Dupont Analysis

This reading covers the tools of financial analysis, the activity, liquidity, solvency and profitability ratios and the relationships among them, DuPont analysis of return on equity, industry-specific ratios, and the use of ratios in modeling and forecasting. A candidate must be able to calculate and interpret each ratio, decompose ROE into three or five parts, and judge a company's position from a set of ratios.

LOS 37.a — Tools and techniques of financial analysis

Raw financial statement numbers are hard to compare. A large firm has larger receivables, larger debt and larger profits than a small one simply because of its size. Step 3 of the financial statement analysis framework therefore converts the (adjusted) data into comparable forms, such as ratios, common-size statements and graphs, and may add statistical work such as regression. The four tools are ratio analysis, common-size analysis, graphical analysis and regression analysis.

Uses of ratio analysis

A ratio relates one statement item to another (for example, net income to revenue), which removes the effect of size. Ratios are most useful for raising questions that the analyst then investigates; a ratio seldom answers a question by itself. Ratios help an analyst to:

• forecast future earnings and cash flow;
• judge the firm's flexibility, meaning its ability to grow and to meet obligations when something unexpected happens;
• rate how well management has performed;
• track how the firm and its industry change over time;
• compare the firm with its industry competitors.

Comparisons run in two directions. Cross-sectional analysis compares a firm's ratios with those of other firms (peers, industry averages) for the same period. Time-series analysis (trend analysis) compares a firm's ratios with its own past values.

Limitations of ratio analysis

• A ratio viewed in isolation says little. It is informative only against peers or the firm's own history.
• Different accounting treatments (methods, estimates, IFRS versus US GAAP) distort comparisons, so the analyst may need to adjust the data first.
• Comparable industry ratios are hard to find for a company that operates in multiple industries (a conglomerate).
• No conclusion should rest on a single ratio; ratios must be read together.
• Deciding on the target or comparison value takes judgment. The benchmark is usually a range of acceptable values rather than one number.
• Ratios must be read in context: prior results, stated strategy, analyst expectations, the stage of the business cycle and peers.
• Definitions vary between analysts and data providers (for example, total liabilities versus interest-bearing debt in leverage ratios). What matters is using a definition consistently and knowing how published ratios were built.
• Reasonable values differ across industries. A grocer's asset turnover, for example, is far higher than a utility's.

Common-size analysis

Common-size statements express every line item relative to a common base so that firms of different size, or one firm across years, can be compared.

Every income statement line is divided by revenue, so a vertical common-size income statement shows the gross profit margin, operating profit margin and net profit margin directly. It also shows which cost lines drive a change in margin. A vertical common-size balance sheet shows ratios such as long-term debt to total assets at a glance.

Check the column order in any exhibit: some put the most recent year on the left, others on the right.

Graphical analysis

Graphs present comparisons and the composition of statement items over time. A stacked column graph (also called a stacked bar graph) shows how each component, such as cash, receivables or inventory, contributes to a total in each year. A line graph plots the same items as lines and makes trends easy to see, for example rising trade payables together with falling cash, which is a possible liquidity warning.

Regression analysis

Regression analysis identifies relationships between variables and is mainly used for forecasting. An analyst might, for example, estimate next year's sales from the historical relationship between the firm's sales and GDP.

LOS 37.b — Activity, liquidity, solvency and profitability ratios

Ratios are grouped by the question they answer. The groups overlap: payables turnover, for example, is an activity ratio that also says something about liquidity.

When a ratio combines an income statement flow with a balance sheet stock, it usually uses the average balance (beginning plus ending, divided by 2), unless a question specifies year-end figures. For seasonal businesses, averages of more data points (for example, quarterly) are better.

Activity ratios

Many analysts put purchases in the numerator of payables turnover instead of COGS, because payables arise from purchases. Purchases are rarely reported as a line item, but the inventory relationship gives them:

When a question gives purchases, use them; otherwise use COGS.

DSO is also called the average collection period, DOH the average inventory processing period, and days of payables the payables payment period. For quarterly turnover ratios, the days in the quarter replace 365.

Interpretation:

• A high receivables turnover points to efficient credit and collection. It can also reflect strict credit terms, a large discount for early payment or heavy penalties for late payment, and credit terms that are too strict cost sales. Comparing revenue growth with peers shows which: slower growth suggests terms are too tight, while growth at or above the peer average suggests good credit management.
• Inventory turnover uses COGS, not sales. Inventory is carried at cost and COGS is also measured at cost, while revenue includes the markup and would overstate how often inventory turns over. A high value suggests good inventory management, or stock levels so low that sales are lost. A low value may indicate obsolete, slow-moving inventory.
• A high payables turnover means the firm pays quickly, perhaps without using supplier credit fully or in order to take early-payment discounts. A low value may signal cash-flow trouble or simply lenient supplier terms; liquidity ratios help decide.
• Total asset turnover differs greatly by industry, from around 1 for capital-intensive manufacturers to around 10 for some retailers, so it is judged against the industry norm. A value that is too low means too much capital is tied up in assets; a value that is too high suggests too few assets for potential sales, or an outdated asset base.
• Fixed asset turnover uses net fixed assets (net of accumulated depreciation), so firms with more recently acquired assets typically show lower turnover and firms with older, heavily depreciated assets show higher turnover. A low value suggests too much capital in fixed assets or inefficient use of them; a very high value may point to obsolete equipment or to capital spending that will soon be needed to support growing revenue.
• Working capital turnover shows revenue generated per dollar of working capital. When payables are as large as inventory and receivables combined, working capital is close to zero and the ratio becomes very large, unstable from period to period and less informative about efficiency.

Liquidity ratios

• The three balance sheet ratios differ only in which current assets they treat as available. The quick ratio (acid-test ratio) excludes inventory and other less-liquid current assets such as prepaid expenses. The cash ratio also excludes receivables. Higher values mean more liquidity. A current ratio below 1 means negative working capital (current assets − current liabilities), which usually signals liquidity trouble.
• The defensive interval ratio is the number of days the firm could pay its cash expenses from liquid assets alone. Expenditures are cash costs (COGS, SG&A, R&D). When they are estimated from income statement expense lines, noncash charges included in those lines, such as depreciation and amortization, are subtracted. Reported expenses of 100 that include depreciation of 20 mean cash expenditures of 80. Depreciation is added back only when the starting point is net income, as in the indirect-method cash flow statement.
• The cash conversion cycle (net operating cycle) is the time between paying suppliers and collecting from customers. DOH + DSO, the time from acquiring inventory to collecting cash for it, is the operating cycle; the cash conversion cycle subtracts the days of supplier credit from it. A long cycle ties up capital and may require short-term financing. A firm that collects before it pays (a negative cycle) can operate with a current ratio below 1.

Effect of transactions on a liquidity ratio. Consider a ratio with a positive numerator and denominator. If it is above 1, an equal decrease in numerator and denominator (for example, paying payables with cash) raises it, and an equal increase lowers it. If the ratio is below 1, the effects are reversed. Equal increases therefore pull the ratio toward 1, and equal decreases push it away from 1. Moving value between two items inside the numerator, such as collecting receivables into cash, leaves the current ratio unchanged but raises the cash ratio.

Solvency ratios

Here total debt means interest-bearing short-term and long-term debt, including the current portion of long-term debt. Exam convention: unless told otherwise, lease liabilities are left out of total debt. Current practice: lease liabilities bear interest and are recognized on the balance sheet under IFRS 16 and ASC 842, and many analysts and rating agencies include them in debt. Leaving them out makes leverage look low in lease-heavy industries such as airlines. Some analysts also count trade payables and other non-interest-bearing current liabilities as debt, while others subtract cash, cash equivalents and marketable securities to get net debt.

Higher debt ratios mean more reliance on debt. The financial leverage ratio is also called the equity multiplier.

Profitability ratios

Operating profit (gross profit − SG&A and other operating costs) is usually approximated by earnings before interest and taxes (EBIT). Earnings before taxes (EBT) equals EBIT − interest, and gross profit equals revenue − COGS. Ratios that compare sales, at the top of the income statement, with a profit figure further down are operating profitability ratios; each margin isolates a different group of costs.

LOS 37.b — Solvency and profitability ratios: interpretation details

The formulas are in Module 37.2. This module adds interpretation points and then turns to reading ratios together (LOS 37.c).

Solvency.

• A financial leverage ratio close to 1 means the assets are financed mostly with equity; the further it rises above 1, the more debt is used, which typically raises risk for both shareholders and bondholders. If "debt" is taken as all liabilities, $A/E=1+L/E$.
• The lower interest coverage is, the harder it is to meet interest payments. Debt-to-EBITDA indicates roughly how many years of operating cash flow, with EBITDA as a proxy, would be needed to repay the debt.
• Fixed charge coverage is the more meaningful measure for firms that lease many of their assets, such as some airlines. It is also useful for US GAAP reporters with operating leases, because an operating lease records a single lease cost and no interest expense in the income statement, so interest coverage alone misses the lease burden. Because lease payments are added to both the numerator and the denominator, they pull the ratio toward 1. When interest coverage is above 1 (the normal case), fixed charge coverage is lower than interest coverage, and the gap widens as lease payments grow. The two are equal at 1. If interest coverage is below 1, fixed charge coverage is higher; with EBIT of 5, interest of 10 and leases of 10, it is $15/20=0.75$ against interest coverage of $5/10=0.50$.
• Firms with stable cash flows can carry more debt, so solvency ratios are judged against cash-flow variability.

Profitability.

• The net profit margin should be based on income from continuing operations, because discontinued operations will not recur.
• The gross profit margin rises with higher prices or lower production costs. Competition limits pricing.
• The EBIT used for the operating profit margin can include some nonoperating items, and some analysts add back depreciation and amortization to use EBITDA. Whichever measure is chosen should be used consistently.
• The adjusted ROA adds back after-tax interest, so the numerator reflects returns to both debt and equity holders. The add-back uses gross interest expense, because lenders earn the full interest; interest income is not netted against it.
• Return on invested capital (ROIC) is after-tax operating profit ÷ average long-term capital, where long-term capital is long-term (interest-bearing) debt + preferred equity + common equity. Exam convention: long-term capital excludes working capital, meaning non-interest-bearing current liabilities such as accounts payable are not counted as capital. Current practice: invested capital is usually total interest-bearing debt, including short-term borrowings and debt due within one year, plus equity, often net of excess cash. Analysts should be concerned if ROIC is too low.
• ROE (return on total equity) uses total equity including preferred stock. Return on common equity removes preferred dividends from the numerator and preferred equity from the denominator.

LOS 37.c — Relationships among ratios and evaluating a company

No single ratio tells the story. An analyst compares each ratio with the firm's history (time-series) and with peers (cross-sectional), then asks which combination of changes explains the picture.

Useful relationships

Higher is not always better. Values should be close to the industry norm. An activity ratio far better than the norm, such as a collection period well below the industry's, is a question to investigate rather than a sure strength; the possible explanations for each turnover ratio are in Module 37.2. Because DSO $=365/\text{turnover}$, a turnover below the industry average implies a collection period longer than the industry's.

Liquidity signals. Better liquidity shows up as higher current, quick and cash ratios and as faster conversion of receivables and inventory into cash (higher turnovers, shorter days). A lower balance of trade payables is ambiguous: it may reflect strong liquidity or suppliers demanding cash on delivery.

ROE $=\text{ROA}\times (1+L/E)$: Year 1 $9.5\%\times 1.9=18.05\%$; Year 2 $8.5\%\times 2.4=20.4\%$; Year 3 $7.5\%\times 3.0=22.5\%$. ROE improved even though ROA and margins deteriorated. The gain comes entirely from more leverage, so shareholders face more risk.

Evaluating a company against its industry. Each group of ratios is read in turn: liquidity (current ratio above or below the industry's), efficiency (asset turnover), profitability (margins, ROE) and leverage (debt ratios). A firm with a higher current ratio, lower margins and ROE, and a lower debt-to-capital ratio than its industry, for instance, is more liquid, less profitable and less leveraged than its peers.

LOS 37.d — DuPont analysis of return on equity

DuPont analysis breaks return on equity (ROE) into component ratios so the analyst can see why ROE is high, low or changing. It decomposes ROE; it is not a different way to measure it. When net income and equity are known, ROE is simply one divided by the other. Average or year-end equity can be used, as long as the choice is consistent.

Two-part decomposition

Original (three-part) DuPont equation

Multiplying ROA by revenue/revenue splits it into margin and turnover:

The third term is the financial leverage ratio (equity multiplier, or leverage ratio) from Module 37.2. A low ROE must come from a poor net profit margin, poor total asset turnover, too little leverage, or a mix of these. Because revenue/equity is equity turnover, ROE also equals net profit margin × equity turnover.

Extended (five-part) DuPont equation

The net profit margin is split into three pieces:

• Tax burden = NI/EBT = $1-\text{tax rate}$. A lower ratio means heavier taxes; with positive pretax income, higher taxes reduce ROE.
• Interest burden = EBT/EBIT. More interest relative to EBIT lowers the ratio, which is a heavier interest burden.
• EBIT margin = EBIT/revenue. If operating income replaces EBIT, the term becomes the operating margin and the interest burden term also captures nonoperating income.
• Tax burden × interest burden × EBIT margin = net profit margin, so the five-part and three-part results must agree.

Leverage cuts both ways. Borrowing helps shareholders only when the assets it funds earn more than the debt costs. Higher leverage raises the equity multiplier but also raises interest expense, which lowers the interest burden ratio. ROE rises with leverage only if the multiplier effect outweighs the fall in the interest burden ratio. For a profitable firm (positive net income and positive equity), holding all other components constant, a higher asset turnover or a higher net profit margin raises ROE. The condition matters. With a net loss, a higher asset turnover makes ROE more negative, and with zero net income it leaves ROE unchanged.

Worked example

Example. Arbutus Freight reports revenue of $1,600, EBIT of $192, interest expense of $32, taxes of $40, average total assets of $1,280 and average total equity of $640.

• Net income $=192-32-40=120$; EBT $=160$; ROE $=120/640=18.75\%$.
• Three-part: $\frac{120}{1,600}\times \frac{1,600}{1,280}\times \frac{1,280}{640}=0.075\times 1.25\times 2.0=18.75\%$.
• Five-part: $\frac{120}{160}\times \frac{160}{192}\times \frac{192}{1,600}\times 1.25\times 2.0=0.75\times 0.8333\times 0.12\times 1.25\times 2.0=18.75\%$.

Comparing two firms. A firm can earn a higher ROE with less leverage if its EBIT margin and asset turnover are clearly better. The five-part decomposition shows whether tax, interest, operating margin, efficiency or leverage explains the gap.

Solving for a missing component. Rearrange the identity. For example, net profit margin $=\text{ROE}/(\text{asset turnover}\times \text{leverage})$, then net income $=\text{margin}\times \text{revenue}$, and equity $=\text{net income}/\text{ROE}$.

Example. Oriel Stores and Paxton Goods both earn an ROE of 12%. Oriel has revenue of $450, average total assets of $300 and average total liabilities of $120, so its average equity is $180. Paxton has revenue of $900, average total assets of $900 and average total liabilities of $600, so its average equity is $300.

• Oriel: asset turnover $=450/300=1.50$, leverage $=300/180=1.667$, net profit margin $=0.12/(1.50\times 1.667)=0.12/2.50=4.8\%$.
• Paxton: asset turnover $=900/900=1.00$, leverage $=900/300=3.00$, net profit margin $=0.12/(1.00\times 3.00)=0.12/3.00=4.0\%$.

The same ROE comes from different sources. Oriel earns it with a higher margin and faster turnover; Paxton relies on more leverage.

LOS 37.e — Industry-specific ratios

Every industry has its own key performance indicators, so part of an analyst's skill is choosing the ratios that matter for the business being analyzed.

Regulators often require financial institutions to keep certain ratios above minimums or below maximums:

• Capital adequacy is a monetary measure of the firm's operational and financial risk relative to its equity capital. Regulators monitor it so that the firm has a buffer to absorb losses and to limit contagion across the banking system.
• Value at risk (VaR) is a common measure of capital risk. It estimates the size of loss that the firm will exceed only a specified percentage of the time over a specified period. This minimum loss in the worst outcomes is equivalent to the maximum loss at the stated confidence level: a 5% one-month VaR is the minimum loss in the worst 5% of months, which is also the maximum loss with 95% confidence. VaR is not the worst possible loss, because larger losses can still occur.
• Reserve requirements set a minimum level of eligible reserves (such as balances at the central bank) relative to a bank's reservable liabilities. Exam convention: banks are subject to minimum reserve requirements. Current practice: some central banks now set the minimum at zero.
• A liquid asset requirement requires a bank's liquid assets to be at least a stated proportion of certain of its liabilities.

Business risk and the coefficient of variation

The standard deviations of revenue, operating income and net income measure how variable (uncertain) a firm's results are, but they grow with firm size. The coefficient of variation (CV) is the size-adjusted version:

A CV is variation per unit of the item, so it says nothing about the level of sales or income. Comparing CVs over time or across peers helps assess business risk:

• The CV of sales measures revenue stability (sales risk).
• The CV of operating income combines sales risk with the cost structure (operating leverage), which together make up business risk. On its own it cannot show whose operating costs are more volatile, because it also depends on how large costs are relative to sales.
• The CV of net income adds the effect of financial leverage (interest), taxes and nonoperating items.

LOS 37.f — Ratio analysis in modeling and forecasting earnings

Pro forma (projected) statements start from a forecast of next-period revenue. Other items are then tied to revenue with ratios the analyst expects to hold:

• If COGS as a percentage of sales is expected to stay constant, the common-size COGS percentage is applied to forecast sales to get forecast COGS (and gross profit).
• Without information suggesting a change, the prior-period operating profit margin can be applied to forecast sales to estimate operating profit.
• Ratios can also be moved in a chosen direction when the analyst expects a change.

Expense items are forecast as percentages of sales, the base of the common-size income statement, and not as percentages of net income.

Instead of relying on single point estimates, the analyst can study the range of outcomes: