Section 1:
Cash Flow Statement
*Refer to excel sheet for all the calculations
**We have started Cash Flow with operating income as even with net income we had to add back items to reach at operating income only.
Importance of Cash Flow Statement
Unlike other financial statements, Cash Flow Statement details the position of cash in the company. While both the income statement and Balance Sheet are made on accrual basis, Cash Flow is made on cash basis of accounting. In this way, Cash Flow Statement provides a detailed and an in-depth overview of cash inflows and outflows from the company. Below discussed is some other important advantages offered by Cash Flow Statement:
- This is the only financial statement that indicates the difference between net profits and the actual cash profits. Important to note, because of accrual accounting, a company may show high net margins but in reality it may be running out of money as the cash could be tied up in accounts receivables, etc.
- It divides the cash position under operating activities, investing activities and financing activities. This provides a more comprehensive overview to the readers.
- It allow the management to see as in which area the cash flow is less and where it is being spent more on comparing with the budgeted amount. In this way, Cash Flow Statement also supports appraisal and future planning in the organization.
Analyzing Cash Flow Statement of Queens Limited
Referring to the cash flow statement of the company we found that the company is having a highly sustainable cash position from operating activities amounting to $578. However, despite of such a promising cash flow number, the company ends up taking a bank overdraft of $36 courtesy high investment expenditure and repayment of debt proceeds. Important to note, while the CFO stood at $578, the company repaid debt amount of $440 alone and another investment expenditure relating to purchase of plant worth $206 followed by other financing and investment expenditure, respectively.
Hence, the operating cash position of the company is really encouraging but it is the high investment and financing outflow that leads to negative cash position at the end.
Section 2:
a) Ratio Analysis
In this section, in order to analyze the financial position of the company and ongoing financial trend, we will use the following set of ratios for the period of 2012 and 2013:
Liquidity Ratios:
The calculation of these ratios will help us in evaluating the credit risk of the company as it indicates the ability of the company to honor its short-term debt. Below are the two popular liquidity ratios of the company:
i)Current Ratio: Current Assets/ Current Liabilities
2013: 841/403= 2.08
2014: 1026/388= 2.64
ii)Acid Test Ratio: Cash+ Receivables/ Current Liabilities
2013: (346+3)/403= 0.86
2014: (478+32)/388= 1.31
Leverage Ratio
Another important ratio section that will provide us with an in-depth analysis relating to the composition of the capital structure of the company. Below calculated is the leverage ratio of the company:
vi)Gearing Ratio: Total Debt/ Total Equity
2013: 300/951= 0.31
2014: 100/1460= 0.06
Profitability Ratios
These ratios carries highest significance for the analysts, management, shareholders and other interested parties as it indicates the profit margin of the company. Below discussed are the profitability ratios of the company:
i)Return on Capital Employed(ROCE)= Operating Income/ Capital Employed
*Capital Employed: Total Assets- Current Liabilities
2013:224/(1681-403)= 17.52%
2014: 229/(1986-388)= 14.33%
ii)Gross Profit Margin: Gross Profit/ Revenue
2013: *Revenue not available
2014:* Revenue not available
iii)Operating Margin: Operating Profit/ Revenue
2013: * Revenue not available
2014: *Revenue not available
iv)Earning Per Share: (Net Income- Preferred Dividend)/Weighted Average Common Shares Outstanding
2013: 141/600= £0.23 per share
2014: 181/900= £0.20 per share
b)Financial Performance Analysis
Referring to the above calculated ratios, we have found that the company has been successful in ensuring strong liquidity roots over a period of one year. Important to note, while the current ratio of the company surged from 2.08 to 2.64 with major source of increase in the ratio multiple coming from current assets that increased by 22% while the current liabilities decreased by 20%, thus providing a combined effect on the increase in current ratio. We even tested the liquidity using the stringent measure, acid ratio and found the similar trend as the ratio multiple increased from 0.86 to 1.31.
However, our major concern came up on witnessing the trend in the leverage ratio and profitability ratios. As for solvency ratios, we noticed that the gearing ratio of the company has reduced significantly from 0.31 to 0.06. However, the decrease is not sustainable as on one hand, the company reduced their reliance on debt financing, but at the same time, equity was increased from£951000 to £1460000. This indicates that while the company removed the financial risk, it increased the dilution authority which is popular for imposing ill effects of clashes of the management with the shareholders.
On the other hand, the profitability ratios provided us with a similar indication as the return on capital employed which indicates how efficient is the management in utilizing its capital resources, decreased from 17.52% to 14.33%. Similar trend was witnessed in EPS multiple that despite of increased net income from £141000 to £181000, declined to £0.20 per share because of significant increase in the number of shares issued from 600 units to 900 units.
Our inference that the company is not performing financially well is validated through a brief analysis of the cash flow statement. Important to note, the net income of the company is hovering at £181000, however, the actual cash flow from operating activities is only £57000. This indicates that the increased net income during 2014 was more because of high dependence on credit basis rather than cash basis. In addition, referring to the cash flow from financing activities, we notice that the company repaid back debt amounting to £200000, however the cash availability was arranged through equity issue which fetched £370000 for the company.
Hence, our analysis indicates that at present, the company is not performing well and the entire trend in the profitability ratios is not appreciable at all. Thus, we would recommend avoiding the stock purchase of Chambers PLC.
c)Factors left out in the analysis process
As we must have noticed that the recommendation provided above, is only on the basis of quantitative analysis of the company. However, the prudent equity valuation process is a three step process that begins with environmental analysis followed by industry analysis and then, company analysis. Hence, we have ignored the beginning two steps of the equity evaluation.
As for economic analysis, we must analyze the ongoing macro-economic policies of the federal government, if any, to ensure the economic growth. As we know, the financial performance of any firm will depend on the existing economic conditions as the same decides the direction of consumer spending and many other economic aspects. Hence, it might be possible that during 2013-14, the economic policies were not good enough to support the economy growth on whole and this lead to poor performance of Chambers PLC. Thus, if it is expected that the new economic policies will be favorable in the upcoming year, we might have to change our recommendation for the company.
The next factor that we did not included in our analysis process is the industry analysis. It might had been possible that the IT industry as a whole could not perform well under the existing economic conditions during 2014 and if the industrial forecast is positive for the future, then once again we wiuld have changed our recommendation.
Thus, our recommendation should be based on both qualitative and quantitative analysis with appropriate consideration to the economic environment and industry trends and forecasts.
Section 3:
The situation described here is one of the most debated topics in the accounting world, but still with no answer to support either the fair value accounting system or any alternative accounting system to substitute it.
According to the provisions of FAS 157 proposed by Federal Accounting Standard Board(FASB), ‘’Fair Value Accounting is a financial reporting approach in which companies are required or permitted to measure and report on an ongoing basis certain assets and liabilities (generally financial instruments) at estimates of the prices they would receive if they were to sell the assets or would pay if they were to be relieved of the liabilities.’’ In other words, the act gives independence to the companies in deciding when to record fair value of their asset decrease or liabilities increase. Although there has always been a discontent among the accounting pundits over usefulness of the fair value accounting, the proposers provides the following benefit for the use of Fair Value Accounting:
- FAV accounting requires the companies to report more accurate and timely accounting items than under the alternative accounting methods, such as historical accounting method, etc.
- FAV accounting requires the companies to update the amount of financial items on regular and ongoing basis.
- FAV accounting limits the ability of the company to manipulate on their gains and losses as the transaction should be reported in the period they take place not when they are realized as a result of transaction.
However, first with Enron and then, the financial crisis of 2008, the academicians have proved that although the intent of GAAP standard is fair, but not of the corporates, as they use the independence over deciding the fair value of assets and liabilities for their own benefit and thus deprive the shareholders and other users of the financial statements with the fair accounting data. One of the primary reasons that we are proposing to avoid the use of Fair Value Accounting that it will indeed have a negative effect on the informational value of the financial statements and the magnitude of the same was seen latest during the financial crisis of 2008 that eroded trillions of dollars as the organizations misused the principles of fair value accounting. During that era, many companies started using FAV accounting considering the increased value it will bring to the business. However, the reality was much different as throughout the 2008 crisis, when the business sector solidified, association's advantages were seen to plunge to costs underneath their actual sensible quality. (Benston 2007) Thus, big banks like Lehman Brothers, Merrill Lynch and many others, reported high losses as their asset which they had recorded at fair value were now actually a misfortune for them. Thus, thousands of firm entered into insolvency as there financial statements which were made under FVA method were actually inflating the asset values providing false information to the investors.(Landsmann, Rayne, 2007) The whole process cost huge loss to the US economy as well.
Thus, considering the ill consequences and evil potentials of Fair Value Accounting, we will recommend not to use this method while the disadvantages could be summarized as follows:
- Every company has its own criteria to estimate the fair value which might be misleading for the shareholders.
- FVA method have been tested to produce adverse market effects and a possible threat to the whole financial system
- The losses reported by the company under FVA method are misleading as they are temporary and they will reverse as markets return to normal. Hence, everything is scripted under this method.
Works Cited
Benston, George J. 2006. “Fair Value Accounting: A Cautionary Tale from Enron.” Journal of Accounting and Public Policy 25. Online. Retrieved 29 June 2014 from http://www.bus.emory.edu/specproj/alumni_comm_tool/Benston%20Fair%20Value%20Acctg%20JAAP%202006.pdf
Landsmann, Wayne R. 2007. “Is fair value accounting information relevant and reliable? Evidence from capital market research.” Accounting and Business Research. Vol 37, Issue 1. Pg. 19-30.
Nikolaev, H. B. (2012). Does Fair Value Accounting for Non-Financial Assets. Chicago: University of Chicago.
Return on Capital Employed. (n.d.). Retrieved December 13, 2014, from Investopedia: http://www.investopedia.com/terms/r/roce.asp
Ryan, S. (2008). FAIR VALUE ACCOUNTING:UNDERSTANDING ISSUES RAISED BY THE CREDIT CRUNCH. New York: New York University.
Walters, S. (n.d.). Don't Overlook the Cash Flow Statement. Retrieved December 13, 2014, from http://www.ssh-cpa.com/newsroom-publications-dont-overlook-the-cash-flow-statement.html
What's the difference between "top-down" and "bottom-up" investing. (n.d.). Retrieved December 13, 2014, from Investopedia: http://www.investopedia.com/ask/answers/193.asp
