Amalgamated Engineering plc makes specialised machiner y for several industries. In recent years, the company has faced severe competition from overseas businesses, and its sales volume has hardly changed. The company has recently applied for an increase in its bank overdraft limit from £750,000 to £1,500,000. The bank manager has asked you, as the bank’s credit analyst, to look at the company’s application.

You have the following information:

(i) Balance sheets as at 31 December 20X5 and 20X6:

696 • Interpretation 20X5 20X6

£000 £000 £000 £000 Tangible non-cur rent assets Freehold land and buildings, at cost 1,800 1,800 Plant and equipment, at net value 3,150 3,300 4,950 5,100 Cur rent assets Inventor y 1,125 1,500 Trade receivables ,825 1,125 Short-term investments ,300 —

2,250 2,625 Cur rent liabilities Bank overdraft ,225 ,675 Trade payables ,300 ,375 Taxation payable ,375 ,300 Dividends payable ,225 ,225 1,125 1,575 Net current assets 1,125 1,050 6,075 6,150 Long-term liability 8% debentures, 20X9 1,500 1,500 4,575 4,650 Capital and reser ves Ordinar y shares of £1 each 2,250 2,250 Share premium account ,750 ,750 Retained earnings 1,575 1,650 4,575 4,650

(ii) Profit and loss accounts for the years ended 31 December 20X5 and 20X6:
Review of financial ratio analysis • 697 20X5 20X6 £000 £000 £000 £000 Turnover 6,300 6,600 Cost of sales: materials 1,500 1,575 : labour 2,160 2,280 : production : overheads ,750 ,825 4,410 4,680 1,890 1,920 Administrative expenses 1,020 1,125 Operating profit ,870 ,795 Investment income , 15 —
,885 ,795 Interest payable: debentures ,120 ,120 : bank overdraft , 15 , 75 ,135 ,195 Profit before taxation ,750 ,600 Taxation ,375 ,300 Profit attributable to shareholders ,375 ,300 Dividends ,225 ,225 Retained earnings for year ,150 , 75 You are also provided with the following information:
(iii) The general price level rose on average by 10% between 20X5 and 20X6. Average wages also rose by 10% during this period.
(iv) The debenture stock is secured by a fixed charge over the freehold land and buildings, which have recently been valued at £3,000,000. The bank overdraft is unsecured.
(v) Additions to plant and equipment in 20X6 amounted to £450,000: depreciation provided in that year was £300,000.
Required:

(a) Prepare a cash flow statement for the year ended 31 December 20X6.

(b) Calculate appropriate ratios to use as a basis for a report to the bank manager.

(c) Draft the outline of a report for the bank manager, highlighting key areas you feel should be the subject of further investigation. Mention any additional information you need, and where appropriate refer to the limitations of conventional historical cost accounts.

(d) On receiving the draft report the bank manager advised that he also required the following three cash-based ratios:
(i) Debt service coverage ratio defined as EBITDA/annual debt repayments and interest.
(ii) Cash flow from operations to current liabilities.
(iii) Cash recovery rate defined as ((cash flow from operations  proceeds from sale of fixed assets)/average gross assets)  100 The director has asked you to explain why the bank manager has requested this additional information given that he has already been supplied with profit-based ratios.