Ch 21 Financial Analysis Ss_2025

Profitability refers to the ability of a business to generate profits (i.e., earning power).

Mark-up measures gross profit as a proportion of the cost of goods sold.

1. Profitability
2. Liquidity
3. Solvency
4. Management Efficiency
5. Return on Investment

Accounting ratios express meaningful relationships between different figures in financial statements, aiding in the interpretation of a business's financial performance.

1. Mark-up
2. Net profit ratio
3. Return on capital employed (ROCE)

Liquidity ratios assess a company's ability to meet its short-term obligations, indicating financial health and operational efficiency.

The gearing ratio indicates the proportion of a company's capital that is financed through debt, reflecting its financial leverage and risk level.

Management efficiency ratios measure how effectively a company utilizes its assets to generate revenue, providing insights into operational performance.

$500,000

$410,000

$198,000

Margin (Gross Profit Ratio) is calculated as:

Gross Profit x 100% = X%

Where gross profit can be derived from:

• Gross profit = Cost of goods sold x mark-up
• Net sales = Sales - Returns inwards

A higher mark-up will necessarily result in a higher margin. They are directly co-related.

When a firm cuts prices to boost sales, both its mark-up and margin will decrease, but the fall in margin will be smaller than the fall in mark-up.

The relationship can be expressed as:

Sales = Gross Profit + Cost Of Goods Sold

Mark-up is calculated as:

Mark-up = Gross Profit / COGS x 100%

A higher mark-up/margin indicates that sales are profitable for the firm.

The Net Profit Ratio measures net profit as a proportion of sales, indicating how profitable a business is. A higher ratio signifies greater profitability.

The Return on Capital Employed (ROCE) is calculated using the formula:

Return = (Net Profit + Interest) / Average Capital Employed x 100%

Where Average Capital Employed is calculated as (Capital + Non-Current Liabilities) / 2.

A ROCE of 15% indicates that for every 100% of resources employed, the company earns 15%. This reflects the efficiency of the company in generating profits from its capital.

The components for calculating Average Capital Employed vary by business structure:

1. Sole Proprietorships: Capital balance
2. Partnerships: Fixed capitals + current account balances
3. Limited Companies: Non-current liabilities + Shareholders’ fund

Liquidity refers to the ability of a business to meet its short-term obligations such as accounts payable when due.

The Working Capital/Current Ratio shows the ability of a business to repay its current liabilities from its current assets. A usual norm is 2:1, indicating that the higher the current ratio, the more liquid the business is.

The ideal Quick/Liquid/Acid-test Ratio should be at least 1 for companies with a slow inventory turnover.

For companies with a fast inventory turnover, a Quick Ratio can be comfortably less than 1 without causing cash flow trouble, while companies with slow inventory turnover should aim for a ratio of at least 1.

The four main financial statements are:

1. Statement of Profit and Loss and Other Comprehensive Income
2. Statement of Financial Position
3. Statement of Changes in Equity
4. Cash Flow Statement

The cash flow statement shows the company's cash inflows and outflows, which helps assess its ability to meet short-term obligations, particularly its capacity to pay bills.

The Statement of Changes in Equity explains the changes in the company's equity, including capital, reserves, and retained profits, allowing analysis of shareholders' interests over accounting periods.

Sole proprietorships and partnerships prepare an Income Statement to calculate Net Profit or Net Loss and a Statement of Financial Position to display the amounts of Assets, Liabilities, and Capital.

The two main types of payment tools used by businesses are cash (hand cash) and bank deposits. Cash refers to the amount held in cash boxes, while bank deposits refer to money stored in various bank accounts, including current accounts and savings accounts.

A cash book is used to record cash or bank deposits' inflows and outflows, helping businesses determine if they have sufficient cash for payments after transactions.

A 3 Column Cash Book includes the following components:

1. Cash Discounts
2. Cash
3. Bank Deposits

It does not include trade discounts.

Monitoring cash inflow and outflow is crucial for businesses to ensure they have enough cash to meet debt obligations and cover operating expenses.

A current account is used for daily transactions and typically allows for unlimited withdrawals, while a fixed deposit account is a savings account where money is deposited for a fixed term at a higher interest rate, with limited access during that term.

Management efficiency refers to the ability of a business to utilize its assets efficiently, generating more revenue or profit as a result.

The Inventory Turnover ratio indicates the efficiency of management on inventory by showing the number of times the inventory is completely purchased and sold during the year.

The formula for calculating Inventory Turnover is:

= COGS / Average Inventory

A low inventory turnover rate suggests that company funds are tied up in inventory, which may induce liquidity problems.

An increase in the Inventory Turnover ratio signifies that inventory is being sold by the business, improving liquidity as inventory can be turned into cash at a faster rate.

The Average Trade Receivables Collection Period measures the average time a business takes to collect trade receivables, indicating the effectiveness of credit control.

A lower Average Trade Receivables Collection Period indicates that trade receivables are collected more easily and efficiently.

A high Average Trade Receivables Collection Period may suggest that the company has too loose or generous credit control on debtors, potentially leading to cash flow issues.

A low Trade Receivables Turnover ratio implies tighter credit control on debtors, which may result in losing sales.

The Trade Receivables Turnover ratio measures the size of accounts receivable relative to sales.

An increase in the Trade Receivables Turnover ratio indicates that trade receivables are being collected by the business, improving liquidity as less cash is tied up in trade receivables.

The Average Trade Payables Repayment Period measures the average time a business takes to settle trade payables.

A lower Average Trade Payables Repayment Period ratio indicates that the business is more effective in settling its trade payables.

Extending the settlement period for trade payables can benefit the business by providing the cheapest form of finance and saving on interest payable on other forms of finance.

Extending the repayment period may risk losing goodwill with suppliers, resulting in loss of discounts, poor relationships, and potential refusal to supply goods in the future.

The Trade Payables Turnover ratio indicates the size of trade payables relative to purchases, reflecting the company's short-term liquidity. A higher ratio suggests improved liquidity and prompt payments to suppliers, while a lower ratio may signal cash flow problems.

A high Trade Payables Turnover ratio implies that the company is making prompt payments to credit suppliers, which may be due to suppliers demanding quick payments or the company taking advantage of early payment discounts.

A low Trade Payables Turnover ratio suggests slow payment to suppliers, which may indicate favorable credit terms or potential cash flow problems, signaling a worsening financial condition.

The Total Assets Turnover ratio measures how efficiently a company's assets (both current and non-current) are being used to generate sales.

A higher Total Assets Turnover ratio indicates a greater efficiency of the business in generating sales from its assets.

Solvency refers to the ability of a business to meet its obligations when due, including both short-term and long-term liabilities and loans.

A high capital gearing ratio indicates that the company is mainly financed by outside debts, making the business considered riskier.

The general norm for the capital gearing ratio is 50%.

A highly geared company is considered a risky investment by potential investors because it pays more interest on loans and dividends on preference shares, which may lead to problems in maintaining dividends for ordinary shareholders during periods of low profits.

Low capital gearing indicates that a larger portion of the capital is composed of common shareholders' equity, suggesting a lower reliance on fixed interest/dividend-bearing funds.

The principle of leverage in business refers to the strategy of using small amounts of initial capital and resources to gradually increase production scale and achieve greater returns. It embodies the concept of 'small investments yielding large returns', especially relevant for startups.

A business owner can choose to expand by:

1. Mortgaging personal assets (e.g., real estate)
2. Inviting new business partners to inject additional capital
3. Borrowing money from banks

Each option reflects different levels of risk and commitment to the business.

The Gearing Ratio is calculated using the formula:

(Non-Current Liabilities + Preference Share Capital) ÷ (Non-Current Liabilities + Shareholders Fund) × 100%

A higher Gearing Ratio indicates that a larger portion of the company's capital is financed through debt, which increases the risk of insolvency if the company cannot meet its repayment obligations.

A high Gearing Ratio implies that the company has a significant amount of debt relative to its equity, which increases the risk of financial distress and indicates potential difficulties in repaying liabilities. It suggests that the company may be over-leveraged and could face challenges during economic downturns.

The Dividend Cover for Ordinary Shares is calculated as:

Dividend Cover = Earnings per Share / Dividend per Share

This ratio indicates the management's preference or policy regarding retaining reserves versus distributing dividends from net profit, reflecting the company's dividend policy.

A higher dividend cover indicates that a larger proportion of profits is being retained rather than distributed as dividends, suggesting the company has the ability to maintain dividends during bad years.

EPS is calculated as: Net profit after tax - Preference dividend / Number of ordinary shares issued.

A high P/E ratio signifies that investors have a high degree of confidence in the company's future earnings potential, but it also indicates that the shares may not be cheap.

A low P/E ratio suggests that the company may be undervalued or that it is performing exceptionally well compared to its past trends.

A high P/E ratio could indicate that it may be a good time to sell a company's shares, as it reflects high investor expectations for future earnings growth.

Earnings per Share (EPS) is calculated using the formula:

EPS = (Net Profit After Tax - Dividends) / Number of Shares Issued

In this case:

• Net Profit After Tax = $2,500,000
• Dividends = $250,000
• Number of Shares Issued = 500,000

So, EPS = ($2,500,000 -$250,000) / 500,000 = $4.50

The Price-Earnings (P/E) Ratio is calculated using the formula:

P/E Ratio = Closing Market Price per Share / Earnings per Share (EPS)

In this case:

• Closing Market Price per Share = $5.5
• EPS = $4.50

So, P/E Ratio = $5.5 /$4.50 = 1.22

Net Profit Ratio = (Net Profit / Sales) x 100

Quick Ratio = (Current Assets - Inventory) / Current Liabilities

Inventory Turnover Rate = Cost of Goods Sold / Average Inventory

Average Trade Receivables Collection Period = (Average Trade Receivables / Sales) x 12 months

Average Trade Payables Repayment Period = (Average Trade Payables / Cost of Goods Sold) x 365 days

Working Capital = Current Assets - Current Liabilities

Shareholders' Fund = Ordinary Share Capital + Retained Profits + General Reserves

To calculate the Trade receivables collection period, use the formula:

Trade Receivables Collection Period = (Trade Receivables / Sales) x 12 months

Where:

• Trade Receivables = Average of Trade Receivables at the beginning and end of the year
• Sales = Total Sales for the year

In this case, the average Trade Receivables = (856,000 + 996,000) / 2 = 926,000.
Thus, the collection period = (926,000 / 10,186,000) x 12 = approximately 1.1 months.

The Inventory turnover ratio can be calculated using the formula:

Inventory Turnover = Cost of Goods Sold (COGS) / Average Inventory

Where:

• COGS = Purchases + Opening Inventory - Closing Inventory
• Average Inventory = (Opening Inventory + Closing Inventory) / 2

For BAFS Company:

• COGS = 7,294,500 + 878,000 - 990,000 = 7,182,500
• Average Inventory = (878,000 + 990,000) / 2 = 934,000

Thus, Inventory Turnover = 7,182,500 / 934,000 = approximately 7.7 times.

Jade Ltd has a current ratio of 2.8:1, which is higher than Pearl Ltd's current ratio of 2.0:1. This indicates that Jade Ltd has a better liquidity position, meaning it is more capable of meeting its short-term obligations compared to Pearl Ltd.

The quick ratio of Jade Ltd is 1.0:1, which is slightly lower than Pearl Ltd's quick ratio of 1.1:1. This suggests that Jade Ltd may have a slightly less liquid position when considering only its most liquid assets, indicating it might be less capable of covering its short-term liabilities without relying on inventory sales compared to Pearl Ltd.

The difference between the quick ratio and current ratio for Jade Ltd suggests that it may have a significant amount of inventory relative to its current assets. This could imply that Jade Ltd is tied up with inventory, which may affect its liquidity if it needs to convert inventory to cash quickly.

Joyce Ltd's gross profit margin is 24%, which is lower than the industry average of 28.33%. This indicates that Joyce Ltd is less efficient in converting sales into gross profit compared to its peers, suggesting potential issues in pricing or cost management.

Joyce Ltd has a current ratio of 3:1, which is significantly higher than the industry average of 2:1. This indicates that Joyce Ltd is in a strong liquidity position, suggesting it can easily cover its short-term liabilities with its short-term assets.

Joyce Ltd's return on capital employed is 17.14%, which exceeds the industry average of 16.20%. This suggests that Joyce Ltd is more effective in generating profits from its capital, indicating better management efficiency.

Joyce Ltd's gearing ratio is 28.57%, which is higher than the industry average of 20.16%. This indicates that Joyce Ltd has a higher proportion of debt in its capital structure, which may pose a higher risk to solvency, especially in adverse economic conditions.

Joyce Ltd's earnings per share (EPS) is $0.19**, which is higher than the industry average of **$0.16. This suggests that Joyce Ltd is providing a better return on investment for its shareholders compared to the industry average, indicating strong profitability relative to its share price.

Joyce Ltd's gross profit ratio was lower than its competitors, indicating that it might be selling goods at lower prices and/or facing a higher cost of goods sold.

Despite having a lower gross profit ratio, Joyce Ltd had a higher net profit ratio, suggesting that it was able to control its expenses better than its competitors.

Joyce Ltd's current ratio and quick ratio were lower than its competitors, indicating potential liquidity issues if these ratios keep falling.

Joyce Ltd's trade receivables turnover was lower than the industry average, indicating slower collection of receivables, while its trade payables turnover was higher, suggesting slower payments to suppliers, which could hurt its creditability and goodwill.

Joyce Ltd's gearing ratio was far below 50%, indicating a lower reliance on debt financing compared to its competitors, but it still relied more heavily on debt than its competitors in the same industry, making it riskier.

Joyce Ltd's asset turnover was higher than the industry average, implying that it utilized its assets more effectively in generating sales revenue, potentially due to its low-price policy.

Joyce Ltd's earnings per share and dividend cover were lower than the industry averages, indicating that more profits would be retained to finance the company's future development, which may not be a bad strategy.

Joyce Ltd's P/E ratio was lower than the industry average, suggesting that if the company's prospects are good, it could be a good opportunity to buy shares at a low price.

Joyce Ltd's ability to generate more sales revenue and profits was likely due to its lower price policy and effective control of expenses. Additionally, its management of assets, particularly inventories, was more efficient.

Joyce Ltd's liquidity and solvency were not as good as its competitors, raising concerns that the company may have difficulty meeting its short-term and long-term financial obligations if liquidity ratios continue to fall or if the gearing ratio continues to rise.

$15,000

$55,000

$12,000

The closing inventory amount is $81,000.

The gross purchases amount to $648,000.

The quick ratio is calculated as follows:

Quick Ratio = (Current Assets - Inventory) / Current Liabilities

Current Assets = Trade Receivables + Cash at Bank = $102,400 +$168,370 = $270,770

Current Liabilities = Trade Payables + Accruals = $184,200 +$4,000 = $188,200

Quick Ratio = ($270,770 -$156,230) / $188,200 = 0.61 (to one decimal place)

The credit period allowed to trade receivables is calculated using the formula:

Credit Period (in days) = (Trade Receivables / Sales) * 365

Using the figures: Trade Receivables = $102,400 Sales =$800,000

Credit Period = ($102,400 /$800,000) * 365 = 46.9 days (to one decimal place)

The inventory turnover rate is calculated using the formula:

Inventory Turnover Rate = Cost of Goods Sold / Average Inventory

Cost of Goods Sold = Purchases + Opening Inventory - Closing Inventory

Using the figures: Cost of Goods Sold = $500,000 +$62,430 - $156,230 =$406,200 Average Inventory = (Opening Inventory + Closing Inventory) / 2 = ($62,430 +$156,230) / 2 = $109,330

Inventory Turnover Rate = $406,200 /$109,330 = 3.71 (to one decimal place)

Shareholders' fund is calculated as follows:

Shareholders' Fund = Share Capital + Retained Profits + General Reserves

Share Capital = (650,000 shares * $1) + (250,000 shares *$1.50) = $650,000 +$375,000 = $1,025,000

Retained Profits = $213,000 General Reserves =$75,000

Shareholders' Fund = $1,025,000 +$213,000 + $75,000 =$1,313,000

The profitability of Able Company in 2023 shows a significant improvement with a net profit ratio of 36.74%, indicating effective cost management and higher sales. The earnings per share also increased to 7.45, reflecting better returns for shareholders. Overall, the company appears to be in a strong financial position in terms of profitability.

1. Increase Cash Reserves: Improve cash flow management to ensure sufficient cash reserves are available for short-term obligations.

2. Reduce Inventory Levels: Optimize inventory management to reduce excess stock, freeing up cash that can be used for immediate needs.

3. Negotiate Better Payment Terms: Work with suppliers to extend payment terms, allowing more time to pay off liabilities and improving cash flow.

Trade creditors (應付貨款)

Total capital and liabilities / Shareholders' Fund and liabilities (股東權益及負債總額/資本及負債總額)

The accounting year-end date is crucial for several reasons:

1. Preparation of Financial Statements: It determines the period for which financial statements, such as the income statement and balance sheet, are prepared.
2. Tax Reporting: It aligns with tax reporting requirements, as companies must submit financial statements to tax authorities based on their fiscal year.
3. Shareholder Meetings: It affects the timing of shareholder meetings and the distribution of reports to shareholders.
4. Accounting Cycle: It is closely related to the accounting cycle, which includes recording transactions, posting to ledgers, and preparing trial balances and adjustments.

The accounting cycle consists of the following steps:

1. Recording Financial Transactions: Documenting all financial transactions in the original entry books.
2. Posting to General Ledger Accounts: Transferring recorded transactions to the appropriate ledger accounts.
3. Preparing and Editing a Trial Balance: Balancing the accounts and preparing a trial balance to ensure accuracy.
4. Performing End-of-Period Adjustments: Making necessary adjustments at the end of the accounting period, such as accruing unpaid expenses.
5. Preparing Financial Statements: Compiling the final financial statements, including the income statement and balance sheet, based on the adjusted trial balance.

The 'Going Concern Concept' assumes that a business will continue to operate for the foreseeable future. This affects financial reporting in the following ways:

• Historical Cost Basis: Financial statements are prepared based on the historical cost concept, reflecting the original cost of assets and liabilities.
• No Intention to Liquidate: It implies that management does not intend to close the business or significantly reduce its operations, which influences asset valuation and liability recognition.
• Long-term Planning: It encourages long-term planning and investment, as stakeholders expect the business to remain viable.

Earnings Per Share (EPS) is calculated using the formula:
EPS = (Net Income - Preferred Dividends) / Number of Outstanding Common Shares.
A higher EPS indicates greater profitability and the ability to distribute dividends to investors.

The Price-to-Earnings (P/E) ratio is calculated using the formula:
P/E Ratio = Current Price of Common Stock / Earnings Per Share (EPS).
A higher P/E ratio suggests that investors expect better future performance and growth, indicating greater confidence in the company.

The Dividend Payout Ratio is calculated as:
Dividend Payout Ratio = (Net Income - Preferred Dividends) / Dividends Paid on Common Stock.
A higher ratio indicates that the company has sufficient earnings to distribute dividends, while a lower ratio may suggest potential difficulties in maintaining current dividend levels.

The 'Going Concern' assumption implies that a business will continue to operate for the foreseeable future. This affects how assets are recorded, as they should be valued at historical cost rather than liquidation value if the business is expected to continue operations.

A balance sheet, also known as a statement of financial position, summarizes a company's assets, liabilities, and equity at a specific point in time. It provides insights into the financial stability and liquidity of the business.