ACCOUNTING, DEFINED

The Committee on Accounting Terminology of the American Institute of Accountants defines

Accounting as “the art of recording, classifying, and summarizing in a significant manner and in
terms of money, transactions and events which are in part at least of a financial character, and
interpreting the results thereof.”

FINANCIAL STATEMENT ANALYSIS

Financial Statement Analysis is a process of evaluating and interpreting an entity’s financial
statements to assess its financial health for the purpose of making better economic decisions.

Financial Ratio Analysis

Financial ratio analysis involves the computation of percentages, fractions or proportions using
certain formulas.

Financial ratios are broadly classified into the following:

1. Liquidity ratios
2. Activity ratios (Asset management ratios)
3. Leverage ratios (Debt management ratios)
4. Profitability ratios

Leverage ratios (Debt management ratios)

Leverage ratios (Debt management ratios) provide a measure of the extent a business uses debt
financing or “leverage.”

a. Debt ratio (Debt-to-asset ratio) – measures the proportion of assets financed through debt. A
high debt to asset ratio implies a high level of debt.
b. Equity ratio – measures the proportion of assets financed through equity.

c. Debt-to-equity ratio – indicates how much debt is used to finance the assets relative to the
amount pertaining to the owner(s).

A high ratio suggests a high level of debt that may result in high interest expense. A debt to
equity ratio of greater than 1 implies that the company’s debt exceeds its capital.

d. Interest coverage ratio - measure the company’s ability to cover the interest expense on its
liability with its operating income.

A ratio greater than 1 means that the company’s operating income can meet its interest expense.
But 1 is a very low ratio. Creditors may prefer a high coverage ratio to give them protection that
interest can be repaid from income.
Profitability ratios
Profitability ratios provide a measure of the performance of a business in terms of its ability to
generate profit from its resources.

Resources- assets and invested capital.

a. Gross profit ratio – shows the relationship between sales and cost of goods sold.

The GROSS PROFIT MARGIN can be interpreted as the peso value of the gross profit earned
for every peso of sales.
We can also infer the average pricing policy from the Gross Profit Margin.
We can also measure the company’s ability to control its cost from the Gross Profit Margin.

b. Net profit ratio – measures profitability after considering all income and expenses.

The NET PROFIT MARGIN can be interpreted as the peso value of the net income earned for
every peso of sales.
A company with a higher net profit margin is considered more profitable.
We can also measure the company’s ability to control its cost from the Gross Profit Margin.
c. Return on assets – measures the profit generated in relation to the total resources available to
the business.

The RETURN ON ASSETS is a popular measure of the profitability of the company’s assets.
It also measures the company’s efficiency to generate income by employing its assets.
In comparing companies, the company with a higher ROA is judged to be more profitable.

d. Return on equity (Return on net assets) – measures the profit generated in relation to the
resources invested by (or attributable to) the owner(s) of the business.

Like ROA, the company with higher RETURN ON EQUITY is judged to be more profitable.
DEBT RATIO
Interpretation: The result means that for every Php1 of an asset, Php0.44 pertains to the
creditors (or 44% of the total asset pertains to the creditors).

EQUITY RATIO
Interpretation: The result means that for every Php1 of an asset, Php0.56 pertains to the
owners (or 56% of the total asset pertains to the owner).

DEBT-TO-EQUITY RATIO
Interpretation: The result means that for every Php0.79 financed through debt, there is
corresponding Php1 that is financed through equity. This indicates that the business relies more
on equity financing than on debt financing.

GROSS PROFIT RATIO

Interpretation: The result means that for every Php1 sale, Php0.65 gross profit is earned.

NET PROFIT RATIO

Interpretation: The result means that for every Php1 sale, Php0.30 net profit is earned.

RETURN ON ASSETS
Interpretation: This means that the business is able to generate a profit of Php0.39 for
every Php1 of its total resources.

RETURN ON EQUITY
Interpretation: This means that the business is able to generate a profit of Php0.71 for
every Php1 of owner’s equity.
 The DuPont Model Return on Equity Formula

What is Return on Equity (ROE)?

Simply stated, return on equity reveals how much after-tax profit a company earned in
comparison to the total amount of shareholder equity found on the balance sheet.

Composition of Return on Equity Using the DuPont Model

There are three components in the calculation of return on equity when doing a DuPont model
analysis. These are:
1. The Net Profit Margin
2. Asset Turnover
3. The Equity Multiplier

What many investors fail to realize, and where a DuPont Return on Equity analysis can help, is
that two companies can have the same return on equity, yet one can be a much better business
with much lower risks. This can have incredible consequences for your portfolio's returns over
long periods of time as the better business is able to generate more free cash flow or owner
earnings.

The First Component of the DuPont Model: Net Profit Margin

The net profit margin is the after-tax profit a company generated for each peso/dollar of
revenue. Net profit margins vary across industries, making it important to compare a potential
investment against its competitors. Although the general rule-of-thumb is that a higher net profit
margin is preferable. There are two ways to calculate net profit margin:
a. Net Income ÷ Revenue
b. Net Income + Minority Interest + Tax-Adjusted Interest ÷ Revenue.

The Second Component of the DuPont Model: Asset Turnover

The asset turnover ratio is a measure of how effectively a company converts its assets
into sales. It is calculated as follows:
Asset Turnover = Revenue ÷ Assets
The asset turnover ratio tends to be inversely related to the net profit margin. That is, the higher
the net profit margin, the lower the asset turnover. The result is that the investor can compare
companies using different models (low-profit, high-volume vs. high-profit, low-volume) and
determine which business is more attractive.

A great example of this comes from Wal-Mart Stores, Inc.. Wal-Mart's founder, the late
Sam Walton, often wrote and spoke about the insight that allowed him to build one of the largest
fortunes in human history through his family holding company, Walton Enterprises, LLC. He
realized that he could make significantly more absolute profit by shoving enormous volumes of
merchandise at relatively lower profit margins over his existing asset base than he could by
extracting huge profit margins on fewer individual sales.

Along with other tricks he used, such as leveraging sources of other people's money using
vendor financing, this allowed him to take market share from competitors and grow
exponentially. He was amazed that the people competing against him could see how rich he was
getting but couldn't bring themselves to switch to the discount model because they had become
addicted to the idea of high-profit margins, focusing on those margins instead of total profits.

By using a DuPont model return on equity breakdown, an investor could have seen how
much higher Wal-Mart's return on shareholder equity was despite its noticeably lower profit
margins. This is one of the reasons it is so important for a small business owner, manager,
executive, or other operator to clearly identify the business model he is she is going to use and
stick to it. Walton was worried that the Wal-Mart staff would someday become more concerned
with improving profits through higher profit margins than sticking to his low-cost, high asset
turnover method that was key to his empire's success. He knew that if that day ever came, Wal-
Mart would be in danger of losing its competitive advantage.
The Third Component of the DuPont Model: The Equity Multiplier
It is possible for a company with terrible sales and margins to take on excessive debt and
artificially increase its return on equity. The equity multiplier, which is a measure of financial
leverage, allows the investor to see what portion of the return on equity is the result of debt.
The equity multiplier is calculated as follows:
Equity Multiplier = Assets ÷ Shareholders’ Equity.

How to Calculate the DuPont Return on Equity

To calculate the return on equity using the DuPont model, all you have to do is multiply the three
components we've just discussed (net profit margin, asset turnover, and equity multiplier)
together.

Return on Equity = (Net Profit Margin) (Asset Turnover) (Equity Multiplier).

Real-World Return on Equity Calculations

Using figures from PepsiCo's 2004 annual report:

Revenue: $29,261,000,000
Net Income: $4,212,000,000
Assets: $27,987,000,000
Shareholders’ Equity: $13,572,000,000

Plug these numbers into the financial ratio formulas to get our components:
Net Profit Margin: Net Income ($4,212,000,000) ÷ Revenue ($29,261,000,000) = 0.1439, or
14.39%
Asset Turnover: Revenue ($29,261,000,000) ÷ Assets ($27,987,000,000) = 1.0455
Equity Multiplier: Assets ($27,987,000,000) ÷ Shareholders’ Equity ($13,572,000,000) = 2.0621
Finally, we multiply the three components together to calculate the return on equity:
Return on Equity: (0.1439) x (1.0455) x (2.0621) = 0.3102, or 31.02%
Calculating the DuPont Return on Equity Model for Johnson & Johnson

It's always good to provide multiple examples so let's take a look at Johnson & Johnson's most
recently completed full fiscal year, 2015. Pulling its Form 10-K filing, we find the necessary
DuPont model return on equity components in the financial section statement:

Revenue: $70,074,000,000
Net Income: $15,409,000,000
Assets: $133,411,000,000
Shareholders' Equity: $71,150,000,000

Putting these numbers into the financial ratio formulas, we can discover our DuPont analysis
components:
Net Profit Margin: Net Income ($15,409,000,000) ÷ Revenue ($70,074,000,000) = 0.2199, or
21.99%
Asset Turnover: Revenue ($70,074,000,000) ÷ Assets ($133,411,000,000) = 0.5252
Equity Multiplier: Assets ($133,411,000,000) ÷ Shareholders' Equity ($71,150,000,000)
= 1.8751
With that, we have the three components we need to calculate return on equity:
Return on Equity: (0.2199) x (0.5252) x (1.8751) = 0.2166, or 21.66%

Analyzing Our DuPont ROE Results for PepsiCo

A 31.02% return on equity was good in any industry back in 2004. Yet, if you left out the
equity multiplier to see how much PepsiCo would have earned had it been completely debt-free,
you would have discovered that ROE dropped to 15.04%. In other words, for the year ended
2004, 15.04% of the return on equity was due to profit margins and sales, while 15.96% was due
to returns earned on the debt at work in the business. If you found a company at a comparable
valuation with the same return on equity yet a higher percentage arose from internally-generated
sales, it would be more attractive.
Compare PepsiCo to Coca-Cola on this basis and it becomes clear, especially after
adjusted for the stock options that were then outstanding, that Coke was the stronger brand.
Analyzing Our DuPont ROE Results for Johnson & Johnson

Looking at its DuPont return on equity analysis, it is clear that it truly is one of the
greatest businesses that has ever existed. What is remarkable is that management has arranged
the firm's structure so that debt plays a major role in the returns while the absolute debt level is
extremely low relative to cash flow.

In fact, Johnson & Johnson's interest coverage ratio is so good, and its cash flows so
secure, that following the 2008-2009 collapse that was the worst economic maelstrom since the
Great Depression back in 1929-1933, it was one of only four companies with Triple A rated
bonds.

Specifically, the DuPont ROE analysis shows us that Johnson & Johnson's non-leveraged
return on equity is 11.55% with the other 10.11% coming from the use of leverage; leverage that
in no way poses any threat to the safety or stability of the enterprise. It could even be said that a
prudent investor might consider acquiring shares of Johnson & Johnson to hold for life and pass
on to children and grandchildren using the stepped up basis loophole, any time it is reasonably
priced or undervalued.

Market test or Valuation Ratios

The followings are the market test or valuation ratios.

1. Dividend Yield Ratio.
2. Dividend Payout Ratio or Payout Ratio.
3. Price Earning Ratio or P/E Ratio (Earnings Yield Ratio).
4. Market value to Book Value Ratio.
1. Dividend Yield Ratio
This ratio is calculated to know the relationship prevailing between dividend per share
issued by the company and the market value of the share of the respective company.
Dividend Yield Ratio Formula
The formula to find dividend yield ratio is as follows
Dividend Yield Ratio = Dividend per Equity Share / Market Value per Share
Dividend per Equity Share = Dividend Paid to Equity Shareholders / Number of Equity Shares

2. Dividend Payout Ratio or Payout Ratio

This ratio is calculated to find out the extend of profits retained within the business
concern. A portion of profits earned retained within the business is called ploughing back of
profits. Such profits helps the company for growth and pay more dividends in future.
Dividend Payout Ratio formula
The formula to find out dividend payout ratio is as follows.
Dividend Payout Ratio = Dividend per Equity Share / Earnings Per Share

3. Price Earning Ratio or P/E Ratio (Earnings Yield Ratio)

This ratio discloses the relationship prevailing between market price per equity share and
earnings per share. Generally, this ratio is calculated by the prospective investors to find the
appreciation in the market value of shares and decide whether or not to buy the shares in a
particular company.
Formula to find P/E Ratio
Price earning ratio is calculated with the help of following formula.
Price Earnings Ratio = Market Price per Equity Share / Earnings Per Share
Earnings Yield Ratio = Earnings per Share / Market Price Per Share x 100

4. Market Value to Book Value Ratio

This ratio is calculated to find out the relationship prevailing between market value per
share and book value per share. This ratio is calculated by the following formula.
Formula to find Market value to Book value ratio
The following formula can be used to find market value to book value ratio
Market value to Book Value Ratio = Market value per Share / Book Value per Share
Book Value per Share = (Equity Share Capital+ Reserves and Surpluses – Accumulated
Losses) / Number of Equity Shares

1. A drop in the market price of a firm’s ordinary share will immediately affect its
a. return on ordinary shareholder’s equity c. dividends payout ratio
c. dividends payout ratio d. dividends yield ratio
2. The Dexter Company had 50,000 ordinary shares issued and outstanding during 2018.
Earnings per share for 2018 were Php15. The dividend to the preference shareholders was Php2
per share. The ordinary shareholders received a dividend totaling Php150,000. The dividend
pay-out ratio for Dexter Company for 2018 was
a. 38.40% c. 23.10%
c. 23.10% d. 20.00%
3. Ryan Company had 20,000 ordinary shares outstanding through 2018. These shares were
originally issued at a price of Php15 per share. The book value on December 31, 2018 was
Php25 per share and the market value on December 31, 2018 was Php30 per share. The dividend
on ordinary shares in total for 2018 was Php45,000. The dividend yield ratio for Ryan Company
for 2018 was
a. 9.0% c. 15%
c. 15% d.10%
4. Throughout 2018, Sherwin Company had 40,000 ordinary shares outstanding. The book value
per share was Php60 and the market value per share was Php75 on December 31, 2018. Net
income for 2018 was Php400,000. Interest on long-term debt was Php40,000. Dividends to
ordinary shares were Php3 per share. The tax rate for 2018 was 30%. Sherwin Company’s
price-earnings ratio would be
a. 25 to 1 b. 20 to 1
c. 7.5 to 1 d. 6 to 1
5. During 2018, Concon Company paid a current dividend of Php35,000 to its preference
shareholders. In addition, Concon Company paid Php55,000 dividend to its ordinary
shareholders. If 25,000 ordinary shares were outstanding through the years and net income was
Php 160,000, then the earning per ordinary share was
a. Php 2.80 b. Php 4.25
c. Php 5.00 d. Php 6.40

6. How are dividends per ordinary share used in the calculation of the following?

Dividend per-share Earnings

Pay-out ratio per share
a. denominator denominator
b. denominator not used
c. numerator not used
d. numerator numerator

Prepared:

ARIEL B. MICLAT
MBA Student