SESSION: 2

Financial statement analysis – part 1

[Common size and comparative statements, profitability analysis]

2-1
Learning objectives

• Get familiar with the structure of real-world financial statement

• Learns the basic steps of financial statement analysis
• Perform comparative analysis
• Perform common-size analysis
• Perform Du-Pont analysis
• Evaluate the profitability and efficiency of the company

2-2
Get familiar with the company

Before even looking at numbers take time to consider the following

1. Nature of business
2. Sources of competitive advantage for this company and how sustainable it is
3. Risks faced by the company
4. Prompters and board of directors
5. Major shareholders
6. Auditors
7. Regulatory environment

2-3
Getting familiar with the layout of real financial statements

Before we undertake the analysis of financial statements, we should be familiar with

the layout and elements of –

1. Balance sheet
2. Income statement
3. Statement of cash flows
4. Statement of shareholders’ equity (to be discussed later)
5. Footnotes (several to be discussed later)

2-4
 Structure of the balance sheet
• Typically, the balance sheet under Ind AS first list assets, then equity, and then followed
by liabilities

• In addition to current and non-current, assets and liabilities are further categorized as
financial and non- financial
• Financial assets include – investments, loans, cash & cash equivalents, accounts
receivable, etc
• Financial liabilities include – borrowings, bank loans, accounts payable, etc

• Under US GAAP / IFRS balance sheet first lists assets, then liability followed by
shareholders’ equity.

• There is no separate classification as financial and non financial assets and liabilities.

2-5
IFRS Balance sheet of Dr. Reddy Labs 2020 2021 Ind AS Balance sheet of Dr. Reddy Labs 2020 2021
ASSETS ASSETS
Current assets Non-current assets
Cash and cash equivalents 2,053 14,829 Property, plant and equipment 47,779 47,322
Other investments 23,687 19,744 Capital work-in-progress 4,364 9,539
Trade and other receivables 50,278 49,641 Goodwill 4,913 5,599
Inventories 35,066 45,412 Other intangible assets 15,811 29,136
Derivative financial instruments 1,105 1,218 Intangible assets under development 10,987 6,112
Tax assets 4,379 2,745 Investment in equity accounted investees 2,763 3,375
Other current assets 13,802 14,509 Financial assets
Total current assets 1,30,370 1,48,098 Investments 328 4958
Non-current assets Trade receivables 1,737 118
Property, plant and equipment, net 52,332 57,111 Other financial assets 793 768
Goodwill 3,994 4,568 Deferred tax assets, net 12,199 10,686
Other intangible assets 27,659 35,648 Tax assets, net 4,379 2,745
Trade and other receivables 1,737 118 Other non-current assets 209 307
Investment in equity accounted investees 2,763 3,375 Total non-current assets 1,06,262 1,20,665
Other investments 328 4,958 Current assets
Deferred tax assets 12,214 10,630 Inventories 35,067 45,412
Other non-current assets 844 834 Financial assets
Total non-current assets 1,01,871 1,17,242 Investments 23,687 19,744
Trade receivables 50,278 49,641
Derivative instruments 1,105 1,218
Cash and cash equivalents 2,053 14,829
Other financial assets 3,377 1,858
Other current assets 10,424 12,650
Total current assets 1,25,991 1,45,352
TOTAL ASSETS 2,32,241 2,65,491 TOTAL ASSETS 2,32,253 2,66,168
2-6
LIABILITIES AND EQUITY (IFRS) EQUITY AND LIABILITIES (Ind AS)
Current liabilities Equity
Trade and other payables 16,659 23,744 Equity share capital 831 832
Short-term borrowings 16,441 23,136 Other equity 1,55,157 1,75,585
Long-term borrowings, current portion 4,266 864 Total Equity 1,55,988 1,76,417
Provisions 3,800 3,435
Tax liabilities 573 1,389
Derivative financial instruments 1,602 326 Liabilities
Bank overdraft 91 9 Non-current liabilities
Other current liabilities 29,382 30,488 Financial Liabilities
Total current liabilities 72,814 83,391 Borrowings 1,304 6,299
Other financial liabilities -
Non-current liabilities Provisions 745 508
Long-term borrowings 1,304 6,299 Deferred tax liabilities, net 20 289
Deferred tax liabilities 275 338 Other non-current liabilities 2,055 1,617
Provisions 54 58 Total Non-current liabilities 4,124 8,713
Other non-current liabilities 2,806 2,343
Total non-current liabilities 4,439 9,038 Current liabilities
Total liabilities 77,253 92,429 Financial Liabilities
Borrowings 16,532 23,145
Equity Trade payables
Share capital 831 832 Total outstanding dues of SME 55 158
Treasury shares -1,006 -1,967 Total outstanding dues of creditors other than SME 15,193 17,951
Share premium 8,495 8,887 Derivative instruments 1,602 326
Share-based payment reserve 1,233 1,461 Other financial liabilities 27,006 24,281
Capital redemption reserve 173 173 Liabilities for current tax, net 572 1,388
Retained earnings 1,44,247 1,56,023 Provisions 4,669 5,015
Other components of equity 1,015 6,327 Other current liabilities 6,512 8,774
Total equity 1,54,988 1,73,062 Total liabilities 72,141 81,038
Total liabilities and equity 2,32,241 2,65,491 Total equity and liabilities 2,32,253 2,66,168

2-7
 Structure of the income statement

• In the US/IFRS Income statement expenses are categorized based on the function such as COGS,
SG&A, R&D, etc.

• In contrast, in India expenses are categorized based in the nature of expenses such as material
consumed, excise duty, salaries & wages, depreciation, etc.

• Implications of this structure

• In the Indian income statement the individual expenses are not broken down into the
components relating to factory employees and equipment versus office and sales employees
and equipment. Hence, we cannot figure out cost of goods sold (which include only factory
costs).
• Conversely, in the US/IFRS approach total employee costs or total depreciation are not
determinable from the income statement as they have been apportioned between manufacturing
and selling & administration and reported under those categories after being combined with
other expenses in the same category.

2-8
 Income statement as per IFRS Income statement as per Ind AS
Income 2020 2021 Income 2020 2021
Revenues 1,74,600 1,89,722 Sales 1,63,574 1,84,202
Cost of revenues 80,591 86,645 Service income and License fees 11,026 5,520
Gross profit 94,009 1,03,077 Other operating income 570 753
Selling, general and administrative expenses 50,129 54,650 Total revenue from operations 1,75,170 1,90,475
Research and development expenses 15,410 16,541 Other income 6,206 2,914
Impairment of non-current assets 16,767 8,588 Total income 1,81,376 1,93,389
Other income, net -4,290 -982 Expenses
Total operating expenses 78,016 78,797 Cost of materials consumed 29,848 42,958
Results from operating activities (A) 15,993 24,280 Purchase of stock-in-trade 25,459 25,736
Finance income 2,461 2,623 Changes in inventories 237 -7,905
Finance expense -983 -970 Employee benefits expense 33,802 36,299
Finance income, net (B) 1,478 1,653 Depreciation and amortisation expense 11,631 12,288
Share of profit of equity accounted investees, net of tax ( C) 561 480 Impairment of non-current assets 16,767 6,768
Profit before tax [(A)+(B)+(C)] 18,032 26,413 Finance costs 983 970
Tax (expense)/benefit, net 1,466 9,175 Selling and other expenses 44,353 47,920
Profit for the year 19,498 17,238 Total expenses 1,63,080 1,65,034
Earnings per share: Profit before tax and before share of equity accounted investees 18,296 28,355
Basic 117.63 103.94 Share of profit of equity accounted investees 561 480
Diluted 117.40 103.65 Profit before tax 18,857 28,835
Tax expense/(benefit)
Current tax 6,616 8,172
Deferred tax -8,019 1,147
Profit for the year 20,260 19,516
Earnings per share:
Basic 122.22 117.67
Diluted 121.99 117.34

2-9
Structure of the statement of cash flows
Important things to look out –

1. Major elements of operating, investing and financing cash flows

• Operating activities are the principal revenue-producing activities of the entity and other
activities that are not investing or financing activities.
• Investing activities are the acquisition and disposal of long-term assets and other investments
not included in cash equivalents.
• Financing activities are activities that result in changes in the size and composition of the
contributed equity and borrowings of the entity

2. Do the overall level and sign of CFO, CFI, and CFF relate with the life cycle of the company

2-10
 Summary of SCF 2020 2021
Net cash from operating activities (1) 29,841 35,703
Net cash used in investing activities (2) -4,923 -22,660
Net cash used in financing activities (3) -25,159 -298
Net Increase/(decrease) in cash and cash equivalents (4) = (1) + (2) + (3) -241 12,745
Effect of exchange rate changes (5) -25 113
Cash and cash equivalents at the beginning of the year (6) 2,228 1,962
Cash and cash equivalents at the end of the year (7) = (4) + (5) + (6) 1,962 14,820

2-11
IFRS Statement of cash flows of Dr. Reddy Labs 2,020 2,021
Cash flows from operating activities:
Profit for the year 19,498 17,238
Adjustments for:
Tax expense/(benefit), net (1,466) 9,175
Fair value changes and profit on sale of units of mutual funds, net (929) (557)
Depreciation and amortization 12,472 12,796
Impairment of non-current assets 16,767 8,588
Allowance for credit losses (on trade receivables and other advances) 190 230
Loss/(gain) on sale or de-recognition of non-current assets, net 68 42 These two sets of
Share of profit of equity accounted investees (561) (480) adjustments
Foreign exchange loss/(gain), net (2,168) 1,856 together help in
Interest expense, net 95 144
Equity settled share-based payment expense 521 584
removing the effect
Dividend income (5) 0 of accruals from
net income to
Changes in operating assets and liabilities: arrive at cash flow
Trade and other receivables (12,446) 2,081 from operations
Inventories (Refer to Note 10 for inventory write downs) (1,487) (9,881)
Trade and other payables 1,576 2,861
Other assets and other liabilities, net 4,821 (3,258)
Cash generated from operations 36,946 41,419
Income tax paid, net (7,105) (5,716)
Net cash from operating activities 29,841 35,703

2-12
 Cash flows used in investing activities:
Expenditures on property, plant and equipment (4,846) (9,741)
Proceeds from sale of property, plant and equipment 131 85
Expenditures on other intangible assets (1,269) (2,820)
Proceeds from sale of other intangible assets 259 -
Payment for acquisition of business (Refer to Note 6) - (15,514)
Purchase of other investments (1,11,918) (75,418)
Proceeds from sale of other investments 1,11,704 79,528
Dividends received from equity accounted investees 392 -
Interest and dividend received 624 1,220
Net cash used in investing activities (4,923) (22,660)

2-13
Cash flows used in financing activities:
Proceeds from issuance of equity shares (including treasury shares) 4 269
Purchase of treasury shares (474) (1,193)
Proceeds from/(repayment of) short-term borrowings, net (Refer to Note 17) 4,235 6,791
Proceeds from long-term borrowings (Refer to Note 17) - 3,800
Repayment of long-term borrowings (Refer to Note 17) (22,918) (3,743)
Payment of principal portion of lease liabilities (Refer to Note 17) (482) (754)
Dividend paid (March 31, 2020 and 2019 including corporate dividend tax) (3,916) (4,147)
Interest paid (1,608) (1,321)
Net cash used in financing activities (25,159) (298)

2-14
Reading footnotes

In this session we will read footnotes regarding two important aspects

1. Revenue recognition

2. Segment reporting

2-15
Revenue recognition footnotes
[Refer to note 1.2. m Revenue recognition details on pages 195-197]
1. Sale of goods
• Sales of generic products in India - Upon delivery of products to distributors by clearing
and forwarding agents of the Company. Control over the generic products is transferred by
the Company when the goods are delivered to distributors from clearing and forwarding
agents.
• Sales of active pharmaceutical ingredients and intermediates in India - Upon delivery of
products to customers (generally formulation manufacturers), from the factories of the
Company.
• Export sales and other sales outside of India - Upon delivery of the products to the
customers unless the terms of the applicable contract provide for specifi c revenue generating
activities to be completed, in which case revenue is recognised once all such activities are
completed.
2. Services (contract research) - revenue over the expected period over which the related services
are expected to be performed.
3. License fees - Revenue from such arrangements is recognised in the period in which the Company
completes all its performance obligations
2-16
 Segment reporting footnote
Refer to note 2.25 Segment reporting on pages 225-226
Major operating segments - Global Generics; Pharmaceutical Services and Active
Ingredients (“PSAI”); Proprietary Products; and Others

Generics PSAI Proprietary Others Total

Products
Revenue 1,54,759 32,379 523 2,814 1,90,475
% 81% 17% 0% 1% 100%

Major Geographic segments – India, USA, Russia, others

Country Revenue %
India 36,252 19.11%
United States 76,702 40.43%
Russia 15,816 8.34%
Others 60,952 32.13%
2-17 Total 1,89,722 100.00%
Major therapeutic areas

Therapeutic areas Generics PSAI

Nervous System 29,040 19% 2,704 8%
Gastrointestinal 21,132 14%
Oncology 16,842 11% 2,385 7%
Cardiovascular 15,460 10% 9,834 31%
Pain Management 15,531 10% 4,657 15%
Respiratory 11,089 7%
Anti-Infective 12,906 8% 4,126 13%
Dermatology 768 2%
Others 32,404 21% 7,508 23%
Total 1,54,404 100% 31,982 100%

2-18
Analysis of financial statement

Tools used in financial statement analysis –

1. Common size statements

2. Comparative statements

3. Ratio analysis – [profitability analysis]

2-19
Common size financial statements

It is hard to spot trends in the financial statements because of growth

– Growth in Assets and Sales drive trends in all of the line items
– Are certain line items growing more or less than would be expected given the growth in
assets or sales?

To address this problem, we can restate financial statement information in ratio form
• Balance sheet - express all numbers as a percent of Total Assets
• Income statement - express all numbers as a percent of Sales
• Cash flow statement - typically not common sized

This process Facilitates comparison

• Across companies of different sizes,
• Between accounts within a set of financial statements

2-20
Common size balance sheet
IFRS Balance sheet of Dr. Reddy Labs March 31,2021 Common size 2021
ASSETS
Current assets
Cash and cash equivalents 14,829 5.59% = 14,829/265,491
Other investments 19744 7.44%
Trade and other receivables 49641 18.70%
Inventories 45412 17.10%
Derivative financial instruments 1218 0.46%
Tax assets 2745 1.03% 56% of all assets can be
Other current assets 14509 5.46% converted into cash within
Total current assets 1,48,098 55.78% 1 year

Non-current assets
Property, plant and equipment 57,111 21.51% PP&E is the largest asset.
Goodwill 4568 1.72% Other major assets include
Other intangible assets 35648 13.43% AR, inventory, investments
Trade and other receivables 118 0.04% and intangibles. The asset
Investment in equity accounted investees 3375 1.27% mix should reflect the
Other investments 4958 1.87%
nature of business.
Deferred tax assets 10630 4.00%
Other non-current assets 834 0.31%
Total non-current assets 1,17,242 44.16%
Total assets 2,65,491 100.00%

2-21
 IFRS Balance sheet of Dr. Reddy Labs March 31,2021 Common size 2021
LIABILITIES AND EQUITY
Current liabilities
Trade and other payables 23,744 8.94% = 23,744/265,491
Short-term borrowings 23136 8.71%
Long-term borrowings, current portion 864 0.33%
Provisions 3435 1.29%
Tax liabilities 1389 0.52%
Derivative financial instruments 326 0.12% 83,391/ 92,429 or 90% of
Bank overdraft 9 0.00%
Other current liabilities 30488 11.48% all liabilities need to be
Total current liabilities 83,391 31.41% repaid within 1 year
Non-current liabilities
Long-term borrowings 6,299 2.37%
Deferred tax liabilities 338 0.13%
Provisions 58 0.02%
Other non-current liabilities 2343 0.88%
Total non-current liabilities 9,038 3.40% 34% of all assets are
Total liabilities 92,429 34.81% funded by liabilities
Equity
Share capital 832 0.31%
Treasury shares -1967 -0.74%
Share premium 8887 3.35%
Share-based payment reserve 1461 0.55%
Capital redemption reserve 173 0.07%
Retained earnings 156023 58.77%
Other components of equity 6327 2.38%
Total equity 1,73,062 65.19% 66% of all assets are
Total liabilities and equity 2,65,491 100.00% funded by shareholders
2-22
Common size income statement
IFRS Balance sheet of Dr. Reddy Labs 2021 Common size 2021

Revenues 1,89,722 100.00%

Cost of revenues 86,645 45.67% = 86,645/189,722
Gross profit 1,03,077 54.33%
Selling, general and administrative expenses 54,650 28.81%
Research and development expenses 16,541 8.72% Major expenses as a % of sale.
Impairment of non-current assets 8,588 4.53% This should reflect the nature of
Other income, net -982 -0.52% business.
Total operating expenses 78,797 41.53%
Results from operating activities (A) 24,280 12.80%
Finance income 2,623 1.38%
Finance expense -970 -0.51%
Finance income, net (B) 1,653 0.87%
Share of profit of equity accounted investees, net of tax ( C) 480 0.25%
Profit before tax [(A)+(B)+(C)] 26,413 13.92%
Tax (expense)/benefit, net 9,175 4.84% If sales are $100 then after
Profit for the year 17,238 9.09%
accounting for all expenses $9 is
Earnings per share:
the profit
Basic EPS 103.94
Diluted EPS 103.65

2-23
Comparative financial statements

Comparing data across two or more consecutive periods assists in analyzing trends in
company performance and in predicting future performance

There are two approaches -

1. Compare the vertical analysis over time. Once the balance sheet or income statement
is expressed in percentage terms, we can look for trends or changes year over year. This
level of analysis points out areas that warrant additional research. We use footnotes, the
MD&A section of the Form 10-K, and external sources to explain unusual changes or
concerning trends.

2. Compute the percentage change, for each line item, as follows.

(Current balance − Previous balance)/Previous balance

2-24
Comparative balance sheet
IFRS Balance sheet of Dr. Reddy Labs March 31, 2020 March 31,2021 YOY change
ASSETS
Current assets
Cash and cash equivalents 2,053 14,829 622.31%
Other investments 23,687 19,744 -16.65%
Trade and other receivables 50,278 49,641 -1.27%
Inventories 35,066 45,412 29.50%
Derivative financial instruments 1,105 1,218 10.23%
Tax assets 4,379 2,745 -37.31%
Other current assets 13,802 14,509 5.12%
Total current assets 1,30,370 1,48,098 13.60%

Non-current assets
Property, plant and equipment 52,332 57,111 9.13%
Goodwill 3,994 4,568 14.37%
Other intangible assets 27,659 35,648 28.88%
Trade and other receivables 1,737 118 -93.21%
Investment in equity accounted investees 2,763 3,375 22.15%
Other investments 328 4,958 1411.59%
Deferred tax assets 12,214 10,630 -12.97%
Other non-current assets 844 834 -1.18% While total assets grew by
Total non-current assets 1,01,871 1,17,242 15.09% 14%, there is a significant
Total assets 2,32,241 2,65,491 14.32% increase in cash, inventory
and intangible assets
2-25
LIABILITIES AND EQUITY
Current liabilities
Trade and other payables 16,659 23,744 42.53%
Short-term borrowings 16,441 23,136 40.72%
Long-term borrowings, current portion 4,266 864 -79.75%
Provisions 3,800 3,435 -9.61%
Tax liabilities 573 1,389 142.41%
Derivative financial instruments 1,602 326 -79.65% There is a significant increase in
Bank overdraft 91 9 -90.11% current tax liabilities and
Other current liabilities 29,382 30,488 3.76%
Total current liabilities 72,814 83,391 14.53%
borrowings (both long and short
term)
Non-current liabilities
Long-term borrowings 1,304 6,299 383.05%
Deferred tax liabilities 275 338 22.91%
Provisions 54 58 7.41%
Other non-current liabilities 2,806 2,343 -16.50%
Total non-current liabilities 4,439 9,038 103.60%
Total liabilities 77,253 92,429 19.64%

Equity
Share capital 831 832 0.12%
Treasury shares -1,006 -1,967 95.53%
Share premium 8,495 8,887 4.61%
Share-based payment reserve 1,233 1,461 18.49%
Capital redemption reserve 173 173 0.00%
Retained earnings 1,44,247 1,56,023 8.16%
Other components of equity 1,015 6,327 523.35% Liabilities have grown slightly
Total equity 1,54,988 1,73,062 11.66% faster than equity
Total liabilities and equity 2,32,241 2,65,491 14.32%

2-26
Comparative income statement
IFRS Balance sheet of Dr. Reddy Labs 2020 2021 YOY change

Revenues 1,74,600 1,89,722 8.66%

Cost of revenues 80,591 86,645 7.51% Sales have grown by 8%. Cost of
Gross profit 94,009 1,03,077 9.65% sales, SG&A and R&D expenses
Selling, general and administrative expenses 50,129 54,650 9.02% have also grown at the same pace.
Research and development expenses 15,410 16,541 7.34%
Impairment of non-current assets 16,767 8,588 -48.78%
Other income, net -4,290 -982 -77.11% Significant decrease impairment
Total operating expenses 78,016 78,797 1.00% charges and other income
Results from operating activities (A) 15,993 24,280 51.82%
Finance income 2,461 2,623 6.58%
Finance expense -983 -970 -1.32%
Finance income, net (B) 1,478 1,653 11.84%
Share of profit of equity accounted investees, net of tax ( C) 561 480 -14.44%
Profit before tax [(A)+(B)+(C)] 18,032 26,413 46.48%
Tax (expense)/benefit, net 1,466 9,175 525.85%
Profit for the year 19,498 17,238 -11.59%
Earnings per share:
Basic EPS 117.63 103.94 -11.64%
Diluted EPS 117.40 103.65 -11.71%

2-27
Comparative income statement – alternate approach

IFRS Balance sheet of Dr. Reddy Labs 2020 2021 Common size 2020 Common size 2021

Revenues 1,74,600 1,89,722 100.00% 100.00%

Cost of revenues 80,591 86,645 46.16% 45.67%
Gross profit 94,009 1,03,077 53.84% 54.33%
Selling, general and administrative expenses 50,129 54,650 28.71% 28.81%
Research and development expenses 15,410 16,541 8.83% 8.72%
Impairment of non-current assets 16,767 8,588 9.60% 4.53%
Other income, net -4,290 -982 -2.46% -0.52%
Total operating expenses 78,016 78,797 44.68% 41.53%
Results from operating activities (A) 15,993 24,280 9.16% 12.80%
Finance income 2,461 2,623 1.41% 1.38%
Finance expense -983 -970 -0.56% -0.51%
Finance income, net (B) 1,478 1,653 0.85% 0.87%
Share of profit of equity accounted investees, net of tax ( C) 561 480 0.32% 0.25%
Profit before tax [(A)+(B)+(C)] 18,032 26,413 10.33% 13.92%
Tax (expense)/benefit, net 1,466 9,175 0.84% 4.84%
Profit for the year 19,498 17,238 11.17% 9.09%

Expenses as a % of sales are fairly stable over time except – impairments

Similar analysis can be done for balance sheet also

2-28
Ratio analysis

• Ratios are useful in assessing the performance of a company along several

dimensions such as - profitability, operational efficiency, liquidity, and risk etc
• Highlight sources of competitive advantage and “red flag” potential trouble

• Ratios must be compared to a benchmark

• Compare same firm across time (time-series analysis)
• Compare firm to other firms or to industry (cross-sectional analysis)

• Ratios are contextual

• Try to determine the underlying activity that the ratio represents to determine
whether it is good or bad news

• Ratio analysis does not provide answers, but instead helps you ask better questions

2-29
Return on equity (ROE)

• It is one of the most common summary performance measure used by managers and
investors
• It captures how much profit does the company generate for each $ invested in it by
shareholders?

• It is defined as
Return on Equity (ROE) = Net Income / Average Shareholders’ Equity
NOTE – The value of equity used in this ratio is based on the balance sheet and not the
value in stock market.

Select numbers as per IFRS 2019 2020 2021

Net income (1) 19,498 17,238
Total equity 1,40,197 1,54,988 1,73,062
Avergae SE (2) 1,47,593 1,64,025

2-30 ROE (1) / (2) 13.21% 10.51%

What drives the ROE of a company ?

• Profit margin: profitability i.e. profit generated for each $ of sale

• Asset turnover: productivity i.e., sales generated for each $ invested in assets
• Leverage: equity multiplier or level of borrowing

This disaggregation of return on equity (ROE) was initially introduced by the E.I. DuPont de
Nemours and Company to aid its managers in performance evaluation

2-31
 Select numbers as per IFRS 2019 2020 2021

Net income 19,498 17,238

Sales 1,74,600 1,89,722
Net income / Sales (1) 11.17% 9.09%

Total assets 2,25,427 2,32,241 2,65,491

Average total assets 2,28,834 2,48,866
Sales / Avg total assets (2) 0.76 0.76

SE 1,40,197 1,54,988 1,73,062

Avg SE 1,47,593 1,64,025
Avg total assets / Avg SE (3) 1.55 1.52

ROE (1) X (2) X (3) 13.21% 10.51%

Why has the ROE declined in the year 2021 ?
2-32
 What if we want to ignore the source of financing and just focus of
profitability of the assets ?

Adj Return on Assets (ROA) = [Net Income + Interest expense *(1-Tax rate)]
Avg Total Assets

• The denominator is total assets and does not reflect the financing choice (i.e. debt vs
equity).

• Hence, we have to convert the numerator Net income to an unlevered basis to remove
the effects of debt. If there is no debt, a company would not have paid interest and
would have paid higher taxes.

• Thus, in calculating ROA we use unlevered profits tell the profitability of the assets,
after removing financing choices.

2-33
 Select numbers as per IFRS 2019 2020 2021

Net income 19,498 17,238

Interest expense I 983 970
Statutory tax rate t 35% 35%
I*(1-t) 639 631
Net income + Interest *(1-t) (1) 20,137 17,869
Total assets 2,25,427 2,32,241 2,65,491
Average total assets (2) 2,28,834 2,48,866
Adj ROA (1) / (2) 8.80% 7.18%

2-34
 Trade-off between profit margin and asset turnover

 ROA can be increased by (i) increasing profit margins; and /or (ii) Increasing asset turnover

 Profit margins are affected by (i) Level of gross profit; (ii) level of operating expenses required
to support sales of products and services; (iii) level of competition and the company’s ability to
manage pricing and control costs

 Asset turnover reveals insights into a company’s productivity and efficiency

 Mix of margin and turnover is often dictated by a company’s industry. Changes in profit margins
or asset turnover results from strategic decisions made by management.

2-35
 Profit margin and turnover across industries
Mix of margin and turnover is often dictated by a company’s industry. Changes in profit margins
or asset turnover results from strategic decisions made by management

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ROE analysis - Drilling down further…

ROE = NI / Avg SE
Profitability - Measures the Productivity - Measures how Leverage - the use of debt / borrowings to
company’s ability to generate profits efficiently the company is utilizing its expad the asset base of the company to magnify
from its resources resources returns.
NI/Sales Sales / Avg Total Assets Avg Total Assets / Avg SE
Gross profit margin AR turnover Solvency - ability to meet long term obligations
Operating profit margin Inventory turnover - Total Liabilities / Total Assets
Pretax margin AP turnover - D/E
Net profit margin Cash conversion cycle Liquidity - ability to meet short-term obligations
Fixed asset turnover - Current ratio
- Quick ratio
Coverage - ability to meet interest and / or
principal repayment obligation from profits
generated in the business
- Interest coverage ratio
- Debt service coverage ratio

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 ROE

ROA FINANCIAL
LEVERAGE

PRODUCTIVITY
PROFITABILITY

Gross profit Operating Pre-tax profit Net profit

margin profit margin margin margin

Profitability analysis
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1. Gross profit margin = Gross profit / Sales; where Gross margin = Sales - COGS
High ratio indicates some combination of higher product pricing and low product costs.
This is determined by competitive advantage of the firm

2. Operating profit margin = Operating profit / Sales

An operating margin increasing faster than gross margin indicates improvements in
controlling operating costs (e.g. SG&A)

3. Pretax margin = EBT / Sales

This ratio also reflects the effect of leverage and non-operating income / expenses. Pretax
margin increasing faster than operating margin indicates increase in non-operating
income, which might be non-recurring in nature.

4. Net profit margin = Net income / Sales

This ratio indicates how much of each dollar in revenue collected by a company translates
into profit. In other words, does the company generate enough revenue to cover ALL
costs.

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Income statement 2021 2021
Revenues 1,89,722
Cost of revenues 86,645
Gross profit 1,03,077 Gross profit margin 54.33% = 103,077 / 189.722
Selling, general and administrative expenses 54,650
Research and development expenses 16,541
Impairment of non-current assets 8,588
Other income, net -982
Total operating expenses 78,797
Results from operating activities (A) 24,280 Operating profit margin 12.80%
=24,280/ 189.722
Finance income 2,623
Finance expense -970
Finance income, net (B) 1,653
Share of profit of equity accounted investees, net of tax ( C) 480
Profit before tax [(A)+(B)+(C)] 26,413 Pre-tax profit margin 13.92% = 26,413 / 189.722
Tax (expense)/benefit, net 9,175
Profit for the year 17,238 Net income margin 9.09% = 17,238 / 189.722
Earnings per share:
Basic 103.94
Diluted 103.65

2-40 Profitability ratios are obtained from common sized income statement
To understand how good or how bad are these ratios, we need to benchmark these
ratios with (i) past, and (ii) competitors

Profitability ratios 2020 2021

Gross profit margin 53.84% 54.33%
Operating profit margin 9.16% 12.80%
Pre-tax profit margin 10.33% 13.92%
Net profit margin 11.17% 9.09%

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 Limitations of ratio analysis
• Standard ratios have multiple definitions
• There is no GAAP for ratio definitions
• Use the same definition to make valid comparisons

• Choosing the appropriate benchmark for comparison is important

• Major changes in the firm distort time-series analysis
• Differences in business strategy, capital structure, or business segments distort
cross-sectional analysis
• Differences in accounting methods make all comparisons difficult

• Ratios may be manipulated by managerial action

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Coming up
• Asset – part 1 – Accounts receivable and inventory
• Productivity ratios – we will discuss these after learnings about assets
• Leverage ratios - we will discuss these after learnings about liabilities

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