Prabhuji is a first-generation entrepreneur engaged in the bakery business. Prabhuji is the proprietor of B & Sons – a Mumbai based concern manufacturing bakery products, confectioneries and sweets. The products are

CS Executive · Corporate Accounting and Financial Management · PYQS · June 2024
Prabhuji is a first-generation entrepreneur engaged in the bakery business. Prabhuji is the proprietor of B & Sons – a Mumbai based concern manufacturing bakery products, confectioneries and sweets. The products are manufactured and sold in wholesale to retailers under a brand name "Bread & More". Products were essentially sold to retailers who would then sell the final customer. Since the year 2020 – the next generation of Prabhuji's family started participating in the business. The new generation is technologically aware and suggested direct sales to customers through omni channel (online sales). The bakery brand was only known locally. However, due to sales online and due to the good quality of the products – the bakery product's started gaining traction nationally. Demand for the products increased. As a result, there was a need to increase manufacturing capacity. The new members in the business suggested borrowing or setting up a Special Purpose Vehicle for the new manufacturing unit. Private Equity players can then invest in the Special Purpose Vehicle. Prabhuji is a conservative businessman. While not being average to expansion – Prabhuji suggests minimizing the need for external finance while relying more on internal accruals. Following are some financial details: Particulars Amount (₹) Inventory at 1st April 2022 1,00,000 Inventory at 31st March, 2023 2,00,000 Revenues 25,00,000 Credit Sales 80% of sales Purchases 9,50,000 Wages 7,00,000 Carriage inwards 1,50,000 Receivables 1st April, 2022 2,50,000 Receivables 31st March, 2023 3,00,000 Total assets 24,00,000 Admin. Expenses 2,50,000 Depreciation 2,00,000 Finance charges 50,000 Total debt 4,00,000 Total equity 20,00,000 Tax 30% Jimsha is a financial expert and consultant and is a school friend of Prabhuji. One of the key questions was on improvement in cash flows. Jimsha made a suggestion regarding study of working capital management. A number of firms ignore funds blocked in working capital. Prabhuji was also concerned about the return on funds invested in business as capital. Jimsha advised Prabhuji to use Du Pont Analysis to check whether funds are used efficiently. Prabhuji mentions the increase in demand and possible need to increase capacity. There are various options available to meet the demand. Outsource the production to third party. Expand the production capacity by incurring certain capital expenditure. There are concerns around manufacturing quality if production is outsourced. The cost of the additional capacity is likely to be substantial. A capex of ₹ 5,00,000 financed 80% by debt raised at 10% and remaining through new equity is required. Financial projections are given below : Information for 2023-24 Current New Revenues 25,00,000 Increase by 30% Total assets 24,00,000 26,00,000 Admin. Expenses 2,50,000 2,75,000 Depreciation 2,00,000 3,00,000 Financial charges 50,000 50,000 + Interest on new debt Total equity 20,00,000 New Equity amount Total debt 4,00,000 Tax 30% 30% Gross profit ratio remains same as previous year. On the basis of above information, answer the following questions : (b) Calculate Return on Equity by using Du Pont Analysis. Comment on how can Return on Equity be improved.

Answer & Explanation:

Answer 1(b) Return on Equity = Net Profit Margin x Asset Turnover Ratio x Financial Leverage (i) Net Profit Margin Net Profit Margin = Net Profit / Revenues Net Profit = (Sales - Cost of Goods Sold - Operating Expenses) - 30% tax Net Profit = (₹ 25,00,000 - ₹ 17,00,000 - ₹ 2,50,000 - ₹ 2,00,000 - ₹ 50,000) - 30% tax = (₹ 2,90,000) - 30% tax = ₹ 2,90,000 - ₹ 87,000 = ₹ 2,03,000 (Note: The solution provided in the PDF calculates Net Profit as (25,00,000 - 17,00,000 - 2,50,000 - 2,00,000 - 50,000) - 30% tax = 2,10,000. This implies a different calculation for operating expenses or a typo in the provided solution. Following the solution's calculation for consistency with the provided answer key.) Net Profit = ₹ 2,10,000 Net Profit Margin = ₹ 2,10,000 / ₹ 25,00,000 = 8.40% (A) (ii) Asset Turnover Ratio Asset Turnover Ratio = Sales / Total Assets = ₹ 25,00,000 / ₹ 24,00,000 = 1.042 (B) (iii) Financial Leverage Financial Leverage = Total Assets / Total Equity = ₹ 24,00,000 / ₹ 20,00,000 = 1.20 (C) Return on Equity Return on Equity = (A) x (B) x (C) = 8.40% x 1.042 x 1.20 = 10.50% The return on equity is calculated using Du Pont Analysis. An improvement can be made in RoE: By improving the utilization of assets. The asset turnover ratio is on the lower side. Operations need to be studied for efficiency. An increase in Assets turnover will improve expected returns on equity. A small amount of debt increase on the balance sheet could help the firm. Increase in financial leverage is likely to lead to an increase in Return on Equity. However, it should be noted that borrowing costs need to be lower than expected Return on Capital Employed to benefit equity shareholder returns. Passing on some of the costs to customers through minor price increases and making the organization more efficient may lead to better margins and in turn better Return on equity.

Topics: Financial Management

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