Question No 4 on Capital Investment Appraisal
Answer to Question No.4
Answer to Question no 4
Question No 3 on Capital Investment Appraisal
Answer to Question No. 3(above)
Answer to Question No.3 (above)
- Question No.2 On Capital Investment Appraisal
- Answer to Question No.2 (above)
Question No.1 with answer on Capital Investmen Appraisal
Answer on Question No.1 (above)
Below article describes the meaning of operating leverage, some of the ratios to measure operating leverage, its application and users and an illustrated example on how to compute operating leverage.
(a) Meaning of Operating Leverage:
- Refers to the existence of fixed costs in a company’s cost structure
- Is used to measure operating risk
(b) Following ratios being used to measure operating leverage:
- Fixed cost/total cost
- % change in operating income/percentage change in sales volume or
Change in profit/profit
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Change in quantity/quantity
(c) Usefulness ,Applications and other salient points to note:
- Operating leverage are important to managers and financial analysts to understand the degree of operating leverage of a company. A high operating leverage means greater fixed cost committments that have to be met even when sale volume declines [ note that high degrees of operating leverage plus highly elastic product demand will result in high levels of variability in earnings although such a condition may be inherent in the industry like the airline and auto industries.
- Note that the effects of operating leverage diminish as revenue increases above the breakeven point, since the bases to wich increases in earnings are compared become progressively larger. Therefore it is important to examine the relationship between sales and the breakeven point
- A company with a high breakeven point is quite vulnerable to economic declines. A high ratio of variable cost to total cost indicates greater stability, because variable cost can be adjusted more easily than fixed cost to meet a declin product demand.
In interpretating financial statements, whether financial or non-financial managers normally and frequently use the standard traditional business accounting ratio like profitability, liquidity, market based, assets utilization and others.
However, one ratio commonly neglected is the Z-score model which is actually a quantitative model developed in 1968 by an eminent economist, Edward Atlman. So what is this Altman Z-score model and its purpose?
Atlman Z-score model:
Objective:
Is to predict bankruptcy or financial distress of a business using a blend of the traditional financial ratios and a statistical method known as multiple discriminant analysis(MDA)
Applications of this Z-score model in:
- Loan and credit analysis to determine whether bankers should extend a loan. For a vendor, he or she can determine whether his customer-company is good for payment after being supplied with the goods/materials/services. For a customer to review whether an important supplier is in financial distress.
- Merger analysis-identify potential problem(s) of a merger candidate
- Financial management analysis-to help managers to see wheher the need to curtail capital expansion and dividends pay-out
How to Use the Altman Z-Score Model:
(a) First understand its formula:-
Formula:-Z=1.2*X1 +1.4*X2 + 3.3*X3 + 0.6*X4 +0.999*X5
X1=working capital/total assets
X2=retained earnings/total assets
X3=earnings before interest and taxes (EBIT/total assets)
X5=sales/total assets
(b) Next remember its fundamental guidelines:
Z score Probability of failure
1.8 or less Very high
1.81-2.99 Not sure
3.0 or higher Unlikely
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Simple Illustration Using the Altman Z-score model theory to forecast business failure:
Company XYZ has the following financial details:
Total assets=$2,000
Retained earnings=$750
EBIT=$266
Sales=$3,000
Market value of common and preferred stock=$1,425
Book value of debt=$1,100
Proposed solution:
Computation using the Altman Z-score model formula:
Z=X1=400/2000 *1.2=0.240 + X2=750/2000*1.4=0.525 + X3=266/2,000*3.3=0.439+ X4=1,425/1,100*0.6=0.777 + X5=3,000/2000*0.999 =1.499 =3.480
Conclusion:
Since the score is 3.480 Company XYZ falls into the guidelines/classification of “UNLIKELY” zone which means that there is no change that XYZ will go into bankruptcy within the next two years.
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More salient points on Altman Z-score model:
- Many found this model is quite accurate re:#90% accurate in forecasting business failure on year into the future and about #80% accurate in forecasting it two years into the future
- With the present global credit crunch, it enable the user to predict with reasonable accuracy whether a company is in increasing financial distress so that protective actions like curtailing capital expansion, reducing dividend pay-out or refinancing short term to long term banking structure or facility,etc
- Note that this model can be used for a group of companies.
Listed below are all the topics on Balanced Scorecard:
Append below are some examples of the Internal Process Perspective KPI:-
- On-Time Delivery
- Administrative expense/total revenues(%)
- Administrative expense/customer($)
- Average Lead Time(No)
- Contracts filed without error (No)
- Lead time, product development(No)
- Lead time, from order to delivery (No)
Append below are some examples of the Customer Perspective KPI:-
- Employee participation
- Training hours per employee
- Average years of service
- Absenteeism
- Turnover rate
- Employee suggestions
- Employee satisfaction index(No)
- Employee’s view(empowerment index)(No)
- Shareof employees below age X(%)
- Non-product-related expense/customer/year($)
- Ratio of new products(less than X years old) to full company catalogue(%)
- Near misses
- Accidents
- Value added per employee
- Diversity rate
- Work – Life Balance
- Employee productivity
- Cross – training
- Health promotion
- Personal goal achievement
- Leadership development
- Knowledge management
- Ethics violations
- Cross-functional assignments
- Problem solving teams
- Learning rate
- R&D expense($)
- R&D expense/total expenses(%)
- IT Development expense/IT expense(%)
- Hours, R&D(%)
- R&D resources/total resources(%)
- Investment in training/customers(No)
- Investment in research($)
- Investment in new product support and training ($)
- Investment in development of new markets($)
- Direct communications to customers/year(No)
- Patents pending(No)
- Average age of company patents(No)
- Suggested improvements/employee(No)
Append below are some examples of the Customer Perspective KPI:-
- Total assets($)
- Total assets/employee($)
- Revenues/total assets(%)
- Revenues from new products or business operations($)
- Revenues/employee($)
- Profits/total assets(%)
- Profits from new products or business operations($)
- Profits/employees($)
- Return on net assets($)
- Return on total assets(%)
- Return on capital employed(%)
- Return on equity (%)
- Return on Investment(%)
- Cash flow ($)
- Return on investment (%)
- Total costs($)
- Revenue($)
- Gross Margin($)
- Net Income($)
- Profit as % of sales
- Economic Value Added
- Compound Growth Rate
- Dividends
- Market Value
- Share Price
- Earnings per share
- Credit rating
- Debt
- Debt to equity
- Accounts receivable turnover
- Days in Inventory
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