Financial Accounting of Enterprise - Research Paper Example

FINANCIAL ACCOUNTING Any business enterprise is financed through various sources of funds, depending upon the tenure of repayment the sources of funds can be classified as Short Term & Long Term funds. Within Long Term the sources of funds as follows: Equity Shares- These are considered "owner's capital" which shoulder the final risk and are considered the safety net for creditors. As no fixed payout is obligated, they insulate business from economic jolts. Preference Shares- Help in financing the enterprise without unduly relinquishing the controlling stake by equity holders. Bonds & Debentures- Have fixed repayment and servicing cycles and carry fixed cost for the enterprise. Help in financial leverage. Retained Earnings - Ploughed into business if the returns are expected to be high or paid out as dividends if expected yield is expected to be low. Other long term borrowings typically with more than one year maturity date- Similar in nature to bonds and debentures. Each source of fund has different cost and risk associated with it. The capital structure should ideally minimise risk to the enterprise, maximise control to ensure that the promoters continue to stay at the helm, minimise cost of capital or maximise return on investment to shareholders. If the effect of taxes is ignored then the debt and equity proportions are irrelevant. But in reality the interest cost is tax deductible thereby giving an edge for their inclusion to create leverage to a certain point. This point of view was first espoused in theModigliani-Miller theorem, proposed byFranco ModiglianiandMerton Miller, which is the very foundation of further thought process on capital structure, even if it is purely theory based as the assumption of tax neutrality and risk neutrality. The theorem states that, in a perfect market, how a firm is financed is irrelevant to its value. On the contrary Market timing hypothesis states that capital structure is the outcome of the historical cumulative timing of the market by managers (Baker, Malcolm P.; Wurgler, Jeffrey p. 57). As per another theory even in absence of agency costs, levered firms use to invest faster because of the existence of default risk (Lyandres, Evgeny and Zhdanov, Alexei, abstract of paper) An analysis of capital structure is undertaken to assess the health of the organisation from the above mentioned points of view. Overall objective of ideal capital structure remains to maximise shareholders wealth without inflicting risk on the enterprise beyond acceptable levels. Financial Leverage- So long as the cost of funds is low ROE (Return on Equity) is high compared to ROA (Return on Assets). If and when the cost of debt rises beyond threshold levels the ROE falls compared to ROA thereby making debt funds disadvantageous for the equity share holders. "Leverage is non stationary, and declines with past profitability. The firm may hold a compensating cash balance while borrowing (at a higher rate) through the credit line." (DeMarzo Peter M., Sannikov Yuliy, p 1) Risk Analysis- Risk is directly proportional to the proportion of debt in capital structure. As debt inherently carries fixed servicing and repayment obligations, adverse earning conditions increase credit risk which rises in the same direction as the quantum of debt in relation to equity funds. Similarly low risk is associated with high equity (low debt) funds of an organisation. Even in periods of lower earnings, the existence of the organisation will be at lower risk as compared to an organisation with higher debt capital. Debt to Capital ratio (average debt / average assets) provides the slice of assets financed through debt. Debt to Equity ratio (average debt / equity base) shows the share of debt in capital structure. What is optimal capital structure There are no definite answers. It varies from industry to industry. Economic cycle of the industry being examined and within the industry the business cycle of the organisation would determine the best mix of capital structure so as to meet the overall objective of maximising the shareholders' wealth without putting the enterprise at undue risk. Main Long Term Sources of funds for banks are as follows: Bonds issued by Banks Equity Capital of Banks & Retained Earnings Bonds are mainly sold to institutional investors like insurance companies (mainly life) and pension funds. Banks do not need long term funds as they do not have long term assets like plant and machinery and equipment. Therefore banks have less need for long term funds. (Madura, 2008, p. 482) Equity Capital for banks is no different from other organizations in terms of definition. Yet banks historically like to keep the equity levels low have high earnings per share. This scenario is risky in absence of tangible assets, only equity capital would be available to absorb losses. To overcome this bank capital is now regulated by Basel II norms. In nutshell the norms require that minimum capital should be maintained at eight percent of risk weighted assets on an average. Individual risk weights are defined separately depending upon their nature for example government bonds would have 0% risk requirement on one hand and on the other side of the spectrum borrowers having very bad credit rating would have 150% weight associated with them. Capital of banks is segmented into layers (Tiers). The ratios should reflect the capital of a bank as a percentage of the assets weighted by their inherent risk. Tier I capital is broadly defined to quantify tangible equity fund by UK FSA. Capital Structure of Manufacturing Industry Here the long term debt requirement is very high to finance acquisition of tangible assets, development of new products and inorganic growth when the atmosphere is conducive. Let us look at the financial statements of two enterprises listed on London Stock Exchange: GlaxoSmithKline - Pharmaceutical Industry GlaxoSmithKline Statement of comprehensive income 9 months 2009 m Profit for the period 4,001 Exchange movements on overseas net assets -142 Fair value movements on available-for-sale investments 93 Deferred tax on fair value movements on available-for-sale investments -9 Actuarial losses on defined benefit plans -486 Deferred tax on actuarial movements in defined benefit plans 147 Fair value movements on cash flow hedges -6 Deferred tax on fair value movements on cash flow hedges 2 Other comprehensive income for the period -401 Total comprehensive income for the period 3,600 Shareholders 3,538 Minority interests 62 Earnings per share 85.2 p GlaxoSmithKline Balance Sheet ASSETS 30th September 2009 m Non-current assets Property, plant and equipment 9,380 Goodwill 3,294 Other intangible assets 7,261 Investments in associates and joint ventures 511 Other investments 558 Deferred tax assets 2,397 Derivative financial instruments 89 Other non-current assets 616 Total non-current assets 24,106 Current assets Inventories 4,193 Current tax recoverable 52 Trade and other receivables 6,050 Derivative financial instruments 288 Liquid investments 274 Cash and cash equivalents 6,467 Assets held for sale 17 Total current assets 17,341 TOTAL ASSETS 41,447 LIABILITIES Current liabilities Short-term borrowings -1,886 Trade and other payables -6,084 Derivative financial instruments -241 Current tax payable -1,179 Short-term provisions -1,730 Total current liabilities -11,120 Non-current liabilities Long-term borrowings -15,035 Deferred tax liabilities -691 Pensions and other post-employment benefits -3,335 Other provisions -1,187 Other non-current liabilities -445 Total non-current liabilities -20,693 TOTAL LIABILITIES -31,813 NET ASSETS 9,634 EQUITY Share capital 1,416 Share premium account 1,344 Retained earnings 5,701 Other reserves 819 Shareholders' equity 9,280 Minority interests 354 TOTAL EQUITY 9,634 Analysis of Long Term Fund Source-GlaxoSmithKline 1. Deferred tax liability has not been considered as a source of long term fund 2. Apart from this other items appearing under the sub heading "non-current liabilities" are considered to be sources of long term fund, on the assumption that payout period for the same is uncertain thus the enterprise can continue to enjoy benefits of the same for funding its business requirements for a fairly long time. Long Term Funds = m 29,636 (Adjusted Noncurrent liabilities + Total Equity) From the balance sheet presented above following ratios emerge: 1 Long-Term Debt to Net Working Capital 3.22 Capacity of the enterprise to repay long term debt from working capital ( Long Term Debt / Current Assets - Current Liabilities) 2 Capitalisation Ratio 0.67 Provides the long term usage of funds for financing the enterprise (Long Term Debt / Long Term Debt + Equity) 3 Debt to Equity 1.03 Shows coverage for creditors in the event of bankruptcy (Total Debt / Total Equity) 4 Total Debts to Assets 1.03 Indicates strength to absorb losses and consequent reduction in assets (Total Liabilities / Total Tangible Assets) Capitalisation of GlaxoSmithKline shows that long term liabilities constitute 67% of the total long term funds of the enterprise. In other words the owners' equity is about 33% of the total long term source of funds. Total Debts to Assets ratio shows that the total liabilities are within the value of total tangible assets. BARCLAYS BANK INCOME STATEMENT Half Year Ended Group Results 30.06.09 m Total income net of insurance claims 16,253 Impairment charges and other credit provisions (4,556) Operating expenses (8,747) Profit before tax 2,984 Profit after tax 2,338 Profit attributable to equity holders of the parent 1,888 Economic (loss)/profit (127) Basic earnings per ordinary share 17.5p Diluted earnings per ordinary share 17.1p Dividend per share - Performance Ratios Return on average shareholders' equity (annualised) 10.1% Cost: income ratio 54% Cost: net income ratio 75% Profit Before Tax by Business m UK Retail Banking 268 Barclays Commercial Bank 404 Barclaycard 391 GRCB - Western Europe 31 GRCB - Emerging Markets (86) GRCB - Absa 248 Barclays Capital 1,047 Barclays Global Investors 276 Barclays Wealth 75 Head Office Functions and Other Operations 330 BALANCE SHEET 30.06.09 Assets m Trading portfolio assets 153,973 Financial assets designated at fair value: - held on own account 43,797 - held in respect of linked liabilities to customers under investment contracts 63,275 Derivative financial instruments 556,045 Loans and advances to banks 52,944 Loans and advances to customers 411,804 Available for sale financial investments 66,799 Reverse repurchase agreements and cash collateral on securities borrowed 144,978 Goodwill 7,599 Intangible assets 2,547 Other assets 41,577 Total assets 1,545,338 Long Term Assets 607,768 As at Liabilities 30.06.09 m Deposits from banks 105,776 Customer accounts 319,101 Trading portfolio liabilities 44,737 Financial liabilities designated at fair value 64,521 Liabilities to customers under investment contracts 66,039 Derivative financial instruments 534,966 Debt securities in issue 142,263 Repurchase agreements and cash collateral on securities lent 175,077 Other liabilities 44,171 Total liabilities 1,496,651 Long Term Liabilities 250,955 Shareholders' Equity Shareholders' equity excluding minority interests 37,699 Minority interests 10,988 Total shareholders' equity 48,687 Total liabilities and shareholders' equity 1,545,338 Analysis of Long Term Fund Source- Barclays Presentation of Balance sheet of Barclays (a bank) is quite different from that of GlaxoSmithKline (a manufacturing concern). Long term sources of funds are not clearly discernable from the consolidated balance sheet. For ascertaining the long term sources of funds, schedules to accounts were scrutinised and one particular schedule namely "Capital and Performance Management" indicated the long term funds deployed. These are included under the subheading "Undated Loan Capital" (m 1,541), "Dated Loan Capital" (m 15,181) under Tier 2 Capital. Hence Long term sources of funds are a sum of equity funds + undated loan capital + dated loan capital amounting to m 65,409. Analysis of the capital structure of the Bank is as follows: 1 Capitalisation Ratio 0.26 Provides the long term usage of funds for financing the enterprise (Long Term Debt / Long Term Debt + Equity) 2 Debt to Equity 0.97 Shows coverage for creditors in the event of bankruptcy (Total Debt / Total Equity) 3 Total Debts to Assets 0.97 Indicates strength to absorb losses and consequent reduction in assets (Total Liabilities / Total Tangible Assets) Long term debts constitute around 26% of the total long term funds deployed by the enterprise. Long term debts are just 1.12 % of the total liabilities. In other words bank has of all the liabilities on the balance sheet of the bank 98.88% are short term liabilities. Comparative Analysis: Barclays GlaxoSmithKline 1 Long-Term Debt to Net Working Capital 3.22 ( Long Term Debt / Current Assets - Current Liabilities) 2 Capitalisation Ratio 0.26 0.67 (Long Term Debt / Long Term Debt + Equity) 3 Debt to Equity 0.97 1.03 (Total Debt / Total Equity) 4 Total Debts to Assets 0.97 1.03 (Total Liabilities / Total Tangible Assets) In case of Barclays it was not possible to ascertain the long term debt to net working capital ratio in absence of details of details for current assets. Comparison of other ratios reveals that the most glaring difference is in the case of Capitalisation Ratio. For Barclays bank it is 26 % where as for GlaxoSmithKline it is 67% thereby showing heavy dependence of manufacturing concerns on long term debt funding. This is exactly the reverse for the bank where the bank has financed its operations mainly from short term funds. It is in sync with the theory propounded above which said that banks highly leveraged to maximise share holders funds. The above comparison clearly brings out the different capital structure employed by different industries. The data for both the analysis was obtained from the respective websites of enterprises. In case of Barclays report for June 2009 (2nd quarter results) was taken as sufficient details were not available in the results for the 3rd quarter. The 3rd quarter report of GlaxoSmithKline on the other hand was comparatively more comprehensive and simpler to analyse. This could also be an indication of the complexity in accounting and financing for financial institutions where the possibility of subjectivity in book keep is much higher than manufacturing concerns. Conclusion The bank is seen to be highly leveraged as per the theory propounded that traditionally banks like to keep equity base low to maximise owners' wealth. They have very easy access to funds both short term and long term in the form of deposits from retail customers, institutions, banks etc. The prime focus of banks is primarily to manage short term asset liability mismatch to ensure smooth operations of the banks. There is very little requirement of long term funds for acquiring tangible assets in contrast to manufacturing industry which cannot afford to finance short term working capital needs from long term funds and vice versa. Recent developments have revealed that quality of debtors play a major part in overall health of the banking industry. As long as the spreads on capital deployed are positive banks can weather economic storms much better than other industrial houses. Manufacturing industry on the other hand must have its assets and liabilities matched in order to ride over bumps in the economy due to slowdown and credit crunch. References Baker, Malcolm P.; Wurgler, Jeffrey (2002). "Market Timing and Capital Structure".Journal of Finance57(1): 1-32. DeMARZO PETER M., SANNIKOV YULIY, 2004 Stanford University and U.C. Berkeley, USA Lyandres, Evgeny and Zhdanov, Alexei, Investment Opportunities and Bankruptcy Prediction (February 2007).available athttp://ssrn.com/abstract=946240 Madura Jeff -2008 Financial Institutions and Markets- Thomson South Western Read More