Organisation Chosen Essay
The organisation chosen in this paper entails John Lewis Partnership. This is a well established firm, which is ranked as one of the top ten retail business in the United Kingdom. During the year under review, 2008, John Lewis had 69 department stores and 187 Waitrose supermarkets (John Lewis 2009, p 1). The competitor selected in this financial analysis is Debenhams, which is an organisation also engaged in the retail industry. This firm specialises in clothing, health and beauty and accessories. It also holds a remarkable reputation in the United Kingdom Industry (Debenhams 2009, p
1). Financial Analysis
The financial analysis of the aforesaid organizations will be classified in three main categories, which encompass the following: financial performance, financial position and financial stability. Once the financial strengths and weaknesses of each firm are properly outlined, special examination will be forwarded to certain disclosures in the accounts, namely accounting policies, property, plant and equipment and directors’ information. This will be followed by a discussion of the weaknesses in ratio analysis and a recommendation of the most optimal company to invest in. Financial Performance of Companies Chosen
An increasing trend in the return on capital employed is portrayed for both companies. This implies that the
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This ratio outlines the operating profit generated out of every ? 100 of sales (Randall 1999, p 464). However, in such instance the operating profit margin is not only low for such organization, but also at a declining trend. On the contrary, John Lewis is experiencing an increasing trend in such ratio. The above mentioned conflicting ratios for Debenhams outline an abnormality that ought to be further examined by conducting further examination on certain items present in the financial statements. In this respect one can note that the operating profit margin decreased by 2.
1%, which substantiates the declining trend in the operating profit margin ratio. Upon examination of the balance sheet, one can note that the net assets are significantly low due to the substantial long-term liabilities that the organisation holds. The net asset is a figure that is normally used as capital employed in the return on capital employed equation (Randall 1999, p 463). Therefore in reality the material return on capital employed of Debenhams does not outline better efficiency, but is the result of material long-term debts.
The return on assets ratio, which outlines the ability of management to generate sales out of assets employed is in favour of John Lewis (Randall 1999, p 467). Both firms are outlining an increase in such ratios; however John Lewis ratio is higher in both years highlighting more proficient management. Therefore in view of the above ratios, one can contend that the profitability of John Lewis is better than that of Debenhams. Financial Position of Companies at Hand The current ratio, which outlines the ability of current assets to cover current liabilities, has remained stable for John Lewis, but deteriorated for Debenhams.
However, the acid test ratio, which denotes the capability of the most liquid assets to cover the current liabilities decreased for both organisations (McKenzie 2003, p 205-206). This implies that the management of liquid assets is deteriorating for both firms. These ratios portray the liquidity of the companies in generic terms. In order to identify the reasons behind such decrease one has to apply other ratios specific on certain items present under the current assets and/or current liabilities. An important variable present for organisations engaged in the retail industry, like the ones examined, is inventory.
Such firms tend to keep high stock of finished goods in order to hinder lost sales, which leads to money tied up in stock and greater risk of stock obsolescence especially for clothing and perishable goods. In this respect it is plausible to apply the days of inventory ratio. This ratio indicates the period (in days) taken for an organisation to sell its stock (Investopedia 2009). A decrease in such ratio is taking place for both firms. This indicates that management is more effective in stock management.
Therefore one can state that stock is the reason behind the working capital problems noted above. Cash and cash equivalents are a vital element in a company that has to be considered in a financial analysis. In the absence of cash an organisation will perish in a few days. In this respect the cash debt coverage is computed, which outlines that the ability of operating cash flow to cover debt (Boise State University). An increase in the cash debt coverage ratio is noted for both organisations, which highlights an improvement in the aforesaid capability.
John Lewis ratio is higher than Debenhams, further pinpointing that the liquidity of this company is better. Financial Stability of Firms Selected Both John Lewis and Debenhams are high-geared companies as indicated by the gearing ratio. This is normally an adverse argument towards the financial stability of the organisation, because the higher the gearing ratio, the greater the amounts of debts. Such medium of finance necessitates higher financial commitments like interest and debt capital repayments (Pike et al. 1999, p 558).
Therefore if high the risk of instability is greater during adverse trading conditions. As regards Debenhams the gearing ratio is excessively high. This abides with the argument outlined in the financial performance section above, where it was stated that the high return on capital employed was the result of significant debt, which reduced the net assets. The interest cover, which portrays the ability of operating profits to cover interest expenditure decreased for Debenhams, but increased for John Lewis (Randall 1999, p 472).
Therefore as regards John Lewis, despite it is a high geared organisation the financial stability is improving in light of a greater profit potential. This is not the case for Debenhams that has a worrying amount of debt. Disclosure of Accounting Policies The main purpose behind accounting policies is two fold. First accounting policies are necessary in order to comply with the requirements of specific accounting standards (IAS 1 – Presentation of Financial Statements 2000, p 87).
For instance, an organisation is required to disclose the accounting policy adopted for the recognition of sales revenue (IAS 18 – Revenue 2000, p 413). In addition, accounting policies are necessary in order to aid the decision-making of interested users. That is in order to provide more pertinent information that can aid in the economic decisions taken by external users (IAS 1 – Presentation of Financial Statements 2000, p 87). For example, the accounting policy on financial instruments can provide further information to users on how financial instruments are accounted for.
It is also contended that the disclosure of appropriate accounting policies to investors in the capital market can mitigate the existence of systematic and substantial asymmetric information across such parties leading to lower transaction costs, higher liquidity of securities and enhancement of gains from trade. However, the present accounting policies disclosed are more focused on faithful representation and neutrality rather than the aforesaid aspect. Indeed a set of equity-orientation disclosures has been forwarded by critics in order to outline how the accounting policies should be prepared (Lev 1988, pp 1, 18-19).
Property, plant and equipment A specific asset that is frequently material and holds a substantial effect on the resources of the organisation is the property, plant and equipment. A number of ratios are adopted in the financial analysis above that incorporate such element, such as the return on capital employed and return on assets. This further highlights its importance. In this respect one would be interested to know more information on such item, which is disclosed in the accounts in line with IAS 16 – Property, Plant and Equipment.
The note in John Lewis Financial Statements (note 12) outlines that the organisation holds three main types of property, plant and equipment, which entail: land and buildings, fixtures and fittings and assets in course of construction. Such note outlines the movement in the value of the aforesaid fixed assets stemming from additions, disposals, impairments and depreciation. Such non-current assets are initially, once acquired valued at cost in line with the applicable standard (IAS 16) and as outlined in an accounting policy pertinent to their valuation.
With respect to Debenhams, there is also another note (note 16) outlining the movement in value of property, plant and equipment. This category of assets is classified in the following headings: freehold land and buildings, leasehold land and buildings, short-leasehold fixtures and fittings and vehicles, fixtures and equipment. The assets are also subject to depreciation, impairment and acquisitions/disposal and are recorded at cost in line with applicable standards as outlined in an accounting policy. Information on Directors
Corporate Governance is another matter that is gaining considerable importance in the business environment. The fears of agency costs stemming from the agency theory were always present. Such theory states that corporate management objectives may differ from those of the firm leading to additional costs that does not create value to the organisation (Pike et al. 1999, p 24). However, recent accounting scandals like Enron increased the aforesaid concern. A typical example of agency costs entails a very high remuneration and/or additional financial benefits that are given to executive management.
In the annual report of John Lewis (note 9) information is conveyed on the financial benefits and remuneration provided to the board of directors. Further more, such note also outlines the pension entitlements that executive management is entitled to. Related party transactions however are not disclosed in this note. Information on directors’ remuneration and other financial benefits is also disclosed in the financial statement of Debenhams via note 9. Such note holds lower information than that of John Lewis.
Limitations of Accounting Ratios The forthcoming conclusion in this paper is highly dependent on the accounting ratios computed. Thus it is important to outline the limitations of accounting ratios in order to comprehend the potential that such technique holds. One of side stems the weaknesses of accounting ratios, which basically encompass neglection of qualitative characteristics and of economic factors present in the external environment like inflation (Weetman 2003, p 374).
Another important aspect that affects ratio analysis is the one concerning the limitations of financial statement information, which is the basic medium on which vertical analysis is conducted. The lack of information present in such financial reports is one of the main reasons of such disadvantage. A typical case in point is the limitation outlined in accounting policies in a section above. The latter category of limitations of vertical analysis arises from the additional information demanded by external users.
In order to identify such factors, apart from attaining a list of these external users, it is also necessary to enter in substantial detail on the information needs of such parties. For instance, lenders like banks a good understanding of the grading provided to the financial health of the company at hand and security measures required ought to be outlined (Pike et al. 1999, p 558-559, 507). In addition, lenders normally request additional information through other reports like business plans. In this respect, an examination of the key features of such reports is critical.