Income Statement and Balance Sheet Components
The income statement and balance sheet are the primary components of the financial statements. The income statement is prepared to show profit or loss of the business for a specified period of time. The major components of an income statement are operating revenues, other income, cost of revenues, gross profit, operating expenses, and profit or loss. The balance sheet is prepared to show the balances of assets, liabilities, and equity of the business. The balance sheet shows the financial position of the business (Tracy, 2011). The major components of balance sheet are current assets (cash, trade payables, prepaid expense etc.), non-current assets (Land and building, plant, machinery etc.), current liabilities (accounts payable, accrued expenses etc.), and non-current liabilities (notes payable, bank loan etc.), and equity (share capital, retained earnings etc.).
The dividend is paid by the firm to the providers of equity capital while the interest is paid to the providers of debt capital. Whether its dividend or interest, both are cost of capital to the firm but there is technical difference. The dividends paid by the firm are not tax deductible because dividend is not considered as expense of the firm. However, the interest paid is tax deductible and it is considered as the expense incurred by the firm. Thus, payment of interest provides advantage of leverage to the firm in the form of tax savings. Further, the firm is under no compulsion to pay dividends but interest is obligatory. The firm usually declares dividends only when it earns profits but the interest is required to be paid even if the firm is incurring losses (Jonathan, 2010).
The working capital of the firm is core capital that enables the firm to operate smoothly and conduct its day to day business hassle free. The working capital of a firm is computed with reference to its current assets and liabilities. The net working capital of a firm is the excess of current assets over the current liabilities. Higher the net working capital better will be the liquidity position of the firm. Liquidity is assessed with reference to the firm’s ability to pay the short term dues on time. The sufficiency of net working capital suggests that the firm’s liquidity position is better (Michalski, 2014).
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A. |
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Particulars |
Amount |
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Revenue |
$ 4,500,000.00 |
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less: COGS |
$ 3,375,000.00 |
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Gross Profit |
$ 1,125,000.00 |
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less: depreciation |
$ 150,000.00 |
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less: other operating expenses |
$ 300,000.00 |
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Operating Profit |
$ 675,000.00 |
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less: tax @30% |
$ 202,500.00 |
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Net Profit |
$ 472,500.00 |
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B. |
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The net profit of the firm is $ 472,500.00 |
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C. |
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Gross Profit of Sandifer Manufacturing Company is $ 1, 125, 000. It is calculated by subtracting the Revenue from Cost of Goods Sold. |
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Operating profit of Sandifer manufacturing company is $ 675, 000. It is calculated after deducting operating expenses from the gross profit. |
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Net Profit of Sandifer manufacturing company is $ 472, 5000. It is calculated after deducting taxation from the operating profit. Net profit determines the overall financial position of the company. Hence, the overall financial position of the company is satisfactory. |
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After analysing the above income statement, it is seen that Sandifer Manufacturing Company is earning Net Profit of $ 472, 500. This depicts that financial health of the company is sound. |
The profit is left for the payment of a cash dividend to Sandifer’s shareholders is computed as follows:
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PARTICULARS |
AMOUNT |
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Net Profit |
$ 472,500.00 |
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less: reinvestment |
$ 50,000.00 |
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Balance profit |
$ 422,500.00 |
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A. |
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The term liquidity position describes about the capacity of the firm to meet the short-term obligations within due time. Hence in this case, King carpet company uses $ 1500000 to retire short-term trade and also pays $ 500000 for the expansion of firm’s truck fleet which signifies that the King Carpet Company ltd is able to meet the current commitments when they fall due and therefore liquidity performance of the company is sound. |
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B. |
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To analyse the liquidity position of the firm, current ratio and quick ratio is computed. |
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C. |
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If they carry this plan through, then the revised current ratio will be computed as follows: |
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Current ratio = current assets/current liabilities |
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where, |
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New Current assets = $ 9000000 + $ 3000000 – $ 2000000 = $ 10000000 |
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New Current Liabilities = $ 6000000 – $ 1500000 = $ 4500000 |
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New Current ratio = |
2.22 |
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The effect on current ratio is that current assets reduced to $ 10000000 whereas current liabilities reduced to $ 4500000. This means that current ratio is enhanced to 2.22 which signifies that the liquidity position is sound. |
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To determine the liquidity position of King Carpet Company, common size statements is one such tool where comparison of performance can be made with other firms. |
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A. |
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Calculation of operating profit: |
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Operating profit margin = operating profit/sales |
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operating profit = 0.12*$ 65 million = $ 7.8 million |
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calculation of net profit: |
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particulars |
Amount ($ million) |
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Operating profit |
$ 7.80 |
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Less: interest |
$ 2.40 |
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Profit before tax |
$ 5.40 |
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less: 30% |
$ 1.62 |
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Profit after tax |
$ 3.78 |
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Working notes: |
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Calculation of interest amount = 12% of $ 20 million = $ 2.4 million |
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For determining whether the firm was achieving a reasonable profit margin, it can be done through by comparing the industry averages or by comparing with the competitors along whether the trend of the company is increasing or decreasing year by year. |
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Calculation of ROA and ROE: |
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ROA = Net profit after tax/Total assets |
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ROA = $ 3.78 million/$ 42 million |
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ROA = 9.00% |
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ROE = net profit after tax/Shareholder’s Equity |
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ROE = $ 3.78 million/$ 22 million |
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ROE = 17.18% |
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Working note: |
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Shareholders Equity = Total Assets – Total Liabilities |
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Shareholders equity = $ 42 million – $ 20 million |
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Shareholders Equity = $ 22 million |
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ROA depicts that the company is effectively earning incomes on its investment in assets. Positive ratio also depicts the upward trend. |
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ROE depicts that the company is efficiently using the shareholders money in order to produce net income. |
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A. |
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Given data: |
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Principal |
$ 50,000.00 |
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Amount |
$ 75,000.00 |
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Rate of interest (r ) |
7% |
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Let the number of years assumed to be ‘n’ |
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75000 = 50000*(1+0.07)^n |
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Solving the above equation, we get n = 6 years |
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Hence, if the inherited amount of $ 50000 is invested for 6 years at 7% compounded annually, it will have grown to $ 75000. |
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B. |
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Given data: |
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Principal |
$ 50,000.00 |
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Rate of interest (r ) |
7% |
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n (years) |
10.25 |
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Let the amount assumed to be ‘x’ |
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Formula is: |
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x = 50000*(1+0.07)^10.25 |
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Solving the above equation, we get x = $ 100035.40 |
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Hence, after 10.25 years the amount will be $ 100035.40 |
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C. |
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Given data: |
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Principal |
$ 50,000.00 |
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Amount |
$ 75,000.00 |
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Rate of interest (r ) |
3% |
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Let the number of years assumed to be ‘n’ |
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75000 = 50000*(1+0.03)^n |
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Solving the above equation, we get n = 13.75 years |
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Hence, if the inherited amount of $ 50000 is invested for 13.75 years at 3% compounded annually, it will have grown to $ 75000. |
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D. |
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Given data: |
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Principal |
$ 50,000.00 |
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Amount |
$ 75,000.00 |
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Rate of interest (r ) |
11% |
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Let the number of years assumed to be ‘n’ |
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75000 = 50000*(1+0.11)^n |
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Solving the above equation, we get n = 3.90 years |
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Hence, if the inherited amount of $ 50000 is invested for 3.9 years at 11% compounded annually, it will have grown to $ 75000. |
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E. |
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The relationship among time, interest rates and future sums will describe the greater benefit of receiving money now rather than later. |
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A. |
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Given data: |
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Future Value |
$ 2 million |
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time |
35 years |
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Rate of interest (r ) |
4% |
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Let us assume the present value is ‘x’ |
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Formula is: |
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PV = $ 2 million/(1+0.04)^35 |
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Thus solving the above equation, |
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PV = $ 506830.94 |
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Hence, Sarah have to invest today of amount of $ 506830.94. |
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B. |
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Given data: |
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Future Value |
$2,000,000 |
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Present value |
$506,830.94 |
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Rate of interest (r ) |
14% |
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Let us assume the time is ‘n’ |
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Formula is: |
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506830.94 = 2000000/(1+0.14)^n |
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Thus solving the above equation, |
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n = 10.50 years |
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Hence, the sarah would then retire in 10.25 years. |
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A. |
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Given data: |
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P0 |
$ 5.75 |
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P1 |
$ 2.24 |
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D1 |
$ 0.35 |
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The formula for rate of return: |
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Rate of return = [(P1 – P0) + D1]/P0 |
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where, |
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P0 = vale of shares of QAN at 12 December 2007 |
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P1 = value of shares of QAN at 12 December 2008 |
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D1 = dividend paid |
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Rate of return = [(2.24 – 5.75) + 0.35]/5.75 |
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Thus calculating the above equation, |
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rate of return = -0.55% |
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B. |
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Realized return means how much the investor earned from the investment. Hence, in this case investor is earned -0.55% from the investment. |
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C. |
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Cash dividends paid to the investors for the amount of investment made in the company. Cash dividends are the earnings to the investors which will reduce the amount of loss on the realized return to the investors. |
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D. |
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Investment’s rate of return is considered as a risk because higher the return higher would be the risk associated with the investment. Thus all the investors must be aware of the risk connoted with the investment amount. |
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Given data: |
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P0 |
$ 6,615.20 |
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P1 |
$ 3,510.43 |
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D1 |
$ 264.61 |
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The formula for rate of return: |
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Rate of return = [(P1 – P0) + D1]/P0 |
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where, |
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P0 = vale of S&P/ASX 200 index at 12 December 2007 |
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P1 = value of S&P/ASX 200 index at 12 December 2008 |
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D1 = dividend paid |
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Rate of return = [(3510.43 – 6615.20) + 264.61]/6615.20 |
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Thus calculating the above equation, |
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rate of return = -0.43% |
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Thus, it can be observed that rate of return earned on QAN is more negative as compare to return earned on S&P/ASX 200 index. Thus, QAN is more risky for investment purpose. |
The expected rate of return of an individual security is the rate of return that the investor wants to earn by investing in that security. The expected return of a security could be computed with reference to the historical returns. The average of the past period returns could be taken as the expected return of the security. On the other hand, portfolio return is the weighted average of the returns of securities included in the portfolio. Thus, in order to compute the portfolio return, it is necessary to have the data of return on individual securities and weight proportion in which fund have been invested (Marty, 2014). For example, consider a portfolio of three stocks such as stock-A, B, and C. The stock -A has a return of 10%, stock-B provides return of 8% and stock-c earns a return of 12%. The stock-A has weight of 50%, stock-B with 30% and stock-C with 20%. The portfolio return will be 9.80% (0.10*0.50+0.08*0.30+0.12*0.20).
The primary objective of constructing a portfolio is to reduce the risk of investment. The risk reduction is achieved by diversifying the investments and diversification is achieved by investing in stocks belonging to different industries. The risk of portfolio is computed with reference to the standard deviation (volatility) of individual stocks and correlation among the stocks. The portfolio risk is not simple weighted average of the standard deviations of individuals stocks; rather it is linked with correlation. The correlation between the stocks plays a major role in assessing the degree to which the portfolio has been diversified (Gitman et al., 2015). The formula shown below is used to compute the risk of portfolio:
It could be observed that the variance of individual stocks is multiplied with the square of weights of individual stocks and then the covariance or the correlation is multiplied with the resultant figure to get the variance of portfolio. Now, if the correlation is escaped from this calculation, then there will not be any risk reduction and the very purpose of portfolio construction will be lost. Thus, correlation between the returns of two stocks could be positive or negative. The value of correlation ranges between -1 to +1. The lower the value of correlation lower will be the variance of portfolio and lower the variance of portfolio greater will be the reduction in risk (Gitman et al., 2015).
The values of standard deviation of individual stocks also play a role in portfolio variance but the real diversification is achieved due to correlation. Consider a portfolio having two stocks from the same industry. With the change in market conditions, the returns of both the stocks changes in the same direction. Now, in this case, the correlation between the returns of both the stocks would be perfectly positive. Consider another example of portfolio of two stocks wherein stocks belong to different industries. The returns of both the stocks run in different direction with the changes in the market conditions. Now, in this case, the correlation between the stocks would not be perfectly positive which means that the value of portfolio variance will reduce. The reduction in value of portfolio variance would achieve the objective of portfolio creation i.e. diversification. Thus, it could be inferred that in order to achieve diversification, the values of individual stock’s variance are important but even more important is the correlation (Gitman et al., 2015).
References
Gitman, L.J., Joehnk, M.D., Smart, S., and Juchau, R.H. 2015. Fundamentals of Investing. Pearson Higher Education AU.
Jonathan, B. 2010. Financial Management. Pearson Education India.
Marty, W. 2014. Portfolio Analytics: An Introduction to Return and Risk Measurement Springer Texts in Business and Economics. Springer Science & Business Media.
Michalski, G. 2014. Value-Based Working Capital Management: Determining Liquid Asset Levels in Entrepreneurial Environments. Springer.
Tracy, J.A. 2011. Accounting Workbook for Dummies. John Wiley & Sons.
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