COMBINING FINANCIAL RATIOS




Up to this point we have considered financial ratios one at a time. However, there is a useful method for combining financial ratios known as Dupont1 analysis. To explain it, we first need to define some financial ratios, together with their abbreviations, as follows:

COMBINING FINANCIAL RATIOS

 

This equation says that Profit Margin × Asset Turnover × Leverage = Return on Equity.

Topics You May Be Interested In
What Are Financial Statements? A Case Study The Nature Of Nonrecurring Items
Points To Remember About Financial Statements Nonrecurring Items In The Income Statement
Financial Statements: Who Uses Them And Why Nonrecurring Items In The Inventory Disclosures Of Lifo Firms
Financial Statement Format Nonrecurring Items In The Income Tax Note
Introduction To Analyzing Business Earnings Nonrecurring Items In The Other Income And Expense Note

Also, this equation provides a financial approach to business strategy. It recognizes that the ultimate goal of business strategy is to maximize stockholder value, that is, the market price of the common stock. This goal requires maximizing the return on common equity. The Dupont equation above breaks the return on common equity into its three component parts: Profit Margin (Net Income/Sales), Asset Turnover (Sales/Total Assets), and Leverage (Total Assets/Common Equity). If any one of these three ratios can be improved (without harm to either or both of the remaining two ratios), then the return on common equity will increase. A firm thus has specific strategic targets:

• Profit Margin improvement can be pursued in a number of ways. On the one hand, revenues might be increased or costs decreased by:
1. Raising prices perhaps by improving product quality or offering extra services. Makers of luxury cars have done this successfully by providing free roadside assistance and loaner cars when customer cars are being serviced.
2. Maintaining prices but reducing the quantity of product in the package. Candy bar manufacturers and other makers of packaged foods often use this method.
3. Initiating or increasing charges for ancillary goods or services. For example, banks have substantially increased their charges to stop checks and for checks written with insufficient funds. Distributors of computers and software have instituted fees for providing technical assistance on their help lines and for restocking returned items.
4. Improving the productivity and efficiency of operations.
5. Cutting costs in a variety of ways.

• Asset Turnover may be improved in ways such as:
1. Speeding up the collection of accounts receivable.
2. Increasing inventory turnover, perhaps by adopting “just in time” inventory methods.
3. Slowing down payments to suppliers, thus increasing accounts payable.
4. Reducing idle capacity of plant and equipment.

• Leverage may be increased, within prudent limits, by means such as:
1. Using long-term debt rather than equity to fund additions to plant, property, and equipment.
2. Repurchasing previously issued common stock in the open market.

Topics You May Be Interested In
What Are Financial Statements? A Case Study The Nature Of Nonrecurring Items
Financial Statements: Who Uses Them And Why The Process Of Identifying Nonrecurring Items
Financial Statement Format Nonrecurring Items In The Statement Of Cash Flows
Combining Financial Ratios Nonrecurring Items In The Other Income And Expense Note
The Z Score Nonrecurring Items In Managements Discussion And Analysis (md&a)

The chief advantage of using the Dupont formula is to focus attention on specific initiatives that will improve return on equity by means of enhancing profit margins, increasing asset turnover, or employing greater financial leverage within prudent limits.

In addition to the Dupont formula, there is another way to combine financial ratios, one that serves another useful purpose—predicting solvency or bankruptcy for a given enterprise. It uses what is known as the z score.



Frequently Asked Questions

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Ans: Some important points to keep in mind when using financial ratios are: • Whereas all balance sheet numbers are end-of-period numbers, all income statement numbers relate to the entire period. For example, when calculating the ratio for Accounts Receivable Turnover, we use a numerator of Credit Sales, which is an entire-period number from the income statement, and a denominator of Accounts Receivable, which is an end-ofperiod number from the balance sheet. view more..
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Ans: We check the financial health of a company in much the same fashion by analyzing the financial statements. The vital signs are tested mostly by various financial ratios that are calculated from the financial statements. These vital signs can be classified into three main categories: view more..
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Ans: Financial statements have a standard format whether an enterprise is as small as Nutrivite or as large as a major corporation. For example, a recent set of financial statements for Microsoft Corporation can be summarized in millions of dollars as follows: view more..
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Ans: Up to this point we have considered financial ratios one at a time. However, there is a useful method for combining financial ratios known as Dupont1 analysis. To explain it, we first need to define some financial ratios, together with their abbreviations, as follows: view more..
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Ans: Financial ratios are useful not only to assess the past or present condition of an enterprise, but also to reliably predict its future solvency or bankruptcy. This type of information is of critical importance to present and potential creditors and investors. There are several different methods of analysis for obtaining this predictive information. view more..
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Ans: A special committee of the American Institute of Certified Public Accountants (AICPA) concluded the following about earnings and the needs of those who use financial statements: Users want information about the portion of a company’s reported earnings that is stable or recurring and that provides a basis for estimating sustainable earnings. view more..
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Ans: Defining nonrecurring items is difficult. Writers often begin with phrases like “unusual” or “infrequent in occurrence.” Donald Keiso and Jerry Weygandt in their popular intermediate accounting text use the term irregular to describe what most statement users would consider nonrecurring items. view more..
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Ans: Careful analysis of past financial performance aimed at removing the effects of nonrecurring items is a more formidable task than one might suspect. This task would be fairly simple if (1) there was general agreement on just what constitutes a nonrecurring item and (2) if most nonrecurring items were prominently displayed on the face of the income statement. view more..
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Ans: An examination of the income statement, the first step in the search sequence, requires an understanding of the design and content of contemporary income statements. This knowledge will aid in the location and analysis of nonrecurring view more..
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Ans: After the income statement, the operating activities section of the statement of cash flows is an excellent secondary source to use in locating nonrecurring items (step 2 in the search sequence in Exhibit 2.3). The diagnostic value of this section of the statement of cash flows results from two factors. First, gains and losses on the sale of investments and fixed assets must be removed from net income in arriving at cash flow from operating activities. Second, noncash items of revenue or gain and expense or loss must also be removed from net income. view more..
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Ans: The carrying values of inventories maintained under the LIFO method are sometimes significantly understated in relationship to their replacement cost. For public companies, the difference between the LIFO carrying value and replacement cost (frequently approximated by FIFO) is a required disclosure under SEC regulations. An example of a substantial difference between LIFO and current replacement value is found in a summary of the inventory disclosures of Handy and Harman Inc. in Exhibit 2.17. view more..
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Ans: Income tax notes are among the more challenging of the disclosures found in annual reports. They can, however, be a rich source of information on nonrecurring items. Fortunately, our emphasis on the persistence of earnings requires a focus on a single key schedule found in the standard income tax note. The goal is simply to identify nonrecurring tax increases and decreases in this schedule. view more..
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Ans: An “other income (expense), net,” or equivalent line item is commonly found in both the single- and multistep income statement. In the case of the multistep format, the composition of other income and expenses is sometimes detailed on the face of the income statement. In both the multi- and single-step formats, the most typical presentation is a single line item with a supporting note. Even though a note detailing the contents of other income and expense may exist, companies typically do not specify its location. Other income and expense notes tend to be listed close to the end of the notes to the financial statements view more..
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Ans: Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is an annual and a quarterly Securities and Exchange Commission reporting requirement. Provisions of this regulation have a direct bearing on the goal of locating nonrecurring items. As part of the MD&A, the SEC requires registrants to: view more..
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Ans: Typically, most material nonrecurring items will have been located by proceeding through the first six steps of the search sequence in Exhibit 2.3. However, some additional nonrecurring items may be located in other notes. Nonrecurring items can surface in virtually any note to the financial statements. We will now discuss three selected notes that frequently contain other nonrecurring items: notes on foreign exchange, restructuring, and quarterly and segment financial data. Recall that inventory, income tax, and other income and expense notes have already been discussed in steps 3 to 5. view more..
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Ans: The last section in the AK Steel Holdings income statement in Exhibit 2.9 is devoted to the reporting of other comprehensive income. This is a relatively new feature of the income statement and was introduced with the issuance by the FASB of SFAS No. 130, Reporting Comprehensive Income.44 The goal of the standard is to expand the concept of income to included selected items of nonrecurring revenue, gain, expense and loss. Under the new standard, traditional net income is combined with a new component, “other comprehensive income,” to produce a new bottom line, “comprehensive income.” view more..
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Ans: The work to this point has laid out important background but is not complete. Still required is a device to assist in summarizing information discovered on nonrecurring items so that new measures of sustainable earnings can be developed. We devote the balance of this chapter to introducing a worksheet specially designed to summarize nonrecurring items and illustrating its development and interpretation in a case study. view more..
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Ans: The sustainable earnings worksheet is shown in Exhibit 2.26. Detailed instructions on completing the worksheet follow: 1. Net income or loss is recorded on the top line of the worksheet. 2. All identified items of nonrecurring expense or loss, which were included in the income statement on a pretax basis, are recorded on the “add” lines provided. view more..




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