Capital Structure, Redemption of Preference Shares, and Cash Flow Management

Profitability has increased due to an increase in revenues and reduction in financial expenses, which are non-cash terms that do not impact cash flow. The company's income statement and cash flow statement both play important roles in evaluating its financial performance. While the income statement provides insight into the company's overall financial wealth, the cash flow statement is crucial for identifying liquidity issues and making decisions regarding project valuation and expense elimination.

Financial Reporting

TABLE OF CONTENTS
Introduction......................................................................................................................................3
Task 1...............................................................................................................................................3
1. Need of distinction between debt and equity...........................................................................3
Task 2...............................................................................................................................................7
1. Objectives of cash flow statement...........................................................................................7
Conclusion.....................................................................................................................................10
References......................................................................................................................................12
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INTRODUCTION
Financial reporting is the process of recording financial transactions of business in a
manner disclosing financial performance of company over a period of time to lenders and
various stakeholders. It helps in forming effective decisions by considering company’s strategies
and objectives. In the present study, financial figures of Pondland are considered for better
understanding of the subject matter. Current study focuses on the need for distinction between
debt and equity, importance and use of gearing ratios and guidelines given by accounting
standards for classifying debt and equity (Sachs, 2007). It also covers the importance of
classification of funds into debt and equity for stakeholders. Objectives of cash flow statements
and the way in which it contributes to user's understanding in evaluating profits of company
through cash flow statement is also covered by this project.
TASK 1
1. Need of distinction between debt and equity
Company’s capital structure consists of two main elements i.e. debt and equity that
encompass an organisation to fund its assets. Optimum capital structure should be planned by
company for the real growth and survival in a long run. Debt-equity structure should be designed
by keeping in mind the shareholder’s interest as well as the financial requirements of company.
Organization can analyse its capital structure through a technique called capital gearing ratios
and proper decisions can be formed on the basis of gearing ratios (Dabrowski and Rostowski,
2012).
Capital gearing ratio states the proportion of equity against debt of company. Gearing
ratios are calculated to know company’s viability to pay its long term debt from existing equity.
In situation where firm’s capital consists of large portion of equity as compared to debt then
company is said to be a low geared firm and in vice versa situation, company will be called as
high geared firm (Thomsett, 2009). Business entity should maintain an optimal gearing ratio by
having correct proportion of debt and equity in capital ratio because too much debt will increase
long term obligation of company and too much equity will increase the amount of dividend to be
distributed. Capital gearing ratio is calculated as:
Gearing Ratio = Stockholder's equity
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Fixed interest bearing securities
Poundland had a gearing ratio of 6.21% for the year ended 31st March 2014 which
represents greater financial stability of company. Firm had less interest bearing securities as
compared to owner's equity. Thus, Poundland is said to be a low geared company for this year.
Forming a strong capital structure is a necessity for company as it forms the basis for all
decisions that are undertaken by company whether financial, growth related or any other
purpose. Gearing ratios are calculated to analyse the capital structure of company which is of
great significance to all the stakeholders including investors, lenders and creditors. On the basis
of gearing ratios, stakeholders analyse the growth, financial strength, effect of financial cost on
profitability and various other factors of company (Lee, 2014). These ratios are useful to various
stakeholders in the following ways:
Investors: Investors means shareholders who had invested their money in company in the
form of equity capital and company in return distributes the dividend to them. Shareholders use
gearing ratios for evaluating the ways in which many earnings are available for their distribution
after meeting debt finance cost. They analyse the financial strength of company through gearing
ratios (Madura, 2007).
Poundland had less fixed income bearing securities as compared to owner’s equity i.e.
less finance cost are borne by company resulting in increase in profits of the firm. Due to
increase in profit, shareholder’s expectations for dividend also raised, thus, dividend yield of
company had increased to 1.09%.
Lenders: Lenders include individuals or any institutions that provide funds to company
which are required to be repaid by the firm over a certain period of time on the payment of
finance cost. These are categorised as debt funds as company is obliged to pay the interest cost.
Lenders need clear distinction between debt and equity in financial statement to analyse the
capital structure of company as they will hesitate and are unwilling to provide funds to a highly
geared company (LLP and E., 2008).
Poundland position from the viewpoint of lenders is good because company is currently
having less fixed income bearing securities i.e. having fewer obligations to pay finance charges.
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Also, firm had shown rising trend in the increment of profits (Stolowy and Lebas, 2006). Thus, it
will be easy for the organization to borrow funds as it had good solvency to repay the same.
Creditors: Creditor is any person to whom amount is due in respect of goods or services
provided by them. Creditors need to know company’s other obligations along with their amount
due so as to determine the payment criterion. Creditors analyse company’s debt-equity structure
to determine whether sufficient funds will be available with the firm after paying other liabilities
or not so that they would not suffer later (Lee, 2007).
According to Poundland annual accounts, 2014, trade payables form the major part of
company’s long term debt. Main obligation thus on company is to pay off its creditors. The
major use of assets of company was for the payment of creditors, thus, they are satisfied as
company has sufficient liquidity to generate funds and pay off the liabilities (Camiolo, Cantale
and Purcell, 2009).
Gearing ratio as stated above is an analytical tool with identifying the proportion of fixed
income bearing securities and shareholder's fund, firm should construct an optimal capital
structure by neither involving too much borrowing nor having whole equity structure. Capital
structure when involve much of debt funds, reduces its credit worthiness as well as long term
obligations of the organization will increase resulting in high interest cost and reduction in
profits (Hull, 2011). On the other hand, more equity will increase the amount of dividend to be
distributed to shareholders by reducing companies retained earnings.
Gearing ratio forms a strong basis for comparing opportunities and risks of similar
entities in an industry. For example, companies having much debt will be treated as more risky
than the firms that are having more equity or less debt. Mostly, people choose to invest their
money in a company having more equity as they seems to be more financially stable (Janjani,
2015).
Poundland’s capital structure consists of less of debt and more of equity as compared to
another company. This means Poundland has to pay less interest cost thus, it leads to increasing
overall profitability of company (Farshadfar, Ng and Brimble, 2008). It cannot be said that
Poundland has optimal capital structure because debt proportion as compared to equity is much
low. Company must balance its debt-equity ratio.
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As compared to equity, borrowing is a much cheaper source of finance. Due to this, most
of the firms adopt practice of involving more debt funds by manipulating the gearing ratio
without considering its consequences on company’s working structure. Highly geared company
is a very risky investment as firms have to pay high interest charges and unlike dividends, these
cannot be delayed. However, a very low geared company requires paying much dividend thus,
very less part of profits are retained in business for the future (Li, 2010).
It is important for the management of company to evaluate the differences between debt
and equity so as to give true and fair view of financial statements. Thus, there is the need for
more clarity in the concepts and definitions of liabilities and assets for debt instruments. This
will remove the dilemmas faced by entities while accounting for financial liabilities, non-
financial liabilities and assets (Armstrong, Guay and Weber, 2010). Company must classify
instrument as debt or equity when they were initially acknowledged.
Various accounting standards have been prescribed by accounting standards board (ASB)
which provides guidelines, rules and principles in accordance of which financial statements are
prepared. These include FRC, FRSSE, ICAEW, GAAP, etc. The purpose of these standards is to
make accounts of different companies easily understandable and comparable. Recently, IASB
had prescribed new standards known as Indian financial reporting standards (IFRS) which
describes provision for recording of debt and equity transactions in financial statements in a
proper manner. There is a need for clear distinction between debt and equity because both have
different nature, cost and obligations for company (Persons, 2011). While forming IFRS, it is
expected that if these standards are applied and adopted worldwide, then different users of
financial statements including investors, lenders, suppliers, etc. will be beneficial.
IAS 32 “Financial Instrument - presentation” was prescribed by IASB with the object to
classify financial instrument as equity or debt by the issuer as these have remarkable impact on
company's gearing ratio, debt treaties and reported earnings of the firm. Distinction between debt
and equity is also important when company raises its fund by issuing financial instruments.
Poundland had also prepared their financial statements in accordance with the IFRS
adopted by EU and complied with the UK accounting standards and UK GAAP. Company had
calculated earnings which are available for the distribution to shareholders in accordance with
IAS 33. IAS 32 as mentioned above is adopted by Poundland but was not made applicable in
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preparation of annual report for the year ending 31st March 2014. Company had also complied
with IAS 39 “Financial Instruments: recognition and measurement” approved by ARC which
states that option for recording the financial liabilities at fair value was removed (Engel, Hayes
and Wang, 2010).
TASK 2
1. Objectives of cash flow statement
Companies carry their operations with an object to achieve higher profitability and
growth. However, profitability is not only the ultimate motive of company as having higher
profitability does not necessarily mean that firm has high liquidity or it will be able to meet its
obligations (Hull, 2011). From the viewpoint of a rational investor, balance of cash and cash
equivalents is also significant along with profitability because profits does not always show
useful or correct picture of company’s operations. Financial statements of an organisation are
prepared on the basis of accrual system of accounting i.e. non-cash items are also taken into
consideration. Company records both profitability and the cash holdings as it is important to
know the extent to which actual cash is generated by company and this information is provided
by the cash flow statements (Stolowy and Lebas, 2006).
Cash inflows and outflows are recorded in a statement known as cash flow statement,
simply, it records all cash transactions incurred by company for a period of time. Cash flow
statement shows the way in which cash and cash equivalents are affected by changes in income
and position statement (Madura, 2007). These are used to determine the ability of company to
generate positive cash flows either internally or externally and short term feasibility of company
can be identified. Cash flow statements are prepared with the following objectives: Cash Measurement: Cash receipts and payments can be measured for a particular period
arising from different activities namely operating, investing and financing activities
through cash flow statement. Companies can identify sources so that cash inflows would
be increased and cash outflows will be reduced (Lee, 2007). Liquidity Assessment: Cash inflows and outflows can be identified through these
statements by ascertaining the occurrence and certainty of cash generating activities
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(Sachs, 2007). Thus, ability of company to generate cash can be identified through cash
flow statements. Future Prediction: Company can easily forecast the future inflows and outflows through
current available data which will help the firm in taking various financing decisions as
cash can easily be synchronized with other elements. All activities are classified into
operating, investing and operating, thus making easy for company to elucidate cash
inflows and outflows of cash (Janjani, 2015). Solvency: It helps to identify the solvency of company that whether cash generated from
current operating activities will be sufficient to meet various future obligations like
expenses, dividends, tax liability, etc. or not. It also determines the need for increasing
transactions in cash if company is unable to generate enough cash to meet its current and
future liabilities (Li, 2010). Like, Poundland had much of the cash available with it
resulting from operating activities so as to pay cash obligations. Planning: Cash flow statements help a company to properly plan the cash flows to be
incurred in future by removing unnecessary expenditure. Company can also analyze
different investment opportunities open to a firm in future by determining the cost
involved and cash inflows which will be generated in future (Dabrowski and Rostowski,
2012). Company can make necessary changes in the current spending pattern if there are
excessive cash expenditures as compared to income in cash nature. For example,
Poundland should do proper planning while managing its financing activities as because
of this, cash equivalents had reduced substantially as compared to the last year
(Poundland Group plc Annual Report & Financial Statements, 2015).
 Useful in decision making: Cash flow statements do not reflect the entire financial
position of company. Then also, these are used by different users including management,
suppliers and lenders in forming decisions relating to inflows and outflows of cash (Hull,
2011).
Cash flow statements enhance the understanding of various users of financial statement in
assessing company’s liquidity and solvency position. Plenty of information is provided through
cash flow statement to the users of financial statements relating to cash inflows and outflows.
Users can easily assess the extent to which company is able to pay off its obligations on their due
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date. Further, users can ascertain net cash and cash equivalents available with company at the
end of the period after considering cash flows from different activities (Farshadfar, Ng and
Brimble, 2008). Users can evaluate the changes in company’s net assets and various other
elements of income and position statement and their ability to affect the cash flows of firm. It
also enhances the comparison of operating performances of different entities as same accounting
treatment is followed for the transactions and events which are of same nature. Users can also
identify the present value of future cash flows and thus, can access company’s ability to generate
positive cash.
Companies having positive cash flows and firms being profitable are two different things.
Organization when brings in cash does not necessarily mean that it has made profit and in the
same way, being profitable does not necessarily indicate that company has sufficient liquidity
(Lee, 2014). Company may face failure due to shortage of cash even when it had sufficient
profits as economic facets are not represented by accrual accounting. Financial performance of
the organization is determined through profitability statement while cash flow statement shows
the amount that company has paid and received over a period of time. Profitability shows net
profit earned by the firm after specifying the expenses incurred and revenues earned whereas
cash flow statement only determines the liquidity position of company for meeting various
expenses (Hull, 2011).
Cash flow statements are linked to profitability statement as net profit forms the base to
calculate cash flows from operating activities i.e. all revenue generating items are adjusted to net
profits giving net cash flow from operations. Another difference is that profit are the net earnings
available with company after incurring all expenses and generating revenues while cash flows
are the amount of actual cash that company has paid or received over a period of time (Camiolo,
Cantale and Purcell, 2009). Cash flow statement reconciles the impact of changes in various
cash elements of income statement and balance sheet.
Income statement does not show cash generating ability of company and cash flow
statement does not show the net profit or loss earned during a period by the firm. Both are
important from the perspective view of investor, thus, it is important to link both these
statements as cash flow indicates what company is doing with its cash and from where cash is
generated but fails to demonstrate whole financial position of the firm. Simply, income statement
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and balance sheet evaluates the financial health and wealth of organization and cash flow
statement is a supplement to these statements, thus, it cannot be neglected (Armstrong, Guay and
Weber, 2010).
In accordance with the annual accounts of Poundland for the year ending 31st March
2014, cash and cash equivalent of company at the end of period had reduced. From this fact, it
cannot be concluded that organization is less profitable as profitability can never be judged by
cash flow statement. Company had an increment in its profits despite of reduction in cash
equivalents (Camiolo, Cantale and Purcell, 2009). This is because; both cash and non-cash items
are considered while calculating the profitability of a company but cash flow statements only
consider the elements resulting in cash inflow or outflow. Major reason behind decline in
Poundland's cash and cash equivalent was repayment of its long term obligations and redemption
of preference shares which are not shown in the profitability statement. On the other hand,
company’s profits have increased because of increase in revenues and reduction in financial
expenses which are in non-cash terms thus, laying no impact on Cash flow statement (Sachs,
2007).
Company’s income statement and cash flow statement both are the components of
financial statements but one must decide as to what extent cash flow statements can be relied as
these does not depict the overall financial wealth of company. In addition to the above, it does
not account assets and liabilities shown in the position statement. Through cash flow statement,
management can identify the problems that company is facing in generating liquidity, value of
different projects can be determined through these statements, decisions can also be formed
regarding elimination of unnecessary expenses and proper management of cash can be done
(Madura, 2007).
CONCLUSION
From the above report, it can be concluded that classification of financial instruments into
debt and equity is important as whole capital structure is divided into these two. Major financing
and growth related decisions are taken on the basis of capital structure of company, thus firm
should form an optimal capital structure (Camiolo, Cantale and Purcell, 2009). Stakeholders
including investors and lenders determine the total obligation of company by analysing debt-
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equity proportion of the firm. Organizations are required to prepare their financial statements in
accordance with the applicable accounting standard so as to give true reporting. Company should
maintain their capital structure so that it will neither be a highly geared company nor a very low
geared company. Besides strong capital structure, firms should properly plan their cash flows as
cash forms is a general element while evaluating company’s liquidity. Firm’s operations and
wealth should be determined by considering both income statement and cash flow statement as
both carry different characteristics. Through cash flow statement, the extent to which company is
spending and the amount that is received during a year can be known and necessary actions can
be taken to reduce the cash expenditure in future.
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REFERENCES
Books and Journals
Sachs, D. J., 2007. Developing Country Debt and the World Economy. University of Chicago
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Lee, A. T., 2014. Cash Flow Reporting (RLE Accounting): A Recent History of an Accounting
Practice. Routledge.
Madura, J., 2007. International Financial Management. 9th ed. Cengage Learning
LLP., Y. and E., 2008. International GAAP 2008: Generally Accepted Accounting Practice
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Stolowy, H. and Lebas, M., 2006. Financial Accounting and Reporting: A Global Perspective.
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Janjani, R., 2015. Comparing US-GAAP and Iran-GAAP operating cash flows to predict future
cash flows. Journal of Financial Reporting and Accounting. 13(1). pp.39 - 65.
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Li, S., 2010. Does mandatory adoption of International Financial Reporting Standards in the
European Union reduce the cost of equity capital?. The Accounting Review. 85(2).
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Armstrong, C. S., Guay, W. R. and Weber, J. P., 2010. The role of information and financial
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Online
Poundland Group plc Annual Report & Financial Statements. 2015. Available through
<http://www.poundlandcorporate.com/~/media/Files/P/Poundland/reports-and-
presentations/Poundland-annual-report-2014.pdf>. [Accessed on 29th December 2015].
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