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Note on Financial Statements Analysis (Global Practices) January 19, 2013

Different Perspectives The terms profit, capital, investment, assets mean different things to a companys various interest groups, each of which view the profit a company makes from a different perspective. Shareholders: Shareholders may be most concerned about the ability of a company to maintain or improve the value of their investment and future income stream. They look to the company to generate sufficient profit to provide for dividend and an increase in the market value of the shares they own. Lenders: Lenders of money may be expected to be most interested in evidence to support the companys ability to continue to pay the interest and instalment of prinicipal on borrowed funds as they fall due. Customers: Customers may be concerned to assess the levels of profit being made, particularly if there is regulation of the business sector (in India for certain segments of the pharmaceutical industry) Competitors: Competitors are most interested in comparing their own performance and efficiency with that of other companies operating in the same business sector. Management and other employees: They are usually mostly interested in the profit being generated from their section of the business and in assessing their employment prospects. Senior executives are expected to focus on the overall levels of profitability being provided by the companys main operating units, its strategic business units (SBUs). Their interest should be focused on the future potential rather than the historic performance of the company. Business and Investment Analysts: They may be expected by their clients or employers to provide an indication of whether a particular companys shares are worth holding or buying for future gain or are best sold immediately.

PROFIT MARGIN RATIOS: In the income statement, the profit margin can be used to begin the analysis of a companys profitability. It is calculated by dividing profit by sales revenue and expressing the result as a percentage. Gross profit margin: Working down the income statement, the first profit normally displayed is the gross profit, which is produced by deducting the cost of sales (in manufacturing and retailing firms, it is often called as cost of goods sold or COGS) from the sales revenue for the year. % gross profit margin = 100 X (gross profit sales revenue) The gross profit margin , often simply referred to as gross margin, offers a reasonable indication of the basic profitability of a business and is useful when comparing the performance of companies operating within the same sector. Operating profit margin: Operating profit usually follows gross profit in the income statement. It normally allows for all of the companys expenses of distribution, administration, research and development and general overheads. The operating profit margin offers an assessment of the profitability of a company after taking into account all the normal costs of producing and supplying goods or services and the income from selling them, but excluding financing costs, such as interest payments on bank loans, or investment income, such as interest earned on bank deposits. % operating profit margin = 100 X (operating profit sales revenue) (operating profit is also referred to as EBIT or PBIT ). Pre-tax profit margin: Moving down the income statement, the next step is to deduct the remaining charges from operating profit to produce the pre-tax profit for the year. When the pre-tax margin is calculated, this shows the level of profitability of a company after all operating costs and expenses except tax and dividends to shareholders have been allowed for. % pre-tax profit margin = 100 X (pre-tax profit sales revenue) (pre-tax profit is also referred to as PBT). After-tax profit and retained profit margins: It is possible to calculate both the after-tax profit margin and the retained profit margin, but such ratios do not offer any significant additional help in the overall appreciation of a companys profitability. (after-tax profit is also referred to as PAT or Net Profit or Net Income).

EFFICIENCY RATIOS: In analyzing the companys efficiency ratios, we combine information from the income statement and the balance sheet in ways that enable us to measure how efficiently a company is using its assets or capital employed. Rate of Return on Assets or Capital Employed: The overall rate of return on capital or assets can be calculated by dividing the profit, taken from the income statement, by assets or capital employed, as shown in the balance sheet, and expressing the result as a percentage.

Which profit? Which assets? Which Capital? When dealing with efficiency ratios, it is important to recognize that there is no single method of calculating rates of return and that the same term may be used to refer to different parameters. A rate of return on assets (ROA) may have been worked out using the gross, operating, pre-tax or post-tax profit. Whichever profit is selected, the end result will be the return on assets (ROA), but each of the possible profits will produce a different level of return. For each ratio, the denominator has remained constant but a different numerator has been used. Similar problems can arise in selecting the denominator for the ROA ratio. This could be equally well the total , operating or net assets. Whichever figures are used, the end ratio is correctly describes as ROA. In calculating comparative rates of return it is essential that there is consistency in both the numerator and the denominator in the equation. In other words, we should ensure that each companys or divisions ROA, which we are comparing, is calculated in the same way.

Source: Guide to Analysing Companies, 4/e, 2006, by A. H. Vause A.H. (Bob) Vause is a Fellow of the Institute of Chartered Accountants (London), and has taught at the Templeton College, Oxford, where he is an Emeritus Fellow for more than 20 years. Before that he held positions at Manchester Business School and Oxford Centre of Management Studies. He is the author of many books and has consulted with many large companies on a wide range of matters affecting control and performance. (The above note is taken as excerpt from page 129 onwards of this book)

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Notes on Financial Statements Analysis (Indian Practices) January 19, 2013 Profitability ratios related to Investments Return on Investments (ROI): Profitability ratios can be computed by relating the profits of a firm to its investments. Such ratios are popularly termed as return on investments (ROI). There are three different concepts in vogue in financial literature: assets, capital employed and shareholders equity. Based on each of them, there are three broad categories of ROIs. They are (i) return on assets, (ii) return on capital employed and (iii) return on shareholders equity. A. Return on Assets: Here the profitability ratio is measured in terms of the relationship between net profits and assets. The ROA may also be called profit-to-asset ratio. There are various possible approaches to define net profits and assets, according to the purpose and intent of the calculation of the ratio. Depending upon how these two terms are defined, many variations of ROA are possible. The concept of net profit may be (i) net profit after taxes, (ii) net profit after taxes plus interest and (iii) net profit after taxes plus interest minus tax savings. Assets may be defined as (i) total assets, (ii) fixed assets and (iii) tangible assets. Accordingly, the different variants of ROA (or return on Total Assets - ROTA)are: 1. Return on Assets = (Net profit after taxes/Average total assets)X100 The ROA based on this ratio would be an underestimate as the interest paid to the lenders is excluded from the net profits. In point of fact, the real return on the total assets is the net earnings available to owners (EAT) and interest to lenders as assets are financed by owners as well as creditors. A more reliable indicator or the true return on assets, therefore, is the net profits inclusive of interest. It reports the total return accruing to all providers of capital (debt and equity). 2. ROA = {(Net profit after taxes + Interest)/Average total assets}X100 3. ROA = {(Net profit after taxes + Interest)/Average tangible assets}X100 4. ROA = {(Net profit after taxes + Interest)/Average fixed assets}X100

These measures, however, may not provide correct results for inter-firm comparisons when these firms markedly varying capital structures as interest payment on debt qualifies for tax deductionin determining net taxable income. Therefore, the effective cash outflows is less than the actual payment of interest by the amount of tax shield on interest payment. As a measure of operating performance , therefore, equations 2,3 and 4 above should be substituted by the following:

5. ROA = [EAT + (Interest Tax advantage on interest) or after interest cost ] [Average total assets / Tangible assets / Fixed assets] (The above method no. 5 is suggested by the co- author of the MCS textbook, Robert N. Anthony in his book Accounting: Text and Cases: page 371)

The equation correctly reports the operating efficiency of firms as if they they are all equity-financed. The ROA measures the profitability of the total funds / investments of a firm. It, however, throws no light on the profitability of the different sources of funds which finance the total assets. These aspects are covered by other ROIs.

2. Return on Capital Employed (ROCE): The ROCE is the second type of ROI. It is similar to the ROA except in one respect. Here, the profits are related to the total capital employed. The term capital employed refers to long-term funds supplied by the lenders and owners of the firm. It can be computed in two ways. First, it is equal to non-current liabilities (long term liabilities) plus owners equity. Alternatively, it is equivalent to net working capital plus fixed assets. Second, it is equal to long-term funds minus investments made outside the firm. Thus, capital employed basis provides a test of profitability related to the sources of long-term funds. A comparison of this ratio with similar firms, with the industry average and over time would provide sufficient insight into how efficiently the long-term funds of owners and lenders are being used. The higher the ratio, the more efficient the use of capital employed. The ROCE can be computed in different ways, using different concepts of profits and capital employed. Thus, 1. ROCE = (EBIT ) X100 (Average capital employed)

2. ROCE = (Net profit after taxes + Interest Tax advantage on interest) X 100 (Average capital employed)

3. ROCE = (Net profit after taxes + Interest Tax advantage on interest) X 100 (Average capital employed Average intangible assets))

Source: Financial Management , Text, Problems and cases, by MY Khan and PK Jain. This book is intended and used as a standard textbook for postgraduate students in commerce and chartered and cost accountancy. The above note has been taken as an excerpt from this book from page 6.21 onwards. 5

Notes on Financial Statements Analysis (Indian Practices contd.)

Profitability Ratios based on Assets/ Investments: A financial analyst can employ another set of financial ratios to find out how efficiently the firm is using its assets because the profitability of a firm can also be analyzed with reference to assets employed to earn a return. Normally, the more the assets employed, greater should be the profits and vice versa. Profitability can be calculated as the profit margin contributed per rupee of sales. Profitability can also be analyzed with reference to profits earned per rupee of investment made in the firm. There are different concepts of assets employed / investments made in the firm such as total assets, tangible assets, net assets, fixed assets, capital employed, etc. So there can be different profitability ratiosbased on assets / investments of the firm. The following are the two important such profitability ratios: (i) Return on Assets (ROA): The ROA measures the profitability of the firm in terms of assets employed in the firm. The ROA is calculated by establishing the relationship between the profits and the assets employed to earn that profit. Usually the profit of the firm is measured in terms of the net profit after tax and the assets are measured in terms of total assets or total tangible assets or total fixed assets. ROA = [ (Net Profit after Taxes)/(Average Total Assets)] X 100 ROA = [ (Net Profit after Taxes)/(Average Tangible Assets)] X 100 ROA = [ (Net Profit after Taxes)/(Average Fixed Assets)] X 100 All these versions of ROA show as to how much is the profit earned by the firm per rupee of assets used. Sometimes the amount of financial charges (interest, etc.) is added back to the net profit figure to relate the net operating profit with the operating assets of the firm. By separating the financial effect from the operating effect, the ROA provides a cleaner measure of the profitability of these assets. In such a case, the ROA can be calculated as follows: ROA =[ [(Net Profit after Taxes) + {Interest X (1 t)}]/( Total Assets)] X 100 ROA =[ {EBIT X (1 t)}/(Total Assets)] X 100 The ROA measures the overall efficiency of the management in generating profits given a level of assets at its disposal. The ROA essentially relate the profits to the size of the firm (which is measured in terms of the assets). If a firm increases its size but is unable to increase its profits proportionately, then ROA will decrease. In such a case, increasing the size of the assets i.e., the size of the firm will not by itself advance the financial welfare of the owners. The ROA of a particular firmshould be compared with the industry average as the amount of assets required depends upon the nature and characteristics of the industry. (ii) Return on Capital Employed (RCE): The profitability of the firm can also be analyzed from the point of view of the total funds employed in the firm. The term funds employed or the 6

capital employed refers to the long term sources of funds. It means that the capital employed comprises of shareholders funds plus long term debts. Alternatively, it can also be defined as fixed assets plus net working capital. As a matter of fact, the amount of capital employed, calculated in either way will be the same because these figures are based on the balance sheet of the firm and are part of the basic accounting equation i.e., (Shareholder Funds + Long Term Debt + Current Liabilities) = (Fixed Assets + Current Assets) Shareholder Funds + Long Term Debt = Fixed Assets + (Current Assets - Current Liabilities) Shareholder Funds + Long Term Debt = Fixed Assets + Net Working Capital The RCE may be calculated as follows: RCE = [(Net Profit after Taxes) + {Interest X (1 t)}] /( Average Capital Employed) X 100 Or, RCE = (EBIT) / (Average Capital Employed) X 100

Source: Financial Management , Theory, Concepts and Problems, by Dr. R. P. Rustagi. This book is intended and used as a standard textbook for postgraduate students in commerce and chartered and cost accountancy. The above note has been taken as an excerpt from this book from page 66 onwards.

Notes on Financial Statements Analysis (For MCS Exams)

As may be seen from the above, globally and in India, it is important to recognize that there is no single exact or correct method of calculating rates of return on assets or investments; the same term may be used to refer to different parameters. For MCS exams, the approach may be as follows: 1. Sometimes the ratio is defined in the question; in such case use that method. 2. If the method is not given, and if the question does not suggest a specific objective leading to a particular ratio, then use the following: Return on Investment: ROI = EBIT X 100; Share Capital + Reserves + Long-term Liabilities

If specifically asked, please note that after- tax ROI is worked out with numerator as NOPAT [i.e., EBIT X (1-t)] instead of EBIT, where t is the rate of income tax.

i.e., ROI =

EBIT X (1-t) X 100; Share Capital + Reserves + Long-term Liabilities

Return on Assets (ROA or ROTA):

ROA =

PAT X 100 Total Assets

If specifically asked, please note that after tax ROA is worked out with denominator as Average total assets instead of Total Assets . Average Total Assets is the average of the Total Assets of the current year and the previous year .

ROA =

PAT X 100 Average total assets