You are on page 1of 14

# 3.

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

## 3.2 METHODS OF DATA COLLECTION:

This project is totally based on the Secondary Data, So all the data of Kaleesuwari Refinery Pvt.
Ltd. have been collected from 1) The annual report of the company.
2) From the Web site of company.
3) From the study Books material.
The data collected from this source have been used and complied with due care as per
requirement of the study.
Period of study:
The present study covers a period of five year from 2010-2014.
Techniques of analysis:
For analyzing the degree of association between DFL, EPS and DPS. The study has been made
by converting the collected data into relative measure such as ratios, percentage rather than
absolute one.
Limitation of study:
1) The study is limited to five year only. Generally twenty years data is ideal to form trend
analysis.
2) This is based on secondary data collected from the annual report of the company. It was not
possible to collect the primary data from the company's office.

52

## 3.3 TOOLS USED FOR RESEARCH

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

## 2. Acid Test Ratio:

A stringent indicator that determines whether a firm has enough short-term assets to cover its
immediate liabilities without selling inventory. The acid-test ratio is far more strenuous than the
working capital ratio, primarily because the working capital ratio allows for the inclusion of
inventory assets.
The Acid Test Ratio formula is:

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

## 3. Fixed Assets Turnover Ratio:

A financial ratio of net sales to fixed assets. The fixed-asset turnover ratio measures a company's
ability to generate net sales from fixed-asset investments - specifically property, plant and
equipment (PP&E) - net of depreciation. A higher fixed-asset turnover ratio shows that the
company has been more effective in using the investment in fixed assets to generate revenues.
The fixed-asset turnover ratio is calculated as:

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

## 5. Net Profit Ratio:

Net profit ratio (NP ratio) is a popular profitability ratio that shows relationship between net
profit after tax and net sales. It is computed by dividing the net profit (after tax) by net sales.

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

## 7. Debt to Equity Ratio:

The debt-equity ratio is another leverage ratio that compares a company's total liabilities to
its total shareholders' equity. This is a measurement of how much suppliers, lenders,
creditors and obligors have committed to the company versus what the shareholders have
committed.

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.

## 8. Debt to Tangible Net Worth Ratio:

A measure of the physical worth of a company, which does not include any value derived
from intangible assets such as copyrights, patents and intellectual property to the total debt
of the company.

## Debt to Tangible Net worth Ratio =

Total liabilities
(Stockholders equityIntangible assets)

58

## 9. Net Worth Ratio:

The net worth ratio states the return that shareholders could receive on their investment in a
company, if all of the profit earned were to be passed through directly to them. Thus, the ratio is
developed from the perspective of the shareholder, not the company, and is used to analyze
investor returns.
The ratio is useful as a measure of how well a company is utilizing the shareholder investment to
create returns for them, and can be used for comparison purposes with competitors in the same
industry.
To calculate the return on net worth, first compile the net profit generated by the company. The
profit figure used should have all financing costs and taxes deducted from it, so that it accurately
reflects the profit available to shareholders. This is the numerator in the formula. Next, add
together the capital contributions made by shareholders, as well as all retained earnings; this is
the denominator in the formula. The final formula is:
Net aftertax profits
Shareholder capital + Retained earnings

59

## 10. Total Capitalization Ratio:

An indicator that measures the total amount of debt in a companys capital structure. The totaldebt-to-capitalization ratio is a gauge of a companys financial leverage, and is calculated as:

## Leverage can be a double-edged sword for a company. While a high total-debt-to-capitalization

ratio can increase shareholders return on equity because of the tax deductibility of interest
payments, a higher proportion of debt reduces a companys financial flexibility and increases the
risk of insolvency. A lower debt-to-capitalization ratio may be preferable for most companies in
order to keep the debt burden within easily manageable levels.
The acceptable level of total debt for a company depends on the industry in which it operates.
While companies in capital-intensive sectors like utilities, pipelines, and telecommunications are
typically highly leveraged, their cash flows have a greater degree of predictability than
companies in other sectors that are exposed to the economys cyclical fluctuations.

## 11. Long Term Asset Vs Long Term Debt:

A measurement representing the percentage of a corporation's assets that are financed with loans
and financial obligations lasting more than one year. The ratio provides a general measure of the
financial position of a company, including its ability to meet financial requirements for
outstanding loans. A year-over-year decrease in this metric would suggest the company is
progressively becoming less dependent on debt to grow their business. The calculation for the
long term debt to total assets ratio is:

60

LongTerm Debt

## 12. Rate of Interest:

This ratio shows the interrelation between the Long term debts in the company and the total
interest paid towards such debt.
It can be calculated by,

Rate of Interest =

Interest
Long Term Debt

## 13. Rate of Return on Investment:

Rate of return on investment calculated to find out the ratio of earnings that are after in the
relation of total capital employed in the firm.
It can be calculated with following formula,

RRI =

## Earnings After Tax

Total Capital Employed

## 14. Operating Leverage:

Operating leverage is a measure of how revenue growth translates into growth in operating
income. It is a measure of leverage, and of how risky, or volatile, a company's operating income
is.

Operating Leverage =

61

Contribution
EBIT

## 15. Degree of Operating Leverage:

A type of leverage ratio summarizing the effect a particular amount of operating leverage has on
a company's earnings before interest and taxes (EBIT). Operating leverage involves using a large
proportion of fixed costs to variable costs in the operations of the firm. The higher the degree of
operating leverage, the more volatile the EBIT figure will be relative to a given change in sales,
all other things remaining the same. The formula is as follows:

## 16. Financial Leverage:

Financial leverage helps to know the responsiveness of E.P.S. to change in the EBIT. It involves
use of funds obtained at fixed cost in the capital structure in such a way that it increase the return
for common shareholders.

Financial Leverage =

EBIT
EBT

## 17. Degree of Financial Leverage:

A ratio that measures the sensitivity of a companys earnings per share (EPS) to
fluctuations in its operating income, as a result of changes in its capital structure. Degree of
Financial Leverage (DFL) measures the percentage change in EPS for a unit change in

62

earnings before interest and taxes (EBIT), and can be mathematically represented as
follows:

63

## 18. Combined Leverage:

When financial leverage is combined with operating leverage the effect of change in revenues or
earning per share is magnified Composite / combined leverage refers to extent to which firm has
fixed operating cost as well as financial cost.
Combined Leverage = Operating Leverage x Financial Leverage

64