2008 Financial Crisis

2008 Financial Crisis

The financial crisis commenced in August 2007 after the preceding inflation. The crisis became more defined throughout 2007 and gained momentum in 2008. This took place even after the financial regulators and the central banks’ tireless attempts to tame the situation. It is alleged that the main factors that influenced its manifestation include corruption, fraud, speculation, greed, bankers and bankers’ bonuses. However, the academic discourse, politics or media has been unable to solve the mystery surrounding the main causes of the crisis.

The mystery is academically relevant to the world of research just like the Great Depression, whose causes are still being discussed. Other sources believe that the crisis might have been as a cause of human failures especially following the refusal to bail out the Investment Bank Lehman Brothers. The housing bubble was the immediate trigger of the 2008 financial crisis. The following were the triggers under the housing bubble.

Subprime Lending

A subprime mortgage is the mortgage that is readily acceptable without imposing strict measures of standard on it. Before the 2008 financial crisis, there existed a fierce competition between mortgage lenders. The competition between the mortgage lenders ensued from the struggle for market share and revenue. It also took place in tandem with limited supply of creditworthy borrowers which put unconditional stress on the financial institutions. The relaxing mood by the mortgage was apparent and hence less creditworthy borrowers were granted mortgages.

This was a financial err due to failure to adhere to high standards of lending and hence riskier mortgages were granted to the borrowers. This was also evident in early 2003 where the Government Sponsored Enterprises (GSE), due to their conservative nature, sustained relatively high underwriting standards. The Government Sponsored Enterprises also policed mortgage originators prior to 2003 while maintaining high underwriting standards at the same time. Consequently, the market power shifted originators straight from the securitizers and hence led to tight competition between Government Sponsored Enterprises and the private securitizers. This competition undermined the power of Government Sponsored Enterprises and therefore compromised the mortgage standards. The situation also led to proliferation of risky loans.

During the years preceding the 2008 financial crisis, there was a competitive pressure that ultimately accelerated the subprime lending by the investment banks in the United States and Government Sponsored Enterprises such as Fannie Mae. The Fannie Mae became the biggest lender while the GSE relaxed their quest for the purpose of catching up with the private banks in the United States. Summarizing the subprime lending, there were low bank interest rates, existence of abundant credit and hiking prices of houses.

Due to these, there was relaxation of the lending standards and hence the increase in the number of loan borrowers. Through the scheme, the borrowers were able to borrow loans to buy very expensive houses that they could not afford initially. Later on, the house prices started to decline, the loans went sour and hence the cause of shock to the financial system and the global economy. This happened prior to 2008 and hence it can be declared as the major instigator of the 2008 financial crisis

Growth of the Housing Bubble

Identification of a bubble is complicated before it bursts. It is counter intuitive to state that early detection of the housing bubble and its immediate eradication is the best mitigation practice. However, mitigation of housing bubble is the worst thing to do because it can damage the economy. It is advisable to wait for the housing bubble to burst and then respond to its effects.

The housing bubble, as far as the 2008 financial crisis is concerned, led to 124 per cent increase in the price of typical American houses. The bubble took place between 1997 and 2006-approximately one decade. The bubble had drastic consequences on the economy and especially to the home owners in the United States of America prior to the 2008 crisis. The homeowners started to finance their mortgages at very low interest rates and hence denying the financial banks room for development. Other homeowners picked on securing secondary mortgage loans due to appreciation of prices.

The housing bubble started to collapse in early 2006. Several factors led to the bursting of the housing bubble. There was decline or stagnation of the hourly wages in the United States of America between 2002 and 2009 and hence house prices could not continue rising. This is because the houses had become completely unaffordable. The second cause of bubble bursting was as a result of increased supply of houses due to the high market demand. Consequently, the supply of houses superseded the demand in the market. This case reduced monopoly by the housing providers and later increased the desired healthy competition in the housing industry. As a result, the house prices began to decline due to the high supply and less demand. The above causes were also related to the subprime lending-another cause of the 2008 financial crisis.

Increased Debt Burden or Over-Leveraging

Before the 2008 financial crisis, there was an increased leveraging of financial institutions. The institutions were very optimistic and hence they did not mind engaging in risky investments. They also set up smart measures that would cushion them from the unexpected consequences. The leverage entailed the use of complicated financial tools such as derivatives and off balance sheet securitization. This was risky because it denied the financial monitors and crediting institutions the capability to curb the impending risks. It became harder to reduce the risk levels due to the vulnerability exposure by the financial institutions and their subsequent moderations. Consequently, the measures could not curb the stress on the financial institutions and hence exacerbating bankruptcy of several commercial banks and other lending institutions.

There was evidence of over-leveraging by the financial institutions in the United States during this prime period. The financial institutions became highly indebted just before the 2008 financial crisis set in. The institutions were hence vulnerable to the failure of the housing bubble. The economic tantrums became worse in precedence to the crisis. At this time, the U.S household debt hit 127 percent in 2007, up from 77 percent in 1990.

Allegedly, the debt led to economic recession that in turn led to the fall in employment rates and increased credit losses by the involved financial institutions. Other effects were also felt prior to the crisis as far as the household and the financial institutions finances are concerned. After the spread of the balance sheet leveraging across the economy, consumers started to save on the purchase of durable goods, businesses started to lay off workers, planned investments were cancelled and the financial institutions started to freeze their assets to improve their financial stability while bolstering capital.

Commodities Boom

Following the collapse of housing bubble in early 2007, prices of essential commodities increased. The increase in commodity prices was one of the very many consequences of the housing bubble burst. The housing bubble, according to economists, was very stressful to the household economy and the banking institutions at large. Consumption of certain commodities was either regulated or cut off to increase on savings and carter for the other basic needs. To prove this, it is on record that the price of oil was approximately three times the initial price. The price tripled to US $147 from a mere US $50 between 2007 and 2008.

There was speculation that money was flowing from the household finances into commodities. The financial institutions were also blamed for the increased commodity prices. There existed an acute shortage of raw materials and hence increasing the cost of production. This scenario subsequently raised the prices of essential commodities. The raw material crisis was somehow contributed by the Chinese dominance in Africa and the other potential states in the world.

The soaring prices of oil directly affect the arithmetic involved in consumer spending. Most often, production cost is transferred to the consumers who are required to spend more on gasoline and gas than on the other essential commodities. During the 2008 financial crisis, house bubble was part and parcel of all these occurrences and hence its exacerbation as a result. The pending issues were not solved in accordance with the economic situation due to the surging oil prices. The oil producing countries were the main beneficiaries of this scheme as they ended up accumulating most of the wealth.

Apparently, the oil importing countries had to spend more in purchasing the oil and hence the cost of commodity production in the respective states increased. The consumers were the main sufferers because they had to redirect finances from other avenues to settle the commodity bills. Copper and Nickel prices also went high prior to the crisis. Without any doubt, it is evident that the effects of the price instabilities and price variations contributed to the financial crisis.

Role of Economic Forecasting

Economists are the principle advisors whenever economic issues such as depression, recession and stability are concerned. They are required to analyze the past financial crisis and should be responsible for forecasting any impending economic crisis. They are also required to advice the ordinary people, stakeholders and financial institutions on economic trends, future crises and the mitigation measures of mitigating them. An unfortunate occurrence took place prior to the eruption of the 2008 financial crisis. The crisis was not predicted by the mainstream economists in the United States.

However, it is rife that several heterodox economics had a feeling of the occurrence of the crisis but there was an argument of misunderstanding between them. They had varying arguments on the estimating of the appropriate time of the crisis. Only 12 of the economists managed to predict the crisis. They included Eric Janszen of the US, Dean Baker of the US, Fred Harrison of the UK, Wynne Godley of the UK, Kurt Richebacher of the US, Peter Schiff of the US, Nouriesl Roubini of the US, Steven Keen of Australia and Denmark’s Jens Kjaer Sorensen.

Schools and other economic institutions also predicted the crisis. The schools based their predictions on observing the effects of artificial and laxity in the supply of money. It was also stated that the economists were unable to predict the crisis since the 1930’s global Great Depression. There were several articles including the New York Times and other university journals that had a revelation of the occurrence of the 2008 global financial crisis. However, from the economic school of thoughts’ perspective point of view, it is stated that predicting financial crises is a nearly impossible task.

Impacts on Financial Markets

The 2008 financial crisis impacted negatively on financial markets. Since the financial markets greatly affect the economy, various stakes were upheld and hence the stress on the economy. The impact was evident on the U.S stock market and the other financial institutions.

U.S Stock Market

In October 2007, the stock market in the United States peaked after exceeding the Dow Jones Industrial Average Index with 14, 000 points. In early 2008, the stock market started experiencing a steady decline until it reached approximately 6, 000 points by March 2009. The statistics started to flourish again between March 2009 and early 2011 when it exceeded 12, 000 points. The points were recorded above 13, 000 points by 2012. This was a positive improvement based on the comparison between the performances of the stock market during 2007, 2008, 2009, 2010, 2011 and 2012. The steady increase was quite beneficial to the economy of the United States at a time when it was experiencing the most drastic effects of an economic downtown.

2008 Financial Crisis
2008 Financial Crisis

Partially, the quantitative easing technique that was applied by the Federal Reserve’s economic policy of aggression was behind the success of recovery of the United States stock market. The recovery of the United States stock market back to its functional status was a welcome effect that was essential to curb the effects of the financial crisis and mitigate the future occurrences of the same caliber. The positive performance in the stock market was also attributed to various factors concerning the efforts steered by the financial community to save the economy from succumbing to the financial crisis. The poor performance by the United States’ stock market was also experienced during the Great Depression.

Financial Institutions

Financial institutions are a conglomerate of bankers and providers of banking services. Lending firms and institutions are also part and parcel of the financial institutions. There was an estimated amount of money by the International Monetary fund alleged to have been lost by the U.S banks and European banks. The estimated amount of the lost money was $ 1 trillion. The money was lost through poor techniques of loan allocations between the time period of 2007 and September 2009. Approximately 60 percent of American banks were affected while 40 percent of the banks in Europe were affected.

Northern Rock bank of Britain was one of the worst-hit banks in the European region. The bank engaged in over leveraging matters of business that later forced it to seek security and protection from the Bank of England. This led to bank-run and instilled panic among the investors in September 2007. The bank’s management was then put under the receivership of the public by the British government after failing to secure the interests of willing private investors to take control of the bank. The Northern Rock’s scenario was just an indication of the very many problems that the other financial institutions were facing.

The mortgage lending firms were the most affected since most of them became bankrupt. They were unable to secure their loans and financial benefits from credit markets. Almost all financial institutions predicted danger in terms of downfall and bankruptcy. The consequences included complete failure of the institutions to survive, subjection to takeover by the government or fire-sale in terms of duress acquisition by the willing investors. Most of the U.S and European banks were completely eliminated from the financial map.

Financial Crisis and its Effects on the Global Economy

Global economy is supposed to be sustained at all costs. It is responsible for diversification of the resources and economic empowerment of the countries that operate under one umbrella. When one country is hit by an economic crisis, the other countries that engage in economic activities with the affected country are likely to experience an economic shakeup. Financial crisis is just like any other crisis but its effects are the most tragic because they impair economic growth.

Economic stability is beneficial to a country while its instability has negative impacts on both the country and the citizens within its borders. Matters of economic interest are given the first priority when it comes to security and protecting citizens from economic depressions and its aftermaths such as high production costs, high interests on the borrowed funds and the subsequent increase in commodity prices. Apparently, the 2008 financial crisis affected several states both directly and indirectly.

Analysis of the commentators’ suggestion is welcome for argumentation. The commentators, with too much experience in the world economic trends commented on the impending effects of liquidity on the global economy. However, if the liquidity crisis persists, recession is likely to continue manifesting. With no mitigation measures urgently put in place to curb the liquidity crisis, it is likely that even more drastic effects of the recession will be experienced.

Continued persistence of the financial crisis is predicted to affect the global economy which in turn can cause a collapse of the economy if not mitigated as soon as possible. This is an argument from a group of certain forecasters. Contrary to this argument, there also exists another group of optimistic forecasters who believe that financial crisis is not likely to affect the global economy.

School of thoughts has it that the financial crisis is likely to cause a major shakeup in the banking industry due to the melt-down of loans and savings. In mid-October 2008, the Investments Banks in the United States and the United Kingdom declared that continued financial crisis was a clear-cut indication of an impending global recession. They even had the audacity to estimate the time it would take for the global recession to start manifesting itself. They estimated the minimum period before the global recession could start shaking the economy as two years or less.

Later on, the economists predicted that the crisis would end soon and that it was now the beginning of its end. This was evidenced by the efforts made by financial stakeholders in the world. This action was supposed to mitigate the financial situation immediately. Subsequently, the government injected reasonable capital into the economy that facilitated the cut-down of interest rates. This was one of the initial steps meant to enhance the well-being of the interested borrowers or the borrowers who were still repaying their loans. This meant that mortgages were now more affordable or better off. Their repayment was made cheaper as compared to the previous times when they were very high.

The United Kingdom was clever enough to mitigate the effects of the financial crisis by injecting the mentioned capital into its economy. The central banks across the globe were forced to cut-down the bank interests imposed on borrowers. This sufficiently helped to revive the deteriorating economy by attracting large numbers of borrowers. The United States was also required to systematically inject capital into its economy. This was not meant to completely mitigate the crisis because the worst was expected. It was only meant to deal with the financial crisis at that time but not the main solution to the crisis and the presumably impending economic crisis such as the global economic recession.

The UBS had already estimated the presumed duration of the expected recession in various economic power houses in the world. Recession in the Euro zone was to last for an approximated period of six months, the United States was to experience it for three quarters while the United Kingdom was to face a recession that would last for four quarters. Iceland is an example of some of the commonest countries on earth to be directly affected by the financial crisis. There was a major banking collapse in Iceland. It is still rated as the world’s major banking collapse in the history of economy.

The other countries in the world were also affected by the crisis because the Unites States was by then, the biggest shareholder in the world economy. Its spending habits were very beneficial to the world and hence it is intuitive to state that the rest of the world depended greatly on its success. The negative effects on the global economy were first observed in 2009 when Japan experienced a 15% decline in its GDP, 14% in Germany, 21% in Mexico, and 7% in the UK. The other developing countries also suffered significant slowdowns in their economic trends. However, the Arab World was least affected by the financial crisis because there were different sources of finances.

Government Responses

The government of the United States was supposed to establish the most appropriate mitigation measures and thereafter implement them for the purpose of streamlining the economy and its subsequent cushioning from any future crisis. There were various measures that were lined up by the government to gain both temporary and permanent stability of the economy. The two main responses included the short-term and emergency responses and long-term responses and regulatory proposals.

The Short-Term and Emergency Responses

The central banks across the world and the US government under the jurisdiction of the Federal Reserve have put the most appropriate measures in place to facilitate money supply and prevent occurrence of deflationary spiral. Deflationary spiral is the situation where high employment rates and lower wages cause low global consumption trends. The governments are also spending and borrowing funds from outside sources to increase demand by the private sector. The Federal Reserve in the United States dealt with the emergency by expanding liquidity facilities to enable the central bank to carry on with its duty of lending money.

In mid-2008, the Central Banks and the Federal Reserves responded promptly to the crisis by settling government debts and buying private assets from the hard-hit banks. The European governments and the United States raised their national banking systems’ capital by approximately U.S$ 1.5 trillion. They purchased stocks from the major banks to set-off the liquidity saga. To curb further liquidity, the U.S government decided to create currency valued at approximately 600 Billion dollars and injected them into its banks. Brave enough, the banks invested the money in foreign investments and currencies.

Long-Term Responses and Regulatory Proposals

There was a series of regulatory proposals introduced in 2009 by President Barack Obama of the U.S. The contents of the proposal included consumer protection, cushioning of bank finances, and regulation of the systems involved with shadow banking. Another proposal was to limit involvement of banks in proprietary banking. In Europe, the regulators drafted regulations for their banks. The proposals required the banks to amend their liquidity requirements, increase capital ratios and limit leverage. The regulations have since increased lending to the government by the banks and hence increasing the risk of a possible financial crisis. More lending to the government has been encouraged.

Without the long-term, short term responses and regulatory proposals, the crisis could have worsened and even led to a global economic recession. The government of the United States through its Federal Reserves, the government of the United Kingdom and the economic regulators in both countries were pivotal in mitigating the crisis and preventing a repeat of the same in the future. The short term measures were meant to deal with the situation immediately before the most appropriate long-term measures could be approved and implemented.

The proposals were also implemented by various central banks across the affected nations in the world. The United States led the other nations such as the United Kingdom in the fight against the financial crisis through the most appropriate short-term and long-term responses. A positive improvement was observed as the economy started to be more stable and sustainable. The proposals were also very significant because they managed to streamline the banking systems which are still effective at the moment. There is optimism that the measures and proposals will continue to be effective for the purpose of decreasing the probability of occurrence of another financial crisis in the future. These measures and proposals are still in place up to now though with subjectivity to legislated amendments.

Response by the Congress of the United States

The United States-being the worst affected by the financial crisis-sort assistance from the law makers and the Congress. Under the leadership of President Barack Obama, the congress and the senate were required to pass the most important financial Bills into law. The Bills were meant to cushion the U.S economy from any impending financial crisis. Stability of the economy was achieved after the implementation of the Bills. At the end of 2009, the House approved a Bill titled Wall Street Reform and Consumer Protection Act 2009.

The Act was enacted to protect the consumers against exorbitant prices of consumer goods and services. The interest rates were also shelved for the benefit of borrowers. Another response involved the enactment of Restoring American Financial Stability Act 2010 in mid 2010 by the U.S Senate. Several other Acts were enacted in response to the financial crisis. Meanwhile, in April 2012, a court in Iceland prosecuted a former Prime Minister for instigating the Icelandic Financial Crisis between 2008 and 2012.

Financial Crisis Stabilization

Economic stability was the main remedy for the persisting financial crisis which impacted greatly on the global economy. Stabilization was to be achieved through the well-researched mitigation measures. The affected economies were supposed to get back on their feet after nullifying the threat from interfering with their finances. The United States and the United Kingdom were the front runners in ensuring economic stability.

The U.S recession lasted between December 2007 and June 2009. Similarly, the financial recession also ended at the same time. By the beginning of 2010, President Barack Obama declared that the markets were stable and that he had managed to retrieve the money spent on the banks during the crisis. The stability can also be evidenced by the observed growth of most stock markets. However, fundamental changes are yet to be made on financial markets and banking.

Bibliography

Duhigg, Charles (October 4, 2008). “NYT-The Reckoning-Pressured to Take More Risk, Fannie Reached Tipping Point”. The New York Times. Retrieved March 22, 2013.

Ivashina, Victoria and Scharfstein, David. Bank Lending During the Financial Crisis of 2008. Working Paper. Harvard: Harvard Business School, 2008.

Jickling, Mark. Causes of the Financial Crisis. April 9, 2010.

John B. Taylor, “The Financial Crisis and the Policy Responses: An Empirical Analysis of What Went Wrong”, November 2008, pp13-14.

Koller, Cynthia A. (2012). “White Collar Crime in Housing: Mortgage Fraud in the United States.” El Paso, TX: LFB Scholarly.

Markus, Brunnermeier, Deciphering the Liquidity and Credit Crunch 2007–2008, Journal of Economic Perspectives, 23:1, Winter 2009.

Simkovic, Michael. “Secret Liens and the Financial Crisis of 2008” American Bankruptcy Law Journal, Vol. 83, p. 253, 2009.

Smith, Gregory. US House Committee on Oversight and Government Reform, Hearing on causes and effects of the Lehman Brothers bankruptcy, 6 October 2008.

Stewart, James B. “Eight Days: the battle to save the American financial system”,

The New Yorker magazine, September 21, 2009. Pages 58–81.

Troshkin, Maxim. Technical Notes on Facts and Myths about the Financial Crisis of 2008. Working Paper 667, Federal Reserve Bank of Minneapolis, 2008, 12.

Williams, Carol J.). “Euro crisis imperils recovering global economy, OECD warns”. (May 22, 2012) Los Angeles Times.

“World Economic Outlook: Financial Crisis and Recovery, April 2009” (PDF). Retrieved March 8, 2013. Federal Deposit Insurance Corporation, History of the Eighties – Lessons for the Future, Vol. 1.

Financial Crisis Relevant Links

Theories of Finance

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Liquidity Risk And Funding

GAP Analysis of Liquidity and Funding

Liquidity Risk: Gap Analysis is a process that helps in determining what all steps are required to be taken by the businesses so that they can make best possible use of all the current resources. In other words, it means comparison between the actual performance and expected performance. When a company is not utilizing its resources economically that means the company is performing below its potential. It is also called need gap analysis or need assessment.

Liquidity simply means the availability of liquid assets to a market or to a company. It determines up to what extent a person or company has the ability to meet its short term commitments. Now liquidity fund means a mutual fund that invests into a large number of securities, bonds and options that have high credit rating but for a short duration. Funding simply means money provided by any bank, financial institutions, Government etc. for particular purpose.

Liquidity Risk And Funding
Liquidity Risk And Funding

In finance liquidity risk is defined as a risk in which a particular security cannot be traded rapidly in the market to prevent loss.  A liquidity gap can be positive or negative depending on the number of assets and liabilities that the company have. Liquidity risk maintains the postures of business ‘AS USUAL’ and thus causing more adverse position. The latest events relating to financial crisis have made a good enough impact on the mind of regulators and have concluded that this matter can’t be taken lightly.

A contingency funding plan frames the firm’s strategies and determines liquidity shortfalls in crucial situations. There are two types of risk:-

Funding Liquidity Risk

It is the risk where the firm is able to fulfill both present as well as future cash flow needs and collateral needs only after changing daily operations and financial position of the firm.

Market Liquidity Risk

It is the risk where because of poor market depth or disruption firm cannot equipoise a position at market price.

Points To Be Considered To Manage Liquidity

In order to manage liquidity gap following points should be considered:

1Allocate cash flows over various time horizons.

2 To control the mismatches set target gap and also warning gap for deficit positions.

3 Design a structure to attain disparities within target gap limits.

Challenges Faced By Company against Liquidity Risk

A company has to face various challenges against liquidity risk and these are:

  1. Positive or active approach to liquidity management.
  2. Incorporate a liquidity culture in the company.
  3. More investment in technology and research their results.
  4. To sustain stability, evenness and symmetry between business and risk.
  5. To measure effect of negative result.
  6. Applying rules and various assumptions while creating models
  7. High pressures in achieving models designed.
  8. Evaluating and analyzing funding sources and framing strategies in order to fulfil urgent liquidity needs.

Solutions to the weaknesses

Cost Impact Ratios

  1. Volatile liabilities to Total deposits: It explains the share of volatile liabilities to total deposits. As per the given records it is 77%
  2. Purchased funds to total assets: It explains the quantum of high cost funds to create assets.
  3. Volatile liabilities to total assets: Through this we get to know about the assets funded through volatile liabilities. It is 55% in the given records. This ratio can be considered adequate.

Cash Flow Impact Ratios

  1. Customer deposits/Total Assets: It gives knowledge about how the asset can be funded.
  2. Liquid Assets / Short term liabilities: It determines the availability of assets to meet short term liabilities or immediate liabilities.
  3. Large Deposits/Total Deposits: It shows the weight of large liabilities.
  4. Large Advances/ Total Advances: Similarly this measures the advances.
  5. Commitment Ratios/ Total Assets : It includes record of off balance sheet items to on balance sheet items

According to the data, the company has a cash ratio of 39% which is good. But on the other hand it has deposit ratio of 77% which is quite high and the asset ratio of 55% is adequate enough. Thus overall Liquidity risk of the company is not that worse.

References

Global Association of Risk Professionals, 2013, Risk Education

Liquidity & Funding Risk, 2013, Examine Balance Sheet Structures under New regulations

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Currency Risk Dissertation

Currency Risk

Currency risk is basically a risk that arises when a price of some country’s currency changes against the currency of some other country (Alastair, 2013). Whenever the companies or investors have their business operations or assets across their national borders, they are exposed to currency risk if they do have their positions hedged (Stephens, 2003). In these modern times of heightening currency volatility and increasing globalization, changes on the currency rates or the exchange rates causes to have a substantial influence over the profitability and operations of companies and even the government in those countries (Graham, 2014). The volatility of the exchange rates or currency rates not only affects the large corporations or multinationals, but also the medium and small sized businesses that operate only in their homeland (Horcer, 2011).

Types of currency risks or exposure

What follows is a brief account of different types of currency risks or exposure that are faced by companies and governments due to the volatility of the currency or exchange rates.

Economic risk

It is among the lesser discussed risks by researchers and scholars, but still is an evident one and has a substantial presence. Such a risk is basically caused by effects of unanticipated or unexpected fluctuations in currency on the future market value and cash flows of a company (Coyle, 2001). The impact of such a risk is long term is nature. It can have a substantial impact on the competitive position of a company even if the company is not making overseas sales or operating overseas. The source behind the economic risk is the change in competitive strengths of exports and imports (Plaza, 2011). This can be understood with an example.

For instance, if a company exports from UK to a country in the Eurozone and the price of the Euro weakens against the pound sterling i.e. it comes from 1.1 euros to 1.3 euros per pound sterling. This is a weak position because one would have to give 0.2 Euros more for one pound sterling. This means that a product from UK priced 100 pounds would cost 130 Euros instead of 110 Euros. This means that the goods from UK would become less competitive in the European market.  On the other hand, the goods that are imported from Europe to UK would cost lesser than previously and would make them competitive in the UK market (MOguillansky, 2003).

Methods of risk mitigation for economic risk could be difficult, and especially the smaller companies which have limited international dealings (Hakala & Wystup, 2002). Some of the following approaches in general could be of importance.

  • Try exporting and importing from multiple currency zones and hope that those zones do not all move together, or move together to the same extent. For example, for the six months from January 2010 to June 2010 €/US$ rate of exchange moved from €/US$0.6867 to €/US$ 0.8164. This caused to strengthen the US dollar against the Euro by 19 percent. This resulted in making it less competitive for the USA manufacturers to make exports to a country in Eurozone. However if during the same period, the value of Pound relative to the US dollar moves from 0.6263 to 0.6783, this would have strengthened the US dollar relative the pound by 8 percent. In such a case, he trade from US to United Kingdom would not have been affected so badly(Poghosyan, 2010).
  • Another method here is to make the goods in the countries to which they are sold. This is something which is followed by multinationals. Though in such a case, the raw materials might need to be imported and affected by change in currency rates, but the other expenses such as electricity bills and wages in the local currency would not be subject to the currency risks(Clark & Ghosh, 2004).

Translational risk

The impact of currency rate fluctuations on the company’s fiscal statements results in translational risks. It is especially the case when the company features foreign subsidiaries (Matsukawa & Habeck, 2007). This risk is normally short to medium term. If the subsidiary of a company is in some country where the currency weakens, the value of assets of such subsidiary in the company’s consolidated accounts will weaken (Homaifar, 2004). The effect is not severe as it does not impact on the day to day cash flows. However, scholars and practitioners have reserved the translation risk usually for the consolidation effects (Stephen, 2003).

The exposure can be partially mitigated through funding of the foreign subsidiary through a foreign loan. For instance, take a USA subsidiary of a company which has been set up by the parent company using equity finance. The financial position statement of the company would appear something like this:

Current assets – 0.5 million US dollars

Non-current assets – 1.5 million US dollar

Equity – 2.0 Million US dollars

Now if the US dollars, the total assets of the company would have a lesser value as a result.

However, in case if the subsidiary for example was formed through using 50 % US borrowings and through 50 % equity, the financial position would be:

Current assets – 0.5 million US dollars

Non-current assets – 1.5 Million US dollars

The breakup of this position or the assets is that $ 1 million loan is used to finance the assets and the rest 1 million is equity borrowings. So the investment of the holding company is only $ 1 million US dollars and the net assets are only worth US dollars 1 million. Now if the US dollars weakens in such a case, only the net assets value of US dollars 1 million decreases (John Y, 2010).

Currency Risk
Currency Risk

Transaction risk

Transaction risks are the most evident and talked about currency risks due to fluctuations in currency (Sebetian & Solnik, 2008). The exposure exists when the companies exporting and importing. This type of risk is of a short to medium term. If the rate of exchange during the time the company enters into contract and the time of actual receipt or payment of money changes, the amount of the home currency to be received or paid will alter and would make the future cash flows uncertain (Bartram & Bodnar, 2007).

Methods of currency risk mitigation and their shortcomings

Some of the most renowned and widely used risk mitigation strategies are those are used by companies to overcome transaction risks. Though in case of foreign currency transactions, there are chances of obtaining profit due to the increase in the rate of foreign currency (Ugur, 2012).

Non-hedging techniques and currency risk

There are two obvious risk mitigation techniques for minimizing the transaction exposure.

Transferring exposure

Under this technique, the exposure or risk of the transaction is transferred to the other company. For instance, an exporter of US selling products in Germany could quote the sale price in US dollars. In such case the transaction exposure or risk for any uncertainty in exchange rate would be faced by the German importer (Ephraim & Judge, 2008).

Netting exposure

The currency risk of transaction is minimized here by netting out. This method is of vital importance for the larger companies that are frequently involved in large amounts of currency transactions (Cavusgil, et al., 2012). Receivable of Deutsche marks of 100 million owed to some US company in 45 days is safe if the USA Company is to pay out some German suppliers Deutsche marks 75 million in about 30 days. The risk increases further if the business only has receipts on continuing basis in Deutsche marks. The risk is decreased when the receipts and payments are in various different currencies. An example has been given earlier in the exposition. Though the transaction of currency cannot be netted off fully, it may become so small that the company accepts the exposure or risks rather than incurring costs associated with hedging that are given below (Judge, 2009).

Hedging techniques for currency risk mitigation (hedging techniques or instruments)

Mitigating short term foreign exchange risks

For eliminating short term transaction exposures of currency, there are various hedging instruments available with different costs.

Forwards contracts

The most direct means to eliminate the transaction risk is by hedging the risk with forward exchange contract. For instance, suppose some USA exporter sells 50 wine cases to some Venezuelan company under sales contract, which specifies an amount of 15 million bolivars to be paid in 60 days. The exporter could eliminate the transaction exposure through the 15 million bolivars to his bank at a 60days forward exchange rate of 750 bolivars / dollar. Now it does not matter what happens to the currency rate during the next month, the company will have assurance that it will be able to convert 15 million bolivars into 20,000 US dollars (Bartram, 2008).

Now the risk or limitation with this method is that exposure could only be eliminated if Venezuelan buyer pays the obligation of 15 million bolivars. The default from the buyer would not relieve the US producer from the obligation towards the bank. Another limitation is that the forward contracts are not usually accessible for the small businesses. Banks normally quote rate that are unfavorable for the smaller businesses because the risk will be borne by the bank in case the company does not fulfill the forward contract. Creditworthy companies are also refused by banks. The non-eligible companies for forward exchange rate contracts can use the option to hedge transaction exposure through future contracts (Bartram, 2008).

Future contracts

The forward market hedge and future market hedge have many similarities. For instance, a US company has payable of $50,000 to be paid by the third Wednesday of September. This organization is able to purchase a Canadian dollar future contract for September. Now if value of Canadian dollar increases, the value of the payable of US Company will increase. However, value of the future contract will also increase by the same amount which would make the net value unchanged. Vice versa would be the case if the Canadian dollar value falls (Qing, et al., 2007).  

The future contracts are marked by the market. The losses are to be met in cash and the offsetting currency transactions would be delayed till the transaction takes place. It might also bear the risk for insolvency for the company (Hull, 2008).

Hedging through the money market

Where future market hedge is expensive, not available, or bears large risk of insolvency, a company can use the money market hedge. Suppose a US exporter is to receive 4 million Brazilian reals in in one month time. The exposure or risk of currency fluctuation could be eliminated here through borrowing Brazilian reals at a 10 percent interest rate per month. The business can them convert them into US dollars at spot rate. When Brazilian customer after one month pays of the 4 million reals, they are utilize the settle the principle and interest on the loan.

Companies should pay out more for borrowing the funds than they could receive when they lend the funds. The interest rates charged by banks rises with risk and the requirement of collateral securities or pledge are also in place. In the situation in which the business borrows future payable, it could pledge reals deposit as the collateral security. The company’s and borrowing rate would be almost risk free when the bank has low risk. In such a case, money market hedge will be normally the least expensive option even if forwards and future contracts are available (Maurer & Valiani, 2007).

Cross hedging

Cross hedging is another hedging method which is of importance for countries where options such as future contracts, forward rates, options or credits in the foreign currency are not available (Madura, 2012). It is a hedge that is established in currency which is related to value of currency in which the payable or receivable is denominated. In some of the cases, finding currencies that are correlated is easy because many small countries try pegging their currencies with major currencies like Euro, Dollar, or franc. However, there might not be perfect correlation among these currencies as efforts for pegging the values fail frequently (Lane & Shambaugh, 2010).

Now for instance, if there is a company that has receivables or payables denominated in the currency of some small nation that has no developed credit market or currency. In such case, it will explore possibility that the currency might be pegged to some major currency value. If not, then the company would observe the previous changes in value of that currency to determine whether such currency in correlated with the changes in value of some major currency. The company then undertakes a futures market, forward market, options or money market hedge in that major currency (Chue & Cook, 2008). A limitation with this method is that its success depends change in major currency value corresponds with the currency of the smaller country (Calamos, 2011).

For now, there is an only limited market for the currency futures options that features maturities greater than 1 year. Only a few banks render foreign exchange contracts of long term with maturities such as seven years. Only the credit worthy and the large corporations qualify for those contracts (Hull, 2008).

Back to back loans

Back to back loan arrangements are a method to reduce currency risks in long term transactions. For instance, where a company enters into a project with some company in another country, it can use parallel or back to back loan arrangements for reducing risk. Here the company will lend loan in its homeland currency to the other company if the other intends to invest in that country. Similarly the other company with whom the lending company is making investment will arrange loan in its own homeland currency for the investing company. Thus they will pay each other from the earnings they derive from their respective investments in the form of currencies of their respective countries. In such case both companies will be under bilateral arrangement which will be outside the scope of foreign exchange markets. Ultimately neither of them would be affected by fluctuations in exchange rate.

However the risk of default from either company always remains and they are not freed from their loan liabilities (Patnaik & Shah, 2010).

There are various other methods that are used for mitigating currency risks, but they vary from country to country and have their own limitations in general and in the context of specific countries.

Conclusion and recommendations

Effective legal drafting could be used to minimize substantial international transaction risk. The risk of currency fluctuation exposure could be eliminated or mitigated using the instruments or methods that have been described in this exposition. Though many of the instruments do not hedge the transaction exposure entirely, but they are more accessible for the medium and small size firms and the individuals. Though the instruments and methods increase transaction cost, but still businesses intend to minimize risks as a priority.

Individuals and companies should have an understanding of the transactions they do in terms of the risks associated with them. Similarly they should have an understanding of their financial and money market so that they can determine the risk mitigation instruments and techniques in those markets. In case the risk is higher, then the cost of mitigation techniques should never be avoided. They should have an eye on both the present and future currency risk of a transaction.

Bibliography

Alastair, G., 2013. Introduction to currency risk. New York: Rutledge.

Bartram, S. M., 2008. What lies beneath: foreign exchange rate exposure, hedging and cash flows. Journal of Banking & Finance, 32(8), pp. 1508-1521`.

Bartram, S. M. & Bodnar, G. M., 2007. The exchange rate exposure puzzle. Managerial Finance, 33(9), pp. 642-666.

Calamos, N. P., 2011. Convertible arbitrage: insights and techniques for successful hedging. London: John Wiley & Sons.

Cavusgil, S. T., Knight, G. & Reisenberger, J. R., 2012. International business. New Jersey: Pearson Education.

Chue, T. K. & Cook, D., 2008. Emerging market exchange rate exposure. Journal of Banking and Finance, 32(7), pp. 1349-1362.

Clark, E. & Ghosh, D. K., 2004. Arbitrage, hedging and speculation: the foreign exchange market. New York: Greenwood Publishing Group.

Coyle, B., 2001. Foreign exchange markets. Chicago: Taylor & Francis.

Ephraim, C. & Judge, A., 2008. The determinants of foreign currency hedging: does foreign currency debt induce a bias? European Financial Management, 14(3), pp. 445-469.

Graham, A., 2014. Hedging currency exposure. New York: Routledge.

Hakala, J. & Wystup, U., 2002. Foreign exchange risk: models, instruments and strategies. London: Risk Books.

Homaifar, G., 2004. Managing global financial and foreign exchange rate risk. New York: John Wiley & Sons.

Horcer, k. A., 2011. Essentials of financial risk management. Hoboken: John Wiley & Sons.

Hull, J. C., 2008. Fundamentals of futures and options markets and derivate. 6th ed. s.l.:Prentice Hall.

John Y, C. M. S.-D. V. L. M., 2010. Global currency hedging. The Journal of Finance, 65(1), pp. 87-121.

Judge, A. E. C., 2009. Foreign currency derivatives versus foreign currency debt and the hedging premium. European Financial Management, 15(3), pp. 606-642.

Lane, P. R. & Shambaugh, J. C., 2010. Financial exchange rates and international currency risk exposures. The American Economic Review, pp. 518-540.

Madura, J., 2012. International financial management. Singapore: Cengage Learning.

Matsukawa, T. & Habeck, O., 2007. Review of risk mitigation instruments for infrastructure financing and recent trends and developments. Washington: World bank Publications.

Maurer, R. & Valiani, S., 2007. Hedging the exchange rate risk in international portfolio diversification: currency forwards versus currency risk options. Managerial Finance, 33(9), pp. 667-692.

MOguillansky, G., 2003. Corporate currency risk management and exchange rate volatility in Latin America. Santiago: United Nations Publications.

Patnaik, l. & Shah, A., 2010. Does the currency risk shape unhedged currency exposure?. Journal of International Money and Finance , 29(5), pp. 760-769.

Plaza, D., 2011. The role of currency risk futures in risk management. Norderstedt: GRIN Verlag.

Poghosyan, T., 2010. Determinants of foreign exchange risk premium in the Gulg cooperation council countries. Washington: International Monetary Fund.

Qing, D., Dong, L. & Kouvelis, P., 2007. On the integration of production and financial hedging techniques in global markets. Operations Research, 55(3), pp. 470-489.

Rose, P. S. & Marquis, M. H. L. J., 2008. Money and capital markets. London: McGraw-Hill/Irwin .

Sebetian, M. & Solnik, B., 2008. Applying regret theory to investment choices: currency hedging decisions. Journal of International Money and Finance, 27(5), pp. 677-694.

Stephen, B., 2003. Managing currency exposure. CFA Magazine, 14(4), pp. 50-51.

Stephens, J. J., 2003. Managing currency risk: using financial derivatives. John Wiley & sons.

Ugur, L., 2012. Currency hedging and corporate governance: a cross country analysis. Journal of Corporate Finance, 18(2), pp. 221-237.

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IFRS IASB Frameworks

Finance Assignment – Various normative theories, measurement issues under IFRS and Conceptual framework

IFRS IASB Frameworks – This report basically provides an analysis of different financial accounting measurement techniques, their advantages and disadvantages and practical implications. Accounting measurement has become a controversial issue due to its assorted nature in financial reporting system. The conceptual framework developed by both systems is unable to provide accurate cost of assets and liabilities at the end of financial year.

There is a misunderstanding behind the rationale that whether measurement is a set of calculation or numbers but it provides no as such vivid explanations and is totally cognitive based. A lot of research work and publications have been made about this topic but the matter is still under consideration. Financial reporting measurement is a debatable issue and still under consideration.

Most of the literature has been published on the issue of historical cost and value accounting. It shows that it is never ending issue. Historical cost measurements narrates that total assets and total liabilities should be recorded and reported at the procured price while current cost accounting states that assets and liabilities should be recorded and reported at existing market value.

Role of IASB & FASB frameworks

International Accounting Standard Board Framework

International Financial Reporting Standards (IFRS) are based on the IASB framework developed for the sake of preparation and presentation of financial statement.

Financial Accounting Standard Board Framework

FASB is U.S primary body for the development of accounting standards. It issues new rules so called Statement of Financial Accounting Standards (SFAS) based upon FASB which are basically derived from Generally Accepted Accounting Principles (GAAP).

IASB and FASB frameworks present a facility of persistent and logical formulation of IFRSs and SFAS respectively. Both of these also aim to provide its users with a platform to resolve various complex accounting issues. Hence, framework has the benefit being the status of conceptual base for development of IFRSs.

The IASB issues IFRS to more than hundred countries which also include European Union but it excludes United States. There is a strong co-relation among both IASB and FASB standards. It is probable that U.S will also move to IFRS in 2016. Despite of all this, both IASB and FASB sat together to reach at a final conclusion about this matter but still there is a room for improvement.

Mary E. Barth has concluded that Fair value measurement provides somewhat precise and specific value of both assets and liabilities. The core objective of this report is to determine why other frameworks lack behind. (Mary E. Barth, 2013, pp 2-3)

Comparison of various cost approaches

There are many cost measurement techniques which are used to record assets and liabilities in financial statements; some of these are as follows:

Unmodified historical cost

This type of cost includes those amounts which were paid at the time of procurement of assets no matter whatsoever the life of asset is. It is totally inadequate way of recording measurement.

Modified historical cost

This cost is modified due to various factors like impairments, amortization due to depreciation or appreciation of asset with the passage of time. It seems to be relatively more valid type of measurements.

Fair value measurement

It is a net price which can be received while selling an asset or paying any liability in a logical transaction among market participants at the measurement time frame.

These are frequently used in financial reporting and possess different characteristics. Only one of these techniques is used to record assets and liabilities in common practice so as to draw conclusion based upon performance. Financial statements are comprised of total assets (both current and fixed), total liabilities (both current and long term) and owner’s equity. The framework indicates that equity is the difference between the assets and liabilities after proper measurements. (Mary E. Barth, 2013)

IFRS IASB Frameworks – A Critical Analysis

The aggregation is a qualitative attribute which slightly affects the quantity. Hence, a minor change in assets and liabilities generally affects net income and expense. However, the Framework does not elucidate the factors behind balancing effects on Statement of Financial Position (SOFP) and Comprehensive Income.

Fair value provide more effective results as compared to un modified and modified costs in case of single assets and liabilities as it contains both qualitative and take into account assets and liabilities. Whereas unmodified cost is totally irrelevant and invalid. Modified cost if not supported with accounting standards cannot be explained in a scenario.

Fair value determination is only more reliable and accurate if it is acquired faithfully with an ethical mentality. Still there is an ambiguity whether modified historical cost is more appropriate than fair value determination. Hence we may conclude that fair value and unmodified costs are set according to a specific economic objective while modified is an accounting calculative work.

Despite of all these measurement techniques, only one selected technique should be used for estimation so as to achieve significant accounting results. Anyhow, other technique can be used where direct measurement is impossible for estimation. This approach will be helpful to maintain consistency, comparability and significant aggregation of accounting data. . (Mary E. Barth, 2013, pp 19-20)

IASB recommended approach

IASB also endeavours to find a single measurement technique in its own projects. IASB also favours fair value measurement that it provides more effective results, though it sometimes fails to assess the cost of any asset. Practically, all the framework of accounting regulations except IFRS is not using single approach of measurement.

For instance, measurement of cost to predict operating cash flows will provide major share of turnover in going concern business approach, while fair value would be more appropriate, relevant and reliable for the valuation of marketable securities and investments. However if you use different approaches in each financial year, the descriptive authority of such aggregation would be more poor and risky.

Preliminary and Subsequent measurements

However, measurement approaches can be distinguished according to preliminary and subsequently with respect to nature of the measurement subject matter. For example, in case of going concern business, long term assets meets the pre-requisites while current liquid assets (inventories) and marketable securities are measured differently. However, it all depends upon standard setters that which measurement technique should be selected.

All the regulations of Accounting including IASB, FASB, UK Accounting Standards Board and Australian Standard Boards possess a common thing that financial statements are primarily developed to help its stake holders (external and internal users) so that they may analyze the organization. Investors can depict growth rate, market value and share value (Jiri Strouhal, 2014).

IFRS IASB Frameworks
IFRS IASB Frameworks

Effects of choosing wrong measurement approach

Determining right choice of measurement is very important for organizations. There are five different approaches like as fair value treatment of costs, historical cost accounting, modified historical cost accounting, current purchasing power accounting, current cost accounting and continuously contemporary accounting. All these techniques have various pros and cons. But fair value treatment of costs is mostly used and reliable approach to recognize costs. Accountant should be prudent while choosing cost approach.

Wrong choice of cost approach may adversely affects the financial statements, shareholders image towards firm’s assets and liabilities. Historical cost accounting deals with recording assets on purchased price which is wrong measurement. If any asset is to be sold, then we need to consider again choose either fair value approach or modified historical cost accounting as a measurement rather than historical cost accounting value. This type of costing is only helpful for long term basis if re-procurement of machine or asset is to be needed.

Current purchasing power accounting measurement shows the impact of inflation on the net value of money. To achieve CPP, firstly historical costs are changed into current prices with the help of consumer price index (CPI). But Price indexes quality includes simply averages and perhaps not matches with expenses incurred by even a single shareholder. It sometimes becomes ridiculous that if re-stated asset values considered everything while the changed amount is neither paid nor is asset value increased. Current cost accounting despite of its importance is not reliable for long term basis. Then we move to historical cost accounting for decision making.

International Accounting Standards

Some of the most important International Accounting Standards have been explained below to elucidate the effect of measurement and reporting accounting on current assets and liabilities.

Fair value measurement (IFRS-13)

Fair value measurements are mostly used and reporting standard. IASB, FASB, AASB lays stress to use this standard but each one provide their own standard guidelines for the determination of fair value. IFRS-13 also tells how preliminary fair value is to be measured and how successive fair value is found.

Fair value: It is an amount which can be gained when an asset is sold or a liability is transferred among market participants in normal transactions at measurement date. Market participant are usually those buyers which have economic and ethical rationale.

Fair values should be gained from principal market as it is pure competitive market and possess large volume of desired nature. If it is unavailable, then accountant should concern from advantageous market. Final fair value must contain location of asset and its condition

Assumptions

  • Transaction cost should be ignored
  • Transportation cost should be incorporated
  • In case of most advantageous market, both transaction and transportation costs should be incorporated

Inventories (IAS-2)

This standard has been developed to assist and provide a valuable accounting treatment for physical inventory which is a current asset. This treats cost of the inventory like an asset which can be easily carry forward unless it is sold. The standard also aimed to provide assistance to recognize and determine the costs along with net realizable value.

Scope

This standard is valid for all inventories excluding:

  1. It is not valid for construction contracts specially treatment of work in progress
  2. Financial instruments including marketable securities
  3. Natural assets or biological assets

Measurement of inventories

Inventories must be recorded at the lesser cost and net realizable value (NRV).

Cost of Inventory

Inventory cost includes cost of purchase, conversion cost (Labour and Production overhead) and the cost freight charges incurred to bring an asset from vendor place to factory.

Cost of purchase

This cost is comprised of purchase price, transportation charges, import duties, taxation other costs incurred to attain asset and trade discount and other discounts are deducted from original cost of purchase.

Cost formulas

Inventory once purchased can be calculated by using first in first method (FIFO) and weighted average cost method while last in first out (LIFO) is not allowed.

Cost of the inventory can be calculated through FIFO and Weighted Average Cost Method. However, LIFO method is not permitted.

Record of reversing (Expense)

Reversal of note down of equivalent inventory might be prepared up to the cost.

Events after reporting period (IAS-10)

IAS-10 tells the treatment for those events which occurs after the financial period. So, adjustments are to be made in financial statements. Management will provide final approval of accounts on 31st Mar, 2014 while final accounts will be forwarded to annual general meeting (AGM) to get approval for shareholders on 30th Apr, 2014. After this, reports will be authorized for issuance.

IAS-10 is appropriate for those events which are took place after the balance sheet date but to the date of authorization by the management i.e. 31st Dec, 2012 to 31st Mar, 2013. Event can be adjusting or non-adjusting.

Adjusting Events

Those events which present supplementary proof of their existence at the financial statement i.e. balance sheet are called adjusting events. Adjusting events are needed to be documented in the financial statements.

Example:

  • Errors and inaccuracies in financial statements if discovered after reporting period, their adjustments will be covered in adjusting events.
  • If a court case was settled validating the compulsions at the end of financial period.
  • If an asset was purchased earlier but cost of purchase confirmed after reporting period. 

Non Adjusting Events

Those events which doesn’t support supplementary proof of their existence at the financial statement i.e. balance sheet are called non-adjusting events. Non adjusting events are needed to be disclosed in the notes of financial statements.

Example:

  • Declaration of dividends is a non-adjusting event as these are recorded once these are proposed after reporting date.
  • Anomalous loss, natural disasters, amalgamation, renovation and acquisitions do not provide supplementary events so these are adjusting events.

Historical Cost Accounting

Historical cost is a sum of price which is paid by firm to acquire an asset for use. It includes all costs incurred to bring the asset for smooth operation. It is an ancient accounting standard which was developed with a rationale that prices are smooth and normal changes occur with a passage of time. Such conservative style of accounting doesn’t make and stipulation for change in purchasing power. There is less manipulation of mangers as it is only recorded at acquisition price every year. Accountants have to meet the expected return of its shareholders and investor despite of the net wealth of the firm. This shows that primarily focus is upon income statement which will be a vivid glance whether firm is working efficiently or not. (Jiri Strouhal, 2014).

Advantages

  • Historical cost has a substantive effect on appraisal evaluation and assortment of decision rules.
  • If management has to determine which decision would be more useful, it may get help from past performance.
  • Historical cost is directly associated with past decision. Past data is helpful to forecast for better decision making. There prime object is to determine what profit did they earn in past not what they can increase.

Disadvantages

Historical cost is inappropriate for decision making as it doesn’t follow stewardship function. Investors have more concern with up and down in their investments return rather stable return.

Modified historical cost

This historical cost is modified by inculcating various factors like impairments, amortization due to depreciation or appreciation of asset with the passage of time. It seems to be relatively more valid type of measurement. Modified cost basically provide better picture of firms assets and liabilities. In Australia, modified historical cost system is used instead of historical cost accounting. It states that assets should be recorded in balance sheet after fair value determination.

Current purchasing power accounting

It is an accounting measurement which shows the impact of inflation on the net vale of money. To achieve CPP, firstly historical costs are changed into current prices with the help of consumer price index (CPI).

This theory is basically derived from macroeconomic “inflation” perspective that persistent rise in general price level of commodities also called inflation adversely affects currency value. If pound value is decreased then it becomes difficult to compare financial statements by using this approach.

Strengths

  • CPP recognized the worth of money which should be generated and maintained in business to sustain overall shareholder’s purchasing power.
  • It is comparatively easy, cheaper and improves overall shareholders worth by eliminating inflationary elements which arise from change in currency from monetary profit.

Weaknesses

  • Price indexes quality includes simply averages and perhaps not matches with expenses incurred by even a single shareholder.
  • It sometimes becomes ridiculous that if re-stated asset values considered everything while the changed amount is never paid nor is asset value increased.

Current Cost Accounting

Assets are usually values at specific amount of cash or its equivalents if same asset is to be acquired for use in firm. Similarly, liabilities are also settled with the discounted amount of cash or its equivalents needed to reconcile the obligation presently.

Advantages

Current cost accounting use present clearer picture of an asset as compared with historical cost accounting which is helpful for decision making. Due to high degree of precariousness in business environment, financial statements should also demonstrate reality instead of past transactions. A study on New Zeland company directors by Duncan & Moorers (1988) signified that current cost accounting presents more valid and reliable information than historical cost accounting.

Disadvantages

Peasnell et. al. (1987) stated that cost accounting information is used by investors in short term assortment decision making. It also doesn’t work as a driving force for long term returns. Shareholders are more concerned with historical cost accounting to get information about investment returns.

Continuously contemporary accounting

This famous accounting theory commonly known as CocoA was given by an Australian Raymond Chambers. The purchasing primacy of money is highly volatile or current and is subject to change with the passage of time. This model basically tells that the current worth of the business is equal to the total cash equivalents of its assets. It just like current cost accounting system measure both assets and liabilities at the existing cash price.

Strengths

The model is designed in this way that accountants can easily deploy it in developing balance sheets and financial statements. The true picture of assets and liabilities in cash price provide an assistance to firm in rapidly changing environment. CoCoA balance sheets only estimates what will be received if its assets are sold to meet short term liquidity challenge.

Weaknesses

CoCoA system requires from the management to shift from cost based system to way out price which is highly opposed by top management in many firms. The CoCoA balance sheets are mostly failing in calculating internal worth of the assets as they only focus on market prices.

Finance Accounting Dissertation Topics
Finance Accounting Dissertation Topics

Case Study (valuation of roads and highways)

Renewal accounting method basically determines the impairment of highway infrastructure and roads. Highway infrastructure is considered a single asset and many performance indicators are applied to evaluate impairment on asset. Asset valuation involves measures to calculate firm’s assets and their current value in monetary terms. Current monetary value is also evaluated by depreciated replacement cost method for highway infrastructure assets specially.

DRC = Gross Replacement Cost – Accumulated Consumption

Impairment should be calculated by a consistent approach. Once an approach is set, valuation should be prescribed. Finite life assets and components by using conventional method is valid valuation impairment approach for highway infrastructure and roads.

All the assets and components can be categorized into two types:

  • Conditions based maintenance

This identifies physical condition and performance data is also used for estimation of consumption of the asset whereas maintenance cost is also paid to make it look new.

  • Time based maintenance

This approach identifies the asset consumption by its age and condition

Modified historical cost would be more applicable for smooth reporting and recording of costs in this case. As roads and highways are long term projects and their value also changes with the passage of time.

References

  1. Mary E. Barth (2013). Measurement in Financial Reporting: The Need for Concepts. Forthcoming, Accounting Horizons 2014, 40(1) 2-20
  2. Jiri Strouhal (2014) Historical Costs or Fair Value in Accounting: Impact on Selected Financial Ratios, Journal of Economics, Business and Management 2015, 3(5)1-5
  3. IASCF Staff (2005). Measurement Bases for Financial Accounting-Measurement on Initial Recognition 70(1) 101-180
  4. International Accounting Standards Board, 2011, International Financial Reporting Standard 2 IASB, London.
  5. International Accounting Standards Board, 2011, International Financial Reporting Standard 13 Fair value measurement. IASB, London.
  6. International Accounting Standards Board, 2011, International Financial Reporting Standard 10 Events after reporting period. IASB, London.
  7. Current-purchasing-power (CPP)
  8. Continuously contemporary accounting (CCA), retrieved Dec, 2014
  9. Guidance Document for Highway Infrastructure Asset Valuation taken

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Financial Reporting Ratio Analysis

Financial Reporting and Ratio Analysis Essay

Ratio Analysis – Part One

Ratio Analysis And Financial Reporting – 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%

Ratio analysis – 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 analysis 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 analysis 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 analysis 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.

Ratio Analysis – 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.

Ratio analysis – 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 and forms of key ratio analysis. 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 – Ratio Analysis

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

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