# CHAPTER 6. P.6.17 The following are the ratios relating to the activities of National Traders Ltd:

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1 CHAPTER 6 Solved Problems P.6.17 The following are the ratios relating to the activities of National Traders Ltd: Debtors velocity (months) 3 Stock velocity (months) 8 Creditors velocity (months) 2 Gross profit ratio (%) 25 Gross profit for the current year ended December 31 amounts to Rs 4,00,000. Closing stock of the year is Rs 10,000 above the opening stock. Bills receivable amount to Rs 25,000 and bills payable to Rs 10,000. Find out: (a) Sales, (b) Sundry debtors, (c) Closing stock, and (d) Sundry creditors. Solution (a) Determination of sales: (b) Determination of sundry debtors: Debtors velocity is 3 months. In other words, debtors collection period is 3 months, or debtors turnover ratio is 4. Assuming all sales to be credit sales and debtors turnover ratio being calculated on the basis of year-end figures, Debtors turnover ratio or Closing debtors + Bills receivable = Rs 4,00,000 Closing debtors= Rs 4,00,000 Rs 25,000 = Rs 3,75,000 (c) Determination of closing stock: Stock velocity of 8 months signifies that the inventory holding period is 8 months, stock turnover ratio is 1.5 = (12 months 8). Stock turnover 1.5 Average stock = = Rs 8,00,000 Closing stock Opening stock = Rs 10,000 (1) Closing stock + Opening stock 2 = Rs 8,00,000 (2) Closing stock + Opening stock = Rs 16,00,000 (3) Subtracting (1) from (3) we have, 2 Opening stock = Rs 15,90,000 Opening stock = Rs 7,95,000 Therefore, Closing stock = Rs 8,05,000 (d) Determination of sundry creditors: Creditors velocity of 2 months signifies that the credit payment period is 2 months. In other words, creditors turnover ratio is 6(12 months 2). Assuming all purchases to be credit purchases and creditors turnover is based on year-end figures, Creditors turnover ratio = 6 = Creditors + Rs 10,000 = = Rs 2,01,667 Creditors = Rs 2,01,667 Rs 10,000 = Rs 1,91,667 Credit purchases are calculated as follows: Cost of goods sold = Opening stock + Purchases Closing stock Rs 12,00,000 = Rs 7,95,000 + Purchases Rs 8,05,000 Rs 12,00,000 + Rs 10,000 = Purchases Rs 12,10,000 = Purchases (credit). P.6.18 While working in a financial institution, you have come across the following statements. Give your views and comments on these statements with the necessary arguments. (a) The sales of company A have been growing at a faster rate than those of company B. The profitability of company A must, therefore, be greater than that of company B. (b) From the viewpoint of equity shareholders, debt in the capital structure affects both the risk and the profitability of the firm. (c) Firm X and firm Y have the same expected sales volume for next year and they are identical in every respect except that the firm X has a greater proportion of fixed costs. If sales are expected to increase (decrease), firm X will have greater (lower) profit from operations than firm Y. (d) Assume Calico has a profit margin of 20 per cent and Mafatlal has a profit margin of 25 per cent. It is,

2 therefore, obvious that Mafatlal is a better investment than Calico. (e) Firm A is aggressively making capital expenditure and firm B is not. Firm A is clearly more efficient and profitable than firm B. Solution (a) The profitability of a company is a product of two factors: (i) margin of profit on sales, and (ii) assets turnover. Symbolically, it is equal to or Margin of net profit Assets turnover Accordingly, the profitability of company A need not necessarily be greater than that of company B. The answer hinges on the margin of profit of company A. If the margin of profit on sales of both the companies is equal, the profitability of company A would certainly be greater than that of B; because of higher sales company A would cause a higher assets turnover vis-a-vis company B (assuming the size of total assets of companies A and B is equal). If the margin of profit of company B is greater than that of A, profitability of company B may be even greater than that of company A. For instance, the margin of profit on sales of company A is 2 per cent and that of company B is 4 per cent. Let us assume further the assets turnover of company A is 8 while that of company B is 5. Due to increased sales, the total rate of return would be 16 per cent of company A, while that of Company B would be 20 per cent. (b) Debt in the capital structure certainly affects both the risk and profitability from the point of view of equityholders. If the company s earnings rate is greater than the interest rate paid on debt, the company is said to have favourable leverage as it enhances the rate of return available to equityholders. Conversely, if the rate of interest paid on debt exceeds the company s earning rate, the company is said to have unfavourable leverage as it will depress the rate of return available to equity holders. Let us take a simple example to make the point clear: Total assets Rs 20,000 Equity capital 10,000 10% Debt 10,000 Net income before interest and taxes 5,000 Tax rate (%) 35 Profit and loss statement Net income before interest and taxes Rs 5,000 Less: Interest on debt 1,000 Net income 4,000 Less: Taxes (0.35) 1,400 Net income available to equityholders 2,600 Rate of return on equity capital (per cent) 26 The company is increasing the profitability of equity holders by employing debt in the capital structure. In the absence of debt, the rate of return would have been per cent [(Rs 5,000 Rs 1,750 taxes) Rs 20,000]. If the net income before interest and taxes is Rs 1,500 only, the use of debt would work against the interest of equityholders, as shown by the following calculations: Net income before interest and taxes Rs 1,500 Less: Interest on debt 1,000 Net income 500 Less: Taxes 175 Net income available to equityholders 325 Rate of return on equity capital (per cent) 3.25 In the absence of debt, the rate of return on equity capital would have been 4.9 per cent [Rs 1,500 Rs 525] Rs 20,000. The use of debt in the company s capital structure increases the financial risk of equityholders, as the use of debt increases the variability of the shareholders returns and probability of insolvency if the firm fails to make the payment of interest and repayment of the principal in time. (c) The profit of firm X need not necessarily be higher than that of Y. The answer hinges on the margin of safety and amount of fixed costs of firms X and Y. Let us take an example. Firms Particulars X Y Sales Rs 1,00,000 Rs 1,00,000 P/V ratio (%) Fixed cost 40,000 20,000

3 Net profit 10,000 30,000 Net profit X, (Sales, Rs 1,00,000 Variable cost, Rs 50,000 Fixed cost, Rs 40,000) = Rs 10,000. Net profit, Y (Sales, Rs 1,00,000 Variable cost, Rs 50,000 Fixed cost, Rs 20,000) = Rs 30,000. If sales increase by 20 per cent, Particulars X Y Sales Rs 1,20,000 Rs 1,20,000 Less: Variable cost (1 P/V ratio) 60,000 60,000 Contribution 60,000 60,000 Less: Fixed costs 40,000 40,000 20,000 20,000 (d) Mafatlal need not necessarily be a better investment than Calico for the following reasons: (i) Profitability is also affected by turnover of total assets and not by margin of profit only. The assets turnover of Calico may be greater than Mafatlal s. (ii) The degree of financial risk in Mafatlal due to the use of debt may be more than that in Calico. Therefore, the required rate of return on equity capital of Mafatlal would be more than that of Calico affecting the market value of their shares. (iii) Calico may be pursuing a stable dividend policy as against an unstable dividend policy by Mafatlal. (iv) The future prospects of the two companies may be different. The above factors taken together determine the quality of investments. (e) The answer rests on the existing position of firm B and the rate of return earned by company A on capital expenditures. If company A is investing in such proposals which will add to the net present value of the shareholders wealth, they will certainly add to the efficiency and profitability of firm A. But if the firm B has already made such investments in the past, the company A need not necessarily be more efficient and profitable than firm B. P.6.19 From the following particulars, prepare the balance sheet of Shri Mohan Ram and Co. Ltd as at March 31, current year. Current ratio, 2 Working capital, Rs 4,00,000 Capital block to current asset, 3:2 Fixed asset to turnover, 1:3 Sales cash/credit, 1:2 Debentures/share capital, 1:2 Stock velocity, 2 months Creditors velocity, 2 months Debtors velocity, 2 months Gross profit ratio, 25 per cent (to sales) Capital block: Net profit, 10 per cent of turnover Reserve, 2.5 per cent of turnover Solution Balance sheet as at March 31 Liabilities Amount Assets Amount Share capital Rs 6,00,000 Fixed assets (net) Rs 8,00,000 Reserves 60,000 Current assets: Profit and loss A/c 2,40,000 Stock 3,00,000 Debentures 3,00,000 Debtors 2,66,667 Creditors 3,50,000 Other current assets 2,33,333 Other current liabilities 50,000 16,00,000 16,00,000 Working Notes 1. Current ratio of 2 implies that CA s = twice CL, i.e., CA - 2CL = 0 Further, CA - CL = Rs 4,00,000 or, CL = Rs 4,00,000 and CA = Rs 8,00, Capital block to current assets ratio of 3:2 implies that long-term capital funds (equity funds + debentures) are 1.5 times current assets, i.e., Rs 8,00, = Rs 12,00, Total assets = Total liabilities = Rs 16,00,000 (Rs 12,00,000 long-term funds + Rs 4,00,000 CL). 4. Fixed assets = Rs 16,00,000, Total assets Rs 8,00,000, CA = Rs 8,00, FA/Turnover (sales) = 1/3 or Sales = Rs 8,00,000 3 = Rs 24,00, Proportion of cash sales to credit sales is 1:2 or cash sales are one-third of total sales, i.e. 1/3 Rs 24,00,000 = Rs 8,00,000; credit sales = Rs 16,00,000.

4 7. Gross profit = 0.25 Rs 24,00,000 = Rs 6,00,000; cost of goods sold = Rs 18,00, Debtors = Rs 16,00,000/6 (Debtors turnover ratio, 12 2) = Rs 2,66, Stock = Rs 18,00,000/6 (Stock turnover ratio, 12 2) = Rs 3,00, Other CAs = Rs 8,00,000 (Rs 2,66,667 + Rs 3,00,00) = Rs 2,33, Reserves = Rs 24,00,000 = Rs 60, Credit purchases = Cost of goods sold + Closing stock = Rs 18,00,000 + Rs 3,00,000 = Rs 21,00, Creditors = Rs 21,00,000 6 (creditors turnover ratio, 12 2) = Rs 3,50, Other CLs = Total CL Creditors, i.e. Rs 4,00,000 Rs 3,50,000 = Rs 50, Debentures to share capital ratio of 1:2 implies that debentures in value are equal to one-half of share capital (2 Debentures = Share capital). Further, capital block (as per working note 3) is Rs 12,00,000. Rs 12,00,000 = Debentures + Share capital + Net profit + Reserves Rs 12,00,000 = 3 Debentures + Rs 2,40,000 (10 per cent of sales) + Rs 60,000 Rs 3,00,000 = Debentures; Share capital = Rs 6,00,000 Review Questions 6.20 You have been supplied data for Royal Plastic Ltd and its industry averages. (a) Determine the indicated ratios for the Royal Plastic Ltd. (b) Indicate the company s strengths and weaknesses in terms of liquidity, solvency and profitability, as revealed by your analysis. Balance sheet, March 31, current year Liabilities Assets Equity share capital Rs 1,00,000 Plant and equipment Rs 1,51,000 10% Preference share capital 40,000 Cash 12,300 Retained earnings 27,400 Debtors 36,000 Long-term debt 34,000 Stock 60,800 Sundry creditors 31,500 Outstanding expenses 1,200 Other current liabilities 26,000 2,60,100 2,60,100 Statement of profit, year ended March 31, current year Sales net Rs 2,25,000 Less: Cost of goods sold Rs 1,52,500 Selling expenses 29,500 Administrative expenses 14,800 Research and development expenses 6,500 Interest 2,900 2,06,200 Earnings before taxes 18,800 Less: Income taxes (0.35) 6,580 Net income 12,220 Dividends paid to equity holders 5,000 Financial ratios of industry 1. Current ratio 2.2 : 1 2. Stock turnover (times) Collection period (days) Total debt/shareholders equity (percentage) Interest coverate ratio (times) Turnover of assets (times) Income before tax/sales (percentage) Rate of return on shareholders equity (percentage) Below are selected ratios for two companies in the same industry, along with industry average: Ratios A B Industry Current ratio Acid-test ratio

5 Answers Debt-asset ratio Operating expenses ratio Number of times interest earned Stock turnover Debtors turnover Rate of return on total assets Can we say on the basis of above ratios and information that company B is better than company A because its ratios are better in six out of eight areas (all except stock turnover and rate of return on total assets)? The company B is better than the industry average in the same six categories (a) (1) 1.86, (2) 2.51 times, (3) 58 days, (4) 55 per cent, (5) 7.48 times, (6) 0.58 times, (7) 8.36 per cent, (8) 5.45 per cent. (b) Company s position both in terms of profitability and solvency is weaker than that of industry Not necessarily.

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