Analysing Financial Statements - Coursework Example

Name Institution Course Tutor Date Analysing Financial statements As I read this chapter on analysing financial statements, I am left to wonder how practical I can get to understand the financial statements, and reasons as to why we need to analyse the past financial statements. When one looks at all the financial statements it is difficult to decide on which one is the most important. Such are the questions I ask myself in this important analysis. Carmichael, Whittington & Lynford (2007) agree that financial statements give a special communication that investor should pay attention to. Therefore a good understanding of them is crucial in any business. The writer begins by drawing a difference between the normal markets, such as a fish market and the capital market, and in essence argues that greater attention to detail should be accorded to the exercise of analysing the financial statements. This is because the financial statements help in predicting the future of a company. This is very fundamental because at least no one is much interested with the past than the future. The writer is insisting on the practical aspects by drawing into practical situations in our lives. This will help very much in quick understanding of the whole concept and therefore this is the most attracting approach to me. From the writer’s assertion that there are two main frameworks of analysing the firms, that is, the discounted cash flows and economic profit, I am uncertain at this point on whether this leaves out the balance sheet as an item that one needs not to pay much attention to. However, this concern is answered since the return on net operating assets (RNOA) is a component of the two frameworks. Value addition to investors is equally an important area that the writer has explained. Contrary to what I had believed that investors get value when they are paid dividends. That this is value transfer and not value addition is quite fascinating to understand at one spot. The writer agrees with Fabozzi et al. (2004) who argue that dividend which is the transfer of value can only be done if the value has been created. Assets acquired are used to generate revenue which eventually increases value through profit. This means that the contrary is true if an organization makes losses because it loses value for the investors, and from the financial rules, transfer of value cannot take place in this case. The writer as well has given a number of differences between free cash flow and dividends. Reading this chapter is proving interesting. One understands issues through reading and for sure this is what I am undergoing now. I had just thought dividends are paid out of the free cash flows. Rather, these two concepts are completely different. One transfers value from the firm to the investors and the other transfers value within the firm. The writer finally disregards free cash flow as not a good way of measuring the firm’s performance but rather economic profit. Therefore economic profit creates value to investors. This economic profit is best measured by return on net operating assets (RNOA). I like the practical way on how the writer explains that capital is never free. The way the writer mirrors our lives that we have very many opportunities and that engaging in one area will mean denying time for another area. So capital will be measured as an opportunity cost even when it comes from the owners of the firm. However, sometimes I wonder how one will determine the cost of this capital in situations that it is hard to find an equivalent cost of capital. Does this method of measuring cost of capital give a precise measurement? I was thinking unless you know the returns of may be various securities and make assumption that you would have invested that capital on the same to earn the returns is when you may assume that return to be the opportunity cost (Fabozzi et al.2004). In viewing a firm, the writer differentiates two important aspects, that is, operating and financial activities. I ardently followed the way he introduced a difference between the two. ‘The kinder surprise’ chocolate is the perfect and practical way of differentiating the two. These two are important in restating the financial statements. Restating financial statements Financial statements are restated by differentiating operating and financial activities of the firm. Therefore an understanding of the difference between the two is very vital. They are applied all through the three financial statements, that is, the statement of financial position, income statement and the statement of changes in equity. Issues and challenges during restating Cash treatment, I found it quite challenging on how I should allocate cash. The cash in my company appeared significant compared to revenue. For the year ending 2010, there was revenue of $8,532.5m and the cash and cash equivalents were $295.5m. This gave roughly 3.5% of the revenue. The same applies to the year ending 2011, the revenue was $8,341.8m whereas cash and cash equivalent was& 334.7m. This gives roughly 4% and therefore I had to apportion 1% to the operating activities and the rest to financial activities. Tax benefit, popularly known as tax shield is the benefit that a firm gets as a result of using borrowings as part of its finances. The interest expense gives the firm this shield and therefore reduces the tax the firm would have paid. In my restating the income statement, I have accorded it its usual treatment. Question three focuses on the relevant costs for decision making. It borrows from the marginal costing approach. This approach differentiates variable costs from fixed costs and recommends variable cost as the best for decision making (Drury 2008). The method follows a number of steps as highlighted below; Identity variable cost from those given, ignoring the fixed costs and calculate the variable cost per unit. Calculate the contribution per unit by subtracting the variable cost from selling price. Rank the various products according to the contribution margin from the best to the worst. Allocate the scarce resource first to the product that gives the highest contribution followed by the next in line with contribution until the resource is exhausted. Finally add all the individual contributions for all the products that were allocated the scarce resource. In our case the scarce resource is steel. There are only 100,000kg available. Terrain suburbs $ Terrain Elite $ City runner $ Sweep axe $ F11 V5 Twin $ S. price 600 250 300 300 200 V. cost 300 150 150 200 250 C. margin 300 100 150 100 (50) Rank 1 3 2 3 4 Steel/unit 2kg 1kg 2kg 0.5kg 1.5kg Units of product 50,000 100,000 50,000 200,000 66,667 Market demand 100,000 units 25,000 units 250,000 units 10,000 units 50,000 units a) The above steps are followed to get a solution as follows; Identify the variable cost and calculate the variable cost per unit. This has already been done. For Terrain suburbs its $300, for Terrain Elite its $150, for City runner its $150, for Sweep Axe its $200 and for F11 V5 its $250. Calculate the contribution margin by subtracting variable cost from selling price. (Result on the table above) Rank the products based on their contribution per unit (Terrain suburbs is number 1 with $300 and others follow as per the table) Identify the limiting factor. In this case it is steel. We only have 100,000kg of steel. First allocate them to Terrain Suburbs as it gives the highest contribution. We require 2kg of Steel to make 1 product of Terrain Suburbs; this means we can make a maximum of 50,000 products of Terrain Suburbs (100,000kg/2kg). However, this has not satisfied the market demand of 100,000 units (see table) Therefore the solution is that the company should produce 50,000 units of Terrain Buggy-suburbs in order to make a contribution of $15m (50,000 units*$300 cm/unit). This is because the 50,000 units produced are below the market demand and this product gives the highest contribution per unit. ……> Ps (not but of the solution just for your understanding) if the 50,000 units produced were above the market demand say of 30,000 units, then it means we could have produced 30,000 units for Terrain taking 30,000*2=60,000kg of steel. The remaining 40,000kg of steel will be allocated to the 2nd best product which is City runner. 1 product of City runner will use 2kg of steel (refer question table). Therefore we shall produce 20,000 units of City runner (40,000kg/2kg). Since the demand is 250,000 units, the 20,000 units is just a drop in the ocean. Our analysis would have ended there and our conclusion would have been; produce 30,000 units of Terrain and 20,000 units of City runner to produce a contribution of 30,000*$300 +20,000*$150=$12m. Hope this will help. b) The analysis shows that Terrain buggy-suburb produces the highest contribution and therefore the management should make a decision to produce this product alone. The method used is marginal costing. According to Drury (2008) the following are the strengths and weaknesses of this method; Strengths Simplicity- the method is simple to learn and use. It can also be used alongside other methods such as budgetary costing. Short term profit planning- it is used in the short run for decision. Deviations can be quickly addressed. Cost control-cost control is greatly achieved since the method does not concentrate on the allocation of overheads thus efforts can be put towards maintaining a consistent marginal cost. Weaknesses It avoids semi variable costs since the method does not consider them. It does not apportion overhead based on the actual but rather through estimates. The management can assist me by facilitating the necessary resources required for example, funds for production as well as market survey to confirm the demand estimates. List of References Carmichael, D.R. Whittington, R. & Lynford, G. 2007. Accountant’s Handbook, 11th edition, New Jersey: John Wiley & Sons. Drury, C. 2008. Management and cost accounting, 7th Edition, China: C & C Offset, Fabozzi,F., Peterson, P. & Habbegger, W. 2004. Financial Management and Analysis workbook, 2nd edition, New Jersey: John Wiley & Sons Read More