Classical and Imputation Taxation System - Assignment Example

Running header: Taxation Student’s name: Instructor’s name Subject code: Date of submission 1. How does the classical taxation system differ from the imputation taxation system and what is the implication of imputation taxation system to the investor In the classical system of taxation, both the company and the investor are treated as two separate legal entities and are hence required to pay corporation tax. The implication of this is that when the company makes profits, it is taxed on this profit (Brian, 2011). When the company pays dividend on profit after tax, the investors are again taxed on the dividend they have received from the company though they had already been taxed as corporate profits. Classical taxation systems are still applicable in such countries as the USA (William, 2004). Imputation taxation system on the other hand is the opposite of classical taxation system. In the imputation system, double taxation of income is removed in that once the company pays corporation tax on the profits; the investors who receive dividends from the taxed earnings are not taxed again on the dividends. This is achieved through use of tax credits in the imputation system that are used in informing the authorities that the dividend was already taxed when the company paid corporation tax. This means that the investor is not again required to pay tax on the dividend income he/she receives from the company. It has been established that the classical system double taxes the dividends given to the investors first as corporate income and then as dividend income. This is due to the fact that the classical system views the investor and the corporation as two separate legal entities with obligations to pay tax on income (Howard, 2006). As such, the classical system can be said to discriminate against the idea of business incorporation. This leads to restraining of the supply of equity finance as investors may fail to invest owing to the double taxation. This prevents the economization of the funds as well as their reallocation of the funds from the incorporated sector of the economy to the unincorporated one resulting in loss of allocation efficiency to the economy as a whole. It is with these shortcomings of the classical tax system that countries such as Australia developed the imputation taxation system (Beth, 2007). The purpose of the tax imputation system is that of refunding corporate taxes through the use of franking credits that result from payment of dividends. What is the implication of the tax imputation system to investors? The tax imputation system is highly beneficial to the investors as opposed to the former classical system of taxation and hence it is important that they acquaint themselves with its workings. As stated above, the tax imputation system eliminates the double taxation aspect common in the earlier classical taxation system (Jones, 2004). It should be noted that with the imputation system, the investor will only be taxed for the difference between the corporate tax rate and the marginal tax rate for Australia owing to the fact that the company had already paid tax on the income that was distributed as income. This can be demonstrated in the example below; James has invested 1250 shares in the Delight Company with each share costing $2. This implies his total investment is $ 2,500. Suppose that the company made a 0.6 cents per share earnings and this attracted a 30% corporation tax, the company has at its disposal 42 cents which it will either retain or distribute as dividends to its shareholders (Howard, 2006). Suppose the company pays an 18 cents dividend while the rest is kept as retained earnings. The tax imputation system will work as follows; Share price = $2 and the number of shares owned is 1250 implying that the investment is worth $2500. The dividend declared per share is 18 cents implying a dividend income of $450 The franking credit associated with the dividend is calculated as $450*30/70 =$192.85 The taxable income in the old classical system of taxation will thus be $450+ 192.85 = $642.85 The dividend yield is given by $450/$2500 = 18% Assuming two scenarios where; a) Tax rate is 0% b) Tax rate is 30% the imputation tax system will have the following effect to the above investors; ; Investor 0% 30% Tax rate 0% 30% Dividend $450 $450 Imputation credit $192.85 $192.85 Tax payable ($192.85) $0.00 After tax income $642.85 $450 After tax equivalent yield 25.7% 18% It has been revealed that imputation taxation system will result in higher dividend payouts owing to the fact that dividend is not taxed twice and hence using the imputation taxation system, the investor receives higher returns (Kenneth, 2009). In a classical taxation system, the investor applying 30% tax rate would receive $ 315 due to taxation as opposed to $ 450 he would receive under the imputation system. 2. The strengths and weaknesses of financial ratio analysis Financial ratio analysis uses financial ratios in assessing the relative strength of an organization using simple calculation based on the items of financial statements including cash flow statement, income statement and the balance sheet. These ratios depict the organizations strength or weakness in terms of operational efficiency, financial stability, liquidity and profitability. As such, the ratios are important to both the investors and other organizational stakeholders. Ratio analysis has the following benefits; a) Acting as a tool for comparison Financial ratio is a standard method through which we are able to compare companies and industries. Using the ratios, companies in the same industry are put on a relatively equal playing field and hence the analysts are able to judge them based on their performance as opposed to their sales volume, size or market share. A comparison of raw data of different companies in the same industry would only give limited insight. On the other hand, ratios go further to reveal how good the company is in terms of profitability, finance, making returns on investments among other factors. For example, though a big company may make 50 times the amount of sales made by a smaller company in the same industry, the smaller company might be found to perform better when their return on assets and net profit margins are compared. This is despite the fact that when using raw figures, the bigger company is seen to perform better in terms of sales revenue. b) Industry analysis Using ratios, one is able to unearthing trends in particular industries and hence creates benchmarks against which actors in the industry can be compared. As such, individual small organizations can utilize the industry benchmarks in crafting organizational strategy and also gauge their own performance against that of the industry. For example, a company that achieves a current ratio of 0.2 can be triggered to take remedial measures if the industry average is 1.2. c) Locating weaknesses Using financial ratios, we are able to locate weakness in a company’s operations though the company’s overall performance is good. This would enable its management pay attention to the weakness hence initiating remedial measures. In the same vein, we can financial ratio analysis to judge the company’s efficiency in its operations and management (David, 2014). How has the company been able to utilize its assets to earn profits? d) Formulation of organizational plans Accounting ratios help the organization analyze its past financial performance and could also be useful in establishing future trends of its financial performance. This can be used as a basis of formulating future plans for the company. e) Stock valuation Financial ratio analysis knowledge helps analysts and investors in evaluating and communicating the company’s strengths and weaknesses in what is known as fundamental analysis. Such an analysis is helpful in revealing whether the company has fundamental strength necessary for increased stock value over time. This would help the investor determine whether investing in the company is potentially profitable or whether it would not be wise to invest in the company. Weaknesses of financial ratio analysis As indicated above, financial ratios are an effective tool for measuring financial performance as well as managerial effectiveness. However, we ought not to use them blindly owing to their shortcomings. These shortcomings include; i) Ratios only indicate the areas of strength or weakness for the company without revealing why something is wrong and what should be done to correct it. In essence, they only serve to pinpoint where the problem is. For instance, the ratios may tell us that the inventory ratio has declined from 10 to 7 despite the industry average being 8. However, they fail to tell us the cause of this and management has to do further investigation in a bid to reveal the cause and hence correct it. ii) Sometimes, comparison of a company to another or with industry averages may not be possible. It is true that there are accepted principles and standards for financial statements preparation. However, several different numbers may be used in the ratios calculations while different companies may employ different policies. For instance, company A in the same industry with B can use cost of sales as the numerator when calculating inventory turnover while B may use sales revenue hence making comparison difficult. iii) Different operating methodologies could be employed in running different businesses hence making comparison of financial ratios impractical. For instance, company A above may have leased most of its assets while B may have purchased them. This may make such ratios as debt to total assets, total assets turnover and return on total assets be unrelated for the two companies and hence not comparable. iv) Inflation may make a particular ratio seem bad or favorable over time when examining trends (Libby, 2013). For instance, deterioration of inventories turnover may not have resulted from increased inventory but from increase in cost of sales. v) Financial statements on which financial ratios are based reflect a company’s financial situation at a certain point in time usually at period end. This might lead to a weak ratio which might not have been the case were the ratio to be calculated say at the middle or beginning of the period. This is especially so for balance sheet items which reflect the situation as at a certain date out of 365 days. What is DuPont identity? This is a performance measurement method started by the DuPont corporation that measures assets in their gross book value as opposed to gross book value in a bid to arrive at a higher return on equity (ROE). Using the identity, it revealed that ROE has three predictors including ; i) Operating efficiency measured by profit margin ii) Asset use efficiency measured by total assets turnover iii) Financial leverage measured by the equity multiplier (Donald, 2012) Using DuPont identity, Return on equity is given by; ROE =Profit margin*total asset turnover*Equity multiplier Profit margin = Profit/sales Total assets turnover = Sales/Assets Equity multiplier = Asset/Equity How does DuPont analysis measure performance? It has been revealed that DuPont measures performance using the following formula; ROE =Profit margin*total asset turnover*Equity multiplier Take an example of a company with the following items in tis financial statements; Total assets $30000 Owner’s equity $6000 Total revenue $12,000 Net income $3,000 We can use the DuPont identity to arrive at the company’s return on equity (ROE) as follows; ROE =Profit margin*total asset turnover*Equity multiplier ROE = (3,000/12,000)* (12,000/30,000)* (30,000/6000) ROE =0.25*0.4*5 ROE = 0.5 OR 50% Usefulness of the DuPont analysis in analyzing performance In judging whether a company generates good returns and hence gauging its suitability for investment, many investors look at its return on equity. However, the ROE calculated using DuPont analysis is a better measure of performance since it gives a better understanding of return on equity. DuPont analysis breaks down ROE into net profit margin implying how well the company is performing in terms of profitability. Assets turnover implying the efficiency of the company in using its assets in revenue generation and equity multiplier measuring how much the company has been leveraged (Peakeffectiveness.com, 2014). Thus, if a company’s ROE rises as a result of increased net profit margin or assets turnover, it is an indication of good performance by the company. However, an increasing ROE as a result of equity multiplier is not a sign of good health for the company since it indicates that the company has been over leveraged and hence the increase in ROE. Even when the company’s ROE remains unchanged, DuPont analysis is still important. For instance, a company can have decreased margins and asset turnover which would imply that ROE has remained constant owing to increased leverage and hence the need for a remedial action. QUESTION 3 (a) 1.Current Ratio = current assets / current liabilities = 3,765,864 / 2,594,496 = 1.45 times 2.Quick Ratio = (current assets - inventory) / current liabilities = (3,765,864 - 1,486,200) / 2,594,496 = 0.88 times 3.Cash Ratio = cash / current liabilities = 438,048 / 2,594,496 = 0.17 times 4.Total Assets Turnover = sales / total assets = 24,092,400 / 18,544,680 = 1.30 times 5.Inventory Turnover = cost of goods sold / inventory = 17,982,000 / 1,486,200 = 12.10 times 6.Receivables Turnover = sales / accounts receivable = 24,092,400 / 1,841,616 = 13.08 times 7.Total Debt Ratio = (total assets - total equity) / total assets = (18,544,680 - 11,360,184) / 18,544,680 =0.39 times 8.Debt-equity Ratio = total debt / total equity = (total assets - total equity) / total equity = (18,544,680 - 11,360,184) / 11,360,184 = 0.63 times 9.Equity Multiplier = total assets / total equity = 18,544,680 / 11,360,184 = 1.63 times 10.Times Interest Earned = EBIT / interest = 2,445,600 / 434,400 = 5.63 times 11.Cash Coverage Ratio = (EBIT + depreciation) / interest = (2,445,600 + 786,000) / 434,400 = 7.44 times 12.Profit Margin = net income / sales = 1,206,720 / 24,092,400 = 5% 13.Return on Assets = net income / total assets = 1,206,720 / 18,544,680 = 7% 14.Return on Equity = net income / total equity = 1,206,720 / 11,360,184 = 11% Question 3b a) Current ratio –The Company’s current ratio is positive relative to that of the company since it is 1.45 which is above the company median of 1.43. b) Quick ratio – The Company’s quick ratio is positive relative to that of the industry since it is 0.88 while the upper quartile of the company is 0.62. c) Cash ratio- The Company’s cash ratio is negative relative to the industry since it is 0.17 compared to the industry median of 0.17. d) Total assets turnover –The Company’s total assets turnover is positive relative to the industry since it is 1.30 while the company median is 0.85. e) Inventory turnover – the company’s inventory turnover is positive relative to the industry since it is 12.10 and is above the industry’s upper quartile of 10.89. f) Receivables turnover – the company’s receivable turnover is positive relative to the industry as it is 13.08 while the industry median is 9.82. g) Total debt ratio – the company’s total debt ratio is positive relative to the industry since it is 0.39 below the company’s lower quartile. h) Debt to equity ratio –the company’s debt to equity ratio of 0.63 is positive relative to the industry since the industry’s lower quartile is 0.79. i) Equity multiplier- the company’s equity multiplier is negative relative to the industry since it is 1.63 which is below the industry’s average of 1.79. j) Times interest coverage ratio – it is 5.63 times and is relative to the industry. j) Cash coverage ratio- it is 7.44 times and is positive relative to the industry k) Profit margin – the company’s profit margin is 5% and is positive relative to the industry. l) Return on asset – the company’s returns on assets is negative since it is 7% which is below the industry’s median of 10.53%. m) Return on equity- the company’s return on equity is 11% and is positive relative to the industry since the industry’s median is 16.54%. References: Brian. C2011, Taxation for individuals and business entities, New York, McGraw-Hill Kenneth, A, 2009, Federal tax, Sydney, Prentice Hall William, R2004, Advanced business entity taxation, Cengage Learning, South-Western. Beth, W2007, Accounting and tax principles for the legal professional, Delmar Learning, Dunham. Jones, S2004, Advanced strategies in taxation, Richard D, Irwin.inc. Kahn, A2009, Corporate income taxation, London, Rutledge. Howard, E2006, Federal taxation (Concepts & Insights), Foundation Press, New York. Weygand, J2013, Intermediate accounting, London, Rutledge. Libby, R2013, Financial Accounting, Oxford, Oxford University Press. Donald, E2012, Financial accounting: Tools for business decision making, London, Prentice Hall. David, I2014, The advantages of Financial ratios analysis, Retrieved on 1st September, 2014, from; http://smallbusiness.chron.com/advantages-financial-ratios-3973.html Peakeffectiveness.com, 2014, The DuPont financial analysis system and why it is important, Retrieved on 1st September 2014, from; http://peakeffectiveness.com/Resources/dupontanalysis.htm Read More