By Rahul Radhakrishnan on The Capital
Welcome back everyone, as mentioned in my previous article my objective is to explain some key concepts in finance which you might encounter in your work or personal investment routine.
The purpose of financial statements has always been to showcase how the entity financially performed during period so as to help the stakeholders to make correct decisions like whether or not to invest in the company, whether or not to lend money etc. So in essence the financial statements are an enabler for decision making, however, have you ever wondered what each and every figure presented in the financials reveal about the company?
For example, a company might have a revenue (from sale of goods or services) of $ 1 billion when its net profit after deducting all expenses would be less than $ 10 million. This might be due to various factors like increased promotion, business expansions, etc. which are legitimate expenses and would result in increased profitability for the company in the future. So evaluating the performance of a company with its peers purely based on the actual figures presented in the financials will result in a biased decision. To avoid this, financial analysts will always resort to a technique called Ratio Analysis.
Ratio analysis is a mathematical method in which different financial ratios of a company, taken from the financial sheets and other publicly available information, are analysed to gain insights into company’s financial and operational details.
Ratio analysis helps in generating some powerful figures which can then be compared with that of competitors to arrive at conclusions about the performance of the company you are looking at. Among the various ratios used, primary one is the Return on Equity (ROE). ROE of a company in simple terms refers to how much an investor earns from every penny of investment in the company. A good company will have higher ROE than its peers. This technique was named after the Dupont Corporation which used it during the early 1920s.
However, ROE as a single measure will not provide clarity on how a company has achieved this performance. To understand this we need to break down the ROE into components like Profitability, Efficiency, and Leverage.
Return on Equity= Return on sales * Asset Turnover * Leverage
- Profitability — Return on sales (Net income/ Total sales), which is profit earned per dollar of sale. Profitability explains how efficient is the company in reducing the operational and ancillary costs of running the business. The objective of the company should be to grow the profit margin by reducing the costs.
- Efficiency– Asset turnover ratio (Total Sales/ Assets), which are sales made per dollar of asset. Asset turnover describes how efficient is the company in churning out maximum benefit out of the amount invested by the company in its assets.
- Leverage– Assets to equity ratio (Total Assets/Equity), which is assets created per dollar of equity investment. The leverage component of the ROE will explain how effectively is the company is using its equity and debt capital. However, it should be noted that over emphasis on debt to boost this ratio will backfire in the long run. Hence prudent companies should always strike a balance between debt capital and equity capital to achieve high growth.
So that’s a wrap for this FinConcept article on DuPont Analysis.
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