XYZ Ltd. is a group of doctors, dentists, professional sports players and celebrities with excess funds who wish to find small companies with great innovative ideas and invest in them. Several of the small companies present their idea to XYZ under a televised show broadcasted on national TV.
The following information has been derived from 3 years’ financial statements of ABC Ltd., one of the small companies looking for investment from XYZ.
Balance Sheets, December 31 2015 2014 2013 Current assets Cash 50,000 45,000 94,000 Account receivable, net 130,000 120,000 110,000 Merchandise inventories 250,000 230,000 195,000 Other current assets 45,000 53,000 42,000 Total current assets 475,000 448,000 441,000 Property, plant & equipment, net 196,000 191,000 175,000 Total assets 671,000 639,000 616,000 Current liabilities Accounts payable 175,000 195,000 185,000 Accrued liabilities 1,000 6,500 21,000 Total current liabilities 176,000 201,500 206,000 Long-term liabilities 230,000 250,000 295,000 Total liabilities 406,000 451,500 501,000 Shareholders’ equity Common shares 110,000 95,000 65,000 Preferred shares, note 5 25,000 25,000 25,000 Retained earnings 130,000 67,500 25,000 Total shareholders’ equity 265,000 187,500 115,000 Total liabilities and shareholders’ equity 671,000 639,000 616,000
Income statements 2015 2014 Net sales £723,700 £694,000 Cost of goods sold 347,350 344,500 Gross margin 376,350 349,500 Operating expenses 183,500 179,750 Income from operations 192,850 169,750 Interest expense 37,525 39,450 Income before income tax 155,325 130,300 Income tax expense 38,831 32,575 Net income £116,494 £97,725
- The common shares are traded on the stock exchange. At the end of 2015, the value of the share was £15.00, and at the end of 2014, the value per share was £14.00.
- The number of shares outstanding on the market is as follows:
- 2015: 25,000
- 2014: 15,000
- 2013: 10,000
- All sales are made on credit.
- The company’s income tax rate is 25%.
- The preferred shares are cumulative, no par value, £2.50, 10,000 shares authorised and 2,000 shares issued and outstanding.
To answer this question:
Assume that you, the consultant, have been hired by XYZ to assist in the analysis of the financial statements and provide a recommendation whether XYZ should invest or not invest in this company. Justify your recommendation based on the calculation of the following financial ratios:
- Current ratio (liquidity)
- Operating profit margin (profitability)
- ROSF (profitability)
- Average settlement period for trade receivables (efficiency)
- Earnings per share (investment)
Bulls Corporation has a December 31 fiscal year end. The controller of the company is currently completing the financial statements of the company in order to present them at the next board meeting. He completed most of the work but did not get around to finishing the cash flow statement. He gives you the following financial information in order for you to help him with the preparation of the cash flows.
Balance Sheet 2015 2014 Cash £38,500 £8,000 Accounts receivable, net 20,000 29,500 Merchandise inventory 37,000 38,000 Prepaid insurance 9,500 15,000 Land 54,500 40,600 Equipment, at cost 104,500 90,700 Less: accumulated amortisation (30,500) (15,500) Patent 49,000 53,200 Total assets £282,500 £259,500 Accounts payable £ 58,500 £ 42,000 Income taxes payable 16,500 11,500 Advertising payable 5,000 – Dividends payable 40,000 10,000 Notes payable 40,000 83,000 Share capital 93,000 78,500 Retained earnings 29,500 34,500 Total liabilities and shareholders’ equity £282,500 £259,500
Sales £1,090,000 Cost of goods sold 672,000 Gross profit 418,000 Operating expense Salaries expense 195,000 Advertising expense 35,000 Rent expense 67,500 Insurance expense 34,500 Amortisation expense 25,000 Total operating expenses 357,000 Income from operations 61,000 Interest expense 2,500 Gain on sale of equipment 7,500 Income before income taxes 66,000 Income tax expense 4,000 Net income £62,000
- Bulls Corp. purchased equipment for £36,300 in cash during the year.
- Bulls Corp. sold equipment for cash during the year.
- No patent has been purchased nor sold in the year.
- Accounts payable relates solely to transactions with suppliers for inventory.
To answer this question
- Prepare a complete cash flow statement using the indirect method for the 2015 fiscal year.
- Compute the following amounts:
- Cash collected from clients during the year.
- Cash paid for advertising expense.
- Cash paid to suppliers for inventory.
Financial Analysis for XYZ Ltd and Bulls Corporation
Current ratio (liquidity)
The current ratio measures a company’s liquidity and the ability of the company to settle short-term debts using current assets such as cash, trade receivable, and inventory (Pradad & Sinha, 1990). The current ratio is obtained by dividing current assets by the current liabilities.
Total current assets: £475,000
Total current liabilities: £ 176,000
Current ratio for 2015=
Current ratio for 2014 =
Current ratio for 2013 =
A ratio that falls between 1.5 and 3 indicates that the company can be able to settle its obligations (Pradad & Sinha, 1990). In all the three years, the company could be able to settle its obligations, which indicates that it is financially sound.
Operating profit margin (profitability)
Operating profit margin is important since it helps analyze the pricing strategy of a company as well as its operating efficiency. Operating profit margin gives the idea about the company’s profitability before interest, taxes, and basing on each amount of sales (Pradad & Sinha, 1990). Operating margin is given by the operating income of the company divided by the net sales, and the result expressed as a percentage.
The results indicate that the company earned £0.26 for every dollar of sale made in 2015, which is an increase from the £0.24 earnings from every dollar of sale made in 2014. This is good earnings for the company.
Return on Shareholder Funds (ROSF)
ROSF measures the profitability of a company (Vause, 2009). It is given by the following formula:
|Preference dividend paid||(5,000)||(5,000)|
|Net Profit after taxation and preference dividend||92,725||111,494|
|Ordinary share capital||95,000||110,000|
|Ordinary share capital and reserves||162,500||240,000|
The results indicate that the company was profitable during 2014 and 2015, which saw shareholders earn returns for their investment as detailed by the percentages. In 2014, the shareholders earned higher returns compared to 2015.
Average settlement period for trade receivables
This is an examination of the trade receivables with regard to collection period (Vause, 2009). The aim is to assess the period taken by customers to pay the company.
The average settlement period is 60 days. The company should aim at reducing the settlement period to 30 days.
Earnings per share (investment)
This shows the basic earnings or revenue per share.
Net income less preferred dividends for 2015: 116,494 – 5,000 = 111,494
The earnings per share indicate that the company was profitable. In 2015, the company could be able to give £5.57 to every shareholder from its total income.
Basing on the above analysis, XYZ should invest in this company. The financial ratios indicate that ABC Ltd. is financially sound, and thus it would be a good opportunity to invest in the company.
- Complete cash flow statement using the indirect method for the 2015 fiscal year
|Net profit before tax and adjustment of extraordinary items||62,000|
|Gain on sale of assets||(7,500)|
|Adjusted income figure||83,700|
|Changes in current liabilities and assets|
|Accounts receivable (Decrease)||9,500|
|Prepaid insurance (increase)||5,500|
|Merchandise inventory (Decrease)||1,000|
|Accounts payable (increase)||16,500|
|Advertising payable (Increase)||5,000|
|Income tax payable (Increase)||5,000|
|Cash flow from operating activities||126,200|
|Purchase of equipment||(36,300)|
|Purchase of land||(13,900)|
|Cash flow from investing activities||(30,200)|
|Share capital increases||14,500|
|Notes payable cleared||(43,000)|
|Cash flow from financing activities||(65,500)|
|Net cash inflow from operating, investing and financing activities||30,500|
|Beginning cash (Add back)||8,000|
|Closing cash balance||38,500|
- Compute the following amounts
Cash collected from clients throughout the year.
|Opening accounts receivable||29,500|
|Closing accounts receivable||(20,000)|
|Total cash collected||1,099,500|
- Cash paid for advertising expense
|Total advertising expense||35,000|
|Closing advertising expense payable||(5,000)|
|Total advertising expenditure||30,000|
Cash paid to suppliers for inventory
|Cost of goods sold||672,000|
|Opening accounts receivable||29,500|
|Closing accounts receivable||(20,000)|
|Cash paid to suppliers for stock||680,500|
Pradad, M., & Sinha, K. (1990). Principles of management accounting. India: Motilal Banardidass.
Vause, B. (2009). Guide to analysing companies. New York: Bloomberg Press.