Financial Performance of a Business - Assignment Example

?Be Able to Evaluate the Financial Performance of a Business PART A: AC 4 Discuss the main financial ments: Different users of financial ments use these for varying purposes: Owners and Managers: They use financial statements to formulate significant business decisions that will affect the company’s operations. Besides they also rely on such financial statements to prepare their annual report to be presented to the board and shareholders. Employees: Employees in a company require these reports to make Collective Bargaining Agreements with management as well as to determine their future incentive negotiations. Prospective Investors: Financial statements are useful instruments to evaluate the feasibility of investing in a company. Investors often use financial analyses for making appropriate investment decisions. Financial Institutions: In order to arrive at suitable decisions regarding granting a company with extended debt securities like debentures or long-term bank loan, or new working capital etc, financial institutions will need to verify the financial statements of companies. Government Entities: They need to verify these statements to determine the correctness and accuracy of taxes and further duties stated and paid by a business. Such statements will also help them in ensuring that the company is operating within the framework of relevant statutes and are complying with all statutory obligations. Vendors: Financial statements help them evaluate the creditworthiness of the company so as to enable them to take appropriate decisions. Media and the General Public: Financial statement allows this interest group to evaluate the performance with respect to ethical trading, compliance of environmental spending etc. IAS 1 modified the financial statements title as they will be used in International Financial Reporting Standards: Balance Sheet' will amend as 'statement of financial position’ Income Statement' will amend as 'Statement of Comprehensive Income' The revised International Accounting Standards (IAS1) has come into effect from the year 2009. However, it is not obligatory on the part of firms to use the latest titles in the financial statements. The Components of the Financial Statements: An entire set of financial statements as specified in the International Accounting Standards comprises: 1. Profit and Loss Account: Also known as Statement of Comprehensive Income, this statement for a specific period reflects the profit or loss for that particular period with other comprehensive income documented in that period. The standard is now using 'profit or loss' instead of the descriptive term 'net profit or loss' for the foot line of the income statement, consequent to the 2003 revision to IAS1. “All items of income and expense recognised in a period must be included in profit or loss unless a Standard or an Interpretation requires otherwise” (Accounting Standard (AS) 5: Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting Policies n.d., p. 50). 2. Balance Sheet: Statement of Financial Position: This contains the detailed description of a company's assets, liabilities and ownership equity at a given point in time. Information to be presented in the statement of financial position IAS 1 specifies the minimum information which must be reflected on the balance sheet. 3. Cash Flow Statement: Cash flow statement after the reissue of IAS 1 is termed as Statement of cash flows and it presents a company’s cash flow activities, mainly it is operating, financing and investing activities. Besides, it also offers users of financial statements with a foundation to evaluate the company’s capability to create cash and cash equivalents and the concern’s requirement to utilise their inward and outward cash flows. IAS 7 specifies requirements for presenting and disclosing cash flow information. PART B: AC 4.2 Compare appropriate formats of financial statements for different types of business. Different types of businesses apply different formats in the maintenance of their financial statements. Generally, there are three types of businesses – sole proprietorship, partnership and limited company. Each business prepares profit and loss statement, balance sheet and cash flow statement in order to analyze its financial performance of a year. Each company will have diverse financial divisions and, therefore, they apply different financial reports under different formats that fulfill those divisions as well as the company’s peculiar requirements. For instance, a sole trader usually plans a simple profit and loss account as opposed to a limited liability company, which will have to devise this statement on the basis of Generally Accepted Accounting Principles (GAAP). The financial statements gather relevant data from the sales and purchase production departments. Besides, they also ascertain the net taxable profit or loss for each month. Some businesses organise a single phase profit and loss statement plan, where all expenses categorised by purpose are subtracted from the total income to present the income before tax deduction. The other is a multi step format, where cost of sales is subtracted from sales to derive at the gross profit, and other expense. Thus, income is determined to present income before tax. These differences are significant in arriving at sound financial decisions. The financial statement of sole proprietor and partnership firms are prepared in a similar manner. The format of balance sheet may differ according to whether the firm is a Sole Trader, Partnership or Limited Company. Financial Statement of a Sole Proprietorship: A sole trader is a business in which the promoter is a single individual, who operates the business for his or her personal profit. On the other hand, a partnership will have more than one owner. Since a sole trader’s business is comparatively small, its financial statements are quite simple and easy to understand. To a large extent, the financial statements of a partnership are similar to those of a sole trader, though by having more than one owner to subscribe capital; partnerships are in general larger businesses. The most important financial statements are those of the largest type of business organizations such as limited companies. The financial statements of limited companies adhere to the same standards as those of sole traders and partnerships, but hold specialised financial terms. Most of the limited companies in the UK make use of vertical format of profit and loss account. The balance sheet of a limited company is prepared in the same format as of a sole trader. Financial Statement of Partnership Business: The profit and loss statement of a partnership business is prepared in the same format as that of a sole trader. The only dissimilarity is that interest on a loan from a partner might be included in the expenses of the profit and loss part. The first division of the balance sheet of a partnership is related to a sole trader and the second division shows the capital and current account of each partner. Financial Statement of a Limited Company: The profit and loss statement of a private limited company follows the same format as that of a sole trader, though interest on debentures and directors’ compensation might be included in the expenses in the profit and loss part. The first division of the balance sheet of a limited company is related to that of a sole trader while the second division reflects the reserves and sharing capital. By virtue of their unique nature, limited companies possess some dissimilarity to that of other firms in their accounts when compared to partnerships and sole traders. These reflect in the profit and loss account as well as balance sheet. The profit and loss statement of the partnership firm illustrate a list on how the net profit/loss is dispersed to the partners and the limited company shows a statement of changes in equity, indicating variations in profit, share capital, revenue and other capital reserves during the year. AC 4.3 Interpret the financial statements using appropriate ratios and comparisons, both internal and external. CASE STUDY 1: R Riggs and J & B Associates, a) R Riggs is a sole proprietor ship company and J & B Associates is a partnership company. b) Profitability Ratio: Profitability ratios are usually calculated either for sales or for investment. It includes: Return on Capital Employed (ROCE): This ratio depicts the connection between the net profits earned during a period and the average long-term capital invested in the business during that period. It is computed by dividing the ‘Earnings before Interest and Tax’ with ‘Total Capital Employed’. Gross Profit Ratio: Gross profit shows the relationship between gross profit and net sales. Gross Profit Gross Profit Ratio = ? 100. Net Sales Net Profit Ratio: Net profit ratio shows the relationship between net profit and net sales. Net Profit Net Profit Ratio = ? 100. Net Sales Ratio R Riggs J & B Associates ROCE -0.82 0.036 Gross Profit 39.85 45.33 Net Profit Margin (before tax) 15.23 23.70 In 2007, based on Returns on Capital Employed, it indicates that the performance of the J & B Associates enjoys an edge over R Riggs. Besides, the Gross and Net profit also show that J & B Associates perform better than R Riggs. c) Liquidity Ratio: Liquidity ratios indicate the short term financial performance of a firm. This ratio reflects the short term solvency of a business. It includes: Current Ratio: Current ratio is defined as ratio of current assets to current liabilities. Current Assets Current Ratio = Current Liabilities Quick Ratio: It forms the connection between quick assets by quick liabilities. Quick Assets Quick ratio = Quick Liabilities Inventory Turnover Ratio: This ratio indicates how many times during the period the firm has during the inventory. It is computed as follows. Cost of Goods Sold Inventory Turnover Ratio = Average Stock Debtors Turnover Ratio: It measures how fast debtors are collected. Net Credit Sales Debtor’s Turnover Ratio = Debtors including B/R Ratio R Riggs J & B Associates Current ratio 3.34 1.24 Quick Ratio 2.91 2.41 Debtors Days 12.76 6.04 Stock Days 29.73 3.97 In 2007, R Riggs shows higher performance of current ratio. In this year, comparatively lower performance is reflected in J & B Associates’ current ratio. In the case of quick ratio comparatively high performance is shown by R Riggs. Debtors days and stock days are decreasing in J & B Associates. CASE STUDY 2: Station Plc. 2 (a). Calculate the following ratios for the year ended 30 April 2008. State the formulae used. Gearing Ratio Long Term Liabilities/Capital Employed * 100 7,880,000/13,688,680 * 100 57.57% Earnings per Share Net Profit/ Ordinary Shares ( Issued) 750,000/5,000,000 15p Dividend per Share Ordinary Dividends/Issued Ordinary Shares 200,000/5000,000 4p Dividend Yield Dividend per Share/ Market Price of Share * 100 4/80*100 5% Dividend Cover Net Profit/ Ordinary Dividends 750,000/200,000 3.75 times Price/Earnings Ratio Market Price of Share/Earnings per Share (EPS) 80/15 5.33 (b) Write a report to Jane advising, with reasons, whether or not she should invest in Station Plc. To: Jane From: Student Date: 5th May 2008 Subject: Report in Advising to Invest in Station Plc. Investment Calculation = ?40,000/0.8 = 50,000 Ratio Analysis: Results: EPS It has enhanced from 12p to 15p per share. This means the profit has improved. Gearing Ratio This ratio has reduced 68.65% to 57.57%. This is still high and so high risk. Dividend per Share Dividend per share has increased from 3.75p to 4p per share. This shows that Jane will collect a more 25p per share. So Jane will get a dividend of ?50,000 * 4p = ?2000. Dividend Yield Dividend yield has Fallen from 6.25% to 5 %, this can be evaluated with risk-free savings in a bank. The dividend yield has decreased so raising the dividend per share. This signifies the share price has improved. Dividend Cover Dividend cover has increased to 3.75. This means they can pay present dividend 3.75 times from profit and that they are maintaining further profit in the business. This signifies the industry is maintaining profit for future savings and development. Price/Earnings Ratio (P/E Ratio) Price/earnings ratio has increased a little 5 to 5.33. It reflects improved confidence in the shares because the earning per share (EPS) has increased. This shows the share price has improved at a faster rate. Advice Yield could be obtained without risks. On the other hand the share price is increasing and can lead to a capital gain. However it is required to evaluate ratios with other businesses. Reference List Accounting Standard (AS) 5: Net Profit or Loss for the Period, Prior Period Items and Changes in Accounting Policies (n.d). Available at [Accessed on 22 Sep. 2012]. Read More