Financial Statements Relevance: Corporate Finance Essay

Question:

Disucss about the Financial Statements Relevance for Corporate Finance.

Answer:

Introduction

Financial statements play a key role in understanding a given company’s financial performance by the stakeholders especially the shareholders. In this regard, the income statement tends to represent the profitability of the operations by highlighting the revenues earned through routine operations and the various expenses incurred therein. The balance sheet represents the financial position of the company at a given date usually the ending of a financial year or quarter and tends to reflect on the underlying liquidity and solvency for the company. The cash flow statement tends to measure the cash surplus or cash deficits that may occur during a given time period. This is imperative as at time the revenues in the income statement may not transform into cash or there may be timing difference between the receipt of revenues and expenses incurred which may be troublesome. These statements together provide a glimpse into the financial and operational performance of the financial statements in the past and predict the estimations for the future (Guerard, 2013). In this background, the financial statements of one of the leading home retailers of Australia i.e. JB-Hi Fi are analysed using ratio analysis as the primary tool so as to comment on the recent performance of the company and estimate the expectations in the future. Additionally the accounting policies of the company would also be reviewed.

Accounting Policies

The various accounting policies adhered by the company in relation to the various items such as inventory and sales, are in line with the applicable norms for the industry and relevant to the company. For instance, the recording of inventories is taken at the value which is lower between the realisable value and cost which is critical especially in the industry the company operates in as technological obsolescence could be sizable and hence it is imperative that the inventory captures the existing value of the inventory. Further, the revenue recognition, provisions and impairment are in line with the relevant provisions of the IFRS. Additionally, the fixed assets of the company are measured at either the historical cost or the fair value depending on the underlying asset. Fair value is primarily applied in case of land while machines and building are primarily measured at cost price in line with the relevant AASB standards. Thus, the accounting policies of the company are compliant with the applicable norms and accounting standards advocated by relevant authority or AASB (JB Hi Fi, 2016).

Analysis of Relevant Ratios

In order to analyse the performance of the company, ratio analysis would be performed as the analysis tool which would take into consideration the financial statements from FY2012 to FY2016 as indicated below.

Profitability

The profitability ratios for the company are summarised in the table below.


The ratios represented above suggest that there is a constant improvement in the profit margins at gross level from FY2012 to FY2016. This is primarily on account of sourcing efficiency exhibited by the company primarily as it grows in size and is able to leverage economies of scale. However, the concerning observation is that the increase in gross margins has been declining and also almost eroded in FY2016 which may be attributed to the excessive competition in the industry and hence efficiency gains need to passed on to consumers. The profitability margins have exhibited a constant improvement primarily on account of decreasing cost on a per unit basis as the number of stores has constantly widened. The company’s profit margin at the net level has also expanded over the given period primarily on improvement in gross profits. The ROA also shown an increasing trend primarily on the back of increased net profits coupled with fluctuations in the total asset base. However, unlike ROA, there is a decline in the ROE. This is apparent as it stood at 56.72% and 37.60% in FY2015 and FY2016 respectively. This may be attributed to rapid rise in equity on the back of high amount of retained earnings which has to lead to significant increase in equity in % terms as compared to profit. The asset turnover from FY2012 to FY2015 has shown an increasing trend but in FY2016 has reduced. This may be attributed to the higher increase in assets caused due to unexpected increase in inventories level at the end of FY2016 (JBHiFi, 2016)

Liquidity

The liquidity ratios for the company are summarised in the table below.


It is apparent from the above table that the inventory turnover has increased in FY2013 indicating that the inventory levels were lower than expected as sales might have been higher in FY2013. In FY2014 and FY2015, the inventory levels have been rather moderate while in FY2016 due to higher inventory level, there has been a drop in the inventory turnover ratio. A steady downfall has been noticed in the receivables turnover which is indicative of the time delay experienced by the company in deriving cash for the credit sales. This may be attributed to the increasing competitive landscape where incentivising the buyers with long credit period and flexible EMI’s becomes essential. Clearly this would have negative impact on the cash cycle as it would become longer and hence enhance the need for working capital. The current ratio has seen a major jump in FY2014. This potentially can be explained by the current liabilities decrease caused due to huge decrease in trade payables which stood at $387 million at the end of FY2013 but reached $ 303 million at the end of FY2014. Further, in subsequent years, the decrease in the current ratio which is primarily on account of the rising trade payables outstanding at the end of FY2015 and FY2016. This is indicative of the higher competition which in turn leads to greater payables period so as to decrease the cash cycle and hence save on requirements in relation to working capital (JB Hi Fi, 2016;2014;2012).

Solvency

The solvency ratios for the company are summarised in the table below.


The debt to equity ratio for the company has reduced from 0.82 at the end of FY2015 to 0.27 at the end of FY2016. The debt to equity ratio trend is highly dependent on the movement of the long term debt as the short term debt is negligible only for the company. Hence, the debt to equity ratio essentially mirrors the movement in long term debt. Also, the decreasing trend in the debt to equity ratio is also caused to an extent by the continuously increasing equity levels on the back of higher retained earnings due to high profits of the company. The interest coverage has grown stronger over the years and augers well for the company as the operating profit is significantly higher than the interest obligations (Graham & Smart, 2012). Also, the interest obligations have also shown a decline in line with the long term debt. As a result, the company is in a strong position to honour its interest obligations and there is negligible risk in this regard. The long term debt to equity has shown a declining trend which was interrupted in FY2014 due to hike in non-current borrowings by about $ 55 million. Further, the declining trend is attributed to the increased equity on the back of higher retained earnings (JBHiFi, 2016;2014;2012).

Market

The market ratios for the company are summarised in the table below.


Evident from the above table is that there is a surge in P/E ratio in FY2013 due to the doubling of firm’s stock price over the last year. This was on account of superior financial performance by the company and the significant growth potential that investors perceived in the company in the near future. Over the years, the company has met the market expectations and hence the P/E ratio has continued to be on FY2013 levels and shown marginal improvement. With regards to dividend yield, due to increase in price by almost 100% in FY2013, the dividend yield in the corresponding year has taken a hit. In subsequent years, the trend has been choppy but still a healthy dividend tiled of about 5.5 -6% is available for company’s stock which is attractive for the investors. Besides, the stock also offers value for long term investors (JBHiFi, 2016).

Conclusion & Future Prospects

From the above discussion, it is apparent that in the recent times despite high competition, the company has managed to retain its gross margins and infact has improved the net margins and hence has delivered a strong performance in terms of profitability. However, going forward, the margins would most likely be stagnant only considering the high competition that the industry is currently facing. Further, in relation to short term liquidity also, there has been an improvement in the current ratio and acid test ratio. This is favourable for the firm and indicates that in the near term there would not any difficulty to meet the obligations outstanding in the books of the company (Guerard, 2013). Also, the solvency concerns do not seem to hover on the company as its equity has increased due to higher retained earnings. As a result of increasing equity levels due to higher retained earnings, the solvency ratios are healthy during the given period and the trend observed in the period reflects that solvency risks are minimal for the company. Further, the superior performance of the company has been aptly rewarded by the markets, which is reflected from the jump in P/E ratio led by price rise (Petty et, al., 2015). These entire factors auger well for the company and indicates for better times ahead for the company as it consolidates the various processes. Also, the company is embarking on an ambitious expansion plan in its major markets (Australia and New Zealand). This is likely to lead to improvement in the stock price further in the future on account of superior operational performance backed by an established brand name coupled with presence and high degree of operational efficiency. However, the macroeconomic environment would continue to be a vital aspect impacting the business prospects particularly the margins as in an adverse trading environment, various competitors launch discount schemes to attract consumers which tend to have adverse impact on the margins which may transform into tumbling of stock prices.

References

Graham, J & Smart, S 2012, Introduction to corporate finance, 5th eds., South-Western Cengage Learning, Sydney

Guerard, J 2013, Introduction to financial forecasting in investment analysis, 6th eds., Springer. New York

JB Hi FI 2016, Annual Report 2016, JB Hi Fi, Available online from (Accessed on October 15, 2016)

JB Hi FI 2014, Annual Report 2014, JB Hi Fi, Available online from (Accessed on October 15, 2016)

JB Hi FI 2012, Annual Report 2012, JB Hi Fi, Available online from (Accessed on October 15, 2016)

Petty, JW, Titman, S, Keown, AJ, Martin, P, Martin JD & Burrow, M 2015, Financial Management: Principles and Applications, 6th eds., Pearson Australia, Sydney

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