1.1 Role and Responsibilities of Financial Managers

1 Financial Analysis 1.1 Role and Responsibilities of Financial Managers (1) Planning and Forecasting set up financial plans for their organisations in order to shape the company s future position (2) Financing and Investing Decisions evaluate the performance of the organization, make financial decisions and investment decision based on the different economic situation of the organisation (3) Coordinating and Controlling ensure the company is operating as efficiently as possible (4) Dealing with the financial market deal with both money markets and capital markets where the value of the company such as fund raising and share pricing are affected 1.2 Assessment of Business Performance Notes Students should be able to describe the key points of the role of financial managers. Notes The main focus of financial manager is to maximize the value of the company. If the financial manager performs well and optimally, the values of the company should maximize. Thus the profitability of the company should increase. A. Purposes of Using Ratios To standardize reporting methods, financial statements and other relevant variables; To allow for comparisons overtime and comparison cross-sections between companies; To measure the company s crucial relationships by relating inputs (costs) with outputs (benefits) and facilitate comparisons of these relationships over time and across companies; To provide a profile of a company and its management s operating, financial and investment decisions; To provide an insight into a company s economic and financial characteristics and competitive strategies. B. Categories of Ratio Analysis (1) Profitability Ratios measures the net income of a company relative to its revenues and capital. (2) Liquidity Ratios measures the adequacy of a company s cash resources to meet its short-term cash obligations. (3) Solvency Ratios access the capital structure of a company in terms of the mix of its financing sources and the ability of the company to satisfy its long-run debt and investment obligations. (4) Management Efficiency Ratios evaluates the levels of output generated by the assets (inputs) used by a company. Notes Students should be able to classify the categories of accounting ratio and their functions. Ratio Analysis 比率分析 Profitability 盈利能力 Liquidity 變現能力 Solvency 償債能力 Management efficiency 管理效能 1

Notes Students have to understand the interrelationship among different ratios. Solvency Ratios Debt Ratios Debt to Equity Debt to Capital Interest Coverage Ratios Times Interest Earned Fixed Charge Coverage Students should clarify how to measure and compare the functions and categories of different financial ratios. Management Efficiency Ratios Short-term (Operating) Activity Raitos Inventory Turnover Ratio Accounts Receivable Turnover Accounts Receivable Collection Period Working Capital Turnover Accounts Payable Turnover Days Purchase in Accounts Payable Long-term (Investment) Activity Ratio Total Asset Turnover Long-term Solvency Measures Long-term Debt Ratio Total Debt Ratio Debt-Equity Ratio Equity Multiplier Ratio Analysis Liquidity Ratios Profitability Ratios Return on Sales Gross Profit Margin Operating Profit Margin Net Profit Margin Return on Investment (ROI) Return on Assets (ROA) Return on Common Equity (ROCE) Return on (Total) Equity (ROE) Working Capital Ratios Current Ratio Quick Ratio Cash Ratio Defensive Interval Classification of Ratio Analysis 1.3 Profitability Ratios Return on investment 投 資 回 報 率 Return on assets (ROA) 資 產 回 報 率 Return on common equity (RCCE) 普 通 股 權 益 報 酬 率 Return on equity (ROE) 權 益 報 酬 率 Notes If ROE exceeds ROA, it reflects the company s use of financial leverage. A. Basic Concept of Profitability Profit is the sum remaining after all expenses have been deducted. B. Ratio Analysis in Profitability (1) Return on Sale - calculated as the return on sale in terms of the cost of company (i) Gross Profit Margin = Gross Profit / Sales (ii) Operating Profit Margin = Operating Profit / Sales (iii) Net Profit Margin = Net Profit / Sales (2) Return on investment - calculated as the return measured before financing costs (interest) or taxes or before both of them. (i) Return on Assets (ROA) = Earnings before Interest and Taxes / Average Total Assets The after-tax interest cost is calculated by multiplying the interest cost by (1 T), where T is the firm s marginal tax rate. (ii) Return on Common Equity (ROCE) = (Net Income Preferred Dividends) / Average Common Equity (iii) Return on (Total) Equity (ROE) = Net Profit / Average Total Equity 2

1. Financial Analysis 1.4 Liquidity Ratio A. Basic Concept of Liquidity Company liquidity the ability of meeting short-term debts, i.e. the ability to convert assets into cash or to obtain cash. B. Cash Cycle / Operating Cycle The cash cycle can reflect the number of days cash is tied up in the firm s operating cycle. If a firm operates without credit, it represents the number of days cash is tied up. If a firm obtains credit, the length of the cash (operating) cycle is reduced. C. Working Capital Ratios (1) Current Ratio = Current Assets / Current Liabilities (2) Quick Ratio = (Current Asset - Inventory) / Current Liabilities (3) Cash Ratio = (Cash + Marketable Securities) / Current Liabilities (4) Defensive Interval = 365 Quick Assets / Projected Expenditure Cash cycle 現 金 循 環 Working capital 營 運 資 金 Current ratio 流 動 比 率 Quick ratio 速 動 比 率 Cash ratio 現 金 比 率 Defensive interval 防 禦 性 的 間 隔 1.5 Solvency Ratio A. Basic Concept of Solvency (1) Capital Structure refers to the sources of financing of a company. (2) Debt Covenants set defaults at a level to allow the lender an opportunity to collect the loan before severing financial distress. Notes In general, the higher the debt ratio, the riskier the firm is. B. Debt Ratios The greater the proportion of debt relative to equity is, the greater the risk to the company as a whole. Thus, debt ratios can be expressed as Debt to equity and Debt to capital. (1) Debt to Equity Ratio = Total Debt / Total Equity (2) Debt to Capital Ratio = Total Debt / Total Capital (i.e. Equity + Debt) C. Interest Coverage Ratios Interest coverage ratio - indicates the degree of protection available to creditors and measures how well a company has its interest obligations covered. (1) Times Interest Earned (Interest Coverage Ratio) = Earnings before interest and taxes (EBIT) / Interest Expense (2) Cash Coverage Ratio = (EBIT + Depreciation) / Interest (3) Fixed Charge Coverage = Earnings before fixed charges and taxes / Fixed Charges Debt ratio 債 務 比 率 Debt to equity ratio 債 務 與 資 本 比 率 Debt to capital ratio 債 務 與 總 資 金 比 率 3

Long-term debt ratio 長 期 債 務 比 率 D. Long-term Solvency Measures (1) Long-term Debt Ratio = Long-term Debt (Long-term Debt + Total Equity) (2) Total Debt Ratio = (Total Assets Total Equity) Total Assets Total debt ratio 總 債 務 比 率 1.6 Management Efficiency Ratios Accounts receivable 應 收 帳 款 Accounts receivable turnover 應 收 帳 款 周 轉 率 Accounts payable turnover 應 付 帳 款 周 轉 率 Notes Students have to concentrate about the average value of some items during calculating some accounting ratios. A. Basic Concept in Management Efficiency Management Efficiency Ratios - show the company s level of operations in related to assets needed to sustain the activity. B. Short-term Activity Ratios (1) Inventory Inventory Turnover = Cost of Goods Sold / Average Inventory A higher ratio indicates that the inventory turn over rapidly as it moves quickly from the time of acquisition to sale. (2) Accounts Receivable (i) Account Receivable Turnover = Sales / Average Account Receivables (ii) Accounts Receivable Collection Period = (Average Accounts Receivable / Sales) 365 = 365 / Account Receivable Turnover (3) Current Labilities (i) Working Capital Turnover = Sales / Average Working Capital (ii) Accounts Payable Turnover = Purchase / Average Accounts Payable C. Long-term (Investment) Activity Ratio Total Asset Turnover = Sales / Average Total Assets 1.7 Earnings per share and Price-to-Earnings (PE) Ratio Earnings per share (EPS) 每 股 盈 利 Price-earnings ratio (p/e ratio) 市 盈 率 (1) Earnings per share (EPS) = Net Income Share Outstanding = (Net Income Preferred Dividends) Weighted Average Common Shares The ratio shows that the higher the EPS, the better the performance of the company in operation and profitability. (2) Price-earnings (PE) ratio = Price per share / Earnings per share It is also expressed as: Market value of equity / Net income 4

1. Financial Analysis 1.8 Limitations of Ratio Analysis It is difficult for large companies to develop a meaningful set of industry averages for comparative purposes. Companies often employ window dressing techniques to make their financial statements look stronger. Different accounting practices can distort the ratio results thus making it hard to make comparisons. Profitability: MTR Consolidation Profit and Loss Account (Extract) as Annual Report 2009: 2009 HK$ million 2008 HK$ million 2007 HK$ million Operating expenses before depreciation and amortization 9,295 8,303 4,778 Operating profit before depreciation and amortization 13,056 13,995 14,216 Operating profit before interest and finance charges 10,065 11,012 11,284 Profit before taxation 11,519 9,027 18,265 Operating income (net income) for the period 9,639 8,280 15,182 Turnover 18,797 17,628 10,690 Interest and Financial Charges 1,504 1,998 1,316 Total Asset 176,494 159,338 155,668 Total Equity 106,387 97,801 91,014 Ratios 2009 2008 Return on Sale Operating Margin 0.51 0.47 Return On Investment (ROI) Return on Assets (ROA) 0.0599 0.0699 Return on (Total) Equity (ROE) 0.094 0.094 Notes During analyzing, students should more specifically analyse the particular ratio. Don t just roughly to say good or bad. Students should refer to the question during answering the question of case study. Students should carefully round up the answer in appropriate decimal points requested by the question. Students should memorize the formulas of the ratio and must understand how to calculate it. In the area of profitability, MTR had a strong ability to gain earning. Compared with the year 2008 and 2009, the operating margin increased from 0.47 to 0.51, which increased 4%. It meant that the operating income in 2009 jumped compared with the earning in 2008. Its operating margin increased 4% compared with 2008, which meant that this company generated 4 cents more than 2008 in profit for every dollar in turnover in 2009. However, the ROE of the company in 2009 had no change (9.4% same as 2008). It generated 9.4 cents in profit for every dollar in equity to the firm s total stockholders. In addition, the ROE exceed ROA of this firm in 2008 and 2009 reflected that the company used debt financing or financial leverage. 5

The ROA in 2009 (0.0599) was a little bit less than the ROA in 2008 (0.0699). It meant that the profit per dollar of assets in 2009 was a little bit less than 2008. The main reason was that the average total asset had a great increase in 2009. Thus, the factor of total asset would become a large denominator. The management group has to concern how to use the total asset more efficiently in future. MTR Corporation Limited Liquidity: MTR Consolidation Balance Sheet (Extract) as Annual Report 2009: Fixed Asset 2009 HK$ million 137,634 2008 HK$ million 131,004 2007 HK$ million 132,417 Total Asset 176,494 159,338 155,668 Total Liabilities 70,041 61,516 64,631 Share capital, share premium and capital reserve 42,497 41,119 39,828 Other reserves 63,890 56,682 51,186 Cash and Cash equivalent 7,115 793 576 Debtors, deposits and payments in advance 2,428 7,190 5,167 Bank overdraft 21 59 2 Short-term Loan 25 1,646 507 Creditors and accrued charges 20,497 5,334 5,412 Taxation 430 450 3 Other short-term liabilities 1,277 1,106 1,200 Long-term Loan and other obligations 47,791 52,921 57,507 Ratios Current Ratio Working Capital Ratio Cash Ratio Defensive Interval 2009 2008 1.75 3.3 0.32 0.092 DI = 4654 days DI = 146 days In the area of liquidity, MTR had a strong ability to meet short-term obligations and convert assets into cash. It can be proved from the current ratio and cash ratio. From the current ratio, it showed that the current assets could cover 1.75 times for current liabilities in 2009. The defensive interval was 4,654 days. It meant that MTR could hang on for 4,654 days. Thus, this company was a very healthy and stable company. The cash ratio also reflected that it had 32 cents in cash per one dollar in liabilities, which was a great improvement from 9.2 cents in 2008. It meant that it could meet the shortterm obligations and convert assets into cash. MTR Corporation Limited Co. Annual Report 6

1. Financial Analysis Business Perspective (P. 2) 1. In early 1900s, financial management emphasised on the legal aspects of mergers, the formation of new companies, and the various types of securities issued to raise capital. In 1930s, financial management emphasis was on bankruptcy and reorganisation, corporate liquidity, and regulation of security markets. 2. Knowledge of financial analysis can help managers do a better job in their daily operations by improving the quality of their decisions making. Discussion Corner (P.4) 1. The tasks of a financial manager are to acquire and use funds in order to maximise the value of the company. The main duties include planning and forecasting, making financing and investment decisions, coordinating, controlling and dealing with financial markets. 2. A financial manager can increase the value of the company from the company s capital budgeting, financing, and liquidity activities by (1) buying assets that generate more cash than they cost or (2) selling bonds and stocks and other financial instruments that raise more cash than they cost. Activity Corner (P.12) (a) (b) Return on assets = ROA (2005) = [$3,211 + 2 (1 17.5%)]/{0.5 ($4,437 + $5,393 + $4,616 + $3,783)} ROA (2005) = 0.35 Return on (total) equity = Net income + After-tax interest cost Average total assets Net profit Average total equity ROE (2005) = $3,211/ [0.5 ($7,039 + $5,415)] = 0.52 = Net profit Equity of common stock + Equity of preferred stock + Reserve Activity Corner (P.16) (a) Current ratio = Current assets / Current liabilities Current ratio = $5,393 / $2,791 = 1.93 (b) Quick ratio = (Current asset - inventory) / Current liabilities Quick ratio = ($5,393 $1,386) / $2,791 = 1.44 (c) Defensive interval = 365 (Cash + marketable securities + accounts receivable) / projected expenditure Projected expenditure = ($9,413 + $2,771 + $1,698 + $2,223) = $16,105 Defensive interval = 365 ($5,393 - $1,386) / $16,105 = 91days 7

Activity Corner (P.20) (a) Total debt ratio = (Total assets total equity) / Total assets Total debt ratio (2005) = [(4,437 + 5,393) 7,039] / (4,437 + 5,393) = 0.28 (b) Debt - Equity ratio = Total debt / Total Equity Debt - Equity ratio (2005) = 0.28 / 0.73 = 0.38 times Activity Corner (P.26) (a) Inventory turnover ratio = Cost of goods sold / Average inventory Inventory turnover ratio (2005) = $9,413 / [($1,137 + $1,386) 0.5] = 7.46 (b) Working capital turnover = Sales / Average working capital Working capital turnover (2005) = $20,632 / [{($4,616 $2,652) + ($7,624 $3,387)} 0.5] = 6.65 Activity Corner (P.29) Basic EPS = (Net income Preferred dividends) / Weighted average ordinary shares Basic EPS (2005) = $3,338 / 1,196 = 2.79 Discussion Corner (P.29) 1. Current Ratio Quick Ratio 2. (a) Inventory Turnover Ratio (b) Accounts Receivable Turnover (c) Accounts Receivable Collection Period (d) Working Capital Turnover (e) Accounts payable Turnover Current Ratio = Current Assets / Current Liabilities Quick Ratio = (Current Asset - Inventory) / Current Liabilities Inventory Turnover = Cost of goods sold / Average Inventory Account Receivable Turnover = Sales / Average accounts receivables Accounts Receivable Collection Period = 365 / Accounts Receivable Turnover Working Capital Turnover = Sales / Average Working Capital Accounts payable Turnover = Purchase / Average accounts payable 3. (a) Gross profit Margin (b) Operating profit Margin (c) Net profit Margin Gross Profit Margin = Gross Profit / Sales Operating Profit Margin = Operating Profit / Sales Net Profit Margin = Net Profit / Sales 8

1. Financial Analysis Revision Exercises (P.31) A. Basic Questions 1. Please refer to section 1.1. Manager always use the management efficient ratios for improving operation management; (2 marks) Credit Analyst always use the solvency and liquidity ratios for checking the health of the company; (2 marks) Security Analyst always use the profitability ratios to forecast the prospect of the company for investment purpose; (2 marks) 2. Please refer to section 1.2 for the useful of the ratio (4 marks) and section 1.8 for the limitation of the ratio. (4 marks) 3. Current Ratio 648/1,183 = 0.55 Quick Ratio 280/1,183 = 0.24 Cash Ratio 88/1,183 = 0.07 Inventory turnover 2,453/368 = 6.7 Receivables turnover 3,756/192 = 19.6 (2 marks) 4. Profit margin = net income / sales; net income = Sales Profit margin = ($5 million) (0.11) = $550,000. (3 marks) 5. Inventory turnover = COGS / inventory = $150,000 / $50,000 = 3 times Days sales in receivables (i.e. Average number of days receivables are outstanding or Accounts Receivable Collection Period) = 365 days / Inventory turnover = 365 / 3 = 122 days. On average, a unit of inventory sat on the shelf 122 days before it was sold. (3 marks) (Students have to know the relationship between these ratios and the result of analyse.) 6. Receivables turnover = sales / receivables = $188,600 / $27,130 = 6.95 times. (3 marks) 7. Answer: Days sales in receivables = 365 days / receivables turnover = 365 / 6.95 = 52.52 days. The average collection period for an outstanding accounts receivable balance was 52.52 days. 8. Net Income = Sales x Profit margin = $7.5 million x 0.165 = $1,237,500 (3 marks) 9. (a) ROA = Net Income / Total Asset = $1,237,500 / $13,500,000 = 0.092 or 9.2% (3 marks) (b) ROE = Net Income / Total Equity = Net Income / (Total Asset Total Debt) ROE = $1,237,500 / ($13.5M 4.5M) = 0.1375 or 13.75% (3 marks) 10. Payables turnover = COGS / payables = $16,650 / $2,200 = 7.57 times Days sales in payables = 365 days / payables turnover = 365 / 7.57 = 48.23 days The company left its bill to suppliers outstanding for 48.23 days on average. A large value for this ratio could imply that either (1) the company is having liquidity problems, making it difficult to pay off its short-term obligations, or (2) that the company has successfully negotiated lenient credit terms from its suppliers. (Any 3 points, max 6 marks) 9

B. Long Questions Question 1 Reference: Book P.14-15 Difficulty: P (P: easiest, PPPP: most difficult) Key words: Action words: Liquidity, Ratio analysis Calculate, Discuss The question consists of three parts. The first part is a straightforward question that requires you to calculate the liquidity ratios, and explain them one by one. Formula is not provided. Thus, students should memorize some formulas. For second part, it requires you to know and analyse financial statement in the section of liquidity. Thus, you have to know the items shown on financial statement and describe what these items changed in three years. For the third part, it requires you to discuss the trends of ratios you calculated. You have to present the changes of the trend such as increasing, decreasing or no changes. You should analyse based on the result of the calculated figures. Be careful of the trend of increasing, decreasing and remaining constant. You should also know how to analyse the result or outcome after the changing of trend. For example, what is the outcome when the quick ratio and cash ratio increase? Answer Structure: (a) Current Ratio Quick Ratio Cash Rato Year 20X6 Year 20X7 Year 20X8 2.00X 2.00X 2.00X 1.20 1.10 1.00 0.40 0.3 0.25 (1 mark each, max 6 marks) (b) Financial statements would show that cash as a percentage of current assets are declining; accounts receivable and inventory are growing. Similarly, current liabilities would show the proportion of (bank) borrowing growing relative to credit granted by suppliers. (1 mark each, max 6 marks) (c) Although the current ratio has remained constant over the 20X6 20X8 period, its components have not as the quick and cash ratios have deteriorated. The firm s liquidity position has weakened over the period as its current assets are less liquid (more inventory and receivables, less cash). At the same time, its trade credit proportion to debt financing has grown. (5 marks) 10

1. Financial Analysis Question 2 Difficulty: PP (P: easiest, PPPP: most difficult) Key words: Action words: Liquidity, Asset Management, Solvency, Profitability Calculate This question mainly let the students know the classification of ratios and test them how to calculate these ratios in different sections. From part (a) to (f), you have to calculate the various ratios with the data given in the question. As the items required in ratios formulas are different, you should be careful in choosing the items to put in the formula to calculate. You also have to be careful in calculating in year-end or average figure that required by the question. After the calculation, you should know the relationship between these ratios. You must know the implication of each ratio. Answer Structure: (a) (2007) CR = (606 + 1,673 + 4,305) / (975 + 563 + 329) = 3.53 times (1 mark) (2008) CR = (371 + 2,424 + 6,338) / (1,019 + 600 + 375) = 4.58 times (1 mark) (2007) QR = (606 + 1,673) / (975 + 563 + 329) = 1.22 times (1 mark) (2008) QR = (371 + 2,424) / (1,019 + 600 + 375) = 1.40 times (1 mark) (2007) Cash Ratio = (606) / (975 + 563 + 329) = 0.325 times (1 mark) (2008) Cash Ratio = (371) / (1,019 + 600 + 375) = 0.186 times (1 mark) (b) (2007) Debt Ratio = (5,100 + 975 + 563 + 329) / 18,722 = 0.372 (1 mark) (2008) Debt Ratio = (4,725 + 1,019 + 600 + 375) / 21,282 = 0.316 (1 mark) (2007) D/E = (5,100 + 975 + 563 + 329) / (750 + 1,960 + 9,596) = 0.567 (1 mark) (2008) D/E = (4,725 + 1,019 + 600 + 375) / (750 + 1,950 + 11,864) = 0.461 (1 mark) (2007) EM = 1 + D/E = 1.567 (1 mark) (2008) EM = 1 + D/E = 1.461 (1 mark) TIE ratio = $5,700 / 900 = 6.33 times (1 mark) Cash coverage ratio = (5,700 + 1,050) / 900 = 7.5 times (1 mark) (c) Asset Management Ratios: TAT = 13,500 / 21,282 = 0.634 times (1 mark) Inventory turnover = 6,750 / 6,338 = 1.07 times (1 mark) Receivable turnover = 13,500 / 2,424 = 5.57 times (1 mark) (d) Profitability ratios: PM = 3,168 / 13,500 = 0.2347 or 23.47% (1 mark) ROA = 3,168 / 21,282 = 0.1489 or 14.89% (1 mark) ROE = 3,168 / (750 + 1,950 + 11,864) = 0.2175 or 21.75% (1 mark) (e) EPS = 3,168 / 600 = 5.28 per share (2 marks) (f) P/E ratio = $52 / $5.28 = 9.85 times (2 marks) a f Reference: Book P.14-15 Reference: Book P.17-18 Reference: Book P.21-25 Reference: Book P.9-11 Reference: Book P.27-28 11

Question 3 a b c Difficulty: PPP (P: easiest, PPPP: most difficult) Key words: Action words: Effectiveness, Weakness, Reasons Calculate, Discuss, Whether This question mainly test the students how to calculate different ratios, through which they analyse the effectiveness and weakness of the company. For part (a), you have to calculate the various ratios with the data given in the question. As the items required in ratios formulas are different, you should be careful in choosing correct components to put in the formula to calculate. You also have to be required by the question to write down all the formulas and steps in calculation. Don t forget to do this, otherwise you will be deducted the marks. For part (b), you are required to analysis the weaknesses in financial area of the company and the reasons. Different factors should be taken in consideration. You should not only state the factors, but also explain them one by one. It would be good if you can relate them specifically to the case or the trading industry of the case. For part (c), it requires you to comment on the effectiveness of ratio analysis. You have to write down the effectiveness such as no effect, great effect or little effect with appropriate reasons. You also have to write down the limitation of ratio analysis if necessary. Answer Structure: (a) 20X3 20X4 20X5 Current Ratio =2,150/695 =3.1 =2,870/1,080 =2.7 =4,200/2,450 =1.7 (2 marks) Return on Asset NIL (1 mark) =[730/(2,925+3,680)] 2 =[210/(3,680+5,050)] 2 =0.221 =0.048 (2 marks) Debt-equity Ratio Total debt ratio: (2,925-1,730)/2,925 =0.41 Debt equity Ratio: 0.41 0.59=0.695 =69.5% Total debt ratio: (3,680-1,970)/3,680 =0.47 Debt equity Ratio: 0.47 0.53=0.887 =88.7% Total debt ratio: (5,050-1,980)/5,050 =0.61 Debt equity Ratio: 0.61 0.39=1.56 =156% (3 marks) Inventory Turnover NIL (1 mark) 7,850/[(990+1700) 2] =5.8 Gross Profit Margin 2,000/9,000 =0.222 =22.2% 1,800/9,650 =0.1872 =18.7% Total Asset Turnover NIL (1 mark) 730/[(2,925+3,680) 2] =0.221 Average collection period (days) NIL (1 mark) [(890+970) 2]/9,650 365 =35.17 days 8,700/[(1,700+2,450) 2] =4.2 (2 marks) 1,520/10,220 =0.149 =14.9% (2 marks) 210/[(3,680+5,050) 2] =0.048 (2 marks) [(970+550) 2]/10,220 365 =45days (2 marks) 12

1. Financial Analysis (b) Debt: Debt ratio is increasing annually and overtook the industry average. This is because the company s accounts payable has been increasing, but reserves only show a slight increase and collaterals only show a slight decline. (1 mark) Inventory: Inventory turnover is decreasing annually to where it is lower than the industry average. This is because the company has too much inventory. Some of its inventory may expire or become out of date and have to be written off. A high level of inventory also causes the current ratio to be high, which shows a high level of liquidity. (1 mark) Fixed assets: Fixed assets turnover is increasing annually, and will reach the industry average by 20X5. (1 mark) Total assets: Return on assets is below the industry average and worsening. Since fixed assets turnover is at a normal level, problems should arise from bad management of current assets. (1 mark) In situations like this, a part of accounts receivable may turn into bad debt and current ratio may not be able to reflect the real liquidity of the company. (1 mark) Profit: Gross profit margin decreased as a result of discounts given by the company. Moreover, cost of goods sold has increased. Net profit ratio decreases, reflecting increases in both revenue and administration costs. Furthermore, decrease in net profit and the rapid increase in total assets has brought about a decrease in return on assets. (1 mark) (c) Not necessarily, reasons include: - A lot of corporations engage in diverse operations, so it is difficult to compute meaningful industry average for comparison purposes. (1 mark) - Corporations may use different approaches to accounting from year to year, causing inventory calculations, bad debt provisions and depreciation calculations to differ, thus making it difficult to compare on the same basis. (1 mark) - Corporations may have different financial years, thus the industry average may not truly represent the year requiring comparison. (1 mark) Question 4 Difficulty: PPP (P: easiest, PPPP: most difficult) Key words: Total Asset Turnover, Earning per share Action words: calculate, explain, discuss, effect For part (a), you have to straightforwardly calculate the required ratios with the data given in the question. Make sure you have to list down the formula with the equation. Don t just write down the answer, otherwise you maybe deducted the marks. For part (b), it is asking why the profitability of the company is so little. You should explain the reasons, which are based on the case through the given data. Different factors should be taken in consideration. You should not only state the factors, but also explain them one by one. It would be good if you can relate them specifically to the case or the stationary industry of the case. For part (c) and (d), it requires you to explain the effectiveness of ratio analysis according to some specially scenario. Thus, you should concentrate to highlight and analysis the outcome of effectiveness such as great, little or no effect based on the two situations given in the question. a b c d 13

Answer Structure: (a) Return on assets: (27/45) x 100% = 6% (1 mark) Return on equity: (27/31.5) x 100% = 8.57% (1 mark) (b) The comparison of Ming Fung and Industry average is shown as follows: (9 marks) (1) Sales / Inventory (2) Days sale in accounts receivable (3) Sales / Fixed assets (4) Sales / Total assets (5) Current ratio (6) Debt / Total assets (7) Sales return (after tax) (8) Return on assets (after tax) (9) Return on equity (after tax) Ming Fung 5 30 5.4 1.8 2.7 30% 3.4% 6% 8.57% Industry average 11 20 6.5 2.8 2 30% 3.5% 9.8% 14% From (1) and (5), we can see that Ming Fung has too much inventory, meaning too much capital tied up, which shows bad inventory management. From (2), we can see that Ming Fung has given a repayment period which is too long, which means that the credit policy is too lenient which leads to bad debts. From (3), (4), (8) and (9), Ming Fung shows an efficiency in fixed assets. The above points all account for Ming Fung s low profitability. (5 marks) (c) Unless Ming Fung s financial year is the same as other companies in the industry, the industry average ratios cannot be compared with Ming Fung s data because ratios relating to sales, current assets and current liabilities will lose their credibility. (d) Since the company has not had enough time to fully utilise the new machines, ratios relating to fixed assets and total assets will experience deviation, so the reported profit will be lower. (2 marks) Question 5 a Difficulty: PPP (P: easiest, PPPP: most difficult) Key words: Credit, missing Action words: Calculate, describe and explain The question consists of two parts. The first part is a straightforward question that requires you to calculate the missing figures one by one. Though the data given in the question, you can straightly find out the answer. Make sure you know the formulas and list down the equations. For the second part, it requires you to state whether you provide credit to the company or not (i.e. yes or no) and why. Therefore, you have to explain the reasons based on the given financial data and the results of the ratio you calculated in part (a) before. The purpose of this part of question is to test you how to analyse the result of the ratios and make judgment. 14

1. Financial Analysis Answer Structure: (a) Current ratio = 310,000 345,000 = 0.90 (2 marks) Quick ratio = ($310,000-$227,500) $345,000=0.24 (2 marks) Inventory turnover = $480,000 $227,500 = 2.11 (2 marks) Interest coverage = $85,000 $40,000 = 2.1 times Gross profit margin = $320,000 $800,000 100% = 40% (2 marks) Return on equity (after tax) = $22,500 $210,000 100% = 10.7% (2 marks) (b) No. Reasons include: Tang Tat Ltd. has a poor liquidity ability Current ratio is deterioating: in 20X7 it is only 0.9, which is half of the industry average Quick ratio is also deteriorating and is much lower than the industry average. Tang Tat has a poor inventory turnover Inventory turnover is deterioating and much lower than the industry average in 20X7. This reflects slow sales and too much inventory (inventory is 73% of current assets). If $40,000 of inventory is acquired, inventory turnover further lowers to 480,000 (227,500+40,000)=1.79, making the situation worse. The credit term is n/120. The credit period is too long for a firm with low liquidity such as Tang Tat, so the risk is too high. The amount of money involved is, so the risk is high, so the risk is hig. (2 marks) Reference: Book P.8, 11, 14, 18, 21 Case Study (P.39) 1. No, it creates many problems. The problem for the banker is that the financial statements of small firm sometimes may not have audited and be also produced on an irregular basis. The quality of its financial data may therefore be a problem for a small business. 2. When examining the prospect of a small firm, a banker should predict essentially about the ability of the company to repay its debt. They always use the indicators of liquidity and about continuing prospects for profitability. Thus, both short-run and long-run abilities of the firm are of interest to them. In addition, when the key man of the firm unexpected death, it would cause the company to fail. Or, the loss of the key family member also creates the equally serious problem. All these problems should be considered. Revision Exercises 1. Explain two different points between return on equity and return on assets. (4 marks) Short Question 15

Short Question 2. Explain three limitations of the ratio analysis. (6 marks) Case Question 3. In 2010, Samuel Company s income statement show its cost of goods sold and sales are $2,500,000 and $4,600,000 respectively. If the sale was increased 15% in 2010, what is the gross profit margin of 2009 if the cost of goods sold of 2009 is $2,000,000? (5 marks) Essay Question 4. Kelvin Christy Co. is a small and medium enterprise. Its main product is Blue-Jean. In recent years, as the market expands, Kelvin Christy Co. plans to borrow money from ABC Bank to develop the China market. It has already given the annual report including income statement and balance sheet to the ABC Bank. (a) Describe and explain FOUR qualitative factors ABC bank should evaluate the Kelvin Christy Co. before the approval of the application. (8 marks) (b) Evaluate FOUR purposes for the bank to use the ratio analysis for analyzing the application of Kelvin Christy Co. (10 marks) 16

1. Financial Analysis 5. After the financial tsunami in 2008, Carmen Toy Limited hardly maintains the business and competes with other competitors. Although it still has net profit in last three years, its business reduces a lot. The follow month will be organized the annual general meeting. CEO, Mrs. Carmen Chan, requests you to analysis the profitability and liquidity of last three years to her so that she can prepare the AGM. Essay Question The Income Statement and Balance Sheet of Carmen Toy Ltd. are presented below: Income Statement For the years ended 31 December 2010 2009 $ $ Credit sales 1,450,000 1 268,000 Less: Cost of goods sold 620,000 540,000 Gross profit 830,000 728,000 Less: Operating expenses 428,000 343,000 Net profit 402,000 385,000 Balance Sheets as at 31 December 2010 2009 2008 $ $ $ Non-current assets (at net book value) 942,600 872,600 763,600 Current assets Inventory 531,200 423,600 310,000 Accountable receivable (net) 489,800 393,800 295,400 Bank 468,000 374,000 358,000 1,489,000 1,191,400 963,400 2,431,600 2,064,000 1,727,000 Capital and reserves $1 Ordinary shares 1,000,000 800,000 800,000 Retained earnings 532,000 421,400 366,200 1,532,000 1,221,400 1,166,200 Non-current liabilities 505,600 412,000 338,000 Current liabilities Account payables 391,200 363,300 189,200 Accruals 2,800 67,300 33,600 394,000 430,600 222,800 2,431,600 2,064,000 1,727,000 17

You are required to: (a) Compute the following ratios for 2010 and 2009: (i) Net profit ratio (ii) Return on shareholders fund (iii) Quick ratio (iv) Debtors collection period (in months) (Calculations round to two decimal places.) (12 marks) (b) Comment briefly on the profitability and liquidity of Carmen Toy Ltd. for 2010. (8 marks) 18