accounting for decision making. sect 1-4 1. identifying economic informationfor decisions and...

Accounting for Decision Making.

Sect 1-4

1

Identifying Economic information for decisions and

Measuring about an entity informed judgments

Communicating

Business Activities

OperatingInvestingFinancing

AccountingMeasuringRecordingReportingAnalysing

BusinessDecisions

Accounting is the process of:

Accounting is the link between business activities and business decisions asillustrated in the diagram below.

Ingram et al (2005:59)

2

Topic 1: Accounting information & managerial decisionsTopic 1: Accounting information & managerial decisions

Accounting information

Traditional FinancialAccounting Information

Non-financial Information

Financial Information

•Balance sheet•Income statement•Cost of goods Manufactured•Gross profit•Operating expenses

Other quantitative information

•Percentage of defects•Number of customer complaints•Warranty claims•Units of inventory

Qualitative information

•Customer satisfaction•Employee satisfaction•Product or service quality•Reputation

Source: Jackson and Sawyers (2006: 5)

3


Step 1: Define the problem

Step 4: Select the best position

Step 3: Identify and analyse available optionsStep 2: Identify objectives

The Decision-making Model

4


Financial Statement Reports on

Balance sheet Financial position on a certain date.

Income statement Financial performance for a particular period.

Statement of changes in equity Investments by and distributions to owners.

Statements of cash flows Cash flows during the period.

Transactions Financial statements

Procedures for sorting, classifying, and presenting (bookkeeping)

Selection of alternative methods of reflecting certain transactions (accounting)

The flow from transactions to financial statements can be illustrated as follows:

The financial statements and what they are intended to report on are as follows:

5

Topic 2: Financial Statements & Accounting conceptsTopic 2: Financial Statements & Accounting concepts

6

MVN ENTERPRISES

BALANCE SHEET AS AT 31 JANUARY 2011

ASSETSProperty, plant and equipmentInventory (merchandise)Accounts receivablesCashTotal assets

EQUITY AND LIABILITIES

Equity

LiabilitiesNon-current debtAccounts payablesTotal equity and liabilities

R

247 00019 00028 500

151 400445 900

220 650

100 000125 250445 900


7


MVN ENTERPRISES

INCOME STATEMENT FOR THE YEAR ENDED 31 JANUARY 2011

R

Sales 300 000

Cost of sales (200 000)

Gross profit 100 000

Selling, general and administrative expenses (54 950)

Operating profit 45 050

Interest expense (15 000)

Net profit 30 050

8

MVN ENTERPRISES

STATEMENT OF CHANGES IN EQUITY FOR THE YEAR ENDED

31JANUARY 2011

Balance at 31 January 2010

Additional capital contributed

Profit for the year

Drawings for the year

Balance at 31 January 2011

R

0

211 000

30 050

(20 400)

220 650


9


MVN ENTERPRISES

CASH FLOW STATEMENT FOR THE YEAR ENDED 31 MARCH 20.6

R

Cash flows from operating activities 135 800

Servicing of finance: (15 000)

Interest paid (15 000)

Cash flows from investing activities (260 000)

Payment to acquire tangible non-current assets (260 000)

Net cash outflows (139 200)

Cash flows from financing activities 290 600

Net cash received from owner 190 600

Cash received from non -current loan 100 000

Increase in cash 151 400

10


NOTES TO THE CASH FLOW STATEMENT

Reconciliation of operating profit

R

Operating profit 45 050

Depreciation 13 000

Increase in inventory (19 000)

Increase in accounts receivable (28 500)

Increase in accounts payable 125 250

Net cash flows from operating activities 135 800

Direct Method

Shows the major classes of gross cash receipts and payments. This method starts with

Revenues and Expenses while also including Current Assets as well as Current Liabilities.

11


Indirect Method

Shows the net profit or loss as a starting point and makes adjustments for all

transactions of a non-cash items.

Balance Sheet

Current assets

Inventories

Notes receivable

Accounts receivable

Short-term marketable securities

Cash and cash equivalents

Non-current assets

Land

Buildings and equipment

Assets acquired by lease

Intangible assets

Natural resources

Other non-current assets

12

Topic 3: Accounting & PresentationTopic 3: Accounting & Presentation

Balance Sheet

Owners’ equity

Ordinary shares

Preference shares

Retained income

Current liabilites

Accounts payable

Short-term debt

Current maturities of long-term debt

Non-current liabilities

Long-term debt

Other long-term liabilities

13


14


Number of Books

Cost per

Book

Total Cost

Inventory at 12-31-09 1 @ $85 = $ 85

First purchase (January 2010) 1 @ 87 = 87

Second purchase (June 2010) 2 @ 89 = 178

Third purchase (December 2010) 1 @ 90 = 90

Total goods available for sale 5 $440

Less: Inventory at 12-31-10 4 350

Cost of goods sold 1 @ $90 $ 90

Periodic LIFO of Corner Shelf Bookstore:

15

Number of Books

Cost per

Book

Total Cost

Inventory at 12-31-09 1 @ $85 = $ 85

First purchase (January 2010) 1 @ 87 = 87

Second purchase (June 2010) 2 @ 89 = 178

Third purchase (December 2010) 1 @ 90 = 90

Total goods available for sale 5 $440

Less: Inventory at 12-31-10 4 351

Cost of goods sold 1 @ $89 $ 89

Perpetual LIFO of Corner Shelf Bookstore:

16

The following table represents a framework of the main items that are reported in an Income Statement.

Income statement

Sales

Cost of sales

Gross profit

Other operating expenses

Income from operations

Interest expense

Interest income

Gains (losses) on sale of assets

Income tax expense

Net profit

Earnings per share

17

Topic 4: Income statement & CashflowTopic 4: Income statement & Cashflow

Cost of goods sold in arriving at gross profit:

Sales

Cost of goods sold

Inventory (1/1/06)

Purchases

Direct labour

Less: Inventory (31/12/06)

Net cost of goods sold

Gross profit on sales

R

5,000

45,000

30,000

R

80,000

10,000

R

100,000

70,000

30,000

Gross profit margin is simply the gross profit expressed as a percentage of sales. This ratio is determined as follows:

100xNetsales

tGrossprofi

100000,100

000,30x

R

R

Gross profit margin =

=

= 30%

18

Consolidated statements of income (R millions)

Years ended Dec 2010 2010 2009 2008

Net income

Less: Cost of sales

Gross profit

Less: Research and development

Marketing, general, and admin

Impairment of goodwill

Amortization and impairment of acquisition-related

intangibles

Purchase in-process R&D

Operating expenses

Operating income

34,209

14,463

19,746

4,778

4,659

------

179

-------

9,616

10,130

30,141

13,047

17,094

4,360

4,278

617

301

5

9,561

7,533

26,764

13,446

13,318

4,034

4,334

------

548

20

8,936

4,382

19

Statement of Cash Flows

Cash Flows From Operations

Net income

Add (subtract) adjustments:

Depreciation

Deferred taxes

Gain on the sale of machinery

Equity in long-term investment

Accounts receivable (use)

Inventory (source)

Accounts payable (source)

Net cash flow from operations:

Investing Cash Flows:

Purchase fixed assets (use)

Sale of old machine (source)

Net cash flow from investing:

Financing Cash Flows

10 year note (source)

Sale of common stock (source)

Dividends paid (use)

Repayment of mortgage note (use)

Net cash flow from financing:

Net cash flow (increase)

R

70

100

10

(10)

(2)

(80)

100

20

208

(100)

30

(70)

100

10

(6)

(50)

54

192

Indirect Method:

20

Operating cash flows – Direct method

Cash inflows:

Sales

Increase in A/R (use)

Cash collections:

Cash inputs:

Cost of goods sold

Decrease in inventory (source)

Increase in A/P (source)

Cash inputs:

Other cash outflows:

Current income taxes

Interest paid

Other cash outflows:

Cash Flow From Operations:

Investing Cash Flows:

Purchase fixed assets (use)

Sale of old machine (source)

Net cash flow from investing:

Financing Cash Flows

10 year note (source)

Sale of common stock (source)

Dividends paid (use)

Repayment of mortgage note (use)

Net cash flow from financing:

Net cash flow (increase)

R

1600

(80)

1520

(1350)

100

20

(1230)

(35)

(47)

(82)

208

(100)

30

(70)

100

10

(6)

(50)

54

192

Direct Method:

21

R000 R000

Sales 1 000

Less: Cost of goods sold:

Opening stock 200

Purchases 700

900

Less: Closing stock 300 600

Gross profit 400

Operating expenses (240)

Operating profit 160

Debenture interest (10)

Net profit before tax 150

Taxation (50)

Net profit after taxation 100

Dividends (60)

Retained profit for the year 40

Question.

You are presented with the following information.

IQUAD Ltd Trading and profit and loss statement for the year ended 31 December 2010

22

2009 2010

R000 R000 R000 R000

Fixed assets at cost 900 1000

Less: Accumulated depreciation 150 750 255 795

Current assets

Stock 200 300

Trade debtors 120 150

Cash 20 45

340 495

Less: Current liabilities

Trade creditors 70 90

Taxation 40 50

Proposed dividend 30 60

140 200 200 295

950 1090

Capital and reserves

Ordinary shares of R1 each 750 750

Profit and loss account 200 240

950 990

Loans

Debenture stock (10% issued 1 Jan 2006) ------ 100

950 1090

IQUAD Ltd Balance sheet at 31 December 2010

Required: Prepare the cash flow statement for the year to 31 December 2010. (20)23

R000

Cash receipts

Sale of goods (R1000 + R120 – R150) 970

Issue of debenture stock (R100 – R0) 100

1070

Cash payments

Purchases (R700 + R70 –R90) (680)

Operating expenses (R240 – (R255 – R150)) (135)

Debenture interest paid (10)

Taxation (40)

Dividends (30)

Purchases of fixed assets (R1050 –R900) (150)

(1045)

Increase in cash during the year 25

Cash at 1 January 2010 20

Cash at 31 December 2010 45

IQUAD LtdCash flow statement for the year ended 31 December 2010

24

The following information applies to Trustworthy Enterprises for November 2010:

02 The owner of Trustworthy Enterprises commenced business by investing R65, 000 cash.

06 Purchased equipment for R15, 000 cash.

10 The owner obtained a long-term loan of R30, 000 from the bank.

14 Purchased merchandise on credit for R40, 000.

28 Sold merchandise that cost R15, 000 for R26, 000 on credit.

31 Paid salaries to the employees, R6000.

Required:

•Prepare the Balance sheet of Trustworthy Enterprises as at end November 2010.

•Prepare the Cash Flow Statement for the month ended November 2010.

25

Balance sheet of Trustworthy Enterprises as at 30 November 2010

ASSETS R

Property, plant and equipment 15 000

Inventory 25 000

Accounts receivable 26 000

Cash 74 000

140 000

EQUITY AND LIABILITIES

Equity 70 000

Liabilities

Long-term debt 30 000

Accounts payable 40 000

Total equity and liabilities 140 000

a)

26

Cash flow statement of Trustworthy Enterprises for the month

ending 30 November 2010

R

Cash flows from operating activities (6000)

Net profit 5 000

Increase in inventory (25 000)

Increase in accounts receivable (26 000)

Increase in accounts payable 40 000

Cash flows from investing activities (15 000)

Purchase of plant, property and equipment (15 000)

Cash flows from financing activities 95 000

Capital contributed 65 000

Cash received from long-term loan 30 000

Net increase in cash for the year 74 000

Cash (Opening balance) 0

Cash (Closing balance) 74 000

(b)

27

Good luck with your studies

28

Accounting for Decision

Making.

Sect 5-8

29

Sect 5: Cost-volume-profit relationships.

Using CVP analysis, managers would be able to get information to use in decision-making relating to:

•How profits are affected by a change in costs.

•What effect a change in sales volume will have on profit.

•The profit that is expected from a certain sales volume.

•How many units need to be sold to achieve a targeted profit.

•At what output of production will the income and costs be the same.

•Setting selling prices.

•Selecting the mix of products to sell.

30

Selling price per crate

Variable costs per crate

Fixed costs in respect of the product

Sales volume in crates

R30

R18

R80, 000

8000 crates

Per unit x Volume = Total %

Sales

Variable costs

Contribution margin

Fixed costs

Operating profit

R30

R18

R12 x8 000 = R96 000

(80 000)

R16 000

40

Calculation of operating profit.

Applying these figures in the model results in the following operating profit:

31


Sales

Variable costs

Contribution margin

Fixed costs

Operating loss

R24

18

R612 000 R72 000

(80 000)

(R8 000)

25%

Drop in selling price by R6 and increase in sales volume to 12000 units.

The operating profit will be:

32


Sales

Variable costs

Contribution margin

Fixed costs

Operating profit

R24

18

R 6 x19 000 = R114 000

(86 000)

R 28 000

25%

Decrease in selling price by R6 accompanied by an increase in advertising expense of

R6 000 and an expected increase in sales volume of 19 000 units.

Operating profit is expected to be:

33


Sales

Variable costs

Contribution margin

Fixed costs

Operating profit

R30

18

R 12 x? = R126 000

(80 000)

R 46 000

40%

Calculating the volume of sales required to achieve a target level of operating profit of R46 000.

The required sales volume is 10 500 units (R126 000 / R12).

34

Variable costs per unit

Total fixed cost

Selling price per unit

Number of units sold

R 72

R 32 000

R 82

6 000


Sales

Variable costs

Contribution margin

Fixed costs

Operating profit

R82

72

R 10 x

6000

6000

6000

R492 000

(432 000)

R 60 000

(36 000)

R 24 000

12,195

%

Greystone CC manufactures one product. The following details relating to the product applies:

Required:i.Calculate the break-even quantity and the break-even value.ii.Calculate the margin of safety in terms of units and value.

35

i. Break-even quantity = Fixed costs / Contribution margin per unit

= R36 000 / R10

= 3 600 units

Total revenue at break-even = Fixed costs / contribution margin ratio

= R36 000 / 12,195%

= R295 200 (or 3 600 x R82)

ii. Margin of safety = Sales units – Break-even sales units

(in terms of units) = 6 000 – 3 600

= 2 400 units

Margin of safety = Sales – Break-even sales

(in terms of value) = R492 000 – R295 200

= R196 800

36

profitOperating

inmonContributi

.

arg.

Sales

xsalesBreakevenSales 100...

Operating leverage is calculated as follows:

Operating leverage =

The formula for the margin of safety is:

Margin of safety =

37

Cost analysis for planning, control and decision-making.

Cost analysis for planning.

•Planning is the management process of identifying and quantifying the goals of the organisation.

•Strategic planning involves an identification of the long-term goals and drawing up plans to achieve them.

•A budget is a plan in financial terms that extends for a period in the future.

•Budgeting process. The first step in the budgeting process is to develop and communicate a set of broad

assumptions about the economy, the industry and the entity’s strategy for the budget period.

•The operating budget is a collection of related budgets comprising the sales forecast (or revenue budget), the

purchase/production budget, the operating expense budget, the income statement budget, the cash budget, and

the budgeted balance sheet. The operating budget is also called the master budget.

38

Cost analysis for decision making.

Net Present Value

•The difference between the market value of a project and its cost.

•How much value is created from undertaking an investment?

The first step is to estimate the expected future cash flows.

The second step is to estimate the required return for projects of this risk level.

The third step is to find the present value of the cash flows and subtract the initial investment.

This is to determine whether the project is viable.

Computing NPV for the Project

You are looking at a new project and you have estimated the following cash flows:

•Year 0: CF = -165,000 (original investment)

•Year 1: CF = 63,120

•Year 2: CF = 70,800

•Year 3: CF = 91,080

Your required return for assets of this risk is 12%.

•Using the formulas: NPV = valPar

k

CF

K

CF

K

CF

eee

.)1()1()1( 3

32

21

–NPV = 63,120/(1.12) + 70,800/(1.12)2 + 91,080/(1.12)3 – 165,000 = 12,627.42 39

Year Cash Flow PV

1 63,120.00 56,363.39

2 70,800.00 56,453.16

3 91,080.00 64,845.76

=NPV @ 12% 177,662.91

Original Investment -165,000.00

NPV 12,662.91

Another way of determining NPV is as follows:

Decision rule.

•If the NPV is positive, accept the project. A positive NPV means that the project is expected to

add value to the firm and will therefore increase the wealth of the owners.

•Since our goal is to increase owner wealth, NPV is a direct measure of how well this project will

meet our goal.

•So, do we accept or reject the project?

NPV is positive at 12% - we can accept the investment!

40

Internal Rate of Return

Internal rates of return (IRR).

•This is the most important alternative to NPV.

•It is often used in practice and is intuitively appealing.

•It is based entirely on the estimated cash flows and is independent of interest rates found elsewhere.

•Definition: IRR is the return that makes the NPV = 0.

•Another way of putting it is that the IRR is the discount rate that equates the PV of cash inflows with the

initial investment associated with the project.

•Decision Rule: Accept the project if the IRR is greater than the required return.

41

Example:

The management of Tiger Engineering are considering the following investment project. The following

data is available:

Cost of plant and equipment 60 000

Salvage value nil

Expected profit/loss

Yr 1 (15 000)

Yr 2 10 000

Yr 3 35 000

Tiger Engineering uses the straight-line method of depreciation for all fixed assets. The estimated cost of

capital is 10% p.a.

42

YearProfit/loss

Depreciation Cash flow

1

2

3

(15 000)

10 000

35 000

20 000

20 000

20 000

5 000

30 000

55 000

YearCash flow I Discount factor 10% PV I

0

1

2

3

(60 000)

5 000

30 000

55 000

1

0.9091

0.8264

0.7513

(60 000)

4 546

24 792

41 321NPV

10 659

entAveInvestm

ofitsAve Pr

30000

10000

Cash flows.

ARR

ARR

=

=

= 33.33%

NPV

x 100

x100

43

YearCash flow Disc fact

17%

PV Disc fact

18%

PV

0

1

2

3

(60 000)

5 000

30 000

55 000

1

0.8547

0.7305

0.6244

(60 000)

4 273

21 915

34 342

1

0.8475

0.7182

0.6086

(60 000)

4 237

21 546

33 473

NPV 530 (744)

IRR

1274

530

1

17

IRR = 17.42%

(Where do I get 1274 from? The diff between PV @ 17% and 18%.)

44

Year 0 -$90,000

Year 1 $132,000

Year 2 $100,000

Year 3 -$150,000

IRR 10.11% Reject

NPV fx 15% $91,769.54

Less initial investment -$90,000.00

NPV at 15% $1,769.54 Accept

Quick example.

Suppose an investment will cost $90,000 initially and will generate the following cash flows:

•Year 1: 132,000

•Year 2: 100,000

•Year 3: -150,000

The required return is 15%.

Should we accept or reject the project?

Hurdle rate is 15%.

45

EC Industrials manufactures a product, Brainagra that sells for R126 each.

The cost of producing and selling 240 000 units are estimated as follows;

Variable costs per unit:

Direct materials R30

Direct labour R18

Factory overhead R12

Selling and administrative expenses R15

R75

Fixed costs:

Factory overheads R3 200 000

Selling and administrative expenses R1 200 000

In the current year, to date 180 000 units were manufactured and sold. An additional 45 000 units are expected to

be sold on the domestic market during the remainder of the year. EC Industrials received an offer from Namibia

Wholesalers for 12 000 units of Brainagra at R84 each. Namibia Wholesalers will market the product in Namibia

with its own name brand and no additional expenses will be incurred by EC Industrials. The sale to Namibia

Wholesalers is not expected to affect domestic sales of the product and the additional units could be produced

during the current year using excess capacity.

As the Marketing Manager you are requested to make a decision to either accept or reject the above proposal and

to motivate the decision you have made. (15) 46

A comparison of the sales offer of R84 with the selling price of R126 indicates that the offer should be

rejected. EC Industrials, however, has excess capacity and the focus should be on the relevant cost, which is the

variable cost. The difference in the profit from accepting the offer is calculated as follows:

Differential Revenue from accepting the offer:

12 000 units @ R84 R 1 008 000

Differential cost by accepting the offer:

12 000 units @ R60 (R30 + R18 + R12) (R 720 000)

Differential profit from accepting the offer 288 000

The offer should therefore be accepted.

47

The following information relates to two projects, Project A and Project B from which one must be chosen by

Construction International.

After-tax cash flows

Year Project A Project B

1 0 36 000

2 18 500 36 000

3 36 200 36 000

4 123 000 36 000

Both projects require an initial investment of R117 700

As the project manager of Construction International you are required to:

3.1 Calculate the Net Present Value (NPV) for each project using a discount rate of 12%. Which project would

you use choose? Why?

3.2 Calculate the Internal Rate of Return (IRR) for both projects. Which project should be chosen? Why (20)

48

PROJECT A

Year Cash Inflow Discount Factor Present Value

1 0 0.8929 0

2 18 500 0.7972 14 748

3 36 200 0.7118 25 767

4 123 000 0.6355 78 611

Total Present Value 119 126

Investment 117 700

NPV (positive) 1 426

PROJECT B

Net Inflow R 36 000

Discount factor x 3.0373

Total Present Value 109 342

Investment 117 700

NPV (negative) 8 358

DECISION:

Project A should be chosen because the NPV is positive. Reject Project B because it has a negative NPV.

49

ii. PROJECT A

Choosing the discount factor:

Step 1

Since we know the NPV is positive and above zero, although by a small margin, pick a higher discount rate e.g.

13% (Trial and error is used to obtain the higher rate).

Step 2

Year Cash Discount Discount Present Present

Inflow Factor Factor Value Value

12% 13% 12% 13%

1 0 0.8929 0.8850 0 0

2 R 18 500 0.7972 0.7831 R14 748 R14 487

3 R 36 200 0.7118 0.6931 R25 767 R25 090

4 R123 000 0.6355 0.6133 R78 166 R75 435

Total PV R118 681 R115 012

Investment (R117 700) (R117 700)

NPV R 981 (R2 688)

50

Step 3

Interpolation:

The IRR is between 12% and 13%

IRR = 12 + ____981__

981+ 2 688

= 12 + 981_

3669

= 12.27%

51

PROJECT B

Choosing the discount factor:

Step 1

Since we know the NPV is negative, pick a lower discount rate e.g. 10% (Trial and error is used to obtain

the lower rate).

Step 2

Year Cash Inflow Discount Discount Discount Present Present Present

p.a. Factor Factor Factor Value Value Value

10% 9% 8% 10% 9% 8%

1-4 36 000 3.1699 3.2397 3.3121 114 116 116629 119235

Investment 117 700 117700 117700

NPV (R3 584) (R1071) R1535

52

Step 3

Interpolation: The IRR is between 8% and 9%

IRR = 8 + __1535___

1071+1535

= 8+ 1535

2606

= 8.59%

Decision: Project A must be chosen because it has a higher IRR (20)

53

Project A Project B

Initial investment R42, 000 R45, 000

Year Operating CF’s Operating CF’s

1 14, 000 28, 000

2 14, 000 12, 000

3 14, 000 10, 000

4 14, 000 10, 000

5 14, 000 10, 000

Average 14, 000 14, 000

Payback Period:

For project A, which is an annuity, the payback period is 3.0 years. Since project B generates a mixed stream

of cash inflows, the calculation of the payback period is not quite as clear cut. In year 1 the firm will recover

R28, 000 of its initial investment. In yr 2 R40, 000 will be recovered (28k + 12k). At the end of year 3, R50,

000 will be recovered. Since the amount received at the end of year 3 is greater than the initial investment,

the payback period is somewhere between 2 & 3 years. Only R5, 000 must be recovered during year 3.

However R10, 000 was recovered. Thus the payback period is 2.5yrs (2yrs + R5, 000/10, 000). If the

maximum acceptable payback period is 2.75yrs, project A would be rejected and project B accepted.

54

Analysis and interpretation of financial statements.

Ratio analysis consists of five major categories, namely:

• Liquidity ratios which indicate the ability of the organization to meet its short-term obligations.

• Profitability ratios which express the effectiveness of the company in earning profits and return on capital

invested.

• Financial leverage ratios which show the relative extent to which capital employed has been provided by

shareholders and providers of debt.

• Market ratios which reflect the performance of the share price on the stock exchange and the implications

for the shareholders of that share.

• Efficiency ratios reflect the management ability of the company with regard to its turnover and working

capital. This is also known as Activity Ratios.

55

1) The three basic measures of liquidity are:

i. Net working capital = CA – CL

ii. Current ratio = CA/CL

iii. Quick (acid-test) ratio = CA – inventory / CL

56

2)Activity ratios.

i) Inventory T/O = Cost of goods sold / Inventory

ii)Fixed asset Turnover = Sales / Net fixed assets

iii)Accounts receivable T/O = Ann cr sales / Acc’s rec

iv) Ave collection period = A/c’s rec / Ave sales per day

= (A/c’s rec / Ann sales)/360

57

•Profitability ratios.

i) Gross prof margin = Sales – cost of goods sold / sales = gross profs / sales

ii) Operating prof margin = EBIT / Sales

= Operating profs / Sales

iii) Return on Total Assets (ROA) = Net profs after tax / owners’ equity

iv) Return on Equity (ROE) = Net profs after taxes / Owners’ equity

v) Earnings per share (EPS) = Earnings available for common shareholders / no of shares of common

stock outstanding

58

4) Leverage ratios.

i) Debt ratio = Tot liabilities / tot assets

ii) Debt-to-equity ratio = Long-term debt / owners’ equity

iii) Times interest earned ratio = EBIT / Interest

iv) Fixed-payment coverage ratio: EBIT + lease payments / int + lease payments + ((principal

payments + pref stock divs) x (1/(1-T)))

59

5) Other ratios.

i) Price / Earnings (P/E) ratio: Mkt P per share of common stock / after tax earnings per share

ii) Dividend payout ratio: Ann divs per share/ After tax earnings per share

60

Barlow Company Income Statement for the year ended 31 December 2010

2010 (R,000) 2009 (R,000)

Sales revenue 3,074 2,567

Less: Cost of goods sold 2,088 1,711

Gross profits 986 856

Less: Operating expenses

Selling expenses 100 108

General admin expenses 194 187

Lease expense 35 35

Depreciation expense 239 223

Total operating expense 568 553

Operating profits 418 303

Less: Interest expense 93 91

Net profits before taxes 325 212

Less: Taxes (rate = 29%) 94 64

Net profits after taxes 231 148

Less: preferred stock dividends 10 10

Earnings available for common shareholders 221 138

61

Barlow Company Balance Sheet for the year ended 31 December 2010

Assets 2010 (R,000) 2009 (R,000)

Current assets

Cash 363 288

Marketable securities 68 51

Accounts receivable 503 365

Inventories 289 300

Total current assets 1,223 1,004

Gross fixed assets

Land and buildings 2072 1903

Machinery and equipment 1,866 1,693

Furniture and fixtures 358 316

Vehicles 275 314

Other 98 96

Total fixed assets 4,669 4,322

Less: Accumulated depreciation 2,295 2,056

Net fixed assets 2,374 2,266

Total assets 3,597 3,270

62

Liabilities and stockholders’ equity 2010 (R,000) 2009 (R,000)

Current liabilities

Accounts payable 382 270

Notes payable 79 99

Accruals 159 114

Total current liabilities 620 483

Long-term debt 1,023 967

Total liabilities 1,643 1,450

Stockholders’ equity

Preferred stock – cumulative 5%, R100 par, 2,000 shares

authorized and issued

200 200

Common stock – R2.50 par, 100,000 shares authorized,

shares issued and outstanding in 2006: 76,262; in 2005:

76,244

191 190

Paid-in capital in excess of par on common stock 428 418

Retained earnings 1,135 1,012

Total stockholders’ equity 1,954 1,820

Total liabilities and stockholders’ equity 3,597 3,270

63

Required: Calculate the following for Barlow Company for 2010.

a) The acid-test ratio. (2)

b) The average collection period. (2)

c) The fixed asset turnover. (2)

d) The debt ratio. (2)

e) Operating profit margin. (2)

f) Net profit margin. (2)

g) Return on equity. (2)

h) Price/earnings ratio. (2)

64

sLiabilitieCurrent

InventoryAssetsCurrent

.

. 000,620

000,289000,223,1 RR a) Acid-test ratio = =

daypersalesave

receivableAccounts

...

.

539,8

000,503Rb) Average collection period =

=

= 58.9 days

= 1.51

assetsFixed

Sales

. 000,374,2

000,074,3Rc) Fixed asset turnover = = = 1.29

assetsTotal

sliabilitieTotal

.

.

000,597,3

000,643,1Rd) Debt ratio = = = 45.7%

65

Sales

profitOperating.

000,074,3

000,418Re) Operating profit margin = = = 13.6%

Sales

taxesafterprofitsNet ...

000,074,3

000,231Rf) Net profit margin = = = 7.5%

assetsTotal

taxesafterprofitsNet

.

...

000,597,3

000,231Rg) Return on equity = = = 6.4%

shareperEarnings

stockcommonofshareperpriceMarket

..

......

90.2

25.32

R

Rh) P/E ratio = = = 11.1

66

Good luck with your studies

67

accounting for decision making. sect 1-4 1. identifying economic informationfor decisions and...

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