Interpretation of Accounts

Interpretation of Accounts
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Key Learning Outcomes

  • Learn all the formulae required for part (a) and part (b) of this question.
  • Learn the analysis points in part (b) of this question i.e. headings used and what is said under each heading.
  • Know when to use %, cent, times, years, and :1 in part (a) and part (b) of this question.
  • Learn all possible theory examinable in part (c) of this question.
  • Know the maximum time for this question ‒ 45 minutes.

Introduction

Interpretation of Accounts has been examined each year as Question 5 in Section 2 of the Accounting examination paper as follows:

(1) Shareholders Analysis: 2002, 2003, 2004, 2005, 2007, 2008, 2009, 2012, 2013, 2015, 2016

(2) Debenture Holders Analysis: 2001, 2006, 2010

(3) Bank Manager’s Analysis: 2011, 2014

The years stated above are listed solely to assist revision ‒ See Practical Matters 4.

Two other topics are examined as Question 6 and Question 7 in Section 2 of the paper.

Each question in Section 2 is worth 100 marks (25% of the total marks).

In Question 5 the marks now awarded are: Part (a) 50m, Part (b) 40m, Part (c) 10m.

The choice in Section 2 is to answer any two questions from the three asked.

Practical Matters:

(1)   Always do the solution in the same way ‒ this will increase speed and confidence.
(2)   Use only one pen in the solution ‒ use of colour slows down the work.
(3)   Write the solution on the left and right hand side of a double page.
(4)   Do not try to predict the examination paper ‒ study all possible questions in this topic.
(5)   Do not use lengthy descriptions in part (b).

Sample Exam Q&A

 Question

The following figures have been taken from the final accounts of Boyle plc, a company involved in the construction industry, for the year ended 31/12/2016. The company has an authorised capital of €900,000 made up of 700,000 ordinary shares at €1 each and 200,000 5% preference shares at €1 each. The company has already issued 500,000 ordinary shares and 100,000 of the preference shares.

0101
01

(a) You are required to calculate the following for 2016: (where appropriate, calculations
should be made to two decimal places.)

  1. The cash sales if the period of credit given to debtors is 2·4 months.
  2. The earnings per share.
  3. The dividend yield.
  4. How long it would take one ordinary share to recover its value at present earnings.
  5. The interest cover.

(b) Indicate if the Debenture Holders would be satisfied with the performance, state of affairs and prospects of the company. Use relevant ratios and other information to support your answer.

(c) The gross profit percentage for 2015 was 21%

  1. Calculate the gross profit percentage for 2016.
  2. Give 5 different explanations for the increase/decrease in 2016.

Sample Answers (a, b & c)

A

(i) Cash Sales:
03
(ii) Earnings per Share:
03
(iii) Dividend Yield:
03
(iv) How long to recover its value at present earnings:
03
(v) Interest Cover:
03

B

  1. Profitability: The ROCE was 10·3% in 2015 and 7·51% in 2016 which is worse. The company is less profitable and is making less efficient use of resources. 7·51% is well above risk free rates of 2% but is now below the debenture interest rate of 8%.
  2. Dividend Policy: The Dividend Cover was 1·7 times in 2015 and 1·4 times in 2016 which is worse. The cover is too low. The company is paying out 71·43% (100 ÷ 1·4) of its profits in dividends. Not enough is being retained to repay the debentures.
  3. Liquidity: The Quick Ratio was 0·94:1 in 2015 and 0·8:1 in 2016 which is worse. There is a slight liquidity problem. Only 80c in liquid assets are available to pay each €1 owed in the short term. If this trend continues debenture interest payments will be difficult.
  4. Gearing: The Gearing Ratio was 31% in 2015 and 42·33% in 2016 which is worse but gearing is still low. The company is more dependent on debt capital. Interest Cover was 5·6 times in 2015 and 2·96 times in 2016 which is worse. Interest payments are more difficult.
  5. Security: The real value of fixed assets €900,000 is uncertain since no depreciation is shown. Tangible Fixed Assets €800,000 are adequate security for debentures €300,000. Investments which cost €100,000 have a market value of €60,000. This drop of €40,000 shows poor management of resources. Debentures are repayable in 2019 meaning that another loan or the sale of fixed assets will be required.
  6. Sector: The sector is construction. Short term prospects are average with properties difficult to sell due to lack of finance. Long term prospects are better with demand greater than supply.
  7. Conclusion: The Debentures Holders would not be satisfied with the company.

C

(i) Gross Profit Percentage 2016:
03
(i) Reasons for a Falling Gross Profit Percentage:

  1. Cash losses – cash sales not recorded.
  2. Stock losses – purchase of out of date stock or theft.
  3. Change in sales mix – more low mark-up goods sold.
  4. Lower selling prices – sale of old stock.
  5. Incorrect stock valuation – opening stock overvalued or closing stock undervalued.
  6. Higher cost of sales – with no change in selling price.

Student Activity

Q1 In the earlier Boyle plc question, calculate the following (use 2 decimal places where appropriate):

  1. Return on Capital Employed.
  2. Return on Equity Funds.
  3. Earnings per Share.
  4. Price Earnings Ratio.
  5. Market Price if P/E is 15·5.
  6. Ordinary Dividend per Share.
  7. Dividend Yield.
  8. Dividend Cover.
  9. How long it would take one ordinary share to recoup (recover) its 2016 market price at present earnings?
  10. How long it would take one ordinary share to recoup (recover) its 2016 market price at present pay out rate?
  11. Current Ratio.
  12. Quick (Acid Test) Ratio.
  13. Gearing Ratio.
  14. Interest Cover
  15. Opening Stock if the rate of stock turnover is 10 based on average stock.
  16. Cash Sales if the period of credit given to debtors is 1·5 months.
  17. Cash Purchases if the period of credit received from trade creditors is 1·3 months and the following figures are shown in the accounts: Opening Stock €70,000, Closing Stock €60,000.
Q2 In the earlier Boyle plc question, state an ordinary shareholder’s comment on:

  1. Dividend Policy.
  2. Market Price.
  3. Earnings per Share.
  4. An opportunity to purchase 160,000 of the already issued shares at €1·20 each using €60,000 of the shareholder’s own savings and borrowing the remainder at a fixed rate of 9%.
Q3 If a company has poor results, what actions would you advise the company to take?
Q4 State the reasons for a falling gross profit percentage.
Q5 A rising liquidity ratio is a sign of prudent management. Briefly discuss.
Q6 Explain the difference between the terms ‘Liquidity’ and ‘Solvency’ when used in Ratio Analysis. Refer to relevant ratios in your explanation.
Q7
  1. Explain the term ‘Gearing’.
  2. What are the benefits to a business of having a low gearing?
  3. State two ways to reduce the gearing of a company.
Q8 State the limitations of ratio analysis as a financial analysis technique.

Student Activity Answers

You can download/view the answers to the above questions here