CASE STUDY - Relaxation Company Ltd.

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Q. 1(a)

(i)

 This description relates to the Statement of Profit and Loss (SPL) as the company is
spending on employing the staff which is an expense. It means the company is losing
money. Here the outflow of money is more in the form of the pay given to the employees.
 This description relates to the Statement of Financial Position (SOFP). The company
needs to get a loan to bear operating expenses. It means the company doesn’t have
enough funds or revenue to operate by itself. A general phenomenon is that when a
company doesn’t have enough funds to run the business smoothly on its own, company
owners have an option to get a loan to expand and operate smoothly.
(ii) Employing staff is a cost so it’s located in SPL with the heading of the cost of sales. The 2nd
statement will be located in SOFP with the heading of long-term borrowing in the liability
section.

Q. 1 (b) Briefly explain the purpose of these financial statements.

The Statement of Profit and Loss:

As the term denotes profit and loss so it is apparent that it is related to the financial position of a
company. It comprises the summary of revenues, cost or expenses, and profit and loss of a
company for a particular period or a whole fiscal year. By this statement, the company can get an
idea about its ability to increase sales and control expenses to get a maximum profit. It is also
called the Income Statement (Elliott and Uphoff, 1972).

The Statement of the Financial Position:

It provides realistic information and a clearer image of the company’s assets, liabilities, and
equity at a particular date or time. Stakeholders can get an idea about investment decisions.
Moreover, it helps in the analysis of the financial position of a company in comparison with
others. It is also called the balance sheet (Hasanaj and Kuqi, 2019).

The Statement of Cash Flows:

Q. 2 (a)

Solution:

9000−5550
% Change in total revenue = ✖ 100
5550

=62.1621%

(b). Calculate the Percentage of total Revenue:

The Retail Operations:

Solution:

6006
% Of total revenue contributed by retail operations = ✖ 100
9000

= 66.7333%

The online store:

1644
% Of total revenue contributed by online operations = ✖ 100
9000

= 18.2666%

The hotel contract:

1350
% Of total revenue contributed by hotel operations = ✖ 100
9000

= 15%

(c) Calculate the Gross Profit Margin Ratio:

The retail operations:

Gross profit
The Gross Profit Margin Ratio of retail operations = ✖ 100
Revenue

1800
= ✖ 100
6006

=29.9700%

The online store:

Gross profit
The Gross Profit Margin Ratio of online operations = ✖ 100
Revenue

494
= ✖ 100
1644

=30.0486%

The hotel contract:

Gross profit
The Gross Profit Margin Ratio of the hotel contract = ✖ 100
Revenue

581
= ✖ 100
1350

=43.0370%

(d) Difference between the Cost of Sales and Operating Expenses.

As the cost of sales refers to the money spent on business directly related to the sales for a
purpose of sale generation. We consider direct labor with the combination of raw materials for
the production and selling of the product. Packaging also carries a cost. Attractive packaging will
enhance the chances of sales. We can say that cost of sales is used to boost or acquire an asset for
business growth. While on the other hand, operating expenses are those expenses used to meet
the operating expenses of a business. In short, the expenses incurred for revenue generation
(Khalid and Khan, 2017).

(e) Operating Profit Margin Ratio

Solution:

544
The Operating Profit Margin Ratio of retail operations= ✖ 100
6006

= 9.0576%

The Online Store:

206
The Gross Profit Margin Ratio of the online store = ✖ 100
1644

= 12.5304%

The hotel contract:

123
The Gross Profit Margin Ratio of the hotel contract = ✖ 100
1350

= 9.1111%

(f) Reason for the higher operating profit margin ratio of the online store:

It is higher than other retail operations because the distribution costs of the online store are far
less than as compared to other segments. While the distribution cost for other retail operations is
high and due to this reason outflow of money is also high.

Q. 3 (a) Explain why depreciation is charged?

Fixed asset depreciation is charged to determine the right profit or loss on the sale, to display the
asset at its correct value on the balance sheet, and to prepare for its replacement. Depreciation
determines a company's genuine financial performance. The company charges depreciation even
if there is a profit or loss condition. Fixed assets stay in use even if there is loss and use
diminishes the asset's value, therefore depreciation is paid even in a loss year.

What are the effects on the value of PPE?

Depreciation minimizes the value and worth of property, plant, and equipment used for business
operations on the balance sheet. As described earlier the value of the above-mentioned assets
depreciates over time due to after-use damages or wear and tear and decreases its useful life. The
depreciation expense is recorded on the income statement as an expense. It is used to decrease
the worth of the net balance.

In accounting, accumulated depreciation is shown as a credit throughout the asset's useful life.
When a fixed asset is sold or retired, the item's credit value is debited for accrued depreciation. It
doesn’t affect net income (Jorgenson, 1996).

(b) The Capital gearing ratio in 2020 and 2019.

Solution:

1593
The Capital Gearing Ratio in 2020 =
1265

= “1.2592”

1440
The Capital Gearing Ratio in 2019 =
1173

= “1.2276”

The Interest cover ratio in 2020 and 2019

Solution:

EBIT
The Interest coverage ratio in 2020 =
Interest expenses

873
=
65

= “13.43”

EBIT
The Interest coverage ratio in 2019 =
Interest expenses

511
=
51

= “10.02”

(c)
The ratio related to finance is called the gearing ratio which compares and contrasts the stock
owned by the owner and to cash which is borrowed by the company. It is the most important
ratio to measure the financial condition of a company. It measures financial leverage and
financial risk. If a company has too much debt, its financial condition can be in danger. A high
gearing ratio means a high debt-to-equity ratio and vice versa (Bird, 1973)

With the help of the interest coverage ratio, a company can notice how many times its earnings
can cover its payments for existing interest. In other words, we can say that it calculates the
margin of safety for a company over a specific period for paying interest on its debt. A larger
ratio is preferable. A corporation may have trouble paying its interest if the ratio is lower than
1.5 (Setiany, 2021).

Q4: Interpreting Relaxation’s Statement of the Cash Flows

Relaxation company was working as a retail business in the start for 10 years and sales were
steady over the year. Relaxation started an online store in April 2020. Initially, the Relaxation
Company was achieving its target for 9 months. Cost and selling prices were almost the same for
both. The problem which arises was that the company has to bear some additional costs in the
form of distribution channels and hiring more employees for customer support. Due to this
reason company cash outflows were greater than inflows.

Meanwhile, the company made a contract with the hotel to use its name and logo to skyrise its
sales. Although the company was earning a profit, the cash inflows were lower due to the rented
installment of machinery for the attachment of the logo and the second appointment of the
administrator to look after the activities.

In addition, the company has to pay its loan amount. The company decided to get more long-
term loans to fulfill its needs but the major reason here for fewer cash inflows was higher interest
rates. All these factors were creating hindrances in the company’s progress.

In the statement profit before tax for the year 2020 is higher as compared to 2019 so, the net cash
flow for the year 2020 is also lower than 2019. In short, We can see that cash flows for the year
2020 are far greater than the year 2019.

Q. 5: Recommendation
After an in-depth study of the case and by careful analysis of business financial ratios, the overall
condition of the company is clearer now. Although it was a good decision to move toward online
stores and hotel agreements to increase the profit. But according to me, it’s not a good decision.
The reason is the company already meeting its operating expenses by gaining loans. It means the
company’s financial position is not strong. The company has to pay most of the money, profit, or
cash inflow in the form of interest due to which there was not such a high gain as it could be.

Enlarging business or contracting with others increases the expenses. So, as per my knowledge
company’s financial position must be strong before taking any new step.

All the facts, figures, and ratios have been discussed above thoroughly.
References:

BIRD, P. 1973. What is Capital Gearing? Accounting and Business Research, 3, 92-97.
COLLINGS, S. 2016. The Statement of Cash Flows.
ELLIOTT, J. W. & UPHOFF, H. L. 1972. Predicting the Near Term Profit and Loss Statement with an
Econometric Model: A Feasibility Study. Journal of Accounting Research, 10, 259.
HASANAJ, P. & KUQI, B. 2019. Analysis of Financial Statements. Humanities and Social Science Research,
2, p17.
JORGENSON, D. W. 1996. Empirical studies of depreciation. Economic inquiry, 34, 24-42.
KHALID, W. & KHAN, S. 2017. Impact of Operating and Financial Expenses on Sales Revenue: The Case of
Fauji Fertilizer Company Limited. International Journal of Business and Economics Research, 6,
40-47.
SETIANY, E. 2021. The Effect of Investment, Free Cash Flow, Earnings Management, and Interest
Coverage Ratio on Financial Distress. Journal of Social Science, 2, 64-69.