DuPont Analysis — The Decomposition of ROE
Decomposition of ROE is sometimes referred to as DuPont analysis because it was developed originally at that company. Decomposing ROE involves expressing the basic ratio (i.e., net income divided by average shareholders’ equity) as the product of component ratios. Because each of these component ratios is an indicator of a distinct aspect of a company’s performance…
Profitability Ratios
Calculation of Profitability Ratios Interpretation of Profitability Ratios Gross Profit Margin Gross profit margin indicates the percentage of revenue available to cover operating and other expenses and to generate profit. Operating Profit Margin Operating profit is calculated as gross profit minus operating costs. So, an operating profit margin increasing faster than the gross profit margin can…
Solvency Ratios
Solvency refers to a company’s ability to fulfill its long-term debt obligations. Assessment of a company’s ability to pay its long-term obligations (i.e., to make interest and principal payments) generally includes an in-depth analysis of the components of its financial structure. Solvency ratios, introduced in earlier modules in Corporate Issuers, provide information regarding the relative…
Liquidity Ratios
Liquidity analysis measures a company’s ability to meet its short-term obligations. Calculation of Liquidity Ratios The defensive interval ratio measures how long a company can pay its daily cash expenditures using only its existing liquid assets, without additional cash flow coming in. Interpretation of Liquidity Ratios Current Ratio A higher current ratio indicates a higher…
Activity Ratios
Activity ratios, also known as asset utilization ratios or operating efficiency ratios, are measures of operational performance — how effectively the company is using working capital and longer term assets. Interpretation of Activity Ratios Inventory Turnover and DOH Inventory turnover indicates the resources tied up in inventory (i.e., the carrying costs) and, therefore, can be…
Common Ratio Categories, Interpretation, and Context
Interpretation and Context Financial ratios can be interpreted only in the context of other information. In general, the financial ratios of a company are compared with those of its major competitors (cross-sectional and trend analysis) and to the company’s prior periods (trend analysis). The goal is to understand the underlying causes of divergence between a…