Accounting Report on Queen Limited

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Calculation of ratios

The table presented below shows the calculation of ratios for Queens Limited the two years ended 30 June 2011 and 2012.

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Ratio 2011 2012
Return on capital employed (ROCE)
Earnings before interest and tax (EBIT) / capital employed
Capital employed = total assets – current liabilities
310 / (2,000 – 400)
19.36%
350 / (2,185 – 485)
20.59%
Return on shareholders fund (ROSF)
Net profit after taxation and preference dividend / (ordinary share capital + reserves)
155 / 1,100
14.09%
175 / 1,200
14.58%
Gross profit margin
Gross profit / sales
1,040 / 2,600
40%
1,150 / 3,500
32.86%
Operating profit margin
EBIT / sales
310 / 2,600
11.92%
350 / 3,500
10%
Current ratio
Current assets / current liabilities
735 / 400
1.84 times
660 / 485
1.36 times
Acid tests ratio
(Current assets – inventory) / current liabilities
(735 – 250) / 400
1.21 times
660 – 400 / 485
0.53 times
Trade receivables settlement period
Days * account receivables / credit sales
365 * 105 / 2,600
14.74 days
365 * 145 / 3,500
15.12 days
Trade payable settlement period
Accounts payable * number of working days / net credit purchases
365 * 300 / 1,560
70.19 days
365 * 375 / 2,350
58.24 days
Inventories turnover period
365 * (inventory / cost of goods sold)
365 * 250 / 1,560
58.49 days
365 * 400 / 2,350
62.13 days
Gearing ratio
Long-term liabilities / capital employed
Debt / equity
500 / (2,000 – 400)
31.25%
500 / 1,100
45.45%
500 / (2,185 – 485)
29.4%
500 / 1,200
41.67%

Comments on the financial position of the company

The ratios calculated in the table above give indication of the financial position of the company. The areas that will be evaluated using ratios calculated above are profitability of the company, liquidity, efficiency, and leverage level.

Profitability

The ratios that will give an indication of the profitability of the company are gross profit margin, operating profit margin, ROCE, and ROSF. The gross profit margin for the company declined from 40% in 2011 to 32.86% in 2012. It can be observed that both the cost of sales and sales increased over the two-year period. However, the rate of increase of sales (34.61%) was lower than the rate of the increase cost of sales (50.64%). This explains the decline in gross profit margin. The decline is not a good indication because it shows that the company is not efficient in managing cost of sales. It also shows that the company is not using the proper strategies to generate more sales. The operating profit margin also declined from 11.92% in 2011 to 10% in 2012. The ratio measures the operating leverage of a company. A decline in the value of the ratio indicates that the company is efficient in controlling costs. It may also show that sales are increasing faster than costs (Holmes, Sugden and Gee 106).

Thus, the two ratios indicate that the company is not efficient in managing pricing strategies and costs of running the business. ROCE increased from 19.36% in 2011 to 20.59% in 2012. Generally, ROCE measures the efficiency in use of capital provided by various stakeholders. The increase is a good indication because it shows that there was an increase in efficiency in the use of capital. In most cases, ROCE should be greater than the cost of capital of the company. ROSF increased from 14.09% in 2011 to 14.58% in 2012. An increase in the value of ROSF is a good indication because it shows that the company makes profits. It also shows that the company has more profit to distribute to the shareholders. Therefore, investors will be more interested in this ratio. From the point of view of a prospective purchaser of a majority of shares, the profitability ratios show that the company is in a position to generate positive returns from the capital invested. Thus, this can motivate a potential majority shareholder (Atrill 27).

Liquidity

The liquidity of the company will be measured using acid test ratio and current ratio. The current ratio for the company declined from 1.84 in 2011 to 1.36 in 2012 while the value of the acid test ratio declined from 1.21 in 2011 to 0.53 in 2012. The ratios measure the ability of the company to pay the current portion of debt. A decline in the value of the two ratios is not a good indication because it shows that the company is not in a position to pay debt. This may discourage a prospective purchaser of a majority of shares.

Efficiency

The efficiency of internal operations of the company will be measured using trade receivables settlement period, trade payable settlement period, and inventory turnover period. The trade receivables settlement period increased from 14.74 days in 2011 to 15.12 days. It shows that the time taken by the company to collect debt increased in 2012. The increase is not a good indication of the efficiency of the company because debtors take longer to pay their debts. The trade payable settlement period increased from 70.19 days in 2011 to 58.24 days in 2012. It shows that the company reduced the period of time it takes to pay debtors. The decline is a good indication because it shows an improvement in efficiency. On the other hand, the increase may not suitable because it reduces the cash flow from operations. The inventory turnover period increased from 58.49 days in 2011 to 62.13 days. The increase implies that it takes the company longer number of days to replenish stock. It shows a decline in efficiency. Therefore, there was a decline overall efficiency of the company. This explains why the company had a decline in liquidity and margin ratios (Collier 98). The decline in efficiency may discourage a prospective purchaser of a majority of shares.

Leverage

The final category of ratios measures leverage of the company. It is an important area to a prospective purchaser of a majority of shares because it shows the proportion of total assets that is financed by debt and equity. The ratio of long-term liabilities to capital employed declined from 31.25% in 2011 to 29.4% in 2012 while the ratio of debt to equity declined from 45.45% in 2011 to 41.67% in 2012. The decline in gearing ratios shows a decline in the amount of debt in the capital structure of the company. This indicates a decline in risk to which the shareholders’ fund is exposed to. Thus, it is a motivating sign to a potential majority shareholder. Therefore, the analysis of the financial position of the company indicates that the company is striving to reduce the gearing level. However, this affects the efficiency, liquidity and profitability because all attention is focused on reducing the gearing level and not increasing profitability and efficiency.

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Other important factors

Apart looking at the financial perspective of an entity, there are a number of other factors that a potential majority shareholder should look at. The first factor to look at is the performance and behavior of the competitors of the company. The shareholder should compare the financial performance of the company and those of the competitors. Under this, the investor should also look at the market share of the company and the ability of the company to survive future threats of competition. Secondly, a potential majority shareholder should evaluate the political risk of the region in which the business operates. Studies show that there is a high probability that a company will perform dismally when there is political instability. To evaluate this, the investor can analyze the mood of the country during the change of government, the presence of war, or the number of coups during a given period. The third factor to look at is the legal cases of the company and the potential impact of such cases on the future operation of the company. The outcome of some cases may have a significant impact on future operations of the company. Also, the investor should look at the credit risk. The risk captures the possibility of the company incurring loss when the debtors fail to pay. It is attributable to receivables and cash at bank. Further, the investor can look at the market risk. The risk arises from changes in market condition especially with regard to foreign exchange and interest rate. The risk also evaluates how the market conditions will affect equity prices and other financial instruments held by the company (McLaney and Atrill 45). Finally, the investor should evaluate the operational risk. It denotes the possibility of loss that arises from internal operation, infrastructure, technology, and employees of the company and other external factors such as regulatory requirements.

Projected income statement

The tables presented below show the project income statement for Queen Limited for the year 2013 for the two methods of financing.

Financing using ordinary shares

Queen Limited

Projected Income statement. For the year ended 30th June, 2013.

2012 Multiply by 2013
£000 £000
Sales revenue 3,500 1.25 4375
Cost of sales -2,350 1.25 -2937.5
Gross profit 1,150 1437.5
Wages and salaries -350 1.20 -420
Overheads -200 1.20 -240
Depreciation -250 1.20 -300
Operating profit 350 477.5
Interest payable -50 -50
Profit before taxation 300 427.5
Taxation -125 (0.4 * 427.5) -171
Profit for the year 175 256.5

When shares are issued to finance the purchase of more machinery, the operating profit will increase from £350,000 in 2012 to the projected £477,500 in 2013. The resulting profit before taxation will also increase from £300,000 in 2012 to the projected £427,500 in 2013 while the profit for the year will increase from £175,000 in 2012 to the projected £265,500 in 2013. Thus, the increase in profit for the year is equivalent to 46.57%.

Financing using loan notes

The preparation of the projected income statement under this method of financing is based on the assumption that the loan is taken at the beginning of the financial year. Therefore, the loan interest at the end of the financial year will be £60,000 (£600,000 * 10% = £60,000).

Queen Limited

Projected Income statement. For the year ended 30th June, 2013.

2012 Multiply by 2013
£000 £000
Sales revenue 3,500 1.25 4375
Cost of sales -2,350 1.25 -2937.5
Gross profit 1,150 1437.5
Wages and salaries -350 1.20 -420
Overheads -200 1.20 -240
Depreciation -250 1.20 -300
Operating profit 350 477.5
Interest payable -50 (50 + 60 = 110) -110
Profit before taxation 300 367.5
Taxation -125 (0.4 * 367.5) -147
Profit for the year 175 220.5

When the company uses debt to finance the purchase of more machinery, the operating profit will increase from £350,000 in 2012 to the projected £477,500 in 2013 just like in the case of issue of shares. However, the interest payable will increase from £50,000 in 2012 to £110,000 because additional interest arising from a debt of £600,000. The resulting profit before taxation will also increase from £300,000 in 2012 to the projected £467,500 in 2013 while the profit for the year will increase from £175,000 in 2012 to the projected £220,500 in 2013. Thus, the increase in profit for the year is equivalent to 26%. It can be noted that the increase in profit under debt financing (26%) is lower than the increase under equity financing (46.57%)

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Projected earnings per share for 2013

Earnings per share = net income / average number of shares outstanding

Financing using ordinary shares

Estimation of average number of shares outstanding.

Calculation Shares
Total number of shares outstanding as at 30thJune 2012
= £490,000 / £1
490,000
Add Shares issued in 2013
The par value of a share = £1
Share premium = £3
The total price of the share = £4
Number of shares issued
= £600,000 / £4
= 150,000 shares
150,000
Total 640,000

Earnings per share = £256,500 / 640,000 = £0.40

Therefore, the projected earnings per share when the purchase of machinery is made through equity will be £0.40

Financing using loan notes

Estimation of average number of shares outstanding.

Calculation Shares
Total number of shares outstanding as at 30thJune 2012
= £490,000 / £1
490,000
Add Zero –there will be no issue of shares under debt financing 0
Total 490,000

Earnings per share = £220,500 / 490,000 = £0.45

Therefore, the projected earnings per share when the purchase of machinery is made through debt will be £0.45. Thus, the use of debt financing results in a higher earnings per share than use of equity financing.

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Projected level of gearing

Based on the calculation of ratio analysis in the first section, the level of gearing will be estimated using two ratios that are presented below.

Financing using ordinary shares

The table presented below shows the estimated value of long-term liabilities, capital employed, debt, and equity when equity financing is used.

Item Calculation Amount
Long-term liabilities £500,000 + 0 £500,000
Capital employed £1,700,000 + £600,000 £2,300,000
Debt £500,000 + 0 £500,000
Equity £1,200,000 + 600,000 £1,800,000

Long-term liabilities / capital employed = (500,000 / 2,300,000) * 100 = 21.74%

Debt / equity = (500,000 / 1,800,000) * 100 = 27.78%

Under equity financing, the projected ratio of long-term liabilities to capital and debt to equity will decline from 29.4% and 41.67% reported in 2012 to 21.74% and 27.78% projected in 2013 respectively.

Financing using loan notes

The table presented below shows the estimated value of long-term liabilities, capital employed, debt, and equity when debt financing is used.

Item Calculation Amount
Long-term liabilities £500,000 + £600,000 £1,100,000
Capital employed £1,700,000 + £600,000 £2,300,000
Debt £500,000 + £600,000 £1,100,000
Equity £1,200,000 + 0 £1,200,000

Long-term liabilities / capital employed = (1,100,000 / 2,300,000) * 100 = 47.82%

Debt / equity = (1,100,000 / 1,200,000) * 100 = 91.67%

Under debt financing, the projected ratio of long-term liabilities to capital and debt to equity will increase from 29.4% and 41.67% reported in 2012 to 47.82% and 91.67% projected in 2013 respectively. Therefore, it can be noted that use of loan notes to finance the purchase of more machineries result in a higher level of gearing than use of equity.

Evaluation of the financing scheme

The evaluation of the two financing scheme will be based on the calculations above. The use of equity to finance the additional purchase results in a higher net earnings, a lower earnings per share and a lower gearing level than the use of debt. An existing shareholder is concerned about the increase in profitability of the company. Besides, the shareholder will not support a decision that puts their investment at risk. Based on the calculations, the use of debt lowers net earnings and increases financial leverage risk. Thus, the potential investor may not endorse the use of debt to purchase the additional machinery (Drury 74)

Fair value and historical cost accounting

The historical cost accounting is built on the assumption of a stable measuring unit. Thus, under this method accounting, items in the balance sheet are reported at the value they were acquired. It assumes that there has been no changes in the value of the items over time. Therefore, the use of historical cost accounting method does not give the current value in the market of the various balance sheet items. The use of this method is supported for a number of reasons. First, the current value of certain item may not be easily available. Besides, obtaining such values can be quite costly. This necessitates companies to use the method. Further, the use of historical approach enhances analysis of a variable over time. On the contrary, this method of accounting does not give the “true value” of the item being analyzed. This creates inaccuracy when reporting. Thus, due to its criticisms, there are several corrections have been made on how to record items in the balance sheet. For instance, the accounting standards allow companies to record assets and liabilities at market values in cases where the market values are readily available. Besides, the International Accounting Standards Board has come up with alternative methods that companies can use in place of historical accounting method (Deegan 38).

Under the fair value method, the company records the value of assets and liabilities at the price they would sell in the market. Therefore, the reporting and measurement of the assets and liabilities is done on an ongoing basis. In this case, a company will report a loss when the fair value declined and a profit when the fair value increases. Such losses cause a reduction of equity and profit. The method is advantageous because it gives the true value of an asset or a liability. On the other hand, the fair value is difficult to estimate and in most cases are unreliable. Further, the values depend on the market conditions. An adverse market condition, for instance the global financial crisis, may cause the company serious losses (Vance 14). Thus, the Chief Executive Officer and the Chief Accountant should use a hybrid of the two methods. This will reduce the market risk that the company is exposed to.

ROI and EVA

ROI is the ratio of income and investment. Companies prefer to use this method to evaluate business because it is comprehensive. It takes into account a number of attributes such as investment, costs and revenue. Thus, it points out to managers the investments that are profitable or not profitable. Therefore, it summarizes all the items that affect the financial statements in a single value. Secondly, companies prefer to use this method because it is easy to compute and understand. Therefore, it has a lot of meaning to the users. Further, the data for ROI is readily available for most companies across various sectors. Therefore, it is a comprehensive method of comparing the performance of various companies. An alternative measurement that can be used is EVA. The ratio puts together the net operating profit after tax, weighted average cost of capital and book value of capital employed in one value. Therefore, this value gives the true economic profit of a company. Therefore, the ratio measures the value by which the earnings exceed or fall short of the minimum required rate of return by capital providers (debt and equity providers). The use of EVA is preferred to ROI for a number of reasons. First, since the method takes into account the cost of capital, it shows the amount of wealth that the business has created or destroyed. This is important for a shareholder. Secondly, the method enables managers to evaluate if the decisions made by the company are in line with shareholders’ wealth. Thus, it eliminates multiple and conflicting goals in an entity. Finally, the method can be used by all levels of management (Brigham and Ehrhardt 117).

References

Atrill, Peter. Financial Management for Decision Makers, London: Financial Times/Prentice Hall, 2009. Print.

Brigham, Eugene, and M. Ehrhardt. Financial Management Theory and Practice, USA: South-Western Cengage Learning, 2009. Print.

Collier, Paul. Accounting for Managers, London, UK: John Wiley & Sons Ltd, 2012. Print.

Deegan, Craig. Financial Accounting Theory, London: McGraw-Hill Publishers, 2009. Print.

Drury, Colin. Management and Cost Accounting, USA: Thompson Learning, 2006. Print.

Holmes, Geoffrey, Alan Sugden and Paul Gee. Interpreting Company Reports, New York: Harlow, 2008. Print.

McLaney, Eddie and P. Atrill. Financial Accounting for Decision Makers, London: Financial Times/Prentice Hall, 2009. Print.

Vance, David. Financial Analysis and Decision Making: Tools and Techniques to Solve, United States: McGraw-Hill books, 2003. Print.

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