FINANCIAL, COST & MANAGEMENT
ACCOUNTING
Session 18
Capital Structure (Solvency or
D/E) Ratio, Activity (Turnover)
Ratio, Coverage Ratio & Du
1
THE CAPITAL STRUCTURE
Capital Structure refers to the mix of Equity & Debt in
the Capital Structure of an organization;
Some amount of debt may be desirable in the capital
structure provided cost of debt remains lower than the
Return on Assets;
However, excessive debt in the capital structure leads
to a risk of bankruptcy and investors are averse to such
capital structures.
2
Illustration:
Situation 1 Situation 2
Particulars Amt (INR) Particulars Amt (INR)
ASSETS 1000 ASSETS 1000
Equity 500 Equity 300
Debt 500 Debt 700
LIABILITIES 1000 LIABILITIES 1000
Cost of Debt 10% Cost of Debt 10%
ROA 12% ROA 12%
Particulars Amt (INR) Particulars Amt (INR)
Earnings 120 Earnings 120
Less: Interest 50 Less: Interest 70
For Shareholders 70 For Shareholders 50
ROE 14% ROE 16.67%
3
The Capital Structure is determined by the Debt-Equity (D/E) Ratio
The D/E Ratio = All Long-Term Debts / Shareholders Funds
Shareholders Funds = Common Stock + Preferred Stock + Reserves
The D/E Ratio is also known by the names of Financial Leverage or
Capital Gearing Ratio.
Question: If the holders of convertible bonds exercise their rights to
convert, how will the D/E Ratio be affected?
Question: If a company declares Stock Dividend, how will the D/E
Ratio be affected?
4
UTILIZATION
OF ASSETS
Utilization of Assets are measured by Activity / Turnover Ratio which
measure the briskness of business activities of an organization;
The focus here is on Sales i.e. Net Operating Revenue and the
investments in assets which generate such revenue;
Turnover Ratios are measures of the capability of an organization to
achieve maximum sales by minimum investment in assets.
Assets for this purpose mean Total Fixed Assets and Net Working
Capital;
Traditionally, two important components of Working capital i.e.
Inventory (Materials) and Debtors (Receivables) are also considered to
measure briskness of activities of an organization.
5
The following five Turnover Ratio are usually calculated:
Total Assets Turnover Ratio = Net Operating Revenue / Total
Assets
Fixed Assets Turnover Ratio = Net Operating Revenue / Fixed
Assets
Inventory Turnover Ratio = Net Operating Revenue / Inventory
Working Capital Turnover Ratio = Net Operating Revenue / Net
Working Capital
Debtors Turnover Ratio = Net Operating Revenue / Debtors
6
Certain Financial Parameters of Cognizant,
Infosys & TCS
Particulars for 2013 Cognizant Infosys TCS
EUR Millions USD Million GBP Million
Particulars for 2013 ABC Inc DEF Inc GHI Plc
Net Operating Revenue 8843 36765 48426
Fixed Assets 2061 10988 19503
Working Capital 4374 27244 13832
Total Assets 6435 38232 33335
Receivables 1649 6365 14076
7
Turnover Ratio of ABC Inc, DEF Inc & GHI Plc
Particulars for 2013 Cognizant Infosys TCS
Total Assets Turnover Ratio 1.37 0.96 1.45
Fixed Assets Turnover Ratio 4.29 3.35 2.48
Working Capital Turnover Ratio 2.02 1.35 3.50
Receivables Turnover Ratio 5.36 5.78 3.44
8
DEBT SERVICING CAPACITY
Coverage Ratio measures the ability of the organization to service its debts
for the relevant accounting period. This ratio has two varieties i.e. Debt
Service Coverage Ratio (DSCR) and Interest Service Coverage Ratio (ISCR).
Traditionally DSCR is calculated by the following formula taking the
necessary data from the Statement of Profitability of the relevant
accounting period.
[Post-Tax Net Profit + Depreciation + Amortizations + Write-Offs + Interest
Liabilities] / (Loan Installment Liabilities + Interest Liabilities)
ISCR is calculated by the following formula taking the necessary data
from the Statement of Profitability of the relevant accounting period.
[Post-Tax Net Profit + Depreciation + Amortizations + Write-Offs + Interest
Liabilities] / Interest Liabilities
An alternate estimate of DSCR can be had by using the
formula:
DSCR = Cash from Operating Activities / (Loan
Installment Liabilities + Interest Liabilities) ;
ISCR = Cash from Operating Activities / Interest
Liabilities
DU-PONT ANALYSIS
The History
The oldest of the stocks that currently make up the Dow Jones
Industrial Index, is the E. I. du Pont de Nemours and Company
which is most commonly known as Du Pont;
DuPont was originally a gunpowder mill founded in 1802 by
Eleuthère Irénée du Pont and today is one of the largest chemical
companies in the world;
DuPont was a pioneer with respect to management accounting
systems, including devising the decomposition of accounting ratio
Return on Equity (ROE);
The Rationale:
The shareholders of an organization remain the focal point of
attention in Financial Management;
Shareholders are primarily interested in the returns on their
investment i.e. Equity. Thus Return on Equity (ROE) is of primary
concern to them.
ROE is derived from the Post-Tax Net Profit (Net Income) and Equity.
The assets of the organization i.e. the Fixed Assets and Working
Capital generate Revenue. Net Income is derived by deducting the
expenses from the Revenue.
Thus the objective of Du Pont Analysis is to decompose ROE into
different ratio so that ROE gets linked with Equity, Revenue, Expenses,
Fixed Assets, Working Capital (with its constituents) and Net Income.
The Schematic Diagram for Du-Pont Analysis:
ASSETS
INVESTORS EQUITY (Fixed Assts + REVENUE
Working Capital
Less:
EXPENSES
POST-TAX NET
RETURN ON EQUITY PROFIT
The Structure:
ROE = Post-Tax Net Profit (PAT) / Equity
∑Assets / Equity
PAT / ∑Assets
(Equity Multiplier)
(ROA )
PAT / SALES
SALES / ∑Assets
(Profit Margin ) X
(TAT )
(Revenue – Cash
Operating Costs – SALES / [Fixed Assets +
Non-Cash Costs – (Inventory + Receivables +
Interest – Cash + Other Current Assets –
Taxes) / SALES Current Liabilities)]
3 Component Decomposition of ROE
ROE =
PAT / SALES X SALES / ASSETS X ASSETS / EQUITY
= PROFITABILITY x ACTIVITY x SOLVENCY
5 Component Decomposition of ROE
ROE =
PAT / SALES X SALES / ASSETS X ASSETS / EQUITY
= [EBIT/SALES X EBT/EBIT X PAT/EBT] X SALES/ASSETS X
ASSETS/EQUITY
15
From the following figures extracted from the Annual
Reports of Oracle Financial Services Software, prepare
a Du Pont Analysis.
Particulars USD Million
Revenue 39,335
Less: Cash Operating Costs 22,548
Less: Depreciation & Amortization 655
Less: Tax Expenses 5,381
Post-Tax Net Profit 10,751
Equity 74,064
Fixed Assets 10,078
Receivables 7,280
Cash in hand and at Bank 54,710
Other Current Assets 5,260
Current Liabilities 9,186
ROE = PAT / EQUITY = 10,751 / 74,064 = 0.1451 = 14.52
X =
PAT / ∑ ASSETS ∑ ASSETS / EQUITY 15.78% x 92.% = 14.52%
X =
PAT* / SALES SALES / ∑ ASSETS** 27.33% x 57.73% = 15.78%
PAT* = REVENUE (39,335) – CASH ∑ ASSETS** = FIXED ASSETS (10,078) + WORKING CAPITAL#
(58,064)
OPERATING COSTS (22,548) –
NON-CASH COSTS (655) –TAXES Working Capital # = Receivables (7,280) + Cash (54,710) +
(5,381) Other Current Assets (5,260) – Current Liabilities (9,186)
