Analysis of Rolls-Royce Company's Financial Statements

Nowadays, the business sector is inundated with numerous kinds of acquisitions and investors. Some investors are considered to be risk-averse, in that they exercise extreme caution when deciding about which investment to pursue. Because of the disposition of certain owners, financial statement interpretation is needed. Financial statement analysis is the method of reviewing and assessing a company's financial accounts in order to better analyze its financial situation and making more successful economic decisions (Bajkowsk, J., 1999). These financial statements include a balance sheet or statement of financial information, an income statement or statement of comprehensive income, a statement of changes in equity or equity statement and a cash flow statement. Before investing in any company, investors need to know financial performance of that company, like in the case of Roll Royce. Rolls-Royce Motor Cars Limited services, manufactures and distributes automobiles and spare parts worldwide. It is a subsidiary of BMW which was founded in 1998 in the United Kingdom. Its headquarters is in Goodwood, England. It aims at providing better power for the changing world. For UK equity to invest in Rolls Royce, they’ll need to study, evaluate and understand its financial health. The objective of this analysis is therefore to determine whether Roll Royce is a suitable investment platform for UK equity.

Rolls Royce Motor Cars Limited is known for engineering, manufacturing and dispensing automobiles and automobiles parts globally but being that UK equity is based in London, the main interest is in United Kingdom. According to London’s Economic Plan, London mostly thrives in trade and commerce. The nature of the economy has drastically changed from manufacturing industries dominating the economy to financial and business services being the dominant sector. The major sector offering employment is the service sector, with 3.2 million people. This presents 85 percent of the total employment in London. The economy is responsible for 17% of the total UK’s Gross Domestic Product (GDP) which is over 360 billion pounds. However, with great changes in technology, manufacturing industry may pick its momentum once again.

The automotive sector in the United Kingdom has registered a lower growth in recent decades, as opposed to 1950s when the industry was second largest in the world. The industry directly employed 180,000 people in 2008 and registered a turnover of 52.5 billion pounds. Other 640,000 people were employed indirectly in the same field. In 2014 however, the statistics tremendously reduced by 18%.

Financial Statement Analysis

Undertaking financial statement analysis is beneficial in many different ways. It gives the investors the power to decide whether to invest in a certain company, like in this case UK equity investing in Rolls Royce. The decision will be based on the past, the present and the forecasted financial performance of the company involved. The company itself will be in a position to determine its financial health when it undertakes financial statement analysis. The regulatory bodies like International Accounting Standards Board (IASB) will be able to ensure that the company is following the right procedures in preparation of the financial statements and is in accordance with the laid rules and regulations governing such, like the Generally Accepted Accounting Principles (GAAP). The government will also benefit in that it will be able to calculate and analyze the amount of taxes the company owes it (Abdel-Rahman, E., 2013).

However, financial statement analysis has limitations too. Due to different accounting methods employed by different companies, the comparison of financial data may prove a little difficult. This calls for comparison going beyond just ratios. Another limitation is that some companies have a tendency of ‘cooking’ their financial data to please potential investors (Florenz, C.T., 2012). Investors will always scramble for profitable companies as their main goal is always to make profits. Unscrupulous companies will therefore try all their might to attract such investors by providing unrealistic financial data to the public during their end financial year.

Financial statement analysis is a process involving six different steps (Masson, D. 2016). The steps are as follows; identifying the industry or sector economic features, identifying the company’s strategies, checking the quality of the company’s financial statement against the relevant accounting standards, analyzing the present profitability and risk, forecasting the future financial status of the firm and the last is valuing the company. In the case of Rolls Royce, the first two steps have already been sorted, making ‘checking the quality of the statement’ the next step. The following are the financial statements of Roll Royce Company.

The Company’s Balance Sheet

Annual Report 2015 (Rolls Royce 2015).

The Consolidated Income Statement

Annual Report 2015(Rolls Royce 2015)

The Consolidated Statement of Comprehensive Income

Annual Report 2015 (Rolls Royce 2015)

The Company’s Statement of Changes in Equity

Annual Report 2015 (Rolls Royce, 2015)

The Consolidated Cash Flow Statement

Annual Report 2015 (RollsRoyce, 2015)

The above financial statements have been properly constructed and can be said to be in accordance with GAAP. To value the firm, ratio analysis in respect of the following must be undertaken:

The company’s profitability

A company’s profitability can be termed as a situation whereits income exceeds its expenses (Peavler, R., 2017). Profitability ratios are categorized into two namely, margins and returns. Margin ratios represents the company’s ability to convert sales revenue into profits at different levels of measurements. Return ratios represents the company’s ability to determine its general efficiency in generating the returns for its stakeholders. These two ratios are further subdivided into smaller definite subdivisions.

Margin Ratios

Gross profit margin. This is a representation of cost of goods sold as percentage of total sales. This ratio helps to determine how well a firm manages its inventory costs and the costs of manufacturing its products, and translate the costs to the customers. The higher the gross profit margin, the better the company. It is calculated by dividing the company’s gross profit by net sales and expressing as a percentage. All these terms are derived from the income statement. That is:

Gross profit/Net sales * 100

In the case of Rolls Royce, for year 2015:

3266/13725 * 100= 23.76%

For the year 2014:

3203/13736 * 100= 23.32%

There is an increase of gross profit margin from 23.32% to 23.76%, hence Rolls Royce is better placed in 2015 than in 2016.

Operating Profit Margin: this is an expression of Earnings Before Interest and Taxes (EBIT) derived from the income statement as a percentage of sales. It measures the overall firm’s operating efficiency. It is calculated by dividing EBIT by net sales and expressing as a percentage. That is;

EBIT/Net sales * 100

In the case of Rolls Royce, for year 2015:

1501/13725 * 100= 10.94%

For year 2014:

1398/13736 * 100= 10.17%

There is an increase in operating profit margin from 10.17% to 10.94% putting Rolls Royce in a better place.

Net Profit Margin: this is the most frequently used margin ratio in profitability ratio analysis. It is a reflection of how much sales revenue translates into net income after all expenses are catered for. The net profit margin determines the profitability after all expenses (depreciation, taxes and interest) are considered. It is calculated by dividing net income (from income statement) by net sales, and then expressing it as a percentage. That is;

Net income/Net sales * 100

In the case of Rolls Royce, for year 2015:

84/13725 * 100= 0.61%

For the year 2014:

58/13736 * 100= 0.42%

There is a notable increase in the net profit margin from o.42% to 0.61% hence the firm is better placed in terms of financial health.

Cash Flow Margin: the cash flow margin shows the correlation between total cash generated from the firm’s operating activities and sales. It evaluates the company’s ability to convert sales into cash. It is calculated by dividing cash flows from operating activities (from the statement of cash flows) by the net sales, then expressed as a percentage. That is;

Cash flows from operating cash flows/Net sales * 100

In the case of Rolls Royce, for year 2015:

1094/13725 * 100= 7.58%

For the year 2014:

1301/13736 * 100= 9.47%

There is a decline in the cash flow margin ratio from 9.47% to 7.58% as a result of decrease in net cash flow from operating activities. This means that the company’s ability to translate sales into cash has decreased, which is not that good.

Return Ratios

Return on Assets (ROA): this literally means the amount of profit a company can generate as a result of investing in its assets. ROA measures the effectiveness with which a firm manages its assets to produce profits. To get ROA, net income (from income statement) is divided by the total assets (from the balance sheet) expressed as a percentage. The higher the ROA the better the firm since it is an indication that the firm is utilizing the available resources to make profits. That is;

ROA = Net income/Total assets * 100

For the case of Rolls Royce, for year 2015;

=84/12016 * 100= 0.7%

For the year 2014

=58/12072 * 100= 0.48%

Return on Equity (ROE): this is the measure of returns on the investors’ money in the firm. It is more of the most important ratio for the potential investors who are planning to invest in the company. It is calculated by dividing the net income (from income statement) by total stakeholders’ equity (from the balance sheet). The higher the percentage the better as it indicates that the firm is properly using the investors’ money. That is;

ROE = Net income/Total equity * 100

For the case of Rolls Royce, for year 2015;

= 84/11145 * 100= 0.75%

For the year 2014;

=58/12050 * 100= 0.48%

The Company’s Liquidity

A company’s liquidity can be defined as its capability to meet its financial obligations, both short and long term, as they come due (Ready Ratios, 2011). To determine a firm’s liquidity, three ratios are calculated. These ratios are current ratio, acid ratio and cash ratio.

Current Ratio: this is the measure of a company’s capability to meet its current financial obligations from its current assets. Is calculated by dividing current assets by current liabilities. Both terms are derived from the balance sheet. The higher the percentage the better the position of the firm as it indicates that the firm is in apposition to pay its liabilities.

Acid Ratio: also known as quick ratio, acid ratio evaluates how fast a firm can pay its short term liabilities using its most liquid assets. Acid ratio is given by (cash and cash equivalents + short term investments + accounts receivable) /current liabilities.

Cash Ratio: this focuses on cash and its equivalent of a firm. It is calculated by (cash plus cash equivalents) divided by current liabilities.

The Company’s Efficiency

A company’s efficiency ratio measures how effectively a company can use its assets and manage its liabilities to produce sales. The following ratios are involved in determining efficiency ratios

Accounts Receivable turnover: this is given by dividing credit sales by accounts receivable.

Inventory turnover: given by the cost of goods sold divided by inventory.

Fixed Asset Turnover: this is calculated by dividing total sales by fixed assets.

Accounts Payable Turnover: this is determined by dividing total purchases (mostly from suppliers) by accounts payables.

Investment Ratios

These are ratios which measure the performance of a firm’s stocks. There are several investment ratios to consider before investing in a firms shares.

Return on Investment (ROI): this is a measure of the company’s performance, which is gotten by dividing its net profit by its net value. Net value represents the cash, inventories, properties, plant, goodwill and debtors balance, all from the balance sheet.

Debt to Equity ratio: this is the ratio of a company’s total liabilities to its stockholders’ equity. A lower percentage is good for the firm as it indicates that the firm may not go down in case of debts.

Earnings per share (EPS): this is arrived at by dividing the net income by the total number of shares. It shows how much profits investors make from their shares in the market.

Price per Earning Ratio: this is the company’s price per share divided by its earning per share. It helps the investors to determine whether the shares are overpriced.

Growth Ratios

According to E-commerce Digest, growth ratios are measures used to determine whether a company is experiencing growth, and at what rate.Growth ratios are discussed above and may include the following ratios; return on assets, return on equity, return on investment, gross profit margin, inventory turnover, operating margin, return on sales and expenses to net sales.

Conclusion

UK equity as an investor will need to understand what the above ratios stand for and their importance. It would be advisable that they invest in Rolls Royce now that they understand its operations and performance in the market. Its shares are not also overpriced. It produces good products and has good management. Rolls Royce can be said to be secure since it has low long term debts and high cash reserves. It is also a low cost producer and their savings can save them during difficult times.

References

Abdel-Rahman, E., 2013.The Role of Financial Analysis Ratio in Evaluating Performance (Case Study: National Chlorine industry). Interdisciplinary Journal of Contemporary Research in Business, 5(2)

Bajkowsk, J., 1999. Financial Ratio Analysis. AAII Journal, pp. 4-5. Accessed at: https://www.aaii.com/journal/article/financial-ratio-analysis-putting-the-numbers-to-work

E-commerce Digest. Investment Measures and Ratios. [Online] Available at: http://www.ecommerce-digest.com/measures-and-ratios.html

Masson, J.D., 2016. 6 Steps to an Effective Financial Statement Analysis. [Online] Available at:https://www.afponline.org/trends-topics/topics/articles/Details/6-steps-to-an-effective-financial-statement-analysis

Peavler, R., 2017. What Is a Profitability Ratio Analysis? Determining Profitability is Important to Company Investors. [Online] Available at https://www.thebalance.com/profitability-ratio-analysis-393185

Florenz, C.T., 2012. A Comparative Analysis of the Financial Ratios of Listed Firms Belonging to theEducation Subsector in the Philippines for the Years 2009-2011. International Journal of Business and Social Science, 3(21), pp. 2-18

Ready Ratios, 2011. Financial Statement Analysis [Updated 3rd April 2013] Available at:https://www.readyratios.com/reference/analysis/financial_statement_analysis.html(Accessed 11th Nov 2017).

Rolls Royce, 2015. Annual reports 2015.[Online] Available at:http://www.annualreports.com/HostedData/AnnualReportArchive/r/LSE_RR_2015.pdf (Accessed 11th Nov 2017)