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Managing Financial Resources and Decisions

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Introduction

Financial Statements shows an official record of the monetary activities of a business (Butler, 1993). These are written reports that compute the monetary strength, performance and liquidity of a business. It reflects the financial impacts of a business transactions and events on the business.

Financial statements are prepared using the concept of Double entry bookkeeping. The equation is:

Assets= Liabilities + Equity

For the accounts to remain in balance, a change in one account must be matched with a change in another account. These changes are made by debits and credits in the accounts.

Discuss the main financial statements (AC4.1)

The following are the main financial statement:

Balance sheet

Balance Sheet displays the fiscal position of a company at a given date (Khan & Jain, 2007). Balance sheet has three main elements:

Assets: Something a business claims or controls (e.g. Cash, stock, land and building, and so forth)

Liabilities: Something a business owes to somebody (e.g. lenders, bank credits, and so on).

Equity: It is what a company owes to its holders. It is the difference between assets and liabilities. It shows what a company has left after paying off its liabilities.

Profit and loss Statement

It represents a company's profit or loss over a period of time. It has the accompanying two components:

Income: What the business has earned over a period (e.g. deals income, profit wage, and so on) (Khan & Jain, 2007).

Expense: The expense caused by the business over a period (e.g. pay rates and wages, devaluation, rental charges, and so forth)

Net profit is calculated by deducting costs from sales/revenue.

Cash Flow Statement

It displays the movement of cash over a certain period of time. This movement is grouped into the accompanying fragments:

Operating Activities: Represents the money stream from normal activities of a business.

Investing Activities: Represents money stream from buying or sales of assets other than inventories (e.g. buying a manufacturing plant).

Financing Activities: Represents money stream generated or used on raising and reimbursing share capital and debt together with the payments of interests and dividends.

Statement of Changes in Equity

It details movements in the holder's equity over a fiscal year (Troy, 2009). It is deduced from the accompanying segments:

  • Net Profit or loss throughout the period as reported in the profit and loss statement.
  • Share capital issued or reimbursed throughout the period
  • Dividend payments.
  • Gains or losses perceived straightforwardly in equity (e.g. revaluation surpluses)
  • Effects of rectification of accounting errors.

Link between Financial Statements

The following diagram summarizes the link between financial statements.

Relationship between financial statements

Compare appropriate formats of financial statements for different businesses (AC4.2)

The four fundamental formats for trading as a profit making organisation in UK are sole traders, partnership, private limited company and public limited company.

Sole Trader

A sole trader is a sole owner of the business. The sole trader is not a separate entity from the business which means if the business gets bankrupt; the sole trader will need to pay off any debts. There is no formal requirement to register the sole trader’s business but he/she needs to register with the Inland Revenue and Customs and excise for tax purposes.

A sole trader can prepare their own accounts. He/she can do so under the self assessment scheme.

Partnership

It is somewhat similar to sole trader except that there are more than one person involved in a partnership. Usually a partnership can be made from 2 to 20 individuals. Each partner is responsible for the actions of others. The liability is unlimited which means if the business go bankrupt, they will need to pay off the debts from their pockets.

Each partner is taxed individually via self assessment route. A partnership may or may not audit its accounts from a professional firm or an accountant.

Private Limited company

These are normally family run business. Privately owned businesses may issue stock and have shareholders. Notwithstanding, their shares don't exchange on open market. Shareholders will most likely be unable to offer their shares without the understanding of other shareholders.

Advantages

  • limited Liability: It implies that if the organization experience budgetary misery in view of typical business movement, the particular holdings of shareholders won't be at danger of being seized by creditors (Butler, 1993).
  • Continuity of presence: business not influenced by the status of the owner.
  • Minimum number of shareholders need to begin the business are only2.
  • More capital could be raised as the maximum number of shareholders permitted is 50.
  • Scope of development is higher in light of the fact that it’s simple to raise capital from financial organizations and advantage of limited liability.

Disadvantages

  • Growth may be constrained in light of the fact that maximum shareholders permitted are just 50.
  • The shares in a private limited organization can't be sold or exchanged to any other person without the agreement of other shareholders.

The accounts of private limited companies must be prepared by an external accountant in certain circumstances, for example large companies. The accounts need to be submitted to Companies House every year.

The accounts for limited companies are normally simpler and often prepared by anyone in the company.

Public Limited company

Most facts between private and public companies are same. Public companies are usually bigger in size. There must be an authorised share issue of at least £50,000 of which £12,500 must be fully paid. Shares can be traded on stock exchange. An external qualified accountant needs to prepare the accounts and must be submitted to Companies House every year.

There are requirements regarding the format of the accounts. The balance sheet must be prepared either using vertical or horizontal formats. The Profit and loss account could have four formats; two vertical and two horizontal. There is also requirement for showing the figures from previous fiscal years in the accounts. Once a business adopts any specific format, it needs to be adopted for the future to ensure consistency in accounts.

Interpret financial statements using ratios (AC4.3)

XYZ Ltd is hypothetical company with rivals ABC Ltd and DEF Ltd. The ratios cover a three year period (Jan 2010-Dec 2012) in order to show how XYZ Ltd is standing in terms of its competitors in the industry. XYZ Ltd is one of the largest energy companies in the world providing its customers with fuel for transportation, energy for heat and light, retail services and petrochemical products for everyday items.

The financial ratios are categorised into following main areas:

  1. Profitability Ratio.
  2. Return on Investment Ratio.
  3. Liquidity Ratio.
  4. Long Term Financial Stability Ratio
  5. Efficiency Ratio

1) Profitability Ratio

Armstrong (1999) Profitability ratio is a key financial indicator in order to analysis company’s financial position. It helps to identify whether the company is generating acceptable profit or not.

Gross Profit Margin

It shows how well a company is controlling its production costs. It is calculated as a ratio of gross profit to revenue a company is able to generate over its period of operation. It is a very good measure in order to analysis a company performance within the same industry.

XYZ’s Gross profit margin is fairly stable over the last two years. Its 31.1% in 2012 compared to ABC Ltd which is 16.6%, although DEF Ltd has the highest gross profit margin among the lot which is 35.8%. XYZ has achieved this through tight control over its production department. The decrease in GPM compared to 2010 is due to the weakening of US natural gas prices. (Appendix 4).

Net Profit Margin

Armstrong (1999) it is calculated by dividing the net profit over the Sales generated in the year.

XYZ’s Net profit margin was 13.3 % in 2010 while in 2012 its 11.1%. The decrease is due to the incident in a particular refinery in 2010 and because of that the company is making an expenditure of around $340 million as a restructuring cost.

ABC’s net profit margin has also gone down from 14.8 % in 2010 to 14.2 % in 2012 while the ratio increased in case of DEF to an impressive figure of 22% in 2012. (Appendix4)

2) Return on Investment Ratio

This ratio tells us whether a company is generating enough return on the investment. (Armstrong, 1999)

Return on Equity

ROE is an important ratio and it is used to identify the company’s ability to generate a profit over the investment of its shareholders. It is calculated as a ratio of company’s after tax profits to shareholder funds which also includes reserves. (Armstrong, 1999)

XYZ’s ROE in 2012 was 22.5 % which means that the company is able to generate 22c over a $ investment by the shareholders. But it has declined by 17.3% and 6.1 % compared to 2011 and 2010 respectively. It is due to the fact that the company has sold some of its fixed assets over which it suffered a loss also some of the impairment losses which significantly reduced its PAT figure.

ABC’s ROE figure has decreased from 27.1% to 24.4% from 2010 to 2011. DEF’s has fairly maintained its ROE and its moving around 31 %. (Appendix 5)

3) Liquidity Ratio

These ratios measure a company’s capabilities to meet its short term obligations as and when they fall due. These ratios also assess how well a company is managing its working capital requirements. (Troy, 2009)

Current ratio

Troy (2009) a current ratio of 2 considered very well as it means that the company has doubled its liquid assets compared to its current liabilities to pay off. Ratio below 1 is considered quite risky as it poses a threat to the survival of the company and also the going concern status. As a rule of thumb a ratio of 1.5 considered as normal.

The current ratio in case of XYZ was 1.03 in 2012 compared to 0.99 in 2011. It is due to the fact that the company has increased its cash and cash equivalent by an impressive 37.5% compared to 2011.

In case of ABC its 1.2 in 2012 compared to 1.19 in 2011 which is higher than ABC. DEF has A ratio of 1.35 in 2012 (Appendix 6).

Quick Ratio

Troy (2009) Quick ratio is just an adjustment in current ratio in order to assess the business ability to meet its obligation with the readily available liquid assets. Stock is deducted from current assets because it’s not considered to be readily convertible into cash.

In case of XYZ, the quick ratio was 0.69 in 2012, compared to 0.74 and 0.78 in 2011 and 2010 respectively which means that the company is sitting on the industry norm and if some of the creditors demand their money quickly, it poses a problem the company although some of the current liability like tax could be paid nine months after the end of the financial year.

As far as ABC is concerned, there was also a gradual decrease from 0.91 in 2010 to 0.88 in 2012. In case of DEF, the quick ratio was highest which 0.96 is in 2012. (Appendix 6)

4) Long Term Financial Stability Ratio

This ratio considers company’s long term financial health in order to identify its ability to pay off its debts in relation to provider and holder and also if there are any loan covenants which could be enforced which in turn poses a threat to the survival of the business (Troy, 2009).

Interest Cover

It estimates the company’s ability to pay off interest over its borrowings. As a general rule, a cover over 3 considered as safe but it varies industry to industry. (Troy, 2009)

XYZ’s Interest cover in 2012 was 29.1 compared to 48.9 and 53 in 2011 and 2010 respectively. Although there was a decrease, it is fairly safe in order for a company to meet its obligations in the long run. (Appendix 7)

5) Efficiency Ratio

It shows how well a company is utilizing its resources in order to generate good return. (Armstrong, 1999)

Inventory Turnover

This ratio indicates how quickly a company is able to sell its inventory. The more is the ratio, the more is the demand of the product. (Troy, 2009)

XYZ’s inventory turnover was 13.2 in 2012 compared to 10.1 and 12.1 in 2011 and 2012 respectively. It means that the products of XYZ are in high demand. ABC and DEF showed a reduced figure of 9.4 and 6.3 in 2007. (Appendix 8)

Receivable Days

It shows how quickly a company is able to convert its debtors into cash. This ratio is usually in days. (Troy, 2009)

XYZ has shown impressive figures of 41, 43 and 50 days in 2012, 2011 and 2010 respectively. The decrease is due to the fact that the company has tight policies over its credit and there is a strong internal control system is in placed to ensure that debtors pay on time.

In case of ABC, there was an increase in debtor days of 76 in 2012 compared to 68 in 2011. (Appendix 8)

Conclusion

XYZ Ltd has been able to show constantly great performance as far as financial and non-financial part of operation. However, the organization has been confronting with a few issues that are demonstrated by the financial ratios. This might be illuminated by enhancing the development programs, by investing into other markets, and even, having a partnership or alliance with other organizations in distinctive parts of the globe.

This could be carried out by further focusing on sources of funds and by attracting more investors. With this, the organization can achieve diverse projects and strategies that will aid in order to prevent or at least, decrease the effect of financial issues towards the organization.

It will be helpful if XYZ Ltd will proceed and even enhance its effort especially with respect to forecasting. This will encourage guaranteeing that the strategies and decisions to be implemented by the organization will be successful in helping the organization to survive the worldwide financial crisis and enhance its position in the global market.

Bibliography

Private limited company (2014). Available: http://www.dineshbakshi.com/igcse-business-studies/business-organisation/revision-notes/879-private-limited-companies. [Last accessed 24 May 2014]

Financial statements (2014). Available: http://accounting-simplified.com/financial/statements/types.html. [Last accessed 24 May 2014]

NetMBA. Financial Ratios (2013). Available: http://www.netmba.com/finance/financial/ratios/ [Accessed 24 May 2014].

Bates, B, Goodman, S Ladson, W, de Varies, C & Botha, S (2005), Business Management: Fresh Perspective, Pearson South Africa

Butler, R (1993). Strategic Investment Decisions: Theory, Practice and Processes, Taylor & Francis.

Khan & Jain 2007, Financial Management, Tata McGraw-Hill.

Gorma, T (2003), The Complete Idiot’s Guide to MBA Basics, Alpha Books.

Armstrong, M (1999), Financial Principles and Techniques.

Price, A D F (1995), International Project Accounting, International Labor Organization.

Troy, L (2009), Almanac of Business and Industrial Financial Ratios, CCH.

Appendix

Appendix 1

The company’s budgeted balance sheet is drawn as follows.

XYZ Balance sheet

       
 

2012

2011

2010

 

$million

$million

$million

       

Noncurrent assets

     

Property Plant & equipments

155,365

142,453

131,876

       

Current assets

     

Trade receivables

33,012

32,460

33,565

Inventory

26,554

18,915

19,760

Cash and bank balance

19856

24,876

25,876

       

Total Current assets

80,202

75,339

75,290

       

Total assets

236,076

217,601

206,914

       

Share capital

158,845

142,249

115,987

Current liabilities

Trade creditors

     
 

43,152

42,236

42,136

Total payables

77,231

75,352

71,497

       

Total equity and liability

236,076

217,601

206,914

       

Appendix 2

Income Statement

 

2012

2011

2010

 

$million

$million

$million

       

Revenue

291,438

274,316

245,486

Cost of Sales

200,766

187,183

163,026

Gross Profit

90,672

87,133

82,460

       

Operating Expenses

     

Production and Manufacturing

25,915

23,793

28,226

Distribution and Administration

15,371

14,417

10,776

Others

17,034

13,735

10,776

Operating Expenses

58,320

51,945

49,778

       

Net Profit (GP-OS)

32,352

35,188

32,682

Appendix 3

Operating Profit Per Annum ( Amount in $ Millions)

 

2012

2011

2010

Operating Profit in the Year

32,352

35,158

32,682

% Change Year by Year growth

(7.9)

7.5

-

       

Appendix 4

Profitability Ratios ( Amount in $ Millions)

Ratio

2012

2011

2010

       

Gross Profit Margin (GPM)

31.1%

31.7%

34.3%

Gross Profit (Sales – Cost of Sales)

90,672

87,133

82,460

Sales Revenue

291,438

274,316

245,486

       

Net Profit Margin ( NPM)

11.1%

12.8%

13.3%

Profit Before Interest and Tax (PBIT)

32,352

35,158

32,682

Sales Revenue

291,438

274,316

245,486

Appendix 5

Return On Investment Ratios ( Amount in $ Millions)

Return On Equity (ROE)

22.5%

26.4%

28.0%

Profit After Tax (PAT)

21,169

22,311

22,448

Ordinary Share Capital and Reserves

93,690

84,624

 
       

Return on Capital Employed (ROCE)

20.3%

24.7%

24.1%

Profit Before Interest and Tax (PBIT)

32,352

35,158

32,682

Capital Employed

158,845

142,249

 
       

Appendix 6

Liquidity Ratios ( Amount in $ Millions)

Ratio

2012

2011

2010

       

Current Ratio

1.03

0.99

1.05

Current Assets

80,202

75,339

75,290

Current Liabilities

77,231

75,352

71,497

       

Quick Ratio

0.69

0.74

0.78

Current assets-Stock

53,648

56,424

55,530

Current liabilities

77,231

75,352

71,497

       

Appendix 7

Long Term Financial Stability Ratios (Amount in $ Millions)

Ratio

2012

2011

2010

       

Interest Cover (Times)

29.1

48.9

53.0

Profit Before Interest and Tax (PAT)

32,352

35,158

32,682

Finance Cost

1,110

718

616

       

Appendix 8

Efficiency Ratios ( Amount in $ millions)

Ratio

2012

2011

2010

       

Inventory Turnover

13.2

10.1

12.1

Cost of Goods Sold (COGS)

200,766

187,183

163,026

Inventory

26,554

18,915

19,760

       

Asset Turnover

1.23

1.26

1.18

Revenue

291,438

274,316

245,486

Total Asset

236,076

217,601

206,914

       

Receivable Turnover (Days)

41

43

50

Trade Receivables

33,012

32,460

33,565

Sales

291,438

274,316

245,486

 

Creditors payment period (Days)

78.1

82.3

94.3

Trade creditors

43,152

42,236

42,136

Average Purchases

200,766

187,183

163,026

       

Appendix 9

Investors’ Ratios ( Amount in $ Millions)

Ratio

2012

2011

2010

       

Earnings Per Share (EPS) Basic

108.7c

109.8c

105.7c

EPS Diluted

107.84

109.12

103.66

       

Appendix 10

COMPETITOR DATA

 

2012

2011

2010

Gross Profit Margin (GPM)

ABC Ltd

16.6%

17.5%

17.6%

DEF Ltd

35.8%

37.1%

39.9%

 

Net Profit Margin (NPM)

   

ABC Ltd

14.2%

14.3%

14.8%

DEF Ltd

22%

18.1%

20.6%

Return On Equity (ROE)

ABC Ltd

24.4%

23%

27.1%

DEF Ltd

31.0%

32.0%

31.1%

 

Return On Capital Employed (ROCE)

ABC Ltd

24.2%

29%

34%

DEF Ltd

38.1%

39.3%

33.2%

 

Current Ratio (Times)

ABC Ltd

1.2

1.19

1.15

DEF Ltd

1.35

1.27

1.30

 

Quick ratio (Times)

ABC Ltd

0.88

0.89

0.91

DEF Ltd

0.96

0.92

0.92

 

Interest Cover

ABC Ltd

36.7

32.8

34.9

DEF Ltd

16.6

16.4

19.9

 

Inventory Turnover

ABC Ltd

9.41

11.32

12.77

DEF Ltd

6.33

7.09

5.53

 

Asset Turnover

ABC Ltd

1.32

1.35

1.39

DEF Ltd

1.2

1.26

1.10

 

Receivable turnover (Days)

ABC Ltd

76

68

78

DEF Ltd

51

47

61

 

Creditors payment period(Days)

ABC Ltd

93

87

81

DEF Ltd

53

54

57

       

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