3.10. Ratio analysis (2) – capital structure

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Core Concepts of Accounting – Numbers and People

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Moscow Institute of Physics and Technology

Core Concepts of Accounting – Numbers and People

7 classificações

Curso 3 de 5 em Specialization Understanding Modern Finance

Whenever the word “accounting” is pronounced, it is immediately associated with the need to memorize endless boring numbers. However, it is the common financial statements that contain important information that provides inputs for valuation of investment projects. The only challenge is how to properly extract them. Accounting and finance are indeed intertwined. Sometimes people that are not experienced in the area even mix them up. But most often emphasis in accounting is on numbers. Still, the deep understanding of key accounting concepts helps reveal the interests and actions of people behind these numbers. And the human dimension of accounting adds invaluable insight in the potential of successful project implementation. This Course discusses core ideas and concepts of both financial and managerial accounting. It by no means pretends to be comprehensive to any extent. But, being rather an accounting overview, it focuses on the issues that are most relevant and important for effective valuation of investment projects. The learners will gain insight into the essence of accounting. They will be able to use the obtained knowledge and skills to successfully advance in their career at a financial institution, as well as in the area of financial management at non-financial businesses. To pursue a career in accounting, a more detailed study is strongly recommended.

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The Statement of Cash Flows. Analysis and Use of Financial Statements. Financial Accounting and Project Valuation

In Week 3 of the Course we discuss the idea and format of the Statement of Cash Flows and use examples to delve deeper in its role and importance. Special attention is paid to the use of financial accounting inputs – cash flows, net income, and investments – in valuation. Then we briefly discuss the analysis and use of financial statements as a powerful tool in the overall assessment of performance, financial stability, and future development of a company or investment project. Finally, wrapping up the first part of the Course, we draw conclusions about the role of financial accounting in financial valuation in the world of uncertainty.

3.1. The statement of cash flows (SCF) – idea and format10:51

3.2. SCF – Example 114:05

3.3. SCF – a more advanced Example 2 (1)12:25

3.4. SCF – a more advanced Example 2 (2)8:24

3.5. Valuation revisited – cash flows, net income, and FCF7:04

3.6. Comparison of interest treatment in SCF and FCF9:49

3.7. The big question – why use earnings?10:25

3.8. Analysis and use of financial statements – an overview12:39

3.9. Ratio analysis (1) – current position and performance6:05

3.10. Ratio analysis (2) – capital structure5:56

3.11. Ratio analysis (3) – operating performance11:11

3.12. Financial accounting and valuation – conclusions8:55

Conheça os instrutores

Konstantin Kontor
Director and Professor of Finance and Strategy
American Institute of Business and Economics (AIBEc)

Now, I'll say a few words about

the special set of ratios that deal with capital structure.

So that will be

Ratio Analysis two, Capital Structure.

Basically, we talk about the one major ratio,

which is debt to equity,

that sometimes is called leverage and that is what this is.

Total liabilities divided by total network,

or you can also find some other things close to that in just a moment.

But here I would like to again recall

that we have to compare these numbers in a special index.

Let me give you two outmost examples.

Well if we take banks,

then the bank leverage of about let's say 10 to 20,

this is a normal thing because banks they have a lot of debt and equity is kind of small,

because the business of a bank and we discussed that

in greatest details in our first course in capital markets.

This is you borrow the money

from the depositors and some other providers of capital and then you take

this money and then you lend this money to your borrowers,

so the two industries.

So you borrow that from depositors and you lend it to companies.

So basically, no wonder that you have a lot of debt,

because it can be shown that returns on your equity

they are higher than most of the returns on your lending.

So in this way you cannot finance your lending operations with equity only.

On the other hand, if you take,

let's say, pharmaceutical companies,

then you will see that this leverage will be very low,

sometimes as low as zero.

Why is that? Because pharmaceutical companies they have a lot

of risk in their RND or in the performance of drugs.

So if, for example, they used a lot of borrowed capital,

something happens to their products and they can lose a significant portion of

their market value overnight and in

this case if you have lots of debt then you can become insolvent.

There were cases when the stock of

large pharmaceutical companies would drop by as high as 25 percent overnight,

if there was something let's say if they found some poison in

pills or drugs and that would result in a huge blow to the company.

Now, so here you can see that clearly you can talk

about ratios like equity over total assets,

and then total liabilities to total assets in these two they are always,

the sum of that is always one.

But the story here is that,

that's the same idea.

And now a very important idea in studying that is the profile of risk,

because basically if you see that over time your debt accumulates,

then not only the project in the company becomes riskier per se,

but also that goes for the risks really that the provided capital are exposed.

Let's see if you had that little debt that would be almost

riskless and then if you keep accumulating then the new debt becomes riskier and riskier.

Now on the other hand,

if you see the redemption of debt,

that accrues to equity,

not one to one but significantly.

Now let me make a pause here and I will tell you that we have

very special discussion of that in our final course of M and As.

There is a special part there that deals with

leveraged buyouts in which we see this is the case when the company is taken private.

When the stock is being repurchased with the use of significant amount of borrowed money.

And we will see that there the idea of leverage is key.

The initial leverage is very high and the performance of

the company depends on its ability to redeem part of that debt and to

bring this leverage down and that can be done as quickly as

possible to the extent that the company can engage in a secondary public offering.

Not to confuse you,

I will not delve deeper on that right now,

but I promise to you that in our fourth course

we have a full-fledged discussion that with

really comprehensive examples and their understanding will be quite profound.

So, again the main idea in this discussion is that we

can see to what extent the debt that has been accumulating in the company is,

let's say, adequate for this company and for the sector,

or maybe it just goes off of the ballpark.

And in this case that sends us a significant signal

that something might have got rotten in the state of Denmark.

That is about the analysis of capital structure.

And in the next episode,

we will talk about efficiency and performance of the company

based on the ratios that study various returns.

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