Analysis of Return on Stockholders Equity (ROE)

Uses

and Limitation of Ratio Analysis Du-Pont Analysis Du-Pont analysis of a company Window Dressing

Ratio Analysis is the most important tool of financial analysis.

The importance of ratio analysis can be summarized for the various groups: 1. For short term creditors: Liquidity Ratios like current ratio and quick ratio help to determine the firms ability to meet its obligations.

2. For long term creditors: With the help of solvency ratios, long term creditors can determine the firms long term financial strength and survival. 3. For management: The management can determine the operating efficiency with which the firm is utilising its various assests in generating revenues with the help of activity ratios such as capital turnover ratio, etc.

4. For investors: Profitability ratios like Earning Per Share, Dividend Per Share etc. help to determine the magnitude and direction of the movements in the firms earning.

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Only Quantitative analysis and not Qualitative analysis.

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Comparing ratios over time is complicated by the fact that economic conditions may change also. Historical analysis. Not free from bias.

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Comparing ratios between two firms is complicated by the fact that the firms may have different economic environments or production technologies even though they produce the same product. Reality behind statement to be considered. Accuracy of the accounts to be considered.

A method of performance measurement that was started by the DuPont Corporation in the 1920s, and has been used by them ever since. With this method, companies analyze the profitability by using performance management tools. To enable this, DU-PONT model integrates elements of income statement and balance sheet.

A type of analysis that examines a company's Return on Equity (ROE) by breaking it into three main components: Profit margin Asset turnover and Leverage factor. By breaking the ROE into distinct parts, investors can examine how effectively a company is using equity, since poorly performing components will drag down the overall figure.

To calculate a firm's ROE through Du Pont analysis, multiply the profit margin (net income divided by sales), asset turnover (sales divided by assets) and leverage factor (total assets divided by shareholders' equity) together. The higher the result, the higher the return on equity

NI ROE Equity

NI ROE Equity NI Sales Assets ROE X X Sales Assets Equity

NI ROE X Sales ROE ( profitability) X

NI Sales ROE X X Sales Assets ROE ( profitability) X (efficiency X )

NI Sales Assets ROE X X Sales Assets Equity ROE ( profitability) X (efficiency X (equitymultipier) )

NI Sales Assets ROE X X Sales Assets Equity ROE ( profitability) X (efficiency X (leverage) )

NI Sales Assets NI ROE X X Sales Assets Equity Equity ROE ( profitability ) X (efficiency ) X (leverage)

Example:

Using the DuPont Breakdown

The Du Pont identity is less useful for some industries, such as banking, that do not use certain concepts or for which the concepts are less meaningful. Du Pont analysis relies upon the accounting identity, which are basically not reliable. Does not include the cost of capital. Garbage In Garbage Out.

Window dressing is presenting company accounts in a manner which enhances the financial position of the company It is a form of creative accounting involving the manipulation of figures to flatter the financial position of the business. The focus of widow dressing: Hiding the deteriorating liquidity position Camouflaging the profit figures.

To influence the share price. To reduce liability for taxation. To encourage investors. To hide poor management decisions. To satisfy demands of major investors concerning the level of return. to hide liquidity problems. To show a stronger market position than warranted.

 Chasing

debtors Bringing sales forward Changing depreciation policy Capital expenditure

Special efforts to chase the debtors before the balance sheet is drawn up. This might involve discounts for prompt payment. Conversions of debtors into cash will improve the balance sheet and cash position of the business. Liquidity does improve but at the expense of sales value.

Sales show up in the P&L account when the order is received- not when the cash is received Encouraging customers to place order earlier then the planned, which will improve the sales revenue figure This can bring sales forward from next year to this year. The drawback is sales cant be included in the next years figure

Increasing the expected life of the asset will reduce the depreciation provision in the profit and loss account. This will increase the net profit shown in the account. Lengthening the expected life boosts profits shortening it, reduces profits. It will also mean that the net book value in the balance sheet will be higher for a longer period thereby increasing the firms asset value on the balance sheet.

The distinction between capital expenditure and revenue expenditure is not clear cut. Computer software with a useful life of 3 years. If treated as a revenue expenditure it is treated as a negative item in P&L account. If treated as a capital expenditure then it is treated as a an asset in balance sheet.