39- Grow by Acquisition

39- Grow by acquisition

Expand is a large group that seeks to grow by acquisition. The directors of Expand have identified two potential target entities (A and B) and obtained copies of their financial statements. Extracts from these financial statements, together with notes providing additional information, are given below.

STATEMENTS OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME

YEAR ENDED 31 DECEMBER 20X1

A / B
$'000 / $'000
Revenue / 68,000 / 66,000
Cost of sales / (42,000) / (45,950)
Gross profit / 26,000 / 20,050
Other operating expenses / (18,000) / (14,000)
Profit from operations / 8,000 / 6,050
Finance cost / (3,000) / (4,000)
Profit before tax / 5,000 / 2,050
Income tax expense / (1,500) / (1,000)
Profit for the year / 3,500 / 1,050
Other comprehensive income (items that will not be reclassified to profit / NIL / 6,000
or loss)
Surplus on revaluation of properties
Total comprehensive income / 3,500 / 7,050

STATEMENTS OF CHANGES IN EQUITY YEAR ENDED 31 DECEMBER 20X1

AB

$'000$'000

Balance at 1 January 20X122,00016,000

Total comprehensive income for the year3,5007,050

Dividends paid(2,000)(1,000)

Balance at 31 December 20X123,50022,050

STATEMENTS OF FINANCIAL POSITION AT 31 DECEMBER 20X1

AB

$'000$'000$'000$'000

Non-current assets

Property, plant and equipment
Current assets
Inventories / 32,000
6,000 / 32,000 / 35,050
7,000 / 35,050
Trade receivables / 12,000 / 10,000
18,000 / 17,000
50,000 / 52,050
Equity
Issued capital ($1 shares) / 16,000 / 12,000
Revaluation reserve / Nil / 5,000
Retained earnings / 7,500 / 5,050
23,500 / 22,050
Non-current liabilities
Interest bearing borrowings / 16,000 / 18,000
Current liabilities
Trade payables / 5,000 / 5,000
Income tax / 1,500 / 1,000
Short-term borrowings / 4,000 / 6,000
10,500 / 12,000
50,000 / 52,050
Notes

1Sale by A to X

On 31 December 20X1, A supplied goods, at the normal selling price of $2.4 million, to another entity, X. A's normal selling price is at a mark up of 60% on cost. X paid for the goods in cash on the same day. The terms of the selling agreement were that A repurchase these goods on 30 June 20X2 for $2.5 million. A has accounted for the transaction as a sale.

2Revaluation of non-current assets by B

B revalued its non-current assets for the first time on 1 January 20X1. The non-current assets of A are very similar in age and type to the non-current assets of B. However, A has a policy of maintaining all its non-current assets at depreciated historical cost. Both entities charge depreciation of non-current assets to cost of sales. B has transferred the excess depreciation on the revalued assets from the revaluation reserve to retained earnings as permitted in IAS 16 – Property, plant and equipment.

Expand uses ratio analysis to appraise potential investment opportunities. It is normal practice to base the appraisal on four key ratios.

Return on capital employed / Turnover of capital employed
Gross profit margin / Leverage

For the purposes of the ratio analysis, Expand computes:

(i)Capital employed as capital and reserves plus borrowings

(ii)Borrowings as interest–bearing borrowings plus short-term borrowings

Your assistant has computed the four key ratios for the two entities from the financial statements provided and the results are summarised below.

Ratio / A / B
Return on capital employed / 18.4% / 13.1%
Gross profit margin / 38.2% / 30.4%
Turnover of capital employed / 1.6 / 1.4
Leverage / 46.0% / 52.1%

Your assistant has informed you that, on the basis of the ratios calculated, the performance of A is superior to that of B in all respects. Therefore, Expand should carry out a more detailed review of A with a view to making a bid to acquire it. However, you are unsure whether this is necessarily the correct conclusion given the information provided in Notes 1 and 2.

Required

(a)Explain and compute the adjustments that would be appropriate in respect of Notes 1 and 2 so as to make the financial statements of A and B comparable for analysis.

(b)Recalculate the four key ratios mentioned in the question for both A and B after making the adjustments you have recommended in your answer to part (a). You should provide appropriate workings to support your calculations.

(c)In the light of the work that you have carried out in answer to parts (a) and (b), evaluate your assistant's conclusion that a more detailed review of A should be carried out, with a view to making a bid to acquire it.