This chapter introduces the following ideas:
capital market
limited liability company shareholders
cash flow statement assets
profit and loss statement balance sheet
fixed assets current assets liabilities
shareholders’ funds work breakdown structure cost breakdown structure
Each is a term defined within the text, as well as in the Glossary at the end of the book.
BASF is one of the world’s leading chemical com- panies, with production sites in 41 countries and customers spread across the world. The head office and main chemical processing complex is located at Lugwigshafen, Germany. The group comprises more than 160 subsidiaries and affiliates. Its main product groups are chemicals, plastics and products for the agricultural industry. It also engages in oil and gas exploration and production.
A main objective of the company is to earn a pre- mium on its cost of capital to ensure profitable growth, thereby giving it a competitive advantage in gaining access to international capital markets. The pursuit of profit has to be achieved while recognising the importance of the principles of sustainable devel- opment, combining economic success with environ- mental protection and social responsibility. BASF’s shares are listed in the Dow Jones Sustainability Index. Research and development is at the heart of the group’s efforts to retain its competitive position.
BASF has successfully developed highly inte- grated processing plants to use resources and materials to maximum advantage. Waste and by- products are used as inputs to other processes. Pipe networks facilitate efficient, safe and environmentally friendly transfer of resources. They describe this inte- gration as Verbund.
The hazardous nature of the industry demands the highest safety standards. Risk identification, measurement and control are most important. The Verbundsystem minimises undesirable emissions, but also benefits BASF customers. The group main- tains close relationships with its customers to find mutually beneficial solutions to their problems. Re- ward systems for employees are as closely related to corporate objectives as possible, especially by using a measure known as earnings before interest on cap- ital and taxation (EBIT).
Case study
A summary of the BASF operating (profit) report for year ended 31 December 2009 is:
Case questions 20.1
What was the company’s profit in the year to 31 December 2009?
What proportion of its sales revenue was spent on research and development?
BASF Group www.basf.com
€millions
Sales 50,693
Lesscost of sales 36,682
Gross profit on sales 14, 011
Selling expenses 5,667
General and administrative expenses 1,133 Research and development expenses 1,398
Other items 2,734
Operating profit before tax (EBIT) 3,079
Lesstaxation 1,424
Minority interests 245
Net income 1,410
Source: Company Annual Report, 2008–2009.
© BASF Aktiengesellschaft
Introduction 20.1
In the financial year that ended on 31 December 2009, BASF made a profit of€1,410 million from its activities. This ‘headline’ figure is a very crude measure of the effectiveness with which the managers have run the company over the year. The problem for investors is how to assess this performance. Is it consistent with the stated targets of the company? Does the way it has been achieved bode well for the future by, for example, investing in research that will bring returns in later years? Investors will also want to know how these broad summary fig- ures relate to the work of managers and staff within the firm – are they motivated and organ- ised in ways that encourage them to produce good returns in the future?
Similar questions arise about the annual report of any firm. Investors and financial analysts continually evaluate a company’s financial performance against its objectives and against com- parable businesses. They try to judge its prospects, and how effectively managers are doing their jobs. Much of the information is qualitative and subjective, designed to create a favourable impression and positive expectations.
Chapter 1 describes organisations as aiming to add value to the resources they use. It is crucial to the success of an organisation that it has the appropriate resources and that these are well managed to achieve the results that stakeholders expect. Most companies depend on people in the external environment for the funds they need to grow the business. The main source of information for people outside the business who wish to assess its performance and prospects is the company’s annual report to shareholders. This contains a great deal of finan- cial and other data – but is more subjective than at first appears. It is important to know how financial performance is measured, and the assumptions that people make in constructing the figures. It is also important to know how these financial measures relate to the per- formance of those working within the firm.
The chapter begins by explaining why companies need the capital market and how they communicate with it. A major link in that process is the annual report, so the chapter then explains important parts of that document. The chapter goes on to show how these figures, which are intended mainly for investors outside the organisation, influence and are them- selves influenced by processes of internal planning and control. It finishes by looking inside the company at how financial targets are planned for and achieved.
The world outside the organisation 20.2
The pressures on companies to perform
Many people reading this book will be expecting to start a career that they hope will provide an income to support an attractive lifestyle. Few will be thinking about retirement or the need to support themselves after their working lives have ended. This may be a sombre subject to introduce, but it is fundamentally important to understanding the financial environment in which organisations operate.
Obtain a copy of the annual report and accounts for Marks & Spencer and Mothercare for the year ended 1 April 2010. What can you discover about the shareholders in the companies?
Reports are available on their websites; www.marksandspencer.com and www.mothercare.com
Activity 20.1 Identifying shareholders
605 THE WORLD OUTSIDE THE ORGANISATION
Investment companies such as pension funds and life assurance companies expect to pay their investors an acceptable income or lump sum when they retire. The funds can only do this if they invest contributions successfully, and investors naturally expect their premi- ums to be invested profitably by fund managers. These companies compete with each other, and the rewards for success, and consequent growth in contributions from investors, are high. There is pressure on the fund managers to perform well by identifying good in- vestment opportunities, which is also in the investors’ best interests as eventual pensioners.
The fund managers will be looking for good investment opportunities in companies that are profitable and well managed. In order to attract money into its business to enable it to expand, management needs to demonstrate to the capital market that it is a profitable and successful business.
The fund managers in the capital marketexpect management to operate their businesses profitably. So this pressure from the external capital market directly affects the organisation and all employees. There may be some periods of low or negative profitability (losses) and the capital markets know that but continual losses will eventually lead to failure, as a company will simply run out of money and fail to meet its financial obligations. So the pressures to perform that managers and employees feel originate outside the organisation. However, as many employees are investors and all are future pensioners dependent on the performance of fund managers, those pressures serve their long-term interests (Coggan, 2002).
Within an organisation it is unlikely that managers, apart from those at the top, will feel the direct pressure from outside. Yet, as the chapter shows, this external pressure does affect the expectations that top managers have of those below them. These expectations are gradu- ally transmitted down the organisation, so all staff experience them in some way, even if indi- rectly. The pressures can be considerable as the senior managers expect to be rewarded with the opportunity to purchase shares in the company at a favourable price at some future time (share or stock options). Sometimes this pressure leads to dubious practices and alleged fraud, designed to enhance the share price, as in the recent cases of Enron and Parmalat. This has brought considerable pressure from regulators to improve corporate governance and the quality of financial reporting.
Raising capital
If you have looked at the annual report of Marks & Spencer or Mothercare you will have dis- covered that life assurance companies and pension funds are major shareholders. They are just one of the many sources from which large organisations raise capital.
A large public company can raise money by issuing shares to people and institutions that respond to a share issue. The main benefit is to enable companies to finance large-scale activ- ities. The shareholders appoint the directors who are ultimately responsible for managing the company. A shareholder is entitled to vote at general meetings in accordance with the num- ber of shares owned. Once the shareholders have paid for their shares in full they cannot gen- erally be required to pay more money into the company, even if it fails.
The affairs of companies are governed by company law, in some countries administered by a government body such as the Securities and Exchange Commission in the US, and by the body governing the share market, such as the Bourse in France and the Stock Exchange in the UK. Before a company can invite the public to subscribe for shares it has to be registered with the national financial regulators and fulfil a number of requirements. The first step after registration, in order to raise money, is to issue a prospectus which explains the history of the company, what it plans to do as a business, and what it plans to do with the money raised.
If the business is small it will not invite the public to buy shares. The promoters will con- tribute their own money, most likely in sufficient amount to ensure that they have control (more than 50 per cent of the shares). The amount of capital available to the company in these circumstances will be limited to the money the founders can afford to contribute. They may go to a bank to seek finance, but the willingness of a bank to lend will also depend on the amount subscribed by the shareholders.
The capital market comprises all the individuals and institutions that have money to invest, including banks, life assurance companies and pension funds and, as users of capital, business organisations, individuals and governments.
Banks, fund managers and investors will contribute only if they believe that it is a sound, well-managed business that is likely to make a profit. The investors have many investment opportunities, they will not invest in a company that will not reward them for the risk they are taking by investing money. The amount of return they expect will be related to the risk – the greater the risk the greater the required return.
A limited liability companyhas an identity and existence in its own right as distinct from its owners (shareholders in Europe, stockholders in North America). A shareholder has an ownership right in the company in which the shares are held.
Shareholdersare the principal risk takers in a company. They contribute the long-term capital for which they expect to be rewarded in the form of dividends – a distribution from the profit of the business.
A cash flow statement shows the sources from which cash has been generated and how it has been spent during a period of time.
Find out the interest rate at which you could borrow money to (a) buy a car, (b) buy a house or (c) spend on your credit card. Can you explain what you discover?
Activity 20.2 Borrowing money
A limited liability companygives a business access to large amounts of capital, but at the same time allows some protection to the shareholders, as they cannot be held liable for the debts of the business in the event of its financial failure. This limited liability means that in- vestors can contribute capital knowing that only their invested capital, and not their private and personal assets, is at risk. This risk is why investors expect a higher return than they would receive if they put their money in a bank or in government securities, where the risk is virtually zero.
Reporting financial performance externally 20.3
Because a company has access to capital in this form there has to be regulation. The Com- panies Act is the principal instrument of control, with the addition of the Stock Exchange for those listed as public companies within the UK. A most important requirement is to provide information about the performance of the business from time to time (Elliott and Elliott, 2006). The capital markets and indeed anyone that is thinking of investing in a company need to understand how the company is performing and financial measures pro- vide a sort of company ‘health check’, indicating how well the company is being controlled by the management. This health check is detailed most comprehensively in the company’s annual report. Among other things the annual report includes financial information of three distinct types: the cash flow statement, the profit and loss (or income) statement, and the balance sheet.
Obtain a copy of a company annual report and list the kind of information that you find in it, for example financial, product, people and management.
Activity 20.3 Reading an annual report
Cash flow statement
The easiest to understand of the three types of statement is the cash flow, which shows where cash has come from and how it has been spent. The following is a simplified summary of the cash flow statementfor Marks and Spencer plc for the year ended 28 March 2009.
607 REPORTING FINANCIAL PERFORMANCE EXTERNALLY
£ millions Net cash inflow from operating activities 1,371.9
Payment of taxation (81.3)
Net cash inflow from operating activities 1,290.6 Cash flows from investing activities
Capital expenditure and financial investment (609.6)
Interest received 12.7
Net cash (outflow) on investing activities (596.9) Cash flows from financing activities
Interest paid (197.1)
Other debt financing 66.2
Equity dividends paid (354.6)
Other equity financing (35.6)
Net cash outflow from financing activities (521.1) Net cash inflow from all activities (above) 172.6
Effect of exchange rate changes 7.8
Opening net cash 117.9
Net closing cash 298.3
In the ordinary course of successful business it might be expected that the cash received from trading (selling products or services) should be greater than the cash spent to purchase components, supplies, labour, energy and all the other resources combined to secure the sales.
The cash surplus could then be reinvested to help finance expansion and some of it paid to the shareholders as dividend on their investment. Their original contribution remains in the company, however, as part of the continuing capital base. In the case of Marks and Spencer plc there was an increase in cash of £172.6 million after paying dividends, making interest payments and investing in new assets.
The idea of a cash surplus being the essential requirement for success is appealing but unfortunately too simplistic. Taking as an example a motor vehicle manufacturer, a car has to be designed and tested, components sourced from suppliers, production lines prepared and cars distributed to dealers before any of the cars can be sold – so there will be very heavy cash outflows before cash starts to come in. This process may take a couple of years. In some in- dustries, such as pharmaceuticals and chemicals, investments in continuing research and de- velopment may take ten years or longer before cash begins to flow back, and then only if the research is successful.
Much the same thing occurs in new technology based service companies such as eBay as they have to invest heavily in building their website and in advertising to make people aware that they exist before cash begins to flow in. It would be highly unlikely in these conditions for the business to show a cash surplus in periods when it is making such heavy investment.
Assetsare the property, plant and equipment, vehicles, stocks of goods for trading, money owed by customers and cash: in other words, the physical resources of the business.
Look at the annual report for BASF (www.basf.com), Siemens (www.siemens.com), Solvay (www.solvay.com) or any large manufacturing business, and find out what it tells you about research and development. List the projects that the report men- tions. What does the report say about the length of time before the projects will be profitable?
Activity 20.4 Measuring R&D expenditure
It is impossible to draw sensible conclusions about the company’s financial performance on the basis of cash flow alone. Not only is the annual surplus or deficit influenced by major investment, but other infrequent events, such as a major restructuring exercise following a new strategy, could also distort the impression.
The profit and loss statement
The profit and loss statement(or income statement) is designed to overcome the limitations of a cash flow statement, although cash has the important characteristic of complete objectiv- ity. Cash flows can be observed, measured and verified. Profit measures are subjective.
The profit after taxation and the profit retained in the business are quite different from the cash surplus reported in the cash flow statement. This is because the profit statement is not based on cash but on business transactions that (a) may result in cash transactions in the future, or (b) reflect cash transactions from previous periods.
Sales may be credit sales that approved customers may pay for later. Cost of goods sold may include the purchase of goods that will be paid for in the next financial year. Operating expenses will include depreciation which, with other terms, is explained below.
A profit and loss statementreflects the benefits derived from the trading activities of the business during a period of time.
Case questions 20.2
Refer to the summary income statement for BASF.
Calculate the gross profit as a percentage of sales.
Calculate the operating profit before tax as a percentage of sales.
Look at the annual report of a company in a similar line of business to M&S.
Calculate the gross profit in a recent year as a percentage of sales.
Calculate the profit before tax as a percentage of sales.
How does the company compare on these measures against M&S?
Is there a major difference in the items in the profit statements of the two companies?
Activity 20.5 Calculating and comparing profit
Depreciation
Depreciation is a major cause of the difference between cash flow and profit. Think about the investments mentioned in relation to motor vehicle production. Apart from occasional modi- fications, the same basic model may be produced and sold for several years. So the initial investment to develop the design and make the cars should be spread over the life of the invest- ment and will be subtracted from sales revenue in each year. This process is called depreci- ation. The idea is simple, but there are several estimates required before the annual amount can be measured.
Depreciation is based on the original cost of the investment, including set-up and train- ing, less the expected scrap value at the end of its life. Hence an estimate must be made of the life of the investment, the residual value and the initial cost, which itself is open to conjecture.
To make matters worse there are at least four methods of spreading the cost over the lifespan.
The simplest is to allocate an equal amount each year. Assets may also be periodically reval- ued to take account of changes in their fair value (the present value of expected future cash