FINANCIAL REPORTING TPPC

46 INTERPRETATION OF ACCOUNTS
46.0 INTRODUCTION

Ratio analysis involves comparing one figure against another to produce a ratio, and assessing
whether the ratio indicates a weakness or strength in the company's affairs.

Basic ratios can be grouped into five categories.

 Profitability and return

 Long-term solvency and stability
 Short-term solvency and liquidity
 Efficiency (turnover ratios)
 Shareholders' investment ratios

Ratio analysis on its own is not sufficient for interpreting company accounts, and that there are
other items of information which should be looked at.

(a) The content of any accompanying commentary on the accounts and other statements
(b) The age and nature of the company's assets
(c) Current and future developments in the company's markets, at home and overseas, recent
acquisitions or disposals of a subsidiary by the company
(d) Any other noticeable features of the report and accounts, such as events after the reporting
period, contingent liabilities, a qualified auditors' report, the company's taxation position

46.1 PROFITABILITY RATIOS

46.1.1 Return on Capital Employed

One profit figure that should be calculated and compared over time is PBIT, profit before
interest and tax, the amount of profit which the company earned before having to pay interest
to the providers of loan capital. By providers of loan capital, we usually mean longer-term loan
capital, such as debentures and medium-term bank loans, which will be shown in the statement
of financial position as 'non-current liabilities'. Also, tax is affected by unusual variations which
have a distorting effect.

Profit before interest and tax is therefore:

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(a) The profit on operating activities before taxation, plus

(b) Interest charges on long-term loan capital

Published accounts do not always give sufficient detail on interest payable to determine how
much is interest on long-term finance.

Issues about comments on profit margin and asset turnover

It might be tempting to think that a high profit margin is good, and a low asset turnover means
sluggish trading. In broad terms, this is so. But there is a trade-off between profit margin and
asset turnover, and you cannot look at one without allowing for the other.

(a) A high profit margin means a high profit per GH¢1 of sales, but if this also means that sales
prices are high, there is a strong possibility that sales revenue will be depressed, and so asset
turnover lower.

(b) A high asset turnover means that the company is generating a lot of sales, but to do this it
might have to keep its prices down and so accept a low profit margin per GH¢1 of sales.

Return on capital employed

PBIT PBIT
ROCE = =
Capital Employed Total assets less current liabilities
ROCE = Asset Turnover × Profit Margin
Sales Profit
ROCE = ×
Total assets Sales
When interpreting ROCE look for the following.
 How risky is the business?
 How capital intensive is it?
 What ROCE do similar businesses have?

46.1.2 Gross Profit Margin

It is useful to compare profit margin to gross profit % to investigate movements which do not
match. Take into account:
 Sales prices, sales volume and sales mix
 Purchase prices and related costs (discount, carriage etc)

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 Production costs, both direct (materials, labour) and indirect (overheads both fixed and
variable)
 Inventory levels and inventory valuation, including errors, cut-off and stock-out costs
Gross Profit
Gross Profit Margin = × 100
Sales

46.1.3 Net Profit Margin

Gross Profit
Net Profit Margin = × 100
Sales
Take into account:
 Sales expenses in relation to sales levels
 Administrative expenses, including salary levels
 Distribution expenses in relation to sales levels
Depreciation should be considered as a separate item for each expense category.

46.2 LIQUIDITY AND WORKING CAPITAL

Liquidity is the amount of cash a company can put its hands on quickly to settle its debts (and
possibly to meet other unforeseen demands for cash payments too). Liquid funds consist of the
following.

 Cash
 Short-term investments for which there is a ready market (as distinct from shares held in
subsidiaries or associated companies)
 Fixed-term deposits with a bank (e.g. a six month high-interest deposit)
 Trade receivables (because they will pay what they owe within a short period of time)
 Bills of exchange receivable (because these represent cash due to be received within a
relatively short period of time)

A company can obtain liquid assets from sources other than sales, such as the issue of shares
for cash, a new loan or the sale of long-term assets. But a company cannot rely on these at all
times, and in general obtaining liquid funds depends on making sales and profits. Even so,
profits do not always lead to increases in liquidity. This is mainly because funds generated
from trading may be immediately invested in long-term assets or paid out as dividends.

Efficiency ratios indicate how well a business is controlling aspects of its working capital.

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46.2.1 Current ratio

Current assets
Current ratio = ∶1
Current liabilities

Assume assets realised at book value, therefore theoretical. 2:1 acceptable? 1.5:1? It depends
on the industry.

46.2.2 Quick ratio

Current assets − Inventory

Quick ratio = ∶1
Current liabilities

Eliminates illiquid and subjectively valued inventory. Care is needed: it could be high if
overtrading with receivables, but no cash. Is 1:1 OK? Many supermarkets operate on 0.3.

46.2.3 Inventory Turnover Period

Inventory
Inventory turnover period = × 365
Cost of Sales

Higher the better? But remember:

 Lead times
 Seasonal fluctuations in orders
 Alternative uses of warehouse space
 Bulk buying discounts
 Likelihood of inventory perishing or becoming obsolete

46.2.4 Debtors Collection Period

Trade recievable
Receivable collection period = × 365
Credit Sales

Is it consistent with quick/current ratio? If not, investigate.

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46.2.5 Creditors Payment Period

Trade payable
Payable payment period = × 365
Cost of Sales
Use cost of sales if purchases are not disclosed.

Reasons for changes in liquidity

 Credit control efficiency altered

 Altering payment period of creditors as a source of funding
 Reduce stock holdings to maintain liquidity

46.3 LONG-TERM SOLVENCY: DEBT & GEARING/LEVERAGE

Debt and gearing ratios are concerned with a company's long-term stability: how much the
company owes in relation to its size, whether it is getting into heavier debt or improving its
situation, and whether its debt burden seems heavy or light.

(a) When a company is heavily in debt, banks and other potential lenders may be unwilling to
advance further funds.

(b) When a company is earning only a modest profit before interest and tax, and has a heavy
debt burden, there will be very little profit left (if any) over for shareholders after the interest
charges have been paid. And so if interest rates were to go up (on bank overdrafts and so on)
or the company were to borrow even more, it might soon be incurring interest charges in excess
of PBIT. This might eventually lead to the liquidation of the company.

Debt and gearing/leverage

Debt/equity

Interest bearing net debt %

Debt/equity ratio = (˃ 100% = ℎ𝑖𝑔ℎ)
Shareholders' fund

I nterest bearing net debt

Or %( 50%=high) '
%(˃ 50%=high)
Shareholders fund + interest bearing net debt

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There is no definitive answer; elements included are subjective. The following could have an
impact.

 Convertible loan stock

 Preferred shares
 Deferred tax
 Goodwill and development expenditure capitalisation
 Revaluation reserve

Gearing/leverage

Prior charge capital

Gearing ratio =
Total capital

T otal capital
Leverage =
Prior charge capital

Interest cover

PBIT (including interest receivable)

Interest cover =
Interest payable

Is this a better way to measure gearing or leverage? Company must generate enough profit to
cover interest. Is a figure of 3+ safe?

The implications of high or low gearing

Gearing or leverage is, amongst other things, an attempt to quantify the degree of risk involved
in holding equity shares in a company, both in terms of the company's ability to remain in
business and in terms of expected ordinary dividends from the company. The problem with a
highly geared company is that, by definition, there is a lot of debt. Debt generally carries a
fixed rate of interest (or fixed rate of dividend if in the form of preferred shares), hence there
is a given (and large) amount to be paid out from profits to holders of debt before arriving at a
residue available for distribution to the holders of equity.

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The more highly geared the company, the greater the risk that little (if anything) will be
available to distribute by way of dividend to the ordinary shareholders. The more highly geared
the company, the greater the percentage change in profit available for ordinary shareholders
for any given percentage change in profit before interest and tax. The relationship similarly
holds when profits increase. This means that there will be greater volatility of amounts
available for ordinary shareholders, and presumably therefore greater volatility in dividends
paid to those shareholders, where a company is highly geared. That is the risk. You may do
extremely well or extremely badly without a particularly large movement in the PBIT of the
company.

The risk of a company's ability to remain in business was referred to earlier. Gearing is relevant
to this. A highly geared company has a large amount of interest to pay annually. If those
borrowings are 'secured' in any way (and debentures in particular are secured), then the holders
of the debt are perfectly entitled to force the company to realise assets to pay their interest if
funds are not available from other sources. Clearly, the more highly geared a company, the
more likely this is to occur when and if profits fall. Note that problems related to off balance
sheet finance hiding the level of gearing have gradually become rarer, due to standards such as
IFRS 16 (on leasing).

Companies will only be able to increase their gearing if they have suitable assets to offer for
security. Companies with assets which are depreciated rapidly or which are at high risk of
obsolescence will be unable to offer sufficient security, e.g. computer software companies. On
the other hand, a property company will have plenty of assets to offer as security whose value
is fairly stable (but note the effect of a property slump).

SHAREHOLDERS' INVESTMENT RATIOS

These are the ratios which help equity shareholders and other investors to assess the value and
quality of an investment in the ordinary shares of a company.

The value of an investment in ordinary shares in a listed company is its market value, and so
investment ratios must have regard not only to information in the company's published
accounts, but also to the current price.

Earnings per share is a valuable indicator of an ordinary share's performance

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Investors' ratios

Dividend yield

Dividend per share

Dividend yield =
Market price per share

 Low yield: the company retains a large proportion of profits to reinvest

 High yield: this is a risky company or slow-growing

Dividend cover

EPS
Dividend cover =
Dividend per share

Profit after tax and pref div

Or
Dividend on ordinary shares

This shows how safe the dividend is, or the extent of profit retention. Variations are due to
maintaining dividend when profits are declining.

P/E ratio

Market price per share

P/E ratio =
EPS

The higher the better here: it reflects the confidence of the market. A rise in EPS will cause an
increase in P/E ratio, but maybe not to same extent: look at the context of the market and
industry norms.

Earnings yield

EPS
Earnings yield =
Market price per share

This shows the dividend yield if there is no retention of profit. It allows you to compare
companies with different dividend policies, showing growth rather than earnings.

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Limitations of inter-period and inter-company comparisons

 The data might need to be adjusted to for inflation if valid comparisons are to be made over
time.
 The financial statements might have been prepared using different accounting policies e.g.
choice of depreciation and stock valuation policies
 Accounts may be made up to a different date which can significantly affect ratios if the
business is seasonal
 Traditional analysis tends to focus on profitability. Greater attention is needed to be paid to
assessing liquidity and the capacity to adapt by reference to cash flow statement
 The statement of financial position is prepared at a single point in time. This means it is
possible to practice window dressing and this can affect ratios.
 The industry average does not indicate the distribution of results around the average. It
would be helpful to have quartile and decile figures.

Question 1

You are a consultant for Glory Ltd, a quoted company operating in the manufacturing sector.
Following are a Statement of Profit or Loss and Statement of Financial Position with
comparatives for the year ended 31st December 2018.

Statement of Profit or Loss for the year ended 31st December, 2018

2018 2017
GH¢ GH¢
Sales revenue 3,095,576 1,909,051
Cost of sales 2,402,609 1,441,950
Gross profit 692,967 467,101
Interest receivable 744 2,782
Administration expenses 333,466 222,872
Operating profit 360,245 247,011
Interest 18,115 21,909
Profit before taxation 342,130 225,102
Income tax expense 74,200 31,272
Profit for the year 267,930 193,830

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Statement of Financial Position as at 31 December 2018

Assets 2018 2017

Non-current assets GH¢ GH¢
Property, plant and equipment 802,180 656,071

Current assets
Inventory 64,422 86,550
Trade receivables 905,679 807,712
Prepayment and accrued income 97,022 45,729
Cash at bank and in hand 1,327 68,363
1,068,450 1,008,354
Total assets 1,870,630 1,664,425

Equity and liabilities

Equity
Ordinary shares 258,178 258,178
Income surplus 651,721 410,591
909,899 668,769
Non-current liabilities
10% loan stock 100,000 100,000

Current liabilities
Trade payables 627,018 545,340
Accruals and deferred income 81,279 280,464
Corporate taxes 108,000 37,200
Other taxes 44,434 32,652
860,731 895,656
1,870,630 1,664,425
Required:

(a) Calculate the following ratios:

i) Profitability ratios - Return on Capital Employed, Return on Equity, Gross profit
margin and Net profit margin
ii) Long term solvency and stability - Debt/Asset ratio, Gearing ratio and Interest cover
iii) Short-term solvency and liquidity – Current ratio and Acid test ratio
iv) Efficiency (turnover ratios) – Account receivable collection period, Account payable
payment period, Inventory turnover (times) (6 marks)
(b) Prepare a report addressed to the Chief Executive Officer, assessing the relative
performance and financial position of Glory Ltd for the year ended 31st December, 2018

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(14 marks)

(Total 20 marks)

Solution

a)

Ratios 2017 2018

Profitability Ratios
Return on capital 𝑃𝐵𝐼𝑇 247,011 360,245
(%) (%) (%)
employed = 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑 768,769 1,009,899
= 32.1% = 35.7%
Return on Equity = 𝑃𝐴𝑇 193,830 267,930
(%) (%) (%)
𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 ′ 𝐹𝑢𝑛𝑑 668,769 909,899
= 29% = 29.4%
Gross Profit Margin 𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡 467,101 692,967
(%) (%) (%)
= 𝑆𝑎𝑙𝑒𝑠 1,909,051 3,095,576
= 24.5% = 22.4%
Net profit margin = 𝑃𝐵𝐼𝑇 247,011 360,245
(%) (%) (%)
𝑆𝑎𝑙𝑒𝑠 1,909,051 3,095,576
= 12.9% = 11.6%
Liquidity/Solvency
Current ratio = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠 1,008,354 1,068,450
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 895,656 860,731
= 1.1:1 = 1.2:1
Acid Test ratio = Current assets − (Stock + Prepayment) 876,075 907,006
Current liabilities 895,656 860,731
= 0.98:1 = 1.05:1
Efficiency Ratios
Inventory Turnover 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 86,550 64,422
× 365 × 365 × 365
Period = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑆𝑎𝑙𝑒𝑠 1,441,950 2,402,609
= 22 days = 10 days
Account receivable 𝑇𝑟𝑎𝑑𝑒 𝑟𝑒𝑐𝑖𝑒𝑣𝑎𝑏𝑙𝑒 807,712 905,679
× 365 × 365 × 365
collection period = 𝑆𝑎𝑙𝑒𝑠 1,909,051 3,095,576
=154 days = 107 days

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Account payable 𝑇𝑟𝑎𝑑𝑒 𝑝𝑎𝑦𝑎𝑏𝑙𝑒 545,340 627,018

× 365 × 365 × 365
payment period = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑆𝑎𝑙𝑒𝑠 1,441,950 2,402,609
= 138 days = 95 days
Asset turnover = 𝑆𝑎𝑙𝑒𝑠 1,909,051 3,095,576
𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑 768,769 1,009,899
= 2.5 times = 3.1 times
Long term solvency
and stability ratios
Debt/Asset ratio 𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠 995,656 960,731
(%) (%)
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠 1,664,425 1,870,630
= 59.8% 51.4%
Gearing ratio 𝐿𝑜𝑛𝑔 𝑡𝑒𝑟𝑚 𝑑𝑒𝑏𝑡𝑠 100,000 100,000
(%) (%)
𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟𝑠 ′ 𝐹𝑢𝑛𝑑 668,769 909,899
= 15% = 11%
Interest cover = 𝑃𝐵𝐼𝑇 247,011 360,245
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑎𝑖𝑑/𝑝𝑎𝑦𝑎𝑏𝑙𝑒 21,909 18,115
= 11.3 times = 19.9 times

b)

To: Chief Executive Officer

From: Consultant
Date: 5th June, 2020
Subject: Financial performance and financial position assessment of Glory Ltd

Introduction

This report is to throw light on the financial position and performance of Glory Ltd and to
assess its performance for the year ended 31st December, 2018.

Profitability

Return on capital employed has increased from 32.1% in 2017 to 35.7% in 2018 caused by an
increase in the operating profit and an increase in capital employed. The rise in operating profit
was caused by an increase in sales revenue, whilst the new investment programme will have
caused an increase in capital employed.

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Overall profitability has fallen as a result of a drop in the net profit /sale percentage from 12.9%
in 2017 to 11.6% in 2018. The gross profit margin also experienced a fall from the 2017 figure
of 24.5% to 22.4% in 2018. The fall in the gross profit margin was caused by a higher cost of
sales in proportion to the sales revenue in 2018.

Efficiency in the utilisation of assets to generate revenue seems to be on the rise. This is
demonstrated by the rise in the asset turnover from 2.5 times in 2017 to about 3.1 times in 2018.
Sales have increased by 62.2% between 2017 and 2018, so the new investment programme
may have had a significant effect on sales.

In the short term, the investment programme has increased assets and costs and influenced
sales.

Short Term Solvency

The Company's Statement of Financial Position as at December 2018 shows liquid position.
Here Glory shows real cause for concern with its current ratio. Its current ratio is far below
expected norms. In spite of the steep increase in receivables, the current ratio remained serious
at 1.2:1. A further review of the current ratio after excluding inventory and prepayments
showed that the situation is not all that serious. The liquid ratio improved from 0.98:1 in 2017
to 1.05:1 in 2018. The management of Glory Ltd must therefore decide on the optimum level
of inventory to keep in stock and try to review its prepayment policies in order to further
improve its liquidity situation.

Efficiency

The inventory turnover period had improved considerably by over 50% in 2018 from the 2017
figure of 22 days. This is seen in the high level of sales in 2018 of over GHS3 million. What
makes the situation disturbing and if not managed will make the company illiquid is its
worsening debt collection ability and shorter creditors’ payment period. The average debt
collection period even though it improved from 154 days in 2017 to 107 days in 2018 still
remained serious. The creditors’ payment period worsened from 138 days in 2017 to 95 days
in 2018. This shows a bad receivable collection policy by the Company as obligation to
suppliers and other short term payables matures about 12 days before receivables settle their
accounts. This must be a worrying situation to the Company and as such management should
strive to reverse the situation.
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Long term solvency and financial stability

There is a growing decline in the dependence on external financing. The total liabilities as a
percentage to total assets indicates a decline in reliance on external debt finance (2017: 59.8%
and 2018: 51.4%). The long term debt to shareholders’ fund shows the company is lowly geared
with a decline in the gearing ratio from 15% in 2017 to 11% in 2018. The current gearing ratio
is currently beneficial for shareholders. The company is making an overall return of 35.7%, but
only paying 10% interest on its loan stocks. This is shown in the higher return to equity of 29%
and 29.4% in 2017 and 2018 respectively. The company also has a very good interest cover of
19.8 times in 2018. Overall the company is not exposed to financial risk.

Question 2

The summarized Statement of Financial Position of ABC ltd as at 31 December 2008 and 2007
were as follows:

2007 2008
GH¢’m GH¢’m
Stated capital 12,000 12,000
Capital Surplus 2,400 2,600
Income Surplus 5,720 5,100
Debenture Inventory - 6,000
Corporation Tax 3,260 2,400
Proposed Dividend 1,800 1,800
Sundry Payables 7,380 10,800
32,560 40,700
Plant at cost 16,200 19,900
Depreciation 6,160 7,360
10,040 12,540
Freehold property 4,000 4,800
Goodwill 3,000 3,000
Inventories 9,900 12,760
Receivables 4,840 7,360
Bank 780 240
32,560 40,700

The following information is relevant to the profits for the years ended 31 December 2007 and
2008

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2007 2008
GH¢’m GH¢’m
Sales 60,000 66,000
Net Profit before tax 5,600 2,000
Among the items charged in the
Calculation of net profit
Before Corporation Tax were:
Depreciation 1,000 1,200
Bad debts 460 1,640
Directors emoluments 500 520
Advertising and sales promotion 2,160 3,240

ABC Co. is a listed company currently engaged in the production of beer, 10% of which is
exported. In January 2009, the Financial Director asked the company's bankers for overdraft
facilities or million during the succeeding year (the overdraft limit in the year ended 31
December 2008 had 1000 million).

In making this request the Director indicated that

1. In the year ended 3 1 December 2008 the company had expanded its production capacity
and the sales organization was extended by the acquisition of retail distribution outlets in
other ECOWAS countries.
2. Initial difficulties with the ECOWAS acquisitions and the increasingly severe competition
in both Home and foreign markets were the cause of the fall in profits in the year ended 3
1 December 2008.
3. These were unprecedented setbacks but his board members were hopeful that conditions
would prove favourable in the coming year.
4. The requested overdraft facility is necessary if the company is to continue to operate
competitively

You are required as an investigating accountant in the bank's regional office:

a) To draw up a memorandum for the bank manager commenting on the financial condition
of ABC as disclosed in the above statements,
b) To set out matters on which you would require further information before making a
recommendation in respect of the proposed overdraft level.

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Solution

To Bank Manager
From Investigating Accountant
Date 10th January 2009
Subject The financial position of ABC Co Ltd

Introduction

This report is to throw light on the financial position of ABC Ltd and to assess its strength to
justify request for increased overdraft facility.

Short Term Solvency

The company's Statement of Financial Position as at December 2008 shows illiquid position.
In spite of the steep increase in receivables, the current ratio remained serious at 1.36:1 while
the liquid ratio remained at 0, 51: 1. What makes the situation all the more serious is the
worsening debt collection ability of the company? The average debt collection period which
used to be about 30 days in 2007 has worsened to about 41 days in 2008.

Long term solvency and financial stability

There is a growing dependence on external financing. The external liabilities as a percentage

of the Beholders fund of about 62 % in 2007 changed to about 107% at December. 2008,
thereby making the company highly geared. The proprietary ratio of about 0.52 or 52% means
that the company is exposed to high financial risk. This means that about 42% of the value of
the company's tangible assets is finance external borrowing.

Profitability and efficiency

Overall profitability has fallen as a result of a drop in the net profit /sale percentage from 9.3%
in 2007 to 3.0% in 2008. The 2008 profit has been depressed by sizeable bad debts, advertising
and sales promotion expenses. Efficiency in the utilisation of assets to generate revenue seems
to be on the decline This is demonstrated by the decline in the asset turnover from 1.84 times
in 2007 to about 1.6 times in 2008 and the Net profit /Total assets ratio from about 17% to
about 5 %.

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Conclusion

From all indications, the company is heading towards deep financial crisis. An increase of the
facility to 4,000 million and utilised to the limit would aggravate the current position to an even
'extent and be accompanied by an increasing risk to unsecured payables.

Further information required

To be able to make a conclusive recommendation on whether to grant the request, further

inform t' would be required on

 whether credit control procedures have been tightened.

 Market projection and cash flow forecast for the subsequent 12 months,
 Whether the Debenture inventory is redeemable, and if so, on what terms and when, and
whether it is secured.
 How the company is able to pay the proposed dividend and the corporation tax Signed

Appendix – relevant rations

2007 2008
1. Current Ratio 15,520/12,440 = 1.25:1 20,360/15,000 = 1.36:1
2. Liquid Ratio 5,620/12,440 = 0.45:1 7,600/15,000 = 0.51:1
3. Debtor Collection 4,840/60,000 x 365 days = 29.5 days 7,360/66,000 x 365 days = 40.7 days
4. Ext. Liab./Sh. Fund 12,440/20,120 = 0.62 21,000 / 19,700 = 1.07
5. Sh. Fund/ Tg Assets 20,120/29,560 = 0.68 19,700/37,700 = 0.52
6. NP/Tot Assets 5,600/32,560 = 17.2% 2,000/40,700 = 4.9%
7. Sales/Total Assets 60,000/92,560 = 1.84 times 66,000/40,700 = 1.62 times
8. Net Profit / Sales 5,600/60,000 = 9.3% 2,000/66,000 = 3.0%

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Question 3

Comparator assembles computer equipment from bought in components and distributes them
to various wholesalers and retailers. It has recently subscribed to an inter-firm comparison
service. Members submit accounting ratios as specified by the operator of the service, and in
return, members receive the average figures for each of the specified ratios taken from all of
the companies in the same sector that subscribe to the service. The specified ratios and the
average figures for Comparator’s sector are shown below.

Ratios of companies reporting a full year’s results for periods ending between 1 July 2012 and
30 September 2012

Return on capital employed 22.10%

Net assets turnover 1.8 times
Gross profit margin 30%
Net profit (before tax) margin 12.50%
Current ratio 1.6:1
Quick ratio 0.9:1
Inventory holding period 46 days
Accounts receivable collection period 45 days
Accounts payable payment period 55 days
Debt to equity 40%
Dividend yield 6%
Dividend cover 3 times

Comparator’s financial statements for the year to 30 September 2012 are set out below:

Income statement GH¢'000

Revenue 2,425
Cost of sales (1,870)
Gross profit 555
Other operating expenses (215)
Profit from operations 340
Finance costs (34)
Exceptional item (note (ii)) (120)
Profit before taxation 186
Income tax (90)
Profit for the period 96

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GH¢'000
Extracts of changes in equity
Retained earnings – 1 October 2011 179
Net profit for the period 96
Dividends paid (interim GH¢60,000; final GH¢30,000) (90)
Retained earnings – 30 September 2012 185

Statement of financial position

GH¢'000 GH¢'000
Non-current assets (note (i)) 540
Current assets
Inventory 275
Accounts receivable 320
Bank nil 595
1,135

Equity
Ordinary shares (25 cents each) 150
Retained earnings 185
335
Non-current liabilities
8% loan notes 300
Current liabilities
Bank overdraft 65
Trade accounts payable 350
Taxation 85 500
1,135

Notes

(i) The details of the non-current assets are:

Cost
Accumulated Net book
depreciation value
GH¢'000 GH¢'000 GH¢'000
At 30 September 2007 3,600 3,060 540

(ii) The exceptional item relates to losses on the sale of a batch of computers that had
become worthless due to improvements in microchip design.
(iii) The market price of Comparator’s shares throughout the year averaged GH¢6.00 each.

Required:
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(a) Explain the problems that are inherent when ratios are used to assess a company’s financial
performance.

Your answer should consider any additional problems that may be encountered when using
inter-firm comparison services such as that used by Comparator. (7 marks)

(b) Calculate the ratios for Comparator equivalent to those provided by the inter-firm
comparison service. (6 marks)
(c) Write a report analysing the financial performance of Comparator based on a comparison
with the sector averages. (12 marks)

(Total: 25 marks)

Solution

(a) Ratios are used to assess the financial performance of a company by comparing the
calculated figures to various other sources. This may be to previous years’ ratios of the same
company, it may be to the ratios of a similar rival company, to accepted norms (say of liquidity
ratios) or, as in this example, to industry averages. The problems inherent in these processes
are several. Probably the most important aspect of using ratios is to realise that they do not give
the answers to the assessment of how well a company has performed, they merely raise the
questions and direct the analyst into trying to determine what has caused favourable or
unfavourable indicators. In many ways it can be said that ratios are only as useful as the skills
of the person using them. It is also true that any assessment should also consider other
information that may be available including non-financial information.

More specific problem areas are:

 Accounting policies: if two companies have different accounting policies, it can invalidate
any comparison between their ratios. For example, return on capital employed is materially
affected by revaluations of assets. Comparing this ratio for two companies where one has
revalued its assets and the other carries them at depreciated historical cost would not be
very meaningful. Similar examples may involve depreciation methods, inventory valuation
policies, etc.
 Accounting practices: this is similar to differing accounting policies in its effects. An
example of this would be the use of factoring of trade receivables. If one company collects

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its accounts receivable in the normal way, then the calculation of the accounts receivable
collection period would be a reasonable indication of the efficiency of its credit control
department. However, if a company chose to factor its accounts receivable (i.e. ‘sell’ them
to a finance company) then the calculation of its collection period would be meaningless.
A more controversial example would be the engineering of a lease such that it fell to be
treated as an operating lease rather than a finance lease.
 Statement of financial position averages: Many ratios are based on comparing income
statement items with items in the statement of financial position. The ratio of accounts
receivable collection period is a good example of this. For such ratios to have any meaning,
there is an assumption that the year-end figures in the statement of financial position are
representative of annual norms. Seasonal trading and other factors may invalidate this
assumption. For example, the level of accounts receivable and inventory of a toy
manufacturer could vary largely due to the nature of its seasonal trading.
 Inflation can distort comparisons over time.
 The definition of an accounting ratio. If a ratio is calculated by two companies using
different definitions, then there is an obvious problem. Common examples of this are
gearing ratios (some use debt/equity, others may use debt/debt + equity). Also where a ratio
is partly based on a profit figure, there can be differences as to what is included and what
is excluded from the profit figure. Problems of this type include the treatment of finance
costs.
 The use of norms can be misleading. A desirable range for the current ratio may be say
between 1.5 and 2:1, but all businesses are different. This would be a very high ratio for a
supermarket (with few accounts receivable), but a low figure for a construction company
(with high levels of work in progress).
 Looking at a single ratio in isolation is rarely useful. It is necessary to form a view when
considering ratios in combination with other ratios. A more controversial aspect of ratio
analysis is that management have sometimes indulged in creative accounting techniques in
order that the ratios calculated from published financial statements will show a more
favourable picture than the true underlying position. Examples of this are sale and
repurchase agreements, which manipulate liquidity figures, and ‘off balance sheet finance’
which distorts return on capital employed.

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Inter firm comparisons:

Of particular concern with this method of using ratios is:

 They are themselves averages and may incorporate large variations in their composition.
Some inter firm comparison agencies produce the ratios analysed into quartiles to attempt
to overcome this problem.
 It may be that the sector in which a company is included may not be sufficiently similar to
the exact type of trade of the specific company. The type of products or markets may be
different.
 Companies of different sizes operate under different economies of scale, this may not be
reflected in the industry average figures.
 The year end accounting dates of the companies included in the averages are not going to
be all the same. Some companies try to minimise this by grouping companies with
approximately similar year-ends together as in the example of this question, but this is not
a complete solution.

(b) Calculation of specified ratios:

Comparator Sector average

Return on capital employed (186 + 34 loan interest/635) 34.60% 22.10%

Net asset turnover (2,425/635) 3.8 times 1.8 times
Gross profit margin (555/2,425 × 100) 22.90% 30%
Net profit (before tax) margin (186/2,425 × 100) 7.70% 12.50%
Current ratio (595/500) 1.19 : 1 1.6 : 1
Quick ratio (320/500) 0.64 : 1 0.9 : 1
Inventory holding period (275/1,870 × 365) 54 days 46 days
Accounts receivable collection period (320/2,425 × 365) 48 days 45 days
Creditor payment period (350/1,870 × 365) 68 days 55 days
(based on cost of sales)
Debt to equity (300/335 × 100) 90% 40%
Dividend yield (see below) 2.50% 6%
Dividend cover (96/90) 1.07 times 3 times

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(c) Analysis of Comparator’s financial performance compared to sector average for the
year to 30 September 2012:

To:
From:
Date:

Operating performance

The return on capital employed of Comparator is impressive being more than 50% higher than
the sector average. The components of the return on capital employed are the asset turnover
and profit margins. In these areas Comparator’s asset turnover is much higher (nearly double)
than the average, but the net profit margin after exceptionals is considerably below the sector
average. However, if the exceptionals are treated as one off costs and excluded, Comparator’s
margins are very similar to the sector average.

This short analysis seems to imply that Comparator’s superior return on capital employed is
due entirely to an efficient asset turnover i.e. Comparator is making its assets work twice as
efficiently as its competitors. A closer inspection of the underlying figures may explain why
its asset turnover is so high. It can be seen from the note to the statement of financial position
that Comparator’s noncurrent assets appear quite old. Their carrying amount is only 15% of
their original cost. This has at least two implications; they will need replacing in the near future
and the company is already struggling for funding; and their low carrying value gives a high
figure for asset turnover. Unless Comparator has underestimated the life of its assets in its
depreciation calculations, its noncurrent assets will need replacing in the near future. When this
occurs its asset turnover and return on capital employed figures will be much lower.

This aspect of ratio analysis often causes problems and to counter this anomaly some
companies calculate the asset turnover using the cost of non-current assets rather than their
carrying amount as this gives a more reliable trend. It is also possible that Comparator is using
assets that are not in its statement of financial position. It may be leasing assets that do not meet
the definition of finance leases and thus the assets and corresponding obligations are not
recognised in the statement of financial position.

A further issue is which of the two calculated margins should be compared to the sector average
(i.e. including or excluding the effects of the exceptional). The gross profit margin of
Comparator is much lower than the sector average. If the exceptional losses were taken in at

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trading account level, which they should be as they relate to obsolete inventory, Comparator’s
gross margin would be even worse. As Comparator’s net margin is similar to the sector average,
it would appear that Comparator has better control over its operating costs. This is especially
true as the other element of the net profit calculation is finance costs and as Comparator has
much higher gearing than the sector average, one would expect Comparator’s interest to be
higher than the sector average.

Liquidity

Here Comparator shows real cause for concern. Its current ratio and quick ratio are much worse
than the sector average, and indeed far below expected norms. Current liquidity problems
appear due to high levels of accounts payable and a high bank overdraft. The high levels of
inventory contribute to the poor quick ratio and may be indicative of further obsolete inventory
(the exceptional item is due to obsolete inventory). The accounts receivable collection figure
is reasonable, but at 68 days, Comparator takes longer to pay its accounts payable than do its
competitors. Whilst this is a source of ‘free’ finance, it can damage relations with suppliers and
may lead to a curtailment of further credit.

Gearing

As referred to above, gearing (as measured by debt/equity) is more than twice the level of the
sector average. Whilst this may be an uncomfortable level, it is currently beneficial for
shareholders. The company is making an overall return of 34.6%, but only paying 8% interest
on its loan notes. The gearing level may become a serious issue if Comparator becomes unable
to maintain the finance costs. The company already has an overdraft and the ability to make
further interest payments could be in doubt.

Investment ratios

Despite reasonable profitability figures, Comparator’s dividend yield is poor compared to the
sector average. From the extracts of the changes in equity it can be seen that total dividends are
GH¢90,000 out of available profit for the year of only GH¢96,000 (hence the very low dividend
cover). It is worthy of note that the interim dividend was GH¢60,000 and the final dividend
only GH¢30,000. Perhaps this indicates a worsening performance during the year, as normally
final dividends are higher than interim dividends. Considering these factors it is surprising the
company’s share price is holding up so well.

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Summary

The company compares favourably with the sector average figures for profitability, however
the company’s liquidity and gearing position is quite poor and gives cause for concern. If it is
to replace its old assets in the near future, it will need to raise further finance. With already
high levels of borrowing and poor dividend yields, this may be a serious problem for
Comparator.

Question 4

(a) It has been suggested that ratio analysis is not necessarily the best way of assessing a
company’s performance.

Required:

i) Describe TWO uses of accounting ratios other than performance assessment. (2 marks)
ii) Explain any THREE limitations of the use of accounting ratios in appraisal of financial
performance. (3 marks)

(b) Below are the financial ratios for the year 2015 for Decimal Limited, a company engaged
in the buying and shipment of agricultural products. The ratios for the industry have also
been provided.

Decimal Industry
Limited Average
Quick ratio 0.52:1 0.84:1
Current ratio 1.20:1 1.80:1
Debtors collection period 46 days 41 days
Creditors payment period 70 days 50 days
Inventory holding period 58 days 48 days
Dividend yield 3.60% 9%
Debt to equity 85% 45%
Dividend cover 1.4 times 3.4 times
Gross profit margin 18% 28%
Net profit margin 8% 12.80%
Return on capital employed 28% 14%
Net assets turnover 4.2 times 1.9 times

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Required:

Write a report to the Shareholders of Decimal Ltd assessing its performance in comparison
with the industry in respect of profitability, liquidity, efficiency and shareholders’ investment

Question 5

Kack Ltd is a listed company that assembles domestic electrical goods which it then sells to
both wholesale and retail customers. Kack Ltd.’s management was disappointed in the
company’s results for the year ended 31 March 2014. In an attempt to improve performance,
the following measures were taken early in the year ended 31 March 2015:

A national advertising campaign was undertaken. Rebates to all wholesale customers

purchasing goods above set quantity levels were introduced.

The assembly of certain lines ceased and was replaced by bought in completed products. This
allowed Kack Ltd to dispose of surplus plant.

Kack Ltd.’s summarised financial statements for the year ended 31 March 2015 are set out
below:

STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME

FOR THE YEAR ENDED 31 MARCH 2015

GH¢’m
Revenue (25% cash sales) 4,000
Cost of sales (3,450)
Gross profit 550
Operating expenses (370)
Operating profit 180
Profit on disposal of plant (note (i)) 40
Financial charges (20)
Profit before tax 200
Income tax expense (50)
Profit for the year 150

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STATEMENT OF FINANCIAL POSITION AS AT 31 MARCH 2015

GH¢’m GH¢’m
Non-current Assets
Property, Plant and equipment (note (ii)) 550
Current Assets
Inventory 250
Trade receivables 360
Bank nil 610
Total Assets 1,160
Equity and Liabilities
Stated capital (400m shares) 100
Income Surplus 380
480
Non-current liabilities
8% loan notes 200
Current liabilities
Bank overdraft 10
Trade payables 430
Current tax payables 40 480
Total equity and liabilities 1,160

Below are ratios calculated for the year ended 31 March 2014:

Return on year end capital employed (profit before interest

and tax over total assets less current liabilities) 28.10%
Net assets (equal to capital employed) turnover 4 times
Gross profit margin 17%
Net profit (before tax) margin 6.30%
Current ratio 1.6:1
Closing inventory holding period 46 days
Trade receivables’ collection period 45 days
Trade payables’ payment period 55 days
Dividend yield 3.75%
Dividend cover 2 times

Notes

Kack Ltd received GH¢ 120m from the sale of plant that had a carrying amount of GH¢ 80m
at the date of its sale.

The market price of Kack Ltd.’s share throughout the year averaged GH¢3.75 each.

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There were no issues or redemption of shares or loans during the year.

Dividends paid during the year ended 31 March 2016 amounted to GH¢ 90m, maintaining the
same dividend paid in the year ended 31 March 2015.

Required:

(a) Calculate ratios for the year ended 31 March, 2015 (showing your workings) for Kack Ltd,
equivalent to those provided above. (10 marks)
(b) Analyse the financial performance and position of Kack Ltd for the year ended 31 March
2015 compared to the previous year. (10 marks)

(Total: 20 marks)

(ICAG Nov. 2015)

Question 6

In 2012, the management team of Sawaleh Ltd, a manufacturer of motorcycle parts, acquired
the company from its parent company in a management buyout deal. The managers of the
company are considering the possibility of listing on the Ghana Stock Exchange. The following
financial statements relates to the company:

Sawaleh Ltd

Statement of financial position as at June 30 2016

Non-current assets GH¢000 GH¢000

Land and buildings 3,600
Plant and machinery 9,900
13,500
Current assets:
Inventories 4,400
Trade receivables 4,700
Cash in hand and at bank 1,000 10,100
23,600
Equity and Liabilities
Ordinary share capital issued at Gh¢1 each
Voting 1,800
“A” Shares (Non-voting) 900
Retained earnings 9,700

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Shareholders’ funds 12,400

Non-Current Liabilities
12% Debenture loan (2018) 2,200

Current Liabilities
Bank Overdraft 2000
Trade payables 7,000
23,600

Statement of profit or loss for the year ended June 30 2016

GH¢'000
Revenue 36,500
Cost of sales (31,600)
Profit before interest and taxes 4,900
Interest (1,300)
Profit before taxes 3,600
Taxation expense (500)
Profit attributable to ordinary shareholders 3,100
Dividends (300)
Retained profit 2,800

The industry performance average ratios in which Sawaleh Ltd operates are stated below.
Industry sector ratios
Price/earnings ratio 10
Interest cover 4.5
Dividend cover 4
Total debt: equity 24%
Quick (acid test) ratio 1.0:1
Current ratio 1.6:1
Operating profit as percentage of sales 11%
Return after tax on equity 16%
Return before interest and tax on long-term capital employed 24%

Required:

As a newly qualified accountant working with Sawaleh Limited, you are to write a memo to
the CEO of the company evaluating the financial position and performance of Sawaleh Limited
by comparing it with that of its industry sector given above. (10 marks)

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(ICAG May 2017 P3)

Question 7

Mion Ltd is a listed company in Ghana and operates many super markets in Ghana. During the
year 2014, there was speculation in the financial press that the entity was likely to be a takeover
target for larger companies in Ghana. A recent newspaper publication has suggested that the
directors are unlikely to resist a takeover. The seven-member board are all nearing retirement
and all own significant minority shareholdings in the business.

You have been approached by a private shareholder in Mion Ltd. She is concerned that the
directors have conflict of interests and that financial statements for 2014 may have been
manipulated. The income statement and summarized statement of changes in equity of Mion
together with comparatives for the year ended 31st December 2014 and a statement of financial
position as at that date are given below:

INCOME STATEMENT FOR THE YEAR ENDED 31ST DECEMBER 2014

2014 2013
GH¢’m GH¢’m
Revenue 1,255 1,220
Cost of sales (1,177) (1,145)
Gross profit 78 75
Operating expenses (21) (29)
Profit from operations 57 46
Finance cost (10) (10)
Profit before tax 47 36
Income tax (14) (13)
Net profit 33 23

SUMMARISED STATEMENT OF CHANGES IN EQUITY

2014 2013
GH¢’m GH¢’m
Opening balance 276 261
Profit for the period 33 23
Dividends (8) (8)
Closing balance 301 276

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STATEMENT OF FINANCIAL POSITION AS AT 31ST DECEMBER 2014

2014 2013
GH¢’m GH¢’m
NON-CURRENT ASSETS
Property, Plant& Equipment 580 575
Goodwill 100 100
680 675
CURRENT ASSET
Inventory 47 46
Receivables 12 13
Cash 46 12
105 71
TOTAL 785 746

EQUITY
Share Capital 150 150
Retained Earnings 151 126
301 276
NON-CURRENT LIABILITIES
Interest-bearing borrowing 142 140
Deferred Tax 25 21
167 161
CURRENT LIABILITIES
Trade & other payables 297 273
Short-term borrowing 20 36
317 309
785 746

The following additional information is relevant:

i) Non-current asset turnover (including both tangible and intangible non-current asset): 1.93

ii) Mion Ltd.’s directors have undertaken a reassessment of useful lives of non-current
tangible assets during the year. In most cases they estimate that the useful lives have
increased and the depreciation charges in 2014 have been adjusted accordingly.

iii) Six new stores have been opened during 2014, bringing the total to 42.

iv) Three key ratios for the supermarket sector (based on the latest available financial statement
of 12 listed entities in the sector) are as follows:
 Annual sales per store: GH¢27.6m

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 Gross Profit margin: 5.9%

 Net profit margin: 3.9%

Required:

(a) Prepare a report and address to the investor, analysing the performance and position of
Mion Ltd based on the financial statements and supplementary information provided above.
The report should also include comparisons with key sector ratios, and it should address
the investor’s concerns about the possible manipulation of the 2014 financial statements.

(15 marks)

(b) Evaluate with examples, the significance of each of the following to an analyst seeking to
estimate the effect on future cash flows or liquidity of a company:
i) a commitment and a contingent liability. (2 marks)
ii) income in advance and a deposit (1.5 marks)
iii) an accrual and a provision (1.5 marks)

(5 marks)
(Total: 20 marks)
(ICAG May 2016 P3)

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