Module 5

Ratio Analysis
 • The relationship between two accounting figures is known
as ratio.
• Ratio analysis is a process of comparison of one figure with
another, which helps to make proper analysis about the
strengths and weaknesses of the firm’s operations.
• The calculation of ratios is a relatively easy and simple
Introduction task, but the proper analysis and interpretation of the ratios
is an important task.
• Ratio analysis is a very powerful analytical tool useful for
measuring performance of an organization. It is extremely
helpful in providing valuable insight onto company’s
financial picture.
 To show the firm’s relative strengths and weaknesses.

To help to analyze the past performance of the firm and to

make future projections.

OBJECTIVES To allow interested parties like shareholders, investors,

OF RATIO creditors and the government to analyze and make
ANALYSIS evaluation of certain aspects of firm’s performance.
To concentrate on inter-relationship among the figures
appearing in the financial statements.

To provide an easy way to compare present performance

with the past
 To depict the areas in which the business is
competitively advantageous and
disadvantageous.

OBJECTIVES To determine the financial condition and

OF RATIO performance of the firm.
ANALYSIS

To help to make suitable corrective measures

when the financial conditions and financial
performance are un-favourable to the firm
 [Link] Financial Statements: Ratio analysis
simplifies the comprehension of financial
statements. Ratios tell the whole story of changes in
the financial condition of a business.

[Link] Past and Forecast Future :It helps to

ADVANTAGES analyze and understand the financial health and
OF RATIO trend of a business, indicating past performance and
ANALYSIS making it possible to forecast the future trends

[Link]-Making and Cost Control: It serves as

a useful tool in management control process for
decision-making and cost control purpose
 4. Summaries Accounting Figures: It makes the
accounting figures easy to understand and highlight the
inter-relationship between various segments of the
business

5. Overall Profitability :Different users of accounting

ADVANTAGES information make use of specific ratios to meet or satisfy
OF RATIO their requirements. But the management is always
interested in overall profitability and efficiency of the
ANALYSIS business enterprise

6. Liquidity Position: The short-term creditors are more

interested in the liquidity position of a firm in the sense
that their money would be repaid on due dates. The
ability of the firm to pay short-term obligations can be
found by computing liquidity ratios
ADVANTAGES • [Link]-term Solvency: This is required by long-term
OF RATIO creditors, security analyst and the present and potential
shareholders of the company. The help of capital structure
ANALYSIS ratios kept the above in assessing the financial status of the
organization.
 [Link] ignore qualitative factors :Ratios are
obtained from the figures expressed in monetary terms.
In this way, qualitative factors, which may be important
are ignored.
LIMITATIONS
OF RATIO
ANALYSIS [Link] are not the actual ratios: The different ratios
calculated from the financial statements of a business
enterprise for one single year are of limited value. It
would be more useful to calculate the important figures
in the case of income, dividends, working capital, etc.,
for a number of years. Such trends are more useful than
absolute ratios.
LIMITATIONS OF RATIO
ANALYSIS
• [Link] accounting information :The ratios are calculated from
accounted data in the financial statements. It means if the information is
defective then the calculation of ratios would be wrong. Thus, the deliberate
omissions would affect the ratios too.
• [Link] in accounting procedures: A comparison of result of two firms
becomes difficult when we find that the firms are using different procedures
related to certain items, such as inventory valuation and treatment of
intangible assets.
• 5. The use of standard ratio: The financial statements represent historical
data and, therefore, the ratios based on them would only disclose what
happened in the past.
Types of Ratios
Liquidity Ratios

• Liquidity or short-term solvency means ability of the business to pay its short-term liabilities.

• Inability to pay-off short-term liabilities affects its credibility as well as its credit rating.

• Continuous default on the part of the business leads to commercial bankruptcy.

• Such commercial bankruptcy may lead to its sickness and dissolution.

• Short-term lenders and creditors are very much interested to know its state of liquidity because of their
financial stake.

• Lack of sufficient liquidity and excess liquidity is bad for the organization
Liquidity Ratios

• 1)Current Ratio-
• It is the most common measure of short-term liquidity
• It measures whether the firm has enough resources to meet its current obligations.
• Current ratio is a comparison of current assets to current liabilities, calculated by dividing
your current assets by your current liabilities.
• It measures the capability of a business to meet its short-term obligations that are due within a year.
• A generally acceptable current ratio is 2:1.
• But whether or not a specific ratio is satisfactory depends on the nature of the business and
characteristics of its current assets and liabilities.
• (The ideal Current Ratio preferred by Banks is 1.33 : 1)
Liquidity Ratios
Liquidity Ratios
• Significance : A very high ratio will have adverse impact on the profitability of the organization.
A high current ratio may be due to high level of inventory, inefficiency in collection of debtors,
high balance in cash and bank accounts without proper investments.
 • 2)Quick ratio-
• This is sometimes called acid-test ratio or liquid ratio
• It is one of the best measures of liquidity.
• It is more conservative measure of short-term liquidity than
the current ratio

Liquidity
Ratios
Liquidity Ratios

• Quick assets consists of only cash and near cash assets.

• Inventories are deducted from current assets on the belief that they are not near
cash assets and also at times of difficulty inventory may be saleable only at
liquidation value.

• An acid test ratio of 1:1 is considered satisfactory .

 These ratios are employed to evaluate the
efficiency with which the firm manages
and utilizes its assets.

They are often called asset management

Activity ratios.
Ratios/Efficiency
ratios/Performance
ratios/Turnover
ratios: These ratios usually indicate the frequency
of sales with respect to its assets.

These ratios are usually calculated with

reference to sales/cost of goods sold and
are expressed in terms of rate or times.
Activity Ratios/Efficiency ratios/Performance
ratios/Turnover ratios:

• 1)Total Asset Turnover Ratio: This ratio measures the efficiency with which the
firm uses its total assets. Higher the ratio, better it is.
Activity Ratios/Efficiency ratios/Performance
ratios/Turnover ratios:
• 2)Fixed assets turnover ratio-
• It measures the efficiency with which the firm uses its fixed assets.
Activity Ratios/Efficiency ratios/Performance
ratios/Turnover ratios:

• 3)Capital Turnover ratio/Net Asset Turnover ratio

 Activity
Ratios/Efficiency
ratios/Performance
ratios/Turnover
ratios:
 Activity
Ratios/Efficiency
ratios/Performance
ratios/Turnover
ratios:
 Activity
Ratios/Efficiency
ratios/Performance
ratios/Turnover
ratios:
 Activity
Ratios/Efficiency
ratios/Performance
ratios/Turnover
ratios:
 Activity
Ratios/Efficiency
ratios/Performance
ratios/Turnover
ratios:
Activity Ratios/Efficiency ratios/Performance
ratios/Turnover ratios:
Profitability ratios
Profitability ratios
Profitability ratios
1)Gross Profit Ratio
• Gross profit ratio as a percentage of revenue from operations is computed to have an idea
about gross margin.
• It is computed as follows:
• Gross Profit Ratio = Gross Profit/Net Revenue of Operations × 100
• Significance: It indicates gross margin on products sold.
• It also indicates the margin available to cover operating expenses, non-operating
expenses, etc.
• Change in gross profit ratio may be due to change in selling price or cost of revenue from
operations or a combination of both.
• A low ratio may indicate unfavourable purchase and sales policy. Higher gross profit ratio
is always a good sign
• Gross Profit=Revenue from operations-Cost of goods Sold
1)Gross Profit Ratio
2)Net Profit Ratio
• Net profit ratio is based on all inclusive concept of profit. It relates revenue from operations to net
profit after operational as well as non-operational expenses and incomes.

• It is calculated as under:

• Net Profit Ratio = Net profit/Revenue from Operations × 100

• Significance: It is a measure of net profit margin in relation to revenue from operations. Besides
revealing profitability, it is the main variable in computation of Return on Investment. It reflects the
overall efficiency of the business, assumes great significance from the point of view of investors.
2)Net Profit Ratio
3)Operating Profit Ratio

• It is calculated to reveal operating margin.

• Operating Profit Ratio = Operating Profit/ Revenue from Operations × 100

• Where Operating Profit = Revenue from Operations – Operating Cost

• OR Operating Profit=Revenue from operations-COGS-expenses(excl interest & taxes)

• OR Operating Profit=EBIT(Earnings before interest and taxes)

3)Operating Profit Ratio
4)Operating Ratio-(Operating
Cost ratio)
• It is computed to analyse cost of operation in relation to revenue from operations. It is calculated
as follows:
• Operating Ratio = (Cost of Revenue from Operations + Operating Expenses)/ Net Revenue from
Operations ×100
• Operating expenses include office expenses, administrative expenses, selling expenses,
distribution expenses, depreciation and employee benefit expenses etc.
• Cost of operation is determined by excluding non-operating incomes and expenses such as loss
on sale of assets, interest paid, dividend received, loss by fire, speculation gain and so on.
• Significance: Operating ratio is computed to express cost of operations excluding financial
charges in relation to revenue from operations. It helps to analyse the performance of business and
throws light on the operational efficiency of the business. It is very useful for inter-firm as well as
intra-firm comparisons. Lower operating ratio is a very healthy sign.
5)Expenses ratio
Return on Investment
Return on Investment
1) Return on Assets
1) Return on Assets
2)Return on Capital Employed
2)Return on Capital Employed
3)Return on Equity
3)Return on Equity
• Interpretation

• Return on Equity is one of most important indicator’s of a firm’s profitability and potential
growth.

• Companies that boast a high return on equity with little or no debt are able to grow without large
capital expenditures ,allowing the owners of the business to withdraw cash and reinvest it
elsewhere.
1) Price-Earnings Ratio
2)Dividend Yield
2) Dividend Yield

• It is the ratio use to measure the percentage return received from the

dividend relative to its market price

• This ratio is important for those investors who purchase shares to earn
dividend income.
3)Market Value/Book Value per
share
4)Q Ratio or Tobin’s Q Ratio
Capital Structure Ratios/Solvency
ratios
• These ratios provide an insight into the financing techniques use by a business and focus on the

long-term solvency position.

• The persons who have advanced money to the business on long-term basis are interested in safety

of their periodic payment of interest as well as the repayment of principal amount at the end of the

loan period.

• Solvency ratios are calculated to determine the ability of the business to service its debt in the long

run.
 1)Debt-Equity Ratio
• Debt-Equity Ratio measures the relationship between long-term debt and equity.

• If debt component of the total long-term funds employed is small, outsiders feel more secure.
From security point of view, capital structure with less debt and more equity is considered
favourable as it reduces the chances of bankruptcy.

• Normally, it is considered to be safe if debt equity ratio is 2 : 1.

• However, it may vary from industry to industry. It is computed as follows:

Debt-Equity Ratio
Debt-Equity Ratio
• Significance: This ratio measures the degree of indebtedness of an enterprise and gives an idea to
the long-term lender regarding extent of security of the debt.

• As indicated earlier, a low debt equity ratio reflects more security.

• A high ratio, on the other hand, is considered risky as it may put the firm into difficulty in meeting
its obligations to outsiders.
2)Debt-Capital Employed Ratio
• The Debt to capital employed ratio refers to the ratio of long-term debt to the total of external and
internal funds (capital employed or net assets).

• It is computed as follows:

• Debt to Capital Employed Ratio = Long-term Debt/Capital Employed (or Net Assets)

• Capital employed is equal to the long-term debt + shareholders’ funds

OR

• Net assets which are equal to the total assets – current liabilities
Debt-Capital Employed Ratio
• Significance: Like debt-equity ratio, it shows proportion of long-term debts in capital employed.

• Low ratio provides security to lenders and high ratio helps management in trading on equity.
3)Debt to Total Assets Ratio
4)Capital-Gearing Ratio
Capital Gearing Ratio
• Company XYZ had the following particulars:
• For the year 2015:
• Total Equity: $5,000,000
• Preferred Stock: $1,500,000
• Common Shareholders’ Equity: $3,500,000 (Total Equity less Preferred Stock)
• Bonds: $1,500,000
• Calculate CG ratio=PS+bonds/Common [Link]=15+15/35=6:7
5)Proprietary Ratio
Interest Coverage ratio
• It indicates the firm’s ability to pay meet interest ( and other fixed
charges obligations).
• It is computed as follows:
Interest Coverage Ratio
 Debt Service Coverage Ratio
• Lenders are interested in debt service coverage to judge the firm’s ability to pay off current interest and instalments.
DSCR
PEG ratio
• The price/earnings to growth ratio (PEG ratio) is a stock's price-to-earnings (P/E) ratio divided by
the growth rate of its earnings for a specified time period.
• The PEG ratio is used to determine a stock's value while also factoring in the company's expected
earnings growth, and it is thought to provide a more complete picture than the more standard P/E
ratio.
• The PEG ratio enhances the P/E ratio by adding in expected earnings growth into the calculation.
• The PEG ratio is considered to be an indicator of a stock's true value, and similar to the P/E ratio,
a lower PEG may indicate that a stock is undervalued.
• The PEG for a given company may differ significantly from one reported source to another,
depending on which growth estimate is used in the calculation, such as one-year or three-year
projected growth.
PEG ratio
PEG ratio
• The price/earnings to growth ratio, or PEG ratio, is a
stock valuation measure that investors and analysts can use to get a broad
assessment of a company's performance and evaluate investment risk.
• In theory, a PEG ratio value of 1 represents a perfect correlation between
the company's market value and its projected earnings growth.
• PEG ratios higher than 1 are generally considered unfavorable,
suggesting a stock is overvalued.
• Conversely, ratios lower than 1 are considered better, indicating a stock
is undervalued.
PEG Ratio vs. P/E Ratio
• The price-to-earnings (P/E) ratio gives analysts a good fundamental
indication of what investors are currently paying for a stock in relation to
the company's earnings.
• One weakness of the P/E ratio, however, is that its calculation does not take
into account the future expected growth of a company.
• The PEG ratio represents a fuller—and hopefully—more accurate valuation
measure than the standard P/E ratio.
• The PEG ratio builds upon the P/E ratio by factoring growth into the
equation.
• Factoring in future growth adds an important element to stock valuation
since equity investments represent a financial interest in a company's future
earnings.
PE Ratio
• PE ratio is just one factor to be considered, there are many other parameters
like Market cap, eps, book value, share capital, reserves and surplus, ROI ,
ROCE , total assets , debt to equity ratio, deliverables %, intrinsic value ,
share holder pattern, mutual fund investing %, cash flow to be consider
before making investment into any stocks.
• PE ratio is something how much money you pay for a stock to earn one rupee
profit from it.. So comparing P/E ratio of two companies in same sector is
valid.. comparing P/E ratio of companies with different sectors is not a valid
thing as P/E ratio tend to change for different sectors. companies with high
P/E ratio may have high potential earnings in future, however you will be
paying more for 1 rupee profit from that company share than the company
with low pe ratio..
Trailing And Forward PE

• Trailing PE uses earnings per share of the company over the

period of the previous 12 months for calculating the price-
earnings ratio, whereas Forward PE uses the forecasted
earnings per share of the company over the period of the next
12 months for calculating the price-earnings ratio.
Trailing And Forward PE
• Trailing PE Ratio Formula (TTM or Trailing Twelve Months) =
Price Per Share / EPS over the previous 12 months.

• Forward PE Ratio Formula = Price Per Share / Forecasted EPS

over the next 12 months
• As you can note from above, the key difference between the two is the
EPS used. For Trailing PE, we use the historical EPS, whereas, for
Forward PE, we use EPS forecasts.
Accuracy of PEG ratio

• The accuracy of the PEG ratio depends on the inputs used.

• When considering a company's PEG ratio from a published source, it's important to find
out which growth rate was used in the calculation.
• Using historical growth rates, for example, may provide an inaccurate PEG ratio if
future growth rates are expected to deviate from a company's historical growth. The
ratio can be calculated using one-year, three-year, or five-year expected growth rates,
for example.
PEG RATIO
• The lower the PEG ratio, the more the stock may be undervalued given its future
earnings expectations. Adding a company's expected growth into the ratio helps to
adjust the result for companies that may have a high growth rate and a high P/E ratio.
• The degree to which a PEG ratio result indicates an over or underpriced stock varies by
industry and by company type. As a broad rule of thumb, some investors feel that a
PEG ratio below one is desirable.
• According to well-known investor Peter Lynch, a company's P/E and expected growth
should be equal, which denotes a fairly valued company and supports a PEG ratio of
1.0. When a company's PEG exceeds 1.0, it's considered overvalued while a stock with
a PEG of less than 1.0 is considered undervalued
Example of How to Use
the PEG Ratio

• The PEG ratio provides useful

information to compare companies
and see which stock might be the
better choice for an investor's
needs, as follows.
• Assume the following data for two
hypothetical companies, Company
A and Company B:
PEG RATIO
• Many investors may look at Company A and find it more attractive since it has a lower
P/E ratio between the two companies. But compared to Company B, it doesn't have a
high enough growth rate to justify its P/E. Company B is trading at a discount to its
growth rate and investors purchasing it are paying less per unit of earnings growth.
PEG and PE ratio
• If you're choosing between two stocks from companies in the same
industry, then you may want to look at their PEG ratios to make your
decision.
• For example, the stock of Company Y may trade for a price that's 15
times its earnings, while Company Z's stock may trade for 18 times
its earnings.
• If you simply look at the P/E ratio, then Company Y may seem like
the more appealing option.
PEG and PE ratio
• However, Company Y has a projected five-year earnings growth rate of 12%
per year while Company Z's earnings have a projected growth rate of 19% per
year for the same period. Here's what their PEG ratio calculations would look
like:

• This shows that when we take possible growth into account, Company Z
could be the better option because it's actually trading for a discount
compared to its value.
Overvaluation or Undervaluation
of company
• The most commonly used metric when it comes to investing is the price-to-earnings ratio.
The earnings multiple reflects the current price of a stock in relation to the earnings of the
company in a quick and easily understandable way.
• The higher the P/E ratio, the more overvalued a stock may be. Conversely, a lower P/E might
indicate a more undervalued stock.
• Different companies across multiple industry sectors will have different standards of P/Es. For
example, a tech stock such as Netflix (NFLX) will generally have a much higher P/E ratio than
a financial company like JPMorgan (JPM).
• Comparing P/Es of tech stocks with financial stocks is like comparing apples to oranges. It
doesn’t really make sense. That’s why the PE ratio of a stock should mainly be used in
comparison with similar companies within the industry, or with its own historical standards.
Overvaluation or Undervaluation
of company
• A major flaw of the P/E ratio is its lack of any future assumptions. In its basic form, the
only two components of the price-to-earnings ratio are the recent earnings and the current
stock price.
• Somehow, the future prospects of a company need to be taken into account, and this is
where the PEG ratio comes into place.
• Note that the PEG ratio for each stock can vary, depending on the growth rate that is has
been used in the calculation. This makes the PEG ratio a little harder to use than the P/E
ratio.
• In theory, a PEG ratio of below 1 suggests that the company is undervalued, while a PEG
ratio of 1 should reflect a fairly valued stock, A PEG ratio above 1 would indicate that the
stock is rather overvalued
Earnings Per Share (EPS) vs. Diluted EPS:

• Earnings per share (EPS) and diluted EPS are profitability measures used in the fundamental
analysis of companies.
• EPS takes into account a company’s common shares, whereas diluted EPS takes into account
all convertible securities, such as convertible bonds or convertible preferred stock, which are
changed into equity or common stock.
• Earnings per share (EPS) take into account only common shares, while diluted EPS includes
convertible securities.
• Dilutive effects occur when the number of shares increases—for example, through a new issue.
• Generally, if a company has convertible securities, then the diluted EPS is less than its basic
EPS.
Earnings Per
Share (EPS)
Diluted EPS

• Conversely, diluted EPS is a metric used in fundamental analysis to gauge a company’s quality of EPS assuming
all convertible securities have been exercised. Convertible securities include all outstanding convertible preferred
shares, convertible debt, equity options (mainly employer-based options), and warrants.
The Profitability Ratios

[Link] Margin (Operating Profit Margin)

1. EBITDA Growth (CAGR)
[Link] Margin
1. PAT Growth (CAGR)
[Link] on Equity (ROE)
[Link] on Asset (ROA)
[Link] on Capital Employed (ROCE)
EBITDA Margin:
• The Earnings before Interest Tax Depreciation & Amortization
(EBITDA) margin
• indicates the efficiency of the management.
• It tells us how efficient the company’s operating model is. EBITDA
Margin tells us how profitable (in percentage terms) the company is at
an operating level.
• It always makes sense to compare the company’s EBITDA margin
versus its competitor to get a sense of the management’s efficiency in
terms of managing their expense.
EBITDA Margin:
• To calculate the EBITDA Margin, we first need to calculate the
EBITDA itself.
• EBITDA = [Operating Revenues – Operating Expense]
• Operating Revenues = [Total Revenue – Other Income]
• Operating Expense = [Total Expense – Finance Cost – Depreciation &
Amortization]
• EBIDTA Margin = EBITDA / [Total Revenue – Other Income]
EBITDA Margin:
• Amara Raja Batteries Limited, the EBITDA Margin calculation for the FY14 is as follows:
• We first calculate EBITDA, which is computed as follows:
• [Total Revenue – Other Income] – [Total Expense – Finance Cost – Depreciation & Amortization]
• Note: Other income is income under investments and other non-operational activity. Including
other income in EBITDA calculation would clearly skew the data. For this reason, we have to
exclude Other Income from Total Revenues.
• [3482 – 46] – [2942 – 0.7 – 65]
• = [3436] – [2876]
• = 560 Crores
• Hence the EBITDA Margin is:
• 560 / 3436
• = 16.3%
EBITDA Margin:
[Link] do an EBITDA of Rs.560 Crs and an EBITDA margin of 16.3%
indicate?
[Link] good or bad an EBITDA margin of 16.3% is?
The first question is fairly simple.
An EBITDA of Rs.560 Crs means that the company has retained Rs.560 Crs from
its operating revenue of Rs.3436 Crs.
This also means out of Rs.3436 Crs the company spent Rs.2876 Crs towards its
expenses.
In percentage terms, the company spent 83.7% of its revenue towards its expenses
and retained 16.3% of the revenue at the operating level, for its operations.
EBITDA Margin:
• A financial ratio on its own conveys very little information. To make sense of it,
we should either see the trend or compare it with its peers. Going with this, a
16.3% EBITDA margin conveys very little information.
• To makes some sense of the EBITDA margin, let us look at Amara Raja’s
EBITDA margin trend for the last 4 years, (all numbers in Rs Crs, except EBITDA
margin):
EBITDA Margin:
• It appears that ARBL has maintained its EBITDA at an average of
15%, and in fact, on a closer look it is clear the EBITDA margin is
increasing. This is a good sign as it shows consistency and efficiency
in the management’s operational capabilities.
• In 2011 the EBITDA was Rs.257 Crs, and in 2014 the EBITDA is
Rs.560Crs. This translates to a 3 year EBITDA CAGR growth of
29.64%
PAT Margin:
• While the EBITDA margin is calculated at the operating level, the Profit After Tax
(PAT) margin is calculated at the final profitability level. At the operating level, we
consider only the operating expenses; however, other expenses such as depreciation
and finance costs are not considered. Along with these expenses, there are tax
expenses as well. When we calculate the PAT margin, all expenses are deducted
from the company’s Total Revenues to identify the company’s overall profitability.
• PAT Margin = [PAT/Total Revenues]
• PAT is explicitly stated in the Annual Report. ARBL’s PAT for the FY14 is Rs.367
Crs on the overall revenue of Rs.3482 Crs (including other income). This translates
to a PAT margin of:
• = 367 / 3482
• =10.5 %
PAT Margin Trend
Return on Equity (RoE):
• The Return on Equity (RoE) is a critical ratio, as it helps the investor assess
the return the shareholder earns for every unit of capital invested.
• RoE measures the entity’s ability to generate profits from the shareholder’s
investments. In other words, RoE shows the efficiency of the company in
terms of generating profits to its shareholders.
• Obviously, the higher the RoE, the better it is for the shareholders. In fact,
this is one of the key ratios that help the investor identify investable attributes
of the company.
• The average RoE of top Indian companies varies between 14 – 16% to give
you a perspective.
• RoE can be calculated as: [Net Profit / Shareholders Equity* 100]
Return on Asset (RoA):
• Return on Assets (RoA) evaluates the effectiveness of the entity’s
ability to use the assets to create profits.
• A well-managed entity limits investments in non-productive assets.
Hence RoA indicates the management’s efficiency at deploying its
assets. Needless to say, the higher the ROA, the better it is.
• RoA = [Net income + interest*(1-tax rate)] / Total Average Assets
Return on Capital Employed (ROCE):
• The Return on Capital employed indicates the company’s profitability,
taking into consideration the overall capital it employs.
• Overall capital includes both equity and debt (both long term and short
term).
• ROCE = [Profit before Interest & Taxes / Overall Capital
Employed]
• Overall Capital Employed = Short term Debt + Long term Debt +
Equity.
Dupont Analysis
• Du Pont is one of the legendary companies in American history which gave the world Nylon
(Remember it is called Nylon because it was simultaneously invented in New York and
London).
• Du Pont does not exist today as it was merged into Dow Chemicals, another big chemical
major in the US.
• Apart from Nylon, the other big contribution that Du Pont made was in the field of financial
analysis.
• Du Pont pioneered the analysis of Return on Equity (ROE) as a means of evaluating the
company and identifying problem areas. Hence this ROE analysis also came to be known
popularly as Du Pont Analysis.
 • Originally popularized by the DuPont
Corporation.
• It is a framework for analyzing fundamental
performance of a company

Dupont
• DuPont analysis is a useful technique used to
decompose the different drivers of return on
Analysis equity (ROE).
• Return on Equity measures the profitability of
equity funds invested in the firm.
• This ratio reveals how profitably the owner’s
funds has been utilized by the firm.
• It also measures the percentage return generated
to equity shareholders.
Dupont Analysis
• Originally devised in the 1920s by Donaldson Brown at DuPont Corporation, the chemical
company, the model is used to analyze the return on equity (ROE) as broken down into
different parts in order to analyze the contribution of each part.
• The purpose of adopting this method was to define ROE based on different components that
affect it.
• The DuPont Analysis Formula is an alternate way to calculate and deconstruct ROE (Return
on Equity) in order to get a better understanding of the underlying factors behind a
company’s ROE.
• It is done through adding additional factors and data points into the basic ROE equation in
order to get a clearer glimpse of what is driving the changes over time in a company’s ROE.
• DuPont Analysis is a tool that may help us to avoid misleading conclusions regarding a
company’s profitability.
Return on Equity
Dupont Analysis
• The DuPont Method has three main components.
• The first is operating efficiency, which is measured by net profit margin.
• This shows how much money in net sales is generated per every dollar in expenses.
• Net profit margin is calculated by dividing net profit, also known as net income, by revenue.
• The second component, asset efficiency, is measured by total asset turnover.
• This determines how many dollars of total revenue a company generates per dollar in assets.
• Total asset turnover is calculated by dividing a company’s revenue by the total assets that it has on
hand.
Dupont Analysis
• The third component is financial leverage, determined by the equity multiplier.
• Unlike the first two components, which directly evaluate a company’s operations, financial
leverage assesses how well a company is using debt, a key driver of ROE, to finance those
operations.
• It is known as financial leverage or equity mulitplier
• The equity multiplier is calculated by dividing a company’s assets by its equity.
Dupont 3 step analysis
Dupont analysis(3 step)
• The DuPont analysis implies that a company can increase its ROE if it:
• Generates Higher Net Profit Margin
• Efficiently Utilizes Assets to Generate More Revenue
• Increases its Financial Leverage
Net Profit Margin

• The net profit margin represents a company’s “bottom line” profitability once all
expenses have been deducted, including the interest expense payments on debt
obligations and taxes to the government.
• If the net profit margin increases, each dollar of revenue will bring in more earnings to
the company, resulting in a higher return on equity (ROE).
• Therefore, a company’s net income represents the remaining profits left over, which are
attributable to one specific group of capital providers – the equity shareholders.
Asset Turnover Ratio

• For the second component, the total asset turnover ratio is an efficiency ratio tracking
the ability of a company to generate more revenue per dollar of asset owned.
• If a company improves upon its turnover ratio, the ROE increases because the
implication is that it can utilize its assets better – i.e. generate more revenue with fewer
assets.
• The first two components – the net profit margin and total asset turnover – represent
measures of operating efficiency and asset efficiency.
Financial Leverage/Equity Multiplier

• The third and final component is financial leverage, which is the amount of debt in the
company’s capital structure.
• The use of more debt financing leads to higher interest expenses, which are tax-deductible and create a
“tax shield” that reduces the amount of taxable income.
• Often called the “equity multiplier,” increasing the amount of debt to benefit from the lower taxes, the
lower cost of capital, and obtaining access to a cheaper funding source could easily backfire from
irresponsible decision-making.
• Hence, the company must be led by a management team with their interests aligned with that of its
shareholders.
• The company must strike the right balance between benefiting from debt financing but not placing
excess leverage on the company, where the company’s cash flows are insufficient to handle all the debt
obligations and are now at risk of default.
The utility of DuPont Analysis

• Profit margin indicates how efficient the company’s management is in operating the
company and in controlling costs.
• Assets turnover measures the efficiency of the company in generating sales for every
dollar of asset.
• The equity multiplier shows how leveraged a company is by computing how much
financing stockholders provided for every dollar of asset.
• It facilitates industry group comparison as a standard measure provided the industry
groups use the same measure.
• It is an approach to analyze the enterprise by evaluating inter-relationships among
many of the performance measures.
• It helps to find out what are the factors that are causing the profit to move up.
Illustration
Illustration
• As you can see in the table, SuperCo improved its profit margins by increasing net income
and reducing its total assets.
• SuperCo's changes improved its profit margin and asset turnover.
• The investor can deduce from the information that SuperCo also reduced some of its debt
since average equity remained the same.
• Looking closely at Gear Inc., the investor can see that the entire change in ROE was due to an
increase in financial leverage.
• This means Gear Inc. borrowed more money, which reduced average equity.
• The investor is concerned because the additional borrowings didn't change the company's
net income, revenue, or profit margin, which means the leverage may not be adding any real
value to the firm.
 • The basic DuPont Analysis model does not isolate the
operating activities from the financing activities.

Five step • A five-step DuPont model helps to solve this problem. In

this model, in order to isolate operations and financial
Dupont impacts on ROE, we will further break down the
components used in the basic model.
model
Dupont 5 step analysis

Net Income/Pre-Tax Income NI/EBT-Tax Burden

Revenue/Total Assets Sales/TA-Total Assets Turnover
Total Assets/Shareholder’s equity TA/Equity-Equity Multiplier
Pre-tax Income/Operating Income EBT/EBIT-Interest Burden
Operating income/Revenue EBIT/Sales –EBIT Efficiency
=ROE
Dupont 5 step ananlysis
• Tax Burden: Proportion of profits retained post-taxes
• Interest Burden: Depicts the extent to how much interest expense impacts profits
• Operating Margin: Operating profit (EBIT) retained per dollar of sales after deducting COGS and
Op-Ex

• All three of these new parts are extensions of the net profit margin calculation.
• Net Profit Margin = EBIT Margin × Tax Burden × Interest Burden

• The rest two i.e equity multiplier and Asset turnover are the same as the dupont 3-step analysis.
Why Dupont Analysis is
important?
• The DuPont Analysis Formula is an alternate way to calculate and deconstruct ROE (Return on
Equity) in order to get a better understanding of the underlying factors behind a company’s
ROE.
• Its important to understand whether the company is generating profits through internal accruals
or through Debt Financing or through raising Equity.
• The DuPont Analysis allows analysts to understand where a company is strong and where it is
weak when it comes to generating profitability.
• The Dupont method is key because Return on Equity is a major component of what an investor
looks at when evaluating the performance of various investments.
• This allows investors to see whether a company is propping up its ROE through accumulating
debt while suffering from a low profit margin and/or depreciating assets.
Altman’s Z-score
• The Altman Z-score is a famous formula for measuring a company’s
financial worthiness devised by Edward Altman.
• The Altman Z-score is a formula for determining whether a company,
notably in the manufacturing space, is headed for bankruptcy.
• The formula takes into account profitability, leverage, liquidity,
solvency, and activity ratios.
• An Altman Z-score close to 0 suggests a company might be headed for
bankruptcy, while a score closer to 3 suggests a company is in solid
financial positioning.
Altman’s Z-score

• The Altman Z-score, a variation of the traditional z-score in statistics,

is based on five financial ratios that can be calculated from data
found on a company's annual 10-K report. It uses profitability,
leverage, liquidity, solvency, and activity to predict whether a
company has a high probability of becoming insolvent.
Altman’s Z-score

• NYU Stern Finance Professor Edward Altman developed the Altman

Z-score formula in 1967, and it was published in 1968. Over the years,
Altman has continued to reevaluate his Z-score. From 1969 until 1975,
Altman looked at 86 companies in distress, then 110 from 1976 to
1995, and finally 120 from 1996 to 1999, finding that the Z-score had
an accuracy of between 82% and 94%
Altman’s Z-score

• In 2012, he released an updated version called the Altman Z-score

Plus that one can use to evaluate public and private companies,
manufacturing and non-manufacturing companies, and U.S. and non-
U.S. companies. One can use Altman Z-score Plus to evaluate
corporate credit risk. The Altman Z-score has become a reliable
measure of calculating credit risk.
Altman’s Z-score
• Altman Z-Score = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E
• Where:
• A = working capital / total assets
• B = retained earnings / total assets
• C = earnings before interest and tax / total assets
• D = market value of equity / total liabilities
• E = sales / total assets
Altman’s Z-score
• A score below 1.8 means it's likely the company is headed for
bankruptcy, while companies with scores above 3 are not likely to go
bankrupt.
• Investors can use Altman Z-scores to determine whether they should
buy or sell a stock if they're concerned about the company's
underlying financial strength.
• Investors may consider purchasing a stock if its Altman Z-Score value
is closer to 3 and selling a stock if the value is closer to 1.8.
Altman’s Z-score

• In more recent years, however, a Z-Score closer to 0 indicates a

company may be in financial trouble. In a lecture given in 2019 titled

"50 Years of the Altman Score," Professor Altman himself noted that

recent data has shown that 0—not 1.8—is the figure at which investors

should worry about a company's financial strength.

Pitrioski Model
• The Piotroski score is a discrete score between zero and nine that reflects nine
criteria used to determine the strength of a firm's financial position.
• The Piotroski score is used to determine the best value stocks, with nine being the
best and zero being the worst.
• The Piotroski F-Score is a financial indicator designed by accounting
professor Joseph Piotroski which puts together nine criteria to evaluate the
financial strength of a business based on its profitability, leverage, liquidity,
source of funds, and operating efficiency.
• Based on his study, a firm with a Piotroski score of 8-9 is in a strong financial
position while companies with a score lower than 3 are financially weak.
Pitrioski Model

• The idea behind the Piotroski F-Score is very simple–using

historical financial statement data to separate winners from

losers. Since not all cheap stocks are value stocks, the

Piotroski Score can help you find the difference between

them and improve your investment performance.

Operating Cycle Ratios
• Operating cycle is the time that elapses between purchases of raw material, its conversion into
work-in process, work-in process converted into finished good, finished goods converted into
receivables and receivables resulting into cash.

• Operating cycle is essential as it indicates the smoothness with which the business is run.
Managers will try to reduce the operating cycle to ensure quick release of funds locked in the
cycle. Managers will, thus, try to shorten the operating cycle to magnify the opportunity cost of
the locked funds
Operating cycle
• Operating cycle=Days Inventory Outstanding
+Receivable collection days
-Creditor payment days

Days Inventory Outstanding=Average Inventory*365/COGS

Receivable Collection days=Average Account receivable*365/Credit sales
Creditors Payment days=Average payables*365/COGS
Operating cycle
• If the Inventory consists of Raw-materials, WIP and Finished goods the Inventory
holding period will be calculated separately for each of the above items.
• Raw material holding period=Average stock of RM*365/Annual cost of raw
material
• WIP Holding period=Average stock of WIP*365/Cost of production(COP)
• Finished goods holding period=Average stock of FG *365/COGS
• The total of all the above three will the Inventory holding period OR Days
Inventory Outstanding
Use of Operating cycle

• An operating cycle refers to the time it takes a company to buy goods, sell them
and receive cash from the sale of said goods.

• In other words, it's how long it takes a company to turn its inventories into cash.
The length of an operating cycle is dependent upon the industry.
Use of Operating cycle
• The length of a company's operating cycle is dictated by a number of factors,
including the payment terms a company extends to its customers and those
extended to the company by its suppliers.
• If a company is given more time to pay its suppliers for inventory, it can reduce its
operating cycle by delaying the outlay of cash.
• On the other hand, if a company gives its customers more time to pay for goods
received, it can extend its operating cycle, as the company will have to wait longer
to get its cash.
• A shorter operating cycle indicates that a company's cash is tied up for a shorter
period of time, which is generally more ideal from a cash flow perspective.
Factors affecting the Duration of Operating Cycle

• 1. Credit Period allowed by the Supplier: –

• The credit period allowed by the supplier affects the total time duration of the OC, Because if the
supplies of the goods allow the business the longer credit period then the OC of the business will
be shorter.
• The increase in the time duration will allow the business to hold some cash or goods in advance.
• 2. Time Duration of the Production: –
• If the production process required a long time period from the conversion of raw material into the
finished product then the time period of OC will be increased or if it required less time then the
duration of OC will be decreased.
Factors affecting the Duration of Operating Cycle

• [Link] Period of Finished Product: –

• If the finished product is held in the warehouse for a long time period then the time duration of OC
will be increased and if it holds for a less time period then the time duration of OC will be
decreased.
• 4. Credit Period allowed to Customer: –
• If the Business allows its customer a longer credit period then the time duration of OC will be
increased and if it allows less credit period of time to the customer then the time duration of OC
will be Decreased.