The Role of Consolidated Financial Statements of a Company - Case Study Example

Requirement 1 Consolidated financial statements of a company are important documents that aid in the analysis of performance of a company (Donald, et al., 2009). For the purposes of evaluation of financial statement, the analysis has been broken down into four major sections: activity, liquidity, solvency, and profitability. Takeda Company Ratio Category Key Ratio Computation Year 1999 Activity Fixed Asset Turnover ratio Net Sales/Fixed Assets 376.69% Total Asset Turnover ratio Net Sales/Total Assets 63.65% Liquidity Current Ratio Current Assets/Current Liabilities 3.2610:1 Quick Ratio Quick Assets/Current Liabilities 2.8762:1 Solvency Debt-to-asset ratio Total Liabilities/Total Assets 0.2937:1 Debt-to-equity Ratio Total debt/Total equity 0.4296:1 Profitability Return on Equity (ROE) Net Income/Total Equity 10.11% Net Profit Margin Net Income/Net Sales 10.86% Requirement 2 Takeda and Pfizer Company Ratio Comparison (Year 1999) Ratio Category Key Ratio Computation Takeda Company Pfizer Company Activity Fixed Asset Turnover ratio Net Sales/Fixed Assets 376.69% 150.62% Total Asset Turnover ratio Net Sales/Total Assets 63.65% 68.69% Liquidity Current Ratio Current Assets/Current Liabilities 3.2610:1 1.2184:1 Quick Ratio Quick Assets/Current Liabilities 2.8762:1 1.0383:1 Solvency Debt-to-asset ratio Total Liabilities/Total Assets 0.2937:1 0.5680:1 Debt-to-equity Ratio Total debt/Total equity 0.4296:1 1.3151:1 Profitability Return on Equity (ROE) Net Income/Total Equity 10.11% 35.77% Net Profit Margin Net Income/Net Sales 10.86% 22.49% Activity The level of activity for Takeda and Pfizer Company show some disparities when different ratios are considered. When we measure efficiency using fixed asset turnover ratio, Takeda company is the most efficient with 376.69%. However, using total asset turnover ratio shows that Pfizer Company is the most efficient in utilizing the total assets with 68.69%. A company is provided with assets for which it is required to use in order to generate revenue for the company. Efficiency/activity ratios are used to show whether the company has utilised its assets efficiently (Weygandt, et al., 2010). If the capacity to produce goods and services is not maximized, then it is argued that the assets of the company are not used efficiently. Barney (1991) observes that it is not rational to buy so many assets when they are only used in the production of very few goods and services. The total asset turnover for Pfizer Company is 68.69%. This is a clear indication that there is maximum utilization of total asset in the production of revenue for the company. However, a high fixed asset turnover ratio like 376.69% for Takeda Company may not be a good signal since it points that the company has employed very few fixed assets in the production of revenue. The fixed asset turnover ratio is very high in both companies because non-current assets constitute a very low proportion of the total assets. Liquidity The liquidity position of the two companies is good. However, the liquidity level of Takeda Company is higher than the liquidity level of Pfizer Company. This is as per current ratio and the quick ratio. Both the current ratio and quick ratio of Takeda Company are higher than the current ratio and quick ratio of Pfizer Company. Horngren and Harrison (2009) notes that a company does not operate in isolation. It has to operate interdependently with other players in the economy. These relationships bring about transactions which result to financial obligations. Liquidity deals with issues related to financial obligations in the short term. Liquidity ratios determine whether the company is well placed to honour its financial obligations in the short term when creditors demand for repayment. The key ratios under this category are the current ratio and the quick ratio. Current ratio shows whether the company is able to cover its short term obligations using the current assets. This ratio is 3.2610:1 and 1.2184:1 for Takeda Company and Pfizer Company respectively. This means that the current assets of Takeda Company will cover 3.2610 times the current liabilities of the company. On the other hand the current assets of Pfizer Company will cover 1.2184 times the current liabilities of the company. The quick ratio indicates the rate at which the company will pay its short term debts using the very liquid assets of the company. Since Takeda Company has the largest ratio it can be argued that it is the most liquid company of the two. Solvency Solvency ratios indicate the financial stability of the company in the long term. Pfizer Company has the highest ratios of both debt-to-asset ratio and debt-to-equity ratio with 0.5680:1 and 1.3151:1. A company is financed either through equity or debt financing. Equity financing is obtained through issuance of shares to the public. According to Brigham and Ehrhardt (2009), the shareholders expect to be compensated by payment of dividends when the company makes profit. Debt financing is obtained through borrowings or loans from finance institutions or other credit facilities. These entities extend funds to the company in exchange for periodic interest payment and principal repayment of the funds given at the expiration of the duration of the loan. This, therefore, places an obligation on the part of the company to honour the agreement and any action contrary to this will force the lender to demand immediate payment. The company thus faces the risk of being sued should it breach this contract. Solvency (stability) ratios are useful measure of the long-term risk of debt default. Institutions that extend long-term credit or loan to companies will be interested with these ratios in order to determine the credit worthiness of the company. The debt-asset ratio of Takeda Company is 0.2937:1 which means it does not have a heavy debt burden. However, the same ratio for Pfizer Company is 0.5680:1 which shows an average debt obligation. This is a favourable sign to debt financiers of the companies as it indicates that the companies do not have a heavy debt burden and that they have enough assets to guarantee payment of debt. The debt to equity ratio of Takeda Company is lower than that of Pfizer Company. A debt-to-equity ratio of 0.4296:1 for Takeda Company shows that the company is mostly financed through equity. Therefore, the fear of being declared insolvent is eliminated. However, a debt-to-equity ratio of 1.3151:1 for Pfizer Company shows that the company is mostly financed through debt. This is a very high ratio which might send bad signals to the shareholders of the company. This is because the ratio suggests that most earnings of the firm will be directed towards repayment of debt at the expense of dividend payment to the investors. Profitability All indications point that Pfizer Company is more profitable than Takeda Company. This is because both the return on equity (ROE) and net profit margin for Pfizer Company are higher than that of Takeda Company. The ROE for Pfizer Company is 35.77% compared to a low ROE of 10.11% for Takeda Company. In the same manner the net profit margin for Pfizer Company is 22.49% compared to a low net profit margin of 10.86% for Takeda Company. A profitable company is attractive to every investor. This is because it reflects the high chances of accruing dividends to investors. This aspect is well captured by profitability ratios. These ratios measure the operating efficiency of the company and include measuring the company’s ability to generate revenue income hence cash flow. Cash flow is a very important aspect of business since it determines the ability of the company to obtain both debt and equity financing (Spiceland and Sepe, 2001). The key ratios used to determine the profitability of the two companies are the ROE and the net profit margin. These ratios show that both companies are profitable. It is only the degree of profitability that differs. However, a close analysis of the profitability of the two companies will place a lot of importance on the net profit margin. This is because of the observation that we had made earlier that Pfizer Company is mostly financed through debt. This means that the equity component in its capital structure is very little. This is exactly what has made its ROE to be very high which may not necessarily mean that the company has been profitable during the period. The comparison of the two companies has been based on ratio analysis as computed from consolidated financial results of the respective company. Unfortunately, ratio analysis is not a very accurate measure of performance because of its limitations. These limitations are the ones responsible for undermining the usefulness this comparison. Some of these shortcomings include; It is true that ratios are valuable analytical tools and serve as screening devices. However, ratios themselves do not give much information. Soffer & Soffer (2003) has shown that they are not predictive. This is because they shed light on the company’s past performance and not forecast on what the company is likely to perform in the future. In this case they are not reliable for a speculative investor who would wish to speculate on the future performance of the company. Specifically, analysis is not definite since it does not make concrete assertion hence it is possible to make wrong investment decision. It is not conclusive that since return on equity (ROE) of Pfizer Company is higher than ROE for Takeda Company, then an investor should invest in Pfizer Company. Ratios do not give meaningful measure of the performance of the company; therefore, they must be analyzed against established standard. The selection of similar company for comparison with the company under evaluation is difficult. This is because no two companies can be exact of the other. They have to differ in some aspects. For instance, you cannot compare two companies whose accounting policies differ materially (Fess and Warren, 2004). Ratios can easily be manipulated through creative accounting or using accounting policies that are inappropriate. In such a case the investment decision made out of this analysis will be misinforming. Ratio analysis is made out of balance sheet figures, consolidated income statements, and cash flow statement of the companies, which are usually true as at a particular point in time or for a given period. This means that the analysis will only hold true as at that point in time or for a period of time. Otherwise it will not be true position of the company since company activities are on-going and every transaction counts for the performance of the company. Subjectivity – ratios have no general standards with respect to presentation formats and their interpretation hence two investors are likely to make differing interpretations from the same ratio (Drake and Fabozzi, 2012). This makes the interpretation of ratios hard and in some case arbitrary. Requirement 3 Integrated ratio analysis of Takeda Company Consolidated Income Statement For the year ended 31st March 1999 Millions of Yen % Revenue 844,643 100.00% Cost of sales 435,787 51.59% Selling, general and administrative 266,636 31.57% Gross profit 142,220 16.84% other Income(expenses) interest and dividend income 8,603 1.02% interest expense (1,059) -0.13% equity earnings - subsidiaries 35,981 4.26% loss on disposal of PPE (332) -0.04% Exchange losses (734) -0.09% Other (2,537) -0.30% Total other Income(expenses) 39,922 4.73% Profit before interest (minority) and tax 182,142 21.56% Income tax expense 89,019 10.54% income before minority interest 93,123 11.03% Net income 91,755 10.86% Consolidated Balance Sheet (extract) As at 31st March 1999 Millions of Yen % Assets Current assets cash and cash equivalents 313,798 23.65% marketable securities 227,032 17.11% Notes & accounts receivables 224,878 16.95% inventories 107,767 8.12% Deferred income taxes 28,180 2.12% Other current assets 11,608 0.87% Total current assets 913,263 68.82% Non -current assets plant, property and equipment land 39,603 2.98% buildings and structures 229,146 17.27% machinery and equipment 382,256 28.81% construction in progress 6,887 0.52% Total plant, property and equipment 657,892 49.58% Accumulated depreciation 433,663 32.68% Net plant, property and equipment 224,229 16.90% Total Non -current assets 224,229 16.90% Investments and other assets 189,507 14.28% Total Assets 1,326,999 100.00% Liabilities and shareholders' equity Current Liabilities bank loans 9,361 0.71% current portion of long-term debt 2,119 0.16% Notes and accounts payable 113,034 8.52% accrued expenses 68,464 5.16% Income tax payable 38,698 2.92% Other current liabilities 48,382 3.65% Total current liabilities 280,058 21.10% Long term liabilities long term debt 9,858 0.74% retirement benefits 93,961 7.08% Reserve for SMON compensation 5,886 0.44% Total long term liabilities 109,705 8.27% Shareholders' equity Common stock 63,540 4.79% Additional paid-in capital 49,637 3.74% legal reserve 14,250 1.07% Retained earnings 779,946 58.78% Total shareholders' equity 907,373 68.38% Total Liabilities and shareholders' equity 1,326,999 100.00% Requirement 4 In 1999 the ROE for Pfizer Company is higher than the ROE for Takeda Company. The ROE for Pfizer Company is 35.77% whereas the ROE for Takeda Company is 10.11%. ROE is computed by factoring in the value of net income which is divided by shareholders’ equity. The key ratios that may explain the difference in ROE are those ratios which are related to ROE. The key ratios that has a relationship to ROE are return on investment (ROI) also called return on assets, the debt-to-equity ratio and debt-asset ratio. When you multiply ROI by debt-equity ratio and then divide the result by debt-asset ratio, you get ROE. That is ROE = (ROI* debt-equity ratio)/Debt asset ratio. ROI is determined as net income divided by total assets. In this case total debt is assumed to be equal to total liabilities. The difference in ROE is also explained by other factors that determine the income and capital structure of the company. This includes; High cost of production: when the cost of producing goods and services is incredibly high, the gross profit of the company will be minimized and consequently the net income for the company will be greatly affected. Operating expenses: when the operating expenses of a company are high, the net income will be low since these expenses are charged against the profit made by the company (White, Sondhi and Fried, 2002). The financial leverage of companies will cause the difference seen in ROE. A company that is financed through debt will show a high ROE while a company that depends on equity financing will have very low ROE. This explains why the ROE of Pfizer is high because it is mostly debt financed whereas the ROE for Takeda Company is low because it depends mostly on equity for financing its investments. Requirement 5 The table below shows computation of ROE and other key ratios for Roche Company in year 2000 and year 1999. Roche Company Ratio Computation Year 2000 Year 1999 Change Return on Equity (ROE) Net Income/Total Equity 31.32% 21.38% 9.94% Return on Investment (ROI) Net Income/Total Assets 12.44% 8.18% 4.25% Debt-to-asset ratio Total Debt/Total Assets 0.5393 0.5740 -0.0348 Debt-to-equity Ratio Total debt/Total equity 1.3583 1.5000 -0.1417 Requirement 5 (i) The overall profitability of Roche Company as measured by ROE has improved. The key ratios that explain the changes in the ROE of the company from 21.38% in year 1999 to 31.32% in year 2000 are Return on Investment (ROI) and Debt-to-asset ratio. Given that ROE = (ROI* debt-equity ratio)/Debt asset ratio, it follows that both ROI and debt-equity ratio have a direct relationship with ROE whereas debt asset ratio has an inverse relationship with ROE. This means that an increase in either ROI or debt-equity ratio will result to an increase in ROE and the reverse is true. Therefore, since ROE has increased the ratio that must have caused the increase is the ratio that has shown increment, which is ROI. On the other hand a decrease in debt asset ratio will result to an increase in ROE. Therefore, since debt asset ratio has decreased then it must explain the increase in ROE. This brings us to a conclusion that the key ratios which have contributed Requirement 5 (ii) Year 1999 Roche Company Pfizer Company ROE 21.38% 35.77% Return on Investment (ROI) 8.18% 15.45% Debt-to-asset ratio 0.5740 0.5680 Debt-to-equity Ratio 1.5000 1.3151 The ROE for Pfizer Company in 1999 is higher than the ROE for Roche Company in the same year. In 1999 the ROE for Pfizer Company is 35.77% whereas the ROE of Roche Company is 21.38%. The increase in ROE will result when either any of Return on Investment (ROI) and Debt-to-equity Ratio is higher than that of the other company or Debt-to-asset ratio of one company is lower than the other. In this case since it is ROE for Pfizer Company that is higher than the ROE for Roche Company, then either Return on Investment (ROI) and Debt-to-equity Ratio of Pfizer Company is higher than that of Roche Company or Debt-to-asset ratio of Pfizer Company is lower than that of Roche Company. The ROI of Pfizer Company (15.45%) is higher than the ROI of Roche Company (8.18%) whereas the Debt-to-equity Ratio Pfizer Company (1.3151) is lower than the Debt-to-equity Ratio Roche Company. The Debt-to-asset ratio of Pfizer Company (0.5680) is lower than the Debt-to-asset ratio of Roche Company (0.5740). Therefore, the key ratios that explain the difference between the ROE for Pfizer and Roche Company in year 1999 are ROI and Debt-to-asset ratio. References Barney, J., (1991). Firm resources and sustained competitive advantage. Journal of Management, 17(1) pp. 99-120. Brigham, E. and Ehrhardt, M. (2009). Financial Management: Theory and Practice, 13th Edition. Ohio: Thompson South-Western. Donald, E. et al., (2009). Intermediate Accounting. New Jersey: John Wiley and Sons. Drake, P. P. and Fabozzi F. J., (2012). Analysis of Financial Statements, (3rd ed.). John Wiley & Sons: Australia. Fess, E. and Warren, C., 2004. Accounting principles. Canada: Southwestern Company. Horngren, C. T., & Harrison, W. T. (2009). Accounting (7th ed.). Upper Saddle River, NJ: Pearson Prentice Hall. Soffer, L., & Soffer, R. (2003). Financial statement analysis. Upper Saddle River, NJ: Prentice Hall Spiceland, J. D. and Sepe, J.F., (2001). Intermediate Accounting. New Delhi: McGraw-Hill Publisher. Weygandt, J. et al., (2010). Managerial Accounting: Tools for Business Decision Making. New York: John Wiley and Sons. White, G.I., Sondhi, A.C. and Fried, D., (2002). The analysis and use of financial statements (3rd ed.). New Jersey: John Wiley and Sons. Read More