Finance & Accounting Essay [financial ratios] PDF

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Summary

Reflecting on recent corporate scandals, such as Carillion and Thomas Cook, critically discuss how useful is accounting information and for who?
a) As a financial analyst, write a report to potential investors evaluating the financial performance (using ratio analysis) of AstraZeneca...

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Finance & Accounting Coursework Programme of Study: BSc Marketing Module: Finance & Accounting Date: 9th March 2020 Word Count: 2,029 words

Part One: Thomas Cook Group PLC is a company positioned in the tourism and travel industry. The company owns, operates, and manages tour operators, travel agencies, and car hire agencies. They also own their own cruise ships, resort properties, and air fleet. It was a 198year-old firm that put 9,000 employees out of work in the United Kingdom, due to its corporate scandal. Moreover, the company left roughly 150,000 British people on holiday stuck overseas (Mustoe, Box and Harte, 2019). An audit firm, Ernst & Young (EY), signed off on the company’s’ financial health right before their collapse. EY also wrote a report in which they awarded the CEO a £5 million bonus. Moreover, in 2018 the audit firm, EY, stated that they had “nothing to report.” Although, in May 2019, Thomas Cook reported a £1.5 billion loss in the first half of its fiscal year, which the accountants should have saw coming. Carillion is a construction company that provides facilities management services and also tackle a number of construction projects, such as hospitals and roads. Carillion used many tactics to attempt to hide its failing financial health, although in the end it did not help. On Carillion’s construction projects, MPs found that the company consistently overestimated the revenue they were generating, which made big-loss projects appear more profitable. A type of “aggressive accounting” was exposed when it revealed. A £845 million financial “black hole” in July of 2017 (Sweet, 2018). Carillion’s “unsustainable dash for cash” ended up taking money away from pensioners, investors, and suppliers, whilst paying out large dividends to the shareholders. It is clear that there was a conflict of interest in the accountants handling Carillion’s finances. The “Big Four” accountancy firms are Deloitte, Ernst & Young (EY), KPMG, PricewaterhouseCoopers (PwC) (Mazareanu, 2019). They offer auditing services, legal and corporate finance services, and so on. The “Big Four” have been putting their own finances before guarding their clients. In the United Kingdom, the auditors earn “less than a quarter of their income from the once core task of auditing (Brooks, 2018). All of the firms earn ninefigures annually from the public sector, which means what they are doing is working for themselves but not their clients that they are trying to help (e.g. Thomas Cook, Carillion, etc.). Accounting information is used most commonly to make business decisions. Income statements, balance sheets, and cash flow statement all exhibit an important overview of the

entire business. Accounting information must be incredibly useful due to these two strong examples. Both of these companies failed rather spectacularly all because of incompetent accountants. In both of these examples the accountants did not provide a faithful representation of the reality of the companies. A faithful representation of reality needs to be complete, neutral, and free from material error. Accounting information when it is transparent, provides investors with a “baseline of analysis for…the financial health of corporations” (Investopedia, 2019). It helps creditors evaluate the liquidity, the company’s ability to pay its debts, and its creditworthiness (what creditors look at before the decide to endorse any new credit to you). Moreover, it aids businesses to make difficult decisions about how to allocate scarce resources. There are many people whom accounting information is useful for. Investors use the information provided by accountants in the forms of balance sheets, income statements, and cash flow statements. They use this information to form most of their decisions for the company, for instance, the value of the company and its creditworthiness. Without this information provided by financial accountants, investors would have a much more difficult time evaluating companies. Alternatively, Lenders also need to know the accounting information. Financial statements outline a specific company’s assets, long and short term debt, and so on. Lenders need to get a good understanding of the company’s creditworthiness. They usually rely on the accounting ratios, such as the debt to equity ratio (D/E), which is a ratio that is used to evaluate a firm’s financial leverage. Essentially, the lender wants to know the risk that is involved when lending a company money, which can always be determined by looking over the firm’s financial accounting. Once the lender has determined this, they will furthermore be able to get a clear idea about how much to lend and what the interest rates will be. Financial accounting is a great way for firms to monitor their operations, and also to provide a clear understanding of their financial health at that point in time. Furthermore, providing the necessary data through balance sheets and income statements, a firm can give their investors and lenders more power and peace of mind when making their financial decisions. Part Two (A): AstraZeneca is a holding company, which is a company which was created in order to buy and own shares of other companies. AstraZeneca is involved with research, development, and the manufacturing of pharmaceutical products. The company produces medicines for neuroscience, inflammation, oncology, cardiovascular, infectious diseases, and many more.

There are many brands in which AstraZeneca distributes their products, these brands include but are not limited to; Diprivan, Atacand, Crestor, Nexium, and so on. GlaxoSmithKline, on the other hand, is one of the largest research-focused pharmaceutical firms which researches, develops, manufactures, and markets health products for people. Ratio analysis is a quantitative method for gaining an understanding into a firms’ profitability, liquidity, efficiency, and so on. Ratio analysis is fundamental to finance accounting because of it allows us to gain insight into a firm’s financial and operational details. Profitability ratios are used in order to judge whether a company has been successful in making a satisfactory level of profit. The profitability ratios are return on capital employed (ROCE), return on equity (ROE), gross profit margin, and net profit margin. Alternatively, there are also liquidity ratios. Liquidity ratios are used to measure how much liquid cash or near cash assets that a company has, and the two main liquidity ratios are; current ratio and quick assets ratio. On the other hand, efficiency ratios measure how much a firm spends, in order to make a dollar. The main two efficiency ratios are asset turnover and inventory holding period. Finally, there are investment ratios, or solvency ratios. They are used by investors in order to gain an understanding of how well a company can cope with its longterm financial obligations. I will apply these formulas to the 2015 annual reports of GlaxoSmithKline and AstraZeneca, in order to know which firm is a better investment opportunity. Table 1.0: Financial Ratios (AstraZeneca) What does it Equation show?

Financial Ratios

Numbers

Ratios

Profitability Ratio Return on capital employed (ROCE)

It expresses a company’s profit as a percentage of the amount of capital invested in the firm.

Operating profit: £4,114 million Non-current liabilities: £26,746 million Share capital & other reserves: £1,751 million

14.4%

Liquidity Ratio Current Ratio

Measures a company’s ability to meet short-term financial obligations.

Current assets: £16,007 million Current liabilities: £14,869 million

1.08

Efficiency Ratio Asset turnover ratio

Measures the efficiency with which a company’s assets are used to generate sales revenue.

Net sales/total revenue: £11,721 million Total assets: £60,124 million

0.195

Finance Ratio Interest coverage ratio

Measures the amount of profit available to cover the interest payable

Earnings before interest & tax [operating profit]: £4,144m Interest expense: £496 million

8.29

Investment Ratio Earnings per share

This ratio can be considered as an indicator of financial performance

0.85p

According to Table 1.0 Financial Ratios (AstraZeneca) got a 14.4% for the ROCE ratio, 1.08 for the current ratio, and 0.195 for the asset turnover ratio. A higher percentage for ROCE, shows that a larger portion of the firm’s value can eventually be returned as profit to the stockholders. In order to demonstrate that a company makes “reasonable efficient use of capital, the ROCE should be equal to at least twice the current interest rates” (Maverick, 2019), which means that AstraZeneca’s ROCE percentage is high (14.4%). Therefore, the company is profitable. The current ratio demonstrates how many times over the firm can pay their current debt obligations, based on the liquid assets they have available at that time. Thus, meaning that AstraZeneca can pay their debt off only one time with their available liquid assets, and have very little left to spare. The asset turnover ratio is often used as an indicator of efficiency of the company, in which the company is using its assets (i.e. products or services) to generate money. The higher the ratio for asset turnover, means the higher the efficiency of a firm. AstraZeneca has a very low asset turnover ratio (0.195), which means that they are not a very efficient company. A higher interest coverage ratio shows that a firm can pay the interest they owe, many times over. With an interest coverage ratio below 1.5, it means that the firm’s ability to meet interest costs is improbable. Thus, meaning that AstraZeneca has a high interest cover ratio and they can afford their interest expenses. A

higher earnings per share ratio is beneficial, because investors will pay more for a firm with larger revenue. Finally, the earnings per share ratio for AZ was 0.85p, which is quite high and desirable for investors.

Table 2.0: Financial Ratios (GlaxoSmithKline) What does it Equations Numbers show?

Financial Ratios

Ratios

Profitability Ratio Return on capital employed (ROCE)

It expresses a company’s profit as a percentage of the amount of capital invested in the firm.

Operating profit: £10.3 billion Non-current liabilities: £8.878 billion Share capital & other reserves: £3.680 billion

82%

Liquidity Ratio Current Ratio

Measures a company’s ability to meet short-term financial obligations.

Current assets: £16,587 million Current liabilities: £13,417 million

1.24

Efficiency Ratio Asset turnover

Measures the efficiency with which a company’s assets are used to generate sales revenue.

Net sales/total revenue: £28,030 million Total assets: £53,446 million

0.524

Finance Ratio Interest coverage ratio

Measures the amount of profit available to cover the interest payable

Investment Ratio

Earnings before interest & tax [operating profit]: £10.3b Interest expense: £719 million

14.3

Earnings per share

This ratio can be considered as an indicator of financial performance

174.3p

According to Table 2.0 Financial Ratios (GlaxoSmithKline) got an 82% for the ROCE ratio, 1.24 for the current ratio, and 0.524 for the asset turnover ratio. GSK’s return on capital employed ratio is much higher than AZ’s, which was 14.4%. This means that GlaxoSmithKline makes reasonable, efficient use of capital. The current ratio for GSK was again higher than AZ’s, which was 1.08. GSK can still only pay off their debt one time with all of their available liquid assets, although they will have more left over. Finally, the asset turnover ratio was 0.524, which was over double what AZ’s was, therefore, meaning that GSK is more efficient than AZ. Furthermore, GSK’s interest coverage ratio is nearly double that of AstraZeneca’s, which means they have more profit to cover their interest expenses. Finally, GSK’s EPS was much higher than AZ’s, which means that their financial performance is off the charts. I recommend that GlaxoSmithKline will be a better investment opportunity than AstraZeneca, because of the data gained by the financial ratios. The financial ratios showed that GSK is overall a better, more efficient, more liquid company, and more profitable. Thus, meaning that they are the most suitable company to invest in. Part Two (B): Personally, I believe that ratio analysis is a very useful tool for evaluating the financial performance of various firms. For certain ratios, it allows us to easily compare to entities with completely different scales. It is very simple, all one has to do is find all the values you need for a specific ratio, then insert them into the equation and solve for the answer. Nonetheless, ratio analysis does not take into account the economic context in which the firm has been operating in. Furthermore, ratios may be distorted because they are based on period-end figures (Elliot, 2019). End-of-year figures are fixed and could possibly not show a faithful representation of the entire business, especially if that business is seasonal. Ratios help tremendously when trying to interpret financial performance, efficiency, and liquidity. However, it might be better if the ratios were used in conjunction with formulae and such, to give a more holistic view of the performance of firm, since they can show a onesided view.

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