This is “Final Thoughts on Ratio Analysis”, section 4.6 from the book Finance for Managers (v. 0.1).
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The DuPont equationMerges ROA and ROE. Breaks it down into profit on a company’s sales and return on a company’s assets. is a handy way to analyze a company’s financial position by merging the balance sheet and income statement using measures of profitability. DuPont merges ROA and ROE. ROA is now defined using two other ratios we calculated: net profit margin and total asset turnover. ROA was calculated as net income divided by total assets.
ROE was calculated as net income divided by earnings available to shareholders (common equity).
The DuPont equation defines ROA as follows:
Remembering that net profit margin is earnings available for shareholders divided by sales and total asset turnover is sales divided by total assets, we can make the following substitutions:
From this we see that sales will cancel out and ROA will become earnings available for shareholders divided by total assets.
This will give us the same number for ROA that was calculated using the original formula. However, the DuPont equation breaks it down into two components: profit on a company’s sales and return to the use of a company’s assets.
Just as important as the actual numbers is the numbers value over time. Trends in ratios tell us a lot about a company and can indicat if a company is trending favorably or unfavorably. Just as time series data is important—so is cross-sectional. We may have what we consider a fantastic ratio, but it may be low for our industtry. Ratios are particularly useful to compare to other companies and competitors. Ratios are available for industries and a company can see how it compares to its competitors.
Ratios are only as good as the head who analyzes them. They can be incredibly helpful tools when used properly and create horrible mistakes if misused.