break even analysis and ratio analysis

7/31/2019 Break Even Analysis and Ratio Analysis

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RATIO ANALYSISAND BREAK EVEN

ANALYSIS


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RATIOANALYSIS

Is a method or process by which the relationship ofitems or groups of items in the financial statementsare computed, and presented.

Is an important tool of financial analysis.

Is used to interpret the financial statements so thatthe strengths and weaknesses of a firm, itshistorical performance and current financialcondition can be determined.


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RATIO

A mathematical yardstick that measures therelationship between two figures or groups of

figures which are related to each other and are

mutually inter-dependent. It can be expressed as a pure ratio, percentage, or

as a rate


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UTILITYOF RATIOS

Accounting ratios are very useful in assessing the

financial position and profitability of an enterprise.

However its utility lies in comparison of the ratios.


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UTILITYOF RATIOS

Comparison may be in any one of thefollowing forms:

For the same enterprise over a number of

yearsFor two enterprises in the same industry

For one enterprise against the industry as awhole

For one enterprise against a pre-determinedstandard

For inter-segment comparison within thesame organisation


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CLASSIFICATIONOF RATIOS

Ratios can be broadly classified into four groups

namely:

Liquidity ratios

Capital structure/leverage ratios Profitability ratios

Activity ratios


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LIQUIDITYRATIOS

These ratios analyse the short-term financial

position of a firm and indicate the ability of the

firm to meet its short-term commitments

(current liabilities) out of its short-termresources (current assets).

These are also known as solvency ratios.

The ratios which indicate the liquidity of a firm

are: Current ratio

Liquidity ratio or Quick ratio or acid test ratio


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CURRENTRATIO

It is calculated by dividing current assets by current

liabilities.

Current ratio = Current assets where

Current liabilities

Conventionally a current ratio of 2:1 is consideredsatisfactory


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CURRENT ASSETS

include Inventories of raw material, WIP, finished goods,

stores and spares,

sundry debtors/receivables,

short term loans deposits and advances,

cash in hand and bank, prepaid expenses,

incomes receivables and

marketable investments and short term securities.


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CURRENT LIABILITIES

include sundry creditors/bills payable,

outstanding expenses,

unclaimed dividend,

advances received, incomes received in advance,

provision for taxation,

proposed dividend,

instalments of loans payable within 12 months,

bank overdraft and cash credit


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QUICK RATIOOR ACID TEST RATIO

This is a ratio between quick current assetsand current liabilities (alternatively quickliabilities).

It is calculated by dividing quick currentassets by current liabilities (quick currentliabilities)

Quick ratio = quick assets

Current liabilities/(quick liabilities)

Conventionally a quick ratio of 1:1 isconsidered satisfactory.


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QUICK ASSETS & QUICK LIABILITIES

QUICK ASSETS are current assets (as stated earlier)

less prepaid expenses and inventories.

QUICK LIABILITIES are current liabilities (as statedearlier)

less bank overdraft and incomes received in advance.


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CAPITALSTRUCTURE/ LEVERAGE

RATIOS

These ratios indicate the long term solvency of a

firm and indicate the ability of the firm to meet its

long-term commitment with respect to

(i) repayment of principal on maturity or in

predetermined instalments at due dates and

(ii) periodic payment of interest during the period of

the loan.


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CAPITALSTRUCTURE/ LEVERAGERATIOS

The different ratios are:

Debt equity ratio

Proprietary ratio

Debt to total capital ratio

Interest coverage ratio

Debt service coverage ratio


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DEBTEQUITYRATIO

This ratio indicates the relative proportion of debtand equity in financing the assets of the firm. It iscalculated by dividing long-term debt byshareholders funds.

Debt equity ratio = long-term debts where

Shareholders funds

Generally, financial institutions favour a ratioof 2:1.

However this standard should be applied havingregard to size and type and nature of business andthe degree of risk involved.


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LONG-TERM FUNDS are long-term loanswhether secured or unsecured like debentures, bonds, loans from financialinstitutions etc.

SHAREHOLDERS FUNDS are equityshare capital plus preference share capital

plus reserves and surplus minus fictitiousassets (eg. Preliminary expenses, pastaccumulated losses, discount on issue ofshares etc.)


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PROPRIETARYRATIO

This ratio indicates the general financial

strength of the firm and the long- term

solvency of the business.

This ratio is calculated by dividing proprietorsfunds by total funds.

Proprietary ratio = proprietors funds

where

Total funds/assets

As a rough guide a 65% to 75% proprietaryratio is advisable


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PROPRIETORS FUNDS are same as explained in

shareholders funds

TOTAL FUNDSare all fixed assets and all currentassets.

Alternatively it can be calculated as proprietors

funds plus long-term funds plus current liabilities.


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DEBTTOTOTALCAPITALRATIO

In this ratio the outside liabilities are related to the

total capitalisation of the firm. It indicates what

proportion of the permanent capital of the firm is in

the form of long-term debt.

Debt to total capital ratio =long- term debt

Shareholders funds + long- term

debt

Conventionally a ratio of 2/3 is consideredsatisfactory.


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INTERESTCOVERAGERATIO

This ratio measures the debt servicing capacity of afirm in so far as the fixed interest on long-term loan isconcerned. It shows how many times the interestcharges are covered by EBIT out of which they will bepaid.

Interest coverage ratio = EBIT

Interest

A ratio of 6 to 7 times is considered satisfactory.

Higher the ratio greater the ability of the firm to payinterest out of its profits. But too high a ratio mayimply lesser use of debt and/or very efficientoperations


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DEBTSERVICECOVERAGERATIO

This is a more comprehensive measure tocompute the debt servicing capacity of a firm. Itshows how many times the total debt serviceobligations consisting of interest and repayment ofprincipal in instalments are covered by the total

operating funds after payment of tax.Debt service coverage ratio =EAT+ interest + depreciation + other non-cash exp

Interest + principal instalment

EAT is earnings after tax.

Generally financial institutions consider 2:1 asa satisfactory ratio.

P


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PROFITABILITYRATIOS

These ratios measure the operating efficiency of the firm

and its ability to ensure adequate returns to itsshareholders.

The profitability of a firm can be measured by its profitability

ratios.

Further the profitability ratios can be determined

(i) in relation to sales and

(ii) in relation to investments


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PROFITABILITYRATIOS

Profitability ratios in relation to sales:

gross profit margin

Net profit margin

Expenses ratio


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PROFITABILITYRATIOS

Profitability ratios in relation to investments

Return on assets (ROA)

Return on capital employed (ROCE)

Return on shareholders equity (ROE)

Earnings per share (EPS)

Dividend per share (DPS)

Dividend payout ratio (D/P)

Price earning ratio (P/E)


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GROSSPROFITMARGIN

This ratio is calculated by dividing gross profit by sales. It

is expressed as a percentage.

Gross profit is the result of relationship between prices,

sales volume and costs.

Gross profit margin = gross profit x 100

Net sales


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GROSSPROFITMARGIN

A firm should have a reasonable gross profit margin

to ensure coverage of its operating expenses and

ensure adequate return to the owners of the

business ie. the shareholders.

To judge whether the ratio is satisfactory or not, it

should be compared with the firms past ratios or

with the ratio of similar firms in the same industry or

with the industry average.


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NETPROFITMARGINThis ratio is calculated by dividing net profit by sales. It isexpressed as a percentage.

This ratio is indicative of the firms ability to leave a marginof reasonable compensation to the owners for providingcapital, after meeting the cost of production, operating

charges and the cost of borrowed funds.Net profit margin =

Net profit after interest and tax x 100

Net sales


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NETPROFITMARGIN

Another variant of net profit margin is operating profit

margin which is calculated as:

Operating profit margin =

net profit before interest and tax x 100

Net sales

Higher the ratio, greater is the capacity of the firm to

withstand adverse economic conditions and vice

versa


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EXPENSESRATIO

These ratios are calculated by dividing the variousexpenses by sales. The variants of expenses ratios are:

Material consumed ratio = Material consumed x 100Net sales

Manufacturing expenses ratio = manufacturing expenses x 100

Net sales

Administration expenses ratio = administration expenses x 100

Net salesSelling expenses ratio = Selling expenses x 100

Net sales

Operating ratio = cost of goods sold plus operating expenses x 100

Net sales

Financial expense ratio = financial expenses x 100Net sales


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EXPENSESRATIO

The expenses ratios should be compared over a

period of time with the industry average as well as

with the ratios of firms of similar type. A low

expenses ratio is favourable.

The implication of a high ratio is that only a smallpercentage share of sales is available for meeting

financial liabilities like interest, tax, dividend etc.


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RETURNONASSETS (ROA)

This ratio measures the profitability of the totalfunds of a firm. It measures the relationshipbetween net profits and total assets. Theobjective is to find out how efficiently the totalassets have been used by the management.

Return on assets =net profit after taxes plus interest x 100

Total assets

Total assets exclude fictitious assets. As the totalassets at the beginning of the year and end of theyear may not be the same, average total assetsmay be used as the denominator.


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RETURNONCAPITALEMPLOYED

(ROCE)

This ratio measures the relationship between net profit andcapital employed. It indicates how efficiently the long-termfunds of owners and creditors are being used.

Return on capital employed =

net profit after taxes plus interest x 100Capital employed

CAPITAL EMPLOYED denotes shareholders funds andlong-term borrowings.

To have a fair representation of the capital employed,average capital employed may be used as the denominator.


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RETURNONSHAREHOLDERSEQUITY

This ratio measures the relationship of profits to owners

funds. Shareholders fall into two groups i.e. preferenceshareholders and equity shareholders. So the variants ofreturn on shareholders equity are

Return on total shareholders equity =

net profits after taxes x 100Total shareholders equity

.


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TOTAL SHAREHOLDERS EQUITY includes

preference share capital plus equity share capital

plus reserves and surplus less accumulated losses

and fictitious assets. To have a fair representation

of the total shareholders funds, average totalshareholders funds may be used as the

denominator


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Return on ordinary shareholders equity =

net profit after taxes pref. dividend x 100

Ordinary shareholders equity or net worth

ORDINARY SHAREHOLDERS EQUITY OR NET

WORTH includes equity share capital plus reserves

and surplus minus fictitious assets.


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EARNINGSPERSHARE (EPS)

This ratio measures the profit available to the equity

shareholders on a per share basis. This ratio is

calculated by dividing net profit available to equity

shareholders by the number of equity shares.

Earnings per share =

net profit after tax preference dividend

Number of equity shares


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DIVIDENDPERSHARE (DPS)

This ratio shows the dividend paid to the shareholderon a per share basis. This is a better indicator thanthe EPS as it shows the amount of dividend receivedby the ordinary shareholders, while EPS merely

shows theoretically how much belongs to the ordinaryshareholders

Dividend per share =

Dividend paid to ordinary shareholders

Number of equity shares


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DIVIDENDPAYOUTRATIO (D/P)

This ratio measures the relationship between the

earnings belonging to the ordinary shareholders

and the dividend paid to them.

Dividend pay out ratio =total dividend paid to ordinary shareholders x 100

Net profit after taxpreference dividend

OR

Dividend pay out ratio=Dividend per share x 100

Earnings per share


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PRICEEARNINGRATIO (P/E)

This ratio is computed by dividing the market price of theshares by the earnings per share. It measures the

expectations of the investors and market appraisal of the

performance of the firm.

Price earning ratio = market price per shareEarnings per share


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ACTIVITYRATIOS

These ratios are also called efficiency ratios /asset utilization ratios or turnover ratios. Theseratios show the relationship between sales andvarious assets of a firm. The various ratiosunder this group are:

Inventory/stock turnover ratio Debtors turnover ratio and average collection period

Asset turnover ratio

Creditors turnover ratio and average credit period


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INVENTORY /STOCKTURNOVERRATIO

This ratio indicates the number of times inventory isreplaced during the year. It measures the relationshipbetween cost of goods sold and the inventory level.There are two approaches for calculating this ratio,namely:Inventory turnover ratio = cost of goods sold

Average stockAVERAGE STOCK can be calculated as

Opening stock+ closing stock2

AlternativelyInventory turnover ratio = sales_________

Closing inventory


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INVENTORY /STOCKTURNOVERRATIO

A firm should have neither too high nor too low

inventory turnover ratio. Too high a ratio may

indicate very low level of inventory and a danger of

being out of stock and incurring high stock out

cost. On the contrary too low a ratio is indicative ofexcessive inventory entailing excessive carrying

cost.

D


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DEBTORSTURNOVERRATIOANDAVERAGE

COLLECTIONPERIOD

This ratio is a test of the liquidity of the debtors of a firm. Itshows the relationship between credit sales and debtors.

Debtors turnover ratio =

Credit sales

Average Debtors and bills receivables

Average collection period =

Months/days in a year

Debtors turnover


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DEBTORSTURNOVERRATIOANDAVERAGE

COLLECTIONPERIOD

These ratios are indicative of the efficiency of thetrade credit management. A high turnover ratio andshorter collection period indicate prompt paymentby the debtor. On the contrary low turnover ratioand longer collection period indicates delayedpayments by the debtor.

In general a high debtor turnover ratio and shortcollection period is preferable.


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ASSETTURNOVERRATIO

Depending on the different concepts of assets employed,there are

many variants of this ratio. These ratios measure theefficiency of a firm in managing and utilising its assets.

Total asset turnover ratio = sales/cost of goods sold

Average total assets

Fixed asset turnover ratio = sales/cost of goods sold

Average fixed assets

Capital turnover ratio = sales/cost of goods sold

Average capital employed

Working capital turnover ratio = sales/cost of goods sold

Net working capital


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ASSETTURNOVERRATIO

Higher ratios are indicative of efficient management

and utilisation of resources while low ratios are

indicative of under-utilisation of resources and

presence of idle capacity.

CREDITORS TURNOVER RATIO AND AVERAGE


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CREDITORSTURNOVERRATIOANDAVERAGE

CREDITPERIOD

This ratio shows the speed with which payments are madeto the suppliers for purchases made from them. It shows

the relationship between credit purchases and average

creditors.

Creditors turnover ratio =

credit purchases

Average creditors & bills payables

Average credit period = months/days in a year

Creditors turnover ratio


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CREDITORSTURNOVERRATIOAND

AVERAGECREDITPERIOD

Higher creditors turnover ratio and short credit

period signifies that the creditors are being paid

promptly and it enhances the creditworthiness of

the firm.


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BREAK EVEN

ANALYSIS


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INTRODUCTION

Break-Even Analysis is used to predict future profits/losses

predict results eg produce Product A or Product

B

Break-Even Point is when Sales Revenueequals Total Costs

at this point no profit or loss is incurred

the firm merely covers its total costsBreak-Even Point can be shown in graph

form or by use of formulae


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BREAK-EVEN ANALYSIS

In order to calculate how profitable a product will be, we must

firstly look at the Costs involved

There are two basic types of costs a company incurs.

Variable Costs

Fixed Costs

Variable costs are costs that change with changes inproduction levels or sales. Examples include: Costs ofmaterials used in the production of the goods.

Fixed costs remain roughly the same regardless ofsales/output levels. Examples include: Rent, Insuranceand Wages


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CONT..

TOTAL COSTS

Total Costs is simply Fixed Costs and Variable Costs

added together.

TC = FC + VC

As Total Costs include some of the Variable Costs

then Total Costs will also change with any changes in

output/sales.

If output/sales rise then so will Total Costs.

If output/sales fall then so will Total Costs.


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CONT.

The Break-even point occurs when Total Costs equals

Revenue (Sales Income)

Revenues (Sales Income) = Total Costs

At this point the business is not making a Profit norincurring a Loss it is merely covering its Total Costs

Let us have a look at a simple example.

Bannerman Trading Companyopens a flower shop.


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CONT.

Fixed Costs:

Rent: Rs.400

Helper (Wages): Rs.200

Variable Costs:

Flowers: Rs.0.50 per bunch

Selling Price:

Flowers: Rs.2 per bunch

So we know that:

Total Fixed Costs = Rs.600

Variable Cost per Unit = Rs.0.50

Selling Price per Unit = Rs.2.00

SP = RS.2.00


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We must firstly calculate how much income from eachbunch of flowers can go towards covering the Fixed

Costs.

This is called the Unit Contribution.

Selling PriceVariable Costs = Unit Contribution

Rs.2.00Rs.0.50 = Rs.1.50

For every bunch of flowers sold Rs.1.50 can go

towards covering Fixed Costs

Break-Even AnalysisSP RS.2.00

VC = RS.0.50

FC = RS.600

B k E A l i SP = Rs 2 00


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Now to calculate how many units must

be sold to cover Total Costs (FC + VC)

This is called the Break Even Point

Break Even Point =

Fixed CostsUnit ContributionRs.600Rs.1.50 = 400 Units

Therefore 400 bunches of flowers must be sold to BreakEven at this the point the business is not making aProfit nor incurring a Loss it is merely covering itsTotal Costs

Break-Even Analysis SP = Rs.2.00VC = Rs.0.50

Unit cont =

Rs.1.50

FC = Rs.600


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BREAK-EVEN CHART

Costs/Revenue

Output/Sales

FC

VCTCTR

The Break-even point

occurs where total

revenue equals total

coststhe firm, in

this example would

have to sell Q1 to

generate sufficient

revenue (income) to

cover its total costs.

Q1

BEP

ADVANTAGES OF BREAK EVEN ANALYSIS IN


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ADVANTAGESOFBREAKEVENANALYSISIN

MANAGERIALDECISIONMAKING

It helps in determining the optimum level of output below

which it would not be profitable for a firm to produce

It helps in determining the target capacity for a firm to get

the benefit of minimum unit cost of production.

The firm can determine minimum cost for a given level of

output.

It helps the firm in deciding which products are to beproduced and which are to be brought by the firm.

Plant expansion and contraction decisions are often

based on the break even analysis of the perceivedsituation.


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Impact of changes in prices and costs on profit of thefirm can also be analyzed with the help of break eventechnique.

Sometimes a management has to take decisions

regarding dropping or adding a product to the productline. The break even analysis comes very handy in such

situation.

It evaluates the percentage financial yield from a project

and thereby helps in the choice between variousalternatives projects

ADVANTAGES OF BREAK EVEN ANALYSIS IN


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The break even analysis can be used in findingthe selling price which would prove most profitable

for the firm

By finding out the break even point the break even

analysis helps in establishing point where from thefirm can start payment of dividend to its

shareholders


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LIMITATIONSOF BREAK EVEN ANALYSIS

Some costs cannot be identified as precisely Fixedor Variable

Semi-variable costs cannot be easily

accommodated in break-even analysisCosts and revenues tend not to be constant

With Fixed costs the assumption that they are

constant over the whole range of output from zeroto maximum capacity is unrealistic


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LIMITATIONS CONTINUED

Price reduction may be necessary to protectsales in the face of increased competition

The sales mix may change with changes in

tastes and fashions

Productivity may be affected by strikes and

absenteeism

The balance between Fixed and Variable

costs may be altered by new technology


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BREAK-EVEN CHART

break even analysis and ratio analysis

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