This research focuses on three different dimension of Financial and management accounting. in the first part it gives a clear picture of company law and professional accounting frameworks which can be used to make financial reports of different companies comparable and reliable. Furthermore, the second given question was Discounted Cash flow and its importance for the business investment appraisal. Lastly, the third part of this research assignment is discussing the importance of profitability and liquidity and how a business can manage its working capital to reduce the risk of short term liquidity problems. An introduction to each mentioned topic is given in the following separate paragraphs.
Financial statements are the sum or conclusion of the performance of a company over a specified span of time which as a result, represents a clear financial status of a company. There are different types of financial reports which are created by a company, but the major reports are: The Balance Sheet, Profit and Loss Statement and Statement of Cash flow. In order to make different companies financial report comparable there has to be a certain rules which should be followed by all companies. These rules are some forced by government in which all companies are being entitled to obey certain rules while preparing the reports. In UK, all companies must act in accordance with provisions the Companies Act 1985. In addition to company law, companies which are listed on stock exchange are required to follow Stock exchange rules and other professional accounting framework such as IFRS. (Atrill, P and Mclaney, E. 2005)
Discounted cash flow is very useful techniques which are used in a wide variety of businesses. Mortgage loan are one of the best examples. Therefore, Discounted Cash flow (DCF) techniques are much preferred by the companies while making investment decisions. As an illustration, DCF analysis is a capital budgeting practice which is used to analyze and quantify the receipt and payment of a particular project or business venture. DCF methods are given preference in investment decisions because it takes in the account the importance of time value of money and amount of risk involved in acceptance of a project. (Ramagopal, C. 2008)
Liquidity and profitability are equally important for existence of a company. A company which cannot pay its creditor on time or cannot meet its short term expenditures will easily become insolvent or bankrupt. On the other hand, Profitability is the amount of revenue exceed from its relevant expense. Therefore, both profitability and liquidity are equally important factor for survival of a business. Working capital is the difference between current asset and current liability. Management of working capital can reduce the risk of liquidity problems in the short run for a company. (Avadhani,V.A. 2010)
Financial Reports and Accounting Frameworks: Financial statements are used to make fair decision by various numbers of users. Therefore, the major users of financial reports are classified into: Employees, Present and Potential Investor, Lenders, Customers, Suppliers and other trade payables, Government, and The Public. The objective of financial reports is to provide necessary and objective information about the company performance in order to allow users make sound economic decisions. (Atrill, P and Mclaney, E. 2005)
Financial statements are the overall conclusion of the performance of a company over a specified span of time which as a result, represents a clear position of a company. There are various types of financial reports which are prepared by a company, but the major reports are: The Balance Sheet, Statement of Cash flow, Profit and Loss Statement, and The statement of changes in equity. (Atrill, P and Mclaney, E. 2011)
Source: Catalogue Pearsoned. 02.09.2013
In order to make different companies financial report comparable there has to be a certain rules which should be followed by all companies. These rules are some forced by government in which all companies are being entitled to obey certain rules while preparing the reports. In UK, all companies must act in accordance with provisions the Companies Act 1985 (CA 1985) which is now changed to Companies Act 2006. Under the mentioned Act, every company is entitled to present their Balance sheet and Income statement at the end of each financial year with true and clear vision. In addition, companies, under Schedule 4 of CA 1985, are further restricted to follow certain format and provide additional information by way of notes.
Moreover, Companies in UK should also comply with Financial Reporting Standard and other professional guidance. And these are:
Accounting Standards: these are comprised of Financial Reporting Standard (FRS) and Statement of Standard Accounting Practice (SSAPs) which have been issued and adopted by Accounting Standard Boards (ASB). Majority of companies apply these two standards.
Financial Reporting Standard for Smaller Entities (FRSSE): this sum up all accounting format which UK small entities are restricted to follow.
International Financial Reporting Standard (IFRS): these are issued by International Accounting Standard Board (IASB). All UK Stock exchange listed companies are required to follow this standard. However, unincorporated companies are exempt from IFRS accounting regulations.
Although Legal and professional accounting framework are designed to meet quality factors (Relevance, reliable, objective, and comparable), but still there are some limitations attached to financial reports which cannot be ignored. And these limitations are:
Conventionalized representation: Business are different in their nature and financial reports are prepared in a highly standardized way. This can limit usefulness and comparability of information. In addition, users often find difficult to understand the component of business since financial reports are highly aggregated. This means several information is combined together and presented in a very few figures which often users struggle to find their correct path. In addition, Standards are basically general purpose which ignores to identify the difference between large and small entities. (Elliot Barry, Elliott Jamie. 2008)
Adverse allocative effects: this can occur if economic consequences as a result of standard regulation are not taken into account by standard setters. For example, preparing such reports in accordance with standard may cost companies higher than their normal reporting system. Now this can affect the company profitability which can be regarded as an adverse effect. (Elliott Barry, Elliott Jamie. 2008)
Backward-Looking: Users are interested in future and certainties however, financial reports are based on past events and provide information which has already affected the company.
Non-Financial information: financial statements do not take into account non-financial factors. This factors could highly affect a company performance. Such as: Business risk and opportunities, Management policies, company performance and prospects analysis, and description of the business major operation.
Other information: basically some companies provide additional information along with its financial report. This additional information is not always relevant to most users is most of the cases. And this could further affect objective and comparability of financial reports.
Companies need to invest in projects in order to expand their business activities and become leader in the market by increasing their market share. Since there are various techniques which are used to analyze an investment decisions, Discounted Cash flow (DCF) techniques are much preferred by the companies while making investment decisions. In other word, DCF analysis is a capital budgeting practice which is used to analyze and quantify the receipt and payment of a particular project or business venture. DCF methods are given preference in investment decisions because it takes in the account the importance of time value of money and amount of risk involved in acceptance of a project.
Time Value of Money: The concept of Time value of money is based on the fact that a pound received today has higher value than a pound received next day. Even a child prefers todayâ€™s enjoyment than waiting for tomorrow.
According to Ramagopal, C. (Financial Management. 2008) there are several factors which support the concept that Money has time value.
Risk and Uncertainity: there is risk and uncertainities always involved in future. Out flows are in a company control but there are is no any gurantee for future cash inflow. Thus a pound today is regarded to have higher value than a pound in future.
Present Need are more important: businesses generally prefer current expenditure and consumption.
Opportunity to invest: an individual or a business can invest money today so that they could gain benefit of Interest or profit as a result of their investment.
Inflation: Inflation in an economy will decrease the money purchasing power. Most government have structural inflation which is fixed every year thus a pound received next year will have much less purchasing power than a pound received today.
To make this concept more clear let suppose that 100 pound is invested today in a bank with a return of 10% interest rate each year. At the end of year one the interest which will be paid for initial investment is 10 pound and the total amount will be 110 pounds. Therefore the value of 110 pounds to be received after a year is equivalent to the value of 100 pound received today.
Discounted cash flow are very useful techniques which is used in a wide variety of businesses. Mortgage loan are one of the best examples. Interestingly, DCF methods can also be used by Investors while purchasing companies stocks. In addition, Managers use this method to identify potential investment decisions or choose the best investment decision among several projects. The overall application of DCF methods is to convert future cash flows into present value by discounting these cash flows at the rate of company cost of capital. (Kern, Andy. 2010. The importance of DCF Valuation)
For example, we purchase a 20 year debenture on the day it issued on the market at face value price. So when we purchased this debenture, in fact we invested on this company and over the period of 20 years we expect to receive an amount greater than the value we purchased. Therefore, the value of this debenture today is calculated by discounting the value of principal and interest to be received over the period of 20 years. Or in other word, the value of today debenture equal to the sum of discounted value of interest and principal payment it will make over the 20 years.
It can be used to identify the value of a business as whole or also it can be used to determine the value of a specific project or component of a business that can be added to the overall value of business after conducting certain investments. It is simple and easy to calculate and understand. But it can be modified to deal with complex structure. In addition, both equity shareholders and investor can use this model to appraise investment. Investor can use DCF techniques to discount the value of shares or debenture in to current amount and calculate the amount of interest they earn over period of time. Meanwhile, companies can also use DCF method to evaluate investment decisions and make proper and sound investment in projects so that the value of the company is encouraged if the NPV or IRR is greater than cost of capital.
Liquidity is generally referred to the ability of an entity to meet its short term obligation or in other word the ability of a company to convert assets into cash. The term short term is basically known as those obligation which matures within one year period of time. Short term is also sometimes regarded as operating cycle: buying, manufacturing, selling and collecting.
Liquidity is very much equally important for existence of a company. A company which cannot pay its creditor on time or cannot meet its short term expenditures will easily become insolvent or bankrupt. Moreover, companies operation and reputation will be in huge danger if the firm is unable to meet its short term obligation. Lack of sufficient cash on hand may affect company to lose some incentives from suppliers which will result in higher cost of goods or services. Thus, higher cost will result in less amount of turnover and profit. Therefore, companies always consider liquidity as an important factor and they always try to retain sufficient amount of liquidity. Nevertheless, there is not any standard procedure with regard to company liquidity requirement but mostly it depends on nature of business, location of the business, scale of operation and so on. (Avadhani,V.A. 2010)
Liquidity is one of the major concerns for users while making any sort of deal with the company. Every stakeholder is interested in companies which has higher liquidity. Suppliers will only deal with the company when they know that their money will be received in specified time and the company is able to provide money for their good and services provided. Shareholders are interested in profitability, however they know higher liquidity will give the company the opportunity to get incentives from suppliers which will result in lower cost of goods and services and finally higher profit and dividend or capital gain. Lastly, Bank and other financial institutions always consider companies liquidity position before signing any sort of contract or loan agreement. The liquidity position of a company can easily be understood by looking at it financial statements. Current asset and current liability are the areas which locate the company liquidity position. In order to understand the liquidity position of a company, a number of ratios can be used. These majors are Current Ratio and Quick Ratio. (Singh, Y.P. 2007)
Profitability is the amount of revenue exceed from its relevant expense. Generally both profitability and liquidity are equally important factor for survival of a business. However in the short run a business need to be liquid enough to proceed with its operation but in the long run profitability comes into consideration. Business which are not profitable in the long run will just simply become insolvent. There is an inverse relationship between profitability and liquidity. The higher profitability the less liquid will be the company. This can best described in the following example:
If the asset side of a company balance sheet is arranged in a sequence of liquidity, we will get the following order.
So if we see the above order, as we go from top to bottom the liquidity decreases. However, profitability is totally vice versa. Fixed assets are more profitable for the companies as compare to receivables, securities and cash. Higher liquidity will result in lower risk and lower profit. However, lower liquidity will result in higher risk and higher return. As a result, there is a trade off between profitability and liquidity. Therefore, the role of managers become more dominant to set certain targets which could achieve both partially so that the business can maximize its profit while meeting its obligation successfully.
Working capital is the difference between current asset and current liability. And this helps us to understand the position of a company from liquidity point of view. Based on the above definition, working capital of a company can take one of the following forms.
Positive working capital: current asset is greater than current liability
Negative working capital: current asset is less than current liability
Zero working capital: when current asset equals current liability
It is generally accepted that higher the positive working capital, better will be the firm liquidity position.Furthermore, managing working capital is not just related to current asset and current liability but it also relies on fixed assets and long term funds. (Satyaprasad, B.G. Raghu, G.A. 2010)
There are various factors which determine the amount or level of working capital for a particular business. These factors are positioned in the following diagram:11.png
Source: Satyaprasad, B.G. Raghu, G.A. 2010
Financing of Working Capital and Liquidity:
Once the size of working capital is determined, then the management of the company need to decide the financing of working capital. There are three major policies to finance working capital called conservative policy (Approach A), Average policy (Approach B), and Aggressive policy (Approach C). If a company invest huge amount of money on current asset rather than fixed asset then it is considering conservative approach. Similarly, if the business invest average in current asset then it follows Average working capital approach. Finally, if the business is investing very less on current asset or in other word, business consider its focus on investing heavily on fixed assets then it said to be Aggressive policy or approach. These approaches are best described in the following diagram. (Satyaprasad, B.G. Raghu, G.A. 2010)1212.png
Source: Satyaprasad, B.G. Raghu, G.A. 2010
Working capital management is also referred to operating efficiency. It all about How efficient the management of a firm could manage its inventory, receivable and payables to reduce short term liquidity problems. The best operating firms never want to have inventory sitting idly in a warehouse for months or years, and at the same time they never run out of product when it comes to selling point of view. Companies are on buying products, raw material from suppliers on credit term and the more the period available to pay off its debt for a company, the lesser liquidity problems will arise. Similarly, companies sell products or services to customer. The period of time the company receive their money from customer also have a huge impact on the liquidity of a firm. Therefore, Companies need to consider several ratios such as Inventory turnover, payable turnover, and receivable turnover in order to reduce the risk of liquidity. Nevertheless, operating efficiency and ratio analysis reduce the liquidity problems in short period of time. (Money-Zine. 07.02.2013)
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