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Ratios are used in order to interpret a company's financial statements. Financial ratios help to identify the areas of good and bad performance. According to Elliot and Elliot (2006), "ratios identify the relationship between different items in the financial statements". More specifically, financial ratios have an advantage; that they provide every user with a lot of information
Many ratios can be calculated from a set of financial statements but the company has to focus on these which provide useful information. The numbers needed in order to calculate financial ratios are taken usually from the balance sheet and the income statement. The balance sheet reports a company's assets, liabilities, and stockholders' equity on a specific date, such as December 31, 2006. The income statement is referred to the profit and loss statement, statement of income, and the statement of operations. The income statement reports the revenues, gains, expenses, losses, net income and other totals for the period of time shown in the heading of the statement. It is important these financial statements to be accurate in order to have the right results.
If ratios have been calculated wrong, they may lead to wrong interpretation of results and may be completely useless. On the other hand if they are correct they may be a very useful tool for analysing a company's financial statement. They can be used either by external or internal users. The main reasons why financial ratios used are to judge the performance of a company, to analyse credit risk and make fundamental analysis in order to predict future performance.
Furthermore financial ratios are used to compare financial statements of two or more companies in order to choose where to invest. But it must be taken under consideration that companies in different countries may use different accounting policies.
Every manager has the ability to create his own ratios depending on his company's financial statements. But there are some ratios that are more common and useful than others. The main categories are:
Use of Assets and
Below it is given a brief description of the most common and useful financial ratios which are going to be used later.
Current Ratio: This ratio compares current assets with current liabilities and it is a short term measure of a company's liquidity position. It should be grater than 2 but this depends on the industry sector.
Quick ratio: or Acid test ratio deals with the company's ability to pay its present liabilities from its present assets but this time not including the sale of the inventories.
Gross profit: or Gross profit margin is a measure of profitability. Measures the sales that are not absorbed by the cost of sales
Return on Capital Employed (ROCE): is used as a measure of the returns that a company is realizing from its capital employed.
Return on Sales: This ratio measures the contribution of the sales to the net income. This ratio detects operational efficiency.
Inventory turnover: This ratio measures how many times the company turns over its inventory. It can also be mentioned that this ratio has great importance for industries which manufacture products that have limited time of life, such as food or chemical industries.
Asset turnover: is used to determine how much sales revenue a company generates from its investment in assets.
Interest cover ratio: This ratio shows how many times a company its interest expenses by its operating earnings.
Dividend yield ratio: This ratio shows the cash return in an investment of a company.
Debtor days: being the number of days of credit taken by customers. In other words indicates the average time taken to collect trade debts.
Creditor days: Should be compared to the debtor days.
Peter Smith would like to invest in a local company either Avon Ltd or Humber Plc. From the balanced sheet and the income statement that was given to us, 16 ratios are calculated in order to make a comparison between these two firms and assist Peter to make the best decision.
As it is observed both firms have current ratios below the ideal. However is over 1.50 and that means that both companies are able to pay their suppliers. According to the acid test ratio Avon has the ability to pay its current creditors quickly. On the other hand Humber has no receivables, however that is in contrast with the acid test ratio which is low.
Humber has a low stock turnover and that means a high stock level. Avon pays its creditors in 30 years although it is being paid by customers in 67 days. Avon should decrease dramatically its debtor days otherwise it will face serious liquidity problems. Humber pays its creditors in 9 days an that may occur because Humber wants to achieve better prices. Stock turnover in Avon is 40 days though in Humber is 19 days. Humber keeps stock fewer days than Avon and though it can not organize very well its stock profits are earned sooner than Avon's.
Too much capital is being used that could be used for other purposes. So Humber should try to reduce stock level in order to improve liquidity. Both companies have big distribution expenses that they have to eliminate. Humber has many administration expenses too that must be reduced. Furthermore Humber has 3 % lower Gross profit than Avon. As far as Humber is concerned a lower Net profit is observed and that is because it operates on a low margin in order to achieve high volume basis
Humber is making a more efficient use of its capital employed which is greater than Avon's. Moreover Humber is achieving a high ROCE through high volume of sales per unit of capital employed. Avon's ROCE is poor comparing to Humber and that comes from a poor Asset turnover. Humber has better profitability but has to eliminate their costs and Avon has to increase the level of sales per capital employed. Humber covers interest from profits better than Avon and that is indicated from Interest cover ratio where in Humber is 7.12 though in Avon is 3.65. In Fixed Asset ratio it is observed that Humber uses better its fixed assets in order to achieve a better sales performance.
Peter is having the opportunity either to invest in Avon Ltd or in Humber plc. According to ratio analysis Humber do not face as many liquidity or profitability problems as Avon. The dividends of Humber have better yield and returns than Avon's dividends. To sum up and Peter should better invest its surplus reserves in Humber in order to make a good decision. Humber has better earnings per share and that is a key ratio for Peter in order to make a decision to invest in Humber.
The IASB Framework
The IASB Framework for the Preparation and Presentation of Financial Statements describes the basic concepts by which financial statements are prepared. The Framework serves as a guide to the Board in developing accounting standards and as a guide to resolving accounting issues that are not addressed directly in an International Accounting Standard or International Financial Reporting Standard or Interpretation (www.iasplus.com). The framework deals with the objective of financial statements, the qualitative characteristics which are useful in order to have the appropriate reliable and relevant information and also defines recognition and measurement of the basic financial elements.
The elements of the financial statements are divided to those which are related to financial performance, such as assets, liabilities and equity and can be found in the balance sheet, and those which are related to performance such as income and expenses and can be found in the income statement.
Recognition is the process of incorporating in the balance sheet or income statement an item that meets the definition of an element and satisfies the following criteria for recognition (www.iasplus.com). For example an asset is recognized if it has a cost or a value which can be measured reliably and can bring future economic profits to the firm.
Measurement involves assigning monetary amounts at which the elements of the financial statements are to be recognised and reported (www.iasplus.com). There are many ways in order to achieve the measurement of the elements of financial statements. Most basic are:
Historical cost, which is the most common,
Current cost and,
Net realisable value.
Property, Plant and Equipment
Property, plant and equipment (PPE) is defined as a tangible asset which is expected to be used for more than one year and it is used in the production or supply of goods or in order to be rented to others or for administrative use. According to IAS 16, items of property, plant, and equipment should be recognised as assets when it is probable that the future economic benefits associated with the asset will flow to the enterprise; and the cost of the asset can be measured reliably (IAS 16.7). Property plant and equipment should be recorded at cost. That cost includes the purchase price, purchase taxes, installation costs, initial delivery costs and all costs needed to bring the asset into working condition.
An asset that is not physical in nature. Corporate intellectual property (items such as patents, trademarks, copyrights and business methodologies), goodwill, research and development and brand recognition are all common intangible assets in today's marketplace (www.investopedia.com). Intangible assets are very crucial for the success or the failure of a firm as they are valuable despite the fact that they do not have the physical value that equipment or buildings have.
According to IAS 38, an enterprise can recognize an intangible asset, both purchased and self-created, if the measurement of cost can be reliable and if it is possible, the output future economic benefits will flow to a company. Moreover intangible assets are being measured in cost, by using either the cost model or the revaluation model. Based on their useful life intangibles may have indefinite life and finite life. Intangible assets comprise life and finite life intangible assets. Indefinite life intangible assets, such as goodwill, are those which there are no limits for their economic life. They are not being amortized but they are annually tested for impairment.
Inventory is a list of goods and materials held available in stock by a business. IAS 2 describes how should inventories be treated, recognized and measured. Inventories must be recognized as expense of the period in which was recognized the relevant revenue. As far as their measurement is concerned measurement inventories should start with the lower possible cost, in which should be included the cost of purchase, the cost of conversion and the other costs that occurred when inventories were in their present location and condition.
The acceptable methods of inventory valuation according to IAS 2 include FIFO (First in- First Out) where inventory is valued at the most recent cost, the Average Cost where inventory is valued at a weighted average cost and Standard cost.
Liabilities are divided into current liabilities and non current liabilities. Current are the liabilities that are going to be held for trading and the company has no right to defer payment for over 12 months All the other liabilities that do not have the above characteristics are considered to be non current. IAS 37 deals with provisions and contingent liabilities which are a part of liabilities. Provisions are "a present obligation requiring a probable transfer of economic benefits that can be reliably estimated" (Elliot & Elliot, 2006). Current liabilities are the firm's debts or obligations that are due within one year. Current liabilities appear onÂ the company's balance sheet andÂ include short term debt, accounts payable, accrued liabilities and other debts. (www.investopedia.com). According to IASB Framework liabilities should be measured reliably.
Nestlé S. A.
In order to have a complete understanding of these four reporting areas Nestlé's annual report was observed. The consolidated financial statements of this company have been prepared according to accordance to International Financial Reporting Standards. The accounts have been prepared on accruals basis and under the historical cost convention.
Property plant and equipment are showed in the balance sheet of Nestle Company at their historical cost and the straight line depreciation method is used in order to depreciate the initial cost down to the residual value over the estimated useful lives. Goodwill has been allocated for an impairment test. All assets, liabilities and contingent liabilities are recognized at the acquisition date and measured at their fair value.
Finally the fair values of the current financial liabilities are not materially different from their carrying amounts. The fair values of the non-current financial