Solution- Financial Analysis Question (Revision handout)
To: Finance Manager, TUL
From: Financial Consultant
Date: Put the exam date
Subject: Evaluation of the financial performance and position of TUL for the year
ended 31 December 2021;
Introduction
Overall, TUL’s financial position and performance do not compare well with industrial
averages as indicated by its relatively poor liquidity position and profitability ratios
compared to the industrial averages. The company’s investor ratios however compare
well with the industrial averages. The detailed evaluation of TUL’s performance and
position is set out below.
Profitabilty:
TUL’s financial performance does not compare well with the rest of the competitors in
the construction sector. The company’s return on capital employed which is a key ratio
for measuring financial performance of 12.3% is significantly lower than the sector
average of 18% however its return on equity at 11.5% is marginally below the sector
average by 0.5%. This poor performance may be attributable to the high
administrative expenses that account for 65% of the total contribution.
Liquidity position:
The company’s liquidity position is worse than the industrial averages in all ratios.
TUL’s current and quick assets ratios which are key ratios for measuring liquidity
positions of entities stand at 1.4:1 and 0.62:1 respectively and are below the industrial
averages of 1.5:1 and 0.8:1 respectively.
By taking a prudent view, TUL’s liquid assets do not effectively match its current
liabilities, and this points to the liquidity problems faced by the company. This is further
demonstrated by the company’s increased reliance on short term borrowings (bank
overdrafts) to finance daily operations. For the past 1 year, TUL’s bank overdraft
increased by 43.5% from Shs 2.25 billion to Shs 3.23 billion in 2021.
Further, the company’s inventory holding and creditors’ payment period at 112 days
and 118 days respectively are also worse than the sector averages of 90 days and 95
days respectively. The lengthening inventory holding period may result into stock
associated costs such as stock obsolescence, inventory theft among others.
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Whereas delaying payments to creditors is a cheap source of finance, it may worsen
TUL’s relationships with the suppliers. Overall, these inefficiencies point to the liquidity
problems facing TUL.
Gearing position:
TUL has a debt-to-equity ratio of 40.4%, which is less than the industrial average of
65%. TUL is not benefiting from employing higher levels of debt capital in its capital
structure because the associated finance cost is a tax allowable expense that results
into tax savings. TUL should maintain its gearing levels at an acceptable level to avoid
costs associated with excessive gearing such as bankruptcy.
The company’s interest cover at 4.6 times is also above the industrial average of 2.5
times. This implies that TUL is able to generate enough profits that can adequately
service interest expense up to almost 5 times.
Investor ratios:
TUL’s diluted EPS of Shs 520.4 and P/E ratio of 2.8 times are better than the
corresponding industrial ratios of Shs 450 and 2 times respectively. The higher P/E
ratio is an indicator of the confidence that investors place in the share prices of TUL
while the higher diluted EPS shows that despite the liquidity, and financial performance
problems, TUL still offers a higher return to its shareholders than its competitors in
the sector.
The details of the above analysis are provided in the Appendix set out below.
APPENDIX
Computation of ratios in Shs ’000’
Return on capital employed = PBIT / (Total assets - current liabilities) x 100
PBIT = 5,292,500 + 2,145,400 + 2,062,500 = 9,500,400
ROCE = [9,500,400/(114,514,300 - 37,319,200)] x 100 = 12.3%
Current ratio = Current assets / Current liabilities : 1
CR = 52,631,900 / 37,319,200 : 1 = 1.4 : 1
Diluted EPS = Revised PAT / Diluted ordinary shares
Diluted shares = Existing shares + newly issued + free shares
At market price: Share proceeds = 100,000 x 1,000 x 1.5 = Shs 150 million
Diluted shares = 10m + 150,000 + 20,000 = 10,170,000 shares
Diluted EPS = 5,292,500/10,170 = Shs.520.4
Return on equity = PAT / Total equity x 100
ROE = (5,292,500/45,969,900) x 100 = 11.5%
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Inventory holding period = Inventory/Direct costs x 365 days
IHP = [29,400,500/96,250,000] x 365 days = 111.5 days
Debt to equity ratio = Debt / Equity x 100
D/E = (31,225,200 / 45,969,900+31,225,200) x 100 = 40.4%
P/E ratio = Market price per share/Earnings per share
But EPS = 5,292,500/10,000 = Shs.529.25
P/E ratio = (1,000 x 1.5) / 529.25 = 2.8 times
Payables payment period =( Payables / Credit purchases )x 365 days
Assuming credit purchases = direct costs
PPP =( 31,010,460 / 96,250,000 )x 365 days = 117.6 days
Interest cover = PBIT / Interest expense
IC = 9,500,400 / 2,062,500 = 4.6 times
Quick assets ratio = (Current assets - Inventory) / Current liabilities : 1
QAR = (52,631,900 - 29,400,500) / 37,319,200 : 1 = 0.62:1
MAY 2023- Solution 5 (Common size Statements)
Evaluation of the financial performance and position of CPL for the year ended
31December 2022.
❖ The production cost accounted for 66.27% of revenue in 2021 decreasing to
63.06% in 2022, resulting into an increase in contribution from 33.73% in 2021
to
36.94% in 2022.
❖ Administrative costs accounted for 15.88% of the total revenue up from
13.83% registered in 2021. In contrast, distribution and finance costs
decreased from 17.35% and 2.05% of revenue in 2021 to 16.82% and 1.74%
in 2022, respectively.
❖ Consequently, the net profit before and after tax increased from 0.51% and
0.35% in 2021 to 2.49% and 1.75% in 2022, respectively, an indication of
improvement in the earnings performance of the company.
❖ Property, plant & equipment (PPE) and inventory accounted for 57.6% and
24.5% of the total assets in 2022 down from 61.5% and 26% in 2021. The
decline in PPE may be attributable to impairment and periodic depreciation of
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these assets while the decrease in inventory levels may be due to increased
stock turnover in CPL.
❖ Trade and other receivables accounted for 10.5% of the total assets in 2022
up from 3.8% registered in 2021. This significant increase in receivables may
pose adverse effects to the liquidity position of CPL since much of the current
assets are held in inventory (24.5%) which is considered less liquid compared
to the holding in cash and cash equivalents of 7.4%.
❖ Current liabilities accounted for 17.4% of the total assets in 2022 down from
19.8% in 2021 while current assets accounted for 42.4% in 2022 from 38.6%
in 2021. Consequently, the company’s net working capital position improved
from 18.8% (38.6% - 19.8%) in 2021 to 25% (42.4% - 17.4%) in 2022. This
improvement in net working capital position results in improved liquidity
position of CPL.
❖ 28.8% of the assets in 2022 were financed by long term liabilities compared to
31.5% in 2021. Whereas this may indicate declining gearing levels, it may also
be attributable to the decline in the total assets which are used as base values
in the analysis.
❖ Total assets financed by equity in 2022 were 53.8% up from 48.8% in 2021.
This is an indicator of increased capital maintenance in the entity and
continuous decline in gearing levels at its associated risks. Please refer to the
Appendix for detailed analysis.
Appendix:
Common size statement of financial performance;
Common size analysis
2022 2021 2022 2021
(Shs.000) (Shs.000)
Revenue 42,500,000 41,500,000 100% 100%
Production cost (26,800,000) (27,500,000) -63.06% -66.27%
Contribution 15,700,000 14,000,000 36.94% 33.73%
Administrative costs (6,750,000) (5,740,000) -15.88% -13.83%
Selling & distribution costs (7,150,000) (7,200,000) -16.82% -17.35%
Finance costs (740,000) (850,400) -1.74% -2.05%
Profit before tax 1,060,000 209,600 2.49% 0.51%
Income tax (318,000) (62,880) -0.75% -0.15%
Profits for the year 742,000 146,720 1.75% 0.35%
Common size statement of financial position;
Common size analysis
2022 2021 2022 2021
Assets: (Shs.000) (Shs.000)
Non-current assets:
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Property, plant & equipment 17,500,000 19,254,000 57.6% 61.5%
Current assets:
Inventory 7,450,000 8,125,000 24.5% 26%
Trade and other receivables 3,175,000 1,177,680 10.5% 3.8%
Cash and cash equivalents 2,240,000 2,750,400 7.4% 8.8%
Total assets 30,365,000 31,307,080 100% 100%
Equity and liabilities:
Ordinary share capital 5,500,000 5,000,000 18.1% 16%
Retained earnings 6,259,500 5,517,500 20.6% 17.6%
Preference share capital 4,570,000 4,754,500 15.1% 15.2%
Non-current liabilities:
Long term loans 8,750,000 9,847,200 28.8% 31.5%
Current liabilities:
Trade and other payables 4,967,500 6,125,000 16.4% 19.6%
Current tax payable 318,000 62,880 1.0% 0.2%
Total equity and liabilities 30,365,000 31,307,080 100% 100%
INDEX FINANCIAL STATEMENT ANALYSIS
Index financial statement analysis, also known as trend analysis, is a method of
financial analysis that involves comparing financial statement data over multiple
periods to identify trends, changes, and patterns in a company's financial
performance. Instead of focusing on absolute values, index analysis uses a common
base period as a reference point to calculate percentage changes in financial
statement items over subsequent periods.
The process of conducting index financial statement analysis involves the following
steps:
❖ Selection of Base Period: The analyst selects a specific period (usually a year
or a quarter) as the base period. All financial statement items for this period
are set as 100% or the base value.
❖ Calculation of Index Numbers: For each subsequent period, financial
statement items are expressed as a percentage of the corresponding base
period value. This is calculated using the following formula:
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Index number = Current year balance x 100
Base year balance
❖ Interpretation: The calculated index numbers are then analyzed to identify
trends and changes in financial performance over time. An index number
greater than 100% indicates growth or improvement compared to the base
period, while a number less than 100% indicates a decline or deterioration.
Example
Let's illustrate index financial statement analysis using a simplified example for a
fictional company, ABC Corp. We will analyze the income statement data for three
consecutive years: Year 1 (base period), Year 2, and Year 3.
Income Statement for ABC Corp: (in $ millions
Year 1 Year 2 Year 3
Revenue $500 $600 $700
COGS ($200) ($240) ($280)
Gross Profit $300 $360 $420
Operating Exp ($100) ($120) ($140)
Net Income $150 $180 $210
Step 1: Selection of Base Period
❖ Let's choose Year 1 as the base year for our index analysis.
Step 2: Calculation of Index Numbers
❖ For each subsequent year (Year 2 and Year 3), we will calculate the index
numbers as follows:
Index number = Current year balance x 100
Base year balance
Year 2 Index Numbers:
Revenue Index = ($600 / $500) x 100 = 120
COGS Index = ($240 / $200) x 100 = 120
Gross Profit Index = ($360 / $300) x 100 = 120
Operating Expenses Index = ($120 / $100) x 100 = 120
Net Income Index = ($180 / $150) x 100 = 120
Year 3 Index Numbers:
Revenue Index = ($700 / $500) x 100 = 140
COGS Index = ($280 / $200) x 100 = 140
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Gross Profit Index = ($420 / $300) x 100 = 140
Operating Expenses Index = ($140 / $100) x 100 = 140
Net Income Index = ($210 / $150) x 100 = 140
Step 3: Interpretation
The calculated index numbers show the percentage change in each financial statement
item relative to the base year (Year 1).
❖ Revenue increased by 20% in Year 2 and 40% in Year 3 compared to the base
year (Year 1).
❖ COGS increased by 20% in Year 2 and 40% in Year 3 compared to the base
year (Year 1).
❖ Gross Profit increased by 20% in Year 2 and 40% in Year 3 compared to the
base year (Year 1).
❖ Operating Expenses increased by 20% in Year 2 and 40% in Year 3 compared
to the base year (Year 1).
❖ Net Income increased by 20% in Year 2 and 40% in Year 3 compared to the
base year (Year 1).
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