FINANCIAL RATIOS

A Basic Introduction
EBIT Earning Before Interest and Tax
An Indicator of an organization profitability

EBIT known as
1. Operating Earnings
2. Operating Profit
3. Operating Income

Formula to calculate EBIT

EBIT = Revenue Cost of Goods Sold Operating Expenses

Or
EBIIT = Net Income + Interest + Taxes

Operating Expenses
E.g.: Selling, Admin and Marketing Expenses, Employee Benefits, R&D
 EBIT Earning Before Interest and Tax
EBIT Calculation Example
Revenue $ 8,000.00
Cost of Goods Sold $ (2,000.00)
Gross Profit $ 6,000.00
Operating Expense $ (4,000.00)
EBIT $ 2,000.00

Exercise 01
Pwc Plc recorded a revenue of $12,000 for 20X5. Cost of
Sales $3,800, Rent $500, Selling & Administration cost $
2,500, Marketing Expense $ 1,000, Non operating income
$1,100
What is the EBIT for 20X5?
EBIT Earning Before Interest and Tax
Benefits of EBIT calculation
1. Investors use EBIT to compare the profitability of one
company to another

2. EBIT is an input in various financial calculation such as

1. Interest coverage ratio
2. Operating profit margin

3. Decision making in acquiring companies when it

operates in different financial structure and different tax
rates
EBITDA - Earnings Before Interest, Taxes,
Depreciation and Amortization
An Indicator of a companys financial performance

EBITDA Calculation Formula

EBITA = Revenue Expense (excluding taxes, interest and

depreciation and amortization)

This measure attempts to calculate a firms profitability before

any legally required payment such as taxes and interest on debt
are paid.

Depreciation is removed because this is an expense the firm

records but does not necessarily have to pay in cash
How to Get EBITDA
Example

Revenue $ 9,000.00 Ignores secondary costs

Cost of Goods Sold $ (3,500.00) like financing charges,
Gross Profit $ 5,500.00 taxes, and non-cash costs
Selling, General and like depreciation and
Administration Cost $ (3,500.00) amortization
EBITDA $ 2,000.00

Exercise 02

R&D Plc annual turnover for 20X8 $9,900. Cost of sales $2,200, Rent and
Rates $600, Depreciation and amortization $2,800, Interest expense $ 450,
Selling and Marketing expense $ 4, 100. Applicable tax rate for the period
30%

Calculate EBITA for year 20X8

What is Valuation used for?
Mergers, Acquisitions, and Leveraged Buyout
Analysis

Comparing Companies within or across industries

General Securities Analysis

Real-Estate Investments
ROI & ROCE
ROI Return on Investment
ROCE Return on Capital Employed
What is ROI
It is ratio of net income
In simple term Excess of income over expenditure

Here is the ROI formula

ROI
Example
John bought a used car for $1200 and sold the car for $1800.
What is the Return on Investment (ROI)
Solution
Net Profit = Revenue Expense
Net Profit = $1800 - 1200 = 600

Net Profit
ROI = x 100
Investment

ROI = 600 x 100 = 50%

1200
Exercise
Project A: Investment $1,500,000, estimated gross profit
$2,000,000 and estimated expense $1,000,000

Project B: Investment $150,000, estimated gross profit

$100,000 and estimated expense $30,000

Project C: Investment $25,000, estimated gross profit

$25,000 and estimated expense $5,000

Required
1. Calculate ROI for each project
2. Select the most profitable project to invest
Why we calculate ROI
Reward for an employee or Division

ROI is an indication of the efficiency of utilization of the

resources used in the business
ROI Advantage and Disadvantage
ROI is a popular measure for divisional performance but
has some serious failings which must be considered when
interpreting results.

Advantages
It is widely used and accepted since it is line with ROCE
which is frequently used to assess overall business
performance.

As a relative measure it enables comparisons to be made

with divisions or companies of different sizes.

It can be broken down into secondary ratios for more

detailed analysis, i.e. profit margin and asset turnover.
ROI Advantage and Disadvantage
Disadvantages
It may lead to dysfunctional decision making, e.g. a division with a
current ROI of 30% would not wish to accept a project offering a
ROI of 25%, as this would dilute its current figure. However, the
25% ROI may meet or exceed the company's target.

ROI increases with the age of the asset if NBVs are used, thus
giving managers an incentive to hang on to possibly inefficient,
obsolescent machines.

It may encourage the manipulation of profit and capital employed

figures to improve results, e.g. in order to obtain a bonus payment.

Different accounting policies can confuse comparisons (e.g.

depreciation policy).
ROCE - Return on Capital Employed
ROCE is an important analysis tool as it allows users to
assess how much profit the business generates from the
capital invested in it. Profit margins of different
companies are not necessarily comparable due to
different sizes and business structures.

In simple terms ROCE measures how much operating

profit is generated for every $1 capital invested in the
business.
ROCE - Return on Capital Employed
It is expressed as:-

Earnings

ROCE = ---------------------------- X 100

Capital Employed

The numerator is Earnings before Interest & Tax. It is

net revenue after all the operating expenses are deducted

The denominator (capital employed) denotes sources of

funds such as equity and short-term debt financing
which is used for the day-to-day running of the company
 Example
Company A makes a profit of $100 on sales of $1000. Capital employed $500. Company B makes a
profit of $150 on sales of $1000. Capital employed $1000
Solution
Profitability
Company A which has 10% profitability ($100 / $1000)
Company B has profitability of 15% ($15 / $1000)
Company B makes the highest profitability

ROCE
Company A - (earnings / capital employed)
($100 / $500) X 100 = 20%

Company B - (earnings / capital employed)

($150 / $1000) X 100 = 15%

Company A makes the highest ROCE

What does ROCE say
It is a useful measurement for comparing the relative
profitability of companies
ROCE does not consider profit margins (percentage of
profit) alone but also considers the amount of capital
utilized for those profits to happen
It is possible that a companys profit margin is higher than
that of another company, but its ability to get better return
on its capital may be lower
ROCE is a measure of efficiency
CAPITAL EXPENDITURE
Capital expenditure is money spent on the purchase of
permanent or fixed assets for setting up the business in
the initial stage.
Improvement or extension of existing assets.
It is to increase the earning capacity of the business
enterprise.
Initial legal cost.
Long term assets.
It provides benefits up to more than one year.
Value added to the assets is depreciated year by year.
Capital expenditure.

Capital expenditure

Intangible assets Tangible assets Cost of financing a

e.g.: land fixed assets
e.g. : trade mark.
e.g.: loan
Operating Expenditure
When some expenditure is incurred in any financial year for
the sake of generation of revenue in the current financial
year , this is called as operating expenditure or revenue
expenditure.

It is charged to the Income Statement of the current

financial year.

It s a money spent on materials & services i.e consumed

by the business in carrying out business activities.

Expenses incurred for maintaining the efficiency of fixed

assets.
example : wages of worker, electricity bill etc.
Operating Expenditure

OPERATING
EXPENDITURE

Upkeep of fixed Purchase of

Day to day assets
expenses stocks
 COMPARISON
OPERATING EXPENDITURE CAPITAL EXPENDITURE

Smaller in size. Comparatively larger in size.

recurring in nature. non- recurring in nature.

Includes operating & non- Includes miscellaneous

operating expenses. expenditures.

Short term expenses. Expense is for long term.

Results in to short term income. Results in to long term income.

Its effect gets exhausted usually Comparatively Its effect last

in a year. longer.
some special expenditure seems to
be revenue expenditure but are
treated as capital expenditure:-

Initial expenses for the set up of company.

Raising loans ,underwriting commission & legal expenses.
payment of Interest on capital(loan) before production of
company begins.
Expenses in acquisition & installation of assets.
Thank you