Income Statement Ratios Important to Investors

Question: Describe and analyse the role of accounting information in a business context.Analyse a set of financial statements including balance sheet, profit and loss accounts and cash flow statements.Demonstrate the relationship between accounting data and financial planning and resource allocation decisions. Answer: 1 a. Trial balance is an accounting report which contains the balance of all the general ledger accounts of an organization. It is generated at the end of the accounting period using the ledgers. The debit contains all the assets and the expenses while the credit side contains liabilities equities and revenue earned by the company. The balances which are to be debited are listed in the debit column while the balances which are to be credited is listed in the credit column. The total of debit column in the trial balance should be equal to the total of credit column in the trial balance. After preparing the unadjusted trial balance, the final adjusted trial balance is made by taking into account all the entries which were either wrongly entered or missed while making the trial balance. In the given question, the adjustment entries were made for Closing inventory Depreciation of both Equipment and Motor vehicles Prepayment of Rent Accrual of Telephone bill Heat and lighting expense Accrual of tax The trial balance and adjustment entries are given below: Weather and Sons Trial Balance as at 30th June 2016 Adjustments - Final TB - DR CR DR CR DR CR Retained Profit 88000 88000 Sales 636000 636000 Share Capital 100000 100000 Share Premium 200000 200000 Inventory 87000 37000 50000 Purchases 230000 37000 267000 Trade payables 86000 86000 Trade receivables 205000 205000 bank 83900 83900 Motor Expenses 12987 12987 Maintenance 12000 12000 Salaries Wages 106000 106000 Administration Expenses 33220 33220 Telephone 5687 4300 9987 Heat Light 14300 5000 9300 Equipment at cost 318000 47700 270300 Provision for depreciation equipment 45000 45000 Motor vehicles at cost 45000 11250 33750 Provision for depn motor vehicles 6000 6000 Rent 68000 8000 60000 Advertsing 19118 19118 Bad Debts 3788 3788 Provision for Bad Debts 2000 2000 Long term loan 90000 90000 Interest 9000 9000 Equipment depreciation 47700 47700 Motor vehicles depreciation 11250 11250 PrePayments 13000 13000 Accrual 4300 4300 Income tax expense 18300 18300 Provision for income tax 18300 18300 Loan interest accrued Total 1253000 1253000 131550 131550 1275600 1275600 B. Income statement also called profit and loss statement is one of the most important financial statements. It is important as it tells about the profitability of the company. The Income statement contains the sources of revenue of the company and the various expenses involved in conducting the business. It tell about the business if it is able to generate profit or not and if the investors should invest in the company. The income statement can be divided into operating part and non operating part. The operating part contains the revenue, expense, which are involved due to daily activities of the business. The non operating part contains expense which does not involve daily activities. Income statement using the adjusted trial balance is given below: Weather and Sons Income Statement as at 30th June 2016 Sales 636000 Purchases 267000 Gross Profit 369000 Operating Expenses Depreciation 58950 Maintenance 12000 Salaries Wages 106000 Administration Expenses 33220 Telephone 9987 Heat Light 9300 Motor Expenses 12987 Rent 60000 Advertising 19118 Bad Debts 3788 Interest 9000 Operating Income 34650 Tax 18300 Net income 16350 Thus from the income statement in can be seen that the Profit earned by the company is 16350. C. Balance Sheet of the company is one of the most important financial statements used by the investors. It represents the financial condition of the company on a specified date. It contains the assets and liabilities owned by the company and the amount invested by the shareholders. Also the balance sheet holds the accounting equation Assets = Liabilities + Shareholder Equity The assets are the documented in the top of balance sheet and is arranged in the order of liquidity with the most liquid assets first. The assets contain current assets and non current assets. The current assets are either cash or cash equivalent which can be converted to cash in less than a year. It consists of cash, prepaid expense, account receivables and inventory. The non current assets take longer time to convert to cash (more than a year). It consists of equipment, long term investment and intangible assets. The liabilities of the company are the amount the company owes to various account holders. It contains current liabilities and non current liabilities. The current liabilities of the company have to be paid by the company in less than a year. The non current liabilities of the company have to be paid by the company in a longer time (more than a year). The shareholder equity is the last part of the balance sheet. The money invested by the shareholders for running the business is called shareholder equity. It contains the money invested while starting the business and the retained earning which is the profit earned by the company and reinvested in the business. The equity of the company helps in understanding if the business is financed by the owners or the company has taken a debt to finance its business. If the debt taken by the company is low, then the risk of the company is lower as the company will have to not have to pay back to the investors immediately and can reinvest the money earned for the growth of the company. If the debt taken by the company is high then the risk of the company is higher as the company will have to pay back to the debtors at the end of the period. The Balance Sheet of the company for 2016 is prepared using the adjusted trial balance Assets Current Assets Bank 83900 Prepayment 13000 Trade receivables 205000 Inventory 50000 Non Current Assets Motor vehicles at cost 33750 Equipment at cost 270300 Total Assets 655950 Liabilities Long term loan 90000 Trade payables 86000 Accrual 22600 Provision for Bad Debts 2000 Provision for depn motor vehicles 6000 Provision for depreciation equipment 45000 Equity Share Capital 100000 Share Premium 200000 Net income 16350 Retained Earnings 88000 Liabilities + Equity 655950 2: For the ratio analysis, the two UKs main airline companies I have chosen from the list provided are British Airways and Ryan Air. The annual reports of the two companies (British Airways and Ryan Air) were downloaded for the year 2013, 2014, and 2015. Profitability ratios: The main aim of the business is to generate profits for its shareholders. The capability of a company to make profits is called Profitability of the company. The income earned by the company is through the sales of goods and services by the business. The company has to incur expense to generate this revenue in the business. Profits are calculated by removing all the expenses incurred in the business from the revenue earned. The profitability ratios help in finding if the business of the company is able to earn profits. The profitability ratios calculated for the two companies are Net Profit Margin and Return on Assets Net Profit Margin: The Net Profit Margin is defined as the profit earned by the company per unit of sales revenue earned. It is given by Net Profit/ Sales. If the company is able to generate more profits per unit of sales then the Net Profit Margin is higher. Thus the company will be able to pay for its expenses easily from the revenue earned. (Profit Margin Ratio) For the company Ryan Air, For the year 2013, The net profit = 569.3 M The total revenue from sales = 4884 M Thus Net Profit Margin = 569.3/ 4884 = 11.66 % For the year 2014, The net profit = 522.8 M The total revenue from sales = 5036.7 M Thus Net Profit Margin = 522.8/ 5036.7 = 10.38 % For the year 2015, The net profit = 866.7 M The total revenue from sales = 5654 M Thus Net Profit Margin = 866.7/ 5654 = 15.33 % The Profit Margin of Ryan Air has increased since 2013. Thus the company is performing well which is sign of growth of the company. For the company British Airways, For the year 2013, The net profit = 281 M The total revenue from sales = 11421 M Thus Net Profit Margin = 281/ 11421 = 2.46 % For the year 2014, The net profit = 702M The total revenue from sales = 11719 M Thus Net Profit Margin = 702/ 11719 = 5.99 % For the year 2015, The net profit = 2508 M The total revenue from sales = 11333 M Thus Net Profit Margin = 2508/ 11333 = 22.13 % The Profit Margin of British Airways has increased by more than 10 times since the year 2013. Thus the company is performing well which is sign of growth of the company. Return on Assets: Return on Assets is defined as the profit earned by the company for the investment in the assets. It is given by Net Profit/ Average Assets. If the Return on Assets is high then the company is able to utilize its assets efficiently. (Return on Assets Ratio - ROA) For the company Ryan Air, For the year 2013, Return on Assets = 569.3/ [(9001 + 8943)/ 2] = 6.35% For the year 2014, Return on Assets = 522.8/ [(8943 + 8812.1)/ 2] = 5.89% For the year 2015, Return on Assets = 866.7/ [(8812.1 + 12185.4)/ 2] = 8.26% The return on assets for Ryan Air has increased since the year 2013. Thus the company has used its assets efficiently. For the company British Airways, For the year 2013, Return on Assets = 281/ [(11136 + 11921)/ 2] = 2.44 % For the year 2014, Return on Assets = 702/ [(11921 + 13426)/ 2] = 5.54 % For the year 2015, Return on Assets = 2508/ [(13426 + 15376)/ 2] = 17.42 % The return on assets for British Airways has increased by more than 8 times since the year 2013. Thus the company has used its assets very efficiently. Liquidity Ratio: Liquidity Ratio of a company helps in determining if the company will be able to pay its short and long term debt using the current assets it has. The liquidity ratios calculated for the two companies are Current Ratio and Cash Ratio Current Ratio: The current ratio of a company is its ability to pay its current liabilities using the current assets owned by the company. It is calculated as current assets/ current liabilities. (Current Ratio) For the company Ryan Air, For the year 2013, Current Assets = 3763.6 M Current Liabilities = 1911.7 M Thus current ratio = 3763.6/ 1911.7 = 1.97 For the year 2014, Current Assets = 3444.3 M Current Liabilities = 2274.5 M Thus current ratio = 3444.3/ 2274.5 = 1.51 For the year 2015, Current Assets = 5742 M Current Liabilities = 3346 M Thus current ratio = 5742/ 3346 = 1.71 The current ratio for Ryan Air has decreased since the year 2013. Hence the company will not be able to cover its current debt as easily as before. For the company British Airways, For the year 2013, Current Assets = 2915 M Current Liabilities = 4627 M Thus current ratio = 2915/ 4627 = 0.63 For the year 2014, Current Assets = 3583 M Current Liabilities = 5502 M Thus current ratio = 3583/ 5508 = 0.65 For the year 2015, Current Assets = 3400 M Current Liabilities = 5700 M Thus current ratio = 3400/ 5700 = 0.59 The current ratio for British Airways has declined since the year 2013. Hence the company will not be able to cover its current debt as easily as before. Cash ratio: The cash ratio of a company is its ability to pay its current liabilities using the cash owned by the company. It is calculated as cash/ current liabilities. For the company Ryan Air, For the year 2013, Cash ratio = 1240.9/ 1911.7 = 0.65 For the year 2014, Cash ratio = 1730.1/ 2274.5 = 0.76 For the year 2015, Cash ratio = 1184.6/ 3346 = 0.35 The cash ratio for Ryan Air has decreased since the year 2013. Hence the company will not be able to cover its current debt as easily as before and the cash of the company has reduced significantly. For the company British Airways, In the year 2013, Cash ratio = 1850/ 4627 = 0.40 In the year 2014, Cash ratio = 2523/ 5502 = 0.45 In the year 2015, Cash ratio = 2047/ 5700 = 0.36 The cash ratio for British Airways has decreased since the year 2013. Hence the company will not be able to cover its current debt as easily as before. Efficiency ratios: The efficiency ratio helps in finding if the company can use its resources efficiently to generate profits. The two efficiency ratio calculated for the two companies are Total Assets Turnover ratio and Equity Turnover ratio. Total Assets Turnover ratio: It helps in finding how efficiently the company can use its assets to generate sales. It is given by the net sales/ Average total assets (Asset Turnover Ratio) For the company Ryan Air, For the year 2013, Total Assets turnover ratio = 4884/ [(9001 + 8943)/ 2] = 0.54 For the year 2014, Total Assets turnover ratio = 5036.7/ [(8943 + 8812.1)/ 2] = 0.57 For the year 2015, Total Assets turnover ratio = 5654/ [(8812.1 + 12185.4)/ 2] = 0.54 The Total Assets Turnover ratio for Ryan Air has not changed effectively since the year 2013. For the company British Airways, In the year 2013, Total Assets turnover ratio = 11421/ [(11136 + 11921)/ 2] = 0.99 In the year 2014, Total Assets turnover ratio = 11719/ [(11921 + 13426)/ 2] = 0.92 In the year 2015, Total Assets turnover ratio = 11333/ [(13426 + 15376)/ 2] = 0.79 The Total Assets turnover ratio for British Airways has decreased since the year 2013. Equity turnover ratio: It helps in finding how efficiently the company can use investment by owners to generate sales. It is given by the net sales/ Average equity. For the company Ryan Air, For the year 2013, Equity turnover ratio = 4884/ [(3306.7 + 3272.6)/ 2] = 1.48 For the year 2014, Equity turnover ratio = 5036.7/ [(3272.6 + 3285.8)/ 2] = 1.54 For the year 2015, Equity turnover ratio = 5654/ [(3285.8 + 4035.1)/ 2] = 1.54 The Equity turnover ratio for Ryan Air has increased since the year 2013. For the company British Airways, For the year 2013, Equity turnover ratio = 11421/ [(2255 + 868)/ 2] = 7.31 For the year 2014, Total Assets turnover ratio = 11719/ [(2255 +1900)/ 2] = 5.64 For the year 2015, Total Assets turnover ratio = 11333/ [(1900+ 4398)/ 2] = 3.59 The Equity turnover ratio for British Airways has decreased by since 2013. Thus from the above analysis it can be concluded that the performance of British airways is better than Ryan air. References Averkamp, H. (n.d.). What is a trial balance? Retrieved on August 6, 2016 from https://www.accountingcoach.com/blog/what-is-a-trial-balance Investopedia. (2013). Income Statement. Retrieved on August 6, 2016 from https://www.investopedia.com/terms/i/incomestatement.asp Investopedia. (n.d.). Balance Sheet. Retrieved from https://www.investopedia.com/terms/b/balancesheet.asp White Claire. (2015). Why are efficiency ratios important to investors. Retrieved from https://www.investopedia.com/ask/answers/032615/why-are-efficiency-ratios-important-investors.asp Chand, S. (2015). Ratio Analysis: Meaning, Classification and Limitation of Ratio Analysis. Retrieved 30 July, 2016, from https://www.yourarticlelibrary.com/financial-management/ratio-analysis-meaning-classification-and-limitation-of-ratio-analysis/29418 Investopedia. (n.d.). Profitability Ratios. Retrieved from https://www.investopedia.com/terms/p/profitabilityratios.asp MyAccountingCourse. (n.d.). Efficiency Ratios. Retrieved from https://www.myaccountingcourse.com/financial-ratios/efficiency-ratios MyAccountingCourse. (n.d.). Liquidity Ratios. Retrieved from https://www.myaccountingcourse.com/financial-ratios/liquidity-ratios