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SCI-FI GEEKS LTD The business trades in electronic equipment purchased from China - NSC Accounting - Question 3 - 2020 - Paper 1
Question 3
SCI-FI GEEKS LTD The business trades in electronic equipment purchased from China. The information relates to the past two financial years, ended 31 March. The COVI... show full transcript
Worked Solution & Example Answer:SCI-FI GEEKS LTD The business trades in electronic equipment purchased from China - NSC Accounting - Question 3 - 2020 - Paper 1
Step 1
Liquidity: Explain why you would disagree with the directors' assessment.
Answer
The directors are overly optimistic about the liquidity situation. While the current ratio and acid-test ratio show improvements, it is essential to look deeper into the underlying financial health of the company.
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Current Ratio:
- The current ratio improved from 1.1:1 to 1.2:1, indicating a better short-term solvency position. However, the stability of this ratio should be considered, especially in the context of the economic downturn due to COVID-19.
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Acid-Test Ratio:
- The acid-test ratio increased from 0.9:1 to 1.1:1, suggesting that the company's ability to cover immediate liabilities with liquid assets has also improved. Despite this, caution is warranted, as a ratio closer to 1 may still indicate vulnerability in a crisis.
Both ratios reflect favorable trends, but the company’s increased stock holding period and rising debt levels are concerning. These factors may imply that the company is struggling to convert inventory into cash efficiently, which can lead to liquidity issues.
Step 2
Dividends: Comment on the dividend per share over the two years.
Answer
The dividend per share (DPS) showed a decrease from 90 cents to 72 cents, which marked a 20% reduction. This decline indicates that the company is prioritizing cash flow over shareholder returns, possibly due to liquidity constraints arising from the pandemic.
Dividend Payout Ratio: The payout ratio varied from 69% to 136.5%, indicating a substantial shift. An increase to above 100% suggests that the company may be paying out more than it earns, which is not sustainable in the long run.
A possible reason for this could be the directors' decision to reduce dividends to allocate funds for business operations and to stabilize the financial situation during uncertain times (e.g., reduced sales due to COVID-19).
Step 3
Explain why you might agree with the shareholder's view on dividends.
Answer
I would agree with the shareholder on the notion that receiving dividends is preferable to not receiving any at all, especially in light of the challenging financial context. Last year's dividends were better, yet being able to receive anything in the current climate shows the company is still committed to returning value to its shareholders. This is crucial for maintaining investor confidence.
However, the significant reduction in the DPS could indicate underlying issues that need to be addressed. The overall view should align with recognizing that managing cash flow prudently in uncertain times is also vital.
Figures to note:
- DPS in the previous year: 90 cents
- DPS in the current year: 72 cents
Step 4
Risk and gearing: Comment on the risk and gearing for both years.
Answer
The debt/equity ratio has changed from 0.3:1 to 0.4:1, indicating a slight increase in the company’s financial leverage. This increase from a relatively low gearing level to a moderate level suggests the company's reliance on debt has become more pronounced, which can elevate financial risk, especially under adverse conditions.
Return on Total Capital Employed (ROTCE): The ROTCE decreased from 39% to 23.2%, reflecting a significant drop of 15.8 percentage points. This decline suggests that, despite the increased borrowing, the effectiveness of using that capital to generate returns has weakened, possibly due to reduced sales and operational challenges.
Thus, while the company has maintained a level of gearing that is manageable, the increase in debt levels alongside a significant drop in profitability places it at a higher risk. The reliance on borrowed capital may lead to increased vulnerability in uncertain economic conditions.