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1. Calculate the following ratios for 2016. The industry average for similar businesses is shown. (6 marks)
Industry average
Rate of return on total assets 22%
Rate of return on ordinary equity 20%
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Profit margin 4%
Earnings per share 45c
Price-earnings ratio 0
Dividend yield 5%
Dividend payout 70%
Current ratio 5:1
Quick ratio (acid ratio)
Receivables turnover 13
Inventory turnover 6
Debt ratio 40%
Times interest earned 6
Assets turnover 8
Given the above industry averages, comment on the company’s profitability, liquidity and use of financial gearing. (4 marks)
2. A local restaurant is noted for its fine food, as evidenced by the large number of customers. A customer was heard to remark that the secret of the restaurant’s success was its fine chef. Would you regard the chef as an asset of the business? If so, would you include the chef on the balance sheet of the business and at what value? Discuss.
Accounting provides much information to help managers make economic decisions in their various workplaces. You are required to provide examples of economic decisions that the following people would need to make with the use of accounting information: (3 MARKS)
A manager of human resources
A factory manager
The management team of an Australian Football League (AFL) club
The manager of a second-hand clothing charity
c) Indicate the effect of each of the following transactions on any or all of the three financial statements of a business: (5 MARKS)
Statement of financial position
Statement of financial performance
Statement of cash flows
Apart from indicating the financial statements (s) involved, use appropriate phrases such as ‘increase total asset’, ‘decrease equity’, ‘increase income’, ‘decrease cash flow’ to describe the transaction concerned.
Purchase equipment for cash.
Provide services to a client, with payment to be received within 40 days.
Pay a liability.
Invest additional cash into the business by the owner.
Collect an account receivable in cash.
Pay wages to employees.
Receive the electricity bill in the mail, to be paid within 30 days.
Sell a piece of equipment for cash.
Withdraw cash by the owner for private use.
Borrow money on a long-term basis from a bank.
1. Rate of return on total assets is defined as the ratio of Net income to the Average asset value of total assets. For the given case, it can be computed as:
Rate of return on total assets = = 15.033 %
Rate of return on ordinary shares is defined as the ratio of Net income to the total no. of shares. For the given case, it can be computed as:
Rate of return on ordinary shares = = 60.583 %
Profit Margin is defined as the ratio of Net income to Sales revenue. For the given case, net income = 4362 and sales revenue = 55000. Therefore,
Profit margin = = 7.931%
Earnings per share is defined as the ratio of the difference between Net Income and Dividend obtained on preference share to the total no. of shares. For the given case,
Earnings per share = (4362 – 50)/ 7200 = 0.598 $
Price earnings ratio is defined as the ratio of Market price of share to the Earnings per share. For the given case, it can be computed as:
Price earnings ratio = 12/ 0.598 = 20.06
Dividend yield is defined as the ratio of Earnings per share to the Market price of the share. For the given case, it is computed as:
Dividend yield = = 4.983 %
Dividend payout is defined as the ratio of Dividend per share to the Earnings per share. For the given case, dividend payout can be computed as:
Dividend payout = (2702/ 7200)/ (0.589) = 62.66 %
Current ratio is defined as the ratio of Current assets to Current liability which, for the given case can be calculated as:
Current Ratio = 12745/ 5780 = 2.21
Quick ratio or acid is defined as the ratio of sum of Cash equivalent and account receivables to the current liability. Cash equivalent = 1645. Amount receivables = 4100. Current Liability = 5780. Therefore, acid ratio = (1645 + 4100)/5780 = 0.99
Receivables turnover is defined as the ratio of sales revenue to the average account receivables. For the given problem, it can be calculated as:
Receivables turnover = 55000*2/ (4100 + 3675) = 14.15
Inventory turnover is defined as the ratio of sales revenue to average inventory.
Inventory turnover = 55000*2/ (7000 + 6930) = 7.90
Debt ratio is defined as the ratio of Total debt to total assets. For the given case, Total debt = 15720. Total assets = 29935. Therefore,
Debt ratio = (15720/ 29935) x 100 % = 53 %
Times interest earned is the ratio between EBIT and Interest. This can be computed as (7830/ 1560) = 5.02
Asset turnover is the ratio between Sales revenue and Average total asset value.
= 55000/ (29935 + 28045)/ 2 = 1.90
(Pandey, 2010)
Company’s Profitability:
It can be seen that the profit margin of the company is 7.93% which is more than the Industry average of 4%. Moreover, the earnings per share is around 60 c which is more than the industry average of 45c. Given these two parameters for judging profitability, it can be inferred that the company’s performance is better than its competitors.
Company’s Liquidity:
The acid ratio and the current ratio of the company are 0.99 and 2.21 respectively which is lower than the industry average of 1.3 and 2.5. This implies that the company has less quick and current assets required to clear the current liabilities. This in turn makes the company riskier. The company needs to increase its liquidity in order to efficiently pay its current liabilities.
Use of Financial Gearing:
The Company has taken a debt which is much higher than the industry average and this enhances its risk. Therefore, the company should aim to decrease its dependency on long term debt and also try to increase equity in the company.
(Averkamp, 2011)
2. Asset can be defined as anything tangible or intangible that can be used or controlled to produce value. In the given case, the skills of the chef constitute an intangible asset for the company which the company is controlling to produce its profits. The company needs to take into account the additional profits generated by chef’s contribution to calculate the value of the chef.
Manager of human resources:
The HR manager can use the accounting information to compare the payroll of the company employees with the industry average. This will help her/him understand how the firm is performing and which areas need improvement. The HR manager can also take initiatives to increase productivity of the company thus increasing its profitability.
A factory manager:
A factory manager can use accounting information to know the inventory of the company and plan accordingly. (S)he should also keep a note on the fixed and variable manufacturing overheads and find ways to keep them under control.
iii. The management team of an Australian Football League (AFL) club:
It is important for the management team to know its budget. This is where accounting information will be useful to the management team. They can plan accordingly to buy training equipments and spend on training sessions.
The manager of a second-hand clothing charity: The manager can use accounting information to decide how to distribute the donations and collections he/she has. They can also use it to check if their performance over previous years is improving.
Purchase equipment for cash: For the Statement of financial position, cash in the assets will decrease while the amount of non-current assets will increase. There will be no impact on the statement of financial performance while cash will decrease in the cash flow statement.
Provide services to a client, with payment to be received within 40 days: Total assets in the Statement of financial position will increase since the account receivables will increase. Income and equity both will increase for the company. Cash flow statement will remain unchanged.
Pay a liability: For the Statement of financial position, cash in the assets will decrease and the account payable in liability will also decrease. There be will no impact on the statement of financial performance while cash will decrease in the cash flow statement.
Invest additional cash into the business by the owner: For the statement of financial position, cash in the assets will increase and the equity will also increase. There will be no impact on the statement of financial performance while cash will increase in the cash flow statement.
Collect an account receivable in cash: For the statement of financial position, cash will increase and the account receivable will decrease. There will be no impact on the statement of financial performance while cash will increase in the cash flow statement.
Pay wages to employees: For the Statement of financial position, cash will decrease from assets and the account payable in liability will also decrease. There will be no impact on the statement of financial performance while cash will decrease in the cash flow statement.
Receive the electricity bill in the mail, to be paid within 30 days: For the Statement of financial position, the account payable in liability will decrease and expenses will increase in the statement of financial performance which will lead to reduction in retained earnings in the equity. There will be no impact on the statement of cash flow.
Sell a piece of equipment for cash: For the Statement of financial position, the assets will decrease while the cash will increase. Total assets will, however, remain unchanged. There will be no impact on the statement of financial performance while cash will increase in the cash flow statement.
Withdraw cash by the owner for private use: For the Statement of financial position, the equity in the assets will decrease and so will the cash in the assets. There will be no impact on the statement of financial performance while cash will increase in the cash flow statement.
Borrow money on a long-term basis from a bank: For the Statement of financial position, the long term liability will increase and as a result the cash in the assets will also increase. There will be no impact on the statement of financial performance while cash will increase in the cash flow statement. (Ittelson, 2008)
References
Pandey, I. (2010). Financial Management. Vikas Publishing House.
Boundless. (2016). Profitability Ratios. Boundless Business. Retrieved on August 17, 2016 from https://www.boundless.com/business/textbooks/boundless-business-textbook/financial-statements-18/ratio-analysis-and-statement-evaluation-108/profitability-ratios-505-6717/
Averkamp, H. (2011). What are accounting ratios?. Retrieved on August 17, 2016 from https://www.accountingcoach.com/blog/what-are-accounting-ratios
Lane, M. (2008). Ratio Analysis. Retrieved on August 17, 2016 from https://www.zenwealth.com/businessfinanceonline/RA/RatioAnalysis.html
My Accounting Course. (n.d.). Financial Ratio Analysis. Retrieved on August 17, 2016 from https://www.myaccountingcourse.com/financial-ratios/
Sarngadharan, M. (2011). Financial Analysis for Management Decisions. Prentice Hall
Tracy, A. (2012). Ratio Analysis Fundamentals: How 17 Financial Ratios Can Allow You to Analyse Any Business on the Planet. Bidi Capital Pty Ltd
Ready Ratios. (2011). Liquidity ratios. https://www.readyratios.com/reference/liquidity/
Ittelson, T. (2008). Financial Statements: A Step by Step Guide to Understanding and Creating Financial Reports. Career Press.
Mc Graw Hill. (2008). Financial Accounting. Retrieved on August 17, 2016 from https://highered.mheducation.com/sites/0073324833/student_view0/ebook/chapter1/chbody1/the_four_basic_financial_statements__an_overview.html
