2: Financial Statement and Cash Flow AnalysisThe advantage of the DuPont system is that it allows the company to break its return on ordinary
equity into three components tied to the financial statements: (1) a profit-on-sales component (net profit
margin) that ties directly to the income statement; (2) an efficiency-of-asset-use component (total asset
turnover) that ties directly to the balance sheet; and (3) a financial leverage use component (assets-to-
equity ratio) that also ties directly to the balance sheet. Analysts can then study the effect of each of
these factors on the overall return to ordinary shareholders, as demonstrated in the following example.^8exampleThe 2016 ratio values for the ROE, ROA, assets-
to-equity ratio, total asset turnover and net profit
margin calculated earlier for GPC are shown below,
along with industry averages for globally active oil
companies.Ratio GPC Industry
average
Return on ordinary equity (ROE ) 22.1% 19.7%
Return on total assets (ROA) 9.9% 12.1%
Assets-to-equity (A/E ) ratio 2.24 1.63
Totals asset turnover 1.34 1.42
Net profit margin 7.4% 8.5%We begin the analysis of GPC’s performance
during 2016 with its return on ordinary equity of
22.1%, which is noticeably above the industry
average of 19.7%. To learn why GPC’s ROE
outperformed the industry, we look at two
components of ROE: ROA and the assets-to-equity
(A/E) ratio. We see that GPC’s ROA of 9.9% was
well below the industry average of 12.1%. Butthanks to its greater use of leverage – an A/E ratio
of 2.24 for GPC versus 1.63 for the industry –
GPC was able to generate a higher ROE than the
average company.
Looking further at the two components of ROA
(the net profit margin and the total asset turnover),
we see that GPC’s total asset turnover of 1.34 is
very close to the industry average of 1.42. However,
its net profit margin of 7.4% is below the industry
average of 8.5%, which caused GPC’s ROA to be
below the industry average, too. This suggests that
GPC was less able than its competitors to manage
costs and generate a profit on sales.
In summary, GPC compensated for its below-
average ROA by using significantly more leverage
than its competitors. Clearly, GPC took greater risk
in order to compensate for low profits on sales. The
company should focus on its income statement to
improve its profitability and also should consider
reducing its leverage to moderate its risk. It appears
that GPC has problems in both its income statement
(net profit margin) and its balance sheet (assets-to-
equity ratio).2-3f MArKET rATIOS
Market ratios relate the company’s market value, as measured by its current share price, to certain
accounting values. These ratios provide insight into how investors think the company is performing,
and they also reflect the ordinary shareholders’ assessment of the company’s past and expected future
performance. Here, we consider two popular market ratios, one that focuses on earnings and another
that considers book value.8 Keep in mind that the ratios in the DuPont system are interdependent, and that the equation is just a mathematical identity. It is easy to draw
questionable conclusions about lines of causality using the DuPont system. For example, consider this farcical version of the formula:ROA
Earningsavailableforordinaryshareholders
SalesSales
AssetsAssets
CEOageCEOage
Ordinaryshares=×××
In this equation, we might interpret the third term on the right as the efficiency with which a CEO of a given age manages the company’s
assets. If a younger CEO manages the same quantity of assets, then this ratio would increase and, holding all other factors constant, we could
say that the company’s ROA would increase. This is clearly silly, but mathematically this expression ultimately gives you the company’s ROA.LO2.5
What financial ratios might you
review in order to gain insight
into how investors think a
company is performing? Does
your choice of ratio depend on
the industry in which a company
operates?thinking cap
questionSee the concept explained
step by step on the
CourseMate website.SMArT
CONCEPTS