Pike Robert, Neal Bill. Corporate finance and investment: decisions and strategy
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Chapter 2 The financial environment 45
■ FT-SE Fledgling covers some 700 smaller companies taken from the main listing
and the Alternative Investment Market (AIM).
■ The techMARK range. These indices reflect the performance of innovative tech-
nology stocks listed on the techMARK market in the following sectors: computer
hardware, semi-conductors, telecoms equipment, computer services, internet and
software. The indices are:
(i) FT-SE techMARK All Share.
(ii) FT-SE techMARK 100. This covers the top 100 firms from the first index.
(iii) FT-SE techMARK medi-science. This covers medical science firms from the fol-
lowing sectors: pharmaceuticals, bio-technology, medical equipment and sup-
pliers (excluding firms in the main FT-SE 100 index).
Using the published information
Financial managers and investors need to study the performance of the shares of their
company, both against the appropriate sector as a whole and also against competitors
within that sector. Two performance statistics that are most commonly reported are the
dividend yield and price:earnings ratio.
Dividend yield
This is the gross, or pre-tax, dividends of companies and whole sectors in the last year
as a percentage of their market value. Generally, sectors with low dividend yields are
those with companies where the market expects high growth. Often we observe that the
dividend yield for leading shares, and also on the overall index, is well below the return
investors could currently earn on a safe investment in Treasury Bills. This is because
shareholders are looking to a capital gain on top of the dividend yield to recompense
them for the higher risks involved.
Price:earnings (P:E) ratio
The P:E ratio is a much-used performance indicator. It is the share price divided by the
most recently reported earnings, or profit, per share. So for the sector, it is the total mar-
ket value of the companies represented divided by total sector earnings. The P:E ratio
is a measure of the market’s confidence in a particular company or industry. A high P:E
usually indicates that investors have confidence that profits will grow strongly in
future, perhaps after a short-term setback, although irregular events like a rumoured
takeover bid will raise the P:E ratio if they lead to a higher share price.
Let us now turn to the performance of individual companies. Table 2.1 is an extract
from the London Share Service pages in the Financial Times, giving the Food and Drug
Table 2.1
Share price information
for the food retail
sector
52 week
Vol
Price Chng high low Yld P/E ‘000s
Big Food 94 182 80 3.1 11.7 13,104
CaffeNro 127 ....... 48 – 28.3 5
Dairy Fm 154 2.2 26.6 5
Greggs 3750 3750 3075 2.3 14.5 32
Morrison 256 1.5 32.3 19,842
Sainsbry 242 5.0 – 9,912
Somerfld 1.4 26.4 1,236
Tesco 237 2.2 19.4 14,082
Thorntns 168 135 4.4 22.8 82
WhitrdCh 220 161 1.8 17.9 22
Source: Financial Times, 11 January 2005.
1189
1
2
1
2
153
1
2
321
3
4
1
2
320
1
4
125
1
2
172
1
4
3
4
154
3
4
*
311
1
2
2270
1
4
171
1
4
1
1
2
215
1
2
50
88
1
2
1
1
4
131
1
4
132
1
2
1
4
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46 Part I A framework for financial decisions
Retailing sector on 11 January 2005. Different information is provided on Mondays
than on other days of the week. We will focus on a major supermarket chain, Tesco
Group. Bold names indicate members of the FTSE 100 index.
Transactions and prices of stocks are published continuously through SEAQ (the
Stock Exchange Automatic Quotation). Quoted prices assume that shareholders buy-
ing a share are entitled to any forthcoming dividend (cum div) unless this is express-
ly precluded. The symbol ‘xd’ (ex div, i.e. excluding dividends) would mean that new
investors are too late to qualify for it. The share price will accordingly be lower to
reflect the forgone dividend.
Tesco’s closing share price of is up from the previous day’s trading
with over 14 million shares traded in the day. The current price is just below its high-
est over the past year. Every Monday, the Financial Times publishes the dividend
cover and market capitalisation value (i.e. number of issued shares times current
share price).
The Yield of 2.2 per cent is the dividend yield, i.e. the dividend expressed as a pro-
portion of the current share price. The price:earnings (P:E) ratio of 19.4 suggests that it
would take over 20 years for investors to get their money back in profit terms. Why
should anyone be willing to wait that long? Remember that the calculation compares
the last reported earnings per share with the current share price. Investors expect the
payback period to be far quicker than 20 years because they anticipate strong earnings
growth for Tesco.
1
2
p320
1
4
p
2.9 TAXATION AND FINANCIAL DECISIONS
Few financial decisions are immune from taxation considerations. Corporate and person-
al taxation affects both the cash flows received by companies and the dividend income received
by shareholders. Consequently, financial managers need to understand the tax conse-
quences of investment and financing decisions. Taxation may be important in three key
areas of financial management:
1 Raising finance. There are clear tax benefits in raising finance by issuing debt rather
than capital. Interest on borrowings attracts tax relief, thereby reducing the compa-
ny’s tax bill, while a dividend payment on equity capital does not attract tax relief.
The tax system is thereby biased in favour of debt finance.
2 Investment in fixed assets. Spending on certain types of fixed asset attracts a form of tax
relief termed capital allowances. This is intended to stimulate certain types of invest-
ment, such as in industrial plant and machinery. The taxation implications of an
investment decision can be very important. We discuss capital allowances and tax
implications for investment decisions in Chapter 6.
3 Paying dividends. Until 1973, in the UK, company profits were effectively taxed
twice – first on the profits achieved and then again on those profits paid to
shareholders in the form of dividends. Such a ‘classical’ tax system (which still
exists in certain countries) is clearly biased in favour of retaining profits rather
than paying out large dividends. The UK taxation system is more neutral, the
same tax bill being paid (for companies making profits) regardless of the dividend
policy.
Finally, the corporate financial manager should understand not only how taxa-
tion affects the company, but also how it affects the company’s shareholders (www.
inlandrevenue.gov.uk). For example, some financial institutions (e.g. pension funds)
pay no tax; some shareholders pay tax at 20 per cent, while others pay higher-rate
income tax at 40 per cent. Some may prefer capital gains to dividends.
price:earnings
The ratio of price per ordinary
share to earnings (i.e. profit
after tax) per share (EPS)
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Chapter 2 The financial environment 47
Self-assessment activity 2.8
Explain why it is important to consider the tax implications of financial and investment
decisions.
(Answer in Appendix A at the back of the book)
This chapter has introduced readers to the financial and tax environment within which
financial and investment decisions take place.
Key points
■ Financial markets consist of numerous specialist markets where financial transac-
tions occur (e.g. the money market, capital market, foreign exchange market, deriv-
atives markets).
■ Financial institutions (e.g. banks, building societies, pension funds) provide a vital
service by acting as financial intermediaries between savers and borrowers.
■ Securitisation and disintermediation have permitted larger companies to create
alternative, more flexible forms of finance.
■ The London Stock Exchange operates two tiers: the Main List for larger established
companies, and the Alternative Investment Market which mainly caters for very
young companies.
■ An efficient capital market is one where investors are rational and share prices
reflect all available information. The Efficient Markets Hypothesis has been exam-
ined in its various forms (weak, semi-strong and strong). In all but the strong form,
it seems to hold up reasonably well, but it is increasingly unable to explain ‘special’
circumstances.
■ The problem of ‘short-termism’ may stem more from managerial attitudes than
those of investors.
■ Taxation can play a key role in financial management, particularly in raising
finance, investing in fixed assets and paying dividends.
SUMMARY
Further reading
Brett (2003) provides a clear explanation of how to read the financial pages in the press. Clear
and more extensive introductions to capital markets are found in Foley (1991), and Weston
Copeland (1992), O’Shea (1986) and Redhead (1990).
The Stock Exchange Fact Book is published annually by the Stock Exchange. Two classic review
articles on market efficiency were written by Fama (1970 and 1992), while Rappaport (1987)
examines the implications for managers. Tests of capital market efficiency are found in Copeland
and Weston (2004) and Keane (1983), while some exceptions to efficiency are found in the June
1977 special issue of Journal of Financial Economics. Peters (1991, 1993) applies Chaos Theory
to stock markets. Discussion on short-termism in the City is found in Marsh (1990) and Ball
(1991). Mastering Finance (1997) offers useful articles on securitisation, financial intermediaries,
the role of financial markets, market efficiency and short-termism.
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48 Part I A framework for financial decisions
Useful websites
www.moneyfactor.co.uk
www.moneysupermarket.com
www.moneyextra.com
www.find.co.uk
www.moneynet.co.uk
www.ftourmoney.co.uk
APPENDIX
FINANCIAL STATEMENT ANALYSIS
Most readers will previously have undertaken a module in accounting and be familiar
with financial statements. This appendix provides a summary of the key elements in
analysing financial statements and the main ratios involved in interpreting accounts.
Investors, whether shareholders or bank managers, ask three basic questions when
they examine the accounts of a business:
■ Position – what is the current financial position, or state of affairs, of the business?
This question is addressed by examining the Balance Sheet, sometimes referred to
as the position statement.
■ Performance – how well has the business performed over the period of time we are
interested in, for example, the past year? This question is addressed by looking at
the Profit and Loss Account, otherwise termed the income statement.
■ Prospects – what are the likely prospects of the business for which we are consider-
ing investment? A bank manager would probably request a cash flow forecast, show-
ing the expected cash receipts and payments for the coming year. However, published
accounts are historical documents and the shareholder will have to settle for the cash
flow statement for the past year. Clues as to the expected future prospects may be
found in the Chairman’s Statement frequently published with the accounts.
We will examine the three financial statements, drawing on the abridged accounts
of a fictitious company called Foto-U, a business specialising in offering instant photo-
graphs through photo booths in public places throughout Europe.
■ The Balance Sheet
Imagine it is possible to take a financial snapshot of Foto-U on the 31 March 2006, the
end of its trading year. What we would see are the very things we find in the Balance
Sheet. Looking at Foto-U’s balance sheet in Table 2.2, we see three main categories –
assets, creditors (or liabilities) and capital and reserves. This statement demonstrates
the ‘accounting equation’: the money invested in the business by shareholders and
creditors is represented by the assets in which they have been invested.
The more permanent assets (typically those with a life beyond a year) are termed
fixed assets while the less permanent are termed current assets. For Foto-U, intangible
fixed assets refer to patents and goodwill, the latter arising from acquiring another
company and paying more for it than the Balance Sheet value of its underlying assets.
Shareholders' of funds £78 m Creditors £60 m Assets £138 m
Where the cash came from Where the cash went
1sources offunds21uses of funds2
Balance Sheet/position
statement
A financial statement that lists
the assets held by a business at
a point in time and explains
how they have been financed
(i.e. by owners’ capital and by
third party liabilities)
Profit and Loss
Account/income statement
A financial statement that
details for a specific time period
the amount of revenue earned
by a firm, the costs it has
incurred, the resulting profit
and how it has been distributed
(‘appropriated’)
cash flow statement
A financial statement that
explains the reasons for cash
inflows and outflow of a busi-
ness, and highlights the resulting
change in cash position
fixed assets
Assets that remain in the
Balance Sheet for more than
one accounting period (i.e. they
are fixed in the Balance Sheet)
current assets
Assets that will leave the
Balance Sheet in the next
accounting period
intangible
Intangible assets cannot be
seen or touched, e.g. the image
and good reputation of a firm
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Chapter 2 The financial environment 49
Table 2.2
Foto-U plc
Balance Sheet as at 31 March 2006
2006 2005
£m £m
Fixed assets
Intangible assets 15 10
Tangible assets 117 92
132 102
Current assets
Stocks 25 24
Debtors 29 25
Investments and short-term deposits 3 –
Cash at bank and in hand 9 5
66 54
Creditors: amounts falling due within one year (60) (62)
Net current assets (liabilities) 6 (8)
Total assets less current liabilities 138 94
Creditors*: amounts falling due after more than one year (60) (23)
Net assets 78 71
Capital and reserves
Called-up share capital 2 2
Reserves 76 69
Shareholders’ funds 78 71
*The creditors figures includes trade creditors 40 42
Profit and Loss Account for the year ended 31 March 2006
Turnover – continuing operations 200 190
Cost of sales (including depreciation of £27 m) (157) (160)
Gross profit 43 30
Administration expenses (21) (20)
Operating profit (Earnings before interest and taxes) 22 10
Interest payable (2) (2)
Profit before taxation 20 8
Tax on profit (6) (4)
Profit after tax attributable to shareholders 14 4
Dividends (7) (3)
Retained profit for year 7 1
Cash Flow Statement for the year ended 31 March 2006
Net cash inflow from operations 36 43
Servicing of finance (2) (2)
Taxation (6) (4)
Capital expenditure (57) (33)
Dividends paid (7) (3)
Financing 37 2
Increase in cash in the year 13 6
Other data: Foto-U has 200 million shares in issue.
Share price at 31 March 2006 is 120p (50p for 2005).
Tangible fixed assets include land and buildings, photo booths, plant and machinery,
vehicles and fixtures and fittings. Their values are not stated at what they could be
sold for, but at their net book value – what they originally cost less an estimate of the
extent to which they have depreciated in value with use or age.
tangible
Tangible assets can quite literal-
ly be seen and touched, e.g.
machinery and buildings
net book value
The original cost of buying an
asset less accumulated depreci-
ation charges to date
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50 Part I A framework for financial decisions
Current assets represent the less permanent items (typically less than a year) the
business owns at the balance sheet date. Our financial snapshot for Foto-U captures four
items – stocks, debtors, investments and cash. Unlike fixed assets, these items are con-
tinuously changing (or ‘turning over’) as trading takes place. Trade creditors and bank
overdraft, where the amount has to be settled within one year, are deducted from the
current assets to give the net current assets figure, commonly termed working capital.
This is the amount of money likely to be turned into cash over the coming weeks.
Creditors to be paid after more than a year are typically in the form of medium/
long-term loans. Finally, shareholders’ funds represent the capital originally paid in by
shareholders plus any reserves created since then. The most common reserve will be
the profit retained in the business rather than paid to the shareholders as dividends.
Does the balance sheet show the worth of the business?
Although the shareholders’ funds for Foto-U of £78 million is the difference between
what it owns, in the form of various assets, and what it owes to third parties, it would
not be correct to say that this is what their investment is worth. The market value for
the company is based on what investors are willing to pay for it. But the assets and lia-
bilities are valued according to Generally Accepted Accounting Principles (GAAP).
We cannot explore them all here, but one principle is that assets are usually valued at
their historical cost less a provision for such things as depreciation, in the case of fixed
assets, and bad or doubtful debts, in the case of debtors. The key difference is that
book values, based on GAAP, are backward-looking, while market values are forward-
looking, based on expected future profits and cash flows.
To get some idea of the difference between the market and book values of the share-
holders’ funds we can look at the share price listed on the Stock Exchange on the bal-
ance sheet date. For Foto-U the share price at the balance sheet date was 120p. There
are 200 million issued shares so the market capitalisation is:
Comparing the market value with the book value for shareholders’ equity, we find
a ratio of approximately 3:1 (£240 m/£78 m). We should not be surprised to find that the
market value is so much higher. Successful businesses are much more than a collection
of assets less liabilities. They include creative people, successful trading strategies,
profitable brands and much more. Generally, we can say that the greater the market-
to-book value ratio, the more successful the business.
■ The profit and loss account
To gain an impression of how well Foto-U has performed over the past year we need
to turn to the Profit and Loss Account or income statement. This shows the sales
income less the costs of trading. Shareholders are primarily interested in the profit
after tax (PAT) available for distribution to them in the form of dividends. Foto-U has
made a PAT of £14 million of which half has or will be paid to shareholders in the form
of dividend, the remainder being retained profit, reinvested in the business, hopefully
to earn a higher profit next year.
Investors also want to know how much profit (or earnings) has been made from its
trading, before the cost of financing is deducted. Earnings before interest and taxes
(EBIT) for Foto-U is:
This is also termed operating profit.
£22 m
£200 m £178 m
EBIT total revenues operating costs 1including depreciation2
1200 million shares 120p a share2 £240 million
net current assets
Current assets less current
liabilities
shareholders’ funds
The value of the owners’ stake
in the business–identically
equal to net assets, or equity
profit after tax (PAT)
Profit available to pay dividends
to shareholders after tax has
been paid
dividend
A periodic payment to a firm’s
owners–usually once or twice a
year–made out of profits after
tax
retained profit
Profit that remains for re-
investment in the business after
a dividend is paid out
operating profit
Revenues less total operating
costs, both variable and
fixed–as distinct from financial
costs such as interest pay-
ments.
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Chapter 2 The financial environment 51
Profit is not the sole consideration for investors. They are perhaps more interested
in how much cash has been created through successful trading. This can be estimated
by adding back the depreciation (a non-cash cost) previously deducted in calculating
EBIT. This is termed earnings before interest, taxes, depreciation and amortisation
(amortisation is just a fancy name for depreciating intangible assets) or EBITDA. For
our company, this is:
■ The cash flow statement
The third and final financial statement in a published set of accounts is the cash flow
statement. This statement is valuable because it reveals the main sources of cash and
how it has been applied. For Foto-U, the main two sources of cash during the year are
additional finance raised from new loans and net cash from operations (basically the
EBITDA referred to above plus a few other adjustments for non-cash items). The main
applications of this cash generated from trading are investment in capital expenditure,
and dividends. The final line on this statement shows that, during the year, cash has
increased by £7 million.
■ A financial health check using ratios
Accountants and bank managers have formulated dozens of financial ratios to help
diagnose the financial health of the business, its position, performance and prospects.
We shall restrict our focus to those key financial ratios that every finance manager and
investor should be acquainted with. These are summarised in Table 2.3 and discussed
briefly below.
£49 m
£22m
£27m
EBITDA EBIT Depreciation
Table 2.3
Foto-U key ratios
Ratio Form 2006 2005
Profitability
Gross profit margin % 21.5 15.8
Net profit margin % 11.0 5.3
Return on capital employed (ROCE) % 15.9 10.6
Activity ratios
Net asset turnover times 1.4 2.0
Debtors days 53 48
Stock days 58 54
Supplier credit period days 93 96
Liquidity and financing ratios
Current ratio times 1.1 0.9
Quick (acid test) ratio times 0.7 0.5
Gearing % 43.5 24.5
Interest cover times 11 5
Investor ratios
Return on shareholders’ funds % 17.9 5.6
Dividend per share pence 3.5 1.5
Earnings per share pence 7 2
Dividend cover times 2 1.3
Price:earnings times 17.1 25
Dividend yield % 2.9 3
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52 Part I A framework for financial decisions
Profitability ratios
To assess the performance of Foto-U, we study a number of profitability ratios.
Profit margin
This ratio shows how much profit is generated from every £ of sales. It can be consid-
ered in the form of a percentage at both the gross and net profit levels.
Gross profit margin
Net profit margin
(EBIT is earnings before interest and tax, i.e. operating profit.)
Return on capital employed (ROCE)
This ratio, also termed the primary ratio, examines the rate of profit the business
makes on the long-term capital invested in it. Foto-U has shareholders’ funds of £78
million and long-term creditors of £60 million giving long-term capital of £138 million.
This is represented by the total assets less current liabilities figure on the balance sheet.
Activity ratios
Here we examine how efficiently Foto-U manages its assets in terms of the level of
sales obtained from the assets invested.
Asset turnover
This can also be expressed in terms of each type of asset, but here, we usually
express it in terms of days. For example, the average number of days it takes for
debtors to pay is given by debtor days.
Debtor days
Note also that we have used the asset figure at the year-end. A more accurate pic-
ture is given by finding the average asset value based on the values at the start and
end of the year.
53 days
148 days last year2
Debtors
Credit sales
365
29
200
365
1.45 times
12 times last year2
Sales
Total assets current liabilities
200
138
15.9%
110.6% last year2
ROCE
EBIT
Long-term capital
100
22
138
100
11%
15.3% last year2
EBIT
Sales
100
22
200
100
21.5%
115.8% last year2
Gross profit
Sales
100
43
200
100
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Chapter 2 The financial environment 53
Similar calculations can be made for stock and creditors, but with one important dif-
ference. Stock and trade creditors are valued in the balance sheet at original cost so
instead of using sales, we use cost of sales, i.e., what it cost the firm to build these stocks.
Stockholding period
Supplier credit days
It is preferable to use purchases rather than cost of sales, although this figure is not
always available.
Liquidity and Financing ratios
To assess whether the company is able to meet its financial obligations as they fall due,
we need to compare short-term assets with short-term creditors. Two such ratios are
commonly employed.
Current ratio
Quick assets
For most firms, it is not easy to convert stock into cash with any great speed. The quick
assets (or acid-test ratio) is a more prudent liquidity ratio which excludes stock entirely.
As a general rule-of-thumb, we would typically expect the current ratio to be 2 and
the quick assets to match creditors (i.e. a quick ratio of 1). However, this guide may
differ from industry to industry depending on the trade credit periods granted to cus-
tomers and claimed from suppliers.
Gearing
A rather different question asks how the capital employed in the business is financed. The
gearing ratio shows the proportion of capital employed funded by long-term borrowings.
An equally acceptable way of expressing the gearing ratio is by the Debt/Equity ratio.
Long-term borrowings
Shareholders’ funds
60
78
0.77:1
43.5%
124.5% last year2
Long-term borrowings
Debt Equity capital
100
60
138
100
0.7 times
10.5 times last year2
Current assets stock
Current liabilities
66 25
60
1.1 times
10.9 times last year2
Current assets
Current liabilities
66
60
93 days
196 days last year2
Trade creditors
Cost of sales
365
40
157
365
58 days
154 days last year2
Stock
Cost of sales
365
25
157
365
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54 Part I A framework for financial decisions
Interest cover
Another way of considering gearing is to look to the profit and loss account by assess-
ing the degree of profits cover the firm has to meet its interest payments.
An interest cover of 11 times is very safe. But were it to fall to, say, below three or
four, concern may arise that taxation and dividends cannot be paid.
Investor ratios
Shareholders are more interested in the return they obtain on their investment rather
than the return the company makes on the total business.
Return on shareholders’ funds (return on equity)
This indicates how profitable the company has been for its shareholders.
Shareholders will also be interested in the earnings per share (what dividend could
be paid) and dividend per share (what dividend is paid) for the year.
Earnings per share (EPS)
In practice, the EPS calculation is usually more complex than this, but the notes to
the accounts will explain the calculation.
Dividend per share (DPS)
Dividend cover
This links the DPS and the EPS to indicate how many times the dividend could be paid,
and, hence, how safe it is, in terms of exposure to a fall in EPS.
The final two ratios relate earnings and dividends to stock market performance as
reflected in the current share price. If the current share price for Foto-U is 120p, we can
calculate the price:earnings ratio and dividend yield.
Price:earnings ratio (P:E)
17.1 times
125 times last year2
Current share price
Earnings per share
120
7
2 times
11.3 times last year2
Earnings per share
Dividend per share
7
3.5
3.5 pence per share
11.5 pence last year2
Total ordinary dividend
Number of ordinary shares in issue
7
200
12 pence last year2
7 pence per share
Earnings after tax and preference dividends
Number of ordinary shares in issue
14
200
17.9%
15.6% last year2
Earnings after tax and preference dividends
Shareholders’ funds
100
14
78
100
11 times 15 times last year2
Earnings before interest and taxes
Interest payable
22
2
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