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Accounting and Finance

Financial Accounting
Techniques
Advanced Higher
Ratio Analysis

8673
.
Spring 2001
HIGHER STILL

Accounting and
Finance
Financial Accounting
Techniques
Advanced Higher
Ratio Analysis

Support Materials
Teacher Note
Subject: Accounting and Finance

Level/s: Advanced Higher and Higher

Unit: Financial Accounting Techniques

Topic: Ratio Analysis

Outcome: Not Applicable

Contents: Theory and Exemplar Exercise – Pages 3 - 12

• Exemplar Exercise – Router Plc

• Exemplar Solutions with detailed explanations

Exercise Section: - Pages 13 - 36

• Exercises 1 - 10

Solutions Section – Pages 37 - 64

• Exemplar Solutions to Exercises 1 –10

Rationale: • The pack articulates with all the requirements of both the Higher and
Advanced Higher levels

• The exemplar exercise provides comprehensive coverage and detailed


explanation of all the required ratios

• Emphasis is given on the use and interpretation of the various ratios with
guidance on what action management might take to improve specific
situations.

Accounting and Finance: Ratio Analysis (AH) 1


Accounting and Finance: Ratio Analysis (AH) 2
RATIO ANALYSIS – EXEMPLAR EXERCISE AND THEORY NOTE

The following are the final accounts and Balance Sheets of Router Plc for Year 1 and Year 2.

TRADING AND PROFIT AND LOSS ACCOUNTS FOR YEAR ENDING 31 DECEMBER

YEAR 1 YEAR 2
£ £ £ £
Sales
Cash 80,000 120,000
Credit 620,000 700,000 810,000 930,000
Less Cost of Sales
Opening Stock 30,000 34,000
Purchases 520,000 650,000
550,000 684,000
Less Closing Stock 34,000 516,000 40,000 644,000
Gross Profit 184,000 286,000
Expenses 115,000 128,010
Net Profit before Interest 69,000 157,990
Interest on Debentures 750 750
Net Profit before Taxation 68,250 157,240
Corporation Tax 17,060 39,310
Net Profit after Taxation 51,190 117,930
Add Profit and Loss Account 7,000 5,790
58,190 123,720
Ordinary Dividend 11,200 21,000
Preference Dividend 1,200 1,200
Transfer to General Reserve 40,000 52,400 100,000 122,200
Unappropriated Profit £ 5,790 £ 1,520

BALANCE SHEET AS AT 31 DECEMBER

YEAR 1 YEAR 2
£ £ £ £
Net Fixed Assets 592,000 696,000
Current Assets
Stock 34,000 40,000
Debtors 51,000 85,000
Bank 14,000 12,780
99,000 137,780
Less Current Liabilities
Creditors 40,000 55,000
Corporation Tax 17,060 39,310
Debenture Interest Due 750 750
Ordinary Dividend Due 11,200 21,000
Preference Dividend Due 1,200 1,200
70,210 28,790 117,260 20,520
620,790 716,520
Less Long-term Liabilities
5% Debentures 15,000 15,000
£ 605,790 £ 701,520
Financed by
Issued Share Capital
Ordinary Shares of £1 each 140,000 140,000
6% Preference Shares of £1 each 20,000 160,000 20,000 160,000
Reserves
General 440,000 540,000
Profit and Loss Account 5,790 445,790 1,520 541,520
£ 605,790 £ 701,520

Accounting and Finance: Ratio Analysis (AH) 3


RATIO ANALYSIS – EXEMPLAR EXERCISE AND THEORY NOTE
(CONTD)

Notes:
a The market value of the ordinary shares was £2.10 in Year 1 and £3 in Year 2.
b Debtors should pay, and creditors should be paid, within 31 days.

You are required to calculate the following ratios for each year (correct to 2 decimal
places) and suggest possible reasons for any differences.

Profitability Ratios:
(a) Return on capital employed;
(b) Gross profit ratio;
(c) Mark-up ratio;
(d) Net profit ratio.

Liquidity Ratios:
(e) Current ratio;
(f) Acid test ratio.

Efficiency Ratios:
(g) Turnover to fixed assets;
(h) Expenses ratio;
(i) Rate of stock turnover;
(j) Debtor collection period;
(k) Creditor payment period.

Investment Ratios:
(l) Dividend yield;
(m) Dividend cover;
(n) Earnings per share;
(o) Price/earnings ratio;
(p) Capital gearing ratio.

A ratio simply shows the relationship between two or more figures that you would
expect to be linked in the final accounts and/or balance sheet of a business, e.g. sales
and profit, sales and expenses, etc.

Ratios are used by management to help to assess performance and to help to detect
underlying trends. Prompt action can then be taken to improve poor performance and
to eliminate trends that are unfavourable.

For a ratio to be of any value it must be compared with a standard to deduce whether
it is good or bad. This standard may be one or more of the following:
a the same ratio for previous years;
b the same ratio for other firms of similar size in the same line of business;
c a predetermined or budgeted ratio (probably best).

For convenience, the most common ratios to be calculated are set out in groups.

Accounting and Finance: Ratio Analysis (AH) 4


RATIO ANALYSIS – EXEMPLAR EXERCISE AND THEORY NOTE
(CONTD)

Profitability Ratios
(a) Return on capital employed
Net profit after tax/((Fixed assets + Net current assets) – Long term liabilities)
x 100%

YEAR 1 £51,190/((£592,000 + 28,790 - £15,000) x 100%


8.45%

YEAR 2 £117,930/((£696,000 + £20,520 - £15,000) x 100%


16.81%

The most obvious test of profitability is the profit that a business earns on the
capital invested in it, and the return on capital employed relates these two
elements.

A return on capital employed of 8.45% means that every £100 of capital


employed has earned a profit of £8.45 for the business. In Year 2, this ratio
has increased to 16.81%, and other ratios must now be calculated to clarify the
possible reasons for this increase.

Other things being equal, the return on capital employed is influenced by 3


basic factors, i.e.

a the pricing policy of the business,


b the efficiency with which the business is run from day-to-day, and
c the efficiency with which the assets of the business are being used.

The two ratios which indicate the pricing policy are the gross profit ratio and
the mark-up ratio.

(b) Gross profit ratio


Gross profit/Turnover x 100%

YEAR 1 £184,000/£700,000 x 100%


26.29%

YEAR 2 £286,000/£930,000
30.75%

A gross profit ratio of 26.29% means that for every £100 of turnover (net
sales) a gross profit of £26.29 is earned on average. Increasing the selling
price of products would increase this ratio, while reducing the selling price of
products would cause it to fall. Similarly, an increase in the purchase price of
a product which is not passed on to customers in the form of a higher selling
price would cause the ratio to fall, and vice versa. In Year 2 the gross profit
ratio has risen to 30.75%, and the most likely cause is an increase in average
selling prices.

Accounting and Finance: Ratio Analysis (AH) 5


(c) Mark-up ratio
Gross profit/Cost of sales x 100%

YEAR 1 £184,000/£516,000 x 100%


35.66%

YEAR 2 £286,000/£644,000 x 100%


44.41%

A mark-up ratio of 35.66% means that on average 35.66% is added to the cost
of items sold to get the selling price. This has increased to 44.41% in Year 2
re-enforcing the conclusion that average prices have been increased.

(d) Net profit ratio


Net profit/Turnover x 100%

YEAR 1 £51,190/£700,000 YEAR 2 £117,930/£930,000 x 100%


7.31% 12.68%

A net profit ratio of 7.31% means that on average a net profit of £7.31 is
earned on every £100 of net sales. Two factors tend to influence this ratio, i.e.

a the pricing policy of the firm, and


b the efficiency with which the business is being run on a day-to-day
basis.

If the gross profit ratio increases by 4.46% because selling prices have been
raised, then the net profit ratio should increase by the same amount if the day-
to-day efficiency with which the business is being run has remained
unchanged. In this example, the net profit ratio has risen by 5.37%, so we can
conclude that the day-to-day efficiency has improved.

Accounting and Finance: Ratio Analysis (AH) 6


RATIO ANALYSIS – EXEMPLAR EXERCISE AND THEORY NOTE
(CONTD)

Liquidity Ratios

(e) Current ratio


Current assets : Current liabilities

YEAR 1 £99,000 : £70,210 YEAR 2 £137,780 : £117,260


1.41 : 1 1.17 : 1

The current assets of a business should be sufficient to enable the business to


carry on trading if all the current liabilities were paid off. A current ratio of
between 1.5 and 2 is considered to be prudent. The ratio of 1.41 : 1 in Year 1
was a little too low. It fell further in Year 2 to 1.17 : 1. This is definitely too
low and action must be taken to improve it. This business has expanded its net
fixed assets from £592,000 in Year 1 to £696,000 in Year 2. This expansion
has been financed solely from within the business and this has led to the
deterioration of the current ratio. The firm should have financed the expansion
by the issue of shares or debentures rather than from working capital. Such an
issue is now imperative. Another cause for a deterioration in the current ratio
is what is known as overtrading. It happens when a firm is successful and
buys in too large a stock, thus increasing both current assets and current
liabilities and causing the current ratio to fall. There is no evidence of
overtrading in this instance.

(f) Acid test ratio


(Current assets – Stock) : Current liabilities

YEAR 1 (£99,000 - £34,000) : £70,210


0.93 : 1

YEAR 2 (£137,780 - £40,000) : £117,260


0.83 : 1

An acid test ratio of 1 : 1 is considered to be safe. In this instance it has fallen


from 0.93 : 1 in Year 1 to 0.83 : 1 in Year 2 and confirms our conclusions
regarding the unsatisfactory working capital situation.

Accounting and Finance: Ratio Analysis (AH) 7


Efficiency Ratios

(g) Turnover to fixed assets


Net turnover: Total fixed assets at net book value

YEAR 1 £700,000 : £592,000 YEAR 2 £930,000 : £696,000


1.18 : 1 1.34 : 1

In Year 1, this ratio was 1.18 : 1 which means that on average each £100
invested in fixed assets generated £118 of sales. The fixed assets in Year 2
were used more efficiently when a £100 investment generated £134 of sales.

(h) Expenses ratio


Expenses/Net turnover x 100%

YEAR 1 £115,000/£700,000 x 100%


16.43%

YEAR 2 £128,010/£930,000 x 100%


13.76%

This ratio shows how much of each £100 of net sales is spent on expenses. It
can be calculated for individual expenses, such as wages, or, as in this
example, for expenses as a whole. In Year 1 £16.43 of each £100 of net sales
was spent on expenses, whereas in Year 2 this had fallen to £13.76. We can
conclude, therefore, that the business was run more efficiently on a day-to-day
basis in Year 2 than it was in Year 1. This confirms our analysis of the net
profit ratio.

(i) Rate of stock turnover


Cost of sales/Average stock

YEAR 1 £516,000/(£30,000 + £34,000)/2


16.13 times

YEAR 2 £644,000/(£34,000 + £40,000)/2


17.41 times

The rate of stock turnover measures how often in a trading period the average
stock is sold and replaced. In effect, it measures how fast the firm is selling its
stock. Average stock is calculated by adding opening stock to closing stock
and dividing by 2.

In Year 1 the firm was replacing stock 16.13 times, whereas in Year 2, the rate
had increased to 17.41 times. Other things being equal, this is an improvement
since profit is earned each time stock is turned over. Firms in some trades
have higher rates of turnover than in others, e.g. the rate of turnover in the
furniture retailing business is low compared with that in the grocery trade. A
low rate of turnover usually means a high mark-up ratio.

Accounting and Finance: Ratio Analysis (AH) 8


(j) Debtor collection period

Debtors/Credit sales x time period

YEAR 1 £51,000/£620,000 x 365 days


30.02 days

YEAR 2 £85,000/£810,000 x 365 days


38.30 days

The time period can either be expressed in days or months whichever is more
convenient for the business concerned. Credit periods of 30 days, and, in
some cases, even 60 days are not uncommon.

The debtor collection period measures the length of time the debtors, on
average, are taking to pay. What constitutes an acceptable ratio depends on
the length of credit being permitted to debtors. In this case, it should be
approximately 31 days. In Year 1 the firm was operating efficiently from this
point of view, whereas in Year 2, the debtors are taking too long to pay. This
can lead to a shortage of cash with which to meet day-to-day expenses, so
credit control needs to be tightened up.

(k) Creditor payment period

Creditors/Credit purchases x time period

YEAR 1 £40,000/£520,000 x 365 days


28.08 days

YEAR 2 £55,000/£650,000 x 365 days


30.88 days

This measures how efficiently the firm is paying its creditors. In this case, the
firm paid suppliers promptly in both years, given that the credit period is 31
days. The firm runs the risk of losing its regular suppliers if it becomes lax
and takes too long to pay. On the other hand, paying too promptly may lead to
a shortage of cash.

Accounting and Finance: Ratio Analysis (AH) 9


RATIO ANALYSIS – EXEMPLAR EXERCISE AND THEORY NOTE
(CONTD)

Investment Ratios

(l) Dividend Yield

Ordinary dividend per share/Market price per share x 100%

YEAR 1 (£11,200/140,000)/£2.10 x 100%


3.81%

YEAR 2 (£21,000/140,000)/£3 x 100%


5%

The ordinary dividend per share in Year 1 is 8p rising to 15p in Year 2. The
dividend per share is the dividend that the directors propose to pay on the face
value of each share, i.e. £1. A new investor, however, would require to pay
the market price for the share, i.e. £2.10 in Year 1 rising to £3 in Year 2. For a
new investor, therefore, the return on his or her investment would be only
3.81p in Year 1 rising to 5p in Year 2. In this instance, the increase in
dividend yield indicates the improved performance of the company in Year 2,
but this need not always be the case. For instance, if the proposed dividend
had remained at 8p in Year 2 and the market value of the share had fallen to
£1.50, the dividend yield would have been 5.3p. The market value of shares is
influenced not only by the performance of the company, but also by many
other factors, such as the economic outlook both at home and abroad. Care,
therefore, is needed when interpreting investment ratios.

(m) Dividend Cover

(Net profit – Preference dividends)/Dividends on ordinary shares

YEAR 1 (£51,190 - £1,200)/£11,200


4.46 times

YEAR 2 (£117,930 - £1,200)/£21,000


5.56 times

This shows the relationship between the maximum amount of dividend on


ordinary shares the directors could have paid if the whole of the current year’s
net profit had been used for this purpose, and the dividend they have, in fact,
proposed to pay. A high dividend cover implies that much of the net profit has
been retained as reserves and re-invested in the company. This is the cheapest
form of investment for expansion and so may lead to better returns for
ordinary shareholders in future. In the exemplar the dividend cover in Year 1
is 4.46 times rising to 5.56 times in Year 2. The directors could have paid a
dividend of 35.7% in Year 1 and 84.24% in Year 2.

Accounting and Finance: Ratio Analysis (AH) 10


(n) Earnings per Share

(Net profit – Preference dividends)/Number of ordinary shares

YEAR 1 (£51,190 - £1,200)/140,000


£0.36

YEAR 2 (£117,930 - £1,200)/140,000


£0.83

This ratio shows how much of the current year’s net profit is attributable to
each ordinary share. In Year 1, each ordinary share earned £0.36, while in
Year 2 the earnings per share had risen to £0.83. The ordinary shareholders,
however, were only paid 8p per share in Year 1 and 15p per share in Year 2,
the remainder of the earnings having been retained and re-invested in the
business. Earnings per share may be a better indicator to potential investors
than either the rate of dividend or the dividend yield. Again, this ratio needs to
be interpreted with care because it can be greatly influenced by a change in
capital gearing, e.g. if the company were to redeem debentures by the issue of
ordinary shares, the capital gearing would fall and the earnings per share
would in all probability do likewise.

(o) Price/earnings Ratio

Market price per share/Earnings per share

YEAR 1 £2.10/£0.36 times YEAR 2 £3/£0.83 times


5.83 times 3.61 times

This ratio shows how the market price of a share compares with its earnings.
In Year 1 an ordinary share cost to buy 5.83 times the amount it earned,
whereas in Year 2, despite the increase in market price to £3, the cost to buy
was only 3.6 times the earnings. The market price of a share is determined by
the demand for it on the stock market in relation to its supply. It might well be
that the market price of shares in this company is likely to increase further, so
this might be a good time to buy.

Accounting and Finance: Ratio Analysis (AH) 11


RATIO ANALYSIS – EXEMPLAR EXERCISE AND THEORY NOTE
(CONTD)

(p) Capital Gearing Ratio

(Preference Shares + Long-term Loans) : Ordinary Shares

YEAR 1 (£20,000 + £15,000) : £140,000


0.25 : 1

YEAR 2 (£20,000 + £15,000) : £140,000


0.25 : 1

Public limited companies attract the funds they require for the long-term
finance of their activities in a variety of ways, i.e. by the issue of

a equity (ordinary) shares on which the returns in the form of dividends


vary with the level of profits from year to year;

b preference shares on which the returns in the form of dividends are


fixed from year to year irrespective of the level of profits;

c long-term loans (debentures) on which the returns in the form of


interest are also fixed from year to year irrespective of the level of
profits.

The Capital Gearing Ratio of a company compares the amount of capital on


which the returns are fixed with the amount of capital on which the returns are
variable.

Debentures are usually the cheapest method of raising finance externally, not
only because the rate of interest is less than the rates of dividend paid on
shares, but also because the interest, being an ordinary business expense, is
deductible before the calculation of corporation tax.

A high geared company is one which raises more long-term finance in the
form of capital on which the returns are fixed than on capital on which the
returns are variable and vice versa. It works on the principle that if it borrows
at, say 5%, it can earn, say 12%, on the capital borrowed and so make an 8%
profit for re-investment and distribution to the ordinary shareholders. When
business is good, it is therefore a distinct advantage to be an ordinary
shareholder in such a company. On the other hand, if business is not so good,
and the company earns only 4% on the capital it employs, the ordinary
shareholder may get little or nothing. When such conditions prevail it is better
to be an ordinary shareholder in a low geared company.

A company is low geared when the capital gearing ratio is less than 1. Router
plc, therefore, is a low geared company.

Accounting and Finance: Ratio Analysis (AH) 12


RATIO ANALYSIS – EXERCISE 1

The following are the final accounts and Balance Sheets of Sands & Stone Plc for Year 1 and Year 2:

TRADING AND PROFIT AND LOSS ACCOUNTS FOR YEAR ENDING 31 DECEMBER

YEAR 1 YEAR 2
£ £ £ £
Sales
Cash 100,000 364,000
Credit 1,200,000 1,300,000 1,300,000 1,664,000
Less Cost of Sales
Opening Stock 240,000 220,000
Purchases 800,000 950,000
1,040,000 1,170,000
Less Closing Stock 220,000 820,000 250,000 920,000
Gross Profit 480,000 744,000
Expenses 120,000 130,000
Net Profit before Interest 360,000 614,000
Interest on Debentures 15,000 5,000
Net Profit before Taxation 345,000 609,000
Corporation Tax 86,250 152,250
Net Profit after Taxation 258,750 456,750
Add Profit and Loss Account 4,000 6,250
262,750 463,000
Ordinary Dividend 13,500 36,000
Preference Dividend 3,000 3,000
Transfer to General Reserve 240,000 256,500 400,000 439,000
Unappropriated Profit £ 6,250 £ 24,000

BALANCE SHEET AS AT 31 DECEMBER

YEAR 1 YEAR 2
£ £ £ £
Net Fixed Assets 1,554,000 2,000,000
Current Assets
Stock 220,000 250,000
Debtors 120,000 160,000
Bank 20,000 25,250
360,000 435,250
Less Current Liabilities
Creditors 50,000 65,000
Corporation Tax 86,250 152,250
Debenture Interest Due 15,000 5,000
Ordinary Dividend Due 13,500 36,000
Preference Dividend Due 3,000 3,000
167,750 192,250 261,250 174,000
1,746,250 2,174,000
Less Long-term Liabilities
5% Debentures 300,000 100,000
£1,446,250 £2,074,000
Financed by
Issued Share Capital
Ordinary Shares of £1 each 150,000 300,000
6 % Preference Shares of £1 each 50,000 200,000 50,000 350,000
Reserves
Share Premium 60,000
General 1,240,000 1,640,000
Profit and Loss Account 6,250 1,246,250 24,000 1,724,000
£1,446,250 £2,074,000

Accounting and Finance: Ratio Analysis (AH) 13


RATIO ANALYSIS – QUESTION 1 (CONTD)

Note:

The market value of the ordinary shares was £2.10 in Year 1 and £3 in Year 2.

You are required to calculate the following ratios for each year (correct to 2 decimal
places) and suggest possible reasons for any differences.

Profitability Ratios:
(a) Return on capital employed;
(b) Gross profit ratio;
(c) Mark-up ratio;
(d) Net profit ratio.

Investment Ratios:
(e) Dividend yield;
(f) Dividend cover;
(g) Earnings per share;
(h) Price/earnings ratio;
(i) Capital gearing ratio.

Accounting and Finance: Ratio Analysis (AH) 14


RATIO ANALYSIS – EXERCISE 2

The following are the final accounts and Balance Sheets of Greenfield Plc for Year 1 and Year 2.

TRADING AND PROFIT AND LOSS ACCOUNTS FOR YEAR ENDING 31 MAY

YEAR 1 YEAR 2
£ £ £ £
Sales
Cash 18,540 25,000
Credit 105,000 123,540 115,000 140,000
Less Cost of Sales
Opening Stock 20,000 25,000
Purchases 82,000 88,450
102,000 113,450
Less Closing Stock 25,000 77,000 24,000 89,450
Gross Profit 46,540 50,550
Expenses 22,400 28,200
Net Profit before Interest 24,140 22,350
Interest on Debentures 700 700
Net Profit before Taxation 23,440 21,650
Corporation Tax 5,860 5,410
Net Profit after Taxation 17,580 16,240
Add Profit and Loss Account 4,000 6,580
21,580 22,820
Ordinary Dividend 9,600 7,200
Preference Dividend 2,400 4,920
Transfer to General Reserve 3,000 15,000 4,400 16,520
Unappropriated Profit £ 6,580 £ 6,300

BALANCE SHEET AS AT 31 DECEMBER

YEAR 1 YEAR 2
£ £ £ £
Net Fixed Assets 131,140 181,130
Current Assets
Stock 25,000 24,000
Debtors 6,000 9,000
Bank 4,000 2,000
35,000 35,000
Less Current Liabilities
Creditors 6,000 10,200
Corporation Tax 5,860 5,410
Debenture Interest Due 700 700
Ordinary Dividend Due 9,600 7,200
Preference Dividend Due 2,400 4,920
24,560 10,440 28,430 6,570
141,580 187,700
Less Long-term Liabilities
5% Debentures 10,000 10,000
£131,580 £177,700
Financed by
Issued Share Capital
Ordinary Shares of £1 each 80,000 80,000
6 % Preference Shares of £1 each 40,000 120,000 82,000 162,000
Reserves
General 5,000 9,400
Profit and Loss Account 6,580 11,580 6,300 15,700
£131,580 £177,700

Accounting and Finance: Ratio Analysis (AH) 15


RATIO ANALYSIS – QUESTION 2 (CONTD)

Notes:

a The market value of the ordinary shares was £1.75 in Year 1 and £1.50 in
Year 2.

b Debtors should pay, and creditors should be paid, within 31 days.

You are required to calculate the following ratios for each year (correct to 2 decimal
places) and suggest possible reasons for any differences.

(a) Return on capital employed;


(b) Turnover to fixed assets;
(c) Expenses ratio;
(d) Rate of stock turnover;
(e) Debtor collection period;
(f) Creditor collection period;
(g) Dividend yield;
(h) Dividend cover;
(i) Earnings per share;
(j) Price/earnings ratio;
(k) Capital gearing ratio.

Accounting and Finance: Ratio Analysis (AH) 16


RATIO ANALYSIS – EXERCISE 3

The following are the final accounts and Balance Sheets of Parkingland Plc for Year 1 and Year 2.

TRADING AND PROFIT AND LOSS ACCOUNTS FOR YEAR ENDING 30 JUNE

YEAR 1 YEAR 2
£ £ £ £
Sales
Cash 16,000 18,000
Credit 210,000 226,000 220,000 238,000
Less Cost of Sales
Opening Stock 24,000 30,000
Purchases 126,000 136,000
150,000 166,000
Less Closing Stock 30,000 120,000 28,000 138,000
Gross Profit 106,000 100,000
Expenses 42,000 40,880
Net Profit before Interest 64,000 59,120
Interest on Debentures 11,000 11,000
Net Profit before Taxation 53,000 48,120
Corporation Tax 13,250 12,030
Net Profit after Taxation 39,750 36,090
Add Profit and Loss Account 4,000 7,250
43,750 43,340
Ordinary Dividend 9,900 14,400
Preference Dividend 3,600 3,600
Transfer to General Reserve 23,000 36,500 14,400 32,400
Unappropriated Profit £ 7,250 £ 10,940

BALANCE SHEET AS AT 30 JUNE

YEAR 1 YEAR 2
£ £ £ £
Net Fixed Assets 375,500 553,550
Current Assets
Stock 30,000 28,000
Debtors 19,000 23,000
Bank 26,000 2,020
75,000 53,020
Less Current Liabilities
Creditors 10,500 10,200
Corporation Tax 13,250 12,030
Debenture Interest Due 11,000 11,000
Ordinary Dividend Due 9,900 14,400
Preference Dividend Due 3,600 3,600
48,250 26,750 51,230 1,790
402,250 555,340
Less Long-term Liabilities
5% Debentures 220,000 220,000
£ 182,250 £ 335,340
Financed by
Issued Share Capital
Ordinary Shares of £1 each 90,000 180,000
6 % Preference Shares of £1 each 60,000 150,000 60,000 240,000
Reserves
Share Premium 45,000
General 25,000 39,400
Profit and Loss Account 7,250 32,250 10,940 95,340
£ 182,250 £ 335,340

Accounting and Finance: Ratio Analysis (AH) 17


RATIO ANALYSIS – QUESTION 3 (CONTD)

Note:

The market value of the ordinary shares was £1.75 in Year 1 and £1.50 in Year 2.

You are required to calculate the following ratios for each year (correct to 2 decimal
places) and suggest possible reasons for any differences.

Liquidity Ratios:
(a) Current ratio;
(b) Acid test ratio.

Investment Ratios:
(c) Dividend yield;
(d) Dividend cover;
(e) Earnings per share;
(f) Price/earnings ratio;
(g) Capital gearing ratio.

Accounting and Finance: Ratio Analysis (AH) 18


RATIO ANALYSIS – EXERCISE 4

The following are the final accounts and Balance Sheets of Staple plc and Nail plc:

TRADING AND PROFIT AND LOSS ACCOUNTS FOR YEAR ENDING 30 NOVEMBER 20XX

Staple plc Nail plc


£ £ £ £
Sales
Cash 112,000 140,000
Credit 820,000 932,000 1,040,000 1,180,000
Less Cost of Sales
Opening Stock 50,000 60,000
Purchases 805,000 986,540
855,000 1,046,540
Less Closing Stock 60,000 795,000 40,000 1,006,540
Gross Profit 137,000 173,460
Expenses 27,000 17,980
Net Profit before Interest 110,000 155,480
Interest on Debentures 2,000 2,000
Net Profit before Taxation 108,000 153,480
Corporation Tax 27,000 38,370
Net Profit after Taxation 81,000 115,110
Add Profit and Loss Account 8,000 7,000
89,000 122,110
Ordinary Dividend 30,800 13,200
Preference Dividend 5,000
Transfer to General Reserve 50,000 80,800 100,000 118,200
Unappropriated Profit £ 8,200 £ 3,910

BALANCE SHEET AS AT 30 NOVEMBER 20XX

Staple plc Nail plc


£ £ £ £
Net Fixed Assets 460,000 480,000
Current Assets
Stock 60,000 40,000
Debtors 68,000 110,000
Bank 15,000 9,020
143,000 159,020
Less Current Liabilities
Creditors 82,000 82,000
Corporation Tax 27,000 38,370
Debenture Interest Due 2,000 2,000
Ordinary Dividend Due 30,800 13,200
Preference Dividend Due 5,000
141,800 1,200 140,570 18,450
461,200 498,450
Less Long-term Liabilities
5% Debentures 50,000 50,000
£ 411,200 £ 448,450
Financed by
Issued Share Capital
Ordinary Shares of £1 each 220,000 120,000
Preference Shares of £1 each 220,000 100,000 220,000
Reserves
General 183,000 224,540
Profit and Loss Account 8,200 191,200 3,910 228,450
£ 411,200 £ 448,450

Accounting and Finance: Ratio Analysis (AH) 19


RATIO ANALYSIS – QUESTION 4 (CONTD)

Notes:

a The fixed dividend on the preference shares in Nail plc is 5%.

b At 30 November 20XX the market value of an ordinary share in Staple plc was
£1.10. At 30 November 20XX the market value of an ordinary share in Nail
plc was £1.30.

c Both companies are of similar size and sell similar products.

Calculate the following ratios for each firm (correct to 2 decimal places) and suggest
possible reasons for differences.

(a) Return on capital employed;


(b) Turnover to fixed assets;
(c) Expenses ratio;
(d) Rate of stock turnover;
(e) Debtor collection period;
(f) Creditor payment period;
(g) Dividend yield;
(h) Dividend cover;
(i) Earnings per share;
(j) Price/earnings ratio;
(k) Capital gearing ratio.

Accounting and Finance: Ratio Analysis (AH) 20


RATIO ANALYSIS – EXERCISE 5

The following are the final accounts and Balance Sheets of Newton plc and Boris plc.

TRADING AND PROFIT AND LOSS ACCOUNTS FOR YEAR ENDING 30 SEPTEMBER 20XX

Newton plc Boris plc


£ £ £ £
Sales
Cash 60,000 114,000
Credit 800,000 860,000 1,220,000 1,334,000
Less Cost of Sales
Opening Stock 15,000 20,000
Purchases 740,000 1,270,000
755,000 1,290,000
Less Closing Stock 21,000 734,000 50,000 1,240,000
Gross Profit 126,000 94,000
Expenses 24,000 27,000
Net Profit before Interest 102,000 67,000
Interest on Debentures 1,800
Net Profit before Taxation 100,200 67,000
Corporation Tax 25,050 16,750
Net Profit after Taxation 75,150 50,250
Add Profit and Loss Account 3,000 4,000
78,150 54,250
Ordinary Dividend 17,600 13,200
Preference Dividend 5,600 8,000
Transfer to General Reserve 50,000 73,200 27,000 48,200
Unappropriated Profit £ 4,950 £ 6,050

BALANCE SHEET AS AT 30 SEPTEMBER 20XX

Newton plc Boris plc


£ £ £ £
Net Fixed Assets 227,000 329,000
Current Assets
Stock 21,000 50,000
Debtors 62,000 106,000
Bank 110,000 4,000
193,000 160,000
Less Current Liabilities
Creditors 60,000 98,000
Corporation Tax 25,050 16,750
Debenture Interest Due 1,800
Ordinary Dividend Due 17,600 13,200
Preference Dividend Due 5,600 8,000
110,050 82,950 135,950 24,050
309,950 353,050
Less Long-term Liabilities
5% Debentures 30,000
£ 279,950 £ 353,050
Financed by
Issued Share Capital
Ordinary Shares of £1 each 110,000 110,000
Preference Shares of £1 each 70,000 180,000 100,000 210,000
Reserves
General 95,000 137,000
Profit and Loss Account 4,950 99,950 6,050 143,050
£ 279,950 £ 353,050

Accounting and Finance: Ratio Analysis (AH) 21


RATIO ANALYSIS – QUESTION 5 (CONTD)

Notes:

a The fixed dividend on the preference shares in Newton plc is 8%. The fixed
dividend on the preference shares in Boris plc is also 8%.

b At 30 September 20XX the market value of an ordinary share in Newton plc


was £2.30. At 30 September 20XX the market value of an ordinary share in
Boris plc was £1.80.

c Both companies are of similar size and sell similar products.

State whether you agree or disagree with each of the following conclusions. Justify
your answers by calculating and explaining the relevant ratios.

i Newton plc has a higher return on capital employed than Boris plc.

ii Newton plc is charging higher prices than Boris plc.

iii Boris plc is in a sounder financial position than Newton plc.

iv Boris plc is more efficiently run on a day-to-day basis than Newton plc.

v Newton plc has a higher dividend yield than Boris plc.

vi Newton plc has a higher dividend cover than Boris plc.

vii Boris plc has a higher earnings per share than Newton plc.

viii Boris plc has a higher price/earnings ratio than Newton plc.

ix The capital gearing ratio is the same for both firms.

Accounting and Finance: Ratio Analysis (AH) 22


RATIO ANALYSIS – EXERCISE 6

The following are the final accounts and Balance Sheets of White Lines Plc for Year 1 and Year 2.

TRADING AND PROFIT AND LOSS ACCOUNTS FOR YEAR ENDING 31 MARCH

YEAR 1 YEAR 2
£ £ £ £
Sales
Cash 40,000 45,000
Credit 928,000 968,000 900,000 945,000
Less Cost of Sales
Opening Stock 124,000 130,000
Purchases 430,000 500,000
554,000 630,000
Less Closing Stock 130,000 424,000 120,000 510,000
Gross Profit 544,000 435,000
Expenses 82,000 80,000
Net Profit before Interest 462,000 355,000
Interest on Debentures 3,000 15,000
Net Profit before Taxation 459,000 340,000
Corporation Tax 114,750 85,000
Net Profit after Taxation 344,250 255,000
Add Profit and Loss Account 8,000 750
352,250 255,750
Ordinary Dividend 10,000 7,500
Preference Dividend 1,500 2,000
Transfer to General Reserve 340,000 351,500 200,000 209,500
Unappropriated Profit £ 750 £ 46,250

BALANCE SHEET AS AT 31 MARCH

YEAR 1 YEAR 2
£ £ £ £
Net Fixed Assets 820,000 1,250,000
Current Assets
Stock 130,000 120,000
Debtors 82,000 70,000
Bank 20,000 65,750
232,000 255,750
Less Current Liabilities
Creditors 52,000 70,000
Corporation Tax 114,750 85,000
Debenture Interest Due 3,000 15,000
Ordinary Dividend Due 10,000 7,500
Preference Dividend Due 1,500 2,000
181,250 50,750 179,500 76,250
870,750 1,326,250
Less Long-term Liabilities
6% Debentures 50,000 250,000
£ 820,750 £1,076,250
Financed by
Issued Share Capital
Ordinary Shares of £1 each 125,000 125,000
5% Preference Shares of £1 each 30,000 155,000 40,000 165,000
Reserves
General 665,000 865,000
Profit and Loss Account 750 665,750 46,250 911,250
£ 820,750 £1,076,250

Accounting and Finance: Ratio Analysis (AH) 23


RATIO ANALYSIS – QUESTION 6 (CONTD)

Note:

a The market value of the ordinary shares was £1.50 in Year 1 and £1.25 in
Year 2.

You are required to calculate the following ratios for each year (correct to 2 decimal
places) and suggest possible reasons for any differences.

Profitability Ratios:
(a) Return on capital employed;
(b) Gross profit ratio;
(c) Mark-up ratio;
(d) Net profit ratio.

Investment Ratios:
(e) Dividend yield;
(f) Dividend cover;
(g) Earnings per share;
(h) Price/earnings ratio;
(i) Capital gearing ratio.

Accounting and Finance: Ratio Analysis (AH) 24


RATIO ANALYSIS – EXERCISE 7

The following are the final accounts and Balance Sheets of Gladmuir Plc and Jodi Plc:

TRADING AND PROFIT AND LOSS ACCOUNTS FOR YEAR ENDING 30 NOVEMBER 20XX

Gladmuir Plc Jodi Plc


£ £ £ £
Sales
Cash 24,000 32,000
Credit 312,000 336,000 390,000 422,000
Less Cost of Sales
Opening Stock 18,000 22,000
Purchases 256,000 320,000
274,000 342,000
Less Closing Stock 24,000 250,000 26,000 316,000
Gross Profit 86,000 106,000
Expenses 42,000 42,000
Net Profit before Interest 44,000 64,000
Interest on Debentures 1,000 6,000
Net Profit before Taxation 43,000 58,000
Corporation Tax 10,750 14,500
Net Profit after Taxation 32,250 43,500
Add Profit and Loss Account 4,000 4,000
36,250 47,500
Ordinary Dividend 28,820 8,960
Preference Dividend 4,800 4,800
Transfer to General Reserve 2,000 35,620 33,000 46,760
Unappropriated Profit £ 630 £ 740

BALANCE SHEET AS AT 30 NOVEMBER 20XX

Gladmuir Plc Jodi Plc


£ £ £ £
Net Fixed Assets 353,000 310,000
Current Assets
Stock 24,000 26,000
Debtors 19,000 16,250
Bank 26,000 46,000
69,000 88,250
Less Current Liabilities
Creditors 10,000 13,300
Corporation Tax 10,750 14,500
Debenture Interest Due 1,000 6,000
Ordinary Dividend Due 28,820 8,960
Preference Dividend Due 4,800 4,800
55,370 13,630 47,560 40,690
366,630 350,690
Less Long-term Liabilities
5% Debentures 20,000 120,000
£ 346,630 £ 230,690
Financed by
Issued Share Capital
Ordinary Shares of £1 each 262,000 112,000
Preference Shares of £1 each 80,000 342,000 80,000 192,000
Reserves
General 4,000 37,950
Profit and Loss Account 630 4,630 740 38,690
£ 346,630 £ 230,690

Accounting and Finance: Ratio Analysis (AH) 25


RATIO ANALYSIS – QUESTION 7 (CONTD)

Notes:

a At 30 November 20XX the market value of an ordinary share in Gladmuir Plc


was £1.20. At 30 November 20XX the market value of an ordinary share in
Jodi Plc was £1.60.

b Both companies are of similar size, sell similar products and charge roughly
the same prices.

Calculate the following ratios for each firm (correct to 2 decimal places) and comment
on any differences.

(a) Return on capital employed;


(b) Current ratio;
(c) Acid test ratio;
(d) Turnover to fixed assets;
(e) Expenses ratio;
(f) Dividend yield;
(g) Dividend cover;
(h) Earnings per share;
(i) Price/earnings ratio;
(j) Capital gearing ratio.

Accounting and Finance: Ratio Analysis (AH) 26


RATIO ANALYSIS – EXERCISE 8

The following are the final accounts and Balance Sheets of Harling Plc for Year 1 and Year 2:

TRADING AND PROFIT AND LOSS ACCOUNTS FOR YEAR ENDING 31 JULY

YEAR 1 YEAR 2
£ £ £ £
Sales
Cash 150,000 210,000
Credit 2,250,000 2,400,000 3,750,000 3,960,000
Less Cost of Sales
Opening Stock 310,000 260,000
Purchases 1,636,000 2,750,000
1,946,000 3,010,000
Less Closing Stock 260,000 1,686,000 280,000 2,730,000
Gross Profit 714,000 1,230,000
Expenses 135,000 122,660
Net Profit before Interest 579,000 1,107,340
Interest on Debentures 16,800 800
Net Profit before Taxation 562,200 1,106,540
Corporation Tax 140,550 276,640
Net Profit after Taxation 421,650 829,910
Add Profit and Loss Account 11,000 35,650
432,650 865,560
Ordinary Dividend 82,500 237,500
Preference Dividend 4,500 4,500
Transfer to General Reserve 310,000 397,000 560,000 802,000
Unappropriated Profit £ 35,650 £ 63,560

BALANCE SHEET AS AT 31 JULY

YEAR 1 YEAR 2
£ £ £ £
Net Fixed Assets 1,594,000 2,288,000
Current Assets
Stock 260,000 280,000
Debtors 210,000 370,000
Bank 22,000 180,000
492,000 830,000
Less Current Liabilities
Creditors 136,000 225,010
Corporation Tax 140,550 276,640
Debenture Interest Due 16,800 800
Ordinary Dividend Due 82,500 237,500
Preference Dividend Due 4,500 4,500
380,350 111,650 744,450 85,560
1,705,650 2,373,560
Less Long-term Liabilities
5% Debentures 420,000 20,000
£1,285,650 £2,353,560
Financed by
Issued Share Capital
Ordinary Shares of £1 each 550,000 950,000
6 % Preference Shares of £1 each 90,000 640,000 90,000 1,040,000
Reserves
Share Premium 80,000
General 610,000 1,170,000
Profit and Loss Account 35,650 645,650 63,560 1,313,560
£1,285,650 £2,353,560

Accounting and Finance: Ratio Analysis (AH) 27


RATIO ANALYSIS – QUESTION 8 (CONTD)

Notes:

a The market value of the ordinary shares was £1.40 in Year 1 and £2.80 in
Year 2.

b Debtors should pay, and creditors should be paid, within 31 days.

You are required to calculate the following ratios for each year (correct to 2 decimal
places) and suggest possible reasons for any differences.

(a) Return on capital employed.


(b) Turnover to fixed assets;
(c) Expenses ratio;
(d) Rate of stock turnover;
(e) Debtor collection period;
(f) Creditor collection period;
(g) Dividend yield;
(h) Dividend cover;
(i) Earnings per share;
(j) Price/earnings ratio;
(k) Capital gearing ratio.

Accounting and Finance: Ratio Analysis (AH) 28


RATIO ANALYSIS – EXERCISE 9

The following are the final accounts and Balance Sheets of Promaker plc and Anglepoise plc.

TRADING AND PROFIT AND LOSS ACCOUNTS FOR YEAR ENDING 30 JUNE 20XX

Promaker plc Anglepoise plc


£ £ £ £
Sales
Cash 160,000 90,000
Credit 2,348,800 2,508,800 1,400,000 1,490,000
Less Cost of Sales
Opening Stock 150,000 160,000
Purchases 2,220,000 1,212,000
2,370,000 1,372,000
Less Closing Stock 140,000 2,230,000 180,000 1,192,000
Gross Profit 278,800 298,000
Expenses 25,080 14,870
Net Profit before Interest 253,720 283,130
Interest on Debentures 35,000 6,250
Net Profit before Taxation 218,720 276,880
Corporation Tax 54,680 69,220
Net Profit after Taxation 164,040 207,660
Add Profit and Loss Account 5,000 6,500
169,040 214,160
Ordinary Dividend 19,500 84,000
Preference Dividend 1,050 1,200
Transfer to General Reserve 130,000 150,550 120,000 205,200
Unappropriated Profit £ 18,490 £ 8,960

BALANCE SHEET AS AT 30 JUNE 20XX

Promaker plc Anglepoise plc


£ £ £ £
Net Fixed Assets 1,063,760 1,017,760
Current Assets
Stock 140,000 180,000
Debtors 97,000 116,000
Bank 19,960 5,870
256,960 301,870
Less Current Liabilities
Creditors 92,000 101,000
Corporation Tax 54,680 69,220
Debenture Interest Due 35,000 6,250
Ordinary Dividend Due 19,500 84,000
Preference Dividend Due 1,050 1,200
202,230 54,730 261,670 40,200
1,118,490 1,057,960
Less Long-term Liabilities
5% Debentures 700,000 125,000
£ 418,490 £ 932,960
Financed by
Issued Share Capital
Ordinary Shares of £1 each 130,000 700,000
Preference Shares of £1 each 15,000 145,000 20,000 720,000
Reserves
General 255,000 204,000
Profit and Loss Account 18,490 273,490 8,960 212,960
£ 418,490 £ 932,960

Accounting and Finance: Ratio Analysis (AH) 29


RATIO ANALYSIS – QUESTION 9 (CONTD)

Notes:

a The fixed dividend on the preference shares in Promaker plc is 7%. The fixed
dividend on the preference shares in Anglepoise is 6%.

b At 30 June 20XX the market value of an ordinary share in Promaker plc was
£3. At 30 June 20XX the market value of an ordinary share in Anglepoise plc
was £2.

c Both companies are of similar size and sell similar products.

d Calculate the following ratios for each firm (correct to 2 decimal places)

Profitability Ratios:
(a) Return on capital employed;
(b) Gross profit ratio;
(c) Mark-up ratio;
(d) Net profit ratio.

Efficiency Ratios:
(e) Turnover to fixed assets;
(f) Rate of stock turnover.

Investment Ratios:
(g) Dividend yield;
(h) Dividend cover;
(i) Earnings per share;
(j) Price/earnings ratio;
(k) Capital gearing ratio.

ii Why is it possible to compare the results of both companies?

iii Comment on the pricing and sales policy of both firms referring to the relevant
calculated ratios.

iv Suggest why the return on capital employed by Promaker plc is so much


higher than that by Anglepoise plc despite the fact that Anglepoise plc earns a
much higher net profit after taxation.

v Why is the net profit ratio for Promaker plc so much lower than that for
Anglepoise plc?

vi Why is the dividend yield for Promaker plc lower than that for Anglepoise plc
when the rate of dividend proposed by Promaker plc is 15% compared with
12% proposed by Anglepoise plc?

Accounting and Finance: Ratio Analysis (AH) 30


vii Why is the dividend cover for Promaker plc much higher than that for
Anglepoise plc?

viii Why is the earnings per share higher for Promaker plc and the price earnings
ratio lower?

ix What is capital gearing and what significance does it have for the potential
investor?

Accounting and Finance: Ratio Analysis (AH) 31


RATIO ANALYSIS – EXERCISE 10

The following are the final accounts and Balance Sheets of Keepgreen Plc for Year 1 and Year 2.

TRADING AND PROFIT AND LOSS ACCOUNTS FOR YEAR ENDING 30 APRIL

YEAR 1 YEAR 2
£000 £000 £000 £000
Sales
Cash 200 400
Credit 1,000 1,200 1,200 1,600
Less Cost of Sales
Opening Stock 70 60
Purchases 800 1,050
870 1,110
Less Closing Stock 60 810 80 1,030
Gross Profit 390 570
Expenses 192 208
Net Profit before Interest 198 362
Interest on Debentures 10 10
Net Profit before Taxation 188 352
Corporation Tax 47 88
Net Profit after Taxation 141 264
Add Profit and Loss Account 2 1
143 265
Ordinary Dividend 18 60
Preference Dividend 4 4
Transfer to General Reserve 120 142 200 264
Unappropriated Profit 1 1

BALANCE SHEET AS AT 30 APRIL

YEAR 1 YEAR 2
£000 £000 £000 £000
Net Fixed Assets 820 1,350
Current Assets
Stock 60 80
Debtors 100 130
Bank 123 96
283 306
Less Current Liabilities
Creditors 70 70
Corporation Tax 47 88
Debenture Interest Due 10 10
Ordinary Dividend Due 18 60
Preference Dividend Due 4 4
149 134 232 74
954 1,424
Less Long-term Liabilities
5% Debentures 200 200
754 1,224
Financed by
Issued Share Capital
Ordinary Shares of £1 each 120 300
8% Preference Shares of £1 each 50 170 50 350
Reserves
Share Premium 90
General 583 783
Profit and Loss Account 1 584 1 874
754 1,224

Accounting and Finance: Ratio Analysis (AH) 32


RATIO ANALYSIS – QUESTION 10 (CONTD)

Note:

a The market value of the ordinary shares was £2 in Year 1 and £3 in Year 2.

b Debtors should pay, and creditors should be paid, within 31 days.

You are required to calculate the following ratios for each year (correct to 2 decimal
places) and suggest possible reasons for any differences.

Profitability Ratios:
(a) Return on capital employed;
(b) Gross profit ratio;
(c) Mark-up ratio;
(d) Net profit ratio.

Liquidity Ratios:
(e) Current ratio;
(f) Acid test ratio.

Efficiency Ratios:
(g) Turnover to fixed assets;
(h) Expenses ratio;
(i) Rate of stock turnover;
(j) Debtor collection period;
(k) Creditor payment period.

Investment Ratios:
(l) Dividend yield;
(m) Dividend cover;
(n) Earnings per share;
(o) Price/earnings ratio;
(p) Capital gearing ratio.

Accounting and Finance: Ratio Analysis (AH) 33


RATIO ANALYSIS – EXERCISE 10 (ALTERNATIVE)

The following are the trial balances of Keepgreen Plc as at 30 April Year 1 and Year 2.

TRIAL BALANCES AS AT 30 APRIL

YEAR 1 YEAR 2
Dr Cr Dr Cr
£000 £000 £000 £000
Ordinary Share Capital (£1 shares) 120 300
8% Preference Share Capital (£1 shares) 50 50
5% Debentures 200 200
Share Premium 90
General Reserve 463 583
Profit and Loss Account 2 1
Opening Stock 70 60
Purchases - Credit 800 1050
Sales:
Credit 1,000 1,200
Cash 200 400
Net Fixed Assets 820 1,350
Debtors 100 130
Creditors 70 70
Cash at Bank 123 96
Expenses (excluding interest on
debentures) 192 208
2,105 2,105 2,894 2,894

Notes:

a The closing stock for Year 2 was £80,000.

b Corporation tax was charged on net profit after interest at the rate of 25%.

c The directors proposed to:

Year 1
i pay an ordinary share dividend of 15%;
ii pay the preference share dividend;
iii transfer £120,000 to general reserve.

Year 2
i pay an ordinary share dividend of 20%;
ii pay the preference share dividend;
iii transfer £200,000 to general reserve.

d The market value of the ordinary shares was £2 in Year 1 and £3 in Year 2.

e Debtors should pay, and creditors should be paid, within 31 days.

Accounting and Finance: Ratio Analysis (AH) 34


You are required to:

(i) prepare, from the above trial balances and notes, the final accounts and
balance sheets as at 30 April, Year 1 and 30 April Year 2.

(ii) calculate the following ratios for each year (correct to 2 decimal places) and
suggest possible reasons for any differences.

Profitability Ratios:
(a) Return on capital employed;
(b) Gross profit ratio;
(c) Mark-up ratio;
(d) Net profit ratio.

Liquidity Ratios:
(e) Current ratio;
(f) Acid test ratio.

Efficiency Ratios:
(g) Turnover to fixed assets;
(h) Expenses ratio;
(i) Rate of stock turnover;
(j) Debtor collection period;
(k) Creditor payment period.

Investment Ratios:
(l) Dividend yield;
(m) Dividend cover;
(n) Earnings per share;
(o) Price/earnings ratio;
(p) Capital gearing ratio.

Accounting and Finance: Ratio Analysis (AH) 35


Accounting and Finance: Ratio Analysis (AH) 36
RATIO ANALYSIS - QUESTION 1 - SUGGESTED SOLUTION

Profitability Ratios:

(a) Return on capital employed

Net profit after tax/(Fixed assets + Net current assets - Long-term liabilities) x 100%

YEAR 1 £258,750/(£1,554,000 + £192,250 - £300,000) x 100%


17.89%

YEAR 2 £456,750/(£2,000,000 + £174,000 - £100,000) x 100%


22.02%

(b) Gross profit ratio

Gross profit/Net turnover x 100%

YEAR 1 £480,000/£1,300,000 x 100% YEAR 2 £744,000/£1,664,000 x 100%


36.92% 44.71%

(c) Mark-up ratio

Gross profit/Cost of sales x 100%

YEAR 1 £480,000/£820,000 x 100% YEAR 2 £744,000/£920,000 x 100%


58.54% 80.87%

(d) Net profit ratio

Net profit after taxation/Sales x 100%

YEAR 1 £258,750/£1,300,000 x 100% YEAR 2 £456,750/£1,664,000 x 100%


19.90% 27.45%

The return on capital employed has increased by 4.13%. This is either due to an increase in
the net profit ratio, or an improvement in the efficiency with which net assets are used, or a
combination of both.

The net profit ratio has increased by 7.55%. This is either due to an increase in the gross profit
ratio or greater efficiency in the day-to-day running of the business, or a combination of both.

The gross profit ratio has increased by 7.79%. This is either due to an increase in average
selling prices, or a change in sales mix resulting in the selling of more items with a higher
mark-up. The mark-up ratio has increased by 22.33% confirming this.

Accounting and Finance: Ratio Analysis (AH) 37


RATIO ANALYSIS - EXERCISE 1 (CONTD)

Investment Ratios:

(e) Dividend yield


Ordinary dividend per share/Market price per share x 100%

YEAR 1 (£13,500/150,000)/£2.10 x 100% YEAR 2 (£36,000/300,000)/£3 x 100%


4.29% 4.00%

(f) Dividend cover


(Net profit after tax - Preference dividends)/Dividends on ordinary shares (paid and proposed) times

YEAR 1 (£258,750 - £3,000)/£13,500 YEAR 2 (£456,750 - £3,000)/£36,000


18.94 times 12.60 times

(g) Earnings per share


(Net profit after tax - Preference dividends)/Number of ordinary shares issued

YEAR 1 (£258,750 - £3,000)/150,000 YEAR 2 (£456,750 - £3,000)/300,000


£1.71 £1.51

(h) Price/earnings ratio


Market price per share/Earnings per share times

YEAR 1 £2.10/£1.71 times YEAR 2 £3.00/£1.51 times


1.23 times 1.99 times

(i) Capital gearing ratio


(Preference share capital + Long-term loans) : Ordinary share capital

YEAR 1 (£50,000 + £300,000) : £150,000 YEAR 2 (£50,000 + £100,000) : £300,000


2.33 : 1 0.5 : 1

The company has changed from high-geared in Year 1 to low-geared in Year 2 because of the decision
to redeem debentures by the issue of ordinary shares.

The dividend yield has fallen, despite the increase in ordinary dividends proposed, because of the larger
number of ordinary shares and the increase in their market value in Year 2. The directors'
decision to finance more investment from retained profits (increased from £246,500 in Year 1 to
£424,000 in Year 2) is also a contributory factor.

Despite the overall increase in net profit after tax from £258,750 in Year 1 to £456,750 in Year 2, the
dividend cover has fallen because of the increased amount of ordinary share dividend both in rate (12%
compared with 9%) and in total due to the larger number of ordinary shares.

This is also borne out by the fall in earnings per share from £1.71 in Year 1 to £1.51 in Year 2.

The price earnings ratio, however, has increased because of the increase in the market value of the
shares - perhaps due to either the market favouring the directors' decision to alter the gearing of the
company or the decision to pay increased dividends, or both.

Accounting and Finance: Ratio Analysis (AH) 38


RATIO ANALYSIS - QUESTION 2 - SUGGESTED SOLUTION

(a) Return on capital employed


Net profit after tax/(Fixed assets + Net current assets - Long-term liabilities) x 100%

YEAR 1 £17,580/(£131,140 + £10,440 - £10,000) x 100%


13.36%

YEAR 2 £16,240/(£181,130 + £6,570 - £10,000) x 100%


9.14%

(b) Turnover to fixed assets


Net turnover : Total fixed assets at net book value

YEAR 1 £123,540 : £131,140 YEAR 2 £140,000 : £181,130


0.94 : 1 0.77 : 1

(c) Expenses ratio


Expenses/Net turnover x 100%

YEAR 1 £22,400/£123,540 x 100% YEAR 2 £28,200/£140,000 x 100%


18.13% 20.14%

(d) Rate of stock turnover


Cost of sales/Average stock times

YEAR 1 £77,000/((£20,000 + £25,000)/2) YEAR 2 £89,450/((£25,000 + £24,000)/2)


3.42 times 3.65 times

(e) Debtor collection period


Debtors/Credit sales x Time period

YEAR 1 £6,000/£105,000 x 365 days YEAR 2 £9,000/£115,000 x 365 days


20.86 days 28.57 days

(f) Creditor payment period


Creditors/Credit purchases x Time period

YEAR 1 £6,000/£82,000 x 365 days YEAR 2 £10,200/£88,450 x 365 days


26.71 days 42.09 days

The return on capital employed has fallen by 4.22%. This is partly due to increased inefficiency in the
day-to-day operation of the business as indicated by the increase in the expenses ratio from 18.13%
to 20.14%. This means that expenses have increased from £18.13 per £100 of sales to £20.14 per £100 of
sales. Another factor is the less efficient use of fixed assets.

Turnover to fixed assets has fallen so that each £100 of fixed assets generates only £77 of sales in Year
2 compared with £94 of sales in Year 1.

Accounting and Finance: Ratio Analysis (AH) 39


The rate of stock turnover, however, has improved marginally with average stock being sold and replaced
3.65 times in Year 2 as compared with 3.42 times in Year 1.

Credit control of debtors has become less strict in Year 2 with debtors taking on average 28.57 days to
pay.

The firm, however, is taking too long to pay creditors, i.e. 42.09 days on average, and needs to speed
up the payment of trade debt or run the risk losing its present suppliers.

(g) Dividend yield


Ordinary dividend per share/Market price per share x 100%

YEAR 1 (£9,600/80,000)/£1.75 x 100% YEAR 2 (£7,200/80,000)/£1.50 x 100%


6.86% 6.00%

(h) Dividend cover


(Net profit after tax - Preference dividends)/Dividends on ordinary shares (paid and proposed) times

YEAR 1 (£17,580 - £2,400)/£9,600 YEAR 2 (£16,240 - £4,920)/£7,200


1.58 times 1.57 times

(i) Earnings per share


(Net profit after tax - Preference dividends)/Number of ordinary shares issued

YEAR 1 (£17,580 - £2,400)/80,000 YEAR 2 (£16,240 - £4,920)/80,000


£0.19 £0.14

(j) Price/earnings ratio


Market price per share/Earnings per share times

YEAR 1 £1.75/£0.19 times YEAR 2 £1.50/£0.14 times


9.21 times 10.71 times

(k) Capital gearing ratio


(Preference share capital + Long-term loans) : Ordinary share capital

YEAR 1 (£40,000 + £10,000) : £80,000 YEAR 2 (£82,000 + £10,000) : £80,000


0.63 : 1 1.15 : 1

The company has changed from low-geared in Year 1 to high-geared in Year 2 because of the decision
to raise additional capital by the issue of preference shares.

Despite the fall of 3% in ordinary dividends proposed, the dividend yield has fallen only slightly. This is
because the market price of the shares has also fallen from £1.75 to £1.50. The fall in proposed
dividends has also meant that the fall in dividend cover is only slight.

The earnings per share have fallen by £0.05 because of the fall in net profit after taxation and the
increase in preference dividends resulting from the extra capital raised.

The price/earnings ratio has risen by 1.5 times because the fall in earnings per share was more
than offset by the fall in the market value of ordinary shares.

Accounting and Finance: Ratio Analysis (AH) 40


RATIO ANALYSIS - QUESTION 3 - SUGGESTED SOLUTION

Liquidity Ratios:

(a) Current ratio


Current assets : Current liabilities

YEAR 1 £75,000 : £48,250 YEAR 2 £53,020 : £51,230


1.55 : 1 1.03 : 1

(b) Acid test ratio


(Current assets - Stock) : Current liabilities

YEAR 1 (£75,000 - £30,000) : £48,250 YEAR 2 (£53,020 - £28,000)/£51,230


0.93 : 1 0.49 : 1

The current ratio in Year 1 at 1.55 : 1 is satisfactory but barely within the 1.5 to 2 range that is
advisable. In Year 2, the ratio has fallen below the safe level and needs to be improved. The firm has
expanded its net fixed assets by £178,050, but has financed only £135,000 of this expansion using
long-term external sources, i.e. the issue of ordinary shares at a premium. A further issue of shares
or debentures is required.

The acid test ratio confirms this analysis. A safe asset test ratio is considered to be 1:1. Clearly, the
Year 2 ratio is too low. The firm needs more cash.

Investment Ratios:

(c) Dividend yield


Ordinary dividend per share/Market price per share x 100%

YEAR 1 (£9,900/90,000)/£1.75 x 100% YEAR 2 (£14,400/180,000)/£1.50 x 100%


6.29% 5.33%

(d) Dividend cover


(Net profit after tax - Preference dividends)/Dividends on ordinary shares (paid and proposed) times

YEAR 1 (£39,750 - £3,600)/£9,900 YEAR 2 (£36,090 - £3,600)/£14,400


3.65 times 2.26 times

(e) Earnings per share


(Net profit after tax - Preference dividends)/Number of ordinary shares issued

YEAR 1 (£39,750 - £3,600)/90,000 YEAR 2 (£36,090 - £3,600)/180,000


£0.40 £0.18

(f) Price/earnings ratio


Market price per share/Earnings per share times

YEAR 1 £1.75/£0.40 times YEAR 2 £1.50/£0.18 times


4.38 times 8.33 times

Accounting and Finance: Ratio Analysis (AH) 41


RATIO ANALYSIS - EXERCISE 3 (CONTD)

(g) Capital gearing ratio


(Preference share capital + Long-term loans) : Ordinary share capital

YEAR 1 (£60,000 + £220,000) : £90,000 YEAR 2 (£60,000 + £220,000) : £180,000


3.11 : 1 1.56 : 1

The dividend yield has fallen from 5.24% in Year 1 to 4.57% in Year 2, despite the fall in the market
value of the ordinary shares. This is due to the fall in the proposed ordinary dividend per share from
£0.11 to £0.08.

The dividend cover has fallen from 3.65 times to 2.26 times. This is due two factors. Although the
rate of proposed dividend is lower, the dividend has to be paid on a larger number of ordinary shares, and
so is greater in total. In addition, the net profit after taxation has fallen from £39,750 to £36,090.

The earnings per share have fallen by £0.22 because the net profit after tax has fallen and the number of
ordinary shares has increased.

The price/earnings ratio shows that the market price of an ordinary share in Year 1 was 4.38 times the
amount that the share earned, whereas in Year 2 the market price is 8.33 times the earnings. The
market price has not fallen sufficiently to compensate for the fall in the earnings per share. This may
mean that it will fall yet further.

This firm is highly geared with more capital being of the fixed return variety. The ratio has decreased in
Year 2 because of the issue of a further 90,000 ordinary shares of £1 each. The firm, however, is still
high geared.

Accounting and Finance: Ratio Analysis (AH) 42


RATIO ANALYSIS - QUESTION 4 - SUGGESTED SOLUTION

(a) Return on capital employed


Net profit after tax/(Fixed assets + Net current assets - Long-term liabilities) x 100%

Staple plc £81,0000/(£460,000 + £1,200 - £50,000) x 100%


19.70%

Nail plc £115,110/(£480,000 + £18,450 -£50,000) x 100%


25.67%

(b) Turnover to fixed assets


Net turnover : Total fixed assets at net book value

Staple plc £932,000 : £460,000 Nail plc £1,180,000 : £480,000


2.03 : 1 2.46 : 1

(c) Expenses ratio


Expenses/Net turnover x 100%

Staple plc £27,000/£932,000 x 100% Nail plc £17,980/£1,180,000 x 100%


2.90% 1.52%

(d) Rate of stock turnover


Cost of sales/Average stock times

Staple plc £795,000/((50,000 + £60,000)/2) Nail plc £1,006,540/((60,000 + £40,000)/2)


14.45 times 20.13 times

(e) Debtor collection period


Debtors/Credit sales x 365 days

Staple plc £68,000/£820,000 x 365 days Nail plc £110,000/£1,040,000 x 365 days
30.27 days 38.61 days

(f) Creditor payment period


Creditors/Credit purchases x 365 days

Staple plc £82,000/£805,000 x 365 days Nail plc £82,000/£986,540 x 365 days
37.18 days 30.34 days

The return on capital employed for Nail plc is 5.97% higher than the return for Staple plc. Nail plc is
operating more efficiently on a day-to-day basis (smaller expenses ratio) and is also making better use
of assets.

Every £100 of fixed assets is generating sales of £246 in the case of Nail plc, but only £203 in the case
of Staple plc.

Expenses per £100 of net turnover in Nail plc are only £1.52 compared with £2.90 in the case of
Staple plc.

Accounting and Finance: Ratio Analysis (AH) 43


RATIO ANALYSIS - EXERCISE 4 (CONTD)

Nail plc sells and replaces average stock more quickly than Staple plc - 20.13 times per annum
compared with 14.45 times per annum.

Staple plc is collecting its debts promptly, but Nail plc is less efficient in this respect, taking on average
38.61 days to collect amounts due from debtors.

On the other hand, Nail plc is paying creditors promptly, whereas Staple plc is taking on average
37.18 days to do so.

(g) Dividend yield


Ordinary dividend per share/Market price per share x 100%

Staple plc (£30,800/220,000)/£1.10 x 100% Nail plc (£13,200/120,000)/£1.30 x 100%


12.73% 8.46%

(h) Dividend cover


(Net profit after tax - Preference dividends)/Dividends on ordinary shares (paid and proposed) times

Staple plc £81,000/£30,800 Nail plc (£115,110 - £5,000)/£13,200


2.63 times 8.34 times

(i) Earnings per share


(Net profit after tax - Preference dividends)/Number of ordinary shares issued

Staple plc £81,000/220,000 Nail plc (£115,110 - £5,000)/120,000


£0.37 £0.92

(j) Price/earnings ratio


Market price per share/Earnings per share times

Staple plc £1.10/£0.37 times Nail plc £1.30/£0.92 times


2.97 times 1.41 times

(k) Capital gearing ratio


(Preference share capital + Long-term loans) : Ordinary share capital

Staple plc £50,000 : £220,000 Nail plc (£100,000 + £50,000) : £120,000


0.23 : 1 1.25 : 1

The dividend yield for Nail plc is smaller than that for Staple plc despite the fact that Nail plc is
earning a much larger profit after tax. This is due partly to the market price of the ordinary shares
in Nail plc being higher, but principally it results from the policy of the directors of Nail plc to plough more
profits back into the business (£103,910 compared with £58,200, i.e. totals of transfers to general
reserves and unappropriated profits).

The dividend cover is much higher for Nail plc than for Staple plc. Staple plc is paying a higher
ordinary dividend (14% compared with 11%) and paying it on a larger number of shares. Staple plc
is also earning less net profit.

Accounting and Finance: Ratio Analysis (AH) 44


RATIO ANALYSIS - EXERCISE 4 (CONTD)

The earnings per share for Nail plc are much higher than for Staple plc because Nail plc is earning
higher profits and has fewer ordinary shares.

The price/earnings ratio for Staple plc is over twice as high because the earnings per share are so much
lower.

Nail plc is a high geared company with £150,000 of the capital it employs from external sources being
of the fixed return variety compared with £120,000 of the variable return variety. If the directors had
chosen to plough back less profit into the business, a much larger dividend could have been paid on the
ordinary shares. The present policy, however, could well benefit the ordinary shareholders in the future.
Staple plc, on the other hand, is low geared.

Accounting and Finance: Ratio Analysis (AH) 45


RATIO ANALYSIS - QUESTION 5 - SUGGESTED SOLUTION

(i) Return on capital employed


Net profit after tax/(Fixed assets + Net current assets - Long-term liabilities) x 100%

Newton plc £75,150/(£227,000 + £82,950 - £30,000) x 100%


26.84%

Boris plc £50,250/(£329,000 + £24,050) x 100%


14.23%

The conclusion that Newton plc has a higher return on capital employed than Boris plc is correct.
Each £100 of capital employed by Newton plc earns £26.84, whereas each £100 of capital employed
by Boris plc earns only £14.23.

(ii) Gross profit ratio


Gross profit/Turnover x 100%

Newton plc £126,000/£860,000 x 100% Boris plc £94,000/£1,334,000 x 100%


14.65% 7.05%

OR

Mark-up ratio
Gross profit/Cost of sales x 100%

Newton plc £126,000/£734,000 x 100% Boris plc £94,000/£1,240,000 x 100%


17.17% 7.58%

The conclusion that Newton plc is charging higher prices than Boris plc is correct. The mark-up
ratio shows that, whereas Newton plc marks up the cost of goods sold by 17.17% on average, Boris
plc marks up the cost by only 7.58% on average.

(iii) Current ratio


Current assets : Current liabilities

Newton plc £193,000 : £110,050 Boris plc £160,000 : £135,950


1.75 : 1 1.18 : 1

OR

Acid test ratio


(Current assets - Stock) : Current liabilities

Newton plc (£193,000 - £21,000) : £110,050 Boris plc (£160,000 - £50,000) : £135,950
1.56 : 1 0.81 : 1

The conclusion that Boris plc is in a sounder financial position than Newton plc is incorrect.
A current ratio of between 1.5 and 2 is considered to be safe financially. The recommended acid
test ratio is 1 : 1. Both ratios are too low in the case of Boris plc. The firm appears to be
overstocking.

Accounting and Finance: Ratio Analysis (AH) 46


RATIO ANALYSIS - QUESTION 5 - SUGGESTED SOLUTION (CONTD)

(iv) Expenses ratio


Expenses/Net turnover x 100%

Newton plc £24,000/£860,000 x 100% Boris plc £27,000/£1,334,000 x 100%


2.79% 2.02%

The expenses ratio shows that Boris plc is more efficiently run on a day-to-day basis with expenses
of £2.02 on each £100 of sales compared with £2.79 in the case of Newton plc.

(v) Dividend yield


Ordinary dividend per share/Market price per share x 100%

Newton plc (£17,600/110,000)/£2.30 x 100% Boris plc (£13,200/110,000)/£1.80 x 100%


6.96% 6.67%

Newton plc does have a higher dividend yield than Boris plc. Although the market value of its
shares is higher, it is paying out a higher rate of dividend - 16% compared with 12% in the case of
Boris plc. This higher rate more than compensates for the higher market value.

(vi) Dividend cover


(Net profit after tax - Preference dividends)/Dividends on ordinary shares (paid and proposed) times

Newton plc (£75,150 - £5,600)/£17,600 Boris plc (£50,250 - £8,000)/£13,200


3.95 times 3.20 times

Newton plc has a higher dividend cover than Boris plc, and, if the directors had chosen to pay all of
the current year's net profit to the shareholders, it could have paid a dividend of 63.22%, compared
with 38.4% in the case of Boris plc. It is prudent, however, to re-invest some of the profit earned in
the business.

(vii) Earnings per share


(Net profit after tax - Preference dividends)/Number of ordinary shares issued

Newton plc (£75,150 - £5,600)/110,000 Boris plc (£50,250 - £8,000)/110,000


£0.63 £0.38

The conclusion that Boris plc has a higher earnings per share than Newton plc is incorrect. Newton
plc is the more profitable firm, and, since both have issued the same number of ordinary shares, the
earnings per share must be higher.

(viii) Price/earnings ratio


Market price per share/Earnings per share times

Newton plc £2.3/£0.63 times Boris plc £1.8/£0.38 times


3.65 times 4.74 times

Boris plc has a higher price/earnings ratio than Newton plc. This means that the market value of an
ordinary share in Boris plc is 4.74 times the amount that the share has earned, compared with the
market value of an ordinary share in Newton plc, which is only 3.65 times the amount it has earned.

Accounting and Finance: Ratio Analysis (AH) 47


RATIO ANALYSIS - QUESTION 5 - SUGGESTED SOLUTION (CONTD)

(ix) Capital gearing ratio


(Preference share capital + Long-term loans) : Ordinary share capital

Newton plc (£70,000 + £30,000) : £110,000 Boris plc (£100,000 + £0) : £110,000
0.91 : 1 0.91 : 1

The conclusion that the capital gearing is the same for both firms is correct. Both firms are low
geared, i.e. a higher amount of variable return capital as compared with fixed return capital.

Accounting and Finance: Ratio Analysis (AH) 48


RATIO ANALYSIS - QUESTION 6 - SUGGESTED SOLUTION

Profitability Ratios:

(a) Return on capital employed


Net profit after tax/(Fixed assets + Net current assets - Long-term liabilities) x 100%

YEAR 1 £344,250/(£820,000 + £50,750 - £50,000) x 100%


41.94%

YEAR 2 £255,000/(£1,250,000 + £76,250 -£250,000) x 100%


23.69%

(b) Gross profit ratio


Gross profit/Turnover x 100%

YEAR 1 £544,000/£968,000 x 100% YEAR 2 £435,000/£945,000 x 100%


56.20% 46.03%

(c) Mark-up ratio


Gross profit/Cost of sales x 100%

YEAR 1 £544,000/£424,000 x 100% YEAR 2 £435,000/£510,000 x 100%


128.30% 85.29%

(d) Net profit ratio


Net profit after Taxation/Sales x 100%

YEAR 1 £344,250/£968,000 x 100% YEAR 2 £255,000/£945,000 x 100%


35.56% 26.98%

The return on capital employed has fallen considerably by 18.25%. This could be due to
either a change in pricing policy or decreased efficiency or a combination of both. The main
cause in this case is reduced average selling prices.

The gross profit ratio has fallen by 10.17% and the mark-up ratio by 43.01%. This indicates a
very considerable reduction in average selling prices, either due to the stocking of lines with
much lower mark-ups, or a deliberate reduction in selling prices because of recession or
increased competition.

Despite the marked reduction in average selling prices, total net profit after taxation has
fallen by £89,250 and the net profit ratio by 8.58% which would suggest a market in recession.

Accounting and Finance: Ratio Analysis (AH) 49


Investment Ratios:

(e) Dividend yield


Ordinary dividend per share/Market price per share x 100%

YEAR 1 (£10,000/125,000)/£1.50 x 100% YEAR 2 £7,500/125,000/£1.25 x 100%


5.33% 4.80%

(f) Dividend cover


(Net profit after tax - Preference dividends)/Dividends on ordinary shares (paid and proposed) times

YEAR 1 (£344,250 - £1,500)/£10,000 YEAR 2 (£255,000 - £2,000)/£7,500


34.28 times 33.73 times

(g) Earnings per share


(Net profit after tax - Preference dividends)/Number of ordinary shares issued

YEAR 1 (£344,250 - £1,500)/125,000 YEAR 2 (£255,000 - £2,000)/125,000


£2.74 £2.02

(h) Price/earnings ratio


Market price per share/Earnings per share times

YEAR 1 £1.50/£2.74 times YEAR 2 £1.25/£2.02 times


0.55 times 0.62 times

(i) Capital gearing ratio


(Preference share capital + Long-term loans) : Ordinary share capital

YEAR 1 (£30,000 + £50,000) : £125,000 YEAR 2 (£40,000 + £250,000) : £125,000


0.64 : 1 2.32 : 1

The company has changed from low-geared in Year 1 to high-geared in Year 2 because of the decision
to raise extra capital by the issue of debentures and preference shares. In times of recession
potential investors tend to be more attracted to fixed interest investments.

The dividend yield has fallen by only 0.53% because the fall in ordinary share dividend from 8% in Year 1
to 6% in Year 2 has been offset to a large extent by a fall in the market value of the shares.

The smaller ordinary share has resulted in a fall in dividend cover of only 0.55 times.

The fall of £0.72 in earnings per share is due to the lower net profit figure and the larger total dividend
payable on preference share capital.

The price earnings ratio has increased by 0.07 times because the fall in the market value of the ordinary
shares has more than offset the fall in earnings per share.

Accounting and Finance: Ratio Analysis (AH) 50


RATIO ANALYSIS - QUESTION 7 - SUGGESTED SOLUTION

(a) Return on capital employed


Net profit after tax/(Fixed assets + Net current assets - Long term liabilities) x 100%

Gladmuir Plc £32,250/(£353,000 + £13,630 - £20,000) x 100%


9.30%

Jodi Plc £43,500/(£310,000 + £40,690 - £120,000) x 100%


18.86%

(b) Current ratio


Current assets : Current liabilities

Gladmuir Plc £69,000 : £55,370 Jodi Plc £88,250 : £47,560


1.25 : 1 1.86 : 1

(c) Acid test ratio


(Current assets - Stock) : Current liabilities

Gladmuir Plc (£69,000 - £24,000) : £55,370 Jodi Plc (£88,250 - £26,000) : £47,560
0.81 : 1 1.31 : 1

(d) Turnover to fixed assets


Net turnover : Total fixed assets at net book value

Gladmuir Plc £336,000 : £353.000 Jodi Plc £422,000 : £310,000


0.95 : 1 1.36 : 1

(e) Expenses ratio


Expenses/Turnover x 100%

Gladmuir Plc £42,000/£336,000 x 100% Jodi Plc £42,000/£422,000 x 100%


12.50% 9.95%

Jodi Plc has a much higher rate of return of capital employed than Gladmuir Plc. Since both firms
charge similar prices, the reasons for this must lie elsewhere. The expenses ratio shows that the
expenses for Jodi Plc are only £9.95 per £100 of turnover compared with £12.50 for Gladmuir Plc.
This means that Jodi Plc are operating more efficiently on a day-to-day basis.

Jodi Plc is also making better use of its fixed assets with each £100 of fixed assets generating sales of
£136 compared with £95 in the case of Gladmuir Plc.

From a financial point of view, Jodi Plc is also in a stronger position. The current ratio of 1.86 : 1 is sound.
Gladmuir Plc has a current ratio of 1.25 : 1 which is a bit low and could lead to financial difficulties if all
the current liabilities had to be paid off immediately. The acid test ratio confirms this, although 1.31 in the
case of Jodi Plc is a bit high, i.e. a bit too much cash lying idle in the bank.

Accounting and Finance: Ratio Analysis (AH) 51


RATIO ANALYSIS - EXERCISE 7 (CONTD)

(f) Dividend yield


Ordinary dividend per share/Market price per share x 100%

Gladmuir Plc (£28,820/262,000)/£1.20 x 100% Jodi Plc (£8,960/112,000)/£1.60 x 100%


9.17% 5.00%

(g) Dividend cover


(Net profit after tax - Preference dividends)/Dividends on ordinary shares (paid and proposed) times

Gladmuir Plc (£32,250 - £4,800)/£28,820 Jodi Plc (£43,500 - £4,800)/£8,960


0.95 times 4.32 times

(h) Earnings per share


(Net profit after tax - Preference dividends)/Number of ordinary shares issued

Gladmuir Plc (£32,250 - £4,800)/262,000 Jodi Plc (£43,500 - £4,800)/112,000


£0.10 £0.35

(i) Price/earnings ratio


Market price per share/Earnings per share times

Gladmuir Plc £1.20/£0.10 times Jodi Plc £1.60/£0.35 times


12.00 times 4.57 times

(j) Capital gearing ratio


(Preference share capital + Long-term loans) : Ordinary share capital

Gladmuir Plc (£80,000 + £20,000) : £262,000 Jodi Plc (£80,000 + £120,000) : £112,000
0.38 : 1 1.79 : 1

Gladmuir Plc propose a higher rate of dividend than Jodi Plc, and, given that the market price of its shares
is lower, the dividend yield must be higher. Jodi Plc, however, retain much more of its profit in the
business to finance expansion. This is the cheapest source of finance.

Jodi Plc have a higher net profit after tax, and, since the rate of dividend paid on the ordinary shares and
the number of ordinary shares are lower, the dividend cover must be higher.

The earnings per share in the case of Jodi Plc must also be higher since the net profit after tax is higher,
the amount proposed for preference dividend is the same and the number of ordinary shares is lower.

Conversely, the price/earnings ratio for Gladmuir Plc is much higher than for Jodi Plc. Although the
market price of its shares is lower, the earnings per share is less than one-third.

Jodi Plc has relatively more capital of the fixed return variety, and so is high geared, whereas Gladmuir Plc
has relatively more capital of the variable return variety and so is low geared.

Accounting and Finance: Ratio Analysis (AH) 52


RATIO ANALYSIS - QUESTION 8 - SUGGESTED SOLUTION

(a) Return on capital employed


Net profit after tax/(Fixed assets + Net current assets - Long-term liabilities) x 100%

YEAR 1 £421,650/(£1,594,000 + £111,650 - £420,000) x 100%


32.80%

YEAR 2 £829,910/(£2,288,000 + £85,560 - £20,000) x 100%


35.26%

(b) Turnover to fixed assets


Net turnover : Total fixed assets at net book value

YEAR 1 £2,400,000 : £1,594,000 YEAR 2 £3,960,000 : £2,288,000


1.51 : 1 1.73 : 1

(c) Expenses ratio


Expenses/Net turnover x 100%

YEAR 1 £135,000/£2,400,000 x 100% YEAR 2 £122,660/£3,960,000 x 100%


5.63% 3.10%

(d) Rate of stock turnover


Cost of sales/Average stock times

YEAR 1 £1,686,000/((£310,000 + £260,000)/2) YEAR 2 £2,730,000/((£260,000 + £280,000)/2)


5.92 times 10.11 times

(e) Debtor collection period


Debtors/Credit sales x Time period

YEAR 1 £210,000/£2,250,000 x 365 days YEAR 2 £370,000/£3,750,000 x 365 days


34.07 days 36.01 days

(f) Creditor payment period


Creditors/Credit purchases x Time period

YEAR 1 £136,000/£1,636,000 x 365 days YEAR 2 £225,010/£2,750,000 x 365 days


30.34 days 29.86 days

The return on capital employed has risen by 2.46%. This is partly due to increased efficiency in the
day-to-day operation of the business as indicated by the decrease in the expenses ratio from 5.63%
to 3.1%. The fixed assets are also being used marginally more efficiently in Year 2 than in Year 1.

The rate of stock turnover has improved considerably. Average stock in Year 2 is being sold and replaced
10.11 times compared with 5.92 times in Year 1.

Credit control, however, is less effective in Year 2. Average debtors are taking 36 days to pay compared
with 34 in Year 1. This could eventually lead to a shortage of cash with which to pay day-to-day
expenses. On the other hand, creditors are being paid promptly.

Accounting and Finance: Ratio Analysis (AH) 53


RATIO ANALYSIS - EXERCISE 8 (CONTD)

(g) Dividend yield


Ordinary dividend per share/Market price per share x 100%

YEAR 1 (£82,500/550,000)/£1.40 x 100% YEAR 2 (£237,500/950,000)/£2.80 x 100%


10.71% 8.93%

(h) Dividend cover


(Net profit after tax - Preference dividends)/Dividends on ordinary shares (paid and proposed) times

YEAR 1 (£421,650 - £4,500)/£82,500 YEAR 2 (£829,910 - £4,500)/£237,500


5.06 times 3.48 times

(i) Earnings per share


(Net profit after tax - Preference dividends)/Number of ordinary shares issued

YEAR 1 (£421,650 - £4,500)/550,000 YEAR 2 (£829,910 - £4,500)/950,000


£0.76 £0.87

(j) Price/earnings ratio


Market price per share/Earnings per share times

YEAR 1 £1.40/£0.76 times YEAR 2 £2.80/£0.87 times


1.84 times 3.22 times

(k) Capital gearing ratio


(Preference share capital + Long-term loans) : Ordinary share capital

YEAR 1 (£90,000 + £420,000) : £550,000 YEAR 2 (£90,000 + £20,000) : £950,000


0.93 : 1 0.12 : 1

The business has moved from being evenly geared in Year 1 to being low geared in Year 2 because of
the decision to repay debentures by the issue of ordinary shares.

Despite an increase of 10% in ordinary dividends proposed, the dividend yield has fallen from 10.71% to
8.93% because of the increase in the market value of ordinary shares from £1.40 to £2.80. The
market demand for shares in this profitable company is high.

The earnings per share have risen by £0.12 despite the fact that during the year a further 400,000
ordinary shares were issued. This helps to explain the high market demand for the shares.

This is further emphasised by the increase in the price/earnings ratio from 1.84 times to 3.22 times.
It seems likely that the market price of the shares will continue to rise.

Accounting and Finance: Ratio Analysis (AH) 54


RATIO ANALYSIS - QUESTION 9 - SUGGESTED SOLUTION

i Profitability Ratios:

(a) Return on capital employed

Net profit after tax/(Fixed assets + Net current assets - Long-term liabilities) x 100%

Promaker plc £164,040/(£1,063,760 + £54,730 - £700,000) x 100%


39.20%

Anglepoise plc £207,660/(£1,017,760 + £40,200 -£125,000) x 100%


22.26%

(b) Gross profit ratio

Gross profit/Turnover x 100%

Promaker plc £278,800/£2,508,800 x 100% Anglepoise plc £298,000/£1,490,000 x 100%


11.11% 20.00%

(c) Mark-up ratio

Gross profit/Cost of sales x 100%

Promaker plc £278,800/£2,230,000 x 100% Anglepoise plc £298,000/£1,192,000 x 100%


12.50% 25.00%

(d) Net profit ratio

Net profit after Taxation/Sales x 100%

Promaker plc £164,040/£2,508,800 x 100% Anglepoise plc £207,660/£1,490,000 x 100%


6.54% 13.94%

Efficiency Ratios:

(e) Turnover to fixed assets

Net turnover : Total fixed assets at net book value

Promaker plc £2,508,800 : £1,063,760 Anglepoise plc £1,490,000 : £1,017,760


2.36 : 1 1.46 : 1

(f) Rate of stock turnover

Cost of sales/Average stock times

Promaker plc £2,230,000/((£150,000 + Anglepoise plc £1,192,000/((£160,000 +


£140,000)/2) times £180,000)/2) times
15.38 times 7.01 times

Accounting and Finance: Ratio Analysis (AH) 55


RATIO ANALYSIS - EXERCISE 9 (CONTD)

Investment Ratios:

(g) Dividend yield


Ordinary dividend per share/Market price per share x 100%

Promaker plc (£19,500/130,000)/£3 x 100% Anglepoise plc (£84,000/700,000)/£2 x 100%


5.00% 6.00%

(h) Dividend cover


(Net profit after tax - Preference dividends)/Dividends on ordinary shares (paid and proposed) times

Promaker plc (£164,040 - £1,050)/£19,500 Anglepoise plc (£207,660 - £1,200)/£84,000


8.36 times 2.46 times

(i) Earnings per share


(Net profit after tax - Preference dividends)/Number of ordinary shares issued

Promaker plc (£164,040 - £1,050)/130,000 Anglepoise plc (£207,660 - £1,200)/700,000


£1.25 £0.29

(j) Price/earnings ratio


Market price per share/Earnings per share times

Promaker plc £3/£1.25 times Anglepoise plc £2/£0.29 times


2.40 times 6.90 times

(k) Capital gearing ratio


(Preference share capital + Long-term loans) : Ordinary share capital

Promaker plc (£15,000 + £700,000) : Anglepoise plc (£20,000 + £125,000) :


£130,000 £700,000
5.50 : 1 0.21 : 1

ii It is possible to compare the performance of Promaker plc and Anglepoise plc because they are
companies of similar size and in the same line of business.

iii Promaker plc price the products much lower than Anglepoise plc. The average mark-up for Profile plc
Promaker plc is 12.5% compared with 25% for Anglepoise plc. As a result Promaker plc have a
much lower gross profit ratio (11.11% compared with 20%) but sell and replace stock much more
quickly. The rate of stock turnover for Promaker plc is 15.38 times compared with 7.01 times for
Anglepoise plc. Because of the pricing policy, sales for Promaker plc are nearly double those of
Anglepoise plc. This is confirmed by the fact that every £1 invested in fixed assets generates sales of
£2.36 in Promaker plc compared with £1.46 in Anglepoise plc.

iv The reason why the return on capital employed by Promaker plc is so very much higher than the
return by Anglepoise plc is that Promaker plc have raised £700,000 of capital by the issue of
debentures compared with Anglepoise plc which has raised only £125,000 in this manner, ie
Promaker plc is much higher geared.

Accounting and Finance: Ratio Analysis (AH) 56


RATIO ANALYSIS - EXERCISE 9 (CONTD)

v The net profit ratio for Promaker plc is much lower than that for Anglepoise plc because of the much
higher interest on debentures payable by Profile plc, ie £35,000 compared with £6,250.

vi The dividend yield is lower for Promaker plc because a potential investor would have to pay £3 for an
ordinary share in Profile plc compared with £2 for one in Anglepoise plc.

vii Because Promaker plc is so much more highly geared than Anglepoise plc (5.50 :1 compared with
0.21 : 1, the proposed dividend is much lower, ie £19,500 compared with £84,000.

viii The number of ordinary shares issued by Promaker plc is only 130,000 compared with the number
issued by Anglepoise plc, ie 700,000. This will make the earnings per share by Promaker plc higher.
The price/earnings ratio is lower for Promaker plc because the potential investor needs to pay £3 to
acquire an ordinary share compared with £2 for an ordinary share in Anglepoise plc.

ix Capital gearing is the relationship between the amounts of capital on which fixed interest/dividend
has to be paid, ie debentures and preference shares and the amount of capital on which variable
dividends are payable. In times of recession, a potential investor would be better to invest in capital
with fixed interest payments since the rate of dividend payable on ordinary shares would be likely
to be low, and vice versa.

Accounting and Finance: Ratio Analysis (AH) 57


RATIO ANALYSIS - QUESTION 10 - SUGGESTED SOLUTION

Profitability Ratios:

(a) Return on capital employed

Net profit after tax/(Fixed assets + Net current assets - Long-term liabilities) x 100%

YEAR 1 £141,000/(£820,000 + £134,000 - £200,000) x 100%


18.70%

YEAR 2 £264,000/(£1,350,000 + £74,000 -£200,000) x 100%


21.57%

(b) Gross profit ratio

Gross profit/Turnover x 100%

YEAR 1 £390,000/£1,200,000 x 100% YEAR 2 £570,000/£1,600,000 x 100%


32.50% 35.63%

(c) Mark-up ratio

Gross profit/Cost of sales x 100%

YEAR 1 £390,000/£810,000 x 100% YEAR 2 £570,000/£1,030,000 x 100%


48.15% 55.34%

(d) Net profit ratio

Net profit after Taxation/Sales x 100%

YEAR 1 £141,000/£1,200,000 x 100% YEAR 2 £264,000/£1,600,000 x 100%


11.75% 16.50%

Liquidity Ratios:

(e) Current ratio

Current assets : Current liabilities

YEAR 1 £283,000 : £149,000 YEAR 2 £306,000 : £232,000


1.90 : 1 1.32 : 1

(f) Acid test ratio

(Current assets - Stock) : Current liabilites

YEAR 1 (£283,000 - £60,000) : £149,000 YEAR 2 (£306,000 - £80,000) : £232,000


1.50 : 1 0.97 : 1

Accounting and Finance: Ratio Analysis (AH) 58


RATIO ANALYSIS - QUESTION 10 - SUGGESTED SOLUTION (CONTD)

Efficiency Ratios:

(g) Turnover to fixed assets

Net turnover : Total fixed assets at net book value

YEAR 1 £1,200,000 : £820,000 YEAR 2 £1,600,000 : £1,350,000


1.46 : 1 1.19 : 1

(h) Expenses ratio

Expenses/Net turnover x 100%

YEAR 1 £192,000/£1,200,000 x 100% YEAR 2 £208,000/£1,600,000 x 100%


16.00% 13.00%

(i) Rate of stock turnover

Cost of sales/Average stock times

YEAR 1 £810,000/((£70,000 + £60,000)/2) YEAR 2 £1,030,000/((£60,000 + £80,000)/2)


12.46 times 14.71 times

(j) Debtor collection period

Debtors/Credit sales x Time period

YEAR 1 £100,000/£1,000,000 x 365 days YEAR 2 £130,000/£1,200,000 x 365 days


36.5 days 39.54 days

(k) Creditor payment period

Creditors/Credit purchases x Time period

YEAR 1 £70,000/£800,000 x 365 days YEAR 2 £70,000/£1,050,000 x 365 days


31.94 days 24.33 days

The return on capital employed has risen by 2.87%. This return is influenced by two factors, ie how
much net profit the firm is earning on its sales, and how much the firm has invested in assets to generate
the sales.

The net profit ratio shows that in Year 2 each £100 of sales earned on average £16.50 compared with
£11.75 in Year 1. This improvement is due to the fact that selling prices have been raised. The average
mark-up on the cost of items sold is 55.34% in Year 2 compared with 48.15% in Year 1. The increase
in average selling prices has increased the gross profit ratio by 3.13%. The net profit ratio, however, has
risen by 4.75%. This means, therefore, that the efficiency with which the business has been run on
a day-to-day basis has improved. Expenses in Year 1 were £16 for every £100 of sales, whereas in
Year 2, they are only £13.

Accounting and Finance: Ratio Analysis (AH) 59


RATIO ANALYSIS - QUESTION 10 - SUGGESTED SOLUTION (CONTD)
The net profit ratio has increased by 4.75%, but the return on capital has only risen by 2.87%. This
must mean that the assets as a whole are being used less efficiently in Year 2. The turnover to fixed
assets ratio shows that every £100 invested in fixed assets generates sales of £119 in Year 2 compared
with £146 in Year 1. The debtors should pay within 31 days, so credit control in Year 1 was not as
good as it should have been with debtors taking on average 36.5 days to pay. In Year 2, the average
collection period has increased to 39.54 days. This means that the firm is taking much longer than it
should to collect the cash needed to meet day-to-day expenses. On the other hand, the creditors in
Year 2 are being paid more promptly than they need to be. This also acts as a drain on cash resources.
The time taken to sell and replace stock has improved from 12.46 times per annum in Year 1 to 14.71
times per annum in Year 2.

The current ratio in Year 1 is very good with current assets being 1.9 times the current liabilities. In
Year 2, however, current assets are only 1.32 times current liabilities. This ratio needs to be improved
to be within the recommended range of 1.5 to 2. The acid test ratio in Year 2 confirms this as it is also
below the recommended 1 : 1.

Investment Ratios:

(e) Dividend yield

Ordinary dividend per share/Market price per share x 100%

YEAR 1 (£18,000/120,000)/£2 x 100% YEAR 2 (£60,000/300,000)/£3 x 100%


7.50% 6.67%

(f) Dividend cover

(Net profit after tax - Preference dividends)/Dividends on ordinary shares (paid and proposed) times

YEAR 1 (£141,000 - £4,000)/£18,000 YEAR 2 (£264,000 - £4,000)/£60,000


7.61 times 4.33 times

(g) Earnings per share

(Net profit after tax - Preference dividends)/Number of ordinary shares issued

YEAR 1 (£141,000 - £4,000)/120,000 YEAR 2 (£264,000 - £4,000)/300,000


£1.14 £0.87

(h) Price/earnings ratio

Market price per share/Earnings per share times

YEAR 1 £2/£1.14 times YEAR 2 £3/£0.87 times


1.75 times 3.45 times

(i) Capital gearing ratio

(Preference share capital + Long-term loans) : Ordinary share capital

YEAR 1 (£50,000 + £200,000) : £120,000 YEAR 2 (£50,000 + £200,000) : £300,000


2.08 : 1 0.83 : 1

Accounting and Finance: Ratio Analysis (AH) 60


RATIO ANALYSIS - QUESTION 10 - SUGGESTED SOLUTION (CONTD)

The dividend yield in Year 2 has fallen by 0.83% despite the rate being paid having increased by 5%.
This is due partly to the increase in the market value of the ordinary shares and partly to the increase
in the number of ordinary shares from 120,000 to 300,000.

The dividend cover has fallen by 3.28 times, partly because of the dividend rate being increased from 15%
to 20%, and partly because the amount being paid out in dividends has increased in total. The
company has changed from being high geared in Year 1 (2.08 : 1) to being low geared in Year 2
(0.83 : 1) ie it has financed expansion by the issue of an additional 180,000 ordinary shares.

The earnings per share has fallen by £0.27 because of the change in gearing. The price/earnings ratio,
on the other hand, has risen by 1.7 times because of the rise in the market value of the ordinary shares
from £2 to £3.

Accounting and Finance: Ratio Analysis (AH) 61


RATIO ANALYSIS - QUESTION 10 (ALTERNATIVE) (i) - SUGGESTED SOLUTION

TRADING AND PROFIT AND LOSS ACCOUNTS FOR YEAR ENDED 30 APRIL
YEAR 1 YEAR 2
£000 £000 £000 £000
Sales
Cash 200 400
Credit 1,000 1,200 1,200 1,600
Less Cost of Sales:
Opening Stock 70 60
Purchases 800 1,050
870 1,110
Less Closing Stock 60 810 80 1,030
GROSS PROFIT 390 570
Expenses 192 208
Net Profit before Interest 198 362
Interest on Debentures 10 10
Net Profit before Taxation 188 352
Corporation Tax 47 88
Net Profit after Taxation 141 264
Add Profit and Loss Account 2 1
143 265
Ordinary Share Dividend 18 60
Preference Share Dividend 4 4
Transfer to General Reserve 120 142 200 264
Unappropriated Profit 1 1

Accounting and Finance: Ratio Analysis (AH) 62


RATIO ANALYSIS - QUESTION 10 (ALTERNATIVE) (i) - SUGGESTED SOLUTION (cont)

BALANCE SHEETS AS AT 30 APRIL


YEAR 1 YEAR 2
£000 £000 £000 £000
Net Fixed Assets 820 1,350
Current Assets
Stock 60 80
Debtors 100 130
Bank 123 96
283 306
Less Current Liabilities
Creditors 70 70
Corporation Tax 47 88
Debenture Interest Due 10 10
Ordinary Dividend Due 18 60
Preference Dividend Due 4 4
149 134 232 74
954 1,424
Less Long-term Liabilities 200 200
754 1,224
Financed by
Issued Share Capital
Ordinary Shares 120 300
Preference Shares 50 170 50 350
Reserves
Share Premium 90
General 583 783
Profit and Loss Account 1 584 1 874
754 1,224

Accounting and Finance: Ratio Analysis (AH) 63


Accounting and Finance: Ratio Analysis (AH) 64