Research Paper Undergraduate 10,952 words

Financial analysis of Williams Company and Devon Energy

~55 min read 63 sections

✍️ How to write this paper — guide & tools ▾

📘 Read the full research paper guide → Generate citations → Build an outline → Draft a literature review →

Essay 10,952 words

Financial Statement Analysis

This study deals with the analysis and reading of financial statements of companies. Such statements include balance sheets, income statements and cash flow statements among others. The paper also looks into the various methods and techniques of financial reporting and their impact on the ultimate outcome of the analysis of financial statement.

For this study we consider the financial statements or annual reports two companies -- Williams Company Inc. and Devon energy, both operational in the field of oil and natural gas. And both are based in the U.S.

The study looks into the various aspects of the financial statements that the two companies had provided in the last three fiscal years and deductions about the company were drawn based on the analysis of the data that was given in the statements.

For the purpose of analysis, the study utilized various financial ratios like the quick ratio, current ratio, other liquidity ratios, performance ratio and profitability ratios. The outcome of the ratios helped in ascertaining the strengths and weaknesses of the companies and understanding in how the figures help in deciding which company is better to invest in and why.

The study also deals with the preparation of pro-forma financial statements and understanding how such statements vary from the actual financial statements that are given by the companies.

This study found considerable fluctuations in results of analysis of the original financial statements and the pro-forma statements in several aspects which impacted the decision to invest in the companies.

Contents

Company Information & Important Financial Ratios 3

Management Discussion and Analysis 8

Ratio Analysis of the Companies 12

Comments on the Major Findings of Williams Company 24

Accounting Treatments of the Companies 26

Selection of the Better Company to Invest 31

Pro-forma Financial Statement of Williams Company Inc. 34

References 42

Company Information & Important Financial Ratios

For this part of the study we chose Williams Company as the primary company to be analyzed in relation to the 10-K reports of the company for the financial years 2011-2012 through to 2013-2014 (Co.williams.com, 2015).

An energy infrastructure company focused on connecting North America's significant hydrocarbon resource, Williams Company is among the leading companies in the oil and gas sector in the U.S. The company has its interests in natural gas, natural gas liquids (NGLs) and olefins. The company has operations in the deepwater Gulf of Mexico and spans to the Canadian oil sands. The company was established in 1908 (Co.williams.com, 2015).

As a competitor the above stated company for this part of the study we chose U.S. based petro-company Devon Energy which is engaged is an independent oil and natural gas exploration and production company with its operations primarily focused on onshore sites in the United States and Canada. It was founded in 1971 (Devonenergy.com, 2015).

This company was chosen as a competitor to Williams as it is in the same field of business or industry. Both the companies are public listed companies and hence it would be apt to compare the two companies with respect to the investor interests. The financials reported by the company can be assumed to have been well scrutinized and error free given the fact that both are public limited companies.

Interestingly, it would also be a matter of comparison as both the companies differ significantly in terms of the age. While Williams was et up in 1908 Devon was established in 1971. Hence it would an interesting comparison in terms of the management outlook and the strategies that the two companies follow given the legacy that they carry with them (Devonenergy.com, 2015)

In order to understand relationships among various items reported in one or more of the financial statements, experts and investors make use of various ratios the define the operations, efficiency and heath of a company. These ratios help to create and understanding and These rations are needed to understand that no analysis is complete unless it leads to an interpretation that helps financial statement users understand and evaluate a company's financial results

Common Size ratios

Horizontal analysis is a form of trend analysis that is done to help financial statement users identify the important financial changes that unfold over time.

The relationship between items on the same financial statement is made possible through vertical analyses and it focus on importance of the relationships.

Trend analyses are usually calculated in terms of year-to-year dollar and percentage changes.

Year-to-year change % = change this year/prior's year's total *100

= (Current year's total -- Prior Year's Total)/Prior's year total * 100

Important relationship within financial statement is focused on vertical or common size analysis. It is a trend to usually pick a value on the financial statement and express all other values on that statement as a percent of the selected amount.

Liquidity Ratios

The ability of a company to pay off both its current liabilities as they become due as well as their long-term liabilities as they become current is analyzed using the Liquidity ratios. The cash levels of a company and the ability to turn other assets into cash so that the company is able to pay off the liabilities and other current financial obligations are displayed by these ratios.

The ease with which a company is able to raise enough cash or convert assets into cash is measured by liquidity ratios and they are not merely measures of how much cash a business has.

Some of the assets that are relatively easy for a company to convert into cash in the short-term, are accounts receivable, trading securities and inventory. Therefore all of these assets go into the liquidity calculation of a company (Wiehle, 2005).

Quick ratio

The ratio that is used to measure the ability of a company to pay its current liabilities when they come due with only quick assets is known as the quick ratio. The current assets that have the ability to be converted into cash within 90 days or in the short-term are termed as quick assets. For companies assets that are considered to be quick assets include elements like cash, cash equivalents, short-term investments or marketable securities and current accounts receivable.

Formula

Quick ratio = Cash + Cash equivalent + short-term investment + current receivables / current liabilities

The higher the quick ratio the better it is for a company and the industry benchmark in the oil and gas sector is 0.27

Current Ratio

The ratio that measures a firm's ability to pay off its short-term liabilities with its current assets is called the current ratio and it is a form of liquidity and efficiency ratio. Short-term liabilities are due within the next year and hence the current ratio is an important measure of liquidity.

Current Ratio = Current Assets/Current Liabilities

Since this ratio shows the company can more easily make current debt payments, therefore a higher current ratio is always more favorable than a lower current ratio.

Working Capital Ratio

This is a form of liquidity ratio that measures a firm's ability to pay off its current liabilities with current assets. Since it shows the liquidity of the company therefore the working capital ratio is important to creditors (Bull, 2008).

Working Capital Ratio = Current Assets/Current Liabilities

Any ration of this sort that is essentially less than 1 is considered to be bad by investors and creditors since is indicates that the company is not running efficiently and can't cover its current debt properly. Such a ratio also referred to as a negative working capital. In case the ratio value is more than 1, it shows that the company can pay all of its current liabilities ad would still be left with current asses and is referred to as positive working capital.

The benchmark for this ratio in the oil and gas industry in the third quarter of 2015 is 1.13

Profit Ratios

Profit Margin Ratio

The amount of net income earned with each dollar of sales generated by comparing the net income and net sales of a company is measured and indicated by the profit margin ratio. It is therefore also called the return on sales ratio or gross profit ratio. What percentage of sales are left over after all expenses are paid by the business is shown by this ratio and hence is very critical to investors.

Profit margin ratio = Net Income / Net sales

What percentage of sales is made up of net income is indicated by the profit margin ratio directly. In other words, it measures how much profits are produced at a certain level of sales. Like sized companies in the same industry are generally compared to each other through this form of profit ratio. The past performance of a company is also effectively measured by this ratio.

Return on capital employed

The measure of the efficiently a company in terms of generating profits from its capital employed is indicated by the return on capital employed ratio. It is calculated by comparing net operating profit to capital employed. How many dollars in profits each dollar of capital employed is generated by the company is shown by the return on capital employed.

Return on Capital Employed = Net Operating Profit / Employed Capital

A higher ratio in the return on capital employed ratio is desirable as it means that more dollars of profits are generated by each dollar of capital employed (Bull, 2008).

Return on Equity Ratio

The ability of a firm to generate profits from its shareholders investments in the company is indicated by the return on equity ratio or the ROE. How much profit each dollar of common stockholders' equity is generated is shown by it.

Return on Equity Ratio = Net Income / Shareholder's Equity

While it is desirable to higher ratios compared to lower ratios, it is also advisable to compare the ratio with other companies' ratios in the industry. ROE cannot be used to compare companies outside of their industries very effectively, as every industry has different levels of investors and income.

Efficiency Ratios

Asset Turnover Ratio

The ratio that is used to measures a company's ability to generate sales from its assets by comparing net sales with average total assets is known as the asset turnover ratio. The efficiency with which a company is able to use its assets to generate sale is shown by this ratio.

Asset Turnover Ratio= Net Sales / Average Total Assets

A higher ratio is always more favorable as this ratio measures how efficiently a firm uses its assets to generate sales. Existence of probable management or production problems is indicated by a lower asset turnover ratio.

The net sales of a company equals the average total assets for the year is indicated when the ratio is 1. This also means that the company is generating 1 dollar of sales for every dollar invested in assets.

Debt to Equity Ratio

The comparison of the total debt to total equity of a company is done by the debt to equity ratio which is also a liquidity ratio. The percentage of company financing that comes from creditors and investors are shown by this ratio. A higher debt to equity ratio indicates that more creditor financing (bank loans) is used than investor financing (shareholders).

Debt to Equity ratio = Total Liabilities / Total Equity

The industry average for this ratio in the third quarter of 2015 was 0.34.

Management Discussion and Analysis

The Williams Companies, Inc.

Company investments

The company management starts off the annual report with a list of the investments that the company has made in the previous year which can have a direct reference to the cash reserves of the company and the liquidity of the company. The annual reports states that the company has made a $6 billion acquisition and merger of Access Midstream Partners and has commissioned several world-scale infrastructure projects. There were several large-scale organic projects that were completed by the company the previous year (2012-2013) and continued growing the gathering and processing capacity in the prolific Utica-Marcellus shale region. Expansions for Geismar, La. olefins plant were done as part of expansion strategy.

The company also states that the lower price of the oil and gas has forced the company to align its financial performance and capital spending with lower assumptions. The company expected that the fee-based revenue model would generate about 88% of Williams Partners' gross margin. The company claimed that this model would bring in returns in the long run which indicated that the costs incurred to set up the model could be reflected in the balance sheet which the company would be financially benefitted later on.

In the Access Mainstream segment of the business, the company clearly mentions that the model would include fee redetermination or cost of service mechanisms that are designed to support a return on invested capital. Revenues would also be generated through certain fee-based models for gas gathering agreements with two major customers.

The Risk Factors

While talking about the performance of the company in the annual report, the company enumerates the risks that are involved with the price of NGLs, olefins, natural gas, oil and other commodities. The company claims that the prices in the market are volatile and this volatility could adversely affect the financial results, cash flows, access to capital and ability to maintain the existing businesses in the near future this statement indicates that the risks involved in this aspect could be reflected in the revenues of the company as stated in the annual report an de balance sheet.

The prices of NGLs, olefins, natural gas, oil or other commodities, and the differences between prices of these commodities would decide the revenues, operating results, future rate of growth and the value of certain components of the businesses, the company clearly states in the annual report. These are indicators to the creditor and the investor that the company is hinting at factors that are beyond their control and which could affect the profitability of the company as reflected in the balance sheet.

There are also apprehensions that the company expresses about the possible lowering of the commodity market and especially the price lowering trend in the oil and gas sector. The amount that the company receives for its products and services and the volume of products and services that the company sells could be impacted by price volatility. Further the company predicts that the markets for NGLs, olefins, natural gas, oil and other commodities are likely to continue to be volatile which is an indication that eth investors should realize about the prospects of business for the future.

Effects of Inflation

The company however claims that the operations of the company would not be affected inflation as the 35% of the gross property, plant, and equipment is comprised of interstate natural gas pipeline assets. However the company makes it clear that recovery of increased costs due to other factors may be limited by factors such as cost-based regulations, along with competition and other market factors.

Environmental

The company has invested more than $25 million in environment related expenditures. The costs were not possible to be recovered in the period for which the report has been prepared and hence the company assures that it would seek recovery of approximately $11 million of the accrued costs through future natural gas transmission rates. The remainder of these costs will be funded from operations. Cleanup and/or remediation and monitoring activities cost the company approximately $11 million in 2014 and the same amount is expected to be invested in 2015. Assessment studies, preliminary results of studies or the experience of the company with other similar cleanup operations is the basis for the estimation of the most likely costs of cleanup.

Devon Energy

The management of Devon Energy has vividly noted down clarifications with regards to performance of the company in the annual statement that provide an insight into the operational advantages and shortfalls. The annual report also sights certain factors that are outside the control of the management of the company and which have the potential to affect the profitability of the company.

Royalties and Incentives

The company management states that the royalties and incentives in Canada play a significant role in the company making profits from the Canadian oil and gas production. The government of the country plays an important role in the determination of the Crown royalties and is generally calculated as a percentage of the value of the gross production, net of allowed deductions. Based on crown posted prices, the royalty percentage is determined on a sliding-scale. Lower royalty rates for oil sands projects until allowable capital costs have been recovered are prescribed by the regulations.

Oil, Gas and NGL Prices are Volatile

Similar to what Williams had mentioned in the annual reports, Devon Energy too lays special emphasis on the volatility of the oil, gas and NGL prices. The company states that the general supply and demand for oil, gas and NGLs is a significant determinant factor in the financial results of the company. It also states that this factor impact the prices that the company ultimately realize from the sales of these commodities.

There has been a significant downturn in the price of these commodities in the recent years and the significant downward movement of the prices for these commodities has had a material adverse effect on the revenues, operating cash flows and profitability of the company for the financial year the report has been prepared. The estimated proved reserves, the carrying value of the oil and gas properties, the level of planned drilling activities and future growth of the company are impacted by the factor -- especially the downward trend of the demand and prices in the global market. The factors behind the volatility are well outside the control of the company and hence the market prices and the realized prices have been volatile and are likely to continue to be volatile in the future, the management states. The company notes that there was significant decrease in the prices of these commodities in towards the end of 2014. This has been attributed to the reduced revenue generation from sale of these products in the annual report. The company expects the volatility to continue throughout 2015 and predict that the prices would be significantly lower than in 2014. This the company says, would result in reduction of operating cash flow which would be require the company to scale back certain uses of cash during 2015 compared to 2014, including most notably the capital expenditures.

Interest Rates

The operating cash flow is expected to be impacted by interest rate fluctuations. The company had a total debt of $11.3 billion as of December 31, 2014, with an overall weighted-average borrowing rate of 4.6%. Nearly $2.0 billion of these borrowings is based on floating rates and hence would be affected by rise in interests in the U.S.

Credit Losses

The company is at risk due to the credit risk of others such the credit risk of the customers who purchase our oil, gas and NGL production. The collection of receivables from our joint-interest partners is also impacted by the credit risks. The credit risk of counterparties to the derivative financial contracts of the company are also at risk, says the company management. The company has made use of instruments like letters of credit, prepayments or collateral postings in order to limit the exposure of the company to the credit risks of the customers, partners and counterparties.

Ratio Analysis of the Companies

Williams Company Inc.

To find out the trend in the company in relation to the three annual financial reports of the company we undertake the trend analyses of the company. This is usually calculated in terms of year-to-year dollar and percentage changes.

The formula for the trend analysis of the company is as follows:

Year-to-year change % = change this year/prior's year's total *100

= (Current year's total -- Prior Year's Total)/Prior's year total * 100

Net Income (loss) Trend (2013-2014)

2339 -668 / 668 *100 = 250.1%

Net Income (loss) Trend (2013-2012)

668-1065/1065*100 = 37.27%

Net Income (loss) Trend (2011-2012)

1065-661/661* 100 = 61.11%

The above ratio indicates that the company's net profit percentage has increased in the three years that are being studied and hence it can be said that despite the gloom in the oil and gas sector globally the company has managed to garner profits for the shareholders. This indicates a positive profit trend in the company. What is significant is that in the last fiscal there has been a 250% jump in the net income trend.

Quick ratio

We will use this ratio to measure the ability of a company to pay its current liabilities when they come due with only quick assets. The current assets that have the ability to be converted into cash within 90 days or in the short-term are termed as quick assets. We will consider the following elements to calculate the quick ratio - cash, cash equivalents, short-term investments or marketable securities and current accounts receivable.

Formula

Quick ratio = Cash + Cash equivalent + short-term investment + current receivables / current liabilities

Calculations (for 2013-2014)

Quick ratio = 129/408 = 0.316

For 2012-2-13

Quick ratio = 681 / 1983 = 0.343

For 2011-2012

Quick ratio = 3764/1549 = 2.42

The above ratios indicate that the company has been steadily losing its liquidity in the last three years primarily the present condition of the global oil and gas market and considering this factor it can be said that the company had enough cash reserves in the fiscal 2011-2012 with a more than 2 quick ratio. But it drastically fell to 0.3 in the next two years indicating depletion of cash and cash equivalents primarily possibly due to loss in revenues.

Net Income Trend (2010-2012)

Year-to-year change % = 4704-4550/4550*100 = 3.384%

The trend analysis shows progressive negative percentages for the successive years which means that the company has been incurring losses over the years in the business and the growing trend is to incur a loss of around 90% every year in comparison to the previous year.

The trend for fiscal 2013-2014 was not calculated as there was a loss in the previous two fiscals and a huge net income in the last fiscal which is evidence of the turnaround of the company in the last fiscal.

Quick ratio

This ratio is used to measure the ability of a company to pay its current liabilities when they come due with only quick assets. The current assets that have the ability to be converted into cash within 90 days or in the short-term are termed as quick assets. Cash, cash equivalents, short-term investments or marketable securities and current accounts receivable are te elements that would be considered for this calculation.

Unlock this full paper and 135,000+ more

View Full Document

Formula

Quick ratio = Cash + Cash equivalent + short-term investment + current receivables / current liabilities

Calculations (for 2013-2014)

Quick ratio = 1480/5935= 0.249

For 2012-2-13

Quick ratio = 6066 / 6655= 0.911

For 2011-2012

Quick ratio = 4637/6003= 0.772

The above ratios indicate that the company has been steady in maintaining its liquidity in the last three years primarily despite the loss in the last fiscal. It can be concluded that the company has almost enough cash reserves in the fiscals 2011-2012 and 2012-2013 while the losses that it made in the last fiscal has reduced the quick liquidity of the company to an extent.

The higher the quick ratio the better it is for a company and the industry benchmark in the oil and gas sector is 0.27. In this respect it can be said that despite the losses to the company in the last fiscal, the company has been doing exceptionally well in terms of its liquidity over the years. However it is far from satisfactory as the company does not have enough cash reserves or assets that can be changed in to cash to pay off current liabilities.

Current Ratio

The current ratio of the company helps to understand the ability of the company to pay off its short-term liabilities with its current assets. Short-term liabilities are due within the next year and hence the current ratio is an important measure of liquidity.

Formula: Current Ratio = Current Assets/Current Liabilities

For 2011-2012

Current ratio = 8971/6003 = 1.49

For 2012-2013

Current ratio = 8005/6655 = 1.20

For 2013-2014

Current ratio = 6489/5935 = 1.09

The ratios indicate that the company has been very strong in terms of its position to make current debt payments over the last three years. It also shows that the current liabilities have been in control while the company has also been able to steadily maintain its current assets. Interestingly in the last fiscal when the company incurred losses, it has more than enough current assets to pay off debts in the near-term despite there being a rise in the current liabilities. This is also equivalent of the working capital ratio of the company. These ratios indicate that the management has been doing well with the company operations.

The above ratios clearly indicate that the company has been progressively better utilizing its assets over the last three years. Since higher ratio is always more favorable as this ratio measures how efficiently a firm uses its assets to generate sales, the figures above indicate that the management of the company has been doing well to use the assets to generate revenue from sale of the products.

Debt to Equity Ratio

Debt to Equity ratio = Total Liabilities (Current liabilities+ Long-term debt +Asset retirement obligations + Other long-term liabilities+ Deferred income taxes) / Total Equity (total of shareholder's equity)

For 2011-2012

Debt to Equity ratio = 22048/21278 = 1.036

For 2012-2013

Debt to Equity ratio = 22378/20499 = 1.091

For 2013-2014

Debt to Equity ratio = 24296/26341 = 0.922

The above ratios indicate that the company has managed to reduce the debt on itself in the last fiscal by increasing the equity in the company while keepi9ng the debt nearly the same as the previous years. In the first two fiscals, the company had a greater debt tan equity although by not very much. This indicates that he financial health and the control of the company is in the right hands and that the company does not need to borrow much money in order to finance its operations and business processes. The above ratios also indicate that the management of the company is competent enough to run the company well. When compared with the industry average for the ratio in the third quarter of 2015 at 0.34, the ratios auger very well for the company and would serve as strong points for the investors to invest in the company.

Comments on the Major Findings of Williams Company

The increasing net income of the company over the three fiscal years in question shows that the company has been managing itself in the wake of the gloom in the oil and gas sector globally the company has managed to garner profits for the shareholders. The year-to-year net income trend has taken off in the last fiscal wit 250% jump compared to the year before. This is a positive trend of the company and is bound to influence the creditors and investors. This trend analysis also shows that the management of the company is in good and safe hands and the strategy and the direction that the company is following at the present moment is apt for the global economic conditions, demand and supply of oil and gas.

Many large companies like Williams are often faced with liquidity crisis especially in the short-term and in the short-term repayments of debts. The quick ratio analysis, using elements like cash, cash equivalents, short-term investments or marketable securities and current accounts receivable, shows that the company has been steadily losing its liquidity over the last three years.

It has subsequently lost heavily on this ratio. It is now well below 1 which indicates a liquidity crunch in the company. The company is not in a position to pay off its current liabilities that are payable by next year. This is a cause of worry for the investors. However some investors can argue that the quick ratio of the company is well above the industry average of 0.27. However, it is a set norm in business that the higher the quick ratio, the better it is for a company in terms of liquidity and its ability to serve debts in the short-term. Therefore in that's respect the ratio is far from satisfactory as the company does not have enough cash reserves or assets that can be changed in to cash to pay off current liabilities.

The current ratio of the company is far from satisfactory. The ratios found out in the earlier chapter clearly indicate that the company is in a sort of liquidity crunch and has not been in a position to make current debt payments over the last three years. It also shows that the current liabilities have increased progressively and highest in the last fiscal which has resulted in a reduced current ratio. This is also considered to be the working capital ratio and the figures calculated indicate that the company has not been able to finance the daily operations and business process from the cash reserves and the current assets. This also forces one to assume that the company has to borrow money from the market in order to finance its affairs. The benchmark for this ratio in the industry in the third quarter of 2015 is 1.13 which shows that the company lags far behind meeting the industry bench mark on this ratio.

Despite the liquidity crunch in the company it has been able to do well in making profits. The Profit Margin Ratio indicates that the company has made a profit of more than 30 cents per dollar of revenue earned from sales in the last fiscal where as in the previous two fiscals the company had made profits but to a lesser degree when compared to the sale revenue generated it was less than the last fiscal. The highest profits were generated in the last fiscal due ot increased revenue from sales. This along with a good net income trend shows that the management of the company is doing well in providing the right direction to the company.

Investors and creditors are also very interested in the Return on Equity Ratio as this determines the ability of a firm to generate profits from its shareholders investments in the company. The study indicates that Williams has been more or less steady in offering some returns to the equity holders in all the three fiscals under consideration. With the best figures being showcased in the last fiscal and despite nearly doubling the equity value in the company is indicative of the future better performance of the company. It is also note worthy that in the last fiscal under consideration, the company has managed to generate the highest net income of all the three fiscals.

One reason or concern is the steadily dwindling asset turnover ratio of the company. Form the study it has been seen that the company has not been able to utilize the assets in the manner it should have. As this ratio measures how efficiently a firm uses its assets to generate sales, a higher ratio is always more favorable. This is indicative of some form of management or production problems in the company in some segments or divisions. However it should also be remembered that the company has maintained the net income and hence this ratio should not be too big an issue for concern.

The company has been doing dismally over the last three years in terms of the debt to equity balance. The ratios indicate this and when compared to the industry average for the ratio in the third quarter of 2015 at 0.34 with the 1.162 for the company in 2013-2014. This also is primarily due to the liquidity crunch in the company where the company has had to rely more on borrowings to fund its operations and other financial obligations. This is evident from the figures of the last fiscal year where the company had more than doubled the equity and yet the ratio declined compared to the previous years.

Accounting Treatments of the Companies

In general there are two approaches of accounting that the companies engaged in exploration and development of crude oil and natural gas has options to adopt and use. These are - the "successful efforts" (SE) method and the "full cost" (FC) method. The difference of these approaches is that they differ in the treatment of the expenses that are incurred in the exploration for new oil and natural gas reserves.

The reporting of the net income and cash flow numbers is decided by the accounting method that a company chooses. Hence it is important to consider the accounting method that companies involved in the exploration and development of oil and natural gas uses and adopts.

As the name suggests, the successful efforts (SE) method costs that are associated with successful attempts for location of new oil and natural gas reserves are capitalized. The expenses that are associated with unsuccessful attempts are immediately put against revenues for that period.

The full cost approach entails the capitalization of the all the operating expenses relating to locating new oil and gas reserves without considering whether the attempts were successful or not.

On the balance sheet, the exploration costs are capitalized under both method as part of long-term assets. This is so because these assets are considered to be revenue generating assets from where the company can generate revenues. The costs that are incurred to acquire those assets are put in the revenues section as assets are used according to the requirements of Generally Accepted Accounting Principles (GAAP).

Two alternative methods for recording oil and gas exploration and development expenses is the result of two alternative views of the realities of exploring and developing oil and gas reserves. Each view insists that the associated accounting method best achieves transparency relative to an oil and gas company's accounting of its earnings and cash flows.

Since the ultimate aim of an oil and gas company is to produce the oil or natural gas from the reserves it locates and develops, therefore according to the view behind the SE method, it is essential to capitalize only those costs that are made relating to successful efforts. Conversely, since unsuccessful attempts do not result in any change in productive assets, hence the costs that are associated with unsuccessful attempts need to be considered as expenses.

On the other hand, the alternative accounting method assumes that exploration and development of oil and gas reserves is the dominant activity of an oil and gas company. In this FC method therefore over the course of a complete operating cycle, all the costs that are incurred in association to that activity should first be capitalized and then written off.

The oil and gas companies have a choice of adopting a particular accounting approach as there is still no consensus between the Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission (SEC) about which accounting approach is best suited for the companies.

In the two companies in question we will now try and ascertain the accounting method that is followed by each of them based on the management analysis of in the annual report and the notes.

Revenue expenses

For the revenue expenses, both the companies make use of the accrual system of accounting.

The accrual accounting method allows readers of a balance sheet to understand where and when expenses took place since the approach records the expenses and measures the performance and position of a company at the time of occurrence. This is regardless of the actual cash transactions and records the events when they occur.

The basic principle that is followed by the two companies is the matching revenues to expenses principle where the economic events are recognized at the time in which the transaction occurs instead of when the actual payment is made or received. Current cash inflows/outflows can be combined with future expected cash inflows/outflows in this method which allows provision of more objective and accurate picture of a company's current financial health.

Regardless of whether or not cash has actually changed hands the accrual method records income and expenses when they occur. For example the sale on credit is recorded as a sale when the event occurs rather than when the actual credit is realized. In a similar manner both the companies record expenses when, for example they order a machine, and not when they actually make the payment.

The above mentioned accounting principle can be witnessed in a number of places in the annual report and balance sheet of Devon Energy.

Devon Energy balance sheet clearly mentions the manner in which it recognizes a transaction and records a transaction in the accounts book. The company states that "cash received relating to future production is deferred and recognized when all revenue recognition criteria are met." This means that once the criteria for revenue recognition are made the transaction is recorded in the books regardless of when the actual cash is received by the company. Taxes from such revenues are also accounted for in the accompanying consolidated comprehensive statements of earnings.

The company note states: "Marketing and midstream revenues are recorded at the time products are sold or services are provided to third parties at a fixed or determinable price, delivery or performance has occurred, title has transferred and collectability of the revenue is probable." This is another evidence of the accrual method of accounting that the company follows.

The company follows the successful effort or the SE method of accounting for exploration and production activities as is evident form a note where the company says that they do not capitalize a deal from a well where Devon has taken less than its share of production unless all revenue recognition criteria are met.

The Williams Company also follows the accrual method of accounting. The company records cash and cash equivalents in the Consolidated Balance Sheet that comprise of the amounts that are primarily invested in funds with high-quality, short-term securities and instruments that are issued or guaranteed by the U.S. government.

The company also notes that the existing economic conditions, the financial condition of the customers and the amount and age of past due accounts are considered when estimates are made for allowance for doubtful accounts. Indications of the method as stated above further comes in the note where the company says that the receivables are considered to be past due if there is no full payment within the due date.

In terms of fixed assets, the Williams Company Inc. follows the conservatism approach to accountancy as is evident in the way the company evaluates its inventory. The company notes that all the inventories are stated at the lower of cost or market in the balance sheet of the company where the average-cost method is used to determine the cost of inventories. The company also records its property, plant and equipment at cost based on estimates, assumptions and judgments relative to capitalized costs, useful lives and salvage values.

Valuation of Intangible Assets

The excess of the consideration plus the fair value of any noncontrolling interest or any previously held equity interest is represented as goodwill in the balance sheet of booth the companies. This is added to the fair value of the net assets acquired.

When there are impairment indicators to goodwill then it is evaluated more than once in a year or else yearly on October 1. This is followed by the Williams Company where the company where it utilizes the market approach to evaluation of intangible assets. This is evident from the note of the company where it says that comparison of estimates of the fair value of the asset with its carrying value or market value. A comparison of the implied fair value of the goodwill is done with its related carrying value in case the market or carrying value of the reporting unit exceeds its fair value. The intangible assets of the company include gas gathering, processing, and fractionation contractual customer relationships which are amortized on a straight-line basis over the period the assets help in generating revenues.

Devon Energy also evaluates goodwill in the market evaluation method and considers it in the excess of the purchase price of business combinations against a fair value of the net assets. This is evaluated against the annual impairment or more frequently if there are more impairment factors. An assessment of qualitative and quantitative factors is considered for such impairment tests. The net book value of the reporting unit, to which the goodwill is allocated along with other assets and liabilities, forms the base for estimation and comparison.

The goodwill is recorded to the implied fair value of the goodwill through a charge to expense in case the estimated market value of the goodwill of the reporting unit is less than the net book value.

Comparable companies, comparable transactions and premiums paid forms the basis of the estimation of the fair values of the reporting units as there is absence of quoted market prices, notes the balance sheet of Devon Energy.

Other intangible assets such as EnLink customer relationships of the company are recorded on the long-term asset column of the company as unamortized capitalized intangible assets. With a range of 10-20 years, the intangible assets are then amortized on a straight-line basis.

These notes clearly show that the two companies follow the market-based valuation method for good will and other intangible assets of the company.

Year-to-year change % = 1447-68/68 * 100 = 2027.94%

This shows that there has been a tremendous turnaround in the company affairs in 2014 after a very minimal profit or net income in 2013. A year earlier in 2012, the company had also made profits though small in comparison to what it managed to achieve in 2014. The net profit % of the company in the last fiscal year was stupendous -- 2027.94%.

In comparison to 2012 this is a 300% hike in net income. Therefore in terms of profitability and net income after paying of taxes, Williams Company has done significantly well in two of the three years under consideration despite the general gloom in the oil market with falling prices and reduced demand over the last few years.

Quick ratio

For 2012

Quick ratio =839/1584= 0.52

For 2013

Quick ratio = 681/1983 = 0.34

For 2014

The debt to equity ratio of the company is dismal. While the desired ratio is 1, the company has steadily had a very high ratio. This means that the company relies more on debt to finance its business operations and processes than on equity. Even though the company has nearly doubled its equity value in the last year, it has not affected the debt to equity ratio and it has more or less remained the same over the period of three years. As investors it is always more desirable that companies have a larger equity than debt.

Reconsideration of the decision to invest in Williams Company Inc. needs to be done in light of the new figures derived from the pro-forma balance sheet and income statement. While the new figures show that the revenues have increased significantly for the company in the last fiscal compared to the first two years under consideration, the amount of net income or profit after tax is reduced even though the net income trend has been the same. Moreover the aspect of a turnaround of the company is also observed in the last year.

But the decision to invest in the company has been impacted by the very high debt to equity ratio in the company according to the pro-forma financial statements. The debt is more than two and half times more than equity in the company indicating that the company has been relying primarily on borrowings to finance itself. Moreover, the value of current and quick ratios is also significantly negatively different from the earlier ones calculated from the extensive balance sheet and income statements. These show that the ability of the company to repay current debts with the current assets is much more reduced and this is the reason that the company has had to borrow more. This is a situation that could get the company in debt trap in the next few years making any investments risky.

Hence it can be concluded that these two factors would influence the decision to invest in Williams Company Inc. negatively.

1,284 Words Hidden

Selection of the Better Company to Invest1,284 words

From the discussions that have been made above it is imperative that Williams Company Inc. is a better company to invest as an investor. The…

View Full Document

Cite This Paper

PaperDue. (2015). Financial analysis of Williams Company and Devon Energy. PaperDue. https://www.paperdue.com/essay/analysis-of-financial-statements-2159189

Always verify citation format against your institution’s current style guide requirements.