Question

Please answer part B question c.

Pete Sandstrom is the CEO of WeRHere4U Ltd. He is speaking with you having shown you these financial statements for the years 2016 through 2019. He is extremely proud of his results; Net profit has steadily increased from $67,200 in 2017 to $73,500 in 2018 and in 2019, $83,300. He also highlights to you that the Return on Equity (ROE) at WeRHere4U Ltd has also improved substantially form 51% in 2017 to 62% in 2019. He is hoping that when these results are presented to the shareholders of WeRHere4U that he will be rewarded with a substantial bonus for all his good efforts. You decide to take a closer look at the performance of WeRHere4U using the techniques you have learnt in ACCT1101 by considering each of the questions below.

PART A:

You perform a “Common-size” analysis on the Statements of Financial Performance for each of the years 2017, 2018 and 2019. This is shown below.

COMMON SIZE ANALYSIS
	2019	2018	2017
Sales	100.00%	100.0%	100.0%
Cost of Sales	47.0%	45.2%	43.0%
Gross Profit	53.0%	54.8%	57.0%
Other expenses	16.2%	18.0%	20.0%
Operating profit	36.8%	36.8%	37.0%
Interest	4.6%	2.9%	1.5%
Profit before Tax	32.2%	33.9%	35.5%
Tax expense	9.6%	10.2%	10.7%
Net Profit	22.6%	23.7%	24.8%

PART B:

You now use the information provided in the WeRHere4U’s financial statements to perform the following DuPont Analysis of the Return on Equity (ROE) for each of the years 2017, 2018 and 2019.

DU PONT ANALYSIS
	2019	2018	2017
Return on Equity (ROE)	0.6170	0.5444	0.5110
Return on Capital Employed (ROCE)	0.5913	0.6000	0.6390
Operating Profit Margin	0.3676	0.3677	0.3704
Capital Turnover	1.6087	1.6316	1.7252
Tax and Interest ratio	0.6125	0.6447	0.6720
Leverage	1.7037	1.4074	1.1901

Required:

1. Explain the meaning and interpretation of EACH of these ratios. [Maximum 60 words EACH]
2. Explain the trend in each of these ratios over the last 3 years? [Maximum 200 words]
3. What is your assessment of Pete’s claims that he has managed a substantial improvement in WeRHere4U’s Return on Equity? How has Pete managed to achieve this performance? Explain using your computations. [Maximum 100 words]
4. Why is this analysis useful to assess Pete’s claims that the performance of WeRHere4U has been excellent over the last 3 years? [Maximum 100 words]

Answer 1

Answer :

Pete's claims that he has managed a substantial improvement in WeRHere4U's return on equity is misleading.

Pete's achieved increase.in return on equity by using more DEBT CAPITAL. As interest payable to bondholders is tax-deductible expense.

Analysis:

Common Size Statement analysis:

Opreating profit has decreased from 37% in 2017 to 36.8% in 2019. But there is significant rise in interest expense from 1.5% in 2017 to 4.6% in 2019.As a result tax expense has decreased (tax saving due interest paid to bondholders) from 10.7% in 2017 to 9.6% in 2019.

DU - Pont analysis :

There is increase in return on equity but RETURN ON CAPITAL EMPLOYED which includes all form of Capital invested whether debt or stocks has significantly reduced by 4.77% ( 63.90% in 2017 - 59.13% in 2019 )

By taking reference of above analysis it can be concluded that rise in return on equity is not due to increae in revenue but managing the capital structure by way of issuing more debt capital and taking advantage of low cost funding and tax saving due to interest paid to bondholders.

So, claim made by CEO is not supported by other ratio indicators that why misleading in nature.