Professional Documents
Culture Documents
1 RESEARCH DESIGN:
The objectives for which study has been undertaken are:
1) To study the methods of raising finance and financial leverages used by the company.
2) To examine the impact of leverage on EPS.
4) To assess the inter relationship between degree of financial leverage (DFL), earning per share
(EPS) and dividend per share (DPS).
5) To summarize main finding of the study and offer some suggestion, if any, for improving EPS
by the use of financial leverage.
Hypothesis:
In order to realize the above objective following hypotheses have formulated.
1) The company uses debt as a cheaper source of finance than equity.
2) DFL and EPS are positively correlated in such a manner that increases in financial
leverage leads to increase in EPS.
51
52
1. Current Ratio:
A liquidity ratio that measures a company's ability to pay short-term obligations. Also known as
"liquidity ratio", "cash asset ratio" and "cash ratio".
The Current Ratio formula is:
The ratio is mainly used to give an idea of the company's ability to pay back its short-term
liabilities (debt and payables) with its short-term assets (cash, inventory, receivables). The higher
the current ratio, the more capable the company is of paying its obligations. A ratio under 1
suggests that the company would be unable to pay off its obligations if they came due at that
point. While this shows the company is not in good financial health, it does not necessarily mean
that it will go bankrupt - as there are many ways to access financing - but it is definitely not a
good sign.
The current ratio can give a sense of the efficiency of a company's operating cycle or its ability to
turn its product into cash. Companies that have trouble getting paid on their receivables or have
long inventory turnover can run into liquidity problems because they are unable to alleviate their
obligations. Because business operations differ in each industry, it is always more useful to
compare companies within the same industry.
This ratio is similar to the acid-test ratio except that the acid-test ratio does not include inventory
and prepaid as assets that can be liquidated. The components of current ratio (current assets and
current liabilities) can be used to derive working capital (difference between current assets and
current liabilities). Working capital is frequently used to derive the working capital ratio, which
is working capital as a ratio of sales.
53
Companies with ratios of less than 1 cannot pay their current liabilities and should be looked at
with extreme caution. Furthermore, if the acid-test ratio is much lower than the working capital
ratio, it means current assets are highly dependent on inventory. Retail stores are examples of
this type of business.
The term comes from the way gold miners would test whether their findings were real gold
nuggets. Unlike other metals, gold does not corrode in acid; if the nugget didn't dissolve when
submerged in acid, it was said to have passed the acid test. If a company's financial statements
pass the figurative acid test, this indicates its financial integrity.
54
This ratio is often used as a measure in manufacturing industries, where major purchases are
made for PP&E to help increase output. When companies make these large purchases, prudent
investors watch this ratio in following years to see how effective the investment in the fixed
assets was.
4. Gross Profit Ratio:
Gross profit ratio (GP ratio) is a profitability ratio that shows the relationship between gross
profit and total net sales revenue. It is a popular tool to evaluate the operational performance of
the business. The ratio is computed by dividing the gross profit figure by net sales.
55
For the purpose of this ratio, net profit is equal to gross profit minus operating expenses and
income tax. All non-operating revenues and expenses are not taken into account because the
purpose of this ratio is to evaluate the profitability of the business from its primary operations.
Examples of non-operating revenues include interest on investments and income from sale of
fixed assets. Examples of non-operating expenses include interest on loan and loss on sale of
assets.
The relationship between net profit and net sales may also be expressed in percentage form.
6. Debt Ratio:
Debt Ratio is a financial ratio that indicates the percentage of a company's assets that are
provided via debt. It is the ratio of total debt (the sum of current liabilities and long-term
liabilities) and total assets (the sum of current assets, fixed assets, and other assets such as
'goodwill')
Total liabilities divided by total assets or the debt/asset ratio shows the proportion of a company's
assets which are financed through debt. If the ratio is less than 1, most of the company's assets
are financed through equity. If the ratio is greater than 1, most of the company's assets are
financed through debt. Companies with high debt/asset ratios are said to be highly leveraged.
The higher the ratio, the greater risk will be associated with the firm's operation. In addition, high
debt to assets ratio may indicate low borrowing capacity of a firm, which in turn will lower the
56
firm's financial flexibility. Like all financial ratios, a company's debt ratio should be compared
with their industry average or other competing firms.
57
To a large degree, the debt-equity ratio provides another vantage point on a company's
leverage position, in this case, comparing total liabilities to shareholders' equity, as opposed
to total assets in the debt ratio. Similar to the debt ratio, a lower the percentage means that
a
company
is
using
less
leverage
and
has
stronger
equity
position.
Total liabilities
(Stockholders equityIntangible assets)
58
59
60
Rate of Interest =
Interest
Long Term Debt
RRI =
Operating Leverage =
61
Contribution
EBIT
Financial Leverage =
EBIT
EBT
62
earnings before interest and taxes (EBIT), and can be mathematically represented as
follows:
63
64