Topic list Syllabus reference

Current and future developments in the company's markets, at home and overseas, recent acquisitions or disposals of a subsidiary by the company

Unusual items separately disclosed in the financial statements

Any other noticeable features of the report and accounts, such as events after the end of the reporting period, contingent liabilities, a qualified auditors' report, the company's taxation position, and so on

2. 
   Example: calculating ratios
   

To illustrate the calculation of ratios, the following draft statement of financial position and statement of profit or loss figures will be used. We are using a separate statement of profit or loss for this example as

no items of other comprehensive income are involved. FURLONG CO STATEMENT OF PROFIT OR LOSS FOR THE YEAR ENDED 31 DECEMBER 20X8	Notes	20X8	20X7
		$	$
Revenue	1	3,095,576	1,909,051
Operating profit	1	359,501	244,229
Interest	2	17,371	19,127
Profit before taxation		342,130	225,102
Income tax expense		74,200	31,272
Profit for the year		267,930	193,830
Earnings per share		12.8c	9.3c
FURLONG CO STATEMENT OF FINANCIAL POSITION AS AT 31 DECEMBER 20X8	Notes	20X8	20X7
		$	$
Assets Non-current assets Property, plant and equipment Current assets		802,180	656,071
Inventories		64,422	86,550
Trade receivables	3	1,002,701	853,441
Cash at bank and in hand		1,327	68,363
		1,068,450	1,008,354
Total assets		1,870,630	1,664,425
Equity and liabilities Equity
Ordinary shares 10c each	5	210,000	210,000
Share premium		48,178	48,178
Retained earnings		651,721	410,591
		909,899	668,769
Non-current liabilities
10% loan stock 20X4/20Y0		100,000	100,000
Current liabilities	4	860,731	895,656
Total equity and liabilities		1,870,630	1,664,425

Notes to the financial statements

	20X8	20X7
1 Sales revenue and profit	$	$
Sales revenue	3,095,576	1,909,051
Cost of sales	2,402,609	1,441,950
Gross profit	692,967	467,101
Administration expenses	333,466	222,872
Operating profit	359,501	244,229
Depreciation charged 2 Interest	151,107	120,147
Payable on bank overdrafts and other loans	8,115	11,909
Payable on loan stock	10,000 18,115	10,000 21,909
Receivable on short-term deposits	744	2,782
Net payable 3 Trade receivables Amounts falling due within one year	17,371	19,127
Trade receivables	905,679	807,712
Prepayments and accrued income 4 Current liabilities	97,022 1,002,701	45,729 853,441
Trade payables	627,018	545,340
Accruals and deferred income	81,279	280,464
Corporate taxes	108,000	37,200
Other taxes 5 Called-up share capital	44,434 860,731	32,652 895,656
Authorised ordinary shares of 10c each	1,000,000	1,000,000
Issued and fully paid ordinary shares of 10c each	210,000	210,000
6 Dividends paid	20,000	—

The following information is also available:

• 
  Furlong Co is a wholesale manufacturing company which makes and sells specialist components for road and racing bikes. It has been established for 20 years and has recently collected a number of awards for its innovative and efficient products.
  
• 
  Furlong Co has recently launched a new product, the Psion85, which is a specialist gearing unit for triathlon bikes. The product required a new piece of machinery, purchased in 20X7 costing the company $380,000 with a useful life of 10 years. The product was launched at the beginning of 20X8. For 20X8, further new machinery was purchased, as well as a new office for the sales team.
  
• 
  The Psion85 has proved to be very successful due to a triathlete winning the ITC World Championships on a Furlong bike with the new gearing facility. This has meant that Furlong has increased capacity on the product by moving the workforce away from other, less popular products.
  
• 
  Furlong Co is looking to move to new premises within the next two years.
  
• 
  Tax depreciation is 75% for the first year, dropping to 5% per year.
  

2. 
   
   FAST FORWARD >
   Profitability and return on capital
   

Return on capital employed (ROCE) may be used by the shareholders or the Board to assess the performance of management.

In our example, the company made a profit in both 20X8 and 20X7, and there was an increase in profit between one year and the next:

1. 
   Of 52% before taxation
   
2. 
   Of 39% after taxation
   

Profit before taxation is generally thought to be a better figure to use than profit after taxation, because there might be unusual variations in the tax charge from year to year which would not affect the underlying profitability of the company's operations. Purchases of capital equipment may attract significant tax depreciation, so an increase in profit may not necessarily result in an equivalent increase in the tax charge. Equally, if the tax charge has increased significantly year on year, the previous year may have benefited from lower tax rates, better capital allowances or even there has been issues with underpaid tax in previous years. The information in the question will assist in providing plausible reasons for unusual changes. If not, then suggest potential logical ones which may work in the given circumstances. For Furlong Co, the tax charge year on year (based on profit for the period) has increased from 16% to 31%, however, information in the question has highlighted the purchase of an expensive piece of machinery, so the 20X7 tax charge is likely to have been reduced by generous tax depreciation, artificially reducing the tax charge for the year.
Another profit figure that should be calculated is PBIT, profit before interest and tax. This is the amount of profit which the company earned before having to pay interest to the providers of loan capital, such as loan notes and medium-term bank loans, which will be shown in the statement of financial position as non-current liabilities.


Profit before interest and tax is therefore:

1. 
   The profit on ordinary activities before taxation; plus
   
2. 
   Interest charges on loan capital.
   

Formula to learn
Published accounts do not always give sufficient detail on interest payable to determine how much is interest on long-term finance. We will assume in our example that the whole of the interest payable ($18,115, Note 2) relates to long-term finance.
PBIT in our example is therefore:

	20X8 $	20X7 $
Profit on ordinary activities before tax	342,130	225,102
Interest payable	18,115	21,909
PBIT	360,245	247,011

This shows a 46% growth between 20X7 and 20X8.

1. 
   Return on capital employed (R0CE)
   

It is impossible to assess profits or profit growth properly without relating them to the amount of funds (capital) that were employed in making the profits. The most important profitability ratio is therefore return on capital employed (ROCE), which states the profit as a percentage of the amount of capital employed.


Profit before interest and taxation
ROCE = -— -
7 ГТ7 ^x 1
Total assets less current liabilities
Capital = Shareholders' equity plus non-current liabilities
employed (or total assets less current liabilities)
Formula to learn
The underlying principle is that we must compare like with like, and so if capital means share capital and reserves plus non-current liabilities and debt capital, profit must mean the profit earned by all this capital together. This is PBIT, since interest is the return for loan capital.
In our example, capital employed = 20X8 $1,870,630 - $860,731 = $1,009,899 20X7 $1,664,425 - $895,656 = $768,769
These total figures are the total assets less current liabilities figures for 20X8 and 20X7 in the statement of financial position.

20X8 20X7

ROCE


$360,245
$1,009,899


$247,011
$768,769


= 32.1%

What does a company's ROCE tell us? What should we be looking for? There are three comparisons that can be made.

1. 
   The change in ROCE from one year to the next can be examined. In this example, there has been an increase in ROCE by about 4 percentage points from its 20X7 level.
   
2. 
   The ROCE being earned by other companies, if this information is available, can be compared with the ROCE of this company. Here the information is not available.
   
3. 
   A comparison of the ROCE with current market borrowing rates may be made.
   

1. 
   What would be the cost of extra borrowing to the company if it needed more loans, and is it earning a ROCE that suggests it could make profits to make such borrowing worthwhile?
   
2. 
   Is the company making a ROCE which suggests that it is getting value for money from its current borrowing?
   
3. 
   Companies are in a risk business and commercial borrowing rates are a good independent yardstick against which company performance can be judged.
   

In this example, if we suppose that current market interest rates, say, for medium-term borrowing from banks, are around 10%, then the company's actual ROCE of 36% in 20X8 would not seem low. On the contrary, it might seem high.
However, it is easier to spot a low ROCE than a high one, because there is always a chance that the company's non-current assets, especially property, are undervalued in its statement of financial position, perhaps because they are carried at historic cost rather than valuation, and so the capital employed figure might be unrealistically low. If the company had earned a ROCE, not of 36%, but of, say only 6%, then its return would have been below current borrowing rates and so disappointingly low.
When considering changes in ROCE consider looking at the numerator (PBT) and denominator (capital employed) separately. If there has been significant investments in assets close to the year end financed by a non-current loan or through a leasing arrangement, this may have little impact on profit for the period, but may have a more significant increase in capital employed. Look at the information given and consider the interactions between increases and decreases in the light of the business's performance for the year. Taking ROCE as a standalone figure does not give the user of the financial statements the whole picture.

2. 
   Return on equity (ROE)
   

Return on equity gives a more restricted view of capital than ROCE, but it is based on the same principles.