Chapter 4 Analysis of Financial Statements 111
The single most important ratio over which management has control is the
ROE—the other ratios are also important, but mainly because they a# ect the ROE.
One tool used to show how ROE is determined is the DuPont equation: ROE! Pro! t
margin " Total assets turnover " Equity multiplier. If the! rm’s ROE is below the in-
dustry average and that of the benchmark companies, a DuPont analysis can help
identify problem areas that should be strengthened. In later chapters, we consider
speci! c actions that can be taken to improve ROE and thus a! rm’s stock price. One
closing note: Although ratio analysis is useful, it must be applied with care and good
judgment. Actions taken to improve one ratio can have negative e# ects on some
other ratio or ratios. For example, it might be possible to improve the ROE by using
more debt, but the risk of the additional debt may lead to a decrease in the P/E ratio
and thus in the! rm’s stock price. Quantitative analysis such as ratio analysis can be
useful, but thinking through the results is even more important.
KEY TERMS Define each of the following terms:
a. Liquidity ratios: current ratio; acid test ratio
b. Asset management ratios: inventory turnover ratio; days sales outstanding (DSO);
fixed assets turnover ratio; total assets turnover ratio
c. Debt management ratios: debt ratio; times-interest-earned (TIE) ratio
d. Profitability ratios: operating margin; profit margin; basic earning power (BEP) ratio;
return on total assets (ROA); return on common equity (ROE)
e. Market value ratios: price/earnings (P/E) ratio; market/book (M/B) ratio
f. Trend analysis
g. DuPont equation
h. Benchmarking
i. “Window dressing” techniques
DEBT RATIO Last year K. Billingsworth & Co. had earnings per share of $4 and divi-
dends per share of $2. Total retained earnings increased by $12 million during the year,
while book value per share at year-end was $40. Billingsworth has no preferred stock, and
no new common stock was issued during the year. If its year-end total debt was $120 mil-
lion, what was the company’s year-end debt/assets ratio?
RATIO ANALYSIS The following data apply to A.L. Kaiser & Company (millions of
dollars):
Cash and equivalents $100.00
Fixed assets 283.50
Sales 1,000.00
Net income 50.00
Current liabilities 105.50
Current ratio 3.0#
DSOa 40.55 days
ROE 12%
a This calculation is based on a 365-day year.
SELF!TEST QUESTIONS AND PROBLEMS
"Solutions Appear in Appendix A
SELF!TEST QUESTIONS AND PROBLEMS
"Solutions Appear in Appendix A
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ST-2ST-2
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