Financial Analysis and Acquisition Recommendation: Deepwater Ltd

This report provides a comprehensive financial analysis of Deepwater Ltd, focusing on its performance and the potential acquisition of Maxshale Ltd. It begins with an executive summary highlighting the importance of financial statement analysis for making informed decisions, followed by an introduction outlining the context of the acquisition. The report is divided into five parts, covering topics such as transaction descriptions, tangible and intangible assets, trend analysis of revenue and profits, application of financial techniques, financial performance indicators, and calculation of financial ratios. The analysis includes computations of gross profit margin, trend analysis, and the impact of changes in operating costs on profitability. The report also examines cash flow statements, working capital improvements, and the specific components that have improved Deepwater Ltd's cash position. Finally, it includes a comparison of Maxshale Ltd's financial position and a recommendation regarding the acquisition, concluding that it is not recommended to buy Maxshale Ltd. The report uses various financial techniques and ratios to assess the financial health of the company and provides insights for making informed investment decisions. The report emphasizes the importance of financial analysis in the context of business acquisitions and strategic planning.

Understanding financial
statements

Executive Summary
Financial statements are quite useful for analysing financial performance in the best
possible manner. Deepwater Ltd planning to acquire Maxshale Ltd will provide competitive
advantage as profits will be maximised. Hence, financials will be assessed for making decisions.

TABLE OF CONTENTS
INTRODUCTION...........................................................................................................................1
Part One...........................................................................................................................................1
A) 1. Description of transaction in financial statements........................................................1
2. Explanation of transactions in specific statements.............................................................1
B) 1. Difference between tangible and intangible non-current assets....................................2
2. Criteria to meet as an asset.................................................................................................2
Part Two...........................................................................................................................................2
A) 1.Computation of gross profit margin...............................................................................2
2. Application of trend analysis in total revenue....................................................................3
3. Application of trend analysis in Oil and Gas exploration..................................................3
4. Reason for change in profits...............................................................................................4
B) 1. Application of financial technique................................................................................4
2. Indicator of financial performance.....................................................................................4
3. Analysis of case study........................................................................................................5
Part Three.........................................................................................................................................5
A) 1. Appropriate financial technique....................................................................................5
2. Financial performance indicators.......................................................................................6
3. Reason for change in financial position.............................................................................6
B) 1. Calculation of financial ratios.......................................................................................6
2. Comparison and recommendation to buy company...........................................................7
Part Four...........................................................................................................................................7
1. SPECIFIC part in cash flows..............................................................................................7
2. Derivation of figures from financial statements.................................................................7
3. Improvement in working capital........................................................................................7
4. Reasons for improved cash flow........................................................................................8
Part Five...........................................................................................................................................8
1. Preparation of business report............................................................................................8
CONCLUSION................................................................................................................................9
REFERENCES..............................................................................................................................10

INTRODUCTION
Business requires making decision for acquisition on several factors. In this context,
financial statements should be interpreted thoroughly so that no wrong decisions may be made
by the company. Present report deals with Deepwater Ltd which is energy exploration
organisation. It is planning to acquire Maxshale Ltd engaged in Shale Gas exploration that could
help company to take advantage of this new resource and earn profits. Thus, financial statements
are used to take decision whether to acquire firm or not.
Part One
A) 1. Description of transaction in financial statements
There are various transaction which are reflected in either income statement or balance
sheet. The description related to each transaction are as follows-
Description 1
Deepwater Ltd received and paid invoice for £50,000 from legal advisors which will be
reflected in Statement of Profit or Loss (SPL).
Description 2
Organisation paid £20,000 for registration of patents will be reflected in Statement of
Financial Position (SOFP) in assets section.
Description 3
Company owes the subcontractor amount of £90,000 and as such, it will be reflected in
SOFP as it is a liability of company to pay creditor.
Description 4
The interest charges paid by the company is non-operating expense and as such, it will be
shown in SPL (Titman, Keown and Martin, 2017).
2. Explanation of transactions in specific statements
The transaction identified in above description can be listed as follows
Description 1- Deepwater Ltd paid legal fees to legal advisors and as such, this amount is
classified as operating expense under SPL and will be deducted from gross profit.
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Description 2- Organisation has paid £20,000 for acquiring patents and it is registered for 25
years. Thus, patents will be shown in Non-current assets in SOFP.
Description 3- The amount which firm owes to subcontractor will be shown in current liabilities
under SOFP.
Description 4- Interest charges will be shown as non-operating expense in SPL and due amount
will be paid in 2025. Thus, due amount should be listed under Other liabilities section in SOFP.
B) 1. Difference between tangible and intangible non-current assets
Tangible non-current assets are land and building, machinery and many others. On these
non-current assets, depreciation is charged as value decreases year by year. On the other hand,
intangible non-current assets such as patents, trademark are reflected in intangible assets and
company deducts amortisation expense as it owed the amount.
2. Criteria to meet as an asset
Patents are considered as non-current asset in the balance sheet of company. Deepwater
Ltd meets this asset as amortisation expenses are paid by organisation for registration for 25
years (Amortization. 2018). The conceptual framework as provided by IASB that asset is termed
as a resource for organisation because of past events and which will produced economic benefits
in the future. Thus, Deepwater Ltd has paid registration fees as it will provide benefit in
forthcoming years.
Part Two
A) 1.Computation of gross profit margin
Gross profit margin for segments
Gas exploration
Oil
Exploration
Renewable
Energy
Particulars Formula 2017 2016 2017 2016 2017 2016
Gross profit
margin
Gross profit / net
sales * 100 15.90% 10.33% 13.75% 10.27% 0 1.43%
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2. Application of trend analysis in total revenue
It can be interpreted that revenue was 56448 in 2016 and decreased to 45351 in 2017.
The revenue is diminished up to a high extent. The revenue is decreased, however, gross profit is
increase of Deepwater Ltd because expenses incurred on attaining sales are alleviated up to a
high extent. This is evident from the fact that Cost of sales was 52124 in 2016 and decreased in
2017 to 38457. Much difference is found between cost of sales and as such, revenue is
minimised, however, gross profit is increased.
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Illustration 1: Total revenue

3. Application of trend analysis in Oil and Gas exploration
The above graph shows that Gas exploration is increased in 2017 to 30648 as it was
26135 in previous year. Moreover, Oil exploration was 13443 in 2016 and maximised to 14703
in 2017 which is good enough for company. Both are increased because as listed in the case
study, contracts with energy producers for exploration is successful, then small commission on
the basis of volume extracted is attained forming a part of other operating income annually.
4. Reason for change in profits
The reason behind decrease in revenue and increase in gross profit is that Deepwater Ltd
has provided aggressive discounts and liberal policies of returns which has lead to decrease in
revenue. It is required that strict return policies should be implemented so that revenue may ne
generated (Minnis and Sutherland, 2017). However, gross profit is maximised from 2016 to 2017
financial years because operating costs are being reduced up to high extent. It has been beneficial
for company as labour expenses, expenditures incurred on selling goods are quite effectively
minimised. Thus, minimising operating costs has lead to increase in gross profit.
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Illustration 2: Trend line for segments

B) 1. Application of financial technique
The graph shows that expenditures are reduced up to a high extent as it was 3995 in 2016
and reached to 2903 which highlights efficiency of organisation in controlling expenses. This has
eventually impacted on other income as it increased quite effectually in 2017. Other expenses
such as employee expenses, research costs are increased which means that expenditures are
reduced quite significantly. Other operating income is maximised because of commission
attained from energy producers.
2. Indicator of financial performance
The performance of the company is overall good in 2017 in comparison to previous year.
This is evident from the fact that linear equation of other expenses clearly shows that Deepwater
Ltd has initiated control on its expenditures. It can be analysed that in 2016, expenditures were
3995 which reduced up to 2903 in 2017 financial year (Kwok, 2017). Thus, it implies that
administration expenditures are minimised and as such, it is good indicator of performance of
company. On the other hand, other income is increased in 2017 as company has earned income
regarding to its profitable operations. It can be interpreted from trend line equation as it is
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Illustration 3: Trend line of Other income and Other expenses

positive as income was 237 in 2016 and maximised to 243. Thus, it shows that movement in
trend analysis is positive indicator of financial performance.
3. Analysis of case study
The movement of other income and other expenses has led to positive indicator of
financial performance for the company. The main reason behind such movement is that
Deepwater Ltd has effectively decrease operating expenses and as a result, other income is
increased. Moreover, cost of goods sold is minimised. This has benefited organisation and
performance is enhanced.
Part Three
A) 1. Appropriate financial technique
It can be interpreted that firm has negative cash flows in 2016 but it maximised to 3215
in 2016 in comparison to -300 in previous year. The changes in equity is also increased in 2017
to 3932 while it was 1652 in 2016. Cash flows are being injected because sale proceeds from
Property, Plant and Equipment of 1320 is being attained in 2017. Changes in equity is being
favourable as profit for the year is increased as it was 197 in 2016 and reached to 2868 in 2017.
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Illustration 4: Trend line on Statement of Financial Position and cash flows

Profitability position is highlighted in above graph. ROCE is immensely improved as it
was 3.93 % in 2016 and increased to 29.80 % in 2017. Gross margin was increased in 2017. Net
operating margin was 1 % and reached to 9.34 % showing organisation has good financial
health. Net operating margin is increase because administration expenses are reduced as it was
3995 in 2016 and diminished to 2903 in 2017. On the other hand, gross margin is enhanced
because of reduction in operational expenditures. ROCE is enhanced which means that firm is
utilising assets quite effectively and producing profits.
2. Financial performance indicators
The above trend line shows that performance of company has increased as cash flows
were negative in previous year while it maximised in next year. Moreover, ratios are also
improved. Thus, movement is positive (Rezaee, Sharbatoghlie, Elam and McMickle, 2018).
3. Reason for change in financial position
The main reason that has increased profitability position of organisation is that it has
initiated control on expenditures on exploration and further, effective strategies are also
implemented.
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Illustration 5: Trend line on the basis of statement of profitability

B) 1. Calculation of financial ratios
Ratios of Maxshale Company
Particulars Formula 2017
Return on Capital Employed
(ROCE) EBIT / Capital Employed 14.47%
Net profit margin Net income / sales 2.35%
Operating profit margin Operating income / sales 4.88%
Current ratio
Current assets / Current
Liabilities 2.03 :1
Interest cover ratio
Earnings before Interest and
Taxes / Interest expenditures 2.2
Gearing ratio Debt / Shareholders' Equity 0.86
2. Comparison and recommendation to buy company
It can be analysed that financial position of Maxshale Ltd is not good as per the
benchmark set by Deepwater Ltd. This is evident from the fact that ROCE is below 20 %, gross
and net operating margin are also low (Johnston and Petacchi, 2017). Interest cover is below 3
and gearing ratio is more than 50%. Only current ratio meets the criteria. Thus, it is
recommended not to buy Maxshale Ltd.
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Part Four
1. SPECIFIC part in cash flows
The SPECIFIC part which has improved cash position of Deepwater Ltd is Proceeds
from sale of Property, Plant and Equipment (PPE). Amount generated from sale of fixed asset is
1320 which has injected positive cash flows. It has resulted into strong cash position of company
(Libby, 2017).
2. Derivation of figures from financial statements
From operating activities, income tax paid is directly taken from SPL. On the other hand,
trade payables is taken from SOFP.
3. Improvement in working capital
The improvement has been made in the working capital which had led to improved cash
flows of Deepwater Ltd as well. This is evident from the financial ratios that company has
satisfactorily garnered payments from receviables and made quick payments to suppliers.
Efficiency ratios such as receivables days and payables days both ratios provide clarity that it has
been improved by company. Both the ratios are good which has improved cash position of
company. Furthermore, it is required that firm should collect outstanding amount from debtors
more quickly which would help to pay-off money to creditors and suppliers. This will further
improve cash position of organisation.
4. Reasons for improved cash flow
There are other two reasons which has led to improvement in cash flows. Proceeds from
sale of intangible assets and proceeds of sale of PPE has effectively improved Deepwater Ltd
cash flow in the best possible manner (Berger, Minnis and Sutherland, 2017). Furthermore,
current ratio is also increased which has further improvised company's cash position in effective
way. Thus, company is able to meet its shot-term liabilities and as such, adequate cash is
available for meeting daily operational requirements.
Part Five
1. Preparation of business report
To: Board of Directors of Deepwater Ltd
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From: Samit Patel, Finance Director
Date: 27 April 2018
Title: To provide advice to acquire Maxshale Ltd
Executive Summary-
It can be analysed that Deepwater Ltd has effective and good financial position as it is
clarified by various financial statements. It has improved its cash flow statement, income
statement also shows desired income has been earned by firm. Moreover, balance sheet is also
good as assets are increased. In the context of acquisition of Maxshale Ltd, it is advised to
Board of Directors that they should not acquire the company as it has low ROCE, gross and net
operating margin, interest cover ratio. Furthermore, gearing ratio is more than 50 %. Thus, it is
recommended not to purchase Maxshale Ltd as it will be not be profitable for company to meet
its objectives.
CONCLUSION
Hereby it can be concluded that acquisition decision should be taken by considering
various elements in order to meet set targets. It is extracted from the report that Maxshale Ltd has
not good financial position as per the criteria set by Deepwater Ltd and as a result, acquisition
should not be done. Thus, acquisition is important decision to be made by analysing varied
factors before making final decision.
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