The Du Pont Equation

As the other tutorials have emphasised, it is the interpretation of accounting ratios that is of significance.
Thus, ratio analysis needs to proceed beyond the simple listing of ratios. But, sadly, this is where many
textbooks seem to stop. Ratio analysis needs to serve some sort of diagnostic purpose as this will enable
the analyst to see where it is that the firm is doing well and where it is doing poorly.
One tool that is useful in analysing various ratios is the so-called Du Pont equation. This is a simple
equation that was developed by the Du Pont chemical company for internal auditing purposes.
The basic argument behind the Du Pont equation is that a firm is interested in the returns to its
shareholders. Thus, the significant ratio is the return on equity (ROE) or return on shareholders' funds
(ROSF). This is shown in the equation below.

The problem with the profitability ratio is that it does not give any detail about why the firm's
profitability might be high or low. All of the information about the firm's performance is collapsed into
one ratio. Therefore, it cannot be ascertained whether a firm that has a good return on equity is performing
well in all areas or just one. Similarly, a firm with a poor profitability ratio might be performing badly in
all areas or just one. To overcome this problem, the Du Pont equation was developed. It is presented
below.

In this equation, the return on equity is given by the net profit margin (profit after tax divided by
sales) multiplied by a turnover ratio (the total asset turnover) multiplied by a gearing ratio.
Margin & Turnover

It might seem obvious that a firm's return on equity will be higher if its profit margin is high. Thus, the
presence of the first term on the right-hand side of the Du Pont equation should be self-evident. Similarly,
if the firm has a high total assets turnover figure, it is generating high sales from its assets. As the sales are
assumed to be profitable, more sales will mean more profit. So the relationship between total asset
turnover and profitability is not difficult to grasp.

Gearing

One problem might arise in understanding the Du Pont equation comes from the inclusion of the gearing
ratio in the equation. First, it should first be noted that, whilst the profit margin and the turnover ratio in
the Du Pont equation are commonly encountered ratios, the gearing ratio in the form that it takes in the
equation above is rarely used outside of the Du Pont equation. That said, why should a high gearing ratio
increase profitability?

Briefly the argument runs as follows. More debt will mean that part of the profits will be diverted to
interest payments. If, however, the return on debt is lower than that on equity, the money raised by
borrowing will be cheaper than equity. Thus, for example, financing half a firm's assets by debt would
halve the number of shareholders but would cost the firm less than half its profits. Thus, the smaller
number of shareholders would have proportionately more to share amongst themselves and so the return
on equity would be greater.
The Du Pont equation shown above is only of use if its elements mean something and can be used to
organise ratio analysis in a rational way. The three terms on the right-hand side of the equation will now
be looked at in turn.

The profit margin

In interpreting the profit margin there are two main elements that have to be considered, the economic
environment and the firm's marketing stance. These two, together, will determine what is meant by a
'satisfactory' profit margin.
Elementary economic theory tells us that one of the reasons for high levels of profits is monopoly
power. If the firm is operating in a competitive environment we would expect the level of profits to be
lower. However, an important element in competition is not the actual number of firms in the market but
the barriers to entry. A firm in an industry with high barriers could be expected to exhibit a higher
profitability ratio than one in a market with low barriers.
If the net profit margin is deemed to be too low, given the consideration of the firm's economic
environment, the analysis could proceed by considering the relationship between the net profit margin and
the gross profit margin i.e. the difference is usually made up of by interest and tax and the costs that are
incurred in administration and sales. A firm with a low net profit but high gross profit would be one where
production was efficient but sales and administration were not.
Another feature of the firm that might influence its profit margin is its marketing stance. It might be
possible to identify two extremes for firms in a market. At one extreme, firms will be operating at the
lower, 'mass' end of the market selling a product which is relatively undifferentiated and for which the
demand is relatively elastic. There will probably be large number of competitors in this sector. In this
case, the level of profitability might be quite low. On the other hand, firms operating at the top end of the
market will probably be selling a differentiated product, the differentiation being sufficient to allow the
product to be identified as high quality. The extra quality will probably result in slower production and so
the turnover ratio will be lower than that for a firm at the bottom end of the market but the profitability
ratio should be higher.

The turnover ratio

The turnover ratio in the Du Pont equation is the total asset turnover. In general terms, this ratio should be
as high as possible provided that the other aspects of the firm are not jeopardised. For example, it would
be no good paring back on assets and forcing sales in order to create a high turnover ratio if the firm is
basing its sales on an image of quality. A low total asset turnover, if it is deemed to be too low, should
lead to an analysis of the other turnover ratios. Logically, if the total asset turnover ratio is too low this
implies that the total asset figure is too high. This might be because fixed assets are being badly utilised,
current assets are too high or a combination of both.
If the total asset ratio is in need of further analysis the next ratio to look at might be the fixed asset
turnover ratio. If the total asset turnover ratio is low but the fixed asset turnover ratio is comparable to
other similar firms, it would suggest that the problem lies in the area of current assets. This would lead to
a look at the current ratio. If the current ratio is high it would imply that either cash, stocks or debtors are
high. Stock can be analysed using the stock turnover ratio and debtors by the days sales outstanding or
debtor days ratio. This further analysis should suggest where the problem lies.

The gearing ratio

Finally, the gearing ratio used in the Du Pont equation should be considered. The problem of a high
gearing ratio is that it could signify that the firm might be unable to service its interest payment. A high
gearing ratio here should lead to an examination of the times interest earned ratio. This will show, in part,
how likely it is that the firm would be in trouble if earnings drop and interest rates rise.
There is another feature here that should be examined. The times-interest-earned ratio implies that
problems might occur if interest payments change or earnings vary. Therefore, if the time-interest-earned
 ratio is too low for comfort the next item to examine would be the nature of debt and the volatility of the
earnings stream. If the debt is largely fixed interest, the firm's interest payments would only increase a
little if rates rose. Similarly, a firm with an earnings stream that was fairly stable would be one that could
stand a relatively high level of debt and so could exhibit a higher gearing ratio and a lower times-interest-
earned ratio. Therefore, the variance of the earnings stream over the past few periods would be a useful
figure to examine.

Concluding remarks

The diagram below suggests a pathway for analysing the position of a firm using ratios and is based on the
discussion above.

Overall, the fundamental issue that the Du Pont equation uncovers is not a specific way to analyse
ratios but rather an illustration of the fact that it is the interpretation and following up of ratios that is
important. What is not so important, indeed what in a lot of students' work is actually trivial, is the
listing of ratios and their calculation with no accompanying analysis. Indeed, many textbooks contain
examples that consist of lists of ratios compared to an industry average followed by the words 'good',
'bad', 'average', etc. This is really not a satisfactory way to proceed. If a firm has a low return on equity
(ROE) there must be a specific reason (or a number of reasons) for this. What is needed is the use of
ratios in a rational, analytical manner so as to uncover the areas within the firm where performance is
poor. The Du Pont equation is one approach to this end.

Dupont Ratio analysis

Financial Analysis and the Changing Role of Credit Professionals

In today's dynamic business environment, it is important for credit professionals to be prepared

to apply their skills both within and outside the specific credit management function. Credit
executives may be called upon to provide insights regarding issues such as strategic financial
planning, measuring the success of a business strategy or determining the viability of an
acquisition candidate. Even so, the normal duties involved in credit assessment and management
call for the credit manager to be equipped to conduct financial analysis in a rapid and meaningful
way.

Financial statement analysis is employed for a variety of reasons. Outside investors are seeking
information as to the long run viability of a business and its prospects for providing an adequate
return in consideration of the risks being taken. Creditors desire to know whether a potential
borrower or customer can service loans being made. Internal analysts and management utilize
financial statement analysis as a means to monitor the outcome of policy decisions, predict future
performance targets, develop investment strategies, and assess capital needs. As the role of the
credit manager is expanded cross-functionally, he or she may be required to answer the call to
conduct financial statement analysis under any of these circumstances. The DuPont ratio is a
useful tool in providing both an overview and a focus for such analysis.

A comprehensive financial statement analysis will provide insights as to a firm's performance

and/or standing in the areas of liquidity, leverage, operating efficiency and profitability. A
complete analysis will involve both time series and cross-sectional perspectives. Time series
analysis will examine trends using the firm's own performance as a benchmark. Cross sectional
analysis will augment the process by using external performance benchmarks for comparison
purposes. Every meaningful analysis will begin with a qualitative inquiry as to the strategy and
policies of the subject company, creating a context for the investigation. Next, goals and
objectives of the analysis will be established, providing a basis for interpreting the results. The
DuPont ratio can be used as a compass in this process by directing the analyst toward significant
areas of strength and weakness evident in the financial statements.

ROE = (Net Income/Sales) X (Sales/Average Assets) X (Average Assets/Average Equity) (1)

The ratio provides measures in three of the four key areas of analysis, each representing a
compass bearing, pointing the way to the next stage of the investigation.

The DuPont Ratio Decomposition

The DuPont ratio is a good place to begin a financial statement analysis because it measures the
return on equity (ROE). A for-profit business exists to create wealth for its owner(s). ROE is,
therefore, arguably the most important of the key ratios, since it indicates the rate at which owner
wealth is increasing. While the DuPont analysis is not an adequate replacement for detailed
financial analysis, it provides an excellent snapshot and starting point, as will be seen below.

The three components of the DuPont ratio, as represented in equation (1), cover the areas of
profitability, operating efficiency and leverage (liquidity analysis needs to be conducted
separately). In the following paragraphs, we examine the meaning of each of these components
by calculating and comparing the DuPont ratio using the financial statements and industry
standards for Atlantic Aquatic Equipment, Inc. (Exhibits 1, 2, and 3), a retailer of water sporting
goods.

Profitability: Net Profit Margin (NPM: Net Income/Sales)

Profitability ratios measure the rate at which either sales or capital is converted into profits at
different levels of the operation. The most common are gross, operating and net profitability,
which describe performance at different activity levels. Of the three, net profitability is the most
comprehensive since it uses the bottom line net income in its measure.

The net profitability for Atlantic Aquatic Equipment in 1996 is:

Net Profit Margin = Net Income/Sales = $70,530/$5,782,000 = 1.22%. (2)

A proper analysis of this ratio would include at least three to five years of trend and cross-
sectional comparison data. The cross sectional comparison can be drawn from a variety of
sources. Most common are the Dun & Bradstreet Index of Key Flnancial Ratios and the Robert
Morris Associates (RMA) Annual Statement Studies. Each of these volumes provide key ratios
estimated for business establishments grouped according to industry (i.e., SIC codes). More will
be discussed in regard to comparisons as our example is continued below.

Operating Ficiency or Asset Uuilisation: Total Asset Turnover (TAT: Sales/Average Assets)

Turnover or efficiency ratios are important because they indicate how well the assets of a firm
are used to generate sales and/or cash. While profitability is important, it doesn't always provide
the complete picture of how well a company provides a product or service. A company can be
very profitable, but not too efficient. Profitability is based upon accounting measures of sales
revenue and costs. Such measures are generated using the matching principle of accounting,
which records revenue when earned and expenses when incurred. Hence, the gross profit margin
measures the difference between sales revenue and the cost of goods actually sold during the
accounting period. The goods sold may be entirely different from the goods produced during that
same period. Goods produced but not sold will show up as inventory assets at the end of the year.
A firm with abnormally large inventory balances is not performing effectively, and the purpose
of efficiency ratios is to reveal that fact.
The total asset turnover (TAI) ratio measures the degree to which a firm generates sales with its
total asset base. As in the case of net profitability, the most comprehensive measure of
performance in this particular area is being employed in the DuPont ratio (other measures being
fixed asset turnover, working capital turnover, inventory and receivables turnover). It is
important to use average assets in the denominator to eliminate bias in the ratio calculation.

Financial ratio bias is commonly present when combining items from both the balance sheet and
income statement. For example, TAT uses income statement sales in its numerator and balance
sheet assets in the denominator. Income statement items are flow variables measured over a time
interval, while balance sheet items are measured at a fixed point in time. In cases where the firm
has been involved in major change, such as an expansion project, balance sheet measures taken
at the end of the year may misrepresent the amount of assets available and/or in use over the
course of the year. Taking a simple average for balance sheet items (i.e., ((beginning ending)/2))
will control for at least some of this bias and provide a more accurate and meaningful ratio. The
limiting assumption is that the change in the balance sheet occurred evenly over the course of the
year, which may not always be the case.

The measure of total asset turnover for Atlantic Aquatic Equipment is:

TAT = Sales/Average Assets= $5,782,000/(($2,203,200 $2,476,200)/2)= 2.47. (3)

In this case, total assets did not substantially change over the course of the year, and therefore,
potential bias caused by using the ending asset amount would not be substantial. Regardless, it is
a good idea to get into the habit of using averages for all balance sheet items when conducting
this type of analysis.

Leverage: The Leverage Multiplier (Average Assets/Average Equity)

Leverage ratios measure the extent to which a company relies on debt financing in its capital
structure. Debt is both beneficial and costly to a firm. The cost of debt is lower than the cost of
equity, an effect which is enhanced by the tax deductibility of interest payments in contrast to
taxable dividend payments and stock repurchases. If debt proceeds are invested in projects which
return more than the cost of debt, owners keep the residual, and hence, the return on equity is
"leveraged up." The debt sword, however, cuts both ways. Adding debt creates a fixed payment
required of the firm whether or not it is earning an operating profit, and therefore, payments may
cut into the equity base. Further, the risk of the equity position is increased by the presence of
debt holders having a superior claim to the assets of the firm.

The leverage multiplier employed in the DuPont ratio is directly related to the proportion of debt
in the firm's capital structure. The measure, which divides average assets by average equity, can
be restated in two ways, as follows:

Average Assets/Average Equity = 1/(1 -(Average Debt/Average Assets)), or

Average Assets/Average Equity = 1 (Average Debt/Average Equity =1 (Average DebtlAvernge
Equity). (S)

Equation (4) employs a simple debt/asset ratio, while equation (5) uses the well known
debt/equity ratio. Once again, averages are used to control for potential bias caused by the end-
of-year values. The leverage multiplier for Atlantic Aquatic Equipment is:

Average Assets/Average Equity = $2,339,700/(($995,652 $1,025,982)/2) = 2.31.(6)

Combination and Analysis of the Results

Once the three components have been calculated, they can be combined to form the ROE, as
follows:

(Net Income/Sales)X(Sales/Average Assets)X(Average Assets)X(Average Assets/Average

Equity) = ROE

1.22% X 2.47 X 2.31 = 6.96%. (7)

While additional measures for prior years would provide the basis for a necessary trend analysis,
this result is not meaningful until it is compared to an industry or best practices benchmark. The
DuPont ratio for the industry (Exhibit 4) is:

3.60% X 2.60 X 2.00 = 18.72% (8)

As can be seen, problems in Atlantic Aquatic Equipment are immediately evident in the
comparison of equations (7) and (8). The company appears to have a significant weaknesses in
profitability, while total asset turnover and leverage seem to be roughly in line with the industry.
The analyst can now focus on the company's profitability. A quick analysis of profitability yields
the following result:

As can be seen, the inventory turnover is significantly lower than the industry average, which
means that the problem is more likely due to poor location or inventory quality rather than the
inventory management processes. The next step in the analysis would most likely be a qualitative
study of the composition of the inventory as well as the retail facility itself.

Concluding Remarks

Sound financial statement analysis is an integral part of the management process for any
organization. The DuPont ratio, while not the end in itself, is an excellent way to get a quick
snapshot view of the overall performance of a firm in three of the four critical areas of ratio
analysis, profitability, operating efficiency and leverage. By identifying strengths and/or
weaknesses in any of the three areas, the DuPont analysis enables the analyst to quickly focus his
or her detailed study on a particular spot, making the subsequent inquiry both easier and more
meaningful. Some caveats, however, are to be noted.
The DuPont ratio consists of very general measures, drawing from the broadest values on the
balance sheets and income statements (e.g., total assets is the most broad of asset measures). A
DuPont study is not a replacement for detailed, comprehensive analysis. Further, there may be
problems that the DuPont decomposition does not readily identify. For example, an average
outcome for net profitability may mask the existence of a low gross margin combined with an
abnormally high operating margin. Without looking at the two detailed measures, understanding
of the true performance of the firm would be lost.

The DuPont ratio can also be broken into more components, depending upon the needs of the
analyst. In any case, the DuPont can add value, even "on the fly," to understand and solving a
broad variety of business problems.
A Practical Approach to Customer Financial Statement
Analysis
The scope of the following presentation is based on the perspective of the trade creditor, who
wants to make sure that bills are paid within terms and who wants to assign a credit line to the
customer. The level of analysis required to make an informed credit decision depends on the
customer requesting credit terms and the amount of credit required. If the customer's financial
condition is not strong and the credit request represents a large portion of the subject company's
net worth, the analysis would be quite detailed. After completing the investigation, the analyst
can determine whether to sell its goods or services to the customer on open account and establish
an appropriate line of credit.

There are several sources of information used in making a credit decision. These sources include
antecedent information, bank information, trade references, and the firm's financial statements
with accompanying notes.

Antecedent Information
Antecedent information presents a clear picture of the type of business the potential customer
operates. There are three primary sources used to collect antecedent information: your firm's
credit application, credit reporting agencies, and trade group meetings. (See The New Customer
Credit Investigation)

The Credit Application provides:

• The business name and address

• How the business is organized
o Corporation
o Partnership
o Proprietorship
• Lines of business and method of operation
• Length of time in business

The Credit Agency's Report and Trade Group Meetings provide information on:

• The character of the principles

• History of the business
• Is the company currently involved in litigation
• How the firm meets its financial obligations

A review of the available antecedent information provides the basis for understanding the
customer's needs and requirements. From this information the analyst can often develop a mental
picture of the customer and what it would be like to do business with them.
Bank Information
Included in the credit application would be a request for bank information. The analyst should
verify the customer's banking relationship. He should inquire about both the deposit relationships
and lines of credit.

Information to be Verified:

• Length of Time as a Bank Customer

• Deposit Balances (Checking, Savings, CD's, etc.)
• Lines of Credit:
o Amount of Credit Line
o Loan Origination Date
o Current Availability on the Line
o Expiration Date
o Are There Any Loan Restrictions
o Are There Any Covenant Violations

The information provided by the bank can serve as a good indicator of the customerës ability to
pay. Covenant information is also very important. If the customer is in violation of one or more
of the loan covenants, the bank has the right to pull the line of credit. Even if the firm could
finance its operations internally, without a bank line, it is very likely that its pay patterns would
slow down.

Trade References
The credit application would include a request for three or four of the customer's current
suppliers. The analyst would request that those suppliers provide the following information:

• Credit Line
• Supplier for What Length of Time
• High Credit
• Current Balance
• Payment Habits

The trade reference information provides a very good indication of what other suppliers consider
to be the credit worthiness of the customer at a given point in time. It is in the best interest of the
customer to provide references that paint the best picture. If the customer does not take care of
his obligations to these suppliers in a timely manner, you can be sure that your relationship with
the customer will not be any better.

Financial Statements with Accompanying Notes

Once you have drawn conclusions from the soft data, it is time to focus your attention on the
hard data -- the financial statements. Often, financial statement analysis will confirm your
preliminary impressions. In addition, analyzing the financial statements enables you to
concentrate more specifically on the sources of payment. There are four major cash sources of a
business: net profit, conversion of an asset to cash, increase in liabilities, and increase in equity.
It is necessary for a company to generate larger sources of cash than uses of cash, if any capacity
for debt repayment is to exist. The primary source of repayment for short term liabilities is the
conversion of an asset to cash. Usually the conversion of inventory to accounts receivable to cash
provides the method of payment.

As the credit grantor, you will most often be presented with two financial statements -- the
income statement and balance sheet. If the financial statements were prepared by a Certified
Public Accountant, the financial statements will include an opinion, income statement, balance
sheet, statement of retained earnings, statement of cash flows, and the accompanying notes to the
financial statements.

Reliability of Financial Statements

Before you begin your analysis of the financial statements, you must assess the reliability of the
financial data. There are four basic types of financial statements: audited, compiled, reviewed,
and management prepared.

Audited Financial Statements

Audited statements offer the analyst the most reliability. Audited statements are prepared by a
Certified Public Accountant and undergo a rigorous examination. This objective, professional
opinion provides considerable comfort as to the quality of the financial statements. The financial
statements are the responsibility of management. However, the accountant is legally liable for
what is said in the opinion.

The Auditor's Opinion is provided in the cover letter of the financial statements. The opinion
defines how much responsibility an auditor actually accepts.

Unqualified Opinion
means that the auditor is willing to take the maximum degree of responsibility. Look for phrases
such as except for or subject to in the opinion. These phrases tell you that the statements are not
unqualified.

Qualified Opinion
means that the auditor assumes the maximum responsibility for the reliability of the statements
except for the items explained in the qualification.

Disclaimer of Opinion
due to serious scope limitations the auditor is unable to express an opinion and does not assume
any significant responsibility.

Adverse Opinion
as a result of material noncompliance to Generally Accepted Accounting Procedures (GAAP),
the Auditor concludes that the statements are not fairly presented.

Unaudited Financial Statements

Depending on your customer base, many of the financial statements that you work with may not
be audited. Many of these statements will be prepared by an accountant who does not express an
opinion. Unaudited financial statements prepared by an accountant fall into two categories
referred to as compilation and review.

Compilation
The accountant prepares the financial statements from the books and records of the client. The
compilation does not include any review or verification procedures. The accountant assumes no
responsibility or liability for the financial information.

Review
The accountant prepares the financial statements from the books of the client and performs
limited inquiry and analytical procedures. The CPA provides limited assurance that the
statements conform to GAAP.

Management Prepared Statements

Statements prepared by management are used most often for interim period analysis. However, if
your potential customer is a small business or privately held, the only financial information
available for your review may be management prepared statements. When reviewing
management prepared statements, antecedent information becomes very important in developing
a framework for judging management's character. Using antecedent information, you can
determine if the management of the company is trustworthy.

Level of Credit Investigation

The level of investigation is driven by the company's credit policy. (See Credit Policy) In the
course of doing business the credit department must set guidelines for the level of analysis
required for establishing credit lines. These guidelines are usually based on several factors: the
industry that the firm operates in, the size of the firm, and the firm's willingness to assume risk in
order to grow market share.

A company's credit policy might establish the following guidelines for setting credit
lines:

For credit lines under $25,000 the analyst is required to review:

• A completed credit application

• Contact bank references to determine account balances and loan availability
• Contact trade references to determine the credit line granted, activity, and payment habits

From those three sources of information the analyst would make a decision whether to offer open
account terms and determine the credit line that would be established.

For credit lines from $25,000 up to $100,000 the level of analysis would be increased to include
the above information, plus:

• A credit report from a reporting agency that includes payment history and antecedent
information.
• The prior three years financial statements from the potential customer.
This level of information would provide the necessary basis for the analyst to make his credit
decision. He could determine the potential customer's payment habits, what other suppliers in the
industry were doing, if there was cash in the bank, or availability on a line of credit, and the
financial health of the business.

The analyst would begin his analysis of the financial statements by reviewing the Accountant's
Opinion. If the accountant found any irregularities with the firm's financial reporting or
management's behavior, it would appear in the opinion.

He would also read through the accompanying notes to the financial statements and determine if
there were any: accounting policies of an unusual nature that were being used; significant
contingencies or potential litigation; any large maturity that would come due in the coming year
that would impact their future cash flow; or any event that occurred during the past year not
appearing in the numbers.

The final step in the analysis would be to review the numbers. The analyst would determine if
the business had a solid equity base, compare the financial information to the industry, insure
that the firm's working capital position was adequate, and if the business was profitable. Based
on his analysis of these criteria, he would make a decision whether to sell the account on open
terms and at what level to establish the credit line.

For credit lines above $100,000 additional approvals would be required.

• The Credit Manager, Director of Credit, and the Chief Financial Officer would have
different levels of credit line authority. As the potential customer's credit requirement
increased, different levels of sign-off would be required.

The analyst would follow all the steps previously discussed, however the review of the financial
statements would be more in-depth. When the analysis requires additional approvals, the analyst
usually spreads the financial statements and calculates a number of ratios. He also provides a
very concise narrative highlighting any significant issues and makes a recommendation to
management. After the credit request has the appropriate approvals, the credit line is assigned.

Although the Credit Policy discussed above may not hold true for your organization, the basic
concept probably does. Increasing levels of exposure, present higher levels of risk, and therefore
require different levels of analysis.

Financial Statement Analysis

Much of the information considered when evaluating a company's financial strength is derived
from the financial statements, notes to the financial statements, and commentary that supplement
the financial statements. The notes to the financial statements explain the accounting polices of
the company and often provide detailed explanations of how those polices were applied.

Sometimes the notes are used to explain specific management actions and the reasons for those
actions. The notes to the financial statements must be read carefully if the statements are to be
understood fully. The basic financial statements are, of course, the balance sheet, the income
statement, the statement of cash flows, and the statement of retained earnings.

Analysis of financial statements often involve some transformation of the reported data.
Techniques such as ratio analysis, percentage analysis, and comparison to industry data make it
possible to identify significant relationships in a company's financial data. These analysis
techniques are most effective when they are applied to data for several accounting periods, which
usually is possible because most companies report two years of comparative financial statement
data at each report date.

The analysis of financial statements, if it is to be a thorough analysis, may be divided into three
parts: the firm's profitability, capital position, and liquidity position.

Operating Performance
Analyzing the operations of a business involves the process of carefully reviewing the income
statement. Management's ultimate goal should be to maximize the return to stockholders, and net
income probably is the best single measure under management's control of how well that goal
has been achieved. The operating results a company achieves will often weigh equally with the
balance sheet in determining whether to extend credit on open account.

The income statement is the summary of the revenue and expenses of the business for a specific
period of time. Using a technique known as common-sizing the financial statements, we can gain
an understanding of the trends of expenses and profit margins that occur over time. Using the
financial statements of Star Stores, Inc., we will demonstrate the use of common-size statements
spread over several years. As illustrated in the common-size income statement of Star Stores,
Inc., each category is calculated as a percentage of sales. (Exhibit 1) When we spread several
years of financial data side by side we can gain significant insight into trends within the
company. As is highlighted in our example, Star's gross margin has continued to erode over the
last three years. Gross margin is the revenue generated in excess of cost of goods. This red flag
would lead to the question of why? The company's response might indicate that due to increased
competition over the last several years, the company was required to lower its price to maintain
market share.

We can use a technique know as comparative analysis, which compares the operating results of
the company under investigation with companies in the same industry. The industry average for
department stores (Star's industry) appears in the far right hand column. Industry averages are
compiled and updated annually by Robert Morris Associates and Dun & Bradstreet. Such
comparisons provide a benchmark for assessing how well the company's management has
performed in relation to others in the industry. We can determine if the erosion in gross margin is
industry wide. Since Star's gross margin is about the same as the industry, it is reasonable to
assume that competitive pressures did in fact force the decrease in gross margin over the past
three years.

We would continue our review of each category in the income statement, looking for significant
deviations in performance from year to year and comparing each category to the industry.
Operating expenses as a percentage of sales often increase from year to year. If there were
significant increases, questions could be raised to determine if the increases were due to non-
recurring expenses. Since net income is often the primary source of cash for a business, we
would zero in on whether the potential customer's net income was increasing or decreasing from
year to year. We would also compare the trend between net income and sales.

Using profitability ratios and the trends between those ratios, we can draw conclusions of how
efficiently the company has operated in the past and how it is likely to operate in the future.
Profitability ratios are helpful for evaluating management's success in generating returns for
those who provide capital to the company. We will discuss three profitability ratios: Profit
Margin on Sales, Return on Total Assets, Return on Stockholders' Equity.

Profit Margin on Sales

is calculated by net income divided by net sales. This ratio indicates the return a company
receives for each dollar of sales. We would compare the trends of the last several years and
compare the ratio to the industry average.

Profit Margin on Sales = Net Income

Net Sales

Return on Total Assets

measures how efficiently the company uses its assets. It indicates the net income generated per
dollar of invested assets. By comparing the customer to the industry, we can determine if the
company has purchased more capital equipment than it really needs. If it is determined that
profitability is a problem, examine the income statement to find the causes of the difficulty.

Return on Total Assets = Net Income

Average Total Assets *
* Average Total Assets = (Begin Total Assets + End Total Assets) / 2

Return on Stockholders' Equity

relates the net profit of a business to the investment made by the firm's owners. ROE is often
used to compare two or more businesses in one industry. ROE summarizes management's
success at maximizing the return to common stockholders.

It also determines if the company will be attractive to other investors.

Return on Stockholders' Equity = Net Income - Preferred Dividends

Average Common Stockholders' Equity

Using common-sized financial statements compared to industry averages, we can identify trends
that lead us to develop an impression of a prospective customer. Using ratio analysis we can
solidify our opinion of how effective the management operates the business.
Financial Position
Our analysis of financial position will focus on the long term indicators of risk taken from the
balance sheet (Exhibit 2). As a trade creditor we are concerned about the riskiness of our
customers. We can use leverage ratios to provide information about the relative emphasis on debt
in the capital structure of the company. We can also determine if the company has the ability to
service both its current and long-term debt. Our analysis of the capital structure will be based on
two ratios: Total Liabilities to Total Assets and Times Interest Earned.

Total Liabilities to Total Assets

provides information about the company's ability to absorb asset reductions arising from losses
without risking the interests of creditors. It is the relationship between borrowed funds and the
assets of the company. If borrowed funds increase more rapidly than the company's net worth,
outside creditors assume more operating risk. Loan covenants often require companies not to
exceed specified levels of the total liabilities to total assets ratio. This presents additional risk for
creditors. Generally, the more stable the historical income, the greater the likelihood that
creditors will tolerate increased debt. We can use the common-size statements to determine if our
potential customer is assuming more risk. By comparing the company to the industry we can
determine if the company is carrying to much debt.

Total Liabilities to Total Assets = Total Liabilities

Total Assets

Times Interest Earned

is used in determining if the prospective customer has the ability to make interest payments on its
debt. It is Income Before Interest and Taxes divided by the Interest Expense. It is very important
to all creditors that the customer have the ability to cover its interest expense. Creditors prefer a
high value for this ratio because a high value indicates the operating income available to pay
interest will be well in excess of annual interest expense.

Times Interest Earned = Income Before Taxes + Interest Expense

Interest Expense

Our analysis of the balance sheet allows us to determine if the customer is leveraged and if it has
the ability to pay the interest expense generated by the debt. Star's capital structure is solid. Its
Total Liabilities to Total Assets has remained at about 47% over the past several years, while the
industry average is 65.9%. Star's ability to cover its interest payments is also favorable. Its Time
Interest Earned ratio for the last year was 1.9 to 1, compared to the industry average of 1.7 to 1.

Liquidity Analysis
Although analysis of the customer's profitability and capital position are important, the most
important factor to the trade creditor is the customer's liquidity position. We can begin to analyze
the liquidity and quality of the current assets by calculating the current ratio. The current ratio
is the relationship of current assets to current liabilities.

Current Ratio = Current Assets

Current Liabilities
It is an indicator of the customer's ability to meet its short-term obligations with current assets.
The trade creditor wants to know if current obligations can be met when they are due? As a
general rule a ratio of 2 to 1 is adequate protection for trade creditors. As a short-term creditor,
we can feel reasonably secure about receiving payment when it is due. We should be very
concerned if the customer has a low current ratio. At best we will not receive prompt payment.
Often it indicates a short-term cash flow problem that if not corrected can force the company into
bankruptcy. The current ratio should be evaluated in light of the company's management plans,
as well as industry and general economic conditions.

A word of caution, the Current Ratio can be manipulated by management. This activity is known
as window-dressing. It is important that you keep in perspective the information that is derived
from any single financial ratio.

The strength of the current ratio can be tested by calculating the quick ratio. The quick ratio
excludes inventory from the calculation. Inventory is usually the less liquid of the current assets.
The closer the quick ratio is to the current ratio the more liquid the current assets.

Quick Ratio = Current Assets - Inventory

Current Liabilities

When evaluating the quick ratio it is important to review the company with an industry
perspective. Some industries may have very liquid inventories while other normally liquid
current assets, such as receivables, may be comparatively nonliquid.

Du Pont Ratio Analysis

The Du Pont Ratio Analysis is a combination of financial ratios in a series to assess investment
return. It combines financial ratios using both the income statement and balance sheet to assess
either the Return On Investment or the Return On Equity. The benefit of the method is that it
provides an understanding of how the company generates its return. This analysis provides
insight into the importance of asset turnover and sales to the overall return. The formula shows
the relationship of profit margin and turnover and how the two complement each other. The
formula also indicates where there are weaknesses.

The analyst can also gain an understanding of how the firm uses debt to generate its return. The
Du Pont Ratio allows us to brake down Return On Equity into three component parts: net profit
margin, total asset turnover, and the company's use of leverage.

Du Pont Ratio Analysis

Return On Equity = Return On Assets x Financial Leverage

ROE = Net Income ROA = Net Income Financial Leverage = Assets
Equity Assets Equity
Return On Assets = Pretax Profit Margin x Total Asset Turnover
ROA = Net Income Pretax Profit = Net Income Total Asset = Sales
Assets Margin Sales Turnover Assets
Our analysis of Star (Exhibit 3) reveals that it turns its assets about 1.4 times a year with a
Return On Assets of 2.46%, which generated a 4.6% Return On Equity.

Cash Flow
The statement of cash flows (Exhibit 4) shows the cash provided by, and used by the operating,
investing, and financing activities of a company for a defined period of time. Operating activities
relate to a companyës primary revenue generating activities. The cash flows from operating
activities are generally the cash effects of transactions included in the determination of income.
Investing activities include lending money and collecting on those loans, buying and selling
securities not classified as cash equivalents. Financing activities include borrowing money from
creditors and repaying the amounts borrowed, and obtaining resources from owners and
providing them with both a return on their investment and a return of their investment.

The Financial Accounting Standards Board (FASB) allows two approaches to reporting cash
flows from operating activities: the direct approach and the indirect approach. FASB encourages
the use of the direct approach. However, the indirect approach is the more widely used method of
displaying cash flows.

Cash Flow from Operating Activities

The major recurring inflow of cash for most companies is from sales of their primary products.
Operating cash outflows include payments to suppliers of merchandise, payments to employees,
interest payments, and taxes. Since the income statement is grounded in accrual accounting, the
equality between net income and cash flow from operating activities is rarely equal. As is
demonstrated in our example of Star's Statement of Cash Flow, the company's operating
activities generated a net cash balance of $25,688,400.

Cash Flows from Investing Activities

Investing activities include purchases and sales of productive assets that are expected to generate
revenues over long periods of time; purchases and sales of securities that are not classified as
cash equivalents; and, lending money and collecting interest on those loans. In our Statement of
Cash Flows example Star incurred an outflow of ($11,777,000) for the purchase of equipment
and land. Star's net cash used in investing activities was ($10,799,000).

Cash Flow from Financing Activities

Financing activities include borrowing money from creditors and repaying the amounts
borrowed, and obtaining resources from owners and providing them with both a return on their
investment and a return of their investment. In our example, Star purchased ($16,415,600) of its
common stock. The company increased its use of LTD by $1,343,200. The net cash used by
financing activities was ($15,072,400).

Next, we sum the net changes in cash for each of the three sections: operating, investing, and
financing. This total represents the net increase or decrease in cash for the period under
investigation. The net change in cash for the period is added to the beginning of the year cash
balance to determine the cash balance at the end of the year.
Information reported in the Statement of Cash Flows, when used with other financial statement
information, helps the analyst assess a company's future cash flow potential. It also helps the user
to assess a company's ability to pay its debts. Finally, the cash flow statement allows us to
understand the differences between the company's income flows and cash flows.

Operating Cycle
The operating cycle (Exhibit 5) refers to the circulation of items within the current assets. The
operating cycle is the process of purchasing inventory, converting it into accounts receivable and
collecting the receivables. The average lapse of time between the investment and final
conversion back to cash is the length of the operating cycle. The average length of time
necessary to complete this cycle is an important factor in determining a company's working
capital needs. A company with a very short operating cycle can manage comfortably on a
relatively small amount of working capital. A long cycle requires a larger margin of current
assets to current liabilities, unless the credit terms of suppliers can be extended.

The average length of the operating cycle can be roughly estimated by adding the number of
days it takes to sell inventory and the number days it takes to convert receivables into cash.

The length of time required to sell the inventory is referred to as Days of Inventory on Hand. We
begin the calculation by determining the inventory turnover. Inventory turnover represents the
total cost of all goods that have been moved out of inventory during the year. This is represented
by the cost of goods sold taken from the income statement. Therefore, the ratio of Costs of
Goods Sold to Average Inventory during any period measures the number of times that inventory
turns over and must be replaced. For example, in 1999 Star's cost of goods sold were
$223,222,000 and its average inventory level is $58,777,000. By dividing COGS by Average
Inventory we can determine that Star turned its inventory about four times.

Inventory = Cost of Goods Sold = $ 223,222,000 = 3.7 inventory turns per year
Turnover Average Inventory $ 60,799,000

The analysis can be extended to determine the number of days that were required to turn the
inventory. This calculation is referred to as Days Inventory on Hand. In our example:

Days Inventory on Hand 365 Days = 99 days

Inventory Turnover

We complete our operating cycle calculations by determining the length of time required to
convert receivables to cash. This is referred to as the Average Collection Period. We begin this
calculation by calculating Accounts Receivable Turnover. Unless a firm has a significant amount
of cash sales, the total sales for any period represents the flow of claims into receivables during
the period, the result is a rough indicator of the number of times the company's receivables
turnover during the year. For example, Star's annual sales in 1999 were $340,591,000 and its
Accounts Receivable balance was $62,352,200. By dividing Sales by Average Accounts
Receivable, we can determine that Star turns its A/R 5.46 times a year. We can extend our
calculation to determine the number of days it takes to collect the accounts receivable. Average
Collection Period is calculated by dividing 365, the number of days in the year, by Accounts
Receivable Turnover. The result is the average length of time necessary to convert receivables to
cash.

Average Collection Period = 365 Days = 66.85 Days

Receivable Turnover *
* Accounts Receivable Turnover = Sales
Accounts Receivable

In our example, if Star offers 60 day terms to its customers, the calculation reveals that its
customers are only paying about 6.85 days beyond terms. Most credit managers would consider
these results satisfactory.

By combining the Days Inventory on Hand with the Average Collection Period, we gain an
understanding of the length of time required by Star to complete its Operating Cycle. In our
example, Star completed the operating cycle in 163 days.

Operating Cycle
Days Inventory on Hand 99
Average Collection Period + 67
Days Required to Complete the Cycle 166

Determining the operating cycle is important for two reasons: first, we can compare these results
to similar companies or to industry averages to determine how efficient the company manages its
current assets. Most importantly, however, the operating cycle analysis can be extended to
determine if Star has adequate working capital to meet its operating requirements. Trade
creditors are paid with cash generated by the conversion of current assets. Working capital is the
gap between current assets and current liabilities. If our analysis reveals a deficit in working
capital, we must determine how Star plans to pay its obligations in a timely manner.

The final step in estimating working capital requirements is to calculate Days Payable
Outstanding. Days Payable Outstanding is equal to 365 days divided by Payables Turnover.
Payables Turnover is calculated by dividing purchases for the period under investigation by
Accounts Payables. Purchases equal ending inventory less beginning inventory plus cost of
goods sold. Accounts Payable is the ending payables balance taken from the balance sheet.

Days Payable Outstanding = 365

Payables Turnover
Payables Turnover = Purchases / Payables

Purchases = Ending Inventory - Beginning Inventory + Cost of Goods Sold

Payables = Accounts Payable balance taken from the Balance Sheet

Days Payable Outstanding is an estimate of the length of time the company takes to pay its
vendors after receiving inventory. If the firm receives favorable terms from suppliers, it has the
net effect of providing the firm with free financing. If terms are reduced and the company is
forced to pay at the time of receipt of goods, it reduces financing by the trade and increases the
firms working capital requirements.

Star's Comparative Operating Cycle vs. Industry

Days Inventory on Hand 99 104
Average Collection Period + 67 + 70
Operating Cycle 166 174

Days Payable Outstanding - 29 - 31

Days to be Financed 137 143

Working Capital Available is determined by subtracting Current Liabilities from Current Assets.
Working Capital Required is equal to Purchases divided by (365 / Days to be Financed). If
Working Capital Available exceeds Working Capital. Required, the firm has adequate working
capital to meet its current obligations. The Operating Cycle can be used to determine if the
potential customer has the ability to meet our payment terms. In our example, Star has a strong
Working Capital position. Working Capital Available has exceeded Working Capital Required in
two of the past three years.

Recommendations
The next step of the analysis would be to develop a narrative about the findings. During the
analysis notes should be made as to the type of opinion given by the accountant and key events
or procedures that are referenced in the notes of the financial statements. Events that might have
an adverse effect on the future of the business such as loan covenant violations or significant
current maturities that would be coming due, should be documented in the narrative. The
highlights of the financial statements would also be discussed, including both positive and
negative factors. Any facts pertinent to the deal or transaction that initiated the account review
would be included in the write-up. A recommendation for a course of action to be taken is the
final step in the process. It could include a statement that the account should be given open terms
and the amount of credit line to be established, or that the account is not recommended for open
terms and an alternative (such as a type of security) would be suggested. The narrative would be
prepared as a one page executive summary, with supporting analysis attached.