Question

You are a senior internal auditor at BHEL Ltd., a machine tool manufacturer. A draft set of financial statements for the year have been prepared by management, and it has fallen to you to examine the figures for reasonableness and at the same time identify significant audit areas which may require further work even though your systems audit during the year has proved satisfactory.

You are aware of the fact that the company is at present contemplating an issue of $2,000,000 15% loan stock (redeemable in the year 20X0) in order to assist the remodeling of its present production facilities. The majority of the directors are in favour of making the issue but a few are reluctant to do so in view of the fact that the machine tools industry is subject to wide-ranging fluctuations in sales and profits. Abbreviated financial statements for BHEL Ltd. together with typical ratios for firms in the machine tool industry are as follows.

INCOME STATEMENTS FOR THE YEARS ENDED 31 DECEMBER

20X2                        20X1 Particular $'000 $'000 $'000 $'000 Sales 23,500 20,500 Cost of goods sold 16,000 14,000 Gross profit 7,500 6,500 Selling expenses 2,700 1,900 Administration expenses 2,300 2,600 5,000 4500 Profit from operations 2,500 2000 Interest paid 500 300 Net profit before taxation 2,000 1,700 Taxation 1,200 1,020 Net profit after taxation 800 680 Dividends paid 525 280 Profit for the year retained 275 400 Retained profit brought forward 6,090 5,690 Retained profit carried forward 6,365 6,090 STATEMENTS OF FINANCIAL POSITION AS AT 31 DECEMBER Total assets Tangible non-current assets (net) 6,315 5,600 Other non-current assets 800 750 7,115 6,350 Current assets Inventory 5,100 3,200 Receivables 2,900 1,900 Prepayments 100 100 Cash and bank 600 590 8,700 5,790 15,815 12,140 Equity and liabilities 350 Called up share capital Ordinary 50p shares authorised, issued and fully paid 350 350 Retained profits 6,365 6,090 6,715 6,440 8% loan stock (20Y0 – 20Y3) 5,500 3,300 Current liabilities 3,600 2,400 15,815 12,140

1. (Inventory valuation at 31 December 20X0 was $2,500,000)

2. (Receivables' balance at 31 December 20X0 totaled $1,700,000)

Typical industrial averages for 20X2 and 20X1 are as follows

Gross profit on sales 34% Acid test ratio 1.2:1 Net profit before tax on sales 11% Average age of receivables 30 days Net profit before tax on net assets employed 19.5% Average age of inventory 73 days Working capital ratio 2.5:1 Interest cover 8 times

Required

1.     Review and communicate parameters for variances in financial outcomes of the BHEL compared to year 20X1 of the financial statement and explains areas which may cause you some concern, describe the main matters (consider risk) which you would need to investigate for future decision making and risk minimisation. Write your response in 400-500 words.

Answer 1

Using the Basic formula we found out the the ratios that compare the company details with the industry average.

Assessing the ratios we figure out that the Gross profit on sales is similar to the Industry average and therefore it is not much of concern or risk variant to the company.

Going further we assess the net profit before tax on sales that there is 2%-3% drop in the net profit in comparison to the industry average which suggest that company has an increased level of indirect expense.

Net profit before tax to net asset employed is also one of the longterm profitability ratio that measure how efficiently a company can generate profits from the net assets employed. It shows how much profit each dollar of employed asset generate. Investors are concerned with ratio if the company is borrrowing at 10% and achiving a return less than 5 % then investors are loosing their money. Also if you see BHEL ltd. has way lower net profit before tax to net asset employed than industry average which is not a good sign and concerns directors attention and also is risky figure for the company.

Rest of the ratios are in accordance to the industry average also the increasing average age of recievable is not a good notion as it means that debtor who have to pay money to the company are taking more time for the payment.

Interest coverage Ratio is lower which means the company has high debt burden and greater is chances of bankcrupty and default. In this scenario you can see an increase in Interest coverage ratio which means company has started to borrow more and therefore negatively affecting both its interest coverage and Net profit before tax to net asset employed. And there fore it is not aggreeable to the directors who are infavour of making an issue.