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

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

2 months ago
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