A financial statement is a written report which describes the financial position of a company. It includes an income statement, balance sheet; retain earning statement and cash flow statement. Financial reports are usually compiled on a quarterly and annual basis.
Analysts who believe in the inherent reliability of GAAP numbers and the good faith of corporate managers misunderstand the essential nature of financial reporting. Their conceptual error connotes no lack of intelligence, however. Rather, it mirrors the standard accounting textbook's idealistic but irrelevant notion of the purpose of financial reporting. [i] (Martin Fridson, Fernando Alvarez, 2002)
The primary goal in financial reporting is the dissemination of financial statements that accurately measure the profitability and financial condition of a company. [ii]
There are four major financial statements used in a business organization to describe the financial health of the company [iii] -
Balance Sheet
Income Statement
Statement Of Retain Earnings
Cash Flow Statement
Balance Sheet: Assets are things that a company owns that have future value. This classically means they can either be sold or used by the company. Assets are used to the production line or provide services that are the primary services or products of the company. The asset can be different type like- physical property, (plants, trucks, equipment and inventory), or things that can't be touched but however they never exist and have value (trademarks and patents. Cash itself is an asset. And cash is the most liquid and called current asset.
Purpose of balance sheet: The balance sheet is a remarkable invention, yet it has two fundamental shortcomings. First, although it is in theory useful to have a summary of the values of all the assets owned by an enterprise, these values frequently prove elusive in practice. Second, many kinds of things have value and could be construed, at least by the layperson, as assets. [iv] (Martin Fridson, Fernando Alvarez, 2002)
Some other purposes are:
Is to show the company's Asset, Liability and the Owners Equity.
Balance sheet helps a business organization rapidly to have control on the financial strength of the business.
It identifies and analyzes trends mostly in the part of receivable and payable.
As the assets and properties are classified in to different categories like short term or long term, it is easily identifiable any data related to this very clearly and quickly.
Figure 1: A Sample of Balance Sheet
Income Statement: Income statement is one of the key financial statements .It is the summery of profit and loss of the company for a specific accounting period. The income statement deals with operating items which are remarkable to investors and analysts alike as this section discloses information about revenues and expenses that are the direct result of the regular business operations. For example, if a business produces cars, then the operating items section would talk about the revenues and expenses involved with the production of car equipment.
Purpose of income statement:
Evaluate the past performance of the company. Examining revenues and expenses indicates how the company performed and allows comparison of its performance to its competitors. For example, analysts use the income data provided by Ford to compare its performance to that of Toyota.
Provide a basis for predicting future performance. Information about past performance helps to determine important trends that, if continued, provide information about future performance. For example, General Electric at one time reported consistent increases in revenues. Obviously past success does not necessarily translate into future success. However, analysts can better predict future revenues, and hence earnings and cash flows, if a reasonable correlation exists between past and future performance.
Help assess the risk or uncertainty of achieving future cash flows. Information on the various components of income-revenues, expenses, gains, and losses-highlights the relationships among them. It also helps to assess the risk of not achieving a particular level of cash flows in the future. For example, investors and creditors often segregate IBM's operating performance from other nonrecurring sources of income because IBM primarily generates revenues and cash through its operations. Thus, results from continuing operations usually have greater significance for predicting future performance than do results from nonrecurring activities and events. [v]
Figure 2: A sample Income Statement
Statement of Retain Earnings: A cash flow statement shows changes in balance sheet accounts and income influenced by cash and cash equivalents. It breaks the analysis in to several activities like operating, investing, and financing activities. The cash flow statement shows the flow of cash in and cash out of the company. The statement presents both the current operating outcomes and the additional changes in the balance sheet. The cash flow statement, as an analytical tool, is handy in determining the short-term capability of a company, mostly its capability to pay bills. International Accounting Standard 7 (IAS 7) is the Accounting Standard that determines the rules of a cash flow statement.
Purpose of Retain Earnings:
The cash flow statement converts the items of the income statement to cash from the view of accrual basis of accounting.
It shows the purchase and sale of investments and non-current property, plant and equipment.
The cash flow statement shows the payment of dividends and issuance or repurchase of the company's own bonds and stock.
Cash flow statement presents the exchange of major non cash items and shows the total of interest and income taxes paid.
Figure 3: A sample Cash Flow Statement.
Describe the differences between the formats of financial statements for different types of business. Comment on the format of Trevor plc's profit and loss account and balance sheet.
Calculate eight ratios that will help in assessing the profitability, liquidity, efficiency and investment ratios of' Trevor plc
Ratios for profitability Analysis of the Business:
Return on capital Employed (ROCE)
ROCE =
2009/2010(£)
ROCE =
0.275 or 27.5%
Gross profit Margin
Gross Profit Margin =
2009/2010(£)
Gross Profit Margin =
0.2895 or 28.95%
Net profit Margin:
Net Profit Margin =
2009/2010(£)
Net profit Margin =
0.091 or 9.1%
Efficiency ratios:
Stock turnover Ratio:
Stock turnover ratio =
2009/2010(£)
Stock turnover ratio =
12.26 times
Sales revenue to capital employed (Asset Turnover Ratio)
Asset Turnover Ratio =
2009/2010(£)
Asset Turnover Ratio =
2.38:1
Liquidity Ratios:
Current Ratio
Current Ratio =
2009/2010(£)
Current Ratio =
2.16:1
Acid Test Ratio
Acid Test Ratio =
2009/2010(£)
Acid Test Ratio =
1.495:1
Operating cash flows to maturing obligations ratio
Cash generated from operations to Maturing obligations =
2009/2010(£)
1.023:1
Financial Gearing:
Two ratios are widely used to assess gearing:
Gearing Ratio
Gearing Ratio = x 100
2009/2010(£)
Gearing Ratio = x 100
42.86%
Interest Cover Ratio
Interest Cover Ratio =
Interest Cover Ratio =
-
Investment Ratios:
Earnings per Share:
Earnings per Share =
2009/2010(£)
Earnings per Share =
£10.1082
Price/Earnings Ratio =
Cash generated from operations per share =
2009/2010(£)
Cash generated from operations per share =
.218
In question 1.3, analyze the results of ratios and draw valid conclusions.
The Balance Sheet and the income statement of Trevor Plc give the information to calculate the financial ratios of the company. From the calculation of profitability ratios, the company is not actually a bad position. Return on capital employed shows that the company return on capital used is 27.5%. And from the gross profit margin ratio, the company's gross profit ratio is 28.9%. But the Net profit margin is quite low and it is only 9%. This indicates that the operating cost of the company is quite high.
Efficiency ratio gives actually a quite satisfactory result. The average Stock turnover is 12.26 and asset turnover ratio is more than double. Liquidity ratio also shows the good position of the company. Current ratio and acid test are 2.16 and 1.49 on 1.
For the financial gearing, only one ratio can be calculated as for the limitation if data. And finally, the investment ratio showing that the EPS of the company in more than 10 pound, against the face value of 1 pound per share.
In question 1.4, critically evaluate the availability of information that facilitates the calculation of ratios.
The data are quite full fill to calculate several ratios, although it is not possible to calculate any desired ratio from these data. For an example, as the company has no interest payable, interest cover ratio cannot be calculated. On the other hand, there are several methods to calculate ROCE and only one method can be applied for limitation of data.
For efficiency ratio calculation, Trade debtor collection period ratio, Trade creditor payment period ratio, cannot be calculated for limitation of data. As we need total sales on credit to calculate that and we do not have that data in that given information.
Answer to the REQUIREMENT-2
Trevor plc is considering investing £1m in a new project to manufacture and sell a brand new toy. The following estimates have been made:
Sales (number of units)
50,000 in the first year, rising by 10,000 units per annum
Life of project
4 years
Unit information
£
Price
25
Material cost
10
Labor and variable overheads
8
In addition, fixed overheads relating to the project are expected to be £90,000 per annum. The investment is expected l to have no residual value.
Calculate the NPV (assuming a cost of capital of 8 %.) and Payback period, of the project.
Initial investment (Present value) = £1,000,000
Cost of Capital= 8%
Return from the project in 4 years:
Year
1
2
3
4
Sales(No. of units)
50,000
60,000
70,000
80,000
Price @ £25
1,250,000
1,500,000
1,750,000
2,000,000
Total Cost
Material Cost @ £10
(500,000)
(600,000)
(700,000)
(800,000)
Labor and
variable cost@ £8
(400,000)
(480,000)
(560,000)
(640,000)
Fixed cost per annum £
(90,000)
(90,000)
(90,000)
(90,000)
Cash Flow £
260,000
330,000
400,000
470000
NPV= - Initial Investment+
NPV = -1,000,000+ [+
=-1,000,000 + 1,186,659.48
= 186659.48
Pay Back Period = 3 +
= 3.021 year.
Advice either to accept or reject the project based on your findings in requirement 2.1.
This project of Trevor plc of investing a brand new product has an initial investment of £1m, and the discount rate is 8%. According to the calculation, the project is making a positive NPV. So in this consideration, Trevor plc should go for the project as this project will earn revenue. But the Payback period is quite high. It is little bit more than three years. So, if there is any alternative project available that will give more NPV than this project, with same amount of investment, and the payback period Trevor plc should consider the project.
Answer to the REQUIREMENT-3
"The methods used to raise long term finance have implications for the capital gearing of a company and the returns to equity holders?
Identify the sources of finance available to a business.
There several ways to raise finance for a company. The way of collecting capital, depends on the character of the business. Large businesses can use a wide range of finance sources and for the smaller companies, it is opposite. Personal savings are major source of investing money into a business. The best and easiest sources of capital are the people from around. Personal loan, from families and friends is the best for small business. Companies collect capital by issuing shares and for this reason large company often have thousands of shareholders.
The sources of the finance of the company, in a wider discussion, can be classified in different heading. The sources can be classified as the time duration of the financing, according to ownership of the control and so on.
BASED ON TIME-DURATION: The sources of capital or finance of business are categorized based on the time duration if which the money is requisite. Time period are commonly categorized into three:
Long Term Financing: Capital required for a period of 5 years to 20 years or may be more is considered as long term financing. This type if capital is invested generally in fixed assets (machinery, land and building etc) of a company as they are long term asset. Some of the working capital which permanently keeps on with the business may also be invested with long term sources of finance. Long term financing sources can be -
Share Capital / Equity Shares
Internal Accruals or Retained Earnings
Debenture or Bonds
Asset Securitization
Financial Institutes, Commercial Banks, and Government
International Financing (Euro Issue, Foreign Currency Loans, GDR).
Medium period Financing: Type of financing, which are for a period between 3 to 5 years, are considered as Medium Period Financing. This type of financing is used in general, for two reasons. First, when long term investment is unavailable for certain period. Second, if deferred revenue costs (ex: advertisements) are made and are amortized over a time limit of 3 to 5 years. Medium period financing sources are-
Preference Shares
Debenture or Bonds
Government loan
Loan from Commercial Banks
Medium Term Loans from, Lease Finance, Financial Institutes, etc.
Short Term Financing: When the financing is done for period of less than 1 year, the finance in called short term financing. Short term financing is needed to meet daily expense or working capital. Other name of short term financing is working capital financing, and it is called so because this money is one of the main sources to manage the smooth running of daily working of the business. Short term finances sources are-
Trade Credit
Working Capital Loans from Commercial Banks
FDR for 1 year or less
Advances received from clients
Bill Discounting
Creditors
Accounts Payables
BASED ON OWNERSHIP AND CONTROL: Sources of finances an also be classified based on ownership and control of the business. 'Ownership of Capital' and 'Control over Management' is two vital concerns while in the decision of selecting the source of finance. Every time the company brings the capital, two costs are there. First is interest of the borrowed money and second one is sharing of ownership and control. Sometimes entrepreneurs do not like to share the ownership rights of business.
Owned Capital: Owned capital also known as equity capital. Owned capital is the capital that is supplied from investors of the business. If the company is public limited, the money can also be collected from public by issuing new equity shares. Business is started by the investor by bringing in the necessary investment. The following sources can be the sources of Owned capital:
Equity Capital
Preference Capital
Convertible Debentures
Private Equity
Retained Earnings
Borrowed Capital: Borrowed capital is the capital borrowed from outside sources. Outside sources include the following:
Financial institutions
Commercial banks or Govt.
General public in case of debentures.
BASED ON SOURCE OF GENERATION:
Internal Sources: Internal source is generated internally from the business and it has the same characteristics of owned capital. Internal sources are as follows:
Retained profits
Sale of assets
decreasing or controlling of working capital
External Sources: The finance which is generated from outside the business is referred as external sources. Apart from the internal sources finance, all the sources are external sources of capital.
Assess the implications regarding tax effect, ownership and control of the different sources. [Pass-P2]
Assess and compare the costs of different sources of finance. [Pass-P4]
Describe the impact of finance on the financial statements. [Pass·P7]
Suggest the best method of raising £1 million for the above project. [Pass-P3]
Critically explain why you have selected the method (or combination of methods) in question 3.5. [Merit- M1]
Apply creative thinking to assess the implications/limitations/impacts of the selection you have made in requirement 3.6 [Distinction-D3]
Answer to the REQUIREMENT-4
Explain the importance of financial planning. [Pass-P5]
Describe the information needs of different decision makers [Pass-P6]
Based on the information provided under the requirement 2,
Calculate unit costs of making a toy and identify the profitability margin for each toy. [Pass-P9]
Do you think it is possible to prepare a cash budget for the new project to manufacture a brand new toy? Explain why. [Pass-P8]
