…is a process of evaluating a company’s economic prospects and risks for the purpose of making business decisions.
This includes analyzing a company’s business environment, its strategies, and its financial position and performance.

the use of financial statements to analyze a company’s financial position and performance, and to assess future financial performance.
It consists of three broad areas:
- profitability analysis
- risk analysis
- analysis of sources and uses of funds

Is the application of analytical tools and techniques to general-purpose financial statements and related data to derive estimates and inferences useful in business analysis.
It decreases the uncertainty of business analysis, and provides a systematic and effective basis for it.

Comparability problems
1. Lack of uniformity in accounting leads to comparability problems.
2. Discretion and imprecision in accounting can distort financial statement information.

Comparability problems
- Arising when different companies adopt different accounting for similar transactions or events, leading to difficulties with interfirm comparability.
- Arising when a coy changes its accounting across time, leading to difficulties with temporal comparability.

Corporate Finance addresses the following three questions:
1. What long-term investments should the firm choose?
2. How should the firm raise funds for the selected investments?
3. How should short-term assets be managed and financed?

The Financial Manager’s primary goal is to increase the value of the firm by:
1. Selecting value creating projects
2. Making smart financing decisions

• The corporate form of business is the standard method for solving the problems encountered in raising large amounts of cash.
• However, businesses can take other forms.

• The Sole Proprietorship
• The Partnership
– General Partnership
– Limited Partnership
• The Corporation

The Goal of Financial Management
• What is the correct goal?
– Maximize profit?
– Minimize costs?
– Maximize market share?
– Maximize shareholder wealth?

• Primary Market
– Issuance of a security for the first time
• Secondary Markets
– Buying and selling of previously issued securities
– Securities may be traded in either a dealer or auction market
• NYSE
• NASDAQ


An accountant’s snapshot of the firm’s accounting value at a specific point in time
 The Balance Sheet Identity is:
Assets ≡ Liabilities + Stockholder’s Equity

Current Assets
Current
Liabilities
Long-Term
Debt
Fixed Assets
1 Tangible
2 Intangible
What long-term investments should the firm choose?
Shareholders’
Equity

Current Assets
Fixed Assets
1 Tangible
2 Intangible
Net
Working
Capital
Current
Liabilities
Long-Term
Debt
How should short-term assets be managed and financed?
Shareholders’
Equity

Current Assets
Fixed Assets
1 Tangible
2 Intangible
How should the firm raise funds for the selected investments?
Current
Liabilities
Long-Term
Debt
Shareholders’
Equity

• Measures financial performance over a specific period of time
• The accounting definition of income is:
Revenue – Expenses ≡ Income

 Net Working Capital ≡
Current Assets – Current Liabilities
 NWC usually grows with the firm

• A measure of both a company's efficiency and its shortterm financial health.
• Positive working capital means that the company is able to pay off its short-term liabilities.
• Negative working capital means that a company currently is unable to meet its short-term liabilities with its current assets (cash, accounts receivable and inventory).
• A declining working capital ratio over a longer time period could also be a red flag that warrants further analysis.

• In finance, the most important item that can be extracted from financial statements is the actual cash flow of the firm.
• the cash flow received from the firm’s assets must equal the cash flows to the firm’s creditors and stockholders.
CF(A) ≡ CF(B) + CF(S)

• is an official accounting statement
• helps explain the change in accounting cash.
• The three components of the statement of cash flows are:
– Cash flow from operating activities
– Cash flow from investing activities
– Cash flow from financing activities

• Common-Size Balance Sheets
– Compute all accounts as a percent of total assets
• Common-Size Income Statements
– Compute all line items as a percent of sales
• Standardized statements make it easier to compare financial information, particularly as the company grows.
• They are also useful for comparing companies of different sizes, particularly within the same industry.

• Ratios are not very helpful by themselves: they need to be compared to something
• Time-Trend Analysis
– Used to see how the firm’s performance is changing through time
• Peer Group Analysis
– Compare to similar companies or within industries

• Ratios also allow for better comparison through time or between companies.
• As we look at each ratio, ask yourself:
– How is the ratio computed?
– What is the ratio trying to measure and why?
– What is the unit of measurement?
– What does the value indicate?
– How can we improve the company’s ratio?

Identification of the user of the analysis
• The IASB Framework states:
The objective of financial statements is to provide information … that is useful to a wide range of users in making economic decisions.
Interpretation and analysis of the financial statements is the process of arranging, examining and comparing the results in order that users are equipped to make such economic decisions.

Differences between users and their needs:
• Present and potential investors are interested in information that is useful in making buy/sell/hold decisions. Return on capital employed (ROCE) and related performance and asset management ratios are likely to be of interest to this group of users.
• Lenders and potential lenders are interested in assessing whether or not the loans that they have made are likely to be repaid, and whether or not the related interest charge will be paid in full and on time. They are particularly interested in ratios such as interest cover and gearing, and will be interested in the nature and longevity of other categories of loan to the entity.

Users of information:
Suppliers and other creditors interested in information that helps them to decide whether or not to supply goods or services to an entity.
Availability of cash will be of particular interest.
Working capital ratios, and the working capital cycle, may be appropriate calculations to undertake when analysing financial statements for the benefit of this class of user.

Users of information:
• Employees they need to be able to assess the stability and performance of the entity in order to gauge how reliable it is likely to be as a source of employment in the longer term. Employees are likely to be interested in disclosures about retirement benefits and remuneration.
• Customers interested in assessing the risks which threaten their supplier. Potentially they may be interested in takeover opportunities in order to ensure the continuing supply of a particular raw material.

Users of information:
• Governments and their agencies require special-purpose reports, especially tax computations, general-purpose reportsstatistics.
• Society

An annual report
• An annual report is a comprehensive report on a company's activities throughout the preceding year.
• Annual reports are intended to give shareholders and other interested people information about the company's activities and financial performance.
• Most jurisdictions require companies to prepare and disclose annual reports, and many require the annual report to be filed at the company's registry.
• Companies listed on a stock exchange are also required to report at more frequent intervals (depending upon the rules of the stock exchange involved).

Typically annual reports includes:
• Chairman's report
• CEO's report
• Auditor's report on corporate governance
• Mission statement
• Corporate governance statement of compliance
• Statement of directors' responsibilities
• Invitation to the company's AGM as well as financial statements including:
• Auditor's report on the financial statements
• Balance sheet
•
Statement of retained earnings
• Income statement
• Cash flow statement
• Notes to the financial statements
• Accounting policies

• Ratio analysis is a diagnostic tool that helps to identify problem areas and opportunities within a company.

The Analysis of Financial Statements
 The Use Of Financial Ratios
 Analyzing Liquidity
 Analyzing Activity
 Analyzing Debt
 Analyzing Profitability
 A Complete Ratio Analysis

 Liquidity refers to the solvency of the firm;
 "liquid firm" is one that can easily meet its shortterm obligations as they come due.
 A second meaning includes the concept of converting an asset into cash with little or no loss in value (cost, time ).
Copyright  1994, HarperCollins Publishers

Net Working Capital (NWC)
NWC = Current Assets - Current Liabilities
Current Ratio (CR)
Current Assets
CR =
Current Liabilities
Quick (Acid-Test) Ratio (QR)
Current Assets - Inventory
QR =
Current Liabilities
Copyright  1994, HarperCollins Publishers

• Expresses the length of time (in days) that a company uses to sell inventory, collect receivables and pay its accounts payable.
• The cash conversion cycle (CCC) measures the number of days a company's cash is tied up in the the production and sales process of its operations and the benefit it gets from payment terms from its creditors.
• The shorter this cycle, the more liquid the company's working capital position is.
• The CCC is also known as the "cash" or "operating" cycle.


is a more sophisticated analysis of a firm's liquidity, evaluating the speed with which certain accounts are converted into sales or cash; also measures a firm's efficiency
Copyright  1994, HarperCollins Publishers

Inventory Turnover (IT)
Average Collection Period (ACP)
Average Payment Period (APP)
Fixed Asset Turnover (FAT)
Total Asset Turnover (TAT)
IT =
ACP =
Cost of Goods Sold
Inventory
Accounts Receivable
Annual Sales/360
Accounts Payable
APP=
FAT =
Annual Purchases/360
Sales
Net Fixed Assets
TAT =
Sales
Total Assets

• Expressed as an indicator (days) of management performance efficiency, the operating cycle is a "twin" of the cash conversion cycle . While the parts are the same receivables, inventory and payables - in the operating cycle, they are analyzed from the perspective of how well the company is managing these critical operational capital assets, as opposed to their impact on cash.

 Debt is a true "double-edged" sword as it allows for the generation of profits with the use of other people's (creditors) money, but creates claims on earnings with a higher priority than those of the firm's owners.
 Financial Leverage is a term used to describe the magnification of risk and return resulting from the use of fixed-cost financing such as debt and preferred stock.

13
 There are Two General Types of Debt
Measures:



Debt Ratio ( DR ) DR=
Capital Structure Ratio( CSR )
CSR =
Long-Term Debt
Stockholders’ Equity
Debt-Equity Ratio ( DER )
DER = Total Debt
Stockholders’ Equity
Times Interest Earned TIE=
Earnings Before Interest
& Taxes (EBIT)
Interest
Ratio ( TIE )

– Profitability Measures assess the firm's ability to operate efficiently and are of concern to owners, creditors, and management
– A Common-Size Income Statement, which expresses each income statement item as a percentage of sales, allows for easy evaluation of the firm’s profitability relative to sales.

Gross Profit Margin (GPM)
Operating Profit Margin (OPM)
Net Profit Margin (NPM)
Return on Total Assets (ROA)
Return On Equity (ROE)
Earnings Per Share (EPS)
Price/Earnings (P/E) Ratio
GPM=
Gross Profits
Sales
OPM =
Operating Profits (EBIT)
Sales
Net Profit After Taxes
NPM=
Sales
Net Profit After Taxes
ROA=
Total Assets
Net Profit After Taxes
ROE=
Stockholders’ Equity
EPS =
P/E =
Earnings Per Share

17
 DuPont System of Analysis
– DuPont System of Analysis is an integrative approach used to dissect a firm's financial statements and assess its financial condition
– It ties together the income statement and balance sheet to determine two summary measures of profitability, namely ROA and ROE

• ROE = NI / TE
• Multiply by 1 and then rearrange:
– ROE = (NI / TE) (TA / TA)
– ROE = (NI / TA) (TA / TE) = ROA * EM
• Multiply by 1 again and then rearrange:
– ROE = (NI / TA) (TA / TE) (Sales / Sales)
– ROE = (NI / Sales) (Sales / TA) (TA / TE)
– ROE = PM * TAT * EM

18
 The firm's return is broken into three components:
– A profitability measure ( net profit margin )
– An efficiency measure ( total asset turnover )
– A leverage measure ( financial leverage multiplier )

19
 An approach that views all aspects of the firm's activities to isolate key areas of concern
 Comparisons are made to industry standards (cross-sectional analysis)
 Comparisons to the firm itself over time are also made (time-series analysis)

ALTMAN MODEL (U.S. - 1968)
He was the first person to successfully use step-wise multiple discriminate analysis to develop a prediction model with a high degree of accuracy. Using the sample of
66 companies, 33 failed and 33 successful, Altman's model achieved an accuracy rate of 95.0%.

ALTMAN MODEL (U.S. - 1968)
• Altman's model takes the following form :
Z = 1.2A + 1.4B + 3.3C + 0.6D + .999E
Z < 2.675
; then the firm is classified as "failed"
WHERE: A = Working Capital / Total Assets
B = Retained Earnings / Total Assets
C = Earnings before Interest and Taxes / Total Assets
D = Market Value of Equity / Book Value of Total Debt
E = Sales / Total Assets

Issues:
• What is capital structure?
• Why is it important?
• What are the sources of capital available to a company?
• What is business risk and financial risk?
• What are the relative costs of debt and equity?
• What are the main theories of capital structure?
• Is there an optimal capital structure?

• The value of a firm is defined to be the sum of the value of the firm’s debt and the firm’s equity.
V = B + S
• If the goal of the firm’s management is to make the firm as valuable as possible, then the firm should pick the debt-equity ratio that makes the pie as big as possible.
S B
Value of the Firm

• Definition
The capital structure of a firm is the mix of different securities issued by the firm to finance its operations.
Securities
• Bonds, bank loans
• Ordinary shares (common stock), Preference shares (preferred stock)
• Hybrids, eg warrants, convertible bonds

• Ordinary shares (common stock)
• Preference shares (preferred stock)
• Hybrid securities
– Warrants
– Convertible bonds
• Loan capital
– Bank loans
– Corporate bonds

• Financial instruments that pay a certain rate of interest until the maturity date of the loan and then return the principal (capital sum borrowed)
• Bank loans or corporate bonds
• Interest on debt is allowed against tax

• Debt causes financial risk because it imposes a fixed cost in the form of interest payments.
• The use of debt financing is referred to as financial leverage .
• Financial leverage increases risk by increasing the variability of a firm’s return on equity or the variability of its earnings per share.

• By altering capital structure firms have the opportunity to change their cost of capital and – therefore – the market value of the firm

• An optimal capital structure is one that minimizes the firm’s cost of capital and thus maximizes firm value
• Cost of Capital:
– Each source of financing has a different cost
– The WACC is the “Weighted Average Cost of
Capital ”
– Capital structure affects the WACC

• Basic question
– Is it possible for firms to create value by altering their capital structure?
• Major theories
– Modigliani and Miller theory
– Trade-off Theory
– Signaling Theory

• A firm’s capital structure is the proportion of a firm’s long-term funding provided by long-term debt and equity.
• Capital structure influences a firm’s cost of capital through the tax advantage to debt financing and the effect of capital structure on firm risk .
• Because of the tradeoff between the tax advantage to debt financing and risk, each firm has an optimal capital structure that minimizes the WACC and maximises firm value.

BUSINESS RISK vs FINANCIAL RISK
• Business Risk :
“the equity risk that arises from the nature of the firm’s operations”
• Financial Risk :
“the equity risk that arises from the financial policy of the firm”

• A technique that illustrates the impact of leverage on EPS at different levels of EBIT
• The objective is to find the EBIT level that will equate EPS regardless of the financing plan chosen
• The limitation of EBIT-EPS analysis is that it considers only the level of the earnings stream and ignores risk

EPS = (EBIT-I)(1-tc)/No. of shares
Company A (no debt)
(EBIT-0)(1-0.4)/4 million
Company B (with debt)
(EBIT£200,000)(1-0.4)/2 million
These are equal when:
(EBIT-0)(1-0.4)/4 m = (EBIT£200,000)(1-0.4)/2 m
With a little algebra, EBIT = £400,000

EBIT-EPS ANALYSIS
SUMMARY
• The effect of financial leverage depends upon EBIT
• When EBIT is high, financial leverage raises EPS and ROE
• The variability of EPS and ROE is increased with financial leverage

• The cost of capital is the rate of return that capital could be expected to earn in an alternative investment of equivalent risk.
• the expected return on capital must be greater than the cost of capital.

• The cost of capital represents the overall cost of financing to the firm
• The cost of capital is normally the relevant discount rate to use in analyzing an investment
• The overall cost of capital is a weighted average of the various sources:
– WACC = Weighted Average Cost of Capital
– WACC = After-tax cost x weights

• The cost of debt to the firm is the effective yield to maturity
(or interest rate) paid to its bondholders
• Since interest is tax deductible to the firm, the actual cost of debt is less than the yield to maturity:
– After-tax cost of debt = yield x (1 - tax rate)
• The cost of debt should also be adjusted for flotation costs
(associated with issuing new bonds)

• Preferred stock:
– has a fixed dividend (similar to debt)
– has no maturity date
– dividends are not tax deductible and are expected to be perpetual or infinite
• Cost of preferred stock = dividend price - flotation cost

• There are a number of methods used to determine the cost of equity
• We will focus on two
• Dividend growth Model
• CAPM

The Dividend Growth Model Approach
Estimating the cost of equity: the dividend growth model approach
According to the constant growth (Gordon) model,
D
1
P
0
=
R
E
- g
Rearranging
R
E
=
D
1
+ g
P
0

kj

R f
 β
( R m

R f
)
Cost of capital Risk-free return
Co-variance of returns against the portfolio
(departure from the average)
B < 1, security is safer than WIG average
B > 1, security is riskier than WIG average
Average rate of return on common stocks
(WIG)

Weighted Average Cost of Capital
(WACC)
• WACC weights the cost of equity and the cost of debt by the percentage of each used in a firm’s capital structure
• WACC=(E/ V) x R
E
+ (D/ V) x R
D x (1-t
C
)
– (E/V)= Equity % of total value
– (D/V)=Debt % of total value
– (1-tc)=After-tax % or reciprocal of corp tax rate tc.
The after-tax rate must be considered because interest on corporate debt is deductible

Final notes on WACC

IMPLICATIONS OF PRE-MM THEORIES
SUMMARY
•
Net Income (NI) Theory
Financial leverage is beneficial
• Net Operating Income (NOI) Theory
Financial leverage is irrelevant
• Traditional Theory
There exists an optimal capital structure


Investors use “homemade” rather than corporate financial leverage
– The share price of firm A rises based on increased demand
– The share price in firm B falls based on selling pressures
• Arbitrage continues until total firm values are identical
• Conclusion: Firm value is independent of capital structure

• Investors can lever up an investment in an unlevered firm by borrowing money and buying stock
• Investors can unlever an investment in a levered firm by selling stock and lending money
• Conclusion : investors can create their own payoff patterns, irrespective of the capital structure

• How can MM seriously argue that financing policy doesn't matter?
• Point : all of their assumptions are unrealistic - if MM were true we would see random D/E ratios across firms
• Their important contribution is to have identified the factors that will make financing policy matter to the firm
• If financing policy does affect the value of the firm it will do so through at least one violation of the underlying assumptions

• PROPOSITION I
The value of the firm is independent of its capital structure
• PROPOSITION II
A firm’s cost of equity capital is a positive linear function of its capital structure

• PROPOSITION I
The WACC is constant, regardless of the capital structure
• PROPOSITION II
The cost of equity must increase, as leverage is increased,in order for the WACC to remain constant

CAPITAL STRUCTURE II
WHAT MM (1958) LEFT OUT
•
•
•
•
•
Corporate taxes
Costs of financial distress
Agency costs of debt
Debt capacity
Pecking order of financing
Personal Taxes

MM PROPOSITION II
WITH TAXES
• With corporate taxes, the firm’s Weighted Average Cost of
Capital is calculated as follows:
WACC = r
0
= (S /V
L
) . r s
+ (B /V
L
) . r
B
. (1 – T
C
)
• With a little algebra: r s
= r
0
+ ( r
0
– r
B
) . ( B/S ) . (1 – T
C
)

• Implication is that firms will maximise their value by taking on maximum debt
• However, empirical evidence suggests that firms take on only modest amounts of debt
• So, what other factors influence the choice of capital structure?

• DIRECT COSTS
“ The legal and administrative expenses associated with bankruptcy or reorganization ”
• INDIRECT COSTS
“ Costs arising from impaired ability to conduct business and agency costs”

• Agency costs arise from potential conflicts of interest between a firm’s security holders
• The interests of creditors and shareholders may be in conflict when the firm is in financial distress
• This ‘agency problem’ gives rise to agency costs of debt
• Shareholders may engage in ‘selfish strategies’ at the expense of creditors

• Lenders will anticipate the costs associated with the selfish strategies
• A higher rate of interest will be demanded in compensation
• Agency costs ultimately come out of shareholders’ pockets

•
•
•
•
•
Marketed claims can be bought & sold in financial markets ie shareholder & bondholder claims
Nonmarketed claims cannot be bought & sold in financial markets, ie tax claims & bankruptcy claims
The total value of all claims is unaltered by capital structure
The value of marketed claims may be affected by capital structure changes
Any increase in marketed claims must imply an identical decrease in nonmarketed claims

TRADE-OFF THEORY OF CAPITAL STRUCTURE
• Target debt ratios will vary across firms
• Firms with safe tangible assets and plenty of taxable income should have high target ratios
• Marginally profitable companies with risky, intangible assets should rely primarily on equity financing

• This implies a “pecking order” of financing:
Retained earnings

Debt finance

External equity finance
 The pecking order model can explain:

Why debt ratios & profitability are inversely related

Why stock markets react negatively to new equity issues

Why managers of successful firms hold on to more cash than common sense suggests they should

• Taxes - firms with high taxable income will have more debt
However, if dividends are taxed at a lower personal tax rate than interest payments, the tax advantage to debt is partially offset
• Costs of financial distress
• Type of assets -firms that have good collateral (tangible assets) tend to have more debt
• Uncertainty of income - firms with safer (ie less variable) income streams will have more debt
• Pecking Order - issue the safest security first because less is given up to outside investors