FINANCIAL ANALYSIS

                                                                       

Academic year: 2009-2010

Professor: André Cabannes

 

Duration: 1 hour 30 minutes

 

Books and class notes forbidden

Computers forbidden

Hand held calculators (including scientific ones) allowed

Write your name in the box :

 

 

 

 

 

 

 

 

 


 

 


FINANCIAL ANALYSIS

2nd semester

 

Write your answers in the blank space below each question.

 

Question 1: In general accounting, explain what we call “revenue accounts” and what we call “capital accounts”.

 

Revenue accounts are accounts recording sales and consumptions during the accounting period under study. For instance :

-         work consumed (which correspond to salaries paid),

-         right to occupy premises (which correspond to rent paid),

-         raw materials,

-         current expenditures,

-         but also depreciation of the year,

-         provisions for bad clients, etc.

 

All the revenue accounts balances, for a given period, form the Income Statement:

 

Sales – [ all consumptions + adjustments ] =  Net profit or loss.

 

Capital accounts are all the other accounts. Their balances end up in the Balance Sheet, plus the balance of the Income Statement (that is the Net profit or loss).

 

 

 

Question 2: If the balance sheet of a firm has a total of 120 million euros (= total assets, and  = total liabilities), and the “free debt” is 35 million euros, and the Net Fixed Assets are 50 million euros, what is the amount of the Working Capital? (Don’t just give a figure, explain your answer.)

 

Working capital = Capital employed – Net fixed assets.

 

Capital employed = Equity + Costly debt = Total liabilities – Free debt

 

So CE = 85 mio euros.

 

And WC = 85 - 50 = 35 mio euros.

 

 

 

 

Question 3: Explain what is the Working Capital, and why it bears this name.

 

The Working capital is the part of the Capital employed which finances something else than the Net fixed assets. (It can be negative.)

 

It is called Working capital, because – if we assimilate “capital” to only the “capital employed” that is capital which needs to be remunerated one way or another – it is the part of the “capital” that is not for fixed assets, but is “working” (stocks, possibly a part of the clients).

 

 

 

Question 4: At the end of its first year of operation, the Trial balance of a firm (before adjustments) is this

 

 

At the end of the year, we make the following adjustments:

  1. yearly depreciation of the van: 600 euros
  2. opening stocks = 0; closing stocks = 2000 euros

 

What are the two accounts we have to create to post the yearly depreciation of 600 euros?

 

We create an account “Yearly depreciation IS”, debited 600 euros, and an account “Yearly depreciation BS”, credited 600 euros.

 

This second account will be renamed “Cumulated depreciation”, and will stay, in the balance sheet, filled with figures from one year to the next.

 

 

What are the two accounts we have to create to post the measurement (after inventory) of the closing stocks of 2000 euros?

 

We create an account “Closing stocks IS”, credited 2000 euros, and an account “Closing stocks BS”, debited 2000 euros.

 

We also may want to create an account “Opening stocks IS”, which receives no entry since this is the first year of operations.

 

Next year, the “Closing stocks BS” will become the “Opening stocks IS”.

 

 

 

Question 5: (question 4 cont’d) Fill in the balance sheet

 

balance sheet

assets

 

liabilities

accounts

debit

credit

 

accounts

debit

credit

 Machinery

0

 

 

 Capital

 

 10 000

 Van

3 000

 

 

 Cum ret. earnings

 

 900

 Cum dep

 

 600

 

 Long term loans

 

0

 Stocks

2 000

 

 

 Creditors

 

6 500

 Clients

1 000

 

 

 

 

 

 Bank & Cash

12 000

 

 

 

 

 

 

 

 

 

 

 

 

total

18 000

600

 

total

 

17 400

 

To plug in the “Cumulated retained earnings” figure requires to have solved question 6.

 

 

 

Question 6: (question 4 cont’d) Fill in the income statement

 

Income statement

accounts

 

debit

credit

 Sales

 

 

9 000

 Opening stocks

 

0

 

 Purchases

 

7 000

 

 Closing stocks IS

 

 

2 000

 

 

 

 

 

 

 

 

gross margin

 

 

4 000

 Salaries

 

0

 

 Rent

 

1 000

 

 Shop expenses

 

1 500

 

 Yearly depreciation

 

600

 

 

 

 

 

profit or loss

 

 

900

 

 

 

 

Question 7: (this exercise is no longer the continuation of question 4) At the end of last year, a firm has a result before interest and taxes of 90 million euros. And its balance sheet (in million of euros) is this:

 

 

What is the ROCE?

 

ROCE = Result before interest and taxes / Capital employed

 

= 90 / 580 = 15,5%

 

(Since, we have only the ending balance sheet, we cannot average the capital employed at the beginning of the year, and the capital employed at the end of the year. So, we use only the CE at the end of the year.)

 

 

 

Question 8: (question 7 cont’d) What is the current ratio?

 

Current ratio = Current assets / Current liabilities = 520 / 160 = 3,25

 

Is this ratio a good figure? What can you say about the management of its free debt by the firm?

 

Generally speaking, this figure is too high. A good figure is around 1. The management does not use enough of its possibilities of “free debt”, which means that it uses “costly debt” to finance a part of its assets, when it is not necessary.

 

Of course, when a firm begins, it doesn’t have access to much free debt. So our comment is very general, and doesn’t apply all the time.

 

 

 

Question 9: Is it possible that a firm see its cash position increase between the beginning and the end of an exercise, and yet the firm make a loss in its income statement? Explain.

 

Yes.

 

The variation of cash in the till is not directly related to the profit or loss. The profit or loss, during the accounting period, is only the change in Equity, provided there was no raising of new capital.

 

It is possible to make a loss, and yet have its cash position increase. It is sufficient for that to sell some assets.

 

 

 

Question 10: A firm F sells for 100 euros on credit to G some product that was recorded in F’s stocks with the value 40 euros. Explain the “income statement” for just this transaction, and the impact on F’s balance sheet.

 

Income statement:

Sales = 100

Opening stocks – Closing stocks = 40

Purchases = 0

Other costs = none

Net profit = 60

 

Balance sheet:

 

Asset side:

Stocks decrease by 40

Clients increase by 100

 

Liability side:

Cumulated retained earnings increase by 60

 

 

 

Question 11: (from now on, questions in elementary finance) What is a financial product?

 

A financial product is a contract between two agents specifying movements of cash, between them, now and in the future, sometimes depending upon various conditions.

 

The movement now can be nil. But there must be movements agreed upon in the future.

 

The simplest example is agent A giving 1000 euros now to agent B, and B promising to give to A 50 euros every year for five years, and on the fifth year B also pays back to A 1000 euros.

 

Such a contract held by A to receive cash flows from B, can be resold later to agent C for a price which will depend on economic conditions at the time of the resale. In effect, A sells to C a stream of future cash flows. It can also be traded by B, it is usually called a swap: B will actually pay C to take charge of its payment responsibilities.

 

There are more complicated financial products. But they always encompass future cash flows (or possibilities of future cash flows) for one or both agents. Both agents can exchange their part of the contract for something else.

 

Another simple example is an insurance policy. Say A is the insurance company, and B is the policy holder. At the initial time, A pays nothing to B. B begins to pay a yearly premium to A. Should a damage occur to B, A will pay B a sum specified in the contract. Such a contract can be traded by A to C, as well as by B to C.

 

 

 

Question 12: An investor buys a bond issued by a firm. What are the two other names of the investor?

 

Lender (of money)

Buyer (of a security)

 

 

And what are the two other names of the issuer?

 

Borrower (of money)

Seller (of a security)

 

 

 

Question 13: A firm is considering making an investment, which will have the following cash flows:

 

C0 = 80 million euros (this is the money to be invested at the beginning)

 

and the three next cash flows will be money produced by the investment:

 

C1 = 30 million euros

C2 = 50 million euros

C3 = 50 million euros

 

 

What are the two fundamental discount rates attached to any investment?

 

The opportunity cost of capital. It is the yield of a security in the same class of risk as the investment.

 

The internal rate of return. It is a generalisation of the concept of profitability.

 

The Op. Cost of Cap. is an external piece of information, which is not obtainable from the figures above. We need more information about the investment and its environment to find it out.

 

The IRR is an internal piece of information (we also say “endogeneous”), which can be calculated from the figures above.

 

 

 

Question 14: (question 13 cont’d) Suppose we discount the cash flows with a discount rate of 10%. What is the NPV of the investment?

 

discount rate

 

10,00%

 

 

 

 

 

 

 

years

0

1

2

3

 

 

 

 

 

cf

-80,00

30,00

50,00

50,00

 

 

 

 

 

pv

-80,00

27,27

41,32

37,57

 

 

 

 

 

npv

26,16

 

 

 

 

 

 

 

Question 15: (question 13 cont’d) Suppose we discount now with a discount rate of 20%. What is the NPV, in that second case, of the investment?

 

discount rate

 

20,00%

 

 

 

 

 

 

 

years

0

1

2

3

 

 

 

 

 

cf

-80,00

30,00

50,00

50,00

 

 

 

 

 

pv

-80,00

25,00

34,72

28,94

 

 

 

 

 

npv

8,66

 

 

 

 

 

 

 

Question 16: (question 13 cont’d) Estimate the IRR of the investment. (Use geometry or any other method, but explain your estimation.)

 

By trial and error, we find IRR equals approximately 26,3%

 

 

 

Question 17: Two friends of yours have, each of them, an investment project and offer you to participate. Friend A offers you to invest 5000 euros in his project, and tells you you will receive 3000 euros after one year, and 3000 euros after two years. Friend B, with his own project, different from A’s, offers you the same cash flows: you invest 5000 and get 3000 et 3000.

 

Are the two projects necessarily equivalent for you from a financial point of view?

 

No.

 

Explain what other parameter must be taken into account to evaluate the projects.

 

It also depends on the risk of each project.

 

I’d rather lend 1000 euros at 10% to a reliable friend, than lend 1000 euros at 20% to a foolhardy one.

 

 

 

Question 18: You are offered to invest 7000 euros today, and get either

a) 10000 euros in two years, or

b) 5000 in one year and 5000 in three years.

 

Everything else being equal, which option do you prefer? Explain

 

Calculations show that b) is better than a).

 

This can be readily seen from the fact that what b) adds to a) (5000 earlier) is higher than what b) loses from a) (5000 later).

 

 

 

Question 19: Why was BKC, who wanted to bail out and take the control of Heuliez and had promised to bring 15 million euros of cash, eventually forced to give up? What did they bring instead of cash and why wasn’t it sufficient?

 

BKC was not able to bring the cash they had promised. Instead they offered client paper. But client paper is less liquid, and less sure, than cash. And if they weren’t able to transform their client paper into almost 15 mio euros, this proves that it wasn’t very good client paper.

 

 

 

Question 20: The public debt of France is approximately 1300 billions euros. Do you believe this debt will ever decrease in the future (either in absolute value, or as a percentage of France GDP)?

 

The teacher doesn’t believe that this debt will ever significantly decrease, either in absolute value or in percentage of the French GDP, in the future.

 

Rather, other financial and monetary phenomena will take place.

 

Which ones?

 

They will happen over the next 30 years, and be momentous:

-         rise of new private moneys (in new currencies, administered by large global firms),

-         loss of relevance of governments of nation-states (that were built over the last thousand years!), relinquishing of the present debt (which will become akin to “Russian bonds”),

-         profound evolution of our societies toward new social categories and relations,

-         and also some sort of new form of feudality.

 

 

What will be the likely consequences during your lifetime?

 

Be aware that your future will be strikingly different from what you know today.