Question 1 a) Calculate the following ratios for Rio Tinto plc. for the year ended 31st December 2019 (20 Marks)
1. Return on Capital Employed
Return on Capital Employed ROCE (%) = (Profit Before Interest and Tax)/(Capital Employed)*100%
Where, capital employed = Total assets less current liabilities
Therefore; ROCE (%) = (17142) / (97390-11,607)*100% = 20%
2. Inventory Turnover (stock days)
Inventory Turnover (stock days) = (Total Inventory / Cost of sales) * Number of days per annum (365 days)
Where Cost of sales = (Raw materials + Cost of goods sold) – (Changes in finished goods and WIP). Thus, (8,490+4,770) – 47 = 13,213.00
Therefore; (3.917/ 13213)*365 days = 108 Days
3. Debtor ratio (debtors’ days)
Debtor ratio (debtors’ days) = (Total trade debtors / Sales turnover)* 365 days
Therefore; Debtors days = (2,543/44611)* 365 days = 21 days
4. Creditor ratio (creditor days)
Creditor ratio (creditor days) = Total trade creditors / Cost of sales)* 365 days
Where Cost of sales = (Raw materials + Cost of goods sold) – (Changes in finished goods and WIP). Thus, (8,490+4,770) – 47 = 13,213
Therefore; Creditor ratio (creditor days) = (3,124.00/13,213.00)*365 days = 86 days
5. Current ratio
Current Ratio = Current Assets/Current Liabilities
Therefore; CR = (20,855.00/11,607.00) = 1.8 times
6. Quick ratio
Quick ratio = (Current assets-Stock)/Current liabilities
Therefore; (20,855.00-3,917.00)/11,607.00 = 1.5 times
7. Debt/equity ratio
Debt/equity ratio = (Long term debt/Share capital and reserves)*100
Therefore; Debt/Equity ratio = (13,247.00/51,903.00)*100 = 25.5%
8. Interest cover
Interest Cover = profit before interest and tax/Interest charges
Therefore; 17,142.00*268 = 64 Times
9. Return on Equity
Return on Equity (%) = (Earnings after preference share dividend/Shareholders funds)*100
Therefore; (10,400.00/51903.00)*100 = 20%
10. Price Earnings Ratio (P/E Ratio)
Additional Information:
Share price at close of business on 31st December 2019 = 4,503 pence £/$ exchange rate @ 31st December 2019 = $1.326
Basic earnings per share in pence = 604.00c/1.326 = 455.5
P/E Ratio = Market price of share/Earnings per share
Therefore; P/E Ratio = 4,503.00/455.5 = 9.9 times
Question 1 b) Using the 2019 ratios you calculated in question 1 (part a) and the 2020 ratios calculated in class write a brief report (500 words in total) which compares the performance of Rio Tinto plc. across both years. Your marks for this question will not be affected by any errors you may make in the calculations in question 1. If you have been unable to calculate any ratios in question 1 you can assume an answer for 2019 and write your report accordingly.
Different Companies and business entities use financial ratios to analyze the financial position of their businesses. The use of ratios is commonly used by management because ratios are easy to understand and simple to compute. Based on the fact that a ratio is simply a mathematically comparison based on proportions, companies of different dimensions can use financial ratios to compare their financial information. In a sense, financial ratios don’t take into consideration the size of a company or the industry. Ratios allow us to compare companies across industries, big and small, to identify their strengths and weaknesses. In the case of Rio Tinto plc, some of the ratios analyzed include debtors, ROCE, creditors’ turnover ratio, equity turnover ratios and price earnings ratio among others.
The return on capital employed will help to determine the amount of profit Rio Tinto Plc. generates per amount of capital employed. Therefore, when ROCE is higher, it is an indication of a stronger profitability in all company comparisons. However, it is important to note that ROCE of different companies will vary with age of fixed assets, which in turn will directly affect capital allowances and hence profits. Equally, the profitability of Rio Tinto is measurable by return on assets. Profit is one of the major objectives of establishing a company. Rio Tinto can achieve the profitability goal by selling goods or services. When the company achieves greater sales volume, it is likely to generate increased profits. Therefore, decreased inventory turnover days indicate low sales volume while increase in inventory turnover days indicates a good sales volume thus, increase in profitability. For example, the stock turnover ratio for Rio Tinto plc focuses on the relationship between the costs of goods sold and average stock of the company.
The activity ratios such as debtors and creditors ratios define the efficiency of Rio Tinto. Therefore, the activity ratios of Rio Tinto show the relationship the company’s sales and its assets. These ratios indicate the ratio between how much Rio Tinto plc. Has invested in a particular group of assets and the rate of return the company realizes on such assets. It enables the management to understand the velocity by which a company converts its stock into sales. Creditors’ turnover ratio shows the relation between Rio Tinto’s credit purchases and the average creditors of the company in the financial years 2019 and 2020. This ratio is vital in calculating the velocity with which Rio Tinto pays off its creditors during the financial years 2019 and 2020. It enables the management of Rio Tinto to determine how the company efficiently handles its accounts payable.
The reliability of the financial ratios calculated in question 1a above depends on the financial information provided for Rio Tinto plc. However, it is not easy to make intercompany comparison based on ratios because of the use of different accounting and financial policies such as stock valuation, depreciation, lease and purchase decisions. Another challenge with these financial ratios of Rio Tinto plc is that they tend to use historic financial information, and may not be a reliable guide to either current position or future activity.
Question 2: Required using the information above for the new project calculates:
1) The undiscounted payback
Depreciation of the new machine = (150,000 – 5,000)/5 = £ 29,000
Average annual profit: Sales-Fixed cost-Variable cost
Year 1: 250,000-120,000-125,000 = £ 5000
Year 2: 305,000-125,000-152,500 = £ 27,500
Year 3: 375,000-130,000-187,500 = £ 57,500
Year 4: 475,000-135,000-237,500 = £ 102,500
Year 5: 400,000-140,000-200,000 = £ 60,000
Average annual profit = (5,000+27,500+57,500+102,500+60,000)/5 = £ 50,500
Average investment = (150,000=5,000)/5 = £ 31,000
Undiscounted payback period = Initial Investment/Annual Payback
Therefore; The undiscounted payback (150,000/50,500) = 3 years
2) The Net Present Value
NPV = Initial investment + project cash flows occurring in years 1,2,3,4 and year 5
Year Cash flow 10% PVF PV
0 (150,000) 1.000 (150,000)
1 5,000 0.909 4,545
2 27,500 1.736 47,740
3 57,500 2.487 143,002.5
4 102,500 3.170 324,925
5 60,000 3.791 227,460
Net Present Value =£597,686.15
Accept the project due to positive NPV
3) The Internal Rate of Return
Internal Rate of Return (IRR) = 0=NPV=t=1∑T(1+IRR)tCt−C0
Where; Ct=Net cash inflow during the period, 5 years =
C0=Total initial investment costs (150,000)
IRR=the internal rate of return 15%
The number of time periods, t 5 years
Cash flows
Year 1: 250,000-120,000-125,000 = £ 5000
Year 2: 305,000-125,000-152,500 = £ 27,500
Year 3: 375,000-130,000-187,500 = £ 57,500
Year 4: 475,000-135,000-237,500 = £ 102,500
Year 5: 400,000-140,000-200,000 = £ 60,000
Net cash flows £252,500
Gross return = 68.33%
Internal Rate of Return = 15.295%
Question 3: Discuss the benefits and drawbacks of raising funding using the following 3 sources of finance
1) Ordinary shares
The ordinary shares of a company are company’s stocks sold on a public exchange. The ordinary shares grant the ordinary shareholders voting right during the company’s annual general meeting and the ability to participate in the election of board of directors. During the board meetings, each share carries the right to one vote. Equally, ordinary shareholders are the owners of the company thus, have the right to receive dividends from the company’s profit realized every financial year.
However, ordinary shares have a set of drawbacks to the ordinary shareholders considering that they are one of the riskiest types of investment. The risk emerges when the shareholders fail to receive their dividends towards the end of a given financial period. This poses the ordinary shareholders to bear operational risks of the organization such as losses. Also, the issue of new shares may result to dilution of the shares held by the existing shareholders.
2) Preference shares
These are the shares the Company’s management issue to the public as a token of ownership in that given company. The preference shares are issued at par value in accordance with how the management calculates the annual dividends. Preference shares is very good source of a company’s source of financing because it is easy to issue. Equally, the company does not have to pay back the amount it raises by selling preference shares. This means that the company considers the principal that it raises as a result of selling preference shares as a long-term investment. Issuing preference shares does not affect the decision-making ownership structure of the company. Since Preference Shares do not have voting rights, they do not have control over the operational affairs in the company. As a result, preference shares act as an incentive for the common shareholders, because they still hold the voting rights.
However, Preference shares impose disadvantages to the holders due to their nature of rewarding fixed dividends irrespective of whether a company makes huge profits in a given financial year. Preference shares sale is only limited to public limited companies thus, making the business available to medium and large organizations listed on the stock exchange.
3) Redeemable bonds
A redeemable bond is a debt instrument that provides a periodic stream of interest payments to investors while repaying the principal sum on a specified maturity date. The terms and conditions of a bond are contained in a legal contract between the buyer and the seller. Redeemable bonds may have more advantages over other stocks because of their volatility. This is evident in the interest payments on bonds which are often higher than the general level of dividend payment. Also bondholders enjoy a measure of legal protection under the law of different countries across the world. In a case a company goes bankrupt; its bondholders will often receive some money back as recovery amounts. However, redeemable bondholders are subject to risks such as the interest rate risk, prepayment risk, credit risk, reinvestment risk, and liquidity risk. These risks expose them to an extent of losing their investment when a company becomes bankrupt.
Question: 4
a) Discuss the merits and limitations of ratio analysis.
Ratio analysis analyses and interprets the financial position of a company of a business. It is an efficient tool that aids the work of management in forecasting and planning business activities. Also, ratio analysis helps the management accountant and a financial manager in computation of various accounting ratios simplifies the whole information contained in the financial statements of the company. It makes understanding of whole financial data quite easy by managers and investors. Equally, ratio analysis measures the efficiency and profitability of a company or business by calculating various ratios. Ratio analysis evaluates the profitability, solvency, and liquidity which help management in assessing fund requirements and capabilities of business units.
However, ratios can also give false results about the company because they are prepared using data obtained from financial statements. Data contained in financial statements suffer from various limitations and may not contain true or fair figures which affect the quality of ratio analysis. Ratio analysis takes into account only quantitative aspects and ignores all qualitative aspects of the business. Sometimes qualitative aspects are quite important and affect the functioning of business to a great level.
b) Explain your understanding of the risk/return relationship and why it is so important in Financial Management.
In business, risk occurs when there is a possibility that actual outcome may differ from expected outcome. The unit measure for risk is standard deviation. There is a direct relationship between risk and return. This is evident in a scenario where an iinvestor require increasing compensation called return for taking on increasing risk. For an investor to yield more returns, the magnitude of risk needs to be high in order to realize higher returns. Return on an investment can be measured over a standard period such as one year. Risk and return are important a factor in financial management because taking risk is an integral part of the business operations. Businesses have considered practicing risk management to keep them in operation.
c) What should be the primary objective of a commercial firm? How does this work in reality and what other objectives might be important for the company?
The primary objective of a commercial firm is profitability. The owners of businesses set up businesses to realize profits. This applies to shareholders and providers of capital. Their main objective is to maximize returns on their investments. When a business makes profits, it is possible for such an organization to achieve growth in terms of increase in profit, revenue and employee prosperity. All these factors will eventually lead to stability and continuity of business. A company can achieve stability through customer satisfactions, creditworthiness, employee satisfaction etc. A stable organization can
