This document discusses ratio analysis and the DuPont system for analyzing financial statements. It defines ratio analysis and identifies common types of ratios including liquidity, activity, leverage, profitability, and market ratios. It then introduces the DuPont system, which breaks down return on equity into operating profit margin, asset turnover, and financial leverage. The document provides examples of key ratios within each category and discusses how ratios are used and viewed by managers, creditors, and board members. It also notes some limitations of ratio analysis.

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Financial Statement Analysis
(Ratio Analysis)

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1. Explain what ratio analysis is, identify
standards against which the results of ratio
analysis can be computed, describe the
function and purposes of ratio analysis,
and identify what ratios express.
2. Identify common classes of ratios,
calculate liquidity and solvency ratios, and
describe how club board members,
creditors, and managers view them.
Competencies for Ratio Analysis

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3. Calculate common activity, profitability,
and operating ratios and describe how club
board members, creditors, and managers
view them.
4. Explain the limitations of ratio analysis.
Competencies for Ratio Analysis
(continued)

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For Managers:
Monitor the club’s operating performance
 Evaluate goal achievement
For Creditors:
Evaluate the solvency of the club
 Assess riskiness of future loans
For Board Members:
 Assess the overall financial health of the club
Function and Purposes
of Ratio Analysis

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• Liquidity ratios;
• Activity Ratios / Asset Management Ratios
• Coverage Ratios
• Debt or leverage ratios/Solvency Ratios;
• Profitability ratios;
• Market value ratios.
Classes of Ratios

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Liquidity ratios
• Current ratio= CA/CL
• Quick (Acid-Test) Ratio
• = (Current assets-Inventory)/CL
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Activity Ratios / Asset
Management Ratios
Inventory turnover
= Cost of goods sold/Inventory
Average collection period
= Accounts receivable/ Average sales per day
= Accounts receivable/ (Annual sales/360)
Average payment period
= Accounts payable/ Average purchases per day
Total asset turnover= Sales/Total assets
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Debt or leverage ratios/Solvency
Ratios
• Debt or Leverage ratios are those which
measure the long-term solvency of a firm.
That is whether a firm has enough financial
solvency to meet its long-term obligations is
measured by debt or leverage ratios.
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Debt or leverage ratios/Solvency Ratios
Financial leverage: The magnification of risk and
return introduced through the use of fixed-cost
financing, such as debt and preferred stock.
Degree of indebtedness: Measures the amount of
debt relative to other significant balance sheet
amounts.
Ability to service debts: The ability of a firm to
make the payments required on a scheduled basis
over the life of a debt.
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Debt or leverage ratios/Solvency
Ratios
• i) Debt ratio:
• ii) Times Interest Earned Ratio
• iii) Fixed-Payment Coverage Ratio
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Debt Ratio
• Measures the proportion of total assets
financed by the firm’s creditors.
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Times Interest Earned Ratio
• Measures the firm’s ability to make
contractual interest payments; sometimes
called the interest coverage ratio.
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Fixed-Payment Coverage Ratio
• Measures the firm’s ability to meet all
fixed-payment obligations.
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Profitability refers to the expression of profits in relation to
sales, investment and equity of a firm. Here, profits may be
gross profits, net profits before and after interest and taxes.
Whenever profits are related to any one of these
parameters; then we get profitability ratio. This ratio helps
measuring earning capacity of a firm. These ratios mainly
include :
i) Gross Profit Margin
ii) Operating Profit Margin
iii) Net Profit Margin
iv) Earnings per Share (EPS)
v) Return on Total Assets (ROA)
vi) Return on Common Equity (ROE)
Profitability Ratios

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Gross Profit Margin
• Measures the percentage of each sales
dollar remaining after the firm has paid
for its goods.
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Operating Profit Margin
• Measures the percentage of each sales dollar
remaining after all costs and expenses other
than interest, taxes, and preferred stock
dividends are deducted; the “pure profits”
earned on each sales dollar.
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Net Profit Margin
• Measures the percentage of each sales
dollar remaining after all costs and
expenses, including interest, taxes, and
preferred stock dividends, have been
deducted.
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Earnings per Share (EPS)
• EPS represents the dollar amount earned on
behalf of each share—not the amount of
earnings actually distributed to shareholders.
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Return on Total Assets (ROA)
• Measures the overall effectiveness of
management in generating profits with
its available assets; also called the return
on investment (ROI).
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Return on Common Equity (ROE)
• Measures the return earned on the
common stockholders’ investment in the
firm.
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Market Ratios
• Relate a firm’s market value, as measured by
its current share price, to certain accounting
values.
i) Price/Earnings (P/E) Ratio
ii) Market/Book (M/B) Ratio
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Price/Earnings (P/E) Ratio
• Measures the amount that investors are
willing to pay for each dollar of a firm’s
earnings; the higher the P/E ratio, the
greater is investor confidence.
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Market/Book (M/B) Ratio
• Provides an assessment of how investors
view the firm’s performance. Firms
expected to earn high returns relative to
their risk typically sell at higher M/B
multiples.
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Introducing the DuPont System for Financial
Analysis

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DuPont System
• Developed in 1919 by a finance executive at E.I.
du Pont de Nemours and Co
• “The DuPont system is a way of visualizing the
information so that everyone can see it.” (Stephen
Jablonsky, Penn State University)
• DuPont analysis “is a good tool for getting people
started in understanding how they can have an
impact on results” (Doug McCallen, Caterpillar
Inc.)
• “Number one, it’s simple” (Sam Siegel, CFO)

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DuPont System
• “DuPont Financial Analysis Model is a
rather straightforward method for assessing
the factors that influence a firm’s financial
performance.” (Gunderson, Detre, and
Boehlje, AgriMarketing 2005)

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DuPont System – What is It?
• The system identifies profitability as being
impacted by three different levers:
1. Earnings & efficiency in earnings
2. Ability of your assets to be turned into profits
3. Financial leverage
Earnings
Turnings
Leverage

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Operating
Profit Margin
Asset
Turnover
Return On
Assets (less
interest adj.)
Financial
Structure
Return On
Equity
X =
X =
Income
Stream
Investment
Stream
Turnings/Asset Use
Leverage
DuPont System
Earnings/Efficiency

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Operating
Profit Margin
Asset
Turnover
Return On
Assets (less
interest adj.)
Financial
Structure
Return On
Equity
X =
X =
Income
Stream
Investment
Stream
Earnings
Turnings
Leverage
DuPont System Ratios

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( )( )( )= ROE
Profit
margin
TA
turnover
Equity
multiplier
NI
Sales
Sales
TA
TA
CE
2003 2.6% x 2.3 x 2.2 = 13.2%
2004 -1.6% x 2.0 x 5.2 = -16.6%
2005 3.6% x 2.0 x 1.8 = 13.0%
Ind. 3.6% x 2.5 x 2.0 = 18.0%
The Du Pont System
x x = ROE.

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Ratios are only indicators.
 Ratios must compare two related numbers to
be meaningful.
 Ratios must be compared to a standard.
 No single ratio tells the entire story.
 Inflation can render some of the figures used
in some ratios less useful.
Limitations of Ratio Analysis