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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

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.