Unit 2

Understanding Accounts

Liquidity, financing and market

A summarised balance sheet

A typical UK balance sheet

Fixed assets 1,000 Share capital500

Debtors (receivables) 500 Retained profits

Stocks (inventories) 300 (earnings) 325

Cash 25

Other current assets 100

Creditors (payables)<12m (350)

Borrowings (750)

Net assets 825 825

Current ratio

This is defined as current assets/current liabilities

From our balance sheet this would be :

Debtors + stocks + cash + others / creditors = (500 + 300 + 25 + 100) / 350

= 2.6

Current ratio

This is defined as current assets/current liabilities

From our balance sheet this would be :

Debtors + stocks + cash + others / creditors = (500 + 300 + 25 + 100) / 350

= 2.6

Current assets (by definition) are those assets we are trying to liquidate

Current liabilities are those liabilities due within 12 months

So we, normally, need the current ratio to be greater than 1 (there are exceptions – businesses with very strong cash flow sometimes have CR < 1, supermarkets)

Current ratio

This is defined as current assets/current liabilities

From our balance sheet this would be :

Debtors + stocks + cash + others / creditors = (500 + 300 + 25 + 100) / 350

= 2.6

Current assets (by definition) are those assets we are trying to liquidate

Current liabilities are those liabilities due within 12 months

So we, normally, need the current ratio to be greater than 1 (there are exceptions – businesses with very strong cash flow sometimes have CR < 1, supermarkets)

Note that this is not a percentage

Problem with current ratio?

Current assets are those assets that are intended to be liquidated.

But what if the assets will not be liquidated for some time – for example stocks (inventories). In some industries these are show as “current” even though it may be a long time before they are liquidated

Problem with current ratio?

Current assets are those assets that are intended to be liquidated.

But what if the assets will not be liquidated for some time – for example stocks (inventories). In some industries these are show as “current” even though it may be a long time before they are liquidated

For example, house builders. They buy land on which to build houses. As they intend to “liquidate” the land (and house) as soon as possible it counts as stock in current assets. But the project may take a few years to get planning permission, a few years to build and then a year or two to sell. The land and subsequent construction will be shown as a “current” asset for all of that time.

Problem with current ratio?

Current assets are those assets that are intended to be liquidated.

But what if the assets will not be liquidated for some time – for example stocks (inventories). In some industries these are show as “current” even though it may be a long time before they are liquidated

For example, house builders. They buy land on which to build houses. As they intend to “liquidate” the land (and house) as soon as possible it counts as stock in current assets. But the project may take a few years to get planning permission, a few years to build and then a year or two to sell. The land and subsequent construction will be shown as a “current” asset for all of that time.

So for some businesses we would ignore stocks (as they are not imminent sources of funds)

This is called the “quick ratio” = (current assets – stocks) / current liabilities

= 1.8 in our example [(500 + 300 + 25 + 100-300 ) / 350 = 1.8]

Interest Cover

Summary p&l account

Revenue 10,000

Operating profit 4,500 (= profit before interest and tax = pbit)

Interest (500)

Profit before tax 4,500

Interest cover is operating profit (or PBIT)/ interest

Interest Cover

Summary p& account

Revenue 10,000

Operating profit 4,500 (= profit before interest and tax = pbit)

Interest (500)

Profit before tax 4,000

Interest cover is operating profit (or PBIT)/ interest

In the above example this is 4500/500 = 9

In other words the company has 9 times the profits available to “cover” (pay) its interest

A summarised balance sheet

Fixed assets 1,000 Share capital 500

Debtors (receivables) 500 Retained profits

Stocks (inventories) 300 (earnings) 325

Cash 25

Other assets 100

Creditors (payables) (350) Borrowings 750

Capital employed 1,5751,575

Equity

Debt

Financing

Businesses need financing

This is usually achieved through a combination of shareholder funding (“equity”) and borrowings (“debt”)

Why have debt?

Financing

Businesses need financing

This is usually achieved through a combination of shareholder funding (“equity”) and borrowings (“debt”)

Why have debt?

Cheaper – why?

(because shareholders are at the back of the queue, so in the riskiest position, hence they need the highest return on their investment)

More flexible

Easier to arrange

If debt is cheaper should we not have lots of it? (see also unit 4)

Let me illustrate this with an example

KevCo has borrowed £5m from OUBank, with a negative pledge. The shareholders have also put in £5m.

The loan costs 7% and the shareholders want 9%.

If debt is cheaper should we not have lots of it? (see also unit 4)

Let me illustrate this with an example

KevCo has borrowed £5m from OUBank, with a negative pledge. The shareholders have also put in £5m.

The loan costs 7% and the shareholders want 9%.

2 years later KevCo needs to borrow another £5m. OUBank will not lend, but SasBank will do so. How do we get OUBank to waive the negative pledge?

If debt is cheaper should we not have lots of it? (see also unit 4)

Let me illustrate this with an example

KevCo has borrowed £5m from OUBank, with a negative pledge. The shareholders have also put in £5m.

The loan costs 7% and the shareholders want 9%.

2 years later KevCo needs to borrow another £5m. OUBank will not lend, but SasBank will do so. How do we get OUBank to waive the negative pledge?

We give OUBank priority over interest payments and repayments (“senior debt”).

So SasBank is “subordinated” debt.

Subordinated debt

So given this scenario how much will SasBank charge?

As they are in a riskier position to OUBank they will want a little more

– say 7 ¼ %

What are the shareholders thinking?

Subordinated debt

So given this scenario how much will HenBank charge?

As they are in a riskier position to OUBank they will want a little more

– say 7 ¼ %

What are the shareholders thinking?

They are still at the back of the queue

BUT the queue just got longer – so their risk just increased – so they will require a higher return – say 9 ¼ %

Average cost of capital

So as the debt increases (which is cheaper than equity), so the average cost does not drop, due to the increased risk.

It stays the same

This is called Modigliani & Millers Theorem No 1.

Average cost of capital

So as the debt increases (which is cheaper than equity), so the average cost does not drop, due to the increased risk.

It stays the same

This is called Modigliani & Millers Theorem No 1.

But this analysis ignores a key difference between debt and equity

Interest on debt is tax deductible. In other words (in the UK) for every £1 of interest a company pays it gets 28p back from the government.

Average cost of capital

So as the debt increases (which is cheaper than equity), so the average cost does not drop, due to the increased risk.

It stays the same

This is called Modigliani & Millers Theorem No 1.

But this analysis ignores a key difference between debt and equity

Interest on debt is tax deductible. In other words (in the UK) for every £1 of interest a company pays it gets 28p back from the government.

Equity returns (dividends) are not tax deductible

This asymmetry means that debt does reduce the average cost (the effect is called the “tax shield”) until debt rises to a degree where the cost of risk outweighs the tax benefit. (M&M No 2)

Debt & Equity

So debt has some attractions if kept to a reasonable level.

Therefore we need a measure of levels of debt

This is called “gearing” or “leverage”

Debt & Equity

So debt has some attractions if kept to a reasonable level.

Therefore we need a measure of levels of debt

This is called “gearing” or “leverage”

Unfortunately these terms are used interchangeably

Also there are a number of different definitions

So for this course pick a term and a definition

Gearing (or leverage)

From now on I shall refer to this measure as “gearing”

The two most common definitions of gearing are:

Debt/equity x 100

And Debt / (Debt + Equity) x 100

Gearing

In our example:

Equity = share capital + retained profits = 500 + 325 = 825

Debt = 750 (you would include both short and long term)

So gearing = (750 x 100)/825 = 90.9%

Or (750 x 100)/(750 + 825) = 47.6%

What is the “right” level of gearing?

It depends!

Some industries traditionally have very high gearing

Others have low gearing

You need to benchmark in the sector to assess a reasonable level.

Think of an example of a highly and lowly geared industry.

What is the “right” level of gearing?

Poor security. Also why would a consultancy need high debt?

Highly geared: property investment

Security is relatively liquid and can appreciate in value

Lowly geared: consultancy

Earnings per share

This is defined as the “earnings” ( normally = profit after tax)

Divided by the average number of shares in issue

EPS = profit after tax/number of shares

This is the amount of distributable profit (available for dividend) made per share

Price earnings ratio (p/e or PER)

This is defined as :

Market Price per share/ earnings per share

Price earnings ratio (p/e or PER)

This is defined as :

Market Price per share/ earnings per share

[nb if you multiply top and bottom by “number of shares” you get:

Price per share x no of shares/ EPS x no shares

=market capitalisation / total earnings (PAT)]

What does it mean?

P/e ratio

A B

Share price £10 £5

EPS £1 £1

p/e 10 5

What does a share price represent? In unit 6 we will conclude that it is the value today of the future dividends expected to be paid by a business

P/e ratio

A B

Share price £10 £5

EPS £1 £1

p/e 10 5

What does a share price represent? In unit 6 we will conclude that it is the value today of the future dividends expected to be paid by a business

So the market is willing to pay 10x this year’s profit for A and 5x for B’s. The market must believe that A will deliver more dividends in the future that B , but they are starting at the same point (£1). So A’s earnings/profits must GROW faster than B’s. P/e is an indicator of the market’s expectation of earnings growth

Price to book ratio

Price to book ratio = market price per share

shareholders’ equity per share

For example the shareholder’s equity for our balance sheet was £825. Let us assume that there are 330 shares in issue, trading at £7.50.

What is the price book ratio?

Price to book ratio

Price to book ratio = market price per share

shareholders’ equity per share

For example the shareholder’s equity for our balance sheet was £825. Let us assume that there are 330 shares in issue, trading at £7.50.

What is the price book ratio?

Equity per share = £825/330 = £2.50. Price/book = £7.50/2.50 = 3.

What does this mean? Note – not a percentage.

Price to book ratio

Differences between book value and market value include?

Price to book ratio

Differences between book value and market value include?

Intangibles not in the accounts (eg goodwill)

Fixed assets not shown at market value – especially property

Investments not shown at market value

Value of debt

Next TimeWe shall look at derived cash flow