Question

You are the audit senior on the audit of EasyFit Pty Limited, a large manufacturer of shoes. EasyFit 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		EasyFit Pty Limited
	Ratio	2018	2017	2018	2017
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
6	Gross margin	0.20	0.26	0.20	0.18

Required:

Explain the general meaning of each of the above ratios, discuss the conclusions that you can draw about EasyFit’s financial position and identify potential audit risks to be investigated further.

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Answer 1

1.Current ratio is one of the liquidity ratio which measures the short term financial obligations paying capacity. This can be expressed current asset as a percentage of current liabilities. Current ratio = current asset /current liability.

Ideal current ratio is 2 : 1. This shows the efficiency with which the business is able to repay it's current liability with the help of it's available current assets.

Current ratio of Easy fit pty Limited is decreasing over thr period and also low as comparison with industries average. It can be said that short term liquidity of the company is not as much expected. it should improve it.

2. Receivable turnover ratios shows the number of times per year that a business collects its average account receivable. This ratio is higher the better. In case of Easy fit pty Limited receivable turnover ratio is decreasing over the period however it is over and above the industries average so it can be considered as good. The company is efficient in collecting from debtor.

3. inventory turnover ratio shows the ability of a company to generate number of times sales. This ratio is higher the better as it shows how much better the company is in generating the sale quickly.

Inventory turnover ratio = cost of goods sold /average inventory.

In this case the company has better inventory turnover ratios it means the company is converting inventory in to sales very quickly than Industries average. and it is a good sign for the company.

4. Return on total asset is the net income expressed as a percentage of total asset. Sometimes in place of net income earning before interest and tax is also used. This ratio is higher the better. Industry has 5 and 7% of return on net asset whereas the company has 13 and 11% respectively. This shows that company is far better than the industry average in generation of net income by efficient use of its total asset.

5. Net profit ratio is one of the profitability ratio which shows the net profit as a percentage of revenue. It shows the efficiency with which the company is able to generate net income on the gross revenue. Net profit ratio is higher the better. In this case the company has 4% of net profit margin was the industry has 6% of net profit margin. So Easy fit pty Limited is not matching the industry standard in profit generation capacity. The company should minimise the expenses to match the industry standard.

6. Gross margin ratio is the another profitability ratio which shows the gross profit as a percentage of net revenue. Gross profit ratio = ( gross profit / net sales )×100

Gross margin ratio is higher the better. in year 2017 the gross margin ratio of the company is lower than the industries average but in year 2018 the company is able to cope up with the industry average of 20%. It shows the sincereness of company that it is working towards improvement.

On the basis of the overall comparison and discussion we can say that in most of the measure Easy fit pty Limited is performing better than its Industries average. only the current ratio is lower than the industry average even though it near the ideal ratio.

The company is good. As far as the potential audit risk is concerned we should focus on the sales purchase entry to determine the gross profit ratio. There is a wide variation in the gross profit ratio from year to year. This may indicate the manipulation in the inventory valuation to adjust the profit. The other thing almost seems good. However in detail evaluation of internal control as well as section of sample from the transactions will put us in a position to comment over some risk associated in the business.