28/06/2010 by admin.

The budget has been well received. The global consensus (as now agreed by the G20) is that early action is the right approach  to bringing down deficits. The City has flagged its approval as evidenced by a drop in the 10 year gilt rate.  What does this mean?

The gilt rate is the return that the UK government has to pay in its borrowing programme. Just as for you and me, the riskier the borrower, the higher the rate that has to be paid to lenders. A drop in the rate means that the global lending market accepts that the UK is not as risky as it was under the stewardship of the previous government. It is prepared to accept a lower rate of interest for lending to the UK.

How does this affect share prices? A number of ways. The obvious way - if the gilt rate is lower, so then is the rate that companies can borrow at. This is because the corporate debt rate is often benchmarked to measures such as LIBOR which tend to follow the gilt rate. So companies pay less interest, thus leaving more profit for shareholders. This leads through to higher share prices (see for example the Gordons growth model)  .

Another reason is given by the Capital Asset Pricing Model (CAPM) . The gilt rate is effectively the risk free rate. A premium is added to he risk free rate to represent the extra return that investors demand for investing in equities rather than bonds or gilts. This premium, the equity risk premium, is fairly static. So if the risk free rate drops then so too does the required return from equities. Just as for property assets, if the yield from a security drops, this is achieved by the price going up. (Eg. if a share is paying £1 a year dividend and is priced at £5, it is yielding 20%. If the required yield drops to 10% then the price needs to rise to £10 to achive that return).

So we have two effects that push up share prices: lower corporate borrowing prices and lower required yields for equity investors.  

Posted in CAPM, Corporate Finance, Banking | Comments Off

16/03/2010 by admin.

With the British Airways strike in the news this week I thought I would add my two pence worth.  Airlines are intrinsically problematic. Why?

Let us imagine you are taking a flight tomorrow morning. You plan on buying the ticket at the airport.  You arrive and buy the ticket. So the airline now has one extra passenger. What extra costs will the airline now incur? The cost of printing the boarding pass, a little bit of extra fuel to carry you and your luggage, a bottle of sauvignon and a packet of peanuts.

All of the other costs are there whether you fly or not. The plane has to take off, full or empty (after all it has a schedule to keep; it might be empty leaving your local airport but there may be a plane full waiting for it in Buenos Aires) . So all of those costs are going to be incurred anyway: flight crew, cabin crew, check in staff, baggage handlers, taxes, cost of slots, cost of the fuel to get the plane in the air, marketing , advertising and all of the other overheads. The extra costs you cause (the “incremental costs”) are, almost literally , peanuts.

Airlines are typical high fixed costs industries. Virtually all of the costs are incurred whether passengers fly with you or not. So if you are the CEO of such a business, what is your imperative? To get passengers on your flight, contributing towards your costs, rather than on the rival flight in the gate next door. What happens then?

Well flights are largely commoditised. If you are flying to New York  there is not much difference in your experience between one airline and another (although some  airlines try to persuade you that their flight is better – more leg room etc). Essentially you are going to discriminate on one thing alone – price. So the airline business is mainly about running the operation as cheaply as possible in order that you can charge the lowest fares. So margins are constantly under attack.

Throw into the mix a business that most commentators believe is overmanned (BA) and you have a company that will struggle to be successful in the airline business. Add a union committed to causing trouble in the run up to an election and this is a lose-lose situation for everyone.

Posted in Strategic costing, Airlines | Comments Off

02/03/2010 by admin.

This is a phrase I use quite early on in my financial awareness programmes. Other presenters might use the cliché “cash is king”. The problem with clichés is that their impact lessens with overuse. But the message is the same.

So why do profitable companies go bust? Well fundamentally it is because the profit and loss account (now more often referred to as the” income statement”) does not measure cash in or cash out. That is the role of the cash flow statement. The cash flow statement is the single most important statement of the three (ie along with income statement and balance sheet) and yet is often the most neglected.

The profit and loss account (p&l) is more of an “activity statement”. For example look at an airline from whom you have just purchased a ticket, today in March, to fly in August. You have paid for the ticket. But the airline , whilst logging the cash receipt,  will not log the “sale” until August. A sale is not a sale until the company has earned it. For an airline that means flying the passenger.

Similarly with costs.  Costs are only costs when the company has had the benefit of those costs. For example , I am a shopkeeper and I buy (and pay for) 100 mobile phones today (this will be an outgoing on the cash flow statement). However if I only sell this week five phones then I will only show in my p&l the cost of 5 phones. The other 95 sitting on the shelf ate “stock” and are to found on  my balance sheet. So despite the fact that I have spent the price of 100 phones my p&l will only show the cost of five until such time as I sell some more. The p&l  is an activity statement not a cash flow.

So what other cash payments do not impact the p&l (leading to cash outflows but no impact on profitability).

Buying fixed assets (“capex”);

Repaying a loan;

Buying another business;

Giving credit to a customer (you can have the profit – make the sale- but not receive the cash);

Buy stock (the example above);

Revaluing property assets (if you have investment properties you will revalue them annually, the uplift being “income” in your p&l, but obviously no cash has been received).

Being bust? Means having no cash – this is entirely a cash flow issue, not profitability.  

Posted in Cash flow | Comments Off

17/02/2010 by admin.

As a finance trainer I have to constantly remind myself that a lot of what I teach is not obvious. For example, I recently ran a programme for newly promoted managers. It was part of a larger induction programme and was what I might describe as a “gentle” introduction to company finance. As usual I offered a post-course e-mail query service. A few days later I received a question: why do companies borrow money? Why not simply rely on the, cheaper , shareholders’ money?

During the course I had mentioned borrowings, or debt, a number of times without getting into the corporate finance issues  - given the relative financial naivety of the audience.   However Kevin’s blog seems to be the perfect home for addressing this issue!

Companies have two sources of cash; from the shareholders, “equity”, or from lenders (eg banks), “debt”. Firstly which is the more expensive? Often when I ask this I get the answer equity – as there is no interest on shareholders’ investment. But to answer this question we have to address what we mean by “expensive”.

Both the shareholders and the lenders have in mind a return when they invest in our business. For shareholders the return comprises a mix of dividends and share price growth. For lenders , normally just interest.   Both returns have to be provided by the company; for shareholders, for example, the company must use the funds in such a way to pay sufficient levels of dividend and drive up share price.

So the most expensive source of finance will be the one that demands the highest returns.  So who wants the highest returns? Well in fact shareholders need a higher return that lenders. Why? Because equity shareholders are the last stakeholder to get a pay out. If a company is liquidated, all of its assets will be sold off and the liabilities paid. The shareholders will only get a pay out once all of the other liabilities have been settled – they are at the back of the queue. So they are taking the most risk; with risk comes return.

So debt is cheaper. Hence simplistically the more debt one has, the cheaper the average of one’s overall finance.  Wrong – sort of. Let me illustrate the problem with this thinking.

My company (“myco”) borrows £5m from Bank A. Bank A has insisted that the loan be subject to a “negative pledge”. This means that myco cannot borrow any further sums from another bank. Bank A charges me 7% and the shareholders want a 10% return.

As myco grows so it eventually needs more cash. Bank A says no, but Bank B is willing to invest a further £5m. But myco needs to get Bank A to waive its negative pledge. So myco agrees with Bank A that it will get all of its interest before Bank B gets its interest and similarly with loan repayments. So Bank A has priority over Bank B. Bank A is the senor debt to Bank B’s subordinated debt – to use the jargon.

What interest rate will Bank B want? Well being in a riskier position than A  it will want a bit more, say 7.25%. What about the shareholders? Well they are still at the back of the queue. But the queue just got longer – so they are in a riskier position, so the will want a higher return – say 10.25%.

So in fact the increased debt does not change the average cost of finance; the cheaper extra debt causes offsetting increases in the cost of equity. This is referred to as Modigliani and Millers Theorem number one.

But companies do borrow – so why? Well M&M #1 does not allow for something. The cost of debt – interest – is tax deductible, whereas dividends are not. So the cost of debt is subsidised by the tax authorities.   In the UK for every £1 of interest paid, the government repays the company 28p. This asymmetry explains why in fact an increase of debt – to certain levels – explains a reduction in the cost of finance. And that is why companies borrow.

See, corporate finance – easy really.

Posted in Corporate Finance, Gearing, Balance Sheet | Comments Off

15/02/2010 by admin.

In the last post I repeated the explanation I recently gave to a director about how futures work and how can be used to hedge prices. Today I will finish off that explanation by looking at options.

An option is an instrument that gives the owner the right to buy or sell the underlying commodity at an agreed price sometime in the future.

Let us look at the definition a little more closely. The owner is the person who has most recently purchased the option. Options are often “traded” that is can be bought or sold on an options market.  

The option gives a right, not an obligation. The owner of the option does not have to exercise the option.  So he or she will only do so if it is more profitable to exercise than to not do so. Contrast this to futures where the buyer of a future must buy and the seller must sell (until such time as they close out their position – see the last post). Because the owner has acquired a right (unlike an obligation) they have acquired something of value  - and so they must pay for it. The price of the option is called its premium.

To buy or sell the underlying commodity.   An option giving the right to buy is called a “call” option, that to sell a “put” option.

At an agreed price sometime in the future.  The price at which the owner can buy or sell the underlying commodity is called the “strike” or “exercise” price. Options have a fixed lifetime and will eventually expire.

If an option is exercised then another party, the “writer” must act. The writer was the recipient of the original premium paid when the option was created.  

Let us look at an example.  Johnny buys a call option for 10p which gives him the right to buy a share in Example plc for £3. For simplicity , assume that the option is going to expire in the next hour.

If the spot price (the spot price is the price of the share in the share market) today is £4, then Johnny has a choice: he can exercise the option or do nothing. So he asks himself – would I be better off buying the share in the open market for £4 or exercising the option and buying it off the writer for £3? Clearly in this instance the  Johnny will exercise the option and buy the share from the writer for £3, which he can then sell into the market for £4. His overall profit is £1 less the premium 10p = 90p.

The writer in this case must sell the share to Johnny for £3. He buys its from the market for £4, sells it to Johnny for £3, making a loss of £1, less the premium he received of 10p, a loss of 90p.

Another example: Jenny buys a put option for Example2 plc for 20p with a strike price of £5. The spot price is £8.

Should she exercise the option? Well should she exercise and sell to the writer for £5 or sell into the open market for £8? Clearly she should let the option lapse and sell into the open market. She will get £8 for her share, and the writer has made 20p from selling the lapsed option.

So owning an option has a limited downside – the most you can lose is the cost of the option, but an unlimited upside. Option writers have a limited upside – the maximum profit the can make is the cost of the option.   

Posted in Derivatives | Comments Off

11/02/2010 by admin.

The other day I was coaching a client (a director of a manufacturing company)  and he mentioned that his company used futures and options to hedge the price of certain commodities it used. However, despite having the process explained to him a number of times by his finance director he simply didn’t get how it all worked. So I explained it all to him, and dear reader, I thought I would impart the same information to you. Today I will look at futures and in the next post I’ll explain options.

Let us start by thinking of a farmer. The farmer reckons he will harvest  100 tons of wheat this summer. He wants to hedge the price of wheat. So what does “hedge” mean? Hedging means removing uncertainty about the price you will receive or pay for something. It does not mean betting what way the price of, say wheat, will do. That latter activity is called “speculating”. Speculators essentially bet whether the price of wheat will rise or fall. Whilst our farmer is concerned about falling prices, he really just wants to know what he will receive in 6 months time.

So our farmer sells a future for 100 tons at £10/ton. This means that he is committed to selling 10 tons for £1,000 sometime within the next 6 months. Someone somewhere has bought that future . This counterparty is committed to buying 100 tons for  £1,000.

Now let us move on 6 months. The market price for wheat is £9/ton. The market price is called the “spot” price in the jargon. The farmer does  not actually want to sell his wheat to someone at the Liffe market or the Chicago Mercantile exchange or wherever it is he has entered the future. So he has to “close out” his position. He has committed to sell 100 tons ,so to negate the arrangement he will buy a future for 100 tons. He is now committed to buying and selling 100 tons and so the arrangement is effectively cancelled.   If the spot price is £9/ton and the future is about to expire then clearly the future will also be priced at about £9/ton. So he has sold at £10/ton and bought at £9/ton. So he has made £1/ton profit on 100 tons. He will receive a cheque for £100 from the futures exchange. The counterparty bought at £10/ton and sold at £9/ton so he has lost £100 and will pay that amount into the exchange.

So how does the hedge work. The farmer will now go to the actual wheat market to sell his 100 tons of wheat. The spot price if £9/ton, so he will receive from the actual physical sale of his wheat £900. He has received £100 from the futures market, so in total he has received £1,000. In other words he has received £10/ton – the amount he hedged at.

To illustrate this further let us assume that the spot price in 6 months time is £12/ton. Our farmer would have sold in the futures market  at £10/ton and bought to close out at £12/ton, so he has made a loss of £2/ton and will send the exchange £200. In the physical market he will get £1,200 for his wheat. However if we deduct his loss on the future he is left with £1,000, or £10/ton – his hedged amount. Simples!

Posted in Derivatives | Comments Off

08/02/2010 by admin.

Nowadays when I run a course, I can pretty much take it for granted that someone will ask me to explain why the banking crisis occurred. Well here’s my “banking crisis for dummies” talk.

Let us first be clear about what banking is. It is a pretty easy activity. Bankers borrow money. They borrow it from you and me (via our deposit accounts) or they borrow it from another bank (who in turn has used a deposit account). They do not borrow all the money they use. A very small percentage (typically around 8%) is put in by the shareholders (we won’t ask where the shareholders get the money - then it starts to get complicated!).   When a bank borrows money it pays interest - for our purposes let us assume that this rate is 3%.

Now, banks need to generate income. They do this by lending the money they have borrowed. By lending they charge an interest rate. The point is, that the riskier the person borrowing the money, the more interest should be charged - as the bank has taken a bigger risk. Let us assume that the average lending rate is 7%.

So our bank is paying 3% and lending at 7%. Let us assume that it is a very small bank and that its overheads are just £50m (to put this in context Barclays had overheads of £13.5 billion in 2008). That means our bank has to borrow and lend £1.25 billion. (£1.25bn x 4% (profit) = £50m) just to break even. This is a lot of lending. Let us consider the mortgage market. This market has become very competitive. There have in recent years been a number of new entrants. 

So our bank would ideally like to lend to borrowers looking to borrow , say 75% of the value of their home. But this is the prime market - all the lenders are chasing these customers. So our bank decides to lend 90% loan to value. Again , a large number of  banks follow suit (remember that all of the banks have to lend in order to cover their overheads). So the banks then chase the 100% (or more!) loan to value. Then , in order to be more competitive, instead of charging a higher rate of interest, to reflect the higher risk, banks start to lower the interest being charged. With a lower interest rate they have to lend even more! If our interest rtae drops from 7% to 6% the bank now must lend £1.67bn to breakeven - and extra £420m.

In the end they have a loan book with  a number of borrowers who are “sub prime” - ie unable (and have never really been able) to repay their loans. They are being charged a rate of interest that a few years earlier would have been the preserve of the very safe, conservative borrower. So what does the bank do with this loan book? Sell it to another bank, of course. In fact the loan book would be split into parts and other banks would buy bits of the loan book. This is called “securitisation”.

But surely the other banks knew what they were getting? Well, yes and no. First by buying another bank’s loan book , it is effectively the same as having made the loans themselves, which is their key objective - make profits to more than cover the overhead, leave increasing profits for the shareholders.  Secondly, the bit of the loan book they purchased would often come with “insurance”. Something called a “credit derivative” was dreamed up. This simply means that in the event of a borrower defaulting on a loan, the insurance company would pay the difference. 

As the insurance provider quite often enjoyed a AAA rating, then arguably the loans being purchased should also be considered AAA, and not the D rating of the true underlying loan. Then the interest being earned was considered acceptable.

The problem? Well the scale of sub prime lending was enormous. One insurance company  (AIG) monopolised this form of cover. When the claims started to roll, AIG realised that it could not possibly meet them all. The recently rated AAA loans suddenly get downgraded to D.

The rest is history…

Posted in Banking | Comments Off

07/02/2010 by admin.

In the last post I looked at the football industry. Today I am going to consider the much stronger (and slightly related) online poker industry. This in my opinion is almost the perfect e-commerce model (E-Bay getting the accolade of best, with possibly Amazon getting the worst - more in a later post) .

Let us look at the online poker model. First how it operates. A customer opens an account and loads his account with some money (just like a bank, but a bank that doesn’t lend to people who cannot afford to repay - the standard banking model that has caused us all so much grief). Once armed with a loaded account the customer joins a table and plays poker. The key thing to realise here is that the customer is not playing the “house” (ie the poker site). He is playing other customers - the house does not “take a position” to use the jargon. So the house is not gambling.

Now the customers play each other and one will win and there is a transfer of money from the losing customer (or customers) to the winner’s who can keep it in his/her account or withdraw it. However the house makes a charge. There are various ways it does this: it takes a percentage of the winnings (the “rake”) or it charges a one-off entry fee to the table. Either way the charge represents a rent for using some of its cyberspace and for introducing the players to each other.  

What investment is required by the site. A server (cheap as chips), the software to drive the game (could be expensive, but face facts, writing the software is what £250k - max?), customer support. Then the main outgoing is simply the cost of getting customers to your site rather than a competitors’. So marketing costs (a nice “discretionary” costs - great in recessions - more in a later post) are the key running costs. See any sporting event on TV and note the number of such sites advertising or indeed sponsoring the event.

So little investment, relatively low running costs ; simply write the programme and sit back and take a percentage off the players. I am writing this on a Sunday morning in the UK (so middle of the night in the US, a key market, despite legal attempts to prevent it being so, around lunchtime for most of Western Europe, early Sunday afternoon for Eastern Europe). I have just gone onto a site and it shows 19, 787 players.  I leave to to you to make your own assumptions about how much the site will take from each of these players over the next hour. And this is the quiet time!

If you look at the balance sheet of such a site you will see that the cash deposits (which earn interest for the site, not the customer) are greater than its total capital employed (capital employed is the total investment in the business - borrowings plus shareholder equity) - indeed it has negative capital employed. This is as good as it gets. It has effectively no investment, using customer money to pay the bills.

One post script to this. PartyGaming has branched out of poker (it took the decision, unlike most of its competitors, to prevent US players getting access to its tables) into more mainstream casino games. At the end of 2009 a customer won $5m on its “Mega Fortune Wheel” . Instead of taking the money and retiring, the customer took $2m and re-gambled (and lost, or “recycled” as Partygaming call it) $3m. Beautiful!

Posted in Capital employed, e-commerce, Gearing, Balance Sheet | Comments Off

05/02/2010 by admin.

In this and the next post I am going to compare two related businesses which are at opposite ends of what I consider ideal models; football and online poker.

But today, football. Let me state up front I am not a football fan. But recently I have taken an interest in its business aspects. A number of clubs are facing financial ruin. Given the money associated with the sport why is this so? As an accountant looking in from the outside I have to say that the business is a basket case. 

The model seems to be as follows:

First, buy the  most expensive assets (players) you can. Fair enough, there is evidence of a direct correlation between the value of the squad and league success.

Second, use debt to fund the acquisitions. This debt is often in the form of loans from the latest mega rich owner.

Third, not only pay a large amount for the assets but only acquire those with high running costs (salaries).

Fourth, do not forget to pay agents fees on all of the above.

Fifth, with league success comes an enhanced revenue stream. Successful teams get a larger share of TV rights, gate takings and sponsorship.

A simple enough model one might think. The problem though is sustainability. Let us look at clubs of which Portsmouth is a good example, although the following analysis applies to many others.

The club went on a spending splurge funded by debt. Having acquired an above average size squad, at above average size cost, the club went on to win the FA cup. But Portsmouth has a 20,000 seater stadium, with little by way of corporate seating.  So success has a limit to the amount taken at the gate.

The wages bill  became 99% of its total revenue. So it had to start to sell off some of its players. The contracts obviously depreciate so the players have the potential to lose value. By selling off the more valuable players one’s chances of league or cup success start to recede. With this comes the drop in revenues (less TV money, lower gate and poorer sponsorship deals), so more players have to be sold and so it goes on in a downward spiral.

Part of the problem is that the running costs of the club are so high. So revenues from selling players does not always get applied to reducing the debt. The clubs are saddled with  debt which is reducing at a lower rate than the asset level (that is players are being sold faster than the money raised is used to pay off the debt). Eventually the balance sheet has more liabilities than assets. Other liabilities then become more pressing. For example, the tax authority (HMRC) has recently become very aggressive in taking clubs to court with winding up petitions. So more of the clubs’ funding has to go on settling overdue debts from the past. So money raised today on player sales is going on “dead” debts - there is no return on paying off agents’ fees, transfer fees or indeed tax relating to two or three years ago.

This then leads to a more pressing and dangerous problem. Most players have a contract that states if their wages are overdue for 14 days or more then their contract is void. Thus these highly expensive assets can just walk away - their value as far as the club is concerned is then zero! So to maintain value in the club it must keep meeting the salary bill (recall this has been as much as 99% of Portsmouth’s revenue). So it must continually be raising more money, either through more debt or through selling more players. Both of these routes just worsen the situation.

The cause and ultimately the soultion of this situation is the players fees and salaries. The amounts being paid is simply not sustainable. My view is that it will take a number of high profile administrations before the industry will come to its senses. The situation is exacerbated by the very wealthy owners who seem to not care about the losses. This is all well and good if they write off those losses. But many clubs are saddled with debt  from previous owners who funded a spending splurge , took the glory and now want their money back - madness!

Until the industry is run by business people (sorry fans - former players really do not fit this profile!) then clubs will continue to suffer. There does appear to be signs of common sense returning. During the January transfer window only £30m was spent in the UK market. This compares to  £170m last year and £150m the year before.  Beautiful?

Posted in Football, Gearing, Balance Sheet | Comments Off

04/02/2010 by admin.

Hello. I am Kevin Amor, the principal of Aqhuman Financial Training.  Aqhuman runs management training courses in (yep, you guessed it) finance. We cater for all levels of management; from new management appointments to one-to-one sessions for directors.

I am also a tutor on the OU MBA programme. And to keep my hand in commercially, I am the investment strategy manager of a property investment fund.

A number of participants on my courses have suggested I write a blog. I assume this is a complement and not just a way for them to reap some revenge on me!

Anyway what seem to be popular is the way I seem to be able to explain fairly complex financial concepts in an easy-to-understand way. Given that, the idea of the blog is to look at the financial and economic stories of the day and try to explain what they mean and give my interpretation or view on them.

I will apologise now if you disagree with me. I also apologise for  simplifying the issues. This is often necessary in order to get across the key points to non-finance readers, my main audience. I hope you enjoy reading this and find it useful.

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