Topic Overview

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Topic Overview

Topic BAFS (Compulsory Part)

Introduction to Accounting – Basic Ratio Analysis

Level S4

Duration 8 lessons (40 minutes per lesson)

Learning Objectives:

1. Understand the concept and general function of accounting ratios.

2. Understand the calculation and interpretation of following financial ratios:

gross profit margin, net profit margin, return on capital employed, working capital, current ratio and acid test ratio.

3. Use accounting ratios to evaluate a company’s profitability and liquidity.

Overview of Contents:

Lesson 1 Concept of Financial Statement Analysis

Lesson 2 Concept and General Function of Accounting Ratios Lesson 3 Calculation and Interpretation of Profitability Ratios

(Gross Profit and Net Profit Margin)

Lesson 4 Calculation and Interpretation of Profitability Ratios (Return on Capital Employed)

Lesson 5 Working Capital and Its Management

Lesson 6 Liquidity Position and Liquidity Problems

Lesson 7 Calculation and Interpretation of Liquidity Ratio (Current Ratio and Acid-test Ratio)

Lesson 8 Evaluation on the Liquidity and Profitability of a Business Using Accounting Ratios and Its Limitation

Resources:

 Topic Overview and Teaching Plan

 PowerPoint Presentation

 Student Worksheet

Suggested Activities:

 Group discussion

 In-class exercise

 Assignment

 Quiz



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Lesson 1

Theme Concept of Financial Statement Analysis Duration 40 minutes

Expected Learning Outcomes:

Upon completion of this lesson, students will be able to:

1. describe the basic concept of financial statement analysis.

Teaching Sequence and Time Allocation:

Activities Reference Time

Allocation Part I: Introduction

 Teacher starts the lesson by a discussion.

 Teacher invites students to share their ideas on how to evaluate the performance of a business.

PPT #2 – 3 6 minutes

Part II: Content

 Teacher explains the concept of financial analysis and different types of users of financial report.

 Teacher describes the format and contents of income statement which is used for financial analysis.

 Activity 1: Class discussion

 Teacher invites students to share their ideas on how to evaluate a business with an income statement.

 Teacher goes through the answer and makes conclusion.

PPT #10 PPT #11

3 minutes 4 minutes

 Teacher describes the format and contents of statement of financial position which is used for financial analysis.

 Teacher asks students to compare income statement and statement of financial position.

PPT #15

PPT #16

3 minutes

4 minutes

Part III: Conclusion

 Teacher concludes the lesson by reviewing the key points covered.

2 minutes

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Lesson 2

Theme Concept and General Function of Accounting Ratios Duration 40 minutes

1. describe the general concept and function of accounting ratios.

 Teacher explains financial statement analysis is a vital part of internal analysis and introduces four areas for financial analysis.

 Teacher invites students to share their ideas on the performance of the business based on the four areas for financial analysis.

PPT #4

PPT #5

4 minutes

3 minutes

 Teacher explains the purpose of financial analysis using ratios.

 Teacher explains the three types of comparison for analysis.

PPT #6 – 7 PPT #8 – 11

7 minutes 9 minutes

 Activity 2: Group Discussion

 Students are divided into groups of three to four for discussion.

 Teacher invites students to share their ideas and makes conclusion.

PPT #12 PPT #13 – 14

8 minutes 4 minutes

2 minutes

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Lesson 3

Theme Calculation and Interpretation of Profitability Ratios (Gross Profit and Net Profit Margin)

Duration 40 minutes

1. calculate gross profit margin and net profit margin;

2. analyse and comment on these profitability ratios.

 Teacher recaps the four areas for financial analysis and explains to students the discussion of the lessons will be focused on profitability and liquidity of a business.

PPT #2 2 minutes

 Teacher explains the concept of profitability ratios.

 Teacher explains the concept of gross profit margin and demonstrates its calculation and provides comments on its result.

PPT #3 – 5 PPT #6 – 8

8 minutes 8 minutes

 Activity 1: Calculation of Gross Profit Margin

 Teacher asks students to calculate and comment the gross profit margin for two years.

PPT #9

PPT #10

3 minutes

4 minutes

 Teacher explains the concept of net profit margin and demonstrates its calculation and comments on its result.

PPT #11 - 13 6 minutes

 Activity 2: Calculation of Net Profit Margin

 Teacher asks students to calculate and comment the net profit margin for two years.

 Teacher goes through answers and makes conclusion.

PPT #14

PPT #15

3 minutes

4 minutes

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2 minutes

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Lesson 4

Theme Calculation and Interpretation of Profitability Ratios (Return on Capital Employed)

1. calculate the return on capital employed;

2. analyse and comment on the profitability ratio.

 Activity 1: Group discussion

 Teacher starts with a discussion to recap students’ understanding of gross profit margin and net profit margin.

PPT #2

PPT #3

6 minutes

4 minutes

 Teacher explains the concept of return on capital employed, demonstrates its calculation and comments on its result.

 Activity 2: Calculation of Profitability Ratio

 Teacher asks students to calculate the gross profit margin, net profit margin and ROCE for XYZ Ltd.

PPT #7

PPT #8

8 minutes

5 minutes

 Teacher explains the purposes of using profitability ratios.

PPT #9 3 minutes

2 minutes

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Lesson 5

Theme Working Capital and Its Management Duration 40 minutes

1. understand the concept of working capital;

2. calculate the working capital of a company.

 Teacher explains the concept of working capital.

PPT #2 2 minutes

 Teacher invites students to share their ideas on the implication of a negative working capital.

PPT #3

PPT #4

3 minutes

 Activity 2: Calculation of Working Capital

 Students are required to calculate and comment the working capital of a company.

PPT #5

PPT #6

4 minutes

3 minutes

 Teacher explains the causes of a change in working capital.

 Teacher explains the concept of working capital management.

 Teacher explains the relationship of working capital management and business solvency.

PPT #11 – 12 PPT #13 – 14

3 minutes 4 minutes

 Students are divided into groups of three to four to discuss the implication of a conservative working capital policy to a company.

PPT #15 4 minutes

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PPT #16 3 minutes

2 minutes

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Lesson 6

Theme Liquidity Position and Liquidity Problems Duration 40 minutes

1. understand the concept of working capital management and liquidity;

2. evaluate the liquidity of a company.

 Teacher explains the concept of Liquidity. PPT #2 4 minutes Part II: Content

 Teacher explains how to measure the liquidity of a company.

 Teacher explains what is liquid asset.

PPT #3 PPT #4

3 minutes 3 minutes

 Teacher invites students to give some examples of liquid assets.

PPT #5 PPT #6

3 minutes 3 minutes

 Teacher explains the risks of a company when there is liquidity problem.

PPT #7 3 minutes

 Students are divided into groups of three to four to discuss the signs of liquidity problem.

PPT #8

PPT #9

9 minutes

7 minutes

 Teacher explains how a company cope with its liquidity problem.

PPT #10 3 minutes

2 minutes

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Lesson 7

Theme Calculation and Interpretation of Liquidity Ratio (Current Ratio and Acid-test Ratio)

1. calculate the liquidity ratio (current ratio);

2. analyse and comment on the current ratio.

3. calculate the liquidity ratio (acid test ratio);

4. analyse and comment on the acid test ratio.

 Teacher introduces liquidity ratios. PPT #2 3 minutes Part II: Content

 Teacher explains how to measure the liquidity of a company.

 Teacher explains the concept of current ratio and demonstrate its calculation and provides comments on its result.

PPT #3 PPT #4 – 7

2 minutes 7 minutes

 Activity 1: Calculation of Current Ratio

 Students are required to calculate and comment the current ratio of a company.

PPT #8 PPT #9

2 minutes 3 minutes

 Teacher explains the limitation of using current ratio.

PPT #10 5 minutes

 Teacher explains the concept of acid test ratio and demonstrate its calculation and provides comments on its result.

 Activity 2: Calculation of Acid Test Ratio

 Students are required to calculate and comment the acid test ratio of a company.

PPT #15 PPT #16

2 minutes 3 minutes

 Teacher explains the advantages and PPT #17 4 minutes

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disadvantages of using acid test ratio.

2 minutes

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Lesson 8

Theme Evaluation on the Liquidity and Profitability of a Business Using Accounting Ratios and Its Limitation

1. evaluate the liquidity and profitability of a business using accounting ratio and make business decision;

2. describe the limitation of using accounting ratios.

 Teacher recaps the question which was asked in the first lesson and invites students to share their learning experience.

 Teacher concludes that the use of accounting ratios can help a company to understand its financial performance and financial position.

PPT #2

PPT #3

2 minutes

 Teacher demonstrates how to work out different accounting ratios for a company and make comments accordingly.



 Activity 1: Case Study

 Students are required to calculate the accounting ratios and make decision.

PPT #7 PPT #8 – 10

8 minutes 9 minutes

 Teacher explains other factors that affecting business decision.

 Teacher explains the limitations of accounting ratio analysis.

PPT #11 PPT #12

3 minutes 5 minutes

2 minutes

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1

Teacher starts the lesson with the question above and explains to students that they will learn how to evaluate a business’s performance using accounting ratios in the lessons followed.

2

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Teacher explains the three basic aspects to evaluate a business. Teacher explains the concept of financial analysis.

4

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Teacher explains to students that it is required by Companies Ordinance that a company must prepare income statement and statement of financial position every year.

5

Teacher explains different types of users of financial reports.

6

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Teacher explains the purpose of preparing income statement.

7

Teacher describes the format and content of an income statement.

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Teacher explains the following calculations:

Sales ‐ Cost of Sales = Gross Profit

The other (operating) expenses are then charged against gross profit to derive operating profit.

i.e. Gross Profit – Operating Expenses = Operating Profit or Net Profit Before Interest and Tax

9

Teacher invites students to share their ideas.

10

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Teacher makes conclusions and provides answer.

11

Teacher explains the nature of statement of financial position.

12

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Teacher describes the content of a statement of financial position. Teacher describes the content of statement of financial position including non‐current assets, current assets, current liabilities, non‐current liabilities and equity.

14

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Teacher asks students to compare income statement and statement of financial position by their purpose, timeframe and major items.

15

16

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17

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1

Teacher explains financial statement analysis is a vital part of internal analysis which:

• Overall performance could be measured in financial terms.

• Indicates the extent to which it is achieving its objectives.

• It can help identifying areas of weakness and formulate appropriate strategies.

Financial statement analysis is also helpful in providing information for external users for investment and financing decisions such as hold/buy/sell shares, assess credit

worthiness etc.

2

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3 Teacher explains there are four areas for financial statements analysis:

• Profitability: Is the business profitable?

• Liquidity and efficiency: Is the trading position satisfactory?

• Solvency: Is the business able to meet its long‐term fixed expenses?

• Market prospects: Is the business fundedproperly and using these funds wisely?

Teacher invites students to share their ideas on the performance of the business based on the four areas for financial statement analysis tht learnt in the previous slides.

4

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Students are free to share their ideas regarding the four aspects. Some suggested solutions may include:

Profitability: The profit after tax in 20X5 is $29,000 higher than 20X4.

Liquidity: The company is able to meet its short‐term obligation because the total of current assets is higher than the total of current liabilities for both 20X4 and 20X5.

Solvency: The company is able to generate future revenues to meet its long‐term debts because profits earned for 20X5 has already covered 67% (332/497) of the long‐term loan.

Market prospects: No idea as there is no market information provided from the financial statements above.

Teacher explains to students that conclusions drawn about the performance of a business is limited if we just refer to the numbers presented on the financial statements.

To overcome such limitation, teacher can then introduce the concepts of accounting ratios in financial analysis.

5 6

Teacher explains that ratio analysis is a quantitative analysis which is one of the elements in financial statements analysis. Qualitative analysis such as customers’

preference etc. is not covered in this course.

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7 Teacher elaborates the importance of comparison in financial statements analysis by

using the information provided in activity 1. For example, there is no meaning by merely knowing sales for the year 20X5 is $1,850,000, the information is insufficient for us to make any comments on the sales performance of the company. However, by comparing the sales figures of 20X4 and 20X5, and knowing that there is an increase of

$290,000, we can understand that the sales performance of the company is better than previous year.

Teacher explains the need of comparative analysis.

8

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Teacher explains the use of intracompany comparison.

9

Teacher explains the use of intercompany comparison.

10

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Teacher explains the use of industry averages comparison.

11

Students are divided into groups of three for discussion. Teacher invites students to share their ideas and makes conclusions (the next two slides).

12

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13 Teacher explains the types of internal users and how financial ratios

assist their decision-making.

14 Teacher explains the types of external users and how financial ratios

assist their decision-making.

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15

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1

Teacher introduces the four types of ratio for financial analysis and explains to students the discussion of the lessons will be focused on profitability and liquidity of a business.

2

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Teacher explains the concept of profitability ratio.

3

Teacher recaps the contents of the income statement and explains the four level of profit for analysis.

4

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Teacher introduces the 3 key profitability ratios that show the operating performance of a business in relation to its sales. Generally, the higher the better.

5

Teacher explains the gross profit margin indicates margin between selling price and cost of good sold.

6

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Teacher distributes the financial statements of ABC Company to students and illustrates how to work out the gross profit margin of the company for the year 20X4 and 20X5.

7

Teacher recaps the financial statements which had been discussed on last lesson and illustrates how to work out the gross profit margin of the company for the year 20X4 and 20X5.

The Gross Profit Margin for ABC Ltd:

20X5: $915/$1,850 x 100% = 49.46%

20X4: $807/$1,560 x 100% = 51.73%

The GP margin in 20X5 is worse than 20X4 by reducing 2.27%.

For the calculations of GP margin for ABC Ltd, teacher can explain to students the decline in GP % may due to lower in selling price because of keen competition or high purchase costs for the year 20X5.

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Teacher asks students to complete the calculation and provide comments on the result.

9

Remarks: The above is a general comment only and teacher can explain that there are many reasons leading to an increase in GP margin such as an increase in selling price or a better use of marketing strategy to promote sales etc.

10

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Teacher explains the net profit margin indicates net income generated by each one hundred dollar of sales. The higher the margin, the higher the return on sales.

11

Teacher illustrates how to work out the net profit margin of the ABC Company for the year 20X4 and 20X5.

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Teacher recaps the financial statements which had been discussed on last lesson and illustrates how to work out the net profit margin of the company for the year 20X4 and 20X5.

The Net Profit Margin for ABC Ltd:

20X5: $398/$1,850 x 100% = 21.51%

20X4: $359/$1,560 x 100% = 23.01%

The NP margin in 20X5 is worse than 20X4 by reducing 1.5%.

For the calculations of NP margin for ABC Ltd, teacher can explain to students the decline in NP % may due to lower GP or high operating cost for the year 20X5.

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Remarks: the above is a general comment only and teacher can explain that there are many reasons leading to a decrease in NP margin such as an unexpected increase in rent or salaries or the strategic increase in marketing expense to build up the company image.

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1

Teacher starts with a discussion to recap students’ understanding of gross profit margin and net profit margin.

Students are invited to present their ideas.

2

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Teacher then introduce the concept of ROCE which is another ratio to assess the profitability of a company.

3

Teacher explains the concept and formula of ROCE and its indication.

In general, the higher the ratio, the better the ability a company using its capital.

4

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Teacher recaps the financial statements which had been discussed on last lesson and illustrates how to work out the ROCE of the company for the years 20X4 and 20X5.

The ROCE for ABC Ltd:

20X5: $424/$3,483 x 100% = 12.17%

20X4: $383/$3,394 x 100% = 11.28%

The ROCE in 20X5 is better than 20X4 by increasing 0.89% which indicates a more effective use of the company’s capital.

5

Teacher explains that from the perspective of the resources providers of the company, it is very important to have adequate return to their investments. Besides, teacher should explain the inter‐company comparison may be distorted if the result of an EBIT is not used as the numerator .

6

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Teacher asks students to calculate the profitability ratios including gross profit margin, net profit margin and ROCE for the two years of XYZ Ltd.

7

Teacher goes through the above and explore other alternative answers in the

“comments” column with students. For example, if the gross profit margin decline, it may due to a lower selling price for competition or a higher cost in purchase. Teacher may also highlight the GP will also affect the NP margin as NP is calculated by GP – Op Exp.

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Teacher explains the advantages of using profitability ratios.

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1

Teacher explains the concept of working capital.

2

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Teacher invites students to share their ideas.

3

4

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Teacher asks students to calculate the working capital for XYZ Ltd.

5

Teacher explains the implication of the following:

A positive working capital indicates that the company has sufficient fund to settle short‐

term obligations.

A negative working capital indicates that the company does not have sufficient immediate fund to settle short‐term obligations. However, it does not mean the company is insolvent as the company can settle short‐term obligations by using long‐

term finance.

Teacher explains the increase in working capital in 20X5 for XYZ Ltd indicates the ability of using available fund to settle short‐term obligations has improved.

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7

Teacher explains with examples the situations that will increase the working capital.

8

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Teacher explains with examples the situations that will not change the working capital.

9

Teacher invites students to answer and makes conclusion as below:

Sales of goods on credit only increase the trade receivable, the cash would not increase since it has not yet been received.

Company will receive cash for sales of a non‐current asset. The loss on disposal is just an accounting calculation.

Payment of dividend to shareholders and settlement to suppliers incur cash outflow.

Therefore, the answer is B.

10

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Teacher explains the concept of working capital management.

11

Teacher explains the importance of working capital management.

12

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Teacher explains the relationship of working capital management and business solvency.

13

Teacher describes two different working capital polices.

14

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Students are divided into groups of three to four and and discuss the question.

15

Teacher invites students to share their answers and debrief the suggested solution.

Teacher also explains that an aggressive policy will lead to an opposite effect.

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1

Teacher explains the concept of liquidity.

2

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Teacher explains how to measure the liquidity of a company.

3 4

Teacher explains what is liquid asset.

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Teacher invites students to share their answers.

5

Teacher also explains that prepayment is not liquid asset as it cannot be converted in cash but just an entitlement to receive goods or services in future.

6

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Teacher explains the risks of a company when there is liquidity problem.

7

Students are divided into groups of three to four and discuss the signals of liquidity problem.

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9

Teacher explains the common ways to cope with liquidity problems in companies.

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11

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1

Teacher introduces liquidity ratios.

2

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3 Teacher introduces the use of current ratio and acid-test ratio which

help to measure the liquidity of a company.

Teacher explains the concept of current ratio.

4

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Teacher explains current ratio indicates a company’s short‐term debt‐paying ability. A higher ratio means greater liquidity.

5

Teacher explains the implications of having too high or too low current ratio to a company.

6

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Teacher reaps the financial statements which had been discussed on first lesson and illustrate how to work out the current ratios of the company for the years 20X4 and 20X5.

The current ratio for ABC Ltd:

20X5: $634/$351= 1.81 times 20X4: $700/$306 = 2.29 times

The current ratio for 20X5 is lower than 20X4 which indicates the ability to settle short‐

term debts is lower. However, it is still satisfactory as it still has sufficient liquidity to cover its liabilities.

7

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Teacher can remark that further investigations can be performed to identify the reasons for the decrease in current ratio such as decline in sales which makes the decline in accounts receivable.

9

Teacher explains the liquidity problem of inventory and introduces the concept of acid test ratio in next slide.

10

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Teacher explains the concepts of acid test ratio.

11

Teacher explains quick ratio indicates a company’s immediate short‐term debt‐paying ability.

The rule of thumb for the quick ratio is 1:1

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Teacher explains the indications of too high or too low of the acid test ratio.

13

Teacher reaps the financial statements which had been discussed on first lesson and illustrate how to work out the acid test ratios of the company for the years 20X4 and 20X5.

The acid test ratio for ABC Ltd:

20X5: ($634 ‐ $212)/$351= 1.20 times 20X4: ($700 ‐ $189)/$306 = 1.67 times

The acid test ratio for 20X5 is lower than 20X4 which indicates the ability of a company to meet its liabilities without having to dispose its inventory is lower. However, it is still satisfactory as it still has sufficient quick assets to cover its liabilities.

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15

16

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Teacher explains the advantages and disadvantages of using current ratio.

17 18

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1

Teacher recaps the question which was asked in the first lesson and invites students to share their learning experience after the learning of accounting ratios.

2

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Teacher concludes that the use of accounting ratios can help a company to understand its financial performance and financial position and to make economic decision.

3

Teacher asks students to work out different accounting ratios for their uncle and make comments accordingly.

4

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Teacher calculates different ratios and comments the results with students.

5

Teacher calculates different ratios and comments the results with students.

6

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Students are required to calculate the accounting ratios and suggest a situation for their uncle.

7 8

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Teacher goes through the answers and makes comments.

9

Teacher explains the decision may be varied because there are other factors to be considered in making business decision.

10

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Teacher explains other factors that affecting business decision and remarks that the use of accounting ratios is just one of the techniques to evaluate a business. Teacher can then bring up the concept of limitation of using accounting ratios.

11 12

Teacher explains the limitations of accounting ratio analysis.

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BAFS (Compulsory Part) – Introduction to Accounting Basic Ratio Analysis

Lesson 1 Activity 1 - Class Discussion

What can we know by reviewing a company’s income statement?

_______________________________________________

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BAFS (Compulsory Part) – Introduction to Accounting Basic Ratio Analysis

Lesson 1

Activity 2 - Class Discussion

A company’s financial statements consist of the income statement and statement of financial position. Compare these two statements.

Income statement Statement of financial position Purpose

Time frame

Major item

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BAFS (Compulsory Part) – Introduction to Accounting Basic Ratio Analysis

Lesson 2

Activity 1 – Discussion

Your uncle has then provided you with the income statement and statement of financial position of his business for the last two financial years for your viewing.

20X5 20X4

$'000 $'000

1,850 1,560 (935) (753) 915 807

Distribution (135) (108)

Selling and marketing (182) (161) General and administrative (174) (155) 424 383 (26) (24) 398 359 (66) (56) 332 303 ABC Ltd

Income Statement

For the year ended 31 December

Profit before tax Income tax expenses Profit after tax Turnover Cost of sales Gross profit Expenses

Operating profit Interest expenses

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20X5 20X4

$'000 $'000

Non-current assets

Equipments 3,200 3,000

Current assets

Inventories 212 189

Trade receivables 304 286 Cash and bank 118 225

634

700 Current liabilities

Trade payables 285 250 Tax payable 66 56

351

306 Total assets less current liabilities 3,483 3,394

Financed by:

Share capital 2,200 2,200

Retained earnings 786 454 2,986

2,654 Non-current liabilities

Long-term loan 497 740 3,483

3,394 ABC Ltd

Statement of Financial Position As at 31 December

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Using the four aspects of financial statement analysis, what can you find out from the information provided on the financial statements?

Profitability: Liquidity and Efficiency:

Solvency: Market Prospects:

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BAFS (Compulsory Part) – Introduction to Accounting Basic Ratio Analysis

Lesson 2

Activity 2 – Group discussion

Divided into three groups which represent the 1. internal management; 2. lenders; 3.

shareholders (investors) of a company and discuss how the financial ratios can help you to make business decisions?

Internal Management:

Lenders:

Shareholders (Investors):

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BAFS (Compulsory Part) – Introduction to Accounting Basic Ratio Analysis

Lesson 3

Activity 1 - Calculation of Gross Profit Margin

Given the following information, calculate and comment the gross profit margin for the years of 20X4 and 20X5.

20X4 20X5

Sales $100,000 $120,000

Cost of goods sold $54,000 $62,000

Gross profit ( ) ( ) Gross profit margin ( ) ( )

Comments:

______________________________________________

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BAFS (Compulsory Part) – Introduction to Accounting Basic Ratio Analysis

Lesson 3

Activity 2 - Calculation of Net Profit Margin

Given the following information, calculate and comment the net profit margin for the years of 20X4 and 20X5.

20X4 20X5

Sales $100,000 $120,000

Cost of goods sold $54,000 $62,000

Gross profit $46,000 $58,000

Operating expenses $33,000 $44,000

Net profit ( ) ( ) Net profit margin ( ) ( )

Comments:

______________________________________________

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BAFS (Compulsory Part) – Introduction to Accounting Basic Ratio Analysis

Lesson 4 Activity 1 – Class Discussion

What are the differences between gross profit margin and net profit margin?

______________________________________________

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BAFS (Compulsory Part) – Introduction to Accounting Basic Ratio Analysis

Lesson 4

Activity 2 – Calculation of Profitability

Refer to the financial statements of XYZ Ltd, calculate and comment its profitability ratios.

20X5 20X4

$'000 $'000

3,310 2,952 (1,840) (1,632) 1,470 1,320 Distribution (288) (225) Selling and marketing (349) (293) General and (227) (187) 606 615 (105) (87) 501 528 (92) (96) 409 432 XYZ Ltd

Income Statement

For the year ended 31 December

Profit before tax Income tax expenses Profit after tax Sales

Cost of sales Gross profit Expenses

Operating profit

Interest expenses

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20X5 20X4

$'000 $'000

Non-current assets

Equipments 5,500 5,220

Current assets

Inventories 331 292

Trade receivables 504 463 Cash and bank 222 108

1,057

863 Current liabilities

Trade payables 396 367 Tax payable 92 96

488 463 Total assets less current liabilities 6,069 5,620 Financed by:

Share capital 4,000 4,000

Retained earnings 1,022 855 5,022

4,855 Non-current liabilities

Long-term loan 1,047 765 6,069

5,620 XYZ Ltd

Statement of Financial Position

As at 31 December

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Calculations Comments Gross Profit Margin

20X5:

20X4:

Net Profit Margin 20X5:

20X4:

Return on Capital Employed 20X5:

20X4:

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BAFS (Compulsory Part) – Introduction to Accounting Basic Ratio Analysis

Lesson 5 Activity 1 - Class Discussion

Companies should have a positive amount of working capital, i.e. current assets are greater than current liabilities.

What happens if there were a negative working capital (i.e. current assets < current liabilities)?

_______________________________________________

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BAFS (Compulsory Part) – Introduction to Accounting Basic Ratio Analysis

Lesson 5

Activity 2 – Calculation of Working Capital

Refer to the financial statements of XYZ Ltd, calculate its working capital.

20X5 20X4

$'000 $'000

3,310 2,952 (1,840) (1,632) 1,470 1,320 Distribution (288) (225) Selling and marketing (349) (293) General and (227) (187) 606 615 (105) (87) 501 528 (92) (96) 409 432 XYZ Ltd

Income Statement

For the year ended 31 December

Profit before tax Income tax expenses Profit after tax Sales

Cost of sales Gross profit Expenses

Operating profit

Interest expenses

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20X5 20X4

$'000 $'000

Non-current assets

Equipments 5,500 5,220

Current assets

Inventories 331 292

Trade receivables 504 463 Cash and bank 222 108

1,057

863 Current liabilities

Trade payables 396 367 Tax payable 92 96

488 463 Total assets less current liabilities 6,069 5,620 Financed by:

Share capital 4,000 4,000

Retained earnings 1,022 855 5,022

4,855 Non-current liabilities

Long-term loan 1,047 765 6,069

5,620 XYZ Ltd

Statement of Financial Position As at 31 December

Working Capital of XYZ Ltd 20X5:

20X4:

(89)

BAFS

Ratio Analysis 5

Activity 3 – Group Discussion

How a conservative working capital policy lowers profitability and risk?

_______________________________________________

(90)

BAFS (Compulsory Part) – Introduction to Accounting Basic Ratio Analysis

Lesson 6 Activity 1 - Class Discussion

Can you give some other examples of liquid assets?

7

_______________________________________________

(91)

BAFS (Compulsory Part) – Introduction to Accounting Basic Ratio Analysis

Lesson 6

Activity 2 – Group Discussion

How can we know if a company has a liquidity problem?

_______________________________________________

(92)

BAFS (Compulsory Part) – Introduction to Accounting Basic Ratio Analysis

Lesson 7 Activity 1 - Calculation of Current Ratio

Given the following information, calculate and comment the current ratio for the years of 20X4 and 20X5.

20X4 20X5

Inventory $163,000 $116,000

Accounts receivable

$146,000 $162,000

Cash and bank $23,000 $44,000

Accounts payable $155,000 $171,000

Calculations Comments

Current ratio 20X4:

20X5:

(93)

BAFS (Compulsory Part) – Introduction to Accounting Basic Ratio Analysis

Lesson 7 Activity 2 - Calculation of Acid Test Ratio

Given the following information, calculate the acid test ratio for the years of 20X4 and 20X5 and comment the ratio by comparing with the current ratio calculated in activity 1.

20X4 20X5

Inventory $163,000 $116,000

Accounts receivable $146,000 $162,000

Cash and bank $23,000 $44,000

Accounts payable $155,000 $171,000

Current ratio Acid test ratio Comments 20X4:

20X5:

20X4:

20X5:

(94)

BAFS (Compulsory Part) – Introduction to Accounting Basic Ratio Analysis

Lesson 8 Activity 1 – Case Study

Your uncle’s business is the supplier of DEF Ltd. Your uncle is now considering whether it is appropriate to sell goods to DEF Ltd on credit or COD (Cash on Delivery).

(Demanding COD might cause DEF Ltd buy less from your uncle’s company.) Use accounting ratios to help your uncle to make decision

(3,380) (3,410) 1,840 2,120 Distribution (522) (482) Selling and marketing (414) (398) General and

administrative (331) (303) 573 937 (108) (66) 465 871 (65) (42) 400 829 Profit before tax

Income tax expenses Profit after tax Cost of sales Gross profit Expenses

Operating profit

Interest expenses

(95)

20X5 20X4

$'000 $'000

Non-current assets

Equipments 8,250 7,273

Current assets

Inventories 338 284

Trade receivables 536 406 Cash and bank 34 128

908 818 Current liabilities

Trade payables 782 434 Tax payable 65 42

847 476 Total assets less current liabilities 8,311 7,615 Financed by:

Share capital 5,500 5,500

Retained earnings 1,688 1,288 7,188

6,788 Non-current liabilities

Long-term loan 1,123 827 8,311

7,615 DEF Ltd

Statement of Financial Position

As at 31 December

(96)

20X5 Ratio Calculation Result

Gross Profit Margin Net Profit Margin ROCE

Current Ratio Acid Test Ratio

20X4 Ratio Calculation Result

Gross Profit Margin Net Profit Margin ROCE

Current Ratio

Acid Test Ratio

(97)

Ratio Comments

Gross Profit Margin Net Profit Margin ROCE

Current Ratio Acid Test Ratio

Suggestion

______________________________________________

(98)

Basic Ratio Analysis

p.1

Basic Ratio Analysis – Home Assignment

Section A: Multiple Choice Questions (@1, total 10 marks)

1. Why does financial analysis involve the expression of the reported numbers in relative term?

A. It is easy to calculate.

B. It helps users to make comparison on the same basis.

C. Absolute numbers are difficult to identify.

D. All of the above.

Level of difficulty: **

2. Which of the following cannot be ascertained from an income statement of a company?

A. Sales generated for the year.

B. Share price of the company.

C. Profit for the year.

D. Operating expenses of the year.

Level of difficulty: *

3. A ratio by itself may have no meaning. Hence, a given ratio is compared to:

A. Ratios from previous years B. Ratios of other companies C. Both A and B.

D. None of the above.

4. The shareholders of the company will analyse the financial statement of the company and

A. decide whether or not to invest in a company.

B. determine a company’s credit worthiness.

C. evaluate performance of employee and determine relevant compensation.

D. understand the financial performance of the company’s competitors.

(99)

p.2

5. A ___________ ratio is a measure of how profitable a company is in doing its business.

A. profitability.

B. liquidity.

C. solvency.

D. investment.

6. Which of the following is the best description for return on capital employed (ROCE)?

A. It describes a company’s ability to earn a net income from sales.

B. It is the difference between current assets and current liabilities C. It is defined as the ability to pay your debts when they come due.

D. It is a measure of efficiency of a company in using its capital to generate profit.

7. Given the following information, calculate the working capital.

Office equipment: $85,000 Furniture & fixture: $24,000 Accounts receivable: $5,200 Inventory: $6,100

Bank overdraft: $1,500 Accounts payable: $4,400 A. $5,400.

B. $8,400.

C. $114,400.

D. $117,400.

(100)

p.3

8. Which of the following description about current ratio is correct?

A. A ratio of 0.8:1 means a company will be liquidated.

B. The higher the ratio the better.

C. Accounts receivables are assumed to be collected on a timely basis.

D. The non-current assets can be sold immediately when there is a liquidity problem.

9. Other than the use of accounting ratios, which of the following factors will not affect the decision of investing in another company?

A. Legal environment.

B. Reputation of the company.

C. Relationship with customers.

D. Research expenses already paid for this investment project.

Level of difficulty: ***

10. If the current ratio of a company is 7:1, the company may be holding ____________ idle short-term assets.

A. too much B. too little C. sufficient D. right level of Level of difficulty: *

(101)

p.4

Section B: Short Questions

Question 1

Briefly describe four internal uses of financial ratios to a company. (4 marks) Level of difficulty: *

Question 2

What is the reason of using ‘profit before interest and tax’ instead of ‘profit after interest and tax’ as the numerator in the ROCE formula? (4 marks)

Level of difficulty: * Question 3

Suggest four methods to a company when there is a liquidity problem to settle the balance with its supplier in next month. (8 marks)

Level of difficulty: ***

Question 4

Given the following information, calculate the current ratio and acid test ratio of the company and provide comment on its liquidity. (10 marks)

Non-current assets: $241,000 Accounts receivable: $6,300 Inventory: $15,500

Cash: $5,500

Accounts payable: $9,800 Tax payable: $3,200 Level of difficulty: **

(102)

p.5

Question 5

(a) State the characteristics of a company using aggressive working capital policy byshowing its effects on the level of items listed in the following table. (4 marks) (b) Briefly describe the overall impacts on profitability and risk to a company using aggressive working capital policy by outlining its implication to the items listed in the following table. (10 marks)

Level of cash

Level of accounts receivable

Level of inventory

Short-term debts/

long-term liabilities

Overall Impact

(a) Characteristics

----

(b) Profitability

Risk

(103)

p.6

Solutions:

Section A: MCQs

1. B 2. B 3. C 4. A 5. A

6. D 7. A 8. C 9. D 10. A

Section B: Short Questions.

Question 1

The four internal uses of financial ratios include:

1. Identify deficiencies of the company and take remedial action.

2. Evaluate performance of employees and determine relevant compensation.

3. Compare the financial performance of different divisions within the company.

4. Understand the financial performance and status of the company’s competitors.

(@1, total 4 marks) Question 2

The reason of using net profit before interest and tax in calculating ROCE is that such profit is the income generated from the company’s assets regardless of how the company’s funds come from.

If the company relies heavily on borrowing, the net profit before tax will be adversely affected because of high interest expense and hence affect the comparison with companies with different capital structure.

(@2, total 4 marks) Question 3

A company might consider the following methods to cope with the liquidity problems:

• Offering an early settlement discount to its customers. This is a reduction in the amount of the payment required from the customer provided that the customer pays within a specified time limit.

• Offering trade discount on cash sales to its customers for receiving immediate cash.

• Buy less inventory = applying Just-in-time inventory system to reduce the carrying cost of the inventory and increase the cash balance.

• Borrow a short to medium-term loan (e.g. 1 to 3 years) to enhance the liquidity.

[remarks: it is not suggested to use long-term loan as the interest expense will be too high when it is only a temporary running short of cash.]