Introduction to Corporate Finance

2: Financial Statement and Cash Flow Analysis

the company’s ROE will exceed its ROA. Conversely, if the company’s earnings fall short of the amount

it must pay to lenders and preferred shareholders, the ROE will be less than ROA. For GPC, the return

on ordinary equity for 2016 was 22.1%, substantially above GPC’s return on total assets:

=

===

Returnoncommonequity

Earningsavailableforordinary shareholders

Ordinary shares

$946

$4,278

0.221 22.1%

DuPont System of Analysis

Financial analysts sometimes conduct a deeper analysis of the ROA and ROE ratios using the DuPont

system. This approach uses both income statement and balance sheet information to break the ROA and

ROE ratios into component pieces, or ‘drivers’ of their values. It highlights the influence of both the net

profit margin and the total asset turnover on a company’s profitability. In the DuPont system, the return

on total assets equals the product of the net profit margin and total asset turnover:

ROA = Net profit margin × Total assets turnover

By definition, the net profit margin equals earnings available for ordinary shareholders divided by

sales, and total asset turnover equals sales divided by total assets. When we multiply these two ratios

together, the sales figure cancels, resulting in the familiar ROA measure:

=×

=×=×==

ROA

Earningsavailableforordinary shareholders

Sales

Sales

Totalassets

$946

$12,843

$12,843

$9,589

0.074 1. 340.099 9.9%

ROA====

Earningsavailableforordinary shareholders

Totalassets

$946

$9,589

0.099 9.9%

DuPont system

An analysis that uses both

income statement and balance

sheet information to break

the ROA and ROE ratios into

component pieces

John Graham, Duke

University

‘We asked companies,

“Do you manage your

earnings?”’

See the entire interview on

the CourseMate website.

Source: Cengage Learning

COurSEMATE

SMArT VIDEO

ANALYSING YOUR PERSONAL FINANCIAL STATEMENTS

Imagine that in early 2017, you prepare an

abbreviated personal balance sheet and income

statement for the year just ended, 30 June 2016.

You also prepare a list of ‘Notes’ and then analyse

the statements using some popular personal

finance ratios, which are shown below. A review of

the statements and ratios should disclose great

similarity between personal and corporate financial

statements and ratios.

BALANCE SHEET AT, 30 JUNE 2016

Assets Liabilities and Equity

Total liquid assets $ 2,225 Total current liabilities $ 905

Total investments $ 5,750 Total long-term liabilities $104,850

Total real and pers. prop. $139,200 (2) Total liabilities $105,755

(1) Total assets $147,175 Net worth [(1)–(2)] $ 41,420

Total liab. and net worth $147,175

finance in practice