ch_6.ppt
TRANSCRIPT
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Chapter 6Chapter 6
Financial Statements AnalysisFinancial Statements Analysis
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FINANCIAL STATEMENTS ANALYSIS
Ratio Analysis
Importance and Limitations of Ratio Analysis
Common Size Statements
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Ratio AnalysisRatio Analysis
Ratio analysis is a widely used tool of financial analysis. It is defined as the systematic use of ratio to interpret the
financial statements so that the strengths and weaknesses of a firm as well as its historical
performance and current financial condition can be determined.
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Basis of ComparisonBasis of Comparison
1) Trend Analysis involves comparison of a firm over a period of time, that is, present ratios are compared with past ratios for the same firm. It indicates the direction of change in the performance – improvement, deterioration or constancy – over the years.
2) Interfirm Comparison involves comparing the ratios of a firm with those of others in the same lines of business or for the industry as a whole. It reflects the firm’s performance in relation to its competitors.
3) Comparison with standards or industry average.
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Types of RatiosTypes of Ratios
Liquidity RatiosLiquidity Ratios Capital Structure RatiosCapital Structure Ratios
Profitability RatiosProfitability Ratios Efficiency ratiosEfficiency ratios
Integrated Analysis Ratios
Integrated Analysis Ratios
Growth RatiosGrowth Ratios
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Net working capital is a measure of liquidity calculated by subtracting current liabilities from current assets.
Table 1: Net Working Capital
Particulars Company A Company B
Total current assets
Total current liabilities
NWC
Rs 1,80,000
1,20,000
60,000
Rs 30,000
10,000
20,000
Table 2: Change in Net Working Capital
Particulars Company A Company B
Current assets
Current liabilities
NWC
Rs 1,00,000
25,000
75,000
Rs 2,00,000
1,00,000
1,00,000
Net Working CapitalNet Working Capital
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Liquidity ratios measure the ability of a firm to meet its short-term
obligations
Liquidity RatiosLiquidity Ratios
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Particulars Firm A Firm B
Current Assets Rs 1,80,000 Rs 30,000
Current Liabilities Rs 1,20,000 Rs 10,000
Current Ratio = 3:2 (1.5:1) 3:1
Current Ratio is a measure of liquidity calculated dividing the current assets by the current liabilities
Current Ratio
Current Ratio =Current Assets
Current Liabilities
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The quick or acid test ratio takes into consideration the differences in the liquidity of the
components of current assets
Quick Assets = Current assets – Stock – Pre-paid expenses
Acid-Test RatioAcid-Test Ratio
Acid-test Ratio =Quick Assets
Current Liabilities
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Example 1: Example 1: Acid-Test RatioAcid-Test Ratio
Cash
Debtors
Inventory
Total current assets
Total current liabilities
Rs 2,000
2,000
12,000
16,000
8,000
(1) Current Ratio
(2) Acid-test Ratio
2 : 1
0.5 : 1
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Supplementary Ratios for Supplementary Ratios for LiquidityLiquidity
Inventory Turnover Ratio
Inventory Turnover Ratio
Debtors Turnover RatioDebtors Turnover Ratio
Creditors Turnover RatioCreditors Turnover Ratio
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Inventory Turnover Ratio
The cost of goods sold means sales minus gross profit.
The average inventory refers to the simple average of the opening and closing inventory.
The ratio indicates how fast inventory is sold. A high ratio is good from the viewpoint of liquidity and vice versa. A low ratio would signify that inventory does not sell fast and stays
on the shelf or in the warehouse for a long time.
Inventory turnover ratio =Cost of goods sold
Average inventory
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Example 2: Example 2: Inventory Turnover Ratio
A firm has sold goods worth Rs 3,00,000 with a gross profit margin of 20 per cent. The stock at the beginning and the end of the year
was Rs 35,000 and Rs 45,000 respectively. What is the inventory turnover ratio?
Inventory turnover ratio
=(Rs 3,00,000 – Rs 60,000)
=6 (times per
year)(Rs 35,000 + Rs 45,000) ÷ 2
Inventory holding period
=12 months
= 2 monthsInventory turnover ratio, (6)
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Debtors Turnover Ratio
Net credit sales consist of gross credit sales minus returns, if any, from customers.
Average debtors is the simple average of debtors (including bills receivable) at the beginning and at the end of year.
The ratio measures how rapidly receivables are collected. A high ratio is indicative of shorter time-lag between credit sales and
cash collection. A low ratio shows that debts are not being collected rapidly.
Debtors turnover ratio =Net credit sales
Average debtors
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Example 3: Debtors Turnover Ratio
A firm has made credit sales of Rs 2,40,000 during the year. The
outstanding amount of debtors at the beginning and at the end
of the year respectively was Rs 27,500 and Rs 32,500.
Determine the debtors turnover ratio.
Debtors turnover ratio
=Rs 2,40,000
=8 (times per
year)(Rs 27,500 + Rs 32,500) ÷ 2
Debtors collection period
=12 Months
=1.5
MonthsDebtors turnover ratio, (8)
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Creditors Turnover RatioCreditors Turnover Ratio
Net credit purchases = Gross credit purchases - Returns to suppliers.
Average creditors = Average of creditors (including bills payable) outstanding at the beginning and at the end of the year.
A low turnover ratio reflects liberal credit terms granted by suppliers, while a high ratio shows that accounts are to be settled rapidly. The creditors turnover ratio is an important tool of analysis as a firm can reduce its requirement of current assets by relying on supplier’s credit.
Creditors turnover ratio
=Net credit purchases
Average creditors
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Example 4: Creditors Turnover Ratio
The firm in previous Examples has made credit purchases of Rs
1,80,000. The amount payable to the creditors at the beginning
and at the end of the year is Rs 42,500 and Rs 47,500
respectively. Find out the creditors turnover ratio.
Creditors turnover ratio
=(Rs 1,80,000)
=4 (times per year)(Rs 42,500 Rs 47,500) ÷ 2
Creditor’s payment period
=12 months
= 3 monthsCreditors turnover ratio, (4)
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The summing up of the three turnover ratios (known as a cash
cycle) has a bearing on the liquidity of a firm. The cash cycle
captures
the interrelationship of sales, collections from debtors
and payment to creditors.
Inventory holding period
Add: Debtor’s collection period
Less: Creditor’s payment period
2 months
+ 1.5 months
– 3 months
0.5 months
As a rule, the shorter is the cash cycle, the better are the liquidity ratios as measured above and vice versa.
The combined effect of the three turnover ratios
is summarised below:
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Defensive interval ratio is the ratio between quick assets and projected daily cash requirement.
DEFENSIVE INTERVAL RATIO
Defensive-
interval ratio=
Liquid assets
Projected daily cash requirement
Projected daily
cash requirement=
Projected cash operating expenditure
Number of days in a year (365)
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Example 5: Defensive Interval Ratio
The projected cash operating expenditure of a firm from the
next year is Rs 1,82,500. It has liquid current assets
amounting to Rs 40,000. Determine the
defensive-interval ratio.
Projected daily cash requirement =Rs 1,82,500
= Rs 500365
Defensive-interval ratio =Rs 40,000
= 80 daysRs 500
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Cash-flow from operation ratio measures liquidity of a firm by comparing actual cash flows from operations
(in lieu of current and potential cash inflows from current assets such as inventory and debtors)
with current liability.
Cash-flow From Operations Ratio
Cash-flow from
operations ratio=
Cash-flow from operations
Current liabilities
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Leverage Capital Structure RatioLeverage Capital Structure Ratio
Capital structure or leverage ratios throw light on the long-term solvency of a firm.
There are two aspects of the long-term solvency of a firm:
(i) Ability to repay the principal when due, and
(ii) Regular payment of the interest .
Accordingly, there are two different types of leverage ratios.
First type: These ratios are computed from the balance
sheet
Second type: These ratios are computed from the Income
Statement
(a) Debt-equity ratio
(b) Debt-assets ratio
(c) Equity-assets ratio
(a) Interest coverage ratio
(b) Dividend coverage ratio
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I. Debt-equity ratioI. Debt-equity ratio
Debt-equity ratio measures the ratio of long-term or total de3bt to shareholders equityDebt-equity ratio =
Total DebtShareholders’ equity
Long-term Debt + Short term debt + Other Current Liabilities = Total external
Obligations
Debt-equity ratio measures the ratio of long-term or total debt to shareholders equity.
If the D/E ratio is high, the owners are putting up relatively less money of their own. It is danger signal for the lenders and
creditors. If the project should fail financially, the creditors would lose heavily.
A low D/E ratio has just the opposite implications. To the creditors, a relatively high stake of the owners implies sufficient safety
margin and substantial protection against shrinkage in assets.
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For the company also, the servicing of debt is less burdensome and consequently its credit standing is not adversely affected, its operational flexibility
is not jeopardised and it will be able to raise additional funds.
The disadvantage of low debt-equity ratio is that the shareholders of the firm are deprived
of the benefits of trading on equity or leverage.
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Trading on EquityTrading on Equity
Trading on Equity (Amount in Rs thousand)
Particular A B C D
(a) Total assets 1,000 1,000 1,000 1,000 Financing pattern: Equity capital 1,000 800 600 200 15% Debt — 200 400 800
(b)Operating profit (EBIT) 300 300 300 300 Less: Interest — 30 60 120
Earnings before taxes 300 270 240 180Less: Taxes (0.35) 105 94.5 84 63Earnings after taxes 195 175.5 156 117Return on equity (per cent) 19.5 21.9 26 58.5
Trading on equity (leverage) is the use of borrowed funds in expectation of higher return to equity-holders.
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II. Debt to Total CapitalII. Debt to Total Capital
The relationship between creditors’ funds and owner’s capital can also be expressed using
Debt to total capital ratio.
Debt to total capital ratio =Total debt
Permanent capital
Permanent Capital = Shareholders’ equity + Long-term debt.
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III. Debt to total assets ratioIII. Debt to total assets ratio
Debt to total assets ratio =Total debt
Total assets
Proprietary ratio indicates the extent to which assets are financed by owners funds.
Proprietary ratio =Proprietary funds
Total assetsX 100
Capital gearing ratio is used to know the relationship between equity funds (net worth) and fixed income bearing funds (Preference
shares, debentures and other borrowed funds.
Proprietary Ratio
Capital Gearing Ratio
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Coverage RatioCoverage Ratio
Interest Coverage Ratio measures the firm’s ability to make contractual interest payments.
Interest coverage ratio =EBIT (Earning before interest and taxes)
Interest
Dividend coverage ratio =EAT (Earning after taxes)
Preference dividend
Dividend Coverage Ratio measures the firm’s ability to pay dividend on preference share which carry a stated rate of return.
Interest Coverage Ratio
Dividend Coverage Ratio
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Total fixed charge coverage ratio measures the firm’s ability to meet all fixed payment obligations.
Total fixed charge coverage ratio
EBIT + Lease Payment
Interest + Lease payments + (Preference dividend + Instalment of Principal)/(1-t)
=
Total fixed charge coverage ratio
However, coverage ratios mentioned above, suffer from one major limitation, that is, they relate the firm’s ability to meet its various
financial obligations to its earnings. Accordingly, it would be more appropriate to relate cash resources of a firm to its
various fixed financial obligations.
Total Cashflow Coverage Ratio
Total cashflow coverage ratio
Lease payment + Interest
EBIT + Lease Payments + Depreciation + Non-cash expenses=
(Principal repayment)
(1– t)
(Preference dividend)
(1 - t)+ +
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Debt Service Coverage RatioDebt Service Coverage Ratio
Debt-service coverage ratio (DSCR) is considered a more comprehensive and apt measure to compute debt
service capacity of a business firm.
DEBT SERVICE CAPACITY
DSCR =Instalmentt
∑n
t=1
EATt OAt+ +∑∑n
t=1Depreciationt+Interestt
Debt service capacity is the ability of a firm to make the contractual payments required on a scheduled
basis over the life of the debt.
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Agro Industries Ltd has submitted the following projections. You are required to work out yearly debt service coverage ratio (DSCR)
and the average DSCR.
(Figures in Rs lakh)
Year Net profit for the year
Interest on term loan
during the year
Repayment of term
loan in the year
1
2
3
4
5
6
7
8
21.67
34.77
36.01
19.20
18.61
18.40
18.33
16.41
19.14
17.64
15.12
12.60
10.08
7.56
5.04
Nil
10.70
18.00
18.00
18.00
18.00
18.00
18.00
18.00
The net profit has been arrived after charging depreciation of Rs 17.68 lakh every year.
Example 6: Debt-Service Coverage RatioExample 6: Debt-Service Coverage Ratio
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SolutionSolutionTable 3: Determination of Debt Service Coverage Ratio
(Amount in lakh of rupees)Year
Net profit
Depreciation Interest Cash
available
(col. 2+3+4)
Principal
instalment
Debt
obligation
(col. 4 + col. 6)
DSCR [col. 5
÷ col. 7
(No. of times)]
1 2 3 4 5 6 7 8
1
2
3
4
5
6
7
8
21.67
34.77
36.01
19.20
18.61
18.40
18.33
16.41
17.68
17.68
17.68
17.68
17.68
17.68
17.68
17.68
19.14
17.64
15.12
12.60
10.08
7.56
5.04
Nil
58.49
70.09
68.81
49.48
46.37
43.64
41.05
34.09
10.70
18.00
18.00
18.00
18.00
18.00
18.00
18.00
29.84
35.64
33.12
30.60
28.08
25.56
23.04
18.00
1.96
1.97
2.08
1.62
1.65
1.71
1.78
1.89
Average DSCR (DSCR ÷ 8) 1.83
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Profitability RatioProfitability Ratio
Profitability ratios can be computed either from sales or investment.
Profitability Ratios
Related to Sales
Profitability Ratios
Related to Investments
(i) Profit Margin
(ii) Expenses Ratio
(i) Return on Investments
(ii) Return on Shareholders’
Equity
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Profit MarginProfit Margin
Gross profit margin measures the percentage of each sales rupee remaining after the firm has paid for its goods.
Gross profit margin = Gross ProfitSales
X 100
Gross Profit Margin
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Net profit margin can be computed in three ways
iii. Net Profit Ratio =Earning after interest and taxes
Net sales
ii. Pre-tax Profit Ratio =Earnings before taxes
Net sales
i. Operating Profit Ratio =Earning before interest and taxes
Net sales
Net profit margin measures the percentage of each sales rupee remaining after all costs and expense including interest
and taxes have been deducted.
Net Profit Margin
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Example 7: From the following information of a firm, determine (i) Gross profit margin and (ii) Net profit margin.
1. Sales
2. Cost of goods sold
3. Other operating expenses
Rs 2,00,000
1,00,000
50,000
(1) Gross profit margin =Rs 1,00,000
= 50 per centRs 2,00,000
(2) Net profit margin =Rs 50,000
= 25 per centRs 2,00,000
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Expenses RatioExpenses Ratio
i. Cost of goods sold =Cost of goods sold
Net salesX 100
ii. Operating expenses =Administrative exp. + Selling exp.
Net salesX 100
iii. Administrative expenses =Administrative expenses
Net salesX 100
iv. Selling expenses ratio =Selling expenses
Net salesX 100
v. Operating ratio =Cost of goods sold + Operating expenses
Net salesX 100
vi. Financial expenses =Financial expenses
Net salesX 100
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Return on InvestmentReturn on Investment
Return on Investments measures the overall effectiveness of management in generating profits with
its available assets.
i. Return on Assets (ROA)
ROA =EAT + (Interest – Tax advantage on interest)
Average total assets
ii. Return on Capital Employed (ROCE)
ROCE =EAT + (Interest – Tax advantage on interest)
Average total capital employed
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Return on Shareholders’ EquityReturn on Shareholders’ Equity
Return on total shareholders’ equity =
Net profit after taxesAverage total shareholders’ equity X 100
Return on ordinary shareholders’ equity (Net worth) =
Net profit after taxes – Preference dividendAverage ordinary shareholders’ equity X 100
Return on shareholders equity measures the return on the owners (both preference and equity shareholders )
investment in the firm.
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Efficiency RatioEfficiency Ratio
Activity ratios measure the speed with which various accounts/assets are converted into sales or cash.
i. Inventory Turnover measures the activity/liquidity of inventory of a firm; the speed with which inventory is soldInventory Turnover Ratio =
Cost of goods soldAverage inventory
i. Inventory Turnover measures the activity/liquidity of inventory of a firm; the speed with which inventory is soldRaw materials turnover =
Cost of raw materials used
Average raw material inventory
i. Inventory Turnover measures the activity/liquidity of inventory of a firm; the speed with which inventory is soldWork-in-progress turnover =
Cost of goods manufactured
Average work-in-progress inventory
Inventory turnover measures the efficiency of various types of inventories.
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Liquidity of a firm’s receivables can be examined in two ways.
i. Inventory Turnover measures the activity/liquidity of inventory of a firm; the speed with which inventory is soldi. Debtors turnover =
Credit salesAverage debtors + Average bills receivable (B/R)
2. Average collection period = Months (days) in a year
Debtors turnover
i. Inventory Turnover measures the activity/liquidity of inventory of a firm; the speed with which inventory is sold
Alternatively =Months (days) in a year (x) (Average Debtors + Average (B/R)
Total credit sales
Ageing Schedule enables analysis to identify slow paying debtors.
Debtors Turnover RatioDebtors Turnover Ratio
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Assets Turnover RatioAssets Turnover Ratio
i. Inventory Turnover measures the activity/liquidity of inventory of a firm; the speed with which inventory is soldi. Total assets turnover =
Cost of goods sold
Average total assets
ii. Fixed assets turnover =Cost of goods sold
Average fixed assets
i. Inventory Turnover measures the activity/liquidity of inventory of a firm; the speed with which inventory is soldiii. Capital turnover =
Cost of goods soldAverage capital employed
iv. Current assets turnover =Cost of goods sold
Average current assets
i. Inventory Turnover measures the activity/liquidity of inventory of a firm; the speed with which inventory is soldv. Working capital turnover =
Cost of goods soldNet working capital
Assets turnover indicates the efficiency with which firm uses all its assets to generate sales.
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1) Return on shareholders’ equity = EAT/Average total shareholders’ equity.
2) Return on equity funds = (EAT – Preference dividend)/Average ordinary
shareholders’ equity (net worth).
3) Earnings per share (EPS) = Net profit available to equity shareholders’
(EAT – Dp)/Number of equity shares outstanding (N).
4) Dividends per share (DPS) = Dividend paid to ordinary
shareholders/Number of ordinary shares outstanding (N).
5) Earnings yield = EPS/Market price per share.
6) Dividend Yield = DPS/Market price per share.
7) Dividend payment/payout (D/P) ratio = DPS/EPS.
8) Price-earnings (P/E) ratio = Market price of a share/EPS.
9) Book value per share = Ordinary shareholders’ equity/Number of equity
shares outstanding.
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Integrated Analysis RatioIntegrated Analysis Ratio
Integrated ratios provide better insight about financial and economic analysis of a firm.
(1) Rate of return on assets (ROA) can be decomposed in to
(i) Net profit margin (EAT/Sales)
(ii) Assets turnover (Sales/Total assets)
(2) Return on Equity (ROE) can be decomposed in to
(i) (EAT/Sales) x (Sales/Assets) x (Assets/Equity)
(ii) (EAT/EBT) x (EBT/EBIT) x (EBIT/Sales) x (Sales/Assets) x
(Assets/Equity)
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Rate of Return on Assets
EAT as percentage of sales
Assets turnover
EAT SalesDivided by Sales Total AssetsDivided by
Current assetsFixed assetsGross profit = Sales less
cost of goods sold
Minus
Expenses: Selling Administrative Interest
Minus
Income-tax
Shareholder equity
Plus
Long-term borrowed funds
Plus
Current liabilities
Plus
Alternatively
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Return on AssetsReturn on Assets
Earning PowerEarning power is the overall profitability of a firm; is computed
by multiplying net profit margin and assets turnover.
Earning power = Net profit margin × Assets turnoverWhere, Net profit margin = Earning after taxes/SalesAsset turnover = Sales/Total assets
i. Inventory Turnover measures the activity/liquidity of inventory of a firm; the speed with which inventory is soldEarning Power =
Earning after taxes
Sales
Sales
Total Assets
EAT
Total assetsxx x
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Assume that there are two firms, A and B, each having total assets amounting to Rs 4,00,000, and average net profits after taxes of 10 per cent, that is, Rs 40,000, each.
Table 4: Return on Assets (ROA) of Firms A and B
Particulars Firm A Firm B
1. Net sales
2. Net profit
3. Total assets
4. Profit margin (2 ÷ 1) (per cent)
5. Assets turnover (1 ÷ 3) (times)
6. ROA ratio (4 × 5) (per cent)
Rs 4,00,000
40,000
4,00,000
10
1
10
Rs 40,00,000
40,000
4,00,000
1
10
10
Firm A has sales of Rs 4,00,000, whereas the sales of firm B aggregate Rs 40,00,000. Determine the ROA of firms A and B. Table 4 shows
the ROA based on two components.
EXAMPLE: 8
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Return on Equity (ROE)Return on Equity (ROE)
ROE is the product of the following three ratios: Net profit ratio (x) Assets turnover (x) Financial leverage/Equity multiplier
Three-component model of ROE can be broadened further to consider the effect of interest and tax payments.
As a result of three sub-parts of net profit ratio, the ROE is composed of the following 5 components.
i. Inventory Turnover measures the activity/liquidity of inventory of a firm; the speed with which inventory is sold
EATEarnings before taxes
EBT
EBIT
EBITSales
Net Profit
Salesxx =
EAT
EBT
EBT
EBITEBITSales
SalesAssets
AssetsEquity
x x x x
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A 5-way break-up of ROE enables the management of a firm to analyse the effect of interest payments and tax payments separately from operating profitability. To illustrate further assume 8 per cent interest rate, 35 per cent tax rate and other operating expense of Rs 3,22,462 (Firm A) and Rs 39,26,462 (Firm B) for the facts contained in Example 8. Table 5 shows the ROE (based on the 5 components) of Firms A and B.
Table 5: ROE (Five-way Basis) of Firms A and B
Particulars Firm A Firm B
Net sales
Less: Operating expenses
Earnings before interest and taxes (EBIT)
Less: Interest (8%)
Earnings before taxes (EBT)
Less: Taxes (35%)
Earnings after taxes (EAT)
Total assets
Debt
Equity
EAT/EBT (times)
EBT/EBIT (times)
EBIT/Sales (per cent)
Sales/Assets (times)
Assets/Equity (times)
ROE (per cent)
Rs 4,00,000
3,22,462
77,538
16,000
61,538
21,538
40,000
4,00,000
2,00,000
2,00,000
0.65
0.79
19.4
1
2
20
Rs 40,00,000
39,26,462
73,538
12,000
61,538
21,538
40,000
4,00,000
2,50,000
1,50,000
0.65
0.84
1.84
10
1.6
16
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Common Size StatementsCommon Size Statements
Preparation of common-size financial statements is an extension of ratio analysis. These statements convert absolute sums into more easily understood percentages of some base amount. It is sales in the case of income statement and totals of assets and liabilities in the case of the balance sheet.
Ratio analysis in view of its several limitations should be considered only as a tool for analysis rather than as an end in itself. The reliability and significance attached to ratios will largely hinge upon the quality of data on which they are based. They are as good or as bad as the data itself. Nevertheless, they are an important tool of financial analysis.
Limitations