B7AF102 Financial Accounting

Interpretation of Financial Statements

Ratio Analysis
Example

The following are the accounts of Crocodile Ltd, a shop which sells clothing and shoes:

Income Statement for the year ended 31 December 2010

€ €
Sales 235,000

Less: Cost of Sales

Opening inventory 84,000
Add Purchases 174,000
258,000
Less Closing inventory (95,000)
(163,000)
Gross Profit 72,000
Less Expenses (53,000)
Net Operating Profit 19,000
Less: Bank Interest (11,000)

Net Profit 8,000

Statement of Financial Position as at 31 December 2010

€ €
Non-current Assets

Building – at book value 475,000

Current Assets
Inventory 95,000
Accounts receivable 34,000
Bank 8,000
137,000
Total Assets 612,000

Equity and liabilities

Capital
Ordinary share capital – Ordinary shares of €1 each 342,000
Retained profits as at 31 December 2010 202,000
544,000

Current liabilities
Accounts payable 68,000

Total equity and liabilities 612,000

Required

Using the above Income Statement and Statement of Financial Position, calculate and
comment on the following ratios:

(i) Gross profit as percentage of sales

(ii) Net profit as percentage of sales

(iii) Current ratio

(iv) Acid test ratio

(v) Debtors days

(vi) Creditors days

(vii) Earnings per share

Total: 30 marks

Marks

(i) Gross Profit:Sales 72,000/235,000 * 100 = 30.64%

(ii) Net Profit : Sales 8,000/235,000 * 100 = 3.40%

(iii) Current Ratio 137,000:68,000 = 2.01 :1

(137,000-
(iv) Acid Test Ratio 95,000):68,000 = 0.62 :1

(v) Acc rec Days 34,000 / 235,000 * 365 = 52.81 days

(vi) Acc pay days 68,000 / 174,000 * 365 = 142.64 days

(vii) Earnings per share 8,000 / 342,000 = 2.34 cent

For each calculation, 3 marks 21.00

For each relevant comment, 1 mark 7.00

Presentation 2.00

Total Marks 30.00

Gross profit margin

This represents the amount of gross profit for every €100 of sales revenue. E.g. 30.64% for
every €100 of sales €30.64 gross profit was made before any expenses were paid.

Compare the 30.64% to the industry average or benchmark and examine the trend over the
last number of years to see if it increasing or decreasing.

Net profit margin

This represents the amount of net profit for every €100 of sales revenue. E.g. 3.40% for every
€100 of sales €3.40 net profit was made after expenses were paid.

Again compare the 3.40% to the industry average or benchmark and examine the trend
over the last number of years to see if it increasing or decreasing.

There is a significant drop from a gp% of 30.64% to a np% of 3.40%. Expenses are the
reason for the difference. It would be beneficial to see what the breakdown of these expenses
is for this year and for the previous year. This additional information may highlight areas in
need of strict cost control measures.

Current ratio

The current ratio of 2.01:1. This is in line with the rule of thumb of 2:1. However, this
should also be compared to the industry average and to competitors.

Acid test ratio

The acid test ratio is 0.62:1 which is well below the 1:1 rule of thumb. Although it is well
below the rule of thumb many firms operated successfully at this level. However, this should
be viewed with caution as it will depend on the industry the firm is operating in.

Both the current ratio and the acid test ratio measure the liquidity of the business i.e. the
ability of the business to pay its debts as they fall due.
The acid test ratio suggests an under investment in working capital, important to analyse
inventory turnover, accounts receivable and accounts payable days for a more detailed
breakdown.

Inventory turnover

This shows the number of days on average that stock is held before it is sold.

(Average inventory/ cost of sales) x 365 = 200 days [(84,000+95,000)/2 x

365]

This is very high particularly when we take into account the Crocodile Ltd sells clothing and
shoes which are particularly exposed to obsolescence due to continuous changes in fashion.

Accounts receivables days

It takes Crocodile Ltd 53 days on average to collect payment from its credit customers.
This is high compared to the norm of 30days i.e. Accounts receivables are taking 23days
extra to pay, Crocodile Ltd need to start implementing a strict credit control policy.

Accounts payables days

143 days is well above the industry average of 30 days. Although this is essentially a free
source of finance, corrective action is required immediately as continuing to take extended
credit from suppliers could jeopardise future supplies and on time supplies and quality of
goods supplied. Suppliers will give priority to those customers that pay on time.

Earnings per share

This is the amount attributable to each ordinary share after everyone else has been paid.

EPS measures performance from the perspective of investors and potential investors. It
shows the amount of earnings available to each ordinary shareholder, so that it indicates the
potential return on individual investments.

It is widely regarded as one of the most important indicators of a company’s performance –

compare to different entities and to the EPS of the same entity in different accounting
periods.
Exercises
Question 1

The following are the summary financial statements of two similar type hardware retailers.
Summary of Income Statement

Hardware Hardware Hardware Hardware

A A B B
€ € € €
Sales 250,000 230,000
Cost of sales
Opening Inventory 15,000 12,000
Purchases 194,000 161,000
Closing Inventory (19,000) (18,000)
Cost of Sales 190,000 155,000
Gross Profit 60,000 75,000
Expenses 15,000 5,000
Net Profit 45,000 70,000
====== ======

Summary Statement of Financial Position

Hardware Hardware Hardware Hardware

A A B B
€ € € €
Non-Current assets 250,000 300,000

Current assets
Inventory 19,000 18,000
Accounts receivables 65,000 45,000
Bank 0 5,000
84,000 68,000
Total assets 334,000 368,000

Total Equity and Liablities

Ordinary Share Capital 100 100
Retained Profits 116,900 266,900
117,000 267,000
Non-Current Liabilities
Long term Loans 150,000 75,000

Current Liabilities
Accounts Payables 56,000 26,000
Bank 11,000 0
67,000 26,000
Total equity and liabilities 334,000 368,000
Required:

A. Calculate and explain the following ratios:

 Current ratio

 Acid test ratio

 Accounts receivables ratio

 Accounts payables ratio

 Gross Profit Margin

 Net Profit Margin

 Return on capital employed

25 marks

B. There are the two main types of analysis that can be made using ratios, explain both.
5 marks
Question 2
The following balances were taken from the books of Q and B Ltd, who are the largest
suppliers of DIY products to small hardware shops and the public.

31 Dec 2006 31 Dec 2007

€ €
Sales 7,500,000 9,000,000
Cost of sales 4,300,000 6,000,000
Expenses 2,000,000 1,500,000
Buildings 1,000,000 1,000,000
Fixtures 500,000 600,000
Inventory 430,000 480,000
Accounts receivables 10,000 11,000
Accounts payables 340,000 521,000
€1 Ordinary shares 1,000,000 1,000,000
8% Debentures 700,000 700,000
Cash and bank 100,000 130,000

Note: Inventory 1 Jan 2006 €400,000.

Required

(a) Calculate and explain the following ratios for 2006 and 2007:
(i) Current ratio
(ii) Acid test ratio
(iii) Accounts receivables payment period
(iv) Accounts payables payment period
(v) Inventory turnover
(vi) Gross profit %
(vii) Net profit %
(viii) Return on capital employed
(20 marks)
(b) Explain the difference between the debtor payment period and the creditor
payment period. (5 marks)

Question 3
The following figures were taken from the books of Prescribe Ltd who manufacture drugs.

31 Dec 2006 31 Dec 2007

Sales 300,000 400,000

Cost of sales 200,000 220,000
Expenses 50,000 55,000
Land and buildings 100,000 100,000
Machinery 80,000 90,000
Accounts receivables 65,000 73,000
Accounts payables 87,000 91,000
Inventory 33,000 22,000
€1 Ordinary shares 112,000 115,500
Long term loan 80,000 80,000
Cash and bank 1,000 1,500

Note: Inventory 1 Jan 2006 €38,000

The long term loan is secured on the land and buildings.

Required

(a) Calculate and explain the following ratios for 2006 and 2007:

(i) Current ratio

(ii) Acid test ratio
(iii) Accounts receivbales payment
period (iv) Accounts payables payment
period (v) Inventory turnover

(vi) Gross profit %

(vii) Net profit %
(viii) Return on capital employed

(20 marks)
SOLUTIONS
Question 1
A. Ratio

1 Current Ratio CA:CL 0.5

84000:67000 68000:26000

1.25 :1 2.62 :1 1

2 Acid Test Ratio CA-S:CL 0.5

65000:67000 50000:26000
0.97 :1 1.92 :1 1

3 Acc rec Days acc rec*365 0.5

Credit Sales

65000*365 94.90 45000*365 71.41304 1

250,000.00 230,000.00

4. Acc pay Days acc pay*365 0.5

Purchases

56000*365 105.36 26000*365 58.9441 1

194,000.00 161,000.00

5. Gross Profit GP *100 0.5

Sales

60000*100 24.00 75000*100 32.6087 1

250,000.00 230,000.00

6. Net Profit NP*100 0.5

Sales
45000*100 18.00 70000*100 30.43478 1
250,000.00 230,000.00

7. ROCE Net profit 0.5

Shareholders funds plus long term loans

45000*100 16.85 70000*100 20.46784

267,000.00 342,000.00 1
Explanations 2 marks each

Current Ratio: Compares current assets to current liabilities, it indicates the extent that
amounts owed to short term creditors can be met from short term assets. Ratios of about 2:1 is
ideal, to allow for stock being high.

Acid Test Ratio: It’s indicated the company’s ability to pay its immediate liabilities. Ideal ratio
would be 1:1.

It indicates the average length of time it takes to convert acc rec into cash. An excessive acc
rec ratio is indicative of poor credit control or even over trading.

It indicates the average length of credit taken by the business in settling its debts. If credit
taken is too high it may result in a loss of goodwill or even credit facilities.

Efficiency and Profitability Ratios

Return on capital employed: profit expressed as a percentage of capital employed. Measure
how efficient a company controls and uses it’s assets and how successful it is in generating
profits.

Gross Profit: expresses gross profit as a percentage of sales. A low result could be a sign of
inefficiency and poor pricing policy. The type of business must be taken into account.
Net Profit: expresses net profit as a percentage of sales. Indicates the relative efficiency of a
business after deducting all expenses.

B Analysis

1. Internal: analysis is made between past performance, budgets and forecasts. 2

2. External: the financial statements are compared to similar companies and industrial averag 3
5
Q2 Q and B Ltd
2006 2007
Sales 7500000 9000000
Less cost of sales 4300000 6000000
Gross profit 3200000 3000000
Less expense 2000000 1500000
Net profit 1200000 1500000

Current assets
Inventory 430000 480000
Acc rec 10000 11000
Cash and bank 100000 130000
540000 621000
Current liabilities
Acc pay 340000 521000

Capital employed
Ordinary shares 1000000 1000000
Debentures 700000 700000
1700000 1700000

2006 2007
2 Current ratio 1.59 1.19
2 Acid test ratio 0.32 0.27
2 Acc rec payment period 1 day 1 day
2 Acc pay payment period 29 days 31 days
2 Inventory turnover 10 times 13 times
2 Gross profit % 43% 33%
2 Net profit % 16% 19%
2 ROCE 71% 88%
16 marks

24 marks explanation of each, mention any benchmarks/ comparisons,

show understanding, interrelationship between ratios (8 x 3 marks)

10 marks show understanding of why no debtors, type of business,

concerned by liquidity position etc
Q3 Prescribe Ltd
2006 2007
Sales 300000 400000
Less cost of sales 200000 220000
Gross profit 100000 180000
Less expense 50000 55000
Net profit 50000 125000

Current assets
Inventory 33000 22000
Acc rec 65000 73000
Cash and bank 1000 1500
99000 96500
Current liabilities
Acc pay 87000 91000

Capital employed
Ordinary shares 112000 115500
Long term loan 80000 80000
192000 195500

2006 2007
2 Current ratio 1.14 1.06
2 Acid test ratio 0.76 0.82
2 Debtor payment period 79 days 67 days
2 Creditor payment period 159 days 151 days
2 Stock turnover 6 times 8 times
2 Gross profit % 33% 45%
2 Net profit % 17% 31%
2 ROCE 26% 64%
16 marks

24 marks explanation of each, mention any benchmarks/ comparisons,

show understanding, interrelationship between ratios (8 x 3 marks)

10 marks mention liquidity problems, how good profitability but no money,

loan secured on buildings, options - issue shares? Etc