Question

Case Study 2: Lakme Cosmetics [7.5 Marks]

The following financial data relate to Lakme, a cosmetic and toiletries company in the Tata Group of Companies for the period ending on 31 March 20X6 and 20X7.

Lakme Financial Data for the year ending on 31 March

(Rs. In lakh)

Particulars	20X6	20X7
Revenue	6561	9773
Operating profit (EBDIT)	625	839
Depreciation	88	115
EBIT	537	724
Interest	216	376
Tax	0	65
PAT	321	283
Share Capital	316	316
Reserve and Surplus	1130	1264
Borrowings	1473	1530
Capital Employed	2919	3110
Gross Fixed Assets	1339	1589
Earnings per Share (EPS)	10.7	8.97
Dividend per share (DPS)	5.00	5.00

Discussion Questions

1. Comment on Lakme’s performance. Show computation to support your answer.
2. How effectively has Lakme used its assets in generating sales?
3. Do you think there is appropriate balance between equity and borrowed funds? Show relevant ratios.
4. Critically evaluate Lakme’s profitability?
5. Does Lakme have sufficient liquidity?

Answer 1

As per answering guidelines, only the first four parts of the question has been answered.

Comment on Lakme's performance:

Particulars	20X6	20X7	Growth (%)
Revenue	6561	9773	49%
EBDIT	625	839	34%
Depreciation	88	115
EBIT	537	724	35%
Interest	216	376	74%
Tax	0	65
Profit after tax	321	283	-12%
EPS	10.7	8.97	-16%

Looking at the comparative performance for years 20X6 and 20X7, following are the comments:

• The company displayed a strong topline growth with revenues shooting up 49% in 20X7 as compared to 20X6
• EBDIT and EBIT margins witnessed a fall as EBDIT growth of 34% and EBIT growth of 35% were lower than revenue growth of 49%
• The company's financing expenses, i.e. saw a massive jump of 74% which severely ate up company's net margins
• The company's Profit after tax fell 12% despite a great revenue growth, primarily due to lower EBIT margins and huge rise in interest cost

Comment: The company had a great year from topline point of view, but couldn't convert its growth into bottomline, resulting in negative EPS growth for the year 20X7

How effectively has Lakme used its assets for generating revenue:

In order to comment on this, we can use fixed assets turnover ratio (as total assets are not available), which signifies the efficiency with which a business uses its fixed assets for generating sales. The formula is as below:

Fixed Asset turnover ratio= Net Sales / (Average fixed assets for the year)

As given in the question, following is available:

Net Sales (20X7)= 9,773

Average fixed assets= [Fixed Assets (20X7) + Fixed Assets (20X6)]/2 = (1589+1339)/2 = 1,464

Therefore, Fixed Assets turnover ratio = 9,773/1,464= 6.7 times

Comment: The company's Fixed asset turnover ratio is a healthy 6.7 times and hence, it seems to be using the fixed assets very well to generate revenue

Balance between Equity and borrowed funds:

To understand if the company has a comfortable balance between debt and equity, we must analyse it's profitability. This is because businesses that generate higher returns on capital can comfortably afford higher debts in their capital structure than the businesses which have lower returns on capital.

Particulars	20X6	20X7
EBIT	537	724
Capital employed	2919	3110
Return on capital (Calculated as EBIT/Capital employed)	18.4%, i.e. (537/2919)	23.3%, i.e. (724/3110)

Calculation of Debt to equity ratio for the company:

Debt to Equity ratio is calculated as total debt to total equity. As per the question, the company has debt of Rs 1,530 lakhs as at 20X7.

Further, total equity shareholder's funds are calculated as sum of Share Capital and Reserves & Surplus

Equity shareholder's funds (20X7)= Share capital + Reserves & Surplus = 316 + 1264 = 1,580

Therefore, debt to equity ratio= 1530/1580 = 97%

Since, the company has a respectable Return on capital of 23.3% for the year 20X7 and a debt to equity ratio of 97% (i.e. debt is almost equal to equity), it can be said that the company has an appropriate balance between debt and equity funds in its capital structure.

Evaluation of company's profitability:-

Particulars	20X6	20X7
EBIT	537	724
Capital employed	2919	3110
Profit after tax	321	283
Return on capital (Calculated as EBIT/Capital employed)	18.4%, i.e. (537/2919)	23.3%, i.e. (724/3110)
Equity Shareholder's funds (Calculated as Share capital + Reserves & Surplus)	1446 (i.e. 316 + 1130)	1580 (i.e. 316 + 1264)
ROE (Calculated as PAT/Equity shareholder funds)	22.2% (i.e. 321/1446)	17.9% (i.e. 283/1580)
Net profit margin (%) [calculated as PAT/Revenue]	4.9%	2.9%

The company's ROE was 22.2% in 20X6 and 17.9% in 20X7, the reduction primarily being because of high interest expenses for the year 20X7.

Similarly, the company's Net profit margin declined from 4.9% to 2.9%, the reduction primarily being because of high interest expenses for the year 20X7.

Therefore, the company's profitability has declined for the year and must be taken care of. The financing expenditure in particular must be reduced to maintain profitability at 20X6 levels.