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Introduction to Ratio Analysis

This document introduces ratio analysis as a tool for financial statement analysis and begins a discussion on asset management, one of the key drivers of profitability.

Example

Before analyzing real-world financial statements like those of Asian Paints, it's helpful to work with a simplified example. Consider the following balance sheet and profit and loss (income) statement for a company over two years:

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The company's performance in Year 2 was significantly better than in Year 1. Let's use ratio analysis to understand why.

Return on Total Assets (ROTA)

The first ratio we'll calculate is Return on Total Assets (ROTA), which measures the profitability generated from the company's assets.

  • Formula: ROTA = Profit before Interest and Tax / Total Assets

Calculations:

  • Year 1: ROTA = 16 / 150 = 0.1067 or 10.67%
  • Year 2: ROTA = 149 / 300 = 0.4967 or 49.67%

ROTA increased dramatically from 10.67% to 49.67%, indicating a substantial improvement in asset utilization and profitability.

Why Use PBIT?

We use PBIT (Profit Before Interest and Taxes) in the numerator of ROTA because total assets are financed by both equity holders and lenders (debt). Both groups have a claim on the profit generated before interest and taxes are deducted.

If we used profit after tax (PAT), only equity holders' claim on profit would be considered, creating an inconsistency between the numerator (profit attributable to equity) and the denominator (total assets funded by both debt and equity). Maintaining consistency between the numerator and denominator is crucial for accurate ratio analysis.

Drivers of Profitability

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