Financial Reporting Ratio Analysis

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Financial Reporting and Ratio Analysis Essay

Part One

According to IAS 7 net cash flow from operating activities can be calculated using either of two methods; direct method and indirect method. The direct method shows operating cash receipts and operating cash payments; including cash receipts from customers, cash payments to and on behalf of employees, cash payments to suppliers; all resulting in the net cash flow from operating activities. The indirect method begins with profit before tax and adjusts for non-cash charges and credits such as depreciation and for the movement in working capital items.

In simpler terms, the direct method looks at all actual cash transactions, while with the indirect method you look at the balance sheet items in relation to the previous year to find the cash inflow and outflows from operating activities while adjusting for non-cash charges and credits such as depreciation and goodwill revaluation rather than look at specific transactions.

The main advantage of the direct method is that it shows the operating cash receipts and payments, this specific knowledge of the sources of these cash receipts and for what purposes cash payments were made is especially useful when trying to forecast future cash flows. The preference of IAS 7 is that the direct method be used but does not require it. The main benefit of the indirect method is that it shows the difference between reported profits and net cash flow from operating profits.

There are differing views among national standard setters as well as within the business community. The main issue of disagreement being whether in all cases the benefit to the user outweighed the costs to the company of providing this type of reporting. The ASB in the UK has generally held the indirect method to be preferable, and has only encouraged the use of the direct method when the possible benefit of the users outweighs the cost of providing it in the new revised version of FRS 1. This is different to the general view of the IASC as well as the FASB in the USA who hold the view that the direct method is preferable. I’m of the opinion that this difference will result in companies giving greater consideration to which method suits them best considering the relevant costs rather than just relying on the advice of a particular standards board; which I think is a positive effect.

David Alexander and Simon Archer the authors of National Accounting/financial reporting standards guide 2013 are of the view that this issue should be viewed from the perspective of the user rather than the prepared and therefore the most beneficial method is the direct method. In an article released by the Institute of Certified Public Accountants in Ireland (CPA) discussing international standards, the CPA expressed the view that most Irish companies are unlikely to adopt the direct method as it requires the segregation of VAT from cash receipts and payments during the year. This is likely to be expensive due to system changes as the accounting programmes are designed to identify VAT at the point of sale or purchase, rather than at the point of cash receipts or payments.

Cash From Operating Activity
2013
£0
Cash received from customers (W1) 30071
Cash paid to suppliers and employees (W2) -18886
Other cash operating expenses (W3) -6033
cash generated from the operations 5152
interest paid -126
tax paid -823
Net cash from operating activities 4203
proceeds on disposal of property, plant & equipment 3
interest received 8
acquisition of property, plant & equipment -2641
Net cash used in investing activities -2630
proceeds from the issuing of share capital 0
repayment of borrowings -400
payment of finance lease liabilities 0
dividends paid -1634
Net cash used in financing activities -2034
Net (decrease)/increase in cash and cash equivalents -897
cash and cash equivalents at 1 January 432
Effect of exchange rate fluctuations on cash held 136
Cash and cash equivalents at 31 December -329
**workings are included in the appendix

Below I would like to provide a summary of Zotefoams Plc.s financial position and operating performance and in doing so analyse the liquidity, profitability, efficiency and gearing of the company.

From looking at the five year trading report it is clear to see that Zotefoams Plc has managed to steadily increase turnover from £25.2m in 2011 to £30.1m in 2013 that is an increase of £4.9m which is a 16.27% over two years. Also operating profit (excluding exceptional items) has increased from £1.6m in 2011 to £2.8m in 2013; that is an increase of £1.2m or 42.86% rise over two years. Furthermore, earnings per share (excluding exception items) has risen from 3.2 in 2011 to 5.4 in 2013, that is an increase of 2.2 which is a rise of 41% over two years. In this discussion I have only considered figures excluding the impact of exceptional items as I believe these figures give a clearer view of its true performance and help forecast for the future more accurately, this is a company that is still at a very early stage of its development and hence is likely to have exceptional items more often now than in the future. A figure that should be taken in to consideration is the profit after tax, in 2011 it was £1.2m, in 2012 it was £2.4m, and then £1.2m in 2013, this does not shown a pattern of a down turn as the great increase in 2012 was caused by an exceptional item, this can be further understood by looking at the profit before tax (excluding exceptional items) whish was £1.3m in 2011, then £1.8m in 2012 and finally £2.7m in 2013; this clearly shows a pattern of strong growth over the last three years. Below, I have done ratio analysis in the areas of liquidity, profitability, efficiency and gearing to illustrate better the company’s performance in these areas.

Profitability Ratios

Return on Capital Employed (ROCE)

Year Result
2012 9.52%
2013 5.41%

ROCE shows the company’s net profit before interest and tax in relation to total capital invested as a percentage. Generally a decrease in the ROCE percentage from one year to the next could signify various internal or external factors affecting their business, externally a more difficult economic climate for the company which could be caused by a general down turn in the industry or fierce competition, internally it is usually due to poor utilization of its total assets by those entrusted to run the company, either way it is the duty of the management to utilize the assets of the company to gain maximum profits. The ROCE has decreased from 9.52% in 2012 to 5.41% in 2013, this is a very major decrease, this would normally lead one to think that the management have severely underutilized the assets of the company showing a poor performance on their part, but on closer inspection it is clear that the results have been skewed as the 9.52% figure for 2012 is largely inflated, as the PBIT of £3.472m was inflated by £1.499m of exceptional items (reduction in administration costs) in the profit calculation, and a decrease in profits in 2013 of £1.074m due to exceptional items (increase in administration costs), had these exceptional items not been considered in calculating the ROCE it would have shown a strong increase between 2012 and 2013.

Gross Profit Margin Ratio

Year Result
2012 22.65%
2013 25.94%

The gross profit margin ratio shows the gross profit as a percentage of its sales revenue. This shows that it has increased from 22.65% to 25.94%, this is a positive increase of 3.29% from 2012 to 2013.

Net Profit Margin Ratio

Year Result
2012 11.75%
2013 5.32%

The net profit margin shows the net profit before tax as a percentage of its sales revenue. It has decreased from 11.75% in 2012 to 5.32% in 2013; that is a decrease of 6.43%. This would normally be a serious issue to consider, but as explained previously the results have been skewed due to negative exceptional items in 2013 and positive exceptional items in 2012, had these items not been considered in this calculation it would have shown a positive increase.

Liquidity Ratios

Current Ratio

Year Result
2012 2.412949
2013 2.1780673

The current ratio is one of the best measures of liquidity. It is generally accepted that a ratio of 2:1 is a strong position to be able to meet the company’s short term liability responsibilities; the higher the ratio is; the more liquidity the company has, making it more likely to be able to cover its short term liabilities. Although it has decreased from 2.41:1 in 2012 to 2.18:1 in 2013, it is still over the accepted 2:1 ratio, therefore there is no reason for investors or the company to fear liquidity problems.

Quick Asset Ratio

Year Result
2012 1.51
2013 1.36

Conventional it is held; the most ideal quick assets ratio equals 1. In 2013 and 2012 the quick asset ratio was comfortably over 1, although it has decreased to some extent. It is not good to have too high a current ratio or quick assets ratio, as this would signify the under-utilization of the company assets.

Efficiency Ratios

Debtors Collection Period (DCP)

Year Result
2012 80.658803
2013 74.853421

The debtors’ collection period ratio shows the average amount of time taken to collect debts from credit sales. In 2012 it is at 80.7 days which has decreased to 74.9 days in 2013, these positive results show that the DCP has significantly decreased from the previous year signifying an improvement in efficiency, this supports the view that its credit control system has functioned more efficiently.

Stock Holding Period (SHP)

Year Result
2012 66.337569
2013 62.071483

The stock holding period ratio shows the average amount of time stock is held before being sold, it has decreased from 66.3 days in 2012 to 62.1 days in 2013, again it shows a improvement in efficiency showing that the company’s stock control systems are running more efficiently than the previous year.

Gearing Ratio

Year Result
2012 35.32%
2013 31.02%

Gearing is calculated to show what proportion of a company’s total capital is provided by loans capital as opposed to equity. The greater the proportion of total capital is provided by loans the greater the vulnerability to a down turn in profits.  This is because the interest on a loan must be paid regardless of the company making a profit.

33.3% gearing is conventionally accepted as medium/high gearing, although this does vary from industry to industry. The gearing ratio of 35.32% in 2012 is not considerably high, this has decreased to 31.02% for 2013; it has been brought down firmly in to the area conventionally accepted as medium gearing thus decreasing the company’s gearing vulnerability to a down turn in profits meaning it is not considered to be a high risk investment.

Part Two

Ratio analysis in the areas of liquidity, profitability, efficiency and gearing are very important when trying to understand the financial position of a company, all of the data required for calculating these ratios are taken from the balance sheet and income statement.

The balance sheet statement summarizes the value of total assets and liabilities, as well as owners’ equity at a specific date. The balance sheet gives the user a good understanding of the company’s value as you can see what it owns and owes. The balance only provides a snapshot of this information on the date of reporting as the items in the balance sheet could change the next day, furthermore the balance sheet can be manipulated in various ways such as incorrectly valuing assets such as work in progress inventory or incorrectly valuing buildings, plant and machinery. It is not straight forward how all items in a balance sheet are calculated. There are many ways that firms try to hide debt by not recording it on the balance sheet such as the well documented case of Enron who were keeping debts off the balance sheet by offloading the debt to special purpose entities (SPEs). It is important to any investor to know that the company they are buying a share into actually owns tangible assets (less liability) that back up the value of the company’s shares; this reduces the risk of the investment.

Beyond risk to investment capital; the investor will look at profitability as this is the objective behind making an investment, for this purpose the income statement is very useful; as it shows net profit for the previous year as well as a breakdown of how this was calculated including figures for revenue, cost of sales and expenses etc. Analysis of previous income statements and the five year trading summary will help the user to get a good understanding of how well the company has been performing in the past. The income statement can also be manipulated, such as the abuse of one time charges in the income statement when the usage of one time charges is misused to result in reported profits being lower than expected in one year, and then be seen to dramatically increase the next year, resulting in share prices rising allowing managers and related individuals to cash in on shares purchased at a lower price the previous year.

The cash flow statement shows all cash and cash equivalents entering and leaving the company for the reporting period. It allows investors to see how money is being spent and where it is coming from. It is generally held to be one of the more reliable financial statements as it is less open to manipulation as it deals with simpler and clearly tangible accounting items. Given this there are still ways to manipulate it such as dishonesty in accounts payable by counting cheques in the mail as cash in hand rather than money paid out or the choice of making payments late on purpose.

Efforts have been made by the introduction of further legislation and tightening of regulatory frameworks as well as implementation of further standards; such as international auditing standards (IASs); to counter act these problems namely the Sarbanes Oxley act 2002 in the USA and similar provisions in the UK.

By providing all three financial statements the user will be able to gain a good understanding of the company’s financial position and profitability; each of them provides different useful information. Furthermore it is more difficult to manipulate one financial statement and not result in contradictions with the others. The cash flow statement helps to back up the balance sheet and income statement. Reporting based on international reporting standards are very important, as it means that prepares of reports must treat accounting items as set out by international standards leading to more reliable and comparable financial statements for the user. Due to international auditing standards one would expect that auditors will find the cases where manipulation and fraud has taken place; which gives the investor more confidence in the financial statements that he must rely upon to make decisions. I would still advise any potential adviser to fully read all reports and notes beyond just the three financial statements.

In this section I will discuss how Zotefoams Plc provides segmented information under IAS 14 and how this will change upon the adoption of IFRS 8 as well as consider the relevance of this information to the company’s current and potential investors.

I would like to begin by explaining IAS 14 and segment reporting. Companies often carry on several types of business or operate in many different geographical locations, with varying opportunities of growth at different levels of risk relative to the geographical location or type of business. It is very difficult for a reader of financial reports to make judgement about the nature of different activities carried out by a company or what impact each activity has on the financial situation of a company unless some segmented analysis of the financial statements are provided. Segmented reporting is required to help the users of financial statement to more thoroughly understand the past activities of the company and thus make a more informed assessment of the company’s future prospects; as well as be aware what impact will occur on the company if there are significant changes in components of the company. All of this helps to assess better the risks and potential returns for the investor.

IAS 14 was set out to standardize segmented financial reporting by companies. IAS 14 only applies to publicly quoted companies or those that are about to be. Zotefoams Plc is a publicly quoted company and therefore should comply with the provisions of IAS 14. IAS 14 does encourage non-publicly quoted companies to report segmented information, and if they do they should comply with its provisions.

According to IAS 14 a company should report on business and geographical segments showing the groupings of products and services provided by each company segment as well as the composition of the geographical segments. One type of segmentation can be deemed as primary; chosen from either business or geographical, the second should be regarded as secondary. This is usually decided based on the company’s internal management and organisational structures as well as the internal financial reporting system for management. Geographical or business segments can be judged to be reportable when the majority of its sales revenue is gained through sales to customers who are external, plus also:

  • The revenue is 10% or above of total revenue of total segments
  • Its profit or loss is 10% or more of the combined total of profits or losses
  • It assets are 19% or above of total assets of the company (combined total of all segments)

Other segments should be reported if the total external revenue from segments that have been deemed reportable does not reach 75% of total company revenue; more segments should be recognized until 75% of the total consolidated revenue is shown as reportable segments. The following is to be disclosed for each primary reportable segment:

  • Revenue, sales to external customers and inter-segment sales disclosed separately, the basis of price setting should be disclosed for inter-segment sales.
  • Profits before interest and tax for continuing operations and discontinuing operations should be disclosed separately
  • Carrying amount of segment assets
  • Segment liabilities
  • Cost applicable to the period for acquiring  property, plant and equipment as well as intangibles;
  • Depreciation and amortization charges, as well as other significant non-cash expenses or otherwise cash flows from operating, investing and financial activities in line with IAS 7 cash flow statements.

Each secondary segment should disclose:

  • Revenue, disclosing separately how much is external sales and how much to other segments
  • Segment assets total
  • Cost applicable to reporting period for purchasing  property, plant and equipment as well as intangibles

Zotefoams primary segment reporting is reported by business area, the company sells two main types of foam which are Polyolefin and HPP. All of the above disclosures listed above for the primary reportable segment are made in the annual report. Furthermore, the revenue from external customers, segment assets; as well as capital expenditure (on property, plant and equipment as well as intangibles) are reported in the annual report for the secondary segment report which is done by geographical location which is separated in to: UK, Europe, North America and the rest of the world. All segment reporting is in accordance with IAS 14. HPP is a new product, it can be seen that the HPP segment is making a loss, this is expected as R&D is likely to cause expense to outstrip revenue at such an early stage, you can see from the segment report that the Polyolefin segment is making strong profits, this would not have been clear if segmental reporting was not provided.

I will try to only discuss the differences between IAS 14 and IFRS 8 that are relevant to Zoatfoams plc. IFRS 8 has affected three main areas of segment reporting, they are; the identification of segments, the measurement of segment information and disclosure.

In terms of identification of segments; IFRS 8 states that segments that sell primarily or exclusively to other operating segments of the company can still be deemed an operating segment if it is operated that way. This is different to IAS 14 which reduced reportable segments to be segments which gain most of their sales revenue from customers who are external, IAS 14 doesn’t oblige that the separate levels of a vertically-integrated company be deemed to be separate entities. I do not believe this will have much effect on Zotefoams Plc as they do not do any inter-segment trade, nor could it be said that from their company structure that it is a vertically-integrated company with separate entities in such a vertical chain to be deemed as separate operating activities.

IFRS 8 requires that the information reported on each segment should be the same information that is provided to the chief decision maker for the activity of allocating resources to that segment and assessing its performance. This may mean for Zotefoams Plc that they may be required to provide more segmental information depending on their internal reporting practices.

A major difference between IFRS 8 and IAS 14 is that IFRS 8 requires an explanation of how profit or loss, assets and liabilities are measured for each operating segment, rather than define revenue, expense, result, assets and liabilities for each operating segment. This results in companies having more control over what is included in segment profit and loss in line with their own internal reporting practices. As companies are given greater choice over disclosure this could put investors at greater risk as there will be more room for manipulation of information.

Interest revenue and interest expense must be reported for each of the reportable segments separately if they are used to calculate segment profit or loss unless the majority of the segments revenue is earned by interest resulting in the chief operating decision maker making decisions to allocate resources or judging the performance of the segment based on information mainly on interest revenue.

The aim behind revising IAS 1 was to make it easier for users to be able to understand and compare financial statements. Financial information that goes in to financial statements are to be aggregated on the basis of shared characteristics, as well as introducing a statement of comprehensive income. This is being done so that it is more visible to see the impact on the company’s equity resulting from transactions between the company and its owners in that capacity; such as share repurchases, separately from the impact caused by transactions between the company and non-owners such as third parties. Comprehensive income can be displayed in either a single statement or be separated in to two statements including a income statement and a statement of comprehensive income statement. The ICAEW as well as the ACCA have both disagreed on giving the choice between the two as they believe it will lead to confusion amongst users making comparability more difficult. The ACCA also disagrees with the decision to change the name of the balance sheet to statement of financial position on the grounds that the definition of the balance sheet is well known; they feel this change will only result in more confusion especially when preparers are not obliged to use the new title which will result in some prepares taking it up and others not; making comparison more confusing for users.

The ACCA are also of the view that the decision to include a statement of financial position at the beginning of the reporting period is not needed and will again lead to further confusion; this information if needed could easily be looked up in the previous year’s report. These changes are not likely to have a major impact on Zotefoams other than the effort required to make these new changes, as the changes have not been made to change how accounting items are treated but rather the changes have just been put in place to affect how some information is displayed as the change in name of the balance sheet, the choice in display of comprehensive income statements and the inclusion of the balance sheet from the beginning of the reporting period, these changes just provide the information to users in a way that it is easier for them to understand the financial position of the company. In the 2013 report a statement of recognized income and expense (SoRIE) was included, by 2009 when the IAS 1 revisions must be implemented; the annual report will have to include a statement of changes in equity in an addition to the SoRIE or choose to combine them into a single statement. This additional information already exists in the annual report in the notes section.

Ratio Analysis
Ratio Analysis

References

ACCA 2.5 Financial Reporting (international stream) Study Text (2012), FTC

David Alexander and Simon Archer, Miller International Accounting/Financial Reporting Standards Guide (2013), CCH

Barry Elliott and Jamie Elliott, Financial Accounting and Reporting: 11th Edition (2013), Financial Times/ Prentice Hall

Company Law, Jerry DeFreitas, 5th edition (2013), Castlevale Handbooks

Zotefoams Plc, Annual report (2013) Technical summary: IAS 7 Cash flow statements Deloitte, IAS Plus, (December 2013)

IASB, press release, (6 September 2013)

Appendix

Ratio Analysis

1. Profitability Ratio
a) Return on capital employed
ROCE= PBIT *100%
Equity+   Long Term Loans
Year Workings RESULT
2012 3472/(25622+9050)*100% 9.52%
2013 1762/(24838+7704)*100% 5.41%
b) Gross profit margin
GP   MARGIN= Gross   profit *100%
Sales   revenue
Year Workings RESULT
2012 6335/27975*100% 22.65%
2013 7795/30052*100% 25.94%
c) Net profit margin
NP MARGIN= PBT *100%
Sales revenue
Year Workings RESULT
2012 3288/27975*100% 11.75%
2013 1599/30052*100% 5.32%
2. Liquidity Ratio
a) Current ratio
Current ratio= Current   assets
Current   liabilities
Year Workings RESULT
2012 10547/4371 2.412949
2013 10030/4605 2.1780673
b) Quick assets ratio
 Quick assets ratio= Current assets less stocks
Current liabilities
Year Workings RESULT
2012 (10547-3933)/4371 1.51
2013 (10030-3785)/4605 1.36
3. Efficiency Ratio
a) Debtor collection period
 DCP= Average trade debtors *365
Credit sales
Year Workings RESULT
2012 6182/27975*365 80.658803
2013 6163/30052*365 74.853421
b) Stock holding period
 SHP= Average stock *365
Cost of sales
Year Workings RESULT
2012 3933/21640*365 66.337569
2013 3785/22257*365 62.071483
4. Gearing Ratio
 Gearing= Total liability-Current liability *100%
Capital employed
Year Workings RESULT
2012 (13421-4371)/25622 35.32%
2013 (12309-4605)/24838 31.02%
 Cash from operating activities
(W1) Cash received from customers £000 £000
opening trade receivables 6182
SALES 30052
36234
less closing trade receivables -6163
cash receipts 30071
(W2) Cash paid to supplier and   employees £000 £000
opening trade payables -3273
Purchases:
cost of sales 22257
closing inventory 3785
less opening inventory -3933 22109
less closing trade payables 3487
less depreciation 3437
net cash paid to suppliers and employees 18886
(W3) Other cash operating expenses
Distribution cost 2117
Administration expense 3916
6033
Notes: All figures for workings are taken from the
balance sheet, income statement and cash flow statement

Did you find any useful knowledge relating to Financial Reporting and Ratio Analysis in this post? What are the key facts that grabbed your attention? Let us know in the comments. Thank you.

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My name is Steve Jones and I’m the creator and administrator of the dissertation topics blog. I’m a senior writer at study-aids.co.uk and hold a BA (hons) Business degree and MBA, I live in Birmingham (just moved here from London), I’m a keen writer, always glued to a book and have an interest in economics theory.

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