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Grade: 11 Subject: Accounting
Name: _____________________ Date:_____________
Ratio Analysis
Worked example 1:
On 1 October 2013 Manny Kyoor and his wife formed a limited company, Kyoor Ltd , and each paid
in $37500 as share capital. The bank loaned the company a further $80000 at 9% interest per
annum. At 30 September 2014 the business’s final accounts were drawn up as follows:
Income statement for the year ended 30 September 2014
Revenue 350000 (-) Cost of Sales: Inventory (1st^ October 2013) 31500 (+) Purchases 280000 311500 (+) Inventory (30th^ September 2014) 66500 245000 Gross Profit 105000 (-) Expenses: Rent and Rates 3950 Advertising 1750 Wages 29000 Heat and Light 5250 Depreciation 12000 (51950) Profit from operations 53050 (-) Finance costs (debenture interest) (7200) Profit for the year 45850
Statement of financial position as at 30 September 2014
Non current assets: Cost $
Depn $
NBV
Premises 124000 - 124000 Fixtures and fittings 48000 12000 36000 172000 12000 160000
Current assets: Inventory 66500 Trade receivables 21500 88000
(-) Current liabilities: Trade payables 21000 Accrued debenture interest 7200 Bank overdraft 18950 (47150) Net current assets 40850 Capital employed 200850 (-) Non current liabilities: 9% Debentures (80000) Net assets 120850 Equity: 75000 Ordinary shares of $1 each 75000 Retained profit 45850 120850
Industry average ratios and other relevant data concerning businesses similar to Kyoor Ltd were as follows:
(i) Gross Profit margin 30.00% (ii) Net Profit percentage 18.07% (iii) Current ratio 2.21: (iv) Liquid (quick) ratio 1.02: (v) Inventory turnover ratio 8 times (vi) Non current assets turnover ratio 50.18% (vii) Return on total assets 25.37%
(viii) Return on net assets 34.93% (ix) Trade receivables collection period 25 days (x) Trade payables payment period 30 days
(a) Calculate each of the above ratios, to 2 decimal places, for Kyoor Ltd.
(b) Define each ratio and Comment on the business performance in the light of the data for the industry. Suggested answer:
(a)
Kyoor Ltd
(i) Gross profit margin = 105000 x 100 = 30 % 350000
(ii) Net profit ratio = 45850 + 7200 x 100 = 15.16 % 350000
but it is not apparent whether this is on the straight line or the reducing balance method. The depreciation charged may be higher than the average rate for the industry.
Current ratio measures a company's ability to pay short-term debts.The current ratio of 1.87:1 is
slightly lower than the industry average of 2.21:1. It may not be worse as a high ratio is not necessarily good. At 1.87 it should be considered ‘safe’.
The Acid-test or quick ratio or liquid ratio measures the ability of a company to use its
current assets (excluding inventory) to cover its current liabilities. A liquid ratio of 0.46:1 is worse than the industry average of 1.02:1 because of the large bank overdraft. It is probably about half what it should be. As the trade payables payment period is only 28 days, the company must be heavily reliant upon its bank overdraft to meet emergencies.
The inventory turnover ratio is an efficiency ratio that shows how effectively inventory is
managed by comparing cost of sales with average inventory for a period. This measures how many times average inventory is "turned" or sold during a period. The inventory turnover ratio is worse than the industry’s’ average as it is only 5 times compared with 8 times for the industry. Closing inventory is more than twice the opening inventory it suggests that the inventory being carried is too high, which may result in additional costs for the company.
Non current assets turnover is an efficiency ratio which tells how successfully the company is
using its assets to generate revenue. If a company can generate more sales with fewer assets it has a higher turnover ratio which tells it is a good company because it is using its assets efficiently. A lower turnover ratio tells that the company is not using its assets optimally. The company’s non current assets turnover percentage of 45.71% is lower than the industry average of 50.18%. The company is not using its non current assets as efficiently as the average company. This may be due to the fact that accounts cover only the first year of the business before it had become properly established.
Return on total assets measures the profit from operations in relation to the total assets. It
identifies how well the investments of the company (the total assets) have generated earnings back to the company. Smart companies strictly control major purchases, attempting to limit those that will best bring a return in greater revenue to the company. The return on total assets is a useful way to measure how well the company is actually able to make intelligent choices on how to spend its money on new assets. The return on total assets is 21.39% as compared to industry average of 25.37%. Similarly, this may be explained by the fact that it is only the first year of the business before it had become properly established.
The return on net assets compares profit from operations to net assets to see how well a
company is able to utilize its asset base to create profits. A high ratio of assets to profits is an indicator of excellent management performance. The company’s return on net assets of 43.89% is higher than the industry average of 34.93%. This is unusual comparing the return on total assets. It could be due to the high level of loan.
The trade receivables collection period is used to measure how effective a company is in
extending credit as well as collecting debts. A high ratio implies either that a company operates on a cash basis or that its extension of credit and collection of trade receivables is efficient. While a low ratio implies the company is not making the timely collection of credit. A period at 23 days is 2 days better than the industry average of 25 days. This marginally helps cash flow of the company.
The trade payables payment period is a short-term liquidity measure used to quantify the rate at
which a company pays off its suppliers. If the payment period is falling from one period to another, this is a sign that the company is taking longer to pay off its suppliers than it was before. A period at 28 days is 2 days less than the industry average of 30 days. Failure to take full advantage of the period of credit allowed by suppliers is generally not the most efficient management of cash. An early payment is good for relations with suppliers, but not good for cash flow.
Worked example 2:
The following information summarises the latest set of final accounts of Worky Tout & Co., a partnership.
At 30 April 2014
Inventory $45000 (This was 50% more than the inventory at 30 April 2013)
For the year ended 30 April 2014
Inventory turnover 12 times
Gross profit margin 40%
Net profit margin 18%
Non current asset turnover 3 times
W 6 Non current assets = 750000 / 3 = $ 250000
W 7 Trade receivables = X x 365 = 36 Days 750000 = 750000 x 36 = $ 74000 365
W 8 Trade payables = 465000 x 40 = $ 51000 365
W 9 Bank (X) = 45000 + 74000 + X = 3 : 1 51000 X = 119000 - 153000 = $ 34000
(a) Income statement for the year ended 30 April 2014
$ $ Sales (W 4) 750000 (-) Cost of Sales: Inventory (1 May 2013) (W 1) 30000 (+) Purchases (balancing figure) 465000 495000 (+) Inventory (30 April 2014) (45000) Cost of sales (W 2) (450000) Gross Profit (W 3) 300000 (-) Expenses: Expenses (165000) Net Profit (W 5) 135000
Statement of financial position as at 30 April 2014
Non current assets: $ $ Non current assets (W 6) 250000
Current assets: Inventory 45000 Trade receivables (W 7) 74000 Bank (W 9) 34000 153000 (-) Current liabilities: Trade payables (W 8) (51000) Working capital 102000 Net Assets 352000
Financed by:
Partners’ Capital (balancing figure) 342000 (+) Net profit 135000 (-) Drawings (125000) 352000
(b) Comments:
Inventory turnover WT’s stock turn of 12 times is better than Z’s 10 times. WT’s gross profit percentage suggests that it is selling inventory at prices below those charged by Z.
Gross profit % WT’s gross profit percentage at 40% is 5% lower than Z’s. While WT’s prices may be lower than Z’s , it is possible that Z is obtaining supplies more cheaply than WT.
Net profit % WT’s net profit percentage at 18% is 2% lower than Z’s. However, WT’s overheads are 22% of sales compared with Z’s 25%. WT appears to control its costs more efficiently than Z.
Non current asset turnover
Z is utilising its assets more efficiently (i.e. 3.5 times) than WT 3 times. This is reflected in profitability of the firm.
Trade receivables days WT’s customers are taking 6 days longer to pay than Z’s customers. Z appears to have a more efficient credit control system. If the trend continues than WT may face cash flow problems in future.
Trade payables days WT takes 12 days longer than Z to pay its suppliers. It suggests that either WT may be straining its relations with its suppliers or Z may not be taking full advantage of its credit to improve its cash flow. Delaying payments to suppliers, may affect WT‘s stock turn ratio and also probably may not be able to avail cash discounts as well.
Worked example 3 –
The Profit and loss account of Ahmed a sole trader at 30 June 2008 has been drawn up and the following balances remain in the books: $ Ahmed capital? 10% bank loan 90 000 Net profit 15 000 Trade creditors 29 00 Trade debtors 36 000 Stock, at cost 111 510 Plant and machinery, at cost 211 800 Provision for depreciation on plant and machinery 76 140
(b) Importance of the ratio for the return employed when using ratio analysis are:
(i) Its main purpose is to give a dependable measure of judging the over-all efficiency or inefficiency of the business. Rate of capital employed reveals how effectively the capital has been used.
(ii) It reflects on a business borrowing policy. For example the return on capital employed is 8%
and the business has borrowed money at 9% then definitely the business borrowing policy is bad and it should depend upon owned capital unless it is impossible for them.
Fixed assets: $ $ Premises at cost 255 000 Plant and machinery at cost 211 800 (-) Provision for depreciation (76 140) 135 660 390660 Current assets: Stock 111 510 Debtors 36 000 Cash in hand 1 170 (148 680) (-) Current Liabilities: Creditors 29 340 Bank Overdraft 45 000 74 340 Working Capital (Current assets – Current liabilities) 74 340 Capital employed 465000
(-) Long term liabilities: 10% bank loan (90000) Net assets 375000
Financed by: Ahmed Capital (1 July 2007) 370000 (+) Net profit 15000 (-) Drawings (10000) Capital (30 June 2008) 375000
(c) (i) Current ratio = Current Assets
Current liabilities
= Debtors + Stock + Cash in hand Creditors + Bank overdraft
Quick ratio = Current Assets - Stock Current liabilities
= Debtors + Cash in hand Creditors + Bank overdraft
Comments - Current ratio helps us to study the ability of the business in paying off its liabilities due in the next 12 months. In the above workings the current ratio is 2 times that is Ahmed has about $2 available in Current Assets to meet every $1 of its current financial obligations.
Quick ratio studies the ability of the business in paying off current liabilities within a short notice, from assets readily convertible into cash. From the calculations in c (i) we see that quick ratio is 0.5 to 1. This means that $0.50 is available in quick /liquid assets to meet every $1 of its current financial obligations. This is not a healthy situation as the reputation of the business will certainly suffer if the business cannot meet its liabilities when they fall due for payment.
At 30 April 2008 Stock $45000 (This was 50% more than the stock at 30 April 2007) For the year ended 30 April 2008 Stockturn 12 times Gross profit margin 40% Net profit margin 18% Fixed asset turnover 3 times Average time taken by debtors to pay: 36 days (based on a year of 365 days) Average time taken to pay creditors: 40 days (based on a year of 365 days) The current ratio is 3 : 1 The only current assets of the firm consist of stock, debtors and balance at bank. Partners’ drawings for the year $125000. All sales and purchases were on a credit basis. Required:
(c) Prepare, in as much detail as possible the Trading and Profit and Loss Account of Worky Tout & Co. for the year ended 30 April 2008 and a Balance Sheet as at that date. (All calculations should be made to the nearest $000.)
The following information is available for Zenopad, a similar business, for the year ended 30 April 2008.
Stockturn 10 times
Gross profit margin 45%
Net profit margin 20%
Fixed asset turnover 3½ times
Time taken by debtors to pay 30 days (based on a year of 365 days) Time taken to pay creditors 28 days (based on a year of 365 days)
(d) Compare the performance of Worky Tout & Co. with that of Zenapod. Indicate the ratios which show that one business is more efficient than the other. Your answer should be in sentence form with supporting figures.
2. Najim wants to analyse the results of his trading for the year ended 31 December 2008 and has prepared his Trading and Profit and Loss Account and Balance Sheet. He compares these with the final accounts for the previous year. The Trading and Profit and Loss Accounts and Balance Sheet for the two years are as follows.
Trading and Profit and Loss Accounts
For the year ended 31 st^ December 2007
For the year ended 31 st^ December 2008 $ $ $ $ Sales 172308 187500 (-) Cost of sales: Opening stock 12000 16000 (+) Purchases 116000 125500 128000 141500 (-) Closing stock 16000 112000 14000 127500 Gross profit 60308 60000 (-) Expenses 38769 32678 Net Profit 21539 27322
Balance Sheet as at
Fixed assets (net book values) 78322 93750 Current assets: Stock 16000 14000 Trade debtors 9914 12511 Bank 4851 7185 30765 33696 (-)Current liabilities: Trade Creditors 13984 16781 17192 16504 95103 110254 Financed by: Opening capital 81176 95103 (+) Net profit 21539 27322 102715 122425 (-) Drawings 7612 12171 95103 110254
Further information:
1. 60% of Najim’s sales are on credit. 2. Najim purchases all his stock of goods on credit. 3. The only current assets are stock, trade debtors and a bank balance.
Required:
Stockturn 12 times Gross profit margin 40% Net profit margin 20% Fixed asset turnover 5 times Debtors’ days 31 Creditors’ days 36
Required:
(b) Compare Virtue’s performance with that of Patience and indicate the ratios that show which business is the more efficient. You should write your answer in sentence form and include supporting figures.
4. During the year to 31 December 2008 Timberlake Ltd has attempted to stimulate sales and increase its profits by reducing selling prices, holding larger stocks and giving customers longer credit. All of the company’s purchases and sales are on credit terms. The summarised accounts for the years to 31 December 2007 and 2008 are as follows:
Timberlake Ltd Profit and Loss accounts for the year to 31 December
2007 $
Turnover 3725 5327 (-) Cost of sales 2905 4420 Gross profit 820 907 (-) Net operating expenses 45 87 Operating profit 775 820 (-) Interest payable 25 130 Profit on ordinary activities before taxation 750 690 (-) Tax on profit on ordinary activities 225 215 Profit on ordinary activities after taxation c/f 525 475 (-) Dividend 400 400 Retained profit for the year 125 75
Timberlake Ltd Balance sheets as at 31 December
$000 $ Fixed assets 5100 5520 Current assets: Stocks 730 1334 Debtors 596 1278 Bank 400 11 1726 2623 (-) Creditors – due within a year: Trade creditors 618 1020 Taxation 225 215 Dividends 400 400 1243 1635 Net Current Assets 483 988
(-)Creditors – due more than a year: Debenture loans 150 1000 5433 5508 Share Capital and reserves: Ordinary shares of $1each 2000 2000 Profit and loss account 3433 3508 5433 5508
Required:
Calculate the following ratios for Timberlake Ltd for each of the two years concerned and comment on your results:
(a) Return on total capital employed (b) Return on equity (c) Gross profit margin (d) Net profit margin (e) Current ratio (f) Quick ratio (g) Stock holding period (h) Debtor collection period
5. The following information concerns two companies - one of which manufactures electrical components and the other is a goods retailer.
Company A Company B Cost of goods sold $400000 $ Gross profit margin 50% 30% Net profit ratio 15% 5% Current ratio 1.5 : 1 6.6 : 1 Debtor days outstanding (calculation based on total sales) 45 days 6 days Stock $ 40000 $ 50000 Bank balance (debit) $ 28000 $ 15000 Loan capital $1200000 $ Gearing ratio (Loans as a percentage of total capital employed) 60% 12½%
Note: Figures for assets and liabilities relate to the balance sheet figures at the end of the year. You may assume that there are 360 days in the year.
Required:
(a) Identify (giving at least two reasons) which company is the electrical manufacturer and which is the food retailer.
(b) Prepare, so far as the information allows, profit and loss accounts and balance sheets for both companies for the past year.
(c) What is meant by liquidity? Which company would you regard as the more likely to have liquidity problems? Why?
6. AX Limited is a manufacturing company which has experienced rapid growth in recent years. The financial director is concerned that although the company is apparently trading successfully, some elements of working capital appear to be getting out of control. He tells you that ‘three years ago
On 1 October 2001 Manny Kyoor and his wife formed a limited company, Kyoor Ltd , to run a beautician’s business, and each paid in $37500 as share capital. The bank loaned the company a further $80000 at 9% interest per annum. At 30 September 2002 the business’s final accounts were drawn up as follows:
Trading and Profit and Loss Account for the year ended 30 September 2002
$ $ Sales and fees 350000 (-) Cost of Sales: Stock (1 October 2001) 31500 (+) Purchases 280000 311500 (+) Stock (30 September 2002) 66500 245000 Gross Profit 105000 (-) Expenses: Rent and Rates 3950 Advertising 1750 Wages 29000 Heat and Light 5250 Interest due 7200 Depreciation 12000 59150 Net Profit 45850
Balance Sheet as at 30 September 2002 Fixed Assets Cost Depn NBV $ $ $ Premises 124000 - 124000 Fixtures and fittings 48000 12000 36000 172000 12000 160000 Current Assets Stock 66500 Debtors 21500 88000
Amounts to be settled within one year Creditors 21000 Interest due 7200 Bank overdraft 18950 47150 40850 200850
Amounts to be settled after more than one year Long term loan 80000 120850
Share Capital and Reserves 75000 Ordinary shares of $1 each 75000 Retained profit 45850 120850 Industry average ratios and other relevant data concerning businesses similar to Kyoor Ltd were as follows:
(i) Gross Profit percentage 30.00% (ii) Net Profit percentage 18.07% (iii) Current ratio 2.21: (iv) Liquid (Quick) ratio 1.02: (v) Stock Turnover ratio 8 times (vi) Fixed Assets to Sales 50.18% (vii) Return on Total Assets 25.37% (viii) Return on Net Assets 34.93% (ix) Debtors’ Payment period 25 days (x) Creditors’ payment period 30 days
(b) Calculate each of the above ratios, to 2 decimal places, for Kyoor Ltd.
(c) Comment on the business performance in the light of the data for the industry.
8. Following are the summarised Profit Statements and Balance Sheets for Greenyards manufacturing company, and Poynder Ltd , a retailer.
Greenyards Ltd Poynder Ltd Profit Statements for the years ended 31 March 2001 2002 2001 2002 $000 $000 $000 $ Sales 500 610 425 460 Cost of sales (245) (355) (210) (230) Operating costs (225) (230) (190) (200) Loan interest paid (7) (10) (7) (3) Net profit 23 15 18 27
Balance sheets at 31 March Fixed Assets at Net Book Value 150 225 220 175 Stock 50 60 27 20 Debtors 20 30 - - Bank 10 (35) 13 57 Creditors (25) (20) (35) (50) 205 260 225 202
Share capital 50 50 50 50 Retained profit 95 110 100 127 Long term loans 60 100 75 25 205 260 225 202
Required:
(a) Use Six ratios to compare the management’s performance from 2001 to 2002 for each company. Use year end figures, not averages, to calculate ratios. Give answers to a maximum of one decimal place. Show all workings.
(b) Comment on your findings.
(c) State six short comings or dangers in using ratio analysis.
