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INSTITUTE OF CHARTERED ACCOUNTANTS (GH) REMEDIAL CLASSES-KUMASI

Lecture notes on ratio analysis


Compiled Suglo A. [JANUARY 2009]

Interpretation of accounts
This topic will be treated under the following headings Horizontal analysis Vertical Analysis Ratio analysis Cash flow statement Value added statement

Horizontal Analysis The mechanics of horizontal analysis between two periods are very simple. Horizontal analysis refers to the study of an individual item in the financial statement over a period of time. Typically, under this method, percentage change (increase or decrease) in one item from one period to another is computed. Usually, a base year is selected in relation to which increase or decrease are compared. The percentage change (positive or negative) for each item in the financial statements between two periods needs to be calculated. Usually, the percentage changes are calculated for all balance sheet items and profit and loss items over two successive years. Although the calculations are straightforward, the skill rests with their interpretation. What do the percentages mean? Which changes are significant and warrant detailed analysis? Which changes require an explanation so that we can determine whether or not we need to implement rectifying measures?

23.5 Vertical analysis common size statements Vertical analysis concentrates solely on one years financial statements, rather than comparing a number of years. Common size statements express all items in each financial statement as a percentage of a selected figure. For instance, all items in the profit and loss account can be expressed in terms of turnover; and all items in the balance sheet can be expressed in terms of capital employed or total shareholders funds. Total assets can also be used as a basis for dividing all balance sheet items. Compiled by Suglo Abdulai Page 2

The advantages of vertical analysis are as follows: Common size statements allow comparisons between companies of different sizes. However, as with ratio analysis, particular care should be taken to ensure the comparison of like companies with like. The balance sheet will identify changes in financial structure relative to the total capital employed or total shareholders funds. The profit and loss account will identify changes in expenses relative to turnover. As all figures are expressed as annual percentages, this will redress many of the distortions of inflation. However, different financial statement items might be affected by different specific rates of inflation. The disadvantages of common size statements are as follows: Accounting policies might distort changes in financial structure and expenditure. Common size statements eliminate the concept of different-sized companies so that comparison is possible. However, the actual size of a company determines the specific risks to which the company is subject to.

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Illustration Kofi Nyame Ltd Income Statement for the year ended 31 December 2008 2007 GHm GHm Sales 69,169 52,857 Cost of goods sold 57,292 45,179 Gross profit 11,877 7,678 Selling & admin expenses 5,353 5,547 Profit before interest and taxes 6,524 2,131 Interest expense 875 1,245 Profit before tax 5,649 886 Taxes 1,977 310 Profit after tax 3,672 576 Balance Sheet as at 31 December 2008 Assets: Cash Debtors Stock Total current assets Property; plant and equipment Net Total Assets Liabilities and Equity Current liabilities Trade creditors Accrued Expenses Total current liabilities Long term debt Total liabilities Preference shares capital Ordinary share capital Retained earnings Total liabilities and equity GHm 1,031 6,652 6,700 14,365 4,496 18,861 2007 GHm 2,025 5,109 10,611 17,745 4,253 21,998

2,331 5,158 7,489 7,825 15,314 40 129 3,378 18,861

1,184 4,803 5,987 15,600 21,587 17 138 256 21,998

Required: a) Make the computations necessary for vertical analysis b) Make the computations necessary for horizontal analysis

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a) Vertical analysis Kofi Nyame Ltd Income Statement for the year ended 31 December 2008 2007 GHm Percent GHm Sales 69,169 100% 52,857 Cost of goods sold 57,292 82.8 45,179 Gross profit 11,877 17.2 7,678 Selling general and Administrative expenses 5,353 7.7 5547 Profit before interest and taxes 6,524 9.5 2,131 Interest expense 875 1.3 1245 Profit before tax 5,649 8.2 886 Taxes 1,977 2.9 310 Profit after tax 3,672 5.3% 576 Kofi Nyame Ltd Balance Sheet as at 31 December 2008 Assets: GHm Percentage Cash 1,031 5.5 Debtors 6,652 35.2 Stock 6,700 35.5 Total current assets 14,365 76.2 Property; plant and equipment 4,496 23.8 Net Total Assets 18,861 100 Liabilities and Equity Current liabilities Trade creditors Accrued Expenses Total current liabilities Long term debt Total liabilities Preference shares capital Ordinary share capital Retained earnings Total liabilities and equity

Percent 100% 85.5 14.5 10.5 4.0 2.4 1.6 0.6 1.0%

2007 GHm 2,025 5,109 10,611 17.745 4,253 21,998

Percent 9.2 23.2 48.2 80.6 19.4 100

2,331 5,158 7,489 7,825 15,314 40 129 3,378 18,861

12.4 27.3 39.7 41.5 81.2 0.2 0.7 17.9 100

1,184 4,803 5,987 15,600 21,587 17 138 256 21,998

5.4 21.8 27.2 70.9 98.1 0.1 0.6 1.2 100

The comparative balance sheet on percentages base is called common size balance sheet.

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b) Horizontal analysis Kofi Nyame Ltd Income Statement for the year ended 31 December 2008 2007 GHm GHm Sales 69,169 52,857 Cost of goods sold 57,292 45,179 Gross profit 11,877 7,678 Selling & administrative 5,353 5,547 Profit before interest and taxes 6,524 2,131 Interest expense 875 1,245 Profit before tax 5,649 886 Taxes 1,977 310 Profit after tax 3,672 576 Add income surplus b/d 256 230 Less dividend 550 550 Income surplus b/d 3,378 256

Change GHm 16,312 12,113 4,199 194 4,393 370 4,763 1,667 3,096

% change 30.8% 26.81 54.69 3.5 206.15 29.72 537.58 537.74 537.74

The horizontal analysis of Kofi Nyame Ltd balance sheet will also be as follows Kofi Nyame Ltd Balance Sheet as at 31 December 2008 2007 Change % change Assets: GHm GHm GHm Cash 1,031 2,025 (994) (49.09) Debtors 6,652 5,109 1,543 30.20 Stock 6,700 10,611 (3,911) (36.86) Total current assets 14,365 17,745 3,380 (19.05) Property: plant and equip. (net) 4.496 4,253 243 5.71 Total Assets 18,861 21,998 (3,137) (14.26) Liabilities and Equity: Current liabilities Trade creditors Accrued Expenses Total current liabilities Long term debt Total liabilities Preference shares capital Ordinary share capital Retained earnings Total liabilities and equity

2,331 5,158 7,489 7,825 15,314 40 129 3,378 8,861

1,184 4,803 5,987 15,600 21,587 17 138 256 21,998

1,147 96.86 355 7.39 1,502 25.09 (7,775) (49.84) 6,273 (29.06) 23 135.29 (-9) (6.52) 3,122 1,219.53 (-3137) 14.26

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Exercise From the following financial statements of Doma Ltd, perform common size analysis. Income statement for the year to 31 March 2008 GHm Sale revenues Operating costs Operating profit before interest Interest expense Interest taxes Profit before tax Income taxes Net profit for the year Dividends paid Retained profit for the year Summarized balance sheets at: Tangible assets Intangible assets Current assets Inventories Trade receivables Interest receivable Investments Cash Total assets Shareholders equity: Ordinary shares 1 each 10% 1 Preferred shares Revaluation surplus Retained earnings Non-current liabilities: Long term borrowings 6% bonds 2008/20 Finance leases Charges-deferred tax Current liabilities 31 March 2008 m 272 3 275 140 132 1 95 4 372 647 154 20 7 135 316 20 50 12 82 249 172 488 125 20 81 226 40 42 8 90 155 110 2 21 288 196 4 200 355 (235) 120 (7) 3 (4) 116 (32) 84 (20) 64 31 March 2007 m GHm

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Total liabilities and shareholders equity

647

488

RATIO ANALYSIS 1.0 Introduction.


Accounting ratios identify irregularities, anomalies and surprises that require further investigation to ascertain the current and future financial standing of a company. Ratios describe the relationship between different items in the financial statements. Obviously, we could calculate hundreds of ratios from a set of financial statements; the expertise lies in knowing which ratios provide useful information. The relative usefulness of each ratio depends on what aspects of a companys business affairs are being investigated. Ratio analysis can be applied to financial statements and similar data in order: To assess the performance of the company To determine whether the company is solvent and financially healthy. To assess the risk attached to its financial structure To analyse the returns generated for its shareholders and other interested parties

1.1 User Groups


Various groups are interested in the performance and financial position of a company. These groups include: Management, who will use comparison to ensure that the business is performing effectively and according to plan, Employees, trade unions and so on Government Present and potential investors will assess the company with the view to judging whether it is a sound investment. Lenders and suppliers will like to judge its credit worthiness

1.2 Comparison/Benchmarking
Using ratio analysis in isolation has little or no significance. To be meaningful, ratios must be interpreted by comparing them to appropriate benchmarks or yardsticks. An Compiled by Suglo Abdulai Page 8

important lesson about ratios is that, if they are applied incorrectly, they may be completely useless or, perhaps even worse, misleading. However, if they are used correctly, they are a powerful tool for understanding and interpreting company accounts. Thus bases of comparison include: Past periods. This is done by comparing the ratio which has been calculated with the same ratio but for a previous period. In this way it is possible to detect whether there has been an improvement or deterioration in performance .This is often referred to as Time or Trend analysis. Thus ratios may be compared with the companies own records over years or periods. Industry analysis: The companies records are compared with industry average to ascertain its performance. Apart from comparing with the industry average, ratios can also be compared with ratios of competitor companies (similar business) in the industry in order to find out how the company fares in the industry. Planned performance expectations: Ratios may also be compared with targets that management have developed before the start of the period under review. The comparison of planned performance with actual performance may therefore be a useful way of revealing the level of achievement attained. However the planned level of performance must be based on realistic assumptions if they are to be useful for comparison purposes. In each case, comparison is possible only if an identical basis of compilation is employed. There must be conformity and uniformity in the preparation of accounts to ensure a comparison of like with like. In addition, if one is comparing companies in different countries, one needs to be aware of any difference in international accounting policies. In analyzing financial statements, other items of information should be looked including: The content of any accompanying commentary on the accounts and other statements The age and nature of the companys assets Current and future developments in the companys management, at home and overseas, recent acquisitions or disposals of a subsidiary by the company

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Any other noticeable features of the report and accounts, such as post balance sheet events, contingent liabilities, a qualified auditors report, the companys taxation position.

1.3 The Broad Categories of Ratios: Five Broad categories of ratios can be identified: Profitability Liquidity of short term solvency Activity or efficiency ratios Gearing ratios Shareholders or investment ratios

1.3.1 Profitability Ratios


Businesses generally exist to with the primary purpose of creating wealth for their owners. Profitability ratios measure the degree of success in achieving this purpose. They express the profits made in relation to other key figures in the financial statements or to some business resource. They are used, among other things, to measure the performance of management, to identify whether a company will be a worthwhile investment opportunity, and to determine the companys performance in relative to its competitors. The following ratios may be used to evaluate the profitability of a business: Return on ordinary shareholders fund / Return on equity Return on capital employed Net profit margin Gross profit margin Asset turnover

These are now discussed in turn. a) Returns on equity The return on ordinary shareholders fund / Return on equity compares the amount of profit for the period available to the owners average stake in the business during the same period. The higher this values the better. This value should be compared to the return the shareholders, could get elsewhere to determine whether they are getting a fair Compiled by Suglo Abdulai Page 10

return. Naturally the risk involved in the business is also a factor. Normally an investor in a high risk type business expects a higher return. Management must be aware that if the return is below average, this will have a negative impact on sustained growth of the companys own resources. The formula which is normally expressed in percentage terms is as follows: Return on equity (ROE) = Profit after tax and preference dividend (if any) Ordinary share capital plus reserves b) Return on capital employed (ROCE). The return on capital employed is a fundamental measure of business performance. The ratio expresses the relationship between the net profit generated during a period and the average long-term capital invested in the business during the period. Thus the ratio compares the profit earned to the funds used to generate that profit. The absolute value of profit earned is not, in itself, significant since the size of the business and earnings may vary enormously. It is significant to consider the size of the profit figure relative to the size of the business, size being expressed in terms of the quantity of capital employed by the business. The return on capital employed, therefore, is the ratio which measures the relationship between profit and the capital employed by the business. The ROCE is a fundamental measure of the profitability of a company. It is a popular indicator of management efficiency because it contrasts the net profit generated by the company with the total value of fixed and current assets, which are presumed to be under management control. Therefore, the ROCE demonstrates how well the management has utilized total assets. ROCE is the often most important measure of profitability, hence it is known as the primary ratio. It is given by the formula: ROCE = Net profit before interest and tax Capital Employed (total assets less current liabilities) Or profit Before Interest & Tax (PBIT) % = Share Capital + Reserves employed + long term loans Compiled by Suglo Abdulai Page 11

When calculated, ROCE is often compared with management target return. It is often termed as the proprietary ratio. This is an important indicator and should be carefully compared to the industry average. There are no fixed norms, but return of at least 5% would generally be regarded as a minimum. In some industries, like consulting, it could be as high as 40%.

c) Net profit margin Net profit margin is another widely used ratio in the assessment of company performance and in comparisons with other companies. It relates the Net Profit for the period to sales revenue during the period. A higher margin generally suggests good performance, but the profit should not be taken at face value. When analysing profit margin we should ask questions such as why the profit margin is higher than average, or why it is lower than it was last year or whether the company management is setting the profit margin strategically. This ratio is also called operating profit margin and it indicates the efficiency with which costs have been controlled in the generation of profit from sales. It is given by the formula: Net profit margin: Profit before interest and tax x 100% Sales or turnover d) Gross profit margin It relates the Gross Profit for the period to sales revenue during the period. Gross Profit represents the difference between sales revenue and the cost of sales. The ratio is therefore a measure of profitability in buying (or producing) and selling goods before any other expenses are taken into account Gross Profit Margin = Gross profit % Sales The Gross Profit Margin is expected to remain reasonably constant. This ratio shows how well costs of production have been controlled. It is given by the formula:

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1.3.2 Liquidity Ratios:


Liquidity is ratios are concerned with the ability of the business to meet its short-term financial obligations as they fall due. Two ratios often used to measure liquidity or short term solvency are: A) Current Ratio The current ratio is a short-term measure of a companys liquidity position. This ratio (which should be appraised in conjunction with the acid test ratio) compares current assets with current liabilities. In cases where the value is greater than unity, the common asset value exceeds the value of current liabilities. It is often claimed that the current ratio should be greater than 2, but the recommended current ratio depends (as always) on the industry sector and each individual companys experience. Thus it compares total current assets to total current liabilities and is intended to indicate whether there are sufficient short-term assets to meet the short-term liabilities. Thus it shows the ability of a company to pay current liabilities out of current assets and it is given by the formula: Current Ratio = Current assets :1 Current liabilities This ratio when calculated may be expressed as either a ratio to 1, with current liabilities set one, or as a number of times representing the relative size of the amount of total current assets compared with total current liabilities. The higher this value the better. A value of 2.00, which is usually regarded as a standard for this ratio, means that liabilities are covered twice by the assets. A value of less than 1.00 means that the current liabilities of the company exceed its current assets, which could indicate a serious situation. What if the current ratio increases beyond the normal range? This may arise for a number of reasons, some beneficial, others unwelcome. Beneficial reasons A build-up of inventory in order to support a recent advertising campaign or increasing popular demand as for, say, a Play Station. Management action will be to establish from a cash budget that the company will not Compiled by Suglo Abdulai Page 13

experience liquidity problems from holding such stock, e.g. a short-term loan, extended credit or bank overdraft may be appropriate. A permanent expansion of the business which will require continuing higher levels of inventory. Management action will be to arrange additional finance, e.g. equity or long-term borrowings to finance the increased working capital. Unwelcome reasons Operating losses may have eroded the working capital base. Management action will vary according to the underlying problem, e.g. implementing a cost reduction programme, disposing of underperforming segments, arranging a sale of assets or inviting a takeover. Inefficient control over working capital, e.g. poor inventory or accounts receivable control. Adverse litigation, e.g. liability to employees for asbestosis. Adverse trading conditions, e.g. inventory becoming obsolete or introduction of new models by competitors.

B) Acid test This ratio shows the ability of the business to pay current liabilities out of quick assets, in other words assets which are either cash or quickly convertible into cash. This excludes the value of inventory. Inventory is omitted as it is considered to be relatively illiquid, because it depends on prevailing and future market forces and may be impossible to convert to cash in a relatively short time. The higher this value is the better. It is denoted by the formula: Acid test: current assets- inventory : 1 Current liabilities Compiled by Suglo Abdulai Page 14

A value of 1.00 which is usually regarded as the standard for this ratio means that the liabilities are covered by quick assets.

1.3.3 Activity (efficiency) Ratios


These ratios may be used to show the efficiently with which particular resources have been used within the business. For each ratio, the average value for the year should be used, e.g. average level of debtors should be used in calculating debtors ratio, but it is usual for the year end value to be substituted in order to obtain figures for comparative purposes. A number of ratios that can be used to calculate activity ratios include: a) Inventory turnover This ratio shows on the average how many times in a month the inventory is turned over. For example, a value of 50 means that the inventory turns over every two months. The higher this value is, the quicker the inventory is being turned over. It is given by the formula: Inventory turnover: Cost of sales Closing inventory There is no specific standard value, and you should use industry averages as well as your own period-to-period comparatives to measure your performance. Inventory days This ratio shows on the average how many days an item is held in inventory prior to being sold. For example, a value of 13.00 indicates that items remain in inventory for 13 days on average prior to being sold. It is given by the formula: Inventory days: Closing inventory 365 days Cost of sales An increasing value could indicate less efficiency purchasing and /or too high inventory holding, where as a decreasing number could indicate more efficient purchasing. There is no standard value, and you should use industry averages as well as your own period-to-period comparatives to measure your performance.

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b) Customer days or collection period: This ratio shows the average number of days it takes customers to pay their accounts. For example a value of 33.00 means that, customers take 33 days on the average to pay you. An increasing value indicates inefficiency in collecting outstanding debt, where as a decreasing value indicates an increase in efficiency in collecting debt. It is denoted by the formula: Customer days: Accounts receivable 365 days Credit sales (or turnover) There is no standard value and you should use industry averages as well as your own period-to-period comparatives to measure your performance.

c) Supplier days or Payment period This ratio shows the average number of days it takes you to pay your suppliers. for example a value of 33.00 means that you pay your suppliers on average 33.00 days after your purchase. Supplier days: Accounts Payable Sales An increasing value means that you are taken more days to pay your suppliers and a decreasing value indicates that you are paying quicker. There is no specific standard value and you should industry averages as well as your own period-to- period comparatives to measure your performance. d) Sales Revenue to capital employed (Net asset turnover) ratio Sales revenue to capital employed ratio or net asset turnover ratio examines how efficiently the assets of a business are being used to generate sales revenue. It is calculated as follows: Fixed asset turnover = Sales or turnover Capital employed Generally speaking, higher sales revenue to capital employed ratio is preferred to a lower one. A higher ratio will normally suggest that the long-term capital invested in assets is being used productively in the generation of revenue. However, a very high ratio may Compiled by Suglo Abdulai Page 16

suggest that the business is over trading on its assets, that is it has insufficient capital (net assets) to sustain the level of sales revenue achieved.

e) Sales revenue per employee


The sales revenue per employee relates sales revenue generated to a particular business resource, that is, labour. It provides the productivity of the work force. The ratio is:

Sales revenue per employee =

Sales revenue No. of employees

Generally a business would prefer to have a high value for this ratio, implying that they are using their staff efficiently

f) The cash Operating Cycle/ Working Capital Cycle


This indicates the length of time it takes a business to convert its stocks into sales (stock turnover period), convert debtors into cash (debtors collection period) and mobilizes cash to pay its trade creditors (creditors payment period). It is the summation of the inventory period and debtors period less creditors days. The longer the period the worse it is for the business because the longer the period the higher the working capital requirement. It is therefore essential that under normal circumstances, a company works towards reduction of the stock turnover period and the debtors period and the expansion of the payment period.

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1.3.4 Gearing Ratios


The gearing ratio represents the proportion of capital employed which is accounted for by long-term fixed-interest debt. The gearing structure of a company refers to the amount of borrowing compared with the amount of shareholders funds. A company with high gearing is predominantly financed by debt, whereas a company with by gearing relies on equity finance. Different user groups prefer different gearing structures. Creditors interest payments and earnings per share. Debt and gearing ratios are concerned with a companys long-term stability: how much a company owes in relation to its size, whether it is getting into heavier debt or improving its situation, and whether its debt burden seems heavy or light.

a) Capital Gearing Ratio This ratio provides the proportion of debt finance (prior charge capital) employed by a company. Long term debt includes debentures, loan stock, preference shares and bank loans. It is denoted by the formula: Capital Gearing Ratio = long-term debt Capital employed or total capital Generally, a company may be considered highly geared if capital gearing is greater than 50 per cent. Lower than 50 percent means the company is lowly geared. b) Debt/ equity ratio: This ratio serves a similar purpose to capital gearing. It is given by the formula: Debt/equity ratio = Long-term Debt Ordinary share capital and reserves Generally a company is highly geared if the ratio is greater than 100 per cent. c) Interest Cover This ratio shows whether enough profits are being earned to meet interest payments when due. It is given by the formula: Interest cover = Net profit before interest and tax Interest charges Usually interest cover of between 3 and 7 is regarded as safe while a figure below 3 is regarded as risky. Compiled by Suglo Abdulai Page 18

The implications of High or low gearing


Gearing is the relationship between a companys equity capital (also known as residual capital) and reserves and its fixed return capital. A company is highly geared if it has a substantial proportion of its capital is in the form of preference shares or loan notes. The problem with highly geared company is that, by definition, there is a lot of debt. Debt generally carries a fixed rate of interest (or a fixed rate of dividend if in the form of preferred shares), hence there is a given (and large) amount to be paid out from profits to holders of debt before arriving at a residue available for distribution to the holders of equity. The more highly geared a company, the greater the risk that little (if anything) will be available to distribute by way of dividend to the ordinary shareholders. A company is said to have low gearing if only a small proportion of its capital is in form of preference share or loan notes. A company financed entirely by equity shares has no gearing. Gearing affects: (a) (b) The creditworthiness on the company The potential return to ordinary shareholders.

1.3.5 Shareholder / Investment ratios


These are various ratios available that are designed to help investors assess the returns on their investment. They indicate how well a company is performing in relation to the price of its shares and other related items including dividends and number of shares in issue. The following ratios are commonly used: Dividend payout ratio Dividend yield our ratio Earnings per share Price /earnings ratio Dividend cover Page 19

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a) The dividend payout ratio measures the proportion of earnings that a business pays out to shareholders in the form of dividends. The ratio is calculated as follows: Dividend payout ratio: dividend declared for the year x 100% Earnings for the year available for dividends The earnings available for the year will normally be the net profit after taxation and preference dividends. b) Dividend yield Dividend yield ratio relates the cash return from a share to its current market value. This can help investors to assess the cash return on their investment in the business. The formula is given as Dividend yield = Dividend per share (DPS) Market price per share (MPS) Or Dividend per share (DPS)/( 1-t) Market price per share (MPS) Where t is the rate of income tax

b) Earnings per share (EPS) The earnings per share (EPS) ratio relates the earnings generated by the business, and available to shareholders, during a period to the number of shares in issue. It indicates how much a companys profit can be attributed to each ordinary share. It is given by the formula: EPS = Profit after tax and preference dividends Number of ordinary shares in issue This is regarded as a key ratio by stock market investors. c) Dividend covers This compares the amount of profit earned per ordinary share with the amount of dividend paid, thereby showing the proportion of profits that could have been distributed, and were actually distributed. It is given by the formula: Dividend cover = Profit after tax and preference dividends Net Dividend on ordinary shares d) Price Earnings (P/E) ratio Compiled by Suglo Abdulai Page 20

The P/E ratio relates to the market value of a share to the earnings per share. Basically it compares the capital value of a business to current value of earnings. It therefore gives an indication of the confidence of investors in the expected future performance of a company, relative to other companies. It is given by the formula: P/E ratio = Market price per share (MPS) Earnings Per share (EPS)

1.4 Commenting on the ratio


Ratios are meaningless on their own, thus most marks in an exam question will be available for sensible, well explained and accurate comments on key ratios If you doubt that you have anything to say the following points should serve as usefulchecklist. What does the ratio literally mean? What does a change in ratio mean? What is the norm? What are the limitations of the ratio? Examination questions sometimes require you to write a report commenting on the performance of the company. In this case the computations may be done in the form of appendix separate from the body of the report. References will be made to the appendix and relevant ratios may be quoted from the appendix, on the body of the report. The report will follow the usual formal report style (such as addressee, subject, date, signature etc.

1.5 USES OF RATIOS Intra-firm comparison-for analyzing the operating efficiency of a firm from one year to another. Inter-firm comparison- making comparisons between the performances of one company with that of some other company. It further provides a general summary of a companys performance and other decision indicators for issues useful to both internal and external users, Accounting ratios are both useful for planning and control purposes. Page 21

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Past ratios showing the trend of a firms operations and performance may be useful for forecasting likely future events.

1.6 Limitations of accounting ratios


Flaws in accounting information may reduce the reliability of the ratios. Ratios can be manipulated to show certain desired results thereby reducing their usefulness Where two firms use different accounting policies, comparison between them using ratios may not show the true state of affairs between the firms. Comparison between firms in different industries may be misleading. Inflation can also distort the information. Ratios have restricted vision It may be difficult to find a suitable benchmark Some ratios can be misleading due to the snapshot nature of the balance sheet.

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Example one Ganja Ltd is a holding company with subsidiaries that have diversified interests. Ganja Ltd Board of directors is interested in the group acquiring a subsidiary in the communication sector. Two companies have been identified as potential acquisitions, Mobile Ltd and Fon Ltd. Summaries of these companies are as follows: Income Statement for the year ended 31st December 2008 Mobile Ltd GH000 Turnover Cost of goods sold: Opening inventory Materials Labour Factory overheads Depreciation Closing stock Gross profit Selling & admin expenses Interest Profit before taxation Taxation Profit after taxation 985 150 255 160 205 35 (155) 650 335 (124) (35) 176 (65) 111 Fon Ltd GH000 560 145 136 125 111 20 (140) 397 163 (75) (10) 78 (25) 53

Balance sheet as at 31st December 2008 Non-current assets Current asset: Inventory Receivables Bank Current liabilities: Trade payables Other Net current assets Debentures 765 155 170 50 375 235 130 365 10 (220) 555 140 395 45 580 300 125 425 155 (70) 495 Page 23 410

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Stated capital Income surplus

450 105 555

440 55 495

Required: Prepare a report for the board of directors of Ganja Ltd assessing the financial performance and position of Mobile ltd and Fon Ltd. Your report should be prepared in the context of Ganja Ltd interest in these two companies and should be illustrated with financial ratios where appropriate. You should sate any assumptions you make as well as any limitations of your analysis.

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Report To: The board of Ganja Ltd From: xxx Date: xxx Subject: Acquisition of a subsidiary in the Communication sector. Introduction: The investigation has been on the accounts of Mobile ltd and Fon ltd and should be viewed as preliminary in nature since more detailed information about the two companies will be required before any decision is made. Assumptions It is assumed that the two companies use similar accounting policies and the balance sheets are representative of the companies normal level of trading. Limitations of the analysis: The analysis is dependent on the assumption being valid. Further work should be carried out to determine whether the assumptions are reasonable. As the accounts are (presumably) prepared under the historical cost convention, the capital employed is not stated in comparable terms i.e. the fixed assets may have been purchased at different dates by the two companies (and thus at different prices). Profitability The appendix shows various profitability ratios. The performance of Mobile Ltd is better than Fon Ltd in terms of profitability to sales and profitability to assets employed. This is due to the markedly high sales per fixed asset employed. Gearing Mobile Ltd is significantly more highly geared than Fon Ltd (see appendix). However, in terms of income, the interest of Mobile Ltd is six times covered by profits which would indicate the advantage that has accrued to Mobile ltd by investing in assets through debt financing. Liquidity / working capital efficiency. The current ratio and acid test ratio are lower for mobile Ltd than for Fon Ltd. The industry averages should be examined to determine whether Mobile Ltd or Fon Ltd is in a stronger position. The debtor collection periods and stock turnover ratios indicate that Compiled by Suglo Abdulai Page 25

Mobile Ltd is in stronger position. Fon Ltd has a very low debtor collection period which indicates a complete lack of credit control. Conclusion From the above analysis it would appear that Mobile Ltd is a stronger and more profitable company. Subject to further detailed investigation and the expected cost of acquisition it may be considered the best option. However, there is ample scope to improve Fon Ltd performance by tightening up controls over working capital. Thus Fon Ltd may be a better purchase if the cost of acquisition is significantly lower than Mobile ltd. Appendix- Calculation of Ratios Mobile Ltd Profitability: Return on capital employed Profit before interest & tax x100 211 x 100 775 27.2% Gross profit x 100 Sales Net profit x 100 Sales Sales Fixed assets 335 x 100 985 34% 176 x 100 985 18% 985 = 1.3 795 88 x 100 565 15.6% 163 x 100 560 29% 78 x 100 560 14% 560 1.4 410 Total assets less current liabilities Fon Ltd

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Mobile Ltd Gearing Capital Debentures x 100 Total assets less current liabilities Interest cover Profit before interest and tax Interest Liquidity Current ratio Current assets Current liabilities Acid test Current assets-inventory Current liabilities Debtors collection period Debtors x 365 Sales Stock turnover Cost of sales Average stock 220 x 100 775 28.4% 211 = 6.0 times 35

Fon Ltd 70 x 100 565 12.5% 88 = 8.8 times 10

375 365 1.0 200 365 0.60 170 x 365 985 63 days

580 425 1.4 440 425 1.0 395 560 257 days

650 397 0.5(150+155) 0.5(145+140) 4.3 times p a 2.8 times p a

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Example two The following information has been extracted from the recently published accounts of DOG Ltd. EXTRACTS FROM THE PROFIT AND LOSS ACCOUNT Sales Cost of sales Net profit before tax This is after charging: Depreciation Debenture interest Interest on bank overdraft Audit fees BALANCE SHEET AS AT 30 APRIL 2008 GHC 1,850 Fixed assets Current assets Stock Debtors Cash Current liabilities Bank overdraft Creditors Taxation Dividends Total assets less current liabilities Long-term capital and reserves Ordinary share capital Reserves 10% debentures 640 1,230 80 1,950 110 750 30 65 955 2,845 800 1,245 2,045 800 2,845 490 1,080 120 1,690 80 690 20 55 845 2,275 800 875 1,675 600 2,275 2007 GHC 1,430 GH 11,200 8,460 465 360 80 12 10 GH 9,750 6,825 320 280 60 10 10

The following ratios are those calculated for DOG LTD, based on its published accounts for the previous year, and also the latest industry average ratios: DOG Ltd 30 April 2007 ROCE (capital employed = equity and debentures) 16.70% Compiled by Suglo Abdulai Industry average 18.50% Page 28

Profits/Sales Asset turnover Current ratio Quick ratio Gross profit margin Debtor control Creditor control Stock turnover Gearing

3.90% 4.29 2.00 1.42 30.00% 40days 37days 13.90 26.37%

4.73% 3.91 1.90 1.27 35.23% 52days 49days 18.30 32.71%

Required a) Calculate comparable ratios (to two decimal places where appropriate) for DOG Ltd for the year ended 30 April 2008. All calculations must be clearly shown. b) Write a report to your board of directors analyzing the performance of DOG Ltd, comparing the results against the previous year and against the industry average

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Answer 2007 ROCE Profit/sales Asset turnover 320 + 60 = 16.70% 2,275 20 + 60 = 3.90% 2008 465 + 80 = 19.16% 2,845 465 + 80 = 11,200 2,845 1,950 = 4.87%

Industry average 18.50% 4.73% 3.91x

9,750 = 4.29x 2,275 1,690 = 2.00 955 1,080 + 120 = 1.42 955 9,750 - 6,825 = 30.00% 9,750

= 3.94x

Current ratio Quick ratio Gross profit Margin Debtors Turnover Creditors Turnover Stock Turnover Gearing

2.04

1.90 1.27 35.23% 52 days 49days

1,230 + 80 = 1.37 11,200 - 8,460 = 24.46% 11,200

1,080 x 365 = 40days 1,230 x 365 = 40days 9,750 11,200 690 x 365 = 37days 6,825 6,825 = 13.9x 490 600 = 2,275 26.37% 750 x 365 = 32days 8,460 8,460 640 800 2,845 = 13.2x

18.30x

= 28.12%

32.71%

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To: From: Subject:

Board of Directors Management accountant Analysis of performance of DOG Ltd.

This report should be read in conjunction with the appendix attached which shows the relevant ratios (from part (a). Trading and profitability Return on capital employed has improved noticeably between the years and is also now marginally ahead of the industry average. Net income as a proportion of sales has also improved noticeably between the years and is also now marginally ahead of the industry average. Gross margin, however, is considerably lower than in the previous year and is only some 70% of the industry average. This suggests either that there has been a change in the cost structure of DOG plc or that there has been a change in the method of cost allocation between the periods. Either way, this is a marked change that requires investigation. The company may be in a period of transition as sales have increased by nearly 15% over the year and it would appear that new fixed assets have been purchased. Asset turnover has declined between the periods although the 2008 figure is in line with the industry average. This reduction might indicate that the efficiency with which assets are used has deteriorated or it might indicate that the assets acquired in 2009 have not yet full contributed to the business. A longer term trend would clarify the picture. Liquidity and working capital management The current ratio has improved slightly over the year and is marginally higher than the industry average. It is also in line with what is generally regarded as satisfactory (2: 1). The quick ratio has declined marginally but is still better than the industry average. This suggest that DOG Ltd has no short term liquidity problems and should have no difficulty in paying its debts as they become due. Debtors as a proportion of sales in unchanged from 2007 and are considerably lower than the industry average. Consequently, there is probably little opportunity to reduce this further and there may be pressure in the future from customers to increase the period of Compiled by Suglo Abdulai Page 31

credit given.

The period of credit taken from suppliers has fallen from 37 days

purchases to 32 days and is much lower than the industry average; thus, it may be possible to finance any additional debtors by negotiating better credit terms from suppliers. Stock turnover has fallen slightly and is much slower than the industry average and this may partly reflect stocking up ahead of a significant increase in sales. Alternatively, there is some danger that the stock could contain certain obsolete items that may require writing off. The relative increase in the level of stock has been financed by an increased overdraft which may reduce if the stock levels can be brought down. The high levels of stock, overdraft and debtors compared to that of creditors suggests a labor intensive company or one where considerable value is added to brought-in products. Gearing The level of gearing has increased only slightly over the year and is below the industry average. Since the return on capital employed is nearly twice the rate of interest on the debentures, profitability is likely to be increased by a modest increase in the level of gearing.

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Example three (a) Alvin Ltd is a medium-sized manufacturing company that plans to increase its capacity. The following are the most recent financial statements of the company: Profit and Loss Accounts for years ending 31 December 2006 2005 Sales Cost of sales Gross profit Administration and distribution expenses Profit before interest and tax Interest Profit before tax Tax Profit after tax Dividends Profit after taxation transferred to Income Surplus Account Balance sheet as at 31 December 2006 m Fixed Assets Current Assets Stock Debtors Cash Current Liabilities 1,170 850 130 2,150 1,150 m 6,500 2005 m m 6,400 m 5,000 (3,100) 1,900 (400) 1,500 (400) 1,100 (330) 770 (390) 380 m 5,000 (3,000) 2,000 (250) 1,750 (380) 1,370 (400) 970 (390) 580

1,000 900 100 2,000 1,280

1,000 720 7,500 7,120 10% Debentures 2007 (3,500) (3,500) 4,000 3,620 Capital and Surplus 4,000 3,620 Average data for the business sector in which Alvin Ltd. operates is as follows Gearing (book value of debt/book value of equity 60% Interest cover 4 times Current ratio 2:1 Stock Days 90 days Return before Interest and Tax/Capital Employed 25% Required: Analyse and comment on the performance of the company based on the above sector average data. (15 marks) Compiled by Suglo Abdulai Page 33

Answer question three. Alvin Ltd Computation of relevant Ratios 2006 (A) Gearing Book Value of debt/Equity (B) Interest Cover Profit before Int. & Tax/Int. Exp (C) Current Ratio Current Assets/*Current Liabilities (D) Stocks Days Average Stock/Cost of Sales *365 days (E) ROCE Profit before Int. Tax/Ca employed * 100 3500/4000*100 87.50% 1500/400 3.75 times 2150/1150 1.86:1 1170/3100*365 days 138 days 1500/7500*100 20%

2005 3500/3620*100 96.60% 1750/380 4.460 times 2000.1280 1.56:1 1000/3000*365 days 122 times 1750/7120*100 25%

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Commentary on Performance of Alvin Ltd. A)

Gearing:
This measures the proportion of equity to long-term debt. Relative to the industrial average, the companys gearing is high, but has fallen from 97% (in 2005) to 88% in 2006. The implication is that Alvin Ltd is relatively exposed to higher risk compared to other companies in the industry.

B)

Interest Cover:
This measures the number of times the companys profit can cover its interest commitments. This has fallen from 4.6 times (in 2005) to 3.75 times (in 2006) which is now lower than the average in the industry.

C)

Current Ratio:
This ratio measures the ability to pay current liabilities from the available current assets. There has been a slight improvement from 1.6 (in 2005) to 1.9 (in 2006) but this is below the industry average of 2 D) Stock Days: This shows the number of days that stock is held before it is sold. The ratio deteriorated from 122 days (in 2005) to 138 (in 2006). It is far in excess of the 90 days for the average company in the industry. The implication is that Alvin Ltd is not managing its inventory well.

E) R O C E:
This measures the ability of a company to generate sales revenue and preserve as much of it as profit through efficient cost management. Alvin Ltds R.O.C.E has declined from 25% (in 2005) to 20% (in 2006) and is now below 25% for the industry. This might be due to less effective use of assets and less efficient cost management.

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Example four The financial statements of Cocoon Ltd, a dealer in Shea-butter confectionery, are set out below: Income Statements for the Year Ended, 31st December, 2004 2005 million million Turnover Profit Before Interest and Tax Interest on Loan Taxation Dividend Retained Profit Balance Sheet as at 31st December, 2004 million Fixed Assets Stock Debtors Cash & Bank Creditors Taxation Proposed Dividend Financed By: Stated Capital Income Surplus 12% Loan 8,200 21,450 18,005 6,015 (16,500) (1,250) (1,500 34,420 10,000 2, 420 12,420 22,000 34,420 2005 million 9,800 25,760 19,800 2,225 (19,600) (2,550) (1,800) 33,635 10,000 (1,365) 8,635 25,000 33,635 230,600 12,300 (2,640) (2,705) (1,500) 5,455 249,800 15,300 (3,000) (3,444) (1,800) 7,056

Additional Information: i. The ordinary shares which were issued many years ago at 1,000 per share were being traded at the Ghana Stock Exchange at 5,000 and 6,000 per share on 31/12/04 and 31/12/05 respectively. ii. Dividends declared in 2004 and 2005 were 150 and 180 per share respectively. Required:

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(a) Prepare a detailed report analyzing the performance over the two year period under profitability, liquidity (short team solvency), long term solvency and investment. (15 Marks) Answer a) General Comment The performance of Cocoon Ltd leaves much to be desired sales increased by 8.3% over the period while net profit percentage increased by from 2.36% to2.82%. However, equity trembled by 2.3% and the reason for this is not entirely clear. Specific Comments Profitability Ratios Return on Capital Employed Profit margin: PBIT CE = PBIT Turnover = 2004 12300 x 100 34420 35.7% 12300 X 100 230600 5.3% 2005 15300 x 100 33635 = 45.5% 15300 X 100 249800 = 6.1%

Comment The ROCE and on turnover have registered significant increases over the period. These may have misled management to increase dividends by 20% which is not good for a company which appears to be facing liquidity problems as evidenced by the steep drop in cash/bank balances (63%). Investment Ratios 2004 2005 EPS = PAT No. of Shares 6955 10000 = 0.720/Share = 6955 1500 = 4.64:1 22000 x 100 22000 + 12420 = 63.9% 8856 10000 = 0.89/Share = 8856 1800 4.92:1 25000 x 100 25000 + 8635 = 74.3%

Dividend Cover : Earnings Dividend Gearing Ratio: LTL x 100 LTL + OE

Comment

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All ratios have registered increases which have various implications. Slight increases in EPS and dividend cover is satisfactory but the sharp rise in the gearing ratio for an already high geared company is a source for money that was the need for additional financing and what was the 3 million funds raised used for to finance the acquisition of assets or what? If so why is the capital employed diminishing? Why increase dividends when the income surplus account is in the negative and interest payment is rising. This does not show . Funds management and is also in breach of the Companies Code 1963 (Act 179) which does not allow the payment of dividends when the income surplus account is in deficit (5.71.1.6). Liquidity Ratios 2004 45470 26220 = 1.73:1 45470 - 21450 26000 = 0.92:1 2005 47785 23950 = 2.0:1 47785 - 25760 23950 = 0.92:1 2225 23950 = 0.09:1

Current Ratio:

CA CL

Liquidity Ratio:

CA S CL

Acid Text: Ratio

Cash & Cash Equivalent 6015 CL 26220 = 0.23:1

Comment While the current ratio has increased slightly over the period, the liquidity ratio has remained stable. But the huge decline in acid test ratio is a real cause for worry. If clearly shows a company in liquidity arising as evidenced by the huge tremble in cash/bank balance (by 63%) and should give management sleepless nights and make creditors worry about the ability to receive payment for their supplies.

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Exercise one: Dzifa and Sons Ltd is an agro processing company at Axim. The companys published financial statements for the year ended 31st December 2008b is as follows: Income statement for the year ended 31st December 2008 GH Revenue 90,336 Cost of Sales 70,002 Gross Profit 20,334 Selling, general and administration expenses 4,520 Profit before tax 15,814 Taxation 3,734 Profit after tax 12,080 Income surplus Balance at 1/01/08 5,200 Profit for the year 12,080 17,280 Dividends: Equity 7,600 7% preference 3,150 Balance as at 31/12/08 6,530 Balance sheet as at 31st December 2008 Non-current assets Property plant and Equipment Net current assets Financed by: Stated Capital: Equity shares (issued at 50 pesewas per share) 75% preference shares (issued at 25 pesewas per share) Income surplus Shareholders funds 8% debentures GH 183,250 16,750 200,000 95,000 45,000 6,530 146,530 53,470 200,000

Additional information Market price per equity shares as at 31st December 2008 was 75 pesewas. (Note 100 pesewas = GH1). You are required to calculate and explain each of the following: i. Book value of net assets per share (3 marks) Compiled by Suglo Abdulai Page 39

ii. iii. iv. v.

Earnings per share Earnings yield Dividend yield Price earnings ratio

(3 marks) (3 marks) (3 marks) (3 marks) (15 marks)

Exercise two: Interpretation of financial statements You are given the following financial information about Dobia Ltd, a limited liability company.
1. Capital and Liabilities as at 31st December 2008. GH Ordinary shares of no par value issued at GH

2,000,000
5% Preference shares of no par value issued at 1

1,000,000 1,000,000 4,000,000 8,000,000

Share deals account Income surplus account Total


2. Ordinary share price at 31st December 2008 is GH7

3. Sales revenue (including GH1,500,000 VAT) is GH12,000,000 4. Dobia Ltd has no non-current liabilities 5. Dividend yield is 2.5%
6. Dividend cover is 1.4

7. Receivables turnover (based on year end-receivables and gross sales revenue is) 8. Non-current assets: Net current assets ratio is 4. (Net current assets equals current assets minus current liabilities) 9. Current ratio is 1.32 10. Quick ratio is 0.92 11. Inventory turnover (based on yearend inventory) is 3. 12. Profit before tax as a percentage of net sales is 10%

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You are required to prepare a balance sheet as at 31st December 2008 and an income statement for the year then ended for Dobia Ltd.

VALUE ADDED STATEMENTS A value added statement is an additional report that is often included in the annual report of entities. It shows the wealth created by the team and how the wealth created has been shared among the various stakeholders constituting the team. The team usually, is made up of providers of long term capital, employees and the government but it excludes other firms which supply goods and service. The main purpose of the statement according to the corporate report is to show how the benefits of the efforts of an enterprise are shared between: Employees Providers of capital The state; and for Reinvestment.

The statement shows what distributions have been attributed to these participants from this fund of added value; the undistributed amount being described as retained for the maintenance and expansion of the business. In the words of The Corporate Report the added value statement is the simplest and most immediate way of putting profit into Compiled by Suglo Abdulai Page 41

proper perspective vis--vis the whole enterprise as a collective effort by capital, management and employees MEASUREMENT OF THE WEALTH (ADDED VALUE) Value added is the difference between the monetary value of outputs and inputs of goods and service attributed to the business. In measuring out put, rewards of members of team are often eliminated. Thus Added value is shown as the increase between the market value of the goods and services used by the business and the market value of the goods and services which finally emerged as the result of its activities.

CONTENTS AND FORMAT OF THE VALUE ADDED STATEMENT A value added statement is basically a rearrangement of the profit and loss account (income statement). It shows the value added for a business for a particular period and how it is arrived at and appropriated to the interested parties. Thus the statement is in two parts: The first part deals with the value added, whilst the second part shows how the value added has been shared between the team members. The stakeholders receive their share in the following forms: Employees: As wages, Salaries and related expenses. Financiers: - As interest on loans and dividends on shares. Government: As corporate tax. Business: As replacement of assets and retained earnings. The illustrative layout proposed in the corporate report was as follows:

Value added statement for the year ended GH


Turnover Less brought in good and services Added value Applied as follows: To pay employees: Wages & salaries Pension Compiled by Suglo Abdulai

GH
xx xx xx

xx xx Page 42

Other benefits To Providers of capital: Interest on loans Dividend to shareholders To pay the government Corporate tax To provide for maintenance and expansion Of assets: Depreciation Retained Profit

xx xx xx

xx

xx xx

xx xx

xx xx

Explanations
Bought in materials and services This heading should include all purchases and business expenses other than: items which it has been decided to deduct from sales value; wages (as defined below); Interest and depreciation, which are normally treated as disposals of added value. Possible deviations from this treatment are discussed in latter paragraphs. Depreciation In preparing value-added statements, most companies include depreciation under provision for maintenance and expansion of assets. Indeed, this presentation agrees with the illustrative format by the corporate report. The other approach is to deduct depreciation before arriving at the value added for the period. The argument for this approach is that the use of an asset during the period whether owned or hired should be reflected in bought-in-materials and services. Again, the purchase of a fixed asset from another firm, a non-group member is a boughtin item and it is only the fact that this asset has a long-life which necessitated the charging of depreciation. Thus in arriving at the value added, it is logical, if not preferable to regard depreciation as an input.

PAYMENT TO EMPLOYEES Compiled by Suglo Abdulai Page 43

There are two approaches to treating payment to employees. One way is to show gross salaries and wages, employers contribution to social security, pension and gratuity payment and fringe benefits. The argument is that all these expenses are incurred because of the employees; the company only acts as a government collector. On the contrary, only employee take home pay can be shown as payable to employees. Thus PAYE and SSF are grouped under payment to government. The main argument is that employees are more interested in their take home pay. This is what they receive in the company. It is important to draw clear distinction between what is received by team and what is on their behalf, more so when what is received is what can be spent in the meantime. PAYMENT TO GOVT Under this heading, there are two ways of treating the items. One way is to show only corporation/company tax. The inclusion of only corporate tax payable avoids the need to draw a distinction between the various taxes and has a further advantage in that the figure can be picked from the income statement without any adjustment. The second approach shows all deductions and taxes paid to the government whether they are on behalf of others or not. Thus items included under this heading include PAYE SSF, Custom & Excise duties, VAT, local rates etc. This approach is sometimes referred to as the all-inclusive approach.

NON-TRADING AND EXCEPTIONAL ITEMS The preferred treatment is to show all non-trading items separately. This is recommended because is will enable us to show the value added from trading operations and at the same time show the effect of the exceptional items and also draw a distinction between value added from trading activities and the total value added.

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Question one The summarised income statement of Guma Ltd (for internal circulation) for year ended 30 September 2008 was: Income statement for the year ended 30 September 2008 Sales Less Cost of Sales Gross profit less Wages and salaries Interest paid Depreciation Other expenses Profit before tax Less Corporation tax Profit after tax Less Dividends paid and proposed Profit for the year retained 18 97 55 GH GH 3,027 2,051 976 260 430 546 119 427 62 365

Required: Prepare a value added statement for the year, treating depreciation as an appropriation of value added.

Answer one a) Guma Ltd Value added statement For the year ended 30 September 2008 GH GH 3,027 2,106 921

Sales Less Cost of bought in goods and services (2,051 + 55) Value added Applied as follows Compiled by Suglo Abdulai

100.0

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To pay employees salaries and wages To pay providers of capital Interest Dividends Payable to government corporation tax Retained in the business for maintenance Of assets and for expansion - depreciation - retained profit

260 18 62 80 119 97 365 462 921 10.5 39.7 2.0 6.7

28.2

8.7 12.9

50.2 100.0

Question two a. You are required to describe your understanding of the term value added as used in accounting. b. Using the following summarised information prepare: i. a conventional income statement of a company ii. a value added statement. Summarised information for XYZ Ltd in respect of the year ended 31 December 2008 GH 200,000 300,000 740,000 60,000 24,000 60,000 40,000 20,000

Salaries and wages Purchased materials used in production Sales Corporation tax on the profit for the year Dividend proposed Services purchased Depreciation of fixed assets Loan interest paid and payable

iii. There is an alternative view on the treatment of depreciation in value added statements. What is this view and how would it affect the answer you have produced in answer to question b ii. Compiled by Suglo Abdulai Page 46

c. What advantages are claimed for including a value added statement in a companys corporate report? Answer two (a) Value added may be regarded either as the difference between the output and input value of an entity, as measured in financial terms, or as wealth created by an entity through the joint efforts of the entity and of its employees using funds provides from external sources and internally generated. (b) (i) Conventional profit statement XYZ Ltd Profit statement for year ended 31 December 2008 GH Sales Less Materials Salaries and wages Services purchased Loan interest Depreciation Profit for year, before tax Less Corporation tax Profit for year, after tax Proposed dividends Profit for year, retained XYZ Ltd Statement of Added Value For the year ended 31st December 2008 GH GH % % 740,000 360,000 380,000 200,000 20,000 24,000 44,000 Compiled by Suglo Abdulai 5,300 6,300 11.60 Page 47 300,000 200,000 60,000 20,000 40,000 620,000 120,000 60,000 60,000 24,000 36,000 GH 740,000

Sales Less: Cost of bought in goods and service (300 + 60 Total value added Applied as follows: To pay employees: Salaries and wages To pay providers of capital: Interest Dividends

100.0 52.60

Payable to government Corporation tax Retained in the business For maintenance of assets and for Expansion: Depreciation Retained profit

60,000

15.80

40,000 36,000

10.5 9.5

76,000 20.00 380,000 100.00 (iii) The majority of companies adopt the above treatment of depreciation. An alternative (minority) view is that it should be treated as an expense (and therefore added in at the bought in stage) instead of as an application of values. If this treatment had been adopted above, total value added would have been reduced to GH340,000 and the last item of applications would have read Retained in the business for expansion GH36,000. Individual percentages of applications would have altered to reflect the charge in the relative shares. (c) Advantages claimed include: to encourage the workforce to regard themselves as part of a wealth creating / wealth sharing team: to demonstrate to the workforce that by creating more added value, for example, through increased productivity, they can increase the amount of wealth applied to them: to demonstrate to the workforce the relative slices of added value attributable to them in their different capacities and the amount retained in the business after the taxation liability has been provided.

Question three The following balances have been extracted from the books of the KOO Ltd for the year ended 30th June 2008: GH Customs and excise duties (included in the turnover) 160,400 Depreciation charge for the year 13,500 Dividends to ordinary shareholders 6,700 Compiled by Suglo Abdulai Page 48

Interest on borrowed money Investment income received Minority interests in subsidiaries (including) Dividends 2.5 payable by the subsidiaries) Profit retained Purchases of plant Raw materials and bought-in services used Stock and work-in-progress at 30th June 19-9 Turnover (excluding value added tax) Corporation tax Wages, salaries and retirement benefits You are required to:

7,300 6,200 4,000 16,500 120,400 323,100 62,700 642,700 15,400 100,000

a. Prepare a value added statement for the year ended 30th June 2008, selecting the appropriate items from the list of balances, and. b. State the purpose(s) of the value added statement now being presented by many public companies

Answer (a) The question requires the preparation of a value added statement for a group of companies. This fact is apparent from the nature of some of the items in the list. The basic format can be adapted to a group situation. KOO Ltd Group Value Added Statement For year ended 30th June 2008 GH % Sales (excluding VAT) Less Cost of bought in raw materials and services Customs and Excise duties Value added by trading Add Investment income Total value added Attributable as follows: To employees Wages, salaries, pensions 61.2 To providers of capital Compiled by Suglo Abdulai 7,300 4.5 Page 49 642,700 325,100 160,400 485,500 157,200 6,200 163,400 100,000

GH

Interest on borrowings Dividends 8.6 To minority shareholders in subsidiaries 2.4 To governments Corporation tax Retained in the group Retained profit Depreciation 18.4

6,700

4.1 14,000 4,000

15,400 16,500 13,500

9.4 10.1 8.3 30,000 163,400

100.0 For consistency, Customs and Excise duties have been eliminated to accord with the treatment of VAT, where the company merely acts as a collector. VAT, of unstated amount, has been deducted from the sales figure. Some companies also deduct Customs and Excise duties at this stage. If this had been done in the above answer, sales would have been reduced to GH482,300 (642,700 160,400), and the deduction from it would have consisted solely of cost of bought in items (GH325,100), thus giving a value added by trading figure of GH157,200 as previously. The amount attributable to minorities has been shown as a separate item. Of the companies showing minority interest, approximately three times as many employ this treatment, as opposed to the alternative which is to split the figure between dividends and retained profit. If this less common treatment has been used, the attributable section of the above answer would have been:

GH Attributable as follows: To employees Wages, salaries, pensions To providers of capital Interest on borrowings Dividends to? Company shareholder Dividends to minority shareholders in Compiled by Suglo Abdulai

GH

% 61.2 4.5 4.1

100,000.0 7,300 6,700

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Subsidiary companies To governments UK and overseas corporation tax Retained in the group Retained profit (16.5 + 1.5) Depreciation

2,500 16,500 15,400 18,000 13,500 31,500 163,400

1.5 10.1 9.4 11.0 8.3 19.3 100.0

b) The purpose which valued added statements are generally considered to serve, are To focus attention on the wealth created by the company rather than on the profit. This latter figure accrues to the benefit of the shareholders and the company whereas wealth accrues to the benefit of all the parties concerned in its creation. To illustrate how the wealth has been disposed amongst its creations To illustrate the relative dependence of the parties concerned with the disposition of wealth, etc.

Question four Moon Ltd includes with its financial statements each year a statement of value added. The draft value added statement for the year ended 31 May 2008 is as follows: GH Revenue from sales 204,052 Bought in materials and services 146,928 Value added by the company 57,124 Applied to: The benefit of employees Salaries Deductions for income tax Pension schemes Employees profit sharing schemes Welfare and staff amenities 17,257 Central and local government Value added tax Compiled by Suglo Abdulai GH

16,468 3,352 13,116 2,810 525 806

30,608 Page 51

Corporation tax Local rates Tax etc deducted from salaries and loan interest 35,750 To the providers of capital interest on loan capital income tax deducted Interest on bank overdrafts Dividends to shareholders of the company 1,870 The replacement of assets and the expansion of the business Depreciation Retained profits 2,247

985 325 3,832

1,600 480 1,120 250 500

1,835 412

57,124 Discussion among the board of directors on the draft figures has revealed a wide variation of opinion on the usefulness of the value added statement to the readers of the accounts. Some board members say that the value added statement is confusing as it is only a redrafting of the results which are shown in the profit and loss account, which gives all the information necessary. Others say that the cash flow statement is more important. Required (a) A report to the directors showing the advantages of the value added statement compared with the profit and loss account and the source and application of funds statement. Your report should deal specifically with the points raised in discussion by the directors. (10 marks) (b) Construct a profit and loss account from the information given. marks) (6

(c) Calculate the funds arising from operations for use in a source and application of funds statement. (4 marks)

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Answer four Moon Ltd (a) To: The Board of Directors From: Chief Accountant Subject: Value added statements Date: 30 June 2008 Introduction This report describes the advantages of the value added statement compared with the profit and loss account and the source and application of funds statements. Advantages of the value added statement There is no statutory or professional requirement obliging companies to include a value added statement in their published accounts. However, The Corporate Report, a discussion paper published in 1975 by the Accounting Standards Committee, identifies value added statements as on of a number of desirable voluntary disclosures. The benefits of publishing such a statement are identified in the discussion paper as follows: The simplest and most immediate way of putting profit into proper perspective vis--vis the whole enterprise as a collective effort by capital, management and employees is by presentation of a statement of value added This statement would show how value added has been used to pay those contributing to its creation. It usefully elaborates on the profit and loss account and in time may come to be regarded as a preferable way of describing performance. An important feature of the value added statement is therefore its emphasis on the business entity as a team working together and earnings the right to share in the profits generated. Many companies see this as being a benefit in the form of improved staff relations. On the same theme, the value added statement can have a motivational effect on employees. The profit and loss account of course focuses on the accounting profit earned by the business, but accounting profit is not a well understood concept. By emphasising the simpler concept of value added, the value added statement is more informative to employees and other non-professional users of accounts. It can be used as the basis of Compiled by Suglo Abdulai Page 53

incentive schemes, perhaps by fixing a target ratio of value added to capital employed and distributing to employees a proportion of any value added in excess of the target. Although it is derived from information which appears elsewhere in the financial statements (particularly in the profit and loss account) it does not follow that the value added statement is superfluous. Inexperienced users of accounts would probably the unable to construct a value added statement if it were not presented to them, and the presentation and emphasis of the statement are in any case very different from the profit and loss account. The statement of source and application of funds is dissimilar to the value added statement both in its purpose and in the information it presents. It is concerned with a wider range of information than the value added statement, in that it discloses details of capital receipts and expenditure as well as revenue items. Its emphasis is on the sources from which funds have been derived, the ways in which they have been applied and the changes in working capital which have resulted. (b) PROFIT AND LOSS ACCOUNT FOR THE YEAR ENDED 31 MAY 2008 Sales GH (204,052 30,608) 173,444 Expenditure: Materials and services Salaries Pension schemes Employees profit sharing schemes Welfare and staff amenities Rates Loan interest Interest on bank overdraft Depreciation 171,547 Profit before tax 1,897 Taxation 985 Profit after tax 912 Compiled by Suglo Abdulai Page 54 GH GH

146,928 16,468 2,810 525 806 325 1,600 250 1,835

Dividends 500 Retained profit for the year 412

Question six The following information has been extracted from the annual report of Wilson Limited, a public quoted company, for the year ended 31 December 2008. GH Dividends to stockholders 59,000 Depreciation 182,000 Employees pay, pension and national insurance 816,000 Exchange gain on net current assets of overseas subsidiaries 29,000 Extraordinary items, net loss 1,000 Government corporate taxes, less grants 125,000 Interest paid on borrowings 73,000 Materials and services used 1,842,000 Minority shareholders in subsidiaries 24,000 Profit retained 112,000 Profit sharing bonus to employees 17,000 Royalties received and other trading income 30,000 Compiled by Suglo Abdulai Page 55

Sales 3,129,000 Share of profits of principal associated companies and investment income 63,000 You are required to prepare a value added statement and discuss briefly its purpose

Answer six

Wilson Limited Value added statement for year ended 31 December 19X1 GH000 GH000 3,129 1,842 1,287

% Sales 100.0 Less: bought in materials and services 58.9 41.1 Royalty income 1.0 Value added 42.1 To pay employees: Pay, pension and NI Profit sharing bonus To pay providers of capital: Interest on loans Dividends to shareholders 816 17 833 63.3 73 59

30 1,317

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132 10.0 To pay governments: Corporation tax (less grants) 9.5 Retained in the business to provide for the Maintenance and expansion of the business: Depreciation Retained profits (see note 1) 17.2 1,317 100.0 Note 1 Reconciliation to retained profits: 000 Retained profit per value added statement 45 Items not included as part of value added: Associated companies and investment income Exchange gains Extraordinary items 91 Less: attributable to minority interests 136 24 Retained profits per profit and loss account (W) 112 The purpose of a value added statement A statement of value added shows the wealth or value created during the year by the activities of a business enterprise and how this value is shared between those who contribute towards its creation: the employees, the providers of capital, the State and the company (for re-investment). The purpose of the statement is to assist users in evaluating the economic performance of the entity as a whole. The statement may be distinguished from the profit and loss account which shows in effect of added value attributable only to those who provide the equity capital for the enterprise. Compiled by Suglo Abdulai Page 57 GH000 GH 125

182 45 227

63 29 (1)

Workings Profit and loss account 000 Sales 3.129 Less: Bought in goods and services Pay, pension and N1 Bonus to employees Depreciation 2,857 Operating profit 272 Less: interest 73 199 Associated companies and investment income Royalty income Profit before taxation 292 Taxation 125 Profit after taxation 167 Less: minority interests 24 Profit attributable to the group 143 Exchange gains Extraordinary items Profit after extraordinary items 171 Less: dividends 59 Retained profit 112 63 30 93 GH000 GH

1,8242 816 17 182

29 (1) 28

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Question seven You are required to: (a) define added value; (b) state briefly how added value differs from conversion cost; (c) list the advantages a statement of added value has over a normal profit and loss account; and (d) describe how you would deal with the following items in calculating added value: (i) (ii) (iii) (iv) (v) (vi) bad debts; Customs and Excise duties; Employers pension contributions; Fixed assets, self-built by company; Rents receivable; Annual lease payments.

Answer seven (a) Added value is the sales value of goods or services minus the cost of materials, goods and services introduced into the firm. (b) Added value is a profit inclusive figure but excludes the cost of introduced goods and services. Conversion cost, on the other hand, does not include profit, but would include certain overhead items, which would not be considered part of added value e.g., maintenance materials. (c) (i) It emphasises that the success of a business depended upon its ability to add value, and that the cost of bought in materials and services is merely passed on to the customer. Profit only comes out of added value. (ii) The traditional view is of profit as a residue. The added value statement moves more towards a stakeholder view of the firm in which the wealth created in somehow apportioned between employees government and shareholders. Compiled by Suglo Abdulai Page 59

(iii) In some firms such statements form a basis for remuneration, in which the ratio of added value per GH of labour cost might be the basis for productivity payments. It must be noted, however, that some suspicion still exists in that it is felt that management actions can directly affect levels of added value and therefore productivity entitlement. (iv) Added value figures are incorporated into a variety of ratios to provide useful management trend and control measures, e.g.: Value added/number employees Value added per of payroll cost Value added/ capital employed d) (i) A sale has been made and therefore value has been added. The bad debt must therefore be included as part of the financing costs in the distribution section. (ii) VAT is not included in any turnover figure since it is merely a tax collected at the point of sale. VAT, therefore, is not value added. Excise duties will be included in sales and therefore added value, and can then be deducted as an application of added value payable to the government. (iii) This can be included with employees wages and salaries in the distribution section. (iv) This item could be omitted entirely from the statement. Alternatively, the capitalised value could be included as a sale, deducting the cost of bought parts and materials to reveal the added value. This is then represented in the wages and salaries (benefits) to employees. (v) Can be included in total sales if comparatively insignificant or under a separate added value if more important. (vii) Treatment depends upon the type of lease represented by the annual payment. An operating lease, for example, can be regarded as a bought in cost whereas a finance lease would be reflected as a distribution of added value.

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