Review Exercises

The P&L statements and balance sheets of two wholesale businesses operated as sole
proprietorships by Perera and Silva are given below. Both businesses operate in the same
area of business.

Profit and Loss Statements

For the year ended 31 December 2004
Perera Silva
Rs. Rs.
Sales (Net) 20,000,000 40,000,000
Less: Cost of Sales

Operating inventory 1,400,000 5,800,000

Plus: Purchases 8,800,000 18,800,000

10,200,000 24,600,000
Less: Closing inventory 1,200,000 9,000,000 6,200,000 18,400,000
Gross Profit 11,000,000 21,600,000
Less: Operating expenses 7,000,000 11,600,000
Operating Profit 4,000,000 10,000,000
Less: Interest expense 400,000 600,000
Net Profit 3,600,000 9,400,000

Balance Sheets
As at 31 December 2004
Perera Silva
Rs. Rs.
Assets:
Non-current assets (net) 20,000,000 35,000,000

Inventory 1,200,000 6,200,000

Trade accounts 816,000 5,100,000

receivable
Less: Provision for 16,000 800,000 100,000 5,000,000
doubtful debts
Cash 1,000,000 3,600,000
23,000,000 49,800,000

Owner’s Equity and

Liabilities
Capital, 1.1.2004 14,000,000 24,200,000
Net Profit for the Year 3,600,000 17,600,000 9,400,000 33,600,000
Non-current liabilities: 4,000,000 6,000,000
bank loan
Current liabilities 1,400,000 10,200,000
23,000,000 49,800,000

Additional Information:

(1) The following ending balances were available at 31 December 2003:

Trade accounts receivable: Rs. 730,000 for Perera; Rs. 4,300,000 for Silva
Total assets: Rs. 22,200,000 for Perera; Rs. 48,200,000 for Silva

Required:
(a) Calculate the following ratios for both businesses:
(1) Return on assets (2) Return on Sales (3) Quick Ratio (4) Current Ratio
(5) Debt ratio

(1) Return on Assets = Net profit + Interest / Average Total Assets

Perera: (3,600,000 + 400,000) / (22,200,000 + 23,000,000)/2 = 17.7%
Silva : (9,400,000 + 600,000) / (48,200,000 + 49,800,000)/2 = 20.4%

(2) Return on Sales = Net profit / Net sales

Perera: 3,600,000 / 20,000,000 = 18%
Silva: 9,400,000 / 40,000,000 = 23.5%

(3) Quick Ratio = Current Assets – (inventory + pre-paid expenses)

Perera : 1,800,000 / 1,400,000 = 1.29:1
Silva : 8,600,000 / 10,200,000 = 0.84:1

(4) Current Ratio = CA / CL

Perera : 3,000,000 / 1,400,000 = 2.14:1
Silva : 14,800,000 / 10,200,000 = 1.45:1

(5) Debt Ratio = Total Liabilities / Total Assets

Perera : 5,400,000 / 23,000,000 = 23.5%
Silva : 16,200,000 / 49,800,000 = 32.5%

(b) On the basis of the ratios calculated, provide a comparative analysis of the
operating performance and financial position of the two businesses.

Both businesses are profitable in terms of their returns on investments. Perera’s ROA
is 17.7% compared with a better return of 20.4% for Silva. This is explained partly by
the fact that Perera’s net profit as a percentage of sales is 18% against that of 23.5%
 for Silva. This indicates that Silva appears to be managing the operating expenses of
his business more efficiently than Perera.

For Perera’s business, the current ratio and the quick ratio are 2.14 and 1.29
respectively. Without any information about the nature of the business being operated
by the two concerns, the adequacy of these ratios is difficult to judge. However, both
current and quick ratios of Perera’s business are above the normally accepted levels
of 2:1 and 1:1. Therefore, these 2 ratios indicate that short-term financial position of
Perera’s business can be considered satisfactory. In contrast, the current ratio of
1.45:1 and the quick ratio of 0.84:1, which are considerably lower than the generally
accepted safety levels, indicate a poor liquidity position of Silva’s business.

The debt ratio reveals that 32.5% of assets in Silva’s business is financed by
creditor’s compared to 23.5% of such financing in Perera’s. This means that
comparatively Silva faces a greater degree of financial risk in terms of his obligations
to creditors.

(c) What limitations would you observe in your analysis?

(c) What limitations would you observe in your analysis?

(i) Lack of competitive figures for previous years and other firms in the same industry
does not permit generalization of results.
In particular, it is not possible to determine the adequacy of profitability and liquidity for
each firm without comparative figures.

(ii) It is not possible to make judgments about acceptability of these ratios without
knowing the type of industry and the current economic climate.

(iii) The ratios may have been distorted by the use of historical cost data, which have not
been adjusted for inflation. Although sales and operating expenses show current rupee
value, non-current assets represent historical cost.

(iv) Differences in accounting policies between the two businesses may also have
distorted comparisons.
For example, a difference in the accounting policy for depreciation of non-current assets
can cause a significant difference in operating performance in the two firms.