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Chapter 11Chapter 11Chapter 11Chapter 11Fundamental analysisFundamental analysisFundamental analysisFundamental analysis
Chapter IndexChapter IndexChapter IndexChapter Index
The Concept of Fundamental Analysis Valuation of Goodwill Valuation of Shares P E Ratio Accounting Ratios
Prices of the securities in the stock exchange keep on fluctuating. The investors
and other operators are always interested in buying the shares at lower prices
and selling them at higher prices to make profit. To achieve this objective, they
estimate the share price.
Fundamental Analysis is the process of finding the intrinsic value or worth of a
share. It is the study of a companys fundamentals with the aim of determining its
exact worth. The process is based on analyzing the information that is
fundamental to the company. Fundamental analysis focuses on creating a
portrait of a company, identifying the intrinsic or fundamental value of its shares
and buying or selling the stock based on that information.1 The investments
made on the basis of fundamental analysis carry less risk if the time horizon of
the investment is long.
The share should be purchased if it is being traded in the market below its
intrinsic value, it should be sold if it is traded in the market at a price above its
intrinsic value. Suppose the intrinsic value of a share is Rs.200, the fundamental
analyst suggests buying it if it is being traded in the market below Rs.200; sale is
recommended if it is traded above Rs.200.
1Investopedia.com
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Fundamental analysis involves three types of analysis:
(i) Economic Analysis(ii) Industry Analysis(iii) Company analysis
Fundamental analysis performed by the investors or their investment advisors. It
is difficult for the ordinary investors to perform the analysis. Hence, generally it
is carried by the consultants who are experts in this filed.
There are two investment philosophies followed by the experts:
(i) Top down philosophy. and
(ii) Bottom up philosophy.
Top down philosophy follows the following investment process (a) First consider
the macro-factors i.e. the state of economy; invest in the economy that is strong
and growing (b) then, consider the industry; invest in the industry which is
expected to outperform other industries (c) finally, consider the company; invest
in the company which is expected to be best in the industry.
Bottom up philosophy gives maximum weight to the company i.e. a bottom-up
investor considers the financial health, products, supply and demand, and other
aspects of a company's performance over a given period of time. Using this
approach the portfolio manager pay less attention to the economy as a whole, or
to the prospects of the industry a company is in.
Economic Analysis: Corporate performance is very much influenced by macro-level
economic factors. Positive factors increase the worth of the shares as such factors have
positive impact on the performance of the company. These factors are: Monsoon, interestrates, GDP growth, foreign exchange rates, inflation, public debts, budgetary deficits,taxation policy, balance of trade, savings rate etc.
Economic analysis is performed not only from the point of national economy but also
from the point of view of the global economy particularly when the company is operating
at global level.
Industry Analysis: Industry analysis gives an investor a deeper understanding of
a company's financial prospectus. The purpose of this analysis is to identity the
companies which are expected to provide good returns to the investors. It is a
study of demand and supply of the industrys products. Industry analysis should
be done from global prospective. The main study in industry analysis is the
phase through which the industry is passing. There are four stages in any
through which every industry has to pass _ (a) Innovation stage (ii) expansion
stage (iii) stagnation stage and (iv) Declining stage. Industry analysis is quite
important part of the fundamental analysis. For example, when the industry is
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passing through expansion stage, not only the leaders but even the laggards
report good performance.
Company AnalysisCompany AnalysisCompany AnalysisCompany Analysis: There are two parts of company analysis:
(i) Non-Financial analysis: This includes analysis of leadership, top management,
corporate governance, corporate vision, corporate policies, relationship with
different stakeholders and competitive advantage/disadvantage.
(ii) Financial Analysis: Financial analysis means analysis of financial statements
using the accounting ratios.
VALUATION OF GOODWILLVALUATION OF GOODWILLVALUATION OF GOODWILLVALUATION OF GOODWILL
Valuation of goodwill is an important step of valuation of shares. Hence before
discussing the valuation of shares, lets understand the concept of valuation of
goodwill.
Goodwill is defined as super profit earning capacity of the business.
Goodwill = Super profit x No. of years of purchase. Hence, before we calculate the
value of goodwill, lets understand these two terms (i) super profit, and (ii) No. of
years of purchase2.
Super profit = Future Maintainable Profit Normal Profit.Future Maintainable ProfitFuture Maintainable ProfitFuture Maintainable ProfitFuture Maintainable Profit
Buyer of goodwill is interested in future profits of the concern. Hence, for
determining value of goodwill, we estimate future maintainable profit on the
basis of following points :
(i) Take profits for a few years of past. We take profit for such number of
years as reveals the future trend of the profit e.g., if the profit has
clear trend we may take profit only for three years but if there is no
clear trend, we may take profit for 4 to 7 years.
(ii) Eliminate the effect of non-trade items. For example:
Income from investment of surplus funds.(iii) Eliminate the effect of abnormal items, for example, loss on account of
strike, flood, etc., abnormal profit on account of war, etc.
(iv) Eliminate the effect of such items which occurred in the past but which
are not likely to take place in the future.
(v) Take average of profits. If the profits have clear trend, take weighted
2The concept of number of years of purchase is not required for SFM paper. It is given in
Appendix A for those who are interested in learning it.
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average, otherwise take simple average.
(vi) Take effect of such transactions into consideration which did not take
place in past but which would take place in future.
(vii) Consider Income-Tax.
Normal profit = Average capital employed x Normal Rate
Capital employed, here, means owners investment in trade assets
(excluding goodwill) of the business.
Open. Cap. Emp. + Closing Cap. Emp.
Average Cap. Emp. =
2
If opening capital employed is not given in the question, we assume openingcapital employed is equal to closing capital employed minus current year post
tax profit. Hence average capital employed:
(Closing C.E. Current Year Post Tax Profit) + Closing C.E.
=
2
= Closing C.E. Half of Current Year Post Tax profit.
Goodwill = Super profit x No. of years of purchase.
Q. No. 1 :Q. No. 1 :Q. No. 1 :Q. No. 1 : Negotiation is going on for transfer of X Ltd. on the basis of the
balance sheet and the additional information as given below:
Balance Sheet of X Ltd. as on 31st March, 1988
Share capital (Rs.10
fully paid up )
10.00,000 Goodwill 1,00,000
Reserve and surplus 4,00,000 Land and building 3,00,000
Creditors 3,00,000 Plant and machinery 8,00,000
Trade Investments 1,00,000
Stock 2,00,000
Debtors 1,50,000
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Cash and bank 50,000
17,00,000 17,00,000
Profit before tax for 1987-88 amounted to Rs. 6,00,000 including Rs. 10,000 as
interest on investment. However, and additional amount of Rs. 50,000 p.a. shall
be required to be spent for smooth running of the business.
Market values of land & buildings and plant & machinery are estimated at Rs.
9,00,000 and Rs. 10,00,000 respectively. In order to match the above figures
further depreciation to the extent of Rs. 40,000 should be taken into
consideration. Income-tax rate may be taken at 50 per cent. Return on capital at
the rate of 10 per cent post tax may be considered normal for this business at
the present stage.It has been agreed that 4 years purchase of super profit shall be
taken as value of goodwill for the purpose of the deal. Value the Goodwill.
AnswerAnswerAnswerAnswer
Working notes:
(i) Closing capital employed
Land and building
Plant and machinery
Trade investment
Stock
Drs.Cash
9,00,000
10,00,000
1,00,000
2,00,000
1,50,00050,000
Crs. -3,00,000
21,00,000
(ii) Average capital employed : 21,00,000 (1/2) (3,00,000) = 19,50,000
(iii) Normal profit : 19,50,000 x 0.10 = 1,95,000
(ii) Future maintainable profit:
PBT 6,00,000
Depreciation - 40,000
Additional expenses 50,000
Tax -2,55,000
2,55,000Super profit = 2,55,000 -195,000 = 60,000
Goodwill = 2,40,000
Q. No. 2 :Q. No. 2 :Q. No. 2 :Q. No. 2 : Given below is the Balance Sheet of S Ltd. as on 31.3.2008
Liabilities Rs. Lakhs Assets Rs. Lakhs
Share capital Land & Buildings 40
(Shares of Rs. 10) 100 Plant & Machinery 80
Reserves and Surplus 40 Investments 10
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Creditors 30 Stock 20
Debtors 15
Cash & bank 5
170 170
You are required to work out the value of the Companys goodwill considering
the following information: (((( AdaptedAdaptedAdaptedAdapted May, 2008)May, 2008)May, 2008)May, 2008)
(i) Profit for the current year Rs. 64 lakhs includes Rs. 4 lakhsextraordinary income and Rs. 1 lakh income from investments of surplus
funds; such surplus funds are unlikely to recur.
(ii) In subsequent years, additional advertisement expenses of Rs. 5 lakhsare expected to be incurred each year.
(iii) Market value of Land and Building and Plant and Machinery have beenascertained at Rs. 96 lakhs and Rs. 100 lakhs respectively. This will
entail additional depreciation of Rs. 6 lakhs each year.
(iv) Effective Income-tax rate is 30%.AnswerAnswerAnswerAnswer
Valuation of Goodwill:
Assumptions:
(i) Profit of Rs.64Lakhs is pre- tax.(ii)Additional depreciation of Rs.6Lakhs will be allowed for tax purposes.
FUTURE MAINTAINABLE PROFIT : (Rs.)
Current profit 64Lakhs
Extraordinary Income ( non-recurring) _ 4Lakhs
Investment Income ( non- recurring,) - 1Lakhs
Advertising - 5.00Lakhs
Depreciation - 6.00 Lakhs
----------
48.00 Lakhs
Less tax - 14.40 L
Future maintainable profit 33.60 L--------------------------------------
Closing capital employed (Rs.)
Plant, land and building 196.00 Lakhs
Investment (assumed as non-trade investment) nil
Working Capital 10.00 Lakhs
----------
206.00 Lakhs
-----------
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Average capital employed:
: Closing capital employed 0.50 of current year post tax profit
: 206 Lakhs 0.50(44.80Lakhs) = 183.60Lakhs
Normal profit = 183.60 L x 0.15 = Rs.27.54Lakhs
Super profit = 33.60 27.54 = 6.06Lakhs
AssumingAssumingAssumingAssuming the number of years of purchase to be 5, goodwill =
6.06 x 5 = 30.30 Lakhs
VALUATIONVALUATIONVALUATIONVALUATION OF SHARESOF SHARESOF SHARESOF SHARES
Valuation of sharesValuation of sharesValuation of sharesValuation of shares is another important step of valuation of business. Hence
before discussing the valuation of business, lets understand the concept of
valuation of shares. There are three important methods of valuation of shares:
(a) Book value method (b) Market value method (c) Fair value method. Fair
value = Average of Book value and Fair value.
(a) Book value(a) Book value(a) Book value(a) Book value / Balance-sheet value / Net asset value of share: (Accountants
refer this value as intrinsic value)
Book value method assumes liquidation (without liquidation expenses) i.e., we
find the amount that the holder of one equity share will get if the company goes
into liquidation. It is obtained by dividing (current value of all assets including
goodwill and non-trade-assets minus outside liabilities minus Preference
shareholders claim) by number of equity shares.
Q. No.3(a):Q. No.3(a):Q. No.3(a):Q. No.3(a): Find the Book value per equity share using the data of Q.No.1
AnswerAnswerAnswerAnswer: Closing capital employed + goodwill
Value per equity share = ------------------------------------
No. of equity shares
21,00,000 + 2,40,000
= ------------------ = Rs.23.40
1,00,000
Q. No.3(b):Q. No.3(b):Q. No.3(b):Q. No.3(b): Find the Book value per equity share using the data of Q.No.2
AnswerAnswerAnswerAnswer :
Net asset value of the equity share =
[Goodwill + closing Capital employed + Investments]/ No. of Equity shares
= (30.30L + 206L + 10L) / 10L = Rs.24.63
Value based on earning capacity =
[Future maintainable profit /Ke]/ No. of equity shares
[33.60Lakhs /0.15] / 10L = Rs. 22.40
Fair value =
Average of net asset value and value based on earning capacity
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= [24.63 + 22.40] / 2 = Rs. 23.52
Q. No. 3 (c) :Q. No. 3 (c) :Q. No. 3 (c) :Q. No. 3 (c) : From the balance sheet of India Trading Company Limited as at 31st
March, 2008, the following figures have been extracted:
Share Capital
9% Preference Share capital (Rs.100)
10,000 E. shares of Rs.10 Each fully paid
10,000 E. shares of Rs.10 Each Rs. 5 paid
10,000 E. shares of Rs.10 Each Rs. 2.50 paid
Rs.
3,00,000
1,00,000
50,000
25,000
Reserve and Surplus:
General Reserve
Profit and Loss account
4,75,000
2,00,000
50,000
7,25,000
On a revaluation of assets on 31st March, 2008, it was found that they had
appreciated by Rs. 75,000 over their book value in the aggregate.
The articles of association of the company provide that in case of liquidation,
preference shareholders would have a further claim to 10 per cent of the surplus
assets, if any.
You are required to determine the value of the business through the values of
preference shares and equity shares assuming that a liquidation of the company has
to take place on 31st March, 2008, and that the expenses of winding up are nil.
AnswerAnswerAnswerAnswer
Valuation of shares
Rs.
Book value of assets
Appreciation
Total
Less Paid up capital
Surplus assets
7,25,000
75,000
8,00,000
4,75,000
3,25,000
Share of preference shareholders in Surplus assets 32,500
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Share of equity shareholders in surplus assets 2,92,500
Share per equity share in surplus assets:
2,92,500/30,000
9.75
Share per pref. share in surplus assets : 32,500/3,000 10.83
Value per preference share : 100 + 10.83 = 110.83
Value per equity share (Rs.10 paid ) : 10 + 9.75 = 19.75
Value per equity share (Rs.5 paid ) : 5 + 9.75 = 14.75
Value per equity share (Rs.2.50 paid ) : 2.50 + 9.75 = 12.25
ALTERNATIVE SOLUTION:ALTERNATIVE SOLUTION:ALTERNATIVE SOLUTION:ALTERNATIVE SOLUTION:
Valuation of shares
Rs.
Book value of assets
Appreciation
Notional call
Total
Less Paid up capital
Surplus assets
7,25,000
75,000
1,25,000
9,25,,000
6,00,000
3,25,000
Share of preference shareholders in Surplus assets 32,500
Share of equity shareholders in surplus assets 2,92,500
Share per equity share in surplus assets: 2,92,500/30,000 9.75
Share per pref. share in surplus assets : 32,500/3,000 10.83
Value per preference share : 100 + 10.83 = 110.83
Value per equity share (Rs.10 paid ) : 10 + 9.75 = 19.75
Value per equity share (Rs.5 paid ) : 19.75 -5.00 = 14.75
Value per equity share (Rs.2.50 paid ) : 19.75 7.50 = 12.25
(b) Market Value / yield value method(b) Market Value / yield value method(b) Market Value / yield value method(b) Market Value / yield value method
This method assumes business as a going concern. Under this two approaches
are there: (i) based on dividend, and (ii) based on EPS. Based on dividend, two
approaches are there, one is based on actual constant dividend (this method is
also called as divided yield method) and the other is based.
D
MP (based on constant div.) =
Ke
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Ke is also referred as normal rate of return on equity shares.
MP ( based on dividend growing at constant rate) :
D1
= ----------------
Ke - g
Ke is also referred as normal rate of return on equity shares.
E.P.S.
MP (based on EPS) =
Ke
Ke is also referred as normal rate of return on equity shares.
(This method is also called as PE method as PE is reciprocal of Ke i.e. Normal
rate)
The value of the share depends upon future EPS/ dividend. (The basic principle
of the share valuation is that the market always discounts the future). Hence, we
should take dividend per share / EPS of coming year and not that of past year.
(Tutorial note: In case there is no specific requirement of the question: WEshould apply the above mentioned methods in the following orders of preference:
(i) Growth based method (ii) EPS based method (iii) Constant dividend based
method)
Q. No.4 :Q. No.4 :Q. No.4 :Q. No.4 : Mind Tree Ltd. belongs to an industry in which equity shares sell at par
on the basis of 10 per cent dividend yield provided the net tangible assets of the
company are 240 per cent of the paid up equity capital and provided that the total
distribution of profit does not exceed 55 per cent of the profits. The dividend
rate fluctuates from year to year in the industry. The balance sheet of Mind Tree
Ltd. stood as follows on 31.3.2005:Liabilities Amount Assets Amount
9% Preference share
Capital (Rs.100) 4,00,000
Goodwill 3,00,000
Equity Share capital
(Rs.100) 10,00,000
FA less Depreciation 14,00,000
P & L account 4,00,000 Investments 3,50,000
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8% Debentures 1,00,000 CA 4,30,000
Current liabilities 6,00,000 Preliminary Expenses 20,000
25,00,000 25,00,000
The company has been earning on the average Rs.3,00,000 as profit after
debenture interest but before tax which may be taken at 30 per cent. The rate of
dividend on equity shares has been maintained at 15 per cent in the past year
and is expected to be maintained. Determine the value of equity shares.
AnswerAnswerAnswerAnswer
Note 1Note 1Note 1Note 1
Net tangible assets:
FA 18,00,000Investment 3,50,000
CA 4,30,000
Debentures -1,00,000
CL -6,00,000
PSC -4,00,000
Net Tangible assets 14,80,000
Paid up equity capital = 10, 00, 000
Net Tangible assets as a % of paid up equity capital=
(14,80,000/10,00,000)x100 = 148%
It is less than 240 % (which is bench mark for the industry). It is a negative
feature of the Mind Tree as compared of industry. It should result in reduction of
value of Mind Tree Ltd. For this purpose, we should raise the normal rate of
Mind Tree Ltd.
Note 2Note 2Note 2Note 2
PBT
Less tax
3,00,000
-90,000
PAT 2,10,000
Preference Dividend - 36,000E. Dividend (10%)2 -100000
Retained profit 74,000
Retained profit is less than 45 % of profit. Lower retained profit means lower
growth in future. It is a negative feature of the Mind Tree Ltd. as compared of
industry. It should result in reduction of value of Mind Tree Ltd. For this
purpose, we should raise the normal rate of Mind Tree Ltd.
Estimation of normal rate of return :
Normal rate of the industry 10%
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Adjustment for lower asset backing +1%
Adjustment for lower retained profit +1%
Adjustment for constant dividend -1%
Normal rate for Mind Tree 11%
Dividend per share
MP of equity share of Mind Tree = ------------------
Normal rate
15
= ----------x 100
11
Rs.= 136.36
P E ratioP E ratioP E ratioP E ratio (also known as P E(also known as P E(also known as P E(also known as P E MultipleMultipleMultipleMultiple))))
P/E is the ratio of a companys share price to its EPS. It is a core measure of a
companys share price in relation to its EPS. To calculate the P/E, we simply
take the current price of the share of a company and divide it by its EPS. For
example, if the current price of a shares Rs.100 and its EPS is 8, we conclude
that the Price Earning ratio is 12.50.
P/E states that how many years it would take for us to recover our investment
amount from the earnings that the company generates. For example, if we buy
the equity shares of a company for Rs.100 and its EPS is Rs.12.50, it would take
us 8 years to recover our investment. (The PE ratio is 8). PE ratio is also defined
as the payback period of the investment in the equity shares.
It is perhaps the most common and widely used tool of valuation of equity shares.
The P/E ratio is a much better indicator of the value of a share than the market
price alone.A share's price is an arbitrary number and is not capable of deciding
whether the share is under-valued or overvalued. As prices alone do not show
the total picture of a companys share, they must be measured against the EPS to
help investors to understand how "expensive" or cheaper a particular share is.
An Example :
A B
Market price equity share Rs. 1,000 Rs.100
Suppose both the companies belong to the same industry. Which share is
overvalued? We cannot decide on the basis of only above data. On the face of it
appears that As share is over-priced. Lets study some more details about these
companies:
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A B
EAT Rs. 50 Crores Rs. 80 Crores
No. of equity shares 5m 160m
EPS 100 5
PE ratio 10 20
The above analysis shows that for each rupee of EPS of A, the investor has to
pay only Rs.10; it is Rs. 20 in case of B. Other things remaining the same, As
share is cheaper. Suppose the industrys PE multiple is 15, As share is
undervalued and Bs share is overvalued. By examining P/E ratios, investors can
make a much more accurate comparison between the values of two different
shares. In our example above, a quick look at the P/E ratios for Company A (P/E
of 10) and Company B (P/E of 20) reveals that Company A is clearly a better buy
(other things remaining unchanged) despite the fact that its price is higher.
The P/E is sometimes referred to as an investors sentiments indicator. As the PE
ratio goes up, it indicates that the investors sentiment is that the companys
future is bright. Higher PE ratio, more the investors are paying and therefore
they expect higher growth. The high PE ratio indicates that the market has high
hopes for the companys future. Higher PE ratio can be justified when high
growth rate is really expected and is sustainable. Sometimes, the PE ratio is high
on account of speculative reasons or purely on the basis of sentiments. In that
case, the investment should be avoided.
A falling PE ratio is an indication that the share is out of favour by the investors.A low PE ratio means a no-confidence vote by the investors, investors are not
taking interest in the shares. Value investing (founded by Prof. Benjamin GrahamBenjamin GrahamBenjamin GrahamBenjamin Graham3333
and followed by his student Warren Buffet) suggests that the longterm investors
should search for such low PE shares which are fundamentally strong. Warren
has made fortunes using this approach.
Three types of PE ratios:
(i) Trailing PE ratio: in this case the EPS of last year is considered.(ii) Current PE ratio: In this case the estimated EPS of current/coming
year is considered. The term PE ratio refers to current PE ratio. It is
widely used for share valuation purposes as it is the future earnings
that determines the value of the shares and not the past earnings.
(iii) Forward PE ratio: In this case, the average estimated EPS , based on anumber of future years, is considered. This is not quite popular as it is
difficult to accurately estimate the future profits for so many years.
3The Concept of PE ratio was used for the first time Prof. Graham.
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High or low PE ratio: For deciding whether a shares price earning ratio is
high or low, we should consider two factors:
(i) Growth: If growth rate is higher and it is sustainable, the Higher PEratio may be justified, other wise not.
(ii) Industrys PE ratio: Industrys PE ratio can guide us in decidingwhether a shares PE ratio is high or Low. Suppose an industrys PE
ratio is 10 and a companys PE ratio is 8, we can say that the PE ratio
of the company is low. The investor should search the reasons for the
low PE ratio. If it is low due to fundamental reasons (low demand for
the companys products, ineffective hangmen etc), the investment
should not me made. If it is low due to speculative reasons, the
investment may be made.
(iii) Companys own historical PE ratio : A companys PE ratio widelydifferes with its historical PE ratios, we should find it s reasons todecide whether the PE ratio is justified or not.
Limitations : There are various limitations of the PE ratios:
(i) These ratios are based on accounting profits. The profits for differentyears/ companies may not be comparable on account of different
accounting policies.
(ii) Many interpretations : There can be many interpretations of the PE ratio. Forexample, a high PE ratio is justified during Bull Run assuming that the reason
for the high PE ratio is expected high growth; the same ratio can also be
interpreted as speculative on the assumption that the growth is not sustainable.
The investors should not base their decisions on the PE ratio alone. Such
decisions require a great deal more than understanding PE ratio.
Q. No.5 :Q. No.5 :Q. No.5 :Q. No.5 : Both Madhav Ltd and Murari Ltd belong to music industry
Madhav Murari
Net Tangible assets to paid up equity share
capital
240 148
Pay out ratio 0.60 0.66
Dividend per share Rs.54 Rs.66
Market value per share Rs. 225 ?
AnswerAnswerAnswerAnswer :Assumption : the dividend per share is expected dividend per share
EPS of Madhav = Rs.90
Ke = EPS/Market price = 90/225m = 40%
EPS of Murari = 100
Calculation of Ke of Murari
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Ke of Madhav 40%
Adjustment for lower asset backing +2%
Adjustment for lower retained profit +2%
Normal rate of return ( Ke) of Murari 44%
Market price per share of Murari = 100 / 0.44 = 227.27
Q. No.Q. No.Q. No.Q. No. 6666: From the following Trial Balance for the year ending 31 March 2007 and
other relevant information, determine the value of the business on the basis of values
of equity shares of Bhakti Ltd as on 1st
April, 2007 assuming the PE ratio to be 10.
Dr. Cr.
Fixed Assets (CP) 1,00,000
E. Share Capital (Rs.10) 3,00,000Reserve and Surplus 1,80,000
Provision for Depreciation 30,000
Purchase /sales 8,00,000 10,00,000
Opening stock 1,00,000
Salaries 80,000
Rent and rates 11,000
Fixed selling expenses 10,000
Variable selling expenses 9,000
Drs./Crs. 2,60,000 80,000
Bank 2,10,000
Bad debts 10,000Total 15,90,000 15,90,000
Stock is Rs.1,50,000 as on 31 March, 2007.
Depreciation is provided at 10 per cent p.a. on cost price, Rs.10,000 worth of fixed
assets is to be added during the middle of 2007. During the year ended 31st
march,
2008 : (i) Sales are likely to go up by 10 per cent at the same price (ii) The purchase
price may go up by 2 per cent (iii) Stock holding is likely to increase by Rs.65,000
(iv) Bad debts are expected to go up by 50 per cent (v) Salaries and fixed selling
expenses are likely to grow up by 10 per cent and 5 per cent respectively and (vi)
the Variable selling expenses are estimated to be higher by 10 per cent per unit,
Ignore tax.
AnswerAnswerAnswerAnswer
(i) Year ended 31st
March, 2007:
Cost of goods sold (COGS) : 7,50,000
Sales : 10,00,000
COGS : 75 % of sales
(ii) Year ended 31st
March, 2008:
Sales : 11,00,000
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COGS (had there been no change in cost) : 8,25,000
There would have been two parts of this amount:
(i) COGS (opening stock) : 1,50,000(ii) COGS (current period purchase) : 6,75,000As the cost has increased by 2%, the COGS for the year 31.3.2008:
1,50,000 + 6,75,000(1.02) = 8,38,500
Profit and Loss account for the year ended 31.3.2008
COGS
Depreciation
Salaries
F. Selling exp.
Rent and ratesBad debts
Variable selling expenses
NP
8,38,500
10,750
88,000
10,500
11,00015,000
10,890
1,15,360
11,00,000
Sales 11,00,000
--------
11,00,000
EPS = 1,15,360 / 30,000 = 3.8453
Market price of the share: E1 x PE ratio = 3.8453 x 10 = Rs.38.45
Q. No.Q. No.Q. No.Q. No. 7777 Balance sheet of A Ltd. as on 31.12.2004 was as under:
Liabilities Amount Assets Amount
ESC (Rs.10 each) 5,00,000 Land and Building 2,00,000
9% PSC 1,00,000 Plant & machinery 4,00,000
Reserves 3,00,000 Stock 2,50,000
Creditors 2,00,000 Drs. 2,10,000
Bank 40,000
Total 11,00,000 Total 11,00,000
Profit and dividend in last several years were as under:
Year PBT Equity Dividend
2004 Rs.3,20,000 18%
2003 Rs.2,50,000 15%
2002 Rs.2,20,000 12%
Managerial remuneration is likely to go up by Rs. 20,000 p.a. Income-tax may be
provided at 30 per cent. Normal rate of return is 10%. Find the value of equity
shares on the basis of EPS.
Answer:Answer:Answer:Answer:
Weighted average PBT: [(220000x1) + (250000X2) +(320000X3)] / 6
==== 2,80,000
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Increase in remuneration = -20,000
2,60,000
Tax - 78,000
EAT 1,82,000
Pref. dividend - 9,000
Profit for equity shareholders 1,73,000
EPS =1,73,000 / 50,000 = 3.46
MP of equity share = 3.46/0.10 = 34.60
Q. No. 8Q. No. 8Q. No. 8Q. No. 8:::: The capital structure of a company on 31st March, 2005 was as follows :
Rs.
Equity share capital (Rs. 10) 5,00,000
11% Preference capital 3,00,000
12% Debentures 4,00,000
Reserves 3,00,000
The company on an average, earns a profit of Rs. 4 Lakhs annually before deduction
of interest on debentures and income tax which works out to 45%.
The normal return of equity shares of companies similarly placed is 15% provided:
(a) The profit after tax covers the fixed interest and fixed dividends at least fourtimes.
(b) Equity capital and reserves are 150% of debentures and preference capital.(c) Yield on shares is calculated at 60%of profits distributed and 5% on
undistributed profits.
The company has been paying regularly an equity dividend of 18%. Ascertain thevalue of equity shares of the company. (NOV, 2003)(NOV, 2003)(NOV, 2003)(NOV, 2003)
AnswerAnswerAnswerAnswer::::
Working note (i) Profit before interest and tax = 4,00,000
Debenture interest = -48,000
PBT = 3,52,000
Tax -1,58,400
PAT 1,93,600
Debenture interest 48,000
Profit after tax before interest before pref. dividend 2,41,600
Fixed interest and fixed dividend cover = (2,41,600) / (48000+33000) =2.98.The interest and dividend cover should be at least 4. Lower cover indicates towards
risk for equity shareholders and this enhances the normal rate for them.
Working note (ii)
Equity and reserves as % of Debentures and Preference capital:
[(8,00,000)/(7,00,000)]x100 = 114
Lower % (as compared to standard of 150) of equity and reserves to debentures and
preference capital points towards higher degree of financial gearing. This enhances
the financial risk of the business and in turn increases the normal rate for equity
shareholders.
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Main answer: Normal rate of the industry : 15%
Adjustment for lower interest and dividend cover: + 0.25%
Adjustment for Lower % of equity and reserves
to debentures and preference capital : +0.25
Normal rate for the company 15.50%
(60% of 90,000) + (5% of 70,600)
Actual yield = -------------------------- x 100 = 11.506 %
5,00,000
Value of equity share = (11.506 / 15.50) x 10 = Rs. 7.42.
Value of business = (50,000 x 7.42) + 300000 + 400000 = 10,71,000
QQQQ. No.9. No.9. No.9. No.9 Following Financial data are available for PQR for the year 2008:
Rs. Lakhs
8% Debentures 125
10% Bonds (2007) 50
Equity shares ( Rs. 10 Each) 100
Reserve and Surplus 300
Total assets 600
Assets turnover ratio 1.1
Effective interest rate 8%Effective tax rate 40%
Operating margin 10%
Dividend pay out ratio 16.67%
Current market price of the share Rs.14
Required rate of return of the
investors.
15%
You are required to :
(i0 Draw the Income statement for the year.
(ii) Calculate its sustainable growth rate.
(iii) Calculate the fair price of the companys share using dividend discount
model.
(iv) What is your opinion on investment in the companys share at current market
price? (Nov. 2009(Nov. 2009(Nov. 2009(Nov. 2009))))
AnswerAnswerAnswerAnswer
Assets turnover = 1.10 Total assets 600 Sales 660
Income statement for the year ended 31sr Dec. 2008 (Rs. Lakhs)
EBIT 66
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Interest -16
EBT 50
Tax -20
EAT 30
EPS 30L/10L = 3.
Dividend per share 3. x 0.16667 = 0.50
Return on equity shareholders fund = 30/ (100 + 300) =7.50%
Ratio of Retained EPS to EPS = 0.83333
Sustainable growth rate = 0.83333 x .075 = 6.25% %
0.50(1.0625) 0.53125Equilibrium value of share = --------------- = ---------- = 6.07
0.15 0.0625 0.0875
The share is overpriced. Investment is not recommended.
[Net profit in the above chart refers to EBIT.
ACCOUNTING RATIOSACCOUNTING RATIOSACCOUNTING RATIOSACCOUNTING RATIOS
Ratio is the relationship between two figures. Accounting ratio is the relationship
between two accounts figures. An absolute figures generally conveys no
meaning. Hence, the ratios. Five categories of Accounting Ratios: (i) Solvency
Ratios, (ii) Profitability Ratios, (iii) Activity Ratios, (iv) Financial Leverage Ratios
(v) Share valuation ratios
SOLVENCY RATIOSSOLVENCY RATIOSSOLVENCY RATIOSSOLVENCY RATIOS
The term solvency refers to ability of meeting liabilities. Solvency ratios may be
studied in two parts: (i) Short-term solvency ratio, and (ii) Long-term solvency
ratio.
ShortShortShortShort----term Solvency Ratiosterm Solvency Ratiosterm Solvency Ratiosterm Solvency Ratios
Short-term solvency refers to ability of meeting current liabilities, in time, out of
current assets. Hence short-term solvency ratios are based on current assets
and current liabilities. Two important ratios are calculated to study the short-
term solvency of a firm.
Current Assets
Current Ratio =
Current Liabilities
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This ratio is also known as working capital ratio, net capital assets ratio,
current assets ratio. Current assets include cash, bank, marketable securities,
debtors, stock, bills receivable, short-term loans and advances (given by the
firm) and prepaid expenses. Current liabilities include creditors, bills payable
outstanding expenses, incomes received in advance, bank overdraft and
provisions.
The current ratio measures the ability of the firm to meet its current
liabilities. Current assets get converted into cash in the operational cycle of the
firm and provide the funds needed to pay the current liabilities. Apparently,
higher the current ratio greater short-term solvency. Generally 2 : 1 is said to be
ideal current ratio but actually what should be the ideal ratio for a concern
depends upon nature of its activities. Lets have two cases. One is the case of
Indian. Railways (I.R.). I.R. generally sell their services on cash basis (not on
credit basis), i.e., before travelling you have to pay for tickets, freight is alsogenerally paid in advance. I.R. gets staff services and other supplies on credit
basis (staff members are paid their salaries at the end of month, coal and other
supplies are obtained on credit basis). Thus I.R. purchases on credit and sells for
cash. In this situation, they can do well with lower current ratio (say for Example
1.50, a ratio less than 1 : 1 would certainly be undesirable in any industry as at
least some safety margin is required to protect the interest of current liabilities).
Lets have another case of a wholesale cloth merchant who purchases goods
from manufacturers on cash basis and sell to retailers on credit basis. He can do
well only with a higher current ratio (say for example : 2.50).
Quick Ratio or Acid Test or Liquidity RatioQuick Ratio or Acid Test or Liquidity RatioQuick Ratio or Acid Test or Liquidity RatioQuick Ratio or Acid Test or Liquidity Ratio
While calculating the current ratio, we overlook the composition of current
assets. (A firm with a high proportion of current assets in the form of cash and
receivable is more liquid than one with a higher proportion of current assets in
the form of inventories even though both the firms have the same current ratio).
This impairs the usefulness of current ratio. Hence we need some other ratios
which may overcome this defect. The other ratio is quick ratio. Quick ratio is a
rigorous measure of a firms short-term solvency.
Quick Assets
Quick Ratio =
Quick Liabilities
The ratio is also known as liquid ratio or acid test. Quick assets refer to
highly liquid assets. In such assets (quick assets) we include all current assets
except inventories (finished, semi-finished and raw materials) and prepaid
expenses. The exclusion of inventory is based on the reasoning that it is not
easily and readily convertible into cash. Prepaid expenses by their very nature
are not available to pay off current debts (they merely reduce the amount of cash
required in one period because of payment in a prior period). Quick liabilities
refer to such current liabilities which would mature for payment quickly. As
PRACTICALLY bank overdraft does not mature for payment quickly, it is
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excluded from current liabilities to get quick liabilities. (By bank overdraft not
maturing quickly, we mean that generally in practical life, firms do not clear their
bank overdrafts. If they clear one bank overdraft, they raise the other bank
overdraft). The ideal quick ratio is said to be 1 : 1 (Alternative approach: Instead
of quick liabilities, we take current liabilities).
LongLongLongLong----term Solvency Ratiosterm Solvency Ratiosterm Solvency Ratiosterm Solvency Ratios
Long-term solvency refers to the firms ability of meeting long-term liabilities.
Financial institutions, etc. which provide funds to the firms for long period, are
interested in long-term solvency of the firms. Long-term solvency of a firm
depends upon two factors (i) Owners investment in the firm, (ii) profits earned
by it. We shall be studying five ratios to test the long-run solvency of a concern.
The first of these five tests the owners investment and the other four test the
profit earning capacity.
Equity Equity
Equity Ratio = or
Total Assets Total Liabilities
Equity means owners funds or shareholders funds. In case of a company,
equity means ESC + PSC + R&S P&L A/c Dr. Balance Misc. Exp.. By total
assets we mean fixed assets plus investments plus current assets; loans and
advances. By total liabilities we mean E.S.C. + P.S.C. + (R&S minus P&L Dr.
Balance Misc. Exp.) + Secured Loans + Unsecured Loans + Current Liabilities
& Provisions.
Equity serves as a protector for outside liabilities. If the company goes intoliquidation, firstly the losses have to be met by equity, the outside liabilities have
to bear the loss only if the amount of loss is more than amount of equity. Hence,
stronger the equity, safer the outside liabilities. Hence, our comment about this
ratio is : Higher the ratio, safer the outside liabilities. Suppose there are two
companies A Ltd. and B Ltd. Both have assets of Rs. 10,00,000 each. A has
equity of Rs. 3,00,000 and outside liabilities of Rs. 7,00,000. B has equity of
Rs. 7,00,000 and outside liabilities of Rs. 3,00,000. Outside liabilities are safer in
case of Bwhere they are safe even if loss of Rs. 7,00,000. In case of A, outside
liabilities would be in trouble as soon as the loss would cross Rs. 3,00,000
danger mark.
Interest Coverage RatioInterest Coverage RatioInterest Coverage RatioInterest Coverage Ratio
It is obtained by dividing the Profit Before Interest and Tax by Annual Interest
Payments. This ratio measures firms interest burden as compared to its profits.
If the interest is small proportion of profit earned by the firm, they would bear
interest burden easily and hence there is every possibility that the firm would be
solvent in long-run. If interest is large portion of profit, the possibility of firms
being solvent in future is reduced. The comment on the ratio is: Higher, Better.
This ratio is also called fixed charge cover.
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Debt Service Coverage RatioDebt Service Coverage RatioDebt Service Coverage RatioDebt Service Coverage Ratio
This ratio is obtained through division of Sum of cash profit and interest by
Sum of Annual Loan Repayment and Interest. Higher the ratio, safer the outsideliabilities are.
Return onReturn onReturn onReturn on EquityEquityEquityEquity
It is obtained by dividing profit after interest and tax before dividend by
Equity. This ratio measures the profitability of the concern from the point of
view of owners. Comment: Higher, Better because higher ratio will result in more
possibility of solvency in long-run.
Return on Capital EmployedReturn on Capital EmployedReturn on Capital EmployedReturn on Capital Employed
It is obtained by dividing Profit Before Interest before Tax by CapitalEmployed. Capital employed means equity plus long-term debt. The ratio
provides a test of profitability in relation to long-term funds. It provides insight
into how efficiently the long-run funds are used. Higher the ratio, better it is.
Higher ratio indicates more efficient use of capital employed which helps the firm
in being solvent in long-run.
PROFITABILITY RATIOSPROFITABILITY RATIOSPROFITABILITY RATIOSPROFITABILITY RATIOS
(i) Return on equity (as studied above)
(ii) Return on capital employed (as studied above)
(iii) Gross Profit Ratio = Gross Profit/Sales
(iv) Net Profit Ratio = Net Profit/Sales
(v) Operating Profit Ratio = Operating Profit/Sales
Operating profit means profit before interest and tax, i.e., this profit is
before non-operating items like income from non-trade investments, profit/loss
on sale of fixed asset, etc. This profit is also referred to as EBIT (earnings
before interest and tax). By non-trade investments we mean such investments
which are not required for smooth running of business. These are made just
because the firm has surplus funds. When the firm will need funds for business
purchases, such investments would be converted into cash. On the other hand,
trade investments are such investments which are required for smooth running of
the business. For example, investments in subsidiary company, investment in
such company from which we get raw materials, investment in company of which
we have dealership or agency, investments for replacement of fixed assets,
investments for repayment of debentures, etc. Comment for all five ratios
discussed above : Higher, Better.
ACTIVITY RATIOSACTIVITY RATIOSACTIVITY RATIOSACTIVITY RATIOS
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(i) Stock turnover Rati(i) Stock turnover Rati(i) Stock turnover Rati(i) Stock turnover Ratio or Inventory Turnover Ratioo or Inventory Turnover Ratioo or Inventory Turnover Ratioo or Inventory Turnover Ratio
This ratio is obtained by dividing Cost of goods sold by average stock. Cost
of goods sold means sales minus gross profit. Average stock means average ofopening and closing finished stocks. The ratio indicates how fast inventory is
sold, i.e., how many times the stock has to be replaced. For example, if the ratio
is 6, it means stock has to be replaced six times, i.e., goods are sold within 2
months of their purchase. If the ratio is 12 it means a stock has to be replaced 12
times, i.e., goods are sold within one month of their purchase. It is clear from the
above example that higher the ratio, better it is.
The ratio is also calculated as inventory holding period, by the following
formula :
Average Stock
360Cost of Goods Sold
For financial analysis purpose, we generally take 360 days in a year. When
calculated by the above formula, we will get the number of days within which the
goods are sold, i.e., stock has to be replaced. If in place of 360, we take 12, we
get stock holding period in month, if we take 52, we get stock holding period in
weeks. When the ratio is calculated as inventory holding period, the comment is
lower the ratio, (i.e., lower the stock holding period), better it is.
Alternative approach for calculating this ratio is that instead of cost of goods
sold, we take sales.
(ii) Debtors Turnover Ratio/Debtors Velocity(ii) Debtors Turnover Ratio/Debtors Velocity(ii) Debtors Turnover Ratio/Debtors Velocity(ii) Debtors Turnover Ratio/Debtors Velocity
This ratio is obtained by dividing Net Credit Sales by Average Receivables.
Net credit sales means total credit sales minus sales return out of credit sales.
Average receivables mean average of Opening Debtors and B/R and Closing
Debtors and B/R. The ratio measures how rapidly the debtors are collected. In
other words, the ratio indicates the time-lag between credit sales and cash
collection. For example, if the ratio is 6, it indicates that net credit sales are six
times of debtors, i.e., the debtors realize in 2 months period. If the ratio is 12, it
indicates that the debtors realize in one month period. As is clear from these two
examples that higher the ratio better it is.
The ratio can also be calculated as average collection period by using the
following formula:
Average Receivable
360
Net Credit Sales
When calculated this way, the ratio will give average collection period and the
comment would be: Lower, Better.
(iii) Fixed Assets Turnover Ratio(iii) Fixed Assets Turnover Ratio(iii) Fixed Assets Turnover Ratio(iii) Fixed Assets Turnover Ratio
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Sales
Fixed Assets Turnover Ratio =
Net Fixed Assets
The term net fixed assets means cost of fixed assets minus depreciation
charged so far. The ratio measures the efficiency with degree of efficiency in
assets utilization and a low rate reflects inefficient use of such assets. The
comment on the ratio is : Higher, Better.
Sales
Working Capital Turnover Ratio =
Working Capital
The ratio measures the efficiency with which working capital is issued.
Comment: Higher, Better.
FINANCIAL LEVERAGE RFINANCIAL LEVERAGE RFINANCIAL LEVERAGE RFINANCIAL LEVERAGE RATIOSATIOSATIOSATIOS
Financial leverage refers to the tendency of disproportionate change in earning
per share (E.P.S.) with change in earning before Interest and tax (EBIT), i.e., EPS
changes at a higher rate than rate of change in EBIT. If EBIT increases, EPS in-
creases at higher rate. If EBIT decreases, EPS decreases at higher rate. This
happens if the concern has fixed interest and fixed dividend bearing funds. Fixed
interest bearing funds refer to debentures/long-term loans. Fixed dividend
bearing funds refer to preference share capital. Suppose a company has 10 per
cent debentures of Rs. 10,00,000. Tax 50 per cent. It has 1,00,000 equity shares
of Rs. 10 each. Suppose its EBIT increased from Rs. 5,00,000 to Rs. 5,50,000 (10per cent increase).
EBIT 5,00,000 5,50,000
Interest 1,00,000 1,00,000
Earnings before tax (EBT)4,00,000 4,50,000
Tax 2,00,000 2,25,000
Earnings after tax (EAT)2,00,000 2,25,000
E.P.S. 2.00 2.25
0.25
Percentage increase in E.P.S. = 100 = 12.50
2.00
Thus when EBIT increased by 10 per cent, EPS increased by 12.50 per cent.
This tendency of disproportionate change in E.P.S. (with change in EBIT) is
known as financial leverage. Thus financial leverage indicates that the firm has
fixed interest and fixed dividend bearing funds. Every firm must have non-fixed
dividend capital (equity share Capital) also. Financial leaverage ratios study the
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relationship between these two types of funds. There are two important ratios of
this category:
Debt (Long-term)Debt Equity Ratio :
Equity
Fixed Interest & Fixed Dividend Bearing Capital
Captial Gear Ratio :
Non-fixed Dividend Bearing Capital
Fixed interest bearing capital includes debentures and long-term debts. Fixed
dividend bearing capital means preference shares. There are two views
regarding non-fixed dividend bearing capital. As per first view, non-fixed
dividend bearing capital means equity share capital. As per second view non-
fixed dividend bearing capital means equity shareholders funds. Equity
shareholders funds = ESC + R&S minus P&L A/c. Dr. minus MISC Exp. Equity
shareholders funds = Equity P.S.C.
If the financial leaverage ratios are high, it is an indication that the firm is
using cheaper source of finance. Debt is cheaper source of finance as interest
payment results in income tax savings, preference share capital is also generally
cheaper source of finance, because the rates of preference dividend are
generally lower than the dividends expected by the equity shareholders. In this
sense, we can say higher the ratio, better it is. But higher financial leverage
ratios also indicate financial risk. (Interest on debt has to be paid even if profit is
not there. If the company fails to pay interest, it may be forced to go intoliquidation). If operating profit falls, a company with higher financial leverage
ratios will face difficulties because of the burden of interest and preference
dividend. A company with lower financial ratios wont have much difficulties as
its burden of interest and preference dividend is low.
How to comment on financial leverage ratios? For this purpose we should find
(A) ROCE (B) Pre-tax benefit cost of debt and Preference share capital. If A is
less than B, financial leverage is undesirable; if A is more than B, financial
leverage is desirable; if A is equal to B, then financial leverage is not beneficial
and it may be avoided because why to take risk when it is not rewarding.
SHARE VALUATION RATISHARE VALUATION RATISHARE VALUATION RATISHARE VALUATION RATIOSOSOSOS
1. EPS:
[Eat Pref. Dividend (including CDT on Preference Dividend)]
No. of equity shares
(Higher the ratio, better it is)
2. Return on Equity: Please refer to Long-term solvency ratios
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(Higher the ratio, better it is)
3. P E Ratio: Market Price per share / EPS (Please the note on this ratio)
4. Dividend Yield: Equity Dividend per share / Market price share
(Comment on this ratio is made on the basis of Walter Model).
5. Earnings Yield: EPS / Market price per share
(Higher the ratio Better it is)
6. Price To Book Value Ratio: Market price / Book value per share
(Lower the ratio, better it is. Value investors use this ratio toidentify the potential investment opportunities)
7. PE / Growth ratio: PE ratio / Prospective Growth rate
(Lower the ratio, better it is. The lower ratio indicates that the
investor is paying less for the futures growth.
DUPONT CHARTDUPONT CHARTDUPONT CHARTDUPONT CHART
Dupont company developed a chart to summarize the companys ratio analysis.
This chart is known as Dupont Chart. This chart is helpful in showing the
interaction between profit and capital employed (C.E.) turnover to derive return
on capital employed (ROCE).
ROCE
Net Profit Ratio C.E. Turnover Ratio
[Net profit in the above chart refers to EBIT]
Net profit ratio = Net Profit Sales
C.E. Turnover Ratio = Sales C.E.
Net profit = Sales Cost of Sales
C.E : .Fixed Assets + Working Capital
Question o 10.
From the following information, you are required to prefer a balance sheet:
Current ratio 1.75 Liquid ratio 1.25
Stock turnover ratio
(Closing stock) 9
Gross profit ratio 25%
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Debt collection period 1.50 months
Reserves and surplus to capital 0.20
Turnover to fixed assets 1.20
Capital gearing ratio 0.60
Fixed assets to net worth 1.25
Sales for the year Rs. 12,00,000
Answer :
Sales Rs. 12,00,000
GP Rs.3,00,000
Cost of goods sold Rs.9,00,000
Closing stock Rs. 1,00,000
Sales / FA = 1.20
12,00,000 / FA = 1.20
FA = 10,00,000
FA/net worth =1.25
Net worth = = Shareholders funds = 8,00,000
[CA/ CL - QA/QL] = 1.75 1.25
Assuming: No bank overdraft and no prepaid exp.
CA CA - Stock---- - ---------------- = 0.50
CL CL
CA CA + Stock
-------------------------- = 0.50
CL
1,00,000
------------ = 0.50
CL
CL = 2,00,000
CA = 3,50,000
Debtors = 12,00,000 x 1.50/12 = 1,50,000
Stock = 1,00,000
Other CAs = 3,50,000 1,00,000- 1,50,000 = 1,00,000
FA + WC = Capital employed
10,00,000 + 1,50,000 = 11,50,000
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11,50,000 = Shareholders fund + Long-term borrowings
11,50,000 = 8,00,000 + Long-term Borrowings
Long-term borrowings = 3,50,000
Let capital = x
x + 0.20x = 8,00,000
x = 6,66,667 = capital Reserve and surplus = 1,33,333
LT Borrowings + PSC
Capital gearing ratio = -------------------
ESC
3,50,000 + PSC
0.60 = --------------------------
6,66,667 PSCPSC = 31,250
B/S as on .
Liabilities :
ESC
PSC
R & S
Borrowings
CL
6,35,417
31,250
1,33,333
3,50,000
2,00,000
Assets
FA
Debtors
Stock
Others
10,00,000
1,50,000
1,00,000
1,00,000
Total 13,50,000 Total 13,50,000
Question No. 11Question No. 11Question No. 11Question No. 11
You are given the following figures worked out from the profit and loss
account and balance sheet of Z Ltd. relating to the year 1974. Prepare the
balance sheet.
Fixed assets (net after writing off 30%) Rs. 10,50,000
Fixed assets turnover ratio 2
Finished goods turnover ratio 6
Rate of gross profit to sales 25%
Net profit (before interest) to sale 8%
Fixed charges over (debenture interest 7%) 8
Debt collection period 1 months
Material consumed to sales 30%
Stock of raw materials (in terms of number of
months consumption) 8
Current ratio 2.4
Quick ratio 1.0
Reserves to capital 0.20
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SC
R & S
Borrowings
CL
11,93,750
2,38,750
3,00,000
4,87,500
FA
Debtors
Stock
Finished
Raw material
Others
10,50,000
2,62,500
2,62,500
4,20,000
2,25,000
Total 22,20,000 Total 13,50,000
Question o. 12
You have asked by the management of The Wonderful Suppliers Ltd. to project a
trading and profit & loss account and the balance sheet on the basis of the
following estimated figures and ratios, for the next financial year ending March
31, 1983:
Gross profit Rs. 12,50,000Ratio of gross profit 25%
Stock turnover ratio 5 times
Average debt collection period 3 months
Creditors velocity 3 months
Current ratio 2
Proprietary ratio (fixed assets to capital employed) 80%
Capital gearing ratio (preference shares &
debenture to Capital Employed) 30%
Net profit to issued capital (equity) 10%
Preference share capital to debentures 2Cost of sales consists of 50% for materials
P&L and G.R. to issued capital (equity) 25%
AnswerAnswerAnswerAnswer
GP = 12,50,000
Sales = 50,00,000
COGS = 37,50,000
Stock Turnover ratio = COGS/Closing Stock
5 = 37,50,000/Closing StockClosing Stock = 7,50,000
Debtors =50,00,000 x 3/12 = Rs. 12,50,000
Creditors = 37,50,000 x 0.50 x 3/12 = 4,68,750
Closing Stock + Debtors
Current ratio = ----------------------------------
Creditors + Bank Overdraft
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7,50,000 + 12,50,000
2 = ---------------------------------
4,68,750 + Bank Overdraft
Bank overdraft = 5,31,250
WC = Stock + Debtors Creditors Bank overdraft
= 7,50,000 + 12,50,000 468750 5,31,250 = 10,00,000
Capital Employed = FA + WC =
1 = 0.80 + 0.20
0.20 CE = WC
0.20 CE = 10,00,000
CE = 50,00,000
Pref. shares and debentures = 30% of CE = 15,00,000Preference share capital = 10,00,000
Debentures =5,00,000
Equity shareholders fund = 50,00,000 -10,00,000 5,00,000 = 35,00,000
Let issued capital equity = x
X + 0.25 x = 35,00,000
x = 28,00,000
ESC = 28,00,000
P&L and GR = 7,00,000
Estimated Trading and Profit & Loss A/c 31.3.1983
Cost of goods sold 37,50,000 Sales 50,00,000
GP c/d 12,50,000
Total 50,00,000 Total 50,00,000
Expenses (Balancing
figure)
9,70,000 GP b/d 12,50,000
NP (10% of ESC) 2,80,000
Total 12,50,000 Total 12,50,000
Estimated B/S as on 31.3.1983
Liabilities :
ESC
PSC
R & S
Borrowings
Creditors
BO
28,00,000
10,00,000
7,00,000
5,00,000
4,68,750
5,31,250
Assets
FA
Debtors
Stock
40,00,000
12,50,000
7,50,000
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Total 60,00,000 Total 60,00,000
Question No. 13Question No. 13Question No. 13Question No. 13
Sunrise Limited has been in existence for two years. Summarised balance sheets
as on 31st December, 1976 and 31st December, 1977 are given below:
Balance SheetBalance SheetBalance SheetBalance Sheet
Liabilities 1976 1977 Assets 1976 1977
(Rs. in Lakhs) (Rs. in Lakhs)
Equity shares of Fixed Assets
Rs. 100 each 2.00 2.00 (Less:Dep.) 4.16 3.96Reserves 0.20 0.40 Stock 0.60 1.20
Profit & Loss A/c 0.28 0.04 Debtors 0.80 1.60
Loans on mortgage2.20 1.60 Cash and Bank
Bank overdraft 0.40 Balance 0.60 0.04
Creditors 0.60 1.80
Provision for
Taxation 0.68 0.26
Proposed dividend0.20 0.30
6.16 6.80 6.16 6.80
You are also given the profit and loss account of the company for the two
years.
Profit and Loss AccountProfit and Loss AccountProfit and Loss AccountProfit and Loss Account
1976 1977 1976 1977
(Rs. in Lakhs) (Rs. in Lakhs)
Interest on Loan .048 .096 Balance B/F 0.28
Directors Remu- Profit for the year
neration 0.20 0.60 after running
Provision for costs & depre-
Taxation 0.68 0.26 ciation 1.608 1.216
Dividends 0.20 0.30
Transfer to
Reserve 0.20 0.20
Balance C/F 0.28 0.04
1.608 1.496 1.608 1.496
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Total sales amounted to Rs. 12 lakhs in 1976 and Rs. 10 lakhs in 1977.
Make a thorough overall analysis of this company.
AnswerAnswerAnswerAnswer
1976 1977
1.408 0.616
ROCE 100 = 30% 100 = 15.20%
4.68 4.04
1.408 0.616Net profit ratio 100 = 11.73% 100 = 6.16%
12 10.00
12 10
C.E. Turnover ratio = 2.56 = 2.47
4.68 4.04
2.00 2.84
Current ratio = 1.35 = 1.03
1.48 2.76
1.40 1.64Quick ratio = 0.95 = 0.69
1.48 2.36
12 10
Stock turnover = 20 = 8.33
0.60 1.20
.80 1.60
Av. Collection period 12 = .80 month 12 = 1.93 months
12 10
2.20 1.60
D.E. Ratio = .89 = .66
2.48 2.44
68000 26000
EPS = 34 = 13
2000 2000
10 15
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P/O Ratio = .29 = 1.15
34 13
Working NotesWorking NotesWorking NotesWorking Notes
1976 1977
ESC 2.00 2.00
Reserve 0.20 0.40
P&L 0.28 0.04
Equity 2.48 2.44
Loan 2.20 1.60
C. E. 4.68 4.04
Comments on individual ratios:
Return on capital employed has come down from 30% in 1976 to 15.20% in1977. This
has been the result of two negative figures :
(i) Decrease in Net Profit ratio ( from 11.73% in 1976 to 6.16% in 1977)
(ii) Decrease in capital employed turnover from 2.56 in 1976 to 2.47 in 1977).
The current ratio has come down from already low level of 1.35 in 1976 toserious level of 1.03 in 1977.The quick ratio has come down from 0.95 (
Moderate level) to dangerous level of 0.69.
Several reasons have been responsible for decline in working capital
position like repayment of loan without raising long term funds, increasein dividend, three fold increase in directors remuneration.
Stock turnover ratio has come down from 20 in 1978 to 8.33 in 1977indicating hat goods are moving very slowly.
Average collection period has been increased from 0.80 month to 1.93months in 1977 indicating abnormal delay in collection from debtors.
Debt equity ratio has declined from 0.89 to 0.66 because of repayment ofloan.
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EPS has declined in tune with the net profit. Surprisingly there has beenextra-ordinary increase in payout ratio. The main payout ratio is greater
than 1. This means that the company is paying out of accumulated profits
as well.
CRITICAL APPRAISAL
(i) Decline in sales is a serious matter
(ii) long-term funds should have been raised for redeeming the long-term debts
(iii) Increase in dividend and directors remuneration should have been avoided.
(iv) cash position ios alarming. Cash balance is only Rs.4,000 as against huge
amount of liablities.
OVERALL COMMENTS
The overall performance of Sunrise Ltd during the year 1977 has been adverse.
SUGGESTIONS FOR FUTURE
(i) Increase in dividend and Directors remuneration may be rolled back(ii) Long term funds may be raised for strengthening the working capital(iii) The company may go for all out efforts for increasing the sales.
Q. o. 14: The following information is taken from the accounts of Charu Ltd, for last
year:
Issued share capital
10,00,000 ordinary shares of Re. 1 each, fully paid
Secured Loan
Rs. 2,50,000 8 per cent debenture
Reserves
Capital Redemption reserve Rs. 1,50,000
General Revenue Rs. 7,50,000
Profit and dividend
Profit for the year Rs.6.0
Ordinary dividend 10 per cent
You are also told that the current market price of Charus ordinary shares is Rs. 3.20
each.
Calculate: (i) EPS, (ii) P.E. Ratio, (iii) Earning yield, (iv) Dividend yield, (v)
Dividend cover.
AnswerAnswerAnswerAnswer
EPS = EAT / No of equity shares = 6,00,000 / 10,00,000 Re.0.60
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PE ratio = Market price per share / EPS 3.20 / 0.60 5.33
Earnings yield = EPS / Market price per share = 0.60/3.20 18.75%
Dividend Yield=Dividend per share / Market price per share =0.10 /3.20 3.125%
Dividend cover= Profit before dividend / Dividend = 6,00,000/1,00,000 6
APPENDIX AAPPENDIX AAPPENDIX AAPPENDIX A
No. of years of purchase depends up on 2 factors:
(i) The period required to attain the profitability level of the business the goodwill
of which we are going to value. Suppose we are going to value the goodwill of abusiness which is reporting the return on equity of 20%. Further assume that if we
start a new business today, it will take us 5 years to achieve the 20% return on
equity. Now the first factor on which the number of years depends is 5.
(ii) Adjustment for nature of business :
For making such adjustments, the businesses are classified into three categories:
(a)Rat type business. These are the businesses of speculative nature i.e. thereare wide fluctuations in their operating results. In one year large amount of
profit may be there, in the next year huge amount of loss may be there.
Sale value of goodwill of such businesses is taken as zero as the buyercannot be assured of super profit.
Adjustment factor for such businesses is taken as negative value of
first factor. For example, if the first factor is 5, this factor is taken
as -5 so that no. of year of purchase is zero; this results in zero
value of goodwill.
(b)Dog type business: Dog follows the owner. These are the
businesses where goodwill is attached with the owner. As the owner
will go , after selling the business, the goodwill will go with him. Hence,
the buyer of the goodwill is not benefited much. In such cases, to keep
the value of goodwill towards lower side, we taken adjustment factor asnegative, say -1, -2.etc.
For example, if the first factor is five and the second factor is taken -1, the no. of
years of purchase will be taken as 4.
(c) Cat type business : Cat generally does not leave its area i.e. generally it does
not follow the owner. These are businesses where goodwill is attached with the
business and not with the owner. Even after the sale of the business, the goodwill
stays with the business (in spite of new owners). Say for example, retail business.
The buyer of the goodwill is benefited much by purchasing the goodwill. Hence, he
is ready to pay higher price for the goodwill. Hence, the adjustment factor is taken
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as positive, say +1, +2 etc. Suppose the first factor is five and the second factor
is +2, the n umber of years of purchase is taken as 7.