Financial Management for Decision Makers 9th edition

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Self-assessment question 3.

1 Required:
For each business, calculate two ratios that are concerned with each of the following aspects:
Both Ali plc and Bhaskar plc operate wholesale electrical stores throughout the UK. The
financial statements of each business for the year ended 30 June last year are as follows: ■ profitability
■ efficiency
Statements of financial position as at 30 June last year ■ liquidity
■ gearing
Ali plc Bhaskar plc
■ investment (ten ratios in total).
£m £m
ASSETS Required:
Non-current assets (a) What can you conclude from the ratios that you have calculated?
Property, plant and equipment (cost less (b) Calculate the Z-scores for each business using the Altman model.
depreciation) (c) Comment on the Z-scores for each business and on the validity of applying the Altman
Land and buildings 360.0 510.0 model to these particular businesses.
Fixtures and fittings 87.0 91.2
The solution to this question can be found at the back of the book on pp. 636–37.
447.0 601.2
Current assets
Inventories 592.0 403.0
Trade receivables 176.4 321.9 SUMMARY
Cash at bank 84.6 91.6
853.0 816.5 The main points of this chapter may be summarised as follows:
Total assets 1,300.0 1,417.7
EQUITY AND LIABILITIES Ratio analysis
Equity ■ Compares two related figures, usually both from the same set of financial statements.
£1 ordinary shares 320.0 250.0 ■ Is an aid to understanding what the financial statements really mean.
Retained earnings 367.6 624.6
■ Is an inexact science and results must be interpreted with caution.
687.6 874.6
Non-current liabilities ■ Usually requires the business’s performance for past periods, the performance of similar
Borrowings – loan notes 190.0 250.0 businesses and/or planned performance as benchmark ratios.
Current liabilities ■ Can benefit from a brief overview of the financial statements to provide insights not
Trade payables 406.4 275.7 revealed by ratios and/or may help in the interpretation of them.
Taxation 16.0 17.4
422.4 293.1 Profitability ratios
Total equity and liabilities 1,300.0 1,417.7 ■ Are concerned with effectiveness at generating profit.
■ Include the return on ordinary shareholders’ funds (ROSF), return on capital employed
(ROCE), operating profit margin and gross profit margin.
Income statements for the year ended 30 June last year
Ali plc Bhaskar plc Efficiency ratios
£m £m ■ Are concerned with efficiency of using assets/resources.
Revenue 1,478.1 1,790.4
■ Include the average inventories turnover period, average settlement period for trade
Cost of sales (1,018.3) (1,214.9)
Gross profit 459.8 575.5 receivables, average settlement period for trade payables, sales revenue to capital
Operating expenses (308.5) (408.6) employed and sales revenue per employee.
Operating profit 151.3 166.9
Liquidity ratios
Interest payable (19.4) (27.5)
Profit before taxation 131.9 139.4 ■ Are concerned with the ability to meet short-term obligations.
Taxation (32.0) (34.8) ■ Include the current ratio and the acid test ratio.
Profit for the year 99.9 104.6
Gearing ratios
All purchases and sales were on credit. Ali plc had announced its intention to pay a divi- ■ Are concerned with the relationship between equity and debt financing.
dend of £135 million and Bhaskar plc £95 million in respect of the year. The market values of
a share in Ali plc and Bhaskar plc at the end of the year were £6.50 and £8.20, respectively. ■ Include the gearing ratio and the interest cover ratio.

SELF-ASSESSMENT QUESTION 135 136 CHAPTER 3 ANALYSING AND INTERPRETING FINANCIAL STATEMENTS
REFERENCES
Investment ratios
1 Beaver, W. H. (1966) ‘Financial ratios as predictors of failure’, in Empirical Research in Accounting: Selected
■ Are concerned with returns to shareholders. Studies, pp. 71–111.
■ Include the dividend payout ratio, dividend yield ratio, earnings per share and price/ 2 Zmijewski, M. E. (1983) ‘Predicting corporate bankruptcy: an empirical comparison of the extent of financial
earnings ratio. distress models’, Research Paper, State University of New York.
3 Altman, E. I. (2000) ‘Predicting financial distress of companies: revisiting the Z-score and Zeta models’,
Uses of ratios New York University Working Paper, June.
■ Can be used to identify signs of overtrading. 4 Neophytou, E., Charitou, A. and Charalambous, C. (2001) ‘Predicting corporate failure: empirical evidence
■ Individual ratios can be tracked (by plotting on a graph, for example) to detect trends. for the UK’, University of Southampton Department of Accounting and Management Science Working
Paper 01-173.
■ Can be used as key performance indicators (KPIs) to help measure the degree of suc-
cess achieved in fulfilling the business’s objectives.
■ Can be used to help predict financial distress. Univariate analysis employs one ratio at FURTHER READING
a time, whereas multiple discriminate analysis combines various ratios within a model. If you would like to explore the topics covered in this chapter in more depth, the following are
recommended:
Limitations of ratio analysis
Alexander, D., Brtitton, A., Jorissen, A., Hoogendoorn, M. and van Mourik, C. (2017) International
■ Ratios are only as reliable as the financial statements from which they derive.
Financial Reporting and Analysis, 7th edn, Cengage Learning EMEA, Chapters 29–31.
■ Creative accounting can deliberately distort the portrayal of financial health. Elliott, B. and Elliott, J. (2017) Financial Accounting and Reporting, 18th edn, Pearson, Chapters 28
■ Inflation can also distort financial information. and 29.
■ Ratios provide only part of the picture and there should not be over-reliance on them. Lessambo, F. (2019) Financial Statements: Analysis and Reporting, Palgrave Macmillan,
Chapter 17.
■ It can be difficult to find a suitable benchmark (for example, another business) to com-
pare with. Revsine, L., Collins, D., Johnson, B. Mittelstaedt, F. and Soffer, L. (2017) Financial Reporting and
Analysis, 7th edn, McGraw-Hill Education, Chapters 5, 8, 9 and 10.
■ Some ratios could mislead due to the ‘snapshot’ nature of the statement of financial
position.

CRITICAL REVIEW QUESTIONS

Solutions to these questions can be found at the back of the book on pp. 650–51.
KEY TERMS
3.1 In the chapter, it was mentioned that ratios help to eliminate some of the problems of com-
Return on ordinary shareholders’ funds Acid test ratio p. 112 paring businesses of different sizes. Does this mean that size is irrelevant when interpreting
ratio (ROSF) p. 96 Financial gearing p. 113 and analysing the position and performance of different businesses?
Return on capital employed ratio Gearing ratio p. 113
(ROCE) p. 97 Interest cover ratio p. 114 3.2 Two businesses operate in the same industry. One has an inventories turnover period that is
longer than the industry average. The other has an inventories turnover period that is shorter
Operating profit margin ratio p. 99 Dividend payout ratio p. 116
than the industry average. Give three possible explanations for each business’s inventories
Gross profit margin ratio p. 101 Dividend cover ratio p. 117
turnover period ratio.
Average inventories turnover Dividend yield ratio p. 117
period ratio p. 104 Earnings per share (EPS) ratio p. 118 3.3 Is it responsible to publish Z-scores of businesses that are in financial difficulties? What are
Average settlement period for trade Price/earnings (P/E) ratio p. 120 the potential problems of doing this?
receivables ratio p. 105 Overtrading p. 124
3.4 Identify and discuss three reasons why the P/E ratio of two businesses operating in the
Average settlement period for trade Key performance indicators (KPIs) p. 125 same industry may differ.
payables ratio p. 105 Univariate analysis p. 128
Sales revenue to capital employed Multiple discriminate analysis p. 129
ratio p. 107 Discriminate function p. 129
Sales revenue per employee ratio p. 108 Creative accounting p. 132
Current ratio p. 111

For definitions of these terms, see the Glossary, pp. 685–94.

KEY TERMS 137 138 CHAPTER 3 ANALYSING AND INTERPRETING FINANCIAL STATEMENTS
2018 2019
EXERCISES
£000 £000 £000 £000
Exercises 3.4 to 3.7 are more advanced than 3.1 to 3.3. Those with coloured numbers have Gross profit 1,440 1,590
solutions at the back of the book, starting on p. 659. Expenses (1,360) (1,500)
If you wish to try more exercises, visit the students’ side of this book’s companion website. Operating profit 80 90
Corporation tax (15) (20)
3.1 Set out below are ratios relating to three different businesses. Each business operates Profit before taxation 65 70
within a different industrial sector. Interest payable – –
Ratio A plc B plc C plc Profit for the year 65 70
Operating profit margin 3.6% 9.7% 6.8%
Sales to capital employed 2.4 times 3.1 times 1.7 times Statement of financial position as at 30 September
Average inventories turnover period 18 days N/A 44 days
2018 2019
Average settlement period for trade receivables 2 days 12 days 26 days £000 £000
Current ratio 0.8 times 0.6 times 1.5 times ASSETS
Required: Non-current assets
State, with reasons, which one of the above is a: Property, plant and equipment 1,900 1,860
Current assets
(a) holiday tour operator Inventories 400 500
(b) supermarket chain
Trade receivables 750 960
(c) food manufacturer.
Cash at bank 8 4
1,158 1,464
3.2 Amsterdam Ltd and Berlin Ltd are both engaged in wholesaling, but they seem to take a
Total assets 3,058 3,324
different approach to it according to the following information:
EQUITY AND LIABILITIES
Ratio Amsterdam Ltd Berlin Ltd Equity
Return on capital employed (ROCE) 20% 17% £1 ordinary shares 1,650 1,700
Return on ordinary shareholders’ funds (ROSF) 30% 18% Share premium account – 116
Average settlement period for trade receivables 63 days 21 days Retained earnings 1,018 1,058
Average settlement period for trade payables 50 days 45 days 2,668 2,874
Gross profit margin 40% 15% Current liabilities 390 450
Operating profit margin 10% 10% Total equity and liabilities 3,058 3,324
Average inventories turnover period 52 days 25 days

Required: Required:
Describe what this information indicates about the differences in approach between the two Using six ratios, comment on the profitability (three ratios) and efficiency (three ratios) of
businesses. If one of them prides itself on personal service and one of them on competitive the business as revealed by the statements shown above.
prices, which do you think is which and why?
3.4 Bradbury Ltd is a family-owned clothes manufacturer. For a number of years, the chair and
3.3 The directors of Helena Beauty Products Ltd have been presented with the following managing director was David Bradbury. During his period of office, sales revenue had grown
abridged financial statements: steadily at a rate of 2 to 3 per cent each year. David Bradbury retired on 30 November 2017
and was succeeded by his son Simon. Soon after taking office, Simon decided to expand
Income statement for the year ended 30 September the business. Within weeks he had successfully negotiated a five-year contract with a large
clothes retailer to make a range of sports and leisurewear items. The contract will result
2018 2019 in an additional £2 million in sales revenue during each year of the contract. To fulfil the
£000 £000 £000 £000 contract, Bradbury Ltd acquired new equipment and premises.

Sales revenue 3,600 3,840


Cost of sales
Opening inventories 320 400
Purchases 2,240 2,350
2,560 2,750
Closing inventories (400) (2,160) (500) (2,250)

EXERCISES 139 140 CHAPTER 3 ANALYSING AND INTERPRETING FINANCIAL STATEMENTS


Financial information concerning the business is given below: 5 trade receivables settlement period
6 sales revenue to capital employed.
Income statements for the years ended 30 November
(b) Using the above ratios, and any other ratios or information you consider relevant, com-
2017 2018 ment on the results of the expansion programme.
£000 £000
3.5 Threads Limited manufactures nuts and bolts, which are sold to industrial users. The abbre-
Revenue 9,482 11,365
viated financial statements for 2018 and 2019 are as follows:
Operating profit 914 1,042
Interest charges (22) (81)
Income statements for the year ended 30 June
Profit before taxation 892 961
Taxation (358) (386)
2018 2019
Profit for the year 534 575
£000 £000
Statements of financial position as at 30 November Sales revenue 1,180 1,200
Cost of sales (680) (750)
2017 2018
Gross profit 500 450
ASSETS £000 £000 Operating expenses (200) (208)
Non-current assets Depreciation (66) (75)
Property, plant and equipment Operating profit 234 167
Premises at cost 5,240 7,360 Interest (–) (8)
Plant and equipment (net) 2,375 4,057 Profit before taxation 234 159
7,615 11,417 Taxation (80) (48)
Profit for the year 154 111
Current assets
Inventories 2,386 3,420
Trade receivables 2,540 4,280 Statements of financial position as at 30 June
4,926 7,700
Total assets 12,541 19,117 2018 2019
EQUITY AND LIABILITIES £000 £000
Equity ASSETS
Share capital 2,000 2,000 Non-current assets
Reserves 7,813 8,268 Property, plant and equipment 702 687
9,813 10,268 Current assets
Non-current liabilities Inventories 148 236
Borrowing – loans 1,220 3,675 Trade receivables 102 156
Current liabilities Cash 3 4
Trade payables 1,157 2,245 253 396
Taxation 179 193 Total assets 955 1,083
Short-term borrowings (all bank overdraft) 172 2,736 EQUITY AND LIABILITIES
1,508 5,174 Equity
Total equity and liabilities 12,541 19,117 Ordinary share capital (£1 shares, fully paid) 500 500
Retained earnings 256 295
Dividends of £120,000 were paid on ordinary shares in respect of each of the two years. 756 795
Required: Non-current liabilities
Borrowings – bank loan – 50
(a) Calculate, for each year (using year-end figures for statement of financial position items),
Current liabilities
the following ratios:
Trade payables 60 76
1 operating profit margin
Other payables and accruals 18 16
2 return on capital employed
Taxation 40 24
3 current ratio
Short-term borrowings (all bank overdraft) 81 122
4 gearing ratio
199 238
Total equity and liabilities 955 1,083

EXERCISES 141 142 CHAPTER 3 ANALYSING AND INTERPRETING FINANCIAL STATEMENTS


Dividends were paid on ordinary shares of £70,000 and £72,000 for 2018 and 2019, Statement of financial position as at 31 October
respectively.
£000
Required: ASSETS
(a) Calculate the following financial ratios for both 2018 and 2019 (using year-end figures Non-current assets
for statement of financial position items): Property, plant and equipment at cost less depreciation
1 return on capital employed Land and buildings 442
2 operating profit margin Fixtures and fittings at cost 116
3 gross profit margin Motor vans at cost 64
4 current ratio 622
5 acid test ratio Current assets
6 settlement period for trade receivables Inventories 128
7 settlement period for trade payables Trade receivables 104
8 inventories turnover period. 232
(b) Comment on the performance of Threads Limited from the viewpoint of a business Total assets 854
considering supplying a substantial amount of goods to Threads Limited on usual trade EQUITY AND LIABILITIES
credit terms. Equity
Ordinary £0.50 shares 60
3.6 Genesis Ltd was incorporated three years ago and has grown rapidly since then. The rapid General reserve 50
rate of growth has created problems for the business, which the directors have found dif- Retained earnings 74
ficult to deal with. Recently, a firm of management consultants has been asked to help the 184
directors to overcome these problems. Non-current liabilities
In a preliminary report to the board of directors, the management consultants state: Borrowings – 10% loan notes (secured) 120
‘Most of the difficulties faced by the business are symptoms of an underlying problem of Current liabilities
overtrading.’
Trade payables 184
The most recent financial statements of the business are set out below.
Taxation 8
Short-term borrowings (all bank overdraft) 358
Income statement for the year ended 31 October
550
£000 £000 Total equity and liabilities 854
Sales revenue 1,640
Notes:
Cost of sales
Opening inventories 116 1 All purchases and sales were on credit.
Purchases 1,260 2 A dividend was paid during the year on ordinary shares of £4,000.
1,376
Closing inventories (128) (1,248) Required:
Gross profit 392
(a) Calculate and discuss five financial ratios that might be used to establish whether the
Selling and distribution expenses (204)
business is overtrading. Do these five ratios suggest that the business is overtrading?
Administration expenses (92) (b) State the ways in which a business may overcome the problem of overtrading.
Operating profit 96
Interest payable (44) 3.7 The financial statements for Clarrods plc are given below for the two years ending 30 June
Profit before taxation 52 2018 and 30 June 2019. Clarrods plc operates a large chain of retail stores.
Taxation (16)
Profit for the year 36 Income statement for the years ending 30 June

2018 2019
£m £m
Sales revenue 2,600 3,500
Cost of sales (1,560) (2,350)
Gross profit 1,040 1,150
Wages and salaries (320) (350)
Overheads (260) (200)
Depreciation (150) (250)

EXERCISES 143 144 CHAPTER 3 ANALYSING AND INTERPRETING FINANCIAL STATEMENTS


2018 2019
£m £m
Operating profit 310 350
Interest payable (50) (50)
Profit before taxation 260 300
Taxation (105) (125)
Profit for the year 155 175

Statement of financial position as at 30 June

2018 2019
£m £m
ASSETS
Non-current assets
Property, plant and equipment 1,265 1,525
Current assets
Inventories 250 400
Trade receivables 105 145
Cash at bank 380 115
735 660
Total assets 2,000 2,185
EQUITY AND LIABILITIES
Equity
Share capital: £1 shares fully paid 490 490
Share premium 260 260
Retained earnings 350 450
1,100 1,200
Non-current liabilities
Borrowings – 10% loan notes 500 500
Current liabilities
Trade payables 300 375
Other payables 100 110
400 485
Total equity and liabilities 2,000 2,185

Dividends paid on ordinary shares for 2018 and 2019 were £65 million and £75 million
respectively.
Required:

(a) Choose and calculate eight ratios that would be helpful in assessing the performance
and position of Clarrods plc. (Use end-of-year values and calculate ratios for both 2018
and 2019.)
(b) Using the ratios calculated in (a) and any others you consider helpful, comment on the
business’s performance and position from the viewpoint of a prospective purchaser of
a majority of shares.

EXERCISES 145

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