Finance for Non Finance- Analysis of Income Statement- Profitability Ratio’s

let's learn to do some analysis of income statement so I am now building an income statement for two hypothetical companies lets a company A & Company B now these companies
are in the same type of business so lets say both of them
are into fruit processing business and this
year company A has made sales of 10,000 company B has made sales of 10,000 now we look at their cogs cogs of company A is five thousand & Company B is 6000 sales man cogs will give us what gross profit so gross profit of company A would be 5,000 & Company B would be 4,000 I'm thinking of IPL match 🙂 now tell me which companies is more efficient at manufacturing process A or B which companies is more smarter at manufacturing process A or B how many of you are feel A how of you feel B company A is more efficient because it is made the same
amount of sales but it manufactured at cheaper place do you agree so when the gross profit is
higher that means you are more efficient at manufacturing this we can calculate using a ratio called gross profit margin ratio let me write that ratio here don't write know just observe I will give you time to write gross profit margin ratio and this is simply calculated as: gross profit divided by sales a gross
profit is how much how much percentage of your sales how
much is that here 50 percent and how much that here is 40-percent and can say Higher are better because if your gross profit margin is
higher that means your cogs has % to sales is lower and that means you are more efficient at the manufacturing process then next item let us say now we have SG&A Selling General And Administrative
expenses let us say SGNA here is 2000 and SGNA here is 1000 what you would get here is called what do we get after reducing SGNA EBITDA EBITDA here would be 3,000 and EBITA here would be 3000 so now what we would say is that even though Company B was not so
good with the manufacturing process maybe it is more efficient in the overall
administration process let maybe it is got more smarter sales
team better advertisement team and there for with lesser SGA they were able to set of be increase in
manufacturing expenses are we fine with this now here we can calculate one more ratio this ratio is calculated as EBITDA divided by Sales and the ratio is called cash operating profit margin cash operating profit margin and in this case cash operating profit
margin is 30 percent cash operating profit margin is 30
percent can you guess why is it called as cash operating profit EBIT is called as operating profit then why EBITDA called cash operating profit
what is the difference between EBIT EBITDA depriciation and is it a cash expense its a non-cash expense so this is giving us an idea of on a cash basis
what is your operating profit margin are we fine with this then next item depreciation let's say 500 and 500 that will give us EBIT of 2500 and 2500 again we will find out or we will calculate one more new ratio this time we will call that ratio as operating profit margin and operating
profit margin would be calculated as: EBIT divided by sales both the cases
ratio would be same so as per as over overall operating efficiencies concern both A & B are same correct now there is some difference in their
cost structure A is more smarter manufacture B is more
efficient that they are overall operations correct but there overall operating profit
margin number are exactly same now let us look at the next item in the line which is interest so let us say interest
paid by A is 1000 interest paid by is Zero know what you would get is earning before Taxes which would be fifteen hundred and this would be how much 2500 let us say taxes is 40% how much would be Tax here and how much would be Tax here 1000 and that will gives us earning after Texas which would be 900 and this
would be 1500 at this is where we would calculate one more ratio so let's call this ratio is net profit margin and how we will calculate this net profit which is nothing but EAT divided by sales and net profit margin
here is how much nine percent and here is how much 15
percent and which one is better company B so because company B is not leeward not leeward means it has
not taken any loan it is net profit margin has come
out to be a better number are we okay so now think
of it this way don't write just listen to me carefully for a minute if I tell you there are two companies company A company B one is got net profit margin of 9 percent other one
is got fifteen percent which one is better company B now can I make a statement that company
B is more operationally efficient or it is
doing its operations better than company A can I make this statement can I say that company B is more smarter with overall business than overall business overall operational business than company A no we cannot say that why we can not say that because they're operating profit margins are same the differences only in net profit margin which is happening because of interest are you following this so as per business
efficiencies concern both the businesses that exactly same
but differences in profit is coming in because of the financial decision-making
so that operating efficiencies exactly same but their financial decisions are different and there for the net profit margins are
different all we okay here so now write down this part can we say that company which has
taken more debt is more risky what do you think yes or no it is relatively more risky so here company A is more riskier than
company B on a relative basis there is reason being what if your EBIT turns out to be less than 1000 if your EBIT was less than 1000 that means you're making losses right but in case of Company B does
not have to pay any profit so it does not have to pay any interest
and therefore if there are two companies and if one
company has less amount of debt then it is considered relatively more safer yeah that's a
really good one what ratio should be considered when we are comparing A & B should be considered EBIT divided by sales which is operating
profit margin or should be consider net profit margin
the answer depends on what is the purpose of analysis so
if your purpose is to see for example let's take two companies in
the same business let's say Pepsi and Coke if you want to see
whether from the business perspective who is
smarter then you look at operating profit margin
only the core business model of making beverages then selling them but if you want to see
over all which means operations as well as financial decisions who is smarter then you look at net profit margin so in
this case from a business perspective both the companies are exactly same but now overall entire financial decision-making as of now be looks better as of now it's going to change very soon now what what's going to happen next seven
minutes if you haven't done this before it's going to completely change the way you look at
companies so be really focused here don't write anything
even if you're not finished now I am adding some more data to the same question let us say company A has total capital invested in the business capital means equity plus debt inclusive
for this analysis so let me call total fund invested total funds invested are 15,000 out
of this fifteen thousand 5,000 is equity capital equity means the amount
of money invested by owners so in to in the previous example we
called simply a capital 10,000 is taken as a loon and the cost of this
loan cost of this loan is 10 percent so on 10,000 how much interest should be pay 1000 have we paid that we paid interest of 1000 whereas company B has totally fund Invested total funds invested of 15,000 can you guess how much of that
is equity entire 15,000 because we did not pay
any interest that means your loan amount is 0 okay now let us say your the owner of the business so in company A how much of your own money you've
invested 5,000 and in Company B how much of your own money you invested 15,000 now what we would do Next calculate how much is the money owners have invested owners have earn on their own amount which would be
called as ROE return on equity the formula for ROE is net income which means net profit divided by total
equity net profit divided by total equity to let us calculate that for Company B
1st how much is a net profit earn 1500 and how much amount did owners invest 15,000 so how
much is the ROE for owner 10 percent let us calculate that for
company B how much is the profit here net profit and how much did the owners invest 5,000 how much would that be 18 percent do you want to be ROE is higher or
lower you want ROE to be higher so when we
calculated net profit margin what was a conclusion which companies
better company B but now when you calculated ROE what is the conclusion which company is better company A what
is happening is that company A has been able to leverage
on the ROE and what they did is they would roughly earning 2500 every year which is in the form of
EBIT what company A said is let me take a
loan of ten thousand let me put five thousand of my own on that loan of ten thousand I'm going
to pay only one thousand which means that after paying Taxes I will be able to 900 on my capital
of 5,000 this is called leveraging its is exactly similar to when you're buying
a house you take some loan so on that loan you don't pay profit you
Pay interest but when you sale the house on
a smaller investment you earn more return this is called leveraging on your capital are we fine with this so the conclusion
here is that company A has a better ROE but it is also more risky company the reason why it is more risky that some day your EBIT turns out to be
lesser then you will not have sufficient money
to pay the interest and therefore there's a possibility of
company a going bankrupt where as Company B is more conservative company it is not taken any loan so in India many
companies most of the IT company's you would see
Infosys or even TCS to some extent so large number of IT companies are debt-free they do not take any amount of loan which means they are in the more conservative category are you following this but you'd see a lot of real estate company's DLF or we take most of the real estate company's they have taken large amount of Debt so
their ROE we might be higher but they're more leverage and therefore
more riskier companies

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