Chapter-2Chapter-2Basic AnalysisBasic Analysis

ProceduresProcedures&&

Chapter 3Chapter 3Analytical MixAnalytical Mix

DEPARTMENT OF ACCOUNTINGDEPARTMENT OF ACCOUNTING

Introduction

FACULTY OF BUSINESS ADMINISTRATIONFACULTY OF BUSINESS ADMINISTRATIONAIUBAIUB

BASIC ANALYSIS PROCEDURES & ANALYTICAL MIX

Table of Contents:

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2.1 Introduction 32.2 Who carries out analysis 32.3 Types of Analysis 32.4 Ratios to Determine Strength & Weaknesses 4

2.5. Types of Ratios 72.6 72.7 Limitation of Financial Statements Analysis 8

2.1. Introduction

Financial statement analysis is the process of examining relationships among financial statement elements and making comparisons with relevant information. It is a valuable tool used by investors and creditors, financial analysts, and others in their decision-making processes related to stocks, bonds, and other financial instruments. The goal in analyzing financial statements is to assess past performance and current financial position and to make predictions about the future performance of a company. Investors who buy stock are primarily interested in a company's profitability and their prospects for earning a return on their investment by receiving dividends and/or increasing the market value of their stock holdings. Creditors and investors who buy debt securities, such as bonds, are more interested in liquidity and solvency: the company's short-and long-run ability to pay its debts. Financial analysts, who frequently specialize in following certain industries, routinely assess the profitability, liquidity, and solvency of companies in order to make recommendations about the purchase or sale of securities, such as stocks and bonds.

Analysts can obtain useful information by comparing a company's most recent financial statements with its results in previous years and with the results of other companies in the same industry. Three primary types of financial statement analysis are commonly known as horizontal analysis, vertical analysis, and ratio analysis.

2.2. Who Carries Out Analysis?

A business must rely on an accountant to prepare financial statements and carry out an important analysis based on these reports. An accountant compiles the information provided by business statements, reviews them with the help of business representatives, and audits the final reports to ensure their accuracy. So, the first task to ensure accurate financial analysis is to hire the services of an expert accountant. Financial statement analysis involves the comparison of information of one entity over different periods of time or the comparison of information of different entities during the same period. The four main statements that are analyzed during the procedure include the balance sheet, income statement, statement of owner's equity, and

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statement of cash flows. The remaining part of the discussion provides information on the three important methods of financial statement analysis-

2.3. Types of Analysis

2.3.1. HORIZONTAL ANALYSIS

A horizontal analysis compares two or more years of a company's financial statements. The analyst can find the same information from different years by reading across the page. In comparing dollar figures and percentages in this way, differences from year to year are easy to find. A variation of the horizontal analysis is called the trend analysis. The trend analysis starts with the first year a company is in business, also known as the base year. The base year percentages are shown as 100 percent, and the increase or decline in percentages can be easily shown.

When an analyst compares financial information for two or more years for a single company, the process is referred to as horizontal analysis, since the analyst is reading across the page to compare any single line item, such as sales revenues. In addition to comparing dollar amounts, the analyst computes percentage changes from year to year for all financial statement balances, such as cash and inventory. Alternatively, in comparing financial statements for a number of years, the analyst may prefer to use a variation of horizontal analysis called trend analysis. Trend analysis involves calculating each year's financial statement balances as percentages of the first year, also known as the base year. When expressed as percentages, the base year figures are always 100 percent, and percentage changes from the base year can be determined.

With the help of horizontal financial analysis, you can compare a business entity over different months or defined periods within a fiscal year. For example, revenue generated over different months of a year can be compared to analyze the overall performance of business or a particular project.

An accountant can follow one of the two given below methods to conduct a horizontal financial analysis:

Dollar analysis is the first way method of horizontal financial analysis in which the amounts in absolute dollars of various items are compared for an entity over different periods of time. This type of analysis helps analyze the spending trend of a business. Besides, it also helps analyze the effects of external factors like rise in prices over business expenditures.

Percentage analysis is based on the change in different items over different periods of time calculated in terms of percentage. With the help of this type of analysis, the performance of a small business can be compared to that of a large business in the same industry.

2.3.2. VERTICAL ANALYSIS

Vertical analysis is called such because the corporation's financial figures are listed vertically on the financial statement. This type of analysis involves the calculation of percentages of a single financial statement. The figures on this financial statement are taken from the company's income statement and balance sheet. Vertical financial statement analysis is also known as component percentages.

When using vertical analysis, the analyst calculates each item on a single financial statement as a percentage of a total. The term vertical analysis applies because each year's figures are listed vertically on a financial statement. The total used by the analyst on the income statement is net sales revenue, while on the balance sheet it is total assets. This approach to financial statement analysis, also known as component percentages, produces common-size financial statements. Common-size balance sheets and income statements can be more easily compared, whether across the years for a single company or across different companies.

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Introduction

This involves the procedure of comparing different figures of separate entities to one specific figure of an entity for one specific period of time. This type of analysis is of great significance in carrying out the decision making process. An accountant can also expand the vertical analysis by comparing the figures of one specific period with those of another period.

Analysis of the balance sheet is one good example of carrying out vertical financial analysis. Each item of the balance sheet can be compared to the total assets calculated. Vertical analysis is useful for answering the questions related to business liabilities and equity. This type of analysis is also referred to as common-size analysis.

2.3.3. RATIO ANALYSIS

A ratio: Is the mathematical relationship between two quantities in the form of a fraction or percentage.Ratio analysis: is essentially concerned with the calculation of relationships which after proper identification and interpretation may provide information about the operations and state of affairs of a business enterprise.

There are several types of ratio analysis that can be used in interpreting financial statements. Ratios may be computed for each year's financial data and the analyst examines the relationship between the findings, finding the business trends over a number of years.

Balance sheet ratio analysis determines a company's ability to pay its debts and how much the company relies on creditors to pay its bills. This is an important indicator of the financial health of the corporation.

Liquidity ratios show how well the company is able to turn assets into cash. When evaluating the liquidity ratio, an analyst looks at the working capital, current ratio and quick ratio.

Working capital is a measure of cash flow. The difference between total current assets and total current liabilities equals the working capital. The working capital calculation is always a positive number.

The current ratio is a popular measure of financial strength. The current ratio is figured by dividing total current assets by total current liabilities. A favorable current ratio would be 2 to 1. If a company's current ratio is low, it may consider ways of improving this figure by decreasing the amount of financial indebtedness or putting more of the company's profits back into the working capital.

The quick ratio measures liquidity, or the ability to pay back debts in a timely manner. To figure the quick ratio, you add government securities, cash and receivables. You then divide this number by total current liabilities. A company's quick ratio is an important measure of its survivability should the sales revenues drastically decrease.

Ratio analysis enables the analyst to compare items on a single financial statement or to examine the relationships between items on two financial statements. After calculating ratios for each year's financial data, the analyst can then examine trends for the company across years. Since ratios adjust for size, using this analytical tool facilitates intercompany as well as intracompany comparisons. Ratios are often classified using the following terms: profitability ratios (also known as operating ratios), liquidity ratios, and solvency ratios. Profitability ratios are gauges of the company's operating success for a given period of time. Liquidity ratios are measures of the short-term ability of the company to pay its debts when they come due and to meet unexpected needs for cash. Solvency ratios indicate the ability of the company to meet its long-term obligations on a continuing basis and thus to survive over a long period of time. In judging how well on a company is doing, analysts typically compare a company's ratios to industry statistics as well as to its own past performance.

This is the method in which the ratio between two or more variables related to the business is compared.

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Introduction

2.3.4. Ratios to Determine Strength & Weaknesses

Everyone in the business of analyzing financial statements has a few favorite ratios they utilize when determining the strengths or weaknesses of a specific financial statement. The ratios that are used could change depending upon the industry the business is in, the size of the business, the accounting the accounting method that is used by the business and the amount of the credit desired and how healthy the company is.

The analysis is used to provide indicators of past performance in terms of critical success factors of a business. This assistance in decision-making reduces reliance on guesswork and intuition and establishes a basis for sound judgment.

Consider a current ratio of 2:1. This means that for every 1 monetary value of current liabilities there are 2 of assets. However each business is different and each has different working capital requirements. From this ratio, we cannot make any comments about the liquidity of the business, whether it carries too much or too little working capital.

2.4. Significance of Using Ratios

The significance of a ratio can only truly be appreciated when:

1. It is compared with other ratios in the same set of financial statements.2. It is compared with the same ratio in previous financial statements (trend analysis). 3. It is compared with a standard of performance (industry average). Such a standard may

be either the ratio which represents the typical performance of the trade or industry, or the ratio which represents the target set by management as desirable for the business.

2.5. Types of Ratios

There are many ratios used to analyze financial statements:

Liquidity Analysis Ratio: For example, the net working capital ratio is calculated between net working capital and total assets.

Profitability Analysis Ratio: For example, return on assets ratio is calculated between net income and average total assets. Profit margin ratio is calculated between net income and sales. Earning per share is calculated between net income and number of outstanding shares.

Activity Analysis Ratio: For example, asset turnover ratio is calculated between sales and average total assets. Inventory turnover ratio is calculated between cost of goods sold and average inventories.

Capital Structure Analysis Ratio: The most important ratio is debt to equity ratio, which is calculated between total liabilities and total stockholder's equity.

Capital Market Analysis Ratio: For example, dividend ratio is calculated between annual dividends per common share and market price of common stock per share.

All these ratios are collectively used to carry out the financial analysis of business to assess growth, profitability, and solvency of a business. Remember that ratio analysis is as important as horizontal and vertical analysis and must not be overlooked.

A: Liquidity Ratios

Liquidity refers to the ability of a firm to meet its short-term financial obligations when and as they fall due.

The main concern of liquidity ratio is to measure the ability of the firms to meet their short-term maturing obligations. Failure to do this will result in the total failure of the business, as it would be forced into liquidation.

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Current Ratio: The Current Ratio expresses the relationship between the firm’s current assets and its current liabilities. A current asset normally includes cash, marketable securities, accounts receivable and inventories. Current liabilities consist of accounts payable, short term notes payable, short-term loans, current maturities of long term debt, accrued income taxes and other accrued expenses (wages).

The rule of thumb says that the current ratio should be at least 2, that is the current assets should meet current liabilities at least twice. What does the calculated ratio tells us? In 2000, the company only had 85 cents worth of current assets for every dollar of liabilities. This grew to 92 cents in 2002 indicating increasing trend on liquidity, however the company is still unable to support its short-term debt from its currents assets.

Quick Ratio: Measures assets that are quickly converted into cash and they are compared with current liabilities. This ratio realizes that some of current assets are not easily convertible to cash e.g. inventories. The quick ratio, also referred to as acid test ratio, examines the ability of the business to cover its short-term obligations from its “quick” assets only (i.e. it ignores stock). The quick ratio is calculated as follows Clearly this ratio will be lower than the current ratio, but the difference between the two (the gap) will indicate the extent to which current assets consist of stock.

Average Collection Period: The average collection period measures the quality of debtors since it indicates the speed of their collection.

The shorter the average collection period, the better the quality of debtors, as a short collection period implies the prompt payment by debtors.

The average collection period should be compared against the firm’s credit terms and policy to judge its credit and collection efficiency.

An excessively long collection period implies a very liberal and inefficient credit and collection performance.

The delay in collection of cash impairs the firm’s liquidity. On the other hand, too low a collection period is not necessarily favourable, rather it may indicate a very restrictive credit and collection policy which may curtail sales and hence adversely affect profit.

Inventory Turnover: This ratio measures the stock in relation to turnover in order to determine how often the stock turns over in the business. It indicates the efficiency of the firm in selling its product. It is calculated by dividing he cost of goods sold by the average inventory.

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The ratio shows a relatively high stock turnover which would seem to suggest that the business deals in fast moving consumer goods.

The company turned over stock every 24 days in 2000 and every 28 days in 2002.

The trend shows a marginal increase in days which indicates a slow down of stock turnover.

The high stock turnover ratio would also tend to indicate that there was little chance of the firm holding damaged or obsolete stock.

Total Assets Turnover: Asset turnover is the relationship between sales and assets

The firm should manage its assets efficiently to maximize sales. The total asset turnover indicates the efficiency with which the firm uses all its assets to

generate sales. It is calculated by dividing the firm’s sales by its total assets.

Generally, the higher the firm’s total asset turnover, the more efficiently its assets have been utilised.

Fixed Asset Turnover: The fixed assets turnover ratio measures the efficiency with which the firm has been using its fixed assets to generate sales. It is calculated by dividing the firm’s sales by its net fixed assets as follows:

Generally, high fixed assets turnovers are preferred since they indicate a better efficiency in fixed assets utilisation.

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From the above calculations:

It appears that the activity of the business is relatively constant, with a slight upward trend.

The ratio also confirms that the business places a much greater reliance on working capital than it does on the fixed assets as the fixed assets (2001 and 2002) turned over more quicker than stock turnover.

C: Financial Leverage (Gearing) Ratios

The ratios indicate the degree to which the activities of a firm are supported by creditors’ funds as opposed to owners.

The relationship of owner’s equity to borrowed funds is an important indicator of financial strength.

The debt requires fixed interest payments and repayment of the loan and legal action can be taken if any amounts due are not paid at the appointed time. A relatively high proportion of funds contributed by the owners indicate a cushion (surplus) which shields creditors against possible losses from default in payment.

Note: The greater the proportion of equity funds, the greater the degree of financial strength. Financial leverage will be to the advantage of the ordinary shareholders as long as the rate of earnings on capital employed is greater than the rate payable on borrowed funds.

The following ratios can be used to identify the financial strength and risk of the business.

Equity Ratio

The equity ratio is calculated as follows:

This indicates that only 32.1% of the total assets in 2002 is supplied by the ordinary stockholders and this has shown a slight decrease from 32.8% in 2000.

A high equity ratio reflects a strong financial structure of the company. A relatively low equity ratio reflects a more speculative situation because of the effect of high leverage and the greater possibility of financial difficulty arising from excessive debt burden.

Debt Ratio: This is the measure of financial strength that reflects the proportion of capital which has been funded by debt, including preference shares.

This ratio is calculated as follows:

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With higher debt ratio (low equity ratio), a very small cushion has developed thus not giving creditors the security they require. The company would therefore find it relatively difficult to raise additional financial support from external sources if it wished to take that route. The higher the debt ratio the more difficult it becomes for the firm to raise debt.

Debt to Equity ratio: This ratio indicates the extent to which debt is covered by shareholders’ funds. It reflects the relative position of the equity holders and the lenders and indicates the company’s policy on the mix of capital funds. The debt to equity ratio is calculated as follows:

The debt to equity ratio shows that for every 1 dollar of shareholders funds in 2002 there was 2.12 dollars of debt. This compares to 2.05 dollars in 2000. This ratio is extremely high and indicates the financial weakness of the business.

Times Interest Earned Ratio: This ratio measure the extent to which earnings can decline without causing financial losses to the firm and creating an inability to meet the interest cost.

The times interest earned shows how many times the business can pay its interest bills from profit earned.

Present and prospective loan creditors such as bondholders, are vitally interested to know how adequate the interest payments on their loans are covered by the earnings available for such payments.

Owners, managers and directors are also interested in the ability of the business to service the fixed interest charges on outstanding debt.

The ratio is calculated as follows:

The company’s major forms of credit are non-interest bearing (trade creditors) which results in the business enjoying very healthy interest coverage rates. In 2002 the company could pay their interest bill 16.5 times from earnings before interest and tax. However this is a massive drop from 51.5 times in 2001 and 37.7 times in 2000.

D: Profitability Ratios

Profitability is the ability of a business to earn profit over a period of time. Although the profit figure is the starting point for any calculation of cash flow, as already pointed out, profitable companies can still fail for a lack of cash.

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Note: Without profit, there is no cash and therefore profitability must be seen as a critical success factors.

A company should earn profits to survive and grow over a long period of time. Profits are essential, but it would be wrong to assume that every action initiated by

management of a company should be aimed at maximizing profits, irrespective of social consequences.

The ratios examined previously have tendered to measure management efficiency and risk.

Profitability is a result of a larger number of policies and decisions. The profitability ratios show the combined effects of liquidity, asset management (activity) and debt management (gearing) on operating results. The overall measure of success of a business is the profitability which results from the effective use of its resources.

Gross Profit Margin

Normally the gross profit has to rise proportionately with sales. It can also be useful to compare the gross profit margin across similar businesses

although there will often be good reasons for any disparity.

The ratio above shows the increasing trend in the gross profit since the ratio has improved from 15.2% in 2000 to 20.3% on 2002. This indicates that the rate in increase in cost of goods sold are less than rate of increase in sales, hence the increased efficiency.

Net Profit Margin

This is a widely used measure of performance and is comparable across companies in similar industries. The fact that a business works on a very low margin need not cause alarm because there are some sectors in the industry that work on a basis of high turnover and low margins, for examples supermarkets and motorcar dealers. What is more important in any trend is the margin and whether it compares well with similar businesses.

The net margin ratio shows that the margin is fairly stable over time with slight improvement to 1.73% in 2001. However, to know how well the firm is performing one has to compare this ratio with the industry average or a firm dealing in a similar business.

Return on Investment (ROI): Income is earned by using the assets of a business productively. The more efficient the production, the more profitable the business. The rate of return on total assets indicates the degree of efficiency with which management has used the assets of the enterprise during an accounting period. This is an important ratio for all readers of financial statements.

Investors have placed funds with the managers of the business. The managers used the funds to purchase assets which will be used to generate returns. If the return is not better than the

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investors can achieve elsewhere, they will instruct the managers to sell the assets and they will invest elsewhere. The managers lose their jobs and the business liquidates.

The ratio indicates that there is increase in the ROI from 8.38% in 2000 to 8.95% in 2002.

Return on Equity (ROE): This ratio shows the profit attributable to the amount invested by the owners of the business. It also shows potential investors into the business what they might hope to receive as a return. The stockholders’ equity includes share capital, share premium, distributable and non-distributable reserves. The ratio is calculated as follows:

Again, the profitability to ordinary shareholders is strong and showing an upward trend. Note that the return in 2002 as in all the years is after tax and the shareholders should be extremely comfortable with these returns.

Earning Per Share (EPS): Whatever income remains in the business after all prior claims, other than owners claims (i.e. ordinary dividends) have been paid, will belong to the ordinary shareholders who can then make a decision as to how much of this income they wish to remove from the business in the form of a dividend, and how much they wish to retain in the business. The shareholders are particularly interested in knowing how much has been earned during the financial year on each of the shares held by them. For this reason, an earning per share figure must be calculated Clearly then, the earning per share calculation will be:

E: Market Value Ratios: These ratios indicate the relationship of the firm’s share price to dividends and earnings. Note that when we refer to the share price, we are talking about the Market value and not the Nominal value as indicated by the par value.

For this reason, it is difficult to perform these ratios on unlisted companies as the market price for their shares is not freely available. One would first have to value the shares of the business before calculating the ratios. Market value ratios are strong indicators of what investors think of the firm’s past performance and future prospects.

Dividend Yield Ratio: The dividend yield ratio indicates the return that investors are obtaining on their investment in the form of dividends. This yield is usually fairly low as the investors are also receiving capital growth on their investment in the form of an increased share price. It is interesting to note that there is strong correlation between dividend yields and market prices. Invariably, the higher the dividend, the higher the market value of the share. The dividend yield ratio compares the dividend per share against the price of the share and is calculated as:

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Notice a healthy increase in the yield from 2000 to 2002. The main reason for this is that the dividend per share increased while at the same time, the price of a share dropped. This is fairly unusual because share prices usually increase when dividends increase. However there could be number of reasons why this has happened, either due to the economy or to mismanagement, leading to a loss of faith in the stock market or in this particular stock. Normally a very high dividend yield signals potential financial difficulties and possible dividend payout cut. The dividend per share is merely the total dividend divided by the number of shares issued. The price per share is the market price of the share at the end of the financial year.

Price/Earning Ratio (P/E ratio)

P/E ratio is a useful indicator of what premium or discount investors are prepared to pay or receive for the investment.

The higher the price in relation to earnings, the higher the P/E ratio which indicates the higher the premium an investor is prepared to pay for the share. This occurs because the investor is extremely confident of the potential growth and earnings of the share.

The price-earning ratio is calculated as follows:

1. High P/E generally reflects lower risk and/or higher growth prospects for earnings. 2. The above ratio shows that the shares were traded at a much higher premium in 2000

than were in 2002. In 2000 the price was 26.8 times higher than earnings while in 2002, the price was only 12 times higher.

Dividend Cover

This ratio measures the extent of earnings that are being paid out in the form of dividends, i.e. how many times the dividends paid are covered by earnings (similar to times interest earned ratio discussed above).

A higher cover would indicate that a larger percentage of earnings are being retained and re-invested in the business while a lower dividend cover would indicate the converse.

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Dividend pay-out ratio: This ratio looks at the dividend payment in relation to net income and can be calculated as follows:

Note: Even though the dividend yield has increased, the dividend payout ratio has reduced, showing that a lower proportion of earnings were paid out as dividend. The ratio has only reduced slightly, however, from 50.7% in 2000 to 49.4% in 2002. Generally, the low growth companies have higher dividends payouts and high growth companies have lower dividend payouts.

Relationship among Ratios

Summary of Financial Ratios & Their Meaning

1. Profitability Ratios

Ratios Formula Meaning Desired Trenda. Contribution Margin to sales

Contribution Margin *1000 / Sales

Measures the margin of profitability on sales throughout the trading year and will vary from industry to industry. The percentage should be relatively constant and any changes investigated. Reasons for changes could be reduced selling price or increase in the cost of sales.

The higher the ratio the higher the cut received on each sales

b. COGS to sales COGS x1000/ Net Sales The % of COGS relative to sales. Helps measure the relative costs of inputs.

The lower the ratio, the lower the costs.

c. Operating expenses to sales

Operating Expenses x100/ Net sales

The % if any operating expenses relative to sales. Measures the relative impact of operating expenses.

The lower the ratio, the lower the expense relative to sales.

d. Net income to sales Net income x 100/ Net Sales

% of net income earned for every sales Taka. Measures ultimate profitability.

The higher the ratio, the more profitable each sale.

2. Return on Investment:

Ratio Formula Meaning Desired Trend

a. Return on Assets

(ROA).

Net Income/ Average Total Assets

(May also use EBIT instead of net income)

Shows the relationships between income & total assets.

High return = Good use of assets.

b. Return on Equity (ROE)

Net Income/ Average Shareholders Equity

Shows the maximum return available to shareholders.

High return = Happy shareholders/owners.

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3. Investment / Assets UtilizationRatio Formula Meaning Desired Trend

Asset Turnover Net Sales / Net Assets Shows how fully the company is using its capital and how many pounds of turnover is generated by each pound of investment.

Helps measure the usefulness of the assets.

Higher is better;

Too low- useless assets but

Too high-perhaps not enough assets may be forgoing opportunities.

Inventory Turnover

COGS / Average Inventory

How many times a year is the inventory being sold?Measures the speed at which the inventory comes in & goes out.

Or, Measures liquidity of inventory.

Higher is better;

Too low- the inventory is sitting around to long.(Obsolescence) but

Too high-may not have enough inventory to meet demand (stock outs)

Fixed Assets Turnover

Net Sales / Average Net Fixed Assets

How many sales dollars are earned for every dollar of fixed assets?

Helps measure how useful the fixed assets are to the business.

Higher is better;

Too low- may have useless assets that can be sold. but

Too high-may sign that are old & need replacing.

4. Liquidity Ratio:Ratios Formula Meaning Desired Trend

a. Current Ratio

Current Assets / Current Liabilities

The number of times that short-term assets can cover short-term debts. It indicates an ability to meet short term obligations as they come due.

Higher to a point (2:1 rule of thumb)

Too low-may lead to insolvency but too high-inefficient use of capital ( since current assets generally have the lowest return)

Liquidity Ratio or Acid Test

Current Assets minus Stock / Current Liabilities

Indicates the ability to meet short term payments, using only the most liquid of assets.

Higher to a point (1:1 rule of thumb)

Working Capital Current Assets - Current Liabilities.

The net amount of money tied up in working capital.

Higher is safer but working capital has a low return; if too high, moneys better spent elsewhere.

Age of Receivable

Or

Account Receivable/ Average daily sales.

How old (in days) is the average outstanding balance on credit sales.

Should be closed to the industry average (Preferably on the

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Average Collection Period.

Average Daily sales =

Total Sales/365

lower end)

If too low- may be the credit policies are too tight & are scaring off business.

5. Solvency Ratios/ Stability Ratios

Ratios Formula Meaning Desired trend

a. Total Debt to total assets ratio

Total liabilities/ Total Equity What percentage of the business is financed through debt. Or

Measures the % of the total assets provided by creditors.

Lower is safer

b. Debt to Equity Total liabilities/ Total Assets The number of times of debt for every dollar of equity.

Lower is safer.

To high-to highly leveraged(either too much debt or too small an equity base.)

c. Net worth to Total Assets

Total Equity/ Total Assets What percentage of the business is owned by equity?

Higher is safer.

Too low- too much debt but Too high likely under leveraged thereby reducing ROE. Also debt is cheaper than equity, use it if possible.

d. Time interest earned

or

Long-term Debt interest Coverage

EBIT/ Interest on long term debt.

The number of times over that a company can meet its interest payments.

Lenders need assurance that their loan charges (interest) can be covered.

 DuPont analysis

DuPont analysis (also known as the DuPont identity, DuPont equation, DuPont Model or the DuPont method) is an expression which breaks ROE (Return on Equity) into three parts. The name comes from the DuPont Corporation that started using this formula in the 1920s.With this method; assets are measured at their gross book value rather than at net book value in order to produce a higher return on equity (ROE). It is also known as “DuPont identity”.

ROE analysis

The Du Pont identity breaks down Return on Equity (that is, the returns that investors receive from the firm) into three distinct elements. This analysis enables the analyst to understand the source of superior (or inferior) return by comparison with companies in similar industries (or

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between industries). The Du Pont identity, however, is less useful for some industries, such as investment banking, that do not use certain concepts or for which the concepts are less meaningful. Variations may be used in certain industries, as long as they also respect the underlying structure of the Du Pont identity. Du Pont analysis relies upon the accounting identity, that is, a statement (formula) that is by definition true.

Examples

High Turnover Industries: Certain types of retail operations, particularly stores, may have very low profit margins on sales, and relatively moderate leverage. In contrast, though, groceries may have very high turnover, selling a significant multiple of their assets per year. The ROE of such firms may be particularly dependent on performance of this metric, and hence asset turnover may be studied extremely carefully for signs of under-, or, over-performance. For example, same store sales of many retailers is considered important as an indication that the firm is deriving greater profits from existing stores (rather than showing improved performance by continually opening stores).

High margin industries: Other industries, such as fashion, may derive a substantial portion of their competitive advantage from selling at a higher margin, rather than higher sales. For high-end fashion brands, increasing sales without sacrificing margin may be critical. The Du Pont identity allows analysts to determine which of the elements is dominant in any change of ROE.

High leverage industries: Some sectors, such as the financial sector, rely on high leverage to generate acceptable ROE. In contrast, however, many other industries would see high levels of leverage as unacceptably risky. Du Pont analysis enables the third party (relying primarily on the financial statements) to compare leverage with other financial elements that determine ROE among similar companies.

ROA and ROE ratio

The return on assets (ROA) ratio developed by DuPont for its own use is now used by many firms to evaluate how effectively assets are used. It measures the combined effects of profit margins and asset turnover.[1]

The return on equity (ROE) ratio is a measure of the rate of return to stockholders .Decomposing the ROE into various factors influencing company performance is often called the Du Pont system.

Where

Net income = net income after taxes Equity = shareholders' equity EBIT = Earnings before interest and taxes

This decomposition presents various ratios used in fundamental analysis.

The company's tax burden is (Net income ÷ pretax profit). This is the proportion of the company's profits retained after paying income taxes. [NI/EBT]

The company's interest burden is (Pretax income ÷ EBIT). This will be 1.00 for a firm with no debt or financial leverage. [EBT/EBIT]

The company's operating income margin or return on sales (ROS) is (EBIT ÷ Sales). This is the operating income per dollar of sales. [EBIT/Sales]

The company's asset turnover (ATO) is (Sales ÷ Assets). The company's leverage ratio is (Assets ÷ Equity), which is equal to the firm's debt to

equity ratio + 1. This is a measure of financial leverage. The company's return on assets (ROA) is (Return on sales x Asset turnover).

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The company's compound leverage factor is (Interest burden x Leverage).

ROE can also be stated as:

ROE = Tax burden x Interest burden x Margin x Turnover x Leverage

ROE = Tax burden x ROA x Compound leverage factor

Profit margin is (Net income ÷ Sales), so the ROE equation can be restated:

Importance of DuPont Analysis

Any decision affecting the product prices, per unit costs, volume or efficiency has an impact on the profit margin or turnover ratios. Similarly any decision affecting the amount and ratio of debt or equity used will affect the financial structure and the overall cost of capital of a company. Therefore, these financial concepts are very important to evaluate as every business is competing for limited capital resources. Understanding the interrelationships among the various ratios such as turnover ratios, leverage, and profitability ratios helps companies to put their money areas where the risk adjusted return is the maximum.

 DuPont analysis tells us that ROE is affected by three things:

1. Operating efficiency, which is measured by profit margin 2. Asset use efficiency, which is measured by total asset turnover 3. Financial leverage, which is measured by the equity multiplier

 ROE = Profit Margin (Profit/Sales) * Total Asset Turnover (Sales/Assets) * Equity Multiplier (Assets/Equity)

 It is believed that measuring assets at gross book value removes the incentive to avoid investing in new assets. New asset avoidance can occur as financial accounting depreciation methods artificially produce lower ROEs in the initial years that an asset is placed into service. If ROE is unsatisfactory, the DuPont analysis helps locate the part of the business that is under performing.

The DuPont System expresses the Return on Assets as: ROA = OPM * ATR

The Operating Profit Margin Ratio is a measure of operating efficiency and the Asset Turnover Ratio is a measure of asset use efficiency.

The DuPont System expresses the Return on Equity as:

ROE = (ROA – Interest Expense/Average Assets) * EM

The Equity Multiplier is a form of leverage ratio and measures financial efficiency.

Below figure shows the DuPont Analysis for a farm operation

Figure: DuPont Analysis for Farm Operations

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DuPont Analysis for Two Farms

Sr.No. Farmer A Farmer B

1 Operating profit margin ratio 0.30 0.12

2 Asset turnover 0.20 0.36

3 ROA (1*2) 0.060 0.043

4 Interest expense to avg. farm assets 0.05 0.03

5 Equity multiplier 2.00 1.50

6 ROE (3-4) * 5 0.02 0.02

 

Farmer A and Farmer B each have a 2 % ROE. The components of the ratios indicate that the sources of the weakness of the farms are different. Farmer A has a stronger profit margin ratio but lower asset turnover compared to Farmer B. Furthermore, Farmer A has a higher leverage ratio than Farmer B.

The weak ratios for each farm may be decomposed into components to determine the potential sources of the weakness. To improve asset turnover Farmer A needs to increase production efficiency or price levels or reduce current or noncurrent assets. To improve profit margins, Farmer B needs to increase production efficiency or price levels more than costs or reduce costs more than revenue.

The DuPont analysis is an excellent method to determine the strengths and weaknesses of a farm. A low or declining ROE is a signal that there may be a weakness. However, using the analysis you can better determine the source of weakness. Asset management, expense

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Introduction

control, production efficiency or marketing could be potential sources of weakness within the farm. Expressing the individual components rather than interpreting ROE it may identify these weaknesses more readily.

In ratio analysis, Du-Pont Control Chart shows the relationship of net profit margin ratio and total investment turnover ratio for calculating return on total investment ratio (ROI). If company wants to increase return on investment (ROI), it has to concentrate to increase net profit margin and total investment turnover ratio.

Following is its screenshot :

Du-Pont Chart

We measure any organization’s performance on the basis of its return on investment. But it is affected from lots of factors.

(A) If return on investment rate is good, it is due to effective use of our total investment. Our total investment may be in fixed assets and in current assets. We invest this money through our long term capital and working capital. If we use both resources best way, our total sales will increase and then our total net profit will increase. This will increase our return on investment.(B) If we have learned the techniques to control our expenses and promoted our sales with innovative methods, at that time this sales will increase our net profit and total investment. Our total worth will increase, if sales will increase.

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We should calculate all three ratios. We should analyze our company's performance on the basis of Du-Pont Control Chart. In this control, we have to control our total expenses and total book value of our all assets. We will control these two things; its direct effect will be on our ROI. It will grow. 

DU Pont Analysis 

The Du Pont Company of the US pioneered a system of financial analysis, which has received widespread recognition and acceptance. This system of analysis considers important interrelationships between different elements based on the information found in the financial statements.  The Du Pont analysis can be depicted via the following chart:

 

At the apex of the Du Pont chart is the Return On Total Assets (ROTA), defined as the product of the Net Profit Margin (NPM) and the Total Assets Turnover Ratio (TATR). As a formula this can be shown as follows:

(Net profit/Total asset)= (Net profit/Net sales)*(Net sales/Total assets)

(ROTA) (NPM) (TATR)

Such decomposition helps in understanding how the return on total assets is influenced by the net profit margin and the total assets turnover ratio. 

The left side of the Du Pont chart shows details underlying the net profit margin ratio. A detailed examination of this side presents areas where cost reductions may be effected to improve the net profit margin.

The right side of the chart highlights the determinants of total assets turnover ratio. If this study is supplemented by the study of other ratios such as inventory, debtors, fixed asset turnover ratios, a deeper insight into efficiencies and inefficiencies of asset utilisation can be sought.

The basic Du Pont analysis can be extended to explore the determinants of the Return On Equity (ROE).

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Return on equity= Asset turnover * Net profit margin*leverage

(Net profit/Equity)= (Net profit/Sales)*(Sales/Total assets)*(Total assets/Equity)

(ROE) (NPM) (TATR) 1/(1-DR)

Where DR is the debt ratio= debt (D)/assets (A)

Breaking ROE into these three parts allows evaluation of how well one can manage the company’s assets, expenses, and debt. A manager has basically three ways of improving operating performance in terms of ROA and ROE. These are:

Increase capital asset turnover Increase operating profit margins Change financial leverage

Each of these primary drivers is impacted by the specific decisions on cost control, efficiency productivity, marketing choices etc. 

Decoding DuPont Analysis

Return on equity (ROE) is a closely watched number among knowledgeable investors. It is a strong measure of how well the management of a company creates value for its shareholders. The number can be misleading, however, as it is vulnerable to measures that increase its value while also making the stock more risky. Without a way of breaking down the components of ROE investors could be duped into believing a company is a good investment when it's not. Read on to learn how to use DuPont analysis to break apart ROE and get a much better understanding about where movements in ROE are coming from. (To learn the basics and value of return on equity, check out Keep Your Eyes On The ROE.)

ROE: Simple, Perhaps Too Simple

The beauty of ROE is that it is an important measure that only requires two numbers to compute: net income and shareholders equity.

ROE = net income / shareholder's equity

If this number goes up, it is generally a great sign for the company as it is showing that the rate of return on the shareholders equity is going up. The problem is that this number can also rise simply when the company takes on more debt, thereby decreasing shareholder equity. This would increase the leverage of the company, which could be a good thing, but it will also make the stock more risky.

Three-Step DuPont

To avoid mistaken assumptions, a more in-depth knowledge of ROE is needed. In the 1920s the DuPont corporation created a method of analysis that fills this need by breaking down ROE into a more complex equation. DuPont analysis shows the causes of shifts in the number.

There are two variants of DuPont analysis, the original three-step equation, and an extended five-step equation. The three-step equation breaks up ROE into three very important components:

ROE = (Net profit margin)* (Asset Turnover) * (Equity multiplier)

These components include:

Operating efficiency - as measured by profit margin.

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Asset use efficiency - as measured by total asset turnover. Financial leverage - as measured by the equity multiplier.

The Three-Step DuPont Calculation

Taking the ROE equation: ROE = net income / shareholder's equity and multiplying the equation by (sales / sales), we get:

ROE = (net income / sales) * (sales / shareholder's equity)

We now have ROE broken into two components, the first is net profit margin, and the second is the equity turnover ratio. Now by multiplying in (assets / assets), we end up with the three-step DuPont identity:

ROE = (net income / sales) * (sales / assets) * (assets / shareholder's equity)

This equation for ROE, breaks it into three widely used and studied components:

ROE = (Net profit margin)* (Asset Turnover) * (Equity multiplier)

We have ROE broken down into net profit margin (how much profit the company gets out of its revenues), asset turnover (how effectively the company makes use of its assets), and equity multiplier (a measure of how much the company is leveraged). The usefulness should now be clearer. If a company's ROE goes up due to an increase in the net profit margin or asset turnover, this is a very positive sign for the company. However, if the equity multiplier is the source of the rise, and the company was already appropriately leveraged, this is simply making things more risky. If the company is getting over leveraged, the stock might deserve more of a discount, despite the rise in ROE . The company could be under-leveraged as well. In this case it could be positive, and show that the company is managing itself better. (Learn to take a deeper look at a company's profitability with the help of profit-margin ratios in The Bottom Line On Margins.)

Even if a company's ROE has remained unchanged, examination in this way can be very helpful. Suppose a company releases numbers and ROE is unchanged. Examination with DuPont analysis could show that both net profit margin and asset turnover decreased, two negative signs for the company, and the only reason ROE stayed the same was a large increase in leverage. No matter what the initial situation of the company, this would be a bad sign.

Five-Step DuPont

The five-step, or extended, DuPont equation breaks down net profit margin further. From the three-step equation we saw that, in general, rises in the net profit margin, asset turnover, and leverage will increase ROE. The five-step equation shows that increases in leverage don't always indicate an increase in ROE.

The Five-Step Calculation

Since the numerator of the net profit margin is net income, this can be made into earnings before taxes (EBT) by multiplying the three-step equation by 1 minus the company's tax rate:

ROE = (earnings before tax / sales) * (sales / assets) *

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(assets / equity) * (1 – tax rate)

We can break this down one more time, since earnings before taxes is simply earnings before interest and taxes (EBIT) minus the company's interest expense. So, if a substitution is made for the interest expense, we get:

ROE = [(EBIT / sales) * (sales / assets) – (interest expense / assets)] * (assets / equity) * (1 – tax rate)

The practicality of this breakdown is not as clear as the three-step, but this identity provides us with:

ROE = [(operating profit margin) * (asset turnover) – (interest expense rate)] * (equity multiplier) * (tax retention rate)

If the company has a high cost of borrowing, its interest expenses on more debt could mute the positive effects of the leverage. (To learn how to use revenue and expenses to break down and analyze a company, read Understanding the Income Statement.)

Learn the Cause behind the Effect

Both the three- and five-step equations provide deeper understanding of a company's return on equity, by examining what is really changing in a company rather than looking at one simple ratio. As always with financial statement ratios, they should be examined against the company's history and its competitors.

For example, when looking at two peer companies, one may have a lower ROE. With the five-step equation, you can see if this is lower because: creditors perceive the company as riskier and charge it higher interest, the company is poorly managed and has leverage that is too low, or the company has higher costs that decrease its operating profit margin. Identifying sources like these leads to better knowledge of the company and how it should be valued. (To learn how to easily compare companies, read Peer Comparison Uncovers Undervalues Stocks.)

Deepen Your Understanding

A simple calculation of return on equity may be easy, and tell quite a bit, but it does not provide the whole picture. If a company's ROE is lower than its peers, the three or five-step identities can help to show where the company is lagging. It can also shed light on how a company is lifting or propping up its ROE. DuPont analysis helps significantly broaden understanding of ROE.

Q. No. 1.

The comparative financial statements of XYZ Company are presented below:

XYZ Company

Statement of Financial PerformanceFor the year ended December 31

Particulars 2009 2008

Net Sales (All on account) $12,00,000 $10,40,000

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Less: Cost & Expenses:

Cost of goods sold 8,30,000 7,08,000

Selling & Administrative exp. 2,00,000 2,00,000

Depreciation on PPE 20,600 15,000

Amortization on patents 17,000 8,000

Derecognizing expenses 7,000 1,600

Loss on sale of old assets 10,000 5,000

Interest Expenses 15,600 12,000

Income Tax Expenses 36,000 28,000

Total Expenses 11,28,200 9,87,600

Net income $70,800 $62,400

XYZ Company

Statement of Financial PositionDecember 31

Assets 2009 2008

Current Assets:

Cash & Cash Equivalents $42,000 $36,000

Trade Receivable (Net) 1,84,000 1,48,000

Inventories 1,68,000 1,40,000

Short -term investments 36,000 30,000

Total Current assets 4,30,000 2,54,000

Property , Plant & Equipment (Net) 8,46,000 7,66,000

Total assets $12,76,000 $11,20,000

Liabilities & Stockholder’s Equity

Current Liabilities:

Trade Payable $2,44,000 $2,20,000

Income Taxes Payable 46,000 40,000

Total Current Liabilities: 2,90,000 2,60,000

Long term Liabilities:

Bond Payable 2,40,000 1,60,000

Total Liabilities 5,30,000 4,20,000

Stockholder’s Equity:

Common Stock ($10 per share) 3,00,000 3,00,000

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Retained Earnings 4,46,000 4,00,000

Total Stockholder’s Equity 7,46,000 7,00,000

Total Liabilities & stockholder’s Equity $12,76,000 $11,20,000

Additional data:

The common stock recently sold at $39.00 per share and the dividends per share $15. Irredeemable Preference share dividend $800 for 2009, Equity dividend paid $5,000. The year end balance in the allowance for doubtful accounts was $6,000 for 2009 & $4,800 for 2008.Required: Compute the following ratios for 2009:

(1) Current Ratio = Total current assets/Total current liabilities(2) Acid -Test Ratio[=Total current assets - inventory/Total current liabilities(3) Trade Receivable Turnover Ratio[=Net sales/Average Trade Receivable(4) Average Collection Period =365/ Trade Receivable Turnover Ratio(5) Inventory turnover Ratio =[Cost of Goods sold/Average Inventory](6) Profit Margin =Income before taxes / Net sales(7) Net Profit Margin =Net Income / Net sales revenue(8) Net income to sales= Net Income / net sales revenue(9) Gross Profit percentage =Net Sales revenue-COGS / Net sales revenue(10) Current Capital =Total Current Assets- Total Current Liabilities(11) Capital employed=Non current assets + working Capital(12) Return on Capital employed =Net Income / Capital employed(13) Assets Turnover Ratio= Net sales/ Average assets(14) Return on total Assets/return on investment =Net Income / Total Assets(15) Operating expenses to sales= Operating expenses / Total Sales(16) Return on common stockholder’s Equity = Net Income – Irredeemable Preference

share dividend / Average Common stockholder’s Equity(17) Earnings Per Share =Net income / Number of shares(18) Price-Earnings ratio= = Market price per share / earnings per share(19) Debt to total assets = Total long term debt/ Total assets(20) Time interest earned = EBIT/ Interest(21) Inventory to Working capital= Inventory/ Working Capital(22) Trade payable turnover ratio= COGS/ Average Trade payable(23) Average payment period=[ 365/Accounts payable Turnover Ratio](24) Non-current Assets turnover ratio = Net Sales/ Average Non-current assets(25) Assets utilization = Net Sales/ Average assets(26) Degree of operating leverage= Contribution margin/ Net income(27) Operating margin = Operating Income / net sales(28) Long term debt to Capital Structure= Long-term liabilities / stockholders' equity(29) Leverage = Assets / stockholders' equity(30) Dividend Yield on Common stock= Dividend per share / market price per share(31) Dividend Payout ratio = Dividends per share /earnings per share(32) Gearing= Net debt/ Equity *100(33) Interest coverage= PBIT+ Investment income/ interest payable(34) Net Cash flows from operating activities= Net income+ Non-cash charges+ Changes

in current assets+ Changes in current liabilities.(35) Cash coverage= Net Cash flows from operating activities +interest paid +income

tax paid/ interest paid(36) Cash return= Cash generated from operations+ interest received + dividend

received(37) Cash return on capital employed= Cash return/Capital employed *100(38) Cash from operation= Cash generated from operations/Profit from operation(39) Cash Interest coverage= Cash return/Interest paid(40) Cash flow per share= Cash flow for ordinary share/No. of ordinary share(41) Cash dividend cover= Cash flow for ordinary share/Equity dividend paid.

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(42) Cash generated from operations=PB tax+ Depreciation charge+ Loss on disposal of PPE+ Investment income+ Finance cost+ increase in inventories+ increase in trade and other receivable+ increase in trade payable.

(43) Quality Income= Net Cash flows from operating activities/Net income(44) Capital acquisition ratio =Net Cash flows from operating activities/Cash paid for PPE

Q. No. 2.

The condensed financial statements of John Cully Company, for the years ended June 30, 2011 and 2010, are presented below:

John Cully Company

Statements of Financial Position

June 30

Assets 2011 (in thousand)

2010(in thousand)

Current Assets:

Cash $553.30 $611.60

Trade Receivable (Net) 776.60 664.90

Inventories 768.30 653.50

Prepaid expenses and other current assets

204.40 269.20

Total Current assets 2302.60 2,199.20

Intangibles and other assets 876.70 849.30

Property , Plant & Equipment (Net) 694.20 647.00

Investments 12.30 12.60

Total assets 3885.80 3,708.10

Liabilities & Stockholder’s Equity

Current Liabilities 1497.70 1322.00

Non-current liabilities 679.50 637.10

Stockholder’s Equity [$10 par] 1708.60 1749.00

Total Liabilities & stockholder’s Equity $3885.80 $3,708.10

John Cully Company

Statement of Financial PerformanceFor the year ended June 30

Particulars 2011 2010

Net Sales (All on account) $6336.30 $5790.40

Less: Cost & Expenses:

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Cost of goods sold 1,617.40 1,476.30

Selling & Administrative exp. 4,007.40 3,679.00

Interest Expenses 13.90 27.10

Total Cost & Expenses 5638.90 5,182.40

Income before income taxes 697.40 608.00

Income Tax Expenses 291.30 232.60

Net income 406.10 375.40

Required: Compute the following ratios for 2011 and 2010:

(1) Current Ratio [ Measures the short term debt paying ability](2) Acid -Test Ratio[ Measures the immediate short term debt paying ability](3) Trade Receivable Turnover Ratio [Trade receivable on 06.30.2009 was $599.00]

{ Measures the liquidity of receivable}(4) Inventory turnover Ratio [{ Measures the liquidity of inventory}(5) Profit Margin [ Measures net income generated by each currency unit of sales](6) Net income as a percentage of net sales [An indicator of management’s ability to

control costs](7) Time interest earned [ Measures the ability to meet interest payments as they come

due](8) Gross Profit percentage [A measure of the profitability of the company’s product](9) Current Capital [A measures of short term debt paying ability](10) Return on assets [Assets on 06.30.2009 were $3,349,90] {Measures the overall

profitability of assets](11) Assets Turnover Ratio [Measures how efficiently assets are used to generate sales](12) Operating expenses to sales(13) Return on common stockholder’s Equity [Measures the profitability of owner’s

investment](14) Debt to total assets ratio [Measures the percentage of total assets provided by

creditors](15) EPS [ Net income applicable to each share of common stock](16) Return on equity [The rate of return earned on the common stockholders equity in

the business](17) Price-earning ratio [ A measure of investors expectations about the company’s

future prospectus](18) Book value per share [The recorded value of net assets underlying each share of

common stock](19) Net cash provided by operating activities [Indicates the cash generated by

operations after allowing for cash payment of expenses and operating liabilities.](20) Cash flow from operations to current liabilities [indicates ability to cover current

maturing obligations from recurring operations]Q. No. 3.

The following data are adapted from a recent annual report of Wall Green Corporation (dollar amounts are stated in millions):

Particulars 2011 2010

Balance sheet data:

Quick assets $1305.00 $815.00

Current assets 5,167.00 4,394.00

Current liabilities 2,955.00 3,012.00

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Stockholder’s equity 6,230.00 5,207.00

Total Assets 9,879.00 8,834.00

Income statement data:

Net sales $28,681.00 $24,623.00

Gross profit 7,605.00 6,574.00

Operating income 1,624.00 1,398.00

Net income 1,019.00 886.00

Required:

(a) Compute the following for 2011 and 2010 (i) working capital (ii) Current ratio (iii) Quick ratio.

(b) Comment on the trends in the liquidity measure and state whether Wall Green Corporation appears to be able to satisfy its liabilities at the end of 2011.

(c) Compute the percentage changes for 2011 in the amounts of net sales and net income.(d) Compute the flowing for 2011 and 2010 (for items 3 and 4, use the year end amounts

stated amounts stated above as substitutes for average assets and average stock-holder’s equity.) (i) Gross profit rate (ii) Net income as a percentage of sales. (iii) Return on assets (iv) Return on Stockholder’s equity.

(e) Comment on the trends in the profitability measures computed in parts c and d.

Q. No. 4.

From the following information of Albert Company as on 31st December 2008:Non current asset $16, 00,000Working capital $10, 00,000Current ratio 2:1Non-current assets turn over ratio 8 timesGross profit @ 25% of salesTrade receivable turnover ratio 10 timesLoss on sale of plant assets $5,000Trade payable turnover ratio 9 timesInterest expenses $50,000Income tax 25%Inventory Turnover 10 timesNet income @ 10% of turn over General Reserve 25% of the net income Capital gearing ratio 3:1Depreciation expenses $10,000Amortization on patent $8,000Doubtful expenses $15,000Derecognizing expenses $10,000Required:

a. Prepare a statement of Financial Performance for the year ended 31st December 2008b. Prepare a Statement of Financial Position as at 31st December 2008.

Q. No. 5.

From the following information of Pearl Fisher company as on 31st December 2009:Profit before interest and tax/Total Assets 15%Profit before interest and tax/Sales 10%Sales $2, 40,000Average collection period 73 days

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Inventory Turnover ratio 4.50 times

Gross profit @ 25% of salesNon-current asset turn over ratio 8 timesCurrent ratio

3:1

Equity Shareholder fund/Capital employed 50%Required: Prepare a classified Financial Position as on 31st December 2009.

Q. No. 6.

From the following information of Hull Company as on 31st December 2009:Sales $20, 00,000Gross profit @ 25% of salesCurrent ratio

1.50:1

Quick ratio

1.25:1Inventory Turnover ratio

15 timesAccounts receivable turnover ratio 8 timesNon-current asset turn over ratio 1.50 timesRatio of reserve to share capital 33%Non-current assets to net worth 83%

Required:

Prepare a classified Financial Position as on 31st December 2009

Q. No. 7.The comparative financial statements of XYZ Company are presented below:

XYZ Company

Statement of Financial PerformanceFor the year ended December 31

Particulars 2009 2008

Net Sales (All on account) $12,00,000 $10,40,000

Less: Cost & Expenses:

Cost of goods sold 8,30,000 7,08,000

Selling & Administrative exp. 2,00,000 2,00,000

Depreciation on PPE 20,600 15,000

Amortization on patents 17,000 8,000

Derecognizing expenses 7,000 1,600

Loss on sale of old assets 10,000 5,000

Interest Expenses 15,600 12,000

Income Tax Expenses 36,000 28,000

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Total Expenses 11,28,200 9,87,600

Net income $70,800 $62,400

XYZ Company

Statement of Financial PositionDecember 31

Assets 2009 2008

Current Assets:

Cash & Cash Equivalents $42,000 $36,000

Trade Receivable (Net) 1,84,000 1,48,000

Inventories 1,68,000 1,40,000

Short -term investments 36,000 30,000

Total Current assets 4,30,000 2,54,000

Property , Plant & Equipment (Net) 8,46,000 7,66,000

Total assets $12,76,000 $11,20,000

Liabilities & Stockholder’s Equity

Current Liabilities:

Trade Payable $2,44,000 $2,20,000

Income Taxes Payable 46,000 40,000

Total Current Liabilities: 2,90,000 2,60,000

Long term Liabilities:

Bond Payable 2,40,000 1,60,000

Total Liabilities 5,30,000 4,20,000

Stockholder’s Equity:

Common Stock ($10 per share) 3,00,000 3,00,000

Retained Earnings 4,46,000 4,00,000

Total Stockholder’s Equity 7,46,000 7,00,000

Total Liabilities & stockholder’s Equity $12,76,000 $11,20,000

Additional data:

The common stock recently sold at $39.00 per share and the dividends per share $15. Irredeemable Preference share dividend $800 for 2009, Equity dividend paid $5,000. The year end balance in the allowance for doubtful accounts was $6,000 for 2009 & $4,800 for 2008.Required: Compute the following ratios for 2009:

(1) Current Ratio = Total current assets/Total current liabilities

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(2) Acid -Test Ratio[=Total current assets - inventory/Total current liabilities(3) Trade Receivable Turnover Ratio[=Net sales/Average Trade Receivable(4) Average Collection Period =365/ Trade Receivable Turnover Ratio(5) Inventory turnover Ratio =[Cost of Goods sold/Average Inventory](6) Profit Margin =Income before taxes / Net sales(7) Net Profit Margin =Net Income / Net sales revenue(8) Net income to sales= Net Income / net sales revenue(9) Gross Profit percentage =Net Sales revenue-COGS / Net sales revenue(10) Current Capital =Total Current Assets- Total Current Liabilities(11) Capital employed=Non current assets + working Capital(12) Return on Capital employed =Net Income / Capital employed(13) Assets Turnover Ratio= Net sales/ Average assets(14) Return on total Assets/return on investment =Net Income / Total Assets(15) Operating expenses to sales= Operating expenses / Total Sales(16) Return on common stockholder’s Equity = Net Income – Irredeemable Preference

share dividend / Average Common stockholder’s Equity(17) Earnings Per Share =Net income / Number of shares(18) Price-Earnings ratio= = Market price per share / earnings per share(19) Debt to total assets = Total long term debt/ Total assets(20) Time interest earned = EBIT/ Interest(21) Inventory to Working capital= Inventory/ Working Capital(22) Trade payable turnover ratio= COGS/ Average Trade payable(23) Average payment period=[ 365/Accounts payable Turnover Ratio](24) Non-current Assets turnover ratio = Net Sales/ Average Non-current assets(25) Assets utilization = Net Sales/ Average assets(26) Degree of operating leverage= Contribution margin/ Net income(27) Operating margin = Operating Income / net sales(28) Long term debt to Capital Structure= Long-term liabilities / stockholders' equity(29) Leverage = Assets / stockholders' equity(30) Dividend Yield on Common stock= Dividend per share / market price per share(31) Dividend Payout ratio = Dividends per share /earnings per share(32) Gearing= Net debt/ Equity *100(33) Interest coverage= PBIT+ Investment income/ interest payable(34) Net Cash flows from operating activities= Net income+ Non-cash charges+ Changes

in current assets+ Changes in current liabilities.(35) Cash coverage= Net Cash flows from operating activities +interest paid +income

tax paid/ interest paid(36) Cash return= Cash generated from operations+ interest received + dividend

received(37) Cash return on capital employed= Cash return/Capital employed *100(38) Cash from operation= Cash generated from operations/Profit from operation(39) Cash Interest coverage= Cash return/Interest paid(40) Cash flow per share= Cash flow for ordinary share/No. of ordinary share(41) Cash dividend cover= Cash flow for ordinary share/Equity dividend paid.(42) Cash generated from operations=PB tax+ Depreciation charge+ Loss on disposal of

PPE+ Investment income+ Finance cost+ increase in inventories+ increase in trade and other receivable+ increase in trade payable.

(43) Quality Income= Net Cash flows from operating activities/Net income(44) Capital acquisition ratio =Net Cash flows from operating activities/Cash paid for PPE

Q. No.8.

From the following information of Albert Company as on 31st December 2008:Non current asset $16, 00,000Working capital $10, 00,000Current ratio 2:1Non-current assets turn over ratio 8 timesGross profit @ 25% of salesTrade receivable turnover ratio 10 timesLoss on sale of plant assets $5,000Trade payable turnover ratio 9 times

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Interest expenses $50,000Income tax 25%Inventory Turnover 10 timesNet income @ 10% of turn over General Reserve 25% of the net income Capital gearing ratio 3:1Depreciation expenses $10,000Amortization on patent $8,000Doubtful expenses $15,000Derecognizing expenses $10,000Required:

a. Prepare a statement of Financial Performance for the year ended 31st December 2008b. Prepare a Statement of Financial Position as at 31st December 2008.

Q. No. 9.

The comparative financial statements of Bedim Company are presented below:Bedim Company Statement of Financial Performance

For the year ended December 31

Particulars 2009 2008

Net Sales revenue $10,00,000 $10,00,000

Investment income 1,40,000 20,000

Dividend revenue 60,000 20,000

Less: Cost & Expenses

Cost of goods sold 8,30,000 7,08,000

Selling & Administrative exp. 1,50,000 1,50,000

Depreciation on PPE 30,600 19,600

Patent amortization 17,000 13,000

Interest Expenses 10,600 9,000

Income Tax Expenses 22,000 18,000

Write off goodwill 7,000 5,000

Loss on sale of machinery 4,000 3,000

Derecognizing expenses 8,000 2,000

Marketing expenses 50,000 50,000

Total Expenses 11,28,200 9,87,600

Net income $70,800 $62,400

Bedim Company Statement of Financial Position

December 31Assets 2009 2008

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Introduction

Current Assets:

Cash & Cash Equivalents $22,000 $20,000

Trade Receivable (Net) 60,000 50,000

Loan receivable held for sale 54,000 48,000

Loan receivable held for investment 35,000 30,000

Cash surrender value of life insurance 30,000 20,000

Advance to employees 5,000 ----

Inventories 1,68,000 1,40,000

Short -term investments 12,000 16,000

Interest receivable 16,000 10,000

Accounts receivable 8,000 4,000

Prepaid insurance 10,000 6,000

Total Current assets 4,30,000 2,54,000

Non-current assets:

Store Equipment 1,00,000 66,000

Property , Plant & Equipment (Net) 4,00,000 4,00,000

Land held for speculation 1,50,000 1,00,00

Capitalize leases 1,46,000 50,000

Leasehold improvements 50,000 50,000

Leasehold property 1,00,000 1,00,000

Total assets $13,76,000 $11,20,000

Liabilities & Stockholder’s Equity

Current Liabilities:

Trade Payable $1,00,000 $1,00,000

Interest payable 20,000 10,000

Income Taxes Payable 46,000 40,000

Bonds payable due in 1 years 1,00,000 1,00,000

Cash dividend payable 20,000 8,000

Salaries payable 4,000 2,000

Total Current Liabilities: 2,90,000 2,60,000

Non-current Liabilities:

Bond Payable due in 5 years 2,40,000 1,60,000

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Introduction

Total Liabilities 5,30,000 4,20,000

Stockholder’s Equity:

Common Stock ($10 per share) 3,00,000 3,00,000

Retained Earnings 4,46,000 4,00,000

Total Stockholder’s Equity 7,46,000 7,00,000

Total Liabilities & stockholder’s Equity $13,76,000 $11,20,000

Additional data: The common stock recently sold at $40.00 per share and the dividends per share $10. The year end balance in the allowance for doubtful accounts was $10,000 for 2009 & $4,000 for 2008. Irredeemable Preference share dividend $20,000 for 2009. Cash flow for ordinary share $2, 00,000.

Required: Compute the following ratios for 2009:

(1) Current Ratio = Total current assets/Total current liabilities(2) Acid -Test Ratio[=Total current assets - inventory/Total current liabilities(3) Trade Receivable Turnover Ratio[=Net sales/Average Trade Receivable(4) Average Collection Period =366/ Trade Receivable Turnover Ratio(5) Inventory turnover Ratio =[Cost of Goods sold/Average Inventory](6) Profit Margin =Income before taxes / Net sales(7) Net Profit Margin =Net Income / Net sales revenue(8) Net income to sales= Net Income / net sales revenue(9) Gross Profit percentage =Net Sales revenue-COGS / Net sales revenue(10) Current Capital =Total Current Assets- Total Current Liabilities(11) Capital employed=Non current assets + working Capital(12) Return on Capital employed =Net Income / Capital employed(13) Assets Turnover Ratio= Net sales/ Average assets(14) Return on total Assets/return on investment =Net Income / Total Assets(15) Operating expenses to sales= Operating expenses / Total Sales(16) Return on common stockholder’s Equity = Net Income – Irredeemable Preference share

dividend / Average Common stockholder’s Equity(17) Earnings Per Share =Net income / Number of shares(18) Price-Earnings ratio= = Market price per share / earnings per share(19) Debt to total assets = Total long term debt/ Total assets(20) Time interest earned = EBIT/ Interest(21) Inventory to Working capital= Inventory/ Working Capital(22) Trade payable turnover ratio= COGS/ Average Trade payable(23) Average payment period=[ 366/Trade payable Turnover Ratio](24) Non-current Assets turnover ratio = Net Sales/ Average Non-current assets(25) Assets utilization = Net Sales/ Average assets(26) Degree of operating leverage= Contribution margin/ Net income(27) Operating margin = Operating Income / net sales(28) Long term debt to Capital Structure= Long-term liabilities / stockholders' equity(29) Leverage = Assets / stockholders' equity(30) Dividend Yield on Common stock= Dividend per share / market price per share(31) Dividend Payout ratio = Dividends per share /earnings per share(32) Gearing= Net debt/ Equity *100(33) Interest coverage= PBIT+ Investment income/ interest payable(34) Net Cash flows from operating activities= Net income+ Non-cash charges+ Changes in

current assets+ Changes in current liabilities.(35) Cash coverage= Net Cash flows from operating activities +interest paid +income tax

paid/ interest paid(36) Cash return= Cash generated from operations+ interest received + dividend received(37) Cash return on capital employed= Cash return/Capital employed *100

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Introduction

(38) Cash from operation= Cash generated from operations/Profit from operation(39) Cash Interest coverage= Cash return/Interest paid(40) Cash flow per share= Cash flow for ordinary share/No. of ordinary share(41) Cash dividend cover= Cash flow for ordinary share/Equity dividend paid.(42) Cash generated from operations=PB tax+ Depreciation charge+ Loss on disposal of PPE+

Investment income+ Finance cost+ increase in inventories+ increase in trade and other receivable+ increase in trade payable.

(43) Quality Income= Net Cash flows from operating activities/Net income(44) Capital acquisition ratio =Net Cash flows from operating activities/Cash paid for PPE

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