Advantages:

• Ratio analysis will help validate or disprove the financing, investment and operating decisions of a firm.
• They summarize the financial statement into comparative figures, thus helping the management to compare and evaluate the financial position of the firm and the results of their decisions.
• It simplified complex accounting statements and financial data into simple ratios of operating efficiency, financial efficiency, solvency, long term positions etc.
• Ratio analysis help identify problem areas and bring the attention of the management to such areas. Some of the information is lost in the complex accounting statements and ratios will pinpoint such problems.
• Allows the company to conduct comparisons with other firms, industry standards, intra-firm comparisons etc. This will help the organization better understand its fiscal position in the economy.                                                                              (Any 4)

Disadvantages:

• The firm can make some year end changes in their financial statements, to improve their ratios. Then the ratios end up being nothing but window dressing.
• Ratios ignore the price level changes due to inflation. Many ratios are calculated using historical costs, and they overlook the changes in price level between the periods. This does not reflect the correct financial situation.
• Accounting ratios completely ignore the qualitative aspects of the firm. They only take into consideration the monetary aspects (quantitative).
• There are no standard definitions of ratios. So firms may be using different formu-las for the ratios. One of such example is Current Ratio, where some firms take into consideration all liabilities but others ignore bank overdraft from current liabilities while calculating current ratio.
• Accounting ratio do not resolve any financial problems of the company. They are a means to the end not the actual solution.                                                                                                                                                                                             (Any 2)

Profitability of Ayawaso

• Revenue increase / (decrease)

The decrease and increase in Ayawaso limited revenue appears to be in line with how the hotel sector has performed in the recession and coming out of the recession in 2017. The hotel sector in Accra has shown a noticeable improvement in revenue in 2018 so Ayawaso limited has displayed a decent performance with its revenue over the period.

• Non-Current Assets increase / (decrease)

Ayawaso limited appears to have carried out a sizeable capital improvement programme in 2016 with some residue of this spend rolling over to 2017. The 2018 spend is small and is consistent with the hotel not needing much capital spend given the refurbishment in 2016 and 2017.

• Gross Profit Percentage

A good performance by Ayawaso limited in capitalising on improving market conditions in 2018 by increasing its rates and thereby increasing its gross margin. Again the results are in line with the hotel sector in Accra.

• Net Profit Percentage

Ayawaso limited performed poorly in this ratio. As Accra gradually came out of recession in 2017, Ayawaso limited net profit percentage increased and showed the hotel was performing well. However, there has been a sizeable decrease in the net profit percentage from 2017 to 2018 which is very disappointing especially in light of the increase in the gross profit percentage. This is an area that the hotel management and shareholders needs to examine closely to identify and correct the reasons for the decrease in net profit percentage from 2017 to 2018.

• Return on Capital Employed

Again a disappointing return and the decrease in profit is the significant reason for the decrease in the ratio. Underneath the line, the capital employed would have increased year on year which would also help to decrease the ratio but the change in profit from 2017 to 2018 has been the main driver for the decrease in the ratio from 2017 to 2018. (4 points @1.5 marks each= 6 marks)

Liquidity of Ayawaso Ltd

• Current Ratio

The company has struggled with this ratio particularly in 2016 and 2017 but it is improving and 2018 is getting closer to the norm of 2:1. Overall, the result from 2016 to 2018 has been decent and continued focus on this ratio can ensure that it gets to a satisfactory level in the years ahead.

• Acid Ratio

Again this ratio has improved from 2016 to 2018 but it is disappointing to see that it decreased from the 2017 level. Therefore, management need to find the reasons for the decrease and work to ensure that it gets back to the norm of 1:1 at a minimum. The 2016 ratio shows that the hotel was carrying a sizeable quantity of inventory which then decreased in 2017 and increased again in 2018. This is surprisingly high for a hotel and needs serious investigation as normally inventory would not be at this level in a hotel.                                                                                                                                     (2 points @ 2 marks each = 4 marks)

Gearing of Ayawaso Ltd

• Debt to Equity Ratio

It is pleasing to note the improvement in this ratio from 2016 to 2018 as the company has paid down its debt and improved its reserves. The decrease has slowed down in 2018 which is probably due to decreased profits leading to decreased cash flow to pay back debt as well as the company trying to improve its current ratio by holding on to more of its cash.

• Dividend Cover

This ratio is going in the right direction as increased profits due to higher revenue are helping to increase the cover. It also appears as if a decision was made to reduce the amount of the dividend and leave more of the profit in the hotel to be used for future investment. Management need to ensure that the shareholders are happy with the decrease in the level of the dividend given the increased profits despite lower profit margins, the hotel is enjoying. Overall, the hotel is performing well with management’s main focus to ensure that inventory levels are reduced to hotel norms and to remedy the decrease in net profits for 2018 while ensuring that the hotel improves its ratios overall due to a more buoyant hotel market existing in Accra.

                                                                                                                                            (2 points @ 2 marks each = 4 marks)

• Comparison

 Financial ratios provide a standardised method with which to compare companies and industries. Ratios can put all companies on a relatively equal playing field in the eyes of analysts; companies are judged on their performance rather than their size, sales volume or market share.

• Industry Analysis

 Ratios can reveal trends in particular industries, creating benchmarks against which the performance of all industry players can be measured thus providing valuable information to users, shareholders, trade payables, banks.

•  Stock/ Shares Valuation

 Ratios help investors and analysts to evaluate the strengths and weaknesses of individual companies or industries and allow them to highlight companies to invest in or to avoid investing in.

• Planning and Performance

Ratios can provide guidance to entrepreneurs when creating business plans or preparing presentations for lenders and investors. Ratios can also serve as an impetus for strategic change within an organisation, providing management with relevant guidance and feedback as ratio valuations shift in response to organisational changes. Ratios help to ensure managers perform by revealing financial weaknesses and opportunities.

• Simplicity

It highlights important information in simple formats. A user can judge a company by just looking at a small amount of numbers instead of reading the whole financial statements.

• Revaluation of fixed assets.
• Additional investment in fixed assets.
• Non-replacement of existing assets.
• Non-disposal of existing assets.

Achiaa Ltd.                                   Aspire Ltd.

2017 – GH¢’000                             2017 – GH¢’000

3,800/20,000 = 19%                      3,500/18,000 = 19.44%                                                                                                 (3 marks)

Achiaa Ltd.                                                       Aspire Ltd.

2017 – GH¢’000                                              2017 – GH¢’000

20,000/11,600*100 = 172.41%                   7,200/7,300*100 = 98.63%                                                                             (3 marks)

Achiaa Ltd.                                                       Aspire Ltd.

2017 – GH¢’000                                              2017 – GH¢’000

1,400/20,000*365 = 26 Days                     300/18,000*365 = 6 Days                                                                                (3 marks)

Achiaa Ltd.                                           Aspire Ltd.

2017 – GH¢’000                                  2017 – GH¢’000

6,400/2,000 = 3.2 Times                     4,800/800 = 6 Times                                                                                                (3 marks)

To: Managing Director of Oware Ltd

From: Financial Accountant

Re: Evaluation of potential purchase of either Achiaa Ltd or Aspire Ltd

Date: September 2013

Please find attached the results of a review of certain key ratios of the above companies for the year ended 31st December 2017.

Net Profit Ratio

The net profit ratio for both companies is broadly similar 19% for Achiaa versus 19.44% for Aspire. Aspire sales are 10% less than Achiaa Ltd and a review of results for prior years would be beneficial before making a definitive decision. Achiaa’s gross profit for 2017 is 40% versus Aspire’s 33.33%. Therefore, Achiaa has a more profitable business on their sales but leaks margin with higher administrative costs – 8% versus 6.67% and extra finance costs – 10% versus 4.44% due to their significant borrowings.

Debt to Equity Ratio

Both companies have a high debt to equity ratio with Achiaa’s in particular being at a dangerously high level. Are the high levels due to significant increases in non-current assets which may drive growth in the future – this needs to be investigated as well as review of the loan agreements to ensure that both companies can adequately cover repayments. Management at Achiaa should be asked whether an injection of capital/funds is needed to ensure its survival. Given the amount of debt in each company, it would appear that Achiaa is making repayments at a lower interest rate than Aspire.

Trade Receivable Days

Aspire’s result is significantly better than Achiaa but both results are within 30 days which is quite good provided both companies are not in an industry with lower normal receivable days than 30 days. Inquiries should be made to Aspire’s management as regards how they manage to keep their trade receivables as low because there may be an opportunity with other companies managed by Oware Ltd to capitalise on their approach.

Interest Cover

Aspire’s interest cover is nearly twice Achiaa’s level – 6 times versus 3.2 times and is at a comfortable level to satisfy banks. Achiaa’s level is at an acceptable level but it would need to be monitored closely for any signs of deterioration given the level of debt the company currently holds.

Recommendation

The most worrying aspect for both companies is the debt levels they currently hold and before purchase significantly questions need to be asked of management of companies re the sustainability of the debt levels and impact on future growth and profitability. Both companies have strong net profit margins. Achiaa has slightly better sales and excluding debt repayments has better profit margins and liquidity in its acid test ratio. Aspire appears to have strong working capital management and interest cover. Therefore, provided Aspire liquidity from a short and long term view is adequately managed, I would recommend it over Achiaa whose debts levels are very significant for Oware to accept as an investment proposition. I would urge that further due diligence be undertaken on both companies before investment proceeds.

I hope that the above responses clarify and answer your queries. If you have any further queries, please do not hesitate to ask.

Yours sincerely,

Financial Accountant

                                                                                                               (2 marks each for every ratio well analysed= 8 marks)

• All three shops have achieved a high return on their owners’ capital (ROCE), although Shop A performed marginally less well than the other two, despite having the highest gross margin and net profit margin. It spends less than the other shops on administration, which is good, but it also spends very little on sales staff wages and commission. Sales staff in Shop A are paid a high proportion of their income as fixed wages, with little being paid as commission. This means sales staff will have little incentive to make sales.
• Shop A also spends less than the others on advertising, which may be contributing to its relatively poor ROCE. Shop A makes the poorest use of its premises, generating much lower sales than the other two shops, but having premises valued at almost the same amount. To improve its overall profitability, Shop A should consider changing the structure of remuneration to sales staff by increasing the proportion paid as commission, and should also spend more on advertising.
• Shop B obviously adopted business policies which follow a middle path between those of Shop A and Shop C. In almost every ratio, Shop B falls between the other two. Shop B does outperform the other two in terms of inventory turnover, as it manages to sell its inventory within only 24 days on average. Apart from this indicator, the shop is adopting ‘safe’ policies, but if it wants to improve its ROCE, it should adopt an approach closer to that of Shop C.
• Shop C is the best overall performer of the three shops, as it has the highest ROCE. It appears to have achieved this by adopting several business strategies, each of which is designed to stimulate sales. It has the lowest gross profit margin, suggesting it has dropped its selling prices in order to encourage sales. It pays its sales staff the highest proportion of their remuneration by way of commission, encouraging them to make sales. It also pays its sales staff the highest overall package of remuneration. It spends more than the other two on advertising, which is likely to generate increased customer sales. It is making the best use of its premises, achieving sales of more than double those of Shop A, despite the premises being of the same value.
• There are three areas where Shop C could improve. It could try to reduce its administration costs, which are higher than those of the other two shops. It could try to turn over inventory faster, although not at the expense of losing sales through lack of choice. Finally, it could hold off paying payables for longer, although only if that did not involve losing any discounts available for prompt payment.                                                                                                                   (5 points @ 2 marks)

Liquidity:

Liquidity is the ability of an entity to be able to pay for its short term obligations as and when they fall due without any difficulties. Again, this payment should not affect the working capital of the firm and as a result the company continues to operate without any operational difficulties. Applying this understanding to both Father and Son limited above suggest that the current assets of Father limited can pay for its current liabilities about 3.5 times as opposed to 1.8 times of Sons limited. However, adjusting for inventories the quick ratios of both companies shows 1.1:1 and 1.2:1 respectively for Father and Son. This suggests that inventories forms a significant part of the current assets of Father limited and may not be convertible into cash very quickly. The quick ratio indicates that slightly Son limited is better off with respect to its liquidity position. At the moment both companies can meet their current short-term obligations but Father Limited may have difficulty going forward with its significant nature of inventories.

Profitability:

Every business wants to make the highest profit possible for its shareholders but care needs to be taken that profit is not equal to cash.

Looking at the gross margin of both Father and Son Limited, the gross margin is 30% and 27% respectively with the same level of sales. Better management of cost of sales may be key to the differences in the margins as depicted by the calculations above. This may also be partly due to the credit policies of both companies. On the face value it may not be fair to say that Father limited is doing well because it has 3% more than that of Sons Limited. Return on capital employed really looks at the efficiency in the utilization of capital in earning or generating profit in percentage terms. The higher this ratio the better management would have better utilize capital invested by shareholders and vice versa. Father Limited from that calculation has return on capital of 7% compared with 12% of Sons Limited. This suggests that Sons Limited is better using every pesewa invested by its shareholders efficiently and effectively as opposed to Father Limited. Father limited may need to change this situation as a matter of urgency.

Efficiency:

Activity or efficiency ratios assesses how efficient and effective an entity is with respect to its credit policies as well as general operational decision making processes. The receivable collection period indicate the time period it takes for management of an entity to be able to collect its debts from credit customers or debtors. Generally, the shorter time it takes the entity to do that the better since this will enhance the liquidity position of the entity. Looking at the ratios above Son Limited collect its debts within 8 days as opposed 31days for Father limited. This suggests that a huge amount of sale of Father Limited is on credit. This cannot be said of Son Limited as significant amount of its sales appears to be in cash sales and therefore it is not surprising that it is slightly better off with respect to its liquidity position. Similarly, trade payable period is the time an entity uses to settle its suppliers. A better supplier relationship could allow for a longer period for payment and this is a very good source of finance to the entity. Both companies seem to have relatively the same period of 48days and 49days for Father and Son Limited respectively.

1,400,000/1,120,000 = 1.25 times

160,000/320,000 = 0.5:1

396,000/22,000 = 18 times

316,000/200,000 = 1.58 times

(550,000/1,120,000) x 100 = 49.11%

316,000/450,000 = 70.22 pesewas

When profits are high the ordinary shareholders will benefit from the high gearing ratio of Gade Ltd and the ordinary shareholders will show an increased earnings per share. Lower interest rates of Gade Ltd will have a minimal effect on profit and will benefit the ordinary shareholders. If the profits of Gade Ltd were to fall, then the shareholders will be disadvantaged because the interest payments and preference share dividends must be met before any ordinary dividends are paid. An increase in interest rates would also affect the return of the ordinary shareholders. Gade Ltd might have to reduce gearing by selling off any surplus assets or increasing revenue reserves as an alternative to payment of dividends.

• net profit margin                               = 4.65%
• return on capital employed               = 15.11%
• current ratio                                       = 7.89:1
• liquid (acid test) ratio                        = 1.78:1
• rate of inventory turnover                 = 6 times

• The net profit as a percentage of sales is lower than the competitor, this may be because the cost of the goods is higher for BB, or he is not marking his purchases up as much as his competitor. It could also be caused by his expenses being higher than his competitor.
• BB’s ROCE is better than his competitor at 15.11% compared to 10.50%, this means that he is making more profit per cedi on investment in the company.
• The current ratio of 7.89:1 is extremely high, the current ratio of his competitor is also on the high side as the generally accepted ratio should be around 2:1, in BB’s case this is probably caused by high inventory holding.
• The acid test ratio at 1.78:1 is also a little high as here the generally accepted ratio is 1:1, however the ratio of his competitor of 0.3:1 is very low and may not be making the best use of resources.
• BB’s inventory-turnover is higher than his competitor which means that he is selling it more frequently than his competitor. This is a better performance than that of his competitor, since he is selling his inventory more frequently than them.
• This means that he makes a profit on every item he sells this contributes to the profitability to a greater extent than his competitor.
• Although BB’s net profit ratio is lower than that of his competitor his other ratios are all better, and his liquidity position is healthier than that of his competitor, in fact his competitor does look to have very poor liquidity which may lead to serious cash flow problems.

Comments:
The company’s Current ratio of 2:1 is higher than the industry average of 1.55:1, while that of Quick ratio of 0.66:1 is below the industry average of 0.95:1

• Current ratio.
• Quick ratio.
• Receivables collection period.
• Payable payment period.
• Inventory turnover period.