Ratios, Financial Statement Analysis & Capital Structure

Return on Investment:

ROI = Operating Income / Investment Required

Project A = 200000 / 500000 = 40%

Project B = 150000 / 250000 = 60%

Residual Income:

RI = Net operating Income - Imputed Interest

Imputed Interest refers to the cost of capital.

RI tells you how much your company's operating income exceeds what it is paying for capital.

Economic Value Added:


EVA = (I - C) * (L + S)

Where I = Income

C = After Tax cost of capital

L = Long-term Liabilities

S = Stockholder's Equity

ROI or Residual Income?


Why do some companies prefer residual income (or EVA) to ROI?

Under ROI, the message is go forth and maximize your rate of return, a percentage.

Under RI, the message is go forth and maximize residual income, an absolute amount.

Invested Capital:

To apply either ROI or residual income, both income and invested capital must be measured and defined.

Total Assets
Total assets employed
Total assets less current liabilities
Stockholders' equity

EBIT & EPS:

Net profit earned before payment of interest and tax is termed as earnings before interest and tax (EBIT). On payment of interest and tax, the firm is left with profit available for distribution of dividend, also called as Earnings After Tax (EAT).

Earning After Tax:

EAT = EBIT - Interest - Tax

Earnings After Tax are available for dividend to both types of shareholders, equity as well as preference.

Equity earnings is profit left after payment of preference dividend from EAT.

Earning per Share (EPS):

EPS is defined as the earnings available for distribution to equity shareholders.

EPS = Equity Earnings / No. of Equity Shares.

The relationship between EBIT and EPS is as follows:

EPS = (EBIT - I)*(1 - T) / n

Example:

The capital structure of a firm would be influenced by the following factors:

Business and Financial risks
SEBI guidelines for Public Issues
The firm's own ability
The Earning per Share is also defined as follows:

EPS = EAT - D / n

Where EAT = Earning After Tax

D = Preference Dividend

n = No. of equity Share