Chapter 18
Interpretation of Financial Statements
Process of Interpretation of Financial Statements
Interpretation and analysis involve:
- Identifying users
- Examining financial information
- Analysing (comparison, evaluation and prediction)
- Reporting in a format to provide information for economic decision-making
Users of Financial Statements
- Internal Users
The ability of an organisation to analyse its financial position is essential for improving its competitive standing. Analysis of financial performance helps organisations identify opportunities to improve performance.
- External Users
The objective of general-purpose financial reporting is to provide information useful to the primary users in making decisions relating to providing resources to the entity. Users external to the entity will generally have access only to published financial statements. Whereas investors may be most interested in growth potential, lenders will be concerned with the availability of cash (to ensure they are paid on time) and the quality of assets provided as security.
Activity 1
Match the following users of financial statements to their corresponding opinions.
Ratio Analysis
Financial statements are analysed with the use of ratios.
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Definitions |
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A ratio is an expression of a quantitative relationship between two numbers. Ratio analysis is determining ratios for meaningful comparisons and interpreting them. |
Purpose of Ratio Analysis
The purpose of calculating and analysing the ratios for a company can assist users of financial statements by:
Providing a uniform measurement which will act as an indicator of:
- areas for further investigation in the current period
- the pattern of results over a series of periods (trend analysis)
- Summarising large quantities of financial data into information that can be used to make qualitative judgments about an entity’s financial performance.
Reducing financial data to fewer expressions of variables which is useful when:
- the relationship between amounts is of interest (rather than absolute monetary amounts)
- the information generated will be reviewed over time (as in trend analysis).
- Indicating areas where the entity may be strong or weak (rather than evaluate financial performance in “good/bad” terms).
Comparisons of Ratio Analysis
The results of the ratio analysis are typically compared between:
- previous and current periods (historical comparison)
- target/budgeted (or standard) and actual figures
- other companies/industry averages (similar industry comparison)
- For comparisons to be meaningful, they should be based on functionally related amounts. For example, bad debt expense is a function of trade receivables rather than revenue (so a percentage of trade receivables will be preferable for analysis).
Classifications of Ratios
Ratios may be classified on several bases. For example:
- Basis of financial statements Ratios are derived from the statement of financial position and the statement of profit or loss. (Position ratios)
By function Ratios consider the needs of users for information about:
- How the business is performing (Profitability and Efficiency)
- How it stands financially (Liquidity and Position)
- Its potential (market standing).
Classification is subjective for example, liquidity ratios are also position ratios.
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Exam advice |
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Investor (market standing) ratios such as earnings per share (EPS), price-earnings ratio (P/E ratio) and dividend yieldare NOT examinable in Financial Accounting. |
Introduction to Profitability Ratios
General profitability ratios are derived from statements of profit and loss alone. In contrast, overall profitability ratios consider the entity’s size as represented by its capital in the statement of financial position.
Profitability ratios show how a company’s income compares with its expenses. They can indicate how well the business has been keeping control of its costs.
The types of profitability ratios are illustrated in the diagram below:
Gross Profit Margin
The gross profit margin ratio shows how profitable a company’s trading has been. It indicates how much the company has been able to mark up the sales price of its goods above the costs it has incurred.
This ratio is often used to compare companies in the same business sector.
Typical gross profit margins will vary across different business sectors, making comparison less useful.
Revenue is net of discounts and customer returns
Gross profit = Revenue - Cost of goods sold
Cost of goods sold (or cost of sales):
For a trading company = Opening inventory + Purchases Closing inventory
For a manufacturing company, it includes conversion costs (labour, overheads, etc.)
The margin must cover all operational expenses and meet management’s requirements for increasing reserves (retained earnings) and shareholders’ requirements (for dividends).
Gross Profit Margin Analysis
Gross profit percentage provides insight into the relationship between purchasing costs and revenues.
A low or declining gross profit margin is usually an adverse sign.
The decline in the gross profit margin may be due to any of the following:
- Fall in selling prices (For example, due to increased competition)
- a change in sales mix (For example, to remain relevant and competitive)
- an increase in purchase costs (For example, due to a fall in discounts received if management is unable to buy sufficient bulk)
- an increase in production costs such as materials, labour, or overheads
- an overstatement of opening inventories (For example, due to an error in counting or valuing inventory or inventory losses)
- an understatement of closing inventories.
- A decline may not always reflect a problem. For example, a drop may be due to the launch of a new product at a low (penetration) price or an attempt to increase market share.
- An increasein the gross profit margin may be due to the following:
- an increase in selling price without a corresponding increase in cost
- a decrease in costs which has not been passed on proportionately to customers
- an understatement of opening inventory or overstatement of closing inventory.
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Exam advice |
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Pay attention to inventory valuation. If allowances for obsolete or slow-moving items are understated, closing inventory will be overstated, and the gross profit percentage will be overstated. |
Operating Profit Margin
The operating profit margin indicates how much revenues exceed the costs of operating the company, which includes the cost of goods sold, selling, and general and administrative expenses. It considers all operating overheads.
Operating profit margin shows the overall profitability of the business after deducting all operating expenses.
It measures how well the business has managed to control indirect costs.
Operating Profit Margin Analysis
The operating profit margin is an indicator of the control of operating expenses.
Therefore, the movement in operating profit margin should be compared to the movement in gross profit margin:
The operating profit margin would be expected to improve/deteriorate in line with the gross profit margin.
A relative improvement in operating profit margin could be due to good indirect cost control or a significant one-off gain (For example, profit on disposal of an asset)
A relative deterioration in operating profit margin could be due to a weakening cost control or high one-off costs.
This ratio may be investigated further by calculating specific expense items as a percentage of sales, for example:
Fixed costs (such as rent) may not change in line with revenue (as they may be stepped costs) which can cause the operating profit percentage to fluctuate when revenues are unstable.
The operating profit percentage would not be expected to fluctuate much if the main costs were variable.
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Example 1 |
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The statement of profit or loss of Caixin Co for the year ended 31 March 20X5 has been prepared as follows:
Caixin Co’s gross profit margin = (Gross Profit 7,090 ÷ Sales 19,350) x 100% = 36.6% Caixin Co’s operating profit margin = (PBFIT 3,680 ÷ Sales 19,350) × 100% = 19.0% Shareholders can compare each company’s ratios to other years and will draw their conclusions on how well the company has kept control of its costs for the current year. Likewise, company directors could compare their figures against other businesses to determine how well the company performs. |
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Return on Capital Employed (ROCE)
The return on capital employed (ROCE) is the primary profitability ratio. It shows how productively (efficiently and effectively) a business has deployed its available resources, irrespective of how they have been financed. It relates the overall profit performance to the amount of capital employed in the business.
The return on capital employed ratio shows how effectively a company generates profit from its capital.
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Profit before financing and income taxes = the profit before interest and dividends have been paid to finance providers, such as banks and shareholders.
Capital employed = the funds that belong to shareholders plus loans not repayable within one year. It can be calculated as:
Total Assets less Current Liabilities or
Shareholder’s Equity plus Long-term Liabilities
Return on Capital Employed Analysis
An increase in the ROCE percentage is generally an improvement.
If the ROCE margin falls or is low, this may indicate the following:
- The entity is not using its resources efficiently. A low return may result in a loss if the economy deteriorates.
- Management will need to investigate further as there may be a need to increase operating profit or sell some assets and invest the proceeds elsewhere to earn a higher return.
However, any trend that emerges by making comparisons with the previous years’ ROCE may be distorted by:
- assets which are written down to low carrying amounts (overstating ROCE)
- revaluations which will depress ROCE (higher capital → higher depreciation → lower profit)
- timing of share/debt issues
- changes in accounting policies
- If a part of the business does not meet the entity’s target ROCE (i.e. budget), management may dispose of it.
The business’s return on capital employed should exceed its cost of capital for long-term sustainability.
Interrelationship with other Ratios
The return on capital employed can be further analysed into operating profit margin and asset turnover as follows:
Profit margin is often seen as a measure of the quality of profits. A high profit margin indicates a high profit on each unit sold.
Asset turnover is often seen as a quantitative measure, indicating how efficiently management uses the assets.
The interrelationship between profitability and efficiency can be used to provide insights into the ROCE for a particular business. For example, if a company experiences a decline in ROCE, it could be due to a fall in profitability or a drop in efficiency (or both).
Note that the calculation of ROCE shown above (operating profit margin x asset turnover) only works if profit before financing and income taxes is the same as operating profit.
Asset Turnover
Asset turnover shows the number of times the carrying amount of assets is turned over in generating revenue. For businesses in the same industry, the higher the ratio, the more efficiently the assets appear to be used.
Asset turnover shows how efficiently an entity uses its capital to generate sales.
Asset turnover is affected by the business’s accounting policy regarding depreciation and amortisation.
For example, two companies are of equivalent size and generate the same revenue. The one with the lower asset value will have a higher asset turnover. The lower carrying amount of assets may be due to tangible assets being written off over shorter estimated useful lives.
Introduction to Liquidity Ratios
Short-term liquidity ratios concern financial stability. If they indicate that an entity cannot meet short-term liabilities from available assets, there will be going concern implications. The two most common measures are the current ratio and the quick ratio.
Current Ratio
The current ratio measures the adequacy of current assets to meet short-term liabilities (without raising additional finance). This ratio is an overall measure of liquidity and the state of trading.
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Current assets and liabilities include all items classified as such on the statement of financial position. Current liabilities will therefore include dividends and taxation payable.
However, where a bank overdraft is permanent (maintained from year to year), it may be excluded from current liabilities even though it is legally repayable on demand.
Current Ratio Analysis
- The higher the current ratio, the more liquid the business is. As liquidity is essential to business survival, a higher ratio usually is preferable to a lower one.
- If low/declining, the entity may not meet its short-term obligations as they become due.
- A high/increasing ratio might suggest over-investment in current assets (inventories, trade receivables or cash).
- A current ratio of 1.5:1 is usually acceptable (to maintain creditworthiness).
- A lowratio may indicate overtrading or under-capitalisation
- A highratio may indicate under-trading or overcapitalisation
The current ratio treats all assets alike though they are not equally or readily realisable. In particular, the nature of inventories should be considered. For example, if inventories are slow-moving, the quick ratio is a better indicator of more immediate solvency.
Quick Test Ratio
The quick test (or acid test) ratio measures immediate liquidity by eliminating from current assets the least liquid assets (inventories). This reflects the possibility that the company finds it challenging to convert inventory into cash compared to other current assets.
The quick ratio is a stricter test of liquidity:
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The quick ratio indicates the sufficiency of resources (trade receivables and cash) to settle short-term liabilities (trade payables in particular).
Quick Ratio Analysis
- A ratio of 1:1 is usually considered the typical acceptable quick ratio. However:
- Industries with high cash sales and high inventory holding period (for example, supermarkets) have very low quick ratios.
- A manufacturing entity with seasonal sales but steady production is likely to have a lower ratio when sales volume is low (lower trade receivables and cash) and a higher ratio when sales are high.
- When analysing the quick ratio, an entity’s operating overdraft and facilities available should be considered. For example, an entity with a low quick ratio may have no problem settling current liabilities if it has adequate overdraft facilities.
Window Dressing
Window dressing may be used to present financial statements in a more favourable light to gain benefits such as:
- obtain funding/borrow money
- reduce tax payments
- smooth profits
- hide liquidity/profitability problems that might reflect poor management decisions.
- Various actions may be taken to create the desired effect.
For example, to improve liquidity, trade payables may be treated as paid at the reporting date, although they are not settled until a later date.
However, accounting for items incorrectly has ethical implications and such practices contravene ACCA’s Code of Ethics and Conduct.
Introduction to Efficiency Ratios
The efficiency ratios analyse how well a company manages its assets and liabilities internally.
The efficiency ratios calculate inventory holding, receivables collection, and payables payment periods.
Inventory Holding Period
Inventory holding period measures the average time a company holds unsold goods. The ratio measures operational and marketing efficiency.
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The ratio above has used the closing inventory, but for a more accurate figure, the average inventory value for the year should be used, if the information is available. In a SFP there should be two years’ figures (the current year and the previous year), which would show the opening and closing inventory figures for the current year. If these two figures are added together then divided by two, it will give the average inventory figure for the current year. Which can be used as follows:
Average inventory holding period in days = (Average inventory ÷ Cost of Sales) x 365.
Inventory Holding Period Analysis
A low inventory holding period ratio generally indicates efficiency in selling goods quickly. If increasing, inventories are turning over less quickly.
Increase in holding period may be caused by:
- fall in demand for goods
- poor inventory control (storage and insurance cost increases)
- over-investment in inventory exceeding immediate requirements
- carrying obsolete inventory (possibly resulting in write-offs)
- Falls in inventory holding period may be due to:
- bulk buying to take advantage of trade (bulk) discounts
- increasing inventory levels to avoid stockouts (For example, due to erratic demand or where supply is unreliable).
- Inventory holding period can vary considerably, for example:
- A fishmonger 1 or 2 days.
- A building contractor 200 days
- Generally, higher turnover may not mean higher profits, as increased volume may be achieved through reduced profit margins.
- For manufacturing companies, inventory holding period:
- should closely relate to production time
- can be further investigated by looking at a breakdown of raw materials, work-in-progress and finished goods.
Receivables Collection Period
The receivables collection period shows the average time it takes to receive payment from credit customers (the number of calendar days over which receivables are uncollected).
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Receivables Collection Period Analysis
As a measure of the liquidity of trade receivables, the receivables collection period should not exceed a reasonable proportion of sales. The longer the period, the greater the expense of collecting slow-paying or uncollectible accounts.
An increasing ratio may be due to the following:
- weak credit control (For example, lack of adequate collection procedures)
- a deliberate policy to extend credit to attract more trade
- major customers being allowed different credit terms (For example, three months of interest-free credit).
- Although a decrease in this ratio over time is generally a positive move, occasionally, it could signal a cash shortage.
- The receivables collection period should be compared with the stated credit policy set out in terms and conditions (on invoices).
- It may be negligible (For example, supermarkets, retailers and other cash-based businesses do not have credit sales).
- It may be distorted for comparative purposes by:
- VAT or other sales taxes
- debt-factoring arrangements (where debts are sold)
- seasonal trading (For example, a company with a year-end of December may have lower trade receivables due to falling trade in the holiday period)
Payables Payment Period
The payables payment period represents (average) the time (i.e. number of days) it takes to pay for supplies received on credit. Note that trade payables is presented as ‘Payables for goods or services received’ in the statement of financial position of a company.
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Payables Payment Period Analysis
- An increasing ratio may be due to liquidity problems, resulting in:
- poor reputation as a slow payer (may not be able to find new suppliers);
- existing suppliers withdrawing supplies (or demanding “cash on delivery”); and
- inability to take advantage of cash discounts (an expensive finance means).
- a deliberate policy to take advantage of interest-free credit (management must not incur late-payment penalties).
- The payables payment period should be compared with average suppliers’ credit terms (on the invoice) or the credit terms of significant suppliers. Distortion may arise if amounts due to suppliers include capital acquisitions.
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Example 3 |
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Continuation from Example 2 previously. The statement of profit or loss and the statement of financial position of Caixin Co for the year ended 31 March 20X5 have been prepared. What liquidity and efficiency ratios can be derived from Caixin Co’s financial statements? Liquidity: Current ratio = Current assets 4,940 ÷ Current liabilities 3,150 = 1.57:1 Quick ratio = (Current assets 4,940 Inventory 1,970) ÷ Current liabilities 3,150 = 0.94:1 Efficiency: Receivables collection period = (Trade receivables 2,320 ÷ Credit sales 19,350) × 365 = 44 days Payables payment period = (Trade payables 2,370 ÷ Cost of sales 12,260) × 365 = 71 days Inventory holding period = (Inventory 1,970 ÷ Cost of sales 12,260) × 365 = 59 days Looking at these figures, Caixin Co appears to be obtaining more generous terms from its suppliers than it offers its customers. However, it may not be managing its customers very well. If customers took less time to pay, it could pay its suppliers sooner and improve relationships with them. |
Operating and Working Capital Cycles
The operating cycle is how long it takes an entity to convert inventory into cash:
Operating cycle = Inventory holding period + Receivables collection period
The working capital cycle shows the amount of time (in days) that an entity takes to convert resource inputs (inventory) to cash receipts. It is the period from when cash is spent on purchases to when money is collected from customers.
The working capital cycle for a trading company is:
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Working capital cycle = Inventory holding period + Receivables collection period − Payable payment period Or Working capital cycle = Operating cycle − Payable payment period |
For a manufacturing business, the inventory holding period includes the average time raw materials are held and the time taken to produce goods.
The operating cycle looks at the entire period from purchase of inventory to cash collection, whereas the working capital cycle looks at the net time the entity’s money is tied up.
Working Capital Cycle Analysis
Working capital is the difference between current assets and current liabilities. If the cycle is increasing, it may be due to the following:
- Poor working capital control
- a deliberate policy to build up finished goods inventory or attract more customers by giving a more extended credit period.
- Working capital requirements are very dependent on the type of business. For example, a supermarket may have a negative cycle as the supermarket receives cash before paying suppliers.
- Working capital indicates whether a business can generate cash as quickly as it uses it and the cash level required to maintain operating capacity. For example, the shorter the cycle, the less reliance on external finance.
- Excessive working capital represents excessive interest paid (or loss of interest income) and lost opportunities (in investing funds for a higher return).
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Example 4 |
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Continuation from Example 3 previously. The working capital cycle for Caixin Co is = Inventory holding period 59 + Receivables collection period 44 – Payable payment period 71 = 32 days The longer the cycle, the higher the level of working capital. However, changes in different items may be linked. For example, if customers take longer to pay, the receivables collection period may rise. The business may have problems paying its suppliers, meaning that the payables payment period rises, cancelling out the impact of the rise in receivables collection period. Caixin Co is likely to want to limit the length of the working capital cycle by putting pressure on customers to reduce the time they take to pay or agreeing to more extended credit periods with suppliers. |
Activity 3
The following information is taken from the financial statements of Xincai Co for the year ended 31 December 20X5.
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$ ‘000 |
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Revenue |
8,790 |
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Cost of sales |
(4,430) |
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Gross profit |
4,360 |
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Other operating expenses |
(1,240) |
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Operating profit/Profit before financing and income taxes |
3,120 |
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Inventory |
670 |
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Trade receivables |
740 |
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Trade payables |
560 |
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Note: The asset turnover ratio was 0.6. |
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- Calculate the operating profit margin of Xincai Co to the nearest 0.1%.
- Calculate the return on capital employed of Xincai Co to the nearest 0.1%.
- Calculate the receivables collection period of Xincai Co to the nearest day.
- Calculate the payables payment period of Xincai Co to the nearest day.
- Calculate the inventory holding period period of Xincai Co to the nearest day.
- Calculate the working capital cycle of Xincai Co to the nearest day.
Introduction to Position Ratios
Position ratios focus on how a company is financed. They indicate whether its current financing mix will likely cause problems over the longer term. The two main position ratios are the debt/gearing ratio and interest cover.
Gearing Ratio (Leverage)
The gearing ratio measures the proportion of borrowed funds (which earn a fixed return) to equity capital (shareholders’ funds) or total capital. This ratio provides information about the financial risk of a company.
Borrowings incur commitments to pay future interest and capital repayments, which can be a financial burden and increase the risk of insolvency.
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Debt includes long-term loans, bonds and preferred shares, and bank overdrafts maintained yearly (of permanent nature).
Equity is the residual (ordinary share capital, share premium, retained earnings, revaluation surplus and other reserves).
Gearing Ratio Analysis
The level of gearing reflects the main benefit and risks of debt finance:
- Debt finance is cheaper than equity (as interest is tax deductible)
- Debt finance increases the risk to shareholders (as interest must be paid regardless of profits earned).
- For the analysis of debt and equity:
- Preferred shares are generally treated as debt if redeemable; otherwise, they are classified as equity.
- Bank borrowings (loans and operating overdrafts) are usually considered debt.
- Financial balance means having long-term capital for long-term investments. Short-term borrowings should not finance a permanent expansion. High gearing suits entities with relatively stable profits (to meet interest payments) and suitable assets for security (For example, those in the hotel/leisure service industry).
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Example 5 |
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For each of the companies below, the gearing is calculated.
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Interest Cover
Interest cover measures the ability to pay interest on outstanding debt from profits generated during the period. It is an indicator of the protection available to loan providers and is often used by lenders when making loan approval decisions.
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In the calculation of interest cover, profit must be before financing and income taxes because this is the profit figure from which interest is deducted.
The interest amount must be the interest expense reported in profit or loss:
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Interest expense = Interest paid + Closing accrual − Opening accrual |
Interest Cover Analysis
- If profit is adequate to cover interest expense, interest cover will be greater than 1.0.
- Interest cover below 1.0 indicates that interest obligations cannot be met.
- A ratio of less than 2.0 is generally considered unsatisfactory.
- Interest must be paid even if profits fall. Low or falling interest cover may indicate:
- potential difficulty financing debts if profits fall
- doubts about going concern
- increased risk to shareholders of falling dividends
Overtrading
Overtrading arises when trade increases rapidly without securing additional long-term capital (it is under-capitalised). Symptoms include:
- fast sales growth
- inventories, receivables, and payables increasing
- cash and cash equivalents decreasing
- A short-term solution is to manage working capital better (for example, speed up the collection from customers and maintain lower inventory levels).
- Increasing capital (by a share issue) or raising long-term financing is a long-term solution.
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Example 6 |
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Continuation from Example 3 previously. The statement of profit or loss and the statement of financial position of Caixin Co for the year ended 31 March 20X5 have been prepared. What position ratios can be derived from Caixin Co’s financial statements? Financial gearing:
Financial gearing (as a proportion of equity):
Interest cover = Profit before financing and income taxes 3,680 ÷ Interest expense 610 = 6.03 From the ratios, users can identify that Caixin Co appears to be able to cover its commitments to pay interest expenses comfortably. The proportion of debt to equity seems low, and debt is likely to have a lower cost to Caixin Co than equity. Links between elements in the ratios: Revenue Links Sales revenue links not only to the cost of sales but also to other operating expenses such as selling expenses. Sales revenue is also a measure of activity, so it is worth reviewing how much general and administrative costs vary with sales. This is because it may be a sign of how well the business is controlling costs. The asset turnover ratio links sales with capital. Increased asset turnover may be good because Caixin Co’s capital generates more sales. However, it may indicate that Caixin Co is slow to invest in response to better opportunities. Matching Comparing the level of non-current assets with long-term funding (share capital, longer-term loans) may demonstrate how much financial risk Caixin Co faces. If long-term finance is significantly greater than non-current assets, Caixin Co is cautious, and the financial risk will be low. Suppose non-current assets are funded by shorter-term liabilities such as a bank overdraft. In that case, the financing policy is aggressive, and Caixin Co may face problems when the short-term finance has to be repaid. Overtrading Overtrading is when a business lacks the resources to support an increased volume of activity. Signs include significant increases in revenue, trade receivables and inventory, but also a rapidly worsening cash position and reliance on short-term funding. Over-capitalisation Over-capitalisation is when a business has large amounts of current assets other than cash but relatively small trade payables. The working capital levels are higher than it needs to be. |
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Example 7 |
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The following example shows Caixin Co’s report on their financial analysis. Report on Caixin Co for the year ended 31 March 20X5 Profitability: Gross and operating profit margins have risen due to a change in sales mix and a greater proportion of sales revenue from higher margin goods, resulting from the marketing initiative at the start of 20X4. Both ratios have also risen due to changes in the supplier base and sourcing of components from cheaper supply sources. Both gross and operating profits have increased as a result of these developments. Returns: All three ratios have had a one-off fall due to the investment in plant and machinery necessary to make the new ranges launched this year outweighing the increase in profits. The contributions from these products should mean that the ratios will increase next year. Liquidity: Falls in receivables collection period and increases in payables payment period have balanced the impact of increases in the inventory holding period period. The inventory holding period has increased because of slow initial sales of the X range, which was launched towards the end of the period and for which there was still substantial inventory at the year-end. Receivables collection period have fallen due to work done by additional credit control staff in chasing slow payers. This has led to a rise in administration costs and has had a limited negative impact on the operating profit margin. The change in supplier base has meant that Caixin Co has been able to negotiate more extended supplier payment periods, increasing the payables payment period. These changes have resulted in falls in the current and quick ratios, although they are not at low enough levels to cause concern. Gearing: Gearing has increased because loans were used to finance plant and machinery investments. However, it is still lower than the industry average. Higher finance costs have resulted in a fall in interest cover, although this is not a cause for concern. Conclusion: The adverse movements in some ratios are due to the investment in plant and machinery, although this is expected to be a temporary fall. The figures show that Caixin Co has fulfilled its objectives to improve profitability and working capital management. Appendices Profitability:
Returns:
Liquidity:
Debt/Gearing:
The potential response of users of the financial statements are as follows: Shareholders: “I am pleased with this report. I am particularly interested in the profitability section because this analysis will help me better understand what kind of dividend I can expect.” Finance Provider: “I am happy with this report. I am interested in a few different areas of the report, particularly the gearing section. Comparing the gearing levels to other companies allows me better understand whether Caixin Co has borrowed too much and may not be able to meet its commitments to me.” Manager: “I am slightly concerned by the report because of our inventory holding period period. Our investment in the new range has hurt our working capital management. Therefore, next year, we need to make an extra effort to increase our sales and decrease our inventory holding period period.” An Employee of Caixin Co: “I am happy with this report because our profits have increased from last year. As long as this continues, I know that the company will continue to trade and that my job is secure.” Supplier: “I am interested in the liquidity section because I want to be sure that Caixin Co will pay me for its purchases. I also want to compare the credit period I gave Caixin Co to other suppliers’ average periods. I am also interested in the gearing section because it indicates whether Caixin Co will have difficulty paying me in the longer term.” Member of the public: “I can see that Caixin Co is not making excessive profits, and therefore am happy to continue purchasing goods and services from this business.” |
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Activity 4
You are given the following annual financial statements of two incorporated entities in similar business areas for the year ended 31 March.
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Statements of profit or loss |
Kappa |
Lamda |
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$000 |
$000 |
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Revenue |
400 |
900 |
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Cost of sales |
170 |
530 |
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Gross profit |
230 |
370 |
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Operating expenses |
160 |
210 |
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Operating profit/Profit before financing and income taxes |
70 |
160 |
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Interest expense |
30 |
5 |
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Profit before income taxes |
40 |
155 |
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Income tax |
15 |
46 |
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Profit after tax |
25 |
109 |
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Statement of Financial Position |
Kappa Co. |
Lamda Co. |
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$000 |
$000 |
$000 |
$000 |
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Non-Current Assets: |
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Tangible non-current assets (carrying amount) |
795 |
1,332 |
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Current Assets: |
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Inventory |
28 |
52 |
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Trade Receivables |
98 |
150 |
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Cash |
4 |
10 |
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130 |
212 |
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Total Assets |
925 |
1,544 |
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Equity |
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Share Capital |
400 |
600 |
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Share Premium |
100 |
200 |
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Revaluation Surplus |
– |
200 |
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Retained Earnings |
6 |
300 |
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560 |
1,300 |
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Non-Current Liabilities: |
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Interest-bearing Borrowings |
300 |
50 |
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Current Liabilities: |
||||
|
Payables for goods or services received |
15 |
128 |
||
|
Operating overdraft |
20 |
– |
||
|
Income tax payable |
15 |
46 |
||
|
Dividend payable |
15 |
20 |
||
|
65 |
194 |
|||
|
Total Equity and Liabilities |
925 |
1,544 |
||
Calculate EIGHT financial ratios for each of the two companies.
*Please use the notes feature in the toolbar to help formulate your answer.
Activity 5
- Which of the following is most likely to lead to an increase in a company’s financial gearing ratio?
A bonus issue of shares
Converting a bank loan into an overdraft
An increase in the cash operating cycle
A payment of dividends to shareholders
Converting debt into share capital
- Drivor Co’s gross profit margin for the year ended 31 December 20X3 fell from 21% to 18%.
Which of the following is MOST likely to have caused the fall?
Understatement of opening inventory at 1 January 20X3
Overstatement of closing inventory at 31 December 20X3
A purchase in January 20X4 being wrongly recorded as happening in December 20X3
A fall in the quantity of sales
Bulk discounts being negotiated with suppliers
- Dexcan Co had the following working capital ratios in the last two years:
|
20X1 |
20X0 |
|
|
Current ratio |
1.3 |
1.1 |
|
Quick ratio |
0.9 |
0.8 |
|
Receivables collection period |
25 |
60 |
|
Payables payment period |
30 |
40 |
|
Inventory holding period |
70 |
55 |
Which of the following statements is FALSE?
Dexcan Co’s operating cycle was lower in 20X1
Dexcan Co is receiving money from customers quicker in 20X1
Dexcan Co is paying suppliers quicker in 20X1
The risk of inventory obsolescence for Dexcan Co has increased
The increase in inventory holding period days has resulted in Dexcan Co’s quick ratio increasing
