FA – May 2019 – L1 – Q7 – Interpretation of financial statements (Financial Ratios)

Analyze the financial performance of Ayawaso Ltd from 2016 to 2018 using various financial ratios, and discuss the advantages of ratio analysis.

Question

Ayawaso Ltd operates a hotel in Accra, and the following are its results for the last three years with its year-end being 31 December:

Year	2016	2017	2018
Revenue increase / (decrease)	(5%)	4%	12%
Non-Current Assets increase / (decrease)	40%	10%	2%
Gross Profit	60%	61%	66%
Net Profit	23%	25%	21%
Return on Capital Employed	12%	15%	10%
Current Ratio	1.4:1	1.6:1	1.8:1
Acid Ratio	0.6:1	1.0:1	0.9:1
Debt to Equity Ratio	50%	44%	43%
Dividend Cover	4 times	8 times	10 times

Required:
a) Using all of the above information, comment on the Gearing, Liquidity, and Profitability of Ayawaso Ltd from 2016 to 2018. (12 marks)

b) Identify and explain FIVE (5) advantages of ratio analysis as a means of assessing the financial performance of a business. (5 marks)

c) State THREE (3) likely reasons for the significant change in non-current assets in 2016 and 2017. (3 marks)

Answer

a) Gearing Analysis

The debt to equity ratio has been decreasing slightly from 2016 to 2018, which indicates a reduction in the company’s reliance on external debt financing. This trend suggests a positive shift towards more sustainable capital structure management.

Liquidity Analysis

The current ratio has shown consistent improvement, indicating that the company has become more capable of covering its short-term obligations. The acid ratio also improved significantly from 2016 to 2017 but decreased slightly in 2018. This may suggest a temporary increase in less liquid current assets.

Profitability Analysis

Despite an increase in gross profit margins, the net profit margin decreased in 2018, suggesting an increase in operating expenses or other costs that need to be investigated further. The return on capital employed also declined in 2018, reflecting reduced efficiency in generating returns from the capital invested.

(12 marks)

b) Advantages of Ratio Analysis

Comparative Analysis: Ratios allow for comparison between different periods, helping identify trends and areas of concern.
Benchmarking: Ratios enable companies to benchmark their performance against industry standards or competitors.
Efficiency Measurement: Ratios like Return on Assets or Return on Equity assess how efficiently management is using company resources.
Investment Decisions: Investors use ratios to evaluate the financial health and performance of a business before making investment decisions.
Creditworthiness: Lenders analyze ratios like the current ratio or debt to equity ratio to assess the risk of lending to a business.

(5 marks)

c) Reasons for Changes in Non-Current Assets

Capital Expenditure: Significant investments in upgrading or expanding facilities may have led to an increase in non-current assets.
Revaluation of Assets: Revaluation of existing assets to reflect their current market value could result in changes in reported figures.
Disposals or Write-offs: The sale or disposal of old assets, or write-offs due to obsolescence, could cause fluctuations in the non-current asset base.