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INTERPRETATION OF FINANCIAL STATEMENTS
473
QUESTION
Liquidity and working capital ratios
Calculate liquidity and working capital ratios from the accounts of the TEB Co, a business which provides
service support (cleaning etc) for customers worldwide. Comment on the results of your calculations.
20X7 20X6
$m
$m
Revenue
2,176.2
2,344.8
Cost of sales
1,659.0
1,731.5
Gross profit
517.2
613.3
Current assets
Inventories
42.7
78.0
Receivables (Note 1)
378.9
431.4
Short-term deposits and cash
205.2
145.0
626.8
654.4
Current liabilities
Loans and overdrafts
32.4
81.1
Tax on profits
67.8
76.7
Dividend
11.7
17.2
Payables (Note 2)
487.2
467.2
599.1
642.2
Net current assets
27.7
12.2
Notes
1 Trade
receivables
295.2
335.5
2 Trade
payables
190.8
188.1
ANSWER
20X7
20X6
Current ratio
626.8
599.1
= 1.05
654.4
642.2
= 1.02
Quick ratio
584.1
599.1
= 0.97
576.4
642.2
= 0.90
Accounts receivable
collection period
295.2
2,176.2
365 = 49.5 days
335.5
2,344.8
365 = 52.2 days
Inventory turnover period
42.7
1,659.0
365 = 9.4 days
78.0
1,731.5
365 = 16.4 days
Accounts payable
payment period
190.8
1,659.0
365 = 42.0 days
188.1
1,731.5
365 = 40.0 days
The company's current ratio is a little lower than average but its quick ratio is better than average and
very little less than the current ratio. This suggests that inventory levels are strictly controlled, which is
reinforced by the low inventory turnover period. It would seem that working capital is tightly managed, to
avoid the poor liquidity which could be caused by a long receivables collection and comparatively high
payables.
The company in the activity is a service company and therefore it would be expected to have very low
inventory and a very short inventory turnover period. The similarity of receivables collection period and
payables payment period means that the company is passing most of the delay in receiving payment on
to its suppliers.
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PART H: INTERPRETATION OF FINANCIAL STATEMENTS
474
4.12 Payables payment period
FORMULA TO LEARN
Accounts payable payment period is ideally calculated by the formula:
Purchases
payable
accounts
Trade
365
It is rare to find purchases disclosed in published accounts and so cost of sales serves as an
approximation. The payment period often helps to assess a company's liquidity. An increase is often a
sign of lack of long-term finance or poor management of current assets, resulting in the use of extended
credit from suppliers, increased bank overdraft and so on.
QUESTION
Operating cycle
(a)
Calculate the operating cycle for Moribund for 20X2 on the basis of the following information.
$
Inventory: raw materials
150,000
work in progress 60,000
finished
goods
200,000
Purchases 500,000
Trade accounts receivable
230,000
Trade accounts payable
120,000
Sales 900,000
Cost of goods sold
750,000
Tip. You will need to calculate inventory turnover periods (total year-end inventory over cost of
goods sold), receivables as daily sales, and payables in relation to purchases, all converted into
'days'.
(b)
List the steps which might be taken in order to improve the operating cycle.
ANSWER
(a)
The operating cycle can be found as follows.
Inventory turnover period:
Total closing inventory × 365
Cost of goods sold
plus
Accounts receivable collection period:
Closing trade receivables × 365
Sales
less
Accounts payable payment period:
Closing trade payables × 365
Purchases
20X2
Total closing inventory ($)
410,000
Cost of goods sold ($)
750,000
Inventory turnover period
199.5 days
Closing receivables ($)
230,000
Sales ($)
900,000
Receivables collection period
93.3 days
Closing payables ($)
120,000
Purchases ($)
500,000
Payables payment period
(87.6 days)
Length of operating cycle (199.5 + 93.3 87.6)
205.2 days
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CHAPTER 26
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INTERPRETATION OF FINANCIAL STATEMENTS
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(b)
The steps that could be taken to reduce the operating cycle include the following.
(i)
Reducing the average raw material inventory turnover
(ii)
Reducing the time taken to produce goods. However, the company must ensure that
quality is not sacrificed as a result of speeding up the production process.
(iii)
Increasing the period of credit taken from suppliers. The credit period seems very long –
the company is allowed three months' credit by its suppliers, and probably could not be
increased. If the credit period is extended then the company may lose discounts for prompt
payment.
(iv)
Reducing the average finished goods inventory turnover.
(v)
Reducing the average receivables collection period. The administrative costs of speeding
up debt collection and the effect on sales of reducing the credit period allowed must be
evaluated. However, the credit period does seem very long by the standards of most
industries. It may be that generous terms have been allowed to secure large contracts and
little will be able to be done about this in the short term.
5
Interpreting information
You must be able to interpret financial data as well as calculate ratios.
Examination questions may try to simulate a real-life situation. An extract from a set of accounts could be
presented and you may be asked to calculate a specified ratio or you could be presented with certain
ratios and asked to interpret them. The question may ask you to select a reason for a particular
fluctuation or trend, or suggest a remedial action.
Try the following interpretation questions.
QUESTION
Interpreting information I
The following information for Hadrian is available.
$'000
PBIT
370
Interest
6
Tax
80
Profit after tax
284
Share capital
2,000
Reserves
314
2,314
Loan liability
100
2,414
Industry average return on capital employed
10%
Hadrian purchased new non-current assets during the year.
Required
Calculate and comment on ROCE for Hadrian.
ANSWER
ROCE =
PBIT × 100% =
370 × 100% = 15%
Capital
employed
2,414
ROCE, at 15% is better than the industry average of 10%. There could be a number of reasons for this.
It may be that the company is exceptionally profitable, or it may be that its assets are undervalued. The
first explanation is more likely, since new assets have been purchased, by definition at market value.
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