SAS DIPLOMA IN BUSINESS ADMINSTRATION

BA-102 Financial Accounting (Group Assignment)

Date of report submission: 15th July 2009

Name of Group member: Kua Siong Zhuang, Gabriel Luo Shao Xuan, Nor Faizah bte Hussain, Damien & Siti Norhadijah bte Mohamed Ali

Synopsis What is meant by the term Financial Statements? How do organizations made use of financial statements to measure their organizations’ performance?

2

Contents Introduction of Financial Statements Page 3

Income Statements Page 4-5 Balance Sheets Page 6-8 Cash flow Statements Page 9-10 Statement of retained earnings Page 11-12 Introduction of Financial Ratios Page 13 Liquidity Ratios Page 14-15 Profitability Ratios Page 16-17 Financial Leverage Ratios Page 18-19 Assets Turnover Ratios Page 20 Dividend Policy Ratios Page 21 Conclusion Page 22 List of references Page 23

3

A. Introduction of Financial Statement

Financial statements are records of a business's financial health and activity. The objective of financial statements is to provide accurate financial information to both internal and external users. Internal users of financial statements include management and employees. Managers need detailed financial statements to make decisions and certain employees, like members of a union, use financial statements to bargain for compensation and benefits. External users of financial statements include investors, creditors, and the government. One of the most important sources of information about a business for shareholders and potential investors are the annual and quarterly reports issued by publicly traded companies, which contain a number of financial statements. Private companies may also issue financial statements especially designed for potential investors. Creditors, such as banks, also use financial statements to help determine the financial health of the company that is applying for a loan. Businesses must keep detailed financial records to help pay taxes so the government is another big user of financial statements. There are four basic types of financial statements: balance sheet (also referred to as "statement of financial position/condition"), income statement (also referred to as "profit and loss statement"), statement of retained earnings, and statement of cash flows. The balance sheet reports the company's assets, liabilities, and owner's equity. The income statement reports the company's income, expenses, and profits. The statement of retained earnings reports and explains changes in retained earnings. The statement of cash flow reports the inflow, outflow, and movement of cash in the company. All statements reveal the financial flows of the company for a given specific period of time. Financial statements sometimes artificially divide the management of the organisation into annual or quarterly periods for the purpose of financial reporting. Today, the international trend has move towards quarterly reporting to provide more accurate information and higher motivation for the employees to work harder. In addition, quarterly reports allow companies to adapt better to market trends as they change strategies base on the information given in the reports. Financial accounting is guided by mainly two principles; objectivity and conservatism. Objectivity means that financial accounting information must be verifiable and reliable. Conservatism refers to the asymmetrical treatment of gains and losses. Losses must first be recorded in the financial statements before potential gains can be earned, and gains go through greater scrutiny than losses. However, this is not to say that financial statements should always understate assets and overstate liabilities. Rather, firms ought to give an unbiased statement in their financial reports to avoid misleading other people. The two principles are stated in the Generally Accepted Accounting Principles (GAAP), but companies would usually abide by the rules voluntarily. There will also be external auditors such as Price Waterhouse and Ernst and Young which valuate the credibility of the financial information provided by firms. In our report, GoldenAgri’s Financial Report for the year 2008 will be used in our examples.

4

Income Statements Income financial statements present information concerning the revenue earned by a company in a specified time period. Income statements also show the company’s expenses in attaining the income and shareholder earnings per share. At the bottom of the income statement, a total of the amount earned or lost is included. Often, income statements provide a record of revenue over a year’s time. Two key principles form the foundation income statement; revenue recognition and matching principle for expenses. Revenue will only be recognized unless two conditions are met; the earnings process is completed and cash collection is reasonably assured. Under the earnings process test, the seller must have no significant remaining obligation to the customer. If an order for five hundred football helmets has been placed and only two hundred delivered, the transaction is not complete. Likewise, if the seller is the manufacturer of appliances and promises extensive warranty coverage, it should not book the sale as revenue unless the cost of providing that service can be reasonably estimated. Additionally, a company that sells a product with an unconditional return policy cannot book the sale until the window has expired. As for assurance of payment, in order to book revenue, the selling company must be able to reasonably estimate the probability that it will be paid for the order. Therefore, if the company had failed to do so, it should not include the sales as part of the revenue.

According to the matching principle, expenses are recognized when obligations are incurred (usually when goods are transferred or services rendered, e.g. sold), and offset against recognized revenues, which were generated from those expenses (related on the cause-and-effect basis), no matter when cash is paid out. If no cause-and-effect relationship exists (e.g., a sale is impossible), costs are recognized as expenses in the accounting period they expired: i.e., when have been used up or consumed (e.g., of spoiled, dated, or substandard goods, or not demanded services). Prepaid expenses are not recognized as expenses, but as assets until one of the qualifying conditions is met resulting in them recognised as expenses. Lastly, if no connection with revenues can be established, costs are recognized immediately as expenses (e.g., general administrative and research and development costs).

Income statements have a few advantages. They can forecast the future performance of the company, and distinguish between core operating performance (day to day items) and transitory components (extraordinary items). It also provides a disclosure on discontinued operations. Lastly, all numbers are assumed after tax, which reflects the true value of profits or losses incurred by the firm. This concludes the explanation of income statements.

5

Below is an example of an income statement from Golden Agri

6

Balance Sheets

Balance sheet financial statements are used to provide insight into a company’s assets and debts at a particular point in time. Information about the company’s shareholder equity is included as well. Typically, a company lists its assets on the left side of the balance sheet and its debts and liabilities on the right. Sometimes, however, a balance sheet has assets listed at the top, debts in the middle, and shareholders’ equity at the bottom. Asset is defined as the probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. Assets are basically divided into two groups; current assets and fixed assets. Current assets refer to those that are reasonably expected to be realised in cash or consumed during the normal operating cycle of the business or within a year, whichever is longer. They include cash and cash equivalents, short term investments, accounts receivables, inventory and prepaid expenses. Long term assets refer to investments that are intended to be held for a period of time usually extending beyond one year. They include debt, equity securities, long term notes and all tangible assets not currently used in operation. Therefore, the main difference between current and fixed assets lies in the one year time span. Liability is defined as the probable future economic sacrifices arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events. Liabilities are also grouped into two categories; current and long term liabilities. Current liabilities are obligations that are expected to be paid ( or services to be performed), within one year, with the use of assets that are listed in the current section of the balance sheet. They include creditors and accruals, wages payable, interest payable, and income taxes payable. Long term liabilities are obligations usually expected to require payment over a period of time beyond one year. They include the issuance of bonds, long term notes and mortgages. The maturity date, rate of interest, and any security pledged to support the borrowing agreement should be clearly shown. Owner’s equity, or stockholders equity, is defined as the residual interest in the assets that remain after deducting the liabilities. If valuations placed on assets do not exceed liabilities, negative equity exists. Hence, the guiding equation of owners’ equity is: Owners’ equity = Contributed capital and Retained earnings This concludes the explanation of balance sheet financial statement.

7

Below is an example of Asset part of the balance sheet from GoldenAgri

8

9

Cash flow statements Cash-flow financial statements provide a look at the movement of cash in and out of a company. These financial statements include information from operating, investing, and financing activities. The cash-flow statement can be important in determining whether or not a company has enough cash to pay its bills, handle expenses, and acquire assets. At the bottom of a cash-flow statement, the net cash increase or decrease can be found. All components of the three activities are certified by International Accounting Standard 7 (IAS 7). Operating activities refer to the production, sales and delivery of company’s product as well as collecting payment from its customers. This includes purchasing raw materials, building inventory, advertising and shipping of products. Operating cash flows comprises of receipts from sales, receipts from sales of loans, debt or equity instruments, interests on loans, dividends received from securities, payment to suppliers, payment to employees, interest payments and rent payment/ received. Investing activities refer to the purchase of an asset or loans made to suppliers or customers. Assets which can be purchased include land, building, and equipment market securities. Financing activities refer to the inflow of cash from investors such as banks and shareholders, as well as the outflow of cash to shareholders as dividends as the company generates income. Other activities that impact the long term liabilities and equity of the company are also listed in the financing activities section in the cash flow statement. Financing cash flows include proceeds from issuing shares and short/long term debts, payment of dividends and repurchase of company shares, repayment of debt principal, and for non-profit organisations, receipts from donors.

Below is an example of an Operating Activities section of cash flow statement from GoldenAgri

10

11

Statement of retained earnings The statement of retained earnings is the percentage of net earnings not paid out as dividends, but retained by the company to be reinvested in its core business or to pay debt. It explains the changes in a company's retained earnings over the reporting period by breaking down the factors affecting the account, such as profits or losses from operations, dividends paid, and any other items charged or credited to retained earnings. A retained earnings statement is required by Generally Accepted Accounting Principles (GAAP) whenever comparative balance sheets and income statements are presented. It may appear in the balance sheet, in a combined income statement and changes in retained earnings statement, or as a separate schedule. The statement of retained earnings is calculated by: Retained earnings = Beginning RE + Net Income – Dividends Beginnings RE refers to the amount of initial capital the owners of a firm has injected into the business. Net income is defined as a company's total earnings (or profit). Net income is calculated by taking revenues and adjusting for the cost of doing business, depreciation, interest, taxes and other expenses. On the other hand, dividends refer to a distribution of a portion of a company's earnings, decided by the board of directors, to a class of its shareholders. The dividend is most often quoted in terms of the dollar amount each share receives (dividends per share). It can also be quoted in terms of a percent of the current market price, referred to as dividend yield. Hence, by calculating a company’s Beginning RE, Net Income and Dividends for a specific year, the company’s retained earnings can be calculated.

12

Below is an example of GoldenAgri’s statement of retained earnings

GOLDEN AGRI-RESOURCES LTD AND ITS SUBSIDIARIES (Incorporated in Mauritius) STATEMENT OF CHANGES IN EQUITY FOR THE YEAR ENDED 31 DECEMBER 2008 Share Capital

US$’000 Share Premium

US$’000

Retained Earnings US$’000

Total US$’000

Balance as at 1January 2008 249,397 1,406,970 36,837 1,693,204

Adjustment to share issuance expenses - 132 - 132

Dividends - - (92,344) (92,344)

Profit for the year - - 68,907 68,907

Balance as at 31 December 2008

249,397 1,407,102 13,400 1,669,899

Balance as at 1 January 2007

216,867 931,465 30,439 1,178,771

Share issue 32,530 494,378 - 526,908 Share issuance expenses

- (18,873) - (18,873)

Dividends - - (67,242) (67,242) Profit for the year - - 73,640 73,640

Balance as at 31 December 2007

249,397 1,406,970 36,837 1,693,204

13

B. Introduction to Financial Ratios Financial Ratio is defined as a ratio of two selected numerical values taken from an enterprise's financial statements. They are used as a relative measure that facilitates the evaluation of efficiency or condition of a particular aspect of a firm's operations and status. Usually, business owners will like to look into the growth, profitability, turnover and financial leverage performance indicators of the company. These indicators explain the rate of revenue generation, the operating margin, the efficiency of asset usage and whether there is an optimal mixture of debt and equity financing for the firm respectively. In addition, financial ratios are also used by current and potential shareholders (owners) of a firm, and by a firm's creditors. There are generally 5 types of financial ratios. They are; liquidity, profitability, leverage, asset turnover, and dividend policy ratios. If shares in a company are traded in a financial market, the market price of the shares is used in certain financial ratios, such as the dividend yield under dividend ratios. Financial statement analysis can be approached using two ways. The first is ratio analysis and the second is analysis approach using comparisons across time and cross sectional analysis. Since the former is our primary focus, we will dwell more into this area of topic in the assignment.

14

Liquidity Ratios Liquidity ratios provide information on a firm’s ability’s to meet its short term financial obligations. Generally, the higher the value of the ratio, the larger the margin of safety that the company possesses to cover short-term debts. They are of particular interest to those extending short term credit to the firm. Bankruptcy analysts and mortgage originators frequently use the liquidity ratios to determine whether a company will be able to continue as a going concern. The two frequently used liquidity ratios are the current ratio (or working capital ratio), quick ratio and cash ratio. The current ratio is the ratio of current assets to current liabilities Current Assets

Current Ratio = ___________________

Current Liabilities Normally, short term creditors prefer a high current ratio since it reduces their risk, Shareholders may prefer a lower current ratio so that more of the firm’s assets are working to grow the business. Different firms and industries have different benchmarks for the current ratio values. For instance, in the auto industry, a high current ratio makes a lot of sense if a company does not want to go bankrupt during the next recession. In contrast, an internet retail blogshop that sells clothes does not need to hold too much liquid assets since its initial low capital investment means that it can survive a recession without much liquidity. But by default, a current ratio of 1.5 or greater can meet near-term operating needs sufficiently. Sometimes, inventories are not necessarily worth the amount they are on the books for. This is particularly true in retail, where you routinely see close-out sales with 60% to 80% markdowns. It is even worse when a company going out of business is forced to liquidate its inventory, sometimes for pennies on the dollar. And if a company has much of its liquid assets tied up in inventory, it will be very dependent on the sale of that inventory to finance operations. If the company is not growing sales very quickly, this can turn into an albatross that forces the company to issue stock or take on debt. Because of all of this, it pays to check the quick ratio. The quick ratio is an alternative measure of liquidity that does not include inventory in the current assets. By taking inventories out of the equation, we can find out if a company has sufficient liquid assets to meet short-term operating needs. The quick ratio is the ratio of current assets less stock to current liabilities Current Assets - Inventory

Quick Ratio = _______________________

Current Liabilities

15

Most people look for a quick ratio greater than 1.0 to be sure there is enough cash on hand to pay bills and keep going. Like the current ratio, the quick ratio can also vary by industry. It always pays to compare this ratio to that of peers in the same industry to understand what it means in context. Finally, the cash ratio is the most conservative of all liquidity ratios. Cash ratio is normally an indication of the firm’s ability to pay off its current liabilities if for some reason immediate payment were demanded. It excludes all current assets except the most liquid: cash and cash equivalents. Cash ratio is calculated as: Cash + Market Securities

Cash Ratios = ________________________ Current Liabilities Whereby market security is defined as a fungible, negotiable instrument representing financial value. Securities can be broadly categorized into debt securities (such as banknotes, bonds and debentures); equity securities, e.g., common stocks; and derivative (finance) contracts, such as forwards, futures, options and swaps.

16

Profitability Ratios Profitability ratios offer several different measures of the success with the firm at generating profits. Generally, the higher the profitability ratio, the larger the earnings of the company’s owners. Potential/current investors are interested in using these ratios to gauge the returns of their future/present investments. There are generally three types of profitability ratios; gross profit margin, return on assets and return on equity. Gross profit margin is a measure of the gross profit earned on sales. The Gross profit margin considers the firm’s cost of goods sold, but does not include other costs. It is defined as follows: Sales – Cost of Goods Sold

Gross Profit Margin = _________________________

Sales

Whereby the cost of goods sold includes purchases of stock less returns, freight and insurance, carriage inwards, duty on purchases, warehouse expenses and packing expenses. The amount of gross margin tends to dictate how profitable the company will be by the time you get down to the net margin level (at the bottom of the income statement). The higher the gross margin, the more revenue dollars will "drop down" to the net income line. Generally, companies that can successfully control costs or pass them along readily to customers (such as from having a huge moat and the pricing power that comes with it), will have more stable or rising gross margins relative to competitors. Hence, the actual dollar value for gross profit isn't really important -- for the analysts, that is. They are more concerned with the consistency in the value of a company’s profitability ratio.

Return on assets is an indicator of how profitable a company is relative to its total assets. ROA gives an idea as to how efficient management is at using its assets to generate earnings. The higher the ROA number, the better, because the company is earning more money on less investment. Calculated by dividing a company's annual earnings by its total assets, ROA can be displayed as a percentage.

ROA is defined as: Net Income

Return on Assets = _________________

Total Assets

17

Net income is defined as a company's earnings or profit as reported on the income statement. Revenue minus all expenses gives you net income. It is for the full fiscal year (before dividends paid to common stock holders but after dividends to preferred stock.) Different companies have different ROA values. A steel company is capital intensive, requiring a lot of costly equipment to generate its earnings. Software companies typically have a much lighter business model. Once the software has been developed, it's simply a matter of copying it onto disks, packaging it, and marketing it, or releasing the software online. Lighter, less-capital-intensive companies tend to be more attractive investments on many counts. Return on equity is the amount of net income returned as a percentage of shareholders equity. Return on equity measures a corporation's profitability by revealing how much profit a company generates with the money shareholders have invested. ROE is expressed as a percentage and calculated as: Net Income

Return on Equity = _________________

Shareholder Equity Whereby shareholder's equity is the portion of a company owned by the shareholders. It is calculated by subtracting liabilities from assets. Shareholder's equity does not include preferred shares.

18

Leverage Ratios Financial leverage ratios provide an indication of the long term solvency of the firm. In other words, it is to get an idea of the company's methods of financing or to measure its ability to meet financial obligations. Unlike liquidity ratios that are concerned with short term assets and liabilities, financial leverage ratios measure the extent to which firms is using long term debt. There are several different ratios, but the main factors looked at include debt, equity, assets and interest expenses. The main ones are; debt ratio, debt to equity ratio and interest coverage. Debt ratio indicates what proportion of debt a company has relative to its assets. The measure gives an idea to the leverage of the company along with the potential risks the company faces in terms of its debt-load. A debt ratio of greater than 1 indicates that a company has more debt than assets; meanwhile, a debt ratio of less than 1 indicates that a company has more assets than debt. Used in conjunction with other measures of financial health, the debt ratio can help investors determine a company's level of risk. Debt ratio is defined as total debt divided by total assets: Total Debt

Debt ratio = _____________________

Total Assets

There are a couple of wrinkles to this ratio, as well (of course). For instance, share buybacks, where the repurchased shares are put on the balance sheet and subtracted from the equity balance. This has the effect of lowering the equity level, which raises the D/E ratio. If the company had borrowed to do that repurchase and had not yet repaid that debt, then the ratio is even higher. Therefore, this can lead to giving a distorted figure of the debt ratio of the firm. Of course, conservative investors could recognize that and then use those numbers as they are, to set the hurdle higher. The debt/equity ratio is the total amount of debt divided by the amount of shareholder's equity. It is a measure of leverage and how much of the company's capital structure is due to debt. Debt to equity ratio is total debt divided by total equity: Total Debt

Debt to equity ratio = ___________________

Total Equity The times interest earned ratio indicates how well the firm’s earnings can cover the interest payments on its debt. The higher it is, it better it indicates a company's ability to meet its debt obligations. It is calculated by taking a company's earnings before interest and taxes (EBIT) and dividing it by the total interest payable on bonds and other contractual debt. This ratio is also known as the interest coverage.

19

The times interest earned ratio is calculated as follows:

Earnings before interest and taxes (EBIT) Interest Coverage = __________________________________

Interest Charges Ensuring interest payments to debt holders and preventing bankruptcy depends mainly on a company's ability to sustain earnings. However, a high ratio can indicate that a company has an undesirable lack of debt or is paying down too much debt with earnings that could be used for other projects. The rationale is that a company would yield greater returns by investing its earnings into other projects and borrowing at a lower cost of capital than what it is currently paying for its current debt to meet its debt obligations.

20

Asset Turnover Ratios Asset turnover is a financial ratio that measures the efficiency of a company's use of its assets in generating sales revenue or sales income to the company. The higher the number the better. They are sometimes referred to as efficiency ratios, asset utilization ratios, asset turnover ratios, or asset management ratios. Two commonly used asset turnover ratios are receivables turnover and inventory turnover. This ratio measures the number of times, on average, receivables (e.g. Accounts Receivable) are collected during the period. A popular variant of the receivables turnover ratio is to convert it into an Average Collection Period in terms of days. It is important to take note that the Receivable turnover ratio is figured as "turnover times" and the Average collection period is in "days". Receivables turnover is defined as follows:

Whereby the average accounts receivables refers to money owed by customers (individuals or corporations) to another entity in exchange for goods or services that have been delivered or used, but not yet paid for. Receivables usually come in the form of operating lines of credit and are usually due within a relatively short time period, ranging from a few days to a year. Net credit sales are all sales made on credit (i.e. excluding cash sales) after the deduction of returns, allowances for damaged or missing goods and any discounts allowed. Companies with low profit margins tend to have high asset turnover, while those with high profit margins have low asset turnover. For instance, wet markets selling vegetables and other groceries will have a faster turnover than say, aerospace manufactures such as Boeing, but their profit margins are way lower than the latter companies. Inventory turnover shows how many times a company's inventory is sold and replaced over a period. A company with high and growing inventory turnover rates would appear to be well managed, freeing up its working capital for other uses.

21

Dividend Policy Ratios Dividend policy ratios provide insight into the dividend policy of the firm and the prospects for future growth. The higher the number, the more it shows that the company is performing well. Two commonly used ratios are the dividend yield and payout ratio. Dividend yield shows how much a company pays out in dividends each year relative to its share price. In the absence of any capital gains, the dividend yield is the return on investment for a stock. Dividend yield is calculated as follows:

The best dividends come from companies with low price/earnings (P/E) ratios. This is because the bigger the pre tax profits a company makes in relation to its share price, the lower the P/E ratio. In addition, some industry sectors are more prone to outbreaks of generosity than others. For instance, ‘dull’ companies like mining and utilities firms have limited growth potential due to the stability in the demand for their products. Hence, to hold their shareholders’ loyalty during a period when the prospects of exciting share price are rather limited, they need to compensate them with big dividend payouts. On the other hand, up and coming firms like Google and Facebook do not have to hand out huge dividends since their shares are already highly in demand. Hence, different firms offer different dividend yields. A high dividend yield does not translate into a high future rate of return. It is important to consider the prospects for continuing and increasing the dividend in the future. The dividend payout ratio is helpful in this regard. Dividend payout yield is the percentage of earnings paid to shareholders in dividends. The payout ratio provides an idea of how well earnings support the dividend payments. More mature companies tend to have a higher payout ratio. The dividend payout ratio is calculated as:

22

Conclusion There are altogether four types of financial statements and five types of financial ratios. Firms made use of these instruments to calculate the performance of their business and take corrective measures should anything goes wrong. However, tools such as financial ratios are not without limitations. To be meaningful, most ratios must be compared to historical values of the same firm, the firm’s forecast, or ratios of similar firms. Therefore, standalone ratio figures mean nothing. In addition, financial ratios must be used in combination to paint a better picture of the firm’s situation. Next, seasonal factors may distort the value of year end financial ratios. Hence, average values should be used wherever available. Lastly, ratios are subject to limitations of accounting methods. Different accounting choices may lead to significantly different ratio values, therefore wrong judgments might be happen when making comparisons between or within firms.

23

List of references http://www.goldenagri.com.sg/ www.financialaccounting.com www.ssrn.com/update/arn/arn_finacctg.html Financial Account, 2002 By Charles E. Johnson, A. N. Mosich, Walter B. Meigs, Mukherjee & Han Financial Accounting, 2004, Edition 11 by Clyde P Stickney, Roman L Weil Introduction to financial accounting, 1999 by Charles T. Horngren, Gary L. Sundem, John A. Elliott