Question 1
Within an organisation, accounting plays an active role to ensure that all business transactions of monetary value are classified, recorded, measured, summarised and reported in an accurate manner by adhering strictly to basic reporting rules such as International Financial Reporting Standards (IFRS) or US GAAP. Accounting rules make sure that financial statements are prepared and reported accurately by complying strictly with all reporting principles. Additionally, accounting steps confirm that all financial information is included in reporting mechanism while financial statements contain no error or any material misstatement having huge financial consequences.
When the industry follows one accounting mechanism, it is ensured that the financial statements are reported with consistency. Here, accounting ensures that the financial statements reported by different companies in the same industry could be compared easily to analyse the financial performance over a certain time-frame. In the same manner, accounting plays an important role in financial reporting that it facilitates comparison of business practices of different organisations within the same industry.
The Role of Accounting within an Organisation with Respect to Decision Making Aspects
The role of accounting within an organisation is to classify, record, measure an summarise business transactions, interpret financial information and communicate the financial results to all stakeholders. As accounting helps managers produce key financial statements, they help different internal and external stakeholders to analyse financial information to make business and investment decisions. The income statement, derived from accounting steps, helps stakeholders gain an insight about financial information of an organisation over a specified period. In contrast, balance sheet shows financial position of the business at end of a specific period.
Given that accounting provides an information about an organisation, sources of income, costs, operating expenses, assets, short and longer term liabilities as well as owner’s equity, business owners rely on this information to make decisions about reducing the costs and expenses while increasing profit generation capacity. Using accounting-based financial statements, management could make decisions about asset utilisation, debt management in the capital structure, cash and receivables management, inventory handling and other critical decisions.
Question 2 - The Structure of and the Terms used within the Main Financial Statements
For every organisation, the financial statements are categorised into the income (profit and loss) statement, the balance sheet (statement of financial position), statement of cash flows (prepared with ether direct or indirect method) as well as statement of changes in equity. In each statement, different structure and numerous terminologies are used to report temporary and permanent accounts.
For instance, income statement which is reported over a specific accounting period analyses different sources of revenue for an organisation followed by deduction of costs of generating such revenue (cost of goods sold). After deriving gross profit this way, operating expenses of the business are deducted to produce operating income. Operating expenses include sales general and administrative (SG&A) expenses, depreciation expense, insurance expense, rent expense and research and development (R&D) expense etc. Afterwards, the interest expense and tax liability over a period are deducted to arrive at net income of an organisation.
The balance is divided into two sections. The first section is the total assets; which is further subdivided into current and non-current (fixed) assets. Current assets include cash, marketable securities, receivables, ending inventory and prepayments. Fixed assets include property, plant and equipment, land, machinery as well as building etc followed by deduction of accumulated depreciation of the concerned fixed or tangible asset. Addition of current and fixed assets figure gives a total of assets at end of a specific period.
The liabilities section of balance sheet includes short and long maturity obligations of an organisation. Short or current liabilities have maturity of one year or less and include accounts payable, notes payable, deferred tax liability and other short maturity obligations. Long-term liabilities include loans/debt borrowed with maturity of over one year. Additionally, the owner’s equity section reflects the financial contributions by all owners including common stock (if any), amount of retained earnings, previous profit and loss as well as treasury stock, if any.
Part 3: Ratio Analysis
Introduction
The section of the paper is commissioned to gain a practical insight of the accounting concepts through the purview of financial statement analysis and using the tool of financial ratios. As part of this paper, we will be performing financial analysis for Arsenal Football Club for the year 2012/13 and 2013.14 using multiple financial ratios. Additionally, the ratio multiples calculated for this club will also be compared with that of UK based supermarket chain, J Sainsbury for the aforesaid financial year. However, before initiating with the ratio analysis section, we will introduce a brief discussion relating to the importance of accounting in a business entity and how it facilitates the decision making process.
Ratio Analysis
As informed in the introductory section of this report, the objective of this report is to perform a comprehensive financial analysis of both the companies, henceforth, we will be calculating multiple ratios to gain insight into the financial standing of the entities:
-Liquidity Analysis
i)Current Ratio: Current Assets/Current Liabilities
Arsenal
2013: 265346/149931= 1.76
2014: 293165/203032=1.44
Sainsbury
2013: 1901/3115= 0.61
2014: 4362/6765= 0.64
ii) Quick Ratio: Cash+ Receivables/Current Liabilities
Arsenal
2013: (153457+88484)/149931= 1.61
2014: (207878+65642)/203032= 1.34
Sainsbury
2013: (517+306)/3115= 0.26
2014: (1592+433)/6765= 0.28
Referring to the above figures, we can see that while Arsenal has witnessed a declining trend in the liquidity ratios, it is relatively more liquid compared to Sainsbury. Beginning with the current ratio, owing to higher proportionate increase in the current liabilities by 35.41% relative to 10.48% increase in the current assets, the ratio multiple decreased from 1.76 to 1.44 during 2014. On the other hand, Sainsbury witnessed an increasing trend with the ratio multiple increasing from 0.61 to 0.64 on account of higher proportionate increase in the current assets compared to the current liabilities.
We also tested the liquidity standing of both the companies using the stringent measure of quick ratio and found the similar trend to what we witnessed in the current ratio. As for Arsenal, the club witnessed a decreasing trend in the quick ratio, which plummeted from 1.61 to 1.34 with the increase in current liabilities surpassing the proportionate increase in the cash and the current receivable amount. On the other hand, Sainsbruy was able to solidify its liquidity position of significant increase in cash that increased by 207.92%, although the effect was neutralized on account of 117.17% increase in the current liabilities, and the quick ratio increased marginally from 0.26 to 0.28.
Overall,our results indicate that even though Arsenal has witnessed a declining trend during 2014, however, compared to Sainsbury, the company is highly liquid and with current and quick ratio of the company close to each other, this signals that the current assets of the company is largely composed of highly liquid assets such as cash and receivables.
Profitability Analysis
i)Operating Margin: Operating Profit/ Revenue
Arsenal:
2013: -28281/280374= -10.08%
2014: 10064/301872= 3.33%
Sainsbury:
2013: 882/23303= 3.78%
2014: 1009/23949= 4.21%
ii) Return on Equity: Net Income/ Total Shareholder Equity
Arsenal:
2013: 5805/303355= 1.91%
2014: 7271/310618= 2.34%
Sainsbury
2013: 602/5838= 10.31%
2014: 716/6005= 11.92%
Profitability ratios are the most sought after ratios by the majority of the stakeholders as it indicates the amount of margin being earned by the company using the available resources. Referring to the above calculations, we can see that during 2014, Arsenal Club successfully managed to pull itself out from the environment of operating losses as compared to the operating loss of -3.30% in 2013, it registered an operating profit of 3.31% during 2014. Important to note, this astounding turnaround in the profitability position of the club is attributed to increase in the revenue figures by 7.66%, while the operating expenses decreased by 5.77%. On the other hand, even Sainsbury witnessed a sustainable increase in the operating margin, which increased from 3.78% to 4.21%. Just like Arsenal, even Sainsbury benefited from the controlled cost structure while the increase in the revenue figures assured high operating margin.
Next, we analyzed the profitability situation from the perspective of the equity shareholders by calculating Return on Equity(ROE). Important to note, equity investors endow immense consideration on this ratio multiple as it indicates the margin earned by the company on the equity capital available with it. Referring to the above calculation, we witnessed that even though both Arsenal and Sainsbury had witnessed an increasing trend in the ROE multiple, Sainsbury profit margin on equity capital clearly surpassed to that of Arsenal. This indicates that investors will show more confidence in Sainsbury compared to Arsenal club.
Overall, the results indicate that even though both the entities are witnessing increasing profitability trend, however, compared to Arsenal, Sainsbury is more profitable and deserves shareholders inkling because of high ROE multiple.
Solvency Position
-Debt/ Equity Ratio: Total Debt/ Total Equity
Arsenal:
2013: 274721/303355= 0.90
2014: 266478/310618= 0.85
Sainsbury:
2013: (144+2478)/5838= 0.44
2014: (507+2089)/6005= 0.44
-Interest Coverage Ratio: Net Interest Expense/ Operating Income
Arsenal:
2013: 12996/-28281= -0.45
2014: 13018/10064= 1.29
Sainsbury:
2013: 134/882= 0.15
2014: 139/1009=0.14
Solvency ratio assists the analyst in understanding the composition of the capital structure of the firm and how capable is the company to handle the debt related burden. Referring to the above calculation, we can see that during 2014, Arsenal Club reduced its reliance on debt financing and the same is validated with debt-equity ratio that decreased from 0.90 to 0.85. At the same time, the interest coverage ratio peaked from -0.45 to 1.29. Therefore, decreasing debt-equity ratio and increasing interest coverage ratio confirm the strong solvency position of the firm. On the other hand, there was no change in the capital structure composition of the company during the year as the debt-equity ratio stood constant at 0.44 although interest coverage ratio declined marginally from 0.14 to 0.13.
Overall, in terms of solvency, both the companies are at par.
Conclusion
Comparing both the entities, we found that each of them is surpassing another in one the ratio sections. For instance, while Arsenal has a strong liquidity standing, Sainsbury surpasses in terms of high operating profitability and return on equity capital.
Overall, both the companies have shown financial strength and we do not see any major risk involved. However, on comparison basis, we will suggest to go for Sainsbury as the entity is earning higher profitability.
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