Understanding financial ratios is crucial for any aspiring finance professional. This blog post breaks down two important concepts often encountered in financial analysis: calculating Return on Equity (ROE) and determining Inventory from liquidity ratios. Let's dive in!

Question 1: Calculating Return on Equity (ROE)

Concept Refresher: Return on Equity (ROE)

ROE measures a company's profitability in relation to the equity invested by its shareholders. It tells us how much profit a company generates for each rupee of shareholders' equity.

Formula: ROE = (Profit After Tax (PAT) / Equity) * 100

The Problem: We need to calculate ROE given the following information:

• EBITDA Margin: 40% (on sales)

• EBITDA Value: ₹100 Crores

• PAT (Profit After Tax) Margin: 10% (on sales)

• Book Value per Share: ₹50

• Total Number of Equity Shares: ₹10 Crores

Step-by-Step Solution:

Step 1: Calculate Total Equity Value Equity is also known as Book Value or Net Worth.

• Total Equity = Book Value per Share * Total Number of Equity Shares

• Total Equity = ₹50/share * ₹10 Crores shares

• Total Equity = ₹500 Crores

Step 2: Calculate Sales We know EBITDA is 40% of Sales and the EBITDA value is ₹100 Crores.

• EBITDA Margin = (EBITDA / Sales) * 100

• 40% = (₹100 Crores / Sales) * 100

• 0.40 = ₹100 Crores / Sales

• Sales = ₹100 Crores / 0.40

• Sales = ₹250 Crores

Step 3: Calculate Profit After Tax (PAT) PAT is 10% of Sales.

• PAT = 10% of Sales

• PAT = 0.10 * ₹250 Crores

• PAT = ₹25 Crores

Step 4: Calculate ROE Now we have all the components to calculate ROE.

• ROE = (PAT / Equity) * 100

• ROE = (₹25 Crores / ₹500 Crores) * 100

• ROE = 0.05 * 100

• ROE = 5%

Therefore, the Return on Equity (ROE) for the company is 5%.

Question 2: Calculating Inventory from Liquidity Ratios

Concept Refresher: Liquidity Ratios

• Current Ratio: Measures a company's ability to cover its short-term liabilities with its short-term assets.

  • Formula: Current Assets / Current Liabilities

• Quick Ratio (Acid-Test Ratio): A more conservative measure than the current ratio, as it excludes inventory (which is less liquid) from current assets.

  • Formula: (Current Assets - Inventory) / Current Liabilities OR Quick Assets / Quick Liabilities

The Problem: We need to compute the Inventory value given the following:

• Current Ratio: 2.5

• Quick Ratio: 1.5

• Current Assets: ₹1,00,000

Step-by-Step Solution:

Step 1: Calculate Current Liabilities Using the Current Ratio formula:

• Current Ratio = Current Assets / Current Liabilities

• 2.5 = ₹1,00,000 / Current Liabilities

• Current Liabilities = ₹1,00,000 / 2.5

• Current Liabilities = ₹40,000

Step 2: Determine Quick Liabilities In the absence of specific information about bank overdrafts or other similar adjustments, we assume that Current Liabilities are equal to Quick Liabilities.

• Quick Liabilities = Current Liabilities = ₹40,000

Step 3: Calculate Quick Assets Using the Quick Ratio formula:

• Quick Ratio = Quick Assets / Quick Liabilities

• 1.5 = Quick Assets / ₹40,000

• Quick Assets = 1.5 * ₹40,000

• Quick Assets = ₹60,000

Step 4: Calculate Inventory The key relationship between Current Assets, Quick Assets, and Inventory is:

• Quick Assets = Current Assets - Inventory

Rearranging the formula to find Inventory:

• Inventory = Current Assets - Quick Assets

• Inventory = ₹1,00,000 - ₹60,000

• Inventory = ₹40,000

Therefore, the Inventory value is ₹40,000.

Key Takeaways:

• ROE helps assess how efficiently a company uses shareholder investments to generate profits.

• Liquidity Ratios (Current and Quick) are essential for understanding a company's short-term financial health. The difference between Current Assets and Quick Assets primarily lies in Inventory, which is considered less liquid.

• These questions, though seemingly complex, become straightforward once you break them down into smaller, logical steps and apply the correct formulas. Practice these concepts to build confidence in your financial analysis skills!