QUESTION FOUR a) X Ltd is a wholesaler trading in computer products. The followe
ID: 2819796 • Letter: Q
Question
QUESTION FOUR a) X Ltd is a wholesaler trading in computer products. The followed information is available from the company and from t the industry it operates in. Return on capital employed before tax Return on owners equity before tax Gross profit margin Net profit margin Leverage Current ratio Quick ratio Accounts receivables collection period Accounts payables payment period Inventory turnover 2017 19% 24% 23% 14% 45% 1.6 0.8 32 days 63 days 68 days 2016 19% 21% 25% 12% 51% 1.8 0.8 26 days 42 days 72 days Industry average 2017 19% 16% 20% 9% 65% 1.4 0.8 29 days 42 days 72 days Required: Comment on the significance of these ratios high-lighting their implications for management strategy in 2017 and for future years. (15 marks) b) Explain the key issues an analyst considers when analysing liabilities. (10 marks)Explanation / Answer
a. Return on capital employed measures a company’s profitability and the efficiency with which it is able to employ its capital. ROCE = EBIT/Capital employed. The company’s ROCE is at par with the industry average and has been constant in 2017. Going forward the management should seek ways to improve its EBIT level at a faster rate than increase in capital employed so as to outpace the industry average.
Return on owner’s equity is a measure of the profitability of a business in relation to the book value of shareholder’s equity. The ratio is = net income/shareholder’s equity. X ltd’s ratio is increasing on a year to year basis and is higher than the industry average. Going forward the management has to sustain this by earning incremental net income on its equity.
Gross profit margin = gross profits/sales. It shows profit level after accounting for cost of goods sold. For X ltd. Its gross profit margin is higher than the industry average but witnessed a decline on a year on year basis. The company should look to reduce its cost of goods sold as a percentage of revenues going forward to increase its margins.
Net profit margin = net income/sales. X ltd’s net profit margin is 500 basis points above the industry average and this means that the company is more profitable than its competitors. The company, in future, needs to keep its costs under control so as to earn higher profits than the industry.
Leverage ratio = total debt/total equity. X Ltd’s leverage ratio stood at 45% in 2017 and this was much lower than the industry average. This means that the company makes lower use of debt than its competitors and hence has a leaner balance sheet. The management should strive to maintain a lower level of debt going forward.
Current ratio = current assets/current liabilities. The company’s current ratio of 1.6 is higher than the industry average but declined on a year on year basis. The management of the company should take actions to increase its current ratio in future to make its liquidity position more comfortable.
Quick ratio = (current assets – inventories)/current liabilities. The company’s quick ratio as at par with the industry average and going forward the management should take steps to ensure that it does not carry too much inventory in its books.
Accounts receivables collection period = average accounts receivable/credit sales*365 days. The company’s collection period of 32 days is higher than the industry average and also increased on a year on year basis. This means that the company will have to make its credit policy less liberal and make it stricter going forward so that its collection period is reduced and working capital position is improved.
Accounts payable payment period = accounts payable/net credit purchase*365 days. The company’s payment period is 63 days, much higher than the industry number of 42 days and 2016 number of 42 days. This means that the management has been able to negotiate well with its creditors and has managed to obtain good credit terms. Going forward this should be maintained to better the working capital position of the company.
Inventory turnover = sales/average inventory. X ltd’s inventory turnover of 68 days is less than the industry average of 72 days. The company’s ratio also declined on a year on basis. Going forward the management needs to increase its inventory turnover ratio so as to more efficiently manage its inventory.
b. An analyst, when analyzing liabilities, should first deal with the issue of separating the liabilities as current liabilities and non-current liabilities. To do this the analyst will have to read the debt instruments and determine if the debt instrument will be paid off within a period of 12 months or more than that. Secondly analysts will have to carefully compute complex items like deferred credits, post employment benefits and unamortized investment tax credits.