Purpose and Key Features of Financial Statements - Example

UFS Contents Introduction 3 Executive summary 3 Main Report 3 Part one- Purpose and key features of financial ments 3 Part two-Auditing and Corporate governance 4 Part three- Interpretation of income statement 5 Part four-Interpretation of financial position and cash flow 6 References 9 Appendix 10 To: Head of Loan’s Department From: Alex Date: Title: UFS Introduction Whenever someone applies for a loan to a bank it is the duty of the financial analyst of the bank to check the prospect of the client in order to access whether the client has the capability to repay the loan. Otherwise the loan has the chance to turn into a bad debt. The purpose of this report is to scrutinize the loan application of Addison and to access whether the initial approval for the loan can be granted to Addison. Executive summary The main problem of the company is recognized as the bankruptcy of one of the receivable of the company. Another thing that is noted is that cash flow from operating activities has decreased which has resulted in the company being cash strapped. This has resulted that company has stopped paying dividends and is issuing bonus share. The company therefore cannot be given loan and its loan application should be properly scrutinized before it is granted if at all it is. Main Report Part one- Purpose and key features of financial statements A.1. the £3 million paid to the auditors will be listed under the operating expenses in the income statement. The £15 million pound that will be paid for the printer will be listed under the statement of financial position balance. The fact that the company owes £34 million to the microchip supplier will be listed under the current liabilities section of the statement of the financial balance. A. 2. The £3 million that the company will pay for the audit charges will be located under the operating overheads. Under the operating overheads the expense will be listed under administration expense. An increase in the operating overhead will read in the decrease in the operating profit for the company. The £15 million pound that will be paid for the printer of the company will be listed under current liability if the amount will be paid for a long period of time. The £34 million that the company will pay to the microchip supplier will be placed under the current liabilities section for the company. Thus it can be stated that as a result of this addition the total amount under the current liability section will increase. b. Since the 150 million £ has now been recognised as a bad debt, it cannot be recognized as an asset any longer. This is because if it is shown as an asset does not picture a realistic picture of the financial condition of the company. c. 1. In the balance sheet the share capital increases in proportion to the issue of bonus share and this is reflected by an increase in share capital from 200 million £ to 300 million £. c. 2. The shareholders are receiving extra share free of cost instead of receiving dividend from the company. C.3. In case of bonus issue the existing shareholders are given extra shares of the company free of cost on prorate basis. Whereas; in case of rights issue, the existing shareholders of the company are given extra shares at a price, that is less than the market price. Part two-Auditing and Corporate governance 2. A.1. At the completion of the audit the auditor will give to the company an auditor’s report. The auditor’s report will specify whether the company has followed all necessary accounting standards and whether the financial statements reflect a fair and true value of the company at the end of the year (Burke, Guy, and Tatum, 2008). 2. A.2. The auditor’s report is addressed to the shareholders of the company as they are the actual owners of the company. 2. B.1. The code requires that the position of chairman and CEO should be separate. However in certain cases non compliance is allowed if the company can provide evidence that effective governance was promoted by the arrangement (Thornton, 2013). 2. B. 2. Reasons are: When the CEO is also the chairman of the company, he or she is the one who votes whether his or her salary should increase or not. Thus there is a conflict of interest. In case of auditing, matters of whistle blowing and selection of external auditor, having a member of the management sit on the board can lead to conflict of interest and cause abuse of the position. 2. B. 3. The reasons are: An executive director has a wealth of experience and knowledge which could prove to be valuable for any company. An executive director is able to direct the company in situation of hard times since they might have faced the difficulties before. Having an executive director on board increases the performance of the company. They have good contacts in the industry and can help the company in marketing. Part three- Interpretation of income statement 3. 1. It is seen from the ratio analysis of 2013 and 2014 that the company has seen an increase in operating profit, ROCE, Gross profit and net profit margin. This means that all aspects of profitability have shown an increase. However the interest coverage ratio is low and gearing ratio in 2014 is high compared to 2013. This means that the share of debt in the capital structure has increased. 3. 2. The increase in the profitability of the company is obviously a positive indicator of performance. The fact that the company is showing a healthy increase in the operating profit, gross profit and the net profit means that the company is able to sell its products effectively in the market and the market share of the company has increased. The increase in the gearing ratio might be a negative sign. On the other hand decrease in the interest coverage ratio is a negative sign. 3.3. If one analyzes the increase in gross profit then it has resulted from an increase in the revenue of the company generated from an increase in sales. However in order to achieve increased sales revenue the company had to incur an increase in cost of sales. For increasing the sales revenue by 608 million £ the cost of goods sold had to increase by 553 million £. If one analyzes the increase in operating profit then it comes from the increase in operating profit and an increase in other operating income. In terms of overhead, it is also noted that during the period the company has been able to reduce the administrative expense where as there has been an increase in the distribution cost that has brought in the extra profit. The company has also posted an increase in the net profit margin which is a result of an increase in gross profit and operating profit. However the increase in gross profit and operating profit has been negated by an increase in the finance costs and income tax expenses. The increase in the gearing ratio on the other hand shows that the proportion of debt has increased in the capital structure. The increase in the debt level is a negative sign for the company. This is due to the fact that debt increases the riskiness of the company. Part four-Interpretation of financial position and cash flow 4. A.1. As seen from the cash flow statement net cash from operating and financing activities is negative and only cash flow from financing activities is positive which has lead to decrease in total cash and cash equivalents. It is also seen that that dividend paid is 0. This shows that the company is short in cash. 4. A. 2. Operating cash cycle= inventory days + receivable days. 2013= 116.38 2014= 74.77 4. A. 3. There has been an increase in operating cash cycle which has resulted in sales being made but cash not being collected in time from the sales. This has resulted in shortage of cash for the company. 4. A. 4. The movement is a reflection of expansion activity being undertaken by Addison and is reflected in negative cash flow from investing activities. This is quite natural for a growth firm. The negative cash flow from operating activities is a reflection of the fact that Addison’s collection mechanism is not good and this has resulted in cash not being collected in time from sales being made. This has resulted in increasing receivable days and amount and is unsustainable business practice for the company. 4. B.1. As per the ratio analysis it is seen that there is a decrease in current ratio and quick ratio, an increase in days of inventory and days of receivable and days payable. 4. B. 2. The decrease in current ratio in 2014 as compared to the levels of 2013 is not a good sign. However the ratio is still above 1. Same is the case about the decrease in quick ratio. The increase in inventory days is also not a good sign as this shows that the no. of days it takes to convert inventory for the purpose of generating sales has increased. The increase in receivable days is a bad sign whereas increase in days payable is a good sign. 4. B. 3. The decrease in current ratio has been caused by an increase in both the current assets and current liabilities at the same time. However the increase in current liabilities has been more than the increase in current assets which has reflected in the decrease in current ratio. The increase in current liability has also led to an increase in the payable days for the company. There has been an increase in inventory levels which has contributed to an increase in current assets, and decrease in quick ratio (Periaswamy, 2009). 4. C. 1. Revised liquidity ratio Revised current ratio = 1.09 This is a bad sign for the company. Revised Quick ratio= 0.57. This is a very bad sign for the company. Revised inventory days= 51.43 This is a bad sign. Revised Receivable days= 44.13 This is not a good sign. Revised Payable days= 43.45 Revised payable days are also high for the company. Revised solvency ratios Revised Gearing= 20.85% The gearing ratio is high but still the fraction of debt in the total capital structure is low (Kuppapally, 2008). Revised interest cover= 4.2 The interest coverage ratio is alarmingly low which not a good sign is for the company. 4. C. 2. After taking into consideration the fact that receivable of 150 million pound from comet has become a bad debt, there have been profound changes to the statement of financial position. The current assets have decreased rapidly which has been reflected in the form of decrease in current ratio and excessive decrease in quick ratio. In fact the decrease in quick ratio has been more profound as the share of inventory has remained the same. There has been also a decrease to receivable days as the numerator has decreased. This is a serious matter of concern and should be carefully looked into before bank gives formal approval to loan application. Another important fact is that the interest coverage ratio has become very low. This is a serious constraint for providing the loan as provision of loan will further increase the financial costs and put more pressure on interest coverage ratio and operating profit. References Thornton, G., 2013. Governance steps up a gear. [Online]. Available at< http://www.grant-thornton.co.uk/Documents/FTSE-350-Corporate-Governance-Review-2013.pdf > [Accessed 1 May 2015]. Burke, F. M., Guy, D. M., and Tatum, K. W., 2008. Audit Committees: A Guide for Directors, Management, and Consultants. Chicago: CCH. Kuppapally, J. J. 2008. Accounting for managers. New Delhi: PHI Learning Pvt. Ltd. Periaswamy, P., 2009. Financial Management. New Delhi: Tata McGraw-Hill Education. Appendix Revised liquidity ratio Revised current ratio = current asset/ current liability= 608/553 = 1.09 Revised Quick ratio= (current asset- inventory)/ current liability = (608-290)/553= 0.57. Revised inventory days= Inventory/ cost of sales * 365 = (290/2058)* 365= 51.43 Revised Receivable days= (Receivables/ Revenue) * 365 = (318/2630)*365= 44.13 Revised Payable days= (Trade payables/ cost of sales)*365= (245/2058)*365= 43.45 Revised solvency ratios Revised Gearing= Debt/ (Debt+ equity) = (250/ (250+949))* 100 = 20.85% Revised interest cover= Operating profit/ Finance costs= 105/25= 4.2 Read More