ACCT10002: Tutorial 10 In-class Exercises SUGGESTED SOLUTIONS

Question 1: Debt V Equity (BE10.8)

(a)
Olga Ltd

Issue Shares Issue Unsecured Notes

Profit before interest and taxes $1,000,000 $1,000,000
Interest ($2,000,000 X 8%) 0 160,000
Profit before income taxes 1,000,000 840,000
Income tax expense (30%) 300,000 252,000
Profit (a) $ 700,000 $ 588,000

Number of shares (b) 900,000 700,000

Earnings per share (a) ÷ (b) $ 0.78 $ 0.84

(b) Profit is higher if shares are used. However, Earnings per share is lower than if unsecured notes are
used because of the additional equity.
Other factors would include:
 Ability to generate cash to meet the interest payments (Plan Two) or possible dividend payments
(Plan One) in the future.
 Tax deductibility of Interest.
 The stability of interest rates in the future and their effect on the early retirement of the debt.
 The increase in financial risk from issuing more debt compared with the increased ROE from
increased leverage.

Question 2: Discontinued Operations

(i) Reconstruct the Income Statement

Apollo Ltd
Statement of Financial Performance
For year ended 30 June 2016

Item $
Continuing Operations
Revenue 2,500,000
Cost of Sales (950,000)
Gross Profit 1,550,000
Other expenses (1,025,000
Gain on sale of equipment 5,000
Income from Continuing Operations (before tax) 530,000
Tax @ 30% 159,000
Income from Continuing Operations (after tax) 371,000

Income from Discontinued Operations

Net Income from sales Product X $20,000 less tax $6,000 20,000
Gain on sale of equipment Product X $3,000 less tax $900 3,000
Income from Discontinued Operations (before tax) 23,000
Tax @ 30% 6,900
Income from Discontinued Operations (after tax) 16,100
Total Income 387,100
 (ii) It is important for potential investors to understand the effect of discontinued operations on the
financial reports particularly the profit is used as a predictor of future cash flows. Investors and other
users of financial statements need to be aware of the lower level of net income arising from continuing
Operations as it may indicate lower profits in the future. This is in keeping with the requirement to
provide relevant and faithful representation of company reports.

Question 3: Restatement

(a) Assuming that the management of ABC Ltd. determine that the missing item is material to the
December 2016 financial statements show the general journal entry to record the required information.

The correction recorded in April 2017 would be:

Dr PPE $500,000
Dr Retained Earnings (Dec 2016) 49,500
Accumulated Depreciation PPE 24,500
Interest Payable 25,000
Bank Loan 500,000
(To record the purchase of equipment, accumulated depreciation and bank loan and to
reduce retained earnings for interest and depreciation expense for the six months from 1 July to
31 December 2016)

(b) Show how the change would be presented in ABC Ltd.’s 31 December 2017 financial statements.
Statement of Financial Performance (Profit or Loss)
2017 2016 (Restated)
Depreciation expense Actual + $24,500
Interest expense Actual + $25,000
Net Profit Actual - $49,500

Statement of Financial Position (Balance Sheet)

2017 2016 (Restated)
Property, Plant and Equipment Actual + $500,000
Accumulated Depreciation PPE Actual + $24,500
Interest payable Actual + $25,000
Bank loan payable Actual + $500,000
Retained earnings Actual - $49,500

(c) If you were interested in buying shares in ABC Ltd. in 2018, would the missing information be of
importance to you? Explain why.

The comparative information provides a more accurate measure of the trend in the firm’s financial
performance. It would distort the earnings of ABC Ltd. over the trend of a few years. The
understatement of depreciation and interest expenses would result in a higher profit being reported in the
2016 year.

(d) Would the missing information affect any ratio analysis that you might use in your analysis of the
potential share purchase? Explain briefly.

Without the restatement of the financial results the Return on Assets and Return on Equity would not
reflect the true ratios. The ROA would be higher as a result of the higher profit and the assets which do
not include the new PPE. The ROE likewise would reflect a higher result based on the higher profit. In
addition, the Debt/Assets ratio (gearing ratio) would most likely be adversely affected as proportionately
the liabilities would become larger than the assets.
Question 5: Ratio analysis - Domino’s Pizza Enterprises Ltd (ASX code DMP)

Using the information contained in the 2021 Annual Report

(a) CFO/NI = 374,410/193,143 = 1.94

Comment: The quality of income ratio indicates a reasonable level of cash from operating activities
which exceeds the net Income.

(b) ROA Level 1:

EBIT/Av Assets: 291,530/0.5(2,358,170 + 2,471,105) = 12.07%

Note: Profit before tax + Finance costs = EBIT

ROA Level 2:

Profit margin: EBIT/Sales = 291,530/2,199,106 = 13.75%

Asset turnover: Sales/Av Assets = 2,199,106/2,414,637 = 0.91

Comment: ROA consists of profit margin based on EBIT multiplied by asset turnover. When compared
to previous years a trend can be observed to assist management to make improvements in the poorer
performing measure.

(c) ROE Level 1:

NPAT/Av Equity = 193,143/0.5(399,167 + 393,373) = 48.7%

ROE Level 2:

Profit margin: NPAT/Sales = 193,143/2,199,106 = 8.79%

Asset turnover: Sales/Av Assets = 2,199,106/2,414,637 = 0.91

Financial leverage: Av Assets/Av Equity = 2,414,637 / 396,270 = 6.09

Comment: ROE consists of three components. Profit margin based on net income, asset turnover and the
financial leverage. When compared to previous years a trend can be observed to assist management to
make improvements in the poorer performing measure of profit or turnover and whether an increase or
decrease in financial leverage is advisable.

(d) Days inventory: Av inventory x 365/COS =26,933 x 365 / 1,311,402 = 7.5 days

Days receivables: Av rec/bles x 365/Sales = 146,109 x 365/ 2,199,106 = 24.25 days

Days payables: Av payables x 365 /COS = 341,094 x 365/ 1,311,402 = 94.9 days

Cash conversion cycle = 7.5 + 24.25 – 94.9 = - 63.15 days

Comment: the negative cash conversion cycle is 31.75 days to fund inventory and receivables but, 94.9
days to make payments to payables. Therefore, has advantage of cash conversion cycle for 63.15 days to
invest spare cash holdings.

(e) Average debt/Average Assets = 2,018,367/2,414,637 = 83.59%

(f) Interest coverage ratio = EBIT/Finance costs = 291,530/18,593 = 15.68

(g) Complete the table

 Domino’s Pizza Enterprises Ltd.

Year 2021 2020 2017 2016

Quality of income 1.94 2.18 1.26 1.29

Profit margin 13.75% 11.69% 19.6% 18.3%

Asset turnover 0.91 0.97 0.7 0.8

Return on Assets 12.07% 11.40% 13.7% 14.7%

NPAT margin 8.79% 7.5% 13.3% 12.3%

Financial leverage 6.09 5.29 2.79 2.51

Return on Equity 48.7% 38.7% 26.1% 24.8%

Cash conversion cycle - 63.15 days - 51.84 days - 42.12 days - 49.59 days

Debt to Assets 83.59% 81.09% 64.19% 60.2%

Interest coverage 15.68 times 11.55 times 47.5 times 39.16 times

(h) Comment on trends

(i) ROA: Maintains a range of between 11% and 15%. Profit margin has generally
fallen whereas the asset turnover has gradually improved.

(ii) ROE: Has doubled over the period from 2016 based on a falling profit margin and
slightly increasing asset turnover but boosted by an almost tripling of the
financial leverage.

(iii) Liquidity: The Current ratio indicates a negative $0.91 of current assets to $1 of
current liabilities which is of some concern if an emergency arose.
However, the Cash Conversion Cycle indicates that Domino’s holds cash
for an extra 63 days before payments are made to Payables. It collects
cash within 32 days but does not pay for 95 days.

(iv) Solvency: the level of debt is high and has enabled Domino’s to leverage its
return to shareholders. It is covering its interest payments with EBIT by
almost 16 times. If interest rates rise then higher interest costs will need
to be paid and the level of debt might need to be reduced as the firm is
relying very heavily on debt.