## Saturday, May 2, 2020

### Analysis and ploicy Tom Ltd and Jerry Ltd

Questions: 1.Calculate the following ratios for Tom Ltd and Jerry Ltd ensuring you show your formula and workings? 2.Write a report commenting on the performance and position of Tom Ltd and Jerry Ltd. Include a summary table of the results you have used in your discussion? 3.With reference to your ratio calculations, comment on the importance of identifying accounting policy choices when comparing ratios for entities, or when comparing ratios for a single entity over time? Answers: 1. Return on assets = EBIT / Total assets Tom Ltd Jerry Ltd = \$65,000 / \$410,000 = 15.9% = \$75,000 / \$310,000 = 24.2% Return on Equity = Profit available to shareholders / Equity Tom Ltd Jerry Ltd = \$55,000 / \$330,000 = 16.7% = \$65,000 / \$230,000 = 28.3% Profit Margin = Net profit / Revenue Tom Ltd Jerry Ltd = \$55,000 / \$300,000 = 18.3% = \$65,000 / \$300,000 = 21.7% Current Ratio = Current assets / current liabilities Tom Ltd Jerry Ltd = \$110,000 / \$30,000 = 3.7 = \$110,000 / \$30,000 = 3.7 Assets Turnover = Net Sales / Total assets Tom Ltd Jerry Ltd = \$300,000 / \$410,000 = 0.7 = \$300,000 / \$310,000 = 1 Debt Ratio = Total liabilities / total assets Tom Ltd Jerry Ltd = \$80,000 / \$410,000 = 0.2 = \$80,000 / \$310,000 = 0.3 (Khan, Jain, 2005) Question One Part b 2. A summary of ratios for both companies Tom Ltd and Jerry Ltd is given below: Ratio Tom Ltd Jerry Ltd Return on assets 15.9% 24.2% Return on equity 16.7% 28.3% Profit margin 18.3% 21.7% Current ratio 3.7 3.7 Asset turnover 0.7 1.0 Debt ratio 0.2 0.3 Performance of Tom Ltd and Jerry Ltd The performance of a company is measured by its profitability and efficiency ratios. The profitability ratios included in the above table are return on assets, return on equity and profit margin. Asset turnover is the efficiency ratio. Jerry Ltd has a higher profitability as compared to Tom ltd as all the profitability ratios for the company is higher. This is majorly because of one expense that is the depreciation expense which is higher for Tom Ltd. ad this expense has made all the difference. The net profit of Tom Ltd. is less. Jerry Ltd has a higher return on assets ratio because it has higher earnings before tax and expenses and also lower total assets. Tom Ltd has taken the fair value of the property, plant and equipment. This reflects a higher value of the non current assets, thus increasing the total assets. Also the depreciation has been applied on this fair value of property, plant and equipment, thus giving higher depreciation expenses. Therefore, Tom Ltd has lower net profits and higher total assets leading to a low return on assets. Tom Ltd has a lower return on equity due to lower net profits available to its shareholders and also a higher value of the equity. This coupled effect has reduced the return on equity for Tom Ltd. whereas Jerry Ltd. has a higher return on equity due to higher net profits and a lower equity value. This means Jerry Ltd is providing higher returns to its shareholders. Jerry Ltd has a higher profit margin due to increased net profit. The revenue for both the companies is the same. As a result of difference in the net profit, the profit margin is different for both the companies. Jerry Ltd. gives higher returns on its sales. Jerry Ltd. has a better assets turnover ratio. This is because it has lower total assets. Jerry records its assets at the historical cost due to which the total assets appear lower on the balance sheet. For Tom Ltd. the assets are recorded at fair value which is higher than the historical cost, thus the total assets value appears higher for Tom Ltd. on the balance sheet. The revenue for both the companies is the same. A higher assets turnover ratio means that the company is able to utilize its assets efficiently in generating sales. With lower total assets, Jerry Ltd. is able to generate the same amount of revenue as Tom Ltd. thus indicating better utilization of assets to generate sales. Thus from the above analysis of the profitability and efficiency ratios, we see that Jerry Ltd. ahs a better performance in both the categories. The difference in the performance is solely based on the difference in the accounting policies of depreciation and recording of fixed assets in the balance sheet. Position of Tom Ltd and Jerry Ltd The financial position of the company is measured through the liquidity and the solvency ratios. In the above table, current ratio is the liquidity ratio and debt ratio is the solvency ratio. The current ratio measures the short term liquidity of the company. It measures if the company has sufficient current assets to pay for its current obligations. Both the companies have the same current ratio. The current ratio of both companies is 3.7. This means the current assets are 3.7 times the current liabilities. This shows high liquidity of both the companies. Both companies have enough current assets to pay for their current liabilities, thus making them highly liquid. The ideal current ratio is 2. The debt ratio is a long term solvency ratio and measures the ability of a company to pay for its assets with its liabilities.(John, Subramanyam, Halsey, 2007) 3. Ratio analysis is majorly used by firms to analyse the performance and also for making financial performance comparisons between two companies. However, there are certain limitations of ratio analysis. One such limitation is on account of the use of different accounting policy being used by the two firms in question. Like in the above case, though both the firms are identical in all their revenues, expenses, assets and liabilities but the only difference lies in the accounting policy relating to measurement of fixed assets of plant property and equipment. The firm which records the fixed assets at the historical cost has recorded the asset at the lower value since the fair value of the asset is higher as per current market prices. Hence, the value of fixed assets of Tom Ltd. is higher than Ltd. This has affected the profit through depreciation charges. The depreciation is calculated on the carrying values of the plant and machinery. Tom Ltd. has higher depreciation charges because of high value of the same assets as possessed by Jerry Ltd. therefore the profits of Tom Ltd. have been reduced by that amount. Also both the companies use different deprecation methods. Jerry Ltd uses diminishing value method of depreciation and Tom Ltd. uses straight line method. Under diminishing method of depreciation, higher depreciation charges are applied in the initial years and lower in the later years. Under straight line method, same percentage of depreciation is applied every year. Due to this difference in accounting policy, the depreciation charges differ for both the companies, and they have a direct impact on the profits. This affects the financial performance of the companies.(Alayemi, 2015) Even for a single firm, ratio analysis may yield misleading results for two years where accounting policy has been changed over the years. Lets say if the company has changed its accounting policy on measuring the companys plant and machinery from historical cost to the fair value. This will have two effects, first a change in the value of fixed assets appearing on the balance sheet and the change in the depreciation charge which will directly impact the profits. Thus both financial performance and the financial position ratio results will change for the same company. Thus ratio analysis cannot be applied for companies using different accounting policies as for the same revenue and profits, the performance results may vary. References Alayemi, S.A., (2015), Choice of Accounting Policy: Effects on Analysis and Interpretation of Financial Statements, American Journal of Economics, Finance and Management, Vol.1, No.3 John, J.W., Subramanyam, K.R., Halsey, R., (2007), Financial Statement Analysis, 9th edition, New Delhi, Tata McGraw- Hill Khan, M.Y., Jain, P.K., (2005), Basic Financial Management, second edition, New Delhi, Tata McGraw-Hill