The financial statements below pertain to two companies operating in the same industrial sector. Both companies manufacture medical equipment.
Some industry average ratios:
Return on capital employed 12.5%
Profit for the year margin 15.3%
Gross profit margin 25.4%
Inventory turnover 6 times
Average collection period 83 days
Average payment period 73 days
You are required to:
i. Calculate three ratios that are useful for indicating the profitability and efficiency of ABC Ltd and XYZ Ltd.
ii.Prepare a report which analyses and compares the profitability and efficiency ratios of ABC Ltd and XYZ Ltd with the industry average ratios.
See the suggested answer to practice activity 10.6 here.
Suggested answer to practice activity 10.6
ii. Report on the profitability and efficiency ratios of ABC Ltd and XYZ Ltd with the industry average ratios
The profitability ratios of ABC Ltd and XYZ Ltd were computed. To assess the profitability of ABC Ltd and XYZ Ltd, return on capital employed, profit for the year margin, and gross profit margin were calculated.
The efficiency ratios of ABC Ltd and XYZ Ltd were computed. To assess the efficiency of ABC Ltd and XYZ Ltd, inventory turnover, average collection period, and average payment period were calculated.
The results of the profitability ratios, efficiency ratios, and industry average are shown below:
The results of return on capital employed of ABC Ltd and XYZ Ltd are below the industry average. Possible reasons why the results of return on capital employed for ABC Ltd and XYZ Ltd are lower than the industry average are: the capital employed by both companies is more than the average capital employed by companies in the industry. Another reason could be the profit before interest and tax. The profit before interest and tax expense of ABC Ltd and XYZ Ltd may not be as high as the average profit before interest and tax expense of companies in the industry where both companies operate.
The profit for the year margin of ABC Ltd is lower than the industry average. The profit for the year margin of XYZ Ltd is higher than the industry average.
The gross profit margin of ABC Ltd is less than the industry average. The gross profit margin of XYZ Ltd is higher than the industry average. Compared to the industry average or the average gross profit of the industry both companies operate in, ABC Ltd is not as profitable as XYZ Ltd.
The inventory turnover measures the efficiency of ABC Ltd and XYZ Ltd in maintaining an adequate level of inventory. The inventory turnover of ABC Ltd is higher than that of XYZ Ltd. Based on the inventory turnover results for both companies, XYZ Ltd is slowing down compared to ABC Ltd. When the inventory turnover of ABC Ltd and XYZ Ltd is compared with the industry average, the business operations of ABC Ltd and XYZ Ltd are both slowing down. Inventory may be piling up because they are not sold. This could reduce the companies' liquidity because money is spent on purchasing inventory that is not sold quickly.
The average collection period of XYZ Ltd is higher than that of ABC Ltd. XYZ Ltd allows more time for its credit customers to pay. This is probably because XYZ Ltd was unable to sell purchased inventory quickly. To quickly sell inventory XYZ Ltd had to allow customers to buy inventory on credit. Therefore XYZ Ltd is unable to control credit given to customers. ABC Ltd does not allow as much time for credit customers to pay compared to XYZ Ltd. It can be inferred that ABC Ltd has an efficient credit collection system. Compared to the average collection period of the industry both companies operate in, ABC Ltd has reduced the average collection period, which means that they are more efficient in credit control.
The average payment period of XYZ Ltd is higher than that of ABC Ltd. XYZ Ltd takes more time to pay suppliers whom they bought goods from on credit. When compared with ABC Ltd, XYZ Ltd is faced with a shortage of cash to pay suppliers. This is probably because XYZ Ltd was unable to sell purchased inventory quickly. To quickly sell inventory XYZ Ltd had to allow customers to buy inventory on credit. Therefore XYZ Ltd is unable to control credit given to customers. ABC Ltd does not spend as much time to pay credit suppliers compared to XYZ Ltd. It can be inferred that ABC Ltd has an efficient credit payment system. Compared to the average payment period of the industry both companies operate in, ABC Ltd has reduced the average payment period, which means that they are more efficient in the credit payment.
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