Interdisciplinary Journal Of Research In Business: Importance And Analysis Of Financial Ratios And Performance Metrics

Objectives of preparing cash flow statement

Discuss About The Interdisciplinary Journal Of Research In Business.

Cash flow statement basically shows the changes occurring in the firm’s cash position. It reflects the inflow and outflow of cash in the business. The statement shows the net effect of the business transaction on cash position and state the reason for the changes occurring (Jury, 2012). It includes the inflow and outflow of cash from three activities named as operating, financing and investing. Following are the objectives of preparing cash flow statement:

• It reflects the cash earning capacity of the firm.
• It defines different sources to which cash has been allocated and from which the cash has been received.
• The statement categorize the flow of cash into three different activities.
• It helps the management to know about the liquidity position of the company.
• The statement assist the managers in finding the reasons for not paying dividend, having surplus cash despite of losses made and so on (Gopal, 2009). 
• Management can easily plan and control the flow of cash in the business by looking at cash flow statement. This helps in avoiding the risk of illiquidity in the business.
• It measures the capability of the firm for meeting its financial obligations such as loan repayment, taxes and many more (Bhattacharyya, 2012). 

The contents of cash flow statement include the three types of activities. On the basis of that, following different questions can be made:

• Questions like ascertaining the net cash flow amount from operating, investing and financing activities can be formed.
• Decision making questions can also be made which includes deciding about the cash amount with help of the statement.
• Categorization of different business transactions into three activities.
• Ascertain the treatment of changing in working capital
• Questions like determining the changes in the cash balance, sources of cash and application of cash can also be addressed on the basis of cash flow statement.
• Explanation about the difference in net income, cash receipts and cash payments can be asked.

So all such question can be addressed by using the contents of cash flow statement.

Woodside Petroleum has high quality earnings as its ratio over the three years remains positive. Whereas, Origin Energy made a loss in the past three years, which makes it quality earnings ratio negative. The earning reported by Woodside are more reliable because the cash generated from its operating activities is more than its net income. Also it has positive ratio as compare to Origin Energy (Bragg, 2012). 

From the calculations done, it can be said that Origin Energy Limited has used its cash flow from operations more efficiently as compare to Woodside Petroleum Ltd. Generally a high CF/CapEX ratio is considered to be better because it indicates that the company has enough cash to fund its capital investments. Origin Limited has high ratio which means it relies more on capital market as it has more capital investments.  It is also a good sign for company’s growth.

Looking at the CQU Oil’s income statement, it can be said that company is efficient enough in terms of generating more revenue as compared to its expenses. Its COGS amounted to $700,000 whereas it has made a revenue of $2.5 million. Also its other expenses including depreciation are also less. The profit earned by CQU amounted to $910,000 after paying a tax liability of $390,000. Due to such high profits, company was able to declare fully franked dividends having imputation credits of $39.00. So, overall it can be concluded that CQU Oil Limited has performed well during the year.

1. b)
2. Liquidity

These ratios tells about the capability of a company to meet its short term financial obligations. The current ratio of Wesfarmers is 0.93 whereas Woolworth has a ratio of 0.79. Looking at the quick ratio, Wesfarmers’ ratio of 0.30 is less than Woolworth’s ratio of 0.33. However, both the companies has ratios less than their ideal ratios. So, it can be said that liquidity position of both companies is better (Saleem & Rehman, 2011).

Quality of earnings ratio

These are the turnover ratios which measures the company’s efficiency of generating income from their assets. Debtor turnover ratio shows how quickly a firm can collect its accounts receivables. Wesfarmers’ DTR is 41.98 while Woolworth has a ratio of 73.8. Also the Woolworth’s average collection period is 5 days which is less than that of Wesfarmers’s 9 days. This implies that WOW is more efficient in collecting its debtors and generating cash from them as compare to WES (Parrino, Kidwell & Bates, 2011). 

Generally, it is said that a high inventory turnover ratio is more desirable. Woolworths has an ITR of 9.20 times whereas the same for Wesfarmers is 7.25 times. This again shows that Woolworths convert its inventory faster than Wesfarmers. The Total asset turnover ratio of Woolworth is 2.40 which is more than the ratio of Wesfarmers. However, company’s Creditor turnover ratio is 6.14 which is less than WES’s ratio of 7.07. Also, Woolworth takes 59 days to pay back its creditors, whereas Wesfarmers take 52 days for the same. Overall, it can be said that Woolworth is more efficient than Wesfarmers in all aspects except the CTR (Tracy, 2012).

These ratios shows the capital structure of a company. They tell about the portion of debt taken by a firm against its equity. The most commonly used ratio is debt/equity ratio. Wesfarmers’s D/E ratio is 23% and Woolworth’s ratio is 31%. This increase is due to the fact that Woolworth has more debt in comparison to its equity. Also, both its debt and equity amount is less than Wesfarmers. The ICR of Wesfarmers is 16.67 whereas Woolworth has ICR of 12.01. So, overall it implies that Wesfarmers has a better capital structure ratio than Woolworths (Jenter & Lewellen, 2015).

1. Profitability ratios

The profitability of a company is measured by calculating several profitability ratios. Net profit margin of Wesfarmers is 4% and of Woolworths is 3%. The operating profit margin of WES is 6% and of WOW is 4%. The ROE of Woolworths is 16% and of Wesfarmers is 12%. Both the companies has same ROA of 7%. All this implies that, there is no much difference between the profitability positions of both the firms. However, Woolworths offer more return on its equity despite having less profit margin (Vogel, 2014).

(Yahoo Finance. 2018)

The P/E ratio of Wesfarmers is more than that of Woolworths. This is because of high market price and due to this the investors are seeking high growth in future. Both the companies as MB ratio above 1 which means their stocks are overvalued. Comparatively, Woolworth’s stocks has performed well as its MB ratio is more than Wesfarmers’ ratio.

Liquidity and Quick Ratios

According to the concept of time value of money, the value of investment worth $20,000 will grow up to 905,185.11 in the coming 40 years.

The amount of money required to be kept aside by Emily is $11,754.67, if she earns an annual interest of 6% on her savings. The figure will change to $10,518.41, if the annual interest rate becomes 10%.

At the age of 60, the value of Emily’s trust fund will be $ 380,612.75. This is the future value of the balance amount of trust fund calculated by using the time value money concept. As per the information provided, the amount left in the fund was $50,000, which after 30 years will turn out to be $380,612.75.

Compounding is a method of determining the future value of the present amount. While on the other hand, discounting is known for measuring the present value of the amount which is to be received in near future. They are the integral part of an economic concept named as time value of money. In other words, both are been used for adjusting the value of money over time (Schwarz, Hall & Shibli, 2015). There is an inverse relationship between the two which can be proved by demonstrating that a present value of some future figure is denoted by the amount which, if compounded with the same rate of interest and time period, results in a future value of the very same amount. In simpler form, it means if the interest rate and number of years remains the same then the present value will be equal to the future value of an amount (Lewis, McGrath & Seidel, 2011).

Following are the two steps which Emily and Paul can take to accumulate more for their retirement:

Firstly, Emily should invest more of her salary in her employer’s retirement saving plan. As it is there in the plan that employer can match dollar for dollar, worker’s compensation up to 5% of their salary. So Emily should take full advantage of this and procure more money for her retirement.

Secondly, Emily should withdraws money from her trust fund to invest in her retirement plan rather than investing it on their marriage.

Generally, investors prefer investing their funds in the securities which has low risk and the one which will derive high returns to them. The amount of profit an investor expects from his investment on a security is known as expected return. Risk basically defines the chances that the actual return from an investment may differs from its expected return.  As per the calculations done for expected return and risk of both the shares, Syntex Ltd should invest in share A as it is offering high returns at low risk.

Asset Management Efficiency

Realized rate of return is that rate at which the actual return is been received on an investment. This rate is an after fact figure which cannot be change by any behaviour or anything. It indicates the actual return and helps the investor by providing information for the future financial decisions. On the other hand, expected rate of return is that rate at which an investor expects returns from its investment. It is totally estimated and can be changed by any behaviour. It is also that rate at which the value of NPV is equal to zero. The fundamental of expected rate is that higher the risk, higher will be the return needed for compensating the increased risk associated with the asset (Chandra, 2017). 

However, it can be said that there is no relation between the realized and expected rate of return as the realized returns only allow the investors to rethink their own decision and learn from their mistakes. The expectations made by the investors are based on the return of risk free investment like U.S Treasury bonds plus risk premium. While, in efficient capital markets, the required and expected rates are theoretically equal because everyone is very much aware, prices are fair and perfectly reflects the risk. But, it is not necessary that markets are always perfect. Uncertainties do prevail in the markets which makes the actual returns different from the expected ones. So, this is how the concept of realized rate and expected rate differs from each other.

The calculation of realized rate of return includes the cash dividends paid by the firm. The dividends are been added to the year end price of the stock and then the beginning price is less. Changes in the amount of cash dividend also affects the rate of return. Increase or decrease in the amount will change the realized rate of return, as a result if which decision related investing in the ordinary shares may get affected.

The equation of rate of return includes a beta factor which measures and indicates the risk of an investment. It shows the volatility or the systematic risk associated with the investment. Another indication of the risk is standard deviation which measures the extent to which the return of the investment deviates from the expected or normal return.

Systematic risk: It is a type of risk that is associated with the whole market or the entire market segment. It is also known as market risk which cannot be reduced through diversification. It is referred as the daily fluctuations in the stock price (Siddaiah, 2009). 

Capital Structure Ratios

Unsystematic risk: It is also called as specific risk or residual risk which is inherent to the company or the industry in which the investment is been made. It is a diversifiable risk and can be reduced through diversification (Hitchner, 2011).

Stock volatility related to the market is measured by an investment factor known as beta. It is basically a measure of systematic or market risk. Company’s beta coefficient is used to measure the unpredictability in the stock prices in relation to the market.

A portfolio beta is basically the weighted sum of the individual assets’ beta. It measures the volatility of a portfolio and is calculated by adding the products of each security’s beta and their proportional weights. It is with the help of individual investment’s beta, that the investors can construct a portfolio with whatever beta they want. All the data they need is the betas of the underlying assets. It is the portfolio beta which describes the fluctuations in individual security with the help of their

Security Market Line (SML) is a graphical representation of Capital Asset Pricing Model. It is line drawn on a chart which represents the various level of market risk associated with different marketable securities. It is plotted against the expected return of the whole market.  The assets which are correctly priced are plotted on SML (Pagdin & Hardy, 2017). The one which lies above the line are known as undervalued and the ones which are below it are overvalued. Slope of SML represent the market risk premium, which is basically the difference between the risk free rate and expected market return.  The slope reflects the risk return trade off at a given level. Usually, a high market risk premium makes the slope steeper and vice-versa. The Y-intercept of SML means the risk free interest rate, which do not involve the risk of financial loss (Bradfield, 2007).

Capital Asset Pricing Model is the most commonly used financial theory that shows the relationship between the beta of the security, risk free rate and risk premium.  It helps in taking investment decisions as it takes into account the systematic risk of the portfolio and involves simplest calculations. CAPM give insights to the investors about the time value of money and the risk associated with the portfolio.  Risk free rate represents the time value and the beta coefficient measures the risk. Beta basically reflects the riskiness of an asset, compared to the entire market. According to CAPM, if the expected return is less than the required return then it is better to avoid the investment. Such insights are been gain from this model (Levy, 2011).

References

Bhattacharyya, A. K. (2012). Financial accounting for business managers. 4^th ed. New Delhi: PHI Learning Pvt. Ltd.

Bradfield, J. (2007). Introduction to the economics of financial markets. New York: Oxford University Press.

Bragg, S. M. (2012). Business ratios and formulas: a comprehensive guide (Vol. 577). 3^rd ed. New Jersey: John Wiley & Sons.

Chandra, P. (2017). Investment analysis and portfolio management. 5^th ed. India: McGraw-Hill Education.

Gopal, C. R. (2009). Accounting for Managers. New Delhi: New Age International.

Hitchner, J. R. (2011). Financial Valuation, Application and Models. 3^rd ed. New Jersey: John Wiley & Sons.

Jenter, D., & Lewellen, K. (2015). CEO preferences and acquisitions. The Journal of Finance, 70(6), 2813-2852.

Jury, T. (2012). Cash flow analysis and forecasting: the definitive guide to understanding and using published cash flow data (Vol. 653). United Kingdom: John Wiley & Sons. 

Levy, H. (2011). The capital asset pricing model in the 21st century: Analytical, empirical, and behavioral perspectives. USA: Cambridge University Press.

Lewis, J., McGrath, R., & Seidel, L. (2011). Essentials of applied quantitative methods for health services. United Kingdom: Jones & Bartlett Learning.

Pagdin, I., & Hardy, M. (2017). Investment and Portfolio Management: A Practical Introduction. United States: Kogan Page Publishers.

Parrino, R., Kidwell, D. S., & Bates, T. (2011). Fundamentals of corporate finance. 2^nd ed. USA: John Wiley & Sons.

Saleem, Q., & Rehman, R. U. (2011). Impacts of liquidity ratios on profitability. Interdisciplinary Journal of Research in Business, 1(7), 95-98.

Schwarz, E. C., Hall, S. A., & Shibli, S. (2015). Sport facility operations management: A global perspective. 2^nd ed. New York: Routledge.

Siddaiah, T. (2009). International financial management. India: Pearson Education.

Tracy, A. (2012). Ratio analysis fundamentals: how 17 financial ratios can allow you to analyse any business on the planet. RatioAnalysis. net.

Vogel, H.L., 2014. Entertainment industry economics: A guide for financial analysis. 9^th ed. USA: Cambridge University Press

Wesfarmers Limited (WES.AX). (2018). Yahoo Finance. Retrieved from https://au.finance.yahoo.com/quote/WES.AX?p=WES.AX 

Woolworths Group Limited (WOW.AX). (2018). Yahoo Finance. Retrieved from https://au.finance.yahoo.com/quote/WOW.AX?p=WOW.AX 

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