International Financial Management - Lecture 6

• Current assets are the most liquid
• Trade receivables are amounts not yet collected from customers for goods or services sold to them
• Inventories are composed of raw materials 
• Non-current assets are the least liquid kind of assets
• Tangible non-current assets include property, plant, and equipment and do not convert to cash from normal business activity
• Intangible non-current assets have no physical existence but can be very valuable (ex: trademark, patent)

• Liabilities are debts (contractual obligations to be repaid)
• Shareholders' equity is the residual difference between assets and liabilities
• Assets - Liabilities = Shareholder's Equity 
• Shareholder's equity can then be understood also as shareholders' ownership

• The accounting value of a firm's assets is frequently referred to as the book value of the assets
• Market or fair value is the price at which willing buyers and sellers would trade the assets

• It measures performance over a specific period
• It is NOT the same as a balance sheet
• The accounting definition is: Reveue - Expenses = Income
• Metaphor: if the balance sheet is like a snapshot, the income statement is like a video recording of what the firm did between two snapshots

• Operations section: Reports the firm's revenues and expenses from principal operations
• Non-operating section: includes all financing costs, such as interest expense
• Then, a second section reports as a separate item the amount of taxes levied on income
• The bottom line: (net income) frequently expressed per share of equity or earnings per share

• they are expenses against revenues but do not affect cash flow 
• the most important is depreciation
• depreciation deflects the accountant's estimate of the cost of equipment used up in the production process
• another one is deferred taxes
• deferred taxes result from differences between accounting income and true taxable income 

Depreciation is a non-cash item that reflects the accountant's estimate of the cost of equipment used up in the production process

• Deferred taxes are a non-cash item that results from differences between accounting income and true taxable income
• If taxable income is less than accounting income in the current year, it will be more than accounting income later on
• Consequently, the taxes that are not paid today will have to be paid in the future (deferred tax liability)

• Often split into two: the short run and the long run
• the short run is the period in which certain equipment, resources and commitments of the firm are fixed, and is not a precise period that will be the same for all industries
  • Short run is long enough to vary its output by using more labor and raw materials
  • It entails fixed costs and variable costs
• in the long run, all costs are variable and the accounting costs fit into a classification that distinguishes product costs from period costs

• Taxes can be one of the largest cash outflows a firm experiences
• determined by the tax code 
• corporate taxes are not normally arithmetic deduction from profit before taxes 
• Almost all countries in the world allow firms to carry forward losses they have made in the previous year to offset their tax bill in the future 

• Average tax rate: is the tax bill divided by the taxable income i.e. the percentage of the income that goes to pay taxes
• Marginal tax rate: is the tax that would have to be paid if one more unit of currency was earned
• with a flat-rate tax, there is only one tax rate for all income levels
• Any new cash flows will be taxes at the marginal rate tax

• It is current assets minus current liabilities
• It is positive when current assets are greater than current liabilities
• In addition to investing in fixed assets, a firm can invest in net working capital 
• The change in net working capital is usually positive in a growing firm

• Cash flow is the most important item that can be extracted from financial statements 
• It works to get an idea of liquidity
• It is usually the third part of an annual report

• It is an official accounting statement that helps to explain the change in accounting cash and equivalents
• Cash flow is not the same as net working capital
• The cash flow received from the firm's assets CF(A), must be equal to the cash flows to the firm's creditors CF(B), and equity investors CF(S):
  • CF(A) = CF(B) + CF(S)

• First you need to figure out the operating cash flow (or also known as the net cash provided by operating activities)
• Another important component is the changes in cash flow from investing activities
  • this component = acquisition of non-current assets + any security investment - the sales of non-current assets 
• the result is the cash flow used for investment purposes

• They could be for investment purposes or for financing purposes
• financing purposes examples: firm buying back its own shares, issuing new shared to the market, increasing or decreasing borrowing

It is the cash flow generated by business activities, including sales of goods and services, and reflects tax payments, but not financing, capital spending, or changes in net working capital

• Operating cash flow: measures the cash generated from operations (not counting cash flows arising from investment expenditure or financing) and is usually positive
• Total cash flow of the firm: includes adjustments for capital spending and new financing, and will be frequently negative
• **profit is not cash flow
• a firm's total cash flow is called free cash flow 

• Comparing annual reports or financial statements of one company with another one is often times tricky, as you might be dealing with different currencies, rules, countries, etc
• Therefore, standardizing statements work as a solution to such obstacles in order for us to be able to compare to competitors and other companies

• The goal of the accountant is to report financial information to the user in a form useful for decision-making
• One important thing is to be able to compare to those statements of similar companies
• Size differences, country, currency
• One common and useful way of doing this is to work with percentages instead of total monetary amounts
  • we call this the common-size statements
• Common size statements of financial position express each item as a percentage of total assets, whereas common size income statements express each item as a percentage of total revenues 

• One way to choose an appropriate benchmark is to apply time trend analysis and use history as a standard 
• a second way is to apply peer group analysis and to identify peer groups that consist of firms similar in the sense that they compete in the same markets, have similar assets, and operate in similar ways
  • one common way to identify "peers" is: SIC Codes - Standard Industrial Classification 
  • there are 21 categories (industry groups), the first digit establishes the general type of business

• there is no underlying theory to help us identify which quantities to look at and guide us in establishing benchmarks
• many firms are conglomerates
• peer group analysis is going to work best when sticking to one same line of business
• major competitors and natural peep group members may be scattered around the globe
• different standards and procedures makes it difficult to compare across national borders
• firms using different accounting procedures, ending fiscal years at different times, unusual or transient events

Another way is to calculate/compare financial ratios

• They are ways of comparing and investigating the relationship between different pieces of financial information 
• one problem with ratios is that different people and different sources frequently do not compute them in exactly the same way 
• If ratios are used, it should be documented how these ratios have been calculated 

• Short-term solvency or liquidity ratios
• Long-term or financial leverage ratios
• Asset management or turnover ratios
• Profitability ratios
• Market value ratios

• Short-term solvency ratios as a group are intended to provide information about a firm's liquidity 
• Primary concern is the firm's ability to pay its bills over the short run without undue stress
• these ratios focus on current assets and current liabilities 
• Liquidity ratios are particularly interesting to short-term creditors 
• current assets and liabilities change rapidly, so today's amounts may not be a reliable guide to the future

• Current ratio = Current assets / current liabilities 
• (Current ratio equals current assets divided by current liabilities)
• a high current ratio indicates liquidity, but it may also indicate an inefficient use of cash and other short-term assets
• we would expect to see a current ratio of at least 1
• a current ratio of less than 1 would mean that net working capital is negative 

• Relatively large inventories are often a sign of short-term trouble
  • Inventory is often the least liquid current asset
• the firm may have a substantial portion of its liquidity tied up in slow-moving inventory
• Quick or acid-test ratio is as follows:
  • Quick ratio = (current assets - inventory) / current liabilities
  • Quick ratio equals current assets minus inventory, divided by current liabilities

• a very short-term creditor might be interested in the cash ratio
• cash ratio = cash and cash equivalents / current liabilities
• this is a extremely conservative measurement for liquidity

Long-term solvency ratios are intended to address the firm's long-run ability to meet its obligations or more generally, its financial leverage 

• It takes into account all debts of all maturities to all creditors 
• Total debt ratio = (total assets - total equity) / total assets
• we can define two useful variations on the total debt ratio: the debt-eqiuty ratio and the equity multiplier 
• Debt equity ratio = total debt / total equity
• Equity multiplier = total assets / total equity

• it is also known as the earnings before interest and taxes (EBIT)
• you must calculate the operating profit plus any non-operating income
• Times interest earned ratio = EBIT / Interest
• for example, a ratio of 8.3 means that we have enough to cover our interests 8.3 times its value
• it is therefore also called the interest coverage ratio

Because the result we obtain from the times interest earned ratio can be interpreted as the amount of times that a firm can cover their interests

A ratio of 6.7 means they can cover their interests 6.7 times

• The cash coverage ratio is = (EBIT + Depreciation) / interest
• Can also be written as EBITD / Interest
• the reason why is that the EBIT is not really a measure of cash available to pay interest
  • which is the case of the times interest earned ratio
• as an improvement, in the cash coverage, we include depreciation