Financial Statements Analysis

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FINANCIAL STATEMENTS ANALYSIS

Ratio Analysis

Common Size Statements Importance and Limitations of Ratio Analysis
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Ratio Analysis

Ratio analysis is a widely used tool of financial analysis. It is defined as the systematic use of ratio to interpret the financial statements so that the strengths and weaknesses of a firm as well as its historical performance and current financial condition can be determined.

© Tata McGraw-Hill Publishing Company Limited, Management Accounting McGraw-

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Basis of Comparison
1) Trend Analysis involves comparison of a firm over a period of time, that is, present ratios are compared with past ratios for the same firm. It indicates the direction of change in the performance ± improvement, deterioration or constancy ± over the years. 2) Interfirm Comparison involves comparing the ratios of a firm with those of others in the same lines of business or for the industry as a whole. It reflects the firm¶s performance in relation to its competitors. 3) Comparison with standards or industry average.
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Types of Ratios
Liquidity Ratios Capital Structure Ratios

Profitability Ratios

Efficiency ratios

Integrated Analysis Ratios

Growth Ratios
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000 60.000 Company B Rs 30.80.00.000 1.000 1.000 75.000 Company B Rs 2. Table 1: Net Working Capital Particulars Total current assets Total current liabilities NWC Table 2: Change in Net Working Capital Particulars Current assets Current liabilities NWC Company A Rs 1.000 1.Net Working Capital Net working capital is a measure of liquidity calculated by subtracting current liabilities from current assets.00.000 20.000 © Tata McGraw-Hill Publishing Company Limited. Management Accounting McGraw- .000 25.00.20.000 10.00.000 6-6 Company A Rs 1.

Liquidity Ratios Liquidity ratios measure the ability of a firm to meet its short-term obligations © Tata McGraw-Hill Publishing Company Limited. Management Accounting McGraw- 6-7 .

000 Rs 1.000 Rs 10.5:1) © Tata McGraw-Hill Publishing Company Limited.000 3:1 6-8 Particulars Current Assets Current Liabilities Current Ratio Firm A Rs 1. Management Accounting McGraw- .000 = 3:2 (1.20.Current Ratio Current Ratio is a measure of liquidity calculated dividing the current assets by the current liabilities Current Ratio = Current Assets Current Liabilities Firm B Rs 30.80.

AcidAcid-Test Ratio The quick or acid test ratio takes into consideration the differences in the liquidity of the components of current assets Quick Assets Current Liabilities Acid-test Ratio = Quick Assets = Current assets ± Stock ± Pre-paid expenses © Tata McGraw-Hill Publishing Company Limited. Management Accounting McGraw- 6-9 .

000 2:1 0.Example 1: Acid-Test Ratio AcidCash Debtors Inventory Total current assets Total current liabilities (1) Current Ratio (2) Acid-test Ratio Rs 2. Management Accounting McGraw- 6 .000 12.10 .5 : 1 © Tata McGraw-Hill Publishing Company Limited.000 8.000 16.000 2.

Supplementary Ratios for Liquidity Inventory Turnover Ratio Debtors Turnover Ratio Creditors Turnover Ratio © Tata McGraw-Hill Publishing Company Limited. Management Accounting McGraw- 6 .11 .

12 .Inventory Turnover Ratio The ratio indicates how fast inventory is sold. © Tata McGraw-Hill Publishing Company Limited. Management Accounting McGraw- 6 . A low ratio would signify that inventory does not sell fast and stays on the shelf or in the warehouse for a long time. Inventory turnover ratio = Cost of goods sold Average inventory The cost of goods sold means sales minus gross profit. A high ratio is good from the viewpoint of liquidity and vice versa. The average inventory refers to the simple average of the opening and closing inventory.

000 and Rs 45. Management Accounting McGraw- 6 .000) (Rs 35. (6) © Tata McGraw-Hill Publishing Company Limited.00.000 ± Rs 60.00.000 respectively. The stock at the beginning and the end of the year was Rs 35.13 .000 with a gross profit margin of 20 per cent. What is the inventory turnover ratio? Inventory turnover ratio = (Rs 3.000 + Rs 45.000) ÷ 2 6 (times = per year) 12 months Inventory = = 2 months holding period Inventory turnover ratio.Example 2: Inventory Turnover Ratio A firm has sold goods worth Rs 3.

from customers.14 . © Tata McGraw-Hill Publishing Company Limited.Debtors Turnover Ratio The ratio measures how rapidly receivables are collected. Debtors turnover ratio = Net credit sales Average debtors Net credit sales consist of gross credit sales minus returns. 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. Average debtors is the simple average of debtors (including bills receivable) at the beginning and at the end of year. if any. Management Accounting McGraw- 6 .

500 and Rs 32.15 .500 + Rs 32. The outstanding amount of debtors at the beginning and at the end of the year respectively was Rs 27.40.500) ÷ 2 = 12 Months Debtors turnover ratio.500.Example 3: Debtors Turnover Ratio A firm has made credit sales of Rs 2.40. (8) = 8 (times per year) 1.000 during the year. Management Accounting McGraw- 6 . Determine the debtors turnover ratio. Debtors turnover ratio = Rs 2.000 (Rs 27.5 Months Debtors collection period = © Tata McGraw-Hill Publishing Company Limited.

while a high ratio shows that accounts are to be settled rapidly.Returns to suppliers. Management Accounting McGraw- 6 . The creditors turnover ratio is an important tool of analysis as a firm can reduce its requirement of current assets by relying on supplier¶s credit. Creditors turnover ratio = Net credit purchases Average creditors Net credit purchases = Gross credit purchases . © Tata McGraw-Hill Publishing Company Limited.Creditors Turnover Ratio A low turnover ratio reflects liberal credit terms granted by suppliers.16 . Average creditors = Average of creditors (including bills payable) outstanding at the beginning and at the end of the year.

Creditors turnover ratio Creditor¶s payment period = (Rs 1.500 respectively. Find out the creditors turnover ratio. Management Accounting McGraw- 6 .80. (4) = 4 (times per year) = = 3 months © Tata McGraw-Hill Publishing Company Limited.500) ÷ 2 12 months Creditors turnover ratio.000) (Rs 42.Example 4: Creditors Turnover Ratio The firm in previous Examples has made credit purchases of Rs 1.80. The amount payable to the creditors at the beginning and at the end of the year is Rs 42.000.17 .500 Rs 47.500 and Rs 47.

5 months ± 3 months 0.5 months As a rule. the better are the liquidity ratios as measured above and vice versa. The cash cycle captures the interrelationship of sales. © Tata McGraw-Hill Publishing Company Limited.18 .The summing up of the three turnover ratios (known as a cash cycle) has a bearing on the liquidity of a firm. Management Accounting McGraw- 6 . collections from debtors and payment to creditors. The combined effect of the three turnover ratios is summarised below: Inventory holding period Add: Debtor¶s collection period Less: Creditor¶s payment period 2 months + 1. the shorter is the cash cycle.

19 . Management Accounting McGraw- 6 .DEFENSIVE INTERVAL RATIO Defensive interval ratio is the ratio between quick assets and projected daily cash requirement. Liquid assets = Projected daily cash requirement Defensiveinterval ratio Projected daily cash requirement = Projected cash operating expenditure Number of days in a year (365) © Tata McGraw-Hill Publishing Company Limited.

500 365 Rs 40.82.000.500.Example 5: Defensive Interval Ratio The projected cash operating expenditure of a firm from the next year is Rs 1. Projected daily cash requirement = Defensive-interval ratio = Rs 1. Determine the defensive-interval ratio.20 © Tata McGraw-Hill Publishing Company Limited. It has liquid current assets amounting to Rs 40.82. Management Accounting McGraw- .000 Rs 500 = Rs 500 = 80 days 6 .

Cash-flow From Operations Ratio Cash-flow from operation ratio measures liquidity of a firm by comparing actual cash flows from operations (in lieu of current and potential cash inflows from current assets such as inventory and debtors) with current liability. Management Accounting McGraw- 6 .21 . Cash-flow from operations ratio Cash-flow from operations Current liabilities = © Tata McGraw-Hill Publishing Company Limited.

Accordingly. and (ii) Regular payment of the interest . Capital structure or leverage ratios throw light on the long-term solvency of a firm.Leverage Capital Structure Ratio There are two aspects of the long-term solvency of a firm: (i) Ability to repay the principal when due.22 . First type: These ratios are computed from the balance sheet (a) Debt-equity ratio (b) Debt-assets ratio (c) Equity-assets ratio © Tata McGraw-Hill Publishing Company Limited. Management Accounting McGraw- Second type: These ratios are computed from the Income Statement (a) Interest coverage ratio (b) Dividend coverage ratio 6 . there are two different types of leverage ratios.

To the creditors.I.23 . Management Accounting McGraw- Long-term Debt + Short 6 . It is danger signal for the lenders and creditors. a relatively high stake of the owners implies sufficient safety margin and substantial protection against shrinkage in assets. Debt-equity ratio DebtDebt-equity ratio measures the ratio of long-term or total debt to shareholders equity. © Tata McGraw-Hill Publishing Company Limited. If the project should fail financially. A low D/E ratio has just the opposite implications. the creditors would lose heavily. the owners are putting up relatively less money of their own. Debt-equity ratio measures the ratio of long-term debt + Other Current Total Debt Debt-equitytotal de3bt to shareholders equity Liabilities = Total external ratio = term or Shareholders¶ equity Obligations If the D/E ratio is high.

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. Management Accounting McGraw- 6 . the servicing of debt is less burdensome and consequently its credit standing is not adversely affected.24 . © Tata McGraw-Hill Publishing Company Limited.For the company also. its operational flexibility is not jeopardised and it will be able to raise additional funds.

25 © Tata McGraw-Hill Publishing Company Limited.Trading on Equity Trading on equity (leverage) is the use of borrowed funds in expectation of higher return to equity-holders. Trading on Equity Particular (a) Total assets Financing pattern: Equity capital 15% Debt (b)Operating profit (EBIT) Less: Interest Earnings before taxes Less: Taxes (0.000 800 200 300 30 270 94.5 21.5 175. Management Accounting McGraw- .5 (Amount in Rs thousand) B 1.35) Earnings after taxes Return on equity (per cent) A 1.9 C 1.000 1.000 600 400 300 60 240 84 156 26 D 1.000 ² 300 ² 300 105 195 19.000 200 800 300 120 180 63 117 58.5 6 .

26 . Debt to total capital ratio = Total debt Permanent capital Permanent Capital = Shareholders¶ equity Long-term debt.II. Management Accounting McGraw- 6 . + © Tata McGraw-Hill Publishing Company Limited. Debt to Total Capital The relationship between creditors¶ funds and owner¶s capital can also be expressed using Debt to total capital ratio.

Management Accounting McGraw- 6 . Total debt Total assets Proprietary ratio = Capital Gearing Ratio Proprietary funds X 100 Total assets Capital gearing ratio is used to know the relationship between equity funds (net worth) and fixed income bearing funds (Preference shares.27 . debentures and other borrowed funds.III. © Tata McGraw-Hill Publishing Company Limited. Debt to total assets ratio Debt to total assets ratio = Proprietary Ratio Proprietary ratio indicates the extent to which assets are financed by owners funds.

Coverage Ratio Interest Coverage Ratio Interest Coverage Ratio measures the firm¶s ability to make contractual interest payments. EBIT (Earning before interest and taxes) Interest Dividend coverage ratio = EAT (Earning after taxes) Preference dividend 6 . Interest coverage ratio = Dividend Coverage Ratio Dividend Coverage Ratio measures the firm¶s ability to pay dividend on preference share which carry a stated rate of return. Management Accounting McGraw- .28 © Tata McGraw-Hill Publishing Company Limited.

coverage ratios mentioned above.Total fixed charge coverage ratio Total fixed charge coverage ratio measures the firm¶s ability to meet all fixed payment obligations. that is. it would be more appropriate to relate cash resources of a firm to its various fixed financial obligations. suffer from one major limitation. they relate the firm¶s ability to meet its various financial obligations to its earnings. Management Accounting McGraw- . EBIT + Lease Payment Total fixed charge = Interest + Lease payments + (Preference dividend coverage ratio + Instalment of Principal)/(1-t) Total Cashflow Coverage Ratio However.29 Total cashflow = coverage ratio © Tata McGraw-Hill Publishing Company Limited. EBIT + Lease Payments + Depreciation + Non-cash expenses Lease payment + + Interest (Principal repayment) (1± t) + (Preference dividend) (1 . Accordingly.t) 6 .

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. ™ DSCR n = t=1 EATt + Interestt ™ t=1 n + Depreciationt + OAt Instalmentt DEBT 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.30 . © Tata McGraw-Hill Publishing Company Limited. Management Accounting McGraw- 6 .

60 10.56 5.00 18.20 18.14 17.00 18.67 34.08 7.64 15.33 16.00 18.61 18.00 18.31 .01 19.77 36.40 18.00 18.70 18.00 18.04 Nil Repayment of term loan in the year 10.41 Interest on term loan during the year 19.Example 6: Debt-Service Coverage Ratio DebtAgro Industries Ltd has submitted the following projections.00 The net profit has been arrived after charging depreciation of Rs 17. (Figures in Rs lakh) Year 1 2 3 4 5 6 7 8 Net profit for the year 21. © Tata McGraw-Hill Publishing Company Limited.68 lakh every year. You are required to work out yearly debt service coverage ratio (DSCR) and the average DSCR. Management Accounting McGraw- 6 .12 12.

6) 7 29.64 15.97 2.56 23.84 35.12 12.56 5.60 28.68 17. of times)] 8 1.33 16.00 1.08 7.41 3 17. 5 ÷ col.20 18. Management Accounting McGraw- .37 43.00 18.70 18. 2+3+4) 5 58.68 17.08 25.89 1 1 2 3 4 5 6 7 8 2 21.00 18.04 18.61 18.68 17.67 34. 4 + col.00 Average DSCR (DSCR ÷ 8) © Tata McGraw-Hill Publishing Company Limited.64 33.09 68.68 17.12 30.00 18.68 17.09 Principal instalment Debt obligation (col.00 18.96 1.81 49.68 17.49 70.65 1.32 DSCR [col.00 18.68 17.71 1.60 10.05 34.04 Nil 6 10. 7 (No.00 18.40 18.77 36.68 4 19.48 46.Solution Table 3: Determination of Debt Service Coverage Ratio (Amount in lakh of rupees) Ye ar Net profit Depreciation Interest Cash available (col.01 19.64 41.14 17.08 1.78 1.83 6 .62 1.

Management Accounting McGraw- .33 © Tata McGraw-Hill Publishing Company Limited. Profitability Ratios Related to Sales (i) Profit Margin (ii) Expenses Ratio Profitability Ratios Related to Investments (i) Return on Investments (ii) Return on Shareholders¶ Equity 6 .Profitability Ratio Profitability ratios can be computed either from sales or investment.

Management Accounting McGraw- 6 .Profit Margin Gross Profit Margin Gross profit margin measures the percentage of each sales rupee remaining after the firm has paid for its goods.34 . Gross profit margin = Gross Profit X 100 Sales © Tata McGraw-Hill Publishing Company Limited.

Net Profit Ratio = © Tata McGraw-Hill Publishing Company Limited. Management Accounting McGraw- . Operating Profit Ratio = ii. Pre-tax Profit Ratio = iii.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 taxes Net sales Earnings before taxes Net sales Earning after interest and taxes Net sales 6 .35 i.

00.00.Example 7: From the following information of a firm.000 Rs 2. Management Accounting McGraw- 6 .36 . Sales Rs 2. Cost of goods sold 1.000 2.000 = 50 per cent (2) Net profit margin = = 25 per cent © Tata McGraw-Hill Publishing Company Limited.000 Rs 2.000 Rs 50.00.000 3. Other operating expenses 50.000 (1) Gross profit margin = Rs 1.00. determine (i) Gross profit margin and (ii) Net profit margin. 1.00.

Operating ratio = Selling expenses Net sales X 100 X 100 Cost of goods sold + Operating expenses X 100 Net sales Financial expenses Net sales X 100 6 .37 vi. Administrative expenses = Net sales iv. Management Accounting McGraw- . Operating expenses = Cost of goods sold Net sales X 100 X 100 Administrative exp.Expenses Ratio i. + Selling exp. Financial expenses = © Tata McGraw-Hill Publishing Company Limited. Cost of goods sold = ii. Net sales Administrative expenses iii. Selling expenses ratio = v.

Return on Assets (ROA) ROA = EAT + (Interest ± Tax advantage on interest) Average total assets ii. Return on Capital Employed (ROCE) ROCE = EAT + (Interest ± Tax advantage on interest) Average total capital employed 6 .38 © Tata McGraw-Hill Publishing Company Limited.Return on Investment Return on Investments measures the overall effectiveness of management in generating profits with its available assets. i. Management Accounting McGraw- .

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¶ equity Return 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 McGraw- 6 .39 .

the speed with which inventory is sold Cost of raw materials of i.Efficiency Ratio Activity ratios measure the speed with which various accounts/assets are converted into sales or cash. Inventory Turnover measures theof goods sold Inventory Turnover Ratio = Average inventory inventory of a firm. Inventory Turnover measuresCost activity/liquidity of the of goods manufactured Work-in-progress turnover = Average work-in-progress inventory inventory of a firm. Inventory turnover measures the efficiency of various types of inventories. the speed with whichmaterial inventory Average raw inventory is sold i.40 . the speed with which inventory is sold © Tata McGraw-Hill Publishing Company Limited. Cost activity/liquidity of i. Management Accounting McGraw- 6 . Inventory Turnover measures the activity/liquidityused Raw materials turnover = inventory of a firm.

Management Accounting McGraw- 6 . Inventory Turnover measures the activity/liquidity of inventory of i. the speed with which inventory is sold bills receivable (B/R) Average debtors + Average 2. © Tata McGraw-Hill Publishing Company Limited. Credit sales i.Debtors Turnover Ratio Liquidity of a firm¶s receivables can be examined in two ways.41 . Inventory Turnover(days) in a yearactivity/liquidity of inventory of a Alternatively = Total sold firm. Debtors turnover = a firm. Average collection period = Months (days) in a year Debtors turnover Months measures the (x) (Average Debtors + Average (B/R) i. the speed with which inventory is credit sales Ageing Schedule enables analysis to identify slow paying debtors.

Inventory Turnover measures the activity/liquidity of inventory of i. Capital turnover = measures the activity/liquidity of inventory of Average capital a firm. Working Net working capital a firm. Management Accounting McGraw- 6 . the speed with which inventory is sold employed iv. Total assets turnover = Average is sold a firm. the speed with which inventory is sold © Tata McGraw-Hill Publishing Company Limited.Assets Turnover Ratio Assets turnover indicates the efficiency with which firm uses all its assets to generate sales. Inventory Turnover iii. Inventorycapital turnover = Costactivity/liquidity of inventory of Turnover measures the of goods sold v. the speed with which inventory total assets ii. Current assets turnover = Cost of goods sold Average current assets i. Cost of goods sold i. Fixed assets turnover = Cost of goods sold Average fixed assets Cost of goods sold i.42 .

1) 2) Return on shareholders¶ equity = EAT/Average total shareholders¶ equity. 4) Dividends per share (DPS) = Dividend paid to ordinary shareholders/Number of ordinary shares outstanding (N). 3) Earnings per share (EPS) = Net profit available to equity shareholders¶ (EAT ± Dp)/Number of equity shares outstanding (N). Dividend payment/payout (D/P) ratio = DPS/EPS. © Tata McGraw-Hill Publishing Company Limited. Return on equity funds = (EAT ± Preference dividend)/Average ordinary shareholders¶ equity (net worth). Management Accounting McGraw- 6 .43 . Book value per share = Ordinary shareholders¶ equity/Number of equity shares outstanding. Dividend Yield = DPS/Market price per share. 5) 6) 7) 8) 9) Earnings yield = EPS/Market price per share. Price-earnings (P/E) ratio = Market price of a share/EPS.

Integrated Analysis Ratio Integrated ratios provide better insight about financial and economic analysis of a firm. Management Accounting McGraw- 6 .44 . (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 McGraw- 6 .Rate of Return on Assets EAT as percentage of sales EAT Divided by Sales Sales Fixed assets Gross profit = Sales less cost of goods sold Minus Expenses: Selling Administrative Interest Minus Income-tax Assets turnover Divided by Plus Total Assets Current assets Alternatively Shareholder equity Plus Long-term borrowed funds Plus Current liabilities © Tata McGraw-Hill Publishing Company Limited.45 .

Net profit margin = Earning after taxes/Sales Asset turnover = Sales/Total assets Earning after the activity/liquidity of inventory of Sales EAT i. Management Accounting McGraw- 6 .46 . Earning power = Net profit margin × Assets turnover Where. is computed by multiplying net profit margin and assets turnover. Inventory Turnover measurestaxes x x x Earning Power = a firm.Return on Assets Earning Power Earning power is the overall profitability of a firm. the speed with which inventory isTotal Assets Total assets Sales sold © Tata McGraw-Hill Publishing Company Limited.

each having total assets amounting to Rs 4.00. Rs 40. Table 4: Return on Assets (ROA) of Firms A and B Particulars 1.000 40.00.EXAMPLE: 8 Assume that there are two firms. whereas the sales of firm B aggregate Rs 40.000 10 1 10 Firm B Rs 40.000 4. Net profit 3.00. Management Accounting McGraw- . Total assets 4. Firm A has sales of Rs 4.000 40. and average net profits after taxes of 10 per cent. that is. Net sales 2.00. ROA ratio (4 × 5) (per cent) Firm A Rs 4.00.000.00. Profit margin (2 ÷ 1) (per cent) 5. Determine the ROA of firms A and B. A and B. each.000 4.47 © Tata McGraw-Hill Publishing Company Limited.000. Table 4 shows the ROA based on two components. Assets turnover (1 ÷ 3) (times) 6.000 1 10 10 6 .000.000.00.

the EBIT As a result of three sub-parts of net profit ratio. EAT EBT x EBT EBIT x EBIT x Sales Sales Assets x Assets Equity 6 .48 © Tata McGraw-Hill Publishing Company Limited. the ROE is composed of the following 5 components.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. Management Accounting McGraw- . Inventory Turnover measures the activity/liquidity of x = x Sales Sales Earnings before taxes speed with which inventory is sold inventory of a firm. Net Profit EBT EBIT EAT i.

538 40.26.000 61.462 (Firm A) and Rs 39.22.538 21.462 (Firm B) for the facts contained in Example 8. Management Accounting McGraw- . 35 per cent tax rate and other operating expense of Rs 3.00. To illustrate further assume 8 per cent interest rate.65 0.000 0.000 2.00.00.49 © Tata McGraw-Hill Publishing Company Limited.000 2. Table 5 shows the ROE (based on the 5 components) of Firms A and B.000 4.000 39.462 77.22.65 0.462 73. Table 5: ROE (Five-way Basis) of Firms A and B Particulars Net sales Less: Operating expenses Earnings before interest and taxes (EBIT) Less: Interest (8%) Earnings before taxes (EBT) Less: Taxes (35%) Earnings after taxes (EAT) Total assets Debt Equity EAT/EBT (times) EBT/EBIT (times) EBIT/Sales (per cent) Sales/Assets (times) Assets/Equity (times) ROE (per cent) Firm A Rs 4.000 4.4 1 2 20 Firm B Rs 40.538 16.00.538 12.6 16 6 .000 1.000 3.26.000 61.538 40.84 1.538 21.50.00.000 2.000 0.84 10 1.A 5-way break-up of ROE enables the management of a firm to analyse the effect of interest payments and tax payments separately from operating profitability.79 19.50.00.

Nevertheless. they are an important tool of financial analysis.Common Size Statements Preparation of common-size financial statements is an extension of ratio analysis.50 . It is sales in the case of income statement and totals of assets and liabilities in the case of the balance sheet. Limitations Ratio analysis in view of its several limitations should be considered only as a tool for analysis rather than as an end in itself. © Tata McGraw-Hill Publishing Company Limited. Management Accounting McGraw- 6 . These statements convert absolute sums into more easily understood percentages of some base amount. The reliability and significance attached to ratios will largely hinge upon the quality of data on which they are based. They are as good or as bad as the data itself.

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