ADA Plc: Essay On Cash Flows, Profitability, Liquidity & Gearing.

Cash flows from operating activities

Answer 1: Option B, 22.22%.

Answer 2: Option D, Public limited company’s shares are traded on the secondary market.

Answer 3: Option A, £1,125.

Answer 4: Option A, During an inflationary period profit are lower under LIFO than FIFO.

Answer 5: Option D, Profit will decrease by £250.

Answer 6: Option B, Expenses will decrease, profit will increase.

Answer 7: Option C, Share capital will increase.

Answer 8: Option C, 126,000 ordinary shares.

Answer 9: Option A, Taxation expense

Answer 10: Option B, Only Statement B is correct.

Requirement (A):

Requirement (B):

As per the question, the company ADA Plc has a negative net cash used in investing activities and a positive net cash from financing activities. The reasons for the same can be extracted from the given set of financials for the company. When it comes to investing cash flows, the statement of financial position illustrates some form of capital investment which is made in the plant and machinery asset. This is because there has been an investment worth £10,000 which is confirmed as the sum of closing balance and depreciation minus the opening balance (55+25-70). Hence any capital investment will require cash flowing out of the business as a result of which investing cash flows are negative. Negative investing cash flows does imply any form of adversity as the company is indulging in some form of growth, expansion or replacement which is in best interests of the business. Lastly, when it comes to the financing cash flows, there is no such change in the value of debentured but the value of ordinary shares have increased from £51,000 in 2020 to £61,000 in 2021 suggesting that the company has raised equity finances by issuing 10,000 ordinary shares of £1 each resulting in a total worth £10,000 increase in the value of ordinary share capital. In case of an issue, cash flows into the business that confirms the positive cash flows. There may be a plethora of reasons for the same but the most visible reason for raising equity is to probably finance the investment requirements.

The profitability of the company can be gauged with the help of gross profit margin ratio and the operating profit margin ratio. The overall profitability performance of the company has deteriorated when compared against the results of the previous financial year. The gross profit ratio gauges the proportion of sales left behind after covering the direct costs which are the company’s cost of sales. The metric has deteriorated from 50% in 2020 to 44% in 2021 which is because of a decline in the total sales revenue and a relative increase in the cost of sales of the company (cost of sales in proportion to revenue). The operating profit margin ratio is the profitability in the ordinary course of operations and gauges the proportion of revenue that is left behind after meeting the direct costs as well as the indicated costs which are an entity’s operating expenses. The metric has declined from 26.67% in 2020 to 20% in 2021 because of the same reasons discussed above alongside a relative increase in operating expenses (operating expenses proportionate to sales revenue).

The liquidity position of the company can be evaluated with the help of the current ratio and the acid test ratio. The term liquidity also refers to the short term solvency which means the ability of the company in relying upon their short term resources (current assets) for meeting their short term debts (current liabilities). While the current ratio considers the total current assets, the acid test ratio prudently eliminates inventory from the total current assets therefore relying upon quick assets to meet current debts. The current ratio of the company has noticeably declined from 2.25 times in 2020 to 1.83 times in 2021 which is because of a decline in closing inventory. However, the quick ratio remains the same at 1 time. Although the liquidity position has deteriorated, the company still has just about sufficient liquid assets for meeting the current liabilities for the metric results are at 1 or above.

The gearing ratio of the company refers to the reliance upon debt capital forming a part of the total capital structure for financing the operations of the company. Debts may lure companies to depend upon it as it is cheaper and have tax benefits but an increasing amount is a cause of concern for interest expenses are statutory and can increase the risk of default if the company’s operating conditions are not favourable. The company’s gearing levels have increased significantly from 46.67% in 2020 to 80% in 2021 because of an increase in loan notes and a decline in total equity. This means that the debt to equity mix of the company has increased and the capital structure is not optimum. This puts the company in an unfavourable solvency position as the risk of financial leverage is high. The interest coverage ratio of the company measures the total number of times a company can meet its interest expense from its available operating profits. The metric has although improved from 1.6 times in 2020 to 2.5 times in 2021 which is a favourable sign given the increase in debts which will result in an increase in interest expense over the future.