- 20 Marks
Question
Kankanfo Group Plc, is a well established company that is planning to expand through acquisition of some companies.
The Directors of the company have identified two potential target companies, Gombe Limited and Uzor Limited.
Extracts from the financial statements of the two companies are as follows:
Statement of profit or loss and other comprehensive income for the year ended December 31, 2021.
| Gombe Limited | Uzor Limited | |
|---|---|---|
| N’000 | N’000 | |
| Revenue | 272,000 | 264,000 |
| Cost of sales | (168,000) | (183,800) |
| Gross profit | 104,000 | 80,200 |
| Administrative expenses | (72,000) | (56,000) |
| Profit from operations | 32,000 | 24,200 |
| Finance costs | (12,000) | (16,000) |
| Net profit before tax | 20,000 | 8,200 |
| Income tax expense | (6,000) | (4,000) |
| Profit for the year | 14,000 | 4,200 |
| Other comprehensive income: | ||
| Items that will not be reclassified to P or L | ||
| Surplus on revaluation | — | 24,000 |
| Total comprehensive income | 14,000 | 28,200 |
Statement of financial position as at December 31, 2021
| Gombe Limited | Uzor Limited | |
|---|---|---|
| N’000 | N’000 | |
| Non-current assets: | ||
| Property, plant and equipment | 128,000 | 140,200 |
| Current assets: | ||
| Inventories | 24,000 | 28,000 |
| Receivables | 48,000 | 40,000 |
| Current assets | 72,000 | 68,000 |
| Total assets | 200,000 | 208,200 |
| Equity and liabilities: | ||
| Equity | ||
| Ordinary share capital (N1 each) | 64,000 | 48,000 |
| Revaluation reserves | — | 20,000 |
| Retained earnings | 30,000 | 20,200 |
| 94,000 | 88,200 | |
| Non-current liabilities: | ||
| Loan notes | 64,000 | 72,000 |
| Current Liabilities: | ||
| Trade payables | 20,000 | 20,000 |
| Income tax | 6,000 | 4,000 |
| Borrowings | 16,000 | 24,000 |
| 42,000 | 48,000 | |
| Equity and liabilities | 200,000 | 208,200 |
Statement of changes in equity for year ended December 31, 2021
| Gombe Limited | Uzor Limited | |
|---|---|---|
| N‟000 | N‟000 | |
| Bal. b/f January 1, 2021 | 88,000 | 64,000 |
| Total comprehensive income | 14,000 | 28,200 |
| Dividend paid | (8,000) | (4,000) |
| Bal. December 31, 2021 | 94,000 | 88,200 |
Additional Information:
(i) Uzor Limited revalued its property, plant and equipment (PPE) for the first time on January 1, 2021. The property, plant and equipment of Gombe Ltd are very similar in age and type to that of Uzor Limited. Gombe Limited has a policy of maintaining all its property, plant and equipment at depreciated historical costs, using 20% rate on straight line basis. Both Gombe Limited and Uzor Limited charge depreciation on PPE to cost of sales. Uzor Limited has transferred the excess depreciation on the re-valued assets from revaluation reserve to retained earnings.
(ii) On December 31, 2021 Gombe Limited supplied goods at the normal selling price of N9,600,000 to another Company Mamagold Limited. Gombe Limited‟s normal selling price is at a mark up of 60% on costs. Mamagold Limited paid for the goods in cash on the same day. The terms of the selling agreement were that Gombe Limited repurchase these goods on June 30, 2022 for N10,000,000. Gombe Limited accounted for this transaction as sales for the year ended December 31, 2021.
(iii) It is the practice of Kakanfo Group Plc to appraise potential investment opportunities by making use of the following ratios:
Gearing;
Turnover to capital employed;
Gross profit margin; and
Return on capital employed.
Your Senior Accountant computed the four key ratios for the two target companies from the financial statement extracts provided and the result are as follows:
| Gombe Limited | Uzor Limited | |
|---|---|---|
| N‟000 | N‟000 | |
| Gearing | 46% | 52.1% |
| Turnover to capital employed | 1.6 | 1.4 |
| Gross profit margin | 38.2% | 30.4% |
| Return on capital employed | 18.4% | 13.1% |
(iv) After the computation in (iii) above, the Senior Accountant concluded that performance of Gombe Limited is better than that of Uzor Limited. Therefore, Kankanfo Group Plc should carry out due diligence on Gombe Limited with a view to making a bid to acquire it.
However, as the Chief Accountant of Kankanfo Group Plc., you are not sure whether the conclusion of your Senior Accountant is correct in view of information in notes (i) and (ii) above.
Required:
a. Carry out the necessary adjustments that would be appropriate on the financial statements of Gombe Limited and Uzor Limited to facilitate comparison showing your answers in tabular form, with columns for original figures, adjustments, new figures and justifying reasons for the adjustments.
(10 Marks)
b. Recalculate the four key ratios for Gombe Limited and Uzor Limited using the new figures obtained after the necessary adjustments. (4 Marks)
c. Evaluate your Senior Accountant‟s conclusion in the light of your answer in (a) and (b) above.
(6 Marks)
Answer
(a) Adjustments of financial statement of Gombe Ltd and Uzor Ltd
| Gombe Ltd | |||
|---|---|---|---|
| Statement of P or L extracts | Original figures ₦’000 | Adjustments ₦’000 | New figures ₦’000 |
| Revenue | 272,000 | 9,600 | 262,400 |
| Cost of sales | (168,000) | (6,000) | (162,000) |
| Gross profit | 104,000 | — | 100,400 |
| Admin expenses | (72,000) | (72,000) | |
| Profit from operations | 32,000 | 28,400 | |
| Extract of SFP | |||
| Inventories | 24,000 | 6,000 | 30,000 |
| Borrowing (Non-current) | 64,000 | — | 64,000 |
| Borrowings (Current) | 16,000 | 9,600 | 25,600 |
| Equity | 94,000 | 3,600 | 90,400 |
Workings:
The sales and lease back should be treated as short-term borrowing, while the cost of the sales and gross profit margin should be adjusted for ease of comparison.
Sales ₦9,600,000 Cost of sales ₦9,600,000 x 100/160 = ₦6,000,000 Margin on Sales = (₦9,600,000 – ₦6,000,000)) = ₦3,600,000
| Uzor Ltd | |||
|---|---|---|---|
| Original figure ₦’000 | Adjustments ₦’000 | New figure ₦’000 | |
| Property plant & equipment | 140,200 | (20,000) | 120,200 |
| Revaluation reserve | 20,000 | (20,000) | — |
| Equity | 88,200 | (20,000) | 68,200 |
| Cost of sales | 183,800 | (4,000) | 179,800 |
| Gross profit | 80,200 | 4,000 | 84,200 |
| Profit from operations | 24,200 | 4,000 | 28,200 |
Working notes for justification:
Excess depreciation on revaluation will be ₦20,000,000 at 20% = ₦4,000,000.
To be comparable the property, plant and equipment of Gombe Ltd and Uzor Ltd should be shown at either cost or at a revalued amount, with revaluation done on the same basis. It is not feasible to revalue Gombe Ltd‟s property, plant and equipment for purpose of comparison. However Uzor‟s Ltd property, plant and equipment can be shown at cost by reversing the revaluation on them and their depreciation effects.
(b) Computation of ratios based on revised financial statements
| Ratios | Formula | Gombe Ltd | Uzor Ltd |
|---|---|---|---|
| (i) Gearing | Total borrowings / Capital employed | = 64,000+25,600 / 90,400+89,600 = 89,600 / 180,000 x 100 / 1 = 49.8% | 72,000 + 24,200 / 96,000 + 68,200 = 96,200 / 164,200 x 100 / 1 = 58.5% |
| (ii) Asset turnover | 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 / 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑 | 262,400 / 180,000 = 1.5 times | 264,000 / 164,200 = 1.6 times |
| (iii) Gross profit margin | Gross profit x 100 / Revenue 1 | 100,400 x 100 / 262,400 1 = 38.3% | 84,200 x 100 / 264,000 x 1 = 31.9% |
| (iv) Return on capital employed | Operating profit / Capital employed = | 28,400 x 100 / 180,000 1 = 15.8% | 28,200 x 100 / 164,200 1 = 17.2% |
(c) Evaluation of the Senior Accountant’s conclusion
i. The reason is to make the financial statements of Gombe Ltd and Uzor Ltd comparable;
ii. Gombe Ltd has a higher gross profit margin, however, the return on capital employed is lower. The main reason for this is that Gombe Ltd administrative expenses are higher than that of Uzor Ltd;
iii. The revenue of both companies is now almost identical due to the elimination of the effect of the inter-company sales from the account of Gombe Ltd;
iv. The assets turnover ratio before and after adjustments do not show any significant difference;
v. Gombe Ltd has advantage in gearing ratio. The gearing ratio of both companies increased but more for Uzor Ltd. This could influence directors only, if they plan or intend to change the financial structure of the company;
vi. Overall it would appear that Uzor Ltd would be a better investment opportunity than Gombe Ltd. This exercise shows the importance of adjusting financial statements to achieve uniform accounting policies when making this kind of decision. It should be noted however, that the sales of Gombe Ltd was incorrectly accounted for, while Uzor revaluation is acceptable if done by registered estate valuer.
- Uploader: Samuel Duah