Ratio analysis involves calculations that use the data from the financial statem
ID: 2756578 • Letter: R
Question
Ratio analysis involves calculations that use the data from the financial statements to evaluate the performance of companies in different key areas. How would this information be used by a credit analyst as compared to someone is going to make an investment decision? Of what significance is the DuPont system in the analysis of a firm’s financial position? How is the DuPont system used when evaluating a firm? What recent government regulations have helped or hindered a firm’s ability to conduct its normal course of business, especially in the area of reporting requirements?
Explanation / Answer
Ratio analysis involves the use of figures from the Income statement and Balance sheet to arrive at measures that indicate the profitabvility and financial position of a firm.
Ratios are mathematical relation ships between two figures. The figures may be taken from the Income Statement or Balance Sheet or from both.
Different classes of ratios namely; short term liquidity ratios, long term solvency ratios, profitability ratios, rate or return, activity or turnover ratios, capital structure or leverage ratios, etc are calculated and used to study various facets of the working and financial position of a firm'
Ratios are used by both existing and prospective creditors of the firm as also investors.
Suppliers of Short term credit would be interested in
Suppliers of long term debt would in addition to the above short term ratios be interested in
An equity investor would in addition to the above ratios use the following ratios: It should be remembered that the equity share holders are the ones who take the maximum risk and hence need the most comprehensive analysis of the financial statementsL
DU PONT SYSTEM OF RATIO ANALYSIS:
It is an integrated system of ratio analysis, by breaking down a ratio into its components in such a way that besides giving a total picture, it also helps to analyse the constituent factors. A Du Pont Ratio Chart based on Return on Total Assets is given below.
Similarly a break of the Return on Equity (ROE)
can be given as EAT/EBT * EBT/EBIT * EBIT/SALES * SALES/ASSETS * ASSETS/EQUITY
The break up of ROE throws light on the asset turnover, profitability, tax effect and leverage.
The break up of the ratios according to the Du Pont system enables an integated analysis of all aspects of an orgainsation,
RETURN ON TOTAL ASSETS (EAT/TOTAL ASSETS) can be seen as the product of the ratios NET PROFIT RATIO TOTAL ASSET TURNOVER RATIO (EAT/NET SALES) (NET SALES/TOTAL ASSETS) Can be broken down into Can be further broken down into GROSS PROFIT RATIO SALES/FIXED ASSETS SALES/CURRENT ASSETS and further into turnover of each item of current asset OPERATING RATIO INCOME TAX EXPENSE RATIORelated Questions
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