Beruflich Dokumente
Kultur Dokumente
Financial Management
Financial Management focuses on decisions of an entity relating to how
much and what types of assets to acquire, how to raise the capital needed to
purchase assets, and how to run the firm so as to maximize its value
(Brigham 2014). This refers to how efficient and effective a financial entity
manages its funds to achieve its organizational objectives. The main goal of
financial management is to maximize shareholders wealth, not accounting
measures such as revenues or return on equity (ROE). However, accounting
data affect stock prices, and this data can be used to see why a company is
performing the way it is and where it is heading (Houston 2009). Financial
Management can also be viewed as the manner of how such entity make
economic decisions. Such decisions, if maintained in the long run, can have
an implication to the financial strategy of the entity including, but not limited to
operational efficiency, asset effectiveness and capital structure. However, for
this study, implications to financial management should be limited to
organizational decisions with regard to operational efficiency, asset
effectiveness and capital structure to match against the components of return
on equity using DuPont analysis.
Return on Equity
Return on equity (ROE) is a profitability ratio that provides investors insight
into how efficiently a company (or more specifically, its management team) is
managing the equity that shareholders have contributed to the company
(Fuhrmann 2015). Mathematically, it is computed by dividing the net income
(bottom-line profits reported on a firms income statement) over total
shareholders equity (assets minus liabilities on a firms balance sheet).
An example of applying return on equity as a profitability measure of a firm
is as follows:
DuPont Analysis
DuPont analysis is a method that can be used to further analyze return on
equity (ROE). According to DuPont analysis, ROE is influenced by three
factors: operational efficiency which is measured by profit margin, asset
effectiveness which is measured by total asset turnover, and capital structure
which is measured by equity multiplier (Pinsent 2014). Mathematically, ROE is
the product of three financial ratios: profit margin, total asset turnover and
equity multiplier. This implies that if ROE is relatively low, the firm could
experiencing a poor profit margin, a poor asset turnover, and/or has too little
equity multiplier.
Operational efficiency is the ability of a firm to deliver products or services
to its customers in the most cost-effective manner possible while still ensuring
the high quality of its products, service and support (Beal 2016). Operational
efficiency is often achieved by streamlining a company's core processes in
order to more effectively respond to continually changing market forces in a
cost-effective manner. Asset effectiveness describes how efficient a firm
deploys its assets to produce sales (Peavler 2016). If you have too much
invested in your company's assets, your operating capital will be too high. If
you don't have enough invested in assets, you will lose sales and that will hurt
your profitability, free cash flow, and stock price. Capital structure refers to
how a firm finances its overall operations and growth by using different
sources of funds: debt, equity and others (Kennon 2015). Debt comes in the
form of bond issues or long-term notes payable, while equity is classified as
common stock, preferred stock or retained earnings. Bonds are considered to
be less risky investments for at least two reasons. First, bond market (market
where debt instruments are traded) returns are less volatile than stock market
(market for trading equity instruments) returns. Second, should the company
run into trouble, bondholders are paid first, before other expenses are paid.
Shareholders are less likely to receive any compensation in this scenario
(Econ 2005). In addition, an example of other forms of capital is vendor
financing where a company can sell goods before they have to pay the bill to
the vendor without incurring any significant cost.
An example of applying DuPont analysis to determine the Return on Equity
(ROE) of a particular firm is as follows:
Elegance Company has the following account balances specially identified
from its 2015 Financial Statements:
Sales
$2,500,000
Total Assets
$5,000,000
Net Income
$450,000
$4,000,000
efficiently deployed its assets to generate revenue. This is also the reason
why the company has a higher return on equity relative to its industry despite
having the other two lower components.
Foreign Studies
A study (Radu et al. 2014) conducted in Alba Iulia, Romania, used the
DuPont model as a primary tool in conducting a performance analysis in the
construction industry of Romania. The main objective of the study is to
provide an analytical framework appropriate for observing factors that make
and influence financial profitability (indicated by return on equity); proposing
ways of growth for the construction industry in Romania. The DuPont analysis
was performed on a cluster of nineteen (19) companies from the construction
industry. The study also used Pearson correlation coefficient to measure the
strength of linear association between variables such as return on equity,
return on assets, return on sales, total asset turnover, equity multiplier, net
income and equity.
The study concluded that there is no significant correlation between net
income and total assets or net income and turnover. However, it was
determined that there is direct, reasonable correlation between net income
and equity. The study further recommended that for the construction industry
to improve its ROE, the companies should consider a growth in asset
utilization efficiency (indicated by return on asset) and operational efficiency
(indicated by return on sales or profit margin). Furthermore, The effect of
increasing the financial leverage (indicated by equity multiplier) would also
increase profitability, but has undesirable effects in the short run as excessive
indebtedness attracts risks of indebtedness that cannot be easily quantified by
the researchers because of a financial crisis in Romania caused by lack of
liquidity.
The study is similar to the researchers study in that both use DuPont
analysis to analyze factors that influence financial profitability of certain sector
and the companies under it. The differences between the study conducted in
Romania and the researchers study are the setting, time horizon and
objective of the study. The formers objective is to determine possible
correlations between variables used in DuPont analysis for one year to furnish
Local Studies
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Chapter 3
METHODOLOGY
(Short intro to inform readers about the different topics included in this
chapter)
Write in the past tense