Publisher: The Open University, 2000, 123 pages
Different people need annual reports: investors, lenders, managers, contributors, managers and employees. Their form vary from country to country with the two main categories being the Angle-American (giving a 'fair' view) and the Franco-German model (precedence of creditors' interests; profits entered when realized, losses/expenses immediately). Concerns about the accuracy of accounting statements have among others pushed new legislature like the Sarbanes-Oxley Act (passed July 2002), requiring CEOs and CFOs in the US to certify financial statements. It also addresses:
Contents of the annual report
Analysts put things into special spread sheets like the OUFS to look at several years of data in a standard way. Before you start, clarify your objective to analyse the right data, profit before tax if you lend money for example.
When you use ratios, consider the economy at the time and the industrial environment. There are four phases for ratios:
Three questions need to be asked:
Consolidated group accounts
100% of shares: subsidiary wholly-owned
20-50%: related or associated company
<20%: trade investment
For subsidiaries: In general you build totals for the profit and loss and balance sheet, eliminating inter group transactions first. Take a good look at the goodwill in relation to the subsidiary. Goodwill is the premium the hodling company paid for the shares it owns over the book assets it acquired. If you paid $2000m to control 80% of a company with net assets of $1000m, you established a goodwill of $1200. This goodwill should be written off over its useful live. There is an example of a consolidated balance sheet on page 22ff.
With associated companies you consolidate net value of assets and portion of profits. Liabilities are not reflected in the balance sheet (example Enron). Trade investments are shown at cost price with only dividends shown as income in the PLS.
Analysis in Context
You need something to structure the segment of the market you are looking at. SWOT, STEEP and Porter's five forces are models to use here. You have three important numbers here:
How you define the market will be critical to the evaluation, as always with STEEP, Porter's five forces of SWOT.
Here the ratios come in. You are looking at the cycle of production, from Cash to (supply) raw materials, (production) work in progress, (demand) finished goods, (collection) trade receivables and back to cash.
(Remember, assets included in the balance sheet might not be those that are used in the income statement)
Very useful if you look at different components of inventory seperately
This is about the payment terms that suppliers are granting.
The small the more efficiently the raw materials are progressed.
Remember: Sales are in relation to current market values but assets might be included at a lower value as they are written off.
Remember: if fully written off the balance sheet does not show it, but it might still be used in the production cycle
Demand and collection phase
If this rises, some sales that were expected might not have materialised or there is an upcoming promotion or ad campaign for which the company stocks up.
Net operating assets
Part of the funding comes from the cycle of production and via supplier's credit terms, which is very attractive. Minimum inventory holds down costs, then collect money quickly and pay suppliers late.
also have a cycle of production in relation to Collection of cash, supply of raw materials and (demand) trade receivables. This means that these ratios are important here too. You might also want to look at things like occupancy rates for hotels for example.
The main point here are liquidity (short-term) and solvency (long-term) ratios.
Management needs to make sure that there are good sources of finance, taking into account maturity, flexibility and stability while minimising costs. They need to keep a balance between dept and equity, where dept has certain clear rules to it like repayment times, first payment in case of liquidation,… and equity offers a higher return or rather has to due to the great risk it carriers for the providers of this finance.
Equity is therefore more expensive but it allows for more flexibility. Managers should match economic lives of assets with maturity of financing.
This can be smaller than 1 in case the company is a going concern, meaning it can finance the liabilities through trading revenues.
Uncertainty with the inventory is addressed here. It might not be worth anything and the liabilities must still be paid for.
again, looking at liquidity here. If the company is very trustworthy this can be a high minus though.
The riskier the business, the greater the dependence on equity rather than dept. Shareholders can be thought as as an equity cushion. They provide money that will not have to paid back in liquidation. The liquidation process of assets must only stay above the book value of the assets minus the invested amount for all senior creditors to be paid. A company is worth $100m in total with $30m in equity. In liquidation the assets need to bring $70m not 100 for all senior creditors to be paid.
the more uncertainty about cash generated, the lowe this number should be, meaning the mor the company should rely on equity.
This is done as marketable securities and cash are not really important in the cycle of production and can repay dept at once
This presents a broader view beyond dept
you might also want to include contigent liabilities here, that just might occur in the future.
Capital employed = short-term dept + long-term dept + long-term liabilities + long-term provisions + shareholders' equity
When looking at dept you might also look at the average dept over several years to see if there is some seasonal pattern in interest expenses (Interest expense / average dept).
Here we look at the income statment and profitability ratios. The income statments looks at the activities of a company on an accrual basis, meaing that revenues and expenses might appear in the income statement before the cash is collected.
In the Anglo-American the fair view is employed and the Franco-German model takes a very prudent view, including revenues only when they are realised and expenses as soon as anticipated. In the long run, the result in the same, but the short term my vary.
We can also look at:
We also have some other relations
Very low tax rate should make you wonder how they come about. In the Anglo-American model the published account are different from the tax accounts.
Tells us what of sales is left over to give to shareholders. For dividends, we look at:
One should also be aware of core (resulting in NOP) and non-core earnings.
You can also look at the prospective ratio by taking expected earnings per share into account instead.
Book value shows the historic cost or current market value of assets.
You can also take a look at other indicators sometimes called output-related performance indicators (ORPIs) but these are complex to define in a meaningful way, can deliver very high information on a companies performance though.
Inappropriate ORPIs can lead to (Peter Smith, 1993)
This part covers core ratios, of which two kinds exist.
Return on Capital Employes = Asset utilisation x Return on sales
Net operating profit / Capital employed = Sales / capital employe x Net operating profit / Sales
This does not consider the financial performance of the company, and for this we need to look at the
Return on equity = Operating efficiency x Financial structure x Profitability
Return on equity = Asset turnover x Asset leverage x Return on sales
NPAT / Equity = Sales / Total assets x Total assets / Equity x NPAT / Sales
Having looked at these, you can continue by looking into more detail, but these give a good overview. To interpret the core ratios, you need to keep the sector and the economy in mind.
The level of asset turnover is related to the amount of technology used in the sector. The asset leverage should be inversely related to the volatility of cash flows, as said before. Profitability needs to be looked at with the help of Porter's five forces model.
For a company to survive, the cash flow from operations needs to be enough to cover all financial needs in the medium/long term. The cash flow statement shows the uses and sources of cash during a financial period. If it is not published, it can be calculated from the other statements.
The calculation of a cash flow statment serves three purposes:
There are several fields needed in a cash flow statement. These are calculated as follows.
To start with, we can look at the operating profit, which already has depreciation deducted though, which is a non-cash charge. Therefor we do:
Net operating profit + Depreciation = EBITDA (Earnings before interest, taxes, depreciation and amortisation). If there are other non-cash charges, you need to add them back in too. The good thing with EBITDA is, that it kind of looks at the core business, factoring out the other stuff, which are more political items than business ones.
If trade receivables from the beginning of the period to the end have shrunk, this is an additional source of cash as the company must have collected some of the previous year's receivables and all of this years. Similarly an increase in an operating liability presents a source of cash. In short:
Adjusting EBITDA with these working capital items, gives the Operating Cash Flow (OCF). This is the cash generated by the operating activities of a company before any financing and long-term investment decisions.
The next item is tax payment, which is often done a lot later than the fiscal year tax payment that is included in the income statement. We start by calculating the corporation tax payable at the start plus during the reporting period, substracting the amount payable at the end of the period. This is the corporation tax paid during the period. You then do the same with the deferred tax payable and prepayments.
The next item is relating to dept, and normally interest and lease expenses can be taken from the income statement. In the previous year balance sheet you can normally find a "current portion of long-term dept", which is the amount that the company would have needed to repay this year.
This brings us to the discretionary cash flow, which is the cash flow available after current operations and metting obligatory payments. The come some things the company can do.
First up on the list are dividends, where you again use those payable at the start of the period, plus declared during the period and still payable at the end.
With the rest of the money the company can choose to do many things. Buy property, plant or aqeuipment for example. To find out what they spent here, you take: PPE at the start of the period + depreciation - PPE at the end of the period + revaluation + foreign exchange gain or losses on PPE + capitalised interest + book value of items sold or bought = expenditure on PPE.
Cash proceeds must be added to the cash flow. Next up are investments. Here you look for any changes, excluding changes in valuation or exchange rates. Also take into account any provisions or other out of the ordinary items that might become due soon (or later) to not be surprised later.
Then you look at how the company financed it's cash shortfalls, with equity, long-term or short-term dept.
When forecasting you should take into account three different cash flows:
If there isn't enough information available, you take Operating Profit and substract taxation to get NOPAT, which is also used a lot in replacement of free operating cash flow.
Cash Flow Ratios
These are used to look at the ratios between cash inflows and obligations. (NOPAT / interest paid) shows how well the interest payment was covered. You can then also add in other stuff lke current portion of long-term dept and leases (CPLTD&L) and/or dividends. It really depends on what you want to calculate.
MBA material, what do you expect?