UNIT 5:

ANALYSIS OF FINANCIAL STATEMENTS

Presentation of financial statements is an important part of the accounting process. The

process provides more meaningful information to enable the owners, investors, creditors or users of
financial statements to evaluate the operational efficiency of the concern during the particular
period. More useful information is required from the financial statements to make the purposeful
decisions about the profitability and financial soundness of the concern. In order to fulfil the needs of
the above, it is essential to consider analysis and interpretation of financial statements.

The term "Analysis" refers to re-arrangement and classification of the data given in the
financial statements. In other words; it is simplification of data by methodical classification of the
data given in the financial statements. However the term "interpretation" refers to "explaining the
meaning and significance of the data so simplified." Both analysis and interpretations are closely
connected and inter related. They are complementary to each other. Therefore presentation of
information becomes more purposeful and meaningful-both analysis and interpretations are to be
considered. Metcalf and Tigard (2003) have defined financial statement analysis and interpretations
as a process of evaluating the relationship between component parts of a financial statement to
obtain a better understanding of a firm's position and performance. The facts and figures in the
financial statements can be transformed into meaningful and useful figures through a process called
"Analysis and Interpretations."

In other words, financial statement analysis and interpretation refer to the process of
establishing meaningful relationships between items of the two financial statements with the
objective of identifying both financial and operational strengths and weaknesses of an organisation.

Problem 5.1

Financial statement analysis

The following ratios describe the performance of Ratio Ltd for 2015 and 2016:

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Ratio Value Value

2015 2016

Debt-to-equity ratio 1.36 times 1.86 times

Inventory turnover 6.70 times 8.00 times

Quick ratio 0.91 times 0.70 times

Gross margin 63.2% 65.0%

Interest coverage 2.8 times 2.00 times

Current ratio 1.89 times 1.29 times

Receivables turnover 7.3 times 7.5 times

Days inventory on hand 54.5 days 45.6 days

Return on assets 13.24% 14.40%

Return on equity 38.43% 34.97%

Required:

1. Classify these ratios into those relating to:

a. Financial performance
b. Liquidity and solvency
c. Financial structure
d. Operating efficiency.

2. Based on the ratio values supplied, comment on the company's performance in 2016 in each of
the following categories/dimensions:

a. Financial performance
b. Liquidity and solvency

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 c. Financial structure
d. Operating efficiency.

In addition, note the limitations of conclusions drawn from the provided information, and indicate
what other information would be helpful in assessing the company's performance.

3. Explain:

a. Why do the return on assets and return on equity ratios differ?

b. Why would the return on assets ratio be calculated if you had already calculated the return
on equity ratio? (You may find it helpful to consider how these ratios are calculated.)

4. Consider the inventory turnover ratio and the days inventory on hand ratio:

a. What information do these ratios provide?

b. From the viewpoint of management, what are the limitations relating to these ratios?

5. During 2016, the chief financial officer (CFO) of Ratio Ltd employed an independent valuer to
assess the current value of the land and buildings owned by the company. The valuer had advised
the CFO that the value of the land and buildings had increased by $50 000 (10 per cent). Assume
that this increased value is reflected in the ratios provided in the first half of this chapter. Explain
how this accounting policy choice would have affected each of the ratios.

Problem 5.1 Solution

1 a. Financial performance: ROE, ROA, Gross margin

b. Liquidity and solvency: Quick ratio, current ratio and interest coverage

c. Financial Structure: Debt-to-equity,

d. Operating Efficiency: Inventory turnover, receivables turnover, days inventory on hand

2 a. The company’s ROA and ROE appear to be high. Gross margin and ROA have increased in
2016. The fact that ROE is greater than ROA in both years indicates that leverage is being
employed to the advantage of shareholders, though this was done to a greater extent in 2015
than in 2016.
b. The company’s current ratio is well above 1 for both years and this suggests it is quite liquid,
though this depends on the industry Ratio Ltd is in and the industry norm. Both the current
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 and quick ratios have dropped in 2016 however, indicating the company is currently less liquid
than it was in 2015.

c. The company’s debt-to-equity ratio shows that it is financed by debt. The drop in the interest
coverage ratio in 2016 suggests that the company is less comfortable in covering its interest
obligations in 2016 compared to in 2015.

d. The company is operating more efficiently than it did in 2015. The modest increase in
receivables turnover suggests that customers are paying the company a little faster. Also
inventory turnover has increased indicating that inventory is being turned over at a quicker
rate.

Limitations: lack of information about the company – e.g., what industry is it in? What are the
industry norms? What kind of inventory does it stock (e.g., perishables)?

3 a. ROA shows the return managers are earning on the assets under their control. In contrast,
ROE indicates how much return the company is generating on the historically accumulated
shareholders’ investment. It captures the combined effect of assets and leverage that the
company uses to create shareholder returns.
b. Because it enables managers to analyse where shareholder returns are being derived (e.g., is
it from the company’s sales and the use of its assets, or is it from leverage), and to identify the
areas for improvement.

4 a. These ratios show how efficiently the company’s inventory is being managed. More
specifically, inventory turnover shows how much sales volume is associated with a dollar of
inventory, while days inventory on hand calculates how many days, on average, inventory is
held.
c. A limitation of these ratios is that they don’t necessarily reflect how well a company is
performing. For a company whose operations are based on a premise of low turnover and
high profit margin, a low inventory turnover ratio may be sustainable. Therefore, these ratios
must be interpreted having regard to the nature of the business and norm for companies in
the same industry which compete in a similar way.

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5

Debt-to-equity Decrease

Inventory turnover No effect

Quick ratio No effect

Gross margin No effect

Interest coverage No effect

Current ratio No effect

Receivables turnover No effect

Days inventory on hand No effect

Return on Assets Decrease

Problem 5.2: Performance evaluation using ratios

International Business Computers (IBC) has enjoyed modest success in penetrating the
personal computer market since it began operations a few years ago. A new computer line
introduced recently has been received well by the general public. However, the general manager,
who is well versed in electronics but not in accounting, is worried about the future of the company.

The company's operating loan is at its limit and more cash is needed to continue operations.
The bank wants more information before it extends the company's credit limit. The general manager
has asked you, as financial controller, to do a preliminary evaluation of the company's performance,
using appropriate financial statement analysis, and to recommend possible courses of action for the
company. The general manager particularly wants to know how the company can obtain additional
cash. Use the summary financial information shown below to do your evaluation and make your
recommendations.

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Other related information included in total expenses:

2016 2015 2014

N$’000 N$’000 N$’000

Interest expense 89 61 –

Income tax expense 95 102 97

Problem 5.2 Solution

In this case several issues are illustrated in the information provided. Just to provide some
analysis relative to the general manager’s concern about availability of cash, a start might be to
estimate what the company’s ability to generate cash has been. You could also start with other ratio
analyses illustrated later in this outline. The 2016 and 2015 statement of cash flows follow (the

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statement of cash flows for 2014 cannot be prepared without the 2013 balance sheet). Marketable
securities, but not bank loans, are included in our definition of cash equivalents as this allows us to
focus on cash given the issue of interest is extending the bank loan.
Statement of cash flows
2016 (‘000) 2015 (‘000)
Cash flows from operating activities
Receipts from operations 3 076,000 2 637,000
Payments to suppliers and (3 157,000) (2 563,000)
employees
Payments for income tax (99,000) ( 100,000)
Net cash outflows from (180,000) (26,000)
operations

Cash flows from investing activities

Purchase of land (100,000)
Purchase of buildings (150,000)
Purchase of equipment (250,000)
Net cash outflows from investing – (500,000)
activities

Cash flows from financing activities

Dividends paid (80,000) (70,000)
Bank loan 255,000 570,000
Net cash inflows from financing 175,000 500,000
activities
Net decrease in cash for year (5,000) (26,000)
Cash and marketable securities – 61,000 87,000
beginning
Cash and marketable securities – 56,000 61,000
end

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 1. Workings/Notes for the statement of cash flows

Accounts receivable trade Inventory

$’000 $’000 $’000 $’000

1/1/2015 Balance 257,000 Cash *2 637,000 1/1/2015 Balance 361,000 Cost of goods 2 150,000
sold
Sales 2 800,000 31/12/2015 Balance 420,000 Purchases 2 292,000 31/12/20 Balance 503,000
* 15
3 057,000 3 057,000 2 653,000 2 653,000

1/1/2016 Balance 420,000 Cash *3 076,000 1/1/2016 Balance 503,000 Cost of goods 2 500,000
sold
Sales 3 200,000 31/12/2016 Balance 544,000 Purchases 2 830,000 31/12/20 Balance 833,000
* 16
3 620,000 3 620,000 3 333,000 3 333,000

1/1/2017 Balance 544,000 1/1/2017 Balance 833,000

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 Payables (Accounts payable & other liabilities)
$’000 $’000
Cash * 2 563,000 1/1/2015 Balance – Accounts payable 144,000
Depreciation expense 84,000 – Other liabilities 75,000
31/12/2015 Balance – Accounts payable 215,000 Expenses (533 – 102) 431,000
– Other liabilities 80,000 Purchases 2 292,000
2 942,000 2 942,000
Cash * 3 157,000 1/1/2016 Balance – Accounts payable 215,000
Depreciation expense 75,000 – Other liabilities 80,000
31/12/2016 Balance – Accounts payable 300,000 Expenses (584 – 95) 489,000
– Other liabilities 82,000 Purchases 2 830,000
3 614,000 3 614,000
1/1/2017 Balance – Accounts payable 300,000
– Other liabilities 82,000

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 Income tax payable
$ $
Cash * 100,000 1/1/15 Balance 50,000
31/12/15 Balance 52,000 P&L summary 102,000
152,000 152,000
Cash * 99,000 1/1/16 Balance 52,000
31/12/16 Balance 48,000 P&L summary 95,000
147,000 147,000
1/1/17 Balance 48,000
* = Balancing figures

The above statements of cash flows indicate several Issues or Interpretation:

1. Receivables have been increasing faster than profit. Further analysis of this situation shows:

2016 2015 2014

Increase in sales over previous year 14.3% 19.7%
Increase in receivables 29.5% 63.4%
Days’ sales in ending receivables
(Receivables/(Sales/365)) 62 55 40
Because receivables have grown so much, the cash flow that would have been expected from the
sales and profit has not happened.

2. Similarly, problems exist in the management of inventories:

2016 2015 2014

Gross profit percentage of sales 21.9% 23.2% 23.1%
Increase in sales over previous year 14.3% 19.7%
Increase in inventory 65.6% 39.3%
Inventory turnover
(COGS/average inventory) 3.74 4.98
times times
Inventory is growing dramatically and gross profit percentage is slipping. The company is piling up
inventory and selling prices have been squeezed: to reduce the inventory, now more than twice
what it was two years ago, would probably produce even more pressure on selling prices and reduce
profit. The company has got itself into apparently serious difficulty.

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3 The increased receivables and inventories, payment of dividends, and $500 000 of noncurrent assets
in 2015, have been financed partly out of cash generated from profit but largely from short-term
borrowing. The increase in accounts payable is moderate, but the company’s reliance on its bank
loan is enormous: $825 000 over the two years 2015 and 2016.

4 The situation is also revealed by examining the company’s working capital:

2016 2015 2014

$’000 $’000 $’000
Curent Assets 1 433 984 705
Current liabilities 1 255 917 269
Working capital 178 67 436
Quick assets 600 481 344
Current ratio 1.14 1.07 2.62
Quick ratio .48 .52 1.28

Clearly the company is not in a strong current position. The general manager knows this, but may
not realise the risk to the company of its lack of liquidity. The quick (acid test) ratio shows that the
company’s ability to meet current debts is strained and declining, but even that ratio may understate
the problem because the quick assets include receivables and the company’s collections are not very
quick!

Some suggestions for the general manager from the above about getting cash:
i. Reduce production or purchasing until inventory is substantially reduced.

ii. Increase collection efforts or change credit terms to get receivables down.

iii. Increase share capital or obtain long-term financing to reduce the reliance on short-term
borrowing (though these would reduce returns to present owners and might not be
popular with the shareholders).

iv. Raise selling prices a little to protect returns from the effects of any further borrowing
(may not work if price competition is strong, of course).

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Case Studies

Case 5D: Financial Statement Analysis

BigBrewery is a large Australian beer brewing company. It sells to wholesalers and commercial
outlets which then deal directly with BigBrewery's target customers. BigBrewery's iconic beers are
also exported to New Zealand, United Kingdom and the United States. BigBrewery manufactures in
various offshore locations and as a result, a significant proportion of BigBrewery's costs of production
are incurred in US Dollars.

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Required:

a. Calculate ratios for Big Brewery Limited for 2015 and 2016 using the available information
as a guide. Be sure to include appropriate units.
b. Comment on the financial performance of Big Brewery in 2016 (relative to 2015) with
reference to the above ratio calculations. You may wish to further research the
performance of the brewing industry to enhance your answer.

Suggested Solution to Case 5D

1. Computation of Ratios

Ratio 2016 Calculations 2016 Result 2015 Calculations 2015 Result

1. Return on Equity 6425/77780 8.26% 3752/50319 7.46%

2. Return on Assets 6425/216661 2.97% 3752/198522 1.89%

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 3. Alternative Return on 10985/216661 5.07% 9150/198522 4.61%
Assets

4. Profit Margin 6425/36480 17.61% 3752/47259 7.94%

5. Alternative Profit 10985/36480 30.11% 9150/47259 19.36%

Margin

6. Gross Margin (36480- 35.15% (47259- 18.37%

23656)/36480 38577)/47259

7. Cash Flow to Total -6847/216661 -3.16% -35/198522 -0.02%

Assets

8. Earnings per Share 6425/76583 8.4 cents 3752/55000 6.8 cents

9. Price-Earnings Ratio 0.95/0.084 11.31 times 0.98/0.068 14.41 times

10. Dividend Pay-out 3/8.4 35.71% 4/6.8 58.82%

Ratio

11. Total Asset Turnover 36480/216661 16.84% 47259/198522 23.81%

12. Inventory Turnover 23656/[(61467+4165 0.46 times 38577/[(41659+1 1.28 times

9)/2] 8436)/2]

13. Days in Inventory 365/0.46 793 days 365/1.28 285 days

14. Debtors Turnover 36480/[(27432+2311 1.44 times 47259/[(23119+5 3.32 times

(NB: Gross trade 9)/2] 345)/2]
debtors used, other
answers may be
acceptable)

15. Days in Debtors (as 365/1.44 253 days 365/3.32 110 days
above)

16. Current Ratio 79564/53789 1.48 times 64530/62035 1.04 times

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 17. Quick Ratio (3804+13758)/53789 0.32 times (73+22107)/6203 0.36 times
5

18. Interest Coverage 10985/3255 3.37 times 9150/3165 2.89 times

Ratio

19. Debt to Equity Ratio 138881/77780 1.79 times 148203/50319 2.95 times

20. Debt to Assets Ratio 138881/216661 0.64 times 148203/198522 0.75 times

21. Leverage Ratio 216661/77780 2.79 times 198522/50319 3.95 times

2. Comments:

i. Profitability ratios
 In general, profitability ratios have increased over the year. However ROA is very low
(2.97%)
 Profit margin and alternative profit margin both increase. This is due to better margins
being captured even though sales have decreased – costs have been well managed.
 Cash flow to total asset ratio has also decreased dramatically, this may explains the
significant decline in the dividend pay-out ratio. Although profitability improves but its
ability to generate cash has deteriorated affecting the amount available for
distribution to shareholders.
 A decrease in price-earnings ratio reflects market expectation of poorer performance
in the future (may reflect a downturn in general market sentiment rather than firm-
specific factors).
ii. Activity ratios
 Total asset turnover has declined over the year indicating less efficient use of assets in
generating revenue.
 Inventory turnover experiences a substantial decline to 0.46 times per year, i.e. on
average beer is held for 793 days – this presents a clear potential obsolescence issue
as I’m not sure beer would taste too good after being held for 2 years. There is a
significant build-up of inventory (nearly 3 years’ worth of sales at current rates) which
may increase storage and holding cost.
 Debtors turnover has declined from 3.32 times to 1.44 times suggesting that urgent
action is required to collect debtors and assist with cash flow.

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 iii. Liquidity ratios
 Current ratio has increased, while quick ratio has declined. This indicates that the
increase in current ratio is due to building up of inventory. This is consistent with the
analysis made above and that while the current ratio has increased, this is not
necessarily good news.
 Quick ratio below 1 which indicates company may have trouble paying its bills as they
fall due unless they can continue to convert inventory to cash.
iv. Financing ratios
 All of the financing ratios have decreased over the year.
 The decrease in the use of debt may indicate less reliance on debt financing, hence,
reduces the riskiness of the firm. Also, a slight increase in interest coverage ratio
reflects the firm’s ability to meet finance cost. Critical to be concerned about short run
liquidity (as long run might not ever happen if firm fails in short term).

Case 5E

Assessing Martin Manufacturing’s Current Financial Position

Terri Spiro, an experienced budget analyst at Martin Manufacturing Company, has been charged with
assessing the firm’s financial performance during 2003 and its financial position at year-end 2003. To
complete this assignment, she gathered the firm’s 2003 financial statements, which follow. In
addition, Terri obtained the firm’s ratio values for 2001 and 2002, along with the 2003 industry
average ratios (also applicable to 2001 and 2002).

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Note: Industry historical ratios appear at the top of the following page.

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Required

a. Calculate the firm’s 2003 financial ratios, and then fill in the preceding table.
b. Analyze the firm’s current financial position using both a cross-sectional and a time-series
viewpoints. Break your analysis into evaluations of the firm’s liquidity, activity, debt, profitability,
and market.
c. Summarize the firm’s overall financial position on the basis of your findings in part b.

Solution to Case 5E

Assessing Martin Manufacturing’s Current Financial Position

Martin Manufacturing Company is an integrative case study addressing financial analysis techniques.
The company is a capital-intensive firm that has poor management of accounts receivable and
inventory. The industry average inventory turnover can fluctuate from 10 to 100 depending on the
market.

a. Ratio calculations

Financial Ratio 2003

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 Current ratio $1,531,181  $616,000

= 2.5%

Quick ratio ($1,531,181 – $700,625)  $616,000

= 1.3%

Inventory turnover (times) $3,704,000  $700,625

= 5.3% Times

Average collection period (days) $805,556  ($5,075,000  365)

= 58.0% Days

Total asset turnover (times) $5,075,000  $3,125,000

= 1.6% Times

Debt ratio $1,781,250  $3,125,000

= 57%

Times interest earned $153,000  $93,000

= 1.6% Times

Gross profit margin $1,371,000  $5,075,000

= 27%

Net profit margin $36,000  $5,075,000

= 0.71%

Return on total assets $36,000  $3,125,000

= 1.2%

Return on equity $36,000  $1,343,750

= 2.7%

Historical Ratios
Martin Manufacturing Company

Actual Actual Actual Industry

Ratio 2001 2002 2003 Average

Current ratio 1.7 1.8 2.5 1.5

Quick ratio 1.0 0.9 1.3 1.2

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 Inventory turnover (times) 5.2 5.0 5.3 10.2
Average collection period 50.7 55.8 58.0 46.0
(days)
Total asset turnover (times) 1.5 1.5 1.6 2.0
Debt ratio 45.8% 54.3% 57% 24.5%
Times interest earned 2.2 1.9 1.6 2.5
Gross profit margin 27.5% 28.0% 27.0% 26.0%
Net profit margin 1.1% 1.0% 0.71% 1.2%
Return on total assets 1.7% 1.5% 1.2% 2.4%
Return on equity 3.1% 3.3% 2.7% 3.2%
Price/earnings ratio 33.5 38.7 34.48 43.4
Market/book 1.0 1.1 0.89 1.2

up to now, you have done the

calculations but not the analysis
b. Analysing the firm’s current financial position

 Liquidity: The firm has sufficient current assets to cover current liabilities. The trend is upward
and is much higher than the industry average. This is an unfavourable position, since it
indicates too much inventory.
 Activity: The inventory turnover is stable but much lower than the industry average. This
indicates the firm is holding too much inventory. The average collection period is increasing
and much higher than the industry average. These are both indicators of a problem in
collecting payment.

The total asset turnover ratio is stable but significantly lower than the industry average. This
indicates that the sales volume is not sufficient for the amount of committed assets.

 Debt: The debt ratio has increased and is substantially higher than the industry average. This
places the company at high risk. Typically industries with heavy capital investment and higher
operating risk try to minimize financial risk. Martin Manufacturing has positioned itself with
both heavy operating and financial risk. The times-interest-earned ratio also indicates a
potential debt service problem. The ratio is decreasing and is far below the industry average.

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  Profitability: The gross profit margin is stable and quite favourable when compared to the
industry average. The net profit margin, however, is deteriorating and far below the industry
average. When the gross profit margin is within expectations but the net profit margin is too
low, high interest payments may be to blame. The high financial leverage has caused the low
profitability.
 Market: The market price of the firm’s common stock shows weakness relative to both
earnings and book value. This result indicates a belief by the market that Martin’s ability to
earn future profits faces increasing uncertainty as perceived by the market.

c. Martin Manufacturing clearly has a problem with its inventory level, and sales are not at an
appropriate level for its capital investment. As a consequence, the firm has acquired a substantial
amount of debt which, due to the high interest payments associated with the large debt burden,
is depressing profitability. These problems are being picked up by investors as shown in their
weak market ratios.

An Integrated Financial Ratios Diagnostics - DuPont Analysis

No single ratio is adequate for assessing all aspects of the firm's financial condition. Two
popular approaches to a complete ratio analysis are: the DuPont system of analysis and the
summary analysis of large number of ratios
The DuPont system of analysis is used to dissect a firm’s financial statements and assess its
financial condition. The analysis merges the income statement and balance sheet into two summary
measures of profitability, return on total assets (ROA) and return on common equity (ROE). Figure
5.2 depicts the basic DuPont system with Bartlett Company’s 2012 monetary and ratio values. The
upper portion of the chart summarizes the income statement activities; the lower portion
summarizes the balance sheet activities.

The DuPont Analysis breaks down ROE (Return on Equity) into a function of 3 or 5 ratios that
help to see the contribution of each ratio component on ROE. Suppose you are going through the
financial ratios of a company and stop at ROE and wondering what are the factors that are
contributing or impacting the ROE. DuPont analysis comes in handy as a tool for dissecting the Return
on Equity (ROE) and therefore suggests how the company is achieving its ROE. It brings spotlight on
the following questions:

i. Is the company’s margins increasing?

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 ii. Is the inventory turnover increasing?
iii. Is the company using leverage?

These are the three questions that the DuPont analysis can help you answer.

Figure 5.2: Basic DuPont system Analysis

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Applying the DuPont System

The advantage of the DuPont system is that it allows the firm to break its return on equity into
a profit-on-sales component (net profit margin), an efficiency-of-asset use component (total asset
turnover), and a use-of-financial-leverage component (financial leverage multiplier). The total return
to owners therefore can be analysed in these important dimensions.

The use of the DuPont system of analysis as a diagnostic tool is best explained using Figure
5.2. Beginning with the rightmost value—the ROE—the financial analyst moves to the left, dissecting
and analyzing the inputs to the formula to isolate the probable cause (s) of the resulting above-
average (or below-average) value.
For the sake of demonstration, let’s ignore all industry average data in Table 3.8 and assume
that Bartlett’s ROE of 12.6% is actually below the industry average. Moving to the left in Figure 5.2,
we would examine the inputs to the ROE—the ROA and the FLM—relative to the industry averages.
Let’s assume that the FLM is in line with the industry average, but the ROA is below the industry
average. Moving farther to the left, we examine the two inputs to the ROA—the net profit margin
and total asset turnover. Assume that the net profit margin is in line with the industry average, but
the total asset turnover is below the industry average.
Moving still farther to the left, we find that whereas the firm’s sales are consistent with the
industry value, Bartlett’s total assets have grown significantly during the past year. Looking further to
the left, we would review the firm’s activity ratios for current assets. Let’s say that whereas the firm’s
inventory turnover is in line with the industry average, its average collection period is well above the
industry average. At this point we readily trace the possible problem back to its cause: Bartlett’s low
ROE is primarily the consequence of slow collections of accounts receivable, which resulted in high
levels of receivables and therefore high levels of total assets. The high total assets slowed Bartlett’s
total asset turnover, driving down its ROA, which then drove down its ROE. By using the DuPont
system of analysis to dissect Bartlett’s overall returns as measured by its ROE, we found that slow
collections of receivables caused the below-industry-average ROE. Clearly, the firm needs to better
manage its credit operations.

DuPont Formula
The DuPont system first brings together the net profit margin, which measures the firm’s
profitability on sales, with its total asset turnover, which indicates how efficiently the firm has used

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its assets to generate sales. In the DuPont formula, the product of these two ratios results in the
return on total assets (ROA):
ROA = Net profit margin x Total asset turnover ………………………………………………………………. 5.1

Substituting the appropriate formulas into the equation and simplifying results in the formula given
earlier,

………………. 5.2

When the 2012 values of the net profit margin and total asset turnover for Bartlett Company,
calculated earlier, are substituted into the DuPont formula, the result is

This value is the same as that calculated directly in an earlier section (page 81). The DuPont
formula enables the firm to break down its return into profit-on sales and efficiency-of-asset-use
components. Typically, a firm with a low net profit margin has a high total asset turnover, which
results in a reasonably good return on total assets. Often, the opposite situation exists.

Modified DuPont Formula

The second step in the DuPont system employs the modified DuPont formula. This formula
relates the firm’s return on total assets (ROA) to its return on common equity (ROE). The latter is
calculated by multiplying the return on total assets (ROA) by the financial leverage multiplier (FLM),
which is the ratio of total assets to common stock equity:

…………………….. 5.3

Substituting the appropriate formulas into the equation and simplifying results in the formula given
earlier,

…….. 5.4

Use of the financial leverage multiplier (FLM) to convert the ROA into the ROE reflects the
impact of financial leverage on owners’ return. Substituting the values for Bartlett Company’s ROA of
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6.1 percent, calculated earlier, and Bartlett’s FLM of 2.06 ($3,597,000 total assets ÷ $1,754,000
common stock equity) into the modified DuPont formula yields

The 12.6 percent ROE calculated by using the modified DuPont formula is the same as that calculated
directly.

Solved Example

Use the following ratio information provided in Table 1 for Johnson International Ltd and the industry
averages for Johnson’s line of business.

Table 1: Financial Ratios for Johnson International Ltd. and Industry.

Requirements:

a. Construct the DuPont system of analysis for both Johnson and the industry.
b. Evaluate Johnson (and the industry) over the 3-year period.
c. Indicate in which areas Johnson requires further analysis. Why?

Solution

DuPont system of analysis is normally represented by the relationship below:

a.

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 Margin  Turnover = ROA (%)  FL Multiple = ROE (%)
(%)

2012

Johnson 4.9  2.34 = 11.47  1.85 = 21.21

Industry 4.1  2.15 = 8.82  1.64 = 14.46

2011

Johnson 5.8  2.18 = 12.64  1.75 = 22.13

Industry 4.7  2.13 = 10.01  1.69 = 16.92

2010

Johnson 5.9  2.11 = 12.45  1.75 = 21.79

Industry 5.4  2.05 = 11.07  1.67 = 18.49

b. Profitability: Industry net profit margins are decreasing; Johnson’s net profit margins have
fallen less.

Efficiency: Both industry’s and Johnson’s asset turnover have increased.

Leverage: Only Johnson shows an increase in leverage from 2011 to 2012, while the industry
has had less stability. Between 2010 and 2011, leverage for the industry increased, while it
decreased between 2011 and 2012.

As a result of these changes, the ROE has fallen for both Johnson and the industry, but
Johnson has experienced a much smaller decline in its ROE.

d. Areas that require further analysis are profitability and debt. Since the total asset turnover is
increasing and is superior to that of the industry, Johnson is generating an appropriate sales
level for the given level of assets. But why is the net profit margin falling for both industry
and Johnson? Has there been increased competition causing downward pressure on prices?
Is the cost of raw materials, labor, or other expenses rising? A common-size income
statement could be useful in determining the cause of the falling net profit margin.

Note: Some management teams attempt to magnify returns through the use of leverage to offset
declining profit margins. This strategy is effective only within a narrow range. A high leverage
strategy may actually result in a decline in stock price due to the increased risk.

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