Introduction to Corporate Finance

PArT 1: INTrODuCTION

Naturally, the ROA value for GPC in 2016 obtained using the DuPont system is the same value we calculated before. Yet now, seeing its two component parts, we can think of the ROA as a product of how much profit the company earns on each dollar of sales and the efficiency with which the company uses its assets to generate sales. Holding the net profit margin constant, an increase in total asset turnover increases the company’s ROA. Similarly, holding total asset turnover constant, an increase in the net profit margin increases ROA. We can push the DuPont system one step further by multiplying the ROA by the assets-to-equity (A/E) ratio, or the equity multiplier. The product of these two ratios equals the return on ordinary equity:

ROE = ROA – A/E

For a company that uses no debt and has no preferred shares, the assets-to-equity ratio equals 1.0, and so the ROA equals the ROE. For all other companies, the assets-to-equity ratio exceeds 1. We can apply this version of the DuPont system to GPC and thereby recalculate its return on ordinary equity in 2016:

=×

=×=×==%

ROE

Earningsavailableforordinary shareholders Totalassets

Totalassets Ordinaryshares $946 $9,589

$9,589 $4,278

0.099 2.24 0.221 22. 1

ROE====%

Earningsavailableforordinary shareholders Ordinary shares

$946 $4, 278

0.221 22. 1

Observe that GPC’s assets-to-equity ratio is 2.24. This means that GPC’s return on ordinary equity was more than twice as large as its return on total assets. Note also that if GPC’s return on total assets were a negative number, then the company’s return on ordinary equity would be even more negative than its ROA.

INCOME STATEMENT, YEAR ENDED 30 JUNE 2016 (1) Total income $73,040 (2) Total expenses $61,704 Cash surplus (deficit) [(1)–(2)] $11,336

Notes: Total current debts = $22,589 Total income taxes = $15,430 Total monthly loan payments = $1,807 Monthly gross (before-tax) income = $6,807

RATIOS Ratio Formula Calculation Interpretation Solvency ratio Totalnetworth Totalassets

==%

$41,420

$147,175

0.28128. 1

You could tolerate about a 28% decline in asset values before becoming insolvent.

Liquidity ratio Totalliquidassets Totcurrentdebts

==9.9%

$2, 225

$22, 589

0.099

You can cover only about 10% of 1-year debts with current liquid assets.

Savings ratio Cash surplus Income after taxes −

==%

$11,336

$73, 040 $15,430

0.197 19. 7

You saved 19.7% of your after-tax cash income during the year.

Debt service ratio

Totalmonthlyloanpayments Monthlygross (beefore-tax) income

$1,807

$6, 087

==0.297 29. 7 %

Your monthly loan payments account for about 30% of monthly gross income.