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. 4
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131 12,411 (32,320) (19,795) 43,820 43,820
(30,091) 275,765
Total net assets

134 50,000 Share capital
135 Share premium account

137 Capital reserves
138 (37,589) Retained earnings (32,320) (19,795) 43,820 43,820
(30,091) 275,765 614,913 1,064,541 1,730,355
139 12,411 (32,320) (19,795) 43,820 43,820 614,913 1,064,541 1,730,355
(30,091) 275,765
Total net capital
141 0 Preference shares
142 12,411 (32,320) (30,091) (19,795) 43,820 43,820 275,765 614,913 1,064,541 1,730,355
Total equity
97




Figure 2.3 Case study “ Amanda “ 5-year plan “ Balance Sheet (prior to equity investment)
Accounting and Business Valuation Methods

Column L = J108
Column M =J108 + M46
Column N = M108 + N46
Column O = N108 + O46
Column P = O108 + P46
Line 109:
Column G = E109 + G35
Column H = G109 + H35
Column I = H109 + I35
Column J = I109 + J35
Column L = J109
Column M = L109 + M35
Column N = M109 + N35
Column O = N109 + O35
Column P = O109 + P35
Line 110: G = G108 ’ G109, H = H108 ’ H109, etc.
Line 112: G = G106 + G110, H = H106 + H110, etc.
Line 114: The ˜20™ in column D represents the number of stock days it is
envisaged the company will have at any one time.
Column G = round((((1/365) — (H70 — 4)) — D114),0)
Column H = round((((1/365) — (I70 — 4)) — D114),0)
Column I = round((((1/365) — (J70 — 4)) — D114),0)
Column J = round((((1/365) — (M70 — 1)) — D114),0)
Column L = J114
Column M = round((((1/365) — (N70 — 1)) — D114),0)
Column N = round((((1/365) — (O70 — 1)) — D114),0)
Column O = round((((1/365) — (P70 — 1)) — D114),0)
Column P = O114 — 1.15

Stock days are calculated on estimated future cost of sales, rather than on
historical cost of sales, as the concept is to assess how much stock is needed
to meet future demand. For this reason, it is impossible to calculate the stock
for year 5. Accordingly, the figure in the plan is simply the best guess.

Line 115: The ˜60™ in column D represents the number of debtor days it is
envisaged the company will have at any one time.
Column G = round((((1/365) — ((G12 + G52) — 4)) — D115),0)
Column H = round((((1/365) — ((H12 + H52) — 4)) — D115),0)


98
Capital structure and basic tools of analysis

Column I = round((((1/365) — ((I12 + I52) — 4)) — D115),0)
Column J = round((((1/365) — ((J12 + J52) — 4)) — D115),0)
Column L = J115
Column M = round((((1/365) — ((M12 + M52) — 1)) — D115),0)
Column N = round((((1/365) — ((N12 + N52) — 1)) — D115),0)
Column O = round((((1/365) — ((O12 + O52) — 1)) — D115),0)
Column P = round((((1/365) — ((P12 + P52) — 1)) — D115),0)
Line 116:
Column G = G117 ’ sum(G114 + G115)
Column H = H117 ’ sum(H114 + H115)
etc.
Line 117:
Column G = G123 + G125
Column H = H123 + H125
etc.
Line 119: The ˜30™ in column D represents the number of creditor days it is
envisaged the company will have at any one time.
Column G = round((((1/365) — ((G14 + G15 + G53) — 4)) — D119),0)
Column H = round((((1/365) — ((H14 + H15 + H53) — 4)) — D119),0)
Column I = round((((1/365) — ((I14 + I15 + I53) — 4)) — D119),0)
Column J = round((((1/365) — ((J14 + J15 + J53) — 4)) — D119),0)
Column L = J119
Column M = round((((1/365) — ((M14 + M15 + M53) — 1)) — D119),0)
Column N = round((((1/365) — ((N14 + N15 + N53) — 1)) — D119),0)
Column O = round((((1/365) — ((O14 + O15 + O53) — 1)) — D119),0)
Column P = round((((1.365) — ((P14 + P15 + P53) — 1)) — D119),0)
Line 120: It is assumed in this plan that VAT is paid (or rebated) quarterly
in arrears, so that VAT for January/February/March would be settled in
April and VAT for April/May/June would be settled in July, etc.
Column G = G56
Column H = H56
Column I = I56
Column J = J56
Column L = J120
Column M = round(((M52 ’ M53)/4),0)
Column N = round(((N52 ’ N53)/4),0)
Column O = round(((O52 ’ O53)/4),0)
Column P = round(((P52 ’ P53)/4),0)


99
Accounting and Business Valuation Methods

Line 121: When Amanda™s business is taken over, it is possible that arrange-
ments would be made to transfer the taxable losses to the new business
so that losses in Amanda™s first year could be offset against profits in the
second year. However, this plan does not allow for this complication for
the same reasons as before (see line 87). It is assumed that corporation
tax is paid annually in arrears.
Column G = G87
Column H = G87 + H87
Column I = sum(G87.I87)
Column J = sum(G87.J87)
Column L = J121
Column M = M87
Column N = N87
Column O = O87
Column P = P87
Line 122: Not shown in Figure 2.3, because at this stage there are no
dividends.
Line 123:
Column G = sum(G119.G122)
Column H = sum(H119.H122)
etc.
Line 125:
Column G = G128 ’ G112
Column H = H128 ’ H112
etc.
Line 128:
Column G = G130 + G131
Column H = H130 + H131
etc.
Line 130: The loans available in any one month are based on the asset
backing available at the prior month.
Column G = E159
Column H = G159
Column I = H159
Column J = I159
Column L = J130
Column M = L159




100
Capital structure and basic tools of analysis

N = M159
Column
O = N159
Column
P = O159
Column
Line 131:
G = G142
Column
H = H142
Column
etc.
Line 138:
G = E138 + G93
Column
H = G138 + H93
Column
I = H138 + I93
Column
J = I138 + J93
Column
L = J138
Column
M = L138 + M93
Column
N = M138 + N93
Column
O = N138 + O93
Column
P = O138 + P93
Column
Line 142:
G = G139 ’ G141
Column
H = H139 ’ H141
Column
etc.


Figure 2.4 shows the calculation of the availability of loan. The amount that
can be borrowed in the form of a loan will be dependent upon negotiations
with banks. Usually, banks will require some form of security and how much
they will lend against such security will again be subject to negotiation. As
discussed in Chapter 1, it is never wise to give a bank a personal guarantee,
nor is it sensible to offer security against personal assets, such as a house.
Accordingly, the usual form of security is to offer the bank a fixed and floating
charge against the assets of the business.

Each case will differ from the next, but Amanda™s 5-year plan is put together
on the basis that the amount the bank will lend will be equal to:


75% of net tangible assets +
80% of debtors +
20% of stock



101
Accounting and Business Valuation Methods
102




E G H I J L M N O P

Amanda Five Year Balance Sheet “ Calculation of loans and interest (prior to equity investment)

Prior Year Qu 1 Qu 2 Qu 3 Qu 4 Year 1 Year 2 Year 3 Year 4 Year 5
Line
Number £ £ £ £ £ £ £ £ £ £

Calculation of availability of loan

156 10,313 75% of net tangible assets 9,454 8,594 483,047 470,000 470,000 418,646 367,847 993,356 869,113
157 94,800 80% of debtors 78,904 94,685 142,290 231,321 231,321 249,146 350,959 544,110 775,890
158 19,152 20% of stock 6,685 7,364 10,586 12,122 12,122 16,351 24,504 33,600 38,640
159 124,265 95,043 110,643 635,924 713,442 713,442 684,143 743,311 1,571,066 1,683,643

161 Interest 2,330 1,782 2,075 11,924 18,111 53,508 51,311 55,748 117,830


Figure 2.4 Case study “ Amanda “ 5-year plan “ calculation of loans and interest (prior to equity investment)
Capital structure and basic tools of analysis

The formulae for Figure 2.4, are as follows:

Line 156:
Column G = G110 — 0.75
Column H = H110 — 0.75
etc.
Line 157:
Column G = G115 — 0.8
Column H = H115 — 0.8
etc.
Line 158:
Column G = G114 — 0.2
Column H = H114 — 0.2
etc.
Line 159:
Column G = sum(G156.G158)
Column H = sum(H156.H158)
etc.
Line 161: As with line 130, it is assumed that the maximum loan available
is based on the prior month™s security. The interest rate charged would
be subject to negotiation and would vary from one deal to the next, but
it is assumed for this plan that Amanda and her advisers have agreed an
annual interest rate of 7.5%.
Column G = round(((E159 — 0.075/4)),0)
Column H = round(((G159 — 0.075)/4)),0)
Column I = round(((H159 — 0.075)/4)),0)
Column J = round(((I159 — 0.075)/4)),0)
Column L = sum(G161.J161)
Column M = round((L159 — 0.075),0)
Column N = round((M159 — 0.075),0)
Column O = round((N159 — 0.075),0)
Column P = round((O159 — 0.075),0)



Case study “ Amanda “ the deal structure
Amanda and her advisers have, at this stage, prepared the following:

(1) A 5-year plan Earnings Statement; and
(2) A 5-year plan Balance Sheet.
103
Accounting and Business Valuation Methods

The amount of debt that will be available to the new business has also been
established.

The next step is to look along the ˜cash at bank™ line (line 116) in Figure 2.3. By
looking across at each column, we are looking for the column with the biggest
overdraft figure. This will tell us how much equity, net of costs, we must raise
to allow us to meet the objectives set in the plan.

Amanda™s advisers told her that she would need to raise roughly £1 million
and the costs associated with raising this money would equate roughly to 15%
of the amount raised. This sum would cover all legal and accountancy costs
associated with the deal.

Amanda™s solicitor confirmed, what he had told her before, that the amount
she required was too small for most venture capital firms that were focusing
on much larger deals. He knew of many business angels who would be willing
to invest the amount she needed, but the problem was that they would likely
want to be heavily involved in the business and to be in the position to control
it. This meant that they would likely want more than 75% of the equity.

If the share of the business that each party owned was based solely on the
capital put in, then Amanda would only own a very small proportion of the new
business. Clearly, at this level of ownership, she would have little incentive
to carry on. However, her solicitor explained to her that she had been very
lucky. He had found a seriously rich business angel from an oil-producing
country who ran his affairs as if he were a venture capital firm. He employed
experts in particular industries and these experts were appointed non-executive
Chairman in the company in which he made an investment. In addition, his
view was that the entrepreneurs who achieved high returns for him should be
aptly rewarded. On the other hand, he was wary of making investments where
the entrepreneur lacked total commitment to make the venture a success. To
achieve both these ends, all his investments involved the use of a deal structure.

Amanda had told her solicitor that by taking into account the net worth of her
business and additional borrowing she could raise, she could put £40 000 into
this business. On the basis of this he had agreed with the business angel:

• The assets and liabilities of Amanda™s original business would be trans-
ferred to the new company and the new company would pay Amanda
the net worth of her business.

104
Capital structure and basic tools of analysis

• The business angel would appoint a part-time non-executive chairman
who would help her to grow the business. The salary of this non-executive
chairman would be paid by the company.
• Amanda would be appointed Managing Director (an executive position)
of the new company at a salary to be agreed.
• The deal would be structured financially, as below.
Amanda was advised that she should discuss this deal structure with her
financial adviser so that she fully understood it and provided she agreed her
solicitor would go ahead and draw up the legal documents.
All deal structures are different and subject to individual negotiation, but in
each case the objectives remain the same:
(1) To offer the entrepreneur the incentive to work hard in the business, so
that the investor gets a good return.
(2) To protect the investor in the event that the business does not proceed
as planned for whatever reason.

The deal structure
The parties agreed that to prevent the business from coming under financial
pressure early on, the loan would be reduced to £100 000 in the first year.
Thereafter, it was to be reduced as cash flow would allow. The planned borrow-
ings were calculated as shown in Figure 2.7. It was agreed that the remaining
capital would be structured as below:

Amanda Business angel Total
£ £ £
25 pence ordinary shares 10 000 15 000 25 000
(for £1)
10% £1 Cumulative redeemable 800 000 800 000
preference shares
25 pence Convertible 35 000 35 000
redeemable preference shares
(for £1)
Share premium on ordinary 30 000 45 000 75 000
shares
Share premium on convertible 105 000 105 000
shares
Total provided by investors 40 000 1 000 000 1 040 000

105
Accounting and Business Valuation Methods

Under this deal structure, Amanda owns 40% of the business for putting in
just 3.8% of the capital, but there is a catch. She will achieve this objective
only if everything goes according to plan. The terms of the deal structure are
as follows:

• The cumulative redeemable preference shares can be redeemed in four
equal instalments, provided the company has sufficient funds to do this,
from the end of year two onwards.
• If by the end of year five any of the cumulative redeemable preference
shares remain unredeemed, then all of the convertible redeemable pref-
erence shares will be converted to ordinary shares on a one-for-one basis.
• Provided all the cumulative redeemable preference shares have been
redeemed at the end of year five, the parties should agree that they will
make arrangements to sell the business within the following 12 months.
The convertible redeemable preference shares will be redeemed at the
rate of 2.8% of the gross selling price and any remaining shares of this
class unredeemed will be converted to ordinary shares.

The effect of this deal structure can be worked out in advance, as the following
two examples illustrate:

(1) All the cumulative redeemable preference shares are redeemed and the
business is sold for £4 million during the year six.
112 000 of the convertible redeemable preference shares are redeemed,
leaving 28 000 shares to be converted to ordinary shares.

Amanda Business angel Total
Number of ordinary shares 40 000 88 000 128 000
% 31.25 68.75 100.00

(2) Things do not go as planned and only 600 000 of the cumulative
redeemable preference shares are redeemed at the end of year five.
The business angel™s 140 000 convertible redeemable preference shares
are converted to ordinary shares, so that the percentage owned by each
party is:

Amanda Business angel Total
Number of ordinary shares 40 000 200 000 240 000
% 16.67 83.33 100.00


106
Capital structure and basic tools of analysis

In addition, the business angel is a priority creditor in that the interest
due to date on the remaining 200 000 cumulative redeemable preference
shares will have to be paid and they will also have to be redeemed in
full before the business can be sold and the net proceeds shared out.

(3) Things go really badly and none of the redeemable preference shares
are redeemed at the end of year five.
The business angel™s 140 000 convertible redeemable preference shares
are converted to ordinary shares, so that the percentage owned by each
party is:

Amanda Business angel Total
Number of ordinary shares 40 000 200 000 240 000
% 16.67 83.33 100.00


In these circumstances, it is likely that the business would not be worth much
and what value there was would go to the priority creditors. In this case,
Amanda™s shares would probably be worthless.
However, the business plan assumes that the business is successful and that
the redeemable convertible preference shares will be redeemed in full by the
end of year five. Based on this capital structure, the 5-year plan is revised. This
is shown in Figures 2.5 and 2.6.
The actual cost of raising the capital is £165 000 and the bottom block of the
Balance Sheet (Figure 2.6) is put together on the following basis:

£ £
100 000 ordinary shares of 25 pence each 25 000
800 000 cumulative redeemable preference shares of £1 800 000
140 000 cumulative redeemable convertible preference 35 000
shares of 25 pence

Share premium on ordinary shares 75 000
Share premium on convertible shares 105 000
180 000
Less: cost of raising capital 165 000
Share premium account (net) 15 000


107
Accounting and Business Valuation Methods
108




G H I J L M N O P
E

Amanda Five Year Plan Earnings Statement

Qu 1 Qu 2 Qu 3 Qu 4 Year 1 Year 2 Year 3 Year 4 Year 5
Line
£ £ £ £ £ £ £ £ £
Number

68 Turnover 150,000 180,000 260,000 410,000 1,000,000 1,750,000 2,450,000 3,700,000 5,200,000

70 Cost of sales 124,500 152,500 168,000 241,500 686,500 1,106,120 1,492,000 2,236,000 3,066,000

72 Gross profit 25,500 27,500 92,000 168,500 313,500 643,880 958,000 1,464,000 2,134,000

74 Distribution 5,000 7,200 13,000 20,500 45,700 87,500 200,000 364,000 532,000
75 Administration 11,145 15,546 38,196 51,257 116,144 193,612 254,491 444,748 596,418

77 Operating profit before Exceptional items 9,355 4,754 40,804 96,743 151,656 362,768 503,509 655,252 1,005,582

79 Exceptional items 0 0 25,000 0 25,000 0 0 0 0

81 Operating profit after Exceptional items 9,355 4,754 15,804 96,743 126,656 362,768 503,509 655,252 1,005,582

83 Interest 1,875 1,875 1,875 1,875 7,500 0 3,750 30,000 3,750

85 Profit/(loss) before tax 7,480 2,879 13,929 94,868 119,156 362,768 499,759 625,252 1,001,832

87 Corporation tax 1,870 720 3,482 23,717 29,789 90,692 124,940 156,313 250,458

89 Earnings 5,610 2,159 10,447 71,151 89,367 272,076 374,819 468,939 751,374

91 Preference dividend 0 0 0 8,000 8,000 8,000 6,000 4,000 2,000

93 Earnings available to equity holders 5,610 2,159 10,447 63,151 81,367 264,076 368,819 464,939 749,374


Figure 2.5 Case study “ Amanda “ 5-year plan “ Earnings Statement
E G H I J L M N O P


Amanda Five Year Plan Balance Sheet

Prior Year Qu 1 Qu 2 Qu 3 Qu 4 Year 1 Year 2 Year 3 Year 4 Year 5
Line
Number Days £ £ £ £ £ £ £ £ £ £

106 25,000 25,000 25,000 25,000 25,000 25,000 25,000 25,000 25,000 25,000
Intangible Assets
108 20,000 Tangible assets 20,000 20,000 670,000 670,000 670,000 670,000 670,000 1,670,000 1,670,000
109 6,250 Depreciation to date 7,395 8,541 25,937 43,334 43,334 111,806 179,537 345,525 511,183
110 13,750 12,605 11,459 644,063 626,666 626,666 558,194 490,463 1,324,475 1,158,817
Net tangible assets
112 38,750 37,605 36,459 669,063 651,666 651,666 583,194 515,463 1,349,475 1,183,817
Total net fixed assets
114 95,761 Stock 33,425 36,822 52,932 60,609 60,609 81,753 122,521 168,000 193,200
20
115 118,500 Debtors 98,630 118,356 177,863 289,151 289,151 311,433 438,699 680,137 969,863
60
116 220 Cash at bank 817,580 808,613 18,309 161,391 161,391 221,225 423,378 50,048 273,108
117 214,481 949,635 963,791 249,104 511,151 511,151 614,411 984,598 898,185 1,436,171
Total current assets
119 43,200 Creditors 44,204 56,190 75,958 100,104 100,104 105,807 154,006 242,856 334,602
30
120 (2,380) VAT (1,855) (3,710) (119,490) 6,146 6,146 10,252 13,442 27,879 51,942
121 0 Corporation tax 1,870 2,590 6,072 29,789 29,789 90,692 124,940 156,313 250,458
122 0 Dividends 0 0 0 8,000 8,000 8,000 6,000 4,000 2,000
123 40,820 44,219 55,070 (37,460) 144,039 144,039 214,751 298,388 431,048 639,002
Total current liabilities
125 173,661 Net current assets/(liabilities) 905,416 908,721 286,564 367,112 367,112 399,660 686,210 467,137 797,169


128 212,411 Total assets less current liabilities 943,021 945,180 955,627 1,018,778 1,018,778 982,854 1,201,673 1,816,612 1,980,986




Capital structure and basic tools of analysis
130 200,000 Less: long term loans 100,000 100,000 100,000 100,000 100,000 0 50,000 400,000 50,000
131 12,411 843,021 845,180 855,627 918,778 918,778 982,854 1,151,673 1,416,612 1,930,986
Total net assets

134 50,000 Share capital “ Ordinary shares of 25p 25,000 25,000 25,000 25,000 25,000 25,000 25,000 25,000 25,000
135 Share premium account 15,000 15,000 15,000 15,000 15,000 15,000 15,000 15,000 15,000
136 10% £1 Cumulative Redeemable preference 800,000 800,000 800,000 800,000 800,000 600,000 400,000 200,000 0
shares
137 Convertible Redeemable preference shares 35,000 35,000 35,000 35,000 35,000 35,000 35,000 35,000 0
Capital reserves
138
139 (37,589) Retained earnings (31,979) (29,820) (19,373) 43,778 43,778 307,854 676,673 1,141,612 1,890,986
140 12,411 843,021 845,180 855,627 918,778 918,778 982,854 1,151,673 1,416,612 1,930,986
Total liabilities
142 0 Preference shares 835,000 835,000 835,000 835,000 835,000 635,000 435,000 235,000 0
143 8,021 10,180 20,627 83,778 83,778 347,854 716,673 1,181,612 1,930,986
12,411
Total equity

Figure 2.6 Case study “ Amanda “ 5-year plan “ Balance Sheet
109
Accounting and Business Valuation Methods

Figures 2.1 (base workings), 2.2 (earnings statement), 2.3 (Balance Sheet)
and 2.4 (calculation of the availability of loan) are copied across into the next
block.

If the base workings remain unchanged, then:

Figure 2.2 becomes Figure 2.5.
Figure 2.3 becomes Figure 2.6.
Figure 2.4 becomes Figure 2.7.

The formulae for Figure 2.5 are the same as that for Figure 2.2, except that line
83 is taken from line 66 (not line 161). Figure 2.5 is completed by inserting the
preference dividend based on the deal structure.

The formulae for Figure 2.6 are the same as that for Figure 2.3. Figure 2.6 is
completed by inserting the share capital and the share premium as per the deal
structure.

Figure 2.6, line 143:
Each column is calculated using the same formula, so:
Column G = G140 ’ G142
Column H = H140 ’ H142
etc.

Figure 2.7 is completed following completion of the deal structure, as discussed
above.




110
E G H I J L M N O P

Amanda Five Year Balance Sheet “ Calculation of loans and interest

Line Qu 1 Qu 2 Qu 3 Qu 4 Year 1 Year 2 Year 3 Year 4 Year 5
Prior Year
Days
Number £ £ £ £ £ £ £ £ £ £

Calculation of availability of loan

156 10,313 75% of net tangible assets 9,454 8,594 483,047 470,000 470,000 418,646 367,847 993,356 869,113
157 94,800 80% of debtors 78,904 94,685 142,290 231,321 231,321 249,146 350,959 544,110 775,890
158 19,152 20% of stock 6,685 7,364 10,586 12,122 12,122 16,351 24,504 33,600 38,640
159 124,265 95,043 110,643 635,924 713,442 713,442 684,143 743,311 1,571,066 1,683,643

161 (24,265) Less: Extra/Repayment 4,957 (10,643) (535,924) (613,442) (713,442) (634,143) (343,311) (1,521,066) (1,683,643)

163 100,000 Loan 100,000 100,000 100,000 100,000 0 50,000 400,000 50,000 0




Capital structure and basic tools of analysis
166 Interest 1,875 1,875 1,875 1,875 7,500 0 3,750 30,000 3,750


Figure 2.7 Case study “ Amanda “ 5-year plan “ calculation of loans and interest
111
Accounting and Business Valuation Methods

The Cash Flow Statement
In the days before the Accounting Standards Board (ASB) was set up, the
preparation of published accounts was left to the interpretation of what was
required by each board of Directors. As long as they complied with legisla-
tion and, for example, met with the requirements of what had to go into the
Directors™ Report, what accounts they presented was up to them.

Some companies did not publish a Cash Flow Statement and even if they did,
it did not appear in a standard format; this was a glaring omission and the first
major problem addressed by the ASB. Accordingly, in 1996 they published their
first FRS (Financial Reporting Standard) “ FRS 1 Cash Flow Statements. Upon
publication of this standard, all companies, except those exempted, had to pre-
pare a Cash Flow Statement in the prescribed format. These exemptions were:

(1) subsidiary undertakings where 90% or more of the voting rights are
controlled within the group, provided that consolidated financial state-
ments in which those subsidiary undertakings are included are publicly
available;
(2) mutual life assurance companies;
(3) pension funds;
(4) open-ended investment funds, subject to certain further conditions;
(5) for two years from the effective date of the FRS, building societies that,
as required by law, prepare a statement of source and application of
funds in a prescribed format; and
(6) small entities (based on the small companies exemption in companies
legislation).

(Source: FRS 1 “ Issued by the ASB in October 1996.)

As we will see in Chapter 4, the Cash Flow Statement is the saviour as it is
the one statement that cannot be manipulated. The Profit and Loss Accounts
is based on a series of judgements, likewise the Balance Sheet, but not the
Cash Flow Statement. Cash comes in and cash goes out; what has happened
cannot be changed. As long as a company™s cash book has been reconciled to
the bank statement, the balancing figures in the Cash Flow Statement (opening
and closing cash) will be correct.

The Cash Flow Statement is simply a summary showing how cash was gener-
ated and how it was spent in a given period. Once the Profit and Loss Account
and Balance Sheet are in hand, the Cash Flow Statement can be produced
entirely by using formulae.

112
Capital structure and basic tools of analysis

To prepare a Cash Flow Statement, every line from the ˜Operating Profit™ down-
wards in the Profit and Loss Account and every line in the Balance Sheet must
be used. The rules for preparing a Cash Flow Statement are simple:

(1) If the line used in the Profit and Loss Account does NOT also appear in
the Balance Sheet (such as ˜operating profit™), then the figure that goes
in the Cash Flow Statement is the same as that shown in the Profit and
Loss Account.
(2) If the line used in the Profit and Loss Account ALSO appears in the
Balance Sheet (such as ˜corporation tax™), then the figure that goes in
the Cash Flow Statement is:
Opening figure in Balance Sheet
PLUS: figure in Profit and Loss Account
LESS: Closing figure in the Balance Sheet;
(3) If the line used is NOT found in the Profit and Loss Account and appears
ONLY in the Balance Sheet (such as ˜stock™), then the figure that goes
in the Cash Flow Statement is the DIFFERENCE between the opening
and closing figure in the Balance Sheet.

The only remaining thing to work out for each line used is whether the figure
calculated is money generated or money spent. Again, simple rules make this
decision easy.

(1) If the figure is taken from the Profit and Loss Account only, then:
˜Operating profit™ = cash generated and ˜Operating loss™ = cash
expended
All other lines = cash expended;
(2) If the figure is taken from the Balance Sheet, then:
If assets increase, then cash has been expended; if assets decrease,
then cash has been generated;
If liabilities increase, then cash has been generated, if liabilities
decrease, then cash has been expended.

On a Cash Flow Statement, cash generated is shown as a plus (+) sign, while
cash expended is shown as a minus (’) sign.

Figure 2.8 shows the 5-year plan Cash Flow Statement. The formulae for
Figure 2.8 are shown below, but note that the lines quoted relate to Figures 2.5
and 2.6.

113
Accounting and Business Valuation Methods
114




E G H I J L M N O P

Amanda Five Year Plan Cash Flow Statement

Line Qu 1 Qu 2 Qu 3 Qu 4 Year 1 Year 2 Year 3 Year 4 Year 5
£ £ £ £ £ £ £ £ £
Number

Reconciliation of operating profit to net
cash inflow from operating activities

180 Operating profit 9,355 4,754 15,804 96,743 126,656 362,768 503,509 655,252 1,005,582

182 Amortisation of intangible assets 0 0 0 0 0 0 0 0 0
183 Depreciation of tangible assets 1,145 1,146 17,396 17,397 37,084 68,472 67,731 165,988 165,658

185 (Increase)/decrease in stocks 62,336 (3,397) (16,110) (7,677) 35,152 (21,144) (40,768) (45,479) (25,200)
186 (Increase)/decrease in debtors 19,870 (19,726) (59,507) (111,288) (170,651) (22,282) (127,266) (241,438) (289,726)
187 Increase/(decrease) in creditors 1,529 10,131 (96,012) 149,782 65,430 9,809 51,389 103,287 115,809

189 Net Cash Inflow/(Outflow) from Operating Activitie 94,235 (7,092) (138,429) 144,957 93,671 397,623 454,595 637,610 972,123

CASH FLOW STATEMENT

193 Net Cash Inflow/(Outflow) from Operating Activitie 94,235 (7,092) (138,429) 144,957 93,671 397,623 454,595 637,610 972,123

195 Return on Investment 0 0 0 0 0 0 0 0 0
196 Servicing of finance (1,875) (1,875) (1,875) (1,875) (7,500) 0 (3,750) (30,000) (3,750)
197 Taxation 0 0 0 0 0 (29,789) (90,692) (124,940) (156,313)
198 Capital expenditure 0 0 (650,000) 0 (650,000) 0 0 (1,000,000) 0
199 Dividends paid 0 0 0 0 0 (8,000) (8,000) (6,000) (4,000)

201 Net Cash Inflow/(Outflow) before Financing 92,360 (8,967) (790,304) 143,082 (563,829) 359,834 352,153 (523,330) 808,060

Financing “ issue/repayment of shares 825,000 0 0 0 825,000 (200,000) (200,000) (200,000) (235,000)
203
204 Financing “ Issue/repayment of loans (100,000) 0 1 0 (100,000) (100,000) 50,000 350,000 (350,000)
205 Increase/(decrease) in Cash 817,360 (8,967) (790,303) 143,082 161,171 59,834 202,153 (373,330) 223,060


Reconciliation of Cash Flow with
Cash Movements

211 Opening Cash 220 817,580 808,613 18,309 220 161,391 221,225 423,378 50,048
212 Closing Cash 817,580 808,613 18,309 161,391 161,391 221,225 423,378 50,048 273,108
213 Movement in Cash balances 817,360 (8,967) (790,303) 143,082 161,171 59,834 202,153 (373,330) 223,060


Figure 2.8 Case study “ Amanda “ 5-year plan “ Cash Flow Statement
Capital structure and basic tools of analysis

Line 180:
Column G = G81
Column H = H81
etc.
Line 182: Nil (0) inserted on all lines, as intangibles were not amortised.
Line 183:
Column G = G109 ’ E109
Column H = H109 ’ G109
Column I = I109 ’ H109
Column J = J109 ’ I109
Column L = sum(G183.J183)
Column M = M109 ’ l109
Column N = N109 ’ M109
Column O = O109 ’ N109
Column P = P109 ’ O109
Line 185:
Column G = E114 ’ G114
Column H = G114 ’ H114
Column I = H114 ’ I114
Column J = I114 ’ J114
Column L = sum(G185.J185)
Column M = L114 ’ M114
Column N = M114 ’ N114
Column O = N114 ’ O114
Column P = O114 ’ P114
Line 186 uses the same formulae as line 185, except line 114 becomes line
115, so:
Column G = E115 = G115
Column H = G115 ’ H115
etc.
Line 187:
Column G = G119 + G120 ’ E119 ’ E120
Column H = H119 + H120 ’ G119 ’ G120
Column I = I119 + I120 ’ H119 ’ H120
Column J = J119 + J120 ’ I119 ’ I120
Column L = sum(G187.J187)
Column M = M119 + M120 ’ L119 ’ L120
Column N = N119 + N190 ’ M119 ’ M120

115
Accounting and Business Valuation Methods

Column O = O119 + O120 ’ N119 ’ N120
Column P = P119 + P120 ’ O119 ’ O120
Line 189:
Column G = sum(G180.G187)
Column H = sum(H180.H187)
etc.
Line 193:
Column G = G189
Column H = H189
etc.
Line 195 is nil (0) on every line as there are no investments (shares in other
companies) in the plan.
Line 196:
Column G = ’ G83
Column H = ’ H83
etc.
Line 197:
Column G = ’ E121 ’ G87 + G121
Column H = ’ G121 ’ H87 + H121
Column I = ’H121’I87+I121
Column J = ’I121’J87+J121
Column L = sum(G197.J197)
Column M = ’L121’M87+M121
Column N = ’M121’N87+N121
Column O = ’N121’O87+O121
Column P = ’O121’P87+P121
Line 198:
Column G = E108 ’ G108
Column H = G108 ’ H108
Column I = H108 ’ I108
Column J = I108 ’ J108
Column L = sum(G108.J108)
Column M = L108 ’ M108
Column N = M108 ’ N108
Column O = N108 ’ O108
Column P = O108 ’ P108
Line 199:
Column G = ’ E122 ’ G91 + G122
Column H = ’ G122 ’ H91 + H122

116
Capital structure and basic tools of analysis

I = ’ H122 ’ I91 + I122
Column
J = ’ I122 ’ J91 + J122
Column
L = sum(G199.J199)
Column
M = ’ L122 ’ M91 + M122
Column
N = ’ M122 ’ N91 + N122
Column
O = ’ N122 ’ O91 + O122
Column
P = ’ O122 ’ P91 + P122
Column
Line 201:
G = sum(G193.G199)
Column
H = sum(H193.H199)
Column
etc.
Line 203:
G = sum(G134.G137) ’ sum(E134.E137)
Column
H = sum(H134.H137) ’ sum(G134.G137)
Column
I = sum(I134.I137) ’ sum(H134.H137)
Column
J = sum(J134.J137) ’ sum(I134.I137)
Column
L = sum(G203.J203)
Column
M = sum(M134.M137) ’ sum(L134.L137)
Column
N = sum(N134.N137) ’ sum(M134.M137)
Column
O = sum(O134.O137) ’ sum(N134.N137)
Column
P = sum(P134.P137) ’ sum(O134.O137)
Column
Line 204:
G = G130 ’ E130
Column
H = H130 ’ G130
Column
I = I130 ’ H130
Column
J = J130 ’ I130
Column
L = sum(G204.J204)
Column
M = M130 ’ L130
Column
N = N130 ’ M130
Column
O = O130 ’ N130
Column
P = P130 ’ O130
Column
Line 205:
G = sum(G201.G204)
Column
H = sum(H201.H204)
Column
etc.
Line 211:
G = E116
Column
H = G116
Column
etc.

117
Accounting and Business Valuation Methods

Line 212:
G = G116
Column
H = H116
Column
etc.
Line 213:
G = G212 ’ G211
Column
H = H212 ’ H211
Column
etc.

If we look at Figures 2.6 and 2.8, we can see that there is a very high cash bal-
ance in the first two quarters. The reason for this is that we have raised capital
ahead of our planned capital expenditure in the third quarter. As explained
earlier, the cash balances shown for later years are not likely to be accurate.
However, it must be remembered that this is a 5-year plan; in later years the
objective is merely to give a reasonable overview.



Capital structure summary and exit strategies
Small business starts with money put in by their owners and debt provided
by banks. If the amount of debt available is limited, then such business may
use hire purchase arrangements to finance the purchase of assets and/or debtor
discounting and the like to finance working capital.

As a business expands and becomes profitable, it will become easier to take
on debt, but such availability will not be limitless and there will come a point
when continued growth is not possible. At this time, the owners of the business
either have to shelve their growth plans or dilute their holding by taking on
equity.

Some business owners attempt to sell only a small proportion of their equity
by organising a sale through the EIS. The deal structures embedded in such
schemes usually mean that investors pay a far higher price for their shares
than the original owners, in return for tax relief. Whether a particular deal
structure between the buyers and sellers is reasonable or not will be a matter
of judgement, but from a buying perspective, the ability to fully understand
a prospectus is paramount. A big disadvantage from a buyer™s point of view,
unless the buyer is a business angel, is that not being connected with the
investment there is no possibility of influencing the way the business is run in
what could probably be described as a high-risk venture.

118
Capital structure and basic tools of analysis

Alternatively, small businesses might attempt to raise capital through venture
capital or private equity funds, the latter including business angels. In invest-
ment terms, the big difference between this and the EIS is that the investor is
usually in the position, through the deal structure, to control how the business
in run.
Private individuals who have insufficient funds to become business angels or to
participate in closed end funds run by the large venture capital companies can
invest in VCTs. This vehicle, attracting tax relief, has the advantage over the
EIS that their investment will be spread amongst several companies and they
have a fund manager looking after things. Nevertheless, VCTs can be high-risk
investments.
Those investing in venture capital will usually seek to exit from their invest-
ment in between 5 years and 10 years. Some investments will end in failure
and will be relatively worthless, while others may be more successful. Moder-
ately successful businesses might be sold through a trade sale, while the more
successful could float on AIM, while the most successful could float on the
full stock exchange.
Companies able to float on the full stock exchange will be assessed by credit
rating agencies to assess their credit worthiness. Companies with a good credit
rating will, in addition to obtaining secured debt from banks, be able to sell
unsecured debt to the general public in the form of bonds. Companies with a
poor credit rating will be able to sell debt to the general public only if they
offer a high rate of interest and such issues are known as ˜junk bonds™.
Large established companies able to raise both debt and equity without too
much trouble will decide the proportion they wish to have of each. This is the
subject of much academic debate, but the reality is that no two boards will
have exactly the same view.


Basic tools of analysis
Once Amanda™s company is up and running, she can compare her financial
results with those of her competitors operating in the same sector. The basic
tools of analysis to achieve this are straightforward and easy to calculate,
but their interpretation is much more difficult. How the various ratios are
calculated is shown below. All the ratios are based on Figure 2.9 “ A Food
Manufacturing Company. As discussed earlier, these ratios can be divided into
four sections and remembered by the acronym “ Pam Sir.

119
Accounting and Business Valuation Methods




A Food Manufacturing Company

31 Dec 06 31 Dec 05 31 Dec 04 31 Dec 03 31 Dec 02
Year ended
£™000 £™000 £™000 £™000 £™000

Turnover 128,500 127,197 105,035 80,892 53,056

Cost of sales 96,700 97,244 77,795 56,530 36,245

Gross profit 31,800 29,953 27,240 24,362 16,811

Distribution and Administration 24,968 23,119 19,592 18,592 12,845

Operating profit/(loss) before amortisation 6,832 6,834 7,648 5,770 3,966

Goodwill/amortisation/impairment/exceptional 1,750 1,787 940 890 440

Operating profit/(loss) 5,082 5,047 6,708 4,880 3,526
Interest payable/(receivable) 2,503 3,100 3,077 1,894 732
Tax on profits 875 590 1,101 1,126 1,265

Earnings 1,704 1,357 2,530 1,860 1,529
Dividends 200 173 150 135 123

Retained profit/(loss) for the year 1,504 1,184 2,380 1,725 1,406

Number of ordinary shares (™000) 86,500 86,500 86,500 84,800 82,100

31 Dec 06 31 Dec 05 31 Dec 04 31 Dec 03 31 Dec 02
Year ended
£™000 £™000 £™000 £™000 £™000

Intangible assets 32,206 33,956 35,743 31,700 22,963
Tangible Assets + other long term assets 61,660 67,400 66,896 41,637 25,600
Fixed Assets 93,866 101,356 102,639 73,337 48,563

Stock 9,720 10,100 8,600 6,600 3,942
Trade Debtors 21,417 30,114 19,894 15,267 10,541
Other debtors/current assets
Cash at bank 4,456 4,751 2,464 4,361 4,405
Total Current Assets 35,593 44,965 30,958 26,228 18,888

29,240 28,136 21,700 17,375 10,315
Trade creditors
3,635 3,200 2,685 2,100 1,543
Other creditors
4,200 9,200 5,000 4,200 3,145
Bank Overdraft and Loans
Total Current Liabilities 37,075 40,536 29,385 23,675 15,003

(1,482) 4,429 1,573 2,553 3,885
Net Current Assets/(Liabilities)

105,785 104,212 75,890 52,448
Total Assets less Current Liabilities 92,384

7,200 7,105 6,716 6,200 5,153
Other long term liabilities (creditors)
50,000 65,000 65,000 40,000 20,009
Long term debt

33,680 32,496 29,690 27,286
Net Assets 35,184

Share capital 3,632 3,632 3,632 3,560 3,446
Share premium account 18,024 18,024 18,024 17,670 17,105
Other capital reserves 2,030 2,030 2,030 2,030 2,030
Profit and Loss Account 11,498 9,994 8,810 6,430 4,705
Other revenue reserves
Equity shareholders™ funds 35,184 33,680 32,496 29,690 27,286

Net (Debt)/Funds (49,744) (69,449) (67,536) (39,839) (18,749)


Figure 2.9 A Food Manufacturing Co. “ Pro¬t and Loss Account and Balance Sheet




120
Capital structure and basic tools of analysis

Performance ratios
What we are looking for is evidence that the company we are reviewing is
innovating. This means that the company is sustaining growth by having a
sustained research plan and developing new ideas and products. It is possible
that growth comes about through the development of innovative concepts and
sometimes this means simply bringing the existing products to the market in a
novel way.

To sustain growth, companies must either be offering products as good as
their competitors, but at cheaper prices, or be offering superior products at
premium prices. Large companies can dominate the market by being the most
cost effective, while small companies have to be innovative to survive.

There are many ways of achieving increased profitability in the short term,
without spending money on research or being innovative, but such strategies
cannot be maintained in the long term. Methods of achieving this include
divesting unprofitable businesses, outsourcing and downsizing.

So, it is known that growth is the key to long-term success, but the objective of
using performance ratios is to assess if growth is being achieved and whether
it is likely to be sustainable or not.


Ratio “ turnover compound growth
This ratio calculates the compound growth in turnover.

2006 2005 2004 2003 2002
Turnover (£™000) 128 500 127 197 105 035 80 892 53 056
Compound growth (%) 24.7 33.8 41.1 52.5


Ratio “ gross pro¬t percentage
This ratio calculates the gross margin as a percentage of sales.

2006 2005 2004 2003 2002
Turnover (£™000) 128 500 127 197 105 035 80 892 53 056
Gross profit (£™000) 31 800 29 953 27 240 24 362 16 811
Percentage (%) 24.7 23.5 25.9 30.1 31.7



121
Accounting and Business Valuation Methods

Ratio “ gross pro¬t compound growth
This ratio calculates the compound growth in gross profit.

2006 2005 2004 2003 2002
Gross profit (£™000) 31 800 29 953 27 240 24 362 16 811
Compound growth (%) 17.3 21.2 27.3 44.9

Ratio “ operating pro¬t (before extraordinary items)
percentage
This ratio calculates the operating profit (before extraordinary items) as a per-
centage of sales.

2006 2005 2004 2003 2002
Turnover (£™000) 128 500 127 197 105 035 80 892 53 056
Operating profit (£™000) 6832 6834 7648 5770 3966
Percentage (%) 5.3 5.4 7.3 7.1 7.5

Ratio “ operating pro¬t (before extraordinary items)
compound growth
This ratio calculates the compound growth in gross profit.

2006 2005 2004 2003 2002
Operating profit (£™000) 6832 6834 7648 5770 3966
Compound growth (%) 14.6 19.9 39.1 45.5

Ratio “ operating pro¬t by employee
Some companies, often retail companies, divide their operating profit by the
average number of employees employed during the year to calculate how much
profit each employee has generated. The same calculation can be done for
turnover and gross profit.




122
Capital structure and basic tools of analysis

Ratio “ return on capital employed
This ratio assesses how well the company is utilising the capital available to
them.


2006 2005 2004 2003 2002
Operating profit (£™000) 6832 6834 7648 5770 3966
Capital employed (£™000) 92 384 105 785 104 212 75 890 52 448
ROCE (%) 7.4 6.5 7.3 7.6 7.6


As companies make new investments, we would expect the ROCE to fall in
the short term because it would take time for such investments to generate
profit. However, after this initial fall, ROCE should increase as profits come
through and should increase, at least in the short term, steeply upwards if
new investments are not made. However, where no new investments were
made over the years, we would expect stagnation to set in and profits to fall,
forcing ROCE in a downward spiral. In our example, ROCE has not increased
over the years, suggesting that the investments made in the earlier years were
disappointing.


Asset management ratios
The purpose of asset management ratios is to assess how well the directors of
the company are controlling the company™s assets.


Ratio “ current ratio
This ratio assesses the ability of the company to meet its short-term liabilities.
Current assets are divided by current liabilities to calculate the ratio. This
should be 1 or greater, as a ratio of less than 1 suggests that the company
cannot meet its everyday liabilities without resorting to bank borrowings.


2006 2005 2004 2003 2002
Current assets (£™000) 35 593 44 965 30 958 26 228 18 888
Current liabilities (£™000) 37 075 40 536 29 385 23 675 15 003
Ratio 0.96 1.11 1.05 1.11 1.26



123
Accounting and Business Valuation Methods

Ratio “ quick ratio
This ratio assesses the ability of the company to service its short-term liabilities
without the need to sell stock or resort to bank borrowings. Again, this ratio
should be 1 or greater, but a figure below this does not necessarily indicate
that there is a problem. For example, a hospitality company, such as a hotel
operator, will be able to negotiate credit terms with its suppliers but will expect
its customers to pay on departure. The result of this is that such companies
often have a quick ratio of less than 1, but can easily meet their short-term
liabilities as they fall due.

2006 2005 2004 2003 2002
CA (excl. stock) (£™000) 25 873 34 865 22 358 19 628 14 946
Current liabilities (£™000) 37 075 40 536 29 385 23 675 15 003
Ratio 0.70 0.86 0.76 0.83 1.00



Ratio “ stock days
Here the objective is to calculate how many days™ stock the company is hold-
ing. The formula to calculate this is stock divided by cost of sales, multiplied
by 365. ˜Cost of sales™ strictly relates to the direct costs of achieving the sales
and should not include allocated overheads, but the figure of ˜cost of sales™ in
published accounts will include all costs associated with bringing the goods
and services to the point they are available to the customer. Given this, the
number of days calculated from published accounts will be lower than the
real figure, but if we are consistent in calculating each year and peer com-
panies in the same way, it should be possible to be able to make a valid
judgement.

Stock days will vary by industry and the correct judgement can be made only
if the particular industry norm is known, but any sudden increase from one
year to the next warrants further investigation.

2006 2005 2004 2003 2002
Stock (£™000) 9720 10 100 8600 6600 3942
Cost of sales (£™000) 96 700 97 244 77 795 56 530 36 245
Days 37 38 40 43 40



124
Capital structure and basic tools of analysis

Ratio “ debtor days
The idea here is to work out how long it is taking the company to recover its
debts. A high number may indicate that the company is having credit control
problems, while taking the worse case scenario it could mean that the company
is taking sales before they are entitled to do so. The formula is debtors divided
by sales plus VAT on the sales multiplied by 365. The sales shown in published
accounts (other than certain ˜retail™ accounts, where sales plus VAT is shown,
prior to VAT on sales being deducted) exclude VAT, so VAT must be added to
calculate this ratio. However, there is no VAT on export sales, so to calculate
sales plus VAT, it will be necessary to do two different calculations. If this
split is unavailable and VAT is added to total sales, then the days calculated
will be slightly lower than the true figure. On the other hand, the figure for
˜trade debtors™ (the figure we should be using) may not be available, so we
have to use the figure shown as ˜debtors™ in the Balance Sheet. This will mean
that our calculation will show debtor days to be higher than they really are.
However, as with the stock calculation, consistency is the key to making the
right judgement. Also, it must be noted that we are primarily looking for the
change from one year to the next, not the absolute figure. Any figure taken in
isolation would only be a concern if it were very high.

2006 2005 2004 2003 2002
Debtors (£™000) 21 417 30 114 19 894 15 267 10 541
Sales + VAT (£™000) 150 988 149 456 123 416 95 048 62 341
Days 52 74 59 59 62

With regard to this example, the 2005 figure would cause concern, and had
debtor days gone out further in 2006, then such concern would have become
critical.


Structure ratios
The reason ˜structure™ ratios are calculated is to assess how risky the business
is in terms of its gearing and its ability to meet key liabilities. It must be
remembered that gearing is critical; companies are forced out of business when
they cannot meet their liabilities as they fall due. Failure to make a profit does
not cause a problem unless the losses are so great as to cause a cash problem.



125
Accounting and Business Valuation Methods

Interest cover
This ratio shows whether (all other things being equal) the company is gen-
erating sufficient profit to meet interest payments as they fall due. Sometimes
a company will be covenant with its bank that the interest cover ratio will be
maintained above a particular figure, so ˜interest cover™ can be a key ratio.

2006 2005 2004 2003 2002
Profit before interest (£™000) 5082 5047 6708 4880 3526
Interest (£™000) 2503 3100 3077 1894 732
Interest cover 2.0 1.6 2.2 2.6 4.8

In this example, the figure of 1.6 in 2005 would likely have caused the bank
concern and may explain why there was no capital expenditure in 2006.


Gearing ratio
The gearing ratio expresses long-term debt as a percentage of total capital
employed. Any figure greater than 50% is considered to be high geared and
therefore high risk.

2006 2005 2004 2003 2002
Long term debt (£™000) 57 200 72 105 71 716 46 200 25 162
Capital employed (£™000) 92 384 105 785 104 212 75 890 52 448
Gearing % 61.9 68.2 68.8 60.9 48.0


Debt to equity ratio
The debt to equity ratio is similar to the gearing ratio but in this case a figure
greater than 100% is considered to be high geared.
2006 2005 2004 2003 2002
Long term debt (£™000) 57 200 72 105 71 716 46 200 25 162
Equity (£™000) 35 184 33 680 32 496 29 690 27 286
Debt to equity % 162.6 214.1 220.7 155.6 92.2


Investor ratios
Investor ratios look at the company from the perspective of the investor; in
other words, the holders of the equity shares.

126
Capital structure and basic tools of analysis

Return on equity
Whereas the ratio ˜return on capital employed™ assesses what the company has
achieved with the total capital available to it, the first investor ratio assesses how
much the company has earned for its investors compared to the money they put
in. That part of a company™s profit that belongs to the owners of the business is
called ˜earnings™ and this is compared with ˜equity shareholders™ funds.

2006 2005 2004 2003 2002
Earnings (£™000) 1704 1357 2530 1860 1529
Shareholders™ funds (£™000) 35 184 33 680 32 496 29 690 27 286
ROE (%) 4.8 4.0 7.8 6.3 5.6


Earnings per share
This ratio calculates how much each share has earned in a particular financial
year. Earnings per share (EPS) is usually declared in pence if the share is quoted
in sterling, or in cents if the share is quoted in euros.

2006 2005 2004 2003 2002
Earnings (£™000) 1704 1357 2530 1860 1529
Number of shares ˜000 86 500 86 500 86 500 84 800 82 100
EPS (pence) 2.0 1.6 2.9 2.2 1.9


Price/earnings ratio
This ratio is calculated by dividing the current price of the share by the EPS.
A P/E ratio of below 10 suggests that the market believes that there is likely
to be very little earnings growth in the future, while a very small P/E ratio
(7 or lower) suggests that the market believes that profitability will decline. As
the P/E goes higher (15 and above), the market forecast is that the company
will grow. A P/E of 100 + suggests the mammoth growth that is unlikely to be
sustained. Indeed P/Es above 100, last experienced in the dot-com boom, is an
indicator of a bubble that could burst at any moment.

2006 2005 2004 2003 2002
Price of share (pence) 41.0 44.0 38.0 45.0 35.0
EPS (pence) 2.0 1.6 2.9 2.2 1.9
P/E ratio 20.5 27.5 13.1 20.5 18.4

127
Accounting and Business Valuation Methods

Dividend cover
Some shareholders buy shares for income. In such cases, the amount of the
dividend is important and especially how it is covered. If the dividend is not
well covered, then there is the risk that it would be lowered in the future.

2006 2005 2004 2003 2002
Earnings (£™000) 1704 1357 2530 1860 1529
Dividends (£™000) 200 173 150 135 123
Dividend cover 8.5 7.8 16.9 13.8 12.4

In this example, although the cover has been dropping, the dividend is well
covered.

Dividend yield

2006 2005 2004 2003 2002
Price of share (pence) 41.0 44.0 38.0 45.0 35.0
Dividend per share (pence) 0.23 0.20 0.17 0.16 0.15
Dividend yield (%) 0.56 0.45 0.45 0.36 0.43

This example is clearly not what could be described as an ˜income share™!

Goodwill built into share
The idea here is to compare the value of the company as determined by the
current share price with the value as shown in the Balance Sheet.
2006 2005 2004 2003 2002
Number of shares ˜000 86 500 86 500 86 500 84 800 82 100
Price of share (pence) 41.0 44.0 38.0 45.0 35.0
Value of company (£™000) 35 465 38 080 32 870 38 160 28 735
Asset value (£™000) 35 184 33 680 32 496 29 690 27 286
Goodwill 281 4400 374 8470 1449
Goodwill (%) 0.8 13.1 1.2 28.5 5.3


The key ratios
The next chapter includes corporate governance and looks at some of the strate-
gies developed to ensure that companies produce accurate accounts, especially
in the light of high-profile cases such as Enron. The fact is though that Enron

128
Capital structure and basic tools of analysis

was an isolated example where the directors of the company acted fraudu-
lently; accounts are usually inaccurate due to errors of judgement rather than
criminal activity.

The difficulty for investors is, that while ratio analysis can draw attention
to problem areas, they are not privy to the internal management accounts
and therefore have to make judgements based on limited information. Nor
can investors know whether a particular management team is on top of the
problem or not; if they are, the problem indicated by the adverse ratio could
go away. However, there are a few cases that crop up each year where the
adverse ratio has predicted a major problem area before it has become a public
knowledge.

The key ratios to look at with a view to spotting potential disasters are all asset
management ratios and are to do with stock, debtors and cash.



Cash is king
If a company is making a profit, it should be generating cash. If it is not,
this is an indicator that something is wrong. The company may spend more
than it earns to buy assets to grow the company and, of course, this is accept-
able, but growth must follow this expenditure. Also, this expenditure must
improve cash generation in the long term, so eventually even growing compa-
nies should generate cash. However, where companies are not buying assets,
but merely consuming cash to fund short-term increases in working capital due
to growth, this can result in ˜overtrading™ and liquidity problems. So, if a com-
pany consistently, year on year, spends more money than it is generating, then
it is an indicator that something may be wrong. This, of course, is especially
dangerous where the company was highly indebted before the growth took
place.

Jarvis plc is a prime example of what can happen when overtrading takes place.
At the company™s year end close at 31 March 2000, intangible assets accounted
for 87% of equity shareholders™ funds (£179 million) and net debt stood at
£118 million. In its 2001 financial year, the company generated £42 million
against earnings of £15 million, so all seemed well, except that the dividend
was covered only 1.1 times. However, it was the 2002 result that should have
caused readers of accounts some concern. Turnover went up by 29% compared
to the previous year and although stock days and debtor days were virtually

129
Accounting and Business Valuation Methods

unchanged, net debt went up to £80 million, despite earnings doubling to
£31 million. At the same time, the company was being blamed for the crash at
Potters Bar and although the company denied this allegation, it came on top of
a weak Balance Sheet.

Many companies suffer problems of the type faced by Jarvis plc (accusations of
doing something wrong in the course of business) and no business is without
risk, but when things go wrong it is the companies that are indebted that are
the most vulnerable. Jarvis™s shares trading at around 334 pence in 2002 ended
below one penny a few years later. So, cash is king.

The first test that needs to be carried out is the ˜Cash Test™. To do this, ˜Net
Cash Inflow from Operations™ (operating activities in UK GAAP accounts) in
the Cash Flow Statement is compared to the ˜Operating Profit™ in the Profit and
Loss Account. ˜Net Cash Inflow from Operations™ should nearly (see exceptions
below) always be higher than the ˜operating profit™, because the cash flow
figure is simply operating profit plus depreciation plus amortisation plus or
minus movement in working capital. If the cash flow figure is lower than
operating profit, the cause may be overtrading and/or poor asset management.
The calculation of stock days and debtor days might provide the necessary
clues.

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