Singapore Institute of Management

UOL International Programme

AC2091 Financial Reporting
Session 13: Analysis and Interpretation of Financial Reports

Practice Question 1 <ANSWERS>

The following are the accounts of Balliol plc, a company that manufactures gardening
equipment, for the year ended 30 November 2010.

Statements of comprehensive income for years ended 30 November

2010 2009
£000 £000
Profit before interest and tax 2,200 1,570
Interest expense 170 150
Profit before tax 2,030 1,420
Taxation 730 520
Profit after tax 1,300 900
Dividends paid 250 250
Retained profit 1,050 650

Statements of financial position as at 30 November

2010 2009
£000 £000
Non-current assets (written-down value) 6350 5600
Current assets
Inventories 2,100 2,070
Receivables 1,710 1,540
Total assets 10160 9210

Current liabilities
Trade payables 1,040 1,130
Taxation 550 450
Bank overdraft 370 480
1,960 2,060

Non-current liabilities
10% debentures 2011 1,500 1,500
Total liabilities 3,460 3,560

Share capital ordinary shares of 50p fully paid up 3,000 3,000

Share premium 750 750
Retained earnings 2,950 1,900
6,700 5,650
Total equity and liabilities 10,160 9,210

The directors are considering two schemes to raise £6,000,000 in order to repay the
debentures and to finance expansion.

Page 1 of 6
Scheme 1 will involve a new issue of debentures redeemable in 15 years.

Scheme 2 will involve a rights issue of ordinary shares at £1.50 per share. The current market
price of the shares is £1.80. The share price in December 2010 was £1.75 and in December
2009 was £1.40.

Required:

(a) Calculate, for 2009 and 2010, and comment on the following ratios from a potential
lender’s (debenture holder’s) viewpoint:

• Return on capital employed

• Liquidity (Quick ratio)
• Interest cover
• Debt to equity

(b) Calculate, for 2009 and 2010, and comment on the following ratios from a shareholder’s
viewpoint:

• Return on equity
• Earnings per share
• Dividend cover
• Debt to capital employed

(c) Explain the usefulness of the Price Earnings ratio for investors. Calculate and comment
on the Price Earnings ratio of Balliol plc at December 2009 and 2010. (The average Price
Earnings ratio for relevant competitors in 2010 was 7.5).

(Adapted: UOL POA 2011 ZA Q3)

Practice Question 1 - ANSWERS

(a)
Formula 2010 2009
£’000 £’000
Return on capital PBIT/(NCL +E) 2,200/(1,500+6,700) 1,570/(1,500+5,650)
employed = 2,200/8,200 = 1,570/7,150
= 26.83% = 21.96%
Liquidity (Quick (CA-Stock)/CL 1,710/1,960 1,540/2,060
ratio) = 0.87 = 0.75
Interest cover PBIT/Interest 2,200/170 1,570/150
= 13 times = 10 times
Debt to equity NCL/E 1,500/6,700 1,500/5,650
= 0.22 = 0.27

Comments from viewpoint of lender

The return on capital employed has increased by 23 per cent. The current ratio at 1.9 and acid
test ratio of 0.87 are both improving, and interest is well covered at 13 times. Gearing is low

Page 2 of 6
and when coupled with the improving return on equity and sound interest cover, it means that
the company is able to increase its long-term borrowing.

(b)
Formula 2010 2009
£’000 £’000
Return on equity (PAT – Pref Div)/ 1,300/6,700 900/5,650
(Ord Sh + Res) = 19.40% = 15.93%
Earnings per share NPAT/No. of Ord Sh) 1,300/(3,000/0.5) 900/(3,000/0.5)
= 1,300/6,000 = 900/6,000
= 21.67p = 15p
Dividend cover NPAT/Div. paid 1,300/250 900/250
= 5.2 times = 3.6 times
Debt to capital NCL/(NCL+E) 1,500/8,200 1,500/7,150
employed = 18.29% = 20.98%

Comments from potential shareholder’s viewpoint

The return on equity has improved by approximately 25 per cent. The dividend is well
covered, and has improved in 2010 from 3.6 in 2009 to 5.2 in current year. The EPS figure is
in line with the return on equity and is acceptable. The gearing is low at 18.3 per cent, so that
the business enjoys lower earnings risk.

(c)
The PE ratio compares a company’s earnings and its share price and can help investors in
deciding whether the shares are under or overvalued by comparison with the PE ratios of
companies of similar risk.
A high PE ratio might reflect confidence in the company’s management and prospects. A low
PE ratio might show a lack of confidence.

PE ratios for Balliol plc

December 2010
175 = 8.1
21.67

December 2009
140 = 9.3
15

These ratios illustrate that the market’s confidence in Balliol’s ability to increase its earnings
in 2010 was reflected in the high PE number. The ratio is still higher than a competitor which
shows remaining confidence.

Practice Question 2

Discuss the impact of increasing long term debt on earnings per share, gearing ratio and
return on equity.
(Adapted: UOL 2012 ZA Q5c)

Page 3 of 6
Practice Question 3

Window Ltd has seen an increase in its return on capital employed between 2011 and 2012.
Discuss possible reasons for return on capital employed increasing.

(Adapted: UOL 2013 ZB Q4a)

Practice Question 4

You are given the following information in relation to company X and company Y:

Company X Company Y
Sales £3,250,000 £4,500,000
Gross profit margin 10% 15%
General expenses £75,000 £425,000
Tax £225,000 £150,000
Number of shares issued at start of the period 50,000 50,000
Number of shares issued at full market price 30,000 20,000
for cash, half way through the period
Share price £50.00 £25.00

Required:

Define and calculate the earnings per share and the price earnings ratio for company X and
company Y. Discuss possible reasons for the difference in the price earnings ratio of the two
companies.
(Adapted: UOL 2014 ZA Q4d)

Practice Question 4 - ANSWERS

Company X
Gross profit 10% X 3,250,000
= 325,000
Profit after tax 325,000 – 75,000 – 225,000
= 25,000
Weighted average no. of (50,000 X 6/12) + (80,000
shares X 6/12) = 65,000
EPS 25,000 / 65,000 = 0.38
PE ratio 50 / 0.38 = 131.58
Company Y
15% X 4,500,000
= 675,000
675,000 – 425,000 –
150,000 = 100,000
(50,000 X 6/12) + (70,000
X 6/12) = 60,000
100,000 / 60,000 = 1.67
25 / 1.67 = 14.97

Despite having a lower EPS, Company X has a higher PE ratio. This can be attributed to the
relatively higher share price of Company X as compared to Company Y. This may indicate
that investors have more confidence in the future prospects of Company X and expect
enhanced earnings growth in Company X.

Page 4 of 6
Practice Question 5

You are given the following information:

2014 2013
Gross profit percentage 20% 25%
Cost of sales £750,000 £1,200,000
Administration and distribution expenses £75,000 £300,000
Ordinary share capital £600,000 £400,000
Preference share capital £450,000 £225,000
Long term loans £150,000 £100,000
Retained earnings £900,000 £700,000

Required:

Calculate the net profit margin and the gearing ratio for 2014 and 2013. Discuss two possible
reasons for the changes seen in the net profit margin and discuss the problems associated with
increasing levels of debt within companies.

(Adapted: UOL 2015 ZB Q3c)

Practice Question 5 - ANSWERS

2014 2013
Sales 750,000 / 0.80 1,200,000 / 0.75
= 937,500 = 1,600,000
Net profit 937.5k – 750k – 75k 1.6m – 1.2m – 300k
= 112,500 = 100,000
Net profit margin 112,500 / 937,500 X 100% 100,000/1,600,000 X 100%
= 12% = 6.25%
Gearing [Debt/Equity] 150k / [600k+450k+900k] 100k / [400k+225k+700k]
= 7.69% = 7.55%

Page 5 of 6
Practice Question 6

On 1 July 2016, Hockey Ltd issued an additional 4 million ordinary shares with nominal
value of 50p for £12.50 per share. The costs of this share issue totalled 1% of the total
money raised in the share issue. After this share issue, Hockey Ltd issued bonus
shares, in respect of all its shares, on a 1 for 5 basis. Before the share issue and the
bonus issue Hockey Ltd’s share capital and reserves were as follows:

£
Ordinary share capital 5,000,000
Ordinary share premium 15,000,000
Preference share capital 4,000,000
Retained earnings 160,000,000

Required:

Show how Hockey Ltd’s share capital and reserves would be affected by the share
issues outlined above.

(Adapted: UOL 2017 ZB Q3d)

Practice Question 6 - ANSWERS

Share Issue Bonus Issue

£ £ £
Ordinary share capital 5m + 2m = 7m + 1.4m = 8.4m
[4m X 0.50] [(7m/0.5)/5 X 1 X 0.50]
Ordinary share 15m + 48m – 0.5m = 62.5m - 1.4m = 61.1m
premium [4m X 12] – [(4m X 12.50) X 1%]
Preference share 4m 4m
capital
Retained earnings 160m 160m

Page 6 of 6