QUESTION ONE
a)    Return on capital employed: R.O.C.E

Since interest is tax allowable, it yield tax shield (interest x tax rate) profits after interest and tax    =    600,000 – interest + tax shied
        =    600,000 – (10% x 2M) + (10% x 2M x 30%)
        =    600,000 – 200,000 + 60,000
        =    Sh.460,000

        ROCE    =        =    3.83%

b)    Earnings per share    =        =    Sh.3.07

c)    Price earnings ratio    =        =    11.73 years

d)    Book value per share    =    Equity (net worth)
                        Number of shares

        Equity    =    1,500,000 + 1,500,000 + 7,000,000    =    10,000,000

        BUPS    =    Sh.10,000,000    =    Sh.66.70
                    150,000

e)    Earning    =    Fixed charge capital    =    Sh.2,000,000 x 100    = 16.7%
                   Total capital            Sh.12,000,000

        Or    =    Fixed charge capital    =    Sh.2,000,000    =    0.20
                    Equity            Sh.10,000,000

        This indicates low gearing.

f)    Market to book value per share (MBVPS) ratio.

        MBVPS    =    MPS
                BVPS

            =      36    =    0.54
                66.70
QUESTION TWO
a)    i)    Inventory turnover ratio    =       Cost of sales       
                        Average stock (closing stock)

        =    1,368,000    =    2.1 times
              649,500

    ii)    Times interest earned ratio    =    Operating profit EBIT)
                               Interest charges

                        =    105,750 = 3.1 times
                            34,500

    iii)    Total assets turnover    =         Sales         
                        Total Assets

                    =    1,972,500 = 1.6 times
                        1,233,750

    iv)    Net profit margin    =    Net profit (profit after tax) x 100
                            Sales

                    =       42,750 x 100    =    2.2%
                        1,972,500

                    i.e 2.2% is the net profit margin
                        97.8% is the cost of sales.

b)    Industrial analysis

-    Industrial analysis involve comparison of firm performance with the industrial average performance or norms.
-    This analysis can only be carried out for a given year. I.e

Times series/trend analysis

-    This involve analysis of the performance of a given firm over time i.e ratio of different year of a given Co. are compared in order to establish whether the performance is improving or declining and in case a weakness is detected e.g decline in liquidity ratio, this will force the management to take a corrective action.

-    When commenting on industrial and trend analysis the following 4 critical points should be highlighted:

a)    In case of individual ratio classify them in their immediate category e.g when commenting on TIER indicate this in a gearing ratio.

When commenting on a given category of ratio identify the ratios in that category e.g if required to comment on liquidity position identify the liquidity ratio from the ratios computed.

b)    State the observation made e.g total asset turnover is declining or increasing over time (in case of trend analysis) or the ratio is lower or higher than the industrial norms (in case of industrial analysis).

c)    State the reason for observation i.e. explain why the ratio is declining or
increasing.

d)    State the implication for observation e.g decline in liquidity ratio means that the ability of the firm to meet in short term financial obligation is declining over time.


Ratio
ABC Ltd.
Industrial Norm
Inventory Turnover
Times interest earned ratio
Total Asset turnover
Net profit margin

• 2.1
• 3.1
• 1.6
• 2.2%
• 6.2
• 5.3
• 2.2
• 3%

i)    Inventory turnover
    -      This is a turnover or efficiency ratio
    -    The rate is lower than industrial norm
    -    A low stock turnover could be attributed to:

                i)    Charging higher price than competition
                ii)    Maintenance of slow moving/obsolete goods
                iii)    Where the firm is selling strictly on cash while
competitors are selling on credit.

-    The firm is not efficiently utilising its inventory to generate sales revenue.

ii)    Times interest earned ratio (TIER)

    -    This is a gearing ratio
    -    It is lower than industrial average or norm
    -    This could be due to low operating profit due to high
operating expenses or high interest charges due to high level of gearing/debt capital.
-    This implies that the firm is using a relatively high level of fixed charge capital to finance the acquisition of assets.

iii)    Total asset turnover

    -    This is efficiency ratio/activity
    -    Lower than industrial average
    -    This could be due to holding large non-operational or fully
depreciated asset which are not utilised by the firms.
-    This implies inefficiency in utilisation of total assets to generate sales revenue.

iv)    Net profit margin
    -    Is a profitability ratio
    -    Lower than industrial norm
    -    This could be due to low level of net profit of the firm
relative to sales revenue.
            -    This implies that the firm has a low ability to control its cost
of sales, operating & financing expenses e.g in case of ABC Ltd selling & admin expenses are equal to 82.5% of gross profit

                498,750 x 100
                604,500

            -    Also the cost of sales expense is 69.4% of sales i.e

                1,368,000 x 100
                1,972,000

QUESTION THREE
a)    i)    Earning per share

    EPS    =    Earning to Ordinary Shareholders
                     No. of ordinary shares

            =         990,000         =    990,000        =    Sh.1.24
                8,000,000 ÷ 10        800,000

-    The ratio indicates earnings attributable to each ordinary share held by shareholders.
        -    Shows earning power of the firm.

ii)    Price earning ratio

PE    =    MPS    =      12      =    9.7 times/years
        EPS        1.24

-    The PE indicate that Miss Hisa will take 9.7 years (payback period) to recover her investment in form of buying price per share i.e the firm.

iii)    Dividend yield

DY    =    DPS    =    0.925 x 100    =    7.7%    
        MPS

-    The ratio indicate % dividend return for every shilling invested in the firm.

iv)    Dividend cover

    DC    =    EPS    =    1.24    =    1.34 times
                DPS        p.925

-    The ratio indicate number of times dividend can be paid from earnings attributable to ordinary shareholders.  The higher the DPS to lower the DC and vice-versa.

    v)    Book value per share (BVPS)

        BVPS    =         Networth (Equity)            
                Number of ordinary shares

        Equity    =    Retained earnings + ordinary share capital

            =    1,060,000 + 8,000,000 = 9,060,000

        BVPS    =        =    Sh.11.325


QUESTION FOUR
i)    Return on Investment    =    Net profit
                    Total asset

    -    This ratio can increase due to increase in net profit or decrease in total asset.
    -    The increase may not be due to improvement in performance if it is caused by:
        a)    disposal of asset
        b)    increase in net profit due to reduction in tax rate
        c)    Increase in net profit due to gain associated with disposal of assets or
reduction in interest charges resulting from repayment of loans.

ii)    Gross profit on sales    =    GP Margin =    Gross profit x 100
                                 Sales

-    This ratio can improve due to increase in gross profit and due to reduction in cost of sales or increase in sales.
    -    It may not be judged as improvement if the increase is caused by:
        a)    increase in sales as a result of increase in selling price.
    b)    increase in GP caused by reduction in cost of raw materials
    c)    Where cost of sales decrease due to the use of low quality materials
production.

iii)    Number of credit given
Debtors collection period

=               365                 or    365 x Average (closing) debtors
    Debtors Turnover            Annual credit sales

-    Reduction in debtors collection period is improvement but it is not a better performance over the years if the reduction:

a)    Was achieved through offering discount to customers which is a cost of credit policy.
b)    If it resulted in decline in credit sales of the firm whereby customers who could not pay within 45 days switch their business to competitors.
iv)    Administration cost of sales

Administrative cost of sales Ratio    =    Administrative cost x 100
                        Sales

-    This ratio can improve (reduction) in ratio over the years in case administration cost reduces or sales increase.  A reduction in this ratio is not an improvement in performance if it is caused by:

    a)    Increase in sales as a result of increase in selling price.
    b)    Decrease in administrative expenses resulting from hiring less qualified
personnel who might compromise the quality of product or service.

b)    i)    Stock Turnover Ratio    =       Cost of Sales       
                        Average Stock

                    =    Average stock =    800,000 + 2,200,000
                                    2

                    =    1,500,000

        Cost of sales        =    75% of 20,000,000
                    =    15,000,000

        Stock turnover        =    15,000,000    =    10 times
                        1,500,000

    ii)    Number of days stock held     =             365             
                            Stock turnover

                    =    

        or            =    365 x Average stock
                             Cost of sales