accounting for decision making. sect 1-4 1. identifying economic informationfor decisions and...
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Accounting for Decision Making.
Sect 1-4
1
Identifying Economic information for decisions and
Measuring about an entity informed judgments
Communicating
Business Activities
OperatingInvestingFinancing
AccountingMeasuringRecordingReportingAnalysing
BusinessDecisions
Accounting is the process of:
Accounting is the link between business activities and business decisions asillustrated in the diagram below.
Ingram et al (2005:59)
2
Topic 1: Accounting information & managerial decisionsTopic 1: Accounting information & managerial decisions
Accounting information
Traditional FinancialAccounting Information
Non-financial Information
Financial Information
•Balance sheet•Income statement•Cost of goods Manufactured•Gross profit•Operating expenses
Other quantitative information
•Percentage of defects•Number of customer complaints•Warranty claims•Units of inventory
Qualitative information
•Customer satisfaction•Employee satisfaction•Product or service quality•Reputation
Source: Jackson and Sawyers (2006: 5)
3
Topic 1: Accounting information & managerial decisionsTopic 1: Accounting information & managerial decisions
Step 1: Define the problem
Step 4: Select the best position
Step 3: Identify and analyse available optionsStep 2: Identify objectives
The Decision-making Model
4
Topic 1: Accounting information & managerial decisionsTopic 1: Accounting information & managerial decisions
Financial Statement Reports on
Balance sheet Financial position on a certain date.
Income statement Financial performance for a particular period.
Statement of changes in equity Investments by and distributions to owners.
Statements of cash flows Cash flows during the period.
Transactions Financial statements
Procedures for sorting, classifying, and presenting (bookkeeping)
Selection of alternative methods of reflecting certain transactions (accounting)
The flow from transactions to financial statements can be illustrated as follows:
The financial statements and what they are intended to report on are as follows:
5
Topic 2: Financial Statements & Accounting conceptsTopic 2: Financial Statements & Accounting concepts
6
MVN ENTERPRISES
BALANCE SHEET AS AT 31 JANUARY 2011
ASSETSProperty, plant and equipmentInventory (merchandise)Accounts receivablesCashTotal assets
EQUITY AND LIABILITIES
Equity
LiabilitiesNon-current debtAccounts payablesTotal equity and liabilities
R
247 00019 00028 500
151 400445 900
220 650
100 000125 250445 900
Topic 2: Financial Statements & Accounting conceptsTopic 2: Financial Statements & Accounting concepts
7
Topic 2: Financial Statements & Accounting conceptsTopic 2: Financial Statements & Accounting concepts
MVN ENTERPRISES
INCOME STATEMENT FOR THE YEAR ENDED 31 JANUARY 2011
R
Sales 300 000
Cost of sales (200 000)
Gross profit 100 000
Selling, general and administrative expenses (54 950)
Operating profit 45 050
Interest expense (15 000)
Net profit 30 050
8
MVN ENTERPRISES
STATEMENT OF CHANGES IN EQUITY FOR THE YEAR ENDED
31JANUARY 2011
Balance at 31 January 2010
Additional capital contributed
Profit for the year
Drawings for the year
Balance at 31 January 2011
R
0
211 000
30 050
(20 400)
220 650
Topic 2: Financial Statements & Accounting conceptsTopic 2: Financial Statements & Accounting concepts
9
Topic 2: Financial Statements & Accounting conceptsTopic 2: Financial Statements & Accounting concepts
MVN ENTERPRISES
CASH FLOW STATEMENT FOR THE YEAR ENDED 31 MARCH 20.6
R
Cash flows from operating activities 135 800
Servicing of finance: (15 000)
Interest paid (15 000)
Cash flows from investing activities (260 000)
Payment to acquire tangible non-current assets (260 000)
Net cash outflows (139 200)
Cash flows from financing activities 290 600
Net cash received from owner 190 600
Cash received from non -current loan 100 000
Increase in cash 151 400
10
Topic 2: Financial Statements & Accounting conceptsTopic 2: Financial Statements & Accounting concepts
NOTES TO THE CASH FLOW STATEMENT
Reconciliation of operating profit
R
Operating profit 45 050
Depreciation 13 000
Increase in inventory (19 000)
Increase in accounts receivable (28 500)
Increase in accounts payable 125 250
Net cash flows from operating activities 135 800
Direct Method
Shows the major classes of gross cash receipts and payments. This method starts with
Revenues and Expenses while also including Current Assets as well as Current Liabilities.
11
Topic 2: Financial Statements & Accounting conceptsTopic 2: Financial Statements & Accounting concepts
Indirect Method
Shows the net profit or loss as a starting point and makes adjustments for all
transactions of a non-cash items.
Balance Sheet
Current assets
Inventories
Notes receivable
Accounts receivable
Short-term marketable securities
Cash and cash equivalents
Non-current assets
Land
Buildings and equipment
Assets acquired by lease
Intangible assets
Natural resources
Other non-current assets
12
Topic 3: Accounting & PresentationTopic 3: Accounting & Presentation
Balance Sheet
Owners’ equity
Ordinary shares
Preference shares
Retained income
Current liabilites
Accounts payable
Short-term debt
Current maturities of long-term debt
Non-current liabilities
Long-term debt
Other long-term liabilities
13
Topic 3: Accounting & PresentationTopic 3: Accounting & Presentation
14
Topic 3: Accounting & PresentationTopic 3: Accounting & Presentation
Number of Books
Cost per
Book
Total Cost
Inventory at 12-31-09 1 @ $85 = $ 85
First purchase (January 2010) 1 @ 87 = 87
Second purchase (June 2010) 2 @ 89 = 178
Third purchase (December 2010) 1 @ 90 = 90
Total goods available for sale 5 $440
Less: Inventory at 12-31-10 4 350
Cost of goods sold 1 @ $90 $ 90
Periodic LIFO of Corner Shelf Bookstore:
15
Number of Books
Cost per
Book
Total Cost
Inventory at 12-31-09 1 @ $85 = $ 85
First purchase (January 2010) 1 @ 87 = 87
Second purchase (June 2010) 2 @ 89 = 178
Third purchase (December 2010) 1 @ 90 = 90
Total goods available for sale 5 $440
Less: Inventory at 12-31-10 4 351
Cost of goods sold 1 @ $89 $ 89
Perpetual LIFO of Corner Shelf Bookstore:
16
The following table represents a framework of the main items that are reported in an Income Statement.
Income statement
Sales
Cost of sales
Gross profit
Other operating expenses
Income from operations
Interest expense
Interest income
Gains (losses) on sale of assets
Income tax expense
Net profit
Earnings per share
17
Topic 4: Income statement & CashflowTopic 4: Income statement & Cashflow
Cost of goods sold in arriving at gross profit:
Sales
Cost of goods sold
Inventory (1/1/06)
Purchases
Direct labour
Less: Inventory (31/12/06)
Net cost of goods sold
Gross profit on sales
R
5,000
45,000
30,000
R
80,000
10,000
R
100,000
70,000
30,000
Gross profit margin is simply the gross profit expressed as a percentage of sales. This ratio is determined as follows:
100xNetsales
tGrossprofi
100000,100
000,30x
R
R
Gross profit margin =
=
= 30%
18
Consolidated statements of income (R millions)
Years ended Dec 2010 2010 2009 2008
Net income
Less: Cost of sales
Gross profit
Less: Research and development
Marketing, general, and admin
Impairment of goodwill
Amortization and impairment of acquisition-related
intangibles
Purchase in-process R&D
Operating expenses
Operating income
34,209
14,463
19,746
4,778
4,659
------
179
-------
9,616
10,130
30,141
13,047
17,094
4,360
4,278
617
301
5
9,561
7,533
26,764
13,446
13,318
4,034
4,334
------
548
20
8,936
4,382
19
Statement of Cash Flows
Cash Flows From Operations
Net income
Add (subtract) adjustments:
Depreciation
Deferred taxes
Gain on the sale of machinery
Equity in long-term investment
Accounts receivable (use)
Inventory (source)
Accounts payable (source)
Net cash flow from operations:
Investing Cash Flows:
Purchase fixed assets (use)
Sale of old machine (source)
Net cash flow from investing:
Financing Cash Flows
10 year note (source)
Sale of common stock (source)
Dividends paid (use)
Repayment of mortgage note (use)
Net cash flow from financing:
Net cash flow (increase)
R
70
100
10
(10)
(2)
(80)
100
20
208
(100)
30
(70)
100
10
(6)
(50)
54
192
Indirect Method:
20
Operating cash flows – Direct method
Cash inflows:
Sales
Increase in A/R (use)
Cash collections:
Cash inputs:
Cost of goods sold
Decrease in inventory (source)
Increase in A/P (source)
Cash inputs:
Other cash outflows:
Current income taxes
Interest paid
Other cash outflows:
Cash Flow From Operations:
Investing Cash Flows:
Purchase fixed assets (use)
Sale of old machine (source)
Net cash flow from investing:
Financing Cash Flows
10 year note (source)
Sale of common stock (source)
Dividends paid (use)
Repayment of mortgage note (use)
Net cash flow from financing:
Net cash flow (increase)
R
1600
(80)
1520
(1350)
100
20
(1230)
(35)
(47)
(82)
208
(100)
30
(70)
100
10
(6)
(50)
54
192
Direct Method:
21
R000 R000
Sales 1 000
Less: Cost of goods sold:
Opening stock 200
Purchases 700
900
Less: Closing stock 300 600
Gross profit 400
Operating expenses (240)
Operating profit 160
Debenture interest (10)
Net profit before tax 150
Taxation (50)
Net profit after taxation 100
Dividends (60)
Retained profit for the year 40
Question.
You are presented with the following information.
IQUAD Ltd Trading and profit and loss statement for the year ended 31 December 2010
22
2009 2010
R000 R000 R000 R000
Fixed assets at cost 900 1000
Less: Accumulated depreciation 150 750 255 795
Current assets
Stock 200 300
Trade debtors 120 150
Cash 20 45
340 495
Less: Current liabilities
Trade creditors 70 90
Taxation 40 50
Proposed dividend 30 60
140 200 200 295
950 1090
Capital and reserves
Ordinary shares of R1 each 750 750
Profit and loss account 200 240
950 990
Loans
Debenture stock (10% issued 1 Jan 2006) ------ 100
950 1090
IQUAD Ltd Balance sheet at 31 December 2010
Required: Prepare the cash flow statement for the year to 31 December 2010. (20)23
R000
Cash receipts
Sale of goods (R1000 + R120 – R150) 970
Issue of debenture stock (R100 – R0) 100
1070
Cash payments
Purchases (R700 + R70 –R90) (680)
Operating expenses (R240 – (R255 – R150)) (135)
Debenture interest paid (10)
Taxation (40)
Dividends (30)
Purchases of fixed assets (R1050 –R900) (150)
(1045)
Increase in cash during the year 25
Cash at 1 January 2010 20
Cash at 31 December 2010 45
IQUAD LtdCash flow statement for the year ended 31 December 2010
24
The following information applies to Trustworthy Enterprises for November 2010:
02 The owner of Trustworthy Enterprises commenced business by investing R65, 000 cash.
06 Purchased equipment for R15, 000 cash.
10 The owner obtained a long-term loan of R30, 000 from the bank.
14 Purchased merchandise on credit for R40, 000.
28 Sold merchandise that cost R15, 000 for R26, 000 on credit.
31 Paid salaries to the employees, R6000.
Required:
•Prepare the Balance sheet of Trustworthy Enterprises as at end November 2010.
•Prepare the Cash Flow Statement for the month ended November 2010.
25
Balance sheet of Trustworthy Enterprises as at 30 November 2010
ASSETS R
Property, plant and equipment 15 000
Inventory 25 000
Accounts receivable 26 000
Cash 74 000
140 000
EQUITY AND LIABILITIES
Equity 70 000
Liabilities
Long-term debt 30 000
Accounts payable 40 000
Total equity and liabilities 140 000
a)
26
Cash flow statement of Trustworthy Enterprises for the month
ending 30 November 2010
R
Cash flows from operating activities (6000)
Net profit 5 000
Increase in inventory (25 000)
Increase in accounts receivable (26 000)
Increase in accounts payable 40 000
Cash flows from investing activities (15 000)
Purchase of plant, property and equipment (15 000)
Cash flows from financing activities 95 000
Capital contributed 65 000
Cash received from long-term loan 30 000
Net increase in cash for the year 74 000
Cash (Opening balance) 0
Cash (Closing balance) 74 000
(b)
27
Good luck with your studies
28
Accounting for Decision
Making.
Sect 5-8
29
Sect 5: Cost-volume-profit relationships.
Using CVP analysis, managers would be able to get information to use in decision-making relating to:
•How profits are affected by a change in costs.
•What effect a change in sales volume will have on profit.
•The profit that is expected from a certain sales volume.
•How many units need to be sold to achieve a targeted profit.
•At what output of production will the income and costs be the same.
•Setting selling prices.
•Selecting the mix of products to sell.
30
Selling price per crate
Variable costs per crate
Fixed costs in respect of the product
Sales volume in crates
R30
R18
R80, 000
8000 crates
Per unit x Volume = Total %
Sales
Variable costs
Contribution margin
Fixed costs
Operating profit
R30
R18
R12 x8 000 = R96 000
(80 000)
R16 000
40
Calculation of operating profit.
Applying these figures in the model results in the following operating profit:
31
Per unit x Volume = Total %
Sales
Variable costs
Contribution margin
Fixed costs
Operating loss
R24
18
R612 000 R72 000
(80 000)
(R8 000)
25%
Drop in selling price by R6 and increase in sales volume to 12000 units.
The operating profit will be:
32
Per unit x Volume = Total %
Sales
Variable costs
Contribution margin
Fixed costs
Operating profit
R24
18
R 6 x19 000 = R114 000
(86 000)
R 28 000
25%
Decrease in selling price by R6 accompanied by an increase in advertising expense of
R6 000 and an expected increase in sales volume of 19 000 units.
Operating profit is expected to be:
33
Per unit x Volume = Total %
Sales
Variable costs
Contribution margin
Fixed costs
Operating profit
R30
18
R 12 x? = R126 000
(80 000)
R 46 000
40%
Calculating the volume of sales required to achieve a target level of operating profit of R46 000.
The required sales volume is 10 500 units (R126 000 / R12).
34
Variable costs per unit
Total fixed cost
Selling price per unit
Number of units sold
R 72
R 32 000
R 82
6 000
Per unit x Volume = Total %
Sales
Variable costs
Contribution margin
Fixed costs
Operating profit
R82
72
R 10 x
6000
6000
6000
R492 000
(432 000)
R 60 000
(36 000)
R 24 000
12,195
%
Greystone CC manufactures one product. The following details relating to the product applies:
Required:i.Calculate the break-even quantity and the break-even value.ii.Calculate the margin of safety in terms of units and value.
35
i. Break-even quantity = Fixed costs / Contribution margin per unit
= R36 000 / R10
= 3 600 units
Total revenue at break-even = Fixed costs / contribution margin ratio
= R36 000 / 12,195%
= R295 200 (or 3 600 x R82)
ii. Margin of safety = Sales units – Break-even sales units
(in terms of units) = 6 000 – 3 600
= 2 400 units
Margin of safety = Sales – Break-even sales
(in terms of value) = R492 000 – R295 200
= R196 800
36
profitOperating
inmonContributi
.
arg.
Sales
xsalesBreakevenSales 100...
Operating leverage is calculated as follows:
Operating leverage =
The formula for the margin of safety is:
Margin of safety =
37
Cost analysis for planning, control and decision-making.
Cost analysis for planning.
•Planning is the management process of identifying and quantifying the goals of the organisation.
•Strategic planning involves an identification of the long-term goals and drawing up plans to achieve them.
•A budget is a plan in financial terms that extends for a period in the future.
•Budgeting process. The first step in the budgeting process is to develop and communicate a set of broad
assumptions about the economy, the industry and the entity’s strategy for the budget period.
•The operating budget is a collection of related budgets comprising the sales forecast (or revenue budget), the
purchase/production budget, the operating expense budget, the income statement budget, the cash budget, and
the budgeted balance sheet. The operating budget is also called the master budget.
38
Cost analysis for decision making.
Net Present Value
•The difference between the market value of a project and its cost.
•How much value is created from undertaking an investment?
The first step is to estimate the expected future cash flows.
The second step is to estimate the required return for projects of this risk level.
The third step is to find the present value of the cash flows and subtract the initial investment.
This is to determine whether the project is viable.
Computing NPV for the Project
You are looking at a new project and you have estimated the following cash flows:
•Year 0: CF = -165,000 (original investment)
•Year 1: CF = 63,120
•Year 2: CF = 70,800
•Year 3: CF = 91,080
Your required return for assets of this risk is 12%.
•Using the formulas: NPV = valPar
k
CF
K
CF
K
CF
eee
.)1()1()1( 3
32
21
–NPV = 63,120/(1.12) + 70,800/(1.12)2 + 91,080/(1.12)3 – 165,000 = 12,627.42 39
Year Cash Flow PV
1 63,120.00 56,363.39
2 70,800.00 56,453.16
3 91,080.00 64,845.76
=NPV @ 12% 177,662.91
Original Investment -165,000.00
NPV 12,662.91
Another way of determining NPV is as follows:
Decision rule.
•If the NPV is positive, accept the project. A positive NPV means that the project is expected to
add value to the firm and will therefore increase the wealth of the owners.
•Since our goal is to increase owner wealth, NPV is a direct measure of how well this project will
meet our goal.
•So, do we accept or reject the project?
NPV is positive at 12% - we can accept the investment!
40
Internal Rate of Return
Internal rates of return (IRR).
•This is the most important alternative to NPV.
•It is often used in practice and is intuitively appealing.
•It is based entirely on the estimated cash flows and is independent of interest rates found elsewhere.
•Definition: IRR is the return that makes the NPV = 0.
•Another way of putting it is that the IRR is the discount rate that equates the PV of cash inflows with the
initial investment associated with the project.
•Decision Rule: Accept the project if the IRR is greater than the required return.
41
Example:
The management of Tiger Engineering are considering the following investment project. The following
data is available:
Cost of plant and equipment 60 000
Salvage value nil
Expected profit/loss
Yr 1 (15 000)
Yr 2 10 000
Yr 3 35 000
Tiger Engineering uses the straight-line method of depreciation for all fixed assets. The estimated cost of
capital is 10% p.a.
42
YearProfit/loss
Depreciation Cash flow
1
2
3
(15 000)
10 000
35 000
20 000
20 000
20 000
5 000
30 000
55 000
YearCash flow I Discount factor 10% PV I
0
1
2
3
(60 000)
5 000
30 000
55 000
1
0.9091
0.8264
0.7513
(60 000)
4 546
24 792
41 321NPV
10 659
entAveInvestm
ofitsAve Pr
30000
10000
Cash flows.
ARR
ARR
=
=
= 33.33%
NPV
x 100
x100
43
YearCash flow Disc fact
17%
PV Disc fact
18%
PV
0
1
2
3
(60 000)
5 000
30 000
55 000
1
0.8547
0.7305
0.6244
(60 000)
4 273
21 915
34 342
1
0.8475
0.7182
0.6086
(60 000)
4 237
21 546
33 473
NPV 530 (744)
IRR
1274
530
1
17
IRR = 17.42%
(Where do I get 1274 from? The diff between PV @ 17% and 18%.)
44
Year 0 -$90,000
Year 1 $132,000
Year 2 $100,000
Year 3 -$150,000
IRR 10.11% Reject
NPV fx 15% $91,769.54
Less initial investment -$90,000.00
NPV at 15% $1,769.54 Accept
Quick example.
Suppose an investment will cost $90,000 initially and will generate the following cash flows:
•Year 1: 132,000
•Year 2: 100,000
•Year 3: -150,000
The required return is 15%.
Should we accept or reject the project?
Hurdle rate is 15%.
45
EC Industrials manufactures a product, Brainagra that sells for R126 each.
The cost of producing and selling 240 000 units are estimated as follows;
Variable costs per unit:
Direct materials R30
Direct labour R18
Factory overhead R12
Selling and administrative expenses R15
R75
Fixed costs:
Factory overheads R3 200 000
Selling and administrative expenses R1 200 000
In the current year, to date 180 000 units were manufactured and sold. An additional 45 000 units are expected to
be sold on the domestic market during the remainder of the year. EC Industrials received an offer from Namibia
Wholesalers for 12 000 units of Brainagra at R84 each. Namibia Wholesalers will market the product in Namibia
with its own name brand and no additional expenses will be incurred by EC Industrials. The sale to Namibia
Wholesalers is not expected to affect domestic sales of the product and the additional units could be produced
during the current year using excess capacity.
As the Marketing Manager you are requested to make a decision to either accept or reject the above proposal and
to motivate the decision you have made. (15) 46
A comparison of the sales offer of R84 with the selling price of R126 indicates that the offer should be
rejected. EC Industrials, however, has excess capacity and the focus should be on the relevant cost, which is the
variable cost. The difference in the profit from accepting the offer is calculated as follows:
Differential Revenue from accepting the offer:
12 000 units @ R84 R 1 008 000
Differential cost by accepting the offer:
12 000 units @ R60 (R30 + R18 + R12) (R 720 000)
Differential profit from accepting the offer 288 000
The offer should therefore be accepted.
47
The following information relates to two projects, Project A and Project B from which one must be chosen by
Construction International.
After-tax cash flows
Year Project A Project B
1 0 36 000
2 18 500 36 000
3 36 200 36 000
4 123 000 36 000
Both projects require an initial investment of R117 700
As the project manager of Construction International you are required to:
3.1 Calculate the Net Present Value (NPV) for each project using a discount rate of 12%. Which project would
you use choose? Why?
3.2 Calculate the Internal Rate of Return (IRR) for both projects. Which project should be chosen? Why (20)
48
PROJECT A
Year Cash Inflow Discount Factor Present Value
1 0 0.8929 0
2 18 500 0.7972 14 748
3 36 200 0.7118 25 767
4 123 000 0.6355 78 611
Total Present Value 119 126
Investment 117 700
NPV (positive) 1 426
PROJECT B
Net Inflow R 36 000
Discount factor x 3.0373
Total Present Value 109 342
Investment 117 700
NPV (negative) 8 358
DECISION:
Project A should be chosen because the NPV is positive. Reject Project B because it has a negative NPV.
49
ii. PROJECT A
Choosing the discount factor:
Step 1
Since we know the NPV is positive and above zero, although by a small margin, pick a higher discount rate e.g.
13% (Trial and error is used to obtain the higher rate).
Step 2
Year Cash Discount Discount Present Present
Inflow Factor Factor Value Value
12% 13% 12% 13%
1 0 0.8929 0.8850 0 0
2 R 18 500 0.7972 0.7831 R14 748 R14 487
3 R 36 200 0.7118 0.6931 R25 767 R25 090
4 R123 000 0.6355 0.6133 R78 166 R75 435
Total PV R118 681 R115 012
Investment (R117 700) (R117 700)
NPV R 981 (R2 688)
50
Step 3
Interpolation:
The IRR is between 12% and 13%
IRR = 12 + ____981__
981+ 2 688
= 12 + 981_
3669
= 12.27%
51
PROJECT B
Choosing the discount factor:
Step 1
Since we know the NPV is negative, pick a lower discount rate e.g. 10% (Trial and error is used to obtain
the lower rate).
Step 2
Year Cash Inflow Discount Discount Discount Present Present Present
p.a. Factor Factor Factor Value Value Value
10% 9% 8% 10% 9% 8%
1-4 36 000 3.1699 3.2397 3.3121 114 116 116629 119235
Investment 117 700 117700 117700
NPV (R3 584) (R1071) R1535
52
Step 3
Interpolation: The IRR is between 8% and 9%
IRR = 8 + __1535___
1071+1535
= 8+ 1535
2606
= 8.59%
Decision: Project A must be chosen because it has a higher IRR (20)
53
Project A Project B
Initial investment R42, 000 R45, 000
Year Operating CF’s Operating CF’s
1 14, 000 28, 000
2 14, 000 12, 000
3 14, 000 10, 000
4 14, 000 10, 000
5 14, 000 10, 000
Average 14, 000 14, 000
Payback Period:
For project A, which is an annuity, the payback period is 3.0 years. Since project B generates a mixed stream
of cash inflows, the calculation of the payback period is not quite as clear cut. In year 1 the firm will recover
R28, 000 of its initial investment. In yr 2 R40, 000 will be recovered (28k + 12k). At the end of year 3, R50,
000 will be recovered. Since the amount received at the end of year 3 is greater than the initial investment,
the payback period is somewhere between 2 & 3 years. Only R5, 000 must be recovered during year 3.
However R10, 000 was recovered. Thus the payback period is 2.5yrs (2yrs + R5, 000/10, 000). If the
maximum acceptable payback period is 2.75yrs, project A would be rejected and project B accepted.
54
Analysis and interpretation of financial statements.
Ratio analysis consists of five major categories, namely:
• Liquidity ratios which indicate the ability of the organization to meet its short-term obligations.
• Profitability ratios which express the effectiveness of the company in earning profits and return on capital
invested.
• Financial leverage ratios which show the relative extent to which capital employed has been provided by
shareholders and providers of debt.
• Market ratios which reflect the performance of the share price on the stock exchange and the implications
for the shareholders of that share.
• Efficiency ratios reflect the management ability of the company with regard to its turnover and working
capital. This is also known as Activity Ratios.
55
1) The three basic measures of liquidity are:
i. Net working capital = CA – CL
ii. Current ratio = CA/CL
iii. Quick (acid-test) ratio = CA – inventory / CL
56
2)Activity ratios.
i) Inventory T/O = Cost of goods sold / Inventory
ii)Fixed asset Turnover = Sales / Net fixed assets
iii)Accounts receivable T/O = Ann cr sales / Acc’s rec
iv) Ave collection period = A/c’s rec / Ave sales per day
= (A/c’s rec / Ann sales)/360
57
•Profitability ratios.
i) Gross prof margin = Sales – cost of goods sold / sales = gross profs / sales
ii) Operating prof margin = EBIT / Sales
= Operating profs / Sales
iii) Return on Total Assets (ROA) = Net profs after tax / owners’ equity
iv) Return on Equity (ROE) = Net profs after taxes / Owners’ equity
v) Earnings per share (EPS) = Earnings available for common shareholders / no of shares of common
stock outstanding
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4) Leverage ratios.
i) Debt ratio = Tot liabilities / tot assets
ii) Debt-to-equity ratio = Long-term debt / owners’ equity
iii) Times interest earned ratio = EBIT / Interest
iv) Fixed-payment coverage ratio: EBIT + lease payments / int + lease payments + ((principal
payments + pref stock divs) x (1/(1-T)))
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5) Other ratios.
i) Price / Earnings (P/E) ratio: Mkt P per share of common stock / after tax earnings per share
ii) Dividend payout ratio: Ann divs per share/ After tax earnings per share
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Barlow Company Income Statement for the year ended 31 December 2010
2010 (R,000) 2009 (R,000)
Sales revenue 3,074 2,567
Less: Cost of goods sold 2,088 1,711
Gross profits 986 856
Less: Operating expenses
Selling expenses 100 108
General admin expenses 194 187
Lease expense 35 35
Depreciation expense 239 223
Total operating expense 568 553
Operating profits 418 303
Less: Interest expense 93 91
Net profits before taxes 325 212
Less: Taxes (rate = 29%) 94 64
Net profits after taxes 231 148
Less: preferred stock dividends 10 10
Earnings available for common shareholders 221 138
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Barlow Company Balance Sheet for the year ended 31 December 2010
Assets 2010 (R,000) 2009 (R,000)
Current assets
Cash 363 288
Marketable securities 68 51
Accounts receivable 503 365
Inventories 289 300
Total current assets 1,223 1,004
Gross fixed assets
Land and buildings 2072 1903
Machinery and equipment 1,866 1,693
Furniture and fixtures 358 316
Vehicles 275 314
Other 98 96
Total fixed assets 4,669 4,322
Less: Accumulated depreciation 2,295 2,056
Net fixed assets 2,374 2,266
Total assets 3,597 3,270
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Liabilities and stockholders’ equity 2010 (R,000) 2009 (R,000)
Current liabilities
Accounts payable 382 270
Notes payable 79 99
Accruals 159 114
Total current liabilities 620 483
Long-term debt 1,023 967
Total liabilities 1,643 1,450
Stockholders’ equity
Preferred stock – cumulative 5%, R100 par, 2,000 shares
authorized and issued
200 200
Common stock – R2.50 par, 100,000 shares authorized,
shares issued and outstanding in 2006: 76,262; in 2005:
76,244
191 190
Paid-in capital in excess of par on common stock 428 418
Retained earnings 1,135 1,012
Total stockholders’ equity 1,954 1,820
Total liabilities and stockholders’ equity 3,597 3,270
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Required: Calculate the following for Barlow Company for 2010.
a) The acid-test ratio. (2)
b) The average collection period. (2)
c) The fixed asset turnover. (2)
d) The debt ratio. (2)
e) Operating profit margin. (2)
f) Net profit margin. (2)
g) Return on equity. (2)
h) Price/earnings ratio. (2)
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sLiabilitieCurrent
InventoryAssetsCurrent
.
. 000,620
000,289000,223,1 RR a) Acid-test ratio = =
daypersalesave
receivableAccounts
...
.
539,8
000,503Rb) Average collection period =
=
= 58.9 days
= 1.51
assetsFixed
Sales
. 000,374,2
000,074,3Rc) Fixed asset turnover = = = 1.29
assetsTotal
sliabilitieTotal
.
.
000,597,3
000,643,1Rd) Debt ratio = = = 45.7%
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Sales
profitOperating.
000,074,3
000,418Re) Operating profit margin = = = 13.6%
Sales
taxesafterprofitsNet ...
000,074,3
000,231Rf) Net profit margin = = = 7.5%
assetsTotal
taxesafterprofitsNet
.
...
000,597,3
000,231Rg) Return on equity = = = 6.4%
shareperEarnings
stockcommonofshareperpriceMarket
..
......
90.2
25.32
R
Rh) P/E ratio = = = 11.1
66
Good luck with your studies
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