Week 5 - Tutorial 4 Flashcards
Ratio Questions
The following information relates to Millar plc:
Income Statements for the two years to 31 December 2016 and 2017
2016 2017
£000 £000
Credit sales 350 800
Cost of sales 210 500
140 300
Expenses 50 100
90 200
Taxation 22 50
Retained profits 68 150
Statements of Financial Position as at 31 December 2016 and 2017
2016 2017
£000 £000
Non-Current Assets
Property, plant & equipment (net book
value) 2,070 1,920
Current Assets
Inventories 80 100
Trade receivables 180 360
Cash 650 150
910 610
2,980 2,530
Capital and Reserves
Ordinary shares £1 each 1,200 1,200
Share premium account 200 200
Retained earnings 430 580
1,830 1,980
Non-Current Liabilities
Loans (15% debenture stock) 1,000 400
Current Liabilities
Trade payables 120 100
Taxation 30 50
150 150
2,980 2,530
Additional information
i) Credit purchases for the year to 31 December 2016 amounted to £230,000 and for the year to 31 December 2017, £520,000.
ii) The market price of the company’s shares at 31 December 2016 was £1.50p per share and at 31 December 2017, £1.70p per share.
Required
(a) Using the above information calculate, for each of the two years to 31 December 2016 and 2017 respectively, the following ratios:
- TWO liquidity ratios, TWO profitability ratios, and
TWO efficiency ratios; and
- the gearing and price/earnings ratios.
(b) Compare the ratios for 2016 and 2017 and give your interpretation of what an analysis of these ratios can tell a user. What possible explanations are there for the differences between the two years?
Financial ratio formulas available on page 5 and 6 of Ratio Questions.docx
Solution to Millar Plc
Ratio 2016; 2017 Current ratio 910/150 = 6.07:1 610/150 = 4.07:1 Quick ratio (910-80)/150 = 5.5:1 (610-100)/150 = 3.4:1 ROCE 90/2,830 * 100 = 3.2% 200/2,380 * 100 = 8.4% Gross profit margin 140/350 * 100 = 40% 300/800 * 100 = 37.5% Net profit margin 90/350 * 100 = 25.7% 200/800 * 100 = 25% Asset turnover ratio 350/2,830 = 0.12:1 800/2,380 = 0.34:1 Inventory days 80/210 * 365 = 139 days 100/500 * 365 = 73 days Receivable days 180/350 * 365 = 188 days 360/800 * 365 = 164 days Payable days 120/230 * 365 = 190 days 100/520 * 365 = 70 days Gearing 1,000/2,830 * 100 = 35.3% 400/2,380 * 100 = 16.8% EPS 68/1,200 = £0.056p 150/1,200 = £0.125p P/E ratio 1.5/0.056 = 27 times 1.7/0.125 = 14 times
The current ratio is far higher than those recommended (i.e. 2:1 for manufacturing and 1:1
for retail), so despite the fact we don’t know what industry Millar is in, they could be making
better use of their working capital, particularly their cash. It is better in 2017, but still too
high.
The quick ratio takes out stock, as it is the least liquid asset. The figure for 2016 is very high
as stock did not make up too much of the current asset figure. As with the current ratio, it
improves in 2017, but is still too high. The cash has been reduced, but the trade receivables
are too high.
The return on capital employed figure in 2016 seemed very low, but it would depend on the
industry average. It improved in 2017 as the profit was higher and there was less capital
employed.
The gross profit margin was very high in 2016 at 40%, but had gone down to 37.5% in 2017.
This could have been because the cost of goods sold has gone up, but this has not been
passed on to their customers. Or the company has changed its product mix and is now
selling goods with a lower profit margin. Or the company has sold its goods at a lower price
or offered discounts.
The net profit margin appears high at 25.7% and has only reduced slightly in 2017 when
compared with the gross profit margin. This means the company is keeping its overheads
under control.
The general guideline for the asset turnover ratio is that it should be a minimum of 1:1,
therefore the figure for 2016 is very low. It improves slightly in 2017, but is still too low. This
means the company is not making the best use of its assets.
The inventory days in 2016 were very high, although it depends on the product being sold. It
improved greatly in 2017, but it is still taking the company over 2 months to turnover their
inventory. Holding inventory leads to costs such as storage, heat and light, audit and the risk
of obsolescence. Holding inventory is also an opportunity cost.
It was taking Millar 188 days to get all the money from its trade receivables in 2016. This
appears to be high, but could be normal in the industry they operate in. The figure is slightly
lower in 2016, but they are still waiting over 5 months to get their debtors to pay. This could
be a fault of the credit control department.
With regard to the trade payable days, these were high in 2016, but much lower in 2017.
However, in 2017, Millar was paying its suppliers before it got money from its debtors.
Therefore, whilst the suppliers were happier, this would have put a strain on its working
capital.
The gearing was at an acceptable level in 2016, but was quite low in 2017 due to paying off
£600,000 of its long-term liabilities. This could make the company seem a bit risk averse.
The EPS was quite low in 2016, but due to a higher profit was better in 2017.
The P/E ratio had gone down in 2017 despite a generally better performance by the
company. This could have been due to factors outside the performance of the company, or
the better performance coming later in the year.
Ratio Questions
The following information relates to McPherson plc:
Income Statements for the two years to 31 December 2016 and 2017
2016 2017
£m £m
Credit sales 850 971
Cost of sales 380 410
470 561
Expenses 282 337
188 224
Taxation 46 36
Retained profits 142 188
Statements of Financial Position as at 31 December 2016 and 2017
2016 2017
£m £m
Non-Current Assets
Property, plant & equipment
(net book value) 1,170 1,128
Current Assets
Inventories 82 70
Trade receivables 278 290
Bank 4 10
364 370
1,534 1,498
Capital and Reserves
Ordinary shares £0.50p each 520 520
Share premium account 98 98
Retained earnings 106 174
General reserve 140 220
864 1,012
Non-Current Liabilities
Long-term loan 500 300
Current Liabilities
Bank overdraft 16 68
Trade payables 108 82
Taxation 46 36
170 186
1,534 1,498
Additional information
Credit purchases for the year to 31 December 2016 amounted to £398m and for the year to 31 December 2017, £416m.The market price of the company’s shares at 31 December 2016 was £1.80p per share and at 31 December 2017, £2.20p per share.
Required
a) Using the above information calculate, for each of the two years to 31 December 2016 and 2017 respectively, the following ratios
- TWO liquidity ratios, TWO profitability ratios, and TWO
efficiency ratios; and
- the gearing and price/earnings ratios.
b) Compare the ratios for 2016 and 2017 and give your
interpretation of what an analysis of these ratios reveals about the financial position of McPherson plc. What possible explanations are there for the differences between the two years?
Financial ratio formulas available on page 5 and 6 of Ratio Questions.docx
Solution to McPherson Plc
Ratio 2016; 2017 Current ratio 364/170 = 2.14:1 370/186 = 2:1 Quick ratio 282/170 = 1.7:1 300/186 = 1.6:1 ROCE 188/1,364 * 100 = 13.8% 224/1,312 * 100 = 17% Gross profit margin 470/850 * 100 = 55.2% 561/971 * 100 = 57.8% Net profit margin 188/850 * 100 = 22.1% 224/971 * 100 = 23% Asset turnover ratio 850/1364 = 0.6:1 971/1312 = 0.7:1 Inventory days 82/380 * 365 = 79 days 70/410 * 365 = 62 days Receivable days 278/850 * 365 = 119 days 290/971 * 365 = 109 days Payable days 108/398 * 365 = 99 days 82/416 * 365 = 72 days Gearing 500/1,364 * 100 = 37% 300/1,312 * 100 = 22.9% EPS 142/1,040 = £0.136p 188/1,040 = £0.18p P/E ratio 1.8/0.136 = 13.2 times 2.2/.18 = 12.2 times
McPherson plc has good current and quick ratios, which only went down slightly in 2017,
still leaving the company able to cover its liabilities. Their trade receivables have gone up
slightly, but this would be expected given the increased sales. Inventory and trade payables
are both down, which would indicate the company is selling its products and has no
difficulty in paying its creditors. However, the average settlement period for receivables
appears to be very high at 119 days, meaning in 2016 it was taking the company almost four
months to receive payment. This went down slightly to 109 days in 2017, but this is still over
three months. In both 2016 and 2017 they were paying their payables before getting paid by
their receivables, which could have an effect on cash flow. However, the average settlement
period for payables has reduced, which means their suppliers should be satisfied. It would
be interesting to know whether they need as much as £10m in their bank account, and
whether this money could be invested elsewhere - particularly as their overdraft is so high.
We do not know what business McPherson plc is in, but it is taking them a long time to clear
their inventory (79 days). However, this figure did improve in 2017.
Their asset turnover appears to be low, although again this has improved in 2017. A rule of
thumb is that a business should turn over its assets at least once, but the company is below
this in both years. The return on capital employed has improved, which is a result of a
higher operating profit and less liabilities, as the company has paid back some of their long-
term loan. The gross profit margin has increased slightly, which is interesting as it was
already quite high. The company may be negotiating better prices with their suppliers or
producing higher quality products with better margins. Their operating profit margin has
also increased slightly, although not as much as the gross profit margin, which could mean
the company is paying out more on expenses. This will need to be monitored
The gearing ratio has reduced, which would be expected following the repayment of some
of the long-term loan. However, the company could probably afford to borrow a bit more,
or use some of their cash reserves, so that investors do not think that it is becoming risk
averse. It would be interesting to compare the interest they are paying on their long-term
loan to that which they are paying on their overdraft. The earnings per share was much
higher in 2017, as was the share price, and whilst the price/earnings ratio is slightly lower
there is clearly still a lot of confidence in the company.
- The chair of the Broadstores company states that the management of the company has performed well in a very difficult economic climate, and that increased profits have been retained within the business to finance profitable expansion.
A shareholder at the annual general meeting of the company claims that the reduction in profits and the absence of dividends prove that the management
of the company is a disaster.
Assess the evidence for each point of view.
Hint: consider the Gross Profit Ratio, Net Profit Ratio, and Return on Shareholders’ Fund – see bottom of document for ratio formulas.
Income Statement of Broadstores Company for the year ended 31 December
Year 7 Year8
Revenue 200 220
Cost of goods sold (120) (131)
Gross profit 80 89
Operating expenses
Selling & distribution (22) (24)
Administration (40) (41)
Total (62) (65)
Operating profit 18 24
Finance expenses (10) (18)
Profit before tax 8 6
Tax on profit for year (3) (2)
Profit after tax for the year 5 4
Statement of changes in equity of Broadstores Company
for the year ended 31 December
Year 7 Year8
Balance at the beginning of year 50 51
Profit for the year 5 4
Dividends paid 4 0
Balance at end of year 51 55
Gross Profit % = Gross Profit/Sales x100 Year 7 80/200 = 40% Year 8 89/220 = 40.45%
Net Profit % = Net Profit/Sales x 100 Year 7 18/200 = 9% Year 8 24/220 = 10.9%
Return on Shareholder’s Funds (ROE) = (Net profit after taxation and preference dividend (if any)/Ordinary share capital + Reserves) x 100 Year 7 5/51 = 9.8% Year 8 4/55 = 7.27%
• The chair is incorrect since there has been a decline in profitability as shown by ROE - this is despite the increase in gross profit and net profit
• The company is not using its capital effectively
• The shareholder is correct in pointing out the decline in overall profitability
• The level of dividends is also lower than in the previous year - in year 8 no dividends were paid
• However, it is not possible to infer the quality of
management from reading the financial statements;
therefore there is a need to further examine the company by comparing this year’s performance with previous year’s figures and industry averages
- a. The Billygate Company operated with a 40 per cent mark-up on the goods that it buys.
Markup = Gross profit/Cost of sales = 40/100
What are the total sales of the company?
Hint: Gross Profit = Sales – Cost of Sales
What is the Gross Profit Margin of the company?
b. The Sillygate Company operates with a 40 per cent gross profit margin.
What percentage mark-up does it use?
Gross profit margin = Gross profit/Sales = 40/100
Calculate the Cost of Sales, and then work out the mark up.
Billygate
Although we are not given the figure for Sales we can work it out:
Markup = Gross profit/Cost of sales = 40/100
From this we can work that sales must be:
Sales = Gross profit + Cost of sales = 40 + 100 = 140
Then we can work out Gross Profit Margin:
Gross Profit Margin = Gross profit/Sales = 40/140 = 0.286 = 28.6%
Sillygate
Although we are not given the figure for Cost of Sales we can work it out:
Gross Profit Margin = Gross profit/Sales = 40/100
From this we can work that Cost of Sales must be:
Cost of sales = Sales - Gross profit = 100 - 40 = 60
Then we can work out the mark-up:
Markup = Gross profit/Cost of sales = 40/60 = 0.667 = 66.7%
- The following trial balance has been drawn up for SuperSoftService as at 31st December 2016 after its first year of trading
£000 £000
Sales 800
Purchases 400
Admin, distrib. and gen. expenses 200
Salaries 116
Non-current assets 472
Trade receivables 320
Trade payables 44
Bank overdraft 12
Long-term loan 600
Capital 52
1,508 1,508
However, some further information has come to light:
i. The closing inventory has been valued at £30,000 (this effects the cost of goods sold – see bottom of document - and will be a current asset on the statement of financial position);
ii. The business has an outstanding utility bill for the final quarter of the year. To date they have paid £45,000 for this service for 2016 (this expense comes under administration, distribution and general expenses and is an example of an accrual);
iii. The business paid for two years’ line rental in advance when it commenced operations on January 1st, 2016. This was £1,000 per annum (this expense comes under administration, distribution and general expenses and is an example of a prepayment);
iv. Depreciation has not been calculated for the year. The non-current assets are depreciated at 5% per annum using the straight line method (remember depreciation is an expense and reduces the value of the non-current assets on the statement of financial position);
v. The company has been informed that one debtor who owes £15,000 has gone bankrupt and will be unable to pay what they owe (this is an expense and will reduce the value of the trade receivables on the statement of financial position);
vi. The company has also been advised by their accountant that it should set up an allowance for doubtful debts provision of 4% of trade receivables (this will be a new expense and also reduce the value of the trade receivables on the statement of financial position – remember the trade receivables figure has been reduced due to the above
point);
vii. In November, another member of staff joined the company, but their salary for the last two months of the year has not been included in the trial balance. They earn £1,000 a month and the company must pay15% national insurance contributions on all salaries (this expense comes under salaries and is a further example of an accrual); and
viii. The company pays corporation tax at 20% (this will be taken off the net profit figure and as it has not been paid will be a current liability on the statement of financial position).
Taking into account the new information above, draw up the income statement for the year ending 31st December 2016 and the statement of financial position as at 31st December 2016. Remember the final profit figure after tax is added to the existing capital in the statement of financial position.
Income statement for SuperSoftService for the year ended 31 December 2016
£000 £000
Revenue 800
Cost of goods sold
Purchases 400
400
Less Closing inventories (30) 370
Gross profit 430
Expenses (214)
Salaries (118.3)
Bad debt (15)
Allowance for doubtful debts
provision (12.2)
Depreciation (23.6)
Profit before taxation 46.9
Taxation (9.4)
Net profit 37.5
Statement of financial position for SuperSoftService as at 31st December 2016
£000 £000
Non-current assets 472
Less Depreciation (23.6)
448.4
Current assets
Inventory 30
Trade receivables 292.8
Prepayments 1 323.8
Total assets 772.2
Capital and reserves
Capital 52
Profit for year 37.5 89.5
Long term liabilities 600
Current liabilities
Trade payables 44
Accruals 17.3
Bank overdraft 12
Taxation 9.4 82.7
Total liabilities 772.2
Workings:
• The expenses currently stand at £200,000; to this we can add the outstanding utility bill (assumed to be £15,000 if the first three quarters amounted to £45,000) and take off the remaining one year’s line rental that has been paid in advance (£1,000). Therefore, the expenses’ figure is £214,000.
• The salaries currently stand at £116,000; to this we must add the £2,000 for the outstanding two months of the new employee, plus £300 for the national insurance contributions. Therefore, the figure for salaries is £118,300.
• We also now have accruals totalling £17,300 and a prepayment of £1,000.
• The bad debt is written off as an expense.
• This also reduces the trade receivables’ figure to £305,000.
• The allowance for for doubtful debts provision is therefore £305,000.04, which equals £12,200.
• On the statement of financial position the trade receivables will be shown as net of this figure; i.e. £292,800.
• The cost value of the non-current assets is £472,000; therefore the depreciation for the year is £472,000.05, which equals £23,600.
• On the statement of financial position, the non-current assets will be shown net of this figure; i.e. £448,400.
- The directors of the Depreciation Company are deciding on their accounting policy on the depreciation of their non-current assets.
They have just purchased some new assets that cost £200,000 and which they expect to sell after five years for £20,000.
a. Calculate the depreciation expense in the income statement and the figures that will appear in the statement of financial position (for the five years of the assets’ life) of the company assuming:
i. They adopt the straight-line basis of depreciation
ii. They adopt the diminishing basis at 30 per cent
b. Advise the directors which method is the more appropriate and why.
Ratio formulas and other information can be found at the bottom of the tutorial sheet
Straight-line basis
(a)(i) Straight-line depreciation:
Cost - scrap value/number of years
= (200,000 – 20,000)/5 = 36,000/year
Cost 200,000
Year 1 depreciation 36,000
net book value: year 1 164,000
Year 2: depreciation 36,000
net book value: year 2 128,000
Year 3: depreciation 36,000
net book value: year 3 92,000
Year 4: depreciation 36,000
net book value: year 4 56,000
Year 5: depreciation 36,000
net book value: year 5 20,000
Reducing balance basis
(a)(ii) Reducing balance basis
net book value x percentage 200,000
Year 1 depreciation 200,000 x 30% 60,000
net book value: year 1 140,000
Year 2: depreciation 140,000 x 30% 42,000
net book value: year 2 98,000
Year 3: depreciation 98,000 x 30% 29,400
net book value: year 3 68,600
Year 4: depreciation 68,600 x 30% 20,580
net book value: year 4 48,020
Year 5: depreciation 48,020 x 30% 14,406
net book value: year 5 33,614
b.
• In theory, the basis should be chosen according to
the pattern of revenues arising from this asset
• If the revenues arising are approximately equal
over the life of the asset, then the straight-line method is more suitable
• If, however, the revenues are expected to decline
as the life of the asset proceeds, then the reducing balance basis is more appropriate
• This way of thinking is based upon the matching concept
