Module 8 - Handout

Assessing Business Performance through

Analysing Financial Statements

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In this module, you learn

• Analysing the financial statements using

• Common size analysis or Percentage analysis

• Trend analysis

• Ratio analysis
Financial Statements

Balance Summarises the

financial position
Reports the
assets, liabilities
Sheet of the business and equity

Statement Summarises the Reports the the

income and profit or loss
of Profit and expenses of the earned by the
Loss business business

Reports the cash

Cash Flow Summarises the
cash transactions flow operating,
Statement of the business investing and
financing activities
Common Size Analysis

• Represents the financial statements items with

respect to a common base

• Enables comparing companies irrespective of size

• Explains the composition of assets and liabilities

 Common Size Analysis

Common Size Balance Sheet Common Size Profit and Loss

Account

Considers total assets as 100 Considers total income as 100

and expresses all other values and expresses all other values
of balance sheet as a of income statement as a
percentage of total assets percentage of total income
 Asian Paints Ltd
Common Size Balance Sheet
31.03.2020 31.03.2019
(%) (%)
FUNDS EMPLOYED
Shareholders' funds 69.57 64.63
Non-current liabilities 6.91 7.30
Current liabilities 23.51 28.07
Total 100.00 100.00

APPLICATION OF FUND
Fixed assets 37.30 39.47
Non-current investments 18.09 14.90
Long-term loans and advances 1.73 1.40
Current assets, loans and advances 42.88 44.24
Total 100.00 100.00
Asian Paints Ltd. For the year ended
Common Size Profit and Loss Account
March 2020 March 2019
INCOME
Sales and operating income (Net of discounts) 97.96 98.29
Other income 2.04 1.71
Total income 100.00 100.00
EXPENDITURE
Materials consumed 54.16 56.43
Employees' remuneration and benefits 5.61 5.40
Other Expenses 16.21 15.45
Less: Interest 0.45 0.47
Less: Depreciation 3.93 3.24
Profit before tax 19.63 19.01
Less: Exceptional items 0.19 0.00
Less: Tax expense 4.32 6.22
Profit after tax 15.12 12.79
Trend Analysis

• Analyses the pattern of the financial statements

numbers with respect to a base year

• Helps in assessing the performance or growth over a period

 Asian Paints Ltd: Trend Analysis of Balance Sheet
(Capital)
Sources of Funds 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

Share Capital 100 100 100 100 100 100 100 100 100 100
Reserves (Other
100 127 156 187 220 310 372 410 466 498
Equity)
Borrowings 100 227 73 65 54 49 53 15 21 25

Trade Payables 100 118 130 161 141 143 179 199 221 189

Other liability items 100 119 155 180 193 164 178 220 247 269

Total Liabilities 100 124 146 174 189 226 269 301 355 352
Asian Paints: Trend Analysis of Profit and Loss Account
2011 2012 2013 2014 2015 2016 2017 2018 2019 2020
Sales 100 126 141 164 184 196 209 234 271 284
Expenses 100 128 143 167 187 193 204 230 264 273

Operating Profit 100 117 134 153 172 209 231 253 303 332
Other Income 100 188 168 232 268 332 400 367 380 447
Interest 100 194 213 181 194 169 138 150 506 488
Depreciation 100 105 135 226 237 250 314 331 576 734

Profit before tax 100 121 135 152 172 214 237 255 283 304
Tax 100 117 134 154 175 225 246 280 299 219
Net Profit 100 124 135 151 171 209 233 245 275 342
EPS in Rs 100 124 136 151 171 209 232 244 275 342
Ratio Analysis

• Analyses one item with respect to another item of

financial statements

• States the relationship between the numerator and

denominator and reflects the efficiency of the
concerned parameter

• Example: Return on Total Assets (ROTA)

 Return on Total Assets

Profit Before Interest and Taxes

Return on Total Assets =
Total Assets
 Balance Sheet Year 1 Year 2 Profit & Loss Account Year 1 Year 2
Equity 100 100 Sales 180 600
Loan 40 180 Raw Materials 100 300
Payables 10 20 Employee Expenses 40 90
Total 150 300 Other Expeses 15 40
Depreciation 9 21
Fixed Assets 90 210 Total Expenses 164 451
Inventory 20 30 Profit Before Interest & Tax 16 149
Receivables 30 50 Interest 5 20
Cash and Bank 10 10 Profit Before Taxes 11 129
Total 150 300 Tax 2 25
Profit After Tax 9 104

Ratios Year 1 Year 2

Return on Total Assets (ROTA) 10.67% 49.67%

16/150 = 10.67%
 Drivers to
Profitability

Asset Cost Leverage Tax

management management management management
Example: Ratio Analysis -

Balance Sheet Year 1 Year 2 Profit & Loss Account Year 1 Year 2
Equity 100 100 Sales 180 600
Loan 40 180 Raw Materials 100 300
Payables 10 20 Employee Expenses 40 90
Total 150 300 Other Expeses 15 40
Depreciation 9 21
Fixed Assets 90 210 Total Expenses 164 451
Profit Before Interest &
Inventory 20 30 Tax 16 149
Receivables 30 50 Interest 5 20
Cash and Bank 10 10 Profit Before Taxes 11 129
Total 150 300 Tax 2 25
Profit After Tax 9 104
Asset Management

• Measures the productivity/efficiency of the asset in

generating revenue

• Example: Asset Turnover Ratios

 Asset Turnover Ratio

Sales
Asset Turnover Ratio =
Total Assets
 Balance Sheet Year 1 Year 2 Profit & Loss Account Year 1 Year 2
Equity 100 100 Sales 180 600
Loan 40 180 Raw Materials 100 300
Payables 10 20 Employee Expenses 40 90
Total 150 300 Other Expeses 15 40
Depreciation 9 21
Fixed Assets 90 210 Total Expenses 164 451
Inventory 20 30 Profit Before Interest & Tax 16 149
Receivables 30 50 Interest 5 20
Cash and Bank 10 10 Profit Before Taxes 11 129
Total 150 300 Tax 2 25
Profit After Tax 9 104

Ratios Year 1 Year 2

Return on Total Assets (ROTA) 10.67% 49.67%

Asset Turnover Ratio 180/150 = 1.2 600/300 = 2

Cost Management

• Assesses the efficiency of the company in managing costs

 Balance Sheet Year 1 Year 2 Profit & Loss Account Year 1 Year 2
Equity 100 100 Sales 180 600
Loan 40 180 Raw Materials 100 300
Payables 10 20 Employee Expenses 40 90
Total 150 300 Other Expeses 15 40
Depreciation 9 21
Fixed Assets 90 210 Total Expenses 164 451
Inventory 20 30 Profit Before Interest & Tax 16 149
Receivables 30 50 Interest 5 20
Cash and Bank 10 10 Profit Before Taxes 11 129
Total 150 300 Tax 2 25
Profit After Tax 9 104

Ratios Year 1 Year 2

Return on Total Assets (ROTA) 10.67% 49.67%
Asset Turnover Ratio 1.2 2
Total expense/Sales (%) 164/180 = 91.11 451/600 = 75.17
Profit Margin

• Assess the profit generated by sales

 Profit Margin Ratio

Profit before interest and taxes

Profit Margin =
Sales
 Balance Sheet Year 1 Year 2 Profit & Loss Account Year 1 Year 2
Equity 100 100 Sales 180 600
Loan 40 180 Raw Materials 100 300
Payables 10 20 Employee Expenses 40 90
Total 150 300 Other Expeses 15 40
Depreciation 9 21
Fixed Assets 90 210 Total Expenses 164 451
Inventory 20 30 Profit Before Interest & Tax 16 149
Receivables 30 50 Interest 5 20
Cash and Bank 10 10 Profit Before Taxes 11 129
Total 150 300 Tax 2 25
Profit After Tax 9 104

Ratios Year 1 Year 2

Return on Total Assets (ROTA) 10.67% 49.67%
Asset Turnover Ratio 1.2 2
Total expense/Sales (%) 91.11 75.17
Profit Margin (%) 16/180 = 8.89 149/600 = 24.83
 Return on Total Assets

Profit Before Interest and Taxes

Return on Total Assets =
Total Assets
 Balance Sheet Year 1 Year 2 Profit & Loss Account Year 1 Year 2
Equity 100 100 Sales 180 600
Loan 40 180 Raw Materials 100 300
Payables 10 20 Employee Expenses 40 90
Total 150 300 Other Expeses 15 40
Depreciation 9 21
Fixed Assets 90 210 Total Expenses 164 451
Inventory 20 30 Profit Before Interest & Tax 16 149
Receivables 30 50 Interest 5 20
Cash and Bank 10 10 Profit Before Taxes 11 129
Total 150 300 Tax 2 25
Profit After Tax 9 104

Ratios Year 1 Year 2

Return on Total Assets (ROTA) 10.67% 49.67%
 Balance Sheet Year 1 Year 2 Profit & Loss Account Year 1 Year 2
Equity 100 100 Sales 180 600
Loan 40 180 Raw Materials 100 300
Payables 10 20 Employee Expenses 40 90
Total 150 300 Other Expeses 15 40
Depreciation 9 21
Fixed Assets 90 210 Total Expenses 164 451
Inventory 20 30 Profit Before Interest & Tax 16 149
Receivables 30 50 Interest 5 20
Cash and Bank 10 10 Profit Before Taxes 11 129
Total 150 300 Tax 2 25
Profit After Tax 9 104

Ratios Year 1 Year 2

Return on Total Assets (ROTA)(%) 10.67 49.67
Asset Turnover Ratio 1.2 2
Total expense/Sales (%) 91.11 75.17
Profit Margin (%) 8.89 24.83
ROTA = Asset turnover
x Profit Margin
=1.2 x 8.89
 Financial
Ratios

ROTA-1 ROTA-2
10.67% 49.67%

ATO-1 PM-1 ATO-2 PM-2

1.20 8.89% 2.00 24.83%
Where,

ROTA = Return on total asset

ATO = Asset turnover
PM = Profit margin
 Financial
Ratios

ROTA-1 ROTA-2
10.67% 49.67%

ATO-1 PM-1 ATO-2 PM-2

1.20 8.89% 2.00 24.83%

Fixed asset Current asset Fixed asset Current asset

turnover turnover turnover turnover

Where,

ROTA = Return on total asset

ATO = Asset turnover
PM = Profit margin
Fixed Asset and Current Asset Productivity

• Fixed Asset Turnover Ratio

– Measures the productivity of fixed assets

• Current Asset Turnover Ratio

– Measures the productivity of current assets

 Fixed Asset Turnover Ratio

Sales
Fixed Asset Turnover Ratio =
Fixed Assets
 Balance Sheet Year 1 Year 2 Profit & Loss Account Year 1 Year 2
Equity 100 100 Sales 180 600
Loan 40 180 Raw Materials 100 300
Payables 10 20 Employee Expenses 40 90
Total 150 300 Other Expeses 15 40
Depreciation 9 21
Fixed Assets 90 210 Total Expenses 164 451
Inventory 20 30 Profit Before Interest & Tax 16 149
Receivables 30 50 Interest 5 20
Cash and Bank 10 10 Profit Before Taxes 11 129
Total 150 300 Tax 2 25
Profit After Tax 9 104

Ratios Year 1 Year 2

Return on total assets (ROTA) 10.67% 49.67%
Asset turnover Ratio 1.2 2
Total expense/Sales (%) 91.11 75.17
Profit margin (%) 8.89 24.83
Fixed asset turnover ratio 180/90 = 2 600/210 = 2.86
 Current Assets Turnover Ratio

Sales
Current Assets Turnover Ratio =
Current Assets
 Balance Sheet Year 1 Year 2 Profit & Loss Account Year 1 Year 2
Equity 100 100 Sales 180 600
Loan 40 180 Raw Materials 100 300
Payables 10 20 Employee Expenses 40 90
Total 150 300 Other Expeses 15 40
Depreciation 9 21
Fixed Assets 90 210 Total Expenses 164 451
Inventory 20 30 Profit Before Interest & Tax 16 149
Receivables 30 50 Interest 5 20
Cash and Bank 10 10 Profit Before Taxes 11 129
Total 150 300 Tax 2 25
Profit After Tax 9 104

Ratios Year 1 Year 2

Total current assets for Year 1 = 60
Returnfor
Total current assets onYear
total
2= assets
90 (ROTA) 10.67% 49.67%
Asset turnover Ratio 1.2 2
Total expense/Sales (%) 91.11 75.17
Profit margin (%) 8.89 24.83
Fixed asset turnover ratio 2 2.86
Current asset turnover ratio 180/60 = 3 600/90 = 6.67
Inventory Days

• Measures the efficiency of the company in managing its

inventory
 Inventory Days

Inventory
Inventory Days =
Average cost of sales or total
expenses per day
 Balance Sheet Year 1 Year 2 Profit & Loss Account Year 1 Year 2
Equity 100 100 Sales 180 600
Loan 40 180 Raw Materials 100 300
Payables 10 20 Employee Expenses 40 90
Total 150 300 Other Expeses 15 40
Depreciation 9 21
Fixed Assets 90 210 Total Expenses 164 451
Inventory 20 30 Profit Before Interest & Tax 16 149
Receivables 30 50 Interest 5 20
Cash and Bank 10 10 Profit Before Taxes 11 129
Total 150 300 Tax Average cost of sales per
2 25
Profit After Taxday = 451/365 = 1.24 9 104

Ratios Year 1 Year 2

Return on total assets (ROTA) 10.67% 49.67%
Asset turnover Ratio 1.2 2
Profit margin (%) 8.89 24.83
Fixed asset turnover ratio 2 2.86
Current asset turnover ratio 3 6.67
Inventory days 20/0.45 = 44.51 30/1.24 = 24.28
Receivable Collection Days

• Measures the efficiency of the company in managing its

receivables
 Receivable Collection Days

Receivables
Receivable Collection Days =
Average sales per day
 Balance Sheet Year 1 Year 2 Profit & Loss Account Year 1 Year 2
Equity 100 100 Sales 180 600
Loan 40 180 Raw Materials 100 300
Payables 10 20 Employee Expenses 40 90
Total 150 300 Other Expeses 15 40
Depreciation 9 21
Fixed Assets 90 210 Average sales per
Total Expenses day 164 451
Inventory 20 30 = 600/365
Profit Before = 1.64
Interest & Tax 16 149
Receivables 30 50 Interest 5 20
Cash and Bank 10 10 Profit Before Taxes 11 129
Total 150 300 Tax 2 25
Profit After Tax 9 104

Ratios Year 1 Year 2

Return on total assets (ROTA) 10.67% 49.67%
Asset turnover Ratio 1.2 2
Profit margin (%) 8.89 24.83
Fixed asset turnover ratio 2 2.86
Current asset turnover ratio 3 6.67
Inventory days 45 24
Receivable collection days 30/0.49 = 61 50/1.64 = 30.42
 Asset
Management

ATO-1 ATO-2
1.20 2.00

FATO-1 CATO-1 FATO-2 CATO-2

2.00 3.00 2.86 6.67

Inventory Collection Inventory Collection

Days-1 Days -1 Days -2 Days -2
45 days 61 days 24 days 30 days
where
ATO = Asset turnover
FATO = Fixed asset turnover
CATO = Current asset turnover
Assessing Cost Efficiency

• Cost efficiency can be measured using cost ratios.

 Cost Ratio

Expense
Cost Ratio =
Sales
 Cost Ratios

Balance Sheet Year 1 Year 2 Profit & Loss Account Year 1 Year 2
Equity 100 100 Sales 180 600
Loan 40 180 Raw Materials 100 300
Payables 10 20 Employee Expenses 40 90
Total 150 300 Other Expenses 15 40
Depreciation 9 21
Fixed Assets 90 210 Total Expenses 164 451
Inventory 20 30 Profit Before Interest & Tax 16 149
Cost heads
Receivables 30 50 Interest 5 20
Cash and Bank 10 10 Profit Before Taxes 11 129
Total 150 300 Tax 2 25
Profit After Tax 9 104
 Cost Ratios
Cost Ratios Expense Sales Ratio
Raw Material to Sales -year 1 100 180 55.56%
Raw Material to Sales -year 2 300 600 50.00%
Employee Cost to Sales - year 1 40 180 22.22%
Employee Cost to Sales - year 2 90 600 15.00%
Other Expenses to Sales - year 1 15 180 8.33%
Other Expenses to Sales - year 2 40 600 6.67%
Depreciation to Sales - year 1 9 180 5.00%
Depreciation to Sales - year 2 21 600 3.50%
Interest Expense to Sales - year 1 5 180 2.78%
Interest Expense to Sales - year 2 20 600 3.33%
 Cost Ratios
Cost Ratios Expense Sales Ratio
Raw Material to Sales -year 1 100 180 55.56%
Raw Material to Sales -year 2 300 600 50.00%
Employee Cost to Sales - year 1 40 180 22.22%
Employee Cost to Sales - year 2 90 600 15.00%
Other Expenses to Sales - year 1 15 180 8.33%
Other Expenses to Sales - year 2 40 600 6.67%
Depreciation to Sales - year 1 9 180 5.00%
Depreciation to Sales - year 2 21 600 3.50%
Interest Expense to Sales - year 1 5 180 2.78%
Interest Expense to Sales - year 2 20 600 3.33%
 Cost Ratios
Cost Ratios Expense Sales Ratio
Raw Material to Sales -year 1 100 180 55.56%
Raw Material to Sales -year 2 300 600 50.00%
Employee Cost to Sales - year 1 40 180 22.22%
Employee Cost to Sales - year 2 90 600 15.00%
Other Expenses to Sales - year 1 15 180 8.33%
Other Expenses to Sales - year 2 40 600 6.67%
Depreciation to Sales - year 1 9 180 5.00%
Depreciation to Sales - year 2 21 600 3.50%
Interest Expense to Sales - year 1 5 180 2.78%
Interest Expense to Sales - year 2 20 600 3.33%
 Cost Ratios
Cost Ratios Expense Sales Ratio
Raw Material to Sales -year 1 100 180 55.56%
Raw Material to Sales -year 2 300 600 50.00%
Employee Cost to Sales - year 1 40 180 22.22%
Employee Cost to Sales - year 2 90 600 15.00%
Other Expenses to Sales - year 1 15 180 8.33%
Other Expenses to Sales - year 2 40 600 6.67%
Depreciation to Sales - year 1 9 180 5.00%
Depreciation to Sales - year 2 21 600 3.50%
Interest Expense to Sales - year 1 5 180 2.78%
Interest Expense to Sales - year 2 20 600 3.33%
 Cost Ratios
Cost Ratios Expense Sales Ratio
Raw Material to Sales -year 1 100 180 55.56%
Raw Material to Sales -year 2 300 600 50.00%
Employee Cost to Sales - year 1 40 180 22.22%
Employee Cost to Sales - year 2 90 600 15.00%
Other Expenses to Sales - year 1 15 180 8.33%
Other Expenses to Sales - year 2 40 600 6.67%
Depreciation to Sales - year 1 9 180 5.00%
Depreciation to Sales - year 2 21 600 3.50%
Interest Expense to Sales - year 1 5 180 2.78%
Interest Expense to Sales - year 2 20 600 3.33%
Leverage Management

• Measures the efficiency with which the company

uses debt and payables to improve its return on
equity
Drivers of Leverage Management

• Payables

• Debt
Leverage Management - Managing Payables

• The contribution of payables can be assessed

through ratios such as return on capital employed
 Return on Capital Employed (ROCE)

Profit before interest and taxes

Return on Capital Employed =
Capital employed

Where

Capital employed = Total assets less payables

 Balance Sheet Year 1 Year 2 Profit & Loss Account Year 1 Year 2
Equity 100 100 Sales 180 600
Loan 40 180 Raw Materials 100 300
Payables 10 20 Employee Expenses 40 90
Total 150 300 Other Expenses 15 40
Depreciation 9 21
Fixed Assets 90 210 Total Expenses 164 451
Inventory 20 30 Profit Before Interest & Tax 16 149
Receivables 30 50 Interest 5 20
Cash and Bank 10 10 Profit Before Taxes 11 129
Total 150 300 Tax 2 25
Profit After Tax 9 104

Ratios Year 1 Year 2

Return on total assets (ROTA) 10.67% 49.67%
Year
Asset 1, Capital
turnover Ratioemployed 1.2 2
= 150 – 10 = 140 Year 2, Capital employed
Profit margin (%) = 300 – 20 = 280
8.89 24.83
Fixed asset turnover ratio 2 2.86
Current asset turnover ratio 3 6.67
Inventory days 45 24
Receivable collection days 61 30
Return on capital employed (ROCE) (%) 16/140 = 11.43 149/280 = 53.21
 Return on Total Assets Return on Capital Employed

Profit Before Interest and Taxes Profit before Interest and Taxes

Total Assets Total Assets less Payables

 Return on Total Assets Return on Capital Employed

Profit Before Interest and Taxes Profit before Interest and Taxes

Total Assets Total Assets less Payables

If the company has no suppliers’

credit, ROTA = ROCE
 Balance Sheet Year 1 Year 2 Profit & Loss Account Year 1 Year 2
Equity 100 100 Sales 180 600
Loan 40 180 Raw Materials 100 300
Payables 10 20 Employee Expenses 40 90
Total 150 300 Other Expenses 15 40
Depreciation 9 21
Fixed Assets 90
Contribution of the payables - 210 Total Expenses 164 451
Inventory 20 30 Profit Before Interest & Tax 16 149
For year 1,
Receivables ROCE – ROTA
30 = 11.43 -
50 10.67 = 0.76%
Interest 5 20
For year
Cash and 2,
BankROCE – ROTA10 = 53.2110 – 49.67 =Before
Profit 3.55%Taxes 11 129
Total 150 300 Tax 2 25
Profit After Tax 9 104

Ratios Year 1 Year 2

Return on total assets (ROTA) (%) 10.67 49.67
Asset turnover Ratio 1.2 2
Profit margin (%) 8.89 24.83
Fixed asset turnover ratio 2 2.86
Current asset turnover ratio 3 6.67
Inventory days 45 24
Receivable collection days 61 30
Return on capital employed (ROCE) (%) 11.43 53.21
Leverage Management - Managing Debt

• The contribution of debt to return on equity can be

measured through –

• Interest rate or cost of debt

• Debt to equity ratio

• Debt service coverage ratio

 Interest Rate

Interest expenses
Interest rate =
Loan
 Balance Sheet Year 1 Year 2 Profit & Loss Account Year 1 Year 2
Equity 100 100 Sales 180 600
Loan 40 180 Raw Materials 100 300
Payables 10 20 Employee Expenses 40 90
Total 150 300 Other Expenses 15 40
Depreciation 9 21
Fixed Assets 90 210 Total Expenses 164 451
Inventory 20 30 Profit Before Interest & Tax 16 149
Receivables 30 50 Interest 5 20
Cash and Bank 10 10 Profit Before Taxes 11 129
Total 150 300 Tax 2 25
Profit After Tax 9 104

Ratios Year 1 Year 2

For(%)
Return on total assets (ROTA) year 1, Interest rate =10.67
5/40 = 12.5% 49.67
For year 2, Interest rate = 20/180 = 11.11%
Asset turnover Ratio 1.2 2
Profit margin (%) 8.89 24.83
Fixed asset turnover ratio 2 2.86
Current asset turnover ratio 3 6.67
Inventory days 45 24
Receivable collection days 61 30
Return on capital employed (ROCE) (%) 11.43 53.21
Debt to Equity (D/E) Ratio

• Measures the composition of debt to equity in the

total capital of the company
 Debt-Equity (D/E) Ratio

Debt
Debt-equity ratio =
Equity
 Balance Sheet Year 1 Year 2 Profit & Loss Account Year 1 Year 2
Equity 100 100 Sales 180 600
Loan 40 180 Raw Materials 100 300
Payables 10 20 Employee Expenses 40 90
Total 150 300 Other Expenses 15 40
Depreciation 9 21
Fixed Assets 90 210 Total Expenses 164 451
Inventory 20 30 Profit Before Interest & Tax 16 149
Receivables 30 50 Interest 5 20
Cash and Bank 10 10 Profit Before Taxes 11 129
Total 150 300 Tax 2 25
Profit After Tax 9 104

Ratios Year 1 Year 2

Return on total assets (ROTA) (%) 10.67 49.67
Asset turnover Ratio 1.2 2
Profit margin (%) 8.89 24.83
Fixed asset turnover ratio 2 2.86
Current asset turnover ratio 3 6.67
Inventory days 45 24
Receivable collection days 61 30
Return on capital employed (ROCE) (%) 11.43 53.21
Debt to equity ratio 40/100 = 0.40 180/100 = 1.80
Spread

• Spread is measured by the difference between

return on capital employed and interest cost

• The impact of debt funds can be derived as the spread

multiplied by debt-equity ratio.
 Balance Sheet Year 1 Year 2 Profit & Loss Account Year 1 Year 2
Equity 100 100 Sales 180 600
Loan 40 180 Raw Materials 100 300
Payables 10 20 Employee Expenses 40 90
Total 150 300 Other Expenses 15 40
Depreciation 9 21
Fixed Assets 90 210 Total Expenses 164 451
Inventory 20 30 Profit Before Interest & Tax 16 149
Receivables 30 50 Interest 5 20
Cash and Bank 10 10 Profit Before Taxes 11 129
Total 150 300 Tax 2 25
Profit After Tax 9 104

Ratios For year 1, Interest rate =Year

5/401 = 12.5% Year 2
For(%)
Return on total assets (ROTA) year 2, Interest rate 10.67
= 20/180 = 11.11% 49.67
Asset turnover Ratio 1.2 2
Year 1 - Spread = 11.43% – 12.5% = - 1.07%
Profit margin (%) 8.89
Year 2 - Spread = 53.21%– 11.11% = 42.1% 24.83
Fixed asset turnover ratio 2 2.86
Current asset turnover ratio 3 6.67
Inventory days 45 24
Receivable collection days 61 30
Return on capital employed (ROCE) (%) 11.43 53.21
Debt to equity ratio 0.40 1.80
 Balance Sheet Year 1 Year 2 Profit & Loss Account Year 1 Year 2
Equity 100 100 Sales 180 600
Loan 40 180 Raw Materials 100 300
Payables 10 20 Employee Expenses 40 90
Total 150 300 Other Expenses 15 40
Depreciation 9 21
Fixed Assets 90 210 Total Expenses 164 451
Inventory 20 30 Profit Before Interest & Tax 16 149
Receivables 30 50 Interest 5 20
Cash and Bank 10 10 Profit Before Taxes 11 129
Total 150 300 Tax 2 25
Profit After Tax 9 104

Ratios Year 1 Year 2

Return on total assets (ROTA) (%) 10.67 49.67
Asset turnover Ratio 1.2 2
Profit margin (%) 8.89 24.83
Year
Fixed1 asset
- Spread = 11.43%
turnover ratio – 12.5% = - 1.07% 2 2.86
Impact of debt = -1.07% x 0.40 = -0.43% Year 2 - Spread = 53.21%– 11.11% = 42.1%
Current asset turnover ratio 3 6.67
Impact of debt = 42.1% x 1.80 = 75.79%
Inventory days 45 24
Receivable collection days 61 30
Return on capital employed (ROCE) (%) 11.43 53.21
Debt to equity ratio 0.40 1.80
 Balance Sheet Year 1 Year 2 Profit & Loss Account Year 1 Year 2
Equity 100 100 Sales 180 600
Loan 40 180 Raw Materials 100 300
Payables 10 20 Employee Expenses 40 90
Total 150 300 Other Expenses 15 40
Depreciation 9 21
Fixed Assets 90 210 Total Expenses 164 451
Inventory 20 30 Profit Before Interest & Tax 16 149
Receivables 30 50 Interest 5 20
Cash and Bank 10 10 Profit Before Taxes 11 129
Total 150 300 Tax 2 25
Profit After Tax 9 104

Ratios Year 1 Year 2

Return on total assets (ROTA) (%) 10.67 49.67
Asset turnover Ratio 1.2 2
Profit margin (%) 8.89 24.83
Fixed asset turnover ratio 2 2.86
Current asset turnover ratio 3 6.67
Inventory days 45 24
Receivable collection days 61 30
Return on capital employed (ROCE) (%) 11.43 53.21
Debt to equity ratio 0.40 1.80
Pre-tax return on equity = 11/100 = 11% =129/100 = 129%
 ROCE - ROE Relationship

ROE = ROCE + (Impact of debt)

ROE = ROCE + (ROCE – Interest rate) x D/E

 Balance Sheet Year 1 Year 2 Profit & Loss Account Year 1 Year 2
Equity 100 100 Sales 180 600
Loan 40 180 Raw Materials 100 300
Payables 10 20 Employee Expenses 40 90
Total 150 300 Other Expenses 15 40
Depreciation 9 21
Fixed Assets 90 210 Total Expenses 164 451
Inventory 20 30 Profit Before Interest & Tax 16 149
Receivables 30 50 Interest 5 20
Cash and Bank 10 10 Profit Before Taxes 11 129
Total 150 300 Tax 2 25
Profit After Tax 9 104

Ratios Year 1 Year 2

Return on total assets (ROTA) (%) 10.67 49.67
Asset turnover Ratio 1.2 2
Profit margin (%) 8.89 24.83
Year 1
Fixed asset
Impact turnover
of debt ratio x 0.40 = -0.43%
= -1.07% 2
Year 2 2.86
ROE = 11.43%
Current + (0.43%)
asset turnover ratio= 11% Impact
3 of debt = 42.1%
6.67x 1.80 = 75.79%
Inventory days ROE
45 = 53.21% + 75.79%
24 = 129%
Receivable collection days 61 30
Return on capital employed (ROCE) (%) 11.43 53.21
Debt to equity ratio 0.40 1.80
Pre-tax return on equity 11% 129%
 Financial Statement Analysis

Year 1 Year 2
ROE (Post-tax)
Contribution of 9.00% 104.00%

debt or leverage ROE (Pre-tax)

effect 11.00% 129.00%

Loan Effect Debt/Equity

-0.43% 75.79% 0.40 1.80

ROCE
11.43% 53.21% Cost of Debt
12.50% 11.11%
ROTA
10.67% 49.67%

Asset Turnover Ratio Profit Margin

1.20 2.00 8.89% 24.83%

Fixed Asset TO Current Asset TO Raw Materials/Sales

2.00 2.86 3.00 6.67 55.56% 50.00%

Current Ratio Inventory Days Employee Cost/Sales

6.00 4.50 41.00 18.00 22.22% 15.00%

DSCR Collection Days Other Expenses to Sales

1.08 2.21 61 30 8.33% 6.67%

Depreciation to Sales
5.00% 3.50%

Finance Cost to Sales

2.78% 3.33%
 Post-tax Return on Equity (Post-tax ROE)

Profit after tax (PAT)

Post-tax ROE =
Equity
 Balance Sheet Year 1 Year 2 Profit & Loss Account Year 1 Year 2
Equity 100 100 Sales 180 600
Loan 40 180 Raw Materials 100 300
Payables 10 20 Employee Expenses 40 90
Total 150 300 Other Expenses 15 40
Depreciation 9 21
Fixed Assets 90 210 Total Expenses 164 451
Inventory 20 30 Profit Before Interest & Tax 16 149
Receivables 30 50 Interest 5 20
Cash and Bank 10 10 Profit Before Taxes 11 129
Total 150 300 Tax 2 25
Profit After Tax 9 104

Ratios Year 1 Year 2

Return on total assets (ROTA) (%) 10.67 49.67
Asset turnover Ratio 1.2 2
Profit margin (%) 8.89 24.83
Fixed asset turnover ratio 2 2.86
Current asset turnover ratio 3 6.67
Return on capital employed (ROCE) (%) 11.43 53.21
Debt to equity ratio 0.40 1.80
Pre-tax return on equity 11% 129%
Post-tax return on equity 9% 104%
Assessing the credit-worthiness

• The creditworthiness of a company can be assessed

through credit score

• Altman Z Score is a popular measure of credit score

Altman Z-score
Z = 1 x 1.2 + 2 x 1.4 + 3 x 3.3 + 4 x 0.6 + 5 x 1.0

1 = Working Capital/Total Assets

2 = Retained Earnings/Total Assets
3 = EBIT/Total Assets
4 = Equity/Total Debt
5 = Sales/Total Assets

Z-score
Altman Z-score
Z = 1 x 1.2 + 2 x 1.4 + 3 x 3.3 + 4 x 0.6 + 5 x 1.0
Year 1 Year 2
1 = Working Capital/Total Assets 0.33 0.23
2 = Retained Earnings/Total Assets 0.67 0.33
3 = EBIT/Total Assets 0.11 0.50
4 = Equity/Total Debt 2.50 0.56
5 = Sales/Total Assets 1.20 2.00

Z-score 4.39 4.72

Tax Management

• Assesses the effective tax paid by the company

Balance Sheet Year 1 Year 2 Profit & Loss Account Year 1 Year 2
Equity 100 100 Sales 180 600
Loan 40 180 Raw Materials 100 300
Payables 10 20 Employee Expenses 40 90
Total 150 300 Other Expenses 15 40
Depreciation 9 21
Fixed Assets 90 210 Total Expenses 164 451
Inventory 20 30 Profit Before Interest & Tax 16 149
Receivables 30 50 Interest 5 20
Cash and Bank 10 10 Profit Before Taxes 11 129
Total 150 300 Tax 2 25
Profit After Tax 9 104

Actual tax rate is 25/129

= 19.38% against the
statutory income tax rate
of 30%
Assessing Solvency Risk

• Risk can be measured in two ways -

– Short-term solvency or liquidity risk - Measures the ability of

the company to pay short-term liabilities

• Short-term solvency (liquidity risk) can be assessed using current ratio.

– Long-term solvency risk - Measures the ability of the company

to pay long-term liabilities

• Long-term solvency risk) can be assessed using debt service coverage

ratio (DSCR)
 Current Ratio

Measures the ability of the company to pay its short-term obligations

Current Assets
Current Ratio =
Current Liabilities
 Balance Sheet Year 1 Year 2 Profit & Loss Account Year 1 Year 2
Equity 100 100 Sales 180 600
Loan 40 180 Raw Materials 100 300
Payables 10 20 Employee Expenses 40 90
Total 150 300 Other Expenses 15 40
Depreciation 9 21
Fixed Assets 90 210 Total Expenses 164 451
Inventory 20 30 Profit Before Interest & Tax 16 149
Receivables 30 50 Interest 5 20
Cash and Bank 10 10 Profit Before Taxes 11 129
Total 150 300 Tax 2 25
Profit After Tax 9 104
Current assets for
Ratios Year 1 = 60 Year 1 Year 2
Return on Year 2= 90(ROTA) (%)
total assets 10.67 49.67
Asset turnover Ratio 1.2 2
Profit margin (%) 8.89 24.83
Fixed asset turnover ratio 2 2.86
Current asset turnover ratio 3 6.67
Return on capital employed (ROCE) (%) 11.43 53.21
Debt to equity ratio 0.40 1.80
Pre-tax return on equity 11% 129%
Current ratio 60/10 = 6 90/20 = 4.50
 Debt Service Coverage Ratio (DSCR)

Measures the ability of the company to pay its long-term debt

PBDIT - Taxes
Debt Service Coverage Ratio =
Interest cost + loan due for the
current year

where

PBDIT= Profit before Depreciation, Interest and Taxes

 Balance Sheet Year 1 Year 2 Profit & Loss Account Year 1 Year 2
Equity 100 100 Sales 180 600
Loan 40 180 Raw Materials 100 300
Payables 10 20 Employee Expenses 40 90
Total 150 300 Other Expenses 15 40
Loan has to be Depreciation 9 21
Fixed Assets 90 210 Total Expenses 164 451
repaid in 5 years Inventory 20 30 Profit Before Interest & Tax 16 149
Receivables 30 50 Interest 5 20
Cash and Bank 10 10 Profit Before Taxes 11 129
Total 150 300 Tax 2 25
Profit After Tax 9 104

Year 1, Int
Ratios
+ Loan due = 5+40/5 Year 1, PBDIT
Year 1less taxes = 16+9 Year 2
= 13 Return on total assets (ROTA) (%) – 2 = 23 10.67 49.67
Year 2, Int + Loan due = 20 + Year 2, PBDIT less tax = 149+21-
+180/5 =Asset
56 turnover Ratio 25= 145 1.2 2
Profit margin (%) 8.89 24.83
Fixed asset turnover ratio 2 2.86
Current asset turnover ratio 3 6.67
Return on capital employed (ROCE) (%) 11.43 53.21
Debt to equity ratio 0.40 1.80
Pre-tax return on equity 11% 129%
Current ratio 6 4.50
Debt service coverage ratio 23/13 = 1.77 145/56 = 2.59
Financial Ratios - Chart
 Financial Statement Analysis

Year 1 Year 2
ROE (Post-tax)
9.00% 104.00%

ROE (Pre-tax)
11.00% 129.00%

Loan Effect Debt/Equity

-0.43% 75.79% 0.40 1.80

ROCE
11.43% 53.21% Cost of Debt
12.50% 11.11%
ROTA
10.67% 49.67%

Asset Turnover Ratio Profit Margin

1.20 2.00 8.89% 24.83%

Fixed Asset TO Current Asset TO Raw Materials/Sales

2.00 2.86 3.00 6.67 55.56% 50.00%

Current Ratio Inventory Days Employee Cost/Sales

6.00 4.50 41.00 18.00 22.22% 15.00%

DSCR Collection Days Other Expenses to Sales

1.08 2.21 61 30 8.33% 6.67%

Depreciation to Sales
5.00% 3.50%

Finance Cost to Sales

2.78% 3.33%
Altman Z-score
Z = 1 x 1.2 + 2 x 1.4 + 3 x 3.3 + 4 x 0.6 + 5 x 1.0
Year 1 Year 2
1 = Working Capital/Total Assets 0.33 0.23
2 = Retained Earnings/Total Assets 0.67 0.33
3 = EBIT/Total Assets 0.11 0.50
4 = Equity/Total Debt 2.50 0.56
5 = Sales/Total Assets 1.20 2.00

Z-score 4.39 4.72