J B GUPTA CLASSES , Copyright: Dr JB Gupta. Chapter 11. Fundamental analysis.

Transcription

1 J B GUPTA CLASSES , drjaibhagwan@gmail.com, Copyright: Dr JB Gupta 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 company s 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 Investopedia.com

2 2 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 industry s 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

3 3 passing through expansion stage, not only the leaders but even the laggards report good performance. Company 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, let s 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, let s understand these two terms (i) super profit, and (ii) No. of years of purchase 2. 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 2 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.

4 4 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 (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

5 5 Cash and bank 50,000 17,00,000 17,00,000 Profit before tax for 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 Land and building Plant and machinery Trade investment Stock Drs. Cash 9,00,000 10,00,000 1,00,000 2,00,000 1,50,000 50,000 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 2,55,000 Super profit = 2,55, ,000 = 60,000 Goodwill = 2,40,000 Q. No. 2 : Given below is the Balance Sheet of S Ltd. as on 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

6 6 Creditors 30 Stock 20 Debtors 15 Cash & bank You are required to work out the value of the Company s goodwill considering the following information: ( Adapted May, 2008) (i) (ii) (iii) 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. (iv) Effective Income-tax rate is 30%. 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 64Lakhs Extraordinary Income ( non-recurring) _ 4Lakhs Investment Income ( non- recurring,) - 1Lakhs Advertising Lakhs Depreciation Lakhs Lakhs Less tax L Future maintainable profit L Closing capital employed (Rs.) Plant, land and building Lakhs Investment (assumed as non-trade investment) nil Working Capital Lakhs Lakhs

7 7 Average capital employed: : Closing capital employed 0.50 of current year post tax profit : 206 Lakhs 0.50(44.80Lakhs) = Lakhs Normal profit = L x 0.15 = Rs.27.54Lakhs Super profit = = 6.06Lakhs Assuming the number of years of purchase to be 5, goodwill = 6.06 x 5 = Lakhs VALUATION OF SHARES Valuation of shares is another important step of valuation of business. Hence before discussing the valuation of business, let s 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 Value per equity share = No. of equity shares 21,00, ,40,000 = = Rs ,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 Value based on earning capacity = [Future maintainable profit /Ke]/ No. of equity shares [33.60Lakhs /0.15] / 10L = Rs Fair value = Average of net asset value and value based on earning capacity

8 8 = [ ] / 2 = Rs 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 paid Reserve and Surplus: General Reserve Profit and Loss account Rs. 3,00,000 1,00,000 50,000 25,000 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. Answer Valuation of shares Rs. Book value of assets 7,25,000 Appreciation 75,000 Total 8,00,000 Less Paid up capital 4,75,000 Surplus assets 3,25,000 Share of preference shareholders in Surplus assets 32,500

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

10 10 Ke is also referred as normal rate of return on equity shares. MP ( based on dividend growing at constant rate) : D 1 = Ke - g Ke is also referred as normal rate of return on equity shares. E.P.S. MP (based on EPS) = Ke Ke is also referred as normal rate of return on equity shares. (This method is also called as PE method as PE is reciprocal of Ke i.e. Normal rate) The value of the share depends upon future EPS/ dividend. (The basic principle of the share valuation is that the market always discounts the future). Hence, we should take dividend per share / EPS of coming year and not that of past year. (Tutorial note: In case there is no specific requirement of the question: 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 : Liabilities Amount Assets Amount 9% Preference share Capital (Rs.100) 4,00,000 Equity Share capital (Rs.100) 10,00,000 Goodwill 3,00,000 FA less Depreciation 14,00,000 P & L account 4,00,000 Investments 3,50,000

11 11 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. Answer Note 1 Net tangible assets: FA 18,00,000 Investment 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 2 PBT 3,00,000 Less tax -90,000 PAT 2,10,000 Preference Dividend - 36,000 E. Dividend (10%) 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%

12 12 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 Rs.= P E ratio (also known as P E Multiple) P/E is the ratio of a company s share price to its EPS. It is a core measure of a company s 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 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 company s 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 A s share is over-priced. Let s study some more details about these companies:

13 13 A B EAT Rs. 50 Crores Rs. 80 Crores No. of equity shares 5m 160m 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, A s share is cheaper. Suppose the industry s PE multiple is 15, A s share is undervalued and B s 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 company s 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 company s 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 Graham 3 and followed by his student Warren Buffet) suggests that the long term 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. 3 The Concept of PE ratio was used for the first time Prof. Graham.

14 14 High or low PE ratio: For deciding whether a share s 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) Industry s PE ratio: Industry s PE ratio can guide us in deciding whether a share s PE ratio is high or Low. Suppose an industry s PE ratio is 10 and a company s 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 company s products, ineffective hangmen etc), the investment should not me made. If it is low due to speculative reasons, the investment may be made. (iii) Company s own historical PE ratio : A company s 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 capital Pay out ratio 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

15 15 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 = 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 1 st April, 2007 assuming the PE ratio to be 10. Dr. Cr. Fixed Assets (CP) 1,00,000 E. Share Capital (Rs.10) 3,00,000 Reserve 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 10,000 Total 15,90,000 15,90,000 Stock is Rs.1,50,000 as on 31 March, 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 During the year ended 31 st 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 31 st March, 2007: Cost of goods sold (COGS) : 7,50,000 Sales : 10,00,000 COGS (ii) Year ended 31 st March, 2008: : 75 % of sales Sales : 11,00,000

16 16 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) : 6,75,000 As the cost has increased by 2%, the COGS for the year : 1,50, ,75,000(1.02) = 8,38,500 Profit and Loss account for the year ended COGS Depreciation Salaries F. Selling exp. Rent and rates Bad debts Variable selling expenses NP EPS = 1,15,360 / 30,000 = ,38,500 10,750 88,000 10,500 11,000 15,000 10,890 1,15,360 11,00,000 Sales 11,00, ,00,000 Market price of the share: E 1 x PE ratio = x 10 = Rs Q. No. 7 Balance sheet of A Ltd. as on 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: Weighted average PBT: [(220000x1) + (250000X2) +(320000X3)] / 6 = 2,80,000

17 17 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 = Q. No. 8: 8 The capital structure of a company on 31 st 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: 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) / ( ) =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.

18 18 Main answer: Normal rate of the industry : 15% Adjustment for lower interest and dividend cover: % Adjustment for Lower % of equity and reserves to debentures and preference capital : Normal rate for the company 15.50% (60% of 90,000) + (5% of 70,600) Actual yield = x 100 = % 5,00,000 Value of equity share = ( / 15.50) x 10 = Rs Value of business = (50,000 x 7.42) = 10,71,000 Q.. No.9 Following Financial data are available for PQR for the year 2008: Rs. Lakhs 8% Debentures % 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 15% investors. 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 company s share using dividend discount model. (iv) What is your opinion on investment in the company s share at current market price? (Nov. 2009) Answer Assets turnover = 1.10 Total assets 600 Sales 660 Income statement for the year ended 31sr Dec (Rs. Lakhs) EBIT 66

19 19 Interest -16 EBT 50 Tax -20 EAT 30 EPS 30L/10L = 3. Dividend per share 3. x = 0.50 Return on equity shareholders fund = 30/ ( ) =7.50% Ratio of Retained EPS to EPS = Sustainable growth rate = x.075 = 6.25% % 0.50(1.0625) Equilibrium value of share = = = 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. Short-term 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 Assets Current Ratio = Current Liabilities

20 20 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. Let s 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). Let s 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 firm s 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 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). Long-term Solvency Ratios Long-term solvency refers to the firm s 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) Owner s 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 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 firm s 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 firm s being solvent in future is reduced. The comment on the ratio is: Higher, Better. This ratio is also called fixed charge cover.

22 22 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

23 23 (i) Stock turnover 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

24 24 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 RATIOS R 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 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 Percentage increase in E.P.S. = 100 = Thus when EBIT increased by 10 per cent, EPS increased by 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 25 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 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 won t 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 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 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 company s 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%

27 27 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 = ,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] = Assuming: No bank overdraft and no prepaid exp. CA CA - Stock = 0.50 CL CL CA CA + Stock = 0.50 CL 1,00, = 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, ,50,000 = 11,50,000

28 28 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 x = 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 = ,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 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. 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 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 Material consumed to sales 30% Stock of raw materials (in terms of number of month s consumption) 8 Current ratio 2.4 Quick ratio 1.0 Reserves to capital ½ months

29 29 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 CA/CL QA/QL = 1.40 Assuming no Bank overdraft, no prepaid exp. Stock /CL = ,62, ,20,000 = 1.40 CL 6 = 15,75,000/ closing finished stock Closing finished stock = 2,62,500 CL = 4,87,500 CA = 11,70,000 WC = 6,82,500 Capital Employed = FA + WC = 10.50, ,82,500 = 17,32,500 Debentures = 3,00,000 Shareholders fund = 17,32,500-3,00,000 = 14,32,500 Let capital = x x x = 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