Session 2 - Ratio Analysis

Financial Statement Analysis

(Ratio Analysis)

Prof. Mishu TripathiFaculty-Finance

Financial Analysis

• Financial analysis is the process of identifying the financial strengths and weaknesses of the firm by establishing relationships between the item of the balance sheet and the profit and loss account.

Financial Analysis • Ratio-analysis is a concept or technique which

is as old as accounting concept. • Financial analysis is a scientific tool. It has been

assumed to be an important tool for appraising the real worth of an enterprise, its performance during a period of time and its pit falls.

• Financial analysis is a vital apparatus for the interpretation of financial statements. It also helps to find out any cross-sectional and time series linkages between various ratios.

Financial Analysis• Unlike in the past when security was considered

to be sufficient consideration for banks and financial institutions to grant loans and advances, nowadays the entire lending is need-based and the emphasis is on the financial viability of a proposal and not only on security alone.

• Further all business decision contains an element of risk. The risk is more in the case of decisions relating to credits.

• Ratio analysis and other quantitative techniques facilitate assessment of this risk.

Ratio Analysis (RA)• Ratio-Analysis is the process of computing,

determining and presenting the relationship of related items/ groups of items of the financial statements.

• RA provide summarized idea about the financial position of a unit. They are important tools for financial analysis.

• RA is used as a decision making tool.

Definition and Uses of Ratio• A ratio can be defined as one number divided

by another. Two numbers when viewed as ratio provide a relationship of one with respect to another.

• Financial ratios is used in 3 ways namely:–As an absolute number–As a historic sequence or time series–As a comparison with the industry or a

benchmark.

Users of Financial Analysis

1. Trade creditors

2. Lenders

3. Investors

4. Management

Importance of Ratio Analysis It is a tool which enables the banker or lender to

arrive at the following factors :• Liquidity position• Profitability• Solvency• Financial Stability• Quality of the Management• Safety & Security of the loans & advances to

be or already been provided

Precaution while using Ratio Analysis

a. The dates and duration of the financial statements being compared should be the same. If not, the effects of seasonality may cause erroneous conclusions to be drawn.

b. The accounts to be compared should have been prepared on the same bases. Different treatment of stocks or depreciations or asset valuations will distort the results.

c. In order to judge the overall performance of the firm a group of ratios, as opposed to just one or two should be used. In order to identify trends at least three years of ratios are normally required.

How a Ratio is Expressed?1. As Percentage-such as 25% or 50% . For

example if net profit is Rs.25,000/- and the sales is Rs.1,00,000/- then the net profit can be said to be 25% of the sales.

2. As Proportion-The above figures may be expressed in terms of the relationship between net profit to sales as 1 : 4.

3. As Pure Number /Times-The same can also be expressed in an alternatively way such as the sale is 4 times of the net profit or profit is 1/4th of the sales.

Types of Financial Ratios

Ratio Analysis

Liquidity Ratios

Leverage Ratios

Asset Management

Ratios

Profitability Ratios

Operating Ratios

Market Based Ratios

Liquidity Ratios• The liquidity ratios measure the liquidity of

the firm and its ability to meet its maturing short term obligations. Liquidity is defined as the ability to realize value in money, the most liquid of assets. It refers to the ability to pay in cash, the obligations that are due.

• The corporate liquidity has two dimensions – Quantitative Concept– Qualitative Concept

Quantitative and Qualitative Concept

• Quantitative aspect includes the quantum, structure and utilization of liquid assets while in the qualitative aspect it is the ability to meet all present and potential demands on cash from any source in a manner that minimizes cost and maximizes the value of the firm.

• Corporate liquidity is the vital factor in business.

How liquid the firm should be?• Excess liquidity though the guarantor of

solvency would reflect lower profitability, deterioration in managerial efficiency, increased speculation ,unjustified expansion and extension of too liberal credit and dividend policies.

• Too little liquidity may lead to frustration, business objections, reduced rate of return, missing of profitable business opportunities and weakening of morale.

Types of Liquidity Ratios

Current Ratio

Quick Ratio/Acid Test Ratio

Cash Ratio

Current Ratio• Current ratio is defined as the ratio of current

assets to current liabilities.• Current assets would include debtors, inventories

and cash while current liabilities would include payment due to suppliers of materials and services, provisions, and installments of loans falling in next 12 months.

• Depending upon the need, some analysts especially bankers are inclined to include bank borrowings, normally forming part of secured loans, for working capital in the current liabilities.

Importance of Current Ratio

• A current ratio of more than 1 indicates the excess of current assets over current liabilities and the firm is said to be liquid.

• Higher the current ratio the better is the firm from the lenders perspective. But the firm has to be cautions of a very high current ratio as it affects the profitability adversely.

Determinants of Current Ratio

• Inventory holding period• Amount and days of credit provided to the

customers • Amount and days of credit availed from

suppliers • A firm keeping inventory and availing credit

as per the requirements of the industry must exhibit the current ratio consistent with what is prevalent in the industry.

Acid Test Ratio• Acid Test Ratio is a more stringent measure of

liquidity than the current ratio. • It is the ratio of all the current assets excluding

inventory to the current liabilities.• It is also referred to as quick ratio.• Why inventory is excluded from current

assets?? – It is the slowest moving component of current

asset.

Acid Test Ratio• It is calculated as:• Acid Test or Quick Ratio =(Current Assets-

Inventory)/Current Liabilities• Quick ratio indicates the extent to which a firm

is able to meets its current liabilities at a very short notice.

• Generally a quick ratio in excess of 1.00 is regarded as satisfactory

Cash Ratio• Cash Ratio is the most stringent measure of

firm’s liquidity. It denotes the extend to which cash and near cash marketable securities are sufficient to meet the current liabilities.

• It is calculated as:

Cash Ratio= Cash + Marketable Securities/Current Liabilities

Significance of Cash Ratio• Measurement of firm liquidity through cash ratio

seems to be more of academic interest rather than of practical significance as firms flush with cash only invest in financial security to earn some income, and the liquidity is measured from current ratio or quick ratio.

• Large values of cash is a indicator of profitability of the firm rather than its liquidity.

• It implies that the firm has paid of creditors before investing surplus in the marketable securities.

• It also indicates the poor utilization of funds as idle cash translates into high opportunity cost.

Types of Capital Structure Ratios

Leverage Ratio

• Debt Equity Ratio

Debt Coverage Ratios

• Interest Cover

• Fixed Charge/Debt Service Coverage Ratio

Capital Structure Ratios

• Capital Structure Ratios measure the relationship between owners funds and borrowed funds.

• A high usage of borrowed funds bring down the cost of financing but makes the firm more risky.

Capital Structure Ratios

• Debt equity ratio, debt to asset ratio, total outside liabilities to net worth, total outside liabilities to assets, debt coverage ratio, interest coverage ratio and the debt service coverage ratio are the most prominent measure of capital structure.

Debt Equity Ratio• The debt equity ratio is defined as amount of

long term debt divided by the amount of shareholder’s funds.

• The current ratio is more meaningful for short-term creditors of the firm, who are concerned about cash generation in immediate future, the long term creditors prepared to look farther into the future are more concerned about debt equity ratio.

Significance of Debt Equity Ratio

• The lower the value the better is the debt equity ratio

• The increasing amount of debt, as reflected in higher debt ratios, the firm is considered more vulnerable to external stocks and its operations are deemed risky.

• The low values of debt ratios imply foregoing the advantage of debt. Since debt is the cheapest source of funds than equity, its use enhances shareholders’ earnings

Significance of Debt Equity Ratio

• Higher value of debt ratio is disliked by one and all because:– Increased debt makes the firm more vulnerable to

economic or business cycles.– Debt always carries with it a fixed interest burden

that remains insensitive to the declining revenues under unfavorable economic conditions.

– The high debt firm is considered to be more risky in its operations

Examples of Debt Equity Ratio

• Capital Intensive Industries such as cement, steel, and infrastructure would have higher debt ratio as compared to industries such as software development, consumer goods etc.

• Role of banks and Financial institutions in debt equity ratio??–More debt is provided to capital intensive

industries because they have large base of fixed assets

Debt Coverage Ratios

• Debt coverage ratios are the measure of the firm’s capacity to service its debt obligations. Higher the coverage safer is the firm from the lenders perspective.

• It includes:– Interest cover Ratio– Fixed Charge Coverage Ratio

Interest Cover Ratio

• It indicates the extend to which profits (PBIT) are sufficient to pay the existing interest obligations.

• Higher the ratio more is the cushion available to lenders.

Interest Cover Ratio (Cash Basis)

• PBIT as stated in the Profit & Loss Account includes many items such as depreciation, amortization, write offs etc, which do not reflect cash flows, interest cover can be calculated on the basis of cash available for payment of interest.

• Formulae: • Interest Cover (on cash basis)= PBIT +

Depreciation + Non cash expense – non cash income/ Interest Obligation

Fixed Charge/Debt Service Coverage Ratio

• It measures the ability of the firm to meet its total debt obligations (both interest and principal)

• Formula for calculating DSCR: PBIT + Depreciation + Non cash expense – non cash income/ (Interest Obligation + Loan Installment/ (1-Tax Rate))

Fixed Charge/Debt Service Coverage Ratio

• The numerator represents the cash available to the firm before taxes. The denominator includes interest obligation and installment for the loan repayable. Since taxes have to be paid before loan installment and the numerator is pre-tax earning, the loan installment must be modified to pre-tax basis by dividing the amount by the factor of (1-tax rate)

Working Capital Ratios

Current Asset

Turnover

Inventory Turnover

Ratio

Debtors Turnover

Ratio

Working Capital Ratios

• It denotes the efficiency of firms in handling its operations. More quickly a firm turns over the different current assets eventually into cash, more efficient is the firm.

Current Asset Turnover

• It indicates how many times the current assets have been turned over into sales in a given period (usually a year)

• An increasing ratio is a sign of improving efficiency

• Formula:• Sales/ Average Current Assets

Current Assets Holding Period

• Formula• Average Current Assets/Sales*365 days• Expressing current assets as holding period in

number of days provides an estimate about the length of the firm’s working cycle.

• There is an inverse relationship between current assets turnover and the holding period.

Significance of Current Assets Holding Period

• A higher turnover ratio or shorter current assets holding period denotes better utilization of funds deployed in current assets

• With smaller holding period- lower level of funds in current assets- it is implied that the firm can achieve larger sales with smaller capital, and exhibits better profitability to the extent of savings made in the cost of funds.

Net Current Assets Turnover

• It expresses the relationship between the sales and long-term financed component of current assets.

• A very high ratio for a given current assets turnover indicates low current ratio, i.e. poor liquidity.

• Formula for calculating is:• Sales/Average Net Current Assets

Significance of Net Current Assets Turnover

• It is higher than the gross current assets turnover.

• The minimum value could be equal to current assets turnover where the firms avail no credit.

• A very high net current assets turnover ratio as compared to current assets turnover ratio signals poor liquidity and/or unsatisfactory capital structure.

Significance of Net Current Assets Turnover

• Net current assets ratio close to zero would give inordinately high returns for the net working capital but it also implies rather lower net working capital than desired.

• Ideally, net current asset ratio should be 4 times of gross current asset ratio.

• Ideally both gross and net ratio is not an aggregate measure of efficiency of working capital. It does not tell us which part of working capital the efficiency or inefficiency comes from.

Inventory Turnover Ratios• Inventory component in the current assets is

farthest from cash and deserves attention.• It expresses the relationship between cost of

goods sold and inventory• It denotes the efficiency in inventory

management. An increasing ratio signifies better inventory management.

• Formula: • Cost of Goods Sold (COGS)/Average

Inventory

Inventory Turnover Ratios

• There are three components of inventory turnover ratio:– Raw-Material Turnover Ratio (Raw Material

Consumption/Average Raw Material Inventory)–W.I.P. Turnover Ratio (Cost of Production/

Average WIP Inventory)– Finished Goods Turnover Ratio (Cost of Sales/

Average Finished Goods Inventory)

Inventory-Holding Period

• It denotes the shelf life of inventory. • It shares the inverse relationship with

inventory turnover ratio.• Formula• Average Inventory/Cost of Goods Sold

(COGS)*365 days.

Reason of using sales as numerator??

1. Uniformity of Interpretation

2. Non-availability of relevant figures of raw material consumption, cost of production and cost of sales in publicly available financial statements

3. As a matter of convenience

Uses of Inventory Turnover Ratios or Holding Periods

1. Measurement tools for determining the efficiency of inventory management, and the trend over successive periods

2. Diagnostic tools to find weak areas such as accumulation of non-moving or slow moving stocks

3. Norm-setting tools for developing guidelines for financing

4. Comparative tools for accessing relative performance of a firm with respect to its competitors, industry and against a benchmark.

Debtors Turnover Ratio• It expresses the relationship between sales and

debtors. • It reflects the efficiency with which the

debtors are turned over into cash• Improvement in the ratio indicates better

receivables management.

Debtors Turnover Ratio

• Debtors Turnover Ratio=Sales/Average Debtors

• Average Collection Period= Average Debtors/Sales*365 days

• Increasing debtors turnover brings down collection period and hence reduces the blockage of fund sin receivables.

Uses of Debtors Turnover Ratio

• It is a measurement tool to know the speed of collection and efficiency of collection department

• It is a comparative tool to assess the collection policy with respect to competitors and industry

• A norm-setting tool to formulate guidelines for financing by banks and financial institutions collection and credit policy on sales, volume and profit.

Ageing of Debtors

Uses of Debtors Turnover Ratio

• A predictive tool for understanding the level of competition and likely changes in the profitability. Normally increasing credit implies hotter competition and declining profitability

• A analytical tool for cost volume profit planning by ascertaining the impact of changes in the collection and credit policy on sales, volume and profit.

• It is a policy determinant for deciding the cash discount incorporating the cost of capital of the firm

Ageing of Debtors

• Debtors’ ageing schedule categorizes the debtors as per the period for which they have been outstanding.

• It is the device for monitoring of receivables and helps in identifying the potential defaulters and the corresponding risk.

Creditors’ Turnover Ratio• It reflects the number of times average dues to

the suppliers is settled.• Higher the turnover, lower the payment period

offered by the suppliers• Creditors Turnover Ratio= Purchases/Average

Creditors• Average Credit Availed= Average

Creditors/Purchases*365 days

Uses Creditors’ Turnover Ratio

• It is better for the firm if it has low creditors turnover or large credit period availed from the creditors. Since higher credit from suppliers means deferment of cash, it provided more leeway to the firm in managing the cash resource.

• For effective working capital management, both current assets and current liabilities should be managed independent to each other.

Use of Average Figures• In case of working capital ratios, average of

the opening and closing values of stock, debtors, creditors and stock is used because the corresponding figure relates to the period rather than one point of time.

• It is to smoothen out the changes over the period of time

• In case of high-growth firms use of average figures rather than end-of-the-period values would lead to more sound conclusions


• Profitability ratios refer to those financial metrics that are used to assess a business’s ability to generate earnings.

• A higher profitability ratio relative to a competitor's ratio or the same ratio from a previous period is indicative of better performance.


Value Addition

Contribu-tion

Margin

Gross Profit

Margin

Net Profit MarginReturn on

Capital Employed (ROCE)

Return on Equity

Earning Per Share

(EPS)

Dividend Per Share

(DPS)

Value Addition• Value addition is the enhancement made to the

value of a product or service before offering the same to customers.

• Higher the value added as a percentage of sales, better is the bottom-line for the firm.

• Value Addition= Sales-Purchases• Value Addition in %=( Sales-

Purchases)Sales*100

Uses of Value Addition• Increasing value addition in absolute terms

without the increase in value addition ratio implies increasing volumes and market share but stagnation in the area of product development

• If value addition ratio is increasing without the increase in value addition ratio in absolute terms it would imply creativity, product innovation etc on part of the firm.

Contribution Margin• The margin available once the variable costs

have been covered before is known as contribution margin.

• The margin goes to meet the fixed costs.• A larger contribution margin is desirable.• Contribution =Sales-Variable Cost• Contribution in % = (Sales-Variable

Cost)*Sales

Gross Profit Margin• Gross profit margin is defined as excess of

sales over cost of goods sold. • While computing Gross Profit Margin the

following must be kept in mind:– Depreciation is to be included in cost of

production– Selling, general and administrative overheads must

be excluded from the cost and– Non-operational income must be excluded from

the revenue

Gross Profit Margin

• Gross Profit Margin is the excess of total sales revenue over its cost of goods sold.

• It reflects production efficiency.• Higher the gross margin, more is the cushion

available to meet its overheads.• Formula• Gross Profit Margin= Sales-Cost of Goods

Sold (COGS)/ Sales and EBIT/Sales*100

Gross Profit Margin

• Gross Margin in absolute terms represents the amount of money the company generated over the cost of producing its goods and services.

• In relation to sales, it reflects the proportion of sales revenue that the company generates as gross profit to be put towards paying off general and administrative expenses and ultimately banked as net income.

Precautions while calculating Gross Profit Margin

1. Depreciation to be included in the cost of production

2. Selling, general and distribution overheads must be excluded from the cost and

3. Non-operational income must be excluded from the revenue.

Significance of Gross Profit Margin

• Good Gross Profit margin reflects the ability of the firm to meet production expenses while EBIT based profitability reflects the ability to recover all expenses of procurement, production and sales. Financial expenses, which depend upon the capital structure are excluded

• The comparison of EBIT based profit of various firm excludes the leverage employed in financing by the enterprise

Significance of Gross Profit Margin

• Poor profit indicates any one of the following:

1. Inability of the firm to procure inputs at competitive prices

2. Selling finished product at lower prices

3. Excessive overheads

4. High capital investment resulting in higher utilization or;

5. Poor utilization of production capacity

Net Profit Margin

• Net profit often referred to as “the bottom line” is arrived by taking revenues and adjusting them for the cost of doing business, depreciation, interest, taxes and other expenses

• Net Margin as a percentage of sale reflects the overall profitability of the business.

• Formula: • PAT/Sales*100

Significance of Net Profit Margin

• It measures the efficiency of the firm in managing production, procurement, sales, financing and tax planning

Return on Capital Employed (ROCE)• Return on capital employed (ROCE) provides a

measure of efficiency of capital. It is also known as return on investment.

• How efficient the firm has been in using the capital at its disposal is reflected by its ROCE.

• Profit after tax (PAT) is a commonly used measure of return, which is erroneous because PAT is the residual available to shareholders while the capital in the firm comes from two sources— equity and debt.

• Therefore, appropriately ROCE is defined as: Return on Capital Employed (ROCE) =

• EBIT(I — T)/Net Assets x 100%

Return on Capital Employed (ROCE)

• The denominator is equal to net assets since investment must equal assets. Net assets would represent capital from all sources-equity and both long-term and short-term debt. Since earnings are made over a period, it is desirable to smoothen the end-of-the-period values by taking the average of the opening and closing net assets. This would be particularly required if substantial changes have taken in the net assets/capital during the period under review.

Return on Capital Employed (ROCE)

• The total capital employed includes both debt and equity, the return is taken as EBIT (1-Tax) and not PAT. EBIT (1-Tax) can be alternatively expressed as (PAT +Interest) with PAT belonging to equity shareholders and interest to lenders.

• Most analysts prefer to measure earning power of the firm by earnings before interest, taxes and depreciation and amortization (EBITDA) and replace the numerator accordingly to arrive at ROCE.

Significance of Return on Capital Employed (ROCE)

• ROCE reflects the post-tax earning power of the firm. It facilitates comparison with the cost of capital of the firm.

• If ROCE is greater than the weighted average cost of capital, the firm can be classified as efficient.

• ROCE of the firm can also be compared with the competing firms in the industry to establish classification of relatively efficient and inefficient firms.

Return on Equity (ROE)• ROE is the return that the firm generates on the funds

provided by equity shareholders.• The overall efficiency of capital or investment is

assessed from ROCE, the main concern for the equity shareholders is the return they get on the part of the capital supplied by them, i.e., net worth.

• Return on equity (ROE) measures the efficiency of a firm in managing its shareholders’ funds. Since profit after tax (PAT) goes to the equity shareholders, ROE is defined as-

• Return on Equity (ROE) =Profit After Tax (PAT)/Net Worth*100

Return on Equity (ROE)• If change in net worth during the period is

large, it is advisable to use average of beginning and end of the period values of net worth in the denominator.

• Net worth would include the capital contributed directly by shareholders and the accumulated undistributed profit of the firm.

Significance of Return on Equity (ROE)

• ROE is not only important for owners of the firm but also to the managers as they have the responsibility towards the shareholders on whose behalf they manage the firm.

• ROE is affected by several factors such as capital structure, tax rates, efficiency of assets, cost of debt, etc.

• Increasing ROE denotes improving efficiency of the firm in handling its shareholders’ funds.

Earning Per Share (EPS) and Dividend Per Share (DPS)

• EPS is the return (profit) earned on a per share basis. It is one of the prominent measures of financial performance.

• The part of EPS that the firm proposes to distribute to the shareholders is known as dividend per share(DPS).

Earning Per Share (EPS)• Earning per share (EPS) is an alternative

representation of ROE. • It is not a ratio but an absolute figure stating

the amount of profit earned on per share basis.• It is calculated as: PAT/Number of shares

outstanding• While ROE measures the earnings for

shareholders is known the shareholders on the funds provided by them, EPS measures the profit that accrues on each share

Earning Per Share (EPS)• ROE signifies current return on original capital

subscribed as well as the accumulated undistributed profits in the past. EPS is not concerned with the past profit retained on behalf of and belonging to the shareholders, but instead considers only the original amount of capital contributed as reflected in the number of shares and the earnings for the period under consideration.

• Since net worth is the fund contributed by shareholders as a group, the individual investor is required to work around on ROE to determine how much belongs to him/ her.

Dividend Per Share (DPS)• The total earnings made by the firm, the management, in

the interest of the shareholders, may decide to distribute only a part of it while retaining some to be deployed in the business to provide growth in earnings in future.

• Dividend per share (DPS) provides the amount of money that the shareholders receive out of his/her entitled earnings.

• It is calculated as: Dividend / Number of shares outstanding

• Both EPS and DPS are of interest to the market as they are considered to be most important determinants of the price of the share.

Valuation Ratios

• Valuation ratios judge the value the stock market places on any given company. If the liquidity, profitability, capital structure, and working capital ratios look good, then the market value ratios will be high.

• The prominent valuation ratios are: earnings. and dividends yield, price earnings and price to book ratios

Valuation Ratios

Market Value to

Book Value Ratio

Price-Earnings

Ratio

Earnings Yield & Dividend Yield

Earnings Yield and Dividend Yield

• Due to the difference of scale, absolute earnings and dividends may be of little relevance while comparing different firms. Hence, they are better expressed as a percentage of market price. This is known as yield.

• It should be noted that earnings and dividend yields keep changing since the market price changes on continuous basis.

Earnings Yield and Dividend Yield

• Formula for calculating Yields:• Earning Yield: EPS/Market Price*100• Dividend Yield: DPS/ Market Price*100

Price-Earning Ratio (P/E Ratio)

• The price earnings ratio commonly referred to as P/E multiple in the financial markets is the inverse of earning yield and is calculated as Market price/EPS.

• The price earnings ratio shows how much the investors are willing to pay per rupee of reported profits. It reflects the confidence that the market reposes in a given firm/scrip.

Significance of Price-Earning Ratio (P/E Ratio)

1. It serves as a measure of faith the investors and financial market pose in the firm and its management

2. It also reflects the confidence the financial markets have in the continued ability of the management and the firm to perform in future.

3. A higher P/E multiple reflects higher level of confidence in the overall functioning of the firm in terms of growth and stability of earnings. It also encompasses factors such as leverage, asset utilization and future business prospects.

Significance of Price-Earning Ratio (P/E Ratio)

• It is taken as a summary measure of performance of the firm as market determines the price of the share factoring in the complex relationship of all the variables of performance measure.

• The markets are supposed to be operating on expected future performance rather than current performance, the P/E multiple is often calculated using expected earnings instead of current earnings

• It is taken as a benchmark of corporate image and projects the future market price for the firm.

Market Value to Book Value Ratio

• The ratio of market price to its book value also reflects the perception of investors towards the stock. Firms with relatively higher returns on equity generally sell at higher multiples of book value as compared to the ones with low returns.

• The formula for calculating book value of the share (Rs/share) is: Net Worth/ Number of shares

• Price to Book Value Ratio: Market Price/ Book Value

Market Value to Book Value Ratio

• Book value of shares would indicate the extend to which the profit shave been retained in the business on a per share basis.

• Comparing book value to market value gives an indication of the firm’s growth potential as perceived by the market.

• If the market value is in excess of book value, if market to book value >1 it indicates a positive outlook of the market in the retention of the funds by the firm.

INTERLINKING THE RATIOS: DuPont ANALYSIS

• Introduced and used by DuPont Co. of USA, the DuPont analysis establishes relationship of few ratios.

• Return on assets (ROA) is the product of net profit margin and assets turnover can be seen from the following formula:

• ROA=PAT/Total Assets • (Net profit After Tax/Sales)* (Sales/ Total Assets)• Net profit margin*Asset Turnover

INTERLINKING THE RATIOS: DuPont ANALYSIS • The return on capital is a function of margin on sales and

the speed of the utilization of the assets. It is a product of profitability and operating efficiency of the firm.

• Firm ‘A’ having net profit margin of 10% and sales to asset turnover of 3 would have a return on capital employed of 30%.

• Firm ‘B’ too can have same return on capital employed of 30% by having a net profit margin of 7.5% and asset turnover of 4.

• Two firms can achieve identical return on total assets by different strategies. One may have greater profit margin and lower turnover of assets, while the other may decide to compensate lower profit margin by increased turnover of assets.


• For a firm that is 100% equity financed, return on equity (ROE) would be same as return on assets (ROA). If a part of equity is replaced by debt, and making assumption that the (ROA) exceeds cost of debt, the return on equity would increase.


• ROE=(PAT/Net Worth)=(PAT/Assets)*(Assets/Net worth)

• (PAT/Assets) *(Loans + Net Worth)/Net Worth)• ROA * (1+Debt/Equity)• Net Profit Margin * Asset Turnover *

(1+Debt/Equity)• Operating Margin*Operating

Efficiency*Financial Leverage


• ROE is said to be product of operating margin, operating efficiency, and the financial leverage. Improved margin, higher efficiency, and increased debt would lead to higher return on equity.

• Dividing ROE into its components helps diagnose the problem in case the ratio is found to be inadequate or does not meet expectations of the shareholders.

• It provides a convenient and systematic way for the management to address the weak areas and formulate strategies to enhance the return to shareholders.


• Return on Equity (ROE) = Net Profit Margin x

Asset Turnover x (1 + Debt/Equity)

• Net Profit/ Sales* Assets/ Sales * Assets /Equity

• Operating Margin x Operating Efficiency x

Financial Leverage

In case ROE of 36.25% does not meet the

benchmark of the industry or expectations of the

investors, a further inquiry would be required as

to what causes it to be low.


• Many options are available to improve upon the ROE while operating margin, operating efficiency, and financial leverage are subjects corresponding to marketing, production, and finance function respectively.

• Depending upon the feasibility and scope available, the management may adopt a suitable strategy to reward the shareholders.

Documents

Session 2 - Ratio Analysis