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4.6 Final Thoughts on Ratio Analysis

PLEASE NOTE: This book is currently in draft form; material is not final.

Learning Objectives

  1. The DuPont equation combines ROE and ROA.
  2. Comments and limitations on ratio .

DuPont Equation

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.

Return on Assets= Net IncomeTotal Assets

ROE was calculated as net income divided by earnings available to shareholders (common equity).

Return on Equity= Net IncomeCommon Equity

The DuPont equation defines ROA as follows:

ROA= Net Profit Margin×Total Asset Turnover

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:

ROA= earnings available for shareholderssales ×salestotal assets

From this we see that sales will cancel out and ROA will become earnings available for shareholders divided by total assets.

ROA= earnings available for shareholderstotal 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.

Trend Analysis, Comparative Ratios and Benchmarking

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.

Uses and Limitations of Ratio Analysis

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.

  1. A single ratio is generally not enough to judge the overall performance of the firm.
  2. Ratios should be used at the same time for each year.
  3. Be sure to use audited financial statements.
  4. Be aware of different accounting treatments behind the financial data and ratios.

Key Takeaways

  • Ratio analysis is an important and can be fun tool to use to analyze the financial health of a company. More than just plugging into equations is the actual analysis of a company. Understanding what the ratios tell us and putting them into context is as important as getting the correct number out of the formula.
  • The DuPont equation combines ROA and ROE to analyze a company.
  • Putting the numbers in context is as important as getting the correct number. Looking at ratios over time and versus competitors gives us insight into the company’s financial health.

Exercises

  1. Calculate the DuPont equation from the following data.
  2. Review the company’s performance given the following time series and cross-sectional data.