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CHAPTER 8 A framework for interpretation. Contents. Introduction – Background for interpretation Financial structure Sources of finance Dividend policy Working capital management Performance measurement. Interpretative framework.

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  • Introduction – Background for interpretation
  • Financial structure
  • Sources of finance
  • Dividend policy
  • Working capital management
  • Performance measurement
interpretative framework
Interpretative framework
  • What are the ground rules against which to judge company behaviour?
  • Two central lines of enquiry:
    • Evaluation of financial structure and financial policy
    • Evaluation of company performance
  • Risk/return relationship as fundamental economic rationale
risk return relationship
Risk/return relationship
  • Expected return =

(1) Compensate inflation

+ (2) Return of risk-free investment

+ (3) Compensate existing risk

  • Financial statements provide information on past returns and financial risk as partial inputs for forecasting future risk/return opportunities
financial structure
Financial structure
  • Relative amount of debt financing (financial loans)
  • Liquidity of assets
  • Dividend policy
  • Composition and management of working capital
sources of finance
Sources of finance
  • Share issue
  • Loans
  • Bonds
  • Leasing
  • Other methods
  • Gearing refers to the proportion of debt to equity
  • In general: Gearing has a positive effect on
    • Financial risk
    • Return (through leverage-effect)
  • Impact of company characteristics:
    • Family-owned companies and private companies
    • Size of company (SME’s)
  • Interest on debt is tax deductible
figure 8 3 gearing



Non-current assets

(fixed assets)


(long-term financing

from owners)


Current assets (inventory, trade receivables, cash)


(long-term financing from lenders)

Current liabilities

(trade payables)

Figure 8.3 Gearing
share issue
Share issue
  • Existing shareholders subscribing to new shares
    • Rights issue
    • Discount relative to market price
    • Prospectus
  • Underwriting of a share issue
  • Issuing shares on different capital markets (multiple listings)
  • Long-term loans from commercial banks and merchant banks
  • Syndicated loans provided by a group of financial institutions
  • Floating rate loans
    • Interest rate in accordance with a market rate indicator
    • x% over minimum lending rate (e.g. Euribor)
  • Debt issued directly to the capital market
  • Usually at a fixed interest rate
  • Stock exchange listing of debt (bond market)
  • Renting an asset with finance often supplied by the supplier of the asset
  • Avoids the need to raise finance separately when buying new assets
  • Finance leases versus operating leases
cost of debt
Cost of Debt
  • Interest on debt is deductible from taxable income
    • Tax advantage of debt = interest expense X tax rate
    • Cost of debt after tax =
      • Cost of debt before tax minus tax advantage of debt
      • Interest expense * (1 – tax rate)
  • Useful when comparing with cost of equity
financial debt other considerations
Financial debt: other considerations
  • Structure of ‘maturity mix’
    • Dates of repayments of debt?
    • Usual to spread out the maturity dates of debt
  • Interest rates
    • Fixed or floating rates
    • LT rates versus ST rates
  • Currency risk
    • Borrowings / debt in foreign currencies
    • Hedging
hedging of currency risk illustration
Hedging of currency risk- Illustration
  • French company (reporting in €) buys a subsidiary (SUB) in the US
  • Investment in SUB is expressed in US $ (reporting currency of SUB = US $)
  • Acquisition is financed by loan in €

= investment with double risk:

  • Performance of SUB as such (return in $) = commercial or industrial risk
  • Fluctuation of $ when translating the investment to € = currency risk
dividend policy
Dividend policy
  • Is the dividend policy relevant when evaluating the financial position and performance of a company ?
  • Link with shareholder value ?
    • Dividends versus increase in stock market value of shares
  • Are shareholders indifferent in these matters?
    • Different profiles of shareholders
    • Clientele effect
  • Impact on cash flows and financing needs
working capital management
Working capital management
  • Figure 8.4 shows a simplified diagram of a working capital cycle
  • Funds are tied up in this cycle
  • Net working capital =
    • Net investment of funds to keep the cycle going
    • Working capital assets (current assets) – working capital liabilities (current liabilities)
figure 8 4 the working capital cycle
Figure 8.4 The working capital cycle


Raw materials/





Trade payables


Work in progress/finished goods

Trade receivables





working capital management objectives
Working capital management objectives
  • Keeping at a minimum the cash tied up in working capital cycle
  • Preserving sufficient cash or readily convertible current assets to meet payment demands

1 = trade-off between financial and commercial policy

2 = liquidity-objective

working capital trade offs
Working capital: trade-offs
  • Inventory of raw materials
    • Quantity discounts (lower unit cost)
    • Risk of inventory shortage (production stop)
  • Inventory of finished goods
    • Risk of inventory shortage (loss of revenue)
    • Delivery flexibility through high and easily accessible inventory level (larger market share)
  • Receivables
    • Credit period as competitive sales argument
  • Trade payables
    • Credit versus lower unit price or higher product quality
liquidity objective of working capital management
Liquidity objective of working capital management
  • Planning of cash outflows and cash inflows related to working capital cycle
  • Active management of potential incoming cash flows from revenue
  • Structural aspects of operating activities affect working capital management
structural aspects with effect on working capital management
Structural aspects with effect on working capital management
  • Length of production cycle
  • Variability of demand
  • Flexibility of production
  • Scale of credit sales
  • Frequency of sale transactions
  • Frequency of payments
  • Purchasing power
performance measurement
Performance measurement
  • Profitability and efficiency issues
  • Evaluation of performance also involves considerations which are not visible from financial statements
  • Performance is judged in a relative sense
  • Short-term and long-term profitability