394 CHAPTER 10 Analysis of Financial Statements
For MicroDrive, we have
The 12.7 percent rate of return could, of course, be calculated directly: both Sales and
Total assets cancel, leaving Net income/Common equity $113.5/$896 12.7%.
However, the Du Pont equation shows how the profit margin, the total assets
turnover, and the use of debt interact to determine the return on equity.
The insights provided by the Du Pont model are valuable, and it can be used for
“quick and dirty” estimates of the impact that operating changes have on returns. For
example, holding all else equal, if MicroDrive can drive up its ratio of sales/total assets
to 1.8, then its ROE will improve to (3.8%)(1.8)(2.23) 15.25%. For more a com-
plete “what if” analysis, most companies use a forecasting model such as the one de-
scribed in the next chapter.
Explain how the extended, or modified, Du Pont equation and chart can be used
to reveal the basic determinants of ROE.
What is the equity multiplier?
Comparative Ratios and “Benchmarking”
Ratio analysis involves comparisons—a company’s ratios are compared with those of
other firms in the same industry, that is, with industry average figures. However, like
most firms, MicroDrive’s managers go one step further—they also compare their ra-
tios with those of a smaller set of the leading computer companies. This technique is
called benchmarking,and the companies used for the comparison are called bench-
mark companies.For example, MicroDrive benchmarks against Apex Systems, Ca-
blenet, Carter Controls, BMR Corporation, Magnetic Sciences, and Luxor Corpora-
tion. MicroDrive’s management considers these to be the best-managed companies
with operations similar to its own. Here is the comparison of MicroDrive’s ROE ver-
sus those of the benchmark firms:
12.7%.
ROE(3.8%)(1.5)(2.23)
ROE
Cablenet 28%
Carter 26
BMR 22
Magnetic Sciences 19
Luxor 16
MicroDrive 13
Apex 9
Similar comparisons are made for the other key ratios, and this procedure allows man-
agement to see, on a company-by-company basis, how it stacks up against its major
competitors.
Many companies also benchmark various parts of their overall operation against
top companies, whether they are in the same industry or not. For example, Micro-
Drive has a division that sells hard drives directly to consumers through catalogs and
the Internet. This division’s shipping department benchmarks against L.L. Bean, even
390 Analysis of Financial Statements
