Ch. 5 & DuPont Analysis

ROE equation
ROE=(Profit Margin*Total Asset Turnover)*Equity Multiplier
profit margin is a measure of
the firm’s operating efficiency- how well it controls costs
total asset turnover is a measure of
a firm’s asset use efficiency-how well does it measure its assets
equity multiplier is a measure of
the firm’s financial leverage
DuPont Analysis
ROE=ROA*Equity Multiplier
Equity Multiplier= Total Assets/ Stockholder’s equity
ROA= Profit Margin*Total Asset Turnover
Profit Margin=Net Income/Sales
Total Asset Turnover=Sales/Total Assets
what drives the value of a firm?
profitability and growth
four levers to achieve growth and profit targets
operating management, investment management, financing strategy, and dividend policy
product market strategies
operating management, investment management
financial market policies
financing decisions, dividen policy
operating management
managing revenue and expenses
investment management
managing working capital and fixed assets
financing decisions
managing liabilities and equity
dividend policy
managing payout
benchmarks for evaluating ratios include
time series, cross-sectional, and absolute benchmarks
ratios over time from prior periods
time series
ratios of other firms in the industry
effective ratio analysis must attempt to
relate underlying business factors to the financial numbers
common sized income statement
facilitate comparisons of key line items across time and different firms
SG&A to sales
influenced by operating activities undertaken to implement strategy (differentiation strategy=higher SG&A for branding and promotion) and influenced by efficiency of over head activities (important to firms pursuing low cost strategy)
tax expense to sales
look at tax expense to earnings before taxes as well (average tax rate)
return measures
profit margin (ROS), ROA, and ROE
profit margin=
net income/sales
profit margin measures
how much money is generated in profit for every dollar in sales
return on assets=
net income/total assets
ROA measures
profit per dollar of assets
return on equity=
net income/total equity
ROE measures
how stockholders fared during the year
key profitability ratios
gross profit margin, EBIT margin, EPS
gross profit margin=
(sales-cost of sales)/sales
gross profit margin measures
the profitability of sales, less direct cost of sales
gross profit margin is an indicator of
the price premium that a firm’s product commands in the market and the efficiency of a firm’s procurement and/or production process
EBIT margin gives
indication of operating performance because it reflects all operating costs and excludes effect of debt financing and taxes
EBIT margin=
earnings before interest and taxes/sales
earnings per share is
one of the most frequently use measures of profitability and is the only financial ratio that GAAP requires firms to disclose on the face of the income statement
basic EPS does not include
outstanding convertible bonds or convertible preferred stock that can be exchanged for shares of common stock or options or warrants that holders can use to acquire common stock
basic EPS=
(net income-preferred dividends) / # of common shares outstanding
diluted EPS includes
convertible securities and or stock options or warrants outstanding
diluted EPS reflects
the dilution potential of convertible securities, options, and warrants
diluted EPS=
(net income-preferred stock dividends) / (# of common shares outstanding+# of shares issuable from dilutive securities)
criticisms of EPS
does not consider amount of assets or capital required to generate a particular level of earnings, 2 firms with same earnings and EPS not necessarily equally profitable, # of shares of common stock outstanding serves as a poor measure of the amount of capital in use