LU3

Basic of Analysis
Learning Objectives
• Construct and explain the use of comparative analysis.
• Construct and explain the use of common-size analysis.
• Examine the purpose and the use of financial ratios.
• Show how the integrated analysis can be used to evaluate business
performance-DuPont System.
Comparative analysis
1. Year-to-year change analysis
 Use both absolute and percentages.

 Horizontal analysis
• Amounts for comparative years are expressed as a percentage of the base year
amount.
Guidelines
a) When an item has value in the base year and none in the next
period, the decrease is 100%.
b) A meaningful percent change cannot be computed when one
number is positive and the other number is negative.
c) A percent change is incomputable when there is no figure for
the base year.

(b) (a)

(c)
Year-to-year: Dell
$49,205 - $41,444

$7,761
÷
$41,444
Comparative analysis
2. Index-number trend
 tools for long term trend comparisons.
 Requires:
• Choosing a base period, for all items, with a preselected index number usually set to
100.
• Certain changes, like those negative amounts to positive amounts, cannot be
expressed by index numbers.
Index-Number Trend: Dell Example: If
sales were
$35,404 in
$49,205 ÷ $35,404 $41,444 ÷ $35,404 2003 and
$41,444 in
2004, then
sales
increase to
117% of the
2003 level in
2004, which
is an
increase of
17%
 Example: If sales were $91,000 in 2007
and $95,000 in 2008, then sales increase
to 104.4% of the 2007 level in 2008,
which is an increase of 4.4%
Index-Number Trend: Melcher Company
Melcher Company
Income Statement
For the Years Ended December 31
2009 2008 2007 2009 2008 2007
Sales revenue $ 100,000 $ 95,000 $ 91,000 109.9% 104.4% 100.0%
Cost of goods sold 65,000 60,800 56,420 115.2% 107.8% 100.0%
Gross profit 35,000 34,200 34,580 101.2% 98.9% 100.0%
Operating expenses:
Selling expense 14,000 11,400 10,000 140.0% 114.0% 100.0%
General expense 16,000 15,200 13,650 117.2% 111.4% 100.0%
Total operating expense 30,000 26,600 23,650 126.8% 112.5% 100.0%
Operating Income before taxes 5,000 7,600 10,930 45.7% 69.5% 100.0%
Taxes related to operations 1,500 2,280 3,279 45.7% 69.5% 100.0%
Net Income $ 3,500 $ 5,320 $ 7,651 45.7% 69.5% 100.0%

 Each financial statement element is presented as a

percentage of a base amount from a selected year.
Common-Size Analysis
 The use of percentages is usually preferable to the use of absolute
amounts.
 Vertical analysis
• All amounts of a year expressed as a percentage of a base amount in
the same year. (e.g., net sales revenue, total assets)
Vertical Analysis GP represents 35%
of sales revenue
Melcher Company
Income Statement
For the Years Ended December 31
2009 2008 2007
Sales revenue $ 100,000 100.0% $ 95,000 100.0% $91,000 100.0%
Cost of goods sold 65,000 65.0% 60,800 64.0% 56,420 62.0%
Gross profit 35,000 35.0% 34,200 36.0% 34,580 38.0%
Operating expenses:
Selling expense 14,000 14.0% 11,400 12.0% 10,000 11.0%
General expense 16,000 16.0% 15,200 16.0% 13,650 15.0%
Total operating expense 30,000 30.0% 26,600 28.0% 23,650 26.0%
Operating Income before taxes 5,000 5.0% 7,600 8.0% 10,930 12.0%
Taxes related to operations 1,500 1.5% 2,280 2.4% 3,279 3.6%
Net Income $ 3,500 3.5% $ 5,320 5.6% $ 7,651 8.4%

 Each financial statement element is presented as a percentage

of a designated base which is sales revenue on the Income
Statement.
Ratio Analysis
 Interpreted in comparison with;
I. Prior ratios
II. Competitor ratios
III. Industry ratios
IV. Predetermined standards

 Trend and variability of a ratio are important considerations.

 Advantage: Eliminate some of the problem related to the use of absolute

number.
Ratio Analysis
Credit (risk) Analysis:
I. Liquidity- evaluate the ability to meet short-term obligations.
II. Capital Structure and Solvency- to assess the ability to meet long-term
obligations.
Profitability Analysis:
I. Return on Investment- assess financial rewards to the supplier of equity and
debt financing.
II. Operating Performance- evaluate profit margins from operating activities.
III. Asset Utilizations- assess effectiveness and intensity of assets in generating
sales (turnover).
Credit Analysis: Liquidity
1. Current Ratio
 Measure the ability of a company to meet its current debts as they fall due.

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑟𝑎𝑡𝑖𝑜 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
 The higher the current ratio means a more liquid current positions.

Indicator:
I. “1” = enough cash to pay off its debt
II. “>1”= successful to pay debt and have cash left
III. “<1” = unable to pay
Credit Analysis: Liquidity
2. Quick (Acid-test) Ratio
 Measure how well the company can pay off its liabilities using its most liquid assets.
𝐶𝑎𝑠ℎ 𝑎𝑛𝑑 𝑐𝑎𝑠ℎ 𝑒𝑞𝑢𝑖𝑣𝑎𝑙𝑒𝑛𝑡𝑠+𝑀𝑎𝑟𝑘𝑒𝑡𝑎𝑏𝑙𝑒 𝑆𝑒𝑐𝑢𝑟𝑖𝑡𝑖𝑒𝑠+𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠
Q𝑢𝑖𝑐𝑘 𝑟𝑎𝑡𝑖𝑜 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

or
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠 − 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
𝑄𝑢𝑖𝑐𝑘 𝑟𝑎𝑡𝑖𝑜 =
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
 Interpretations:
I. “=1” means that the business can pay its bills without having to sell inventory.
II. “<1” means that the business relies too much on inventories or other assets to pay
its short-term liabilities.
 If CR>QR, current assets are dependent on inventory.
Credit Analysis: Liquidity
3. Collection Period
 Average number of days required to convert receivables into cash

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑎𝑐𝑐𝑜𝑢𝑛𝑡𝑠 𝑟𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒

𝐶𝑜𝑙𝑙𝑒𝑐𝑡𝑖𝑜𝑛 𝑃𝑒𝑟𝑖𝑜𝑑 =
𝑆𝑎𝑙𝑒𝑠/365
 indicate days in collecting debts

 Interpretation:

I. The greater the period of the collection, the more time is required to
collect debts.
Credit Analysis: Liquidity
4. Days to Sell Inventory
 Average number of days required to sell inventory to customers

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
𝐷𝑎𝑦𝑠 𝑡𝑜 𝑠𝑒𝑙𝑙 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 =
𝐶𝑜𝑠𝑡 𝑜𝑓 𝑆𝑎𝑙𝑒𝑠/365
 Convert inventory into sales

 Interpretations

I. The faster the better

Credit Analysis: Capital Structure & Solvency
1. Total Debt to Equity
 Measures the riskiness of the firm’s capital structure in terms of the relationship
between the funds supplied by creditors (debt) and investors (equity)

𝑇𝑜𝑡𝑎𝑙 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡 𝑡𝑜 𝐸𝑞𝑢𝑖𝑡𝑦 =
𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟 ′ 𝑠 𝐸𝑞𝑢𝑖𝑡𝑦
 The higher the ratio, the higher the risks
 Interpretations:
I. “<1”= company assets are mainly supplied by equity
II. “>1”= company assets are mainly finance by debt
Credit Analysis: Capital Structure & Solvency
2. Long-Term Debt to Equity
 To know how much debt of the company has to pay

𝐿𝑜𝑛𝑔 − 𝑡𝑒𝑟𝑚 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

𝑆ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟 ′ 𝑠 𝑜𝑟 (𝐶𝑜𝑚𝑚𝑜𝑛 𝑠𝑡𝑜𝑐𝑘 + 𝑃𝑟𝑒𝑓𝑒𝑟𝑟𝑟𝑒𝑑 𝑆𝑡𝑜𝑐𝑘 + 𝑅𝑒𝑡𝑎𝑖𝑛𝑒𝑑 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠)
 The greater the leverage, the higher the ratio
 higher ratios are thought to be more risky because they have more liabilities
and less equity.
Credit Analysis: Capital Structure & Solvency
3. Total Debt to Asset
 Tells us what portion of company’s assets is finance through debt.

𝑇𝑜𝑡𝑎𝑙 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
𝑇𝑜𝑡𝑎𝑙 𝐷𝑒𝑏𝑡 𝑡𝑜 𝐴𝑠𝑠𝑒𝑡 =
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
 Low percentage means that the company is less dependent on leverage.
Credit Analysis: Capital Structure & Solvency
4. Times Interest Earned
 Indicates how well operating earnings cover fixed interest expenses

𝐼𝑛𝑐𝑜𝑚𝑒 𝑏𝑒𝑓𝑜𝑟𝑒 𝑖𝑛𝑐𝑜𝑚𝑒 𝑡𝑎𝑥𝑒𝑠 + 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒

𝑇𝑖𝑚𝑒𝑠 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝐸𝑎𝑟𝑛𝑒𝑑 =
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒

 The lower the ratio, the more of a burden the company’s interest debt is
on the company.
Profitability Analysis: Return on Asset
1. Return on Assets (ROA)
 Measure the firm’s ability to utilize its assets to create profits.

𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
𝑅𝑂𝐴 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
 The higher the return, the more efficient management is in utilizing its
asset base.
Profitability Analysis: Return on Investment
1. Return on Investment (ROI)
 the income earned on the invested capital .

 Show the ability of the firm to reward those who provide long-term
funds and to attract providers of future funds.

𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 + 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 ∗ (1 − 𝑇𝑎𝑥 𝑟𝑎𝑡𝑒)

𝑅𝑂𝐼 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑙𝑜𝑛𝑔 𝑡𝑒𝑟𝑚 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑦 + 𝑒𝑞𝑢𝑖𝑡𝑦
 Indicate gain or loss generated on an investment relative to the amount
of fund invested.
Profitability Analysis: Return on Investment
2. Return on equity (ROE)
 Measure how much both common and preferred shareholders earned
for their investment in the company.
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
𝑅𝑂𝐸 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑠ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟 ′ 𝑠 𝑒𝑞𝑢𝑖𝑡𝑦
 The higher the ratio percentage, the more efficient management is in
utilizing its equity base and the better return is to the investors.
Profitability Analysis: Return on Investment
2. Return on common equity (ROCE)
 Measure how much the common shareholders earned for their
investment in the company.
𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 − 𝑃𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠
𝑅𝑂𝐶𝐸 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑐𝑜𝑚𝑚𝑜𝑛 𝑠ℎ𝑎𝑟𝑒ℎ𝑜𝑙𝑑𝑒𝑟 ′ 𝑠 𝑒𝑞𝑢𝑖𝑡𝑦
 The higher the ratio percentage, the more efficient management is in
utilizing its equity base and the better return is to the investors.
Profitability Analysis: Operating Performance
1. Gross Profit Margin
 Represents firm’s ability to translate sales into profits

 Shows the relationship between sales and the cost of products sold

𝑅𝑒𝑣𝑒𝑛𝑢𝑒 𝑜𝑟 𝑁𝑒𝑡 𝑆𝑎𝑙𝑒𝑠 − 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑆𝑎𝑙𝑒𝑠

𝐺𝑟𝑜𝑠𝑠 𝑃𝑟𝑜𝑓𝑖𝑡 𝑀𝑎𝑟𝑔𝑖𝑛 =
𝑆𝑎𝑙𝑒𝑠
 Interpretation:

I. Indicate how many percent the company uses its revenue/net sales to pay
for the direct cost.
II. Higher profit margin indicates a favorable profit indicator
Profitability Analysis: Operating Performance
2. Operating profit margin (pretax)
 To understand the financial health of the company in terms of knowing
whether or not the company’s profit is enough to pay off its other expenses.
 Demonstrates how much revenues are left over after all the variable or
operating cost have been paid

𝐼𝑛𝑐𝑜𝑚𝑒 𝑓𝑟𝑜𝑚 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛𝑠

𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑝𝑟𝑜𝑓𝑖𝑡 𝑚𝑎𝑟𝑔𝑖𝑛 =
𝑆𝑎𝑙𝑒𝑠

 Examples: if OPM is 25%, this means that 75% of sales is used to pay for
variable cost and the remaining 25% is to cover all the non-operating or fixed
cost.
Profitability Analysis: Operating Performance
3. Net Profit Margin
 Measures profitability after consideration of all revenue and expense,
including interest, taxes, and operating expenses items

𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒
𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡 𝑚𝑎𝑟𝑔𝑖𝑛 =
𝑆𝑎𝑙𝑒𝑠
 Low profit margin indicate lower sales but does not reflects that the
company is doing poorly, but rather the possible pricing strategy or the
impact of competition.
Profitability Analysis: Asset Utilization
1. Inventory Turnover (Turns per year)
 Measures how many times on average inventory is sold during the year

𝐶𝑜𝑠𝑡 𝑜𝑓 𝑆𝑎𝑙𝑒𝑠
𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦
 The higher the ratio, the stronger the sales

 A low ratio would possibly indicate poor sales

 It is more understandable if we determine the days of the inventory by

dividing the turnover into 365 days.
Profitability Analysis: Asset Utilization
2. Total Asset Turnover
 Assesses management’s effectiveness in generating sales from investments in
assets
𝑆𝑎𝑙𝑒𝑠
𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠
 High ratio generally means only a small investment is required to generate
sales (and thus the firm will be more profitable).
 Lower ratios mean that the company isn't using its assets efficiently and most
likely have management or production problems.
Interpretation:
I. 1 means the net sales of a company equals the average total assets for the
year.
Profitability Analysis: Asset Utilization
3. Account Receivable Turnover (Times)
 Measure the firm’s ability to collect payment from its customers, its ability to
collect cash from someone who paid by credit.

𝑆𝑎𝑙𝑒𝑠
𝐴𝑐𝑐𝑜𝑢𝑛𝑡 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒 𝑇𝑢𝑟𝑛𝑜𝑣𝑒𝑟 =
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑐𝑐𝑜𝑢𝑛𝑡 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒
 Higher ratio indicates the firm’s efficiency in its ability to collect those
payments, and/or the company operates more on a cash basis.
 A low ratio may means that the company should possibly re-think its credit
policies and find out why the firm cannot collects its customer’s payment on a
timely fashion.
Valuation: Market Measure
1. Earning per share
 Represents the profit of the company equally split among each share of
the stock.

𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒 − 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑜𝑛 𝑝𝑟𝑒𝑓𝑒𝑟𝑒𝑑 𝑠𝑡𝑜𝑐𝑘

𝐸𝑎𝑟𝑛𝑖𝑛𝑔 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒 =
𝑁𝑜. 𝑜𝑓 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 𝑆ℎ𝑎𝑟𝑒𝑠 𝑜𝑟 𝐶𝑜𝑚𝑚𝑜𝑛 𝑆𝑡𝑜𝑐𝑘

 In essence, if you own one share of the company, how much of that profit
is designated to your share.
Valuation: Market Measure
2. Book Value per Share
 Provides investors a way to compare the market value, or what they are
paying for each share, to a consecutive measure of the value of the firm.

𝑆𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠 ′ 𝐸𝑞𝑢𝑖𝑡𝑦 − 𝑃𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝑆ℎ𝑎𝑟𝑒𝑠

𝐵𝑜𝑜𝑘 𝑉𝑎𝑙𝑢𝑒 𝑝𝑒𝑟 𝑆ℎ𝑎𝑟𝑒 =
𝑁𝑜. 𝑜𝑓 𝑂𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 𝑆ℎ𝑎𝑟𝑒 𝑜𝑟 𝐶𝑜𝑚𝑚𝑜𝑛 𝑆𝑡𝑜𝑐𝑘
Valuation: Market Measure
3. Price-to-earnings
 Best known as investment valuation indicators
 Tells us how much investors are willing to pay for every one dollar of earnings the
company pulls in.

𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒

𝑃𝑟𝑖𝑐𝑒 − 𝑡𝑜 − 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 =
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
 Investors are willing to pay more than simply matching dollar for dollar because they
expect the company to appreciate in value i.e the stock price to go up.
 High P/E ratio means that investors are anticipating higher growth in the future.

 General P/E ratio is 20

Valuation: Market Measure
4. Dividend Yield
 Shows the relationship between cash dividends and market price

𝐶𝑎𝑠ℎ 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒

𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑 𝑦𝑖𝑒𝑙𝑑 =
𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
 Dividend yields are a measure of an investment’s productivity, or
"interest rate" earned on an investment.
DuPont System: Relating the ratios
 Helpful to complete the evaluation of a firm by considering the
interrelationship among the individual ratios
 Looks at how the various pieces of financial measurement work
together to produce an overall return
 Helps analyst see how the firm’s decisions and activities over the course
of an accounting period interact to produce overall return to
shareholders
Summary ratios
(1) (2) (3)
Net profit margin (%) Total asset turnover Return on asset (%)

Net income Net sales Net income

Net sales X Total assets = Total assets

(3) (4) (5)

Return on asset (%) Financial leverage Return on equity (%)

Net income Total assets Net income

Total assets X Stockholder equity = Stockholder equity
DuPont System: Relating the ratios
 The first three ratios reveal that return on investment is a product of the
net profit margin and the total asset turnover.
 The second three ratios show how the return on equity is the product of
return on investment and financial leverage.
DuPont System: Relating the ratios
 By reviewing this series of relationships, the analyst can identify
strengths and weaknesses as well as trace potential causes of
problems in the overall financial condition and performance of the firm.
 Analyst can evaluate changes in condition and performance.

 Evaluation can then focus on specific areas contributing to changes.

Net Profit Margin

Net Income
Sales

 Also referred to as return on sales

 Reflects net income dollars generated by each dollar of

sales
 Potential distortion
• Net “other” income or loss
Total Asset Turnover

Net Sales
Total Assets
 Measures the activity of the assets and the ability of the firm to
generate sales through the use of the assets
 he higher the asset turnover ratio, the better the company is
performing, since higher ratios imply that the company is
generating more revenue per dollar of assets.
 Potential distortion
• Investments
• Construction in progress
• Other assets that do not relate to net sales
Return On Assets

Net Income
Total Assets
 Measures the ability to utilize assets to create profits

 Measures income earned on investment and how well

the firm utilizes its asset base
DuPont Return on Asset (Investment)
Net Profit Margin x Total Asset Turnover = Return on Asset
 DuPont analysis separates return on assets into net profit
margin and total asset turnover

 Separating the ratio into the two elements allows

evaluation of the causes for the change in return on assets
 http://www.myaccountingcourse.com/financial-ratios/dupont-analysis
DuPont Analysis Variation
 Consider only operating assets and income
I. Operating assets exclude;
• Construction in progress
• Long-term investments
• Intangibles
• ‘Other’ assets
II. Operating income includes only
• Net sales
• Operating expenses

 May give significantly different results

 Reflective of ROA from primary business
Return on Total Equity

Net Income
Total shareholders’ Equity
 Measures the return to both common and preferred
stockholders.
 Measure the success of the firm in generating profit
DuPont ROE
 ROE = NPM x TAT x FINANCIAL LEVERAGE
 Financial leverage or equity multiplier
• Captures the effect of the firm’s use of debt financing on its ROE

1
= 𝑅𝑂𝐴 𝑥
1 − 𝐷𝑒𝑏𝑡 𝑅𝑎𝑡𝑖𝑜

• high equity multiplier indicates that a larger portion of asset financing

is being done through debt.
 I. Generating sales while I. Selling product
maintaining a lower COGS at a smaller
II. Having a difficult time margin
turning over large amounts II. Turning over a
Illustration of sales lot of products

Ratio Chibi Maruko Chan Shin Chan

Profit Margin 30% 15%
Total Asset Turnover .50 6.0
Financial Leverage 3.0 .50

Identical ROE
End of LU3