Income Statements for Arabtec Holding - Case Study Example

Analysis of Balance Sheet & Income ments for Arabtec Holding PJSC and its Subsidiaries of Executive Summary Arabtec Holding was already profitable, liquid and solvent. Yet from the analysis made on its accounts from 2010 to 2011, revenues actually decline yet it was able to maintain profitability, liquidity and solvency at acceptable level, even higher than industry averages from the construction industry. It can however still improve its situation by increasing its profitability first by increasing revenues and second by minimizing expenses. Increasing profitability should consider the proper balance of its liquidity and solvency that its managers must managed as well properly with professionalism to avoid unnecessary risky that may eventually affect its profitability. The decline in revenues from 2011 was most critical yet the company was able to do and therefore it must resilient. Although this paper was aimed at explaining whether the increases or decreased in in assets, equity, liabilities, revenues and expenses accounts from the balance sheet and income statements of Arabtec, it was inevitable to go to the deeper implication of the accounts which led to the discussion of profitability, liquidity and solvency as better basis of determining how to improve the situation of the company. Contents Executive Summary 2 1. Introduction 4 2. Definition of all items under assets, liabilities, equity, expenses and revenue categories 4 2.1 Assets 4 2.2. Equity 9 2.3 Liabilities 10 2.4 Income Statement 12 2.4.1 Revenues 12 2.4.2 Direct costs 12 3. Calculate percentage increase/decrease between 2 years. 14 4. Explain if increase/decrease is good or bad for the company. 15 4.1 To increase assets is generally good. 15 4.2 To increase liabilities could be good or bad. 16 4.3 To increase equity is good most of times good. 16 4.5 Increase of expenses is generally good most of times. 17 4.6 Using financial ratios as better way to understand whether the changes in the accounts 18 5. Recommendation on how the company can further improve the situation. 23 References: 24 1. Introduction This paper seeks to analyses every item that can be found under the assets, liabilities, equity, expense, and revenue categories of Arabtec Holding PJSC and its Subsidiaries (or "Arabtec") for the years 2010 and 2011. The work will include defining first what each item means in the financial items, combining them into groups and making ratios of each accounts in relation to accounts for purpose of measuring the financial performance of the company from 2010 as compared with 2011. . This will then be followed by the analysis of the items from the notes to the accounts and also on the previous year’s figures. This will further analyse the increase or decrease from the previous year and explain if the increase/decrease are good for the company. Finally, the paper will recommend what the company needs to do to further enhance its position with regards to its assets. 2. Definition of all items under assets, liabilities, equity, expenses and revenue categories 2.1 Assets Assets are resources that generate benefit for value for a firm particularly in the production of revenues. They are subdivided into current assets and non-currents. Current assets are those are used in working capital of the company such cash , receivables, inventories, prepaid expenses, short-term investments and others while non-current assets are those which usually long-term in use like equipment, land, building or the so called plant property and equipment which lumped those fixed assets used in business. Non-current assets may also include long-term investments where the company is not using those assets in operations but are makings investments possible in other corporations like the form of bonds or investment in subsidiaries. If the investees are majority owned by the parent company, consolidated financial statements will be prepared which combines all the assets and equities of the entities. If less than majority, the stock ownership may just be called investments in the balance sheet of reporting entity. When assets are used are expended by the company, they are intended to produce revenues and while doing the same the said decreases of assets are recorded under the double entry bookkeeping system as expenses as well. The assets as contained in the balance sheet of Arabtec for the years 2010 and 2011 are the following. Each is defined and explained before they could be used to summarized and extract meaning for purposes of making improvement in the situation of the company. 2.1.1 Property, plant and equipments (PPEs) These are tangible assets or assets with physical substance owned by the companies which are used in business for production, supply of goods and services, for rental purposes and for administrative purposes. They are expected to be used over a period of more than one year (p.28, 29). When used the related expenses would include depreciation expenses and repairs and maintenance. 2.1.2 Intangible assets These are identifiable non-monetary assets without physical substance that must be controlled by the entity as a result of past event. They are recognized in the financial statements of the company if it is probable that future economic benefits that are attributable to the asset will flow to the entity and the cost of such intangible asset can be measured reliably. (p.30,31) 2.1.3 Investment in associate This is an account that on investment in common stocks to an entity or the investee in which the company has a significant influence on such investee. Significant influence is the power to participate in the financial and operating policy decisions of the investee but not control or joint control over those policies. Control means the power to govern the financial and operating policies of the investee to obtain benefits from its activities. (p.31) 2.4 Goodwill This asset account arises when earnings exceed normal earnings by reason of good name, capable staff and personnel, high credit standing, reputation for fair dealings, reputation for superior products, favorable location and a list of regular customers. In other words, it is created by good relationship between the company and its customers. There are two kinds of goodwill which are developed goodwill and purchased goodwill. Developed goodwill is generated internally and not recorded. Expense from such goodwill for developing, maintaining or restoring goodwill shall be expensed as incurred. Purchase goodwill arises when a company bought a business and recognized in the books as an asset. Therefore, goodwill reported on the financial statements comes from acquisition of businesses (Arabtec, 2014). 2.1.5 Trade and other receivables They are either current or non-current can be divided into two parts: the trade receivables and the nontrade receivables. They can be classified according to their nature and term of existence in the balance sheet. Trade receivables arises from the main source of revenue of the business , expected to be realized within one year or within the normal operating cycle of the business and is always classified as current assets. Nontrade receivables arises from sources of other revenues of the business and if expected to be realized within one year, it shall be classified as current, otherwise it will be classified as non-current if its term exceeded one year. (Arabtec, 2014) 2.1.6 Other financial assets These are entered into to earn additional investment income, dividend income or capital gains income which can come from financial assets carried at fair value aside from investment in available for sale securities. Also it is composed of investment in debt securities measured at amortized cost to earn interest income, or measured at fair value to earn income from increases in fair value. 2.1.7 Other assets They can be current or non-current constitutes a small percentage of the total assets but are important to maintain the current operations of the business like prepaid assets, due from employees, and other receivables. 2.1.8 Inventories These are held for sale in the ordinary course of business. The construction company currently keeps work in progress to be used in performing its construction services for its customers. The work in progress is composed of labor and other costs of personnel directly involved in providing the service. Aside from the work in progress, materials to be used in construction are also part of the inventories. 2.1.9 Due from related parties These are receivables from related parties which can be an entity or an individual which has the ability to control, exercise significant influence or joint control over the company or vice versa. Related parties for Arabtec Holding PJSC comprise the Group’s directors and entities related to them, companies under common ownership and /or common management and control, and partners and key personnel. They are measured at amortized cost. 2.1.10 Cash and cash equivalents are the most liquid assets of the company and comprises of all cash items such as cash on hand, cash in bank, cash equivalents, which are investments that can be converted into cash within three months’ time, and petty cash fund. These are used for working capital of the company and are considered as current assets 2.1.11 Deferred Tax assets They represent income tax paid in advance to the government and can be deducted to income tax liabilities in the future. They are called deferred because they could be still made as expense in the future. This kind of keeping information is consistent with the accrual accounting which is the principle used under International Financial Reporting Standards (IFRS). In the case of Arabtec the financial statements must follow the guidelines under UAE Federal Commercial Companies Law No. 8 of 1984 or the Articles of Association of the Group of Companies (Arabtec, 2014, p.3). The latter appears to be counterpart of the so-called IFRS used in Europe or the generally accepted accounting principles (GAAP) in the United States. Accrual accounting records expenses when they are incurred. Thus, the taxes are already paid but they cannot be considered as expense yet until they will be made applicable in the proper future period (Kieso, et al, 2007). These deferred taxes are essentially akin to prepaid expenses. 2.2. Equity 2.2.1 Share Capital The account represents the investment of stockholders to the company. They may include commons shares or preferred shares. 2.2.2 Statutory reserve The account represents the reserve accumulated from minimum of the 10% of net income every year until it reaches 50% of the share capital of the company as mandated by law, which cannot be distributed to stockholders unless allowed by law. 2.2.3 Fair value adjustment reserve The above account represents the reserve accumulated from net unrealized gains or losses arising from fluctuations in the fair value of investments in available for sale securities. 2.2.4 Foreign currency translation reserve The above account arises from translating financial statements of a foreign operation into the presentation currency of the company. 2.2.5 Retained Earnings The above account basically pertains to the cumulative balance of net income or net loss for each period. However, the transactions that affect retained earnings will also be included as part of retained earnings like dividend declaration and distribution, error corrections from prior periods, effect of changes in accounting policy, and other adjustments in capital. 2.2.6 Equity attributable to equity holders of the parent The above account pertains to equity of major stockholders company of the company owning more than 50% of the company’s stocks while equity attributable to non-controlling interests represents ownership of non-controlling interests of the company. 2.3 Liabilities These are obligations to be paid requiring assets or resources. Under the balance sheet the following falls under said group 2.3.1 Bank borrowings They represent loans from the bank with a term of 1 to 5 years. The interest rates are subject to fixed (EIBOR of 2% in 2011 and 3% in 2010) and variable interest rates (EIBOR of 2% in 2011 and in 2010). Loans with variable interest rates are incurred for purchasing inventories and property plant and equipment. These borrowings are collateralized by inventories and tangible assets of the company. Also, the company is subject to restrictive covenants due to its loan to the bank such as irrevocable assignment of the company and its subsidiaries of the proceeds from customers to the financing banks. See Note 20 of the Financial Statements (Arabtec, 2014). 2.3.2 Provision for employees’ end of service indemnity The account includes retirement benefits given to employees at the end of their service to the company. These are not subject to actuarial valuation because future salary increases and discount rates will not materially affect the value of the provisions. 2.3.2 Non-current portion of Retentions payable The above account represents payments due to the subcontractors withheld by the Group. They are given to the subcontractors by the time all the services required by the Group to be performed are complete. 2.3.3 Trade and other payables The above account can be classified according to term and according to initial measurement. Current liabilities have a term of one and are measured initially at face amount, meaning not discounted anymore. A non-current liability have a term of more than one year and is measured initially at present value which is discounted using the applicable discount rate in case of non-interest bearing notes to arrive at present value and interest-bearing notes is taken at face amount which is already its present value. 2.3.4 Due to related parties The above account represents payables to related parties. They are measured at amortized cost. 2.3.5 Income taxes payable The above account represents taxes due to the government for the period. This is computed by multiplying the accounting income from the applicable tax rate after deducting or adding permanent differences which are not taxable or deductible for income tax purposes. 2.4 Income Statement Included under this category are revenues and expense and other items in the document 2.4.1 Revenues They are the measured outputs from delivering goods or services to customers. The main source of revenue comes from contract revenue arising from sale of services evidenced by construction contracts with clients or customers. Contract revenue is recognized based on the percentage of completion method. The percentage of completion is based on the percentage of actual cost incurred over the total estimated costs on the contract. Other sources of revenue come from sale of goods to customers which will be used for construction. Revenue from sale of goods is recognized when there is a transfer of risk and rewards of ownership, when there is no more managerial involvement or control on such goods sold, amount of revenue can be measured reliably, the probable economic benefits associated with the transaction will flow to the entity, and the cost incurred or expected to be incurred can be measured reliably. See Note 24 to Financial Statements (Arabtec, 2014). 2.4.2 Direct costs The account comes from contract costs chargeable to the customer under the agreements specified in the contract. In other words, these are contract costs that can be allocated to construction projects of the company. 2.4.3 Gross Profit The account is the difference between gross revenues and direct costs. It determines Income generated by the business after deducting direct costs. 2.4.4 Other operating income The account includes manpower and other charges to joint ventures which come from operating activities of the business. 2.4.5 General and administrative expenses They are costs that cannot be allocated to construction project. 2.4.6 Gain on derecognition of financial assets The account arises from sale of financial assets of the company. 2.4.7 Other income The account arises from transactions not connected with the ordinary course of business such as gain on sale of property, plant and equipment, and derecognition of financial assets and financial liabilities. 2.4.8 Net changes in fair value of non-current retentions and trade receivables The account arises from net decrease in fair value of trade receivables and non-current retentions which are the results of change in agreed payment plans and estimated likely payment periods of certain trade receivables. 2.4.9 Investment income The account arises from interest income and amortization of discount on held to maturity investments of debt securities. 2.4.10 Finance costs These are interest expenses arising from loans from bank borrowings and other loans that charges costs of lending credit to the company. 2.4.11 Profits before tax The account represents profits of the company after deducting all expenses except income tax incurred to total revenues of the Group. 2.4.12 Income tax expense The account is the sum of income tax payable and income tax liability. 2.4.13 Profits for the year The term represents are the net income closed to retained earnings of the Group. The same would increase equity account. 3. Calculate percentage increase/decrease between 2 years. The defined accounts are summarized below into their respective group. The comparison in Table I below indicates the change and the remarks column tells whether the effect is favorable (positive) or unfavorable (negative). Table 1- Comparative values for 2010 and 2011 4. Explain if increase/decrease is good or bad for the company. To appreciate the whether the increase or decrease in the asset, equity, liability, revenue and expenses accounts is to understand their nature from their definitions and explanations done earlier. 4.1 To increase assets is generally good. Increasing assets is normal for companies as they grow. Hence generally increase in assets may mean increase in wealth or value to the business but not necessarily. As defined earlier, assets are used provide benefits. Hence it is possible to increase assets yet wealth will not be increase. That is the net effect of procuring such an assets will only result to a loss. A simple example would be in acquiring non-current asset or PPEs which will not be used. Since it’s not in use, it will not generate revenues but expenses will be recognized and recorded since passage of time would be the basis for incurring expenses. Companies should only aim to increase assets if it will be useful and will help in generation of wealth. 4.2 To increase liabilities could be good or bad. In the ordinary course of things, increase liabilities is not good generally considering that the company would be made to spend more resources more to meet the obligations. Considering that payment of liabilities will entail use of resources or charges on them, then increasing the same would in effect be lessening resources or assets that would be used to pay creditors instead of owners. However when assets are acquired on accounts, liabilities would have to be increased as assets are increased at the same time. This means that as the company would need resource to finance its working capital needs and long-term capital needs as a result of acquiring fixed assets, increasing liability is necessary to have more revenues to meet the increasing demand of customers. The company under study is a construction company and for it to build more projects or make more construction for customers, it must be able to invest first in more fixed assets that will be used in making the goods and services delivered to customers and sometimes liabilities have to increased accordingly. 4.3 To increase equity is good most of times good. For equity to increase the same will naturally come from increase in profit and increase in investment by owners. Note that the increase in profit will come from increase in difference of increase in revenues and expenses. As stockholders equity increase the, wealth of the company would increase. The evidence of this is when net retained earnings will increase since this will show that dividends can be declared due to the presence of retained earnings. An instance when equity increased becomes bad is when no dividends are distributed and no expansion plans for ever. In other words, benefits from corporations must be returned to the owners in the form of dividends to keep them maintaining the corporation. 4.4 To increase revenues is most of the times good for the company but not all times. Increase in revenues is usually matched with increase in expenses because of the employment of assets in generating those revenues. Since every sale transaction is a source of revenue, a company should generally enter into a revenue transaction when there is a net advantage of the same. Increasing revenue in a transaction where there would be higher cost could be bad for the company. 4.5 Increase of expenses is generally good most of times. Like revenues, the incurring of expenses must be matched by corresponding increase in revenues. For purpose of understanding better the effect on increase or decrease in the accounts, it is important to look at these accounts in general as the data from the financial statements have already summarized them per period. It is therefore not easy to go to every transaction whether the company did benefit from the increase. This would explain what was earlier where the accounts are lumped for purpose of determining the changes from 2010 to 2011. Note however, that as long-term assets are used in business, the effect is incurrence of expenses. For example, to depreciate equipment would be an expense but as to whether the effect is good could only be view from long-term perspective. Thus shareholder value is meant to be long-term rather than short-term. 4.6 Using financial ratios as better way to understand whether the changes in the accounts Changes in assets, liabilities, equity, revenues and expense are analyzed better through the use of financial ratios. The ratios relate one group of accounts with the other to appreciate the meaning. Some of these ratios include gross margin, operating margin, and net profit margin, return on assets, return on equity. Other ratios include current ratio, quick asset ratio, and debt to equity ratio. It is in understanding these ratios that an understanding of the company would appear better. The change of perspective from viewing the account on per item basis to a group-basis will enhance a better understanding on what is happening with the company. Since the aim of business is to increase wealth, generally companies need to profitable and able to manage risks. 4.6.1 Profitability is seen in increase in profitability and efficiency ratios. Profitability of Arabtec was almost consistent for the past two, however there was a slight decrease in the ratios mainly because of the decline in revenues from 2010 to 2011. The resiliency of the company to generate value from each amount of expenses used in its operation is evident. The average gross margin for the past two years registered at 13.86% as against industry average of 19.43% See Table II below in relation to Appendices A and B and C. Table II –Summary of Financial Ratios (ARABTEC, 2014a; Reuters 2014b). This would mean that the decreased in gross margin was affected by decrease in revenues. It also resulted to lower gross margin, lower operating margin and lower net profit margin. From the decreased gross margin in 2011, with the decreased revenues for the past two years, the net operating margin naturally resulted in lower rate also in 2010. See Table II above in relation to Appendices C. (Arabtec Holding, 2014a). From the operating margin changes, the result could be further analyzed in what happened to the net profit margin. Generally, operating margin decreases when compared to net profit margin, given the fact the company is assumed to spend non-operating expenses like interest expenses after computing the operating profit. The decreases from operating margin and net profit margin in 2011 mean that the company has yet start to find other sources of profitability outside its main operations starting 2011, although the profitability of its main operations are still high. The result would therefore mean that the company must have extra funds to invest elsewhere and to produce extra non-operating income to possibly further boost its profitability. See Table II above. Connecting the analysis of gross margin, operating margin and net profit margin with return on assets (ROA) and return on equity (ROE) could give more meaning to how the company performed better compared with its competitors in construction industry. The positive results likewise happened in ROA and ROE in 2011 . This is very logical considering that the other measures of profitability like gross margin, operating margin and net profit margin reflected positive rates although there was slight decrease from 2010 to those in 2011. Necessarily, all the profitability ratios for 2011 are also positive. There is therefore no issue as to how companys assets were fully utilized during 2011. Such so remarkable level of profitability may cause some problems with the other measures of financial strength like liquidity and solvency. As to how the same may happen may have something to do with company practices. It is possible that the company may be reflecting very high revenues, but it may happen that revenues may not be collected on time and the cash flow or liquidity of the company may get affected. On the other hand, the companys desire to generate profitability, necessarily require employing more assets, which will have to be financed either by equity or debts. Better evaluation would have to be deferred until brought to proper sections of this paper in liquidity and gearing. Profitability is a requirement for companies for practical reasons. It is a way to convince first the investors that these companies are capable to earn a satisfactory return on sales, total assets, and invested capital. However, the term satisfactory to may have a relative definition for different users of information. Thus across companies and industries, there is need to have properly prepared accounting and financial information as basis for decision making. This is the reason that publicly listed companies are regulated also in terms of their financial reporting which must follow generally accepted accounting principles in the US or the international financial reporting standards (IFRS) for those in Europe (Kieso, et al, 2007). This analysis report therefore gathered the financial statements which include the income statement, balance sheet and cash flow statement for the past five years as prepared by the management of ARABTEC and audited by their auditors to ensure reliability of the accounting information. From the financial data as summarized in Appendix A , financial ratios are generated as those appearing now in Table I above. This group of ratios includes, profitability, efficiency, liquidity and solvency or gearing ratios . ARABTECs two-year average return on equity (ROE) of 12% indicated an more than double superior performance about of its past performance compared to industry average of 5.3% The 12% ROE implies that for every AED 100, the investors profit about AED 12 which is very high compared with the risk-free rate investment. The other profitability ratios include, gross margin, net operating margin and net profit margin. The other ratio worth mentioning and comparing with the industry is return on assets which incidentally measures also the efficiency of management capacity to manage corporate assets 4.6.2 Managing risk is making sure that the company is liquid and solvent. 4.6.2 .1 Liquidity management Liquidity ratios indicate survival capacity against threats of bankruptcy or insolvency that could send business to halt operation. Companies therefore need to show to investor s that they can establish a capability to meet its currently ripening obligations. A liquid and functioning company (Johnson, et al, 2003) is the aim of every healthy company in the same way a human being would want to have good health for the day (Helftert, 2001). Having then liquidity makes employees to come to work because salaries are paid on time, expenses paid and liquidated on time to allow efficient operating cycle of the business and suppliers’ accounts are settled. Arabtec appears to have managed its liquidity well. Its current ratio registered at 1.20 and 1.22 in 2010 and 2011 respectively or an average of 1.21 for the past tw0 years as against the industry average of 1.03 Evidently, Arabtec is more liquid than average competitors, and it is even above the level of 1.0. See Table I above. A current ratio above 1.0 indicates normal liquidity but to have excessive liquidity may not be good from a financial theory viewpoint. It quick assets ratio, on the other hand, registered at 0.96 and 0.93 for the years 2010 and 2011 respectively or an average of 0.94 for the two five years as against industry average of 0.79. 4.6.2 .1 Solvency or Financial leverage management Leverage is a must to a company as balance between work and play required for a properly functioning individual. Leverage arises as borrowings are resorted to finance expansions. Companies especially publicly listed ones like Arabtec cannot finance all its needs via equity alone by requiring investments from its shareholders as there are disadvantage of having the same financial strategy. Thus, not borrowing would not be normal if a company has to finance all the assets to be used in business as it would mean leaving all the shareholders to suffer with the risk although entitling themselves to full ownership of profitability of the business entity. Almost all companies including Arabtec are to mandated create and build shareholder value, and resorting to borrowings such may not be avoided as in issuing bond and going to banks to finance its capital needs. Borrowing allows more profits and better cash flows at times from the context of optimum capital structure (Arnold, 2004). Thus a balance between level of equity and debt is needed. This power to borrow cannot be overdone since this could mean poor utilization of its debts. To do so would be just like paying finance charges if the extra funds remain idle with the company in addition to endangering liquidity for misused of funds to loan repayment that could otherwise be put the working capital. Based on the foregoing discussion Arabtec registered gearing of 1.80 and 1.60 for the years 2010 and respectively or an average of 1.70 respectively as against industry average of 0.94 (Reuters, 2014). As against industry average of 0.71 Arabtec’s gearing ratio makes it at almost twice higher than the industry average. See Note 20 of the Notes to FS (Arabtec, 2014) 5. Recommendation on how the company can further improve the situation. Arabtec can improve its situation by increasing its profitability first by increasing revenues and second by minimizing expenses. Increasing profitability however should not adversely affect its liquidity and solvency which deserved to be managed as well properly in order not to make the company face unnecessary risky that may eventually affect its profitability. The decline in revenues from 2011 was most critical yet the company was able to maintain profitability, albeit lower than the previous year. Its present level of liquidity and solvency are acceptable and should be maintain subject of course to the behavior of the market. The final arbiter on how the company is performing is the market on whether the increasing shareholder value in the balance sheet is matched with increase stock price in the market to indicate the real economic values of the company. References: Arabtec Holding (2014). Reports and Consolidated Financial Statements for the year ended December 2011 of Arabtec Holding. Retrieved 25 April 2014 Arnold, G. (2004). The Financial Times Guide To Investing: The Definitive Companion to Investment and the Financial Markets. London: FT Prentice Hall. Helfert, E. (2001). Financial Analysis: Tools and techniques: a guide for managers. McGraw-Hill Professional Kieso, et al (2007). Intermediate Accounting. John Wiley and Sons Reuters (2014). Construction Industry Ratios. Retrieved 25 April 2014 < http://www.reuters.com/finance/stocks/financialHighlights?symbol=1820.T> Appendices: Appendix A- Balance Sheet; (Arabtec, 2014) Appendix B – Income Statement; (Arabtec, 2014) Read More