FINANCIAL STATEMENTS ANALYSIS
The financial data contained in the financial statements should be evaluated to determine the
financial position and operating performance of the business.
Financial statements analysis is the process of assessing the financial condition, operating
performance and viability of an enterprise. It is a powerful and effective measurement tool which
assists financial statement users in making informed judgment and decisions. Figures and
disclosures in the financial statements alone will not give the user a complete picture of the
company’s health. The use of financial statements analysis requires the use of formulas that
convert figures into ratios, percentages and turnovers in order to facilitate the interpretation of
financial statements.
THE FINANCIAL STATEMENTS
The financial statements prepared at the end of the accounting period are the following:
Statement of Comprehensive Income
It provides a summary of the business’ operating results during a specified period. The result of
business operation could be a net income, net loss, or break-even.
Statement of Financial Position
It presents information on the firm’s financial condition as of a given date. It provides information
about the company’s liquidity, solvency, financial structure and capacity for adaptation.
Statement of Changes in Equity
It presents the owner/s investments, withdrawals made and net income earned or net loss incurred
during a given period of time. It shows the ending balance of the owner/s’ capital at the end of a
certain period of time.
Statement of Cash Flows – It shows the summary of cash flows of a firm over a given period of
time. The statement provides an insight as to the firm’s operating, investing, and financing cash
flows and reconciles them with the changes in its cash and cash equivalents during the period.
Notes to Financial Statements
These are detailed information on the accounting policies, procedures, calculations, and
transactions underlying the assertions found on the face of the financial statements. The notes to
the financial statements usually include a brief background of the company, a description of the
accounting policies used in preparing the financial statements, a breakdown of the items that
comprise the line items and other disclosures such as but not limited to income taxes, debt and
lease terms and contingencies.
TOOLS USED IN FINANCIAL STATEMENTS ANALYSIS
There are three tools used in analyzing financial statements, these are:
1. Horizontal Analysis – The comparison of financial statements across several time periods,
showing both absolute and relative changes.
2. Vertical Analysis – It is an analysis tool that converts the peso amounts of the components of
the financial statements into percentages of some base item which is given a weight of 100%. All
other components of the financial statements are expressed as a certain percentage of a selected
base. This tool analyzes the relative importance of a component item in the financial statements in
relation to the base.
3. Ratio Analysis – It is a method of financial evaluation whereby certain relationships between
various financial statements items are highlighted by computing certain ratios and evaluating them
in relation to other information about other firms, the industry and the economy. Ratios are also
referred to as summary indicators which take the form of amounts, ratios, and other computations
that detail some key information about businesses.
HORIZONTAL ANALYSIS
Information contained in the current year financial statements are made more useful when
presented alongside with prior years’ financial statements. Horizontal analysis is a tool used in
financial statements analysis which requires the determination of absolute and relative changes in
financial items across several time periods. This type of analysis is employed through the use of
comparative statements and trend ratios.
Comparative Statements
The preparation of comparative statements facilitates the determination of absolute and
relative changes in financial statements. The financial statements of the present year are presented
together with the financial statements of the previous year. Absolute and relative changes are
determined through the following computations:
Absolute change
=
Relative change (%) =
Peso amount current year – Peso amount base year
(Peso change / Base year or earlier year) x 100
Illustration: The following comparative statements of comprehensive income were provided by
ACSTAT Company:
ACSTAT
Comparative Statements of Comprehensive Income
For the years ended December 31
Net Sales
Cost of Sales
Gross Income
Operating Expenses
Net Income
2021
2020
5,000,000.00
3,000,000.00
2,000,000.00
1,200,000.00
800,000.00
4,000,000.00
2,800,000.00
1,200,000.00
780,000.00
420,000.00
The absolute and relative changes were determined as follows:
Absolute
Change
1,000,000.00
200,000.00
800,000.00
420,000.00
380,000.00
Relative
Change
25%
7%
67%
54%
90%
On Net Sales:
Absolute change
=
Peso amount current year – Peso amount base year
=
5,000,000 – 4,000,000
=
1,000,000
Relative change (%) =
(Peso change / Base year or earlier year) x 100
=
(1,000,000 / 4,000,000) x 100
=
25%
The following must be observed when determining absolute and relative changes:
1. If the figure for the base year is zero or negative, an absolute change can be determined.
However, a relative change cannot be calculated.
2. If the figure for the current year is zero, absolute and relative changes can be determined where
the latter is always equal to 100%.
3. If the figure for the current year is negative, absolute and relative changes can be determined.
However, the relative change must be higher than 100%.
Trend Analysis
Financial statements are analyzed in order to assess the past financial performance and
conditions of a firm so as to properly plan for the future. Financial analysis plays an important role
in the budgeting process since it provides certain financial data and analysis that are used in
predicting the company’s future performance and position. The use of trend analysis that are used
in company in predicting the future behavior of an item in the financial statements. Trend analysis
requires the use of trend ratios which are computed based on the comparative data provided by the
firm. The earliest year for a particular item is assigned as weight of 100%. All other years are
decimals or whole numbers. A trend ratio is determined as follows:
Trend ratio
=
[absolute amount (succeeding year) / absolute amount (base year)] x 100
Illustration: ACSTAT Company presented the following comparative statements of
comprehensive income for the years 2019 – 2021:
ACSTAT Company
Comparative Statements of Comprehensive Income
For the years ended December 31,
2021
Net Sales
5,000,000.00
Cost of Sales
3,000,000.00
Gross Income
2,000,000.00
Operating Expenses 1,200,000.00
Net Income
800,000.00
2020
4,000,000.00
2,800,000.00
1,200,000.00
780,000.00
420,000.00
2019
2,500,000.00
1,750,000.00
750,000.00
500,000.00
250,000.00
Trend Ratios
2021
2020
2019
200
160
100
171
160
100
267
160
100
240
156
100
320
168
100
The trend ratios for net sales were determined as follows:
2019 (base year)
=
100
2020
=
(4,000,000 / 2,500,000) x 100
=
160
=
(5,000,000 / 2,500,000) x 100
=
200
2021
VERTICAL ANALYSIS
Vertical analysis is a technique used in the analysis of financial statements that presents
each line item in the financial statements as a percent of certain baseline item. The procedure
requires the identification of the item which will serve as the base and which will be assigned a
weight of 100%. All other items in the statement are then expressed in relation to the chosen
particular base. This tool helps the analyst in determining the relative importance of items that
comprise a particular base. It satisfies both intra-comparability and inter-comparability of financial
statements. Intra-comparability refers to the comparison of the company’s current financial
statements with previous ones. Vertical analysis will help the company in identifying changes or
movements in the items that comprise a certain base. Inter-comparability on the other hand refers
to the comparison between or among companies that operate in the same industry. The absolute
size of companies may hinder them in properly comparing their financial performance and
condition. To facilitate both intra-comparability and inter-comparability, analysts use commonsize statements which are actually financial statements presented in percentage form and
component ratios which show the relative weight of a particular component item in relation to
the base. Component ratios are arrived at as follows:
Component ratio
=
(item or component of a statement / baseline item) x 100
Common Baseline Items Used in Vertical Analysis
1. Net Sales – Statement of Comprehensive Income
2. Total Assets (Total Liabilities and Shareholders’ Equity) – Statement of Financial Position
3. Total Operating/Investing/Financing Cash Flows – Statement of Cash Flows
4. Total Shareholders’ Equity – Statement of Changes in Equity
Illustration
ACSTAT Company presented the following comparative statements of comprehensive
income for the years 2020 and 2021:
ACSTAT Company
Comparative Statements of Comprehensive Income
For the years ended December 31,
Net Sales
Cost of Sales
Gross Income
Operating Expenses
Net Income
2021
5,000,000.00
3,000,000.00
2,000,000.00
1,200,000.00
800,000.00
2020
4,000,000.00
2,800,000.00
1,200,000.00
780,000.00
420,000.00
2021
100.00%
60.00%
40.00%
24.00%
16.00%
2020
100.00%
70.00%
30.00%
19.50%
10.50%
Note that other items in the statement are expressed as a percentage of the net sales which
was identified as the baseline item for purposes of analysis.
RATIO ANALYSIS
Financial ratios are mathematical representations of the significant relationships among the
items found in the financial statements. As indicators of financial performance and condition, they
are used to highlight possible areas of strengths and weaknesses in terms of the organization’s
profitability, liquidity and stability.
Ratio analysis is one of the major techniques used in financial statements analysis. It is
useful to both the management and the external stakeholders of the company. The company’s
management uses ratio analysis in evaluating and monitoring its custodianship function on the
resources of the business. It should be able to properly appraise whether the company’s current
operations are well within the bounds of prior years’ performance, budgets, and performances of
other companies belonging in the same industry. External stakeholders on the other hand use the
financial ratios of a given company in order to assess its viability and sustainability. This will guide
them in the decision-making process pertaining to the company’s competitiveness. Due to the
foregoing significance of the financial ratios, due care and diligence must be observed when
calculating for ratios in as much the financial statements analysis process does not end in the
determination of the same but extend up to the analysis and the eventual interpretation of its effect
on the overall health of the business.
Significance of Financial Ratios
Financial ratios help the firm and its stakeholders in the proper analysis and interpretation
of the items that affect the economic decisions that they make. Specifically, financial ratios:
a) serve as financial indicators on the performance of a business
b) provide logical solutions to financial problems; and
c) indicate areas of possible of strengths and weaknesses of the company.
Interested Parties
The following are among the interested parties in the affairs of the business:
1. Shareholders – interested in the firm’s current and future level of risk and returns which
directly affects share price.
2. Creditors – interested in the short-term liquidity, profitability and the ability of the
company to make interest and principal payments.
3. Managers – interested in all aspects of the firm’s financial performance and condition.
4. Suppliers – interested in the liquidity and ability of the company to pay deliveries of
merchandise.
5. Employees – interested in the profitability, liquidity and ability the company to pay basic
salaries and future benefits.
TYPES OF RATIO COMPARISONS
Cross-sectional Analysis
It refers to the comparison of different financial ratios during the same period of time.
1.1 Benchmarking – an application of the cross-sectional analysis where the firm’s ratios
are compared with the ratios of key competitors
1.2 Industry Average – a variant of the cross-sectional analysis where the firm’s ratios are
compared with industry averages. The use of industry averages is not particularly useful
for analyzing firms with multi-products.
Time Series Analysis
It refers to the comparison of the firm’s current financial ratios with those of the prior years. It
intends to evaluate the performance of the firm over time.
Combined Analysis
It refers to the most informative approach to ratio analysis which combines cross-sectional and
time-series analyses. It assesses the trend in the behavior of the ratio in relation to the trend
prevailing in the industry.
Guidelines to be Observed When Using Financial Ratios
o Ratios with large deviations from the norm merely indicate some symptoms of a problem.
Again, ratios are just indicators of the possible occurrence of a certain item, therefore,
further analysis and investigation is to be made on the deviations brought out by the ratios.
o A single ratio does not provide sufficient information about a firm. Ratios must be related
with one another to enhance the analysis and interpretation of the firm’s financial condition
and performance.
o Ratios being compared should be calculated on financial statements of the same accounting
period being analyzed.
o Audited financial statements must be used when applying ratio analysis.
o Accounting policies must be applied consistently over time to facilitate the analysis and
interpretation of the financial statements. Changes made in the accounting treatment of
items must be noted in order to prevent misinterpretation of the same.
o Inflation and other economic factors can distort the use of ratio analysis.
CATEGORIES OF FINANCIAL RATIOS
LIQUIDITY RATIOS
Liquidity
It is the firm’s ability to satisfy its short-term obligations as they fall due. The more liquid the firm,
the more likely it is to be able to pay its employees, suppliers and holders of its short-term debts.
Basic Measures of Liquidity
Working Capital
Working capital is the difference between the firm’s current assets and current liabilities. It
measures the sufficiency of current assets to meet the firm’s obligations and to support current
operations.
Working Capital
=
Current Assets – Current Liabilities
Current Ratio
It is a measure of the firm’s ability to meet its short-term obligations. It takes into account
differences in absolute size. It can be used to compare firms of different sizes in terms of total
current assets base and total current liabilities base. If the current assets of a company are more
than twice the current liabilities, then the company is generally considered to have a good shortterm financial strength. If current liabilities exceed current assets, then the company may have
problems meeting its short-term obligations.
Current Ratio
=
Current Assets
Current Liabilities
Quick (Acid Test) Ratio
It is a measure of the firm’s liquidity which considers only cash and other current asset items that
are very near to being realized into cash. The quick ratio provides a better measure of overall
liquidity only if the firm’s inventory cannot be easily converted into cash. In general, a quick ratio
of 1 or more is favored by most creditors; however, quick ratios vary greatly from industry to
industry.
Factors why inventory is excluded:
1. Many types of inventories cannot be sold easily because they are partially completed items
and/or are held for special purposes.
2. Inventory is typically sold on credit
Quick Ratio
=
Current Assets - Inventory
Current Liabilities
Components Percentages (Ratio of Each Current Asset Item to Total Current Assets)
It indicates the liquidity of the total current assets and the distribution thereof to the items that
comprise it. The use of totals like total current assets and total current liabilities may mask the
information that would be conveyed by looking at the components of the total individually. To
address this problem, the financial manager reviews the potential magnitude of the composition
problem and checks the extent to which current assets are made up of relatively liquid items.
Ratio of Each Current Asset Item
to Total Current Assets
=
Each Current Asset Item
Total Current Assets
Cash Ratio / Absolute Liquidity Ratio
It is the most conservative liquidity ratio. It indicates the ability of the firm to pay its current
obligations, if for some reasons, immediate payment is demandable.
Cash Ratio
=
Cash + Cash Equivalents
Total Current Assets
ACTIVITY RATIOS
This measures the speed with which various accounts are converted into revenues or cash inflows
or outflows. These ratios are also known as efficiency or turnover in as much as they measure the
firm’s efficiency in utilizing its resources.
Total Asset Turnover
Indicates the efficiency with which the firm uses its assets to generate sales. The asset turnover
ratio measures the amount of revenues earned by the firm for every peso of asset utilized.
Total asset turnover
=
Net Sales
Average Total Assets
Merchandise Inventory (Finished Goods Inventory) Turnover
It measures the activity or liquidity of a firm’s inventory. Specifically, it measures the number of
times average inventory is turned over to the company’s customers. Further, the ratio is also used
to indicate over or under investment in inventory. The resulting inventory turnover should be
compared with other firms in the same industry to make it more useful and meaningful. A high
inventory turnover, in general, indicates that the company holds fast moving inventory in its stock
which, in effect, decreases the company’s cost of investment in the same because of the decrease
in inventory handling cost.
Inventory Turnover
=
Cost of Goods Sold
Average Inventory
Average Age of Inventory
This ratio identifies the average length of time in days it takes the company to turnover (sell) its
inventory. The shorter is the age of the inventory, the faster and more efficient is the company in
selling the same.
Average Age of Inventory
=
360 days
Inventory Turnover
Work In Process Inventory Turnover
It indicates the number of times average work in process inventory was manufactured during the
period.
Work in Process Turnover
=
Cost of Goods Manufactured
Average Work In Process Inventory
Number of Days to Process Average Age Inventory
Indicates the length of time needed to complete the manufacturing process.
No. of Days to Process Average Inventory
=
360 days
Work in Process Inventory Turnover
Raw Materials Inventory Turnover
Indicates the number of times average inventory was used during the period.
Raw Materials Inventory Turnover
=
Raw Materials Used
Average Raw Materials Inventory
No. of Days Usage in Average Inventory
Indicates the number of days required to consume average raw materials inventory. It is used in
the determining the sufficiency of materials available for use in production.
No. of Days' Usage in Average Inventory
=
360 days
Raw Materials Inventory Turnover
In general, high turnover rates may indicate that the inventory levels are too low. In this
case, it is possible that operations are sometimes hampered by non-availability of inventory items
and orders are placed more frequently resulting in high ordering cost. On the other hand, low
turnover rates may indicate that inventories are slow-moving thereby increasing the company’s
storage cost.
Accounts Receivable Turnover
It indicates the number of times average amount of receivables is collected during the period. It is
useful in evaluating the firm’s efficiency in realizing its receivables. By maintaining accounts
receivable, firms are in effect, indirectly extending interest-free loans to their clients. Further,
opportunity cost is tied up on accounts that are outstanding. These necessitate the firms to
periodically review their credit and collection policies in order to ensure the sustainability of their
operations. A high ratio implies that the firm’s credit extension and collection policy is efficient.
A low ratio on the other hand, indicates inefficiency in managing receivables.
Accounts Receivable Turnover
=
Net Credit Sales
Average Accounts Receivable
Average Collection Period
It indicates the number of days needed to collect or realize average receivables.
Average Collection Period
=
360
Accounts Receivable Turnover
Accounts Payable Turnover
The payable turnover indicates the number of times the average accounts payable are paid during
a given period and is used in determining whether a business entity is able to pay its suppliers on
or before maturity date. A low turnover ratio indicates that the business has either decided to hold
on its money longer and stretch its payables or it is indeed having a hard time paying its creditors.
The analyst should compare the receivable turnover rate with the turnover rate of the accounts
payable to determine the gap between collection period and the length of time before payables are
paid so the proceeds from sales can be used for the payment of the latter.
Accounts Payable Turnover
=
Net Credit Purchases
Average Accounts Payable
Average Payment Period
It is a short-term liquidity measure which is used to quantify the rate at which a company pays off
its suppliers. It is the average amount of time needed to pay accounts payable. A decrease in the
ratio is a sign that the company is taking a longer time to pay off its suppliers that it was before.
An increase on the other hand indicates that the company is able to pay off its liabilities within a
short period of time. The length of time it takes the company to settle its obligations directly
impacts its credit worthiness. Hence, care should be exercised when managing the firm’s accounts
payable.
Average Payment Period
=
360
Accounts Payable Turnover
SOLVENCY RATIOS
Solvency ratios help the company in analyzing its abilities in meeting the payment requirements
of its long-term debts. It indicates the company’s ability in satisfying the repayment of the principal
of a long-term debt as well as meeting its interest payment requirements.
Debt
An amount owed to a person or organization for funds borrowed. Debt can be represented
by a loan note, bond, mortgage, or other form stating repayment terms and if applicable, interest
requirements. These different forms all imply intent to pay back an amount owed on a specific
date, which is set forth in the repayment terms.
The debt position of a firm indicates the amount of other people’s money being used to
generate profits. In general, the financial analyst is most concerned with long-term debts, because
these commit the firm to a stream of contractual payments over the long run. The more debt a firm
uses in relation assets, the greater is its financial leverage.
Financial Leverage
It is a term used to describe the magnification of risk and return resulting from the use of
fixed-cost financing such as debt and preferred stock.
There are two general types of debt measures. These are the measures of the degree of
indebtedness and measures of the ability to service debts.
The degree of indebtedness measures the amount of debt relative to other significant balance
sheet amounts. A popular measure of it is the debt ratio.
Debt Ratio
This indicates the degree by which the company relies on debt to finance assets. When calculating
this ratio, it is conventional to consider both current and non-current debt assets. In general, the
lower the company’s reliance on debt for asset formation, the less risky the company’s position is
since excessive debt can lead to a very heavy interest and principal repayment burden. However,
when a company chooses to forego debt and rely largely on equity, they are also giving up the tax
deduction effect of interest payments. Thus, a company will have to consider both risk and tax
issues when deciding on an optimal debt ratio.
Debt ratio
=
Total Liabilities / Total Assets
Equity Ratio
This ratio indicates the level of reliance of the company on invested capital to finance its assets. In
general, the higher the company’s reliance on equity for asset formation, the less risky the
company’s position is. However, the firm foregoes its opportunity to enjoy tax reductions arising
from the interest that will have to be incurred on borrowings each time it chooses to rely more on
equity financing. Again, the company will have to consider both risk and tax issues when deciding
on an optimal equity ratio.
Equity Ratio =
Total Shareholders’ Equity / Total Assets
Debt to Equity Ratio
This ratio measures the proportion of borrowed capital to the capital provided by the owners. The
higher the reliance of the company on debt in financing its assets, the higher the debt to equity
ratio.
Debt-Equity ratio
=
Total Liabilities / Shareholders’ Equity
The ability to service debts reflects a firm’s ability to make the payments required on a
scheduled basis over the life of a debt. The firm’s ability to pay certain fixed changes is measured
using coverage ratios.
Two popular coverage ratios are the times interest earned and the fixed-payment coverage
ratio.
Times Interest Earned Ratio
The times interest ratio indicates the extent by which earnings are available to meet interest
payments. It shows the company’s ability to pay fixed interest charges. A lower times interest
earned ratio means less earnings are available to meet interest payments and that the business is
more vulnerable to having defaults in satisfying fixed interest charges.
Times interest earned ratio
=
earnings before interest and taxes / interest
PROFITABILITY RATIOS
These are ratios that enable the analyst to evaluate the firm’s profit with respect to a given level of
sales, a certain level of assets, or the owners’ investment.
Common-size Income Statement
It is an income statement in which each items are expressed as a percentage of net sales. It is also
called as Percent Income Statement. There are three readily seen ratios from this statement, the
Gross Profit Margin, Operating Profit Margin, and the Net Profit Margin.
Gross Profit Ratio
It indicates the gross margin per peso of net sales. It is used in determining the adequacy of gross
margin to cover operating expenses and provide desired profit.
Gross Profit Ratio
=
Net Sales - Cost of Goods Sold
Net Sales
=
Gross Profit
Net Sales
Operating Profit Ratio
It indicates the operating margin per peso of net sales. It shows the portion of net sales that remain
after all costs and expenses, but before interest, taxes, and preference share dividends are deducted.
Operating Profit Ratio
Gross Profit - Operating Expenses
Net Sales
=
=
Operating Profit
Net Sales
Net Profit Ratio
It indicates the amount of net income per peso of net sales. It shows the portion of net sales that
remain after all costs and expenses, interest, and taxes are deducted.
Net Profit Ratio
Operating Profit - Interest - Taxes
Net Sales
=
=
Net Profit
Net Sales
Earnings per Share (EPS)
It indicates the amount earned attributable to every ordinary share capital outstanding during the
period.
Earnings Per Share
=
Net Income - Preference Share Dividends
Average Number of Ordinary Shares Outstanding
Dividends per Share
It shows the amount of earnings distributed to each ordinary share.
Dividends Per Share
=
Dividends Paid/Declared to Ordinary Shares
Number of Ordinary Shares Outstanding
RATE OF RETURN CONCEPT
The Rate of Return concept is employed to evaluate the earning power of a firm. It reveals
the relationship between the net earnings and sales revenue, net earnings and the net assets
employed and net earnings and the owners’ interest in the business.
Rate of Return on Sales (ROS)
It is the Net Profit Ratio seen on the Common-Size Income Statement.
Rate of Return on Total Asset (ROA)
It measures the overall effectiveness of management in generating profit with its available
assets. Also called Rate of Return on Investment.
Rate of Return on Total Asset (ROA)
=
Net Profit
Average Total Assets
Rate of Return on Ordinary Equity (ROE)
It measures the return earned on the ordinary shareholders’ investment in the firm
Rate of Return on Ordinary Equity (ROE)
=
Net Profit - Preference Dividends
Average Ordinary Share Equity
MARKET RATIOS
Relates the firm’s market value, as measured by its current share price, to certain accounting
values.
Price/Earnings (P/E) Ratio
It shows the amount that investors are willing to pay for every peso of a firm’s earnings. It further
indicates the relationship between market price and earnings on each share. The degree of
confidence that investor have in the firm’s future performance is reflected in this ratio. Generally,
investors are willing to pay higher prices for shares that have higher earnings.
Price/Earnings (P/E) Ratio
=
Market Price Per Share of Ordinary Share
Earnings Per Share
Dividend Yield
It indicates the ratio of dividends per share to the share’s market price.
Dividend Yield Ratio
=
Cash Dividends per Ordinary Share
Market Price Per Share of Ordinary Share
Market Price to Book Value per Share (M/B) Ratio
This ratio provides an assessment of how investors view the firm’s performance. It indicates
whether the stock is undervalued or not. To get the firm’s M/B ratio, first get the Book Value per
Share of Ordinary Share.
Book Value Per Share of Ordinary Share
Ordinary Share Equity
Number of Ordinary Shares Outstanding
=
Then substitute the computed value of the M/B Ratio formula
Market Price to Book Value per Share Ratio
=
Market Price per Share of Ordinary Share
Book Value Per Share of Ordinary Share
COMPLETE RATIO ANALYSIS
1. Summarizing All Ratios
- An approach that views all aspects of the firm’s activities to isolate key areas. It also
shows the formula for each ratio. The summary of ratios – liquidity, activity, debt, profitability
and market – is used to perform the complete ratio analysis using the cross-sectional and time
series analysis.
2. DuPont System of Analysis
- It is used to dissect the firm’s financial statements and to assess its financial performance
and condition. The income statement data and the balance sheet data are merged to measure the
profitability of the firm into two summary ratios: Return on Total Assets and Return on Ordinary
Equity.
DuPont Formula:
Return on total assets (ROA) = Net profit margin x Total asset turnover
Modified DuPont Formula:
Return on ordinary equity (ROE) = ROA x Financial leverage multiplier (FLM)
Financial leverage multiplier
-
It refers to the firm’s ratio of total assets to ordinary share equity
Financial leverage multiplier
=
Total Assets
Ordinary Share Equity
The DuPont system of analysis is a diagnostic tool used to find the key areas responsible
for the firm’s financial performance. It enables the firm to break the return into three components:
profit on sales, efficiency of asset use, and use of leverage. The DuPont system of analysis makes
it possible to assess all aspects of the firm’s activities in order to isolate key areas of responsibility.
Comprehensive Illustration on Ratio Analysis:
(Refer to FINANCIAL STATEMENTS ANALYSIS Excel file)