Financial management revision question and answer

Rafiki Hardware Tools Company Limited sells plumbing fixtures on terms of 2/10 net 30. Its financial statements for the last three years are as follows:


Required:
(a) For each of the three years, calculate the following ratios:
Acid test ratio, Average collection period, inventory turnover, Total debt/equity, Net profit margin and return on assets. (12 marks)

(b) From the ratios calculated above, comment on the liquidity, profitability and gearing positions of the company. (8 marks)

Answer

Note:
(i) All sales are on credit since they are made on terms of 2/10 net 30 i.e pay within 10 days and get a 2% discount or take 30 days to pay without getting any discount.
(ii) Debtors = Account Receivable while ordinary share capital = common stock.
(iii) Current Asset – Stock = Cash + Accounts receivable

(b) When commenting on ratios, always indicate the following:
(i) Identify the ratios for a given category e.g when commenting on deficiency, identify efficiency or turnover ratios.
(ii) State the observation made e.g ratios are declining or increasing in case of trend or time series analysis.
(iii) State the reasons for the observation.
(iv) State the implications of the observation.

Comment on liquidity position:
– This is shown acid test/quick ratio
– The ratio improved slightly in 1999 but declined in year 2000.
– The ratio is lower than the acceptable level of 1.0

This is due to poor working capital management policy as indicated increasing current liabilities while cash is consistently declining.

– The firms ability to meet its set financial obligations is poor due to a very low quick ratio.

Comment on profitability position:
– This is shown net profit margin and return on total assets.
– Both ratios are declining over time
– This is particularly due to decline in net profits thus decline in the net profit margin and increase in total accounts as net profit decline thus reduction in ROTA.
– The firm‟s ability to control its cost of sales and other operating expenses is declining over time e.g Sales – Net profit will indicate the total costs.
These costs as a percentage of sales are as follows:

Comment on gearing position:
– This is shown debt/equity ratio
– This was 50% in 1998 and declined to 46.2% in 1999 and 2000
– It has been fairly constant
– This is due to the constant long term debt and ordinary share capital
– The decline in 1999 and 2000 was due to increase in retained earnings

Generally the firm has financed most of its assets with either short term or long term debt i.e current liabilities + long term debt

Example: the total liabilities (long term debt + Current liabilities) as a percentage of total assets are as follows:

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