PFR 5-2

Warringah PLC case   – OTQ case

The following scenario relates to questions 166–170.

Warringah PLC is a listed manufacturing company. Its summarised statement of financial position is

given below.

STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 2020

166. What is Warringah PLC’s current ratio at 31 December 2020?

167. The finance controller of Warringah PLC is concerned about its current ratio. He is considering a number of actions that he hopes will enhance Warringah PLC’s current ratio.

Which of the following would increase Warringah PLC’s current ratio?

168. What is Warringah PLC’s acid test (quick) ratio at 31 December 2020? (Enter your answer to two decimal places)

169. The finance controller of Warringah PLC knows that the acid test ratio is below 1. Therefore he is planning the following two changes:

Proposal 1: Offering a 2% early settlement discount to credit customers

Proposal 2: Delaying payment to all trade payables by one extra month

Using the options below, match the effect the proposals would have on the acid test ratio (tokens can used more than once)

A. Proposal 1

B. Proposal 2

170. Warringah PLC is a manufacturing company. Which of the following ratios would best assess the efficiency of Warringah PLC?

171   Berri Co

Berri Co would like to acquire 100% of a suitable private entity. It has obtained the following draft

financial statements for two entities, Volka and Redel. They operate in the same industry and their

managements have indicated that they would be receptive to a takeover.

Statements of profit or loss for the year ended 30 September 2020

Statement of financial position as at 30 September 2020

Notes:

1          Both entities operate from similar premises

2          Additional details of the two entities’ plant are:

Volka                             Rebel

$000                              $000

Owned plant – cost                                           8,000                            10,000

Right‐of‐use plant – initial value                        Nil                                7,500

There were no disposals of plant during the year by either entity.

3          The interest rate implicit within Rebel’s leases is 7.5% per annum. For the purpose of calculating ROCE and gearing, all lease obligations are treated as long‐term interest bearing borrowings.

4          The following ratios have been calculated for Volka and can be taken to be correct:

Return on year end capital employed (ROCE)                                                     14.8%

(capital employed taken as shareholders’ funds plus long‐term interest

bearing borrowings – see note (iii) above)

Gross profit margin                                                                                           12.5%

Operating profit margin                                                                                     10.5%

Current ratio                                                                                                     1.2:1

Closing inventory holding period                                                                       70 days

Trade receivables’ collection period                                                                   73 days

Trade payables’ payment period (using cost of sales)                                           108 days

Gearing (see note (iii) above)                                                                             35.3%

Required:

a) Calculate for Rebel the ratios equivalent to all those given for Volka above.

B. Assess the relative performance and financial position of Volka and Rebe; for the year ended 30 September 2020 to inform the directors of Berri Co in their acquisition decision.

C. Outline the problems in using ratios for comparison purposes between entities, and suggest what additional information would be useful for Berri Co in reaching its decision.

172. Tumora Co Case

Below are extracts from the statements of profit or loss for the Tumora group and Tumora Co for the years ending 31 December 20X7 and 20X6 respectively.

The following information is relevant:

On 1 September 20X7, Tumora Co sold all of its shares in Simon Co, its only subsidiary, for $28·64m. At this date, Simon Co had net assets of $26·1m. Tumora Co originally acquired 80% of Simon Co for $19·2m, when Simon Co had net assets of $19·8m. Tumora Co uses the fair value method for valuing the non-controlling interest, which was measured at $4·9m at the date of acquisition. Goodwill in Simon Co has not been impaired since acquisition.

In order to compare Tumora Co’s results for the years ended 20X6 and 20X7, the results of Simon Co need to be eliminated from the above consolidated statements of profit or loss for 20X7. Although Simon Co was correctly accounted for in the group financial statements for the year ended 31 December 20X7, a gain on disposal of Simon Co of $9·44m is currently included in operating expenses. This reflects the gain which should have been shown in Tumora Co’s individual financial statements.

In the year ended 31 December 20X7, Simon Co had the following results:

$m

Revenue                                   13.50

Cost of sales                             6.60

Operating expenses                2.51

Finance costs                            1.20

During the period from 1 January 20X7 to 1 September 20X7, Tumora Co sold $1m of goods to Simon Co at a margin of 30%. Simon Co had sold all of these goods on to third parties by 1 September 20X7.

Simon Co previously used space in Tumora Co’s properties, which Tumora Co did not charge Simon Co for. Since the disposal of Simon Co, Tumora Co has rented that space to a new tenant, recording the rental income in operating expenses.

The following ratios have been correctly calculated based on the above financial statements:

Required

a) Calculate the gain on disposal which should have been shown in the consolidated statement of profit or loss for the Tumora group for the year ended 31 December 20X7.

B. Remove the results of Simon Co and the gain on disposal of the subsidiary to prepare a revised statement of profit or loss for the year ended 31 December 20X7 for Tumora Co only.

C. Calculate the equivalent ratios to those given for Tumora Co for 20X7 based on the revised figures in part (b) of your answer.

D. Using the ratios calculated in part (c) and those provided in the question, comment on the performance of Tumora Co for the years ended 31 December 20X6 and 20X7.

173. Zrappa Co

Zrappa sells jewellery through stores in retail shopping centres throughout the country. Over the last two years it has experienced declining profitability and is wondering if this is related to the sector as whole. It has recently subscribed to an agency that produces average ratios across many businesses. Below are the ratios that have been provided by the agency for Zrappa’s business sector based on a year end of 30 June 20X2. Zrappa sells jewellery through stores in retail shopping centres throughout the country. Over the last two years it has experienced declining profitability and is wondering if this is related to the sector as whole. It has recently subscribed to an agency that produces average ratios across many businesses. Below are the ratios that have been provided by the agency for Zrappa’s business sector based on a year end of 30 June 20X2.

The financial statements of Zrappa for the year ended 30 September 20X2 are shown below.

Note: The deferred development expenditure relates to an investment in a process to manufacture artificial precious gems for future sale by Zrappa in the retail jewellery market.

Required:

A. Prepare the ratios for Zrappa equivalent to those of the sector.                  

B. Assess the financial and operating performance of Zrappa in comparison to its sector averages.  

174. Dangal Co

Shown below are the recently issued (summarised) financial statements of Dangal Co, a listed company, for the year ended 30 September 20X7, together with comparatives for 20X6 and extracts from the chief executive’s report that accompanied their issue.

Extracts from the chief executive’s report:

‘Highlights of Dangal Co’s performance for the year ended 30 September 20X7:

An increase in sales revenue of 39%

Gross profit margin up from 16.7% to 20%

A doubling of the profit for the period

In response to the improved position, the board paid a dividend of 10 cents per share in September 20X7 an increase of 25% on the previous year.

You have also been provided with the following further information.

On 1 October 20X6 Dangal Co purchased the whole of the net assets of Ruso Co (previously a privately owned entity) for $100 million, financed by the issue of $100,000 8% loan notes. The contribution of the purchase to Dangal Co’s results for the year ended 30 September 20X7 was:

$’000

Revenue                                                                                     70,000

Cost of sales                                                                             (40,000)

Gross profit                                                                              30,000

Operating expenses                                                                   (8,000)

Profit before tax                                                                      22,000

There were no disposals of non-current assets during the year.

The following ratios have been calculated for Dangal Co for the year ended 30 September.

Required

A. Calculate equivalent ratios for Dangal Co for 20X7

B. Assess the financial performance and position of Dangal Co for the year ended 30 September 20X7 compared to the previous year. Your answer should refer to the information in the chief executive’s report and the impact of the purchase of the net assets of Ruso.            

175. Fox Co

Orange is a publicly listed entity which has experienced rapid growth in recent years through the

acquisition and integration of other entities. Orange is interested in acquiring Fox, a retailing business,

which is one of several entities owned and managed by the same family, of which Lodan is the ultimate

parent.

The summarised financial statements of Fox for the year ended 30 September 20X4 are:

Statement of profit or loss

$000

Revenue                                                                                                                                      70,000 

Cost of sales                                                                                                                             (45,000)

Gross profit                                                                                                                                25,000

Operating costs                                                                                                                         (7,000)

Directors’ salaries                                                                                                                     (1,000)

Profit before tax                                                                                                                       17,000

Income tax expense                                                                                                                 (3,000)

Profit for the year                                                                                                                     14,000

Statement of financial position

$000                                    $000

Assets

Non‐current assets

Property, plant and equipment                                                                                                           32,400

Current assets

Inventory                                                                                                      7,500

Bank                                                                                                                  100                                   7,600

Total assets                                                                                                                                               40,000

Equity and liabilities

Equity

Equity shares of $1 each                                                                                                                           1,000

Retained earnings                                                                                                                                     18,700

19,700

Non‐current liabilities

Directors’ loan accounts (interest free)                                                                                                            10,000

Current liabilities

Trade payables                                                                                            7,500

Current tax payable                                                                                   2,800                                   10,300

Total equity and liabilities                                                                                                                     40,000

From the above financial statements, Orange has calculated for Fox the ratios below for the year

ended 30 September 20X4. It has also obtained the equivalent ratios for the retail sector average which

can be taken to represent Fox’s sector.

                                                                                    Fox                                       Sector average

Return on equity (ROE) (including

directors’ loan accounts)                                                           47.1%                                        22.0%

Net asset turnover                                                                      2.36 times                            1.67 times

Gross profit margin                                                                     35.7%                                        30.0%

Net profit margin                                                                         20.0%                                         12.0%

From enquiries made, Orange has learned the following information:

1             Fox buys all of its trading inventory from another of the family entities at a price which is 10% less than the market price for such goods.

2             After the acquisition, Orange would replace the existing board of directors and need to pay remuneration of $2.5 million per annum.

3             The directors’ loan accounts would be repaid by obtaining a loan of the same amount with interest at 10% per annum.

4             Orange expects the purchase price of Fox to be $30 million.

Required:

A. Recalculate the ratios for Fox after making appropriate adjustments to the financial statements for notes (i) to (iv) above. For this purpose, the expected purchase price of $30 million should be taken as Fox’s equity and net assets are equal to this equity plus the loan. You may assume the changes will have no effect on taxation.

B. In relation to the ratios calculated in (a) above, and the ratios for Fox given in the question, comment on the performance of Fox compared to its retail sector average.  

C. One of Orange’s directors has suggested that it would be wise to look at the Lodan group’s consolidated financial statements rather than Fox’s individual financial statements.

As an adviser to Orange, explain any concerns you would raise about basing an investment decision on the information available in Lodan’s consolidated financial statements and Fox’s entity financial statements.          

176. Heathman Co

The Heathman group owns a number of subsidiaries. On 31 March 20X6, the Heathman group sold its entire holding in Grey. The consolidated statement of profit or loss of the Heathman group for 20X6 has been produced without the results of Grey due to its disposal. No profit or loss on disposal has been included in the 20X6 consolidated statement of profit or loss.

Extracts from the consolidated statements of profit or loss for the Heathman group are below:

Statements of profit or loss (extracts) for the year ended 31 March

                                                                                                20X6                                    20X5

$000                                    $000

Revenue                                                                                         86,000                                99,000

Cost of sales (note (ii))                                                              (63,400)                             (67,200)

Gross profit                                                                                   22,600                                31,800

Other income (notes (i) and (iii))                                                3,400                                 1,500

Operating expenses                                                                    (21,300)                             (23,200)

Profit from operations                                                                   4,700                              10,100

Finance costs                                                                                (1,500)                                (1,900)

The following notes are relevant:

1          Grey was based in the Heathman head offices, for which it pays annual rent to Heathman of $300,000, significantly below the cost of equivalent office space in Grey’s local area. As Grey is no longer in the group, Heathman hasincluded thisincome within other income. Grey expenses rent payments in operating expenses.

2          Greysold goodstotalling $8 million to Heathman (included in Heathman’s cost ofsales above)  during the year. Heathman held none of these goods in inventory at 31 March 20X6. Grey made a margin of 40% on all goods sold to Heathman.

3          Heathman received a dividend of $1 million from Grey during the year, as well asrecording  interest of $500,000 on a loan given to Grey in 20X3. Both of these amounts are included within Heathman’s other income.

4          The following selected ratios for the Heathman group have been calculated for the years      ended 31 March 20X5 and 31 March 20X6 from the information above.

20X6                                    20X5

Gross profit margin                                                      26.3%                                  32.1%

Operating margin                                                           5.5%                                  10.2%

Interest cover                                                                3.1 times                            5.3 times

5             Grey’s individual statement of profit or loss for the year ended shows the following:

$000

Revenue                                                                                                        16,000

Cost of sales                                                                                                 (10,400)

Gross profit                                                                                                    5,600

Operating expenses                                                                                   (3,200)

Profit from operations                                                                                2,400

Finance costs                                                                                                 (900)

Required:

A. Calculate the equivalent ratios for the consolidated statement of profit or loss for the         year ended 31 March 20X6 if Grey had been consolidated 

B. Analyse the performance of the Heathman group for the year ended 31 March 20X6. This should also include a discussion of Grey  

C. Heathman acquired 80% of Grey’s 10 million $1 shares on 1 April 20X1 for $17 million when Grey had retained earnings of $3 million. Heathman uses the fair value method for valuing the non‐controlling interest. At acquisition the fair value of the non‐controlling interest was $3 million.

On 31 March 20X6, Heathman sold its entire shareholding in Grey for $25 million when Grey had retained earnings of $7 million. Goodwill had suffered no impairment since acquisition.

Calculate the gain/loss on disposal to be shown in the consolidated statement of profit or loss for the year ended 31 March 20X6.

177. Squad Co (Sept/Dec 17)                      

Squad Co is an international airline which flies to destinations all over the world. Squad Co

experienced strong initial growth but in recent periods the company has been criticised for under-

investing in its non-current assets.

Extracts from Squad Co’s financial statements are provided below.

Statements of financial position as at 30 June:

                                                                                                20X7                                    20X6

$’000                                   $’000

Assets

Non-current assets

Property, plant and equipment                                                              317,000                              174,000

Intangible assets (note ii)                                                                           20,000                                 16,000

337,000                              190,000

Current assets

Inventories                                                                                                      580                                        490

Trade and other receivables                                                                    6,100                                      6,300                

Cash and cash equivalents                                                                       9,300                                    22,100

Total current assets                                                                                   15,980                                28,890

Total assets                                                                                                  352,980                              218,890

Equity and liabilities

Equity

Equity shares                                                                                                3,000                                     3,000

Retained earnings                                                                                      44,100                                41,800

Revaluation surplus                                                                                   145,000                                  Nil

Total equity                                                                                                  192,100                              44,800

Liabilities

Non-current liabilities

6% loan notes                                                                                              130,960                              150,400

Current liabilities

Trade and other payables                                                                          10,480                                  4,250

6% loan notes                                                                                                19,440                                19,440

Total current liabilities                                                                                29,920                                23,690

Total equity and liabilities                                                                        352,980                              218,890

Other EXTRACTS from Squad Co’s financial statements for the years ended 30 June:

20X7                     20X6

$’000                    $’000

Revenue                                                                                                        154,000               159,000

Profit from operations                                                                                12,300                 18,600

Finance costs                                                                                                 (9,200)               (10,200)

Cash generated from operations                                                            18,480                  24,310

The following information is also relevant:

1             Squad Co had exactly the same flight schedule in 20X7 as in 20X6, with the overall number of flights and destinations being the same in both years.

2             In April 20X7, Squad Co had to renegotiate its licences with five major airports, which led to an increase in the prices Squad Co had to pay for the right to operate flights there. The licences with ten more major airports are due to expire in December 20X7, and Squad Co is currently in negotiation with these airports.

Required

A. Calculate the following ratios for the years ended 30 June 20X6 and 20X7:

               1             Operating profit margin;

               2             Return on capital employed;

               3             Net asset turnover

               4             Current ratio;

               5             Interest cover;

               6             Gearing (Debt/Equity).

Note. For calculation purposes, all loan notes should be treated as debt.

B. Comment on the performance and position of Squad Co for the year ended 30 June 20X7.

Note. Your answer should highlight any issues which Squad Co should be considering in the near future.

178. Tinto Co

Tinto is considering the acquisition of Archway, a retail entity. The summarised financial statements

of Archway for the year ended 30 September 20X6 are:

Statement of profit or loss

$000

Revenue                                                                                                                                      94,000

Cost of sales                                                                                                                             (73,000)

Gross profit                                                                                                                                21,000

Distribution costs                                                                                                                     (4,000)

Administrative expenses                                                                                                        (6,000)

Finance costs                                                                                                                                (400)

Profit before tax                                                                                                                       10,600

Income tax expense (at 20%)                                                                                                (2,120)

Profit for the year                                                                                                                       8,480

Statement of financial position

$000                                    $000

Non‐current assets

Property, plant and equipment                                                                                            29,400

Current assets

Inventory                                                                                       10,500

Bank                                                                                                      100                                10,600

Total assets                                                                                                                                40,000

Equity and liabilities

Equity shares of $1 each                                                                                                         10,000

Retained earnings                                                                                                                      8,800

18,800

Current liabilities

4% loan notes (redeemable 1 November 20X6)                                 10,000

Trade payables                                                                                               9,200

Current tax payable                                                                                     2,000                  21,200

Total equity and liabilities                                                                                                      40,000

From enquiries made, Tinto has obtained the following information:

1             Archway pays an annual licence fee of $1m to Cardol (included in cost of sales) for the right to package and sell some goods under a well‐known brand name owned by Cardol. If Archway is acquired, this arrangement would be discontinued. Tinto estimates that this would not affect Archway’s volume of sales, but without the use of the brand name packaging, overall sales revenue would be 5% lower than currently.

2             Archway buys 50% of its purchases for resale from Cardol, one of Tinto’s rivals, and receives a bulk buying discount of 10% off normal prices (this discount does not apply to the annual licence fee referred to in note (i) above). This discount would not be available if Archway is acquired by Tinto

3             The 4% loan notes have been classified as a current liability due to their imminent redemption. As such, they should not be treated as long‐term funding. However, they will be replaced immediately after redemption by 8% loan notes with the same nominal value, repayable in ten years’ time.

4             Tinto has obtained some of Archway’s retail sector average ratios for the year ended 30 September 20X6. It has then calculated the equivalent ratios for Archway as shown below:

Sector                                 Archway

average

Annual sales per square metre of floor space       $8,000                                   $7,833

Return on capital employed (ROCE)                        18.0%                                       58.5%

Net asset (total assets less

current liabilities) turnover                                        2.7 times                              5.0 times

Gross profit margin                                                       22.0%                                    22.3%

Operating profit (profit before

interest and tax) margin                                               6.7%                                    11.7%

Gearing (debt/equity)                                                   30.0%                                      nil

A note accompanying the sector average ratios explains that it is the practice of the sector to carry retail property at market value. The market value of Archway’s retail property is $3m more than its carrying amount (ignore the effect of any consequent additional depreciation) and gives 12,000 square metres of floor space.

Required

A. After making adjustments to the financial statements of Archway which you think may be appropriate for comparability purposes, restate:

(i) Revenue

(ii) Cost of sales

(iii) Finance costs

(iv) Equity (assume that your adjustments to profit or loss result in retained earnings of $2.3 million at 30 September 20X6) and

(v) Non‐current liabilities.

B. Recalculate comparable sector average ratios for Archway based on your restated figures in (a) above.

C. Comment on the performance and gearing of Archway compared to the retail sector average as a basis for advising Tinto regarding the possible acquisition of Archway.

179. Woobly Co

Woobly Co is a bakery which also owns two shops/cafés. Over the last two years, the company has

experienced declining profitability due to increased competition and so the directors wish to investigate

if this is a sector‐wide problem. Consequently, they have acquired equivalent ratios for the sector, some

of which have been reproduced below.

 Sector averages for the year ended 30 June 20X7:

Return on capital employed 18.6%

Operating profit margin 8.6%

Net asset turnover 2.01

Inventory holding period 4 days

Debt to equity 80%

The following information has been extracted from the draft financial statements of Woobly Co for the

year ended 31 December 20X7.

Statement of profit or loss for the year ended 31 December 20X7

                                                                                                                                                      $000

Revenue                                                                                                                                      100,800

Cost of sales                                                                                                                               (70,000)

Gross profit                                                                                                                                30,800

Operating expenses                                                                                                                 (17,640)

Profit from operations                                                                                                           13,160

Statement of financial position as at 31 December 20X7:

                                                                                                                        $000

Non‐current assets                                                                                                                   55,000

Inventory                                                                                                                                    3,960

Equity:

Equity shares of $1 each                                                                                                         17,000

Revaluation surplus                                                                                                                   5,400

Retained earnings                                                                                                                    10,480

Total equity                                                                                                                                32,880

Non‐current liabilities: 10%

bank loan                                                                                                                                    14,400

Other  information relevant  to Woobly Co: 

1          In 20X6, Woobly Co acquired a popular brand name. At 31 December 20X7, the brand represented 20% of non‐current assets. The remaining 80% of non‐current assets comprises of the property from which Woobly Co operates its bakery and shops. This property is owned by Woobly Co and has no directly associated finance. The property was revalued in 20X4.

2             In the year ended 31 December 20X7, Woobly Co began offering discounted meal deals to customers. Woobly Co hoped this strategy would help to reduce perishable inventory and reduce inventory holding periods.

3             In January 20X8, it was decided to discount some slow‐moving seasonal inventory which had a selling price of $1.5m. Under normal circumstances, these products have a gross profit margin of 20%. The inventory was sold in February 20X8 for 50% of what it had cost Woobly Co to produce. The financial statements for the year ended 31 December 20X7 were authorised for issue on 15 March 20X8.

Required:

A. Adjust for the information in note (iii) and calculate the 20X7 sector average equivalent ratios for Woobly Co.  

B. Assess the financial performance and position of Woobly Co for the year ended 31 December 20X7 in comparison with the sector average ratios.

C. Explain three possible limitations of the comparison between Woobly Co and the sector average ratios provided.