CHAPTER 6
SUGGESTED SOLUTIONS
SOLUTION TO MULTIPLE CHOICE QUESTIONS 6.1 6.2 6.3 6.4 6.5 6.6 6.7 6.8 6.9 6.10
(b) (a) (d) (a) (c) (c) (c) (a) (c) (c)
(R8 000 – R2 000)/R6 000 R35 800 – R31 700 [R24 000 + R2 000(1-0,40)]/R145 000 R28 000/ R82 000 (R80 000-R24 300)/R26 300 R114 000 – R82 000 – R23 500 END OF CHAPTER QUESTIONS
6.1 A potential shareholder is interested in the future prospects of the company with regard to growth and profitability. This is considered relative to other companies which are potential investment targets. The use of technical analysis may be considered if the company is listed, but the most significant analysis will be the use of fundamental analysis. Information will be gathered with regard to the economy, both globally and locally. Information will be gathered with regard to the industry in which the company operates Information will be gathered with regard to competitors Select the appropriate ratio’s. An in depth analysis will require that all aspects of the company be considered, over a period of at least the three previous years. These would include ratio’s with regard to: Profitability – Margins, mark-ups and returns on assets and equity Liquidity – Ability to meet short-term obligations from cash and near cash resources Efficiency, notably of working capital Financial leverage – the effective use of debt without undue increase in risk Market performance – if listed, how well it has performed relative to other companies in the industry. Compare the selected ratio’, once calculated with other companies, over the time period and with industry benchmarks Evaluate the company and its prospects on the basis of trends or significant issues which are apparent from the calculations Finally, a prediction must be made. A potential shareholder is only interested in future prospects, using past performance as an indicator of possible future prospects.
6.2 External variables, which could have an impact on the expected performance of a company would include: Economic factors: The global economy and the national economy, to gain an insight into whether future growth can be anticipated, as well as the growth rate. For the local economy, factors such as the inflation rate, exchange rates, gross domestic product and foreign direct investment would all be significant.
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The industry in which the company operates causes external factors to impact on possible performance, The factors of particular interest would be: The type of operation The type of product The clientele The suppliers The competition
6.3 There are many potential sources of information about a company, the most obvious sources are: The Annual Report of the company, which will contain at least the following: • The Director’s Report
• • • • • •
The Auditor’s Report The Balance Sheet with accompanying n otes The Income Statement with accompanying n otes The Cash Flow Statement with accompanying n otes General information about the company with a five year review Extensive notes of accounting policies
Reports in the financial press, such as Business Review, Financial Mail Reports by analysts, available from large stockbroking firms Brochures and leaflets available from the company on request Internet services
6.4 The client has already identified the company in which he is interested. The fact that he has selected an investment in a company rather than in a risk-free security, such as a Government or Escom bond, indicates that he is prepared to take the risks, which accompany such investments. Risk may be defined as the probability that the company may generate a smaller return than that which is expected. This probability is dependent upon future events, which cannot be predicted with certainty. However, the past record of the company is a useful starting point for the analysis. The past record of profitability may be seen in the recent income statements of the company. One would expect to see steady growth in turnover and net income attributable to ordinary shareholders, as reflected in the earnings per share figure. If net income has been unstable or erratic, the likelihood of steady future growth and profitability is lower. The financial stability of the company can be assessed by examining past balance sheets. The client should focus particularly on the company's liquidity and solvency history. The trends in the market price of the share should also be studied. Once again, the investor will feel more confident in the quality of his investment if the share price history has shown steady growth over the last few years. Once the information relating to the company has been gathered, it must be compared with information relating to similar companies.
6.5 Previous years: Every company would wish to increase its performance each year. Should a company obtain results which are worse than those of the previous year, it is a clear indication that something is wrong. Of course, it may be because the industry has suffered or the entire economy is in a state of recession. Nevertheless, no company will survive unless it achieves growth in the long term. Budgets and targets: Budgets and targets represent the plans which management has for the company. If those budgets and targets are not achieved, it indicates that management has been unable to achieve what it had intended. This failure may result from factors which were not know at the time of planning, but, nevertheless, failure to meet budgets will be a source of concern.
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Similar companies: All business activity takes place within a competitive environment. A company which is achieving results which are less impressive than those of its competitors is likely to be operating less efficiently. It is thus important for a company to know its position in relation to its competition. Industry standards: Industry standards reflect the averages being achieved by companies in a similar industry. Obviously, companies will be both below and above such averages. Nevertheless, if a company achieves results or has financial ratios which are below the industry averages, management would wish to be aware of this and to have some explanation as to why its strategies produce inferior results.
6.6 A sudden drop in the value of the Rand means that it becomes cheaper for foreigners to buy Rands with which to pay for goods and services exported by South Africa. Similarly, South Africans must pay more for overseas currencies, which are used to pay for imports to South Africa. A company, which specialises in the demolition of old buildings and the redevelopment of the land for the erection of shopping complexes, is not directly involved with goods or services, which are imported or exported. One may thus be inclined to think that a drop in the value of the Rand will have no direct effect on such a business. There are, however, at least two reasons why this may not be so. Firstly, it is possible that the company uses imported fixed assets for the purpose of demolition. In such cases, the cost of these assets will rise as a result of the change in value of the Rand. Secondly, the economy as a whole will be affected by the change in value of the Rand. The demand for space in shopping complexes may fall, thus placing pressure on the redevelopment business.
6.7 The selection of techniques for purposes of analysis is dependent on the objective of the analysis and the party for whom the analysis is being performed. In this case, management is the party for whom the analysis is being performed and the purpose of the analysis is to assess the performance of the company. The term performance has many interpretations, but is most closely related to profitability and efficiency. The profitability may be assessed by analysing the figures generated in the annual financial statements and the market performance of the company, if it is listed on the Johannesburg Stock Exchange. The efficiency is usually measured by selecting financial ratios, which are compared against past performance and other benchmarks. It is unlikely that management would use only one technique if it wished to perform a thorough analysis. The use of time series techniques will assist in identifying problem areas. Once the weak areas have been identified, financial ratios may be used for further analysis.
6.8 MOTOPASSION LTD a)
Reduction in gross profit margin • Change in stock mix. The company could have sold more vehicles of a lower mark-up than in the past. • The sales price may not have increased in proportion to the cost of the vehicles, resulting in a lower gross profit. • The method used in valuing stock may have changed during the current year.
• b)
The gross profit fluctuation may also be due to errors in the quantity or pricing of stock on hand. Increase in current ratio
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• • • c)
A change in the credit policy to debtors, whereby credit terms are extended, may result in a sharp increase in debtors. The current ratio could also increase due to sharp increases in stock on hand or changes in stock valuation policies. Creditors may have decreased considerably due either to more cash purchases, or to a change in the credit policies of suppliers.
The effect of an increase in the current ratio An increase in the current ratio does not necessarily indicate an improvement in the business. It is necessary to establish the reasons for the increase. It is possible that it increased due to excessive stock holdings; stock may be moving very slowly. An increase due to higher debtors could mean a decline in the quality of credit control within the company. If considered in conjunction with an increase in the acid-test ratio, an increase in the current ratio could have arisen because large cash reserves are being held. Unless there is a valid reason (for example, purchase of a fixed asset in the near future), such excessive cash holdings could reflect mismanagement of cash resources.
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6.9 Dear Mr Avens Re:
Gross profit investigation - Sterling's Country Bar
We have analysed the sales for April and May 20.1. Our analysis confirms your impression that the gross profit is worsening. It has in fact fallen from 36,7% in April to 35,1% of sales in May. This would appear to be due to the change in the sales mix (the proportion of products sold) set out in Appendix A. We are continuing to review the business records and will report back to you shortly on the other question of the reason for the difference between your gross profit of 37% for the year and the industry average of 40%. The effect of the 3% difference in gross profit could be approximately R7 000 based on using cost of sales as the base (R90 720 ö 60 x 100 - R144 000 = R7 200). That means that one would expect the gross profit to be approximately R7 000 more than shown, based on the existing cost of sales figure. In order to identify the precise reasons for the shortfall in gross profit, the total cost of R90 720 should be analysed into its constituent parts (bar food, beer, etc) and the sales estimate based on that analysis. Purchase invoices will need to be obtained for this purpose. There should also be a reconciliation of physical stock movements to identify whether there has been any misallocation of sales to product type. Yours faithfully for Hunt and Partners Appendix A Trading Statement for the year ended 31 May 20.1 Sales 144,000 Gross Cost of Sales 90,720 Profit % Gross Profit 53,280 37.0% ANALYSIS OF GROSS PROFIT AND SALES MIX APRIL
Bar food Beer (draught) Beer (bottled) Wines Spirits Minerals
Sales R 3,000 R 2,800 R 1,700 R 1,200 R 2,000 R 1,100 R 11,800
Gross Profit %
Gross Profit
% Mix
25.0% 33.0% 40.0% 46.0% 48.0% 42.0%
R 750 R 924 R 680 R 552 R 960 R 462
25.4% 23.7% 14.4% 10.2% 16.9% 9.3%
36.7% *
4,328
100.0%
R 975 R 1,089 R 600 R 414 R 864 R 378
31.7% 26.8% 12.2% 7.3% 14.6% 7.3%
4,320
100.0%
MAY Bar food Beer (draught) Beer (bottled) Wines Spirits Minerals
R 3,900 R 3,300 R 1,500 R 900 R 1,800 R 900 R 12,300
25.0% 33.0% 40.0% 46.0% 48.0% 42.0% 35.1% *
* Gross Profit / Sales
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6.10 Sunderland Ltd Report to: Prepared by: Date: Subject:
Mr Sibanje Proposed loan to Sunderland Ltd
Proposal A loan of R100 000 to be made to Sunderland Ltd at a fixed rate of interest of 16% per annum, the capital sum to be repaid in five years by a single payment. Information analysed This report is based on the balance sheets and income statements for the three years 20.1 to 20.3 inclusive, and from the the general explanations provided to you. It has not been possible to verify the accuracy of the financial statements or the bases on which the general explanations have been founded. Requirements of the lender In terms of a fixed interest loan, the lender requires sufficient cash flow to ensure that interest is paid at the appropriate time and that capital is repaid when due. You will therefore need assurance that your annual interest will be met when due and that the R100 000 will be repaid in five years' time. It is also normal for a lender to have some security in case of default by the borrower. Analysis of the company (Supporting schedules attached) a)
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The working capital of the company has barely increased since 20.1, despite the fact that the business has expanded, as evidenced by the increase in sales volume, particularly in 20.3. The balance sheet also highlights the increase in the overdraft from 20.2 to 20.3. There are a number of reasons for these liquidity problems, the most important being the following: i)
Relatively high dividend per share payments in each of the years (i.e. 24%, 22% and 26%), which has also meant that virtually no profits have been ploughed back for expansion.
ii)
Debentures are being repaid at the rate of R16 000 per annum without any other finance coming back into the business to replace this loss of long-term capital finance.
iii)
There has been an increase of approximately 16% in the level of stock between 20.2 and 20.3 and an increase of approximately 9% in the level of debtors between those two years.
iv)
Development costs of R7 000 per annum have been incurred in 20.2 and 20.3. When reference is made to the balance sheets and income statements, it can be seen that all development costs have been capitalised and there is no evidence that there is a policy of writing off such costs against profits. It would normally be expected that some proportion of such costs would be charged against profits each year, and thus the profits would appear to be overstated in this respect.
v)
It is likely that the rent payable under any new lease could substantially increase, thus making the business less profitable. The current rent is R4 000 per annum, but if the same charge per square metre is adopted as for the new adjacent factory building, the rent payable on the renewal of the existing lease could be R36 000 per annum (R18000/500=R36 per square metre).
vi)
Plant acquisitions over the last two years have been fairly insignificant and the depreciation charges have been calculated at 10% p.a. on a straight-line basis. It is clear that the majority of the plant held at present is very near the end of its working life, which is why money is urgently required for plant replacement. The business seems to have taken no steps to make provision for the replacement of fixed assets, either in terms of charging depreciation on a replacement cost basis, or in providing adequate cash for replacement.
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b)
The effect on existing profits of the projected expansion (schedule b) shows clearly that, after payment of the 16% interest on the R100 000 loan, there are virtually no additional profits which will arise from the increased turnover.
c)
Reference to schedule (c) clearly indicates that the R100 000 loan will not be sufficient for the required expansion, the further requirement being some R213 000. If such additional finance could be found at (say) 16%, then the profits of R10000 per schedule (b) would not in fact be sufficient to cover the interest on the extra finance required.
d)
As already indicated, the company requires approximately R213000 in addition to the R100000 loan being requested at the moment and it is obvious that the additional profits will not cover interest payments. There does not seem to be any suggestion of additional equity finance. It is unlikely that the two widows will be able to provide additional finance, as the large amount of dividends that they are being paid from the company implies that they need the cash. Consequently new equity shareholders would be required in order to raise funds in this way.
e)
There seems to be an excessive amount of optimism by the directors in anticipating a 50% increase in sales volume whilst not expecting the overheads to increase very much. The factory space will be increased by 50% to meet the additional business and it seems certain that a number of costs will increase, e.g. lighting and heating, supervision, repairs, selling and distribution and directors' remuneration. This aspect must be investigated in more detail if you wish to consider this proposition further.
f)
There is serious doubt whether the the company would be able to repay the R100 000 in five years' time. The only way in which it would be able to do this would be to obtain further finance, which may prove difficult in view of the fact that overall profitability in the next few years does not seem likely to improve; in fact, it may well decline. The question of security, which might be given against the loan, has not yet been considered and there could be a problem here. There is no property held by the company against which a charge could be made. There is a possibility of a charge on the new plant and machinery, but it is probable that the bank's existing charge would extend to this.
Conclusions It is not recommended that money should be advanced to Sunderland Ltd, the main reasons being as follows: a)
it does not seem that adequate security will be able to be provided against your loan;
b)
there are serious doubts as to whether the company will be able to repay the R100 000 in five years' time and there could well be problems in meeting your annual interest;
c)
the company requires, in addition to the R100 000 requested from you, at least another R213 000 to finance its proposed expansion;
d)
the proposed expansion will provide profits which will barely cover the interest on your loan, and there is insufficient to cover interest on the balance of R213 000 required;
e)
many of the directors' assumptions appear to be excessively optimistic, and
f)
the accounting and dividend policies at present adopted by the company are very imprudent.
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Supporting schedules: Sunderland a)
Significant ratios (i) (ii) (iii) (iv) (v) (vi) (vii) (viii) *
b)
Ltd
Current ratio Current assets/Current liabilities Acid-test Debtors/Current liabilities Average age of debtors* Average age of stock* Profit before interest and tax as % of capital employed Net profit margin Gross profit margin Total asset turnover (Sales/Total assets)
20.1
20.2
20.3
1,55
1,64
0,71 61 days 103 days
0,77 60 days 95 days
0,70 61 days 101 days
24% 5% 30%
23,7% 4% 29%
26,5% 4% 28%
1,68x
1,83x
1,88x
1,53
(assuming all sales on credit and using year-end figures Effect on existing profits of projected expansion R 50% increase in gross profit 100 000. Less: 10% discount on extra turnover (10% x 360 000) 36 000 Additional contribution 64 000 Rent 18 000 Depreciation (10% x 200 000) 20 000 38 000 26 000 Interest on R100 000 at 16% 16 000 Additional profit before tax 10 000
c) Additional finance required for expansion Applications New plant Stocks, 50% x R144 000 Debtors, 50% x R120 000 Less: 10% discount 1 extra month's credit *
R
R 200 000
72 000 60 000 6 000 54 000 27 000
Less: creditors, 50% x R60 000 Sources Loan at 16% Pre-tax profit Further requirement
R
100 000 10 000
81 000 153 000 30 000
123 000 323 000 110 000 213 000
*
Existing debtors are allowed 2 months credit. The extra month will represent a further 50%.
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6.11 CROWE (PTY) LTD
Income statement of Crowe (Pty) Ltd for the year ended 31 December 20.0 Sales Cost of sales (85%) Gross profit Less: Expenses: Interest Other Net Profit before Tax Taxation Net income Dividends (4,40 x 500) Retained income for the year Retained income: beginning Retained income: end
100,000 85,000 15,000 5,000 2,000 3,000 10,000 5,000 5,000 2,200 2,800 24,200 27,000
Balance sheet of Crowe (Pty) Ltd at 31 December 20.0 EQUITY AND LIABILITIES Share capital - 500 ordinary shares of R1 each 500 Retained income 27,000 Shareholders' interest 27,500 Long-term liabilities 15,000 Current liabilities 20,000 62,500 ASSETS Non-current assets 12,500 Current assets 50,000 Stock 24,000 Other 26,000 62,500
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6.12 WONDER PRODUCTS LTD a)
Calculation of two ratios significant to: i)
ii)
iii)
20.1
20.0
2,1:1 1,1:1
2,5:1 1,4:1
Creditors Current ratio Acid-test ratio
[W1] [W2]
Management Trading profit as % of capital employed Trading profit as % of sales
[W3]28,4% 3,5%
27,4% 3,8%
Shareholders Earnings per share Dividend cover, EPS/DPS
[W4] [W4]
37,2c 2,7 x
40c 2,7 x
b)
Comments on changes in ratios between 20.0 and 20.1:
i)
Both the current ratio and the acid-test ratio have deteriorated slightly, but are still within acceptable limits.
ii)
Return on capital employed has improved slightly; the reasons for this are not apparent.
iii)
Earnings per share has increased because earnings have increased, while the number of equity shares has remained constant. The dividend has increased in proportion to earnings, thus maintaining dividend cover.
c)
Debt/equity ratio,
Long-term liabilities / Shareholders' funds
At present Under alternatives: i) Issue of convertible debentures ii) Rights issue iii) Issue of debentures d)
Effect on earnings per share: At present Under alternatives: i) Basic EPS R4m + 0,5(R3,5m - R1,6m)/10m Fully diluted EPS R4m + 0,5(R3,5m)/26m ii) EPS R4m +0,5(R3,5m)/(10m + 20m) iii) EPS R4m + 0,5(R3,5m - R2,08m/10m
10 000:23 030
43,4%
26 000:23 030 10 000:39 030 26 000:23 030
112,9% 25,6% 112,9%
R4m/10M
= 40c = 49,5c = 22,1c = 19,2c = 47,1
e)
Comments on the most appropriate financing method: i) Although the use of convertible debentures gives the highest earnings per share at present, it will lead to dilution of earnings per share on conversion. Conversion will not take place, however, until 20.6, unless there are specific earlier conversion dates. ii) The rights issue reduces earnings per share considerably. Earnings on the new project are well below those received on existing projects. iii) The issue of debentures takes advantage of gearing and thus increases earnings per share without the dilution caused by convertible debentures. It is assumed that the company's borrowing powers permit it to issue debentures in excess of the amount of share capital plus reserves.
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Workings: 1.
WONDER PRODUCTS LTD
Current assets Stock Debtors Bank Current liabilities Creditors Taxation Dividend payable
2.
Quick assets Debtors Bank Current liabilities Creditors Dividend payable Taxation
3.
25 426 21 856 2 917 50 199.
20 231 20 264 6 094 46 589
20 928 1 642 1 000 23 570
16 431 1 247 900 18 578
21 856 2 917 24 773
20 264 6 094 26 358
20 928 1 000 1 642 23 570
16 431 900 1 247 18 578
5 000 18 030 23 030 10 000 33 030
5 000 15 530 20 530 10 000 30 530
9 380 1 000 8 380 4 380
8 362 1 000 7 362 3 642
4 000 1 500 2 500
3 720 1 400 2 320
Earnings and dividend cover calculations Trading profit Less: loan interest Less: taxation Earnings attributable to ordinary shareholders Less: dividend
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20.0 R'000
Return on capital employed Capital employed Share capital Distributable reserves Shareholders' funds Loan capital
4.
20.1 R'000
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6.13 GLOWORLD LTD GLOWORLD
1 2
3 4
PROFITABILITY Sales growth Gross margin Net margin Growth in Profit to Shareholders Return onAssets Return on Equity (based on year end) Return on Equity (based on beg equity)
20.3
20.5
20.6
Cureent year sales/previous year = Gross margin/Sales = Net Profit/Sales Current year profit/previous year
= =
48.1% 19.1%
12.1% 46.2% 18.6% 9.1%
17.7% 42.5% 17.5% 11.2%
14.7% 40.4% 18.4% 20.5%
= Net operating profit/Total Assets
=
= Net profit / Equity at year end
=
52.0% 54.6%
42.7% 40.0%
34.1% 32.4%
34.0% 29.8%
59.6%
44.5%
39.1%
R 2.19 per R1 R 1.23 per R1
R 2.59 per R1 R 1.63 per R1
R 2.20 per R1 R 1.00 per R1
Net profit / Equity at beginning of the year
5 6
LIQUIDITY Current ratio Acid test ratio
= Cur assets/Cur Liabilities = [Cur assets – Inv] /Cur Liabilities
= =
7 8 9 10
EFFICIENCY Fixed asset turnover Days’ inventory Debtors’ collection days Creditors’ settlement days
= = = =
= = = =
11 12
LEVERAGE Debt ratio Interest cover
= Total debt/Total Assets = Net profit before Int/Interest
= =
13 14
MARKET Return to shareholder Dividend yield (DY)
= [SP(end-beg)+Div]/ SP(beg) = Dividend per share/Share price (end)
= =
15
Earnings yield (EY)
= Earnings per share/Share price (end)
=
Price earnings ratio (P/E)
=
=
16
20.4
Turnover/Fixed Assets [Inventory x 365]/Cost of sales [Debtors x 365]/Credit Sales [Creditors x 365]/Purchases
Price per share/Earnings per share
R 1.83 per R1 R 1.10 per R1
4.24 87 31 47
times days days days
3.77 109 37 49
times days days days
3.42 97 39 49
times days days days
2.76 107 37 52
times days days days
48.9% 13.3 times
41.4% 11.8 times
37.4% 12.0 times
24.4% 36.2 times
8.2% 50.1%
77.0% 12.5% 34.7%
35.4% 10.2% 31.4%
66.5% 10.1% 25.0%
2.0 times
2.9 times
3.2 times
4.0 times
NOTE The above ratio's are a selection. Other appropriate ratio's may be selected Profitability: This company shows an interesting decline in profitability ratio's, which could mistakenly be interpreted as poor performance. The profitability ratio's must be seen against the sales growth. Management seem to have introduced policies which increase turnover, being satisfied with lower margins. This had led to the RAND value of the profit margin increasing and a consistent growth in the profit to shareholders. They will need to watch future movements carefully, as whatever policies to boost sales are introduced, must result in continuing growth on the "bottom-line". Liquidity: The current ratio has been relatively consistent and well within reasonable ranges to foster confidence that this is being managed. With the increasing turnover, inventory levels have risen (giving customers a greater selection), and this has caused the acid test ratio to show a decline. They should not let this ration fall much below 1:1. Efficiency: The company, in a growth phase has invested more each year in non-current assets. This has had a negative effect on the non-current assets to turnover ratio, but is not a cause for concern. The other 3 working capital items are all being managed well. Debtors are being given slightly longer to settle their accounts (thus keeping them happy and attracting more customers), inventory is reasonably consistent between 100 and 110 days, and creditors are being kept waiting just a little longer, to make use of the free finance, without incurring any interest penalties. Financial Leverage: The growth in the company has had positive effects on cash, and loans have been repaid. While this reduces the opportunity to lever shareholders profits, it also reduces risk and makes the company more attractive to investors. The interest cover at 36 times in well within all safety limits, and could lead to further loans (if required), being obtained at very reasonable interest rates. Market Performance: The JSE investors have responded well to the good management of the company and confidence in this company is growing. This is reflected in the steady climb of the share price over the last 3 years from R6.10, to a remarkable R17.85 a the end of the 20.6 financial year. There is no reason to indicate that this growth pattern will not continue. end
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6.14 ATHLETICS LIMITED (a)
Liquidity and current asset management
LIQUIDITY AND CURRENT ASSETS Current Ratio (:1) Acid Test Ratio (:1) Stock turnover (times) Days Inventory (days) Debtors Collection (days) Creditors Payment (days - using COS)
20.01 1.89 0.79 4.1 119 52 28
20.00 2.27 1.13 5.0 99 49 29
Industry 2.00 1.00 6.00 unknown 40.00 unknown
Comment The company's liquidity position has deteriorated over the year. In 20.0 the company's current and quick ratios were slightly above the industry averages. In 20.1, these ratios are below the industry averages. The lower current ratio is not supported by more effective management of stock. Stock is a significant percentage of current assets. The stock turnover ratio of 4.1 x is lower than that in 20.0 and is substantially below the industry average. There may be significant quantities of unsaleable or obsolete stock on hand. The company is taking a substantially longer time than the industry in collecting its accounts receivable. The collection period has increased slightly in 20.1. This may indicate that certain debts All the indicators point towards a deteriorating liquidity position during the year. Moreover all indicators are below the industry norm. The acid-test ratio is particularly significant and reflects an increase of 21% in debtors, a decline of 38% in funds at the bank and an increase of 13% in accounts payable. Stock turnover has declined, debtor’s collection period has increased and creditors settlement period has decreased, thus extending the cash collection period by circa 24 days. There are thus warning signals regarding possible future liquidity problems. These can be addressed in a number of ways, but particular attention must be paid to moving stock and collecting cash from debtors. (b)
Use of Debt
USE OF DEBT Debt ratio (Total debt to Total Assets) Times Interest earned
20.01 58.2% 3.6
20.00 53.4% 5.5
Industry 50.0% 6.0
Comment The company is relatively highly geared. The debt ratio of 58.2% compares unfavourably with the industry. In addition, the company's debt ratio is higher than in the previous year. The times interest earned ratio is almost half the industry average and is significantly below the prior year figure. The above clearly illustrate that the financial risk of the company is higher than average. The company's increased investment in debtors and stock has been financed through the use of shortterm loans. The acquisition of Non-current assets has also been financed through the use of shortterm borrowings. Non-current asset acquisitions should rather be financed with long-term debt, than short-term. One basis of calculation of the debt ratio includes all debt to total assets. On this basis the company has increased its debt component relative to equity in the financing of assets. This increases the financial risk of the company but may also offer further leverage to shareholders. However, as 20.1 was not a growth year, shareholders have had to bear the additional interest burden. It would seem that interest rates rose during 20.1, as the interest expense has risen by a relatively greater proportion than the increase in interest bearing debt.
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It is the interest expenses which has resulted in a lower net income before taxation. This is reflected in the smaller times interest earned ratio. This decline will be of concern to debt holders who may perceive a risk of interest default. They may respond by requesting capital repayment or by increasing the interest rate further to compensate for the higher risk. The problem lies with short term loans, which should be repaid as early as possible. The possibility will materialise if the negative liquidity trend can be reversed. (c)
Calculation of headline earnings and dividends per share
Profit available to shareholders 275 400 Less: Preference dividend 32 400 Net Income attributable to ordinary shareholders 243 000 Number of shares in issue Earnings per share
675 000 R243 000/675000
= 36 cents per share
Ordinary dividend Dividend per share Earnings yield Dividend yield
R40 500 R40 500/675 000 36c/R4,70 6c/R4,70
= 6 cents = 7.7% = 1.3%
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FLYNN D K: UNDERSTANDING FINANCE AND ACOUNTING: 2ND EDITION: SUGGESTED SOLUTIONS
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6.15 NEVRON HOLDING LTD Below is a list of the main ratio’s which would be calculated in order to perform a thorough fundamental analysis of this company. Each sub section can be responded to by reference to the numbers.
20.1
BASIC BALANCE SHEETS 20.2 20.3
35,670
41,555
73,678 NCA
8,750
8,750
21,834
21,455
12,788 NWC
66,254
71,760
89,866
42,788
46,344
58,932 EQUITY
23,466
25,416
30,934 DEBT
66,254
71,760
89,866
21,834
21,455
12,788
NET WORKING CAPITAL
66,254
71,760
89,866
NET ASSETS
3,400 INVESTMNTS
PROFITABILITY
20.1
20.2
20.3
Markup
99.9%
99.1%
80.0%
Gross Margin
50.0%
49.8%
44.4%
Net Margin Return on Assets
17.0% 22.1%
17.6% 21.5%
14.4% 22.2%
RAO(BIAT)
13.3%
13.4%
13.2%
Return on Equity
17.3%
18.1%
17.6%
20.1
20.2
20.3
LIQUIDITY Current ratio
3 52/100 3 16/100 1 83/100
Quick ratio
1 97/100 1 57/100
Cash ratio SOLVENCY (Gearing)
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53/100
9/100
99/100 16/100
20.1
20.2
20.3
Total debt ratio Debt to Equity ratio (Net Assets)
42.9% 35.4%
43.3% 35.4%
44.0% 34.4%
LT Debt/Total Assets
31.3%
31.1%
29.4%
Times interest earned
3.9
4.3
4.0
MANAGEMENT
20.1
20.2
20.3
Days inventory
226
240
116
Days debtors
105
112
65
Days creditors NWC turnover
95 2.0
96 2.2
113 5.6
FA turnover
1.2
1.2
1.0
MARKET
20.1
20.2
20.3
Price Earnings (P/E)
7.0
6.3
6.9
Dividend yield (DY)
8.5%
9.1%
0.0%
Earnings yield (EY) Return ot Shareholder
14.3% n/a
15.8% 10.4%
14.5% 39.3%
FLYNN D K: UNDERSTANDING FINANCE AND ACOUNTING: 2ND EDITION: SUGGESTED SOLUTIONS
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(a)
Materials have been marked up by 80%, instead of 100%. This reduction in mark up has led to an increase in revenue from contracts of 50,8% (72162/47833) and an increase in return on assets from 21,5% to 22,2% which is a reasonable increase considering it is the first year under the new policy. Lower material mark up has led to more contracts, thus increasing the salary and wage expense by 50% (5 179/3 432).
(b)
Changes in working capital management policy were due to: Reduce debtor's days as above. Increase creditors collection period days as above. Reduce days inventory days as above. These policies have been implemented successfully, particularly debtors collection and stock turnover. The impact has been reduction in liquidity, but not below norms, which are acceptable. Cash resources are considerably improved from 20.5.
(c)
To finance the expansion of Non-current assets, which increased by 77% (73 678/41 555), the major sources were used: New share issue (350 shares @ R6,28) No dividends were paid in 20.6 Additional long-term loans were raised (R5 518) Investments were liquidated (R5 350) Working capital policy changes (Release of R8 667) The additional financing has thus come both from shareholders and from further debt. The debt equity ratio has thus remained reasonably constant. The impact on ROE is not apparent using conventional accounting ratios, because the equity base in 20.6 is inflated by the non-payment of dividends. The share market has however reacted by discounting expected future profits into the share price.
(d) Shareholders Equity : R70 000 Assuming no additional share issue, no dividend payment and a return on equity during 20.7 of around 20% Long Term Loans : R37 000 Assuming we retain the present capital structure and growth of around 20%. Gross Margin : R40 000. The new policy of lower mark up on material is attracting additional contracts. An increase in gross margin of at least 20% therefore seems appropriate.
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FLYNN D K: UNDERSTANDING FINANCE AND ACOUNTING: 2ND EDITION: SUGGESTED SOLUTIONS
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6.16 LEISURE TIME (PTY) LTD 20.2 1,000,000
20.3 1,300,000
20.4 1,894,000
Growth in Sales :(LT Ltd) (Industry)
20.30% 8.75%
20.00% 9.98%
20.50% 10.02%
Gross Margin : (LT Ltd) (Industry)
36.60% 34.20%
37.70% 35.10%
39.60% 36.20%
Net Income Sales (LT Ltd (Industry)
6.26% 5.75%
5.62% 5.80%
5.54% 5.81%
Return on Assets: (LT Ltd) (Industry)
11.30% 10.50%
9.79% 10.80%
9.26% 11.20%
Return on Equity: (LT Ltd) (Industry)
17.10% 13.26%
15.50% 13.62%
13.90% 14.16%
Total Assets
LT Ltd has achieved a significant growth in sales, which is in excess of the inflation rate, whereas the industry has not achieved a real volume growth. They have improved on their margin, which indicates that they have managed to obtain good selling prices for their goods and/or have obtained good cost prices from suppliers. The other expenses, including interest have however risen and the decline in net profit margin is a cause for concern. This has resulted in a serious decline in return on assets and equity. This trend will have to be reversed for LT Ltd to be an attractive investment opportunity. end
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FLYNN D K: UNDERSTANDING FINANCE AND ACOUNTING: 2ND EDITION: SUGGESTED SOLUTIONS
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6.17 NUANCE TRONICS LTS PROFITABILITY Markup Gross Margin Net Margin Return on Total Assets RAO(BIAT) Return on Equity LIQUIDITY Current ratio Quick ratio Cash ratio SOLVENCY (Gearing) Total debt ratio Debt to Equity ratio (Net Assets) LT Debt/Total Assets Times interest earned MANAGEMENT Days inventory Days debtors Days creditors NWC turnover FA turnover
20.0 108.5% 52.0% 23.0% 25.2% 17.7% 24.4% 20.0 3.52 1.97 0.53 20.0 35.3% 34.4% 22.2% 9.5 20.0 226 100 95 2.1 1.3
20.1 107.7% 51.9% 23.7% 22.3% 16.7% 22.0% 20.1 3.18 1.59 0.11 20.1 33.2% 31.1% 20.8% 8.3 20.1 240 107 96 2.3 1.0
20.2 52.9% 34.6% 6.4% 10.7% 7.5% 8.4% 20.2 2.60 1.03 0.13 20.2 50.5% 60.3% 29.9% 2.2 20.2 279 104 155 2.0 1.4
MARKET Price Earnings (P/E) Dividend yield (DY) Earnings yield (EY) Return ot Shareholder DUPONT Net Profit to Sales [Income Stream] Sales Total Assets [Investment Stream] Total assets to Equity [Financing Stream] RESULTS IN ROE
20.0 7.0 4.1% 14.3% n/a 20.0 23.0%
20.1 7.5 4.7% 13.4% 21.3% 20.1 23.7%
20.2 11.0 8.4% 9.1% -38.9% 20.2 6.4%
68.5%
62.2%
64.9%
154.6% 149.6% 201.9% 24.4%
22.0%
The report should contain
An introduction stating the objective of the report A Table with a selection of 8 of the above possible ratios Reasons for the financial deterioration as measured by accounting ROE and market RTS Suggestions for action to be taken.
Possible reasons
Pressure on margins (competitors, wrong choice of inventory, increasing costs) Strategic decisions to lower prices and increase turnover, which has not come to fruition Pressure on costs for additional employees and/or salary and wag increases. Pressure on other costs probably for advertising and marketing Stock not moving, resulting in longer creditors settlement, which may incur interest, or refusals to supply. Slow liquidity leading to incurrence of more long-term debt and therefore higher perception of financial risk and resultant higher cost of equity. By far the most pressing issue is to move the Inventory as a matter of urgency.
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FLYNN D K: UNDERSTANDING FINANCE AND ACOUNTING: 2ND EDITION: SUGGESTED SOLUTIONS
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8.4%