Understanding Financial Statements of Alchimist - Assignment Example

Number of words

Understanding Financial Statements

Executive Summary

This report analyse the financial performance and position of Alchimist and come up with a report for Seth. This is important in making recommendations as to whether this request for investment needs to be approved or rejected. The investment will be approved only if it leads to increased efficiency as measured by profitability ratios, increased liquidity as measured by liquidity ratio and increased solvency as indicated by leverage ratios. By comparing the key financial statements over the two years, I recommend undertaking the investment.

Question 1 – Features of Alchimist’s Financial Statements.

• From the two descriptions above
• For the statement on Alchimist securing long-term debt funding from the bank, relates to the Statement of Financial Position (SOFP) while that of hiring an administrator to oversee and co-ordinate the contract relate to the Statement of Comprehensive Income (SOCI).
• This is because the long-term debt financing is a liability which categorized as non-current liabilities and appears in a company’s Statement of Financial Position, (SOFP) or balance sheet. Thus it relates the Alchimist’s SOFP because it will show the assets company owns and the liabilities it owes the financiers. The payment made to the administrator is an expense which the company has to meet before it can compute its net profit. Thus it relates to Alchimist’s statement of comprehensive income or simply the income statement and shows how the amount of revenue the company generated, the cost of generating the revenue and the expenses to cater for the labour force that helps in generating the revenue (Nelson & Couto, 2002).

• One specific example on how the three primary financial statements are linked together, in which numbers from one statement are featuring in the other two.
• Alchimist’s Statement of Comprehensive income (SOCI) feeds into the Statement of Financial Position (SOFP);
• This is by Profit for the Period from SOCI which in SOFP is represented as Retained earnings.
• Retained earnings = Opening Retained Earnings + Profit for this period – dividend paid (Lan, 2012).
• For 2014 = £333,000 – retained earnings (this was extracted from 2013 balance sheet) + Profit for 2014 (£227,000 – SOCI 2014) – less dividend (£150,000) = (£410,000) which is retained earnings for 2014, as shown by SOFP of 2014.
• For 2015, = £410,000 (opening balance of retained earnings) + Profit for 2015 (£405,000 – SOCI 2015) – less dividend paid (£303,000) = £512,000 – Retained earnings for year 2015 as shown by SOFP.
• Alchimist’s SOFP feeds into the Statement of Cash flows (SOCF);
• SOFP or balance sheet current assets and liabilities or working capital are linked to those in Statement of Cash Flows (SOCF) in that they are either source or uses of cash.
• From SOFP, inventories 2014 = £980,000 while for 2015 = £1,050,000, implying an increase of £70,000.
• This in SOCF is usage of cash shown as increase in inventories of £70,000 and with negative sign.
• Alchimist’s SOCI feeds into the SOCF.
• In statement of Comprehensive Income, (SOCI) – operating profit for 2014 = £341,000 which is the first thing in Statement of Cash Flow (SOCF) with same value and description.
• The Company’s perfumes, lotions are considered Fashionable Products.
• According to IAS 2: Inventories, at what value should inventories be recognized in the financial statements?
• Basically, fashionable products can easily become out dated and obsolete quite fast. According to IAS 2, these inventories need to be valued at the lower cost and net realizable value. This will mostly indicate decreasing value but it takes care of the risks involved because their value could change quite fast (Deloitte, 2016).

• How does this rule comply with the recognition criteria in the Regulatory Framework?
• This rule takes into considerations the risks involved in Regulatory Framework of accounting for inventories with short life span.
• The rule ensures that companies do not over value inventories whose price may depreciate quite fast depending on their nature.
• If some of Alchimist’s inventories were found to have gone ‘out of fashion’ and had to be written down at the year end, what effect would this have on the SOCI and the SOFP?
• On the SOCI, depreciation expenses will increase hence decreasing the net income. This is to account for the Alchimist’s inventories that were found to give gone out of the fashion and thus cannot be sold.
• On the SOFP, the value of inventories will decrease by same amount to that of the inventories that have been declared out-dated.

Question 2 - Interpreting Alchimist’s Statement of Comprehensive Income

• Revenue
• Trend analysis using the SOCI; is as shown below

Alchimist Ltd

Income Statement

Year Ended December 31

(Amount in £'000)

Increase (decrease) from 2014 to 2015

2015

2014

Change Amount

Percentage

Revenue

6,000

3,700

2,300

62.16%

Cost of Sales

(4,083)

(2,590)

(1,493)

57.64%

Gross Profit

1,917

1,110

807

72.70%

Overheads

Administration expenses

(670)

(413)

(257)

62.23%

Distribution costs

(664)

(356)

(308)

86.52%

Operating Profit

583

341

242

70.97%

Finance Costs

(43)

(34)

(9)

26.47%

Profit Before Tax

540

307

233

75.90%

Income Tax Expense

(135)

(80)

(55)

68.75%

Profit for the Period

405

227

178

78.41%

• The percentage of total revenue contributed by retail operations, the online and the hotel contract
• This is computed by dividing any of the above segment by total revenue and multiplying by 100%

To get

£'000

Percentage of Total Revenue

Total Revenue

6000

100%

Retail Operations

4004

66.73%

Online Store

1096

18.27%

Hotel contract

900

15.00%

It can be seen that retail operations contributed the highest at 66.73%

• The revenue generated by retail operations in 2015 contributed about 66.73%. Comparing total revenue trend in 2014 and 2015, it changed by 62.16 which implies that the revenue generated from operations had also increased by similar percentage.
• Additional information is helpful in explaining how each component of each of the financial statement was arrived at. From the additional informational here, we are able to know that the total revenue was contributed by three segments such as retail operations, online store and hotel contract (McGraw-Hill Global Education Holdings, 2016)
• Gross profit
• A gross profit is generated by a company after deducting cost of sales from the sales generated. From the statement, it can be noted that Alchimist’s gross profit increased in 2015 compared to 2014 indicating increased trading efficiency.
• Gross profit margin ratio is computed as gross profit / sales revenue *100%. We thus compute it as follows

Revenue

Gross profit

Gross Profit Margin

£'000

£'000

Retail Operations

4,004

1,200

29.97%

Online Store

1,096

330

30.11%

Hotel contract

900

387

43.00%

• It is higher as shown above because it has the lowest total revenue thus leading to lowest denominator.

• Other SCI Costs
• Cost of sales is incurred in acquiring the goods to be sold. This may include factory costs in case of manufacturing entity or cost of purchasing the goods for re-sale in case of a trading company. This cost determines the gross profit generated. An overhead are the expenses incurred in undertaking the sales activities and determines the net profit generated (Crosson & Needles, 2011).
• Delivery and transport costs increased in 2015 compared to 2014 while royalty costs decreased in 2015 compared to 2014.
• This is important in identifying the cost to monitor in subsequent year by trying to reduce it.
• Net profit
• The amount of the net profit is the most important figure for the company. This is the amount available to the shareholders after deducting the costs of the sales and expenses incurred in generating these sales.
• Net profit ratio is computed as = Net profit / sales revenue

As below

Revenue

Net Profit

Net Profit Margin

£'000

Retail Operations

4,004

105.00

1.75%

Online Store

1,096

200.00

3.33%

Hotel contract

900

100.00

1.67%

• This is because online store has the least operations to maintain. For example, online store requires the least salaries, no rent, and least expenses to rent.

Question 3 – Interpreting Alchimist’s Statement of Financial Position (SOFP)

• Non-current Assets
• Property, plant and Equipment (PPE) and development costs are items on this statement with a life span of more than one year. Once put together they can be monitored over different financial years.
• Depreciation and amortization are employed to prorate the cost of a particular kind of asset to its life (Bradley University, 2012).
• Research cost are incurred and paid for within one accounting year while development costs are expensed over the life span of the project in question.
• Proposed Investment
• Within the SOFP, Redstone investment of 500,000 pounds is an additional equity. This will change the total equity, non-current assets and long-term borrowings
• Gearing ratio measures the portion of debt employed in providing a capital to a business. The higher the ratio, the higher the amount of debt capital. Interest coverage measures the percentage of interest paid as a percentage of assets. When higher, it is an indication that most of the assets have been procured using borrowed capital. These ratios determines a company’s solvency on how it easily it can meet its financial obligations (Gibson, C., 2010).
• Re-calculation as follows, Gearing Ratio = (long-term debt+ short-term+ bank overdraft) / Shareholder’s equity.

New

Debt to equity ratio

0.102686

Debt ratio

0.064613

• Alchimist is less risky because of increased equity funding

Question 4 – Interpreting Alchimist’s Statement of Cash Flow

• This is because
• Cash inflow from operating activities is less that cash outflow
• Cash inflow from financing activities is less that cash outflow
• Cash inflow from investing activities is less that cash outflow
• Using
• Operating margin is quite low thus it should consider reducing operating cost
• Receivable days are many implying delayed cash receipts from credit sales. Alchimist need to review its credit policy.