Ratio analysis for (FIM) (Financial Management)
Ratio analysis is a financial analysis technique that involves evaluating and interpreting the relationships between various financial variables in a company's financial statements. Ratios are calculated by dividing one number by another, providing insights into different aspects of a company's performance, profitability, liquidity, solvency, and efficiency. Analysts, investors, and management use ratio analysis to assess the financial health and performance of a business.
Here are some common categories of ratios used in financial ratio analysis:
1. Liquidity Ratios:
Current Ratio:
- Formula: Current Assets / Current Liabilities
- Measures the ability of a company to cover its short-term obligations with its short-term assets.
Quick Ratio (Acid-Test Ratio):
- Formula: (Current Assets - Inventory) / Current Liabilities
- Provides a more stringent measure of short-term liquidity by excluding inventory.
2. Profitability Ratios:
Profit Margin:
- Formula: (Net Income / Sales) * 100
- Measures the percentage of each sales dollar that represents profit.
Return on Assets (ROA):
- Formula: Net Income / Average Total Assets
- Evaluates how efficiently a company utilizes its assets to generate profit.
Return on Equity (ROE):
- Formula: Net Income / Average Shareholders' Equity
- Measures the return earned on shareholders' equity.
3. Solvency Ratios:
Debt-to-Equity Ratio:
- Formula: Total Debt / Shareholders' Equity
- Indicates the proportion of debt used to finance the company's assets relative to equity.
Interest Coverage Ratio:
- Formula: Earnings Before Interest and Taxes (EBIT) / Interest Expense
- Assesses the company's ability to meet its interest obligations with operating income.
4. Efficiency Ratios:
Inventory Turnover:
- Formula: Cost of Goods Sold / Average Inventory
- Measures how quickly a company sells its inventory.
Days Sales Outstanding (DSO):
- Formula: (Accounts Receivable / Sales) * Number of Days
- Evaluates the average number of days it takes to collect payment from customers.
Asset Turnover:
- Formula: Sales / Average Total Assets
- Examines how efficiently a company utilizes its assets to generate sales.
5. Market Ratios:
Price-to-Earnings Ratio (P/E Ratio):
- Formula: Market Price per Share / Earnings per Share (EPS)
- Compares the market value of a share to the company's earnings.
Dividend Yield:
- Formula: Dividend per Share / Market Price per Share
- Represents the dividend income an investor can expect relative to the market price of the stock.
Ratio analysis provides a comprehensive view of a company's financial performance, allowing stakeholders to make informed decisions. It is important to compare ratios with industry benchmarks and historical performance for meaningful interpretation. Additionally, ratios should be used in conjunction with qualitative analysis to gain a holistic understanding of a company's financial health.
Here some formulas for ratio analysis
01. Segment margin = Sales -Variable Operating cost- Traceable/ direct fixed cost
02. Average Asset:
Assets at the beginning (A) = ****
Add: Asset at the ending (B) = ****
Total Asset (A+B) = ****
Average Assets= (Total Asset/ 02)
03. Profit margin = (segment margin /sales)
or, Profit margin = Net operating income/sales
04. Asset turnover = (sales/Average operating assets)
05. ROI = (Profit margin%*Asset turnover)
or, ROI = Net operating income/Average operating Assets
06. Residual income (RI) =Segment margin-(AV Assets*% of Target rate of return on investment*)
07. Economic value added (EVA) =after tax profit-(AV fair market value of invested capital* % of cost of capital)
08.After tax profit = Pre-Tax segment income -Taxes on pretax segment income
Lets start with some practical Example
Practical Example -01(CMA-May-2023-old)
The ABC service Ltd provides business to business service on the internet. Data concerning the most recent years appear below-
Particulars Amount(Tk.)
Sales 30,00,000
Net operating income 1,50,000
Average operating Asset 7,50,000
Requirement:
Consider each question below independently. carry out all computation to two decimal places.
(I). Computation the company's return on investment(ROI)
(II) .The founder of the ABC company is convinced that sales will increase next year by 50% and that net operating income will also increase by 200%, with no increase in average operating assets .what would be the Company's (ROI)?
(III). The CFO of the said company believes a more realistic scenario would be a Tk.10,00,000 increase in sales ,requiring a Tk.2,50,000 increase in average operating assets,with resulting Tk.2,00,000 increase in Average net operating income. what would be the Company's (ROI) in this scenario?
Ans: req-(I)
We know that ,
ROI = Net operating income/Average operating Assets
= 150000/750000
= 20%
Ans: req-(II)
Note-01.
New sales will be
Current sales = Tk.30,00,000
Add: increase(50%*30,00,000) = TK.1,50,0000
Total revised sales = Tk.45,00,000
Note-02.
New net operating will be
Current operating income = Tk.1,50,000
Add: increase(200%*1,50,000) = TK.3,00,000
Total revised net operating income = Tk.4,50,000
Profit Margin=Net operating income/ sales
=4,50,000/45,00,000
=10%
Asset turn over = sales/Average operating Assets
= 6 times
So, New ROI for the Company =Profit margin*Asset turnover
=10%*6
= 60%
Ans: req-(III)
Note-03.
New sales will be
Current sales = Tk.30,00,000
Add: increase = TK.10,00,000
Total revised sales = Tk.40,00,000
Note-04.
Average operating assets would be
Current = Tk.750000
Add: Increase = Tk.250000
New asset turn over = Tk.10,00,000
Note-05.
Net operating income would be
Current =Tk.150000
Add: increase =Tk.2,00,000
Revised Net operating income =Tk.3,50,000
We know that,
Profit margin =Net operating income /sales
= 3,50,000/40,00,000
= 8.75%
We know that,
Assets turnover =Sales/Average operating assets
= 40,00,000/10,00,000
=4 times
So, New ROI for the Company(Revised) =Profit margin*Asset turnover
=8.75%*4
= 35%
Practical Example -02 (CMA-September -2023)
House hold products is a division of Delaware Electronics.The division had the following performance target for 2020
Asset turnover = 3.1
Profit margin = 6%
Target rate of return on investment for R = 15%
Cost of capital = 9%
Income tax rate = 35%
At the end of the year -2020 following actual information concerning g the company performance available:
Total asset at beginning of the year =2,48,00,000
Total asset at the end of the year =2,96,00,000
AV fair market value of invested capital for year = 3,60,00,000
sales = 6,80,00,000
Variable operating costs = 3,48,00,000
Direct fixed cost = 2,74,40,000
Allocated fixed cost = 27,00,000
Requirement:
(I) Compute the 2020 segment margin & and Average asset for household products
(II) Based on segment margin & Av asset, compute the profit margin,Asset turnover, & ROI
(III) Evaluate the the ROI performance of Household products
(IV) Using your answer from (II) compute the residual income for household products
(V) Compute the EVA for Household product using after tax segment margin.What causes EVA & RI To differ
(Vi) Based on the data given in the
problem,discuss why ROI ,EVA and RI could be inappropriate measure of
performance for household products?
Ans req-(I)
we know that ,
Segment margin =Sale -Variable operating cost- direct fixed cost
= 6,80,00,000-3,48,00,000-2,74,40,000
= 57,60,000
Average operating asset= (Beginning Asset+ Ending Asset) /2
=(2,48,00,000+2,96,00,000)/2
= 2,72,00,000
Ans req-(II)
We know that,
Profit margin = (segment margin /sales)
= 57,60,000 /6,80,00,000
=8.47%
We know that,
Asset Turnover = (sales /Average operating assets)
= 6,80,00,000 / 2,72,00,000
= 2.50
We know that,
ROI = (Profit
margin%*Asset turnover)
= 8.47%*2.50
= 21.18%
Ans req-(III)
The target ROI for the division was 18.6%(6%*3.10). the division generated an ROI 21.18%. The division exceeded it target profit margin but fell short of its target asset turnover . Because the profit margin effect dominated the asset turnover effect. the achieved ROI was above the target ROI by more than 2.50%.
Ans req-(IV)
We know that,
Residual income (RI) = Segment margin-(AV Assets*% of Target rate of return on investment*)
= 57,60,000--(2,72,00,000*0.15)
= 57,60,000-40,80,000
= 16,80,000
Ans req-(V)
After tax profit = Pre-Tax segment income -(Taxes on pretax segment income)
= 57,60 000-(57,60,000*0.35)
=57,60 000-20,16,000
=37,44,000
We know that,
Economic value added (EVA) = after tax profit-(AV fair market value of invested capital* % of cost of capital)
= 37,44,000-(3,60,00,000*0.09)
= 37,44,000-32,40,000
= 5,04,000
EVA & RI differ for three reason :
First;RI is based on pretax, rather tan after tax,income RI is based on the book value of investment where as EVA is based on the market value of investment. and target rates of return differ between the method.
Ans req-(VI)
ROI,RI,EVA are all measures of short term performance.These measures may be particularly inappropriate for the division that have long term mission(such as high growth).