Question

You are the audit senior on the audit for the year ended 30 June 2019 of Neptune Pty Ltd, a large manufacturer of lighting accessories. This is the first year that your firm has performed Neptune’s audit. As part of the planning work, you have annualised Neptune’s interim financial accounts and performed analytical procedures on the annualised figures and compared the results to industry averages and last year’s audited financial information. The results are given below.

Industry Average Neptune Pty Ltd

RATIO 2019 2018 2019 2018

Current ratio 2.51 2.72 2.15 2.55

Net profit ratio 0.08 0.07 0.063 0.05

Gross profit ratio 0.24 0.29 0.24 0.21

Inventory turnover ratio 3.41 3.52 4.24 4.53

Receivables turnover ratio 6.02 5.81 6.38 7.17

Return on total assets 8.4% 6.0% 15.0% 11.0%

Required

Providing a brief explanation of each of the above ratios, outline what conclusions can be drawn about Gleam’s financial position and identify potential audit risks to be investigated further.

Answer 1

Answer:-

Current Ratio= Decreasing; Less than Industry Average

Net Profit Ratio= Increasing; Less than Industry Average

Gross Profit Ratio= Increasing; Equal to Industry Average

Inventory Turnover Ratio= Decreasing; Greater than Industry Average

Receivables Turnover Ratio= Decreasing; Greater than Industry Average

Return on Total Assets= Increasing; Greater than Industry Average.

Detailed Explanation:-

Definitions and Conclusions:

Current Ratio= (Current Assets/Current Liabilities); a ratio that measures a firm's liquidity or the ability of a firm to meet its short-term obligations. Relative to the previous period and to most firms from the same industry, Neptune is less liquid and is less likely to meet its present obligations.

Net Profit Ratio= (Net Profit/Sales); a profitability ratio that measures the percentage of a company's Sales or Revenue that pertains to Net Profit. While his net profit margin is increasing, Neptune is still less profitable than most firms in his industry.

Gross Profit Ratio= (Gross Profit/Sales); similar to the net profit margin, the gross profit ratio is also a profitability ratio; however, it only takes into account the profit resulting from only deducting the company's cost of sales. The increasing Gross Profit may be a result of an increased sales price or a decrease in the the company's cost of sales.

Inventory Turnover Ratio= (Cost of Goods Sold/Avg. Inventory); refers to the average number of times inventory was sold during the year. While the average number of times Gleam's inventory is sold has decreased, it still exceeds the industry average.

Receivables Turnover Ratio= (Credit Sales/Avg. Receivables); refers to the average number of times receivables are collected in a year. Based on the table, collection is much slower for 2019 though Neptune is still able to collect several more times compared to most firms in his industry,

Return on Assets= (Net Profit/Avg. Total Assets); a profitability ratio that measures how well a company utilizes its assets in order to generate revenue. RoA is increasing for Gleam and it is in fact greater than the industry average.

Audit Risks:

Liquidity Risk= lower current ratio means lower liquidity

High Selling and Administrative Expenses= Neptune's gross profit rate is equal to the industry average, but while his Net Profit margin is increasing, it is still less than the industry' average. This could mean that Neptune is incurring higher amounts of selling and administrative expenses than what is expected from his industry.

Valuation of Assets= Neptune's ROA is quite higher compared to the industry average; however, it appears less profitable in term of its net profit margin. The higher ROA may be attributed to a lower Avg. Total Asset value. Neptune may either be holding less assets or have undervalued some of their assets.