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Chapter: 17Profitability Analysis
LEARNING OBJECTIVES
After you have studied this chapter, you should be able to understand the following:Meaning of solvencyMeasures of solvencyComposition of capital employedImpact of financing decisions on profitabilityImpact of financing decisions on interest coverage ratioFinancing of assets
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INTRODUCTION
Every stakeholder has interest in understanding the profitability of a company. Analysis of profitability requires one understand the following:
Meaning of profit Meaning of revenue Composition of expenses Composition of investment
Meaning of ProfitProfit is generally defined as excess of income or revenue over the expenses. Profit is always is determined for a particular period. Such period is called accounting period or reporting period. So profit is calculated for a year or for a quarter. Profit calculation is always based on the Generally Accepted Accounting Principles (GAPP) assumptions. Some of the important assumptions are as follows:
Accrual: Transactions should be recorded independent of actual payment or receipts. Matching: Profit should be determining by deducting the corresponding expenses.
Expenses should be charged for the period of the benefit. In most of the cases, profit can be managed (changed) by using the above assumptions as shown by table 17.1.
Table 17.1
Profit Management using the Matching Principle
Case 1 Case 2 Case 3Profit before Amortisation 100,000 100,000 100,000Amortisation of Advertisement Expenses 5,000 10,000 25,000Profit after Amortisation 95,000 90,000 75,000
Un amortised expenses 45,000 40,000 25,000
Profit, in the above case has changed due to the change in the amortisation period. Advertisement expenses of Rs. 50,000 has been amortised over ten years in the first case whereas, in the case 3, it has been amortised over a period of two years. So one has to keep in mind the impact of the accounting assumptions while undertaking the analysis of the profit.
Variations of ProfitProfit has different meaning to different stakeholders. Some stakeholders have interest in the profit generating ability. Others may have interest in the profit distributing ability. Profit can be classified into three broad categories
Accounting Profit Cash Profit Economic Profit
Accounting Profit Accounting profit is the profit shown by the financial statements prepared on the basis of the GAAP. It is the information provided by the management to the shareholders on a regular basis. Financial statements are supposed to show the true and fair profit to the shareholders. However,
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nowhere, ‘true and fair’ view has been defined properly. One can get to see the profit of a company in the Income statement (profit and loss account) and/or the balance sheet. Income statement shows the profit for the current period and the balance sheet shows the accumulated profit. Some of the important assumptions while computing profit are as follows:
Accrual principle: expenses and income should be shown in the income statement at the time of the transaction independent of the actual payment and actual receipt.
Matching principle: Revenue should be compared with the corresponding expenses only. Conservative principle: Provisions can be created to meet future expenses or losses. Financial assumptions: Borrowings (loans/debt) has cost. Equity has no cost. In other
words, interest is treated as an expense. Whereas dividend is not treated as an expense. Interest is an expense, whereas, dividend is an appropriation of profit.
In the income statement one can see following profits:o Gross Profit = Total Income- Cost of Goods Sold (COGS)o Profit Before Depreciation, Interest, Tax and Amortisation (PBDITA) =
Gross Profit – Operating Expenseso Profit Before Interest and Tax (PBIT) = PBDITA – Depreciation -
Amortisationo Profit Before Tax = PBDITA - Interesto Profit After Tax = PBT – Taxo
Table 17.2 shows different profits of TVS motors.Table 17.2
Summarised Income Statement of TVS (Rs. Crores)
2001-02 2002-03 2003-04
Sales & Other Income 1944 2725 2856
Expenditure 1850 95% 2521 93% 2641 92%
PBIT 94 5% 204 7% 216 8%
Interest 12 1% 3 0% 1 0%
PBT 83 4% 201 7% 215 8%
Tax 29 1% 73 3% 76 3%
PAT 54 3% 128 5% 138 5%Source: Annual Reports for the respective year
Cash ProfitAs mentioned in the previous section accounting profit is subjected to the accounting assumptions. Expenses in the income statement includes some non-cash items. Depreciation and amortisation are some of non-cash items. It is possible to change the profit by changing these non-cash items. These non-cash items can be changed by changing the accounting assumptions. Cash profit is determined by keeping aside these assumptions. Cash profit = PAT + Depreciation + Amortisation
Profit and Business DecisionsIt is necessary to check whether the profit is changing due to the operating decisions, investment decisions or financing decisions.
Table 1.3 shows that in some cases depreciation may account for huge difference in the profits. Such high depreciation may be due to high investments in the depreciable assets or some time it may be due to the accounting assumptions.
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Table 17.3 Impact of Investment Decision (Depreciation) on Profit ( for the year ending March 2006) Rs. In crores
Company Name PBDIT PBIT PBIT % of
PBDIT
Bharat Petroleum Corpn. Ltd. 1447.84 679.83 47%
Hindustan Petroleum Corpn. Ltd. 1354.86 665.89 49%
Tata Consultancy Services Ltd. 3422.21 3164.83 92%
Satyam Computer Services Ltd. 1640.15 1517.34 93%Source: Calculated from the respective annual reports
Sometimes the financing decision may affect the profits. If a company finances its business with debt, it may affect the profit distributing ability reflected in the form of PAT. Table 17.4 shows PAT and PBIT of some well known companies of India.
Table 17.4Impact of Financing Decision(interest) on Profit ( for the year ending March 2006) Rs. In crores
Company Name PBIT PAT PAT as % of PBIT
Jet Airways (India) Ltd. 1,430 452 32%
Oil & Natural Gas Corpn. Ltd. 25,463 14,431 57%
Tata Consultancy Services Ltd. 3,165 2,717 86%
Infosys Technologies Ltd. 2,781 2,421 87%
H C L Technologies Ltd. 350 329 94%Source: Calculated from the respective annual reports
Analysis of ProfitProfit is the excess of income over expenses. Expenses is the summation of cost of goods sold (COGS), operating expenses, depreciation, and interest.
Some of the important items which, which affect profit, are as follows:
Revenue Cost of Goods Sold Depreciation Amortisation Interest Tax
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RevenueAccounting Standard (AS-9) governs the recognition of revenue in the financial statements. For the details of AS refer to chapter – Revenue is recognized as follows:
Revenue can change due to the quantity, price, or segment composition. See the table 17.5 to get an understanding of the relevance of segment level analysis.
Table 17.5Hindalco (Rs. In crores)
Segment Profitability for the year2006
Aluminium Copper Total
Total Revenue 6042 5354 11,397
53% 47%
Assets 7134 6731 13,865
51% 49%
Profit 2128 19 2,147
99% 1% Source: Annual Report: http://www.hindalco.com
Copper contributes 47% of the total revenue and has equally high percentage of investment. However, copper contributes only 1% of the total profit.
Cost of Goods SoldMeasuring cost of goods sold (COGS) will also have impact on the profit. COGS depends on the methods of valuing inventory. One can change COGS by changing the methods of inventory valuation. For details on inventory valuation see chapter 12
Example 17.1On 1st April 2006 ABC ltd had 5000 units of goods costing Rs. 5 per unit. During the first quarter purchased 10,000 units@ 10. The company sold 12,000 units @ 20. Find cost of goods using LIFO, Simple average, and FIFO method of inventory valuation.
Value of COGS under different methods of inventory valuation is shown in table 17.6. Table 17.6
Profit and Inventory Valuation
LIFO Average FIFO
Opening Stock 5000 25,000 25,000 25,000
Purchase 10,000 100,000 100,000 100,000
COGS 12000 110,000 90,000 95,000
Closing Stock 3,000 15,000 35,000 30,000
Workings: COGS under LIFO = (10,000*10) +(2,000*5) = 110,000 COGS under Average= (12,000*7.5 = 90,000 COGS under FIFO = (10,000*10) +(2,000*5) = 110,000
Change in profit as shown by table 17.7 is only due to the change in the methods of valuing inventory. Cost of goods purchased is apportioned between COGS (expense) and the value of closing stock(asset).
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Table 17.7 Profit and Inventory Valuation
LIFO Average FIFO
Sales 12,000 240,000 240,000 240,000
Less
COGS 12,000 110,000 90,000 95,000
Profit 130,000 150,000 145,000
DepreciationDepreciation is another item that will influence the profits. Profit can be managed by changing depreciation. Selection of depreciation method is a managerial choice. Managers may use depreciation to increase or decrease profit of a particular reporting period. For details on depreciation see chapter 11.
Example 17.2Sales of ABC ltd = 100,000; COGS = 30,000; Cost of Plant = 100,000; find profit using different methods of depreciation.
Straight line method = 10% Reducing balance method = 25% Double declining method = 20%
Table 17.8 shows the profit under different methods of depreciation. Table 17.8Depreciation
SLM RBM DDM
Cost of the asset 100,000 100,000 100,000
Rate 10% 25% 20%
Depreciation 10,000 25,000 20,000
Depreciation and Profit
Sales 100,000 100,000 100,000
COGS 30,000 30,000 30,000
PBDIT 70,000 70,000 70,000
Depreciation 10,000 25,000 20,000
PBIT 60,000 45,000 50,000
In this case also, change in profit is due to the change in depreciation rather than the change in the operating efficiency.
Interest
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A company can raise funds from shareholders (capital) or loan givers (debt). Accounting treats the cost of these funds differently. Interest on debt is treated as an expense, whereas, dividend is treated as an appropriation of profit. Moreover, interest is allowed as an expenses while computing the taxable profits. As a result a company has the opportunity to change the profit after tax (PAT) just by changing the capital structure.
Example 17.3ABC ltd expects to earn 20% profit (before interest and tax) on the total assets. Assets can be financed by 10% debt and capital (of Rs.10). Find impact of different ways of financing on the profit.Suppose the company plans to invest Rs. 60,000 in the assets in the following ways:
Case 1: Debt ( 10,000) and Capital( 50,000) Case II: Debt ( 20,000) and Capital( 40,000) Case II1: Debt ( 50,000) and Capital( 10,000)
Table 17.9 shows the impact of different combinations of debt and capital on the profit after tax.
Table 17.9 Profit and Interest
DER 0.2 0.5 5
10% Debt 10000 20000 50000
Capital ( RS. 10 per share) 50000 40000 10000
Capital Employed 60000 60000 60000
PBIT (20%) 12000 12000 12000
Interest 1000 2000 5000
PBT 11000 10000 7000
PAT (tax 40%) 6600 6000 4200
EPS 1.32 1.5 4.2
Change in PBT, PAT, and EPS is solely due to the change in the capital structure and the differential treatment of interest.
Profit Ratios Income statement shows different profit. One can determine different profit ratios depending on the requirement of the analyst.
Gross Profit Ratio: This is also called gross margin. Gross profit is the excess of sales over the cost of goods sold (COGS).
Gross Profit Ratio = Gross Profit/Sales Gross Profit = Sales –Cost of Goods Sold Gross profit can also be calculated after deducting other direct expenses.
However, there is no consistency in presenting the gross profit. Moreover, gross profit has not defined any where. One has to keep in mind the possibility of arriving at different gross profit. Gross profit shows the basic profitability of a company. However, as mentioned in the previous section, COGS depends on the inventory valuation methods. Inventory valuation can, therefore, may distort the comparison solely based on the gross margin.
Operating Profit Ratio:
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Operating Profit is the excess of gross profit over the operating expenses, depreciation, and amortisation.
Operating Profit Ratio = Operating Profit /Sales Operating Profit = Gross Profit – Operating Expenses – Depreciation -Amortisation
In this case also, there is no consistency in determining the gross profit. Moreover, one has to keep in mind the possibility of arriving at different operating profit. This ratio shows the profit generating ability of the business from its core activities. However, as mentioned in the previous section, many components of this ratio, viz, COGS, depreciation, and amortisation depend on the accounting assumptions.
If a company has a consistently decently gross margin with low or negative operating profit ratio, one has to investigate the operating expenses and other non-cash expenses: depreciation and amortisation.
Return on Investment (ROI)Return on investment helps in understanding the overall performance of a company. ROI is computed as follows:
ROI = Return / Investment
Before getting into the details of ROI let us define return and investment and understand different connotations of Return and Investment.
Understanding InvestmentThere is no single definition of investment. It depends on the purpose of the analysis. In its widest connotation, the term investment refer to total sources of funds. Similarly, in the narrow sense, it connotes the equity capital. Between these two extremes, there are different combinations. See the following exhibit:
Exhibit 17.1: Composition of Sources
14%25%
61%40%
16%
27%56%
86%75%
39% 33% 28%
0%
20%
40%
60%
80%
100%
OF 86% 75% 39% 33% 28%
LTL 27% 56%
CL 14% 25% 61% 40% 16%
Satyam Infosys ABB Bharti Jet
The exhibit shows the different companies use different combination of sources of funds to finance its activities. So the term investment can be explained as follows:
Investment as Total Sources
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Total sources is the summation of all sources. It shows the funds raised from all sources: shareholders, outsiders and the money generated from the business.
Total Sources = Capital + Reserves + Borrowings (short term and long term)- Losses and Miscellaneous Expenses not written off
Total Sources = Owners Funds + LTL + CL Total Sources = Total Assets
Investment as Capital EmployedInvestment can also be seen as the long term sources only. In that case, investment means capital employed.
Capital Employed = Owners Funds + Long Term Funds Capital Employed = Total Sources – Current Liabilities Capital Employed = Total Assets – Current Assets – Current Liabilities Capital Employed = Fixed Assets +Investment +Networking Capital
Investment as Owners FundInvestment can also seen as the owners money. Owners money is money contributed by the owners (shareholders) and the money generated by the business after meeting all expenses including interest.
Owners Fund = Capital + Reserves –Miscellaneous expenses not written off Owners Fund = Capital Employed –Long Term Borrowings Owners Fund = Total Sources – Long Term Borrowings – Current Liabilities Owners Fund = Total Assets – Liabilities
Investment as CapitalInvestment can also as the money contributed by the owners (shareholders).
Understanding ReturnReturn in the simplest understanding is the profit. But, which profit? The answer depends on the purpose of ROI analysis.
Are we interested in analysing the profit available for all suppliers of money? Are we interested in analysing the profit available for the supplies of long term funds? Are we interested in analysing the profit available for the supplies of equity?
As mentioned at the beginning of the chapter, profit can be gross profit, profit before interest and tax (PBIT) and profit after tax (PAT).
Calculating Return on Investment
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While calculating ROI, we establish a relationship between return and investment. As mentioned in the previous section, definition of return (numerator) depends on the definition of the investment (denominator).
Example17.4
Refer to the table 17.10. Find different profits and different investments that can be used for determining the ROI.
Table 17.10 Balance Sheet Income Statement
Fixed Assets 150,000 Sales 100,000Current Assets 50,000 COGS 20,000Investments 20,000 Operating Expenses 10,000 220,000 Depreciation 5,000Capital 60,000 Interest 2,000Reserves 80,000 Amortisation 2,000Long Term loans 50,000 Tax 10,000Current Liabilities 30,000 Total Expense 49,000 220,000 Profit 51,000
Investment Capital = 60,000 Net-worth = Capital + Reserves = 60,000 + 80,000 = 140,000 Capital Employed = Capital + Reserves + Long Term Loans = 140,000+50,000 Total investment or Total Assets = Capital Employed + Current Liabilities = 220,000
Return Gross Profit = Sales –COGS = 80,000 Profit before interest, depreciation, amortisation, and tax (PBDITA) = 70,000 Profit before interest and tax (PBIT) = 63,000 Profit before tax (PBT) = 61,000 Profit after tax (PAT) = 51,000
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ReturnPBIT
PAT
InvestmentTotal sources/assets
Capital Employed
Owners FundEquity Capital
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While determining the ROI, one has to ask the following question: Are we interested in analysing the profit generating ability of the company? Are we interested in analysing the profit distributing ability of the company?
Profit Generating AbilityPGA shows the ability of the company to use the resources to generate income to meet the expenses and leave some return for the investors: loan givers and capital givers. PGA, therefore, shows the relationship between return and total assets or capital employed. Following ratios are useful indicators of profit generating ability a company:
Return on Total Assets (ROTA) Return on Capital Employed (ROCE)
Return on Total Assets (ROTA)It is the relationship between PBIT and total assets. ROTA is calculated as follows:
ROTA = PBIT/Total Assets Where
o PBIT = Sales –COGS – Operating Expenses – Depreciation and Amortisationo Total Assets = Fixed Assets +Investments + Current Assets
Table 17.11 ROTA as on 31st March 2006
% %
Tata Consultancy Services Ltd. 43% Ranbaxy Laboratories Ltd. 5%
Hero Honda Motors Ltd. 38% Zee Entertainment Enterprises Ltd. 5%
National Aluminium Co. Ltd. 33% Mahanagar Telephone Nigam Ltd. 3%
Infosys Technologies Ltd. 31% Hindustan Petroleum Corpn. Ltd. 3%
Satyam Computer Services Ltd. 30% Bharat Petroleum Corpn. Ltd. 2%Source: CMIE Database
Return on Investment
Profit Generating Ability Profit Distributing Ability
Return on Total Assets
Return on Capital Employed
Return on Owners Fund
Return on Equity Capital
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Example17.5Table 17.12 shows the balance sheet and income statement of ABC ltd. As on 1st April 2006. Find ROTA
Table 17.12 Balance Sheet Income Statement
Fixed Assets 50,000 Sales 100,000Current Assets 20,000 COGS 20,000Investments 20,000 Operating Expenses 10,000 90,000 Depreciation 5,000Capital 10,000 Interest 2,000Reserves 60,000 Total Expenses 37,000Long Term loans 20,000 PBT 63,000 90,000 PAT 37,800
To calculate ROTA we have to find the following:
PBIT = Sales – COGS – Operating Expenses- Depreciation = 65,000 Total Assets = 90,000 ROTA = PBIT/Total Assets = 65,000/90,000 = 72.2%
Example17.6Profit after tax = 12,000; Tax rate = 40%; Net-worth = 50,000; Working Capital = 20,000; Current Asses = 30,000; Interest = 2,000; Rate of interest = 10%. Find ROTA.
PBIT = PAT + Tax = 12,000 +8,000 = 20,000 Total Assets = Net-worth + Current Liabilities + Long Term Loans
o Net-worth = 50,000o Current Liabilities = Current Assets –Working Capital = 10,000 o Long Term Loans = Interest /rate of interest = 20,000
Total Assets = 50,000 + 10,000+ 20,000 = 80,000 ROTA = PBIT/TA = 20,000/80,000 = 25%
Return on Capital Employed (ROCE)This ratio shows the money available for long term investors (equity and debt) and other statutory payments like tax. ROCE is calculated as follows:
ROCE = PBIT/Capital Employed PBIT = Sales –COGS – Operating Expenses – Depreciation and Amortisation Capital Employed = Owners Fund + Long Term Loans Capital Employed = Total Assets – Current Liabilities
Example17.7
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Table 17.13 shows the balance sheet and income statement of ABC ltd. As on 1st April 2006. Find ROCE
Table 17.13 Balance Sheet Income Statement
Fixed Assets 100,000 Sales 100,000Current Assets 50,000 COGS 20,000Investments 20,000 Operating Expenses 10,000 170,000 Depreciation 5,000Capital 20,000 Interest 2,000Reserves 80,000Long Term loans 40,000 Tax 10,000Current Liabilities 30,000 Total Expense 47,000 170,000 Profit 53,000
PBIT = Sales – COGS –Operating Expenses –Depreciation = 65,000 Capital Employed = Total Asses – Current Liabilites = 170,000 -30,000 = 140,000 Or Capital Employed = Capital + Reserves + Long Term Liabilities = 140,000 ROCE = PBIT/CE = 65,000/140,000 = 46.4%
Profit Distributing AbilityAs the name suggests profit distributing ability shows the money that a company generates which can be distributed among the equity shareholders. A company may be having consistent positive PBIT, but due to high leverage it may not be in a position to distribute anything among the shareholders. Money available for distribution among the shareholders is the profit after meeting all expenses including the interest and statutory payments like taxes. Following ratios help in understanding the profit distributing ability of a company.
Return on Networth (RONW) Earning Per Share (EPS) Dividend Per share (DPS)
Return on Owners Fund or Net worth (RONW)This ratio shows the money available for the equity shareholders.
RONW = (PAT – Preference Dividends)/Networth Net- worth = Equity shareholders money = Capital + Reserves, or Net-worth = Total Assets – Outsiders money
Table 17.11 shows RONW of some Indian companies.
Table 17.14 RONW as on 31st March 2006
% %
Bharat Petroleum Corpn. Ltd. 3% Dabur India Ltd. 45%
Hindustan Petroleum Corpn. Ltd. 4% Hero Honda Motors Ltd. 47%
Zee Entertainment Enterprises Ltd. 4% Tata Consultancy Services Ltd. 48%
Mahanagar Telephone Nigam Ltd. 5% Glaxosmithkline Pharmaceuticals Ltd. 55%
Reliance Energy Ltd. 8% Hindustan Lever Ltd. 68%Source: CMIE Data baseExample17.7Find RONW using the information given in the table 17.15
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Table 17.15 Balance Sheet Income Statement
Fixed Assets 30,000 Sales 50,000Current Assets 50,000 COGS 20,000Investments 20,000 Operating Expenses 10,000 100,000 Depreciation 5,000Capital 20,000 Interest 2,000Reserves 30,000 Long Term loans 30,000 Tax 10,000Current Liabilities 20,000 Total Expense 47,000 100,000 Profit 3,000
PAT = Sales – All Expenses –Tax = 3,000 Net-worth = Capital + Reserves = 50,000, or Net-worth = Total Assets – Long Term Loans –Current Liabilities = 50,000 RONW = PAT/Net-worth = 3,000/50,000 = 6%
Example17.8PBIT = 25,000; Tax rate = 40%; Working Capital = 20,000; Current Liabilities = 30,000; Fixed Assets =30,000; No other investments. Interest = 5,000; Rate of interest = 20%. Find RONW.
PAT = PBIT – Interest – Tax = (25,000 – 5,000)*60% = 12,000 Net-worth = Total Assets – Current Liabilities –Long Term Liabilities
o Total Assets = Fixed Assets + Current Assetso Fixed Assets = 30,000o Current Assets = Current Liabilities + Working Capital = 50,000o Total Assets = FA + CA = 80,000o Long Term Liabilities = Interest/Rate of interest = 25,000
Net-worth = Total Assets – Current Liabilities – Long Term Liabilities Net-worth = 80,000 – 30,000 – 25,000 = 25,000 RONW = PAT/Net-worth = 12,000/25,000 = 48%
Earnings Per Share (EPS)EPS is a variation of RONW. It shows the earnings or profit available per share. It is calculated as follows:
EPS = RONW = (PAT – Preference Dividends)/Number of equity shares
As per the Accounting Standard (AS)20 all listed companies are required to show basic and diluted earnings per share with equal prominence for all periods presented. AS-20 explains the process of defining basic and diluted EPS.
Basic EPS Basic earnings per share should be calculated by dividing the net profit or loss for the
period attributable to equity shareholders by the weighted average number of equity shares outstanding during the period.
For the purpose of calculating basic earnings per share, the net profit or loss for the period attributable to equity shareholders should be the net profit or loss for the period after deducting preference dividends and any attributable tax thereto for the period.
All items of income and expense which are recognised in a period, including tax expense and extraordinary items, are included in the determination of the net profit or loss for the period.
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the number of equity shares should be the weighted average number of equity shares outstanding during the period
If an enterprise has more than one class of equity shares, net profit or loss for the period is apportioned over the different classes of shares in accordance with their dividend rights.
Diluted EPS For the purpose of calculating diluted earnings per share, the net profit or loss for the
period attributable to equity shareholders and the weighted average number of shares outstanding during the period should be adjusted for the effects of all dilutive potential equity shares.
the net profit for the period attributable to equity shares is: o increased by the amount of dividends recognised in the period in respect of the
dilutive potential equity shares as adjusted for any attributable change in tax expense for the period;
o increased by the amount of interest recognised in the period in respect of the dilutive potential equity shares as adjusted for any attributable change in tax expense for the period; and
o adjusted for the after-tax amount of any other changes in expenses or income that would result from the conversion of the dilutive potential equity shares.
DuPont Analysis: Disaggregating ROIDupont analysis provides the framework to understand the drivers of ROI. In DuPont analysis, an effort is made to decompose ROI and go to the root cause of ROI. We undertake the DuPont analysis by taking any variation of ROI, viz ROTA, ROCE, or RONW.Before we get into the details of DuPont Analysis let us go back to the classification of the business decisions. The business decisions can be broadly divided into three categories: Financing, Investment, and Operating Decisions. So the profitability or ROI will depend on these decisions.
First Level Disaggregation ROI depends on Operating Decisions, Investment Decisions, Financing Decisions. So managing ROI means managing these decisions. Let us take Return on Capital Employed (ROCE) as the basis to understand DuPont Analysis.
ROCE = Profitability Measures * Efficiency Measures * Leverage Measures ROCE = Profit Margin *Asset Turnover * Asset to Capital Employed R OCE = PBIT/Capital Employed Profit Margin = PBIT/Sales Asset Turnover = Sales /Total Asset Asset to Capital Employed = Total Asset/Capital
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ROCE = PBIT/CE
ro
PBIT/Sales
ro
Sales/Total Assets
ro
Total Assets/CE
ro
= * *
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Example17.8Table 17.16 shows relevant financial information relating to two companies. Comment on the performance.
Table 17.16 Disaggregating Return on Capital
Employed A BSALES 100,000 200,000PBIT 10,000 3,000Capital Employed 100,000 20,000Total Assets 300,000 20,000 ROCE 10% 15%PBIT/SALES 10% 1.50%SALES/TA 0.33 10TA/CE 3 1
Let us investigate why the ROCE of A is lower than that of B. ROCE of A is low despite high profit margin. So low ROCE of A is due to low asset turnover ratio. In other words, it is possible that the A is using large quantity of assets to generate the present sales. Other interpretation can be that the efficiency with which B uses its assets is much higher than that of A. Total assets to capital employed ratio of A three times that of B. So the profit margin of A is very high but the asset turnover is very low. So it seems the A has huge quantity of assets. Similarly, though the ROCE of B is higher than that of A, the profit margin (PBIT/Sales) is very low. So there is a need to investigate the low profit margins of B.
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PBIT/ CE
ro
PBIT/Sales
ro
Total Assets/CE
ro
= **
Sales/Total Assets
ro
A10%
ro
10%
ro
3= **
0.33
ro
B15%
ro
1.5%
ro
1.0= **
1.0
ro
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Second Level Disaggregation Under the second level Disaggregation, each component i.e profit margin, asset turnover, and the leverage is disaggregated.
Example17.9
Disaggregating Profit MarginTable 17.17 shows income statement of two companies. Examine why the profitability of the companies different.
Table 17.17Income Statment
A BSales 100,000 200,000COGS 45,000 98,500
Gross Margin 55,000 101,500Office Expenses 9,000 59,100Selling Expenses 18,000 39,400Depreciation 18,000 0Total Expenses 45,000 98,500
PBIT 55,000 3,000
Profit margin depends on the sales and expenses. Expenses consist of cost of goods sold, office & administrative expenses, selling expenses, and depreciation. Since, PBIT was the basis of the Dupont Analysis, interest has not been considered. Interest and tax can be part of the analysis, if RONW has to be disaggregated.
Following exhibit shows the decomposition of profit margin.
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PBIT/Sales
ro
Gross Profit/Sales
ro
Office Expenses/
Sales
ro
Depreciation/Sales
ro
= - -Selling Expense/
Sales
ro
-
A10%
ro
55%
ro
9%
ro
18%
ro
= - -18%
ro
-
B1.5%
ro
51%
ro
29.5%
ro
0%
ro
= - -20%
ro
-
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Gross Profit AnalysisOne of the most important items on the income statement is the cost of goods sold. Sales less cost of goods sold is gross profit. Gross profit can change if there is change in the selling price, cost of goods sold, number of units sold, and inventory management. In the above example, though the profit margin (PBIT/Sales) of A is much better than that of B, the gross profit margin of both companies is same. So the low profit margin( PBIT/Sales) of B may be due to other expenses.
Expenses AnalysisGross profit less other expenses will be PBIT. Expenses may be classified into different types. In the above example, the expenses were classified into office expenses, selling expenses, and depreciation. DuPont analysis will help in understanding the relationship between expenses and sales. The Disaggregation of expenses will show the efficiency with which a company earns its revenue. In the above example, the office expenses of B is much higher than that of A. High office expense is responsible for low profit margin of B. On the other hand, the depreciation accounts of 18% of total sales of A. There is no depreciation in the case of B. High depreciation of A may be due to the high investment in the fixed assets. Such high fixed asset may affect the over all profitability in the short run due to high depreciation. So there is a need to disaggregate the asset turnover ratio.
Disaggregating Asset TurnoverReturn on capital employed is also influenced by the amount of investment in the assets. Sometimes, the high or low ROCE may be due to the low or high investment in the assets. There fore, there is need to understand whether there is an over-investment or under-investment. Disaggregating asset turnover, will help in answering the following questions:
Is there an over-investment in the company?
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Is the company using its assets efficiently? Is the company creating assets to generate future profits?
Asset turnover shows the productivity of the assets. It shows the sales generated from the given investment in the assets. Total assets can be broadly classified into three categories: fixed assets, current assets, and investments. The amount of capital employed depends on the composition of the assets. Capital employed can be calculated as follows:
Capital employed = Capital + Reserves & Surplus + Long Term Liabilities, or Capital employed = Total Assets – Current Assets, or Capital employed =Fixed Assets + Current Asset – Current Liabilities Capital employed = Fixed Assets + Net Working Capital
So capital employed can be managed by managing fixed assets and working capital. Sometimes, the capital employed may be high due to high fixed assets or current assets to low current liabilities
Fixed Assets TurnoverFixed Assets Turnover ratio shows the relationship between fixed assets and the sales. In a capital intensive companies, the sales to fixed assets may be lower than that of the non-capital intensive companies.
Example17.9Table 17.18 shows the income statement and balance sheet of ABC ltd. Undertake DuPont analysis
Table 17.19 Balance Sheet Income Statement
Fixed Assets 150,000 Sales 100,000Current Assets 50,000 COGS 20,000Investments 20,000 Operating Expenses 10,000 220,000 Depreciation 5,000Capital 60,000 Interest 2,000Reserves 80,000 Long Term loans 50,000 Tax 10,000Current Liabilities 30,000 Total Expense 47,000 220,000 Profit 53,000
1. Find ROCE = PBIT/ CEROCE 46%
PBIT 65,000CE 140,000
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2. ROCE = PBIT/CE = PBIT/Sales * Sales/TA * TA/Capital Employed 46% = 65% * 0.45 * 2
Profit Margin 65%
* Asset
Turnover 0.45
*
Leverage 2PBIT 65,000 Sales 100,000 TA 220,000Sales 100,000 TA 220,000 CE 140,000
Economic Profit (EVA)As discussed in the previous sections, profit is the output of the GAAP driven accounting assumptions. One of the important accounting assumptions is that the interest is treated as an expense, whereas the dividend is treated as distribution of profit. Sometimes, such assumption results is situations where the company show the accounting profit but may be destroying the wealth of the shareholders. So address such anomaly, the concept of the residual profit (from the economics literature) has been made popularized as Economic Value Added by Stern and Stewart.
EVA measures whether the operating profit is enough compared to the total costs of capital employed. EVA is defined as excess of Net operating profit after taxes (NOPAT) over the capital charge.
Economic Value Added is calculated as follows: EVA = NOPAT – Capital Charge NOPAT = Net Operating Profit After Tax (before interest) Capital Charge = Cost of both Debt and Equity Capital Charge = WaCC * CE Capital Charge = Ke*Capital + Kd*Debt
Cost of capital or Weighted average cost of capital (WACC) is the average cost of both equity capital and interest bearing debt. Cost of equity capital is the opportunity return from an investment with same risk as the company has. Cost of equity is usually defined with Capital asset pricing model (CAPM). The estimation of cost of debt is naturally more straightforward, since its cost is explicit. Cost of debt includes also the tax shield due to tax allowance on interest expenses.
Example17.10
Table 17.20 shows the income statement and balance sheet of ABC ltd. You are required to find EVA.
Table 17.20 Balance Sheet as on 31st Mar 06 Income Statement
Sources Amount Assets Amount Sales 20,000Capital (10) 10,000 FA 20,000 COGS 10,000
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Profits 22,000 Investment 3,000 Expenses 2,000LTL (10%) 10,000 Stock 15,000 Depreciation 1,000Creditors 11,000 Debtors 10,000 Interest on LTL 1,200 Cash 5,000 14,200 PBT 5,800 Tax (40%) 2,320 53,000 53,000 PAT 3,480
Additional information: Risk free return (Rf) = 7%; Market Return (Rm) = 18%; Beta = 1.5
Step I: Find NOPAT
Different ways of determining NOPAT is shown by table 17.21
NOPAT = Sales – Expenses (other than interest)- Tax NOPAT = PAT +Interest – Tax Benefits of interest NOPAT = PAT + Interest(1-t)
Table 17.21 NOPAT
NOPAT
NOPATSales 20,000 PAT 3,480 PAT 3,480Less Add COGS 10,000 Interest 1,200 Add Expenses 2,000 Less Net Interest 720Depreciation 1,000 Tax Benefits of Interest 480 13,000 NOPBT 7,000 Less Tax 2800 NOPAT 4,200 NOPAT 4,200 4,200
Step II: Find Capital Employed
Different ways of determining capital employed is shown by table 17.22
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Capital Employed = Capital + Profit + Long Term Liabilities + Interest Bearing Current Liabilities
Capital Employed = Total Assets – Non Interest Bearing Current Liabilities Capital Employed = Fixed Asset + Investment + Working Capital
o Working Capital = Current Asses – Non Interest Bearing Current Liabilities
Table 17.22Capital Employed Capital Employed Capital Employed
Capital 10,000 Fixed Assets 20,000 Fixed Assets 20,000Profits 22,000 Investments 3,000 Investments 3,000LTL 10,000 Current Assets 30,000 Working Capital 19,000 Less Current Liabilities 11,000 Capital Employed 42,000 Capital Employed 42,000 Capital Employed 42,000
Step III: Find cost of debt and cost of equity
Cost of Debt (Kd) = i(1-t) = 10% (1-40%) = 6% Cost of Equity (Ke) = Rf + b (Rm-Rf) = 7% + 1.5*(18%-7%) = 24%
Step IV: Find Capital Charge
Capital Charge = Ke * Equity + Kd*DebtCapital Charge
Amount Rate CostEquity 32,000 24% 7,520Debt 10,000 6% 600
Capital Charge 8,120
Capital Charge can also be calculated as = WaCC * Capital Employed
Weighted Average Cost of Capital (WaCC)
Ke 24% 0.76 17.9%Kd 6% 0.24 1.4%
WaCC 19.3%
Capital Employed = 19.3% * 42000 = 8120
Step V: Find EVA
EVA = NOPAT – Capital Charge EVA = 4200 - 8120 = Negative 3920
EVA can also be determined as follows:
EVA = (Rate of Return on Capital Employed – WaCC)*Capital Employed
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o Rate of Return on capital employed = NOPAT/Capital Employedo Rate of Return on capital employed = 4200/42000 = 10%o WaCC = 19.3%o Capital Employed = 42,000
EVA = (10% - 19.3%) * 42,000 = Negative 3920
The idea behind EVA is that shareholders must earn a return that compensates the risk taken. In other words equity capital has to earn at least same return as similarly risky investments at equity markets. If that is not the case, then there is no real profit made and actually the company operates at a loss from the viewpoint of shareholders. On the other hand if EVA is zero, this should be treated as a sufficient achievement because the shareholders have earned a return that compensates the risk. This approach - using average risk-adjusted market return as a minimum requirement - is justified since that average return is easily obtained from diversified long-term investments on stock markets. Average long-term stock market return reflects the average return that the public companies generate from their operations.
Accounting Adjustments
As defined earlier EVA is the Net operating profit after taxes (NOPAT) subtracted with the cost of capital employed. But the calculation is not so simple as calculating the total capital employed is a difficult task due to the plethora of accounting distortion in the balance sheet. So there are more than 250 accounting adjustments as proposed by Stern Stewart to be done in moving to EVA. In practice most organisation do no more than fifteen relevant adjustment to do the calculation. The adjustment include netting the non-interest bearing liabilities against the current asset that means adding back to the equity the gross write-offs, reserves, provisions and capitalised value of the R & D and Advertising. These accounting adjustment are referred as equity equivalents and their effects on the Capital and NOPAT are summarised below.
Add to Capital Add to NOPAT
Equity Equivalents Increase in Equity Equivalents
Deferred tax reserve Increase in deferred tax reserve
Cumulative goodwill amortisation Goodwill amortisation
Capitalised intangibles Increase in intangibles
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Cumulative usual gains/losses Usual gain/losses
Other Reserves Increase in Other Reserves
(Bad debt, warranty etc.) (Bad debt, warranty etc.)
LIFO Reserves Increase in LIFO Reserves
Unrecognised goodwill
Example17.11
Table 17.23 shows the balance sheet and Income Statement of ABC .
Table 17.23 Balance Sheet as on 31st Mar 06 Income Statement
Sources Amount Assets Amount Sales 80,000Capital (10) 20,000 FA 20,000 COGS 10,000Profits 22,000 Investment 3,000 Expenses 2,000LTL (12%) 10,000 Goodwill 10000 Goodwill 10,000Creditors 11,000 Stock 15,000 R&D Expenses 15,000 Debtors 10,000 Depreciation 1,000 Cash 5,000 Interest on LTL 1,200 39,200 PBT 40,800 Tax (40%) 26,320 63,000 63,000 PAT 14,480
During the year the company acquired a new business and excess money paid over the book value of the asset taken over was Rs. 20,000. It decides to amortise it over two years. It had spent money of research and development and it was fully shown as an expense. For calculating EVA take cost of equity as 24%.
Step II: Find NOPAT
Table 17.24 NOPAT
NOPAT
NOPATSales 80,000 PAT 14,480 PAT 14,480Less Add
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COGS 10,000 Interest 1,200 Add Expenses 2,000 Goodwill 10,000 Net Interest 720Depreciation 1,000 R&D Expenses 15,000 Goodwill 10,000 13,000 Less R&D Expenses 15,000NOPBT 67,000 Tax Benefits of Interest 480 Less Tax 26,800 NOPAT 40,200 NOPAT 40,200 40,200
While computing NOPAT , goodwill and R&D expenses have been added back.. These are not treated as an expenses.
Step II: Find Capital Employed
Table 17.25 Capital Employed Capital Employed Capital Employed
Capital 20,000 Fixed Assets 20,000 Fixed Assets 20,000Profits 22,000 Investments 3,000 Investments 3,000LTL 10,000 Current Assets 30,000 Working Capital 19,000Add Goodwill 10,000 Goodwill 10,000 EE EE 25,000 Goodwill 10,000 EE 25,000 R&D Expenses 15,000 Less Current Liabilities 11,000 Capital Employed 77,000
Capital Employed 77,000
Capital Employed 77,000
Goodwill and R&D Expenses amortised have been removed from the income statement and added to the assets.
Step III: Find Capital Charge
Capital Charge Amount Rate CostEquity 42,000 24% 9,870EE 25,000 24% 5,875Debt 10,000 7.2% 720
Capital Charge 16,465
Step IV: Find EVA
EVA = NOPAT – CC = 40,200 -16,465 = 23,735
Accounting Adjustments
EE = Equity Equivalent = Accounting Adjustments for converting accounting profit and accounting capital into economic profit and accounting capital
EE = Goodwill amortised and R&D Expenses amortised EE = 10,000 + 15,000 = 25,000
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Market Value Added
For listed companies Stewart defined another measure that assesses if the company has created shareholder value. If the total market value of a company is more than the amount of capital invested in it, the company has managed to create shareholder value. If the case is opposite, the market value is less than capital invested, the company has destroyed shareholder value. Stewart calls that difference between the company's market and book value as Market
Market Value Added = Company's Total Market Value - Capital Invested
and with simplifying assumption that market and book value of debt are equal, this is the same as:
Market Value Added = Market Value of Equity - Book Value of Equity.
Book value of equity refers to all equity equivalent items like reserves, retained earnings and provisions. In other words, in this context, all the items that are not debt (interest bearing or non-interest bearing) are classified as equity.
According to Stewart Market value added tells us how much value company has added to, or subtracted from, its shareholders' investment. Successful companies add their MVA and thus increase the value of capital invested in the company. Unsuccessful companies decrease the value of the capital originally invested in the company. Whether a company succeeds in creating MVA (increasing shareholder value) or not, depends on its rate of return. If a company's rate of return exceeds its cost of capital, the company will sell on the stock markets with premium compared to the original capital (has positive MVA). On the other hand, companies that have rate of return smaller than their cost of capital sell with discount compared to the original capital invested in company. Whether a company has positive or negative MVA depends on the level of rate of return compared to the cost of capital. All this applies also to EVA. Thus positive EVA means also positive MVA and vice versa.
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Key TermsProfitProfit is generally defined as excess of income or revenue over the expenses. Profit is always is determined for a particular period.
Accrual PrincipleTransactions should be recorded independent of actual payment or receipts.
Matching PrincipleProfit should be determining by deducting the corresponding expenses. Expenses should be charged for the period of the benefit.
Accounting Profit Accounting profit is the profit shown by the financial statements prepared on the basis of the GAAP.Gross Profit Ratio: This is also called gross margin. Gross profit is the excess of sales over the cost of goods sold (COGS). Gross profit ratio shows the relationship between gross profit and sales.
Operating Profit Ratio: Operating Profit is the excess of gross profit over the operating expenses, depreciation, and amortisation. It is calculated by dividing Operating Profit by Sales.Total SourcesTotal sources is the summation of all sources. It shows the funds raised from all sources: shareholders, outsiders and the money generated from the business.Capital EmployedCapital employed is summation of all long term sources. Capital employed = Owners Funds + Long Term Funds or Capital employed = Total sources – Current liabilities.Owners FundOwners money is money contributed by the owners (shareholders) and the money generated by the business after meeting all expenses including interest. Owners fund = Capital + Reserves and Surplus or Owners fund = Total Assets – Outsiders money.Profit Generating AbilityProfit generating ability shows the ability of the company to use the resources to generate income to meet the expenses and leave some return for the investors: loan givers and capital givers.
Return on Total Assets (ROTA)It is the relationship between PBIT and total assets. ROTA is calculated as ROTA = PBIT/Total Assets.Return on Capital Employed (ROCE)This ratio shows the money available for long term investors (equity and debt) and other statutory payments like tax. ROCE is calculated as follows:ROCE = PBIT/Capital Employed.
Profit Distributing AbilityProfit distributing ability shows the money that a company generates which can be distributed among the equity shareholders.Return on Owners Fund or Net worth (RONW)This ratio shows the money available for the equity shareholders and is calculated as RONW = (PAT – Preference Dividends)/Net-worth. PAT is profit after tax.Earnings Per Share (EPS)
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EPS is a variation of RONW. It shows the earnings or profit available per share. It is calculated as follows:EPS = RONW = (PAT – Preference Dividends)/Number of equity sharesBasic EPSBasic earnings per share should be calculated by dividing the net profit or loss for the period attributable to equity shareholders by the weighted average number of equity shares outstanding during the period.
Diluted EPSDiluted EPS takes into account the potential equity shares. For the purpose of calculating diluted earnings per share, the net profit or loss for the period attributable to equity shareholders and the weighted average number of shares outstanding during the period should be adjusted for the effects of all dilutive potential equity shares.
DuPont AnalysisDupont analysis provides the framework to understand the drivers of ROI. In DuPont analysis, an effort is made to decompose ROI and go to the root cause of ROI. We undertake the DuPont analysis by taking any variation of ROI, viz ROTA, ROCE, or RONW.
Economic Value AddedEVA is excess of NOPAT over the capital charge. EVA measures whether the operating profit is enough compared to the total costs of capital employed.
Cost of capitalCost of capital or Weighted average cost of capital (WACC) is the average cost of both equity capital and interest bearing debt.
Equity EquivalentsAccounting adjustments required to convert accounting profit or accounting capital into economic profit or economic capital. Such adjustments reflect the deviations from GAAP.
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Theoretical Questions1. Examine difference between profit generating and profit distributing
ability of a company.2. Why is it necessary to study the asset turnover to understand the
profitability position of a company?3. What is the purpose of disaggregating profit margin?4. What is DuPont Analysis?5. Explain the process disaggregating RONW?6. Examine the impact of Debt Equity Ratio on the Earning Per Share.7. What is EVA?8. Explain in detail the process of calculating EVA.9. Explain the difference between PAT and EVA.10. What is NOPAT/11. How is NOPAT different from PAT?12. What is capital charge?13. Explain in brief the relationship between the Debt Equity Ratio and
EVA.14. Return on capital employed is a function of profit margin, assets
turnover, and leverage. Explain.15. Examine some of the important accounting adjustments required while
determining the EVA of a company.16. Explain the difference between accounting profit, economic profit, and
cash profit.17. Examine the impact of the financing decision on the profit distributing
ability of a company.18. Examine the impact of the investment decision on the profit generating
and distributing ability of a company.19. What is Market Value Added?20. What are equity equivalents?
Numericals1. PAT = 5000; Interest = 1000; Tax Rate = 40%. WaCC = 15%; Capital Employed =
20,000. Find EVA2. PAT = 5000; Interest = 1000; Tax Rate = 40%. WaCC = 15%; Find NOPAT.3. NOPAT = 50000; 4. Profit Margin (PBIT /Sales) = 10%; Assets Turnover = 2; Assets to Capital Employed =
3. Find ROCE.5. RONW (PAT/NW) = 15%; PAT/Sales = 20%; Sales to Assets = 0.5; Find what
percentage of assets were financed by net-worth. 6. Debt Equity Ratio = 2; Capital Employed = 100,000; Rate of interest = 10%; Face value
per share = 5; Tax rate = 30%; Find Earning per Share, if the DER is changed to 3.7. 12% Debt = 200,000; Equity = 300,000; Risk free return = 5%; Market Return = 15%;
Beta = 1.5; Tax rate = 40%; Find WaCC;8. Refer to the above question. Find WaCC, if the company changes the DER to 3:2.
9. Present sales = 500; Margin on sales = 10% Capital = 1000. They have new proposal:. Investment = 500; Additional sales due to the new investment = 200
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with a margin of 20% on sales. Evaluate the proposal. WaCC = 12%. Management accepted the proposal. Comment.
10. Present sales = 2000; Margin on sales = 25% Capital = 1000. They have new proposal:. Investment = 500; Additional sales due to the new investment = 1000 with a margin of 20% on sales. Evaluate the proposal. WaCC = 12%. Management rejected the proposal. Comment
11. Find EVA :Balance Sheet of ABC Ltd
Capital 10000 Fixed Assets 50000Reserves 50000 Investments 20000Loans 20000 Current Assets 20000Creditors 10000 90000 90000
Tax Rate : 30%Ke = 15%
12. The management of A ltd was quite happy that the EPS of the company has been consistently increasing and in the current year it reached all time high of 7.2. However, the shareholders are not happy with the company. In fact, the price decreased in the recent past. Will EVA explain the behavior of shareholders? Relevant information for calculating EVA: Interest on Government Bonds = 6%; Average Market Return = 18%; Beta = 1.8.
Balance Sheet as on 31st Mar 06Sources Amount Assets AmountCapital (10) 5,000 FA 20,000Profits 25,000 Investment 3,000LTL (12%) 10,000 Cash 30,000STL (12.5%) 8,000 Creditors 5,000 53,000 53,000
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Income StatementSales 20000COGS 10000Expenses 2000Depreciation 1000Interest on LTL 1200Interest on STL 1000PBT 4800Tax (40%) 1920PAT 2880
Income StatementSales 200000Cost of material 30000Operating Expenses 30000Depreciation 20000Patent 40000Interest 2000 122000PBIT 78000
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13. Evaluate the performance of the following divisions:Financial Data of AB Ltd.
D1 D2 D3 TOTAL
Revenue 300 250 150 700Variable Cost 70 60 30 160Fixed Cost 150 130 80 360
PBIT 180Interest 40
PBT 140Tax 56
PAT 84
Balance SheetCurrent Assets 200 100 80 380Fixed Assets 300 200 120 620Total Assets 500 300 200 1000C. Liabilities 40 30 30 100Loan Funds 400Own Funds 500
14. Following are the financial statements of AB ltd.Balance Sheet
2005 2004 2005 2004Creditors 671 645 Cash 28 31Short Term Loans 137 131 Debtors 879 842Outstanding Salaries 250 231 Stock 1121 977Current Liabilities 1058 1007 Others 77 81 2105 1931Long Term Debt 52 604 Fixed Assets 395 369 Capital 633 27 Accumulated Profits 757 662 Total 2500 2300 Total 2500 2300
Income Statement 2005 2004
Sales 4500 4700COGS 2813 3008Other Expanses 1396 1504
PBIT 291 188Interest 21 70
PBT 270 118Tax 108 47
PAT 162 71
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Interest Rate: 10%
Risk free return = 5%
Market Return = 18%
Beta = 1.5
Tax rate : 40%Average Interest rate : 10%
Risk free return (Rf): 5%
Risk Premium : 15%
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The company is quite happy with the performance. Management also declared dividend for the shareholders. Management is proposing high percentage of bonus for the top management for the approval of the shareholders. Give your comments.
15. Mr. A prepared the financial statements as shown below. Income statement shows loss. But Mr. A feels the financial statements fail to show the economic reality. He asks you to find EVA, which reflects the correct performance. He even suggests that you should 15% as the cost of equity.
Balance Sheet as on 31st Mar 06 Income Statement
Sources Amount Assets Amount Sales 100,000Capital (10) 20,000 FA 20,000 COGS 25,000Profits 22,000 Investment 3,000 Expenses 2,000LTL (10%) 25,000 Goodwill 40000 Goodwill 40,000Creditors 26,000 Stock 15,000 R&D Expenses 18,500 Debtors 10,000 Depreciation 1,000 Cash 5,000 Interest on LTL 2,500 89,000 PBT 11,000 Tax (40%) 27,800 93,000 93,000 PAT -16,800
Required: Find EVA and explain why is it different from PAT?Real Life Questions
1. Following table shows the relevant profitability ratios of Bajaj Auto Limited:DuPont Analysis of Bajaj Auto Limited
2004-05 2003-04 2002-03RONW 19% 20% 16%
Profit Margin 13.33% ? 12.88%Asset Turnover 86.30% 78.44% 74.70%
Asset Leverage ? 164.12% ?Required: Find the missing numbers
2. Refer to the balance sheet and the income statement of Bajaj Auto Limited (given as an Annexure). Undertake a detailed DuPont Analysis (for RONW, ROCE, ROTA) for the year ending March 2005.
3. Following are the balance sheet and income statement of Satyam Computers Services Limited.
Satyam Computer Services Ltd.Income Statement
Year 2002-03 2003-04 2004-05Sales 202,365 254,154 346,423Other income 2,786 8,173 8,255
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Total Income 205,151 262,328 354,678Expenditure Operating Expenses 140,512 184,897 257,508
PBDIT 64,639 77,431 97,170Less: Interest 72 75 76
PBDT 64,567 77,356 97,095Less: Depreciation 12,418 11,162 10,394
PBT 36,903 66,194 86,700Tax provision 6,160 10,615 11,674
PAT 30,742 55,579 75,026Dividends 9,436 12,672 15,963
Satyam Computer Services Ltd.Balance Sheet
Year 2002-03 2003-04 2004-05Fixed Assets 31,930 27,158 31,697Investments 5,761 7,475 7,848
Deferred Tax Assets(net) 345 529 1,071
Current Assets 212,637 259,022 327,282 250,672 294,184 367,898 Share capital 6,291 6,344 6,430Reserves & surplus 207,197 251,752 315,317
Total borrowings 1,836 730 987
Current liabilities & provisions 35,349 35,359 45,164 250,672 294,184 367,898
Required: Return on Capital Employed Return on Net-worth Comment on the overall profitability using DuPont Analysis
4. Following table shows the Return on Total Assets of three companies belonging to the automobile sector.
Return on Total Assets (%) 2001-02 2002-03 2003-04Hero Honda 39.79 40.39 40.21
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Bajaj 13.27 12.75 13.45TVS 22.87 19.07 17.01
Visit the web site of these companies and examine the reasons how and why the ROTA of Hero Honda was higher than that of its competitors.
5. Following tables show the balance sheet and income statement items of HLL for the year ending 2005.
Balance Items of ITC 2005
Cash and bank Balances 55.66
Secured loans 88.69
Other Current Assets 142.52
Unsecured Loans 156.67
CWIP 186.15
Capital 249.43
Deferred tax net 376.09
Sundry Debtors 527.76
Loans and Advances 810.36
Provisions 1108.18Accumulated depreciation 1795.51
Liabilities 1925.64
Inventories 2002.99
Net Block 3950.76
Gross Block 5746.27
Reserves 7646.18
Required: Balance Sheet and Income Statement
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Income Statement Items of ITC 2005
Gross income 13585.39
Gross Sales 13349.58
Net Sales 7639.45
Excess duties taxes 5710.13
Raw Materials etc. 2769.55
profit before taxation 2673.07Manufacturing and Selling Expenses 2119.77
Profit after Taxation 1837.07
Provision for Taxation 836
Depreciation 312.87
Other Income 235.81
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Disaggregate RONW and prepare the DuPont chart.
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