Question 3.SAQ.1: Both Ali plc and Bhaskar plc operate wholesale electrical st...
Both Ali plc and Bhaskar plc operate wholesale electrical stores throughout the UK. The financial statements of each business for the year ended 30 June last year are as follows:
| Statements of financial position as at 30 June last year | ||
| Ali plc
£m |
Bhaskar plc
£m |
|
| ASSETS Non-current assets |
||
| Property, plant and equipment (cost less depreciation) | ||
| Land and buildings | 360.0 | 510.0 |
| Fixtures and fittings | 87.0 | 91.2 |
| 447.0 | 601.2 | |
| Current assets | ||
| Inventories | 592.0 | 403.0 |
| Trade receivables | 176.4 | 321.9 |
| Cash at bank | 84.6 | 91.6 |
| 853.0 | 816.5 | |
| Total assets | 1,300.0 | 1,417.7 |
| EQUITY AND LIABILITIES Equity |
||
| £1 ordinary shares | 320.0 | 250.0 |
| Retained earnings | 367.6 | 624.6 |
| 687.6 | 874.6 | |
| Non-current liabilities | ||
| Borrowings – loan notes | 190.0 | 250.0 |
| Current liabilities | ||
| Trade payables | 406.4 | 275.7 |
| Taxation | 16.0 | 17.4 |
| 422.4 | 293.1 | |
| Total equity and liabilities | 1,300.0 | 1,417.7 |
| Income statements for the year ended 30 June last year | ||
| Ali plc £m |
Bhaskar plc £m |
|
| Revenue | 1,478.1 | 1,790.4 |
| Cost of sales | (1,018.3) | (1,214.9) |
| Gross profit | 459.8 | 575.5 |
| Operating expenses | (308.5) | (408.6) |
| Operating profit | 151.3 | 166.9 |
| Interest payable | (19.4) | (27.5) |
| Profit before taxation | 131.9 | 139.4 |
| Taxation | (32.0) | (34.8) |
| Profit for the year | 99.9 | 104.6 |
All purchases and sales were on credit. Ali plc had announced its intention to pay a dividend of £135 million and Bhaskar plc £95 million in respect of the year. The market values of a share in Ali plc and Bhaskar plc at the end of the year were £6.50 and £8.20, respectively.
Required:
For each business, calculate two ratios that are concerned with each of the following aspects:
■ profitability
■ efficiency
■ liquidity
■ gearing
■ investment (ten ratios in total).
Required:
(a) What can you conclude from the ratios that you have calculated?
(b) Calculate the Z-scores for each business using the Altman model.
(c) Comment on the Z-scores for each business and on the validity of applying the Altman model to these particular businesses.
Ali plc and Bhaskar plc
(a) To answer this question, you may have used the following ratios:
| Ali plc | Bhaskar plc | |
| Return on ordinary shareholders’ funds ratio |
99.9/687.6 × 100 = 14.5% | 104.6/874.6 × 100 = 12.0% |
| Operating profit margin ratio |
151.3/1,478.1 × 100 = 10.2% | 166.9/1,790.4 × 100 = 9.3% |
| Inventories turnover period ratio |
592.0/1,018.3 × 12 = 7.0 months | 403.0/1,214.9 × 12 = 4.0 months |
| Settlement
period for trade |
176.4/1,478.1 × 12 = 1.4 months |
321.9/1,790.4 × 12 = 2.2 months |
| Current ratio | \frac{853.0}{422.4}= 2.0 | \frac{816.5}{293.1}= 2.8 |
| Acid test ratio | \frac{(853.0 – 592.0)}{422.4}= 0.6 | \frac{(816.5 – 403.0)}{293.1}= 1.4 |
| Gearing ratio | \frac{190}{(687.6 + 190)} × 100 = 21.6\% | \frac{250}{(874.6 + 250)} × 100 = 22.2\% |
| Interest cover ratio | \frac{151.3}{19.4}= 7.8 times | \frac{166.9}{27.5}= 6.1 times |
| Earnings per share | 99.9/320 = 31.2 p | 104.6/250 = 41.8 p |
| Price/earnings ratio | 650/31.2 = 20.8 times | 820/41.8 = 19.6 times |
(Note: It is not possible to use any average ratios because only the end-of-year figures are provided for each business.)
Ali plc seems more effective than Bhaskar plc at generating returns for shareholders indicated by the higher ROSF ratio. This may be partly caused by Ali plc’s higher operating profit margin.
Both businesses have a very high inventories turnover period; this probably needs to be investigated. This ratio is particularly high for Ali plc. Both may suffer from poor inventories management.
Ali plc has a lower settlement period for trade receivables than Bhaskar plc. This may suggest that Bhaskar plc needs to exert greater control over trade receivables.
Ali plc has a much lower current ratio and acid test ratio than Bhaskar plc. The acid test ratio of Ali plc is substantially below 1.0: this may suggest a liquidity problem.
The gearing ratio of each business is quite similar. Neither business seems to have excessive borrowing. The interest cover ratio for each business is also similar. The ratios indicate that both businesses have good profit coverage for their interest charges.
Earnings per share is significantly higher for Bhaskar plc than for Ali plc. However, the P/E ratio for Bhaskar plc is slightly lower. This latter ratio suggests that the market considers Ali plc has slightly better prospects than Bhaskar plc.
To draw better comparisons between the two businesses, it would be useful to calculate other ratios from the financial statements. It would also be helpful to calculate ratios for both businesses over (say) five years as well as key ratios of other businesses operating in the same industry.
(b) The Altman Z-score model is as follows:
Z = 0.717 a + 0.847 b + 3.107 c + 0.420 d + 0.998 e
where a = Working capital/Total assets
b = Accumulated retained profits/Total assets
c = Operating profit/Total assets
d = Book (statement of financial position) value of ordinary and preference shares/Total liabilities at book (statement of financial position) value
e = Sales revenue/Total assets
For Ali plc, the Z-score is:
0.717[(853.0 – 422.4)/1,300.0] + 0.847(367.6/1,300.0) + 3.107(151.3/1,300.0) + 0.420[320.0/(190.0 + 422.4)] + 0.998(1,478.1/1,300.0) = 2.193
For Bhaskar plc, the Z-score is:
0.717[(816.5 – 293.1)/1,417.7] + 0.847(624.6/1,417.7) + 3.107(166.9/1,417.7) + 0.420[250.0/(250.0 + 293.1)] + 0.998(1,790.4/1,417.7) = 2.457
(c) The Z-scores for these two businesses are quite close, with Bhaskar looking slightly safer. They are both in the category of businesses in the ‘zone of ignorance’ and therefore difficult to classify (a Z-score between 1.23 and 4.14). This is quite unusual in that the Altman model is able confidently to classify 91 per cent of businesses. Clearly, these two businesses fall into the remaining 9 per cent.
It is questionable whether the Altman model is strictly applicable to UK businesses, since it was derived from data relating to US businesses that had failed. Nevertheless, it probably provides some insight.