The Purpose of Statement of Financial Position and Income Statement - Morrison Supermarkets - Case Study Example

BUSINESS FINANCE The purpose of ment of financial position and income ment This is a financial statement that shows incomes earned and expenses incurred by an entity in the course of its operations. It provides a snapshot of an entitys profitability in a given period. Therefore, it has one section that presents revenues and incomes and the other reflecting expenses for the same period. When revenues are more than expenses, then the entity will have made a profit, but, if expenses exceed revenues, then it will have made losses (Reeves, 2015). On the other hand, the statement of financial position was formally called a balance sheet, and this financial statement is used to show the net worth of an entity (Reeves, 2015). Its elements include assets, owners equity and liabilities. The financial statements and income statement are two of the four financial statements that entities are required to prepare and present. The prepared reports are presented to the various users of financial information about the reporting entity with an objective of assisting them in the economic decision-making process. Each one of these financial information users has varied needs from the presented reports. Shareholders are interested in its long-term and short-term survival. They, therefore, use financial information to perform some analyses such as profitability analysis to establish its viability, and dividend analysis to establish their investment’s returns (Sabău, 2013, p. 647). Creditors’ interest on the other hand in the reporting entity’s financial statements is to establish its ability to honour its short-term obligations and loan decisions. For the presented information to be useful to the users mentioned above for decision-making and evaluations, it must possess certain attributes, popularly called qualitative characteristics. These qualitative characteristics include relevance, faithful representation, comparability, verifiability, understandability and timeliness. To achieve these features, entities are guided by accounting standards and principles in treatment of transactions. Principles used by Morrison Supermarkets in the preparation of its financial statements and report Accounting principles are the basic rules and concepts used to guide the modern accounting practices. As such, Morrison Supermarkets use these principles to account and treat its operations. Among them is the going concern concept. According to Morrison Supermarkets (2014, p. 55 & 83), the company’s directors use this concept to assess the ability of it to continue being in operations in the foreseeable future using cash flow forecasts. These forecasts are based on the future trading performance, retail market conditions, working capital requirements and the wide economy. Morrison Supermarkets also uses the periodicity concept since its accounting reference date is twelve months and falls between January 29 and February 4 each year (Morrison Supermarkets, 2014, p. 83). Another principle that Morrison Supermarkets uses is consistency. According to this principle, once an entity adopts a given accounting method, it should continue using it. In this respect, Morrison Supermarkets has consistently applied its accounting policies to all periods presented in its 2013/2014 financial statements (Morrison Supermarkets, 2014, p. 83). This principle will enhance comparability and adds to the comparative information (2013 results) already presented by Morrison Supermarkets. The materiality principle is also used as Morrison Supermarkets material items have been presented separately in the financial statements. Morrison Supermarkets also uses conservatism principle that requires an entity to record expenses and liabilities immediately they are incurred but record assets and revenues only when it is evident that they will be received. Morrison Supermarkets recognises its fuel revenues when transactions are completed in store. In the case of food online, revenues are recognised when customers accept goods on delivery (Morrison Supermarkets, 2014, p. 84). This recognition of revenues also relates to the revenue recognition principle where an entity is required to recognise revenues when the earning process is substantially complete. The cost principle is another concept that Morrison Supermarkets uses and require an entity to record its assets, equity investments and liabilities at their original purchase costs. Morrison Supermarkets states its property, plant and equipment and investment property at cost less accumulated depreciation as well as accumulated impairment losses (Morrison Supermarkets, 2014, p. 91). These costs are the directly attributable costs. This principle helps in achieving the reliability qualitative characteristic of financial information. Ratio analysis Liquidity ratios These ratios help in establishing an entitys ability to meet its short-term maturing obligations as and when they fall due (Babalola & Abiola, 2013, p. 134; Greuning et al., 2011, p. 25). Lower liquidity ratios translate to higher liquidity risk as compared to when these ratios are high. Inadequate liquidity makes it difficult for a firm to meet its short-term liabilities, resulting to litigations instituted by the creditors, poor credit worthiness or even insolvency. The ratios analyzed under this category were the current ratio and the quick ratio. Table 1 Liquidity ratios Liquidity ratios 2014 Million 2013 Million Current ratio = Current Asset Current liabilities =1,430 / 2,873 = 0.50:1 =1,342/ 2,334 = 0.57:1 Acid test ratios = Current Asset - Inventories Current liabilities = (1,430-852) / 2,873 = 0.20:1 = (1,342-781)/ 2,334 = 0.24:1 The current ratio shows how many times current liabilities can be settled from current assets before these assets are exhausted (Tracy, 2012, p. 20; Tugas, 2012, p. 175). As shown in Table one above, this paper established that the current ratios of Morrison Supermarkets were 0.50 and 0.57 in 2014 and 2013 respectively. These ratios imply that Morrison Supermarkets was could not settle its short-term maturing obligations as and when they fell due from its available current assets. Indeed, the case worsened in 2014 as this ratio slightly dropped to 0.50 from 0.57 in 2013. Further results from the analysis of its acid test ratio, which is a more refined current ratio that excludes inventory amounts as the inventory is valued on the historical cost basis and it may not be quickly converted into cash established that this ratio also dropped in 2014 to 0.66 from 0.24 in 2013. This drop was attributable to the increase in the value of stock in 2014 to £852 million from £781 million in 2013. From this analysis, besides the fact that Morrison Supermarkets could also not pay its current liabilities without selling inventories in the two period, it could also not pay them using the available current assets as indicated by the current ratio above. This paper, therefore, advises the management of Morrison Supermarkets to review their working capital management policies to avoid unnecessary interruptions of its operations. During worst situations, Morrison Supermarkets can be forced to dispose off some of its non-current assets in order to pay the maturing obligations. This move would put it in a very risky situation that might force it into liquation. Leverage ratios These ratios are used to measure the entity’s capital structure. They show the extent to which the business has borrowed fixed charge capital in order to finance assets and other resource acquisitions for the business to enable it efficiently carry out its normal operations (Bull, 2007, p. 35). The following gearing ratios were established for the past fiscal years. Table 2 Leverage ratios Leverage ratio 2014 Million 2013 Million Debt to total equity ratio = Long-term debt x 100 Equity capital = (3,164/ 4,692) *100 =67% = (2,963/ 5,230) *100 = 56.65% Debt ratio = Total debt Total assets = 6,037/ 10,729 = 0.56 = 5,297/10,527 = 0.50 Interest coverage ratio = EBIT/Interest expense = (95)/85 = (1.12) = 949/75 = 12.65 As indicated in Table 2 above, this paper analysed the Morrison Supermarkets’s debt to total equity ratio, so as to establish the relationship between its debt and equity financing. The results indicated that the debt to total equity ratio was 67% and 56.65% in 2014 and 2013. This implies that, for every £1 equity financing there was £0.67 of debt in 2014 and £0.5665 of debt in 2013. This shows that Morrison Supermarkets borrowed more in 2014 than in 2013 and therefore negatively affected its financial healthiness and increased its risk. The excessive use of debt to finance its operations was also manifested from the analysis of its debt ratio. This paper sought to establish the proportion of an entity’s assets that have been financed through borrowings. As indicated in Table 2 above, Morrison Supermarkets’ debt ratio deteriorated in 2014 as it was 56% from 50% in 2013. This implies that in the year 2014, Morrison Supermarkets used £0.56 and £0.50 in 2013 of debt to finance its assets. This further shows that only £0.44 and £0.50 of the shareholders was used to finance £1 of its assets. This situation shows that Morrison Supermarkets is slightly leveraged, and it would be technically challenging in case it wanted to acquire a bank loan. This is because, the bank would view it as already being highly leveraged, and an additional loan would entail possibilities of experiencing financial distress while resurfacing the principal amount. Another leverage ratio analysed by this paper was the interest coverage ratio. This ratio shows the debt interest portion that is covered using company’s cash flows. Where the ratio is below 1, it indicates that the company is experiencing difficulties in generating enough cash flows to pay its interest expenses. The results of this analysis as indicated in Table 2 above clearly shows that Morrison Supermarkets was not able to generate enough operating incomes to cover its interest charge in 2014 but in the year 2013 it generated enough operating incomes that would cover its interest charge 12.56 times. The poor performance in 2014 could make it difficult for Morrison Supermarkets to acquire an extra loan, as aforesaid, since it is crystal clear that the company could not raise operating incomes to pay the accrued interest expense. This was attributable to the presence of non-recurring exceptional costs of £903 million. Profitability ratios These ratios are used to evaluate entity’s earnings in relation to a given level of assets, a given level of sales, owners’ investment or share value (Wahlen et al., 2010, p. 246). This paper conducted profitability analysis since it was found necessary in evaluating Morrison Supermarkets’s future profitability potential since it is crucial that it must operate profitably to survive in the long-run. Table 3 Profitability Profitability ratios 2013 Million 2012 Million Return on net sales = operating income/sales *100 = (95)/17,680 = (0.54%) = 949/18,116 = 5.23% Net profit margin = net profit/sales *100 = (236)/17,680 = (1.33%) = 637/18,116 = 3.52% Gross profit margin = (sales-cost of sales)/sales*100 = 1,074/17,680 = 6.07% = 1,206/18,116 = 6.66% Return on equity (ROE) = net profit/ common shareholders equity*100 = (236)/4,692 = (5.03%) = 637/5,230 = 12.18% Return on total assets = net income/ total assets*100 = (236)/ 10,729 = (2.20%) = 637/10,527 = 6.05% Gross profit margin was analysed to show the ability of Morrison Supermarkets to control its cost of sales and management’s efficiency in producing each unit of a product (Tracy, 2012, pp.14). This paper’s findings established that Morrison Supermarkets’s gross profit margin slightly declined in 2014 to 6.07% from 6.66% in 2013.This implies that 93.94% of sales turnover was absorbed by the cost of goods sales making in 2014 and 93.94% in 2013. The analysis of operating profit margin was conducted to show the ability of Morrison Supermarkets’ to control its operating expenses such as selling and distribution costs, and administrative expenses. Similar to gross profit margin, its operating profit margin worsened in 2014 by recording a negative operating profit margin from 5.23% in 2013. These findings indicate that Morrison Supermarkets could not control the operating expenses leading to negative operating incomes and the sales revenue raised in 2014 could not even cover the cost of sales and all operating expenses. In 2013, this paper found that the cost of sales and operating expenses consumed 94.77% of sales. This trend was also manifested by the net profit margin. The results of this paper established that Morrison Supermarkets’ net profit was (1.33%) and 3.52% in 2014 and 2013 respectively. Besides inability of Morrison Supermarkets to control its the cost of sales and operating expenses, these results indicate that the company also experienced difficulties controlling its finance costs. This was shown by the increase in the finance costs in 2014 to £87 million from £75 million in 2013. The reasons for this increase were the increase in its borrowings in 2014 since they stood at £2,480 million up from £2,380 million in 2013. This paper also analysed the return on equity of this company. This ratio was found necessary because it would show the return of profitability on £1 of equity capital that its shareholders contributed. From the analysis of Morrison Supermarkets’ return on equity, this paper established that it was (5.03%) and 12.18% in 2014 and 2013 respectively. As evidenced by the results in 2014, the £1 of equity capital contributed by its ordinary shareholders did not earn them profits but rather it earned losses. This was an indication of poor performance because in the year 2013, £0.1218. However, though a positive return, this result was also too low. The results on the return on total assets analysis found that Morrison Supermarkets ratio dropped in 2014 to (2.20%) from 6.05% in 2013. This implies that, in the year 2013, £1 use of assets towards the generation of profit earned losses while in the year 2013 it earned £0.0605 of profit. From the analysis of profitability ratios of Morrison Supermarkets, this paper advises its management to improve its efficiency in managing the costs of sales by having favourable arrangements with its vendors. In addition, it should develop the necessary actions to contain operating expenses and financing costs to desirable levels. Turnover ratios These ratios are also called activity or efficiency ratios. According to (Sahaf, 2009, pp. 105-106,), note that efficiency ratios are used to establish how efficiently the management uses an entitys assets and other resources to generate sales revenue. Ratios 2014 Million 2015 Million Debtors turnover = net sales/ debtors =17,680/ 316 = 55.95 = 18,116/ 291 = 62.25 Average days sales uncollected = 365 days/ debtors turnover = 365 days/55.95 = 6.52days = 365 days/62.25 = 5.86 days Inventory turnover = cost of sales/average inventory = 16,606/ 816.5 = 20.34 = 16,910/ 781 = 21.65 Inventory holding period = 365 days/inventory turnover = 365 days/ 20.34 =17.94 days = 365 days/21.65 = 16.86 days The debtors turnover is used to show the frequency with which credit customers are converted into sale and whether the amount tied to those sales are reasonable (Tugas, 2012, p. 175). The results of this study established that the Morrison Supermarkets’ debtors turnover ratio was 55.95 times and 62.25 times in 2014 and 2013 respectively as indicated in Table 4 above. This showed a drop in the number of times that customers came to buy on credit in 2014 after paying their dues compared to 2013. Consequently, this resulted in the customers taking longer periods to pay for their credit purchases. This was as established by this paper that the debtors collection period increased in 2014 to 6.52 days from 5.86 days in 2013 as shown in Table 4 above. The inventory turnover is used to establish the number of times an entity sold its inventory during the fiscal period (Bhat, 2008, p. 57). From this paper’s analysis, the results on the Morrison Supermarkets’ inventory turnover were 20.34 and 21.65 times in 2014 and 2013 respectively as shown in Table 4 above. This implies that the Morrison Supermarkets’ ability to turn its inventory into sales in 2014 slightly dropped compared to 2013. As a result, the period that the Morrison Supermarkets held its inventory in the warehouse before selling it increased as indicated by Table 4 above where, the inventory turnover in days increased to 17.94 days in 2014 from 16.86 days in 2013. Interpretation of Morrison Supermarkets’ Cash Flow Statement A cash flow statement is one of the major financial statements that companies are required to prepare. It indicates the effects of an entitys investing, financing and operating activities on its cash balance. It provides relevant information about an entitys cash receipts as well as cash payments during a given accounting period (Moyer et al., 2011). As such, a complete indication of sources and uses of cash resources by an entity are indicated. This paper established that Morrison Supermarkets uses an indirect method to prepare its cash flow statement. This method reports cash flows from operating activities by way of adjustments of the net profit for the period as reported in the income statement. As aforesaid, cash flows from operating activities are those primarily derived from the entity’s principal revenue-producing activities. These cash flows arise from the transactions as well as other events considered while determining net profit or loss. The results of the study of Morrison Supermarkets cash flow statement showed that its cash flows from operations decreased in 2014 to £722 million from £1,107 million in 2013. The reduction was due to an increase in the stock and debtors by £71 million and £25 million respectively. These increases were also shown in the statement of financial position. The Cash flows from investing activities deals with cash flows relating to capital expenditure, inter-corporate acquisitions and investments as well as cash realized from non-current assets’ disposal. This paper found that, the cash outflows from investing activities of Morrison Supermarkets slightly increased to £1,052 million in 2014 from £1,011 million in 2013. Over the two periods, Morrison Supermarkets have heavily invested in capital assets such as property, plant and equipment as well as software. The increase in 2014 was attributable to cash used in investment in joint venture adding up to £66 million. The cash flow from financing activities are those cash inflows and outflows and affect the equity capital as well as an entity’s borrowing structure (Global Services Limited, 2015). In 2014, this paper established that Morrison Supermarkets had net cash inflows from financing activities of £325 million compared to net cash outflows of £45 million in 2013. The excess cash outflows in 2013 were due to the repurchase of own shares and treasury shares. Overall, Morrison Supermarkets recorded a net decrease in cash and cash equivalents of £5 million in 2014 against a net cash and cash equivalent increase of £51 million in 2013. References Babalola, Y.A. & Abiola, F.R., 2013. Financial Ratio Analysis of Firms: A Tool for Decision Making. International Journal of Management Sciences, 1(4), pp.132-37. Bull, R., 2007. Financial Ratios: How to use financial ratios to maximize value and success for your business. Waltham, Massachusetts: Elsevier. Global Services Limited, 2015. IAS 7 — Statement of Cash Flows. [Online] Available at: HYPERLINK "http://www.iasplus.com/en/standards/ias/ias7" http://www.iasplus.com/en/standards/ias/ias7 [Accessed 14 April 2015]. Greuning, H.v., Scott, D. & Terblanche, S., 2011. International Financial Reporting Standards: A Practical Guide. illustrated ed. Washington D.C.: World Bank Publishers. Morrison Supermarkets, 2014. Wm Morrison Supermarkets PLC Annual report and financial statements 2013/14. Financial report. Bradford, West Yorkshire: Morrison Supermarkets Morrison Supermarkets. Moyer, R.C., McGuigan, J., Rao, R. & Kretlow, W., 2011. Contemporary Financial Management. Boston, Massachusetts: Cengage Learning. Reeves, L., 2015. The Purpose of a Balance Sheet & Income Statement. [Online] Available at: HYPERLINK "http://smallbusiness.chron.com/purpose-balance-sheet-income-statement-61847.html" http://smallbusiness.chron.com/purpose-balance-sheet-income-statement-61847.html [Accessed 14 April 2015]. Sahaf, M.A., 2009. Management Accounting: Principles & Practice, 2E. Noida, Uttar Pradesh: Vikas Publishing House Pvt Ltd. Tracy, A., 2012. Ratio Analysis Fundamentals: How 17 Financial Ratios Can Allow You to Analyze Any Business on the Planet. Sydney: RatioAnalysis.net. Tugas, F.C., 2012. A Comparative Analysis of the Financial Ratios of Listed Firms Belonging to the Education Subsector in the Philippines for the Years 2009-2011. International Journal of Business and Social Science, 3(21), pp.173-90. Wahlen, J., Baginski, S. & Bradshaw, M., 2010. Financial Reporting, Financial Statement Analysis and Valuation: A Strategic Perspective. 7th ed. Boston, Massachusets: Cengage. Read More