Course topics
This training course covers six focus areas which touch upon topics related to these aspects. The modules build up on each other and guide participants step-by-step through the content:
- Financial accounting
- Financial analysis
- Financial modelling
- Asset valuation
- Investment analysis
- Cost of capital
FINANCIAL ACCOUNTING
This training module explains the major accounting principles, and the role and structure of the main financial statements used for business purposes (balance sheets, the profit and loss account and cash flow statement).
It provides a detailed analysis of their components including asset and liability items in the balance sheet, revenue and expense items in the profit and loss account, sources and uses of funds in the cash flow statement.
Furthermore, the training module explains the role of regulatory accounts and the links between financial and regulatory accounting. In addition to the conceptual part of the training module, appropriate examples and exercises that help the participants to understand the practical use of the concepts is also provided.
FINANCIAL ANALYSIS
Management (but also regulatory) decisions are made and companies’ performance monitored against a range of financial indicators. The training module covers four groups of financial indicators that characterise profitability, liquidity, capital structure and financial viability. The role, calculation and the interpretation of the indicators is explained with the help of appropriate examples and exercises.
The first group of financial indicators refers to the profit achieved by the company. It can relate to the profit margin, i.e. the pre-tax or after-tax profit earned for every monetary unit of sales by the company, or to the financial return such as return on equity or return on capital employed.
The second group of indicators (liquidity) describes the ability of a company to satisfy its short- term obligations with current assets.
The analysis of a firm’s capital structure (third group) is essential to evaluate its long-term risk and return prospects. Since debt carries fixed-interest and repayment commitments, a highly geared firm (i.e. a firm with large fraction of debt in its capital) has greater chances of failing on its financial commitments and the returns for equity shareholders become volatile and risky.
The last group of indicators (financial viability) centres on the ability of the companies to meet their payment obligation and to serve their debt, and ultimately to continue sustaining a commercially appropriate credit rating.
FINANCIAL MODELLING
The financial models are used to simulate companies’ financial performance resulting from revenues based on market or regulated prices. This training module illustrates the mechanics of the financial modelling. Specifically, it explains how to model the financial statements (balance sheet, income statement and cash flow statement) and building on that to calculate the financial indicators explained in the previous training module.
The work is based on a simplified financial model developed specifically for the training module that demonstrate the interactions between the financial statements and the implementation of financial ratios. The model applies iteration cycles to arrive at an equilibrium that balances the company cash flows. The cash inflows integrate the cash generated from internal sources and external (debt and equity) financing while the cash outflows cover investments in assets, changes in working capital and debt repayment.
ASSET VALUATION
This training module focusses on asset valuation techniques. A range of methods can be used by regulators and companies’ management to value assets. These methods include historic cost (original purchase price), indexation (values assets at their historic cost for the effect of inflation), replacement (and optimised) value and deprival value.
The historic cost methodology values assets at their original purchase price. In general, “indexation” refers to the procedure for adjusting the value of the asset base for the effect of inflation (price changes in the regulated assets or price changes in the economy as a whole).
Replacement value methodologies calculates the cost of replacing an asset with another asset (not necessarily the same asset) that will provide the same services (maybe using more efficient technology) and capacity as the existing asset. Deprival value is the loss the business would suffer if it were deprived of the asset.
The training module explains the role of asset valuation and the conceptual models used for valuation purposes. In addition to the conceptual part of the training module also comprises appropriate examples and exercises that help the participants to understand the practical use of the concepts.
INVESTMENT ANALYSIS
The inclusion of capital costs in the allowed revenues recognises the owner’s investment in the regulated company and the capital-intensive nature of the business. Failure to include adequate capital costs risks to discourage investments and may lead to the deterioration of quality level in the industry.
This training module provides first classification of investments (e.g. replacement versus extension investments, reliability versus economic investments) and then explains the appraisal techniques used to assess the efficiency of investments. Regulators apply inter alia engineering analysis, benchmarking against other businesses and cost-benefit analysis (CBA) to inform their decisions.
Furthermore, the training module explains the ex-ante and ex-post inclusion of investments in the regulatory asset base. In the former case the investment allowance is set with reference to planned investments. Consequently, regulatory arrangements should include provisions dealing with differences between planned and actual capital expenditure at each review. In contrast the ex-post integration assesses the efficiency of the actual investment expenditure incurred.
In addition to the conceptual part of the training module, appropriate examples and exercises that help the participants to understand the practical use of the methods for investment analysis are also provided.
COST OF CAPITAL
The allowed rate of return describes the return the firm is permitted to earn. It aims to adequately reflect the risk of regulated industry and provides return to encourage investments. The allowed rate of return is typically set by using the weighted average of the cost of debt and equity financing (WACC).
The training module explains the definition and the estimation of the WACC components including cost of equity, cost of debt and capital structure. It addresses the role of inflation and corporate tax for the purposes of WACC setting. For example, WACC may include or exclude corporate taxes (pre-tax or post-tax specification) and can be computed in real or nominal terms, i.e. excluding or including inflation.
The estimation of WACC is discussed in the context of the application of the capital asset pricing model (CAPM). CAPM calculates the rate of return with reference to risk-free rate (the expected return on an asset which bears no risk at all) and a risk premium that reflects the additional return that investors should require to invest in the regulated assets.
In addition to the conceptual part, the participants will carry out several specific exercises that will help them develop understanding the practical WACC estimation.
