Principles of Corporate Finance - Essay Example

1. Introduction Ticker TIM Listing Date 30th May 1996 Industry Materials Number of Subsidiaries Financial Year end 30th September Audit Firm Deloitte Touche Tohmatsu Audit Partner S Pelusi Audit Opinion Unqualified Audit Opinion Date 24th December 2008 Total Number of Subsidiaries Total Financial Report Audit Fees Total Other Auditor Renumeration 2. Understanding the Company The company is described in its 2008 Annual Report as one of Australia’s leading agribusiness companies. It manages high-quality, large-scale forestry and horticulture assets. It is a major supplier of almonds, olive oil, citrus, table grapes, mangoes, avocados, and glasshouse tomatoes to both the domestic and overseas consumers (http://www.timbercorp.com.au/userdocs/1/corporate%20shareholders/documents/2008%20Timbercorp%20Annual%20Report%20-%20Interactive.pdf). Like any other business, Timbercorp Limited is facing a number of developments in its business and operating environment, which serve as both threats and opportunities for future development. It is left for the company to identify and capitalise on the opportunities while at the same time anticipating the threats and putting strategies in place to deal with them. For example, the year 2008 witnessed a global financial crisis, which had a significant impact on the cash flows of firms that depend on banks for funding. Even if Timbercorp may not have been directly affected, it may have indirectly been affected by a reduction in demand for its products on a global scale as consumers find it difficult meeting up with payments. Secondly, the economic environment is constantly changing. Interest rates and exchange rates continue to change and this has an effect on Timbercorp’s financing and investment decisions. As earlier mentioned, the company is a leading participant in the agribusiness sector through the food and fibre industries and the land and water rights and infrastructure associated with these industries. The sector provides a lot of opportunities and threats. As far as opportunities are concerned, the agribusiness sector remains a crucial part of the global economy and it is estimated to be worth approximately US$5trillion. In addition to its importance for delivering food security, it also encompasses half of the world’s labour force and assets as well as 40% of consumer purchases. Global population is expected to grow to approximately 8.3billion by the year 2030. These developments will help boost demand for Timbercorp’s products. The company anticipates a 60% rise in the demand for food and fibre products by 2030. However, there are also challenges for the company. For example, the amount of arable land is declining and these may adversely affect the company’s ability to meet rising demand for its products. Other challenges facing the company include rising operational costs, limitations on the access of water resources, as well as rising oil and gas prices. The company reports that high oil and gas prices had a material adverse impact on harvesting and transportation costs as well as on the costs of fertilisers. (http://www.timbercorp.com.au/userdocs/1/corporate%20shareholders/documents/2008%20Timbercorp%20Annual%20Report%20-%20Interactive.pdf). According to the Institute of Chartered Accountants in Australia, “audit risk is the possibility that an auditor expresses an inappropriate audit opinion on the financial report that is materially misstated” (http://www.charteredaccountants.com.au/files/documents/part_b.pdf). The main risk factor that may affect audit risk is business risk. As business risk increases, the risk of material misstatements also increases. Other risk factors that may affect audit risk can be grouped under four categories in accordance with the Institute of Chartered Accountants of Australia. These include External Factors such as: the state of the economy, high degree of complex regulation, changes in the entity’s industry, etc; Business strategies including: operations in regions that are economically unstable, operations exposed to volatile markets, developing or offering of new products or services or moving into new lines of business, aggressive expansion into new locations, etc; Entity’s organisation such as: poor corporate structure, incompetent personnel in key management positions, changes in key personnel including departure of key executives, complexity in operations, organisational structure and products, etc; Other factors such as: product or service flaws that may result in liabilities, relationships with external funders such as banks, going concern and liquidity concerns, installation of significant new IT systems related to financial reporting. The external factors that may affect the company’s inherent or control risk for the year 2008 was the recent financial crisis. This may affect the company in that some managers may wish to keep their positions in the company and as such may engage in fraudulent behaviour. The impact on the audit plan is that the audit plan needs to take this into consideration. The audit plan may have to consider observing how the company operates and is organised such as management’s operating style and attitude toward internal control; operation of various internal control procedures, and compliance with certain policies. Business strategies: the company’s business strategies may have an impact on inherent risk in that the business strategy has an 3. Ratio Analysis of Timbercorp Limited Ratios Formula 2007 2008 Current Ratio Current Assets/Current Liabilities 0.814473 0.921907 Quick Ratio Current Assets less Stock/Current Liabilities 0.796878 0.921907 Receivables Turnover Sales/Accounts Receivable 4.775027 4.75304 Return on assets Net Profit/Total Assets 0.041512 0.024077 Return on equity Net Profit/Total Total Equity 0.12773 0.069912 Debt/Equity Long Term Debt/Total Equity 1.272025 0.754937 Debt/Assets Long Term Debt/Total Assets 0.413409 0.259994 Net Profit Ratio Net Profit/Sales 0.203377 0.084215 The table above shows various ratios calculated for Timbercorp Limited for the years 2007 and 2008. Before discussing the ratios, it is important to provide brief discussion on what ratio analysis is all about. Financial statements provide shareholders, analysts and other parties to financial statements with basic information to assess the financial standing of a company. (Myers and Brealey, 2002; Penman, 2007). However, financial statements typically contain large amounts of data that users may find difficult to interpret. Key financial ratios are often used to condense the large amounts of data into a convenient form which is more suitable for understanding the financial, standing, liquidity, profitability and efficiency of the company (Myers and Brealey, 2002; Penman, 2007). Key financial ratios enable analysts and shareholders to answer five main questions (Myers and Brealey, 2002: 822): (i) “How much has the company borrowed? Is the amount of debt likely to result in financial distress? (ii) How liquid is the company? Can it easility lay its hands on cash if needed? (iii) How productively is the company using its assets? Are there any signs that the assets are not being used efficiently? (iv) How profitable is the company? (v) How highly is the firm valued by investors? Are investors’ expectations reasonable? The table above shows a selected number of ratios for Timbercorp Limited for the years 2007 and 2008. The ratios are geared towards understanding how the liquidity, profitability, activity, and solvency, as well as analysing how they may have influenced the audit. Liquidity ratios measure the company’s ability to meet its short term financial obligations as and when they fall due. The most common liquidity ratios are the current ratio and the quick ratio. The current ratio expresses current assets (assets expected to be consumed or converted into cash within one year) in relation to the current liabilities (liabilities falling due within one year) (Robinson et al., 2009). A higher ratio indicates a level of liquidity (i.e., greater ability to meet short-term obligations). A current ratio of 1.0 would indicate that the book value of current assets exactly equals the book value of current liabilities. A lower ratio indicates less liquidity, indicating a greater reliance on operating cash flow and external financing to meet short-term obligations. Liquidity affects the company’s ability to take on debt (Robinson et al., 2009). Looking at table above, it can be observed that the current ratio has been below 1.0 for 2007 and 2008. The ratio however increased from 0.814473 in 2007 to 0.921907 indicating and improvement in the company’s liquidity from the year 2007 to 2008. Given that the ratio remained below 1.0 throughout the period under study, it calls into question the company’s ability to meet its short-term financial obligations. As Robinson et al. (2009) explain: it may be the case that the company is depending on operating cash flow and external financing which may result into asset-liability mismatch (trying to finance short-term obligations with long-term borrowing). The implicit assumption of the current ratio is that inventories and accounts receivables are indeed liquid. However, the quick ratio remains more conservative because it includes only the more liquid current assets (often referred to as “quick assets”) in relation to current liabilities. Like the current ratio, the quick ratio indicates greater liquidity and a better ability of the company to meet its short-term financial obligations as and when they fall due (Myers and Brealey, 2002: Penman, 2007; Robinson et al., 2009). The quick ratio reflects the fact that certain current assets – such as prepaid expenses, some taxes, and employee-related prepayments – represents costs of the current period that have been paid in advance and cannot usually be converted back into cash (Robinson et al., 2009). It also reflects the fact that inventory might not easily be converted into cash, and moreover, that a company would possibly not be able to sell its entire inventory at balance sheet carrying amount, especially if it were to sell the inventory quickly. In situations where inventories are illiquid, the quick ratio represents a better indicator of liquidity than the current ratio (Robinson et al., 2009). It can be observed from the table and from figure 1 that the current ratio for 2007 is greater than the quick ratio for 2007 because the company had inventory outstanding at the end of the year 2007. The quick ratio improved between the year 2007 and 2008. The quick ratio and current ratio for 2008 are equal because the company had no closing inventory in 2008. Thus, its current assets in 2008 comprised only of “quick assets” : accounts receivables and cash. Again, the quick ratio shows that the company is not in a good liquidity position. Figure 1: Ratio Analysis for Timbercorp Limited Profitability ratios measure the company’s ability to generate profit on invested capital. Profitability serves as a measure of the company’s competitive position in the market and by extension, the quality of its management (Robinson et al., 2009). Profitability ratios measure the return earned by the company during a period. Commonly used profitability ratios include return on assets, return on equity and net profit margin. Return on assets measure the return earned by a company on its assets. The higher the ratio, the more profit is generated by a given level of assets. For Timbercorp Limited, it can be observed that the return on assets deteriorated from 0.041512 in 2007 to 0.024077 in 2008. This indicates that the company did not generate enough profit per unit of assets in 2008 as it did in 2007. Return on equity measures the return earned by a company on its equity capital, including minority equity, preferred equity and common equity. It is calculated as net income divided by total equity. The higher the return on equity, the better is the performance of the company. Looking at figure 1 and the ratios table above, it can be observed that the return on equity also declined over the period 2007 to 2008 indicating a decline in profitability over the period. Activity ratios measure how efficiently a company performs day-to-day tasks such as the collection of receivables and the management of inventory. Commonly used activity ratios include inventory turnover ratio, receivables turnover ratio, fixed asset turnover ratio, total asset turnover ratio, etc. For Timbercorp Limited, only the receivables turnover ratio has been calculated. It is calculated by expressing sales in the numerator in relation to receivables in the denominator. A high receivables turnover ratio may be an indication of highly efficient credit and collection. On the contrary, a high receivables turnover ratio could indicate that the company’s credit collection policies are too stringent, suggesting the possibility of sales being lost to competitors offering more lenient terms (Robinson et al., 2009). A relatively low receivables turnover ratio would typically call into question the efficiency of the company’s credit and collection procedures. One can observed that Timbercorp Limited witnessed a slight decline in its receivables turnover ratio over the period 2007 to 2008. Finally, solvency ratios measure the company’s ability to fulfil its long-term financial obligations. Solvency ratios provide information regarding the relative amount of debt in the company’s capital structure and the adequacy of earnings and cash flow to cover interest expenses and other fixed charges (such as lease or rental payments) as they fall due (Robinson et al., 2009). To measure the solvency of Timbercorp Limited, two solvency ratios including debt to assets ratio and the debt to equity ratio have been calculated as shown in the table above. It can be observed that both ratios witnessed a decline over the period 2007 to 2008. This shows that the company reduced the amount of debt in its capital structure. The reason for this may be to increase its financial flexibility. According to Myers (1984) and Myers and Maljuf (1984) companies tend to use less debt financing as a means of maintaining the flexibility with which long-term investments are financed. They recognise that external funds are costly and reduce the firm’s ability to take on more debt. Consequently, firms find it necessary to make minimal use of external funds. Rather, they prefer using internally generated funds such as retained earnings. It can be observed from the above analysis that Timbercorp Corporation has poor liquidity and profitability ratios. This may have influenced the audit in that the auditor may have found it difficult to provide an unqualified opinion based on the company’s poor liquidity. The low current ratio may have also influenced the auditor’s analytical procedures employed in conducting the audit. That is, the auditor may have found it necessary to employ more substantive tests on the company’s accounting systems. Although the auditor has not qualified the audit report, the audit report includes a paragraph relating to material uncertainty regarding Timbercorp’s and its subsidiaries’ continuation as going concerns. This paragraph may have been included in part owing to the poor liquidity condition. The paragraph reads as follows: “Without qualifying our opinion, we draw your attention to Note 1 in the financial report which indicates that the consolidated entity, in the absence of waivers, would have breached certain bank covenants at balance sheet date. The consolidated entity has, subsequent to year end, obtained waivers for the breach of covenants as at 30 September 2008 and varied future covenants and terms. This includes an undertaking to sell selected assets and apply a portion of the proceeds to reduce debt. These factors along with other mitigating factors being relied on by management to address these issues are as set forth in Note 1 “Going Concern”. In the event that the mitigating factors as disclosed in Note 1 do not eventuate as management anticipate, there exists a material uncertainty about the company’s and consolidated entity’s ability to continue as a going concerns and whether they will realise their assets and extinguish their liabilities in the normal course of business and at the amounts stated in the annual report”. (Timbercorp Limited Annual Report, 2008: 107). 4. Accounting Policy on Property, Plant and Equipment Company’s Policy The company measures freehold land, plant and equipment, as well as equipment under finance lease at cost less accumulated depreciation and impairment. Cost is considered to be expenditure that is directly related to the acquisition of the asset. Apart from land, all other property, plant and equipment are subject to depreciation. The company employs the straight line method of depredation, which entails writing off the net cost of the asset over its estimated useful life to its residual value. Estimated useful lives, residual values and depreciation methods are reviewed on an annual basis and the effects of any changes are recognised prospectively in subsequent financial reports. Assets held under finance leases are depreciated over their expected useful lives on the same basis as owned assets or, the lease term whichever is shorter. Gains and losses on the disposal of property plant and equipment are calculated as the difference between the disposal proceeds less cost to sale and the carrying value of the asset. Such gains and losses are recognised in profit and loss. Specifically, the company uses the following estimated useful lives to calculate depreciation: -Plant and equipment: 5-22 years -Equipment under Finance Lease: 3-22 years. (see Timbercorp Limited Annual Report, 2008: 55). Four (4) paragraphs of applicable accounting standards Accounting for property, plant and equipment is governed by paragraphs 1-79 of the Australian Accounting Standard AASB 116 Property, Plant and Equipment. Like IAS 16 under IFRS issued by the IASB, AASB 116 provides similar conditions that an item of property, plant and equipment must satisfy to be recognised as an asset. Paragraph 7 of the standard requires an item of property, plant and equipment to be recognised as an asset if and only if: it is probable that future economic benefits associated with the item will flow to the entity (paragraph 7a); and the cost of the item can be measured reliably (paragraph 7b) (AASB, 2007). Paragraph 10 stipulates that an entity should evaluate all its property, plant and equipment cost at the time of acquisition. These include costs incurred initially to acquire or construct an item of property, plant and equipment and costs incurred subsequently to add to, replace part of, or service it. Paragraph 43 states that each part of an item of property, plant and equipment with a cost that is significant in relation to the total cost of the item shall be depreciated separately. Compensation from third parties for items of property, plant and equipment that were impaired, lost or given up shall be included in profit or loss when the compensation becomes receivable. (Paragraph 65). Comparison between the company’s accounting policy and the applicable accounting standards identified It can be observed from above that the company’s policies are in compliance with the AASB 116 that governs the accounting for property plant and equipment under Australian GAAP. However, the company has not stated clearly how it decides to recognises an item as property, plant and equipment. The standard requires an item to be recognised only when it is probable that future economic benefits will flow to the entity; and that the cost of the item can be measured reliably. However, the company makes no mention of this under its accounting policy for property, plant and equipment. All the company states is that property, plant and equipment is stated at cost less accumulated depreciation and impairment. Therefore, it is not clear how the company decides whether to recognise an item as property, plant and equipment. As concerns depreciation, the company appears to be fully compliant with AASB 16 paragraph 43. It is also compliant with paragraph 65 on impairment. Therefore, the entity is to a certain extent compliant with AASB 116 but it needs to make certain points clearer for shareholders to understand. Audit plan to test compliance To test the compliance with AASB 116, it may be necessary for the auditor to begin by examining the different items to see if they qualify as property, plant and equipment. For example, determining whether the item is capable of generating future economic benefits and whether the entity was able to measure the cost of the item reliably. The audit plan should consider leases to determine whether all leases that ought to be classified as finance leases have been classified as such as this is likely to affect the value of property, plant and equipment. It is also necessary to look at how subsequent costs on the item are treated. Are they capitalised or expensed? Is the company expensing costs that ought to be capitalised or is it capitalising costs that ought to be expensed. The audit plan should also consider depreciation. Is the useful life of the different items appropriate? Finally, the audit plan should consider physically examining the different items to see if they actually exist. 5. Critical Dates the financial reporting date is 30th September 2008. The audit opinion date is 24th December 2008 and the subsequent events dates include 25th November 2008, 27th November 2008, and 19th December 2008 Subsequent events Date of the event and auditor’s responsibility in relation to the event Account(s) affected Actions taken Revised banking terms 25th and 27th November. Auditor included a going concern paragraph in the audit report Non-current liabilities and assets classified as held for sale Group agreed on revised bank facility terns including waivers of certain covenants in relation to some of its banking facilities Test Case Decision 19th December No information about auditor’s involvement No accounts were affected The court found by majority/unanimous decision that participants in non-forestry managed investment schemes are carrying on business of primary production and are entitled to be treated accordingly for the purposes of taxation References AASB (2007) “Compiled Accounting Standard AASB 116 Property, Plant and Equipment”. Available online at: http://www.aasb.com.au/admin/file/content105/c9/AASB116_07-04_COMPapr07_07-07.pdf Institute of Chartered Accountants in Australia “Part B Risk Assessment”, Available online at: http://www.charteredaccountants.com.au/files/documents/part_b.pdf Myers S. C. Brealey R. (2002). Principles of Corporate Finance. Seventh Edition. McGraw-Hill Irwin. Penman, S. (2007), “Financial Statement Analysis and Security Valuation, Third Edition, McGraw-Hill International Edition. Robinson, T. R., van Greuning J. H., Henry, E., Broihahn M. A. (2009), “Financial Analysis Techniques”, in Financial Reporting and Analysis; CFA Program Curriculum, Level 1, Vol. 3; Pearson Custom Publishing. Timbercorp Limited (2008) “Annual Report 2008”, available online at: Anhttp://www.timbercorp.com.au/userdocs/1/corporate%20shareholders/documents/2008%20Timbercorp%20Annual%20Report%20-%20Interactive.pdf Read More