Topic 9 (Part 1) Recommended Tutorial/Homework Solutions

Comprehension questions
8.10 Discuss three limitations of ratio analysis as a fundamental analysis tool.
Ratio analysis relies on financial numbers in financial statements. Accordingly, the

quality of the ratios calculated is dependent on the quality of the entitys financial
statements. The quality may be affected by inadequate disclosures and lack of
details in financial statements and/or a firms accounting policy choices and
estimations.
Many of the ratios that are calculated rely on the asset, liability or equity numbers
reported in the balance sheet. This statement reflects the financial position of an
ongoing entity at a particular date and may not be representative of the financial
position at other times of the year.
Financial statements are historical statements reflecting past transactions. Often,
the past is a good guide to the future; however, the use of information outside the
financial statements also needs to be considered when forming predictions as to an
entitys future financial health.

Application and analysis exercises

8.20

Examine what happens to the current ratio when:

a.
an accounts payable is paid with cash.
b.
inventory is purchased on credit.
c.
money is received from a debtor.

Current ratio

Current assets
Current liabilities

a.

Although the dollar reduction in the current assets (cash) equals the reduction in
current liabilities, this does not necessarily mean that the ratio remains
unchanged. It will only remain unchanged if the current assets and current
liabilities are the same amounts prior to the transaction. If the current assets
exceed current liabilities, the effect of the transaction is to increase the current
ratio. If the current liabilities exceed the current assets, the effect of the
transaction is to reduce the ratio. Note: This is best illustrated to students using a
basic example. Create three scenarios: (1) CA >CL; (2) CA < CL; and (3) CA =
CL using fictitious amounts. Get students to calculate the current ratio before
and after the transaction.

b.

Same as above except current assets are increasing and current liabilities are
also increasing by the same amount. The impact on the current ratio will depend
on the CA relative to CL prior to the transaction.

c.

8.21

As money is received from a debtor, the accounts receivable will decrease and
cash will increase at the same amount. This transaction leaves the total amount
of current assets unchanged. As a result, the current ratio will remain the same.
Examine what happens to the gross profit margin when:
a.
advertising is incurred.
b.
selling prices are increased.
c.
suppliers increase their prices.

Gross profit
margin

Gross profit
Sales revenue

100
1

a.

The advertising expense does not have an impact on gross profit margins as the
advertising expense is not included in the calculation of gross profit. Although
the advertising campaign may increase sales revenue if successful, the cost of
sales will also increase proportionately with the increase in sales revenue,
leaving the gross profit margin unchanged.

b.

If selling prices increase and cost of sales remains the same, the gross profit
margin will increase as the entity will be generating a higher gross profit per
dollar of sales.

c.

When suppliers increase their prices, the entitys cost of sales will increase.
Assuming selling price remains the same, gross profit margin will decrease as a
higher percentage of sales dollars is consumed by the cost of sales. If the entity
increases its selling price following the increase in cost of sales, the impact on
gross profit margin for the entity will depend on the rate of increase. If selling
prices increases at a lower (higher) rate than the rate of increase in cost of sales,
gross profit margin will decrease (increase).
To illustrate this point, take an example where initial selling price is $4 and cost
of sales is $2. When suppliers increase the cost of sales to $3, ask students to
calculate the impact on gross profit margin when selling price: a) remains
unchanged and b) is increased to $5, $6, and $7.

8.23 Explain how it is possible for an entity with a high current ratio to have
difficulty paying its bills.
The current ratio is a liquidity ratio, calculated as current assets divided by current
liabilities. An entity with a high current ratio could still find it difficult to pay bills,
because the days debtors can be much longer than the days creditors. The entity may
have significant investment in debtors with many of the debtors being slow payers (or
even doubtful debts). An analysis of the cash cycle could be used to explain the
problem. The cash cycle is the period of time that elapses between paying for the

inventory, selling the inventory, and receiving cash for the inventory. It is the time that
the entity is financing the investments and incurring negative cash flows. The longer
the cash cycle the higher the current ratio will need to be, as the entity needs to have
sufficient cash during the cash cycle period in order to pay for its bills when they fall
due.
Furthermore, it is also possible that an entity with a high current ratio has a large
proportion of its current assets tied up in the form of inventory. Excessive inventory
could pose a liquidity problem as the money used to invest in the inventory is earning
a zero rate of return and cannot be used until the inventory is converted back into
cash. If the entity has a high days inventory, it will take longer for the entity to sell the
inventory and convert it to cash. When the period of converting the inventory into
cash is longer than the days creditors, the entity will have problems in paying its bills
since there is no sufficient cash available to cover the current liabilities.

8.24

If days inventory for Forever20 retail outlet was 47 days and days
creditors was 39 days, calculate what the cash cycle would be if credit
sales for a year amounted to $45 000 and the average trade debtors
balance at the end of the year was $18 000.

Cash cycle = Days inventory + Days debtors Days creditors

Cash cycle = 47 days + ? 39 days.
Days debtors
=

Average trade debtors

Sales revenue

365
1

18 000
45 000

365
1

146 days

Cash cycle = 47 days + 146 days 39 days

Cash cycle = 154 days

Synthesis and analysis problems

8.36

The income statement figures for the past five years for Phom Ltd are
presented in the question. Prepare a trend analysis and a vertical analysis
(using sales revenue as the base amount) and comment on the trends.

Phom Ltd
Trend Analysis
2009

2010

2011

2012

2013

Sales revenue
Interest
received

100.00

102.99

109.68

113.54

115.75

100.00

104.00

106.00

104.00

102.00

Total revenue

100.00

103.00

109.65

113.47

115.64

Cost of sales
Advertising
expense
Insurance
expense

100.00

114.29

116.43

125.00

128.57

100.00

106.67

120.00

133.33

133.33

100.00

100.00

103.33

103.33

133.33

Rent expense
Utilities
expense

100.00

108.33

116.67

125.00

133.33

100.00

105.56

109.44

113.89

116.67

Depreciation
Wages and
salaries

100.00

100.00

100.00

125.00

125.00

100.00

105.00

107.50

111.67

115.00

Interest expense

100.00

102.22

108.89

113.33

115.56

Total expenses

100.00

109.47

113.42

121.70

126.45

Profit

100.00

52.05

79.95

48.63

30.55

Expenses

The trend analysis shows that Phoms profitability has declined during the period of
2009 to 2013, despite the upward trend of the sales revenue. Sales revenue has gone
up from a base of 100 in 2009 to nearly 116 in 2013. However, total expenses has also
increased at a greater rate than total revenue (i.e. from a base of 100 in 2009 to 126 in
2013) and this has caused profit to decline from a base of 100 in 2009 to just 30 in
2013. The rapid increase in cost of sales, advertising expense, insurance expense, and

rent expense over the five year period have contributed to total expenses rising faster
than total revenue.
Note: Spreadsheet below is available as separate document.

8.37

Calculating days inventory turnover, days debtors, current ratio and

quick asset ratio
The income statement for Ugg Company for the year ending 30 June 2013 is
detailed below:

The operating expenses include $17 500 of interest expense.

The following amounts have been extracted from the companys balance sheet at
30 June 2013:

Required
a.

Calculate and interpret the following:

(i) days inventory turnover

Days inventory

Average inventory*
Cost of sales

365
1

37 500
325 000

365
1

42 days

*Note: Year-end figure (instead of average) is used to calculate the days inventory
turnover.
The days inventory of 42 days suggests that it takes Ugg Company on average 42
days to sell its inventory.

(ii) days debtors

Days debtors
=

Average accounts receivable*

Sales revenue

365
1

62 500
425 000

365
1

54 days

*Note: Year-end figure (instead of average) is used to calculate the debtors.

The days debtors of 54 days suggests that it takes Ugg Company on average 54 days
to collect the cash from its trade debtors.
(iii) current ratio
Current ratio
=

Current assets
Current liabilities

62 500 + 5 000 + 7 500 + 37 500

6 500 + 40 000 + 3 000

112 500
49 500

2.27 times

Current ratio is a measure of liquidity and a current ratio of 2.27 times suggests that
Ugg Company has $2.27 of current assets for every dollar of current liabilities.

(iv) quick asset ratio

Quick asset ratio
=

Current assets Inventory

Current liabilities

112 500 37 500

49 500

75 000
49 500

1.52 times

Quick asset ratio is a more stringent test of liquidity compared to current ratio. A
quick asset ratio of 1.52 times suggests that Ugg Company has $1.52 of current assets,
excluding inventory, for every dollar of current liabilities.
Note: This ratio could also be calculated by deducting bank overdraft from the
denominator, resulting in a quick asset ratio of 1.74 times.
b.

Report on what these ratios reveal about Ugg Company.

Summary of the ratios calculated above is as follows:

days inventory
= 42 days
days debtors
= 54 days
current ratio
= 2.27 times
quick asset ratio
= 1.52 times
Days inventory and days debtors reflect how efficient an entity manages its assets.
Ugg Companys days inventory of 42 days indicates that it takes 42 days for the
company to sell its inventory. Similarly, from the days debtors ratio it can be seen that
Ugg Company takes on average 54 days to collect the money from its trade debtors.
These ratios need to be compared with the ratios of other companies in the same
industries (i.e. those who sell uggs) to determine if they are appropriate for Ugg
Company. The days debtors also needs to be examined in conjunction with Ugg
Companys credit sales terms. If the companys credit terms is higher than the days
debtors (for example 50 or 60 days), then Ugg Company is doing well in being able to
collect its receivables quicker than the credit terms. In addition, it is important to
monitor the days inventory and days debtors in comparison with previous years
ratios, as concerns should be raised if these ratios show an upward trend.

Current ratio and quick asset ratio are used to assess an entitys liquidity position. Ugg
Companys current ratio of 2.27 times indicates that there is $2.27 of current assets to
cover for every $1 of current liabilities. Considering the arbitrary benchmark of 1.50
for current ratio, it appears that Ugg Company does not have liquidity problems, since
it has sufficient current assets to repay its short-term obligations. Quick asset ratio is a
more stringent measure of liquidity, as it does not take into account the amount of
inventory in the current assets. The quick asset ratio for Ugg Company is 1.52 times,
indicating that Ugg Company has $1.52 of current assets excluding inventory for
every dollar of current liabilities. Again, as Ugg Companys quick asset ratio exceeds
the arbitrary benchmark of 0.80, it seems that the company is in a good liquidity
position. However, given that its quick asset ratio nearly doubles the arbitrary
benchmark, it may be that the company retains excess investments in unprofitable
assets particularly in accounts receivable, which makes up over 55% of the total
current assets.