LAW AND BUSINESS

Unit 4
Guide
Financial Analysis

Context

Clients will often invest in/sell/buy/transact with businesses and seek your advice in
doing so. It is important that you are able to discuss the non-legal aspects of a
business with the client, while obviously refraining from giving financial advice.
Understanding the financial background to a transaction will inform your legal work
by ensuring you focus your efforts on matters that are of commercial importance to
your client.

Lawyers need to be able to look at the fundamentals underpinning the finances of a

business and be able to conclude whether it is in good health or not. Published
financial information for a business can indicate its profitability, efficiency and
liquidity. When figures are compared with those of previous years and with the
figures of competitors, one can see trends emerging which may indicate growth or
decline and may pinpoint areas requiring improvement.

An ability to perform quick ratio calculations and then interpret that financial data
allows a commercial lawyer to discuss a client’s investment or intended investment
intelligently. This helps inspire client confidence that the lawyer understands the
background to the legal work which will be carried out.

Outcomes

By the end of this unit you should be able to:

1. Explain a basic income statement and balance sheet.

2. Calculate some key financial ratios.

3. Interpret those ratios and discuss an investment opportunity with your client.

4. Read and draw conclusions from published accounts.

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Preparation

To prepare for this unit workshop you should:

1. View the i-tutorial “Introduction to Business Accounts” which formed part of the
IPP course “Business Accounts”.

2. Complete the reading for this unit set out in the Reading List on Elite.

3. Access the Assessment Criteria in the Student Handbook and pay particular
attention to the Grade descriptors where you are told what you need to do to
achieve a Distinction, Commendation and Pass in respect of each of the
Assessment Criteria. You will have the opportunity in the workshop to apply
the criteria to a piece of work in order to mark it.

4. Complete the Preparatory Task.

Materials required for the Workshop

Please bring with you to the Unit Workshop:

1. This Guide.

2. Your answers to the Preparatory Task.

3. A calculator.

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LAW AND BUSINESS

Unit 4
Preparatory Task

You act for Alpha Group plc “Alpha”. Alpha is considering the acquisition of the
entire issued share capital (80 million shares) of BelgaMart SA “BM” (SA - a broad
equivalent to a PLC). Alpha has instructed a firm of accountants to conduct financial
due diligence.

The directors of BM and Alpha are to meet tomorrow to discuss preliminary matters
concerning the proposed acquisition. You decide to conduct a quick financial
analysis yourself as part of your background preparation in advance of the meeting.
Your analysis is for your own use so that you can assess where the commercial
sticking points on the acquisition might be.

You have gathered the following from an online search:

BM was established 30 years ago and is engaged in the food retail business in
Belgium. BM is a household name in Belgium and has a reputation for providing
quality food at affordable prices. It sets itself apart from its competitors by offering a
large range of specialist organic and vegetarian products alongside the usual
everyday products.

BM was originally established as a family business and until recently key positions on
the board were occupied by family members. In the past year, a number of those
family members have stepped down from their management roles and would like to
sell their shares.

BM owns 30 large supermarkets in and around the region of Brussels serving over
2.5 million customers weekly. BM employs 4,000 employees across its business.

BM is facing competition from other supermarkets and foreign low cost retailers who
have penetrated the Belgian market, particularly German and French companies.
Close ties with both customers and suppliers are key factors for success in this
business.

BM has recently started an online shopping service which requires significant

ongoing investment. BM’s online business is managed separately from its
supermarket business. BM would like to develop its online offering given the
changes in consumption patterns in its market and increasing online sales.

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Preparatory Task

It is essential that you arrive having calculated the following ratios so that workshop
time can be spent analysing the results.

Calculation of BM Ratios

1. Write an explanation of each of the ratios listed in question 2 below in your

own words. You must write one sentence per ratio and use plain English.

2. Using the income statement and balance sheet at Appendix A to this Guide
please calculate the following financial ratios for BM. Refer to the Ratio Guide
at Appendix B to assist you.

 Return on capital employed

 Gross profit margin
 Net Profit margin
 Sales to Capital Employed

 Current ratio
 Acid test ratio

 Creditor days
 Debtor days
 Stock turnover

 Gearing
 Interest cover

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LAW AND BUSINESS

Unit 4
Task

A: Review of Financial Statements

1. Review BM’s income statement and balance sheet at Appendix A to this

Guide and explain what they show regarding the financial health of BM
(without the benefit of the ratio calculations you have carried out).

2. Share your answers to the Preparatory Task in your teams and review your
answers with your tutor.

3. Using BM’s financial ratios and those of their competitors (see points to note)
together with the factual information provided to you as part of the Preparatory
Task:

 Analyse what the ratios tell you about BM’s:

o Profitability
o Efficiency
o Liquidity

 Benchmark the ratios and comment on your benchmarking.

 What questions do you have of BM?

4. You will analyse the investment ratios (gearing and interest cover) with your
tutor using the example answer at Appendix C in order to focus on what is
required of you in an assessment.

B: Netflix

1. In your small groups compare the notes you made on reading the letter to
shareholders and from your viewing of the most recent Quarter results.

2. You will discuss the financial performance of Netflix with your tutor.

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Appendix A

BelgaMart SA

Income Statement for the year ending 31 December 2019

€ million € million
Sales 1, 490.00

Cost of goods sold (1,404.90)

Gross Profit 85.10

Less Expenses

Marketing (1.30)

Admin (20.50)

Depreciation (3.70)

Other operating costs (2.50)

Operating Profit /EBIT 57.10

Investment Income 0

Interest payments (6.90)

Profit before tax 50.20

Tax payable (13.40)

Profit for the financial year 36.80

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BelgaMart SA

Balance Sheet as at 31 December 2019

€ million € million € million

Non-current assets
Tangible assets 622.00

Intangible assets 11.00

Investments 55.00

Total non-current assets 688.00

Current assets
Inventory 63.00
Debtors 15.50
Cash 48.00

Total current assets 126.50

Total assets 814.50

Current liabilities
Creditors (188.00)
Overdraft (10.00)
Current tax liabilities (13.40)
Other current liabilities (62.00)

Total current liabilities (273.40)

Non-current liabilities
Long-term debt (174.00)
Retirement benefit obligations (44.00)
Deferred tax liabilities (20.00)

Total non-current liabilities (238.00)

Net assets 303.10

Capital and Reserves

Share Capital 80.00

Share Premium 140.00
Retained earnings 83.10

Total capital and reserves 303.10

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Appendix B - Ratio Guide

Please round figures to the nearest 2 decimal places save where the result is expressed as a
number of days, in that case please round to the nearest whole day.

Profitability:

 Return on Capital Employed = operating profit/capital employed 1 x 100

 Gross profit margin = gross profit/sales x 100

 Net Profit Margin = operating profit/sales x 100

 Sales to Capital Employed= sales/capital employed 1

Liquidity and solvency:

 Current Ratio = current assets/current liabilities : 1

 Acid Test = current assets – closing stock /current liabilities : 1

Efficiency:

 Creditor days = Creditors/cost of goods sold x 365

 Debtor days = Debtors/sales x 365

 Stock turnover = closing stock2/cost of goods sold x 365

Investment:

 Gearing = Debt3/capital employed1 x 100

 Interest cover = EBIT/interest payments

1
Capital employed i.e. the total of the shareholders’ equity (capital, premium plus retained earnings)
and long-term debt.
2
It is acceptable to use the closing balance for inventory where this is the only data available.
3
Use long-term debt.

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Appendix C: Assessment focus

1. Read the Assessment Criteria and the description in the Student handbook of
what you need to do to achieve a Distinction, Commendation and Pass.

2. Read the question set out below carefully.

3. Review the example answer alongside the Assessment Criteria and mark the
example answer. Please award the piece of work a Distinction,
Commendation or a Pass.

4. You will discuss the marking process with your tutor.

The Assessment Criteria:

1. Demonstration of knowledge and understanding of the relevant area;

2. Analysis of complex legal, factual, business and/or management issues,

as appropriate;

5. Application of knowledge and understanding to the task;

6. Ability to select and use appropriate information in support of the

argument;

5. Ability critically to evaluate information as appropriate;

6. Ability to reach a clear and reasoned solution to the problem(s) raised in

the task, addressing any ethical and commercial issues, as appropriate;

7. Ability to communicate using a clear and logical structure and language

appropriate to the task.
.

Please note if you evidence your written work with research drawn from the Reading
List alone you will not gain as much credit as if you demonstrate relevant and
independent research. However there are questions that require more application
and analysis than research and a question on ratios will generally be of this type.
You will as a result see that there are fewer diverse footnotes in the following extract
than those in the extract you were provided with in workshop 1.

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Question

Calculate the following ratios:

• Gearing = debt/capital employed x 100

• Interest cover = EBIT/interest payments

Analyse the ratios calculated from Alpha’s point of view.

Which questions would you raise and which 2 additional ratios would you like
to see in order to provide more information?

Gearing

For calculations see points to note.

BelgaMart SA (BM) relies more on equity (64%) than debt (36%) in financing its
operations. Over the past 3 years it is evident that the reliance on debt has
increased from 30% in 2017. The capital structure of BM is slightly less geared than
the sector average.

BM should be asked whether the shift to debt from equity was a deliberate move on
BM’s part and if so why? The tax deductibility of interest payments and historically
low rates could make debt a cheaper source of finance than equity from BM’s point of
view so it would be useful to know if this was the reason for the shift. 1

A relatively low gearing is a positive sign as it gives BM headroom for increased

borrowing in the future. It also means the management can operate relatively freely,
without the constraints that long term debt finance can bring. Long term debt will
contain financial covenants that must be met and interest payments that must be
paid.2 Finally less reliance on debt (than competitors) means that BM can use its
surplus cash to opt to pay a dividend, or plough it back into the business because it is
not bound to make regular interest and capital repayments.

The balance between debt and equity must be judged carefully, having pointed out
that debt is a cheaper source of finance, a company that is too highly geared will be
under increased pressure to meet interest payments regardless of profit levels. If BM
were in this position it would need to pay shareholders a higher return to compensate
for the risk associated with having a high gearing. 3

It would be useful to see BM’s dividend payment history. An additional ratio which it
would be useful to calculate is dividend yield (Annual dividend per share / market
price per share) over the last 3 years. 4 This is a useful ratio for Alpha to use to
compare BM to other companies where it is looking for high dividend returns.
Dividend yield can be difficult to rely on and interpret. A high dividend yield could be
interpreted by some to indicate an opportunity because the share price is
undervalued, however some may perceive the low share price to be a reflection of
low anticipated future performance. Similarly a low dividend yield may reflect shares
that are over-priced rather than an inherently low yield. Dividend cover (Net
Profit/Annual dividend paid) may provide more certainty, it reflects the number of
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times earnings cover dividends paid. Both dividend ratios only take us so far in
analysing the likelihood of dividend payments. Dividend payments are in the
discretion of the directors. Presumably Alpha will control the board after the
purchase and so future dividend policy will be within its control.

BM’s previous years’ income statements would be useful to discover the size of
interest payments. BM’s current loan terms would allow the calculation of the relative
cost of borrowing of both debt and equity. 5 In addition we should examine the current
debt arrangements with a view to establishing the security and guarantee package
surrounding it and the maturity dates of the debt. 6

Interest cover

BM’s interest cover is increasing over time and is relatively healthy at just over 8
times. Generally, an interest coverage ratio of at least 2 is considered the minimum
acceptable amount for a company that has solid, consistent revenues. Analysts
prefer to see a coverage ratio of 3 or better. 7

BM’s interest cover ratio is higher than the industry average which reflects also the
higher profitability of the company relative to the sector. Interest cover of BM is not
quite as healthy as that of its competitor.

If BM has loans with a variable interest rate, the interest expense will be liable to rise
in a rising interest rate environment. A lender’s financial covenants will specify the
level of interest cover required and this will be monitored over time. 8 We should ask
to see the interest cover specified in BM’s loan agreements.

BM’s level of interest cover indicates there are enough profits available to service its
debt, but it may also mean that BM is not using its debt properly in terms of
leverage.9 For example, if BM is not borrowing enough, it may not be investing in new
products and technologies to stay ahead of the competition in the long-term. BM may
have a need to invest in the online business long term. This might be funded by
borrowing. The ratios suggest that BM has headroom within which to borrow. This
will have the effect of increasing the gearing of BM.

1. Warner & Hussain, ‘The Finance Book ’(1st ed, Pearson Education Ltd, 2017)
p244.
2. Ibid 246
3. Accounts for Solicitors 8.8.5 p85
4. Warner & Hussain, ‘The Finance Book ’(1st ed, Pearson Education Ltd,
2017)p 215
5. Horner, ‘Accounting for Non-Accountants’(11th ed, Kogan Page, 2017) p366.
6. Warner & Hussain, ‘The Finance Book ’(1st ed, Pearson Education Ltd,
2017)p 250
7. Investopaedia, ‘What is a good interest coverage ratio?’
<https://www.investopedia.com/ask/answers/121814/what-good-interest-
coverage-ratio.asp.>Accessed 22 April 2020
8. Estates Gazette, ‘Recession Lesson’ (9 March 2013) Issue 1310, p73-73.
9. Warner & Hussain, ‘The Finance Book ’(1st ed, Pearson Education Ltd, 2017)
p205

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