CH-19 Analysis and Interpretation of Financial Statements – Accounting : Book Guide

Chapter 19: Analysis and interpretation of financial statements Questions and solutions which have a GST version: • Exercise 19.8 • Problem 19.14 Discussion questions 1. After calculating the current ratio for an entity and finding that the ratio’s value was 5:1, a student decided that the company was in a sound position for paying its liquid liabilities. Discuss the shortcomings of making such a conclusion. An arbitrary rule of thumb used when assessing current ratio is that there should about $1.50 of current assets available to cover for every $1 of current liabilities. However, this is a rule of thumb and operating with a current ratio above or below this can be okay. Based on the rule of thumb, it appears that the entity is able to pay its current liabilities comfortably using its current assets. Nevertheless, a number of additional factors must also be considered in analysing the entity’s liquidity position, such as: • trends in this ratio from prior periods • current ratios for other entities in the same industry • other ratios such as the quick ratio which takes into account only the most liquid current assets • cash flow ratios showing the entity’s ability to generate efficient cash flows from its operations • future cash flow requirements, including capital expenditure commitments and future payments under leases • future economic conditions facing the entity. Most importantly, a high current ratio is not necessarily good as it can be due to excess investments in assets that do not generate high returns (i.e. cash, receivables and inventory). The current ratio of 5:1 may indicate that the entity has built up too much inventory on hand (low inventory turnover) or cash from debtors is not being collected efficiently. 2. Discuss how, in choosing the accounting methods below, the following ratios can be affected — return on assets, quick ratio, profit margin, asset turnover: (a) a change in accounting method for depreciation from straight line to diminishing balance (b) revaluation of a non-current asset upwards at the beginning of the current year (c) recognising a loss through obsolescence of certain items inventory. Return on assets: (a) In the early years of an asset’s life, a change from straight line to diminishing balance will cause depreciation expense to rise and asset balances to fall by the same amount, thus causing this ratio to fall. This effect will reverse in the later years of an asset’s life when diminishing balance depreciation falls below the straight-line charge. (b) Revaluation of a non-current asset upwards will increase the asset balance with a non-proportional fall in the year’s profit levels (caused by an increased depreciation charge), assuming that the revaluation increase is not the reversal of a previous decrease and that the revaluation is credited to an asset revaluation surplus. Hence the ratio will fall. If the upward revaluation is a reversal of a previous decrease, then the asset balance will rise and so too will the profit level, after adjustment for depreciation. In this circumstance the ratio will rise. (c) The solution depends on the treatment in the accounts in this case. If, following the Conceptual Framework, the loss is treated as an increase in an expense and a reduction in the asset (inventory), the ratio will fall. This is the preferred treatment. Quick ratio: (a) No effect. (b) No effect. (c) No effect. Profit margin: (a) This ratio will fall in the early years due to increased depreciation expense, and rise in later years as the depreciation expense decreases. (b) This ratio will fall due to the increased depreciation expense caused by the revaluation, provided that the revaluation is credited to an asset revaluation surplus. However, if the revaluation is a reversal of a previous decrease, the profit will rise and so too will the ratio. (c) If the loss is debited to an expense, the ratio will fall. See earlier discussion under the rate of return on assets. Asset turnover: (a) This ratio will fall in the early years due to increased depreciation expense causing a fall in the total assets, and rise in later years as the depreciation expense decreases and asset levels do not fall to the same extent as under the straight line method. (b) This ratio will fall due to the increased asset balances caused by the revaluation upwards. (c) This ratio will fall if the inventory asset is reduced. See earlier discussion under the rate of return on assets for further consideration. 3. In analysing the financial statements of an entity, the following ratios were calculated. Evaluate the entity’s liquidity. Both current ratio and quick ratio have decreased from 2019 to 2020, indicating that the entity’s ability to settle its current liabilities using current assets has weakened. In 2020, there is $1.10 of current assets available for every $1 of current liabilities. When taking into account the most liquid assets (i.e. cash, receivables and short-term investments), the entity does not have sufficient liquid assets to cover its current liabilities. Hence, based on current ratio and quick ratio, both of which are below the arbitrary benchmark of 1.5:1 and 0.9:1 respectively, it appears that the entity will have difficulty paying off its short-term obligations when they are due. The entity’s receivables turnover has shown improvement, indicating that the entity collects it receivables faster. In 2020, it takes the entity on average 30 days to collect cash from debtors, which is a significant reduction of 15 days compared to the previous year. However, inventory turnover has fallen in 2020, indicating that it takes the entity longer to sell its inventory in 2020 compared to 2019. Despite the decrease in inventory turnover (i.e. less sales), an increase in profit margin from 7% to 10% demonstrates the entity’s ability to increase gross profit margins on sales through increase in selling price or to reduce its operating expenses. Overall, the entity appears to have a low liquidity level, as shown in the current ratio and quick ratio. Although the entity manages to collect its receivables faster in 2020, it takes longer on average for the entity to turn over its inventory. In this case, the decrease in current ratio and quick ratio may be caused by the drop in accounts receivables or increase in current borrowings. If the trend continues, the entity may face problems in repaying its maturing short-term obligations. 4. Discuss the role(s) that an entity’s cash flow data can play in analysing the entity’s financial performance. Cash flow data is used to assess an entity’s cash sufficiency and cash flow efficiency by a series of ratios. Cash sufficiency ratios measure the adequacy of the entity’s operating cash flows to meet its cash needs for payment of long-term debt, dividend payments, payments for replacement and purchase of non-current assets, and coverage of long-term debt commitments. Cash flow efficiency ratios measure the entity’s ability to generate operating cash flows from its sales and its ability to produce profits which result in the generation of operating cash flows. A cash flow return on total assets can be compared with the accrual return on assets. Comparison of ratios for other entities, particularly in the same industry is useful in judging an entity’s cash flow performance. 5. Explain the association between the profit margin and asset turnover. Using the ‘Du Pont formula’, profit margin and asset turnover impact on an entity’s Return On Assets (ROA). As per the formula, ROA is the product of profit margin and asset turnover, that is: ROA = profit margin  asset turnover. This demonstrates that an entity’s ROA is attributable to its profitability (profit margin) and its asset efficiency (asset turnover). In other words, in order for an entity to maximise its ROA, it needs to maximise its profit margin and asset turnover. This could pose some difficulties, however, as there are trade-offs between these two ratios. Increasing profit margin would involve increasing selling price, which may decrease asset turnover (i.e. less sales). Similarly, increasing asset turnover would involve lowering selling price, which may cause profit margin to fall. A healthy balance between the two ratios is required in order to achieve a target ROA. 6. Describe the information conveyed by: (a) a cash adequacy ratio (b) an operations index. (a) A cash adequacy ratio measures an entity’s ability to generate sufficient operating cash flows required to pay debts as they fall due, acquire assets and pay for dividends. Cash adequacy ratio is calculated as cash flows from operating activities divided by the sum of debt repayments, assets acquired and dividends paid. A ratio of 1 (100%) or more indicates that the entity’s operations produce sufficient cash to meet the main cash requirements for the entity’s operations. (b) An operations index, calculated as cash flows from operating activities divided by profit, measures the productivity of an entity’s continuing operations in generating cash. The higher the operations index, the more efficient an entity is in turning accrual-basis profit into actual cash. 7. Discuss the general limitations of financial statement analysis. Some limitations of financial statement analysis are below. Historical data used in financial statement analysis may not be a good predictor for future performance due to changes in economy, business environment, and the entity’s internal factors. In addition, financial statements also contain numerous estimates, for example in determining depreciation expense. Inaccurate estimates will reduce the quality of the financial statements and hence the quality of any financial analysis. Using historical cost, or modified historical cost, as the measurement base in calculating ratios for financial statement analysis may provide misleading information given that inflation and changes in fair value are not taken into consideration. Financial statement analysis mostly uses financial year-end data in calculating performance measures, which may not be typical or representative of the entity’s position and financial condition during the year. Lack of disclosures in the general purpose financial reports may inhibit the extent of the analysis. Furthermore, sometimes the information contained in the financial reports may be subject to modifications, supplementations, and/or qualifications expressed in other documents such as directors’ reports. Failure to take this additional information into consideration will negatively impact on the financial statement analysis prepared. Performance trends may be difficult to determine due to the existence of one-off or non-recurring items in a statement of profit or loss and other comprehensive income. Entities operating in the same industry may not be comparable due to differences in size, accounting methods, and diversification of product lines. Hence, comparing financial ratios between entities has limitations. 8. Some accountants believe that financial statement analysis is of little benefit as it contradicts the findings of capital markets research. Discuss the findings of capital markets research and its implications for financial statement analysis. If capital markets are efficient, at least in the semi-strong form, the markets have already incorporated all publicly available information into the share price. Hence, any attempt to use financial statements analysis based on the capital market is futile. The message from capital markets research is that share prices reflect all public data currently known and are therefore an accurate reflection of the worth of the entity, assuming no significant impact from inside information. Analysts and their clients cannot therefore make abnormal profits by analysing public data to advise which shares to buy or sell. However, many analysts continue to engage in this practice of carefully studying published data. Why? Are they ignorant of the research? Refer to the limitations of capital markets research as discussed under Study Objective 8 in this chapter. Exercises Exercise 19.1 Horizontal analysis Niagra Ltd reported the following financial data over a 5-year period. Required (a) Prepare a trend analysis of the data using 2017 as the base year. (b) Graph the trends and discuss if the trends signify a favourable or unfavourable situation. (LO3) (a) 2017 2018 2019 2020 2021 Income 100 100 103 105 107 Gross profit 100 103 104 103 104 Other expenses 100 105 108 109 110 (b) The Gross Profit trend is initially positive (2017–2019), declines (2019–2020) and then rebounds to its 2019 level. Given that income has increased each year, this implies that the increase in income was greater than the increase in cost of sales initially but in 2020, the increase in the cost of sales outstripped that in income. Other expenses are increasing year on year and at a faster rate than gross profit, which suggests that profit is declining. Intercompany and industry comparisons need to be taken into account in analysing Niagra’s performance. Exercise 19.2 Trend analysis The asset section of the statement of financial position and notes thereto of Megabus Ltd is shown below. Required (a) Calculate the changes in dollar amounts and percentages for the company. (LO3) (a) Changes during the year Dollar amount Percentage Cash assets $5 800 8.0 Receivables 9 030 7.0 Inventories (18 270) (5.0) Prepaid insurance (380) (10.0) Furniture and fittings 19 560 10.00 Plant and equipment 25 200 8.0 Exercise 19.3 Common size statements of profit or loss and other comprehensive income Comparative figures from the statement of profit or loss of Misty Ltd are shown below. Required (a) Prepare common size statements for the company for both years, and comment on any significant changes. (LO3) (a) Per cent of revenue 2020 2019 Revenue (all sales) 100.0 100.0 Cost of sales 65.0 73.6 Gross profit 35.0 26.4 Expenses (including tax) 19.8 17.6 Profit 15.2 8.8 Misty’s common size statements for 2019 and 2020 show a favourable trends in both gross profit and profit. Gross profit has increased from 26.4 per cent to 35 per cent of sales. This increase is mainly due to decreasing cost of sales. In 2019, cost of sales comprises 73.6 per cent of sales, and this has fallen to 65 per cent in 2020. The decrease in cost of sales as a percentage of sales could be the result of higher selling prices, or lower cost of sales through bulk discounts or the ability to find cheaper suppliers of goods. Although other expenses has slightly increased from 17.6 per cent to 19.8 per cent, the significant increase in gross profit is able to offset the increase in other expenses, leaving profit to rise to nearly double than it was in the previous year. Exercise 19.4 Common size statement of financial position Comparative figures from the statement of financial position for Border Ltd are shown below. Required (a) Prepare common size statements for the company for both years, and comment on what this analysis reveals about Border’s financing policy. (LO3 and LO4) (a) Percent of total assets 2020 2019 Current assets Cash at bank 7.6 6.8 Accounts receivable 13.1 14.8 Inventory 21.2 23.6 41.9 45.2 Non-current assets Term deposit 12.6 11.0 Plant and equipment (net) 45.5 43.8 58.1 54.8 Total assets 100.0 100.0 Current liabilities Accounts payable 12.1 14.2 Mortgage 5.1 5.5 17.2 19.7 Non-current liabilities Mortgage 30.3 27.4 30.3 27.4 Total liabilities 47.5 47.1 Net assets 52.5 52.9 Equity Share capital 25.3 27.4 Retained earnings 27.3 25.5 52.5 52.9 The common size statements show that Border uses slightly more equity than debt to finance its assets. In 2019, 52.9 per cent of Border’s assets are funded by equity. This percentage dropped slightly to 52.5 per cent in 2020, leaving the debt proportion to be 47.5 per cent of total assets. As seen from the common size statements, the slight increase in debts is contributed by increase in long-term mortgage. It appears that Border has a fairly conservative and stable policy of financing around half of its assets with debt financing. While debt is cheaper than equity, debt increases a firm’s financial risk. Exercise 19.5 Liquidity analysis The following information has been extracted from the financial statements and the notes of Porcini Ltd. Required (a) Calculate the following for 2020 to one decimal place: i. current ratio ii. quick ratio iii. receivables turnover ratio iv. average collection period of accounts receivable v. inventory turnover ratio vi. average period for inventory turnover. (b) Analyse Porcini’s liquidity. (LO4) (a) i. Current ratio = ii. Quick ratio = iii. Receivables turnover ratio = iv. Average collection period of accounts receivable = v. Inventory turnover ratio = vi. Average period for inventory turnover = (b) Using the rule of thumb approach, liquidity would appear to be satisfactory with the current ratio over 1.5 and the quick ratio over 0.9. Average collection of receivables is good at 28.1 days (assuming a 30 day credit period). To assess inventory turnover, it would be necessary to obtain data relating to the industry and/or trends over the past few years. Exercise 19.6 Profitability and financial stability analysis The following information has been extracted from the financial statements and notes thereto of Bass and Dide Ltd, consultants. Required (a) Calculate the following ratios for 2020: i. return on assets ii. return on ordinary equity. (b) Calculate the following ratios for 2019 and 2020: i. profit margin ii. debt ratio iii. times interest earned. (c) Analyse the company’s profitability and financial stability. (LO4) (a) i. Return on total assets = ii. Return on ordinary equity = (b) i. Profit margin 2016 = Profit margin 2017 = ii. Debt ratio 2016 = Debt ratio 2017 = iii. Times interest earned 2016 = Times interest earned 2017 = (c) All measures of profitability appear satisfactory, despite a slight decrease in profit margin in 2020. These ratios can also be compared with other companies’ ratios and industry averages. The debt ratio has decreased in 2020 relative to 2019 although the company is still financing more than half its total assets from borrowings. Times interest earned has slightly increased as less interest expense was incurred in 2020 from less amount of borrowings and/or a cheaper cost of debt. Exercise 19.7 Profitability analysis The following information relates to the operations of Branded Ltd. The profit was $1 500 000. The company distributed preference dividends of $50 000, and ordinary dividends of $600 000. Over the year, issued ordinary shares were 2 000 000. Ordinary shares are currently selling for $8.00 per share. Required Calculate the following ratios: (a) earnings per share (b) price–earnings ratio (c) dividend yield (d) dividend payout. (LO4) (a) earnings per share = (b) price-earnings ratio = (c) dividend yield = (d) dividend payout = Exercise 19.8 Effect of transactions on current ratio Non-GST version Paul’s Parts Ltd’s statement of financial position (extract only) on 30 June 2020 is set out below. Required (a) Calculate the current and quick ratios. (b) A loan agreement entered into by the company in 2018 requires the company to maintain a minimum current ratio of 1.5:1. Management is concerned that this requirement will not be met and is considering entering into one or more of the following transactions before the end of the financial year, 30 June. Calculate the current and quick ratios after each of the following transactions and indicate whether the ratio would be increased, decreased or unaffected by the transaction. i. Purchase $12 000 worth of inventory on credit. i. Pay $75 000 on payables. ii. Give existing creditors a $60 000 bill to settle some payables. iii. Borrow $90 000 using a long-term bank loan. iv. Give existing creditors a $60 000 long-term loan to settle some payables. (LO4) (a) Current ratio = Quick ratio = (b) Current ratio Quick ratio i. ii. iii. iv. v. Exercise 19.8 Effect of transactions on current ratio GST version Paul’s Parts Ltd’s statement of financial position (extract only) on 30 June 2020 is set out below. PAUL'S PARTS LTD Statement of Financial Position as at 30 June 2020 CURRENT ASSETS $ CURRENT LIABILITIES $ Cash 180,000 GST Payable 10,400 GST Receivable 4,400 Other Payables 180,000 Other Receivables 125,600 Other Liabilities 208,000 Inventories 270,400 Prepaid Expenses 24,800 $605,200 $398,400 Required (a) Calculate the current and quick ratios. (b) A loan agreement entered into by the company in 2018 requires the company to maintain a minimum current ratio of 1.5:1. Management is concerned that this requirement will not be met and is considering entering into one or more of the following transactions before the end of the financial year, 30 June. Calculate the current and quick ratios after each of the following transactions and indicate whether the ratio would be increased, decreased or unaffected by the transaction. i. Purchase $13 200 worth of inventory (including GST 10%) on credit. ii. Pay $75 000 on payables. iii. Give existing creditors a $60 000 bill to settle some payables. iv. Borrow $90 000 using a long-term bank loan. v. Give existing creditors a $60 000 long-term loan to settle some payables. (LO4) (a) 605,200 = 1.52 : 1 398,400 Current ratio = 310,000 = 0.78 : 1 398,400 Quick ratio = (b) Current ratio Quick ratio 1. 618,400 = 1.50 : 1 Decreased 411,600 311,200 = 0.76 : 1 Decreased 411,600 2. 530,200 = 1.6 : 1 Increased 323,400 235,000 = 0.7 : 1 Decreased 323,400 3. 605,200 = 1.52 : 1 Unaffected 398,400 310,000 = 0.78 : 1 Unaffected 398,400 4. 695,200 = 1.7 : 1 Increased 398,400 400,000 = 1 : 1 Increased 398,400 5. 605,200 = 1.79 : 1 Increased 338,400 310,000 = 0.92 : 1 Increased 338,400 Exercise 19.9 Cash sufficiency ratios You are provided with the following information from the statement of cash flows for Precedent Ltd. Required (a) Calculate the following cash sufficiency ratios for Precedent Ltd for 2020 and 2019: i. cash flow adequacy ratio ii. repayment of long-term borrowings ratio iii. dividend payment ratio. (LO6) (a) 2020 2019 i. Cash flow adequacy ratio ii. Repayment of long-term borrowings iii. Dividend payment ratio Exercise 19.10 Market efficiency Warren Buffett is regarded as one of the world’s most successful investors. He does not believe that markets are efficient. The following quote is attributed to him: ‘I’d be a bum on the street with a tin cup if markets were always efficient. Investing in a market where people believe in efficiency is like playing bridge with someone who has been told it doesn’t do any good to look at the cards.’ Required (a) Explain the distinction between price and value and why many analysts engage in the practice of fundamental analysis. (LO8) (a) In the share market, the price of a share is the amount that a willing buyer and a willing seller agree to exchange for that share. Although how much the share is worth depends on what buyers are willing to pay, the supply/demand rule largely influences share price in short-term (i.e. if there are more demands/buyers than supplies/sellers, then price will rise, and vice versa). Value, on the other hand, is the amount that market participants (e.g. investors and analysts) believe the share should trade for on the market. The value of a share can be determined by looking at various factors including earnings, cash flows, revenue over time and potential growth. Fundamental analysis is undertaken to assist in the determination of a share’s value. Taking the assumption that share markets are inefficient, investors and analysts believe that they will be able to determine the value of an entity’s share by studying all publicly available information about the entity. Determining the value of an entity’s share and comparing it to the share’s price will drive investment decisions. If an investor believes that the share’s value is higher than its current market price, the share should be purchased. Conversely, if an investor believes that the share’s value is lower than its current market price, the share should be sold. Despite the common belief that share markets are inefficient, findings from capital market research have demonstrated that the markets in fact are efficient in incorporating all published information into the share price of an entity. This implies that an entity’s share price reflects the entity’s value, and hence people will not be able to gain abnormal profits from the market by studying publicly available information. Nevertheless, many analysts still engage in the practice of fundamental analysis because: • some analysts may not have sufficient understanding about what capital market research has found about market efficiency; • many investors believe that they can make profits from the share markets and subsequently consult analysts to help them to achieve their goals; • the efficiency of share markets may be contributed by the works of a large number of analysts who use publicly available information to determine the value of shares. Consequently, if the analysts ceased to perform fundamental analysis, the share markets may become less efficient; and • the evidence from capital markets research is still inconclusive, and some theories are being developed in relation to why it is possible to make abnormal profits using publicly available information. Exercise 19.11 Limitations of ratio analysis Match Ltd and Box Ltd both began operations on 1 January 2020. For illustrative purposes, assume that at that date their statement of financial positions were identical and that their operations during 2020 were also identical. The only difference between the two companies is that they elected to use different accounting methods as can be seen below. Summary financial information for both companies at the end of 2020 is presented below. Required (a) Calculate and interpret the following ratios for each company: i. return on assets ii. return on ordinary equity iii. profit margin iv. current ratio v. receivables turnover vi. inventory turnover vii. debt ratio. (b) Comment on the impact that use of different accounting methods can have on the calculation of ratios. (LO7) (a) MATCH LTD BOX LTD i. Return on assets Note: end-of-year total assets figure is used instead of average total assets. Match Ltd yields higher return on assets relative to Box Ltd. For every dollar of investment in assets, Match Ltd is generating 39 cents of profit, whereas Box Ltd is generating 30.3 cents of profit. ii. Rate of return on ordinary equity Note: end-of-year equity figure is used instead of average equity. Match Ltd and Box Ltd generate 67.6 cents and 58.8 cents of profit respectively for every dollar invested by ordinary shareholders. The rate of return on ordinary equity for both companies is greater than their return on assets, demonstrating both companies’ efficiency in using gearing/leverage to lever returns. iii. Profit margin Both companies generate the same amount of revenue from sales. However, Match Ltd earns more profit compared to Box Ltd due to lower cost of sales and other expenses. As shown by the profit margin, Match Ltd retains 27.6 cents of total revenue as profit, whereas Box Ltd only retains 18.8 cents of profit per dollar of revenue. Hence, Match Ltd can be regarded as more profitable. iv. Current ratio The current ratio shows that Match Ltd and Box Ltd have $4.10 and $3.70 of current assets respectively to cover every dollar of current liabilities. Following the rule of thumb of 1.5:1, both companies are in strong liquidity position as they are able to repay their maturing short-term obligations. The issue is whether the high ratios are indicative of inventory build-up or difficulty collecting debtors. v. Receivables turnover Note: end-of-year receivables figure is used instead of average receivables balance. Both companies have the same receivable turnover as they generate the same amount of revenue and have the same receivables balance. The receivable turnover indicates that Match Ltd and Box Ltd are able to convert their receivables balance into cash five times during the year. In other words, it takes on average 73 days for both companies to collect payments from customers. This needs to be compared with their credit policy in order to assess whether the companies have performed well. vi. Inventory turnover Note: end-of-year inventory figure is used instead of average inventory balance. The inventory turnover indicate that Box Ltd has outperformed Match Ltd in turning inventory into sales. In 2020, Box Ltd is able to sell its inventory more often (3.75 times during the year) compared to Match Ltd (2.65 times). The quicker inventory can be sold (assuming that it is not being heavily discounted) the better for the company. vii. Debt ratio The debt ratio shows that 42.4% of Match Ltd’s assets and 48.4% of Box Ltd’s assets are funded by creditors. Thus both companies rely more on equity funding than they do debt funding. Box Ltd is more reliant on debt funding compared to Match Ltd. The debt ratio for both companies needs to be compared with trend from previous years, as an increasing ratio indicates higher risk that the companies will not be able to pay their maturing obligations when they fall due. (b) As can be seen from the above ratios, the impact of different accounting methods on ratio calculations is significant. Using the FIFO method for inventory costing generally results in lower cost of sales compared to the weighted average cost method, as goods that were purchased earlier (at a cheaper purchase price assuming prices rise) are assumed to be sold first. In addition, Match Ltd incurs lower depreciation expense compared to Box Ltd ($10 000 and $20 000 respectively) because of the difference in the depreciation method used. All else constant, lower cost of sales and depreciation expense result in Match Ltd generating higher profit ($69 000) compared to Box Ltd ($47 000), as shown in the statement of profit or loss. The flip side of using different accounting methods can also be seen in the statement of financial position. Match Ltd’s inventories and property, plant and equipment balance are higher than Box Ltd’s, resulting in higher total assets. The difference in profit and total assets figures does have an impact on ratios, especially for ratios that use those figures. Compare, in particular, the return on assets, return on equity, profit margin and debt ratio. Since Match Ltd has higher profit and total assets compared to Box Ltd, it has higher return on asset, return on equity, and profit margin, as well as lower debt ratio (due to larger asset base). These ratios highlight the need for adjustments to accounting figures to achieve consistent accounting methods when comparing similar entities. But how do we decide which method to use — FIFO or weighted average, straight line or diminishing balance? Problems Problem 19.12 Trend analysis Comparative data extracted from the general purpose financial statements and notes thereto of Express Delivery Ltd are presented below. Required (a) Prepare a trend analysis of the data. (b) Comment on any trends revealed by the analysis that you consider should be reported to managers. (LO3) (a) EXPRESS DELIVERY LTD Comparative Statements of Profit or Loss (extract) for the years ended 31 December 2015–2020 2015 2016 2017 2018 2019 2020 Revenue 100 105 105 108 130 138 Cost of sales 100 103 100 104 116 135 Gross profit 100 109 113 116 152 143 Expenses 100 105 101 123 138 140 Profit 100 118 142 97 188 152 EXPRESS DELIVERY LTD Comparative Statements of Financial Position as at 31 December 2015–2020 2015 2016 2017 2018 2019 2020 ASSETS Cash 100 106 100 144 139 78 Receivables 100 120 112 172 208 296 Inventories 100 114 120 159 203 216 Property, plant & equipment 100 108 116 193 191 189 Total assets 100 110 115 180 192 198 LIABILITIES Payables 100 122 131 180 219 236 Non-current liabilities 100 96 92 208 201 199 EQUITY Share capital 100 100 100 150 150 150 Retained earnings 100 146 178 220 256 278 Total liabilities & equity 100 110 115 180 192 198 (b) From 2015 to 2020, revenue increased at a faster rate than cost of sales, resulting in increased gross profit. The wide fluctuations in profit is an unfavourable situation which indicates instability and requires further investigation. For example, expenses have shown a steep increase from 2018 onwards. The substantial increase in profit between 2018 and 2019, as shown in the trend figures, is misleading because of the relative size of the absolute dollar amounts. During 2018, the company financed investments in property, plant and equipment and other assets by increasing long-term borrowing and by issuing ordinary shares. The large increase in revenue during 2019 was probably a result of this investment. The increase in retained earnings indicates that the company is increasingly financing a part of its growth internally. The increase in receivables, especially after 2017, indicates that the increase in revenue is probably being achieved by allowing easier access to credit. The steady increase in inventory holdings and a similar trend in short term payables is another sign that the company may be relying on credit for retailing transactions. Problems 19.13 Percentage analysis Certain items taken from the financial statements, the notes thereto and other records of Lucky Nine Ltd have been expressed as percentages of net revenue. Net revenue was $600 000 in 2019; it increased by 12% in 2020. Average trade accounts receivable were $69 000 in 2020 and $66 000 in 2019. Credit sales were 75% of total revenue in both years. Required (a) By what percentage did the entity’s profit increase or decrease in 2020 compared with 2019? Prepare a comparative statement of profit or loss (showing relevant items) including common size figures to support your answer. (b) Calculate and comment on the average collection period for the company’s trade accounts receivable for both years, showing the basis for your calculation. (LO3 and LO4) (a) Reconstructing the statement of profit or loss from the common size statements: Statement of profit or loss Common size statements 2020 2019 2020 2019 Revenues (net) $672 000 $600 000 100% 100% Beginning inventories 201 600 192 000 30 32 Purchases (net) 403 200 366 000 60 61 604 800 558 000 90 93 Ending inventories 174 720 198 000 26 33 Cost of sales 430 080 360 000 64 60 Gross profit 241 920 240 000 36 40 Selling and distribution expenses 94 080 72 000 14 12 Administrative expenses 60 480 60 000 9 10 154 560 132 000 23 22 Profit before income tax 87 360 108 000 13 18 Income tax expense 26 208 32 400 3.9 5.4 Profit $61 152 75 600 9.1 12.6 Profit after tax decreased in 2020 by $14 448, a decrease of 19.11% compared with 2019. (b) Note: credit sales were 75% of total revenue in both years. • 2020 credit sales = 75%  $672 000 = $504 000 • 2019 credit sales = 75%  $600 000 = 450 000 2020 2019 Receivable turnover Average collection period The average collection period for the company’s trade accounts receivable has improved in 2020 compared to 2019. In 2019, it took the company just over 53 days to collect its receivables, and this figure has decreased to 50 days in 2020. The company has managed to collect payments from credit customers more quickly in 2020 than in 2019. Although the company’s average collection period shows a favourable trend, the collection period needs to be compared with the company’s credit policy. If the company provides customers with 60 days of credit terms, the average collection period of 50 days in 2020 indicates that the credit policy is effective and that the company is able to collect payments from customers before the due date. However, if the credit terms extended to customers is 45 days, this indicates that the company has issues with its collection policies or may be burdened by excessive amounts of bad debts that have not been written-off. Problem 19.14 Effect of transactions on ratios Non-GST version Sunrise Ltd completed the following transactions during a given year: Transaction Ratio 1. Sold obsolete inventory at cost 2 Redeemed debentures by issuing ordinary shares 3. Issued a share dividend on ordinary shares 4. Declared a cash dividend on ordinary shares 5. Purchased inventory on credit 6. Sold inventory for cash 7. Wrote off a bad debt against Allowance for Doubtful Debts 8. Collected an account receivable 9. Sold inventory on credit 10. Issued additional ordinary shares for cash 11. Paid trade accounts payable Profit margin Return on ordinary equity Earnings per share Dividend payout Quick ratio Current ratio Current ratio Receivables turnover Inventory turnover Debt ratio Return on assets Required (a) State whether each transaction would cause the ratio listed with the transaction to increase, decrease or remain unchanged. (LO4) (a) 1. Decrease – will increase sales and cost of sales by the same amount, resulting in a zero change in operating profit. 2. Decrease – issuing additional shares will increase shareholders’ equity (denominator), while profit is assumed to remain the same. 3. Decrease – issuing a share dividend will increase the number of ordinary shares on issue (denominator), while profit is assumed to remain the same. 4. Increase – declaring more cash dividend will increase the proportion of profit distributed to shareholders as dividends. 5. Decrease – purchasing inventory on credit will increase current liabilities (denominator), whilst the numerator remains constants as inventory is excluded from the calculation of quick ratio. 6. • Remain unchanged if selling price equals to cost – because the amount received as cash will be the same as the reduction in inventory balance, resulting in zero change in total current assets whilst current liabilities remain constant. • Increase if selling price is greater than cost of sales – because cash received is greater than the reduction in inventory balance, resulting in the increase in current assets (numerator) whilst current liabilities (denominator) remain constant. 7. Remain unchanged – writing-off (estimated) bad debt against allowance for doubtful debts account does not decrease gross accounts receivable (current assets), until the actual bad debt is write-off. 8. Increase – collecting an account receivable will reduce accounts receivable balance (denominator), while net sales revenue is assumed to remain constant. 9. Increase – selling inventory will reduce inventory balance (denominator), while cost of sales (numerator) will increase. 10. Decrease – issuing additional ordinary shares for cash will increase total assets (denominator), whilst total liabilities (numerator) remain the same. 11. Increase – paying accounts payable will decrease total assets (denominator) through reduction in cash, while profit is assumed to remain the same. Problem 19.14 Effect of transactions on ratios GST version Sunrise Ltd completed the following transactions during a given year. Required (a) State whether each transaction would cause the ratio listed with the transaction to increase, decrease or remain unchanged. (LO4) (a) 1. Decrease – will increase sales and cost of sales by the same amount, resulting in a zero change in operating profit. 2. Decrease – issuing additional shares will increase shareholders’ equity (denominator), while profit is assumed to remain the same. 3. Decrease – issuing a share dividend will increase the number of ordinary shares on issue (denominator), while profit is assumed to remain the same. 4. Increase – declaring more cash dividend will increase the proportion of profit distributed to shareholders as dividends. 5. Remain unchanged – paying GST owing will affect total assets and total liabilities, not dividend paid or market price per share. 6. Decrease – purchasing inventory on credit will increase current liabilities (denominator), whilst the numerator remains constants as inventory is excluded from the calculation of quick ratio. 7. • Remain unchanged if selling price equals to cost – because the amount received as cash will be the same as the reduction in inventory balance, resulting in zero change in total current assets whilst current liabilities remain constant. • Increase if selling price is greater than cost of sales – because cash received is greater than the reduction in inventory balance, resulting in the increase in current assets (numerator) whilst current liabilities (denominator) remain constant. 8. Remain unchanged – writing-off (estimated) bad debt against allowance for doubtful debts account does not decrease gross accounts receivable (current assets), until the actual bad debt is write-off. 9. Increase – collecting an account receivable will reduce accounts receivable balance (denominator), while net sales revenue is assumed to remain constant. 10. Increase – selling inventory will reduce inventory balance (denominator), while cost of sales (numerator) will increase. 11. Decrease – issuing additional ordinary shares for cash will increase total assets (denominator), whilst total liabilities (numerator) remain the same. 12. Increase – paying accounts payable will decrease total assets (denominator) through reduction in cash, while profit is assumed to remain the same. Problem 19.15 Ratio analysis and report The following information relates to the business of Chef One, and the owner is concerned about the profitability and financial structure of his business at 30 June 2020, especially since the bank is requiring repayment of the business’s overdraft. Inventory at 1 July 2019 was $22 500. Required (a) Calculate the following ratios for 2019 and 2020: i. profit margin ii. return on proprietor’s capital iii. current ratio iv. quick ratio v. equity ratio vi. inventory turnover. (b) Write a short report to the owner in relation to the profitability and financial stability of the business. (c) Identify the cash flow ratios that would be useful to calculate to assist K. Pastry to more fully understand the financial health of the business. (LO4, LO5 and LO6) (a) 2019 1. Profit margin 2. Rate of return on proprietor’s capital 3. Current ratio 4. Quick ratio 5. Equity ratio 6. Inventory turnover 2020 1. Profit margin 2. Rate of return on proprietor’s capital 3. Current ratio 4. Quick ratio 5. Equity ratio 6. Inventory turnover (b) To: K. Pastry Re: Profitability and financial stability report Profitability has fallen significantly from 2017 to 2020 as indicated by the lower profit margin and rate of return on capital. Furthermore, there are signs of a worsening liquidity situation, particularly reflected in the sharp drop in both the current and quick ratios. Long term stability is less assured as indicated by the firm’s equity ratio, which points to a significant increase in liabilities in relation to equity. If the firm is to improve its profitability, both inventory turnover and profit margin would need to increase in 2021. (c) Cash flow ratios that would be useful for K. Pastry to understand the financial health of the business are: • cash flow adequacy ratio, which assesses the ability of the business to generate adequate cash flows from operating activities to pay for debts and acquisition of assets. It seems that Chef One might not have sufficient cash flows from operating activities to cover for its main cash requirements (debt payments and asset acquisition), as indicated by the overdraft in 2020. • repayment of long-term borrowings ratio, which assesses the ability of the business to cover for the repayment of long-term debts in the current period. This ratio is particularly useful as Chef One as it begins to have long-term borrowings in 2020. • reinvestment ratio, which assesses the ability of the business to generate sufficient cash flows from operating activities to acquire non-current assets. The financial information given shows that Chef One has acquired more non-current assets in 2020, which is likely to contribute towards the business’ overdraft. • debt coverage ratio, which measures how many years it takes for the business to repay its long-term debts, given its current level of cash flows from operating activities. • cash flow to revenue ratio, which measures the proportion of the business’ revenue which is eventually realised as cash flows from operating activities. • operations index, which measures the ability of the business in turning accrual-based profit into actual cash. • cash flow return on asset, which measures the business’ efficiency in managing its assets to generate cash flows from operating activities. Problem 19.16 Ratio analysis Financial statements of iPud Ltd are presented below. Additional information 1. Payables includes $5620 (2020) and $5730 (2019) trade accounts payable; the remainder is accrued expenses. 2. Market prices of issued shares at year-end (2020): Ordinary, $12.00; Preference, $6.70. Required (a) Calculate the following ratios for 2020. The industry average for similar businesses is also provided. (LO4, LO5 and LO7) (b) Given the above industry averages, comment on the company’s profitability, liquidity and use of financial gearing. (c) Discuss the limitations of such an analysis. (LO4, LO5 and LO7) (a) i. Return on assets ii. Return on ordinary equity iii. Profit margin iv. Earnings per share v. Price-earnings ratio vi. Dividend yield vii. Dividend payout viii. Current ratio ix. Quick ratio x. Receivables turnover xi. Inventory turnover xii. Debt ratio xiii. Times interest earned xiv. Asset turnover (b) Despite a lower return on assets, the company’s profitability ratios are above the industry average, with the profit margin nearly doubled the industry average. In 2020, the company earns 59.9 cents of profit per ordinary share, compared to the industry average of 45 cents. This is reflected in the share market, with ordinary shares of iPud Ltd selling for 20 times its current profits. The company’s liquidity position, however, is not as strong as its profitability. Most of iPud Ltd’s liquidity ratios are below the industry average, apart from receivables turnover. Although iPud Ltd possesses sufficient current assets and most liquid assets to cover for current liabilities, its current ratio and quick ratio are slightly below industry average. The company outperforms industry average in converting receivables into cash (as indicated by higher receivables turnover), but is less efficient in managing its inventory. iPud Ltd should focus on strategies to improve its liquidity. In regards to financial gearing, the company’s debt ratio of 52.5% shows that it relies more on debt (compared to the industry average of only 40%). Although the company has managed to efficiently use its borrowings to increase profitability (as shown by high return on equity), there is a risk that the company may not be able to meet its future debt commitments. The current profit before income tax is only 5 times greater than interest paid on borrowings during current period, which is below the industry average of 6 times. Hence, reducing the level of debt financing should be a priority for the company. The company should also continue to effectively manage the use of its assets to generate revenue and endeavour to increase its asset turnover (which has slightly outperformed the industry average). (c) Some limitations of ratio analysis are: • Ratio analysis is performed using past data with a purpose to forecast future performance. There may be changes in general economic condition, the environment in which the entity operates or in management structure, which will affect business performance. As a result, future predictions based on trend analysis may not be accurate. • Ratio analysis uses historical cost from financial statements, which potentially could result in misleading information if the figures are not adjusted for inflation or changes in fair value. • Many of the ratios that are calculated rely on the asset, liability or equity numbers reported in the statement of financial position. This statement reflects the financial position of an ongoing entity at a particular date and may not be representative of the financial position at other times of the year. • Ratio analysis relies on financial numbers in financial statements. Accordingly, the quality of the ratios calculated is dependent on the quality of the entity’s financial statements. The quality may be affected by inadequate disclosures and lack of details in financial statements and/or an entity’s accounting policy choices and estimations. • There may be one-off or non-recurring items in the statement of profit or loss and other comprehensive income that happen during current period, which could distort the entity’s trend. • Entities may not be comparable, even though they are classified under the same industry. Factors such as the use of different accounting methods, size, and diversification of product lines could result in significant differences when comparing entities. As such, comparing ratio analysis between those entities may not be meaningful. Problem 19.17 Preparation of financial statements from ratios The following values relate to various ratios determined for a sole trader, A. Solve, for the year ended 30 June 2020. At that date, the total assets in the statement of financial position was $1 200 000. The ratios relate to the accounts either in respect of the 12-month period or at the date of the statement of financial position for the end of the period. Required Assuming there are no prepaid expenses and that trade accounts payable are the only liability, and rounding answers to the nearest dollar, prepare: (a) a detailed statement of profit or loss for the year ended 30 June 2020, including an itemised cost of sales calculation (assuming a periodic inventory system) (b) a statement of financial position as at 30 June 2020. (LO4) (a) A. SOLVE Statement of Profit or Loss for the year ended 30 June 2020 SALES REVENUE: Cash $450 000 Credit 1 350 000 $1 800 000 Cost of sales: Opening inventory 477 271 Purchases 1 090 910 1 568 181 Closing inventory 218 181 1 350 000 Gross profit 450 000 Expenses 270 000 Profit 180 000 (b) A. SOLVE Statement of Financial Position as at 30 June 2020 CURRENT ASSETS: Cash at bank $692 728 Trade receivables (net) 180 000 Inventory 218 181 $1 090 909 NON-CURRENT ASSETS 109 091 TOTAL ASSETS $1 200 000 CURRENT LIABILITIES: Trade payables 436 364 NET ASSETS 763 636 EQUITY: Capital, A. Solve 763 636 Workings: Profit = $1 200 000  0.15 = $180 000 Total sales = $180 000/0.10 = $1 800 000 Credit sales = $1 800 000  0.75 = $1 350 000 Cash sales = $1 800 000 – $1 350 000 = $450 000 Gross profit = $1 800 000  0.25 = $450 000 Equity at commencement = $180 000/0.3 = $600 000 Cost of sales = $1 800 000 – $450 000 = $1 350 000 Let C = current assets, N = non-current assets C + N = $1 200 000 N : C = 0.1 0.1C + 1C = $1 200 000 Current assets (C) = $1 090 909 Non-current assets (N) = $109 091 Current liabilities = $1 090 90 0/2.5 = $436 364 trade creditors Capital at end = $1 200 000 – $436 364 = $763 636 Drawings = $600 000 + $180 000 – $763 636 = $16 364 Cash at bank + Receivables = $436 364  2 = $872 728 Inventory = $1 090 909 – $872 728 = $218 181 Trade receivables = $1 350 000/7.5 = $180 000 Cash at bank = $872 728 – $180 000 = $692 728 Purchases = $436 364/0.4 = $1 090 910 Opening inventory = $1 350 000 + $218 181 – $1 090 910 = $477 271 Proof of closing Capital = 600 000 + 180 000 – 16 364 = $763 636 Problem 19.18 Ratio analysis The following financial statements were prepared for the management of Worldcorp Ltd. The statements contain some information that will be disclosed in note form in the general purpose financial statements to be issued. Additional information 1. The balances of certain accounts at the beginning of the year are as follows. 2. Total assets and total equity at the beginning of the year were $756 000 and $368 550 respectively. Required (a) Identify the ratios that a financial analyst might calculate to give some indication of the following: i. a company’s earning power ii. the extent to which internal sources have been used to finance acquisitions of assets iii. rapidity with which trade accounts receivable are collected iv. the ability of a business to meet quickly unexpected demands for working capital v. the ability of the entity’s earnings to cover its interest commitments vi. the length of time taken by the business to sell its inventories. (b) Calculate and interpret each of the above ratios you have identified. (c) Identify what comparative analysis could be undertaken to better access Worldcorp’s financial performance and position. (LO4 and LO5) (a) i. A company’s earning power → return on assets, and return on ordinary equity ii. The extent to which internal sources have been used to finance acquisitions of assets → equity ratio, as well as comparative statement analysis, especially horizontal and vertical analysis iii. Rapidity with which trade account receivable are collected → average collection period for receivables iv. The ability of a business to meet quickly unexpected demands for working capital → quick ratio v. The ability of the entity’s earnings to cover its interest commitments → times interest earned vi. The length of time taken by the business to sell its inventories → inventory turnover, or average days per turnover (b) 1. Return on assets = This ratio measures the return earned by management through use of the assets in the firm’s operations. The ratio depends heavily on the accuracy of the figures used, and the method of measurement, e.g. fluctuations may occur depending on the accounting methods used for inventory, depreciation, and so on. Trends across time should be considered. The rate of return to ordinary equity, although subject to the same problems of measurement, shows the net return that the company is earning for its ordinary shareholders after consideration of tax, interest and preference dividends. Return on ordinary equity = (Ordinary equity at beginning: $368 550 – $63 000 = $305 550.) (Ordinary equity at end: $434070 - $63000 = $371 070.) Comparison of the two ratios indicates that WorldCorp Ltd has favourable leverage or gearing, as the return generated using the gearing exceeds the interest paid on borrowings (shown by higher return on equity). 2. Equity ratio = This ratio is limited in that it shows the percentage of total assets being financed by total equity including preference and ordinary shareholders’ equity. Worldcorp Ltd’s equity ratio shows that the company is more reliant on equity funding than debt funding, with around 54% of the company’s assets are funded by equity. A vertical analysis (common size statements) will reveal the percentage of assets financed by internal sources, viz. retained earnings. Total assets = $809 550 = 100% Retained earnings = $119 070 = 14.7% Horizontal analysis and vertical analysis across time will show whether purchases of assets and increases in retained earnings are changing in proportion to each other. 3. Average collection period = This ratio assumes that all sales were made on credit and is therefore limited by the assumption. It further assumes that average receivables (net) can be determined using a simple average for the year. If gross receivables are used in the calculation (which provides a better measure of turnover), the average collection period. = Comparisons with the firm’s stated collection policy, trends over time, and comparisons with industry averages are desirable. 4. Quick ratio = The quick ratio measures the firm’s ability to cover its short-term commitments. The ratio may be influenced by management which can cause its value to rise near the end of the period, .e.g. by paying short term creditors, giving short term creditors a long term bill in settlement of their accounts. Worldcorp Ltd’s quick ratio indicates that the company is able to cover its short-term liabilities with the most liquid assets (i.e. cash and trade receivables). Nevertheless, comparison with trends over time, other entities and the industry average are desirable to see if Worldcorp Ltd has a good liquidity position. 5. Times interest earned = This ratio is a general guide to the long-term stability of the company in that it indicates how many times earnings for the year have covered interest commitments. The size of the ratio over time is important information. The ratio depends on accounting methods assumed in calculating operating profit. Worldcorp Ltd’s times interest earned shows that the company can comfortably cover interest payments using the profit it generates during the current period. 6. Average turnover period = = 365  = 152 days This ratio measures how many days it takes to convert inventory into cash. The ratio varies depending on the inventory method used, and it should be determined on a consistent basis over time to examine trends. (c) To gain a better understanding of Worldcorp Ltd’s financial performance and position, the company’s ratio analysis for the current period could be compared with the following analysis. • Trend analysis: this involves undertaking ratio analysis for Worldcorp over the past few years in order to establish the trend, which would be useful in predicting future performance. Trend analysis could also be used to assess whether Worldcorp’s financial performance and position in the current period have shown improvement compared to previous years. • Inter-entity (peer) analysis: Worldcorp’s ratio analysis could also be compared with ratio analysis of other entities in the same industry, i.e. its competitors. It would be more meaningful to do a comparison with entities with similar size and operations. • Industry average: average ratios for the industry that Worldcorp is operating in are useful benchmarks in assessing how Worldcorp performs relative to other entities in the same industry. Worldcorp’s ratio analysis might show results that are above the minimum requirements. However, if the industry average ratios exceed Worldcorp’s ratios, it implies that Worldcorp does not perform very well within the industry. Problem 19.19 Horizontal and vertical analysis The comparative financial statements of Stratum Ltd are shown below. Required (a) Calculate the changes in the financial statements from 2020 to 2019 in both dollar amounts and percentages. (b) Prepare common size financial statements for 2020 and 2019. (c) Comment on any relationships revealed by the horizontal and vertical analyses. (LO3) (a) STRATUM LTD Statement of Profit or Loss Horizontal Analysis for the years ending 30 June 2019 and 2020 Change during the year Dollar amount ($000) Percentage (%) Revenue 2 250 16.4 Expenses, excluding finance costs 1 740 14.5 Finance costs — — Profit before income tax expense 510 28.6 Income tax expense 343 64.1 Profit 167 13.4 STRATUM LTD Statement of Financial Position Horizontal Analysis as at 30 June 2019 and 2020 Change during the year Dollar amount ($000) Percentage (%) Current assets Cash and cash equivalents (20) (20.0) Trade and other receivables 45 13.4 Inventories 50 6.9 Total current assets 75 6.5 Non-current assets Other financial assets (20) (12.5) Property, plant and equipment 615 22.1 Total non-current assets 595 20.2 Total assets 670 16.3 Current liabilities Trade and other payables (Note 14) 5 1.0 Total current liabilities 5 1.0 Non-current liabilities Long-term borrowings — — Non-current liabilities — — Total liabilities 5 0.2 Net assets 665 35.9 Equity Share capital 100 6.7 Retained earnings 565 161.4 Total equity 665 35.9 STRATUM LTD Statement of Changes in Equity Horizontal Analysis for the years ending 30 June 2019 and 2020 Change during the year Dollar amount ($000) Percentage (%) Share capital Balance at start of period — — Issue of share capital 100 Balance at end of period 100 6.7 Retained earnings Balance at start of period 150 75.0 Total recognised profit for the period 167 13.4 Dividends paid – ordinary (248) (22.5) Balance at end of period 565 161.4 Notes to the financial statements ($000) Horizontal Analysis for the years ended 30 June 2019 and 2020 Change during the year Dollar amount ($000) Percentage (%) Note 2: Revenue Sales revenue (net) 2 250 16.4 Note 4: Expenses Cost of sales 150 1.7 Selling and distribution expenses 420 24.3 Administration expenses 540 39.0 Note 14: Payables Trade creditors 35 9.7 Other creditors and accruals (30) (21.4) (b) STRATUM LTD Statement of Profit or Loss Common Size Statements for the years ending 30 June 2020 and 2019 2020 2019 Revenue 100.0 100.0 Expenses, excluding finance costs 85.7 87.0 Finance costs — — Profit before income tax expense 14.3 13.0 Income tax expense 5.5 3.9 Profit 8.8 9.1 STRATUM LTD Statement of Financial Position Common Size Statements as at 30 June 2019 and 2020 2020 2019 Current assets Cash and cash equivalents 1.7 2.4 Trade and other receivables 8.0 8.2 Inventories 16.1 17.6 Total current assets 25.8 28.2 Non-current assets Other financial assets 2.9 3.9 Property, plant and equipment 71.3 67.9 Total non-current assets 74.2 71.8 Total assets 100.0 100.0 Current liabilities Trade and other payables (Note 14) 10.6 12.2 Total current liabilities 10.6 12.2 Non-current liabilities Long-term borrowings 36.7 42.7 Non-current liabilities 36.7 42.7 Total liabilities 47.3 54.9 Net assets 52.7 45.1 Equity Share capital 33.5 36.6 Retained earnings 19.2 8.5 Total equity 52.7 45.1 STRATUM LTD Statement of Changes in Equity Common Size Statements for the years ending 30 June 2019 and 2020 2020 2019 Share capital Balance at start of period 31.4 36.6 Issue of share capital 2.1 — Balance at end of period 33.5 36.6 Retained earnings Balance at start of period 7.3 4.9 Total recognised profit for the period 29.7 30.5 Dividends paid – ordinary (17.9) (26.8) Balance at end of period 19.2 8.5 Notes to the financial statements ($000) Common Size Statements for the years ended 30 June 2019 and 2020 2020 2019 Note 2: Revenue Sales revenue (net) 100.0 100.0 Note 4: Expenses Cost of sales 56.3 64.4 Selling and distribution expenses 13.4 12.6 Administration expenses 12.0 10.1 Note 14: Payables Trade creditors 8.3 8.8 Other creditors and accruals 2.3 3.4 (c) Stratum Ltd appears to be doing well. Sales revenue has increased by 16.4%, which is higher than the increase in total expenses (14.5%). Cost of sales as a percentage of sales has slightly decreased, which contributes to the overall increase in profit. The statement of financial position horizontal analysis shows that Stratum Ltd has invested in additional plant and equipment, apparently using funds obtained from the sale of ordinary shares and from the 2019 profit. Total liabilities as a percentage of total assets has decreased from 54.9% to 47.3%, making Stratum Ltd less reliant on debt funding. The decrease is as a result of a significant increase in the company’s retained earnings from the period’s profit and proceeds from issue of ordinary shares. Problem 19.20 Ratio analysis comparing entities Required (a) Calculate the following ratios for the four major Australian Banks for the most recent common financial year. i. return on assets ii. return on equity. (b) Explain the factors contributing to the banks’ differing return of assets and return on equity. (c) For each of the banks, compare the earnings per share, price-earnings ratio, dividend payout and dividend yield. Discuss which bank you believe is the better investment. (LO4, LO5 and LO7) At the time of writing, the most recent common financial year for the four banks is the financial year 2016. (a) National Australia Bank (NAB) i. Return on assets ii. Return on equity Commonwealth Bank of Australia (CBA) i. Return on assets ii. Return on equity ANZ Bank (ANZ) i. Return on assets ii. Return on equity Westpac (WBC) i. Return on assets ii. Return on equity (b) The two factors that contribute to return on assets are profit after tax and average total assets. NAB and ANZ have the lowest profit among the four banks, resulting in the lowest return on assets (0.7% and 0.6% respectively). NAB’s result is even poorer if the loss from discontinued operations ($6068m) is taken into consideration as the profit is then only $352m. Commonwealth Bank has the highest profit and highest average total assets and Westpac’s profit is lower than Commonwealth Bank’s, but it also has less total assets. Hence, Commonwealth Bank and Westpac share the same return on assets of 1.0%, which is the highest among the four banks. The differences in ROA is largely a function of differences in the banks’ asset portfolios (primarily loans) and the margins (interest rates) that they generate on the portfolios. Profit attributable to ordinary shareholders divided by the average equity (excluding preference shares) are used in calculating return on equity. None of the banks have preference shares. Some do have convertible preference shares but these are classified as liabilities rather than equity. The four banks have similar amount of average ordinary equity (between $50000m and $60000m). This is not surprising given that strict prudential rules govern the capital that banks must maintain relative to their various asset portfolios. Hence, the primary determining factor in the level of difference in return on equity is profit earned during the period. For example, NAB and ANZ have the lowest profits and hence the lowest returns on equity (12% and 10% respectively) amongst the four banks. On the contrary, Commonwealth Bank has the highest profit, which then contributes to the highest return on equity (16.2%). It is also worth noting that the banks’ return on equities exceed their return on assets, indicating efficient use of gearing. (c) Note: the ratios for the four banks as summarised in the table below were taken from a Yahoo finnace. Students could use other sources in finding the ratios (such as financial newspapers or the banks’ financial statements) or attempt to calculate the ratios themselves. Depending on how the ratios are calculated there can be discrepancies in the ratios from different sources. Year 2016 Earnings per Share Price-Earnings Ratio Dividend Payout Dividend Yield NAB 0.16c 207.03 times 116.67% 6.23% Commonwealth 539c 15.47 times 111.26% 5.08% ANZ 189c 16.57 times 132.07% 5.20% Westpac 218c 15.56 times 123.31% 5.62% Source: Yahoo Finance Apart from the ‘blip’ with NAB due to the loss from discontinued operations, the table above shows that the banks have similar price-earnings ratio, dividend payout and dividend yield. Investors are willing to pay for the banks’ ordinary shares, on average, 15-16 times of their current profits. The banks are distributing more than 100% of their profits to ordinary shareholders as dividends in the 2016 financial year, with ANZ distributing more than 132%. The rate of returns per dollar invested in ordinary shares are also similar for the four banks, ranging from 5.08% to 6.23%. The most notable difference lies in the earnings per share, where Commonwealth Bank outperforms the other banks by generating 539 cents of profit per share on the average number of ordinary shares issued, which is doubled than what any of the other banks earn per share. Considering that the other three ratios show similar results, it seems that Commonwealth Bank is the best investment amongst the four banks, as it generates the highest earnings per average ordinary shares for the shareholders. Case studies Decision analysis Financial position of Needy Ltd Needy Ltd has issued convertible notes under an agreement to maintain net assets, defined in the agreement as assets minus all liabilities except the convertible notes, at an amount not less than 2 times the amount of the convertible notes issued. Also under the agreement, working capital is to be maintained at not less than 100% of the convertible notes issued. Certain financial information for Needy Ltd is presented below. Additional information 1. Needy Ltd had recorded, as at 30 June 2020, $160 000 of collections from its customers which were not received until 2 July 2020 on the basis that such collections were probably in the mail before midnight on 30 June 2020. 2. In the afternoon of 2 July 2020, Needy Ltd issued cheques to its creditors, dating and recording the cheques as at 30 June 2020. The cheques amounted to $160 000 which is equal to the collections in transit. 3. Needy Ltd is considering a 1-day extension on the due date of the loan payable to 1 July 2021. Required (a) Contrast, by means of comparative ratios, the reported conditions with those that you believe more appropriately represent the financial position of the company. Limit your comparison to the convertible note holders’ agreement. (b) Explain if you believe the company met the conditions of the loan agreement. (c) Discuss the purpose of having such conditions in loan agreements. (a) The conditions that are specified in the agreement on the issue of the convertible notes (CN) can be translated into the following. 1. Total Assets (TA) – Total Liabilities (TL) = > $4 000 000 (CN of $2M  2) 2. Current Assets (CA) – Current Liabilities (CL) => $2 000 000 (Amount of CN). Applying the above to the accounts of Needy Ltd at 30 June 2020, the following figures are obtained: 1. TA $5 370 000 – TL $1 500 000 = $3 870 000, and 2. CA $2 420 000 – CL $1 500 000 = $920 000. Before assessing whether the company meets the conditions imposed with the CN, the impact of the accounts of items contained in the additional information needs to be considered. Item 1: • Collections from A/R received on 2 July have been incorrectly included in the accounts at 30 June. Cash should only be recorded when received. The Cash at Bank figure needs to be reduced by $160 000, and Accounts Receivable increased by $160 000. Since both TA and CA will not change as a result, this item will have no effect on the conditions pertaining to the CN. Item 2: • The cheques issued on 2 July should not be included in the accounts at 30 June. Removal would have the effect of increasing Cash at Bank and increasing the Accounts Payable. Again, since both TA and CA and TL and CL are equally affected, this adjustment, whether made or not, will not have an effect on the conditions attaching to the CN. Item 3: • By changing the loan payable from 30 June 2021 to 1 July 2021 this changes from a current liability to a non-current liability. After adjustment of the above items, the conditions of the CN agreement will be: 1. TA $5 370 000 – TL $1 500 000 = $3 870 000, and 2. CA $2 420 000 – CL $750 000 = $1 670 000. (b) Based on the accounts presented in the adjusted trial balance at 30 June 2020, the company has not met either condition imposed under the CN agreement — see above. If the accounts are adjusted for items 1–3, the company still does not meet the conditions. This serves to highlight the importance of bases used to classify assets and liabilities and how the basis of classification can impact significantly on the calculation of ratios. In this case, the classification of the Loan Payable determines whether or not the loan condition is met. However, given the above situation, management will need to take immediate action to ensure that the conditions under the CN agreement are met. (c) When lenders (such as banks) grant loans to businesses, their requirements to borrowers are more than just paying monthly repayments. The lenders’ main concern is the ability of the borrowers to repay the loan and interest when due. To ensure that the borrowers are able to meet their debt obligations, the lenders impose conditions in loan agreements. The conditions usually require the borrowers to maintain minimum or maximum level of liquidity and solvency ratios during the terms of the loan. Failure to keep the conditions in the loan agreements may result in the loans being called by the lenders (i.e. the borrowers must pay the loans back immediately). Liquidity ratios (e.g. working capital) asses the businesses’ ability to pay off short-term liabilities and show the lenders whether the borrowers will have sufficient funds to repay the debts they owe in the next 12 months. If liquidity ratios start to fall, the borrowers may not have enough assets to cover to the loan in the coming year. This will the lenders’ risk assessment of the loan. Hence, the lenders usually require the borrowers to maintain minimum liquidity ratios to prove their ability to pay off the loan in the next year. Solvency ratios indicate the businesses’ ability to continue their operations in the long term. This includes monitoring the amount of debts as a percentage of the businesses’ assets or equity. Solvency ratios will rise when the businesses take on more loans, which subsequently will increase the risk to default on the existing loans. Hence, the loan agreements usually stipulate the maximum solvency ratios that the borrowers must not exceed. Communication and leadership Financial analyses Find the latest available annual report for a university (preferably your university). Write a report (no more than three pages) and prepare a five-minute oral and visual presentation focusing on the university’s financial performance and position and the main factors contributing to these. Students should find the latest available report for their University or higher education provider and analyse the institution’s performance, noting that a University may be classified as a not-for-profit organisation. The report and presentation should cover the trend in liquidity, solvency and profitability ratios, as well as the main factors contributing to changes in those ratios. A related activity would be to then do an intra-industry comparison. Ethics and governance Are SMEs too small to invest in social enterprises? Required (a) Describe the difference between ethical investment and social impact investment. (b) Given the fiduciary maximisation duty, explain if cancer charities can exclude tobacco company shares. (c) If ethical shares earned a lower return than other shares, discuss how much lower return you would be prepared to accept and still invest in ethical shares only. (The answer could be as low as 0% if you don’t care if your investments are in ethical companies or not.) (d) The responsible investment sector constitutes a growing force in the finance and capital markets of Australasia. Over 50% of the major super funds and eight of the top ten fund managers have committed to a more responsible approach to undertaking investments. Identify and describe a retail investment product certified by the Responsible Investment Association of Australasia. (a) As described in the article, ethical investing is where the “investment takes environmental, social, ethical and governance factors into consideration and is based on achieving the greatest impact from investments by both pursuing maximum financial return and ensuring investments complement, rather than undermine, the wider aims of the organisation.” The screening decision associated with ethical investing may be to screen out companies making harmful products such as tobacco and alcohol (passive screening). Social impact investing is defined as “investments made with the intention of generating measurable social and/or environmental outcomes in addition to a financial return. Social impact investing is an emerging approach that brings together governments, service providers, investors, philanthropists and communities to tackle a range of social and environmental issues.” (see http://www.treasury.gov.au/ConsultationsandReviews/Consultations/2017/Social-impact-investing) The impact of social impact investing is usually measured and reported. The distinction may appear subtle. One way of differentiating the two is that impact investing goes beyond a passive screen by actively seeking to invest in companies or projects that have the potential to create positive economic, social and/or environmental impact. For example, the investing for social impact maybe in areas such as sustainable products, medical solutions, aged care, responsible banking, healthcare, recycling, innovative technology and education. (b) Cancer charities could exclude tobacco companies given that such an investment conflicts with the aims of the organisation, namely to support research into cancer of which tobacco is a major contributor. The charity would have to articulate its reasons for doing so and the possible impact of such a decision on the returns and risk. A major reason fro negative screening of tobacco companies would be the reputational risk of such investments for a cancer charity. The leading case law in this area is the 1991 Bishop of Oxford Case, a test case to clarify the law on the conflict between the maximisation of return and the primary principle of the charity’s mission. It clarified that an ethical constraint based on the charity’s mission takes precedence over the fiduciary maximisation duty, so cancer charities can exclude tobacco company shares. In Australia, a campaigning organisation –Tobacco Free Portfolios in Australia – is arguing for superannuation funds to disinvest in tobacco. The reputational risk associated with such investments was highlighted in 2016 with the revelation that scientists funded by Cancer Research UK, who spend their lives hunting for cures for the disease, are among thousands of academics whose pensions are invested in the tobacco industry. Many of the academics found it unacceptable that investments in the industry were being made with their funds supporting companies that were creating the harm that they were devotingtheir careers to fixing the harm. (c) It will be a matter of personal choice as to how much lower a student (investor) would be prepared to accept and still invest in ethical shares only. This should promopt a discussion of risk and return as well as a discussion of individual preferences and being true to those preferences. Students can also discuss the companies that they would not invest in. To prompt discussion, it may be useful to refer to return data for Australian Ethical Investment. Australian Ethical Investment’s charter guides the investments that the company seeks and the investments that they avoid. It seeks positive investments that support people, quality and sustainability. It avoids investments that harm people, animals, society and the environment. The company excludes unethical investments from its ‘investable universe’ noting that it doesn’t lead to lower performance potential; it just means there is more money available to make positive, profitable investments. It offers different investment options for superannuation funds and managed funds. The returns for 3 and 5 years are summarised below as at end February 2017 (refer to https://www.australianethical.com.au/performance-and-returns/) Superannuation Managed Funds 3 year 5years (p.a.) 1 year 3 years (p.a.) Defensive 1.4% 1.7% Balanced 5.9% 9.0% Conservative 3.5% 3.9% Australian shares 12.7% 14.8% Balanced Accumulation 6.5% 8.2% Diversified shares 7.6% 13.8% Growth 6.7% 9.9% International shares 6.0% 14.9% Smaller Companies 12.8% 14.5% Emerging companies Return for 1 year is 20% International Shares 6.1% 12.7% Source: Australian Ethical Investment website (d) Responsible Investment Association of Australiasia (RIAA) has a certification program whereby an assessment of investment and banking products can result in the products being certified as responsible. RIAA lists the certified investment products on its website (http://www.responsiblereturns.com.au/certified_products). Each student should have selected a certified product from the website and described its features focusing on why it is deemed to be a responsible investment product. An example of a certified banking product is the Community Sector Banking Social Impact Deposit Account. This is a savings account where the Community Sector Banking donates 50% percentage of its net profits from these accounts, and account holders are invited to also donate the interest that they earn, towards social projects and community organisations through the bank’s Social Investment Grants Program. Financial analysis Required (a) Describe Kogan’s business model and what it means to ‘float’ on the Australian Securities Exchange. (b) At a trading price of $1.50, what is Kogan’s price earnings ratio? Compare Kogan’s price earnings ratio with that of other Australian retailers. (c) Kogan forecast revenue of $241.2 million for 2016/2017 with pre-tax earnings of $6.9 million. Using the most recent years of financial information, report on Kogan’s revenue, pre-tax earnings, after-tax profit, and earnings per share. (d) Graph Kogan’s share price since listing on the ASX and explain the trend. What has happened to the value of Mr Kogan and Mr Shafer’s 's 69.2 per cent stake in the business’ since listing? (a) Kogan is a company that provides online retailing for customers. It was a business insprired by the internet and is often associated with the online retailing revoluation inAustralia. The business commenced selling TVs online and has grown its product offerings substantially. Kogan’s business edge is that it aims to be more responsive than its competitors and squeeze manufacturers more. The business does not enter into exclusive manufacturing deals for Kogan-branded products but rather creates an online bidding system, with all manufacturers able to see Kogan orders and each other’s bids. Kogan's mission is to provide what customers want; at prices they can afford; with a safe retunrs policy; and daily deals for loyal customers. To ‘float’ on the Australian Securities Exchange (ASX) means the company’s shares are listed on the Australian Securities Exchange. Kogan was listed on the ASX on 7 July 2016. Kogan offered shares to the public and being listed enables the buying and selling of the issued shares. Companies that are not listed in the ASX can only raise capital from private sources and not from public investors. On the first day of trading on the ASX, the shares traded at a discount to their $1.80 list price. (b) Price earnings multiple, also known as price earnings ratio (P/E ratio) shows how much investors are willing to pay for a company’s shares per dollar of the company’s earnings. In general, a high P/E ratio is associated with higher earnings growth in the future. It s determined by dividing the share price by the earning per share. Based on the information above, it is not possible to determine Kogan’s P/E ratio as the EPS is not provided. However, being a public company the necessary information can be ascertained. The financial statements for the year ended 30 June 2016 report a profit of $809149 and shares of 343 (before listing). Thus the EPS pre listing is $2359 per share! After the float, Kogan has 93.34million shares outstanding. Using the 2016 profit figure, this represents an EPS of around 0.8cents. With a share price of $1.50, this represents a PER of 187.5 times. Over time it is predicted that the PER will be around 15-17 times. The PER for a selection of other Australian retailers (as at March 2016) are: David Jones 23.47 times; SuperRetail Group 21.83 times; Adhairs 8.12 times; and JB Hi-Fi 14.99 times. (Students should be able to come up with a range of retail firms and their PERs). High P/E ratios are quite common for technology-based companies, as there is potentially high growth for such companies with rapid advance in technology and their profits are relative low in initial years. The case can also be that the PER is negative as a firm may list without having generated earnings. For example, the 2017 listing of Snap (the parent entity of Snapchat) sees Snap with a negative PER as its earnings are negative. (c) At the time of writing, Kogan had released its half year report to 31 December 2016. The half year results reported revenue of $143.8 million, profit before tax of $3.352 million and profit after tax of $1.460 million. The actual six month revenue and PBT results represent 60% and 49% respectively of the full year projections. Assuming that the sales and expenses are fairly evenly spread across the financial year, Kogan is on track to meet its projections as the actuals for the six months are 49% or higher of the full year projections. It may be that for a retailer such as Kogan, sales peak in December due to Christmas trade. If December is the largest trading month, then full year projections may not be realised. (d) The Kogan share price graph is available at Yahoo finance: https://au.finance.yahoo.com/quote/KGN.AX?p=KGN.AX. Since listing and up until 24 March 2017, the shares have traded in the range of $1.32 to $1.78. Upon listing at $1.80, the shares traded at a discount. The downward trend continued from listing date to early December 2016 recording a low of $1.32. Since then the shares have trended upwards to close at $1.72 in late March 2016. This remains below their listing price of $1.80. The value of Mr Kogan’s and Mr Shafer’s share portfolio declined on listing representing a paper loss for the two. Their retained ownership of 69.2% (with each share valued at $1.80) is now worth less with the shares trading below $1.80. Mr Kogan owns 47million shares and Mt Shafer 17.8 million shares. At a price of $1.80, the market capitalization of the company was $168 million (of which Mr Kogan and Mr Shafer own 69.2%, approx. worth $116 million). At the close of trade on listing date, the market capiatlaisation of the company was $140 million, representing an approx. value of $97 million. Based on the most recent price of $1.72 at end March 2017, the market capiatlisation is around $161 million, with a 69.2% stake worth $111 million. Solution Manual for Accounting John Hoggett, John Medlin, Claire Beattie, Keryn Chalmers, Andreas Hellmann, Jodie Maxfield 9780730344568