Question 1 Rock Ltd
You are an accountant working for Rock Ltd. Geoff, the Managing Director of Rock Ltd has been given the following financial ratios for Scissors Ltd for the past years:
Scissors Ltd is about to issue some debentures that would be repaid in ten years’ time and has asked Geoff if Rock Ltd would be willing to purchase some of them. The money raised from the issue will be used to buy new equipment for Scissors Ltd, clear its overdraft and provide an amount of cash for use in its day-to-day operations.
Geoff has asked you to prepare a memo for him that explains what the ratios mean and what they tell us about the company. In addition, you should provide a recommendation as to whether the opportunity to purchases debentures in Scissors Ltd should be rejected or if it should be considered further.
[Hint: In writing your memo, deal with each ratio in turn. State whether the ratio is getting better or worse, explain what it means and provide a reason why the ratio might have changed. When doing so, keep in mind how the proposed issue of debentures could affect the ratio. Lastly, provide a recommendation]
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Memo
To: Geoff
From: A N Accountant
Date: XX/XX/XXXX
Subject: Analysis of the financial ratios of Scissors Ltd
Dear Geoff
As requested, I am writing in respect of the financial ratios provided in respect of Scissors Ltd.
Sales revenue growth
The company’s sales have grown over the past two years and the rate of growth has improved from 11% to 17%.
Gross profit percentage
The company’s gross profit percentage has worsened from 47% last year to 44% for the current year.
Gross profit percentage is a measure of the portion of sales revenue left after the cost of the goods sold (or cost of the services delivered) is deducted.
This change in the ratio could be because of a reduction in the company’s sales prices (which might explain the company’s sales revenue growth) or could be because of increases in cost prices such as rates for raw materials, labour rates or production overheads.
Operating profit percentage
The company’s operating profit percentage has improved from 18% last year to 20% for the current year.
Operating profit percentage is a measure of the portion of sales revenue left after the cost of the goods sold/services delivered and the cost of running the business are deducted.
As the company’s gross profit percentage worsened from the previous year, we might have expected the operating profit percentage to do so as well but this has not happened. The company’s overheads as a percentage of sales revenue must therefore have fallen/improved, either because they are largely fixed in nature and will therefore stay constant despite rising sales, or because of good cost control on the part of the company’s management.
Current ratio
The company’s current ratio has worsened from 1.8:1 last year to 1.5:1 for the current year.
The current ratio compares a company’s current assets compared to its current liabilities. It is a measure of the company’s liquidity, that is, its ability to pay its debts as they fall due. As this is becoming worse there must be concern over the company’s solvency.
The proposed issue of debentures should clear the company’s bank overdraft and provide an amount of cash. This will have the effect of reducing the company’s current liabilities and increasing its current assets and thereby improve its liquidity and current ratio.
Gearing ratio
The company’s gearing has improved from 12% last year to 10% for the current year.
Gearing measures the relative scale of the business’ long-term debt to the total of its long-term debt and equity. High gearing can be a problem as there is a greater risk that the business will be unable to pay its lenders and may therefore fail. The gearing of Scissors Ltd is low however and indicates that more debt could be taken on without a significant increase to its financial risk.
Recommendation
Scissors Ltd is a company with strong sales growth and whilst its gross profit percentage has worsened, its operating profit has improved. Its main weakness is that it has poor liquidity, but this is something that might be solved by the proposed issue of debentures. I would therefore recommend further consideration of the purchase of debentures in Scissors Ltd.
Question 2 Loch Ltd
You are an accountant working in practice. One of your clients is Monica Plover, who owns shares in Loch Ltd and has asked you to assist her in assessing the company’s performance and the level of risk of retaining her shareholding in the company. The company’s statement of profit or loss and statement of financial position for the last year are shown below.
- Calculate the following ratios for both years to two decimal places; gross profit percentage, operating profit percentage, return on shareholders’ funds and interest cover
- Comment on the relative performance of the company
- Recommend whether Monica Plover should retain or sell her shares in Loch Ltd
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1)
- Gross profit percentage 20X8: 10503/19940 x 100 = 52.67%
- Gross profit percentage 20X7: 10816/21364 x 100 = 50.63%
- Operating profit percentage 20X8: 1506/19940 x 100 = 7.55%
- Operating profit percentage 20X7: 2037/21364 x 100 = 9.53%
- Return on shareholders’ funds 20X8: 374/8642 x 100 = 4.33%
- Return on shareholders’ funds 20X7: 1193/8268 x 100 = 14.43%
- Interest cover 20X8: 1506/844 = 1.78 times
- Interest cover 20X7: 2037/741 = 2.75 times
2)
The gross profit percentage of Loch Ltd improved from 20X7 to 20X8. Gross profit percentage measures the efficiency with which the company converts sales revenue into gross profit. The improvement might have been caused by an increase in the company’s selling prices or a reduction in the cost per unit sold.
The company’s operating profit percentage has deteriorated from 20X7 to 20X8. Operating profit percentage measures the efficiency with which the company converts sales revenue into profit from operations. The deterioration is despite the increase in gross profit percentage and was caused by increases in distribution costs and administration costs.
The company’s return on shareholders’ funds has deteriorated from 20X7 to 20X8. This ratio measures the return generated by the company for the equity invested in the company by its shareholders. Whilst the value of equity has increased over the year, most of the reduction has been caused by the large fall in profit after tax.
Interest cover has deteriorated from 20X7 to 20X8. Interest cover measures the company’s ability to service its debts from profits. It has fallen as profits before interests have fallen whereas finance costs have risen.
3) Only the gross profit percentage has improved, whilst other ratios have worsened. Performance has become worse and whilst financial risk (measured by interest cover) has increased. Monica Plover is therefore recommended to sell her shares in Loch ltd.
3 Kolb plc
You have been asked by Luna, the Finance Director, to prepare a memo commenting on the performance and risk of Kolb plc. You have been given the following ratios on the company and the industrial sector it operates in.
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Memorandum
To: Luna (Finance Director)
From: A N Accountant
Date: XX/XX/20XX
Subject: Performance and risk of Kolb plc
Luna,
As requested, I include an analysis of the performance and risk of Kolb plc based upon the ratios for the company and the industry averages that have been provided.
[Note: this answer comments on those ratios that tell us about performance first, i.e., asset turnover (net assets), selling costs/revenue percentage and return on capital employed, before those that look at risk, i.e., the current ratio and gearing ratio. These ratios could also be commented upon in a different order]
Asset turnover (net assets)
Kolb plc’s asset turnover (net assets) of 0.8 times is worse than the industry average of 1.0 times. This means that the company’s performance in generating sales from its net assets, or long-term funding, of the funding is worse than the industry average.
Selling costs/revenue percentage
Kolb plc’s selling costs/revenue percentage of 12.4% is better than the industry average of 14.1%. This means that the company is spending a smaller portion of its sales revenue on selling costs than other businesses in its industry. The lower ratio, however, may be the reason why Kolb plc’s asset turnover (net assets) is worse than the industry average.
Return on capital employed
Kolb plc’s return on capital employed of 10.3% is better than the industry average of 9.6%. This means that the business is generating profits for its providers of long-term finance at a higher rate than the industry average.
Current ratio
Kolb plc’s current ratio of 2.5:1 is better than the industry average of 2.2:1. This means that the company should be able to pay its debts as they fall due from its current assets and is at a lower risk of insolvency in the short-term.
Gearing
Kolb plc’s gearing of 57.2% is worse than the industry average of 39.4%. This means that the majority of the company’s long-term funding comes from lenders rather than shareholders. The company is therefore at a greater financial risk than the industry average.
4 Sherbet Ltd
You are the accountant for Dip Ltd who has been asked by one of its customers, Sherbet Ltd, for a higher credit limit. You have been provided with the financial ratios shown below which have calculated from Sherbet Ltd’s latest financial statements.
Comment on the ratios and make a recommendation based on your comments as to whether a higher credit limit should be offered.
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Quick ratio
Sherbet Ltd’s quick ratio has worsened from 20X1 to 20X2. This means that the company has become less able to pay its debts as they fall due from its current assets (excluding inventories).
Trade payables payment period
Sherbet Ltd’s trade payables payment period has worsened from 20X1 to 20X2 by 10 days. This means that on average, the company’s suppliers are having to wait longer for their invoices to be paid by Sherbet Ltd.
Trade receivables collection period
Sherbet Ltd’s trade receivables collection period has improved from 20X1 to 20X2 by 4 days. This means that on average, the company’s customers are paying the company more quickly.
Inventory holding period
Sherbet Ltd’s inventory holding period has worsened from 20X1 to 20X2 by 15 days. This means that on average, it is taking longer for the company’s inventories to be completed and/or sold.
Recommendation
Whilst the company is collecting its customer debts more quickly, all other ratios have worsened. Sherbet Ltd appears to be having liquidity issues, its quick ratio is poor and the company the amount of time it takes to convert inventory to cash is of great concern. For this reason it is recommended that Dip Ltd does not offer to increase the credit given to Sherbet Ltd.
5 Ribbit Ltd
You are a Credit Control Assistant for Lory Ltd and have received an application for credit from Ribbit Ltd. The following ratios are available to you:
Comment on the ratios and explain whether or not you believe that Ribbit Ltd should be granted credit.
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Working capital cycle
Ribbit Ltd’s working capital cycle of 23.7 days is worse than the industry average of 21.2 days. This means that there is an additional 1.5 days between the date the company pays for its inventories and the day it receives payment from customers for the inventories.
Acid test
Ribbit Ltd’s acid test ratio of 1.4:1 is better than the industry average of 1.1:1. This means that the company is better able to pay its current liabilities from its current assets and is less likely to run into cash flow problems in the short-term.
Operating profit percentage
Ribbit Ltd’s operating profit percentage of 17.5% is slightly worse than the industry average of 17.6%. This means that it is almost as good as the industry average in converting its sales revenue into profit for its providers of long-term finance.
Interest cover
Ribbit Ltd’s interest cover of 4.0 times is better than the industry average of 3.8 times. This means that it is easily able to service its debts from its profits and its financial risk appears to be low.
Recommendation
Ribbit Ltd’s acid test and interest cover are better than the industry average, whilst its working capital cycle its worse and its operating profit percentage is slightly worse. As the company’s liquidity and financial position appears to be good it is recommended that credit be offered to Ribbit Ltd.
