BAFS – Accounting Ratios / Financial analysis HKALE - Answer

1. AL2008.Q1(b)
(b)
$ $
$1 ordinary share capital ($8 000 000 + $1 200 000) 9 200 000
Share premium ($1 500 000 + $1 800 000) 3 300 000
General reserve 600 000
Retained profits Balance b/d 1 280 000
Profit for the year
($3 700 000 - $2 000 000 x 6% - 200 000) 3 380 000 4 660 000
Shareholders’ equity 17 760 000
6% debentures 2 000 000
Capital employed 19 760 000

Alternative
$ $
Shareholders’ equity as at 31 December 2006 11 380 000
Issue of 1 200 000 ordinary shares at $2.50 each (1,200,000 x $2.5) 3 000 000
Profit before interest and tax 3 700 000
Interest expense ($2 000 000 x 6%) (120 000)
Tax expense (200 000)
Profit after tax 3 380 000
Shareholders’ equity as at 31 December 2007 17 760 000
Issue of $2 000 000 6% debentures at par 2 000 000
Capital employed 19 760 000

(1) Return on capital employed: Profit before interest and tax / Capital employed
$ 3 700 000 / $19 760 000 = 18.72% 2
(2) Return on equity: Profit after interest and tax / Shareholders’ equity
$3 380 000 / $17 760 000 = 19.03% 2
(3) Earnings per share: Profit after interest and tax / Number of ordinary shares
$3 380 000 / (8 000 000 + 1 200 000) = 36.74 cents 2
(6)

Reference: Part (a) Distinguish between equity capital and loan capital:

Equity capital Loan capital

- Shareholders have voting right - Debenture holders have no voting right
- Dividend is an appropriation of profit - Interest is an expense
- Dividend rate is not fixed - Interest rate is fixed
- There is no / stipulated date for repayment of capital- There is a stipulated date for redemption of
debentures
- In case of liquidation, shareholders rank the last to - Debenture holders rank before shareholders in case
receive back the fund invested of liquidation

(2 marks for each relevant comparison, max. 4 marks)

(4)

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BAFS – Accounting Ratios / Financial analysis HKALE - Answer
2. AL.2009.Q4(a)(b)
(a)
(1) Gearing ratio [$5 500 000 / ($5 346 000 + $5 500 000)] 50.71% 1
(or 0.51)

(2) Earnings per share [$1 126 000 / ($2 000 000 / 5)] $2.82 1

(3) Return on equity

$1 126 000 / {[($5 346 000 - $1 126 000) + $5 346 000] /2} 23.54% 1
(or 0.24)

(4) Return on Capital employed 13.62% 1

[$1 126 000 + ($5 500 000 x 5%)] / or 0.14
{[$5 346 000 - $1 126 000 + $5 500 000] + ($5 346 000 + $5 500 000) / 2 }
(4)

(b)
- Tai Wo Ltd is a highly geared company with half of its capital employed contributed by loan capital.
- When the overall return of the company exceeds the fixed return to debenture holders, the profit in
excess (residual profit) will go to the shareholders.
- In this case, the return on capital employed is 13.62% which is in excess of 5%. The profit in excess of (3)
5% will go to the shareholders, resulting in a return on capital of 23.54%.
Max. 3

3. AL2011.Q1(a)
Receivables collection period
- The collection period of the partnership is longer than that of the industry average by 0.7 month. 0.5
- It may be the result of a more lenient credit policy with a longer credit period granted to its 1
customers in order to promote sales
(max 1 mark)

Payables repayment period

- The repayment period of the partnership is shorter than the industry average by 0.6 month 0.5
- The business has to repay the supplier faster than its competitors, which hampered the liquidity of the 1
business.
(max 1 mark)

Inventory turnover rate

- The inventory turnover rate is higher than industrial average by 0.7 times. 0.5
- The higher the rate, the faster the flow of inventory, the faster the inventory replenishment and there 1
is less obsolescence and outdated inventories.
(max 1 mark)

Overall comment
- The higher inventory turnover rate implied the partnership was more able to sell inventories at a
faster rate in 2009 and thus in a better liquidity position in this period.
- Yet, the longer collection period and the shorter repayment period indicated that the overall liquidity
of the business was worse than its competitors in 2009.
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BAFS – Accounting Ratios / Financial analysis HKALE - Answer
- The partnership can give cash discount to encourage early settlement from trade receivables, or try
to find other suppliers with a longer credit period so as to maintain its liquidity.
(1 mark each, max 1 mark)

Note: Making suggestions based on the ratios calculated is NOT REQUIRED in HKDSE since 2017.

(4)

4. AL2012.Q5(a)(b)
(a)
(1) Capital gearing ratio
= (Non-current liabilities + Preference share capital) / Capital Employed
= ($800 000 + $600 000) / $3 462 000 (W1)
= 40.44% (or 0.40 / 0.40 : 1) (2)
(2) Return on capital employed
= Profit before interest and tax / Capital employed
= [$320 000 + ($800 000 x 4%) + $90 000] / $3 356 000 (W1)
= 13.17% (2)
(3) Earnings per share:
= (Net profit after tax – Preference share dividend) / Number of ordinary shares outstanding
= ($320 000 - $36 000) – ($970 000 / $2)
= $0.59 or $58.57 cents (2)
(4) Dividend cover
= (Net profit after tax – Preference share dividend) / Ordinary dividend paid
= ($320 000 - $36 000) – ($72 000)
= $3.94 times (2)
(8)

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BAFS – Accounting Ratios / Financial analysis HKALE - Answer
Workings:

W1
Capital Employed $ $
Ordinary share capital 970 000
Preference share capital 600 000
1 570 000
Retained profits brought forward, 1 January 880 000
2010
Add: Net profit after tax for the year 2010 320 000
1 200 000
Less: Dividend paid ($36 000 + $72 000) 108 000 1 092 000
2 662 000
Non-current liabilities 800 000
Capital employed as at 31 December 2010 3 462 000

Capital Employed $ $
Ordinary share capital 970 000
Preference share capital 600 000
Retained profits, 1 January 2010 880 000
2 450 000
Non-current liabilities 800 000
Capital employed as at 1 January 2010 3 250 000

Average capital employed = ($3 250 000 + $3 462 000) / 2 = $3 356 000

(b)
Advice:
- To reduce the capital gearing ratio, ordinary shares should be issued. 1
Explanation: Max. 2
- Issuing preference shares would lead to higher capital gearing ratio as it would be added to the
non-current liabilities in the calculation of the ratio.
- The company is committed to pay out preference share dividend at a stated rate, no matter the
profitability is high or not.
- Other methods, e.g. issuing debentures, can raise capital but would lead to higher capital gearing
ratio, so should not be considered.
(1 mark for each relevant point, max. 2 marks)
(3)

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BAFS – Accounting Ratios / Financial analysis HKALE - Answer
5. AL2010.Q4(A)(B) (Modified, added share premium to general reserve)
(A)(a) Dividend cover measures the number of time annual ordinary dividend is covered by annual 1
profit attributable to ordinary shareholders.

Interpretation: The higher the ratio, the more likely that the dividend can be maintained in the future. 1

(b) Limitation of ratio analysis: 3

- Misleading results if the underpinning financial information is poor, e.g. poor estimation on
depreciation and allowance for doubtful debts.
- Timeliness of information: ratio is based on past financial information, however, past performance of
a firm does not necessarily indicate its future performance.
- Different judgment on the accounting policies to be used for certain transactions. With different
accepted accounting policies used for the same transaction by different companies, it is difficult to
compare and draw conclusion on their performance.
- Ratios can only identify the symptoms, but not the causes. Different interpretations can be drawn by
different people.
- Adhere to the money measurement concept, non-monetary but significant items, such as quality of
goods, management, the diversity of product, could not be reviewed.
(1 mark each, max 3 marks)

(B)(a) Earnings per share: (EPS)

= ($2 950 000 - $4 000 000 x 8%)/($12 000 000/$2)
= $0.44 per share 1
(b) Price-earnings (P/E) ratio
= $5/ $0.44
= 11.36 1
Or
$5/{($2 950 000 - $4 000 000 x 8%)/($12 000 000/$2)}
= 11.41

(c) Dividend cover

($2 950 000 - $320 000)/($12 000 000/$2 x $0.2)
= 2.19 times 1
(3)