FINANCIAL ANALYSIS AND

INTRODUCTION

FINANCIAL MODEL OF A COMPANY

Objectives of a company
Shareholders’ wealth maximization

Objectives of a company
Stakeholders’ income increase:
Shareholders
Employees
Managers
Suppliers
Clients
Society

Functions of a financial manager
Activity spheres of a financial manager:
Strategic management – general objectives and long-term planning
Operational management – everyday management
Risk management – ways to minimize impact of unfortunate events and maximize the realization of opportunities

Functions of a financial manager

Functions of a financial manager
Key objectives of a financial manager
Financial planning
Assessment of investment projects
Decisions on financing
Operations on capital markets
Financial control

Financial structure of the company
Financial structure is a hierarchical system of financial responsibility centres (FRC) which define the order of financial results forming and responsibility distribution to achieve one common objective of a company.

Financial structure of the company
Financial responsibility centers (FRC):
Cost center (CC)
Revenue center (RC)
Marginal revenue center (MRC)
Profit center (PC)
Investment center (IC)

Financial structure of the company

Financial structure of the company
How to from a financial structure:
Organizational approach
Process approach
Define investment activities
Define assets
Define a profit structure
Outline the main managerial relationships

Organizational approach
An organizational structure is a mainly hierarchical concept of subordination of entities that collaborate and contribute to serve one common aim. (Wikipedia)

Organizational approach
Functional organization

Organizational approach
Functional organization

Organizational approach
Projectized organization

Organizational approach
Projectized organization

Organizational approach
Matrix organization

Organizational approach
Matrix organization

Organizational approach
Financial
structure
PC
Director + Fin.Director
CC
Manufacturing
Workshop 1
Workshop 2
PC
Enterprises
Region 1
Region 2
MRC
Departments
Business 1
Business 2
RC
Sales Department
CC
Administration
Accounting
Development
IC
Projects
Project 1
Project 2
Product 1
Product 2
IC
Board of Directors

Organizational approach
Differences between organizational and financial structures

Process approach
A process is an activity which transforms input into output.
A business process is an activity that uses specific resources to produce a specific service or product for a particular customer.

Process scheme

Process approach
Business-process types:
Main
Supporting
Development
Corporate management

Process approach
Process decomposition
Process 1
Process 2
Process 3
Process 2.1
Process 2.2
Process 2.3
Process 2.3.1
Recording
Process 2.3.2
Recording
Process 2.3.3
Recording
A0 Level
A2 Level
A2.2 Level

Process approach
Business process and budgets
P&L
Balance
CF
Financial budgets
Operational budgets
Business-processes

BASIC PRINCIPLES OF FINANCIAL MANAGEMENT

Concept of cash flows
Cash turnover concept

Concept of cash flows
Cash flow - the movement of cash into or out of a business, a project, or a financial product during a specified, finite period of time.

Relationship between risk & profit
Nothing ventured, nothing gained
Britain’s Special Air Service motto: Who dares, wins
The higher profits are usually connected with the higher risk

ACCOUNTING SYSTEMS

Bookkeeping, financial & management accounting
Bookkeeping is the recording of day-to-day financial transactions (purchase, sales, receipts, and payments)
Financial accounting concerned with the preparation of financial statements for decision makers (stockholders, suppliers, banks, employees, government agencies, owners, and other stakeholders)
Management accounting provides managers of the company with the essential internal data to direct and control the company’s activity

Bookkeeping, financial & management accounting

Financial reporting standards used in Russia
Russian Accounting Standards (RAS) – accounting standards issued by the Russian Ministry of Finance; obligatory in Russia.
International Financial Reporting Standards (IFRS) – standards adopted by the International Accounting Standards Board (IASB)
Generally Accepted Accounting Principles (GAAP) - accounting rules used to prepare, present, and report financial statements in the US.

Financial reporting standards used in Russia
Differences between RAS and IFRS

Financial reporting standards used in Russia
Main concepts of the IFRS:
accrual basis
going concern
individual evaluation concept
conservatism
matching
substance over form

FINANCIAL STATEMENTS

Annual reports

BALANCE SHEET

Loan
capital
Invested
capital
EQUITY &
LIABILITIES?
Where from?
ASSETS
What?
Structure of assets & liabilities
Fixed
assets
Current
assets
Equity
Profit/Losses
Long-term
debt
Current
liabilities

Structure of assets & liabilities
Balance equation
Total Assets = Total Liabilities & Equity = FA + CA = IC + CL = E + P/L +LC

Structure of assets & liabilities
Fixed assets:
land
plant & equipment
transport
long-term financial investments
license
good-will

Structure of assets & liabilities
Current assets:
cash
inventories
work-in-process
accounts receivable
short-term financial investments
pre-paid expenditures

Structure of assets & liabilities
Equity:
shareholders’ equity
retained earnings
additional capital
reserves

Structure of assets & liabilities
Loan capital:
long-term liabilities (longer than 12 months)
short-term liabilities
loans & credits
liabilities to suppliers
liabilities to employees
taxes to be paid
future earnings

Net working capital
Invested
capital
Current
assets
Current
liabilities
Net working
capital
Fixed
assets

Net working capital
NWC = CA – CL = IC – FA
Represents operating liquidity available to a business
Positive working capital is required to ensure that a firm is able to continue its operations and that it has sufficient funds to satisfy both maturing short-term debt and upcoming operational expenses.

INCOME STATEMENT

Income statement
Receipts:
Sales
Interests
Payments for services
Rent …
Disbursements:
Cost of sales
Salaries & wages
Rent
Equipment maintenance
Insurance
Office
Communication means
Operating expenses…
Profit =
Receipts –
Disbursements

Income statement

Balance sheet & income statement

Balance sheet & income statement
Assets = Equity + (-) Profit (Loss) + Liabilities
Assets = Equity + (Receipts – Disbursements) + Liabilities

STATEMENT OF CASH FLOWS

Cash flow statement
Operating activities:
Cash received from customers
Cash paid to suppliers and employees
Operating expenses
Securities
Interest received
Interest paid
Income tax paid
Cash flow provided (used) by operating activities

Cash flow statement
Investing activities
Proceeds from sales of assets
Capital expenditures
Shares acquisition
Proceeds from sales of shares
Proceeds from investing activities (dividends, interests)
Cash flow provided (used) by investing activities

Cash flow statement
Financing activities
Equity
Loans
Proceeds from issuance of long-term debt
Repayment of loans
Interest payments
Leasing payments
Dividend payments
Cash flow provided (used) by financing activities

Cash flow statement

Cash flow statement
Methods of representing cash flows from operating activities:
Direct - all the inflows and outflows are calculated using accrual method
Indirect - adjusting net income to reconcile it to net cash flow from operating activities

Cash flow statement
Steps of the indirect method:
Add back noncash expenses, primarily depreciation / Subtract noncash earnings
Show increases/decreases in current asset and current liability accounts
Calculate cash flow from operating activities

Cash flow statement
Signs for adjustments (indirect method)
? Current assets
? Current liabilities
Noncash earnings
? Current assets
? Current liabilities
Noncash expenses

Cash flow statement
Differences between EAT and CF:
? EAT show economic effectiveness of sales,
don’t concern payments spread in time
CF shows real in- and outflows during the period
? EAT exclude VAT
CF shows VAT
? EAT includes depreciation as a disbursement
CF exclude depreciation as an outflow
? Income statement concerns only operating activities
Statement of cash flows concerns all the types of the company’s activities

FINANCIAL ANALYSIS

BASIC PRINCIPLES

Financial ratios
A financial ratio is a relationship that indicates something about a firm’s activities and enables an analyst to make a comparison of a firm financial condition over time or in relation to other firms.

Financial ratios
Successful financial ratio analysis:
Requires only representative sample of possible ratios
A financial ratio is meaningful only in comparison to some standard or tendency
While comparing to another firm remember about possible differences in accounting techniques and ratios names.

Financial ratios
Advantages of financial ratios:
Possible to compare companies and projects of different sizes
Just several ratios can provide a relatively full information about the performance of the company
Show relationship between earnings, disbursements, assets, equity and liabilities
Easy to calculate

Financial ratios
Disadvantages of financial ratios:
Strongly depend on accuracy of reports
Don’t analyze absolute values of sales, profit, used capital
Difficult to find a standard or a base for comparison
Ratios based on annual reports don’t show the company’s performance during the year
Don’t consider sudden changes on the market or inflation

Financial ratios
Users of financial analysis results:

FIVE GROUPS OF FINANCIAL RAIOS

Financial ratios
Five groups of financial ratios
Profitability
Liquidity
Activity
Financial
leverage
Market
based

Liquidity ratios
Liquidity ratios indicate a firm’s ability to meet short-term financial obligations.
Current ratio=Current assets /
Current liabilities
>2
Quick ratio=(Current assets-
Inventories) / Current liabilities
>0.9-1.0

Liquidity ratios
Aging schedule

Activity ratios
Activity ratios indicate how efficiently a firm is utilizing its assets to generate the sales.
Asset turnover = Sales / Av.asset
Turnover period = Av.asset/Daily sales
Av.asset = (Beg.asset+End.asset)/2

Activity ratios
Average collection period = Accounts receivable/
(Annual credit sales/365)
Inventory turnover =
Costs of sales /Average inventory
Fixed-asset turnover =
Sales / Net fixed assets
Total asset turnover =
Sales / Total assets

Financial leverage ratios
Financial leverage ratios measure the degree to which a firm is financing its assets with fixed-charge sources of funds such as debt, preferred stock, or leases
Debt ratio = Total debt/Total assets
Debt-to-equity =
Total debt / Total equity

Financial leverage ratios
Financial leverage rule:
if the rate of return on equity exceed the cost of the borrowed funds (interest rate) – the more is the share of the debt, the more is return on assets
ROI>i : ?debt → ?ROE
if the rate of return on equity is lower than the cost of the borrowed funds – the more is the share of debt, the lower is return on assets
ROI

Profitability ratios
Profitability ratios measure the total effectiveness of a company’s management in generating profits.
Gross profit margin =
(Sales - Cost of sales) / Sales
Net profit margin = EAT / Sales
Return on investment (ROI) =
EAT / Total investments
Return on stockholders’ equity(ROE) = EAT / Stockholders’ equity
Return on assets (ROA) =
EAT / Total assets

Market-based ratios
Market-based ratios measure the market’s (investor’s) assessment of the risk and performance of a firm.
P/E = Market price per share / Current earnings per share
P/BV = Market price per share / Book value per share

SOME METHODS OF FINANCIAL ANALYSIS

Methods of financial analysis
Vertical analysis – structure analysis of a company’s statements
Horizontal analysis – comparison of a company’s statements through several periods
Trend analysis – comparison of a company’s results to a basic period or industry standards
DuPont chart – profitability analysis
Factor analysis – assessment of the most important factors influencing ROE
Z-analysis – forecasting probability of bankruptcy

Trend analysis
Steps of the trend analysis:
Choose a ratio
Choose a basic period / find industry standards
Find information on the previous periods
Draw a trend for the previous periods
Analyze the trend comparing to the basic period or industry standard
Make forecast for the future periods and draw the results at the trend

Trend analysis
Ratio value
Industry standard

DuPont Chart analysis
ROI = NPM * TAT
ROE = NPM * TAT * EM

DuPont Chart analysis
Net profit margin
4,45%
Total Asset Turnover
1,377
Earnings after taxes
$5,016
Sales
$112,760
Sales
$112,760
Total assets
$81,890
Sales
$112,760
Total Expenses
Cost of sales
$85,300
Operating expenses
$15,940
Interest Charges
$3,160
Income taxes
$3,344
Current Assets
ROI
6,13%
Cash
$2,540
Marketable securities
$1,800
Accounts receiv.
$18,320
Invento-ries
$27,530
Net plant and equipment
$31,700
Total Assets to stockholders’ equity
2,382
ROE
14,60%

Factor analysis

Factor analysis

Z-analysis

CASH FLOW MANAGEMENT

NET CASH FLOW

Cash as a company’s working capital

Cash as a company’s working capital
Cash volume depends on:
Production phase
Sales
Collection of accounts receivable
Capital expenditures
Financing

Cash as a company’s working capital
Control of a cash rest
Cash
rest,
RUR
External limit
External limit
Internal limit
Internal limit
Target cash rest
Time, days

Cash as a company’s working capital
Cash turnover cycle

Accounts
payable
payment
period
Accounts
receivable
collection
period
Cash as a company’s working capital
Cash turnover cycle
Inventories
lifetime
Cash
turnover
cycle

Statement of cash sources & disbursements
Cash sources
Current assets reduction (excl. cash)
Fixed assets reduction
Liabilities increase
Proceeds from sales of shares
Cash acquired through operating activity
Cash disbursements:
Current assts increase (excl. cash)
Fixed assts increase
Liabilities reduction
Acquisition of shares
Dividends

Depreciation
Depreciation norm depends on:
Initial
Lifetime:
Technical
Effective
Rest cost
Method of depreciation:
Straight line
Accelerated

Depreciation
Straight-line
Accelerated

Deferred taxes
Straight-line
Accelerated

Deferred taxes

CASH FLOW FORECASTING

Forecasting of financial statements
5 steps:
Define basic data for forecasting:
external
income tax rate
interest rate
inflation
technological changes
volume of the market and growth perspectives
competition level
market strength of suppliers and customers…

Forecasting of financial statements
internal:
investments policy
external financing policy
accounting policy
dividend policy
planned profitability level
cost structure
asset base and structure
sources of funds structure

Forecasting of financial statements
Forecast the volume of sales
bottom-up forecasting
statistics analysis
marketing analysis
Forecast other items of the statements
variable & fixed costs
balance items depending on sales
cash flow
Prepare pro-forma financial statements

Forecasting of financial statements
Analysis of pro forma financial statements
Cash flows
Additional financing & sources
Reinvestment possibilities
Profit/risk analysis
Sales/costs analysis
General financial performance
Financial leverage

Percentage of sales forecasting method
The percentage of sales forecasting method:
permits a company to forecast the amount of financing it will need for a given increase of sales
while sales increase, increase company’s assets and liabilities
the difference between the forecasted asset increase and the forecasted current liability is equal to the total financing the company will need.

Percentage of sales forecasting method
Internal net cash provided = Forecasted CF - Dividends

Percentage of sales forecasting method
To support the sales increase the management of the company has to decide whether to
(1) borrow on a short-term basis,
(2) to borrow on a long-term basis,
(3) sell additional common stock, or
(4) cut dividends.

Budgeting
Five steps in preparing a budget

COSTS PLANNING

Types of costs
Variable costs are expenses that change in proportion to the volume of production:
Materials
Labor
Fixed costs are business expenses that are not dependent on the activities of the business:
Heating
Water for non-production purposes
Salaries
Selling & administrative expenses…
Semi variable cost is an expense which contains both a fixed cost component and a variable cost component.:
Electricity
Communication means…

Types of costs
Dependence of per unit cost on the volume of production
Per unit cost,
RUR
Quantity, units

Types of costs
Total costs / quantity
TC =
FC + (VC*Q)
Total costs, RUR
Quantity, units
Fixed costs
Semi variable costs
Variable costs
Total costs

Cost structure
A cost is the value of money that has been used up to produce something
Direct costs are those for activities or services that benefit specific projects
Indirect costs are those for activities or services that benefit more than one project.

Cost structure
Costs usually charged directly
Project staff
Consultants
Project supplies
Publications
Travel
Training
Costs either charged directly or allocated indirectly
Telephone charges
Computer use
Project clerical personnel
Postage and printing
Miscellaneous office supplies
Costs usually allocated indirectly
Utilities
Rent
Audit and legal
Administrative staff
Equipment rental