ACC9011M - Seminar 7 Solutions - Ratio Analysis
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Seminar 7 – Financial Analysis Question
XYZ plc is the second largest company in its sector. Its most recent income statement
and balance sheet are as follows:
Income Statement for the year ended 31 March 2023
Revenue
500,000
Cost of sale
(220,000)
Gross profit
280,000
Operating expenses
Distribution costs
110,000
Administrative expenses
50,000
(160,000)
Profit before interest and tax
120,000
Finance cost
(10,000)
Profit before tax
110,000
Taxation
(30,000)
Profit after tax
80,000
Dividends
20,000
Retained profits
60,000
Statement of financial position as of 31 March 2023
Non-current assets
Current liabilities
Land and buildings
130,000
Bank loans due Sep 2023
20,000
Plant and machinery
90,000
Trade payables
190,000
Fixtures and fittings
20,000
Tax payable
40,000
Vehicles
70,000
Dividends payable
20,000
310,000
270,000
Current assets
Non-current liabilities
Inventory
200,000
Bank loan due 2030
90,000
Receivables
120,000
90,000
Cash and cash equivalents
50,000
Total liabilities
360,000
370,000
Equity
Ordinary shares
150,000
Retained profits
170,000
Total equity
320,000
Total assets
680,000
Total liabilities and equity
680,000
The shares have a nominal price of £1 and a current market price of £2.
1
Analysis of the market leader’s most recent accounts has revealed the following ratios:
Gross profit margin
52%
Sales to fixed assets
1.6
Operating profit margin
29%
Inventory days
240 days
ROCE
32%
Receivables days
62 days
Gearing
28%
Payables days
280 days
Interest cover
8 times
EPS
62p
Fixed asset ratio
0.7
P/E
6.3 times
Current ratio
1.8
Dividend per share
17p
Quick ratio
0.8
Dividend yield
4.35%
Sales to capital employed
1.17
Dividend cover
3.65 times
Required:
1.
Calculate the corresponding ratios for XYZ plc.
When answering ratio questions, it is recommended that you follow these steps:
-
Step 1: Provide the formula
-
Step 2: Apply the formula (plug in the correct figures and calculate)
-
Step 3: Interpret the result
-
Step 4: Compare the result to a competitor (where suitable)
-
Step 5: Explain how the business could improve (what causes the ratios to be
high or low and what can be done about it)
PROFITABILITY RATIOS
Gross profit margin
= Gross profit ÷ Turnover
= 280,000 ÷ 500,000
= 56%
Operating profit margin
= Operating profit ÷ Turnover
= 120,000 ÷ 500,000
= 24%
ROCE
= Operating profit ÷ Capital employed
= 120,000 ÷ 410,000
= 29%
(Capital employed = Non-current liabilities + Equity = 90,000 + 320,000 = 410,000)
2
LONG-TERM SOLVENCY AND STABILITY RATIOS
Gearing
= Debt ÷ (Debt + Equity)
= 90,000 ÷ (90,000 + 320,000)
= 22%
Interest cover
= EBIT ÷ Interest expense
= 120,000 ÷ 10,000
= 12 times
Fixed asset ratio
= Non-current assets ÷ Capital employed
= 310,000 ÷ 410,000
= 0.76
LIQUIDITY RATIOS
Current ratio
= Current assets ÷ Current liabilities
= 370,000 ÷ 270,000
= 1.37
Quick ratio
= (Current assets – Inventory) ÷ Current liabilities
= (370,000 – 200,000) ÷ 270,000
= 0.63
EFFICIENCY RATIOS
Inventory days
= (Inventory ÷ Cost of sales) × 365
= 200,000 ÷ 220,000 × 365
= 332 days
Receivables days
= (Trade receivables ÷ Revenues) × 365
= 120,000 ÷ 500,000 × 365
= 88 days
Payables days
= (Trade payables ÷ Cost of sales) × 365 = 190,000 ÷ 220,000 × 365
= 315 days
Sales to capital employed
= Revenues ÷ Capital employed
= 500,000 ÷ 410,000
= 1.22
Sales to fixed assets
= Revenues ÷ Non-current assets
= 500,000 ÷ 310,000
= 1.61
3
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INVESTMENT RATIOS
(number of shares = Ordinary share balance ÷ Nominal value = £150,000 ÷ £1 = 150,000)
EPS
= Profit after tax ÷ Number of shares
= £80,000 ÷ 150,000
= £0.5333 = 53.33p
P/E
= Share price ÷ EPS
= £2 ÷ £0.5333
= 3.75 times
Dividend per share
= Dividends ÷ Number of shares
= £20,000 ÷ 150,000
= £0.1333 = 13.33p
Dividend yield
= Dividend per share ÷ Share price
= £0.1333 ÷ £2
= 0.067 = 6.7%
Dividend cover
= EPS ÷ Dividend per share
= £0.5333 ÷ £0.1333
= 4 times
2.
Comment on the performance and position of XYZ plc compared to the
market leader, using the ratios calculated above.
Note that the analyses below are not definitive. Alternative discussions would also be
accepted, provided they refer to the correct figures and make sense.
Ratio
Market
leader
XYZ
plc
Analysis
Gross profit margin
52%
56%
For every £1 in sales revenues, XYZ plc was able to generate 56p in gross profit. This is higher than the market
leader. This could have come from XYZ plc having a higher mark-up on its products or being able to control cost of sales better.
Operating profit margin
29%
24%
For every £1 in sales revenues, XYZ plc was able to generate 24p in operating profit. This is lower than the market leader. Since XYZ plc has a higher gross profit margin, the lower operating profit margin indicates that XYZ plc is spending a higher proportion of its sales on operating expenses.
ROCE
32%
29%
For every £1 in capital employed, XYZ plc was able to generate 29p in operating profit. This is lower than the market leader, which could have resulted from the higher operating expenses as noted above, or higher levels of capital employed. Shareholders would prefer a higher ROCE since it would indicate that the funds used in the business are being better utilised.
Gearing
28%
22%
22% of XYZ plc’s long-term funding comes from debts, 4
Ratio
Market
leader
XYZ
plc
Analysis
compared to 28% in the case of the market leader. This shows that XYZ plc is less reliant on debt. This could be in
XYZ plc’s favour, since it would suggest a lower financial risk. However, if the industry norm is around 30%, XYZ plc
might want to consider borrowing more to take advantage of the additional tax shield from debts. This should also take into account shareholder’s risk appetite since higher gearing with increase their risk of losing their investment in
the company.
Interest cover
8 times
12 times
The operating profit for the year was able to cover interest expense 12 times. This is higher than the market leader, and is in line with the lower level of gearing. This is also sufficiently high that there should not be a significant risk of failing to make interest payments in the short term.
Fixed asset ratio
0.70
0.76
This ratio should be less than 1. This is because long-term
assets (fixed assets) should be funded by long-term finance (capital employed). If this ratio is higher than 1, it would suggest that some of the fixed assets are financed by short-term liabilities. If these fixed assets take time to yield sufficient positive cash flows, the business might have difficulties settling the current liabilities when they are due.
Current ratio
1.80
1.37
XYZ plc has sufficient short-term assets to cover its short-
term liabilities 1.37 times. As a rule of thumb, this ratio should be between 1.00 and 2.00. It should be above 1 so
that there are sufficient current assets to cover current liabilities. A current ratio that is too high could result from excessive levels of cash, or inventory, or receivables, which would indicate inefficiencies.
Quick ratio
0.80
0.63
The quick ratio excludes inventory in the numerator, on the assumption that inventory could be less liquid than other current assets. While a quick ratio that is less than 1 is not always worrying, 0.63 could be considered low, and reflects the fact the inventory accounts for a considerable portion of XYZ plc’s current assets (£200,000 out of £370,000, or 54%). The business might want to improve its inventory management or policies.
Inventory days
240 days
332 days
On average, it took XYZ plc 332 days to sell its inventory. This is quite long in general (11 months), and considerably
higher than the market leader (8 months). This is in line 5
Ratio
Market
leader
XYZ
plc
Analysis
with the high level of inventory in XYZ plc’s current assets.
This puts the business at risk of inventory obsolescence and could put strain on liquidity, since significant resources are being tied up in stocks. Receivables days
62 days
88 days
On average, it took XYZ plc 88 days to collect cash from its credit customers. Again, this is quite long (3 months) and 1.5 times longer than the market leader (2 months). XYZ plc should consider tightening its credit policies, identifying overdue customers and chasing customers for payments.
Payables days
280 days
315 days
On average, it took XYZ plc 315 days to pay its credit suppliers. This is quite long (10.5 months) and longer than
the market leader (9.5 months). Whilst a longer payables settlement period gives the business more time and a cash flow advantage, it risks causing frictions with credit suppliers, which could lead to penalty interests, higher future prices, delayed deliveries or reduced credit limits.
Sales to capital employed
1.17
1.22
For every £1 of capital employed, the XYZ plc was able to generate £1.22 in sales, which is slightly higher than the market leader. A higher ratio would suggest greater efficiency in utilising capital employed to generate revenues. Sales to fixed assets
1.60
1.61
For every £1 of fixed assets, the XYZ plc was able to generate £1.61 in sales. A higher ratio would suggest greater efficiency in utilising non-current assets to generate revenues. Again, XYZ plc is comparable to the market leader.
EPS
62p
53.33p
The business was able to generate 53p in after-tax profit for every share in issue. This is lower than the market leader’s EPS of 62p. This could be a combination of the lower operating profit margin and higher number of shares. Interest expense would not have been the cause, since XYZ plc has lower gearing and higher interest cover.
Shareholders would prefer a higher EPS since it could mean a higher increase in share price or dividends.
P/E
6.3
times
3.75
times
The shareholders are willing to pay 3.75 times the current EPS for each share in XYZ plc. The higher this is, the more optimistic shareholders seem about the future prospects of the business (although in some cases, it could suggest that the shares are overpriced). The market
6
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Ratio
Market
leader
XYZ
plc
Analysis
leader’s EPS is almost twice as much as XYZ plc’s (6.3 vs
3.75), so investors appear to be more bullish about the market leader than XYZ.
Dividend per share
17p
13.33p
Each XYZ plc shareholder will receive 13.33p for every share that they hold in the company. This is lower than the
17p DPS of the market leader. Perhaps the market leader is able to offer a higher dividend per share because they generate more profit per share (EPS). Different businesses will have different dividend policies, so shareholders might be happy with 13.33p per share if this is what they expect from XYZ plc this year, based on past experiences.
Dividend yield
4.35%
6.7%
The dividend per share is equal to 6.7% of the share price.
This forms part of the returns to the shareholder from investing in XYZ plc, the remaining being capital gains (increase in share price). A higher dividend yield than the market leader (4.35%) could be a positive sign of a higher return, but only if it does not lead to a shortage of cash or cause stock prices to decrease.
Dividend cover
3.65
times
4 times
The after-tax profit for the year was able to cover the dividends paid 4 times. A higher dividend cover would suggest that the business is retaining more of its profits, either because it wants to make additional investments in the future, or it is in need of cash. XYZ plc might need to communicate the rationale for the chosen level of dividends to avoid negative speculation about its financial health.
3.
Discuss the different types of ratio analysis.
Standard analysis: a company’s ratios for the current or latest accounting period are
compared to a set of standard or target ratios.
Time-series analysis: a company’s ratios for several accounting periods are compared
to identify any trend.
7
Cross-sectional analysis: a company’s ratios for an accounting period are compared
to those of the market leader or a close competitor.
4.
Briefly discuss the limitations of using ratio analysis as an interpretative
tool.
Ratio analysis relies on historical financial data. It may not capture current market
conditions, changes in consumer behaviour, or sudden economic shifts.
Companies may use creative accounting practices to manipulate their financial
statements, which can distort the ratios and make them less reliable. Companies in
different countries may use different accounting standards, making it challenging to
compare ratios across borders.
Historical cost accounting does not account for inflation and changes in the price level,
impacting the accuracy of ratios over time.
While there are common ratios used in financial analysis, there is no universal
standard for which ratios or which definition of a ratio should be used. Different
analysts may use different ratios to assess the same company.
Ratios do not consider non-financial factors like management quality and
technological changes that can significantly impact a company's performance.
Seasonality or even extreme events may mislead us. Ratios are based on point-in-
time financial data, so they may not capture important changes or events that
occurred between reporting periods.
5.
Describe the advantages of ratio analysis for decision making.
Ratios are relatively simple to calculate and understand, making them accessible to a
wide range of users, from financial analysts to business owners.
Ratios provide a quick snapshot of a company's financial health, allowing for a quick
initial assessment of its performance and position. It also enables historical
comparisons, helping to identify trends and changes in a company's financial
performance over time.
Ratios can highlight areas of concern, such as liquidity problems, declining
profitability, or excessive debt, which may require further investigation and action.
Ratios allow for comparisons between different companies and industries, aiding in
benchmarking and identifying relative strengths and weaknesses.
6.
Describe the advantages of preparing an Income Statement and Balance Sheet.
The Income statement and Balance sheet provide users with figures to enable the
calculations and analysis of financial ratios.
Each statement has a key function. The income statement sets out all the income
generated and expenses incurred during the year, whilst the balance sheet provides a
8
snapshot of the company’s assets and claims on those assets (liabilities and equity) at
year-end.
The statements tend to have similar formats as a result of companies following local
or international accounting standards. This enables and facilitates comparisons
between companies.
Larger companies prepare these statements to meet legal obligations, but smaller
companies can also benefit because banks often ask for financial statements as part
of the funding approval process.
7.
Identify the limitations of an Income Statement and Balance Sheet.
The statements use historical information. It could take up to 9 months after the
financial year-end for the statements to be made publicly available, by which time
circumstances might have significantly changed.
These statements do not show cash flows, which is an important aspect of a
company’s performance and operations.
Accounting figures can be manipulated, for example through adopting inappropriate
accounting policies or through fraudulent financial reporting.
Statements do not include non-financial information which may help users better
assess the company, e.g. key personnel, competitor advantage.
9
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