FINANCIAL ACCOUNTING

FORMATION 2 EXAMINATION - APRIL 2010 NOTES:

You are required to answer Question 1. You are also required to answer any three out of Questions 2 to 5. (If you provide answers to all of Questions 2 to 5, you must draw a clearly distinguishable line through the answer not to be marked. Otherwise, only the first three answers to hand for Questions 2 to 5 will be marked.) Note: Students have optional use of the Extended Trial Balance, which if used, must be included in the answer booklet.

PRO-FORMA STATEMENT OF COMPREHENSIVE INCOME BY NATURE, STATEMENT OF COMPREHENSIVE INCOME BY FUNCTION AND STATEMENT OF FINANCIAL POSITION ARE PROVIDED.

TIME ALLOWED:

3.5 hours, plus 10 minutes to read the paper.

INSTRUCTIONS:

During the reading time you may write notes on the examination paper but you may not commence writing in your answer book. Marks for each question are shown. The pass mark required is 50% in total over the whole paper. Start your answer to each question on a new page.

You are reminded that candidates are expected to pay particular attention to their communication skills and care must be taken regarding the format and literacy of the solutions. The marking system will take into account the content of the candidates' answers and the extent to which answers are supported with relevant legislation, case law or examples where appropriate. List on the cover of each answer booklet, in the space provided, the number of each question(s) attempted.

The Institute of Certified Public Accountants in Ireland, 17 Harcourt Street, Dublin 2.

FINANCIAL ACCOUNTING THE INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS IN IRELAND FORMATION 2 EXAMINATION - APRIL 2010

Time allowed: 3.5 hours plus 10 minutes to read the paper.

1.

(a)

(i)

(ii) (b)

Answer Question 1 and three of the remaining four questions.

Note: Students have optional use of the Extended Trial Balance, which if used, must be included in the answer booklet.

Define and explain, with an example, the relevance of each of the following concepts: • • •

Accruals. Consistency. Substance over form.

(6 marks)

Explain, with the aid of an example, the impact the going concern concept has on figures recognised in the financial statements for non current assets. (4 marks)

The following trial balance was extracted from the books of Antrim Ltd at 31 December 2009: Land Buildings Motor vehicles Plant and machinery Retained profit at 01/01/09 8% Debentures 2017 Ordinary shares €0.50 each Share premium Buildings depreciation at 31/12/08 Motor vehicles depreciation at 31/12/08 Plant and machinery depreciation at 31/12/08 Returns Revenue Purchases Discounts Carriage inwards Carriage outwards Inventory at 01/01/09 7% Preference shares Provision for bad debts Trade receivables/trade payables General reserve Advertising Staff training costs Bad debts Motor expenses Rent and rates Bank VAT Grant Wages and salaries Proceeds from sale of motor vehicles Debenture interest Page1

Debit € 500,000 200,000 120,000 70,000

3,600

400,000 5,000 7,700 8,000 52,000 66,000

18,000 4,000 12,500 27,000 90,000 115,000

6,000 1,704,800

Credit €

312,150 150,000 200,000 30,000 60,000 69,250 40,000 4,100 700,000 3,500

50,000 2,000 43,200 25,000

2,500 3,100 2,000

8,000

1,704,800

The following additional information is also provided: (a) Closing inventory at 31 December 2009 was valued at €65,000. This excluded the following items: (i) Product A, which had cost €3,000 to produce and had a net realisable value of €2,900. (ii) Product B, which was partly completed. This had incurred costs to date of €900 and it is estimated that it will require a further €500 to complete. (b)

(c)

(d)

During the year the company received a grant towards the training of staff. This is recorded in the trial balance.

In December 2009, the company sent goods on a sale or return basis to one of their customers. These goods were included, at their sales value, in the revenue figure in the trial balance. These goods had a cost price of €8,000 and it is the policy of the company to add a margin of 20% to these types of goods. As at 31 December the customer had not agreed to buy these goods. One of Antrim Ltd’s customers, who owed €4,000, was declared bankrupt. This is to be written off.

(e)

The provision for bad debts should be 4% of trade receivables.

(g)

Rent prepaid during the period was €12,000 and the rates outstanding at the end of the year were €4,000.

(f)

(h) (i) (j)

(k)

(l)

In December 2009, the company got the land professionally valued at €600,000. The company has decided to include this valuation in their financial statement.

On 10 December 2009 the Directors of Antrim Ltd declared a final dividend of 3 cent per share. This dividend was authorised for payment at a subsequent board meeting on 30 December 2009.

The proceeds for sale of a motor vehicle, in the trial balance, relates to the disposal, in November, of a motor vehicle that was purchased for €12,000 during 2007.

Depreciation is to be charged as follows:

Buildings 2% on cost Motor vehicles 25% reducing balance Plant and machinery 20% on cost A full year’s depreciation is charged in the year of purchase and none in the year of sale.

Provide for the debenture interest and preference dividend outstanding at year end.

During January 2009, the company realised that the closing inventory at 31 December 2008 was understated by €7,700.

REQUIRED: Prepare, for internal use, a Statement of Comprehensive Income for the year ending 31 December 2009 and a Statement of Financial Position as at that date. (30 marks) [Total: 40 marks]

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2.

You have just attended a conference on IAS 18 Revenue. On your return to the office, the Managing Director has asked you to prepare a report, for him, in relation to IAS 18. Your report should: (a)

(3 marks)

(b)

State how revenue should be measured in financial statements.

(d)

Describe how revenue from interest, royalties and dividends are recognised in financial statements. (6 marks)

(c)

(e)

3.

State the definition of revenue.

(2 marks)

Describe the conditions that should be satisfied before revenue from the sale of goods should be recognised in the financial statements. (6 marks)

List three disclosure requirements of IAS 18.

(3 marks)

[Total: 20 marks]

John Kelly, a sole trader, extracted a trial balance on 31 December 2009. Having completed this exercise he found that the sum of the debit balances did not equal the sum of the credit balances. He recorded the differences in a suspense account and prepared a draft income statement and statement of financial position using this suspense account. John then undertook an investigation into the causes of the differences and this revealed the following: (i)

(ii)

(iii) (iv)

(v)

(vi)

Machinery purchased during the year, costing €50,000, was recorded in the purchases account. Depreciation on machinery is charged at 20% of cost. A full year’s depreciation is charged in the year of purchase and none in the year of sale. Purchase returns of €1,250 were recorded on the debit side of the sales return account.

During the year John sold a piece of machinery for €6,500 which had originally cost €12,000 in June 2006. The only part of this transaction recorded in the financial statements was to debit the revenue account with the sales proceeds and to credit the bank account with the corresponding amount.

The balance of €2,500 on the electricity account had been omitted from the trial balance.

Discounts received of €3,100 were recorded as a debit in the discount allowed account.

€2,300 rent prepaid at 1 January 2009 had not been brought down as an opening balance in determining the amount in the trial balance.

(vii)

A motor expense, of €1,750, paid during the year was recorded by debiting the electricity account.

(a)

(i)

REQUIRED:

(ii) (b)

Prepare the journal entries necessary to correct any errors made and to record any other transactions so as to ensure that the accounts are correct (narratives are not required). (12 marks)

Post the relevant entries to the suspense account and derive the opening suspense account balance. (4 marks) Explain the following terms, giving an example of each term:

(i) (ii) (iii) (iv)

Error of principle. Error of commission. Error of omission. Transposition error.

Page 3

(4 marks)

4.

[Total: 20 marks]

On the 1 January 2009 Gregory Murphy had the following balances in his books:

Buildings €200,000; Land €100,000; Plant and machinery €82,000; Motor vehicles €53,000; Inventory €55,000; Trade receivables €22,000; Trade payables €18,500; Rent prepaid €4,500; Electricity due €420 and Bank overdraft €1,500. Gregory does not keep proper books of accounts, but bank statements covering the year from 1 January 2009 to 31 December 2009 were obtained from the bank and summarised as follows: Money paid into the bank: Cash sales Receipts from trade receivable Receipt of loan Receipt from sale of plant

€ 350,000 150,000 50,000 7,000

Payments made by cheque: Cash purchases Credit purchases Purchase of new motor vehicle Rent Electricity Wages Stationery Sundry expenses

25,000 255,000 31,000 25,000 2,800 39,000 1,250 3,300

You are provided with the following additional information: (i) Gregory had paid all cash receipts into the bank account with the exception of €1,500 per month in drawings. (ii) The sale of the plant occurred on 1 January, when the plant had a net book value of €8,000. (iii) Depreciation for the year on buildings is €8,000 and the remaining non-current assets are depreciated as follows: Plant and machinery Motor vehicles

(iv)

15% reducing balance method 25% reducing balance method

A full year’s depreciation is charged in the year of purchase and none in the year of sale.

Gregory had the following balances in his accounts at the 31 December 2009: Inventory Trade receivables Trade payables Rent prepaid Electricity due

€62,000 €30,000 €17,200 €5,000 €370

(v)

Gregory received the loan on 1 July 2009. Interest is to be charged at a rate of 10% per annum.

(a)

Calculate the value of the opening capital at 1January 2009.

REQUIRED: (b)

(2 marks)

Prepare a Statement of Comprehensive Income for Gregory Murphy for the year ended 31 December 2009. (18 marks)

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5.

[Total: 20 Marks] You are the Financial Accountant for Mayo Ltd; a company that manufactures garden furniture in the west of Ireland. Due to the current economic climate, Mayo Ltd has experienced both a reduction in sales revenue and cash flow during the last financial period. You are provided with the following information regarding Mayo Ltd for the years ended 31 December 2008 and 2009: Statement of Comprehensive Income for years ended:

31/12/2008 €’000 700 350 350 140 210 50 160 20 140

Revenue Cost of sales Gross profit Operating expenses Operating profit Interest on debentures Profit before tax Tax Profit after tax

Statement of financial position as at: Non-current assets Property at cost Less Depreciation Plant at cost Less Depreciation

Current Assets Inventory Trade receivables Bank

Equity and Liabilities Issued equity shares Retained earnings

€’000

31/12/2008 €’000

2,000 800

1,200

600 200

39 67 150

0 27

Calculate the following ratios for both years: (i) (ii) (iii) (iv) (v) (vi)

Operating profit margin. Current ratio. Acid test ratio. Inventory days. Receivable days. Payable days.

2,000 840 900 250

41 69 0

Page 5

27 1,856

1,160 650 1,810

110 1,920

800 612 1,412

500

REQUIRED: (a)

256 1,856

31/12/2009 €’000 €’000

800 529 1,329

Non-current liabilities 10% Debentures

Current liabilities Bank overdraft Trade payables

400 1,600

31/12/2009 €’000 500 300 200 75 125 30 95 12 83

300

171 37

208 1,920

(b)

(c)

(vii) Return on capital employed. (viii) Debt/equity ratio.

(8 marks)

Write a report to the Managing Director of Mayo Ltd explaining why the cash-flow of the company has deteriorated during the current financial year. You should base your report on both the ratios calculated in Part (a) and any additional information provided in the financial statements. (9 marks)

Outline three limitations of ratio analysis.

(3 marks)

[Total: 20 Marks]

END OF PAPER

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SUGGESTED SOLUTIONS

FINANCIAL ACCOUNTING THE INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS IN IRELAND FORMATION 2 EXAMINATION - APRIL 2010

SOLUTION 1 (a) Accruals The accruals concept is fundamental to most methods of accounting. It asserts that profit for a period can only be arrived at by taking into account all revenue and expenditure relating to that period, whether or not they have been received or paid. The accruals concept is relevant in building up most all of the figures in the profit and loss account, most of which reflect adjustment for revenue due but not yet received, or expenses relating to the earning of that revenue but not yet paid. The accruals concept includes the matching concept, that revenue and profits in the profit and loss account are matched with costs incurred in earning that revenue. Example: The inclusion of an adjustment in preparing the income statement for rent accrued but not paid.

Consistency The consistency concept requires that the financial effect of like transactions and other events should be given similar treatment within a single set of accounts and from one period to the next.

Example: Valuation of stocks. The method selected should be applied consistently from period to period.

(b

Substance over form It may be that the legal form of a transaction differs from its real nature. For example, if a company is acquiring a fixed asset under a hire purchase agreement, the legal ownership does not pass until the last instalment is paid. The substance over form convention is that the reality and commercial effect of the transaction are recognised – the asset is controlled by the company and is therefore included as such in the balance sheet, with the corresponding liability recognised for the unpaid amount. The going concern assumption indicates that the business is going to continue its operations for the foreseeable future. If this were not the case, assets and liabilities would have to be shown at valuations relating to their realisable value at the time of preparing the statement of financial position.

Non current assets are shown at net book value that is cost less accumulated depreciation. The annual depreciation charge is calculated on the basis of the asset’s useful life, and there is therefore an underlying assumption that the business will continue for the rest of that asset’s life. The depreciation charge may not have any direct relation to the realizable value of the asset at the balance sheet date. For example: Cost of asset Useful life Annual depreciation charge

€80,000 8 years €10,000

Four years after the purchase of the machine the NBV will be €40,000. The machine might have a sale value of €25,000 yet the statement of financial position will show €40,000 where the business is a going concern.

If the ‘going concern’ is deemed to be no longer applicable, non-current assets must be shown at their net realizable values.

Page 7

1(b)

Revenue (w1) Returns

Income statement of Antrim Ltd for year ended 31 December 2009

Less Cost of Sales Opening inventory (w8) Purchases Carriage inwards Returns Closing inventory (w5) Gross Profit Profit on disposal of vehicle (w6) Discount received

59,700 400,000 7,700 (4,100) (76,800)

Less Expenses Increase in bad debt provision (w3) Discount allowed Carriage outwards Advertising Bad debts (w4) Motor expenses Rent & rates (w9) Wages and salaries Depreciation (w7) Buildings Motor vehicles Plant & machinery Debenture interest (w11) Staff training (w14) Net loss

80 5,000 8,000 18,000 16,500 27,000 82,000 115,000 4,000 11,000 14,000 12,000 2,000

Appropriation account Net loss Ordinary dividends (w10) Preference dividends (w12) Retained profit b/f(w8) Retained profit c/f

690,000 (3,600) 686,400

(386,500) 299,900 1,250 3,500 304,650

(314,580) (9,930) (9,930) (12,000) (3,500) 319,850 294,420

Page 8

Statement of financial Position of Antrim Ltd as at 31 December 2009 Assets Non-Current Assets Cost Depreciation (w7) Net book Value Land (w13) 600,000 0 600,000 Buildings 200,000 64,000 136,000 108,000 75,000 33,000 Motor vehicles 70,000 54,000 16,000 Plant and machinery 785,000 Current Assets Trade receivables (w2) 52,000 Bad debt provision (w3) (2,080) Closing inventory (w5) 76,800 Rent prepaid 12,000 138,720 Total Assets 923,720

Equity and Liabilities Equity Ordinary share capital Share premium Revaluation reserve (w13) 8% Preference shares Retained profit General reserve Retained profits

200,000 30,000 100,000 50,000 294,420 25,000 699,420

Non-Current Liabilities 8% Debentures 2017

150,000

Current Liabilities Bank VAT Trade payables Rates due Proposed ordinary dividend Debenture interest due (w11) Preference dividend due (w12) Total equity and liabilities

2,500 3,100 43,200 4,000 12,000 6,000 3,500

Workings 1. Revenue As per trial balance Less sale or return 2.

Trade receivables As per trial balance Less sale or return Bad debt to write off

3.

Provision for bad debts Opening provision (trial balance) Income statement Required closing provision [52,000*4%]

4.

700,000 (10,000) 690,000 66,000 (10,000) (4,000) 52,000 2,000 80 2,080

Bad debts As per trial balance Bad debts to be written off (w2)

12,500 4,000 16,500 Page 9

74,300 923,720

5.

Closing inventory As per question Sale or return Note a(i) in question Note a(i) in question

6.

Profit/loss on disposal of motor vehicle Cost price of motor sold Dep to date on vehicle sold [3,000+ 2,250]

7.

Sales proceeds Profit on disposal [8,000 – 6,750]

65,000 8,000 2,900 900 76,800 12,000 (5,250) 6,750 8,000 1,250

Depreciation Buildings: [200,000*2%] 4,000 (Income Statement) Buildings: Depreciation to date [60,000 + 4,000] 64,000 (Statement of Financial Position)

Motor vehicles [(120,000 – 12,000) – (69,250 – 5,250)]*25% 11,000 (Income Statement) Motor Veh: Depreciation to date [69,250 – 5,250 +11,000] 75,000 (Statement of Financial Position)

8.

Plant & mach [70,000*20%] 14,000 (Income Statement) Plant & mach: Depreciation to date [40,000 +14,000] 54,000 (Statement of Financial Position)

Error from previous year Retained earning brought forward [312,150 + 7,700] 319,850 Opening inventory [52,000+ 7,700] 59,700

9.

Rent and rates As per trial balance Rent prepaid Rates due

10.

Ordinary Dividends 400,000 shares *3c = 12,000

11

12

13.

14.

90,000 (12,000) 4,000 82,000

Debenture interest [150,000 * 8%] = 12,000 (Income statement) Amount paid (trial balance) 6,000 Therefore amount due = 6,000 (current liability in statement of financial position)

Preference dividend [50,000*7%] 3,500 None of this has been paid by year end therefore it must also be recognised as a current liability in the statement of financial position Land revaluation Dr Land a/c Cr Revaluation a/c

100,000 100,000

After recording the double entry above this will give the following balances in the respective accounts: Land a/c [500,000 +100,000] 600,000 Revaluation a/c 100,000

Grant Staff training in trial balance Government grant received Staff training in Income statement

4,000 (2,000) 2,000 Page 10

SOLUTION 2

To: Managing Director From:Financial Accountant Re: IAS 18

REPORT

Date April 2009

(a) (b)

(c)

(d) (d)

Revenue is defined as “the gross inflow of economic benefits during the period arising in the course of the ordinary activities of an enterprise when those inflows result in increases in equity, other than increases relating to contributions from equity participants” Revenue should be measured at the fair value of the consideration received or receivable.

The following conditions should be satisfied before revenue from the sale of goods should be recognised in the financial statements: (i) The enterprise has transferred to the buyer the significant risks and rewards of ownership of the goods; (ii) The enterprise retains no continuing managerial involvement, nor effective control over the goods sold; (iii) The amount of revenue can be measured reliably; (iv) It is probable that the economic benefits associated with the transaction will flow to the enterprise; and (v) The transaction costs can be measured reliably.

Interest should be recognised on a time proportion basis based on the effective yield. Royalties should be recognised on an accruals basis in accordance with the substance of the agreement. Dividends should be recognised when the shareholder’s right to the dividend is established. Disclosure requirements of IAS 18 Accounting policy for each recognition The amount of each significant category of revenue The amount of revenue arising from exchanges of goods or services

Yours Sincerely Financial Accountant

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SOLUTION 3 (a) (i) Dr Cr

Dr Cr

(ii) (iii)

Dr Cr Cr

Dr Cr Cr Dr Cr

Dr Cr Dr Cr (iv) (v) (vi) (vii)

Dr Cr

Dr Cr Cr

Dr Cr

Dr Cr

Machinery a/c Purchases a/c

Depreciation (Income Statement) Accumulated depreciation (Statement of Financial Position)

(i)

(ii)

€10,000 €10,000

Suspense a/c Purchases returns a/c Sales returns a/c

€2,500 €1,250 €1,250

Bank a/c Sales revenue a/c Disposal a/c

€6,500 €6,500 €6,500

Disposal a/c Machinery a/c

€12,000 €12,000

Accumulated depreciation a/c Disposal a/c

€7,200 €7,200

Disposal a/c Income statement a/c [This is the profit on the disposal]

€1,700 €1,700

Electricity a/c Suspense a/c

€2,500 €2,500

Suspense a/c Discount allowed a/c Discount received a/c

€6,200 €3,100 €3,100

Rent prepaid a/c Suspense a/c

Motor expenses a/c Electricity a/c

Purchase returns Sales returns Discount allowed Discount received (b)

€50,000 €50,000

€2,300 €2,300 €1,750 €1,750 Suspense a/c 1,250 1,250 3,100 3,100 8,700

O/Bal [Bal figure] Electricity Rent prepaid

Error of principle This is where a transaction is recorded in the correct side of an incorrect type of account. Example: Purchase of a machine is debited to the purchase account

3,900 2,500 2,300 8,700

Error of commission This is where a transaction is recorded in the correct type of account, but in the wrong account. Example: Purchase of goods from John Kelly was credited to the account of Tom Kelly. Page 12

(iii) (iv)

Error of omission This is where no part of a transaction is recorded in the accounts. Example: a purchase of a new motor car is not recorded anywhere in the accounts.

Transposition error This is where the correct figures are recorded, but in the wrong order. Example: Payment of rent of €510 is recorded as €150.

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SOLUTION 4

Working 1: Opening capital (a) Buildings Land P&M Motor vehicles Inventory Trade receivables Trade payables Rent prepaid Electricity due Bank overdraft Income Statement of Gregory Murphy for the year ended 31 December 2009 € Revenue (w1) Less cost of sales Opening inventory 55,000 Purchases (w2) 278,700 Closing inventory (62,000) Cross Profit Less Expenses Wages 39,000 Stationery 1,250 Sundry expenses 3,300 loss on disposal (w3) 1,000 Depreciation (w4) 40,100 Rent (w5) 24,500 Electricity (w6) 2,750 Interest on loan (w7) 2,500 Profit for period Working 1: Revenue Cash sales

Credit sales Opening trade receivables Amount received from trade rec. Closing trade receivables Total revenue

[350,000 + (1,500*12)] (22,000) 150,000 30,000

Working 2: Purchases Cash purchases

368,000

158,000 526,000 25,000

Credit purchases Opening trade payables Amount paid to trade payables Closing trade payables Total purchases

(18,500) 255,000 17,200

Working 3: loss on sale of plant Sales proceeds NBV of plant sold Loss on sale

7,000 8,000 1,000 Page 14

253,700 278,700

€ 200,000 100,000 82,000 53,000 55,000 22,000 (18,500) 4,500 (420) (1,500) 496,080 € 526,000 (271,700) 254,300

(114,400) 139,900

Working 4: Depreciation Buildings Plant [82,000 – 8,000]*15% Motor vehicles [53,000+31,000]*25%

8,000 11,100 21,000 40,100

Working 5: Rent Amount paid Prepaid at start of year Prepaid at end of year

25,000 4,500 (5,000) 24,500

Working 6: Electricity Amount paid Due at start of year Due at end of year

2,800 (420) 370 2,750

Working 7: Interest on loan 50,000*10%* 6/12 2,500 (Income Statement) This has not been paid by year end and must be recorded as a current liability in the statement of financial position.

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SOLUTION 5 (a) Operating profit margin

Current ratio

Acid test ratio

Inventory days

y/e 31/12/08

(210/700) (256:27)

(256-39:27) (39/350)

Receivable days

Payable days

Return on capital employed

Gearing ratio (b)

(67/700)

31%

(125/500)

8.03:1

(110-41:208)

35 days

(69/500)

9.48:1

41 days

(27/350)

28 days

(500/1,829)

27.34%

(210/1,829)

To:Managing Director From:Certified Public Accountant Re:Liquidity problems

11.48%

y/e 31/12/09

25%

(110:208)

0.53:1

(41/300)

50 days

0.33:1

51 days

(37/300)

45 days

(300/1,712)

17.52%

(125/1,712)

7.3%

REPORT

Date:April 2009

Mayo Ltd is performing well in terms of generating profit. For the year ended 31 December 2009 the company generated a profit after tax of €83,000. Operating margin has reduced to 25% in the period and there is also a reduction in the ROCE in 2009. The ability of the company to generate profits is not the reason that the company is experiencing a cash-flow problem.

During 2009 the company repaid debentures of €200,000 and purchased plant costing, at least, €300,000. The company did not raise any long term sources of finance to undertake this exercise, they paid it out of short term funds. At the end of 2008 the company only had €68,000 in the bank and therefore did not have any excess short term funds to undertake this exercise. This lead to a drastic reduction, in both the current ratio and acid test ratio during 2009. At the end of 2009 Mayo Ltd has an acid test ratio of 0.33:1. This means that they do not have enough liquid short term funds to pay their short term liabilities.

During 2009 it took the company 16 days longer to receive money from their trade receivables. This also meant that the company were not receiving cash as quick as in the past. Inventory days increased to 50 days which could have lead to an increase in their expenses (storage cost) and therefore reduced their cash-flow.

Payable days increased by 17 days, probably as the company did not have the cash to pay on time. The company need to review this situation as it may damage their credit rating and this will have a negative impact on future cash-flow.

(c)

The debt/equit ratio has reduces due to the repayment of the debentures. The company needs to correct their liquidity problem by injecting new debt capital or equity into the company. As the company is generating sufficient profits to repay new debt this would offer a solution to their problem. Ratio analysis is based on historical data. Different companies use different accounting policies and this reduces the benefit of comparing one company against another. Ratios are not definitive measures; they only provide clues to a company’s performance or situation.

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