Note: References to 20X6 and 20X5 are to the years ending 31 March 20X6 and 20X5

respectively.
Comment (1)
I see the profit for the year has increased by $1m which is up 20% on last year, but I thought it
would be more as Tamsin Co was supposed to be a very profitable company.
There are two issues with this statement: first, last year’s profit is not comparable with the current
year’s profit because in 20X5 Gregory Co was a single entity and in 20X6 it is now a group with a
subsidiary. A second issue is that the consolidated statement of profit or loss for the year ended
31 March 20X6 only includes six months of the results of Tamsin Co, and, assuming Tamsin Co
is profitable, future results will include a full year’s profit. This latter point may, at least in part,
mitigate the CEO’s disappointment.
Comment (2)
I have calculated the EPS for 20X6 at 13 cents (6,000/46,000 x 100 shares) and at 12·5 cents for
20X5 (5,000/40,000x 100) and, although the profit has increased 20%, our EPS has
barely
changed.
The stated EPS calculation for 20X6 is incorrect
for two reasons; first, it is the profit attributable to only the equity shareholders of the parent which
should be used and second, the 6 million new shares were only in issue for six months and should
be weighted by 6/12.
Thus, the correct EPS for 20X6 is 13.3 cents (5,700/43,000 x 100). This gives an increase of 6%
(13.3–12·5)/12·5) on 20X5 EPS which is still less than the increase in profit. The reason why the
EPS may not have increased in line with reported profit is that the acquisition was financed
by a share exchange which increased the number of shares in issue. Thus, the EPS takes
account of the additional consideration used to generate profit, whereas the trend of
absolute
profit does not take additional consideration into account. This is why the EPS is often
said to be a more accurate reflection of company performance than the trend of profits.
Comment (3)
I am worried that the low price at which we are selling goods to Tamsin Co is undermining our
group’s overall profitability. Assuming the consolidated financial statements have been
correctly prepared, all intra-group trading has been eliminated, thus the pricing policy will
have had no effect on these financial statements. The comment is incorrect and reflects a
misunderstanding of the consolidation process.
Comment (4)
I note that our share price is now $2·30, how does this compare with our share price immediately
before we bought Tamsin
Co?
The increase in share capital is 6 million shares, the increase in the share premium is $6m, thus
the total proceeds for the 6 million shares was $12m giving a share price of $2·00 at the date of
acquisition of Tamsin Co. The current price of $2·30 presumably reflects the market’s favourable
view of Gregory Co’s current and future performance.
(b)
20X6
20X5
(i)
Return on capital employed (ROCE) (7,500/74,300 x 100)
10·1%
11·3%
(ii)
Net asset turnover (46,500/74,300)
0·63 times
0·53 times
(iii)
Gross profit margin (9,300/46,500 x 100)
20·0%
25·7%
(iv)
Operating profit margin (7,500/46,500 x 100)
16·1%
21·4%
Looking at the above ratios, it appears that the overall performance of Gregory Co has declined
marginally; the ROCE has fallen from 11·3% to 10·1%. This is has been caused by a substantial
fall in the gross profit margin (down from 25·7% in 20X5 to 20% in 20X6); this is over a
22% (5·7%/25·7%) decrease. The group/company have relatively low operating expenses(at
around 4% of revenue), so the poor gross profit margin feeds through to the operating profit
margin. The overall decline in the ROCE, due to the weaker profit margins, has been
mitigated by an improvement in net asset turnover, increasing from 0·53 times to 0·63
times. Despite the
improvement in net asset turnover, it is still very low with only 63 cents of sales generated from
every $1 invested in the business, although this will depend on the type of business Gregory Co
and Tamsin Co are engaged in. On this analysis, the effect of the acquisition of Tamsin Co
seems to have had a detrimental effect on overall performance, but this may not
necessarily be the case; there could be some distorting factors in the analysis. As mentioned
above, the 20X6 results include only six months of Tamsin Co’s results, but the statement of
financial position includes the full amount of the consideration for Tamsin Co. [The
consideration has been calculated (see comment (4) above) as $12m for the parent’s 75% share
plus $3.3m (3,600 –300 share of post-acquisition profit) for the non-controlling interest’s 25%,
giving total consideration of $15.3m.] The above factors disproportionately increase the
denominator of ROCE which has the effect of worsening the calculated ROCE. This
distortion should be corrected in 20X7 when a full year’s results for Tamsin Co will be included
in group profit. Another factor is that it could take time to fully integrate the activities of the
two companies and more savings and other synergies may be forthcoming such as bulk
buying discounts. The non-controlling interest share in the profit for the year in 20X6 of
$300,000 allows a rough calculation of the full year’s profit of Tamsin Co at $2·4m (300,000/25%
x 12/6, i.e. the $300,000 represents 25% of 6/12 of the annual profit). This figure is subject to
some uncertainty such as the effect of probable increased post-acquisition depreciation
charges. However, a profit of $2·4m on the investment of $15.3m represents a return of 16%
(and would be higher if the profit was adjusted to a pre-tax figure) which is much higher than the
current year ROCE (at 10·1%) of the group. This implies that the performance of Tamsin Co is
much better than that of Gregory Co (as a separate entity) and that Gregory Co’s performance in
20X6 must have deteriorated considerably from that in 20X5 and this is the real cause of the
deteriorating performance of the group. Another issue potentially affecting the ROCE is that,
as a result of the consolidation process, Tamsin Co’s net assets, including goodwill, are
included in the statement of financial position at fair value, whereas Gregory Co’s net assets
appear to be based on historical cost (as there is no revaluation surplus). As the values of
property, plant and equipment have been rising, this effect favourably flatters the 20X5 ratios.
This is because the statement of financial position of 20X5 only contains Gregory
Co’s assets which, at historical cost, may considerably understate their fair value and, on a
comparative basis, overstate 20X5 ROCE.
In summary, although on first impression the acquisition of Tamsin Co appears to have caused a
marginal worsening of the group’s performance, the distorting factors and imputation of the non-
controlling interest’s profit in 20X6 indicate the underlying performance may be better than the
ratios portray and the contribution from Tamsin Co is a very significant positive. Future
performance may be even better. Without information on the separate financial statements of
Tamsin Co, it is difficult to form a more definite view.
The four observations made by the CEO are
(1) I see the profit for the year has increased by $1m which is up 20% on last year, but I thought it
would be more as Tamsin Co was supposed to be a very profitable company.
The profit might have not increased as per the expectations of the CEO as the cost of sales has
increased by almost 78% compared to the last year. Cost of sales is a major factor contributing to
the low profit earned. Profit can be increased by increasing further sales and reducing costs to a
minimum level. There might be price inflation. This also indicates that the costs are increasing at a
higher rate than the sales which was only 66% compared to the last year.
(2) I have calculated the earnings per share (EPS) for 20X6 at 13 cents (6,000/46,000 x 100) and
for 20X5 at 12·5 cents (5,000/40,000 x 100) and, although the profit has increased 20%, our EPS
has barely changed.
Earning per share is affected by 2 factors; profit and number of shares, there was a rise in number
of shares due to the acquisition of Tamsin co. and the profit has not increased in the same
percentage as the number of shares. The profits available to the shareholders is after tax and
other expenses. Profit margin could be increased by reducing the cost levels.
(3) I am worried that the low price at which we are selling goods to Tamsin Co is undermining our
group’s overall profitability.
The goods sold to Tamsin co will not affect the group's overall profitability as the unrealised profit
is subtracted from the inventory and from retained earnings. Selling goods to group companies at
any margin would not impact the consolidated profit. Value of sales against the customers are
considered. The profitability could be increased if the focus is shifted to increasing sales and
reducing costs. The synergy of Tamsin co shall also be considered for the same.
(4) I note that our share price is now $2.30, how does this compare with our share price
immediately before we bought Tamsin Co?

Calculation of ratios for the year ended 31 march x6 and x5

working working
Ratio Formula 31/3/x6 31/3/x5
s s
Operating
profit/Capital
employed*100 CE=
CE= 7500/74300*1
Capital 77500- 6000/53000*1
ROCE 101600- 00
employed 24500 00
(%) 27300 =10.09
(CE)= total = =11.32
=74300
assets - 53000
Current
liabilities
Asset
Revenue/Net 46500/101600 28000/77500
turnover
assets =0.46 =0.36
(times)
Gross
Gross
profit 9300/46500 7200/28000
profit/Sales*10
margin = 20 = 25.7
0
(%)
Operatin
operating
g profit 7500/46500 6000/28000
profit/sales*10
margin =16.13 =21.43
0
(%)