Essay: Calculation of financial ratios

Q.1.

Part-A Calculation of financial ratios

Liquidity ratios:

Current Ratio = Current Assets

Current Liabilities

Year wise Current ratio of Burberry Plc

Burberry Plc		2007	2008	2009
		£m	£m	£m
Current Assets		423.7	588.4	742.4
Current Liabilities		330.4	436.2	546,8
Current Ratio		1.28:1	1.34:1	1.34:1

Quick Ratio or Acid test ratio = Quick Assets (current assets – stock) / current liabilities

Year wise Current ratio of Burberry Plc

Burberry Plc		2007	2008	2009
		£m	£m	£m
Quick Assets		423.7	588.4	742.4
Current Liabilities		330.4	436.2	546,8
Quick Ratio		1.28:1	1.34:1	1.34:1

Acid Test Ratio For Burberry Plc
2007 £m	Current Assets – Stocks: Current Liabilities 423.7-149.8/ 330.4	273.9: 330.4	0.82: 1
2008 £m	Current Assets – Stocks: Current Liabilities 588.4 – 268.6 / 436.2	301.8 : 436.2	0.69 : 1
2009 £m	Current Assets – Stocks: Current Liabilities 742.4 – 262.4 / 546.8	479.8 : 546.8	0.88: 1

Profitability Ratio:

Gross Profit Margin	=	Gross Profit	* 100
		Turnover

Remember:

Turnover = Sales

Gross Profit = Turnover – Cost of Sales

Gross profit Ratio For Burberry Plc
2007 £m	Gross Profit Margin = 521.3 * 100 850.3	61.3%
2008 £m	Gross Profit Margin = 617.7 * 100 995.4	62%
2009 £m	Gross Profit Margin = 665.8 * 100 1201.5	55.4%

Net Profit Margin	=	Net Profit	* 100	=	Profit before Interest and Taxation	* 100
		Turnover			Turnover

Remember:

Net Profit = Gross Profit – Expenses

Net profit Ratio For Burberry Plc
2007 £m	Net Profit Margin = 156.3 * 100 850.3	61.3%
2008 £m	Net Profit Margin = 195.7 * 100 995.4	62%
2009 £m	Net Profit Margin = -16.1 * 100 1201.5	-1.33%

Ratios				2007 £m		2008 £m		2009 £m
Operating Profit/Net Assets				157/396.9 =39.5%		201.7/495.3=40%		-19.9/543.9=-1.8%
Return on Capital Employed)
Net Profit/Sales				156,3/850.3=18.38%		195.7/995.4=19.66%		-16.1/1201.5=-1.33
Operating profit margin)
Sales/Net Assets				850.3/396.9=2		995.4/495.3=2		1201.5/543.9=2.2
Net asset turnover)
Gross Profit/Sales				512.3/850.3 =60.24%		617.7/995.4=62%		665.8/1201.5=55.4%
Sales/Fixed Assets				850.3/162.7=5		995.4/177.5=5.6		1201.5/258.6=4.4
Expenses/Sales
Sales/Current Assets				850.3/423.7= 2		995.4/588.4=1.7		1201.5/742.4=1.6
Cost of Sales/Sales				329/850.3=38%		337.7/995.4=33.9%		535.7/1201.5=44.58%
Fixed Assets/Current Assets				162.7/423.7=0.38:1		177.5/588.4=0.30:1		258.6/742.4=0.35:1

Return on Asset ratio:

Net profit before Tax

Total Assets

2007£m		156.3/749.7=20%
2008£m		195.7/953.2=20%
2009£m		-16.1/1125.7=-1.4

Rate on Investment return:Net profit before Tax Net Worth

Total Assets

2007£m		156.3/396.9=39.38%
2008£m		195.7495.3=39.5%
2009£m		-16.1/543.9=-2.96

Q. B.

Interpretation of ratios

Comparison	Current	Acid Test
2007	1.28:1	0.82: 1
2008	1.34:1	0.69 : 1
2009	1.34:1	0.88: 1

Acid test ratio is similar to the current ratio as it highlights liquidity of the company. Company may struggle to raise money

Q.2

Q.2.A

Pay back period for project A and project B for Boston Ltd

Payback period and cash flows

The payback method is the simplest way of looking at one or more major project ideas. It tells you how long it will take to earn back the money you’ll spend on the project. The formula is:

Payback Period (years) =Investment Outlay
Cash inflows

Project-A		100,000/30,000=3.3= 3 years and four months
Project- B		200,000/28000=7.1 =seven years and 1.7 month (Aprrox:)

WACC
	$	Cost	$
Shares	50,000	12%	6,000
Debt	50,000	8%	4000
4% risk premium, then this would need to be added on to the WACC.		4%	2000
	100000		42000		0.12

Q. 2. B

Part A BOSTON LTD
						WACC %
Investment A						12
End year		Outflow	Inflow	Taxation	Net Cash	Discount	Present
						Factor	Value
0	(Now)	-100,000			-100,000	1.0000	-100,000
1		– 20,000	50,000		30,000	0.8929	26,787
2		– 20,000	50,000		60,000	0.7972	47,832
3		– 20,000	50,000		90,000	0.7118	64,062
4		– 20,000	50,000		120,000	0.6355	76,260
5		– 20,000	50,000		150,000	0.5674	85,110
6		– 20,000	50,000		180,000	0.5066	91.188
Net present value							291293
						WACC %
Investment B						12
End year		Outflow	Inflow	Taxation	Net Cash	Discount	Present
						Factor	Value
0	(Now)	-200,000			-200,000	1.0000	-200,000
1		-12,000	40,000		28,000	0.8929	2,5000
2		-12,000	40,000		56,000	0.7972	44,643
3		-12,000	40,000	–	74,000	0.7118	52,673
4		-12,000	40,000		112,000	0.6355	71,176
5		-12,000	40,000		140,000	0.5674	79,436
6		-12,000	40,000		168,000	0.5066	85,109
7		– 12,000	40,000		196,000	0.4525	88.690
8		-12,000	40,000		224,000	0.4040	90,496
Net present value 337223

On the basis of the above, Investment A would be more marginally more advantageous to Boston LtdQ.2.cNet present value

: It is the difference between the present value of cash inflow and present value of cash out flow. NPV is used in capital budgeting to analyze profitability of future cash inflows which an investment or project will yield in the future. Formula:

NPV is the sum of all terms,

Internal rate of return:

It is the rate of return used in capital budgeting to measure and compare the profitability of investment made. It is also called discounted cash flow rate of return. IRR is the rate quantity and an indicator of efficiency quality or yield of investment. This is in contrast with net present value. NPV, which is an indicator of value or magnitude of investment.

An investment is considered acceptable if its rate of return is greater that a cost of capital. It is profitable).

Accounting rate of return:

It is a financial ratio used in capital budgeting. It is the simple way of gauging return on an investment in project or purchase.

ARR calculates the return, generated from net income of the proposed capital investment. The ARR is a percentage return. If the ARR is equal to or greater that the required rate of return, the project is acceptable. If the ARR is less than desired rate then project should be rejected. The Accounting Rate of Return is calculated from the formula;

Average annual operating profit x 100
Average Capital employed.

Q.2.C

ARR for project A: 30,000/100,000= 30%

ARR for project B: 28,000/200,000= 14%

Therefore project should be selected for Boston Ltd

Q.3. Zero-based Budgeting

It is a method of budgeting in which all the expenses must be justified for each new period. Zero- based budgeting starts from a Zero and every function in the organization is analyzed for its needs and costs. A budget is made for the need irrespective if that it is higher or lower.

It is used in high level strategic goals Zero budgeting can lower the cost by avoiding blanket increase or decrease to a prior period of budget.

Zero-based budgeting can lower costs by avoiding blanket increases or decreases to a prior period’s budget. However, it is time consuming and may take longer that traditional cost-based budgeting.

Zero based budgeting requires one to justify all planned expenditures for each new business period.

Zero based budgeting is widely used in charitable organization and Government budgets because expenses can easily go out of control.

Unique features:

1. It requires justification and prioritization of all activities before allocating any resources.
2. All business forecasts must start from base by justifying all expenses
3. It requires grouping all relevant activities in decision package.

Advantages:

1. Efficient allocation of resources on based needs
2. Managers find cost effective ways to improve functions.
3. It helps to detect inflated forecast.
4. Useful for service business
5. Increase staff motivation by giving responsibility in decision making
6. Increases communication and co-ordination
7. It helps in identifying opportunities for outsourcing.
8. It identifies and eliminates wastage and obsolete operations.
9. Cost centers identify their mission and relationship to over all goals.

Disadvantages:

1. Very time consuming and difficulty in defining decisions
2. It requires justifications of every detail related to expenditure.
3. Research and development activities are threatened.
4. Managers needs training for zero budgeting
5. Difficulty in reading volume of forms in the large company
6. Honesty of managers must be reliable and uniform

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