(This paper discusses
the topics of Profitability Ratio, Companies routes
to raising money for the
business, and relationship between present and
future values).
4. What are the distortions caused by differing
accounting procedures in the profitability ratio
(e.g., using EBIT versus net operating income)?
A company’s profitability ratio is determined
by stating its net profits as a percentage of
net sales. While some companies choose to use
EBIT (Earnings Before Interest and Taxes) as a
representative figure for the numerator value
i.e. net profits, others use the Net Operating
Income as the figure representing net profits.
A typical income statement would consist of the
following items:
Sales
Less: Cost of Goods Sold
Gross Profit
Less: Operating Expenses & Depreciation
Net Operating Income (A)
Add: Other Incomes
Earnings Before Interest & Taxes (B)
Less: Interest Expense
Net Profit Before Taxes
Less: Tax Expense
Net Profit After Tax
From the example, using the Net Operating Income
figure would lead to a lower Profitability Ratio
because this NOI figure comes before the EBIT
figure. Also we are adding other incomes to Net
Operating Income to arrive at EBIT. A distortion
is also created because the other incomes being
added may have no relevance to the actual business
operations, and are therefore not representative
of the business e.g. Rental Income of Property,
when the company is in the textile business.
Analysts may make incorrect assumptions of business
profitability if they look at the profitability
ratio without inquiring into the composition of
the income statement.
5. How do corporations resolve external funds
requirements?
Corporations resolve external funds requirements
either by issuing shares or issuing debentures.
By issuing stock, corporations invite a participation
in the ownership of the firm. Should the company
make a sufficient profit, it will distribute part
of the profits to the shareholders in the form
of Dividend.
By choosing to issue debentures, a company takes
on additional debt in its balance sheet. The debenture
holders are the creditors of the firm, and have
the right to receive interest. Interest is a fixed
expense and the company must pay it regularly
as and when due. Also interest is payable whether
or not a company earns a profit.
This being the situation, companies generally
prefer equity (issuing shares) to debt (issuing
debentures).
6. What is the relationship between present and
future values?
Present Value bears an inverse relationship to
Future Value. Finding the Present Value of a future
sum or amount involves finding the value of that
sum in today’s terms. We use the term Discounting
to describe this process. Conversely, finding
the future value of a sum of money means finding
the value of the money at a certain point in the
future. We use the term Compounding to describe
this process. Discounting means working backwards
from the future to the present time. Compounding
means working forwards from the present time to
the future.
Thus if the rate of interest is 5% per annum
and the time period two years, the future value
of $ 1000 would be 1000(1.05)2 i.e. $ 1102.50.
Conversely we can say that the present value of
$ 1102.50 two years from now at 5% per annum,
is $1000 today.
7. What are the decision rules?
Question could not be answered because they was
no relevant topic against which it could be discussed.
|