J B GUPTA CLASSES

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Chapter 11
Fundamental analysis

Chapter 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.

Investopedia.com

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, interest rates, 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 Analysis: 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 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 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

The 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 opening capital 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 : 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 fully paid up ) (Rs.10 10.00,000 Goodwill 1,00,000

Reserve and surplus Creditors

4,00,000 3,00,000

Land and building Plant and machinery Trade Investments Stock Debtors

3,00,000 8,00,000 1,00,000 2,00,000 1,50,000

Cash and bank 17,00,000

50,000 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. Answer
Working notes: (i) Closing capital employed 9,00,000 10,00,000 1,00,000 2,00,000 1,50,000 50,000 -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 2,55,000 Super profit = 2,55,000 -195,000 = 60,000 Goodwill = 2,40,000 Land and building Plant and machinery Trade investment Stock Drs. Cash Crs.

Q. No. 2 : Given below is the Balance Sheet of S Ltd. as on 31.3.2008 Liabilities Share capital (Shares of Rs. 10) Reserves and Surplus Rs. Lakhs Assets Land & Buildings 100 Plant & Machinery 40 Investments Rs. Lakhs 40 80 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: ( Adapted May, 2008) (i) Profit for the current year Rs. 64 lakhs includes Rs. 4 lakhs extraordinary income and Rs. 1 lakh income from investments of surplus funds; such surplus funds are unlikely to recur. In subsequent years, additional advertisement expenses of Rs. 5 lakhs are expected to be incurred each year. Market value of Land and Building and Plant and Machinery have been ascertained at Rs. 96 lakhs and Rs. 100 lakhs respectively. This will entail additional depreciation of Rs. 6 lakhs each year. Effective Income-tax rate is 30%.

(ii)

(iii)

(iv)

Answer 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 Extraordinary Income ( non-recurring) Investment Income ( non- recurring,) Advertising Depreciation 64Lakhs _ 4Lakhs - 1Lakhs - 5.00Lakhs - 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 Assuming the number of years of purchase to be 5, goodwill = 6.06 x 5 = 30.30 Lakhs VALUATION OF SHARES Valuation 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 / 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): Find the Book value per equity share using the data of Q.No.1 Answer: Closing capital employed + goodwill Answer Value per equity share = -----------------------------------No. of equity shares
21,00,000 + 2,40,000 = ------------------ = Rs.23.40 1,00,000

Q. No.3(b): Find the Book value per equity share using the data of Q.No.2 Answer : 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) : 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 4,75,000

Reserve and Surplus: General Reserve Profit and Loss account 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.

Answer Valuation of shares Rs. Book value of assets Appreciation Total Less Paid up capital Surplus assets Share of preference shareholders in Surplus assets 7,25,000 75,000 8,00,000 4,75,000 3,25,000 32,500

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Share of equity shareholders in surplus assets Share per equity share in surplus assets: 2,92,500/30,000 Share per pref. share in surplus assets : 32,500/3,000 Value per preference share : 100 + 10.83 = Value per equity share (Rs.10 paid ) : 10 + 9.75 = Value per equity share (Rs.5 paid ) : 5 + 9.75 = 2,92,500 9.75 10.83 110.83 19.75 14.75 12.25

Value per equity share (Rs.2.50 paid ) : 2.50 + 9.75 =

ALTERNATIVE SOLUTION: Valuation of shares Rs. Book value of assets Appreciation Notional call Total Less Paid up capital Surplus assets Share of preference shareholders in Surplus assets Share of equity shareholders in surplus assets Share per equity share in surplus assets: 2,92,500/30,000 Share per pref. share in surplus assets : 32,500/3,000 Value per preference share : 100 + 10.83 = Value per equity share (Rs.10 paid ) : 10 + 9.75 = Value per equity share (Rs.5 paid ) : 19.75 -5.00 = Value per equity share (Rs.2.50 paid ) : 19.75 7.50 = 7,25,000 75,000 1,25,000 9,25,,000 6,00,000 3,25,000 32,500 2,92,500 9.75 10.83 110.83 19.75 14.75 12.25

(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. MP (based on constant div.) = D 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.

MP (based on EPS)

E.P.S. 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: WE should 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 : 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 9% Preference share Capital (Rs.100) Equity Share capital (Rs.100) P & L account 10,00,000 4,00,000 Investments 3,50,000 4,00,000 FA less Depreciation 14,00,000 Amount Assets Goodwill Amount 3,00,000

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8% Debentures Current liabilities 1,00,000 CA 6,00,000 Preliminary Expenses 25,00,000 4,30,000 20,000 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. Answer Note 1 Net tangible assets: FA Investment CA Debentures CL PSC Net Tangible assets 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 2 PBT 3,00,000 Less tax -90,000 PAT 2,10,000 Preference Dividend - 36,000 2 E. Dividend (10%) -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

18,00,000 3,50,000 4,30,000 -1,00,000 -6,00,000 -4,00,000 14,80,000

10%

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Adjustment for lower asset backing Adjustment for lower retained profit Adjustment for constant dividend Normal rate for Mind Tree +1% +1% -1% 11%

Dividend per share MP of equity share of Mind Tree = -----------------Normal rate 15 = ----------x 100 11 Rs.= 136.36

P E ratio (also known as P E Multiple) Multiple)

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 Rs. 50 Crores 5m 100 10 B Rs. 80 Crores 160m 5 20

EAT No. of equity shares EPS PE ratio

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 Graham3 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 a number of future years, is considered. This is not quite popular as it is difficult to accurately estimate the future profits for so many years.

The 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 PE ratio may be justified, other wise not. (ii) Industrys PE ratio: Industrys PE ratio can guide us in deciding whether 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 widely differes with its historical PE ratios, we should find it s reasons to decide 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 different years/ companies may not be comparable on account of different accounting policies. (ii) Many interpretations : There can be many interpretations of the PE ratio. For

example, 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 : Both Madhav Ltd and Murari Ltd belong to music industry Madhav Murari Net Tangible assets to paid up equity share 240 148 capital Pay out ratio 0.60 0.66 Dividend per share Rs.54 Rs.66 Market value per share Rs. 225 ? Answer :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 Adjustment for lower asset backing Adjustment for lower retained profit Normal rate of return ( Ke) of Murari 40% +2% +2% 44%

Market price per share of Murari = 100 / 0.44 = 227.27

Q. No. 6: 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. Fixed Assets (CP) 1,00,000 E. Share Capital (Rs.10) Reserve and Surplus Provision for Depreciation Purchase /sales 8,00,000 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 Bank 2,10,000 Bad debts 10,000 Total 15,90,000 Stock is Rs.1,50,000 as on 31 March, 2007. Cr. 3,00,000 1,80,000 30,000 10,00,000

80,000

15,90,000

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. Answer (i) Year ended 31st March, 2007: Cost of goods sold (COGS) Sales COGS (ii) Year ended 31 March, 2008: Sales : 11,00,000
st

: 7,50,000 : 10,00,000 : 75 % of sales

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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) (ii) COGS (opening stock) : 1,50,000 COGS (current period purchase) : 6,75,000 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 rates Bad debts Variable selling expenses NP 8,38,500 10,750 88,000 10,500 11,000 15,000 10,890 1,15,360 11,00,000 Sales 11,00,000

As the cost has increased by 2%, the COGS for the year 31.3.2008:

-------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. 7 Balance sheet of A Ltd. as on 31.12.2004 was as under: Liabilities ESC (Rs.10 each) 9% PSC Reserves Creditors Total Amount 5,00,000 1,00,000 3,00,000 2,00,000 11,00,000 Assets Land and Building Plant & machinery Stock Drs. Bank Total Amount 2,00,000 4,00,000 2,50,000 2,10,000 40,000 11,00,000

Profit and dividend in last several years were as under:

Year
2004 2003 2002

PBT
Rs.3,20,000 Rs.2,50,000 Rs.2,20,000

Equity Dividend
18% 15% 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: Weighted average PBT: [(220000x1) + (250000X2) +(320000X3)] / 6 = 2,80,000

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Increase in remuneration = -20,000 2,60,000 - 78,000 1,82,000 - 9,000 1,73,000 3.46

Tax EAT Pref. dividend Profit for equity shareholders EPS =1,73,000 / 50,000 = MP of equity share = 3.46/0.10 = 34.60 st Q. No. 8: 8: The capital structure of a company on 31 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 four times. (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 the value of equity shares of the company. (NOV, 2003) Answer: Answer: 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

Q. 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 Effective interest rate Effective tax rate Operating margin Dividend pay out ratio Current market price of the share Required rate of return of investors. 1.1 8% 40% 10% 16.67% Rs.14 the 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) 2009) Answer Assets turnover = 1.10

Total assets 600 Sales 660

EBIT

Income statement for the year ended 31sr Dec. 2008 (Rs. Lakhs) 66

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Interest EBT Tax EAT EPS Dividend per share -16 50 -20 30 30L/10L = 3. 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) 0.53125 Equilibrium 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 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 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. ShortShort-term 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 shortterm solvency of a firm. Current Ratio = Current Assets 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 also generally 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 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

21
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). LongLong-term 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 Ratio = Equity Total Assets or Equity 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 into liquidation, 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 B where 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 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 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 outside liabilities are.

Return on Equity 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 Employed It is obtained by dividing Profit Before Interest before Tax by Capital Employed. 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 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 RATIOS

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(i) Stock turnover Ratio Ratio 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 of opening 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 360 Cost 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 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

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Sales Net Fixed Assets

Fixed Assets Turnover Ratio

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. Working Capital Turnover Ratio = Sales Working Capital

The ratio measures the efficiency with which working capital is issued. Comment: Higher, Better. FINANCIAL LEVERAGE RATIOS RATIOS 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 increases 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 (10 per cent increase). EBIT Interest 5,00,000 1,00,000 Earnings before tax (EBT)4,00,000 Tax 2,00,000 Earnings after tax (EAT)2,00,000 E.P.S. 2.00 Percentage increase in E.P.S. = 5,50,000 1,00,000 4,50,000 2,25,000 2,25,000 2.25 0.25 100 = 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

25
relationship between these two types of funds. There are two important ratios of this category: Debt Equity Ratio : Debt (Long-term) 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 nonfixed 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 into liquidation). 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 RATIOS RATIOS 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

26
(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 to identify 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 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 [Net profit in the above chart refers to EBIT] Net profit ratio = Net Profit Sales C.E. Turnover Ratio = Sales C.E.

C.E. Turnover Ratio

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 Stock turnover ratio (Closing stock) Gross profit ratio Liquid ratio 9 25% 1.25

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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 ---CL CA - Stock - ---------------- = 0.50 CL

CA CA + Stock -------------------------CL 1,00,000 ------------ = 0.50 CL CL = 2,00,000 CA = 3,50,000

= 0.50

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 PSC PSC = 31,250 B/S as on . Liabilities : ESC 6,35,417 PSC 31,250 R&S 1,33,333 Borrowings 3,50,000 CL 2,00,000 Total 13,50,000 Question 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%) Fixed assets turnover ratio Finished goods turnover ratio Rate of gross profit to sales Net profit (before interest) to sale Fixed charges over (debenture interest 7%) Debt collection period Material consumed to sales Rs. 10,50,000 2 6 25% 8% 8 1 months 30%

Assets FA 10,00,000 Debtors 1,50,000 Stock 1,00,000 Others 1,00,000 Total 13,50,000

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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Answer Sales /FA= 2 Sales / 10,50,000 =2 Sales = 21,00,000 GP = 5,25,000 Cost of goods sold = 15,75,000 Profit before interest = 21,00,000 x 0.08 = 1,68,000 Fixed charge cover = Profit before interest / Annual interest 8 = 1,68,000/Annual interest Annual interest = 21,000 Debentures carry 7% Interest . Hence, amount of debentures = Rs. 3,00,000 Debtors = 21,00,000 x 1.50/12 = 2,62,500 Material consumed = 21,00,000 x 0.30 = 6,30,000 Raw material Stock = 6,30,000 x 8/12 = 4,20,000 Finished Stock Turnover = 6 = Cost of goods sold/closing finished Stock 6 = 15,75,000/ closing finished stock Closing finished stock = 2,62,500 CA/CL QA/QL = 1.40 Assuming no Bank overdraft, no prepaid exp. Stock /CL = 1.40 2,62,500 + 4,20,000 CL CL = 4,87,500 WC = 6,82,500 Capital Employed = FA + WC = 10.50,000 + 6,82,500 = 17,32,500 Debentures = 3,00,000 Shareholders fund = 17,32,500-3,00,000 = 14,32,500 CA = 11,70,000 = 1.40

Let capital = x x + 0.20x = 14,32,500 x = 11,93,750 Reserve and surplus = 0.20 x 11,93,750 = 2,38,750 B/S as on . Liabilities : Assets

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SC 10,50,000 11,93,750 FA R&S 2,38,750 Debtors 2,62,500 Borrowings 3,00,000 Stock 2,62,500 CL 4,87,500 Finished Raw material 4,20,000 Others 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. 12,50,000 Ratio 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 2 Cost of sales consists of 50% for materials P&L and G.R. to issued capital (equity) 25% Answer GP = 12,50,000 Sales = 50,00,000 COGS = 37,50,000 Stock Turnover ratio = COGS/Closing Stock 5 = 37,50,000/Closing Stock Closing 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 = 15,00,000 Preference 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 GP c/d 12,50,000 Total 50,00,000 Total Expenses (Balancing 9,70,000 GP b/d figure) NP (10% of ESC) 2,80,000 Total 12,50,000 Total Estimated B/S as on 31.3.1983

50,00,000 50,00,000 12,50,000

12,50,000

Liabilities : ESC PSC R&S Borrowings Creditors BO

Assets 28,00,000 FA 10,00,000 Debtors 7,00,000 Stock 5,00,000 4,68,750 5,31,250

40,00,000 12,50,000 7,50,000

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Total 60,00,000 Total 60,00,000

Question 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 Sheet

Liabilities

1976 1977 (Rs. in Lakhs)

2.00 0.40 0.04 1.60 0.40 1.80 0.26 0.30 6.80

Assets

1976 1977 (Rs. in Lakhs)

4.16 0.60 0.80 0.60 3.96 1.20 1.60 0.04

Equity shares of Rs. 100 each 2.00 Reserves 0.20 Profit & Loss A/c 0.28 Loans on mortgage2.20 Bank overdraft Creditors 0.60 Provision for Taxation 0.68 Proposed dividend0.20 6.16

Fixed Assets (Less: Dep.) Stock Debtors Cash and Bank Balance

6.16

6.80

You are also given the profit and loss account of the company for the two years. Profit and Loss Account

1976 1977 (Rs. in Lakhs)

Interest on Loan .048 .096 Directors Remuneration 0.20 0.60 Provision for Taxation 0.68 0.26 Dividends 0.20 0.30 Transfer to Reserve 0.20 0.20 Balance C/F 0.28 0.04 1.608 1.496

1976 1977 (Rs. in Lakhs)

Balance B/F 0.28 Profit for the year after running costs & depreciation 1.608 1.216

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.

Answer 1976
ROCE 1.408 100 = 30% 4.68

1977
0.616 100 = 15.20% 4.04

Net profit ratio

1.408 0.616 100 = 11.73% 100 = 6.16% 12 10.00 10 = 2.47 4.04 2.84 = 1.03 2.76 1.64 = 0.69 2.36 10 = 8.33 1.20 1.60 12 = .80 month 10 12 = 1.93 months

12 C.E. Turnover ratio = 2.56 4.68 Current ratio 2.00 = 1.35 1.48 1.40 = 0.95 1.48 12 = 20 0.60

Quick ratio

Stock turnover

.80 Av. Collection period 12

D.E. Ratio

2.20 = .89 2.48 68000 = 34 2000 10

1.60 = .66 2.44 26000 = 13 2000 15

EPS

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P/O Ratio 34 = .29 13 = 1.15

Working Notes
1976
ESC Reserve P&L Equity Loan C. E. 2.00 0.20 0.28 2.48 2.20 4.68

1977
2.00 0.40 0.04 2.44 1.60 4.04

Comments on individual ratios: Return on capital employed has come down from 30% in 1976 to 15.20% in 1977. 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 to serious 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, increase in dividend, three fold increase in directors remuneration. Stock turnover ratio has come down from 20 in 1978 to 8.33 in 1977 indicating hat goods are moving very slowly. Average collection period has been increased from 0.80 month to 1.93 months in 1977 indicating abnormal delay in collection from debtors. Debt equity ratio has declined from 0.89 to 0.66 because of repayment of loan.

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EPS has declined in tune with the net profit. Surprisingly there has been extra-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) (ii) (iii) Increase in dividend and Directors remuneration may be rolled back Long term funds may be raised for strengthening the working capital 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 General Revenue 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. Answer EPS = EAT / No of equity shares = 6,00,000 / 10,00,000 Re.0.60 Rs. 1,50,000 Rs. 7,50,000

36
PE ratio = Market price per share / EPS 3.20 / 0.60 Earnings yield = EPS / Market price per share = 0.60/3.20 Dividend Yield=Dividend per share / Market price per share =0.10 /3.20 Dividend cover= Profit before dividend / Dividend = 6,00,000/1,00,000 5.33 18.75% 3.125% 6

APPENDIX 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 a business 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. there are 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 buyer cannot 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 as negative, 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.