Business Finance Assignment #1 Solution

Business Finance ( ACC501
Assignment #1 solution
Spring-2012

Question No.1 (10 Marks)

ABC Company Limited and XYZ Company Limited are involved in the manufacturing of Leather

products. Following are the balance sheets of both the companies for the year 2010.

Balance Sheets

As on 31st December 2010

Particulars ABC Company XYZ Company

Rs. (in millions) Rs. (in millions)

Cash 86 20

Account Receivable 172 27

Inventory 396 45

Total Current Assets 654 92

Net Plant and Equipment 2,735 49

Total Assets 3,389 141

Accounts payable 315 8

Notes payable 232 10

Total Current Liabilities 547 18

Long term debt 532 50

common stock and paid in surplus 510 55

Retained earnings 1800 18

Total owners’ equity 2,310 73

Total Liabilities & Owners’ Equity 3,389 141

Although both the firms are involved in the same kind of business but their balance sheets represent

a huge difference in their financial strength. As a finance student, you are required to analyze these

balance sheets by using the common size analysis technique. Also provide comments on the

liquidity and leverage position of both the companies with the help of your analysis.

Note: Your solution should be in the following form of single comparative statement followed by the

comparative comments regarding the liquidity and leverage position of both companies.

Comparative Common-Size Balance Sheet

As on 31st December 2010

Particulars ABC Company XYZ Company

Cash XX.XX % XX.XX %

Comparison of Liquidity Position

ABC Company XYZ Company

(comments on the liquidity position of

ABC Company)

(comments on the liquidity position of

XYZ Company)

Comparison of Leverage Position

ABC Company XYZ Company

(comments on the Leverage position of

ABC Company)

(comments on the Leverage position of

XYZ Company)

SOLUTION:

Comparative Common-Size Balance Sheet

As on 31st December 2010

ABC Limited XYZ Limited

Cash 2.54% 14.18%

Account Receivable 5.08% 19.15%

Inventory 11.68% 31.91%

Total Current Assets 19.30% 65.25%

Net Plant and Equipment’s 80.70% 34.75%

Total Assets 100% 100%

Accounts payable 9.29% 5.67%

Notes payable 6.85% 7.09%

Total current liabilities 16.14% 12.77%

Long term debt 15.70% 35.46%

common stock and paid in surplus 15.05% 39.01%

Retained earnings 53.11% 12.77%

Total owners’ equity 68.16% 51.77%

Total Liabilities & Owners’ Equity 100% 100%

Comparison of Liquidity Position

ABC Company XYZ Company

By looking at the balance sheet of ABC

Company, we can say that the

company is having more current assets

as compared with current liabilities so

the liquidity position of the company is

satisfactory as it is able to meet its

short term obligations. One important

point to note here is that a major

portion of the current assets of the

company is stuck with inventory

(11.68% out of 19.30%) so the

company would not be able to meet its

short-term obligations on quick basis.

The balance sheet of XYZ Company

shows that this company is also having

more current assets as compared with

current liabilities so the liquidity

position of the company is satisfactory

as it is able to meet its short term

obligations. Contrary to ABC Company,

this company has not put a major

portion of the current assets in

inventory (31.91% out of 65.25%) so

the company would be able to meet its

short-term obligations on quick basis

as well.

Comparison of Leverage Position

ABC Company XYZ Company

The balance sheet of ABC Company

shows that the company is not a highly

leveraged company as a reasonable

majority of its assets has been financed

through equity. From the common size

analysis, we can easily observe that the

capital structure of the company shows

that it’s having a mix of 68.16% equity

and 31.84% debt.

The balance sheet of XYZ Company

shows that this company highly

leveraged as compared with ABC

Company as almost half of its assets

are financed through debt. From the

common size analysis, we can easily

observe that the capital structure of the

company shows that it’s having a mix

of 51.77% equity and 48.23% debt.

Question # 2 (10 Marks)

Fawad Farooq is working as Chief Financial Officer (CFO) in a manufacturing concern. One of his job

responsibilities is to analyze the company’s financial results every year in order to make necessary

improvements. While analyzing the financial results for the current year, he noticed that Return on

Equity (ROE) of the company is lower than that of previous year. He called up Faiq Aslam, the

Finance Manager of the company, to discuss the matter but Faiq remained failed to provide any

reasonable justification in this regard. Fawad was well aware of the fact that the technique of Du-

Pont Analysis is widely used to analyze ROE of the company by looking at its different aspects. He

asked Faiq to provide him with some information and Faiq presented him the following information

related to the current year and previous years:

Particulars Current Year Previous Year

Total Assets Rs.10,253,000 -

Total Equity Rs. 6,582,000 -

Total Debt Rs. 3,671,000 -

Sales Rs. 5,352,000 Rs.5,250,000

Gross Profit Rs. 3,201,000 Rs.3,198,000

Net Profit Rs. 2,000,000 -

Profit Margin - 52%

Total Assets Turnover - 0.50 times

Equity Multiplier - 1.55 times

You are required to explain (with the help of calculations) that how CFO will perform the Du-Pont

Analysis by using the above information. Also, indicate the exact reason of unsatisfactory ROE for the

current year.

Note: You are required to provide complete calculations along with interpretations.

SOLUTION:

To conduct the Du-Pont Analysis, CFO would break down ROE into its components as follows:

ROE = Profit Margin x Total Assets Turnover x Equity Multiplier

ROE = (Net Profit / Sales) x (Sales / Assets) x (Assets / Equity)

By Using the given information,

ROE = (2,000,000 / 5,352,000) x (5,352,000 / 10,253,000) x (10,253,000/6,582,000)

ROE = 37% x 0.52 x 1.56

ROE = 30%

After calculations, the results for all three components are compared to the results of previous year

for the same and it is observed that the only effected area is Profit Margin. Then, the reason for low

profit margin is investigated by looking at the figures of Sales and Gross Profit for both years which are

found almost same. So, the only reason that makes sense is that there is a reasonable fall in net profit.

It can be concluded after conducting the analysis that the company has incurred a reasonably high

amount of operating and financial charges due to which there is fall in Net Profit that is leading to low

profit margin. So, the company should cut down its operating and financial charges in order to improve

its ROE in coming years.

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