Question

Financial Ratio 2 - Interpretation

1. Debt: Interest Coverage Ratio [ EBIT/int. exp] :
   - would it make sense to use the cash version of EBIT?
2. Return on Assets [operating return on assets = ROA = operating Profits / Total Assets]
   - Any linkage between ROA and Valuation equation [ V0 = CF/(1+r)^t ] ?
3. Operating Profit Margin [OPM = EBIT/ SALES]: - what pictures of operating efficiency do ROA and OPM give to us?
4. Asset Turnover [Sales/ Assets]
   1. This is similar to inventory turnover and A/R turnover?
   2. What type of asset should be used in calculating asset turnover?
5. Total Asset Turnover Vs. Fixed Asset Turnover: how do the meaning of two different schemes differ?
6. Return on Shareholders [ROE= Net income / Equity*] *Equity = total common equity + retained earning
7. 1. Should net income (NI) be before or after the tax expense?
   2. Do we want to see ROE without the tax effect?
   3. How does ROE economically differ from ROA? [ or the things that ROA cannot reveal ]  

Answer 1

Debt : Interest Coverage ratio [ EBIT/int. exp}]

First of all to reach cash version of EBIT we need two Adjustment ;-

• One is adjustment of Add back of Depreciation
• Second is adjustment of Change in Working Capital

This Ratio we generally calculated to present to Lender, Lender always looks for the viability of company to pay interest and debt.

Therefore add back of Depreciation is necessary in this ratio because it is just a fictional expense it is no a actual expense. it is not going to affect the operation of company whether depreciation expense is more or less.

Second is Change in Working Capital:- In my point of view Change in working capital adjustment should not be done. Because if we prepare EBIT after adjustment of Change in Working Capital, then to Shown high EBIT company will start taking advance money from debtor and pay to creditor after a credit period. This will not show the perfect image of the Company. This way company can manipulate.

Therefore Depreciation should be add back and Change in Working should not be consider.

Return on Assets [operating return on assets = ROA = operating Profits / Total Assets

Any linkage between ROA and Valuation equation [ V0 = CF/(1+r)^t ]

Ans:- Valuation Equation is the Present value of all the cash flow you can generate from the the assets. V0/Total Asset shown the actual benefit you will get in future from the asset. ( considering the PV factor)

What pictures of operating efficiency do ROA and OPM give to us?

OPM :- Operating Profit Margin shows the net benefit you are receiving out of sale amount. It show the net operating profit( Sale - Direct Expense)  you are earning from the sale. If the OPM is high it shows that your operation are very efficient and earning good cash flows for the company and Vice Versa.

ROA:- Return on asset show the operating income you earned from the total asset employed. If the ROA is high, that means you are very efficient and you can recover whole the cost of the assets very quickly and Vice Versa.

Asset Turnover [Sales/ Assets]

This is similar to inventory turnover and A/R turnover?

Answer ;- Asset turnover, inventory turnover and A/R turnover all are difference and some different aspect

Asset Turnover shows that turnover of the company in comparison of the asset of the company.

Inventory Turnover show average how much inventory is lying with the company in comparison to the sales of the company. It is required to efficiently managing the inventory

A/R Turnover shows the company's effectiveness to recovery amount from the debtor.

1. What type of asset should be used in calculating asset turnover?

Total Asset Turnover Vs. Fixed Asset Turnover:

how do the meaning of two different schemes differ?

Ans In total asset turnover, we took all the asset of the company including fixed and current asset i.e. we compare turnover of the company in comparison to the total asset of the company, whereas in Fixed asset turnover, we took only the fixed asset of the company and not consider current asset i.e. we compare turnover of the company in comparison to the total fixed asset( land, Plant , Machinery, etc.) of the company

Return on Shareholders [ROE= Net income / Equity*] *Equity = total common equity + retained earning

1. Should net income (NI) be before or after the tax expense?

Answer: - Net Income should always be after tax because company first pay tax and then profit left after tax goes to share holders. Therefore net income should be after tax.

2.Do we want to see ROE without the tax effect?

No we cannot see ROE without tax effect because it is indirectly expense for company there we should not see ROE without tax effect.

3. How does ROE economically differ from ROA? [ or the things that ROA cannot reveal ]

ROE show that Return for shareholder whereas ROA shows return for the total asset employed i.e. total return to the capital employed i.e. ROA include Return to debt + Preference share + Equity Share.

Share holder cannot identify their return from ROA. It may happen that ROA of the Company is very good but ROE is negative.