Chapters 1 Introduction to Financial Management

What Is Finance?
Finance is defined by Webster’s Dictionary as “the system that includes the circulation of money, the granting
of credit, the making of investments, and the provision of banking facilities.” Finance has many facets, which
makes it difficult to provide one concise definition. The discussion in this section will give you an idea of what
finance professionals do and what you might do if you enter the finance field after
you graduate.

Finance as taught in universities is generally divided into three areas: (1) financial management, (2) capital
markets, and (3) investments.

Financial management,
-​ also called corporate finance, focuses on decisions relating to how much and what types of assets to
acquire, how to raise the capital needed to purchase assets, and how to run the firm so as to maximize
its value.
-​ The same principles apply to both for-profit and not-for-profit organizations, and as the title suggests,
much of this book is concerned with financial management.
Capital markets
-​ relate to the markets where interest rates, along with stock and bond prices, are determined. Also
studied here are the financial institutions that supply capital to businesses. Banks, investment banks,
stockbrokers, mutual funds, insurance companies, and the like bring together “savers” who have money
to invest and businesses, individuals, and other entities that need capital for various purposes.
Governmental organizations such as the Federal Reserve System, which regulates banks and controls
the supply of money, and the Securities and Exchange Commission (SEC), which regulates the trading
of stocks and bonds in public markets, are also studied as part of capital markets.
Investments
-​ relate to decisions concerning stocks and bonds and include a number of activities: (1) Security
analysis deals with finding the proper values of individual securities (i.e., stocks and bonds). (2)
Portfolio theory deals with the best way to structure portfolios, or “baskets,” of stocks and bonds.
Rational investors want to hold diversified portfolios in order to limit risks, so choosing a properly
balanced portfolio is an important issue for any investor. (3) Market analysis deals with the issue of
whether stock and bond markets at any given time are “too high,” “too low,” or “about right.” Included in
market analysis is behavioral finance, where investor psychology is examined in an effort to determine
whether stock prices have been bid up to unreasonable heights in a speculative bubble or driven down
to unreasonable lows in a fit of irrational pessimism.
CHAPTER 3
Financial Statements and Reports

The annual report is the most important report that corporations issue to stock-
holders, and it contains two types of information. First, there is a verbal section, often presented as a letter
from the chairperson, which describes the firm’s operating results during the past year and discusses new
developments that will affect future operations. Second, the report provides these four basic financial
statements:
1.​ Balance sheet – provides a snapshot of a firm’s financial position at one point in time.
2.​ Income statement – summarizes a firm’s revenues and expenses over a given period of time.
3.​ Statement of cash flows – reports the impact of a firm’s activities on cash flows over a given period of
time.
4.​ Statement of stockholders’ equity – shows how much of the firm’s earnings were retained, rather
than paid out as dividends.

The Balance Sheet

The balance sheet is a “snapshot” of a firm’s position at a specific point in time.

Figure 3.1 shows the layout of a typical balance sheet. The left side of the statement shows the assets that the
company owns, and the right side shows the firm’s liabilities and stockholders’ equity, which are claims against
the firm’s assets.

Stockholders’ equity = Paid-in capital + Retained earnings

The retained earnings are not just the earnings retained in the latest year - they are the cumulative total of all
of the earnings the company has earned and retained during its life.

Stockholders’ equity can also be thought of as a residual:

Stockholders’ equity = Total assets - Total liabilities
The Income Statement
Net sales are shown at the top of the statement; then operating costs, interest, and taxes are subtracted to
obtain the net income available to common shareholders.

Earnings per share (EPS)

-​ is often called “the bottom line,” denoting that of all items on the income statement
-​ is the one that is most important to stockholders.
-​ is an important financial measure, which indicates the profitability of a company.
-​ calculated by dividing the company's net income after interest & taxes by the total number of outstanding
shares.
𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
★​ EPS = 𝐶𝑜𝑚𝑚𝑜𝑛 𝑠ℎ𝑎𝑟𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔

Operating income (EBIT)

-​ is derived from the firm’s regular core business
-​ is also called EBIT, or earnings before interest and taxes.
-​ EBT means Earnings Before Taxes
★​ Operating income (or EBIT) = Sales revenues - Operating costs

Deposit Pension Scheme or DPS

-​ is an installment based savings deposit (on monthly basis) for individual customer.
-​ In this account a customer deposit a certain amount of money for a certain period. And on maturity an
agreed amount will be paid to the customer. At the same time the applicant must choose a tenor and the
amount of monthly deposit.
Relationship 1: Employees provide services to the employer and, in return, they receive wages.
Relationship 2: Employers make contributions to the pension trust.
Relationship 3: Funds are used from the pension trust to pay the employee in the future and, sometimes,
employees can also make contributions to the trust.
𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑝𝑎𝑖𝑑 𝑡𝑜 𝑐𝑜𝑚𝑚𝑜𝑛 𝑠𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠
★​ DPS = 𝐶𝑜𝑚𝑚𝑜𝑛 𝑠ℎ𝑎𝑟𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔

𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑚𝑚𝑜𝑛 𝑒𝑞𝑢𝑖𝑡𝑦

★​ Book value per share or BVPS= 𝐶𝑜𝑚𝑚𝑜𝑛 𝑠ℎ𝑎𝑟𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔

Examples of sources and uses of cash according to the cash flow viewpoint is as follows:
Sources of cash: (Add to Funds)
-​ Decreases in assets (other than cash)
-​ Increases in liabilities
-​ Increases in equity
Uses of cash: (Deduct to Funds)
-​ Increases in assets (other than cash)
-​ Decreases in liabilities
-​ Decreases in equity
Phrases used in Stt. of CFs:
Current assets & liabilities:
-​ Provided by operating activities
Non-current assets:
-​ Used in investing activities
Non-current liabilities & dividends payment:
-​ Provided by financing activities

The statement of cash flows is the accounting report that shows how much cash the firm is generating. The
statement is divided into four sections, and we explain it on a line-by-line basis.9
Here is a line-by-line explanation of the statement

Operating Activities - This section deals with items that occur as part of normal ongoing operations.
-​ Net income
-​ Depreciation and amortization
-​ Increase in inventories
-​ Increase in accounts receivable
-​ Increase in accounts payable
-​ Increase in accrued wages and taxes
-​ Net cash provided by (used in) operating activities.

Investing Activities - All activities involving long-term assets are covered in this section. It also includes the
purchase and sale of short-term investments, other than trading securities, and lending and collecting on notes
receivables.
-​ Additions to property, plant, and equipment
-​ Net cash used in investing activities

Financing Activities
-​ Increase in notes payable
-​ Increase in bonds
-​ Payment of dividends to stockholders
-​ Net cash provided by financing activities

Summary - This section summarizes the change in cash and cash equivalents
over the year.
-​ Net decrease in cash (Net sum of I, II, and III)
-​ Cash and equivalents at the beginning of the year
-​ Cash and equivalents at the end of the year

After-tax (AT) operating income

★​ AT operating income = EBIT(1 – Tax rate)

Net Working Capital

-​ Current assets - current liabilities.
Net Operating Working Capital (NOWC)
-​ Operating current assets minus operating current liabilities.
★​ NOWC = Current assets − (Current liabilities − Notes payable)
★​ NOWC = Total Current Assets - Total Current Liabilities*
*TCL must exclude Notes Payable because it is a Financing activity rather than operating.

Free cash flow

-​ The most important modification is the concept of free cash flow (FCF), defined as “the amount of cash that
could be withdrawn without harming a firm’s ability to operate and to produce future cash flows.”
-​ is actually the net cash that is left after paying off all the expenses.
-​ A company with negative cash flow doesn't signify that it is bad because new companies usually spend a
lot of cash. They do investments getting a high rate of return due to which they run out of cash at hand.
★​ 𝐹𝐶𝐹 = [𝐸𝐵𝐼𝑇 (1 − 𝑇) + 𝐷𝑒𝑝𝑟. 𝑎𝑛𝑑 𝑎𝑚𝑜𝑟𝑡𝑖𝑧𝑎𝑡𝑖𝑜𝑛] − [∆𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑒𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒𝑠 + ∆𝑁𝑂𝑊𝐶 ]

EBIT (1 - T) is often referred to as NOPAT, or net operating profit after taxes.

Depreciation and amortization are added back because these are non-cash expenses that reduce EBIT but do
not reduce the amount of cash the company has available to pay its investors.
The second bracketed term Indicates the amount of cash that the company is investing in its fixed assets
(capital expenditures) and operating working capital in order to sustain ongoing operations.

Performance Measures for Evaluating Managers/Executives

Accounting statements are insufficient for evaluating managers’ performance because they do not reflect
market values.
Performance Measures: MVA and EVA

Market value added (MVA)

-​ Difference between market value and book value of a firm’s common equity.
-​ is a calculation that shows the Difference between The market value of a company and the capital
contributed by all investors, both bondholders and shareholders.
In other words, it is
-​ the market value of debt and equity minus
-​ all capital claims held against the company.
★​ 𝑀𝑉𝐴 = ( 𝑃0 × 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠) − 𝐵𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝐶𝐸

Economic value added (EVA)

-​ is a measure of a company's financial performance based on the residual wealth calculated by
deducting its Cost of Capital from its Operating profit, adjusted for taxes on a cash basis.
-​ Estimate of a business’ true economic profit for a given year.\
-​ Operating Profit after Tax minus Cost of Capital
★​ 𝐸𝑉𝐴 = 𝐸𝐵𝐼𝑇 (1 − 𝑇) − [ 𝑇𝑜𝑡𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 × 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 ]

Cost of capital
 -​ represents the return a company needs to achieve in order to justify the cost of a capital project, such
as purchasing new equipment or constructing a new building.
-​ Cost of capital encompasses the cost of both equity and debt, weighted according to the company's
preferred or existing capital structure.

CHAPTER 4: Analysis of Financial Statements

Why are ratios useful?

-​ Ratios standardize numbers and facilitate comparisons.
-​ Ratios are used to highlight weaknesses and strengths.
-​ Ratio comparisons should be made through time and with competitors.
➢​ Industry analysis
➢​ Benchmark (peer) analysis
➢​ Trend analysis

Five Major Categories of Ratios and the Questions They Answer

1.​ Liquidity: Can we make required payments?
2.​ Asset management: Right amount of assets vs. sales?
3.​ Debt management: Right mix of debt and equity?
4.​ Profitability: Do sales prices exceed unit costs, and are sales high enough as reflected in PM (Profit
Margin), ROE, and ROA?
5.​ Market value: Do investors like what they see as reflected in P/E and M/B ratios?

Market value: Do investors like what they see as reflected in P/E and M/B ratios?
-​ The price-to-earnings ratio (P/E ratio) is the ratio for valuing a company that measures its current share
price relative to its earnings per share (EPS). The price-to-earnings ratio is also sometimes known as the
price multiple or the earnings multiple.
-​ The market-to-book ratio (M/B ratio) helps a company determine whether or not its asset value is
comparable to the market price of its stock. It is best to compare Market to Book ratios between companies
within the same industry.

Liquidity Ratios
-​ The liquidity ratios help answer this question: Will the firm be able to pay off its as they come due and thus
remain a viable organization? If the answer is no, liquidity must be addressed.
-​ A liquid asset is one that trades in an active market and thus can be quickly converted to cash at the going
market price.

1.​ CURRENT RATIO

-​ The primary liquidity ratio is the current ratio, which is calculated by dividing current assets by current
liabilities:
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠
★​ 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑟𝑎𝑡𝑖𝑜 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

2.​ QUICK, OR ACID TEST, RATIO

-​ The second liquidity ratio is the quick, or acid test, ratio, which is calculated by deducting inventories
from current assets and then dividing the remainder by current liabilities:
𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠 − 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑖𝑒𝑠
★​ 𝑄𝑢𝑖𝑐𝑘, 𝑜𝑟 𝑎𝑐𝑖𝑑 𝑡𝑒𝑠𝑡, 𝑟𝑎𝑡𝑖𝑜 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠
3.​ INVENTORY TURNOVER RATIO
-​ “Turnover ratios” divide sales by some asset: Sales/Various assets. As the name implies, these ratios
show how many times the particular asset is “turned over” during the year
-​ is a financial ratio showing how many times a company has sold and replaced inventory during a given
period.
𝑆𝑎𝑙𝑒𝑠
★​ 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑟𝑎𝑡𝑖𝑜 = 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑖𝑒𝑠

4.​ DAYS SALES OUTSTANDING

-​ Accounts receivable are evaluated by the days sales outstanding (DSO) ratio, also called the average
collection period (ACP).
-​ represents the average number of days it takes credit sales to be converted into cash or how long it
takes a company to collect its account receivables.
-​ It is calculated by dividing accounts receivable by the average daily sales to find how many days’ sales
are tied up in receivables.
𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠 𝑅𝑒𝑐𝑒𝑖𝑣𝑎𝑏𝑙𝑒𝑠
★​ 𝐷𝑆𝑂 = 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑠𝑎𝑙𝑒𝑠 𝑝𝑒𝑟 𝑑𝑎𝑦
= 𝐴𝑛𝑛𝑢𝑎𝑙 𝑠𝑎𝑙𝑒𝑠/365

5.​ Fixed Assets Turnover Ratio

-​ The ratio of sales to net fixed assets.
-​ It measures how effectively the firm uses its plant and equipment.
𝑆𝑎𝑙𝑒𝑠
★​ 𝐹𝑖𝑥𝑒𝑑 𝑎𝑠𝑠𝑒𝑡𝑠 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑟𝑎𝑡𝑖𝑜 = 𝑁𝑒𝑡 𝑓𝑖𝑥𝑒𝑑 𝑎𝑠𝑠𝑒𝑡𝑠

6.​ Total Assets Turnover Ratio

-​ This ratio is calculated by dividing sales by total assets.
-​ It measures how effectively the firm uses its total assets.
-​ The asset turnover ratio can be used as an indicator of the efficiency with which a company is using its
assets to generate revenue.
𝑆𝑎𝑙𝑒𝑠
★​ 𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 𝑟𝑎𝑡𝑖𝑜 = 𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠

Debt Management Ratios

1.​ Total Debt to Total Capital

-​ The ratio of total debt to total capital; it measures the percentage of the firm’s capital provided by
debtholders.
-​ gives analysts and investors a better idea of a company's financial structure and whether or not the
company is a suitable investment.
-​ All else being equal, the higher the debt-to-capital ratio, the riskier the company.
𝑇𝑜𝑡𝑎𝑙 𝑑𝑒𝑏𝑡 𝑇𝑜𝑡𝑎𝑙 𝑑𝑒𝑏𝑡
★​ = 𝑇𝑜𝑡𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝑐𝑎𝑝𝑖𝑡𝑎𝑙
= [(𝑁/𝑃 + 𝐿𝑇𝐷)] + 𝐶𝑜𝑚𝑚𝑜𝑛 𝐸𝑞𝑢𝑖𝑡𝑦

2.​ TIMES-INTEREST-EARNED RATIO

-​ The ratio of earnings before interest and taxes (EBIT) to interest charges
-​ a measure of the firm’s ability to meet its annual interest payments.
-​ The result is a number that shows how many times a company could cover its interest charges with its
pretax earnings.
 𝐸𝐵𝐼𝑇
★​ 𝑇𝑖𝑚𝑒𝑠 − 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 − 𝑒𝑎𝑟𝑛𝑒𝑑 (𝑇𝐼𝐸) 𝑟𝑎𝑡𝑖𝑜 = 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑐ℎ𝑎𝑟𝑔𝑒𝑠

The Times Interest Earned (TIE) ratio is a measure of a company's ability to meet its debt obligations based on
its current income. The result is a number that shows how many times a company could cover its interest
charges with its pretax earnings (or the Operating Profit before Interest and Taxes).

A higher times interest earned ratio is favorable because it means that the company presents less of a risk to
investors and creditors in terms of solvency.
ROThumb: From an investor or creditor's perspective, an organization that has a times interest earned ratio
greater than 2.5 is considered an acceptable risk.
Companies that have a times interest earned ratio of less than 2.5 are considered a much higher risk for
bankruptcy or default and, therefore, financially unstable.

Debt/Total invested capital and TIE are better than the industry average.
• Note: In D/TIC ratio, the lower (vs. Ind. ave.) the better. In TIE ratio, the higher (vs. Ind. ave.) the better.

Profitability Ratios
A group of ratios that show the combined effects of liquidity, asset management, and debt on operating results.

Operating Margin
-​ This ratio measures operating income, or EBIT, per dollar of sales; it is calculated by dividing operating
income by sales.
𝐸𝐵𝐼𝑇
★​ 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑚𝑎𝑟𝑔𝑖𝑛 = 𝑆𝑎𝑙𝑒𝑠

Profit Margin
-​ This ratio measures net income per dollar of sales and is calculated by dividing net income by sales.
𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
★​ 𝑃𝑟𝑜𝑓𝑖𝑡 𝑚𝑎𝑟𝑔𝑖𝑛 = 𝑆𝑎𝑙𝑒𝑠

Return on Total Assets (ROA)

-​ The ratio of net income to total assets; it measures the rate of return on the firm’s assets.
𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
★​ 𝑅𝑂𝐴 = 𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠

Return on Common Equity (ROE)

-​ The ratio of net income to common equity; it measures the rate of return on common stock- holders’
investment.
𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
★​ 𝑅𝑂𝐸 = 𝐶𝑜𝑚𝑚𝑜𝑛 𝑒𝑞𝑢𝑖𝑡𝑦

Problems with ROE

-​ ROE and shareholder wealth are correlated, but problems can arise when ROE is the sole measure of
performance.
➢​ ROE does not consider risk.
➢​ ROE does not consider the amount of capital invested.
(Since unlike TIC which includes N/P & LTD + CE)
-​ Given these problems, reliance on ROE may encourage managers to make investments that do not benefit
shareholders. As a result, analysts have looked to develop other performance measures, such as EVA.
Effects of Debt on ROA and ROE
-​ Holding assets constant, if debt increases:
➢​ Equity declines. (A = L + E) due to Iosses incurred w/c decreases RE and
➢​ Interest expense increases – which leads to a reduction in net income.
-​ ROA declines (due to the reduction in net income).
-​ ROE may increase or decrease (since both net income and equity decline depends on net effect).

Return on Invested Capital (ROIC)

-​ The ratio of after-tax operating income to total invested capital; it measures the total return that the
company has provided for its investors.
𝐸𝐵𝐼𝑇(1 − 𝑇)
★​ 𝑅𝑂𝐼𝐶 = 𝑇𝑜𝑡𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝑐𝑎𝑝𝑖𝑡𝑎𝑙

Basic Earning Power (BEP) Ratio

-​ This ratio indicates the ability of the firm’s assets to generate operating income; it is calculated by
dividing EBIT by total assets.
-​ is a measure of the company’s efficiency at producing earnings relative to its assets.
-​ All things being equal, a company with a higher BEP ratio is a more profitable company; it's more
efficient at generating income from its assets. The greater the ratio's value, the greater the profitability
created from the assets of the company.
𝐸𝐵𝐼𝑇
★​ 𝐵𝐸𝑃 = 𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠

Market Value Ratios

-​ Ratios that relate the firm’s stock price to its earnings and book value per share.
Price/Earnings (P/E) Ratio
-​ The ratio of the price per share to earnings per share;
-​ shows the dollar amount investors will pay for $1 of current earnings.
-​ known as the price multiple or the earnings multiple.
𝑃𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
★​ (𝑃/𝐸) 𝑟𝑎𝑡𝑖𝑜 = 𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒

Market/Book (M/B) Ratio

-​ The ratio of a stock’s market price to its book value.
-​ helps a company determine whether or not its asset value is comparable to the market price of its
stock.
-​ It is best to compare Market to Book ratios between companies within the same industry.
𝑀𝑎𝑟𝑘𝑒𝑡 𝑃𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒
★​ (𝑀/𝐵) 𝑅𝑎𝑡𝑖𝑜 = 𝐵𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 𝑝𝑒𝑟 𝑠ℎ𝑎𝑟𝑒

Enterprise Value/ EBITDA (EV/EBITDA) Ratio

-​ The ratio of a firm’s enterprise value relative to its EBITDA.
★​ Enterprise value (EV)
= Market value of equity + Market value of total debt + Market value of other financial claims - (Cash
and equivalents)

The DuPont Equation

★​ 𝑅𝑂𝐸 = 𝑃𝑟𝑜𝑓𝑖𝑡 𝑚𝑎𝑟𝑔𝑖𝑛 × 𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠 𝑡𝑢𝑟𝑛𝑜𝑣𝑒𝑟 × 𝐸𝑞𝑢𝑖𝑡𝑦 𝑚𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟
★​ 𝑅𝑂𝐸 = ( 𝑁𝑒𝑡 𝑖𝑛𝑐𝑜𝑚𝑒
𝑆𝑎𝑙𝑒𝑠 )× ( 𝑆𝑎𝑙𝑒𝑠
𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠 )× ( 𝑇𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠
𝑇𝑜𝑡𝑎𝑙 𝐸𝑞𝑢𝑖𝑡𝑦 )
Focuses on:
➢​ -expense control (PM),
➢​ asset utilization (TA TO), and
➢​ debt utilization (equity multiplier).
DuPont analysis is a useful technique used to decompose the different drivers of return on equity (ROE) for a
business. This allows an investor to determine what financial activities are contributing the most to the changes
in ROE. An investor can use analysis like this to compare the operational efficiency of two similar firms.
Introduced by DuPont Corporations salesman in 1912, named Mr. Brown.
Potential Uses of Freed Up Cash
➢​ Repurchase stock
➢​ Expand business
➢​ Reduce debt
➢​ All these actions would likely improve the stock price.

Potential Problems and Limitations of Financial Ratio Analysis

-​ Comparison with industry averages is difficult for a conglomerate firm that operates in many different
divisions. (e.g., Holding companies)
-​ Different operating and accounting practices can distort comparisons. (e.g., Types of depreciation)
-​ Sometimes it is hard to tell if a ratio is “good” or “bad.” (e.g., ratio may be a temporary thing for a certain
period under review. New and expanding firms may tend to borrow in trade for higher market w/c is
good in the long run.)
-​ Difficult to tell whether a company is, on balance, in a strong or weak position. (Hence, requires deeper
analysis is needed before arriving at conclusion.)