International Financial Accounting – Comparison of the Annual Reports 2005 of Goldman Sachs and Close Brothers
Description of activities and source and type of revenues
Goldman Sachs has three main types of activities
Investment banking. This covers services like merger and acquisition advice, helping clients raise debt.
Trading and principal investments. This covers trading and investing in fixed income and equity products, currencies and commodities. This is the largest division in terms of net revenues and generated 66% of net revenues in 2005.
Asset management and security services. This division provides advisory and financial planning services including brokerage and advisory services to wide range of clients like pension fund and hedge funds.
Table 1 shows the net income of the above three divisions in 2005.
Table 1 – Goldman Sachs: Net income in the year ended November 2005[1]
Division
Net revenues, $ billion
Revenue as % of total
Investment banking
3.67
15%
Trading and principal investments
16.36
66%
Asset management and security services
4.75
19%
Total
24.78
100%
Close Brothers provides following main activities
Investment banking. Close Brothers has three main divisions under investment banking:
Asset management. This division manages assets of private clients, trust funds and offshore funds.
Corporate finance provides merger and acquisition, financial restructuring and debt advisory services to corporate clients.
Market-making division specialises in providing liquidity to the London retail market-making markets in UK and many international shares.
Banking division normal banking services like deposits and foreign exchange facilities to personal and professional clients.
Table 2 shows the distribution of operating income, as a measure of revenues, of different divisions
Table 2 – Close Brothers: Operating income in the year ended 31 July 2005[2]
Division
Operating income as % of total
Asset management
21%
Corporate Finance
7%
Market-making
24%
Investment banking
52%
Banking
48%
Total
100%
Profitability of the two companies from the company and shareholders perspectives
The table 3 shows the profitability of Goldman Sachs in the years ended November 2004 and 2005
Table 3 – Goldman Sachs: Profitability[3]
2005
2004
% change
Net revenues, $ billion
24.78
20.55
20.6%
Pre-tax earnings, $ billion
8.27
6.68
23.8%
% of revenues
33.4%
32.5%
Net earnings, $ billion
5.63
4.55
23.7%
% of revenues
22.7%
22.1%
Diluted earnings per common share, $
11.21
8.92
25.7%
Return on average common shareholders equity
21.80%
19.80%
10.1%
Goldman Sachs increased its net revenues by 20.6 % in 2005 whereas pre-tax earnings increased by 23.8 % in the corresponding period. This shows that the company achieved not only higher profits in 2005 but also increased the profitability by limiting growth in expenses. This is supported by the fact that pre-tax earnings as a percent of net revenues were 33.4 % in 2005 compared to 32.5 % in 2004. Net earnings also increased by 23.7 % in the year 2005 in line with growth in pre-tax earnings. The higher growth in net earnings compared to net revenues shows that higher sales were not achieved at the expense of lower margins.
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Profitability for shareholders is measured in terms of diluted earnings per share. The growth in diluted earnings per share was 25.7 % in 2005. This was even higher than the growth in net-earnings. Shareholders’ profitability is also measured in terms of return on shareholders equity which is net earnings divided by the shareholders equity. This increased by 10% from 19.8 % in 2004 to 21.8 % in 2005. Higher return indicates Goldman Sachs is using equity to earn higher profits.
The table 4 shows the profitability of Close Brothers for the years ended July 2004 and 2005
Table 4 – Close Brothers: Profitability[4]
2005
2004
% change
Operating income, £ m
448
401.2
11.7%
Pre-tax profit, £ m
108.62
101.34
7.2%
% of operating income
24.2%
25.3%
Profit after tax, £ m
70.75
67.42
4.9%
% of operating income
15.8%
16.8%
Diluted earnings per common share, £
0.47
0.45
4.4%
Profit attributable to shareholders, £ m
68.58
65.21
Shareholders equity, £ m
540.32
509.26
Return on average common shareholders equity
12.69%
12.80%
-0.9%
Close Brothers increased its operating income by 11.7 % in 2005 whereas pre-tax earnings increased by 7.2 % only in the corresponding period. This shows that the increase in pre-tax profits was countered by a much higher increase in expenses. The operating margin dropped by 1% from 25.3 % in 2004 to 24.2 % in 2005. Operating margins of Close Brother were about 9 % lower than that of Goldman Sachs indicating that Close Brothers operates in a more competitive environment. Similarly profit after tax as a percent of revenues were 7 % lower in case of Close Brothers – 15.8 % for Close Brothers compared to 22.7 % for Goldman Sachs.
The growth in diluted earnings per share was only 4.4 % in 2005. This is much lower than the growth in Goldman Sachs earning per share. The return on common shareholder equity was only 12.70 % in case of Close Brother which means that from shareholders point of view return in Goldman Sachs is higher than Close Brothers.
Long-term financial structure of two companies
Table 5 shows the financial structure of Goldman Sachs looking at its short and long-term borrowings along with shareholders equity.
Table 5 – Financial structure of Goldman Sachs[5]
2005
2004
$ billion
%
$ billion
%
Short term borrowings
55.22
36%
54.96
41%
Long term borrowings
Secured
15.67
10%
12.09
9%
Unsecured
84.34
54%
68.61
51%
100.01
64%
80.7
59%
Total borrowings
155.23
100%
135.66
100%
Cash and cash equivalent
10.26
4.36
Net debt
144.97
131.30
Shareholders equity
28.00
25.08
Long term debt to equity
78%
76%
Net debt / (net debt + equity)
84%
84%
The % of long-term borrowings has increased from 59 % to 64 % in the year 2005. This has mainly come from the increase in unsecured long-term borrowings. The company is highly geared and its net debt to total capital ratio is 84 %. As of November 2005, 84 % of Goldman Sachs was financed through net debt, i.e., out of every $1 of its capital, 84 cents came from debt.
The table 6 shows the financial structure of Close Brothers.
Table 6 – Financial Structure of Close Brothers[6]
2005
2004
£ m
%
£ m
%
Short term borrowings
132.22
15%
287.36
40%
Long term borrowings
729.28
85%
434.00
60%
Total borrowings
861.5
100%
721.36
100%
Cash and cash equivalent
1.25
0.85
Net debt
860.25
720.51
Shareholders equity
540.32
509.26
Long term debt to equity
57%
46%
Net debt / (net debt + equity)
61%
59%
Company’s long-term borrowings have increased significantly from 60 % to 85 % in the year 2005. Close Brothers gearing are more on long-term borrowings as compared to Goldman Sachs.
The net debt to total capital ratio is 61 % which means that Close Brothers is less geared compared to Goldman Sachs. Because of higher equity percent in Close Brothers, the long-term debt to equity ratio of Close Brothers is only 57 % in 2005 as compared to 78 % of Goldman Sachs.
Analysis of difference in cash flow from profit
Cash flows differ from profits because of the following major items:
Inclusion of non-cash items like depreciation and amortisation in net profits
Cash inflow and outflow in purchase and sale of property and businesses. In case of purchase, no impact is on profit and loss. In case of a sale, only profit or loss over the cost price is included in the profits and not the full amount of sale.
Cash inflow or outflow from the financing activities like raising or retiring loan, issue of equity. This impacts cash flow but is not included in the profit and loss statement.
We now look at the above sources of difference for both Goldman Sachs and Close Brothers.
Table 7 shows the cash flow calculation from net profits of Goldman Sachs for the year 2005.
Table 7 – Comparison of cash flow and profits of Goldman Sachs[7]
$ bln
Net profits
5.63
Cash flow
Net profits
5.63
Non-cash items in net earnings
2.16
Cash used in assets and liabilities
-20.203
Cash used in operating activities
-12.413
Cash from investing activities
-1.06
Cash from financing activities
19.37
Change in cash
5.90
Goldman used $12.4 billion of cash in operating activities in 2005 and this includes $20.20 billion of cash used in assets and liabilities. Operating activities also include $2.16 billion of non-cash items like depreciation and amortisation, deferred income tax and stock options. Another $ 1 billion of cash was used in purchase of businesses, property and leases. The cash outflow from operating activities was compensated by cash inflow from financing of $19.37 billion. This was mainly made up of cash inflow of $43 billion from long-term borrowings.
Table 8 shows the cash flow calculation of Close Brothers for the year 2005.
Table 8 – Comparison of cash flow and profits of Close Brothers for the year ended 31 July 2005[8]
£ m
Profit after tax
70.75
Cash flow
Cash flow from operating
521.52
Tax
-37.82
Net cash flow from operating activities
483.70
Cash from investing activities
-171.23
Cash from financing activities
-67.98
Change in cash
244.49
While the profit after tax was only £70.75 million, cash increased by £244.49 million in the year 2005. This was mainly due to net cash inflow from operating activities of £483 million.
The differences in the sources of cash generation arise between Goldman Sachs and Close Brothers arise from the way they include cash items under different categories. Close Brother was able to show high cash inflow from operating activities because of classification of reduction in loan advances of £190 million and loan notes issuance of £260 million under trading activities. If we take out the above two ash inflows form operating activities, then net cash inflow from operating activities would be only £33.7 million (483.7 – 190 – 260). Also then the cash flow form financing activities would change from -£68 million to £382 million.
Examples of accounting transactions subject to different GAAP
Goodwill amortisation and impairment. Goldman Sachs is listed at New York Stock Exchange and subject to US GAAP. Under US accounting SFAS No. 142 “Goodwill and Other Intangible Asset”, Goldman Sachs tests goodwill each year for impairment[9]. It amortises intangible assets over the useful life which was on average 16 years in 2005[10]. Close Brothers follows Financial Reporting Standard No. 10 and amortised the goodwill over 20 years[11]. Where Goldman Sachs has an option to choose the useful life, companies in UK normally follow the option of 20 years. The change in amortisation years results in difference in profits even though this is a non-cash item.
Share based compensation. Goldman Sachs followed US accounting principles SFAS 123 and SFAS 148 under which the compensation expense is recognised over the relevant service period[12]. Close Brother didn’t expense the share based compensation in the year 2005 and expects that future alignment with International Financial Reporting Standards on expensing of share based award will reduce profits by £ 4 million[13].
Summary of non-numeric information in the annual report and importance to the shareholders
Summary of information for Goldman Sachs
Investment banking backlog increased in 2005 over 2004[14]. This means that the company was expecting more business to materialise in fees in 2005 and also shows the healthy environment in financial markets.
The company increased its market risk in equities and interest rate products in the second half of 2005 assuming that market conditions will remain favourable[15]. If market conditions turn against Goldman Sachs assumption, the riskier investments would lead to higher losses.
The business is very prone to financial market conditions and hence it is difficult to predict future earnings[16]. Investors with good knowledge of financial markets – mainly sophisticated institutional investors – can predict with some reasonability future earnings of a company like Goldman Sachs. It would be difficult for individual investors to do the same and hence they have to rely on credible sources for future earning potential of Goldman Sachs.
Summary of information for Close Brothers
The business performance is subject to economic conditions in UK[17]. Bad debt charge was low in 2005 due to low interest rate and full employment. Increase in interest rate and low employment would increase bad debt charge and reduce profitability.
Reputation risk is the most importance and any public failure can lead to significant reduction in income[18].
Implementation of International Financial Reporting Standards could have a material impact on income because of issues like recognition of share based awards[19].
BIBLIOGRAPHY
Goldman Sachs, Annual Report 2005, http://www2.goldmansachs.com/our_firm/investor_relations/financial_reports/annual_reports/2005/
Close Brothers, Annual Report 2005, http://www.closebrothers.co.uk/uploads/cbg2005full.pdf
Footnotes
[1] Goldman Sachs, Annual Report 2005
[2] Close Brothers, Annual Report 2005
[3] Goldman Sachs, Annual Report 2005
[4] Close Brothers, Annual Report 2005
[5] Goldman Sachs, Annual Report 2005
[6] Close Brothers, Annual Report 2005
[7] Goldman Sachs, Annual Report 2005
[8] Close Brothers, Annual Report 2005
[9] Goldman Sachs, Annual Report 2005, Pg. 74
[10] Goldman Sachs, Annual Report 2005, Pg. 89
[11] Close Brothers, Annual Report 2005, Pg. 31
[12] Goldman Sachs, Annual Report 2005, Pg. 73
[13] Close Brothers, Annual Report 2005, Pg. 8
[14] Goldman Sachs, Annual Report 2005, Pg. 24
[15] Goldman Sachs, Annual Report 2005, Pg. 25
[16] Goldman Sachs, Annual Report 2005, Pg. 25
[17] Close Brothers, Annual Report 2005, Pg. 5
[18] Close Brothers, Annual Report 2005, Pg. 6
[19] Close Brothers, Annual Report 2005, Pg. 8
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