CHAPTER NINE :
NATURE & USES OF ACCOUNTING RATIOS
Ratio analysis is a tool for interpreting and analyzing
financial statements. It helps management in providing an overall plan to
achieve profitability and maximization
of shareholder value. Ratio
can be classified into four main groups as shown below:
|
Type
|
Goal
|
Examples
|
|
Profitability Ratios
|
Measure performance of the
company and its managers
|
1. Return on Capital
Employed (ROCE)
2. Gross Profit as % of
sales
3. Net Profit as % of
sales
4. Return on Assets (ROA)
|
|
Management
Efficiency Ratios
|
Measure the efficiency of assets usage of
the company
|
1.Stock (Inventory)
Turnover
2. Debtors (Accounts
Receivable) Collection Period
3. Creditors (Accounts
Payable) Payment Period
|
|
Financial Ratios
|
Measure the financial structure and
stability of the company
|
1. Equity to assets ratio
2. Current Ratio
3. Liquid Ratio
|
|
Investment Ratios
|
Measure the extend of the
relationship of the number of ordinary shares and their price to the profit,
dividends and assets of the company
|
1. Earning per share (EPS)
2. Price / Earning Ratio
3. Dividend Cover
4. Dividend Yield
5. Earning Yield
6. Debt Ratio
7. Times-Interest – Earned
Ratio
8. Gearing
9. Equity Gearing
|
Profitability Ratios
These measure the
performance of a company and its managers. They indicate how efficiently the
organization has used its available resources. The profitability ratios are
normally presented as percentages and, in generally, the higher the profitability percentage, the better is the aspect of
the organization’s performance to which the ratio relates.
Return on Capital Employed (ROCE)
: This measures the size of the profit figure relevant to the size of the
business, size being express in terms of the quantity of capital employed by
the business. It reflects the earning power of the business operations. This is
also known as the primary ratio because it is often the most important measure
of profitability. It is measure in several ways.
1. ROCE based on total
capital employed in the business is calculated as follows:
|
ROCE = ( PBIT / Capital Employed ) x 100
|
2. ROCE based on equity
shareholder’s capital employed is calculated as follows:
|
ROCE = ( Profit after tax & preference dividend / Ordinary Share
Capital + Reserves ) x 100
|
Gross Profit-Sales % = (Gross Profit / Sales) x 100
Net Profit as % of Sales = Net Profit / Sales x 100
Return on Assets (ROA) : This measures the success a company has in
using its assets to earn a profit. It is calculated as follows:
|
ROA = (Net Profit + Interest Expense) / Total (Average) Assets ) /
100
|
Management Efficiency
This measures the efficiency
of asset usage. It includes the following ratio types:
Stock Turnover (Period):
This ratio measures the average length of time during which a firm holds the
stock. A long holding period, implying high stock level relative to the amount
of goods sold, has some advantages, for example – it reduces the risk of stock-
out and the resultant inability to satisfy demand, and it provides more scope
for bulk buying which may produce quantity discount and other economics of
scale. Alternatively it might indicate the existence of slow-moving or obsolete
stock. It is calculated as follows:
|
Stock Turnover (Period) = (Average Stock / Cost of goods sold) x 365
days
|
The stock turnover can also
be expressed in times as follows:
This measures the number of
times a company sells its average level of stock during a year. A high rate of
turnover indicates relative ease in selling stock, whereas a low times turnover
indicates difficulty in selling. However, a higher value can mean that the
business is not keeping
enough stock on hand, and inadequate stock can result in lost sales if the
company cannot fill a customer’s order. Therefore, a business strives for the
most profitable rate of stock turnover, not necessarily the highest. The stock
turnover (times) is calculated as follows:
|
Stock Turnover (Times) = Cost of goods sold / Average Stock = X times
|
Debtor Collection Period : This measures the average length of time
taken by debtors to pay amount due to the business. It is an important aspect
of the assessment of management’s ability to control working capital. A long
debtor collection period have disadvantages. For instance, the business may
incur high interest cost on the working capital to finance debtors, and so run
the risk of incurring bad debts. It is expressed in days and is calculated as
follows:
|
Debtors’ Collection Period = (Average Trade Debtors / Credit Sales) x
365 days
|
The debtor collection period
can also be expressed in times :
|
Debtors’ Collection (Times) = Credit Sales / Average Trade Debtors =
X times
|
Creditor Turnover : Measures the company’s ability to pay cash to
its suppliers. A long creditor payment period has an advantage to the company.
This is because it serves as a source of financing to the company. The
creditors’ payment period is computed as follows:
|
Creditors’ Payment Period = (Trade Creditors / Cost of Sales) x 365
days
|
It can also be expressed in
times as follows:
|
Creditors Turnover (Times) = Cost of Sales / Average Trade Creditors
= X times
|
NB : If the cost of sales figure is not given then use the purchase
figure as a proxy.
The Length of Working Capital Cycles (days) = Debtors Collection Period + Stock
Turnover Period – Creditors
Payment Period
Financial Ratio
These ratios measure the
financial structure of the company. These ratios include:
Current Ratio : Indicates the business’s ability to meet its short
term cash obligations (current liabilities) out of its current assets without
having to raise finance by borrowing, using more shares, or selling fixed
assets. It is calculated as follows:
|
Current Ratio = Current Asset / Current Liabilities = A : 1
|
Liquid Ratio : This is also known as Acid Test / Quick Ratio. It
tells us whether the firm business could pay all its current liabilities if
they come due immediately. It is a more stringent test of a firm’s ability to
pay its debt as they fall due. This is computed as follows:
|
Liquid/Acid Test/Quick Ratio = (Current Asset–Stock)/Current
Liabilities = A : 1
|
Investment Ratio
These ratios measure the
relationship of the number of ordinary shares and their price to the profit,
dividend and assets of the company.
Earning Per Share (EPS)
: This is the most widely quoted of all financial statistics. The EPS is the only ratio that must appear
on the face of the profit and loss account. It is the amount of net profit
per share of the company’s issued ordinary share. Preference dividends are
subtracted from net profit because the preference shareholders have prior claim
to their dividends. It is calculated as follows:
|
EPS = (Net Profit – Preference Dividends) / No. of Ordinary Shares
Issued = ₤X
|
Price / Earning (P/E) Ratio: This is the market price of an
ordinary share of the company’s earning per share. It shows how long it would
take for the investors to recover his outlay at a particular EPS. It is measure
as follows:
|
Price / Earning Ratio = Market Price / Earning Per Share
|
Dividend Yield : Measures the ratio of dividends per share to the
share’s market price per share. This ratio gives the percentage of a share’s
market value that is returned annually as dividends, an important concern of
shareholders. It is computed as follows:
|
Dividend Yield = Dividend Per Share / Market Price Per Share
|
Dividend Cover : Shows by how much earnings should fall for
dividend not to be paid. It is calculated as follows:
|
Dividend Cover = Total Earnings/ Total Dividend OR EPS / Dividend per share
|
Earning Yield : This expresses the earning per share as percentage
of the current share price. It is computed as follows:
|
Earning Yield = EPS/ Current Share Price x 100
OR
1 / PE Ratio (This would implies the earning yield is merely the
reciprocal of the PE ratio
|
Long-Term Solvency : This is concern with the ability of a company
to survive over many years. Survival of a company may be affected by the
long-term financial commitments. These commitments are often related to the
manner in which the company finances its operations.
Debt Ratio : This tells us about the proportion of the company’s
assets that it has financed with debt. If the debt ratio is 1, then debt has
been used to finance all the assets. Similarly a debt ratio of 0.5 means that
the company has used debt to finance half of its assets and that the owners of
the business have financed the other half. The higher the debt ratio, the
higher the strain on the firm, to pay interest each year and the principal
amount at maturity. It is calculated as follows:
|
Debt Ratio = Total Liabilities/ Total Assets
|
Times – Interest –Earned Ratio : This relates net profit to
interest expense. It indicates the ability of the company to pay interest
expense. This ratio also measures the number of times that the net profit can
cover interest expense. It is computed as follows:
|
Times-Interest –Earned Ratio = Net Profit Before Interest / Interest
Expense
|
|
Gearing = Debt / Capital Employed
|
|
Equity Gearing = (Preference Share Capital + Loans) / Ordinary Share
Capital + Reserves
|
Limitations of Ratio Analysis
In interpreting the
financial statements of companies we should always bear in mind that the
analysis are based on profit and loss accounts and balance sheets which are
subject to
all the limitations of
historical cost accounting. Inflation, specific price changes and differing
bases of valuation are likely to distort comparisons, whether cross sectional
or time series.
Report / Memo Writing
Exam questions sometimes
require us to write either a report or a memo for superior. Thus before
concluding our discussion on ratio analysis it would be useful for us to know
the required Report / Memo format. The format is as outlined below:
REPORT / MEMO
To: Chief Accountant, TALL Plc
From : Accountant, TALL Plc
Date : 01st January 2007
Subject : Trend Analysis
Introduction : We will be required to state the requirement in the
question in this introduction and also make mention of any assumption(s) that
we may make in our discussion and / calculation.
Body : We commend on our results obtained in our calculation(s).
The results obtained are used to answer
the requirement(s) in the question. If we are given the financial statement(s)
of a company for two period then we should make comparison of the similar ratio
results. We may show our workings in the body or just use an appendix. The appendix will serve as our work sheet
and reference should be made to it in our discussion. If we choose to use
appendix then it should be shown at the end of our report (meaning that the appendix would not be part of our report).However,
due to exam pressure it is sometimes recommended to show all workings in the
body of our report. This helps to save time in the exam hall.
Conclusion : This ends the report and we will be required to make
our final comment as per our discussion in the body above. In short we give
answer to the requirement stated in the question in our conclusion.
RATIO FORMULA LIST
|
RATIO
|
FORMULA
|
HOW IS IT PRESENTED?
|
|
Profitability
Ratios
|
|
|
|
1. Gross Profit as % of Sales (Gross Profit Margin)
|
(Gross Profit ÷Sales) x 100
|
The answer is
always expressed in % terms
|
|
2. Net Profit as % of Sales (Net Profit Margin)
|
(Net Profit ÷Sales) x 100
|
The answer is
always expressed in % terms
|
|
3. Return On Assets (ROA)
|
((Net Profit + Interest Expense) ÷ Total Assets ) x 100
|
It is also expressed in %. And it measures the success a
company has in using its assets to earn a profit.
|
|
4. ROCE
|
(PBIT ÷ Capital Employed) x 100. where capital employed is just the business Net Assets.
|
It measures the size of the profit figure relevant to the
size of the business, size being express in terms of the quantity of capital
employed by the business. It reflects the earning power of the business
operations. It is also expressed in %.
|
|
|
|
|
|
Financial Ratios
|
|
|
|
1. Current Ratio
|
Current Assets ÷ Current Liabilities
|
The answer is expressed in the form A : 1, where A is just the
result of CA ÷ CL. Indicates the business’s ability to meet its short term
cash obligations (current liabilities) out of its current assets without
having to raise finance by borrowing, using more shares, or selling fixed
assets.
|
|
2. Liquid / Acid Test / Quick Ratio
|
(Current Assets – Stock) ÷ Current Liabilities
|
This is also expressed in the form A : 1, where A is just the
result of CA ÷ CL. It tells us whether the firm business could pay all its
current liabilities if they come due immediately.
|
|
|
|
|
|
Management
Efficiency Ratios
|
|
|
|
1. (a) Stock
Turnover (Period)
|
(Average Stock ÷ Cost of goods sold) x 365 days
|
This ratio measures the average length of time during
which a firm holds the stock. A long holding period, implying high stock
level relative to the amount of goods sold. It is expressed in days.
|
|
(b) Stock Turnover
(Times)
|
Cost of goods sold ÷ Average Stock
|
This measures the number of times a company sells its average
level of stock during a year. A high rate of turnover indicates relative ease
in selling stock, whereas a low times turnover indicates difficulty in
selling. It is expressed in times , i.e. K times, where is just the result of
the division.
|
|
2. (a) Debtors Collection (Period)
|
(Average Trade Debtors ÷ Credit Sales) x 365 days
|
This measures the average length of time taken by debtors
to pay amount due to the business. It is expressed in days.
|
|
(b) Debtors Collection (Times)
|
Credit Sales ÷ Average Trade Debtors
|
K times
|
|
3. (a) Creditors Payment (Period)
|
(Trade Creditors ÷ Cost of Sales) x 365 days
If the cost of sales figure is not given then use the purchase figure
as a proxy.
|
Measures the company’s ability to pay cash to its
suppliers. A long creditor payment period has an advantage to the company. It
is expressed in days.
|
|
(b) Creditors
Payment (Times)
|
Cost of Sales ÷ Average Trade Creditors
|
K times
|
|
|
|
|
|
Length of Working
Capital Cycles (days)
|
Debtors Collection Period + Stock
Turnover Period – Creditors Payment Period
|
|
|
|
|
|
|
Investment Ratios
|
|
|
|
1. Earnings per Shares (EPS)
|
(Net Profit – Preference Dividends) ÷ No. of Ordinary
Shares Issued
|
It is in this form ₤X.
This is the most widely quoted of all financial statistics. The EPS is the only ratio that must
appear on the face of the profit and loss account. It is the amount of
net profit per share of the company’s issued ordinary share. Preference
dividends are subtracted from net profit because the preference shareholders
have prior claim to their dividends.
|
|
2. Price / Earning (P/E) Ratio
|
Market Price ÷ Earning Per Share
|
This is the market price of an ordinary share of the
company’s earning per share. It shows how long it would take for the
investors to recover his outlay at a particular EPS.
|
|
3. Dividend Yield
|
(Dividend Per Share ÷ Market Price Per Share) x 100
|
Measures the ratio of dividends per share to the share’s
market price per share. This ratio gives the percentage of a share’s market
value that is returned annually as dividends, an important concern of
shareholders.
|
|
4. Dividend Cover
|
(Total Earnings ÷ Total Dividend) x 100 OR (EPS
÷ Dividend per share) x 100
|
Shows by how much earnings should fall for dividend not to
be paid.
|
|
5. Earning Yield
|
(EPS ÷ Current Share Price) x 100
OR
(1 ÷ PE Ratio) , This
would implies the earning yield is merely the reciprocal of the PE ratio
|
This expresses the earning per share as percentage of the
current share price.
|
|
6. Debt Ratio
|
Total Liabilities ÷ Total Assets
|
This tells us about the proportion of the company’s assets
that it has financed with debt. If the debt ratio is 1, then debt has been
used to finance all the assets.
|
|
7. Gearing
|
(Debt ÷ Capital Employed) x 100
|
This is expressed in %.
|
|
|
|
|
|
|
|
|
|
Limitations of
Ratios
|
In interpreting the financial statements of companies we should
always bear in mind that the analysis are based on profit and loss accounts
and balance sheets which are subject to all the limitations of historical
cost accounting. Inflation, specific price changes and differing bases of
valuation are likely to distort comparisons, whether cross sectional or time
series.
|
|
Worked Examples
1. Bond Ltd and Fraser Ltd
Bond Ltd and Fraser Ltd are
companies operating in a similar market. Your manager has asked you to help her
review the performance of both companies from their financial statements which
are summarized.
Profit and Loss accounts for the year ended
31 October 2008
|
|
GMD
|
GMD
|
|
Sales
|
23,800
|
24,000
|
|
Cost of sales
|
17,850
|
16,800
|
|
Gross Profit
|
5,950
|
7,200
|
|
Expenses
|
2,500
|
4,800
|
|
Profit before tax
|
3,450
|
2,400
|
|
Tax on profit
|
900
|
600
|
|
Profit after tax
|
2,550
|
1,800
|
|
|
1,000
|
900
|
|
Retained Profit
|
1,550
|
900
|
Balance Sheet as at 31 October 2008
|
Bond
Limited
|
Fraser Limited
|
|||
|
|
GMD’000
|
GMD’000
|
GMD’000
|
GMD’000
|
|
Fixed Assets
|
|
15,000
|
|
24,000
|
|
Current Assets
Stock
Debtors
Bank
|
500
2,000
100
|
|
1,200
600
-
|
|
|
|
2,600
|
|
1,800
|
|
|
Current Liabilities
Creditors
Overdraft
Tax
|
775
-
900
|
|
150
55
600
|
|
|
|
1,675
|
|
805
|
|
|
Net Current Assets
|
|
925
|
|
995
|
|
|
|
15,925
|
|
24,995
|
|
Debentures
|
|
300
|
|
1,000
|
|
Net Assets
|
|
15,625
|
|
23,995
|
|
Capital and reserves
|
|
|
|
|
|
GMD1 Ordinary shares
|
|
12,000
|
|
20,000
|
|
Reserves
|
|
3,625
|
|
3,995
|
|
|
|
15,625
|
|
23,995
|
Required :
(a) Calculate four
profitability ratios and two liquidity ratios for Bond Ltd and Fraser Ltd. Show
all workings. (12
marks)
(b) Comment briefly on the
performance of two companies as indicated by the ratios you have calculated in
Part (a). (8 marks)
(20 Marks)
Answer : Bond Ltd and Fraser Ltd
|
Ratio
|
Formulae
|
Bond Limited
|
Fraser Limited
|
|
Profitability Ratios
|
|
|
|
|
Gross profit %
|
(Gross profit ÷ Sales) x
100
|
(5,950 ÷ 23,800) x 100 =
25%
|
(7,200 ÷ 24,000) x 100 =
30%
|
|
Net Profit %
|
(Net profit ÷ Sales) x 100
|
(3,450 ÷ 23,800) x 100 =
14%
|
(2,400÷24,000) x 100 = 10%
|
|
Earning on capital
employed
|
(Net Profit after tax ÷
No. of Ordinary shares
|
2,500 ÷ 12,000 = 21p
|
1,800 ÷ 20,000 = 9p
|
|
Return on capital employed
|
(Net profit ÷ Capital
employed) x 100
|
(3,450 ÷ 15,625) x 100 =
22%
|
(2,400 ÷ 23,995) x 100 =
10%
|
|
Liquidity ratios
|
|
|
|
|
Current ratio
|
(Current Assets ÷ Current
Liabilities) : 1
|
(2,600 ÷ 1,675) :1 = 1.6 :
1
|
(1,800 ÷ 805) : 1 = 2.2 :
1
|
|
Acid test ratio
|
((Current Assets – Stock)
÷ Current Liabilities) : 1
|
(2,100 ÷ 1,675) :1 = 1.3 :
1
|
(600 ÷ 805) : 1 = 0.7 : 1
|
(b) Profitability ratio
Gross profit percentage : Fraser Ltd has a higher gross profit
percentage than Bond Ltd. The companies both operate in a similar market and
have similar turnovers, so it is unclear why there is a difference. Possibly
Fraser is better at keeping supplier costs.
Net profit percentage : Bond does better than Fraser on net profit
percentage, reversing the gross profit percentage finding. The company is
obviously better at controlling its expenses, which are around half those of
Fraser.
Earning per share : Bond Ltd’s EPS figure is twice that of Fraser
Ltd, suggesting on the face of it that it is a better investment. The
difference is mainly due to the number of shares by which the earnings figure
is being divided. However, Bond Ltd’s post tax profit is also higher than that
of Fraser Ltd. We do not know the market value of the shares, which would be an
important factor when deciding to invest.
Return on capital employed : Bond Ltd’s return on capital employed
is double that of Fraser Ltd. Fraser Ltd has more money invested, in both
shares and loans, but is not making an effective use of the capital employed.
Liquidity Ratios
Current ratio : Both companies have sufficient assets to cover
their liabilities. The current ratio of Bond Ltd is not as high as that of
Fraser Ltd. However, it is important to look at the individual companies of working
capital.
Both Ltd’s cash position (GMD100,000)
is more favourable than Fraser Ltd’s GMD55,000 overdraft).
Acid test ratio : Much of Fraser Ltd’s working capital is tied up
in stock. When this is taken out to give the acid test ratio, Bond Ltd’s is better.
Fraser Ltd may be storing up liquidity or cash flow problems.
Conclusion : Overall Bond Ltd looks to be the better performer,
both in term of liquidity and profitability. It would be helpful to have more
background information about the market in which the companies operate, for
example industry average ratios, and also to see the trend compared with
previous years.
2. Hester Ltd
A business as you to invest
in Hester Ltd. He has watched the company steadily grow over the last three
years and considers it a good investment. You have requested the following
financial information so that you can draw your own conclusions.
Hester Ltd
Balances as at end of ………
|
|
2006
|
2005
|
2008
|
|
|
GMD’000
|
GMD’000
|
GMD’000
|
|
Sales
|
1,000
|
1,250
|
1,500
|
|
Cost of sales
|
(700)
|
(850)
|
(975)
|
|
Gross profit
|
300
|
400
|
525
|
|
Distribution costs
|
(55)
|
(75)
|
(100)
|
|
Administration expenses
|
(100)
|
(200)
|
(300)
|
|
Profit on ordinary
activities before interest
|
145
|
125
|
125
|
|
Interest payable
|
(10)
|
(15)
|
(30)
|
|
Profit on ordinary
activities before taxation
|
135
|
110
|
95
|
|
Taxation on ordinary
activities
|
(30)
|
(25)
|
(25)
|
|
Profit on ordinary
activities after taxation
|
105
|
85
|
70
|
|
Less proposed dividends
|
(50)
|
(35)
|
(35)
|
|
Retained profit for the
year
|
55
|
50
|
35
|
|
Debentures
|
100
|
150
|
300
|
|
Share capital : 500,000
ordinary shares of GMD1 each
|
500
|
500
|
500
|
|
Share premium account
|
20
|
20
|
20
|
|
Profit and loss account
|
250
|
300
|
335
|
|
|
870
|
970
|
1,155
|
Financial Performance Ratios
|
Gross Profit Percentage
|
30.0%
|
32.0%
|
35.0%
|
|
Operating Profit
Percentage
|
14.5%
|
10.0%
|
8.3%
|
|
Return on Capital Employed
|
16.7%
|
12.9%
|
10.8%
|
Required
(a) Identify and comment on
the key financial trends as indicated by the above information. (7 marks)
(b) Calculate the following
ratios for Hester Ltd for 2008 only and explain the purpose of the ration.
(i) Return on shareholders’
capital
(ii) Capital gearing ratio
(iii) Earning per share
(iv) Dividend cover.
Answer : Hester Ltd
(a) Hester Ltd is clearly a
growth company with sales value increasing by 50% over the three years. Gross
profit has also increased over the period indicating either that a premium is
being added to the selling price or that cost of sales has increased perhaps
due to bulk purchase discounts.
The increase in activity of
the company has also brought about a disproportionate increase in expenses.
Distribution costs have almost cost doubled over the three years
whilst administrative costs
have tripled. These huge increases will need to be investigated and controlled
by management.
The increase expenses have
caused the fall in operating profit percentage from 14.5% (given) in 2006 to
only 8.3% (also given) in 2008. A similar decrease in return on capital
employed from 16.7% to 10.8% over the period would also indicate that despite
the issue of the debentures the funds are not being used as profitable as they
once were.
A further effect of the
decrease in profitability has been the reduction in proposed dividend from GMD50,000
in 2006 to GMD35,000 for the next two years. However even with the significant
decreased in dividend the proportion of retained earning for use within the
company has fallen dramatically.
(b) (i) Return on shareholders’ capital = (Profit on ordinary activities
before tax ÷ Share capital and reserves) x 100% = (95 ÷ (500+20+335)) x 100% =
11.1%
Purpose : The return on shareholders’ capital measures
profitability from the
Perspective of the
shareholders. It shows the return that the company is making on the investment
that is owned by the shareholders i.e. their share capital and retained profits
in the form of reserves.
(ii) Capital
gearing ratio = (Prior charge capital÷ Total capital) x 100% = (300÷1,155)
x 100% = 26% OR
= (Prior charge÷Share capital and
reserves) x 100%
= (300÷855) x 100% = 35%
Purpose: This ratio show the proportion of the financing of a
company that is made up of prior charge capital. Prior charge capital that
requires a fixed return to be paid and will normally consist of preference
shares and debentures. The higher a company’s capital gearing then the greater
will be the amount of fixed return that must be paid each year before there is
any profit for shareholders. A highly geared company is therefore more likely
to run the risk of earning insufficient profits to service all of its prior charge
capital.
(iii) Earnings per share = (Profit on ordinary activity after tax ÷Number
of ordinary shares in issue) = GMD70÷500 =14 pence
Purpose : This ratio shows how much profit there is available for
each ordinary share. This is an important financial indicator for comparison
year on year and between companies.
(iv) Dividend cover = Profit on ordinary activities after tax ÷ Dividend
for the year = 70÷35 = 2 times
Purpose: This ratio gives an
indication of how safe the ordinary shareholders’ dividend is. A low dividend
cover means that the dividend is high compared to the profit available and this
may indicate problems with paying the dividend in future.
PRACTICE QUESTIONS :
1. Paper Ltd
Paper Ltd trades in the distribution of paper products. You
have been given the following balance sheets as at 31 December and some
addition information.
|
|
2008
|
2009
|
|
|
GMD’000
|
GMD’000
|
|
Fixed assets at cost
|
850
|
1,272
|
|
Less depreciation
|
400
|
550
|
|
|
450
|
722
|
|
Stock
|
75
|
130
|
|
Debtors
|
98
|
150
|
|
Bank
|
75
|
0
|
|
|
698
|
1,002
|
|
Trade creditors
|
(80)
|
(130)
|
|
Taxation
|
(30)
|
(55)
|
|
Dividend
|
(20)
|
(20)
|
|
Overdraft
|
0
|
(50)
|
|
|
568
|
747
|
|
Debentures
|
(70)
|
(190)
|
|
|
498
|
557
|
|
Issued share capital (5p shares)
|
200
|
200
|
|
Profit and loss account
|
298
|
357
|
|
|
498
|
557
|
Extracts from the
profit and loss accounts for the year ended
|
|
1998
|
1999
|
|
|
GMD’000
|
GMD’000
|
|
Sales (all on credit)
|
880
|
1200
|
|
Gross profit
|
380
|
532
|
|
Overheads
|
300
|
370
|
|
Net Profit
|
80
|
162
|
|
Interest
|
10
|
38
|
|
Profit before tax
|
70
|
124
|
|
Tax
|
30
|
45
|
|
|
40
|
79
|
|
Dividend
|
20
|
20
|
|
|
20
|
59
|
Required:
(a) Your manager has asked you to calculate and commend on
the following ratios, for 2008 and 2009 years, for Paper Ltd:
(a) Gearing
ration;
(ii) Interest cover;
(iii) Stock turnover;
(iv) return on capital employed;
(v) Debtors payment period;
(vi) Quick / Acid test ratio.
Give your workings and clearly
state the definitions used for each ratio.
(9 Marks)
(b) Prepare your manager a memorandum that explains the
limitation of ratio analysis. (6 Marks)
2. Moran
Your manager has asked you to analyse the financial
performance of Moran Ltd. You have been given the following summarized
financial information.
MORAN Ltd
Financial Year Ended
30 April
|
|
2000
|
2001
|
2002
|
|
|
GMD’000
|
GMD’000
|
GMD’000
|
|
Sales
|
75
|
120
|
200
|
|
Cost of sales
|
40
|
70
|
130
|
|
Gross profit
|
35
|
50
|
70
|
|
Distribution & administration expenses
|
6
|
20
|
38
|
|
Profit before tax
|
29
|
30
|
32
|
|
Tax
|
5
|
6
|
7
|
|
Profit after tax
|
24
|
24
|
25
|
|
Dividends
|
4
|
4
|
5
|
|
Retained Profit
|
20
|
20
|
20
|
|
|
|
|
|
|
Fixed assets
|
30
|
60
|
100
|
|
Current assets:
|
|
|
|
|
Stock
|
15
|
20
|
50
|
|
Debtors
|
10
|
40
|
45
|
|
Cash and bank
|
70
|
30
|
5
|
|
|
95
|
90
|
100
|
|
Current liabilities:
|
|
|
|
|
Creditors
|
(5)
|
(10)
|
(40)
|
|
Net current assets
|
90
|
80
|
60
|
|
Net Assets
|
120
|
140
|
160
|
|
|
|
|
|
|
Capital and
Reserves
|
|
|
|
|
GMD1 Ordinary shares
|
100
|
100
|
100
|
|
Reserves
|
20
|
40
|
60
|
|
|
120
|
140
|
160
|
Required
(a) Identify and comment on the main trends as shown by the
above financial information. (5
Marks)
( Use the figures provided above – do not calculate ratios
to answer this part of the question.)
(b) State the further information that would be useful to
help interpret Moran Ltd’s financial position. (3 Marks)
( c) Calculate the following ratios for Moran Ltd for the
year ended 30 April 2002 only. Clearly state the definitions used for each
ratio.
(i) Return on capital
employed
(ii) Quick / acid test ratio
(iii) Stock turnover (days)
(iv) Debtors collection period
(v) Earnings per share (7 Marks)
3. Lewis and Gordon
You have been provided with the following information for
Lewis Ltd and Gordon Ltd which are retail companies selling similar products in
a similar market.
|
Ratio
|
Lewis Ltd
|
Gordon Ltd
|
|
Gross profit percentage
|
18%
|
30%
|
|
Net profit percentage
|
10%
|
10%
|
|
Return on capital employed (ROCE)
|
16%
|
19%
|
|
Stock turnover
|
21 days
|
40 days
|
|
Average settlement period for debtors
|
23 days
|
67 days
|
|
Average settlement period for creditors
|
39 days
|
44 days
|
Required
(a) State how each ratio is calculated. (3 Marks)
(b) Comment on the performance of the two companies as
indicated by the ratios.
(8 Marks)
( c) Briefly explain what further information about the
companies would be helpful in assessing their performance. (4 Marks)
(15 Marks)
4. Gilson and Warner
You have been asked to analyse the performance of two sole
traders who run similar businesses. Their financial statements for the year
ending 31 October 2009 are given below.
|
John Gilson
|
David Wardner
|
||||
|
|
GMD’000
|
GMD’000
|
GMD’000
|
GMD’000
|
|
|
TRADING &
PROFIT AND LOSS
|
|
|
|
|
|
|
Sakes
|
|
140
|
|
200
|
|
|
Less cost of goods
sold :
|
|
|
|
|
|
|
Opening stock
|
36
|
|
40
|
|
|
|
Purchases
|
85
|
|
137
|
|
|
|
|
121
|
|
177
|
|
|
|
Less Closing stock
|
18
|
|
45
|
|
|
|
|
|
103
|
|
132
|
|
|
Gross profit
|
|
37
|
|
68
|
|
|
Less depreciation
|
3
|
|
5
|
|
|
|
Other expenses
|
16
|
|
11
|
|
|
|
|
|
19
|
|
16
|
|
|
Net profit
|
|
18
|
|
52
|
|
BALANCE SHEET
|
John Gilson
|
David Wardner
|
||||
|
|
GMD’000
|
GMD’000
|
GMD’000
|
GMD’000
|
|
|
Fixed assets:
|
|
|
|
|
|
|
Fixture and
fittings
|
18
|
|
35
|
|
|
|
Less depreciation
|
14
|
|
11
|
|
|
|
|
|
4
|
|
24
|
|
|
Current assets:
|
|
|
|
|
|
|
Stock
|
18
|
|
45
|
|
|
|
Debtors
|
44
|
|
35
|
|
|
|
Bank
|
9
|
|
4
|
|
|
|
|
71
|
|
84
|
|
|
|
Current liabilities:
Creditors
|
19
|
|
50
|
|
|
|
Net current assets
|
|
52
|
|
34
|
|
|
Capital
|
|
|
|
|
|
|
Balance at start of
year
|
|
53
|
|
70
|
|
|
Add net profit
|
|
18
|
|
52
|
|
|
|
|
71
|
|
122
|
|
|
Less drawings
|
|
15
|
|
64
|
|
|
|
|
56
|
|
64
|
|
Required
Your manager has asked you to prepare two things.
(a) A table of accounting ratios (with supporting workings)
which compares the profitability, liquidity and efficiency of the two
business. (6 Marks)
(b) A brief report which comments on the accounting ratios
you have calculated. (9 Marks)
(15 Marks)
5. Holden Ltd
The directors of Holden Ltd wish to compare the company’s
most recent financial statements with those of the previous year. The company’s
financial statements are given below:
Holden Ltd
Income Statements
Year ended
|
31 March
2008
|
31 March
2007
|
||
|
|
GMD’000
|
GMD’000
|
|
|
Sakes
|
1,800
|
2,500
|
|
|
Cost of sales (see note below)
|
(1,200)
|
(1,800)
|
|
|
Gross Profit
|
600
|
700
|
|
|
Distribution costs
|
(160)
|
(250)
|
|
|
Administrative expenses
|
(200)
|
(200)
|
|
|
Profit from operations
|
240
|
250
|
|
|
Finance cost
|
(50)
|
(50)
|
|
|
Profit before tax
|
190
|
200
|
|
|
Income tax expense
|
(44)
|
(46)
|
|
|
Net Profit for the period
|
146
|
154
|
|
Note: Cost of
sales figure are made up of as follows:
|
31 March
2008
|
31 March
2007
|
||
|
|
GMD’000
|
GMD’000
|
|
|
Opening inventory
|
180
|
200
|
|
|
Purchases (all on credit)
|
1,220
|
1,960
|
|
|
|
1,400
|
2,160
|
|
|
Less Closing inventory
|
(200)
|
(360)
|
|
|
Cost of sales
|
1,200
|
1,800
|
|
|
31 March
2008
|
31 March
2007
|
||
|
|
GMD’000
|
GMD’000
|
|
|
Opening inventory
|
180
|
200
|
|
|
Purchases (all on credit)
|
1,220
|
1,960
|
|
|
|
1,400
|
2,160
|
|
|
Less Closing inventory
|
(200)
|
(360)
|
|
|
Cost of sales
|
1,200
|
1,800
|
|
BALANCE SHEET AS AT
|
31 March 2008
|
31 March 2007
|
||||
|
|
GMD’000
|
GMD’000
|
GMD’000
|
GMD’000
|
|
|
Non-current assets – cost
|
3,100
|
|
3,674
|
|
|
|
Less depreciation
|
1,214
|
|
1,422
|
|
|
|
|
|
1,886
|
|
2,252
|
|
|
Current assets:
|
|
|
|
|
|
|
Inventory
|
200
|
|
360
|
|
|
|
Trade receivables
|
400
|
|
750
|
|
|
|
Cash at bank
|
100
|
|
120
|
|
|
|
|
700
|
|
1,230
|
|
|
|
Current liabilities:
|
|
|
|
|
|
|
Trade payables
|
210
|
|
380
|
|
|
|
Sundry
|
260
|
|
430
|
|
|
|
Income tax
|
48
|
|
50
|
|
|
|
|
518
|
|
860
|
|
|
|
Net current assets
|
|
182
|
|
370
|
|
|
Non- current liabilities: 10% Loan notes
|
|
(500)
|
|
(500)
|
|
|
Net Assets
|
|
1,568
|
|
2,122
|
|
|
Capital and
reserves
|
|
|
|
|
|
|
Issued ordinary
share capital *
|
|
1,000
|
|
1,200
|
|
|
Share premium
account*
|
|
400
|
|
600
|
|
|
Accumulated profits
|
|
168
|
|
322
|
|
|
|
|
1,568
|
|
2,122
|
|
|
31 March 2008
|
31 March 2007
|
||||
|
|
GMD’000
|
GMD’000
|
GMD’000
|
GMD’000
|
|
|
Non-current assets – cost
|
3,100
|
|
3,674
|
|
|
|
Less depreciation
|
1,214
|
|
1,422
|
|
|
|
|
|
1,886
|
|
2,252
|
|
|
Current assets:
|
|
|
|
|
|
|
Inventory
|
200
|
|
360
|
|
|
|
Trade receivables
|
400
|
|
750
|
|
|
|
Cash at bank
|
100
|
|
120
|
|
|
|
|
700
|
|
1,230
|
|
|
|
Current liabilities:
|
|
|
|
|
|
|
Trade payables
|
210
|
|
380
|
|
|
|
Sundry
|
260
|
|
430
|
|
|
|
Income tax
|
48
|
|
50
|
|
|
|
|
518
|
|
860
|
|
|
|
Net current assets
|
|
182
|
|
370
|
|
|
Non- current liabilities: 10% Loan notes
|
|
(500)
|
|
(500)
|
|
|
Net Assets
|
|
1,568
|
|
2,122
|
|
|
Capital and
reserves
|
|
|
|
|
|
|
Issued ordinary
share capital *
|
|
1,000
|
|
1,200
|
|
|
Share premium
account*
|
|
400
|
|
600
|
|
|
Accumulated profits
|
|
168
|
|
322
|
|
|
|
|
1,568
|
|
2,122
|
|
* The additional share capital was issued on 1 April 2006.
Required:
(a) Calculate, for each of the two years, eight accounting ratios which should assist
the directors in their comparison, using closing figures for balance sheet
items concerned.
(12 Marks)
(b) Suggest possible reasons for the changes in the ratios
between the two years.
(8 Marks)
(20 Marks)
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