A Quicker Way for the Directors to Pay Dividends - Coursework Example

Journals and Contents Journals 4 Y4 Trial balance 4 Extended Trial balance Y5 4 Quicker wayfor the directors to pay dividends 7 Suggestion on lack of debentures and loan notes 7 Financial statements 7 (a)Statement of profit or loss 7 (b)Statement of financial position 8 (c) Statement of changes in equity 8 Ratios 9 Profitability 9 Gross margin 9 Net margin 10 Free cash flow margin 10 Return on assets (ROA) 10 Return on equity (ROE) 11 Liquidity ratios 11 Acid test ratio 11 Quick ratio 11 Current ratio 12 Cash ratio 12 Management efficiency 12 Inventory turnover 13 Accounts receivable turnover 13 Accounts payable turnover 13 Total assets turnover 14 Gearing 14 Debt equity 14 Interest coverage ratio 15 Conclusion and recommendations 15 Conclusions 15 Recommendations 16 References 17 Journals Y4 Trial balance As at 31 December Y4 Dr ($ ‘000’) Cr ($ ‘000’) Sales revenue 279,571 Other income 5,253 Cost of sales 202,298 Administration expenses 43,325 Selling and distribution costs 18,984 Loss on disposal of NCA 1,122 Interest expense 928 Taxation 3,440 Profit/ (Loss) 14,727 284,824 284,824 Tangible Non-Current Assets (NCA) 173,656 Inventory 18,784 Accounts Receivable 7,174 Bank & Cash 19,086 Ordinary shares of $ 1 each 10,000 Share Premium 50,000 Revaluation reserve 27,000 Retained Losses c/fwd 78,017 Short term borrowing 31,544 Accounts payable 54,733 Tax creditor 3,440 Long term borrowing 120,000 296,717 296,717 Extended Trial balance Y5 As at 31 December Y5 Starting TB Journals Ending TB Dr ($ ‘000’) Cr ($ ‘000’) Dr ($ ‘000’) Cr ($ ‘000’) Dr ($ ‘000’) Cr ($ ‘000’) Sales revenue 279,571 23,789 303,360 Other income 5,253 3,201 2,052 Cost of sales 202,298 23,654 225,952 Administration expenses 43,325 2,515 45,840 Selling and distribution costs 18,984 10,637 8,347 Loss/(Gain) on disposal of NCA 1,122 1, 438 - 316 Interest expense 928 190 1,118 Taxation 3,440 1,862 5,302 Profit/ (Loss) 14,727 4,442 19,169 284,844 284,844 35,864 35,864 305,728 305,728 Tangible Non-Current Assets (NCA) 173,656 5,161 178,817 Inventory 18,784 5,432 24,216 Accounts Receivable 7,174 5,385 12,559 Bank & Cash 19,086 7,739 11,347 Ordinary shares of $ 1 each 10,000 10,000 Share Premium 50,000 50,000 Revaluation reserve 27,000 27,000 Retained Losses c/fwd 78,017 19,169 58,848 Short term borrowing 31,544 9,042 22,502 Accounts payable 54,733 3,750 50,983 Tax creditor 3,440 1,862 5,302 Long term borrowing 120,000 120,000 276,717 276,717 28,770 28,770 285,787 285,787 Trial balance As at 31 December Y5 Starting TB Journals Ending TB Dr ($ ‘000’) Cr ($ ‘000’) Dr ($ ‘000’) Cr ($ ‘000’) Dr ($ ‘000’) Cr ($ ‘000’) Sales revenue 303,360 672,840 976,200 Other income 2,052 16,420 18,472 Gain on disposal 2,532 2,848 Cost of sales 225,952 1,264 451,904 677,856 Administration expenses 45,840 91,680 137,520 Selling and distribution costs 8,347 51,909 60,256 Loss/(Gain) on disposal of NCA - Interest expense 1,118 2,234 3,352 Taxation 5,302 25,986 31,288 Profit/ (Loss) 19,169 87,248 305,728 305,728 997,520 997,520 Tangible Non-Current Assets (NCA) 178,817 357,635 536,452 Inventory 24,216 39,432 63,648 Accounts Receivable 12,559 27,117 34,676 Bank & Cash 11,347 22,693 34,040 Prepayments Ordinary shares of $ 1 each 10,000 90,000 100,000 Share Premium 50,000 18,000 32,000 Revaluation reserve 27,000 21,000 48,000 Retained Losses c/fwd 58,848 70,080 128,928 Short term borrowing 22,502 57,006 79,508 Accounts payable 50,983 95,965 146,948 Accruals Tax creditor 5,302 25,986 31,288 Long term borrowing 120,000 240,000 360,000 285,787 285,787 797,744 797,744 Quicker way for the directors to pay dividends The company is presently making profits thus offsetting the losses carried forward. The faster way to offset the losses brought forward includes reducing the share premium by transferring such equivalent amount profits (Stretcher and Johnson, 2011). Through this option, the company will quickly offset all the losses brought forward and be within the law when declaring dividends to shareholders. Ideally, the company major source of capital is from shareholders and since they are becoming reluctant to advance more finances to the company, the directors should consider transferring part of share premium to profits for the company to comply with the law and be able to utilize the available finances to pay dividends and as such be able to acquire further finances from shareholders. Suggestion on lack of debentures and loan notes Lack of debentures and loan notes means that the company is entirely financed through share capital. Gearing ratio= (Long term debt short term debt+ bank overdrafts / shareholders equity). A high gearing ratio means the company is mainly financed through debt capital. However, low gearing ratio indicates that a company is financed mostly by share capital. The problem of financing a company mostly by share capital is that in the event of poor performance whereby a company continuously makes losses, the shareholder may decline to commit their monies further in such a business (Ariff and Hassan, 2008). Nevertheless, the company can acquire finances from other providers of capital if it has a mixed debt structure. Financial statements (a) Statement of profit or loss Dr ($ ‘000’) Cr ($ ‘000’) Sales revenue 976,200 Other income 18,472 Gain on disposal 2,848 Cost of sales 677,856 Administration expenses 137,520 Selling and distribution costs 60,256 Loss/(Gain) on disposal of NCA Interest expense 3,352 Taxation 31,288 Profit/ (Loss) 87,248 997,520 997,520 (b) Statement of financial position Tangible Non-Current Assets (NCA) 536,452 Inventory 63,648 Accounts Receivable 34,676 Bank & Cash 34,040 Prepayments Ordinary shares of $ 1 each 100,000 Share Premium 32,000 Revaluation reserve 48,000 Retained Losses c/fwd 128,928 Short term borrowing 79,508 Accounts payable 146,948 Tax creditor 31,288 Long term borrowing 360,000 797,744 797,744 (c) Statement of changes in equity Particulars Share capital Share premium Opening balance 10,000 50,000 Rights issue 90,000 - To profit or loss acc - (18,000) Closing balance 100,000 32,000 Ratios Profitability Profitability ratios determine the ability of a business to generate profits after netting all the expenses incurred during the year. A high ratio is indicative of good performance whereas lower rate shows the business is performing poorly. These ratios include: Gross margin Gross margin = Gross profit/ sales Gross margin= 298,344/976,200=0.31 Gross profit is difference obtained between sales turnover and cost of goods or services. The higher the gross margin, the more profit a company charges for its goods. The ratio of 0.31 is quite small in relation to sales made. This means the company is charging very low margins. Operating margin= (operating margin/ loss)/ sales Operating margin= 87,248/976,200=0.09 This ratio captures gives the figure of how much a company makes or loses from its sales. Primarily, it indicates company’s level of performance as it accounts other components of operating income other than cost of sales. The ratio of 0.09 indicates the profits are relatively low compared to sales made. Net margin This ratio indicates the net revenue that goes to the company after considering all other forms of incomes and netting all expenses. Net margin= (net income/loss)/ sales Net margin = 87,248/976,200=0.09 Net margin is similar to operating margin and both show that profits are relatively low compared to sales made. Free cash flow margin Free cash flow margin determines how revenue generated can be translated into free cash flow. Free cash flow margin = free cash flow/ sales Free cash flow margin = 34,040/ 976,200 = 0.03 The ratio of 0.03 shows that revenue generated cannot be easily translated into free cash flow. Return on assets (ROA) ROA measures the company’s ability to convert assets into profitability. ROA measures company’s profitability on all it assets irrespective of whether they are financed by debt or equity holders. ROA= (Net income+ after tax interest expense) / (Average total assets) ROA= (87,248+3,352)/668,816=0.14 The low ratio shows that it is not easy to convert the company assets into profitability. Return on equity (ROE) This ratio assesses return on investment by shareholders. Return on equity (ROE) = Net income/ Average shareholders’ equity ROE=87,248/ (100,000+32,000) =0.66 The ratio indicates an average return on shareholders’ investment. Liquidity ratios Liquidity ratios determine the business capacity to meet its short term debt obligations. In other words, these ratios assess business ability to settle its short term liabilities when they fall due. Acid test ratio This ratio is also commonly known as quick ratio. It measures the current liquidity position of a company. This is achieved by weighing the current assets against current liabilities (Kaminski and Guan, 2004). A high ratio indicates that a company is more liquid and therefore able to pay short term obligations when they become due. This ratio does not include pre paid expenses and inventory since it considers them as quite difficult to convert in to cash. Quick ratio Quick ratio = (short term investments+ cash and cash equivalents accounts receivable)/ current liabilities Quick ratio =34,040/257,744=0.13 A ratio of 0.13 is quite low meaning that the company will face problems in paying its short term liabilities. Current ratio Current ratio signifies business capacity to pay its short term obligations. When equal or greater than one, it indicates that current assets can satisfy business short term obligations. Current ratio = current assets/ current liabilities Current ratio = 132,364/257,744 = 0.51 The average ratio of 0.51 shows the company is not liquid enough to pay it short term liabilities when they become due. Cash ratio This ratio is highly conservative and only measures ability of a business to covert it investments in to cash to boost the already available cash to pay short term obligations (Kimmell, 1994). Like other liquidity ratios, a higher cash ration signifies a company is in sound financial shape. Cash ratio= (Cash marketable/ short term securities)/ current liabilities Cash ratio =34,040/257,744=0.13 The ratio of 0.13 is low meaning that the company will have a problem in paying its short term liabilities. Management efficiency These forms of ratios determine how best a business uses its assets as well as how it effectively manages its liabilities. Inventory turnover This is a ration that determines how well a company manages its inventories. Higher inventory turnover is better whereas a low figure shows overbuilding overstocking of inventory. Inventory turnover = cost of sales/ average inventory Inventory turnover=677,856/63,648 = 10.65 The ratio shows the stock of the company to be moving well. Accounts receivable turnover This ratio seeks to assess the effectiveness of a company’s credit policies. A low figure means a company has lenient credit policies making it difficult to collect debts from credit customers. Accounts receivable turnover= revenue/ average accounts receivable Accounts receivable turnover=976,200/34,676 =28.15 A ratio of 28.15 means the company has stringent credit policies and as such takes shorter time to collect its debts. Accounts payable turnover This ratio determines how a company manages its accounts payables. A high accounts payable rate signifies stringent terms from suppliers. Accounts payable turnover= cost of sales/ average accounts payable Accounts payable turnover=677,856/146,948=4.6 A ratio of 4.6 indicates the company negotiates favorable terms with its creditors. Total assets turnover This ratio uses both long and short term assets to determine the efficiency of a firm. The higher the ratio the better a firm is managed. Total asset turn over= Revenue/ Average total assets Total asset turn over=976,200/668,816=1.46 The ratio of 1.46 is relatively low meaning the company is not properly managed. Gearing Gearing concerns the debt a company has in its books of accounts. Ideally, the more debts a company acquires, the more risky it is for such company since debt holder has a first claim over company assets in the event of liquidation. In this regard, if a company becomes bankrupt, there could be nothing left for shareholders. Debt equity Debt equity ration determines the extent to which a company is financed through debt. A company that is mainly financed through debt has a high debt equity ratio while the converse is true. Debt/ Equity ratio= (Long term- short term debt) / Total equity Debt/ Equity ratio= (360,000-257,744)/123,000=0.83 A ratio of 0.83 shows the company has a significant debt capital in its capital structure. Interest coverage ratio Ideally, when a company is financed through debt capital, most likely such company will incur interest charges. In this regard, this ratio measures a company’s ability to meet interest obligations based on income generated by the business (Milauskas, 2003). A high interest coverage ratio is favorable whereas a low rate shows a company is unable to pay interest. Interest coverage ratio= Operating income/ interest expense Interest coverage ratio=976,200/3,352= 291 A high ration of 291 indicates that the company is able to meet its interest obligations when they become due. Conclusion and recommendations Conclusions Ideally, from the ratios above, it is evident that the company is not performing well. It is apparent from the profitability ratios that the company cannot meet its short term obligations with ease. In addition, the profitability ratios indicate that the company is not profitable. This was also reflected in its financial statements which showed a history of loss making as reflected by losses carried forward. Nevertheless, on the part of management efficiency ratios, it is evident that the company is now being managed well as evidenced by stringent credit policies and lenient credit terms with its creditors (Osteryoung, Constand and Nast, 1992). The company also manages it stock well as depicted by inventory turnover ratio. Gearing ratio shows that the company is partly financed through debt capital and it is well placed to meet its interest obligations when they fall due. The company requires additional financing and due to its state of performance, the shareholders have remained adamant by expressing their unwillingness to fund a company that does not give them returns. Recommendations As mentioned earlier, the shareholders are pressurizing the company directors to pay them a dividend and since the company has been consistently reporting losses, I recommend the directors to consider converting part of share premium into retained earnings in order to offset the losses brought forward. Notably, the company has started reporting profits meaning that going forward; it will have enough to pay dividends to the shareholders. Further, I would also recommend to the directors to consider mixing share capital, debt and retained earnings in its capital structure. A proper balance of these components of capital structure ensures that the company does not suffer lack of capital as is the case now where shareholders are reluctant to inject more capital to the company. Again, high debt capital exposes the company to higher cost of capital since interest on debt ranks higher than dividends and the company is obligated to pay. References Osteryoung, J., Constand, R.L., and Nast, D., 1992, Financial Ratios in Large Public and Small Private Firms, Journal of Small Business Management, 30 (3), pp. 35. Kaminski, K.a., T, S.W., and Guan, L., 2004, Can financial ratios detect fraudulent financial reporting?, Managerial Auditing Journal, 19(1), pp. 15-28. Kimmell, D.L., 1994, Using Ratios and Graphics in Financial Reporting, The Internal Auditor, 51(5), pp. 17. Milauskas, S., 2003, Taking the mystery out of financial ratios, Journal of Forestry, 101(1), pp. 4. Ariff, M. and Hassan, T., 2008, How Capital Structure adjusts Dynamically During Financial Crises, Corporate Finance Review, 13(3), pp. 11-24. Stretcher, R. and Johnson, S., 2011, Capital structure: professional management guidance, Managerial Finance, 37(8), pp. 788-804. Read More