Report on Management Accounting

Question: The report gives an overview financial performance of two companies, namely The Pearl Company and Gulfa Mineral Water Company. Answer: Introduction The report gives an overview financial performance of two companies, namely The Pearl Company and Gulfa Mineral Water Company. The analysis of the financial performance is based on the findings of several ratios. The first part of the report shows the statement of cash flows of the Pearl Company. It also states the free cash flow which is available with the company at the end of 2015. The latter part of the report shows the financial analysis based on the various types of liquidity ratios and earning test ratios. Some of the important concepts for the rationale of comparing the ratios include computation of the financial ratios such as current ratio, quick ratio and interest coverage ratio. The report also highlights the important changes in the net income for the year 2014 in compare to 2013. The reason for this change has also been shown. Part 1 The statement of cash flows for the year 31st December 2015 has been illustrated below as follows: In the Books of Pearl Company Statement of Cash Flows as on 31st December,2015 Particulars Amount Amount (AED in millions) (AED in millions) Cash Flow from Operational Activity : Net Income 150 Add : Depreciation on Assets Balance on 2015 654 Balance on 2014 561 93 Less : Gain on Sale of Equipments -3 Increase in Current Assets : Closing Balance -1314 Opening Balance -1220 -94 Increase in Current Liabilities: Closing Balance 2015 532 Opening Balance 2014 481 51 Net Cash Inflow from Operational Activities 197 Cash Flow from Investing Activity: Net Purchase of Property, Plant Equipment : Closing Balance of Long Term Assets 2015 -1517 Opening Balance of Long Term Assets 2014 -1394 -123 Net Cash Outflow from Investing Activities -123 Cash Flow from Financing Activity: Cash flow from Debt Financing: Closing Balance of Long Term Liabilities 2015 1011 Opening Balance of Long Term Liabilities 2014 1001 10 Cash flow from Equity Financing: Closing Balance of Share Capital 2015 157 Opening Balance of Share Capital 2014 155 2 Dividend Paid (Balancing Amount) -24 Net Cash Inflow from Financing Activities -12 Net Cash Inflow Increase in the Current Year 62 Add : Opening Balance of Cash Cash Equivalent 29 Closing Balance of Cash Cash Equivalent 91 From the above prepared cash flow statement it can be seen that the first component calculated from the cash flow statement is net cash inflow from the operational activities. In order to compute this value the net income of the company has been considered and the changes in the depreciation in the in the value of assets is added along with it. The balance in the year 2015 was observed as 654 in the year 2015 and 561 in the year 2014. This shows a change of AED 93 million. Several other overheads such as gain on sale of equipments, increase in the value of current assets (both opening and closing) is subtracted from the net income value of the company. The Pearl Company has shown an increase in the opening balance of the current liabilities which was AED 532 million in the year 2015 to AED 481 million this is projected with an increase of AED 51 million in the cash flow statement. After performing all the necessary calculations based on the given data it has been observed that the ne t cash inflow from the operational activities is AED 197 million. (Larkin 2013). The second most important aspect in preparing the cash flow statement is computation of net cash outflow from the investing activities. In order to calculate this value the difference in the opening and closing balance in the opening and closing balance Net Purchase of Property, Plant Equipment for both 2015 and 2015 has been taken into consideration. It can be clearly observed from the given statement that the Closing Balance of Long Term Assets in the year 2015 was (1517) and Opening Balance of Long Term Assets in the year 2014 was (1394). Hence the difference of these two values which is AED (123) million is considered as the net cash outflow from the investing activities. (DimitrijeviĆ¡ 2015). In order to calculate the free cash flow available with the company the cash flow statement clearly shows the calculation of Net Cash Inflow from Financing Activities and Net Cash Inflow Increase in the Current Year. The calculation of the former value is based on cash flow from debt financing. In order to calculate this value the difference between the Closing Balance of Long Term Liabilities for the year 2015 and Opening Balance of Long Term Liabilities for the year 2014 has been taken into consideration. The respective difference of the values was observed as AED 10 million. This value has been further added with the net cash flow from the equity financing value. The closing balance of the share capital has been obtained as 157 in the year 2015 and 155 in the year 2014. This shows a difference of AED 2 million. The dividend paid amount is further subtracted as the balancing amount. Hence the Net Cash Inflow from Financing Activities has been calculated as AED (12) million (Barua a nd Saha 2015). For the purpose of calculating Net Cash Inflow Increase in the Current Year we need to use the following formula Net Cash Inflow Increase = Net Cash Inflow from Operational Activities + Net Cash Outflow from Investing Activities + Net Cash Inflow from Financing Activities = 197-123-12 = AED 62 million. In order to calculate the free cash flow amount available with the company we need to add Opening Balance of Cash Cash Equivalent. The value has been given as AED 29 million. Thus the Closing Balance of Cash Cash Equivalent is AED 91 million. Free cash available with the company = Increase in net cash inflow + Opening Balance of Cash Cash Equivalent = 62+29 = AED 91 million. (Farshadfar and Monem 2013). Part 2 The net income of the company on 2014 was observed as AED 6414305 and AED 4700594 in the year 2013. This shows an increase by 36.47% in the net income of the Gulf Mineral Water Company. This increase shows that the company was able to generate more sales in the year 2014 than in the year 2013. This is clearly stated by the increase in the revenue of the company. According to the given balance sheet data the sales in the year 2013 was AED 51485387 and it further increased to AED 62381921. Although the company had to bear higher amount of cost of sales the gross profit was also higher. This is the reason for higher net profit of the company in the year 2014. Workings: AED 6414305 - AED 4700594 = AED 1713711 Percentage change in net income = 1713711 /4700594 = 0.3647 = 36.47% The percentage of cost of sales is calculated on the basis total sales amount. It can be observed from the balance sheet of 2014 that the total sales amount on December 2014 has been AED 62381921 and cost of sales was AED 40642329. The percentage of cost of sales is observed as 65.15 % Workings: (40642329/62381921) x 100 = 65.15% (Brigham and Ehrhardt 2013) The rate of return on average assets (ROAA) is used to determine the profitability of a firms total amount of asset. This rate is often paid emphasis by financial institutions and banks and used to measure the financial performance of a company. It also states the ability of a company to use the available assets efficiently in compare to other industries. In the given balance sheet of Pearl Company, the total average asset for the year 2015 is given as 2177 and 2053 for the year 2014. In order to calculate the rate of return on average assets (ROAA) we need to divide the current years average assets with previous years average assets (Needles et al. 2013). Workings: ROAA = (2177 / 2053) = 1.06 % The rate of return on average shareholders equity is calculated on the basis of net income and shareholders equity. This particular tool is used to reveal the amount of net income return in terms of the total percentage of the value of shareholders equity fund (Beatty and Liao 2014). The net income of the company is observed as AED 6414305. The share holders equity of the company is observed as AED 51189197 for the year 2014. The rate of return on shareholders holders equity is calculated by dividing net income of the company by shareholders equity. The increase in the rate of return from the year 2013 to 2014 shows a positive increase from 2013 to 2014. The workings are shown below as follows. Workings: 2014 6414305/ 51189197 = .125 2013 4700594/44774892 = 0.104 The calculation current ratio, quick ratio and no. of times interest coverage is shown below as follows: Current Ratio In order to calculate the value of current ratio we use Current Ratio = Current Assets/ Current Liability 2014 2015 Current Assets = 1220 Current Liabilities = 481 Current Ratio = 1220/481 = 2.53 Current Assets = 1314 Current Liabilities = 532 Current Ratio = 1314/532 = 2.46 The decrease in the amount of current ratio in the year from 2014 to 2015 shows that the company is having lesser source of liquid flow of money. These sources of liquid money are generated from cash, cash equivalent, short-term investments, Accounts receivable, inventory and other assets. The computation of total current liability is based on liabilities share holders equity, accounts payable, accrued liabilities, and accounts payable to the company. The calculation current liabilities also include accounts payable. (Brigham and Daves 2012). Quick Ratio The quick ratio is calculated for the purpose of evaluating companys short term liquidity, and various obligations related to meet the short term liquid assets. This ratio is often referred as acid test ratio. It can be calculated by using two methods. In order to determine the quick ratio we need to consider the following formula: Quick Ratio = (Current Assets Inventory Prepaid Expenses)/ Current Liabilities Bank Overdraft* Note (*) Bank overdraft is generally excluded if the amount is payable on demand. 2014 2015 Current Assets = 1220 Inventory = 527 Current Liabilities = 481 Quick Ratio = (1220-527)/481 = 1.44 Current Assets = 1314 Inventory = 574 Current Liabilities = 532 Quick Ratio = (1314-574)/532 = 1.39 Similarly another method for the purpose of calculating the quick ratio is Quick Ratio = (Cash and equivalents +marketable securities+ accounts receivable) / current liabilities able width="638" 2014 2015 Cash and equivalents = 29 Accounts receivable = 600 Current Liabilities = 481 Quick Ratio = (29+ 600)/481 = 1.30 Cash and equivalents = 91 Accounts receivable = 605 Current Liabilities = 532 Quick Ratio = (91+ 605)/ 532 = 1.29 The interest coverage ratio of the company is calculated in order to determine the easiness the pay off the interest amount on the total outstanding debt of the company. The calculation is based on dividing the earnings before interest and tax with the interest expenses. Hence the formula used to calculate the interest coverage ratio is: Interest Coverage Ratio = Earnings before Interest and Tax (EBIT)/ Interest Expense Earnings before Interest and Tax = 231 Interest Expenses = 91 Interest Coverage Ratio = 231/91 = 2.5 times It is preferable for a company to maintain the interest coverage ratio more than 1.5. In this case we can clearly see that the company has been able to maintain the ratio 2.5 times, hence it can easily payoff the interest amount on the outstanding debt of the company. (Heikal et al. 2014). Based on the interest coverage ratio and other financial indicators for assessing companys performance such as current ratio and acid test ratio it can be stated that the company does not have the potential to the meet its long term debts. Although the ideal ratio for maintaining the interest coverage ratio is 1 times more than the standard ratio which is 1.5, the bank cannot finance the company to meet its long term obligations. It can be observed from the comparative balance sheet that Pearl company has been incapable of meeting the long term bank loan of the company which was AED 200 million in the year 2014 and same as AED 200 in the year 2015, this illustrates that the company has been to unable to pay off its long term loan and the total loan amount payable remained the same. (Iyer et al. 2014). Moreover it has been observed that the financial ratios are in the increasing trend, this shows the improvement trend of the company in terms of financial performance. It can be clearly seen that the current ratio of the company has decreased from 2.53 to 2.46 in the year 2015; this states the decrease in the firms liquid asset to pay off its liabilities. The acid test ratio also gives the projections about the inability of the company to meet its short term liquidity obligations has made an questioning impact on whether it will be able to meet the bank loan. In case of severe financial crunch, the company can look forward to incest its some portion of capital in the Government bonds, at a risk free rate as it will be the safest option for the company to exercise. The decision to invest in the shares of the company is dependent on average rate of return on shareholders holders equity. The share holders equity of the company for the year 2014 is observed as AED 51189197. The rate of return on shareholders holders equity is calculated by dividing net income of the company by shareholders equity. The increase in the rate of return from the year 2013 to 2014 has depicted an increasing trend and hence an investor may look forward to invest in the share of Pearl Company. Moreover from the data given in comparable balance sheet it can seen that the share capital in the year 2015 was AED 157 millions and AED 155 million in the year 2014, this shows an increment in the share capital of the company by AED 3 million. Hence from an investors point of view, it will be lucrative to invest in the shares of the Pearl Company. Conclusion The report shows the import aspects of the cash flow statement of the company by clearly stating the cash flow from operational activities, Cash Flow from Investing Activity, Cash Flow from Financing Activity and Net Cash Inflow Increase in the Current Year. The main objective of preparation of the cash flow statement was to compute the value of Closing Balance of Cash Cash Equivalent, which was observed as AED 91 million. The latter portion of the report clearly shows the declining situation of the company in terms of liquidly obligations and the ability to meet its long term debt. Despite of several financial downturns the shareholders have potential to gain from this company due to increasing return on shares and increasing share capital. Reference List Barua, S. and Saha, A.K., 2015. Traditional Ratios vs. Cash Flow based Ratios: Which One is Better Performance Indicator?. Advances in Economics and Business, 3(6), pp.232-251. Beatty, A. and Liao, S., 2014. Financial accounting in the banking industry: A review of the empirical literature. Journal of Accounting and Economics, 58(2), pp.339-383. Brigham, E.F. and Daves, P.R., 2012. Intermediate financial management. Nelson Education. Brigham, E.F. and Ehrhardt, M.C., 2013. Financial management: Theory practice. Cengage Learning. DimitrijeviĆ¡, D., 2015. The detection and prevention of manipulations in the balance sheet and the cash flow statement. Ekonomski horizonti, 17(2), pp.137-153. Farshadfar, S. and Monem, R., 2013. 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