- 15 Marks
Question
Salt Ltd is a Government Business Entity that would like to acquire 100% of a viable private company. It has obtained the following draft financial statements for two companies, Light Ltd and Favour Ltd. They operate in the same industry, and their managements have indicated they would be receptive to a takeover.
Statement of Profit or Loss for the year ended 31 December 2017:
| Description | Light Ltd (GH¢’000) | Favour Ltd (GH¢’000) |
|---|---|---|
| Revenue | 12,000 | 20,500 |
| Cost of sales | (10,500) | (18,000) |
| Gross profit | 1,500 | 2,500 |
| Operating expenses | (240) | (500) |
| Finance costs | (210) | (600) |
| Profit before tax | 1,050 | 1,400 |
| Income tax expense | (150) | (400) |
| Profit for the year | 900 | 1,000 |
| Dividends paid | 250 | 700 |
Statements of Financial Position as at 31 December 2017:
| Description | Light Ltd (GH¢’000) | Favour Ltd (GH¢’000) |
|---|---|---|
| Assets | ||
| Non-current assets: | ||
| Freehold factory | 4,400 | – |
| Owned plant | 5,000 | 2,200 |
| Leased plant | – | 5,300 |
| Total non-current assets | 9,400 | 7,500 |
| Current assets: | ||
| Inventory | 2,000 | 3,600 |
| Trade receivables | 2,400 | 3,700 |
| Bank | 600 | – |
| Total current assets | 5,000 | 7,300 |
| Total assets | 14,400 | 14,800 |
| Equity and Liabilities | ||
| Equity shares of GH¢1 each | 2,000 | 2,000 |
| Property revaluation reserve | 900 | – |
| Retained earnings | 2,600 | 800 |
| Total equity | 5,500 | 2,800 |
| Non-current liabilities | ||
| Finance lease obligations | – | 3,200 |
| 7% loan notes | 3,000 | – |
| 10% loan notes | – | 3,000 |
| Deferred tax | 600 | 100 |
| Government grants | 1,200 | – |
| Total non-current liabilities | 4,800 | 6,300 |
| Current liabilities | ||
| Bank overdraft | – | 1,200 |
| Trade payables | 3,100 | 3,800 |
| Government grants | 400 | – |
| Finance lease obligations | – | 500 |
| Taxation | 600 | 200 |
| Total current liabilities | 4,100 | 5,700 |
| Total equity and liabilities | 14,400 | 14,800 |
Notes:
i. Both companies operate from the same premises.
ii. Additional details of the two companies’ plant are:
| Description | Light Ltd (GH¢’000) | Favour Ltd (GH¢’000) |
|---|---|---|
| Owned plant – Historical cost | 8,000 | 10,000 |
| Leased plant – Original fair value | – | 7,500 |
There were no disposals of plant during the year by either company.
iii. The interest rate implicit within Favour Ltd’s finance leases is 7.5% per annum. For the purpose of calculating ROCE and gearing, all finance lease obligations are treated as long-term interest-bearing borrowings.
Required:
Assess the relative financial performance and financial position of Light Ltd and Favour Ltd for the year ended 31 December 2017 to inform the directors of Salt Ltd in their acquisition decision. Your analysis should focus on profitability, liquidity, and gearing.
(15 marks)
Answer
Appendix – Ratio Calculations
| Ratio | Formula | Light Ltd | Favour Ltd |
|---|---|---|---|
| Gross profit margin | Gross profit / Revenue | 12.5% | 12.2% |
| Operating profit margin | Profit before interest and tax / Revenue | 10.5% | 9.8% |
| ROCE | Profit before interest and tax / (Equity + Long-term borrowings) | 14.8% | 21.0% |
| Return on equity (ROE) | Profit after tax / Equity | 16.4% | 35.7% |
| Pre-tax ROE | Profit before tax / Equity | 19.1% | 50.0% |
| Net asset turnover | Revenue / (Total assets – Total liabilities) | 2.2 times | 7.3 times |
| Current ratio | Current assets / Current liabilities | 1.2:1 | 1.3:1 |
| Acid test ratio | (Current assets – Inventory) / Current liabilities | 0.73:1 | 0.65:1 |
| Interest cover | Profit before interest and tax / Finance costs | 6.0 times | 3.3 times |
| Inventory holding period | Inventory / Cost of sales * 365 days | 70 days | 73 days |
| Trade receivables collection period | Trade receivables / Revenue * 365 days | 73 days | 66 days |
| Trade payables payment period | Trade payables / Cost of sales * 365 days | 108 days | 77 days |
| Gearing ratio | Long-term debt / (Long-term debt + Equity) * 100 | 35.3% | 70.5% |
| Dividend cover | Profit after tax / Dividends paid | 3.6 times | 1.4 times |
Analysis of Profitability, Liquidity, and Gearing:
- Profitability:
Favour Ltd has a higher return on capital employed (ROCE) of 21%, compared to 14.8% for Light Ltd, driven by a more efficient use of its assets. However, Light Ltd has a slightly better operating profit margin at 10.5% versus 9.8% for Favour Ltd, indicating slightly more efficient operations despite lower overall profitability. - Liquidity:
Both companies have similar liquidity ratios, but Favour Ltd has a higher current ratio (1.3:1) compared to Light Ltd (1.2:1). However, Favour Ltd’s significant bank overdraft and lower acid test ratio (0.65:1 compared to Light Ltd’s 0.73:1) may raise concerns about its short-term financial stability. - Gearing:
Favour Ltd’s gearing is much higher at 70.5% compared to Light Ltd’s 35.3%, indicating a higher reliance on debt financing. Favour Ltd’s interest cover is also lower at 3.3 times compared to Light Ltd’s 6 times, suggesting higher financial risk for Favour Ltd in terms of meeting its interest obligations.
Conclusion:
While Favour Ltd shows better profitability and asset utilization, its high gearing and reliance on debt make it a riskier investment compared to Light Ltd, which has more stable liquidity and lower financial risk.
(15 marks)
- Tags: Acquisition Decision, Financial Performance, Gearing, Liquidity, Profitability, Ratio Analysis
- Level: Level 2, Level 3
- Topic: Financial Statement Analysis
- Series: NOV 2018
- Uploader: Dotse