Financial Statements: Theory, Practice & Critique Essay Sample

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Introduction:

       This paper seeks to analyze and discuss the financial statements of British Airways (BA) and United Airlines (UA), where BA is taken the main company and comparing it’s with UA.  This paper will make an identification of the major challenges faced by British Airways plc and UA while highlighting the differing issues brought out from analysis. In addition, this will be followed by the identification and discussion of the possible main issues that the companies are facing specifying any risks from both a financial and non-financial nature concerning the company for the purpose of improving performance and enhancing their reputations within the financial markets they are operating.

 The later part of the paper will make critically discussion about the usefulness of financial reporting, and financial analysis, in relation to the comments made by John Rishton of BA. This will be complemented by using analysis made in earlier part based on ratios by discussing  the importance of international accounting differences from the perspective of financial analysts and other users of financial statements, under the scenario that the U.S. have still not implemented IFRS.

  1. Questions and Answers:

2.1. Using the Annual Report and Accounts of British Airways plc for the year ended 31 March 2007 and a non-UK based international airline company of your choice (i.e. us airlines); compare the performance of the two companies.

(a) Evaluate the performance of British Airways and the other company in the following areas, using ratio analysis:

a.1 Profitability: ROCE/gross profit margin/net profit margin/asset turnover

     The following summary is of financial ratios are extracted from the financial statements of BA and UA and industry data to facilitate analysis in terms of profitability, liquidity and solvency of the company  (Droms, 1990; Weston and Brigham, 1993; Van Horne ,1992 Ross et. al,1996).

 

Accounting Ratios            
  British Airways United Airlines  
  2007 Y1 2006 2005 2006 2005 2004  
Profitability ratios              
ROCE before tax 27.60% 33.30% 43.30% 1066% na na  
      after tax 13.7% or 19.8%? 25.10% 33.10% 1065% na na  
Gross profit margin 7.10% 8.30% 7.20% 14% 12% 10%  
Net profit margin 3.60% 5.50% 5.00% 121% -119% -8%  
Asset  turnover 3.8 4.6 6.6 0.76 0.90 0.79  
               
Liquidity              
Current ratios 0.95 1.07 0.84 0.79 0.81 0.61  
               
Working capital efficiency              
Average debtors collection period 28 29 32 18 18 23  
Average creditor payment period 33 35 45 20 33 15  
               
Long term financial structure              
Gearing 151.30% 219.30% 379.10% 1064% -176% -370%  

 Sources:  British Airways (2007), United Airlines (2007) and Yahoo Finance (2007)

 

     The profitability of British Airways (BA) is obviously better than UA. BA’s net profit margins of 3.60%, 5.50% and 5.00% respectively for years 2007, 2006 and 2005 (also called BA’s Year 3, Year 2 and Year 1 respectively) are better than the  net profit margin of the United Airlines (UA) for the year the 2006, 2005 and 2004 (also called UA’ Year 3, Year 2 and Year 3 respectively) , except for 2006 where UA had its rehabilitation plan approved from bankruptcy; hence UA had a fresh start as evidenced by the very high net profit margin of more than 100%.  It must be noted at this point the latest financial statement available for BA is as of fiscal year ending March 31, 2007 while that of UA is as of calendar year December 31, 2006, hence there is only a three month difference in actual time to merit comparison of the BA’s 2007 to UA’s 2006 and the rest of the periods respectively.

     There is a difference in behaviour when the basis is gross margin as UA had reflected definitely higher rates than BA. But again what is more controlling is the operating margin which again proved better for BA for Year 1 and Year 2 except for Year 3 where US appeared again better than BA because of the rehabilitation of UA.

             The Return on capital employed (ROCE) appeared better for BA than UA for Year 1 and Year 2 but not again in Year 3 when UA was rehabilitated.  It must be emphasized what without the fresh start for UA in Year 3, BA would be definitely better in terms of profitability.   This is in fact confirmed by the higher asset turnovers for BA a for the last three years as compared  at 3.8, 4.6 and 6.6 for Year 3, Year 2 and Year 1 respectively as against UA’s 0.76, 0.90 and 0.79 for the same years respectively.

        As a general rule every business should have profitability as its primary goal in all of its business ventures for without which the business will not survive in the long run, thus the need to measure current and past profitability as well us making projection of future profitability.

     Fundamentally, profitability ratios (Bernstein,1993; Brigham and Houston, 2002, Meigs and Meigs, 1995)  measure income and expenses to arrive at the profit. A company is required to have higher income than expenses therefore to have profits. The relationship of the two accounts is not actually as simple as being defined since it could happen that expenses become higher than income. Before comparing the two it must be made clear that income is money generated from the activities of the business but said activities had cost and they are called expenses.  Before expenses could be incurred however, the business entity must have assets.  Assets are either generated from the investment of the owners or from the assets provided by the company creditors.

     Profitability is therefore simply measured in the income statement with the desired effect of having more revenues over expenses.  The said accounting information could however be further manipulated by converting them into ratios as used in this paper.

a.2 Liquidity/Solvency: current ratios

      The company’s liquidity shows the capacity of the company to meet currently maturing obligations and the same could be measured by the current ratios. BA’s current ratios are 0.95,       1.07 and 0.84 for the Year 3, Year 2 and Year 1 respectively as against UA’s 0.79, 0.81 and 0.61 for the same years respectively.

        As a general rule,  a good liquidity for a company should show a  ratio of current assets to current liabilities at least (1.0) to indicate a company must be able to match 1 British pound sterling from it current assets to every pound sterling of its current liabilities. Inability of a company to address could result to bankruptcy and may cause the same company to cease operation. This could be best illustrated by not being able to pay the salaries of its employees who cannot wait longer have their living expenses supplied during payday.

     Using this knowledge therefore in the case of the BA and UA, it may be noted that quick ratios for both companies in had almost not reached 1.0 except for 2006 in the case of BA.  This would therefore indicate the industry players are suffering from the problem of liquidity.

         What may be surprising to note is the almost the same below 1.0 liquidity for BA except for the year mentioned despite the fact the BA was basically earning for the last three years and the still positive liquidity of UA for  Year 1 and Year despite the declared losses of UA for the said years.  As for BA, the company is slightly better than UA and is almost close to 1.0 for the last three years. As for UA it liquidity for Year 1 and Year 2 was not coming from operation but from financing from other sources, which could additional investment for borrowings from creditors.

a.3 Working capital efficiency: Average debtors collection period/Average creditor payment period

      Working capital efficiency is better observed for BA in Year 1 only as Year 2 and Year 3 are good for both companies as evidenced by the shorter collection period than payment period. Their wise management of their working capital makes it possible for both companies to address the not so quite good liquidity situation which are generally below 1.0.   A shorter collection period than payment period means that the companies would have collected their receivables when they needed to funds to pay their obligations then they may not need to resort to additional investment or additional borrowings.

a.4 Long term financial structure: Gearing

      Finance theory has it that solvency (Helfert, Erich, 1994) like liquidity has also something to do with addressing an enterprise issue with to pay its debts with available funds like cash which is presumed to exist. However, this time it is different from liquidity since solvency is for long term purpose as it must speak for the financial stability of the company to survive short term problems. This is proved by the fact of its possession of sufficient investment from stockholders to match long term debt of the company hand in hand with currently maturing obligation.

       It is also a different concept from profitability, as the former refers to the ability of a company to earn a profit. Logically businesses may indicate a profitable result of its operation without being solvent such that these companies are on the expanding stage in the early part of business. Conversely business entities can achieve solvency without being profitable for the meantime as could be gleaned in company that destroys future cash flows, by selling accounts receivable. Hence, ideally a company must have the capacity be profitable, liquid and solvent. Solvency is normally measured using the gearing ratios or debt to equity ratios.

       Applying the knowledge in the case of the company,  gearing or debt to equity ratios for BA are 151.30%, 219.30% and 379.10% for Year 1, Year 2 and Year 3 respectively as against  UA’s  104 %, -176% and -370%  for the same years respectively. The ratios are better for BA because lower ratios means are better.

     The behaviour in the solvency ratios appear to confirm the behaviour of profitability since it was only in Year 3 that UA showed a positive ratio because of the rehabilitation but such ratio in Year 3 is still very high as rehabilitation has not really resulted in higher investment from stock holders but was just to keep the company running after its bankruptcy problem..

a.5 Investors’ perspective: Earnings per share/P/E ratio

    Due to absence of information from case facts on earnings per share from BA as well as P/E ratio, this part was intentionally not acted upon for analysis.

  1. (b) From both a managerial and financial perspective, identify the major challenges faced by British Airways plc and your chosen Company and highlight the differing issues brought out from your analysis.

      Identify and briefly discuss what you consider to be the main issues the companies are facing (specifying any risks from both a financial and non-financial nature concerning the company) in order to improve performance and enhance their reputations within the financial markets they are operating .

     The major challenges that is faced by BA from both a managerial and financial perspective is on the choice of its strategies with due consideration of its external and internal environments.   These strategic choices are at the same time the main issues if the company wants to improve its performance and enhance its reputations. In so designing and making the said strategies, BA must have basis of doing so and said basis will make us of the so called SWOT which stands for company’s strengths and weakness as well as industry opportunities and threats.

The first two are called internal environments and this paper will use the result of the financial analysis derived in earlier part to determine the company’s strengths and weaknesses. For the external environment, this paper will use PESTEL or a part of Porter’s Five Forces Model for analysis which normally includes the analysis of the economic environments (Carroll, Thomas,1983; Samuelson and Nordhaus,1992; Slavin ,1996). Following therefore said SWOT analysis the following are derived as strengths, weaknesses, opportunities and threats respectively as case may be:

      Strengths

     The Company has the profitability to sustain its operation and compete in the industry.  Compared with its American counter part which is UA, it has shown better profitability. In addition the BA is also almost liquid as its current ratio is almost one and it has good working capital efficiency as shown by its shorter collection period than payment period thus the company faces lesser risks of bankruptcy compared with its competitors including that of UA which has already under gone a rehabilitation program.

     Weaknesses:

     One if it weakness is its high gearing ratio measuring more than 200% for the years 2006 and 2005. This has however improved in 2007 to less than the same rate, hence it is a sign of an improve effort to reduce short term risk.

    Opportunities

     The industry where the company belongs will always be there and hence as the world economy will improve so the business of the company will.

Given therefore the resolution of some of the problems in Iraq and with decreased resistance of North Korea to continue with its nuclear program, the world is facing a more peaceful future compared to the situation a few after the 9/11 attack.  The mobility of people may also be further enhance as a result of globalization and the invention of better aircrafts of which the company has already to compete against competitors in the market.   BA can take advantage of these opportunities and this increase the company’s profitability.

      Threats

    Since world peace is the requirement of frequent travel any threat to world security is also a threat to the airline industry. The threat posed by Iran and the continuing occasional acts of world terrorism are potential source of threats which may cause of similar repeat of the effect of 9/11 attack.  The increasing oil prices which are expected to exceed US$100 per barrel of crude oil will also be a major that would affect the company.  Another threat is the strong bargaining power of suppliers in the industry particularly the supplier of aircrafts. The industry does have a limited number of known manufacturers of known manufacturers of aircraft that is exercising a strong influence in setting prices of services in the airline industry.

  1. (c) For the first time, BA implemented International Financial Reporting Standards (IFRS) for the year ended 31 March, 2006. The results for the year ended 31 March 2005 have also been restated. The adoption of IFRS has resulted in significant differences in both the Profit and Loss Account figures.

        The Chief Financial Officer of British Airways, John Rishton said “The impacts of new accounting rules on our income statement are minor”. Furthermore, he said “the adoption of IFRS represents an accounting change only, and does not affect the underlying operation of the business or its cash flows for 2004/05”.

          Critically discuss the usefulness of financial reporting, and therefore financial analysis, in relation to the comments made by John Rishton.

          Using your analysis in part (a) as a basis, discuss the importance of international accounting differences from the perspective of financial analysts and other users of financial statements, given that the U.S. have still not implemented IFRS.

         Your discussion should incorporate the limitations of financial analysis, especially when comparing companies from different countries which are using different accounting standards. In this section should discuss: is harmonization possible? /different accounting policies/same accounting policies but different judgment (Weighting 40%)

         Financial reporting is important although there is truth to the statement by the comments made by John Rishton that cash flow is not affected.   The lack of effect of the transition of UK GAAP to IFRS was sustained by the independent auditor British Airways in its 2006 financial statements.  The BA’s annual report of 2006 stated that the transition from UK GAAP to IFRSs has no effect upon the reported cash flows generated by the Group. The same report further explained that the IFRSs cash flow statement is presented in a different format from that required under UK GAAP with cash flows split into three categories of activities – operating activities, investing activities and financing activities. Given also the presence of the reconciling items between the UK GAAP presentation and the IFRSs presentation which showed lack of net impact on the cash flows generated, the statement of Rishton must be upheld.

      What could be noted from the auditor’s confirmation is just a modification in the presentation. Since the people who are preparing the IFRS are looking at it from the point of view of an international standard there could a good reason on why they European Union required its adoption to the members of EU. On the same note that UK companies are also required to comply with the same standard, there is a strong reason to believe it helps to bring the uniformity of information for business decision making.

   The fact however that it will not affect that cash flow should not be taken as the sole reason why it adoption of the IFRS should not be done. Since UK cannot afford to exist without the world community, it may have to adjust to some of its inherently local predisposition to lend itself to international or global agreements if only to enhance understanding. The change in the presentation and treatment of some of the accounting information is some of them.

       Thus the BA’s notes to accounts of its 2006 financial statement provided that as results of “the treatment of major engine overhaul as a capital item under IFRS £55 million of expenditure previously reported as a deduction in operating cash flow has now been shown under the purchase of property, plant and equipment.”

There was also an statement on the notes that cash flow statement preparation under IFRSs, “cash and cash equivalents include cash at bank and in hand, highly liquid interest bearing securities with original maturities of three months or less, and bank overdrafts” while UK GAAP does not classify them as cash equivalents. It is therefore evident that it is just a question of presentation and understanding. It may be argued that UK business people may already understood some of the things without the conversion to IFRS but there are other decision makers that will inevitably get affected, the international investors which UK also tries to have.

            The usefulness of financial reporting also lies in its declared objective to deliver to the user of the financial information with the necessary qualitative characteristics of the said information.  These qualitative objectives include relevance, reliability, comparability and Understandability.

       Moreover, it must be noted that one cannot prepare the cash flow statement without the use of the accounts in financial information; hence cash flow statement will always be dependent of financial accounting information.  Since the accuracy of the financial information contained from the income statement and balance sheet, it follows that there is a need for an accurate financial reporting.

       The importance of international accounting differences from the perspective of financial analysts and other users of financial statements, given that the U.S. have still not implemented IFRS is that that without making an attempt to harmonize the differences, it would come out that interpretation would utmost be localized in this would be a big issues if a company is global or has operations that are affected by countries than the home.  From the point of view of financial investors, they would not be able to make a better comparison of the alternative options for being unable to express consolidated financial statements under a uniform framework.

        Decision makers could be made to believe that one subsidiary could be made to appear better or less in performance than another subsidiary in another country when there could be standard to find the differences between the two due the lack of an international standard that will govern the preparation of the financial statement.

      What would then be the effect if the US has not yet adopted the IFRS? If the US has not adopted the IFRS, the US authorities would always be looking in their own way as far as the financial accounting standards are the same.  Since the US can still be considered one of the most economically powerful nations in the world, its failure to adopt the IFRS would have the effect of US imposing its own GAAP and not opening as what Europe would like to see it. This is in the light of the development that the European Union has required its member states to use the IFRS.

       In the matter now on evaluating the soundness of a business proposal which will be affected by the use of accounting information, it would be very difficult for the international business community to agree on what accounting rules will be applied in case there would be conflict in the matter of interpretation of the accounting rules.

        As to the limitations of financial analysis, especially when comparing companies from different countries which are using different accounting standards, it may be argued that different countries have different cultures which will always be a factor in the difficulty in attaining harmonization of the standards. Bringing the standards to harmonization is just like arguing to have a common language which until this time is not yet fully realized because people will always separateness of cultures and hence difference in beliefs and ideologies.

        In case however when there is failure to harmonize because of the limitations of financial analysis in regard to external factors that it cannot control, the international business community may always agree on what standards to use in measuring financial information. Hence for example a UK company may always insist that treatments of accounting information may have to follow its own UK GAAP while a US company may insist on its own.  Since international respects the  independence of nations by bringing people to enter into contracts under agreed conditions integrating which standard to follow even in case of conflicts in which  case IFRS could an option, there should be no reason why the world will not run if harmonization moves fail. In fact the world has run without the harmonization. It should be therefore very big deal if such harmonization will not happen at least in the next five years.

  1. Conclusion

    This paper has analysed and discussed the financial statements of British Airways (BA) and United Airlines (UA), by having BA as the main company and comparing with other. An identification of the major challenges faced by British Airways plc and UA while highlighting the differing issues were brought out from analysis and this has something to do with the internal and external environment. This paper therefore was able to derive the company’s strengths and weaknesses as well as the industry opportunities and threats for the purpose of formulating its strategic options (Byars, L.,1991; Johnson and Scholes, 1993; Pearson, 1999; Porter, 1980)  in helping the company to attain its objectives.

The paper also discussed analyzed critically the usefulness of financial reporting, and financial analysis, in relation to the comments made by John Rishton of BA which was found supported by the report of annual report of the BA for 2006 with the conformity of its auditors; hence lending credence to claim that changes in accounting standards does not affect the cash flow. It was however established that financial accounting information are important for the preparation of cash flows and for enhancing the quality of information to be delivered to the users who will make use of the information and for whose the benefit the accounting standards is being enhance because the users of information is already international and UK may not have a choice if not to lend flexibility in its reporting as part of the international business community.

    The analysis made extensive use of financial ratios where it was demonstrated that they assume many things in helping the decision makers as proven in this paper.

    It was asserted that with or without the harmonization the world of business will still run as its is still running now but there are significant advantages of harmonization if  countries would like to promote a language that may be understood by wider group of decision makers.

References:

Bernstein (1993) Financial Statement Analysis, IRWIN, Sydney, Australia

Brigham and Houston (2002) Fundamentals of Financial Management, Thomson South-Western, London, UK

British Airways (2007), Annual reports, 2007 , 2006 and 2006 from company Website, {www document} URL http://www.britishairways.com/, Accessed December 12, 2007

Byars, L. (1991) Strategic Management, Formulation and Implementation – Concepts and Cases, New York: HarperCollins

Carroll, Thomas (1983) Microeconomic Theory  Concepts and Applications, St. Martin Press ,New York , USA

Cooper, L. (2000) Strategic marketing planning for radically new products, Journal of Marketing, Vol. 64 Issue 1, pp.1-15.

Droms (1990) Finance and Accounting for Non Financial Managers, Addison-Wesley Publishing Company, England

Helfert, Erich (1994), Techniques for Financial Analysis,  IRWIN, Syndey, Australia

Johnson, G. and Scholes, K. (1993) Exploring Corporate Strategy – Text and Cases, Hemel Hempstead: Prentice-Hall.

Meigs and Meigs (1995) Financial Accounting,  McGraw-Hill, New York, USA

Pearson, G. (1999), Strategy in Action, Prentice Hall Financial Times.

Porter (1980) Competitive Strategy, Free Press , London,UK

Ross et. al (1996)  Essentials of Corporate Finance ,IRWIN, London,UK

Samuelson and Nordhaus (1992), Economics, McGraw-Hill, Inc, London, UK

Slavin (1996) Economics , Fourth Edition,  IRWIN, London,

United Airlines  (2007) 2006 Annual Report, Company Website, {www document}URL http://ir.united.com/phoenix.zhtml?c=83680&p=irol-reportsAnnual, Accessed December 12, 2007

Van Horne (1992) Financial Management Policy,  Prentice-Hall, Inc., London, UK

Weston and Brigham (1993) Essential of Managerial Finance, Dryden Publishers,  London, UK

Yahoo Finance (2007) Financial Statements if United Airlines, 2006, 2005 and 2004, {www document}URL http://finance.yahoo.com/q/is?s=UAUA&annual, Accessed December 12, 2007

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