Accounting and Finance for Managers - Accounting Essay Example

Financial Statements play a significant role in the decision-making process of several stakeholders in a company’s operations - Accounting and Finance for Managers introduction. Existing and potential stakeholders have been found to be typically unsatisfied over the level of detail offered in GAAP financial statements (Sinnett & Graziano 2006, p.4). In the study published by the Finance Executives Research Foundation (FERF), it was further found that shareholders, in general, find operating data more useful and, hence, more desirable for their purposes. Although the interests of existing and potential shareholders vary, i.e. potential shareholders can profit from short selling over-valued stocks whilst existing shareholders are mainly concerned with continued profitability, the informational requirements are more or less equal.

In the annual reports provided for Marks & Spencer Group PLC and Tesco PLC, accounting and non-accounting metrics were found in somewhat copious amounts but were intended to highlight only certain aspects of operations. As an example, both companies have made significant investments on operations in other parts of the globe such as Asia. Both existing and potential investors would be wont to closely monitor the performance of subsidiaries and operational extensions in these parts as indicative of long-term growth potential, particularly with respect to emerging economies such as China, India and Southeast Asia. However, the utility of segment data is, as can be seen in the table below, questionable. Although the figures relay information such as the profitability of main segments, the level of detail offered in the annual reports fails to relay crucial information such as the extent of either company’s operations in specific parts and specific localities of the globe. In the case of M&S, the annual report aggregates operations outside of the U.K. into “international”, and segment reporting fails to adequately provide existing and potential shareholders the information needed to assess growth potential in international markets or to even make reasonable estimates on the scope of operations in particular markets.

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Tesco, PLC
M&S, PLC
(figures in £ millions)
UK
Rest of Europe
Asia
UK
Inter-national
Sales Revenue
29,990
5,095
4,369
7,275
522.7
Segment Operating Profit
1,788
263
229
785
65.6
Operating Profit Margin
5.96%
5.16%
5.24%
10.78%
12.55%
Table 1
In the study performed by FERF, it was found that lenders and, to infer, suppliers require information on the liquidity and stress the importance of auditing in generating an accurate picture of financial position. Also mentioned was that among the most important information required by creditors is an up-to-date schedule of aged receivables, payables and inventory. Neither annual report includes such a schedule, but lenders could conceivably affix such a requirement among debt covenants as an arrangement undisclosed in the annual report. It is also of note that M&S PLC’s financials lack figures concerning the cost of goods sold and operating expenses, unlike Tesco PLC. Cost data is of great utility in analysing inventory turnover – a measure of the firm’s ability to convert purchases into sales and an indirect measure of its ability to efficiently handle liquidity.

Financial statements, lacking supplementary data on accounts with bearing on liquidity, are still useful in analysing the ability of the company to finance credit obligations since acceptable measures such as current, acid-test, and interest coverage ratios can be determined with financial statement data. Creditors would find that M&S PLC’s preference for aggregating operating costs and the cost incurred in the purchase of inventory to be

Employees would be interested in financial statements in cases where internal incentive plans are based on financial performance (Sinnett & Graziano 2006, p.7). Financial statements are of use also to employee unions and potential vested pensioners. The continued profitability and participation in pension plans signal a healthy company for employees. Financial statements can provide adequate information on the operating and financial health of the company – enabling employees to make informed decisions based on personal knowledge of the workings of the company and information from financial statements.

In either annual report, pension plans are suffering from deficits that could hinder the ability of both companies to finance its post-employment benefits in the future – a situation which might lead to a case similar to General Motors wherein the company’s pension liability hinders the ability of GM to competitively price their products. A salient point in the case of GM is that the deteriorating financial health of the company eroded its ability to compete and consequently led to layoffs and the closure of production plants.  Employees, then, look at company financial statements also to ascertain job security, aside from ensuring that pension benefits are more or less guaranteed.

As opposed to the employee monitoring company financials for job security and pension benefits, some employees can look into financials to ensure that the business is not too successful. Interest groups like labour unions can utilise financial statements when negotiating for improvements on compensation packages. For example, a firm continually outperforms other industry players in terms of return on investment. Financial statements provide sufficient information in this regard, and may be employed by unions in promoting the welfare of employees by justifying a general increases in remuneration because employees have made significant contributions in attaining above-average returns.

 

For the past operating year, M&S, PLC’s liquidity has made a definite downturn. As can be seen in the basic liquidity measures, the current ratio went down almost 15 percent from 0,67 to 0,57, constituting a 10 pence decrease in current assets for each Pound of current liabilities. The quick ratio, a more stringent measure likewise reports lowered liquidity albeit at lower rates, decreasing by a mere 2 pence per pound of current liability. A look at the company’s balance sheet accounts show an actually hefty increase of 32 percent in current assets. However, the lower liquidity is due to a disproportionate 62 percent increase in current liabilities. In particular, a cursory study of the company balance sheet shows that borrowings have more than doubled over the operating year. The main driver for the growth in borrowings are medium term notes maturing within the current year and is bolstered by the fact that non-current assets have made a significant dip by 25 percent.

The repayment of the medium-term notes pose some worry for creditors as the company has operated on a working capital deficit for the 2 operating years under review. However, it is noteworthy that free cash flow, measured by subtracting necessary capital expenditures from operating cash inflows, shows healthy levels with respect to the size of borrowings despite the 50 percent dip from 2005 levels. In 2005, free cash flow was valued at £1.688,1 million but went down to £842,6 million in 2006. The decrease in FCF is mainly due to a sudden surge in capital spending, indicative of improved future earnings (however, again, information presented in the annual report is incomplete and the level of detail is wanting, hence no data can be found to assure increases in profitability).

The company’s capital structure has made drastic improvements between the 2 operating years. In 2005, there was some £4,35 worth of debt for every £1 in equity as compared to 2006 which posted a mere £3,51 of debt for each £1 of equity. Presumably, the significant dip in the company’s liquidity position and decrease in debt-to-equity ratio was due to the usage of funds to clear debts. However, the true nature of the lower debt ratio was due to a 5 percent increase in retained earnings – half of which was based on the £523,1 million net profit raked in during 2006 and £586.2 million in 2005. The two successive years of profit allowed for, perhaps justifiably so, increases in debt holdings while actually improving the debt ratio.

It terms if profitability, the company managed to squeeze out 2 pence more for each £1 in revenue. The figures say that revenue grew by a mere 4 percent while operating costs and the cost of goods sold increased, aggregately, 31 percent. In real terms, the growth in revenue outstripped the growth in operating costs by more than £1,5 – meaning that for each £1,5 increase in revenue, operating costs increased by only £1, explaining the increase in both gross and profit margins. With the maturing medium-term debts mentioned above, the profit margin is likely to increase further as some £900 million matures in the current year, lowering the demands on income before interest payments.

Total asset turnover is lower during 2006 as the ratio shows a drop of approximately 4p constituting lower productivity for investments in assets, even with the £300 million increase in revenue. This is because assets grew by a full 7 percent between the operating years – largely because of increases in inventory and cash & cash equivalents. Perhaps the company is currently in an expansionary phase further indicated by a 134% increase in capital expenditures during 2006. In 2005, capital expenditures and financial investments capped at £113 million but made a dramatic increase to £266 million in 2006. Since, as aforementioned, the company lacks cost data, inventory turnover could not be reasonably ascertained. However, the disproportionate increase in operational costs is still of concern for existing and potential shareholders. Should the trend continue, the profitability of the company is sure to be eroded in no time at all.

M&S, PLC has had a successful run in the past 2 operating years. The earnings-per-share ratio shows that the company managed to increase profitability for investors by some 7,61 percent between 2005 and 2006. A measure of investor confidence is the P/E ratio. In this particular case, the historical prices could not be found without difficulty, hence the most current price was used. As of January 5, 2006, company shares are trading at 0,734 per share and, computing for the P/E ratio, shows that investor confidence is waning. In 2005, the P/E ratio was at 2,54 but dipped down to 2,36 in 2006. Should the figures prove more or less accurate, investor sentiment has gone down but the company appears poised for growth. The expansionary setup of increased capital expenditures and increased holdings in cash and inventory show that the company could turn out to be undervalued – worthy of some note and perhaps of investment.

Overall, M&S, PLC shows the picture of a healthy British company capitalizing on profitable years by channelling funds into capital expenditures. The company appears to be poised for growth but the lower investors’ confidence evidenced by the lower P/E ratio shows that the company’s liquidity position is cause for worry. However, it is the contention of this analysis that the lower investor confidence is driven mainly by inaccuracies in the computation of the P/E ratio since historical share prices could not be found. Moreover, the lower liquidity is actually a signal for growth and a sign that the company is currently in an expansionary phase poised for growth and further improved profitability in the current operating year.

 

 

 

 

 

 

 

 

 

 

 
2006
2005
Current Ratio
0.57
0.67
Quick Ratio
0.38
0.40
Working Capital (in £ m)
-874.9
-405.1
Total Debt-to-Equity Ratio
3.51
4.35
Profit Margin
0.07
0.05
Gross Margin
0.11
0.08
Total Asset Turnover
1.50
1.54
Total Equity Turnover
6.75
8.24
EPS
0.311
0.289
P/E Ratio
2.36
2.54
FCF (in £ m)
842.6
1688.1
Table 2
 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Reference List:

 

2006, ‘Annual report’, Marks and Spencer Group PLC, [Online], Available at:

http://www2.marksandspencer.com/thecompany/investorrelations/annual_review06/downloads/index.shtml

 

 

Sinnett & Graziano 2006, ‘What do users of private company financial statements want?’, Financial Executives Research Foundation (FERF), [Online], Available at:

http://www.nfib.com/object/IO_29293.html

 

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