ACC/ACF1200 Self-study questions SOLUTIONS

Topic 6 – Analysis and interpretation

Question 1
(a) Comment on the change in each ratio over the three year period. Identify any conclusions you
have drawn from the movements.

Return on assets measures the efficiency with which assets are used to generate profit. A higher ratio is
preferred, so the trend over the three years is favourable, but quite low. In 2015, Penny’s business is
making 4.5% of the value of assets in profit. This can be improved further by increasing profit or decreasing
total assets.

Profit margin measures the proportion of each dollar of sales that is kept as profit. Higher is better, yet the
ratio has remained constant for Penny’s business over the three years. This would indicate that she has
kept selling prices and expenses in a constant proportion.

The asset turnover measures the efficiency with which assets are used to generate revenue, therefore
ignoring expenses. Higher is better therefore the trend over the three years is very positive. Penny’s
business is now making 1.8 times the value of assets in revenue.

Conclusion – the ROA has improved as Penny has used assets more efficiently and generated more
revenue, not due to increasing her selling price or lowering expenses.

(b) Identify two other benchmarks that are useful to compare ratios against, other than the prior
years that are used above.

Management targets (budgets)

Industry averages
Competitor’s results

Question 2
For each of the ratios listed below, explain briefly what the ratio means and comment on the company’s
performance based on each individual ratio over the two year period.
The current ratio for the business has increased from an already very comfortable level to a very high
$11.61 of current assets to each $1 of current liabilities. This could possibly be due to holding more
inventory.
The quick ratio is a more accurate measure of liquidity as it excludes current assets that are not quickly
converted to cash. It has increased over four times during the two years. The business now has $4.40 of
liquid assets to each $1 of current liabilities. The entity should consider a short-term investment, as it is in
a very comfortable liquidity position.
Return on equity indicates the profit or loss result compared to the equity invested in the business. Higher
is better and the business is now earning a 148% return which is very good. This result in 2016 could be
due to a decrease in capital and/or possibly due to an increase in profit.
The debt to assets ratio indicates the proportion of assets financed by liabilities. A lower level is preferable
as it indicates less financial risk. This business has increased its debt ratio in 2016 to 35.6% which is
unfavourable. If would be helpful to see the financial statements to see what the liabilities are.
Question 3
Users are interested in an entity’s future profitability, asset efficiency, liquidity and capital structure.
Describe the ratios that would be of interest to users and the purpose of computing these ratios.

In analysing an entity’s future profitability, users normally look at return on equity (ROE), return on asset
(ROA), and profit margin. ROE indicates how much return an entity is generating for owners for each dollar
of the owner’s fund invested in the entity, ROA reflects an entity’s ability to generate return from asset
investments, and profit margin ratio compares an entity’s earnings to its sales revenue. Users are
interested in assessing an entity’s past profitability through profitability ratios, as it will shape the users’
expectations as to the entity’s future profitability.

Asset turnover, days inventory, and days debtors ratios are commonly used to assess an entity’s asset
efficiency. Asset turnover ratio measures an entity’s overall efficiency in generating income/sales from its
asset investments. Days inventory and days debtors indicate the average period of time it takes for an
entity to sell its inventory and collect money from its trade debtors. By computing the asset efficiency
ratios, users would be able to make evaluations from past decisions to see how efficient the entity
manages its asset investments, which are mostly in inventory and accounts receivable, to generate income.

In terms of liquidity, users are interested in the current ratio and quick asset ratio. The current ratio
measures an entity’s current assets in dollar amount as per dollar of current liabilities, while the quick
asset ratio indicates how many dollars of current assets available (excluding inventory) to pay for a dollar
of current liabilities. It is important for users to analyse an entity’s liquidity position, as liquidity is a
measure of the entity’s ability to pay for its debts when they fall due.

When assessing an entity’s capital structure, users would be interested in calculating debt to equity ratio,
debt ratio, and equity ratio. Debt to equity ratio reflects the proportion of using external financing (debt)
to internal financing (equity) in asset investments. Debt ratio and equity ratio show the dollars of debt and
equity respectively per dollar of asset. Capital structure ratios depict the proportion of debt to equity
funding, and are useful when assessing an entity’s long term viability.

Question 4
The working capital (current) ratio for Beesnees Business has progressively increased from 1.2 times to
3.0 over the past three years. Discuss if this trend is favourable.

The current ratio (working capital ratio) is a liquidity ratio that indicates the dollars of current assets the
entity has per dollar of current liabilities. It is undesirable to have a ratio that is too low, as this suggests
that the entity may have difficulty in meeting its short-term obligations. However, a high current ratio is
not necessarily good, as it could be due to excess investments in assets that do not generate high returns –
cash, debtors or inventory. When assessing the current ratio, an arbitrary rule of thumb is that it should be
around $1.50 - $2.00 of current assets for every $1 of current liabilities. The trend in this ratio is important.
An upward trend in the ratio could suggest that the entity is building up excessive levels of inventory or
accounts receivable (i.e. inventory is not selling or cash is not being collected from debtors efficiently).
Similarly, a downward trend can suggests that the entity is having difficulty finding sufficient cash to meet
its short term obligations. The trend for Beesnees Business is favourable at present, however if it continues
to increase the business should consider the composition of current assets it has on hand.

Question 5
Examine what happens to the gross profit margin when:
(a) advertising is incurred.
(b) selling prices are increased assuming customers buy the same amount.
(c) suppliers increase their prices.
 Gross profit = Gross profit × 100
margin Sales revenue 1

a. The advertising expense does not have an impact on gross profit margins as the advertising expense is
not included in the calculation of gross profit. Although the advertising campaign may increase sales
revenue if successful, the cost of sales will also increase proportionately with the increase in sales
revenue, leaving the gross profit margin unchanged.

b. If selling prices increase and cost of sales remains the same, the gross profit margin will increase as the
entity will be generating a higher gross profit per dollar of sales.

c. When suppliers increase their prices, the entity’s cost of sales will increase. Assuming selling price
remains the same, gross profit margin will decrease as a higher percentage of sales dollars is
consumed by the cost of sales. If the entity increases its selling price following the increase in cost of
sales, the impact on gross profit margin for the entity will depend on the rate of increase. If selling
prices increases at a lower (higher) rate than the rate of increase in cost of sales, gross profit margin
will decrease (increase).

To illustrate this point, take an example where initial selling price is $4 and cost of sales is $2. When
suppliers increase the cost of sales to $3, the gross profit margin drops from 50% to 25% if the selling
price is unchanged.

Question 6
The current ratio represents the proportion of current assets to current liabilities. Higher is better to a
certain extent, as it implies that an entity would have sufficient current assets to pay off current liabilities.
However, a very high current ratio might indicate that an entity would be better off investing rather than
holding large amounts of cash on hand, inventory or prepayments. The current ratio for Ken’s Bicycle
World was already very comfortable, and has grown higher to $6.81 of current assets to each $1 of current
liabilities. The quick (acid test) ratio is another measure of liquidity, but it excludes inventory from the
formula to better measure immediate debt paying ability. It will naturally be lower with the exclusion of
some assets. For Ken’s Bicycle World, the acid test ratio has increased to $5.10 of liquid current assets to
pay of current liabilities. This is a dramatic increase, and would indicate that liabilities are lower, or
cash/receivables are much higher than in the previous year.

The days’ debtors indicates the average time in which accounts receivable clients settle their outstanding
balances. Fewer days is preferable, as it indicates improved liquidity. It is important to collect cash from
credit clients as quickly as possible to minimise costs and reduce the chance of bad debts. Ken’s Bicycle
World seems to have little trouble with this as they collect from customers within 23 days, but that is
based on the assumption of offering clients 30 day terms. If in fact the terms are shorter (say 14 days),
then Ken should consider better credit control as the period has extended by 2 days.

The debt ratio shows the proportion of assets financed by debt. Lower levels are preferred, as they indicate
less financial risk. However, an acceptable level depends very much on the industry that the entity is
operating in. Ken’s Bicycle World had a debt level of nearly 74% last year, but has managed to decrease
that to 61% in the current period. It could be because some of the loan was repaid, there are fewer dollars
owed to other payables, or there are more assets in the current year. Whatever the reason, the level has
improved and indicates less financial risk. The return on equity ratio shows the percentage return of profit
compared to the owner’s investment in the business. A higher return is preferable, and Ken’s return is an
impressive 93.9%, up from 88.4% last year. This means that Ken is earning profits almost equal to his
capital in the business. This increase can be explained by either an increase in profit, or a reduction in
capital.