FINANCE FOR LAWYERS - DLA Piper WIN · PDF fileFINANCE FOR LAWYERS ... • Demonstrate an...
Transcript of FINANCE FOR LAWYERS - DLA Piper WIN · PDF fileFINANCE FOR LAWYERS ... • Demonstrate an...
FINANCE FOR LAWYERS
READING & INTERPRETING
FINANCIAL STATEMENTS
MARK HUNT,
TIM NEATHERCOAT,
JONATHAN COMPTON &
JAMES BARRACLOUGH
13 NOVEMBER 2013
SESSION OBJECTIVES
• Demonstrate an understanding of accounting principles and understand
how financial information is prepared
• Understand the composition of a set of financial statements, and be
able to, at a high level, interpret a set of financial statements
• Understand the judgements or estimates that a preparer of a set of
financial statements may have used and the impact these have
• Understand frequently used terminology both in respect to financial
statements and through completion of a transaction
By the end of today you should be able to…
AGENDA Your session roadmap
TIMING CONTENT
10 mins Introduction and Agenda
50 mins Explaining Accounting Principles
1 hour Understanding Financial Statements
• Composition
1 hour Interpreting Financial Statements
• Ratio analysis & KPI’s
• Management estimates & judgements
20 mins Accounting principles for transactions
10 mins What the future holds
ACCOUNTING CONCEPTS
Going Concern
Prudence
Separate
entity
Materiality Accruals/
Matching
Relevance True & Fair
Understandable Consistency Substance
over form
CONCEPTS QUIZ
Working in your teams, work through the 10 accounting concept
definitions shown on the handout and create a definition for each of the
concepts.
You have 10 minutes for this activity.
Accounting concepts
WHAT IS ACCOUNTING?
Accounting
• The process of identifying, measuring and communicating information
which is useful for economic decision making
• Ultimately accounts provide a narrative on the performance and
position of an organisation.
Management Accounting
• Provision of information for use within the organisation.
Financial Reporting
• Provision of information for external users – often termed financial
statements.
TYPES OF ACCOUNTING
MANAGEMENT ACCOUNTING FINANCIAL ACCOUNTING
Internal use External use
Designed to meet individual needs Inflexible formats
Management tool Regulatory compliance
Both backward and forward looking Historic: backward looking
Aids assessment of performance and
facilitates planning
Aids assessment of performance and
stewardship
Prepared as regularly as needed Annually prepared
Greater detail Some information aggregated
May be subject to internal audit in those
entities that have that function and
direction from management
Subject to statutory audit
(by external auditors such as BDO LLP)
PRODUCTION OF SET OF FINANCIAL STATEMENTS How are financial statements created?
Transactions recorded in
book of prime entry
Subtotals from Books of Prime entry post to
nominal ledger
Trial Balance extracted
Adjustments made to Trial Balance (and
consolidated?)
Financial Statements
created
PRODUCTION OF SET OF FINANCIAL STATEMENTS How are financial statements created?
Transactions recorded in
book of prime entry
Subtotals from Books of Prime entry post to
nominal ledger
Trial Balance extracted
Adjustments made to Trial Balance (and
consolidated?)
Financial Statements
created
In most clients, this will be performed by
an accounting package
Auditors will performing testing on this
element and will raise audit adjustments
Performed by the accounting
function, FC, FD, CFO
Approved by Board
WHAT’S IN A SET OF FINANCIAL STATEMENTS?
Profit & Loss
/ Income
Statement
Directors’
Report
Report of
Independent
Auditors
Balance Sheet
/ Financial
position
STRGL / OCI
Cash flow
statement
Notes to the
F/Stats
THE CORE SET OF FINANCIAL STATEMENTS
BALANCE SHEET
Financial position
Solvency
Available funds
INCOME STATEMENT
Performance
Efficiency
Stewardship
CASH FLOW
Liquidity
WHAT DOES A BALANCE SHEET TELL US?
Shareholder Equity (i.e. what is
owed to the shareholders as
investors in the company)
Assets to be utilised
and safeguarded
Liabilities and
obligations incurred
to date LESS
BOTTOM OF BALANCE SHEET
Top of balance sheet
EQUALS
BALANCE SHEET
A snapshot of the business at a
particular point in time
“Balance sheet AS AT” a
particular date
Provides a picture of the
company’s financial position
What the company HAS less what
the company OWES
ASSETS - WHAT WE HAVE
Right or other access to future economic benefits as a result of past
transactions or events
• Fixed Assets - those held for continuing use in the business rather
than for resale
• Current Assets - acquired with the intention of use/disposal within a
year.
ASSETS - EXAMPLES
Fixed
• Land and Buildings
• Plant and Machinery
• Fixtures and Fittings
• Motor Vehicles
• Investments.
Current
• Stock (raw material, work-in-progress, finished goods)
• Debtors (trade, other, prepayments, accrued income)
• Short-term investment
• Cash at Bank
• Cash in Hand.
LIABILITIES - WHAT WE OWE
An obligation to transfer economic benefits as a result of past
transactions
• Current liabilities - amounts due for payment within one year
• Long-term liabilities - amounts due for payment after more than one
year
• Categorised by the Companies Act as “Creditors”.
LIABILITIES - EXAMPLES
Current
• Bank overdraft
• Trade creditors
(Owed for purchases)
• Accruals
• Lease payments/loan
repayments due within
one year.
Long-term
• Debenture loan stock
• Mortgages
• Lease payment/loan
repayments due after more
than one year.
BOTTOM HALF OF BALANCE SHEET
Funds (not necessarily cash) accumulated
by a business since it started
Together they
show the amount
received by the
company on issue
of new shares
Cumulative profits
retained by the company
CASH FLOW STATEMENT
• Operating activities
• Investing activities
• Financing activities
• Increase/decrease in cash.
Areas of focus
TERMINOLOGY DIFFERENCES UK GAAP IFRS
Profit & Loss (‘P&L’) Income Statement
Balance sheet Statement of financial position
Statement of total recognised gains &
losses (‘STRGL’)
Statement of other comprehensive
income
Turnover Revenue
Interest payable Finance cost
Tax Income tax expense
Fixed assets Non-current assets
Debtors Receivables
Creditors Payables
Bad debt Irrecoverable debt
Creditors: amounts falling due within one
year | over one year
Current liabilities | Non-current
liabilities
WHO MIGHT READ THE ANNUAL REPORT AND WHY?
Directors /
Management
Competitors
Regulators
(FRRP)
Providers of
finance
Employees
Shareholders
Government
(Tax)
Lawyers
Suppliers
USING RATIOS Types of ratios WHY ARE RATIOS USEFUL? TYPES OF RATIOS
1. Identification of trends
2. Quick measurement
3. Overcomes problems of scale
4. Easy to calculate
5. Used with sector knowledge.
• Profitability
• Efficiency
• Liquidity
• Investment/Gearing.
CONSIDER KEY PERFORMANCE INDICATORS (KPI)
• Performance - Turnover growth | Like for Like
- Gross | operating | net margin
- Earnings before interest, tax & depreciation (‘EBITDA’)
- Profit to cash conversion
- Return on capital employed
- Sector specific
• Interaction with financial covenants
- Interest cover (EBITDA / Finance cost)
- Senior debt cover (Net debt / EBITDA)
- Cash flow available for debt service (CFADS / Finance cost)
YOUR TASK – 20 MINUTES, WORKING IN TEAMS Accounting ratios task
TASK 1
A friend has analysed the performance and financial position of three
companies with a view to potential investment. One of the companies
supplies music and video products via the internet, another company
manufactures motor vehicles in Coventry and Birmingham, and the third
is an Anglo-American lease finance company.
Having calculated selected ratios for the three companies your friend is
surprised to find that in some cases there are wide variations
UNDERSTANDING THE BUSINESS Different focus? INCOME CAPITAL
• Performance
• Margin | EBITDA
• Working capital
• Operating - Retail, Professional
service, Leisure & Hospitality
• Position
• Return on capital employed
• Gearing
• Leveraged - Real Estate, Natural
Resources, Financial Services
MANAGEMENT ESTIMATES & JUDGEMENT
Impact of:
• Accounting principals:
- True and fair
- Substance over legal form
• Preparation of financial statements:
- Post trial balance adjustments
• Management motivations:
- Attitude / perception of risk
- Remuneration – income or capital growth
- Covenant headroom
- Business aspirations
Impact on the financial statements
EXERCISE
Working in your tables, consider the set of financial statements provided
and discuss:
• What type of business is this?
• What areas of the financial statements would you be interested in?
• What ratio’s or KPI’s do you think are relevant?
• What levels of management estimate or judgement are included in the
financial statements
You have 15 minutes for this activity.
Understanding the business
WHY DO PROFITABLE COMPANIES FAIL?
• Lack of cash – ‘CASH IS KING’
• Surpluses do not equal cash
– Accruals
– Prudence
– Accounting non-cash entries (eg depreciation)
– Cash entries not recorded in the I&E (eg purchasing fixed assets).
Does an entity’s cash flows arise evenly over the year?
AREAS OF POTENTIAL JUDGEMENT Keeping the cash moving
Stock holding period
Credit period given
Credit period
taken
Buy
inventory Pay our
supplier
Sell stock/
inventory Cash received
from customer
Funding period
INDICATORS OF OVERTRADING
• Finance available cannot support level of trading
• Results indicate liquidity problems
• Current ratio declines
• Lower debtor days
• Higher creditor days
• Lower stock days
• Trend analysis relative to competitors/market.
What could tell us something is wrong?
VALUATION V CASH PAID
On 30 June 2008 the FT Reported that Saltire Plc had acquired
St George’s Cross Ltd for £1,080m
• Cash actually handed over……
• £840m (£240m less than reported by the FT)
• Why are the two different?
THE WORKING CAPITAL MECHANISM USED CAN HAVE A SIGNIFICANT IMPACT ON THE CASH ACTUALLY PAID
£ in millions
Bankers/IM Enterprise Value 1,234 Initial valuation
QoE/Run rate adjustments (83)
Pension (6)
Capex underspend (5)
Minority interest (60)
Approved EV [Cash free/debt free price] 1,080 Starting point for price in SPA
Plus £x for Cash 220
Less £x for Debt (334)
Net debt adjustment (114)
Plus £x for Actual Working Capital 454
Less Normal Working Capital (580)
Working Capital Adjustment (126)
Purchase Price (Equity Value) 840 Price actually paid to Seller
Represents the actual working
capital balance at the date of
close
The working capital Peg/Target
set out in the SPA
WE THEREFORE NEED ADJUSTMENTS IN THE SPA TO HELP US……
Get from Enterprise value to Equity value
• ‘Headline’ price to actual value extracted by shareholders.
Balance sheet adjustments to P&L valuation
• Cash free debt free basis.
Normalising working capital, stopping manipulation
• Relevant to both buy and sell side.
Direct and potentially significant effect on value realised / price paid
• Guideline treatments are starting point for negotiations.
OPTIONS…
Mechanisms to get from enterprise value to equity value
• Completion accounts: traditional approach
• ‘Locked box’ mechanism: increasingly common
• Net asset adjustment
• Hybrid methods.
First two are most common
• Similar principles and treatments between them though locked box brings
timings forward.
Stems from unavailability of an ‘instant’ balance sheet
• Time lag in production.
TRADITIONAL COMPLETION ACCOUNTS
Pre completion:
• Vendor estimates completion
balance sheet
• Usually one or more target
figures set:
– Target net working capital
– Target net debt
– Target net assets
• Proportion of completion funds
held back, to cover £ for £
adjustment for difference to
actual
• Usually after de minimis ‘collar’.
Post completion:
• Purchaser or vendor prepares
Completion accounts – depends
on circumstances
• Other side has timetable for
review
• Timetable for disputes and
negotiations
– before last resort referral to President
of ICAEW
• Final “true up” payment made
from set-aside funds based on
Actuals vs Targets.
LOCKED BOXES
• ‘Pretend’ ownership actually transferred pre-completion on ‘Locked box date’
• Use recent actual balance sheet date pre-completion
• Agree normalised working capital and adjustments
• Ensure no ‘leakage’ except ‘permitted leakage’ between Locked box date and
completion
• Other pricing issues (eg capex underspend to budget) viewed based on Locked
box date not Completion
• Adjustments to the Vendor account (cash, debt, working capital) agreed based
on Locked box balance sheet
• Idea is to push risks and rewards of ownership onto purchaser from Locked box
date
• Purchaser settles debt at completion date, takes control of Company with cash
/ working capital at completion date
LOCKED BOX VS COMPLETION ACCOUNTS
LOCKED BOX COMPLETION ACCOUNTS
Control Vendor Purchaser
Balance Sheet Date Pre-completion Completion
Balance Sheet Production Pre-completion Post-Completion
Economic Risk to Purchaser From Locked Box date From Completion date
Negotiations Second Round / Exclusivity Exclusivity / Post-completion
Certainty of Proceeds 100% Released on Completion Some Post-Completion payments
Post-completion work None Review of Completion Accounts
and Balancing Payment
Cost Lower Higher
Subjectivity More – taking views on forecast
financial info Less – historical items
LOCKED BOX: PRO’S & CON’S
• Locked Box mechanics perceived to favour Vendors
• In reality simpler and cheaper to produce
• Sustainability in bear market?
Vendor Purchaser
Pro
s
• Control over process
• Maintain competitive tension
• Simplicity
• Cost savings
• Transfer risk pre-completion
• Simplicity
• Cost savings
• Certainty
Cons
• PE house using LB as Vendor will have difficulty
avoiding it as Purchaser
• Used aggressively can alienate potential
purchasers
• Loss of trading upside
• Lose “chip” potential of completion accounts
and exclusive negotiations
• Information disadvantage, need DD and access
to management
• Extra business risk pre-completion
CONCLUSION
• Locked box increasingly the mechanism of choice in our market: Important for
both buy- and sell-side
• Purchasers must get into the detail, and ensure appropriate due diligence and
time with management to protect themselves
• No standard method of calculation, and treatment of many items can be
subjective
• Right or wrong treatment less important than negotiating power
– Stronger party may neutralise adjustments through headline price
• Vendors have more to gain from locked box structure: Now the Completion
mechanism of choice for Vendors in our marketplace
• Private equity sellers and buyers prefer the fixed price and clean completion
Locked box offers
• But Purchasers lose some protection – IMPORTANCE OF WARRANTIES!!