Interpretation of financial statements (Section 2: 100 marks)
This question has been on the exam paper every year as Question 5. It requires students to learn off ratios and to be able to write a report for current/potential shareholders, debenture holders or the bank manager on the performance of a company.
The following figures have been extracted from the final accounts of Seafront Ltd, a manufacturer of sportswear, for the year ended 31/12/2107. Its authorised capital is €1,150,000, made up of 900,000 ordinary shares at €1 each and 250,000 9% preference shares.. You are required to calculate the following: (a) (i) The cash purchases if the average period of credit received from creditors is 1.8 months.
(ii) The return on capital employed in 2017. (iii) The ordinary dividend cover in 2017. (iv) Dividend yield on ordinary shares for 2016. (v) How long would it take one ordinary share to recoup (recover) its market price (assuming current performance is maintained)? (45)
(b) Assume that the company wishes to raise further finance by issuing the remaining shares at €1.60 per share. Would you as a shareholder be prepared to purchase these shares? Outline your reasons for purchasing/not purchasing some shares. Your answer should include all relevant information included in the above figures and references to any other information that you consider necessary. (45)
(c) What might an unfavourable comparison of stock turnover ratios indicate? (10)
Solution:
(a) Advice:
• Always write the formula before doing the calculations as marks will be given for the formula even if the answer is incorrect.
• Round off answers to two decimal places where appropriate.
• Remember to include appropriate units in your answers (cent, €, times, %, years)
(b) Gearing:
Gearing is 36% of total capital which is low.
Interest cover is 7.46 times so there is little risk from outside investors.
Gearing and interest cover for 2016 were 28% and 6 times. These figures indicate an improved situation and the company is less at risk and is better able to pay interest in 2017 than in 2016.
The prospects of being able to pay dividends are good.
Dividends:
Dividend per share is 3c which has decreased from 3.9c. Dividend cover is 5.05 times and the dividend yield is 1.82% decreased from 2.52% in 2016.
Dividend policy is such that shareholders can expect a decent amount of profits to be paid out each year and at the same time the long-term prospects of capital gain are good.
The real return to ordinary shareholders would be 9.19% based on available profits is well above the return from risk-free investments.
Profitability:
Return on capital employed has increased from 10.25% to 11.93%.
Return on shareholders’ equity has increased from 12.4% to
13.95%.
This indicates a healthy trend and rewards the shareholder sufficiently for taking on the risk, compared to the interest rate of 8% being charged on the loan.
It also compares favourably to the return from risk-free investments of about 4 to 6%.
Liquidity:
Current ratio is 1.4:1 in 2017.
Quick ratio has decreased from 1.11 to 0.92:1 in 2017.
This is an unsatisfactory position as the firm has only 92c for every €1 it owes and is not in a position to meet its short-term debts.
Proportion of shares owned:
The remaining 200,000 shares would give the purchaser 22% ownership of the company.
This amount added to shares already owned would bring the owner’s shareholding close to the point of having to bid for the remainder of the shares.
Market price of the share:
Market value of each share has increased from €1.55 to €1.65 in 2017.
The remaining shares are being issued at €1.60 per share which is 0.05c lower than the current market value.
Reserves:
Reserves have risen by €85,000 to €60,000 in 2017. The company is retaining profits and building up reserves which is good for the long term and should increase the market price of its shares.
Conclusion:
I would purchase shares in this company.
(c)
Inefficiency in production Poor stock control Obsolete stock lines Carrying too much stock Drop in sales demand, etc.