1. Introduction – Objective of Financial AccountingThe main objective of financial accounting is, as usually stated by the regulators of accounting in their framework, to provide financial information about the financial performance, position and stability of an organization over a stipulated time period, to aid interested users in their economic decisions (International Accounting Standards 2000, p 46). A vast number of interested external users are identified by the International Accounting Standards Framework on page 44. Out of this list we will discuss in the following sub-section how financial accounting aids investors, lenders, governments and their agencies and employees and union representatives in the decision-making process.
1. 1 Evaluation of financial accounting in decision-making1. 1.
1 InvestorsThe users of financial information that will be discussed under this section are those that provide finance to limited liability companies. Frequently these types of investors are not directly involved in the management of the company, like those that invest in sole traders and partnerships. Therefore they demand financial information in order to evaluate their investment and also assess management stewardship (Weetman P.
2003, p 13). An important economic decision that arises for investors is do I need to keep the same investment balance, invest more in the company or sell this equity investment. The answer to this question arises from judging a number of factors concerning the corporation. For instance, they will evaluate the financial performance of the company, assess the return derived from the investment, gauge the liquidity of the business enterprise and its ability to pay its long-term commitments, ascertain the capital structure of the firm and more (Wettman P.
2003, p 13 – 14). The financial information provided in the profit and loss account, balance sheet, cash flow statement and accompanying notes presented in the annual financial statements, provide valuable information to endow a good judgment on the aforesaid points (International Accounting Standard 2000, p 82). For example, the Balance Sheet can assist in the determination of the capital structure, financial stability and liquidity of the organisation. Therefore with the aid of financial statements the investor can evaluate the financial health of the company and assess the risk of his investment. However, we have to keep in mind that today’s business environments entail fierce competition and highly dynamic markets, which drastically increase the risk of bankruptcy. Thus the need arose for the investor to forecast the future operations of the firm. A severe disapproval arises on financial accounting on this area.
Critics contend that financial information conveyed in financial statements is not appropriate to aid investors because it is based on past events and the values portrayed are measured on historical costs that do not reflect the true value of the assets and liabilities as at that date (Lewis R. et al 1996, p 45 – 46). 1.
1. 2 LendersThe main objective of lenders is to ascertain that the loans forwarded to the organisation are secure in the sense that they will be repaid together with interests due. Loans are normally granted on a long-term basis. Therefore lenders will not only focus on the financial position of the firm. They will also consider the financial stability together with the profitability of the corporation that provides significant evidence on the going concern of the company. The information shown in the financial statements provides proper financial information to help these entities evaluate the financial health of the firm (Wettman P. 2003, p 15). The limitation mentioned in the previous section about information set on past events holds too for this group of users.
However, sometimes lenders seek additional financial information specific to the loan demanded. For example, if an organisation requests debt finance for a specific project, lenders would demand financial information concentrated on such activity. A business plan is normally provided in these instances, which consists of a specified plan on the project at hand. It normally comprises description of the project, objectives and strategies, market information, financial information like forecasted profit and loss and cash budget together with operational controls. Therefore financial accounting provides other valuable information to lenders in order to assist them in their decisions.
Indeed these documents entail even forecasts which diminish the limitation on lack of budgeted information mentioned in the previous paragraph. 1. 1. 3 Governments and their AgenciesThe government together with its regulatory agencies seeks accounting information to examine the allocation of resources, control the activities of the firm and obtain funds to sustain the public goods and the economy of the country through fiscal measures (Wettman P. 2003, p 16).
With respect to the latter aim, the profit and loss account provided in the financial statements wholly meets such request. The assessment of taxation due is carried out by examining the profit on operations. Indeed these financial reports provide additional disclosure on the computation of taxation (Wettman P. 2003, p 181).
As regards the first two objectives, information is periodically demanded to meet such aim. For example, in the United Kingdom, The Office of Telecommunications and The Office of Gas and Electricity Markets demand financial information to monitor the prices charged to clients by these firms (Wettman P. 2003, p 16).
As one can note, the information portrayed in the financial statements is not sufficient for such economic needs. In this respect, organisations are intermittently asked to provide accounting data necessary for such activities. Yet financial accounting is also able to cater for the aforementioned specialised needs. 1. 1.
4 Employees and Union RepresentativesWorkers and their representatives are interested in accounting information that helps them assess the profitability and financial stability of the corporation in order to evaluate the job security (Wettman P. 2003, p 14). This is an important issue for employees and should not be taken lightly, especially when specialised jobs are performed in the firm.
We ought to keep in mind the financial hardships that employees face from unexpected bankruptcies like Enron that suddenly result in lost jobs and pension funds. Staff will also take into account the cash flow position of the business enterprise to ensure that the company holds sufficient cash to meet wage commitments (Wettman P. 2003, p 14). Financial statements portray appropriate information to aid in the above mentioned decisions. By examining thoroughly the financial statements of the firm one can appropriately assess the financial position, performance and stability of the company. Yet, at this stage, one may state, if they provide suitable accounting data, how do incidents like Enron happen? The answer to this question stems from analysing the case at hand and understanding the facts that arose in such incidents. For example in Enron, employees were not aware of the financial crises of the company because the executive management in charge cooked the books by adopting a different accounting measurement, showing substantial fictitious profits. Therefore this highlights the need that appropriate controls are enacted by accounting regulators and good measurement bases are suggested in the preparation of financial accounting information to ensure appropriate reliability in the accounting reports, which as we can see are an important tool in the decision making process.
1. 2 Financial Analysis of Companies X, Y and ZThe financial examination of companies X, Y and Z shall concentrate on three important facets of the organisation that have already been referred to in the previous section. These are the financial performance, position and investor’s solidity on the firms. A final thought will be put forward at the end of this assignment in which we will contend which is the most financially feasible corporation to invest in its equity capital. 1. 2. 1 Financial Performance of Companies X, Y and ZThe ratios that will be examined under the profitability section are the gross profit margin, net profit margin, return on capital employed and return on shareholders funds. The gross profit and net profit margin, which indicate the gross profit and net profit generated from every $100 of sales, are the highest for Company Z (Randall H.
1996, p 464 – 465). This means that this company was capable to control operating costs and generate the highest profits in this industry in relation to the other two firms. The primary profitability ratio, the return on capital employed, which portrays the efficiency of management in generating profits out of the resources employed in the organization is again in favour of Company Z, which holds the greatest ratio. A high return on capital employed is always a desirable feature in an organisation, because it provides a good margin of safety on the profits of the firm (Randall H. 1996, p 463). We have to remember that firm’s market share is normally vulnerable to economic conditions especially in case of luxury goods and competitive moves. Thus a good return on capital employed ratio minimizes the risk on the financial performance of the corporation.
The return on shareholders funds that means the profit return derived from the equity finance is the only profitability ratio that is very weak for Company Z (Randall H. 1996, p 464). Indeed Company X, the one attaining the best ratio, exceeds Company Z by 8%. However, this ratio has to be considered carefully when one is examining different organisations because the capital structure of the firm may affect it misleading the analysis. If Companies X and Y are high-geared companies, which signifies that their debts are in higher proportion than equity capital then a high ratio will be achieved with lower profits than Company Z if this is a low-geared firm (Randall H.
1996, p 470). 1. 2.
2 Financial Position of Companies X, Y and ZThe financial ratios that fall under this category are the stock days, debtors’ days and creditors’ days ratios. The stock days indicate the number of days required for the company to sell its stock (McKenzie W. 2003, p 242).
In this case, the lower the stock days ratio the better the financial position of the business enterprise because the quicker is the stock turned into cash or accounts receivable. We have to keep in mind that inventory is the least liquid current asset. Therefore it is important that the money tied up in stock is kept low.
In this case, Company X holds the better stock days ratio. The debtors’ days and creditors’ days ratios will be examined in amalgamation because cumulatively they influence the working capital of the firm. They portray the number of days taken to collect the money from our debtors and pay the bills due to our trade creditors (Randall H. 1996, p 469 – 470). In this case it is important that the debtors’ days ratio is kept low to ensure that we collect early money from debtors, while the creditors’ ratio is held high to permit more time for us to utilise the cash and cash equivalents. Likewise it is of utmost importance that the debtors’ days ratio is lower than the creditors’ days ratio.
Company X again holds the lowest average collection period, which is the same as the creditors’ payment period. On the contrary, Company Z has a very high debtors’ ratio, which amounts to 65 days, which is greater than the average payment period to creditors of 55 days. This is a very serious concern on the working capital of this firm because they are paying their creditors before receiving money from their trade debtors. If this corporation continues with this approach, liquidity problems will soon arise. 1. 2.
3 Investor’s Position in Companies X, Y and ZThe latter three ratios provided, which are earnings per share, price earnings ratio and dividend yield comprise the investment ratios. These ratios mainly concentrate on the return shareholders can attain and capital appreciation of the firm. The earnings per share examine the total profits the shareholder can attain for each share he holds.
Investors are frequently attracted to companies with high earnings per share ratio (McKenzie W. 2003, p 266 – 267). In this case, Company Z provides the best earnings per share to investors. The Price Earnings Ratio is a performance indicator that reveals the market’s confidence in a particular organisation. The higher the ratio the greater the buoyancy of investors that profits will grow strong in the nearby future (McKenzie W.
2003, p 271). Again, Company Z has attained the highest price earnings ratio and this compliments the remark made on the earning per share ratio. Since the earnings per share is a ratio of high importance to investors, the better this ratio, the greater the confidence of the capital market in the company, as shown by a high price earnings ratio. Frequently, not all the profits generated by the company are distributed to shareholders. Some investors are more inclined in the dividend they are receiving rather than the capital appreciation of the firm. In this respect, the dividend yield is adopted to analyse the return on investment in real terms for that particular period (McKenzie W.
2003, p 270). In this case, the organisation paying the best dividend in relation to the market share price is Company Y. 1. 2. 4 Final thought – Most Optimal Company to invest in.
In the previous sub-sections, we have identified the strengths of each company which are summarised in the following table: Company XCompany YCompany ZEquity return: best utilization of equity to generate profits. Profit: highest net profit/gross profit margin. Working capital management: positive financial position as regards management of stock, trade debtors and creditors. Efficiency: best utilisation of firm’s resources. Capital appreciation: highest earnings per share.
Market confidence: perceived as the firm with the best ability to make profits. Dividend return: best dividend paid to investors. As shown by the table above, Company Z provides a good financial performance and is ideal for investors in view of a good capital appreciation and market confidence. The only area of concern that this organisation holds is the working capital management. This indicates that the firm may face or is already facing cash flow problems.
Unfortunately a cash flow statement was not provided in the assignment to further highlight this area. However, with the information provided, we can state that Company Z is the most optimal organisation to invest in, in view of the financial strengths noted. References: International Accounting Standards (2000). Framework for the Preparation and Presentation of Financial Statements. London: International Accounting Standards Committee. International Accounting Standards (2000).
IAS 1 – Presentation of Financial Statements. London: International Accounting Standards Committee. Lewis R.; Pendrill D. (1996). Advanced Financial Accounting. Fifth Edition. London: Pitman Publishing.
McKenzie W. (2003). Using and Interpreting Company Accounts.
Third Edition. Essex: Pearson Education Limited. Randall H.
(1999). A Level Accounting. Third Edition. Great Britain: Ashford Colour Press Ltd. Weetman P. (2003). Financial and Management Accounting. Third Edition.
Essex: Pearson Education Limited. A corporation whose share capital is in a greater proportion than the long-term borrowings.