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Chapter 20
KAPLAN PUBLISHING
395
Test your understanding 1
Neville is an entity that manufactures and retails office products. Its
summarised financial statements for the years ended 30 June 20X4 and
20X5 are given below:
Statements of profit or loss for the year ended 30 June
20X4 20X5
$000
$000
Revenue 1,159,850
1,391,820
Cost of sales
(753,450)
(1,050,825)
––––––––
––––––––
Gross profit
406,400
340,995
Operating expenses
(170,950)
(161,450)
––––––––
––––––––
Profit from operations
235,450
179,545
Finance costs
(14,000)
(10,000)
––––––––
––––––––
Profits before tax
221,450
169,545
Tax (66,300)
(50,800)
––––––––
––––––––
Net profit
155,150
118,745
Statements of financial position as at 30 June
20X4
20X5
$000
$000
$000
$000
Non-current assets
341,400
509,590
Current Assets
Inventory 88,760
109,400
Receivables 206,550
419,455
Bank 95,400
–
–––––––
–––––––
390,710
528,855
–––––––
––––––––
732,110
1,038,445
–––––––
––––––––
Interpretation of financial statements
396
KAPLAN PUBLISHING
Equity and reserves
Share capital
100,000
100,000
Share premium
20,000
20,000
Revaluation reserve
–
50,000
Retained earnings
287,420
376,165
–––––––
–––––––
407,420
546,165
Non-current liabilities
Loans
83,100
61,600
Current liabilities
Payables 179,590
345,480
Overdraft –
30,200
Tax 62,000
55,000
–––––––
–––––––
241,590
430,680
–––––––
––––––––
732,110
1,038,445
–––––––
––––––––
The directors concluded that the revenue for the year ended 30 June
20X4 fell below budget and introduced measures during the year ended
30 June 20X5 to improve the situation. These included:
•
cutting selling prices
•
extending credit facilities to customers
•
leasing additional machinery in order to be able to manufacture
more products.
The directors’ are now reviewing the results for the year ended 30 June
20X5.
Calculate the ratios for and comment upon the profitability,
liquidity/efficiency and financial position of Neville for 20X4 and
20X5.
Chapter 20
KAPLAN PUBLISHING
397
Chapter summary
Interpretation of financial statements
398
KAPLAN PUBLISHING
Test your understanding answers
Test your understanding 1
Profitability
20X4 20X5
406,400
340,995
GP% ––––––––
35.0%
––––––––
24.5%
1,159,850
1,391,820
235,450 179,545
OP% ––––––––
20.3%
––––––––
12.9%
1,159,850
1,391,820
235,450 179,545
ROCE –––––––
48.0%
–––––––
29.5%
490,520 607,765
1,159,850
1,391,820
Asset
turnover
–––––––– 2.36 –––––––– 2.29
490,520 607,765
The revenue of the entity has increased by 20% on last year. It would
therefore appear that the strategy of cutting prices and extending credit
facilities has attracted customers and generated an increase in revenue.
Despite this increase, the operating profit margin has declined from
20.3% to 12.9%.
There are several possible reasons behind this deterioration:
•
the reduction in sales prices
•
increased leasing costs
•
increased depreciation due to the revaluation and additional
purchases of non-current assets
•
increased irrecoverable debt due to the extended credit facilities.
The return on capital employed has dropped significantly from 48% to
29.5%. The possible reasons for this decline include:
•
the reduction in operating profit margins
•
the revaluation of non-current assets, which would increase capital
employed.
Chapter 20
KAPLAN PUBLISHING
399
Liquidity/efficiency
20X4
20X5
Inventory days
88,760 × 365
753,450
43 days
109,400 × 365
1,050,825
38 days
Receivables days
206,550 × 365
1,159,850
65 days
419,455 × 365
1,391,820
110 days
Payables days
179,590 × 365
753,450
87 days
345,480 × 365
1,050,825
120 days
Current ratio
390,710
241,590
1.6:1
528,855
430,680
1.2:1
Quick ratio
301,950
241,590
1.2:1
419,455
430,680
1:1
The entity’s results show a deteriorating liquidity position; both the current
and quick ratios have worsened. The main reasons for this appear to be:
•
the reduction in cash and consequent increase in overdrafts
•
the increase in trade payables.
The overall cause could be the extension of credit facilities to customers.
Credit customers are taking an extra 45 days to pay on average. As a
result, Neville appear to have less cash to pay their suppliers and it is
using its cash resources and overdraft facilities.
Receivables days have increased from an appropriate level of 65 days to
110 days. Although the benefits of this strategy have been shown by the
increase in revenue, it would seem that Neville have now allowed
customers too much credit. It would be recommended that receivables
days should be reduced to closer to 90 days.
The large increase in payables days could lead to problems, unless
suppliers have specifically agreed to offer Neville extended repayment
deadlines. If not, then suppliers may refuse to sell goods to Neville on a
credit basis.
Interpretation of financial statements
400
KAPLAN PUBLISHING
Financial position
20X4
20X5
Interest cover
235,450
14,000
16.8
179,545
10,000
17.9
Gearing*
83,100
490,520
16.9%
61,600
607,765
10.1%
* Gearing has been calculated using the 'debt/debt + equity' formula.
Gearing has fallen, whilst interest cover has increased. The key reason
for this appears to be the reduction in loans (along with the consequent
reduction in finance costs) during the year.
It appears as though Neville have used cash to repay their loan finance.
This does not appear to be a sensible decision because the reduction in
cash within the business has led to an increase in expensive overdrafts
and an increase in payables days, which may upset suppliers.
Both gearing and interest cover were strong in 20X4 (i.e. the interest
cover was more than adequate and the gearing level appeared to be low).
This indicated that Neville could afford to sustain its loans without
significant penalty. It is now using an overdraft facility which is likely to
carry a much higher interest charge than long-term loans.
To improve its position Neville could seek further long terms loans. It is
not a risky business from a gearing perspective and it has plenty of
assets to use as security for any lenders.
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