Upload
jaywanti-akshra-gurbani
View
235
Download
0
Embed Size (px)
Citation preview
7/31/2019 Break Even Analysis and Ratio Analysis
1/63
RATIO ANALYSISAND BREAK EVEN
ANALYSIS
7/31/2019 Break Even Analysis and Ratio Analysis
2/63
RATIOANALYSIS
Is a method or process by which the relationship ofitems or groups of items in the financial statementsare computed, and presented.
Is an important tool of financial analysis.
Is used to interpret the financial statements so thatthe strengths and weaknesses of a firm, itshistorical performance and current financialcondition can be determined.
7/31/2019 Break Even Analysis and Ratio Analysis
3/63
RATIO
A mathematical yardstick that measures therelationship between two figures or groups of
figures which are related to each other and are
mutually inter-dependent. It can be expressed as a pure ratio, percentage, or
as a rate
7/31/2019 Break Even Analysis and Ratio Analysis
4/63
UTILITYOF RATIOS
Accounting ratios are very useful in assessing the
financial position and profitability of an enterprise.
However its utility lies in comparison of the ratios.
7/31/2019 Break Even Analysis and Ratio Analysis
5/63
UTILITYOF RATIOS
Comparison may be in any one of thefollowing forms:
For the same enterprise over a number of
yearsFor two enterprises in the same industry
For one enterprise against the industry as awhole
For one enterprise against a pre-determinedstandard
For inter-segment comparison within thesame organisation
7/31/2019 Break Even Analysis and Ratio Analysis
6/63
CLASSIFICATIONOF RATIOS
Ratios can be broadly classified into four groups
namely:
Liquidity ratios
Capital structure/leverage ratios Profitability ratios
Activity ratios
7/31/2019 Break Even Analysis and Ratio Analysis
7/63
LIQUIDITYRATIOS
These ratios analyse the short-term financial
position of a firm and indicate the ability of the
firm to meet its short-term commitments
(current liabilities) out of its short-termresources (current assets).
These are also known as solvency ratios.
The ratios which indicate the liquidity of a firm
are: Current ratio
Liquidity ratio or Quick ratio or acid test ratio
7/31/2019 Break Even Analysis and Ratio Analysis
8/63
CURRENTRATIO
It is calculated by dividing current assets by current
liabilities.
Current ratio = Current assets where
Current liabilities
Conventionally a current ratio of 2:1 is consideredsatisfactory
7/31/2019 Break Even Analysis and Ratio Analysis
9/63
CURRENT ASSETS
include Inventories of raw material, WIP, finished goods,
stores and spares,
sundry debtors/receivables,
short term loans deposits and advances,
cash in hand and bank, prepaid expenses,
incomes receivables and
marketable investments and short term securities.
7/31/2019 Break Even Analysis and Ratio Analysis
10/63
CURRENT LIABILITIES
include sundry creditors/bills payable,
outstanding expenses,
unclaimed dividend,
advances received, incomes received in advance,
provision for taxation,
proposed dividend,
instalments of loans payable within 12 months,
bank overdraft and cash credit
7/31/2019 Break Even Analysis and Ratio Analysis
11/63
QUICK RATIOOR ACID TEST RATIO
This is a ratio between quick current assetsand current liabilities (alternatively quickliabilities).
It is calculated by dividing quick currentassets by current liabilities (quick currentliabilities)
Quick ratio = quick assets
Current liabilities/(quick liabilities)
Conventionally a quick ratio of 1:1 isconsidered satisfactory.
7/31/2019 Break Even Analysis and Ratio Analysis
12/63
QUICK ASSETS & QUICK LIABILITIES
QUICK ASSETS are current assets (as stated earlier)
less prepaid expenses and inventories.
QUICK LIABILITIES are current liabilities (as statedearlier)
less bank overdraft and incomes received in advance.
7/31/2019 Break Even Analysis and Ratio Analysis
13/63
CAPITALSTRUCTURE/ LEVERAGE
RATIOS
These ratios indicate the long term solvency of a
firm and indicate the ability of the firm to meet its
long-term commitment with respect to
(i) repayment of principal on maturity or in
predetermined instalments at due dates and
(ii) periodic payment of interest during the period of
the loan.
7/31/2019 Break Even Analysis and Ratio Analysis
14/63
CAPITALSTRUCTURE/ LEVERAGERATIOS
The different ratios are:
Debt equity ratio
Proprietary ratio
Debt to total capital ratio
Interest coverage ratio
Debt service coverage ratio
7/31/2019 Break Even Analysis and Ratio Analysis
15/63
DEBTEQUITYRATIO
This ratio indicates the relative proportion of debtand equity in financing the assets of the firm. It iscalculated by dividing long-term debt byshareholders funds.
Debt equity ratio = long-term debts where
Shareholders funds
Generally, financial institutions favour a ratioof 2:1.
However this standard should be applied havingregard to size and type and nature of business andthe degree of risk involved.
7/31/2019 Break Even Analysis and Ratio Analysis
16/63
LONG-TERM FUNDS are long-term loanswhether secured or unsecured like debentures, bonds, loans from financialinstitutions etc.
SHAREHOLDERS FUNDS are equityshare capital plus preference share capital
plus reserves and surplus minus fictitiousassets (eg. Preliminary expenses, pastaccumulated losses, discount on issue ofshares etc.)
7/31/2019 Break Even Analysis and Ratio Analysis
17/63
PROPRIETARYRATIO
This ratio indicates the general financial
strength of the firm and the long- term
solvency of the business.
This ratio is calculated by dividing proprietorsfunds by total funds.
Proprietary ratio = proprietors funds
where
Total funds/assets
As a rough guide a 65% to 75% proprietaryratio is advisable
7/31/2019 Break Even Analysis and Ratio Analysis
18/63
PROPRIETORS FUNDS are same as explained in
shareholders funds
TOTAL FUNDSare all fixed assets and all currentassets.
Alternatively it can be calculated as proprietors
funds plus long-term funds plus current liabilities.
7/31/2019 Break Even Analysis and Ratio Analysis
19/63
DEBTTOTOTALCAPITALRATIO
In this ratio the outside liabilities are related to the
total capitalisation of the firm. It indicates what
proportion of the permanent capital of the firm is in
the form of long-term debt.
Debt to total capital ratio =long- term debt
Shareholders funds + long- term
debt
Conventionally a ratio of 2/3 is consideredsatisfactory.
7/31/2019 Break Even Analysis and Ratio Analysis
20/63
INTERESTCOVERAGERATIO
This ratio measures the debt servicing capacity of afirm in so far as the fixed interest on long-term loan isconcerned. It shows how many times the interestcharges are covered by EBIT out of which they will bepaid.
Interest coverage ratio = EBIT
Interest
A ratio of 6 to 7 times is considered satisfactory.
Higher the ratio greater the ability of the firm to payinterest out of its profits. But too high a ratio mayimply lesser use of debt and/or very efficientoperations
7/31/2019 Break Even Analysis and Ratio Analysis
21/63
DEBTSERVICECOVERAGERATIO
This is a more comprehensive measure tocompute the debt servicing capacity of a firm. Itshows how many times the total debt serviceobligations consisting of interest and repayment ofprincipal in instalments are covered by the total
operating funds after payment of tax.Debt service coverage ratio =EAT+ interest + depreciation + other non-cash exp
Interest + principal instalment
EAT is earnings after tax.
Generally financial institutions consider 2:1 asa satisfactory ratio.
P
7/31/2019 Break Even Analysis and Ratio Analysis
22/63
PROFITABILITYRATIOS
These ratios measure the operating efficiency of the firm
and its ability to ensure adequate returns to itsshareholders.
The profitability of a firm can be measured by its profitability
ratios.
Further the profitability ratios can be determined
(i) in relation to sales and
(ii) in relation to investments
7/31/2019 Break Even Analysis and Ratio Analysis
23/63
PROFITABILITYRATIOS
Profitability ratios in relation to sales:
gross profit margin
Net profit margin
Expenses ratio
7/31/2019 Break Even Analysis and Ratio Analysis
24/63
PROFITABILITYRATIOS
Profitability ratios in relation to investments
Return on assets (ROA)
Return on capital employed (ROCE)
Return on shareholders equity (ROE)
Earnings per share (EPS)
Dividend per share (DPS)
Dividend payout ratio (D/P)
Price earning ratio (P/E)
7/31/2019 Break Even Analysis and Ratio Analysis
25/63
GROSSPROFITMARGIN
This ratio is calculated by dividing gross profit by sales. It
is expressed as a percentage.
Gross profit is the result of relationship between prices,
sales volume and costs.
Gross profit margin = gross profit x 100
Net sales
7/31/2019 Break Even Analysis and Ratio Analysis
26/63
GROSSPROFITMARGIN
A firm should have a reasonable gross profit margin
to ensure coverage of its operating expenses and
ensure adequate return to the owners of the
business ie. the shareholders.
To judge whether the ratio is satisfactory or not, it
should be compared with the firms past ratios or
with the ratio of similar firms in the same industry or
with the industry average.
7/31/2019 Break Even Analysis and Ratio Analysis
27/63
NETPROFITMARGINThis ratio is calculated by dividing net profit by sales. It isexpressed as a percentage.
This ratio is indicative of the firms ability to leave a marginof reasonable compensation to the owners for providingcapital, after meeting the cost of production, operating
charges and the cost of borrowed funds.Net profit margin =
Net profit after interest and tax x 100
Net sales
7/31/2019 Break Even Analysis and Ratio Analysis
28/63
NETPROFITMARGIN
Another variant of net profit margin is operating profit
margin which is calculated as:
Operating profit margin =
net profit before interest and tax x 100
Net sales
Higher the ratio, greater is the capacity of the firm to
withstand adverse economic conditions and vice
versa
7/31/2019 Break Even Analysis and Ratio Analysis
29/63
EXPENSESRATIO
These ratios are calculated by dividing the variousexpenses by sales. The variants of expenses ratios are:
Material consumed ratio = Material consumed x 100Net sales
Manufacturing expenses ratio = manufacturing expenses x 100
Net sales
Administration expenses ratio = administration expenses x 100
Net salesSelling expenses ratio = Selling expenses x 100
Net sales
Operating ratio = cost of goods sold plus operating expenses x 100
Net sales
Financial expense ratio = financial expenses x 100Net sales
7/31/2019 Break Even Analysis and Ratio Analysis
30/63
EXPENSESRATIO
The expenses ratios should be compared over a
period of time with the industry average as well as
with the ratios of firms of similar type. A low
expenses ratio is favourable.
The implication of a high ratio is that only a smallpercentage share of sales is available for meeting
financial liabilities like interest, tax, dividend etc.
7/31/2019 Break Even Analysis and Ratio Analysis
31/63
RETURNONASSETS (ROA)
This ratio measures the profitability of the totalfunds of a firm. It measures the relationshipbetween net profits and total assets. Theobjective is to find out how efficiently the totalassets have been used by the management.
Return on assets =net profit after taxes plus interest x 100
Total assets
Total assets exclude fictitious assets. As the totalassets at the beginning of the year and end of theyear may not be the same, average total assetsmay be used as the denominator.
7/31/2019 Break Even Analysis and Ratio Analysis
32/63
RETURNONCAPITALEMPLOYED
(ROCE)
This ratio measures the relationship between net profit andcapital employed. It indicates how efficiently the long-termfunds of owners and creditors are being used.
Return on capital employed =
net profit after taxes plus interest x 100Capital employed
CAPITAL EMPLOYED denotes shareholders funds andlong-term borrowings.
To have a fair representation of the capital employed,average capital employed may be used as the denominator.
7/31/2019 Break Even Analysis and Ratio Analysis
33/63
RETURNONSHAREHOLDERSEQUITY
This ratio measures the relationship of profits to owners
funds. Shareholders fall into two groups i.e. preferenceshareholders and equity shareholders. So the variants ofreturn on shareholders equity are
Return on total shareholders equity =
net profits after taxes x 100Total shareholders equity
.
7/31/2019 Break Even Analysis and Ratio Analysis
34/63
TOTAL SHAREHOLDERS EQUITY includes
preference share capital plus equity share capital
plus reserves and surplus less accumulated losses
and fictitious assets. To have a fair representation
of the total shareholders funds, average totalshareholders funds may be used as the
denominator
7/31/2019 Break Even Analysis and Ratio Analysis
35/63
Return on ordinary shareholders equity =
net profit after taxes pref. dividend x 100
Ordinary shareholders equity or net worth
ORDINARY SHAREHOLDERS EQUITY OR NET
WORTH includes equity share capital plus reserves
and surplus minus fictitious assets.
7/31/2019 Break Even Analysis and Ratio Analysis
36/63
EARNINGSPERSHARE (EPS)
This ratio measures the profit available to the equity
shareholders on a per share basis. This ratio is
calculated by dividing net profit available to equity
shareholders by the number of equity shares.
Earnings per share =
net profit after tax preference dividend
Number of equity shares
7/31/2019 Break Even Analysis and Ratio Analysis
37/63
DIVIDENDPERSHARE (DPS)
This ratio shows the dividend paid to the shareholderon a per share basis. This is a better indicator thanthe EPS as it shows the amount of dividend receivedby the ordinary shareholders, while EPS merely
shows theoretically how much belongs to the ordinaryshareholders
Dividend per share =
Dividend paid to ordinary shareholders
Number of equity shares
7/31/2019 Break Even Analysis and Ratio Analysis
38/63
DIVIDENDPAYOUTRATIO (D/P)
This ratio measures the relationship between the
earnings belonging to the ordinary shareholders
and the dividend paid to them.
Dividend pay out ratio =total dividend paid to ordinary shareholders x 100
Net profit after taxpreference dividend
OR
Dividend pay out ratio=Dividend per share x 100
Earnings per share
7/31/2019 Break Even Analysis and Ratio Analysis
39/63
PRICEEARNINGRATIO (P/E)
This ratio is computed by dividing the market price of theshares by the earnings per share. It measures the
expectations of the investors and market appraisal of the
performance of the firm.
Price earning ratio = market price per shareEarnings per share
7/31/2019 Break Even Analysis and Ratio Analysis
40/63
ACTIVITYRATIOS
These ratios are also called efficiency ratios /asset utilization ratios or turnover ratios. Theseratios show the relationship between sales andvarious assets of a firm. The various ratiosunder this group are:
Inventory/stock turnover ratio Debtors turnover ratio and average collection period
Asset turnover ratio
Creditors turnover ratio and average credit period
7/31/2019 Break Even Analysis and Ratio Analysis
41/63
INVENTORY /STOCKTURNOVERRATIO
This ratio indicates the number of times inventory isreplaced during the year. It measures the relationshipbetween cost of goods sold and the inventory level.There are two approaches for calculating this ratio,namely:Inventory turnover ratio = cost of goods sold
Average stockAVERAGE STOCK can be calculated as
Opening stock+ closing stock2
AlternativelyInventory turnover ratio = sales_________
Closing inventory
7/31/2019 Break Even Analysis and Ratio Analysis
42/63
INVENTORY /STOCKTURNOVERRATIO
A firm should have neither too high nor too low
inventory turnover ratio. Too high a ratio may
indicate very low level of inventory and a danger of
being out of stock and incurring high stock out
cost. On the contrary too low a ratio is indicative ofexcessive inventory entailing excessive carrying
cost.
D
7/31/2019 Break Even Analysis and Ratio Analysis
43/63
DEBTORSTURNOVERRATIOANDAVERAGE
COLLECTIONPERIOD
This ratio is a test of the liquidity of the debtors of a firm. Itshows the relationship between credit sales and debtors.
Debtors turnover ratio =
Credit sales
Average Debtors and bills receivables
Average collection period =
Months/days in a year
Debtors turnover
7/31/2019 Break Even Analysis and Ratio Analysis
44/63
DEBTORSTURNOVERRATIOANDAVERAGE
COLLECTIONPERIOD
These ratios are indicative of the efficiency of thetrade credit management. A high turnover ratio andshorter collection period indicate prompt paymentby the debtor. On the contrary low turnover ratioand longer collection period indicates delayedpayments by the debtor.
In general a high debtor turnover ratio and shortcollection period is preferable.
7/31/2019 Break Even Analysis and Ratio Analysis
45/63
ASSETTURNOVERRATIO
Depending on the different concepts of assets employed,there are
many variants of this ratio. These ratios measure theefficiency of a firm in managing and utilising its assets.
Total asset turnover ratio = sales/cost of goods sold
Average total assets
Fixed asset turnover ratio = sales/cost of goods sold
Average fixed assets
Capital turnover ratio = sales/cost of goods sold
Average capital employed
Working capital turnover ratio = sales/cost of goods sold
Net working capital
7/31/2019 Break Even Analysis and Ratio Analysis
46/63
ASSETTURNOVERRATIO
Higher ratios are indicative of efficient management
and utilisation of resources while low ratios are
indicative of under-utilisation of resources and
presence of idle capacity.
CREDITORS TURNOVER RATIO AND AVERAGE
7/31/2019 Break Even Analysis and Ratio Analysis
47/63
CREDITORSTURNOVERRATIOANDAVERAGE
CREDITPERIOD
This ratio shows the speed with which payments are madeto the suppliers for purchases made from them. It shows
the relationship between credit purchases and average
creditors.
Creditors turnover ratio =
credit purchases
Average creditors & bills payables
Average credit period = months/days in a year
Creditors turnover ratio
7/31/2019 Break Even Analysis and Ratio Analysis
48/63
CREDITORSTURNOVERRATIOAND
AVERAGECREDITPERIOD
Higher creditors turnover ratio and short credit
period signifies that the creditors are being paid
promptly and it enhances the creditworthiness of
the firm.
7/31/2019 Break Even Analysis and Ratio Analysis
49/63
BREAK EVEN
ANALYSIS
7/31/2019 Break Even Analysis and Ratio Analysis
50/63
INTRODUCTION
Break-Even Analysis is used to predict future profits/losses
predict results eg produce Product A or Product
B
Break-Even Point is when Sales Revenueequals Total Costs
at this point no profit or loss is incurred
the firm merely covers its total costsBreak-Even Point can be shown in graph
form or by use of formulae
7/31/2019 Break Even Analysis and Ratio Analysis
51/63
BREAK-EVEN ANALYSIS
In order to calculate how profitable a product will be, we must
firstly look at the Costs involved
There are two basic types of costs a company incurs.
Variable Costs
Fixed Costs
Variable costs are costs that change with changes inproduction levels or sales. Examples include: Costs ofmaterials used in the production of the goods.
Fixed costs remain roughly the same regardless ofsales/output levels. Examples include: Rent, Insuranceand Wages
7/31/2019 Break Even Analysis and Ratio Analysis
52/63
CONT..
TOTAL COSTS
Total Costs is simply Fixed Costs and Variable Costs
added together.
TC = FC + VC
As Total Costs include some of the Variable Costs
then Total Costs will also change with any changes in
output/sales.
If output/sales rise then so will Total Costs.
If output/sales fall then so will Total Costs.
7/31/2019 Break Even Analysis and Ratio Analysis
53/63
CONT.
The Break-even point occurs when Total Costs equals
Revenue (Sales Income)
Revenues (Sales Income) = Total Costs
At this point the business is not making a Profit norincurring a Loss it is merely covering its Total Costs
Let us have a look at a simple example.
Bannerman Trading Companyopens a flower shop.
7/31/2019 Break Even Analysis and Ratio Analysis
54/63
CONT.
Fixed Costs:
Rent: Rs.400
Helper (Wages): Rs.200
Variable Costs:
Flowers: Rs.0.50 per bunch
Selling Price:
Flowers: Rs.2 per bunch
So we know that:
Total Fixed Costs = Rs.600
Variable Cost per Unit = Rs.0.50
Selling Price per Unit = Rs.2.00
SP = RS.2.00
7/31/2019 Break Even Analysis and Ratio Analysis
55/63
We must firstly calculate how much income from eachbunch of flowers can go towards covering the Fixed
Costs.
This is called the Unit Contribution.
Selling PriceVariable Costs = Unit Contribution
Rs.2.00Rs.0.50 = Rs.1.50
For every bunch of flowers sold Rs.1.50 can go
towards covering Fixed Costs
Break-Even AnalysisSP RS.2.00
VC = RS.0.50
FC = RS.600
B k E A l i SP = Rs 2 00
7/31/2019 Break Even Analysis and Ratio Analysis
56/63
Now to calculate how many units must
be sold to cover Total Costs (FC + VC)
This is called the Break Even Point
Break Even Point =
Fixed CostsUnit ContributionRs.600Rs.1.50 = 400 Units
Therefore 400 bunches of flowers must be sold to BreakEven at this the point the business is not making aProfit nor incurring a Loss it is merely covering itsTotal Costs
Break-Even Analysis SP = Rs.2.00VC = Rs.0.50
Unit cont =
Rs.1.50
FC = Rs.600
7/31/2019 Break Even Analysis and Ratio Analysis
57/63
BREAK-EVEN CHART
Costs/Revenue
Output/Sales
FC
VCTCTR
The Break-even point
occurs where total
revenue equals total
coststhe firm, in
this example would
have to sell Q1 to
generate sufficient
revenue (income) to
cover its total costs.
Q1
BEP
ADVANTAGES OF BREAK EVEN ANALYSIS IN
7/31/2019 Break Even Analysis and Ratio Analysis
58/63
58
ADVANTAGESOFBREAKEVENANALYSISIN
MANAGERIALDECISIONMAKING
It helps in determining the optimum level of output below
which it would not be profitable for a firm to produce
It helps in determining the target capacity for a firm to get
the benefit of minimum unit cost of production.
The firm can determine minimum cost for a given level of
output.
It helps the firm in deciding which products are to beproduced and which are to be brought by the firm.
Plant expansion and contraction decisions are often
based on the break even analysis of the perceivedsituation.
7/31/2019 Break Even Analysis and Ratio Analysis
59/63
59
ADVANTAGESOFBREAKEVENANALYSISIN
MANAGERIALDECISIONMAKING
Impact of changes in prices and costs on profit of thefirm can also be analyzed with the help of break eventechnique.
Sometimes a management has to take decisions
regarding dropping or adding a product to the productline. The break even analysis comes very handy in such
situation.
It evaluates the percentage financial yield from a project
and thereby helps in the choice between variousalternatives projects
ADVANTAGES OF BREAK EVEN ANALYSIS IN
7/31/2019 Break Even Analysis and Ratio Analysis
60/63
60
ADVANTAGESOFBREAKEVENANALYSISIN
MANAGERIALDECISIONMAKING
The break even analysis can be used in findingthe selling price which would prove most profitable
for the firm
By finding out the break even point the break even
analysis helps in establishing point where from thefirm can start payment of dividend to its
shareholders
7/31/2019 Break Even Analysis and Ratio Analysis
61/63
LIMITATIONSOF BREAK EVEN ANALYSIS
Some costs cannot be identified as precisely Fixedor Variable
Semi-variable costs cannot be easily
accommodated in break-even analysisCosts and revenues tend not to be constant
With Fixed costs the assumption that they are
constant over the whole range of output from zeroto maximum capacity is unrealistic
7/31/2019 Break Even Analysis and Ratio Analysis
62/63
LIMITATIONS CONTINUED
Price reduction may be necessary to protectsales in the face of increased competition
The sales mix may change with changes in
tastes and fashions
Productivity may be affected by strikes and
absenteeism
The balance between Fixed and Variable
costs may be altered by new technology
7/31/2019 Break Even Analysis and Ratio Analysis
63/63
BREAK-EVEN CHART