Accounting for Decision Making.

Sect 1-4

1
 Topic 1: Accounting information & managerial decisions

Accounting is the process of:

Identifying Economic information for decisions and

Measuring about an entity informed judgments
Communicating

Accounting is the link between business activities and business decisions as

illustrated in the diagram below.

Business Accounting Business

Activities Measuring Decisions
Operating Recording
Investing
Reporting
Financing
Analysing

Ingram et al (2005:59)

2
Topic 1: Accounting information & managerial decisions

Accounting information

Traditional Financial Non-financial

Accounting Information
Information

Financial Other Qualitative

Information quantitative information
•Balance sheet information •Customer satisfaction
•Income statement •Percentage of defects •Employee satisfaction
•Cost of goods •Number of customer •Product or service
Manufactured complaints quality
•Gross profit •Warranty claims •Reputation
•Operating expenses •Units of inventory

Source: Jackson and Sawyers (2006: 5)

3
Topic 1: Accounting information & managerial decisions

The Decision-making Model

Step 4: Select the best position

Step 3: Identify and analyse available
options
Step 2: Identify objectives
Step 1: Define the problem

4
Topic 2: Financial Statements & Accounting concepts
The flow from transactions to financial statements can be illustrated as follows:

Procedures for sorting,

classifying, and presenting
(bookkeeping)
Transactions Selection of alternative Financial statements
methods of reflecting certain
transactions (accounting)

The financial statements and what they are intended to report on are as follows:

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.

5
Topic 2: Financial Statements & Accounting concepts

MVN ENTERPRISES
BALANCE SHEET AS AT 31 JANUARY 2011
R
ASSETS
Property, plant and equipment 247 000
Inventory (merchandise) 19 000
Accounts receivables 28 500
Cash 151 400
Total assets 445 900

EQUITY AND LIABILITIES

Equity 220 650
Liabilities
100 000
Non-current debt
125 250
Accounts payables
445 900
Total equity and liabilities

6
Topic 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

7
Topic 2: Financial Statements & Accounting concepts

MVN ENTERPRISES
STATEMENT OF CHANGES IN EQUITY FOR THE YEAR ENDED
31JANUARY 2011
R
Balance at 31 January 2010
0
Additional capital contributed
211 000
Profit for the year
30 050
Drawings for the year
(20 400)
Balance at 31 January 2011
220 650

8
Topic 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

9
Topic 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

10
 Topic 2: Financial Statements & Accounting concepts

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.

Indirect Method
Shows the net profit or loss as a starting point and makes adjustments for all
transactions of a non-cash items.

11
 Topic 3: Accounting & Presentation
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 & 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 & Presentation

14
Periodic LIFO of Corner Shelf Bookstore:

Cost
Number of Total
per
Books Cost
Book

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

15
Perpetual LIFO of Corner Shelf Bookstore:

Cost
Number of Total
per
Books Cost
Book

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

16
 Topic 4: Income statement & Cashflow

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
 Cost of goods sold in arriving at gross profit:

R R R
Sales
100,000
Cost of goods sold
Inventory (1/1/06)
5,000
Purchases
45,000
Direct labour
30,000
80,000
Less: Inventory (31/12/06)
10,000
Net cost of goods sold
70,000
Gross profit on sales
30,000

Gross profit margin is simply the gross profit expressed as a percentage of sales. This ratio
is determined as follows:
Grossprofi t
Gross profit margin = x100
Netsales
= R30,000
x100
R100,000
= 30%

18
 Consolidated statements of income (R millions)
Years ended Dec 2010 2010 2009 2008
Net income 34,209 30,141 26,764
Less: Cost of sales 14,463 13,047 13,446
Gross profit 19,746 17,094 13,318
Less: Research and development 4,778 4,360 4,034
Marketing, general, and admin 4,659 4,278 4,334
Impairment of goodwill ------ 617 ------
Amortization and impairment of acquisition-related
intangibles 179 301 548
Purchase in-process R&D ------- 5 20
Operating expenses 9,616 9,561 8,936
Operating income 10,130 7,533 4,382

19
Indirect Method:

Statement of Cash Flows

Cash Flows From Operations R
Net income 70
Add (subtract) adjustments:
Depreciation 100
Deferred taxes 10
Gain on the sale of machinery (10)
Equity in long-term investment (2)
Accounts receivable (use) (80)
Inventory (source) 100
Accounts payable (source) 20
Net cash flow from operations: 208
Investing Cash Flows:
Purchase fixed assets (use) (100)
Sale of old machine (source) 30
Net cash flow from investing: (70)
Financing Cash Flows
10 year note (source) 100
Sale of common stock (source) 10
Dividends paid (use) (6)
Repayment of mortgage note (use) (50)
Net cash flow from financing: 54
Net cash flow (increase) 192

20
Direct Method:
Operating cash flows – Direct method
Cash inflows: R
Sales 1600
Increase in A/R (use) (80)
Cash collections: 1520
Cash inputs:
Cost of goods sold (1350)
Decrease in inventory (source) 100
Increase in A/P (source) 20
Cash inputs: (1230)
Other cash outflows:
Current income taxes (35)
Interest paid (47)
Other cash outflows: (82)
Cash Flow From Operations: 208
Investing Cash Flows:
Purchase fixed assets (use) (100)
Sale of old machine (source) 30
Net cash flow from investing: (70)
Financing Cash Flows
10 year note (source) 100
Sale of common stock (source) 10
Dividends paid (use) (6)
Repayment of mortgage note (use) (50)
Net cash flow from financing: 54
Net cash flow (increase) 192
21
Question.

You are presented with the following information.

IQUAD Ltd Trading and profit and loss statement for the year ended 31 December 2010

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

22
 IQUAD Ltd Balance sheet at 31 December 2010

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

Required: Prepare the cash flow statement for the year to 31 December 2010. (20)
23
 IQUAD Ltd
Cash flow statement for the year ended 31 December 2010

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

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
a)
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

26
(b)
Cash flow statement of Trustworthy Enterprises for the month R
ending 30 November 2010

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

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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
Calculation of operating profit.

Selling price per crate R30

Variable costs per crate R18

Fixed costs in respect of the product R80, 000

Sales volume in crates 8000 crates

Applying these figures in the model results in the following operating profit:

Per unit x Volume = Total %

Sales R30

Variable costs R18

8 000 = R96 000 40
Contribution margin R12 x
(80 000)
Fixed costs
R16 000
Operating profit

31
Drop in selling price by R6 and increase in sales volume to 12000 units.

The operating profit will be:

Per unit x Volume = Total %

Sales R24

Variable costs 18
12 000 R72 000 25%
Contribution margin R6
(80 000)
Fixed costs
(R8 000)
Operating loss

32
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:

Per unit x Volume = Total %

Sales R24

Variable costs 18
19 000 = R114 000 25%
Contribution margin R 6 x
(86 000)
Fixed costs
R 28 000
Operating profit

33
Calculating the volume of sales required to achieve a target level of operating profit of R46 000.

Per unit x Volume = Total %

Sales R30

Variable costs 18
? = R126 000 40%
Contribution margin R 12 x
(80 000)
Fixed costs
R 46 000
Operating profit

The required sales volume is 10 500 units (R126 000 / R12).

34
Greystone CC manufactures one product. The following details relating to the product applies:

Variable costs per unit R 72

Total fixed cost R 32 000

Selling price per unit R 82

Number of units sold 6 000

Required:
i.Calculate the break-even quantity and the break-even value.
ii.Calculate the margin of safety in terms of units and value.

Per unit x Volume = Total %

Sales R82 6000 R492 000

Variable costs 72 6000 (432 000)

12,195
Contribution margin R 10 x 6000 R 60 000
%
Fixed costs (36 000)

Operating profit R 24 000

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
Operating leverage is calculated as follows:

Contribution.m arg in
Operating leverage = Operating . profit

The formula for the margin of safety is:

Sales  Breakeven.sales.x.100
Margin of safety = Sales

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%.

CF1 CF2 CF3

   Par.val
•Using the formulas: NPV = (1  K e ) (1  K e ) (1  k e ) 3
2

–NPV = 63,120/(1.12) + 70,800/(1.12) 2 + 91,080/(1.12)3 – 165,000 = 12,627.42 39

Another way of determining NPV is as follows:

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

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
Cash flows.
Profit/loss
Year Depreciation Cash flow
1 (15 000) 20 000 5 000
2 10 000 20 000 30 000
3 35 000 20 000 55 000
ARR

Ave Pr ofits
ARR = AveInvestm ent x100

= 10000
30000
x 100

= 33.33%

NPV
Year
Cash flow I Discount factor 10% PV I
0 (60 000) 1 (60 000)
1 5 000 0.9091 4 546
2 30 000 0.8264 24 792
3 55 000 0.7513 41 321
NPV
10 659

43
IRR

Year
Cash flow Disc fact PV Disc fact PV
17% 18%
0 (60 000) 1 (60 000) 1 (60 000)
1 5 000 0.8547 4 273 0.8475 4 237
2 30 000 0.7305 21 915 0.7182 21 546
3 55 000 0.6244 34 342 0.6086 33 473
NPV 530 (744)

17 530
 (Where do I get 1274 from? The diff between PV @ 17% and 18%.)
1 1274

IRR = 17.42%

44
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%.

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
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
46
to motivate the decision you have made. (15)
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
Payback Period:

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

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

58
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)))

59
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

60
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 200 200
authorized and issued
Common stock – R2.50 par, 100,000 shares authorized, 191 190
shares issued and outstanding in 2006: 76,262; in 2005:
76,244
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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a) Acid-test ratio = Current . Assets  Inventory = R1,223,000  R 289,000
= 1.51
Current .Liabilitie s 620,000

Accounts.receivable = R503,000
b) Average collection period = ave.sales. per.day 8,539 = 58.9 days

Sales R3,074,000
c) Fixed asset turnover = Fixed .assets = = 1.29
2,374,000

Total .liabilities R1,643,000

d) Debt ratio = = = 45.7%
Total .assets 3,597,000

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e) Operating profit margin = Operating. profit =
R 418,000
= 13.6%
Sales 3,074,000

f) Net profit margin = Net. profits.after.taxes =

R 231,000
= 7.5%
Sales 3,074,000

g) Return on equity = Net. profits.after.taxes = R 231,000 = 6.4%

Total .assets 3,597,000

Market. price. per.share.of .common.stock R32.25

h) P/E ratio = = = 11.1
Earnings. per.share R 2.90

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Good luck with your studies

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