Question

QUESTION 4 GANYO plc has embarked on a programme of growth through acquisitions and has identified Alpha Ltd and Beta Ltd as companies in the same industrial sector, as potential targets. Using recent financial statement of both Alpha and Beta and further information obtained from a trade association, GANYO plc has managed to build up the following comparability table Industrial Alpha Beta average Profitabilitv ratios ROCE before tax % Return on equity % Net profit margin % Gross profit margin % Activity ratios Total assets turnover- times Non-current asset turnover times Receivables collection period in weeks Inventory holding period in weeks Liquidity ratios Current ratio Acid test 28 20 15 25 12 20 12 8 6.5 21 13.5 1.8 2.8 0.5 0.9 Debt-equity ratio % 80 20 65 Required (a) Prepare a performance report for the two companies for consideration by the directors of GANYO plc indicating which of the two companies you consider to be a better acquisition. (13 marks) (b) Indicate what further information is needed before a final decision can be made. (2 marks) (c) Briefly explain seven limitations of ratio analysis. (5 marks)

Answer 1

(c)

1)Diversified product lines:Many businesses operate a large number of divisions in quite different industries In such cases ratios calculated on the basis of aggregate data cannot be used for inter-firm comparisons.

2)Financial data are badly distorted by inflation :historical cost values may be substantially different from true values. Such distortions of financial data are also carried in the financial ratios.

3)Differences in accounting policies and period : it can make the accounting data of two firms non comparable as also the accounting ratios .

4)There is no standard set of ratio :Sometimes a firm's ratios are compared with industry average .But if a firm desires to be above the average then industry average becomes a low standard .

5)It is very difficult to generalise whether a particular ratio is good or bad:For example, a low current ratio may be said bad from point of view of low liquidity, but a high current ratio may not be good as may result from inefficient management

6)interrelated, not independent :Viewed in isolation one ratio may highlight efficiency .But when considered as a set of ratios they may speak differently.

7)Seasonal factors may also influence financial data:Liquidity and inventory ratios will produce biased picture . Year and picture may not be the average picture of business .Even in some cases monthly inventory figures may not be available.