SOLUTIONS

Analysis
work

Tutorial 7 - Class-

Question 1 Liquidity and solvency

XYZ Company is a medium sized retailer. For each of the ratios listed below,
explain briefly what the ratio means, and comment on XYZ Companys
performance based on each individual ratio over the three year period.

Current ratio
Acid-test ratio
Receivables turnover
Inventory turnover
Creditors turnover
Debt to total assets
Times Interest Earned
Cash debt coverage

2012

2013

2014

3.8
1.6
8.7 times
24.3 times
20.3 times
0.42
5.8 times
120%

3.4
1.5
9.4 times
24.3 times
12.2 times
0.48
4.5 times
103%

2.8
1.1
10.1 times
28.1 times
8.1 times
0.65
3.2 times
78%

The Current ratio shows how many dollars of current assets are available
to cover current liabilities. A higher figure is generally better and a suggested
minimum of around 2:1 is desirable for a new business. The analysis shows the
current ratio deteriorating over the three year period. If the trend continues, it
may fall below the desired minimum level. This is not a good trend.
The Acid-test ratio shows how many dollars of quick assets are available
to pay the most urgent liabilities. Inventory and prepaid expenses are excluded
as they are not considered to be assets that can be quickly converted into cash.
Again, a higher figure is generally better, with a suggested minimum of at least
1:1 for a new business. The XYZ Company analysis shows this ratio is on a
decreasing trend, with the most current year very close to the minimum desired
level of 1. If the trend continues, it appears likely that the company may
experience liquidity problems which may lead to solvency problems (i.e. an
inability to pay debts in full by due date.)

The Receivables turnover shows, on average, how many times per

year debtors are paying their accounts. The higher the turnover per year the
better, as the longer debtors are outstanding the greater the probability they will
become bad debts. It also costs time and money to send reminder letters to slow
-paying customers. The debtors of XYZ Company in 2014 are paying faster than
previous years. It could be due to the company offering settlement discounts to
encourage customers to pay on time. This is a positive trend which will hopefully
continue. (However, it might also point to a company facing liquidity stress and a
need to encourage prompt payment by debtors.)
The Inventory turnover shows how many times per annum inventory is
sold on average. A higher turnover is generally better. Nevertheless, you must
consider what the business is selling before making a judgement about whether
the turnover is too low. XYZ Companys inventory turnover is quite stable over
the period under analysis. It appears that the liquidity (i.e. ability to convert
assets into cash) has remained steady or has slightly improved during the three
year period.
Creditors turnover indicates, on average, how many times per year the
company pays its creditors. From the point of view of a supplier, this should be
as frequent as possible as creditors should not give credit to customers with a
poor credit history. XYZ Company appears to be having difficulty paying its
creditors as evidenced by the significant slowdown over the three year period.
This is supported by findings of the analysis into the Current ratio which
indicated that the ability to repay debts was declining.
The Debt ratio shows the percentage of total assets financed by interestbearing liabilities. Conservative companies normally like this ratio to be as low as
possible, as debt can negatively affect both profit (through interest expense) and
cash flow (through loan repayments). The debt level of XYZ Company has
increased the most in 2014, indicating a higher level of financial risk.
The Times Interest Earned ratio provides insight into how comfortably
historical profit has covered interest expense. As debt levels increase, companies
often experience a reducing times interest earned ratio. If profits fall, companies
may have more difficulty in covering the higher interest expense incurred. An
exception to this would be where the debt was incurred to perhaps finance
construction of a new production facility. In this situation, increased production
may lead to more revenue and higher profits, so that a decrease in times
interest earned may not occur. This is not the case for XYZ Company where there
was an increase in debt resulting in an increase in interest expense but without a
proportionate increase in profit.

The Cash Debt Coverage ratio indicates the percentage of cash flows
from operating activities per dollar of liabilities of an entity. For XYZ Company
this has declined considerably. In 2012, the company had 120% of liabilities
covered by cash flows from operating activities. This has decreased to just 78%
in 2014. This is consistent with the additional borrowings.

Question 2 Profitability ratios ( the owners perspective)

The following information has been provided about ABC Company:

Net Profit After Tax

Owners Equity
Number of Shares
Issued
Dividends Paid
Share Price
Borrowings
Assets

2008
$ 300,000
$ 800,000
400,000 (issued at $
2.00)
$ 100,000
$ 3.20
$ 700,000
$ 1,500,000

2009
$ 330,000
$ 1,200,000
600,000 (issued at $
2.00)
$ 100,000
$ 3.40
$ 300,000
$ 1,500,000

Debt to Total Assets

Payout ratio
Return on Equity

0.47
0.33
0.375

0.20
0.30
0.275

Comment on the profitability over the two year period:

The Debt to Total Assets ratio indicates the level of borrowings. This
has decreased significantly over the two years as the company has issued equity
to repay most of its debt. This sees a reduction in finance risk which is a good
trend.
The (Dividend) Payout ratio indicates the proportion of profits paid out
to shareholders. This has decreased slightly as the dividend payment remained
the same while profit increased slightly.
Return on Equity(ROE) indicates the return from the owners
perspective. A higher figure is preferable to compensate the owners for the risk
they are taking. ROE has decreased for ABC Companys shareholders. The net
profit has increased slightly, but the issue of additional shares has caused a
reduction in the ROE.

This example illustrates the effect of gearing. Repayment of the

borrowings via a share issue is positive in that it reduces financial risk, but it has
resulted in a reduction in the return for the owners.

Question 3 Profitability ratios (managements efficiency)

(a) Consider the following ratios for DEF Company and discuss
over the three year period:
2007
Return on Assets = Profit before I T / Average
0.40
Total Assets
Asset (Sales) Turnover = Revenue / Average
10
Total Assets
Return on Sales = Profit before I T / Sales
0.04

the performance
2008
0.52

2009
0.58

6.5

5.3

0.08

0.11

Return on Assets has been improving over the period indicating that the
business is making more profit from the assets used in the business. The higher,
the better for this ratio as businesses should use assets efficiently to generate
reasonable returns. The result for this ratio is improving.
Asset (Sales) Turnover has declined considerably over the three years
which is not a favourable trend. This ratio indicates that the amount of revenue
generated per dollar of assets has fallen. The decline for this business means
that is less efficient in using its assets to make sales.
Return on Sales has increased over the period indicating the business is
making more profit from every dollar of revenue earned. This is surprising as
Asset (sales) turnover indicated less efficiency. The business may have lost sales
overall, but either increased selling price or reduced expenses to compensate.

(b) A sole trader business that offers a lawn mowing and gardening service has
the following information for the year:
Revenue
Net profit before interest and tax
Average total assets
Return on Assets

$ 78,000
$ 52,000
$ 26,000

Sales Turnover

Return on Sales

2.0

3.0

0.67

Discuss why these results are so much higher than the company analysed in the
previous exercise, and whether the returns are adequate.
An analysis of ABC Company is very difficult as so little information has
been provided. There is a need to compare this information to benchmarks
(previous years results, competitors results, industry averages, etc.) to get a
better idea of performance.
This is a small business with few non-current assets used to generate
profits. It is a labour intensive entity where the more the owner works, the more
profit he/she can earn with the same assets. The owner is earning twice as much
profit as the value of assets, and three times as much revenue as the value of
assets. These returns are very good, indicating efficient use of the assets of the
business to generate profits. Return on sales indicates that the business earns
around 67% profit from every dollar of revenue generated, with only 33% of
revenue used to cover expenses.
While the ratios appear to be excellent, compared to DEF Company in
example (a), the ratios cannot incorporate the many hours of work contributed
by the owner to achieve these results. Would it be better to work for someone
and earn this amount as a salary? Would the owner prefer to be an employee
with guaranteed wages rather than have the stress of wondering whether the
business will succeed and trying to find ways to generate more revenue?
Question 4
A (1) What do the ratios suggest about the companies respective profitability?
The Return on Equity (ROE) of each company exceeds the Return on Assets
(ROA) of that specific company.
Infomedia has the highest ROE and ROA of the companies. MYOB has the
highest asset turnover This indicates that it utilises its assets more efficiently to
generate sales. However, MYOB has a lower profit margin and this is negatively
affecting the ROA.
Computershare has a lower asset turnover, but a higher profit margin, than
MYOB. This could indicate that it controls its expenses better or is able to
achieve higher gross margins, but it needs to work on the efficient use of its
assets.

A (2) What do the ratios suggest about the companies respective short
term position?
Infomedias days inventory and days receivables are extremely high. This
could reflect differences in the nature of the assets held. For example,
Infomedias inventory may include specialist software for the car industry that
may take longer to produce. Funds invested in inventory and debtors are earning
a zero rate of return, so it is advantageous for an entity to turn over its inventory
and debtors as quickly as possible. Higher days inventory and days debtors
generally reflect poor management efficiency.
A (3) What do the ratios suggest about the companies respective longterm financial structure?
The debt to equity ratio indicates how many dollars of debt exist per dollar of
equity financing. If this ratio exceeds 100 per cent, then the entity is more reliant
on debt funding that equity funding. Informedias debt to equity ratio is the
highest and MYOBs debt to equity ratio is the lowest. However, for all companies
less debt financing is used to fund assets relative to equity financing. Effective
use of debt (e.g. using borrowed funds to acquire assets that return more than
the cost of funds) will have a positive impact on ROE.
B Explain any limitations to the analysis and any additional information,
which could assist in making a more reliable assessment.
This exercise involves an analysis of ratios across companies in the same
industry. When comparing ratios across companies or within the same company
over time, attention needs to be given to each entitys accounting policy
choices. For example, the lower ROA for MYOB could be due to a policy of fair
valuing property, plant and equipment (PPE) whereas the other entities may
measure PPE at cost.
Consideration should also be given to the differences between the companies
including their different strategic directions. MYOB is selling software to a variety
of industries. Computershare provides services to a diverse range of companies
on the stock exchange. Infomedia provides software for the automotive industry
and so is a far more specialised company.
Information is necessary about past (historic) and forecasted performance.
Results for one period may not be typical and are subject to the limitations of
attempting to measure flow concepts with static information. Information over as
many as five periods may reduce the effect of the limitations of static
information.

Question 5: See Tute 8 solutions

Question 6
We are told that the entity belongs to the white goods industry, which was prone
to recessionary economic situation during this period.
o

The liquidity situation of the company seems to have improved with

the current ratio increasing from 1.43 last year to 1.92 this year.
The quick ratio also improved from 0.82 to 1.07 which seems
comfortable by normal recommended standards.

However, the increase in the first ratio seems to be a result of

higher inventory, compared to the sales. This could indicate lack of
demand for the companys products or poor stocking policies.

Also, the companys long term liability increased by over 50% over
the previous year. This indicates that more of the current assets are
funded by debt rather than by current liabilities. From the liquidity
point of view this is good, but it may have an impact on profitability
and risk.

There has been a sharp fall in the profitability as indicated by all

these four ratios. Unless the industry ratios are available to
compare, it is difficult to establish a benchmark. The sales turnover
has fallen by 17% bringing down all the four ratios in this category.

Administrative and selling expenses, as well as finance costs,

increased substantially leading to the decline in profitability. It
appears that the company spent more to promote sales in a difficult
market.

The solvency of the company has been hit adversely as can be seen
by the decline in the Debt to Assets ratio which increased from 54%
to 56.3% in 2014. By itself it is not a very disturbing, but combined
with the falling sales for the year and a deep dip in the Interest
cover, it shows a likely failure to meet financial obligations in future
if difficult conditions continue.

(a)

(b)

The risks for the company have gone up. The financial leveraging
which improved the liquidity of the firm also caused interest liability
to go up, hit the interest coverage, and could possibly make debt
servicing difficult in future.

I hesitate to give a further loan to this company due to the following

reasons:

(c)

The interest coverage is low, indicating an inability to service more

loans.
Plummeting sales evidencing economic downturn in the industry.
Higher costs affecting profitability
Already high debt with an increase in long term debt in 2014.
I recommend that the owners bring in additional equity to shore up
the long term funds and reduce interest liability/expense of the
company.

Question 7

2013
2014
(a)

Current

Acid-test

1.4 : 1
1.5 : 1

0.82 : 1
0.90 : 1

Receivables
Turnover
7.5 times
7.2 times

Inventory
Turnover
5.2 times
5.4 times

Calculate the missing ratios above for the year 2014

Current ratio = $215,000 / $145,000 =

1.5 : 1
Acid test ratio = ($21,000 + $18,000 + $92,000)/$145,000 =
0.90 : 1
Receivables turnover = $600,000 / [$92,000+$74,000]/2 =
7.2 times
Inventory turnover = $415,000 / [$84,000+$70,000]/2 =
5.4 times
(b)
Comment on the liquidity of Outside Inn Company over the two year period with reference
to the ratios provided and those calculated in part (a).
The current ratio assists in evaluating liquidity and short-term debt paying capacity. For every dollar
of current liabilities, Outside Inn Company has $1.50 of current assets in 2014. This shows an
increase from the previous year of 10 cents which is a positive trend.

The acid-test ratio better measures immediate short term liquidity as it excludes inventory and
prepayments current assets that are not always readily exchangeable for cash. The company has a
ratio of 90 cents in 2014, an increase of 8 cents since 2013. This means that while all immediate
liabilities may not be paid with existing quick assets, the ratio is closer to 1 than it was previously.
This is a positive trend.
The receivables turnover assesses how frequently accounts receivable amounts are collected in a year.
The more often they are collected, the better the liquidity. In Outside Inns situation, this ratio has
deteriorated slightly as the turnover has decreased from 7.5 to 7.2 times per year. The company may
need to monitor the behaviour of debtors.
The inventory turnover illustrates how many times inventory is sold during the year. The company
was selling inventory at an average of 5.2 times per year in 2013 which improved to 5.4 times in
2014. This is a positive trend. It may have come about from promotions, sales or other price
reductions.
Question 8
Normally Debt to Assets ratios and Interest coverage (earned) ratios are inverse
that is an increase in one ratio leads to a decrease in the other ratio and vice
versa. The Manager of YM Company noticed that the debt to asset ratio over the
past two years has decreased from 71% to 60% and during the same period the
interest coverage ratio has also decreased from 4.9 times to 3.1 times. He has
asked you as the Accountant to explain to him why this could happen.
There may be many reasons why this may occur including:
A decrease in profit has occurred
A decrease in debt may be due to repayment of non interest bearing liabilities (eg creditors)
An increase in interest rates paid on borrowings
A repayment of a loan may have happened at the end of the period which would have
minimal affect on the interest paid for the period