Report on Analysis of Financial Statements and Recommendations for

Lexicon Ltd
To: Managing Director, Lexicon Ltd
From: Sandra Masson, Financial Advisor

Terms of Reference
Two profitability, efficiency, liquidity and capital structure ratios and four investment ratios
have been calculated and analysed. Conclusions and recommendations are included based
on the findings. Two sources of long term finance have been recommended appropriate to
the company’s situation.

PROFITABILITY RATIOS
Operating Profit Ratio
This indicates per £1 of revenue how much operating profit the company is earning. The
higher the better. There has been a reduction from 16.4% to 10.8%. This is not good. The
improvement in the company’s control of expenses has been more than offset by the
reduction in the gross profit %age.
Return on Capital (Equity) Employed
This shows us how well the company is using its capital to generate profits. There has been
a decrease, from 34.9% to 24.6% Despite the increase in ordinary share capital there has
been a sharp decrease in operating profit.

LIQUIDITY RATIOS (ABILITY OF COMPANY TO PAY IN SHORT TERM)

Current Ratio
This is an indication of the companies’ ability to pay debts in the short term. At the end of
2017 the company had £2.90 of current assets for every £1 of current liabilities. This was an
increase from last year’s figure of £2.50. This ratio is satisfactory but an industry norm
would be advantageous.
Acid Test Ratio
At the end of 2017 the company had £1.50 liquid assets for every £1 of current liabilities,
indicating that it is still solvent. This ratio recognises that inventory (particularly raw
materials and WIP) are not always easily converted into cash. Again an increase from last
year but satisfactory. The company would not like to fall below £1 as this would indicate a
difficulty of paying debts in the short term. Has been a change for a healthy cash position to
on overdraft so will be monitoring in the future. There has been a change from healthy cash
position to an overdraft so this will have to be monitored in the future.

EFFICIENCY RATIOS (HOW EFFICIENT IS THE COMPANY AT USING ITS ASSETS)

Inventory Turnover
This indicates how many times the inventory is turned over. There has been an increase
from 5 times to 6 times. This is good. It means that the company is more efficient at
managing inventory. Less obsolete stock on shelf and not buying so much inventory in
advance.

Tangible non-current asset turnover

There has been an increase from 2.5 to 2.7 time which means that the company is using its
tangible assets more efficiently to generate sales. The business has invested in more
tangible assets (£120,000) and have used these efficiently.
120 este diefrenta dintre 1000 si 1120 din SOFP tangible assets

INVESTMENT/SHAREHOLDER RATIOS
Earnings Per Share
This is a key ratio. It measures the earnings available to the ordinary shareholders after tax
and preference dividend have been paid. The higher the better. There has been a fall in
earning per share, from 53p to 30p, which is not good for the company. There has been an
increase in ordinary shares without a corresponding increase in earnings. There hopefully
will be an increase in earnings per share next year when the new funds are fully utilised.
Dividend Cover
This ratio compares the profit earned per ordinary share (after payment of tax and
preference dividends) with the amount of dividend paid to the ordinary shareholders. It
shows the proportion of profits that could have been distributed had the Directors chosen
to do so. The cover has decreased from 1.9 to 1.1 times, which is not good. The directors
have maintained the level of dividends but because the earnings have decreased the level of
cover has reduced which may indicate that the company will be unable to pay this level of
dividends in the future.

Dividend Yield
This ratio measures the real rate of return by comparing the dividends paid to ordinary
shareholders to the market price of a share. The ratio has fallen from 18.7% to 15.9%,
mainly because of the increase in share price. It is an excellent return compared with what
an investor could earn by putting their money in a bank account.
Price Earnings Ratio
This ratio relates the earnings per share to the market price of the share. A high ratio
indicate that the shares are an attractive investment and act as a general guide to the
confidence of the stock market in the company. The price earnings have increased from 2.8
times to 5.7 times despite the fact that the earnings have fallen considerably in the year.
This is good news for the company

CAPITAL STRUCTURE/GEARING
Gearing Ratio
In 2017 19.4% of the company’s capital was made up of fixed interest capital (pref share +
loans). This was a small increase from last year – 18.9% and would be considered a low to
medium risk company.

Interest Cover
This ratio shows whether enough profits are being earned to meet interest payments when
due. Interest cover has fallen from 17 times to 10.3 times. This is still an adequate level of
cover. Interest payable has increase from £24,000 to £32,000 because of an increase in the
loan. 24 sii 32 este from finance cost income statement
CONCLUSION (Summary)
Profitability
Gross margin has decreased dramatically, possibly because of an increase in raw material
costs. Recommend look at change of supplier or bulk discounts.
ROCE as a result fell dramatically because of a fall in net margin and also an increase in
capital employed. Recommend that company ensures that any investment in new tangible
assets increases revenues and profits in the future.
Liquidity
The current and acid test ratios are increasing. They are currently at a satisfactory level. If
the ratios are falling to a low level this may be of a concern over the company’s ability to
pay debts in the short term.
Efficiency
There has been an improvement in inventory turnover. The increase in investment in
tangible assets has resulted in an improvement in the tangible asset turnover.
Capital Gearing
The company is a low to medium risk company 19.4 %, although interest cover has fallen
Investment
EPS and Dividend Cover have decreased because of the fall in earnings and the Dividend
yield has decreased because of the increase in market value of the shares. However, the PE
ratio has increased which is good news for the company as this indicates the stock market
has confidence in it.

RECOMMENDATIONS
It is recommended that the company monitor and ensure that the non-current assets
investment is fully utilised and this should increase profitability and earnings per share for
next year.

Also, the company should convert bank overdraft to more long term finance. This would
improve the company’s cash position (if this is relevant).
SOURCES OF LONG TERM FINANCE
Ordinary Shares
The company could issue more Ordinary Shares if their authorised shares capital allows it.
The advantage to the company is that there is no fixed amount to be issued as dividends
each year. The question is whether existing or potential investors will invest in the
company. EPS and Dividends are down but the Market Price of the Share is up.

Preference Shares
There is a fixed amount of interest that the company must pay each year (10%) This is well
below the current ordinary dividend level, (27%). Management must consider their ability
to cover the preference dividends.

Debentures
Again a fixed amount of interest must be paid each year and it is below the current ordinary
dividend level. One advantage of issuing debentures is that the interest is tax deductible.
Again management must consider their ability to pay fixed interest in the future.

Long Term Loan

The major disadvantage of a long term loan is that usually long term lenders want to fix a
guarantee on assets of the company.

The gearing ratio is low so any of the last three options could be suitable.
APPENDIX 1

MOCK ASSESSMENT - Ratios Lexicon

2016 2017
Profitability
(690/2500) (809/3060)
Operating Profit Ratio 16.4% 10.8%
(410/2500) (331/3060)
ROCE 34.9% 24.6%
(410/1176 (331/1345)

Liquidity
Current Ratio 2.5:1 2.9:1

Acid Test Ratio 1.2:1 1.5:1

Efficiency
Inventory turnover 5 times 6 times
(1400/280) (1920/320)
Tangible Assets Turnover 2.5 times 2.7 times
(2500/1000) (3060/1120)
Investment
Earnings per share £0.53 £0.30
(remember to deduct pref div) (326-10)/600 (219-10)/700
Dividend Cover 1.9 times 1.1 times
(326-10)/163 (219-10)/190
Price Earnings 2.8 times 5.7
1.50/0.53 1.70/0.30
Dividend Per Share £0.27 £0.27
(163/600) (190/700)
Dividend Yield 18.0% 15.9%
0.27/1.50 0.27/1.70
Capital Structure
Gearing Ratio 18.9% 19.4%
(100+150)/ (100+200)/(1345+200)
(1176+150)
Interest Cover 17.0 times 10.3 times
410/24 331/32