Reading Material: Week-3

Module: Financial Strategy and Decision Making 1

Consider the Balance Sheet for financial years 2023 and 2024.
2024 2023
Current Assets
Cash in hand 15000 14000
Cash in bank 20000 18000
Marketable securities 31100 21000
Accounts receivables / Debtors 4600 7800
Inventories / Stock 6500 8811
Other current assets 2150 2980
Total Current Assets 79350 72591
Fixed Assets / Non-Current Assets
Plant and equipment 24000 28836
Less accumulated depreciation -4500 -7475
Long term investments 2530 5090
Storage 12000 26000
Total Fixed Assets 34030 52451
Total Assets 113380 125042
Current Liabilities
Debt due for repayment 24000 18500
Accounts payable / Creditors 5500 8200
Taxation 8000 10000
Overdraft 6800 14000
Total Current Liabilities 44300 50700
Fixed Liabilities
Long-term debt / Loans 12000 21000
Other long-term liabilities 12000 18000
Deferred income taxes 6660 7670
Total Fixed Liabilities 30660 46670
Total Liabilities 74960 97370
Equity
Share capital 22800 13250
Retained earnings 15620 14422
Total shareholders’ equity 38420 27672
Total Liabilities and Equity 113380 125042
Income Statements for the years ended 31st December.
2024 2023
Net Sales 48500 50000
Cost of goods sold 32000 38000
Administrative cost 3000 4000
Selling and distribution cost 2500 4000
Research and innovation cost 3000 500
Loss on sale of unused machine 1600 -
Depreciation 1300 2000
Earnings before interest & taxes 5100 1500
Interest expense 298 160
Taxable income 4802 1340
Taxes 1200 500
Net Profit 3602 840

The owners of the company are not satisfied with the company’s performance
in 2023. They ask managers to improve the company’s:
(1) Profitability
(2) Liquidity
(3) Efficiency
(4) Leverage
(5) Duration of debtors and creditors payments
(6) Company’s market performance

The managers worked hard and there is improvement in the business.

Calculate the relevant financial ratios and analyse the performance in
response to the owners’ criticism.

NOTE: Shares outstanding for years 2023 and 2024 are 20,000 and share price
is 2 and 3.5 respectively. Besides, the corporate tax is 30%.
(1) Measuring Profitability
Return ratios are used to calculate profitability of a business. The current year
return ratios are compared with the previous years’ ratios to analyse the
performance. Similarly, these returns can also be compared with other
companies in the similar business.

𝑔𝑟𝑜𝑠𝑠 𝑝𝑟𝑜𝑓𝑖𝑡
1.1 Gross profit percentage = ( ) × 100%
𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟

𝑛𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡
1.2 Net profit margin = ( ) × 100%
𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟

(1−𝑇𝑎𝑥)𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡+𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
1.3 Return on capital (𝑅𝑂𝐶) = × 100%
𝑇𝑜𝑡𝑎𝑙 𝐶𝑎𝑝𝑖𝑡𝑎𝑙
It measures company’s profitability relative to the capital invested by
shareholders and the creditors.

𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
1.4 Return on equity (𝑅𝑂𝐸) = × 100%
𝐸𝑞𝑢𝑖𝑡𝑦
It measures company’s profitability in relation to stockholders’ equity.

(1−𝑇𝑎𝑥)𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡+𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
1.5 Return on assets (𝑅𝑂𝐴) = × 100%
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
It measures how efficient a company is in generating profit from their
total assets.

(2) Measuring Liquidity

Liquidity for companies typically refers to a company’s ability to use its current
assets to meet its current or short-term liabilities.

2.1 𝑁𝑒𝑡 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠
2.2 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑅𝑎𝑡𝑖𝑜 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠−𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑖𝑒𝑠
2.3 𝑄𝑢𝑖𝑐𝑘 𝑅𝑎𝑡𝑖𝑜 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
(3) Measuring Efficiency
Efficiency ratios are used to measure the performance of a company’s short-
term or current performance. These measures are used to analyse how
efficiently a company is using its assets.

𝐶𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑 𝑠𝑜𝑙𝑑

3.1 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
It measures how many times a company turned over its inventory in a
given period of time (i.e., a year). It is a measure of how efficiently a
company uses its inventory.

How many days it takes, on average, to sell its inventory:

365
𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟

𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟
3.2 𝐴𝑠𝑠𝑒𝑡𝑠 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =
𝐴𝑠𝑠𝑒𝑡𝑠
Or
𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟
𝐹𝑖𝑥𝑒𝑑 𝑎𝑠𝑠𝑒𝑡𝑠 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =
𝐹𝑖𝑥𝑒𝑑 𝑎𝑠𝑠𝑒𝑡𝑠
It measures how effectively a company uses its assets to generate sales.

𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟
3.3 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =
𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠
It measures company’s efficiency to collect its receivables or the credit
it extends to customers.

𝑅𝑒𝑠𝑒𝑎𝑟𝑐ℎ 𝑒𝑥𝑝𝑒𝑛𝑠𝑒𝑠
3.4 𝑅𝑒𝑠𝑒𝑎𝑟𝑐ℎ & 𝐼𝑛𝑛𝑜𝑣𝑎𝑡𝑖𝑜𝑛 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =
𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟
It measures research & innovation expenses in relation to the total sales.

(4) Measuring Leverage

It measures how much financial leverage the firm has taken on. It assesses
company’s ability to meet its financial obligations.
𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
4.1 𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡 𝑅𝑎𝑡𝑖𝑜 =
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠

𝐿𝑜𝑛𝑔 𝑇𝑒𝑟𝑚 𝐷𝑒𝑏𝑡

4.2 𝐿𝑜𝑛𝑔 𝑇𝑒𝑟𝑚 𝐷𝑒𝑏𝑡 𝑅𝑎𝑡𝑖𝑜 (𝐺𝑒𝑎𝑟𝑖𝑛𝑔) =
𝐿𝑜𝑛𝑔 𝑇𝑒𝑟𝑚 𝐷𝑒𝑏𝑡+𝐸𝑞𝑢𝑖𝑡𝑦
(5) Duration of Debtors and Creditors Payments

𝐷𝑒𝑏𝑡𝑜𝑟𝑠
5.1 𝐷𝑒𝑏𝑡𝑜𝑟𝑠 𝑑𝑎𝑦𝑠 = × 365
𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟
Debtor days are the length of time it takes for a business to get paid by a
customer for a sale made on credit.

𝐶𝑟𝑒𝑑𝑖𝑡𝑜𝑟𝑠
5.2 𝐶𝑟𝑒𝑑𝑖𝑡𝑜𝑟𝑠 𝑑𝑎𝑦𝑠 = × 365
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑠𝑜𝑙𝑑
It measures how long on average it takes a company to pay its creditors.

(6) Market Performance

6.1 𝑀𝑎𝑟𝑘𝑒𝑡 𝑐𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑎𝑡𝑖𝑜𝑛 = 𝑆ℎ𝑎𝑟𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 × 𝑆ℎ𝑎𝑟𝑒 𝑝𝑟𝑖𝑐𝑒

Market value of the company.

𝑛𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
6.2 𝐸𝑃𝑆 =
𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠
It measures how much profit each outstanding share of common stock
has earned.

𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦

6.3 𝑀𝑎𝑟𝑘𝑒𝑡 − 𝑡𝑜 − 𝑏𝑜𝑜𝑘 𝑟𝑎𝑡𝑖𝑜 =
𝐵𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑒𝑞𝑢𝑖𝑡𝑦
How much value has been added for each dollar that shareholders have
invested? Answer: The company has multiplied the value of its
shareholders’ investment x times.

6.4 𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑎𝑑𝑑𝑒𝑑 = 𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 − 𝑏𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒

The book value measures shareholders’ cumulative investment in the
company. While market value is the market capitalization. Therefore,
market value added is difference of market value and the book value.