ch_6 ratio analysis
TRANSCRIPT
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Chapter 6
Financial Statements Analysis
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FINANCIAL STATEMENTS
ANALYSIS
Ratio Analysis
Importance and Limitations ofRatio Analysis
Common Size Statements
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Ratio Analysis
Ratio analysis is a widely used tool of financial analysis. It
is defined as the systematic use of ratio to interpret thefinancial statements so that the strengths andweaknesses of a firm as well as its historical
performance and current financialcondition can be determined.
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Basis of Comparison
1) Trend Analysis involves comparison of a firm over aperiod of time, that is, present ratios are compared withpast ratios for the same firm. It indicates the direction ofchange in the performance improvement, deteriorationor constancy over the years.
2) Interfirm Comparison involves comparing the ratios of afirm with those of others in the same lines of business or
for the industry as a whole. It reflects the firmsperformance in relation to its competitors.
3) Comparison with standards or industry average.
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Types of Ratios
Liquidity Ratios Capital Structure Ratios
Profitability Ratios Efficiency ratios
IntegratedAnalysis Ratios
Growth Ratios
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Net working capital is a measure of liquidity calculated bysubtracting 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 Capital
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Liquidity ratios measure the abilityof a firm to meet its short-term
obligations
Liquidity 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 dividingthe current assets by the current liabilities
Current Ratio
Current Ratio = Current AssetsCurrent Liabilities
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The quick or acid test ratio takes into considerationthe differences in the liquidity of the
components of current assets
Quick Assets = Current assets StockPre-paid expenses
Acid-Test Ratio
Acid-test Ratio =Quick Assets
Current Liabilities
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Example 1: Acid-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 : 10.5 : 1
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Supplementary Ratios forLiquidity
Inventory TurnoverRatio
Debtors Turnover Ratio
Creditors 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 openingand closing inventory.
The ratio indicates how fast inventory is sold. A high ratio is goodfrom the viewpoint of liquidity and vice versa. A low ratiowould 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: 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 yearwas Rs 35,000 and Rs 45,000 respectively. What is the
inventory turnover ratio?
Inventoryturnover ratio
=(Rs 3,00,000 Rs 60,000)
=6 (timesper year)(Rs 35,000 + Rs 45,000) 2
Inventoryholding period
=12 months
= 2 monthsInventory turnover ratio, (6)
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Debtors Turnover Ratio
Net credit sales consist of gross credit sales minusreturns, if any, from customers.
Average debtors is the simple average of debtors (includingbills receivable) at the beginning and at the end of year.
The ratio measures how rapidly receivables are collected. A highratio is indicative of shorter time-lag between credit sales and
cash collection. A low ratio shows that debts are notbeing 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.
Debtorsturnover ratio
=Rs 2,40,000
=8 (timesper year)(Rs 27,500 + Rs 32,500) 2
Debtorscollection period
=12 Months
=1.5
MonthsDebtors turnover ratio, (8)
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Creditors Turnover Ratio
Net credit purchases = Gross credit purchases - Returns tosuppliers.
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 bysuppliers, while a high ratio shows that accounts are to be settledrapidly. The creditors turnover ratio is an important tool ofanalysis as a firm can reduce its requirement of current assets by
relying on suppliers credit.
Creditors turnoverratio
=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.
Creditorsturnover ratio
=(Rs 1,80,000)
=4 (timesper year)(Rs 42,500 Rs 47,500) 2
Creditors
payment period=
12 months= 3 months
Creditors 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: Debtors collection period
Less: Creditors payment period
2 months
+ 1.5 months
3 months0.5 months
As a rule, the shorter is the cash cycle, the better are the liquidityratios 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 quickassets 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 thedefensive-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 afirm by comparing actual cash flows from operations
(in lieu of current and potential cash inflows fromcurrent 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 Ratio
Capital structure or leverage ratios throw light on thelong-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 ratio
Debt-equity ratio measures the ratio of long-
term or total de3bt to shareholders equityDebt-equity ratio =Total Debt
Shareholders equity
Long-term Debt + Shortterm debt + Other CurrentLiabilities = 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 lessburdensome and consequently its credit standingis not adversely affected, its operational flexibility
is not jeopardised and it will be able toraise additional funds.
The disadvantage of low debt-equity ratio is thatthe shareholders of the firm are deprived
of the benefits of trading on equity
or leverage.
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Trading on Equity
Trading on Equity (Amount in Rs thousand)
Particular A B C D
(a) Total assets 1,000 1,000 1,000 1,000Financing 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 120Earnings 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 inexpectation of higher return to equity-holders.
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II. Debt to Total Capital
The relationship between creditors funds and
owners 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 ratio
Debt to total assets ratio =Total debt
Total assets
Proprietary ratio indicates the extent to which assetsare financed by owners funds.
Proprietary ratio =Proprietary funds
Total assetsX 100
Capital gearing ratio is used to know the relationship between equityfunds (net worth) and fixed income bearing funds (Preference
shares, debentures and other borrowed funds.
Proprietary Ratio
Capital Gearing Ratio
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Coverage Ratio
Interest Coverage Ratio measures the firms 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 firms ability to pay dividendon 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 firms ability to meet all fixed
payment obligations.
Total fixed chargecoverage 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 majorlimitation, that is, they relate the firms ability to meet its various
financial obligations to its earnings. Accordingly, it would bemore appropriate to relate cash resources of a firm to its
various fixed financial obligations.
Total Cashflow Coverage Ratio
Total cashflowcoverage 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 Ratio
Debt-service coverage ratio (DSCR) is considered a morecomprehensive 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 thecontractual 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 arerequired to work out yearly debt service coverage ratio (DSCR)
and the average DSCR.
(Figures in Rs lakh)
Year Net profit for theyear
Interest on term loan
during the year
Repayment of term
loan in the year
12
3
4
5
6
7
8
21.6734.77
36.01
19.20
18.61
18.40
18.33
16.41
19.1417.64
15.12
12.60
10.08
7.56
5.04
Nil
10.7018.00
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 lakhevery year.
Example 6: Debt-Service Coverage Ratio
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SolutionTable 3: Determination of Debt Service Coverage Ratio
(Amount in lakh of rupees)
Year
Netprofit
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 Ratio
Profitability ratios can be computed either fromsales or investment.
Profitability RatiosRelated to Sales
Profitability RatiosRelated to Investments
(i) Profit Margin
(ii) Expenses Ratio
(i) Return on Investments
(ii) Return on Shareholders
Equity
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Profit Margin
Gross profit margin measures the percentage of each salesrupee 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 interestand 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 profitmargin.
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 Ratio
i. Cost of goods sold =Cost of goods sold
Net sales X 100
ii. Operating expenses =Administrative exp. + Selling exp.
Net salesX 100
iii. Administrative expenses = Administrative expensesNet sales
X 100
iv. Selling expenses ratio =Selling expenses
Net salesX 100
v. Operating ratio = Cost of goods sold + Operating expensesNet sales
X 100
vi. Financial expenses =Financial expenses
Net salesX 100
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Return on Investment
Return on Investments measures the overall effectivenessof 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 Equity
Return on total shareholders equity =Net profit after taxes
Average total shareholders equityX 100
Return on ordinary shareholders equity (Net worth) =
Net profit after taxes Preference dividend
Average ordinary shareholders equityX 100
Return on shareholders equity measures the return on theowners (both preference and equity shareholders )
investment in the firm.
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Efficiency Ratio
Activity ratios measure the speed with which variousaccounts/assets are converted into sales or cash.
i. Inventory Turnover measures the activity/liquidity ofinventory of a firm; the speed with which inventory is soldInventory Turnover Ratio =
Cost of goods sold
Average inventory
i. Inventory Turnover measures the activity/liquidity ofinventory 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 ofinventory 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 firms receivables can be examinedin two ways.
i. Inventory Turnover measures the activity/liquidity of inventory ofa firm; the speed with which inventory is soldi. Debtors turnover =
Credit sales
Average 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 identifyslow paying debtors.
Debtors Turnover Ratio
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Assets Turnover Ratio
i. Inventory Turnover measures the activity/liquidity of inventory ofa 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 ofa firm; the speed with which inventory is soldiii. Capital turnover =
Cost of goods sold
Average capital employed
iv. Current assets turnover = Cost of goods soldAverage current assets
i. Inventory Turnover measures the activity/liquidity of inventory ofa firm; the speed with which inventory is soldv. Working capital turnover =
Cost of goods sold
Net working capital
Assets turnover indicates the efficiency with which firmuses 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 Ratio
Integrated ratios provide better insight about financial andeconomic 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)
R t f R t A t
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Rate of Return on Assets
EAT as percentage ofsales
Assetsturnover
EAT SalesDivided by Sales Total AssetsDivided by
Current assetsFixed assetsGross profit = Sales less
cost of goods sold
Minus
Expenses: SellingAdministrative Interest
Minus
Income-tax
Shareholder equity
Plus
Long-term borrowedfunds
Plus
Current liabilities
Plus
Alternatively
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Return on Assets
Earning Power
Earning power is the overall profitability of a firm; is computedby 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 ofa 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 assetsamounting 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 assets4. 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
4,00,00010
1
10
Rs 40,00,000
40,000
4,00,0001
10
10
Firm A has sales of Rs 4,00,000, whereas the sales of firm B aggregateRs 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)
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 toconsider the effect of interest and tax payments.
As a result of three sub-parts of net profit ratio, the ROEis composed of the following 5 components.
i. Inventory Turnover measures the activity/liquidity ofinventory of a firm; the speed with which inventory is sold
EAT
Earnings before taxes
EBT
EBIT
EBIT
Sales
Net Profit
Salesxx =
EAT
EBT
EBT
EBIT
EBIT
Sales
Sales
Assets
Assets
Equityx 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 interestpayments and tax payments separately from operating profitability. To illustrate further assume 8per cent interest rate, 35 per cent tax rate and other operating expense of Rs 3,22,462 (Firm A) andRs 39,26,462 (Firm B) for the facts contained in Example 8. Table 5 shows the ROE (based on the 5components) 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
-
8/2/2019 Ch_6 Ratio Analysis
50/50
Common Size Statements
Preparation of common-size financial statements is an extensionof ratio analysis. These statements convert absolute sums intomore easily understood percentages of some base amount. It issales 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 beconsidered only as a tool for analysis rather than as an end in
itself. The reliability and significance attached to ratios will largelyhinge upon the quality of data on which they are based. They areas good or as bad as the data itself. Nevertheless, they are animportant tool of financial analysis.
Limitations