Managing Finance 3000 words

Answer to part (a)

Financial statements have to be prepared and submitted to the relevant authorities for statutory obligation and also for other users of the financial reports such as investors to make investment decisions.

For that reasons published financial statements of companies have to be reliable and free from material misstatements that would lead to making wrong decisions.

There could me various reasons why users of published financial statements may questions reliability of the published statements of companies. It could be result of a deliberate act to publish false figures then it becomes a fraud, or could be mistakes on the figures or even could be due to the accounts policy differences between the companies in the same country or accounting standards of countries that make it difficult to make comparisons.

One obvious reason is the manipulation of figures to report more profit on Profit and Loss (P&L) account or trying to show higher value for the company’s net assets on the Balance Sheet (BS). This way company can attract more investors for the shares or possible acquisitions. It can be argued that directors of the company may be involved in the preparation of manipulated figures of the statements to report high profits in order to receive more cash bonuses at the end of financial year.

The second reason might be due to accounting policy of the companies. Some companies use historical cost records for the tangible assets and no value for the intangibles. The assets thus do not give the true value of the company. Intangibles also are very difficult to value.

Another reason would be issues related to the independence of external auditor. External auditor of companies verifies the financial statements and confirms whether or not statements give “true and fair view” of the company’s situation and they report this to the shareholders. As the test carried out by external auditor is an important verification to shareholder they are expected to report any material misstatements that would give users wrong information. The external auditor may however have a commercial interest too and that affects the independency of the auditor and misstatement may be overlooked and if the company does not have an audit committee or it has but not noticed by them then financial statements will give wrong information.

For above reasons the accuracy and reliability of financial statements will be questioned by their users. Harmonisation and standardisation of accounting standards work towards the way to close the gap between different countries standards and treatments of transactions. There are also new governance regulations such as Sarbanes-Oxley that have emerged as a response to corporate failures that have failed to protect the interests of shareholders and other stakeholders. But one can argue that to what extent these improvements can prevent companies to give deliberate misstaments on their financial reports to achieve their short-term profit targets at the expense of long-term targets or how much the differences between countries will erode.

Answer to part (b)

Limited Liability means that the limited company’s potential liability to ‘outsiders’ with whom it deals is limited to its own assets irrespective of, and distinct from, its shareholders’ assets plus, in the event the limited liability company is wound up, any moneys owing to the limited company by its shareholders representing unpaid moneys is nil.

It also means that the liability of the shareholder to the limited company, in normal circumstances, can never be more than what the shareholder has agreed to pay the limited company for the shares in the company

Very common criticism is that corporations receive special privileges from the state “limited liability”. They can take all the benefits of being their liability limited and in case of failure of the organisation the risks are passed on to the community because when a big corporations fails its effects are felt by many of smaller units, employees and other organisations due to increased regulations in corporate governance and related standards, which put extra costs on all businesses because there is more compliance required and technical staff needed to ensure the compliance. Employees however do not have any protection against this and they feel the much pain when jobs are lost.

Limited liability protects the owner of the organisation and its directors walk free. There are several large corporate failures which have brought corporate governance into scrutiny. Enron and World.com are classic examples.

Enron case

Enron, once the world’s largest energy company, was ranked number seven in Fortune’s ranking by market capitalization of the five hundred largest corporations in the United States. On December 2001, Enron filed for bankruptcy. The sudden and swift collapse in the market value of this corporate giant has had major ramifications for nearly all of its stakeholders including, but not limited to, its shareholders, employees, creditors, and auditors. The causes and consequences of the Enron bankruptcy filing highlights the social impact of business failure.

Uma et al (2002) argued that it has become increasingly evident that corporate failure of the magnitude of Enron causes serious economic, political, and social dislocation.

The public firm’s financial statements are to be reviewed by independent external auditors. The firm’s external auditors have a duty to be objective in their review of the firm’s financial statements. While it is the responsibility of the firm’s management to prepare the financial reports, it is the responsibility of the firm’s external auditors to express an opinion on these financial statements based on their independent audit.

Enron’s external auditors Andersen LLP (Andersen) performed both the external and the internal audits for Enron and also served Enron as a consultant in non-audit and tax matters. Andersen’s three-way relationship with Enron created the possibility for several conflicts of interest. The consequences of this failure and its social effects can be summarised as follow:

• As the value of Enron stock plunged in value, many Enron employees lost their jobs and nearly all of their retirement savings. To make matters worse, many of these employees were restricted from selling their stock even as the stock price declined in value, while senior officers of the firm were able to sell their Enron stock without similar restrictions.
• The steep financial losses and loss of jobs is not limited to the employees of Enron. Over 28,000 employees at Andersen’s U.S. operations, many of whom were completely uninvolved with the Enron audit, are at risk of losing their jobs and thousands of Andersen employees have already been laid off.
• The sharp and sudden decline in the value of Enron stock adversely affected the retirement savings of thousands of ordinary Americans who had no direct connection with the firm.

There are many levels of blame in this corporate crisis. Enron’s top managers are clearly responsible for poor business decisions and mismanagement of the corporation because the Board of Directors for any corporation is an important body in the provision of effective corporate governance and oversight of management. Enron’s collapse also might have been averted had there been a truly independent and objective review of its financial statements by its auditors

As all of these points discussed above justifies Dan Atkinson’s comments. He may have taken too extreme view on the nature of limited company as there are also benefits of limited liability to the stakeholders. Several corporate failures due to limited liability should not provide enough grounds to reject it altogether.

A limited company has a legal existence separate from management and its members (the shareholders)

The protection given by limited liability is perhaps the most important advantage of incorporation. The members’ only liability is for the amount unpaid on their shares. Since most private companies issue shares as “fully paid”, if things go wrong, a members’ only loss is the value of the shares and any loans made to the company. Personal assets are not put at risk. This should encourage entrepreneurs to invest and bring their ideas to the market to the customers to benefit from.

Once formed, a company has everlasting life. Directors, management and employees act as agent of the company. If they leave, retire, die – the company remains in existence. New Shareholders and Investors can be easily introduced

The process of lending to a company is also easier than with other business forms. The lending bank may be able to secure its loan against certain assets of the business (a “floating charge”) or against the business as a whole (“fixed charge”.

Approved company pension schemes usually provide better benefits than those paid under contracts to self-employed sole trading businesses.

As limited liability companies especially PLC has access to capital markets and can offer its shares for sale to the public through a recognised stock exchange.

Reference: Uma V. Sridharan, Lori Dickes, W. Royce Caines, “The Social Impact of Business Failure: Enron”, American Journal of Business Fall 2002: Vol. 17, No.2

Answer to part (c)

Profitability ratios

Profitability ratios are used to assess a business’ ability to generate earnings as compared to expenses over a specified time period. These ratios show how profitable is the business, measuring its overall performance. They examine the profits made by a firm and compare the figures with the size of the firm, the assets employed by the firm or its level of sales. These ratios can be used to examine how well the firm is operating or how well current performance compares to past records or to other firms.

Profit margin

It is calculated by finding the profit as a percentage of the sales (Profit / Sales x 100)

Profit before taxation is generally thought to be a better figure to use than profit after taxation, because there might be unusual variations in the tax charge from year to year which would not affect the underlying profitability of the company’s operations. Therefore, taxation is ignored in the calculations of profitability ratios.

Another profit figure that should be calculated is Profit Before Interest and Tax (PBIT) because this is the amount of profit which the company earned before having to pay interest to the providers of loan capital. However, it is not possible to work out this profit figure as the finance cost is not given.

Tesco Plc

Although Tesco’s sales increased by 4.3% over the year profit increased by nearly 6% due to the fact that purchases did not rise in the same proportion as sales. This is reflected in the profit margin by improvement from 7.5% to 7.6%.

Sainsbury has had a good growth in revenue (13.3%) but the profit margin has dropped by 0.3 percentage point. This is due to the percentage increase in cost of sales being more than percentage growth in revenue. It could be due to poor cost control, one-off high expenses during the period, increased costs of stock, as stock has risen by £50m, or even could be because of fixed cost behave in a manner that they are fixed up to a certain level of volume, and then they increase to an even higher level of fixed cost to a certain level of volume (step-fixed costs). The reason can be analysed with further information.

ROCE

It is impossible to assess profits or profit growth properly without relating them to the amounts of funds (capital) that were employed in making the profits. The most important profitability is therefore return on capital employed (ROCE), which states the profit as a percentage of the amount of capital employed. Capital here means the share capital and reserves plus long-term liabilities and debt capital, thus profit must mean the profit earned by all this capital together. This is PBIT, since interest is the return for loan capital and dividend is the return for the equity providers

ROCE = Profit before interest and taxation   x 100

Capital employed

From the calculations it can be argued that Tesco’s ROCE has fallen but Sainsbury’s ROCE has gone up. As ROCE is a measure of how well the capital of a business are being used to generate profits it is certain that Sainsbury’s capital returned more profit than Tesco’s.

It can also be argued that Sainsbury’s ROCE has improved over the year (from 20.1% to 21.7%) whereas Tesco’s ROCE has dropped (from 20.6% to 19.4%). Some of this may be due to the increase in fixed assets of Tesco which will have increased capital employed and reduced profit by larger depreciation charges. Because Tesco’s fixed assets are £794m higher than previous year, its equity and reserves are also £728m higher. The effect of this should be considered.

It is also worth commenting on the change in sales revenue from one year to the next. It is noticed that Sainsbury achieved sales growth of over 13% from £14,500m to £16,433m over the year and this is certainly one of the most significant aspect of higher ROCE than Tesco, which has attained only 4.3% sales growth.

Liquidity ratios

The standard test of liquidity is the current ratio. It can be obtained from the balance sheet.

Current ratio = Current assets

Current liabilities

The idea behind this is that a company should have enough current assets that give a promise of cash to come to meet its future commitments to pay off its current liabilities. A ratio in excess of 1 should be expected.

Both Tesco and Sainsbury’s current ratio from the calculations is just below 1 but cash is excluded in the figure because it is not known.

Most inventories are not very liquid assets, because the cash cycle is so long. For these reasons, an additional liquidity ratio known as the quick ratio or acid test ratio should be calculated.

Quick ratio: Current assets less inventory

Current liabilities

Quick ratio should be ideally at least 1. However, different businesses operate in very different ways. Tesco and Sainsbury are a supermarket group thus have low receivables (people do not buy groceries on credit), low cash (good cash management), medium inventories (high inventories but quick turnover, particularly in view of perishability) and very high payables. Therefore, it is normal to expect both current and quick ratios to be lower than 1 for retailers such as supermarkets as we cannot compare this with manufacturing organisations.

What is important us the trend of these ratios. From thus, we can easily ascertain whether liquidity is improving or deteriorating. If Tesco and Sainsbury have traded for the last ten years with current ratios of 0.8 and quick ratio 0.7 then it should be supposed that they can continue in business with those levels of liquidity. It is the relative position that is far more important than the absolute figures.

To understand the liquidity position of organisation we need also to analyse the efficiency ratios; control of receivables and inventories.

Accounts receivable collection period

A rough measure of the average length of time it takes for a company’s customers to pay what they owe is the accounts receivable collection period and is calculated as:

Trade receivables x 365 days

Sales

From the calculations Tesco’s and Sainsbury’s receivable collection period is pretty similar in the range of 30.3 days to 31.0 days.

This ratio does not help in identifying whether or not the companies in retail business are doing well. It is because majority of the sales of supermarket groups are in cash therefore they have hardly any trade receivables at all, which is as low as 0.5% in this case.

It is also the estimate of the accounts receivable collection period is only approximated, because:

• The balance sheet value of receivables might be abnormally high or low compared with the normal level the company usually has
• Sales revenue in the P&L s exclusive of sales taxes, but trade debtors in the balance sheet are inclusive of sales tax. We are not strictly comparing like with like.

Accounts payable period

This is ideally calculated by the formula:

Trade creditors x 365 days

Purchases

The payment period often helps to assess a company’s liquidity; an increase is often a sign of lack of long-term finance or poor management of current assets, resulting in the use of extended credit from suppliers, increased bank overdraft and so on.

From the calculation we see that Sainsbury’s payable period is 1 ½ days shorter than Tesco’s in this year whereas it is almost same in the previous year.

Both supermarket chains show similar characteristics just below 30 days. If we assume normal credit given by the suppliers is 30 days and both pays before due dates it may be because they receive a good discount if payments are made earlier. Because Tesco and Sainsbury is cash rich business they have no problems in paying the suppliers, as it is the case in manufacturing businesses.

Stock turnover period

Another ratio worth calculating is the stock turnover period, which indicates the average number of days that items of inventory are held for. It is calculated as follow:

Stock turnover =           Stock x 365 days

Cost of sales

This is another measure of how vigorously a business is trading. A lengthening stock turnover period from one year to the next indicates:

• slowdown in trading; or
• a build-up stock levels, perhaps suggesting that the investment in inventories is becoming excessive.

From the calculations it can be argued that Sainsbury converts inventory into cash quicker than Tesco, about 6 – 8 days faster. However, Sainsbury’s stock turnover increased by 1.1 day at the same time as Tesco’s improved by 1.4 day. Presumably if the stock turnover period and receivables collection period are added together, this should give us an indication of how soon the stock is converted into cash. This year Tesco converts the stock into cash in 55.8 days (30.4 + 25.4) but Sainsbury did it in 49.3 days (30.3 + 19), whereas last year it was 57.8 days for Tesco and 48.3 days for Sainsbury. This definitely indicates that Sainsbury receives the cash back from the inventories quicker which can be stated that it gives better liquidity position to Sainsbury than Tesco.

However, it is difficult to say higher the stock turnover the better or the lower the better because there are several other aspects of stock holding policy have to be balanced such as lead times, alternative use of warehouse space, bulk buying discounts and seasonal fluctuations in orders. Cost of stock to businesses like Tesco and Sainsbury is quite high, as there are hundreds of products to store and some of them are highly perishable. Companies try to use Just in Time stock policy to reduce the cost of holding stock and product obsolescence.

APPENDIX