CHAPTER 6 SUGGESTED SOLUTIONS

SOLUTION TO MULTIPLE CHOICE QUESTIONS

6.1 (b)
6.2 (a)
6.3 (d)
6.4 (a) (R8 000 – R2 000)/R6 000
6.5 (c)
6.6 (c) R35 800 – R31 700
6.7 (c) [R24 000 + R2 000(1-0,40)]/R145 000
6.8 (a) R28 000/ R82 000
6.9 (c) (R80 000-R24 300)/R26 300
6.10 (c) R114 000 – R82 000 – R23 500

END OF CHAPTER QUESTIONS

6.1
A potential shareholder is interested in the future prospects of the company with regard to growth and
profitability. This is considered relative to other companies which are potential investment targets. The
use of technical analysis may be considered if the company is listed, but the most significant analysis
will be the use of fundamental analysis.
Information will be gathered with regard to the economy, both globally and locally.
Information will be gathered with regard to the industry in which the company operates
Information will be gathered with regard to competitors
Select the appropriate ratio’s. An in depth analysis will require that all aspects of the company be
considered, over a period of at least the three previous years. These would include ratio’s with regard
to:
 Profitability – Margins, mark-ups and returns on assets and equity
 Liquidity – Ability to meet short-term obligations from cash and near cash resources
 Efficiency, notably of working capital
 Financial leverage – the effective use of debt without undue increase in risk
 Market performance – if listed, how well it has performed relative to other companies in the
industry.
Compare the selected ratio’, once calculated with other companies, over the time period and with
industry benchmarks
Evaluate the company and its prospects on the basis of trends or significant issues which are apparent
from the calculations
Finally, a prediction must be made. A potential shareholder is only interested in future prospects, using
past performance as an indicator of possible future prospects.

6.2
External variables, which could have an impact on the expected performance of a company would
include:
Economic factors: The global economy and the national economy, to gain an insight into whether
future growth can be anticipated, as well as the growth rate. For the local economy, factors such as
the inflation rate, exchange rates, gross domestic product and foreign direct investment would all be
significant.

© FLYNN D K: UNDERSTANDING FINANCE AND ACOUNTING: 2ND EDITION: SUGGESTED SOLUTIONS 1

The industry in which the company operates causes external factors to impact on possible
performance, The factors of particular interest would be:
The type of operation
The type of product
The clientele
The suppliers
The competition

6.3
There are many potential sources of information about a company, the most obvious sources are:
 The Annual Report of the company, which will contain at least the following:
• The Director’s Report
• The Auditor’s Report
• The Balance Sheet with accompanying n otes
• The Income Statement with accompanying n otes
• The Cash Flow Statement with accompanying n otes
• General information about the company with a five year review
• Extensive notes of accounting policies
 Reports in the financial press, such as Business Review, Financial Mail
 Reports by analysts, available from large stockbroking firms
 Brochures and leaflets available from the company on request
 Internet services

6.4
The client has already identified the company in which he is interested. The fact that he has selected
an investment in a company rather than in a risk-free security, such as a Government or Escom bond,
indicates that he is prepared to take the risks, which accompany such investments. Risk may be
defined as the probability that the company may generate a smaller return than that which is expected.
This probability is dependent upon future events, which cannot be predicted with certainty. However,
the past record of the company is a useful starting point for the analysis.
The past record of profitability may be seen in the recent income statements of the company. One
would expect to see steady growth in turnover and net income attributable to ordinary shareholders, as
reflected in the earnings per share figure. If net income has been unstable or erratic, the likelihood of
steady future growth and profitability is lower.
The financial stability of the company can be assessed by examining past balance sheets. The client
should focus particularly on the company's liquidity and solvency history. The trends in the market
price of the share should also be studied. Once again, the investor will feel more confident in the
quality of his investment if the share price history has shown steady growth over the last few years.
Once the information relating to the company has been gathered, it must be compared with
information relating to similar companies.

6.5
Previous years: Every company would wish to increase its performance each year. Should a company
obtain results which are worse than those of the previous year, it is a clear indication that something is
wrong. Of course, it may be because the industry has suffered or the entire economy is in a state of
recession. Nevertheless, no company will survive unless it achieves growth in the long term.
Budgets and targets: Budgets and targets represent the plans which management has for the
company. If those budgets and targets are not achieved, it indicates that management has been
unable to achieve what it had intended. This failure may result from factors which were not know at the
time of planning, but, nevertheless, failure to meet budgets will be a source of concern.

© FLYNN D K: UNDERSTANDING FINANCE AND ACOUNTING: 2ND EDITION: SUGGESTED SOLUTIONS 2

Similar companies: All business activity takes place within a competitive environment. A company
which is achieving results which are less impressive than those of its competitors is likely to be
operating less efficiently. It is thus important for a company to know its position in relation to its
competition.
Industry standards: Industry standards reflect the averages being achieved by companies in a similar
industry. Obviously, companies will be both below and above such averages. Nevertheless, if a
company achieves results or has financial ratios which are below the industry averages, management
would wish to be aware of this and to have some explanation as to why its strategies produce inferior
results.

6.6
A sudden drop in the value of the Rand means that it becomes cheaper for foreigners to buy Rands
with which to pay for goods and services exported by South Africa. Similarly, South Africans must pay
more for overseas currencies, which are used to pay for imports to South Africa.
A company, which specialises in the demolition of old buildings and the redevelopment of the land for
the erection of shopping complexes, is not directly involved with goods or services, which are imported
or exported. One may thus be inclined to think that a drop in the value of the Rand will have no direct
effect on such a business. There are, however, at least two reasons why this may not be so.
Firstly, it is possible that the company uses imported fixed assets for the purpose of demolition. In
such cases, the cost of these assets will rise as a result of the change in value of the Rand. Secondly,
the economy as a whole will be affected by the change in value of the Rand. The demand for space in
shopping complexes may fall, thus placing pressure on the redevelopment business.

6.7
The selection of techniques for purposes of analysis is dependent on the objective of the analysis and
the party for whom the analysis is being performed. In this case, management is the party for whom
the analysis is being performed and the purpose of the analysis is to assess the performance of the
company.
The term performance has many interpretations, but is most closely related to profitability and
efficiency. The profitability may be assessed by analysing the figures generated in the annual financial
statements and the market performance of the company, if it is listed on the Johannesburg Stock
Exchange. The efficiency is usually measured by selecting financial ratios, which are compared
against past performance and other benchmarks.
It is unlikely that management would use only one technique if it wished to perform a thorough
analysis. The use of time series techniques will assist in identifying problem areas. Once the weak
areas have been identified, financial ratios may be used for further analysis.

6.8
MOTOPASSION LTD
a) Reduction in gross profit margin
• Change in stock mix. The company could have sold more vehicles of a lower mark-up
than in the past.
• The sales price may not have increased in proportion to the cost of the vehicles, resulting
in a lower gross profit.
• The method used in valuing stock may have changed during the current year.
• The gross profit fluctuation may also be due to errors in the quantity or pricing of stock on
hand.
b) Increase in current ratio

© FLYNN D K: UNDERSTANDING FINANCE AND ACOUNTING: 2ND EDITION: SUGGESTED SOLUTIONS 3

 • A change in the credit policy to debtors, whereby credit terms are extended, may result in
a sharp increase in debtors.
• The current ratio could also increase due to sharp increases in stock on hand or changes
in stock valuation policies.
• Creditors may have decreased considerably due either to more cash purchases, or to a
change in the credit policies of suppliers.
c) The effect of an increase in the current ratio
An increase in the current ratio does not necessarily indicate an improvement in the business.
It is necessary to establish the reasons for the increase. It is possible that it increased due to
excessive stock holdings; stock may be moving very slowly. An increase due to higher debtors
could mean a decline in the quality of credit control within the company.
If considered in conjunction with an increase in the acid-test ratio, an increase in the current
ratio could have arisen because large cash reserves are being held. Unless there is a valid
reason (for example, purchase of a fixed asset in the near future), such excessive cash
holdings could reflect mismanagement of cash resources.

© FLYNN D K: UNDERSTANDING FINANCE AND ACOUNTING: 2ND EDITION: SUGGESTED SOLUTIONS 4

6.9
Dear Mr Avens

Re: Gross profit investigation - Sterling's Country Bar

We have analysed the sales for April and May 20.1. Our analysis confirms your impression that the
gross profit is worsening. It has in fact fallen from 36,7% in April to 35,1% of sales in May. This would
appear to be due to the change in the sales mix (the proportion of products sold) set out in Appendix
A. We are continuing to review the business records and will report back to you shortly on the other
question of the reason for the difference between your gross profit of 37% for the year and the industry
average of 40%.
The effect of the 3% difference in gross profit could be approximately R7 000 based on using cost of
sales as the base (R90 720 ö 60 x 100 - R144 000 = R7 200). That means that one would expect the
gross profit to be approximately R7 000 more than shown, based on the existing cost of sales figure.
In order to identify the precise reasons for the shortfall in gross profit, the total cost of R90 720 should
be analysed into its constituent parts (bar food, beer, etc) and the sales estimate based on that
analysis. Purchase invoices will need to be obtained for this purpose. There should also be a
reconciliation of physical stock movements to identify whether there has been any misallocation of
sales to product type.
Yours faithfully

for Hunt and Partners

Appendix A

Trading Statement for the year ended 31

May 20.1
Sales 144,000 Gross
Cost of Sales 90,720 Profit %
Gross Profit 53,280 37.0%

ANALYSIS OF GROSS PROFIT AND SALES MIX

APRIL Gross Gross

Sales % Mix
Profit % Profit

Bar food R 3,000 25.0% R 750 25.4%

Beer (draught) R 2,800 33.0% R 924 23.7%
Beer (bottled) R 1,700 40.0% R 680 14.4%
Wines R 1,200 46.0% R 552 10.2%
Spirits R 2,000 48.0% R 960 16.9%
Minerals R 1,100 42.0% R 462 9.3%
R 11,800 36.7% * 4,328 100.0%
MAY
Bar food R 3,900 25.0% R 975 31.7%
Beer (draught) R 3,300 33.0% R 1,089 26.8%
Beer (bottled) R 1,500 40.0% R 600 12.2%
Wines R 900 46.0% R 414 7.3%
Spirits R 1,800 48.0% R 864 14.6%
Minerals R 900 42.0% R 378 7.3%
R 12,300 35.1% * 4,320 100.0%

* Gross Profit / Sales

© FLYNN D K: UNDERSTANDING FINANCE AND ACOUNTING: 2ND EDITION: SUGGESTED SOLUTIONS 5

6.10

Sunderland Ltd
Report to: Mr Sibanje
Prepared by:
Date:
Subject: Proposed loan to Sunderland Ltd

Proposal
A loan of R100 000 to be made to Sunderland Ltd at a fixed rate of interest of 16% per annum, the
capital sum to be repaid in five years by a single payment.
Information analysed
This report is based on the balance sheets and income statements for the three years 20.1 to 20.3
inclusive, and from the the general explanations provided to you. It has not been possible to verify the
accuracy of the financial statements or the bases on which the general explanations have been
founded.
Requirements of the lender
In terms of a fixed interest loan, the lender requires sufficient cash flow to ensure that interest is paid
at the appropriate time and that capital is repaid when due. You will therefore need assurance that
your annual interest will be met when due and that the R100 000 will be repaid in five years' time. It is
also normal for a lender to have some security in case of default by the borrower.
Analysis of the company (Supporting schedules attached)
a) The working capital of the company has barely increased since 20.1, despite the fact that the
business has expanded, as evidenced by the increase in sales volume, particularly in 20.3. The
balance sheet also highlights the increase in the overdraft from 20.2 to 20.3. There are a number
of reasons for these liquidity problems, the most important being the following:
i) Relatively high dividend per share payments in each of the years (i.e. 24%, 22% and 26%),
which has also meant that virtually no profits have been ploughed back for expansion.
ii) Debentures are being repaid at the rate of R16 000 per annum without any other finance
coming back into the business to replace this loss of long-term capital finance.
iii) There has been an increase of approximately 16% in the level of stock between 20.2 and
20.3 and an increase of approximately 9% in the level of debtors between those two years.
iv) Development costs of R7 000 per annum have been incurred in 20.2 and 20.3. When
reference is made to the balance sheets and income statements, it can be seen that all
development costs have been capitalised and there is no evidence that there is a policy of
writing off such costs against profits. It would normally be expected that some proportion of
such costs would be charged against profits each year, and thus the profits would appear to
be overstated in this respect.
v) It is likely that the rent payable under any new lease could substantially increase, thus
making the business less profitable. The current rent is R4 000 per annum, but if the same
charge per square metre is adopted as for the new adjacent factory building, the rent
payable on the renewal of the existing lease could be R36 000 per annum
(R18000/500=R36 per square metre).
vi) Plant acquisitions over the last two years have been fairly insignificant and the depreciation
charges have been calculated at 10% p.a. on a straight-line basis. It is clear that the majority
of the plant held at present is very near the end of its working life, which is why money is
urgently required for plant replacement. The business seems to have taken no steps to make
provision for the replacement of fixed assets, either in terms of charging depreciation on a
replacement cost basis, or in providing adequate cash for replacement.

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b) The effect on existing profits of the projected expansion (schedule b) shows clearly that, after
payment of the 16% interest on the R100 000 loan, there are virtually no additional profits which
will arise from the increased turnover.
c) Reference to schedule (c) clearly indicates that the R100 000 loan will not be sufficient for the
required expansion, the further requirement being some R213 000. If such additional finance
could be found at (say) 16%, then the profits of R10000 per schedule (b) would not in fact be
sufficient to cover the interest on the extra finance required.
d) As already indicated, the company requires approximately R213000 in addition to the R100000
loan being requested at the moment and it is obvious that the additional profits will not cover
interest payments. There does not seem to be any suggestion of additional equity finance. It is
unlikely that the two widows will be able to provide additional finance, as the large amount of
dividends that they are being paid from the company implies that they need the cash.
Consequently new equity shareholders would be required in order to raise funds in this way.
e) There seems to be an excessive amount of optimism by the directors in anticipating a 50%
increase in sales volume whilst not expecting the overheads to increase very much. The factory
space will be increased by 50% to meet the additional business and it seems certain that a
number of costs will increase, e.g. lighting and heating, supervision, repairs, selling and
distribution and directors' remuneration. This aspect must be investigated in more detail if you
wish to consider this proposition further.
f) There is serious doubt whether the the company would be able to repay the R100 000 in five
years' time. The only way in which it would be able to do this would be to obtain further finance,
which may prove difficult in view of the fact that overall profitability in the next few years does not
seem likely to improve; in fact, it may well decline. The question of security, which might be given
against the loan, has not yet been considered and there could be a problem here. There is no
property held by the company against which a charge could be made. There is a possibility of a
charge on the new plant and machinery, but it is probable that the bank's existing charge would
extend to this.
Conclusions
It is not recommended that money should be advanced to Sunderland Ltd, the main reasons being as
follows:
a) it does not seem that adequate security will be able to be provided against your loan;
b) there are serious doubts as to whether the company will be able to repay the R100 000 in five
years' time and there could well be problems in meeting your annual interest;
c) the company requires, in addition to the R100 000 requested from you, at least another R213 000
to finance its proposed expansion;
d) the proposed expansion will provide profits which will barely cover the interest on your loan, and
there is insufficient to cover interest on the balance of R213 000 required;
e) many of the directors' assumptions appear to be excessively optimistic, and
f) the accounting and dividend policies at present adopted by the company are very imprudent.

© FLYNN D K: UNDERSTANDING FINANCE AND ACOUNTING: 2ND EDITION: SUGGESTED SOLUTIONS 7

Supporting schedules: Sunderland Ltd

a) Significant ratios 20.1 20.2 20.3

(i) Current ratio

Current assets/Current liabilities 1,55 1,64 1,53
(ii) Acid-test
Debtors/Current liabilities 0,71 0,77 0,70
(iii) Average age of debtors* 61 days 60 days 61 days
(iv) Average age of stock* 103 days 95 days 101 days
(v) Profit before interest and tax
as % of capital employed 24% 23,7% 26,5%
(vi) Net profit margin 5% 4% 4%
(vii) Gross profit margin 30% 29% 28%
(viii) Total asset turnover
(Sales/Total assets) 1,68x 1,83x 1,88x
* (assuming all sales on credit and using year-end figures

b) Effect on existing profits of projected expansion

R
50% increase in gross profit 100 000.
Less: 10% discount on extra turnover (10% x 360 000) 36 000
Additional contribution 64 000
Rent 18 000
Depreciation (10% x 200 000) 20 000 38 000
26 000
Interest on R100 000 at 16% 16 000
Additional profit before tax 10 000

c) Additional finance required for expansion

Applications R R R
New plant 200 000
Stocks, 50% x R144 000 72 000
Debtors, 50% x R120 000 60 000
Less: 10% discount 6 000
54 000
1 extra month's credit * 27 000 81 000
153 000
Less: creditors, 50% x R60 000 30 000 123 000
323 000
Sources
Loan at 16% 100 000
Pre-tax profit 10 000 110 000
Further requirement 213 000

* Existing debtors are allowed 2 months credit. The extra month will represent a further 50%.

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6.11
CROWE (PTY) LTD

Income statement of Crowe (Pty) Ltd

for the year ended 31 December 20.0
Sales 100,000
Cost of sales (85%) 85,000
Gross profit 15,000
Less: Expenses: 5,000
Interest 2,000
Other 3,000
Net Profit before Tax 10,000
Taxation 5,000
Net income 5,000
Dividends (4,40 x 500) 2,200
Retained income for the year 2,800
Retained income: beginning 24,200
Retained income: end 27,000

Balance sheet of Crowe (Pty) Ltd at 31 December 20.0

EQUITY AND LIABILITIES
Share capital - 500 ordinary shares of R1 each 500
Retained income 27,000
Shareholders' interest 27,500
Long-term liabilities 15,000
Current liabilities 20,000
62,500
ASSETS
Non-current assets 12,500
Current assets 50,000
Stock 24,000
Other 26,000
62,500

© FLYNN D K: UNDERSTANDING FINANCE AND ACOUNTING: 2ND EDITION: SUGGESTED SOLUTIONS 9

6.12
WONDER PRODUCTS LTD
a) Calculation of two ratios significant to:
20.1 20.0
i) Creditors
Current ratio [W1] 2,1:1 2,5:1
Acid-test ratio [W2] 1,1:1 1,4:1

ii) Management
Trading profit as % of capital employed [W3]28,4% 27,4%
Trading profit as % of sales 3,5% 3,8%

iii) Shareholders
Earnings per share [W4] 40c 37,2c
Dividend cover, EPS/DPS [W4] 2,7 x 2,7 x

b) Comments on changes in ratios between 20.0 and 20.1:

i) Both the current ratio and the acid-test ratio have deteriorated slightly, but are still within
acceptable limits.

ii) Return on capital employed has improved slightly; the reasons for this are not apparent.

iii) Earnings per share has increased because earnings have increased, while the number of
equity shares has remained constant. The dividend has increased in proportion to earnings,
thus maintaining dividend cover.

c) Debt/equity ratio, Long-term liabilities / Shareholders' funds

At present 10 000:23 030 43,4%

Under alternatives:
i) Issue of convertible debentures 26 000:23 030 112,9%
ii) Rights issue 10 000:39 030 25,6%
iii) Issue of debentures 26 000:23 030 112,9%

d) Effect on earnings per share:

At present R4m/10M = 40c
Under alternatives:
i) Basic EPS R4m + 0,5(R3,5m - R1,6m)/10m = 49,5c
Fully diluted EPS R4m + 0,5(R3,5m)/26m = 22,1c
ii) EPS R4m +0,5(R3,5m)/(10m + 20m) = 19,2c
iii) EPS R4m + 0,5(R3,5m - R2,08m/10m = 47,1

e) Comments on the most appropriate financing method:

i) Although the use of convertible debentures gives the highest earnings per share at
present, it will lead to dilution of earnings per share on conversion. Conversion will not
take place, however, until 20.6, unless there are specific earlier conversion dates.
ii) The rights issue reduces earnings per share considerably. Earnings on the new project
are well below those received on existing projects.
iii) The issue of debentures takes advantage of gearing and thus increases earnings per
share without the dilution caused by convertible debentures.
It is assumed that the company's borrowing powers permit it to issue debentures in excess of
the amount of share capital plus reserves.

© FLYNN D K: UNDERSTANDING FINANCE AND ACOUNTING: 2ND EDITION: SUGGESTED SOLUTIONS 10

Workings: WONDER PRODUCTS LTD
20.1 20.0
R'000 R'000
1. Current assets
Stock 25 426 20 231
Debtors 21 856 20 264
Bank 2 917 6 094
50 199. 46 589
Current liabilities
Creditors 20 928 16 431
Taxation 1 642 1 247
Dividend payable 1 000 900
23 570 18 578
2. Quick assets
Debtors 21 856 20 264
Bank 2 917 6 094
24 773 26 358
Current liabilities
Creditors 20 928 16 431
Dividend payable 1 000 900
Taxation 1 642 1 247
23 570 18 578

3. Return on capital employed

Capital employed
Share capital 5 000 5 000
Distributable reserves 18 030 15 530
Shareholders' funds 23 030 20 530
Loan capital 10 000 10 000
33 030 30 530

4. Earnings and dividend cover calculations

Trading profit 9 380 8 362

Less: loan interest 1 000 1 000
8 380 7 362
Less: taxation 4 380 3 642
Earnings attributable to
ordinary shareholders 4 000 3 720
Less: dividend 1 500 1 400
2 500 2 320

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6.13
GLOWORLD LTD
GLOWORLD 20.3 20.4 20.5 20.6
PROFITABILITY
Sales growth Cureent year sales/previous year 12.1% 17.7% 14.7%
1 Gross margin = Gross margin/Sales = 48.1% 46.2% 42.5% 40.4%
2 Net margin = Net Profit/Sales = 19.1% 18.6% 17.5% 18.4%
Growth in Profit to Shareholders Current year profit/previous year 9.1% 11.2% 20.5%

3 Return onAssets = Net operating profit/Total Assets = 52.0% 42.7% 34.1% 34.0%
Return on Equity (based on year 54.6% 40.0% 32.4% 29.8%
4 = Net profit / Equity at year end =
end)
Return on Equity (based on beg Net profit / Equity at beginning of the 59.6% 44.5% 39.1%
equity) year

LIQUIDITY
5 Current ratio = Cur assets/Cur Liabilities = R 1.83 per R1 R 2.19 per R1 R 2.59 per R1 R 2.20 per R1
6 Acid test ratio = [Cur assets – Inv] /Cur Liabilities = R 1.10 per R1 R 1.23 per R1 R 1.63 per R1 R 1.00 per R1

EFFICIENCY
7 Fixed asset turnover = Turnover/Fixed Assets = 4.24 times 3.77 times 3.42 times 2.76 times
8 Days’ inventory = [Inventory x 365]/Cost of sales = 87 days 109 days 97 days 107 days
9 Debtors’ collection days = [Debtors x 365]/Credit Sales = 31 days 37 days 39 days 37 days
10 Creditors’ settlement days = [Creditors x 365]/Purchases = 47 days 49 days 49 days 52 days

LEVERAGE
11 Debt ratio = Total debt/Total Assets = 48.9% 41.4% 37.4% 24.4%
12 Interest cover = Net profit before Int/Interest = 13.3 times 11.8 times 12.0 times 36.2 times

MARKET
13 Return to shareholder = [SP(end-beg)+Div]/ SP(beg) = 77.0% 35.4% 66.5%
14 Dividend yield (DY) = Dividend per share/Share price (end) = 8.2% 12.5% 10.2% 10.1%
50.1% 34.7% 31.4% 25.0%
15 Earnings yield (EY) = Earnings per share/Share price (end) =

Price earnings ratio (P/E) = = 2.0 times 2.9 times 3.2 times 4.0 times
16 Price per share/Earnings per share

NOTE
The above ratio's are a selection. Other appropriate ratio's may be selected
Profitability: This company shows an interesting decline in profitability ratio's, which could mistakenly
be interpreted as poor performance. The profitability ratio's must be seen against the sales growth.
Management seem to have introduced policies which increase turnover, being satisfied with lower
margins. This had led to the RAND value of the profit margin increasing and a consistent growth in the
profit to shareholders. They will need to watch future movements carefully, as whatever policies to
boost sales are introduced, must result in continuing growth on the "bottom-line".
Liquidity: The current ratio has been relatively consistent and well within reasonable ranges to foster
confidence that this is being managed. With the increasing turnover, inventory levels have risen (giving
customers a greater selection), and this has caused the acid test ratio to show a decline. They should
not let this ration fall much below 1:1.
Efficiency: The company, in a growth phase has invested more each year in non-current assets. This
has had a negative effect on the non-current assets to turnover ratio, but is not a cause for concern.
The other 3 working capital items are all being managed well. Debtors are being given slightly longer
to settle their accounts (thus keeping them happy and attracting more customers), inventory is
reasonably consistent between 100 and 110 days, and creditors are being kept waiting just a little
longer, to make use of the free finance, without incurring any interest penalties.
Financial Leverage: The growth in the company has had positive effects on cash, and loans have
been repaid. While this reduces the opportunity to lever shareholders profits, it also reduces risk and
makes the company more attractive to investors. The interest cover at 36 times in well within all safety
limits, and could lead to further loans (if required), being obtained at very reasonable interest rates.
Market Performance: The JSE investors have responded well to the good management of the
company and confidence in this company is growing. This is reflected in the steady climb of the share
price over the last 3 years from R6.10, to a remarkable R17.85 a the end of the 20.6 financial year.
There is no reason to indicate that this growth pattern will not continue.
end

© FLYNN D K: UNDERSTANDING FINANCE AND ACOUNTING: 2ND EDITION: SUGGESTED SOLUTIONS 12

6.14
ATHLETICS LIMITED
(a) Liquidity and current asset management

LIQUIDITY AND CURRENT ASSETS 20.01 20.00 Industry

Current Ratio (:1) 1.89 2.27 2.00
Acid Test Ratio (:1) 0.79 1.13 1.00
Stock turnover (times) 4.1 5.0 6.00
Days Inventory (days) 119 99 unknown
Debtors Collection (days) 52 49 40.00
Creditors Payment (days - using COS) 28 29 unknown

Comment
The company's liquidity position has deteriorated over the year. In 20.0 the company's current and
quick ratios were slightly above the industry averages. In 20.1, these ratios are below the industry
averages. The lower current ratio is not supported by more effective management of stock.
Stock is a significant percentage of current assets. The stock turnover ratio of 4.1 x is lower than that
in 20.0 and is substantially below the industry average. There may be significant quantities of
unsaleable or obsolete stock on hand.
The company is taking a substantially longer time than the industry in collecting its accounts
receivable. The collection period has increased slightly in 20.1. This may indicate that certain debts
All the indicators point towards a deteriorating liquidity position during the year. Moreover all indicators
are below the industry norm. The acid-test ratio is particularly significant and reflects an increase of
21% in debtors, a decline of 38% in funds at the bank and an increase of 13% in accounts payable.
Stock turnover has declined, debtor’s collection period has increased and creditors settlement period
has decreased, thus extending the cash collection period by circa 24 days. There are thus warning
signals regarding possible future liquidity problems. These can be addressed in a number of ways, but
particular attention must be paid to moving stock and collecting cash from debtors.
(b) Use of Debt

USE OF DEBT 20.01 20.00 Industry

Debt ratio (Total debt to Total Assets) 58.2% 53.4% 50.0%
Times Interest earned 3.6 5.5 6.0

Comment
The company is relatively highly geared. The debt ratio of 58.2% compares unfavourably with the
industry. In addition, the company's debt ratio is higher than in the previous year.
The times interest earned ratio is almost half the industry average and is significantly below the prior
year figure.
The above clearly illustrate that the financial risk of the company is higher than average.
The company's increased investment in debtors and stock has been financed through the use of short-
term loans. The acquisition of Non-current assets has also been financed through the use of short-
term borrowings. Non-current asset acquisitions should rather be financed with long-term debt, than
short-term.
One basis of calculation of the debt ratio includes all debt to total assets. On this basis the company
has increased its debt component relative to equity in the financing of assets. This increases the
financial risk of the company but may also offer further leverage to shareholders. However, as 20.1
was not a growth year, shareholders have had to bear the additional interest burden. It would seem
that interest rates rose during 20.1, as the interest expense has risen by a relatively greater proportion
than the increase in interest bearing debt.

© FLYNN D K: UNDERSTANDING FINANCE AND ACOUNTING: 2ND EDITION: SUGGESTED SOLUTIONS 13

It is the interest expenses which has resulted in a lower net income before taxation. This is reflected in
the smaller times interest earned ratio. This decline will be of concern to debt holders who may
perceive a risk of interest default. They may respond by requesting capital repayment or by increasing
the interest rate further to compensate for the higher risk. The problem lies with short term loans,
which should be repaid as early as possible. The possibility will materialise if the negative liquidity
trend can be reversed.

(c) Calculation of headline earnings and dividends per share

Profit available to shareholders 275 400
Less: Preference dividend 32 400
Net Income attributable to ordinary shareholders 243 000

Number of shares in issue 675 000

Earnings per share R243 000/675000 = 36 cents per share

Ordinary dividend R40 500

Dividend per share R40 500/675 000 = 6 cents
Earnings yield 36c/R4,70 = 7.7%
Dividend yield 6c/R4,70 = 1.3%

© FLYNN D K: UNDERSTANDING FINANCE AND ACOUNTING: 2ND EDITION: SUGGESTED SOLUTIONS 14

6.15

NEVRON HOLDING LTD

Below is a list of the main ratio’s which would be calculated in order to perform a thorough
fundamental analysis of this company. Each sub section can be responded to by reference to the
numbers.

BASIC BALANCE SHEETS

20.1 20.2 20.3
35,670 41,555 73,678 NCA

8,750 8,750 3,400 INVESTMNTS

21,834 21,455 12,788 NWC

66,254 71,760 89,866

42,788 46,344 58,932 EQUITY

23,466 25,416 30,934 DEBT

66,254 71,760 89,866

21,834 21,455 12,788 NET WORKING CAPITAL

66,254 71,760 89,866 NET ASSETS

PROFITABILITY 20.1 20.2 20.3

Markup 99.9% 99.1% 80.0%
Gross Margin 50.0% 49.8% 44.4%
Net Margin 17.0% 17.6% 14.4%
Return on Assets 22.1% 21.5% 22.2%
RAO(BIAT) 13.3% 13.4% 13.2%
Return on Equity 17.3% 18.1% 17.6%
LIQUIDITY 20.1 20.2 20.3
Current ratio 3 52/100 3 16/100 1 83/100
Quick ratio 1 97/100 1 57/100 99/100
Cash ratio 53/100 9/100 16/100
SOLVENCY (Gearing) 20.1 20.2 20.3
Total debt ratio 42.9% 43.3% 44.0%
Debt to Equity ratio (Net Assets) 35.4% 35.4% 34.4%
LT Debt/Total Assets 31.3% 31.1% 29.4%
Times interest earned 3.9 4.3 4.0
MANAGEMENT 20.1 20.2 20.3
Days inventory 226 240 116
Days debtors 105 112 65
Days creditors 95 96 113
NWC turnover 2.0 2.2 5.6
FA turnover 1.2 1.2 1.0
MARKET 20.1 20.2 20.3
Price Earnings (P/E) 7.0 6.3 6.9
Dividend yield (DY) 8.5% 9.1% 0.0%
Earnings yield (EY) 14.3% 15.8% 14.5%
Return ot Shareholder n/a 10.4% 39.3%

© FLYNN D K: UNDERSTANDING FINANCE AND ACOUNTING: 2ND EDITION: SUGGESTED SOLUTIONS 15

(a) Materials have been marked up by 80%, instead of 100%. This reduction in mark up has led
to an increase in revenue from contracts of 50,8% (72162/47833) and an increase in return on
assets from 21,5% to 22,2% which is a reasonable increase considering it is the first year
under the new policy. Lower material mark up has led to more contracts, thus increasing the
salary and wage expense by 50% (5 179/3 432).
(b) Changes in working capital management policy were due to:
Reduce debtor's days as above.
Increase creditors collection period days as above.
Reduce days inventory days as above.
These policies have been implemented successfully, particularly debtors collection and
stock turnover. The impact has been reduction in liquidity, but not below norms, which are
acceptable. Cash resources are considerably improved from 20.5.
(c) To finance the expansion of Non-current assets, which increased by 77% (73 678/41 555), the
major sources were used:
New share issue (350 shares @ R6,28)
No dividends were paid in 20.6
Additional long-term loans were raised (R5 518)
Investments were liquidated (R5 350)
Working capital policy changes (Release of R8 667)
The additional financing has thus come both from shareholders and from further debt. The debt
equity ratio has thus remained reasonably constant. The impact on ROE is not apparent using
conventional accounting ratios, because the equity base in 20.6 is inflated by the non-payment
of dividends. The share market has however reacted by discounting expected future profits into
the share price.
(d)
Shareholders Equity : R70 000 Assuming no additional share issue, no dividend payment
and a return on equity during 20.7 of around 20%
Long Term Loans : R37 000 Assuming we retain the present capital structure and growth of
around 20%.
Gross Margin : R40 000. The new policy of lower mark up on material is attracting
additional contracts. An increase in gross margin of at least 20% therefore seems
appropriate.

© FLYNN D K: UNDERSTANDING FINANCE AND ACOUNTING: 2ND EDITION: SUGGESTED SOLUTIONS 16

6.16

LEISURE TIME (PTY) LTD

20.2 20.3 20.4

Total Assets 1,000,000 1,300,000 1,894,000

Growth in Sales :(LT Ltd) 20.30% 20.00% 20.50%

(Industry) 8.75% 9.98% 10.02%

Gross Margin : (LT Ltd) 36.60% 37.70% 39.60%

(Industry) 34.20% 35.10% 36.20%

Net Income Sales (LT Ltd 6.26% 5.62% 5.54%

(Industry) 5.75% 5.80% 5.81%

Return on Assets: (LT Ltd) 11.30% 9.79% 9.26%

(Industry) 10.50% 10.80% 11.20%

Return on Equity: (LT Ltd) 17.10% 15.50% 13.90%

(Industry) 13.26% 13.62% 14.16%

LT Ltd has achieved a significant growth in sales, which is in excess of the inflation rate, whereas the
industry has not achieved a real volume growth. They have improved on their margin, which indicates
that they have managed to obtain good selling prices for their goods and/or have obtained good cost
prices from suppliers. The other expenses, including interest have however risen and the decline in
net profit margin is a cause for concern. This has resulted in a serious decline in return on assets and
equity. This trend will have to be reversed for LT Ltd to be an attractive investment opportunity.

end

© FLYNN D K: UNDERSTANDING FINANCE AND ACOUNTING: 2ND EDITION: SUGGESTED SOLUTIONS 17

 6.17
NUANCE TRONICS LTS

PROFITABILITY 20.0 20.1 20.2

Markup 108.5% 107.7% 52.9%
Gross Margin 52.0% 51.9% 34.6% MARKET 20.0 20.1 20.2
Net Margin 23.0% 23.7% 6.4% Price Earnings (P/E) 7.0 7.5 11.0
Return on Total Assets 25.2% 22.3% 10.7% Dividend yield (DY) 4.1% 4.7% 8.4%
RAO(BIAT) 17.7% 16.7% 7.5% Earnings yield (EY) 14.3% 13.4% 9.1%
Return on Equity 24.4% 22.0% 8.4% Return ot Shareholder n/a 21.3% -38.9%
LIQUIDITY 20.0 20.1 20.2 DUPONT 20.0 20.1 20.2
Current ratio 3.52 3.18 2.60 Net Profit to Sales 23.0% 23.7% 6.4%
Quick ratio 1.97 1.59 1.03 [Income Stream]
Cash ratio 0.53 0.11 0.13 Sales Total Assets 68.5% 62.2% 64.9%
SOLVENCY (Gearing) 20.0 20.1 20.2 [Investment Stream]
Total assets to Equity 154.6% 149.6% 201.9%
Total debt ratio 35.3% 33.2% 50.5%
[Financing Stream]
Debt to Equity ratio (Net Assets) 34.4% 31.1% 60.3%
RESULTS IN ROE 24.4% 22.0% 8.4%
LT Debt/Total Assets 22.2% 20.8% 29.9%
Times interest earned 9.5 8.3 2.2
MANAGEMENT 20.0 20.1 20.2
Days inventory 226 240 279
Days debtors 100 107 104
Days creditors 95 96 155
NWC turnover 2.1 2.3 2.0
FA turnover 1.3 1.0 1.4

The report should contain

 An introduction stating the objective of the report

 A Table with a selection of 8 of the above possible ratios
 Reasons for the financial deterioration as measured by accounting ROE and market RTS
 Suggestions for action to be taken.

Possible reasons
 Pressure on margins (competitors, wrong choice of inventory, increasing costs)
 Strategic decisions to lower prices and increase turnover, which has not come to fruition
 Pressure on costs for additional employees and/or salary and wag increases.
 Pressure on other costs probably for advertising and marketing
 Stock not moving, resulting in longer creditors settlement, which may incur interest, or refusals to
supply.
 Slow liquidity leading to incurrence of more long-term debt and therefore higher perception of
financial risk and resultant higher cost of equity.

By far the most pressing issue is to move the Inventory as a matter of urgency.

END

© FLYNN D K: UNDERSTANDING FINANCE AND ACOUNTING: 2ND EDITION: SUGGESTED SOLUTIONS 18