FINANCIAL ACCOUNTING

FINANCIAL ACCOUNTING

2014 ASSIGNMENT

i) Gross Profit Margin
ii) Net Profit Margin
iii) Return on Capital Employed
iv) Asset Turnover Ratio
v) Current Ratio
vi) Quick Asset Ratio
vii) Stock Days
viii) Debtors Days
ix) Debt Equity Ratio.
x) Gearing Ratio
40%
10%
15%
3:1
2:1
1.5:1
75
30
1.0:1
55%

Formula Ratios Year 2013 Year 2012
Gross profit Margin=
(Gross Profit)/Sales×100 1580/3590×100≈44% 1016/2217×100≈46%
Net Profit Margin = Profit after tax and Ratings (252/3590)x100≈7% (148/2217)x100≈6,68%
Return on Capital Employed=
(Profit before Long Term Interest &Tax)/(Share Capital+Resrves+Non-Current Liabilities)×100 475/(1100+925)×100
≈21% 284/(1028+1146)×100
≈13%
Asset Turnover = Sales/Net Asset 3590/(2755-550)≈1.63 2217/(2521-347) ≈1.02
Current Ratio=
(Current Assets)/(Current Liabilities) 1020/550=1.85 times 886/347
=2.5 times
Quick Asset Ratio=
(Current Asset-Inventories)/(Current Liabilities) (1020-312)/550≈1.29 times (886-296)/347
=1.7 times
Stock Days = Inventories / Cost of Sales (312/2010)≈57 Days (296/1201)≈90 Days
Debtors Days=
(Trade Receivables )/Sales×365 (350/3590)x365≈36 days (290/2217)×365≈48 days
Debt Equity Ratio=
(Total Liabilities)/(Total Equity) 1475/1280=1.115 1493/1028 =1.45
Gearing Ratio=
(Preference Share Capital+Non-Current Liabilities)/(total Share Capital+Reserves+Non-Current Liabilities)×100 925/(420+925)×100≈69% 1146/(420+1146)×100 ≈73%

Question
1. Industry averages provided on the assignment refer to year 2013. You have to compare the 2013 figures of the company with the ones of the industry. You don’t have to present a comparative analysis of the company’s financial performance against the industry averages using the 2012 figures.
Ratio analysis usually provides valuable information about a firm’s financial health. A financial ratio weighs a firm’s performance in a specific area. However, importance is not placed too much one ratio. To obtain a better indication of the direction in which a company is moving, it is important to take several ratios as a group. In this analysis, the ratios are split into four categories so as to give a clear indication of the status of the company and also observe the trend between 2012 and 2013.
1. Profitability Ratios. These ratios use margin analysis and show the return on sales and capital employed.
Formula Ratio Year 2013 Year 2012
Gross profit Margin=
(Gross Profit)/Sales×100 1580/3590×100≈44% 1016/2217×100≈46%
Gross profit margin provides information about the business’s ability to control production costs or manage margins on products it buys or sells. It is observed that the gross profit margin decreased from 46% in 2012 to 44% in 2013 showing that the cost of production improved in 2013. Additionally, it was estimated the industry margin in 2013 was 40% while Softwood Limited had a gross profit margin of 44%. This indicates that Softwood Limited is operating at lower production costs as compared to the industry and this translates into higher profit margins. Therefore, Softwood Limited should strive to improve efficiency in the production process so as to remain above the industry average.
Formula Ratio Year 2013 Year 2012
Net Profit Margin = Profit after tax and Ratings (252/3590)x100≈7% (148/2217)x100≈6,68%
Assuming a constant gross profit margin reflects information about a company’s ability to control its other operating costs or overheads. The net profit margin increased from 6.68% in 2012 to 7% in 2013 indicating that Softwood Limited was able to lower its operating costs and overheads in the year 2013. The industry net profit margin stood at 10% in 2013 indicating that Softwood Limited was incurring more overheads and operating expenses that the industry peers. Softwood Limited should strive to lower its overheads and operating expenses to match the industry.

Formula Ratio Year 2013 Year 2012
Return on Capital Employed=
(Profit before Long Term Interest &Tax)/(Share Capital+Reserves+Non-Current Liabilities)×100 475/(1100+925)×100
≈21% 284/(1028+1146)×100
≈13%
Return on Capital Employed shows return on resources used prior to the dissemination of returns. Softwood Limited retained a return on capital employed of 21% in 2013 up from 13 percent in 2012. This indicates an increase in the returns on the capital employed in 2013 as compared to 2012 translating to a higher return to the investors. The industry average stood at 15 percent showing that Softwood Limited was able to generate more returns to the its stakeholders as compared to the industry. Softwood Limited should continue to improve efficiency in order to maintain the high levels of return on capital employed.
2. Liquidity Ratios provide a picture of a company’s short-term financial situation or solvency.
Formula Ratio Year 2013 Year 2012
Current Ratio=
(Current Assets)/(Current Liabilities) 1020/550=1.85 times 886/347
=2.5 times
The current ratio estimates whether the business can pay its debts due within one year with the assets it expects to turn into cash in the year. The greater the ratio, the easier a firm might meet its short-term obligations. The current ratio should be at least 1.0 times. Softwood Limited had a current ratio of 1.85 in 2013 compared to 2.5 in 2012. This indicates that there was a decrease in Softwoods ability to pay their current obligations. In 2013 the industry average was 2, equated to Softwood’s 1.85 which is lower than that of the industry average suggesting that the company may have liquidity problems. Softwood Limited should aim to lower its current liabilities.

Formula Ratio
Year 2013 Year 2012
Quick Asset Ratio=
(Current Asset-Inventories)/(Current Liabilities) (1020-312)/550≈1.29 times (886-296)/347=1.7 times
The quick asset ratio is an adjustment to current ratio to reflect only cash or near cash assets since it may take longer than 1 year to turn inventory into cash. Inventory is excluded in this ratio since, in numerous industries; inventory might not be speedily transformed to cash. Softwood Limited had a quick asset ratio of 1.7 in 2012 as compared to 1.29 in 2013. This indicates a drop in the quick asset ratio depicting that Softwood’s Limited ability to meet its short-term maturing obligations is decreasing. Softwood limited had a lower quick asset ratio as compared to the industry average of 1.5. This suggests that the company may be facing liquidity problems and should seek to lower their current liabilities.
3. Efficiency Ratios provide insight into how efficiently the business is employing those resources invested in fixed assets and working capital.
Formula Ratio Year 2013 Year 2012
Asset Turnover = Sales/Net Asset 3590/(2755-550)≈1.63 2217/(2521-347) ≈1.02
Asset Turnover is a measure of total asset utilization. It helps answer the question “what sales are being generated by each dollar’s worth of venture”. Softwood Limited boasted of an asset turnover of 1.63 in 2013 as compared to 1.02 in 2012. This shows an increase in asset turnover depicting a higher level of asset utilization to generate sales in 2013 as compared to 2012. However, Softwood Limited was poorly utilizing its total assets in generation of sales as depicted by the industry average of 3. Softwood Limited should take a look at their operations with the aim of improving efficiency in the way they are employing their assets in generating sales.
Formula Ratio Year 2013 Year 2012
Stock Days = Inventories / Cost of Sales (312/2010)≈57 Days (296/1201)≈90 Days
Stock day’s ratio is a measure of how long a company is taking to convert its stock into sales. Softwood Limited had stock days of 57 days in 2013 as compared to 90 days in 2012. This indicates an increase in the efficiency of Softwood limited in converting its stock to sales. the industry average stood at 75 days indicating that softwood was more efficient in converting its stock to sales as compared to the industry. The company should strive to maintain the same level of efficiency in converting stock into sales.
Formula Ratio Year 2013 Year 2012
Debtors Days=
(Trade Receivables )/Sales×365
(350/3590)x365≈36 days (290/2217)×365≈48 days
Debtor days are a measure of how long a company takes to collect its account receivables. Softwood Limited had 36 debtor days in 2013 as compared to 48 in 2012. This indicates an increase in Softwoods ability to collect its debts in 2013 as compared to 2012. The industry average stood at 30 days indicating that Softwood Limited had a problem in collecting its debts. Softwood Limited should improve its debt collection procedure or vet its customers better to avoid the long debt collection periods.
4. Leverage Ratios are ratios that measure a company’s capital structure. They measure how a company finances their assets. Whether they rely strictly on equity or, on a combination of equity and debt?
Formula Ratios Year 2013 Year 2012
Debt Equity Ratio=
(Total Liabilities)/(Total Equity) 1475/1280=1.115 1493/1028 =1.45
Debt equity ratio measures how much debt a company is using to finance its operations. Since companies can affect either the current ratio or the long-term debt to equity ratio by altering their mix of short-term as well as long-term debt, debt equity ratio might often be additionally valuable than the other two. Debt equity ratio is calculated through dividing all long-term debt, short-term debt and lease obligations by the shareholders’ equity. Softwood Limited had a Debt Equity Ratio of 1.115 in 2013 as compared to 1.45 in 2012. This indicates a drop in the Debt Equity Ratio depicting that Softwood Limited had incurred more debt in 2013 as compared to 2012. The industry average stood at 1.0 demonstrating that Softwood Limited was using less debt to finance its operations and also signifies efficient use of the financing alternatives available to Softwood Limited. This makes it more attractive to potential investors and signifies that Softwood Limited was not likely to face future liquidity problems.
Formula Ratio Year 2013 Year 2012
Gearing Ratio=
(Preference Share Capital+Non-Current Liabilities)/(total Share Capital+Reserves+Non-Current Liabilities)×100 925/(420+925)×100≈69% 1146/(420+1146)×100 ≈73%
The gearing ratio indicates the proportion of a company’s debt to its equity. A higher gearing ratio represents a high proportion of debt to equity and a low gearing ratio represents a low proportion of debt to equity. Softwood Limited boasts of a Gearing Ratio of 69% in 2013 as compared to 73% in 2012. This shows that Softwood Limited had a lower proportion of debt to equity in 2013 as compared to 2012. The industry average in 2013 stood at 55% which was lower than Softwood Limited’s gearing ratio. This shows that the financial risk of Softwood Limited was higher than others in the industry. Softwood Limited should strive to lower its financial risk by improving the proportion of debt to equity in its capital structure.
Recommendations to Softwood Limited
1. Improve utilization of its assets and in the generation of sales.
2. Increase efficiency in operations so as to improve inventory turnover and debtor days
3. Dispose of surplus assets
4. Reduce its operating costs and overheads to improve margins,
5. Improve liquidity by reducing and controlling inventory; and accounts receivable.
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