Question

Ali and Bashir are chartered accountants and have been working as Managing Director (MD) and Chief Financial Officer (CFO) in a listed company. In a recent meeting of the Board, the directors have decided to expand the business within six months by opening 20 retail outlets. This expansion would require financing of Rs. 300 million which may be arranged through bank loan.
The following information has been extracted from latest draft financial statements of the company:
     Rs. in ‘000
Sales 1,700
Gross profit     545
Tax expense        23
Profit after tax        40
Total assets 2,500
Non-current assets      900
Inventories      850
Trade receivables      600
Share capital      800
Reserves       152
Long term debt @ 9%       750
Following additional information is also available:
1. 80% of the sales are on credit.
2. Opening inventory was Rs. 100 million.
3. 40% of current liabilities comprise of trade payables.
MD has advised the CFO to arrange the loan from MN Bank. He has also informed that the President of the bank is his good friend and the loan can be arranged on a fast track basis at a mark-up of 15% per annum, subject to the following conditions:
1. current ratio and quick ratio should be at least 2:1 and 1:1 respectively;
2. gearing ratio should not exceed 40%; and
3. Interest cover should be at least 3.
CFO is not comfortable with this deal as the mark-up offered by the bank is much higher than the rate on the existing loan and it is difficult for the company to meet the gearing requirements of the bank. However, MD has asked him to make certain changes in the draft financial statements before submission to the bank; which according to the CFO are not in accordance with the IFRSs.
Required: (a) Compute liquidity, working capital and debt ratios of the company.                (10)
(b) What Are The Major Constraints On Relevant And Reliable Financial Statements?    (05)
(c) Discuss the major findings of your class project on NESTLE Pakistan.

Answer 1

(a) Computation of liquidity, working capital and debt ratios

First let's calculate all Balance Sheet items from data provided:
(Rs. in '000)

Line Item	Working	Amount
Share Capital	-	800
Reserves	-	152
Long term debt @9%	-	750
Trade Payables	40% of 798*	319
Other Current Liabilities	798-319	479
Total Liabilities	Total liabilities=Total assets	2500
Non current assets	-	900
Inventories (closing)	-	850
Trade Receivables	-	600
Other Current assets (Cash)	2500-(900+850+600)	150
Total assets	-	2500

*Current Liabilities = 2500-(800+152+750) = 798
Liquidity Ratios
Current Ratio = Current assets
Current Liabilites
= (850+600+150) [Inventories, Trade Receivables and other current assets]
(319+479) [Trade payables and other current liabilities]
= 2.005 or 2:1
Quick Ratio = Current assets - Inventories
Current liabilities
= 1600 - 850 = 0.9398 or 0.93:1
798
Working Capital = Current assets - Current liabilites = 1600 - 798 = 802 mn
Inventory Turnover Ratio = Sales or Cost Of Goods Sold
Avg Inventory ((opening+closing stock)/2)
= 1700 / ((100+850)/2 = 3.578 or 4 times
Collection period ratio = Trade Receivables
Credit sales/365
= 600/((1700*80%)/365) = 161 days

Debt Ratios
Debt to Equity Ratio = Total liabilities  = Long term debt+trade payables+other current liabilites
Total equity share capital and reserves
= 750+798 / 800+152 = 1548 / 952 = 1.626:1
Debt to Asset ratio = Total Debt/ Total assets = 1548 / 2500 = 0.619:1

(b) Major constraints on relevant and reliable Financial Statements
There are 4 major constraints on presenting relevant and reliable information in the financial statements:
Timeliness
There should be a balance between providing information at the right time when users need that information to make decisions and not entirely compromising on the quality of information. If all aspects of a transacton are to be reported it may cause a delay whereas if information os provided but material aspects of a transaction are not considered it may influence the User's decisions.

Balance between benefit and cost
The benefits accruing from using the information provided in the financial statements should be more than the cost of providing it. It is possible that the cost of providing is borne by management but benefits are taken by all users making decisions based on those statements. This cost benefit analysis is left to judgement.

Balance between qualitative charecteristics
Qualitative characteristics must be judged on importance while reporting. The idea is to ensure true and fair view of financial performance and position is reported. Keeping this objective in mind qualitative characteristics should be considered.

True and fair view
The objective is to provide information which is not materially defective and is relevant and reliable, for users to take decisions. Applying various quality/ethical principles and accounting standards ensures this.

Pls note that no information is provided on Nestle Pakistan to make a comment. Pls provide the same so that question (c) can be answered.