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Understanding the Financial Statements

Submitted By:Salina Thapa Rana Magar (12077697)Sona Limbu (12078108)FINC20018

Managerial FinanceProfessor: Angelique McInnesCentral Queensland UniversityBrisbane Campus

Term 1 201821st April 2018Table of ContentsQuestion No. 1: Understanding the Financial Statements (Chapter 3)

Answer:Part 1:Financial Statement shows the total financial functioning of the firm.

Any business entities can easily assume the financial status of the company by using the financial statement of the company.

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At the end of specific period, each business prepares Profit and Loss Account (Income Statement), Statement of Financial Position (Balance Sheet), Statement of Cash Flows (Cash flow statement) and Statement of Changes in Equity.

Cash flow statement is one of the major financial statement which records all the amount that a business is receiving from its business transactions as well as the amount that it disburses. The cash flow statement is prepared to find out how business is generating cash and how effectively they are utilizing their cash resources in productive sector. Cash flow statement if managed properly would help the firm to skip cash crisis in the business.

As a result, business can assure the availability of cash to cover the due expenses. Cash flow statement depicts the position of economic status of the companyThe main objective of preparing cash flow is:To find out the sources and areas of cash incoming and cash outgoing respectively.To allocate the situation on which business might be in the position of cash insufficiency or cash surplus.Cash flow statement is prepared to predict future cash inflows or outflows.

To deliver information regarding the capability of firm to pay its liabilities or taxes.To evaluate whether the firm is on the right track or not by measuring the overall financial records of the company at specific time.To deliver information for making capital budgeting decisions. To evaluate the overall performance of the firm by making comparison between their actual performance and future predictions of cash flow.

Part 2Cash flow statement shows the mobility cash in three different areas of business activities: Operating activitiesFinancing activitiesInvesting activitiesCash flow statement provides the answer to the following questions:What are the primary sources of cash incoming?What are the basic operating activities of a firm to generate cash?

How does the firm manage their extra funds if the business faces shortages?What are the main investment areas of business?What is the reason behind increase or decrease in cash flow?Part 3a) Calculation of Quality of Earnings RatioThe quality of earnings ratio for two firms i.e. Woodside Petroleum Ltd and Origin Energy for the latest three years is calculated as follows:Woodside Petroleum Ltd (WPL.AX)2017 2016 2015Quality of Earning Ratio = Cash flow from operationsNet Profit = 2,400,0001,024,000 = 2.3438 = 2,587,000868,000= 2.9804 = 2,475,00026,000 = 95.

1923Origin Energy (ORG.AX)2017 2016 2015Quality of Earning Ratio = Cash flow from operationsNet Profit = 1,289,000-2,226,000 = – 0.5791 = 1,404,000-628,000= – 2.2357 = 1,833,000-658,000 = -2.7857b)c) Capital Acquisition RatioThe capital acquisition ratio for both firms i.e. Woodside Petroleum Ltd and Origin Energy for the latest three years is calculated in the following tables:Woodside Petroleum Ltd (WPL.AX)2017 2016 2015

Cash Acquisition

Ratio= Cash flow from operationsCash paid forcapital expenditure= 2,400,0001,390,000 = 1.7266 = 2,587,0001,860,000= 1.3909 = 2,475,0001,819,000 = 1.3606Origin Energy (ORG.AX)2017 2016 2015Cash AcquisitionRatio= Cash flow from operationsCash paid forcapital expenditure = 1,289,000-419,000 = – 3.0764 = 1,404,000-572,000= – 2.4545 = 1,833,000-1,484,000 = -1.2352

d)After comparing Woodside Petroleum Ltd and Origin Energy’s ability to utilize the operating cash flow to finance their capital expenditure, we came to the conclusion that ……….Question No. 2: The Income Statement (Chapter 3)Answer: a.CQU Oil LimitedIncome StatementFor the year ended….Sales $ 2,500,000Cost of Goods Sold (700,000)Gross Profit 1,800,000Operating Expenses Cash Operating Expenses 150,000 Depreciation Expenses 150,000 Total Operating Expenses (300,000)Operating Profit 1,500,000Interest Expenses (200,000)Profit Before Tax 1300,000Tax (390,000)Net Profit 910,000b.

From the above income statement, we can see that CQU Oil’s taxable Income and Tax Payable for the year are $ 1300,000 and $ 390,000 respectively. d.Question No. 3: Financial Analysis (Chapter 4)Calculation of Financial RatiosThe financial ratios for both firms i.e. West farmers Ltd and Woolworths Ltd for the most recent year i.e. 2017 are calculated as follows:West farmers Ltd (WES) Woolworths Ltd (WOW)1.

Liquidity RatioCurrent Ratio = Current AssetsCurrent Liabilities = 9667 / 10417 = 0.928002303 = 0.9280 times Current Ratio = Current AssetsCurrent Liabilities. = 6994.2 / 15921.6 = 0.43929 = 0.4393 timesQuick Ratio= Current Assets –InventoryCurrent Liabilities = (9667 -6530) / 10417 = 3137 / 10417 = 0.3012 times Quick Ratio= Current Assets –InventoryCurrent Liabilities = (6994.2 – 4080.4) / 15921.6 = 2913.80 / 15921.6 = 0.1830 timesInventory Ratio=Cost of Goods SoldInventoryInventory Ratio=Cost of Goods SoldInventory = 39739.7 / 4080.4 = 9.7392 times2.

Capital Structure RatioDebt Ratio = Total LiabilitiesTotal Assets = 16174 / 40115 = 0.4032 = 40.32% Debt Ratio = Total LiabilitiesTotal Assets= 13039.7 / 22915.8 = 0.5690= 56.90%Interest Coverage Ratio =EBITInterest Expense = 4402 / 213 = 20.6667 Interest Coverage Ratio =EBITInterest Expense3. Asset Management Efficiency RatioTotal Asset Turnover =SalesTotal Assets = 68444 / 40115 = 1.7062 times Total Asset Turnover =SalesTotal Assets= 55475 / 22915.8 = 2.4208 timesFixed AssetTurnover=SalesNet Property, plan & Equipment = 68444 / 9440 = 7.2504 times Fixed AssetTurnover=SalesNet Property, plan & Equipment = 55475 / 8437.5 = 6.5748 times4.

Probability RatioGross Profit Margin= Gross ProfitSales= Gross Profit Margin= Gross ProfitSales = 15928.9 / 55475 = 0.2871 = 28.71%Operating Profit Margin =EBITSales = 4402 / 68444 = 0.0643 = 6.4315% Operating Profit Margin =EBITSales = 2326 / 55475 = 0.0419 = 4.19 %Net Profit Margin=Net ProfitSales = 2873 / 68444 = 0.04197 = 4.1976% Net Profit Margin=Net ProfitSales = 1482 / 55475 = 0.0267 = 2.67%Return on Assets=Operating Profit or EBITTotal Assets = 4402 / 40115 = 0.1097 = 10.97% Return on Assets=Operating Profit or EBITTotal Assets = 2326 / 22915.

8 = 0.1015 = 10.15%Evaluation of Relative Performance of Two Firms in terms of:Liquidity West farmers Ltd (WES) Woolworths Ltd (WOW)Current Ratio 0.9280 times 0.4393 timesQuick Ratio 0.3012 times 0.1830 timesInventory Ratio 9.7392 timesLiquidity Ratio shows the financial status of the company. From the above calculation, we can interpret that West Farmers Limited is more liquid than Woolworths based on its Current Ratio and Quick Ratio.

West Farmers had $0.9280 current assets and $0.3012 cash and accounts receivable for every $1 of current liabilities. Whereas Woolworths had $0.1830 current assets and $0.1830 cash and account receivable to pay $1 current liabilities.ii) Asset Management EfficiencyWest farmers Ltd (WES) Woolworths Ltd (WOW)Total Asset Turnover 1.7062 times 2.4208 timesFixed Asset Turnover 7.2504 times 6.5748 timesiii) Financing Practices (Capital Structure)West farmers Ltd (WES) Woolworths Ltd (WOW)Debt Ratio 40.32% 56.90%Interest Coverage Ratio 20.6667

iv) ProfitabilityWest farmers Ltd (WES) Woolworths Ltd (WOW)Gross Profit Margin 28.71%Operating Profit Margin 6.4315% 4.19%Net Profit Margin 4.1976% 2.67%Return on Assets 10.97% 10.15%…………………………Calculation of Current Price-Earnings Ratio and Market-to-book Ratio:West farmers Ltd (WES) Woolworths Ltd (WOW)Market Value RatiosPrice Earnings Ratio = Market Price Per ShareEarnings Per SharePrice Earnings Ratio = Market Price Per ShareEarnings Per ShareMarket to Book Ratio =Market Price Per ShareBook Value Per ShareMarket to Book Ratio =Market Price Per ShareBook Value Per ShareQuestion no. 4: Time Value of Money (Chapter 5)Solution:Present Value (PV) =$20,000 Time (n) = 40 yearsInterest Rate (i) = 10 % per annum = 0.10

Future Value (FV)=?Timeline i=10% p.a FV=? 0 1 2 3………………… n= 40 years PV=$20,000FV= PV (1+i)n = 20,000(1+0.10)40 = 20,000×45.25925557 = $ 905,185.1114From the above calculation, Emily’s investment from her retirement plan will grow to $905,185.1114 after 40 years at 12% annual interest. b)Timeline i=6% p.a FV=$14,000 0 1 2 n= 3 years PMT=?Deposit on Car (PV)= $14,000No of years (n) = 3 years Annual Interest (i)= 6% =0.06Annuity Payment (PMT)=?We have,FV = PMT (1+i)n-1i14000 = PMT 1+0.06)3-10.06 PMT = 140003.1836PMT = $ 4397.5374To cover the cost of deposit on a new car, Emily needs to keep aside $4397.5374 from her bonus this year.

Now, If Annual Interest on Saving (i)=10%=0.10PMT=?FVn = PMT (1+i)n-1i14000 = PMT1+0.10)3-10.10PMT = 140003.31PMT = $4229.6073If the annual rate of interest grows to 10%, then the amount of payment will decrease to $4229.6073.c)At the age 60 years, value of Trust Fund (FV)=?Time (n) = 60-30=30 yearsInterest rate =7%= 0.07Timeline i=7% p.a FV=? 0 1 2 3………………… n= 30 years PV=$50,000 FV = PV ((1+i)n = 50,000 (1+0.07)30 = 50,000 ×7.612255043 = $ 380,612.7521When Emily turn 60 years, the value of her trust fund will grow to $380,612.7521 at the rateOf 7% government bond.

d)Compounding and discounting have inverse relationship. Compounding method is the way of calculating the future value of money with the given current value of investment at certain compound rate. Whereas Discounting method is used to find out the Present Value of future cash flow using discounting rate.

Mathematically,In Compounding Method,Future valuein year nFVn= Present Value(PV) ×1+ Annual interest rate (i)number of years nIn Discounting Method,Present ValuePV = Future Value in year nFVn 11+ Annual Interest Rate (i)Number of years (n)e)Question no 5: Risk and Return (Chapter 7)a.Given:Share A Share BProbability Return Probability Return0.3 11% 0.2 -5%0.4 15% 0.3 6%0.3 19% 0.3 14%0.2 22%

For Share AExpected rateof returnE(r)=rate of return 1 r1×probabilityof return 1Pr(r1)+rate of return 2 r2×probabilityof return 2Pr(r2) +rate of return 3r3×probabilityof return 3Prr3)= 0.3 × 0.11 + 0.4 × 0.15 + 0.3 ×0.19= 0.033 + 0.06 + 0.057= 0.15= 15%Variance in rate of return?2 = rate of return 1 r1-expected rate of returnEr2×probabilityof return 1Pr(r1) + rate of return 1 r1-expected rate of returnEr2×probabilityof return 1Pr(r1) + rate of return 3r3-expected rate of returnE(r)2×probabilityof return 3Pr(r3) = [(0.11 – 0.15)2 × 0.3] + [(0.15 – 0.15)2 × 0.4] + [(0.19 – 0.15)2 × 0.3] = 0.00048 + 0 + 0.00048 = 0.00096

Standard Deviation = Variance =0.00096 = 0.030983867 = 3.0984%For Share BExpected rateof returnE(r)=rate of return 1 r1×probabilityof return 1Pr(r1)+rate of return 2 r2×probabilityof return 2Pr(r2) +rate of return 3r3×probabilityof return 3Prr3)+rate of return 4r4×probabilityof return 4Pr(r4)= 0.2 × (-0.05) + 0.3 × 0.06 + 0.3 ×0.14 + 0.2 × 0.22= (-0.01) + 0.018 + 0.042 + 0.044= 0.094= 9.4%

Now, Variance in rate of return?2 = rate of return 1 r1-expected rate of returnEr2×probabilityof return 1Pr(r1) + rate of return 1 r1-expected rate of returnEr2×probabilityof return 1Pr(r1) + rate of return 3r3-expected rate of returnE(r)2×probabilityof return 3Pr(r3) + rate of return 4r4-expected rate of returnE(r)2×probabilityof return 4Prr4) = [(-0.05 – 0.094)2 × 0.2] + [(0.06 – 0.094)2 × 0.3] + [(0.14 – 0.094)2 × 0.3] + [(0.22 – 0.094)2 × 0.3] = 0.0041472 + 0.0003468 + 0.0006348 + 0.0031752 = 0.008304Standard Deviation = Variance = 0.008304 = 0.091126286 = 9.1126%

b)Shareholders or investors of the company always assume to gain certain profit from the investment they made on their business. Such expectation is referred to as Expected Rate of Return. Whereas Realized Rate of Return is the actual amount of profit or loss that that face from their investment in certain duration of time.

c) d. Question No 6: Risk and Return (Chapter 8)Answer:Part 1Systematic Risk and Unsystematic RiskSystematic risk refers to those risks that are associated with the overall market or industry (Vasigh, Fleming ; Mackay, 2010) and cannot be diversified away while unsystematic risk refers to those risk that are associated with the single investment or small class of investment and can be diversified away (Swedroe ; Hempen, 2007).

Investment beta is the measure of change in investments’ return to the change in return of the market portfolio. Johnson (2014) also stated that investment’s beta measures the volatility of share relative to volatility of market. Thus, investment’s beta helps to measure the systematic risk of an investment. Therefore, it is very useful in the investment decision. For example: if we want to know the systematic risk of particular investments, we can calculate beta and know the volatility and go for that investments with low volatility.

In terms of unsystematic risk, it is calculated by deducting the beta scaled by the market volatility from the volatility of the single stock. Part 2Beta of a Portfolio and Betas of the Individual Investments in the PortfolioPart 3Security Market LineSecurity market line is the graphical representation of Capital Asset Pricing Model (CAPM) i.e. the straight line relationship between expected return and betas that also explains the market price of risk in capital market (Khan, 2004).

Return (%)Security Market Liners =rf+rm-rf?rfRisk Beta (?)Figure. Security Market Line. Adapted from “Investments: An Introduction” by H. B. Mayo, 2013, Boston: Cengage Learning. From the above graph, we can see that risk beta is at the x-axis and expected return on the y-axis. The slope of the security market line is represented by market risk premium which is the difference between expected rate of return on the market portfolio and the risk free rate (i.e.Erm-rf) while the y-intercept of this line represents the risk free interest rate i.e. rf .

Part 4Capital Asset Pricing ModelCapital asset pricing model (CAPM) refers to the model that explains the relationship with expected return and the systematic risk of an investment. In a simple word, CAPM is that model which estimates the expected return for any risky assets. According to Mellen (2018), this model helps the business analyst and investor evaluate a suitable rate of return for an investment by giving the general economic, industry and firm’s conditions.

CAPM helps to inform the investment decision by first of all measuring the fairest price for an investment on the basis of risk, potential return and other factors and then comparing this fair price with the market price.Therefore, this is how the CAPM can be used to inform the investment decision.

Reference

  • Johnson, R. S. (2014). Equity Markets and Portfolio Analysis. New York: John Wiley ; Sons, Inc.Khan, M. Y., ;
  • Jain, P. K. (2004). Financial Management: Text, Problems and Cases. New Delhi: Tata McGraw Hill Publishing Company Limited.
  • Mayo, H. B. (2013). Investments: An Introduction. Boston: Cengage Learning.Mellen, C. M. (2018). Valuation for M ; A: Building and Measuring Private Company Value. New York: John Wiley ; Sons, Inc.Swedroe, L. E., ;
  • Hempen, J. H. (2007). The only guide to a winning bond strategy you’ll ever need: The way smart money preserves wealth today. New York: St. Martin’s PressVasigh, B., Fleming, K., ;
  • Mackay, L. (2010). Foundation of Airline Finance: Methodology and Practice. Farnham: Ashgate Publishing, Ltd. Reference