Topic Overview - Education Bureau

Topic Overview

Topic BAFS (Compulsory Part)

Introduction to Accounting – Basic Ratio Analysis

Level S4

Duration 8 lessons (40 minutes per lesson)

Learning Objectives:

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

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

gross profit margin, net profit margin, return on capital employed, working

capital, current ratio and acid test ratio.

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

Overview of Contents:

Lesson 1 Concept of Financial Statement Analysis

Lesson 2 Concept and General Function of Accounting Ratios

Lesson 3 Calculation and Interpretation of Profitability Ratios

(Gross Profit and Net Profit Margin)

Lesson 4 Calculation and Interpretation of Profitability Ratios

(Return on Capital Employed)

Lesson 5 Working Capital and Its Management

Lesson 6 Liquidity Position and Liquidity Problems

Lesson 7 Calculation and Interpretation of Liquidity Ratio

(Current Ratio and Acid-test Ratio)

Lesson 8 Evaluation on the Liquidity and Profitability of a

Business Using Accounting Ratios and Its Limitation

Resources:

Topic Overview and Teaching Plan

PowerPoint Presentation

Student Worksheet

Suggested Activities:

Group discussion

In-class exercise

Assignment

Quiz

Lesson 1

Theme Concept of Financial Statement Analysis

Duration 40 minutes

Expected Learning Outcomes:

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

1. describe the basic concept of financial statement analysis.

Teaching Sequence and Time Allocation:

Activities Reference Time

Allocation

Part I: Introduction

Teacher starts the lesson by a discussion.

Teacher invites students to share their ideas on

how to evaluate the performance of a business.

PPT #2 – 3 6 minutes

Part II: Content

Teacher explains the concept of financial

analysis and different types of users of financial

report.


Teacher describes the format and contents of

income statement which is used for financial

analysis.

PPT #7 – 9

6 minutes

Activity 1: Class discussion

Teacher invites students to share their

ideas on how to evaluate a business with

an income statement.

Teacher goes through the answer and

makes conclusion.

PPT #10

PPT #11

3 minutes

4 minutes

Teacher describes the format and contents of

statement of financial position which is used for

financial analysis.



Teacher asks students to compare income

statement and statement of financial

position.


makes conclusion.

PPT #15

PPT #16

3 minutes

4 minutes

Part III: Conclusion

Teacher concludes the lesson by reviewing the

key points covered.

2 minutes

Lesson 2

Theme Concept and General Function of Accounting Ratios

Duration 40 minutes



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



Allocation


Teacher explains financial statement analysis is

a vital part of internal analysis and introduces

four areas for financial analysis.


Part II: Content



ideas on the performance of the business

based on the four areas for financial

analysis.


makes conclusion.

PPT #4

PPT #5

4 minutes

3 minutes

Teacher explains the purpose of financial

analysis using ratios.

Teacher explains the three types of comparison

for analysis.

PPT #6 – 7

PPT #8 – 11

7 minutes

9 minutes

Activity 2: Group Discussion

Students are divided into groups of three

to four for discussion.


ideas and makes conclusion.

PPT #12

PPT #13 – 14

8 minutes

4 minutes



key points covered.

2 minutes

Lesson 3

Theme Calculation and Interpretation of Profitability Ratios (Gross Profit

and Net Profit Margin)

Duration 40 minutes



1. calculate gross profit margin and net profit margin;

2. analyse and comment on these profitability ratios.



Allocation


Teacher recaps the four areas for financial

analysis and explains to students the discussion

of the lessons will be focused on profitability

and liquidity of a business.

PPT #2 2 minutes

Part II: Content

Teacher explains the concept of profitability

ratios.

Teacher explains the concept of gross profit

margin and demonstrates its calculation and

provides comments on its result.

PPT #3 – 5

PPT #6 – 8

8 minutes

8 minutes

Activity 1: Calculation of Gross Profit Margin

Teacher asks students to calculate and

comment the gross profit margin for two

years.


makes conclusion.

PPT #9

PPT #10

3 minutes

4 minutes

Teacher explains the concept of net profit

margin and demonstrates its calculation and

comments on its result.

PPT #11 - 13

6 minutes

Activity 2: Calculation of Net Profit Margin

Teacher asks students to calculate and

comment the net profit margin for two

years.

Teacher goes through answers and makes

conclusion.

PPT #14

PPT #15

3 minutes

4 minutes



key points covered.

2 minutes

Lesson 4

Theme Calculation and Interpretation of Profitability Ratios (Return on

Capital Employed)

Duration 40 minutes



1. calculate the return on capital employed;

2. analyse and comment on the profitability ratio.



Allocation


Activity 1: Group discussion

Teacher starts with a discussion to recap

students’ understanding of gross profit

margin and net profit margin.


makes conclusion.

PPT #2

PPT #3

6 minutes

4 minutes

Part II: Content

Teacher explains the concept of return on

capital employed, demonstrates its calculation

and comments on its result.

PPT #4 – 6

12 minutes

Activity 2: Calculation of Profitability Ratio

Teacher asks students to calculate the

gross profit margin, net profit margin and

ROCE for XYZ Ltd.


makes conclusion.

PPT #7

PPT #8

8 minutes

5 minutes

Teacher explains the purposes of using

profitability ratios.

PPT #9

3 minutes



key points covered.

2 minutes

Lesson 5

Theme Working Capital and Its Management

Duration 40 minutes



1. understand the concept of working capital;

2. calculate the working capital of a company.



Allocation


Teacher explains the concept of working

capital.

PPT #2 2 minutes

Part II: Content



ideas on the implication of a negative

working capital.


makes conclusion.

PPT #3

PPT #4

3 minutes

3 minutes

Activity 2: Calculation of Working Capital

Students are required to calculate and

comment the working capital of a

company.


makes conclusion.

PPT #5

PPT #6

4 minutes

3 minutes

Teacher explains the causes of a change in

working capital.


Teacher explains the concept of working capital

management.

Teacher explains the relationship of working

capital management and business solvency.

PPT #11 – 12

PPT #13 – 14

3 minutes

4 minutes



to four to discuss the implication of a

conservative working capital policy to a

company.

PPT #15

4 minutes


makes conclusion.

PPT #16 3 minutes



key points covered.

2 minutes

Lesson 6

Theme Liquidity Position and Liquidity Problems

Duration 40 minutes



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

2. evaluate the liquidity of a company.



Allocation


Teacher explains the concept of Liquidity. PPT #2 4 minutes

Part II: Content

Teacher explains how to measure the liquidity

of a company.

Teacher explains what is liquid asset.

PPT #3

PPT #4

3 minutes

3 minutes


Teacher invites students to give some

examples of liquid assets.


makes conclusion.

PPT #5

PPT #6

3 minutes

3 minutes

Teacher explains the risks of a company when

there is liquidity problem.

PPT #7 3 minutes



to four to discuss the signs of liquidity

problem.


makes conclusion.

PPT #8

PPT #9

9 minutes

7 minutes

Teacher explains how a company cope with its

liquidity problem.

PPT #10 3 minutes



key points covered.

2 minutes

Lesson 7

Theme Calculation and Interpretation of Liquidity Ratio (Current Ratio

and Acid-test Ratio)

Duration 40 minutes



1. calculate the liquidity ratio (current ratio);

2. analyse and comment on the current ratio.

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

4. analyse and comment on the acid test ratio.



Allocation


Teacher introduces liquidity ratios. PPT #2 3 minutes

Part II: Content

Teacher explains how to measure the liquidity

of a company.

Teacher explains the concept of current ratio

and demonstrate its calculation and provides


PPT #3

PPT #4 – 7

2 minutes

7 minutes

Activity 1: Calculation of Current Ratio


comment the current ratio of a company.


makes conclusion.

PPT #8

PPT #9

2 minutes

3 minutes

Teacher explains the limitation of using current

ratio.

PPT #10 5 minutes

Teacher explains the concept of acid test ratio

and demonstrate its calculation and provides


PPT #11 – 14

7 minutes

Activity 2: Calculation of Acid Test Ratio


comment the acid test ratio of a company.


makes conclusion.

PPT #15

PPT #16

2 minutes

3 minutes

Teacher explains the advantages and PPT #17 4 minutes

disadvantages of using acid test ratio.



key points covered.

2 minutes

Lesson 8

Theme Evaluation on the Liquidity and Profitability of a Business Using

Accounting Ratios and Its Limitation

Duration 40 minutes



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

make business decision;

2. describe the limitation of using accounting ratios.



Allocation


Teacher recaps the question which was asked in

the first lesson and invites students to share

their learning experience.

Teacher concludes that the use of accounting

ratios can help a company to understand its

financial performance and financial position.

PPT #2

PPT #3

2 minutes

2 minutes

Part II: Content

Teacher demonstrates how to work out

different accounting ratios for a company and

make comments accordingly.

PPT #4 – 6

9 minutes

Activity 1: Case Study

Students are required to calculate the

accounting ratios and make decision.


makes conclusion.

PPT #7

PPT #8 – 10

8 minutes

9 minutes

Teacher explains other factors that affecting

business decision.

Teacher explains the limitations of accounting

ratio analysis.

PPT #11

PPT #12

3 minutes

5 minutes



key points covered.

2 minutes

1

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

2

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

4

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

5

Teacher explains different types of users of financial reports.

6

Teacher explains the purpose of preparing income statement.

7

Teacher describes the format and content of an income statement.

Teacher explains the following calculations:

Sales ‐ Cost of Sales = Gross Profit

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

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

9

Teacher invites students to share their ideas.

10

Teacher makes conclusions and provides answer.

11

Teacher explains the nature of statement of financial position.

12

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

14

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

15


16

1

Teacher explains financial statement analysis is a vital part of internal analysis which: • Overall performance could be measured in financial terms.• Indicates the extent to which it is achieving its objectives.• It can help identifying areas of weakness and formulate appropriate strategies.Financial statement analysis is also helpful in providing information for external users for investment and financing decisions such as hold/buy/sell shares, assess credit worthiness etc.

2

3

Teacher explains there are four areas for financial statements analysis:• Profitability: Is the business profitable?• Liquidity and efficiency: Is the trading position satisfactory?• Solvency: Is the business able to meet its long‐term fixed expenses?• Market prospects: Is the business funded properly and using these funds wisely?

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

4

Students are free to share their ideas regarding the four aspects. Some suggested solutions may include:Profitability: The profit after tax in 20X5 is $29,000 higher than 20X4.Liquidity: The company is able to meet its short‐term obligation because the total of current assets is higher than the total of current liabilities for both 20X4 and 20X5.Solvency: The company is able to generate future revenues to meet its long‐term debts because profits earned for 20X5 has already covered 67% (332/497) of the long‐term loan.Market prospects: No idea as there is no market information provided from the financial statements above.Teacher explains to students that conclusions drawn about the performance of a business is limited if we just refer to the numbers presented on the financial statements. To overcome such limitation, teacher can then introduce the concepts of accounting ratios in financial analysis.

5 6

Teacher explains that ratio analysis is a quantitative analysis which is one of the elements in financial statements analysis. Qualitative analysis such as customers’ preference etc. is not covered in this course.

7

Teacher elaborates the importance of comparison in financial statements analysis by using the information provided in activity 1. For example, there is no meaning by merely knowing sales for the year 20X5 is $1,850,000, the information is insufficient for us to make any comments on the sales performance of the company. However, by comparing the sales figures of 20X4 and 20X5, and knowing that there is an increase of $290,000, we can understand that the sales performance of the company is better than previous year.

Teacher explains the need of comparative analysis.

8

Teacher explains the use of intracompany comparison.

9

Teacher explains the use of intercompany comparison.

10

Teacher explains the use of industry averages comparison.

11

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

12

13

Teacher explains the types of internal users and how financial ratios assist their decision-making.

14

Teacher explains the types of external users and how financial ratios assist their decision-making.

1

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

2

Teacher explains the concept of profitability ratio.

3

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

4

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

5

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

6

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

7

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

The Gross Profit Margin for ABC Ltd:

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

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

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

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

8

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

9


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

10

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

11

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

12

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

The Net Profit Margin for ABC Ltd:

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

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

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

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

13


14


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

15 16

1

Teacher starts with a discussion to recap students’ understanding of gross profit margin and net profit margin.Students are invited to present their ideas.

2

Teacher makes conclusions and provides answer.Teacher then introduce the concept of ROCE which is another ratio to assess the profitability of a company.

3

Teacher explains the concept and formula of ROCE and its indication.In general, the higher the ratio, the better the ability a company using its capital.

4

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

The ROCE for ABC Ltd:

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

20X4: $383/$3,394 x 100% = 11.28%The ROCE in 20X5 is better than 20X4 by increasing 0.89% which indicates a more effective use of the company’s capital.

5

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

6

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

7

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

8

Teacher explains the advantages of using profitability ratios.

9 10

1

Teacher explains the concept of working capital.

2

Teacher invites students to share their ideas.

3


4

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

5

Teacher explains the implication of the following:

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

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

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

6

7

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

8

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

9

Teacher invites students to answer and makes conclusion as below:

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

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

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

Therefore, the answer is B.

10

Teacher explains the concept of working capital management.

11

Teacher explains the importance of working capital management.

12

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

13

Teacher describes two different working capital polices.

14

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

15

Teacher invites students to share their answers and debrief the suggested solution. Teacher also explains that an aggressive policy will lead to an opposite effect.

16

1

Teacher explains the concept of liquidity.

2

Teacher explains how to measure the liquidity of a company.

3 4

Teacher explains what is liquid asset.

Teacher invites students to share their answers.

5

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

6

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

7

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

8


9

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

10

1

Teacher introduces liquidity ratios.

2

3

Teacher introduces the use of current ratio and acid-test ratio which help to measure the liquidity of a company.

Teacher explains the concept of current ratio.

4

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

5

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

6

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

The current ratio for ABC Ltd:

20X5: $634/$351= 1.81 times

20X4: $700/$306 = 2.29 times

The current ratio for 20X5 is lower than 20X4 which indicates the ability to settle short‐term debts is lower. However, it is still satisfactory as it still has sufficient liquidity to cover its liabilities.

7


8


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

9

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

10

Teacher explains the concepts of acid test ratio.

11

Teacher explains quick ratio indicates a company’s immediate short‐term debt‐paying ability.The rule of thumb for the quick ratio is 1:1

12

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

13

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

The acid test ratio for ABC Ltd:

20X5: ($634 ‐ $212)/$351= 1.20 times

20X4: ($700 ‐ $189)/$306 = 1.67 times

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

14


15


16

Teacher explains the advantages and disadvantages of using current ratio.

17 18

1

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

2

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

3

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

4

Teacher calculates different ratios and comments the results with students.

5

Teacher calculates different ratios and comments the results with students.

6

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

7 8

Teacher goes through the answers and makes comments.

9

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

10

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

11 12

Teacher explains the limitations of accounting ratio analysis.

BAFS (Compulsory Part) – Introduction to Accounting

Basic Ratio Analysis

Lesson 1

Activity 1 - Class Discussion

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

_______________________________________________

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_______________________________________________

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Lesson 1


A company’s financial statements consist of the income statement and statement of

financial position. Compare these two statements.

Income statement Statement of financial position

Purpose

Time frame

Major item



Lesson 2

Activity 1 – Discussion

Your uncle has then provided you with the income statement and statement of financial

position of his business for the last two financial years for your viewing.

20X5 20X4

$'000 $'000

1,850 1,560

(935) (753)

915 807

Distribution (135) (108)

Selling and marketing (182) (161)

General and administrative (174) (155)

424 383

(26) (24)

398 359

(66) (56)

332 303

ABC Ltd

Income Statement

For the year ended 31 December

Profit before tax

Income tax expenses

Profit after tax

Turnover

Cost of sales

Gross profit

Expenses

Operating profit

Interest expenses

20X5 20X4

$'000 $'000

Non-current assets

Equipments 3,200 3,000

Current assets

Inventories 212 189

Trade receivables 304 286

Cash and bank 118 225

634 700

Current liabilities

Trade payables 285 250

Tax payable 66 56

351 306

Total assets less current liabilities 3,483 3,394

Financed by:

Share capital 2,200 2,200

Retained earnings 786 454

2,986 2,654

Non-current liabilities

Long-term loan 497 740

3,483 3,394

ABC Ltd

Statement of Financial Position

As at 31 December

Using the four aspects of financial statement analysis, what can you find out from the

information provided on the financial statements?

Profitability:

Liquidity and Efficiency:

Solvency:

Market Prospects:

BAFS (Compulsory Part) –

Introduction to Accounting


Lesson 2

Activity 2 – Group discussion

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

shareholders (investors) of a company and discuss how the financial ratios can help

you to make business decisions?

Internal Management:

Lenders:

Shareholders (Investors):



Lesson 3

Activity 1 - Calculation of Gross Profit Margin Given the following information, calculate and comment the gross profit margin for

the years of 20X4 and 20X5.

20X4 20X5

Sales $100,000 $120,000

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

Gross profit ( ) ( )

Gross profit margin ( ) ( )

Comments:

______________________________________________

______________________________________________

______________________________________________

______________________________________________

______________________________________________

______________________________________________



Lesson 3

Activity 2 - Calculation of Net Profit Margin

Given the following information, calculate and comment the net profit margin for

the years of 20X4 and 20X5.

20X4 20X5

Sales $100,000 $120,000

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

Gross profit $46,000 $58,000

Operating expenses $33,000 $44,000

Net profit ( ) ( )

Net profit margin ( ) ( )

Comments:

______________________________________________

______________________________________________

______________________________________________

______________________________________________

______________________________________________

______________________________________________



Lesson 4

Activity 1 – Class Discussion

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

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Lesson 4

Activity 2 – Calculation of Profitability

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

ratios.

20X5 20X4

$'000 $'000

3,310 2,952

(1,840) (1,632)

1,470 1,320



General and (227) (187)

606 615

(105) (87)

501 528

(92) (96)

409 432

XYZ Ltd

Income Statement


Profit before tax

Income tax expenses

Profit after tax

Sales

Cost of sales

Gross profit

Expenses

Operating profit

Interest expenses

20X5 20X4

$'000 $'000

Non-current assets


Current assets

Inventories 331 292



1,057 863

Current liabilities


Tax payable 92 96

488 463


Financed by:


Retained earnings 1,022 855

5,022 4,855


Long-term loan 1,047 765

6,069 5,620

XYZ Ltd


As at 31 December

Calculations Comments

Gross Profit Margin

20X5:

20X4:

Net Profit Margin

20X5:

20X4:

Return on Capital Employed

20X5:

20X4:



Lesson 5


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

greater than current liabilities.

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

liabilities)?

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Lesson 5

Activity 2 – Calculation of Working Capital

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

20X5 20X4

$'000 $'000

3,310 2,952

(1,840) (1,632)

1,470 1,320



General and (227) (187)

606 615

(105) (87)

501 528

(92) (96)

409 432

XYZ Ltd

Income Statement


Profit before tax

Income tax expenses

Profit after tax

Sales

Cost of sales

Gross profit

Expenses

Operating profit

Interest expenses

20X5 20X4

$'000 $'000

Non-current assets


Current assets

Inventories 331 292



1,057 863

Current liabilities


Tax payable 92 96

488 463


Financed by:


Retained earnings 1,022 855

5,022 4,855



6,069 5,620

XYZ Ltd


As at 31 December

Working Capital of XYZ Ltd

20X5:

20X4:

BAFS

Ratio Analysis 5

Activity 3 – Group Discussion

How a conservative working capital policy lowers profitability and risk?

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Lesson 6


Can you give some other examples of liquid assets?

7

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Lesson 6

Activity 2 – Group Discussion

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

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Lesson 7

Activity 1 - Calculation of Current Ratio

Given the following information, calculate and comment the current ratio for the years of

20X4 and 20X5.

20X4 20X5

Inventory $163,000 $116,000

Accounts receivable

$146,000 $162,000

Cash and bank $23,000 $44,000

Accounts payable $155,000 $171,000

Calculations Comments

Current ratio

20X4:

20X5:



Lesson 7

Activity 2 - Calculation of Acid Test Ratio

Given the following information, calculate the acid test ratio for the years of 20X4 and 20X5

and comment the ratio by comparing with the current ratio calculated in activity 1.

20X4 20X5

Inventory $163,000 $116,000

Accounts receivable $146,000 $162,000

Cash and bank $23,000 $44,000

Accounts payable $155,000 $171,000

Current ratio Acid test ratio Comments

20X4:

20X5:

20X4:

20X5:



Lesson 8

Activity 1 – Case Study

Your uncle’s business is the supplier of DEF Ltd. Your uncle is now considering

whether it is appropriate to sell goods to DEF Ltd on credit or COD (Cash on Delivery).

(Demanding COD might cause DEF Ltd buy less from your uncle’s company.)

Use accounting ratios to help your uncle to make decision

(3,380) (3,410)

1,840 2,120


Selling and marketing (414) (398)General and

administrative (331) (303)

573 937

(108) (66)

465 871

(65) (42)

400 829

Profit before tax

Income tax expenses

Profit after tax

Cost of sales

Gross profit

Expenses

Operating profit

Interest expenses

20X5 20X4

$'000 $'000

Non-current assets


Current assets

Inventories 338 284



908 818

Current liabilities


Tax payable 65 42

847 476


Financed by:


Retained earnings 1,688 1,288

7,188 6,788



8,311 7,615

DEF Ltd


As at 31 December

20X5 Ratio Calculation Result

Gross Profit Margin

Net Profit Margin

ROCE

Current Ratio

Acid Test Ratio

20X4 Ratio Calculation Result

Gross Profit Margin

Net Profit Margin

ROCE

Current Ratio

Acid Test Ratio

Ratio Comments

Gross Profit Margin

Net Profit Margin

ROCE

Current Ratio

Acid Test Ratio

Suggestion

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p.1

Basic Ratio Analysis – Home Assignment

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

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

relative term?

A. It is easy to calculate.

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

C. Absolute numbers are difficult to identify.

D. All of the above.

Level of difficulty: **

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

company?

A. Sales generated for the year.

B. Share price of the company.

C. Profit for the year.

D. Operating expenses of the year.

Level of difficulty: *

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

A. Ratios from previous years

B. Ratios of other companies

C. Both A and B.

D. None of the above.


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

company and

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

B. determine a company’s credit worthiness.

C. evaluate performance of employee and determine relevant compensation.

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


p.2


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

business.

A. profitability.

B. liquidity.

C. solvency.

D. investment.


6. Which of the following is the best description for return on capital employed

(ROCE)?

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

B. It is the difference between current assets and current liabilities

C. It is defined as the ability to pay your debts when they come due.

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


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

Office equipment: $85,000

Furniture & fixture: $24,000

Accounts receivable: $5,200

Inventory: $6,100

Bank overdraft: $1,500

Accounts payable: $4,400

A. $5,400.

B. $8,400.

C. $114,400.

D. $117,400.



p.3

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

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

B. The higher the ratio the better.

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

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

problem.


9. Other than the use of accounting ratios, which of the following factors will not

affect the decision of investing in another company?

A. Legal environment.

B. Reputation of the company.

C. Relationship with customers.

D. Research expenses already paid for this investment project.

Level of difficulty: ***

10. If the current ratio of a company is 7:1, the company may be holding

____________ idle short-term assets.

A. too much

B. too little

C. sufficient

D. right level of



p.4

Section B: Short Questions

Question 1

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


Question 2

What is the reason of using ‘profit before interest and tax’ instead of ‘profit after

interest and tax’ as the numerator in the ROCE formula? (4 marks)


Question 3

Suggest four methods to a company when there is a liquidity problem to settle the

balance with its supplier in next month. (8 marks)


Question 4

Given the following information, calculate the current ratio and acid test ratio of the

company and provide comment on its liquidity. (10 marks)

Non-current assets: $241,000

Accounts receivable: $6,300

Inventory: $15,500

Cash: $5,500

Accounts payable: $9,800

Tax payable: $3,200



p.5

Question 5

(a) State the characteristics of a company using aggressive working capital policy

byshowing its effects on the level of items listed in the following table. (4 marks)

(b) Briefly describe the overall impacts on profitability and risk to a company using

aggressive working capital policy by outlining its implication to the items listed

in the following table. (10 marks)

Level of

cash

Level of

accounts

receivable

Level of

inventory

Short-term

debts/

long-term

liabilities

Overall

Impact

(a)

Characteristics

----

(b)

Profitability

Risk



p.6

Solutions:

Section A: MCQs

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

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

Section B: Short Questions.

Question 1

The four internal uses of financial ratios include:

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

2. Evaluate performance of employees and determine relevant compensation.

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

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

(@1, total 4 marks)

Question 2

The reason of using net profit before interest and tax in calculating ROCE is that such

profit is the income generated from the company’s assets regardless of how the

company’s funds come from.

If the company relies heavily on borrowing, the net profit before tax will be adversely

affected because of high interest expense and hence affect the comparison with

companies with different capital structure.

(@2, total 4 marks)

Question 3

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

problems:

• Offering an early settlement discount to its customers. This is a reduction in

the amount of the payment required from the customer provided that the

customer pays within a specified time limit.

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

cash.

• Buy less inventory = applying Just-in-time inventory system to reduce the

carrying cost of the inventory and increase the cash balance.

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

[remarks: it is not suggested to use long-term loan as the interest expense will

be too high when it is only a temporary running short of cash.]


p.7

• Disposal of idle non-current assets to improve the liquidity.

• Any other valid suggestions.

(@2, max 8 marks)

Question 4

Calculation Comments

Current

ratio

($6,300 + $15,500 +

$5,500) / ($9,800 +

$3,200) = 2.1:1

(2 marks)

The current ratio is satisfactory as the current

assets are about two times of its current

liabilities which indicates the company has

sufficient short-term funds to settle its

short-term obligations. (2 marks)

Acid test

ratio

($6,300 + $5,500) /

($9,800 + $3,200) =

0.91:1

(2 marks)

The acid test ratio is a bit unsatisfactory as there

is less than $1 dollar of liquid assets to cover $1

dollar of current liabilities. The significant

drop of the ratio indicates there are too many

inventories on hand and the company may not

have sufficient short-term funds without the

sale of inventory to settle its short-term

obligations. (4 marks)

Question 5

Level of

cash

Level of

accounts

receivable

Level of

inventory

Short-term

debts/

long-term

liabilities

Overall

Impact

(a)

Characteristics

Lower Lower Lower Higher/lower -

(b)

Profitability

Increase

investment

opportunity.

Less cost

of

financing

when cash

is

received.

Lower

carrying costs

and

obsolescence.

Lower

interest

expenses.

Higher

return

Risk Higher risk

as less

immediate

cash.

Higher

probably

of bad

debts.

Probability of

stock out and

miss the

chance of

sales.

More

short-term

obligation to

meet.

Higher

risk

(@1, total 14 marks)

Ratio Analysis

p. 1

Basic Ratio Analysis – Quiz

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

1. Which of the following issue can be indicated by reviewing the income statement

of a company?

A. The operating expense spent for the year in percentage of the income for the

year.

B. How much non-current asset is employed to generate profit.

C. Whether the debt level is high or low.

D. Whether the company is able to pay for their short-term obligation.


2. What can be showed by comparing a computer company’s the financial

information over the past 5 years?

A. Trends of financial performance.

B. Company’s competitive position.

C. Development of the industry.

D. Technological change.


3. What is the implication of having a higher return on capital employed (ROCE)?

A. The company has a better control on cost of goods sold.

B. The company is able to settle its short-term loan.

C. The company relies too much on capital.

D. The company is more effective in using its capital assets to generate returns.


Ratio Analysis

p. 2

4. Which of the following may be affected by the profitability of a company?

A. Its ability to obtain debt and equity financing

B. Its liquidity position.

C. Its ability to grow.

D. All of the above.


5. What is the implication when a company has high gross profit but low net profit?

A. Poor control on working capital.

B. Better control on cost of goods sold and operating expense.

C. Better control on cost of goods sold but poor control on operating expense.

D. Decline in sales demand.


6. Which of the following would lead to an immediate outflow of cash in a period?

A. Purchase of goods on credit.

B. Payment to suppliers.

C. Unpaid dividend declared.

D. Receipt from customers.


7. By using aggressive working capital policies, current assets are often financed by

___________.

A. Selling non-current assets.

B. Borrowing short-term debts.

C. Issuing bonds.

D. Issuing shares.


Ratio Analysis

p. 3

8. Which of the following is not a component of working capital?

A. Plant and machinery.

B. Cash.

C. Trade payables.

D. Inventory.


9. Which of the following is not a component of quick assets?

A. Trade receivable.

B. Cash.

C. Inventory.

D. None of the above.


10. Which of the following is not the limitation of financial ratio analysis?

A. Seasonal factor cannot be reflected.

B. Information used are historical.

C. Different accounting practices adopted by companies.

D. Too much accounting information included.


Ratio Analysis

p. 4

Section B: Short Questions

Question 1

Briefly describe the signs of liquidity problems of a company. (10 marks)


Question 2

Calculate the following financial ratios for XYZ Ltd for both 20X4 and 20X5, and

comment briefly the result of each ratio.

Gross profit margin.

Net profit margin.

Return on capital employed.

Current ratio.

Acid test ratio.

20X5 20X4

$'000 $'000

23,220 20,123

(16,420) (14,836)

6,800 5,287


Selling and marketing (1,322) (1,201)

General and (1,054) (988)

3,526 2,394

(435) (332)

3,091 2,062

(456) (354)

2,635 1,708Profit after tax

Sales

Cost of sales

Gross profit

Expenses

Operating profit

Interest expenses

XYZ Ltd

Income Statement


Profit before tax

Income tax expenses

Ratio Analysis

p. 5

20X5 20X4

$'000 $'000

Non-current assets


Current assets

Inventories 1,564 1,186

Trade receivables 2,349 2,561


4,764 4,105

Current liabilities

Trade payables 1,894 2,334

Tax payable 456 354

2,350 2,688


Financed by:


Retained earnings 8,515 5,880

38,515 35,880


Long-term loan 9,104 7,621

47,619 43,501

XYZ Ltd


As at 31 December

(20 marks)


Ratio Analysis

p. 6

Solutions:

Section A: MCQs

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

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

Section B: Short Questions.

Question 1

The signs of liquidity problems of a company include:

1. Persistent decline in daily or weekly cash inflows.

2. Significant decline in operating profit which indicates the company is unable to

pass the cost on to customers.

3. Unexpected build-up of accounts receivable and inventory which indicates the

company may not be able to collect money from customers or is unable to sell

goods.

4. Unexpected build-up of accounts payable indicates the company is unable to pay

to its suppliers.

5. Shape decline in company’s working capital.

(@2, total 10 marks)

Question 2

Formula 20X5 20X4

Gross

profit

margin

Gross profit /

Sales

$6,800/$23,220 = 29.29% $5,287/$20,123 = 26.27%

Comment: The gross profit margin for 20X5 is better than 20X4 which indicates a

better control on purchase costs (e.g. good bargain with suppliers) and/or

better sales performance of the company.

Net profit

margin

Net profit

before tax /

sales

$3,091/$23,220 = 13.31% $2,062/$20,123 = 10.25%

Comment: The net profit margin for 20X5 is better than 20X4 which indicates a

better control on purchase costs and/or operating expenses and/or better

sales performance of the company..

ROCE PBIT / Average $3,526/$47,619 = 7.4% $2,394/$43,501= 5.5%

Ratio Analysis

p. 7

capital

employed

Comment: The ROCE for 20X5 is better than 20X4 which indicates the company is

more efficient in using its capital asset to generate income.

Current

ratio

Current

assets/Current

liabilities

$4,764/$2,350 = 2.03:1 $4,105/$2,688 = 1.53:1

Comment: There is an increase in current ratio which indicates the ability of the

company to settle its short-term debts is improved. Besides, the current

ratio suggests that the company has sufficient current assets to meet its

short term debts.

Acid test

ratio

(Current

assets –

Inventory)/

Current

liabilities

($4,764 - $1,564)/$2,350 =

1.36:1

($4,105 - $1,186)/$2,688

= 1.09:1

Comment: There is an increase in acid test ratio which indicates the ability of the

company to use settle its short-term debts without having disposed of its

inventory is improved. Besides, the acid test ratio suggests that the

company has sufficient liquid assets to meet its short term debts.

(1 mark for each ratio and 2 marks for each comment, total 20 marks)

Topic Overview - Education Bureau

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