Question

1. The net profit margin of JCH ltd has declined from 12% to 8% over the last year. Discuss a scenario in which the decline in the ratio might be considered to be a positive trend.

2. The D/E ratio as measured by book value for CAB Ltd is 0.45, however when measured by market values, the D/E ratio is 2.18

a) Can you suggest reasons why such a divergence in ratio values is possible?

b) What message does this circumstance convey about the financial state of CAB Ltd?

Answer 1

1. Net Profit margin is basically Net Profit / Total Sales

So if this ratio is getting declined, it either means that :

- Profit is decreasing at higher pace (1)

- Sales is increasing but not the profit (2)

In my openion, in scenario (2), we might take this as a positive trend because company's revenue is increasing from the past which can be resulted out of increase in capacity or expansion or new product launch etc. In that case Overall Cost will also increase initially at higher rate. But in the long run, company will get the benefit

2,

a, This because of the difference between book value and market value. The book value of an asset is its original purchase cost, adjusted for any subsequent changes, such as for impairment or depreciation. Market value is the price that could be obtained by selling an asset on a competitive, open market.

b. In this case D/E by book value is less than D/E by market value so this implies any of the below mentioned circumstances :

- Market Value of Debt is higher than its Book Value

-Market Value of Equity is lower than its Book Value

In my openion both the above mentioned outcomes are not good for a company. It implies that debt is increase but equity is getting diluted, so financial state of the company is not stable