Question

Part B

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

20X2

20X1

Industry Average

1

Gross Profit on Sales

Gross Profit/Sales

7500/23500

6500/20500

31.91%

31.71%

34%

The gross profit ratio for 20X2 and 20X1 is less than the industry average of 34% which is a concern for the company

2

20X2

20X1

Industry Average

Net Profit before tax on sales

Net profit before tax/Sales

2000/23500

1700/20500

8.51%

8.29%

11%

The Net profit before tax on sales ratio for 20X2 and 20X1 is less than the industry average of 11% which is a concern for the company

3

20X2

20X1

Industry Average

Net profit before tax on net assets employed

2000/(15815-3600)

1700/(12140-2400)

16.37%

17.45%

19.50%

The Net profit before tax on net assets employed ratio for 20X2 and 20X1 is less than the industry average of 19.50% which is a concern for the company

4

20X2

20X1

Industry Average

Working capital Ratio

Current assets/Current liabilities

8700/3600

5790/2400

2.5 : 1

2.42 : 1

2.41: 1

The working capital ratio is marginally less than the industrial average of 2.5 : 1

5

20X2

20X1

Industry Average

Acid Test Ratio

Current assets - stock-prepayments/Current liabilities

(8700-5100-100)/3600

(5790-3200-100)/2400

0.97 : 1

1.04 : 1

1.2 : 1

The acid test ratio is less than the industry average of 1.2 which is concern for the company

6

20X2

20X1

Industry Average

Average age of receivables

365/Receivable turnover ratio

365/(23500/(2900+1900)/2))

365/(20500/(1900+1700)/2))

37 days

32 days

30 days

The average age of receivables as per industry average is 30 days and the company’s average age of receivables is more which is concern for the company as it takes more days for the company to recover the receivables

7

20X2

20X1

Industry Average

Average age of Inventory

365/Inventory turnover ratio

365/(16000/(5100+3200)/2)

365/(14000/(2500+3200)/2)

95 days

65 days

73 days

The average age of inventory has increase from 65 days to 95 days which is concern for the company as it is more than the industry average of 73 days

8

20X2

20X1

Industry Average

Interest Cover

EBIT/Interest

2500/500

2000/300

5

6.666666667

8 times

The interest cover has reduced in 20X2 to 5 times from 6.67 times in 20X1 which is a concern for the company as it is less than 8 times which is the industry average