Friday, September 16, 2011

Income statement and related ratios for financial performance

The income statement of a company helps in evaluating the financial performance, by providing data pertaining to the revenues, costs and other expenses, involved in day to day business operations.
Whether for comparitive study of several firms or performing the trend analysis, the ratios are an important tool. Whether a company is into profit or loss, can be judged from the P/L a/c or the income statement.
Profit in layman's terms is Revenue- expenditure, It could be PAT or EBIT.
Here's a look at the key ratios that is calculated from the Income statement.

1) Profit Margin/ Net profit margin = Net Profit/ Net sales OR Net Income/ Net sales
Net income is a company's net earnings after deducting the Cost of goods, interest expenses and other expenses. The ratio measures how much a company actually earns from a unit of sales. A higher profit margin is a measure of higher profitability. However, when doing trend analysis, it may happen that Net income and net sales has increased in a given year, but the profit margin is low. This may appear when the costs have increased greater than sales. So by just comparing Net income and sales will be misleading, comparing the ratios and reasoning the underlying cause is important, for which ratio is used.

2) Operating Margin/ Gross profit margin = operating profit/ sales OR EBIT/ sales
Operating profit measures the earnings from the core operating activities of the firm after the variable costs are deducted. It measures what proprtion of earnings is left after paying for variable costs such as raw materials, wages etc. A high operating cost would imply that the company has sufficient margin to pay for fixed costs.

3) Interest coverage ratio = EBIT/ Interest expenses
It measures the ability of the firm to pay its debt obligations i.e the amount of earnings available per unit of Interest liability. The greater the ratio, the better is the ability.

4) P/E ratio or price to earnings ratio = MV of share/ EPS
The ratio measures the price that the investors are willing to pay for unit earning of the firm. The greater the ratio, implies that investors are willing to pay more for every single earning of the company.

5) Return on assets = PAT + interests / Average total assets
The ROA measures the ability of the firm to generate sales from the assets employed.