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Financial Statement Analysis

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Financial Statement Analysis-FIN621
VU
Lesson-38
PROFITABILITY RATIOS
(Continued)
d)
Analysis by Preferred Stockholders
If convertible, interest of preferred stockholders is similar to those of common one. If
not, then their interest is similar to that of long-term creditors.
Dividend Coverage Ratio: =
Net income
.
Amount of annual preferred dividend
Normal Ratio: 5 to 10
Note:
Ratios should be used with other elements of financial analysis. Most important is to use
common sense and judgments. Also study the industrial sector in which the company operates and relate
"Industry Sector" climate to current and projected economic developments.
Analysis by management:
The main concern of management is to watch the interest of all those who have provided capital to the
business. For this, it has to ensure efficient use of capital and resources employed. To watch the interests
and needs of customers and clients, the management has to take care of profitability, solvency and long-
term stability of the business. It would see as to which operating areas have contributed to success and
which have not? It would also determine strengths and weaknesses and reasons thereof. It would also
take appropriate measures for improvement and correction.
Indicators of profitability:
Difference between Profit and Profitability. Profit is an absolute figure whereas
profitability is ratio of profit to some other item like sales.
(i) Return on total assets = Operating income x 100
= 25 x 10 = 12.5 %
Average assets
200
Operating income is used, since interest and income taxes are factors beyond control of
management. Also since operating income is earned throughout the year, we relate it to average
investment in assets.
Return on Total Assets (ROTA). A measure of how effectively a company uses its assets. Calculated
by (income before interest and tax) / (fixed assets + current assets).
Importance of Return on Total Assets:
Smart companies strictly control major purchases, attempting to limit those that will best bring a return
in greater revenue to the company. The Return on Total Assets is a useful way to measure how well the
company is actually able to make intelligent choices on how to spend its money on new assets.
ii) Return on Investment = Operating income
= 25 x 100 = 14.3%
(Total Assets) Stockholders equity + fixed liabilities (1)
175
Measures overall effectiveness in generating profits with available assets ; earning power of
invested capital
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Financial Statement Analysis-FIN621
VU
Return on Investment (ROI) analysis is one of several approaches to building a financial business case.
The term means that decision makers evaluate the investment by comparing the magnitude and timing
of expected gains to the investment costs.
Decision makers will also look for ways to improve ROI by reducing costs, increasing gains, or
accelerating gains.
In the last few decades, this approach has been applied to asset purchase decisions (computer systems or
a fleet of vehicles, for example), "go/no-go" decisions for programs of all kinds (including marketing
programs, recruiting programs, and training programs), and to more traditional investment decisions
Return on Investment (ROI) analysis is one of several approaches to building a financial business case.
The term means that decision makers evaluate the investment by comparing the magnitude and timing
of expected gains to the investment costs.
Decision makers will also look for ways to improve ROI by reducing costs, increasing gains, or
accelerating gains.
In the last few decades, this approach has been applied to asset purchase decisions (computer systems or
a fleet of vehicles, for example), "go/no-go" decisions for programs of all kinds (including marketing
programs, recruiting programs, and training programs), and to more traditional investment decisions
(such as the management of stock portfolios or the use of venture capital
The Simple Return on Investment
Return on investment is frequently derived as the "return" (incremental gain) from an action divided by
the cost of that action. That is "simple ROI". For example, what is the ROI for a new marketing
program that is expected to cost $500,000 over the next five years and deliver an additional $700,000 in
increased profits during the same time?
Simple ROI = Gains ­ Investments costs
Investments Costs
Simple ROI works well in situations where both the gains and the costs of an investment are easily
known and where they clearly result from the action. Other things being equal, the investment with the
higher ROI is the better investment. The return on investment metric itself, however, says nothing about
the magnitude of returns or risks in the investment.
In complex business settings, however, it is not always easy to match specific returns (such as increased
profits) with the specific costs that bring them, and this makes ROI less trustworthy as a guide for
decision support. Simple ROI also becomes less trustworthy as a useful metric when the cost figures
include allocated or indirect costs, which are probably not caused directly by the action or the
investment.
Business investments typically involve financial consequences extending several years or more. In such
cases, the metric has meaning only when the time period is clearly stated. Shorter or longer time periods
may produce quite different ROI figures for the same investment. When financial impacts extend across
several years, moreover, the analyst must decide whether to use discounted (net present value) figures or
non discounted values.
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Financial Statement Analysis-FIN621
VU
Return on Sales Ratio
What it is?
This ratio compares after tax profit to sales. It can help you determine if you are making enough of a
return on your sales effort.
When to use it?
If your company is experiencing a cash flow crunch, it could be because its mark-up is not enough to
cover expenses. Return on sales can help point this out, and allow you to adjust prices for an adequate
profit. Also, be sure to look for trends in this figure. If it appears to be dropping over time, it could be a
signal that you will soon be experiencing financial problems.
iii)Return on Sales = Net income x 100 = 20% or 13%
Net sales
A ratio widely used to evaluate a company's operational efficiency. ROS is also known as a firm's
"operating profit margin".
This measure is helpful to management, providing insight into how much profit is being produced per
dollar of sales. As with many ratios, it is best to compare a company's ROS over time to look for trends,
and compare it to other companies in the industry. An increasing ROS indicates the company is growing
more efficient, while a decreasing ROS could signal looming financial troubles.
iv)
Assets turn over ratio:
It shows relative effectiveness of assets utilization =
Net Sales
= 50%
Average assets
Measures relative Efficiency of total assets to generate sales.
Asset turnover measures how effectively a business is using assets to generate sales. It is:
Sales ÷assets
There are a few variations on this, depending on what measure of assets is used. The most obvious is
total assets, i.e., fixed assets + current assets. This measures how many pounds in sales is generated for
each pound invested in assets.
From an investor's point of view, it can be argued that current liabilities should be deducted from the
amount of assets used. Investors are concerned with returns on their investment; therefore the funding of
current assets from current liabilities can be ignored.
Note: Current liabilities are excluded while calculating Return on Investment, since these are not
"investments". As such ROI is a measure of management's skill in exploiting moneys invested in the
business. Hence "Operating Income" is taken i.e. Income before non-operating expenses and taxes.
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