Finance and Taxation - Essay Example

Running header: Finance and Taxation Student’s name: Instructor’s name Subject code: Date of submission: 1. The difference between the classical system of taxation and the imputation system of taxation and the implication of tax imputation on investors The classical tax system is a taxation system which requires both the company and its owners to pay corporation tax as two different entities. This means that the company’s taxed income is paid out to shareholders and they are taxed again on the dividends in turn. The system is common in countries such as the USA and the Netherlands. On the other hand, the tax imputation system is common in such countries as Australia and unlike the classical system; the tax imputation system eliminates the double taxation of income from the corporation to its shareholders. This means that when the corporation has paid tax on its income, the shareholder will not be taxed gain on the dividend he/she receives from the corporation. The imputation uses tax credits known as franking credits or imputed tax credits in which it informs authorities that it has already been taxed on the income that has been distributed as dividends to the shareholders. As such, the shareholder is not required to pay tax on the dividends income. As stated above, the classical system of taxation taxes distributed corporate earnings twice both at the corporate level and at the individual level. This implies that the corporation and its owners are regarded as separate tax entities and hence their income is double taxed first the company then the owners on their dividends and realized capital gains. The classical system therefore discriminates against incorporation of business ideas hence restraining the supply of equity finance necessary for their economic utilization, reallocation of resources from the corporate to the unincorporated sector which results in in efficiency loss to the entire economy. In eliminating the distortions that resulted from the classical taxation system, an imputation system was developed. The imputation system serves to refund corporate taxes using the franking credits associated with dividend payments. Impact of the tax imputation system to investors Those who invest in shares in an imputation tax regime can benefit from the knowledge of the system as well as how the credit system works. This is because with the imputation system, the investor doesn’t have to be taxed twice and hence the investor gets greater return than he would in a classical tax system. The following example demonstrates how the investor benefits from a tax imputation system; With the imputation system, investors receiving dividend are only taxed the difference between 30% and the marginal tax rate in Australia since the company has already paid corporation tax at 30%. For instance, supposing an investor has 625 shares in company Y worth $1.6 per share and hence the total investment is $1,000. If the company makes a 30 cents earnings per share and pays a 30% corporate tax, the company will have 21 cents to either retain or distribute as dividends. The company decides to pay 12 cents as dividends and retain the rest. The dividend carries with it 30% imputation credit that one does not physically receive but has to be declared in the tax return as income and claimed back as tax rebate. The following is an explanation of how tax imputation system works; Share price = $1.6 # of shares = 625 investment worth = 625*1.6 = $1,000 Dividend per share =$ 1.20 Dividend income = 625*12 cents =$75 Franking credit $750*30/70 = $32.143 Taxable income 75+32.14 = $107.143 Dividend yield $75/$1,000 =7.5% The effect of the imputation tax system is analyzed using three investors as follows; Investor A B C Tax rate 0% 30% 45% Dividend $75 $75 $75 Imputation credit $32.143 32.143 32.143 Tax payable ($32.143) $0.00 $176.79 After tax income $107.143 $75 $57.321 After tax equivalent yield 10.71% 7.5% $5.73% As can be seen above, imputation tax system results in improved dividend payout since it doesn’t have to be taxed twice. Hence, such a system would lead to improved investment since it would result in higher amounts of returns. In the above example, investor B would receive $ 75 less 30% tax while in the above case; the investor receives the full amount of $75. 2. Strengths and weaknesses of financial ratio analysis When used effectively, financial ratio analysis reveals most of the company’s information. However, one needs to be aware of its strengths and weaknesses use that they can apply it in the right manner. Strengths Financial ratio analysis is helpful when used in comparing company’s performance against previous years, industry averages and other companies. Such a comparison is important in helping analysts and owners identify its weaknesses, strengths and also evaluate its financial position while foreseeing the risks that the company may be exposed to in future. By using the ratios, analysts are able to implement plans aimed at improving profitability, gearing problems, liquidity as well as the business’ market value. Though ratio analysis reports on past performance, it is useful for predictive purposes in catching potential problems. For instance, it is possible to predict whether the company has enough liquidity for paying its future debts and predicting whether shareholders are happy with its performance. Weaknesses It is not possible to compare all financial ratios and hence there are several points that ought to be taken into account in carrying out the analysis. For company operating different divisions in different industries, it is difficult to find a meaningful set of industry with which to compare the company. Inflation may badly distort the company’s balance sheet hence the need to apply judgment in carrying out the analysis for different periods. Seasonal factors are also able to affect the analysis hence leading to misinterpretation. On the other hand, application of different accounting policies can distort comparison even of the same company. It is also difficult to generalize whether the ratio is good or not especially since a company may have some good and some bad ratios and hence it may be difficult to tell whether the company is good or weak. Meaning of DuPont identity DuPont identity is an explanation which breaks down return on equity (ROE) into three parts including profit margin, financial leverage and total assets turnover. It shows that ROE is affected by three factors including operating efficiency measured by profit margin, asset efficiency measured by total asset turnover and financial leverage measured by the equity multiplier. How DuPont analysis works: As stated above, DuPont breaks ROE down further into; ROE= (Net income/Revenues)* (Revenues/Total Assets)* (Total Assets/Shareholders equity) For instance; the following are portions of company Y’s balance sheet and income statement for this year. Balance Sheet Total assets $2,500 Owner’s equity $500 Income statement Revenue $1,000 Net Income $200 Using the DuPont formula, ROE =(200/100)*(1,000/2,500)*(2,500*500) =0.2*0.4*5 =0.4 OR 40% Implication of DuPont identity: The identity helps one understand what drives the company’s return on equity. In addition to profitability, DuPont identity helps in understanding how efficiently the firm’s assets generate revenue or cash and how efficiently the company uses debt in producing incremental returns. This allows one to efficiently determine where the company is strong or weak and quickly discern what areas to look at. DuPont identity uses both income statement measures and balance sheet measures implying that major asset purchases or significant changes in balance sheet could distort DuPont. 3 Financial ratios analysis a) Quick Ratio = (Current assets-inventories)/Current liabilities = $(3,765,864-1,486,200)/2,594,496 =0.88 b) Current ratio = Current assets /Current liabilities = $3,765,864/2,594,496 =1.45 c) Cash ratio = Cash and cash equivalents/Current liabilities =$438,048/2,594,496 =0.169 d) Total Asset Turnover Ratio = Sales revenue/total assets =24,092,400/18,544,680 =1.299 e) Inventory turnover ratio= sales/Inventory =$24,092,400/1,486,200 =16.21 f) Receivables turnover ratio = Net credit sales/Average accounts receivable =$24,092,400/1,841,616 =13.082 g) Total debt ratio= total debt/total assets = (18,544,680-11,360,184)/18,544,680 =0.387 h) Debt –equity ratio = Total Liabilities/ Shareholders Equity =$7,184,496/$11,360,184 =0.63 i) Equity multiplier= Total assets /Stock holders’ equity =18,544,680/11,360,184 =1.6324 j) Times interest earned ratio= Income before interest and taxes/Interest expense =$2,445,600/434,400 =5.63 k) Cash coverage ratio= Operating cash flows/Total debt =$438,048/7,184,496 =0.061 l) Profit margin=net profit/Sales =$1,206,720/24,092,400 =5% m) Return on assets= Net income/Total assets =$1,206,720/18,544,680 =6.5% n) Return on equity= Net income/Shareholders’ equity =$1,206,720/11,360,184 =10.62% 3b) Comparison of ratios with industry average Ratio Industry Lower quartile Industry median Industry upper quartile Company Current ratio 0.5 1.43 1.89 1.45 Quick ratio 0.21 0.38 0.62 0.88 Cash ratio 0.08 0.21 0.39 0.169 Total assets turnover 0.68 0.85 1.38 1.299 Inventory turnover 4.89 6.15 10.89 16.21 Receivables turnover 6.27 9.82 14.11 13.08 Total debt ratio 0.44 0.52 0.61 0.39 Debt –Equity ratio 0.79 1.08 1.56 0.63 Equity multiplier 1.79 2.08 2.56 1.6 Times interest earned 5.18 8.06 9.83 5.63 Cash coverage ratio 5.84 8.43 10.27 16.41 Profit margin 4.05% 6.98% 9.87% 5% Return on assets 6.05% 10.53% 13.21% 6.5% Return on equity 9.93% 16.54% 26.15% 10.62% a) Current ratio – the company’s current ratio may be viewed as positive relative to the industry. This is because the current ratio is 1.45 which is above the industry median of 1.45. This implies that the company is more liquid than the rest of the industry and is under no liquidity risks. b) Quick ratio – the company’s quick ratio may be viewed as positive relative to the industry. This is because the company’s quick ratio of 0.88 is well above the industry’s upper quartile of 0.62. this implies that the company is more liquid than the rest of the industry and is under no liquidity risks c) Cash ratio- the company’s cash ratio may be viewed as negative relative to the industry owing to the fact that it is below the industry median of 0.21 since it is 0.169. This means that the company may experience cash problems faster than the rest of the industry. d) Total assets turnover –the company’s total assets turnover may be viewed as positive relative to the industry since it is well above the industry median of 0.85. In fact, the 1.299 is very close to the industry’s upper quartile. e) Inventory turnover – the company’s inventory turnover may be viewed as positive relative to the industry owing to the fact that it is 16.21 being well above the industry’s upper quartile average of 10.89. f) Receivables turnover – the company’s receivable turnover may be viewed as positive relative to the industry since it is 13.08. this is above the industry median of 9.82 and close to the upper quartile of14.11 g) Total debt ratio – the company’s total debt ratio could be viewed as positive since it is well below the company’s lower quartile of 0.44 with it being 0.39. h) Debt to equity ratio –the company’s debt to equity ratio is 0.63 which is well below the company’s lower quartile average of 0.79 implying that the company does very well in managing its debts. i) Equity multiplier- the company’s equity multiplier of 1.6 is well below the industry’s lower quartile average of 1.79. This could be considered negative in relation to the average since it implies that most of the company’s assets have been financed using debt than the industry’s norm. j) Cash coverage ratio is 16.41 times which is well above the industry’s upper quartile of 10.27. This may be considered positive in relation to the industry. k) Profit margin – the company’s profit margin is 5%. This is well below the industry’s median and hence may be considered negative in relation to the industry as it implies the company’s inability to generate sufficient profits relative to the industry. l) Return on asset – the company’s returns on assets is 6.5% which is well below the industry’s median of 10.53%. This may be considered negative relative to the industry since it implies that the company is unable to use its assets to generate revenues as efficiently as the industry does. m) Return on equity- the company’s return on equity is 10.62%. This is well below the industry’s median of 16.54% and may be considered negative relative to the industry as it implies that the company does not use its equity as efficiently as the rest of the industry does in generating revenues. References: Johansen, B2012, Fundamental principles of finance, Oxford, Oxford University Press. Read More