Financial Statements and the Monetary Situation of Morrisons - Essay Example

Financial Statement Analysis Table of Contents Introduction 2 Purpose of Financial statements 2 Income Statement 2 Balance Sheet 3 Investment Decision 4 Problems in using Financial Statements 5 Applying Key Techniques for Increasing Efficiency 5 Transparency 5 Closure and reporting cycle 5 Technology 6 Knowing shareholder needs 6 Calculation and Interpretation of Key Financial Ratios 6 Gross Profit Margin 6 Net Profit Margin 7 Return on Equity 7 EPS 8 Current Ratio 8 Debt Equity Ratio 8 Inventory Turnover Ratio 9 Interpretation of Cash Flow Statements 9 Conclusion 9 Reference List 11 Introduction Investment decision calls for adequate financial analysis. The primary aim of investment decision making is to earn positive returns and to enhance the volume of capital invested initially. The current assignment deals with analysing the objectives of financial statements and the manner in which key figures present in the financial statements should be interpreted. The interpretation of financial statements plays an important role in investment decision making for the long run (S. H. Penman and S. H. Penman, 2007). The report is aimed towards guiding interested shareholders to rationally invest in Morrisons Supermarkets. Morrisons is one of the largest chains of super markets located in the U.K. The firm has their headquarters located in Bradford, England. Morrisons is counted amongst the big four supermarkets in the U.K, after Tesco, Sainsbury and Asda. Currently, the company holds approximately 11% market share in the supermarket sector of the U.K. The company had initially begun as retailers of butter and egg in the year 1899. However, the firm has remained successful in expanding itself and presently it has 515 superstores and 113 local stores spread across the U.K, England, Wales and Scotland. The U.K supermarkets are highly competitive and also possess the ability to earn a very high level of revenues. Consumers in general are seen to gain benefits from such high competition as they are able to procure goods and services at reduced prices (Morrisons, 2014). The current paper is associated with analysing the financial statements and the monetary situation of Morrisons, so as to gain a deeper understanding relating to the economic position and profitability of the company for effective investment decision making. The purpose of the paper is to understand how analysis of financial statements facilitates better investments decision making. Purpose of Financial statements Income Statement Income statements are prepared to estimate the level of profitability existing in a firm. They also indicate the efficiency with which an organization performs and earns revenue. Investments decisions are crucial as they may either cause a shareholder to earn adequate profits or lose earnings on the capital invested. Shareholders face the risk of losing their savings if financial statement interpretations are not carried out effectively. The income statement is essentially a summary of the incomes and expenses of a firm presented in a summarised form for a particular period. By analysing the incomes, expenses and the profits of a number of years, investors can understand how effectively a firm manages their internal operational expenses so as to earn sufficient profits. Investors use the income statement for estimating whether firm posses the capability of earning profits in the future or not. Earnings provided to shareholders are out of the residual profits gained after meeting all types of expenses (Saunders, Cornett and McGraw, 2006). From the profits obtained after meeting all types of operational expenses, interests and tax related expenses are paid off. The profits retained after paying off interests and taxes are then used for distribution between shareholders. Hence, the profits stated in the income statements should be adequate enough for meeting all subsequent expenses and providing adequate returns to shareholders. Shareholders therefore carefully assess the income statements to ensure that the company does not misguide them through profit overstating or understanding. Also, it is essential to review each type of revenue shown in the income statement and assess whether the firm has accounted for revenues and expenses diligently (Revsine, et al., 2005). Balance Sheet A balance sheet can be briefly described to be a summarized statement depicting the net worth of a business. It provides the investors and other stakeholder’s information regarding the value of an organization, the assets possessed by it, the debt-equity structure and the manner in which the firm pays off their current liabilities from current assets. Stakeholders rely upon the information procured from the balance sheet to predict the manner in which a firm finances their financial operations (Saunders, Cornett and McGraw, 2006). Apart from providing valuable information to the stakeholders, managers also use the balance sheet to assess when to invest in fixed assets and whether purchasing new types of assets or making investments would improve the financial position of the firm. Balance sheet is also used by organizations to determine the risk levels. It is generally presumed that if the debt value is high, it induces greater risks within the firm. However, highly geared organizations also gain leverage advantages which may result in higher profitability depending upon the structure of the organization. In general, most investors use the balance sheet to gain information relating to solvency, productivity and asset conversion into capital. Broadly, the balance sheet provides information in relation to the financial state of a business at a given point of time (Palepu and Healy, 2007). Investment Decision It is essential for organizations to develop financial statements in a manner such that they can easily be understood and interpreted by stakeholders. Additionally, it is essential that the financial statements are prepared following all the instructions established by the regulatory authorities. Disclosure of vital information, truthfulness and fair means of presentation of information are vital aspects which managers must bear in mind while preparing financial statements. Hence, accountants involved in the process of preparing financial statements must possess the sound knowledge of the principles of accounting (Saunders, Cornett and McGraw, 2006). Published financial statements are used by creditors, investors and suppliers of raw materials to assess liquidity, profitability, solvency and risk factors. Hence, analysing the compliance of financial statements with various regulatory policies is essential so that fruitful decisions can be taken. Organizations main objective of publishing financial statements is to enhance the level of rational investment and credit related decisions. However, the most important role of the financial statements is to provide timely and accurate information to shareholders in respect of the financial position of the firm (Hung, 2000). If shareholders perceive that the organization is unable to reap sufficient profits, they may choose to withdraw their investments from the firm. Additionally, published financial statements must be well audited. Auditing checks the truthfulness and the fairness with which financial statements are prepared. Usually, the users of accounting statements may not possess sound knowledge of the manner in which financial statements are required to be interpreted. Auditing is carried out by highly skilled individuals who posses sound knowledge of the subject matter of finance. Auditors ensure that all types of standards, conventions and concepts are followed by the organization while preparing the financial statements. Hence, users of financial statements can easily depend upon such audited statements and accordingly take investments related decisions. Financial statements must be able to reveal the type of resources possessed by an organization (Hung, 2000). Problems in using Financial Statements Financial statements only reveal the efficiency existing in the financial statements. However, the management efficiency cannot be judged only through the analysis of the financial statements. Even though the financial statements reveal operational soundness, in the long run firms may lose their capabilities of generating adequate profits due to loss of financial soundness. Financial statements must be assessed in association with different economic and social settings. When there are changes in the external economic conditions, it may impact the future revenues of a firm. Many investors neglect the external economic factors while taking important long term investment decisions. This leads to loss of financial revenue. Additionally, at times in order to cover up financial inefficiencies and to misguide investors, organizations may take false approaches towards the preparation of financial statements. Such errors and faulty accounting practices are many at times neglected by the shareholders leading to false decision making. Another major short coming of financial statements is that they do not reveal the prestige, goodwill and creditability of the firm in the industry. Such aspects may also impact the long term profitability of the organization. Shareholders may take into account these aspects alongside of financial statement analysis while taking long term investment decisions (Piotroski, 2000). Applying Key Techniques for Increasing Efficiency Transparency Transparency is an important virtue in financial statements. Expenses and revenues must be clearly stated in the books of accounts before they are finally published. The explanations regarding changes of methods of valuation and the techniques used for valuing different assets must be clearly shown in the books of accounts (Hung, 2000). Closure and reporting cycle Companies must close accounts in a timely manner. Another important issue facing the closure of accounts at the end of a given time period is related to making timely and correct adjustments. Insisting upon timeliness without delay in making records and adjustments is one of the most effective ways of reducing mistakes in closure and reporting. Improving the closure techniques is seen to be an effective way for enhancing reporting quality (Barth, Beaver and Landsman, 2001). Technology Organizations must be able to leverage the technology procured by them so that reporting and recording of transactions are effective. The usage of many decentralised system and reliance upon manual storage are the primary indicators of lack of efficiency existing in the reporting systems of an organization. Advanced IT systems must be implemented and used to reduce manual errors and increase timeliness (Hung, 2000). Knowing shareholder needs A business organization must be able to adequately understand the information procurement needs of the shareholders. It is essential to ensure that the reports published by an organization can easily be understood and interpreted by shareholders. Also vital figures relating to profitability, liquidity and long term solvency must be revealed in the statements (Piotroski, 2000). Calculation and Interpretation of Key Financial Ratios On the basis of the financial information procured from the income statements and the balance sheet of Morrisons Supermarket, the following ratios have been calculated. The information has been primarily been procured from the annual reports of the years 2012, 2013 and 2014. Summary of ratio analysis 2014 2013 2012 Gross profit margin 6.07% 6.66% 6.89% Net profit margin -1.33% 3.52% 3.52% Return on equity -5.03% 12.18% 11.51% Earnings per share -10.23 26.65 26.68 Current ratio -0.50 -0.57 -0.57 Debt equity ratio -0.67 -0.57 -0.40 Inventory turnover ratio (in times) 20.75 23.20 23.27 (Source: Morrisons, 2014; Morrisons, 2012) Gross Profit Margin Gross profit ratio facilitates in measuring the level of profits retained after meeting all operational expenses. It basically indicates the level of proportion of sales revenue spent upon manufacturing activities. It is essential to have a high proportion of gross profits so that costs associated with administrations, sales and distribution can be met effectively. However, in order to understand whether a firm is earning adequate gross profits or not, the ratio must be compared with other firms operating in the same industry. In case of Morrisons, it can be seen that the company earns very less gross profits. This may hamper the company’s ability to meet subsequent expenses and payments to stakeholders (Barth, Cram and Nelson, 2001). Net Profit Margin Net profit margin indicates the profits retained by the organization after paying off all types of expenses associated with administration, selling, distribution and marketing related activities. The higher the net profits margin the better it is for the organization to earn profits and develop different types of assets in the long run (Barth, Cram and Nelson, 2001). The net profits ratios of Morrisons are seen to be extremely low for the year 2014. The company has however been successful in obtaining adequate net profits during its previous financial years, but failed to do in the year 2014. The reason has been major rise in the operational expenses. Morrisons in the recent times have increased their sales, administration and marketing related activities which have ultimately led to lowering profits. As a result, the earnings available to shareholders are expected to be low for the fiscal year of 2014. Return on Equity The return on equity ratio depicts whether an organization is able to generate sufficient cash from the investments received from shareholders. The ratio depicts the operating income as a percentage of the total equity value. It is usually considered that a higher return on equity ratio is favourable for the company. Investors perceive the return on equity ratio as a vital measure of profitability. It is essential to analyse the return on equity ratio of at least three previous years of a company in order to understand whether enough earnings for shareholders is being generated or not. In case of Morrisons, the return on equity had been adequately high during the financial years 2012 and 2013. However, in the year 2014 the return on equity ratio was seen to be negative. Negative net profits were the prime reasons for such a decline. Hence, shareholders were not provided with any returns during the financial year 2014 (Barth, Cram and Nelson, 2001). EPS Since the returns on equity were low for the year 2014, consequently the earning per share (EPS) for the year was also adequately low. The company could therefore provide little or no earnings to their shareholders. In the previous financial years, the firm generated sufficient levels of EPS. A falling level of EPS is considered to be unfavourable for investing. Investors perceiving such a situation might consider not investing in the company. Morrisons must therefore reduce their operating expenses considerably so that shareholders can be provided with adequate results. If immediate steps are not taken to improve the revenue position, the firm may end up shareholders. The capital position of the company may ultimately weaken (Barth, Cram and Nelson, 2001). Current Ratio The current ratio facilitates in measuring the level of liquidity existing in an organization. A current ratio of 2:1 is considered to be most satisfactory. However, the current ratio situation might differ from industry to industry on the basis of the nature of activities. The ratio is essentially a comparison of the level of current assets existing in an organization in respect to the level of current liabilities. The purpose of having adequate levels of current ratio is essential for paying off the short term expenses and to maintain adequate cash levels in the organization (Barth, Cram and Nelson, 2001b). Debt Equity Ratio The debt equity ratio shows the level of debt existing in an organization as compared with the equity. A high debt equity ratio is not considered to be favourable for an organization as it indicates greater presence of fixed interest bearing capital. It also indicates that creditor presence in the organizations capital structure is higher than the level of investors. Investors refrain from investing in such organizations as a large sum of revenue is lost for providing returns to creditors and very less revenue is left for providing returns to shareholders. Morrisons have consistently very low levels of debt equity ratio. This indicates that the company is mainly financed through equity. The risk factor associated with interests is therefore low for the company (Krishnan, 2005). Inventory Turnover Ratio The inventory turnover ratio shows the efficiency with which closing stock is converted into sales revenue. The faster the goods move from the company’s production to the customers hands the higher is expected to be the profits for the company. Morrisons have an adequately high level of closing stock as a result of which the turnover ratio is not very satisfactory. This can be cited to be another important reason due to which the profits of the company are low. Interpretation of Cash Flow Statements Cash flow statement figures 2014 2013 2012 Net cash inflow from operating activities 722 1107 928 Net cash outflow from investing activities (1,052) (1,011) (891) Net cash outflow from financing activities 325 (45) (53) Cash and cash equivalents at end of period 258 263 212 (Source: Morrisons, 2014; Morrisons, 2012) The cash flow information acquired from the annual reports of Morrisons reveals that cash position at the end of the period has been adequately satisfactory. The cash flows from investing activities are seen to be the highest from operating cash flows. Cash flows from investing activities are seen to be negative. This indicates that the company has engaged itself in acquiring a number of assets (Krishnan, 2005). Conclusion From the financial analysis conducted, it can be stated that Morrisons retained earnings available for shareholders has been very low. This is mainly due to enhanced investing activities and augmentation in the operating activities. Financial statements analysis of Morrisons has therefore provided a large amount of information in respect to profitability and revenue situation. It is expected that the company would remain in similar fiscal situation at least for the next two financial years. It would take a considerable amount of time to churn adequate revenues from the investments made and accordingly enhance productivity and sales revenue. Therefore, it is suggested that investments in the company must only be made after a few years. The current paper adequately reveals that financial statements are a highly useful source of information and investments decisions must only be made after analysing such reports carefully. Reference List Barth, M. E., Beaver, W. H. and Landsman, W. R., 2001a. The relevance of the value relevance literature for financial accounting standard setting: another view. Journal of accounting and economics, 31(1), pp.77-104. Barth, M. E., Cram, D. P. and Nelson, K. K., 2001b. Accruals and the prediction of future cash flows. The accounting review, 76(1), pp. 27-58. Hung, M., 2000. Accounting standards and value relevance of financial statements: An international analysis. Journal of accounting and economics, 30(3), pp. 401-420. Krishnan, J., 2005. Audit committee quality and internal control: An empirical analysis. The accounting review, 80(2), pp. 649-675. Morrisons, 2012. Annual report. [Online] Available at: http://www.morrisons-corporate.com/Documents/Final%20annual%20report%202011_12.pdf> [Accessed 25 April 2015]. Morrisons, 2014. Annual report. [Online] Available at: [Accessed 25 April 2015]. Palepu, K. and Healy, P., 2007. Business analysis and valuation: Using financial statements. Connecticut: Cengage Learning. Penman, S. H. and Penman, S. H., 2007. Financial statement analysis and security valuation. New York: McGraw-Hill. Piotroski, J. D., 2000. Value investing: The use of historical financial statement information to separate winners from losers. Journal of Accounting Research, 1(1), pp. 1-41. Revsine, L., Collins, D. W., Johnson, W. B., Collins, D. W. and Johnson, W. B., 2005. Financial reporting and analysis. New York: Pearson/Prentice Hall. Saunders, A., Cornett, M. M. and McGraw, P. A., 2006. Financial institutions management: A risk management approach. New York: McGraw-Hill/Irwin. Read More