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Ratio analysis

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  • 1. Financial Statements Analysis © Tata McGraw-Hill Publishing Company Limited, Management Accounting 6-1
  • 2. FINANCIAL STATEMENTS ANALYSIS Ratio Analysis Common Size Statements Importance and Limitations of Ratio Analysis© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6-2
  • 3. Ratio AnalysisRatio analysis is a widely used tool of financial analysis. It is defined as the systematic use of ratio to interpret the financial statements so that the strengths and weaknesses of a firm as well as its historical performance and current financial condition can be determined. © Tata McGraw-Hill Publishing Company Limited, Management Accounting 6-3
  • 4. Basis of Comparison1) Trend Analysis involves comparison of a firm over a period of time, that is, present ratios are compared with past ratios for the same firm. It indicates the direction of change in the performance – improvement, deterioration or constancy – over the years.2) Interfirm Comparison involves comparing the ratios of a firm with those of others in the same lines of business or for the industry as a whole. It reflects the firm’s performance in relation to its competitors.3) Comparison with standards or industry average. © Tata McGraw-Hill Publishing Company Limited, Management Accounting 6-4
  • 5. Types of Ratios Liquidity Ratios Capital Structure RatiosProfitability Ratios Efficiency ratios Integrated Growth Ratios Analysis Ratios© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6-5
  • 6. Net Working Capital Net working capital is a measure of liquidity calculated by subtracting current liabilities from current assets.Table 1: Net Working CapitalParticulars Company A Company BTotal current assets Rs 1,80,000 Rs 30,000Total current liabilities 1,20,000 10,000NWC 60,000 20,000Table 2: Change in Net Working CapitalParticulars Company A Company BCurrent assets Rs 1,00,000 Rs 2,00,000Current liabilities 25,000 1,00,000NWC 75,000 1,00,000 © Tata McGraw-Hill Publishing Company Limited, Management Accounting 6-6
  • 7. Liquidity Ratios Liquidity ratios measure the ability of a firm to meet its short-term obligations© Tata McGraw-Hill Publishing Company Limited, Management Accounting 6-7
  • 8. Current Ratio Current Ratio is a measure of liquidity calculated dividing the current assets by the current liabilities Current Assets Current Ratio = Current LiabilitiesParticulars Firm A Firm BCurrent Assets Rs 1,80,000 Rs 30,000Current Liabilities Rs 1,20,000 Rs 10,000Current Ratio = 3:2 (1.5:1) 3:1 © Tata McGraw-Hill Publishing Company Limited, Management Accounting 6-8
  • 9. Acid-Test RatioThe quick or acid test ratio takes into consideration the differences in the liquidity of the components of current assets Quick Assets Acid-test Ratio = Current Liabilities Quick Assets = Current assets – Stock – Pre-paid expenses © Tata McGraw-Hill Publishing Company Limited, Management Accounting 6-9
  • 10. Example 1: Acid-Test RatioCash Rs 2,000Debtors 2,000Inventory 12,000Total current assets 16,000Total current liabilities 8,000(1) Current Ratio 2:1(2) Acid-test Ratio 0.5 : 1 © Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 10
  • 11. Supplementary Ratios for LiquidityInventory Turnover Debtors Turnover Ratio Ratio Creditors Turnover Ratio © Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 11
  • 12. Inventory Turnover RatioThe ratio indicates how fast inventory is sold. A high ratio is good from the viewpoint of liquidity and vice versa. A low ratio would signify that inventory does not sell fast and stays on the shelf or in the warehouse for a long time. Cost of goods soldInventory turnover ratio = Average inventory The cost of goods sold means sales minus gross profit.The average inventory refers to the simple average of the opening and closing inventory. © Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 12
  • 13. Example 2: Inventory Turnover RatioA firm has sold goods worth Rs 3,00,000 with a gross profit margin of 20 per cent. The stock at the beginning and the end of the year was Rs 35,000 and Rs 45,000 respectively. What is the inventory turnover ratio? Inventory (Rs 3,00,000 – Rs 60,000) 6 (times = =turnover ratio (Rs 35,000 + Rs 45,000) ÷ 2 per year) Inventory 12 months = = 2 monthsholding period Inventory turnover ratio, (6) © Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 13
  • 14. Debtors Turnover RatioThe ratio measures how rapidly receivables are collected. A high ratio is indicative of shorter time-lag between credit sales and cash collection. A low ratio shows that debts are not being collected rapidly. Net credit salesDebtors turnover ratio = Average debtors Net credit sales consist of gross credit sales minus returns, if any, from customers. Average debtors is the simple average of debtors (including bills receivable) at the beginning and at the end of year. © Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 14
  • 15. Example 3: Debtors Turnover Ratio A firm has made credit sales of Rs 2,40,000 during the year. The outstanding amount of debtors at the beginning and at the end of the year respectively was Rs 27,500 and Rs 32,500. Determine the debtors turnover ratio. Debtors Rs 2,40,000 8 (times = =turnover ratio (Rs 27,500 + Rs 32,500) ÷ 2 per year) Debtors 12 Months 1.5 = =collection period Debtors turnover ratio, (8) Months © Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 15
  • 16. Creditors Turnover RatioA low turnover ratio reflects liberal credit terms granted bysuppliers, while a high ratio shows that accounts are to be settledrapidly. The creditors turnover ratio is an important tool ofanalysis as a firm can reduce its requirement of current assets byrelying on supplier’s credit. Creditors turnover Net credit purchases = ratio Average creditors Net credit purchases = Gross credit purchases - Returns to suppliers.Average creditors = Average of creditors (including bills payable) outstanding at the beginning and at the end of the year. © Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 16
  • 17. Example 4: Creditors Turnover Ratio The firm in previous Examples has made credit purchases of Rs 1,80,000. The amount payable to the creditors at the beginning and at the end of the year is Rs 42,500 and Rs 47,500 respectively. Find out the creditors turnover ratio. Creditors (Rs 1,80,000) 4 (times = =turnover ratio (Rs 42,500 Rs 47,500) ÷ 2 per year) Creditor’s 12 months = = 3 monthspayment period Creditors turnover ratio, (4) © Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 17
  • 18. The summing up of the three turnover ratios (known as a cash cycle) has a bearing on the liquidity of a firm. The cash cycle captures the interrelationship of sales, collections from debtors and payment to creditors. The combined effect of the three turnover ratios is summarised below:Inventory holding period 2 months Add: Debtor’s collection period + 1.5 months Less: Creditor’s payment period – 3 months 0.5 months As a rule, the shorter is the cash cycle, the better are the liquidity ratios as measured above and vice versa. © Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 18
  • 19. DEFENSIVE INTERVAL RATIO Defensive interval ratio is the ratio between quick assets and projected daily cash requirement. Defensive- Liquid assets =interval ratio Projected daily cash requirement Projected daily Projected cash operating expenditure =cash requirement Number of days in a year (365) © Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 19
  • 20. Example 5: Defensive Interval RatioThe projected cash operating expenditure of a firm from the next year is Rs 1,82,500. It has liquid current assets amounting to Rs 40,000. Determine the defensive-interval ratio. Rs 1,82,500 Projected daily cash requirement = = Rs 500 365 Rs 40,000 Defensive-interval ratio = = 80 days Rs 500 © Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 20
  • 21. Cash-flow From Operations RatioCash-flow from operation ratio measures liquidity of afirm by comparing actual cash flows from operations (in lieu of current and potential cash inflows from current assets such as inventory and debtors) with current liability. Cash-flow from Cash-flow from operations = operations ratio Current liabilities © Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 21
  • 22. Leverage Capital Structure RatioThere are two aspects of the long-term solvency of a firm:(i) Ability to repay the principal when due, and(ii) Regular payment of the interest . Capital structure or leverage ratios throw light on the long-term solvency of a firm. Accordingly, there are two different types of leverage ratios. First type: These ratios are Second type: These ratios are computed from the balance computed from the Income sheet Statement(a) Debt-equity ratio (a) Interest coverage ratio(b) Debt-assets ratio (b) Dividend coverage ratio(c) Equity-assets ratio © Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 22
  • 23. I. Debt-equity ratio Debt-equity ratio measures the ratio of long-term or total debt to shareholders equity. Long-term Debt + Short Debt-equity ratio measures the ratio of long-term debt + Other Current Total Debt Debt-equitytotal de3bt to shareholders equity Liabilities = Total external term or ratio = Shareholders’ equity Obligations If the D/E ratio is high, the owners are putting up relatively less money of their own. It is danger signal for the lenders and creditors. If the project should fail financially, the creditors would lose heavily.A low D/E ratio has just the opposite implications. To the creditors, a relatively high stake of the owners implies sufficient safety margin and substantial protection against shrinkage in assets. © Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 23
  • 24. For the company also, the servicing of debt is lessburdensome and consequently its credit standingis not adversely affected, its operational flexibility is not jeopardised and it will be able to raise additional funds.The disadvantage of low debt-equity ratio is that the shareholders of the firm are deprived of the benefits of trading on equity or leverage. © Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 24
  • 25. Trading on Equity Trading on equity (leverage) is the use of borrowed funds in expectation of higher return to equity-holders.Trading on Equity (Amount in Rs thousand) Particular A B C D(a) Total assets 1,000 1,000 1,000 1,000 Financing pattern: Equity capital 1,000 800 600 200 15% Debt — 200 400 800(b)Operating profit (EBIT) 300 300 300 300 Less: Interest — 30 60 120Earnings before taxes 300 270 240 180Less: Taxes (0.35) 105 94.5 84 63Earnings after taxes 195 175.5 156 117Return on equity (per cent) 19.5 21.9 26 58.5 © Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 25
  • 26. II. Debt to Total Capital The relationship between creditors’ funds and owner’s capital can also be expressed using Debt to total capital ratio. Total debtDebt to total capital ratio = Permanent capitalPermanent Capital = Shareholders’ equity + Long-term debt. © Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 26
  • 27. III. Debt to total assets ratio Total debtDebt to total assets ratio = Total assetsProprietary Ratio Proprietary ratio indicates the extent to which assets are financed by owners funds. Proprietary fundsProprietary ratio = X 100 Total assetsCapital Gearing RatioCapital gearing ratio is used to know the relationship between equity funds (net worth) and fixed income bearing funds (Preference shares, debentures and other borrowed funds. © Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 27
  • 28. Coverage RatioInterest Coverage Ratio Interest Coverage Ratio measures the firm’s ability to make contractual interest payments. EBIT (Earning before interest and taxes)Interest coverage ratio = InterestDividend Coverage RatioDividend Coverage Ratio measures the firm’s ability to pay dividend on preference share which carry a stated rate of return. EAT (Earning after taxes)Dividend coverage ratio = Preference dividend © Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 28
  • 29. Total fixed charge coverage ratioTotal fixed charge coverage ratio measures the firm’s ability to meet all fixed payment obligations. Total fixed charge EBIT + Lease Payment coverage ratio = Interest + Lease payments + (Preference dividend + Instalment of Principal)/(1-t)Total Cashflow Coverage Ratio However, coverage ratios mentioned above, suffer from one major limitation, that is, they relate the firm’s ability to meet its various financial obligations to its earnings. Accordingly, it would be more appropriate to relate cash resources of a firm to its various fixed financial obligations. EBIT + Lease Payments + Depreciation + Non-cash expensesTotal cashflow =coverage ratio (Principal repayment) (Preference dividend) Lease payment + + + Interest (1– t) (1 - t) © Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 29
  • 30. Debt Service Coverage Ratio Debt-service coverage ratio (DSCR) is considered a more comprehensive and apt measure to compute debt service capacity of a business firm. n ∑ EATt + Interestt + Depreciationt + OAt t=1 DSCR = n ∑ Instalmentt t=1DEBT SERVICE CAPACITY Debt service capacity is the ability of a firm to make the contractual payments required on a scheduled basis over the life of the debt. © Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 30
  • 31. Example 6: Debt-Service Coverage RatioAgro Industries Ltd has submitted the following projections. You are required to work out yearly debt service coverage ratio (DSCR) and the average DSCR. (Figures in Rs lakh)Year Net profit for the Interest on term loan Repayment of term year during the year loan in the year 1 21.67 19.14 10.70 2 34.77 17.64 18.00 3 36.01 15.12 18.00 4 19.20 12.60 18.00 5 18.61 10.08 18.00 6 18.40 7.56 18.00 7 18.33 5.04 18.00 8 16.41 Nil 18.00The net profit has been arrived after charging depreciation of Rs 17.68 lakhevery year. © Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 31
  • 32. SolutionTable 3: Determination of Debt Service Coverage Ratio (Amount in lakh of rupees)Ye Net Depreciation Interest Cash Principal Debt DSCR [col. 5ar profit available instalment obligation ÷ col. 7 (col. (col. 4 + col. 6) (No. of times)] 2+3+4)1 2 3 4 5 6 7 81 21.67 17.68 19.14 58.49 10.70 29.84 1.962 34.77 17.68 17.64 70.09 18.00 35.64 1.973 36.01 17.68 15.12 68.81 18.00 33.12 2.084 19.20 17.68 12.60 49.48 18.00 30.60 1.625 18.61 17.68 10.08 46.37 18.00 28.08 1.656 18.40 17.68 7.56 43.64 18.00 25.56 1.717 18.33 17.68 5.04 41.05 18.00 23.04 1.788 16.41 17.68 Nil 34.09 18.00 18.00 1.89Average DSCR (DSCR ÷ 8) 1.83 © Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 32
  • 33. Profitability Ratio Profitability ratios can be computed either from sales or investment. Profitability Ratios Profitability Ratios Related to Sales Related to Investments(i) Profit Margin (i) Return on Investments(ii) Expenses Ratio (ii) Return on Shareholders’ Equity © Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 33
  • 34. Profit Margin Gross Profit MarginGross profit margin measures the percentage of each sales rupee remaining after the firm has paid for its goods.Gross profit margin = Gross Profit X 100 Sales © Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 34
  • 35. Net Profit Margin Net profit margin measures the percentage of each sales rupee remaining after all costs and expense including interest and taxes have been deducted. Net profit margin can be computed in three ways Earning before interest and taxesi. Operating Profit Ratio = Net sales Earnings before taxesii. Pre-tax Profit Ratio = Net sales Earning after interest and taxesiii. Net Profit Ratio = Net sales © Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 35
  • 36. Example 7: From the following information of a firm,determine (i) Gross profit margin and (ii) Net profitmargin.1. Sales Rs 2,00,0002. Cost of goods sold 1,00,0003. Other operating expenses 50,000 Rs 1,00,000 (1) Gross profit margin = = 50 per cent Rs 2,00,000 Rs 50,000 (2) Net profit margin = = 25 per cent Rs 2,00,000 © Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 36
  • 37. Expenses Ratio Cost of goods soldi. Cost of goods sold = X 100 Net sales Administrative exp. + Selling exp.ii. Operating expenses = X 100 Net sales Administrative expensesiii. Administrative expenses = X 100 Net sales Selling expensesiv. Selling expenses ratio = X 100 Net sales Cost of goods sold + Operating expensesv. Operating ratio = X 100 Net sales Financial expensesvi. Financial expenses = X 100 Net sales © Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 37
  • 38. Return on InvestmentReturn on Investments measures the overall effectiveness of management in generating profits with its available assets.i. Return on Assets (ROA) EAT + (Interest – Tax advantage on interest)ROA = Average total assetsii. Return on Capital Employed (ROCE) EAT + (Interest – Tax advantage on interest)ROCE = Average total capital employed © Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 38
  • 39. Return on Shareholders’ Equity Return on shareholders equity measures the return on the owners (both preference and equity shareholders ) investment in the firm.Return on total shareholders’ equity = Net profit after taxes X 100 Average total shareholders’ equityReturn on ordinary shareholders’ equity (Net worth) = Net profit after taxes – Preference dividend X 100 Average ordinary shareholders’ equity © Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 39
  • 40. Efficiency Ratio Activity ratios measure the speed with which various accounts/assets are converted into sales or cash.Inventory turnover measures the efficiency of various types of inventories.i. Inventory Turnover measures theof goods soldInventory Turnover Ratio = Cost activity/liquidity of Average inventoryinventory of a firm; the speed with which inventory is soldi. Inventory Turnover measures the activity/liquidityusedRaw materials turnover = Cost of raw materials ofinventory of a firm; the speed with whichmaterial inventory Average raw inventory is soldi. Inventory Turnover measuresCost activity/liquidity of the of goods manufacturedWork-in-progress turnover = Average work-in-progress inventoryinventory of a firm; the speed with which inventory is sold © Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 40
  • 41. Debtors Turnover Ratio Liquidity of a firm’s receivables can be examined in two ways. Credit salesi. Debtors turnover = measures the activity/liquidity of inventory of Inventory Turnoveri.a firm; the speed with which inventoryAverage bills receivable (B/R) Average debtors + is sold Months (days) in a year2. Average collection period = Debtors turnoveri. Inventory =Months (days) in a year (x) (Average Debtors + Average (B/R)Alternatively Turnover measures the activity/liquidity of inventory of afirm; the speed with which inventory is credit sales Total sold Ageing Schedule enables analysis to identify slow paying debtors. © Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 41
  • 42. Assets Turnover Ratio Assets turnover indicates the efficiency with which firm uses all its assets to generate sales.i. Total assets turnover = Cost of goods sold Inventory Turnover measures the activity/liquidity of inventory ofi.a firm; the speed with which inventory total assets Average is sold Cost of goods soldii. Fixed assets turnover = Average fixed assets Cost of goods soldi. Inventory Turnover measures the activity/liquidity of inventory ofiii. Capital turnover =a firm; the speed with which inventory is sold employed Average capital Cost of goods soldiv. Current assets turnover = Average current assetsi. Inventorycapital turnover = Costactivity/liquidity of inventory ofv. Working Turnover measures the of goods sold Net working capitala firm; the speed with which inventory is sold © Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 42
  • 43. 1) Return on shareholders’ equity = EAT/Average total shareholders’ equity.2) Return on equity funds = (EAT – Preference dividend)/Average ordinary shareholders’ equity (net worth).3) Earnings per share (EPS) = Net profit available to equity shareholders’ (EAT – Dp)/Number of equity shares outstanding (N).4) Dividends per share (DPS) = Dividend paid to ordinary shareholders/Number of ordinary shares outstanding (N).5) Earnings yield = EPS/Market price per share.6) Dividend Yield = DPS/Market price per share.7) Dividend payment/payout (D/P) ratio = DPS/EPS.8) Price-earnings (P/E) ratio = Market price of a share/EPS.9) Book value per share = Ordinary shareholders’ equity/Number of equity shares outstanding. © Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 43
  • 44. Integrated Analysis Ratio Integrated ratios provide better insight about financial and economic analysis of a firm.(1) Rate of return on assets (ROA) can be decomposed in to (i) Net profit margin (EAT/Sales) (ii) Assets turnover (Sales/Total assets)(2) Return on Equity (ROE) can be decomposed in to (i) (EAT/Sales) x (Sales/Assets) x (Assets/Equity) (ii) (EAT/EBT) x (EBT/EBIT) x (EBIT/Sales) x (Sales/Assets) x (Assets/Equity) © Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 44
  • 45. Rate of Return on Assets EAT as percentage of Assets sales turnoverEAT Divided by Sales Sales Divided by Total Assets Fixed assets Plus Current assetsGross profit = Sales less cost of goods sold Alternatively Minus Shareholder equity Expenses: Selling PlusAdministrative Interest Long-term borrowed Minus funds Income-tax Plus Current liabilities © Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 45
  • 46. Return on AssetsEarning Power Earning power is the overall profitability of a firm; is computed by multiplying net profit margin and assets turnover.Earning power = Net profit margin Assets turnoverWhere, Net profit margin = Earning after taxes/SalesAsset turnover = Sales/Total assetsi. Inventory Turnover measurestaxes xEarning Power = Earning after the activity/liquidity of inventory of Sales x EATa firm; the speed with which inventory isTotal Assets Total assets Sales sold © Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 46
  • 47. EXAMPLE: 8Assume that there are two firms, A and B, each having total assetsamounting to Rs 4,00,000, and average net profits aftertaxes of 10 per cent, that is, Rs 40,000, each.Firm A has sales of Rs 4,00,000, whereas the sales of firm B aggregate Rs 40,00,000. Determine the ROA of firms A and B. Table 4 shows the ROA based on two components.Table 4: Return on Assets (ROA) of Firms A and BParticulars Firm A Firm B1. Net sales Rs 4,00,000 Rs 40,00,0002. Net profit 40,000 40,0003. Total assets 4,00,000 4,00,0004. Profit margin (2 ÷ 1) (per cent) 10 15. Assets turnover (1 ÷ 3) (times) 1 106. ROA ratio (4 × 5) (per cent) 10 10 © Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 47
  • 48. Return on Equity (ROE)ROE is the product of the following three ratios: Net profit ratio (x) Assets turnover (x) Financial leverage/Equity multiplier Three-component model of ROE can be broadened further to consider the effect of interest and tax payments. EAT EBT EBIT Net Profiti. Inventory Turnover measures the activity/liquidity of x x =inventory of a firm; the EBIT SalesEarnings before taxes speed with which inventory is sold Sales As a result of three sub-parts of net profit ratio, the ROE is composed of the following 5 components. EAT EBT EBIT Sales Assets x x x x EBT EBIT Sales Assets Equity © Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 48
  • 49. A 5-way break-up of ROE enables the management of a firm to analyse the effect of interestpayments and tax payments separately from operating profitability. To illustrate further assume 8per cent interest rate, 35 per cent tax rate and other operating expense of Rs 3,22,462 (Firm A) andRs 39,26,462 (Firm B) for the facts contained in Example 8. Table 5 shows the ROE (based on the 5components) of Firms A and B.Table 5: ROE (Five-way Basis) of Firms A and BParticulars Firm A Firm BNet sales Rs 4,00,000 Rs 40,00,000 Less: Operating expenses 3,22,462 39,26,462Earnings before interest and taxes (EBIT) 77,538 73,538 Less: Interest (8%) 16,000 12,000Earnings before taxes (EBT) 61,538 61,538 Less: Taxes (35%) 21,538 21,538Earnings after taxes (EAT) 40,000 40,000Total assets 4,00,000 4,00,000Debt 2,00,000 2,50,000Equity 2,00,000 1,50,000EAT/EBT (times) 0.65 0.65EBT/EBIT (times) 0.79 0.84EBIT/Sales (per cent) 19.4 1.84Sales/Assets (times) 1 10Assets/Equity (times) 2 1.6ROE (per cent) 20 16 © Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 49
  • 50. Common Size StatementsPreparation of common-size financial statements is an extensionof ratio analysis. These statements convert absolute sums intomore easily understood percentages of some base amount. It issales in the case of income statement and totals of assets andliabilities in the case of the balance sheet. LimitationsRatio analysis in view of its several limitations should beconsidered only as a tool for analysis rather than as an end initself. The reliability and significance attached to ratios will largelyhinge upon the quality of data on which they are based. They areas good or as bad as the data itself. Nevertheless, they are animportant tool of financial analysis. © Tata McGraw-Hill Publishing Company Limited, Management Accounting 6 - 50

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