Chapter 11 Fundamental Analysis

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J B GUPTA CLASSES98184931932, [email protected],

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Copyright: Dr JB Gupta

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.


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.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.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


E.P.S.

MP (based on EPS) =

Ke


(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.


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.


(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))))


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%


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.


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.


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.

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Chapter 11 Fundamental Analysis

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