Accounting for Business: Analysis of Financial Ratios and Revenue Recognition
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This article analyzes the financial ratios of Green Apple Ltd, including short term solvency and efficiency. It also discusses revenue recognition as per AASB 118 and compares two companies based on their capital structure and liabilities. The article provides insights into the company's financial performance and highlights areas of improvement.
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PART A a)1) Current Ratio โ It is a measure of short term liquidity and highlights the ability of the company to meet current liabilities. Current Ratio = Current Assets/ Current Liabilities Current Assets (2018) = 12,000 + 60,000 + 150,000 = $ 222,000 Current Assets (2019) = 18,000 + 70,000 + 130,000 = $228,000 Current Ratio (2018) = 222000/81000 = 2.74 Current Ratio (2019) = 228000/105000 = 2.17 2) Quick Ratio: It is also a measure of short term liquidity but a more stringent one since it considers only the liquid assets. Quick Ratio = (Current Assets โ Inventories)/Current Liabilities Quick Ratio (2018) = (222,000-150,000)/81,000 = 0.89 Quick Ratio (2019) = (228,000 โ 130,000)/105,000 = 0.93 3) Accounts Receivable Turnover โ It is an efficiency ratio and highlights the amount of time required to convert accounts receivables into cash. Accounts Receivable Turnover (in times) = Credit Sales/ Average accounts receivables Accounts Receivable Days = (365/Accounts Receivable Turnover) Accounts Receivable Turnover (2018) = 490000/((60000+78000)/2) = 7.10 Account Receivable Days (2018) = 365/7.10 = 51.4 days Accounts Receivable Turnover (2019) = 630000/((70000+60000)/2) = 9.69 Account Receivable Days (2019) = 365/9.69= 37.66 days 4) Inventory Turnover โ It is an efficiency ratio which highlights the ability of the company to convert inventory into sales. 2
Inventory Turnover (in times) = Cost of Goods Sold/ Average inventory Inventory Days = (365/Inventory Turnover) Inventory Turnover (2018) = 250000/((150000+130000)/2) = 1.79 times Inventory Days (2018) = 365/1.79 = 204.4 days Inventory Turnover (2019) = 290000/((130000+150000)/2) = 2.07 times Inventory Days (2019) = 365/2.07 = 176.20 days b)With regards to short term solvency, there is deterioration in performance since current ratio has declined in 2019 as compared to the corresponding value in 2018. However, a positive aspect is that there has been a marginal improvement in the quick ratioin 2019 compared to 2018 levels. The short term solvency does not pose any significant risk to the business considering that for both years the current ratio and quick ratio continue to be healthy (Brealey, Myers and Allen, 2014). Withregardstoefficiency,itcanbeconcludedthatthecompanyissignificantly underperforming the industry as the performance is lower than the industry average. While the credit period given by the company is only 30 days, the actual collection period is much higher which shows a matter of concern. The company has achieved significant improvement in this regards in 2019 as compared to 2018 level but the same needs to brought down to about 30 days. With regards to converting inventory to sale, there has been improvement by the company in 2019 since the turnover period has reduced. However, it still continues to be much higher than the industry average of 101 days. This would lead to a higher cash cycle for the company which would result in higher working capital requirements (Damodaran, 2015). PART B As per AASB 118, revenue is defined as the income which is derived from the ordinary activities that are conducted by the business. Also, the forms assumed by revenues may be manifold such as sales, royalties, interest, dividends or fees (AASB, 2014). The given streams of cash flow for the company would be analysed in the wake of the above understanding. It is evident that the primary business of Green Apple Ltd is making sales of the anti-virus software. The sale of software leading to invoice of $ 25 million would be considered as 3
revenue as it is the sale of the primary product which the company sells. Additionally, $ 3 million earned by the company from update downloads would also be classified as revenue as this is also related to the primary business of selling software as these require regular updates which is chargeable by the company. The $ 50,000 receipt of interest would not be termed as revenue as this is not realised on account of the primary business activities of the company. The payment of $ 2,000 received on early settlement of liability would also not be termed as revenue. The shares proceed are on account of issue of shares and thus not revenue (Berk et. al.,2016). It is imperative to note that all revenues are essentially income before consideration of expenses. Hence, sale of anti-virus software and updates would result in generation of income. Further, interest generated to the tune of $50,000 from short term investments would also be termed as income. The $ 2,000 realised on early settlement of liability would not be considered as income but rather a discount in expense. Also, the proceeds of share sale are not income as they are essentially financing cash flows realised from issue or shares and hence merely exchange of funds (Lasher,2017). PART C a)In the given scenario, the application of XYZ Company would be more favourable than ABC Company. This is because of the current ratio of XYZ being significantly higher than ABC. The loan is required for short duration where clearly ABC has a cash crunch since the current liabilities are $52,800 as against current assets are $ 7,200. This is in contrast with the situation with XYZ whose current assets are more than twice of current liabilities which offers support to the lender (Damodaran,2015). b)In the given scenario, I would be willing to pay a higher price for XYZ Company in comparison to ABC Company. This is because of the difference in capital structure where company XYZ has debt to the extent of $ 7,200 only. Further, the short term position of the XYZ company is also superior in comparison to ABC thereby lowering the overall risk. With regards to ABC, the loan payable is much higher at $ 31,200 owing to which the buyer would assume a higher liability reducing the price paid for the business (Lasher, 2017). c)If the existing liabilities are paid by the current owners, then the decision would change. This is because the equity base for ABC company would be quite small when compared 4
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to XYZ company. This augers well since the earnings per share would be higher for ABC in comparison to XYZ company assuming similar earnings. As a result, the valuation derived by ABC company would be higher than XYZ making the former a better buy candidate (Petty et. al., 2016). 5
References AASB (2014)AASB 118 โ Revenue,[Online] Available at https://www.aasb.gov.au/admin/file/content105/c9/AASB118_07-04_%20COMPapr07_07- 07.pdf[Accessed April 28 2019] Berk, J., DeMarzo, P., Harford, J., Ford, G., Mollica, V. and Finch, N. (2016)Fundamentals of corporate finance. London: Pearson Higher Education AU, pp.203 Brealey, R.A., Myers, S.C. and Allen, F. (2014)Principles of corporate finance. 2nd ed. New York: McGraw-Hill Inc, pp. 176 Damodaran, A. (2015)Applied corporate finance: A userโs manual. 3rd ed. New York: Wiley, John & Sons,pp. 131-132 Lasher, W. R., (2017)Practical Financial Management.5th ed. London:South- Western College Publisher, pp. 99 Petty, J.W., Titman, S., Keown, A., Martin, J.D., Martin, P., Burrow, M., and Nguyen, H. (2016) Financial Management, Principles and Applications.6th ed. NSW: Pearson Education, French Forest Australi, pp.154 6