Question

You are the audit senior on the audit of Easy Fit Pty Limited, a large manufacturer of shoes. Easy Fit Pty Limited’s main market lies with 18 to 24-year olds. This is the first year in which your firm has performed the audit. As part of the planning work, you have performed analytical procedures on an annualised basis and compared the results to industry averages and last year’s audited financial information. The results are given below: Industry Average Easy Fit Pty Limited Ratio 20X7 20X6 20X7 20X6 1 Current ratio 2.84 3.27 1.89 2.24 2 Receivables turnover ratio 4.9 4.6 6.3 7.0 3 Inventory turnover ratio 3.7 3.8 5.0 5.5 4 Return on total assets 7% 5% 13% 11% 5 Net profit ratio 0.06 0.06 0.04 0.04 Required: Explain the general meaning of each of the above ratios (1 - 5), discuss the conclusions that you can draw about Easy Fit’s financial position and identify potential audit risks to be investigated further.

Answer 1

Hello buddy, before I start answering i'll just list down the ratios using proper rows and columns.

	INDUSTRY	INDUSTRY	EFPL	EFPL
Ratios	20X7	20X6	20X7	20X6
Current Ratios	2.84	3.27	1.89	2.24
Receivables T/o Ratio	4.9	4.6	6.3	7.0
Inventory T/o Ratio	3.7	3.8	5.0	5.5
Return on Total Assets	7	5	13	11
Net Profit Ratio	0.06	0.06	0.04	0.4

1) Meaning of all ratios

Current Ratio - It shows how many times can the current assets of a company satisfy its current liabilities.If the current ratio is 2, it means its current assets are twice its current liabilities. Similarly, current ratio of 1 implies that current assets = current liabilities. Formula Current Ratio = Current Assets / Current Liabilities

Receivables T/o Ratio - It shows how many times are the receivables collected in a given period. For eg, a ratio of 5 implies that in a year, a company collects its receivables 5 times. Formula = Net Credit Sales / Average Trade Receivables.

Inventory T/o Ratio - It measures the number of times inventory is sold or consumed in a given time period. For eg a ratio of 4 would indicate that in a year the company has rotated its inventory 4 times. Formula - Cost of Goods Sold / Average Inventory.

Return on Total Assets - It measures the amount company has earned by effectively utilizing its assets. It is a measure of efficiency of utilization of assets. The higher the return, the more effective is the use. Formula - Net Profit/Total Assets x 100.

Net Profit Ratio - Indicates the net amount earned by an organization by the total revenue generated by it. It is calculated after considering all expenses including depreciation, interests and taxes. Formula - Net Profit / Total Sals.

2) Conclusions about EFPL's financials and potential audit risks to be identified -

Current Ratio - Both, the industry's as well as EFPL's current ratios have fallen as compared to the previous year, indicating a liquidity crunch that the entire industry is facing and not just a single firm. However, it is to the firms to ensure that they are able to control and survive such liquidity crunch.

Receivables T/o Ratio - Though EFPL's ratio has fallen a bit as compared to its previous year, it is still in a much better position as compared to the industry, which means it is more effecting in collections from debtors, thus also indicating the liquidity position of its debtors as well.

Inventory T/o Ratio - Similar to the above ratio, EFPL is also more efficient in rotating its inventory as compared to the industry. This is a good position to be in as it shows that the working capital of the company is freed up much quicker than the industry.

Return on Total Assets - There are many ways to interpret this ratio, one can say that its generating excellent returns on its assets, almost double than that of the industry. But this also can mean that it is over utilizing its assets which in the longer run can lead to increased repair and maintenance costs.

Net Profit Ratio - This does show that EFPL is underperforming here. However the position of the industry is not convincing either. So it is possible that it is a low growth industry.

Potential Audit Risks to be investigated further can include 1) Are the assets being over utilized than their normal capacity? any threats in form heavy capital expenditure that may be incurred by the firm? 2) If EFPL faces another bad year or two, will it be able to survive given the declining trend of current ratio of the industry.

I hope the above solution is what you were looking for. For any further queries or doubts in the solution, please feel free to drop a comment. Please do leave a positive feedback, Thank you :)