Ratio Analysis

Financial Statement Analysis

• Managers, creditors, investors and other use the information contained in financial statements such as funds and cash
flow statements to form judgement about the operating performance and financial position of the firm.

• Users of financial statements can get further insights about financial strengths and weaknesses of the firm if they
properly analyze information reported in these statements.

• Management should be particularly interested in knowing financial strengths of the firm to make their best use and to
be able to spot out financial weaknesses of the firm to take suitable corrective actions.

• The future plans of the firm should be laid down in view of the firm’s financial strengths and weaknesses.

• Thus, financial analysis is the starting point for making plans, before using any sophisticated forecasting and planning
procedures.

• Understanding the past is a prerequisite for anticipating the future.

 Users of Financial Analysis
• Financial analysis is the process of identifying the financial strength and weaknesses of the firm by properly
establishing relationships between the items of the balance sheet and the profit and loss account.

• Financial analysis can be undertaken by the management of the firm, or by parties outside the firm, viz., owners,
creditors, investors, and others.

• The nature of analysis will differ depending on the purpose of the analyst:
 Trade creditors are interested in a firm’s ability to meet their claims over a very short period of time. Their
analysis will, therefore, confine to the evaluation of the firm’s liquidity position.
 Suppliers of long-term debt, on the other hand, are concerned with the firm’s long-term solvency and
survival.
 They analyze the firm’s profitability over time, its ability to generate cash to be able to pay interest
and repay principal, and the relationship between various sources of funds (capital structure
relationships).
 Long-term creditors do analyze the historical financial statements, but they place more emphasis on
the firm’s projected, or pro forma, financial statements to make analysis about its future solvency and
profitability.
Users of Financial Analysis

 Investors, who have invested their money in the firm’s shares, are most concerned about the
firm’s earnings.
 They restore more confidence in those firms that show steady growth in earnings.
 As such, they concentrate on the analysis of the firm’s present and future profitability.
They are also interested in the firm’s financial structure to the extent it influences the firm’s
earnings ability and risk.

 Management of the firm would be interested in every aspect of the financial analysis. It is their
overall responsibility to see that the resources of the firm are used most effectively and efficiently,
and that the firm’s financial condition is sound.
 Nature of Ratio Analysis
• Ratio analysis is a powerful tool of financial analysis.

• A ratio is defined as “the indicated quotient of two mathematical expressions” and as “the
relationship between two or more things.”

• In financial analysis, a ratio is used as a benchmark for evaluating the financial position and
performance of a firm.

• The absolute accounting figures reported in the financial statements do not provide a meaningful
understanding of the performance and financial position of a firm.

• An accounting figure conveys meaning when it is related to some other relevant information.

• For example, a Rs. 5 crore net profit may look impressive, but the firm’s performance can be said to
be good or bad only when the net profit figure is related to the firm’s investment.

• The relationship between two accounting figures, expressed mathematically, is known as a

financial ratio (or simply as a ratio).
 Nature of Ratio Analysis
• Ratios help to summarize large quantities of financial data and to make qualitative judgement
about the firm’s financial performance.

• For example, consider current ratio (discussed in detail later on). It is calculated by dividing
current assets by current liabilities; the ratio indicates a relationship - a quantified relationship
between current assets and current liabilities.

• This relationship is an index or yardstick, which permits a qualitative judgement to be formed

about the firm’s ability to meet its current obligations.

• It measures the firm’s liquidity. The greater the ratio, the greater is the firm’s liquidity and vice
versa.

• The point to note is that a ratio reflecting a quantitative relationship helps to form a
qualitative judgement. Such is the nature of all financial ratios.
 Standards of Comparison
• The ratio analysis involves comparison for a useful interpretation of the financial statements.

• A single ratio in itself might not indicate favorable or unfavorable condition. It should be compared with
some standard.

• Standards of comparison may consists of:

 Past ratios, i.e., ratios calculated from the past financial statements of the same firm;
 Competitor’s ratios, i.e., ratios of some selected firms, especially the most progressive and
successful competitor, at the same point in time;
 Industry ratios, i.e., ratios of the industry to which the firm belongs; and
 Projected ratios, i.e., ratios developed using the projected, or pro forma, financial
statements of the same firm.

• Time series analysis:

 The easiest way to evaluate the performance of a firm is to compare its present ratios with the past
ratios.
 When financial ratios over a period of time are compared, it is known as the time series analysis.
 It gives an indication of the direction of change and reflects whether the firm’s financial performance
has improved, deteriorated or remained constant over time.
 Standards of Comparison
• Cross-sectional analysis:
 Another way of comparison is to compare ratios of one firm with some selected firms in the same
industry at the same point in time.
 This kind of comparison is known as the cross-sectional analysis or inter-firm analysis.
 This kind of a comparison indicates the relative financial position and performance of the firm.

• Industry analysis:
 To determine the financial condition and performance of a firm, its ratios may be compared with
average ratios of the industry of which the firm is a member.
 This sort of analysis, known as the industry analysis, helps to ascertain the financial standing and
capability of the firm vis-à-vis other firms in the industry.

• Pro forma analysis:

 Sometimes future ratios are used as the standard of comparison.
 Future ratios can be developed from the projected, or pro forma financial statements.
 The comparison of current or past ratios with future ratios shows the firm’s relative strengths and
weaknesses in the past and the future.
 If the future ratios indicate weak financial position, corrective actions should be initiated.
 Standards of Comparison
In view of the requirements of the various users of the ratios, we may classify them into the following four
important categories:

Liquidity ratios Leverage ratios Activity ratios Profitability ratios

Liquidity ratios: It measures the firm’s ability to meet current obligations.

Leverage ratios: It shows the proportions of debt and equity in financing the firm’s assets.

Activity ratios: It reflect the firm’s efficiency in utilizing its assets.

Profitability ratios: It measures the overall performance and effectiveness of the firm.
 (A) Liquidity Ratios
• It is extremely essential for a firm to be able to meet its obligations as they become due.

• Liquidity ratios measure the ability of the firm to meet its current obligations (liabilities).

• In fact, analysis of liquidity needs the preparation of cash budgets and cash and fund flow statements; but
liquidity ratios, by establishing a relationship between cash and other assets to current obligations, provide
a quick measure of liquidity.

• A firm should ensure that it does not suffer from lack of liquidity, and also that it does not have excess
liquidity.

• The failure of a company to meet its obligations due to lack of sufficient liquidity will result in a poor credit
worthiness, loss of creditor’s confidence or even in legal tangles resulting in the closure of the company.

• A very high degree of liquidity is also bad; idle assets earn nothing. The firm’s funds will be unnecessarily
tied up in current assets.

• Therefore, it is necessary to strike a proper balance between high liquidity and lack of liquidity.
 (i) Current Ratio
• Current ratio is calculated by dividing current assets by current liabilities:

Current ratio =

• Current assets include cash and those assets that can be converted into cash within a year, such as
marketable securities, debtors, and inventories.

• Prepaid expenses are also included in current assets as they represent the payments that will not be made
by the firm in the future.

• All obligations maturing within a year are included in current liabilities.

• Current liabilities include creditors, bills payable, accrued expenses, short-term bank loan, income-tax
liability, and long-term debt maturing in the current year.

• The current ratio is a measure of the firm’s short-term solvency. It indicates the availability of current
assets in rupees for every one rupee of current liability.

• A ratio of greater than one means that the firm has more current assets than current claims against them.
 Interpretation of Current Ratio
• Current ratio is calculated by dividing current assets by current liabilities:

Current ratio =

• As a conventional rule, a current ratio of 2 to 1 or more is considered satisfactory.

• This rule is based on the logic that in a worse situation, even if the value of current assets become half, the
firm will be able to meet its obligations.

• The current ratio represents a margin of safety for creditors.

• The higher the current ratio, the greater the margin of safety.

• The larger the amount of current assets in relation to current liabilities, the more the firm’s ability to meet
its current obligations.
 (ii) Quick Ratio

• Quick ratio, is called acid-test ratio, establishes a relationship between quick, or liquid assets and current
liabilities.

• Quick ratio is calculated by dividing the difference of current assets and inventories by current liabilities:

Quick ratio =

• An asset is liquid if it can be converted into cash immediately or reasonably soon without a loss of value.

• Inventories ae considered to be less liquid. Inventories normally require some time for realizing into cash;
their value also has a tendency to fluctuate.
 Interpretation of Quick Ratio

• Quick ratio of 1 to 1 is considered to represent a satisfactory current financial condition.

• A quick ratio of 1 to 1 or more does not necessarily imply sound liquidity position.

• It should be remembered that all debtors may not be liquid, and cash may be immediately needed
to pay operating expenses.

• A company with high value of quick ratio can suffer from a shortage of funds if it has slow paying,
doubtful and long-duration outstanding debtors.

• On the other hand, a company with a low value of quick ratio may really be prospering and paying
its current obligation in time if it has been turning over its inventories efficiently.

• Nevertheless, the quick ratio remains an important index of the firm’s liquidity.
 (iii) Cash Ratio

• Since cash is the most liquid asset, a financial analyst may examine cash ratio and its equivalent to
current liabilities.

• Trade investment or marketable securities are equivalent of cash; therefore, they may be included
in the computation of cash ratio:

Cash ratio =

• There is nothing to be worried about the lack of cash if the company has reserve
borrowing power.

• In India, firms have credit limits sanctioned from banks, and can easily draw cash.
(iv) Interval Measure
• This ratio assesses a firm’s ability to meet its regular cash expenses, is the interval measure.

• Interval measures relates liquid assets to average daily operating cash outflows.

• The daily operating expenses will be equal to the cost of goods sold plus selling, administrative and general
expenses less depreciation (and other non-cash expenditures) divided by number of days in the year (normally
360).

Interval measure =

• Interval measure indicates that it has sufficient liquid assets to finance its operations for 77 days, even if it does
not receive any cash.
 (v) Net Working Capital Ratio
• The difference between current assets and current liabilities excluding short-term bank borrowing is called net working
capital (NWC) or net current assets (NCA).

• MWC is sometimes used as a measure of a firm’s liquidity.

• It is considered that, between two firms, the one having the larger NWC has the greater ability to meet its current
obligations.

• It measures the firm’s potential reservoir of funds.

NWC ratio =

2011 2012 2013

Current ratio 1.24 1.25 1.20
Quick ratio 0.56 0.56 0.46
Results Cash ratio 0.01 0.09 0.02
Interval measure (days) 65.00 87.00 77.00
Net working capital ratio 0.53 0.58 0.61
(B) Leverage Ratios
• The short-term creditors, like bankers and suppliers of raw material, are more concerned with the firm’s
current debt-paying ability.

• On the other hand, long-term creditors like debenture holders, financial institutions, etc., are more concerned
with the firm’s long –term financial strength.

• To judge the long-term financial position of the firm, financial leverage, or capital structure ratios are
calculated.

• These ratios indicate mix of funds provided by owners and lenders.

• The process of magnifying the shareholder’s return through the use of debt is called
“financial leverage” or “financial gearing” or “trading on equity.”
• Leverage ratios are calculated to measure the financial risk and the firm’s ability of using debt to shareholder’s
advantage.

• Many variations of leverage ratios exist; but all these ratios indicate the same thing – the extent to which the
firm has relied on debt in financing assets.
(i) Debt Ratio
• Total debt will include short and long-term borrowings from financial institutions, debentures/bonds, deferred
payment arrangements for buying capital equipments, bank borrowings, public deposits and any other interest
bearing loan.

Debt ratio =

Debt ratio =

• Note that capital employed (CE) equals net assets (NA) that consists of net fixed assets (NFA) and net current
assets (NCA). Net current assets are current assets (CA) minus current liabilities (CL) excluding interest-bearing
short-term debt for working capital. These relationship are:

NFA + CA = NW + TD + CL
NFA + CA – CL = NW + TD
NFA + NCA = NW + TD
NA = CE
(i) Debt Ratio
• Because of the equality of capital employed and net assets, debt ratio can also be defined as total debt divided
by net assets:

Debt ratio =

(ii) Debt-Equity Ratio

This relationship describes the lender’s contribution for each rupee of the owner’s contribution is called debt-
equity ratio.
Debt-Equity Ratio =

(iii) Total Liabilities to Total Assets Ratio

TL to TA ratio =
(iv) Long-term Debt to Capitalization or Funds Ratios
• A firm may wish to calculate leverage ratios in terms of the long-term capitalization of funds (LTF) alone.

• Long-term funds or capitalization will include long-term debt and net worth.

• Thus, the firm may calculate the following long-term debt ratios:

LT-to-LF ratio = = = 0.366

LT-to-NW ratio =
= = 0.581

• Long-term debt to capitalization ratio is a solvency measure that shows the degree of financial leverage a firm
takes on. It calculates the proportion of long-term debt a company uses to finance its assets, relative to the
amount of equity used for the same purpose.

• So, what is a good long-term debt to capitalization ratio?

• A good ratio should be of course less than 1.0, and should be somewhere between 0.4 to 0.6. Or in other
words, the company's long-term debt should account for 40% to 60% of the company's total capitalization.
 What Do Debt Ratios Imply?
• It shows the extent to which debt financing has been used in the business.

• A high ratio means that claims of creditors are greater than those of owners.

• Heavy indebtedness leads to creditor’s pressures and constraints on the management’s independent functioning and
energies.

• During the periods of low profits, a highly debt-financed company suffers great strains: it cannot even pay the
interest charges of creditors.

• As a result, their pressure and control are further tightened.

• To meet their working capital needs, the firm finds difficulty in getting credit.

• It may have to borrow on highly unfavorable terms.

• Thus, it gets entangled in a debt trap.
• From the creditors point of view, low debt-equity ratio represents a satisfactory situation since a high proportion of
equity provides a larger margin of safety for them.
 What Do Debt Ratios Imply?
• From the shareholder’s point of view, there is a disadvantage during the periods of good economic activities if the firm
employs a low amount of debt.

• The higher the debt-equity ratio, the larger the shareholder’s earnings when the cost of debt is less than the firm’s
overall rate of return on investment.

• Thus, there is a need to strike a proper balance between the use of debt and equity.

• The most appropriate debt-equity combination would involve a trade-off between return and risk.

Results of Leverage Ratios

2011 2012 2013 Results implies the following points:

 More dependence on outsider’s funds for financing its expanding
Total debt ratio 0.56 0.63 0.65 activities.
 Level of long-term debt is not very excessive, but the proportion of
Debt-Equity ratio 1.26 1.72 1.83 other liabilities is increasing.
Total liabilities ratio 0.64 0.71 0.74  From the creditor’s point of view, the trend is risky and undesirable.

Long-term debt ratio 0.28 0.38 0.37

 (C) Coverage Ratios
• Debt ratios described previously are static in nature (i.e., they show the extent to which debt financing is used in the
business), and fail to indicate the firm’s ability to meet interest (and other fixed-charges) obligations.

(i) Interest Coverage Ratio

• The interest coverage ratio or the times-interest-earned is used to test the firm’s debt-servicing capacity.

• The interest coverage ratio is computed by: Interest coverage =

Interest coverage = = 2.4

• The interest coverage ratio shows the number of times the interest charges are covered by funds that are ordinarily available for their
payment.

• Since taxes are computed after interest, interest coverage is calculated in relation to before-tax earnings.

• This ratio indicates the extent to which earnings may fail without causing any embarrassment to the firm regarding the payment of the
interest charges.

• A higher ratio is desirable; but too high ratio indicates that the firm is very conservative in using debt, and that it is not using credit to
the best advantage of shareholders. A lower ratio indicates excessive use of debt or inefficient operations.
(D) Activity Ratios / Turnover Ratios
• Funds of creditors and owners are invested in various assets to generate sales and profits.

• The better the management of assets, the larger the amount of sales.

• Activity ratios are employed to evaluate the efficiency with which the firm manages and utilizes its
assets.

• These ratios are also called turnover ratios because they indicate the speed with which assets are
being converted or turned over into sales.

• Activity ratios, thus, involve a relationship between sales and assets.

• A proper balance between sales and assets generally reflects that assets are managed well.

• Several activity ratios can be calculated to judge the effectiveness of asset utilization.
(i) Inventory Turnover
• Inventory turnover indicates the efficiency of the firm in producing and selling its product.

Inventory turnover = = = 8.6 times

• The average inventory is the average of opening and closing balances of inventory.

• In a manufacturing company inventory of finished goods is used to calculate inventory turnover.

• The company is turning its inventory of finished goods into sales (at cost) 8.6 times in a year.

• In other words, it holds average inventory of: 12 months / 8.6 = 1.4 months

• The reciprocal of inventory turnover gives average inventory holdings in percentage term.

• When the number of days in a year (say, 360) are divided by inventory turnover, we obtain days of inventory holdings (DIH):

Days of Inventory Holdings (DIH) = 360 =

• A good inventory turnover ratio is between 5 and 10 for most industries, which indicates that you sell and restock your inventory every
1-2 months. This ratio strikes a good balance between having enough inventory on hand and not having to reorder too frequently

Days of Inventory Holdings (DIH) = = 42 days

 Components of Inventory
• The manufacturing firm’s inventory consists of two or more components: raw materials and work-in-process.

• An analyst may also be interested in examining the efficiency with which the firm converts raw materials into work-in-process and
work-in-process into finished goods.

• That is, the analyst would like to know the levels of raw materials inventory and work in process inventory held by the firm on an
average.

• The raw material inventory should be related to materials consumed, and work-in-process to the cost of production. Thus:

(ii) Raw Material Inventory Turnover and Work-in-process Inventory Turnover

Raw material inventory turnover = Work-in-process inventory turnover =

• Materials consumed = (Opening balance of raw material) + (Purchases) – (Closing balance of raw material)

• Cost of production = (Material consumed) + (other manufacturing expenses) + (opening balance – closing balance of work-in-process)

Raw material inventory turnover = = 6.5 times Work-in-process inventory turnover = = 17 times
 What Does Inventory Turnover Indicate?
• The inventory turnover shows how rapidly the inventory is turning into receivable through sales.

• Generally, a high inventory turnover is indicative of good inventory management.

• A low inventory turnover implies excessive inventory levels than warranted by production and sales activities, or a slow-moving or obsolete
inventory.

• A high level of sluggish inventory amounts to unnecessary tie-up of funds, reduced profit and increased costs.

• A high inventory turnover may be the result of a very low level of inventory, which results in frequent stock outs; the firm may be living
from hand-to-mouth.

• The turnover will also be high if the firm replenishes its inventory in too many small lot sizes.

• The situations of frequent stock outs and too many small inventory replacements are costly for the firm. Thus, too high and too low
inventory turnover ratios should be investigated further.

• To judge whether a firm’s inventory turnover is good or not, it should be compared with the past and the expected ratios as well as with
inventory turnover ratios of similar firms and industry average.

Results of Inventory Turnover Ratios

2011 2012 201
3 Results implies the following points:
Finished goods turnover 12.9 11.9 8.6  Firm’s efficiency in turning its inventories is continuously deteriorating.
 The company’s utilization of inventories in generating sales is poor.
Work-in-process turnover 27.0 20.5 17.1
 The yearly holding of all types of inventories is increasing.
Materials turnover 6.5 6.4 6.5
(iii) Debtors (Accounts Receivable) Turnover
• A firm sells goods for cash and credit.

• Credit is used as a marketing tool by a number of companies.

• When the firm extends credit to its customers, debtors (accounts receivables) are created in the firm’s accounts.

• Debtors are convertible into cash over a short period and, therefore, are included in current assets.

• The liquidity position of the firm depends on the quality of debtors to a great extent.

• Financial analysts apply two ratios to judge the quality or liquidity of debtors : a) debtors turnover, and b) collection period.

Debtors turnover =

• Debtors turnover indicates the number of times debtors turnover each year. Generally, the higher the value of debtors turnover, the more
efficient is the management of credit.

• To an outside analyst, information about credit sales and opening and closing balances of debtors may not be available. Therefore,
debtors turnover can be calculated by dividing total sales by the year-end balance of debtors.

Debtors turnover = = = 7.7 times

(iii) Debtors (Accounts Receivable) Turnover
• Firm is able to turnover its debtors 7.7 times in a year.

• In other words, its debtors remain outstanding for: 12 months / 7.7 = 1.56 months

• The average number of days for which debtors remain outstanding is called the average collection period (ACP) and can be computed as
follows:
Average Collection Period (ACP) = = 360

Average Collection Period (ACP) = = 47 days

What does collection period measure ?

• The average collection period measures the quality of debtors since it indicates the speed of their collection.

• The shorter the average collection period, the better the quality of debtors, since a short collection period implies the prompt payment by debtors.

• The average collection period should be compared against the firm’s credit terms and policy to judge its credit and collection efficiency.

• For example, if the credit period granted by a firm is 35 days, and its average collection period is 50 days, the comparison reveals that the firm’s debtors are
outstanding for a longer period than warranted by the credit period of 35 days.

• An excessive long collection period implies a very liberal and inefficient credit and collection performance.

• This certainly delays the collection of cash and impairs the firm’s liquidity.

• The chances of bad debt losses are also increased.

What does collection period measure ?
• A low collection period is not necessarily favorable. Rather, it may indicate a very restrictive credit and collection policy.

• Because of the fear of bad debt losses, the firm sells only to those customers whose financial conditions are undoubtedly sound, and who
are very prompt in making the payment.

• Such a policy succeeds in avoiding the bad debt losses, but it so severely curtails sales that overall profits are reduced.

• In addition to measuring the firm’s credit-and-collection efficiency with its own credit terms, the analyst must compare the firm’s average
collection period with the industry average.

• The collection period ratio thus helps an analyst in two respects:

 in determining the collectability of debtors and thus, the efficiency of collection efforts, and
 In ascertaining the firm’s comparative strength and advantage relative to its credit policy and performance vis-à-vis the
competitors’ credit policies and performance.

• It is useful to examine the trend in average collection period to know the firm’s collection experience.

Results of Average Collection Period

2011 2012 2013
Debtors turnover (times) 9.2 8.3 7.7 Results implies the following points:
Average collection period (days) 39 43 47  Average collection period has been increasing; it has increased from 39
days to 47 days.
Debtors/sales ratio (per cent) 10.9 12.1 13.0  This increase may be due to change in the economic conditions and/or
laxity in managing receivables.
 Student Activities
Question: X company has made plans for the next year. It is estimated that the company
will employ total assets of rupees Rs. 8,00,000; 50 per cent of the assets being financed by
borrowed capital at an interest cost of rupees 8 per cent per year. The direct cost for the
year are estimated at Rs. 4,80,000 and all other operating expenses are estimated at Rs.
80,000. The goods will be sold to customers at 150 per cent of the direct costs. Tax rate is
assumed to be 50%. Calculate (i) net profit margin; (ii) return on assets; (iii) assets turnover,
(iv) return on owner’s equity.
Solution: Rs. Rs.
Sales (150 % of Rs. 4,80,000) 7,20,000
Less: Direct costs 4,80,000
Gross profit 2,40,000
Operating expenses 80,000
Interest charges (8 % of 4,00,000) 32,000 1,12,000
Profit before taxes 1,28,000
Less: taxes (@ 50 %) 64,000
Net profit after taxes 64,000
Answers:

Net profit margin = = = 0.089 or 8.9 %

Net profit margin = = = 0.111 or 11.1 %

Return on assets = = = 0.10 or 10 %

Assets turnover = = = 0.9 times

Return on equity = = = 0.16 or 16 %

 Student Activities
Question: The total sales (all credit) of a firm is Rs. 6,40,000. It has a gross profit margin of
15 per cent and a current ratio of 2.5. The firm’s current liabilities are Rs. 96,000; inventories
Rs. 48,000; and cash Rs. 16,000.
(a) Determine the average inventory to be carried by the firm, if an inventory turnover of 5
times is expected? (Assume a 360-day year).
(b) Determine the average collection period if the opening balance of debtors is intended
to be of Rs. 80,000? (Assume a 360-day year).
Solution:
Inventory turnover =

(a) Since gross profit margin is 15 per cent, the cost of goods should be 85 per cent of the sales.

Cost of goods sold = 0.85 6,40,000 = Rs. 5,44,000

5 =
So, average inventory = = Rs. 1,08,800
Student Activities
Average collection period = 360

Average debtors = (Opening debtors + Closing debtors)/2

Closing balance of debtors is found as follows:

Current assets (2.5 of current liabilities) 2,40,000

Less: Inventories 48,000

Cash 16,000 64,000

Debtors 1,76,000

Average collection period = 360

Average debtors=
= 72 days
 (E) Profitability Ratios (Why ?)
• A company should earn profits to survive and grow over a long period of time.

• Sufficient profits must be earned to sustain the operations of the business to be able to obtain funds from investors for
expansion and growth and to contribute towards the social overheads for the welfare of the society.

• Profit is the difference between revenues and expenses over a period of time.

• Profit is the ultimate ‘output’ of a company, and it will have no future if it fails to make sufficient profits.

• Therefore, the financial manager should continuously evaluate the efficiency of the company in terms of profits.

• The profitability ratios are calculated to measure the operating efficiency of the company.

• Besides management of the company, creditors and owners are also interested in the profitability of the firm.

• Creditors want to get interest and repayment of principal regularly.

• Owners want to get a required rate of return on their investment.

• This is possible only when the company earns enough profits.

• Generally, two major types of profitability ratios are calculated: profitability in relation to sales and profitability in relation to
investment.
 How is Profit Measured ?

• Gross profit (GP) is the difference between sales and the manufacturing cost of goods sold.

• The most common measure of profit is profit after taxes (PAT), or net income (NI), which is a result of the impact of all
factors on the firm’s earnings.

• Taxes are not controllable by management. To separate the influence of taxes, therefore, profit before taxes (PBT) may be
computed.

• If the firm’s profit has to be examined from the point of view of all investors (lenders and owners), the appropriate measure
of profit is operating profit.

• Operating profit is equivalent of earnings before interest and taxes (EBIT).

• This measure of profit shows earnings arising directly from the commercial operations of the business without the effect of
financing.

• On an after tax basis, profit to investors is equal to: EBIT(1-T), where T is the corporate tax. This profit measure is called net
operating profit after tax or NOPAT.
Net Operating Profit after tax (NOPAT)

• The profit after tax (PAT) figure excludes interest on borrowing.

• Interest is tax deductible, and therefore, a firm that pays more interest pay less tax.

• Tax saved on account of payment of interest is called interest tax shield.

• Thus, the conventional measure of net-profit margin – PAT to sales ratio – is affected by the firm’s financing policy.

• It can mislead if we compare two firms with different debt ratios.

• For a true comparison of the operating performance of firms, we must ignore the effect of financial leverage, viz.,
the measure of profit should ignore interest and its tax effect.

• For example, net profit margin (for evaluating operating performance) may be computed in the following way:

Net profit margin = =

where,
T is the corporate tax
EBIT (1-T) is the after-tax operating profit, assuming that the firm has no debt.
(i) Gross Profit Margin or Gross Margin Ratio and what does it reflects ?

• The gross profit margin reflects the efficiency with which management produces each unit of product.

Gross profit margin = =

Gross profit margin = = 0.179 or 17.9%

High or Low Gross Profit Margin ?
• A high gross profit margin relative to the industry average implies that the firm is able to produce at relatively lower cost.

• A high gross profit margin ratio is a sign of good management.

• A gross margin ratio may increase due to any of the following factors:
 Higher sales price, cost of goods sold remaining constant.
 Lower cost of goods sold, sales price remaining constant.
 A combination of variations in sales prices and costs, the margin widening.
 An increase in the proportionate volume of higher margin items.

• A low gross profit margin may reflect higher cost of goods sold due to the firm’s inability to purchase raw materials at
favorable terms, inefficient utilization of plant and machinery, or over-investment in plant and machinery, resulting in
higher cost of production.

• The ratio will also be low due to a fall in prices in the market, or marked reduction in selling price by the firm in an
attempt to obtain large sales volume, the cost of goods sold remaining unchanged.
(ii) Net Profit Margin and what does it reflects ?

• Net profit is obtained when operating expenses, interest and taxes are subtracted from the gross profit.

Net profit margin = = = 0.036 or 3.6 %

High or Low Net Profit Margin ?

• Net profit margin ratio establishes a relationship between net profit and sales and indicates management’s efficiency in
manufacturing, administering and selling the products.

• This ratio is the overall measure of the firm’s ability to turn each rupee sales into net profit.

• If the net margin is inadequate, the firm will fail to achieve satisfactory return on shareholder’s funds.

• This ratio also indicates the firm’s capacity to withstand adverse economic conditions.

• A firm with a higher net profit margin ratio would be in advantageous position to survive in the face of falling selling prices,
rising cost of production or declining demand for the product.

• It would be really difficult for a low net margin firm to withstand these adversities.
Interpretation – Gross Profit Margin and Net profit Margin

• An analyst will be able to interpret the firm’s profitability more meaningfully if he/she evaluates both the
ratios – gross margin and net-margin – jointly.

• To illustrate, if the gross profit margin has increased over the years, but the net profit margin has either
remained constant or declined, or has not increased as fast as the gross margin, it implies that the
operating expenses relative to sales have been increasing.

• The increasing expenses should be identified and controlled.

• Gross profit margin may decline due to fall in sales price or increase in the cost of production.

• As a consequence, net profit margin will decline unless operating expenses decrease significantly.

• The crux of the argument is that both the ratios should be jointly analyzed, and each item of expense
should be thoroughly investigated to find out the causes of decline in any or both the ratios.
(iii) Net Margin Based on NOPAT
• For a true comparison of the operating performance of firms, we must ignore the effect of financial leverage, viz.,
the measure of profit should ignore interest and its tax effect.

• Net profit margin for evaluating operating performance may be computed in the following way:

Net profit margin = = = = = 0.063 or 6.3 %

• Taxes are not controllable by a firm, and also, one may not know the marginal corporate tax rate while analysing the
published data.

• Therefore, the margin ratio may be calculated on before-tax basis.

Profit margin = = = 0.092 or 9.2%

(v) Return on Investment (ROI)
• The term investment may refer to total assets.

• The conventional approach of calculating return on investment (ROI) is to divide profit after tax (PAT) by
investment.

• Investment represents pool of funds supplied by shareholders and lenders, while PAT represents residue income of
shareholders; therefore, it is conceptually unsound to use PAT in the calculation of ROI.

• Also, as discussed earlier, PAT is affected by capital structure.

• It is therefore more appropriate to use one of the following measures of ROI for comparing the operating efficiency
of firms:

ROI = ROTA = =

• where, ROI = ROTA = = 0.089 = 8.9%

• ROI is return on investment
• ROTA is return on total assets
• EBIT is earnings before interest and taxes
• T is the tax rate
• TA is total assets
(vi) Return on Equity (ROE)
• Common or ordinary shareholders are entitled to the residual profits.

• The rate of dividend is not fixed; the earnings may be distributed to shareholders or retained in the business.

• Nevertheless, the net profits after taxes represent their return.

• A return on shareholder’s equity is calculated to see the profitability of owners’ investment.

ROE =

• The shareholder’s equity or net worth will include paid-up share capital, share premium and reserves and surplus
less accumulated losses.

• Net worth can also be found by subtracting total liabilities from total assets.

ROE = = 0.20 = 20%

• ROE indicates how well the firm has used the resources of owners.
• The returns on owners’ equity of the company should be compared with the ratios for other similar companies and
the industry average.
• This will reveal the relative performance and strength of the company in attracting future investments.
 (vii) Earnings per Share (EPS)
• The earnings per share (EPS) is calculated by dividing the profit after taxes by the total number of ordinary shares outstanding.

EPS = = = Rs. 6.00

• EPS calculations made over the years indicate whether or not the firm’s earnings power on per-share basis has changed over that
period.

• The EPS of the company should be compared with the industry average and the earnings per share of other firms.

• EPS simply shows the profitability of the firm on a per-share basis; it does not reflect how much is paid as dividend and how much
is retained in the business.

(viii) Dividend per Share (DPS or DIV)

• The net profits after taxes belong to shareholders. But the income, which they really receive, is the amount of earnings distributed
as cash dividends.

• Therefore, a large number of present and potential investors may be interested in DPS, rather than EPS.

• DPS is the earnings distributed to ordinary shareholders divided by the number of ordinary shares outstanding.

DPS = = = Rs. 2.00

The company distributed Rs. 2.00 per share as dividend out of Rs. 6.00 earned per share. The difference per share is retained in
the business.