Analysis of Financial Statements Chapter 4  Ratio Analysis  DuPont System 4-1

Why are ratios useful?  Ratios standardize numbers and facilitate comparisons.  Ratio comparisons should be made through time and with competitors.  Trend analysis.  Peer (or industry) analysis. 4-2

Five Major Categories of Ratios and the Questions They Answer  Liquidity: Can we make required payments? Current ratio, Quick ratio.  Asset management: right amount of assets vs. sales? Inventory Turnover  Debt management: Right mix of debt and equity? Debt ratio, Times-Interest-Earned  Profitability: Gross Margin, Operating Margin and Net Profit Margin.  Market value: Do investors like what they see as reflected in P/E and M/B ratios? 4-3

Analysis of Income Statement  Margin /Common Size Analysis  Gross Margin  Operating Margin  Research and Development  Sales and Administrative  Tax rate  Profit Margin

Income Statement  Trend analysis  Margin comparison: are we becoming more profitable?  Growth rate: has the company been growing its sales, Earnings? What is driving the growth? Is the growth sustainable?  Peer analysis

The Du Pont System  Objective: A set of manageable ratios leading to maximize ROE  ROE=NI/Equity  Why ROE: reward/investment; comparable across industry  To increase ROE, lower Equity, higher NI, Invest less(equity) but make more(NI)  However, lower equity is related to higher debt and hence higher interest burden  NI—(from)Sales—(generated by)Assets— (funded by) Equity

The Du Pont system Du Pond Analysis can be expressed as: ROE = (NI/Sales) x (Sales/TA) x (TA/Equity) ROE= (Profit margin) x (TA turnover) x (Equity multiplier) Focuses on:  Expense control (PM)  Asset utilization (TATO)  Debt utilization (Eq. Mult.)  Shows how these factors combine to determine ROE.

Some examples applying Du Pond system  GE: 50% financed, TATO is 2, NI=1B, S=10B what is ROE?  Ford: PM=5%, TATO=0.5 ROE=10%, what is its capital structure?

DuPont equation: a real life example  Resource:  Decompose ROE of Ford  Compare with Microsoft