assets 1,343 1,822 Equity and liabilities Share capital 250 250 Retained earnings 165 365 Non-current liabilities 150 125 Current liabilities 778 1,082 Total equity and liabilities 1,343 1,822 Note: 1. The non-current assets are primarily motor vehicles, furniture and fittings and computers. The company s premises are rented. The net book value is after charging depreciation of 100,000 and 150,000 in 20X8 and 20X9 respectively. 2. The tax charge for 20X8 was 220,000 and the forecast for 20X9 is 375,000. 3. Inflation, as it affects this company s business, has been negligible over the three-year period. ABC Ltd is now considering expanding its product range and moving into new international markets. These markets are highly competitive but expected to be very profitable in the long term. The company estimates it will need 2 million to establish local operations and support facilities in three main centres outside western Europe. If financing can be obtained and the expansion proceeds, turnover and profits could treble by 20X12. The shares of listed companies trading in ABC Ltd s industry are currently capitalised at PE ratios between 16 and 20. Client number 2: DEF plc DEF plc is a clothes retailing company which has been established for over 50 years. It has shops mainly in small towns in the UK, selling to low-income families. The company has been listed on the Stock Exchange for over 30 years. Summary financial statistics for 20X8 and forecast for 20X9 extracted from their management accounts are as follows. 6 TPS Advanced Finance Module 11
Statement of profit or loss for years 20X8 20X9 Actual Forecast 000 000 Revenue 1,250 1,450 Profit after tax 113 118 Note: Dividends were 60,000 in 20X8 and 72,000 in 20X9 Statement of financial position (extracts) at end of year 20X8 20X9 Actual Forecast m m Non-current assets 925 915 Current assets 153 229 Total assets 1,078 1,144 Equity and liabilities Share capital 100 100 Retained earnings 573 619 Non-current liabilities 210 210 Current liabilities 195 215 Total equities and liabilities 1,078 1,144 Share price (pence, average) 314 n/a The company has recently launched a profit improvement programme, a number of cost-cutting measures have been implemented and the product range has been revised; a number of older products have been discontinued and new ones introduced. Overall, the company is moving into a higher priced section of the market and believes it can now open new shops in towns where it has no presence and where it will come into direct competition with the major retailing stores. It estimates it will require 250 million to undertake this expansion. The current share price is 245 pence and the ordinary shares have a nominal value of 25 pence each. Debt of similar risk and maturity to that in DEF plc s statement of financial position is currently trading in the market at 125 per 100 nominal. TPS Advanced Finance Module 11 7
The methods of finance being considered by the two companies include, but are not limited to, the following: Mortgage debt; Convertible debt; and Debt with warrants. Required 1. Evaluate, very briefly, the methods of finance listed above. (6 marks) 2. Prepare, for discussion with the senior consultant, a set of briefing notes for each of your clients. These should contain reasoned arguments for an appropriate method, or methods, of financing taking into account the circumstances of each company. Make whatever assumptions you think necessary but state them clearly in your notes but note that detailed calculations are not required. (22 marks) Total (28 marks) 8 TPS Advanced Finance Module 11
Workshop Exercise 5 Question 1 What sources of finance will be most appropriate for a business in the take-off stage of the business lifecycle? Question 2 Give three forms of debt funding available to small businesses other than bank loans and overdrafts. Question 3 Give three aspects of a finance lease that differ from an operating lease. Question 4 Why are preference shares attractive to a business? Question 5 Why are convertible debentures attractive to an investor? Question 6 What are deferred shares? Question 7 What is the enterprise finance guarantee scheme? Question 8 What is subordinated debt, and where it is commonly used? Question 9 What is the main difference between a convertible bond and equity warrants. Question 10 What is meant by overtrading? TPS Advanced Finance Module 11 9
Question 11 What are the three types of crowdfunding? 10 TPS Advanced Finance Module 11
Solution to Workshop Exercise 1 1. Under-capitalised A company that is undercapitalised does not have a sufficient capital base to allow the business to operate effectively and as a result the company may go out of business. (1 mark) To minimise this risk, a company must ensure that a sensible proportion of debt to equity is maintained within the business ensuring that the company can meet interest payments on debts and therefore not be liquidated. (1 mark) 2. Incorrect debt mix A business that has the wrong mix of short and long term debt will be unable to manage its cash efficiently. (1 mark) The objective of short-term debt is to ensure a company s liquidity (its ability to meet its liabilities as and when they fall due). (1 mark) A business with too high a proportion of long term debt will not have the same flexibility in its financial management. (1 mark) A company which has too much short term debt runs the risk of being crippled by interest payments (which are much higher for short term debt than long term debt) if it tries to use that short term debt for a longer period of time. (1 mark) The company should produce regular cash-flow forecasts to enable it to monitor its cash requirements and match the funding of the business to its requirements. (1 mark) 3. Ignorant of sources of finance A company that is ignorant of the sources of funding available to it runs the risk of selecting an source of finance that is not flexible enough, liquid enough or secure enough for its requirements. (1 mark) As a result of failing to select the most appropriate financial product, a company may not achieve best rates of interest. The company management should keep up to date with financial products available through training, the financial press and use of professional advisors. (1 mark) 4. Ignorant of need for cash planning and financial control A company which is ignorant of the need for adequate cash planning and financial control runs the risk of running out of cash and therefore being unable to continue to trade. (1 mark) A company which lacks control over its finances will be unable to ensure that its financial systems provide accurate financial information facilitating management to make appropriate investment/funding decisions. (1 mark) In addition, financial controls provide management with a method of preventing and detecting fraudulent activity. TPS Advanced Finance Module 11 1
In order to become less ignorant in these matters, they should seek training and/or advice from advisers. In particular, the company s auditors should be able to provide a significant amount of advice in relation to the control issues. (1 mark) 5. Overtrading Over-trading occurs when a company grows at a rate at which its demand for funds exceeds its supply of funds. It usually occurs when revenue grows but cash collection lags behind the cash outflow required to make a sale. As a result the company runs out of cash. (1 mark) The company must forecast its short and long-term working capital requirement in order that sufficient cash can be brought into the company to cope with demand. (1 mark) The working capital requirement should be reviewed regularly to ensure that deviations from the forecast can be dealt with as required. The management may wish to tighten credit control or negotiate to extend payment terms with to creditors or shorten stockholding times to improve the working capital of the company. (1 mark) 2 TPS Advanced Finance Module 11
Solution to Workshop Exercise 2 1. Type of business? It is important to know the area of operation in order to understand the future and seasonality of such a market. (1 mark) 2. Stage of development? A different package would be considered for a fast-growing business compared to one facing a maturity plateau. (1 mark) 3. Is it profitable; what are the details? It is possible that the business is suffering from fundamental problems and that new funding would be of no assistance at all. (1 mark) 4. What are the cash movements; peaks and troughs? A look at the past year's cash flows on a monthly basis would outline some of the problems and their severity. (1 mark) 5. What security is available? Discussion needs to cover the potential for raising funds. A business in decline or one that is already at its borrowing capacity will have to consider its future much more aggressively. (1 mark) 6. What is the current level of long-term funding? Who has funded and might fund further equity? Even if debt funding is a possibility, there needs to be evidence that the owners are prepared to invest. (1 mark) 7. Who else is on the management team? The performance of the business and its credibility from a financier's point of view depends on the people who manage the enterprise. (1 mark) 8. Who has been giving financial, taxation and legal advice? It is quite common for businesses to go round in circles seeking the advice that suits them. It is also possible to be entering into the provision of advice when the client is not going to accept it. (1 mark) TPS Advanced Finance Module 11 3
Solution to Workshop Exercise 3 1. When a business is growing but lacks sufficient long-term funding it experiences overtrading (1 mark). Its working capital requirements increase as more funds are invested in work-in-progress, stock and debtors. Cash collection can lag behind the cash outflow. Too much use can be made of the bank overdraft facility that is frequently at the limit. Long-term finance is needed. (1 mark) Overtrading can be identified by various ratios and the increase in sales-related figures such as discounts offered, lower margins and higher bonuses for salespersons. Profits in total may have increased. (1 mark) 2. Evidences and causes: Rapid growth (1 mark) Increases include non-current assets by 22% and revenue by over 60% (1 mark). Revenue is dependent on the availability of assets to underpin the production of goods or services. Both are increasing at a very rapid rate. High proportion of short-term finance (1 mark) the overdraft is up 79%; trade payables are up by more than the revenue increase; trade payables up 79% compared to revenue up by 60% (1 mark). The current and quick ratios have decreased. Current ratio is down from 1.48 to 1.15 and the acid test ratio from 0.77 to 0.66. (1 mark) No new long-term funding. (1 mark) Profits margins are tighter (1 mark) Margins of gross and net profit are down; gross margin is down from 12% to 9% and net margin is down from 7% to 6%. (1 mark) Inventory days; (1 mark) down from 78 to 58 days. Calculation using cost of sales; (170/795) x 365 and (210/1,320) x 365. This reduction may be due to lack of funds and therefore inability to replace inventory timeously. Days trade receivables; little change from 73 days (180/900 x 365) to 72 days (285/1,450 x 365) (1 mark) Days trade payables; calculated using cost of sales; up from 78 days to 84 days. Danube Ltd is already taking longer to pay its debts due to shortage of funds. (1 mark) 3. Advice: Grow more slowly; note that the sales increase is being made possible by reducing profit margins. Which is not sustainable. (1 mark) Access long-term capital. (1 mark) 4 TPS Advanced Finance Module 11
Consider the control of the working capital cycle. Inventory days plus days trade receivables less days trade payables is the working capital cycle. Currently it stands at 58 + 72-84 = 46 days. Previously it was 73 days (78 + 73 78). (1 mark) TPS Advanced Finance Module 11 5
Solution to Workshop Exercise 4 1. a) Mortgage debt takes the form of a loan to the company which is secured on specified assets (normally tangible). In the event of default the lender will be entitled to claim ownership of the assets which have been mortgaged. Interest will be calculated on either a fixed or floating rate basis and payments will be allowable against tax for the borrower. (2 marks) b) Convertible debt takes the form of conventional debt such as a debenture, but has a right to convert into equity attached. This option allows the debt to be exchanged for shares in the company at some time in the future. The conversion rate, that is, the number of shares for which the debt may be exchanged, and the exercise period (dates between which the exchange may take place) are specified at the time of issue. (2 marks) c) Debt with warrants. This is similar to convertible debt in that it is issued with a view to issuing further equity in the future. The debt element is identical in form to other types of conventional debt. However it is issued with warrants attached which give the holder the right to purchase shares in the company at a predetermined future price (the exercise price) and during a specified future period (the exercise period). The exercise price will be pitched at a discount to the projected share price at the exercise date in order to make the warrants attractive. Once the debt has been issued, the warrants are detachable and can be traded separately. (2 marks) 2. a) ABC Ltd: Briefing notes If the forecasts of performance in the new expansion are reliable, then this opportunity appears even more attractive than the existing operations. (1 mark) If this performance is achieved then the payback period will be very short, and ABC should therefore avoid taking on significant amounts of long-term debt. The options available depend to some extent on the long-term objectives and aspirations of the shareholders, but if it is assumed that they wish to maximise the value of their investment and to maintain control, then the possible courses of action include the following: i) To finance the investment as far as possible from retained earnings. (1 mark) The current level of dividends is high and is increasing. It is not known what the shareholders remuneration policy is, nor the extent to which dividend forms a significant part of their total remuneration. However, the temporary restriction of dividends could provide significant internal funds for further investment. (1 mark) ii) It appears that the shareholders have been withdrawing significant amounts of money from the business by way of dividends. This may mean that their personal financial situations will permit them to make significant individual borrowings for investment in the business either as debt or equity. (1 mark) 6 TPS Advanced Finance Module 11
iii) The level of fixed assets is relatively low and the premises are leased and therefore it will not be possible to raise all the funds needed in the form of secured debt. (1 mark) However, further internal funds could be released by minimising the need for capital by leasing or hiring fixed assets, and by factoring debts or discounting invoices. (1 mark) iv) It may be possible to find new investors to take a minority stake in the company. (1 mark) These could be friends, family, employees, customers, suppliers or even potential competitors who might wish to enter the new market through some form of joint venture. v) The company should be able to take on further short to medium term debt, possibly in the form of a bank loan although security may be an issue (as discussed above). (1 mark) vi) The company would be attractive to venture capitalists, and the amount of money required is appropriate for this form of investment. (1 mark) However, there would be some dilution of control, the venture capital company would be likely to demand representation on the board, and they would also expect to see returns continuing in excess of their target rate of return into the future. (1 mark) This would therefore be an expensive and demanding form of finance and would probably lock ABC in for longer than is strictly necessary. b) DEF plc: Briefing notes It appears that the profit improvement programme has not been forecast to have an impact on the 20X9 figures. Unfortunately, no projections have been provided as to the impact on profitability of the expansion programme, nor of the timescale over which the investment is to be made. It is therefore very difficult to provide DEF plc with appropriate financing advice. (1 mark) However, if it can be assumed that the return on the new investment will be similar to that on the existing operations, and that the performance of the existing operations will be unaffected, then some general suggestions can be made. i) If the new investment has a lengthy payback period some form of long-term finance will be needed. (1 mark) DEF s gearing level is currently only 29.2% ( 210m/( 100m + 619m)). (1 mark) It therefore has sufficient capacity to raise a part if not the whole of the required amount through debt. (1 mark) An additional 250m of debt would increase the gearing to 64%. However it would be helpful to have more information on the volatility of DEF s earnings performance in order to make a better assessment of the likely cost of debt and of the level of risk involved. (1 mark) The likely costs of the debt will also depend on the form in which it is raised. (1 mark) Since a large part of the investment is to be made in new shops it should be possible to secure a significant proportion of the finance on property and thus to obtain a better rate of interest than on a less well secured investment. ii) An alternative approach would be to raise the new funds by means of a rights issue. (1 mark) This would be more expensive than the use of debt, partly because there has been a significant drop in the share price over the last few months, and partly because in these circumstances, and given the size of the new issue relative to the current market capitalisation ( 2.45 x 400m = 980m), the issue would need to be TPS Advanced Finance Module 11 7
iii) underwritten. (1 mark) The new shares would need to be priced at a discount to the existing share price in order to make them attractive to investors (say a maximum price of 220p, this being a discount of 10%). (1 mark) Investors would also expect to see some projections of the financial performance of the expanded company. The directors would need to ensure that they had obtained the necessary authority to make such an issue. (1 mark) A combination approach could be used, perhaps in the form of some type of convertible debenture. (1 mark) This can be an attractive way of raising delayed equity at a time when the share price is depressed and equity is relatively expensive. However, such an issue would need careful pricing which would have to be substantiated on the basis of detailed cash flow projections. (1 mark) 8 TPS Advanced Finance Module 11
Solution to Workshop Exercise 5 1. Owners capital Friends and family Venture capital Government grants Bank loans (unless too risky) Retained earnings (if positive cash flow) 2. Soft loans Hire purchase / leasing Factoring / invoice discounting Sale and leaseback 3. Finance Operating Lasts for economic life of asset Rental period less than economic life Risks and rewards passed to lessee Risks and rewards stay within lessor Present value of rentals asset value Present value of rentals < asset value 4. Preference shares do not usually carry voting rights, therefore, there is less influence over management of the company; The dividend is limited, therefore, super-profits stay within the business (unless shares are participating); and The dividends can be more flexible than interest payment as they do not have to be paid if there are insufficient profits in a particular year. 5. Convertible debentures offer a compromise between the safety of bonds and the potential reward of equity. When stock markets are volatile the potential downside risk can worry equity investors. Convertible bonds allow them to safeguard their capital if the company underperforms. Fixed income investors can benefit from an alternative to government bonds at a time of low interest rates when market yields are low. 6. Deferred ordinary shares rank below the other ordinary shares for dividend payments. On this basis they may not be very appealing to investors. 7. The EFG scheme aims to help small businesses with a sound business proposition but with funding problems. The BERR guarantees 75% of a bank loan up to 1.2m for a premium of 2% over the variable loan rate. 8. Subordinated debt is a type of debt where, in a winding-up, lenders only have the right to payment of interest and repayment of principal after the senior debt has been repaid in full. Its significance and usage has increased in recent years, particularly in companies which have been the subject of a leveraged buy-out or which are, for business reasons, heavily geared. Banks also issue subordinated debt. TPS Advanced Finance Module 11 9
9. The essential difference between a convertible and a bond with equity warrants is that to effect conversion (of a convertible), an investor will surrender convertible stock in return for new shares; (thus a company s debt is reduced and its equity increased simultaneously and no new money is raised), whereas an investor in a bond with warrants surrenders the warrant with cash (to purchase shares) separately from the bond. This increases the company s equity and raises new cash whilst its debt remains unchanged. 10. Overtrading occurs when a business expands faster than its finances allow. The time delay inherent in the working capital cycle results in an increasing cash drain. The solution to this problem is a mixture of improved working capital control, reduced growth and an injection of long term finance. 11. Donation crowdfunding this is where people invest because they believe in the cause. Rewards can be offered (also referred to as reward crowdfunding) such as acknowledgements on an album cover, tickets to an event and free gifts. This has been used for motion picture promotion, scientific research and software development in the past. Debt crowdfunding in this form, investors receive their money back with interest. Returns are financial, but investors also have the benefit of having contributed to the success of an idea they believe in. Borrowers must therefore demonstrate creditworthiness and the capability to repay the debt, therefore this form of finance is less suitable for start-ups. Equity crowdfunding in this type, money is exchanged for shares. If the venture is successful the value of the shares increases. 10 TPS Advanced Finance Module 11