Tata McGraw-Hill Publishing Company Limited, Management Accounting

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Financial 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 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 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 firms
performance 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
Integrated
Analysis Ratios
Growth 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 Capital
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Liquidity ratios measure the ability
of 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 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 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 : 1
0.5 : 1
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Supplementary Ratios for
Liquidity
Inventory Turnover
Ratio
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 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: 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 months
Inventory 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
Months
Debtors turnover ratio, (8)
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Creditors 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 suppliers 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
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 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 500
365
Defensive-interval ratio =
Rs 40,000
= 80 days
Rs 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 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 ratio
Debt-equity ratio measures the ratio of long-
term or total de3bt to shareholders equity
Debt-equity ratio =
Total Debt
Shareholders 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 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 300 270 240 180
Less: Taxes (0.35) 105 94.5 84 63
Earnings after taxes 195 175.5 156 117
Return 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 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 assets
are financed by owners funds.
Proprietary ratio =
Proprietary funds
Total assets
X 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 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 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 firms 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 firms 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 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
=
Instalment
t


n
t=1
EAT
t
OA
t

+ +

n
t=1
Depreciation
t

+
Interest
t

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 Ratio
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Solution
Table 3: Determination of Debt Service Coverage Ratio
(Amount in lakh of rupees)
Ye
ar
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 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 Margin
Gross profit margin measures the percentage of each sales
rupee remaining after the firm has paid for its goods.
Gross profit margin =
Gross Profit
Sales
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 cent
Rs 2,00,000
(2) Net profit margin =
Rs 50,000
= 25 per cent
Rs 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 sales
X 100
iii. Administrative expenses =
Administrative expenses
Net sales
X 100
iv. Selling expenses ratio =
Selling expenses
Net sales
X 100
v. Operating ratio =
Cost of goods sold + Operating expenses
Net sales
X 100
vi. Financial expenses =
Financial expenses
Net sales
X 100
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Return 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 Equity
Return on total shareholders equity =
Net profit after taxes
Average total shareholders equity
X 100
Return on ordinary shareholders equity (Net worth) =
Net profit after taxes Preference dividend
Average 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 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 sold
Inventory Turnover Ratio =
Cost of goods sold
Average inventory
i. Inventory Turnover measures the activity/liquidity of
inventory of a firm; the speed with which inventory is sold
Raw 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 sold
Work-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 examined
in two ways.
i. Inventory Turnover measures the activity/liquidity of inventory of
a firm; the speed with which inventory is sold
i. 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 identify
slow paying debtors.
Debtors Turnover Ratio
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Assets Turnover Ratio
i. Inventory Turnover measures the activity/liquidity of inventory of
a firm; the speed with which inventory is sold
i. 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 sold
iii. Capital turnover =
Cost of goods sold
Average 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 sold
v. Working capital turnover =
Cost of goods sold
Net 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 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 Sales Divided by Sales Total Assets Divided by
Current assets Fixed assets
Gross 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 Assets
Earning Power
Earning power is the overall profitability of a firm; is computed
by multiplying net profit margin and
assets turnover.
Earning power = Net profit margin Assets turnover
Where, Net profit margin = Earning after taxes/Sales
Asset turnover = Sales/Total assets
i. Inventory Turnover measures the activity/liquidity of inventory of
a firm; the speed with which inventory is sold
Earning Power =
Earning after taxes
Sales
Sales
Total Assets
EAT
Total assets
x x 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)
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
EAT
Earnings before taxes
EBT
EBIT
EBIT
Sales
Net Profit
Sales
x
x
=
EAT
EBT
EBT
EBIT
EBIT
Sales
Sales
Assets
Assets
Equity
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 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