This lesson provides an in-depth examination of ratio analysis, the most widely used technique for evaluating financial performance and position. It covers the major categories of ratios, their calculation, interpretation, and the DuPont framework for decomposing return on equity (ROE).

• Introduction to Ratio Analysis: Ratio analysis is a quantitative technique for evaluating a company’s performance and financial position by comparing relationships between different financial statement items. Ratios are indicators of some aspect of a company’s performance, but they tell what happened, not why it happened. Evaluations require comparisons—it is difficult to say a company’s performance was “good” or “bad” without a basis for comparison, such as cross-sectional analysis (comparing multiple companies) or trend analysis (comparing measures over time) .

• Categories of Financial Ratios: Financial ratios are typically grouped into the following categories:

  • Profitability Ratios: Measure the company’s ability to generate profits from its operations and investments. Major ratios include gross profit margin, operating profit margin, net profit margin, return on assets (ROA), and return on equity (ROE).

  • Liquidity Ratios: Measure the company’s ability to meet short-term obligations. Major ratios include the current ratio, quick (acid-test) ratio, cash ratio, and the cash conversion cycle.

  • Solvency/Leverage Ratios: Measure the company’s ability to meet long-term obligations and its reliance on debt. Major ratios include debt-to-assets ratio, debt-to-equity ratio, financial leverage ratio, and interest coverage.

  • Activity/Efficiency Ratios: Measure the efficiency of the company’s operations and asset utilization. Major ratios include inventory turnover, days of inventory on hand, receivables turnover, days of sales outstanding, payables turnover, and total asset turnover.

  • Valuation Ratios: Compare the company’s market value to its financial performance. Includes Price-to-Earnings (P/E) ratio, Price-to-Book (P/B) ratio, and Enterprise Value multiples.

• The DuPont Analysis: A Deeper Look at ROE: In the 1920s, the management at DuPont Corporation developed a model called DuPont Analysis for a detailed assessment of the company’s profitability. DuPont Analysis is a tool that may help to avoid misleading conclusions regarding a company’s profitability . The analysis of a company’s profitability involves nuances; for example, the ROE formula uses the book value of common equity, and we cannot be sure what caused the change in common equity . To avoid erroneous conclusions, we can use a more in-depth analysis of this measure.

• The Basic Three-Step DuPont Model: The basic DuPont Analysis model is a method for breaking down the original ROE equation into three components: operating efficiency, asset efficiency, and leverage. Operating efficiency is measured by Net Profit Margin and indicates the amount of net income generated per dollar of sales. Asset efficiency is measured by the Total Asset Turnover and represents the sales amount generated per dollar of assets. Finally, financial leverage is determined by the Equity Multiplier. The equation is:

  ROE = Net Profit Margin × Total Asset Turnover × Equity Multiplier

  The first two components assess the operations of the business. The larger these components, the more productive the business is. The last component, financial leverage, captures the company’s financial activities. The more leverage the company takes, the higher the risk of default.

• A Five-Step DuPont Model: The basic DuPont Analysis model does not isolate operating activities from financing activities. A five-step DuPont model helps to solve this problem. In this model, in order to isolate operations and financial impacts on ROE, we further break down the components used in the basic model. The formula isolates the effect of interest expense on the Net Profit Margin, allowing the analyst to see whether increased leverage will influence net income or boost ROE. This provides a more in-depth analysis of the drivers behind ROE changes.