M. K. Berry is the managing director of CE Ltd. a small, family-owned company which manufactures cutlery. His company belongs to a trade association which publishes a monthly magazine. The latest issue of the magazine contains a very brief article based on the analysis of the accounting statements published by the 40 companies which manufacture this type of product. The article contains the following table: Average for all companies in the industryReturn on equity 33%Return on total assets 29%Gross margin percentage 30%Current ratio 1.9:1 Average sale period 37daysAverage collection period 41days?CE Ltd's latest financial statements are as follows:CE Ltd.Income Statementfor the year ended 31 October(in thousands)Sales$900 Cost of goods sold 720 Gross margin 180 Selling and
administrative expenses 55 Interest 15 Net income$110 The country in which the company operates has no corporate income tax. No dividends were paid during the year. All sales are on account.CE Ltd.Balance Sheetsas of 31 October(in thousands) This YearLast YearCurrent assets: Cash$5 $20 Accounts receivable, net 120 110 Inventories 96 80 Noncurrent assets 500 460 Total assets$721 $670 Current liabilities: Accounts payable$147 $206 Noncurrent liabilities: Bonds payable 150 150 Common stock 100 100 Retained earnings 324 214 Total liabilities and stockholders' equity$721 $670 Required:a. Calculate each of the ratios listed in the magazine article for this year for CE, and comment briefly on CE Ltd's performance in comparison to the industrial averages.b. Explain why it could be misleading to compare CE Ltd's ratios with those taken from the article.
What will be an ideal response?
A.
Return on equity = Net income ÷ Average total stockholders' equity*
= $110 ÷ $369 = 29.8%
*Average total stockholders' equity = [($100 + $324) + ($100 + $214)] ÷ 2 = $369
Return on total assets = {Net income + [Interest expense × (1 - Tax rate)]} ÷ Average total assets*
= {$110 + [$15 × (1 - 0.00)]} ÷ $695.5 = 18.0%
*Average total assets = ($721 + $670) ÷ 2 = $695.5
Gross margin percentage = Gross margin ÷ Sales
= $180 ÷$900= 20%
Current ratio = Current assets* ÷ Current liabilities
= $221 ÷ $147 = 1.5
*Current assets = $5 + $120 + $96 = $221
Inventory turnover = Cost of goods sold ÷ Average inventory balance
= $720 ÷ [($96 + $80) ÷ 2] = 8.2 (rounded)
Average sale period = 365 days ÷ Inventory turnover*
= 365 days ÷ 8.2 = 45 days(rounded)
Accounts receivable turnover = Sales on account ÷ Average accounts receivable balance*
= $900 ÷ $115 = 7.8 (rounded)
*Average accounts receivable balance = ($120 + $110) ÷ 2 = $115
Average collection period = 365 days ÷ Accounts receivable turnover
= 365 days ÷ 7.8 = 47 days (rounded)
CE Ltd's return on stockholders' equity is not as good as the industry's average. For every dollar invested, stockholders are obtaining a return which is smaller than they should expect, based on the article's figures. Similarly, the return on total assets is much less than the average. This indicates that the company is unable to make good use of the funds invested in the company.
CE Ltd's gross margin percentage is also lower than average--perhaps because its selling prices are lower than the average or its cost of sales are higher.
The current ratio indicates that CE Ltd's current assets are greater than its current liabilities by a factor of 1.5. The industry average shows an even higher figure, with current assets amounting to almost double current liabilities.
Most companies aim to turn over inventory as quickly as possible, in order to improve cash flow. CE Ltd is not managing to do this as quickly as the industry's average of 37 days. Similarly, companies should try to obtain payment from customers as soon as possible. CE Ltd is taking much longer to do this than the average for the industry.
B.
Care must be taken when comparing CE Ltd's ratios with industry averages because there may be differences in accounting methods. Although accounting standards have reduced the range of acceptable accounting policies, there is still scope for different firms to apply different accounting policies. For example, one firm may use straight-line depreciation, while another may use accelerated depreciation. These variations make comparisons difficult.
Size differences may also mean that ratios are not comparable. A very large manufacturing business should be able to achieve economies of scale which are not possible for CE Ltd. For example, large companies may be able to negotiate sizable discounts from suppliers.
A third problem arises from differences in product range. CE Ltd may produce cutlery which is sold at the top end of the market, for very high prices, and in small volumes. Alternatively, it may be producing high-volume, low quality cutlery for the catering industry. Either situation will reduce the value of comparisons with the industry average.
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