Module 08: Assessing Business Performance through Financial Statements

Module 7 taught you to read a statement. Module 8 teaches you to judge it. Three methods are used: common size analysis, trend analysis and ratio analysis. The ratio half is organised around four profitability drivers and assembles them into a single build-up chain from return on total assets all the way to post-tax return on equity. It ends with risk: short-term solvency, long-term solvency and a credit score.

8.1 The three methods

8.2 Common size analysis

The problem is that companies differ in size, so absolute figures cannot be compared. The fix:

Formula: For the balance sheet, set total assets = 100 and express every line as a percentage of total assets. For the profit and loss account, set total income = 100 and express every line as a percentage of total income.

Asian Paints, common size balance sheet, two years:

Reading: the company is reducing debt and no new capacity was created this year; surplus went into financial investments instead.

Asian Paints, common size profit and loss account:

Answer: the improvement in PAT margin is driven mainly by tax, not by operations, which is exactly why Module 7 warned against reading PAT as an efficiency measure.

Common size analysis also drives inter-firm comparison, which is what all four case analyses in 8.15 to 8.18 do.

8.3 Trend analysis

Formula: Choose a base year, set every base-year value to 100, and express all later years relative to it.

Asian Paints, base year 2011 = 100, over roughly ten years:

Capital side

Asset side

Outcome

Common trap: A 4.69 times increase in assets should normally produce a similar increase in sales. Fixed assets and sales track each other closely until 2018, then assets double in 2019 ahead of sales. That is not a failure; it means capacity has been added and it will take some time to reach full capacity utilisation. Read the lag, do not read it as inefficiency.

8.4 The ratio framework and the running example

Every ratio in this module is worked on one small two-year dataset. Memorise it; the whole chapter is built on it.

The headline ratio of the whole module is return on total assets.

Answer: return on total assets jumped from 10.67% to 49.67%. The rest of the module explains how.

Memory hook: Why PBIT and not PAT in the numerator? Total assets are funded by both equity holders and lenders, and both have a claim on PBIT. Profit after tax belongs only to equity holders. Numerator and denominator must be consistent in every ratio you build.

The four profitability drivers, with leverage split in two:

Memory hook: ROTA does not specifically come under asset management; it is mainly affected by asset management and cost management. The framework's diagram sometimes suggests otherwise. ROTA sits at the junction of the first two drivers, and the leverage and tax drivers act above it.

8.5 Asset management

Every Re 1 invested in assets generated Rs 1.20 of revenue in year 1 and Rs 2.00 in year 2.

Drilling down, the asset base splits in two.

The two big current assets are inventory and receivables.

Answer: inventory days fell from about 45 to about 24, and collection days halved from 61 to 30. The faster inventory moves, the sooner profit is realised.

Common trap (source discrepancy): The lecture's summary chart shows inventory days as 41 and 18 rather than 45 and 24, because it divides by sales per day instead of cost of sales per day. Use the formula above, in which the numerator (inventory, at cost) and the denominator (cost of sales, at cost) are consistent. Collection days is the one that legitimately uses sales per day, because receivables are recorded at selling price.

8.6 Cost management

Answer: the company spent Rs 91 per Rs 100 of sales in year 1 and only Rs 75 in year 2, so profit margin nearly tripled.

The component cost ratios in the image show exactly where the saving came from:

The identity that joins the first two drivers is this.

Answer: both fundamental drivers improved, and their product reproduces ROTA exactly.

8.7 Leverage management, part 1: payables

Suppliers do not charge interest for the credit period (although they may build an implicit rate into the price). Free capital should improve returns, and the ratio that captures it is return on capital employed.

Answer: suppliers' credit added 0.76 percentage points in year 1 and 3.54 in year 2.

Memory hook: If a company avails no suppliers' credit, ROTA and ROCE are identical. The gap between them is the payables leverage, and it is the fastest thing to spot in a two-company comparison.

8.8 Leverage management, part 2: debt

Two inputs are needed.

Answer: both routes agree exactly. Without any debt, year 2 pre-tax ROE would have stopped at 53.21%; debt added 75.79 percentage points to shareholders.

Common trap: The spread was negative in year 1, so debt destroyed value. The damage was small only because the debt-equity ratio was a modest 0.40. The debt-equity ratio does not create the benefit, it magnifies whatever sign the spread has. The lesson is: do not take a loan when the fundamental profitability drivers are weak. In year 2 the foundation was strong, so the same instrument did wonders.

8.9 Tax management

Unlike the other drivers, tax management measures how much tax was saved against the statutory benchmark. The corporate rate is taken as 30% for simplicity (the actual rate is 30% plus surcharge and levies).

Answer: the saving is slightly lower in percentage terms in year 2, but it applies to a far larger pre-tax profit.

Memory hook: "In tax management, just compare the percentage of taxes you paid vs the market rate."

Two alternative measures used in the case analyses:

1. Compare actual post-tax ROE against pre-tax ROE × 0.7. If the actual exceeds the benchmark, tax planning added value.
2. Deferred tax as a share of total capital. Since deferred tax carries no interest, it is an interest-free loan from the government, and this ratio measures how much of total capital it supplies.

8.10 The complete build-up chain

This is the organising spine of the whole module. Read it bottom to top.

Memory hook: Four drivers, four steps. Asset and cost management make ROTA. Payables leverage makes ROCE. Debt leverage makes pre-tax ROE. Tax management makes post-tax ROE. Every case analysis in this module is nothing more than reading which of those four steps a company is winning.

Practical exclusions when computing these ratios:

• Exclude capital work in progress from fixed assets. It is not yet commercially used, so it unfairly depresses fixed asset turnover.
• Exclude exceptional items, which are one-time.

8.11 Short-term solvency (liquidity risk)

The question a supplier asks: I am giving 30 days' credit, and I am confident the customer will eventually pay, but will I be paid on the due date?

A current ratio of 2 and above is considered good, so a decline from 6.00 to 4.50 is not a concern.

Where the "2" comes from. You trade in an item, buying two units a day at Rs 100 and selling them at Rs 110, with five days' credit taken and five days' credit given.

In the second version, on day 6 you owe Rs 100 to the day-1 supplier and two customers owe you Rs 110 each. Even if only one of the two pays, you can settle. The required probability of collection is therefore 50%, which is the fair-coin case.

Memory hook: "If the probability of collection is 100%, then we do not have to be concerned about a current ratio of below 2." The benchmark is not a law; it is a translation of a collection probability. Asian Paints, with very low collection days, is safe at a current ratio well under 2.

8.12 Long-term solvency

Debt to equity. A ratio of 2 : 1 or lower was considered good a few decades ago. Today investors are comfortable up to 1 : 1, so an equity of 100 supports a maximum debt of 100.

Common trap: A universal prescription on debt to equity is incorrect. The nature of the industry matters most: infrastructure companies normally carry much higher debt. Capital structure is a corporate finance topic in its own right.

Debt service coverage ratio.

Answer: DSCR of 1.77 and 2.59. A DSCR above 1 is considered adequate, so long-term solvency is good in both years. Long-term lenders use this ratio because it asks a cash question: can the year's earnings cover this year's interest plus this year's principal?

Common trap: Add depreciation back before deducting tax. The numerator is PBDIT, not PBIT, because depreciation is a non-cash charge and this ratio measures cash available to service debt. Skipping the add-back understates the numerator and makes a comfortable borrower look stretched. Here it would give 14 and 124 instead of 23 and 145, and a DSCR of 1.08 and 2.21 rather than 1.77 and 2.59. You may see that lower pair quoted in places; both readings clear the benchmark of 1, so the solvency conclusion is the same either way.

8.13 Credit score: the Altman Z-score

The coefficients transcribed as text, because they appear nowhere in the spoken lecture:

Worked on the running example.

Answer: Z = 4.39 in year 1 and 4.72 in year 2. The cut-off is 2.675, above which the probability of the firm turning sick in the near future is low. Both years pass, so long-term solvency is good.

Common trap: Do not read meaning into differences between two already-high scores. The Z-score is a threshold test against 2.675, not a ranking. A genuinely debt-free company produces an enormous equity-to-debt ratio which can push Z to 17 or even 80 or 90 without saying anything extra about its health. Kansai Nerolac scores 17.57 for exactly this reason.

8.14 Case 1: Asian Paints FY2019 versus FY2020

Every driver improved except one.

Check the ROTA identity: 1.22 × 19.48 = 23.74 and 1.29 × 20.08 = 25.94. Both tie.

Actual post-tax ROE is 28.07%, so tax planning added 2.55 percentage points.

Answer: for every Rs 100 of capital, Rs 2.08 comes from the government as an interest-free deferred tax loan.

Conclusion: the company improved on almost every driver. The one action item is inventory days rising from 73 to 77; management should find the root cause. The current ratio of 1.82 is below the benchmark of 2 but is not a concern, because collection days are very low and the probability of collection is correspondingly high.

8.15 Case 2: Asian Paints versus Kansai Nerolac (2024)

Answer: Asian Paints' core competency is cost management, specifically raw material to sales at 54.88% against Kansai Nerolac's 64.54%. The likely cause is economies of scale: being four times larger, Asian Paints bargains harder with suppliers.

The benchmarking prescription. If you sit inside Kansai Nerolac, the single number to attack is raw material consumption. Better negotiation by the purchase department or better process technology from operations would lift profit margin, which lifts ROTA (margin × turnover), and the whole chain above it improves. Note also that Kansai's Z-score of 17.57 looks spectacular only because equity ÷ debt is 24.16, contributing 14.49 of the score. Ignore that difference; both simply clear 2.675.

8.16 Case 3: Infosys versus TCS

Answer: the difference between the two is asset management, not cost management. Their margins are within two points, but TCS turns its assets over at 1.73 against Infosys' 1.19.

The single biggest driver, though, is payables leverage. TCS's current liabilities are Rs 43,061 crore against Infosys' Rs 21,786 crore, driven mainly by much larger trade payables, and that produces a 21-point jump from ROTA to ROCE where Infosys gets only 5.

A caution on cost comparison. Employee cost is 49% of sales for TCS against 61.44% for Infosys, but TCS's other expenses are proportionately far larger (Rs 40,026 crore against Infosys' Rs 6,508 crore). The likely explanation is outsourced manpower, which is booked as an expense rather than an employee cost. Add the two together (about 69% for TCS, about 65% for Infosys) and the apparent advantage reverses. Always check whether two companies classify the same economic cost under the same head.

Common trap: This framework does not apply to banks. Many of these ratios are meaningless for a banking company, which needs a separate framework.

8.17 Case 4: Apollo Hospitals versus Narayana Hrudayalaya (2024)

Hospitals combine manufacturing and service characteristics. Apollo is about four times larger by assets but earns only about twice the revenue, which is the whole story.

Answer: Apollo's core strength is cost management; Narayana Hrudayalaya's is asset management. Read the other way round: NH must attack other expenses (39% of sales, and the note discloses about 20 line items to work through), while Apollo must attack fixed asset turnover and collection days, the latter driven by slow processing of insurance claims.

Note also that neither hospital leverages payables much, because their largest cost is employee expense and employees do not extend credit days.

8.18 Summary

• Three methods: common size (normalise for size), trend (normalise for time), ratio (explain profitability).
• Common size: total assets = 100 on the balance sheet, total income = 100 on the P&L. Trend: base year = 100.
• Ratio analysis rests on four drivers: asset management, cost management, leverage management (payables and debt) and tax management. Return on total assets

PBIT is used because total assets are funded by both lenders and shareholders, and both have a claim on it.

• Do not borrow when the fundamental drivers are weak; the debt-equity ratio magnifies a negative spread just as readily as a positive one.
• Tax management: effective rate against a 30% benchmark, or post-tax ROE against pre-tax ROE × 0.7, or deferred tax over total capital.
• Short-term risk: current ratio, benchmark 2, and $\text{Probability of collection required} = \frac{1}{\text{Current ratio}}$. A low ratio is acceptable when collection is near certain.
• Long-term risk: debt to equity (industry dependent), $\text{DSCR} = \frac{\text{PBDIT} - \text{Taxes}}{\text{Interest} + \text{Instalment}}$ with the instalment at 20% of the loan, benchmark above 1, and the Altman Z-score with coefficients 1.2, 1.4, 3.3, 0.6, 1.0 against a cut-off of 2.675.
• Exclude capital work in progress and exceptional items from performance analysis, and do not apply this framework to banks.
• Across the four case analyses the diagnosis is always the same question: which of the four drivers is this company winning? Asian Paints wins on cost, TCS on assets (and hugely on payables leverage), Apollo on cost, Narayana Hrudayalaya on assets.