Chapter 2/Session 6

Financial Statements Analysis

 Objectives of Session 6
• Meaning & Significance of Growth Ratios
• Types of Growth Ratios
• Du Pont Analysis
 Meaning & Significance of Growth Ratios
 Growth Ratios measure the rate at which a firm grows.
 A firm is said to grow when there is growth or increase
in sales.
 Growth in sales need additional investment to support
incremental sales both in terms of current assets (such as
inventory and debtors) and productive capacity/long-term
assets (such as plant and machinery).
 Additional investment requires funds, either from inside
(retained earnings-reserves & surplus) or from outside
(external financing-equity and/or debt)
 Accordingly, there are two types of growth rates:
a) Internal Growth Rate (when retained earnings are used), &
b) Sustainable Growth Rate (when besides retained earnings,
external financing is also used)
 Meaning & Significance of Growth Ratios
 The firm’s growth rate is higher when external
finances are used.
 It is lower when it uses internally generated funds
(retained earnings) only to finance its assets.
 Thus, SGR> IGR
 Types of Growth Ratios
Internal Growth Rate/IGR
• The IGR is the maximum rate at which a firm can grow
(in terms of sales or assets) without external financing of
any kind.
• To determine IGR, the following assumptions are made:
o There is an increase in assets of the firm in proportion to
the sales,
o The net profit after taxes (PAT) is in direct proportion to
sales,
o The firm has a target dividend pay-out ratio (in other
words, it has a target retention ratio) which it wants to
maintain,
o The firm does not raise external finance (neither equity
nor debt) to finance assets.
 Internal Growth Rate/IGR
IGR (based upon internal financing) = ROA x b
1− (ROA x b)
Where,
i. ROA = Return on Assets
= PAT + Effective Interest = PAT
Average total assets Total Assets
ii. b = Retention ratio
= 1 – Dividend payout ratio
= 1 – DPS
EPS
 Financial Statements of ABC Ltd and its IGR
Income Statement (Amount in Rs lac)
Sales Revenue 200
Less: Costs (@ 70 %) 140
Profits before taxes (PBT) 60
Less: Taxes (35 % ) 21
Profit after tax (PAT) 39
Less: Dividend (dividend payout ratio = 1/3) 13 (Rs 39 lac x 1/3)
Retained earnings (2/3) 26

Balance Sheet
Liabilities Amount Assets Amount

Equity 150 Total Assets 200

Debt 50 (Assets/Sales=1:1)
200 200
ROA = PAT/TA IGR=ROA*b / 1– (ROA*b)
= 39/200 = .195 * 2/3 = .1494 = 14.94 %
= .195 = 19.5 % 1– (.195 * 2/3)
 Financial Statements of ABC Ltd (After Growth)
Income Statement (Amount in Rs lac)
Sales Revenue (200 lac + 14.94% of 200 lac) 229.88
Less: Costs (@ 70 % of Rs 229.88 lac)) 160.92
Profits before taxes (PBT) 68.96
Less: Taxes (35 % ) 24.14
Profit after tax (PAT) 44.82
Less: Dividend (dividend payout ratio = 1/3) 14.94 (44.82 lac x 1/3)
Retained earnings (2/3) 29.88

Balance Sheet
Liabilities Amount Assets Amount
Equity (150 + 29.88) 179.88 Total Assets 229.88
Debt 50.00 (Assets/Sales=1:1)
229.88 229.88
ROA = PAT/TA IGR=ROA * b / 1– (ROA*b)
= 44.82/229.88 = .195 * 2/3 = .1494 = 14.94 %
=.195= 19.5 % 1– (.195 * 2/3)
 Sustainable Growth Rate/SGR
• The SGR is the maximum rate at which the firm can grow by
using internal sources (retained earnings) as well as additional
external debt but without increasing its financial leverage (i.e.
Debt-Equity ratio).
• To determine SGR, the following assumptions are made in
addition to those made earlier:
o The firm has a target capital structure (D/E ratio) which it
wants to maintain, and
o The firm does not intend to issue new equity shares as it is a
costly source of finance
 Sustainable Growth Rate/SGR
SGR (based upon internal = ROE x b
& external debt financing) 1− (ROE x b)
Where,
i. ROE = Return on equity
= PAT – Preference Dividend
ESH’s funds (Equity SC + R & S – Fictitious Assets)
= PAT
Equity SC + R & S
ii. b = Retention ratio
= 1 – Dividend payout ratio
= 1 – DPS
EPS
 Financial Statements of ABC Ltd and its SGR
Income Statement (Amount in Rs lac)
Sales Revenue 200
Less: Costs (@ 70 %) 140
Profits before taxes (PBT) 60
Less: Taxes (35 % ) 21
Profit after tax (PAT) 39
Less: Dividend (dividend payout ratio = 1/3) 13 (Rs 39 lac x 1/3)
Retained earnings (2/3) 26

Balance Sheet
Liabilities Amount Assets Amount

Equity 150 Total Assets 200

Debt (D/E= 1:3) 50
200 200
ROE = PAT/Net worth of ESH SGR=ROE*b / 1– (ROE*b)
= 39/150 = .26 * 2/3 = .2097 = 20.97 %
= .26 = 26 % 1– (.26 * 2/3)
 Financial Statements of ABC Ltd (After Growth)
Income Statement (Amount in Rs lac)
Sales Revenue (200 lac + 20.97% of 200 lac) 241.94
Less: Costs (@ 70 % of Rs 241.94 lac) 169.36
Profits before taxes (PBT) 72.58
Less: Taxes (35 % ) 25.40
Profit after tax (PAT) 47.18
Less: Dividend (dividend payout ratio = 1/3) 15.73 (47.18 x 1/3)
Retained earnings (2/3) 31.45

Balance Sheet
Liabilities Amount Assets Amount
Equity (150 + 31.45) 181.45 Total Assets 241.94
Debt (D/E =1/3) 60.49 (Assets/Sales=1:1)

241.94 241.94
ROE = PAT/Net worth of ESH SGR=ROE*b / 1– (ROE*b)
= 47.18/181.45 = .26 * 2/3 = .2097 = 20.97 %
= .26 = 26 % 1– (.26 * 2/3)
 Du Pont Analysis
• The Du Pont Company of the US developed a system of
financial analysis which has got good recognition and
acceptance
• Du Pont analysis divides a particular ratio into
components and studies the effect of each and every
component on the ratio.
• It analyzes the return ratios (like ROA & ROE) in terms of
Net Profit Margin and Asset Turnover Ratios due to which
it is referred to as the Du Pont system
 Du Pont Analysis
ROA = PAT
Total Assets
ROA as per the Du Pont system
ROA = PAT x Sales
Sales Total Assets
Since, PAT/Sales = Net Profit Margin, and
Sales/ Total Assets = Total Assets T/O Ratio
Thus, ROA = Net Profit Margin x Total Assets T/O ratio
The above relationship indicates that the return earned on
assets (ROA) is a function of the Net profit margin (which
measures the profit earned by the firm on its sales) and the
Total Assets turnover (which measures the company’s ability to
generate sales with the assets that it has).
 ROA as per the Du Pont system

• ROA = Net Profit Margin x Total Assets T/O ratio

• The said equation implies that the performance of a firm
can be improved either by increasing the profit margin
per rupee of sales (Net Profit margin ↑) or by generating
more sales volume per rupee of investment (Total Assets
T/O ratio ↑)
• In other words, ROA, as per the Du Pont system, is a
central measure of the overall profitability and
operational efficiency of a firm.
 ROE as per the Du Pont system
ROE = PAT
ESH’s funds
ROE as per the Du Pont system
ROE = PAT x Sales x Total Assets
Sales Total Assets ESH’s funds
Since, PAT/Sales = Net Profit Margin,
Sales/ Total Assets = Total Assets T/O Ratio, and
Total Assets/ ESH’s funds = Financial Leverage/Equity Multiplier
Thus, ROE = Net Profit Margin x Total Assets T/O ratio x
Financial Leverage/Equity Multiplier
The above relationship indicates that the return earned on
ESH’s funds (ROE) is a function of the Net profit margin
(indicating profitability), total Assets turnover (indicating
efficiency in operations) and financial leverage (indicating the
extent to which the assets are financed by owners’ funds).
 ROE as per the Du Pont system
• ROE = Net Profit Margin x Total Assets T/O ratio x
Financial Leverage/Equity Multiplier
• The said equation implies that the management of a firm has three
levers through which it can control ROE :
i. the net profit margin per rupee of sales;
ii. the sales generated per rupee of assets employed, and
iii. the amount of equity shareholders’ funds used to finance the assets
• ROE can be further analyzed as follows (5-way break-up)
ROE = PAT x PBT x PBIT x Sales x Total Assets
PBT PBIT Sales Total Assets ESH’s funds
This break-up of ROE enables the management of a firm to
analyze the effect of interest payment & tax payment
separately from the operating profitability of the firm.